Chapter 5 Valuation Concepts

2 Basic Valuation From “The Time Value of Money” we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future.

3 Basic Valuation  The Value of the Asset  = the sum of the discounted cash flows the asset is expected to generate over time  Required return = the rate you use to discount the cash flows back.  = the rate of return investors consider appropriate for holding such an asset  = based on riskiness and economic conditions

4 Key Terms for Bonds  Principal Amount = Face Value = Maturity Value,= Par Value:  Principal Amount = Face Value = Maturity Value,= Par Value: The amount of money borrowed  Coupon Payment:  Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond.  Coupon Interest Rate:  Coupon Interest Rate: The stated annual rate of interest paid on a bond.  Maturity Date:  Maturity Date: A specified date on which the par value of a bond must be repaid.  Original Maturity:  Original Maturity: The number of years to maturity at the time the bond is issued.  Call Provision:  Call Provision: Gives the issuer the right to pay off bonds prior to maturity.

5 Task: Find the present Value of Genesco’s 15%, 15-year, $1,000 bonds valued at 15% required rate of return

6 Financial calculator solution: Task: Find the present Value of Genesco’s 15%, 15-year, $1,000 bonds valued at 15% required rate of return INPUTS OUTPUT ? NI/YR PV PMTFV -1000

7 Changes in Bond Values Over Time  Par Value Bond  Discount Bond  Premium Bond

8 Par Value Bonds  Par Value Bond:  When the going interest rate = the bond’s coupon interest rate  The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt.

9 Discount Bonds  An increase in interest rates in the economy causes the price to fall  Discount Bond  = when a bond sells below its par value  occurs whenever the going rate of interest rises above the coupon rate  The bond value decreases so that the rate of return investors earn equates to the higher k d.

10 Premium Bonds  A decrease in interest rates in the economy causes the bond price to rise  Premium  = when a bond sells above its par value  occurs whenever the going rate of interest falls below the coupon rate  The bond value increases so that the rate of return investors earn equates to the lower k d.

11 Current yield Current yield Current yield = the annual interest payment on a bond divided by its current market value Calculating a Bond’s Current Yield

12 Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

13 k d = Coupon Rate k d < Coupon Rate k d > Coupon Rate Years Bond Value Changes in Bond Values Over Time  Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

14 Finding the Interest Rate on a Bond: Yield to Maturity YTM YTM is the average rate of return earned on a bond if it is held to maturity. Financial calculator solution: INPUTS OUTPUT 15 ? NI/YR PV PMTFV 15.89

15 Interest Rate Risk on a Bond  Interest Rate Price Risk: the risk of changes in bond prices to which investors are exposed due to changing interest rates.  Interest Rate Reinvestment Rate Risk: the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current (presumably lower) market rates.

16 Value of Long and Short-Term 15% Annual Coupon Rate Bonds

17 Valuation of Financial Assets - Equity (Stock)  Common Stock  Preferred Stock: hybrid  similar to bonds with fixed dividend amounts  similar to common stock as dividends are not required and have no fixed maturity date

18 Stock Valuation Models Expected Dividends Term: Expected Dividends

19 Market Price Term: Market Price Stock Valuation Models

20 Intrinsic Value Term: Intrinsic Value Stock Valuation Models

21 Expected Price Term: Expected Price Stock Valuation Models

22 Growth Rate Term: Growth Rate Stock Valuation Models

23 Required Rate of Return Term: Required Rate of Return Stock Valuation Models

24 Dividend Yield Term: Dividend Yield Stock Valuation Models

25 Capital Gain Yield Term: Capital Gain Yield Stock Valuation Models

26 Expected Rate of Return Term: Expected Rate of Return = Expected dividend yield + capital gains yield Stock Valuation Models

27 Actual Rate of Return Term: Actual Rate of Return Stock Valuation Models

28 Expected Dividends as the Basis for Stock Values  If you hold a stock forever, all you receive is the dividend payments.  The value of the stock today is the present value of the future dividend payments.

29 Stock Values with Zero Growth Zero Growth Stock A Zero Growth Stock is a common stock whose future dividends are not expected to grow at all = A PERPETUITY

30 Normal, or Constant, Growth Normal Growth is growth that is expected to continue into the foreseeable future at about the same rate as that of the economy as a whole. g = a constant

31 Normal, or Constant, Growth (Gordon Growth Model) Constant Growth Stock A Constant Growth Stock is a common stock whose future dividends are expected to grow at a constant rate = A GROWING PERPETUITY

32 Expected Rate of Return on a Constant Growth Stock  Rearrange the formula for the price to get Dividend Yield

33 Valuing Stocks with Nonconstant Growth  Nonconstant Growth:  Nonconstant Growth: The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole.

34 1.Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends. 2.Find the price of the stock at the end of the nonconstant growth period, at which time it has become a constant growth stock, and discount this price back to the present. 3.Add these two components to find the intrinsic value of the stock P 0. Valuing Stocks with Nonconstant Growth

35 1.The expected rate of return as seen by the marginal investor must equal the required rate of return, 2.The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor, ^ k x = k x. P 0 = P 0. ^ Stock Market Equilibrium

36 Changes in Stock Prices  Investors change the rates of return required to invest in stocks.  Expectations change about the cash flows associated with particular stocks.

37 The Efficient Markets Hypothesis  The weak form  The weak form of the EMH states that all information contained in the past price movements is fully reflected in current market prices.  The semistrong form  The semistrong form states that current market prices reflect all publicly available information.  The strong form  The strong form states that current market prices reflect all pertinent information, whether publicly available or privately held.

38 Valuation of Real (Tangible) Assets  A company proposes to buy a machine so it can manufacture a new product. After five years the machine will be worthless, but during the five years it is used, the company will be able to increase its net cash flows by the following amounts:

39 Year Expected Cash Flow, CF 1$120,000 2$100,000 3$150,000 4 $80,000 5 $50,000 To earn a 14% return on investments like this, what is the value of this machine? Valuation of Real (Tangible) Assets ^

40 In “CF” register: Type: 2 nd, CE/C to clear information stored CF0 = 0 C01 = 120,000 F01 = 1 C02 = 100,000 F02 = 1 C03 = 120,000 F03 = 1 C04 = 80,000 F04 = 1 C05 = 50,000 F05 = 1 In “NPV” Register: Type: I = 14, enter, down arrow See: NPV = (varies) Type: CPT See: NPV = 356, Calculator Solution:

41 For Next Class  Review Chapter 5 materials  Do Chapter 5 homework  Prepare for Quiz on Chapter 5  Read Chapter 6 (Capital Budgeting)