6-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Six Valuing Shares and Bonds

6-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 6.1 Bonds and Bond Valuation 6.2 Ordinary Share Valuation Summary and Conclusions Chapter Organisation

6-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Outline the features of bonds. Calculate the value (price) of a bond assuming annual and semi-annual coupons. Understand the implications of interest rate risk for the value of a bond. Calculate the value of an ordinary share under different dividend growth scenarios. Explain the components of required return.

6-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Debt Securities Debt securities are issued when an organisation wishes to borrow money from the public on a long-term basis. Bonds are issued by the government. Debentures are secured and issued by a corporation. Notes are unsecured debt securities issued by a corporation. More recently, these are all known as bonds.

6-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Features Coupon payments are the stated interest payments. Payment is constant and payable every year or half-year. Face value (par value) is the principal amount repayable at the end of the term. Coupon rate is the annual coupon divided by the face value of a bond. Maturity is the specified date at which the principal amount is payable.

6-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Yields When interest rates rise, the present value of the bond’s remaining cash flows declines, and the bond is worth less. When interest rates fall, the bond is worth more. An inverse relationship exists between market interest rates and bond price. The inverse relationship between interest rates and values is one of the fundamental concepts of finance theory. It is applicable to any cash flow that is being valued today.

6-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Yields Yield to maturity (YTM) is the market interest rate that equates a bond’s present value of interest payments and principal repayment with its price. Given the yield to maturity or ‘yield’, we can calculate the present value of the cash flows as an estimate of the bond’s current market value. There is an inverse relationship between market interest rates and bond price.

6-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Price Sensitivity to Interest Rates (YTM) 4%6%8%10% 12% 14%16% $1 800 $1 600 $1 400 $1 200 $1 000 $ 800 $ 600 Bond price Yield to maturity, YTM Coupon = $ years to maturity $1000 face value Key Insight: Bond prices and YTMs are inversely related.

6-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Value

6-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example 1—Bond Value A bond with a face value of $1000 and a coupon rate of 6 per cent has 10 years to maturity. What is the market price of this bond if the market interest rate is 12 per cent?

6-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example 2—Bond Value Assume now that the bond’s coupons are paid half-yearly.

6-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Values If the market interest rate is the same as the coupon rate, the bond’s value is the same as the face value. If the market interest rate rises above the coupon rate, the bond’s value falls below the face value. The bond is then said to be a discount bond. If the market interest rate falls below the coupon rate, the bond’s value rises above the face value. The bond is then said to be a premium bond.

6-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Interest Rate Risk Interest rate risk is the risk that arises for bond holders from changes in interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. This depends on two things: –All other things being equal, the longer the time to maturity, the greater the interest rate risk. –All other things being equal, the lower the coupon rate, the greater the interest rate risk.

6-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Interest Rate Risk and Time to Maturity Interest rate 1 year 30 years 5%$ $ Time to Maturity

6-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Calculating Yield to Maturity (YTM) Yield to maturity (YTM) is the rate implied by the current bond price. Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity. If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign).

6-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example―Calculating YTM Consider a bond with a 8 per cent annual coupon rate, 10 years to maturity and a par value of $1000. The current price is $ –Will the yield be more or less than 8 per cent? Enter: NI/YPVFVPMT Solve for → 9.00 YTM = 9%

6-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Bond Price Reporting Each working day an estimated $7–8 billion of securities is traded in Australian money and fixed interest markets. Information on notes, bonds, and debentures issued by large companies and government bodies are reported in newspapers (e.g. Australian Financial Review) and by financial agencies (e.g. Bloomberg). A typical reporting system lists the issuer, the coupon, maturity date, quantity in millions, the YTM bid and offer, and the last traded yield.

6-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Ordinary Share Valuation Share valuation is more difficult than debenture valuation for a number of reasons: –uncertainty of promised cash flows –shares have no maturity –observing the market rate of return is not easy. However, there are cases in which the present value of future cash flows for a share can be derived and thus the share’s value determined.

6-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Ordinary Share Valuation The market value of a share is the present value of all expected net cash flows to be received from the share, discounted at a rate of return that reflects the riskiness of those cash flows. The expected net cash flows to be received from a share are all future dividends. Dividend growth is an important aspect of share valuation.

6-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Zero Growth Dividend Shares have a constant dividend into perpetuity, with no growth in dividends. A share in a company with a constant dividend is much like a preference share. The value of a share is then the same as the value of an ordinary perpetuity.

6-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Constant Growth Dividend Dividends grow at a constant rate each time period. Therefore we have a growing perpetuity. The constant dividend growth model determines the current price of a share as its dividend next period divided by the discount rate less the dividend growth rate.

6-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Constant Growth Dividend Company ABC has just paid a dividend of 30 cents per share, which is expected to grow at 3 per cent per annum. What price should you pay for the share if the required rate of return on the investment is 12 per cent?

6-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Non-constant Growth Dividend The growth rate cannot exceed the required rate of return indefinitely but can do so for a number of years. Allows for ‘super normal’ growth rates over some finite length of time. The dividends have to grow at a constant rate at some point in the future.

6-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Non-constant Growth Dividend A company has just paid a dividend of 30 cents per share and that dividend is expected to grow at a rate of 10 per cent per annum for the next three years, and at a rate of 3 per cent per annum forever after that. Assuming a required rate of return of 14 per cent, calculate the current market price of the share.

6-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Non-constant Growth Dividend

6-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Non-constant Growth Dividend (continued)

6-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Solution—Non-constant Growth Dividend (continued)

6-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Share Price Sensitivity to Dividend Growth, g 0 2% 4% 6% 8% 10% Share price ($) Dividend growth rate, g D 1 = $1 Required return, R, = 12%

6-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Share Price Sensitivity to Required Return, r 6% 8% 10% 12% 14% Share price ($) Required return, R D 1 = $1 Dividend growth rate, g, = 5%

6-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Components of the Required Return The total return, r, has two components: –Dividend yield –Capital gains yield The dividend yield is a share’s cash dividend divided by its current price (D 1 /P 0 ). The growth rate (g) can be interpreted as the capital gains yield, and is the rate at which the value of the investment grows.

6-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Components of Required Return

6-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Share Market Reporting Information on the Australian stock market is reported in newspapers (e.g. Australian Financial Review), by financial agencies (e.g. Bloomberg), and by the Australian Stock Exchange (ASX). Detailed information is provided for stocks, options, futures, warrants, interest rates and foreign currency. A typical stock report lists the issuer, the ASX code/series, the last sale, volume, the bid and offer, daily/yearly high and lows, and dividends.

6-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Bonds are issued when an organisation wishes to borrow money from the public on a long-term basis. An inverse relationship exists between market interest rates and bond price. The market value of a share is the present value of all expected net cash flows to be received from the share, discounted at a rate of return that reflects the risk of those cash flows. Dividend growth is an important aspect of share valuation.