Valuation Concepts Chapter 10

Basic Valuation uFrom 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

Basic Valuation ^ ^^ ^ Asset value CF t = the cash flow expected to be generated by the asset in period t ^

uk = the return investors consider appropriate for holding such an asset - usually referred to as the required return, based on riskiness and economic conditions Basic Valuation

Valuation of Financial Assets - Bonds uBond is a long term debt instrument uValue is based on present value of: F stream of interest payments F principal repayment at maturity

Valuation of Financial Assets - Bonds uk d = required rate of return on a debt instrument uN = number of years before the bond matures uINT = dollars of interest paid each year (Coupon rate  Par value) uM = par or face, value of the bond to be paid off at maturity

Bond value Valuation of Financial Assets - Bonds

uGenesco 15%, 15year, $1,000 bonds valued at 15% required rated of return

uNumerical solution: V d = $150 (5.8474) + $1,000 (0.1229) = $ $ = $1,000 Bond value Valuation of Financial Assets - Bonds

uFinancial Calculator Solution: Inputs: N = 15; I = k = 15; PMT = INT = 150 M = FV = 1000; PV = ? Output: PV = -1,000 Valuation of Financial Assets - Bonds

Changes in Bond Values over Time uIf the market rate associated with a bond (k d ) equals the coupon rate of interest, the bond will sell at its par value

Changes in Bond Values over Time uIf interest rates in the economy fall after the bonds are issued, k d is below the coupon rate. The interest payments and maturity payoff stay the same, causing the bond’s value to increase (investors demand lower returns, so they are willing to pay higher prices for bonds).

uCurrent yield is the annual interest payment on a bond divided by its current market value Current yield Capital gains yield Changes in Bond Values over Time

uDiscount bond F A bond that sells below its par value, which occurs whenever the going rate of interest rises above the coupon rate uPremium bond F A bond that sells above its par value, which occurs whenever the going rate of interest falls below the coupon rate

Changes in Bond Values over Time uAn increase in interest rates will cause the price of an outstanding bond to fall uA decrease in interest rates will cause the price to rise uThe market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt

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

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

Yield to Maturity uYTM is the average rate of return earned on a bond if it is held to maturity Approximate yield to maturity

Bond Values with Semiannual Compounding

Interest Rate Risk on a Bond uInterest Rate Price Risk - the risk of changes in bond prices to which investors are exposed due to changing interest rates uInterest Rate Reinvestment Rate Risk - the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current market rates

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

2,000 1,500 1, Year Bond 1-Year Bond Value of Long and Short-Term 15% Annual Coupon Rate Bonds

Valuation of Financial Assets - Equity (Stock) uCommon stock uPreferred stock F hybrid v similar to bonds with fixed dividend amounts v similar to common stock as dividends are not required and have no fixed maturity date

Stock Valuation Models uTerms:

Stock Valuation Models uTerms: Expected Dividends

uTerms: Market Price Stock Valuation Models

uTerms: Intrinsic Value

uTerms: Expected Price Stock Valuation Models

uTerms: Growth Rate

Stock Valuation Models uTerms: Required Rate of Return

Stock Valuation Models uTerms: Dividend Yield

Stock Valuation Models uTerms: Capital Gain Yield

Stock Valuation Models uTerms: Expected Rate of Return

uTerms: Actual Rate of Return Stock Valuation Models

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

Stock Valuation Models uExpected Dividends as the Basis for Stock Values

uStock Values with Zero Growth F A zero growth stock is a common stock whose future dividends are not expected to grow at all Stock Valuation Models

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

Stock Valuation Models uNormal, or Constant, Growth F (Gordon Model)

Expected Rate of Return on a Constant Growth Stock

uThe 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 Nonconstant Growth

u1. Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends u2. Find the price of the stock at the end of the nonconstant growth period, at which time it becomes a constant growth stock, and discount this price back to the present u3. Add these two components to find the intrinsic value of the stock,.

Changes in Stock Prices uInvestors change the rates of return required to invest in stocks uExpectations about the cash flows associated with stocks change

Valuation of Real (Tangible) Assets uValuation is still based on expected cash flows of the asset

Valuation of Real (Tangible) Assets Year Expected Cash Flow, CF 1 $120, , , , ,000 To earn a 14% return on investments like this, what is the value of this machine?

% $120,000 $100,000$150,000 $80,000$50,000 PV of $120,000 PV of $100,000 PV of $150,000 PV of $80,000 PF of $50,000 Asset Value = V 0 Cash Flow Time Lines

End of Chapter 10 Valuation Concepts