Chapter 10 Valuation and Rates of Return

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 10-1 FIGURE 10-1 The relationship between time value of money, required return, cost of financing, and investment decisions

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 10-2 TABLE 10-1 Bond price table

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 10-3 TABLE 10-2 Impact of time to maturity on bond prices

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 10-4 FIGURE 10-2 Relationship between time to maturity and bond price

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 10-5 FIGURE 10C-1 Stock valuation under supernormal growth analysis

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 10 - Outline LT 10-1 Valuation of Bonds 3 Factors that Influence the Required Rate of Return Relationship Between Bond Prices and Yields Preferred Stock Valuation of Common Stock Valuation Using the Price-Earnings Ratio

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Valuation of Bonds LT 10-2 The value of a bond is made up of 2 parts added together: – PV of the interest payments (an annuity) – PV of the principal payment (a lump sum) The principal payment at maturity: – can also be called the par value or face value – is usually $1,000 The interest rate used: – is the yield to maturity or discount rate – is also the required rate of return

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 Factors that Influence the Required Rate of Return LT 10-3 Real Rate of Return: – represents the opportunity cost of the investment Inflation Premium: – a premium to compensate for the effects of inflation Risk Premium: – a premium associated with business and financial risk So, the Required Rate of Return equals: – Real Rate of Return + Inflation Premium + Risk Premium

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Between Bond Prices and Yields LT 10-4 Bond prices are inversely related to bond yields (move in opposite directions) As interest rates in the economy change, the price or value of a bond changes: – if the required rate of return increases, the price of the bond will decrease – if the required rate of return decreases, the price of the bond will increase

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Preferred Stock LT 10-5 Preferred stock: – usually represents a perpetuity (something with no maturity date) – has a fixed dividend payment – is valued without any principal payment since it has no ending life – is considered a hybrid security (a mixture of a stock and a bond) – owners have a higher priority than common stockholders

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Valuation of Common Stock LT 10-6 The value of common stock is the present value of a stream of future dividends Common stock dividends can vary, unlike preferred stock dividends There are 3 possible cases: – No growth in dividends (valued like preferred stock) – Constant growth in dividends – Variable growth in dividends

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Valuation Using the Price-Earnings Ratio LT 10-7 The Price-Earnings (P/E) ratio can also be used to value stocks The P/E ratio is influenced by: – the earnings and sales growth of the firm – the risk (or volatility in performance) – the debt-equity structure of the firm – the dividend policy – the quality of management – a number of other factors

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. High vs. Low P/Es LT 10-8 A stock with a high P/E ratio: – indicates positive expectations for the future of the company – means the stock is more expensive relative to earnings – typically represents a successful and fast-growing company – is called a growth stock A stock with a low P/E ratio: – indicates negative expectations for the future of the company – may suggest that the stock is a better value or buy – is called a value stock