1. 10
Chapter
Valuation and Rates of Return

2. PPT 10-1

3. PPT 10-2

4. PPT 10-3

5. PPT 10-4

6. PPT 10-5

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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