1. Valuation Concepts
© 2005 Thomson/South-Western

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

5. Changes in Bond Values Over Time
Par Value Bond
Discount Bond
Premium Bond

6. 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.

7. 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 kd.

8. 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 kd.

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

10. 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.

11. 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

12. Stock Valuation Models
Term: Expected Dividends

13. Stock Valuation Models
Term: Market Price

14. Stock Valuation Models
Term: Intrinsic Value

15. Stock Valuation Models
Term: Expected Price

16. Stock Valuation Models
Term: Growth Rate

17. Stock Valuation Models
Term: Required Rate of Return

18. Stock Valuation Models
Term: Dividend Yield

19. Stock Valuation Models
Term: Capital Gain Yield

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

21. Stock Valuation Models
Term: Actual Rate of Return

22. 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.

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

24. 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

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

26. Valuing Stocks with 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.

27. Valuing Stocks with Nonconstant Growth
Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends.
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.
Add these two components to find the intrinsic value of the stock P0.

28. Stock Market Equilibrium
The expected rate of return as seen by the marginal investor must equal the required rate of return,
The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor, ^
kx = kx.
P0 = P0. ^

29. 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.