1. 7-1 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Chapter 7 Valuation Concepts Bond Values Stock Values Rates of Return Market Equilibrium Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to the following address: Permissions Department, Harcourt, Inc., 6277 Sea Harbor Drive, Orlando, Florida 32887- 6777.

2. 7-2 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 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. 7-3 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. ^^^ Asset value ^ Basic Valuation k = the return investors consider appropriate for holding such an asset - usually referred to as the required return, based on riskiness and economic conditions CF t = the cash flow expected to be generated by the asset in period t ^

4. 7-4 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Valuation of Financial Assets: Bonds - long term debt instruments 4 Principal Amount, Face Value, Maturity Value, Par Value: 4 Principal Amount, Face Value, Maturity Value, Par Value: The amount of money the firm borrows and promises to repay at some future date, often at maturity. 4 Coupon Payment: 4 Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond. Key Terms

5. 7-5 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 4 Coupon Interest Rate: 4 Coupon Interest Rate: The stated annual rate of interest paid on a bond. 4 Maturity Date: 4 Maturity Date: A specified date on which the par value of a bond must be repaid. 4 Original Maturity: 4 Original Maturity: The number of years to maturity at the time the bond is issued. 4 Call Provision: 4 Call Provision: Gives the issuer right to pay off bonds prior to maturity. Key Terms

6. 7-6 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The Basic Bond Valuation Model k d = required rate of return on a debt instrument N = number of years before the bond matures INT = dollars of interest paid each year (Coupon rate x Par value) M = par or face, value of the bond to be paid off at maturity

7. 7-7 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Bond Value

8. 7-8 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Genesco 15%, 15year, $1,000 bonds valued at 15% required rate of return V d = $150 (5.8474) + $1,000 (0.1229) = $877.11 + $122.89 = $1,000 Bond value Numerical solution:

9. 7-9 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Look up the PVIF and PVIFA values in Tables A-1 and A-2 and insert them in the equation V d = $150 (5.8474) + $1,000 (0.1229) = $877.11 + $122.89 = $1,000 Genesco 15%, 15year, $1,000 bonds valued at 15% required rate of return Tabular solution:

10. 7-10 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Genesco 15%, 15year, $1,000 bonds valued at 15% required rate of return Financial calculator solution: 1515 1501000 NI/YR PV PMTFV - 1000 INPUTS OUTPUT

11. 7-11 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Changes in Bond Values Over Time 4 If the market rate associated with a bond, k d, equals the coupon rate of interest, the bond will sell at its par value. 4 If interest rates in the economy fall after the bonds are issued, k d is below the coupon rate. 4 The interest payments and maturity payoff stay the same, but the PVIF and PVIFA values are based on the new k d increasing the bond value

12. 7-12 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Current yield Capital gains yield Current yield Current yield is the annual interest payment on a bond divided by its current market value Changes in Bond Values Over Time

13. 7-13 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Discount Bond A bond that sells below its par value, which occurs whenever the going rate of interest rises above the coupon rate Premium Bond 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

14. 7-14 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. An increase in interest rates will cause the price of an outstanding bond to fall A decrease in interest rates will cause the price to rise The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt Changes in Bond Values Over Time

15. 7-15 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

16. 7-16 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Time 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 Changes in Bond Values Over Time

17. 7-17 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Finding the Interest Rate on a Bond: Yield to Maturity YTM YTM is the average rate of return earned on a bond if it is held to maturity Approximate yield to maturity (does not consider time value of money)

18. 7-18 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Bond Values with Semiannual Compounding

19. 7-19 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Interest Rate Risk on a Bond èInterest Rate Price Risk èInterest Rate Price Risk - the risk of changes in bond prices to which investors are exposed due to changing interest rates èInterest Rate Reinvestment Rate Risk èInterest 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

20. 7-20 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Value of Long and Short-Term 15% Annual Coupon Rate Bonds

21. 7-21 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 2,000 1,500 1,000 500 0 5 10 15 20 25 14-Year Bond 1-Year Bond Value of Long and Short-Term 15% Annual Coupon Rate Bonds

22. 7-22 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Bond Prices in Recent Years

23. 7-23 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Valuation of Financial Assets - Equity (Stock) èCommon Stock èPreferred Stock –hybrid similar to bonds with fixed dividend amounts similar to common stock as dividends are not required and have no fixed maturity date

24. 7-24 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Expected Dividends Terms: Expected Dividends Stock Valuation Models

25. 7-25 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Market Price Terms: Market Price Stock Valuation Models

26. 7-26 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Intrinsic Value Terms: Intrinsic Value Stock Valuation Models

27. 7-27 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Expected Price Terms: Expected Price Stock Valuation Models

28. 7-28 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Growth Rate Terms: Growth Rate Stock Valuation Models

29. 7-29 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Required Rate of Return Terms: Required Rate of Return Stock Valuation Models

30. 7-30 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Dividend Yield Terms: Dividend Yield Stock Valuation Models

31. 7-31 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Capital Gain Yield Terms: Capital Gain Yield Stock Valuation Models

32. 7-32 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Expected Rate of Return Terms: Expected Rate of Return Stock Valuation Models

33. 7-33 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Valuation Models Actual Rate of Return Terms: Actual Rate of Return Stock Valuation Models

34. 7-34 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Expected Dividends as the Basis for Stock Values èIf you hold a stock forever, all you receive is the dividend payments èThe value of the stock today is the present value of the future dividend payments

35. 7-35 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Expected Dividends as the Basis for Stock Values

36. 7-36 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Values with Zero Growth Zero Growth Stock A Zero Growth Stock is a common stock whose future dividends are not expected to grow at all

37. 7-37 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Normal, or Constant, Growth 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

38. 7-38 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Gordon Model Normal, or Constant, Growth (Gordon Model)

39. 7-39 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Expected Rate of Return on a Constant Growth Stock èDividend yield èExpected growth rate, or capital gains yield

40. 7-40 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Valuing Stocks with Nonconstant Growth 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

41. 7-41 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. 1. Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends 2. Find the price of the stock at the end of the nonconstant growth period, at which it has become a constant growth stock, and discount this price back to the present 3. Add these two components to find the intrinsic value of the stock,. Valuing Stocks with Nonconstant Growth

42. 7-42 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Stock Market Equilibrium 1. The expected rate of return as seen by the marginal investor must equal the required rate of return, 2. The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor, ^ k x = k x, P 0 = P 0 ^

43. 7-43 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Changes in Stock Prices èInvestors change the rates of return required to invest in stocks èExpectations about the cash flows associated with stocks change

44. 7-44 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. The Efficient Markets Hypothesis l The weak form l The weak form of the EMH states that all information contained in the past price movements is fully reflected in current market prices. l The semistrong form l The semistrong form states that current market prices reflect all publicly available information l The strong form l The strong form states that current market prices reflect all pertinent information, whether publicly available or privately held.

45. 7-45 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Valuation of Real (Tangible) Assets A company proposes to buy a machine so it can manufacture a new product. After five years the machine will be worthless, but during the five years it is used, the company will be able to increase its net cash flows by the following amounts:

46. 7-46 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Year Expected Cash Flow, CF 1$120,000 2$100,000 3$150,000 4 $80,000 5 $50,000 To earn a 14% return on investments like this, what is the value of this machine? Valuation of Real (Tangible) Assets

47. 7-47 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. Cash Flow Time Lines 012345 14% $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

48. 7-48 Copyright (C) 2000 by Harcourt, Inc. All rights reserved. End of Chapter 7 Valuation Concepts