1. Value of Bonds and Common Stocks
Principles of
Corporate Finance
Eighth Edition
Chapter 4
Value of Bonds and Common Stocks
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered Using PV Formulas to Value Bonds
How Common Stocks are Traded
How Common Stocks are Valued
Estimating the Cost of Equity Capital
Stock Prices and EPS

3. Bonds
By selling debt securities, bonds, companies can borrow money from the public
Usually interest-only loan: principal is paid at the end
Coupon = the stated interest (paid regularly)
Par value = Face value = the principal amount repaid
Coupon rate = the annual coupon divided by face value
Maturity = the number of years until par value is repaid
Current yield = coupon payment divided by bond’s market price
Yield (to maturity) = interest rate required by the market

4. Valuing a Bond Cash Flows Example
If today is September 2008, what is the value of the following bond?
A German Government bond (Bund) pays a percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.
Cash Flows

5. Valuing a Bond Example continued
If today is September 2008, what is the value of the following bond?
A German Government bond (Bund) pays a percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.
The price at a 3.8% YTM is as follows

6. Valuing a Bond Example continued PV = PV(coupons) + PV(face amount)
= ,95

7. Valuing a Bond Example continued
If today is September 2008, what is the value of the following bond?
A German Government bond (Bund) pays a percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.
The price at a 2.0% YTM is as follows

8. Bond Prices and Yields
Price
Yield

9. Interest rate risk
The interest rate risk refers to changes in bond prices arising from fluctuating interest rates
The risk increases, when
The time to maturity increases
The coupon rate decreases

10. Stocks & Stock Market
Common Stock - Ownership shares in a publicly held corporation.
Secondary Market - market in which already issued securities are traded by investors.
Dividend - Periodic cash distribution from the firm to the shareholders.
P/E Ratio - Price per share divided by earnings per share.

11. Stocks & Stock Market
Book Value - Net worth of the firm according to the balance sheet.
Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.
Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.

12. Valuing Common Stocks
Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.
H - Time horizon for your investment.

13. Valuing Common Stocks Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

14. Valuing Common Stocks Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $ What is the price of the stock given a 12% expected return?

15. Valuing Common Stocks

16. Assumes all earnings are paid to shareholders.
Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.
Assumes all earnings are paid to shareholders.

17. Valuing Common Stocks
Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).
Dividend grows at a steady rate g
r > g

18. Valuing Common Stocks
Nonconstant Growth - A version of the dividend growth model in which dividends grow at a supernormal rate first and then continue at a constant rate thereafter.

19. Valuing Common Stocks
Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

20. Valuing Common Stocks
Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

21. Dividend Yield + Capital Appreciation
Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation

22. Valuing Common Stocks
Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

23. Valuing Common Stocks Example- continued
If a stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?
Answer
The market is assuming the dividend will grow at 9% per year, indefinitely.

24. Valuing Common Stocks
Return Measurements

25. Valuing Common Stocks
If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as dividends
Plowback Ratio - Fraction of earnings retained by the firm.

26. Valuing Common Stocks
Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.
g = return on equity X plowback ratio

27. Valuing Common Stocks Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

28. Valuing Common Stocks No Growth With Growth Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?
No Growth
With Growth

29. Valuing Common Stocks Example - continued
If the company did not plowback some earnings, the stock price would remain at $ With the plowback, the price rose to $
The difference between these two numbers) is called the Present Value of Growth Opportunities (PVGO).

30. Valuing Common Stocks
Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.
Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.