1. Chapter 7 Valuation Concepts © 2005 Thomson/South-Western

2. 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. 3 ^^^ Asset value CF t = the cash flow expected to be generated by the asset in period t ^ ^ 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.

4. 4 Key Terms Valuation of Financial Assets: Bonds - long term debt instruments  Principal Amount, Face Value, Maturity Value, Par Value:  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.  Coupon Payment:  Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond.

5. 5 Key Terms  Coupon Interest Rate:  Coupon Interest Rate: The stated annual rate of interest paid on a bond.  Maturity Date:  Maturity Date: A specified date on which the par value of a bond must be repaid.  Original Maturity:  Original Maturity: The number of years to maturity at the time the bond is issued.  Call Provision:  Call Provision: Gives the issuer right to pay off bonds prior to maturity.

6. 6 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 Bond Value

8. 8 V d = $150 (5.8474) + $1,000 (0.1229) = $877.11 + $122.89 = $1,000 Bond value Numerical solution: Genesco 15%, 15-year, $1,000 bonds valued at 15% required rate of return

9. 9 Financial calculator solution: Genesco 15%, 15-year, $1,000 bonds valued at 15% required rate of return INPUTS OUTPUT 15 15 ? 150 1000 NI/YR PV PMTFV -1000

10. 10 Changes in Bond Values Over Time  If the market rate associated with a bond, k d, equals the coupon rate of interest, the bond will sell at its par value.  If interest rates in the economy fall after the bonds are issued, k d is below the coupon rate.  The interest payments and maturity payoff stay the same, but market values are based on the new k d.  The bond value increases so that the rate of return investors earn equates to the lower k d.

11. 11 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

12. 12 Changes in Bond Values Over Time  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.

13. 13 Changes in Bond Values Over Time  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.

14. 14 Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

15. 15 k d = Coupon Rate k d < Coupon Rate k d > Coupon Rate Years Bond Value Changes in Bond Values Over Time  Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

16. 16 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)

17. 17 Bond Values with Semiannual Compounding

18. 18 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.

19. 19 Value of Long and Short-Term 15% Annual Coupon Rate Bonds

20. 20 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

21. 21 Value of a $1,000 Bond Issued September 30, 1993 that Matures on September 30, 2008 Bond value if interest rates remain constant from October 1, 2003 through September 30, 2008 Month /Year

22. 22 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

23. 23 Stock Valuation Models Expected Dividends Terms: Expected Dividends

24. 24 Market Price Terms: Market Price Stock Valuation Models

25. 25 Intrinsic Value Terms: Intrinsic Value Stock Valuation Models

26. 26 Expected Price Terms: Expected Price Stock Valuation Models

27. 27 Growth Rate Terms: Growth Rate Stock Valuation Models

28. 28 Required Rate of Return Terms: Required Rate of Return Stock Valuation Models

29. 29 Dividend Yield Terms: Dividend Yield Stock Valuation Models

30. 30 Capital Gain Yield Terms: Capital Gain Yield Stock Valuation Models

31. 31 Expected Rate of Return Terms: Expected Rate of Return Stock Valuation Models

32. 32 Actual Rate of Return Terms: Actual Rate of Return Stock Valuation Models

33. 33 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.

34. 34 Expected Dividends as the Basis for Stock Values

35. 35 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.

36. 36 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

37. 37 Normal, or Constant, Growth (Gordon Model)

38. 38 Expected Rate of Return on a Constant Growth Stock  Dividend yield  Expected growth rate, or capital gains yield

39. 39 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.

40. 40 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 time it has become a constant growth stock, and discount this price back to the present, and 3.Add these two components to find the intrinsic value of the stock P 0. Valuing Stocks with Nonconstant Growth

41. 41 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. ^ Stock Market Equilibrium

42. 42 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.

43. 43 The Efficient Markets Hypothesis  The weak form  The weak form of the EMH states that all information contained in the past price movements is fully reflected in current market prices.  The semistrong form  The semistrong form states that current market prices reflect all publicly available information.  The strong form  The strong form states that current market prices reflect all pertinent information, whether publicly available or privately held.

44. 44 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:

45. 45 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 ^

46. 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

47. 47 End of Chapter 5 Valuation Concepts