1. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Valuation of Fixed Incomes Corporate Finance Class 5: March 19 (LA) and March 8 (OCC)

2. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Basic Steps to Valuation in Finance u Estimate cash flows (CASH, TIME) –Easy or hard depending on asset –Look for patterns in cash flows u Choose a discount rate (TIME, RISK) –Risk adjusted –Opportunity cost u Calculate present value and net present value

3. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Valuation in Finance u Applies to all investment opportunities u Applies to fixed plant and equipment u Applies to new business opportunities u Applies to bonds and stocks u Applies to real estate u Used by financial managers, stock and bond analysts, real estate investors

4. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Valuation of Bonds and Stocks u Calculation of present value of future cash flows at a risk-adjusted discount rate is estimate of intrinsic value or the value to the buyer (uses buyer’s assumptions and opportunity rates) u Comparison of current price to intrinsic value (calculation of net present value) is fundamental analysis u Fundamental analysis differs from “technical analysis”

5. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Alternative to Present Value Techniques in Valuation u If claims on similar cash flows trade in markets such that market values from them are available u If claims on similar cash flows can be combined in a portfolio to replicate flows for investment at hand u If arbitrage not hard, value of replicating portfolio must be identical to investment at hand

6. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Examples of Arbitrage Pricing (We will study later) u Value of total claims on a firm consists of value of debt and equity claims u Value of a given Treasury bonds must be the same as portfolio of corresponding stripped Treasuries u Payoffs from contingent claims like options can be replicated with other assets

7. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Review of PV Analysis u General formulas u Simplified cash flow formulas u Sources of present value –Geometric presentation from Class 4 –The timing and amounts of cash flows greatly affect their impact on valuation –The notion of multipliers and capitalization or cap rates and their relation to each other depend on the use of simplified formulas (perpetuities, etc.) for easy interpretation

8. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Pricing Bonds u Five basic types of “fixed income” securities – Discounted notes or bill – Consols – Self-amortizing loans (e.g. mortgages) – Coupon bonds – Equal principal repayment loans u Projecting contractual cash flows is not difficult with fixed income securities

9. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Types of Fixed Incomes

10. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Capital Structure in PVFIRM05 u Market-traded debt –Find quote and multiply by book value u Estimated market values of debt –Four pre-programmed formulas –Enter book value and details, choose yield u Non-standard debt - enter present values u Floating rate debt - yield is always close to market rate, hence estimated value is par

11. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Pricing Discounted Notes, Bills, and Coupon Bonds u Bills and zeros (strips) - one cash flow u Consols pay constant “coupon” cash flow u Consols are extremely rare and are not included in PVFIRM05

12. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Loans and Coupon Bonds u Self-amortizing loan or lease (with payment = $X): u Coupon bonds - an annuity and a single “balloon” payment:

13. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Bond Price Formula u Book gives previous formula where C=cF: u Market quotes in percent of face value where p is decimal and c coupon rate

14. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Constant Principal Payment u Each period pay F/T in principal plus accrued interest at rate c of outstanding principal u Not a standard formula (from textbooks) but demonstrates what can be done with formulas

15. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Discount Rate on Bonds u Risk-free rate (typically the rate on U.S. Treasuries) is lowest rate possible on taxable bonds u Other rates must be adjusted for risk u Default risk premiums are added to risk-free rate of the same maturity u Sources and examples from Wall Street Journal, Standard and Poor’s Bond Guide, NASD Bondinfo, Bloomberg and Bondsonline

16. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 For Next Classes u Review Chapter 5 and read Chapter 7 u Study Baldwin example (Chapter 7) carefully for class 7 discussion u Read PVFIRM: Introduction and Overview u Put together documentation for your stock and bond price calculations including debt details and sources of assumptions u Be prepared to discuss problems with data or other issues with me or TAs in time to hand in Part I by March 26 (LA) or 20 (OCC)