finman - ch10

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C h a p t e r

C h a p t e r

Valuation and Ratesof Return

Valuation and Ratesof Return

8/3/2019 FinMan - Ch10


Chapter 10 - Outline

Valuation Concepts

Valuation of Bonds3 Factors that Influence

the Required Rate of ReturnRelationship Between Bond Prices and Yields

Preferred StockValuation of Common Stock

Valuation Using the Price-Earnings Ratio

Summary and Conclusions

PPT 10-2

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PPT 10-3Figure 10-1 / The relationship betweentime value of money, required return, cost

of financing, and investment decisions

Presentvalue

concepts

Required rates of return by investors

Valuation

Analysis of projects based

on cost of financingto the firm

Cost of financing

to the firm

Chapter 10

Chapter 9 Chapter 11 Chapters 12 and 13

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Valuation Concepts

The value or price of a stock or bond is based upon

the present value of future expected cash flows tothe investor

The discount rate used is investors’ required rate of

return, based on the market’s estimates of risk,

efficiency, and expected future returns

PPT 10-4

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Valuation of Bonds

The value of a bond is made up of 2 parts:

PV of the interest payments (an annuity)

PV of the principal payment (a lump sum)

The principal payment at maturity: can also be called the par value or face value

is usually $1,000

The interest rate used:

is the yield to maturity or discount rate is also the required rate of return

PPT 10-5

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The present value (price) of a bond

return)of rate(requiredmaturitytoyieldthe Y

periodsof numbertotalthen

nto1fromperiodthet

maturityatpaymentprincipalthePn

paymentsinterestperiodictheItbondtheof pricemarketthe Pb

:where

)1()1(1

=

=

=

=

==

+++= ∑=n

nn

t t

t

bY

P

Y

I

P

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Relationship BetweenBond Prices and Yields

Bond prices are inversely related to bond yields (move

in opposite directions)

As interest rates in the economy change, the price or

value of a bond changes: if the required rate of return increases, the price of

the bond will decrease

if the required rate of return decreases, the price of

the bond will increase

PPT 10-8

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Bond price and required rate of

return(yield to maturity) If the market rate is higher than the coupon rate

(the annual interest payment divided by the parvalue), the bond will sell at discount (below par

value)

If the market rate is equal to the coupon rate, the

bond will sell at par value

If the market rate is lower than the coupon rate, thebond will sell at premium ( above par value)

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Table 10-1

Bond price table

(10 Percent Interest Payment, 20 Years to Maturity)

Yield to Maturity Bond Price

246

789

10

11121314162025

% . . . . . . . . . . . . . . . . . . . . . . $2,308.11. . . . . . . . . . . . . . . . . . . . . . . . 1,815.42. . . . . . . . . . . . . . . . . . . . . . . . 1,458.80

. . . . . . . . . . . . . . . . . . . . . . . . 1,317.82. . . . . . . . . . . . . . . . . . . . . . . . 1,196.36

. . . . . . . . . . . . . . . . . . . . . . . . 1,091.29

. . . . . . . . . . . . . . . . . . . . . . . . 1,000.00

. . . . . . . . . . . . . . . . . . . . . . . . 920.37. . . . . . . . . . . . . . . . . . . . . . . . 850.61

. . . . . . . . . . . . . . . . . . . . . . . . 789.26

. . . . . . . . . . . . . . . . . . . . . . . . 735.07

. . . . . . . . . . . . . . . . . . . . . . . . 644.27

. . . . . . . . . . . . . . . . . . . . . . . . 513.04

. . . . . . . . . . . . . . . . . . . . . . . . 406.92

PPT 10-7

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3 Factors that Influence theRequired Rate of Return

Real Rate of Return:

represents the opportunity cost of the investment

in the early 1990’s, 5-7%, but now about 3-4%

Inflation Premium:

a premium to compensate for the effects of inflation lately, 2%

Risk Premium:

a premium associated with business and financial risk

typically, 2-6%

So, the Required Rate of Return equals:

Real Rate of Return + Inflation Premium + Risk Premium

PPT 10-6

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Bond price, required rate of return, time to

maturityBond prices are inversely related to required rate of

return. A change in the required rate of return willcause a change in the bond price in the opposite

direction

The impact of the change in required rate of return

on the bond price is depend upon the remainingtime to maturity. The impact will be greater the

longer the time to maturity.

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0 . . . . . . . . $1,000.00 $1,000.00

1 . . . . . . . . 1,018.52 982.14

5 . . . . . . . . 1,079.85 927.90

10 . . . . . . . . 1,134.20 887.00

15 . . . . . . . . 1,171.19 863.78

20 . . . . . . . . 1,196.36 850.6125 . . . . . . . . 1,213.50 843.14

30 . . . . . . . . 1,225.16 838.90

Time Period Bond Price with Bond Price with

in Years 8 Percent Yield 12 Percent Yield(of 10 percent bond) to Maturity to Maturity

PPT 10-9

Table 10-2

Impact of time to maturity on bond prices

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1,300

1,200

1,100

1,000

900

800

700

Bond Price ($)

30 25 15Number of years to maturity

10% bond, $1,000 par value

Assumes 12% yield to maturity

* The relationship in the graph is not symmetrical in nature.

5 0

Assumes 8% yield to maturity

PPT 10-10Figure 10-2

Relationship between time to maturity and

bond price*

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Your Daily PaperIssuer Coupon Maturity Price Yield Change

BC Tel 9.65 Apr 8-22 138.5 6.488 +1.118

CompanyCompany NameNameCouponCoupon

(interest rate %)(interest rate %)

Maturity DateMaturity Date(April 8, 2022)(April 8, 2022)

PricePrice

(Last transaction(Last transactionprice = $138.50/ $100price = $138.50/ $100

of face value)of face value)

Yield Yield(( Annual interest Annual interest

Market price)Market price)

ChangeChange

(Closing(Closingprice up $1.12/price up $1.12/

$100 from$100 from

previous day)previous day)

PPT 10-11

Reading Bond Quotations

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Compute the yield to maturity

Trial and error process

Interpolation methodA less exact calculation of the yield to maturity

Principal -Price of the bond

Approximate Yield=

Annual interest payment + Number of years to maturity

to Maturity . 6 (Price of the bond) +.4( Principal payment)

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Valuation of Preferred Stock

Preferred stock:

usually represents a perpetuity (something with nomaturity date)

has a fixed dividend payment

is valued without any principal payment since it hasno ending life

is considered a hybrid security

owners have a higher priority of claim than commonshareholders

price is based upon PV of future dividends

PPT 10-12

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Valuation of Preferred Stock

p

p

p p

p

p

p

p

p

p

K

D

K

D

K

D

K

D

K

DP

=

++⋅⋅⋅⋅+

++

++

+=

∞

∞

)1()1()1()1( 321

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Valuation of Common Stock

The value of common stock is the present value of a

stream of future dividends

Common stock dividends can vary, unlike preferred

stock dividends

There are 3 possible cases: No growth in dividends (valued like preferred stock)

Constant growth in dividends

Variable growth in dividends

Required rate of return reflects the dividend yield

on the stock and the expected growth rate in thedividend

PPT 10-13

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Valuation of Common Stock

General formula

No growth in dividends

Constant growth in dividends

eK

DP 0

0 =

gK

DP

e −= 1

0

∑∑∞

==

∞

∞

+=

++

+=

++⋅⋅⋅⋅+

++

++

+=

11

3

3

2

2

1

1

0

)1()1()1(

)1()1()1()1(

t t

e

t

n

e

nn

t t

e

t

eeee

K

D

K

P

K

D

K

D

K

D

K

D

K

D

P

PPT 10 14

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Valuation Using the Price-Earnings RatioPPT 10-14

The Price-Earnings (P/E) ratio can also be used tovalue common stocks

The P/E ratio is influenced by many factors:

the earnings and sales growth of the firm

the risk (or volatility in performance)the debt-equity structure

the dividend policy

the quality of management

a number of other factors The average P/E ratio for TSX Composite, excluding Nortel and JDS

Uniphase, in early 2002 was 33 to 1

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High vs. Low P/Es

PPT 10-15

A stock with a high P/E ratio:

indicates positive expectations for the future of thecompany

means the stock is more expensive relative to earnings

typically represents a successful and fast-growingcompany

is called a growth stock

A stock with a low P/E ratio: indicates negative expectations for the future of the

company

may suggest that the stock is a better value or buy

is called a value stock

T bl 10 4 PPT 10 16

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Table 10-4

An example of stock quotations from the

Globe and Mail

PPT 10-16

Source: ILX Systems, a division of Thomson Information Services Inc.

PPT 10-17

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Your Daily PaperCompany Volume High Low Close Change

Inco 3760 29.150 28.500 28.600 -.400

Stock Stock

Volume Volume(Total number of(Total number of

shares traded (100s)shares traded (100s)

CloseClose(Last price paid(Last price paid

at close of trading)at close of trading)

HighHigh

(Highest(Highestprice paidprice paid

per share forper share for

the daythe day was $29.15) was $29.15)

LowLow(Lowest price paid(Lowest price paid

per share for the dayper share for the day

was $28.50) was $28.50)

ChangeChange(Difference between(Difference betweentodaytoday’’s price ands price and

previous dayprevious day’’s. A s. A

.40 decrease).40 decrease)

PPT 10-17

Reading Stock Quotations

PPT 10-18

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Valuation of a Supernormal Growth Firm

0 8

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Stock valuation under supernormal growth

n

ece

n

sn

t t

e

t

s

K gK

g D

K

g DP

)1)((

)1(

)1(

)1( 0

1

00

+−

++

+

+=∑

=

PPT 10-19Figure 10B-1

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PPT 10 19Figure 10B-1

Stock valuation under supernormal growth

analysis

PPT 10-20

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Summary and Conclusions

The price of a bond reflects thepresent value of future payments of

interest and principal, discounted at

current market bond yields

The price of a preferred orcommon stock reflects the present

value of future dividends,

discounted at current market

dividend yields

An alternative for valuing

common stock is the price-earnings

ratio

The value of securities is based uponthe present value of expected future

cash flows from the investment,discounted at the rate of returnrequired by investors

The required rate of return includes

premiums for expected inflation andthe perceived risk of the investment

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