61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 6: VALUATION
1. What are the fundamental differences between debt and equity?

This question can be answered by comparing debt and equity in terms of cash flow, maturity, redemption, and
riskiness

 Cash flow – In what form does the investor receive cash from his investment?
 Maturity – When does the investment mature?
 Redemption – How does the investor “redeem” (or get back) his investment?
 Riskiness – Which type of investment is riskier, and why?

Debt securities Equity securities

Cash flow Cash is received by way of periodic Cash is received from the company by way of
interest payments and the dividends. Ultimately the investor can sell his
repayment of the face value on shares on the stock exchange, or if the company is
maturity. liquidated, has a claim on the residual assets of the
firm after debt holders have been repaid.
Maturity There is normally a fixed term to Although under certain circumstances it is possible
maturity, at which time the face for a firm to buy back some of its shares, shares are
value of the debt is repaid. normally considered to have an infinite life.
Redemption Debt is redeemed (the face value Shares are not redeemed, although they can be
is repaid) upon maturity. sold on a stock exchange or, in some situations,
bought back by the firm
Riskiness Lower Higher
The nature of the claim held by debt holders and equity holders is fundamentally
different. Debt holders rank first in the payment of interest and repayment of the debt in
the event of the firm’s liquidation. The claim held by equity holders is called a “residual”
claim, because they are only entitled to a return after the claims of debt holders have
been met. Debt holders normally receive a fixed return, determined by an interest rate.
Equity holders get what remains; hence their return is generally more variable.
Because returns to equity holders are less secure, and more variable, this makes the
investment much riskier.

2. Five different terms used as discount rate:

- Interest rate is used to value a bank loan.

- Required rate of return is used to value a share.

- Yield to maturity is used to value a bond.

- Opportunity cost is used to value any investment.

- Cost of capital is used to value a firm: cost of equity and cost of debt.

3. What is yield to maturity – YTM? Is YTM the same thing as required return? Is YTM the same thing as
coupon rate?

YTM The rate of return earned on a bond if it is held to maturity.

YTM is the same thing as required return in a straight bond.

YTM is different from coupon rate: YTM is the interest rate that is used as discount rate to value a bond but
coupon rate is not. Coupon rate is used to calculate coupon payment and that is usually fixed percentage over
the life of a bond.

4. Callaghan Motors’ bonds have 10 years remaining to maturity. Interest is paid annually, they have a $1,000
par value, the coupon interest rate is 8%, and the yield to maturity is 9%. What is the bond’s current market
price?

CPN = 8%*$1,000 = $80; N=10; YTM=9%; FV = $1,000

$80 1 $1,000
= 1− + = $935.82
9% (1 + 9%) (1 + 9%)
This bond is selling at the discount.

5. A bond has a $1,000 par value, 10 years to maturity, and a 7% annual coupon and sells for $985.

a. What is its yield to maturity (YTM)?

b. Assume that the yield to maturity remains constant for the next 3 years. What will the price be 3 years from
today?

A.

P0 = $985; FV= $1,000; N= 10; CPN = $1,000*7% = $70

$70 1 $1,000
$985 = 1− +
(1 + ) (1 + )
>>> YTM = 7.22%

B. In three years, the time to maturity is no longer 10 periods, it will be only 7 periods remaining before
maturity

FV = $1,000; N= 7; CPN = $70

YTM = 7.22% (as in part A)

$70 1 $1,000
= 1− + = $988.23
7.22% (1 + 7.22%) (1 + 7.22%)
The bond values approach its par value.

6. Nungesser Corporation’s outstanding bonds have a $1,000 par value, a 9% semiannual coupon, 8 years to
maturity, and an 8.5% YTM. What is the bond’s price?

FV = $1,000; CPN = (9%/2)*$1,000 = $45; I = 8.5%/2 = 4.25%; N = 8*2 = 16

$45 1 $1,000
= 1− + = $1,028.60
4.25% (1 + 4.25%) (1 + 4.25%)
This bond is selling at a premium.

7. Bond X is noncallable and has 20 years to maturity, a 9% annual coupon, and a $1,000 par value. Your
required return on Bond X is 10%; and if you buy it, you plan to hold it for 5 years. You (and the market) have
expectations that in 5 years, the yield to maturity on a 15-year bond with similar risk will be 8.5%. How much
should you be willing to pay for Bond X today? (Hint: You will need to know how much the bond will be worth
at the end of 5 years.

The timeline:

Your investment lasts for 5 years, you will need to find cash flows relevant to the five year periods: you will
receive 5 coupon payments of $90 each, and at the end of year 5, you will sell and receive some amount (P1).

You require 10% for your investment, thus the price you should be willing to pay now is as follows

$90 1
= 1− +
10% (1 + 10%) (1 + 10%)
Now, finding the selling price of the bond at the end of year 5

FV = $1,000; N = 15; YTM = 8.5%; CPN = $90

$90 1 $1,000
= 1− + = $1,041.52
8.5% (1 + 8.5%) (1 + 8.5%)

So, the price of the bond you should pay today

$90 1 $1,041.52
= 1− + = $987.87
10% (1 + 10%) (1 + 10%)

8. Warr Corporation just paid a dividend of $1.50 a share (that is, D0= $1.50). The dividend is expected to grow
7% a year for the next 3 years and then at 5% a year thereafter. What is the expected dividend per share for
each of the next 5 years?

D1 = D0(1+g) = $1.5 x (1+7%) = $1.6050

D2 = D1(1+g) = $1.605 x (1+7%) = $1.7174

D3 = D2(1+g) = $1.7174 x (1+7%) = $1.8376

D4 = D3(1+g) =$1.8376 x (1+5%) = $1.9294

D5 = D4(1+g) = $1.9294 x (1+5%) = $2.0259

9. Thomas Brothers is expected to pay a $0.50 per share dividend at the end of the year (that is, D1= $0.50).
The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on the stock, rs,
is 15%. What is the stock’s current value per share?
 D1 = $0.50; g=7%, rs=15%
$0.50
= = = $6.25
( − ) (15% − 7%)
10. Harrison Clothiers’ stock currently sells for $20.00 a share. It just paid a dividend of $1.00 a share (that is,
D0= $1.00). The dividend is expected to grow at a constant rate of 6% a year. What stock price is expected 1
year from now? What is the required rate of return?

D0 =$1.00; g=6%; P0 =$20.00

=
( − )

( ) $ . ( %)
So = + = + = + 6% = 11.30%
$

P1 = P0(1+g) = $20.00(1+6%) = $21.20

Alternatively,

$1.00(1 + 6%)
= = = $21.20
( − ) (11.3% − 6%)

11. Smith Technologies is expected to generate $150 million in free cash flow next year, and FCF is expected to
grow at a constant rate of 5% per year indefinitely. Smith has no debt or preferred stock, and its WACC is 10%.
If Smith has 50 million shares of stock outstanding, what is the stock’s value per share?

VE = VA – VD

VA = Present value of future FCF

$150
= = = = $3,000
( − ) ( − ) (10% − 5%)
Since VD = 0

VE = VA = $3,000m

Price per share = VE/N = $3,000m/50m = $60

 12.

A. Value of the firm in year 3 (continuing value)

$40 (1 + 7%)
= = = $713.33
− 13% − 7%

B. Value of the firm today:

−20 30 40 733.33
= + + + = $527.89
(1 + 13%) (1 + 13%) (1 + 13%) (1 + 13%)

C. Current price:

VE = VA – VD = 527.89m – 100m = $427.89m

So
$427.89
= = $42.79
10

13. Ezzell Corporation issued perpetual preferred stock with a 10% annual dividend. The stock currently yields
8%, and its par value is $100.

a. What is the stock’s value?

b. Suppose interest rates rise and pull the preferred stock’s yield up to 12%. What is its new market value?
 A. Perpetual stock pays constant dividend of $10 ($100*10%)

Dp $10
Vp    $125.
rp 0.08

$10
B. Vp   $83.33.
0.12

14. Microtech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does
not pay dividends. However, investors expect Microtech to begin paying dividends, beginning with a dividend
of $1.00 coming 3 years from today. The dividend should grow rapidly—at a rate of 50% per year—during
Years 4 and 5; but after Year 5, growth should be a constant 8% per year. If the required return on Microtech
is 15%, what is the value of the stock today?

Step 1: Find price of the stock at the end of year 5

After year 5, dividend grows at the constant rate of 8%, so we might apply the constant growth model to
value the stock

=
( − )
We have the following dividends
D4 = $1(1+50%) = $1.5
D5 = $1.5(1+50%) = $2.25
D6 = $2.25(1+8%) = $2.43

Plug the number into the above formula

$2.43
= = = $34.71
( − ) (15% − 8%)
Step 2: Calculate the P0

$1 $1.25 $2.43 $34.71

= + + + = $19.84
(1 + 15%) (1 + 15%) (1 + 15%) (1 + 15%)
Additional Exercises

1. Your broker offers to sell you some shares of Bahnsen & Co. common stock that paid a dividend of $2.00
yesterday. Bahnsen’s dividend is expected to grow at 5% per year for the next 3 years. If you buy the stock,
you plan to hold it for 3 years and then sell it. The appropriate discount rate is 12%.

a. Find the expected dividend for each of the next 3 years; that is, calculate D1, D2, and D3.

b. Given that the first dividend payment will occur 1 year from now, find the present value of the dividend
stream; that is, calculate the PVs of D1, D2, and D3and then sum these PVs.

c. You expect the price of the stock 3 years from now to be $34.73; that is, you expect P3 to equal $34.73.
Discounted at a 12% rate, what is the present value of this expected future stock price? In other words,
calculate the PV of $34.73.

d. If you plan to buy the stock, hold it for 3 years, and then sell it for $34.73, what is the most you should
pay for it today?

e. Use Equation 9-2 to calculate the present value of this stock. Assume that g = 5% and that it is constant.

f. Is the value of this stock dependent upon how long you plan to hold it? In other words, if your planned
holding period was 2 years or 5 years rather than 3 years, would this affect the value of the stock today,
P0? Explain.

A. D1 = $2(1+5%) = $2.1
D2 = $2.1(1+5%) = $2.205
D3 = $2.205(1+5%) = $2.31525

$ . $ . $ .
B. =( %)
+( %)
+( %)
= $5.28

$ .
C. = = $24.72
( %)

D. = $5.28 + $24.72 = $30.00

$ .
E. =( )
=( % %)
= $30

F. The value of this stock does not depend on our holding time. It depends on the dividends, the required
rate of return, and the timing of these cash flows. Since there are no change in these three factors,
stock value does not change. It is obviously seen from part D and E that the value of the stock is the
same regardless of holding period of the investors. Investors might hold the stock for 3 years (part D)
or hold it forever (part E), the value is still $30 at the current time.

2. Clifford Clark is a recent retiree who is interested in investing some of his savings in corporate bonds. His
financial planner has suggested the following bonds:

Bond A has a 7% annual coupon, matures in 12 years, and has a $1,000 face value.

Bond B has a 9% annual coupon, matures in 12 years, and has a $1,000 face value.

Bond C has an 11% annual coupon, matures in 12 years, and has a $1,000 face value.

Each bond has a yield to maturity of 9%.

a. Before calculating the prices of the bonds, indicate whether each bond is trading at a premium, at a
discount, or at par.

b. Calculate the price of each of the three bonds.

c. If the yield to maturity for each bond remains at 9%, what will be the price of each bond 1 year from now?

A. Bond A is selling at a discount since the C% < YTM

Bond B is selling at par since the C% = YTM
Bond C is selling at a premium since the C% > YTM
B. Price of each bond

$70 1 $1,000
= 1− + = $856.79
9% (1 + 9%) (1 + 9%)

$90 1 $1,000
= 1− + = $1,000
9% (1 + 9%) (1 + 9%)

$110 1 $1,000
= 1− + = $1,143.21
9% (1 + 9%) (1 + 9%)

C. Given that the YTM does not change, the expected total return to each bond will be the same as the YTM.

$70 1 $1,000
= 1− + = $863.90
9% (1 + 9%) (1 + 9%)

$90 1 $1,000
= 1− + = $1,000
9% (1 + 9%) (1 + 9%)

$110 1 $1,000
= 1− + = $1,136.10
9% (1 + 9%) (1 + 9%)

3. Martell Mining Company’s ore reserves are being depleted, so its sales are falling. Also, because its pit
getting deeper each year, its costs are rising. As a result, the company’s earnings and dividends are declining
at the constant rate of 5% per year. If D0= $5 and rs = 15%, what is the value of Martell Mining’s stock?

D1 D (1  g) $5 [1  ( 0.05)] $5 (0.95) $4.75

P̂0   0     $23.75.
rs  g rs  g 0.15  (0.05) 0.15  0.05 0.20

4. You are considering an investment in Keller Corp’s stock, which is expected to pay a dividend of $2.00 a
share at the end of the year (D1= $2.00) and has a beta of 0.9. The risk-free rate is 5.6%, and the market risk
premium is 6%. Keller currently sells for $25.00 a share, and its dividend is expected to grow at some constant
rate g. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end
of 3 years? (That is, what is^ P3?)
The problem asks you to determine the value of P̂3 , given the following facts: D1 = $2, b = 0.9, rRF = 5.6%,
RPM = 6%, and P0 = $25. Proceed as follows:

Step 1: Calculate the required rate of return (Topic 7)

rs = rRF + (rM – rRF)b = 5.6% + (6%)0.9 = 11%.

Step 2: Use the constant growth rate formula to calculate g:

D1
r̂s  g
P0
$2
0.11  g
$25
g  0.03  3%.

Step 3: Calculate P̂3 :

P̂3 = P0(1 + g)3 = $25(1.03)3 = $27.3182  $27.32.

Alternatively, you could calculate D4 and then use the constant growth rate formula to solve for P̂3 :
D4 = D1(1 + g)3 = $2.00(1.03)3 = $2.1855.

P̂3 = $2.1855/(0.11 – 0.03) = $27.3182  $27.32.