Financial Management

Instructor: WangNan
Tel:13770638264
E-mail :[email protected]

1
 Chapter 4
The
The Valuation
Valuation of
of
Long-Term
Long-Term
Securities
Securities
2
 The
The Valuation
Valuation of
of
Long-Term
Long-Term Securities
Securities
 Distinctions Among Valuation
Concepts
 Bond Valuation
 Common Stock Valuation
 Rates of Return (or Yields)

3
 What
What is
is Value?
Value?
 Liquidation value represents the
amount of money that could be
realized if an asset or group of
assets is sold separately from its
operating organization.
 Going-concern value represents the
amount a firm could be sold for as a
continuing operating business.
4
 What
What is
is Value?
Value?
 Book value represents either
(1) an asset: the accounting value
of an asset -- the asset’s cost
minus its accumulated
depreciation;
(2) a firm: total assets minus liabilities
and preferred stock as listed on the
balance sheet.
5
 What
What is
is Value?
Value?
 Market value represents the
market price at which an asset
trades.
 Intrinsic value represents the
price a security “ought to have”
based on all factors bearing on
valuation.

6
 Bond
Bond Valuation
Valuation

 Important Terms
 Types of Bonds
 Valuation of Bonds

7
 Important
Important Bond
Bond Terms
Terms
 A bond is a long-term debt
instrument issued by a
corporation or government.
 The maturity value (MV)
MV [or face
value] of a bond is the stated
value. In the case of a U.S. bond,
the face value is usually $1,000.
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 Important
Important Bond
Bond Terms
Terms
 The bond’s coupon rate is the stated
rate of interest; the annual interest
payment divided by the bond’s face
value.
 The discount rate (capitalization rate)
is dependent on the risk of the bond
and is composed of the risk-free rate
plus a premium for risk.
9
 Different
Different Types
Types of
of Bonds
Bonds
A perpetual bond is a bond that never
matures. It has an infinite life.

I I I
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)
 I
= (1 + kd)t or I (PVIFA k )
t=1 d, 

V = I / kd [Reduced Form]
10
 Perpetual
Perpetual Bond
Bond Example
Example
Bond P has a $1,000 face value and provides an
8% coupon. The appropriate discount rate is
10%. What is the value of the perpetual bond?
bond

I = $1,000 ( 8%) = $80.

$80
kd = 10%.
10%
V = I / kd [Reduced Form]
= $80 / 10% = $800.
$800
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 Different
Different Types
Types of
of Bonds
Bonds
A non-zero coupon-paying bond is a
coupon-paying bond with a finite life.

I I I + MV
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)n
n I MV
= (1 + kd) t
+
t=1 (1 + kd)n
V = I (PVIFA k ) + MV (PVIF kd, n)
d, n
12
 Coupon
Coupon Bond
Bond Example
Example
Bond C has a $1,000 face value and provides
an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the
value of the coupon bond?
V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)
= $80 (9.427) + $1,000 (.057)
[Table IV] [Table II]
= $754.16 + $57.00
= $811.16.
$811.16
13
 Different
Different Types
Types of
of Bonds
Bonds
A zero-coupon bond is a bond that
pays no interest but sells at a deep
discount from its face value; it provides
compensation to investors in the form
of price appreciation.

MV
V= = MV (PVIFk )
(1 + kd)n d, n

14
 Zero-Coupon
Zero-Coupon
Bond
Bond Example
Example
Bond Z has a $1,000 face value and
a 30-year life. The appropriate
discount rate is 10%. What is the
value of the zero-coupon bond?
V = $1,000 (PVIF10%, 30)
= $1,000 (.057)
= $57.00
15
 Common
Common Stock
Stock Valuation
Valuation
Common stock represents a
residual ownership position in the
corporation.
 Pro rata share of future earnings
after all other obligations of
the firm (if any remain).
 Dividends may be paid out of
the pro rata share of earnings.
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 Common
Common Stock
Stock Valuation
Valuation

What cash flows will a shareholder

receive when owning shares of
common stock?
stock

(1) Future dividends

(2) Future sale of the
common stock shares
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 Dividend
Dividend Valuation
Valuation Model
Model
Basic dividend valuation model accounts
for the PV of all future dividends.

Div1 Div2 Div

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + ke)
 Divt Divt: Cash dividend
= (1 + ke)t at time t
t=1
ke: Equity investor’s
18 required return
 Adjusted
Adjusted Dividend
Dividend
Valuation
Valuation Model
Model
The basic dividend valuation model
adjusted for the future stock sale.

Div1 Div2 Divn + Pricen

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + k )n
e

n: The year in which the firm’s

shares are expected to be sold.
Pricen: The expected share price in year n.
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 Dividend
Dividend Growth
Growth
Pattern
Pattern Assumptions
Assumptions
The dividend valuation model requires the
forecast of all future dividends. The
following dividend growth rate assumptions
simplify the valuation process.
Constant Growth
No Growth
Growth Phases
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 Constant
Constant Growth
Growth Model
Model
The constant growth model assumes that
dividends will grow forever at the rate g.

D0(1+g) D0(1+g)2 D0(1+g)

V = (1 + k )1 + (1 + k )2 + ... + (1 + k ) 
e e e

D1: Dividend paid at time 1.

D1
= g: The constant growth rate.
(ke - g) ke: Investor’s required return.
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 Constant
Constant Growth
Growth
Model
Model Example
Example
Stock CG has an expected growth rate of
8%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What
is the value of the common stock?
stock
D1 = $3.24 ( 1 + .08 ) = $3.50

VCG = D1 / ( ke - g ) = $3.50 / ( .15 - .08 )

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= $50
 Zero
Zero Growth
Growth Model
Model
The zero growth model assumes that
dividends will grow forever at the rate g = 0.

D1 D2 D
VZG = + + ... +


(1 + ke)1 (1 + ke)2 (1 + ke)

D1 D1: Dividend paid at time 1.

=
ke ke: Investor’s required return.
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 Zero
Zero Growth
Growth
Model
Model Example
Example
Stock ZG has an expected growth rate of
0%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What
is the value of the common stock?
stock

D1 = $3.24 ( 1 + 0 ) = $3.24

VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )

= $21.60
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 Growth
Growth Phases
Phases Model
Model
The growth phases model assumes
that dividends for each share will grow
at two or more different growth rates.

n D0(1+g1) t  Dn(1+g2)t
V = +  (1 + ke)t
t=1 (1 + ke) t
t=n+1
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 Growth
Growth Phases
Phases Model
Model
Note that the second phase of the growth
phases model assumes that dividends will
grow at a constant rate g2. We can rewrite
the formula as:

n D0(1+g1)t 1 Dn+1
V = +
(1 + ke)n (ke - g2)
t=1 (1 + ke)t
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 Growth
Growth Phases
Phases
Model
Model Example
Example
Stock GP has an expected growth
rate of 16% for the first 3 years and
8% thereafter. Each share of stock
just received an annual $3.24
dividend per share. The appropriate
discount rate is 15%. What is the
value of the common stock under
this scenario?
27
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3 4 5 6

D1 D2 D3 D4 D5 D6

Growth of 16% for 3 years Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%,

starts at time t=0 for 3 years and is followed by 8%
thereafter starting at time t=3. We should view the time
line as two separate time lines in the valuation.

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 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3 Growth Phase
#1 plus the infinitely
long Phase #2
D1 D2 D3
0 1 2 3 4 5 6

D4 D5 D6
Note that we can value Phase #2 using the
Constant Growth Model
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 Growth
Growth Phases
Phases
Model
Model Example
Example

V3 = D 4
We can use this model because
dividends grow at a constant 8%
k-g rate beginning at the end of Year 3.

0 1 2 3 4 5 6

D4 D5 D6
Note that we can now replace all dividends from Year
4 to infinity with the value at time t=3, V3! Simpler!!
30
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3 New Time
Line
D1 D2 D3
0 1 2 3 D4
Where V3 =
V3 k-g
Now we only need to find the first four dividends
to calculate the necessary cash flows.
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 Growth
Growth Phases
Phases
Model
Model Example
Example
Determine the annual dividends.
D0 = $3.24 (this has been paid already)
D1 = D0(1+g1)1 = $3.24(1.16)1 =$3.76
D2 = D0(1+g1)2 = $3.24(1.16)2 =$4.36
D3 = D0(1+g1)3 = $3.24(1.16)3 =$5.06

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D4 = D3(1+g2)1 = $5.06(1.08)1 =$5.46
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3 Actual
Values
3.76 4.36 5.06
0 1 2 3 5.46
Where $78 =
.15-.08
78
Now we need to find the present value
of the cash flows.

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 Growth
Growth Phases
Phases
Model
Model Example
Example
We determine the PV of cash flows.
PV(D1) = D1(PVIF15%, 1) = $3.76 (.870) = $3.27

PV(D2) = D2(PVIF15%, 2) = $4.36 (.756) = $3.30

PV(D3) = D3(PVIF15%, 3) = $5.06 (.658) = $3.33

P3 = $5.46 / (.15 - .08) = $78 [CG Model]

PV(P3) = P3(PVIF15%, 3) = $78 (.658) = $51.32

34
 Growth
Growth Phases
Phases
Model
Model Example
Example
Finally, we calculate the intrinsic value by
summing all the cash flow present values.

V = $3.27 + $3.30 + $3.33 + $51.32

V = $61.22
3 D (1+.16)t 1 D4
V=
0
+
t=1 (1 + .15) t (1+.15)n (.15-.08)
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 Calculating
Calculating Rates
Rates of
of
Return
Return (or
(or Yields)
Yields)
Steps to calculate the rate of
return (or yield).
1. Determine the expected cash flows.
flows
2. Replace the intrinsic value (V) with the
market price (P0).
3. Solve for the market required rate of
return that equates the discounted cash
flows to the market price.
price
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 Determining
Determining Bond
Bond YTM
YTM
Determine the Yield-to-Maturity
(YTM) for the coupon-paying bond
with a finite life.
n
I MV
P0 =  (1 + kd )t
+
(1 + kd )n
t=1

= I (PVIFA k ) + MV (PVIF kd , n)
d,n
kd = YTM
37
 Determining
Determining the
the YTM
YTM
Julie Miller want to determine the YTM
for an issue of outstanding bonds at
Basket Wonders (BW). BW has an
issue of 10% annual coupon bonds
with 15 years left to maturity. The
bonds have a current market value of
$1,250.
$1,250
What is the YTM?
38
 YTM
YTM Solution
Solution (Try
(Try 9%)
9%)
$1,250 = $100(PVIFA9%,15) +
$1,000(PVIF9%, 15)
$1,250 = $100(8.061) +
$1,000(.275)
$1,250 = $806.10 + $275.00
= $1,081.10
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[Rate is too high!]
 YTM
YTM Solution
Solution (Try
(Try 7%)
7%)
$1,250 = $100(PVIFA7%,15) +
$1,000(PVIF7%, 15)
$1,250 = $100(9.108) +
$1,000(.362)
$1,250 = $910.80 + $362.00
= $1,272.80
40
[Rate is too low!]
 YTM
YTM Solution
Solution (Interpolate)
(Interpolate)
.07 $1,273
X $23
.02 IRR $1,250 $192
.09 $1,081

X $23
.02 = $192

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 YTM
YTM Solution
Solution (Interpolate)
(Interpolate)
.07 $1,273
X $23
.02 IRR $1,250 $192
.09 $1,081

X $23
.02 = $192

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 YTM
YTM Solution
Solution (Interpolate)
(Interpolate)
.07 $1273
X $23
.02 YTM $1250 $192
.09 $1081

X= ($23)(0.02) X = .0024
$192
YTM = .07 + .0024 = .0724 or 7.24%
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 Determining
Determining the
the Yield
Yield on
on
Common
Common Stock
Stock
Assume the constant growth model
is appropriate. Determine the yield
on the common stock.
P 0 = D 1 / ( ke - g )

Solving for ke such that

ke = ( D 1 / P 0 ) + g
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 Common
Common Stock
Stock
Yield
Yield Example
Example
Assume that the expected dividend
(D1) on each share of common stock
is $3. Each share of common stock
is currently trading at $30 and has an
expected growth rate of 5%. What is
the yield on common stock?
ke = ( $3 / $30 ) + 5%

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ke = 15%