Chapter 4 Principles of Corporate Finance Eighth Edition Value of Bond and Common Stocks Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,

Chapter 4

Principles of

Corporate FinanceEighth Edition

Value of Bond and Common Stocks

Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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Topics CoveredUsing PV Formulas to Value BondsHow Common Stocks are TradedHow Common Stocks are ValuedEstimating the Cost of Equity CapitalStock Prices and EPS


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Valuing a Bond

Example

If today is January 2004, what is the value of the following bond?

A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.

Cash Flows

375.105375.5375.5375.5375.5375.5

10'09'08'07'06'05'


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Valuing a Bond

Example continued If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every

year for 6 years. The par value of the bond is 100 EURO. The price at a 3.8% YTM is as follows

31.108$

038.1

375.105

038.1

375.5

038.1

375.5

038.1

375.5

038.1

375.55432

PV


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Bond Prices and Yields

0

200

400

600

800

1000

1200

1400

1600

0 2 4 6 8 10 12 14

5 Year 9% Bond 1 Year 9% Bond

Yield

Pri

ce


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Valuing a Bond

Example continued If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every

year for 6 years. The par value of the bond is 100 EURO. The price at a 2.0% YTM is as follows

90.118$

02.1

375.105

02.1

375.5

02.1

375.5

02.1

375.5

02.1

375.55432

PV


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Stocks & Stock Market

Common Stock - Ownership shares in a publicly held corporation.

Secondary Market - market in which already issued securities are traded by investors.

Dividend - Periodic cash distribution from the firm to the shareholders.

P/E Ratio - Price per share divided by earnings per share.


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Stocks & Stock Market

Book Value - Net worth of the firm according to the balance sheet.

Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.

Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.


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Valuing Common Stocks

Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

Expected Return

rDiv P P

P1 1 0

0


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Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

15.100

1001105Return Expected


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The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

Expected Return

rDiv

P

P P

P1

0

1 0

0


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Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

gP

Divr

gr

DivP

0

1

10 RatetionCapitaliza


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Return Measurements

0

1

P

Div YieldDividend

Sharey Per Book Equit

EPS

Equityon Return

ROE

ROE


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Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.

PDiv

r

Div

r

Div P

rH H

H01

12

21 1 1

( ) ( )

...( )

H - Time horizon for your investment.


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Example

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?


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Example

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

PV

PV

300

1 12

324

1 12

350 94 48

1 12

00

1 2 3

.

( . )

.

( . )

. .

( . )

$75.


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If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

Perpetuity PDiv

ror

EPS

r 0

1 1

Assumes all earnings are paid to shareholders.


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Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).


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Example- continued

If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?

$100$3.

.

.

00

12

09

g

g

Answer

The market is assuming the dividend will grow at 9% per year, indefinitely.


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If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as dividends

Plowback Ratio - Fraction of earnings retained by the firm.


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Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.

g = return on equity X plowback ratio


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Example

Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?


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Example

Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

56.55$15.

33.80 P

No Growth With Growth

00.100$10.15.

00.5

10.40.25.

0

P

g


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Example - continuedIf the company did not plowback some earnings, the stock price would remain at $55.56. With the plowback, the price rose to $100.00.

The difference between these two numbers) is called the Present Value of Growth Opportunities (PVGO).

44.44$56.5500.100 PVGO


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Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.

Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.

Documents

Chapter 4 Principles of Corporate Finance Eighth Edition Value of Bond and Common Stocks Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,