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

Chapter 4

Principles of

Corporate FinanceEighth Edition

Value of Bonds 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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Bonds

By selling debt securities, bonds, companies can borrow money from the public

Usually interest-only loan: principal is paid at the end

Coupon = the stated interest (paid regularly)

Par value = Face value = the principal amount repaid

Coupon rate = the annual coupon divided by face value

Maturity = the number of years until par value is repaid

Current yield = coupon payment divided by bond’s market price

Yield (to maturity) = interest rate required by the market


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Valuing a Bond

Example

If today is September 2008, 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

14'13'12'11'10'09'


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Valuing a Bond

Example continued If today is September 2008, 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

375.5

038.1

375.565432

PV


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Valuing a Bond

31.108$038.1

375.105

038.1

375.5

038.1

375.5

038.1

375.5

038.1

375.5

038.1

375.565432 PV

Example continued

31.108$038.1

100

)038.01(038.0

1

038.0

1375.5 66

PV

PV = PV(coupons) + PV(face amount)

= 28.36 + 79,95


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Valuing a Bond

Example continued If today is September 2008, 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

375.5

02.1

375.565432

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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Interest rate risk

The interest rate risk refers to changes in bond prices arising from fluctuating interest rates

The risk increases, when– The time to maturity increases– The coupon rate decreases


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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

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).- Dividend grows at a steady rate g

- r > g

)()(

)1(P 10

0 gr

Div

gr

gDiv


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Nonconstant Growth - A version of the dividend growth model in which dividends grow at a supernormal rate first and then continue at a constant rate thereafter.


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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

110

:Ratetion Capitaliza


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Example- continued

If a 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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Return Measurements

0

1

P

Div YieldDividend

Sharey Per Book Equit

EPS

Equityon Return

ROE

ROE


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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 Bonds and Common Stocks Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,