*Business ValuationNov 26, 2012

*Learning ObjectivesUnderstand the importance of business valuation.Understand the importance of stock and bond valuation.Learn to compute the value and yield to maturity of bonds.Learn to compute the value and expected yield on preferred stock and common stock. Learn to compute the value of a complete business.

Importance of Business ValuationIf the basic goal of the firm is to maximize the value of the firm, then it is important to be able to measure that valueWhen a firm contemplates raising money, it needs to know the value of its securities so it knows how much (shares/bonds) to issue.If you want to invest in a company, its important to know if the company is over valued or under valued

*General Valuation ModelTo develop a general model for valuing a business, we consider three factors that affect future earnings:Size of cash flows (Axiom 3)Timing of cash flows (Axiom 2)Risk of receiving cash flows (Axiom 1)

Total Value of a Business ModelThe present value of a firm is equal to:Present value of current liabilities+ present value of long term debt+ present value of preferred stock+ present value of stockholders equity= Total present value of the Business

(Note: the present value of the current liabilities is basically the same as their book value)

*Bond Valuation ModelBond Valuation is an application of time value model introduced in chapter 8.The value of the bond is the present value of the cash flows the investor expects to receive.What are the cash flows from a bond investment?

*Bond Valuation Model3 Types of Cash FlowsAmount paid to buy the bond (PV)Coupon interest payments made to the bondholders (PMT)Repayment of Par value at end of Bonds life (FV).

Other Factors in Bond valuation:Bonds time to maturity (N)Discount rate (I/Y)

*Bond Valuation ModelCalculator:n = time until maturityI/Y = k = discount rate/cost of capitalPV = value of the bond (Vb)PMT = coupon interest paid ($ Int)FV = par value at maturity

*CurNet BondsYldVolCloseChgAMR624cv691-1ATT8.35s258.3110102+IBM 63/8 056.6228965/8 -1/8

Kroger 9s198.8741017/8 -Link to Bondtrac Financial InformationIBM Bond Wall Street Journal Information:

*Suppose IBM makes annual coupon payments. The person who buys the bond at the beginning of 2009 for $966.25 will receive 5 annual coupon payments of $63.75 each and a $1,000 principal payment in 5 years (at the end of 2013). Assume t0 is the beginning of 2009.IBM Bond Wall Street Journal Information:

*Compute the Value for the IBM Bond given that you require an 8% return on your investment.IBM Bond Timeline:

*Bond is selling for $966.25. Would you buy it?935.125 8 ? 63.75 1,000IBM Bond Timeline:

*Yield to Maturity (IRR)VB = 63.75(PVIFA5, x%) + 1000(PVIF5,x%)Mathematically, solve by trial and error.

*Yield to MaturityCalculator Solution:7.203%5 ? -966.25 63.75 1,000

*If YTM (7.203%) > Coupon Rate (6.375%), bond Sells at a DISCOUNTIf YTM < Coupon Rate bond Sells at a PREMIUMYield to Maturity

*Most Bonds Pay Interest Semi-Annually:e.g. semiannual coupon bond with 5 years to maturity, 9% annual coupon rate. K = 10%

Instead of 5 annual payments of $90, the bondholder receives 10 semiannual payments of $45.

*Calculator Solution:961.3810 5 ? 45 1,000

*Interest Rate RiskBond Prices fluctuate over TimeAs interest rates in the economy change, required rates on bonds will also change resulting in changing market prices.Interest RatesVB

*Interest Rate Risk

*Valuing Preferred StockP0 = Value of Preferred Stock= PV of ALL dividends discounted at investors Required Rate of Return

*Valuing Preferred StockBuy?

Yield (K) on Preferred StockThe rate of return (K) an investor would earn if they pay the current market price (MP) and receive the promised dividends (Div)If MP = Div / K, then solving for K, we getK = Div / MPIf Div is $2.31 and MP is $23.75, thenK = YTM = $2.31/$23.75 = 9.73%

*Valuing Individual Shares of Common StockP0 = PV of ALL expected dividends discounted at investors Required Rate of ReturnNot like Preferred Stock since D0 = D1 = D2 = D3 = DN , therefore the cash flows are no longer an annuity.

*Valuing Individual Shares of Common StockP0 = PV of ALL expected dividends discounted at investors Required Rate of ReturnInvestors do not know the values of D1, D2, .... , DN. The future dividends must be estimated.Link to Quote.com

*Requires ks > gReduces to:Constant Growth Dividend Model

*What is the value of a share of common stock if themost recently paid dividend (D0) was $1.14 per share anddividends are expected to grow at a rate of 7%?Assume that you require a rate of return of 11% on this investment.Constant Growth Dividend Model

*Yield, or Total Return on Common StockWhat is the yield on stock when D0 = .08, g=.20, and current price (P0) = $28.875Link to Financial WebLink to Yahoo Finance

*Yield, or Total Return on Common Stock= .0033 + 0.20 = 20.33%What is the yield on stock when D0 = .08, g=.20, and current price (P0) = 28.875

Total Market Value of a BusinessMarket value of a business:Present value of current liabilities+ present value of long term debt+ present value of preferred stock+ present value of stockholders equity= Total value of Business Assets

(Note: the present value of the current liabilities is basically the same as their book value)

The P/E Valuation ModelYou can use the Price/Earnings ratio to value a share of stock if you can determine the P/E ratio of the IndustryStock Price = Industry P/E ratio x EPSEPS is earnings per share of the firmIf projected EPS is $2 and industry P/E is 15,The Stock price = $2 x 15 = $30Stock price x shares outstanding = firm valueIf 10M shares, then x $30 = $300,000,000

Other Valuation MethodsAngel investor investments (uses what investors are willing to pay for stock during development stage)Present value of discounted future cash flows from operations (depends on predictability of future cash flows)Rule of thumb 10 times future earnings(assumes 10% desired rate of return)

Market CapitalizationMarket Cap = Shares Outstanding x market price per shareCurrent Market price = $25 per shareShares Outstanding = 100,000,000Then market cap = $2.5 billion