chapter 4 value- driven management

AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

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CHAPTER 4

Value- Driven Management


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The goal of managerial finance is to maximize the value of the firm.

It is critical to understand the valuation process so we know what affects the value of the firm.

Price: refers to an amount of money per unit of measure at which someone buys, or is willing to buy or sell.


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Value: is used to mean the price that would exist in a market that is perfect based on the information set currently available to Investors.

Intrinsic Value Intrinsic Value: is the value that would

exist If all potential investors had the same information that was available to the

person determining the intrinsic value.


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The intrinsic value is the true worth of a security which may differ from the market price.Intrinsic value can be estimated but can

never be observed.

intrinsic value is based on the present value of the cash flows the asset is expected to produce in the future.


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0 K% 1 2 n-1 n

CF1 CF2 CFn-1 CFn

^ ^ ^ ^

Value

PVCF1

PVCF2

PVCFn-1

PVCFn


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1. Wealth is created by acquiring assets that have values in excess of their costs. (PV of expected cash flows exceeds the cost or

the initial investment)2. Such assets are acquired through competitive

advantage.

3. Competitive advantage + Time value of money provide the basis for value creation- Arbitrage pricing principal.


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Arbitrage Valuation

Arbitrage is the process of increasing benefits without increasing costs or risk by taking advantage of market imperfection.

The arbitrage pricing principal (APP) states that Identical streams of cash flows will have identical prices.


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Assets A and B have identical streams of future benefits:Asset A Asset B$1,000 Not worth

more than $1,000

If B is offered at a price below $1,000, Holders of A cannot sell their assets For $1,000 in order to buy asset B.


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The Sum of the Parts Equal the Whole

Year1 Year2X $100.00 $200.00Y $100.00 0Z 0 $200.00

∑= CFt / i+k

At k= 10 percent:PV(Y) = $100/1.1= $90.1PV(Z) = $200/(1.10) = $165.29PV(X) = $100/1.1 + 200/1.10=$90/91+$65.29=$256.20PV(Y+Z) = $90.91 + $165.29 = $256.20 = PV(X)


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For arbitrage pricing pressures to be effective, it is necessary that financial markets meet specific standard of perfection (see page 104)

If financial markets are perfect, they will also be informationally efficient.

Markets could be informationaaly efficient without being perfect.

=0


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Value of BondsA bond is a long-term debt instrument issued by a business or governmental unit. Bonds are typically in $1,000 denominations.The bond provides a promise to pay a fixed

interest payment on the $1,000 face value, and a promise to repay the face value at the maturity date specified in the bond contract.

Bonds can be bought and sold in the bonds markets prior to maturity


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The value of a bond is found as the present value of an annuity ( the interest payments) plus the present value of a lump sum ( the principal).

The bond is evaluated at the appropriate periodic interest rate ( market rate) over the number of periods for which interest payments are made.


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Sunshine corporation bonds maturing in two years has a coupon rate of 8%. The interest is paid every six monthly. What is the price of the bond if the opportunity cost of money is 4 percent. What is the price if the opportunity cost of money is 3 percent.

PV( at 4 percent) = $40.00PVIFA14perid,4% + $1,000xPVIF4,4% =$1,000

PV (at 3 percent) =$40.00PVIF14periods,3% +

$1,000xPVIF4,3%=$1,037.18


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Yield to Maturity

YTM is the interest rate that would be earned by a bondholder who bought the bond at the current price and held it until maturity.

YTM is the discount rate that causes the present value of the future payments to equal the price.

From previous example:YTM = 4% at market price of $1,000, and

YTM = 3% at market price of $1,037.17


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Market price of the bond and the Yield toMaturity:If the market price of the bond is greater than $1,000, t he yield to maturity is less the coupon rateIf the market price of the bond is less than $1,000, the yield to maturity is greater than the coupon rate.If the market price is $1,000 the yield to

maturity is the same as the coupon rate


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If the coupon rate is 8 percent and sold toyield 3% YTM each six-months, withinterest paid semiannually. Then theEffective Annual interest rate is:K = (1 + .03)2 -1 = 1.0609 -1 = .0609 = 6.09%

Bonds are quoted as a number of pointsout of 32. A bond with a price of 103 23/32 = 103.71875 percent of the par value= $1,000x103.71875% = $1,037.19


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Bond prices are affected by the time until the next interest payment.

If the price of the bond is $1,037.17. TheYTM is 3 percent, and the next interest payment for the company is only 4 monthaway instead of six months, all paymentsare moved closer by a third of a 6- months,so the value of the bond increases to:$1,037.17 (1.03)1/3 = $1,047.44


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Some Alternativ Yield DefinitionsYield to Maturity: interest rate that would be

earned by a bondholder who bought the bond at the current price and held it until maturity.

Coupon Rate: annual interest payment divided by face value

Current Yield: annual interest payment divided by current price

Yield to Call: interest rate that would be earned by a bondholder who bought the bond at the current price and held it until it was called


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Value of Stock

Stock value = ∑ Dt /(1+k)t

t=1

Stock value = D1 / k………. Zero growth model

Stock value = D1 / (k- g) … Constant growth model


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The Value of the Preferred Stock is:

Dividend/ required return = Dpf /kIf the preferred stock of XYZ corporation paysan annual dividend of $1.70 , and investmentsof similar risk pay an expected return of 6.77percent, the value of the preferred stock is: D / k = $1.71/.0677 = $25.11


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Valuation of Common stock of Disney

Price was $125 a share in 1998Dividends were forecast to be $0.7 a share in 1999Required rate of return = 15 percentGrowth in dividends = 0.1444 percent

Value of the stock = D1 /k- g = $.70/(.15-0.1444) =$125


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$ 0.70 0.80 0.92 1.05 1.2 1.37

P0= $125, P5= $1.37/(0.15-0.1444) = $245

X .8696 x.7561 x.6575 x.5718 x.4972

PVD1PVD2PVD3PVD4PVD5

=$3

D1 D2 D3 D4 D5 D6


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The investors who bough at $125, received 5years of dividends, and sold at $245, onlyearned the 15 percent rate that could havebeen expected elsewhere.

Superior returns would occur if the pricerose to more than $245 in 5 years, eitherbecause dividend forecasts had been revisedupward or the rate that could be earnedelsewhere had declined.


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Sources of Change in Stock Price

Change in Stock price

Change inAlternative

opportunitiesChange in

required return

Change in expected dividends

Change in theCompany’s riskiness

News about the company or economy in general


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Value of Investment OpportunitiesA company is viewed as:a set of existing investments and a set of potential investment opportunitiesIn the absence of other investmentopportunities: The value of the company = the presentValue of future dividends


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If the company has additional investment Opportunities The value of the company willincrease by the present value of those investment opportunities.

Vcomp = PV (future dividends) + PV of future

investment opportunities


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The value of the company is independent of whether equity needed to finance thoseopportunities will come form:a. retention of earnings or b. sale of additional stockExample on page 113- Delta Corporation Net income = $100,000 Shares outstanding= 100,000 Dividends= $1/share ( no investments opp.) Investors’ opportunity cost = 10 percent


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Value of the company = $1/.10 =$10.00The company discovers a new investment opportunity that requires $50,000 a year from

Now.The opportunity will earn additional income of

$10,000 a year after ( available to distribute as dividends).

NPV ( one year from now) = $10,000/.10 – $50,000 = $50,000.Present value (PV) of the opportunity today

= $50,000/1.10=$45,455.


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0 Y1 Y2

Investment opportunityCosts $50,000

NPVopp. = $10,000/.10 -$50,000 =$50,000

AdditionalIncome of$10,000,paid out asdividends

PV = $50,00/1.10= 45,455= $0.45 per shareThe value of stock will increase by $0.45 to $10.45


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Scenario A: Delta get the needed equity($50,000) by reducing dividends first years

Year 1 2 TotalIncome $100,00 $110,000Div/share $0.5 $1.10PV factor 0.9091 9.0909*Present value $0.45 $ 10.000 $10.45

* = (1/0.1)/1.10


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Scenario B: Delta wants to maintain its dividend and sell additional shares at the end of the first year, immediately after the dividend payment, to get the equity needed for the new investment.

Y0 Y1 Y2

Number of shares Sn =$50,000/P1

P1 = D2+ /.10

D2+

Sn = $50,000/P1

P1 = D2+ /.10

D2+ =$110,000/100,000 +Sn


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P1 = $50,000/Sn = D2+ /.10 = ($110,000/100,000 + Sn)/.10 = $50,000/Sn

$5,000/Sn = $110,000/(100,000 + Sn)110,000Sn = 500,000,000 + 5,000Sn

105,000Sn = 500,000,000, Sn = 4,762 sharesD2+ = $1.05P1 = $10.50Value of the share today = (P0) = ($10.50 + $1.00)/1.1 = $10.45


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Economic Profit and Wealth

Wealth Creation is :The present value of future investment opportunities andThe present value of economic profit

created by investment opportunities


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$50,000 of new equity at the end of Y1 generated cash flow of $10,000 a year for equity holders forever

At a 10% required return, the annual economic profit in Y2 and beyond is:

Annual cash flow $10,000Normal profit (.10x $50,000) 5,000Economic profit $5,000


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What if Investors Do Not Know?No investment = P0 = $10/shareThe company announce a New investment

of $50,000 to provide $10,000 a yearThe intrinsic value at the end of year 1 is

$10.5/share Y1 Y2

Investors are not well informed about the new investments and the stock isactually selling for $4.00 a share

$10, $10.5


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Scenario A Scenario BDrop the plan ( P=$10) the number of new

shares Sn @Y1 = $50,000/4

=12,500 Shs

D2+ =

$110,000/(100,000 +12,500) = $0.98

The intrinsic value at the end of year1 declines to $0.98/.10 = $9.80.


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Wealth and Value

$50,000 $3,000 a year for everEquity investmentNPV=$3,000/.10- $50,000= -$20,000D1 = $.50 D2+ =$1.03P1 = $1.03/0.1= $10.30

Y1 Y2

P0 = $(10.30 +$.50)/1.10 = $9.82

Price increased, value increased , and wealth decreased.


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Stock Splits and Stock DividendsStock splits: a method commonly used to lower the price of a firm’s stock by increasing the number of shares belonging to each shareholder.

Stock dividends: the payment to existing owners of a dividend in the form of stock.

Stock splits and stock dividends both have no effect on the firm’s capital structure.


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Why do companies engage in stock splits and dividends if they achieve nothing?

Making the stock available to more investors.

Stock splits and stock dividends provide a signal that management expects the company to increase its competitive advantage in the future.

Some investors believe that they receive something of value.


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Value of CurrencyThe value of currency provides another example of arbitrage pricing principals at

work

Tow important factors affecting the exchangerates between currencies:Purchasing power parityInterest arte power parity


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Purchasing power parity (PPP)

PPP states that equilibrium exchange rates between two countries will result in identical goodsselling at identical prices

BIG Mac (UK) BIG Mac (US)£1.1 $1.54Price of the pound = $1.54/1.1 = $1.4/1 £


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If inflation is 20% in Uk , and 10% in US, thenBIG Mac (UK) BIG Mac (US)£1.32 (1.1 x1.2) $1.694 (1.54 x1.1)

Price of one pound =$1.694/ £ 1.32 = $1.2833/ £1

Forward rate = Spot rate(1+INFd/(1+INFf) = 1.4 (1+.1)/ (1+.2) =1.4(1.1)/(1.2) = $1.2833/ £ 1.


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Interest Rate Parity Theory (IRP)IRP predicts a specific relationship betweenspot exchange rates, forward exchangerates, and interest rates.IR(GB) >IR (USA)a. Convert dollar into pounds and buy the pound-denominated securitiesb. Enter into a future contract to repurchase dollars at the maturity date for the pound- denominated security


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Rforeign = (ERSpot / ERForeard ) (1+ RDDomestic ) -1If:

a. Spot exchange rate= $1.40/ £b. 1-year forward contract rate=$1.2833/ £Risk-free interest rate in dollar-denominatedsecurity = 12.2 percent, then equilibrium rate in pound- denominatedsecurities is:

Rforeign = (1.40/1.2833)(1+.122) -1 = 22.4%


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Government InterventionDriving exchange rates out of purchasingpower equilibrium.If US FRB. decreases the money supply,driving interest rates up t0 14%. For IRP tohold, it is necessary for the spot rate tochange as follows:

0.224= (ERSpot /1.2833)(1+.14) -1;

ERSpot = $1.378/ £

chapter 4 value- driven management

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