chapter 5 valuation concepts. 2 basic valuation from “the time value of money” we realize that...
TRANSCRIPT
Chapter 5
Valuation Concepts
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Basic Valuation
From “The Time Value of Money” we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future.
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Basic Valuation
The Value of the Asset = the sum of the discounted cash flows the asset is expected
to generate over time
Required return = the rate you use to discount the cash flows back.= the rate of return investors consider appropriate for holding
such an asset= based on riskiness and economic conditions
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Key Terms for Bonds
Principal Amount = Face Value = Maturity Value,= Par Principal Amount = Face Value = Maturity Value,= Par Value:Value: The amount of money borrowed
Coupon Payment:Coupon Payment: The specified number of dollars of interest paid each period, generally each six months, on a bond.
Coupon Interest Rate:Coupon Interest Rate: The stated annual rate of interest paid on a bond.
Maturity Date:Maturity Date: A specified date on which the par value of a bond must be repaid.
Original Maturity:Original Maturity: The number of years to maturity at the time the bond is issued.
Call Provision:Call Provision: Gives the issuer the right to pay off bonds prior to maturity.
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Task: Find the present Value of Genesco’s 15%, 15-year, $1,000 bonds valued at 15% required rate of return
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Financial calculator solution:Financial calculator solution:
Task: Find the present Value of Genesco’s 15%, 15-year, $1,000 bonds valued at 15% required rate of return
INPUTS
OUTPUT
15 15 ? 150 1000 N I/YR PV PMT FV
-1000
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Changes in Bond Values Over Time
Par Value BondPar Value Bond
Discount BondDiscount Bond
Premium BondPremium Bond
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Par Value Bonds
Par Value Bond:Par Value Bond:When the going interest rate = the
bond’s coupon interest rate The market value of a bond will
always approach its par value as its maturity date approaches, provided the firm does not go bankrupt.
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Discount Bonds
An increase in interest rates in the economy causes the price to fallDiscount Bond
= when a bond sells below its par value occurs whenever the going rate of
interest rises above the coupon rate
The bond value decreases so that the rate of return investors earn equates to the higher kd.
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Premium Bonds
A decrease in interest rates in the economy causes the bond price to risePremium
= when a bond sells above its par valueoccurs whenever the going rate of
interest falls below the coupon rate
The bond value increases so that the rate of return investors earn equates to the lower kd.
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dV
INTCurrent
yield
Current yieldCurrent yield = the annual interest payment on a bond divided by its current market value
Calculating a Bond’s Current Yield
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Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%
Year kd = 10% kd = 15% kd = 20%
0 $1,380.30 $1,000.00 $766.231 $1,368.33 $1,000.00 $769.472 $1,355.17 $1,000.00 $773.373 $1,340.68 $1,000.00 $778.044 $1,324.75 $1,000.00 $783.655 $1,307.23 $1,000.00 $790.386 $1,287.95 $1,000.00 $798.457 $1,266.75 $1,000.00 $808.148 $1,243.42 $1,000.00 $819.779 $1,217.76 $1,000.00 $833.7210 $1,189.54 $1,000.00 $850.4711 $1,158.49 $1,000.00 $870.5612 $1,124.34 $1,000.00 $894.6813 $1,086.78 $1,000.00 $923.6114 $1,045.45 $1,000.00 $958.3315 $1,000.00 $1,000.00 $1,000.00
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$0
$250
$500
$750
$1,000
$1,250
$1,500
1 3 5 7 9 11 13 15
kd = Coupon Rate
kd < Coupon Rate
kd > Coupon Rate
Years
Bond Value
Changes in Bond Values Over Time
Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%
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Finding the Interest Rate on a Bond: Yield to Maturity
YTMYTM is the average rate of return earned on a bond if it is held to maturity.
Financial calculator solution:Financial calculator solution:
INPUTS
OUTPUT
15 ? -950 150 1000 N I/YR PV PMT FV
15.89
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Interest Rate Risk on a Bond
Interest Rate Price Risk: the risk of changes in bond prices to which investors are exposed due to changing interest rates.
Interest Rate Reinvestment Rate Risk: the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current (presumably lower) market rates.
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Current Market Interest Rate, kd
1-Year Bond 14-Year Bond
5% 1,095.24$ 1,989.86$ 10% 1,045.45$ 1,368.33$ 15% 1,000.00$ 1,000.00$ 20% 958.33$ 769.47$ 25% 920.00$ 617.59$
Value of
Value of Long and Short-Term15% Annual Coupon Rate Bonds
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Valuation of Financial Assets - Equity (Stock)
Common Stock Preferred Stock: hybrid
similar to bonds with fixed dividend amounts
similar to common stock as dividends are not required and have no fixed maturity date
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Stock Valuation Models
Term: Expected DividendsExpected Dividends
investors. amongdiffer may estimates
theso values,expected are dividends future All
years twoof end at the expected dividend theis 2D̂
year thisof end at the paid be it will and
paid, be toexpected dividendnext theis 1D̂
paidalready dividendrecent most theis 0D
Year t of end at the receive
toexpectsr stockholde thedividendtD̂
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ay.market tod in the sells
stock aat which price theP0
Term: Market PriceMarket Price
Stock Valuation Models
20both.or ,book value its price,
market current sasset' thefrom
differmay facts; by the
justified is investor,an of mind
in the ,asset thatan of value theP̂0
Term: Intrinsic ValueIntrinsic Value
Stock Valuation Models
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Year t.each of end at the
stock theof price expected theP̂t
Term: Expected PriceExpected Price
Stock Valuation Models
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shareper dividendsin
change of rate expected theg
Term: Growth RateGrowth Rate
Stock Valuation Models
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s.investmentother
on available returns and riskiness
itsgiven acceptableconsider
rsstockholde stock thatcommon
aon return of rate minimum thek s
Term: Required Rate of ReturnRequired Rate of Return
Stock Valuation Models
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stock of
share a of pricecurrent by the
divided dividend expected theP
D̂
0
1
Term: Dividend YieldDividend Yield
Stock Valuation Models
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year theof beginning at the price
itsby dividedyear given a during
gain) (capital pricein change theP
PP
0
01
Term: Capital Gain YieldCapital Gain Yield
Stock Valuation Models
260
01
0
1
s
P
PP
P
D̂
receive toexpects investor individualan stock that
common aon return of rate thek̂
Term: Expected Rate of ReturnExpected Rate of Return= Expected dividend yield + capital gains = Expected dividend yield + capital gains yieldyield
Stock Valuation Models
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yield. gains capital the
plus yield dividend the toequal
fact; after the receives,actually
investor individualan stock that
common aon return of rate thes k
Term: Actual Rate of ReturnActual Rate of Return
Stock Valuation Models
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Expected Dividends as the Basis for Stock Values
If you hold a stock forever, all you receive is the dividend payments.
The value of the stock today is the present value of the future dividend payments.
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Stock Values with Zero Growth
A Zero Growth StockZero Growth Stock is a common stock whose future dividends are not expected to grow at all = A PERPETUITY
02 DD̂D̂D̂ and 0, g1
s0 k
D P̂
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Normal, or Constant, Growth
Normal Growth is growth that is expected to continue into the foreseeable future at about the same rate as that of the economy as a whole.
g = a constant
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g
s
10
k
Div P̂
Normal, or Constant, Growth(Gordon Growth Model)
A Constant Growth StockConstant Growth Stock is a common stock whose future dividends are expected to grow at a constant rate = A GROWING PERPETUITY
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g P
D̂ k̂
0
1s
Expected Rate of Return on a Constant Growth Stock
Rearrange the formula for the price to get Dividend Yield
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Valuing Stocks with Nonconstant Growth
Nonconstant Growth:Nonconstant Growth: The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole.
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1. Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends.
2. Find the price of the stock at the end of the nonconstant growth period, at which time it has become a constant growth stock, and discount this price back to the present.
3. Add these two components to find the intrinsic value of the stock P0.
Valuing Stocks with Nonconstant Growth
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1. The expected rate of return as seen by the marginal investor must equal the required rate of return,
2. The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor,
k̂x = kx.
P0 = P0.^
Stock Market Equilibrium
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Changes in Stock Prices
Investors change the rates of return required to invest in stocks.
Expectations change about the cash flows associated with particular stocks.
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The Efficient Markets Hypothesis
The weak formThe weak form of the EMH states that all information contained in the past price movements is fully reflected in current market prices.
The semistrong formThe semistrong form states that current market prices reflect all publicly available information.
The strong formThe strong form states that current market prices reflect all pertinent information, whether publicly available or privately held.
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Valuation of Real (Tangible) Assets
A company proposes to buy a machine so it can manufacture a new product. After five years the machine will be worthless, but during the five years it is used, the company will be able to increase its net cash flows by the following amounts:
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Year Expected Cash Flow, CF 1 $120,000
2 $100,000 3 $150,000 4 $80,000 5 $50,000
To earn a 14% return on investments like this, what is the value of this machine?
Valuation of Real (Tangible) Assets
^
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In “CF” register:Type: 2nd, CE/C to clear information storedCF0 = 0
C01 = 120,000 F01 = 1C02 = 100,000 F02 = 1C03 = 120,000 F03 = 1C04 = 80,000 F04 = 1 C05 = 50,000 F05 = 1
In “NPV” Register:Type: I = 14, enter, down arrowSee: NPV = (varies)Type: CPTSee: NPV = 356,790.50
Calculator Solution:
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For Next Class
Review Chapter 5 materialsDo Chapter 5 homeworkPrepare for Quiz on Chapter 5Read Chapter 6 (Capital Budgeting)