Planning

4-1
2002 Pearson Education Canada Inc., Toronto, Ontario

Outline: Chapter 4
Valuation of Bonds and Stocks
Financial Assets
Determining Bond Values and Yields
Bond valuation
Interest rates and bond prices
Bonds issued by the government
Bonds issue by firms
Determining the yield to maturity
Bonds with semi-annual interest
Consols and preferred stock
Bond valuation and financial management

4-2
Outline: Chapter 4
(continued)
Determining Common Stock Values
Dividend valuation
No growth in cash dividends
Constant growth in cash dividends
Nonconstant growth in cash dividends
To invest or not to invest?
Non-dividend-paying stocks
Volatility, liquidity, and stock prices

4-3
Outline: Chapter 4
(concluded)
The Present Value of Growth Opportunities
Price/earnings ratios
Growth opportunities and value creation
Growth opportunities and bond valuation
Returns and Financial Management
Returns
Expected versus realized returns
Importance for financial management

4-4
Financial Assets
Two major financial assets
Bonds
What is a bond?
A financial asset, or claim against a firm
Promissory note
Fixed income security
Issued by a firm or government
10 to 30 years maturity
Source of funding for corporations
Stock
What is a stock?
A financial asset, ownership of the firm
4-5

Definitions
Par (maturity) value is the stated or face value of a bond
(usually $1,000)
Coupon interest rate is the interest, as a percentage of
par, that is paid annually
Maturity is the length or term, expressed in years, at the
end of which the firm is legally obligated to redeem the
bond at par
New corporate bond issues are sold in the primary
market with the proceeds going to the issuing company
Outstanding bonds trade in the secondary market
between investors

4-6
Bond Valuation

Market price of a bond
Equal to the sum of the present values of the series of
interest payments and of the maturity value
Equation

bond of alue maturity v or Par value M
bond for return of rate Required k
bond for maturity to years of Number n
rate) interest coupon x (par value year each
received be to expected interest of amount Dollar I
bond the of price market Current B
b
0
=
=
=
=
=
4-7
Bond Valuation
(continued)

( ) ( )
( )
( )
n
b
b
n
b
n
1 t
n
b
t
b
0
k 1
M
k
k 1
1
1
I
k 1
M
k 1
I
B
+
+
(
(
(
(
=
+
+
+
=

=
4-8
Bond Valuation
(concluded)
An example
Consider a $1,000 par value bond that has a 10%
coupon rate and a 25 year maturity. If this bond has a
required rate of return of 10% and pays interest
annually, what is its market value?
Answer:

( )
( )
$1,000
0.10 1
$1,000
0.10
0.10 1
1
1
$100 B
25
25
0
=
+
+
(
(
(
(
(
=
The market price of the bond is equal to its face value because the
market rate (or required rate of return) is equal to the coupon rate

4-9
Interest Rates and Bond Prices
Market price of bonds fluctuates with changes in
Risk-free rate
Compensates for changes is expected inflation
Best proxy is short term T-Bill rate
Investors risk premium

Bond prices (returns) are negatively (positively)
related to
Risk-free rate
Risk premium

premium Specific - Issue premium Liquidity
premium Default premium Maturity premium risk Bond
+ +
+ =
4-10
Bonds Issued by the Government
Expected inflation
An example
Assume that the 25-year, 10% coupon rate, bond from
the last example is a Government of Canada bond.
Expected inflation jumps by 6%. If you own this bond
what is the new market value of your $1,000 par value
bond? Is your bond selling at a premium or a discount
from its par value?
Answer:

( )
( )
$634.17
0.16 1
$1,000
0.16
0.16 1
1
1
$100 B
25
25
0
=
+
+
(
(
(
(
=

Your bond is selling at a discount because the market
interest rate is greater than the coupon rate
4-11
(continued)
An example
Assume that expected inflation falls by 2%, such that
the required return is 8% for similar government bonds
issued today. What is the market value of your $1,000
par value bond? Is it selling at a premium or a
discount?
Answer:

( )
( )
$1,213.50
0.08 1
$1,000
0.08
0.08 1
1
1
$100 B
25
25
0
=
+
+
(
(
(
(
=
Your bond is selling at a premium because the market
interest rate is less than the coupon rate
4-12
(continued)

Interest rate risk and the maturity premium
An example
Assume you own a government bond with three years
to maturity (instead of 25 years). Coupon rate is still
10%. Relative to a 25-year government bond, how will
an increase in expected inflation of 6% and a decrease
in expected inflation of 2% affect the value of your
three year bond? What can we conclude?

4-13
(continued)
Answer:

Given our previous answers of $634.17 and $1,213.50
we can conclude that bonds of shorter maturity are less
sensitive to changes in expected inflation i.e., they have
less interest rate risk.
( )
( )
( )
( )
$1,051.54
0.08 1
$1,000
0.08
0.08 1
1
1
$100 B
$865.25
0.16 1
$1,000
0.16
0.16 1
1
1
$100 B
3
3
0
3
3
0
=
+
+
(
(
(
(
=
=
+
+
(
(
(
(
=
4-14
(continued)
Bonds market price, interest, and maturity

8 0 4 12 16

1,400
Par value = 1,000
600
Market rate of interest (%)
25 - year bond
3 year bond
Market value
of bond ($)
4-15
Bonds Issued By Firms
Unlike government bonds, corporate bonds have
Default premium
To cover expected costs if firm goes out of business
Liquidity premium
To cover expected costs when bonds are not easily traded on
secondary markets
Issue-specific premium
To cover expected costs from special provisions attached to
bond agreements
4-16
Bonds Issued By Firms
(concluded)
Reinvestment risk
The risk that an investor's income will fall if there is a need to
reinvest in another bond issue
Event risk
Risk shifting due to a firm's capital structure change
4-17
Determining a Bond's Yield to Maturity
An example
You are told that your 20-year maturity, $1,000 par
value bond with an 8% coupon rate sells for $908.32.
What discount rate makes the present value of the
interest of $80 per year and the maturity value of
$1,000 equal to $908.32?

4-18
Determining a Bond's Yield to Maturity
(concluded)
Answer:
We know your bond is selling at a discount. This
implies that the yield to maturity must be more than
8%. The yield to maturity is simply an internal rate of
return

By financial calculator, k
b
= 9%

( )
( )
=
+
+
+
=
20
1 t
20
b
b
k 1
$1,000
k 1
$80
$908.32
4-19
Bond Values With Semiannual Interest
Equation

2n
b
b
2n
b
2n
1 t
2n
b
t
b
0
2
k
1
M
2
k
2
k
1
1
1

2
I
2
k
1
M
2
k
1
2
I
B
|
.
|
\
|
+
+
(
(
(
(
(
(
(
(
(
(
(
(
(
|
.
|
\
|
+
=
|
.
|
\
|
+
+
|
.
|
\
|
+
=
=
4-20
Bond Values With Semiannual Interest
(concluded)
An example
Consider a bond with 20 years to maturity remaining
and with a 14% coupon rate that pays interest
semiannually. Assume a 10% annual or a 5%
semiannual rate of return is presently required on this
bond. What is the value of the bond?
Answer:
( )
( )
$1,343.18
2
0.10
1
$1,000
2
0.10
2
0.10
1
1
1
2
$140
B
2x20
2x20
0
=
+
+
(
(
(
(
(
(
(
(
(
=
4-21
Consol Bonds and Preferred Stock
Consol
Perpetual coupon rate bond
The value of a perpetual bond is

An example
If the required rate of return is 7.5% and the coupon
rate is 10%, then a $1,000 par value perpetual bond
would be worth $100 / 0.075 = $1,333.33
b
0
k
I
B =
4-22
Consol Bonds and Preferred Stock
(concluded)
Preferred stock
The valuation is similar to consols as long as the
preferred has no sinking fund provisions
An example
If a preferred stock has a $50 par value and the dividend
is 6.5% per year and the required rate of return is 9%,
then the preferred stock's value is ($50)(0.065) / 0.09 =
$36.11

4-23
Bond Valuation and Financial Management
Bonds, like stocks, are means of providing capital
for firms

Financial managers need to know how to value
bonds

Financial managers need to know the yield to
maturity, since it helps determine a firm's
opportunity cost of capital

Knowing bond valuation helps managers decide
between stocks and bonds

4-24
Definitions to understand common stock valuation

price market
in the growth of rate the be to assumed dividends;
cash the of rate growth (compound) Expected g
) D dividend, cash the
of receipt today price the is P (where
t period of end at the stock the of price Market P
years or periods, time of Number n
stock on the return of rate Required k
paid) just dividend current the is D (where
year or period, t the of end at the received
be to expected share per dividends cash of amount Annual D
0
0
t
s
0
th
t
=
=
=
=
=
r right af te
4-25
Determining Common Stock Values Common
Dividend Valuation
Dividend valuation approach
Common stock value is the present value of all expected cash
dividends and future market price

An example
You expect $5, $6, and $7 in dividends over the next three
years, at which time you expect to sell your stock for $100.
What is the current market value if the required rate of return
on the stock is 14%?
Answer:
P
0
= $5/(1.14)
1
+ $6/(1.14)
2
+ $107/(1.14)
3
= $81.22
( ) ( )
=
+
+
+
=
n
1 t
n
s
n
t
s
t
0
k 1
P
k 1
D
P
4-26
No growth in cash dividends

Common stock value is the present value of a
perpetuity if infinite constant dividends with no
growth is assumed

An example
What is Po if you expect $1.00 dividend in perpetuity
and k
s
= 16%?
Answer:
P
0
= $1.00/0.16 = $6.25

s
0
k
D
P =
4-27
Constant Growth in Cash Dividend
Since dividends are expected to grow at a constant
rate each year we are valuing a growing
perpetuity

Common stock value is the cash dividend expected
in one year (at t = 1) divided by the required return
adjusted for expected growth

g k
D
P
s
1
0
=
4-28
Constant Growth in Cash Dividend
(concluded)

Example
The current (t = 0) cash dividend of $1.00 is expected
to grow to grow at 5% per year to infinity. Your
required rate of return is 8%. What price would you
place on this common stock?
Answer:

$35.00
0.05 0.08
) $1.00(1.05
0.05 0.08
(1.05) D
g k
D
P
0
s
1
0
=
=
4-29
Nonconstant Growth in Cash Dividends

Employ four steps to solve problems involving
nonconstant growth in cash dividends
Step 1: Determine the cash dividends until the series
reverts to constant growth to infinity or no growth
Step 2: Determine the first year's dividend after the
growth rate changes to constant growth to infinity or no
growth
Step 3: Determine the market price of the stock as of
the end of the nonconstant (or rapid) growth period
Step 4: Use Equation 4.4 and the required rate of return
to discount both the expected cash dividends from step
1 and the expected market price from step 3 back to the
present

4-30
(continued)
An example
Assume a required rate of return of 16%, Do = $1.00, and 10%
growth in dividends for years 1 through 3, followed by 3%
compound growth thereafter to infinity.
Answer:
Step 1:

Step 2:
Step 3:

$10.5462
0.13
$1.371
g k
D
P
s
4
3
= =
=
( ) 371 . 1 1.03 1.331 D
1.331 1.00(1.10) D
1.210 1.00(1.10) D
$1.100 1.00(1.10) D
4
3
3
2
2
1
= =
= =
= =
= =
4-31
(continued)
Step 4: Using Equation 4.4, we discount (by 16%) D
l
, D
2
,
D
3
and P
3
back to t = 0 and get P
0
equal to about $9.46

=
$1.371
k
S
- g
P
3
=
D
4
0.16 - 0.03
$1.371 $1.210 $1.331 $1. 100
2 0 1 3 4
$0.9483
0.8992
0.8527

6.7565

$9.46 = P
0

= $10.5462
4-32
(continued)

Relationship between expected growth and market
value
There is a direct relationship between the amount and
length of expected growth in cash dividends and a
stock's market value, as can be seen from the previous
calculations. If we had different conditions, then we
would have had different results.
4-33
(concluded)

Resulting P
0
assumes D
0
= $1 and k
s
= 16%.

Condition Resulting P
0

g = 0% $6.25

10% Compound growth $8.03
for years 1-3, then g = 0%

10% compound growth $9.46
for years 1-3, then g = 3%
to infinity

g = 10% to infinity $18.33

4-34
To Invest or not to Invest?

Applying the concept of net present value (NPV) to
stocks

Criteria for investment
Invest in all stocks with a NPV > 0
Do not invest in , or sell, stocks with NPV < 0

price Market - P NPV
0
=
4-35
(continued)
An example
An investor is considering buying some shares of a
stock today when the market price is $20. If it is
expected that the current per share dividend (D
0
) of $1
will grow indefinitely at 10 % per year and the investor
has a required rate of return of 16% should he buy the
stock?
Answer:

NPV = $18.33 - $20 = -$1.67
He should not buy the shares
$18.33
0.10 0.16
$1.10
P
0
=
=
4-36
(continued)

Applying the concept of internal rate of return
(IRR) to stocks:
Calculate the rate of return that we expect to earn from
an investment in the stock and compare it to our
required rate of return, k
s
Expected rate of return, k
x

Criteria for investment:
If k
x
> k
s
invest in the stock
If k
x
< k
s
do not invest in the stock

g
P
D
k
0
1
X
+ =
4-37
(concluded)
An example
If an investor pays $15 for a share of stock today when
it is expected that the current dividend (D
0
) of $1 will
grow indefinitely at 10 percent per year. If the investor
has a required rate of return of 16% should she buy the
stock?

Since this is greater than her required rate of return of
16%, she should buy this stock.
17.3% 0.10
$15
$1.10
k
X
= + =
4-38
Non-Dividend Paying Stocks

Three ways to value non-dividend paying stocks
Estimate when the firm will start paying dividends, as
well as their size, growth rate, etc. Then proceed as
previously discussed

Estimate some future market price and discount it back
to the present

Employ earnings and multiply them by some factor
(based on perceived growth, risk and/or estimates from
similar firms) to arrive at value

4-39
Volatility, Liquidity, and Stock Prices

Three variables affecting stock price volatility
Unexpected changes in a firm's cash flows and,
therefore, cash dividends
Changes in the discount rate (k
s
) due to predictable
changes in macro forces such as GDP, industrial
production, and investment
Unexpected changes in the discount rate used

Investors demand additional compensation for
investing in less-liquid stocks

4-40
Volatility, Liquidity, and Stock Prices
(concluded)
Although most investors do not employ the
dividend valuation model directly, the intuition
behind the dividend valuation model underlies
their decision making process

Common characteristics between the dividend
valuation model and investor's decision making
process
Focus on cash flows and dividends
Consider the returns needed to compensate them for the
risks incurred
Look for growth opportunities

4-41
Price/Earnings Ratios

Expected growth is valuable
Other things being equal, the market price of a firm
which is expected to grow is higher than the market
price of a firm that is not expected to grow

P/E ratio is the market price per share of common
stock divided by the earnings per share, EPS

Dividend payout ratio
(Cash dividends paid per share of common stock)/EPS
D
1
= (EPS
1
)(Dividend payout ratio)

4-42
Price/Earnings Ratios
(concluded)

Using the constant growth model

This implies that the P/E ratio is a function of the firm's
dividend payout ratio, the return demanded by investors, k
s
,
and the expected future growth, g, for the firm

High P/E ratios may be "good news" or "bad news"

( )
g k
ratio payout Dividend
EPS
P
g k
ratio payout Dividend EPS
P
s 1
0
s
1
0
=
4-43
Growth Opportunities and Value Creation
The value of a firm does not increase or decrease
when it accepts zero NPV projects
To increase the value of the firm, projects with
NPV > 0 are necessary
Investing in projects that provide the return
demanded by investors, which is also the firm's
opportunity cost of capital, does not create value
When firms accept projects with NPV < 0 , the
firm and its investors suffer a loss in value

4-44
Growth Opportunities and Value Creation
(concluded)

Investing in a project that provides an average rate of
return is not growth!

ies opportunit growth PVof place in assets of PV
PVGO
k
EPS
P
s
1
0
+ =
+ =
4-45
Growth Opportunities and Bond Valuation
Convertible bonds
Allow the bondholder to exchange the bond for a
specified number of common stocks
To value convertible bonds we must recognize:
The conversion date (not the maturity date) is important
The conversion value (not the maturity value) at the
conversion date is important
Represent the total value of the shares that the bond will
be converted into
Option to wait
This option has value and may be an important
consideration in valuing convertible bonds

4-46
(continued)
An example
FSB Inc expects to grow at 8% for the foreseeable
future. The firms stock is currently trading at $4.63.
A years ago the firm issued 15-year bonds with a face
value of $1,000 and a coupon rate of 7% that are
convertible into 110 shares of common stock. The
issue also has a call price of $1,025. FSB will call the
bonds when the share price hits $10.87. The current
required rate of return is 7.5%. How much would you
be willing to pay for one of FSBs bonds?
4-47
(continued)
Answer:
The growth rate is 8% therefore

( )
( )
years 11
years 11.08937 n
63 $10.87/$4. log log(1.08) n
$10.87 0.08 1 $4.63
n
~
=
=
= +
70 . 1195 $
(110) $10.87 value conversion Furure
=
=
4-48
(concluded)

( )
( )
75 . 051 , 1 $
67 . 539 $ 08 . 512 $
1.075
$1,195.70
0.075
1.075
1
1
$70 value Bond
11
11
=
+ =
+
(
(
(
(
=
You would be willing to pay up to $1,051.75 for the bond
4-49
Returns
Returns from investing in any financial asset comes
from one of two sources:
Income from interest, dividends and so forth
Capital gains or losses

( )
0
0 1 1
P
P P D
k
+
=
zero at time stock the of price Beginning P
D receiving after y immediatel 1 t at time stock the of Price P
1 t at time now from period one received dividends Cash D
0
1 1
1
=
= =
= =
4-50
Returns
(concluded)
An example
You own 100 shares of stock in Canada Ltd. and expect
to receive cash dividends of $5.00 per share at time t =
1. You pay $50 per share at time t = 0. At time t = 1, the
price per share is $51. What is your return?
Answer:
k = [$5.00 + ($51 - $50)]/$50 = 12%

For the 100 shares, your return is $6.00 ($5 dividend
and $1 capital gain) per share or $600.00 total
during this time period

4-51
Expected Versus Realized Returns
Ex-post or realized returns may differ from their
expected or ex-ante returns
Expected returns are always positive, but realized
returns are not always positive
James Thomas buys 100 shares of Acme Ltd. expecting a
12% rate of return. He owns the stock for three years,
receives no dividends, and the price he has paid for the
100 shares falls 5%. His realized or ex-post return is
negative
Over the 1965-1999 time period 31% of the total
return on common stocks came from dividend
income; the remainder was due to changes in the
market price of common stocks
4-52
Importance for Financial Management

Relationship among the firm's financial
management decisions, investors' actions, and
valuation

V = S + B
1. Magnitude
2. Timing
3. Riskiness of expected
cash flows
1. Perceived risk
2. Required rate of
return
Influences
investors
Influences
financial
management
decisions, which affect
Determines
the size of the pie

Planning

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4-1

2002 Pearson Education Canada Inc., Toronto, Ontario

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