Valuation

The general concept is very simple

the current value of any asset is the
present value of the future cash flows
it is expected to generate.

It makes sense that you are willing to

pay (invest) some amount today to
receive future benefits (cash flows).

ValuationCash Flow Time

Line
0

k
^

^
CF
1

^
CF2

^
CF3

PV of
CF1 ^
PV of
CF2 ^
PV of
CF3 ..

^
PV of CFn
^
PV of CF = Value

n
^
CFn

General Valuation
Equation

Asset CF1 CF 2 CF n

1
2
n
value (1 k ) (1 k )
(1 k )
n

CF t

t 1 (1 k )

Value

Bonds (Debt)

long-term debt where the amount borrowed is

repaid at maturitythat is, the end of the bonds life
principal amount, face value, maturity value, and
par value
coupon interest rate
maturity date
call provision
new issuesthe coupon rate on a bond is
approximately equal to the rate at which similar risk
bonds are trading in the financial markets when the
bond is issued

Valuation of Bonds
0

kd

INT

INT

INT

PV of INT
PV of M
Bond Value = Vd
INT = $ interest paid each period
M = maturity, or face, value

N
INT
M

Valuation of Bonds
Bond
INT
INT
INT
M
Vd

1
2
N
Value
(1 k d )
(1 k d )
(1 k d )
(1 k d ) N

INT
(1 k d ) t

t1

1
(1 kd )N

kd

INT

1-

M
(1 k d ) N

1
M
N
(1 k d )

Bond ValuationExample
Bond Characteristics:
Face (maturity) value, M $1,000
Coupon rate of interest, C
5%
Annual interest payment, INT $50 = $1,000 x
0.05
Years to maturity, N
8
Market rate, kd1
6%
1 - (1 k )N

1
d
(1.06)
Vd INT
M
1,000

50 0.06
N
n
8
kd
kd )
(1.06)

(1
n
8

= 50(6.20979) + 1,000(0.62741) = 937.90

Bond ValuationFinancial
Calculator Solution

Bond Characteristics:
Face (maturity) value, M $1,000
Coupon rate of interest, C
5%
Annual interest payment, INT $50
Years to maturity, N
8
Market rate, kd
6%
8

50

1,000

PV

PMT

FV

937.90

Bond ValuationYield to
Maturity, kd

Bond Characteristics:
Face (maturity) value, M $1,000
Coupon rate of interest, C
10%
Annual interest payment, INT$100 = $1,000 x
0.10
Years to maturity, N
5
Market price, Vd
$1,123
1
1 - (1 k )N5

1
d
1,123
100
Vd INT
M
1,000
N
5
kdd

(1 kdd )
d

kd = Yield to maturity, YTM

Bond ValuationYield to
Maturity, kd ,

INT
YTM
Approximation

M - Vd
N

Approximat
ion

2(Vd ) M
3

Example: M = $1,000, INT = $100, N = 5, Vd=

$1,123
1,000- 1,123

75.40
100

5
YTM

0.0699 7.0%
Approximat
ion
1,082
2(1,123) 1,000

Bond ValuationFinancial
Calculator Solution

Bond Characteristics:
Face (maturity) value, M $1,000
Coupon rate of interest, C
10%
Annual interest payment, INT$100
Years to maturity, N
5
Market price, Vd
$1,123
5

-1,123

PV

7.0

100
PMT

1,000
FV

Bond Valuation
Relationship of YTM,
Example: N = 10
Coupon, and Price
yrs;
C = 6%; M = 1,000

Relationship of rates

Market
If kd =
Price, Vd

Vd =

Coupon rate,
=
C

par;
Vd = M

6%

$1,000.00

Market rate,
kd

Coupon rate,
>
C

discount
;
Vd < M

10%

$754.22

Market rate,
kd

Coupon rate, premium

<
C
V >M

4%

$1,162.22

Market rate,
kd

Bond Return
kd
Rate of
return

INT
V
d

Current
yield

Vd1 Vd0
Vd0

Capital
+
gains yield

Bond ValuationChange
in Value Over Time
Bond Characteristics: M = $1,000.00, INT = $60.00, kd
= 8%
Years to
Maturity

End of
Year
Value, Vd

$920.15

4
4
3
3
2

933.76
933.76
948.46
948.46
964.33

2
1
1
0
0

Capital Gain
= (Vd1-Vd0)/Vd0

Current
Yield =
INT/Vd0

Total
Return

1.48%
1.48%

6.52%
6.52%

1.57

6.43

8.00

964.33
981.48
981.48
1,000.00

1.67

6.33

8.00

1.78

6.22

8.00

1,000.00

1.89

6.11

8.00

8.00%

Bond ValuationChange
in
Value
Over
Time
Market Value ($), V
d

1,100.00

1,079.85
Premium bond, Vd > M

1,050.00
Par bond, Vd = M

1,000.00
950.00

M = 1,000
Discount bond, Vd <
M

900.00

920.15

850.00
800.00
5

Years to
Maturity

Bond Valuation
Semiannual Payment of
Most bonds pay interest every six monthsthat
Interest
is,
semiannually
Adjustments to computations

N = # years x m; m = # of interest payments per year

i = kd/m
INT = interest payment per period = Annual INT/m

Example: M = $1,000, C = 5%, Yrs to maturity = 8, kd

= 6%
16
3.0
?
25
1,000
N

PV

-931.23

PMT

FV

Interest-Rate Risk

When
change,
bondholders
are are
Whenmarket
marketrates
rates
change,
bondholders
affected
affectedinintwo
twoways:
ways:

bond
in in
anan
opposite
directionprice
risk
bondprices
priceschange
change
opposite
directionprice
the
riskrate investors earn changesreinvestment risk

the rate investors earn changesreinvestment

Rate, kd Value, Vd
risk
Bond
Characteristics:
M = $1,000.00
INT =
$60.00
N = 5 yrs
Annual Interest

4%

$1,089.04

1,000.00

920.15

10

848.37

12

783.71

Stock Valuation
Value of V P PV of expected future dividends
s
0
stock
1
2

D
D
D

1
2
(1 k s ) (1 k s )
(1 k s )

Stock ValuationConstant
Growth, g

D
(
1
g
)
D
(
1
g
)
D
(
1
g)
0
0
0
P0

1
2
(1 k s )
(1 k s )
(1 k s )
1

1
D0 (1g) D

k s g k s g
growth = g = g1 = g2 = = g
ks > g

Stock ValuationConstant
Growth, g
Example:
D0 = $2
g = 4%
ks = 12%

$2(1.04)
$2.08
P0

26.00
0.12 0.04 0.08

Stock ValuationConstant
Growth, g=0

D
D
D
1
2

P0

(1 k s )1 (1 k s ) 2
(1 k s )
g=0

P0

D
D
D
D
1
2

D
D
D
D

1
2

ks
(1 k s )
(1 k s )
(1 k s )

Stock Return
k s

Expected rate
=
of return

D
1
P0
Expected
dividend
yield

Expected growth
rate (capital
+
gains yield)

Stock Return
P0 =$50
D0 = $2
g =7%
k $2.00(1.07) 0.07 0.0428 0.07 0.1128 11.28%
s
$50

Stock Return
In one year, the price of the stock is
expected to be:

3
2

2
D
D
D
D

P1
1
1
2
k s g
(1 k s ) (1 k s )
(1 k s )
$2.14(1.07) $2.2898

$53.50
0.1128 0.07 0.0428

Stock Return
Because the value of the stock is expected to
increase to $53.50 one year from now,
Ending value - Beginning value P1 P0
Capital

gains yield
Beginning value
P0
$53.50 $50.00

0.07 7.0%
$50.00

Dividend D
1 $2.14

0.0428 4.28%
yield
P
$50
0

= 11.28%

Stock Valuation
Nonconstant Growth

P
D
D
D
1
2
N
N

P0

(1 k s )1 (1 k s ) 2
(1 k s ) N
(1 g )
(1 g ) P
D0 (1 g1 ) D
D
1
2
N 1
N
N

(1 k s )1
(1 k s ) 2
(1 k s ) N

N (1 g norm )
N1
D
D
PN

k s g norm
k s g norm

Stock Valuation Example

D0 = $1.00
g1 = 18%
g2 = 16%
g3 = -6%
g4 = 10%
g5 = 8%
g6 = 6% = g7 = = g
ks =12%

Stock Valuation Example

Year Dividend
12%

Computation

1 $1.1800= $1.0000(1.18)
2
1.3688= $1.1800(1.16)
3
1.2867= $1.3688(0.94)
4
1.4153= $1.2867(1.10)
5
1.5286= $1.4153(1.08)

@
PV of D
t

$1.0536
1.0912
0.9158
0.8994
0.8674
$4.8274

Stock Valuation Example

Because the dividends grow at a constant
rate after Year 5, we can apply the
constant growth model such that:

6 1.5286(1.06)
D

P5
k s g n 0.12 0.06
1
.
6203

$27.00
0.12 0.06

ValuationCash Flow Time

Line
0

12%

1.1800 1.3688

1.2867 1.4153 1.5286 D

4.8274
15.3205

27.00

20.1479

0 $20.15
P

5
P

Stock Valuation
Nonconstant Growth

The key to computing the value of a stock that

experiences nonconstant growth is that we
assume constant growth occurs at some point in
the futureit might start in five years, 50 years,
or 100 yearsat which time we can apply the
constant growth model to compute the value of
the expected dividends from that point forward.
Prior to the point where nonconstant growth
occurs, we have to compute the dividend for
each year, find the present value of each
dividend, and sum the results

Market Equilibrium

1
D
g k s k s k RF (k M k RF )s
P0

Efficient Markets
Hypothesis

Weak form efficiencypast price

information is contained in current prices
Semistrong form efficiencypublicly
available information is contained in
current prices
Strong form efficiencyall information,
public and private, is contained in current
prices

Valuation of Real
(Tangible) Assets

The valuation of a real asset is the

same as for a financial assetthat
is, value equals the present value of
the cash flows the asset is expected
to generate during its life.
Capital budgeting decisions

Valuation of Real
(Tangible) Assets
0 10% 1
2
3
Example
1,000

5,000

3,000 8,000

909.09
4,132.23
2,253.94
5,464.11
12,759.37

Solve using:
Numerical solution
Financial calculator solution
Spreadsheet solution