Risk - Types

Business risk Financial risk Liquidity risk Exchange rate risk Country risk

Business Risk
Uncertainty of income flows caused by the nature of a firms business Sales volatility and operating leverage determine the level of business risk.

Financial Risk
Uncertainty caused by the use of debt financing. Borrowing requires fixed payments which must be paid ahead of payments to stockholders. The use of debt increases uncertainty of stockholder income and causes an increase in the stocks risk premium.

Liquidity Risk
Uncertainty is introduced by the secondary market for an investment.
How long will it take to convert an investment into cash? How certain is the price that will be received?

Exchange Rate Risk

Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor. Changes in exchange rates affect the investors return when converting an investment back into the home currency.

Country Risk
Political risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country. Individuals who invest in countries that have unstable political-economic systems must include a country riskpremium when determining their required rate of return

Valuation
How to determine the correct price??

Basics
Return Relationship Req return = Rf + Risk Prem(Rp)
Risk Fixed Deposits Bonds Preference Shares Equity Shares

Present Value Concept How to calculate Price??

Bonds

A bond is a long-term debt instrument issued by a corporation or government.

Maturity value (MV) Coupon rate Discount Rate

Valuation for Different Bonds

A perpetual bond is a bond that never matures. It has an infinite life.

V=

I
(1 + kd)1

I
(1 + kd)2

+ ... +

I
(1 + kd)
,) d

=S

I
(1 + kd)t

or

t=1

I (PVIFA k

V = I / kd

[Reduced Form]

Perpetual Bond Example

Bond P has a Rs.1,000 face value and provides an 8% coupon. The appropriate discount rate is 10%. What is the value of the perpetual bond?

I kd

= Rs.1,000 ( 8%) = 10%.

= Rs.80.

= I / kd

[Reduced Form]

= Rs.80 / 10% = Rs.800

Coupon Bond Example

Bond C has a Rs1,000 face value and provides an 8% annual coupon for 3 years. The appropriate discount rate is 10%. What is the value of the coupon bond?

V = [80/1.10] + [80/(1.10)^2] + [(80+1000)/1.10^3]

Zero Coupon Bond Example

Bond Z has a Rs.1,000 face value and a 30-year life. The appropriate discount rate is 10%. What is the value of the zero-coupon bond?
= 1,000 (PVIF10%, 30) = 1,000 (.057) = Rs.57.00 V

Semiannual Coupon Bond Example

Bond C has a Rs.1,000 face value and provides an 8% semiannual coupon for 15 years. The appropriate discount rate is 10% (annual rate). What is the value of the coupon bond?
V = Rs.40 (PVIFA5%, 30) + Rs.1,000 (PVIF5%, 30) = Rs.40 (15.373) + Rs.1,000 (.231) = Rs.614.92 + Rs.231.00 = Rs.845.92

Preferred Stock
Preferred Stock is a type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors.
Preferred Stock has preference over common stock in the payment of dividends and claims on assets.

Preferred Stock Valuation

DivP
(1 + kP

V=

)1

+ (1 + k

DivP
)2 P

+ ... +

DivP
(1 + kP)
,) P

=S

DivP
(1 + kP)t

t=1

or DivP(PVIFA k

This reduces to a perpetuity!

V = DivP / kP

Preferred Stock Valuation Example

Stock PS has an 8%, Rs.100 par value issue outstanding. The appropriate discount rate is 10%. What is the value of the preferred stock?
DivP kP = Rs.100 ( 8% ) = Rs.8.00.

= 10%. V = DivP / kP = Rs.8.00 / 10% = Rs.80

Common Stock Valuation

What cash flows will a shareholder receive when owning shares of common stock?

(1) Future dividends (2) Future sale of the common stock shares

Dividend Valuation Model

Basic dividend valuation model accounts for the PV of all future dividends.

V=

Div1
(1 + ke)1

Div2
(1 + ke)2

Div

+ ... +

(1 + ke)

=S

Divt
(1 + ke)t

Divt: Cash dividend at time t k e: Equity investors required return

t=1

Adjusted Dividend Valuation Model

The basic dividend valuation model adjusted for the future stock sale.

V=
n:

Div1
(1 + ke)1

Div2
(1 + ke)2

Divn + Pricen + ... + (1 + k )n

e

Pricen:

The year in which the firms shares are expected to be sold. The expected share price in year n.

Dividend Growth Patterns

The dividend valuation model requires the forecast of all future dividends. The following dividend growth rate assumptions simplify the valuation process.

Constant Growth No Growth Growth Phases

Constant Growth Model

The constant growth model assumes that dividends will grow forever at the rate g.

D0(1+g) D0(1+g)2 D0(1+g) V = (1 + k )1 + (1 + k )2 + ... + (1 + k )

e e e

D1 = (ke - g)

D1:

Dividend paid at time 1.

g:
ke:

The constant growth rate.

Investors required return.

Constant Growth Model Example

Stock CG has an expected growth rate of 8%. Each share of stock just received an annual Rs.3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock? D1 = Rs.3.24 ( 1 + .08 ) = Rs.3.50 VCG = D1 / ( ke - g ) = Rs.3.50 / ( .15 - .08 ) Rs.50 =

Zero Growth Model

The zero growth model assumes that dividends will grow forever at the rate g = 0.

VZG =

D1
(1 + ke)1

D2
(1 + ke)2
D1: ke:

+ ... +

D
(1 + ke)

D1 ke

Dividend paid at time 1. Investors required return.

Zero Growth Model Example

Stock ZG has an expected growth rate of 0%. Each share of stock just received an annual Rs.3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock?

D1

= Rs.3.24 ( 1 + 0 ) = Rs.3.24

VZG = D1 / ( ke - 0 ) = Rs.3.24 / ( .15 - 0 ) = Rs.21.60

Growth Phases Model

The growth phases model assumes that dividends for each share will grow at two or more different growth rates.

V =S

D0(1+g1)t (1 + ke)t

t=1

S t=n+1

Dn(1+g2)t
(1 + ke)t

Growth Phases Model

Note that the second phase of the growth phases model assumes that dividends will grow at a constant rate g2. We can rewrite the formula as:

V =S

D0(1+g1)t (1 + ke)t

t=1

Dn+1

(1 + ke)n (ke - g2)

Growth Phases Model

Stock GP has an expected growth rate of 16% for the first 3 years and 8% thereafter. Each share of stock just received an annual Rs.3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock under this scenario?

Growth Phases Model

0 1 D1 2 D2 3 D3 4 D4 5 D5 6 D6

Growth of 16% for 3 years

Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%, starts at time t=0 for 3 years and is followed by 8% thereafter starting at time t=3. We should view the time line as two separate time lines in the valuation.

Growth Phases Model

0 1 D1 0 1 2 D2 2 3 D3 3 4 D4
Growth Phase #1 plus the infinitely long Phase #2

5 D5

6 D6

Note that we can value Phase #2 using the Constant Growth Model

Growth Phases Model

D4 V3 = k-g
0 1 2
We can use this model because dividends grow at a constant 8% rate beginning at the end of Year 3.

4 D4

5 D5

6 D6

Note that we can now replace all dividends from Year 4 to infinity with the value at time t=3, V3! Simpler!!

Growth Phases Model

0 1 D1 0 1 2 D2 2 3 D3 3 Where V3
New Time Line

D4 V3 = k-g

Now we only need to find the first four dividends to calculate the necessary cash flows.