Chapter 5

Valuation
Concepts

2005 Thomson/South-Western
 Basic Valuation
The Time Value of Money = the value of
anything is based on the PV of the CFs the
asset is expected to produce in the future.

Asset
^
CF
^
CF
^
CF
V 1
2
N
value 1 k 1 k
1 2
1 k N

N
^
CF
t k = required return-- based on

t1 1 k t riskiness and economic conditions

2
 Valuation of Financial Assets: Bonds
Key Inputs
Cash Flows
Timing
RRR (RISK) the greater the risk of the CF the
lower its value
CAPM: the greater the risk the greater the
RRR (Discount rate)

3
 Valuation of Bonds
Principal, Face/Maturity/Par Value: borrowed and
promised to repay at future date, often at maturity.
Coupon Payment: The specified $ of interest paid
each period (6 months).
Coupon Interest Rate: The stated annual rate of
interest paid on a bond.
Maturity Date: Repayment date of the par value
Original Maturity: the years to mat. at issued date
Call Provision: right to pay off bonds prior to mat

4
Bond Value:
10 yr bond, BD1000 FV, 10% coupon rate
INT M

V N
d
t 1

1 k t 1 k N
d d
OR: Vd = (INTt x PVAIFt) + (Mn x PVIFn)
kd = RRR on a debt instrument
N = no. of years before the bond matures
INT = dollars of interest paid each year (Coupon rate x Par value)
M = par/face value of the bond to be paid off at maturity

5
Fin 320 Dr. B. Asiri - 2010 Class work 2 - Bond Valuation
You have decided to invest in 10-year bond with a face value of BD1000 and a coupon rate of 10%.
a) Compute the present market value for the bond.
b) If you held the bond for two years, what is the new market value?
c) Suppose due to some economic conditions the rate of interest dec to 8%, what is the new mkt value?
d) Suppose the required rate is constant over the life of the bond, compute the present mkt value for the bond for the
period 10 to maturity.
e) If due to some economic pressure the rate of interest inc to 12%, what will be the mkt value?
f) If the required return is constant over the period of the bond, compute the mkt value of the bond for years 10 to 0.

Years I = 10% I = 8% I =12%

10
9
8
7
6
5
4
3
2
1
0
 Changes in Bond Values Over Time
The value of the bond is rarely constant
Forces of the economy
Passage of the time

If market rate = coupon rate, the bond will sell at par value.
If market rate > coupon rate, the bond will sell at discount.
If market rate < coupon rate, the bond will sell at premium.

The bond value approaches Face Value at maturity for all

cases.

7
 Year kd = 10% kd = 15% kd = 20%
0 $1,380.30 $1,000.00 $766.23
1 $1,368.33 $1,000.00 $769.47
2 $1,355.17 $1,000.00 $773.37
3 $1,340.68 $1,000.00 $778.04

Time path of value

4 $1,324.75 $1,000.00 $783.65
5 $1,307.23 $1,000.00 $790.38
of a 15% Coupon, 6 $1,287.95 $1,000.00 $798.45
$1000 par value 7 $1,266.75 $1,000.00 $808.14
8 $1,243.42 $1,000.00 $819.77
bond when interest 9 $1,217.76 $1,000.00 $833.72
rates are 10%, 10 $1,189.54 $1,000.00 $850.47
15%, and 20% 11
12
$1,158.49
$1,124.34
$1,000.00
$1,000.00
$870.56
$894.68
13 $1,086.78 $1,000.00 $923.61
14 $1,045.45 $1,000.00 $958.33
15 $1,000.00 $1,000.00 $1,000.00
8
 Changes in Bond Values Over Time
Time path of value of a 15% Coupon, $1000 par
value bond when interest rates are 10%, 15% & 20%
Bond Value
$1,500
kd < Coupon Rate
$1,250
kd = Coupon Rate
$1,000
$750 kd > Coupon Rate
$500
$250
$0
1 3 5 7 9 11 13 15
Years 9
 Yield to maturity (YTM)
YTM: The rate of return investors earn if they buy the bond
at a specific price and hold it until maturity. (Given the mkt
value of a bond what return do investors expect?)

If Vb = par, YTM always = I

If Vb par, YTM should be computed

Current yield = Annual interest / market value.

10
 Finding the Interest Rate on a
Bond: Yield to Maturity

YTM is the average rate of return earned on a bond

if it is held to maturity. Annual Accrued

Approximate interest capital gains

yield to maturity Average value of bond
M - Vd
INT
(does not consider time
N
value of money)
2 Vd M
3 11
 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.

12
Valuation of Equity (common stock)
What is a stock?
Ownership of a company
Dividends (Expected and current)
Capital gain (Future > current price)
Expected price
Required, actual and expected returns
Factors affecting stock price
Managers action
EPS
Inflation
EXPECTATION
others 13
 Stock Valuation Models:
Key terms
D t E(dividend ) to be recieved at the end of yr t
D 0 the recent dividend paid
D1 the next E(dividend ) to be paid (end of this yr)
D 2 E(dividend ) at the end of two years
All future dividends are expected values, ...
estimates may differ among investors.

14
 Stock Valuation Models:
Key terms
P0 current market price
P0 the value of an asset that , in the mind
of an investor, is justified by the facts;
may differ from the asset' s current
market price, its book value , or both.
Pt the E(price) at the end of each yr t.
g E(rate) of change in dividends per share.
15
 Stock Valuation Models:
Key terms
ks the min rate of return given its risks and returns
D1 P1 P0
Dividend yield Capital gain
P0 P0
k s the E rate of return on a common
stock an investor expects to receive
D1 P1 P0

P0 P0
ks rate of return investor actually receives,
dividend yield capital gains yield
16
 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.

17
 Expected Dividends as
the Basis for Stock Values

Value of Stock Vs P 0 PV of expected future dividends

D1 D 2 D
P0
1 k s 1
1 k s 2
1 k s

D t

t 1 1 k s t

18
 Stock Values with Zero Growth
A Zero Growth Stock is a common stock whose
future dividends are not expected to grow at all.

g 0, and D 1 D 2 D D 0
D D D
P0
1 k s 1 k s
1 2
1 k s

D
Perpetuity
ks 19
 Normal, or Constant, Growth
(Gordon Model)
g = a constant

D 0 1 g 1
D 0 1 g 2
D 0 1 g
P0
1 k s
1
1 k s 2
1 k s

D 0 1 g D1

ks g ks g
20
 Expected Rate of Return on a
Constant Growth Stock
Dividend yield (Expected)
Expected growth rate, or capital gains yield

D1
k s g
P0
21
 Valuing Stocks: 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.

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, and
3. Add these two components to find the intrinsic
value of the stock P0.
22
 Stock Market Equilibrium

1. The expected rate of return as seen by the

marginal investor must equal the required
rate of return, k
^ =k .
x x

2. The actual market price of the stock must

equal its intrinsic value as estimated by the
marginal investor, P ^ P
0 = 0.

23
The Efficient Markets Hypothesis
The weak form of the EMH states that all
information contained in the past price
movements is fully reflected in current
market prices.
The semistrong form states that current
market prices reflect all publicly available
information.
The strong form states that current market
prices reflect all pertinent information,
whether publicly available or privately held.

24
 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.

25
 Valuation of Real
(Tangible) Assets
^
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?
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 Cash Flow Time Lines
0 14% 1 2 3 4 5

$120,000 $100,000 $150,000 $80,000 $50,000

PV of $120,000
PV of $100,000
PV of $150,000
PV of $80,000
PF of $50,000
Asset Value =V0
$120,000 $100,000 $150,000 $80,000 $50,000
$356,790
1.14
1
1.14 2
1.14
3
1.14 4
1.14
5