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Corporate Financial Policy
Semester A 201213
City University of Hong Kong
AC4331 – Week 4
Topic 4
.
12
Introduction to Financial Management
Free Cash Flow
Financial Planning and Forecasting
Financial Assets and Time Value of Money
Risk and Return
Bond and Stock Valuation
Cost of Capital
Cash Flow Estimation and Risk Analysis
Capital Structure and Leverage
Treasury and Valuation
Enterprise Risk Management
Dividends and Share Repurchase
Merger and Acquisitions
Working Capital Management
Extra Ref:
Financial Management, Theory and Practice, 12e Eugene and
Brigham
Topic 4a:
Bond Valuation
54
Know the important bond features
and bond types
Understand bond values and why they
fluctuate
Understand bond ratings and what
they mean
Understand the impact of inflation on
interest rates
Understand the term structure of
interest rates and the determinants of
bond yields (WEEK 3)
Key Features of Bonds
Bond Valuation
Measuring Yield
Assessing Risk
95
56
Debt
◦ Not an ownership
interest
◦ Creditors do not have
voting rights
◦ Interest is considered a
cost of doing business
and is tax deductible
◦ Creditors have legal
recourse if interest or
principal payments are
missed
◦ Excess debt can lead to
financial distress and
bankruptcy
Equity
◦ Ownership interest
◦ Common stockholders
vote for the board of
directors and other issues
◦ Dividends are not
considered a cost of doing
business and are not tax
deductible
◦ Dividends are not a
liability of the firm, and
stockholders have no legal
recourse if dividends are
not paid
◦ An allequity firm cannot
go bankrupt
A longterm debt instrument in which a
borrower agrees to make payments of
principal and interest, on specific dates, to
the holders of the bond.
97
Primarily traded in the overthecounter
(OTC) market.
Most bonds are owned by and traded among
large financial institutions.
The Wall Street Journal reports key
developments in the Treasury, corporate, and
municipal markets. Online edition lists
trading for each day the most activelytraded
investmentgrade, highyield, and
convertible bonds.
98
Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply
by par value to get dollar payment of
interest.
Maturity date – years until the bond must be
repaid.
Issue date – when the bond was issued.
Yield to maturity – rate of return earned on
a bond held until maturity (also called the
“promised yield”).
99
Allows issuer to refund the bond issue if
rates decline (helps the issuer, but hurts the
investor).
Borrowers are willing to pay more, and
lenders require more, for callable bonds.
Most bonds have a deferred call and a
declining call premium.
910
Provision to pay off a loan over its life rather
than all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens average
maturity.
But not good for investors if rates decline
after issuance.
911
Call x% of the issue at par, for sinking fund
purposes.
◦ Likely to be used if r
d
is below the coupon rate and
the bond sells at a premium.
Buy bonds in the open market.
◦ Likely to be used if r
d
is above the coupon rate and
the bond sells at a discount.
912
N
N
2
2
1
1
r) (1
CF
...
r) (1
CF
r) (1
CF
Value
+
+ +
+
+
+
=
0 1 2 N
r%
CF
1
CF
N
CF
2
Value
...
913
Convertible bond – may be exchanged for common
stock of the firm, at the holder’s option.
Warrant – longterm option to buy a stated number
of shares of common stock at a specified price.
Putable bond – allows holder to sell the bond back to
the company prior to maturity.
Income bond – pays interest only when interest is
earned by the firm.
Indexed bond – interest rate paid is based upon the
rate of inflation.
914
The discount rate (r
i
) is the opportunity cost
of capital, and is the rate that could be
earned on alternative investments of equal
risk.
r
i
= r* + IP + MRP + DRP + LP
915
$1,000 V
$385.54 $38.55 ... $90.91 V
(1.10)
$1,000
(1.10)
$100
...
(1.10)
$100
V
B
B
10 10 1
B
=
+ + + =
+ + + =
916
0 1 2 N
r%
100
100 + 1,000
100
V
B
= ?
...
This bond has a $1,000 lump sum (the par
value) due at maturity (t = 10), and annual
$100 coupon payments beginning at t = 1
and continuing through t = 10, the price of
the bond can be found by solving for the PV
of these cash flows.
INPUTS
OUTPUT
N
I/YR PMT PV FV
10 10 100 1000
1000
917
This bond has an annual coupon payment of
$130. Since the risk is the same the bond
has the same yield to maturity as the
previous bond (10%). In this case the bond
sells at a premium because the coupon rate
exceeds the yield to maturity.
INPUTS
OUTPUT
N
I/YR PMT PV FV
10 10 130 1000
1184.34
918
This bond has an annual coupon payment of
$70. Since the risk is the same the bond has
the same yield to maturity as the previous
bonds (10%). In this case, the bond sells at a
discount because the coupon rate is less
than the yield to maturity.
INPUTS
OUTPUT
N
I/YR PMT PV FV
10 10 70 1000
815.66
919
What would happen to the value of these
three bonds if the required rate of return
remained at 10%?
920
Years
to Maturity
1,184
1,000
816
10
13% coupon rate
7% coupon rate
10% coupon rate
V
B
5 0
At maturity, the value of any bond must
equal its par value.
If r
d
remains constant:
◦ The value of a premium bond would decrease over
time, until it reached $1,000.
◦ The value of a discount bond would increase over
time, until it reached $1,000.
◦ A value of a par bond stays at $1,000.
921
10
d
10
d
1
d
N
d
N
d
1
d
B
) r (1
1,000
) r (1
90
...
) r (1
90
$887
) r (1
M
) r (1
INT
...
) r (1
INT
V
+
+
+
+ +
+
=
+
+
+
+ +
+
=
922
Must find the r
d
that solves this model.
Solving for I/YR, the YTM of this bond is
10.91%. This bond sells at a discount,
because YTM > coupon rate.
923
INPUTS
OUTPUT
N
I/YR PMT PV FV
10
10.91
90 1000  887
Solving for I/YR, the YTM of this bond is
7.08%. This bond sells at a premium,
because YTM < coupon rate.
INPUTS
OUTPUT
N
I/YR PMT PV FV
10
7.08
90 1000 1134.2
924

.

\

+

.

\

= =
=
=
CGY
Expected
CY
Expected
YTM return total Expected
price Beginning
price in Change
(CGY) y ield gains Capital
price Current
pay ment coupon Annual
(CY) eld Current y i
925
Find the current yield and the capital gains
yield for a 10year, 9% annual coupon bond
that sells for $887, and has a face value of
$1,000.
926
% 15 . 10 1015 . 0
887 $
90 $
eld Current yi
= =
=
YTM = Current yield + Capital gains yield
Could also find the expected price one year
from now and divide the change in price by the
beginning price, which gives the same answer.
927
% 76 . 0
10.15% 10.91%
CY YTM CGY
=
÷ =
÷ =
Interest rate risk is the concern that rising r
d
will cause the value of a bond to fall.
r
d
1year Change 10year Change
5% $1,048 $1,386
10% 1,000 1,000
15% 956 749
928
The 10year bond is more sensitive to
interest rate changes, and hence has
more interest rate risk.
+ 4.8%
– 4.4%
+38.6%
–25.1%
0
200
400
600
800
1,000
1,200
1,400
1,600
0 5 10 15 20
V
a
l
u
e
(
$
)
YTM (%)
929
10Year Bond
1Year Bond
Reinvestment rate risk is the concern that r
d
will fall, and future CFs will have to be
reinvested at lower rates, hence reducing
income.
EXAMPLE: Suppose you just won $500,000
playing the lottery. You intend to invest the
money and live off the interest.
930
You may invest in either a 10year bond or a
series of ten 1year bonds. Both 10year
and 1year bonds currently yield 10%.
If you choose the 1year bond strategy:
◦ After Year 1, you receive $50,000 in income and
have $500,000 to reinvest. But, if 1year rates fall
to 3%, your annual income would fall to $15,000.
If you choose the 10year bond strategy:
◦ You can lock in a 10% interest rate, and $50,000
annual income for 10 years, assuming the bond is
not callable.
931
CONCLUSION: Nothing is riskless!
932
Shortterm
AND/OR
Highcoupon
Bonds
Longterm
AND/OR
Lowcoupon
Bonds
Interest rate risk Low High
Reinvestment rate risk High Low
1.Multiply years by 2:
Number of periods = 2N
2.Divide nominal rate by 2:
Periodic rate (I/YR) = r
d
/2
3.Divide annual coupon by 2:
PMT = Annual coupon/2
INPUTS
OUTPUT
N
I/YR PMT PV FV
2N r
d
/2 cpn/2 OK OK
933
1.Multiply years by 2:
N = 2 x 10 = 20.
2.Divide nominal rate by 2:
I/YR = 13/2 = 6.5.
3.Divide annual coupon by 2:
PMT = 100/2 = 50.
INPUTS
OUTPUT
N
I/YR PMT PV FV
20 6.5 50 1000
 834.72
934
The semiannual bond’s effective rate is:
10.25% > 10% (the annual bond’s effective
rate), so you would prefer the semiannual
bond.
935
10.25% 1
2
0.10
1 1
M
r
1 EFF%
2 M
NOM
= ÷ 
.

\

+ = ÷


.

\

+ =
The semiannual coupon bond has an
effective rate of 10.25%, and the annual
coupon bond should earn the same EAR. At
these prices, the annual and semiannual
coupon bonds are in equilibrium, as they
earn the same effective return.
INPUTS
OUTPUT
N
I/YR PMT PV FV
10 10.25 100 1000
 984.80
936
The bond’s yield to maturity can be
determined to be 8%. Solving for the YTC is
identical to solving for YTM, except the time
to call is used for N and the call premium is
FV.
INPUTS
OUTPUT
N
I/YR PMT PV FV
8
3.568
50 1050  1135.90
937
3.568% represents the periodic semiannual
yield to call.
YTC
NOM
= r
NOM
= 3.568% x 2 = 7.137% is the
rate that a broker would quote.
The effective yield to call can be calculated.
YTC
EFF
= (1.03568)
2
– 1 = 7.26%
938
The coupon rate = 10% compared to YTC =
7.137%. The firm could raise money by
selling new bonds which pay 7.137%.
Could replace bonds paying $100 per year
with bonds paying only $71.37 per year.
Investors should expect a call, and to earn
the YTC of 7.137%, rather than the YTM of
8%.
939
In general, if a bond sells at a premium, then
(1) coupon > r
d
, so (2) a call is more likely.
So, expect to earn:
◦ YTC on premium bonds.
◦ YTM on par and discount bonds.
940
If an issuer defaults, investors receive less
than the promised return. Therefore, the
expected return on corporate and municipal
bonds is less than the promised return.
Influenced by the issuer’s financial strength
and the terms of the bond contract.
941
Mortgage bonds
Debentures
Subordinated debentures
Investmentgrade bonds
Junk bonds
942
Investment Grade Junk Bonds
Moody’s Aaa Aa A Baa Ba B Caa C
S & P AAA AA A BBB BB B CCC C
Bond ratings are designed to reflect the
probability of a bond issue going into
default.
943
Financial performance
◦ Debt ratio
◦ TIE ratio
◦ Current ratio
Qualitative factors: Bond contract provisions
◦ Secured vs. Unsecured debt
◦ Senior vs. subordinated debt
◦ Guarantee and sinking fund provisions
◦ Debt maturity
944
Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities
Potential labor problems
945
5
46
Default risk premium – remember bond
ratings
Taxability premium – remember municipal
versus taxable
Liquidity premium – bonds that have more
frequent trading will generally have lower
required returns (remember bidask spreads)
Anything else that affects the risk of the cash
flows to the bondholders will affect the
required returns.
5
47
How do you find the value of a bond, and
why do bond prices change?
What is a bond indenture, and what are
some of the important features?
What are bond ratings, and why are they
important?
How does inflation affect interest rates?
What is the term structure of interest rates?
What factors determine the required return
on bonds?
You are in charge of a fixedincome investment
fund. With a view that the economy may
encounter a hard landing next year and the
central bank will have no choice but to cut the
interest rate aggressively, you approached his
broker to buy the following bond:
Issuer : HK Asset Co Ltd
Credit Rating : AA
Par Value : $1,000,000
Original Maturity : 10 years
Remaining Maturity : 5 years
Coupon : 6.0%
Market Yield : 7.5%
48
Contrary to your expectation, the interest rate surged twelve
months later. Even worse, the rating agency downgraded HK
Asset’s credit rating to A. You decided to stop the loss on
this investment and obtained the following market
information:
5year 4year
Government Bond Yield: 8.5% 8.00%
Credit Spreads for Corporate Bonds
5year 4year
AAA 0.10% 0.05%
AA 0.30% 0.20%
A 0.60% 0.50%
BBB 0.85% 0.65%
49
(a) (i) How much have you paid to purchase
the bond? (4 marks)
(ii) What would be the amount that you could
receive by selling the bond? (4 marks)
(iii) How much would you lose from the
depreciation of the bond price? (1 mark)
Module B (February 2007 Session) Page 6 of 6
50
(i) Year 1 2 3 4 5
Coupon 60,000 60,000 60,000 60,000 1,060,000
Discount Rate 1.075 1.156 1.242 1.335 1.436
Discounted CF 55,814 51,920 48,298 44,928 738,352
Bond Price $939,312
(ii)
Year 1 2 3 4
Coupon 60,000 60,000 60,000 1,060,000
Discount Rate 1.085 1.177 1.277 1.386
Discounted CF 55,300 50,967 46,974 764,869
Bond Price $918,110
(iii)
Change in price = $918,110 – $939,312
= $21,202
51
Topic 4b:
Stock Valuation
53
Fundamentals of valuations
Valuation Methods
◦ Book Value
◦ Discounted Cash Flow Method
◦ Relative Method
Features of Common Stock
Determining Common Stock
Values using Dividend Growth
Model, Corporate Valuation
Model and Multiples
Preferred Stock
1054
Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Management’s goal: Maximize the stock
price
1055
Outside investors, corporate insiders, and
analysts use a variety of approaches to
estimate a stock’s intrinsic value (P
0
).
In equilibrium we assume that a stock’s price
equals its intrinsic value.
◦ Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell.
◦ Stocks with a price below (above) its intrinsic value
are undervalued (overvalued).
1056
1057
“True”
Investor
Returns
“True”
Risk
“Perceived”
Investor
Returns
“Perceived”
Risk
Managerial Actions, the Economic
Environment, Taxes, and the Political
Climate
Stock’s
Intrinsic
Value
Stock’s
Market Price
Market Equilibrium:
Intrinsic Value = Stock
Price
Discounted dividend model
Corporate valuation model
Using the multiples of comparable firms
1058
Value of a stock is the present value of the
future dividends expected to be generated by
the stock.
ˆ
·
·
3 1 2
0
1 2 3
s s s s
D D D D
P = + + + ... +
(1+r ) (1+r ) (1+r ) (1+r )
1059
ˆ
÷ ÷
0 1
0
s s
D (1+g) D
P = =
r g r g
1060
A stock whose dividends are expected to
grow forever at a constant rate, g.
D
1
= D
0
(1 + g)
1
D
2
= D
0
(1 + g)
2
D
t
= D
0
(1 + g)
t
If g is constant, the discounted dividend
formula converges to:
1061
t
t
t
) r 1 (
D
PVD
+
=
t 0
PVD P ¿ =
$
0.25
Years (t)
0
t
0 t
) g 1 ( D D + =
If g > r
s
, the constant growth formula leads
to a negative stock price, which does not
make sense.
The constant growth model can only be used
if:
◦ r
s
> g.
◦ g is expected to be constant forever.
1062
If r
RF
= 7%, r
M
= 12%, and b = 1.2, what is
the required rate of return on the firm’s
stock?
r
s
= r
RF
+ (r
M
– r
RF
)b
= 7% + (12% – 7%)1.2
= 13%
1063
1064
1.8761
1.7599
D
0
= 2.00
1.6509
r
s
= 13%
g = 6%
0 1
2.247
2
2.382
3
2.12
D
0
= $2 and g is a constant 6%.
Using the constant growth model:
$30.29
0.07
$2.12
0.06 0.13
$2.12
g r
D
P
ˆ
s
1
0
=
=
÷
=
÷
=
1065
D
1
will have been paid out already. So, P
1
is
the present value (as of Year 1) of D
2
, D
3
, D
4
,
etc.
Could also find expected P
1
as:
$32.10
0.06 0.13
$2.247
g r
D
P
ˆ
s
2
1
=
÷
=
÷
=
$32.10 (1.06) P P
ˆ
0 1
= =
1066
Dividend yield
= D
1
/P
0
= $2.12/$30.29 = 7.0%
Capital gains yield
= (P
1
– P
0
)/P
0
= ($32.10 – $30.29)/$30.29 = 6.0%
Total return (r
s
)
= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
1067
The dividend stream would be a perpetuity.
$15.38
0.13
$2.00
r
PMT
P
ˆ
0
= = =
2.00 2.00 2.00
0 1 2 3
r
s
= 13%
1068
Can no longer use just the constant growth
model to find stock value.
However, the growth does become constant
after 3 years.
1069
r
s
= 13%
g = 30% g = 30% g = 30% g = 6%
2.301
2.647
3.045
46.114
54.107 =
0 1 2 3 4
D
0
= 2.00 2.600 3.380 4.394 4.65
8
P
ˆ
0
$66.54
06 . 0 0.13
4.658
P
ˆ
3
=
÷
=
1070
Dividend yield (first year)
= $2.60/$54.11 = 4.81%
Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%
During nonconstant growth, dividend yield
and capital gains yield are not constant, and
capital gains yield ≠ g.
After t = 3, the stock has constant growth
and dividend yield = 7%, while capital gains
yield = 6%.
1071
1072
r
s
= 13%
g = 0% g = 0% g = 0% g = 6%
1.77
1.57
1.39
20.99
25.72 =
0 1 2 3 4
D
0
= 2.00 2.00 2.00
2.00
2.12
P
ˆ
0
$30.29
06 . 0 0.13
2.12
P
ˆ
3
=
÷
=
Dividend yield (first year)
= $2.00/$25.72 = 7.78%
Capital gains yield (first year)
= 13.00% – 7.78% = 5.22%
After t = 3, the stock has constant growth
and dividend yield = 7%, while capital gains
yield = 6%.
1073
Yes. Even though the dividends are
declining, the stock is still producing
cash flows and therefore has positive
value.
$9.89
0.19
$1.88
(0.06) 0.13
(0.94) $2.00
g r
) g (1 D
g r
D
P
ˆ
s
0
s
1
0
= =
÷
=
÷
+
=
÷
=
1074
Capital gains yield
= g = –6.00%
Dividend yield
= 13.00% – (–6.00%) = 19.00%
Since the stock is experiencing constant
growth, dividend yield and capital gains yield
are constant. Dividend yield is sufficiently
large (19%) to offset a negative capital gains.
1075
Also called the free cash flow method.
Suggests the value of the entire firm equals
the present value of the firm’s free cash
flows.
Remember, free cash flow is the firm’s after
tax operating income less the net capital
investment.
FCF = EBIT(1 – T) + Depreciation Expense –
Net capital investment
1076
Find the market value (MV) of the firm, by
finding the PV of the firm’s future FCFs.
Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
Divide MV of common stock by the number
of shares outstanding to get intrinsic stock
price (value).
1077
Often preferred to the discounted dividend
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
Similar to discounted dividend model,
assumes at some point free cash flow will
grow at a constant rate.
Terminal value (TV
N
) represents value of firm
at the point that growth becomes constant.
1078
Given: LongRun g
FCF
= 6% and WACC = 10%
1079
r
= 10%
g = 6%
4.545
8.264
15.026
398.197
416.942
0 1 2 3 4
5 21.2
0
3
TV
06 . 0 0.10
21.20
530 =
÷
=
10 20
1080
The firm has $40 million total in debt and
preferred stock and has 10 million shares of
stock.
÷
÷
MV of equity = MV of firm MV of debt
=$416.94 $40
=$376.94 million
Value per share = MV of equity / # of shares
=$376.94 /10
=$37.69
The firm’s total value is calculated as follows:
Using your financial calculator, enter the following inputs:
CF
0
= 0; CF
1
= 3000000; CF
2
= 6000000; CF
3
= 10000000;
CF
4
= 15000000 + 321000000 = 336000000; I/YR = 12;
and then solve for NPV = $228,113,612.
1081
What is the firm’s intrinsic value
per share?
To find Barrett’s stock price, you need to first find
the value of its equity. The value of Barrett’s
equity is equal to the value of the total firm less
the market value of its debt and preferred stock.
Total firm value $228,113,612
Market value, debt + preferred 60,000,000
Market value of equity $168,113,612
1082
What is the firm’s intrinsic value
per share?
Analysts often use the following multiples to
value stocks.
◦ P/E
◦ P/CF
◦ P/Sales
EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an estimate
of the stock price.
1083
Hybrid security.
Like bonds, preferred stockholders receive a
fixed dividend that must be paid before
dividends are paid to common stockholders.
However, companies can omit preferred
dividend payments without fear of pushing
the firm into bankruptcy.
1084
1085
p
p
p
D
V =
r
$5
$50=
r
ˆ
p
$5
r =
$50
=0.10 =10%
86
What are three main methods of valuation?
What determines the price of a share of stock?
What determines g and R in the DGM?
Discuss the importance of the PE ratio.
Bond Duration
87
For Point 5.8, Source: Financial Markets and Institutions by Mishkin
and Eakins , 7
th
Edition
DUR= t
CP
t
1+ i ( )
t
t =1
n
¿
CP
t
1+ i ( )
t
t =1
n
¿
Duration is a measure of bond price sensitivity to
change in yield
One can derivate the duration measure by taking
derivatives of the following bond formula with
respect to the yield to maturity
P =
C
1+ i ( )
+
C
1+ i ( )
2
+
C
1+ i ( )
3
+ ...+
C
1+ i ( )
n
+
F
1+ i ( )
n
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
%AP ~ ÷DUR×
Ai
1 +i
%AP ~ ÷6.76×
0.01
1 + 0.10
%AP ~÷0.0615= ÷6.15%
i  10% to 11%:
◦ Table 34, ÷10% coupon bond
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
i  10% to 11%:
◦ 20% coupon bond, DUR = 5.72 years
%AP ~ ÷5.72×
0.01
1 + 0.10
%AP ~÷0.0520= ÷5.20%
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
The greater is the duration of a security, the
greater is the percentage change in the
market value of the security for a given
change in interest rates
Therefore, the greater is the duration of a
security, the greater is its interestrate risk
Copyright © 2009 Pearson
Prentice Hall. All rights reserved.
Key facts about duration
1. All else equal, when the maturity of a bond
lengthens, the duration rises as well
2. All else equal, when interest rates rise, the
duration of a coupon bond fall
3. The higher is the coupon rate on the bond, the
shorter is the duration of the bond
4. Duration is additive: the duration of a portfolio of
securities is the weightedaverage of the durations
of the individual securities, with the weights
equaling the proportion of the portfolio invested in
each
Matching the durations of bank assets and
liabilities
In 1980s, the duration of assets in US savings
and loans associations (S&Ls) were
mismatched with longterm fixedrate
mortgage and shortterm deposits, the whole
industry failed when market interest rate rose
to double digit
s liabilitie asset
D D =