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If an investor buys a bond and holds it to maturity, he knows exactly how much money he will collect in annual interest and how much he will eventually get back. Bond values are linked to the face value and the amount of annual interest and are therefore easier to calculate. Distressed Debt Things get trickier with bonds when a company gets into financial trouble. If there is a real risk of bankruptcy, or if a company hasdeclared bankruptcy, bondholders are not likely to get back the full face value of their holdings. The question becomes: How much can they expect to get? Investors who can accurately estimate the amount they can get for a distressed bond can make money by buying the bond below that value and either reselling it at a higher price or collecting on it through bankruptcy proceedings. Variables and Multiples Stocks are perpetual securities with no face value that investors can use as a basis for their calculations. Stock valuation is based on multiple variables, such as current and future earnings and dividends, price-to-earnings ratio, and a company's business prospects and financial condition. External factors such as economic and market conditions, political developments and investor sentiment can also impact the current and future stock price. Even if the estimates are accurate, it is next to impossible to combine all these variables into a workable valuation formula to get an accurate forecast. Depending on their opinions and outlooks, investors use different estimates and multiples and arrive at different values. Convertible Bonds Convertible bonds can be converted into shares of common stock under certain conditions. An investor must use both the bond's and the underlying stock's information to determine the value of a convertible bond. If upon conversion an investor stands to realize a capital gain, the bond will be valued on the basis of the underlying stock's value at conversion; if not, it will be valued like a regular bond.

and B). Part A has a higher growth dividend; Part B has a constant growth dividend. (For more, see How Dividends Work For Investors.) A) Higher Growth This part is pretty straight forward - calculate each dividend amount at the higher growth rate and discount it back to the present period. This takes care of the supernormal growth period; all that is left is the value of the dividend payments which will grow at a continuous rate. B) Regular Growth Still working with the last period of higher growth, calculate the value of the remaining dividends using the V = D1/(k-g) equation from the previous section. But D1 in this case would be next year's dividend, expected to be growing at the constant rate. Now discount back to the present value through four periods. A common mistake is discounting back five periods instead of four. But we use the fourth period because the valuation of the perpetuity of dividends is based on the end of year dividend in period four, which takes into account dividends in year five and on. The values of all discounted dividend payments are added up to get the net present value. For example if you have a stock which pays a $1.45 dividend which is expected to grow at 15% for four years then at a constant 6% into the future. The discount rate is 11%. Steps 1. Find the four high growth dividends. 2. Find the value of the constant growth dividends from the fifth dividend onward. 3. Discount each value. 4. Add up the total amount. Valuing the Common Stock of Companies with Supernormal Growth When valuing a common stock of a company which is experiencing significant growth, we take a similar approach to valuing the common stock with a multi-year holding period. The difference in the approaches is related to the dividend. A multiyear holding period approach assumes a stable dividend, whereas the dividend changes given the supernormal growth in this approach. Formula 13.5

Dividend Discount Model with Supernormal Growth Now that we know how to calculate the value of a stock with a constantly growing dividend we can move on to a supernormal growth dividend. One way to think about the dividend payments is in two parts (A

Example: Calculate the value of common stock with temporary supernormal growth An investor plans to hold Newco's stock for 3 years. In that time period, Newco plans to grow at a rate of 6% in the first two years and 3% thereafter. Newco's last dividend was $0.25. Given a rate of return of 10%, what is the value of Newco's common stock at the end of the three-year time period? Answer:

2.25) 2 2. or sales 2.00(1.20) 3 (1.25) 3 (1.15) 3 (1.00(1.289 Since we expect the dividend to grow indefinitely in year 3 and on.00(1.20) 2.25) 3 (1. .289 = 4. – All valuation approaches are affected by the estimated growth rate of the variable used in the valuation technique Valuation with Temporary Supernormal Growth Combine the models to evaluate the years of supernormal growth and then use DDM to compute the remaining years at a sustainable rate For example: With a 14 percent required rate of return and dividend growth of.25)(1.20) 2 1.265 + $0.142 1.00(1.25) 3 1.25) 2.265 D2 = (0.15) 2 2.00(1. 3.20) 3 (1.146 1. Dividend Growth Rate 25% 20% 15% 9% Year 1-3: 4-6: 7-9: 10 on: The value equation becomes Vi 2.10) (1.00(1. Valuation of Bonds Calculating the value of bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known. the present value of the stock price in year 3 is calculated as follows: P3 = 0.15) 3 1.20) 3 2.09) (1.289 + $4.14) 9 3.144 1.10) (1. the dividend in each time period must be calculated [D = D0(1+g)] D1 = (0. The payment of the principal on the bond’s maturity date . Approaches to the Valuation of Common Stock Two approaches have developed 1. book value.281)(1.148 1.03) The value of Newco's common stock is as follows: Newco'scs = $0.145 2.281 + 0.00(1.20) 3 (1.00(1.133 (0. A bond typically promises 1.281 D3 = (0. 2.265)(1.80 1 2 3 3 (1.14 1. Zero-growth – which assumes that all dividend paid by stocks remain the same.133 = $3.06) = 0.149 2.10-0. Constant growth model . Relative valuation technique • Approaches to the Valuation of Common Stock • Both of these approaches and all of these valuation techniques have several common factors: – All of them are significantly affected by investor’s required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate.15) 1. such as earnings.25) 3 (1. Discounted cash-flow valuation • Value of the stock is estimated based upon the present value of some measure of cash flow. Fast initial Slow transition that ultimately ends with a lower rate that Is sustainable over long period of time.25) 3 (1.25) 3 (1.00(1.06) = 0.To begin. cash flow. operating cash flow.03) = 0.00(1.25) (1. Variable growth model – divides growth into 3 phases: 1. and free cash flow Value estimated based upon its current price relative to significant variables.10) 3 Methods Used in the Dividend Discount Model (DDM) 1.09) (.14 .20)3 (1.143 3 3 2.10) (1. Interest payments every six months equal to one-half the coupon rate times the face value of the bond 2. including dividends.147 2.assumes that dividends grow by a specific percent annually.25) (1.

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