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CHAPTER

TEN

Valuation and Rates of


Return

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Foundations of Financial PPT 10-1


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Figure 10-1 / The relationship between time value of money,


required return, cost of financing, and investment decisions
Chapter 10
Required rates of
return by investors

Chapter 9
Present
value
concepts

Chapter 11

Chapters 12 and 13

Cost of
financing
to the firm

Analysis of
projects based
on cost of financing
to the firm

Valuation
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Foundations of Financial PPT 10-2


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Table 10-1
Bond price table
(10 Percent Interest Payment, 20 Years to Maturity)
Yield to Maturity

Bond Price

2% . . . . . . . . . . . . $2,308.11
4 . . . . . . . . . . . . 1,815.42
6 . . . . . . . . . . . . 1,458.80

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8
9

. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . .

1,317.82
1,196.36
1,091.29

10
11
12

. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . .

1,000.00
920.37
850.61

13
14
16

. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . .

789.26
735.07
644.27

20
25

. . . . . . . . . . . .
. . . . . . . . . . . .

513.04
406.92
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Table 10-2
Impact of time to maturity on bond prices
Time Period
in Years
(of 10 percent bond)

Bond Price with


8 Percent Yield
to Maturity

Bond Price with


12 Percent Yield
to Maturity

0
1
5

. . . . . . . .
. . . . . . . .
. . . . . . . .

$1,000.00
1,018.52
1,079.85

$1,000.00
982.14
927.90

10
15
20

. . . . . . . .
. . . . . . . .
. . . . . . . .

1,134.20
1,171.19
1,196.36

887.00
863.78
850.61

25
30

. . . . . . . .
. . . . . . . .

1,213.50
1,225.16

843.14
838.90

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Figure 10-2
Relationship between time to maturity and bond price*
Bond Price ($)
Assumes 8% yield to maturity

1,300
1,200
1,100

10% bond, $1,000 par value

1,000
900
800

Assumes 12% yield to maturity

700

30
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25

15
5
Number of years to maturity

* The relationship in the graph is not symmetrical in nature.


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Table 10-3
An example of stock quotations from the Globe and Mail

Source: ILX Systems, a division of Thomson Information Services Inc.


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Stock valuation under supernormal growth analysis

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Chapter 10 - Outline

LT 10-1

Valuation Concepts
3 Factors that Influence the Required Rate of
Return
Valuation of Bonds
Relationship Between Bond Prices and Yields
Preferred Stock
Valuation of Common Stock
Valuation Using the Price-Earnings Ratio
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Valuation concepts

LT 10-2

Value or price of a stock or bond is based upon the present


value of future cash flows to the investor

Discount rate used is investors required rate of return,


based on the markets estimates of risk, efficiency, and
expected future returns
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3 Factors that Influence the


Required Rate of Return

LT 10-3

Real Rate of Return:


represents the opportunity cost of the investment
in the early 1990s, 5-7%, but now about 3-4%
Inflation Premium:
a premium to compensate for the effects of inflation
lately, 2%
Risk Premium:
a premium associated with business and financial risk
typically, 2-6%
So, the Required Rate of Return equals:
Real Rate of Return + Inflation Premium + Risk
Premium

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Valuation of Bonds

LT 10-4

The value of a bond is made up of 2 parts:


PV of the interest payments (an annuity)
PV of the principal payment (a lump sum)
The principal payment at maturity:
can also be called the par value or face value
is usually $1,000

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The interest rate used:


is the yield to maturity or discount rate
is also the required rate of return
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Relationship Between
Bond Prices and Yields

LT 10-5

Bond prices are inversely related to bond yields (move in


opposite directions)
As interest rates in the economy change, the price or value
of a bond changes:
if the required rate of return increases, the price of the
bond will decrease
if the required rate of return decreases, the price of the
bond will increase
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Valuation of Preferred Stock

LT 10-6

Preferred stock:
usually represents a perpetuity (something with no
maturity date)
has a fixed dividend payment
is valued without any principal payment since it has no
ending life
is considered a hybrid security
owners have a higher priority than common
shareholders
price is based upon PV of future dividends
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Valuation of Common Stock

LT 10-7

The value of common stock is the present value of a stream


of future dividends
Common stock dividends can vary, unlike preferred stock
dividends
There are 3 possible cases:
No growth in dividends (valued like preferred stock)
Constant growth in dividends
Variable growth in dividends
Required rate of return reflects the dividend yield on the
stock and the expected growth rate in the dividend
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Valuation Using the


Price-Earnings Ratio

LT 10-8

The Price-Earnings (P/E) ratio can also be used to value


common stocks
The P/E ratio is influenced by many factors:
the earnings and sales growth of the firm
the risk (or volatility in performance)
the debt-equity structure
the dividend policy
the quality of management
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Average P/E ratio for TSE 300 in early 1999 was 27 to 1


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High vs. Low P/Es

LT 10-9

A high P/E ratio:


indicates positive expectations for the future of the
company
means the stock is more expensive relative to earnings
typically represents a successful and fast-growing
company

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A low P/E ratio:


indicates negative expectations for the future of the
company
may suggest that the stock is a better value or buy
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