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Rationale

General Valuation Model

Valuing Bonds

Bond yields

Valuing Preference Stock

Valuing Common Stock

Rate of Return

Rationale

Value of an asset is derived from the cash

flows associated with that asset.

This applies whether the asset is a financial

asset or a real asset.

The cash flows must be evaluated on a

present value basis.

Thus the value of any asset at time 0 would

then be the discounted value of net cash

flows over a relevant time horizon.

General Valuation Model

C1 C2 Cn

V0 = + ++

(1 + i)1 (1 + i)2 (1 + i)n

V0 = Value at time 0

C = Year's cash flow

i = Annual interest rate

n = Number of years

Example

A three-year asset with cash flows of Rs 2000

in year one, Rs 3000 in year two and Rs 5000

in year three would be valued at Rs 9144 if

interest is 4% as follows :

1 2000 .962 = Rs 1924

2 3000 .925 = Rs 2775

3 5000 .889 = Rs 4445

Rs 9144

Example contd.

What it means if the current price is more or

less than Rs 9144

What shall be market behavior for

equilibrium

Efficient vs. Inefficient markets

Overview of Cost of Capital

definitions

The rate of return a firm must earn on its

projects or investments to maintain the

market value of its stock, assuming

constant risk

The rate of return required by the market

suppliers of capital to attract their funds

to the firm

Basic Assumptions

Business Risk

likelihood that a company will have lower

than anticipated profits or experience

loss instead of profit.

Financial Risk

likelihood of a company going bankrupt

and its inability to pay its debts

After-Tax Costs

Risk

Risk

Composition of Financing Cost

The general relationship between risk and

financing costs can be explained by the following

equation:

kl = RF + bp + fp

WHERE:

kl = specific cost of a given source of long-

term financing

RF = risk-free cost of a given type of financing

bp = business risk premium

fp = financial risk premium

Basic Concept

Cost of capital is measured at a given point in time

Cost of capital reflects the interrelatedness of

financing activities

Cost of capital assumes a deliberate financing mix

called a target capital structure

Given the target capital structure, the firms overall

cost of capital - often measured as the "weighted

average cost of capital" - is of greatest importance

Example

A firm that has a target capital structure of 40% debt

and 60% equity should consider the long run overall

cost of capital when making capital budgeting

decisions. If, for example, debt financing is available

at a cost of 8% (after tax) and equity financing is

available at a cost of 15%, the weighted average

long-term cost of capital is [(.40 x 8%) + (.60 x 15%)]

= 12.2%, reflecting the interrelatedness of financing

decisions. Decisions made with the weighted

average cost of capital in mind generally are in the

best interests of the firm and its shareholders.

The Cost of Specific Sources of

Capital

There are four basic sources of long-term funds

Long-term debt

Preferred stock

Common stock

Retained earnings

after-tax cost of obtaining the financing today

The techniques used to determine specific costs of

capital generate rough approximations due to their

numerous assumptions and underlying forecasts

Valuing Bonds

Bonds are corporate security representing

debt of the company.

Can be easily valued since the cash flows

are easy to identify.

The cash flows associated with bonds are

the coupon payments on the bond for each

coupon period and the maturity value or

face value of the bond.

Most bonds pay coupons semi-annually

Cost of Bond

Example - 2

Price a 5% coupon, Rs1000 bond with 5

years to maturity if other bonds of similar

quality are sold to yield 8%.

1-10 Rs 25 8.111 = Rs 202.78

10 Rs1000 .676 = Rs 676.00

Rs 878.78

Example 3 Post Tax Cost

Example 3 Post Tax Cost

Valuing Preferred Stock

Preferred stock is an equity instrument

Technically it is a perpetuity.

The annual return in dollars for a share of

preferred stock would be the dividend rate

To value a perpetuity, simply take the

annual return in dollars and divide by the

appropriate discount rate

Valuing Preferred Stock

D

P0 =

kp

D = Annual dividend in Rs

Kp = Investors required rate of return

Valuing Preferred Stock - Example

per share. The stock will pay $8 per year in

dividends. Flotation costs of $3 per share

were incurred by the firm. Find kp

k

p = $8 = $ 8 = .1067 or 10.67%

$78-$3 $75

Valuing Equity Stock

The cash flows are not stable or easily

identified.

One simple model that is sometimes used

to value common stock is the Gordon

Dividend Valuation Model.

Valuing Equity Stock

D 1

k =

e + g

P0

D1 = Annual dividend of next year in Rs

Ke = Investors required rate of return

P0 = Current Price

g = Dividend growth rate

Example

it expects to pay a dividend of $1.76 per share

next year, and dividends have been growing at a

compound annual rate of 5%. Find ke?

$1.76

ke = + .05 = .08 + .05 = .13 or 13%

$ 22

Capital Asset Pricing Model

Beta Computation

Capital Asset Pricing Model

Beta Computation

Slope Method

Regression Method

Example

the market return is 11.5%, find ks.

=12.875%

WACC

(WACC) is computed with the use of the

corporation's existing capital structure

Determine the percentage composition of each

source of capital in the capital structure (The

"Weight")

Multiply the specific cost of each source of

capital by its weight

Sum the products and you have the WACC

WACC

ka = (wi x kd) + (wp x kp) + (ws x ke or kn)

WHERE:

structure

wp = Proportion of preferred stock in the capital

structure

ws = Proportion of common equity in the capital

structure

Note: wi + wp + ws = 1.0

Example

The Axis Company seeks a target capital structure

of 40% long-term debt, 20% preferred stock, and

40% common stock equity. Assuming that Axis

can obtain long-term financing at the after tax

costs of 7.32% for debt, 10.67% for preferred

stock, and 13% for common stock equity, find ka

.02928 + .02134 + .052 = .10262 or 10.26%

END

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