Issues in Corporate Finance

Valuation
Net Present Value; Stock Valuation
 Concepts of Valuation
• Time Value of Money
• Opportunity Cost
• Simple Interest
• Compound Interest
• Future Value
• Present Value
• Net Present Value (NPV)
• Frequency of Compounding
• Annuities
• Perpetuities
• Multiple Cash Flows
• Uneven Cash Flow Streams
• Bond Valuation
Opportunity Cost
• The cost of an alternative that must be forgone in order
to pursue a certain action.

• A benefit, profit, or value of something that must be

given up to acquire or achieve something else.
 Which would you rather have -- $1,000 today or
$1,000 in 5 years?

Obviously, $1,000 today.

Why?

• Risk

• Preference for consumption

• Investment Opportunities
 Simple Interest
• Simple interest is determined by multiplying the interest
rate by the principal by the number of periods.

Simple interest= P * I * N
Where:
P is the loan amount
I is the interest rate
N is the duration of the loan, using number of periods
Compound Interest
When interest is paid on not only the principal amount
invested, but also on any previous interest earned, this is called
compound interest.

FV = Principal + (Principal x Interest)

= 2000 + (2000 x .06)
= 2000 (1 + i)
= PV (1 + i)

Note: PV refers to Present Value or Principal

Future Value
(Graphic)
If you invested $2,000 today in an account that
pays 6% interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?
0 1 2
6%
$2,000
FV
Future Value
(Formula)
FV1 = PV (1+i)n = $2,000 (1.06)2
= $2,247.20

FV = future value, a value at some future point in time

PV = present value, a value today which is usually designated as time 0
i = rate of interest per compounding period
n = number of compounding periods

Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =

 Future Value Example
John wants to know how large his $5,000 deposit will
become at an annual compound interest rate of 8% at
the end of 5 years.

0 1 2 3 4 5
8%
$5,000
FV5
Future Value Solution
 Calculation based on general formula:
FVn = PV (1+i)n
FV5 = $5,000 (1+ 0.08)5
= $7,346.64
 Present Value

• Since FV = PV(1 + i)n.

PV = FV / (1+i)n.

• Discounting is the process of translating a future value or a set of

future cash flows into a present value.
Present Value (Graphic)
Assume that you need to have exactly $4,000 saved
10 years from now. How much must you deposit
today in an account that pays 6% interest,
compounded annually, so that you reach your goal of
$4,000?

0 5 10
6%
$4,000
PV0
Present Value Example
Joann needs to know how large of a deposit to
make today so that the money will grow to $2,500
in 5 years. Assume today’s deposit will grow at a
compound rate of 4% annually.

0 1 2 3 4 5
4%
$2,500
PV0
Present Value Solution
• Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $2,500/(1.04)5
= $2,054.81
Finding “n” or “i” when one knows PV and FV

• If one invests $2,000 today and has accumulated $2,676.45

after exactly five years, what rate of annual compound interest
was earned?
Frequency of
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn

n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
Frequency of Compounding Example

• Suppose you deposit $1,000 in an account that

pays 12% interest, compounded quarterly. How
much will be in the account after eight years if
there are no withdrawals?

PV = $1,000
i = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
Solution based on formula:

FV= PV (1 + i)n
= 1,000(1.03)32

= 2,575.10
Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.

• Examples of Annuities Include:

Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
• Ordinary Annuity: Continuing with the same example
from the Present Value of an Annuity page, the following
illustration shows how payments are applied in the case
of an ordinary annuity:
• Annuity-Due: With an annuity-due the payments are
made at the beginning rather than the end of the period
Example of an Ordinary Annuity -
- FVA
End of Year
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 + $1,000(1.07)1 +
$1,000(1.07)0 = $3,215
$3,215 = FVA3
If one saves $1,000 a year at the end of every year for three
years in an account earning 7% interest, compounded
annually, how much will one have at the end of the third
year?
 Example of anOrdinary Annuity -
- PVA
End of Year
0 1 2 3 4
7%

$1,000 $1,000 $1,000

$934.58
$873.44
$816.30
PVA3 = $1,000/(1.07)1 + $1,000/(1.07)2 +
$2,624.32 = PVA3
$1,000/(1.07)3 = $2,624.32
If one agrees to repay a loan by paying $1,000 a year at
the end of every year for three years and the discount
rate is 7%, how much could one borrow today?
 Multiple Cash Flows Example

Suppose an investment promises a cash flow of $500 in one

year, $600 at the end of two years and $10,700 at the end of
the third year. If the discount rate is 5%, what is the value of
this investment today?

0 1 2 3
5%
$500 $600 $10,700
PV0
Multiple Cash Flow Solution

0 1 2 3
5%
$500 $600 $10,700
$476.19
$544.22
$9,243.06

$10,263.47 = PV0 of the Multiple

Cash Flows
 Bond Valuation Problem

Find today’s value of a coupon bond with a maturity value of

$1,000 and a coupon rate of 6%. The bond will mature exactly
ten years from today, and interest is paid semi-annually. Assume
the discount rate used to value the bond is 8.00% because that is
your required rate of return on an investment such as this.

Interest = $30 every six months for 20 periods

Interest rate = 8%/2 = 4% every six months
Problem #1
You must decide between $25,000 in cash today or $30,000 in cash to
be received two years from now. If you can earn 8% interest on your
investments, which is the better deal?
Problem #2
• What is the value of $100 per year for four years, with the first cash
flow one year from today, if one is earning 5% interest, compounded
annually? Find the value of these cash flows four years from today.
Common Shares
• Common shares are evidence of ownership.

• Common shareholders own the firm.

• Common shares are a form of long-term financing for

a firm.

• Common shares are often called a residual security as

their value represents whatever assets are left after
all prior claims against the assets have been settled.

• Common shareholders elect the Board of Directors.

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Balance Sheet Accounts
• Par Value of Common Shares (can ignore for all
practical purposes)

• Contributed Capital in Excess of Par

• Additional paid in capital
• Capital surplus

• Retained earnings

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Book Value per Share
• The book value of a company’s assets attributable to each share of
common stock
Common Shares + Retained Earnings
Number of Shares Outstanding

Example: ZBC Corporation reports a common share account balance

of $10M and a retained earnings of $5M with 100M shares
outstanding. The book value per share is $0.15.

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Common Shareholder Rights
• Right to vote at shareholder meetings.

• Right to share in the profits of an organization (paid either as a

dividend or as reinvested profits).

• Right to share in the residual assets of an organization after all other

stakeholder (i.e. governments, creditors, employees) claims are
satisfied.

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Voting for the Board of Directors
• Majority voting
• Each share carries one vote
• Requires more than 50% of the votes to elect a Director

• Cumulative voting
• Each share carries as many votes as there are Directors
to be elected
• Shareholders may cast all votes for one candidate

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Voting by Proxy
• Shareholders may elect to assign their voting rights to someone else.

• Management actively solicits proxies.

• A dissent shareholder group may attempt to solicit proxies to wrest

control away from management.

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Common Share Features
• Certificate of ownership

• Classes
• Voting vs. non-voting

• Amount shareholder invests in common shares is the maximum

capital at risk (shares are said to be “fully paid and non-assessable”).

• Common shares are marketable securities that can be transferred

from one investor to another.

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Common Share Features
• Advantages
• Flexible
• Reduces financial risk

• Disadvantages
• Dilute Earnings Per Share
• Most expensive form of financing

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Common Share Transactions
• Cash Dividend
• Firm pays a portion of retained earnings in cash to shareholders based upon
number of shares owned (i.e. $0.60/share)

• Stock Dividend
• Funds transferred from retained earnings to the common share account.
• Shareholders receive certificate for additional shares.

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Common Share Transactions
• Stock Split
• Firm increases the number of shares outstanding by issuing a specific number
of new shares for every old shares outstanding
• Example: stock splits 3 for 1.

• Reverse Stock Split

• Firm decreases the number of shares outstanding by consolidating a specific
number of old shares into one share.
• Example: stock reverse split of 1 for 3

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Common Share Transactions
• Stock Repurchases
• Disposition of excess cash
• Repurchased shares are often cancelled
• Earnings power of remaining shares is increased
• Financial restructuring
• Future corporate needs (stock option plans)
• Reduction of takeover risk

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Valuation of Common Shares

• Cash flows attributable to a common stock accrue from:

• Dividend stream (while owning the stock)

• Sale price (the future dividends that would have been received from sale date
to perpetuity)

The market value of a common stock is

equal to the present value of its
expected future cash flows!

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Dividend Valuation Models
• Zero growth model

• Constant growth model

• Nonconstant growth model

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Dividend Valuation Models
• Zero Growth Model
• The cash flow (dividend) is expected to remain the same
over time.
• Identical to model applied to preferred shares

D1
P0 =
ke
D = Dividend at time period 1
k = Required Rate of Return

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Zero Growth: Example
• Firm ABC currently pays a dividend of $1.00 per share. This is
expected to remain the same into the foreseeable future. If
shareholders require a return of 20% to hold the stock, what is each
share worth in the market?

D1 1.00
P0 = 
k e 0.20
 $5.00

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Dividend Valuation Models
• Constant Growth Model
• The cash flow (dividend) is expected to increase at a
constant rate over time

D1
P0 =
ke - g
D1 = Dividend in Next Period [D1 = D0 x (1+g)]
k = Required Rate of Return
g = constant growth rate

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Constant Growth: Example
• Yesterday, Tinkerbell Corporation paid a dividend of $1.00 per share.
The dividend is expected to grow at a rate of 5% per year for the
foreseeable future. If the shareholders require a 15% return to hold
Tinkerbell shares, what is each share worth in the market?

D1 D0 1  g
P0 = 
ke - g ke - g
1.00 1.05 
  $10.50
0.15  0.05
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Dividend Valuation Models
• Nonconstant Growth Model
• Many firms grow rapidly for period of time. However, eventually, growth
slows to a long-run sustainable constant rate
• To deal with the nonconstant growth example, we simply present value all
dividends back to time period zero

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Nonconstant Growth: Example
• Tiny Toys Inc. is a new firm that is expected to grow at a 20% rate for
3 years. From then on, growth is expected to be 10% per year. The
firm paid a dividend of $1.00 yesterday. The dividend is expected to
grow at the same rate as the firm’s growth rate. If the shareholders
require a 15% return to hold the common stock, what is each share
worth in the market?

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Nonconstant Growth: Solution
• Draw a time line showing the expected cash flows. Each dividend
must be calculated, using the growth rate for the period.

0 20% 1 20% 2 20% 3 10% 4

∞
$1.00 $1.20 $1.44 $1.73 $1.90

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Nonconstant Growth: Solution
D1= D0 1+g D3= D2 1+g
= 1.00 1.20  = 1.44 1.20 
= $1.20 = $1.73

D2= D1 1+g D4= D3 1+g

= 1.20 1.20  = 1.73 1.20 
= $1.44 = $1.90

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Nonconstant Growth: Solution

D1 D2 D3  D4   1 
P0= + + +   
1+K e 1+Ke 2
1+Ke   Ke -g   1+Ke  
3 3

1.20 1.44 1.73  1.90  1 

      
1.15 1.15 2
1.15  0.15  0.10   1.15 
3 3

 1.0435  1.0888  1.1375  38  .6575 

 $28.25

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Nonconstant Growth: Helpful Hints
• Draw a timeline

• Calculate each dividend on the timeline

• During the period of nonconstant growth, present value dividends back to

time zero

• Once growth has stabilized:

• Calculate the present value of all dividends from that point forward out to infinity.
• Calculated value must be brought back to time zero.  1 
• Example: Dividend4, multiply by:  
 1+K  3
 e 
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Major Points
• Common shares are a form of long-term financing for a firm.

• The value of a common share is equal to the present value of its

future cash flows.

• The value of a common share is determined using:

• Zero growth model (preferred shares)
• Constant growth model (blue chip stocks)
• Nonconstant growth model (growth stocks)

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