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Securities

asset or company.

There are many techniques that can be usedto

determinevalue,some are subjective and others are

objective.

company's management, the composition of its capital structure,

prospectof future earnings, and market value of assets.

Judging the contributions of a company's management would be

more of a subjective valuation technique, while calculating

intrinsic value based on futureearnings would be an objective

technique.

liability. Valuations can be done on assets (for

example, investments in marketable securities such

as stocks, options, business enterprises, or intangible

assets such as patents and trademarks) or on

liabilities (e.g., bonds issued by a company).

Valuations are needed for many reasons such as

investment analysis, capital budgeting, merger and

acquisition transactions, financial reporting, taxable

events to determine the proper tax liability etc.

types of models:

asset's expected future cash flows. These kinds of models take

two general forms: multi-period models such as discounted cash

flow models or single-period models such as the Gordon model.

These models rely on mathematics rather than price observation.

Relative value models determine value based on the observation of

market prices of similar assets.

Option pricing models are used for certain types of financial

assets (e.g., warrants, put options, call options, employee stock

options, investments with embedded options such as a callable

bond) and are a complex present value model. The most common

option pricing models are the BlackScholes-Merton models and

lattice models.

The

future benefits, the higher the discount rate

investors will apply when discounting those

benefits to the present.

The

return to determine its price.

Risk

Valuation

borrowed and is to be paid back along with interest.

than 10 years, and bills in less than one year. In this presentation

we will use the term bond to refer to all maturities.

predetermined, as stated in the bond contract.

Value of all the future cash flows to be received by the

bondholder.

A bond promises to pay a predetermined stream of future cash

flows.

Callable

before maturity, at a predetermined price that is

always specified in the bond contract.

Almost all corporate bonds are callable. If interest rates

then fall in the future, firms can retire these existing

bonds and replace them with new lower rate bonds.

Callable bonds will command a higher interest rate or yield

(lower price) than a comparable risk non-callable bond.

Mortgage

some physical asset in case the issuer defaults.

Commonly used in the transportation industry.

predetermined number of shares of common stock.

Investors are willing to accept a lower yield on such

bonds. The right to convert may become very

valuable.

A convertible bond thus has the opportunity to become an

exciting investment if the firm does unexpectedly well.

ability to generate future cash flow to make the

promised payments. There is no collateral.

retire a certain amount of an issue each year. For

example, having to retire 10% of a 20 year bond issue

each year from year 11 to year 20.

Bond contract (indenture): a legal contract between

the issuer and bondholders that specifies all of the

terms and conditions of the bond issue.

has an infinite life.

V=

I

(1 + kd)1

t=1

(1 + kd)t

V = I / kd

I

(1 + kd)2

or

+ ... +

I

(1 + kd)

I (PVIFA k

[Reduced Form]

d,

coupon. The appropriate discount rate is 10%. What

is the value of the perpetual bond?

bond

$80

kd

= 10%.

10%

= I / kd

[Reduced Form]

$800

bond with a finite life.

V=

I

(1 + kd)1

t=1

(1 + kd)

V = I (PVIFA k

I

(1 + kd)2

+ ... +

I + MV

(1 + kd)n

MV

(1 + kd)n

) + MV (PVIF kd, n)

d, n

8% annual coupon for 30 years. The appropriate

discount rate is 10%. What is the value of the

coupon bond?

= $80 (9.427) + $1,000 (.057)

[Table IV]

= $754.16 + $57.00

= $811.16.

$811.16

[Table II]

but sells at a deep discount from its face value; it

provides compensation to investors in the form of

price appreciation.

V=

MV

(1 + kd)n

= MV (PVIFk

d, n

The appropriate discount rate is 10%. What is the

value of the zero-coupon bond?

V

$57.00

= $1,000 (.057)

year (1/2 of the annual coupon).

Adjustments needed:

(1) Divide kd by 2

(2) Multiply n by 2

(3) Divide I by 2

compounding.

I

/

2

I

/

2

I

/

2

+

MV

V =(1 + k /2 )1 +(1 + k /2 )2 + ... +

2 n

d

2*n

t=1

I/2

(1 + kd /2 )

= I/2 (PVIFAk

(1 + kd/2 ) *

MV

(1 + kd /2 ) 2*n

) + MV (PVIFkd /2 , 2*n)

/2 ,2*n

an 8% semiannual coupon for 15 years. The

appropriate discount rate is 10% (annual rate).

What is the value of the coupon bond?

V

= $40 (15.373) + $1,000 (.231)

[Table IV]

[Table II]

= $614.92 + $231.00

= $845.92

bondholder will earn under the following assumptions:

The bond is held to maturity

The interest payments are reinvested at the YTM

The rate of return a bond investor actually earns depends on

the bond price paid.

Note that bonds usually sell at market prices quite different

from their face value, so investors can earn actual rates of

return quite different from the bonds coupon rate.

The yield to maturity is the same as the bonds internal rate of

return (IRR)

(or yield).

1. Determine the expected cash flows.

flows

2. Replace the intrinsic value (V) with the market

price (P0).

3. Solve for the market required rate of return that

equates the discounted cash flows to the market

price.

price

coupon-paying bond with a finite life.

P0 =

t=1

I

(1 + kd )t

= I (PVIFA k

MV

+

(1 + kd )n

) + MV (PVIF kd , n)

d,n

kd = YTM

outstanding bonds of $1000 face value. The

bond has an issue of 10% annual coupon bonds

with 15 years left to maturity. The bonds have

a current market value of $1,250.

$1,250

What is the YTM?

$1,250

$1,250

= $100(8.061) + $1,000(.275)

$1,250

= $806.10 + $275.00

=$1,081.10

[Rate is too high!]

$1,250

$1,250

$1,250

= $100(9.108) + $1,000(.362)

= $910.80 + $362.00

= $1,272.80

[Rate is too low!]

.02

X=

.07

YTM

.09

$1273

$1250

$1081

($23)(0.02)

$192

$23

X = .0024

$192

the semiannual coupon-paying bond with a finite

life.

P0 =

2n

t=1

I/2

(1 + kd

+

/2 )

t

= (I/2)(PVIFAk

MV

(1 + kd /2 )2n

) + MV(PVIFkd /2 , 2n)

d /2, 2n

[ 1 + (kd / 2) ]2 -1 = YTM

of outstanding bonds. The firm has an issue of 8%

semiannual coupon bonds with 20 years left to

maturity. The bonds have a current market value of

$950.

What is the YTM?

(YTM) for the semiannual couponpaying bond with a finite life.

[ 1 + (kd / 2) ]2 -1 = YTM

[ 1 + (.042626) ]2 -1 = .0871

or 8.71%

must then substitute it into the

following formula.

[ 1 + (kd / 2) ]2 -1 = YTM

[ 1 + (.0852514/2) ]2 -1 = .0871

or 8.71% (same result!)

exceeds the coupon rate (Par > P0 ).

Premium Bond -- The coupon rate exceeds the market

required rate of return (P0 > Par).

Par Bond -- The coupon rate equals the market required

rate of return (P0 = Par).

dividend, but at the discretion of the board of directors.

Preferred

Par

Preferred

value of the preferred stock. The annual preferred dividend is

determined by multiplying the preferred dividend rate times the par

value of the preferred stock.

V=

DivP

(1 + kP)

DivP

+ (1 + k

DivP

t=1

(1 + kP)

P)

+ ... +

DivP

(1 + kP)

or DivP(PVIFA k

P,

perpetuity

V = DivP / kP

outstanding. The appropriate discount rate

is 10%. What is the value of the preferred

stock?

stock

DivP

kP

V

= $100 ( 8% ) = $8.00.

$8.00

= 10%.

10%

= DivP / kP = $8.00 / 10%

= $80

an infinite life.

P0 = DivP / kP

Solving for kP such that

kP = DivP / P0

preferred stock is $10. Each share of preferred stock

is currently trading at $100. What is the yield on

preferred stock?

kP = $10 / $100.

kP = 10%.

10%

The holders of debt or bonds have a senior claim on the firm.

Stockholders have a residual claim, what remains after other

obligations met, including any new asset investment in the firm.

Stocks are risky investments; however, we seek to understand

the basics of stock valuation and how to price the risk.

Current stock prices reflect todays expectations of future

cash flow performance of firms and the risk of these cash

flows.

Expectations concerning future performance can never be

proven in the present.

Firms pay out excess (residual) cash to shareholders primarily

as: (1) cash dividends and (2) share repurchases.

Intrinsic Value is the Present Value of all future

forecasted cash flows.

We define Free Cash Flow to Equity (FCFE) as the firms

excess cash flow that can be paid out through both dividends

and stock repurchases.

We calculate the PV of all future forecasted FCFE at a

discount rate or cost of equity capital Ke that is (assumed to

be) estimated using the Capital Asset Pricing Model (CAPM)

which will be covered in next classes.

of all future dividends.

V=

Div1

(1 + ke)1

Divt

t=1

(1 + ke)t

Div2

(1 + ke)2

+ ... +

Div

(1 + ke)

at time t

ke:

Equity investors

required return

adjusted for the future stock sale.

V=

Div1

(1 + ke)1

n:

Pricen:

Div2

(1 + ke)2

Divn + Pricen

+ ... +

(1 + k )n

e

shares are expected to be sold.

The expected share price in year n.

forecast of all future dividends. The

following dividend growth rate assumptions

simplify the valuation process.

Constant Growth

No Growth

Growth Phases

mature and is expected to grow at an assumed

constant rate g throughout the future.

firms cash dividends; however, everything associated with the

firm is also assumed to grow at the same rate g.

growth in the coming years, then constant growth

valuation is not appropriate. However, we will always

assume that constant growth does begin somewhere

out in the future.

dividends will grow forever at the rate g.

D0(1+g) D0(1+g)2

D0(1+g)

V = (1 + k )1 + (1 + k )2 + ... + (1 + k )

D1

=

(ke - g)

D1:

g:

ke:

growth rate of 8%. Each share of stock

just received an annual $3.24 dividend.

The appropriate discount rate is 15%.

What is the value of the common stock?

stock

D1 = $3.24 ( 1 + .08 ) = $3.50

VCG = D1 / ( ke - g ) = $3.50 / ( .15 - .

08 )

= $50

expected to grow at all; that is, g = 0.

VZG =

D1

(1 + ke)1

D1

ke

D2

(1 + ke)2

+ ... +

(1 + ke)

D1:

ke:

0%. Each share of stock just received an

annual $3.24 dividend per share. The

appropriate discount rate is 15%. What

is the value of the common stock?

stock

D1

= $3.24 ( 1 + 0 ) = $3.24

= $21.60

that dividends for each share will

grow at two or more different

growth rates.

n

V =

t=1

D0(1+g1)

(1 + ke)

Dn(1+g2)t

t=n+1

(1 + ke)t

growth phases model assumes that

dividends will grow at a constant rate

g2. We can rewrite the formula as:

n

V =

t=1

D0(1+g1)t

(1 + ke)t

Dn+1

for the first 3 years and 8% thereafter. Each

share of stock just received an annual $3.24

dividend per share. The appropriate discount

rate is 15%. What is the value of the

common stock under this scenario?

D1

D2

D3

D4

D5

D6

Growth of 8% to infinity!

starts at time t=0 for 3 years and is followed by 8%

thereafter starting at time t=3. We should view the

time line as two separate time lines in the valuation.

D1

D2

D3

Growth Phase

#1 plus the infinitely

long Phase #2

D4

D5

D6

Constant Growth Model

D

4

V3 =

k-g

0

dividends grow at a constant 8%

rate beginning at the end of Year 3.

D4

D5

D6

4 to infinity with the value at time t=3, V3! Simpler!!

D1

D2

D3

New Time

Line

Where

V3

D4

V3 =

k-g

to calculate the necessary cash flows.

D0 = $3.24 (this has been paid already)

D1 = D0(1+g1)1 = $3.24(1.16)1 =$3.76

D2 = D0(1+g1)2 = $3.24(1.16)2 =$4.36

D3 = D0(1+g1)3 = $3.24(1.16)3 =$5.06

D4 = D3(1+g2)1 = $5.06(1.08)1 =$5.46

0

3

78

Actual

Values

5.46

Where $78 =

.15-.08

value of the cash flows.

PV(D1) = D1(PVIF15%, 1) = $3.76 (.870) = $3.27

PV(D2) = D2(PVIF15%, 2) = $4.36 (.756) = $3.30

PV(D3) = D3(PVIF15%, 3) = $5.06 (.658) = $3.33

P3 = $5.46 / (.15 - .08) = $78 [CG Model]

PV(P3) = P3(PVIF15%, 3) = $78 (.658) = $51.32

summing all of cash flow present values.

3

V=

V = $61.22

D0(1+.16)t

1

t=1

+

t

(1 + .15)

D4

(1+.15)n (.15-.08)

appropriate. Determine the yield on the common

stock.

P0 = D1 / ( ke - g )

Solving for ke such that

ke = ( D1 / P0 ) + g

of common stock is $3. Each share of common stock is

currently trading at $30 and has an expected growth

rate of 5%. What is the yield on common stock?

ke = ( $3 / $30 ) + 5%

ke = 15%

Key issues:

What is the difference between a real return and a

nominal return?

How can we convert from one to the other?

Example:

six pack. We can buy 500 six packs. Now suppose the

rate of inflation is 5%, so that the price rises to $2.10

in one year. We invest the $1000 and it grows to $1100

in one year. Whats our return in dollars? In six packs?

($1,100 - $1,000)/$1,000 = $100/$1,000 = .10.

B. Six packs. We can buy $1,100/$2.10 = 523.81 six

packs, so our return is

change in the amount of money you have.

Your real return is the percentage change

in the amount of stuff you can actually buy.

described by the Fisher Effect. Let:

R =

the nominal return

r

=

the real return

h =

the inflation rate

According to the Fisher Effect:

1 + R = (1 + r) x (1 + h)

From the example, the real return is 4.76%; the

nominal return is 10%, and the inflation rate is 5%:

(1 + R) = 1.10

(1 + r) x (1 + h) = 1.0476 x 1.05 = 1.10

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