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The Valuation of Long-Term

Securities

The process of determining the current worth of an


asset or company.
There are many techniques that can be usedto
determinevalue,some are subjective and others are
objective.

For example, an analyst valuing a company may look at the


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.

Items that are usually valued are a financial asset or


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.

Valuation of financial assets is done using one or more of these


types of models:

Absolute value models that determine the present value of an


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

greater the uncertainty about an assets


future benefits, the higher the discount rate
investors will apply when discounting those
benefits to the present.

The

valuation process links an assets risk and


return to determine its price.

Future Cash Flows

Risk

Valuation

A bond is a debt security, where money/capital is


borrowed and is to be paid back along with interest.

More specifically, bonds mature in more than 10 years, notes in less


than 10 years, and bills in less than one year. In this presentation
we will use the term bond to refer to all maturities.

Bonds are known as fixed income securities.

All of the future payments to be made on the bond are fixed or


predetermined, as stated in the bond contract.

The current value of a bond is defined as the Present


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

bond: the issuer has right to retire the bond


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

bond: bond is secured or collateralized by


some physical asset in case the issuer defaults.
Commonly used in the transportation industry.

Convertible bond: bond can be converted into a


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.

Debenture bond: bond is backed by the issuers


ability to generate future cash flow to make the
promised payments. There is no collateral.

Sinking fund provision: issuer may be required to


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.

A perpetual bond is a bond that never matures. It


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,

Bond P has a $1,000 face value and provides an 8%


coupon. The appropriate discount rate is 10%. What
is the value of the perpetual bond?
bond

= $1,000 ( 8%) = $80.


$80

kd

= 10%.
10%

= I / kd

[Reduced Form]

= $80 / 10% = $800.


$800

A non-zero coupon-paying bond is a coupon-paying


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

Bond C has a $1,000 face value and provides an


8% annual coupon for 30 years. The appropriate
discount rate is 10%. What is the value of the
coupon bond?

= $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)


= $80 (9.427) + $1,000 (.057)
[Table IV]
= $754.16 + $57.00
= $811.16.
$811.16

[Table II]

A zero-coupon bond is a bond that pays no interest


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

Bond Z has a $1,000 face value and a 30-year life.


The appropriate discount rate is 10%. What is the
value of the zero-coupon bond?

V
$57.00

= $1,000 (PVIF10%, 30)


= $1,000 (.057)

Most bonds pay interest twice a


year (1/2 of the annual coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2

A non-zero coupon bond adjusted for semiannual


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

Bond C has a $1,000 face value and provides


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 (PVIFA5%, 30) + $1,000 (PVIF5%, 30)


= $40 (15.373) + $1,000 (.231)
[Table IV]

[Table II]

= $614.92 + $231.00

= $845.92

The yield to maturity is the average annual rate of return that a


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)

Steps to calculate the rate of return


(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

Determine the Yield-to-Maturity (YTM) for the


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

Ali want to determine the YTM for an issue of


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

= $100(PVIFA9%,15) + $1,000(PVIF9%, 15)

$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(PVIFA7%,15) + $1,000(PVIF7%, 15)


= $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

YTM = .07 + .0024 = .0724 or 7.24%

$192

Determine the Yield-to-Maturity (YTM) for


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

Ali want to determine the YTM for another issue


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?

Determine the Yield-to-Maturity


(YTM) for the semiannual couponpaying bond with a finite life.
[ 1 + (kd / 2) ]2 -1 = YTM
[ 1 + (.042626) ]2 -1 = .0871
or 8.71%

This technique will calculate kd. You


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!)

Discount Bond -- The market required rate of return


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).

Preferred Stock is a type of stock that promises a (usually) fixed


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

Stock has preference over common stock in the

payment of dividends and claims on assets.


Par

Value: The par value represents the claim of the preferred

stockholder against the value of the firm.


Preferred

Dividend / Preferred Dividend Rate

The preferred dividend rate is expressed as a percentage of the par


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,

This reduces to a perpetuity!


perpetuity

V = DivP / kP

Stock PS has an 8%, $100 par value issue


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

Determine the yield for preferred stock with


an infinite life.
P0 = DivP / kP
Solving for kP such that
kP = DivP / P0

Assume that the annual dividend on each share of


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%

Common stock represents the ownership of a corporation.


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.

The primary focus here is placed on Intrinsic Value.


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.

Basic dividend valuation model accounts for the PV


of all future dividends.

V=

Div1
(1 + ke)1

Divt

t=1

(1 + ke)t

Div2
(1 + ke)2

+ ... +

Div
(1 + ke)

Divt: Cash Dividend


at time t
ke:

Equity investors
required return

The basic dividend valuation model


adjusted for the future stock sale.

V=

Div1
(1 + ke)1

n:
Pricen:

Div2
(1 + ke)2

Divn + Pricen
+ ... +
(1 + k )n
e

The year in which the firms


shares are expected to be sold.
The expected share price in year n.

The dividend valuation model requires the


forecast of all future dividends. The
following dividend growth rate assumptions
simplify the valuation process.
Constant Growth
No Growth
Growth Phases

The term constant growth indicates that a firm is


mature and is expected to grow at an assumed
constant rate g throughout the future.

The term growth rate typically refers to the growth of the


firms cash dividends; however, everything associated with the
firm is also assumed to grow at the same rate g.

If a firm is expected to have a variable rate of


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.

The constant growth model assumes that


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:

Dividend paid at time 1.

g:

The constant growth rate.

ke:

Investors required return.

Stock CG has an expected dividend


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

A common stock whose future dividends are not


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

VZG =

D1
(1 + ke)1

D1
ke

D2
(1 + ke)2

+ ... +

(1 + ke)

D1:

Dividend paid at time 1.

ke:

Investors required return.

Stock ZG has an expected growth rate of


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

VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )


= $21.60

The growth phases model assumes


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

Note that the second phase of the


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

(1 + ke)n (ke - g2)

Stock GP has an expected growth rate of 16%


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 16% for 3 years

Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%,


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

Note that we can value Phase #2 using the


Constant Growth Model

D
4
V3 =
k-g
0

We can use this model because


dividends grow at a constant 8%
rate beginning at the end of Year 3.

D4

D5

D6

Note that we can now replace all dividends from year


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

D1

D2

D3

New Time
Line

Where
V3

D4
V3 =
k-g

Now we only need to find the first four dividends


to calculate the necessary cash flows.

Determine the annual dividends.


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

3.76 4.36 5.06


0

3
78

Actual
Values

5.46
Where $78 =
.15-.08

Now we need to find the present


value of the cash flows.

We determine the PV of 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

Finally, we calculate the intrinsic value by


summing all of cash flow present values.

V = $3.27 + $3.30 + $3.33 + $51.32


3

V=

V = $61.22
D0(1+.16)t
1

t=1

+
t

(1 + .15)

D4

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

Assume the constant growth model is


appropriate. Determine the yield on the common
stock.
P0 = D1 / ( ke - g )
Solving for ke such that
ke = ( D1 / P0 ) + g

Assume that the expected dividend (D1) on each share


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:

Suppose we have $1000, and Diet Coke costs $2.00 per


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?

A. Dollars. Our return is


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

The percentage increase of our return is 10%.


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

(523.81 - 500)/500 = 23.81/500 = 4.76%

The percentage increase of our return is 4.76%.

Real versus nominal returns:

Your nominal return is the percentage


change in the amount of money you have.
Your real return is the percentage change
in the amount of stuff you can actually buy.

The relationship between real and nominal returns is


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