10

Valuation and Rates of

Return
Block, Hirt, and Danielsen
Foundations of Financial Management
18th edition

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 Learning Objectives

• Know the valuation of a financial asset is based

on the present value of future cash flows.
• Recognize that the required rate of return in
valuing an asset is based on the risk involved.
• Recall that bond valuation is based on the
process of determining the present value of
interest payments plus the present value of the
principal payment at maturity.
• Explain the basis of preferred stock valuation.
• Explain how stock valuation is determined.

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 Chapter Opening (Figure 10-1)
• Valuation of financial assets
• Helps to determine how financial assets are valued
• Bonds, preferred stock, and common stock
• Helps to determine how investors establish rates of return
• Cost of corporate financing (capital) is used in analyzing feasibility of
investment on ensuing project

Figure 10-1 The Relationship between time value of money, required

return, cost of financing, and investment decisions

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What are bonds with examples?
Bond:

Financial Meaning With

Examples and How They Are
Priced
A bond is a fixed-income
instrument that represents a
loan made by an investor to a
borrower (typically corporate or
governmental). A bond could be
thought of as an I.O.U. between
the lender and borrower that
includes the details of the loan
and its payments.

What Is an IOU? An IOU, a

phonetic acronym of the words "I
owe you," is a document that
acknowledges the existence of a
debt.
What do you mean by preferred
stock?

Preferred stock is a different type

of equity that represents
ownership of a company and the
right to claim income from the
company's operations. Preferred
stockholders have a higher claim
on distributions (e.g. dividends)
than common stockholders

What are examples of preferred

stock?
Preferred stock is issued with a par
value, often $25 per share, and
dividends are then paid based on a
percentage of that par. For example,
if a preferred stock is issued with a
par value of $25 and an 8 percent
annual dividend, this means the
dividend payment will be $2 per
share.
 Common stock - also called
common shares, capital shares, or
capital stock - represents units of
ownership in a corporation.

Is capital stock the same as

common stock?

Capital stock is the common

Example of Capital Stock
If a company obtains authorization to raise
$5 million and its stock has a par value of
$1, it may issue and sell up to 5 million
shares of stock. The difference between
the par value and the sale price of the
stock is logged under shareholders' equity
as additional paid-in capital.
stock and preferred stock that a
company is allowed to issue
according to its corporate
charter. Common and Preferred
stock can be separated into
different classes of stock with
their own features. In
accounting, capital stock is one
part of the equity section on a
balance sheet.
 Valuation Concepts
• Valuation of a financial asset is based on
determining present value of future cash flows
• Required rate of return (discount rate)
• Depends on market’s perceived level of risk associated
with individual security
• Also competitively determined among companies
seeking financial capital
• Implies investors willing to accept low return for low
risk and vice versa
• Previous efficient use of capital results in lower
required rate of return for investors

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 Valuation of Bonds
• Bond provides an annuity stream of interest
payments and principal payment at maturity
• Cash flows discounted at Y (the yield to maturity)
• Value of Y determined in bond market
• Price of bond equals
• Present value of regular interest payments
discounted
by the yield to maturity
• Added to present value of principal (also discounted
by
the yield to maturity)
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 Valuation of Bonds Continued
n
b It
P 

• Pb = Price of bond; It = Interest payments; Pn =
Principal payment at maturity; t = Number corresponding
to period (running from 1 to n); n = Number of periods; Y
= Yield to maturity (or required rate of return)
• Assuming interest payments (It) = $100; principal payments at
maturity (Pn) = $1,000; yield to maturity (Y) = 10%; total
number of periods (n) = 20; price of bonds (Pb):
n
Pb   $100

$1,000
t
1 (1 0.10)t (1 0.10)20
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 Present Value of Interest Payments

• To determine present value of $100 annuity for

20 years with discount rate of 10 percent

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 Present Value of Principal Payment
(Par Value) at Maturity
• Principal payment at maturity used interchangeably with par value or face
value of bond
• Discounting $1,000 back to present at 10 percent

• Current price of bond, based on present value of interest payments and

present value of principal payment at maturity:
Present value of interest payments $851.36
Present value of principal payment at maturity $148.64
Total present value (price) of bond $1,000.00

• Here, price of bond is essentially same as its par, or stated, value to be

received at maturity of $1,000

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 Using Excel’s PV to Calculate a
Bond Price
• Bond values can be found using PV function:

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 Concept of Yield to Maturity
• Yield to maturity, or discount rate, is the
bondholders’ required rate of return
• Three factors influence required rate of return
• Real rate of return
• Demanded for giving up the current use of the funds on a
noninflation-adjusted basis (“rent”)
• Inflation premium
• Compensation for the eroding effect of inflation on the value of
the dollar
• Added to the real rate of return to ensure this doesn’t happen
• Risk premium
• Toward special risks of an investment
• Of primary interest are business risk and financial risk

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 Concept of Yield to Maturity
Continued
• Business Risk—Inability of firm to retain competitive
position, stability, growth in its earnings
• Financial risk—Inability of firm to meet debt obligations
when they come due
• Real rate of return 3 percent; inflation premium 4
percent; risk premium 3 percent; overall required rate
of return 10 percent

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 Changing the Yield to Maturity and the
Impact on Bond Valuation
• Assume inflation premium goes up from 4 to 6 percent,
everything else constant

• Present value of interest payments

• $100 annuity for 20 years at 12 percent discount rate

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 Changing the Yield to Maturity and the
Impact on Bond Valuation Continued 1
• Present value of principal payment at maturity
• Present value of $1,000 after 20 years at 12 percent discount rate

• Total present value

• Assumes increased inflation increases required rate of return,
decreases bond price by approximately $150

Present value of interest payments $746.94

Present value of principal payment at maturity $103.67
Total present value (price) of bond $850.61

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 Changing the Yield to Maturity and the
Impact on Bond Valuation Continued 2
• Decrease in inflation premium
• Required rate of return decreases to 8 percent, where 20-year bond with
10 percent interest rate will sell for:

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 Changing the Yield to Maturity and the
Impact on Bond Valuation Concluded
• Decrease in inflation premium cont’d
• Total present value
Present value of interest payments $981.81
Present value of principal payment at maturity $214.55
Total present value, or price, of the bond $1,196.36

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 Table 10-1 Bond Prices Given Various Yields
to Maturity (20-year bond, 10% coupon)
• As yield to maturity on bond changes from
stated interest rate on bond, price
change increases in size

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 Time to Maturity
• Time to maturity influences impact of change
in yield to maturity on valuation
• Longer maturity means greater impact of
changes in yield
• Amount (premium) above par value reduced as
number of years to maturity decreases
• Amount (discount) below par value reduced with
progressively fewer years to maturity
• Effect of time to maturity on bond price
sensitivity
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 Table 10-2 Impact of Time to Maturity
on Bond Prices

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 Figure 10-2 Relationship between Time
to Maturity and Bond Price

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 Determining Yield to Maturity from
the Bond Price
• Yield to maturity (Y) that will equate interest
payments (It) and principal payments (Pn)
to price of bond (Pb)

n
It
Pb  

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 Using Goal Seek in Excel

1. Calculate arbitrary bond price by putting

interest rate in cell D1
2. Open Goal Seek feature
3. Enter reference for cell with bond price
formula in “Set cell” box
4. Type price of bond in “To value” box
5. Enter reference for cell with discount
rate in
“By changing cell” box
6. Click “OK”
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 Table 10-3 Excel Functions for YTM

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 Figure 10-3 Finding the Goal Seek
Function in Excel

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 Semiannual Interest and Bond Prices
• 10 percent interest rate may be paid as $50 twice per
year in case of semiannual payments
• To convert
1. Divide annual interest rate by 2
2. Multiply number of years by 2
3. Divide annual yield to maturity by 2
• Assume a 10 percent, $1,000 par value bond has 20-
year maturity, annual yield 12 percent
1. 10%/2 = 5% semiannual interest rate; 5% × $1,000 = $50
semiannual interest
2. 20 × 2 = 40 periods to maturity
3. 12%/2 = 6% yield to maturity, expressed on semiannual
basis

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 Valuation and Preferred Stock
• Preferred stock represents perpetuity, having
no maturity date
• Fixed dividend payment carrying a higher order of
precedence than common stock dividends
• No binding contractual obligation of interest on
debt
• Does not have
• Ownership privilege of common stock
• Legal provisions that could be enforced on debt

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 Valuation and Preferred Stock
Continued
Dp Dp Dp Dp
Pp    ...
(1 K p ) 1
(1 Kp ) 2
(1 K p ) 3
(1 Kp )
• PP = price of preferred stock; DP = annual dividend for preferred
stock (a constant value); KP = required rate of return (discount rate)
applied to preferred stock dividends
Dp
• More usable formula
Pp 
Kp
• Assuming $10 annual dividend and stockholder requires 10 percent rate
of return, price of the preferred stock is:
Dp
$10
Pp   
K p $100
0.10

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 Valuation and Preferred Stock
Concluded
• If rate of return required by security holders' changes, value
of preferred stock also changes
• Longer period of investment = greater impact of change in
required rate of return
• With perpetual security the impact is at a maximum
• Assuming required rate of return has increased to 12
percent,
Dp is:$10
value of preferred stock
Pp   
K p $83.33
0.12
• If required rate of return reduced to 8 percent, value of
preferred stock is:
Dp $10
Pp   
K p $125
0.08
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 Determining the Required Rate of
Return (Yield) from the Market Price

• Assuming the annual preferred dividend (Dp) is $10, and the

price of the preferred stock (Pp) is $100, the required rate of
return (yield) is: D p$10
Kp   
Pp 10%
$100
• A higher market price provides quite a decline in the yield

$10
K p  $130  7.69%

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 Valuation of Common Stock
• Interpreted by shareholder as present value of
expected stream of future dividends
• Ultimate value of holding lies with
• Distribution of earnings in form of dividend
payments
• Earnings must be translated into cash flow for
stockholder

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 Dividend Valuation Model
D1 D2 D3 D
P0    ...
(1 K e ) (1 Ke )
1 2
(1 Ke ) 3
(1 K e )
• Where,
• P0 = Price of stock today;
• D = Dividend for each year;
• Ke = Required rate of return for common stock (discount rate)
• Generally applied (with modifications) to three different
situations
1. No growth in dividends
2. Constant growth in dividends
3. Variable growth in dividends

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 No Growth in Dividends
• Common stock pays constant dividend as in preferred stock
• No-growth policy does not hold much appeal for investors
D1
P0 
Ke
• P0 = Price of common stock today
• D1 = Current annual common stock dividend (constant)
• Ke = Required rate of return for common stock
• Assuming D1 = $1.87 and Ke = 12 percent, price of stock is:

$1.87
P0  0.12  $15.58

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 Constant Growth in Dividends

• General valuation process

D (1 g)1 D (1 g) 2 D (1 g)3
P0  (1
0
K )1
0

0

• P0 = Price of common stock today

• D0 (1 + g)1 = Dividend in year 1, D1
• D0 (1 + g)2 = Dividend in year 2, D2, etc.
• g = Constant growth rate in dividends
• Ke = Required rate of return for common stock (discount rate)

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 Constant Growth in Dividends
Continued
• Assume:
• D0 = Dividend for last 12 months (assume $1.87)
• D1 = First year, $2.00 (growth rate, 7%)
• D2 = Second year, $2.14 (growth rate, 7%)
• D3 = Third year, $2.29 (growth rate, 7%) etc.
• Ke = Required rate of return (discount rate), 12%

0 $2.001 (1.12)
(1.12) $2.14 2 (1.12)
$2.29 3 Infinite dividend
P    ...
(1.12)

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 Constant Growth Dividend
Valuation Model
• The formula shown can be modified to a simple form if
1. The firm has a constant dividend growth rate (g)
2. The discount rate (Ke) exceeds the growth rate (g)
D1
P0 
where, Ke 
P0 = Price of the stock today g
D1 = Dividend at the end of the first year
Ke = Required rate of return (discount rate)
g = Constant growth rate in dividends
• Based on the current example: D1 = $2.00;
Ke = 0.12; g = 0.07; P0 is computed
as P0  D1  $2.00 $2.00
K e  g 0.12  0.07 0.05  $40


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 Stock Valuation Based on
Future Stock Value
• To know present value of investment
• Assume stock held for three years then sold
• Adding present value of three years of dividends and
present value of stock price after three years gives
present value of benefits
• The appropriate formula

D4
P3 
Ke 
g

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 Determining the Required Rate of
Return from the Market Price
• Determining required rate of return, knowing first year’s
dividend (D1), stock price (P0) , and growth rate (g)

Assuming
• Ke = Required rate of return (to be solved)
• D1 = Dividend at end of first year, $2.00
• P0 = Price of stock today, $40
• g = Constant growth rate 7%

$2.00
K  $40  7%  5%  7% 
e

12%
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 Determining the Required Rate of Return
from the Market Price Continued
• Stockholder receives current dividend plus anticipated
growth in future
• If dividend yield low, the growth rate must be high to
provide
necessary return
• If growth rate low, a high dividend yield will be expected

• First term represents dividend yield stockholder will receive

• Second represents anticipated growth in dividends, earnings,
and stock price

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 The Price-Earnings Ratio Concept
and Valuation
• Multiplier applied to current earnings to
determine value of share of stock in the
market
• Influenced by
• Earnings and sales growth of firm
• Risk (or volatility in performance)
• Debt-equity structure of firm
• Dividend policy
• Quality of management

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 Figure 10-4 Quotations from
finance.yahoo.com

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 Variable Growth in Dividends
• In evaluating firm with initial pattern of supernormal
(very rapid) growth for a number of years
• Take present value of dividends during exceptional growth
period
• Determine price of stock at end of supernormal growth
period by taking
• Present value of normal, constant dividends that follow
supernormal growth period
• Discount the price to the present
• Add to present value of supernormal dividends
• This gives current price of stock

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 Variable Growth in
Dividends Continued
• Approach 1 (though no dividends paid currently)
• Stockholders will be paid cash dividends at later date
• Present value of deferred payments may be used
• Approach 2 (no cash dividends)
• Take present value of earnings per share for several
periods
• Add to present value of future anticipated stock
price
• Discount rate applied to future earnings generally
higher
than discount rate applied to future dividends

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 Figure 10A-1 Stock Valuation Under
Supernormal Growth Analysis

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