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Chapter
10
McGraw-Hill/Irwin
Valuation and
Rates of Return
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Valuation of assets, based on the present
value of future cash flows
• The required rate of return in valuing an
asset based on the risk involved
• Bond valuation and determination of present
value of interest and maturity payments
• Preferred stock valuation based on dividend
paid
• Stock valuation and determination of present
value of future benefits
10-2
Valuation of Financial Assets
• Helps in evaluating financial commitment a firm needs to make to:
– Stockholders and bondholders
– Attract investment
• Cost of corporate financing (capital) is used in analyzing the feasibility
of an investment on an ensuing project
• The relationship between time value of money, required return, cost of
financing, and investment decisions is shown in the following diagram:
10-3
Valuation Concepts
• Valuation of a financial asset is based on
determining the present value of future cash
flows
– Required rate of return (the discount rate)
• Depends on the market’s perceived level of risk
associated with the individual security
• It is also competitively determined among companies
seeking financial capital
• Implying that investors are willing to accept low return
for low risk and vice versa
• Efficient use of capital in the past results in a lower
required rate of return for investors
10-4
Valuation of Bonds
• A bond provides an annuity stream of
interest payments and a principal payment at
maturity
– Cash flows are discounted at Y (yield to maturity)
– Value of Y is determined in the bond market
– The price of the bond is equal to:
• The present value of regular interest payments
discounted at Y
• Added to the present value of the principal (also
discounted at Y)
10-5
Valuation of Bonds (cont’d)
• Where:
•
= Price of the bond; = Interest payments;
= Principal payment
at maturity; t = Number corresponding to a period (running from 1 to n);
n = Number of periods; Y = Yield to maturity (or required rate of return)
• Assuming interest payments ( ) = $100; principal payments at maturity
( ) = $1,000; yield to maturity (Y) = 10% and total number of periods
(n) = 20. Thus, the price of bonds ( );
10-6
Present Value of Interest Payments
• To determine the present value of a $100 annuity for 20
years, with a discount rate of 10%
– We have:
10-7
Present Value of Principal Payment
(Par Value) at Maturity
• Principal payment at maturity is used interchangeably with par value or
face value of the bond
• Discounting $1,000 back to the present at 10%, we have:
• The current price of the bond, based on the present value of interest
payments and the present value of the principal payment at maturity:
• Here, the price of the bond is essentially the same as its par, or stated
value to be received at maturity of $1,000
10-8
Concept of Yield to Maturity
• The yield to maturity or the discount rate is the
required rate of return required by bondholders
• Three factors influence the required rate of return:
– Required real rate of return
• Demanded by the investor against current use of the funds on a
non-adjusted basis
– Inflation premium
• Compensation towards the negative effect of inflation on the
value of a dollar
• Risk free rate of return compensates for the use of funds and
loss due to inflation
– Risk premium
• Towards special risks of an investment
10-9
Concept of Yield to Maturity
(cont’d)
• Business Risk: inability of the firm to retain its competitive
position and stability and growth
• Financial risk: inability of the firm to meet its debt
obligations as and when due
• Assuming: The real rate of return 3%, inflation premium 4%
and risk premium is 3%, an overall required rate of return of
10% can be computed;
10-10
Price of a Bond with Increase in
Inflation Premium
• Assume Inflation premium goes up from 4 to 6%, with
everything else being constant
– Present value of interest payments:
$100 annuity for 20 years at a discount rate of 12%;
10-11
Price of a Bond with Increase in
Inflation Premium (cont’d)
– Present value of principal payment at maturity:
Present value of $1,000 after 20 years at a discount rate of 12%;
– Total present value:
Assuming that increased inflation increases required rate of return
and decreases the bond price by $150 approximately
10-12
Price of a Bond with Decrease in
Inflation Premium
• Assuming that the inflation premium declines:
– The required rate of return decrease to 8%, where the 20 year bond
with a 10% interest rate would now sell for;
– Present value of interest payments
– Present value of principal payment at maturity
– Total present value
10-13
Bond Price Table
The further the yield to maturity on a bond changes from the stated interest rate on
the bond, the greater the price change effect will be. The following table illustrates
the impact of differences between yield to maturity and coupon rates on bond
prices.
10-14
Time to Maturity
• Influences the impact of a change in yield to
maturity on valuation
• Longer the maturity, the greater the impact
of changes in yield
10-15
Impact of Time to Maturity on Bond
Prices
• The amount (premium) above par value is reduced as the number of
years to maturity becomes smaller and smaller
• The amount (discount) below par value is reduced with progressively
fewer years to maturity
• The following table shows the critical effect of time to maturity on bond
price sensitivity
10-16
Relationship Between Time to
Maturity and Bond Price
10-17
Determining Yield to Maturity from
the Bond Price
• The yield to maturity (Y), that will equate the
interest payments ( ) and the principal payments
( ) to the price of the bond ( )
10-18
Determining Yield to Maturity from
the Bond Price (cont’d)
– Assuming that a 15 year bond pays $110 per year (11%)
in interest and $1,000 after 15 years in principal
repayment
– Choosing 13% as an initial discount rate, we have:
• Present value of interest payments:
• Present value of principal payment at maturity
• Total present value
10-19
Determining Yield to Maturity from
the Bond Price (cont’d)
• Present value of interest payments at 12%
• Present value of principal payment at maturity
• Total present value
10-20
Formula for Bond Yield
• Weighted average is used to get the average investment over 15 year
holding period, principal payment $1,000, with annual interest payment
$110 and price of the Bond is $932.21
*
*This formula is developed by Gabriel A. Hawawini and Ashok Vora, “Yield Approximations: A Historical Perspective,”
Journal of Finance 37 (March 1982), pp. 145–56.
10-21
Semiannual Interest and Bond Prices
• A 10% interest rate may be paid as $50 twice a
year in the case of semiannual payments
• To make the conversion:
– Divide the annual interest rate by two
– Multiply the number of years by two
– Divide the annual yield to maturity by two
• Assuming a 10%, $1,000 par value bond has a
maturity of 20 years, the annual yield at 12%
– 10%/2 = 5% semiannual interest rate; hence 5% ×
$1,000 = $50 semiannual interest
– 20 × 2 = 40 periods to maturity
– 12%/2 = 6% yield to maturity, expressed on a
semiannual basis
10-22
Semiannual Interest and Bond Prices
(cont’d)
• At a present value of a $50 annuity for the 40 periods, at
discount rate of 6%:
– Present value of interest payments
– Present value of principal payment at maturity
– Total present value
10-23
Valuation and Preferred Stock
• Preferred stock represents a perpetuity,
having no maturity date
– It has a fixed dividend payment
– It has no binding contractual obligation of
interest on debt
– Being a hybrid security, it does not have:
• The ownership privilege of a common stock
• The legal provisions that could be enforced on debt
10-24
Perpetuity of a Preferred Stock
• Where,
•
= the price of the preferred stock;
= the annual dividend for the
preferred stock (constant);
= required rate of return (discount rate)
applied to preferred stock dividends
• A more usable formula is:
• Assuming, the annual dividend is $10, and the stockholder requires a
10% rate of return, the price of the preferred stock would be:
10-25
Perpetuity of a Preferred Stock
(cont’d)
• If the rate of return required by security holders change, the value of the
preferred stock also changes
• The longer the period of an investment, the greater the impact of a
change in the require rate of return
• With perpetual security, the impact is at a maximum
• Assuming that the required rate of return has increased to 12%. The
value of the preferred stock would be:
• If it were reduced to 8%, the value of the preferred stock would be:
10-26
Determining the Rate of Return
(Yield) from the Market Price
• Assuming the annual preferred dividend (
) is $10 and the price of
the preferred stock (
) is $100, the required rate of return (yield):
• A higher market price provides quite a decline in the yield:
10-27
Valuation of Common Stock
• Interpreted by the shareholder as the
present value of an expected stream of
future dividends
• The ultimate value of any holding lies with:
– The distribution of earnings in the form of
dividend payments
• The earnings must be translated into cash flow for the
stockholder
10-28
Dividend Valuation Model
Where,
•
= Price of stock today;
• D = Dividend for each year;
•
= the required rate of return for common stock (discount rate)
• This formula, with modifications is generally applied to three
different situations:
– No growth in dividends
– Constant growth in dividends
– Variable growth in dividends
10-29
No Growth in Dividends
• The common stock pays a constant dividend as in the case of a
preferred stock
• This is not a very popular option
Where,
= Price of the common stock;
= Current annual common stock
dividend (constant); = Required rate of return for common stock
• Assuming
= $1.86 and
= 12%, the price of the stock would be:
10-30
Constant Growth in Dividends
• The general valuation process is shown:
•
•
•
•
•
Where,
= Price of common stock today
= Dividend in year 1,
= Dividend in year 2, , and so on
g = Constant growth rate in dividends
= Required rate of return for common stock (discount rate)
10-31
Constant Growth in Dividends
(cont’d)
• Assuming:
–
–
–
–
–
= Last 12 month’s dividend (assume $1.87)
= First year, $2.00 (growth rate, 7%)
= Second year, $2.14 (growth rate, 7%)
= Third year, $2.29 (growth rate, 7%) etc
= Required rate of return (discount rate), 12%
10-32
Constant Growth Dividend
Valuation Model
•
The formula shown can be modified to a simple form if:
– The firm must have a constant dividend growth rate (g)
– The discount rate (Ke) must exceed the growth rate (g)
• Where:
P0 = Price of the stock today
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 = .12; g = .07. P0 is computed
as:
10-33
Stock Valuation Based on Future
Stock Value
• Assumption: To know the present value of
an investment
– Stock is held on for three years and then sold
– Adding the present value of three years of
dividends, and the present value of the stock
price after three years gives the present value of
the benefits
– The appropriate formula to be used is:
10-34
Determining the Required Rate of
Return from the Market Price
• Determining the required rate of return, knowing the first
year’s dividend, the stock price, and the growth rate (g):
•
•
•
•
Assuming;
= Required rate of return (to be solved)
= Dividend at the end of the first year, $2.00
= Price of the stock today, $40
g = Constant growth rate 7%, we have:
= $2.00 + 7% = 5% + 7% = 12%
$40
10-35
Determining the Required Rate of
Return from Market Price (cont’d)
• The stockholder is receiving a current dividend
plus anticipated growth in the future
– If the dividend yield is low, the growth rate must be high to
provide the necessary return
– If the growth rate is low, a high dividend yield will be
expected
– The first term represent the dividend yield the stockholder will
receive
– The second represents the anticipated growth in dividends,
earnings, and stock price
10-36
Price-Earnings Ratio Concept and
Valuation
• A multiplier applied to current earnings to
determine the value of a share of stock in
the market
• Influenced by:
– Earnings and sales growth of a firm
– Risk (or volatility in performance)
– The debt-equity structure of the firm
– The dividend policy
– The quality of management
10-37
Variable Growth in Dividends –
Supernormal Growth
• In evaluating a firm with an initial pattern of
supernormal growth:
– First, take the present value of dividends during the
exceptional growth period
– Then determine the price of the stock at the end of the
supernormal growth period by taking the:
• present value of the normal, constant dividends that follow the
supernormal growth period
– Discount this price to the present
– Add it to the present value of the supernormal dividends
– This gives the current price of the stock
10-38
Variable Growth in Dividends – No
Dividends
• Approach 1: though no dividend is paid currently
– The stockholders will be paid a cash dividend at a later
date
• The present value of their deferred payments may be used
• Approach 2:
– Take the present value of earnings per share for a
number of periods
– Add that to the present value of the future anticipated
stock price
– The discount rate applied to future earnings is generally
higher than the discount rate applied to future dividends
10-39
Stock Valuation under
Supernormal Growth Analysis
10-40