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Chapter 10
Valuation and Rates
of Return
PPT 10-1
FIGURE 10-1
The relationship between time value
of money, required return, cost of
financing, and investment decisions
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
PPT 10-2
TABLE 10-1
Bond price table
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
PPT 10-3
TABLE 10-2
Impact of time to maturity
on bond prices
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
PPT 10-4
FIGURE 10-2
Relationship
between time
to maturity and
bond price
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
PPT 10-5
FIGURE 10C-1
Stock valuation under
supernormal growth analysis
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter 10 - Outline
LT 10-1
 Valuation
of Bonds
 3 Factors that Influence the Required Rate of
Return
 Relationship Between Bond Prices and Yields
 Preferred Stock
 Valuation of Common Stock
 Valuation Using the Price-Earnings Ratio
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Valuation of Bonds
LT 10-2
The value of a bond is made up of 2 parts added together:
– PV of the interest payments (an annuity)
– PV of the principal payment (a lump sum)
The principal payment at maturity:
– can also be called the par value or face value
– is usually $1,000
The interest rate used:
– is the yield to maturity or discount rate
– is also the required rate of return
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© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
3 Factors that Influence the
Required Rate of Return

LT 10-3
Real Rate of Return:
– represents the opportunity cost of the investment

Inflation Premium:
– a premium to compensate for the effects of inflation

Risk Premium:
– a premium associated with business and financial risk

So , the Required Rate of Return equals:
– Real Rate of Return + Inflation Premium + Risk Premium
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Relationship Between Bond Prices
and Yields
LT 10-4
 Bond
prices are inversely related to bond yields
(move in opposite directions)
 As interest rates in the economy change, the price
or value of a bond changes:
– if the required rate of return increases, the price of
the bond will decrease
– if the required rate of return decreases, the price of
the bond will increase
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Preferred Stock

LT 10-5
Preferred stock:
– usually represents a perpetuity (something with no maturity
date)
– has a fixed dividend payment
– is valued without any principal payment since it has no
ending life
– is considered a hybrid security (a mixture of a stock and a
bond)
– owners have a higher priority than common stockholders
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Valuation of Common Stock
LT 10-6
The value of common stock is the present value of a
stream of future dividends
 Common stock dividends can vary, unlike preferred
stock dividends
 There are 3 possible cases:

– No growth in dividends (valued like preferred stock)
– Constant growth in dividends
– Variable growth in dividends
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
Valuation Using the Price-Earnings
Ratio
LT 10-7
The Price-Earnings (P/E) ratio can also be used to value
stocks
The P/E ratio is influenced by:
– the earnings and sales growth of the firm
– the risk (or volatility in performance)
– the debt-equity structure of the firm
– the dividend policy
– the quality of management
– a number of other factors
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
High vs. Low P/Es
LT 10-8
A stock with a high P/E ratio:
– indicates positive expectations for the future of the company
– means the stock is more expensive relative to earnings
– typically represents a successful and fast-growing company
– is called a growth stock
A stock with a low P/E ratio:
– indicates negative expectations for the future of the company
– may suggest that the stock is a better value or buy
– is called a value stock
McGraw-Hill/Irwin
© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.