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Financial Institutions and Markets FIN 304

Financial Institutions and Markets FIN 304. Dr. Andrew L. H. Parkes Day 9 “How do financial markets work?”. 卜安吉. Chapter 10: Bonds and Stocks. What is Yield to a Call? Remember what Call means? Higher yield – potential early maturity date Only if favorable to the issuer!

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Financial Institutions and Markets FIN 304

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  1. Financial Institutions and MarketsFIN 304 Dr. Andrew L. H. Parkes Day 9 “How do financial markets work?” 卜安吉

  2. Chapter 10: Bonds and Stocks What is Yield to a Call? • Remember what Call means? • Higher yield – potential early maturity date • Only if favorable to the issuer! • Only done in Excel and with a FINANCIAL calculator => The U.S. Budget Financial Institutions & Markets, Day 9

  3. Callable Bond Financial Institutions & Markets, Day 9

  4. Callable Bond A 10-year, 10% semiannual coupon, $1,000 par value bond is selling for $1,135.90 with an 8% yield to maturity. It can be called after 5 years at $1,050. What’s the bond’s nominal yield to call (YTC)? INPUTS 10 -1135.9 50 1050 N I/YR PV PMT FV 3.765 x 2 = 7.53% OUTPUT Financial Institutions & Markets, Day 9

  5. Callable Bond Continued - EAR rNom = 7.53% is the rate brokers would quote. Could also calculate EAR (Equivalent Annual Rate) to call: EAR = (1.03765)2 - 1 = 7.672%. This rate could be compared to monthly mortgages, and so on. Financial Institutions & Markets, Day 9

  6. If you bought bonds, would you be more likely to earn YTM or YTC? • The Coupon rate = 10%  YTC = rd = 7.53%. • Could raise money by selling new bonds which pay 7.53%. • Then replace bonds which pay $100/year with bonds that pay only $75.30/year. • Investors will expect a call, hence YTC = 7.5%, not YTM = 8% will be the return for investors. Financial Institutions & Markets, Day 9

  7. In General: • If a bond sells at a premium, then (1) coupon > rd, so (2) a call is likely. • So, expect to earn: • YTC on premium bonds. • YTM on par & discount bonds. Financial Institutions & Markets, Day 9

  8. Disney Bonds • Disney recently issued 100-year bonds with a YTM of 7.5%--this represents the promised return. The expected return was less than 7.5% when the bonds were issued. • If issuer defaults, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. Financial Institutions & Markets, Day 9

  9. Bond Ratings Provide One Measureof Default Risk Investment Grade Junk Bonds Moody’s Aaa Aa A Baa Ba B Caa C S&P AAA AA A BBB BB B CCC D Financial Institutions & Markets, Day 9

  10. What factors affect default risk and bond ratings? • Financial performance • Debt ratio • Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio • Current ratios (More…) Financial Institutions & Markets, Day 9

  11. Bankruptcy • Two main chapters of Federal Bankruptcy Act: • Chapter 11, Reorganization • Chapter 7, Liquidation • Typically, company wants Chapter 11, creditors may prefer Chapter 7. Financial Institutions & Markets, Day 9

  12. Bankruptcy continued • If company can’t meet its obligations, it files under Chapter 11. That stops creditors from foreclosing, taking assets, and shutting down the business. • Company has 120 days to file a reorganization plan. • Court appoints a “trustee” to supervise reorganization. • Management usually stays in control. Financial Institutions & Markets, Day 9

  13. Bankruptcy continued • Very Simply: A company must demonstrate in its reorganization plan that it is “worth more alive than dead.” Otherwise, judge will order liquidation under Chapter 7. Financial Institutions & Markets, Day 9

  14. Bankruptcy continued • If the company is liquidated, here’s the payment priority: 1. Secured creditors from sales of secured assets. 2. Trustee’s costs 3. Wages, subject to limits 4. Taxes 5. Unfunded pension liabilities 6. Unsecured creditors 7. Preferred stock 8. Common stock Financial Institutions & Markets, Day 9

  15. Bankruptcy continued • In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back. • Various groups of creditors vote on the reorganization plan. If both the majority of the creditors and the judge approve, company “emerges” from bankruptcy with lower debts, reduced interest charges, and a chance for success. Financial Institutions & Markets, Day 9

  16. Approaches for Valuing Common Stock • Dividend growth model • Using the multiples of comparable firms • Free cash flow method (covered in Fin 102) Financial Institutions & Markets, Day 9

  17. Dividend growth model Stock Value = PV of Dividends What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g. Financial Institutions & Markets, Day 9

  18. As you know: for a constant growth stock, If g is constant, then: Financial Institutions & Markets, Day 9

  19. $ 0.25 0 Years (t) Financial Institutions & Markets, Day 9

  20. What happens if g > rs (ke)? • If rs< g, get negative stock price, which is nonsense. • We can’t use model unless (1) g  rs and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be  rs. Financial Institutions & Markets, Day 9

  21. Assume beta = 1.2, rRF = 7%, and RPM = 5%. What is the required rate of return on the firm’s stock? Use the SML to calculate rs (ke): rs = rRF + (RPM)bFirm = 7% + (5%) (1.2) = 13%. Financial Institutions & Markets, Day 9

  22. D0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. rs = 13%. 0 1 2 3 4 g=6% D0=2.00 2.12 2.2472 2.3820 13% 1.8761 1.7599 1.6508 Financial Institutions & Markets, Day 9

  23. What’s the stock’s market value? D0 = 2.00, rs = 13%, g = 6%. Constant growth model: $2.12 $2.12 = = $30.29. 0.13 - 0.06 0.07 Financial Institutions & Markets, Day 9

  24. What is the stock’s market value one year from now, P1? ^ • D1 will have been paid, so expected dividends are D2,D3, D4 and so on. Thus, Financial Institutions & Markets, Day 9

  25. Find the expected dividend yield and capital gains yield during the first year. D1 $2.12 Dividend yield = = = 7.0%. P0 $30.29 ^ P1 - P0 $32.10 - $30.29 CG Yield = = P0 $30.29 = 6.0%. Financial Institutions & Markets, Day 9

  26. Find the total return during the first year. • Total return = Dividend yield + Capital gains yield. • Total return = 7% + 6% = 13%. • Total return = 13% = rs. • For constant growth stock: Capital gains yield = 6% = g. Financial Institutions & Markets, Day 9

  27. Rearrange model to rate of return form: ^ Then, rs = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. Financial Institutions & Markets, Day 9

  28. What would P0 be if g = 0? The dividend stream would be a perpetuity. 0 1 2 3 rs=13% 2.00 2.00 2.00 PMT $2.00 ^ P0 = = = $15.38. r 0.13 Financial Institutions & Markets, Day 9

  29. If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P0? r is still 13%. ^ • Can no longer use constant growth model. • However, growth becomes constant after 3 years. Financial Institutions & Markets, Day 9

  30. Nonconstant growth followed by constant growth: 0 1 2 3 4 rs=13% g = 30% g = 30% g = 30% g = 6% D0 = 2.00 2.60 3.38 4.394 4.6576 2.3009 2.6470 3.0453 46.1135 ^ 54.1067= P0 Financial Institutions & Markets, Day 9

  31. What is the expected dividend yield and capital gains yield at t = 0? At t = 4? At t = 0: D1 $2.60 Dividend yield = = = 4.8%. P0 $54.11 CG Yield = 13.0% - 4.8% = 8.2%. (More…) Financial Institutions & Markets, Day 9

  32. During nonconstant growth, dividend yield and capital gains yield are not constant. • If current growth isgreater than g, current capital gains yield is greater than g. • After t = 3, g = constant = 6%, so the t = 4 capital gains gains yield = 6%. • Because rs = 13%, the t = 4 dividend yield = 13% - 6% = 7%. Financial Institutions & Markets, Day 9

  33. $46.11 = 85.2%. $54.11 Is the stock price based on short-term growth? • The current stock price is $54.11. • The PV of dividends beyond year 3 is $46.11 (P3 discounted back to t = 0). • The percentage of stock price due to “long-term” dividends is: ^ Financial Institutions & Markets, Day 9

  34. If most of a stock’s value is due to long-term cash flows, why do so many managers focus on quarterly earnings? • Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. • Sometimes managers have bonuses tied to quarterly earnings. Financial Institutions & Markets, Day 9

  35. Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P0? ^ 0 1 2 3 4 ... rs=13% g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 1.7699 1.5663 2.12 1.3861    P 30.2857 20.9895 3 0 . 07 25.7118 Financial Institutions & Markets, Day 9

  36. What is dividend yield and capital gains yield at t = 0 and at t = 3? D1 2.00 t = 0:   7.8%. $25.72 P0 CGY = 13.0% - 7.8% =5.2%. t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%. Financial Institutions & Markets, Day 9

  37. If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P0 > 0: ^ $2.00(0.94) $1.88 = = = $9.89. 0.13 - (-0.06) 0.19 Financial Institutions & Markets, Day 9

  38. What are the annual dividendand capital gains yield? Capital gains yield = g = -6.0%. Dividend yield = 13.0% - (-6.0%) = 19.0%. Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield. Financial Institutions & Markets, Day 9

  39. Using the Stock Price Multiples to Estimate Stock Price • Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. • Example: • Estimate the average P/E ratio of comparable firms. This is the P/E multiple. • Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. Financial Institutions & Markets, Day 9

  40. Using Entity Multiples • The entity value (V) is: • the market value of equity (# shares of stock multiplied by the price per share) • plus the value of debt. • Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. • Calculate the average entity ratio for a sample of comparable firms. For example, • V/EBITDA • V/Customers Financial Institutions & Markets, Day 9

  41. Using Entity Multiples (Continued) • Find the entity value of the firm in question. For example, • Multiply the firm’s sales by the V/Sales multiple. • Multiply the firm’s # of customers by the V/Customers ratio • The result is the total value of the firm. • Subtract the firm’s debt to get the total value of equity. • Divide by the number of shares to get the price per share. Financial Institutions & Markets, Day 9

  42. Problems with Market Multiple Methods • It is often hard to find comparable firms. • The average ratio for the sample of comparable firms often has a wide range. • For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers? Financial Institutions & Markets, Day 9

  43. Why are stock prices volatile? ^ • rs = rRF + (RPM)bi could change. • Inflation expectations • Risk aversion • Company risk • g could change. Financial Institutions & Markets, Day 9

  44. What is market equilibrium? In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. ^ (More…) Financial Institutions & Markets, Day 9

  45. In equilibrium, expected returns must equal required returns: rs = D1/P0 + g = rs = rRF + (rM - rRF)b. ^ Financial Institutions & Markets, Day 9

  46. How is equilibrium established? ^ D1 P0 ^ If rs = + g > rs, then P0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the price will be bid up, and D1/P0 falls until D1/P0 + g = rs = rs. ^ Financial Institutions & Markets, Day 9

  47. Now take a look at YOURS! You will want to begin looking for a Chinese company to value as well! I want you to look at the Chinese company as you would the U.S. company. What problems do you have now? Financial Institutions & Markets, Day 9

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