Principles of Corporate Finance

Principles of Corporate Finance Session 38 Unit V: Bond & Stock Valuation

Valuation Fundamentals • The (market) value of any investment asset is simply the present value of expected cash flows. • The interest rate that these cash flows are discounted at is called the asset’s required return. • The required return is a function of the expected rate of inflation and the perceived risk of the asset. • Higher perceived risk results in a higher required return and lower asset market values.

Basic Valuation Model V0 = CF1 + CF2 + … + CFn (1 + k)1 (1 + k)2 (1 + k)n Where: V0 = value of the asset at time zero CFt = cash flow expected at the end of year t k = appropriate required return (discount rate) n = relevant time period

What is a Bond? A bond is a long-term debt instrument that pays the bondholder a specified amount of periodic interest over a specified period of time. (note that a bond = debt)

General Features of Debt Instruments • The bond’s principal is the amount borrowed by the company and the amount owed to the bond holder on the maturity date. • The bond’s maturity date is the time at which a bond becomes due and the principal must be repaid. • The bond’s coupon rate is the specified interest rate (or $ amount) that must be periodically paid. • The bond’s current yield is the annual interest (income) divided by the current price of the security.

General Features of Debt Instruments • The bond’s yield to maturity is the yield (expressed as a compound rate of return) earned on a bond from the time it is acquired until the maturity date of the bond. • A yield curve graphically shows the relationship between the time to maturity and yields for debt in a given risk class.

Principles of Corporate Finance Session 39 Unit V: Bond & Stock Valuation

Bonds with Maturity Dates Annual Compounding B0 = I1 + I2 + … + (In + Pn) (1+i)1 (1+i)2 (1+i)n For example, find the price of a 10% coupon bond with three years to maturity if market interest rates are currently 10%. B0 = 100 + 100 + (100+1,000) (1+.10)1 (1+i)2 (1+.10)3

Yields • The Current Yield measures the annual return to an investor based on the current price. Current = Annual Coupon Interest Yield Current Market Price For example, a 10% coupon bond which is currently selling at $1,150 would have a current yield of: Current = $100 = 8.7% Yield $1,150

Yields • The yield to maturity measures the compound annual return to an investor and considers all bond cash flows. It is essentially the bond’s IRR based on the current price. PV = I1 + I2 + … + (In + Pn) (1+i)1 (1+i)2 (1+i)n Notice that this is the same equation we saw earlier when we solved for price. The only difference then is that we are solving for a different unknown. In this case, we know the market price but are solving for return.

Yields • The yield to maturity measures the compound annual return to an investor and considers all bond cash flows. It is essentially the bond’s IRR based on the current price. Using Excel For Example, suppose we wished to determine the YTM on the following bond.

Principles of Corporate Finance Session 40 & 41 Unit V: Bond & Stock Valuation

Common Stock Valuation Stock Returns are derived from both dividends and capital gains, where the capital gain results from the appreciation of the stock’s market price.due to the growth in the firm’s earnings. Mathematically, the expected return may be expressed as follows: E(r) = D/P + g For example, if the firm’s $1 dividend on a $25 stock is expected to grow at 7%, the expected return is: E(r) = 1/25 + .07 = 11%

Stock Valuation Models The Basic Stock Valuation Equation

Stock Valuation Models The Zero Growth Model • The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year. • For assistance and illustration purposes, I have developed a spreadsheet tutorial on Excel. • A non-functional excerpt from the spreadsheet appears on the following slide.

Stock Valuation Models The Zero Growth Model Using Excel

Stock Valuation Models The Constant Growth Model • The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year -- year after year. • For assistance and illustration purposes, I have developed a spreadsheet tutorial using Excel • A non-functional excerpt from the spreadsheet appears on the following slide.

Stock Valuation Models The Constant Growth Model Using Excel

Principles of Corporate Finance