chapter 4 principles of corporate finance eighth edition value of bond and common stocks slides by...
TRANSCRIPT
Chapter 4
Principles of
Corporate FinanceEighth Edition
Value of Bond and Common Stocks
Slides by
Matthew Will
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
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Topics CoveredUsing PV Formulas to Value BondsHow Common Stocks are TradedHow Common Stocks are ValuedEstimating the Cost of Equity CapitalStock Prices and EPS
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Valuing a Bond
Example
If today is January 2004, what is the value of the following bond?
A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.
Cash Flows
375.105375.5375.5375.5375.5375.5
10'09'08'07'06'05'
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Valuing a Bond
Example continued If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every
year for 6 years. The par value of the bond is 100 EURO. The price at a 3.8% YTM is as follows
31.108$
038.1
375.105
038.1
375.5
038.1
375.5
038.1
375.5
038.1
375.55432
PV
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Bond Prices and Yields
0
200
400
600
800
1000
1200
1400
1600
0 2 4 6 8 10 12 14
5 Year 9% Bond 1 Year 9% Bond
Yield
Pri
ce
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Valuing a Bond
Example continued If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every
year for 6 years. The par value of the bond is 100 EURO. The price at a 2.0% YTM is as follows
90.118$
02.1
375.105
02.1
375.5
02.1
375.5
02.1
375.5
02.1
375.55432
PV
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Stocks & Stock Market
Common Stock - Ownership shares in a publicly held corporation.
Secondary Market - market in which already issued securities are traded by investors.
Dividend - Periodic cash distribution from the firm to the shareholders.
P/E Ratio - Price per share divided by earnings per share.
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Stocks & Stock Market
Book Value - Net worth of the firm according to the balance sheet.
Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.
Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.
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Valuing Common Stocks
Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.
Expected Return
rDiv P P
P1 1 0
0
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Valuing Common Stocks
Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?
15.100
1001105Return Expected
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Valuing Common Stocks
The formula can be broken into two parts.
Dividend Yield + Capital Appreciation
Expected Return
rDiv
P
P P
P1
0
1 0
0
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Valuing Common Stocks
Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.
gP
Divr
gr
DivP
0
1
10 RatetionCapitaliza
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Valuing Common Stocks
Return Measurements
0
1
P
Div YieldDividend
Sharey Per Book Equit
EPS
Equityon Return
ROE
ROE
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Valuing Common Stocks
Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.
PDiv
r
Div
r
Div P
rH H
H01
12
21 1 1
( ) ( )
...( )
H - Time horizon for your investment.
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Valuing Common Stocks
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Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?
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Valuing Common Stocks
Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?
PV
PV
300
1 12
324
1 12
350 94 48
1 12
00
1 2 3
.
( . )
.
( . )
. .
( . )
$75.
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Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.
Perpetuity PDiv
ror
EPS
r 0
1 1
Assumes all earnings are paid to shareholders.
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Valuing Common Stocks
Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).
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Valuing Common Stocks
Example- continued
If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?
$100$3.
.
.
00
12
09
g
g
Answer
The market is assuming the dividend will grow at 9% per year, indefinitely.
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Valuing Common Stocks
If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher.
Payout Ratio - Fraction of earnings paid out as dividends
Plowback Ratio - Fraction of earnings retained by the firm.
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Valuing Common Stocks
Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations.
g = return on equity X plowback ratio
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Valuing Common Stocks
Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?
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Valuing Common Stocks
Example
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?
56.55$15.
33.80 P
No Growth With Growth
00.100$10.15.
00.5
10.40.25.
0
P
g
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Valuing Common Stocks
Example - continuedIf the company did not plowback some earnings, the stock price would remain at $55.56. With the plowback, the price rose to $100.00.
The difference between these two numbers) is called the Present Value of Growth Opportunities (PVGO).
44.44$56.5500.100 PVGO
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Valuing Common Stocks
Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments.
Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.