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CHAPTER 4 Value- Driven Management

CHAPTER 4 Value- Driven Management. The goal of managerial finance is to maximize the value of the firm. It is critical to understand the valuation process so we know what affects the value of the firm.

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CHAPTER 4 Value- Driven Management

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  1. CHAPTER 4 Value- Driven Management AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  2. The goal of managerial finance is to maximize the value of the firm. • It is critical to understand the valuation process so we know what affects the value of the firm. • Price: refers to an amount of money per unit of measure at which someone buys, or is willing to buy or sell. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  3. Value: is used to mean the price that would exist in a market that is perfect based on the information set currently available to Investors. • Intrinsic Value Intrinsic Value: is the value that would exist If all potential investors had the same information that was available to the person determining the intrinsic value. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  4. The intrinsic value is the true worth of a security which may differ from the market price. • Intrinsic value can be estimated but can never be observed. • intrinsic value is based on the present value of the cash flows the asset is expected to produce in the future. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  5. 0 K% 1 2 n-1 n ^ ^ ^ ^ CF1 CF2 CFn-1 CFn PVCF1 PVCF2 PVCFn-1 PVCFn Value AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  6. Wealth is created by acquiring assets that have values in excess of their costs. (PV of expected cash flows exceeds the cost or the initial investment) 2. Such assets are acquired through competitive advantage. 3. Competitive advantage + Time value of money provide the basis for value creation- Arbitrage pricing principal. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  7. Arbitrage Valuation • Arbitrage is the process of increasing benefits without increasing costs or risk by taking advantage of market imperfection. • The arbitrage pricing principal (APP) states that Identical streams of cash flows will have identical prices. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  8. Assets A and B have identical streams of future benefits: Asset AAsset B $1,000 Not worth more than $1,000 If B is offered at a price below $1,000, Holders of A cannot sell their assets For $1,000 in order to buy asset B. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  9. The Sum of the Parts Equal the Whole Year1 Year2 X $100.00 $200.00 Y $100.00 0 Z 0 $200.00 ∑= CFt / i+k At k= 10 percent: PV(Y) = $100/1.1= $90.1 PV(Z) = $200/(1.10) = $165.29 PV(X) = $100/1.1 + 200/1.10=$90/91+$65.29=$256.20 PV(Y+Z) = $90.91 + $165.29 = $256.20 = PV(X) AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  10. =0 • For arbitrage pricing pressures to be effective, it is necessary that financial markets meet specific standard of perfection (see page 104) • If financial markets are perfect, they will also be informationally efficient. • Markets could be informationaaly efficient without being perfect. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  11. Value of Bonds • A bond is a long-term debt instrument issued by a business or governmental unit. • Bonds are typically in $1,000 denominations. • The bond provides a promise to pay a fixed interest payment on the $1,000 face value, and a promise to repay the face value at the maturity date specified in the bond contract. • Bonds can be bought and sold in the bonds markets prior to maturity AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  12. The value of a bond is found as the present value of an annuity ( the interest payments) plus the present value of a lump sum ( the principal). • The bond is evaluated at the appropriate periodic interest rate ( market rate) over the number of periods for which interest payments are made. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  13. Sunshine corporation bonds maturing in two years has a coupon rate of 8%. The interest is paid every six monthly. What is the price of the bond if the opportunity cost of money is 4 percent. What is the price if the opportunity cost of money is 3 percent. PV( at 4 percent) = $40.00PVIFA14perid,4% + $1,000xPVIF4,4% =$1,000 PV (at 3 percent) =$40.00PVIF14periods,3%+ $1,000xPVIF4,3%=$1,037.18 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  14. Yield to Maturity • YTM is the interest rate that would be earned by a bondholder who bought the bond at the current price and held it until maturity. • YTM is the discount rate that causes the present value of the future payments to equal the price. • From previous example: • YTM = 4% at market price of $1,000, and YTM = 3% at market price of $1,037.17 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  15. Market price of the bond and the Yield to Maturity: • If the market price of the bond is greater than $1,000, t he yield to maturity is less the coupon rate • If the market price of the bond is less than $1,000, the yield to maturity is greater than the coupon rate. • If the market price is $1,000 the yield to maturity is the same as the coupon rate AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  16. If the coupon rate is 8 percent and sold to yield 3% YTM each six-months, with interest paid semiannually. Then the Effective Annual interest rate is: K = (1 + .03)2 -1= 1.0609 -1 = .0609 = 6.09% Bonds are quoted as a number of points out of 32. A bond with a price of 103 23/32 = 103.71875 percent of the par value = $1,000x103.71875% = $1,037.19 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  17. Bond prices are affected by the time until the next interest payment. If the price of the bond is $1,037.17. The YTM is 3 percent, and the next interest payment for the company is only 4 month away instead of six months, all payments are moved closer by a third of a 6- months, so the value of the bond increases to: $1,037.17 (1.03)1/3 = $1,047.44 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  18. Some Alternativ Yield Definitions • Yield to Maturity: interest rate that would be earned by a bondholder who bought the bond at the current price and held it until maturity. • Coupon Rate: annual interest payment divided by face value • Current Yield: annual interest payment divided by current price • Yield to Call: interest rate that would be earned by a bondholder who bought the bond at the current price and held it until it was called AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  19. Value of Stock Stock value = ∑ Dt /(1+k)t t=1 Stock value = D1 / k………. Zero growth model Stock value = D1 / (k- g) … Constant growth model AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  20. The Value of the Preferred Stock is: Dividend/ required return = Dpf /k If the preferred stock of XYZ corporation pays an annual dividend of $1.70 , and investments of similar risk pay an expected return of 6.77 percent, the value of the preferred stock is: D / k = $1.71/.0677 = $25.11 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  21. Valuation of Common stock of Disney • Price was $125 a share in 1998 • Dividends were forecast to be $0.7 a share in 1999 • Required rate of return = 15 percent • Growth in dividends = 0.1444 percent Value of the stock = D1 /k- g = $.70/(.15-0.1444) =$125 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  22. D1 D2 D3 D4 D5 D6 $ 0.70 0.80 0.92 1.05 1.2 1.37 X .8696 x.7561 x.6575 x.5718 x.4972 PVD1 PVD2 PVD3 PVD4 PVD5 =$3 P0= $125, P5= $1.37/(0.15-0.1444) = $245 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  23. The investors who bough at $125, received 5 years of dividends, and sold at $245, only earned the 15 percent rate that could have been expected elsewhere. Superior returns would occur if the price rose to more than $245 in 5 years, either because dividend forecasts had been revised upward or the rate that could be earned elsewhere had declined. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  24. News about the company or economy in general Change in expected dividends • Sources of Change in Stock Price Change in Stock price Change in Alternative opportunities Change in required return Change in the Company’s riskiness AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  25. Value of Investment Opportunities A company is viewed as: • a set of existing investments and • a set of potential investment opportunities In the absence of other investment opportunities: The value of the company = the present Value of future dividends AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  26. If the company has additional investment Opportunities The value of the company will increase by the present value of those investment opportunities. Vcomp = PV (future dividends) + PV of future investment opportunities AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  27. The value of the company is independent of whether equity needed to finance those opportunities will come form: • retention of earnings or • sale of additional stock Example on page 113- Delta Corporation • Net income = $100,000 • Shares outstanding= 100,000 • Dividends= $1/share ( no investments opp.) • Investors’ opportunity cost = 10 percent AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  28. Value of the company = $1/.10 =$10.00 • The company discovers a new investment opportunity that requires $50,000 a year from Now. • The opportunity will earn additional income of $10,000 a year after ( available to distribute as dividends). • NPV ( one year from now) = $10,000/.10 – $50,000 = $50,000. • Present value (PV) of the opportunity today = $50,000/1.10=$45,455. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  29. 0 Y1 Y2 Investment opportunity Costs $50,000 NPVopp. = $10,000/.10 -$50,000 =$50,000 Additional Income of $10,000, paid out as dividends PV = $50,00/1.10 = 45,455 = $0.45 per share The value of stock will increase by $0.45 to $10.45 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  30. Scenario A: Delta get the needed equity ($50,000) by reducing dividends first years Year 1 2 Total Income $100,00 $110,000 Div/share $0.5 $1.10 PV factor 0.9091 9.0909* Present value $0.45 $ 10.000 $10.45 * = (1/0.1)/1.10 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  31. Scenario B: Delta wants to maintain its dividend and sell additional shares at the end of the first year, immediately after the dividend payment, to get the equity needed for the new investment. Y0 Y1 Y2 D2+ Number of shares Sn = $50,000/P1 P1 = D2+ /.10 Sn = $50,000/P1 P1 = D2+ /.10 D2+ =$110,000/100,000 +Sn AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  32. P1 = $50,000/Sn = D2+ /.10 = • ($110,000/100,000 + Sn)/.10 = $50,000/Sn • $5,000/Sn = $110,000/(100,000 + Sn) • 110,000Sn = 500,000,000 + 5,000Sn 105,000Sn = 500,000,000, • Sn = 4,762 shares • D2+ = $1.05 • P1 = $10.50 • Value of the share today = (P0) = ($10.50 + $1.00)/1.1 = $10.45 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  33. Economic Profit and Wealth Wealth Creation is : • The present value of future investment opportunities and • The present value of economic profit created by investment opportunities AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  34. $50,000 of new equity at the end of Y1 generated cash flow of $10,000 a year for equity holders forever • At a 10% required return, the annual economic profit in Y2 and beyond is: Annual cash flow $10,000 Normal profit (.10x $50,000) 5,000 Economic profit $5,000 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  35. What if Investors Do Not Know? • No investment = P0 = $10/share • The company announce a New investment of $50,000 to provide $10,000 a year • The intrinsic value at the end of year 1 is $10.5/share Y1 Y2 Investors are not well informed about the new investments and the stock is actually selling for $4.00 a share $10, $10.5 AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  36. Scenario A Scenario B Drop the plan ( P=$10) the number of new shares Sn @Y1 = $50,000/4 =12,500 Shs D2+ = $110,000/(100,000 +12,500) = $0.98 The intrinsic value at the end of year1 declines to $0.98/.10 = $9.80. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  37. Y1 Y2 Wealth and Value $50,000 $3,000 a year for ever Equity investment NPV=$3,000/.10- $50,000 = -$20,000 D1 = $.50 D2+ =$1.03 P1 = $1.03/0.1= $10.30 P0 = $(10.30 +$.50)/1.10 = $9.82 Price increased, value increased , and wealth decreased. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  38. Stock Splits and Stock Dividends • Stock splits: a method commonly used to lower the price of a firm’s stock by increasing the number of shares belonging to each shareholder. • Stock dividends: the payment to existing owners of a dividend in the form of stock. • Stock splits and stock dividends both have no effect on the firm’s capital structure. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  39. Why do companies engage in stock splits and dividends if they achieve nothing? • Making the stock available to more investors. • Stock splits and stock dividends provide a signal that management expects the company to increase its competitive advantage in the future. • Some investors believe that they receive something of value. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  40. Value of Currency The value of currency provides another example of arbitrage pricing principals at work Tow important factors affecting the exchange rates between currencies: • Purchasing power parity • Interest arte power parity AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  41. Purchasing power parity (PPP) PPPstates that equilibrium exchange rates between two countries will result in identical goods selling at identical prices BIG Mac (UK) BIG Mac (US) £1.1 $1.54 Price of the pound = $1.54/1.1 = $1.4/1 £ AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  42. If inflation is 20% in Uk , and 10% in US, then BIG Mac (UK)BIG Mac (US) £1.32 (1.1 x1.2) $1.694 (1.54 x1.1) Price of one pound = $1.694/ £ 1.32 = $1.2833/ £1 Forward rate = Spot rate(1+INFd/(1+INFf) = 1.4 (1+.1)/ (1+.2) =1.4(1.1)/(1.2) = $1.2833/ £ 1. AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  43. Interest Rate Parity Theory (IRP) IRP predicts a specific relationship between spot exchange rates, forward exchange rates, and interest rates. IR(GB) >IR (USA) a. Convert dollar into pounds and buy the pound-denominated securities b. Enter into a future contract to repurchase dollars at the maturity date for the pound- denominated security AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  44. Rforeign = (ERSpot / ERForeard ) (1+ RDDomestic ) -1 If: a. Spot exchange rate= $1.40/ £ b. 1-year forward contract rate=$1.2833/ £ Risk-free interest rate in dollar-denominated security = 12.2 percent, then equilibrium rate in pound- denominated securities is: Rforeign = (1.40/1.2833)(1+.122) -1 = 22.4% AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

  45. Government Intervention Driving exchange rates out of purchasing power equilibrium. If US FRB. decreases the money supply, driving interest rates up t0 14%. For IRP to hold, it is necessary for the spot rate to change as follows: 0.224= (ERSpot /1.2833)(1+.14) -1; ERSpot = $1.378/ £ AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

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