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Chapter 5

Chapter 5. Bond and Stock Valuation. Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai. Learning Objectives. Explain the concept of market efficiency and how it influences the market price of securities.

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Chapter 5

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  1. Chapter 5 Bond and Stock Valuation Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

  2. Learning Objectives • Explain the concept of market efficiency and how it influences the market price of securities. • Describe the features of bonds, preferred stock, and common stock. • Understand the concept of an investment’s required rate of return and its importance in the valuation of marketable securities. • Use valuation principles to calculate a bond’s value and/or its yield to maturity.

  3. Learning Objectives (Cont.) • Calculate prices and required rate of return for common stock using the constant dividend growth model. • Use stock valuation models to describe when corporate growth strategies can create shareholder value. • Use stock valuation principles to value the acquisition of a company. • List and describe the various theories for explaining the term structure of interest rates. • Use the concept of duration concepts to evaluate the interest sensitivity of both individual bonds and bond portfolios.

  4. Competitive Capital Markets and Asset Valuation In well-developed capital markets, two individuals who can agree on the future cash flows and risk characteristics of a specific financial asset will always assign the same price. This “law of one price” depends on the existence of perfectly competitive capital market. In such a market: • buyers and sellers can enter and leave the market freely; • market participants can buy and sell securities with no transactions costs; • market participants have cost-free access to all relevant information.

  5. Market Efficiency and Asset Valuation In efficient capital markets, current security prices reflect everything that is known about the prospects of an individual security. There are three levels of market efficiency: • weakly efficient market • semi-strong efficient market • strong-form efficient market

  6. Price and Value The priceof a security is what a buyer is ready to pay a willing seller at a given point in time. Prices are very precise quantities. The valueof a corporate security should reflect the economic value of the firm’s assets whose value in turn is related to their ability to generate cash. Expectations play a vital role in the valuation process.

  7. Nature of Corporate Bonds • Represent a credit instrument where the company promises to pay some principal amount plus periodic interest to an investor. • Principal and interest payments must be met before dividends can be paid to either preferred or common stockholders. • Failure to meet interest and principal payment is an act of default that can lead to bankruptcy and possible liquidation. • Creditors have first claim on the proceeds from the sales of assets.

  8. Features of Corporate Debt • Par, or Face Value • Coupon Interest Rate • Maturity Date • Sinking Fund • Call Provision

  9. Types of Corporate Debt • Unsecured Obligations • Debentures • Notes • Mortgage Bonds • Collateral Trust Certificates • Equipment Trust Certificates • Subordinated Debentures • Convertible Debt • Fixed versus Floating-Rate Bonds

  10. Global Credit Markets • Domestic Bonds • Foreign Bonds • Eurobonds • ECU Bonds

  11. U.S. Domestic and Eurobond Markets - Some Differences • Virtually all bond issues in the US pay interest semiannually. Eurobonds pay interest annually. • All bonds in the US are in registered form. Most Eurobonds are in bearerform.

  12. Bond Credit Ratings Bond ratings represent a credit agency’s assessment of a firm’s ability to meet its debt obligations. The main credit rating agencies are Moody’s and Standard and Poor’s. In coming up with their ratings, agencies consider many factors including earnings stability, leverage, interest and fixed charge coverage, and asset protection. The assessment of management quality is also an important intangible aspect of the rating process.

  13. Investment Grade Versus Junk Bonds • Bonds rated Baa or better by Moody’s or BBB by Standard and Poor’s are considered investment grade. Banks and other financial institutions can only hold investment grade bonds. • Bonds not considered investment grade are referred to as junk, or high-yield bonds. In the 1980s, start-up companies who could not get bank accommodation, issued these bonds to finance growth.

  14. Bond Valuation Where: P = the price (or value) of the bond C = the periodic interest payments in dollars N = the number of years to maturity M = the maturity (par) value of the bond kd = the required rate of return

  15. Bond Valuation • The value of the bond is the present value of the coupon interest payments plus the face value at maturity, discounted at the bond’s required rate of return. • Traders refer to a bond’s required rate of return as its yield to maturity (YTM). • Coupon interest payments and maturity values are typically set at the time of issue. Bond prices change in response to market interest rates.

  16. Bond Valuation - An Example VALUATION OF AT&T 7 2005 ASSUMING AN 7.5 PERCENT YIELD TO MATURITY PERIOD CASH PRESENT VALUE PRESENT FLOWS FACTOR@ 7.5% VALUE 1-7 $70 5.2966 $370.76 7 $1,000 .6028 602.80 VALUE OF BOND = $973.56

  17. Bond Valuation - Another Example VALUATION OF ATT 7 2005 ASSUMING AN 6.5 PERCENT YIELD TO MATURITY PERIOD CASH PRESENT VALUE PRESENT FLOWS FACTOR@ 6.5% VALUE 1-7 $70 5.4845 $383.92 7 $1,000 .6435 643.50 VALUE OF BOND = $1,027.42

  18. Bonds, YTMs, Coupon Rates and Bond Prices PRICES OF 10- AND 20-YEAR BONDS 8 PERCENT COUPON $1,000 FACE INTEREST PAID ANNUALLY YTM 10-YEAR BOND 20-YEAR BONDS 6 % $1,147.20 $1,229.40 8 % $1,000.00 $1,000.00 10 % $877.11 $829.73

  19. Interest Rate Sensitivity of Bonds • Prices and YTMs are inversely related. Increases in market yields cause prices to fall; conversely, a drop in interest rates leads to a rise in prices. • Longer maturity bonds are more sensitive to changes in YTMs than are shorter-term bonds. • All other things equal, the prices of high coupon bonds are less price-sensitive to a given change in YTM than lower coupon bonds.

  20. Yield to Maturity (YTM) A bond’s yield to maturity (YTM) is the discount rate that equates the present value of coupon interest payments plus the principal at maturity with the bond’s current price.

  21. Computing the Yield to Maturity - Approximation Formula Where: C= the annual interest payments M = the maturity (face) value of the bond P = the current market price of the bond N = the number of years to maturity

  22. Computing the Yield to Maturity - An Example Suppose AT&T had a bond selling at 107.25% of face value. The bond matures in 7 years and carries a coupon rate of 7%. What is the bond’s YTM?

  23. Computing the Yield to Maturity - Solution [$70.00 + ($1,000.00 - $1072.50)/7] YTM = ¾¾¾¾¾¾¾¾¾¾¾¾¾¾¾¾ ($1,000.00 + $1072.50)/2 = 5.76 %

  24. Bond Pricing - Semiannual Interest Payments VALUATION OF AT&T 7 2005 PERIOD CASH PRESENT VALUE PRESENT FLOWS FACTOR@ 3.75% VALUE 1-14 $35.00 10.7396 $375.89 14 $1,000 .5973 597.30 VALUE OF BOND = $973.19

  25. Characteristics of Preferred Stock • Dividends are typically fixed at the time of issue and must be paid before common stockholders receive any payment. • Creditors have prior claim on earnings; interest on debt must be paid before preferred stockholders can receive anything. • Failure to pay preferred dividend does not result in bankruptcy. • Once creditor claims have been met, preferred stock has priority over common stockholders in terms of claims on assets in liquidation.

  26. Features of Preferred Stock • Par Value • Dividend Rate • Cumulative Feature • Voting Rights • Sinking Funds

  27. Features of Preferred Stock - An Example PREFERRED STOCK OF DU PONT DECEMBER 31, 1997 Cumulative Preferred Stock, Without Par Value, 23 million shares authorized, Issued at December 31: $4.50 Series - 1,672,594 shares issued (Callable at $120) Aggregate Book Value $167,259,400 $3.50 Series - 700,000 shares issued (Callable at $102) Aggregate Book Value $70,000,000

  28. Valuation of Preferred Stock Where: P = the value of a share of preferred stock D = the stated dividend per share of preferred stock kp = the required rate of return on preferred stock M = the issues’ per share redemption value in year N

  29. Valuation of Preferred Stock Where: P = the value of a share of preferred stock D = the stated dividend per share of preferred stock kp = the required rate of return on preferred stock

  30. Valuation of Preferred Stock - An Example Suppose an investor is considering the purchase of a preferred stock issue that is expected to pay $3.00 a share in perpetuity. If the investor assigns a required rate of return of 7.5 percent to the issue, what’s the maximum amount he/she should be willing to pay?

  31. Valuation of Preferred Stock - Solution

  32. Characteristics of Common Stock • Common stockholders are the owners of a company • Shareholders are residual claimholders getting what’s left over from income and assets once the claims of creditors and preferred stockholders have been satisfied. • Because of limited liability, shareholder losses cannot exceed their initial investment. • Unlike preferred stock, there is no pre-set dividend rate. Instead, dividends are paid at the discretion of the firm’s board of directors.

  33. Accounting for Common Stock SHAREHOLDER’S EQUITY FOR COCA-COLA DECEMBER 31,1997 (in millions except share data) Common Stock $0.25 par value $ 861 Capital Surplus 1,527 Reinvested Earnings 17,869 Adjustments (1,364) Treasury Stock at Cost (11,582) Total Shareholder’s Equity $7,311 Shares Authorized 5,600,000,000 Shares Issued 3,443,441,902 Shares Outstanding 2,470,629,181

  34. Return on Investment in Common Stock Where: Po = the current price of the stock P1 = the price expected at the end-of-the- year D1 = the dividends expected over the year

  35. Return on Investment in Common Stock - An Example Suppose that a share of stock was selling for $50 at the beginning of the year. If you believe that dividends during the year will be $2.00, and the stock price will go to $60 by the end of the year. The expected return will be: [$2 + ($60 - $50)] $22 Expected Return = ¾¾¾¾¾¾¾¾¾ = ¾¾ $50 $50 = 0.24 or 24%

  36. Valuation of Common Stock - The Dividend Discount Model Where: Po = the value of a share of stock D1, D2, … = the expected dividends in year 1, 2, … ke = the required rate of return on common stock

  37. Constant Dividend Growth Model Where: Po = the value of a share of stock D1 = the expected dividends in year 1 ke = the required rate of return on common stock g = the expected growth rate of the company

  38. Constant Dividend Growth Model

  39. Constant Dividend Growth Model - An Example Suppose a firm is expected to pay a dividend of $2.00 per share next year, and this dividend is expected to grow at a 4% compound annual rate into the indefinite future. The rate of return on common stock is 12 %, the value of a share would be:

  40. Determining Required Rates of Return on Common Stock

  41. Determining Required Rates of Return on Common Stock - An Example Suppose PG’s common stock is selling for $66 per share, and has a current dividend of $1.14. Past dividends have grown at 13 percent, and this growth is expected into the indefinite future. PG’s required rate of return would be:

  42. Constant Dividend Growth Model and P/E Multiples

  43. Determinants of P/E Multiples • Dividend payout ratio • Risk as reflected by the required return • Expected growth in earnings or dividends

  44. Present Value of Growth Opportunities Where: PVGO = the present value of growth opportunities E1 = the earnings of a no-growth firm ke = the required rate of return on common stock

  45. Growth Strategies and Value Creation To create value through growth, managers have to find investment projects offering returns that are greater than the shareholders’ required rate of return. Otherwise, stockholders would be better off getting all of the earnings in the form of dividends and doing their own investing.

  46. Above-Average Growth - An Example Suppose that Logicon Semiconductor has recently developed a line of specialty microchip that was well-received by the market. Logicon just paid a dividend of $1.50 a share, and this dividend is expected to grow at a rate of 20% over the next 5 years. Beginning in year 6, Logicon’s long-run dividend growth rate will settle down to 4% annually. How much would you pay for the stock if your required return were 13 %?

  47. Above-Average Growth Model - Components of Value • Present Value of Dividends During Period of Above -Average Growth • Present Value of Stock Price at End of Above-Average Growth Period

  48. Above-Average Growth Model - Valuing the High Growth Dividend Stream Year Dividend x Present Value Factor@13 = Present Value 1 $1.80 0.8850 $1.59 2 2.16 0.7832 1.69 3 2.59 0.6931 1.80 4 3.11 0.6133 1.91 5 3.73 0.5428 2.02 Total $9.01

  49. Above-Average Growth Model - Valuing the End of High Growth Period Stock Price Total Value of Logicon = $9.01 + $23.39 = $32.40

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