INTRODUCTION

Financial managers must often make decisions regarding the benefits and
costs. Associated with an investment. we capture the benefits and cost in
valuation determining what an investment is worth today and comparing
this to the cost of investment.


The key to valuation is determining the unexpected



What is Value..


In general, the value of an asset is the price that a willing and able
buyer pays to a willing and able seller
Note that if either the buyer or seller is not both willing and able,
then an offer does not establish the value of the asset



Different types of value


Book Value represents either

an asset: the accounting value of an asset -- the assets cost
minus its accumulated depreciation;
a firm: total assets minus liabilities and preferred stock as
listed on the balance sheet
Market value represents the market price at which an asset
trades.
Intrinsic value represents the price a security ought to
have based on all factors bearing on valuation.




Determinants of Intrinsic Value


= There are two primary determinants of the intrinsic value
of an asset to an individual:
The size and timing of the expected future cash flows
The individuals required rate of return (this is
determined by a number of other factors such as
risk/return preferences, returns on competing
investments, expected inflation, etc.)
= Note that the intrinsic value of an asset can be, and often
is, different for each individual (thats what makes markets
work)

BONDS

= A bond is a long-term debt instrument issued by a
corporation or government
= Most corporate, and some government, bonds are callable.
That means that at the companys option, it may force the
bondholders to sell them back to the company. Ordinarily,
there are restrictions on the timing of the call and the
amount that must be paid.
The maturity value (MV) [or face value] of a bond is
the stated value. - This is the date after which the
bond no longer exists. It is also the date on which
the loan is repaid and the last interest payment is
made.
The bonds coupon rate is the stated rate of interest; the
annual interest payment divided by the bonds face value.
The discount rate (capitalization rate) is dependent on the
risk of the bond and is composed of the risk-free rate plus
a premium for risk

Types of Bonds


Bonds with Maturity
Pure Discount Bonds
Perpetual Bonds

Bond Yields


Coupon rate
Current yield
Yield to maturity
Yield to call

Perpetual bond

A perpetual bond is a bond that never matures. It has an infinite
life.

Perpetual Bond Example


Bond P has a $1,000 face value and provides an 8% annual
coupon. The appropriate discount rate is 10%. What is
the value of the perpetual bond?
I = $1,000 ( 8%) = $80.
k
d
= 10%.
V = I / k
d
[Reduced Form]
= $80 / 10% = $800.

Non-Zero coupon-paying bond

It is a coupon paying bond with a finite life.
Example-
Bond C has a $1,000 face value and provides an 8% annual
coupon for 30 years. The appropriate discount rate is 10%.
What is the value of the coupon bond?
V = $80 (PVIFA
10%, 30
) + $1,000 (PVIF
10%, 30
)
= $80 (9.427) + $1,000 (.057)
[Table IV ] [Table II ]
= $754.16 + $57.00
= $811.16.

Zero coupon bonds


A zero coupon bond is a bond that pays no interest but sells at a
deep discount from its face value; it provides compensation to
investors in the form of price appreciation.

Zero-Coupon Bond Example


Bond Z has a $1,000 face value and a 30 year life. The
appropriate discount rate is 10%. What is the value of the
zero-coupon bond?

V = $1,000 (PVIF
10%, 30
) = $1,000
(.057)
= $57.00




Calculating the Value of a Bond


= There are two types of cash flows that are provided by a
bond investments:
Periodic interest payments (usually every six months,
but any frequency is possible)
Repayment of the face value (also called the
principal amount, which is usually $1,000) at
maturity
= The following timeline illustrates a typical bonds cash
flows:
We can use the principle of value additivity to find the
value of this stream of cash flows
= Note that the interest payments are an annuity, and that the
face value is a lump sum
= Therefore, the value of the bond is simply the present
value of the annuity-type cash flow and the lump sum:


Valuation: An Example

= Assume that you are interested in purchasing a bond with
5 years to maturity and a 10% coupon rate. If your
required return is 12%, what is the highest price that you
would be willing to pay?






( )
( )
V
B
=

+

(
(
(
+
+
= 100
1
1
1 012
012
1 000
1 012
927 90
5
5
.
.
,
.
.
Some Notes About Bond Valuation

= The value of a bond depends on several factors such as
time to maturity, coupon rate, and required return
= We can note several facts about the relationship between
bond prices and these variables (ceteris paribus):
Higher required returns lead to lower bond prices,
and vice-versa
Higher coupon rates lead to higher bond prices, and
vice versa
Longer terms to maturity lead to lower bond prices,
and vice-versa

Common Stock Valuation

Common stock represents a residual ownership position in the
corporation.
= A share of common stock represents an ownership position
in the firm. Typically, the owners are entitled to vote on
important matters regarding the firm, to vote on the
membership of the board of directors, and (often) to
receive dividends.
= In the event of liquidation of the firm, the common
shareholders will receive a pro-rata share of the assets
remaining after the creditors and preferred stockholders
have been paid off.Just like with bonds, the first step in
valuing common stocks is to determine the cash flows
= For a stock, there are two:
Dividend payments
The future selling price
= Again, finding the present values of these cash flows and
adding them together will give us the value




Common Stock Valuation: An Example

= Assume that you are considering the purchase of a stock
which will pay dividends of $2 next year, and $2.16 the
following year. After receiving the second dividend, you
plan on selling the stock for $33.33. What is the intrinsic
value of this stock if your required return is 15%?





Some Notes About Common Stock


= In valuing the common stock, we have made two
assumptions:
We know the dividends that will be paid in the future
We know how much you will be able to sell the
stock for in the future
= Both of these assumptions are unrealistic, especially
knowledge of the future selling price
= Furthermore, suppose that you intend on holding on to the
stock for twenty years, the calculations would be very
tedious!

Common Stock: Some Assumptions


( ) ( )
V
CS
=
+
+
+
+
=
2 00
1 15
216 3333
1 15
2857
1 2
.
.
. .
.
.
= We cannot value common stock without making some
simplifying assumptions
= If we make the following assumptions, we can derive a
simple model for common stock valuation:
= Assume:
Your holding period is infinite (i.e., you will never
sell the stock)
The dividends will grow at a constant rate forever
= Note that the second assumption allows us to predict every
future dividend, as long as we know the most recent
dividend


The Dividend Discount Model (DDM)

= With these assumptions, we can derive a model which is
known as the Dividend Discount Model, or the Gordon
Model
= This model gives us the present value of an infinite stream
of dividends that are growing at a constant rate:



The dividend valuation model requires the forecast of all future
dividends. The following dividend growth rate assumptions
simplify the valuation process.
Constant Growth
No Growth
Growth Phases

The DDM: An Example
( )
V
D g
k g
D
k g
CS
CS CS
=
+

0
1
1

= Recall our previous example in which the dividends were
growing at 8% per year, and your required return was 15%
= The value of the stock must be:



= Note that this is exactly the same value that we got earlier

The DDM Extended

= There is no reason that we cant use the DDM at any point
in time
= For example, we might want to calculate the price that a
stock should sell for in two years
To do this, we can simply generalize the DDM:





Preferred Stock

= Preferred stock represents an ownership claim on the firm
that is superior to common stock in the event of
liquidation. Typically, preferred stock pays a fixed
dividend periodically and the preferred stockholders are
( )
V
CS
=
+

=
185 1 08
15 08
2 00
015 08
2857
. .
. .
.
. .
.
( )
V
D g
k g
D
k g
N
N
CS
N
CS
=
+

+
1
1
usually not entitled to vote as are the common
shareholders.


Preferred Stock Valuation
= Preferred stock is very much like common stock, except
that the dividends are constant (i.e., the growth rate is
0%)Therefore, we can use the DDM with a 0% growth rate
to find the value




Preferred Stock: An Example


= Suppose that you are interested in purchasing shares of a
preferred stock which pays a $5 dividend every year. If
your required return is 7%, what is the intrinsic value of
this stock?







summary:

( )
V
D
k
D
k
P
CS CS
=
+

=
0
1 0
0
V
P
= =
5
0 07
7143
.
.
The valuation of debts securities is a application of time
value of money mathematics. The key is to take bond
characteristic (i.e. coupon,maturity,value) and translate
them into input for the financial mathematics.
Securities valuation can be more complicated what we
have discussed because issuer have a great deal of
flexibility in designing these securities, but any feature
that a issuer include in the debts security is usually just an
simple of extension of assets valuation principles and
mathematics.