© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 1 Chapter 4: Valuation Corporate Finance, 3e Graham, Smart, and Megginson

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 2  The value of any asset is the present value of all its future benefits.  The greater the uncertainty about an asset’s future benefits, the higher the discount rate investors will apply when discounting those benefits to the present.  The valuation process links an asset’s risk and return to determine its price. Valuation Fundamentals

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 3 The Basic Valuation Model  P 0 = Price of asset at time 0 (today)  CF t = Cash flow expected at time t  r = Discount rate (reflecting asset’s risk)  n = Number of discounting periods (usually years) This model can express mathematically the price of any asset at t = 0.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 4 Bond Basics  Bonds are debt instruments used by business and government to raise large sums of money.  Most bonds share certain basic characteristics: 1. A bond promises to pay investors a fixed amount of interest, called the bond’s coupon. 2. Bonds typically have a limited life and will repay the full face value (or par value) on the maturity date. 3. A bond’s coupon rate equals the bond’s annual coupon payment divided by its par value. 4. A bond’s coupon yield equals the coupon payment divided by the bond’s current market price.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 5 The Basic Equation (Assuming Annual Interest)  Cash flows include two components:  The annual coupon, C, which equals the stated coupon rate times the par value, received for each of the n years  The par value, M, received at maturity in n years

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 6 Bonds: Premiums & Discounts P 0 < par value P 0 > par value The bond's price will differ from its par value. DISCOUNT  PREMIUM  What happens to bond values if the required return is not equal to the coupon rate? r > Coupon Interest Rate r < Coupon Interest Rate  

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 7 Risk-Free vs. Risky Bonds  A risk-free bond has no chance of default by its issuer.  Valuing an ordinary corporate bond involves the same steps: 1. Write down the cash flows. 2. Determine an appropriate discount rate. 3. Calculate the present value.  Discount rate on corporate bond should be higher than on Treasury bond with the same maturity because corporate bonds carry default risk.  Yield spread between Treasury and corporate bonds

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 8 Yield to Maturity (YTM) Rate of return investors earn if they buy the bond at P 0 and hold it until maturity. The YTM on a bond selling at par will always equal the coupon interest rate. YTM is the discount rate that equates the PV of a bond’s cash flows with its price.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 9 Bond Issuers  Bond issuers  Corporate bonds  Municipal bonds  Treasury bills, notes, and bonds  Agency bonds

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 10 Bond Ratings  Bond rating agencies  Moody’s  Standard & Poor’s (S&P)  Fitch

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 11 Bond Price Behavior  Bond spreads are directly related to default risk.  Bond price behavior  Prices and yields change constantly.  Prices and yields are inversely related.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12 Term Structure of Interest Rates  Relationship between yield and maturity is called the term structure of interest rates  Graphical depiction is called a yield curve  Yield curves normally upward-sloping  Can be flat or even inverted during times of financial stress

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 13 Evaluating the Yield Curve  Yields vary with maturity.  Yields offered by bonds must be sufficient to offer investors a positive real return.  The real return on an investment approximately equals the difference between its stated or nominal return and the inflation rate.  The shape of the yield curve can change over time.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 14 Term Structure Theories  Expectations theory  Liquidity preference theory  Preferred habitat theory

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 15 Liquidity Preference Theory  Liquidity preference theory of the term structure states that the slope of the yield curve is influenced not only by expected interest-rate changes,  but also by the liquidity premium that investors require on long-term bonds.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 16 Preferred Habitat Theory  Investment in long term bonds (the longest available in the market) in order to match the maturity of liabilities  Demand for very long term bonds by pension funds and life insurance companies is one of the driving forces behind the recent decisions of some governments to issue bonds with maturities as long as 50 years.  Economists use the preferred habitat theory (or the market segmentation theory) to describe the effect of this behavior on the yield curve.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 17 Stock Valuation: Preferred Stock Preferred stock is an equity security (generally without voting rights) that is expected to pay a fixed annual dividend for its life. PS 0 = Preferred stock’s value D p = Preferred dividend r p = Required rate of return

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 18 Basic Common Stock Valuation P 0 = D 1 + P 1 (1+r) Value of a Share of Common Stock P 0 = Current stock price D 1 = Dividend received at the end of year 1 P 1 = Stock price at the end of year 1 r = Discount rate

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 19 Zero Growth Model  To value common stock, you must make assumptions about the growth of future dividends.  The zero growth model assumes a constant, non-growing dividend stream: D 1 = D 2 =... = D   Under this assumption, the dividend stream is just a perpetuity, and the common stock valuation formula reduces to: P 0 = D / r

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 20 Constant Growth Model  Assumes dividends will grow at a constant rate ( g ) that is less than the required return ( r )  If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next year’s dividend as D 1 : P 0 = D1D1 r - g Commonly called the Gordon Growth Model.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 21 Variable Growth

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 22 Free Cash Flow Approach  What is the total operating cash flow (OCF) generated by a firm each year?  Subtract from the firm’s OCF the amount needed to fund new investments in both fixed and current assets.  The difference is total free cash flow (FCF).

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 23 Free Cash Flow Approach  The value of the firm (V F ) is the present value of all its future free cash flows.  The total value of all the firm’s stock can be found by subtracting the value of debtholders’ and preferred stockholders’ claims: V S = V F – V D – V P  Divide by the number of common shares outstanding to obtain the value of one share.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 24 Common Stock Valuation: Other Options  Book value  Liquidation value  Price / Earnings (P/E) multiples