1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-1 Chapter Six Valuing Shares and Bonds

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-2 6.1 Bonds and Bond Valuation 6.2 Ordinary Share Valuation 6.3 Summary and Conclusions Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-3 Chapter Objectives Outline the features of bonds. Calculate the value (price) of a bond assuming annual and semi-annual coupons. Understand the implications of interest rate risk for the value of a bond. Calculate the value of an ordinary share under different dividend growth scenarios. Explain the components of required return.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-4 Debt Securities Debt securities are issued when an organisation wishes to borrow money from the public on a long-term basis. Bonds are issued by the government. Debentures are secured and issued by a corporation. Notes are unsecured debt securities issued by a corporation. More recently, these are all known as bonds.

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-5 Bond Features Coupon payments are the stated interest payments. Payment is constant and payable every year or half-year. Face value (par value) is the principal amount repayable at the end of the term. Coupon rate is the annual coupon divided by the face value. Maturity is the specified date at which the principal amount is payable.

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-6 Bond Yields Yield to maturity is the market interest rate that equates a bond’s present value of interest payments and principal repayment with its price. There is an inverse relationship between market interest rates and bond price.

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-7 Bond Price Sensitivity to Interest Rates (YTM) 4%6%8%10% 12% 14%16% $1 800 $1 600 $1 400 $1 200 $1 000 $ 800 $ 600 Bond price Yield to maturity, YTM Coupon = $100 20 years to maturity $1000 face value Key Insight: Bond prices and YTMs are inversely related.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-8 Bond Value

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-9 Example 1—Bond Value A bond with a face value of $1000 and a coupon rate of 6 per cent has 10 years to maturity. What is the market price of this bond if the market interest rate is 10 per cent?

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-10 Example 2—Bond Value Assume now that the bond’s coupons are paid half-yearly.

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-11 Interest Rate Risk Interest rate risk is the risk that arises for bond holders from changes in interest rates. All other things being equal, the longer the time to maturity, the greater the interest rate risk. All other things being equal, the lower the coupon rate, the greater the interest rate risk.

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-12 Interest Rate Risk and Time to Maturity Interest rate 1 year 30 years 5%$1 047.62$1 768.62 101 000.001 000.00 15956.52671.70 20916.67502.11 Time to Maturity

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-13 Computing Yield to Maturity Yield to maturity (YTM) is the rate implied by the current bond price. Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity. If you have a financial calculator, enter N, PV, PMT and FV, remembering the sign convention (PMT and FV need to have the same sign, PV the opposite sign).

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-14 YTM with Annual Coupons Consider a bond with a 10 per cent annual coupon rate, 15 years to maturity and a par value of $1000. The current price is $928.09. – Will the yield be more or less than 10 per cent? – N = 15; PV =  928.09; FV = 1000; PMT = 100 – CPT I/Y = 11%

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-15 Ordinary Share Valuation Share valuation is more difficult than debenture valuation for a number of reasons: – uncertainty of promised cash flows – shares have no maturity – observing the market rate of return is not easy.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-16 Ordinary Share Valuation The market value of a share is the present value of all expected net cash flows to be received from the share, discounted at a rate of return that reflects the riskiness of those cash flows. The expected net cash flows to be received from a share are all future dividends. Dividend growth is an important aspect of share valuation.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-17 Zero Growth Dividend Shares have a constant dividend into perpetuity, with no growth in dividends. The value of a share is then the same as the value of an ordinary perpetuity.

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-18 Constant Growth Dividend Dividends grow at a constant rate each time period. Called the constant dividend growth model.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-19 Example—Constant Growth Dividend Company XYZ has just paid a dividend of 15 cents per share, which is expected to grow at 5 per cent per annum. What price should you pay for the share if the required rate of return on the investment is 10 per cent?

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-20 Non-constant Growth Dividend The growth rate cannot exceed the required rate of return indefinitely but can do so for a number of years. Allows for ‘super normal’ growth rates over some finite length of time. The dividends have to grow at a constant rate at some point in the future.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-21 Example—Non-constant Growth Dividend A company has just paid a dividend of 15 cents per share and that dividend is expected to grow at a rate of 20 per cent per annum for the next three years, and at a rate of 5 per cent per annum forever after that. Assuming a required rate of return of 10 per cent, calculate the current market price of the share.

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-22 Solution—Non-constant Growth Dividend

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-23 Solution—Non-constant Growth Dividend (continued)

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-24 Solution—Non-constant Growth Dividend (continued)

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-25 Share Price Sensitivity to Dividend Growth, g 0 2% 4% 6% 8% 10% 50 45 40 35 30 25 20 Share price ($) Dividend growth rate, g D 1 = $1 Required return, R, = 12% 15 10 5

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-26 Share Price Sensitivity to Required Return, r 6% 8% 10% 12% 14% 100 90 80 70 60 50 40 Share price ($) Required return, R D 1 = $1 Dividend growth rate, g, = 5% 30 20 10

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 6-27 Components of Required Return