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Valuation Concepts

Valuation Concepts. Chapter 10. Basic Valuation. From the time value of money we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future. ^. ^. ^. ^. ^.

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Valuation Concepts

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  1. Valuation Concepts Chapter 10

  2. Basic Valuation • From the time value of money we realize that the value of anything is based on the present value of the cash flows the asset is expected to produce in the future

  3. ^ ^ ^ ^ ^ CFt = the cash flow expected to be generated by the asset in period t Basic Valuation Asset value

  4. Basic Valuation • k = the return investors consider appropriate for holding such an asset - usually referred to as the required return, based on riskiness and economic conditions

  5. Valuation of Financial Assets - Bonds • Bond is a long term debt instrument • Value is based on present value of: • stream of interest payments • principal repayment at maturity

  6. Valuation of Financial Assets - Bonds • kd = required rate of return on a debt instrument • N = number of years before the bond matures • INT = dollars of interest paid each year (Coupon rate  Par value) • M = par or face, value of the bond to be paid off at maturity

  7. Valuation of Financial Assets - Bonds Bond value

  8. Valuation of Financial Assets - Bonds • Genesco 15%, 15year, $1,000 bonds valued at 15% required rated of return

  9. Bond value Valuation of Financial Assets - Bonds • Numerical solution: Vd = $150 (5.8474) + $1,000 (0.1229) = $877.11 + $122.89 = $1,000

  10. Valuation of Financial Assets - Bonds • Financial Calculator Solution: Inputs: N = 15; I = k = 15; PMT = INT = 150 M = FV = 1000; PV = ? Output: PV = -1,000

  11. Changes in Bond Values over Time • If the market rate associated with a bond (kd) equals the coupon rate of interest, the bond will sell at its par value

  12. Changes in Bond Values over Time • If interest rates in the economy fall after the bonds are issued, kd is below the coupon rate. The interest payments and maturity payoff stay the same, causing the bond’s value to increase (investors demand lower returns, so they are willing to pay higher prices for bonds).

  13. Changes in Bond Values over Time • Current yield is the annual interest payment on a bond divided by its current market value Current yield Capital gains yield

  14. Changes in Bond Values over Time • Discount bond • A bond that sells below its par value, which occurs whenever the going rate of interest rises above the coupon rate • Premium bond • A bond that sells above its par value, which occurs whenever the going rate of interest falls below the coupon rate

  15. Changes in Bond Values over Time • An increase in interest rates will cause the price of an outstanding bond to fall • A decrease in interest rates will cause the price to rise • The market value of a bond will always approach its par value as its maturity date approaches, provided the firm does not go bankrupt

  16. Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

  17. Bond Value Kd < Coupon Rate Kd = Coupon Rate Kd > Coupon Rate Years Changes in Bond Values over Time • Time path of value of a 15% Coupon, $1000 par value bond when interest rates are 10%, 15%, and 20%

  18. Approximate yield to maturity Yield to Maturity • YTM is the average rate of return earned on a bond if it is held to maturity

  19. Bond Values with Semiannual Compounding

  20. Interest Rate Risk on a Bond • Interest Rate Price Risk - the risk of changes in bond prices to which investors are exposed due to changing interest rates • Interest Rate Reinvestment Rate Risk - the risk that income from a bond portfolio will vary because cash flows have to be reinvested at current market rates

  21. Value of Long and Short-Term15% Annual Coupon Rate Bonds

  22. Value of Long and Short-Term15% Annual Coupon Rate Bonds 2,000 1,500 1,000 500 14-Year Bond 1-Year Bond 0 5 10 15 20 25

  23. Valuation of Financial Assets - Equity (Stock) • Common stock • Preferred stock • hybrid • similar to bonds with fixed dividend amounts • similar to common stock as dividends are not required and have no fixed maturity date

  24. Stock Valuation Models • Terms:

  25. Stock Valuation Models • Terms: Expected Dividends

  26. Stock Valuation Models • Terms: Market Price

  27. Stock Valuation Models • Terms: Intrinsic Value

  28. Stock Valuation Models • Terms: Expected Price

  29. Stock Valuation Models • Terms: Growth Rate

  30. Stock Valuation Models • Terms: Required Rate of Return

  31. Stock Valuation Models • Terms: Dividend Yield

  32. Stock Valuation Models • Terms: Capital Gain Yield

  33. Stock Valuation Models • Terms: Expected Rate of Return

  34. Stock Valuation Models • Terms: Actual Rate of Return

  35. Stock Valuation Models • Expected Dividends as the Basis for Stock Values • If you hold a stock forever, all you receive is the dividend payments • The value of the stock today is the present value of the future dividend payments

  36. Stock Valuation Models • Expected Dividends as the Basis for Stock Values

  37. Stock Valuation Models • Stock Values with Zero Growth • A zero growth stock is a common stock whose future dividends are not expected to grow at all

  38. Stock Valuation Models • Normal, or Constant, Growth • Growth that is expected to continue into the foreseeable future at about the same rate as that of the economy as a whole • g = a constant

  39. Stock Valuation Models • Normal, or Constant, Growth • (Gordon Model)

  40. Expected Rate of Return on a Constant Growth Stock

  41. Nonconstant Growth • The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole

  42. Nonconstant Growth • 1. Compute the value of the dividends that experience nonconstant growth, and then find the PV of these dividends • 2. Find the price of the stock at the end of the nonconstant growth period, at which time it becomes a constant growth stock, and discount this price back to the present • 3. Add these two components to find the intrinsic value of the stock, .

  43. Changes in Stock Prices • Investors change the rates of return required to invest in stocks • Expectations about the cash flows associated with stocks change

  44. Valuation of Real (Tangible) Assets • Valuation is still based on expected cash flows of the asset

  45. Valuation of Real (Tangible) Assets Year Expected Cash Flow, CF 1 $120,000 2 100,000 3 150,000 4 80,000 5 50,000 To earn a 14% return on investments like this, what is the value of this machine?

  46. 0 1 2 3 4 5 14% PV of $120,000 PV of $100,000 PV of $150,000 PV of $80,000 PF of $50,000 $120,000 $100,000 $150,000 $80,000 $50,000 Asset Value = V0 Cash Flow Time Lines

  47. End of Chapter 10 ValuationConcepts

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