Chapter 4

1. Chapter 4 Principles of Corporate Finance, 8/e (Special Indian Edition) The Value of Bonds and Common Stocks

2. Topics Covered • Using PV Formulas to Value Bonds • How Common Stocks are Traded • How Common Stocks are Valued • Estimating the Cost of Equity Capital • Stock Prices and EPS

3. Valuing a Bond Example If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. Cash Flows

4. Valuing a Bond Example continued • If today is January 2004, what is the value of the following bond? • A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. • The price at a 3.8% YTM is as follows

5. Bond Prices and Yields Price Yield

6. Valuing a Bond Example continued • If today is January 2004, what is the value of the following bond? • A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. • The price at a 2.0% YTM is as follows

7. Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation. Secondary Market - market in which already issued securities are traded by investors. Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by earnings per share.

8. Stocks & Stock Market Book Value - Net worth of the firm according to the balance sheet. Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors. Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.

9. Trading of Stocks • Primary Market • Secondary Market Quotations of Infosys in NSE as on 29 April, 2006

10. Valuing Common Stocks Expected Return- The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

11. Valuing Common Stocks Example: If Fledgling Electronics is selling for Rs.100 per share today and is expected to sell for Rs.110 one year from now, what is the expected return if the dividend one year from now is forecasted to be Rs.5.00?

12. Valuing Common Stocks The formula can be broken into two parts. Dividend Yield + Capital Appreciation

13. Valuing Common Stocks Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

14. Valuing Common Stocks Return Measurements

15. H - Time horizon for your investment. Valuing Common Stocks Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.

16. Valuing Common Stocks

17. Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of Rs.3, Rs.3.24, and Rs.3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of Rs.94.48. What is the price of the stock given a 12% expected return?

18. Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of Rs.3, Rs.3.24, and Rs.3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of Rs.94.48. What is the price of the stock given a 12% expected return?

19. Assumes all earnings are paid to shareholders. Valuing Common Stocks If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

20. Valuing Common Stocks Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).

21. Valuing Common Stocks Example- continued If the same stock is selling for Rs.100 in the stock market, what might the market be assuming about the growth in dividends? Answer The market is assuming the dividend will grow at 9% per year, indefinitely.

22. Valuing Common Stocks • If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher. Payout Ratio - Fraction of earnings paid out as dividends Plowback Ratio - Fraction of earnings retained by the firm.

23. Valuing Common Stocks Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations. g = return on equity X plowback ratio

24. Valuing Common Stocks Example Our company forecasts to pay a Rs.8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

25. Valuing Common Stocks Example Our company forecasts to pay a Rs.8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision? No Growth With Growth

26. Valuing Common Stocks Example - continued If the company did not plowback some earnings, the stock price would remain at Rs.55.56. With the plowback, the price rose to Rs.100.00. The difference between these two numbers) is called the Present Value of Growth Opportunities (PVGO).

27. Valuing Common Stocks Present Value of Growth Opportunities (PVGO) - Net present value of a firm’s future investments. Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio X return on equity.