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Corporate Financial Policy
Semester A 2012-13City University of Hong Kong
AC4331 Week 4
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Topic 4
.
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1-2
Introduction to Financial Management
Free Cash Flow
Financial Planning and Forecasting
Financial Assets and Time Value of Money
Risk and Return Bond and Stock Valuation
Cost of Capital
Cash Flow Estimation and Risk Analysis
Capital Structure and Leverage
Treasury and Valuation
Enterprise Risk Management Dividends and Share Repurchase
Merger and Acquisitions
Working Capital Management
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Extra Ref:Financial Management, Theory and Practice, 12eEugene and
Brigham
Topic 4a:Bond Valuation
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5-4
Know the important bond featuresand bond types
Understand bond values and why theyfluctuate
Understand bond ratings and whatthey mean
Understand the impact of inflation on
interest rates Understand the term structure of
interest rates and the determinants of
bond yields (WEEK 3
)
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Chapter 9
Key Features of Bonds
Bond Valuation
Measuring Yield Assessing Risk
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Debt
Not an ownershipinterest
Creditors do not have
voting rights Interest is considered a
cost of doing businessand is tax deductible
Creditors have legalrecourse if interest or
principal payments aremissed
Excess debt can lead tofinancial distress andbankruptcy
Equity
Ownership interest
Common stockholdersvote for the board of
directors and other issues Dividends are not
considered a cost of doingbusiness and are not taxdeductible
Dividends are not aliability of the firm, andstockholders have no legalrecourse if dividends arenot paid
An all-equity firm cannotgo bankrupt
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A long-term debt instrument in which aborrower agrees to make payments ofprincipal and interest, on specific dates, to
the holders of the bond.
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Primarily traded in the over-the-counter(OTC) market.
Most bonds are owned by and traded among
large financial institutions. The Wall Street Journalreports key
developments in the Treasury, corporate, andmunicipal markets. Online edition lists
trading for each day the most actively-tradedinvestment-grade, high-yield, andconvertible bonds.
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Par value face amount of the bond, whichis paid at maturity (assume $1,000).
Coupon interest rate stated interest rate
(generally fixed) paid by the issuer. Multiplyby par value to get dollar payment ofinterest.
Maturity date years until the bond must be
repaid. Issue date when the bond was issued.
Yield to maturity rate of return earned ona bond held until maturity (also called the
promised yield). 9-9
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Allows issuer to refund the bond issue ifrates decline (helps the issuer, but hurts theinvestor).
Borrowers are willing to pay more, andlenders require more, for callable bonds.
Most bonds have a deferred call and adeclining call premium.
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Provision to pay off a loan over its life ratherthan all at maturity.
Similar to amortization on a term loan.
Reduces risk to investor, shortens averagematurity.
But not good for investors if rates declineafter issuance.
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Call x% of the issue at par, for sinking fundpurposes. Likely to be used if rd is below the coupon rate and
the bond sells at a premium.
Buy bonds in the open market. Likely to be used if rd is above the coupon rate and
the bond sells at a discount.
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N
N
2
2
1
1
r)(1
CF
...r)(1
CF
r)(1
CF
Value
0 1 2 Nr%
CF1 CFNCF2Value
...
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Convertible bond may be exchanged for commonstock of the firm, at the holders option.
Warrant long-term option to buy a stated numberof shares of common stock at a specified price.
Putable bond allows holder to sell the bond back tothe company prior to maturity.
Income bond pays interest only when interest isearned by the firm.
Indexed bond interest rate paid is based upon therate of inflation.
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The discount rate (ri) is the opportunity costof capital, and is the rate that could beearned on alternative investments of equal
risk.
ri = r* + IP + MRP + DRP + LP
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$1,000V
$385.54$38.55...$90.91V(1.10)
$1,000
(1.10)
$100...
(1.10)
$100V
B
B
10101B
9-16
0 1 2 Nr%
100 100 + 1,000100VB = ?
...
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This bond has a $1,000 lump sum (the parvalue) due at maturity (t = 10), and annual$100 coupon payments beginning at t = 1
and continuing through t = 10, the price ofthe bond can be found by solving for the PVof these cash flows.
INPUTS
OUTPUTN I/YR PMTV FV10 10 100 1000
-10009-17
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This bond has an annual coupon payment of$130. Since the risk is the same the bondhas the same yield to maturity as the
previous bond (10%). In this case the bondsells at a premium because the coupon rateexceeds the yield to maturity.
INPUTS
OUTPUTN I/YR PMTV FV10 10 130 1000
-1184.349-18
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This bond has an annual coupon payment of$70. Since the risk is the same the bond hasthe same yield to maturity as the previousbonds (10%). In this case, the bond sells at adiscount because the coupon rate is lessthan the yield to maturity.
INPUTS
OUTPUTN I/YR PMTV FV10 10 70 1000
-815.669-19
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What would happen to the value of thesethree bonds if the required rate of returnremained at 10%?
9-20
Yearsto Maturity
1,184
1,000
816
10
13% coupon rate
7% coupon rate
10% coupon rate
VB
5 0
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At maturity, the value of any bond mustequal its par value.
If rd remains constant:
The value of a premium bond would decrease overtime, until it reached $1,000.
The value of a discount bond would increase overtime, until it reached $1,000.
A value of a par bond stays at $1,000.
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10d
10d
1d
Nd
Nd
1d
B
)r(1
1,000
)r(1
90...
)r(1
90$887
)r(1
M
)r(1
INT...
)r(1
INTV
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Must find the rd that solves this model.
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Solving for I/YR, the YTM of this bond is10.91%. This bond sells at a discount,because YTM > coupon rate.
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INPUTS
OUTPUTN I/YR PMTV FV10
10.91
90 1000887
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Solving for I/YR, the YTM of this bond is7.08%. This bond sells at a premium,because YTM < coupon rate.
INPUTS
OUTPUTN I/YR PMTV FV10
7.08
90 10001134.2
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CGYExpected
CYExpected
YTMreturntotalExpected
priceBeginning
priceinChange(CGY)yieldgainsCapital
priceCurrent
paymentcouponAnnual(CY)eldCurrent y i
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Find the current yield and the capital gainsyield for a 10-year, 9% annual coupon bondthat sells for $887, and has a face value of$1,000.
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%15.101015.0
887$
90$eldCurrent y i
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YTM = Current yield + Capital gains yield
Could also find the expected price one yearfrom now and divide the change in price by the
beginning price, which gives the same answer.
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%76.0
10.15%10.91%
CYYTMCGY
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Interest rate risk is the concern that rising rdwill cause the value of a bond to fall.
rd 1-year Change 10-year Change
5% $1,048 $1,38610% 1,000 1,000
15% 956 749
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The 10-year bond is more sensitive tointerest rate changes, and hence hasmore interest rate risk.
+ 4.8%
4.4%
+38.6%
25.1%
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0
200
400
600
8001,000
1,200
1,400
1,600
0 5 10 15 20
Value($)
YTM (%)
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10-Year Bond
1-Year Bond
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Reinvestment rate risk is the concern that rdwill fall, and future CFs will have to bereinvested at lower rates, hence reducingincome.
EXAMPLE: Suppose you just won $500,000playing the lottery. You intend to invest the
money and live off the interest.
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You may invest in either a 10-year bond or aseries of ten 1-year bonds. Both 10-yearand 1-year bonds currently yield 10%.
If you choose the 1-year bond strategy: After Year 1, you receive $50,000 in income and
have $500,000 to reinvest. But, if 1-year rates fallto 3%, your annual income would fall to $15,000.
If you choose the 10-year bond strategy: You can lock in a 10% interest rate, and $50,000
annual income for 10 years, assuming the bond isnot callable.
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CONCLUSION: Nothing is riskless!
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Short-term
AND/OR
High-coupon
Bonds
Long-term
AND/OR
Low-coupon
Bonds
Interest rate risk Low HighReinvestment rate risk High Low
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1.Multiply years by 2:Number of periods = 2N
2.Divide nominal rate by 2:
Periodic rate (I/YR) = rd/23.Divide annual coupon by 2:
PMT = Annual coupon/2
INPUTS
OUTPUTN I/YR PMTV FV2N rd/2 cpn/2 OKK
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1.Multiply years by 2:N = 2 x 10 = 20.
2.Divide nominal rate by 2:
I/YR = 13/2 = 6.5.3.Divide annual coupon by 2:
PMT = 100/2 = 50.
INPUTS
OUTPUTN I/YR PMTV FV20 6.5 50 1000
- 834.729-34
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The semiannual bonds effective rate is:
10.25% > 10% (the annual bonds effectiverate), so you would prefer the semiannualbond.
9-35
10.25%1
2
0.1011
M
r1EFF%
2M
NOM
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The semiannual coupon bond has aneffective rate of 10.25%, and the annualcoupon bond should earn the same EAR. Atthese prices, the annual and semiannualcoupon bonds are in equilibrium, as theyearn the same effective return.
INPUTS
OUTPUTN I/YR PMTV FV10 10.25 100 1000
- 984.809-36
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The bonds yield to maturity can bedetermined to be 8%. Solving for the YTC isidentical to solving for YTM, except the timeto call is used for N and the call premium isFV.
INPUTS
OUTPUTN I/YR PMTV FV8
3.568
50 10501135.90
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3.568% represents the periodic semiannualyield to call.
YTCNOM = rNOM = 3.568% x 2 = 7.137% is the
rate that a broker would quote. The effective yield to call can be calculated.
YTCEFF = (1.03568)2 1 = 7.26%
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The coupon rate = 10% compared to YTC =7.137%. The firm could raise money byselling new bonds which pay 7.137%.
Could replace bonds paying $100 per yearwith bonds paying only $71.37 per year.
Investors should expect a call, and to earnthe YTC of 7.137%, rather than the YTM of
8%.
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In general, if a bond sells at a premium, then(1) coupon > rd, so (2) a call is more likely.
So, expect to earn: YTC on premium bonds.
YTM on par and discount bonds.
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If an issuer defaults, investors receive lessthan the promised return. Therefore, theexpected return on corporate and municipalbonds is less than the promised return.
Influenced by the issuers financial strengthand the terms of the bond contract.
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Mortgage bonds
Debentures
Subordinated debentures
Investment-grade bondsJunk bonds
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Investment Grade Junk Bonds
Moodys Aaa Aa A Baa Ba B Caa C
S & P AAA AA A BBB BB B CCC C
Bond ratings are designed to reflect the
probability of a bond issue going intodefault.
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Financial performance Debt ratio
TIE ratio
Current ratio
Qualitative factors: Bond contract provisions Secured vs. Unsecured debt
Senior vs. subordinated debt
Guarantee and sinking fund provisions
Debt maturity
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Earnings stability
Regulatory environment
Potential antitrust or product liabilities
Pension liabilities Potential labor problems
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Default risk premium remember bondratings
Taxability premium remember municipalversus taxable
Liquidity premium bonds that have morefrequent trading will generally have lowerrequired returns (remember bid-ask spreads)
Anything else that affects the risk of the cash
flows to the bondholders will affect therequired returns.
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5-47
How do you find the value of a bond, andwhy do bond prices change?
What is a bond indenture, and what aresome of the important features?
What are bond ratings, and why are theyimportant?
How does inflation affect interest rates?
What is the term structure of interest rates? What factors determine the required return
on bonds?
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You are in charge of a fixed-income investment
fund. With a view that the economy mayencounter a hard landing next year and thecentral bank will have no choice but to cut theinterest rate aggressively, you approached his
broker to buy the following bond:Issuer : HK Asset Co Ltd Credit Rating : AA
Par Value : $1,000,000
Original Maturity : 10 years
Remaining Maturity : 5 years
Coupon : 6.0%
Market Yield : 7.5%
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Contrary to your expectation, the interest rate surged twelvemonths later. Even worse, the rating agency downgraded HK
Assets credit rating to A. You decided to stop the loss onthis investment and obtained the following marketinformation:
5-year 4-year
Government Bond Yield: 8.5% 8.00%
Credit Spreads for Corporate Bonds
5-year 4-year
AAA 0.10% 0.05%
AA 0.30% 0.20% A 0.60% 0.50%
BBB 0.85% 0.65%
49
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(a) (i) How much have you paid to purchasethe bond? (4 marks) (ii) What would be the amount that you couldreceive by selling the bond? (4 marks) (iii) How much would you lose from thedepreciation of the bond price? (1 mark)
Module B (February 2007 Session) Page 6 of 6
50
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(i) Year 1 2 3 4 5 Coupon 60,000 60,000 60,000 60,000 1,060,000
Discount Rate 1.075 1.156 1.242 1.335 1.436 Discounted CF 55,814 51,920 48,298 44,928 738,352
Bond Price $939,312
(ii) Year 1 2 3 4
Coupon 60,000 60,000 60,000 1,060,000
Discount Rate 1.085 1.177 1.277 1.386
Discounted CF 55,300 50,967 46,974 764,869
Bond Price $918,110
(iii)Change in price = $918,110 $939,312
= -$21,202
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Topic 4b:Stock Valuation
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53
Fundamentals of valuations
Valuation Methods Book Value Discounted Cash Flow Method Relative Method
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Chapter 10
Features of Common Stock
Determining Common Stock
Values using Dividend GrowthModel, Corporate ValuationModel and Multiples
Preferred Stock10-54
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Represents ownership Ownership implies control
Stockholders elect directors
Directors elect management Managements goal: Maximize the stock
price
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Outside investors, corporate insiders, andanalysts use a variety of approaches toestimate a stocks intrinsic value (P0).
In equilibrium we assume that a stocks priceequals its intrinsic value. Outsiders estimate intrinsic value to help
determine which stocks are attractive to buyand/or sell.
Stocks with a price below (above) its intrinsic valueare undervalued(overvalued).
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10-57
True
InvestorReturns
TrueRisk
Perceived
InvestorReturns
PerceivedRisk
Managerial Actions, the EconomicEnvironment, Taxes, and the Political
Climate
StocksIntrinsic
Value
StocksMarket Price
Market Equilibrium:Intrinsic Value = Stock
Price
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Discounted dividend model
Corporate valuation model
Using the multiples of comparable firms
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Value of a stock is the present value of thefuture dividends expected to be generated bythe stock.
31 20 1 2 3
s s s s
DD D DP = + + + ... +
(1+r ) (1+r ) (1+r ) (1+r )
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0 1
0
s s
D (1+g) DP = =
r g r g
10-60
A stock whose dividends are expected togrow forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
If g is constant, the discounted dividend
formula converges to:
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10-61
t
tt
)r1(
DPVD
t0 PVDP
$
0.25
Years (t)0
t0t )g1(DD
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If g > rs, the constant growth formula leadsto a negative stock price, which does notmake sense.
The constant growth model can only be usedif: rs > g.
g is expected to be constant forever.
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If rRF = 7%, rM = 12%, and b = 1.2, what isthe required rate of return on the firmsstock?
rs = rRF + (rM rRF)b= 7% + (12% 7%)1.2= 13%
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10-64
1.8761
1.7599
D0 = 2.00
1.6509
rs = 13%
g = 6%0 1
2.247
2
2.382
3
2.12
D0 = $2 and g is a constant 6%.
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Using the constant growth model:
$30.29
0.07
$2.12
0.060.13
$2.12
gr
DP
s
10
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D1 will have been paid out already. So, P1 isthe present value (as of Year 1) of D2, D3, D4,etc.
Could also find expected P1 as:
$32.10
0.060.13
$2.247gr
DP
s
21
$32.10(1.06)PP 01
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Dividend yield= D1/P0 = $2.12/$30.29 = 7.0%
Capital gains yield
= (P1 P0)/P0= ($32.10 $30.29)/$30.29 = 6.0%
Total return (rs)
= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
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The dividend stream would be a perpetuity.
$15.380.13$2.00
rPMTP0
2.00 2.002.00
0 1 2 3rs = 13%
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Can no longer use just the constant growthmodel to find stock value.
However, the growth does become constantafter 3 years.
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rs = 13%
g = 30% g = 30% g = 30% g = 6%
2.301
2.647
3.045
46.114
54.107 =
0 1 2 3 4
D0 = 2.00 2.600 3.380 4.394 4.658
P0
$66.5406.00.13
4.658P
3
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Dividend yield (first year)= $2.60/$54.11 = 4.81%
Capital gains yield (first year)
= 13.00% 4.81% = 8.19% During nonconstant growth, dividend yield
and capital gains yield are not constant, andcapital gains yield g.
After t = 3, the stock has constant growthand dividend yield = 7%, while capital gainsyield = 6%.
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10-72
rs = 13%
g = 0% g = 0% g = 0% g = 6%
1.77
1.57
1.39
20.99
25.72 =
0 1 2 3 4
D0 = 2.00 2.00 2.002.00
2.12
P0
$30.2906.00.13
2.12P3
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Dividend yield (first year)= $2.00/$25.72 = 7.78%
Capital gains yield (first year)
= 13.00% 7.78% = 5.22%
After t = 3, the stock has constant growthand dividend yield = 7%, while capital gains
yield = 6%.
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Yes. Even though the dividends aredeclining, the stock is still producingcash flows and therefore has positivevalue.
$9.890.19
$1.88
(-0.06)0.13
(0.94)$2.00
gr
)g(1D
gr
DP
s
0
s
10
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Capital gains yield= g = 6.00%
Dividend yield
= 13.00% (6.00%) = 19.00%
Since the stock is experiencing constantgrowth, dividend yield and capital gains yield
are constant. Dividend yield is sufficientlylarge (19%) to offset a negative capital gains.
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Also called the free cash flow method.Suggests the value of the entire firm equalsthe present value of the firms free cashflows.
Remember, free cash flow is the firms after-tax operating income less the net capitalinvestment.
FCF = EBIT(1 T) + Depreciation Expense Net capital investment
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Find the market value (MV) of the firm, byfinding the PV of the firms future FCFs.
Subtract MV of firms debt and preferredstock to get MV of common stock.
Divide MV of common stock by the numberof shares outstanding to get intrinsic stockprice (value).
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Often preferred to the discounted dividendmodel, especially when considering numberof firms that dont pay dividends or whendividends are hard to forecast.
Similar to discounted dividend model,assumes at some point free cash flow willgrow at a constant rate.
Terminal value (TVN) represents value of firmat the point that growth becomes constant.
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Given: Long-Run gFCF = 6% and WACC = 10%
10-79
r= 10%
g = 6%
-4.545
8.264
15.026
398.197
416.942
0 1 2 3 4
-5 21.20
3TV06.00.10
21.20530
10 20
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10-80
The firm has $40 million total in debt andpreferred stock and has 10 million shares ofstock.
MV of equity = MV of firm MV of debt
=$416.94 $40
=$376.94 million
Value per share = MV of equity /# of shares=$376.94 /10
=$37.69
What is the firms intrinsic value
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The firms total value is calculated as follows:
Using your financial calculator, enter the following inputs:CF0 = 0; CF1 = 3000000; CF2 = 6000000; CF3 = 10000000;CF
4= 15000000 + 321000000 = 336000000; I/YR = 12;
and then solve for NPV = $228,113,612.
10-81
per share?
What is the firms intrinsic value
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To find Barretts stock price, you need to first findthe value of its equity. The value of Barrettsequity is equal to the value of the total firm lessthe market value of its debt and preferred stock.
Total firm value $228,113,612Market value, debt + preferred 60,000,000Market value of equity $168,113,612
10-82
per share?
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Analysts often use the following multiples tovalue stocks. P/E P/CF
P/Sales
EXAMPLE: Based on comparable firms,estimate the appropriate P/E. Multiply thisby expected earnings to back out an estimateof the stock price.
10-83
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Hybrid security. Like bonds, preferred stockholders receive a
fixed dividend that must be paid beforedividends are paid to common stockholders.
However, companies can omit preferreddividend payments without fear of pushingthe firm into bankruptcy.
10-84
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10-85
p
p
p
DV =
r
$5$50=
r
p
$5r =
$50
=0.10 =10%
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86
What are three main methods of valuation? What determines the price of a share of stock?
What determines gand Rin the DGM?
Discuss the importance of the PE ratio.
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Bond Duration
87
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For Point 5.8, Source: Financial Markets and Institutions by Mishkin
and Eakins , 7th Edition
DUR tCP
t
1 i tt1
n
CPt1 i tt1
n
Duration is a measure of bond price sensitivity tochange in yield
One can derivate the duration measure by takingderivatives of the following bond formula with
respect to the yield to maturity
P C
1 i
C
1 i 2
C
1 i 3 ...
C
1 i n
F
1 i n
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Copyright 2009 Pearson
Prentice Hall. All rights reserved.
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Copyright 2009 Pearson
Prentice Hall. All rights reserved.
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Copyright 2009 Pearson
Prentice Hall. All rights reserved.
%P DUR i1 i
%P 6.760.01
1 0.10%P 0.0615 6.15%
i 10% to 11%:
Table 3-4, 10% coupon bond
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Copyright 2009 Pearson
Prentice Hall. All rights reserved.
i 10% to 11%: 20% coupon bond, DUR= 5.72 years
%P 5.72 0.011 0.10
%P 0.0520 5.20%
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Copyright 2009 Pearson
Prentice Hall. All rights reserved.
The greater is the duration of a security, thegreater is the percentage change in themarket value of the security for a givenchange in interest rates
Therefore, the greater is the duration of asecurity, the greater is its interest-rate risk
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Copyright 2009 Pearson
Prentice Hall. All rights reserved.
Key facts about duration1. All else equal, when the maturity of a bond
lengthens, the duration rises as well
2. All else equal, when interest rates rise, the
duration of a coupon bond fall3. The higher is the coupon rate on the bond, the
shorter is the duration of the bond
4. Duration is additive: the duration of a portfolio of
securities is the weighted-average of the durationsof the individual securities, with the weightsequaling the proportion of the portfolio invested ineach
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Matching the durations of bank assets andliabilities
In 1980s, the duration of assets in US savingsand loans associations (S&Ls) weremismatched with long-term fixed-ratemortgage and short-term deposits, the wholeindustry failed when market interest rate roseto double digit
sliabilitieassetDD