© Prentice Hall, 2000 1 Chapter 5 Bond and Stock Valuation Shapiro and Balbirer: Modern Corporate...

© Prentice Hall, 2000

1

Chapter 5

Bond and Stock Valuation

Shapiro and Balbirer: Modern Corporate Finance:

A Multidisciplinary Approach to Value Creation

Graphics by Peeradej Supmonchai


2

Learning Objectives

Explain the concept of market efficiency and how it influences the market price of securities.

Describe the features of bonds, preferred stock, and common stock.

Understand the concept of an investment’s required rate of return and its importance in the valuation of marketable securities.

Use valuation principles to calculate a bond’s value and/or its yield to maturity.


3

Learning Objectives (Cont.) Calculate prices and required rate of return for

common stock using the constant dividend growth model.

Use stock valuation models to describe when corporate growth strategies can create shareholder value.

Use stock valuation principles to value the acquisition of a company.

List and describe the various theories for explaining the term structure of interest rates.

Use the concept of duration concepts to evaluate the interest sensitivity of both individual bonds and bond portfolios.


4

Competitive Capital Markets and Asset Valuation

In well-developed capital markets, two individuals who can agree on the future cash flows and risk characteristics of a specific financial asset will always assign the same price. This “law of one price” depends on the existence of perfectly competitive capital market. In such a market:

buyers and sellers can enter and leave the market freely;

market participants can buy and sell securities with no transactions costs;

market participants have cost-free access to all relevant information.


5

Market Efficiency and Asset Valuation

In efficient capital markets, current security prices reflect everything that is known about the prospects of an individual security. There are three levels of market efficiency:

weakly efficient market

semi-strong efficient market

strong-form efficient market


6

Price and Value

The price of a security is what a buyer is ready to pay a willing seller at a given point in time. Prices are very precise quantities.

The value of a corporate security should reflect the economic value of the firm’s assets whose value in turn is related to their ability to generate cash. Expectations play a vital role in the valuation process.


7

Nature of Corporate Bonds

Represent a credit instrument where the company promises to pay some principal amount plus periodic interest to an investor.

Principal and interest payments must be met before dividends can be paid to either preferred or common stockholders.

Failure to meet interest and principal payment is an act of default that can lead to bankruptcy and possible liquidation.

Creditors have first claim on the proceeds from the sales of assets.


8

Features of Corporate Debt

Par, or Face Value

Coupon Interest Rate

Maturity Date

Sinking Fund

Call Provision


9

Types of Corporate Debt

Unsecured Obligations Debentures Notes

Mortgage Bonds

Collateral Trust Certificates

Equipment Trust Certificates

Subordinated Debentures

Convertible Debt

Fixed versus Floating-Rate Bonds


10

Global Credit Markets

Domestic Bonds

Foreign Bonds

Eurobonds

ECU Bonds


11

U.S. Domestic and Eurobond Markets - Some Differences

Virtually all bond issues in the US pay

interest semiannually. Eurobonds pay

interest annually.

All bonds in the US are in registered form.

Most Eurobonds are in bearer form.


12

Bond Credit Ratings

Bond ratings represent a credit agency’s assessment of a firm’s ability to meet its debt obligations. The main credit rating agencies are Moody’s and Standard and Poor’s. In coming up with their ratings, agencies consider many factors including earnings stability, leverage, interest and fixed charge coverage, and asset protection. The assessment of management quality is also an important intangible aspect of the rating process.


13

Investment Grade Versus Junk Bonds

Bonds rated Baa or better by Moody’s or BBB by Standard and Poor’s are considered investment grade. Banks and other financial institutions can only hold investment grade bonds.

Bonds not considered investment grade are referred to as junk, or high-yield bonds. In the 1980s, start-up companies who could not get bank accommodation, issued these bonds to finance growth.


14

Bond Valuation

Where:

P = the price (or value) of the bond

C = the periodic interest payments in dollars

N = the number of years to maturity

M = the maturity (par) value of the bond

kd = the required rate of return

NN

dddd k

M

k

C

k

C

k

CP

11...

112


15

Bond Valuation

The value of the bond is the present value of the coupon interest payments plus the face value at maturity, discounted at the bond’s required rate of return.

Traders refer to a bond’s required rate of return as its yield to maturity (YTM).

Coupon interest payments and maturity values are typically set at the time of issue. Bond prices change in response to market interest rates.


16

Bond Valuation - An Example

VALUATION OF AT&T 7 2005

ASSUMING AN 7.5 PERCENT YIELD TO MATURITY

PERIOD CASH PRESENT VALUE PRESENT

FLOWS FACTOR@ 7.5% VALUE

1-7 $70 5.2966 $370.76

7 $1,000 .6028 602.80

VALUE OF BOND $973.56


17

Bond Valuation - Another Example

VALUATION OF ATT 7 2005

ASSUMING AN 6.5 PERCENT YIELD TO MATURITY

PERIOD CASH PRESENT VALUE PRESENT FLOWS FACTOR@ 6.5% VALUE

1-7 $70 5.4845 $383.92

7 $1,000 .6435 643.50

VALUE OF BOND $1,027.42


18

Bonds, YTMs, Coupon Rates and Bond Prices

PRICES OF 10- AND 20-YEAR BONDS

8 PERCENT COUPON

$1,000 FACE

INTEREST PAID ANNUALLY

YTM 10-YEAR BOND 20-YEAR BONDS

6 % $1,147.20 $1,229.40

8 % $1,000.00 $1,000.00

10 % $877.11 $829.73


19

Interest Rate Sensitivity of Bonds

Prices and YTMs are inversely related. Increases in market yields cause prices to fall; conversely, a drop in interest rates leads to a rise in prices.

Longer maturity bonds are more sensitive to changes in YTMs than are shorter-term bonds.

All other things equal, the prices of high coupon bonds are less price-sensitive to a given change in YTM than lower coupon bonds.


20

Yield to Maturity (YTM)

A bond’s yield to maturity (YTM) is the discount rate that equates the present value of coupon interest payments plus the principal at maturity with the bond’s current price.


21

Computing the Yield to Maturity - Approximation Formula

Where:

C = the annual interest payments

M = the maturity (face) value of the bond

P = the current market price of the bond

N = the number of years to maturity

2

])(

[

PMNPM

CYTM


22

Computing the Yield to Maturity - An Example

Suppose AT&T had a bond selling at 107.25% of face value. The bond matures in 7 years and carries a coupon rate of 7%. What is the bond’s YTM?


23

Computing the Yield to Maturity - Solution

[$70.00 + ($1,000.00 - $1072.50)/7]

YTM =

($1,000.00 + $1072.50)/2

= 5.76 %


24

Bond Pricing - Semiannual Interest Payments

VALUATION OF AT&T 7 2005

PERIOD CASH PRESENT VALUE PRESENT

FLOWS FACTOR@ 3.75% VALUE

1-14 $35.00 10.7396 $375.89

14 $1,000 .5973 597.30

VALUE OF BOND $973.19


25

Characteristics of Preferred Stock

Dividends are typically fixed at the time of issue and must be paid before common stockholders receive any payment.

Creditors have prior claim on earnings; interest on debt must be paid before preferred stockholders can receive anything.

Failure to pay preferred dividend does not result in bankruptcy.

Once creditor claims have been met, preferred stock has priority over common stockholders in terms of claims on assets in liquidation.


26

Features of Preferred Stock

Par Value

Dividend Rate

Cumulative Feature

Voting Rights

Sinking Funds


27

Features of Preferred Stock - An Example

PREFERRED STOCK OF DU PONT DECEMBER 31, 1997

Cumulative Preferred Stock, Without Par Value, 23 million shares

authorized, Issued at December 31:

$4.50 Series - 1,672,594 shares issued (Callable at $120)

Aggregate Book Value $167,259,400

$3.50 Series - 700,000 shares issued (Callable at $102)

Aggregate Book Value $70,000,000


28

Valuation of Preferred Stock

Where:

P = the value of a share of preferred stock

D = the stated dividend per share of preferred stock

kp = the required rate of return on preferred stock

M = the issues’ per share redemption value in year N

NN

pppp k

M

k

D

k

D

k

DP

11...

112


29

Valuation of Preferred Stock

Where:

P = the value of a share of preferred stock

D = the stated dividend per share of preferred stock

kp = the required rate of return on preferred stock

pk

DP


30

Valuation of Preferred Stock - An Example

Suppose an investor is considering the

purchase of a preferred stock issue that is

expected to pay $3.00 a share in perpetuity.

If the investor assigns a required rate of

return of 7.5 percent to the issue, what’s the

maximum amount he/she should be willing

to pay?


31

Valuation of Preferred Stock - Solution

shareP /40$075.0

00.3$


32

Characteristics of Common Stock

Common stockholders are the owners of a company

Shareholders are residual claimholders getting what’s left over from income and assets once the claims of creditors and preferred stockholders have been satisfied.

Because of limited liability, shareholder losses cannot exceed their initial investment.

Unlike preferred stock, there is no pre-set dividend rate. Instead, dividends are paid at the discretion of the firm’s board of directors.


33

Accounting for Common Stock

SHAREHOLDER’S EQUITY FOR COCA-COLA

DECEMBER 31,1997

(in millions except share data)

Common Stock $0.25 par value $ 861

Capital Surplus 1,527

Reinvested Earnings 17,869

Adjustments (1,364)

Treasury Stock at Cost (11,582)

Total Shareholder’s Equity $7,311

Shares Authorized 5,600,000,000

Shares Issued 3,443,441,902

Shares Outstanding 2,470,629,181


34

Return on Investment in Common Stock

Where:

Po = the current price of the stock

P1 = the price expected at the end-of-the-year

D1 = the dividends expected over the year

0

011ReP

PPDturnExpected


35

Return on Investment in Common Stock - An Example

Suppose that a share of stock was selling for $50 at the beginning of the year. If you believe that dividends during the year will be $2.00, and the stock price will go to $60 by the end of the year. The expected return will be:

[$2 + ($60 - $50)] $22Expected Return = =

$50 $50

= 0.24 or 24%


36

Valuation of Common Stock - The Dividend Discount Model

Where:

Po = the value of a share of stock

D1, D2, … = the expected dividends in year 1, 2, …

ke = the required rate of return on common stock

Ne

N

eek

D

k

D

k

DP

1...

112

210


37

Constant Dividend Growth Model

Where:

Po = the value of a share of stock

D1 = the expected dividends in year 1


g = the expected growth rate of the company

Ne

N

eek

gD

k

gD

k

DP

1

)1(...

1

)1(

1

11

211

0


38

Constant Dividend Growth Model

gk

DP

e 1

0


39

Constant Dividend Growth Model - An Example

Suppose a firm is expected to pay a dividend of $2.00 per share next year, and this dividend is expected to grow at a 4% compound annual rate into the indefinite future. The rate of return on common stock is 12 %, the value of a share would be:

25$)04.012.0(

00.2$0

P


40

Determining Required Rates of Return on Common Stock

gP

Dke

0

1


41

Determining Required Rates of Return on Common Stock - An Example

Suppose PG’s common stock is selling for $66 per share, and has a current dividend of $1.14. Past dividends have grown at 13 percent, and this growth is expected into the indefinite future. PG’s required rate of return would be:

%1513.002.0

13.066$

)13.1(14.1$)1(

0

0

e

e

k

gP

gDk


42

Constant Dividend Growth Model and P/E Multiples

gk

EDEP

e 11

10

//


43

Determinants of P/E Multiples

Dividend payout ratio

Risk as reflected by the required return

Expected growth in earnings or dividends


44

Present Value of Growth Opportunities

Where:

PVGO = the present value of growth opportunities

E1 = the earnings of a no-growth firm


PVGOk

EP

e

10


45

Growth Strategies and Value Creation

To create value through growth, managers have to find investment projects offering returns that are greater than the shareholders’ required rate of return. Otherwise, stockholders would be better off getting all of the earnings in the form of dividends and doing their own investing.


46

Above-Average Growth - An Example

Suppose that Logicon Semiconductor has recently developed a line of specialty microchip that was well-received by the market. Logicon just paid a dividend of $1.50 a share, and this dividend is expected to grow at a rate of 20% over the next 5 years. Beginning in year 6, Logicon’s long-run dividend growth rate will settle down to 4% annually. How much would you pay for the stock if your required return were 13 %?


47

Above-Average Growth Model - Components of Value

Present Value of Dividends During Period

of Above -Average Growth

Present Value of Stock Price at End of

Above-Average Growth Period


48

Above-Average Growth Model - Valuing the High Growth Dividend Stream

Year Dividend x Present Value Factor@13 = Present Value

1 $1.80 0.8850 $1.59

2 2.16 0.7832 1.69

3 2.59 0.6931 1.80

4 3.11 0.6133 1.91

5 3.73 0.5428 2.02

Total $9.01


49

Above-Average Growth Model - Valuing the End of High Growth Period Stock Price

Total Value of Logicon = $9.01 + $23.39 = $32.40

39.23)13.1(

10.43$)(

10.43$)04.013.0(

)04.1(73.3$

)(

)1(

55

55

PPV

gk

gDIVP

e

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