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Fundamentals of Corporate Finance 3e

Fundamentals of Corporate Finance 3e

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- 1. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-1Chapter SixValuing Shares and Bonds
- 2. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-26.1 Bonds and Bond Valuation6.2 Ordinary Share Valuation6.3 Summary and ConclusionsChapter Organisation
- 3. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-3Chapter Objectives• Outline the features of bonds.• Calculate the value (price) of a bond assuming annual andsemi-annual coupons.• Understand the implications of interest rate risk for the valueof a bond.• Calculate the value of an ordinary share under differentdividend growth scenarios.• Explain the components of required return.
- 4. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-4Debt Securities• Debt securities are issued when an organisation wishes toborrow 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 AustraliaPty Ltd6-5Bond 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 atthe 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 ispayable.
- 6. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-6Bond Yields• Yield to maturity is the market interest rate that equates abond’s present value of interest payments and principalrepayment with its price.• There is an inverse relationship between market interestrates and bond price.
- 7. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-7Bond Price Sensitivity to InterestRates (YTM)4% 6% 8% 10% 12% 14% 16%$1 800$1 600$1 400$1 200$1 000$ 800$ 600Bond priceYield to maturity, YTMCoupon = $10020 years to maturity$1000 face valueKey Insight: Bond prices andYTMs are inversely related.
- 8. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-8Bond Value( )( )trFrtr/C++ +−×=+=1111valuefaceofPVpaymentscouponofPVV
- 9. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-9Example 1—Bond Value• A bond with a face value of $1000 and a coupon rate of 6 percent has 10 years to maturity. What is the market price ofthis bond if the market interest rate is 10 per cent?( )( )( )( )$771.102.5937$10006.1446$601.10$10000.101.101/1$60V 1010=+×=+−×=
- 10. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-10Example 2—Bond Value• Assume now that the bond’s coupons are paid half-yearly.( )( )( )$750.762.6533$100012.4622$30201.05$10000.05201.051/1$30V=+×=+−×=
- 11. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-11Interest Rate Risk• Interest rate risk is the risk that arises for bond holders fromchanges 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, thegreater the interest rate risk.
- 12. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-12Interest Rate Risk and Time toMaturityInterest rate 1 year 30 years5% $1 047.62$1 768.6210 1 000.001 000.0015 956.52 671.7020 916.67 502.11Time to Maturity
- 13. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-13Computing Yield to Maturity• Yield to maturity (YTM) is the rate implied by thecurrent bond price.• Finding the YTM requires trial and error if you donot have a financial calculator and is similar to theprocess for finding r with an annuity.• If you have a financial calculator, enter N, PV, PMTand FV, remembering the sign convention (PMTand FV need to have the same sign, PV theopposite sign).
- 14. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-14YTM with Annual Coupons• Consider a bond with a 10 per cent annual couponrate, 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 AustraliaPty Ltd6-15Ordinary Share ValuationShare valuation is more difficult than debenturevaluation 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 AustraliaPty Ltd6-16Ordinary Share Valuation• The market value of a share is the present value of allexpected net cash flows to be received from the share,discounted at a rate of return that reflects the riskiness ofthose cash flows.• The expected net cash flows to be received from a share areall future dividends.• Dividend growth is an important aspect of share valuation.
- 17. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-17Zero Growth Dividend• Shares have a constant dividend into perpetuity, with nogrowth in dividends.• The value of a share is then the same as the value of anordinary perpetuity.rDP =0
- 18. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-18( )( )grDgrgDPgDDtt−=−+×=+×=100011Constant Growth Dividend• Dividends grow at a constant rate each time period.• Called the constant dividend growth model.
- 19. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-19Example—Constant Growth DividendCompany XYZ has just paid a dividend of 15 cents per share,which is expected to grow at 5 per cent per annum. What priceshould you pay for the share if the required rate of return on theinvestment is 10 per cent?( )15.3$0.050.101.050.150=−=P
- 20. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-20Non-constant Growth Dividend• The growth rate cannot exceed the required rate of returnindefinitely but can do so for a number of years.• Allows for ‘super normal’ growth rates over some finite lengthof time.• The dividends have to grow at a constant rate at some pointin the future.
- 21. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-21Example—Non-constant GrowthDividend• A company has just paid a dividend of 15 cents per shareand that dividend is expected to grow at a rate of 20 per centper annum for the next three years, and at a rate of 5 percent per annum forever after that.• Assuming a required rate of return of 10 per cent, calculatethe current market price of the share.
- 22. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-22Solution—Non-constant GrowthDividend
- 23. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-23Solution—Non-constant GrowthDividend (continued)$5.440.050.10$0.27243 grDP=−=−=
- 24. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-24( ) ( ) ( ) ( )( ) ( ) ( )$4.63$4.087$0.195$0.179$0.1641.10$5.441.10$0.2591.10$0.2161.10$0.1801111332333322110rPrDrDrDP=+++=+++=+++++++=Solution—Non-constant GrowthDividend (continued)
- 25. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-25Share Price Sensitivity to DividendGrowth, g0 2% 4% 6% 8% 10%50454035302520Share price ($)Dividend growthrate, gD1 = $1Required return, R, = 12%15105
- 26. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-26Share Price Sensitivity to RequiredReturn, r6% 8% 10% 12% 14%100908070605040Share price ($)Required return, RD1 = $1Dividend growth rate, g, = 5%302010
- 27. Copyright 2004 McGraw-Hill AustraliaPty Ltd6-27Components of Required Return( )( )yieldgainscapitalyielddividend010110rgPDrPDgrgrDP+=+==−−=

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