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# GSB711-Lecture-Note-04-Valuation-of-Bonds-and-Shares

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This is the fourth presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at returns on different types of investment.

This is the fourth presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at returns on different types of investment.

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• 1. Valuation of Bonds and Shares Topic 04 GSB711 – Managerial Finance Readings: Chapter: Valuing Bonds (Pages 154 - 179) Questions: 1, 4, 7 and Problems: 10, 14, 18, 19, 21 and 24. Chapter: Valuing Stocks (Pages 180 - 218) Questions: 1, 3, 6 and Problems: 12, 17, 19, 24, 27 and 30.
• 2. Topics Covered…. Valuation of Bonds The Bond Market Interest Rates and Bond Prices Current Yield and Yield to Maturity Bond Rates and Returns The Yield Curve Corporate Bonds and the Risk of Default
• 3. Topics Covered Valuation of Shares Stocks and the Stock Market Market Values, Book Values, and Liquidation Values Valuing Common Stocks Simplifying the Dividend Discount Model Growth Stocks and Income Stocks There Are No Free Lunches on Wall Street Market Anomalies and Behavioral Finance
• 4. Terminology Bond - Security that obligates the issuer to make specified payments to the bondholder. Coupon - The interest payments made to the bondholder. Face Value(Par Value or Principal Value) - Payment at the maturity of the bond. Please assume \$1000 as Face Value unless otherwise stated. Coupon Rate - Annual interest payment, as a percentage of face value. Bonds
• 5. Bonds WARNING The coupon rate IS NOT the discount rate used in the Present Value calculations. The coupon rate merely tells us what cash flow the bond will produce. Coupon payments are interest payments that we receive periodically when we invest in a bond. Since the coupon rate is listed as a %, this misconception is quite common.
• 6. Bond Pricing The price of a bond is the Present Value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return.
• 7. Bond Cash Flows
• 8. Bond Pricing Example What is the price of a 5.0 % annual coupon bond, with a \$1,000 face value, which matures in 3 years? Assume a required return of 2.15%.
• 9. Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments?
• 10. Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 2.15% AND the coupons are paid semi-annually?
• 11. Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 5.0 %?
• 12. Bond Pricing Example (continued) What is the price of the bond if the required rate of return is 8 %?
• 13. Bond Pricing Example (continued) Q: How did the calculation change, given semi-annual coupons versus annual coupon payments? Discount Rate Since the time periods are now half years, the discount rate is also changed from the annual rate to the half year rate. Time Periods Paying coupons twice a year, instead of once doubles the total number of cash flows to be discounted in the PV formula.
• 14. Interest Rate Risk The value of the 5% bond falls as interest rates rise
• 15. Interest Rate Risk When the interest rate equals the 5.0% coupon rate, both bonds sell at face value 30 yr bond 3 yr bond
• 16. Current Yield - Annual coupon payments divided by bond price. Yield To Maturity - Interest rate for which the present value of the bond’s payments equal the price. Bond Yields
• 17. Bond Yields Calculating Yield to Maturity (YTM=r) If you are given the price of a bond (PV) and the coupon rate, the yield to maturity can be found by solving for r.
• 18. Bond Yields Example What is the YTM of a 5.0 % annual coupon bond, with a \$1,000 face value, which matures in 3 years? The market price of the bond is \$1,081.95. YTM = 2.15%
• 19. Bond Yields WARNING Calculating YTM by hand can be very tedious. It is highly recommended that you learn to use the “IRR” or “YTM” or “i” functions on a financial calculator.
• 20. Bond Yields Rate of Return - Earnings per period per dollar invested.
• 22. Interest Rate Risk Price path for Premium Bond Price path for Discount Bond Today Maturity
• 24. The Yield Curve Term Structure of Interest Rates - A listing of bond maturity dates and the interest rates that correspond with each date. Yield Curve - Graph of the term structure.
• 25. The Yield Curve Treasury strips are bonds that make a single payment. The yields on Treasury strips in February 2008 show that investors received a higher yield on longer term bonds.
• 26. Corporate Bonds Zero coupons Floating rate bonds Convertible bonds
• 27. Nominal and Real rates Yield on UK nominal bonds Yield on UK indexed bonds
• 28. Default Risk Credit risk Default premium Investment grade Junk bonds
• 29. Default Risk
• 30. Valuation of Shares
• 31. Primary Market - Market for the sale of new securities by corporations. Initial Public Offering (IPO) - First offering of stock to the general public. Seasoned Issue - Sale of new shares by a firm that has already been through an IPO Stocks &amp; Stock Market
• 32. Stocks &amp; Stock Market Common Stock - Ownership shares in a publicly held corporation. Secondary Market - Market in which previously issued securities are traded among investors. Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by earnings per share.
• 33. Stocks &amp; Stock Market The difference between a firm’s actual market value and its’ liquidation or book value is attributable to its “going concern value.” Factors of “Going Concern Value” Extra earning power Intangible assets Value of future investments
• 34. Stocks &amp; Stock Market Book Value - Net worth of the firm according to the balance sheet. Liquidation Value - Net proceeds that could be realized by selling the firm’s assets and paying off its creditors. Market Value Balance Sheet - Financial statement that uses market value of all assets and liabilities.
• 35. Valuing Common Stocks Stock Valuation Methods Valuation by comparables Ratios Multiples Price and Intrinsic Value Dividend Discount Model
• 36. 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 holding period return (HPR).
• 37. Valuing Common Stocks The formula can be broken into two parts. Dividend Yield + Capital Appreciation
• 38. 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. H - Time horizon for your investment.
• 39. Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of \$3, \$3.24, and \$3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of \$94.48. What is the price of the stock given a 12% expected return?
• 40. Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of \$3, \$3.24, and \$3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of \$94.48. What is the price of the stock given a 12% expected return?
• 41. Blue Skies Value
• 42. Valuing Common Stocks If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Assumes all earnings are paid to shareholders.
• 43. Valuing Common Stocks Given any combination of variables in the equation, you can solve for the unknown variable. Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).
• 44. Valuing Common Stocks Example What is the value of a stock that expects to pay a \$3.00 dividend next year, and then increase the dividend at a rate of 8% per year, indefinitely? Assume a 12% expected return.
• 45. Valuing Common Stocks Example- continued If the same stock is selling for \$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.
• 46. Valuing Common Stocks Valuing Non-Constant Growth
• 47. 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 Sustainable Growth Rate - Steady rate at which firm can grow; return on equity x plowback ratio
• 48. 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
• 49. Example Our company forecasts to pay a \$5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 20%. What is the value of the stock before and after the plowback decision? Valuing Common Stocks
• 50. Valuing Common Stocks Example Our company forecasts to pay a \$5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plowback 40% of the earnings at the firm’s current return on equity of 20%. What is the value of the stock before and after the plowback decision? No Growth With Growth
• 51. Valuing Common Stocks Example - continued If the company did not plowback some earnings, the stock price would remain at \$41.67. With the plowback, the price rose to \$75.00. The difference between these two numbers (75.00-41.67=33.33) is called the Present Value of Growth Opportunities (PVGO). Present Value of Growth Opportunities (PVGO). Net present value of a firm’s future investments.