1
Valuation Concepts
The valuation of a financial asset is based on determining the present value of future cash flows. Thus we need to know the value of future cash flows and the discount rate to be applied to the future cash flows to determine the current value.
The market-determined required rate of return, which is the discount rate, depends on the market’s perceived level of risk associated with the individual security. Also important is the idea that required rates of return are competitively determined among the many companies seeking financial capital. For example ExxonMobil, due to its low financial risk, relatively high return, and strong market position, is likely to raise debt capital at a significantly lower cost than can United Airlines, a financially troubled firm. This implies that investors are willing to accept low return for low risk, and vice versa. The market allocates capital to companies based on risk, efficiency, and expected returns—which are based to a large degree on past performance. The reward to the financial manager for efficient use of capital in the past is a lower required return for investors than that of competing companies that did not manage their financial resources as well.
Throughout this course, we apply concepts of valuation to corporate bonds, preferred stock, and common stock. For that purpose we have to be aware of the basic characteristics of each form of security as part of the valuation process. We have to consider the following:
· The valuation of a financial asset is based on the present value of future cash flows.
· The required rate of return in valuing an asset is based on the risk involved.
· Bond valuation is based on the process of determining the present value of interest payments plus the present value of the principal payment at maturity.
· Preferred stock valuation is based on the dividend paid.
· Stock valuation is based on determining the present value of the future benefits of equity ownership.
List of terms:
required rate of return
That rate of return that investors demand from an investment to compensate them for the amount of risk involved.
yield to maturity
The required rate of return on a bond issue. It is the discount rate used in present-valuing future interest payments and the principal payment at maturity. The term is used interchangeably with market rate of interest.
real rate of return
The rate of return that an investor demands for giving up the current use of his or her funds on a noninflation-adjusted basis. It is payment for forgoing current consumption. Historically, the real rate of return demanded by investors has been of the magnitude of 2 to 3 percent.
inflation premium
A premium to compensate the investor for the eroding effect of inflation on the value of the dollar.
risk-free rate of return
Rate of return on an asset that carries no risk. U.S. Treasury bills are often used to represent this measure, although longer-term government securities have al.
1Valuation ConceptsThe valuation of a financial asset is b.docx
1. 1
Valuation Concepts
The valuation of a financial asset is based on determining the
present value of future cash flows. Thus we need to know the
value of future cash flows and the discount rate to be applied to
the future cash flows to determine the current value.
The market-determined required rate of return, which is the
discount rate, depends on the market’s perceived level of risk
associated with the individual security. Also important is the
idea that required rates of return are competitively determined
among the many companies seeking financial capital. For
example ExxonMobil, due to its low financial risk, relatively
high return, and strong market position, is likely to raise debt
capital at a significantly lower cost than can United Airlines, a
financially troubled firm. This implies that investors are willing
to accept low return for low risk, and vice versa. The market
allocates capital to companies based on risk, efficiency, and
expected returns—which are based to a large degree on past
performance. The reward to the financial manager for efficient
use of capital in the past is a lower required return for investors
than that of competing companies that did not manage their
financial resources as well.
Throughout this course, we apply concepts of valuation to
corporate bonds, preferred stock, and common stock. For that
purpose we have to be aware of the basic characteristics of each
form of security as part of the valuation process. We have to
consider the following:
· The valuation of a financial asset is based on the present value
of future cash flows.
· The required rate of return in valuing an asset is based on the
risk involved.
· Bond valuation is based on the process of determining the
2. present value of interest payments plus the present value of the
principal payment at maturity.
· Preferred stock valuation is based on the dividend paid.
· Stock valuation is based on determining the present value of
the future benefits of equity ownership.
List of terms:
required rate of return
That rate of return that investors demand from an investment to
compensate them for the amount of risk involved.
yield to maturity
The required rate of return on a bond issue. It is the discount
rate used in present-valuing future interest payments and the
principal payment at maturity. The term is used interchangeably
with market rate of interest.
real rate of return
The rate of return that an investor demands for giving up the
current use of his or her funds on a noninflation-adjusted basis.
It is payment for forgoing current consumption. Historically,
the real rate of return demanded by investors has been of the
magnitude of 2 to 3 percent.
inflation premium
A premium to compensate the investor for the eroding effect of
inflation on the value of the dollar.
risk-free rate of return
Rate of return on an asset that carries no risk. U.S. Treasury
bills are often used to represent this measure, although longer-
term government securities have also proved appropriate in
some studies.
risk premium
A premium associated with the special risks of an investment.
Of primary interest are two types of risk, business risk and
financial risk. Business risk relates to the inability of the firm
to maintain its competitive position and sustain stability and
growth in earnings. Financial risk relates to the inability of the
firm to meet its debt obligations as they come due. The risk
premium will also differ (be greater or less) for different types
3. of investments (bonds, stocks, and the like).
business risk
The risk related to the inability of the firm to hold its
competitive position and maintain stability and growth in
earnings.
financial risk
The risk related to the inability of the firm to meet its debt
obligations as they come due.
perpetuity
An investment without a maturity date.
dividend valuation model
A model for determining the value of a share of stock by taking
the present value of an expected stream of future dividends.
dividend yield
Dividends per share divided by market price per share. Dividend
yield indicates the percentage return that a stockholder will
receive on dividends alone.
dual trading
Exists when one security, such as General Motors common
stock, is traded on more than one stock exchange. This practice
is quite common between NYSE-listed companies and regional
exchanges.
par value
Sometimes referred to as the face value or the principal value of
the bond. Most bond issues have a par value of $1,000 per bond.
Common and preferred stock may also have assigned par values.
price-earnings ratio
The multiplier applied to earnings per share to determine
current value. The P/E ratio is influenced by the earnings and
sales growth of the firm, the risk or volatility of its
performance, the debt-equity structure, and other factors.
supernormal growth
Superior growth a firm may achieve during its early years,
before leveling off to more normal growth. Supernormal growth
is often achieved by firms in emerging industries.
4. 1. Bonds
The price, or current value, of a bond is equal to the present
value of interest payments (It) over the life of the bond plus the
present value of the principal payment (Pe) at maturity. The
discount rate used in the analytical process is the yield to
maturity (Y). The yield to maturity (required rate of return) is
determined in the marketplace by such factors as the real rate of
return, an inflation premium, and a risk premium.
We add these two values together to determine the price of the
bond. We use both annual or semiannual analysis.
The value of the bond will be strongly influenced by the
relationship of the yield to maturity in the market to the interest
rate on the bond and also the length of time to maturity.
If you know the price of the bond, the size of the interest
payments, and the maturity of the bond, you can solve for the
yield to maturity through a trial and error approach by an
approximation approach, or by using financially oriented
calculators or appropriate computer software.
2. Preferred Stock
In determining the value of preferred stock, we are taking the
present value of an infinite stream of level dividend payments.
This would be a tedious process if the mathematical calculations
could not be compressed into a simple formula.
To find the preferred stock price (Pp) we take the constant
annual dividend payment (Dp) and divide this value by the rate
of return that preferred stockholders are demanding (Kp).
If, on the other hand, we know the price of the preferred stock
and the constant annual dividend payment, we can solve for the
required rate of return on preferred stock as:
Kp = Dp / Pp
3. Common Stock
The value of common stock is also based on the concept of the
present value of an expected stream of future dividends. Unlike
preferred stock, the dividends are not necessarily level. The
firm and shareholders may experience:
5. 3.1. No growth in dividends.
2.2. Constant growth in dividends.
3.3. Variable or supernormal growth in dividends.
It is the second circumstance that receives most of the attention
in the financial literature. If a firm has constant growth (g) in
dividends (D) and the required rate of return (Ke) exceeds the
growth rate, this formula can be utilized.
P0=(D1/Ke) −g
In using that formula, all we need to know is the value of the
dividend at the end of the first year, the required rate of return,
and the discount rate. Most of our valuation calculations with
common stock utilize the same Formula.
If we need to know the required rate of return (Ke) for common
stock, the following Formula can be employed:
Ke= (D1 / P0) + g
The first term represents the dividend yield on the stock and the
second term the growth rate. Together they provide the total
return demanded by the investor.
As previously stated, the value of a financial asset is based on
the concept of the present value of future cash flows. Let’s
apply this approach to bond valuation. A bond provides an
annuity stream of interest payments and a $1,000 principal
payment at maturity. These cash flows are discounted at Y, the
yield to maturity. The value of Y is determined in the bond
market and represents the required rate of return for bonds of a
given risk and maturity.
The price of a bond is thus equal to the present value of regular
interest payments discounted by the yield to maturity added to
the present value of the principal (also discounted by the yield
to maturity).
Let’s assume that It (interest payments) equals $100; Pn
(principal payment at maturity) equals $1,000; Y (yield to
maturity) is 10 percent; and n (total number of periods) equals
20. We could say that Pb (the price of the bond) equals to:
Present Value of interest payments in every period (t) +
Present Value of the Principal Payment at maturity (Pn)
6. Although the price of the bond could be determined with
extensive calculations, it is much simpler to use computer
software or financial calculators. We take the present value of
the interest payments and then add this value to the present
value of the principal payment at maturity.
Present Value of Interest Payments
Let’s assume that It (interest payments) equals $100; Pn
(principal payment at maturity) equals $1,000; Y (yield to
maturity) is 10 percent; and n (total number of periods) equals
20.
In this case, first, we determine the present value of a $100
annuity for 20 years. The discount rate is 10 percent, and we
find the following:
PVA= A×PVIFA (n=20), i=10%
PVA=$851.40
Present Value of Principal Payment (Par Value) at Maturity
The single value of $1,000 will be received after 20 years. Note
the term principal payment at maturity is used interchangeably
with par value or face value of the bond. We discount $1,000
back to the present at 10 percent. For the present value of a
single amount, we find the following:
PV=FV×PVIF (n=20,i=10%)
PV=$1,000×.149=$149
The current price of the bond, based on the present value of
interest payments and the present value of the principal payment
at maturity, is $1,000.40.
Concept of Yield to Maturity
In the previous example, the yield to maturity that was used as
the discount rate was 10 percent. The yield to maturity, or
discount rate, is the rate of return required by bondholders. The
bondholder, or any investor for that matter, will allow three
factors to influence his or her required rate of return.
1. The required real rate of return—This is the rate of return
the investor demands for giving up the current use of the funds
on a noninflation-adjusted basis. It is the financial “rent” the
7. investor charges for using his or her funds for one year, five
years, or any given period. Although it varies from time to time,
historically the real rate of return demanded by investors has
been about 2 to 3 percent.
2. Inflation premium—In addition to the real rate of return
discussed above, the investor requires a premium to compensate
for the eroding effect of inflation on the value of the dollar. It
would hardly satisfy an investor to have a 3 percent total rate of
return in a 5 percent inflationary economy. Under such
circumstances, the lender (investor) would be paying the
borrower 2 percent (in purchasing power) for use of the funds.
This would represent an irrational action. No one wishes to pay
another party to use his or her funds. The inflation premium
added to the real rate of return ensures that this will not happen.
The size of the inflation premium will be based on the
investor’s expectations about future inflation. In the last two
decades, the inflation premium has been 2 to 4 percent. In the
late 1970s, it was in excess of 10 percent.
If one combines the real rate of return (part 1) and the inflation
premium (part 2), the risk-free rate of return is determined. This
is the rate that compensates the investor for the current use of
his or her funds and for the loss in purchasing power due to
inflation, but not for taking risks. As an example, if the real rate
of return were 3 percent and the inflation premium were 4
percent, we would say the risk-free rate of return is 7 percent.
3. Risk premium—We must now add the risk premium to the
risk-free rate of return. This is a premium associated with the
special risks of a given investment. Of primary interest to us are
two types of risk: business risk and financial risk. Business risk
relates to the inability of the firm to hold its competitive
position and maintain stability and growth in its earnings.
Financial risk relates to the inability of the firm to meet its debt
obligations as they come due. In addition to the two forms of
risk mentioned above, the risk premium will be greater or less
for different types of investments. For example, because bonds
possess a contractual obligation for the firm to pay interest to
8. bondholders, they are considered less risky than common stock
where no such obligation exists.
The risk premium of an investment may range from as low as
zero on a very-short-term U.S. government–backed security to
10 to 15 percent on a gold mining expedition. The typical risk
premium is 2 to 6 percent. Just as the required real rate of
return and the inflation premium change over time, so does the
risk premium. For example, high-risk corporate bonds
(sometimes referred to as junk bonds) normally require a risk
premium of about 5 percentage points over the risk-free rate.
However, in September 1989 the bottom fell out of the junk
bond market as Campeau Corp., International Resources, and
Resorts International began facing difficulties in making their
payments. Risk premiums almost doubled. The same
phenomenon took place in the spring of 2008.
There is a strong correlation between the risk the investor is
taking and the return the investor demands. Supposedly, in
finance as in other parts of business, “There is no such thing as
a free lunch.” If you want a higher return, you must take a
greater risk.
Let us assume that in the investment we are examining the risk
premium is 3 percent. If we add this risk premium to the two
components of the risk-free rate of return developed in parts 1
and 2, we arrive at an overall required rate of return of 10
percent.
In this instance, we assume we are evaluating the required
return on a bond issued by a firm. If the security had been the
common stock of the same firm, the risk premium might be 5 to
6 percent and the required rate of return 12 to 13 percent.
Finally, you should recall that the required rate of return on a
bond is effectively the same concept as required yield to
maturity.
Changing the Yield to Maturity and the Impact on Bond
Valuation.
In the earlier bond value calculation, we assumed the interest
rate was 10 percent ($100 annual interest on a $1,000 par value
9. bond) and the yield to maturity was also 10 percent. Under
those circumstances, the price of the bond was basically equal
to par value. Now let’s assume conditions in the market cause
the yield to maturity to change:
Increase in Inflation Premium
For example, assume the inflation premium goes up from 4 to 6
percent. All else remains constant. The required rate of return
would now be 12 percent.
With the required rate of return, or yield to maturity, now at 12
percent, the price of the bond will change. A bond that pays
only 10 percent interest when the required rate of return (yield
to maturity) is 12 percent will fall below its current value of
approximately $1,000. The new price of the bond, as computed
below, is $850.90.
Present Value of Interest Payments
We take the present value of a $100 annuity for 20 years. The
discount rate is 12 percent. Using Appendix D:
Present Value of Principal Payment at Maturity
We take the present value of $1,000 after 20 years. The discount
rate is 12 percent. Using Appendix B:
Total Present Value
In this example we assumed increasing inflation caused the
required rate of return (yield to maturity) to go up and the bond
price to fall by approximately $150. The same effect would
occur if the business risk increased or the demanded level for
the real value of return became higher.
10. (
PS2100:
Week
1
Assignment Worksheet
)
(
Type your name here
)
As you complete your weekly reading, answer the questions
below.
Please review the following writing guidelines prior to
answering the questions:
· Remember to respond to the questions using your own words.
· Do NOT copy responses from the textbook, internet or other
resources. This is plagiarism, which is illegal, and may result
in a failing grade.
· You MUST paraphrase information in your own words and not
transfer word-for-word.
· For information on how to avoid plagiarism, please visit the
Writing Center in the Student Success Center.
Part 1: After reading pages 3 – 4 in your textbook, answer the
following questions about Human Relations.
20 points
What are two (2) examples of the myths that surround human
relations?
Type the first example here
Type the second example here
11. 4 points
What is the goal of human relations?
Type your answer here
6 points
Describe a personal or professional situation when you had to
use human relation skills. Include in your description what
human relation skills you used in the situation.
Type your answer here
10 points
(See next page for part 2)
Part 2: The Hawthorn Effect refers to an increase in
performance caused by a change in environment (i.e. the special
attention given to employees), rather than changes in the actual
task at hand.
After reading page 9 of your textbook, describe a time when
your performance increased due to the Hawthorne Effect.
10 points
Answer:
Type your answer here
Part 3: Stress can deplete your energy, weaken your
relationships, weaken your brain, cause aging and weight gain
and affect your immune system.
After reading page 38 in your textbook, list four (4) causes of
stress and how you can help control the effects of stress in your
life.
10 points
What are four (4) causes of stress?
12. Type a first cause here
Type a second cause here
Type a third cause here
Type a fourth cause here
4 points
How you can help control the effect of stress in your life?
Type your answer here
6 points
(See next page for part 4)
(
Type your name here
)
Part 4: Projecting a positive image by way of appearance,
nonverbal communication and/or behavior is not easy for
everyone.
After reading page 48 in your textbook, describe which area of
projecting a positive image is your strongest and why?
10 points
Answer:
13. Type your answer here
Part 5: The Pygmalion Effect states that an employee’s
performance can be determined by a supervisor’s attitude,
expectations of the employee and treatment of the employee.
After reading page 61 in your textbook, list two (2) examples of
when you lived up or lived down to someone else’s expectations
of your performance. Examples may include but are not limited
to the expectations of a boss, coach, partner, parent or
supervisor.
10 points
Answer:
Type your first example here
Type your second example here
Part 6: Priorities are defined as giving preference to one
activity over another.
After reading page 93 in your textbook, explain how you
prioritize in both your personal and professional life.
10 points
Answer:
Type your answer here
14. You will earn additional points if you correctly submit the
worksheet to the assignment dropbox.
5 points
You will earn additional points if you use proper sentence
structure, grammar and spelling.
5 points
Revised 9/7/14
(
SO1050
:
Week
3
Assignment Worksheet
)
As you complete your weekly reading, answer the questions
below.
Please review the following writing guidelines prior to
answering the questions:
· Use the grammar and spell-check tools in MS Word to ensure
the sentences are free of grammatical and spelling errors.
· When citing and referencing sources, please ensure to
reference APA Format and include in-text citations as well as a
Reference Page.
· Do NOT copy responses from the textbook, internet or other
resources. This is plagiarism, which is illegal, and may result
in a failing grade.
· You MUST paraphrase information in your own words and not
transfer word-for-word.
· For information on how to avoid plagiarism, please visit the
Writing Center in the Student Success Center
15. Part 1: The textbook identifies six common myths about the
poor.
After reading page 146 (within the box) in your textbook,
identify these six myths and the data (evidence) provided in the
chapter that refutes these myths.
60 points
What is the first myth of the poor?
Type the first myth of the poor here
5 points
What data (evidence) provided in the chapter refutes this first
myth?
Type your answer here
5 points
What is the second myth of the poor?
Type the second myth of the poor here
5 points
What data (evidence) provided in the chapter refutes this second
myth?
Type your answer here
5 points
What is the third myth of the poor?
Type the third myth of the poor here
5 points
16. What data (evidence) provided in the chapter refutes this third
myth?
Type your answer here
5 points
What is the fourth myth of the poor?
Type the fourth myth of the poor here
5 points
What data (evidence) provided in the chapter refutes this fourth
myth?
Type your answer here
5 points
What is the fifth myth of the poor?
Type the fifth myth of the poor here
5 points
What data (evidence) provided in the chapter refutes this fifth
myth?
Type your answer here
5 points
What is the sixth myth of the poor?
Type the sixth myth of the poor here
5 points
What data (evidence) provided in the chapter refutes this sixth
myth?
17. Type your answer here
5 points
(See next page for part 2)
(
Type your name here
)
Part 2: Please share your personal insights about the six
common myths of the poor and any additional myths you
believe exist about the poor.
10 points
Type your answer here
You will earn additional points if you correctly submit the
worksheet to the assignment dropbox.
5 points
You will earn additional points if you use proper sentence
structure, grammar and spelling.
5 points
Revised 9/15/14
18. (
PS2100:
Week
3
Assignment Worksheet
)
As you complete your weekly reading, answer the questions
below.
Please review the following writing guidelines prior to
answering the questions:
· Remember to respond to the questions using your own words.
· Do NOT copy responses from the textbook, internet or other
resources. This is plagiarism, which is illegal, and may result
in a failing grade.
· You MUST paraphrase information in your own words and not
transfer word-for-word.
· For information on how to avoid plagiarism, please visit the
Writing Center in the Student Success Center
Part 1:, Leadership is the process of influencing others to work
towards the achievement of objectives. Being a manager does
not necessarily make you a leader.
After reading page 205 in your textbook, describe a time of
when you looked up to someone as a “leader” even if that
person wasn’t your manager. Be sure to include how that
person influenced you to work towards the achievement of
objectives.
10 points
Answer:
Type your answer here
Part 2: The Ghiselli Study identifies six (6) traits of an
effective leader: supervisory ability, need for occupational
19. achievement, intelligence, decisiveness, self-assurance and
initiative.
After reading page 206 in your textbook, describe a manager
you had and which of the six (6) traits he or she either
possessed or lacked.
10 points
Answer:
Type your answer here
(
Type your name here
)(See next page for part 3)
(
Type your name here
)
Part 3: Based on Blake and Mounton’s Leadership Grid, there
are five (5) major leadership styles: the impoverished manager,
the sweatshop manager, the country club manager, the
organized-person manager, and the team manager.
After reading page 209 in your textbook, describe a manager
you had and indicate the manager’s leadership style. Be sure to
indicate one of the five leadership styles listed above.
10 points
Answer:
Type your answer here
Part 4: Trust is the positive expectation that another person
will not take advantage of you. There are three (3) types of
trust: deterrence-based, knowledge-based and identification-
based.
20. After reading page 225 in your textbook, please answer the
following questions about trust.
18 points
Provide an example of each type of trust and list someone you
know that falls into that category.
Type an example of deterrence-based trust here and list
someone you know
Type an example of knowledge-based trust here and list
someone you know
Type an example of identification-based trust here and list
someone you know
12 points
Explain why you agree or disagree with the following
statement:
“Trust is not simply given, it takes time to develop.”
Type your answer here
6 points
(
Type your name here
)(See next page for part 5)
Part 5: After reading page 239 in your textbook, list the three
factors in how performance is attained.
6 points
Answer:
Type the first factor here
21. Type the second factor here
Type the third factor here
Part 6: Maslow’ theory of motivation is based on five (5)
needs.
After reading page 241 in your textbook, list Maslow’s five (5)
needs in the order you feel is most important (1=the most
important).
10 points
Answer:
List the need that you feel is the most important
List the need that you feel is the second most important
List the need that you feel is the third most important
List the need that you feel is fourth most important
List the need that you feel is fifth most important
(
Type your name here
)(See next page for part 7)
22. Part 7: Power is a person’s ability to influence others to do
something they would not otherwise do.
After reading page 269 in your textbook, list an example of
when someone used power to get you do something you would
not have otherwise done.
6 points
Answer:
Type your answer here
You will earn additional points if you correctly submit the
worksheet to the assignment dropbox.
5 points
You will earn additional points if you use proper sentence
structure, grammar and spelling.
5 points
Revised 9/8/14
4
COST OF CAPITAL
The Overall Concept
How does the firm determine the cost of its funds or, more
properly stated, the cost of capital? Suppose the plant
superintendent wishes to borrow money at 6 percent to purchase
a conveyor system, while a division manager suggests stock be
sold at an effective cost of 12 percent to develop a new product.
Not only would it be foolish for each investment to be judged
against the specific means of financing used to implement it,
but this would also make investment selection decisions
inconsistent. For example, imagine financing a conveyor system
23. having an 8 percent return with 6 percent debt and also
evaluating a new product having an 11 percent return but
financed with 12 percent common stock. If projects and
financing are matched in this way, the project with the lower
return would be accepted and the project with the higher return
would be rejected. In reality if stock and debt are sold in equal
proportions, the average cost of financing would be 9 percent
(one-half debt at 6 percent and one-half stock at 12 percent).
With a 9 percent average cost of financing, we would now reject
the 8 percent conveyor system and accept the 11 percent new
product. This would be a rational and consistent decision.
Though an investment financed by low-cost debt might appear
acceptable at first glance, the use of debt might increase the
overall risk of the firm and eventually make all forms of
financing more expensive. Each project must be measured
against the overall cost of funds to the firm. We now consider
cost of capital in a broader context.
The determination of cost of capital can best be understood by
examining the capital structure of a hypothetical firm, the Baker
Corporation. Note that the aftertax costs of the individual
sources of financing are shown, then weights are assigned to
each, and finally a weighted average cost is determined. (The
costs under consideration are those related to new funds that
can be used for future financing, rather than historical costs.)
Cost of capital—Baker Corporation
Each element in the capital structure has an explicit, or
opportunity, cost associated with it, herein referred to by the
symbol K. These costs are directly related to the valuation
concepts developed previously. If a reader understands how a
security is valued, then there is little problem in determining its
cost. The mathematics involved in the cost of capital are not
difficult. We begin our analysis with a consideration of the cost
of debt.
Cost of Debt
The cost of debt is measured by the interest rate, or yield, paid
24. to bondholders. The simplest case would be a $1,000 bond
paying $100 annual interest, thus providing a 10 percent yield.
The computation may be more difficult if the bond is priced at a
discount or premium from par value.
Assume the firm is preparing to issue new debt. To determine
the likely cost of the new debt in the marketplace, the firm will
compute the yield on its currently outstanding debt. This is not
the rate at which the old debt was issued, but the rate that
investors are demanding today. Assume the debt issue pays
$101.50 per year in interest, has a 20-year life, and is currently
selling for $940. To find the current yield to maturity on the
debt, we could use the trial and error process. That is, we would
experiment with discount rates until we found the rate that
would equate the current bond price of $940 with interest
payments of $101.50 for 20 years and a maturity payment of
$1,000. A simpler process would be to use which gives us the
approximate yield to maturity. We reproduce the formula below:
Approximate yield to maturity (Y') =
{Annual interest payment + (Principal payment − Price of the
bond/Number of years to maturity)}/{0.6(Price of the bond) +
0.4(Principal payment)}
For the bond under discussion, the approximate yield to
maturity (Y’) would be:
Y’={$101.50 + [($1,000−$940)/20]}/{0.6($940)+0.4($1.000)}
Y’=[$101.50+(60/20)]/($564+$400)]
Y’=[($101.50+3)/$964
Y’=$104.50/$964=10.84%
In many cases you will not have to compute the yield to
maturity. It will simply be given to you. The practicing
corporate financial manager also can normally consult a source
such as Standard & Poor’s Bond Guide to determine the yield to
maturity on the firm’s outstanding debt. An excerpt from this
bond guide is presented in Table 11–2 on page 334. If the firm
involved is MBNA Capital, for example, the financial manager
could observe that debt maturing in 2026 would have a yield to
maturity of 7.86 percent as shown in the last column of the
25. table.
Excerpt from Standard & Poor’s Bond Guide
Once the bond yield is determined through the formula or the
tables (or is given to you), you must adjust the yield for tax
considerations. Yield to maturity indicates how much the
corporation has to pay on a before-tax basis. But keep in mind
the interest payment on debt is a tax-deductible expense. Since
interest is tax-deductible, its true cost is less than its stated cost
because the government is picking up part of the tab by
allowing the firm to pay less taxes. The aftertax cost of debt is
actually the yield to maturity times one minus the tax rate.
Kd (Cost of debt) = Y (Yield) (1 – T)
The term yield in the formula is interchangeable with yield to
maturity or approximate yield to maturity. In using the
approximate yield to maturity formula earlier in this section, we
determined that the existing yield on the debt was 10.84
percent. We shall assume new debt can be issued at the same
going market rate, and that the firm is paying a 35 percent tax
(a nice, easy rate with which to work). Applying the tax
adjustment factor, the aftertax cost of debt would be 7.05
percent.
Kd(Cost of debt)=Y(Yield)(1−T)
=10.84%(1−.35)=10.84%(.65)=7.05%
Please refer back to Table 1 and observe in column (1) that the
aftertax cost of debt is the 7.05 percent that we have just
computed.
Cost of Preferred Stock
The cost of preferred stock is similar to the cost of debt in that
a constant annual payment is made, but dissimilar in that there
is no maturity date on which a principal payment must be made.
Determining the yield on preferred stock is simpler than
26. determining the yield on debt. All you have to do is divide the
annual dividend by the current price. This represents the rate of
return to preferred stockholders as well as the annual cost to the
corporation for the preferred stock issue.
We need to make one slight alteration to this process by
dividing the dividend payment by the net price or proceeds
received by the firm. Since a new share of preferred stock has a
selling cost (flotation cost), the proceeds to the firm are equal
to the selling price in the market minus the flotation cost. The
cost of preferred stock presented as Formula is:
Kp(Cost of preferred stock)=DpPp−F