MODULE 4:

VALUATION
Prepared by Pamela Peterson Drake

OUTLINE

1.
2.
3.
4.

1.

Introduction
Learning outcomes
Module 4 tasks
Module 4 overview and discussion

Introduction
Financial managers must often make decisions regarding the benefits and costs associated
with an investment. We capture the benefits and costs in valuation: determining what an
investment is worth today and comparing this to the cost of the investment.
The key to valuation is determining the expected future cash flows both the amount and
timing and the discount rate. The discount rate is the rate the investors require or demand
form the investment; hence, the discount rate is often referred to as the required rate of
return. The more uncertain the future cash flows, the higher the required rate of return.
The purpose of this module is to introduce you to the valuation of assets. We will apply the
financial mathematics that you learned in the time value of money module to assets in
general and then specifically to the valuation of bonds and stocks.

2.

Learning outcomes
LO4.1 Apply financial math to value assets with different patterns of cash flows.
LO4.2 Calculate growth rates associated with cash flows and values of assets.
LO4.3 Relate growth in cash flows to values.
LO4.4 Calculate returns and yields on investments with different patterns of cash flows.
LO4.5 Apply valuation principles to calculate the value of a bond, considering the bonds
coupon rate, maturity, and time to maturity.
LO4.6 Analyze the effect of a change in yield-to-maturity on the value of a bond.
LO4.7 Calculate the yield-to-maturity on a bond.
LO4.8 Apply valuation principles to calculate the value of a stock.
LO4.9 Relate the different patterns of cash flows on stocks to the valuation of a stock.
LO4.10 Infer the return on stocks from for different patterns of future cash flows and the
stocks current value.

Module 4 Overview

3.

Module 4 tasks

A.

Readings
i

Required reading
Asset valuation
(a)
Bond valuation
(b)
Stock valuation
(c)
Problem: Two-stage dividend growth
(1)
Equity valuation: A comparison of models
(2)

ii

Other resources
(a)
(b)
(c)

iii

Optional reading

B.

Study Finance: Valuation of corporate securities. An overview of the

valuation provided by the University of Arizona.
Bond Valuation at Corporate Finance Live by Rock Mathis, Prentice-Hall
Stock Valuation at Corporate Finance Live by Rock Mathis, Prentice-Hall
Fabozzi and Peterson text, Chapter 8 (Principles of Asset Valuation and
Investment Returns) and Chapter 9, pp. 211-245 (Valuation of Securities and
Options)

Problem sets
These problems sets are non-graded tasks. It is recommended that you complete these
problem sets prior to attempting the graded online quiz.

Valuation practice problems and solutions

5-minutes workouts: Bond valuation and Bond yields
Bond valuation practice problems
Two-stage dividend problems
Valuation review
Valuation quiz (non-credit)
StudyMate Activity

4.

Module 4 overview and discussion

A.

Asset valuation
Financial managers must evaluate the valuation of the companys investments, whether
these are investments in assets in place that is, the existing property, plant, equipment,
and land, among other assets or assets that the company may wish to acquire. Financial
managers make decisions that require evaluating the acquisition or disposition of equipment,
subsidiaries, patents, etc. In making these decisions, the financial manager must compare
the cost of the investment with the future cash flows that are associated with the
investment. To accomplish this, the financial manager must value the investments, assessing
whether the benefits outweigh the costs associated with the investment.
In this reading, you are introduced to the principles and mathematics of the valuation of
assets. We examine the valuation mathematics for different cash flow: uneven, even and
infinite, and even and finite. In addition to the valuation of assets, you are introduced to the
calculation of returns on assets.

Module 4 Overview

B.

Bond valuation
Interest rates in the economy change every moment and this means that any security whose
value is affected by the interest rates changes every moment. Debt securities are securities
that involve a promise by the borrower to repay the amount of the loan (the maturity value),
as a promise to pay periodic interest. The value of a debt security is the present value of this
interest and the maturity value, discounted at some rate, which we refer to as a yield. Yields
change constantly, hence bond values change constantly: as interest rates increase, bond
values decrease, and vice-versa.
In this reading, you learn how to value both coupon and zero-coupon bonds. In addition,
you learn how to calculate the yield on a bond given a current price. Through examples,
youll see how bonds values change as yields change. In addition, you will see how a bonds
price will change simply from the passage of time.

C.

Stock valuation
The valuation of preferred and common stocks is very challenging because the cash flows for
these securities, the cash dividends, are not contractual as they are for bonds. Cash
dividends on stocks are paid at the discretion of the board of directors. A company can start
or stop paying dividends at any time and a company can change the amount of dividends at
any time. Dividends can be paid quarterly, annually, semi-annually, or at irregular intervals,
though most companies that pay dividends do so on a quarterly basis.
Dividends on preferred stock are generally stated as a fixed amount per quarter, though
there is no guarantee that the company will pay them. The board of directors could decide
not to pay them or, if they are cumulative, pay them later. The only catch is that a company
must pay any preferred dividends before they pay any dividends to common shareholders.
The dividends on common stocks can take on many different patterns or no pattern at all.
These dividends may be constant, may grow at a constant rate forever, or grow at one rate
and then grow at a different rate some time in the future. The many variations make the
valuation of common stock quite challenging.
Investors constantly revalue stocks as information is received; this information may include
information concerning the economy, markets, the company, regulation, and world events, to
name a few. This means that expectations concerning the future cash flows and the
uncertainty related to these cash flows is constantly changing resulting in changing stock
prices. Take a look at a stocks price within a given trading day and youll see just how much
things change.

D.

Whats next?
In this module, weve focused on the cash flow component of valuation. The discount rate
that we have been using in valuation is the rate that reflects the time value of money and the
compensation for bearing risk. In the next module, we focus on risk, taking a look at the
different definitions of risk, methods of quantifying risk, and the relevant risk for valuation
purposes. This will prepare you for capital budgeting, covered in Module 6

2007 Pamela Peterson Drake

Module 4 Overview