SOUTHVILLE INTERNATIONAL SCHOOL & COLLEGES

COLLEGE OF BUSINESS ADSMINISTRATION

FINANCIAL MANAGEMENT 2
OUTLINE OF LESSON FOR
PART 4 VALUATION OF FINANCIAL ASSETS

LEARNING OBJECTIVES

1. Explain the fundamentals of financial assets valuation.

2. Demonstrate bond valuation.
3. Demonstrate share capital valuation
4. Help in deciding on ordinary share valuation.

FUNDAMENTALS OF VALUATION

Capitalization of-Income Method

Financial asset: a security (e.g. a share of stock or bond) that represents a claim against
the future income or assets of issuer.

Value of financial asset may be determined as discounted present value of expected

future cash flows earned on that asset

Two areas of concern:

1. Determining appropriate earnings to be capitalized.
2. Determining appropriate capitalization rate.

Selecting Appropriate Capitalization Rates

1. Given risk characteristics of a particular investment opportunity or security, define
appropriate capitalization rate (K) as minimum expected rate or return required to
induce investors to accept that investment.

According to capital asset pricing model (CAPM), the higher the risk involved in
investing in asset, the higher will be minimum expected rate of return necessary to
induce investors to invest in asset.
 Appropriate capitalization rate for any financial asset is function of riskiness of asset.

Risk: standard deviation of expected future returns:

- Standard deviation measures expected variability around expected future rate of
return
- Higher variability -> higher standard deviation -> higher risk.
-
Capital market line (CML): graphic representation of risk/return trade-off line

See exhibit 14.1

CAPM states that appropriate capitalization rate (K) should be equal to risk-
free rate (Rf)) plus risk premium:

- Risk-free rate is intercept of CML, since this is return that should be earned when
standard deviation is zero (where there is no risk)
- Risk premium is function of standard deviation of expected future returns (S)
- M is slope of CML
K = Rf + MS
What determines risk-free rate?
- RF is generally measured as short-term Treasury bill rate, which is highly
responsive to inflation.
- Increased inflation -> intercept of CML curve shifts upward
- Decreased inflation -> intercept of CML curve shifts downward

What determines slope of CML?

- Slope of CML reflects investors attitudes toward risk

- Increased economic uncertainty -> increase in investors risk aversion -> increase
in M
Greater risk aversion -> steeper CML curve
Decrease in economic uncertainty -> flatter CML curve

Capitalization rate depends on general level of inflation and interest rates, risk
involved in particular investment being considered, and investors attitudes
towards risk.

Find slope and intercept of CML in order to determine K.

Use regression analysis to estimate CML empirically.

 Accept going rate for particular asset as appropriate K.
- Ex. Consult Standard and Poors Bond Guide to determine average rate of return
being earned on 20-year, AAA-rated corporate bonds. This rate can be used as
appropriate K.

Use hurdle rate for K: minimum rate of return acceptable for particular investment
as judged by individual or organization doing valuation.

Once appropriate K is determined

in validation process, determine discounted present value of expected future cash
flows.

Bond Valuation

Two cash flows for regular, bullet bonds:

1. Cash flow provided by semi-annual interest payments:

Discount rate used in valuing bond is one-half appropriate annual-bond
capitalization rate.
Number of discount periods is twice number of years to maturity.

2. Cash flow provided by repayment of bond par value at maturity

Value of bond is equal to present value of future interest payments plus present
value of par value received at maturity.
Value of particular bond may be found by using present-value tables, specially
constructed bond-valuation tables or any business-oriented calculator.

Note: Refer to next page for meaning of bullet bonds.

Equation for value of bond:

V = C [(1-1/(1+(K/2)2n)/(K/2)] + P[1/(1+(K/2)2n)]

Where:
C = semi-annual coupon interest payments
K = annual capitalization rate, compounded semi-annually
n = number of years to maturity
P = par value of bond received at maturity

First term represents present value of annuity of n years duration discounted

semi-annually at rate of K/2. This figure is present value of semi-annual
coupon interest payments.
 Second term represents present value of par value of bond to be received n
years (n/2 periods) from now.

Ex. Suppose appropriate capitalization rate for AAA-rated corporate bonds is 12%,
compounded semi-annually.
What is value of seasoned AAA-rated bond with par value of $1,000, and 8% coupon rate
($40 paid semi-annually), and 20 years to maturity?

Using the formula cited earlier, the solution is:

V = $40[(1-1/(1+.06)40)/.06] + $1,000[1/(1+/06)40]
V = ($40)(15.0463) + ($1,000)(.0972)
V = $699.05

Use same bond-valuation equation to determine yield to maturity of bond that is

available at known price.

- Treat V, C, n, and P as given, but solve equation for K.

- Yield to maturity on bond is then effective annual yield at K%, compounded
semi-annually.
- Ex. (continued) Yield to maturity is 12.36%, which is effective rate of return form
12% compounded semi-annually ([1.06]2 1).

Use calculators or computer spreadsheets to solve bond-valuation equation for K.

Zero Coupon Bonds

(Also known as an accrual bond, is a debt security that does not pay interest (a coupon)
but is traded at a deep (large) discount, rendering profit at maturity when the bond is
redeemed for its full face value)

Zero coupon bonds (in contrast to bullet bonds) are originally sold at discount from par
value and pay full par value at maturity.
- Have no coupons
- Pay no current interest

Note: Bullet Bond (BB) is a debt instrument whose entire face value is paid at once on
the maturity date, vs. amortizing the bond over its lifetime BBs are non-callable (i.e.
cannot be redeemed early by the issuer) Because of this, bullet bonds may pay a
relatively low rate of interest due to the issuers interest rate exposure.

From investors point of view, zero coupon bonds are attractive because they
eliminate reinvestment risk.
.
- Reinvestment risk: risk that one may not be able to reinvest coupon payments
received from conventional bond at same rate that bond is earning.
 - Ex. Investor buying newly issued 10% bond at par will not actually earn 10%
yield to maturity unless future cash interest payments can be reinvested at 10%.
Since there are no cash interest payments to be reinvested on zero coupon bond,
risk is eliminated.

Zero coupon bonds benefit issuer during periods of high interest rates.

- Since bond eliminates reinvestment risk, investors will accept lower rate of return
on zero coupon bond than they would accept on conventional bond.
- Zero coupon bond lowers issuers interest costs.
- Zero coupon bonds have sinking fund provision.

In periods of low interest rates, rates on zero coupon bonds tend to be higher than bullet
bonds.

According to IRS (BIR in the Phils.). Discount on zero coupon bond is taxable as if
current interest were being paid.

Zero coupon bonds are generally suitable for non-taxable investors (i.e. corporate pension
funds).

Present value of zero coupon bond is present value of par value paid at maturity.

Ex. Present value of ten-year, $1,000 par, 12% zero coupon bond:

V = ($1,000) [1/(1.12)10]
V = $322

Preference (Preferred) Stock Valuation

Preferred stock has no maturity date.

Value of share of preferred stock is present value of dividend payment from date of
purchase to infinity.

Consider two factors when discounting out to infinity:

1. There are corporations that have existed for 50 or more years and can be expected to
survive for another 50 or more years.
2. Economic infinity for discounting purposes is not as far away as the word infinity
implies.
 Assuming that dividends are paid annually, value of share of preferred stock is:

V= D/(1+K) +D/(1+K)2 + D/(1+K)3 + + D/(1+K)

Where: V = value of preferred stock

D = annual dividend payment
K = appropriate capitalization rate
= infinity

Since present value of each years dividend decreases each year, preferred-stock-
valuation equation is infinite series of decreasing numbers.

Sum of preferred-stock-dividend series:

V = D/K

Ex. If K is 12%, value of share of preferred stock paying an $8.00 annual dividend is:

V = $8.00/0.12
V = $66.67

At price of $66.67, share of preferred stock paying $8.00 dividend provides annual yield
of 12% from now to infinity.

Preferred stocks are riskier investments than bonds.

- Unlike bond-interest payments, preferred stock is not guaranteed.

- Preferred stock is junior to debt in priority.

However, market-capitalization rates for preferred stock are often lower than
capitalization rates. Why?

85% of stock dividends paid to corporation are tax free (per U.S. tax laws).

- Dividends paid by corporations are subject to tax at long-term capital gains rate,
which is significantly lower than highest personal marginal income tax rate.
- Bond interest is fully taxable at highest marginal rate.
 For corporation or individual investor, dollars worth of preferred dividends is
worth much more than dollars worth of bond interest.

Investors willing to accept lower pre-tax yield on preferred stocks than on bonds.

Market activities generally result in lower pre-tax capitalization rates for preferred
stocks than for bonds.

Common-Stock Valuation
Two forms of expected cash flows from common stocks:

1. Dividends received over investors stock holding period

2. Price expected to be received when stock is sold.

Two major concerns for valuation:

1. Earnings and dividends per share are expected to increase over time.
- Cannot use annuity formulas for common-stock valuation because calculating
present value of annuity requires that cash flows be constant annual amount.

2. Uncertainty surrounding expected future dividend payments and expected

future stock price.
- Common-stock dividends are never guaranteed and stock prices fluctuate.
- Account for uncertainty in valuation process by assigning higher capitalization
rate to common stocks than to bonds or preferred stocks.

Most models are based on premise that common-stock values are function of expected
future cash flows from dividends and expected future value of stock.

Widely accepted model views common-stock values as dependent on dividend-

paying capacity of corporation.

- Explanation: Price at end of any year is always equal to present value of following
years dividend and price.
- As price approaches economic infinity, present value of terminal price (price in
final year) becomes zero for valuation purposes.
- Any financial asset is equal to present value of future cash flows.
- Since stock may exist until economic infinity, only cash flows that will be
received from share of common stocks are dividends.
 - Present value of share of common stock is equal to present value of future
expected dividends from now until infinity.
Value of common stock is sum of infinite series of growing dividends.

Two assumptions must be made:

1. Dividends will grow at constant rate.
2. Constant growth rate will be less than capitalization rate that will be applied to
value of stream of growing dividends.

Value of share of common stock:

Po = D1/(K-g)
Where Po = present value of share of common stock

D1 = expected dividend in year 1

K = appropriate capitalization rate

g = expected future growth rate of dividends

Ex. Suppose XYZ common stock is expected to pay dividend of $2.16 in coming year.
This dividend is expected to increase at average annual rate of 8% per year. Appropriate
capitalization rate is 15%. What is present value of XYZs common stock?

Po = $2.16/(.15-0.08)
= $30.86

What if expected future growth rate is not constant?

- Each years expected dividend must be discounted separately out to year for
which it is estimated that dividend growth will settle down to some constant
rate.
- Use dividend-capitalization model to determine value of stock at end of last year
of irregular growth.
- Present value of stock price at end of irregular growth period plus present value of
dividends received during irregular growth period equals present value of stock
.
What if growth rate exceeds capitalization rate?

- For temporary supernormal growth, discount value of dividends received during

that period separately.
 - Use dividend-capitalization model to determine value of stock at end of
supernormal growth period.
- Present value of stock equals present value of dividends received during
supernormal growth period plus present value if stock price at end of same period.

What if stocks pay no dividends and sell for positive prices (capitalizing dividends)?

- Estimate whether company will be able to start paying dividends in future.

- Use dividend-capitalization model to determine value of stock at time.
- Discount this value back to present to determine present value of stock.

See Exhibit 15.2: Application of dividend-capitalization model to no-growth stock,

normal growth stock, and supernormal growth stock.
- High-growth stock sell at higher multiples of earnings than do lower-growth
stocks because growing dividends impart more value to stock price.

- High-growth stocks have much lower dividend yields than low-growth stocks
because value of growth potential of high-growth stock drives up price of stock
and thus drives down dividend payment as percentage of stock price.

Intrinsic Values and Market Values

Intrinsic value: value of share of stock as determined by a valuation model. (The
intrinsic value is the actual value of a company or an asset based on an underlying
perception if its true value including all aspects of the business, in terms of both tangible
and intangible factors.)

When market price equals intrinsic value, stock price is in equilibrium.

- Remember, there are different common-stock valuation methods!

- Changes in market-capitalization rates used by investors and changes in growth
outlook for stock cause intrinsic value and market price to fluctuate, and thereby
prevents equilibrium.

If market price is less than intrinsic value, stock is undervalued and should be purchased.

If market price is greater than intrinsic value, stock is overvalued and should be sold.

If market price equals intrinsic value, stock is in equilibrium and may be held or
purchased.
 Efficient markets hypothesis (EMH):

- Large number of well-educated, professional market participants has access to

same databases.
- All of these participants analyze these data in same way.
- Most draw same conclusions about intrinsic value of most stocks.
- Market activities cause most stocks to be priced t their intrinsic values
Price at which rate of return earned on common-stock investment
is commensurate with risk involved in investment.
- It is not possible to beat the market by earning an above-average rate of
return.
-