Fundamentals of Financial Management, 13e

Chapter 4: The Valuation of Long-Term Securities

Important Bond Terms

A bond is a long-term debt

The Valuation of

instrument issued by a
corporation or government.
Long-Term The maturity value (MV) [or face
Securities value] of a bond is the stated
value. In the case of a US bond,
the face value is usually $1,000.
4.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Important Bond Terms Different Types of Bonds

The bonds coupon rate is the stated A perpetual bond is a bond that never
matures. It has an infinite life.
rate of interest; the annual interest
payment divided by the bonds face
value. I I I
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)
The discount rate (capitalization rate)
is dependent on the risk of the bond I
= (1 + kd)t or I (PVIFA k
d,
)
and is composed of the risk-free rate t=1
plus a premium for risk. V = I / kd [Reduced Form]
4.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Perpetual Bond Example Different Types of Bonds

Bond P has a $1,000 face value and A non-zero coupon-paying bond is a
provides an 8% annual coupon. The
coupon paying bond with a finite life.
appropriate discount rate is 10%. What is
the value of the perpetual bond?
V= I I I + MV
(1 + kd)1 + (1 + kd)2 + ... + (1 + kd)n
I = $1,000 ( 8%) = $80.
kd = 10%. n I MV
= (1 + kd)t
+ (1 + kd)n
V = I / kd [Reduced Form] t=1

= $80 / 10% = $800. V = I (PVIFA k

d, n
) + MV (PVIF kd, n)
4.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Coupon Bond Example Different Types of Bonds

Bond C has a $1,000 face value and provides
an 8% annual coupon for 30 years. The A zero coupon bond is a bond that
appropriate discount rate is 10%. What is the pays no interest but sells at a deep
value of the coupon bond? discount from its face value; it provides
V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30) compensation to investors in the form
= $80 (9.427) + $1,000 (.057) of price appreciation.
[Table IV] [Table II] MV
V= = MV (PVIFk
d, n
)
= $754.16 + $57.00 (1 + kd)n
= $811.16.
4.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Zero-Coupon
Bond Example Semiannual Compounding
Bond Z has a $1,000 face value and Most bonds in the US pay interest
a 30 year life. The appropriate twice a year (1/2 of the annual
discount rate is 10%. What is the coupon).
value of the zero-coupon bond?
Adjustments needed:
V = $1,000 (PVIF10%, 30) (1) Divide kd by 2
= $1,000 (0.057) (2) Multiply n by 2
= $57.00
(3) Divide I by 2
4.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Semiannual Coupon
Semiannual Compounding Bond Example
Bond C has a $1,000 face value and provides
A non-zero coupon bond adjusted for an 8% semi-annual coupon for 15 years. The
semi-annual compounding. appropriate discount rate is 10% (annual rate).
What is the value of the coupon bond?
V =(1 +I /k 2/2 )1 +(1 +I k/ 2
/2 )2
+ ... +(1I +/ k2 /2
+ MV
) 2* n V = $40 (PVIFA5%, 30) + $1,000 (PVIF5%, 30)
d d d
= $40 (15.373) + $1,000 (.231)
2*n I/2 MV
= (1 + kd /2 )t
+ (1 + kd /2 ) 2*n [Table IV] [Table II]
t=1
= $614.92 + $231.00
= I/2 (PVIFAkd /2 ,2*n) + MV (PVIFkd /2 ,2*n) = $845.92
4.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Semiannual Coupon Semiannual Coupon

Bond Example Bond Example
Let us use another worksheet on your 1. What is its 84.628% of par
calculator to solve this problem. Assume percent of par? (as quoted in
that Bond C was purchased (settlement financial papers)
date) on 12-31-2004 and will be redeemed
on 12-31-2019. This is identical to the 15- 2. What is the 84.628% x
year period we discussed for Bond C. value of the $1,000 face
What is its percent of par? What is the bond? value = $846.28
value of the bond?
4.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Preferred Stock Valuation Preferred Stock Valuation

Preferred Stock is a type of stock DivP Div Div
that promises a (usually) fixed V= (1 + kP)1
+ (1 + k P)2 + ... + (1 + kP)
P P
dividend, but at the discretion of
the board of directors. DivP
= (1 + kP)t
or DivP(PVIFA k
P,
)
t=1
Preferred Stock has preference over
common stock in the payment of
This reduces to a perpetuity!
dividends and claims on assets. V = DivP / kP
4.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Van Horne & Wachowicz, IV - 4 by Gregory A. Kuhlemeyer, Ph.D.,

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Preferred Stock Example Common Stock Valuation

Stock PS has an 8%, $100 par value Common stock represents a
issue outstanding. The appropriate residual ownership position in the
discount rate is 10%. What is the value of corporation.
the preferred stock?
Pro rata share of future earnings
DivP = $100 ( 8% ) = $8.00. after all other obligations of the
kP = 10%. firm (if any remain).
V = DivP / kP = $8.00 / 10%
= $80 Dividends may be paid out of
the pro rata share of earnings.
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Common Stock Valuation Dividend Valuation Model

What cash flows will a shareholder Basic dividend valuation model accounts
receive when owning shares of for the PV of all future dividends.
common stock? Div1 Div2 Div
V= (1 + ke )1 + (1 + ke )2 + ... + (1 + ke)
(1) Future dividends
Divt Divt: Cash Dividend
(2) Future sale of the common = (1 + ke )t at time t
t=1
stock shares ke: Equity investors
required return
4.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Adjusted Dividend Dividend Growth

Valuation Model Pattern Assumptions
The basic dividend valuation model The dividend valuation model requires the
adjusted for the future stock sale. forecast of all future dividends. The
following dividend growth rate assumptions
Div1 Div2 Divn + Pricen simplify the valuation process.
V= (1 + ke)1 + (1 + ke)2 + ... + (1 + k )n e
Constant Growth
n: The year in which the firms
shares are expected to be sold. No Growth
Pricen: The expected share price in year n.
Growth Phases
4.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Constant Growth
Constant Growth Model Model Example
Stock CG has an expected dividend
The constant growth model assumes that
growth rate of 8%. Each share of stock
dividends will grow forever at the rate g.
just received an annual $3.24 dividend.
D0(1+g) D0(1+g)2 D0(1+g) The appropriate discount rate is 15%.
V= (1 + k )1 + (1 + k )2 + ... + (1 + k ) What is the value of the common stock?
e e e
D1 = $3.24 ( 1 + 0.08 ) = $3.50
D1: Dividend paid at time 1.
D1
= g: The constant growth rate. VCG = D1 / ( ke - g ) = $3.50 / (0.15 - 0.08 )
(ke - g) ke: Investors required return. = $50
4.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Van Horne & Wachowicz, IV - 6 by Gregory A. Kuhlemeyer, Ph.D.,

Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Zero Growth
Zero Growth Model Model Example
Stock ZG has an expected growth rate of
The zero growth model assumes that 0%. Each share of stock just received an
dividends will grow forever at the rate g = 0. annual $3.24 dividend per share. The
appropriate discount rate is 15%. What is
D1 D2 D the value of the common stock?
VZG = + + ... +
(1 + ke)1 (1 + ke)2 (1 + ke)
D1 = $3.24 ( 1 + 0 ) = $3.24
D1 D1: Dividend paid at time 1.
= VZG = D1 / ( ke - 0 ) = $3.24 / (0.15 - 0 )
ke ke: Investors required return.
= $21.60
4.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases Model Growth Phases Model

The growth phases model assumes Note that the second phase of the
that dividends for each share will grow growth phases model assumes that
at two or more different growth rates. dividends will grow at a constant rate g2.
We can rewrite the formula as:

n D0(1 + g1)t Dn(1 + g2)t n D0(1 + g1)t 1 Dn+1

V = + (1 + ke)t V = +
(1 + ke)n (ke g2)
t=1 (1 + ke)t t=n+1 t=1 (1 + ke)t
4.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Growth Phases Growth Phases

Model Example Model Example
Stock GP has an expected growth 0 1 2 3 4 5 6
rate of 16% for the first 3 years and
8% thereafter. Each share of stock D1 D2 D3 D4 D5 D6
just received an annual $3.24 Growth of 16% for 3 years Growth of 8% to infinity!
dividend per share. The appropriate
Stock GP has two phases of growth. The first, 16%,
discount rate is 15%. What is the starts at time t=0 for 3 years and is followed by 8%
value of the common stock under thereafter starting at time t=3. We should view the time
line as two separate time lines in the valuation.
this scenario?
4.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases Growth Phases

Model Example Model Example
0 1 2 3 Growth Phase
V3 = D4
We can use this model because
#1 plus the infinitely dividends grow at a constant 8%
D1 D2 D3 long Phase #2 k-g rate beginning at the end of Year 3.

0 1 2 3 4 5 6 0 1 2 3 4 5 6

D4 D5 D6 D4 D5 D6
Note that we can value Phase #2 using the Note that we can now replace all dividends from
Constant Growth Model year 4 to infinity with the value at time t=3, V3!
Simpler!!
4.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Growth Phases Growth Phases

Model Example Model Example
0 1 2 3
Determine the annual dividends.
New Time
Line D0 = $3.24 (this has been paid already)
D1 D2 D3
D1 = D0(1 + g1)1 = $3.24(1.16)1 =$3.76
0 1 2 3 D4
Where V3 = D2 = D0(1 + g1)2 = $3.24(1.16)2 =$4.36
V3
k-g
D3 = D0(1 + g1)3 = $3.24(1.16)3 =$5.06
Now we only need to find the first four dividends
to calculate the necessary cash flows. D4 = D3(1 + g2)1 = $5.06(1.08)1 =$5.46
4.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growth Phases Growth Phases

Model Example Model Example
We determine the PV of cash flows.
0 1 2 3
Actual
Values PV(D1) = D1(PVIF15%, 1) = $3.76 (0.870) = $3.27
3.76 4.36 5.06
PV(D2) = D2(PVIF15%, 2) = $4.36 (0.756) = $3.30
0 1 2 3
5.46 PV(D3) = D3(PVIF15%, 3) = $5.06 (0.658) = $3.33
Where $78 = 0.150.08
78
P3 = $5.46 / (0.15 - 0.08) = $78 [CG Model]
Now we need to find the present value
of the cash flows. PV(P3) = P3(PVIF15%, 3) = $78 (0.658) = $51.32
4.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 4.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 4: The Valuation of Long-Term Securities

Growth Phases
Model Example
Finally, we calculate the intrinsic value by
summing all of cash flow present values.

V = $3.27 + $3.30 + $3.33 + $51.32

V = $61.22
3 D0(1 +0.16)t 1 D4
V= +
t=1 (1 +0.15)
t
(1+0.15)n (0.150.08)
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