FINS3625

Applied Corporate Finance

Semester 1, 2015

Week 1

Welcome

Name: Ying Dou

Email: ying.dou@unsw.edu.au
Office:
Phone:
Consultation: Weeks 2-4: Tuesday, 1-3pm in Room
302 ASB.

Assessments
Course will be graded as follows:
Tutorial attendance and participation

10%

Case study report and presentation

15%

Case study discussion

10%

Mid-term exam

30%

Final exam

35%

Chapter 6 Valuing Bonds

6.1 Bond Cash Flows, Prices, and Yields
6.2 Dynamic Behavior of Bond Prices
6.3 The Yield Curve and Bond Arbitrage
6.4 Corporate Bonds

6.1.1 Terminologies
Bond Certificate
States the terms of the bond

Maturity Date
Final repayment date

Term
The time remaining until the repayment date

Coupon
Promised interest payments
5

6.1.1 Terminologies (Cont.)

Face Value
Notional amount used to compute the interest payments

Coupon Rate
Determines the amount of each coupon payment, expressed as an
APR

Coupon Payment
CPN

Coupon Rate Face Value

Number of Coupon Payments per Year

6.1.2 Zero-Coupon Bonds

A bond that makes no coupon payments during its
life
Your interest is the difference between the initial price and the face
value.

Example: one-year, risk-free, zero-coupon bond with

a $100,000 face value and a $96,618.36 initial price

6.1.2 Zero-Coupon Bonds (Cont.)

Yield to Maturity
The discount rate that sets the present value of the promised bond
payments equal to the current market price of the bond.

FV
(1 YTM n )n

In the previous example:

96,618.36

100,000
(1 YTM1 )

YTM=3.5%

6.1.2 Zero-Coupon Bonds (Cont.)

What if the duration is greater than 1 year?
YTM n

FV

Example (Face Value=$100):

Maturity 1 year
Price
$98.04

2 years
$95.18

3 years
$91.51

4 years
$87.14

Solution:
YTM (100 / 98.04) 1 0.02 2%
YTM (100 / 95.18)1/2 1 0.025 2.5%
YTM (100 / 91.51)1/3 1 0.03 3%
YTM (100 / 87.14)1/4 1 0.035 3.5%
9

6.1.3 Coupon Bonds

Example: five-year, $1000 bond with a 5% coupon
and semi-annual coupon payments.
Semi-annual coupon payment: $10005%0.5=$25

10

6.1.3 Coupon Bonds (Cont.)

Yield to Maturity of a Coupon Bond:

P CPN

1
1
FV

y
(1 y ) N
(1 y ) N

Note: N=number of coupon payments, NOT number of years.

Example: five-year, $1000 bond with 5% coupon rate

and semi-annual coupons has YTM of 6.3%. What
price is the bond trading for now?
= 25

1
0.0315

1
1.031510

1000
1.031510

= $944.98

11

6.2.1 Discounts and Premiums

12

6.2.2 Time and Bond Prices

Example based on a Coupon Bond:

1. Initial price:

13

6.2.2 Time and Bond Prices (Cont.)

2. Immediately before the 1st coupon payment:

P=

3. Immediately after the 1st coupon payment:

P=

14

6.2.2 Time and Bond Prices (Cont.)

Clean and Dirty Prices
Bond prices rise as the next coupon payment gets closer and drops
after it has been paid.
Bond traders are more concerned about the price change caused by
the bonds yield, not these predictable patterns.
Actual cash price (dirty price), is noisy. Adjustments are needed for a
clean price.
Clean price = dirty price Accrued interest
Accrued interest = Coupon amount (

days since last coupon payment

)
days in current coupon period

15

6.2.3 Interest Rates and Bond Prices

Negative relation between interest rates and bond prices
Why?

16

6.3.1 Replicating a Coupon Bond

Using the Law of One Price and the yields of default-free
zero-coupon bonds, one can determine the price and
yield of any other default-free bond.
Lets replicate a 3-year $1000 bond with 10% annual
coupon payment.
Available zero-coupon bond:
Maturity

1 year

2 years

3 years

YTM

3.5%

4%

4.5%

Price

$96.62

$92.45

$87.63

17

6.3.1 Replicating a Coupon Bond (Cont.)

Cash flows:

Our total costs:

Price of the
3-year coupon
bond

18

6.4.1 Corporate Bonds

So far, our bonds have been default-free.
For corporate bonds, the issuer may default.
This risk of default is called credit risk of the bond.

Investors pay less for bonds with credit risk than they
would for an otherwise identical default-free bond.

19

6.4.1 Corporate Bonds (Cont.)

Example: 1-year, $1000 ZC bond with a YTM of 4%.
No default:

1000
1000

$961.54
1 YTM1
1.04

Certain default:
Suppose now bond issuer will pay 90% of the obligation.
900
900
P

$865.38

1 YTM1
1.04
FV
1000
1
1 15.56%
YTM
P
865.38

Use promised cash flow

20

6.4.1 Corporate Bonds (Cont.)

Risk of default:
There is a 50% chance that the bond will repay its face value in full and a 50%
chance that the bond will default and you will receive $900.
Discount rate is 5.1%.
You should expect to receive $100050%+$90050%=$950.
P 950 $903.90
YTM

1.051

Use promised cash flow

FV
1000
1
1 .1063
P
903.90

21

6.4.2 Bond Ratings

Creditworthiness of bonds rated by certain companies.
Available to investors.
Encourages widespread investor participation.
Improves market liquidity.

22

Chapter 9 Valuing Stocks

9.1 The Dividend Discount Model
9.2 Applying the Dividend Discount Model
9.3 Total Payout and Free Cash Flow Valuation Models
9.4 Valuation Based on Comparable Firms

23

9.1.1 One-year Investor

Two potential cash inflows:
Dividend
Sale of stock
Timeline:

Cash flows are risky.

Cannot discount using risk-free rate.
Use equity cost of capital instead.

Div1 P1
P0

1 rE

Question: what happens when the equality fails to hold?

24

9.1.2 Dividend Yield & Capital Gains

If we re-arrange the previous equation:
r Div1 P1 1
E

P0

Div1
P0
Dividend Yield

P1 P0
P0
Capital Gain Rate

Total Return = Dividend Yield + Capital Gain Rate

25

9.1.2 Dividend Yield & Capital Gains (Cont.)

Example:
3M (MMM) is expected to pay paid dividends of $1.92 per share in the
coming year.
You expect the stock price to be $85 per share at the end of the year.
Investments with equivalent risk have an expected return of 11%.
What is the most you would pay today for 3M stock?
What dividend yield and capital gain rate would you expect at this price?

26

9.1.2 Dividend Yield & Capital Gains (Cont.)

Solution:
P0

Div1 P1
$1.92 $85

$78.31
(1 rE )
(1 .11)

Dividend Yield

Capital Gains Yield

Div1
$1.92

2.45%
P0
$78.31

P1 P0
$85.00 $78.31

8.54%
P0
$78.31

Total Return = 2.45% + 8.54% = 10.99%

27

9.1.3 Multi-year Investor

What is the price if we plan on holding the stock for two
years?

P0

Div1
Div2 P2

1 rE
(1 rE ) 2

What is the price if we plan on holding the stock for N

years?

P0

Div1
Div2

1 rE
(1 rE )2

DivN
PN

(1 rE ) N
(1 rE ) N

This is known as the Dividend Discount Model

28

9.1.3 Multi-year Investor (Cont.)

What if we hold the stock forever?
Let N go to infinity
Forever means that we do not sell the stock (i.e., no capital gains.)
With no capital gains, dividends become our only cash inflow.

Div3
Div1
Div2
P0

1 rE
(1 rE )2
(1 rE )3

n 1

Divn
(1 rE ) n

The price of any stock is equal to the present value of the

expected future dividends it will pay.
29

9.2.1 Constant Dividend Growth

If the firms future dividends will grow at a constant rate,
g, forever:

Calculating the value of the stock is straight-forward:

Div1
P0
rE g

30

9.2.2 Dividends vs. Growth

How is the amount of dividends determined?
Divt

Earningst
Dividend Payout Ratet
Shares Outstandingt
EPSt

Dividend Payout Rate: The fraction of earnings paid as dividends each year.

Assuming the number of shares outstanding is constant,

the firm can do two things to increase its dividend:
Increase its earnings
Increase its dividend payout rate

Lets focus on earnings first.

31

9.2.2 Dividends vs. Growth (Cont.)

A firm can do one of two things with its earnings:
It can pay them out to investors.
It can retain and reinvest them.
(See the trade-off?)

Assume: no investment, no growth.

Change in Earnings = New Investment Return on New Investment

(1)

New Investment = Earnings Retention Rate

(2)

Retention Rate: Fraction of current earnings that the firm retains.

32

9.2.2 Dividends vs. Growth (Cont.)

Substitute (2) into (1):
Change in Earnings = Earnings Retention Rate Return on New Investment (3)

Divide (3) by Earnings:

Change in Earnings Earnings Retention Rate Return on New Investment
=
Earnings
Earnings
Left Hand Side: Earnings Growth Rate

Earnings Growth Rate = Retention Rate Return on New Investment

Keeping dividend payout rate constant, then the growth in

dividends will equal growth of earnings:
g = Retention Rate Return on New Investment

33

9.2.2 Dividends vs. Growth (Cont.)

Example:
Dren Industries is considering expanding into a new product line. Earnings per
share are $5 at the beginning of this year and are expected to grow annually at
5% without the new product line but growth would increase to 7% if the new
product line is introduced. To finance the expansion, Dren would need to cut its
dividend payout ratio from 80% to 50%. If Drens equity cost of capital is 11%,
what would be the impact on Drens stock price if they introduce the new
product line? Assume the equity cost of capital will remain unchanged.

34

9.2.2 Dividends vs. Growth (Cont.)

Solution:
First, calculate the current price for Dren if they do not introduce the new
product. To calculate the price, D1 is needed. To find D1, EPS1 is required:
EPS1 = EPS0 (1 + g) = $5.00 1.05 = $5.25
D1 = EPS1 Payout Ratio = $5.25 0.8 = $4.20
P0 = D1/(rE-g) = $4.20/(.11 - .05) = $70.00
Thus, the current price without the new product should be $70 per share.
Next, calculate the expected current price for Dren if they introduce the new
product:
EPS1 = EPS0 (1 + g) = $5.00 1.07 = $5.35
D1 = EPS1 Payout Ratio = $5.35 0.50 = $2.675
P0 = D1/(rE-g) = $2.675/(.11 - .07) = $66.875
Thus, the current price is expected to fall from $70 to $66.875 if the new
product line is introduced.
35

9.2.3 Limitations of the Dividend-Discount Model

There is a tremendous amount of uncertainty associated
with forecasting a firms dividend growth rate and future
dividends.
Small changes in the assumed dividend growth rate can
lead to large changes in the estimated stock price.

36

9.3.1 Discounted Free Cash Flow Model

Determines the value of the firm to all investors, including
both equity and debt holders
Step 1: Enterprise Value = PV(Future Free Cash Flows)
Step 2: Market Value of Equity = Enterprise Value + Cash Debt
Step 3: P =

Market Value of Equity

Shares Outstanding

The tricky part is Step 1

Unlevered Net Income

Free Cash Flow EBIT (1 ) Depreciation

c
Capital Expenditures Increases in Net Working Capital

Since we are discounting cash flows to both equity holders and debt holders,
the free cash flows should be discounted at the firms weighted average cost
of capital, rwacc.
37

9.3.1 Discounted Free Cash Flow Model (Cont.)

To discount all the future cash flows:
V0

FCF1
FCF2

2
1 rwacc
(1 rwacc )

FCFN
VN

(1 rwacc ) N
(1 rwacc ) N

Often, the terminal value (VN) is estimated by assuming a

constant long-run growth rate gFCF for free cash flows
beyond year N, so that:

VN

1 g FCF
FCFN 1

FCFN
rwacc g FCF
(rwacc g FCF )

38

9.3.1 Discounted Free Cash Flow Model (Cont.)

Example:

39

9.3.1 Discounted Free Cash Flow Model (Cont.)

Solution:

40

9.4.0 Comparable Firms Valuation

Estimate the value of the firm based on the value of other
comparable firms or investments that we expect will
generate very similar cash flows in the future.

41

9.4.1 Valuation Multiples

The Price-Earnings Ratio
P/E ratio
Share price divided by earnings per share

Forward P/E

P0
Div1 / EPS1
Dividend Payout Rate

EPS1
rE g
rE g

Firms with high growth rates, and which generate cash well in excess of their
investment needs so that they can maintain high payout rates, should have
high P/E multiples.

Enterprise Value Multiples

V0
FCF1 / EBITDA1

EBITDA1
rwacc g FCF

Higher for firms with high growth rates and low capital requirements (so that
free cash flow is high in proportion to EBITDA).
A better measure when comparing firms with different amounts of leverage.

See Example 9.10 (Page 271) for numerical examples.

42

9.4.2 Limitations of Multiples

When valuing a firm using multiples, there is no clear
guidance about how to adjust for differences in expected
future growth rates, risk, or differences in accounting
policies.
Comparables only provide information regarding the
value of a firm relative to other firms in the comparison
set.
Using multiples will not help us determine if an entire industry is overvalued.

43

Homework
Chapter 6: 17, 23
Chapter 9: 6, 8, 11, 15, 19, 27

44