HANDOUTS ON FUNDAMENTALS OF
FINANCIAL MANAGEMENT 1
(Chapter 4: The Valuation of Long-term
Securities)
Ms. Carmelita U. de Guzman
1. Distinctions among valuation
concepts:
Liquidation value the amount of
money that could be realized if an asset
or a group of assets (e.g., a firm) is sold
separately from its operating
organization.
Going-concern value the amount a
firm could be sold for as a continuing
operating business.
Book value (a) an asset: the
accounting value of an asset the
assets cost minus its accumulated
depreciation; (b) a firm: total assets
minus liabilities and preferred stock as
listed on the balance sheet.
Market value the market price at which
an asset trades in an open marketplace.
Intrinsic value the price a security
ought to have based on all factors
bearing on valuation. This is the
economic value of a security. If markets
are reasonably efficient and informed,
the current market price of a security
should fluctuate closely around its
intrinsic value
2. The valuation approach is usually one
of determining a securitys intrinsic
value what the security ought to be
worth based on hard facts. This value is
the present value of the cash flow
stream provided to the investor,
discounted at a required rate of return
appropriate for the risk involved.
3. Bond Valuation
a) A bond is a security that pays a stated
amount of interest to the investor,
period after period, until it is finally
retired by the issuing company.
b) A bond has a face value, the stated
value of an asset; and a stated maturity,
which is the time when the company is
obligated to pay the bondholder the face
value of the instrument.
c) Likewise stated on the bonds face is
the coupon rate, or the stated rate of
interest on a bond; the annual interest
1
payment divided by the bonds face
value.
d) In valuing a bond, or any security for
that matter, primary consideration is
given to the discounting, or capitalizing,
the cash-flow stream that the security
holder would receive over the life of the
instrument.
e) The terms of a bond establish a
legally binding payment pattern at the
time the bond is originally issued. This
pattern consists of the payment of a
stated amount of interest over a given
number of years coupled with a final
payment, when the bond matures, equal
to the bonds face value.
f) Perpetual Bonds (consol) a bond
that never matures, a perpetuity in the
form of a bond. The present (intrinsic)
value of a perpetual bond would simply
be equal to the capitalized value of an
infinite stream of interest payments; or
simply the periodic interest payment
divided by the appropriate discount rate
per period.
g) Bonds with a Finite Maturity
1) Nonzero coupon bonds In valuing
the bond, not only the interest stream
but also the terminal or maturity value
(face value) should be considered.
Hence, the intrinsic value of this
interest-bearing bond with a finite
maturity is equal to the present value of
the interest payments plus the present
value of principal payment at maturity,
all discounted at the investors required
rate of return.
2) Zero coupon bonds a bond that
makes no periodic interest payments
but instead is sold at a deep discount
from its face value. The buyer of such a
bond receives a return which consists of
the gradual increase (or appreciation) in
the value of the security from its
original, below-face-value purchase price
until it is redeemed at face value on its
maturity date. Hence, the intrinsic value
of this zero coupon bonds is the present
value of the principal payment at
maturity, discounted at the investors
required rate of return.
4. Preferred Stock Valuation
a) Preferred stock is a type of stock that
promises a fixed dividend, but at the
discretion of the board of directors. It
has preference over common stock in
the payment of dividends and claims on
assets.
b) It has no stated maturity date and,
given the fixed nature of its payments, is
similar to a perpetual bond.
c) The intrinsic value of preferred stock
is equal to the stated annual dividend
per share divided by the investors
required rate of return.
5. Common Stock Valuation
a) Common stock is a security that
represents the ultimate ownership (and
risk) position in a corporation.
b) Unlike bonds and preferred stock, for
which the future cash flows are
contractually stated, much more
uncertainty surrounds the future stream
of returns connected with common
stock.
c) The intrinsic value of a share of
common stock can be viewed as the
discounted value of all expected cash
dividends provided by the issuing firm
until the end of time.
6. Rates of Return (or Yields)
a) Yield to Maturity (YTM) on Bonds the
expected rate of return on a bond if
bought at its current market price and
held to maturity. It is also known as the
bonds internal rate of return (IRR).
b) Behavior of Bond Prices
(1) Bond Discount: When the market
required rate of return is more than the
stated coupon rate, the price of the bond
will be less than its face value. Such a
bond is said to be selling at a discount
from face value. The amount by which
the face value exceeds the current price
is the bond discount.
(2) Bond Premium: When the market
required rate of return is less than the
stated coupon rate, the price of the bond
will be more than its face value. The
amount by which the current price
exceeds the face value is the bond
premium.
(3) When the market required rate of
return equals the stated coupon rate,
the price of the bond will equal its face
value. Such a bond is said to be selling
at par.
2
(4) If interest rates rise so that the
market required rate of return increases,
the bonds price will fall. If interest rates
fall, the bonds price will increase. In
short, interest rates and bond prices
move in opposite directions.
It is clear that variability in interest
rates should lead to variability in bond
prices. This variation in the market price
of a security caused by changes in
interest rates is referred to as interest-
rate (or yield) risk. It should be noted
that an investor incurs a loss due to
interest-rate (or yield) risk only if a
security is sold prior to maturity and the
level of interest rates has increased
since time of purchase.
(5) For a given change in market
required return, the price of a bond will
change by a greater amount, the longer
its maturity.
In general, the longer the maturity
for a bond, the greater the bonds price
fluctuation associated with a given
change in market required return. The
closer in time that you are to this
relatively large maturity value being
realized, the less important are interest
payments in determining the market
price, and the less important is a change
in market required return on the market
price of the security. Hence, the longer
the maturity of a bond, the greater the
risk of price change to the investor when
changes occur in the overall level of
interest rates.
(6) For a given change in market
required rate of return, the price of a
bond will change by proportionally more,
the lower the coupon rate. Or, bond
price volatility is inversely related to
coupon rate.
The reason for this effect is that
the lower the coupon rate, the more
return to the investor is reflected in the
principal payment at maturity as
opposed to interim interest payments.
Or investors realize their returns later
with a low-coupon-rate bond than with a
high-coupon-rate bond. In general, the
further in the future the bulk of the
payment stream, the greater the present
value effect caused by a change in
required return. Even if high-and-low
coupon rate bonds have the same
maturity, the price of the low-coupon
rate bond tends to be more volatile.
Hence, the lower the coupon rate,
the more sensitive that relative bond
price changes are to changes in market
yields.
c) The yield on common stock comes
from two sources. The first source is the
expected dividend yield (the expected
compound annual growth rate in
dividends), and the second source is the
expected capital gains yield (the
expected annual percent change in
stock price.

Reference:

Van Horne and John M. Wachowicz,

Fundamentals of Financial Management,
13th edition