Fundamentals of Corporate Finance, Slide

Preah Kossomak Polytechnic Institute (PPI)
FUNDAMENTALS OF
CORPORATE FINANCE
Eighth Edition @2008
Stephen A. Ross
Randolph W. Westerfield
Bradford D. Jordan
Prepared and Taught by Lecturer: YIN SOKHNG
E-mail: yin_sokheng@yahoo.com
Chapter 1 Introduction to Corporate Finance
Chapter 2 Financial Statements, Taxes, and Cash Flow
Chapter 3 Working with Financial Statements
Chapter 4 Long-Term Financial Planning and Growth
Chapter 5 Introduction to Valuation: The Time Value of Money
Chapter 6 Discounted Cash Flow Valuation
Chapter 7 Interest Rates and Bond Valuation
Chapter 8 Stock Valuation
Chapter 9 Net Present Value and Other Investment Criteria
Table of Contents
Instructed by YIN SOKHENG, Master in Finance
Chapter 1
Introduction to Corporate Finance
Chapter Outline
1.1 Corporate Finance and the Financial Manager
1.2 Corporate Firm/Forms of Business Organization
1.3 Corporate Securities as Contingent Claims on
Total Firm Value
1.4 The Goal of Financial Management
1.5 The Agency Problem and Control of the
Corporation
1.6 Financial Markets and the Corporation
3
Corporate finance is the study of financial
decision-making in business organizations.
1.1 What is Corporate Finance?
Corporate Finance is the activity of providing :
- money to corporations for investment, and
- the ways that corporations' use this money.
Corporate Finance branch of economics concerned
with how businesses raise and spend their money.
4
Financial Management Decisions
Capital
Budgeting
Capital Structure
Working Capital
Management
5
Corporate Finance addresses the following three
questions:
1. What long-term investments should the firm engage
in?
2. How can the firm raise the money for the required
investments?
3. How much short-term cash flow does a company
need to pay its bills?
Financial Management Decisions
6
The Capital Budgeting Decision
1. What long-term investments should the firm engage
in?
Type and proportions of assets the firm need tend
to be set by the nature of the business.
Use the terms capital budgeting and capital
expenditure to making and managing expenditures
on long-lived assets.
7
The Capital Structure Decision
2. How can the firm raise the money for the required
investments?
The answer to this involves the capital
structure, which represents the proportions of :
the firms financing from current debt,
the firms financing from long-term debt, and
the firms financing from equity
8
The Net Working Capital Investment
Decision
3. How much short-term cash flow does a company
need to pay its bills?
The answer to this involves :
the firms net working capital,
the subject of short-term finance,
the firms short-term management cash flow, and
the timing of cash inflows and cash outflows.
9
Hypothetical Organization Chart
Chairman of the Board and
Chief Executive Officer (CEO)
Board of Directors
President and Chief
Operating Officer (COO)
Vice President and
Chief Financial Officer (CFO)
Treasurer Controller
Cash Manager
Capital Expenditures
Credit Manager
Financial Planning
Tax Manager
Financial Accounting
Cost Accounting
Data Processing
10
The Financial Manager
A member of the top manager team (CFO)
responsible for:
Providing the timely and relevant data to
support planning and control activities.
Preparing financial statement for external
users.
The treasurer is responsible for:
handing cash flows,
managing capital expenditures decisions, and
making financial plans.
11
The Financial Manager
To create value from the firms capital budgeting,
financing, and net working capital activities, the
financial manager should:
1. Try to make smart investment decisions (try to buy
assets that generate more cash than cost).
2. Try to make smart financing decisions (sell bonds or
stocks and other financing instruments that raise
more cash than cost).
12
The Firm and the Financial Markets
Cash flow
from firm (C)
T
a
x
e
s

(
D
)
Firm
Government
Firm issues securities (A)
Retained
cash flows (F)
Dividends and
debt payments (E)
Financial
markets
Invests
in assets
(B)
Current assets
Fixed assets
Short-term debt
Long-term debt
Equity shares
13
1.2 The Corporate Firm
The corporate form of business is the standard
method for solving the problems encountered
in raising large amounts of cash.
However, businesses can take other forms.
14
Forms of Business Organization
The Sole Proprietorship
The Partnership
General Partnership
Limited Partnership
The Corporation
Advantages and Disadvantages
Liquidity and Marketability of Ownership
Control
Liability
Continuity of Existence
Tax Considerations
15
A Comparison of Partnership
and Corporations
Corporation Partnership
Liquidity Shares can easily be
exchanged.
Subject to substantial
restrictions.
Voting Rights Usually each share gets
one vote
General Partner is in
charge; limited partners
may have some voting
rights.
Taxation Double Partners pay taxes on
distributions.
Reinvestment and
dividend payout
Broad latitude All net cash flow is
distributed to partners.
Liability Limited liability General partners may
have unlimited liability.
Limited partners enjoy
limited liability.
Continuity Perpetual life Limited life
16
1.3 Corporate Securities as Contingent
Claims on Total Firm Value
17
Bonds Compared to Stock
Bondholders are
creditors
Bonds a liability
Interest is fixed
charge
Interest is expense
Interest tax
deductible
No voting
Stockholders are
owners
Stock is equity
Dividends not fixed
charges
Dividends not
expense
Dividends not tax
deductible
Voting
18
Corporate Securities as Contingent Claims
on Total Firm Value
The basic feature of a debt is that it is a promise by the
borrowing firm to repay a fixed dollar amount of by a
certain date.
The shareholders claim on firm value is the residual
amount that remains after the debtholders are paid.
If the value of the firm is less than the amount
promised to the debtholders, the shareholders get
nothing.
19
Debt and Equity as Contingent Claims
Payoff to
debt holders
Value of the firm (X)
Debt holders are promised $F.
If the value of the firm is less than $F, they get the
whatever the firm if worth.
If the value of the firm is
more than $F, debt holders
get a maximum of $F.
Payoff to
shareholders
less than $F, share holders
get nothing.
more than $F, share holders
get everything above $F.
Algebraically, the bondholders claim is:
Min[$F,$X]
Algebraically, the shareholders claim is:
Max[0,$X $F]
20
$F
$F
Combined Payoffs to debt holders
and shareholders
Debt holders are promised
$F.
Payoff to debt
holders
Payoff to
shareholders
If the value of the firm is less than
$F, the shareholders claim is:
Max[0,$X $F] = $0 and the debt
holders claim is Min[$F,$X] =
$X.
The sum of these is = $X
If the value of the firm is more
than $F, the shareholders claim
is: Max[0,$X $F] = $X $F and
the debt holders claim is:
Min[$F,$X] = $F.
The sum of these is = $X
Combined Payoffs to Debt and Equity
21
1.4 Goals of the Corporate Firm
The traditional answer is that the managers of
the corporation are obliged to make efforts to
maximize shareholder wealth.
22
Managerial Goals
Managerial goals may be different from
shareholder goals
Survival
Independence
Minimize costs and Maximize profits.
Increased growth and size are not necessarily
the same thing as increased shareholder
wealth.
23
1.5 The Agency Problem
The agency relationship
Will managers work in the shareholders
best interests?
Agency costs
Direct agency Costs
Indirect agency Costs
Control of the firm
How do agency costs affect firm value (and
shareholder wealth)?
24
1.6 Financial Markets
Financial markets are composed of the money
markets and capital markets.
Money Markets
For debt securities that will pay off in the short
term.
Usually less than one year.
Capital Markets
For long-term debt (equity securities).
With maturity at over one yare.
For equity shares.
25
Money Market
Capital Markets
Non-government securities:
Debt securities:
-Certificate of Deposits (CDs)
-Commercial Paper (CP)
-Repurchase Agreements (Repo.)
-Bankers acceptances (BAs)
Non-government securities:
- Corporate bond/ Bond
payable
Stock/Equity shares:
-Preferred stock
- Common stock
Financial Instruments
Government securities:
-Treasury notes (T-notes)
-Long-term Municipal Bonds
-Treasury bonds (T-bonds)
Government securities:
- Treasury bills (T-bills)
- Short term Municipal
bonds
26
Financial Markets
The function of market in financial market are
divided two (transaction) markets:
Primary Market
When a corporation issues securities, cash flows
from investors to the firm.
Usually an underwriter is involved
Secondary Markets
Involve the sale of used securities from one
investor to another.
Securities may be exchange traded or trade over-
the-counter (OTC) in a dealer market.
27
Financial Markets
Firms
Investors
Secondary Market
money
securities
Stocks and
Bonds
Money
Primary Market
SBUs
28
SBUs
29
The Public Issue
The Basic Procedure
Management gets the approval of the Board of
Directors.
The firm prepares and files a registration
statement with the SEC.
The SEC studies the registration statement during
the waiting period.
The firm prepares and files an amended
registration statement with the SEC.
30
Exchange Trading of Listed Stocks
Auction markets are different from dealer
markets in two ways:
Trading in a given auction exchange takes place at
a single site on the floor of the exchange.
Transaction prices of shares are communicated
almost immediately to the public.
Chapter 2
Financial Statements, Taxes, and
Cash Flow
Prepared and Taught by Lecturer: YIN SOKHNG
Chapter Outline
2.1The Balance Sheet
2.2 The Income Statement
2.3 Net Working Capital
2.4 Taxes
2.5 Cash Flow
2
3
Figure 2.1
2.1 The Balance Sheet
4
Assets 2006 2007 Liabilities and Equity 2006 2007
Current Assets Current Liabilities
Cash $ 104 $ 160 Accounts Payable $ 232 $ 266
A/R 455 688 Notes Payable 196 123
Inventory 553 555 Total $ 428 $ 389
Total $1,112 $1,403
Long-term Debt $ 208 $ 454
Fixed Assets
Net Fixed Assets$1,644 $1,709
Stockholders Equity
Common Stock and
Paid in Surplus $ 600 $ 640
Retained Earnings 1,320 1,629
Total $ 1,920 $ 2,269
Total Assets $2,756 $3,112 Total Claims $ 2,756 $ 3,112
US Corporation
Balance Sheet ($ in millions) Table 2.1
5
Balance Sheet Analysis
When analyzing a balance sheet, the
financial manager should be aware of three
concerns:
1.Accounting liquidity
2.Debt versus equity
3.Value versus cost
6
Accounting Liquidity
Refers to the ease and quickness with which
assets can be converted to cash.
Current assets are the most liquid.
Some fixed assets are intangible.
Liquid assets frequently have lower rates of
return than fixed assets.
7
Debt versus Equity
Generally, when a firm borrows it gives the
bondholders first claim on the firms cash flow.
Thus shareholders equity is the residual
difference between assets and liabilities.
Assets Liabilities = Stockholders equity
8
Value versus Cost
Under GAAP audited financial statements of
firms in the U.S. carry assets at cost.
Market value is a completely different concept.
In fact, managements job is to create a value
for the firm that is higher than its cost.
Many users of financial statement, including
managers and investors, want to know the
value of the firm, not its cost
9
Table 2.2
2007
2.2 The Income Statement
10
Income Statement Analysis
There are three things to keep in mind when
analyzing an income statement:
1. GAAP
2. Non Cash Items
3. Time and Costs
11
Generally Accepted Accounting Principles
1. GAAP
The matching principal of GAAP dictates that
revenues be matched with expenses.
Thus, income is reported when it is earned,
even though no cash flow may have occurred
12
2. Non Cash Items
Depreciation is the most apparent. No firm
ever writes a check for depreciation.
Another noncash item is deferred taxes, which
does not represent a cash flow.
13
3. Time and Costs
In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labor and raw materials.
In the long run, all inputs of production (and hence
costs) are variable.
Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that
distinguishes product costs from period costs.
14
2.3 Taxes
Federal income tax rate increases with
the level of taxable income.
Marginal vs. average tax rates
Marginal Rate the percentage paid
on the next dollar earned
Average Rate the tax bill / taxable
income
15
Corporate Tax Rate
Taxable Income Tax rate
0 - 50,000 15%
50,001-75,000 25%
75,001-100,000 34%
100,001-335,000 39%
335,001-10,000,000 34%
10,000,001-15,000,000 35%
15,000,001-18,333,333 38%
18,333,333+ 35%
16
Example: Marginal Vs. Average Rates
Suppose our corporation has a taxable
income of $200,000.
What is the firms tax liability?
What is the average tax rate?
What is the marginal tax rate?
17
Example: Marginal Vs. Average Rates
The firms tax liabilities
0 - 50,000 x 15% = $7,500
50,000-75,000 x 25% = $6,250
75,000-100,000 x 34% = $8,500
100,000-200,000 x 39% = $39,000
$61,250
Average tax rate = 61,250/200,000 = 30.625%
If we made one more dollar, the tax rate on that dollar
would be 39%, so our marginal is 39%.
18
2.4 Net Working Capital (NWC)
Net working capital is current assets minus current
liabilities.
Net working capital is positive when current assets are
greater than current liabilities.
Net Working Capital = Current Assets Current
Liabilities
NWC is usually growing with the firm.
19
2.5 Financial Cash Flow
In finance, the most important item that can be
extracted from financial statements is the actual
cash flow of the firm.
The cash from received from the firms assets
must equal the cash flows to the firms creditors
and stockholders.
CF(A)= CF(B) + CF(S)
CF(A)= OCF NCS Change in NWC
20
Table 2.5
21
Cash flow from assets
Operating cash flow:
EBIT $ 694
+ Depreciation + 65
Taxes 212 $ 547
Change in net working capital:
Ending net working capital $ 1,014
Beginning net working capital 684 $ 330
Net capital spending:
Ending non-current assets $ 1,709
Beginning non-current assets 1,644
+ Depreciation + 65 $ 130
Cash flow from assets: $ 87
US Corporation
Financial Cash Flow ($ in millions)
22
Cash flow to debtholders and shareholders
Cash flow to debtholders:
Interest paid $ 70
Net new borrowing 46 $ 24
Cash flow to shareholders:
Dividends paid $ 103
Net new equity raised 40 $ 63
Cash flow to debtholders and shareholders $ 87
Chapter 3
Working with
Financial Statements
Prepared and Taught by Lecturer : YIN SOKHNG
Chapter Outline
3.1 Cash Flow and Financial Statements
3.2 Standardized Financial Statements
3.3 Ratio Analysis
3.4 The Du Pont Identity
3.5 Using Financial Statement Information
2
3
3.1 Cash Flow and Financial Statements
Chapter 2: Financial cash flow:
Cash flow from assets
= Cash flow to creditor + Cash flow to owners
This Chapter: Identify cash flow activities:
1. Statement of Cash Flows and
2. SOURCES and USES OF CASH
4
Reading the Balance Sheet on page 50.
Table 3.1
Reading the Income Statement on page 51.
Table 3.2
Prufrock Corporation
5
6
Identification of Cash Flows
The identification of cash flows involves the
accounting statement to :
1. Obtain information.
2. Financial analysis.
3. Extract cash flow information.
7
Risk of Cash Flows
The firm must consider risk depends on:
1. Amount of cash flows.
2. Timing of cash flows.
3. Mismatching of cash inflows and outflows.
8
The Statement of Cash Flows
The three components of the statement of
cash flows are:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
9
Indirect Statement of Cash Flows
Operating activities
+ Net income
+ Depreciation
- Increase in A/R
- Increase in Inventory
+ Increase in accounts payable
+ Increase in accruals
Investment activities (cash going out)
+ Ending fixed assets
Beginning fixed assets
+ Depreciation
+ Increase in marketable securities
10
Indirect Statement of Cash Flows
Financing activities
+ Increase in notes payable
+ Increase in long-term debt
+ Increase in common stock
Dividends paid
=> The answers about cash flows of Prufrock
Corporations on page 52.
Table 3.3 & 3.4
11
3.2 Standardized Financial Statements
In this section, we describe two different ways of
standardizing financial statement along these lines:
1. COMMON-SIZE Statement: The standardizing
financial statement is to express each item as a
percentage. Looking at Table 3.5 & 3.6
2. COMMON-BASE YEAR Statement:
The standardizing financial statement in this case is to
choose a base year and then express each item as a
percentage relative to base amount.
Looking at Table 3.7
12
3.3 Ratio Analysis
Ratios also allow for better comparison
through time or between companies
As we look at each ratio, ask yourself what
the ratio is trying to measure and why is that
information important
Ratios are used both internally and externally
13
Categories of Financial Ratios
Short-Term Solvency or Liquidity
Ability to pay bills in the short-run
Long-Term Solvency
Ability to meet long-term obligations
Asset Management
Intensity and efficiency of asset use
Profitability
Market Value
Going beyond financial statements
14
Short-Term Solvency or Liquidity Ratios
Current ratio =
Current assets - Inventory
Quick ratio =
Current liabilities
Cash
Cash ratio =
Current liabilities
NWC
NWC to total assets =
Total assets
Current assets
Interval measure =
Average daily operating costs
Current assets
Current liabilities
15
Long-Term Solvency
Total assets - Total equity
Total debt ratio =
Total assets
Debtequity ratio = Total debt / Total equity
Equity multiplier = Total assets / Total equity
EBIT
Times interest earned ratio =
Interest
EBIT + depreciation
Cash coverage ratio =
Interest
Total assets - Total equity
Total debt ratio =
Total assets
16
Cost of goods sold
Inventory turnover =
Inventory
Sales
Fixed asset turnover =
Net fixed assets
365 days
Days sales in inventory =
Inventory turnover
Sales
Total asset turnover =
Total assets
Sales
Receivables turnover =
Accounts receivable
Days sales in receivables = 365 days / A/R turnover
NWC turnover = Sales / NWC
Asset Utilization or Turnover Ratios
17
Profitability Ratios
Net income
Profit margin =
Sales
Net income
Return on assets (ROA) =
Total assets
Net income
Return on equity (ROE) =
Total equity
ROE = (N.I. / Sales) x (Sales / T. A.). x (T. A. / Equity)
18
Market Value Ratios
Price per share
Price earnings ratio =
Earnings per share
Market value per share
Market-to-book ratio =
Book value per share
19
20
Return on equity (ROE) can be decomposed as follows:
ROE = Net income / Total equity
= Profit margin x Total asset turnover x Equity multiplier
= (N.I. / Sales) x (Sales / T. A.). x (T. A. / Equity)
= ROA x Equity multiplier
Profitability (or the lack thereof!) thus has three parts:
Operating efficiency
Asset use efficiency
Financial leverage
3.4 The Du Pont Identity
Table 3.3
21
3.5 Using Financial Statement
Information
For analyzing financial statements
Why evaluate financial statement?
Looking at accounting information
Looking at market value information
To comparing ratios for one business
For INTERNAL & EXTERNAL Users.
Chapter 4
Long-Term Financial Planning and
Growth
Chapter Outline
4.1 What is Corporate Financial Planning?
4.2 Financial Planning Model: The Ingredient
4.3 The Percentage of Sales Approach
4.4 External Financing and Growth
4.5 Uses of the Sustainable Growth Rate
2
Financial Plan
To develop an explicit financial plan, manager
must establish certain basic elements of the
firms financial policy:
The firms needed investment in new assets
The degree of financial leverage the firm chooses
to employ
The amount of cash the firm think is necessary
and appropriate to pay shareholders
The amount of liquidity and working capital the
firm needs on an going basis.
3
4
4.1 What is Corporate Financial
Planning?
It formulates the method by which financial goals are to
be achieved.
There are two dimensions:
1. A Time Frame
Short run is probably anything less than a year.
Long run is anything over that; usually taken to be a two-year to five-
year period.
2. A Level of Aggregation
Each division and operational unit should have a plan.
As the capital-budgeting analyses of each of the firms divisions are
added up, the firm aggregates these small projects as a big project.
5
What Will the Planning Process
Accomplish?
Interactions
The plan must make explicit the linkages between
investment proposals and the firms financing
choices.
Options
The plan provides an opportunity for the firm to
weigh its various options.
Feasibility
Avoiding Surprises
Nobody plans to fail, but many fail to plan.
6
4.2 A Financial Planning Model:
1. Sales forecast
2. Pro forma statements
3. Asset requirements
4. Financial requirements
5. Plug
6. Economic assumptions
7
Sales Forecast
All financial plans require a sales forecast.
Perfect foreknowledge is impossible since
sales depend on the uncertain future state of
the economy.
Businesses that specialize in macroeconomic
and industry projects can be help in estimating
sales.
8
Pro Forma Statements
The financial plan will have a forecast balance
sheet, a forecast income statement, and a
forecast sources-and-uses-of-cash statement.
These are called pro forma statements or pro
formas.
9
Asset Requirements
The financial plan will describe projected
capital spending.
In addition it will the discuss the proposed
uses of net working capital.
10
Financial Requirements
The plan will include a section on financing
arrangements.
Dividend policy and capital structure policy
should be addressed.
If new funds are to be raised, the plan should
consider what kinds of securities must be sold
and what methods of issuance are most
appropriate.
11
Plug
After the has a sales forecast and an estimate of the
required spending on assets, some amount of new
financing will often be necessary because project
total assets will exceed projected total liabilities and
equity (in other words, the balance sheet will no
longer balance).
The plug is the designated source or sources of
external financing needed to deal with any shortfall
(or surplus) in financing and thereby bring the
balance sheet into balance sheet.
12
Economic Assumptions
The plan must explicitly state the economic
environment in which the firm expects to
reside over the life of the plan.
Interest rate forecasts are part of the plan.
13
The Steps in Estimation of Pro Forma Balance Sheet:
1. Express balance-sheet items that vary with
sales as a percentage of sales.
2. Multiply the percentages determine in step 1
by projected sales to obtain the amount for
the future period.
3. When no percentage applies, simply insert the
previous balance-sheet figure into the future
period.
14
The Steps in Estimation of Pro Forma Balance Sheet
Present retained earnings
+ Projected net income
Cash dividends
Projected retained earnings
5. Add the asset accounts to determine projected assets.
Next, add the liabilities and equity accounts to determine
the total financing; any difference is the shortfall. This
equals the external funds needed.
6. Use the plug to fill EFN.
4. Computer Projected retained earnings as
15
A Brief Example
The Rosengarten Corporation is think of acquiring a
new machine. The machine will increase sales from
$20 million to $22 million10% growth.
The firm believes that its assets and liabilities grow
directly with its level of sales. Its profit margin on
sales is 10%, and its dividend-payout ratio is 50%.
Will the firm be able to finance growth in sales with
retained earnings and forecast increases in debt?
16
Current Balance Sheet
Current assets $6
Fixed assets $24
Total assets $30
Short-term debt
$10
Long-term debt $6
Common stock $4
Retained Earnings
$10
Total financing $30
Pro forma Balance Sheet
Explanation
$6.6
$26.4 120% of sales
$33 150% of sales
$11 50% of sales
$6.6 30% of sales
$4 Constant
$11.1 Net Income
External Funds Needed
$32.7
$300,000
(millions) (millions)
30% of sales
17
4.3 The Percentage of Sales Approach: EFN
The external funds needed for a 10% growth in
sales:
) 1 ( Sales) Projected ( Sales
Sales
Debt
Sales
Sales
Assets
d p
p = Net profit margin = 0.10

d = Dividend payout ratio = 0.5
Sales = Projected change in sales = $2 million
m m 2 5 . 1 2
20 $
30 $
Sales
Sales
Assets
= =
8 . 0
20 $
16 $
Sales
Debt
= =

18
The Percentage Sales Method: EFN
The external funds needed
19
4.4 External Financing and Growth
What Determines Growth?
The firms ability to sustain growth depends on
explicitly on the following four factors:
1. Profit margin
2. Dividend policy
3. Financial policy
4. Total asset turnover
20
EFN and Growth, looking at Table 4.6 & 4.7
What Determines Growth?
Change in assets = Change in debt + Change in equity
The growth ratio equation:
New equity + Borrowing = Capital spending
21
Table 4.9
22
The Sustainable Growth Rate in Sales is given by:
) 1 ( ) 1 ( (
) 1 ( ) 1 (
0
E
D
d p T
E
D
d p
S
S
+
+
=
T = ratio of total assets to sales

p = net profit margin on sales
d = dividend payout ratio
L = debt-equity ratio (D/E)
S
0
= Current sales
S = Change in sales
)] 1 ( ) 1 ( [(
) 1 ( ) 1 (
0
L d p T
L d p
S
S
+
+
=

23
4.5 Uses of the Sustainable Growth Rate
A commercial lender would want to compare a
potential borrowers actual growth rate with
their sustainable growth rate.
If the actual growth rate is much higher than
the sustainable growth rate, the borrower runs
the risk of growing broke and any lending
must be viewed as a down payment on a much
more comprehensive lending arrangement than
just one round of financing.
24
Increasing the Sustainable Growth Rate
A firm can do several things to increase its
sustainable growth rate:
Sell new shares of stock
Increase its reliance on debt
Reduce its dividend-payout ratio
Increase profit margins
Decrease its asset-requirement ratio
Chapter 5,6
Time Value of Money
Chapter Outline
5.1 The One-Period Case
5.2 The Multiperiod Case
5.3 Compounding Periods & Continuous
Compounding
5.4 Valuing Level Cash Flows: Annuities and
Perpetuities
5.5 Loan Amortization
2 Instructed by YIN SOKHENG, Master in Finance
3
5.1 The One-Period Case:
Future Value
If you were to invest $10,000 at 5-percent interest for
one year, your investment would grow to $10,500
$500 would be interest ($10,000 .05)
$10,000 is the principal repayment ($10,000 1)
$10,500 is the total due. It can be calculated as:
$10,500 = $10,000(1.05).
The total amount due at the end of the investment is
call the Future Value (FV).
4
In the one-period case, the formula for FV
can be written as:
FV = C
0
(1 + r)
T
Where C
0
is cash flow today (time zero) and
r is the appropriate interest rate.
5
Present Value
If you were to be promised $10,000 due in one
year when interest rates are at 5-percent, your
investment be worth $9,523.81 in todays
dollars.
05 . 1
000 , 10 $
81 . 523 , 9 $ =
The amount that a borrower would need to set aside
today to to able to meet the promised payment of
$10,000 in one year is call the Present Value (PV) of
$10,000.
Note that $10,000 = $9,523.81(1.05).
6
In the one-period case, the formula for PV can be
written as:
r
C
PV
+
=
1
1
Where C
1
is cash flow at date 1 and
r is the appropriate interest rate.
7
5.2 The Multiperiod Case:
Future Value
The general formula for the future value of an
investment over many periods can be written as:
FV = C
0
(1 + r)
T
Where
C
0
is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.
8
Suppose that Jay Ritter invested in the initial
public offering of the Modigliani company.
Modigliani pays a current dividend of $1.10,
which is expected to grow at 40-percent per
year for the next five years.
What will the dividend be in five years?
FV = C
0
(1 + r)
T
$5.92 = $1.10(1.40)
5
9
Future Value and Compounding
Notice that the dividend in year five, $5.92, is
considerably higher than the sum of the
original dividend plus five increases of 40-
percent on the original $1.10 dividend:
$5.92 > $1.10 + 5[$1.10.40] = $3.30
This is due to compounding.
Future Value and Compounding
10
0 1 2 3 4 5
10 . 1 $
3
) 40 . 1 ( 10 . 1 $
02 . 3 $
) 40 . 1 ( 10 . 1 $
54 . 1 $
2
) 40 . 1 ( 10 . 1 $
16 . 2 $
5
) 40 . 1 ( 10 . 1 $
92 . 5 $
4
) 40 . 1 ( 10 . 1 $
23 . 4 $
11
Present Value and Compounding
How much would an investor have to set aside today in order to
have $20,000 five years from now if the current rate is 15%?
0 1 2 3 4 5
$20,000 PV
5
) 15 . 1 (
000 , 20 $
53 . 943 , 9 $ =
12
How Long is the Wait?
If we deposit $5,000 today in an account paying
10%, how long does it take to grow to $10,000?
T
r C FV ) 1 (
0
+ =
T
) 10 . 1 ( 000 , 5 $ 000 , 10 $ =
2
000 , 5 $
000 , 10 $
) 10 . 1 ( = =
T
2 ln ) 10 . 1 ln( =
T
years 27 . 7
0953 . 0
6931 . 0
) 10 . 1 ln(
2 ln
= = = T
13
What Rate Is Enough?
Assume the total cost of a college education
will be $50,000 when your child enters
college in 12 years. You have $5,000 to invest
today. What rate of interest must you earn on
your investment to cover the cost of your
childs education?
T
r C FV ) 1 (
0
+ =
12
) 1 ( 000 , 5 $ 000 , 50 $ r + =
10
000 , 5 $
000 , 50 $
) 1 (
12
= = + r
12 1
10 ) 1 ( = + r
2115 . 1 2115 . 1 1 10
12 1
= = = r
14
5.3 Compounding Periods & Continuous
Compounding
Compounding an investment m times a year for T
years provides for future value of wealth:
T m
m
r
C FV
|
.
|
\
|
+ = 1
0
For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to
93 . 70 $ ) 06 . 1 ( 50 $
2
12 .
1 50 $
6
3 2
= =
|
.
|
\
|
+ =

FV
15
Effective Annual Interest Rates
A reasonable question to ask in the above
example is what is the effective annual rate of
interest on that investment?
The Effective Annual Interest Rate (EAR) is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
93 . 70 $ ) 06 . 1 ( 50 $ )
2
12 .
1 ( 50 $
6 3 2
= = + =

FV
93 . 70 $ ) 1 ( 50 $
3
= + EAR
16
Effective Annual Interest Rates (continued)
So, investing at 12.36% compounded annually
is the same as investing at 12% compounded
semiannually.
93 . 70 $ ) 1 ( 50 $
3
= + = EAR FV
50 $
93 . 70 $
) 1 (
3
= + EAR
1236 . 1
50 $
93 . 70 $
3 1
=
|
.
|
\
|
= EAR
17
Effective Annual Interest Rates (continued)
Find the Effective Annual Rate (EAR) of an 18%
APR loan that is compounded monthly.
What we have is a loan with a monthly interest
rate of 1 percent.
This is equivalent to a loan with an annual interest
rate of 19.56 percent
19561817 . 1 ) 015 . 1 (
12
18 .
1 1
12
12
= =
|
.
|
\
|
+ =
|
.
|
\
|
+
m n
m
r
18
Continuous Compounding
The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C
0
e
rT
Where
C
0
is cash flow at date 0,
r is the stated annual interest rate,
T is the number of periods over which the cash is
invested, and
e is a transcendental number approximately equal to
2.718. e
x
is a key on your calculator.
19
5.4 Valuing Level Cash Flows: Annuities
and Perpetuities
Annuity finite series of equal payments that
occur at regular intervals
If the first payment occurs at the end of the period,
it is called an ordinary annuity
If the first payment occurs at the beginning of the
period, it is called an annuity due
Perpetuity infinite series of equal payments
20
Ordinary Annuity vs. Annuity Due
Ordinary Annuity
Annuity starts at
end of period
Annuity Due
Annuity starts
NOW
21
Annuity
A stream of constant cash flows that lasts for a
fixed number of periods.
Growing annuity
A stream of cash flows that grows at a constant
rate for a fixed number of periods.
Perpetuity
A constant stream of cash flows that lasts forever.
Growing perpetuity
A stream of cash flows that grows at a constant
rate forever.
22
Ordinary Annuities
(
+
=
(
(
(
(
=
r
r
C FV
r
r
C PV
T
T
1 ) 1 (
) 1 (
1
1
Note: C = PMT
23
Annuities Due
( )
( ) r
r
r
C FV
r
r
r
C PV
T
T
+
(
+
=
+
(
(
(
(
=
1
1 ) 1 (
1
) 1 (
1
1
Note: C = PMT
24
Ordinary Annuity
A constant stream of cash flows with a fixed maturity.
The formula for the present value of an ordinary
annuity is:
T
r
C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
3 2
+
+
+
+
+
+
+
=
(
+
=
T
r r
C
PV
) 1 (
1
1
0 1
C
2
C
3
C
T
C

25
Annuity Intuition
An annuity is valued as the difference between two
perpetuities:
one perpetuity that starts at time 1
less a perpetuity that starts at time T + 1
0 1
C
2
C
3
C
T
C
T
r
r
C
r
C
PV
) 1 ( +
|
.
|
\
|
=
26
Annuity: Example
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on 36-
month loans?
59 . 954 , 12 $
) 12 07 . 1 (
1
1
12 / 07 .
400 $
36
=
(
+
= PV
0
1
$400
2
$400
3
$400
36
$400

27
What is the present value of a four-year annuity of
$100 per year that makes its first payment two years
from today if the discount rate is 9%?
22 . 297 $
09 . 1
97 . 327 $
0
= = PV
0 1 2 3 4 5
$100 $100 $100 $100 $323.97 $297.22
97 . 327 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
4 3 2 1
4
1
1
= + + + = =
= t
t
PV
28
Growing Annuity
A growing stream of cash flows with a fixed maturity.
The formula for the present value of a growing
annuity:
T
T
r
g C
r
g C
r
C
PV
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1
2
+
+
+ +
+
+
+
+
=

(
(
|
|
.
|
\
|
+
+
=
T
r
g
g r
C
PV
) 1 (
1
1
0 1
C
2
C(1+g)
3
C (1+g)
2
T
C(1+g)
T-1
29
Growing Annuity
A defined-benefit retirement plan offers to pay $20,000
per year for 40 years and increase the annual payment
by three-percent each year. What is the present value at
retirement if the discount rate is 10 percent?
57 . 121 , 265 $
10 . 1
03 . 1
1
03 . 10 .
000 , 20 $
40
=
(
(
|
.
|
\
|
= PV
0 1
$20,000
2
$20,000(1.03)
40
$20,000(1.03)
39
30
PV of Growing Annuity
You are evaluating an income property that is providing
increasing rents. Net rent is received at the end of each year. The
first year's rent is expected to be $8,500 and rent is expected to
increase 7% each year. Each payment occur at the end of the year.
What is the present value of the estimated income stream over the
first 5 years if the discount rate is 12%?
0 1 2 3 4 5
500 , 8 $
=
2
) 07 . 1 ( 500 , 8 $
095 , 9 $
65 . 731 , 9 $
=
3
) 07 . 1 ( 500 , 8 $
87 . 412 , 10 $
=
4
) 07 . 1 ( 500 , 8 $
77 . 141 , 11 $
$34,706.26
= ) 07 . 1 ( 500 , 8 $
31
PV of a delayed growing annuity
Your firm is about to make its initial public offering of
stock and your job is to estimate the correct offering price.
Forecast dividends are as follows.
Year: 1 2 3 4
Dividends per
share
$1.50 $1.65 $1.82 5% growth
thereafter
If investors demand a 10% return on investments of this risk
level, what price will they be willing to pay?
Year
0 1 2 3
Cash flow
$1.50 $1.65 $1.82
4
$1.821.05

32
PV of a delayed growing annuity
Year
0 1 2 3
Cash flow
$1.50 $1.65
$1.82 dividend + P
3
PV of cash flow $32.81
22 . 38 $
05 . 10 .
05 . 1 82 . 1
3
=
= P
81 . 32 $
) 10 . 1 (
22 . 38 $ 82 . 1 $
) 10 . 1 (
65 . 1 $
) 10 . 1 (
50 . 1 $
3 2
0
=
+
+ + = P
= $1.82 + $38.22
33
Perpetuity
A constant stream of cash flows that lasts forever.
0
1
C
2
C
3
C
The formula for the present value of a perpetuity is:
+
+
+
+
+
+
=
3 2
) 1 ( ) 1 ( ) 1 ( r
C
r
C
r
C
PV
r
C
PV =
34
Perpetuity: Example
What is the value of a British consol that promises to
pay 15 each year?
The interest rate is 10-percent.
0
1
15
2
15
3
15
150
10 .
15
= = PV
35
Growing Perpetuity
A growing stream of cash flows that lasts forever.
0
1
C
2
C(1+g)
3
C (1+g)
2
The formula for the present value of a growing perpetuity is:
+
+
+
+
+
+
+
+
=
3
2
2
) 1 (
) 1 (
) 1 (
) 1 (
) 1 ( r
g C
r
g C
r
C
PV
g r
C
PV
=
36
Growing Perpetuity: Example
The expected dividend next year is $1.30 and dividends
are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?
0
1
$1.30
2
$1.30(1.05)
3
$1.30 (1.05)
2
00 . 26 $
05 . 10 .
30 . 1 $
=
= PV
37
5.5 Loan Amortization
1. Interest only loan, the principal is repaid all at once.
e.g. corporate bond, T-note, T-bond
2. Principal and Interest Loans: Interest declines as your
outstanding principal declines (principal fixed).e.g.
small, smallest , and medium loan
3. Fixed payment loan:
loan is repaid with equal (monthly) payments
each payment is combination of principal and interest
e.g. car loan, mortgage loan
38
Amortization Table:
Principal and Interest Loan
. Interest declines as your outstanding
principal declines (principal fixed).
. Suppose we borrow $5,000 to be repaid in 5
annual payments with a 9% annual interest
rate.
39
Amortization Schedule
Year Beginning
Balance
Total
Payment
Interest
Paid
Principal
Paid
Ending
Balance
1 $5,000 $ 1,450 $ 450 $ 1,000 $ 4,000
2 $ 4000 $ 1,360 $ 360 $ 1,000 $ 3,000
3 $ 3000 $ 1,270 $ 270 $ 1,000 $ 2,000
4 $ 2000 $ 1,180 $ 180 $ 1,000 $ 1,000
5 $ 1000 $ 1,090 $ 90 $ 1,000 $--0--
Total $ 6,350 $ 1,350 $ 5,000

40
Amortization Table:
Fixed Payment Loan
Show breakdown of the payment into interest and
principal
Step 1: Determine the amount of each loan payment.
Solve for present value of annuity
Step 2: Determine how much of each payment is
interest versus principal.
Suppose our 5 years, 9 percent, $5,000 loan (car
loan) was amortized. How would the amortization
schedule look?
41
Fixed Payment Loan
) 1 (
) 1 (
1
1
) 1 (
1
1
r
r
r
PV
PMT
r
r
PV
PMT
T
T
+
(
(
(
(
=
(
(
(
(
=
(Ordinary Annuities)
(Annuities due)
42
Amortization Schedule
Year Beginning
Balance
Total
Payment(PMT)
Interest
Paid
Principal
Paid
Ending
Balance
1 $5,000.00 $ 1,285.46 $ 450.00 $ 835.46 $ 4,164.54
2 $ 4,164.54 $ 1,285.46 $ 374.81 $ 910.60 $ 3,253.88
3 $ 3,253.88 $ 1,285.46 $ 292.85 $ 992.61 $ 2,261.27
4 $ 2,261.27 $ 1,285.46 $ 203.51 $ 1,081.95 $ 1,179.32
5 $ 1,179.32 $ 1,285.46 $ 106.14 $ 1,179.32 $--0--
Total $6,427.30 $1,427.31 $5,000.00

Chapter 7
Interest Rates and
Bond Valuation
Chapter Outline
7.1 Bond Definition
7.2 More about Bond Features
7.3 Bond Ratings
7.4 Different Types of Bonds
7.5 Bond Markets
7.6 Inflation and Interest Rates
7.7 Determinants of Bond Yields
7.8 Bond Risky
3
7.1 Bond Definition
The corporation or government are borrow money
from the public by issuing or selling debt securities
that are generically called bonds.
Normally an interest-only loan (when issued at par),
the principal is paid until the end of the loan.
Interest paid in the form of a periodic coupon.
Term basis:
Short term basis
Long term basis.
4
The Bond Indenture
Contract between the corporation (borrower)
and the creditor (bondholders) that includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as security, if
applicable
Repayment agreements
Call provisions
Details of protective covenants
7.2 More about Bond Features
5
The Indenture
Forms of a Bond
Registered Form: The corporation keeps track of the
owner.
Bearer Form: Certificate is the only evidence of ownership.
Security
Collateral secured by other securities
Mortgage secured by real property, normally land or
buildings; Chattel Mortgage (mortgage on a specific
property)
Debentures unsecured bond with original maturity of 10
years or more
Notes unsecured bond with original maturity less than 10
years
6
Bonds Compared to Stock
Bondholders are
creditors
Bonds a liability
Interest is fixed
charge
Interest is expense
Interest tax deductible
No voting
Stockholders are owners
Stock is equity
Dividends not fixed
charges
Dividends not expense
Dividends not tax
deductible
Voting
7
Bond Term
Par value (face value), F
Coupon rate, R
Coupon payment, C
Maturity date, T
Discount rate or Yield to maturity, r or YTM
8
7.3 Bond Ratings
Investment Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more impact
on the firms ability to pay
9
Bond Ratings - Speculative
Low Grade
Moodys Ba, B, Caa and Ca
S&P BB, B, CCC, CC
Considered speculative with respect to capacity to
pay. The B ratings are the lowest degree of
speculation.
Very Low Grade
Moodys C and S&P C income bonds with no
interest being paid
Moodys D and S&P D in default with principal and
interest in arrears
10
7.4 Different Types of Bonds
zero coupon bonds or discount bonds
e.g. T-bills One year and less, no coupons
fixed payment loans
e.g. mortgages, car loans- Between 3 and 15years
coupon bonds
e.g. -T-notes Between 2 and 10 years,
-T-bonds Longer than 10 years,
-Corporate bonds Longer than 10 years
consols: no maturity date (forever).
11
Zero coupon bonds
discount bonds
purchased price less than face value, F > P
face value at maturity
no interest payments
(

=
365
) (
1
T r
F P
P = Current price
F = Face value
r = discount rate
T = Number of maturity date
T
r
F
P
) 1 ( +
=
OR
12
Zero coupon bonds
Yield to maturity, YTM
OR
1
360
|
.
|
\
|
=
d
P
F
r
r =
F - P
P
x
360
d
13
Fixed-payment loan
loan is repaid with equal (monthly) payment, PMT
each payment is combination of principal and
interest
( )
( ) ( )
T
m m
m
i
PMT
i
PMT
i
PMT
PV
+
+ +
+
+
+
=
1
...
1
1
2
(
(
(
(
=
i
i
m
T
m
PV
PMT
) 1 (
1
1
14
r is annual rate
(effective annual interest rate, EAR)
but payments are monthly, & compound
monthly
r = (1+ i
m
)
12
-1
i
m
= (1+ r)
1/12
-1
i
m
is the periodic rate
note: APR (annual percentage rate)
APR = i
m
x 12
15
Coupon Bond
purchase price, PV
promised of a series of payments until maturity
face value at maturity, F (principal, par value)
coupon payments (6 months), C
size of coupon payment
annual coupon rate, R
face value
6 mo. pmt.,C = (F x R)/2
16
Value of a coupon bond = PV of coupon payment annuity
+ PV of face value
0
C $
1
C $
2
C $
1 T
F C $ $ +
T
Information needed to value coupon bonds:
Coupon payment dates and time to maturity (T)
Coupon payment (C) per period and Face value (F)
Coupon rate (R) and Discount rate (r or YTM)
T T
r
F
r r
C
PV
) 1 ( ) 1 (
1
1
+
+
(
+
=
17
PV, F and YTM
PV = F then YTM = coupon rate
PV < F then YTM > coupon rate (at a discount)
PV > F then YTM < coupon rate (at a premium)
PV and YTM move in opposite directions
interest rates and value of debt securities move in
opposite directions
if rates rise, bond prices fall
if rates fall, bond prices rise
18
Interest Rate Risk
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-
term bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows
can be reinvested
Short-term bonds have more reinvestment rate risk
than long-term bonds
19
Figure 7.2
20
Current yield,
approximation of YTM for coupon bonds
i
c
=
annual coupon payment, C
bond price, PV
i
c
21
Yield-to-maturity
Yield-to-maturity is the rate implied by the current
bond price
Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the process
for finding r with an annuity
YTM = [C + (F PV)/T]/(F + PV)/2
C = Coupon payment
F = Face/Par value of bond
PV = Current price of bond
T = Maturity date
22
Holding period return
sell bond before maturity
return depends on
holding period
interest payments
resale price
t
t t
t
P
P P
P
C
RET

+ =
+1
g i RET
c
+ =
23
Holding period return
RET : Rate of Return at Holding Period
: Current yield
C : Coupon payment
: Price at T period
: Price at T+1 period
g : Rate of Capital Gains or the Change of
Price
i
c
P
t
P
t+1
24
Consols Bond
0
C $
1
C $
2
C $
... $C
forever
r
C
PV =
25
7.5 Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues, but
generally low daily volume in single issues
Makes getting up-to-date prices difficult,
particularly on small company or municipal
issues
Treasury securities are an exception
26
Bond Quotations
Highlighted quote:
ATT 7 06 7.7 554 97.63 -0.38
What company are we looking at?
What is the coupon rate? If the bond has a $1000 face
value, what is the coupon payment each year?
When does the bond mature?
What is the current yield? How is it computed?
How many bonds trade that day?
What is the quoted price?
How much did the price change from the previous day?
27
Treasury Quotations
Highlighted quote:
9.000 Nov 18133:27 133.28 24 5.78
What is the coupon rate on the bond?
When does the bond mature?
What is the bid price? What does this mean?
What is the ask price? What does this mean?
How much did the price change from the previous
day?
What is the yield based on the ask price?
28
7.6 Inflation and Interest Rates
Real rate of interest change in purchasing
power
Nominal rate of interest quoted rate of
interest, change in purchasing power and
inflation
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation
29
Inflation
if inflation is high
lenders demand higher nominal rate, especially
for long term loans
long-term i depends A LOT on inflation
expectations
30
The Fisher Effect
The Fisher Effect defines the relationship
between real rates, nominal rates and inflation
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
Approximation
R = r + h
31
Inflation and Present Value
( )
(
(
(
(
=
r
r
C PV
T
1
1
1
r = Discount rate
32
Term Structure of Interest Rates
Term structure is the relationship between time
to maturity and yields, all else equal
It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
Yield curve graphical representation of the
term structure
Normal upward-sloping, long-term yields are
higher than short-term yields
Inverted downward-sloping, long-term yields are
lower than short-term yields
7.7 Determinants of Bond Yields
33
Figure 7.6.A. Upward-Sloping Yield Curve
34
Figure7.6. B. Downward-Sloping Yield Curve
35
7.8 Bond risky
Why are bonds risky?
Default risk
Risk that the issuer fails to make promised payments on
time
Zero for govt debt
Other issuers: corporate, municipal, foreign have some
default risk
Greater default risk means a greater yield
36
Inflation risk
Most bonds promise fixed dollar payments
Inflation erodes the real value of these payments
Future inflation is unknown
Larger for longer term bonds
Interest rate risk
Changing interest rates change the value (price) of a bond
in the opposite direction.
All bonds have interest rate risk
But it is larger for the long term bonds
Chapter 8
Stock Valuation
Chapter Outline
8.1 Common Stock Valuation
8.2 The Present Value of Common Stock
8.3 Estimates of Parameters in the Dividend-
Discount Model
8.4 Growth Opportunities
8.5 The Dividend Growth Model and the
NPVGO Model (Advanced)
8.6 Price Earnings Ratio
8.7 The Stock Markets
3
Valuation of Bonds and Stock
First Principles:
Value of financial securities = PV of expected future
cash flows
To value bonds and stocks we need to:
Estimate future cash flows:
Size (how much) and
Timing (when)
Discount future cash flows at an appropriate rate:
The rate should be appropriate to the risk presented by the
security.
4
Cash Flows to Stockholders
If you buy a share of stock, you can receive cash
in two ways
The company pays dividends
You sell your shares, either to another investor in the
market or back to the company
As with bonds, the price of the stock is the
present value of these expected cash flows
5
Common stock valuation for one period
P
0
= D
1
/(1 + r) + P
1
/(1 + r)
P
0
= Value of stock at time 0
P
1
= Price of stock at the end of the period
D
1
= Dividend at the end of the period
8.1 Common stock valuation
6
One Period Example
Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. and you expect it to pay a $2 dividend
in one year and you believe that you can sell the stock
for $14 at that time. If you require a return of 20% on
investments of this risk, what is the maximum you
would be willing to pay?
P
0
= D
1
/(1 + r) + P
1
/(1 + r)
P
0
= 2/(1.2) + 14/(1.2) = $13.33
7
Common stock valuation for two period
P
0
= D
1
/(1 + r) + D
2
/(1 + r)
t
+P
2
/(1 + r)
t
Now what if you decide to hold the stock for two
years? In addition to the dividend in one year,
you expect a dividend of $2.10 in and a stock
price of $14.70 at the end of year 2. Now how
much would you be willing to pay?
P
0
= 2/(1.2) + 2.1/(1.2)
2
+14.7/(1.2)
2
= $13.33
8
Three Period Example
Finally, what if you decide to hold the stock for three
periods? In addition to the dividends at the end of years
1 and 2, you expect to receive a dividend of $2.205 at
the end of year 3 and a stock price of $15.435. Now
how much would you be willing to pay?
PV = 2 / 1.2 + 2.10 / (1.2)
2
+ (2.205 + 15.435) / (1.2)
3
=
13.33
Or CF
0
= 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03
= 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33
9
Three Period Example
Finally, what if you decide to hold the stock for
three periods? In addition to the dividends at the
end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and a
stock price of $15.435. Now how much would
you be willing to pay?
P
0
= 2 / 1.2 + 2.10 / (1.2)
2
+ 2.205/ (1.2)
3
+ 15.435 /(1.2)
3
= $13.33
10
Multiple-Period Dividend Valuation Model
P
0
= D
1
/(1+R) + D
2
/(1+R)
2
+ D
3
/(1+R)
3
+..or
P
0
= D
1
/(1+R) + D
2
/(1+R)
2
+.+ D
n
/(1+R)
n
Suppose that the investor is considering purchasing a share of this stock
and holding it for 5 years. Assume that the investor's required rate of
return is still 14 %. Dividends from the stock are expected to be $1 in the
first year, $1 in the second year, $1 in the third year, $1.25 in the fourth
year, and $1.25 in the fifth year. The expected selling price of the stock at
the end of 5 years is $41.
P
0
= 1/ (1 + 0.14) + 1/ (1 + 0.14)
2
+ 1/ (1 + 0.14)
3
+ 1.25/ (1 + 0.14)
4
+
1.25/ (1 + 0.14)
5
+ 41/ (1 + 0.14)
5
P
0
= $24.99 or 25
11
8.2 The Present Value
of Common Stocks
Dividends versus Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth
12
Estimating Dividends: Special Cases
Zero growth /Constant dividend
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
Constant dividend growth
The firm will increase the dividend by a constant percent
every period
Differential /Supernormal growth
Dividend growth is not consistent initially, but settles
down to constant growth eventually
13
Case 1: Zero Growth
Assume that dividends will remain at the same level
forever
r r r
P
) 1 (
Div
) 1 (
Div
) 1 (
Div
3
3
2
2
1
1
0
+
+
+
+
+
+
=
L
L
= = =
3 2 1
Div Div Div
Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:
Suppose stock is expected to pay a $0.50 dividend
every quarter and the required return is 10% with
quarterly compounding. What is the price?
P
0
= .50 / (.1 / 4) = $20
r
Div
=
14
Case 2: Constant Growth
) 1 ( Div Div
0 1
g
+ =
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present
value of a growing perpetuity:
Assume that dividends will grow at a constant rate, g,
forever. i.e.
2
0 1 2
) 1 ( Div ) 1 ( Div Div g g
+ = + =
.
.
3
0 2 3
) 1 ( Div ) 1 ( Div Div g g
+ = + =
.
g - r
Div
g - r
g) 1 ( Div
P
1 0
0
=
+
=
15
CGDM Example 1
Suppose Big D, Inc. just paid a dividend of $.50.
It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on
assets of this risk, how much should the stock be
selling for?
P
0
= .50(1+.02) / (.15 - .02) = $3.92
16
Case 3: Differential Growth
Assume that dividends will grow at different
rates in the foreseeable future and then will grow
at a constant rate thereafter.
To value a Differential Growth Stock, we need
to:
Estimate future dividends in the foreseeable future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
17
) (1 Div Div
1 0 1
g
+ =
Assume that dividends will grow at rate g
1
for N
years and grow at rate g
2
thereafter
2
1 0 1 1 2
) (1 Div ) (1 Div Div g g
+ = + =
N
N N
g g ) (1 Div ) (1 Div Div
1 0 1 1
+ = + =
-
) (1 ) (1 Div ) (1 Div Div
2 1 0 2 1
g g g
N
N N
+ + = + =
+
18
Dividends will grow at rate g
1
for N years and grow at
rate g
2
thereafter
) (1 Div
1 0
g
+
2
1 0
) (1 Div g
+
0 1 2
N
g ) (1 Div
1 0
+
) (1 ) (1 Div
) (1 Div
2 1 0
2
g g
g
N
N
+ + =
+
N N+1

19
To value a Differential Growth Stock, we can use
Or we can cash flow it out.
N T
T
r
g r
r
g
g r
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 N
1
1
+
\
|
+
(
+
+
=
+
\

20
A Differential Growth Example
A common stock just paid a dividend of $2.
The dividend is expected to grow at 8% for 3
years, then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is
12%.
21
With the Formula
N T
T
r
g r
r
g
g r
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 N
1
1
+
.
|
\
|
+
(
+
+
=
+
3
3
3
3
) 12 . 1 (
04 . 12 .
) 04 . 1 ( ) 08 . 1 ( 2 $
) 12 . 1 (
) 08 . 1 (
1
08 . 12 .
) 08 . 1 ( 2 $
.
|
\
|
+
(
x
=
P
| |
( )
3
) 12 . 1 (
75 . 32 $
8966 . 1 54 $
+ x =
P
31 . 23 $ 58 . 5 $
+ =
P 89 . 28 $
=
P

22
A Differential Growth Example (continued)
08) . 2(1 $
2
08) . 2(1 $
0 1 2 3 4
3
08) . 2(1 $ ) 04 . 1 ( 08) . 2(1 $
3
16 . 2 $ 33 . 2 $
08 .
62 . 2 $
52 . 2
+
89 . 28 $
) 12 . 1 (
75 . 32 $ 52 . 2 $
) 12 . 1 (
33 . 2 $
12 . 1
16 . 2 $
3 2
0
=
+
+ + =
P
75 . 32 $
08 .
62 . 2 $
3
= = P
The constant
growth phase
beginning in year 4
can be valued as a
growing perpetuity
at time 3.
$
23
Supernormal Growth Problem Statement
Suppose a firm is expected to increase
dividends by 20% in one year and by 15% in
two years. After that dividends will increase at
a rate of 5% per year indefinitely. If the last
dividend was $1 and the required return is
20%, what is the price of the stock?
Remember that we have to find the PV of all
expected future dividends.
24
Supernormal Growth Example Solution
Compute the dividends until growth levels off
D
1
= 1(1.2) = $1.20
D
2
= 1.20(1.15) = $1.38
D
3
= 1.38(1.05) = $1.449
Find the expected future price
P
2
= D
3
/ (R g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future
cash flows
P
0
= 1.20 / (1.2) + 1.38/ (1.2)
2
+ 9.66/ (1.2)
2
= $8.67
25
Using the DGM to Find R
Start with the DGM:
g
P
D
g
P
g) 1 ( D
R
R for solve and rearrange
g - R
D
g - R
g) 1 ( D
P
0
1
0
0
1 0
0
+ = +
+
=
=
+
=
26
Finding the Required Return - Example
Suppose a firms stock is selling for $10.50.
They just paid a $1 dividend and dividends are
expected to grow at 5% per year. What is the
required return?
R = [1(1.05)/10.50] + .05 = 15%
What is the dividend yield?
1(1.05) / 10.50 = 10%
What is the capital gains yield?
g =5%
27
8.3 Estimates of Parameters in the
Dividend-Discount Model
The value of a firm depends upon its growth
rate, g, and its discount rate, r.
Where does g come from?
Where does r come from?
Where does g come from?
g = Retention ratio Return on retained earnings
28
Where does r come from?
The discount rate can be broken into two
parts.
The dividend yield
The growth rate (in dividends)
In practice, there is a great deal of estimation
error involved in estimating r.
29
8.4 Growth Opportunities
Growth opportunities are opportunities to
invest in positive NPV projects.
The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100-percent of its earnings as dividends and
the net present value of the growth
opportunities.
NPVGO
r
EPS
P
+ =
30
8.5 The Dividend Growth Model and the
NPVGO Model (Advanced)
We have two ways to value a stock:
The dividend discount model.
The price of a share of stock can be calculated as
the sum of its price as a cash cow plus the per-
share value of its growth opportunities.
31
Consider a firm that has EPS of $5 at the end of the
first year, a dividend-payout ratio of 30%, a discount
rate of 16-percent, and a return on retained earnings of
20-percent.
The dividend at year one will be $5 .30 = $1.50 per
share.
The retention ratio is .70 ( = 1 -.30) implying a growth
rate in dividends of 14% = .70 20%
From the dividend growth model, the price of a share is:
75 $
14 . 16 .
50 . 1 $ Div
1
0
=
=
g r
P
32
The NPVGO Model
First, we must calculate the value of the firm as a
cash cow.
25 . 31 $
16 .
5 $ Div
1
0
= = =
r
P
Second, we must calculate the value of the growth
opportunities.
Finally,
75 $ 75 . 43 25 . 31
0
= + =
P
75 . 43 $
14 . 16 .
875 $.
16 .
20 . 50 . 3
50 . 3
0
=
x
+
=
g r
P
33
8.6 Price Earnings Ratio
Many analysts frequently relate earnings per share to
price.
The price earnings ratio is a.k.a. the multiple
Calculated as current stock price divided by annual EPS
The Wall Street Journal uses last 4 quarters earnings
EPS
share per Price
ratio P/E
=
34
Other Price Ratio Analysis
Many analysts frequently relate earnings per
share to variables other than price, e.g.:
Price/Cash Flow Ratio
cash flow = net income + depreciation = cash flow
from operations or operating cash flow
Price/Sales
current stock price divided by annual sales per share
Price/Book (a.k.a. Market to Book Ratio)
price divided by book value of equity, which is
measured as assets liabilities
35
8.7 Stock Market Reporting
Gap has
been as
high as
$52.75 in
the last
year.
Gap has been
as low as
$19.06 in the
last year.
Given the current
price, the PE ratio
is 15 times earnings
6,517,200 shares
traded hands in the
last days trading
Gap ended trading
at $19.25, down
$1.75 from
yesterdays close
Gap pays a
dividend of 9
cents/share
Given the
current price,
the dividend
yield is %
36
Stock Market Reporting
Gap Incorporated is having a tough year, trading near their 52-
week low. Imagine how you would feel if within the past year you
had paid $52.75 for a share of Gap and now had a share worth
$19.25! That 9-cent dividend wouldnt go very far in making
amends.
Yesterday, Gap had another rough day in a rough year. Gap
opened the day down beginning trading at $20.50, which was
down from the previous close of $21.00 = $19.25 + $1.75
Looks like cargo pants arent the only things on sale at Gap.
Chapter 9
Net Present Value and Other
Investment Criteria
Chapter Outline
9.1 Net Present Value (NPV)
9.2 The Payback Rule (PR)
9.3 The Discounted Payback Period Rule (DPR)
9.4 The Average Accounting Return (AAR)
9.5 The Internal Rate of Return (IRR)
9.6 The Profitability Index (PI)
9.7 The Practice of Capital Budgeting
3
Accepting positive NPV projects benefits
shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly
The difference between the market value of a
project and its cost
How much value is created from undertaking
an investment?
9.1 Net Present Value
4
The Net Present Value (NPV) Rule
Net Present Value (NPV) = Initial Investment (costs)
+ PV of future CFs
Estimating NPV:
1. Estimate initial costs
2. Estimate future cash flows: how much? and when?
3. Estimate discount rate
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
5
Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule
assumes that all cash flows can be reinvested
at the discount rate.
6
For example of NPV
Year Cash flow (net income)
0 $9,000
1 6,000
2 4,000
3 3,000
4 2,000
Initial cash flow = $9,000; IR = 10%; Do you
Recommend this project?
7
For example of NPV
PV = 6,000 /(1.1) + 4,000 /(1.1)
2
+ 3,000
/(1.1)
3
+ 2,000 /(1.1)
4
= $12,377
NPV = $12,377 9,000 = $3,377
EX
2
: IBM Company has two projects to invest:
1. Project (A) is initial cost of $350,000 and
cash inflow in year one is $400,000
2. Project (B) invests in treasury bill with 7%
of interest rate, Do you recommend?
8
For example of NPV
PV of Project (B)= 400,000 / (1.07) =
$373,832
NPV = $373,832 350,000 = $23,832
Invest in project (A) is best
9
9.2 The Payback Period
How long does it take the project to pay
back its initial investment?
Computation
Estimate the cash flows
Subtract the future cash flows from the initial cost
until the initial investment has been recovered
Payback Period = number of years to recover
initial costs
10
The Payback Period Rule
Decision Rule Accept if the payback
period is less than some preset limit
Minimum Acceptance Criteria:
set by management
Ranking Criteria:
set by management
11
The Payback Period Rule
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria
may not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
12
Computing Payback For The
Project
Assume we will accept the project if it pays
back within two years.
Year 1: 165,000 63,120 = 101,880 still to recover
Year 2: 101,880 70,800 = 31,080 still to recover
Year 3: 31,080 91,080 = -60,000 project pays
back in year 3
Do we accept or reject the project?
13
Payback Period
Assume ABC Co. plans to invest in a project
that has a $50,000 initial outlay. It is estimated
that the project will provide regular cash
inflows of $30,000 in year 1, $20,000 in year 2,
$10,000 in year 3, and $5,000 in year 4.
Payback period = 2 years
14
For example of Payback period
Year A B C D E
0 -100 -200 -200 -200 -50
1 30 40 40 100 100
2 40 20 20 100 -50,000
3 50 10 10 10 -200
4 60 130 200
15
For example of Payback period
Payback period (A) = 2 years + (100 70 )
/ 50 = 2.6 years
Payback period (B) = Never payback
Payback period ( C) = 4 years
Payback period (D) = 2 years
Payback period (E) = 6 months
16
9.3 The Discounted Payback
Period Rule
How long does it take the project to pay
back its initial investment taking the time
value of money into account?
By the time you have discounted the cash
flows, you might as well calculate the NPV.
17
9.4 The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria
set by management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
18
Investent of Value Book Average
Income Net Average
AAR =
Book value is a started investment
Average book value of Investment
= a stated investment / 2
Decision Rule: Accept the project if the AAR
is greater than a preset rate.
19
Computing AAR For The Project
Assume we require an average accounting
return of 25%
Average Net Income:
(13,620 + 3,300 + 29,100) / 3 = 15,340
AAR = 15,340 / 72,000 = .213 = 21.3%
20
Example of AAR
Assume we require an average accounting return of
25%
Assume that net earnings for the next 4 years are
estimated to be $10,000, 15,000, $20,000, and
$30,000, respectively. If the initial investment is
$100,000, find the average rate of return
Average net earnings = 10,000 + 15,000 + 20,000 +
30,000 / 4 = $18,750
Average Book value = 100,000 / 2 = $50,000
AAR = $18,750 / $50,000 = 37.5%
21
9.5 The Internal Rate of Return (IRR)
Rule
IRR: the discount that sets NPV to zero
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.
Disadvantages:
Does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate
22
The Internal Rate of Return:
Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
3 2
) 1 (
150 $
) 1 (
100 $
) 1 (
50 $
0
IRR IRR IRR
NPV
+
+
+
+
+
= =
23
The NPV Payoff Profile for This Example
If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
IRR = 19.44%
($60.00)
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
-1% 9% 19% 29% 39%
N
P
V
Discount rate
24
Problems with the IRR Approach
Multiple IRRs.
Are We Borrowing or Lending?
The Scale Problem
The Timing Problem
25
Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200 $800
-$200
- $800
($150.00)
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50% 0% 50% 100% 150% 200%
Discount rate
N
P
V
100% = IRR
2
Which one
should we use?
0% = IRR
1
26
The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investment
while the 50% return is on a $1,000
investment?
27
The Timing Problem
0 1 2 3
$10,000 $1,000 $1,000
-$10,000
Project A
0 1 2 3
$1,000 $1,000 $12,000
-$10,000
Project B
The preferred project in this case depends on the discount rate, not
the IRR.
28
The Timing Problem
($4,000.00)
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
$4,000.00
$5,000.00
0% 10% 20% 30% 40%
Discount rate
N
P
V
Project A
Project B
10.55% = crossover
rate
16.04% = IRR
A
12.94% = IRR
B
29
Calculating the Crossover Rate
Compute the IRR for either project A-B or B-A
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
0% 5% 10% 15% 20%
Discount rate
N
P
V A-B
B-A
10.55% = IRR
30
Mutually Exclusive vs.
Independent Project
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring an
accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
Must exceed a MINIMUM acceptance criteria.
31
IRR and Mutually Exclusive
Projects
Mutually exclusive projects
If you choose one, you cant choose the other
Example: You can choose to attend graduate
school next year at either Harvard or Stanford, but
not both
Intuitively you would use the following
decision rules:
NPV choose the project with the higher NPV
IRR choose the project with the higher IRR
32
Example With Mutually Exclusive Projects
Period Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
The required
return for both
projects is 10%.
Which project
should you
accept and why?
33
9.6 The Profitability Index (PI) Rule
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
Investent Initial
Flows Cash Future of PV Total
PI =
34
9.7 The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting
rate of return.
The most frequently used technique for large
corporations is IRR or NPV.
35
Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
36
Project A Project B
CF
0
-$200.00 -$150.00
PV
0
of CF
1-3
$241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
37
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
38
Relationship Between NPV and IRR
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
39
Project A
Project B
($200)
($100)
$0
$100
$200
$300
$400
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
Discount rates
N
P
V
IRR
1
(A) IRR (B)
NPV Profiles
Cross-over Rate
IRR
2
(A)

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Preah Kossomak Polytechnic Institute (PPI)

p = Net profit margin = 0.10

Instructed by YIN SOKHENG, Master in Finance

T = ratio of total assets to sales

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

Instructed by YIN SOKHENG, Master in Finance

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