Sld10 Valuation and ROR

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Valuation and Rates ofReturn

McGraw-Hill Ryerson McGraw-Hill Ryerson Limited 2000

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McGraw-Hill Ryerson Limited 2000

Foundations of FinancialManagement CANADIAN

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PPT 10-1

Figure 10-1 / The relationship between time value of money,required return, cost of financing, and investment decisions

Presentvalue

concepts

Required rates ofreturn by investors

Valuation

Analysis ofprojects based

on cost of financingto the firm

Cost offinancing

to the firm

Chapter 10

Chapter 9 Chapter 11 Chapters 12 and 13

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(10 Percent Interest Payment, 20 Years to Maturity)

Yield to Maturity Bond Price

2% . . . . . . . . . . . . $2,308.114 . . . . . . . . . . . . 1,815.426 . . . . . . . . . . . . 1,458.80

7 . . . . . . . . . . . . 1,317.828 . . . . . . . . . . . . 1,196.36

9 . . . . . . . . . . . . 1,091.29

10 . . . . . . . . . . . . 1,000.0011 . . . . . . . . . . . . 920.3712 . . . . . . . . . . . . 850.61

13 . . . . . . . . . . . . 789.2614 . . . . . . . . . . . . 735.0716 . . . . . . . . . . . . 644.27

20 . . . . . . . . . . . . 513.0425 . . . . . . . . . . . . 406.92

PPT 10-2

Table 10-1Bond price table

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0 . . . . . . . . $1,000.00 $1,000.001 . . . . . . . . 1,018.52 982.145 . . . . . . . . 1,079.85 927.90

10 . . . . . . . . 1,134.20 887.0015 . . . . . . . . 1,171.19 863.7820 . . . . . . . . 1,196.36 850.61

25 . . . . . . . . 1,213.50 843.14

30 . . . . . . . . 1,225.16 838.90

Time Period Bond Price with Bond Price within Years 8 Percent Yield 12 Percent Yield

(of 10 percent bond) to Maturity to Maturity

PPT 10-3

Table 10-2Impact of time to maturity on bond prices

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1,300

1,200

1,100

1,000

900

800

700

Bond Price ($)

30 25 15Number of years to maturity

* The relationship in the graph is not symmetrical in nature.

10% bond, $1,000 par value

Assumes 12% yield to maturity

5 0

Assumes 8% yield to maturity

PPT 10-4

Figure 10-2Relationship between time to maturity and bond price*

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Table 10-3An example of stock quotations from the Globe and Mail

PPT 10-5

Source: ILX Systems, a division of Thomson Information Services Inc.

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Stock valuation under supernormal growth analysis

PPT 10-6

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Chapter 10 - Outline LT 10-1

Valuation Concepts

3 Factors that Influence the Required Rate ofReturn

Valuation of Bonds

Relationship Between Bond Prices and Yields

Preferred Stock

Valuation of Common Stock

Valuation Using the Price-Earnings Ratio

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Valuation concepts

Value or price of a stock or bond is based upon the presentvalue of future cash flows to the investor

Discount rate used is investors required rate of return,based on the markets estimates of risk, efficiency, andexpected future returns

LT 10-2

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3 Factors that Influence theRequired Rate of Return LT 10-3

Real Rate of Return:

represents the opportunity cost of the investment

in the early 1990s, 5-7%, but now about 3-4%

Inflation Premium:

a premium to compensate for the effects of inflation

lately, 2%

Risk Premium:

a premium associated with business and financial risk

typically, 2-6%

So, the Required Rate of Return equals:

Real Rate of Return + Inflation Premium + RiskPremium

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Valuation of Bonds LT 10-4

The value of a bond is made up of 2 parts:

PV of the interest payments (an annuity)

PV of the principal payment (a lump sum)

The principal payment at maturity:

can also be called the par value or face value

is usually $1,000

The interest rate used:

is the yield to maturity or discount rate

is also the required rate of return

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Relationship BetweenBond Prices and Yields LT 10-5

Bond prices are inversely related to bond yields (move inopposite directions)

As interest rates in the economy change, the price or valueof a bond changes:

if the required rate of return increases, the price of thebond will decrease

if the required rate of return decreases, the price of thebond will increase

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Valuation of Preferred Stock LT 10-6

Preferred stock:

usually represents a perpetuity (something with nomaturity date)

has a fixed dividend payment

is valued without any principal payment since it has noending life

is considered a hybrid security

owners have a higher priority than commonshareholders

price is based upon PV of future dividends

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Valuation of Common Stock LT 10-7

The value of common stock is the present value of a streamof future dividends

Common stock dividends can vary, unlike preferred stockdividends

There are 3 possible cases:

No growth in dividends (valued like preferred stock)

Constant growth in dividends

Variable growth in dividends

Required rate of return reflects the dividend yield on thestock and the expected growth rate in the dividend

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Valuation Using thePrice-Earnings Ratio LT 10-8

The Price-Earnings (P/E) ratio can also be used to valuecommon stocks

The P/E ratio is influenced by many factors:

the earnings and sales growth of the firm

the risk (or volatility in performance)

the debt-equity structure

the dividend policy

the quality of management

Average P/E ratio for TSE 300 in early 1999 was 27 to 1

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High vs. Low P/Es LT 10-9

A high P/E ratio:

indicates positive expectations for the future of thecompany

means the stock is more expensive relative to earnings

typically represents a successful and fast-growingcompany

A low P/E ratio:

indicates negative expectations for the future of thecompany

may suggest that the stock is a better value or buy

Documents

Sld10 Valuation and ROR