Strategic Financial Management

Time Value of Money

 What Is The Time Value Of Money?

The principle of time value of money – the notion that a given sum of money is more valuable the
sooner it is received, due to its capacity to earn interest – is the foundation for numerous applications
in investment finance.
The Five Components Of Interest Rates
•Real Risk-Free Rate – This assumes no risk or uncertainty, simply reflecting differences in timing: the
preference to spend now/pay back later versus lend now/collect later.
•Expected Inflation - The market expects aggregate prices to rise, and the currency's purchasing power
is reduced by a rate known as the inflation rate. Inflation makes real dollars less valuable in the future
and is factored into determining the nominal interest rate (from the economics material: nominal rate
= real rate + inflation rate).
•Default-Risk Premium - What is the chance that the borrower won't make payments on time, or will
be unable to pay what is owed? This component will be high or low depending on the creditworthiness
of the person or entity involved.
•Liquidity Premium- Some investments are highly liquid, meaning they are easily exchanged for cash
(U.S. Treasury debt, for example). Other securities are less liquid, and there may be a certain loss
expected if it's an issue that trades infrequently. Holding other factors equal, a less liquid security must
compensate the holder by offering a higher interest rate.
•Maturity Premium - All else being equal, a bond obligation will be more sensitive to interest rate
fluctuations the longer to maturity it is.
Nominal Interest Rate: Rate at which money invested grows.
Real interest rate = nominal interest rate – inflation rate
Real Interest Rate: Rate at which the purchasing power of an investment increases.
The real rate of interest is calculated by
1 + real interest rate = 1 + nominal interest rate
1 + inflation rate
Effective Annual Interest Rate: Interest rate that is annualized using compound
interest.
The effective annual yield represents the actual rate of return, reflecting all of the compounding periods
during the year. The effective annual yield (or EAR) can be computed given the stated rate and the
frequency of compounding.
Effective annual rate (EAR) = (1 + Periodic interest rate)m – 1

Where: m = number of compounding periods in one year, and

periodic interest rate = (stated interest rate) / m
Example: Effective Annual Rate
Suppose we are given a stated interest rate of 9%, compounded monthly, here is what we get for EAR:
Annual Percentage Rate (APR): Interest rate that is annualized using simple interest rate.
The effective annual rate is the rate at which invested funds will grow over the course of a year. It
equals the rate of interest per period compounded for the number of periods in a year.
Keep in mind that the effective annual rate will always be higher than the stated rate if there is more
than one compounding period (m > 1 in our formula), and the more frequent the compounding, the
higher the EAR.
 Future Value
Definition: The value to which a beginning lump sum or Present Value (PV) will grow in a certain number of
periods, n, at a specified rate of interest, i.
Formula:
FV = PV (1 + i)n
Where: i = the stated rate of interest
            n = number of years
            (1 + i)n = the future value interest factor
Compound Interest: Interest earned on interest.
Simple Interest: Interest earned only on the original investment; no interest is earned on interest.
Example: In six years, Frank will be eligible for membership in the elite Flat lounger Club. A lifetime
membership will cost him $14,000. Frank currently has $11,000 in a savings account that pays an
annual interest rate of 4.2 percent. In six years, will he have enough money in the account to pay his
membership fees?
Example: Jane has inherited $4,500 dollars, and she has decided to deposit it in her savings account
for six months before she decides how to spend/invest it. If Jane’s savings account pays 3 percent
compounded monthly, how much money will she have in six months?
Compound growth means that value increases each period by the factor (1 + growth rate). The value
after t periods will equal the initial value times (1 + growth rate)t. When money is invested at
compound interest, the growth rate is the interest rate.
 Present Value
Present Value: A dollar today is worth more than a dollar tomorrow.
The time line in the future and look back toward time 0 to see what was the beginning amount.
Formula: PV= FV / ( 1+ r )n
Discount Rate: Interest rate used to compute present values of future cash flows.
Example: If I promised to give you one million dollars 50 years from now, what would it be worth today if
the discount rate is 15 percent compounded annually?
Example : In our previous example, I asked what a million dollars would be worth 50 years from now at 15
percent compounded annually. What would it be worth if the discount rate were 15 percent
compounded semiannually?
Example: Will Williams grandmother always gives him $200 on his birthday which is nine months away.
Will needs the money now in order to buy his finance text. Fred Fredrickson has agreed to lend Will
some money at 18 percent compounded quarterly. If Will plans to pay back Fred in nine months
with his birthday money, how much can he borrow from Fred now?
Example: If you borrow $10,000 today and pay back $12,167 at end of 5 years what rate of interest did you
pay on the loan?

Example: Suppose you invest $2,000 at 4.5% and want your investment to grow to $4,205. How long will it
take?
Recall from your math classes that ln(xn)= n ln(x)
Example: Which rate would you prefer as a borrower? 10 percent compounded semiannually or 9.8
percent compounded daily (365 days in a year)
 Annuity
Annuity: Equally spaced level stream of cash flows.

Perpetuity: Stream of level cash payments that never ends.

Present Value of a Perpetuity

A perpetuity starts as an ordinary annuity (first cash flow is one period from today)
but has no end and continues indefinitely with level, sequential payments
PV of a perpetuity =  annuity payment A
                                   interest rate r 
Example: perpetuity paying $1,000 annually at an interest rate of 8% would be worth?
Present value of t-year annuity = payment annuity factor

Future Value Annuity Factor =   (1 + r)n - 1

                                                    r
Present Value Annuity Factor =     1 -      1          
                                                      (1 + r)n
                                                                     
                                                           r
Annuity Due: Level stream of cash flow starting immediately.
Saving for Retirement
In only 50 more years, you will retire. (That’s right—by the time you
retire, the retirement age will be around 70 years. Longevity is not an
unmixed blessing.) Have you started saving yet? Suppose you believe
you will need to accumulate $500,000 by your retirement date in order
to support your desired standard of living. How much must you save
each year between now and your retirement to meet that future goal?
Let’s say that the interest rate is 10 percent per year. You need to find
how large the annuity in the following figure must be to provide a future
value of $500,000:
We know that if you were to save $1 each year your funds would accumulate to
Future value of annuity of $1 a year = (1 + r)t – 1 = (1.10)50 – 1
_________ __________
= $1,163.91 r 0.10
Therefore, if we save an amount of $C each year, we will accumulate $C × 1,163.91.
We need to choose C to ensure that $C × 1,163.91 = $500,000. Thus C =
$500,000/1,163.91 = $429.59. This appears to be surprisingly good news. Saving
$429.59 a year does not seem to be an extremely demanding savings program. Don’t
celebrate yet, however. The news will get worse when we consider the impact of
inflation.
 Problems

Assume that it is now January 1, 1997 and you will need $ 1,000 on January 1,
2001. Your bank compounds interest at an 8% annual rate.
– How much must you deposit on January 1, 1998, to have a balance of $
1,000 on January 1, 2001?
– If you want to make equal payments on each January 1 from 1998 through
2001 to accumulate the $ 1,000, how large must each of the 4 payments
be?
– If you have only $ 750 on January 1, 1998, what interest rate, compounded
annually, would you have to earn to have necessary $ 1,000 on January 1,
2001?
– Suppose you can only deposits the stream of payments only $ 186.29 each
January 1 from 1998 through 2001, but you still need $ 1,000 on January 1,
2001. What interest rate compounded annually must you seek out to
achieve your goal?
Strategic Financial Management

Bond Valuation
 BONDS
A bond indenture is the contract between a bondholder and the issuer. It is a legal document
that states what the issuer can and cannot do, and states the bondholders rights. Since there
tends to be a ton of legalese involved, the contract is managed by the corporate trustee who
polices the actions of the issuer to ensure the rights of the bondholder are upheld.
Within the indenture, there are affirmative and negative covenants:
 
• Affirmative Covenants
Affirmative covenants are what the issuer promises to do for the investor. These promises
include things such as paying interest and principle in a    timely manner; paying taxes and
other expenses when due; maintaining the assets backing the bond and issuing reports to the
trustee to ensure compliance.
 
• Negative Covenants
Negative convents are the restraints put on a borrower. These restraints include issuing
additional securities or taking on additional debt that may harm the current
bondholders. This is generally done without meeting certain tests and/or ratios or receiving
permission from the current bondholders.
 Basic Features of Bonds
Governments and corporations borrow money by selling bonds to investors. Security that obligates the issuer
to make specified payments to the bondholder.
1.Maturity
2.Par Value
3.Coupon Rate
4.Redemption
5.Currency Denomination
6.Options Granted to the Issuer or Investors 

1. Maturity
Maturity is the time at which the bond matures and the holder receives the final payment of principal
and interest. The “term to maturity” is the amount of time until the bond actually matures. 

There are 3 basic classes of maturity:

A. Short-Term Maturity – One to five years in length
B.Intermediate-Term Maturity – Five to twelve years in length
C. Long-Term Maturity – Twelve years or more in length 

2.Par Value
Par value is the dollar amount the holder will receive at the bond's maturity. It can be any amount but
is typically $1,000 per bond. Par value is also known as principle, face, maturity or redemption
value. Bond prices are quoted as a percentage of par.
Example: Premiums and Discounts
Imagine that par for ABC Corp. is $1000, which would =100. If the ABC Corp. bonds trade at
85 what would the dollar value of the bond be? What if ABC Corp. bonds at 102?
Answer:
At 85, the ABC Corp. bonds would trade at a discount to par at $850. If ABC Corp. bonds at
102, the bonds would trade at a premium of $1,020.

3.Coupon Rate
A coupon rate states the interest rate the bond will pay the holders each year. To find the
coupon's dollar value, simply multiply the coupon rate by the par value. The rate is for one year
and payments are usually made on a semi-annual basis. Some asset-backed securities pay
monthly, while many international securities pay only annually. The coupon rate also affects a
bond's price. Typically, the higher the rate, the less price sensitivity for the bond price because
of interest rate movements.
4.Currency Denomination
Currency denomination indicates what currency the interest and principle will be paid in. 
Other currency denomination structures can use various types of currencies to make payments.
Because the provisions for redeeming bonds and options that are granted to the issuer or
investor are more complicated topics, we will discuss them later in this LOS section.
 Types of Bonds
Example: Bond Table
Let's take a look at an example of a bond with the features we've discussed so far,
within a bond table format you'd see in a paper. 
ABC Corp 7.00% 6/1/10 at 90.
 The issuer is ABC Corp.
The maturity is 2010 with a term to maturity of roughly 5 years.
Par value is 1,000 per bond or 100
Coupon rate is 7%.
Coupon Payment is $70 per year (coupon=coupon rate* par value = .07 *$1,000 = $70
Trading Price in dollars is $90
ABC Corp is a U.S. company and all payments of interest ant principle are in USD.

Zero-Coupon Bonds - These instruments pay no interest to the holder and are issued at a
deep discount. As the bond nears maturity, its price increases to reach par value. At
maturity, the bondholder will receive the par price. The interest earned is the difference
between the purchase price of the bond and what the holders receives at maturity.
Floating-Rate Bonds - These bonds have coupon rates that reset at predetermined times. The
rate is usually based on an index or benchmark with some sort of spread added or
subtracted to the benchmark.
 Example: Floating Rate Security: Federal Funds
Assume the coupon rate of a floating-rate bond is based on the Federal Funds rate plus 25
basis points at three-month intervals. If the Federal Funds are at 3%, what would the coupon
rate for this bond be?
Coupon rate = Reference Rate + influencing variable.
Answer: 
Coupon rate = 3% (Fed Funds) + 25 basis points.
Coupon rate = 3.25%
The coupon rate for this bond would be 3.25% until the next reset date. Floating- rate
securities come in many forms. Other forms of floating-rate securities involve caps and
floors; these are discussed in detail below.
Caps and Floors
Some floating-rate securities have restrictions placed on how high or how low the coupon rate
can become.
          Even though the formula states a 4% coupon should be paid this period, the    cap holds
the coupon at 3.90%. 
          Example: Floors
          Now lets add a floor of 2% and assume that Fed Funds are trading at 1.50%         
         Answer: Coupon rate = 1.50% (Fed Funds) + 25 basis points
          Coupon rate = 1.75
   Even though the formula states a 1.75% coupon should be paid, there is a 2% floor in place, which
means that the investor will receive 2% instead of the 1.75% derived from the formula.
Bond price valuation:
Bond prices are usually expressed as a percentage of their face value. Thus we can
say that our 6 percent Treasury bond is worth 101.077 percent of face value, and its
price would usually be quoted as 101.077, or about 101 232.
Did you notice that the coupon payments on the bond are an annuity? In other
words, the holder of our 6 percent Treasury bond receives a level stream of
coupon payments of $60 a year for each of 3 years. At maturity the
bondholder gets an additional payment of $1,000. Therefore, you can use the
annuity formula to value the coupon payments and then add on the present
value of the final payment of face value:
PV = PV (coupons) + PV (face value)
= (coupon annuity factor) + (face value discount factor)
Problem:
Calculate the present value of a 6-year bond with a 9 percent coupon. The
interest rate is 12 percent?
FIGURE
Cash flows to an investor in the 6 percent coupon bond maturing in 2002.
The bond pays semiannual coupons, so there are two payments of $30
each year.
 If the Treasury bond with an interest rate, which is lower than the coupon rate.
In that case the price of the bond was higher than its face value i.e. bond is at
premium. We then valued it using an interest rate that is equal to the coupon
rate and found that bond price equaled face value. You have probably already
guessed that when the cash flows are discounted at a rate that is higher than
the bond’s coupon rate, the bond is worth less than its face value.
Investors will pay $1,000 for a 6 percent, 3-year Treasury bond, when the interest rate
is 6 percent. Suppose that the interest rate is higher than the coupon rate at (say) 15
percent. Now what is the value of the bond? Simple! We just repeat our initial
calculation but with r = .15:
We conclude that when the market interest rate exceeds the coupon rate,
bonds sell for less than face value. When the market interest rate is below the
coupon rate, bonds sell for more than face value.
Bond Valuation Basics
The fundamental principle of valuation is that the value is equal to the present value of its expected cash
flows. The valuation process involves the following three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by using the interest rate or interest
rates determined in step two.
Computing a Bond’s Value
First of all, we need to find the present value (PV) of the future cash flows  in order to value the bond. The present
value is the amount that would be needed to be invested today to generate that future cash flow. PV is dependant
on the timing of the cash flow and the interest rate used to calculate the present value. To figure out the value the
PV of each individual cash flow must be found. Then, just add the figures together to determine the bonds price.
PV at time T = expected cash flows in period T / (1 + I) to the T power
Value = present value @ T1 + present value @ T2 + present value @Tn
Let’s throw some numbers around to further illustrate this concept.
Example: The Value of a Bond
Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of $1,000. For simplicity’s sake,
the bond pays annually and the discount rate is 5%.
The cash flow for each of the years is:
Year one = $70 Year Two = $70 Year Three = $70, Year Four is $70 and Year Five is $1,070.
PV of the cash flows is: Year one = 70 / (1.05) to the 1st power = $66.67
                                    Year two = 70 / (1.05) to the 2nd power = $ 63.49
                                    Year three = 70 / (1.05) to the 3rd power = $ 60.47
                                    Year four = 70 / (1.05) to the 4th power = $ 57.59
                                    Year five = 1070 / (1.05) to the 5th power = $ 838.37
Value = 66.67 + 63.49 + 60.47 + 57.59 + 838.37
Value = 1, 086.59
Computing the Value of a Zero-coupon Bond
This may be the easiest of securities to value because there is only one cash flow – the
maturity value. 
Value of a zero coupon bond that matures N years from now is:
Maturity value / (1 + I) to the power of the number of years * 2
Where I is the semi-annual discount rate.
Example: The Value of a Zero-Coupon Bond
For illustration purposes, let’s look at a zero coupon with a maturity of three    years and a
maturity value of $1,000 discounted at 7%
Answer:
I = 0.035 (.07 / 2)
N=3
Value of a Zero = 1,000 / (1.035) to the 6th power (3*2)
                         = 1,000 / 1.229255
                         = 813.50

YIELD TO MATURITY VERSUS CURRENT YIELD:

Current Yield: annual coupon payments divided by bond price. A bond that is
priced above its face value is said to sell at a premium. Investors who buy a bond at a
premium face a capital loss over the life of the bond, so the return on these bonds is
always less than the bond’s current yield. A bond priced below face value sells at a
discount. Investors in discount bonds face a capital gain over the life of the bond; the
return on these bonds is greater than the current yield:
Yield to Maturity (YTM): Interest rate for which the present value of the bond’s payment
equals the price. The yield to maturity is defined as the discount rate that makes
the present value of the bond’s payments equal to its price. Price The value of the 6
percent bond is lower at higher discount rates. The yield to maturity is the discount
rate at which price equals present value of cash flows.
Problems on YTM using hit and trial method:
1) A $ 1000 par value bond, current market price of the bond is $ 761, 12 years
remaining till maturity, coupon rate is 8%, using hit and trial method calculate
YTM?
2) A 10 year bond, 5years remaining till maturity and the market price of the
bond is $ 650 whose par is at $ 1000. If Coupon rate is 6%, calculate YTM
using interpolation.

Accrued Interest and Price Terminology

Accrued interest - the amount of interest that builds up in between coupon payments that
will be received by the buyer of the bond when a sale occurs between these coupon
payments, even though the seller of the bonds earned it.
Full Price - is sometimes referred to as a bond's dirty price, which is the amount the buyer
will pay the seller. It equals the negotiated price of the bond plus the accrued interest. 
Clean Price - is simply the price of the bond without the accrued interest
Typical Yield measures:
There are three sources of return an investor can expect to receive by investing
in bonds:
• The coupon payment made by the issuer.
• Any Capital gain or Loss when the bond matures or sold.
• Income from the reinvestment.
1.     Current Yield
Current yield relates the annual dollar coupon interest to the bond's market price:
Current Yield = annual dollar coupon interest / price
Example: Current Yield
IBM ten-year bond with a rate of 5% and market price of 98.
Answer:
Step1 - Figure out the annual dollar coupon interest= .05 * $100 = 5$
Current Yield = $5 / 98 = .05102= 5.1%
Current yield is greater when bond is selling at a discount. The opposite is true for a
premium bond.  If a bond is selling at par, the current yield will equal the coupon rate. 
The drawback using current yield is that it only considers the coupon interest and
nothing else.
2.Yield to Maturity (YTM)
Yield to maturity is the most popular measure of yield in the market. It isthe rate that
will make the present value of a bond's cash flows equal toits market price plus
accrued interest. To find YTM, one has to develop the cash flows and then, through
trial and error, find the interest rate thatmakes the present value of cash flow equal to
the market price plus accrued interest.
This is basically a special type of internal rate of return (IRR).
• Bond Price, Coupon Rate, Current Yield and Yield to Maturity 
For a bond selling at par:
Coupon Rate = Current Yield = Yield to Maturity
• For a bond selling at a discount:
Coupon Rate < Current Yield < Yield to Maturity
• For a bond selling at a premium:
Coupon Rate > Current Yield > Yield to Maturity
•
The limitations of the yield to maturity measure are that it assumes that the coupon
rate will be reinvested at an interest rate equal to the YTM. Besides that it does take
into consideration the coupon income and capital gains or loss as well as the timing of
the cash flows.
3.Yield to First Call
Yield to first call is computed for a callable bond that is not currently callable. The
actual calculation is the same as the Yield to Maturity with the only difference being
that instead of using a par value and the stated maturity, the analyst will use the call
price and the first call date in calculating the yield.
4.Yield to First Par Call
Again, yield to first par call is the same procedure as above, with the difference being
that the maturity date that will be used instead of the stated maturity date is the first
time the issuer can call the bonds at par value
5.Yield to Put
Yield to put is the yield to the first put date. It is calculated the same way as YTM but
instead of the stated maturity of the bond, one uses the first put date.
Options that Benefit the Issuer.
Call options - allows the issuer to call the bonds prior to maturity if prevailing rates
decrease enough to make it economically feasible for the issuer to replace the existing
issue (consisting of higher rate coupons) with lower coupon bonds.
Options that Benefit the Holder
Puts - This option is the exact opposite of a call. It allows the bondholder to sell the
bond or "put" the bond back to the issuer at a certain price and date(s) before its
maturity. As rates rise, this helps the bondholders dump their holdings and reinvest
their proceeds at a higher rate.
Provisions for Redeeming Bonds:
The provisions for redeeming bonds are found in the indenture.  
They can be: 
1.Called
2.Refunded
3.Have Prepayment Options and/or
4.Sinking Fund Provisions 
1.Call Redemption
By adding a call feature in the indenture, a bond becomes a callable bond. A callable
bond gives the issuer the right to redeem the bonds on a stated date or a schedule of
dates before the stated maturity date for the bonds arrives. 
Let's look at callable bonds in a little more detail. First, some terminology: 
• Call Price - This is the price that the issuer will pay the bondholder; also know as the
redemption price. 
• Call Date - This is the date or dates that the issuer can call the bond from the holders. 
• Deferred Call - When a callable bond is originally issued, it is said to have a deferred
call of so many years up to the first call date, which is the first day the bond can be
called by the issuer. 
Strategic Financial Management

Stock Valuation
Security Valuation
The Top-Down Approach
The top-down approach is a valuation approach that begins with first
analyzing the overall economy and then continuing to drill down to the
specific analysis. The idea behind the top-down approach when valuing
securities is to start from a high level analysis: the general economic
conditions. The next step would then be to analyze a specific industry
within the economy. Last, an investor would compare and analyze
specific securities to invest in.
The top-down approach allows an investor to make an informed
investment decision based on a keen understanding of the economy and
industry and how that relates the stock, versus comparing the stocks
fundamentally against their peers without thinking about the overall
movement in the market.
The top-down approach can be particularly useful when analyzing the
valuation of world stocks. Given the starting point of understanding the
world economies, an investor is able choose an appropriate stock based
on areas of the world that may be doing better. a
Valuation Model / Technique
1. Dividend Discount Model – DDM Uses only when company has constant
or longer time horizon based dividend.
 Mature
 Constant Dividend
 Not Cyclical Companies
2. Discounted Cash flow Method- DCF – Depends on the Capital Structure
 Free Cash Flow to Firm (FCFF) – Higher Debt in a capital Structure
 Free Cash Flow to Equity (FCFE)
3. Relative Valuation Technique – in comparison with peer companies
Service industry like banks, financial institutions, IT solutions
 Justified Price to Book (Equity Value)
 Justified Price to Earning (EPS)
 Price to Sales
 Price FCF

4. Sum of Part Method

The Dividend Discount Model (DDM)
Value of a Preferred Stock
Unlike common equity, preferred stocks pay a fixed dividend. As such, the value of a
preferred stock can be calculated using the dividend discount model. The value of
the preferred stock is essentially the present value of the dividend in perpetuity,
where k is the required return.

Value of preferred stock

Example: Calculating the value of a preferred stock

Assume that Newco’s preferred stock pays out to an investor an annual dividend of
$8 per share. Given a rate of return of 10%, what is the value of Newco’s preferred
stock?
Value of Newco’s preferred stock = ($5/0.10) = $50
Value of a Common Stock
Much like a preferred stock, holders of common stock can also receive
dividends. However, dividends on common stock are not guaranteed, nor are they a
fixed amount from year-to-year. As such, we can value common stock using
dividends over various time horizons.
Expected return r = DIV1 + P1 – P0
_____________
P0
Let us now look at how our formula works. Suppose Blue Skies stock
is selling for $75 a share (P0 = $75). Investors expect a $3 cash
dividend over the next year (DIV1 = $3). They also expect the stock to
sell for $81 a year hence (P1 = $81). Then the expected return to
stockholders is 12 percent:

Expected rate of return = expected dividend yield + expected capital gain

Problem: Androscoggin Copper is increasing next year’s dividend to

$5.00 per share. The forecast stock price next year is $105. Equally
risky stocks of other companies offer expected rates of return of 10
percent. What should Androscoggin common stock sell for?
THE CONSTANT-GROWTH DIVIDEND DISCOUNT MODEL
– Version of the dividend discount model in which dividends grow
at constant rate.
Suppose forecast dividends grow at a constant rate into the indefinite
future. If dividends grow at a steady rate, then instead of forecasting
an infinite number of dividends, we need to forecast only the next
dividend and the dividend growth rate.
Recall Blue Skies Inc. It will pay a $3 dividend in 1 year. If the dividend grows
at a constant rate of g = .08 (8 percent) thereafter, then dividends in
future years will be
DIV1 = $3 = $3.00
DIV2 = $3 × (1 + g) = $3 × 1.08 = $3.24
DIV3 = $3 × (1 + g)2 = $3 × 1.082 = $3.50
P0 = DIV1
________
r-g
This equation is called the constant-growth dividend discount model.
THE PRICE-EARNINGS RATIO:

The superior prospects of Blue Skies are reflected in its price-

earnings ratio. With a stock price of $75.00 and earnings of $5.00,
the P/E ratio is $75/$5 = 15. If Blue Skies had no growth
opportunities, its stock price would be only $41.67 and its P/E would
be $41.67/$5 = 8.33. The P/E ratio, therefore, is an indicator of the
prospects of the firm. To justify a high P/E, one must believe the firm
is endowed with ample growth opportunities.
To determine the price to earnings multiple, the price of the stock is simply
divided by the earnings per share of the stock as follows:

Example: Determining a company’s price-to-earnings ratio using the DDM

With Newco’s $0.25 dividend payout, an EPS of $1.00, calculate the stock’s P/E ratio
assuming 10% required return and 5% growth.
Answer:
P/E ratio = 0.25/1.00 = 5%
               (0.10-0.05)

                     
Example: Calculate the value of common stock with temporary supernormal growth
An investor plans to hold Newco’s stock for 3 years. In that time period, Newco
plans to grow at a rate of 6% in the first two years and 3% thereafter. Newco’s
last dividend was $0.25. Given a rate of return of 10%, what is the value of
Newco’s common stock at the end of the three-year time period?
Answer:
To begin, the dividend in each time period must be calculated [D = D0(1+g)]
D1 = (0.25)(1.06) = 0.265
D2 = (0.265)(1.06) = 0.281
D3 = (0.281)(1.03) = 0.289
Since we expect the dividend to grow indefinitely in year 3 and on, the present
value of the stock price in year 3 is calculated as follows:
P3 =     0.289 (1+0.03)    = 4.252
       (0.10-0.03)
The value of Newco’s common stock is as follows:
Newco’scs =   $0.265 +   $0.281    +   0.289    +   $4.252     = ****
                     (1.10)1       (1.10)2         (1.10)3         (1.10)3
The Components of An Investors’ Required Rate of Return
• Real risk-free rate - This rate assumes no inflation or risk is prevalent, but that it
is simply generated by the supply and demand of the markets.
• Expected rate of inflation – This rate anticipates the potential inflation that is
going to occur in the market. 
• Risk premium – The premium is reflective of the risks inherent in the stock, as
well as the market. Such risks include liquidity risk, business risk and general
macroeconomic risk.
The Country Risk Premium
The country risk premium is the general risk of a security inherent with the
foreign country related to the security. 
The country risk premium should be added to the general risks a security faces
when estimating the required return for a foreign security

The Implied Dividend Growth Rate

A company’s dividend growth rate can be derived from a company’s ROE and its
retention rate. 
The retention rate of a company is the amount of earnings a company retains for
its internal growth. A company’s ROE is the return on the funds invested back
into the company. Keep in mind that the growth rate of the firm is the identified
ability of a firm to grow its operations and the ROE is the return the company is
able to earn on invested funds. The company’s growth rate can be calculated as
follows:
Growth rate = (retention rate)(ROE)
  Example: Calculate the required inputs to be used in the DDM
Newco’s annual EPS last year was $1.00. The company maintained its annual
dividend payout ratio of 40% and ROE of 16%. Newco’s beta is 1.3. Given a risk-
free rate of 4% and an expected return on the market of 18%, determine Newco’s
required rate of return, expected growth rate and next year’s dividend and price?
Answer:
Required rate of return
RNewco = 4% + 1.3(18% - 4%) = 22.2%
Expected growth rate
Retention rate = (1 – payout rate) = (1 – 0.40) = 0.60
g = (0.60)(0.16) = 0.096 or 9.6%
Dividend
D1 = D0(1+g) = $1.00(1+.096) = $1.096
Future price
P1 =   D1/(r – g) = $1.096/(22.2% - 9.6%) = $8.70
               
Analyzing a Company - Types of Stock
Growth Company and Growth Stock
•  A growth company is a company that consistently grows by investing in projects that will
generate growth. A growth stock, however, is a stock that earns a higher rate of return
over stocks with a similar risk profile. Feasibly, a company could be a growth company, but
its stock could be a value stock if it is trading below its peers of similar risk. 
• Defensive Company and Defensive Stock
A defensive company is a company whose earnings are relatively unaffected in a business
cycle downturn. A defensive company is typically reflective of products that we “need”
versus “want”. A food company, such as Kellogg, is considered a defensive company. A
defensive stock, however, will hold its value relatively well in a business cycle downturn.  
• Cyclical Company and Cyclical Stock
A cyclical company is a company whose earnings are affected relative to a business cycle. A
cyclical company is typically reflects products we “want”. A retail store, such as The Gap, is
considered a cyclical company. A cyclical stock, however, will move with the market in
relation to the business cycle. 
• Speculative Company and Speculative Stock.
A speculative company is a company that invests in a business with an uncertain
outcome. An oil exploration company is an example of a speculative company. A
speculative stock, however, is a stock that has potential for a large return, as well as the
potential for considerable losses. An example of speculative stocks can be found in the tech
bubble, where investors put money into speculative stocks, but the investor could have been hurt
financially or made large gains depending on the stock the investor invested in.
Technical analysis is the practice of valuing stocks on past volume and pricing information.
Technical analysis assumes the following: 
• Market value of the asset is a reflection of supply and demand of the asset.
• Supply and demand are driven by rational factors, such as data and economic
analysis, as well as irrational factors, such as guesses.
• Markets and individual stocks move together given trends.
• Shifts in supply and demand will shift the trends in the market and can be detected in
the market.
Technical vs. Fundamental Analysis
The main difference between technical analysis and fundamental analysis is the use of
financial statements to value equities. Technical analysis is the practice of valuing
stocks on past volume and pricing information. Technical analysis combines both the
use of past information (how stocks have reacted previously) and “feeling” (how the
market is moving the name) to value a security. 

Fundamental analysis, however, takes a more formal approach. Fundamental analysts

review the financial statements of a company and generate metrics, such as price-to-
book value and enterprise value-to-EBITDA to value a security.