Chapter 4 –

Support

The
The Valuation
Valuation of
of Long-
Long-
Term
Term Securities
Securities

4b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Liquidation Value vs. Go-
ing Concern Value
 Liquidation Value:
 The amount of money that could be realized if an asset
or a group of assets is sold separately from its operat-
ing organization

 Going – Concern Value:

 The amount a firm could be sold for as a continuing op-
erating business.

4b.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Book Value vs. Market
Value
 Book Value
 The book value of an asset is the accounting value of the as-
set.
 The book value of a firm is equal to the dollar difference be-
tween the firm’s total assets and its liabilities and preferred
stock as listed on it’s balance sheet.

 Market Value
 The market value of an asset is the market price at which the
asset trades in an open marketplace.
 The market value of firm is the higher of the firm’s liquidation
value or going – concern value.

4b.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Market Value vs. Intrinsic
Value
 Market Value
 The market value of an actively traded security is the
last reported price at which the security was sold.
 The market value of an inactively traded security is the
estimated market price that would be needed.

 Intrinsic Value
 The intrinsic value of a security is what the price of a
security should be if properly priced based on all fac-
tors bearing on valuation.

4b.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bond Valuation
 Bond
 A security that pays a stated amount of interest to the investor,
period after period, until it finally retired by the issuing com-
pany.
 Face Value
 The stated value of the bond.
 Maturity
 The time when the company is obligated to pay the bond-
holder the face value of the instrument.
 Coupon Rate
 Nominal annual rate of interest.
 The stated rate of interest on a bond.

4b.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Behavior of Bond Prices
1. Bond Discount
The amount by which the face value of a bond exceeds its
current price.
Rate of return is more than the stated coupon rate, the
price of the bond will be less than its face value.
2. Bond Premium
The amount by which the current price of a bond ex-
ceeds its face value.
Rate of return is less than the stated coupon rate, the price
of the bond will be more than its face value.

4b.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Behavior of Bond Prices
3. When the market required rate of return equals the stated
coupon rate, the price of the bond will equal its face value.
4. Interest rates and bond prices move in opposite direction.
5. For a given change in market required return, the price of
a bond will change by a greater amount, the longer its ma-
turity.
6. Bond price volatility is inversely related to coupon rate.

4b.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Perpetual
Bond Example
Bond C has a $1,000 face value and provides an 8%
annual coupon for 30 years. The appropriate discount
rate is 10%. What is the value of the coupon bond?
Where V = ?.

V = $80/10%

4b.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Coupon
Bond Example
Bond C has a $1,000 face value and provides an 8%
annual coupon for 30 years. The appropriate discount
rate is 10%. What is the value of the coupon bond?

4b.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Coupon Bond Example
B C D E F

2 Inputs for Bond Valuation! Explanations

3 rate: 10.00%  10% Reqd return per pd (yearly)
4 nper: 30  Number of periods (30 years here)
5 pmt: $ 80.00  $80 received per yr (positive)
6 fv: $ 1,000.00  Assumed face amount of $1000
7 type: 0  Ordinary Annuity

8 Output - Bond Valuation

9 Bond Value today (pv) ($811.46)  =PV(D3,D4,D5,D6,D7)
This amount is "negative" as we assume the investor
will purchase the bond for that amount today.

(NZCP) V = $80(9.4269) + $1,000(0.05731)

(ZCB) V = $1,000(0.05731)

4b.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Coupon
Bond Example
Bond C has a $10,000 face value and provides an 9%
annual coupon for 20 years. The appropriate discount
rate is 10%. What is the value of the coupon bond?

4b.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Coupon Bond Example
NZCR
V = $900 (8.5136) + $10,000 (0.1486)
V = $7,662.21 + $1,486.44
V = $9,148.65

ZCR
V = $10,000 (0.1486)
V = $1,486.44
4b.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Zero-Coupon
Bond Example
Bond Z has a $1,000 face value and a 30 year
life. The appropriate discount rate is 10%.
What is the value of the zero-coupon bond?

4b.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Zero-Coupon Bond Ex-
ample
B C D E F

2 Inputs for Bond Valuation! Explanations

3 rate: 10.00%  10% Reqd return per pd (yearly)
4 nper: 30  Number of periods (30 years here)
5 pmt: $ -  $0 received per yr (positive)
6 fv: $ 1,000.00  Assumed face amount of $1000
7 type: 0  Ordinary Annuity

8 Output - Bond Valuation

9 Bond Value today (pv) ($57.31)  =PV(D3,D4,D5,D6,D7)
This amount is "negative" as we assume the investor
will purchase the bond for that amount today.

4b.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Zero-Coupon
Bond Example
Bond Z has a $10,000 face value and a 25
year life. The appropriate discount rate is
8%. What is the value of the zero-coupon
bond?

4b.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Zero-Coupon Bond Ex-
ample

V = $10,000 (0.1460)
V = $1,460.18

4b.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Semiannual
Compounding
Bonds that pay interest twice a year
(1/2 of the annual coupon).
Adjustments needed:

(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2
4b.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Semiannual Coupon
Bond Example
• Bond C was purchased on 12-31-2009 and will be re-
deemed on 12-31-2024. This is identical to the 15-
year period we discussed for Bond C.
• It pays its annual coupon interest semiannually. The
stated coupon rate is 7%.
• The market interest rates have fallen to 5.5%.
• You expect to hold the bond to maturity to redeem
the $1,000 face amount.
• What is the value of this bond?

4b.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Semiannual Coupon
Bond Example
B C D E F

2 Inputs for Bond Valuation! Explanations

3 rate: 2.75%  5.5% Reqd return annual (2.75/semi)
4 nper: 30  Number of periods (15 years x 2)
5 pmt: $ 35.00  7% is $70/yr or $35 per semiannual
6 fv: $ 1,000.00  Stated maturity amount of $1000
7 type: 0  Ordinary Annuity

8 Output - Bond Valuation

9 Bond Value today (pv) ($1,151.87)  =PV(D3,D4,D5,D6,D7)
This amount is "negative" as we assume the investor
will purchase the bond for that amount today.

$35 [1-(1.0275^-30) / .0275]

$1,000 (1.0275^-30)
4b.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Preferred
Stock Example
Stock PS has an 8%, $100 par value is-
sue outstanding. The appropriate dis-
count rate is 10%. What is the value of
the preferred stock?
V = D/k
V = ($100*8%)/10%
V = $80

4b.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Preferred Stock Example
B C D E F

2 Inputs for Bond Valuation! Explanations

3 rate: 10.00%  10% Reqd return annual
4 nper: 3,000  Assume a large number of pds
5 pmt: $ 8.00  Dividend is 8% of $100 par value
6 fv: $ -  No cash flow as infinite life
7 type: 0  Ordinary Annuity

8 Output - Bond Valuation

9 Bond Value today (pv) ($80.00)  =PV(D3,D4,D5,D6,D7)
This amount is "negative" as we assume the investor
will purchase the preferred stock for that amount today.

Normal Calculation: $ 80.00  =D5/D3

4b.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Constant
Growth Model Example
Stock GP has an expected growth
rate of 8%. The share of stock is ex-
pected to received an annual $3.24
dividend per share. The appropriate
discount rate is 15%. What is the
value of the common stock under
this scenario?
V = D /(k – g)
4b.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Constant
Growth Model Example
V = D1/(ke – g)

V = $3.24 / (0.15 – 0.08)

V = $46.29

4b.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember? Conversion
Conversion toto an
an
Earning
Earning Multiplier
Multiplier Approach
Approach
Example
Example
Stock GP has an expected growth
rate of 8% and the appropriate dis-
count rate is 15%. Assuming the re-
tention rate of Stock GP is 40% and
the earnings per share for period 1 is
expected to be $6.50. What is the
value of the common stock under
this scenario?
4b.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember?
Remember? Conversion
Conversion toto an
an
Earning
Earning Multiplier
Multiplier Approach
Approach
Example
Example
(1-b) = D1 / E1 [(1-.40)$6.50]
V=
(1-b) E1 = D1 (0.15 – 0.08)
Substitution:
V = $ 55.71
V = D1/(ke – g)
V = (1-b) E1 / (ke – g) 55.71 / 6.50 = 8.57times

(1-0.40) / (0.15-.08) = 8.57 times

4b.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? No Growth
Example
Assuming that the stock has a par
value of $75, pays a 10% dividend
and you have an 7% required re-
turn, what is this stock worth to
you?
V = D/k

4b.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? No Growth
Model Example
V = D1/ke

V = ($75 x 10%) / 7%
V = $107.14

4b.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? No Growth
Example
Assuming that the shares has a
par value of $55 and pays a 10%
dividend. If you have a 12% re-
quired return, what is this stock
worth to you?

4b.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Constant
Growth Model Example
V = D1/ke

V = ($55 x 10%) / 12%

V = $45.83

4b.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Growth
Phases Model Example
Stock GP has an expected growth
rate of 16% for the first 3 years and
8% thereafter. Each share of stock
just received an annual $3.24 divi-
dend per share. The appropriate
discount rate is 15%. What is the
value of the common stock under
this scenario?
4b.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Common Stock Example
Phase 1: Present value of dividends to be received
over first 3 years
3 D0 (1+g)t
Σ
t=1 (1+ ke)t
[3.24 (1+0.16) 1
][1.15 -1
]

Year 1 Year 3
3.24 (1+0.16)1 3.24 (1+0.16)3
= $3.27 = $3.33
(1+ 0.15)1 (1+ 0.15)3
Year 1
3.24 (1+0.16)2
= $3.30 = $9.89
(1+ 0.15)2

4b.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Common Stock Example
Phase 2: Present value of constant growth component

1. Dividend at the end of year 6.

1 D6 D5 (1+g)t
(1 + ke)t (ke - g) 2. Value of the stock at the
end of year 3.

1 $3.33 (1.08)1
3. Present value of the value
(1 + 0.15)3 (0.15 – 0.08)
of the stock at the end of = (0.6575)(51.3771)
year 3.
=$33.78
4b.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Common Stock Example
Present value of the stock

3 D0 (1+g)t 1 D6
Σ (1+ ke) t
+ (1 + ke)t (ke - g)
t=1

V = $9.89 + $33.78
V = $43.67

4b.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Determin-
ing the YTM
Julie Miller want to determine the YTM
for an issue of outstanding bonds at
Basket Wonders (BW). BW has an is-
sue of 10% annual coupon bonds with
15 years left to maturity. The bonds
have a par value of $1,000 and current
market value of $1,250.
$100(PVIFA) + $1,000(PVIF)
4b.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bond YTM Example
At 8%
V = $100 (8.5595) + $1,000 (0.3152)
V = $855.95 + $315.20
V = $1,171.15
At 11%
V = $100 (7.1909) + $1,000 (.2090)
V = $719.09 + $209
V = $928.09

4b.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bond YTM Example
At 6%
V = $100 (9.7122) + $1,000 (0.4173)
V = $971.22 + $417.23
V = $1,388.45

4b.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bond YTM Example
6% $1,388.45
$138.45
2% YTM $1,250.00 $217.30
8% $1,171.15

x $138.45
0.02 = $217.30
x = (0.02)($138.45)
$217.30
x = .01274 or 1.27%
4b.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bond YTM Example
x $138.45
0.02 = $217.30
x = (0.02)($138.45)
$217.30
x = 0.01274 or 1.27%

YTM = .06 + X
YTM = .06 + 0.01274
YTM = .07274 or 7.274%
4b.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Bond YTM Example
At 7.274%
V = $100 (8.9524) + $1,000 (0.3488)
V = $895.24 + $348.80
V = $1,244.04

4b.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Remember? Determining
Semiannual YTM
Julie Miller want to determine the YTM for
another issue of outstanding bonds. The firm
has an issue of 8% semiannual coupon
bonds with 20 years left to maturity. The
bonds have a current market value of $950.
What is the YTM?
[ 1 + (.0852514 / 2)2 ] -1 = 0.0871
or 8.71% (same result!)
4b.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.