© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 1 Topics Covered What Is A Corporation? The Role of The Financial Manager Who Is The.

©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill

1- 1

Topics Covered

What Is A Corporation? The Role of The Financial Manager Who Is The Financial Manager? Separation of Ownership and Management Financial Markets


1- 2

Corporate Structure

Sole Proprietorships

Corporations

Partnerships

Unlimited Liability

Personal tax on profits

Limited Liability

Corporate tax on profits +

Personal tax on dividends


1- 3

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors

(2) Cash invested in firm

(3) Cash generated by operations

(4a) Cash reinvested

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)


1- 4

Ownership vs. Management

Difference in Information

Stock prices and returns Issues of shares and

other securities Dividends Financing

Different Objectives

Managers vs. stockholders

Top mgmt vs. operating mgmt

Stockholders vs. banks and lenders


1- 5

Valuation Rule

Mean – Variance Valuation Rule

1 20 , C , CC

1 2

0 2

C C+ ,

1+r (1+r)PV C


1- 6

Valuing an Office Building

Step 1: Forecast cash flows

Cost of building = C0 = 350

Sale price in Year 1 = C1 = 400

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market

offer a return of 7%, then

Cost of capital = r = 7%


1- 7

Valuing an Office Building

Step 3: Discount future cash flows

Step 4: Go ahead if PV of payoff exceeds investment

374)07.1(400

)1(1 r

CPV

24374350 NPV


1- 8

Risk and Present Value

Higher risk projects require a higher rate of return.

Higher required rates of return cause lower PVs.

374.071

400PV

7%at $400 C of PV 1


1- 9

Risk and Present Value

374.071

400PV

7%at $400 C of PV 1

357.121

400PV

12%at $400 C of PV 1


1- 10 General Rule For Valuation Of Any Risky Cash Stream

1. Expected cashflows

2. Required rate of return

3. Discounted value

• Mean – Variance Rule

• Other valuation rules

0 1 2, C , CC

Fr R


1- 11

Net Present Value Rule

Accept investments that have positive net present value

Required rate of return = cost of capital


1- 12

Net Present Value Rule

Accept investments that have positive net present value.

Example

Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

55.4$1.10

60+-50=NPV


1- 13

Topics Covered

Valuing Long-Lived Assets PV Calculation Short Cuts Compound Interest Interest Rates and Inflation Example: Present Values and Bonds


1- 14

Present Values

Discount Factor = DF = PV of $1

Discount Factors can be used to compute the present value of any cash flow.

DFr t

1

1( )


1- 15

Present Values

Example

You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

PV 30001 08 2 572 02

( . )$2, .


1- 16

Present Values

PVs can be added together to evaluate multiple cash flows.

PV C

r

C

r

1

12

21 1( ) ( )....


1- 17

Present Values

Discount Factors can be used to compute the present value of any cash flow.

DFr t

1

1( )

1

11 1 r

CCDFPV


1- 18

Present Values

Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.

t

tt r

CCDFPV

1


1- 19

Short Cuts

Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly.


1- 20

Short Cuts

Perpetuity - Financial concept in which a cash flow is theoretically received forever.

r

CPV 1

ratediscount

flow cash FlowCash of PV


1- 21

Short Cuts

Annuity - An asset that pays a fixed sum each year for a specified number of years.

trrrC

1

11annuity of PV


1- 22

Annuity Short Cut

Example - continuedYou agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

10.774,12$

005.1005.

1

005.

1300Cost Lease 48

Cost


1- 23

Valuing a Bond

Example

If today is October 2000, what is the value of the following bond? An IBM Bond pays $115 every Sept for 5 years. In Sept 2005 it pays

an additional $1000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%).

Cash Flows

Sept 0102 03 04 05

115 115 115 115 1115


1- 24

Valuing a Bond

Example continuedIf today is October 2000, what is the value of the following bond?

An IBM Bond pays $115 every Sept for 5 years. In Sept 2005 it pays an additional $1000 and retires the bond.

The bond is rated AAA (WSJ AAA YTM is 7.5%).

84.161,1$

075.1

115,1

075.1

115

075.1

115

075.1

115

075.1

1155432

PV


1- 25

Bond Prices and Yields

0

200

400

600

800

1000

1200

1400

1600

0 2 4 6 8 10 12 14

5 Year 9% Bond 1 Year 9% Bond

Yield

Pri

ce


1- 26

Topics Covered

How To Value Common Stock Capitalization Rates Stock Prices and EPS Cash Flows and the Value of a Business


1- 27

Stocks & Stock Market

Common Stock - Ownership shares in a publicly held corporation.

Secondary Market - market in which already issued securities are traded by investors.

Dividend - Periodic cash distribution from the firm to the shareholders.

P/E Ratio - Price per share divided by earnings per share.


1- 28

MANAGERS SHOULD BE MAKING DECISIONS WHICH INCREASE SHARE PRICE

NEED TO UNDERSTAND HOW SHARE PRICE IS DETERMINED

CASES WHERE WE CANNOT DIRECTLY OBSERVE STOCK PRICE

WE ARE TRYING TO VALUE • A DIVISION OF A COMPANY • PRIVATELY HELD FIRM FOR POSSIBLE SALE

WHY IS IT IMPORTANT TO HAVE A THEORY OF THE VALUATION OF

COMMON STOCKS?


1- 29

HOW MUCH SHOULD I PAY FOR A STOCK

TODAY (P0)

IF I AM GOING TO RECEIVE A DIVIDEND AT

THE END OF ONE YEAR (DIV1)

AND THEN I’M GOING TO SELL IT (AT

A PRICE P1)?

LET’S CHANGE OUR ASSUMPTIONS


1- 30

PRICE OF THE STOCK IS THE PRESENT VALUE OF THE CASH

FLOWS RECEIVED BY THE INVESTOR

PP

r01 1

DIV1

TWO EQUIVALENT WAYS OF ANSWERING THE QUESTION


1- 31

I CAN CALCULATE TODAY’S PRICE ONLY IF I KNOW THE PRICE AT THE END OF THE YEAR.

I AM ASSUMING THAT I HOLD THE STOCK FOR ONE YEAR AND I SELL IT.

WHAT HAPPENS IF MY HOLDING PERIOD IS NOT ONE YEAR?

LET’S GET RID OF BOTH LIMITATIONS.

HAVE I REALLY SAID ANYTHING USEFUL? WHAT ARE THE LIMITATIONS OF MY

ANSWER?


1- 32

HOW MUCH SHOULD THE PERSON WHO BUYS IT FROM ME PAY FOR THE STOCK IN A YEAR’S TIME (P1)

IF SHE IS GOING TO RECEIVE A DIVIDEND

AFTER ONE YEAR (DIV2)

AND THEN SHE IS GOING TO SELL IT

(AT A PRICE P2)?

LET’S SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK IN A YEAR’S TIME


1- 33

DIV1

DIVDIV1

1DIV1

DIV

1

1 1

12 2

1 22

22( ) ( )

Pr

Pr

r

r r

P

r1

PP

r12 2

DIV1

P0


1- 34

EXPECTED DIVIDENDS IN YEARS 1 AND 2, DIV1 AND DIV2

EXPECTED PRICE AT END OF YEAR 2, P2

WE CAN REPEAT THE PROCESS

WE HAVE NOW SUCCEEDED IN RELATING TODAY’S PRICE TO:


1- 35

HOW MUCH SHOULD THE PERSON PAY FOR

THE STOCK IN TWO YEAR’S TIME (P2)

IF SHE IS GOING TO RECEIVE A DIVIDEND

AFTER ONE YEAR (DIV3)

AND THEN SHE IS GOING TO SELL IT

(AT A PRICE P3)?

LET’S SEE HOW MUCH SOMEONE WILL PAY FOR THE STOCK IN TWO YEAR’S TIME


1- 36

DIV DIV( ) ( )

DIV( )

DIVDIV

( )( )

DIV DIV( )

DIV( ) ( )

1 22

22

12

3 3

2

1 22

33

33

1 1 1

11

1 1 1 1

r rP

r

r

Pr

1 r

r r rP

r

P0


1- 37

Pr r r

P

r01 2

233

H HH

DIV DIV

( )

DIV

( )......

DIV

( )

1 1 1 1

DIVHH(1 r)=

P

rH

H( )1

NOW THE PRICE OF THE STOCK IS OBVIOUSLY INDEPENDENT OF THE TIME HORIZON, H.AS WE GO OUT FURTHER IN TIME, MORE OF THE PRICE IS ACCOUNTED FOR BY THE DIVIDEND TERMS, SO THAT THE PRESENT VALUE OF THE TERMINAL PRICE BECOMES LESS IMPORTANT.


1- 38

1. BY CONSIDERING HOW MUCH A BUYER WILL PAY FOR THE STOCK

WHEN IT IS REPEATEDLY SOLD, WE FIND THAT THE STOCK PRICE IS THE PV OF ALL FUTURE DIVIDENDS.

2. WE OBTAIN THE SAME RESULT INDEPENDENTLY OF THE ASSUMPTIONS WE MAKE

ABOUT THE LENGTH OF SUCCESSIVE HOLDING PERIODS.

DIV

( )HH1 r

P0 =


1- 39

SPECIAL CASESWHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS

ABOUT THE GROWTH PATTERN OF FUTURE

DIVIDENDS


1- 40

Pr0

D IV

GOOD APPROXIMATION FOR MANY UTILITY STOCKS

SPECIAL CASES

1. NO GROWTH SIMILAR TO PREFERRED STOCK, WITH CONSTANT DIVIDENDSDIV1=DIV2=.......=DIVORDINARY PERPETUITY

WHERE WE CAN MAKE SOME SIMPLIFYING ASSUMPTIONS BOUT THE GROWTH PATTERN OF FUTURE DIVIDENDS


1- 41

DIVIDENDS EXPECTED TO GROW AT CONSTANT RATE

WE KNOW THIS WON’T HAPPEN EXACTLY REASONABLE APPROXIMATION WITHIN THE

ACCURACY OF OUR ESTIMATE OFTEN STATED AS COMPANY GOAL

GROWING PERPETUITY

CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL)


1- 42

IF DIVIDENDS ARE EXPECTED TO GROW AT A CONSTANT RATE (g < r), VALUE OF THE STOCK IS

DIV1 DIV0(1+g) P0 = = r - g r - g

FOR FLEDGLING ELECTRONICS,

DIV1 = 5.00, g = .10, r = .15

DIV1 5P0 = = = $100 r - g .15 - .10

CONSTANT EXPECTED DIVIDEND GROWTH (GORDON MODEL)


1- 43

DIV1 5P0 = = = $50 r - g .15 - .05

WHAT HAPPENS TO THE STOCK PRICE WHENREQUIRED RATE OF RETURN INCREASES

FROM 15% TO 20%WITH INCREASE IN GENERAL LEVEL OF INTEREST

RATES? EXPECTED GROWTH RATE 10%.


1- 44

CHANGES IN EXPECTED GROWTH RATES

CAN HAVE MAJOR IMPACT

ON STOCK PRICES.


1- 45

WHAT HAPPENS TO THE STOCK PRICE WHENREQUIRED RATE OF RETURN INCREASES

FROM 15% TO 20%WITH INCREASE IN GENERAL LEVEL OF INTEREST

RATES? EXPECTED GROWTH RATE 10%.

DIV1 5P0 = = = $50 r - g .20 - .10


1- 46

CHANGES IN REQUIRED RATES OF RETURN ON STOCKS

CAN HAVE MAJOR IMPACT

ON STOCK PRICES.


1- 47

If dividends are expected to grow at a constant rate, g

DIV1

P0 = r - g

DIV1

so that r = + g P0MARKET CAPITALIZATION RATE

=DIVIDEND YIELD, (D1 /P0)

+ EXPECTED RATE OF GROWTH IN DIVIDENDS, g

ESTIMATING THE CAPITALIZATION RATEOR REQUIRED RATE OF RETURN


1- 48

Pr r

P

r01 2

23 3

3

DIV1

DIV

(1 )

DIV

(1 )

DIV =DIV (1+g )

DIV =DIV (1+g )

DIV =DIV (1+g )

DIVg

1 0 s

2 0 s2

2 0 s3

34

n

Pr

SUPERNORMAL GROWTH


1- 49

INVESTORS OFTEN DISTINGUISH BETWEEN :

• GROWTH STOCKS

– EXPECTATION OF CAPITAL GAINS, BASED ON FUTURE GROWTH IN EARNINGS

• INCOME STOCKS

– CASH DIVIDENDS

DOES THIS DISTINCTION MAKE SENSE?

STOCK PRICE AND EARNINGS PER SHARE (EPS)


1- 50

SIMILAR TO PREFERRED STOCK, WITH CONSTANT DIVIDENDS, DIV1=DIV2=......

ORDINARY PERPETUITY

Pr r

rP P

01 1

1

0

1

0

D IV EPS

DIV EPS

EXPECTED RETURN = DIVIDEND YIELD = EARNINGS PRICE RATIO

NO GROWTH


1- 51

WE CAN THINK OF STOCK PRICE AS

THE CAPITALIZED VALUE OF EARNINGS UNDER A NO-GROWTH POLICY; PLUS

PRESENT VALUE OF GROWTH OPPORTUNITIES

GROWTH COMPANY


1- 52

Pr

Pr

P

01

0 0

EPSPVGO

EPS(1

PVGO

)

EARNINGS PRICE RATIO WILL UNDERESTIMATE MARKET

CAPITALIZATION RATE , r, BECAUSE PVGO > 0

GROWTH COMPANY


1- 53

A MAJOR PART OF THE VALUE

OF A GROWTH STOCK IS

THE NPV OF FUTURE

INVESTMENTS

MAY PAY NO CURRENT DIVIDENDS

GROWTH COMPANY


1- 54

PVGO = PVGO

P0 EPS r P0 - EPS/r % of P0

Income stocks

AT&T 51.13 3.76 .136 23.88 47

Conagra 32.88 2.16 .139 17.38 53

Duke Power 38.25 3.10 .097 6.16 16

Exxon 64.00 4.42 .109 23.26 36

Intl Paper 72.75 8.51 .143 13.06 18

Growth stocks

Genzyme 39.00 2.09 .244 30.45 72

Hewlett Packard 118.50 9.33 .214 74.90 63

Merck 42.50 2.84 .152 23.82 56

Microsoft 64.31 2.57 .165 48.73 76

WalMart 24.38 1.54 .153 10.05 59

Estimated PVGOs

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 1 Topics Covered What Is A Corporation? The Role of The Financial Manager Who Is The.

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