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Corporate Financial Policy

Semester A 2012-13City University of Hong Kong

AC4331 Week 4

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Topic 4

.

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1-2

Introduction to Financial Management

Free Cash Flow

Financial Planning and Forecasting

Financial Assets and Time Value of Money

Risk and Return Bond and Stock Valuation

Cost of Capital

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Treasury and Valuation

Enterprise Risk Management Dividends and Share Repurchase

Merger and Acquisitions

Working Capital Management

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Extra Ref:Financial Management, Theory and Practice, 12eEugene and

Brigham

Topic 4a:Bond Valuation

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5-4

Know the important bond featuresand bond types

Understand bond values and why theyfluctuate

Understand bond ratings and whatthey mean

Understand the impact of inflation on

interest rates Understand the term structure of

interest rates and the determinants of

bond yields (WEEK 3

)

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Chapter 9

Key Features of Bonds

Bond Valuation

Measuring Yield Assessing Risk

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Debt

Not an ownershipinterest

Creditors do not have

voting rights Interest is considered a

cost of doing businessand is tax deductible

Creditors have legalrecourse if interest or

principal payments aremissed

Excess debt can lead tofinancial distress andbankruptcy

Equity

Ownership interest

Common stockholdersvote for the board of

directors and other issues Dividends are not

considered a cost of doingbusiness and are not taxdeductible

Dividends are not aliability of the firm, andstockholders have no legalrecourse if dividends arenot paid

An all-equity firm cannotgo bankrupt

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A long-term debt instrument in which aborrower agrees to make payments ofprincipal and interest, on specific dates, to

the holders of the bond.

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Primarily traded in the over-the-counter(OTC) market.

Most bonds are owned by and traded among

large financial institutions. The Wall Street Journalreports key

developments in the Treasury, corporate, andmunicipal markets. Online edition lists

trading for each day the most actively-tradedinvestment-grade, high-yield, andconvertible bonds.

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Par value face amount of the bond, whichis paid at maturity (assume $1,000).

Coupon interest rate stated interest rate

(generally fixed) paid by the issuer. Multiplyby par value to get dollar payment ofinterest.

Maturity date years until the bond must be

repaid. Issue date when the bond was issued.

Yield to maturity rate of return earned ona bond held until maturity (also called the

promised yield). 9-9

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Allows issuer to refund the bond issue ifrates decline (helps the issuer, but hurts theinvestor).

Borrowers are willing to pay more, andlenders require more, for callable bonds.

Most bonds have a deferred call and adeclining call premium.

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Provision to pay off a loan over its life ratherthan all at maturity.

Similar to amortization on a term loan.

Reduces risk to investor, shortens averagematurity.

But not good for investors if rates declineafter issuance.

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Call x% of the issue at par, for sinking fundpurposes. Likely to be used if rd is below the coupon rate and

the bond sells at a premium.

Buy bonds in the open market. Likely to be used if rd is above the coupon rate and

the bond sells at a discount.

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N

N

2

2

1

1

r)(1

CF

...r)(1

CF

r)(1

CF

Value

0 1 2 Nr%

CF1 CFNCF2Value

...

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Convertible bond may be exchanged for commonstock of the firm, at the holders option.

Warrant long-term option to buy a stated numberof shares of common stock at a specified price.

Putable bond allows holder to sell the bond back tothe company prior to maturity.

Income bond pays interest only when interest isearned by the firm.

Indexed bond interest rate paid is based upon therate of inflation.

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The discount rate (ri) is the opportunity costof capital, and is the rate that could beearned on alternative investments of equal

risk.

ri = r* + IP + MRP + DRP + LP

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$1,000V

$385.54$38.55...$90.91V(1.10)

$1,000

(1.10)

$100...

(1.10)

$100V

B

B

10101B

9-16

0 1 2 Nr%

100 100 + 1,000100VB = ?

...

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This bond has a $1,000 lump sum (the parvalue) due at maturity (t = 10), and annual$100 coupon payments beginning at t = 1

and continuing through t = 10, the price ofthe bond can be found by solving for the PVof these cash flows.

INPUTS

OUTPUTN I/YR PMTV FV10 10 100 1000

-10009-17

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This bond has an annual coupon payment of$130. Since the risk is the same the bondhas the same yield to maturity as the

previous bond (10%). In this case the bondsells at a premium because the coupon rateexceeds the yield to maturity.

INPUTS


-1184.349-18

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This bond has an annual coupon payment of$70. Since the risk is the same the bond hasthe same yield to maturity as the previousbonds (10%). In this case, the bond sells at adiscount because the coupon rate is lessthan the yield to maturity.

INPUTS


-815.669-19

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What would happen to the value of thesethree bonds if the required rate of returnremained at 10%?

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Yearsto Maturity

1,184

1,000

816

10

13% coupon rate

7% coupon rate

10% coupon rate

VB

5 0

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At maturity, the value of any bond mustequal its par value.

If rd remains constant:

The value of a premium bond would decrease overtime, until it reached $1,000.

The value of a discount bond would increase overtime, until it reached $1,000.

A value of a par bond stays at $1,000.

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10d

10d

1d

Nd

Nd

1d

B

)r(1

1,000

)r(1

90...

)r(1

90$887

)r(1

M

)r(1

INT...

)r(1

INTV

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Must find the rd that solves this model.

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Solving for I/YR, the YTM of this bond is10.91%. This bond sells at a discount,because YTM > coupon rate.

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INPUTS

OUTPUTN I/YR PMTV FV10

10.91

90 1000887

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Solving for I/YR, the YTM of this bond is7.08%. This bond sells at a premium,because YTM < coupon rate.

INPUTS


7.08

90 10001134.2

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CGYExpected

CYExpected

YTMreturntotalExpected

priceBeginning

priceinChange(CGY)yieldgainsCapital

priceCurrent

paymentcouponAnnual(CY)eldCurrent y i

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Find the current yield and the capital gainsyield for a 10-year, 9% annual coupon bondthat sells for $887, and has a face value of$1,000.

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%15.101015.0

887$

90$eldCurrent y i

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YTM = Current yield + Capital gains yield

Could also find the expected price one yearfrom now and divide the change in price by the

beginning price, which gives the same answer.

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%76.0

10.15%10.91%

CYYTMCGY

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Interest rate risk is the concern that rising rdwill cause the value of a bond to fall.

rd 1-year Change 10-year Change

5% $1,048 $1,38610% 1,000 1,000

15% 956 749

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The 10-year bond is more sensitive tointerest rate changes, and hence hasmore interest rate risk.

+ 4.8%

4.4%

+38.6%

25.1%

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0

200

400

600

8001,000

1,200

1,400

1,600

0 5 10 15 20

Value($)

YTM (%)

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10-Year Bond

1-Year Bond

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Reinvestment rate risk is the concern that rdwill fall, and future CFs will have to bereinvested at lower rates, hence reducingincome.

EXAMPLE: Suppose you just won $500,000playing the lottery. You intend to invest the

money and live off the interest.

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You may invest in either a 10-year bond or aseries of ten 1-year bonds. Both 10-yearand 1-year bonds currently yield 10%.

If you choose the 1-year bond strategy: After Year 1, you receive $50,000 in income and

have $500,000 to reinvest. But, if 1-year rates fallto 3%, your annual income would fall to $15,000.

If you choose the 10-year bond strategy: You can lock in a 10% interest rate, and $50,000

annual income for 10 years, assuming the bond isnot callable.

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CONCLUSION: Nothing is riskless!

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Short-term

AND/OR

High-coupon

Bonds

Long-term

AND/OR

Low-coupon

Bonds

Interest rate risk Low HighReinvestment rate risk High Low

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1.Multiply years by 2:Number of periods = 2N

2.Divide nominal rate by 2:

Periodic rate (I/YR) = rd/23.Divide annual coupon by 2:

PMT = Annual coupon/2

INPUTS

OUTPUTN I/YR PMTV FV2N rd/2 cpn/2 OKK

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1.Multiply years by 2:N = 2 x 10 = 20.

2.Divide nominal rate by 2:

I/YR = 13/2 = 6.5.3.Divide annual coupon by 2:

PMT = 100/2 = 50.

INPUTS

OUTPUTN I/YR PMTV FV20 6.5 50 1000

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The semiannual bonds effective rate is:

10.25% > 10% (the annual bonds effectiverate), so you would prefer the semiannualbond.

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10.25%1

2

0.1011

M

r1EFF%

2M

NOM

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The semiannual coupon bond has aneffective rate of 10.25%, and the annualcoupon bond should earn the same EAR. Atthese prices, the annual and semiannualcoupon bonds are in equilibrium, as theyearn the same effective return.

INPUTS

OUTPUTN I/YR PMTV FV10 10.25 100 1000

- 984.809-36

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The bonds yield to maturity can bedetermined to be 8%. Solving for the YTC isidentical to solving for YTM, except the timeto call is used for N and the call premium isFV.

INPUTS


3.568

50 10501135.90

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3.568% represents the periodic semiannualyield to call.

YTCNOM = rNOM = 3.568% x 2 = 7.137% is the

rate that a broker would quote. The effective yield to call can be calculated.

YTCEFF = (1.03568)2 1 = 7.26%

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The coupon rate = 10% compared to YTC =7.137%. The firm could raise money byselling new bonds which pay 7.137%.

Could replace bonds paying $100 per yearwith bonds paying only $71.37 per year.

Investors should expect a call, and to earnthe YTC of 7.137%, rather than the YTM of

8%.

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In general, if a bond sells at a premium, then(1) coupon > rd, so (2) a call is more likely.

So, expect to earn: YTC on premium bonds.

YTM on par and discount bonds.

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If an issuer defaults, investors receive lessthan the promised return. Therefore, theexpected return on corporate and municipalbonds is less than the promised return.

Influenced by the issuers financial strengthand the terms of the bond contract.

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Mortgage bonds

Debentures

Subordinated debentures

Investment-grade bondsJunk bonds

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Investment Grade Junk Bonds

Moodys Aaa Aa A Baa Ba B Caa C

S & P AAA AA A BBB BB B CCC C

Bond ratings are designed to reflect the

probability of a bond issue going intodefault.

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Financial performance Debt ratio

TIE ratio

Current ratio

Qualitative factors: Bond contract provisions Secured vs. Unsecured debt

Senior vs. subordinated debt

Guarantee and sinking fund provisions

Debt maturity

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Earnings stability

Regulatory environment

Potential antitrust or product liabilities

Pension liabilities Potential labor problems

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Default risk premium remember bondratings

Taxability premium remember municipalversus taxable

Liquidity premium bonds that have morefrequent trading will generally have lowerrequired returns (remember bid-ask spreads)

Anything else that affects the risk of the cash

flows to the bondholders will affect therequired returns.

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How do you find the value of a bond, andwhy do bond prices change?

What is a bond indenture, and what aresome of the important features?

What are bond ratings, and why are theyimportant?

How does inflation affect interest rates?

What is the term structure of interest rates? What factors determine the required return

on bonds?

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You are in charge of a fixed-income investment

fund. With a view that the economy mayencounter a hard landing next year and thecentral bank will have no choice but to cut theinterest rate aggressively, you approached his

broker to buy the following bond:Issuer : HK Asset Co Ltd Credit Rating : AA

Par Value : $1,000,000

Original Maturity : 10 years

Remaining Maturity : 5 years

Coupon : 6.0%

Market Yield : 7.5%

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Contrary to your expectation, the interest rate surged twelvemonths later. Even worse, the rating agency downgraded HK

Assets credit rating to A. You decided to stop the loss onthis investment and obtained the following marketinformation:

5-year 4-year

Government Bond Yield: 8.5% 8.00%

Credit Spreads for Corporate Bonds

5-year 4-year

AAA 0.10% 0.05%

AA 0.30% 0.20% A 0.60% 0.50%

BBB 0.85% 0.65%

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(a) (i) How much have you paid to purchasethe bond? (4 marks) (ii) What would be the amount that you couldreceive by selling the bond? (4 marks) (iii) How much would you lose from thedepreciation of the bond price? (1 mark)

Module B (February 2007 Session) Page 6 of 6

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(i) Year 1 2 3 4 5 Coupon 60,000 60,000 60,000 60,000 1,060,000

Discount Rate 1.075 1.156 1.242 1.335 1.436 Discounted CF 55,814 51,920 48,298 44,928 738,352

Bond Price $939,312

(ii) Year 1 2 3 4

Coupon 60,000 60,000 60,000 1,060,000

Discount Rate 1.085 1.177 1.277 1.386

Discounted CF 55,300 50,967 46,974 764,869

Bond Price $918,110

(iii)Change in price = $918,110 $939,312

= -$21,202

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Topic 4b:Stock Valuation

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Fundamentals of valuations

Valuation Methods Book Value Discounted Cash Flow Method Relative Method

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Chapter 10

Features of Common Stock

Determining Common Stock

Values using Dividend GrowthModel, Corporate ValuationModel and Multiples

Preferred Stock10-54

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Represents ownership Ownership implies control

Stockholders elect directors

Directors elect management Managements goal: Maximize the stock

price

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Outside investors, corporate insiders, andanalysts use a variety of approaches toestimate a stocks intrinsic value (P0).

In equilibrium we assume that a stocks priceequals its intrinsic value. Outsiders estimate intrinsic value to help

determine which stocks are attractive to buyand/or sell.

Stocks with a price below (above) its intrinsic valueare undervalued(overvalued).

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10-57

True

InvestorReturns

TrueRisk

Perceived

InvestorReturns

PerceivedRisk

Managerial Actions, the EconomicEnvironment, Taxes, and the Political

Climate

StocksIntrinsic

Value

StocksMarket Price

Market Equilibrium:Intrinsic Value = Stock

Price

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Discounted dividend model

Corporate valuation model

Using the multiples of comparable firms

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Value of a stock is the present value of thefuture dividends expected to be generated bythe stock.

31 20 1 2 3

s s s s

DD D DP = + + + ... +

(1+r ) (1+r ) (1+r ) (1+r )

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0 1

0

s s

D (1+g) DP = =

r g r g

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A stock whose dividends are expected togrow forever at a constant rate, g.

D1 = D0(1 + g)1

D2 = D0(1 + g)2

Dt = D0(1 + g)t

If g is constant, the discounted dividend

formula converges to:

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10-61

t

tt

)r1(

DPVD

t0 PVDP

$

0.25

Years (t)0

t0t )g1(DD

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If g > rs, the constant growth formula leadsto a negative stock price, which does notmake sense.

The constant growth model can only be usedif: rs > g.

g is expected to be constant forever.

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If rRF = 7%, rM = 12%, and b = 1.2, what isthe required rate of return on the firmsstock?

rs = rRF + (rM rRF)b= 7% + (12% 7%)1.2= 13%

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10-64

1.8761

1.7599

D0 = 2.00

1.6509

rs = 13%

g = 6%0 1

2.247

2

2.382

3

2.12

D0 = $2 and g is a constant 6%.

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Using the constant growth model:

$30.29

0.07

$2.12

0.060.13

$2.12

gr

DP

s

10

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D1 will have been paid out already. So, P1 isthe present value (as of Year 1) of D2, D3, D4,etc.

Could also find expected P1 as:

$32.10

0.060.13

$2.247gr

DP

s

21

$32.10(1.06)PP 01

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Dividend yield= D1/P0 = $2.12/$30.29 = 7.0%

Capital gains yield

= (P1 P0)/P0= ($32.10 $30.29)/$30.29 = 6.0%

Total return (rs)

= Dividend yield + Capital gains yield

= 7.0% + 6.0% = 13.0%

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The dividend stream would be a perpetuity.

$15.380.13$2.00

rPMTP0

2.00 2.002.00

0 1 2 3rs = 13%

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Can no longer use just the constant growthmodel to find stock value.

However, the growth does become constantafter 3 years.

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rs = 13%

g = 30% g = 30% g = 30% g = 6%

2.301

2.647

3.045

46.114

54.107 =

0 1 2 3 4

D0 = 2.00 2.600 3.380 4.394 4.658

P0

$66.5406.00.13

4.658P

3

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Dividend yield (first year)= $2.60/$54.11 = 4.81%

Capital gains yield (first year)

= 13.00% 4.81% = 8.19% During nonconstant growth, dividend yield

and capital gains yield are not constant, andcapital gains yield g.

After t = 3, the stock has constant growthand dividend yield = 7%, while capital gainsyield = 6%.

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10-72

rs = 13%

g = 0% g = 0% g = 0% g = 6%

1.77

1.57

1.39

20.99

25.72 =

0 1 2 3 4

D0 = 2.00 2.00 2.002.00

2.12

P0

$30.2906.00.13

2.12P3

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Dividend yield (first year)= $2.00/$25.72 = 7.78%

Capital gains yield (first year)

= 13.00% 7.78% = 5.22%

After t = 3, the stock has constant growthand dividend yield = 7%, while capital gains

yield = 6%.

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Yes. Even though the dividends aredeclining, the stock is still producingcash flows and therefore has positivevalue.

$9.890.19

$1.88

(-0.06)0.13

(0.94)$2.00

gr

)g(1D

gr

DP

s

0

s

10

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Capital gains yield= g = 6.00%

Dividend yield

= 13.00% (6.00%) = 19.00%

Since the stock is experiencing constantgrowth, dividend yield and capital gains yield

are constant. Dividend yield is sufficientlylarge (19%) to offset a negative capital gains.

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Also called the free cash flow method.Suggests the value of the entire firm equalsthe present value of the firms free cashflows.

Remember, free cash flow is the firms after-tax operating income less the net capitalinvestment.

FCF = EBIT(1 T) + Depreciation Expense Net capital investment

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Find the market value (MV) of the firm, byfinding the PV of the firms future FCFs.

Subtract MV of firms debt and preferredstock to get MV of common stock.

Divide MV of common stock by the numberof shares outstanding to get intrinsic stockprice (value).

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Often preferred to the discounted dividendmodel, especially when considering numberof firms that dont pay dividends or whendividends are hard to forecast.

Similar to discounted dividend model,assumes at some point free cash flow willgrow at a constant rate.

Terminal value (TVN) represents value of firmat the point that growth becomes constant.

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Given: Long-Run gFCF = 6% and WACC = 10%

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r= 10%

g = 6%

-4.545

8.264

15.026

398.197

416.942

0 1 2 3 4

-5 21.20

3TV06.00.10

21.20530

10 20

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The firm has $40 million total in debt andpreferred stock and has 10 million shares ofstock.

MV of equity = MV of firm MV of debt

=$416.94 $40

=$376.94 million

Value per share = MV of equity /# of shares=$376.94 /10

=$37.69

What is the firms intrinsic value

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The firms total value is calculated as follows:

Using your financial calculator, enter the following inputs:CF0 = 0; CF1 = 3000000; CF2 = 6000000; CF3 = 10000000;CF

4= 15000000 + 321000000 = 336000000; I/YR = 12;

and then solve for NPV = $228,113,612.

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per share?

What is the firms intrinsic value

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To find Barretts stock price, you need to first findthe value of its equity. The value of Barrettsequity is equal to the value of the total firm lessthe market value of its debt and preferred stock.

Total firm value $228,113,612Market value, debt + preferred 60,000,000Market value of equity $168,113,612

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per share?

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Analysts often use the following multiples tovalue stocks. P/E P/CF

P/Sales

EXAMPLE: Based on comparable firms,estimate the appropriate P/E. Multiply thisby expected earnings to back out an estimateof the stock price.

10-83

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Hybrid security. Like bonds, preferred stockholders receive a

fixed dividend that must be paid beforedividends are paid to common stockholders.

However, companies can omit preferreddividend payments without fear of pushingthe firm into bankruptcy.

10-84

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10-85

p

p

p

DV =

r

$5$50=

r

p

$5r =

$50

=0.10 =10%

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86

What are three main methods of valuation? What determines the price of a share of stock?

What determines gand Rin the DGM?

Discuss the importance of the PE ratio.

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Bond Duration

87

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For Point 5.8, Source: Financial Markets and Institutions by Mishkin

and Eakins , 7th Edition

DUR tCP

t

1 i tt1

n

CPt1 i tt1

n

Duration is a measure of bond price sensitivity tochange in yield

One can derivate the duration measure by takingderivatives of the following bond formula with

respect to the yield to maturity

P C

1 i

C

1 i 2

C

1 i 3 ...

C

1 i n

F

1 i n

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%P DUR i1 i

%P 6.760.01

1 0.10%P 0.0615 6.15%

i 10% to 11%:

Table 3-4, 10% coupon bond

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i 10% to 11%: 20% coupon bond, DUR= 5.72 years

%P 5.72 0.011 0.10

%P 0.0520 5.20%

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The greater is the duration of a security, thegreater is the percentage change in themarket value of the security for a givenchange in interest rates

Therefore, the greater is the duration of asecurity, the greater is its interest-rate risk

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Key facts about duration1. All else equal, when the maturity of a bond

lengthens, the duration rises as well

2. All else equal, when interest rates rise, the

duration of a coupon bond fall3. The higher is the coupon rate on the bond, the

shorter is the duration of the bond

4. Duration is additive: the duration of a portfolio of

securities is the weighted-average of the durationsof the individual securities, with the weightsequaling the proportion of the portfolio invested ineach

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Matching the durations of bank assets andliabilities

In 1980s, the duration of assets in US savingsand loans associations (S&Ls) weremismatched with long-term fixed-ratemortgage and short-term deposits, the wholeindustry failed when market interest rate roseto double digit

sliabilitieassetDD

Topic 4 (2012-13A)MP

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