Amount, timing and riskiness of expected cash flows
Investors assessment of riskiness and their willingness to bear risk
Purpose of Valuation
Understand how to value financial securities if you want to meet the objective of maximising the shareholders wealth
Assisst a lender in quantifiying the security value for a loan
Formula: Value of an Asset
Features of Common Stock
Variable Income Security
Represents Equity Ownership
Includes voting rights/proxy voting
Dividends may be increased or decreased
Priority: Lower than debt and preferred shares
Common stockholder receive dividends and price appreciation
Common Stock Valuation: Constant Growth/Zero Growth
Growth < Required Rate of Return
Zero Growth means EPS = Dividends
Formula: Retention of earnings/ Internal Growth
Where r = % of earnings retained in the firm
Common Stock Valuation: Non-constant growth
Common Stock Valuation: P/E Ratio
EPS carries the level of earnings information
P/E carries the risk information
Problems with P/E Multiple Method
P/E depends on reported accounting earnings
Often hard to find comparable firms
Features of Preferred Stock
No fixed maturity
Ranks behind bonds but ahead of common stock
Most are cumulative meaning any missed preferred stock dividends in any year will have to be paid before dividends can be paid to any common stockholder
Does not usually carry voting rights
Formula: Preferred Stock Valuation
Characteristics of a Bond
Company is commited to paying coupon and the repayment of principal
Only variable causing change in value is investors required rate of return
Bond financing is less costly than equity financing because equity holders bear most of the risk and require greater returns. Also the cost of debt is tax deductible whereas dividend(cost of equity) are not tax deductible.
Suppliers of debt finance have no control over the affairs of the company apart from those outline in bond indenture
May be secured or unsecured
Bond Indenture
Lists all the bonds features
Describes repayment provisions
Lists covenants designed to protect bondholders eg minimum coverage working capital, max dividends
Advantages of Long term debt financing
Relatively low cost after tax
Leverage Increases EPS
Owners maintain control of firm
Disadvantages of Long term debt financing
Increase financial risk
Restrictions by lenders
Types of Bonds
Debentures - unsecured bonds
Mortgage Bonds - Secured Bonds
Zero Coupon - bonds that only pay par value at maturity, no coupons
Eurobonds - Bonds denominated in one currency and sold in another country (benefit is lower interest rates in other country and to avoid domestic regulations)
Formula: Bond Valuation
Premium vs Discount Bonds
Coupon Rate = Discount Rate then Bond will sell at par value
Coupon Rate > Discount Rate the bond will sell at a premium
Coupon Rate < Discount Rate the bond will sell at a discount
Formula: Perpetual Bond
Zero Coupon Bond
Yield to Maturity
Rate of return investors earn if they buy the Bond and hold it until maturity
YTM on a bond selling at Par will always equal the coupon interest rate
YTM is the discount rate that equates the PV of a bonds cash flows with its price.
Call Feature
An optional retirement provision that permits the issuing company to redeem a debt issue prior to its maturity date.