T here are a number of factors that affect a stock’s price and its value to
T here are a number of factors that affect a stock’s price and its value to
investors. The financial manager regularly has to figure out whether a particular investment is good or bad. A good investment will enhance shareholder wealth. A bad one won’t. To decide whether an investment is good or bad, the manager must determine whether the benefits from the investment—often expected in future periods—will outweigh its costs.
To make the best investment decisions, the financial manager must also consider the way the investment is financed. If the firm takes on more debt, is this harmful to shareholders? If the firm issues more shares of equity, how does this affect the value of equity? Furthermore, recog- nizing that the value of equity is the difference between the value of the firm’s assets and its debt obligations, we must be aware of how debt securities are valued as well.
Valuation compares the benefits of a future investment decision with its cost. Another way of evaluating an investment is to answer the ques- tion: Given its cost and its expected future benefits, what return will a particular investment provide? In this chapter we focus on the principles of valuation and how to calculate the return on investments. In the next chapter we focus on the valuation of stocks and bonds.
PRINCIPLES OF ASSET VALUATION Suppose you are offered the following investment opportunity by a
company: Lend the company $90 today, and you will be paid $100 one
THE FUNDAMENTALS OF VALUATION
year from today by the company. Whether or not this is a good invest- ment depends on:
■ what you could have done with your $90 instead of investing it with the company, and ■ how certain you are that the company will pay the $100 in one year.
If your other opportunities with the same amount of uncertainty pro- vide a return of 10%, is this loan a good investment? There are two ways to evaluate this.
First, you can figure out what you could have wound up with after one year, investing your $90 at 10%:
Value at the end of one year = $90 + 10% of $90 = $90 1 ( + 0.10 ) = $99
Since the $100 promised is more than $99, you are better off with the investment offered by the company.
Another way of looking at this is to figure out what the $100 prom- ised in the future is worth today. To calculate its present value, we must discount the $100 at some rate. The rate we’ll use is the opportunity cost of funds, which in this case is 10%:
Value today of $100 in one year = ----------------------------- = $90.91
( 1 1 + 0.10 ) This means that you consider $90.91 today to be worth the same as
$100 in one year. In other words, if you invested $90.91 today in an investment that yields 10%, you end up with $100 in one year. Since today’s value of the receipt of $100 in the future is $90.91 and it only costs $90 to get into this deal, the investment is attractive: it costs less than what you have determined it is worth.
Since there are two ways to look at this—through its future value or through its present value—which way should you go? While both approaches get you to the same decision, the approach in terms of the present value of the investment is usually easier.
Let’s look at another example. Suppose you have an opportunity to buy an asset expected to give you $500 in one year and $600 in two years. If your other investment opportunities with the same amount of risk give you a return of 5% a year, how much are you willing to pay today to get these two future receipts?
Principles of Asset Valuation and Investment Returns
We can figure this out by discounting the $500 in year 1 at 5% and $600 in year 2 at 5%:
$600 Present value of an investment =
This investment is worth $1,020.41 today, so you will be willing to pay $1,020.41 or less for this investment:
■ if you pay more than $1,020.41, you get a return of less than 5%; ■ if you pay less than $1,020.41 you get a return of more than 5%; and,
■ if you pay $1,020.41 you get a return of 5%. Suppose you are evaluating an investment that promises $10 every
year forever. The value of this investment is the present value of the stream of $10 to be received each year to infinity where each $10 is dis- counted at the appropriate number of years at some annual rate i:
Present value of an investment = ------------------ $10 + ------------------ $10 + ------------------ $10 + + ------------------- $10 …
1 + i 1 ) ( 1 + i ( 2 ) ( 1 + i 3 i ) ∞ ( 1 + ) which we can write in shorthand notation using summation notation as:
1 Present value of an investment =
∑ -----------------
----------------- = $10
t = 1 ( 1 + i ) Or, since the last term is equal to 1/ i, we can rewrite the present value of
this perpetual stream as:
Present value of investment = $10 (1/ i) = $10/i
If the discount rate to translate this future stream into a present value is 10%, the value of the investment is $100:
Present value of investment = $10 (1/0.10) = $10/0.10 = $100 The 10% is the discount rate, also referred to as the capitalization rate,
for the future cash flows comprising this stream. Let’s look at this
THE FUNDAMENTALS OF VALUATION
investment from another angle: If you consider the investment to be worth $100 today, you are capitalizing—translating future flows into a present value—the future cash flows at 10% per year.
As you see from these examples, the value of an investment depends on:
1. the amount and timing of the future cash flows, and
2. the discount rate used to translate these future cash flows into a value today.
This discount rate represents how much an investor is willing to pay today for the right to receive a future cash flow. Or, to put it another way, the discount rate is the rate of return the investor requires on an investment, given the price he or she is willing to pay for its expected future cash flow.
We can generalize this relationship a bit more. Let CF t represent the cash flow from the investment in period t, so that CF 1 is the cash flow at the end of period 1, CF 2 is the cash flow at the end of period 2, and so on, until the last cash flow at the end of period N, CF N . If the invest- ment produces cash flows for N periods and the discount rate is i, the value of the investment—the present value—is:
Present value of an investment
= ------------------ + ------------------ 3 ------------------ CF + 2 + … + -------------------- N
CF 1 CF CF
1 2 3 ( N 1 + i ) ( 1 + i ) ( 1 + i ) ( 1 + i ) which we can write more compactly as:
CF Present value of an investment =
----------------- ∑ t
1 ( 1 + i ) In the special case where the cash flows are all equal, we can sim-
plify this by letting CF represent each cash flow and use CF in place of CF 1 , CF 2 , and so on. The valuation relation becomes:
CF 1 Present value of an investment =
----------------- = CF ∑ -----------------
( t 1 + i ) t = 1 ( 1 + i ) which we can write in terms of the annuity factor,
Principles of Asset Valuation and Investment Returns
Present value of an investment = CF Present value annuity factor ( )
If the cash flow stream is level and is promised each period forever, N is infinite. As the number of future periods approaches infinity, the present value annuity factor approaches 1/ i. Therefore, the present value of a perpetual stream of cash flows is equal to:
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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