10

Valuation and Rates of

Return
Block, Hirt, and Danielsen
Foundations of Financial Management
17th edition

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-1
 Learning Objectives

• The valuation of a financial asset is based on the present

value of future cash flows.
• The required rate of return in valuing an asset is based on
the risk involved.
• Bond valuation is based on the process of determining the
present value of interest payments plus the present value
of the principal payment at maturity.
• Preferred stock valuation is based on the dividend paid and
the market required return.
• Stock valuation is based on determining the present value
of the future benefits of equity ownership.

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-2
 Chapter Opening (Figure 10-1)
• Valuation of financial assets
• Helps to determine how financial assets are valued
• Bonds, preferred stock, and common stock
• Helps to determine how investors establish rates of return
• Cost of corporate financing (capital) is used in analyzing feasibility of
investment on ensuing project
• Figure 10-1 The Relationship between Time value of Money, Required
Return, Cost of Financing, and Investment Decisions

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-3
 Valuation Concepts
• Valuation of a financial asset is based on
determining present value of future cash flows
• Required rate of return (discount rate)
• Depends on market’s perceived level of risk associated
with individual security
• Also competitively determined among companies
seeking financial capital
• Implies investors willing to accept low return for low
risk and vice versa
• Previous efficient use of capital results in lower
required rate of return for investors

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-4
 Valuation of Bonds
• Bond provides an annuity stream of interest
payments and principal payment at maturity
• Cash flows discounted at Y (the yield to maturity)
• Value of Y determined in bond market
• Price of bond equals
• Present value of regular interest payments discounted
by the yield to maturity
• Added to present value of principal (also discounted by
the yield to maturity)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-5
 Valuation of Bonds Continued
n
It Pn
Pb   
t 1 (1  Y ) t
(1  Y ) n

• Pb = Price of bond; It = Interest payments; Pn = Principal

payment at maturity; t = Number corresponding to period
(running from 1 to n); n = Number of periods; Y = Yield to
maturity (or required rate of return)
• Assuming interest payments (It) = $100; principal payments at
maturity (Pn) = $1,000; yield to maturity (Y) = 10%; total
number of periods (n) = 20; price of bonds (Pb):
n
$100 $1,000
Pb   
t 1 (1  0.10 ) t
(1  0 .10) 20

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-6
 Present Value of Interest Payments

• To determine present value of $100 annuity for

20 years with discount rate of 10 percent

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-7
 Present Value of Principal Payment (Par
Value) at Maturity
• Principal payment at maturity used interchangeably with par value or face
value of bond
• Discounting $1,000 back to present at 10 percent

• Current price of bond, based on present value of interest payments and

present value of principal payment at maturity:
Present value of interest payments $851.36
Present value of principal payment at maturity $148.64
Total present value (price) of bond $1,000.00

• Here, price of bond is essentially same as its par, or stated, value to be

received at maturity of $1,000
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-8
 Using Excel’s PV to Calculate a
Bond Price
• Bond values can be found using PV function:

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-9
 Concept of Yield to Maturity
• Yield to maturity, or discount rate, is the
bondholders’ required rate of return
• Three factors influence required rate of return
• Real rate of return
• Demanded for giving up the current use of the funds on a
noninflation-adjusted basis (“rent”)
• Inflation premium
• Compensation for the eroding effect of inflation on the value of
the dollar
• Added to the real rate of return to ensure this doesn’t happen
• Risk premium
• Toward special risks of an investment
• Of primary interest are business risk and financial risk

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-10
 Concept of Yield to Maturity Continued
• Business Risk—Inability of firm to retain competitive
position, stability, growth in its earnings
• Financial risk—Inability of firm to meet debt obligations
when they come due
• Real rate of return 3 percent; inflation premium 4
percent; risk premium 3 percent; overall required rate
of return 10 percent

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-11
 Changing the Yield to Maturity and the
Impact on Bond Valuation
• Assume inflation premium goes up from 4 to 6 percent,
everything else constant

• Present value of interest payments

• $100 annuity for 20 years at 12 percent discount rate

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-12
 Changing the Yield to Maturity and the
Impact on Bond Valuation Continued 1
• Present value of principal payment at maturity
• Present value of $1,000 after 20 years at 12 percent discount rate

• Total present value

• Assumes increased inflation increases required rate of return,
decreases bond price by approximately $150

Present value of interest payments $746.94

Present value of principal payment at maturity $103.67
Total present value (price) of bond $850.61

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-13
 Changing the Yield to Maturity and the
Impact on Bond Valuation Continued 2
• Decrease in inflation premium
• Required rate of return decreases to 8 percent, where 20-year bond with
10 percent interest rate will sell for:

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-14
 Changing the Yield to Maturity and the
Impact on Bond Valuation Concluded

• Decrease in inflation premium cont’d

• Total present value
Present value of interest payments $981.81
Present value of principal payment at maturity $214.55
Total present value, or price, of the bond $1,196.36

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-15
 Table 10-1 Bond Price Table
• As yield to maturity on bond changes from
stated interest rate on bond, price change
increases in size

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-16
 Time to Maturity
• Time to maturity influences impact of change
in yield to maturity on valuation
• Longer maturity means greater impact of
changes in yield
• Amount (premium) above par value reduced as
number of years to maturity decreases
• Amount (discount) below par value reduced with
progressively fewer years to maturity
• Effect of time to maturity on bond price sensitivity

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-17
 Table 10-2 Impact of Time to Maturity
on Bond Prices

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-18
 Figure 10-2 Relationship between Time to
Maturity and Bond Price

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-19
 Determining Yield to Maturity from the Bond
Price

• Yield to maturity (Y) that will equate interest

payments (It) and principal payments (Pn) to
price of bond (Pb)

n
It Pn
Pb   
t 1 (1  Y ) (1  Y )
t n

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-20
 Using Goal Seek in Excel

1. Calculate arbitrary bond price by putting

interest rate in cell D1
2. Open Goal Seek feature
3. Enter reference for cell with bond price
formula in “Set cell” box
4. Type price of bond in “To value” box
5. Enter reference for cell with discount rate in
“By changing cell” box
6. Click “OK”

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-21
 Table 10-3 Excel Functions for YTM

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-22
 Figure 10-3 Finding the Goal Seek Function in
Excel

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-23
 Semiannual Interest and Bond Prices
• 10 percent interest rate may be paid as $50 twice per
year in case of semiannual payments
• To convert
1. Divide annual interest rate by 2
2. Multiply number of years by 2
3. Divide annual yield to maturity by 2
• Assume a 10 percent, $1,000 par value bond has 20-
year maturity, annual yield 12 percent
1. 10%/2 = 5% semiannual interest rate; 5% × $1,000 = $50
semiannual interest
2. 20 × 2 = 40 periods to maturity
3. 12%/2 = 6% yield to maturity, expressed on semiannual
basis

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-24
 Valuation and Preferred Stock
• Preferred stock represents perpetuity, having
no maturity date
• Fixed dividend payment carrying a higher order of
precedence than common stock dividends
• No binding contractual obligation of interest on
debt
• Does not have
• Ownership privilege of common stock
• Legal provisions that could be enforced on debt

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-25
 Valuation and Preferred Stock Continued

Dp Dp Dp Dp
Pp     ... 
(1  K p ) 1
(1  K p ) 2
(1  K p ) 3
(1  K p ) 
• PP = price of preferred stock; DP = annual dividend for preferred stock (a
constant value); KP = required rate of return (discount rate) applied to
preferred stock dividends
Dp
• More usable formula Pp 
Kp
• Assuming $10 annual dividend and stockholder requires 10 percent rate of
return, price of the preferred stock is:
Dp $10
Pp = = =$100
K p 0.10

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-26
 Valuation and Preferred Stock Concluded

• If rate of return required by security holders changes, value of

preferred stock also changes
• Longer period of investment = greater impact of change in
required rate of return
• With perpetual security the impact is at a maximum
• Assuming required rate of return has increased to 12 percent,
value of preferred stock is:
Dp $10
Pp = = =$83.33
K p 0.12
• If required rate of return reduced to 8 percent, value of
preferred stock is:
Dp $10
Pp = = =$125
K p 0.08
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-27
 Determining the Required Rate of Return
(Yield) from the Market Price

• Assuming the annual preferred dividend (Dp) is $10 and the

price of the preferred stock (Pp) is $100, the required rate of
return (yield) is: D $10 p
Kp    10%
Pp $100

• A higher market price provides quite a decline in the yield

$10
Kp   7.69%
$130
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-28
 Valuation of Common Stock
• Interpreted by shareholder as present value of
expected stream of future dividends
• Ultimate value of holding lies with
• Distribution of earnings in form of dividend
payments
• Earnings must be translated into cash flow for
stockholder

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-29
 Dividend Valuation Model
D1 D2 D3 D
P0     ... 
(1  K e ) (1  K e ) (1  K e )
1 2 3
(1  K e ) 
• Where,
• P0 = Price of stock today;
• D = Dividend for each year;
• Ke = Required rate of return for common stock (discount rate)
• Generally applied (with modifications) to three different
situations
1. No growth in dividends
2. Constant growth in dividends
3. Variable growth in dividends

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-30
 No Growth in Dividends
• Common stock pays constant dividend as in preferred stock
• No-growth policy does not hold much appeal for investors
D1
P0 
Ke
• P0 = Price of common stock today
• D1 = Current annual common stock dividend (constant)
• Ke = Required rate of return for common stock
• Assuming D1 = $1.87 and Ke = 12 percent, price of stock is:
$1.87
P0   $15.58
0.12

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-31
 Constant Growth in Dividends

• General valuation process

D0 (1  g )1 D0 (1  g ) 2 D0 (1  g )3 D0 (1  g ) 
P0     ... 
(1  K e )1
(1  K e ) 2
(1  K e ) 3
(1  K e ) 

• P0 = Price of common stock today

• D0 (1 + g)1 = Dividend in year 1, D1
• D0 (1 + g)2 = Dividend in year 2, D2, etc.
• g = Constant growth rate in dividends
• Ke = Required rate of return for common stock (discount rate)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-32
 Constant Growth in Dividends
Continued
• Assume:
• D0 = Last 12 month’s dividend (assume $1.87)
• D1 = First year, $2.00 (growth rate, 7%)
• D2 = Second year, $2.14 (growth rate, 7%)
• D3 = Third year, $2.29 (growth rate, 7%) etc.
• Ke = Required rate of return (discount rate), 12%

$2.00 $2.14 $2.29 Infinite dividend

P0     ... 
1 2
(1.12) (1.12) (1.12) 3
(1.12) 

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-33
 Constant Growth Dividend
Valuation Model
• The formula shown can be modified to a simple form if
1. The firm has a constant dividend growth rate (g)
2. The discount rate (Ke) exceeds the growth rate (g)

D1
P0 
• Where
Ke  g
P0 = Price of the stock today
D1 = Dividend at the end of the first year
Ke = Required rate of return (discount rate)
g = Constant growth rate in dividends
• Based on the current example: D1 = $2.00; Ke = .12; g = .07; P0 is computed as
D1 $2.00 $2.00
P0     $40
K e  g 0.12  0.07 0.05
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-34
 Stock Valuation Based on
Future Stock Value
• To know present value of investment
• Assume stock held for three years then sold
• Adding present value of three years of dividends and
present value of stock price after three years gives
present value of benefits
• The appropriate formula

D4
P3 
Ke  g

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-35
 Determining the Required Rate of
Return from the Market Price
• Determining required rate of return, knowing first year’s dividend
(D1), stock price (P0) , and growth rate (g)

Assuming
• Ke = Required rate of return (to be solved)
• D1 = Dividend at end of first year, $2.00
• P0 = Price of stock today, $40
• g = Constant growth rate 7%

$2.00
Ke   7%  5%  7%  12%
$40
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-36
 Determining the Required Rate of Return
from the Market Price Continued
• Stockholder receives current dividend plus anticipated
growth in future
• If dividend yield low, the growth rate must be high to provide
necessary return
• If growth rate low, a high dividend yield will be expected

• First term represents dividend yield stockholder will receive

• Second represents anticipated growth in dividends, earnings,
and stock price

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-37
 The Price-Earnings Ratio Concept
and Valuation
• Multiplier applied to current earnings to
determine value of share of stock in the
market
• Influenced by
• Earnings and sales growth of firm
• Risk (or volatility in performance)
• Debt-equity structure of firm
• Dividend policy
• Quality of management

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-38
 Table 10-4 Quotations from Barron’s

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-39
 Variable Growth in Dividends
• In evaluating firm with initial pattern of supernormal
(very rapid) growth for a number of years
• Take present value of dividends during exceptional growth
period
• Determine price of stock at end of supernormal growth
period by taking
• Present value of normal, constant dividends that follow
supernormal growth period
• Discount the price to the present
• Add to present value of supernormal dividends
• This gives current price of stock

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-40
 Variable Growth in
Dividends Continued
• Approach 1 (though no dividends paid currently)
• Stockholders will be paid cash dividends at later date
• Present value of deferred payments may be used
• Approach 2 (no cash dividends)
• Take present value of earnings per share for several
periods
• Add to present value of future anticipated stock price
• Discount rate applied to future earnings generally higher
than discount rate applied to future dividends

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-41
 Figure 10A-1 Stock Valuation Under
Supernormal Growth Analysis

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 10-42