CH 02

Chapter 2
Concepts in Valuation
®2002 Prentice Hall Publishing

1
The Time Value of Money
•One of the most important principle in finance
$1 today
Relationship
$1 future
2
Compound Interest
• Mathematics of finance
• Interest earned on interest
• Terminal values (future values)
– The value at some future time
– Tables of terminal values

3
Compounding
• Annual
• Quarterly
• Infinite
– e is approximately 2.71828
• More compounding in a year results in a
higher terminal value

4
Present Value (PV)
• A future amount discounted to the present
by some required rate
• One period
• Beyond one period

5
PV of an Annuity
• A series of even cash flows
• PV tables
• Relationship between PV and the discount
rate k
– As k increases, PV decreases
– Relationship is not linear
– Value decreases at a decreasing rate
6
Amortizing a Loan
• The reduction of a loan’s principal through
equal payments
• Payments embrace both interest and

principal
• Payment determination

7
PV When Interest is
Compounded More Than Once
a Year
• As the compounding interval shortens, PV

decreases at a decreasing rate

8
Internal Rate of Return (IRR)
or Yield
• The discount rate r that equates the PV of
expected cash outflows
n
At

t 0 (1  r ) t
– At is the cash outflow or inflow for period t
– n is the last period
– r is the discount rate
9
Bond Returns
• Pure discount(zero coupon) bonds
• Coupon bonds

10
Pure Discount (Zero Coupon) Bonds
• Make a single payment at a specified date
• Payment = Face value 100
P
• PV of a zero coupon bond r 2n
(1  )
– P is the present market price 2
– r is the yield to maturity
– n is the maturity
– Use semiannual compounding
– Face value = $100

11
Coupon Bonds
• Pay interest payments
• Final principal payment = Face value
• Yield to maturity
C/2 C/2 C/2 FV

P   ...  
 r  2 r
2n 2n
r    r
– P is1 the
 present
2  1  market
 price
1   1  
2  2  2
– C is the annual coupon payment
– n is the number of years to maturity
– FV is the face value

12
Four Factors
Coupon rate Final Maturity
Market price Yield to maturity

13
Relationship Between
Price and Yield
• Discount (market price < face value)
– Yield > coupon rate
• Premium (market price > face value)
– Yield < coupon rate
• Face value = market price
– Yield = coupon rate

14
Holding-Period Return
• The rate of discount that equates the PV of
interest payments plus the PV of terminal
value at the end of the holding period with
the price paid for the bond

15
Perpetuities
• A fixed cash inflow expected at equal
intervals forever
• Examples
– British consol
– Preferred stock

16
Duration
• Weighted average time to the interest and
principal payments
• Higher the coupon rate the less the duration, all
else equal
• Zero coupon
– Duration equals maturity
• Coupon bonds
– Duration is less than maturity

17
Return from a Stock
Investment
• Features of common stock
• Return on investment
• Dividends
• Discount models
• Growth phases
• Price/earnings (P/E) horizon value
• Measuring risk
18
Features of Common Stock
• Authorized shares • Book value
• Outstanding shares • Market value
• Treasury stock • Liquidating value

19
Return on Investment
• One-period return
Dividends  Ending price - Beginning price 
r
Beginning price
• Two-period return
2
Dt P2
P0   1  r   1  r 
t 1
t 2
• Multiple holding periods


Dt
P0   1  r 
t 1
t

20
Are Dividends the Foundation?
• Yes
• Sum of distributions by a company
– Regular cash dividends
– Liquidating dividends
– Share repurchase

21
Discount Models
• Perpetual growth
• Growth phases
• Assuming a price/earnings horizon value

22
Perpetual Growth Model
• Constant growth rate
• Assuming r is greater than g
• P0 = D1/(r - g)
• D1 = D0(1 + g)

23
Retained Earnings and
Dividend Growth
• If expected ROE is constant over time
– g = b x ROE
– ROE is the return on equity

– b is a constant retention rate

24
Growth Phases
• Nonlinear growth
• Summing the parts

– In a multiphase situation
• Approximation model for three-phase

growth
25
P/E Horizon Value
• Assuming a P/E ratio at the horizon
• Multiplying EPS by P/E
• Disaggregate dividends
– EPS
– Dividend-payout ratio
26
Measuring Risk: Standard
Deviation
• Security risk is greater with
– Larger magnitudes of deviation
– Higher probabilities of deviations
• Probability distribution parameters

– Expected return
– Standard deviation
27
Use of Standard Deviation
Information
• Discrete probability distributions
• Continuous distributions
• Normal distributions
• Dispersion
– Reflects the degree of the investor’s
uncertainty
• Expected utility
28

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Chapter 2

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

• Beyond one period

®2002 Prentice Hall Publishing

• Payments embrace both interest and

®2002 Prentice Hall Publishing

• As the compounding interval shortens, PV

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

C/2 C/2 C/2 FV

®2002 Prentice Hall Publishing

Market price Yield to maturity

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

• Outstanding shares • Market value

• Treasury stock • Liquidating value

®2002 Prentice Hall Publishing

• Multiple holding periods

®2002 Prentice Hall Publishing

®2002 Prentice Hall Publishing

• Assuming a price/earnings horizon value

®2002 Prentice Hall Publishing

• Assuming r is greater than g

®2002 Prentice Hall Publishing

– ROE is the return on equity

®2002 Prentice Hall Publishing

• Summing the parts

• Approximation model for three-phase

• Multiplying EPS by P/E

• Probability distribution parameters

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