CHAPTER 4
Value- Driven Management
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

The goal of managerial finance is to maximize
the value of the firm.

It is critical to understand the valuation process
so we know what affects the value of the firm.

Price: refers to an amount of money per unit of
measure at which someone buys, or is willing
to buy or sell.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

Value: is used to mean the price that would
exist in a market that is perfect based on
the information set currently available to
Investors.
 Intrinsic
Value
Intrinsic Value: is the value that would
exist If all potential investors had the same
information that was available to the
person determining the intrinsic value.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
The intrinsic value is the true worth of a
security which may differ from the market
price.
 Intrinsic value can be estimated but can
never be observed.


intrinsic value is based on the present value of
the cash flows the asset is expected to
produce in the future.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
0
K%
1
2
n-1
n
^
CF1
^
CF2
^
CFn-1
^
CFn
PVCF1
PVCF2
PVCFn-1
PVCFn
Value
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Wealth is created by acquiring assets that
have values in excess of their costs.
(PV of expected cash flows exceeds the cost or
the initial investment)
2. Such assets are acquired through competitive
advantage.
1.
3. Competitive advantage + Time value of money
provide the basis for value creation- Arbitrage
pricing principal.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Arbitrage Valuation

Arbitrage is the process of increasing
benefits without increasing costs or risk by
taking advantage of market imperfection.

The arbitrage pricing principal (APP) states that
Identical streams of cash flows will have
identical prices.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Assets A and B have identical streams of
future benefits:
Asset A
Asset B
$1,000
Not worth
more than
$1,000
If B is offered at a price below $1,000,
Holders of A cannot sell their assets For
$1,000 in order to buy asset B.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

The Sum of the Parts Equal the Whole
Year1
$100.00
$100.00
0
X
Y
Z
Year2
$200.00
0
$200.00
∑= CFt / i+k
At k= 10 percent:
PV(Y) = $100/1.1= $90.1
PV(Z) = $200/(1.10) = $165.29
PV(X) = $100/1.1 + 200/1.10=$90/91+$65.29=$256.20
PV(Y+Z) = $90.91 + $165.29 = $256.20 = PV(X)
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

For arbitrage pricing pressures to be
effective, it is necessary that financial
=0
markets meet specific standard of perfection
(see page 104)

If financial markets are perfect, they will also
be informationally efficient.

Markets could be informationaaly efficient
without being perfect.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Value of Bonds
 A bond is a long-term debt instrument issued
by a business or governmental unit.
 Bonds are typically in $1,000 denominations.
 The bond provides a promise to pay a fixed
interest payment on the $1,000 face value, and
a promise to repay the face value at the maturity
date specified in the bond contract.
 Bonds can be bought and sold in the bonds
markets prior to maturity
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

The value of a bond is found as the present
value of an annuity ( the interest payments)
plus the present value of a lump sum ( the
principal).

The bond is evaluated at the appropriate
periodic interest rate ( market rate) over the
number of periods for which interest payments
are made.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Sunshine corporation bonds maturing in two
years has a coupon rate of 8%. The interest is
paid every six monthly. What is the price of the
bond if the opportunity cost of money is 4
percent. What is the price if the opportunity
cost of money is 3 percent.
PV( at 4 percent) = $40.00PVIFA14perid,4% +
$1,000xPVIF4,4% =$1,000
PV (at 3 percent) =$40.00PVIF14periods,3% +
$1,000xPVIF4,3%=$1,037.18

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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Yield to Maturity
YTM is the interest rate that would be earned by
a bondholder who bought the bond at the current
price and held it until maturity.
 YTM is the discount rate that causes the
present value of the future payments to equal the
price.
 From previous example:
 YTM = 4% at market price of $1,000, and
YTM = 3% at market price of $1,037.17

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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Market price of the bond and the Yield to
Maturity:
 If the market price of the bond is greater than
$1,000, t he yield to maturity is less the
coupon rate
 If the market price of the bond is less than
$1,000, the yield to maturity is greater than
the coupon rate.
 If the market price is $1,000 the yield to
maturity is the same as the coupon rate
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
If the coupon rate is 8 percent and sold to
yield 3% YTM each six-months, with
interest paid semiannually. Then the
Effective Annual interest rate is:
K = (1 + .03)2 -1 = 1.0609 -1 = .0609 = 6.09%
Bonds are quoted as a number of points
out of 32. A bond with a price of 103 23/32
= 103.71875 percent of the par value
= $1,000x103.71875% = $1,037.19
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
 Bond
prices are affected by the time until
the next interest payment.
If the price of the bond is $1,037.17. The
YTM is 3 percent, and the next interest
payment for the company is only 4 month
away instead of six months, all payments
are moved closer by a third of a 6- months,
so the value of the bond increases to:
$1,037.17 (1.03)1/3 = $1,047.44
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Some Alternativ Yield Definitions
 Yield to Maturity: interest rate that would be
earned by a bondholder who bought the
bond at the current price and held it until
maturity.
 Coupon Rate: annual interest payment
divided by face value
 Current Yield: annual interest payment
divided by current price
 Yield to Call: interest rate that would be
earned by a bondholder who bought the
bond at the current price and held it until it
was called
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Value of Stock
Stock value = ∑ Dt /(1+k)t
t=1
Stock value = D1 / k………. Zero growth
model
Stock value = D1 / (k- g) … Constant growth
model
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
The Value of the Preferred Stock is:
Dividend/ required return = Dpf /k
If the preferred stock of XYZ corporation pays
an annual dividend of $1.70 , and investments
of similar risk pay an expected return of 6.77
percent, the value of the preferred stock is:
D / k = $1.71/.0677 = $25.11
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Valuation of Common stock of Disney
Price was $125 a share in 1998
 Dividends were forecast to be $0.7 a share
in 1999
 Required rate of return = 15 percent
 Growth in dividends = 0.1444 percent

Value of the stock = D1 /k- g
= $.70/(.15-0.1444) =$125
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
D1
$ 0.70
X .8696
D2
D3
0.80
0.92
x.7561
x.6575
D4
D5
D6
1.05
1.2
1.37
x.5718
x.4972
PVD1
PVD2
PVD3
PVD4
PVD5
=$3
P0= $125, P5= $1.37/(0.15-0.1444) = $245
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
The investors who bough at $125, received 5
years of dividends, and sold at $245, only
earned the 15 percent rate that could have
been expected elsewhere.
Superior returns would occur if the price
rose to more than $245 in 5 years, either
because dividend forecasts had been revised
upward or the rate that could be earned
elsewhere had declined.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

Sources of Change in Stock Price
Change in
expected
dividends
Change in
Stock price
News about the company
or economy in general
Change in
Alternative
opportunities
Change in
required return
Change in the
Company’s riskiness
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Value of Investment Opportunities
A company is viewed as:
 a set of existing investments and
 a set of potential investment opportunities
In the absence of other investment
opportunities:
The value of the company = the present
Value of future dividends
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
If the company has additional investment
Opportunities The value of the company will
increase by the present value of those
investment opportunities.
Vcomp = PV (future dividends) + PV of future
investment
opportunities
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
The value of the company is independent of
whether equity needed to finance those
opportunities will come form:
a. retention of earnings or
b. sale of additional stock
Example on page 113- Delta Corporation
 Net income = $100,000
 Shares outstanding= 100,000
 Dividends= $1/share ( no investments opp.)
 Investors’ opportunity cost = 10 percent
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Value of the company = $1/.10 =$10.00
 The company discovers a new investment
opportunity that requires $50,000 a year from
Now.
 The opportunity will earn additional income of
$10,000 a year after ( available to distribute as
dividends).
 NPV ( one year from now) =
$10,000/.10 – $50,000 = $50,000.
 Present value (PV) of the opportunity today
= $50,000/1.10=$45,455.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
0
Y1
Y2
Investment
opportunity
Costs $50,000
PV = $50,00/1.10
= 45,455
= $0.45 per share
The value of stock will
increase by $0.45 to $10.45
Additional
Income of
$10,000,
NPVopp. =
paid out as
$10,000/.10 -$50,000 dividends
=$50,000
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Scenario A: Delta get the needed equity
($50,000) by reducing dividends first years
Year
Income
Div/share
PV factor
Present value
1
$100,00
$0.5
0.9091
$0.45
2
$110,000
$1.10
9.0909*
$ 10.000
Total
$10.45
* = (1/0.1)/1.10
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

Scenario B: Delta wants to maintain its
dividend and sell additional shares at the end
of the first year, immediately
after the
dividend payment, to get the equity needed
for the new investment.
Y0
Y1
Y2
D2+
Sn = $50,000/P1
P1 = D2+ /.10
Number of shares Sn =
$50,000/P1
P1 = D2+ /.10
D2+ =$110,000/100,000 +Sn
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
P1 = $50,000/Sn = D2+ /.10 =
 ($110,000/100,000 + Sn)/.10 = $50,000/Sn
 $5,000/Sn = $110,000/(100,000 + Sn)
 110,000Sn = 500,000,000 + 5,000Sn
105,000Sn = 500,000,000,
 Sn = 4,762 shares
 D2+ = $1.05
 P1 = $10.50
 Value of the share today = (P0) =
($10.50 + $1.00)/1.1 = $10.45

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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Economic Profit and Wealth
Wealth Creation is :
 The present value of future investment
opportunities and
 The present value of economic profit
created by investment opportunities
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
$50,000 of new equity at the end of Y1
generated cash flow of $10,000 a year for
equity holders forever
 At a 10% required return, the annual
economic profit in Y2 and beyond is:

Annual cash flow
Normal profit (.10x $50,000)
Economic profit
$10,000
5,000
$5,000
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
What if Investors Do Not Know?
 No investment = P0 = $10/share
 The company announce a New investment
of $50,000 to provide $10,000 a year
 The intrinsic value at the end of year 1 is
$10.5/share
Y1
Y2
$10, $10.5
Investors are not well informed about
the new investments and the stock is
actually selling for $4.00 a share
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Scenario A
Drop the plan ( P=$10)
Scenario B
the number of new
shares Sn @Y1 =
$50,000/4 =12,500 Shs
D2+ =
$110,000/(100,000
+12,500) = $0.98
The intrinsic value at the end of year1 declines
to $0.98/.10 = $9.80.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Wealth and Value
Y1
Y2
$50,000
$3,000 a year for ever
Equity investment
NPV=$3,000/.10- $50,000
= -$20,000
D1 = $.50
D2+ =$1.03
P1 = $1.03/0.1= $10.30
P0 = $(10.30 +$.50)/1.10 = $9.82
Price increased, value increased , and wealth decreased.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Stock Splits and Stock Dividends

Stock splits: a method commonly used to
lower the price of a firm’s stock by
increasing the number of shares belonging
to each shareholder.

Stock dividends: the payment to existing
owners of a dividend in the form of stock.

Stock splits and stock dividends both have no
effect on the firm’s capital structure.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Why do companies engage in stock splits
and dividends if they achieve nothing?
Making the stock available to more
investors.
 Stock splits and stock dividends provide
a signal that management expects the
company to increase its
competitive
advantage in the future.
 Some investors believe that they receive
something of value.

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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
 Value
of Currency
The value of currency provides another
example of arbitrage pricing principals at
work
Tow important factors affecting the exchange
rates between currencies:
 Purchasing power parity
 Interest arte power parity
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management

Purchasing power parity (PPP)
PPP states that
equilibrium exchange rates
between two countries will result in identical goods
selling at identical prices
BIG Mac (UK)
BIG Mac (US)
£1.1
$1.54
Price of the pound = $1.54/1.1 = $1.4/1 £
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
If inflation is 20% in Uk , and 10% in US, then
BIG Mac (UK)
£1.32 (1.1 x1.2)
BIG Mac (US)
$1.694 (1.54 x1.1)
Price of one pound =
$1.694/ £ 1.32 = $1.2833/ £1
Forward rate = Spot rate(1+INFd/(1+INFf)
= 1.4 (1+.1)/ (1+.2) =1.4(1.1)/(1.2)
= $1.2833/ £ 1.
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
 Interest
Rate Parity Theory (IRP)
IRP predicts a specific relationship between
spot exchange rates, forward exchange
rates, and interest rates.
IR(GB) >IR (USA)
a. Convert dollar into pounds and buy the
pound-denominated securities
b. Enter into a future contract to repurchase
dollars at the maturity date for the pounddenominated security
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Rforeign = (ERSpot / ERForeard ) (1+ RDDomestic ) -1
If:
a. Spot exchange rate= $1.40/ £
b. 1-year forward contract rate=$1.2833/ £
Risk-free interest rate in dollar-denominated
security = 12.2 percent,
then equilibrium rate in pound- denominated
securities is:
Rforeign = (1.40/1.2833)(1+.122) -1 = 22.4%
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management
Government Intervention
Driving exchange rates out of purchasing
power equilibrium.
If US FRB. decreases the money supply,
driving interest rates up t0 14%. For IRP to
hold, it is necessary for the spot rate to
change as follows:
0.224= (ERSpot /1.2833)(1+.14) -1;
ERSpot = $1.378/ £
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AL-SALEH -FIN 421 Chapter 4 Value-Driven Management