CHAPTER
TEN
Valuation and Rates of
Return
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Foundations of Financial PPT 10-1
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Figure 10-1 / The relationship between time value of money,
required return, cost of financing, and investment decisions
Chapter 10
Required rates of
return by investors
Chapter 9
Present
value
concepts
Chapter 11
Chapters 12 and 13
Cost of
financing
to the firm
Analysis of
projects based
on cost of financing
to the firm
Valuation
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Table 10-1
Bond price table
(10 Percent Interest Payment, 20 Years to Maturity)
Yield to Maturity
Bond Price
2% . . . . . . . . . . . . $2,308.11
4 . . . . . . . . . . . . 1,815.42
6 . . . . . . . . . . . . 1,458.80
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7
8
9
. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . .
1,317.82
1,196.36
1,091.29
10
11
12
. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . .
1,000.00
920.37
850.61
13
14
16
. . . . . . . . . . . .
. . . . . . . . . . . .
. . . . . . . . . . . .
789.26
735.07
644.27
20
25
. . . . . . . . . . . .
. . . . . . . . . . . .
513.04
406.92
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Table 10-2
Impact of time to maturity on bond prices
Time Period
in Years
(of 10 percent bond)
Bond Price with
8 Percent Yield
to Maturity
Bond Price with
12 Percent Yield
to Maturity
0
1
5
. . . . . . . .
. . . . . . . .
. . . . . . . .
$1,000.00
1,018.52
1,079.85
$1,000.00
982.14
927.90
10
15
20
. . . . . . . .
. . . . . . . .
. . . . . . . .
1,134.20
1,171.19
1,196.36
887.00
863.78
850.61
25
30
. . . . . . . .
. . . . . . . .
1,213.50
1,225.16
843.14
838.90
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Figure 10-2
Relationship between time to maturity and bond price*
Bond Price ($)
Assumes 8% yield to maturity
1,300
1,200
1,100
10% bond, $1,000 par value
1,000
900
800
Assumes 12% yield to maturity
700
30
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25
15
5
Number of years to maturity
0
* The relationship in the graph is not symmetrical in nature.
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Table 10-3
An example of stock quotations from the Globe and Mail
Source: ILX Systems, a division of Thomson Information Services Inc.
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Stock valuation under supernormal growth analysis
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Chapter 10 - Outline
LT 10-1
• Valuation Concepts
• 3 Factors that Influence the Required Rate of
Return
• Valuation of Bonds
• Relationship Between Bond Prices and Yields
• Preferred Stock
• Valuation of Common Stock
• Valuation Using the Price-Earnings Ratio
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Valuation concepts
LT 10-2
• Value or price of a stock or bond is based upon the present
value of future cash flows to the investor
• Discount rate used is investors’ required rate of return,
based on the market’s estimates of risk, efficiency, and
expected future returns
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3 Factors that Influence the
Required Rate of Return
LT 10-3
Real Rate of Return:
– represents the opportunity cost of the investment
– in the early 1990’s, 5-7%, but now about 3-4%
Inflation Premium:
– a premium to compensate for the effects of inflation
– lately, 2%
Risk Premium:
– a premium associated with business and financial risk
– typically, 2-6%
So, the Required Rate of Return equals:
– Real Rate of Return + Inflation Premium + Risk
Premium
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Valuation of Bonds
LT 10-4
The value of a bond is made up of 2 parts:
– PV of the interest payments (an annuity)
– PV of the principal payment (a lump sum)
The principal payment at maturity:
– can also be called the par value or face value
– is usually $1,000
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The interest rate used:
– is the yield to maturity or discount rate
– is also the required rate of return
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Relationship Between
Bond Prices and Yields
LT 10-5
• Bond prices are inversely related to bond yields (move in
opposite directions)
• As interest rates in the economy change, the price or value
of a bond changes:
– if the required rate of return increases, the price of the
bond will decrease
– if the required rate of return decreases, the price of the
bond will increase
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Valuation of Preferred Stock
LT 10-6
Preferred stock:
– usually represents a perpetuity (something with no
maturity date)
– has a fixed dividend payment
– is valued without any principal payment since it has no
ending life
– is considered a hybrid security
– owners have a higher priority than common
shareholders
– price is based upon PV of future dividends
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Valuation of Common Stock
LT 10-7
• The value of common stock is the present value of a stream
of future dividends
• Common stock dividends can vary, unlike preferred stock
dividends
• There are 3 possible cases:
– No growth in dividends (valued like preferred stock)
– Constant growth in dividends
– Variable growth in dividends
• Required rate of return reflects the dividend yield on the
stock and the expected growth rate in the dividend
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Valuation Using the
Price-Earnings Ratio
LT 10-8
• The Price-Earnings (P/E) ratio can also be used to value
common stocks
• The P/E ratio is influenced by many factors:
– the earnings and sales growth of the firm
– the risk (or volatility in performance)
– the debt-equity structure
– the dividend policy
– the quality of management
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• Average P/E ratio for TSE 300 in early 1999 was 27 to 1
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High vs. Low P/Es
LT 10-9
A high P/E ratio:
– indicates positive expectations for the future of the
company
– means the stock is more expensive relative to earnings
– typically represents a successful and fast-growing
company
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A low P/E ratio:
– indicates negative expectations for the future of the
company
– may suggest that the stock is a better value or buy
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