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What Is The Time Value Of Money?

The principle of time value of money the notion that a given sum of money is
more valuable the sooner it is received, due to its capacity to earn
interest is the foundation for numerous applications in investment
finance.
The Five Components Of Interest Rates
Real Risk-Free Rate This assumes no risk or uncertainty, simply
reflecting differences in timing: the preference to spend now/pay back
later versus lend now/collect later.
Expected Inflation - The market expects aggregate prices to rise, and
the currency's purchasing power is reduced by a rate known as the
inflation rate. Inflation makes real dollars less valuable in the future and
is factored into determining the nominal interest rate (from the
economics material: nominal rate = real rate + inflation rate).
Default-Risk Premium - What is the chance that the borrower won't
make payments on time, or will be unable to pay what is owed? This
component will be high or low depending on the creditworthiness of the
person or entity involved.
Liquidity Premium- Some investments are highly liquid, meaning they
are easily exchanged for cash (U.S. Treasury debt, for example). Other
securities are less liquid, and there may be a certain loss expected if it's
an issue that trades infrequently. Holding other factors equal, a less

Nominal Interest Rate: Rate at which money invested grows.


Real interest rate = nominal interest rate inflation rate
Real Interest Rate: Rate at which the purchasing power of an investment increases.
The real rate of interest is calculated by
1 + real interest rate =

1 + nominal interest rate

____________________
1 + inflation rate
Effective Annual Interest Rate: Interest rate that is annualized using compound interest.
Theeffective annual yield represents the actual rate of return, reflecting all of the compounding
periods during the year. The effective annual yield (or EAR) can be computed given the
stated rate and the frequency of compounding.
Effective annual rate (EAR) = (1 + Periodic interest rate)m 1
Where: m = number of compounding periods in one year, and
periodic interest rate = (stated interest rate) / m
Example:Effective Annual Rate
Suppose we are given a stated interest rate of 9%, compounded monthly, here is what we
get for EAR:
Annual Percentage Rate (APR): Interest rate that is annualized using simple interest rate.
The effective annual rate is the rate at which invested funds will grow over the course of a
year. It equals the rate of interest per period compounded for the number of periods in a
year.
Keep in mind that the effective annual rate will always be higher than the stated rate if there

Future Value:
Definition: The value to which a beginning lump sum or Present Value (PV) will grow in a certain
number of periods, n, at a specified rate of interest, i.
Formula:
FV = PV (1 + i)n
Where: i = the stated rate of interest
n = number of years
(1 + i)n = the future value interest factor
Compound Interest: Interest earned on interest.
Simple Interest: Interest earned only on the original investment; no interest is earned on interest.
Example: In six years, Frank will be eligible for membership in the elite Flat lounger Club. A lifetime
membership will cost him $14,000. Frank currently has $11,000 in a savings account that
pays an annual interest rate of 4.2 percent. In six years, will he have enough money in the
account to pay his membership fees?
When compounding occurs more than once a year
Example: Jane has inherited $4,500 dollars, and she has decided to deposit it in her savings
account for six months before she decides how to spend/invest it. If Janes savings account
pays 3 percent compounded monthly, how much money will she have in six months?
Compound growth means that value increases each period by the factor (1 + growth rate).
The value after t periods will equal the initial value times (1 + growth rate)t. When money is
invested at compound interest, the growth rate is the interest rate.

Present Value: A dollar today is worth more than a dollar tomorrow.


The time line in the future and look back toward time 0 to see what was the beginning
amount.
Formula: PV= FV / ( 1+ r )n
Discount Rate: Interest rate used to compute present values of future cash flows.
Example: If I promised to give you one million dollars 50 years from now, what would it be
worth today if the discount rate is 15 percent compounded annually?
When compounding occurs more than once a year
Example : In our previous example, I asked what a million dollars would be worth 50 years from
now at 15 percent compounded annually. What would it be worth if the discount rate
were 15 percent compounded semiannually?
Example: Will Williams grandmother always gives him $200 on his birthday which is nine
months away. Will needs the money now in order to buy his finance text. Fred
Fredrickson has agreed to lend Will some money at 18 percent compounded quarterly. If
Will plans to pay back Fred in nine months with his birthday money, how much can he
borrow from Fred now?
Example: If you borrow $10,000 today and pay back $12,167 at end of 5 years what rate of
interest did you pay on the loan?
Example: Suppose you invest $2,000 at 4.5% and want your investment to grow to
$4,205. How long will it take?
Recall from your math classes that ln(xn)= n ln(x)

Annuity: Equally spaced level stream of cash flows.


Perpetuity: Stream of level cash payments that never ends.
Present Value of a Perpetuity
A perpetuity starts as an ordinary annuity (first cash flow is one period from today) but
has no end and continues indefinitely with level, sequential payments
PV of a perpetuity =
annuity payment A
interest rate r
Example: perpetuity paying $1,000 annually at an interest rate of 8% would be worth?
Present value of t-year annuity = payment annuity factor
Future Value Annuity Factor = (1 + r)n - 1
r
Present Value Annuity Factor = 1 -1

(1 + r)n

r
Annuity Due: Level stream of cash flow starting immediately.

Saving for Retirement


In only 50 more years, you will retire. (Thats rightby
the time you retire, the retirement age will be around 70
years. Longevity is not an unmixed blessing.) Have you
started saving yet? Suppose you believe you will need to
accumulate $500,000 by your retirement date in order to
support your desired standard of living. How much must
you save each year between now and your retirement to
meet that future goal? Lets say that the interest rate is
10 percent per year. You need to find how large the
annuity in the following figure must be to provide a future
value of $500,000:

We know that if you were to save $1 each year your funds would
accumulate to
Future value of annuity of $1 a year = (1 + r)t 1 = (1.10)50 1
_________
__________
= $1,163.91
r
0.10
Therefore, if we save an amount of $C each year, we will accumulate $C
1,163.91.
We need to choose C to ensure that $C 1,163.91 = $500,000. Thus C =
$500,000/1,163.91 = $429.59. This appears to be surprisingly good news.
Saving
$429.59 a year does not seem to be an extremely demanding savings
program. Dont
celebrate yet, however. The news will get worse when we consider the

Problems

Assume that it is now January 1, 1997 and you will need $ 1,000 on January 1,
2001. Your bank compounds interest at an 8% annual rate.
How much must you deposit on January 1, 1998, to have a balance of $
1,000 on January 1, 2001?
If you want to make equal payments on each January 1 from 1998 through
2001 to accumulate the $ 1,000, how large must each of the 4 payments
be?
If you have only $ 750 on January 1, 1998, what interest rate, compounded
annually, would you have to earn to have necessary $ 1,000 on January 1,
2001?
Suppose you can only deposits the stream of payments only $ 186.29 each
January 1 from 1998 through 2001, but you still need $ 1,000 on January 1,
2001. What interest rate compounded annually must you seek out to
achieve your goal?

Strategic Financial
Management
Bond Valuation

A bondindenture is the contract between a bondholder and the issuer.It is


a legal document that states what the issuer can and cannot do, and
states the bondholders rights.Since there tends to be a ton of legalese
involved, the contract is managed by the corporate trustee who polices
the actions of the issuer to ensure the rights of the bondholder are upheld.

Within the indenture, there are affirmative and negative covenants:


Affirmative Covenants
Affirmative covenants are what the issuer promises to do for the investor.
These promises include things such as paying interest and principle in a
timely manner; paying taxes and other expenses when due; maintaining
the assets backing the bond and issuing reports to the trustee to
ensurecompliance.

Negative Covenants
Negative convents are the restraints put on a borrower.These restraints
include issuing additional securities or taking on additional debt that may
harm the current bondholders.This is generally done without meeting
certain tests and/or ratios or receiving permission from the current
bondholders.

Basic Features of Bonds

Governments and corporations borrow money by selling bonds to


investors. Security that obligates the issuer to make specified
payments to the bondholder.
1.Maturity
2.Par Value
3.Coupon Rate
4.Redemption
5.Currency Denomination
6.Options Granted to the Issuer or Investors
Maturity
Maturity is the time at which the bond matures and the holder receives the
final payment of principal and interest.The term to maturity is the amount
of time until the bond actually matures.
There are 3 basic classes of maturity:
A. Short-Term Maturity One to five years in length
B.Intermediate-Term Maturity Five to twelve years in length
C.Long-Term Maturity Twelve years or more in length
2.Par Value
Par value is the dollar amount the holder will receive at the bond's maturity.It
can be any amount but is typically $1,000 per bond.Par value is also known
as principle, face, maturity or redemption value.Bond prices are quoted as a
percentage of par.

Example: Premiums and Discounts


Imagine that par for ABC Corp. is $1000, which would =100.If the ABC
Corp. bonds trade at 85 what would the dollar value of the bond
be?What if ABC Corp. bonds at 102?
Answer:
At 85, the ABC Corp. bonds would trade at a discount to par at $850.If
ABC Corp. bonds at 102, the bonds would trade at a premium of $1,020.
3.Coupon Rate
A coupon rate states the interest rate the bond will pay the holders each
year.To find the coupon's dollar value, simply multiply the coupon rate
by the par value.The rate is for one year and payments are usually made
on a semi-annual basis.Some asset-backed securities pay monthly, while
many international securities pay only annually.The coupon rate also
affects a bond's price.Typically, the higher the rate, the less price
sensitivity for the bond price because of interest rate movements.
4.Currency Denomination
Currency denomination indicates what currency the interest and principle
will be paid in.
Other currency denomination structures can use various types of
currencies to make payments.
Because the provisions for redeeming bonds and options that are
granted to the issuer or investor are more complicated topics, we will
discuss them later in this LOS section.

Example: Bond Table


Let's take a look at an example of a bond with the features we've
discussed so far, within a bond table format you'd see in a paper.
ABC Corp 7.00% 6/1/10 at 90.
The issuer is ABC Corp.
Thematurity is 2010 with aterm to maturity of roughly 5 years.
Par valueis 1,000 per bond or 100
Coupon rateis 7%.
Coupon Payment is $70 per year (coupon=coupon rate* par value = .
07 *$1,000 = $70
Trading Price in dollars is $90
ABC Corp is a U.S. company and all payments of interest ant principle
are in USD.
Zero-Coupon Bonds - These instruments pay no interest to the holder
and are issued at a deep discount.As the bond nears maturity, its
price increases to reach par value.At maturity, the bondholder will
receive the par price.The interest earned is the difference between
the purchase price of the bond and what the holders receives at
maturity.
Floating-Rate Bonds - These bonds have coupon rates that reset at
predetermined times.The rate is usually based on an index or
benchmark with some sort of spread added or subtracted to the
benchmark.

Example: Floating Rate Security: Federal Funds


Assume the coupon rate of a floating-rate bond is based on the Federal
Funds rate plus 25 basis points at three-month intervals.If the Federal
Funds are at 3%, what would the coupon rate for this bond be?
Coupon rate = Reference Rate + influencing variable.
Answer:
Coupon rate = 3% (Fed Funds) + 25 basis points.
Coupon rate = 3.25%
The coupon rate for this bond would be 3.25% until the next reset
date.Floating- rate securities come in many forms.Other forms of floatingratesecurities involve caps and floors; these are discussed in detail below.
Caps and Floors
Some floating-rate securities have restrictions placed on how high or how
low the coupon rate can become.
Even though the formula states a 4% coupon should be paid this
period, the cap holds the coupon at 3.90%.
Example: Floors
Now lets add a floor of 2% and assume that Fed Funds are trading at
1.50%
Answer: Coupon rate = 1.50% (Fed Funds) + 25 basis points
Coupon rate = 1.75
Even though the formula states a 1.75% coupon should be paid, there is a 2%
floor in place, which means that the investor will receive 2% instead of the
1.75% derived from the formula.

Bond price valuation:


Bond prices are usually expressed as a percentage of their face value. Thus
we can
say that our 6 percent Treasury bond is worth 101.077 percent of face
value, and its
price would usually be quoted as 101.077, or about 101 232.

Did you notice that the coupon payments on the bond are an
annuity? In other words, the holder of our 6 percent Treasury
bond receives a level stream of coupon payments of $60 a
year for each of 3 years. At maturity the bondholder gets an
additional payment of $1,000. Therefore, you can use the
annuity formula to value the coupon payments and then add
on the present value of the final payment of face value:
PV = PV (coupons) + PV (face value)
= (coupon annuity factor) + (face value discount
factor)
Problem:
Calculate the present value of a 6-year bond with a 9 percent
coupon. The interest rate is 12 percent?

FIGURE

Cash flows to an investor in


the 6 percent coupon bond
maturing in 2002. The bond
pays semiannual coupons, so
there are two payments of
$30 each year.

If the Treasury bond with an interest rate, which is lower than


the coupon rate. In that case the price of the bond was higher
than its face value i.e. bond is at premium. We then valued it
using an interest rate that is equal to the coupon rate and
found that bond price equaled face value. You have probably
already guessed that when the cash flows are discounted at a
rate that is higher than the bonds coupon rate, the bond is
worth less than its face value.
Investors will pay $1,000 for a 6 percent, 3-year Treasury bond, when
the interest rate is 6 percent. Suppose that the interest rate is higher
than the coupon rate at (say) 15 percent. Now what is the value of
the bond? Simple! We just repeat our initial calculation but with r = .
15:
We conclude that when the market interest rate exceeds the coupon rate,
bonds sell for less than face value. When the market interest rate is below
the
coupon rate, bonds sell for more than face value.

Bond Valuation Basics


The fundamental principle of valuation is that the value is equal to the present
value of its expected cash flows.The valuation process involves the following
three steps:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate or interest rates that should be used to
discount the cash flows.
3. Calculate the present value of the expected cash flows found in step one by
using the interest rate or interest rates determined in step two.
Computing a Bonds Value
First of all, we need to find thepresent value (PV) of the future cash flows in
order to value the bond.The present value is the amount that would be needed
to be invested today to generate that future cash flow.PV is dependant on the
timing of the cash flow and the interest rate used to calculate the present
value.To figure out the value the PV of each individual cash flow must be
found.Then, just add the figures together to determine the bonds price.
PV at time T = expected cash flows in period T / (1 + I) to the T power
Value = present value @ T1 + present value @ T2 + present value @Tn
Lets throw some numbers around to further illustrate this concept.
Example: The Value of a Bond
Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of
$1,000. For simplicitys sake, the bond pays annually and the discount rate is 5%.
The cash flow for each of the years is:
Year one = $70 Year Two = $70 Year Three = $70, Year Four is $70 and Year Five
is $1,070.
PV of the cash flows is: Year one = 70 / (1.05) to the 1st power =$66.67
Year two = 70 / (1.05) to the 2nd power = $ 63.49
Year three = 70 / (1.05) to the 3rd power = $ 60.47
Year four = 70 / (1.05) to the 4th power = $ 57.59
Year five = 1070 / (1.05) to the 5th power = $ 838.37
Value = 66.67 + 63.49 + 60.47 + 57.59 + 838.37
Value = 1, 086.59

Computing the Value of a Zero-coupon Bond


This may be the easiest of securities to value because there is only
one cash flow the maturity value.
Value of a zero coupon bond that matures N years from now is:
Maturity value / (1 + I) to the power of the number of years * 2
Where I is the semi-annual discount rate.
Example:The Value of a Zero-Coupon Bond
For illustration purposes, lets look at a zero coupon with a maturity of
three years and a maturity value of $1,000 discounted at 7%
Answer:
I = 0.035 (.07 / 2)
N=3
Value of a Zero = 1,000 / (1.035) to the 6th power (3*2)
= 1,000 / 1.229255
= 813.50
YIELD TO MATURITY VERSUS CURRENT YIELD:
Current Yield: annual coupon payments divided by bond price. A bond
that is priced above its face value is said to sell at a premium.
Investors who buy a bond at a premium face a capital loss over the life
of the bond, so the return on these bonds is always less than the
bonds current yield. A bond priced below face value sells at a
discount. Investors in discount bonds face a capital gain over the life
of the bond; the return on these bonds is greater than the current
yield:

Yield to Maturity (YTM): Interest rate for which the present value of the
bonds payment equals the price. The yield to maturity is defined
as the discount rate that makes the present value of the
bonds payments equal to its price. Price The value of the 6
percent bond is lower at higher discount rates. The yield to maturity
is the discount rate at which price equals present value of cash flows.

Problems on YTM using hit and trial method:


1) A $ 1000 par value bond, current market price of the bond is $
761, 12 years remaining till maturity, coupon rate is 8%, using
hit and trial method calculate YTM?
2) A 10 year bond, 5years remaining till maturity and the market
price of the bond is $ 650 whose par is at $ 1000. If Coupon
rate is 6%, calculate YTM using interpolation.
Accrued Interest and Price Terminology
Accrued interest - the amount of interest that builds up in between
coupon payments that will be received by the buyer of the bond
when a sale occurs between these coupon payments, even though
the seller of the bonds earned it.
Full Price - is sometimes referred to as a bond's dirty price, which is the
amount the buyer will pay the seller.It equals the negotiated price of
the bond plus the accrued interest.
Clean Price - is simply the price of the bond without the accrued interest

Typical Yield measures:


There are three sources of return an investor can expect to receive by
investing
in bonds:

The coupon payment made by the issuer.

Any Capital gain or Loss when the bond matures or sold.

Income from the reinvestment.


1. Current Yield
Current yield relates the annual dollar coupon interest to the
bond'smarket price:
Current Yield = annual dollar coupon interest / price
Example: Current Yield
IBM ten-year bond with a rate of 5% and market price of 98.
Answer:
Step1 - Figure out the annual dollar coupon interest= .05 * $100 = 5$
Current Yield = $5 / 98 = .05102= 5.1%
Current yield is greater when bond is selling at a discount.The
opposite is true for a premium bond. If a bond is selling at par, the
current yield will equal the coupon rate.
The drawback using current yield is that it only considers the coupon
interest and nothing else.

2.Yield to Maturity (YTM)


Yield to maturity is the most popular measure of yield in the
market.It isthe rate that will make the present value of a bond's cash
flows equal toits market price plus accrued interest.To find YTM, one
has to developthe cash flows and then, through trial and error, find
the interest rate thatmakes the present value of cash flow equal to
the market price plus accrued interest.

This is basically a special type ofinternal rate of return (IRR).


Bond Price, Coupon Rate, Current Yield and Yield to Maturity
For a bond selling at par:
Coupon Rate = Current Yield = Yield to Maturity
For a bond selling at a discount:
Coupon Rate < Current Yield < Yield to Maturity
For a bond selling at a premium:
Coupon Rate > Current Yield > Yield to Maturity

The limitations of the yield to maturity measure are that it assumes


that the coupon rate will be reinvested at an interest rate equal to
the YTM.Besides that it does take into consideration the coupon
income and capital gains or loss as well as the timing of the cash
flows.

3.Yield to First Call


Yield to first call is computed for a callable bond that is not currently
callable.The actual calculation is the same as the Yield to Maturity
withthe only difference being that instead of using a par value and
the stated maturity, the analyst will use the call price and the first
call date in calculating the yield.
4.Yield to First Par Call
Again, yield to first par call is the same procedure as above, with
thedifference being that the maturity date that will be used instead
of the stated maturity date is the first time the issuer can call the
bonds at par value
5.Yield to Put
Yield to put is the yield to the first put date.It is calculated the same
wayas YTM but instead of the stated maturity of the bond, one uses
the first put date.
Options that Benefit the Issuer.
Call options - allows the issuer to call the bonds prior to maturity if
prevailing rates decrease enough to make it economically feasible for
the issuer to replace the existing issue (consisting of higher rate
coupons) with lower coupon bonds.
Options that Benefit the Holder
Puts - This option is the exact opposite of a call.It allows the
bondholder to sell the bond or "put" the bond back to the issuer at a
certain price and date(s) before its maturity.As rates rise, this helps
the bondholders dump their holdings and reinvest their proceeds at a
higher rate.

Provisions for Redeeming Bonds:


The provisions for redeeming bonds are found in the indenture.
They can be:
1.Called
2.Refunded
3.Have Prepayment Options and/or
4.Sinking Fund Provisions
1.Call Redemption
By adding a call feature in the indenture, a bond becomes a callable
bond.A callable bond gives the issuer the right to redeem the bonds
on a stated date or a schedule of dates before the stated maturity
date for the bonds arrives.
Let's look at callable bonds in a little more detail.First, some
terminology:

Call Price - This is the price that the issuer will pay the bondholder;
also know as the redemption price.

Call Date - This is the date or dates that the issuer can call the bond
from the holders.

Deferred Call - When a callable bond is originally issued, it is said to


have a deferred call of so many years up to the first call date, which
is the first day the bond can be called by the issuer.

Strategic Financial
Management
Stock Valuation

Security Valuation
The Top-Down Approach
The top-down approach is a valuation approach that begins
with first analyzing the overall economy and then
continuing to drill down to the specific analysis.The idea
behind the top-down approach when valuing securities is to
start from a high level analysis: the general economic
conditions. The next step would then be to analyze a
specific industry within the economy.Last, an investor
would compare and analyze specific securities to invest in.
The top-down approach allows an investor to make an
informed investment decision based on a keen
understanding of the economy and industry and how that
relates the stock, versus comparing the stocks
fundamentally against their peers without thinking about
the overall movement in the market.
The top-down approach can be particularly useful when
analyzing the valuation of world stocks.Given the starting
point of understanding the world economies, an investor is
able choose an appropriate stock based on areas of the
world that may be doing better.a

The Dividend Discount Model (DDM)


Value of a Preferred Stock
Unlike common equity, preferred stocks pay a fixed dividend.
As such, the value of a preferred stock can be calculated
using the dividend discount model.The value of the
preferred stock is essentially the present value of the
dividend in perpetuity, where k is the required return.
Value of preferred stock

Example:Calculating the value of a preferred stock


Assume that Newcos preferred stock pays out to an investor
an annual dividend of $8 per share.Given a rate of return of
10%, what is the value of Newcos preferred stock?
Value of Newcos preferred stock = ($5/0.10) = $50
Value of a Common Stock
Much like a preferred stock, holders of common stock can
also receive dividends.However, dividends on common stock
are not guaranteed, nor are they a fixed amount from year-

Expected return r = DIV1 + P1 P0


_____________
P0
Let us now look at how our formula works. Suppose Blue Skies stock
is selling for $75 a share (P0 = $75). Investors expect a $3 cash
dividend over the next year (DIV1 = $3). They also expect the stock to
sell for $81 a year hence (P1 = $81). Then the expected return to
stockholders is 12 percent:
Expected rate of return = expected dividend yield + expected capital gain
Problem: Androscoggin Copper is increasing next years dividend to
$5.00 per share. The forecast stock price next year is $105. Equally
risky stocks of other companies offer expected rates of return of 10
percent. What should Androscoggin common stock sell for?

THE CONSTANT-GROWTH DIVIDEND DISCOUNT MODEL

Version of the dividend discount model in which


dividends grow at constant rate.
Suppose forecast dividends grow at a constant rate into
the indefinite future. If dividends grow at a steady rate,
then instead of forecasting an infinite number of
dividends, we need to forecast only the next dividend
and the dividend growth rate.
Recall Blue Skies Inc. It will pay a $3 dividend in 1 year. If the
dividend grows at a constant rate of g = .08 (8 percent)
thereafter, then dividends in future years will be
DIV1 = $3 = $3.00
DIV2 = $3 (1 + g) = $3 1.08 = $3.24
DIV3 = $3 (1 + g)2 = $3 1.082 = $3.50
P0 = DIV1
________
r-g
This equation is called the constant-growth dividend
discount model.

THE PRICE-EARNINGS RATIO:


The superior prospects of Blue Skies are reflected
in its price-earnings ratio. With a stock price of
$75.00 and earnings of $5.00, the P/E ratio is
$75/$5 = 15. If Blue Skies had no growth
opportunities, its stock price would be only $41.67
and its P/E would be $41.67/$5 = 8.33. The P/E
ratio, therefore, is an indicator of the prospects of
the firm. To justify a high P/E, one must believe
the firm is endowed with ample growth
opportunities.

To determine the price to earnings multiple, the price of the


stock is simply
divided by the earnings per share of the stock as follows:
Example: Determining a companys price-to-earnings ratio using
the DDM
With Newcos $0.25 dividend payout, an EPS of $1.00,
calculate the stocks P/E ratio assuming 10% required return
and 5% growth.
Answer:
P/E ratio = 0.25/1.00 = 5%
(0.10-0.05)

Example: Calculate the value of common stock with temporary


supernormal growth
An investor plans to hold Newcos stock for 3 years.In that time
period, Newco plans to grow at a rate of 6% in the first two years
and 3% thereafter.Newcos last dividend was $0.25.Given a rate
of return of 10%, what is the value of Newcos common stock at
the end of the three-year time period?
Answer:
To begin, the dividend in each time period must be calculated [D
= D0(1+g)]
D1 = (0.25)(1.06) = 0.265
D2 = (0.265)(1.06) = 0.281
D3 = (0.281)(1.03) = 0.289
Since we expect the dividend to grow indefinitely in year 3 and
on, the present value of the stock price in year 3 is calculated as
follows:
P3 = 0.289 (1+0.03) = 4.252

(0.10-0.03)
The value of Newcos common stock is as follows:
Newcoscs = $0.265+ $0.281 + 0.289 + $4.252 =
****
(1.10)1 (1.10)2 (1.10)3 (1.10)3

The Components of An Investors Required Rate of Return

Real risk-free rate - This rate assumes no inflation or risk


is prevalent, but that it is simply generated by the supply
and demand of the markets.

Expected rate of inflation This rate anticipates the


potential inflation that is going to occur in the market.

Risk premium The premium is reflective of the risks


inherent in the stock, as well as the market.Such risks
include liquidity risk, business risk and general
macroeconomic risk.
The Country Risk Premium
Thecountry risk premium is the general risk of a security
inherent with the foreign country related to the security.
The country risk premium should be added to the general
risks a security faces when estimating the required return
for a foreign security
The Implied Dividend Growth Rate
A companys dividend growth rate can be derived from a
companys ROE and its retention rate.
The retention rate of a company is the amount of earnings a
company retains for its internal growth. A companys ROE is the
return on the funds invested back into the company. Keep in mind

Example: Calculate the required inputs to be used in the DDM


Newcos annual EPS last year was $1.00.The company
maintained its annual dividend payout ratio of 40% and ROE of
16%.Newcos beta is 1.3.Given a risk-free rate of 4% and an
expected return on the market of 18%, determine Newcos
required rate of return, expected growth rate and next years
dividend and price?
Answer:
Required rate of return
RNewco = 4% + 1.3(18% - 4%) = 22.2%
Expected growth rate
Retention rate = (1 payout rate) = (1 0.40) = 0.60
g = (0.60)(0.16) = 0.096 or 9.6%
Dividend
D1 = D0(1+g) = $1.00(1+.096) = $1.096
Future price
P1 = D1/(r g) = $1.096/(22.2% - 9.6%) = $8.70

Analyzing a Company - Types of Stock


Growth Company and Growth Stock

A growth company is a company that consistently grows by investing in


projects that will generate growth.A growth stock, however, is a stock
that earns a higher rate of return over stocks with a similar risk
profile.Feasibly, a company could be a growth company, but its stock
could be a value stock if it is trading below its peers of similar risk.
Defensive Company and Defensive Stock
A defensive company is a company whose earnings are relatively
unaffected in a business cycle downturn.A defensive company is
typically reflective of products that we need versus want.A food
company, such as Kellogg, is considered a defensive company.A
defensive stock, however, will hold its value relatively well in a business
cycle downturn.
Cyclical Company and Cyclical Stock
A cyclical company is a company whose earnings are affected relative to
a business cycle.A cyclical company is typically reflects products we
want.A retail store, such as The Gap, is considered a cyclical
company.A cyclical stock, however, will move with the market in relation
to the business cycle.
Speculative Company and Speculative Stock.
A speculative company is a company that invests in a business with an
uncertain outcome.An oil exploration company is an example of a
speculative company.A speculative stock, however, is a stock that has

Technical analysisis the practice of valuing stocks on past volume and


pricing information. Technical analysis assumes the following:

Market value of the asset is a reflection of supply and demand of the


asset.

Supply and demand are driven by rational factors, such as data and
economic analysis, as well as irrational factors, such as guesses.

Markets and individual stocks move together given trends.

Shifts in supply and demand will shift the trends in the market and
can be detected in the market.
Technical vs. Fundamental Analysis
The main difference between technical analysis and fundamental
analysis is the use of financial statements to value equities. Technical
analysis is the practice of valuing stocks on past volume and pricing
information.Technical analysis combines both the use of past
information (how stocks have reacted previously) and feeling (how
the market is moving the name) to value a security.
Fundamental analysis, however, takes a more formal
approach.Fundamental analysts review the financial statements of a
company and generate metrics, such as price-to-book value and
enterprise value-to-EBITDA to value a security.