VALUATION METHODS 1) cash flows (returns), (2) timing and (3) measure of risk.

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Leo Gregory
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VALUATION METHODS Why is it important for the financial manager to understand the valuation process? Valuation is the process that links risk and return to determine the worth of an asset.

To determine an assets worth at a given point in time, a financial manager uses the timevalueofmoney techniques (we did previously) and the concept of risk and returns (as we also did in the last

1 VALUATION METHODS Why is it important for the financial manager to understand the valuation process? Valuation is the process that links risk and return to determine the worth of an asset. It is a relatively simple process that can be applied to expected streams of benefits from bonds, stock, income properties, an oil well and so on. To determine an assets worth at a given point in time, a financial manager uses the timevalueofmoney techniques (we did previously) and the concept of risk and returns (as we also did in the last lecture). Terms to note: What are the three (3) key inputs to the valuation process? Does the valuation process ONLY apply to assets/investments that provide an annual cash flow? The 3 main inputs in the valuation process are: (1) cash flows (returns), (2) timing and (3) measure of risk. It does not have to have an annual cash flow. It may be give and intermittent or even a single cash flow for the period. Timing is assumed to be at the end of the period / year unless otherwise stated. The level of risk associated with the cash flows can significantly affect the values. The greater the risk, the greater the discount factor should be, vice versa.

Identify and explain the variables in the general equation for the valuation of any asset/investment The valuation of any asset is the present value of all future cash flows it is expected to provide

2 Identify and explain the variables in the general equation for the valuation of any asset/investment The valuation of any asset is the present value of all future cash flows it is expected to provide over the relevant period. Basic valuation model (Pg. 240) : Where: Vo = CFt = r = n = Using an example describe the basic procedure used to value a bond that pays annual interest. The basic valuation equation can be used to value bonds, common stock and preferred stock. The basic model for the value, Bo, is (Pg. 242): Where: Bo = I = n = M = rd = OR We can use a simple time line and PV of an annuity = (CF/r) ( 1 1/(1+r n ) ( See Pg. 242 Eg 6.8) : Explain what must be the relationship between the required return and the coupon interest rate.

nd value will be less than its par value. b. At a premium: This is when the required return is less than the coupon interest rate, the bond value will be more than its par value.

3 Bonds can be bought/sold in the following circumstances a. At a discount: This is when the required return is greater than the coupon interest rate, the bond value will be less than its par value. b. At a premium: This is when the required return is less than the coupon interest rate, the bond value will be more than its par value. c. At par value: This is the face value of the bond. This is when the required return is equal to the coupon interest rate To protect oneself against the potential impact of rising interest rates which type of bond will a riskaverse investor prefer and why i) A bond with a short period until maturity this one ii) A bond with a long period until maturity

4 What is an efficient market? (Pg 277) What does the efficient market hypothesis (EMH) (Pg 278) say about the following? o Securities prices o Their reaction to new information o Investor opportunities to profit Describe debt and equity. Briefly explain the differences between debt and equity and identify and briefly describe the various types of equity.

5 Types of Equity: Common and Preferred Stock ii) Briefly describe the following common stock dividend valuation models: a. Zerogrowth b. Constant Growth Variable Growth

Compare the following common stock dividend valuation models by

commonalities: Zerogrowth : Fixed/ constant % dividend annually

annually plus a constant growth rate Variable Growth : A mixture of

Describe the free cash flow valuation model (Pg 284) Explain each

are: (a) book value, (b) liquidation value, (c) price/earnings

6 Compare the following common stock dividend valuation models by identifying and briefly describing their differences and commonalities: Zerogrowth : Fixed/ constant % dividend annually Constant Growth / Gordon Growth model : Fixed/ constant % dividend annually plus a constant growth rate Variable Growth : A mixture of the 2 above. Much more complicated. Describe the free cash flow valuation model (Pg 284) Explain each of the three other approaches to common stock valuation and explain which is considered the best. (Please note the three other approaches to common stock valuation are: (a) book value, (b) liquidation value, (c) price/earnings (P/E) multiples) : P/E is considered best Identify and briefly describe the risks that common stockholders take that other suppliers of capital do not face?

7 What is a rights offering? Describe how a rights offering protects a firm s stockholders from dilution of ownership. Describe the following and explain the relationship that exists among them: Authorised shares Outstanding shares Treasury Stock Issued Shares Identify and briefly describe the claims that preferred stock holders have that common stock holders do not enjoy Explain the cumulative feature of preferred stock and the purpose of a call feature in a preferred stock issue.

Bond and Common Share Valuation

Bond and Common Share Valuation Lakehead University Fall 2004 Outline of the Lecture Bonds and Bond Valuation The Determinants of Interest Rates Common Share Valuation 2 Bonds and Bond Valuation A corporation