Week 3 Weekly Podcast Transcript Valuing Stocks and Bonds and Investment Rules It is not uncommon for the daily news to feature stories of current activity in the stock market. Whether the news story details activity about a bear or bull market, blue chip stocks, futures, or convertible bonds and coupon rates, most of the terms are meaningless to the average reader. For a financial planner, however, each of these terms provides critical insight into the current financial climate and can be used to calculate the value of potential investments. Such calculations are essential in capital budgeting decisions. This week, you will be introduced to many important bond terms and concepts, and become experienced at using time value of money skills to price both bonds and stocks. You will also learn about utilizing capital budgeting procedures to determine which strategic investments a company chooses to undertake. You will go on to become familiar with several different techniques used to assess the desirability of a project, including the net present value and internal rate of return. By the end of this week, you will be able to: Calculate bond prices and yields Analyze the yield to maturity Appraise how stock prices can be derived by taking the present value of a stream of dividends
Defend the benefits of using MPV in capital budgeting Evaluate the IRR and the conditions that cause it and NPV to produce different results During Week 3, you will use a variety of resources including selections from the course text, journal articles, audio versions of key readings, and a video interview. Audio versions of the key readings include those resources used for completing both Discussion Questions and Applications. This week, you begin with Chapters 5 and 6 of your course text, Corporate Finance, identified in your Syllabus and in Resources under Week 3. In Chapter 5, you will be introduced to the process of valuing bonds and stocks and the different types of calculations that may be used to determine both present value and potential dividend growth. Chapter 6 introduces the concept of investment decision rules, such as net present value, payback periods, and the internal rate of return, demonstrates how they are calculated, and describes their use in capital budgeting. The journal article for this week, The Dividend Discount Model in the Long- Run: A Clinical Study, explores the accuracy of using valuation methods to discount cash flows and determine dividends. This resource, which will be reviewed more in depth in a resource audio summary, may give you ideas on how to approach your research for this week s Discussion Question. Let s outline some of the individual resources that you will use in this week s activities.
Video: "Understanding NRV and IRR, Bond Calculations, and the Impact of Lower Interest Rates on Bond and Stock Prices" featuring Dr. Melissa Frye Narrator: We are excited to continue our conversation with Dr. Melissa Frye. This week, we will be conversing with her about capital budging, calculating bond prices, and other important. Dr. Frye, welcome back! Dr. Melissa Frye: Thank you. It s my pleasure to be here. Narrator: Our textbook seems to stress using the NPV for capital budgeting. Why would firms still prefer to use IRR? What are the benefits of each? Dr. Melissa Frye: Both the NPV and the IRR are really trying to capture whether you are creating shareholder wealth, but they re going about it in two different ways. Essentially, the NPV is measuring shareholder wealth creation in terms of dollars; whereas, the IRR is trying to capture it in a percentage term. IRR does have some weaknesses. There are times you can find an IRR for a project that s maybe undefined. There can be multiple IRRs; or if you have mutually exclusive projects, IRR can sometimes actually tell you to do the wrong thing. Now, why do firms still use the IRR? Well, if you think about it in your own life when you talk about maybe how your portfolio did last quarter or last year, we don t go to lunch and talk about, My portfolio returned $3,000 dollars last year. We talk about it, you know, My portfolio was up 10%. Same thing when you see reports on T.V. about the stock market. Everything is quoted in percentage terms, and so IRR for a lot of people is a little bit easier to relate to in that it quotes things on a percentage basis. So that s part of the reasons why firms still use IRR. The other thing that IRR does is it can actually bias in favor of small projects, so some managers might believe that using the IRR is a more conservative approach than the NPV. However, your textbook is really correct in that the
NPV is the single method that s always going to lead you to the correct decision. Narrator: As a manager, why would I need to be able to calculate bond prices and yields and how are they used? Dr. Melissa Frye: Bonds represent a way for the firm to borrow money. So, for a manager, you have a couple of options in terms of raising funding to pay for a new project or new investment, and that s usually either some sort of equity financing or some sort of debt financing, such as a bond. And to understand what rate you re borrowing at, what the current rates are, how much that debt is really costing you, you ve really got to understand the pricing mechanisms underneath that security. So that means you need to be able to understand the cash flows associated with the bond, the yields associated with the bond, how to calculate the prices, and how all of these interrelate. Narrator: If the Federal Reserve cuts interest rates what should happen to bond prices and stock prices? Dr. Melissa Frye: Bond prices, they move inversely with interest rates. So that means if interest rates fall, bond prices go up, and vice versa. So if the Federal Reserve cuts interest rates that means the bond price would be expected to increase. Discount rates go down, prices go up; and really the same logic holds with stock prices. If you think about estimating the price of the stock as the present value of say all the future expected cash flows or dividends, you discount those back to present value using the required rate of return. Part of that required rate of return is going to be the cost of money that the Fed controls, so if the Fed drops interest rates, again, that discount rate would fall causing the stock price to increase, as well. The other way to think about it with stock price is to use a little bit more intuition, and that is to say, you know, those discount rates you re using to find the present value, essentially represent kind of a hurdle rate for the firm. That s the rate that they need to earn to keep their shareholders happy. So, if the Fed makes that rate
lower it becomes suddenly easier to find positive NPV projects for companies; therefore, we d expect the stock price to go up. Narrator: Thanks again for the wonderful information you have given us. We look forward to hearing from you again! Dr. Melissa Frye: Thank you. I enjoyed it, as well. You will now hear a summary of the following reading that will help in completing your assignments for the week. Chapter 5, How to Value Bonds and Stocks, in Corporate Finance. Using present value formulas introduced in Chapter 4, in this chapter you will learn how to price stocks and bonds. A bond is a certificate that shows the amount a borrower owes and includes information on interest and principal payments. Calculating the value of a variety of bond types is covered as well as examples of the uses of the resulting data. Focus on the discussion of the relationship between interest rates and bond prices. Also covered in this chapter is the valuation of different types of stocks by determining future cash flows from dividends and capital gains. You will be introduced to the dividend growth model and showed how to calculate growth rates and growth opportunities. A comparison is made between using the dividend growth model versus using the net present value of growth opportunities (NPVGO) model for calculations. Finally, the price-earnings ratio is defined and its strengths and shortcomings as a financial tool are debated.
You will now hear a summary of the following reading that will help in completing your assignments for the week. Chapter 6, Net Present Value and Other Investment Rules, in Corporate Finance. In this chapter, you will be introduced to the topic of capital budgeting, which involves making decisions to accept or reject projects. One of the easiest calculations to use is net present value and the advantages of using this formula are presented. Other methods described include the payback period method, which uses the time before the project will begin producing revenues, and the average accounting return method. Similar to the use of the net present value, the internal rate of return (IRR) is also commonly used in decision-making because of the ease of its calculation. The main difference between the two is that the IRR does not rely on information from the capital marketplace. The chapter goes into detail describing problems with the IRR approach when applied to independent or mutually exclusive projects. Focus on the discussion on how the different methods can be used as a part of capital budgeting. You will now hear a summary of the following reading that will help in completing your assignments for the week. Article, The dividend discount model in the long-run: A clinical study, from the Journal of Applied Finance.
In this article, the authors compare several different models used to value equity and determine the success of each to accurately value equity when used over long periods of time. In their research, the authors review information on the share price, dividend payments, and earnings of the Bank of Montreal over a period of 120 years. Using each of the different models, the authors calculate the expected share price and compared this with the actual share price. Although the relationship between dividends and earning had evolved during the time period, the authors conclude that dividend based models performed well at explaining actual share prices, much better than other approaches.