Financial Management 3301 Unit VI Assignment

BBA 3301, Financial Management 1 Cou rse Learning Outcomes for Unit VI Upon completion of this unit, students should be able to: 6. Evaluate stock and bond valuation. 6.1 Calculate the value of corporate bonds. 6.2 Estimate values for both common and preferred stock. Reading Assignment Chapter 9: Debt Valuation and Interest Rates, pp. 252 -291 Chapter 10: Stock Valuation, pp. 298 -323 Unit Lesson Stock and bond valuation techniques allow in vestors to evaluate securities’ prices in the market. Investors do not want to overpay and lose potential returns. Valuation techniques are critical to finance for this reason.

Take the case of Ron Reese. Ron Reese inherited a large sum from his rich uncle and wants to invest in the market. Reese's friend, George Santos, has a large portfolio and Reese asked him how he could evaluate securities in which he might have an interest. Santos explained the basic securities include stocks and b onds, but other securities are also available. Santos explained some of the risks associated with bonds to give an investor an idea about the value of returns associated with corporate bonds. Santos told Reese interest payments correspond with different pr emiums that consider various risks. For example , nominal rates or yield to maturity is the risk of holding bonds to maturity. Another risk premium is an interest rate associated with fixed -income securities with no risk and no inflation called a risk -free rate . Yet, another risk premium is an inflation premium attached to an expected rate for inflation that accounts for increases in prices of goods and services. Default -risk premiums are also a part of a debt security's interest rate reflecting the risk of default by a borrower. Risk of default stem from a company's bond rating ranging from AAA to C. Those securities with the highest rating carry the lowest risk of default; those with the lowest rating carry the highest default risk. Another risk premium is the maturity -risk premium , which compensates investors for greater risk associated with price fluctuations stemming from holding these securities for a longer time. Interest rates can change more over a longer time, and investors demand compensation for ri sk associated with holding securities to maturity. Last, liquidity -risk premiums compensate investors for the inability to convert a security into cash at a reasonable price. Santos explained to Reese the longer the term of a bond the greater the risk because interest rates can change more over a longer term. Price fluctuations present a greater risk when interest rates change. The term structure of interest rates depicts this relationship with a yield curve. Generally, a yield curve has an upward slope that diminishes as a debt security approaches maturity. Yield curves can shift as expectations change over time. Although this explanation helped Reese understand why bond pric es change, he still did not understand how to value bonds when buying them. Reese asked Santos to explain the calculation of a bond value. Reese started by explaining the importance of understanding bond terminology. Corporate bonds have a face or stated v alue in increments of $1,000 along with a stated coupon interest rate. A bond issuer will state these terms because they do not change over the term of a bond. However, market rates change regularly as bond market values change. An inverse relationship exi sts between bond prices (values) and market interest rates. UNIT VI STUDY GUIDE Stock and Bond Valuation BBA 3301, Financial Management 2 UNIT x STUDY GUIDE Title As market interest rates rise bond values decline because of less demand for bonds with equivalent terms.

Similarly, as market interest rates decline, more demand for comparable bonds cause value to rise because of lower demand for these securities. Besides this relationship, Santos explained that investors can calculate bond values by computing the present value of the interest payments plus the present value of the maturity value. The present v alue of a bonds interest payments depends also on the frequency an issuer pays them. For example, bond issuers can pay bonds monthly, semi -monthly, or quarterly. Suppose a company issues 20 -year bonds with a stated or par value of $10,000 with a coupon int erest rate of 8% paid semiannually when market rates are at 7.75%. Regular interest payments will amount to $400 or 8% times $10,000 divided by two because the issuer pays interest twice a year. An investor can calculate the present value of these interest payments using Excel as follows: This calculation shows the present value of 40 interest payments (20 years paid semiannually), which results in interest payments with a present value of $8.066.54. These bonds also will pay $10,000 at maturity. Santos calculated the present value of the amount paid at maturity as follows: The present value of the interest payments and amount paid at maturity is the sum of $8,066.54 plus $2,185.54 or $10,252.08. Alternatively, Santos combined the annuity interest pa yments and the single sum paid at maturity as follows: BBA 3301, Financial Management 3 UNIT x STUDY GUIDE Title This calculation also confirmed an inverse relationship between a market interest rate of 7.75% and the bonds value of $10,252.08. Because market interest rates are lower than the 8% stated rate, t he market value of the bonds is more than the $10,000 face value. Santos suggested Reese rework the calculation assuming market rates rose to 8.25%. Santos asked Reese what he would expect about the value of the bonds then. After reworking this calculatio n, Reese asked Santos how to value equity securities. Santos explained the constant dividend growth model (Gordon Model) with the following equation (Titman, Keown, & Martin, 2014, p. 305): = 0(1+) − In this formula equals the val ue of a share of common stock, 0 equals the most recent annual common stock dividend paid to shareholders, equals an expected growth rate for cash dividends assumed forever, equals a required rate of return stockholders expect on common stock for infinity. Another model Santos explained is the P/E ratio valuation model, which is found by the following formula (Titman, Keown, & Martin, 2014, p. 310): = 1 1 In this formula equals the value of a share of common stock, equals an appropriate price of the common shares, /1 equals the price earnings ratio for the firm, and 1 equals estimated earnings per common share. Santos rewrote this equation as follows: = 0(1+) − Assuming the current market price ( ) of the firm's common stock equals the value of its shares, the above equation by substitution becomes the following: = 1 − This formula results in the price of the firm's common stock. To calculate the P/E ratio, divide both sides o f the equation by estimated earnings per share for next year as follows: 1 = 1/1 − BBA 3301, Financial Management 4 UNIT x STUDY GUIDE Title Armed with these formulas, Reese next asked Santos about valuing preferred stock. Santos explained he could calculate the value of preferred stock ( ) simply by dividing the annual preferred stock dividend by the required yield on preferred stock as determined by the market or using the following formula: = where equals a preferred share's value, equals the annual divid end on preferred a preferred share, and equals the required market interest rate yield. Reese now has a way to value both debt and equity securities. In summary, securities valuation is a fundamental function of finance because investors must unde rstand the value of securities they want to invest in. Calculating the values of debt and equity securities is different. A good investor has to understand how these investments work to maximize their returns. Santos did a good job explaining to Reese how debt and equity securities work to enable him to make informed investments. Reference Titman, S., Keown, A. J., & Martin J. D. (2014). Financial management: Principles and application s (12th ed.) . Upper Saddle River, NJ: Learning Activities (Non -Graded) The following video tutorials will help you with the concepts covered in the textbook chapters. It is strongly encouraged to watch these videos prior to starting the unit assessment. Click here for Checkpoint 9.1: Calculating the Rate of Interest on a Floating -Rate Loan Click here for Checkpoint 9.2: Calculating t he Yield to Maturity Click here for Checkpoint 9.3: Valuing a Bond Click here for Checkpoint 9.4: Valuing a Bond with Semiannual Interest Payments Click here for Checkpoint 9.5: Solving for the Real Rate of Interest Click here for Checkpoint: 9.6: Solving for the Nominal Interest Rate Click here for Castle in the Air Theory Click here for Stocks 101 Click here for Checkpoint 10.1: Valu ing Common Stock Click here for Checkpoint 10.2: Valuing Common Stock Using the P/E Ratio Click here for Checkpoint 10.3: Valuing Preferred Stock Non -graded Learning Activities are provided to aid students in their course of study. You do not have to submit them . If you have questions, contact your instructor for further guidance and information.