Basic Definitions

1
Basic Definitions

• Present Value earlier money on a time line
• Future Value later money on a time line
• Interest rate exchange rate between earlier
  money and later money
• Discount rate
• Cost of capital
• Opportunity cost of capital
• Required return

2
Future Values

• Suppose you invest 1000 for one year at 5 per
  year. What is the future value in one year?
• Suppose you leave the money in for another year.
  How much will you have two years from now?

3
Future Values General Formula

• FV PV(1 r)t
• FV future value
• PV present value
• r period interest rate, expressed as a decimal
• T number of periods
• Future value interest factor (1 r)t

4
Effects of Compounding

• Simple interest
• Compound interest
• Consider the previous example
• FV with simple interest 1000 50 50 1100
• FV with compound interest 1102.50
• The extra 2.50 comes from the interest of .05(50)
  2.50 earned on the first interest payment

5
Future Values Example 2

• Suppose you invest the 1000 from the previous
  example for 5 years. How much would you have?
• The effect of compounding is small for a small
  number of periods, but increases as the number of
  periods increases. (Simple interest would have a
  future value of 1250, for a difference of
  26.28.)

6
Future Values Example 3

• Suppose you had a relative deposit 10 at 5.5
  interest 200 years ago. How much would the
  investment be worth today?
• What is the effect of compounding?
• Simple interest 10 200(10)(.055) 210.55
• Compounding added 446,979.29 to the value of the
  investment

7
Future Value as a General Growth Formula

• Suppose your company expects to increase unit
  sales of widgets by 15 per year for the next 5
  years. If you currently sell 3 million widgets in
  one year, how many widgets do you expect to sell
  in 5 years?

8
Quick Quiz Part I

• What is the difference between simple interest
  and compound interest?
• Suppose you have 500 to invest and you believe
  that you can earn 8 per year over the next 15
  years.
• How much would you have at the end of 15 years
  using compound interest?
• How much would you have using simple interest?

9
Present Values

• How much do I have to invest today to have some
  amount in the future?
• FV PV(1 r)t
• Rearrange to solve for PV FV / (1 r)t
• When we talk about discounting, we mean finding
  the present value of some future amount.
• When we talk about the value of something, we
  are talking about the present value unless we
  specifically indicate that we want the future
  value.

10
Present Value One Period Example

• Suppose you need 10,000 in one year for the down
  payment on a new car. If you can earn 7
  annually, how much do you need to invest today?

11
Present Values Example 2

• You want to begin saving for you daughters
  college education and you estimate that she will
  need 150,000 in 17 years. If you feel confident
  that you can earn 8 per year, how much do you
  need to invest today?

12
Present Values Example 3

• Your parents set up a trust fund for you 10 years
  ago that is now worth 19,671.51. If the fund
  earned 7 per year, how much did your parents
  invest?

13
Present Value Important Relationship I

• For a given interest rate the longer the time
  period, the lower the present value
• What is the present value of 500 to be received
  in 5 years? 10 years? The discount rate is 10

14
Present Value Important Relationship II

• For a given time period the higher the interest
  rate, the smaller the present value
• What is the present value of 500 received in 5
  years if the interest rate is 10? 15?

15
Quick Quiz Part II

• What is the relationship between present value
  and future value?
• Suppose you need 15,000 in 3 years. If you can
  earn 6 annually, how much do you need to invest
  today?
• If you could invest the money at 8, would you
  have to invest more or less than at 6? How much?

16
The Basic PV Equation - Refresher

• PV FV / (1 r)t
• There are four parts to this equation
• PV, FV, r and t
• If we know any three, we can solve for the fourth
• If you are using a financial calculator, be sure
  and remember the sign convention or you will
  receive an error when solving for r or t

17
Multiple Cash Flows FV Example 2

• Suppose you invest 500 in a mutual fund today
  and 600 in one year. If the fund pays 9
  annually, how much will you have in two years?

18
Multiple Cash Flows Example 2 Continued

• How much will you have in 5 years if you make no
  further deposits?
• First way
• Second way use value at year 2

19
Multiple Cash Flows FV Example 3

• Suppose you plan to deposit 100 into an account
  in one year and 300 into the account in three
  years. How much will be in the account in five
  years if the interest rate is 8?

20
Multiple Cash Flows Present Value Example 6.3

• Find the PV of each cash flows and add them
• Year 1 CF 200
• Year 2 CF 400
• Year 3 CF 600
• Year 4 CF 800
• 12 Interest

21
Example 6.3 Timeline
22
Multiple Cash Flows PV Another Example

• You are considering an investment that will pay
  you 1000 in one year, 2000 in two years and
  3000 in three years. If you want to earn 10 on
  your money, how much would you be willing to pay?

23
Annuities and Perpetuities Defined

• Annuity finite series of equal payments that
  occur at regular intervals
• If the first payment occurs at the end of the
  period, it is called an ordinary annuity
• If the first payment occurs at the beginning of
  the period, it is called an annuity due
• Perpetuity infinite series of equal payments

24
Annuity Sweepstakes Example

• Suppose you win the Publishers Clearinghouse 10
  million sweepstakes. The money is paid in equal
  annual installments of 333,333.33 over 30 years.
  If the appropriate discount rate is 5, how much
  is the sweepstakes actually worth today?

25
Finding the Payment

• Suppose you want to borrow 20,000 for a new car.
  You can borrow at 8 per year, compounded monthly
  (8/12 .66667 per month). If you take a 4 year
  loan, what is your monthly payment?

26
Future Values for Annuities

• Suppose you begin saving for your retirement by
  depositing 2000 per year in an IRA. If the
  interest rate is 7.5, how much will you have in
  40 years?

27
Bond Definitions

• Bond
• Par value (face value)
• Coupon rate
• Coupon payment
• Maturity date
• Yield or Yield to maturity

28
Present Value of Cash Flows as Rates Change

• Bond Value PV of coupons PV of par
• Bond Value PV annuity PV of lump sum
• Remember, as interest rates increase the PVs
  decrease
• So, as interest rates increase, bond prices
  decrease and vice versa

29
Valuing a Discount Bond with Annual Coupons

• Consider a bond with a coupon rate of 10 and
  coupons paid annually. The par value is 1000 and
  the bond has 5 years to maturity. The yield to
  maturity is 10. What is the value of the bond?
• Using the formula
• B PV of annuity PV of lump sum

30
Valuing a Premium Bond with Annual Coupons

• Suppose you are looking at a bond that has a 10
  annual coupon and a face value of 1000. There
  are 20 years to maturity and the yield to
  maturity is 8. What is the price of this bond?
• Using the formula
• B PV of annuity PV of lump sum

31
Graphical Relationship Between Price
andYield-to-maturity
32
Bond Prices Relationship Between Couponand Yield

• If YTM coupon rate, then par value bond price
• If YTM gt coupon rate, then par value gt bond price
• Why?
• Selling at a discount, called a discount bond
• If YTM lt coupon rate, then par value lt bond price
• Why?
• Selling at a premium, called a premium bond

33
The Bond-Pricing Equation
34
Computing Yield-to-maturity

• Yield-to-maturity is the rate implied by the
  current bond price
• Finding the YTM requires trial and error if you
  do not have a financial calculator and is similar
  to the process for finding r with an annuity
• If you have a financial calculator, enter N, PV,
  PMT and FV, remembering the sign convention (PMT
  and FV need to have the same sign, PV the
  opposite sign)

35
YTM with Annual Coupons

• Consider a bond with a 10 annual coupon rate, 15
  years to maturity and a par value of 1000. The
  current price is 928.09.
• Will the yield be more or less than 10?

36
YTM with Semiannual Coupons

• Suppose a bond with a 10 coupon rate and
  semiannual coupons, has a face value of 1000, 20
  years to maturity and is selling for 1197.93.
• Is the YTM more or less than 10?
• What is the semiannual coupon payment?
• How many periods are there?

37
Bond Pricing Theorems

• Bonds of similar risk (and maturity) will be
  priced to yield about the same return, regardless
  of the coupon rate
• If you know the price of one bond, you can
  estimate its YTM and use that to find the price
  of the second bond
• This is a useful concept that can be transferred
  to valuing assets other than bonds

38
Differences Between Debt and Equity

• Debt
• Not an ownership interest
• Creditors do not have voting rights
• Interest is considered a cost of doing business
  and is tax deductible
• Creditors have legal recourse if interest or
  principal payments are missed
• Excess debt can lead to financial distress and
  bankruptcy

• Equity
• Ownership interest
• Common stockholders vote for the board of
  directors and other issues
• Dividends are not considered a cost of doing
  business and are not tax deductible
• Dividends are not a liability of the firm and
  stockholders have no legal recourse if dividends
  are not paid
• An all equity firm can not go bankrupt

39
The Bond Indenture

• Contract between the company and the bondholders
  and includes
• The basic terms of the bonds
• The total amount of bonds issued
• A description of property used as security, if
  applicable
• Sinking fund provisions
• Call provisions
• Details of protective covenants

40
Bond Ratings Investment Quality

• High Grade
• Moodys Aaa and SP AAA capacity to pay is
  extremely strong
• Moodys Aa and SP AA capacity to pay is very
  strong
• Medium Grade
• Moodys A and SP A capacity to pay is strong,
  but more susceptible to changes in circumstances
• Moodys Baa and SP BBB capacity to pay is
  adequate, adverse conditions will have more
  impact on the firms ability to pay

41
Bond Ratings - Speculative

• Low Grade
• Moodys Ba, B, Caa and Ca
• SP BB, B, CCC, CC
• Considered speculative with respect to capacity
  to pay. The B ratings are the lowest degree of
  speculation.
• Very Low Grade
• Moodys C and SP C income bonds with no
  interest being paid
• Moodys D and SP D in default with principal
  and interest in arrears

42
Government Bonds

• Treasury Securities
• Federal government debt
• T-bills pure discount bonds with original
  maturity of one year or less
• T-notes coupon debt with original maturity
  between one and ten years
• T-bonds coupon debt with original maturity
  greater than ten years
• Municipal Securities
• Debt of state and local governments
• Varying degrees of default risk, rated similar to
  corporate debt
• Interest received is tax-exempt at the federal
  level

43
Example 7.3

• A taxable bond has a yield of 8 and a municipal
  bond has a yield of 6
• If you are in a 40 tax bracket, which bond do
  you prefer?
• At what tax rate would you be indifferent between
  the two bonds?

44
Bond Markets

• Primarily over-the-counter transactions with
  dealers connected electronically
• Extremely large number of bond issues, but
  generally low daily volume in single issues
• Makes getting up-to-date prices difficult,
  particularly on small company or municipal issues
• Treasury securities are an exception

45
Bond Quotations

• Highlighted quote in Figure 7.3
• ATT 6s09 6.4 177 93 7/8 ¼
• What company are we looking at?
• What is the coupon rate? If the bond has a 1000
  face value, what is the coupon payment each year?
• When does the bond mature?
• What is the current yield? How is it computed?
• How many bonds trade that day?
• What is the quoted price?
• How much did the price change from the previous
  day?

46
Treasury Quotations

• Highlighted quote in Figure 7.4
• 8 Nov 21 12505 12511 -46 5.86
• What is the coupon rate on the bond?
• When does the bond mature?
• What is the bid price? What does this mean?
• What is the ask price? What does this mean?
• How much did the price change from the previous
  day?
• What is the yield based on the ask price?

47
Cash Flows for Stockholders

• If you buy a share of stock, you can receive cash
  in two ways
• The company pays dividends
• You sell your shares, either to another investor
  in the market or back to the company
• As with bonds, the price of the stock is the
  present value of these expected cash flows

48
Developing The Model

• You could continue to push back when you would
  sell the stock
• You would find that the price of the stock is
  really just the present value of all expected
  future dividends
• So, how can we estimate all future dividend
  payments?

49
Estimating Dividends Special Cases

• Constant dividend
• The firm will pay a constant dividend forever
• This is like preferred stock
• The price is computed using the perpetuity
  formula
• Constant dividend growth
• The firm will increase the dividend by a constant
  percent every period
• Supernormal growth
• Dividend growth is not consistent initially, but
  settles down to constant growth eventually

50
Zero Growth

• If dividends are expected at regular intervals
  forever, then this is like preferred stock and is
  valued as a perpetuity
• P0 D / R
• Suppose stock is expected to pay a 0.50 dividend
  every quarter and the required return is 10 with
  quarterly compounding. What is the price?

51
Dividend Growth Model

• Dividends are expected to grow at a constant
  percent per period.
• P0 D1 /(1R) D2 /(1R)2 D3 /(1R)3
• P0 D0(1g)/(1R) D0(1g)2/(1R)2
  D0(1g)3/(1R)3
• With a little algebra, this reduces to

52
DGM Example 1

• Suppose Big D, Inc. just paid a dividend of .50.
  It is expected to increase its dividend by 2 per
  year. If the market requires a return of 15 on
  assets of this risk, how much should the stock be
  selling for?

53
DGM Example 2

• Suppose TB Pirates, Inc. is expected to pay a 2
  dividend in one year. If the dividend is expected
  to grow at 5 per year and the required return is
  20, what is the price?

54
Example 8.3 Gordon Growth Company - I

• Gordon Growth Company is expected to pay a
  dividend of 4 next period and dividends are
  expected to grow at 6 per year. The required
  return is 16.
• What is the current price?

55
Using the DGM to Find R

• Start with the DGM

56
Finding the Required Return - Example

• Suppose a firms stock is selling for 10.50.
  They just paid a 1 dividend and dividends are
  expected to grow at 5 per year. What is the
  required return?
• What is the dividend yield?

57
Feature of Common Stock

• Voting Rights
• Proxy voting
• Classes of stock
• Other Rights
• Share proportionally in declared dividends
• Share proportionally in remaining assets during
  liquidation
• Preemptive right first shot at new stock issue
  to maintain proportional ownership if desired

58
Dividend Characteristics

• Dividends are not a liability of the firm until a
  dividend has been declared by the Board
• Consequently, a firm cannot go bankrupt for not
  declaring dividends
• Dividends and Taxes
• Dividend payments are not considered a business
  expense, therefore, they are not tax deductible
• Dividends received by individuals are taxed as
  ordinary income
• Dividends received by corporations have a minimum
  70 exclusion from taxable income

59
Features of Preferred Stock

• Dividends
• Stated dividend that must be paid before
  dividends can be paid to common stockholders
• Dividends are not a liability of the firm and
  preferred dividends can be deferred indefinitely
• Most preferred dividends are cumulative any
  missed preferred dividends have to be paid before
  common dividends can be paid
• Preferred stock generally does not carry voting
  rights

60
Stock Market

• Dealers vs. Brokers
• New York Stock Exchange (NYSE)
• Largest stock market in the world
• Members
• Own seats on the exchange
• Commission brokers
• Specialists
• Floor brokers
• Floor traders
• Operations
• Floor activity

61
NASDAQ

• Not a physical exchange computer based
  quotation system
• Multiple market makers
• Electronic Communications Networks
• Three levels of information
• Level 1 median quotes, registered
  representatives
• Level 2 view quotes, brokers dealers
• Level 3 view and update quotes, dealers only
• Large portion of technology stocks

62
Reading Stock Quotes

• Sample Quote
• -3.3 33.25 20.75 Harris HRS .20 .7 87
  3358 29.60 0.50
• What information is provided in the stock quote?
• Click on the web surfer to go to CNBC for current
  stock quotes.