FINANCIAL MANAGEMENT

By Waqas Sarwar
 Recap Ch 3.
■ In the last chapter we discussed the time value of money and explored the
wonders of compound interest.
■ We are now able to apply these concepts to determining the value of different
securities, particularly, the valuation of the firm’s long-term securities (bonds,
preferred stock, and common stock).
■ Major decisions of a company are all interrelated in their effect on valuation, we
must understand how investors value the financial instruments of a company.
 The Valuation of Long-Term Securities
Valuation?
■ The value of any financial asset (a stock, a bond, a lease, or even a physical asset such as an apartment building
or a piece of machinery ) is the present value of the cash flows the asset is expected to produce.
Financial Securities?
■ An instrument issued by the government or companies in order to raise finance, broadly categorized into:
Debt securities (e.g., bonds and debentures etc) Equity securities (e.g., common stocks).
Distinction Among Valuation Concepts:
Liquidation Value:
■ The amount of money that could be realized if an asset or a group of assets (e.g., a firm) is sold
separately from its operating organization.
Going Concern Value:
■ The amount a firm could be sold for as a continuing operating business.
■ These two aforementioned values are rarely equal, and sometimes a company is actually worth more
dead than alive.
■ We will generally assume that we are dealing with going concerns – operating firms able to generate positive cash flows to security investors. In instances
where this assumption is not appropriate (e.g., impending bankruptcy), the firm’s liquidation value will have a major role in determining the value of the
firm’s financial securities
 Book Value:
■ For an asset: The asset’s cost minus its accumulated depreciation.
■ For a firm: Total assets minus liabilities and preferred stock as listed on the balance sheet.
Market Value:
■ The market price at which an asset trades in an open marketplace. For a firm, market value is often
viewed as being the higher of the firm’s liquidation or going-concern value.
Intrinsic Value:
■ The price a security “ought to have” based on all factors bearing on valuation. (Factors include ,
earnings, future prospects, risk, management, and so on).
■ This measure is arrived at by means of an objective calculation or complex financial model, rather
than using the currently trading market price of that asset.
■ An estimate of a security’s “true” value based on accurate risk and return data. The intrinsic value can
be estimated, but not measured precisely.
■ If markets are reasonably efficient and informed, the current market price of a security should
fluctuate closely around its intrinsic value.
The valuation approach taken in this chapter is one of determining a security’s intrinsic value – what the
security ought to be worth based on hard facts. This value is the present value of the cash-flow stream
provided to the investor, discounted at a required rate of return appropriate for the risk involved.
 Bond
Bond
■ Bond A long-term debt instrument issued by a corporation or government looking for long-term debt
capital.
■ A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal on specific dates to the holders of the bond.
Treasury Bond
■ Bonds issued by the federal government, sometimes referred to as government bonds.
Risk: Govt. promise payments, so Treasuries have no default risk. However, these bonds’ prices do
decline when economy’s interest rates rise; so, they are not completely riskless.
Corporate Bond
■ Bonds issued by corporations.
Risk: Corporates are exposed to default risk—if the issuing company gets into trouble, it may be unable to
make the promised interest and principal payments and bondholders may suffer losses.
Foreign Bond
■ Bonds issued by foreign governments or by foreign corporations.
■ Risk: Countries are exposed to default risk like Corporates—if the issuing country gets into trouble.
( e.g., concerns have arisen about Greece , Ireland and Portugal etc.) it may be unable to make the
promised interest and principal payments and bondholders may suffer losses.
■ An additional risk exists when the bonds are denominated in a currency other than that of the
investor’s home currency. When the investor will want to close out his investment and convert the
foreign currency back to home currency. (Exchange rate risk).
Key Characteristics of Bonds
Par Value
■ The face value of a bond. The par value generally represents the amount of money the firm borrows
and promises to repay on the maturity date.
Coupon/Interest Rate
■ The stated rate of interest on a bond.
Coupon Payment: The specified number of dollars of interest paid each year.
Fixed-Rate Bonds: Bonds whose interest rate is fixed for their entire life.
Floating-Rate Bonds: Bonds whose interest rate fluctuates with shifts in the general level of interest
rates.
Zero Coupon Bonds: Bonds that pay no annual interest but are sold at a discount below par, thus
compensating investors in the form of capital appreciation.
Original Issue Discount (OID) Bond: Any bond originally offered at a price below its par value.
Maturity Date.
■ A specified date on which the par value of a bond must be repaid.
Original Maturity: The number of years to maturity at the time a bond is issued.
Call Provisions
■ A provision in a bond contract that gives the issuer the right to redeem the bonds under specified
terms prior to the normal maturity date.
■ The call provision generally states that the issuer must pay the bondholders an amount greater than
the par value if they are called. The additional sum, is termed a call premium.
■ Companies are not likely to call bonds unless market interest rates have declined significantly since
the bonds were issued.
Refunding operation:
■ Issuance of low-yielding securities by companies when market interest rates drop in order to use the
proceeds of the new issue to retire the high-rate issue, and thus reduce its interest expense.
Suppose a company sold bonds when interest rates were relatively high. Provided the issue is callable,
the company could sell a new issue of low-yielding securities if and when interest rates drop, use the
proceeds of the new issue to retire the high-rate issue, and thus reduce its interest expense. This process
is called a refunding operation.
■ The call privilege is valuable to the firm but detrimental to long-term investors, who will need to
reinvest the funds they receive at the new and lower rates.
 Putable Bond
■ Bonds with a provision that allows investors to sell them back to the company prior to maturity at a
prearranged price.
Sinking Fund Provisions
■ A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year.
■ Sinking fund provisions require the issuer to buy back a specified percentage of the issue each year.
■ A failure to meet the sinking fund requirement constitutes a default, which may throw the company into
bankruptcy.
Suppose a company issued $100 million of 20-year bonds and it is required to call 5% of the issue, or $5
million of bonds, each year. In most cases, the issuer can handle the sinking fund requirement in either of two
ways:
1. It can call in for redemption, at par value, the required $5 million of bonds. The bonds are numbered
serially, and those called for redemption would be determined by a lottery administered by the trustee.
2. The company can buy the required number of bonds on the open market.
The firm will choose the least-cost method depends on the economy’s interest rate.
■ If market interest rates have fallen since the bond was issued, the bond will sell for more than its par
value (investor would happily buy because its giving more interest as compared to market, demand for such bond will be higher and price will
go up) . In this case, the firm will use the call option.

■ However, if interest rates have risen, the bonds will sell at a price below par; so the firm can and will buy
$5 million par value of bonds in the open market for less than $5 million.
• Market interest rate and Bond price move in opposite direction.

Bonds Valuation
■ Value of any financial asset is the present value of the cash flows the asset is expected to produce.
■ This is the maximum amount that you would be willing to pay for the bond if you want to buy/invest in
that bond. If the market price is greater than this amount, however, you would not want to buy it.
Bonds with a Finite Maturity
■ In order to determine the bond’s value (intrinsic value/current/Present Price) with a finite maturity we
will consider the interest stream (Cashflows) and the terminal or maturity value (face value).
For a “regular” bond with a fixed coupon, here is the situation:

=The market rate of interest on the bond. This is the discount rate used to calculate the present
value (Bonds Price) of the cash flows, which is also the bond’s price.
N = The number of years before the bond matures.
INT= Interest paid each year calculated as Coupon rate× Par value .
M = The par, Face, or maturity, value of the bond
The following general equation can be solved to find the value of any bond

= 𝐼𝑁𝑇 𝑃𝑉𝐼𝐹 , + M (PVIF )

* Cash flow of Bond is interest (INT) we will find out the present value of cash flow using discount rate (Market
interest rate i.e. rd%)
Example: What would be the value of a $1,000-par-value bond with a 10 percent coupon and 9 years to
maturity, market interest (Discount rate) is 12%.

■ This is the maximum amount that you would be willing to pay for this bond. If the market price is
greater than this amount, however, you would not want to buy it.
Step By Step Approach
 Perpetual Bonds
■ A bond that never matures; a perpetuity in the form of a bond.
■ The present value of a perpetual bond would simply be equal to the capitalized value of an infinite
stream of interest payments.
■ If a bond promises a fixed annual payment of INT forever, its present (intrinsic) value, V, at the
investor’s required rate of return for this debt issue, is

which, from Chapter 3’s discussion of perpetuities, we know should reduce to

Example: A bond with a par value $500 and pays coupon 10% a year forever. Assuming that your
required rate of return (discount rate) for this type of bond is 12 percent, what would be the present value
of this security ?
Theses types of bonds are rarely issued, Originally issued by Great Britain after the Napoleonic Wars to consolidate debt issues.
 Zero Coupon Bonds
■ A zero-coupon bond makes no periodic interest payments but instead is sold at a deep discount from
its face value.
Why buy a bond that pays no interest?
■ The buyer of such a bond does receive a return. This return consists of the gradual increase (or
appreciation) in the value of the security from its original, below-face-value purchase price until it is
redeemed at face value on its maturity date.
■ Since this bonds pay no interest INT , only cash flow would be its maturity value M.

Example: Amex. Enterprises issues a zero-coupon bond having a 10-year maturity and a $1,000 face
value. If required return is 12 percent, then what would be the value of this bond

You will have to buy this $1000 par value bonds for $322 (Heavy discount) if you want to earn 12% each year till maturity.
Discount Bond.
■ A bond that sells below its par value; occurs whenever the market (economy’s) rate of interest is
above the coupon rate.
Premium Bond.
■ A bond that sells above its par value; occurs whenever the going rate of interest is below the coupon
rate.

Question: A friend of yours just invested in an outstanding bond with a 5% annual coupon and a
remaining maturity of 10 years. The bond has a par value of $1,000 and the market interest rate is
currently 7%. How much did your friend pay for the bond? Is it a par, premium, or discount bond?
Answer:
(Bond’s value $859.53. Because the bond’s coupon rate (5%) is less than the current market interest
rate (7%), the bond is a discount bond—reflecting that interest rates have increased since this bond was
originally issued.)
Price–yield relationship for two bonds where each price–yield curve represents a set of prices for that bond for
different assumed market required rates of return (market yields)
 Bonds Yield/Rates of Return
■ Its mean to find out the the market required rate of return
■ Unlike the coupon interest rate, which is fixed, the bond’s yield varies from day to day,
depending on current market conditions.
■ This Is the rate, which sets the discounted value of the expected cash inflows equal to the
security’s value/intrinsic value/current market price, is also referred to as the security’s
(market) yield.
■ It is important to recognize that only when the intrinsic value of a security to an investor
equals the security’s market value (price) would the investor’s required rate of return equal
the security’s (market) yield.
Interest-rate (or yield) risk: The variation in the market price of a security caused by
changes in interest rates.

Yield To Maturity (YTM)

■ The rate of return earned on a bond if it is held to maturity.
■ What rate of interest would you earn on your investment if you bought the bond, held it to
maturity, and received the promised interest payments and maturity value?
Example:
You have just purchased an outstanding 14-year bond with a par value of $1,000 for
$1,494 93. Its annual coupon payment is $100. What is the bond’s yield to maturity?

Answer is 5%, You will earn 5 % each year till maturity.

 Yield To Call (YTC)
■ The rate of return earned on a bond when it is called before its maturity date.
■ If you purchase a bond that is callable and the company calls it, you do not have the option of holding
it to maturity.

To illustrate, suppose Allied’s bonds had a deferred call provision that permitted the company, if it
desired, to call them 10 years after their issue date at a price of $1,100. Suppose further that interest
rates had fallen and that 1 year after issuance, the going interest rate had declined, causing their price
to rise to $1,494.93. Here is the time line and the setup for finding the bonds’ YTC with a financial
calculator:

The YTC is 4.21% this is the return you would earn if you bought an Allied bond at a price of $1,494.93
and it was called 9 years from today. (It could not be called until 10 years after issuance because of its
deferred call provision. One year has gone by, so there are 9 years left until the first call date.)
 Stocks and Their Valuation
■ Cash flows provided by bonds are set by contract, it is generally easy to predict their cash flows.
Preferred stock dividends are also set by contract, which makes them similar to bonds; and they are
valued in much the same way.
■ Common stock dividends are not contractual—they depend on the firm’s earnings, which in turn
depend on many random factors, making their valuation more difficult.
■ Two fairly straightforward models are used to estimate common stocks’ intrinsic (or “true”) values:
1. The discounted dividend model and
2. The corporate valuation model.
■ A stock should, of course, be bought if its price is less than its estimated intrinsic value and sold if its
price exceeds its intrinsic value.
Stock Price versus intrinsic Value
■ The stock price is simply the current market price, and it is easily observed for publicly traded
companies.
■ By contrast, intrinsic value, which represents the “true” value of the company’s stock, cannot be
directly observed and must instead be estimated.
So, Valuation of Stock means to find out its intrinsic (or “true”) value.
Determinants of Intrinsic Values and Stock Prices
 Preferred Stock Valuation
■ A type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors.
It has preference over common stock in the payment of dividends and claims on assets.
Thus the present value of preferred stock is

is the stated annual dividend per share of preferred stock

is the appropriate discount rate (Capitalisation rate, cost of equity, investor’s required rate of return).
*(In Bonds we discount with market interest rate here we discount with cost of equity)
Example: If Margana Cipher Corporation had a 9 percent, $100-par-value preferred stock issue
outstanding and your required return was 14 percent on this investment, its value per share to you would
be
V = $9/0.14 = $64.29
■ Virtually all preferred stock issues have a call feature (a provision that allows the company to force
retirement), and many are eventually retired. When valuing a preferred stock that is expected to be
called, we can apply a modified version of the formula used for valuing a bond with a finite maturity.
 Common Stock Valuation
■ Securities that represent the ultimate ownership (and risk) position in a corporation.
■ Unlike bond and preferred stock cash flows, which are contractually stated, much
more uncertainty surrounds the future stream of returns connected with common
stock.
■ The value of a share of common stock depends on the cash flows it is expected to
provide, and those flows consist of two elements:
1. The dividends the investor receives each year while he or she holds the stock and
2. The price received when the stock is sold. The final price includes the original price
paid plus an expected capital gain.
■ The theory surrounding the valuation of common stock has undergone profound
change during the last few decades. It is a subject of considerable controversy, and
no one method for valuation is universally accepted.
Are Dividends the Foundation for stock valuation?
■ Unless a firm is liquidated or sold to another concern, the cash flows it provides to its
stockholders will consist only of a stream of dividends. Therefore, the value of a
share of stock must be established as the present value of the stock’s expected
dividend stream.
 Dividend Discount Models
■ Dividend discount models are designed to compute the intrinsic value of a share of common stock
under specific assumptions as to the expected growth pattern of future dividends and the
appropriate discount rate to employ.
■ We will consider the following assumptions of future dividend for common stock valuation.

Constant Growth
No Growth
Growth Phases
Constant Growth
If dividends are expected to grow at a constant rate, we can find out the stock value using following
formula.

D The annual dividend expected by the end of the coming year. : (investor required rate of return)

Example: LKN, Inc.’s dividend per share at t = 1 is expected to be $4, that it is expected to grow at a 6
percent rate forever, and that the appropriate discount rate is 14 percent. What would be the value of
one share of LKN stock ?
■ The critical assumption in this valuation model is that dividends per share are expected to
grow perpetually at a compound rate of g. For many companies this assumption may be a
fair approximation of reality.
■ For companies in the mature stage of their life cycle, the perpetual growth model is often
reasonable.
■ Rearranging, the investor’s required return (Cost of equity) can be expressed as

No Growth
■ Here the assumption is that dividends will be maintained at their current level forever.
■ If we put the zero in constant growth equation given on previous slide , the equation for now
growth will be

■ Not many stocks can be expected simply to maintain a constant dividend forever.
■ when a stable dividend is expected to be maintained for a long period of time, the above
equation can provide a good approximation of value .
 Growth Phases
■ When the pattern of expected dividend growth is such that a constant growth model is not
appropriate, modifications of the following constant growth equation can be used.

Is the present dividend per share.

■ Firms may exhibit above-normal growth for a number of years (g may even be larger than ke during
this phase), but eventually the growth rate will taper off.
■ If dividends per share are expected to grow at a 10 percent compound rate for five years and
thereafter at a 6 percent rate forever, the above equation becomes

■ Note that the growth in dividends in the second phase uses the expected dividend in period 5 as its
foundation. Therefore the growth-term exponent is t − 5, which means that the exponent in period 6
equals 1, in period 7 it equals 2, and so forth.
■ This second phase is nothing more than a constant-growth model following a period of above-normal
growth.
■ If the current dividend, , is $2 per share and the required rate of return, , is 14 percent, we could
solve for V
 Stocks Yield/Rates of Return
■ This Is the rate, which sets the discounted value of the expected cash inflows equal to the security’s
value/intrinsic value/current market price, is also referred to as the security’s (market) yield.
■ The rate of return that sets the discounted value of the expected cash dividends from a share of stock
equal to the share’s current market price is the yield on that stock.
Yield on Proffered Stock
■ Substituting current market price for intrinsic value (V) in preferred stock valuation

market required return for this stock, or simply the yield on preferred stock. By rearranging the above
equation the equation for yield on preferred stock will be

Example: current market price per share of Acme Zarf Company’s 10 percent, $100-par-value preferred
stock is $91.25. Acme’s preferred stock is therefore priced to provide a yield of
 Yield on Common Stock
■ If, for example, the constant dividend growth model was appropriate to apply to the common stock of
a particular company, the current market price could be said to be

■ From this above expression, it becomes clear that the yield on common stock comes from two
sources.
■ The first source is the expected dividend yield, Plus expected capital gains yield "
■ Yes, g wears a number of hats. It is the expected compound annual growth rate in dividends. But,
here in this model of yield, it is also the expected annual percent change in stock price (that is,
P1/P0 − 1 = g) and, as such, is referred to as the capital gains yield.
Example: What market yield is implied by a share of common stock currently selling for $40 whose
dividends are expected to grow at a rate of 9 percent per year and whose dividend next year is expected
to be $2.40?
Solution: