Managerial Finance

Chapter 4 Time Value Applications: Security Valuation and Expected Returns Image of a trading board. Alan Schein Photography/Corbis Learning Objectives After studying this chapter, you should be able to: Solve for the value of zero-coupon bonds using time value of money mathematics. Determine the value of preferred stock using time value of money mathematics. Solve for the value of constant-growth common stock using time value of money mathematics. Determine the value of nonconstant-growth common stock using time value of money mathematics. Explain how factors such as coupon rate, interest rates, and maturity affect bond values over time. Solve for the expected rates of return for securities, given their market prices and cash flow characteristics. Ch. 4 Introduction In Chapter 3, we began the study of money's time value. In this chapter, we apply those basics to the valuation of securities (stocks and bonds) and to solving for expected returns from investing. Along the way, we present some of the terminology and features of corporate securities. The ability to solve for the value of a share of common stock is a fundamental skill for a corporate manager to have. Recall from Chapter 1 that it is management's job to maximize shareholders' wealth, a task impossible to carry out without knowledge of what factors influence share prices and therefore determine the wealth of shareholders. Common and preferred stock valuation as well as bond valuation are also important topics for anyone who may wish to personally invest in such securities. The first part of this chapter introduces security valuation. Solving for expected returns is the topic that concludes Chapter 4. When price is known, it may be helpful for the manager (or the investor) to estimate the return or yield that can reasonably be expected from a project or investment. Such an expected return can be compared to returns offered by competing projects or investments. An investor, for example, would not want to invest in a corporate bond whose expected yield was below that of a less risky government bond. Before beginning, let's quickly review value. Recall from earlier chapters that value is dependent on cash flows to investors, the timing of those cash flows, and their riskiness. The cash flow that a security holder receives is the principal benefit of ownership. Without that benefit, the security would be nearly worthless. Cash flows from the firm to shareholders come in the form of dividends, and for bondholders the cash received comes in the form of coupon interest payment. As we will demonstrate, shareholders also receive cash flows from other investors when they sell their stock at a (hopefully!) higher price. This price appreciation is due to the expectation of higher future dividends, making the claim on future cash flows more valuable. Now we apply the time value of money techniques introduced in Chapter 3 to the valuation of commonly encountered securities. 4.1 Zero-Coupon Bonds: A Single Cash Flow Corporations and the government sometimes issue bonds known as zero-coupon bonds. These bonds differ from typical bonds in that they make no payments to the bondholders until maturity. Let's consider a bond that matures in 20 years, pays no coupon interest, and has a par value, or maturity value, of $1,000. That is, the investor will receive $1,000 on the bond's maturity date but no other cash payments during the life of the bond. If investors require an 8% annual return from this security, based on annual compounding, what should be the selling price of the bond? The problem is illustrated with a timeline in Figure 4.1, and practiced in the Applying Finance: Price of a Zero-Coupon Bond feature. Figure 4.1: Determining the present value of a zero-coupon bond Timeline that seeks to determine the present value of a zero coupon bond. What is the present value of a zero-coupon bond that pays $1,000 in 20 years with a required return of 8% annually? Use Equation (3.7) from Chapter 3 to find the current value: (3.7) PV0 = FVn(1 + r)-n or FVn /(1 + r)n PV0 = $1,000(1.08)-20 = $1,000(0.21455) + $214.55 Applying Finance: Price of a Zero-Coupon Bond Present Value of a Zero-Coupon Bond: How much would an investor pay today for a zero-coupon bond that pays $1,000 in 20 years and earns 8% per year? To Solve Using TI Business Analyst Calculator 1000 [FV] 8 [I/Y] 20 [N] 0 [PMT] [CPT] [PV] = $214.55 Note: Similar to Excel, the PV is displayed as a negative. Also, you may enter the keystrokes in any order you wish so long as you enter CPT PV at the end. To Solve Using Excel Use the PV function. The inputs for this function are: = PV(Rate%,NPER,PMT,FV,Type) = PV(8%,20,0,1000,0) = (214.55) The answer displayed is negative (in parentheses or red or signed negative) because that is how much the investor will pay today (an outflow or negative cash flow) to receive $1,000 in 20 years. Remember that Excel requires an outflow and an inflow (i.e., a cash flow signed positive and a cash flow signed negative). When we entered the positive FV of $1,000 that meant that the PV had to be negative. Caution: Remember that numbers cannot be entered with commas separating thousands of dollars because commas separate inputs in Excel functions. Image of a $1,000 US Savings Bond. One of the most common types of zero-coupon bonds is the U.S. savings bond. Can you think of any other examples of zero-coupon bonds? Associated Press The secondary market for zero-coupon bonds is very active. Suppose one is selling for $425, maturing in 14 years, at which time it will pay $1,000 to its holder. In this case, investors would be interested in the yield-to-maturity (YTM), or the return that the bond offers given its current market price and other characteristics. This problem is illustrated in Figure 4.2, and practiced in the Applying Finance: Yield-to-Maturity of a Zero-Coupon Bond feature. Figure 4.2: Determining the YTM of a zero-coupon bond Timeline that seeks to determine the YTM of a zero coupon bond. What is the YTM of a zero-coupon bond selling for $425 today, if it will pay $1,000 in 14 years? To solve for r, Equation (3.4) from Chapter 3 could be used. (3.4) FVn=PV0(1+r)n$1,000=$425(1+r)14(1+r)14=1,000425(1+r)14=2.3529411+r=(2.352941)1/14r=(2.352941)1/14−1r=1.06303−1r=0.06303YTM=6.303% This bond is expected to yield 6.303% if held to maturity. Applying Finance: Yield-to-Maturity of a Zero-Coupon Bond Yield-to-Maturity of a Zero-Coupon Bond: What annual rate of return will an investor earn if she pays $425 today for a zero coupon that pays $1,000 when it matures in 14 years? To Solve Using TI Business Analyst 14 [N], 0 [PMT], 425 [+/–] [PV], 1000 [FV], [CPT] [I/I] Note that, like the Excel keystrokes, either the price (PV) or the par value (FV) has to be negative in order to "tell" the calculator that one cash flow is going to the firm and one is going to the investor. To Solve Using Excel Use the Rate function with the format: RATE(NPER, PMT, PV, FV, TYPE, GUESS) =RATE(14,0, –425,1000,0,10%) = 6.303% Note: One of the cash flows is negative (the $425) and the other is positive ($1000). There is no comma or dollar sign in the $1000. The TYPE is zero because we assume interest accrues at the end of the period. GUESS can be left out or enter something that seems reasonable. The display of the answer can be adjusted to show more or fewer decimal places by formatting the cells. 4.2 Preferred Stock: A Perpetuity The most common type of perpetuity is preferred stock. Preferred stock generally pays a fixed dividend. Thus, eight-dollar preferred refers to a share of preferred stock that promises to pay a dividend of $8 once per year into the foreseeable future. Preferred stock is known as a hybrid security in that it combines features of both fixed claims (bonds—i.e., debt) and residual claims (stocks—i.e., equity). Table 4.1 outlines the hybrid qualities of preferred stock. Table 4.1: Hybrid security features of preferred stock Bond-like qualities Stock-like qualities • Fixed dividend payments • Dividend payments not legally guaranteed • Callable • Interest is not tax deductible • No maturity date Preferred stock is fixed in the sense that the amount the issuing corporation is obligated to pay does not vary; it is fixed like the coupon rate on debt (in this case it is $8 once every year). Also, similar to some bond issues, preferred stock can be redeemable or callable (we will discuss this further in Section 4.6). On the other hand, preferred stock is residual because there is no legal obligation for the company to pay a dividend unless it has cash flows left over after all other fixed claims (such as interest on bonds) have been paid. Preferred claims have a lower priority than other fixed claims, but a higher priority than common stock. Therefore, no dividends can be paid to common stockholders unless preferred dividends have been paid first. This contrasts to interest on debt, which must be paid or the company risks legal action by bondholders. Interest on debt is tax deductible, but dividends on preferred stock (and common stock) is not, making $1.00 of dividends more expensive for the company than $1.00 of interest. Also, like common stock, preferred stock has no maturity date. The present value of a perpetuity formula is used to find the price of a share of eight-dollar preferred. The interest rate equals 16% in the example. (3.12) PV0=CFrP0=DrP0=$80.16P0=$50.00 PG&E president Chris Johns speaking at a news conference. Public utility companies like Pacific Gas & Electric are among the main issuers of preferred stocks. What do you think are the benefits of preferred stocks? Getty Images News/Getty Images PV0 = CF/r is re-expressed as = D/r because today's price (P0) is equal to the present value of future cash flows (PV0) and preferred's dividend (D) is the perpetuity's cash flow (CF). The price is $50 per share. Most preferred stock in the United States is issued by public utilities, financial institutions, or REITs (real estate investment trusts). For example, Pacific Gas & Electric (PG&E with ticker symbol PCG), a large California public utility, has eight different issues of preferred stock. One issue is the 6.0% nonredeemable preferred with a par value of $25.00. Each year the stock pays a dividend of 6% of $25 or $1.50. Dividends are paid quarterly so each quarter an investor receives $0.375 per share in dividends. The 5% preferred, also with a $25.00 par value, pays quarterly dividends of $0.3125 = 5% × $25/4. On May 29, 2012, the 6% PG&E preferred stock sold for $29.35, down a bit from a price of $29.92 a few days before. At the $29.35 price, investors are earning a return of 5.1107%. See the Web Resources at the end of the chapter for a link to the trades in this preferred stock. Preferred stock issues, like PG&E, do not trade very often. 4.3 Common Stock: A Growing Perpetuity An image of the share price of Google at the NASDAQ marketsite. Common stocks for companies such as Google are more familiar to us than preferred stocks. What are the benefits and drawbacks to common stocks? Associated Press Unlike preferred stock, common stock does not pay dividends that are a constant amount through time. On the other hand, common dividends are equally spaced in time and do continue indefinitely. Common stock, therefore, satisfies all the criteria of a perpetuity except the changing amount of its dividend payment. To find the price of common stock we might use the general formula for the present value of a stream of cash flows. Again, recognizing that PV0 = P0 and CF1 = D1, CF2 = D2, and so on, we may re-express the formula in terms of the price (P0) and dividends (D1, D2, . . .) of the common stock: (4.1) P0=D1(1+r)1+D2(1+r)2+D3(1+r)3+...=∑n=1∞Dn(1+r)n Clearly, it is impossible to solve this equation explicitly because the cash flows (dividends) go on forever. A number of models have been developed to allow this formula to be solved. The simplest model requires the assumption that successive dividends grow at a constant rate. We call this a growing perpetuity. Let that rate be termed gN, the long-run normal growth rate of dividends. The dividends may be expressed as (1 + gN) multiplied by the preceding year's dividend payment: D0 = the current dividend D1 = D0(1 + gN) D2 = D1(1 + gN) = D0(1 + gN)2 D3 = D2(1 + gN) = D0(1 + gN)3 Substituting into Equation (4.1) yields a geometric series: (4.2) P0=D0(1+gN)(1+r)+D0(1+gN)2(1+r)2+D0(1+gN)3(1+r)3+...=∑n=1∞D0(1+gN)n(1+r)n Mathematicians have shown that as long as g is less than r, this series can be summed fairly easily. A constant-growth stock may be valued using the constant-growth formula, (4.3) P0=D0(1+gN)r−gN=D1r−gN To illustrate the formula, let's assume a stock has just paid a $5.00-per-share dividend. We believe that future dividends will grow at a 6% rate forever, and investors require a 13% return on their investment in this stock. The stock's price should be P0=$5.00(1.06)0.13−0.06P0=$5.300.07P0=$75.71 The growth rate plays a very important role in determining the value of a share of stock (or any asset). In this example, suppose the dividend growth rate had been 2% instead of 6%. Then the value of the stock today would be $46.36 = $5.00(1.02)/(0.13 – 0.02). Had the growth rate been zero (like a share of preferred stock), the value today would be just $5.00/0.13 = $38.46. You can see that the additional growth has a large effect on the value of the stock. 4.4 Common Stock: Nonconstant Dividend Growth The constant-growth valuation model works well for securities whose forecasted financial behavior corresponds to the model's assumption of dividends that grow at a constant rate. Some companies, such as electric utilities, compete in mature markets that offer few prospects for rapid growth. Demand for their product is pretty stable, varying little with economic cycles. Such firms may be good candidates for valuation using the constant-growth model. For many corporations, however, the constant-growth assumption does not hold. Often firms have new products that have competitive advantages over their competitors' products. Patent protection, new technology, low-cost production methods, and brand name recognition may enable a firm to experience rapid growth for a period of time. In the long run, though, this rapid growth is not sustainable as competitors' technology, manufacturing efficiency, and so on, catches up with the industry leader's, leveling the playing field in the marketplace. A constant-growth valuation model is clearly inappropriate for firms that experience a period of nonconstant growth. McDonald's Rise from Financial Downturn Even a company as successful as McDonald's experiences non-constant growth and drops in stock prices. There are many other examples of non-constant growth corporations. How is non-constant growth significant to a financial manager? Table 4.2 shows the annual dividends that Johnson & Johnson has paid since 2000. Notice that the constant-growth model would probably not be appropriate for Johnson & Johnson since the growth rates have been somewhat erratic. Also notice that the firm experienced double-digit growth rates between 2000 and 2008, but then dividend growth tapered off fairly dramatically. Table 4.2: Johnson & Johnson annual dividends since 2000 Year Dividend Annual % change 2000 $0.620 13.8% 2001 $0.700 12.9% 2002 $0.795 13.6% 2003 $0.925 16.4% 2004 $1.095 18.4% 2005 $1.275 16.4% 2006 $1.455 14.1% 2007 $1.620 11.3% 2008 $1.795 10.8% 2009 $1.930 7.5% 2010 $2.110 9.3% 2011 $2.250 6.6% Note: Based on data from http://finance.yahoo.com A lineup of Johnson & Johnson products: Band-Aids, baby powder, and baby shampoo. Most corporations, even large ones like Johnson & Johnson, experience nonconstant growth due to competition with other companies. How is the ability to calculate dividends helpful when buying stock? Getty Images News/Getty Images One method for valuing firms in a nonconstant-growth cycle is presented here. Let's assume that we are valuing a stock whose dividends are expected to grow at an 18% rate for each of the next three years. After this abnormal growth period, normal growth will continue at a 5% annual rate. The company's last annual dividend was $2.00 per share. The discount rate for the stock is 16%. The timeline in Figure 4.3 illustrates the growth assumptions of this example. Figure 4.3: Nonconstant dividend growth Timeline illustrating non-constant dividend growth. There are many reasons why a company might have nonconstant dividend growth. What might account for abnormal growth periods? As shown in Figure 4.3 gA = abnormal growth rate = 18% A = length of abnormal growth period = 3 gN = normal or constant-growth rate = 5% Because today's price should equal the present value of future dividends, the first step is to find the size of these dividends. D0 = $2.00 last dividend paid D1 = $2.00(1.18) = $2.36 In year 1 dividends grow at 18% D2 = $2.36(1.18) = $2.78 In year 2 dividends grow at 18% D3 = $2.78(1.18) = $3.28 In year 3 dividends grow at 18% D4 = $3.28(1.05) = $3.44 In year 4 dividends grow at 5% Dividends growth at 5% from D4. . . It is impossible to solve explicitly for the value of all future dividends, and, thus, it is also impossible to find explicitly the present value of all future dividends. But, note that from point A forward, the growth rate is constant. This means that the assumptions of the constant-growth valuation model are met from period 3 onward. We can, therefore, solve for P3, the stock's price at time 3, using the constant-growth model. This value, P3, incorporates the value of all the dividends from time 3 onward. P3 includes the present value of D4, D5, D6, and so on. Recognizing this gives us a strategy for solving for P0, the current price. P0=D1(1+r)1+D2(1+r)2+D3(1+r)3+D4(1+r)4+D5(1+r)5+... But P3=D4(1+r)4+D5(1+r)5+...(4.4) P0=D1(1+r)1+D2(1+r)2+D3(1+r)3+P3(1+r)3 So Note that P3 is discounted for three periods because it is the price as of period 3 in Figure 4.3. We already know the value of D1, D2, D3, and r, so these values may be substituted into Equation (4.4). P0=$2.361.16+$2.78(1.16)2+$3.28(1.16)3+P3(1.16)3 To solve for P3, recall the constant-growth formula from the prior section: P0=D1r−gN It solved for P0 using D1 because the constant-growth assumption held from time 0 onward. In this example, the constant growth holds from time 3 onward, so we can adjust the formula relative to time 3 and solve for P3. (4.5) P3=D4r−gN P3=$3.440.16−0.05=$3.440.11=$31.27 We now have all the values we need to solve for P0, the current price of the stock. P0=$2.361.16+$2.78(1.16)2+$3.28(1.16)3+$31.27(1.16)3=$2.03+$2.07+$2.10+$20.04=$26.24 This price, $26.24, accounts for the present value of all future dividends. The present values of D0, D1 through D3 are solved for explicitly. The present values of D4, D5, D6, and so on are solved for implicitly by finding the present value of P3. P3 is able to incorporate the values of all dividends after time 3 because dividends grow at a constant rate from time 3 onward. This method may be generalized in the following formula. (4.6) P0=∑t=1ADt(1+r)t+PA(1+r)A where (4.7) PA=DA+1r−gNA=the number of years until constant growth begins.DA+1=DA(1+gN)=D0(1+gA)A(1+gN)D1,D2,.......,DA= dividends during the nonconstant-growth period 4.5 Bonds: An Annuity and Single Cash Flow Bonds can be thought of as a combination of an annuity and a single cash flow. Bond investors receive from the corporation both a stream of coupon interest payments over the life of the bond (annuity), and a payment of par value at maturity (single cash flow). Most bonds make coupon payments semiannually, and corporate bonds generally carry a $1,000 par value. The cash flows for a typical bond are illustrated in Figure 4.4. Figure 4.4: Cash flows for a typical bond Timeline illustrating cash flows for a typical bond. Bonds have characteristics of annuities and single cash flows. In the figure, m is the number of coupon payment periods until the bond matures. For bonds paying coupons semiannually, m is twice the number of years until maturity. Every semiannual coupon payment equals one-half the coupon rate multiplied by the bond's par value, so a bond with an 8% coupon rate would make two $40 interest payments every year (8% × $1,000)/2. The price of a bond is the present value of the coupon stream plus the present value of par value. The coupon stream is an annuity and the repayment of par value is a single cash flow. The timeline in Figure 4.5 may be used to find the present value (the price) of a bond. Figure 4.5: Determining the present value of a bond Timeline seeking to determine the present value of a bond. A bond's price is equal to the present value of the coupon stream, plus the present value of par value. The formula for solving for a bond's value is given here; keep in mind that r is the investors' required return for the bond (the discount rate per payment period). PV0=(Coupon)(1−[1/(1−r)m])r+Par value(1+r)m A bond that carries an annual coupon rate of 6.5%, makes coupon payments semiannually, has a $1,000 par value, and matures in 10 years would have a value of $684.58 if the investors discount its cash flows at a 12% annual rate. Note that the 6.5% annual coupon rate is equal to 3.25% semiannually, yielding the $32.50 semiannual coupon payment. The 12% annual required return is re-expressed as 6% semiannually to agree with the semiannual payment period, and the number of periods is (10)(2) = 20. PV0=(32.50)(1−[1/(1−1.06)20])0.06+$1,000(1.06)20PV0=$372.77+311.80PV0=$684.57 This problem is also practiced in the Applying Finance: The Price of a Bond feature. Applying Finance: The Price of a Bond Finding the Price of a Corporate Bond: If an investor wants to earn a 12% annual return, how much would she pay today for a bond that carries an annual coupon rate of 6.5%, makes coupon payments semiannually, has a $1,000 par value, and matures in 10 years? To Solve Using TI Business Analyst 6 [I/Y], 20 [N], 1000 [FV], 32.50 [PMT], [CPT] [PV] Note that both the FV and the PMT are signed positive because they are both cash inflows for investors, and therefore the answer for PV will be negative because it will be the price investors are willing to pay. Of course, one could make both the FV and PMT negative, and the answer would be positive, taking the cash flows from the firm's perspective. To Solve Using Excel Excel Solution: Use the PV functions with the following inputs: RATE = 6% (This is the semiannual version of the 12% annual discount rate.) NPER = 20 (There are 20 semiannual periods in 10 years.) PMT = $32.50 (This is the semiannual interest payment to investors = $1,000x6.5%/2) FV = $1000 (This is the par or face value of the bond that is repaid at maturity.) TYPE = 0 (Interest payments are paid at the end of periods after interest has had time to accrue.) = PV(6%,20,32.50,1000,0) = PV(6%,20,32.50,1000,0) Display shows ($684.577). This is signed negative because this is the amount the investor will pay to purchase the future promised payments. Men using Caterpillar Incorporated machines to dig into the ground. Many corporations, like Caterpillar Incorporated, rely on various types of bond issues. What do you think are the benefits of bonds versus stocks? Associated Press Note that this bond is selling below its par value ($684.58 < $1,000). It is said to be selling at a discount. Had the bond been valued at $1,000 so that the price was the par value, the bond would be selling at par. A bond whose price is above par is selling at a premium. These pricing differences can be attributed to the relationship between the bond's annual coupon rate and the investor's required return for the bond. In our example, the annual coupon rate was below the annual required return (6.5% < 12%). If investors paid full par value for the bond, it would only yield the coupon rate—below their requirements for making the investment. Bondholders could not sell this bond for $1,000 because there would be no demand. In order to market the bond, the bondholder must lower the price until the yield to the buyer equals the required return. Note that when purchasing a bond at a discount, investors will receive not only coupon payments but also a capital gain because they invest less than $1,000 yet receive the full par value when the bond matures. Buying a bond priced at a premium will lower the yield to investors because they will realize a capital loss over the life of the bond, offsetting a portion of their return from the coupon payments. A capital gain or loss becomes part of the bond's return to investors. Caterpillar Incorporated (CAT) has a number of bonds outstanding. One bond issue has 9.375% coupon rate and matures in 2021. In Figure 4.6, we show how the price of the bond (the red line) changes as the yield on BAA-rated corporate bonds changes (the blue line) from 2003 through 2010. You can see the almost inverse relationship between market yields and the price of the bond. As yields fall, as they did in early 2008, the price of the bond rises. Since the bond has a high coupon rate (9.375%), investors place a high value on the bond when yields are low. Figure 4.6: CAT bond price change in relation to BAA-rated corporate bonds Graph illustrating price changes in the corporate bond yields from 2003-2012 Important information can be obtained by examining the historical price changes of corporate bonds. Based on data from www.bondsonline.com The CAT 9.375% bonds are not callable; that is, they cannot be redeemed before their maturity date in 2021. CAT has over a dozen different bonds issues. Some are callable, so the company can redeem them (buy them back for a fixed price) before the maturity date if it wants. To see the entire list of CAT bonds (as well as bonds issued by its financing subsidiary), see the Web Resources section at the end of the chapter. Bonds are useful for illustrating the relationship between the time value of cash flows and interest rates. Consider a 20-year bond that carries a 10% annual coupon rate, has a $1,000 par value, and makes coupon payments semiannually. If investors require a 10% return on the date the bond is initially sold to the public, then the bond's price will be $1,000. It will sell at par. On the following day, let's assume that interest rates rise dramatically and investors now require a 12% annual return on the bond. Those investors who bought the bond on the previous day own a security that pays a series of fixed payments that yield 10% on their $1,000 outlay. In order to sell the bond, they must lower the price so the series of payments will yield a 12% return to the purchaser. Solving for the present value of the bond, given the new 12% annual discount rate, yields a price of $849.54. If rates had dropped to 8%, for example, the bond would sell for $1,197.93. Thus, the price of a bond moves in the opposite direction from interest rates. To see how to find the price for both these rates using Excel, see the Applying Finance: Solving for Price on a 20-year Bond feature. Applying Finance: Solving for Price on a 20-year Bond We can find the bond prices for the 20-year bond easily in Excel: Excel formula: =PV(6%,40,50,1000,0) = $849.54 Excel formula: =PV(4%,40,50,1000,0) = $1197.93 Now let's consider a bond identical to the one just described, except it matures in 30 years rather than 20 years. Again, when the appropriate discount rate is 10%, the bond will sell at par, $1,000. We solve for the price of the bond using a 12% discount rate and an 8% discount rate (see Applying Finance: Solving for Price on a 30-year Bond). Applying Finance: Solving for Price on a 30-year Bond We can find the bond prices for the 30-year bond in Excel: Excel formula: =PV(12%,60,50,1000,0) = $838.39 Excel formula: =PV(8%,60,50,1000,0) = $1226.23 Compare the way that the 20-year and 30-year bond's prices responded to changes in the interest rate. Note that the longer the maturity of the bond, the more sensitive it is to interest rate changes. Investors, knowing this, generally require a higher return for longer maturity bonds because their prices will have greater responses to any changes in interest rates. For this reason, yields on longer-term bonds tend to be higher than short-term bond yields, assuming they are issued by equally risky borrowers. Table 4.3 shows how the prices of bonds vary with maturity and market interest rates. Notice the longer the maturity is, the greater price change is due to shifts in market interest rates. Table 4.3: Variations in price for a 10% coupon (semiannual payments) Years to maturity 6.00% Market rate 8.00% Market rate 10.00% Market rate 12.00% Market rate 14.00% Market rate 5 $1,170.60 $1,081.11 $1,000.00 $926.40 $859.53 10 $1,297.55 $1,135.90 $1,000.00 $885.30 $788.12 15 $1,392.01 $1,172.92 $1,000.00 $862.35 $751.82 20 $1,462.30 $1,197.93 $1,000.00 $849.54 $733.37 25 $1,514.60 $1,214.82 $1,000.00 $842.38 $723.99 30 $1,553.51 $1,226.23 $1,000.00 $838.39 $719.22 There are two important lessons here. First, bond prices move in the opposite direction as movements in interest rates; and second, the longer the maturity of the bond is, the greater the change in its price is for a given change in rates. This relationship is illustrated in Figure 4.7 using a teeter totter. When the interest rate side goes down, the price side goes up. The length of the right-hand side of the teeter-totter may be thought of as the time until the bond matures. The longer the right-hand side, the greater the movement in price for a given movement in interest rates. Therefore, the longer the maturity, the more risk there is of a large adverse price change. This risk is termed interest rate risk. Figure 4.7: The interest rate-bond price teeter-totter Graph illustrating price changes in the corporate bond yields from 2003-2012 As interest rates rise, bond prices fall, and vice versa. Why is this? 4.6 Solving for Expected Returns Image of various copies of the Wall Street Journal. Sources like the Wall Street Journal are useful when calculating expected returns. What are some other helpful resources? Jerry Arcieri/Corbis In the preceding sections, we solved for the value of preferred stock, common stock, and bonds. Many issues of these securities are actively traded in financial markets. It is often more useful for investors to solve for the returns they might expect to realize from an investment in such securities than to solve for their value. After all, prices are generally known in the marketplace, so investors would be more interested in expected returns on competing securities, rather than prices. Similarly, corporate managers can compare expected returns from prospective LHS projects when deciding how to allocate the firm's investment dollars among assets. Solving for expected returns is analogous to finding value because the same formulas are used. Instead of knowing the discount rate and solving for price, however, now we know the price and are solving for the rate of return. Let's consider a preferred stock with a price, as quoted in the Wall Street Journal, of $53.50. We note that this preferred stock pays a $4.50 dividend annually. Recognizing that this preferred stock is a perpetuity, we substitute the known quantities into the perpetuity formula: P0=Dr$53.30=$4.50rr=$4.50$53.50=0.0841 The return on this preferred stock is 8.41%. More precisely, 8.41% is the expected return because buyers cannot be certain that they will realize the 8.41% return (the firm could go bankrupt). The expected return for common stock is found using Equation (4.3), if we assume the stock's dividends will grow at a constant rate. (4.3) P0=D1r−gN (r−gN)P0=D1 r−gN=D1P0 r=D1P0+gN Equation (4.3) is useful for two reasons. First, it may be used to find the expected return on a share of stock. For example, if a share is selling for $35, next year's dividend is expected to be $3 per share, and dividends are expected to grow at a 6% rate indefinitely, then the expected return on an investment in the stock is 14.57%: r=$3$35+0.06r=0.0857+0.06r=0.1457=14.57% The second use of Equation (4.3) is to illustrate the sources of the expected return. The first term to the right of the equal sign in Equation (4.3) is the dividend yield, D1/ P0. The second term, gN, is equal to the capital gains rate. For our stock, investors expect an 8.57% return each year from dividends and a 6% return from price appreciation. Let's now turn to bonds. Because of the complexity of the bond formula, expected returns from bond investments must be solved using either trial and error or a good financial calculator. To illustrate the trial-and-error method, let's solve for the expected return on a bond that sells for $800, pays coupons semiannually, matures in 10 years, carries a 9% coupon rate, and has a $1,000 par value. $800=($45)(1−[1/(1+r)20])r+$1,000(1+r)20 Now we must take an educated guess at what r might be. We do have a clue about r: The bond is selling at a discount. Recall that a bond sells at a discount when its yield is greater than the coupon rate. Therefore, we know that r > 4.5% (expressing rates on a semiannual basis to conform to the coupon payment period). Say that our first guess for r is 5.5%: $800⇔?($45)(1−[1/(1.055)20])0.055+$1,000(1.055)20$800⇔?$880 Because $880 is above the actual price, we know we must raise the interest rate, lowering the value of the right-hand side of the equation. This time let's try 6%. Using 6%, we get a value of $827.95, still too high, but closer. Now let's try 6.25%. This time the answer is $803.29, close enough using trial and error. The approximate expected return when buying this bond for $800 is 6.25% semiannually, or 12.5% per year. For a bond, the expected return is also called the bond's yield to maturity, or YTM. This problem is practiced in the Applying Finance: Corporate Bond YTM feature. Applying Finance: Corporate Bond YTM Solving for the rate that equates the price to the promised future cash flows: What is the YTM (yield to maturity) of a 10-year bond with a 9% coupon rate, $1,000 face value, if its price today is $800, and it pays interest semiannually? To Solve Using TI Business Analyst 20 [N], 45 [PMT], 800 [+/–] [PV], 1000 [FV], [CPT][I/Y] = 6.284% Note: The answer will be given as a percentage and will be a semiannual rate so it must be doubled to find the YTM. 12.568% = 6.284 x 2 To Solve Using Excel =RATE(20,45,–800,1000,0,5%) = 6.284% This is the semiannual rate, so the annual return (yield to maturity) is 12.568%. GUESS can be left out as in : =RATE(20,45,–800,1000,0) Many bonds are what is known as callable, meaning that the issuing corporation has the option to repurchase the bond at a fixed price above the bond's par value at some date prior to the bond's maturity. These features are attractive to corporations because if the firm issues bonds at a time when interest rates are high, the call allows the company to repurchase the bonds early and avoid high interest payments in the future. Corporations that call a bond issue usually finance the repurchase by issuing new bonds that carry lower yields. This process is known as refunding debt. For an investor, a callable bond carries the risk that the corporation may repurchase the bond prior to maturity, and the bondholder, therefore, will not collect the high interest payment for the length of time initially anticipated. Thus, the yield to maturity for a callable bond may be misleading, and most investors also calculate the yield to call to see what return on their bond investment they are likely to realize. The yield to call is calculated in the same fashion as the yield to maturity except the time until call is substituted for the time until maturity (thus the number of coupon payments is reduced), and the call price is substituted for the call premium (thus the ending cash flow is greater than par). Let's demonstrate finding the yield to call by using the same bond we just used in the YTM example (see Applying Finance: Yield to Call). We assume that the call price is $1,100, and the call date is five years from now. This changes the future value to $1,100 rather than the $1,000 used in the earlier example and changes the number of semiannual coupon payment periods to 10 instead of 20. The discount rate that equates the $800 price with the future cash flows is 8.2% semiannually, for a yield to call of 16.4%. The yield to call is higher than the yield to maturity of 12.5% because of the higher ending cash flow that will be paid sooner if the bond is called. In this case, investors should not expect that the bond will be called. The bond is selling at a discount, meaning that market rates are currently above the coupon rate offered by the bond. Thus, the corporation would not choose to refund such an issue because it would have to issue bonds carrying a higher yield to replace these existing bonds. It is cheaper for the corporation to let the bonds mature rather than call them. This is the case whenever the yield to maturity is below the yield to call. Applying Finance: Yield to Call To Solve Using TI Business Analyst 800 [+/–] [PV] Today's Price 1100 [FV] The Call Price 10 [N] Semiannual Periods Until the Call Date 45 [PMT] Semiannual Coupon [CPT][ I/Y] = 8.19%, the Semiannual Yield 8.19% x 2 Yield to Call Most callable bonds have a period during which they cannot be redeemed, usually the first three to seven years after issuance. This assures investors that they will receive some of the interest payments before the bond is redeemed. Another standard feature of callable bonds is a call premium. If the bond is called before it reaches half of its stated maturity, the company has to pay investors a bonus to repay the bond. Think of this as an early payment penalty. Usually the call premium is an extra year's interest. Ch. 4 Conclusion Chapter 4 has applied the time value skills from Chapter 3 to the valuation of corporate securities. Pricing preferred stock was shown to be an application of the formula for valuing perpetuity. Common stock, when dividends are expected to grow at a constant rate, was valued using the growing perpetuity formula. Bonds were priced using a combination of the present value of a single cash flow (to value the return of par value at maturity) and the formula for finding present value of an annuity (to value the coupon payments). Variations of the formulas were also used to solve for the expected returns of traded securities. The ability to express equivalent values of cash flows at different points in time is a fundamental skill in finance. As with any skill, practice increases proficiency and understanding in solving time value problems. Ch. 4 Learning Resources Key Ideas Zero-coupon bonds differ from typical bonds in that they make no payments to the bondholders until maturity. Preferred stock is the most common type of perpetuity and is known as a hybrid security because it combines features of both fixed and residual claims. Common stock does not pay dividends that are a constant amount through time; rather, common dividends are equally spaced in time and continue indefinitely. The constant-growth assumption does not hold for all companies, and these firms must use the nonconstant-growth dividend model. Bonds can be thought of as a combination of an annuity and a single cash flow. Callable bonds carry the risk that the corporation may repurchase the bond before maturity, meaning the bondholder would lose the high interest payment for the length of time initially anticipated. Key Equations Critical Thinking Questions Corporate bonds can have lots of different features. To test your intuition about how investors look at bonds consider how the presence of the following features would affect the price an investor would be willing to pay for a bond. Sinking Fund: A sinking fund requires a company to set aside money over time to retire its bonds. For example, if a bond has a 20-year maturity, the company might begin setting aside funds in Year 11 so it will have a significant portion of the principal accumulated before the bond matures. Sometimes the sinking fund amount is used to purchase bonds early, but for this question assume that the fund is invested and the bonds are repaid at maturity. How would the existence of a sinking fund change the price investors are willing to pay for a bond? Call Feature: This allows a company to repurchase bonds before maturity. Usually callable bonds will have a no-call period (say the first five years) during which the company cannot repay the debt. For the next five years, the company may have to pay a premium to repay the bonds early. How would the existence of a call feature change the price investors are willing to pay for a bond? Think about when companies are most likely to want to repay bonds early. Collateral: Some loans are backed up with collateral; that is, the lenders have the first right to funds from specific corporate assets. We usually call such loans mortgages. How would the existence of collateral tied to a bond change the price investors are willing to pay for the bond? Suppose you purchase a bond with an 8% coupon rate for $1,000, which is the bond's face value. If you hold the bond to maturity, you will earn 8%. If you sell the bond before it matures, why might you not earn 8%? Preferred stock has fixed dividend payments, though they are somewhat discretionary. The dividends are not tax-deductible like interest on debt. The dividend payout rate must be higher than the yield on a company's debt since the preferred stock has lower priority in bankruptcy. Why would companies issue such a security? We developed a model to value stock based on dividends and dividend growth. If a stock doesn't pay any dividends does it have no value? Since there are many companies with valuable stock that don't pay dividends, we know the answer is "No." Explain why. What type of investors would be attracted to zero-coupon bonds? Why would they give up the interim coupon payments in favor of a larger payout at maturity? Common stock is often modeled as a growing perpetuity in which the growth rate is constant. If the overall economy is expected to grow at 6% per year over the long run, would it be reasonable to expect a firm's stock to grow at an average constant rate of 15% forever? Why or why not? (Hint: Imagine the economy as a pie that gets 6% bigger each year; then imagine the firm as a piece of that pie that gets 15% bigger every year.) Consider the constant-growth model for valuing a share of stock: (4.3) P0=D0(1+gN)r−gN=D1r−gN Can you develop a rule regarding the maximize value of gN that can be used in the constant-growth model? Negative values for gN are allowable. Under what circumstances might a firm's growth be seen as negative? How would stock price be affected as investors continue to lower their expectations about a company's growth prospects? Do the results from the constant-growth model match your intuition about how the price would change? If the constant-growth formula is applied to a stock whose growth rate is zero (gN = 0), what will the formula resemble? Will D1 differ from D0 from for a zero-growth stock? Key Terms Click on each key term to see the definition. call premium Amount in excess of par value that a company must pay when it calls a bond. It is the difference between the call price and the maturity value. callable bond A bond that gives the issuing corporation the option to repurchase the bond at a price above the bond's par value at some date prior to the bond's maturity. constant-growth formula A present value formula applied to stock valuation where dividends are modeled as a growing perpetuity. coupon rate The fixed interest paid by a bond, stated as a percentage of par value. dividend yield The return due to dividends received equals the annual dividend divided by share price. expected return The probability weighted value of an investment, computed by assigning a probability of occurrence to the various possible future values. growing perpetuity An infinite cash flow stream that makes payments at regular intervals (e.g., monthly, annually, etc.), with each payment equaling its predecessor times a fixed growth factor. hybrid security Investments that combines features of both fixed claims and residual claims. interest rate risk The amount a bond will repay to the bondholder when it matures. Corporate bonds often have a face amount of $1.000. preferred stock The most common type of perpetuity and generally pays a fixed dividend. refunding debt Corporations that call a bond issue usually finance the repurchase by issuing new bonds that carry lower yields. selling at a discount Selling the bond below par value. selling at par Selling the bond at the face amount. selling at a premium Selling the bond at a price above par. yield to call Calculation used to see what the return on bond investment is for callable bonds. yield to maturity (YTM) The yield of a debt security computed by considering its price and the timing of all cash flows, identical to an IRR (internal rate of return). zero coupon bond Bonds issued by corporations and the government which make no payments to bondholders until maturity. Web Resources PG&E 6% nonredeemable preferred price and volume data for May 2012: http://finance.yahoo.com/echarts?s=PCG-PA+Interactive#symbol=pcg-pa;range=5d;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined; List of CAT bonds: http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=CAT&Country=USA