Course Textbook Lasher, W. R. (2011). Practical financial management (6th ed.). Mason, OH: South-Western.

question1

1) Valuation options

The following information refers to a six-month call option on the stock of XYZ, Inc.

• Price of the underlying stock: $50
• Strike price of the three-month call: $45
• Market price of the option: $10

a) What is the intrinsic value of the option?

b) What is the options time premium at this price?

2) Valuation corporate bond A $1,000 corporate bond with 20 years to maturity pays a coupon of 7% (semi-annual) and the market required rate of return is a) 6.6% b) 13%. What is the current selling price for a) and b)?

3) Valuation - preferred stock What is the value of a share of preferred stock that pays a $9.50 dividend, assume k is 12%.

4) Charlie Company is expected to grow at an annual rate of 6% indefinitely. The return on similar stocks is currently 11%. Charlie's board of directors declared a dividend of $1.85 yesterday. What should a share of Charlie Company sell for?

5) Valuation corporate bond A $1,000 corporate bond with 10 years to maturity pays a coupon of 8% (semi-annual) and the market required rate of return is a) 7.2% and b) 10%. What is the current selling price for a) and b)?

Question 2

1) Risk & Return and the CAPM. Based on the following information, calculate the required return based on the CAPM: Risk Free Rate = 3.5% Market Return =10% Beta = 1.08

2) Risk & Return and the CAPM. Based on the following information, calculate the required return based on the CAPM: Risk Free Rate = 3% Market Return =10.5% Beta = 1.2

3) Risk and Return, Coefficient of Variation Based on the following information, calculate the coefficient of variation and select the best investment based on the risk/reward relationship. Std Dev. Exp. Return Company A 7.4 13.2 Company B 11.6 18.9

4) Sources of Risk. Identify sources of risk and contrast them (include examples) and explain why investors should be concerned with them. Your response should be at least 250 words in length.

Question 3

1) (Part 1) Using a 3.8% discount rate, calculate the Net Present Value, Payback, Profitability Index, and IRR for each of the investment projects below (note, the inflows are for each year). Based on your calculations rank the projects and support you answer. Project 1 Initial Invest= $520,000, Cash inflows of $100,000 for years 1-5 and $50,000 for years 6-10. Project 2 Initial Invest= $1,050,000, Cash inflows of $400,000 for years 1-3, $0 for years 4-7 and $250,000 for years 8-10. Project 3 Initial Invest= $820,000, Cash inflows of $300,000 for years 1-5, $0 for years 6-9 and $100,000 for year 10. (Part 2) Assuming a budget of $1,300,000 what are your recommendations for the three projects in the above problem. Explain. Assuming a budget of $2,100,000 what are your recommendations for the above problem? Explain.

Question4

1) Based on the information below, calculate the weighted average cost of capital. Great Corporation has the following capital situation. Debt: One thousand bonds were issued five years ago at a coupon rate of 11%. They had 20-year terms and $1,000 face values. They are now selling to yield 9%. The tax rate is 37% Preferred stock: Two thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 11%. Equity: Great Corp has 108,000 shares of common stock outstanding, currently selling at $18.48 per share. Use the risk premium approach and assume a 3% risk premium

UNIT V STUDY GUIDE Valuation of Securities Learning Objectives Reading Assignment Chapter 7: The Valuation and Characteristics of Bonds Chapter 8: The Valuation and Characteristics of Stock Supplemental Reading See information below. Key Terms 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Bonds Call Common stock Convertible bond Coupon Face value (par value) Financial asset Option Preferred stock Put Return Term to maturity Yield Upon completion of this unit, students should be able to: 1. Calculate the value of a common stock using the constant-growth assumption. 2. Calculate the value of preferred stock. 3. Calculate the value of a corporate bond. 4. Calculate the value of a convertible bond. 5. Calculate the value of a zero coupon bond. 6. Apply the CAPM to calculate required return on common stock. 7. Calculate the intrinsic value of a stock option. 8. Describe the factors that impact option value. Written Lecture As clearly seen in your daily lives, business relies on the issuance of financial assets to raise capital (money) to make investments, expand, or develop new products. Further, financial assets are a part of daily life in the areas of insurance, banking and retirement planning. This unit concentrates on the intrinsic valuation of financial assets. Financial assets can include a variety of investments. The two primary financial assets that will be addressed in this unit are fixed income (bonds) and equity (stock). Valuation involves the assessment of future cash flows discounted to present day. Similar to the methodology seen in Unit IV, discounting cash flows (DCF) is needed to value bonds and stocks. Rate of return used in discounting methodology is the interest rate that equates the present value of an investment's expected future cash flows with its current price. Return is also known as yield or interest. Bonds represent a debt relationship in which an issuing company borrows and buyers lend. A bond issue represents borrowing from many lenders (investors) at one time under a single agreement. A bond's term (or maturity) is the time from the present until the principal is returned. A bond's face (or par) value represents the amount the firm intends to borrow (the principal) at the coupon rate of interest. The coupon rate is the fixed rate of interest paid by a bond. Most bonds pay coupon interest on a semiannual basis. Although bonds have fixed coupons, market interest rates constantly change. Changes in prevailing market interest rates (yield to maturity) result in changes in the market price of the bond. Bond prices and interest rates move in opposite directions: Selling at a premium - bond price increases above face value Selling at a discount - bond price falls below face value Longer term bond prices fluctuate more in response to changes in interest rates than shorter term bonds. This is known as interest rate risk. BBA 3301, Financial Management 1 To value bonds it is important to note expected cash flows are predictable. Interest payments are fixed, occurring at regular intervals. Principal is returned along with the last interest payment at maturity. Below is an example of a corporate bond with 10 years to maturity, and a coupon rate of 10%: The above figure can be found in your textbook on page 303. Kinds of Bonds Secured bonds and mortgage bonds are backed by the value of specific assets - collateral. Debentures are unsecured bonds issued with higher interest rates. Subordinated debentures are lower in priority than senior debt. Junk bonds are issued by risky companies and pay high interest rates. Bonds are assigned quality ratings reflecting their probability of default. Higher ratings mean lower default probability. Bond rating agencies (such as Moody's and S&P) evaluate bonds (and issuers), and assign a rating. A bond's rating affects the size of the differential between the rate it must pay to borrow and the rate demanded by high quality issuers. It reflects the perceived risk of default of lower-quality issuers. Investment grade rating is important to institutional investors who are prohibited from trading below-investment-grade bonds Bond Valuation The price of a bond is the present value of a stream of interest payments plus the present value of the principal repayment. PB PV(interest payments) + PV(principal repayment) Interest payments are annuities--can use the present value of an annuity formula: PMT[PVFAk,n ] Principal repayment is a lump sum in the future--can use the future value formula: FV[PVFk, n ] If interest rates fall, a firm may wish to retire old, high interest bonds through a call provision. Thus corporations refinance old, high interest debt with new lower interest debt. Investors don't like calls because they lose high interest. Call provisions usually have a call premium (to the investor) and a call protection where the bond won't be called for a certain number of years. Corporate Bond Valuation Example: Assumptions: A $1,000 corporate bond with 15 years to maturity pays a coupon of 10% (semi-annual) and the market required rate of return is a) 8% b) 12%. What is the current selling price? BBA 3301, Financial Management 2 Texas Instruments BAII Plus Key Strokes*: a) 1,000 = FV, 30 = N, 4 = I/Y, 50=PMT, CPT PV = $1,172.92 b) 1,000 = FV, 30 = N, 6 = I/Y, 50=PMT, CPT PV = $862.35 *Note N, I/Y and PMT are adjusted for a semi-annual basis! Zero Coupon Bond Valuation Example: Assumptions: A U.S. Government bond with a face amount of $10,000 with 12 years to maturity is yielding 4%. What is the current selling price? Algebraic Solution: $10,000/(1.04)12 = $6,245.97 Texas Instruments BAII Plus Key Strokes: 10,000 = FV, 12 = N, 4 = I/Y, 0=PMT, CPT PV = $6,245.97 A sinking fund provision requires an issuer to call in and retire a fixed percentage of the issue each year called. Convertible bonds are unsecured bonds exchangeable for a fixed number of shares of stock at the bondholder's discretion. Convertible bonds are usually issued at lower coupon rates. The following factors impact their valuation: Conversion ratio - the number of shares of stock received for each bond Conversion price - the implied stock price if bond is converted into a certain number of shares Advantages of Convertible Bonds To issuing companies Convertible features are \"sweeteners\" enabling a risky firm to pay a lower interest rate Viewed as a way to sell equity at a price above market Usually have few or no restrictions To Buyers Offer the chance to participate in stock price appreciation Offer a way to limit risk associated with a stock investment A convertible's price can depend on either its value as a traditional bond or the market value of the stock into which it can be converted. A convertible is always worth at least the larger of its value as a bond or as stock. Upon conversion convertible bonds cause dilution in EPS. EPS drops due to the increase in the number of shares of stock. Thus, outstanding convertibles represent a potential to dilution of EPS. Convertible Bond Example Harry Jenson purchased one of Algo Corp.'s 9%, 25-year convertible bonds at its $1,000 par value a year ago when the company's common stock was selling for $20. Similar bonds without a conversion feature returned 12% at the time. The bond is convertible into stock at a price of $25. The stock is now selling for $29. Algo pays no dividends. (Notice that this bond's coupon rate was set below the market rate for nonconvertible issues.) BBA 3301, Financial Management Harry exercised the conversion feature today and immediately sold the stock he received. Calculate the total return on his investment. What would Harry's return have been if he had invested $1,000 in Algo's stock instead of the bond? 3 BBA 3301, Financial Management 4 The above figure can be found in your textbook on page 319-321. Common Stock Income in a stock investment comes from dividends and the gain or loss on the difference between the purchase and sale price. A stock's intrinsic value is based on assumptions about future cash flows made from fundamental analysis of the firm and its industry. A stock's value today is the sum of the present values of the dividends received while the investor holds it and the price for which it is eventually sold. This is often based on predicted growth rates since forecasting exact future prices and dividends is difficult. Known as the Gordon Growth Model, the Dividend Valuation Model and also a variation of the Discounted Cash Flow approach, the following model is the core to intrinsically valuing common stock: Pe = D0 x (1 +g) / (Ke - g) or Pe = D1 / (Ke - g) Where: D0 = Most recent (past) annual dividend on one share of common stock. Note, dividends on common stock are usually paid on a quarterly basis so we must sum the last four quarters or annualize the most recent quarter. By multiplying D0 by (1 +g) we calculate D1. g = sustainable growth. (if g is not given is then it is calculated as ROE x Retention Ratio of Earnings*) ROE = Return on Equity or Net Income/Owner's Equity Retention Ratio = EPS-DPS/EPS (EPS = Earnings per share; DPS =Dividends per share) Ke = Required return on equity capital It should be noted that for the above model to be valid, the corporation must pay BBA 3301, Financial Management 5 a dividend and g 1.0 -- the stock moves more than the market Beta 0 accept NPV NPVB choose Project A over B Assuming a cost of capital of 10%, the net-present-value of the above cash flows would be calculated as: Time Period Cash Flow Present Value Cost of Capital 0 50,000. 00 50,000. 00 1 2 3 4 5 15,000.0 0 15,000. 00 15,000. 00 15,000. 00 15,000. 00 NPV 13,636.3 6 12,396. 69 11,269. 72 10,245. 20 9,313.8 2 6,861. 80 10% Note, that the cash flows above are calculated for each year based on this formula, then summed for the NPV. For example the present value of $15,000 th 4 received in the 4 year is: $15,000/1.10 = $10,245.20 Internal Rate of Return (IRR): A project's IRR is the return it generates on the investment of its cash outflows. Furthermore, the IRR is the interest rate that makes a project's NPV zero. Finding IRRs usually require an iterative technique where you guess the project's IRR through trial and error. The first step involves calculating the project's NPV using this interest rate. If NPV = zero, the guessed interest rate is the project's IRR. If NPV > 0, try a higher interest rate. If NPV 1. PI is also known as the benefit/cost ratio because positive future cash flows are the benefit and the negative initial outlay is the cost. With mutually exclusive projects NPV and PI methods may not lead to the same choices. But, PI includes the size (magnitude of the initial investment). Thus, PI is preferred because it compares the benefits to the size of the initial investment. Decision rules for PI: For stand-alone projects If PI > 1.0 accept If PI PIB choose Project A over Project B Using the previous example, the profitability index is calculated as: PV of benefits/PV of costs = $56,861.80/$50,000 = 1.137 (approve for investment based on decision rule) BBA 3301, Financial Management 4 UNIT VIII STUDY GUIDE Cost of Capital Learning Objectives Reading Assignment Chapter 13: Cost of Capital Key Terms 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Cost of capital Cost of debt Cost of equity Cost of preferred stock Flotation cost Gordon model (dividend discount model) Investment opportunity schedule (IOS) IRR Marginal cost of capital NPV Retained earnings Risk premium Weighted average cost of capital (WACC) Upon completion of this unit, students should be able to: 1. 2. 3. 4. 5. 6. Calculate the cost of debt capital. Apply the CAPM to assessing the cost of equity capital. Calculate the cost of equity capital using the Gordon Growth Model. Develop the cost of capital for preferred equity. Create a weighting schedule based on market value of securities. Develop a model to measure the weighted average cost of capital. Written Lecture The last unit in this course is dedicated to developing a measure of the cost of capital. The cost of capital is the average rate paid for the use of the firm's capital funds. Capital refers to money acquired for use over a long period. The cost of capital provides a benchmark against which to evaluate investment returns. Projects should not be undertaken unless they return more than the cost of the funds invested in them. The cost of capital is used as the discount rate in net present value (NPV) analysis and also as a comparison point for the internal rate of return (IRR). From Unit VII recall the following rules supporting a capital investment decision: Project IRR exceeds the cost of capital Project NPV > 0 when calculated at the cost of capital A firm's capital components include debt, common equity (stock) and preferred stock. Equity is the riskiest investment, earns the highest return, and has the highest cost. Debt is the safest investment, earns the lowest return, costs the firm less and is tax advantaged. Preferred stock offers investors intermediate risk and return levels and has a cost between that of equity and debt. Capital structure is the mix of the three capital components - generally expressed in percentages as seen below: The above figure can be found in your textbook on page 559. Target capital structure is a mix of components that management considers optimal and strives to maintain. Additionally, management seeks to raise money BBA 3301, Financial Management 1 in the proportion of the capital structure. Thus, in cost of capital calculations, we assume money is raised in a constant proportion of debt, preferred and common equity. Investors provide capital by purchasing securities. Returns paid to investors adjusted for taxes and administrative expenses are the firm's costs. A firm's cost of capital is a weighted average of the costs of the three capital components where the weights reflect the $ amounts of each component in use. This is usually referred to in two ways: k, the cost of capital WACC, for weighted average cost of capital Example: Calculate the Weighted Average Cost of Capital (WACC) for the Following Capital Component Debt Preferred Stock Common Stock Value $60,000 $50,000 $90,000 $200,000 Cost 9% 11% 14% Below: First, calculate the component weights by dividing their individual dollar values by the total. For instance the weighting of Debt is $60,000/$200,000. Then, multiply the weight by cost to arrive at the last column. For example, .25 x 11% = 2.75% for preferred stock. Capital Component Debt Preferred Stock Common Stock Value Weight Cost $60,000 $50,000 $90,000 $200,000 30% 25% 45% 9% 11% 14% WACC 2.70% 2.75% 6.30% 11.75% WACC is expressed in terms of either book or market values of capital components. WACC is used to evaluate next year's capital projects as the discount rate in NPV and PI. Also, it can be used as a hurdle mark for IRR. Market values are the appropriate basis for WACC. The formal steps in calculating WACC are as follows: Step 1: Develop a market-value-based capital structure Step 2: Adjust market returns on the underlying securities to reflect the costs of the underlying capital components Step 3: Combine in calculating the WACC Example: Developing Market Value Capital Structure The ABC Corporation has the following capital situation. Debt: Two thousand bonds were issued five years ago at a coupon rate of 12%. They had 30-year terms and $1,000 face values. They are now selling to yield 10%. Preferred stock: Four thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 13%. Equity: ABC has 200,000 shares of common stock outstanding, currently selling at $15 per share. BBA 3301, Financial Management 2 Solution The price of ABC's bonds in the market must be determined. We know the bonds have 25 years remaining until maturity, pay interest of $120 annually ($60 semi-annually) and are yielding 10% annually (5% semi-annually). Thus, each bond is selling for $1,182.55 in the market (per Bond Calculations earlier in Course). Since there are 2,000 bonds outstanding, the market value of debt is: $1,182.55 x 2,000 = $2,365,100. The firm's preferred stock represents a perpetuity that pays $7.50 annually and is yielding 13%. Thus, the value of each share of preferred stock is $7.50 / .13 = $57.69. The total market value of ABC's preferred stock is: $57.69 x 4,000 = $230,760 Each share of ABC's common stock is trading at $15, thus the total market value of the firm's equity is: $15 x 200,000 shares = $3,000,000 Next summarize and calculate the component weights: Debt Preferred Stock Equity (Common Stock) $2,365,100 $230,760 $3,000,000 42.3% 4.1% 53.6% $5,595,860 100.0% Calculating the Component Costs of Capital Begin with the market return received by new investors in each capital component kd, kp, and ke . Cost of Debt Tax adjustment applies only to debt (Tax rate is T), Cost of debt = kd (1 - T). Debt, the cheapest source, is made even cheaper by tax adjustment. Flotation costs are a percentage of a security's price (f). This is applied to preferred and new sales of common equity which increases effective cost. With flotation the costs are found with the following equation: kp / (1 - f) ke / (1 - f) Example: Cost of Debt Blackstone Inc. has 12% coupon rate bonds outstanding that yield 8% to investors buying them now. Blackstone's marginal tax rate including federal and state taxes is 37%. What is Blackstone's cost of debt? First notice that kd is the current market yield of 8%, not the coupon rate. To calculate the cost of debt we simply write equation 13.1 and substitute from the information given cost of debt = k d(1 - T) = .08(1 - .37) = 5.04% BBA 3301, Financial Management 3 Cost of Equity The cost of common stock is not precise due to the uncertainty of future equity cash flows. The market return on common equity is estimated through three models: CAPM Gordon model Risk premium The CAPM Approach The sources of new common equity include retained earnings and newly sold stock. Retained earnings (RE) are not free because they belong to stockholders. No adjustments to the return on RE are necessary to calculate component cost of equity from RE. Payments to stockholders are not tax deductible to the firm. Thus, investor return on RE = Component cost of RE. The market return on a stock can be approximated by estimating the required or expected return using the CAPM's SML (security market line): kx = kRF + (kM - kRF) bX where: kX is the required return on stock X kRF is the risk-free rate (return on three-month T bills) kM is the return on the market or on an \"average\" stock (usually estimated through a market index like the S&P 500) bX is stock X's beta, the measure of its market risk Example: Cost of RE using the CAPM The return on the Strand Corporation's stock is relatively volatile as reflected by the company's beta of 1.8. The return on the S&P 500 is currently 12% and is expected to remain at that level. Treasury bills are yielding 6.5%. Estimate Strand's cost of retained earnings. Write equation 13.5 and substitute directly, using the return on the S&P 500 as kM and the treasury bill yield as kRF. cost of RE = kX kRF (kM kRF)bX = 6.5% (12% 6.5%)1.8 = 16.4% The Dividend Growth Approach (the Gordon Model) The Gordon model is used to calculate the intrinsic value of a stock. However, we can use the Gordon model to solve for the expected return by plugging in the current price of the stock. The above figure can be found in your textbook on page 570. The Risk Premium Approach The relationship between the risks of debt and equity is fairly constant among firms. The incremental risk premium between debt and equity returns is similar for high-risk and low-risk firms. The return on a firm's equity can be estimated by BBA 3301, Financial Management 4 adding 3 to 5 percentage points to the market return on its debt, if rpe is the additional risk premium on equity: ke = kd + rpe The Cost of New Common Stock Firms often need to raise more equity than that generated by retained earnings. Equity from new stock is just like equity from RE, except it involves flotation costs. Market return estimates for RE must be adjusted for flotation costs to determine the cost of issuing new common stock. Use the Gordon model and insert (1- f) to recognize flotation cost (see below). The above figure can be found in your textbook on page 572. Marginal Cost of Capital A firm's WACC is not independent of the amount of capital raised. The WACC typically rises as the firm raises more capital. The Marginal Cost of Capital (MCC) is a graph of the WACC, showing abrupt increases as larger amounts of capital are raised in a planning period. Breaks (jumps) in the MCC occur when cheap sources of financing are used up. The first increase in MCC usually occurs when the firm runs out of RE and starts raising external equity by selling stock. As debt increases the firm becomes riskier so lenders require higher interest rates. This causes further upward breaks in the MCC. See the following example for better explanation: Example: Marginal Cost of Capital These figures can be found in your textbook on pages 573-574. BBA 3301, Financial Management 5 Assume the business plan projects RE of $3,000,000 and note that capital structure is 60% equity. Since capital is raised in the proportions of the capital structure we ask $3M is 60% of what number? $3M / .6 = $5M The above figure can be found in your textbook on page 575. The investment opportunity schedule (IOS) is a plot of the IRRs of available projects arranged in descending order. The MCC and IOS plotted together show which projects should be undertaken. The firm's WACC for the planning period is at the intersection of the MCC and the IOS (see below). BBA 3301, Financial Management 6 The above figure can be found in your textbook on page 576. BBA 3301, Financial Management 7