VALORATING FINANCIAL INSTRUMENT

BONDSTOCK

RISK, RATE OF RETURN AND CAPITAL COST

BONDS

Bond – Security that obligates the issuer make specified payments to the bondholder.Coupon – The interest payments paid to the bondholder.Face Value – Payment at the maturity of the bond. Also called par value or maturity value.Coupon Rate – Annual interest payments a percentage of face value.

BOND PRICES AND YIELDSPV = PV(coupons) + PV(face value)= (coupon x annuity factor) + (face value x discount factor).Example: In 1999, Treasury bonds with 3-year maturities offered a return of about 5.6%; face value = $1,000; coupon rate = 6%; coupon = $60.

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RATE OF RETURN

Rate of Return – Total income per period per dollar invested.

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VARIATION IN CORPORATE BONDS

Zero-Coupon Bonds – coupon rate = 0; do not receive a regular coupon payment. These bonds are issued at prices considerably below face value.Floating-Rate Bonds – coupon payments are tied to some measure of current market rates. The rate might be reset once a year to the current Treasury bill rate plus 2 percent.Convertible Bonds – you can choose later to exchange it for a specified number of share of common stock.

STOCK VALORATION

STOCK MARKET

COMMON STOCK

Common stock – Ownership shares in a publicly held corporation.Primary Market – Market for newly-issued securities, sold by the company to raise cash.Initial Public Offering (IPO) – First offering of stock to the general public.Secondary Market – Market in which already-issued securities are traded among investors.

COMMON STOCK

Dividend – Periodic cash distribution from the firm to its shareholders.Price-Earnings (P/E) – Ratio of stock price to earnings per share.Book Value – Net worth of the firm according to the balance sheet.Liquidation Value – Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.

COMMON STOCK VALORATION

Today price =

Tomorrow price =

Expected return =

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DIVIDEND DISCOUNT MODEL

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THE CONSTANT GROWTH DIVIDEND DISCOUNT MODEL

Definition – Version of the dividend discount model in which dividends grow at a constant rate.

Expected Rates of Return = r = dividend yield + growth rate.

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GROWTH STOCKS AND INCOME STOCKS

Payout Ratio – Fraction of earnings paid out as dividends.P/R – g = %DIV + earning per share (E/P).Plowback Ratio – Fraction of earnings retained by the firm.Return=g=returns on equity x plowback ratio

VALUING ENTIRE BUSINESSES

VEB = PV = Capital value/(r-g)Example: Suppose 20,000 common stock outstanding and paid dividend by $2 per share. Investor expect a steady dividend growth of 4% a year and required a return of 9%. So the total value of the firm will be: PV = 40,000/(.09-.04) = $800,000. Also we can get PV = number of shares outstanding x market price of share.

RISK, RETURN, AND CAPITAL COST

RATE OF RETURNMARKET INDEXESMEASURING RISK

RATES OF RETURN

The percentage return on the investment would be:

Example: Supose that you bought stock from GE at the beginning of 2002 at $102 a share. By the end of the year the value of that investment had appreciated to $155 (capital gain = $53). In addition, in 2002 GE paid a dividend of $1.46 per share. The result would be like follow:PR = (CG + Div.)/IPS = (53+1.49)/102 = .534 or 53.4%

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RATES OF RETURN CONT…

Dividend yield = dividend/initial share pricePercentage capital gain = capital gain/initial share price1+real rate of return = (1+nominal rate of return)/(1+inflation rate)

MARKET INDEXES

Market Index – Measure of the investment performance of the overall market.Dow Jones Industrial Average – Index of the investment performance of a portfolio of 30 large industrial stock.Standard & Poor’s Composite Index – Index on the investment performance of a portfolio of 500 large stocks. Also called the S&P 500.

PREMIUM

Maturity Premium – Extra average return from investing in long-term versus short-term Treasury securities.Risk Premium – Expected return in excess of risk-free return as compensation for risk.Rate of Return on Common Stock = Interest rate on Treasury bills + Market risk premium.

MEASURING RISK

Expected return – probability (weighted average of possible outcomes)Variance – Average value of squared deviations from mean. A measure of volatility.Standard Deviation – Square root of variance. Another measure of volatility.

EXAMPLE

Year Rate of Return

Dev. From Ave. Ret.

Squared Dev.

1997 1.31 -23.44 549.43

1998 37.43 12.68 160.78

1999 23.07 -1.68 2.82

2000 33.36 8.61 74.13

2001 28.56 3.83 14.67

Total 135.53 801.84

EXAMPLE CONT….

Variance = 801.84/5 = 160.37Standard Deviation = square root of 160.37 = 12.66%

RISK AND DIVERSIFICATION

Diversification – Strategy designed to reduce risk by spreading the portfolio across many investment.Unique Risk – Risk factors affecting only that firm. Also called diversifiable risk.Market Risk – Economy wide (macroeconomic) sources of risk that affect the overall stock market. Also called systematic risk.

EXAMPLE PORTFOLIO ANALYSISScenario Probability Auto Stock Gold Stock Portfolio

Return%

Recession 1/3 -8% +20% -1%

Normal 1/3 +5% +3% +4.5%

Boom 1/3 +18% -20% +8.5%

Expected Return

5% 1% 4%

Variance 112.7 268.7 15.2

Stand. Dev. 10.6% 16.4% 3.9%

PORTFOLIO RATE OF RETURN

Portfolio rate of return = (Fraction of portfolio in first asset x rate of return on first asset) + (Fraction of portfolio in second asset x rate of return on second asset)For example if the investor diversified the portfolio and invested 75% in autos and 25% in gold, the portfolio return will be: Portfolio return in recession = [.75 x (-8%)] + [.25 x (20%)] = -1%.