Principles Of Corporate Finance Essentials Of Investment - Free Sampl

Questions: To fill out the first table, you will need to select 3 bonds with maturities between 10 and 20 years with bond ratings of "A to AAA," "B to BBB" and "C to CC" (you may want to use bond screener at the Web site linked above).All of these bonds will have these values (future values) of $1,000. You will need to use a coupon rate of the bond times the face value to calculate the annual coupon payment. You should subtract the maturity date from the current year to determine the time to maturity. The Web site should provide you with the yield to maturity and the current quote for the bond. (Be sure to multiply the bond quote by 10 to get the current market value.) You will then need to indicate whether the bond is currently trading at a discount, premium, or par. Bond Company/ Rating Face Value (FV) Coupon Rate Annual Payment (PMT) Time-to Maturity (NPER) Yield-to-Maturity (RATE) Market Value (Quote) Discount, Premium, Par A-Rated $1,000 B-Rated $1,000 C-Rated $1,000 Explain the relationship observed between ratings and yield to maturity. Explain why the coupon rate and the yield to maturity determine why the bonds would trade at a discount, premium, or par. Based on the material you learn in this Phase, what would you expect to happen to the yield to maturity and market value of the bonds if the time to maturity was increased or decreased by 5 years? Answers: The completed table is shown below (Morningstar, 2016a, 2016b, 2016c) There is an inverse relationship between credit rating and yield to maturity. This is primarily because corporate bonds having lesser credit rating are more vulnerable to default and hence there is a higher risk for the investors. As a result, investors tend to expect a higher yield on these bonds that acts as compensation to the additional risk assumed by the investor (Damodaran, 2008). The coupon rate along with the YTM defines whether the bond would be traded at a premium, par or discount. Hence, when the coupon rate and YTM are equal, then the bonds tend to trade at par since the coupon rate offered is equal to the yield expected by the investors. However, when the coupon rate is greater than the YTM, then the bond would trade at a premium (i.e. greater than the par value) since the coupon offered by the bond is greater than the expected yield on the bond due to which there is a greater demand of such bonds in the market. Additionally, when the coupon rate is lower than the YTM, then the bond would trade at a discount (i.e. lesser than par value) as the coupon offered by the bond is less than that expected by the investors (Kane Marcus, 2013). A decrease in the maturity date tends to decrease the YTM and thus increases the bond prices. Whereas, an increase in the maturity date tends to increase the YTM and thus decreases the bond prices (Parrino Kidwell, 2011). CAPM Approach The completed table is shown below (Yahoo Finance, 2016). Company 5-year Risk-Free Rate of Return Beta () 5-Year Return on Top 500 Stocks Required Rate of Return (CAPM) Microsoft 1.45% 1.02 8.77% 8.92% Apple 1.45% 1.06 8.77% 9.21% IBM 1.45% 0.63 8.77% 6.06% The riskfree rate is taken as the yield on US treasury 5 year bond that comes out as 1.45% pa. The beta of the various stocks has been estimated from Yahoo Finance website. As per the CAPM model (Brealey, Myers Allen, 2008). Required rate of return = Risk free rate + Beta*(Market return Risk free rate) Required rate of return (Microsoft) = 1.45 + 1.02*(8.77-1.45) = 8.92% pa Required rate of return (Apple) = 1.45 + 1.06*(8.77-1.45) = 9.21% pa Required rate of return (IBM) = 1.45 + 0.63*(8.77-1.45) = 6.06% pa Valuation using Gordon Model Company Current Dividend ($) Projected Growth Rate (next year) Required Rate of Return (CAPM) Estimated Stock Price (Gordon Model) Current Stock Price Over/Under Priced Microsoft 1.24 4% 8.92% 26.2 50.80 Over Apple 2.08 4.5% 9.21% 46.2 96.30 Over IBM 5.2 3.5% 6.06% 210.2 129.56 Under Estimated stock price (Microsoft) = 1.24*1.04/(0.0892-0.04) = $26.2 Estimated stock price (Apple) = 2.08*1.045/(0.0921-0.045) = $ 46.2 Estimated stock price (IBM) = 5.2*1.035/(0.0606-0.035) = $ 210.2 Valuation using P/E ratio Company Estimated Earning (next year) P/E Ratio Estimated Stock Price (P/E) Current Stock Price Over/Under Priced Microsoft 3.12 33.51 104.5 50.80 Under Apple 10.49 10.35 108.6 96.30 Under IBM 15.01 8.97 133.14 129.56 Under All the relevant data for the above table has been obtained from Yahoo Finance (2016). As per the Gordon dividend growth model, Estimated stock price = Dividend next year/(Required return dividend growth rate) Thus, the estimated stock price is inversely proportional to the required return on stock while it is directly proportional to the dividend growth rate. This is primarily because a higher dividend growth rate would increase the numerator and also would decrease the denominator and thus, lead to a higher estimated stock price. Additionally, a higher dividend paying stock would have a higher value assuming that denominator remains constant similar to the higher price of a higher coupon paying bond assuming YTM as constant. As per the Gordon dividend model, the current stock is the present value of all the dividends that would be paid over the life of the stock assuming perpetual holding period (Kane Marcus, 2013). Advantage of Gordon Growth Model It is an easy and convenient method to estimate the value of the stock of a particular company irrespective of the industry it belongs to (Parrino Kidwell, 2011). Disadvantages of Gordon Growth Model It cannot be used to estimate the stock price of those companies that do not pay dividends (Marcus Kane, 2013). It does not give emphasis to factors other than dividends for the determination of stock price particularly the presence of intangible assets that are critical in modern knowledge based economy (Parrino Kidwell, 2011). The dividend growth does not remain constant and typically varies even for mature stocks. The dividend growth rate always has to be lower than the required rate on equity that is not always true and thus, prices of such stocks cannot be determined (Damodaran, 2008). The P/E approach primarily relies on estimation of EPS in the next year and multiplying that with the current P/E ratio so as to determine the estimated price of the stock in the next year assuming that P/E ratio remains constant (Parrino Kidwell, 2011). Hence, estimated value of stock = Current P/E ratio * Estimated EPS in the next year The P/E model seems to be more accurate in determining the value of stock. This is primarily because the prices in the Gordon dividend growth model are highly sensitive to the dividend growth rate that cannot be predicted with high degree of accuracy in the future. As a result, the values obtained through P/E multiple are closer to the current market price (Brealey, Myers Allen, 2008). If the growth rate of the company would increase, then the value of the stock would increase as the next year dividend would increase while the denominator in Gordon growth model would decrease. An increase in the required rate of return would lower the stock value. Further, an increase in the dividends would increase the stock price in line with the Gordon growth model where the stock price is directly proportional to the dividends being paid. If the EPS of the stock would increase, then the stock price would increase due to higher profitability in line with the P/E approach (Damodaran, 2008). References Brealey, R., Myers, S. Allen, F. (2008), Principles of Corporate Finance, New York: McGraw Hill Publications Damodaran, A. (2008), Corporate Finance, London: Wiley Publications Kane, B.Z. Marcus, A.J. (2013). Essentials of Investment, Singapore: McGraw-Hill International Morningstar (2016a), Verizon Communications Inc, MorningStar Website, Retrieved on January 12, 2016 https://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=vz Morningstar (2016b), KLA-Tencor Corp, MorningStar Website, Retrieved on January 12, 2016 ttp://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=KLACcountry=USA Morningstar (2016c), Oracle Corp, MorningStar Website, Retrieved on January 12, 2016 https://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=ORCLcountry=USA Parrino, R. Kidwell, D. (2011), Fundamentals of Corporate Finance, London: Wiley Publications Yahoo Finance (2016), Historical prices, Yahoo Finance, Retrieved on January 12, 2016 https://finance.yahoo.com/