FM 4: Financial Management

GROUP 9 REPORTERS:
Rea Angela Penalba
Ma. Glie Anne S. Rapiz
Naharah Maguindanao
Grace Ann Masula

CONTENTS
• Asset Valuation: Basic Bond and Stock Valuation Models
Valuing Bonds
Valuation of Common Stock Using Dividend Discount Models
Appendix: Valuing Convertible Bonds
• Asset Valuation: The Theory of Asset Pricing
Characteristics of an Asset Pricing Models
Capital Asset Pricing Model
Arbitrage Pricing Theory Model

INSTRUCTOR:
MS. JOHANA CHRISTINE ALBERTO

ASSET EVALUATION: BASIC BONDS AND STOCK VALUATION MODEL

Valuation is the process of determining the fair value of a financial asset. The process
is also referred to as ‘’valuing’’ or ‘’pricing’’ a financial asset. The fundamental principle
of valuation is that value of any financial asset is the present value of the expected cash
flow.

THE VALUATION OF FINANCIAL ASSET INVOLVES 3 STEPS

 Estimate the expected cash flow
 Determine the appropriate interest rate or interest rates that should be used to
discount the cash flow.
 Calculate the present value of expected cash flows using the interest rate or
interest rates.
 VALUING BONDS
Valuation begin with the estimation of the cash flows. Cash flow is simply the cash
that is expected to be received at some time from an investment. In the case of a bond,
the cash flow consist of interest and principal repayment. It does not make any
difference whether the cash flow is interest income or repayment of principal. The cash
flow of a security are the collection of each period cash flow. In the case of simple bond
that does not grant the issuer or the bondholder the option to alter the maturity date or
exchange the bond for another type of financial instrument, the cash flow are easy to
determine assuming that the issuer does not default.

Determining the Appropriate Rate or Rates

Minimum Interest Rate

The minimum interest rate that investors want is referred to as the base interest
rate.

Premium Over the Base Interest Rate

The premium over the base interest rate on a Treasury security that investor will
require reflects the additional risk the investor faces by acquiring a security that is not
issued by the U.S government.

Perceived Creditworthiness of Issuer

Default risk refers to the risk that the issuer of a bond may be unable to make timely
principal or interest payment.

Taxability of Interest
The federal tax code specifically exempts the interest income from qualified tax-
exempt securities from taxation at the federal level.

Expected Liquidity of an Issue

Bonds trade with different degrees of liquidity.

Single or Multiple Interest Rates

For each cash flow estimated, the same interest rate can be used to calculate the
present value

Discounting the Estimated Cash Flows

Given the estimated cash flow and the appropriate interest rate or interest rates that
should be used to discount the estimated cash flows, the final step in the valuation
process is to value the cash flow.
Arbitrage-Free Valuation Approach
The fundamental flaw of the traditional approach is that it views each security as the
same package of cash flows.

Valuation Using Treasury Spot Rates

Credit Spread and the Valuation of Non-Treasury Securities

The Treasury spot rates can be used to value any default-free security. The value of
non-Treasury security is found by discounting the cash flows by the Treasury spot rates
which is the base interest rates plus a risk premium to reflect the additional risk we noted
earlier that are associated with investing in a non-security.

Valuing Bonds with Embedded Option

A treasury security and an option-free non-treasury security can be valued using the
procedures described previously.

VALUATION OF COMMON STOCK USING DIVIDEND DISCOUNT MODEL

There are various models used to value common stock, particularly focusing on
Dividend Discount Models (DDMs). These models are based on the premise that
dividends, as cash payments made by corporations to their shareholders, are critical in
assessing a stock's value.

3 TYPES OF DIVIDEND MEASURES

- Dividends per Share (DPS)

It refers to the total dividends paid out by the company divided by the number of
shares outstanding. It helps investors understand how much income they can expect
from each share they own.

- Dividend Yield
This is the ratio of annual dividends per share to the stock’s current market price.
It shows how much return (in the form of dividends) an investor can expect relative to the
stock's price.

- Dividend Payout Ratio

It represents the proportion of earnings paid out as dividends to shareholders. A
high payout ratio may indicate the company prioritizes distributing income to
shareholders rather than reinvesting in growth.
DIVIDENDS AND STOCK PRICES

 Common Stock

- represent ownership in a company

- dividends are not guaranteed; they depend on the company's profit and board
decision

 Preferred Stock

- fixed dividend payments providing more predictability

- dividends are paid before those of common stock

- dividends can accumulate cumulative feature ensuring eventual payout

 Discounted Cash Flow Approach

- projects future dividends to estimate stock value using Dividends Discount

Models (DDMs)

 Dividend Discount Models (DDMs)

- a method to value stock by using predicted dividends and discounting them to

present value

- assumes the value of a stock is the present value of all future dividends it will
pay

BASIC DIVIDEND DISCOUNT MODELS

The basis for the dividend discount model (DDM) is simply the application of
present value analysis, which asserts that the fair price of an asset is the present value
of the expected cash flows. This model was first suggested by Williams (1938).

Dividend Discount Model (DDM) is a method used to value a company’s stock

based on the present value of expected future dividends. The core principle is that the
value of a stock today is the sum of all future dividends discounted to their present value.
And assumes that dividends are the primary form of return for stockholders.

Types of Basic Dividend Discount Models:

  Finite Life General Dividend Discount Model (DDM) – is a modified version of
the basic Dividend Discount Model, used to value a stock by assuming a finite
period for the expected cash flows. And this model is used when an investor
plans to hold a stock for a limited period (finite life).
 Constant Growth Dividend Discount Model – it is commonly known as the
Gordon Growth Model and it is built on the premise that a company's dividend
will grow at a steady, constant rate over time. This model is particularly used for
valuing mature companies that have a history of stable predictable growth.

MULTIPHASE DIVIDEND DISCOUNT MODELS

Multiphase dividend discount models are enhancement of the traditional constant

growth model DDM that recognize that a company's dividend growth is not static and
can vary significantly over time. Rather than assuming a single constant growth rate
indefinitely, multiphase models allow for different growth rates during distinct phases of a
company's life cycle

2 Types:

1. Two-Stage Growth Model

– simplest form of a multiphase DDM

– values a company's stock based on two distinct growth phases of dividends. The
first phase features a high growth rate (g₁) for a specified number of years (e.g., 4
years), followed by a lower, constant growth rate (g₂) for all subsequent years

– this model allows for a more realistic projection of dividend growth by recognizing
that companies do not grow at the same rate indefinitely.

2. Three-Stage Growth Model

– appears to be the most popular multiphase model employed by practitioners

– it further refines the valuation process by incorporating three growth phases akin to a
product lifecycle:

 Growth Phase - Rapid earnings and dividend growth as the company expands its
market share.
 Transition Phase - Deceleration of growth as the company matures, aligning its
growth rate closer to that of the overall economy.
 Maturity Phase - Steady dividend growth at the long-term economic growth rate,
reflecting stability in the company’s earnings.
 APPENDIX: VALUING CONVERTIBLE BONDS

Convertible Bond

– is a bond that can be converted into common stock at the option of the
bondholder

– its conversion provision grants the bondholder the right to convert the bond into
a predetermined number of shares of common stock of the issuer

– it is a bond with an embedded call option to buy the common stock of the issuer

TRADITIONAL VALUE OF CONVERTIBLE BONDS

Conversion Value

 The coversion value or parity value, of a convertible bonds or note is the

value of the debt if it is converted immediately.

Straight value

 The straight value is then the present value of the bond’s cash flows using
this yield to discount the cash flows.

Market Conversion Price

 The market conversion price is a useful benchmark because, once the

actual market price stock rises above the market conversion price, any
further stock price increase is certain to increase the value of the covertible
bond by at least the same percentage

Busted convertible

 The convertible bond in such instances is referred to fixed income

equivalent or a busted convertible

Common stock equivalent

 When the price of the stock is such that the conversion value is
considerably higher than the conversion value, then the convertible bond
will trade as if it were an equity instrument.
 ASSET VALUATION: THE THEORY OF ASSET PRICING

Asset Pricing Model

 Describe the relationship between the risks of and the expected return.

CHARACTERISTICS OF AN ASSET PRICING MODEL

 risks are also referred to as “risk factors” or “factors”.

 we can express an asset pricing model in general term based on risk factors

Risk factors can be divided into 2 general categories

1. Systematic risk factors or nondiversifiable risk factors – is a risk factors that
cannot be diversified. That is, no matter what the investor does, the investor
cannot eliminate these risk factors.
2. Unsystematic risk factors or diversifiable risk factors – is a risk factors that
can be eliminated via diversification. These risk factors are unique to the asset.

CAPITAL ASSET PRICING MODEL (CAPM)

 The first pricing model derived from economic theory was formulated by
Sharpe(1964), Lintner(1965), Treynor(1961), and Mossin(1966).
 CAPM has only one systematic risk factor – the risk of overall movement of the
market. This risk is referred to as market risk.
 Market Risk means the risk associated with holding a portfolio consisting of all
assets, that is, the market portfolio.

Derivation of the CAMP

 The CAMP is an equilibrium asset pricing model derived from a set of
assumptions.

Harry Markowitz (1952)

 Presented a normative theory of portfolio selection, now popularly referred to as
the theory of portfolio selection or modern portfolio theory.
 A normative theory is one that describes a standard or norm of behavior that
investors should pursue in constructing a portfolio, in contrast to a theory that is
actually followed.
 The theory is based on the goal of constructing a portfolio that maximizes
expected returns consistent with individually acceptable levels of risk
Capital Market Line

The line from the risk-free rate that is tangent to portfolio M is called the capital
market line (CML).

What is Portfolio M?

 Fama (1970) demonstrated that portfolio M must consist of all assets

available to investors, and each asset must be held in proportion to its
market value relative to the total market value of all assets. That is,
portfolio M is the market portfolio described earlier. So, rather than
referring to the market portfolio, we can simply refer to the market.)

Risk Premium in the CML

 The CML says that the expected return on a portfolio is equal to the risk-
free rate, plus a risk premium equal to the market price of risk (as
measured by the reward per unit of market risk), multiplied by the quantity
of risk for the portfolio (as measured by the standard deviation of the
portfolio).

Systematic and Unsystematic Risk

 Systematic risk is the minimum level of risk that can be obtained for a
portfolio by means of diversification across a large number of randomly
chosen assets. As such, systematic risk is that which results from general
market and economic conditions that cannot be diversified away.
 Sharpe defined the portion of an asset’s variability that can be diversified
away as nonsystematic risk. It is also sometimes called unsystematic risk,
diversifiable risk, unique risk, residual risk, and company-specific risk. This
is the risk that is unique to an asset.

ARBITRAGE PRICING THEORY MODEL

An alternative to the equilibrium asset pricing model just discussed, an as set

pricing model based purely on arbitrage arguments was derived by Ross (1976). The
model, called the arbitrage pricing theory (APT) model, postulates that an asset’s
expected return is influenced by a variety of risk factors, as opposed to just market risk
as suggested by the CAPM. The APT model states that the return on a security is
linearly related to H risk factors. How ever, the APT model does not specify what these
risk factors are, but it is assumed that the relationship between asset returns and the risk
factors is linear.

APT Model Formulation

 The APT model postulates that an asset’s expected return is influenced by

a variety of risk factors, as opposed to just market risk of the CAPM. That
is, the APT model asserts that the return on an asset is linearly related to H
“factors.” The APT does not specify what these factors are, but it is
assumed that the relationship between asset returns and the factors is
linear.