Corp Finance Notes

Corp Finance Notes - 1 2 3 4 the valuation of a financial...

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the valuation of a financial asset is based on the present value of future cash flows 1. the required rate of return in valuing an asset is based on the risk involved 2. bond valuation is based on the process of determining the present value of interest payments plus the principle payment at maturity 3. Stock Valuation is based on determining the present value of the future benefits of equity ownership 4. A price-earnings ratio may also be applied to a firm’s earnings to determine value Valuation Concepts Valuation is based on determining the present value of cash flows Required Rate of Return i. The discount rate ii. Depends on the market’s perceived level of risk associated with the individual security iii. Competitively determined among the many companies seeking financial capital iv. Investors are willing to accept low return for low risk and vice versa v. Market allocates capital to companies based on risk, efficiency, and expected returns—which are based to a large degree on past performance Valuation of Bonds Concept of Yield to Maturity Yield to Maturity- is the rate of return required by bondholders Three Factors to influence required rate of return i. Real Rate of Return- 1. the rate of return the investor demands for giving up the current use of the funds on a noninflation-adjusted basis. a. It is the financial rent investors charge for using their funds for a given period of time 2. Inflation Premium a. Investor requires a premium to compensate for the eroding effect of inflation on the value of the dollar b. Risk-Free Rate of Return i. If one combines the previous two ii. Rate that compensates the invesetor for the current use of his/her funds and for the loss in purchasing power due to inflation but not for taking risks 3. Risk Premium a. Premium associated with the special risk of a given investment b. Two types i. Business Risk
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1. relates to the inability of the firm to hold its competitive position and maintain stability and growth in its earnings ii. Financial Risk 1. relates to the inability of the firm to meet its obligations as they come due c. will be different for different types of investments i. ex: b/c bonds have a contractual obligation for the firm to pay interest to bondholders, they are considered less risky than common stock where no obligation exists ii. PAGE 286 MIDDLE OF PAGE EQUATIONS FOR R Changing the YTM and the Impact on Bond Valuation Increase in inflation premium i. Increasing inflation caused the required rate of return (YTM) to go up and the bond price fell Decrease in Inflation Premium i. Opposite effect would happen if rate of return went down because of lower inflation, less risk, or other factors ii. Bond trades for over par value Time to Maturity Impact of a change in YTM on valuation is also affected by the remaining time to maturity Bond paying 2% more or less that average is different for 20 year bond than 1 year bond Determining the Yield to Maturity from the Bond Price
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