# SEC04 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL...

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UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL LECTURE NOTES FNCE 601 FINANCIAL ANALYSIS Franklin Allen Fall 2003 QUARTER 1 - WEEK 3 Tu: 9/16/03 Copyright © 2003 by Franklin Allen

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FNCE 601 - Section 4 - Page 1 Section 4: The Valuation of Bonds and Stocks Read Chapter 4 BM Motivation Example Firms A and B have the following stock prices, earnings per share and price/earnings ratios. Price EPS Price/EPS Firm A \$100 \$10 10 Firm B \$100 \$5 20 There is no uncertainty associated with either stock. Which stock would you buy? It seems as though Firm A is the better buy since you get \$10 earnings for every \$100 invested whereas with Firm B you get only \$5 for every \$100 invested. Is this argument correct? (i) Present Values and Market Values So far we have been considering present values. Why are we interested in present values? As we'll see next, present values must be equal to market values in a competitive market. We shall consider the relationship between market values and present values using the following example, which is also a useful exercise in calculating PV. Example 1 A company called the Wensum Bridge Company is to be formed at the end of 20X0 for the sole purpose of building a bridge across the river Wensum. The contract for the construction
FNCE 601 - Section 4 - Page 2 of the bridge involves the Wensum Bridge Company receiving payments from the local township of \$1,089,000 at the end of 20X1 and \$1,320,000 at the end of 20X2, at which time the bridge will be finished and the company liquidated. The firm must pay out a total of \$630,000 at the end of 20X1 for materials and to its employees for building the bridge. Similarly, at the end of 20X2 it must pay out \$780,000. After the 20X1 and 20X2 payments for materials and to employees the remaining cash flow will be paid out in dividends. All cash flows occur with certainty. Investors opportunity cost of capital is 10%. If there are 10,000 shares, what is the price of each share at the end of 20X0? Year 20X0 20X1 20X2 |__________________|_________________| (a) Township Payments \$0 \$1,089,000 \$1,320,000 (b) Construction Costs \$0 \$630,000 \$780,000 (c) Dividends = (a)-(b) \$0 \$459,000 \$540,000 (d) PV Divs = (c)/1.1 t \$0 \$417,273 \$446,281 Solution Total PV of firm = 417,273 + 446,281 = \$863,554 PV each share = 863,554/10,000 = \$86.36 Suppose these shares were being sold in the market at a price of \$80. What would you do? You should borrow money at 10% and buy as many as possible. You can use the dividend

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FNCE 601 - Section 4 - Page 3 payments to pay back the \$80 you borrow for each share. Since you receive the equivalent of \$86.36 in today’s money, you make \$6.36 on each share in terms of today’s money. Let’s see exactly how this would work.
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## This note was uploaded on 03/16/2010 for the course FNCE FINANCIAL taught by Professor Franklinallen during the Spring '03 term at UPenn.

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SEC04 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL...

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