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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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View Full Document 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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View Full Document 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.
 Spring '03
 FranklinAllen

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