Financial Management and Valuation Review

Valuation Relationships

The value of a bond is driven by the relationship between its coupon rate and the market required rate of return (the discount rate):

• Premium Bond: If the required rate < coupon rate, the bond sells above par (Price > Par).
• Discount Bond: If the required rate > coupon rate, the bond sells below par (Price < Par).
• Par Bond: If the required rate = coupon rate, the bond sells at par (Price = Par).

Special types of bonds include zero-coupon bonds, which pay no periodic interest and are sold at a deep discount to their face value. When evaluating bonds, investors look at several yield metrics: Yield to Maturity (YTM), Yield to Call (YTC), and Current Yield (CY).

Exam Tip: Inverse Relationship Always remember that the value of a bond is inversely related to changes in the investor's required rate of return. If market interest rates rise, bond prices fall.

Key Bond Risks

1. Interest Rate Risk: The variability in a bond's value caused by changing interest rates. Long-term bonds generally carry higher interest rate risk than short-term bonds.
2. Reinvestment Risk: The risk that a decrease in interest rates will lead to lower income when the bond's cash flows are reinvested.

Risk and Return: The CAPM Framework

In finance, risk is categorized based on whether it can be eliminated through a portfolio.

• Stand-alone Risk: The risk of holding a single asset, typically measured by its standard deviation.
• Diversifiable (Unsystematic/Firm-specific) Risk: Risk that can be eliminated by increasing the number of securities in a portfolio.
• Market (Systematic/Non-diversifiable) Risk: Risk that remains even in a well-diversified portfolio.

The Beta Coefficient and CAPM

The beta coefficient ($\beta$) measures market risk—the sensitivity of an asset's returns to the movements of the overall market. This relationship is formally expressed through the Capital Asset Pricing Model (CAPM): $r_i = r_{RF} + \beta_i(r_M - r_{RF})$

In this equation, $(r_M - r_{RF})$ is the market risk premium. When plotted, this relationship forms the Security Market Line (SML), where the risk-free rate is the intercept and the market risk premium is the slope.

Stock and Corporate Valuation

Common Stock Valuation

Common stock represents ownership with residual claims on a firm. The most common way to value stock is through the Discounted Dividend Model (DDM), which posits that a stock's fair value is the present value of all future dividends.

Under the Constant Growth Model (also known as the Gordon Growth Model), we assume dividends grow at a constant rate $g$: $P_0 = \frac{D_1}{r_s - g}$

If a stock's expected return exceeds its required return, the stock is considered undervalued (a "good buy").

Corporate Valuation and WACC

To value an entire firm, analysts often use the Corporate Valuation Model (the free cash flow approach), which estimates the present value of expected future free cash flows.

To discount these cash flows, firms use the Weighted Average Cost of Capital (WACC). The WACC represents the weighted average of the costs of the firm's various capital components:

• Debt (after-tax cost)
• Preferred Stock
• Equity (Retained earnings or new common stock)

Note on Capital Components When calculating WACC, include long-term debt, preferred stock, and equity. Do not include accounts payable, as these are not considered capital components.

The weights used in the WACC calculation are determined by the firm's target capital structure, which is the optimal mix of debt and equity intended to maximize shareholder wealth.