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Finance Review

Essay by   •  April 18, 2016  •  Study Guide  •  3,678 Words (15 Pages)  •  917 Views

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Final Review Class

Foundations of Finance

Overview

  • For first half of semester, see review class recording online
  • Today:
  • Go through key points of second part of course
  • Not exhaustive
  • Do a few sample questions
  • Answer any questions you may have.

Outline

  1. Balance sheet valuation concepts
  • Backward looking, easy to manipulate

  1. Fundamental value / intrinsic value

Dividend Discount Model (DDM)

  • Zero dividend growth
  • Constant dividend growth

= Gordon Growth Model

  • Valuation ratios
  • Two-stage dividend growth

3


DDM Case 2: constant dividend growth

Gordon’s Growth Model (GGM)

  • Suppose that expected dividends grow at a rate g, that is,

E(D1 ) =(1+g)D0, E(D2 ) =(1+g)2D0, etc.

  • Use the Dividend-Discount Model:

V0  =


E(D1 ) +

1+ R[pic 1]


E(D2 )

(1+ R)2[pic 2]


+        E(D3 )

(1+ R)3[pic 3]

2[pic 4]


+ ...

3

= D0 (1+ g) +[pic 5]


D0 (1+ g)


+ D0 (1+ g)


+...

1+ R[pic 6]


(1+ R)2


(1+ R)3

= D0 (1+ g) =[pic 7][pic 8]


E(D1 )

R  g


R  g


Assumption: R > G

4


Using GGM to study Valuation Ratios

  • Price-dividend ratio. If GGM applies then:

P0        =  1+ g        [pic 9][pic 10]

D0

  • Price-earnings ratio.

R  g

  • How much do you have to pay for every dollar of earnings generated?
  • How do we go between dividends and earnings?
  • D0=(1-b)E0   with “earnings retention ratio” – “plowback ratio”of b.
  • Inverse of the “dividend payout ratio”

P0        = (1+ g)(1b)[pic 11]

E0        R g

5


Other things discussed

  • How to go from stock prices to implied expected growth rate.
  • Microsoft vs. Apple exercise in class
  • Twitter IPO example
  • When should firms pay out dividends?
  • Apple dividend battle

  • Bond Pricing

Fixed Income

  • Forward Rate / Yield Curve
  • Duration/Immunization

Yield to Maturity (YTM) on Annual-

Pay Coupon Bonds

-Po        c        c………F + c[pic 12]

  • Multiple payment security

0        1        2        T

  • For an annual-pay coupon bond, the YTM is

calculated as the Internal Rate of Return.

  • Hence, YTM is the rate that solves:

[pic 13]

8


Yield to Maturity on

Semi-Annual-Pay Coupon Bonds

  • For a semi-annual-pay coupon bond, the

YTM is computed in 2 steps:

  1. Find the semi-annual IRR, that is, the rate r

that solves:

P0


=  _        Ct


  •  _        FT

t =1[pic 14]


(1+


r)t


(1+


r)T

  1. The YTM is the corresponding annual percentage rate (APR):        YTM = 2 r
  • The corresponding effective annual yield

is (1+YTM /2 )2 –1

9


Example: YTM on a

Semi-Annual-Pay Coupon Bond

  • Suppose that a 3-year bond has a face value of 1000 and pays semi-annual coupons of 40. If the price is 900 then what is the YTM?[pic 15][pic 16][pic 17][pic 18][pic 19][pic 20][pic 21]

-900

40

40

40

40

40

1040

t=0

t=1

t=2

t=3

  • Step 1 use calculator to find that r = 6.036% solves:

900 =


 _        40        

(1+ r )1


+... +


 _        40        

(1+ r )5


+  1040        

(1+ r )6

•        Step 2: YTM = 2r = 12.072%

...

...

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