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Why Is It Important For The Financial Manager To Understand The Valuation Process?

The document discusses valuation methods and key concepts for valuing assets. It explains that valuation is the process of linking risk and return to determine an asset's worth. Valuation uses time-value-of-money techniques and concepts of risk and return to determine an asset's value at a given time. The three key inputs to valuation are cash flows, timing of cash flows, and measure of risk. Valuation can be applied to various asset types that provide expected cash flows.

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Jamilia Lewis
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236 views7 pages

Why Is It Important For The Financial Manager To Understand The Valuation Process?

The document discusses valuation methods and key concepts for valuing assets. It explains that valuation is the process of linking risk and return to determine an asset's worth. Valuation uses time-value-of-money techniques and concepts of risk and return to determine an asset's value at a given time. The three key inputs to valuation are cash flows, timing of cash flows, and measure of risk. Valuation can be applied to various asset types that provide expected cash flows.

Uploaded by

Jamilia Lewis
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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VALUATION METHODS

Why is it important for the financial manager to understand the valuation process?
Valuation is the process that links risk and return to determine the worth of an
asset. It is a relatively simple process that can be applied to expected streams of
benefits from bonds, stock, income properties, an oil well and so on. To determine
an assets worth at a given point in time, a financial manager uses the time-value-ofmoney techniques (we did previously) and the concept of risk and returns (as we
also did in the last lecture).
Terms to note:

What are the three (3) key inputs to the valuation process? Does the valuation
process ONLY apply to assets/investments that provide an annual cash flow?
The 3 main inputs in the valuation process are: (1) cash flows (returns), (2)
timing and (3) measure of risk.
- It does not have to have an annual cash flow. It may be give and intermittent
or even a single cash flow for the period.
- Timing is assumed to be at the end of the period / year unless otherwise
stated.
- The level of risk associated with the cash flows can significantly affect the
values. The greater the risk, the greater the discount factor should be, vice
versa.

Identify and explain the variables in the general equation for the valuation of any
asset/investment
The valuation of any asset is the present value of all future cash flows it is expected
to provide over the relevant period.
Basic valuation model (Pg. 240) :
Where: Vo =
CFt =
r=
n=
Using an example describe the basic procedure used to value a bond that pays
annual interest.
The basic valuation equation can be used to value bonds, common stock and
preferred stock.
The basic model for the value, Bo, is (Pg. 242):
Where: Bo =
I=
n=
M=
rd =
OR We can use a simple time line and PV of an annuity = (CF/r) ( 1- 1/(1+r n) ( See
Pg. 242 Eg 6.8) :

Explain what must be the relationship between the required return and the coupon
interest rate.

Bonds can be bought/sold in the following circumstances


a. At a discount: This is when the required return is greater than the coupon
interest rate, the bond value will be less than its par value.

b. At a premium: This is when the required return is less than the coupon
interest rate, the bond value will be more than its par value.

c. At par value: This is the face value of the bond. This is when the required
return is equal to the coupon interest rate

To protect oneself against the potential impact of rising interest rates which
type of bond will a risk-averse investor prefer and why
i)
ii)

A bond with a short period until maturity this one


A bond with a long period until maturity

What is an efficient market? (Pg 277)

What does the efficient market hypothesis (EMH) (Pg 278) say about the
following?
o
o
o

Securities prices
Their reaction to new information
Investor opportunities to profit

Describe debt and equity. Briefly explain the differences between debt and equity
and identify and briefly describe the various types of equity.

Types of Equity: Common and Preferred Stock

ii) Briefly describe the following common stock dividend valuation models:
a. Zero-growth

b. Constant Growth

Variable Growth

Compare the following common stock dividend valuation models by identifying and
briefly describing their differences and commonalities:
Zero-growth

: Fixed/ constant % dividend annually

Constant Growth / Gordon Growth model : Fixed/ constant % dividend annually plus
a constant growth rate
Variable Growth : A mixture of the 2 above. Much more complicated.
Describe the free cash flow valuation model (Pg 284)

Explain each of the three other approaches to common stock valuation and
explain which is considered the best. (Please note the three other
approaches to common stock valuation are: (a) book value, (b) liquidation
value, (c) price/earnings (P/E) multiples) : P/E is considered best

Identify and briefly describe the risks that common stockholders take that
other suppliers of capital do not face?
-

What is a rights offering? Describe how a rights offering protects a firms


stockholders from dilution of ownership.
Describe the following and explain the relationship that exists among them:
- Authorised shares -

Outstanding shares

Treasury Stock
Issued Shares

Identify and briefly describe the claims that preferred stock holders have that
common stock holders do not enjoy
Explain the cumulative feature of preferred stock and the purpose of a call feature
in a preferred stock issue.
-

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