Need some help preparing for your exams? Look here for e-learning sessions, interactive outlines that cover the key points in each chapter.

1. Introduction to Valuation and Rates of Return
   1. What is valuation? In finance, time value of money, presented in Chapter 9, is one key concept you must understand in order to understand valuation. Business firms have to know the value, in today's dollars, of projects in which they invest. Valuation is the process of determining the value of financial assets like stocks and bonds. We also must understand how investors establish the rates of return they demand from financial assets. Both the value of financial assets and the rates of return demanded by investors help determine the cost of financing projects for the business firm. See Slide 2 (39.0K) .
   2. Valuation concepts. According to your text, The value of a financial asset is the ____ of the ____ generated by that asset( Critical Concept ). In order to value a financial asset we have to know the present value of the future cash flows generated by that asset. We also need to know the discount rate, or interest rate, that we will use to find the present value of the future cash flows. The market's required rate of return, which is the discount rate is determined by the market's perceived level of ____( Critical Concept ) of that particular business firm or security. Riskier firms will command higher discount rates than less risky firms.
2. Valuation of Bonds
   1. What is the worth of a bond in today's dollars? Bonds provide investors with two forms of cash flows: ____ and ____( Critical Concept ). Interest payments are usually made semiannually and the principal is returned to the investor at the bond's maturity. Interest payments are annuities. They are equal, consecutive payments made to the investor. The principal repayment, sometimes called the ____ Critical Concept ) value of the bond, is repaid to the investor at maturity in a lump sum. In order to determine the present value of a bond, you must add together the present value of the semiannual interest payments and the present value of the principal repayment. See Valuation of Bonds (58.0K) . The discount rate that you use to obtain the present value is the yield to maturity for the bond. The yield to maturity is defined as the bond's ____( Key Term ). You can use either the formula or the present value tables at the end of your textbook to determine the present value of a bond. See this website for a good and quick tutorial on bonds and bond valuation.
   2. Yield to Maturity. The yield to maturity has three components: ____, ____ and ____( Critical Concept ). The required real rate of return is the base interest rate demanded by investors on a noninflation-adjusted basis. Historically, the real rate of return has been about ____ percent( Critical Concept ). Inflation erodes purchasing power. The inflation premium compensates the investor for that erosion. Since 1980, the inflation premium has been about 3-4 percent. The real rate of return added to the inflation premium makes up the risk-free rate of return, or the approximate rate of return an investor can earn on risk-free investments like Treasury securities. The third component of yield to maturity is the risk premium. The risk premium compensates the investor for the riskiness of the particular security. The discount rate or yield to maturity is the sum of these parts. See Slide 3 Factors That Influence the Required Rate of Return (64.0K) .
   3. Impact of Yield to Maturity on Bond Valuation. If the yield to maturity changes, the present value of a bond will also change. If the yield to maturity rises, the present value of the bond____( Critical Concept ). If the yield to maturity falls, the present value of the bond rises. The relationship between the interest or discount rate and the value of a bond is inverse. See Slide Relationship between Bond Prices and Yields (62.0K) .
   4. Impact of Time to Maturity on Bond Valuation.As the maturity of a bond draws closer, the value of that bond moves toward ____( Critical Concept ). See Slide 5 (37.0K) .
   5. Calculation of Yield to Maturity. You can use the bond valuation formula given in your textbook to calculate yield to maturity. Instead of solving for the value of the bond, you solve for yield to maturity. However, you arrive at your answer by trial and error. You can also use the approximation formula, which is equation 10-2 in your textbook.
3. Valuation of Preferred Stock
   1. Characteristics of preferred stock. Preferred stock is valued as a perpetuity because it has no maturity date. It is a hybrid security with characteristics similar to both common stock and debt. Just like with common stock, preferred stock has no maturity. Like debt, it carries a fixed dividend payment similar to the coupon payment on debt. You can calculate the value of a share of preferred stock by dividing the fixed dividend payment by the required rate of return for the investor. See Slide Preferred Stock (56.0K) .
   2. Solving for the yield on preferred stock. Instead of solving for the value of the preferred stock, you can turn the equation around and solve for the required rate of return or yield. You divide the fixed dividend payment by the value of the share of preferred stock.
4. Valuation of Common Stock
   1. Calculation of the value of common stock. The value of a share of common stock is the present value of an expected stream of future dividends. Even though capital gains also benefit the shareholder, earnings must be eventually translated into cash flows for the shareholder.
   2. No growth in dividends. If a share of common stock does not pay dividends, then it is valued exactly like a share of preferred stock, in other words, like perpetuity.
   3. Constant growth in dividends.If a share of common stock increases its dividends at a constant rate, then it can be valued according to this model: ________( Critical Concept ) This formula can be turned around and solved for required rate of return instead of value. You can see from the formula that required rate of return has two components as it relates to common stock -- the dividend yield and the capital gains yield. Generally, if the dividend yield for a stock is high, capital gains yield is low and vice versa. Take a look at this website for a brief tutorial on valuation of common and preferred stock.
   4. Variable growth in dividends. Firms whose dividends grow but not at a constant rate are, in the real world, the rule. The most common scenario is when a firm grows at a fast rate during one time period and a more normal rate in another time period. In this case, we must solve for the present value of the cash flows in each time period and add them together to get the value of the stock. See Slide Valuation of Common Stock (56.0K) .
5. The Price/Earnings Ratio
   1. Using the P/E Ratio to Value Stock. The price/earnings ratio, which is defined as ______________, can be used to value stock. It is impacted by the dividend policy of the firm, whether or not the firm is a growing or mature firm, the riskiness of the firm and the debt structure of the firm to name a few. See Slide Valuation using Price-Earnings Ratio (55.0K) P/E ratios that are ____ usually indicate stocks that are growing, positive expectations exist for their future and have prices that are expensive relative to earnings( Critical Concept ) . Low P/E stocks, however, may have these characteristics:________( Critical Concept ). See Slide High vs Low P/Es (58.0K) . Take a look at this site (10024) and this site for a better understanding of price/earnings ratio.