To describe the stock and bond valuations that Tech Temps Company should invest in, it is essential to comprehensively analyze the factors affecting such valuations. This begins from their respective definitions of the individual terms and how the companies’ current financial status and objectives will influence buying specific stocks or bonds.
Stocks Valuation
Common and preferred stock are the two primary types of stocks sold by corporations and traded in the open market. However, their difference lies in the variation of their features. For instance, common stock is characterized to have a variable dividend, unlike the preferred stock that pays a fixed dividend. Moreover, common stockholders have a sense of ownership to a corporation; thus, they possess the capacity to elect its board of directors (Zutters & Smart, 2018). On the other hand, preferred stockholders do not have such voting rights. Third, any proceeds from the liquidation of a firm or dividend are usually paid to preferred stockholders before the former. Lastly, since preferred stocks have fixed dividends, they can be referred to as less risky and associated with a less amount of earnings.
Classified stock is defined as a type of common stock accompanied by special privileges, including voting liberties, dividends, and liquidation rights. In this instance, small companies that are going public might designate some stock as founder shares as they provide the privilege of voting right but have dividend restrictions.
It is essential to be aware that stocks are valued based on the present value of their future cash flows (Zutters & Smart, 2018). Since stocks are presumed to be held forever, their associated dividend streams or cash flows are infinite. Hence, the discounted dividend formula;
Where,
- Po = Today’s price of stock
- D = Amount of dividends
- r = Required return of stock
A constant growth stock is a type of stock whose dividends are expected to grow steadily forever (Zutters & Smart, 2018). It is valued based on the present values of their future cash flows. The Gordon Growth Model is used only if the stock is held forever; the dividends are growing at a constant rate that is less than the required rate; and dividends are expected to be paid at equal time intervals one year from now (Zutters & Smart, 2018). This can be represented by the following formula:
Where:
- Po = Today’s price of stock
= expected dividend one year from today- g = Growth rate
- r = Required rate of return
If the growth constant is constant, and g is more significant than rs, there will be a negative stock price. This further suggests that the firm has undergone supernormal growth and is popular among companies that are rapidly expanding, for instance, startups. Nevertheless, this cannot be sustained in the long-run.
If Tech Temps has issued preferred stocks paying stockholders a dividend equal to $10 annually, with a required rate of return of 8%, its market value can be calculated as follows:
- D = $10
- rs = 8% = 0.08
Thus,
= $12.50Tech Temp Performance
Economic value added ((EVA) is used to measure the true economic profit of a firm (Zutters & Smart, 2018). Based on the financial statement, Tech Temp’s EVA is determined as:
EVA = EBIT (1 − Tax Rate) – (Cost of capital% * Total capital)
= 500,000 (1 – 30%) – (10% * 1,250,000)
= $350,000 – $125,000
= $225,000
From the above calculations, it can be seen that Tech Temp’s EVA for a period is positive. Therefore, this suggests that the profit generated by the company is greater than its cost of capital and this means an increase in the company’s value over the period.
The Price Earnings Ratio (P/E Ratio) is the association between a company’s stock price and earnings per share (EPS) (Cecchetti & Schoenholtz, 2016).
Market price per share = P/E * Earning Per Share:
- =20 * 2
- =$40
Bond Valuation
Other than stocks, individuals can also invest in bonds. A bond is characterized to have a face value of $1000 to $5000 (Ross et al., 2020). Secondly, most bonds pay interest after every 6 months, however, it is still possible for them to be paid monthly, quarterly, or annually. Moreover, they can be further categorized as fixed-rate (generates a constant interest rate) or adjustable floating rate. Fourthly, maturity of bonds ranges from a single day to as long as 30 years.
The value of a coupon bond can be determined by the flowing formula:
Where:
- Pb = Price of the bond
- r = Coupon interest
- F = Principal payment at maturity (par value)
- T = Interest payment in period
- C = Coupon value
= $1000Value of 10-yr bond = Annual coupon payment * Discounted Cumulative PV@10% + maturity value for 10 years = (1000*0.1)6.14 +1000*0.386 = $1000
Interest rate price risk is defined as the risk of a reduction in the price of a bond as a result of increased interest rates. A 10-year bond has a higher interest rate price risk than the former. The longer the maturity period, the more extended the time that will take to pay off the bond, so that the investor can replace it with another one having higher coupons (Jordan et al., 2018).
Interest reinvestment rate risk is defined as the risk of reducing interest rates that might adversely affect the income from a bond portfolio. A one-year bond has a higher reinvestment interest rate risk than the latter. The shorter the maturity, the more limited the duration it takes to replace high old-coupon bonds with new low-coupon bonds.
References
Cecchetti, S., & Schoenholtz, K. (Eds.). (2016). Money, banking and financial markets. McGraw-Hill Higher Education.
Jordan, B., Miller, T., & Dovlin, S (Eds.). (2018). Fundamentals of investments: Valuation and management. McGraw-Hill Higher Education.
Ross, S., Westerfield, R., & Jordan, B (Eds.). (2020). Essentials of corporate finance. McGraw-Hill Higher Education.
Zutters, C., & Smart, S (Eds.). (2018). Principles of managerial finance, Global edition. Pearson.