W3: Bond & Stocks Valuation

Select one question to analyze. Referring to the three fundamental principles and three precepts of finance below, integrate a principle, a precept, or both in your response. In addition, integrate 1-2 external credible references to support your thoughts.

• FP1: The value of any asset is equal to the present value of the cash flows the asset is expected to produce over its economic life.
• FP2: There is a direct relationship between risk and return; as perceived risk increases, required return will also increase (and vice versa), holding other things constant.
• FP3: There is an inverse relationship between price and yield; if an asset’s price increases, its return will decrease (and vice versa), holding other things constant.

• PR1: The present value of a cash flow (or an asset) is inversely related to its discount rate; increasing the discount rate decreases the present value (and vice versa), holding other things constant.
• PR2: The timing of the cash flows of an asset is important; sooner is better (later cash flows are more heavily discounted, reducing their present value).
• PR3: The present value of a cash flow (or an asset) is inversely related to its perceived risk; the higher the risk, the higher the discount rate, and therefore the lower the present value.

1. Companies pay rating agencies such as Moody’s and S&P to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated in the first place; doing so is strictly voluntary. Why do you think they do it?

2. Why does the value of a share of stock depend on dividends? A substantial percentage of the companies listed on the NYSE and the NASDAQ don’t pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible keeping in mind your answer to the previous question? Under what circumstances might a company choose not to pay dividends?