Principles of Managerial Finance

6–7 Differentiate between standard debt provisionsand restrictive covenants

included in a bond indenture. What are the consequences of violation of

them by the bond issuer?

6–8 How is the cost of bond financing typically related to the cost of short-

term borrowing? In addition to a bond’s maturity, what other major fac-

tors affect its cost to the issuer?

6–9 What is a conversion feature?A call feature? Stock purchase warrants?

6–10 What information is found in a bond quotation?How are bonds rated,

and why?

6–11 Compare the basic characteristics of Eurobondsand foreign bonds.

6.3 Valuation Fundamentals

Valuationis 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 expectedstreams of

benefits from bonds, stocks, income properties, oil wells, and so on. To deter-

mine an asset’s worth at a given point in time, a financial manager uses the time-

value-of-money techniques presented in Chapter 4 and the concepts of risk and

return developed in Chapter 5.

Key Inputs

There are three key inputs to the valuation process: (1) cash flows (returns), (2)

timing, and (3) a measure of risk, which determines the required return. Each is

described below.

Cash Flows (Returns)

The value of any asset depends on the cash flow(s) it is expectedto provide over

the ownership period. To have value, an asset does not have to provide an annual

cash flow; it can provide an intermittent cash flow or even a single cash flow over

the period.

EXAMPLE Celia Sargent, financial analyst for Groton Corporation, a diversified holding

company, wishes to estimate the value of three of its assets: common stock in

Michaels Enterprises, an interest in an oil well, and an original painting by a well-

known artist. Her cash flow estimates for each are as follows:

Stock in Michaels Enterprises Expectto receive cash dividends of $300 per

year indefinitely.

Oil well Expectto receive cash flow of $2,000 at the end of year 1, $4,000 at

the end of year 2, and $10,000 at the end of year 4, when the well is to be sold.

Original painting Expectto be able to sell the painting in 5 years for

$85,000.

With these cash flow estimates, Celia has taken the first step toward placing a

value on each of the assets.

CHAPTER 6 Interest Rates and Bond Valuation 281

valuation
The process that links risk and
return to determine the worth of
an asset.

LG4