Chapter 4

The
The Valuation
Valuation of
of
Long-Term
Long-Term
Securities
Securities
1
 The
The Valuation
Valuation of
of
Long-Term
Long-Term Securities
Securities
 Distinctions Among Valuation
Concepts
 Bond Valuation
 Preferred Stock Valuation
 Common Stock Valuation
 Rates of Return (or Yields)
2
 What
What is
is Value?
Value?
 Liquidation value represents the
amount of money that could be
realized if an asset or group of assets
is sold separately from its operating
organization.
 Going-concern value represents the
amount a firm could be sold for as a
continuing operating business.
3
 What
What is
is Value?
Value?
 Book value represents either
(1) an asset: the accounting value of
an asset -- the asset’s cost minus
its accumulated depreciation;

(2) a firm: total assets minus liabilities

and preferred stock as listed on the
balance sheet.
4
 What
What is
is Value?
Value?
 Market value represents the
market price at which an asset
trades.
 Intrinsic value represents the
price a security “ought to have”
based on all factors bearing on
valuation.

5
 Bond
Bond Valuation
Valuation
 Important Terms
 Types of Bonds
 Valuation of Bonds
 Handling Semiannual
Compounding

6
 Important
Important Bond
Bond Terms
Terms
 A bond is a long-term debt
instrument issued by a
corporation or government.
 The maturity value (MV)
MV [or face
value] of a bond is the stated
value. In the case of a U.S. bond,
the face value is usually $1,000.
7
 Important
Important Bond
Bond Terms
Terms
 The bond’s coupon rate is the stated
rate of interest; the annual interest
payment divided by the bond’s face
value.
 The discount rate (capitalization rate)
is dependent on the risk of the bond
and is composed of the risk-free rate
plus a premium for risk.
8
 Different
Different Types
Types of
of Bonds
Bonds
A perpetual bond is a bond that never
matures. It has an infinite life.

I I I
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)
 I
= (1 + kd)t or I (PVIFA k )
t=1 d, 

V = I / kd [Reduced Form]
9
 Perpetual
Perpetual Bond
Bond Example
Example
Bond P has a $1,000 face value and provides an
8% coupon. The appropriate discount rate is
10%. What is the value of the perpetual bond?
bond

I = $1,000 ( 8%) = $80.

$80
kd = 10%.
10%
V = I / kd [Reduced Form]
= $80 / 10% = $800.
$800
10
 ““Tricking”
Tricking” the
the
Calculator
Calculator to
to Solve
Solve
Inputs 1,000,000 10 80 0
N I/Y PV PMT FV
Compute -800.0

N: “Trick” by using huge N like 1,000,000!

I/Y: 10% interest rate per period (enter as 10 NOT .10)
PV: Compute (resulting answer is cost to purchase)
PMT: $80 annual interest forever (8% x $1,000 face)
FV: $0 (investor never receives the face value)
11
 Different
Different Types
Types of
of Bonds
Bonds
A non-zero coupon-paying bond is a
coupon-paying bond with a finite life.

I I I + MV
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)n
n I MV
= (1 + kd) t
+
t=1 (1 + kd)n
V = I (PVIFA k ) + MV (PVIF kd, n)
12
d, n
 Coupon
Coupon Bond
Bond Example
Example
Bond C has a $1,000 face value and provides
an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the
value of the coupon bond?
V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)
= $80 (9.427) + $1,000 (.057)
[Table IV] [Table II]
= $754.16 + $57.00 = $811.16.
$811.16

13
 Solving
Solving the
the Coupon
Coupon
Bond
Bond on
on the
the Calculator
Calculator
Inputs 30 10 80 +$1,000
N I/Y PV PMT FV
-811.46 (Actual, rounding
Compute error in tables)

N: 30-year annual bond

I/Y: 10% interest rate per period (enter as 10 NOT .10)
PV: Compute (resulting answer is cost to purchase)
PMT: $80 annual interest (8% x $1,000 face value)
FV: $1,000 (investor receives face value in 30 years)
14
 Different
Different Types
Types of
of Bonds
Bonds
A zero-coupon bond is a bond that
pays no interest but sells at a deep
discount from its face value; it provides
compensation to investors in the form
of price appreciation.

MV
V= = MV (PVIFk )
(1 + kd)n d, n

15
 Zero-Coupon
Zero-Coupon
Bond
Bond Example
Example
Bond Z has a $1,000 face value and a
30-year life. The appropriate
discount rate is 10%. What is the
value of the zero-coupon bond?
V = $1,000 (PVIF10%, 30)
= $1,000 (.057)
= $57.00
16
 Solving
Solving the
the Zero-Coupon
Zero-Coupon
Bond
Bond on
on the
the Calculator
Calculator
Inputs 30 10 0 +$1,000
N I/Y PV PMT FV
-57.31 (Actual, rounding
Compute error in tables)

N: 30-year zero-coupon bond

I/Y: 10% interest rate per period (enter as 10 NOT .10)
PV: Compute (resulting answer is cost to purchase)
PMT: $0 coupon interest since it pays no coupon
FV: $1,000 (investor receives only face in 30 years)
17
 Semiannual
Semiannual Compounding
Compounding
Most bonds in the U.S. pay interest
twice a year (1/2 of the annual
coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2
18
 Semiannual
Semiannual Compounding
Compounding
A non-zero coupon bond adjusted for
semiannual compounding.
I / 2 I / 2 I / 2 + MV
V =(1 + k /2 )1 +(1 + k /2 )2 + ... +
d 2 d 2 2 n
(1 + kd/2 ) *
2*n I/2 MV
= (1 + kd /2 ) t
+
t=1 (1 + kd /2 ) 2*n
= I/2 (PVIFAk /2 ,2*n ) + MV (PVIFkd /2 , 2*n)
19
d
 Semiannual
Semiannual Coupon
Coupon
Bond
Bond Example
Example
Bond C has a $1,000 face value and provides an
8% semiannual coupon for 15 years. The
appropriate discount rate is 10% (annual rate).
What is the value of the coupon bond?

V = $40 (PVIFA5%, 30) + $1,000 (PVIF5%, 30)

= $40 (15.373) + $1,000 (.231)
[Table IV] [Table II]
= $614.92 + $231.00 = $845.92

20
 Preferred
Preferred Stock
Stock Valuation
Valuation
Preferred Stock is a type of stock
that promises a (usually) fixed
dividend, but at the discretion of
the board of directors.
Preferred Stock has preference over
common stock in the payment of
dividends and claims on assets.
21
 Preferred
Preferred Stock
Stock Valuation
Valuation
DivP DivP DivP
V= (1 + kP) 1
+ (1 + kP)
2
+ ... + (1 + kP)

 DivP
= or DivP(PVIFA k )
t=1 (1 + kP) t
P, 

This reduces to a perpetuity!

perpetuity
V = DivP / kP
22
 Preferred
Preferred Stock
Stock Example
Example
Stock PS has an 8%, $100 par value issue
outstanding. The appropriate discount
rate is 10%. What is the value of the
preferred stock?
stock
DivP = $100 ( 8% ) = $8.00.
$8.00
kP = 10%.
10%
V = DivP / kP = $8.00 / 10%
= $80

23
 Common
Common Stock
Stock Valuation
Valuation
Common stock represents a
residual ownership position in the
corporation.
 Pro rata share of future earnings
after all other obligations of the
firm (if any remain).
 Dividends may be paid out of
the pro rata share of earnings.
24
 Common
Common Stock
Stock Valuation
Valuation

What cash flows will a shareholder

receive when owning shares of
common stock?
stock

(1) Future dividends

(2) Future sale of the common
stock shares
25
 Dividend
Dividend Valuation
Valuation Model
Model
Basic dividend valuation model accounts
for the PV of all future dividends.

Div1 Div2 Div

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + ke)
 Divt Divt: Cash dividend at
= (1 + ke)t time t
t=1
ke: Equity investor’s
required return
26
 Adjusted
Adjusted Dividend
Dividend
Valuation
Valuation Model
Model
The basic dividend valuation model
adjusted for the future stock sale.

Div1 Div2 Divn + Pricen

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + k )n
e

n: The year in which the firm’s

shares are expected to be sold.
Pricen: The expected share price in year n.
27
 Dividend
Dividend Growth
Growth
Pattern
Pattern Assumptions
Assumptions
The dividend valuation model requires the
forecast of all future dividends. The
following dividend growth rate assumptions
simplify the valuation process.
Constant Growth
No Growth
Growth Phases
28
 Constant
Constant Growth
Growth Model
Model
The constant growth model assumes that
dividends will grow forever at the rate g.

D0(1+g) D0(1+g)2 D0(1+g)

V = (1 + k )1 + (1 + k )2 + ... + (1 + k ) 
e e e

D1: Dividend paid at time 1.

D1
= g: The constant growth rate.
(ke - g) ke: Investor’s required return.
29
 Constant
Constant Growth
Growth
Model
Model Example
Example
Stock CG has an expected growth rate of
8%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What
is the value of the common stock?
stock
D1 = $3.24 ( 1 + .08 ) = $3.50

VCG = D1 / ( ke - g ) = $3.50 / ( .15 - .08 )

= $50
30
 Zero
Zero Growth
Growth Model
Model
The zero growth model assumes that
dividends will grow forever at the rate g = 0.

D1 D2 D
VZG = + + ... +


(1 + ke)1 (1 + ke)2 (1 + ke)

D1 D1: Dividend paid at time 1.

=
ke ke: Investor’s required return.

31
 Zero
Zero Growth
Growth
Model
Model Example
Example
Stock ZG has an expected growth rate of
0%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What
is the value of the common stock?
stock

D1 = $3.24 ( 1 + 0 ) = $3.24

VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )

= $21.60
32
 Growth
Growth Phases
Phases Model
Model
The growth phases model assumes
that dividends for each share will grow
at two or more different growth rates.

n D0(1+g1) t  Dn(1+g2)t
V = +  (1 + ke)t
t=1 (1 + ke)
t
t=n+1
33
 Growth
Growth Phases
Phases Model
Model
Note that the second phase of the growth
phases model assumes that dividends will
grow at a constant rate g2. We can rewrite
the formula as:

n D0(1+g1)t 1 Dn+1
V = +
(1 + ke)n (ke - g2)
t=1 (1 + ke)t
34
 Growth
Growth Phases
Phases
Model
Model Example
Example
Stock GP has an expected growth
rate of 16% for the first 3 years and
8% thereafter. Each share of stock
just received an annual $3.24
dividend per share. The appropriate
discount rate is 15%. What is the
value of the common stock under
this scenario?
35
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3 4 5 6

D1 D2 D3 D4 D5 D6

Growth of 16% for 3 years Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%,

starts at time t=0 for 3 years and is followed by 8%
thereafter starting at time t=3. We should view the time
line as two separate time lines in the valuation.

36
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3 Growth Phase
#1 plus the infinitely
long Phase #2
D1 D2 D3
0 1 2 3 4 5 6

D4 D5 D6
Note that we can value Phase #2 using the
Constant Growth Model
37
 Growth
Growth Phases
Phases
Model
Model Example
Example

V3 = D 4
We can use this model because
dividends grow at a constant 8%
k-g rate beginning at the end of Year 3.

0 1 2 3 4 5 6

D4 D5 D6
Note that we can now replace all dividends from Year
4 to infinity with the value at time t=3, V3! Simpler!!
38
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3
New Time
Line
D1 D2 D3
0 1 2 3 D4
Where V3 =
V3 k-g
Now we only need to find the first four dividends
to calculate the necessary cash flows.
39
 Growth
Growth Phases
Phases
Model
Model Example
Example
Determine the annual dividends.
D0 = $3.24 (this has been paid already)
D1 = D0(1+g1)1 = $3.24(1.16)1 =$3.76
D2 = D0(1+g1)2 = $3.24(1.16)2 =$4.36
D3 = D0(1+g1)3 = $3.24(1.16)3 =$5.06
D4 = D3(1+g2)1 = $5.06(1.08)1 =$5.46
40
 Growth
Growth Phases
Phases
Model
Model Example
Example
0 1 2 3
Actual
Values
3.76 4.36 5.06
0 1 2 3 5.46
Where $78 =
.15-.08
78
Now we need to find the present value
of the cash flows.

41
 Growth
Growth Phases
Phases
Model
Model Example
Example
We determine the PV of cash flows.
PV(D1) = D1(PVIF15%, 1) = $3.76 (.870) = $3.27
PV(D2) = D2(PVIF15%, 2) = $4.36 (.756) = $3.30
PV(D3) = D3(PVIF15%, 3) = $5.06 (.658) = $3.33
P3 = $5.46 / (.15 - .08) = $78 [CG Model]
PV(P3) = P3(PVIF15%, 3) = $78 (.658) = $51.32
42
 Growth
Growth Phases
Phases
Model
Model Example
Example
Finally, we calculate the intrinsic value by
summing all the cash flow present values.

V = $3.27 + $3.30 + $3.33 + $51.32

V = $61.22
3 D (1+.16)t 1 D4
V=
0
+
t=1 (1 + .15)t (1+.15)n (.15-.08)
43
 Calculating
Calculating Rates
Rates of
of
Return
Return (or
(or Yields)
Yields)
Steps to calculate the rate of
return (or yield).
1. Determine the expected cash flows.
flows
2. Replace the intrinsic value (V) with the
market price (P0).
3. Solve for the market required rate of
return that equates the discounted cash
flows to the market price.
price
44
 Determining
Determining Bond
Bond YTM
YTM
Determine the Yield-to-Maturity
(YTM) for the coupon-paying bond
with a finite life.
n
I MV
P0 =  (1 + kd )t
+
(1 + kd )n
t=1

= I (PVIFA k ) + MV (PVIF kd , n)
d,n
kd = YTM
45
 Determining
Determining the
the YTM
YTM
Julie Miller want to determine the YTM
for an issue of outstanding bonds at
Basket Wonders (BW). BW has an
issue of 10% annual coupon bonds
with 15 years left to maturity. The
bonds have a current market value of
$1,250.
$1,250
What is the YTM?
46
 YTM
YTM Solution
Solution (Try
(Try 9%)
9%)
$1,250 = $100(PVIFA9%,15) +
$1,000(PVIF9%, 15)
$1,250 = $100(8.061) +
$1,000(.275)
$1,250 = $806.10 + $275.00
= $1,081.10
[Rate is too high!]
47
 YTM
YTM Solution
Solution (Try
(Try 7%)
7%)
$1,250 = $100(PVIFA7%,15) +
$1,000(PVIF7%, 15)
$1,250 = $100(9.108) +
$1,000(.362)
$1,250 = $910.80 + $362.00
= $1,272.80
[Rate is too low!]
48
 YTM
YTM Solution
Solution (Interpolate)
(Interpolate)
.07 $1,273
X $23
.02 IRR $1,250 $192
.09 $1,081

X $23
.02 = $192

49
 Determining
Determining Semiannual
Semiannual
Coupon
Coupon Bond
Bond YTM
YTM
Determine the Yield-to-Maturity
(YTM) for the semiannual coupon-
paying bond with a finite life.
2n
I/2 MV
P0 = 
t=1 (1 + kd /2 )
t
+
(1 + kd /2 )2n

= (I/2)(PVIFAk ) + MV(PVIFkd /2 , 2n)

d /2, 2n
[ 1 + (kd / 2) ]2 -1 = YTM
50
 Determining
Determining the
the Semiannual
Semiannual
Coupon
Coupon Bond
Bond YTM
YTM
Julie Miller want to determine the YTM
for another issue of outstanding
bonds. The firm has an issue of 8%
semiannual coupon bonds with 20
years left to maturity. The bonds
have a current market value of $950.
$950
What is the YTM?
51
 Determining
Determining Semiannual
Semiannual
Coupon
Coupon Bond
Bond YTM
YTM
Determine the Yield-to-Maturity
(YTM) for the semiannual coupon-
paying bond with a finite life.
[ 1 + (kd / 2) ]2 -1 = YTM

[ 1 + (.042626) ]2 -1 = .0871
or 8.71%

52
 Determining
Determining Semiannual
Semiannual
Coupon
Coupon Bond
Bond YTM
YTM
This technique will calculate kd. You
must then substitute it into the
following formula.
[ 1 + (kd / 2) ]2 -1 = YTM

[ 1 + (.0852514/2) ]2 -1 = .0871
or 8.71% (same result!)

53
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
Discount Bond -- The market required
rate of return exceeds the coupon rate
(Par > P0 ).
Premium Bond -- The coupon rate
exceeds the market required rate of
return (P0 > Par).
Par Bond -- The coupon rate equals the
market required rate of return (P0 = Par).
54
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
55
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
When interest rates rise,
rise then the
market required rates of return rise
and bond prices will fall.
fall
Assume that the required rate of
return on a 15-year, 10% coupon-
paying bond rises from 10% to 12%.
What happens to the bond price?
56
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
57
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship (Rising
(Rising Rates)
Rates)

The required rate of return on a 15-

year, 10% coupon-paying bond
has risen from 10% to 12%.

Therefore, the bond price has fallen

from $1,000 to $864.

58
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
When interest rates fall,
fall then the
market required rates of return fall
and bond prices will rise.
rise
Assume that the required rate of
return on a 15-year, 10% coupon-
paying bond falls from 10% to 8%.
What happens to the bond price?
59
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
60
 Bond
Bond Price-Yield
Price-Yield Relationship
Relationship
(Declining
(Declining Rates)
Rates)

The required rate of return on a 15-

year, 10% coupon-paying bond
has fallen from 10% to 8%.

Therefore, the bond price has

risen from $1,000 to $1,171.

61
 The
The Role
Role of
of Bond
Bond Maturity
Maturity
The longer the bond maturity, the greater
the change in bond price for a given
change in the market required rate of
return.
Assume that the required rate of return
on both the 5- and 15-year, 10% coupon-
paying bonds fall from 10% to 8%. What
happens to the changes in bond prices?
62
 Bond
Bond Price-Yield
Price-Yield
Relationship
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
63
 The
The Role
Role of
of Bond
Bond Maturity
Maturity
The required rate of return on both the
5- and 15-year, 10% coupon-paying
bonds has fallen from 10% to 8%.
The 5-year bond price has risen from
$1,000 to $1,080 for the 5-year bond
(+8.0%).
The 15-year bond price has risen from
$1,000 to $1,171 (+17.1%). Twice as fast!
64
 The
The Role
Role of
of the
the
Coupon
Coupon Rate
Rate
For a given change in the
market required rate of return,
the price of a bond will change
by proportionally more, the
lower the coupon rate.

65
 Example
Example of
of the
the Role
Role of
of
the
the Coupon
Coupon Rate
Rate
Assume that the market required rate
of return on two equally risky 15-year
bonds is 10%. The coupon rate for
Bond H is 10% and Bond L is 8%.

What is the rate of change in each of

the bond prices if market required
rates fall to 8%?
66
 Example
Example of
of the
the Role
Role of
of the
the
Coupon
Coupon Rate
Rate
The price on Bonds H and L prior to the
change in the market required rate of
return is $1,000 and $848, respectively.

The price for Bond H will rise from $1,000

to $1,171 (+17.1%).
The price for Bond L will rise from $848 to
$1,000 (+17.9%). It rises faster!
67
 Determining
Determining the
the Yield
Yield on
on
Preferred
Preferred Stock
Stock
Determine the yield for preferred
stock with an infinite life.
P0 = DivP / kP

Solving for kP such that

kP = DivP / P0

68
 Preferred
Preferred Stock
Stock Yield
Yield
Example
Example
Assume that the annual dividend on
each share of preferred stock is $10.
Each share of preferred stock is
currently trading at $100. What is the
yield on preferred stock?

kP = $10 / $100.
kP = 10%.
10%
69
 Determining
Determining the
the Yield
Yield on
on
Common
Common Stock
Stock
Assume the constant growth model
is appropriate. Determine the yield
on the common stock.
P0 = D1 / ( ke - g )

Solving for ke such that

ke = ( D1 / P0 ) + g
70
 Common
Common Stock
Stock
Yield
Yield Example
Example
Assume that the expected dividend
(D1) on each share of common stock is
$3. Each share of common stock is
currently trading at $30 and has an
expected growth rate of 5%. What is
the yield on common stock?
ke = ( $3 / $30 ) + 5%

71
ke = 15%