Chapter 6

Valuation of Securities
What is a Bond ?
 Bond: is a form of debt , basically just a
certificate showing that a borrower promises
to pay interest in a specified date.
 Issued by both government and corporation

 Bonds may be of 2 types: bonds with maturity

and perpetual bonds.
Example of bonds
 A government of Canada issued a bonds with
a face value of $1,000 in June 2002 which
matures in June 2022. The stated annual
interest rate is 8%.
- face value (par value, principal: $1,000
- annual coupon: $80
- coupon rate= interest rate (i): 8%
- Time to mature :20 years
- Maturity date : June 1 2022
The Coupon Rate
 The coupon rate of a bond is the stated rate
of interest that the bond will pay
 The coupon rate does not normally change
during the life of the bond, instead the price
of the bond changes as the coupon rate
becomes more or less attractive relative to
other interest rates
 The coupon rate determines the dollar
amount of the annual interest payment:
6.1.Valuation of Bonds
 Bonds valuations is based on determining the
present value of interest payments plus
the principal payment at maturity.
 The Formula
It It Pn
PVb = + + ... +
(1 + kd)1 (1 + kd)2 (1 + kd)n
Pb: Price of The Bond
It: Interest payments
Pn: Principal payment at maturity
t = Number corresponding to a period; running from 1 to n
n = Number of periods
Kd= YTM ( Yield to maturity) = required rate of return
The Yield to Maturity
 The yield to maturity is the average annual
rate of return that a bondholder will earn
under the following assumptions:
 The bond is held to maturity
 The interest payments are reinvested at the YTM
 The yield to maturity is the same as the
bond’s internal rate of return (IRR)
 Reading B.Block p. 262-264
 Ross 7.6 (p 224)
 Semi annual payment

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
 Semi annual payment
½ *It ½ *It Pn
PVb = + + ... +
(1 + kd/2) 1
(1 + kd/2) 2
(1 + kd/2 ) 2*n
 Semiannual Coupon Bond
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?
PV = $40 (PVIFA5%, 30) + $1,000 (PVIF5%, 30)
= $40 (15.373) + $1,000 (.231)
= $614.92 + $231.00
= $845.92
 Perpetual Bonds
A perpetual bond is a bond that never matures. It
has an infinite life.

I I I
PV =(1 + k )1 + (1 + kd)2 + ... + (1 + kd)
d

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

PV = I / kd [Reduced Form]
 Perpetual Bond 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%
PV = I / kd [Reduced Form]
= $80 / 10% = $800.
$800
Bond maturity and Interest rate
risk
 See B.Block 265-266 (table 10.2);
 ROSS p.197
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?
Exercise :
 Bonds issued by the T company have a face value
of VND1 million which matures after 5years
remaining, coupon rate is 10%/a.n.
these bonds have 3 years remaining to mature and
now are selling for VND 1,1million.
a. Should you buy these bonds if you want required
rate of return 9%/a.n ?
b. Assume that you buy these bonds and keep them
only next 2 year and sell them at price of VND1,05
million. How much you should pay for these bond at
present?
 6.2Preferred Stock Valuation

DivP DivP DivP

PV =(1 + k )1 + (1 + kP)
2
+ ... + (1 + kP)
P

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

This reduces to a perpetuity!

perpetuity

V = DivP / kP
 Preferred Stock 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%

PV = DivP / kP = $8.00 / 10% =

$80

B.Block: 14,15 (286)

 Determining the Yield on
Preferred Stock

Determine the yield for preferred stock with an

infinite life.
P0 = DivP / kP
Solving for kP such that
kP = DivP / P0
Kp: required rate of return (yield)
 Preferred Stock Yield 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%
B.Block 16 (286)
 6.3.Common Stock 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
 Dividend Valuation 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
 Adjusted Dividend Valuation
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.
 Dividend Growth Pattern
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
Variable growth in dividends (Growth Phase)
 Constant Growth 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)

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

D 1: Dividend paid at time 1.

D1
= g: The constant growth rate.
(ke - g) ke : Investor’s required return.
 Constant Growth Model
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

PVCG = D1 / ( ke - g ) = $3.50 / ( .15 - .08 ) = $50

 Zero Growth 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 D 1: Dividend paid at time 1.

=
ke ke : Investor’s required return.
 Zero (No) Growth
Model 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
 Growth Phases 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 = + 
t=1 (1 + ke) t
t=n+1 (1 + ke)t
 Growth Phases 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
 Growth Phases Model
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?
 Growth Phases Model
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.
 Growth Phases Model
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
 Growth Phases Model
Example

PV3 =
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!!
 Growth Phases Model
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.
 Growth Phases Model
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
 Growth Phases Model
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.
 Calculating Rates of Return
(or 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
 Determining Bond 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
 Determining the 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?
Using B.Block Formula :10-2 P269
 Bond Price-Yield 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).
 Bond Price-Yield 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?
 Bond Price-Yield 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 (%)
 Bond Price-Yield Relationship
(Rising 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.
 Bond Price-Yield 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?
 Bond Price-Yield Relationship
(Declining 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.
 The Role of Bond 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?
 The Role of Bond 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!
 Determining the Yield on
Common 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
 Common Stock
Yield 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%
ke = 15%