Lecture note 5

Valuation of Corporate Securities

A corporate security has three possible sources

of value:
Terminal value of the security on its
maturity date;
Interim cash flows, such as coupon or
dividend payments;
Value of the security in the event of
recapitalization of the firm.
We look at all three sources of value in an
options context.

Basic Securities:
Stocks and Zero-Coupon Bonds
Consider a firm that has only two securities
outstanding: zero-coupon bonds maturing at
time T and common stock. The total current
market value of the firm, V, is
V = S + B,
where S is the current market value of the stock
on which no dividends are paid before the
maturity date of the bonds, T, and B is the
current market value of the zero-coupon bonds
with a face value F payable at date T.

The contractual payoff of these securities at date

T can be stated as
BT = min [VT, F],
= F max [F VT, 0]
ST = max [VT F, 0]
= VT F + max [F VT, 0]
Option to default

 Example: Suppose that the current market value

of the firm, V, is 100. The rate of return on the
assets of the firm, over one period, is either
u 1 = 20% with probability p or d 1 = 20%
with probability 1 p. The risk-free rate is 10%.
The face value, i.e., the promised payoff at the
end of one period, of the (risky) discount bond
issued by the firm is 100. What are the market
values of the stock and bond of the firm?

Solution
120
100
80

= [(1 + r) d] / (u d)
= (1.1 0.8) / (1.2 0.8) = 0.75
Bond value = (0.75 x 100 + 0.25 x 80) / 1.1
= 86.36

Stock value = 100 86.36 = 13.64

= (0.75 x 20 + 0.25 x 0) / 1.1
YTM = 100 / 86.36 1 = 15.79%
Default premium = 15.79% 10% = 5.79%
Riskless bond value = 100 / 1.1 = 90.91
=> Default premium = 90.91 86.36 = 4.55

Coupon Bonds
If a firm has coupon bonds outstanding with
more than one period left until maturity, we can
view the common stock as a compound option
or an option on an option.
- Option 1: On the maturity date, the stockholders
have the option to buy the firm from the
bondholders for the face value plus the last
coupon of the bonds

- Option 2: One period before the maturity date,

the stockholders have the option to buy option 1
by making the second to last coupon payment.

Option 3
N2

Option 2
N1

Coupon

Coupon

Option 1
N
Mature
Coupon + face value

Example: Suppose that the current market value

of a firm, V, is 150. The firm lasts for two periods
with three dates, 0, 1, and 2. The rate of return
on the assets of the firm, over one period, is
either u 1 = 20% with probability p, or d 1 =
20% with probability 1 p. The risk-free rate is
5% in each period. If any cash payout, coupon
and/or dividend, is made at time 1, then the expayout firm value will change by either u 1 or
d 1 over the second period. The firm pays no
dividends on the stock at time 1 and pays
liquidating dividends at time 2.

What is the price of a coupon bond that has a

face value of 100 and a coupon rate of 6.02%,
and matures at time 2?
Solution
rf = 5% u = 1.2 d = 0.8
Risk neutral probability
= (1.05 0.8) / (1.2 0.8) = 0.625

150
(100)

180 6.02 =
173.98
(100.97)

208.78

Bond
106.02

139.18

106.02

120 6.02 =
113.98
(95.67)

136.78

106.02

91.18

91.18

Bond values in (.)

Value of the coupon bond

YTM = 6.02%
Default premium = 1.02% per period
Value of an otherwise equivalent riskless bond

Default premium = 101.9 100 = 1.9

Callable Bonds
Many corporate bonds have a call provision that
allows the firm to repurchase (i.e., call) the bond
during a specified period (call period) for a prespecified price (call price) plus the accrued
coupon since the last coupon date.
The firm calls its bonds either to refinance the
debt at a lower interest cost or to obtain
operating flexibility by removing restrictive
covenants that may impede M&A or other major
investment projects.

1) general interest rate decreases

2) firms prospects improve => default
premium decreases
Immediate call: The call period starts
immediately after the issue.
Rolling call: The call period starts after a call
protection period has elapsed.
Call premium: The call price over and above the
face value of the bond.
Declining call schedule: The call premium is
declining over the life of the bond to reach the
face value by maturity.

Under the optimal call strategy, the ex-coupon

value of a callable bond will never exceed the
call price: B < K (A constraint that has to be
satisfied throughout the life of the bond.)
If B > K, the firm can sell new bond at a price, B,
and buy back its existing bond at K. The firm has
an immediate gain, B K.

 Example: Suppose that the firm pays no

dividends on the stock at time 1. Consider a
callable bond that has the coupon rate of 6.02%
and the face value of 100, and matures at the
end of the second period. The call price on an
ex-coupon basis is 100. What is the market price
of this callable bond?

180 6.02 =
173.98

208.78
139.18

150
120 6.02 =
113.98

136.78
91.18

Called 106.02 106.99

B
99.43

Bu
100.97
(106.02/1.05)
Bd
95.67

Not called 106.02 101.69

208.78 106.02
139.18 106.02
136.78 106.02
91.18 106.02
(default)

Call option value = 100 99.43 = 0.57

For par pricing, the coupon rate = 6.56%
Additional coupon = 6.56% 6.02% = 0.54%

10

180 6.56 =
173.44

208.13
138.75

150
120 6.56 =
113.44

136.13
90.75

Called 106.56 108.05

B
100

Bu
101.49
(106.56/1.05)
Bd
95.84

Not called 106.56 102.40

208.13 106.56
138.75 106.56
136.13 106.56
90.75 106.56
(default)

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Convertible Bonds
A convertible bond offers investors the right to
convert the bond into the stock of the issuing
firm during the conversion period at the specified
conversion terms.
Conversion ratio: The number of shares of
common stock into which a bond can be
converted.
Conversion price: The face value of the bond
divided by the conversion ratio.
Dilution factor, a: The fraction of the postconversion equity value that accrues to the
bondholders.

Suppose the firm has 40 shares outstanding

initially and the conversion ratio of the
convertible bond is 60 shares.
The dilution factor is a = 60 / (40 + 60) = 60%
Under the optimal conversion strategy, the value
of the convertible bond will be max [aV, B + c],
i.e., the conversion value or the cum-coupon
value of the convertible bond, whichever is
higher (Presumption: Conversion does not carry
an accrued coupon).

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 Example: Suppose that the firm pays no

dividends on the stock. Consider a convertible
bond that has the coupon rate of 6.02% and the
face value of 100, and matures at time 2. The
bond can be converted into 60% of firm value
either at time 1 or at time 2 (maturity). What is
the market price of this convertible bond?

180 6.02 =
173.98

208.78
139.18

150
120 6.02 =
113.98

136.78
91.18

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(No conversion)

108.00 118.45

Bu
112.43

(converted) 125.27

(No conversion) 83.51

139.18 106.02

82.07

136.78 106.02

54.71

91.18 106.02

B
106.82
Bd
95.67
(No conversion)

72

208.78 106.02

(default)

101.69

Value of conversion option = 106.82 100

= 6.82

If the firm pays dividend, D, at time 1.

D = 25. D + C = 25 + 6.02 = 31.02
180 31.02 =
148.98

178.78
119.18

150
120 31.02 =
88.98

106.78
71.18

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Converted

101.72

Not converted

Converted

98.05
No conversion

88.53
(default)

Reduction in bond value = 106.82 98.05

= 8.77

Warrants
A warrant is a security that gives the owner the
right to purchase a common stock at a
prespecified price before an expiration date.
A warrant differs from a call option on stocks in
three ways:
A warrant is issued by a firm rather than by an
investor.
The expiration dates of warrants are typically
several years from the issue date.
The exercise of warrants results in the dilution of
the value of the underlying equity.

15

 Let n be the number of shares initially

m be the number of warrants
W be the warrant price
X be the exercise price

Since VT = nST, we have

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= dilution factor
= number of warrants per share outstanding upon
exercise of warrants

Example: Suppose that the firm has only one

share on which no dividends are paid at time 1.
The firm issues one European warrant with an
exercise price of 150. The proceeds are paid out
as dividends to shareholders. The European
warrant expires at time 2.

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Solution:
216
180
150

144

120
96

Call X = 150
39.28
23.38
0

18

Warrant X = 150
19.64
11.69
(0.5 x 23.38)

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