Module 2

Bond and Stock Valuation

Tex tb ook: F u n d am entals o f Co r p orate F i n a nce, N i nt h
Ca n a dian Ed i t ion by S te p hen A . Ro s s , R a n do lph W.
We ste rfi eld, Bra d ford D. J o rdan a n d G o rdon S . Ro b ert s,
M c G raw -Hill Rye rson, 2 0 1 6.

© 2016 McGraw-Hill Education Limited

Outline
Chapter 7

Interest Rates and Bond Valuation

Chapter 8

Stock Valuation
Chapter 7
Interest Rates and Bond Valuation

© 2016 McGraw-Hill Education Limited

Bond Definitions
Bond—long term debt instruments issued by
corporations or governmental entities

Coupons—the regular interest payments promised

by issuer. In Canada, most bonds issue semi-annual
coupon bonds
Face value—the promised repayment amount at
maturity, typically $1000
◦ can also be called Principal value, Par Value, Maturity
Value, or Redemption Value

© 2016 McGraw-Hill Education Limited

Bond Definitions Continued
Coupon rate—annual dollar coupon ÷ face value

Maturity—specified date in which the principal

amount is due
Yield to Maturity—total return anticipated if bond is
held to maturity

Current Yield = Annual Interest Payment/ Current

Price of bond

© 2016 McGraw-Hill Education Limited

Bond Value and Yields
We can calculate the value of a bond by using the Present Value
concepts we learned in Chapter 5 and 6.
Bond Cash Flows:
• Coupon payments – Annuity Cash Flow Stream
• Face Value – Lump-sum Payment

𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 + 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉

1
1− FV
1+r t
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = C +
r 1+r t

© 2016 McGraw-Hill Education Limited

Example: Bond Price and Effective Yield
Suppose a company issues a 5-year bond with a
coupon rate of 6% and a face value of $1000. The
coupons are paid semi-annually, and similar bonds
have a yield to maturity of 6%.

What is the value of the bond?

© 2016 McGraw-Hill Education Limited

Example: Bond Price and Effective Yield
𝐶𝐶𝐶𝐶 = 6%
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = $1000 ∗ 6% = $60
$60
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = = $30
2
6%
𝑌𝑌𝑌𝑌𝑌𝑌 = 6%, 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑌𝑌𝑌𝑌𝑌𝑌 = = 3%
2
𝑡𝑡 = 5 ∗ 2 = 10 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
1− 1.03 −10 −10
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 30 + 1000 1.03 = $𝟏𝟏𝟏𝟏𝟏𝟏𝟏𝟏
0.03

© 2016 McGraw-Hill Education Limited

Relationship between Rates and Bond Value

Yield to Maturity Price

YTM = Coupon Rate At Par
YTM > Coupon Rate Below Par (Discount)
YTM < Coupon Rate Above Par (Premium)

© 2016 McGraw-Hill Education Limited

Example Continued
In our previous example, what is the value of the
bond if the yield to maturity is:
a) 5%
b) 7%

Under which circumstance is the bond trading for a:

1. Discount
2. Premium

© 2016 McGraw-Hill Education Limited

Example Continued
a) YTM = 5%
1 − 1.025 −10
−10
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 30 + 1000 1.025 = $𝟏𝟏, 𝟎𝟎𝟎𝟎𝟎𝟎. 𝟕𝟕𝟕𝟕
0.025

b) YTM = 7%

1− 1.035 −10 −10

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 30 + 1000 1.035 = $𝟗𝟗𝟗𝟗𝟗𝟗. 𝟒𝟒𝟒𝟒
0.035

© 2016 McGraw-Hill Education Limited

Interest Rate Risk
Sensitivity to interest rates depends on the time to
maturity and the coupon rate. With all else equal,
interest rate risk is greater when:

◦ The time to maturity is greater

◦ The coupon rate is lower

© 2016 McGraw-Hill Education Limited

Finding the Yield to Maturity
1
1− 1000
1+𝑟𝑟 𝑡𝑡
𝑃𝑃 = 𝐶𝐶 +
𝑟𝑟 (1+𝑟𝑟)𝑡𝑡

If we know all variables except r, there is no analytical

solution for r. We can use the following methods to
calculate:
◦ Trial and Error
◦ Approximation formula (next slide)
◦ Financial calculator/Excel

© 2016 McGraw-Hill Education Limited

YTM Approximation

𝐹𝐹𝐹𝐹 − 𝑀𝑀𝑀𝑀
𝐶𝐶 +
𝑌𝑌𝑌𝑌𝑌𝑌𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = 𝑡𝑡
𝐹𝐹𝐹𝐹 + 𝑀𝑀𝑀𝑀
2

Note that if coupons are paid semi-annually, we need to multiply the

YTM approx. by 2 to get the annual rate

© 2016 McGraw-Hill Education Limited

Example: Yield to Maturity (YTM)
Suppose a bond is trading for $1021.95, the coupon
rate is 5%, the time to maturity is five years, and the
face value is $1000. Coupons are paid semi-annually.

a) Based on the bond price, is the YTM greater than or

less than the coupon rate?

b) What is the YTM?

© 2016 McGraw-Hill Education Limited

 Example: Yield to Maturity (YTM)

a) The bond is trading for a premium; YTM < CR

1000−1021.95
25+
b) YTMapprox = 10
1000+1021.95 = 2.255743218% S. A.
2

Annual YTM = 2.255743218% ∗ 2 = 4.511486436% ≅ 4.51%

© 2016 McGraw-Hill Education Limited

Example: Yield to Maturity (YTM)
Bond Pricing Theorems
The market will require the same yield for bonds
that have similar risk and maturity
Bonds will be priced accordingly to reflect the
required yield
Knowing the price of one bond allows us to
estimate the yield to maturity and use this to
estimate the price of another bond with similar risk
See Example 7.2 on page 228 of your textbook

© 2016 McGraw-Hill Education Limited

Bond Indenture

Legal contract between the firm

and the bondholders,
highlighting the bond terms and
characteristics

© 2016 McGraw-Hill Education Limited

Bond Characteristics
Bond Terms
◦ Face value, par value, and form (registered or bearer)
Security
◦ Collateral, Mortgage, Debenture, Note
Seniority
◦ Senior, Subordinated
Repayment
◦ Sinking Fund

© 2016 McGraw-Hill Education Limited

Bond Characteristics Continued
Call provision
◦ Call premium
◦ Deferred call
◦ Call protected

Protective covenants
◦ Negative and Positive covenants

© 2016 McGraw-Hill Education Limited

Bond Ratings
Independent rating agencies, such as Standard and Poor’s
(S&P), Moody's, and DBRS, provide credit ratings for bond
issuers.
The rating indicates the creditworthiness of the issuer and,
therefore, the credit risk.

The following link is to the Standard and Poor’s website. You

will find information on their current rating process and
rating scale, in addition to useful videos.
Standard and Poor's Website - Understanding Ratings

© 2016 McGraw-Hill Education Limited

Different Types of Bonds
Zero-coupon Bond
◦ a bond that does not pay coupon payments
◦ always sold at a deep discount
Stripped Bond
◦ a bond that is “stripped” of its coupon payments
◦ coupons are sold as separate securities and the bond
becomes a zero coupon bond
◦ Sold at a deep discount

© 2016 McGraw-Hill Education Limited

Different Types of Bonds Continued
Floating Rate Bonds – coupon payments adjusted
over time based on a index
◦ Reduced interest rate risk
◦ Put provision – holder can sell back bond at par value
after a specified time
◦ Coupon rate has a floor and ceiling (range in which it
can fluctuate)

© 2016 McGraw-Hill Education Limited

Different Types of Bonds Continued
Income bonds
◦ Coupons are paid if the firm has enough income

Convertible bond
◦ the bond can be converted to a fixed number of
shares of stock at any time prior to maturity

Put bond
◦ allows holder to sell back the bond to the issuer
for par

© 2016 McGraw-Hill Education Limited

Bond Markets
Bonds typically trade on the Over the Counter (OTC)
market
◦ Dealers are connected electronically

◦ Trades are privately negotiated

◦ Little centralized reporting and transparency

© 2016 McGraw-Hill Education Limited

Bond Quote
Quote will state the coupon rate, maturity date, bid
price, and yield
Price is quoted as a percentage of Face value
Example: a bond trading at a premium for
$1035.70 would be quoted as 103.57

Refer to Figure 7.4 on page 243 of your textbook for

examples of Bond Quotes

© 2016 McGraw-Hill Education Limited

Bond Price Quotes
Accrued Interest = fraction of the coupon period that has passed
multiplied by the coupon payment
Clean price is the price of the bond less any accrued interest.
Dirty price is the price of the bond that includes the accrued interest.

Example: Suppose you just purchased a bond with a 6% coupon rate and a face
value of $1000. Coupons are paid semi-annually, and the next coupon is due in
exactly two months. The price you paid for the bond was $1060.
a) What is the dirty price?
b) What is the clean price?

© 2016 McGraw-Hill Education Limited

Example: Dirty and Clean Price
a) The Dirty price is $1060
b) The Clean price is $1040
6%
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = ∗ $1000 = $30
2

4
𝐴𝐴𝐴𝐴 = ∗ 30 = $20
6

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 − 𝐴𝐴𝐴𝐴 = $1060 − $20 = $1040

© 2016 McGraw-Hill Education Limited

Fisher Effect
Relationship between nominal returns, real
returns, and the expected inflation rate.
Let R = nominal rate, r = real rate, and h
=expected inflation rate
(1 + R) = (1 + r) × (1 + h)

Approximate Relationship: 𝑹𝑹 ≈ 𝒓𝒓 + 𝒉𝒉

© 2016 McGraw-Hill Education Limited

Example: Fisher Effect
Suppose you invested $100, and it grew
to $107 by the end of the year. If the
inflation rate is 3%:
a) What is your nominal return?
b) What is your real return?

© 2016 McGraw-Hill Education Limited

Example: Fisher Effect
107−100
a) 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
100
= 7%

b) 1 + 𝑅𝑅 = 1 + 𝑟𝑟 1 + ℎ

1+𝑅𝑅 1.07
𝑟𝑟 = −1= − 1 = 3.88%
1+ℎ 1.03

Approximation:
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 ≈ 7% − 3% = 4%

© 2016 McGraw-Hill Education Limited

Present Value – Adjusting for Inflation
Two Ways:
◦ Discount real cash flows using the real rate
◦ Discount nominal cash flows with the nominal rate
Suppose you require $5000 (current dollars) each
year in real purchasing power for the next 7 years.
The current inflation rate is 2% per year and the
nominal discount rate is 8%.
How much do you need to invest today to allow
you to make annual withdraws?

© 2016 McGraw-Hill Education Limited

Example – Adjusting for Inflation
1. Real Cash Flows and Real Rates
1+𝑅𝑅 1.08
𝑃𝑃 = −1= − 1 = 5.8823529%
1+ℎ 1.02
1− 1.058823529 −7
𝑃𝑃𝑃𝑃 = 5000 = $28,029.00
0.058823529

2. Using Nominal Cash Flows and Nominal Rates

Cash flows need to grow by 2% each period to keep up with
inflation. Using the growing annuity formula:
5100 1.02 7
𝑃𝑃𝑃𝑃 = 1− = $28,029.00
0.08−0.02 1.08

© 2016 McGraw-Hill Education Limited

The Term Structure of Interest Rates
Relationship between short and long-term nominal
interest rates for default free, pure discount bonds
◦ Upward Sloping– long term rates are higher than
short-term rates
◦ Downward Sloping– short-term rates are higher than
long term rates
◦ Humped– medium-term rates are higher than short-
term and long-term rates. This type of curve is rare

© 2016 McGraw-Hill Education Limited

© 2016 McGraw-Hill Education Limited
Yield Curve
Based on coupon bond yields
Default Risk Premium
◦ compensation demanded for the risk that the issuer
does not make all promised payments
Liquidity Premium
◦ compensation demanded for bonds that do not trade
often

© 2016 McGraw-Hill Education Limited

Task: Self Assessment 4

It’s time to check your

understanding by completing
the Self Assessment!