Chapter 3

Stocks & Bond Valuation

To Thi Thanh Truc

Faculty of Finance and Banking
University of Economics and Law

3-1
 Learning outcomes
After studying this chapter you should be able to:
 Explain the theory framework of discounting cash flow (DCF)
approach in valuation.
 Understand how stock’s value depend on future dividends and
dividend growth and compute stock’s intrinsic value using the
dividend growth model
 Understand how a stock’s intrinsic value can be estimate using
corporate’s FCF discounting model.
 Understand how to value stocks using multiples.
 Explain how to estimate the value of preferred stock.
 Explain how to estimate the value of bonds

3-2
 Materials
 Handout
 Brigham & Houston, Fundamentals of financial
management, chapter 8, 9.
 Jim DeMello, 2006, Cases in Finance, Mc Graw- Hill (Case
10, 11, 12)

3-3
 Outline

 Common Stock valuation

 Preferred stock valuation
 Bond valuation

3-4
Common Stock valuation

3-5
Values concepts

3-6
 Liquidation value vs going
concern value
Liquidation value: Net proceeds that could be
realized by selling the firm’s assets
separately and paying off its creditors.
Going concern Value: the amount the firm could
be sold for as a continuing operating
business.
Book Value: Net worth of the firm according to
the balance sheet.

3-7
 Intrinsic value vs market value

Market value: the market price at which the

asset trades in an open marketplace.

Intrinsic value: What the price of a security

should be if properly priced based on all
factors bearing on valuation.

3-8
 Intrinsic value vs market value

 If markets are reasonably efficient and

informed, the current market price of a
security should fluctuate closely around its
intrinsic value.
 The valuation approach taken in this
chapter is one of determining a security’s
intrinsic value – what the security ought to
be worth based on hard facts

3-9
 Intrinsic Value and Stock Price
 Outside investors, corporate insiders, and
analysts use a variety of approaches to
estimate a stock’s intrinsic value (P0).
 In equilibrium we assume that a stock’s price
equals its intrinsic value.
 Outsiders estimate intrinsic value to help
determine which stocks are attractive to
buy and/or sell.
 Stocks with a price below (above) its
intrinsic value are undervalued
(overvalued).
3-10
Determinants of Intrinsic Value
and Stock Prices (Figure 1-1)

3-11
General DCF model

3-12
 General DCF Model
0 1 2 n
r% ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  r) (1  r) (1  r)

3-13
General DCF model

The value of an asset is the present

value of the cash-flow stream
provided to the investor, discounted at
a required rate of return appropriate
for the risk involved.

3-14
 General DCF model

 Value of an assets = Total present

value of CFs from the assets.
 CF1,2,…n: CF at time t.
 r: required rate of return on the
assets. It depends on the risk of CFs

3-15
 Different approaches for estimating the
intrinsic value of a common stock

 Dividend discount model

 Corporate value model
 Using the multiples of comparable
firms

3-16
Dividend discount model

3-17
 Cash Flows for Stockholders
 If you buy a share of stock, you can receive cash
in two ways
 Receive Dividends (Periodic cash distribution

from the firm to the shareholders)

 You sell your shares, either to another investor

in the market or back to the company

 The value of the stock is the present value of
these expected cash flows.
 The expected return depends on the current
price, the expected dividend and the price at the
end of period. 3-18
 Intrinsic value at t=0 for 1
period holding
 Purchase stock at t=0, hold for 1 year
 At the end of the year (in one year) you expect it
to pay a D1 and you believe that you can sell the
stock for P1 at that time.
 If you require a return of r on investments of this
risk, what is the maximum you would be willing to
pay?

3-19
 Intrinsic value at t=0 for 1
period holding
 The value of the stock is the present value of
expected dividend (D1) and expected price (P1) in 1
year, discounted at required rate on the stock.

^ D1 P1
P0  
(1  rs ) 1
(1  rs )1

3-20
 Stock valuation
One-Period Example
 Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. You expect it to pay a $2 dividend in
one year, and you believe that you can sell the stock
for $14 at that time. If you require a return of 20% on
investments of this risk, what is the maximum you
would be willing to pay?

 Compute the PV of the expected cash flows

 Price = (14 + 2) / (1.2) = $13.33

3-21
Expected Return
Expected Return - The percentage yield that an
investor forecasts from a specific investment
over a set period of time. Sometimes called
the holding period return (HPR).

^D1  P1  P0
Expected Return  r 
P0

3-22
Expected Return

The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

^ D1 P1  P0
Expected Return  r  
P0 P0

3-23
 Intrinsic value at t=1 for 1
period holding
 What determine the stock price at t=1?
 Those are expected dividend and expected stock
price at t=2, (D2 and P2)
 The value of the stock at t=1 is the present value of
expected dividend (D2) and expected price (P2) in 2
year, discounted at required rate on the stock.
^ D2 P2
P1  
(1  rs ) 1
(1  rs )1
3-24
 Intrinsic value at t=0 for 2
periods
 If you hold the stock for 2 period. The intrinsic value
at t=0 is the present value of expected dividend at
t=1 (D1), expected dividend at t=2 (D2), and the
expected stock price at t=2 (P2).

^ D1 D2 P2
P0   
(1  r )1
(1  r ) 2
(1  r ) 2

3-25
 Stock valuation
Two-Period Example
 Now, what if you decide to hold the stock for two
years? In addition to the dividend in one year,
you expect a dividend of $2.10 in two years and a
stock price of $14.70 at the end of year 2. Now
how much would you be willing to pay?

 PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 =

13.33

3-26
 Stock valuation
Three-Period Example
 Finally, what if you decide to hold the stock for
three years? In addition to the dividends at the
end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and the
stock price is expected to be $15.435. Now how
much would you be willing to pay?

 PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435)

/ (1.2)3 = 13.33
3-27
 Developing The Stock
Valuation Model
 You could continue to push back the year in
which you will sell the stock
 You would find that the price of the stock is
really just the present value of all expected
future dividends
 So, how can we estimate all future dividend
payments?

3-28
Dividend discount model
Dividend Discount Model - Computation of
today’s stock price which states that share
value equals the present value of all expected
future dividends.

^ D1 D2 D H  PH
P0    ... 
(1  rs ) 1
(1  rs ) 2
(1  rs ) H

H - Time horizon for your investment.

3-29
 Dividend discount model

^ D1 D2 D3 D
P0     ... 
(1  rs ) (1  rs )
1 2
(1  rs ) 3
(1  rs ) 

 The value of the stock is really just the present

value of all expected future dividends
 So, how can we estimate all future dividend
payments?

3-30
 Estimating Dividends:
Special Cases
 Constant dividend
 The firm will pay a constant dividend forever
 This is like preferred stock
 The price is computed using the perpetuity formula
 Constant dividend growth
 The firm will increase the dividend by a constant percent
every period
 The price is computed using the growing perpetuity model
 Supernormal growth
 Dividend growth is not consistent initially, but settles
down to constant growth eventually
 The price is computed using a multistage model
3-31
Zero Growth
If we forecast no growth, and plan to hold
out stock indefinitely, we will then value the
stock as a PERPETUITY.

^ D1 EPS1
Perpetuity  P 0  or
rs rs

Assumes all earnings are paid to

shareholders.

3-32
Zero Growth
Suppose stock is expected to pay a $0.50 dividend
every quarter and the required return is 10% with
quarterly compounding. What is the price?

𝑃0= 0.50 / (0.1 / 4) = $20

3-33
Constant growth stock
 A stock whose dividends are expected to
grow forever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

 If g is constant, the dividend growth formula

converges to:
^ D 0 (1  g) D1
P0  
rs - g rs - g
3-34
 Future dividends and their
present values
t
$ D t  D0 ( 1  g )

Dt
0.25 PVD t 
( 1  r )t

P0   PVD t

0 Years (t)
3-35
What happens if g > rs?
 If g > rs, the constant growth formula
leads to a negative stock price, which
does not make sense.
 The constant growth model can only be
used if:
 rs > g
 g is expected to be constant forever

3-36
 DGM – Example 1
 Suppose Big D, Inc., just paid a dividend of
$0.50 per share. It is expected to increase its
dividend by 2% per year. If the market
requires a return of 15% on assets of this
risk, how much should the stock be selling
for?
 P0= .50(1+.02) / (.15 - .02) = $3.92

3-37
 DGM – Example 2
 Suppose TB Pirates, Inc., is expected to pay a
$2 dividend in one year. If the dividend is
expected to grow at 5% per year and the
required return is 20%, what is the price?
 P0 = 2 / (0.2 - 0.05) = $13.33

 Why isn’t the $2 in the numerator

multiplied by (1.05) in this example?

3-38
 Stock Price Sensitivity to
Dividend Growth, g
250
D1 = $2; r = 20%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

3-398-39
 Stock Price Sensitivity to
Required Return, r
250
D1 = $2; g = 5%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Required return

3-40
Example 3 Gordon Growth
Company - I
 Gordon Growth Company is expected to pay
a dividend of $4 next period, and dividends
are expected to grow at 6% per year. The
required return is 16%.
 What is the intrinsic value today?
 P0= 4 / (0.16 - 0.06) = $40
 Remember that we already have the dividend
expected next year, so we don’t multiply the
dividend by 1+g

3-41
 Example 3 – Gordon Growth
Company - II

 What is the price expected to be in year 4?

 P4= D4(1 + g) / (rs – g) = D5 / (rs – g)

 P4= 4(1+.06) / (.16 - .06) = 50.50

4

 What is the implied growth rate given the change in

price during the four year period?
 50.50 = 40(1+ growth rate) ; growth rate = 6%
4

 The price is assumed to grow at the same rate as the

dividends

3-428-42
Finding the Required Return -
Example
 Suppose a firm’s stock is selling for $10.50.
It just paid a $1 dividend, and dividends
are expected to grow at 5% per year.
What is the required return?
 rs = [1(1.05)/10.50] + .05 = 15%
 What is the dividend yield?
 1(1.05) / 10.50 = 10%
 What is the capital gains yield?
 g =5%
3-43
Nonconstant Growth
 Valuing Non-Constant Growth

^ D1 D2 DH PH
P0    ...  
(1  rs ) (1  rs )
1 2
(1  rs ) H
(1  rs ) H

3-44
 Nonconstant Growth
Problem Statement
 Suppose a firm is expected to increase
dividends by 20% in one year and by 15%
in two years. After that, dividends will
increase at a rate of 5% per year
indefinitely. If the last dividend was $1
and the required return is 20%, what is
the price of the stock?
 Remember that we have to find the PV of
all expected future dividends.
3-458-45
 Nonconstant Growth
Example Solution
 Compute the dividends until growth levels off
 D1 = 1(1.2) = $1.20
 D2 = 1.20(1.15) = $1.38
 D3 = 1.38(1.05) = $1.449
 Find the expected future price
 P2= D3 / (rs – g) = 1.449 / (0.2 - 0.05) = 9.66
 Find the present value of the expected future cash
flows
 P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

3-46
 Break down stock’s value
 If a firm elects to pay a lower dividend, and reinvest the
funds, the stock price may increase because future
dividends may be higher. The price and dividend growth
rate depends on Plowback ratio (retention ratio) and Return
on Equity
• Payout Ratio: Fraction of earnings paid out as
dividends
• Plowback Ratio (retention ratio): Fraction of earnings
retained by the firm

3-47
 Break down stock’s value
 Growth can be derived from applying the return
on equity to the percentage of earnings plowed
back into operations.
g = return on equity X plowback ratio
 g is also called Sustainable Growth Rate: Steady
rate at which firm can grow with no external equity
needed and unchanged capital structure.

3-48
Break down stock’s value-
Example
Our company forecasts to pay a $5.00
dividend next year, which represents
100% of its earnings. This will provide
investors with a 12% expected return.
Instead, we decide to plowback 40% of
the earnings at the firm’s current return
on equity of 20%. What is the value of
the stock before and after the plowback
decision?

3-49
Example -continued
No Growth With Growth

g .20.40 .08
5
P0   $41.67 3
.12 P0   $75.00
.12 .08

3-50
 Example -continued
If the company did not plow back some earnings, the
stock price would remain at $41.67. With the
plowback, the price rose to $75.00.

The difference between these two numbers (75.00-

41.67=33.33) is called the Present Value of Growth
Opportunities (PVGO).

 Present Value of Growth Opportunities (PVGO).

 Net present value of a firm’s future investments.

3-51
 Quiz
Assume that Bon Temps has a beta coefficient of 1.2, that the risk-
free rate (the yield on T-bonds) is 7%, and that the required rate
of return on the market is 12%.
 What is Bon Temps’s required rate of return?
 Assume that Bon Temps is a constant growth company whose
last dividend (D0, which was paid yesterday) was $2.00 and
whose dividend is expected to grow indefinitely at a 6% rate.
(1) What is the firm’s expected dividend stream over the next 3
years?
(2) What is its current stock price?
(3) What is the stock’s expected value 1 year from now?
(4) What are the expected dividend yield, capital gains yield, and
total return during the first year?
3-52
 Quiz
 Now assume that the stock is currently selling at
$30.29. What is its expected rate of return?
 What would the stock price be if its dividends were
expected to have zero growth?
 Now assume that Bon Temps is expected to
experience nonconstant growth of 30% for the next
3 years, then return to its long-run constant growth
rate of 6%. What is the stock’s value under these
conditions? What are its expected dividend and
capital gains yields in Year 1? Year 4?

3-53
 Quiz
 Suppose Bon Temps is expected to experience zero
growth during the first 3 years and then resume its
steady-state growth of 6% in the fourth year. What
would be its value then? What would be its expected
dividend and capital gains yields in Year 1? in Year 4?
 Finally, assume that Bon Temps’s earnings and
dividends are expected to decline at a constant rate
of 6% per year, that is, g ¼ –6%. Why would
anyone be willing to buy such a stock, and at what
price should it sell? What would be its dividend and
capital gains yields in each year?
3-54
If rRF = 7%, rM = 12%, and b = 1.2,
what is the required rate of return on
the firm’s stock?
 Use the SML to calculate the required
rate of return (rs):

rs = rRF + (rM – rRF)b

= 7% + (12% - 7%)1.2
= 13%

3-55
 If D0 = $2 and g is a constant 6%,
find the expected dividend stream for
the next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

3-56
What is the stock’s intrinsic value?
 Using the constant growth model:

ˆP  D1  $2.12
0
rs - g 0.13 - 0.06
$2.12

0.07
 $30.29

3-57
What is the expected market price
of the stock, one year from now?
 D1 will have been paid out already. So,
P1 is the present value (as of year 1) of
D2, D3, D4, etc.
^ D2 $2.247
P1  
rs - g 0.13 - 0.06
 $32.10

 Could also find expected P1 as:

^
P1  P0 (1.06)  $32.10
3-58
What are the expected dividend yield,
capital gains yield, and total return
during the first year?
 Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
 Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
 Total return (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%

3-59
What would the expected price
today be, if g = 0?
 The dividend stream would be a
perpetuity.

0 1 2 3
rs = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0    $15.38
r 0.13

3-60
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
 Can no longer use just the constant growth
model to find stock value.
 However, the growth does become
constant after 3 years.

3-61
 Valuing common stock with
nonconstant growth

0 r = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
$ 4.658
46.114 P3   $66.54
^ 0.13  0.06
54.107 = P0
3-62
Find expected dividend and capital gains
yields during the first and fourth years.
 Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% - 4.81% = 8.19%
 During nonconstant growth, dividend yield
and capital gains yield are not constant,
and capital gains yield ≠ g.
 After t = 3, the stock has constant growth
and dividend yield = 7%, while capital
gains yield = 6%.
3-63
 Nonconstant growth:
What if g = 0% for 3 years before long-
run growth of 6%?

0 r = 13% 1 2 3 4
s
...
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
$ 2.12
20.99 P3   $30.29
^ 0.13  0.06
25.72 = P0
3-64
Find expected dividend and capital gains
yields during the first and fourth years.

 Dividend yield (first year)

= $2.00 / $25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
 After t = 3, the stock has constant
growth and dividend yield = 7%,
while capital gains yield = 6%.

3-65
If the stock was expected to have
negative growth (g = -6%), would anyone
buy the stock, and what is its value?

 The firm still has earnings and pays

dividends, even though they may be
declining, they still have value.

^ D1 D0 ( 1  g )
P0  
rs - g rs - g
$2.00 (0.94) $1.88
   $9.89
0.13 - (-0.06) 0.19

3-66
Find expected annual dividend and
capital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% - (-6.00%) = 19.00%

 Since the stock is experiencing constant

growth, dividend yield and capital gains
yield are constant. Dividend yield is
sufficiently large (19%) to offset a negative
capital gains.
3-67
Corporate Value Model

3-68
Corporate value model
 Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s
free cash flows.
 Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
 FCF = NOPAT – Net capital investment
3-69
 Applying the corporate value model

 Find the value of the firm, by finding the

PV of the firm’s future FCFs.
 Subtract the market value of firm’s debt
and preferred stock to get the value of
common stock.
 Divide the value of common stock by the
number of shares outstanding to get
intrinsic stock price (value).
3-70
Issues regarding the
corporate value model
 Often preferred to the dividend growth
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
 Similar to dividend growth model, assumes at
some point free cash flow will grow at a
constant rate.
 Terminal value (TVN) represents value of firm
at the point that growth becomes constant.
3-71
Firm Value


FCFt
V
t 1 (1 WACC) t

3-72
Constant growth FCF
Assume FCFs grow at a steady rate
forever 
FCFt
V  1  WACC
t 1
t


FCF0 (1  g ) t

t 1 1  WACC t

3-73
Constant growth formula

FCF1
V
WACC  g 
FCF0 (1  g )

WACC  g 
3-74
 Corporate value model – Quiz
 The Bon Temps Company, a total equity financed employment
agency that supplies word processor operators and computer
programmers to businesses with temporarily heavy workloads.
 Now suppose Bon Temps embarked on an aggressive expansion
that requires additional capital. Management decided to finance
the expansion by borrowing $40 million and by halting dividend
payments to increase retained earnings. Its WACC is now 10%,
and the projected free cash flows for the next 3 years are –$5
million, $10 million, and $20 million. After Year 3, free cash flow
is projected to grow at a constant 6%. What is Bon Temps’s
total value? If it has 10 million shares of stock and $40 million
of debt and preferred stock combined, what is the price per
share?

3-75
 Nonconstant Growth

 Finance expansion by borrowing $40 million and

halting dividends.
 Projected free cash flows (FCF):
 Year 1 FCF = -$5 million.

 Year 2 FCF = $10 million.

 Year 3 FCF = $20 million

 FCF grows at constant rate of 6% after year 3.

(More…)
3-76
 The weighted average cost of capital,
rc, is 10%.
 The company has 10 million shares of
stock.

3-77
Horizon Value
 Free cash flows are forecast for three
years in this example, so the forecast
horizon is three years.
 Growth in free cash flows is not
constant during the forecast,so we can’t
use the constant growth formula to find
the value of operations at time 0.

3-78
Horizon Value (Cont.)
 Growth is constant after the horizon (3
years), so we can modify the constant
growth formula to find the value of all
free cash flows beyond the horizon,
discounted back to the horizon.

3-79
 Horizon Value Formula

FCFt (1  g )
HV  V at time t 
WACC  g 
 Horizon value is also called terminal
value, or continuing value.

3-80
 Find the value of operations by discounting
the free cash flows at the cost of capital.
0 r =10% 1 2 3 4
c

g = 6%
FCF= -5.00 10.00 20.00 21.2

-4.545
8.264
15.026
$21.2
398.197 Vop at 3
  $530.
0 .10  0.06
416.942 = V

3-81
Find the price per share of common
stock.

Value of equity = Value of operations

- Value of debt
= $416.94 - $40
= $376.94 million.

Price per share = $376.94 /10 = $37.69.

3-82
Firm multiples method
 Analysts often use the following multiples
to value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.
3-83
Market equilibrium

3-84
What is market equilibrium?
 In equilibrium, stock prices are stable and
there is no general tendency for people to
buy versus to sell.
 In equilibrium, two conditions hold:
 The current market stock price equals its
^
intrinsic value (P0 = P0).
 Expected returns must equal required returns.
^ D1
rs  g  rs  rRF  (rM  rRF )b
P0
3-85
Market equilibrium
 Expected returns are determined by
estimating dividends and expected
capital gains.
 Required returns are determined by
estimating risk and applying the CAPM.

3-86
How is market equilibrium
established?
 If price is below intrinsic value …
 The current price (P0) is “too low” and
offers a bargain.
 Buy orders will be greater than sell
orders.
 P0 will be bid up until expected return
equals required return.

3-87
How are the equilibrium
values determined?
 Are the equilibrium intrinsic value and
expected return estimated by
managers or are they determined by
something else?
 Equilibrium levels are based on the
market’s estimate of intrinsic value and
the market’s required rate of return, which
are both dependent upon the attitudes of
the marginal investor.

3-88
Preferred Stock Valuation

3-89
Preferred stock
 Hybrid security.
 Like bonds, preferred stockholders
receive a fixed dividend that must be
paid before dividends are paid to
common stockholders.
 However, companies can omit
preferred dividend payments without
fear of pushing the firm into
bankruptcy.
3-90
If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?

Vp = D / rp
$50 = $5 / rp

^r = $5 / $50
p
= 0.10 = 10%

3-91
Bond Valuation

3-92
 Key Features of a Bond
 Bond - evidence of debt issued by a corporation or a
governmental body. A bond represents a loan made by
investors to the issuer. In return for his/her money, the
investor receives a legal claim on future cash flows of the
borrower. The issuer promises to:
Make regular coupon payments every period until the bond
matures, and
Pay the face/par/maturity value of the bond when it
matures.
 Default - since the abovementioned promises are
contractual obligations, an issuer who fails to keep them is
subject to legal action on behalf of the lenders
(bondholders). 3-93
Key Features of a Bond
 Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply by par
value to get dollar payment of interest.
 Maturity date – years until the bond must be
repaid.
 Issue date – when the bond was issued.
 Yield to maturity - rate of return earned on
a bond held until maturity (also called the
“promised yield”).
3-94
 The value of financial assets
0 1 2 n
r% ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ...  n
(1  r) (1  r) (1  r)

3-95
What is the opportunity cost of
debt capital?

The discount rate (rd ) is the

opportunity cost of capital, and is the
rate that could be earned on
alternative investments of equal risk.

rd= r* + IP + MRP + DRP + LP

3-96
 What’s the value of a 10-year, 10%
coupon bond if rd = 10%?

0 1 2 10
10%
...
V=? 100 100 100 + 1,000

$100 $100 $1,000

VB  + . . . + +
1 + rd  1 + r d  1+ r d 
1 10 10

= $90.91 + . . . + $38.55 + $385.54

= $1,000.
3-97
 Example
 If a bond has five years to maturity, an $80 annual coupon, and a
$1000 face value, its cash flows would look like this:

Time 0 1 2 3 4 5
Coupons $80 $80 $80 $80 $80
Face Value $ 1000
Market Price $____

 How much is this bond worth? It depends on the level of current

market interest rates. If the going rate on bonds like this one is 10%,
then this bond has a market value of $924.18.

3-98
 Using a financial calculator to
value a bond
 This bond has a $1,000 lump sum (the par value)
due at maturity (t = 10), and annual $100 coupon
payments beginning at t = 1 and continuing through
t = 10, the price of the bond can be found by solving
for the PV of these cash flows.

INPUTS 10 10 100 1000

N I/YR PV PMT FV
OUTPUT -1000

3-99
 The same company also has 10-year
bonds outstanding with the same risk but
a 13% annual coupon rate
 This bond has an annual coupon payment of $130.
Since the risk is the same the bond has the same
yield to maturity as the previous bond (10%). In this
case the bond sells at a premium because the
coupon rate exceeds the yield to maturity.

INPUTS 10 10 130 1000

N I/YR PV PMT FV
OUTPUT -1184.34

3-100
 The same company also has 10-year
bonds outstanding with the same risk but
a 7% annual coupon rate
 This bond has an annual coupon payment of $70.
Since the risk is the same the bond has the same
yield to maturity as the previous bonds (10%). In
this case, the bond sells at a discount because the
coupon rate is less than the yield to maturity.

INPUTS 10 10 70 1000
N I/YR PV PMT FV
OUTPUT -815.66

3-101