FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

MODULE 2B –
VALUATION OF
BONDS AND SHARES
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Learning Outcomes

• Be able to describe types and features of bonds

• Able to calculate the cash flows from bonds
• Determine the Present Value of Bonds
• Understand the term structure of interest rates and
the determinants of bond yields 2
• Able to determine cash flows from stocks or shares
• Determine the Present Value of Shares using a
variety of models e.g. Dividend Valuation Models
• Determine Present Value of Preference shares
• Understand how growth opportunities affect stock
values
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

What to cover on Bonds

• Bonds and Bond Valuation
• Government and Corporate Bonds
• Bond Markets
• Inflation and Interest Rates
• Determinants of Bond Yields 3
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Characteristics of Bonds

A bond is a legally binding agreement (contract) between a

borrower and a lender that specifies the:
• Par (face and maturity) value
• Coupon rate 4

• Coupon payment
• Maturity Date
• The yield to maturity (YTM) is the required market
interest rate (return/yield) on the bond.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Bond Valuation
• Value of financial securities = PV of all expected
future cash flows
• Present value of bond = present value of coupon
payments and the par value (maturity value).
• Interest rates are inversely related to present value 5

of bonds.

• If there is an increase in interest rates bond investors

will demand higher yields

• If there is a decrease in interest rates bond investors

will demand lower yields
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

The Bond-Pricing Equation

PV of coupons PV of Face Value

C  1  F
Bond Value  1 - 
 (1  r) T  (1  r) T
6

r  
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Example – Present Value of a Bond

Consider a U.S. government bond with as 6.375%
coupon that expires on 31 December 2013.
The Par Value of the bond is $1,000.
Coupon payments are made semiannually (June 30
and December 31 for this particular bond).
Since the coupon rate is 6.375%, the payment is
$31.875. 7

On January 1, 2009 the size and timing of cash flows

are:
$31.875 $31.875 $31.875 $1,031.875

1 / 1 / 09 6 / 30 / 09 12 / 31 / 09 6 / 30 / 13 12 / 31 / 13
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Example continued

On January 1, 2009, the required yield is 5%.

The current value is:

$31.875 1 $1,000
𝑃𝑉 = 1− 10
+ 10
= $1,060.17
Τ
0.05 2 (1.025) (1.025) 8
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Bond Value (Price) & Market Interest Rates

Now assume that the required yield is 6.375%.

How does this change the bond’s price?

$31.875  1  $1,000
PV  1  10 
 10
 $1,000
0.06375 2  (1.031875)  (1.031875)
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Bond prices and market interest rates

• Bond prices and market interest rates

move in opposite directions.
• When coupon rate = YTM,
price = par value 10

• When coupon rate > YTM,

price > par value (premium bond)

• When coupon rate < YTM,

price < par value (discount bond)
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Interest Rate Risk

Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
Low coupon rate bonds have more price risk than high coupon
rate bonds.
11
Reinvestment Rate Risk
• Uncertainty concerning rates at which cash flows can be
reinvested
• Short-term bonds have more reinvestment rate risk than
long-term bonds.
• High coupon rate bonds have more reinvestment rate risk
than low coupon rate bonds.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Yield To Maturity (YTM) with Annual Coupons

Consider a bond with a 10% annual coupon rate, 15 years

to maturity, and a par value of $1,000. The current price is
$928.09. Will the yield be more or less than 10%?
12
Since the bond price is less than par value, the YTM will be
more than 10%.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Zero Coupon Bonds

• Make no periodic interest payments (coupon rate = 0%)

The entire yield to maturity comes from the difference between the
purchase price and the par value

• Cannot sell for more than par value 13

• Sometimes called zeroes, deep discount bonds

Treasury Bills are a good example
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Pure Discount Bonds

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - today’s date
Face value (F)
Discount rate (r) 14

$0 $0 $0 $F

0 1 2 T 1 T

Present value of a pure discount bond at time 0:

F
PV 
(1  r ) T
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Pure Discount Bonds: Example

Find the value of a 30-year zero-coupon bond

with a $1,000 par value and a YTM of 12%.

PV = ?-33.38 FV = 1,000
15

0 1
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Bond Markets

• Primarily over-the-counter transactions with dealers

connected electronically

• Extremely large number of bond issues, but generally 16

low daily volume in single issues
Makes getting up-to-date prices difficult, particularly on a small company or
municipal issues. Treasury securities are an exception
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Government and Corporate Bonds

(US definition)

Treasury Securities
• Federal government debt
• T-bills – pure discount bonds with original maturity less than one year
• T-notes – coupon debt with original maturity between one and ten years
• T-bonds – coupon debt with original maturity greater than ten years
17

Municipal Securities
• Debt of state and local governments
• Varying degrees of default risk, rated similar to corporate debt
• Interest received is tax-exempt at the federal level
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Corporate Bonds

• Greater default risk relative to government bonds

• The promised yield (YTM) may be higher than the

18
expected return due to this added default risk
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Inflation and Interest Rates

Real rate of interest – measures change in purchasing power

Nominal rate of interest – quoted rate of interest,

(factors changes in purchasing power and inflation)
19
Nominal rate of interest includes our desired real rate of return
plus an adjustment for expected inflation, i.e.
(1 + R) = (1 + r)(1 + h),
Where R = nominal rate, r = real rate, h = expected inflation rate

Approximation: R = r + h
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

The Fisher Effect: Example

If we require a 10% real return and we expect inflation to be

8%, what is the nominal rate?
R = (1.1)(1.08) – 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18% 20

Because the real return and expected inflation are relatively

high, there is a significant difference between the actual
Fisher Effect and the approximation.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Determinants of Bond Yields

Term structure is the relationship between time to

maturity and yields, all else equal.
• It is important to recognize that we pull out the effect
of default risk, different coupons, etc.
21

• Yield curve – graphical representation of the term

structure of interest rates
• Normal – upward-sloping, long-term yields are higher
than short-term yields
• Inverted – downward-sloping, long-term yields are
lower than short-term yields
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Factors Affecting Required Return

• Default risk premium – remember bond ratings

• Taxability premium – remember municipal

versus taxable
22

• Liquidity premium – bonds that have more

frequent trading will generally have lower
required returns (remember bid-
ask spreads)

• Anything else that affects the risk of the cash flows

to the bondholders will affect the required returns.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Shares (Stocks)

• The Present Value of Shares (Common Stocks)

• Estimates of Parameters in the Dividend Discount

Model
23
• Growth Opportunities

• Price-Earnings Ratio

• The Stock Markets

FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

The PV of Shares (Stocks)

The value of any asset is the present value of its

expected future cash flows.
Stock or Share ownership produces cash flows from:
Dividends = Total Yield
Capital Gains
24

Valuation of Different Types of Stocks

• Zero Growth in Dividends
• Constant Growth in Dividends
• Differential Growth in Dividends
(Dividend Valuation Models consider value of shares to be equal to
the PV of all future dividends)
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Case 1: Zero Growth in Dividends

Assume that dividends will remain at the same level

forever
Div  Div  Div
Since future cash 1flows are2 constant,
 
3 the value of a
zero growth stock is the present value of a
perpetuity: 25

Div1 Div 2 Div 3

P0     
(1  R) (1  R) (1  R)
1 2 3

Div
P0 
R
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Case 2: Constant Growth in Dividends

Assume that dividends will grow at a constant rate, g, forever, i.e.,

Div𝟏 = Div𝟎 (𝟏 + 𝒈)
Div 2  Div1 (1  .g )  Div 0 (1  g ) 2
26
..
Div 3  Div 2 (1  g )  Div 0 (1  g ) 3

Since future cash flows grow at a constant rate forever, the value
of a constant growth stock is the present value of a growing
perpetuity:
Div 1
P0 
Rg
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Constant Growth Example

Suppose Big D, Inc., just paid a dividend of $0.50.
It is expected to increase its dividend by 2% per year.

If the market requires a return of 15% on assets of this risk

level, how much should the stock be selling for? 27

Div1
P0 
Rg
P0 = 0.50(1+0.02)/(0.15 - 0.02) = $3.92
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Case 3: Differential Growth

Assume that dividends will grow at different rates in the
foreseeable future and then will grow at a constant rate thereafter.

• To value a Differential Growth Stock, we need to:

• Estimate future dividends in the foreseeable future. 28

• Estimate the future stock price when the stock becomes a

Constant Growth Stock (case 2).
• Compute the total present value of the estimated future
dividends and future stock price at the appropriate discount
rate.
 A Differential Growth Example
A common stock just paid a dividend of $2. The dividend is
expected to grow at 8% for 3 years, then it will grow at 4% in
perpetuity.

0
Rs = 12%
1 2 3 4 ...
g = 8% g = 8% g = 8% g = 4%
29

D0 = 2.00 2.16 2.3328 2.5194 2.62

What is the stock worth? The discount rate is 12%.

 Step by step approach
D4 is D1 in the
constant growth phase
0 1 2 3 4
Rs = 12%
...
g = 8% g = 8% g = 8% g = 4%
D0 = 2.00 2.16 2.3328
30
2.5194 2.62

1.929
1.86
1.793
$ 2.62
.
23.31 P3   $32.75
0 .12  0 .04
28.89 = P0
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Estimates of Parameters

The value of a firm depends upon its growth rate, g, and

its discount rate, R.

Where does g come from? 31

g = Retention ratio × Return on equity (ROE)

FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Where Does R Come From?

• The discount rate can be broken into two parts.

• The dividend yield

32

• The growth rate (in dividends)

• In practice, there is a great deal of estimation error involved
in estimating R.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Using the DGM to Find R

Start with the DGM:

D 0 (1  g) D1
P0  
R -g R -g
33

Rearrange and solve for R:

D 0 (1  g) D1
R g  g
P0 P0
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Growth Opportunities

• Growth opportunities are opportunities to invest in positive

NPV projects.
• The value of a firm can be conceptualized as the sum of the
value of a firm that pays out 100% of its earnings as 34
dividends plus the net present value of the growth
opportunities.
• P= Value of share
• EPS = Earnings per share NPVGO
• = Net Present Value of Growth Opportunities
EPS
P  NPVGO
R
 NPVGO Model: Example

Consider a firm that has forecasted EPS of $5, a

discount rate of 16%, and is currently priced at $75 per
share.

We can calculate the value of the firm as a cash cow. 35

EPS $5
P0    $31.25
R 0.16
So, NPVGO must be: $75 - $31.25 = $43.75

FINA6000 MODULE 2B – VALUATION OF BONDS AND

SHARES
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Retention Rate and Firm Value

An increase in the retention rate will:

• Reduce the dividend paid to shareholders
• Increase the firm’s growth rate
36

These have offsetting influences on stock price

Which one dominates?
• If ROE>R, then increased retention increases firm value since
reinvested capital earns more than the cost of capital.
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Price-Earnings (P/E) Ratio

• Many analysts frequently relate earnings per share

to price.

• The price-earnings ratio is calculated as the

current stock price divided by annual EPS. 37

• The Wall Street Journal uses last 4 quarter’s

earnings

Price per share

P/E ratio 
EPS
 PE and NPVGO
Recall,
EPS
P  NPVGO
R
Dividing every term by EPS provides the following 38

description of the PE ratio:

1 NPVGO
PE  
R EPS
So, a firm’s PE ratio is positively related to growth
opportunities and negatively related to risk (R)
FINA6000 MODULE 2B – VALUATION OF BONDS AND SHARES

Valuation of Preference shares

Preference dividend is considered a perpetuity

39
XYZ preference shares pay a $4.12 dividend
per year. If our required rate of return on XYZ
preference shares is 9.5%, what would we
consider a fair price for these shares?

Value P0 = ($4.12/0.095) = $43.37