Finance and Banking Lesson 4

Valuation of financial assets – Bonds and Shares

Bonds
Bills/Commercial Paper – Debt  Short-term (< 1 year)
Bonds – Debt  Long-term debt (> 1 year)
Issuers (Sellers/Borrowers) of Bonds:
Government/Treasury, Government Agencies, Corporations.

Valuation (Price) = maximum/fair to pay for the asset

Compare with the market price
Example: Purchase apartment
Valuation Price Market Price
$950,000 < $6,000,000  over-priced
 Don’t buy
$900,000 > $120,000  under-priced
 Buy

How to do valuation?
Valuation Price = PV (of all future cash flows received)
Bond Valuation
Loan = $9,000

$1,000 (Bond)

Features:
Loan Bond
Principal Face/Par Value
Interest rate Coupon rate
Interest ($) Coupon ($)
= Interest rate x Principal =Coupon rate x Face Value
Period Maturity

Example:
Face Value (FV) = $1,000
Coupon rate = 10%
Coupon $ (C) = 0.1 x 1,000 = $100
Maturity = 3 years
Example:
Face Value (FV) = $1,000
Coupon rate = 10%
Coupon $ (C) = 0.1 x 1,000 = $100
Maturity (n) = 3 years

|-----------------|-------------------|-----------------|
0 1 2 3
$100 $100 $100+$1,000
C C C + FV
Annuity Single
Price = PVA(coupons) + PV(face value)
P = PMT/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n
P = C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n
= 100/i [ 1 – 1/(1+i)^3 ] + 1000/(1+i)^3
i = required rate of return
 (a) Marigold Merchants has an outstanding issue of $1,000 par value bonds with an 8%
coupon interest rate. The issue pays interest annually and has 15 years remaining to
its maturity date. Bonds of similar risk are currently yielding a 10% rate of return. What
is the value of these Marigold Merchants bonds?

C = Coupon ($) = coupon rate x face value = 0.08 x 1,000 = $80

n = term to maturity (remaining years left) = 15

FV = Face value = $1,000

i = market interest rate/required rate of return = 0.1

P = C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n

= 80/0.1 [ 1 – 1/(1+0.1)^15 ] + 1000/(1+0.1)^15

= 80/0.1 x (0.7606) + 239.3948

= $847.87

Maturity = remaining years of the bond not original maturity

 term to maturity
|-----------------|-------------------|-----------------|
0 1 2 3
C1 C2 C3 + FV
Vincent Vincent sells
Buys
n=3 Daryl buys
n=2
Two years ago bonds were issued with 10 years until maturity, selling at par, and a 7%
coupon. If interest rates for that grade of bond are currently 8.25%, what will be the market
price of these bonds? FV = $1,000

Price = 70
[
1
−
1
+
1000
]
.0825 . 0825(1.0825) (1. 0825) 8
8

Price = $928.84

Coupons can be paid annually or semi-annually.

P = C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n
If semi-annual  i/2, n x2, C/2
Marigold Merchants also has an outstanding issue of $1,000 par value bonds with a 12% interest
rate. The issue pays interest semi-annually and has 10 years remaining to maturity. Bonds of
similar risk are currently selling to yield a 10% rate of return. What is the value of these
Marigold Merchants bonds?

C = Coupon ($) = coupon rate x face value = 0.12 x 1,000 = $120

n = term to maturity (remaining years left) = 10

FV = Face value = $1,000

i = market interest rate/required rate of return = 0.1

C = C/2 = 120/2 = $60

n = n x 2 = 10 x 2 = 20

i = i/2 = 0.1/2 = 0.05

P = C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n

= 60/0.05 [ 1 – 1/(1+0.05)^20 ] + 1,000/(1+0.05)^20

= $1,124.60
Price > Face Value  Premium
Price < Face Value  Discount

Price ($)

Valuation

Rate of return (%)

P = C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n

C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n - P = 0

Market Price
Solve for i  return generated by the bond investment when
you hold till maturity  Yield to Maturity (YTM)

|-----------------|-------------------|-----------------|
0 1 2 3
($950) $100 $100 $100+$1,000
C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n - P = 0
100/i [ 1 – 1/(1+i)^3 ] + 1000/(1+i)^3 - 950 = 0
Solve for i  Financial Calculator and Excel
Approximation for YTM:
i = C + [ (Par – Price) / n ]
[Par + Price] / 2

= 100 + [ (1000 – 950) / 3 ]

[ 1000 + 950 ] / 2
= 11.97%
RG Coffee House issued a $1,000 par value bond that pays a
9 percent interest annually. The bond matures in 14 years and
is currently selling at $1,120. Your required rate of return is
8.5 percent.
a. Compute the bond’s expected rate of return.
b. Determine the value of the bond to you, given your
required rate of return.
c. Should you purchase the bond?

a. YTM = 7.58%
b. P = $1,040.05
P = C/i [ 1 – 1/(1+i)^n ] + FV/(1+i)^n
= 90/0.085 [ 1 – 1/(1+0.085)^14 ] + 1000/(1+0.085)^14
c. From (a), Required rate of return > Return from bond
8.5 % 7.58%
 Don’t buy
From (b), Market Price > Valuation price
$1,120 $1,040.05
 Over-priced  Don’t buy
Bond Price Relationships
Factors that impact Bond prices/cause bond prices to change

Bond Coupon Maturity 3% 5% 7%

U 0 5 86.26 78.35 71.30
V 0 15 64.19 48.10 36.24
W 5 5 109.16 100 91.80
X 5 15 123.88 100 81.78
Y 8 5 122.90 112.99 104.10
Z 8 15 159.69 131.14 109.11

 Bond price and YTM are inversely related.

[Take any bond and see how P changes with YTM.]
When YTM   P decrease .
When YTM   P increase .
 Relationships between C, YTM and F:
If YTM < C  P > F (Premium)
If YTM = C  P = F (Par)  1st day/Issue day
If YTM > C  P < F (Discount)

Longer maturity
Bond price volatility increase
Lower coupon rate
 Type of Bonds

Coupon Bonds Zero-Coupon Perpetual

Zero-Coupon/Discount Bond
|-----------------|-------------------|-----------------|
0 1 2 3
(900) $1000
P = FV/(1+i)^n

Perpetual Bond
|-----------------|-------------------|-----------------|… forever
0 1 2 3
C C C
P = C/i
 Shares (No maturity)

Ordinary/Common Preferred
No fixed dividend Fixed dividend
Voting rights No voting rights

Residual Claim - Order of Priority

Government
Bank loans
Bond investors
Preferred
Ordinary

Valuation of shares – Common shares

Dividend = D (Annual)
|-----------------|-------------------|-----------------|
0 1 2 3
D1 D2 D3+P3
P = D1/(1+i)^1 + D2/(1+i)^2 + (D3+P3)/(1+i)^3
i = ke  required rate of return
Assume hold the shares to forever, continue to receive
dividends to forever.
|-----------------|-------------------|-----------------|… forever
0 1 2 3
D0 D1 D2 D3

Assumption on dividends:
(1) Dividends grow at a constant rate of g% every year to
forever.
D1 = D0(1+g)
D2 = D1(1+g)
D3 = D2(1+g) …
P = D1/(1+ke)^1 + D2/(1+ke)^2 + D3/(1+ke)^3 + ….
Gordon’s Constant Dividend growth model
P = D1/(ke – g) OR P = D0(1+g)/(ke – g)
If D1 is given If D0 is given
1-years’ time, next year just paid, current dividend

(2) Dividends are constant  D0 = D1 = D2 …

(Preferred shares)
P = D/ke
Constant Dividend Growth Model
P = D1/(ke – g)
ke = D1/P + g  rate of return %

Market Price

No growth model / Constant Dividend model

P = D/ke
ke = D/P  rate of return %

Market Price
Question 1

What should be the price for a common stock paying $3.50 annually in dividends if the
growth rate is zero and the discount rate is 8%?

Div 3.50
= =$43 .75
Po = r . 08

Question 2

If next year’s dividend is forecast to be $5.00, the constant growth rate is 4%, and the
discount rate is 16%, then the current stock price should be:

$5.00
Po = .16−.04
$5 .00
$41.67 = .12

Question 3

What should be the current price of a share of stock if a $5 dividend was just paid, the stock
has a required return of 20%, and a constant dividend growth rate of 6%?

P = $5(1.06)/(.20 - .06)
P = 5.30/.14
P = $37.86