Valuation of

Bonds and Shares

by Uditha Jayasinghe
Contents
• Financial Assets
• Bonds and Bond Valuation
• Different Types of Bonds
• Stock Valuation
• Estimating Cost of Equity
• Capital Asset Pricing Model (CAPM)
• References

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Financial Assets

• Financial asset is any asset that is:

– Cash;
– an equity instrument of another entity;
– a contractual right or
– a contract that will or may be settled in the entity's own equity instruments.
[definition as per International Accounting Standard (IAS) 32 – Financial Instruments:
Presentations]

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Bonds and Bond Valuation

• What is a bond?
– When a corporation or government wishes to borrow money from the public on a
long-term basis, it usually does so by issuing or selling debt securities that are
generically called bonds.
– Long-term debt (bonds), usually in the form of loan notes that are backed up by
collaterals or physical assets, is frequently used as a source of long-term finance as
an alternative to equity.
A bond is a written acknowledgment of a debt by a
company, normally containing provisions as to payment of
interest and the terms of repayment of principal.

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Bonds and Bond Valuation

▪ Features:
Coupon rate of 5.5%
(The stated interest payment made
on a bond)

Nominal bond price £100

(Face value. The principal amount of
a bond that is repaid at the end of
the term. Also called par value)

Redemption at the
company’s discretion
(Maturity. The specified date on
which the principal amount of a
bond is paid
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Bonds and Bond Valuation

• Bond valuation
– As time passes, interest rates change in the marketplace.
– The cash flows from a bond, however, stay the same. i.e. fixed interest
– When interest rates rise, the present value of the bond’s remaining cash flows
declines, and the bond is worth less.
– When interest rates fall, the bond is worth more.
– This interest rate required in the market on a bond is called the bond’s yield to
maturity (YTM) .

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Bonds and Bond Valuation

• Bond valuation – Example: (P5.1)

AA Co. were to issue a $1,000 par value bond with 10 years to maturity. The AA bond
has an annual coupon of $80. Similar bonds have a yield to maturity of 8%. The AA
bond will pay $80 per year for the next 10 years in coupon interest. In 10 years, AA will
pay $1,000 to the owner of the bond. The cash flows from the bond are shown below.
What would this bond sell for?

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Bonds and Bond Valuation

• Bond valuation formula:

Bond value = PV of the coupons + PV of the face value

Bond value = C*[1 - 1/(1+r)^t]/r + F/(1 + r)^t
Where C = coupon
F = face value
t = maturity period
r = yield per period

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Different Types of Bonds

• Government bonds
– When the government wishes to borrow money for more than one year, it sells
what are known as Treasury notes and bonds to the public.
• Zero coupon bonds
– A bond that makes no coupon payments and is thus initially priced at a deep
discount.
• Floating rate bonds
– With floating-rate bonds, coupon payments are adjustable. The adjustments are
tied to an interest rate index such as the Treasury bill interest rate or the 30-year
Treasury bond rate.

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Stock Valuation

• The INTRINSIC VALUE of a stock depends on the dividend and earnings that can be
expected from the firm.

• The intrinsic value is defined as the present value of all cash payments to the investor in
the stock, including dividends as well as the proceeds from the ultimate sale of the
stock, discounted at the appropriate risk-adjusted interest rate.

• If Intrinsic value > Market value, buy that share. Vice versa

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Stock Valuation

• Single period valuation

V0 = E(D1) + E(P1)
1+r

Question: (P5.1)
ABC stock has an expected dividend per share E(D1), of $4 and the expected price at the
end of a year E(P1) is $52. if the required rate of return (k) is 12%, how much would be the
intrinsic value at the end of year 1?

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Stock Valuation

• Multiple period valuation

– E.g. 2 years V0 = D1 + D2 + P2
1+r (1+r)^2

– E.g. n years V0 = D1 + D2 + ……… + Dn + Pn

1+r (1+r)^2 (1 + r)^n
Question: (P5.2)
If an investor expects to get $3.50, $4.00 and $4.50 as dividends from a share during the
next three years and hopes to sell off the share at $75.00 at the end of the third year, and if
his required rate of return is 25%, what is the value of his share today?

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Stock Valuation

• Dividend Discount Model

In perpetuity
V0 = D1 + D2 + D3 + …….
1+r (1+r)^2 (1+r)^3
Above equation states that the stock price should equal the present value of all expected future
dividends into perpetuity. This formula is called the Dividend Discount Model of stock prices.

If the dividend growth is constant in perpetuity; (also known as Dividend Growth Model)
V0 = D0 (1+g) . or V0 = D1 .
(r – g) (r – g)
Where: g is the growth rate
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Stock Valuation

Question: (P5.3)
If dividend growth is 5%, and the most recently paid dividend was (D0) $3.81 and the
market capitalization rate for is 12%. What would be the intrinsic value of a stock?

Question: (P5.4)
Preferred stock that pays a fixed dividend can be valued using the constant-growth
dividend discount model. The constant-growth rate of dividends is simply zero. Value a
preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%.

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Estimating Cost of Equity

Calculating the cost of equity (re) using the dividend growth model:

How much a shareholder is prepared to pay for a share today (P0)? The answer should be
based on the return they are expecting;

re = D0(1+g) + g
P0

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Estimating Cost of Equity

Question: (P5.5)
Alpha Co has just paid a dividend of 10c. Shareholders expect dividends to grow at 7% pa.
Alpha Co.'s current share price is $2.05.
Calculate the cost of equity of Alpha Co. using dividend growth model.

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Capital Asset Pricing Model (CAPM)

• The purpose of CAPM

– It provides a benchmark rate of return for evaluating possible investment.
– CAMP model is based on portfolio theory and it assumes that investors diversify
their investments to reduce their exposure to risk.
– Diversification means that many assets are held in the portfolio so that the
exposure to any particular asset is limited.

Additional reading:
https://bpscl.co.uk/investments-do-not-put-eggs-one-basket/
https://www.youtube.com/watch?v=9MZxkgRjcDk
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Capital Asset Pricing Model (CAPM)

Required Return = Risk-free Return + Risk premium

E(Ri) = E(RF) + βi[E(RM) − E(RF)]

Where:
E(Ri) = Expected Return on a Security i
E(RF) = Risk Free Rate
βi = Beta of the Security i
E(RM) = Expected Return on Market
E(RM)−E(RF) = Market Risk Premium
(Beta expresses the relationship between the investment risk and the market risk)

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Capital Asset Pricing Model (CAPM)

Question: (P5.6)
Suppose that the equity holders have invested $100 million in the firm and that the beta of
the equity is 0.6. If the T-bill rate is 6% and the market risk premium is 8%., what would be
the expected rate of return and the amount?

Question: (P5.7)
The current average market return being paid on risky investments is 12%, compared with
5% on Treasury bills. G Co has a beta of 1.2.
What is the required return of an equity investor in G Co?

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References
• Bodie, Z., Kane, A. & Marcus, A. J., 2014. Investments. 10th ed. New York: McGraw-Hill
Education.

• Reilly, F. K. & Brown, K. C., 2012. Investment Analysis & Portfolio Management. 10th ed.
Mason, OH: South-Western, Cengage Learning.

• Ross, S. A., Westerfield, R. W. & Jordan, B. D., 2010. Fundamentals of Corporate Finance.
9th ed. New York, NY, 10020: McGraw-Hill/Irwin.

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 Thank You

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