Chap.

Bond, Equity and Firm

Valuation
5.1 Definition of a Bond
• A bond is a legally binding agreement between a
borrower and a lender that specifies the:

• Par (face) value

• Coupon rate

• Coupon payment

• Maturity Date

• The yield to maturity is the required market interest

rate on the bond.
5.2 How to Value Bonds
• Primary Principle:

• Value of financial securities = PV of expected

future cash flows

• Bond value is, therefore, determined by the present

value of the coupon payments and par value.

• Interest rates are inversely related to present (i.e.,

bond) values.
 The Bond Pricing
Equation
2 3
1
6 1
(1 + R)T 7 F
Bond value = C 6
4
7+
5 (1 + R)T
R
 Pure Discount 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

 Pure Discount Bonds
€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
Pure Discount Bond:
Example
Suppose that the interest rate is 10 percent. What is
the value of a bond with face value of €1 million that
matures in 20 years?

€0 €0 €0 €1 million
…
0 1 2 19 20
F 1 million
PV = = = 148, 644
(1 + R)T 1.120
 Level Coupon Bonds

• Make periodic coupon payments in addition to the

maturity value

• The payments are equal each period.

• Therefore, the bond is just a combination of an

annuity and a terminal (maturity) value.

• Coupon payments are typically semiannual.

Level Coupon Bond: Example
• Consider the EIB bond from Figure 5.1 that was issued on
October, 2011. The coupon is 2.5 percent and the face value
is €1,000.

• The coupon of €25 is paid annually in October.

• The face value is paid out in October 2018, seven years

from the issue date.

• If the stated annual interest rate in the market is 2.53

percent per year, what is the present value of the bond?
 25 25 25 25
PV = + + + +
(1.0253) (1.0253)2 (1.0253)3 (1.0253)4
25 25 25 1000
+ + + +
(1.0253)5 (1.0253)6 (1.0253)7 (1.0253)7
7 1000
= 25 ⇥ A0.0253 + = 998.29
(1.0253)7
 Consols
• Not all bonds have a final maturity.

• British consols pay a set amount (i.e., coupon) every

period forever.

• These are examples of a perpetuity.

C
PV =
R
 5.3 Bond Concepts

• Interest Rates and Bond Prices

• Yield to Maturity
 Example 5.2: Bond
Valuation
• A Two Year Bond with a 10% Annual
Coupon. r = 10%, 12%, 8%
10 10 + 100
PV = + = 100
1.1 1.12
10 10 + 100
PV = + = 96.62
1.12 1.122
10 10 + 100
PV = + 2
= 103.567
1.08 1.08
 Yield to Maturity
10 10 + 100
103.567 = +
1+y (1 + y)2

• y is the Yield to Maturity

• What is the Yield to Maturity? (Use trial
and error)

• Yield to Maturity is 8 percent

 YTM and Bond Value
When the YTM < coupon, the bond trades at a
1300
premium.

1200
Bond Value

1100
When the YTM = coupon, the bond trades
at par.

1000

800

6 3/8 Discount Rate

When the YTM > coupon, the bond trades at a discount.

5.4 The Present Value of
Equity
• The value of any asset is the present value
of its expected future cash flows.
• Stock ownership produces cash flows from:
• Dividends
• Capital Gains
5.4 The Present Value of
Equity
• Valuation of Different Types of Stocks
• Zero Growth
• Constant Growth
• Differential Growth
 Case 1: Zero Growth
• Assume that dividends will remain at the same
level forever
Div1 = Div2 = Div3 = ...

• Since future cash flows are constant, the value of a

zero growth stock is the present value of a
perpetuity:
Div1 Div2 Div3
P0 = + + + ...
(1 + R)1 (1 + R)2 (1 + R)3
Div1
P0 =
R
 Case 2: Constant
Growth
• Assume that dividends will grow at a
constant rate, g, forever, i.e.,

Div1 = Div0 (1 + g)
2
Div2 = Div1 (1 + g) = Div0 (1 + g)
3
Div3 = Div2 (1 + g) = Div0 (1 + g)
 Case 2: Constant
Growth
• 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:

Div1
P0 =
R g
 Example
• Suppose an investor is considering the purchase
of a share of the Avila Mining Company. The
equity will pay a €3 dividend a year from today.
This dividend is expected to grow at 10 percent
per year (g = 10%) for the foreseeable future. The
investor thinks that the required return (R) on
this equity is 15 percent, given her assessment of
Avila Mining’s risk.

• What is the share price of Avila Mining Company?

3
P0 = = 60
0.15 0.1
Case 3: Differential Growth

• Consider the equity of Mint Drug Company, which has

a new massage ointment and is enjoying rapid growth.
The dividend per share a year from today will be
€1.15. During the following five years the dividend will
grow at 15 percent per year (g1 = 15%). After that,
growth (g2) will equal 10 percent per year.

• Can you calculate the present value of the equity if the

required return (R) is 15 percent?
Case 3: Differential Growth

Step 1
Calculate the present value of the dividends
growing at 15 percent per annum

Step 2
Calculate the present value of the dividends that
begin at the end of year 6
 Step 1
€1.15 €1.15(1.15) €1.15(1.15)3 €1.15(1.15)4
…
0 1 2 4 5

2
1.15 1.15(1.15) 1.15(1.15 )
+ 2
+ 3
+
1.15 1.15 1.15
1.15(1.153 ) 1.15(1.154 )
+ 4
+ 5
=5
1.15 1.15
 Step 2
Div5(1.10)1 Div5(1.10)2 Div5(1.10)3
… …
0 5 6 7 8

Div5 = 1.15(1.15)4 = 1.155

1.155 (1.1)
P5 = = 44.25
0.15 0.1
P5 44.25
P0 = = = 22
1.155 1.155
 Step 3

Value of equity = 5 + 22 = 27
 5.5 Estimates of
Parameters

The value of a firm depends upon its growth

rate, g, and its discount rate, R.
 Where does g come
from?
Earnings Earnings Retained Return on
next = this + earnings × retained
year year this year 
earnings 

Increase in earnings

Earnings next year Earnings this year æ Re tained earnings this year ö
= +ç ÷ø
Earnings this year Earnings this year è Earnings this year
× Return on retained earnings

1 + g = 1 + (Retention ratio Return on retained earnings)

g = Retention ratio × Return on retained earnings

 Where does R come
from?
• The discount rate can be broken into two
parts.
• The dividend yield
• The growth rate (in dividends)
• In practice, there is a great deal of
estimation error involved in estimating R.
Using the DGM to Find R

• Start with the DGM:

D0 (1 + g) D1
P0 = =
R g R g
D0 (1 + g) D1
R= +g = +g
P0 P0
5.6 Growth Opportunities
• Growth opportunities are opportunities to
invest in positive NPV projects.
• The value of a firm can be conceptualised
as the sum of the value of a firm that pays
out 100% of its earnings as dividends and
the net present value of the growth
opportunities.
EP S
P = + N P V GO
R
 Example
• Sarro Shipping plc expects to earn £1 million per year in
perpetuity if it undertakes no new investment opportunities.
There are 100,000 shares of equity outstanding, so earnings
per share equal £10 (= £1,000,000/100,000).

• The firm will have an opportunity at date 1 to spend

£1,000,000 on a new marketing campaign. The new campaign
will increase earnings in every subsequent period by
£210,000 (or £2.10 per share). This is a 21 percent return
per year on the project. The firm’s discount rate is 10
percent.

• What is the share price before and after deciding to accept

the marketing campaign?
 Example
• Share Price of Sarro When Firm Acts as a Cash Cow:
EP S 10
= = 100
R 0.1

• Value of Marketing Campaign at Date 1:

210, 000
1, 000, 000 + = 1, 100, 000
0.1
• Value of Marketing Campaign at Date 0:
1, 100, 000
= 1, 000, 000
1.1
• NPVGO per share is £10 (= £1,000,000/100,000).

• The share price is EPS/R + NPVGO = £100 + 10 = £110

 5.7 The Dividend Growth
Model and the NPVGO Model
• We have two ways to value a stock:
• The dividend discount model
• The sum of its price as a “cash cow” plus
the per share value of its growth
opportunities
• They are equivalent
 Example

• Suppose Manama Books has EPS of €10 at

the end of the first year, a dividend payout
ratio of 40 percent, a discount rate of 16
percent, and a return on its retained
earnings of 20 percent.
• What is the value of the firm?
The Dividend Growth
Model
• The dividends at date 1 are 0.40 x €10 =
€4 per share.
• The retention ratio is 0.60 (1 - 0.40),
• This implies a growth rate in dividends of
0.12 (= .60 × .20).
• The price today is:
Div1 4
= = 100
R g 0.16 0.12
 The NPVGO Model
Step 1
Calculate NPV of all Growth Opportunities

Step 2
Calculate Share Price if Firm acts like a Cash
Cow

Step 3
Value of Firm is the sum of values from Steps 1
and 2
 Step 1
• Value per share of a single growth
opportunity: Out of the earnings per
share of €10 at date 1, the firm retains €6
(= 0.6 x €10) at that date.
• The firm earns €1.20 (= €6 X 0.20) per
year in perpetuity on that €6 investment.
• Per-Share NPV Generated from Investment
of Date 1:
1.20
6+ = 1.5
0.16
 Step 1

• Value per share of all opportunities: As

pointed out earlier, the growth rate of
earnings and dividends is 12 percent.
• This means that the stream of investments
leads to a growing perpetuity.
• The present value of this perpetuity is:
1.5
N P GO = = 37.5
0.16 0.12
 Step 2

• Value per share if the firm is a

cash cow
• We now assume that the firm pays out all
of its earnings as dividends. The dividends
would be €10 per year in this case.
• The Value per share is:
Div 10
= = 62.5
R 0.16
 Step 3
Share price is the value of a cash cow plus the
value of the growth opportunities. This is:

100 = 62.5 + 37.5

Same result as Dividend Growth

Model