CHAPTER THREE: BOND AND STOCK VALUATION AND COST OF CAPITAL

Introduction

 Dear students! How do you understand value from the perspective of bond and stock
Valuation? How a bond can be valued?

The valuation of assets is a critical as well as challenging task. In this chapter, we examine the
concepts and procedures for valuing assets, especially financial assets (securities) such as bonds,
preferred stocks, and common stocks.

4.1. Valuation an Overview:-

For our purposes the value of an asset is its intrinsic value, which is the present value of its
expected future cash flows, where these cash flows are discounted back to the present value
using the investor’s required rate of return. Thus, value is a function of three elements.
1. The amount and timing of the assets expected cash flows.
2. The risky ness of these cash flows.
3. The investor’s required rate of return for undertaking the investment.
4.2. Valuation: - The Basic Process
The valuation process can be described as assigning value to an asset (bond, preferred stock, and
common stock) by calculating the present value of its expected future cash flows.
4.3. Bond Valuation
Bond: is a long term promissory note that promises to pay the bond holder a predetermined,
fixed amount of interest each year until maturity. At maturity, the principal will be paid to the
bond holder. In the case of a firm’s insolvency, a bond holder has a priority of claim to the firm’s
assets before the preferred and common stock holders. Also, bondholders must be paid interest
due them before dividends can be distributed to the stockholders. The process of valuing a bond
requires first that we understand the terminologies and institutional characteristics of a bond.

Terminologies
Par Value: - The par value is the stated face value of the bond at the end of the life of the bond,
it is usually set at $ 1000. This amount, defined as the par value or face value, can not be altered
after the bond has been issued. The par value is essentially independent of the intrinsic value of
the bond. Thus, although the price of the bond fluctuates in response to changing economic
conditions, the par value remains constant.
Coupon Interest Rate: - The rate which is generally fixed determines the periodic coupon or
interest payments. It is expressed as a percentage of bonds face value. It also represents the
interest cost of the bond to the issuer.
Coupon Payments: - The coupon payments represent the periodic interest payments from the
bond issuer to the bond holder. The annual coupon payments are calculated by multiplying the
coupon rate by the bond’s face value. Since most bonds pay interest semi -annually, generally
one half of the annual coupon is paid to the bond holders every six-month.
Maturity Date: - The maturity date represents the date on which the bond matures, i.e. the date
on which the face value is repaid. The last coupon payment is also paid on the maturity date.
Call Date: - for bonds which are callable, i.e. bonds which can be redeemed by the issuer prior
to maturity, the call date represents the earliest date at which the bond can be called.
Call Price: - The amount of price the issuer has to pay to call a callable bond (there is a premium
for calling the bond early). When a bond first callable, i.e. on the call date, the call price is often
set to equal the face value plus one year’s interest.
Required Return: the rate of return that investors currently require on a bond
Yield-to-Maturity: the rate of return that an investor could earn if he bought the bond at its
current market price and held it until maturity. Alternatively, it represents the discount rate which
equates the discounted value of bonds future cash flows to its current market rice.
Valuation Procedure:
The value of the bond is the present value of both interest to be received and the par or maturity
value of the bond. This may be expressed as:
N
 It $M
Vb = t  1 (1  Kb)t + (1  kb) N or Vb = (It x Pv 1FA k b,n ) + (Mx PVl Fkb,n)
Where
It = the dollar interest to be received in each payment
M= the par value of the bond
Kb = the required rate of return for the bond holder
N = the number of periods to maturity
The valuation process for a bond requires knowledge of three essential elements.
1. The amount of the cash flows to be received by the investor
2. The maturity date of the loan
3. The investors required rate of return. The amount of cash flow is dictated by the periodic
interest to be received and the par value to be paid at maturity. Given these elements, we can
compute the intrinsic value of the bond.
Example 1. Consider that Habesha cement, on Jan1, 2010 issued a 10% coupon interest rate, 10
year bond with Br 1000 par value that pays interest annually. If the investor requires a 10% rate
of return on this bond. What is the value of the bond to such an investor?
Solution:
I (interest) = M x Kc
= Br 1000* 10%
= Br 100
n
 I M
Vb = t  1 (1  Kb)t + (1  kb) N or I (PVIFA kb,n) + M (PVIF kb,n)
10
 100 1000
= t  1 (1.1)10 + (1.1)10
= (Br 100 * 6.1446) + (Br 1000 X0.38 55)
= Br 1000.

Example 2: Assume that another investor viewed the bond of Habasha cement to be riskier and
thus requires 12% rate of return on this bond. Find the value.
Solution:
n
 I M
Vb = t  1 (1  Kb)t + (1  kb) N or I (PVIFA kb,n ) + M (PVIF kb,n)
10
 100 1000
= t  1 (1.12)10 + (1.12)10 = (Br 100 X 5.650) + 1000 (0.322) = Br 887

Example 3:- Further assume that an investor requires 8% return on this bond. Find its value
Solution: 8
 n
 I M
Vb = t  1 (1  Kb)t + (1  kb) N
10
 100 1000
= t  1 (1.12)10 + (1.1)10 = (100 X 6.710) + (1000 0.463) = Br 1,134

Note: - The bond’s coupon rate is fixed by its nature and the coupon rate and required rate of
return moves in the opposite direction.
Semi-Annual Interest Payments
For bonds that pay interest semi annually, we need to adjust the size of interest payments as the
coupon interest amount is to be paid in two semiannual installments rather than a one time
annual payments. The valuation equation becomes,
I /2
N Kb M
(1  )2t
 2 kb
(1  )2t ( I XPVIFA , )
Vb = t  1 + 2 or Vb= ( 2 Kb / 2 2t +
( MxPVIF ,2t )
kb / 2

Example 4: - Suppose a bond has $ 1000 face value, a 10 percent coupon (paid semiannually),
five years remaining to maturity, and is priced to yield 8 percent. What is its value?
I = MC = $1000 x 10% = 100
I
N 2 M
Kb
 (1  ) at kb 100 / 2 1000
2 (1  )t
Vb = t  1 + 2 or Vb= (1  8% / 2)10 + (1  8% / 2)10
= $ 405 .54 + $ 675. 60 = $1,081.14

1.4. Preferred Stock Valuation

Dear students! Why preferred stock can be called as a hybrid security? What are the main
features of preferred stock? What differentiates common stock from preferred stock and
bond?

Preferred stock is defined as equity with priority over common stock with respect to the payment
of dividends and the distribution of assets in liquidation. Preferred stock is a hybrid security
which shares features with both common stock and debt. Preferred stock is similar to common
stock in that it entitle its owners to receive dividends which the firm must pay out of after – tax
in come.
Moreover, the use of preferred stock as a source of financing does not increase the profitability
of bankruptcy for the firm. However, like the coupon payments on debt, the dividends on
preferred stock are generally fixed. Also, the claims of the preferred stock holders against the
assets of the firm are fixed as are the claims of the debt holders.
Preferred Dividend/Preferred Dividend Rate: The preferred dividend rate is expressed as a
percentage of the par value of the preferred stock. The annual preferred dividend is determined
by multiplying the preferred dividend rate times the par value of the preferred stock. Since the
preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock
with a dividend growth rate equal to zero. Thus, the price of a share of preferred stock can be
determined using the following equation.
Dp
Vp = Kp Where
Vp = the preferred stock price
Dp = the preferred dividend and
Kp = the required return on the stock

Example: - Find the price of a share of preferred stock given that the par value is $100 per share,
the preferred dividend rate is 8% and the required return is 10%.
Dp $8
Solution: - Vp = Kp but Dp = Mx Dr = 100x0.8=$8, Vp = 0.1 = $80

Common Stock Valuation

Like bonds and preferred stocks, a common stock’s value is equal to the present value of all
future cash flows expected to be received by the stock holder. However, in contrast to bonds,
common stock does not promise its owners interest income or a maturity payment at some
specified time in the future. Nor does common stock entitle the holder to a predetermined
constant dividend as does preferred stock. For common stock, the dividend is based on the
profitability of the firm and on managements’ decision to pay dividends or to retain the profits
for reinvestment purposes. As of consequence dividend streams tend to in crease with the growth
in corporate earnings. Thus, the growth of future dividends is a prime distinguishing feature of
common stock. This does not mean that divided will always increase in the future. Let’s develop
common stock valuation process by steps starting with a one – period horizon and progressing to
a multiple period horizon.
1.4.1. One Period Valuation Model

For an investor holding a common stock for only one year, the value of the stock would be the
present value of both the expected cash dividend to be received in one year (D1) and the
expected market price per share of the stock at year end (P1) .If ks represents an investors
required rate of return, the value of common stock (po) would be:
D1 p1
Po = 1  ks + 1  ks

Example: - Assume kuku Company is considering the purchase of stock at the beginning of the
year. The divided at year end is expected to be Br 3 and the market price by the end of the year is
expected to be Br 80. If the investor’s required rate of return is 15 percent. What would be the
value of the stock?

Given:- Required solution

D1 P1 Br 3 Br80
D1= Br 3 Po=? Po= 1  ks + 1  ks = (1 . 15)1 + 1.15
P1= Br 80 Br 3 (0.870) + Br 80 (0.870)
Ks = 15% Br2. 61 + Br 69.6
Br 72.21

Interpretation; - The implication of Br 72.21 is that if the investor buys this stock for Br 72.21
today, receives a Br 3 dividend, and sells the stock for Br 80 one year form now, the investor will
earn the 15% rate of return that was required to invest.
4.5.2. Two Period Valuation Models

Now, suppose the investor plans to hold a stock for two years before selling. How is the value of
the stock determined when the investment horizon changes? The answer is to in corporate the
additional years in formation be.
D1 D2 P2
Po= (1  ks)1 + (1  ks )2 + (1  ks )2
Example 1:-Assume the expected dividend for KUKU Company in the second year be Br 4, the
expected price at the end of the second year be Br100, and the required rate of return remains
15%. Find the value of the common stock.
Value of the Common Stock
Given Required Solution
D1 D2 D2
D1 = Br 3 Po= ? Po = (1  ks) + (1  ks)2 + (1  ks)2
D2 = Br 4
P2= Br 100
4 100
3 
(1  15)2 (1.15) 2
Ks = 15% = (1  15)1 +
3 (0.870) + 4 (0.7561) + 100 (0.7561) = Br
79.38

4.5.3. Multiple Period Valuation Model

Since common stock has no maturity date and is held for many years, a more general, multi
period model is needed. The general formula for common stock valuation model is defined as
follows:

 Dt Pn
Po = t  1 (1  Ks)n + (1  ks )n
D1 D2 Dn Pn
Po = (1  Ks )1 + (1  ks )2 + D3 + …………. + (1  ks )n + (1  ks )n
Example: - Assume that an investor expects Br 3 dividend for each of 10 years and a selling
price of Br 50 at the end of 10 years. What would be the value of the common stock to day?

Given Required Solution

10
 Br 3 Br 50
D1, D 2.......D10  Br 3 Po=? Po = t  1 (1.1)10 + (1.1)10 = 3 (6.15) + Br 50 (0.38)
n  10Years
P  Br 50
10 Br 8.4 5 + Br. 19.30 = Br
37.75
1.5. An Overview of cost of capital
1.5.1Cost of debt
cost of debt when it borrows money by issuing bonds is the interest rate demanded by the bond
investor. When borrowing money from an individual or financial institution, the interest rate on
the loan is the firm’s cost of debt. The cost of debt to the borrower: the firms cost of debt is the
investors required rate of return on debt adjusted for tax and flotation costs.
This is because interest on debt is a tax –deductible expenses; it reduces the firm's taxable
income by the amount of deductible interest. The interest deduction, therefore, reduces taxes by
an amount equal to the product of the deductible interest and the firm’s tax rate. Flotation costs
which are costs incurred in issuing debt securities – increases the cost of debt. Thus, the after tax
cost of debt, kd, is computed as follows:

(1  T ) Where
dk iK
(1  F ) T = Corporate tax rate
F= Flotation cost as a percentage of value of debt
Ki = investor required rate of return before tax
If there is no flotation costs, the Kd can be computed using the formula
kd  ki(1  T )
Example 1:- Assume that MULU Co. is to issue long term notes, investors will pay Br, 1000 per
note when they are issued if the annual interest payment by the firm is Br 100.The firm’s tax
rates is 45%, and flotation costs are 2%.calculate the cost of this debt.
Given Required Solution
ki(1  T )
I = Br 100 Kd = ? kd=  8%(1  45) = 4.4%
M = Br 1000
T = 45%

1.5.2 Cost of Preferred Stock (kp)

The cost of preferred stock (kp) is the rate of return investors require on a company’s new
preferred stock plus the cost of issuing the stock. Therefore, to calculate kp; a firm’s managers
must estimate the rate of return that preferred stock holders would demand and add in the cost of
the stock issue. Because preferred stock investors normally buy preferred stock to obtain the
stream of constant preferred stock dividends associated with the preferred stock issue, their
return on investment can normally be measured by dividing the amount of the firm’s expected
preferred stock dividend by the price of the shares. The cost of issuing the new securities known
as flotation cost includes investment bankers’ fees and commissions, and attorneys' fees. These
costs must be deducted form the preferred stock price paid by investors to obtain the net price
received by the firm. The following equation shows how to estimate the cost of preferred stock.

PD Or
pK  PD
PK pK 
If flotation pP  F cost exists

Where:-
Kp = The cost of the preferred stock issue; the expected return
Dp = The amount of the expected preferred stock dividend
Pp = the current price of the preferred stock
F = the flotation costs per share
Example 1: - Suppose that Midrock Company has preferred stock that pays Br 13 dividend per
share and sells for Br 100 per share in the market. Compute the cost of preferred stock.
DP Br 13
Kp = Pp = Br 100 = 13%

Example 2; - Suppose Ellis industries has issued preferred stock that has been paying annual
dividends of $ 2.50 and is expected to continue to do so indefinitely. The current price of Ellis
preferred stock is $ 22 a share and the flotation cost is $ 2 per share. Compute the cost of the
preferred stock.

Given Required Solution

( DP ) $2.50
DP = $ 2.50 Kp =? Kp = ( Pp  F ) = $22  2
Pp = $ 22 a share = 0.125 or 12.5%
F = $ 2 a share

Note: - There is not tax adjustments in the cost of preferred stock calculation unlike interest
payments on debt, firms may not deduct preferred stock dividends on their tax returns.
The dividends are paid out of after tax profits. Moreover, the cost of preferred stock higher than
the after tax cost of debt, kd because a company’s bond holders and bankers have a prior claim
on the earnings of the firm and its assets in the event of liquidation. Preferred stock holders, as
the result, take a greater risk than bond holders or bankers and demand a correspondingly greater
rate of return.

1.5.3. The Cost of Common Stock (ks) (Cost of Internal Equity)

The cost of common stock equity, ks is the rate at which investors discount the expected
dividends of the firm to determine its share value. Two techniques for measuring the cost of
common stock equity capital are available. One uses the constant growth valuation model
(Gordon growth model); the other uses the capital asset pricing (CAPM).
I. Using the Constant Growth Valuation Model (the Gordon Growth Model)
Using the Gordon growth model, the cost of common stock, Ks is computed as follows:-
D1
Po 
Ks  g
Where Po= Value of common stock
D1 = Dividend to be received in 1 year
Ks = Investors required rate of return
g = rate of growth
Solving the model for ks results in the formula for the cost of common stock
D1 Do(1  g )
Ks  Ks 
Po + g or Po
Example: - Suppose that IBM industries common stock is selling for $ 40 a share. A next year's
common stock dividend is expected to be$4.20 and the dividend is expected to grow at a rate of
5% per year indefinitely. Compute the expected rate of return on IBM’s common stock.
Given Required Solution
D1 $ 420
Ks  g
Po  $40 Ks =? Po + g = 540
D1 = $4.20 0.105 + 0.5 = 0.155 or 15.5%
g = 5%
ii. The Capital Asset Pricing Model (CAPM) Approach to Estimating (ks): a firm may pay
dividends that grow at changing rate; it may pay dividends that grow at changing rate; it may pay
no dividends at all for the managers of the firm may believe that market risk is the relevant risk.
In such cases, the firm may chose to use the capital asset pricing model (CAPM) to calculate the
rate of return that investors require for holding company’s common stock according to the degree
of non-diversifiable risk present in the stock. The CAPM formula for the cost of common stock
is:

Ks = rf = b (rm - rf )

Where:-
Ks = the required rate of return from the company’s common stock equity
B = Beta coefficient which is an index of systematic risk
rf = Risk free rate
rm = Return on the market portfolio
Example:- Suppose BATU industries has a beta of 1.39, the risk free rate as measured by the
rate on short term U.S. Treasury bill is 3% and the expected rate of return on the overall stock
market is 12%. Given those market conditions find the required rate of return for BATU’S
common Stock.
Given Required Solution
B= 1.39 Ks = Ks = rf + b (rm-rf)
rf = 3% = 3% + 1.39 (12%-3%)
rm= 12% = 3% + 1.39 (9%)
0.1551 or 15.5%

1.5.4 The Cost of Equity from new Common Stock ( kn): The cost incurred by a company
when new common stock s is sold at the cost of equity from new common stock (Kn) .Capital
from existing stock holders is internal equity capital, i.e. the firm already has these funds. In
contrast, capital from issuing new stock is external equity capital. The firm is trying to raise new
funds from outside source. New stock some times finance a capital budgeting project the cost of
this capital includes not only stockholders’ expected returns on their investment but also flotation
costs incurred to issue new securities. flotation costs makes the cost of using funds supplied by
new stock holders slightly higher than using retained earnings supplied by the existing
stockholders .
To estimate the cost of using fund supplied by new stockholders, we use a variation of the
dividend growth model that includes flotation costs.

D1
nK 
(  f ) g
op
Kn = the cost of new common stock equity
Po = price of one share of the common stock
D1 = the amount of the common stock dividend expected to be paid in one year
F = the flotation cost per share
g = the expected constant growth rate of the company’s common stock dividends
Example: Assume again that IBM industries anticipated dividend next year is $4.20 a share, its
growth rate is 5% a year and its existing common stock is selling for $40 a share. New shares of
stock can be Sold to the public for the same price but to do so IBM pay its investment bankers
5% of the stock’s selling price or $2 per share . Given these condition s compute IBM’s new
common equity.
Given Required Solution
D1
Kn  g
D1 = $ 4.20 Kn =? ( Po  F )
$4.20 $4.20
  5%  5%  16.05%
Po = $ 40 $40  $2 $38
F= $ 2 , g= 5%
 Activity4. 10
1. When a company issues new securities? How do flotation costs affect the cost of raising that
capital?
______________________________________________________________________________
______________________________________________________________________________
______________
1.5.6 Cost of Retained Earnings (Kr)
The cost of retained earnings, Kr, is closely related to the cost of existing common stock since
the cost of equity obtained by retained earnings is the same as the rate of return investors require
on the firm’s common stock. There fore

Ks = Kr

1.6 The Weighted Average Cost of Capital (WACC)

 Dear students! How does one calculate the weighed average cost of capital?

A firm’s weighted average cost of capital (WACC) is a composite of the individual costs of
financing, weighted by the percentage of financing provided by each source. Therefore, a firm’s
WACC is a function of (1) the individual costs of capital and (2) the makeup of the capital
1structure – the percentage of funds provided by long term debt, preferred stock and common
stock. Thus, the computation of the cost of capital requires three things.
1) Compute the cost of capital for each and every source of financing used by the firm.
2) Determine the weight percentage of each financing in the capital structure of the firm.
3) Calculate the firm’s weighted average cost of capital (WACC) using the values in (1) & (2)
Example: Assume that IBM industries finance its assets through a mixture of capital sources, as
shown on its balance sheet.
Total Br 1.000,000
Long and short term debt Br 400,000
Preferred stock Br 100,000
Common equity Br 500,000
Total liability and equity Br 1,000,000
And the IBM’s cost of capital were, Kd = 6%, Kp = 12.5% and Ks= 15.5% compute the
weighted average cost of capital;
Solution Ko = ∑% of total capital structure * cost of capital for each
Supplied by each type of capital source of capital
W
= Wd * kd + p* kP + Ws * Ks + Wr * Kr where

Wd =% of total capital supplied by debt

Wp = % of total capital supplied by preferred stock
Ws = % of total capital supplied by common stock
Wr = % of total capital supplied by retained earnings
Source (a) Marketvalue (b) Weight ( c ) Cost (d) Weighted costse=( cxd)
Long and short term Br 400,000 40% 6% 2.4%
debt
Preferred stock Br 100,000 10% 12.5% 1.25%
Common equity Br 500,000 50% 15.5% 7.75%
Total Br 1,000,000 100% 11.40%

The weighted average cost of capital (WACC) is 11.40%

4.8.1. The Marginal Cost of Capital (MCC)
Because external equity capital has a higher cost than retained earnings due to flotation costs the
weighted cost of capital increases for each dollar of new financing. There fore lower cost of
capital sources are used first.
In fact the firms cost of capital is a function of the size it’s total investment. A schedule or
graph relating the firm’s costs of capital to the level of new financing is called the weighted
marginal cost of capital (WMCC). Such a schedule is used to determine the discount rate to be
used in the firm’s capital budgeting process. The steps to be followed in calculating the firm’s
marginal cost of capital are:
1. Determine the cost and percentage of financing to be used for each source of capital (debt,
preferred stock, common stock equity).
2. Compute the break even points on the MCC curve where the weighted cost will in increase
Breakeven point = maximum amount of the lower cost source of capital
Percentage of financing provided by the source
3. Calculate the weighted cost of capital over the range of total financing between break points.
4. Construct a MCC schedule or graph that shows the weighted costs of capital for each, level
of total new financing. This schedule will be used in conjunction with the firm’s available
investment opportunities (IOs) in order to select the investments. As long as a profit’s IRR is
greater than the marginal cost of new financing, the project should be accepted. Also the
point at which the IRR intersects the MCC gives the optimal capital budget.
Example: LULA company is considering three investment Proposals whose initial costs and
internal rates of return are given below ‘
Company Initial cost ($) Internal rate of Rerun (IRR) (% )
A 100,000 19
B 125,000 15
C 225,000 12
The company finances all expansion with 40% debt, and 60% equity capital. The after tax cost is
8% for the first $ 100,000 after which the cost will be 10 percent .Retained earnings in the
amount of $ 150,000 available, and the common stock holders’ required rate of rectum is 18% .
If the new stock is issued, the cost will be 22%.
Calculate
A) the dollar amounts at which break occur and
B) Calculate the weighted cost of capital in each of the intervals between the breaks.
 C) Graph the firm’s weighted marginal cost of capital MCC) schedule and investment
opportunities schedule ( IOS)
D) Decide which projects should be selected and calculate the total amount of the optimal
capital budget.
Solution
a) Breaks (increase ) in the weighted marginal cost capital will occur as follow
For debt

Debt
Debt total assets
$100,000  $250.000

0 .4
For common stock Retain earning
$150,000  $250.000

Equity assets 0 .6
The debt break is caused by exhausting the lower cost of debt, while the common stock break is
caused by using up retained earnings.
b) The weighted cost of capital in each intervals between the breaks is computed as follows
With $ 0-$ 250,000 total financing
Source of capital weight cost weighted cost
Debt 0.4 8% 3.2%
10.8%
Common stock 0.6 18% 14.0%
With over $ 250, 000 total financing
Source of capital weight cost weighted cost
Debt 0.4 10% 4%
Common stock 0.6 22% 13.2%
K= 17.2%
c) See fig (d) below
d) Accepts projects A and B for a total of $ 225,000, which is the optimal budget

20
B MCC 17.2%
16
 12 IOS
C
8

100 200 225 300 400 500

New financing (thousand dollars)