Valuation of Securities

Valuation Fundamentals
• Valuation is the process that links risk and return to determine the
worth of an asset.
• It is a relatively simple process that can be applied to expected
streams of benefits from bonds, stocks, income properties, and so on.
Key Inputs:
There are three key inputs to the valuation process:
1. Cash flows(returns)‐it is expected to provide over the o
2. Timing‐the timing of cash flow
3. A measure of risk ,which determines the required return‐the higher
the risk the greater the return.
The Basic Valuation Model
• The value of an asset is the present value of an asset is the present
value of all future cash flows it is expected to provide over the
relevant time period.
Bond Valuation
• A bond is a long‐term debt instrument that pays the bondholder a
specified amount of periodic interest rate over a specified period of
time.
• The bond’s principal is the amount borrowed by the company and the
amount owed to the bond holder on the maturity date.
• The bond’s maturity date is the time at which a bond becomes due
and the principal must be repaid.
• The bond’s coupon rate is the specified interest rate (or $ amount)
that must be periodically paid.
• The bond’s current yield is the annual interest (income) divided by the
current price of the security.
• The bond’s yield‐to‐maturity is the yield (expressed as a compound
rate of return) earned on a bond from the time it is acquired until the
maturity date of the bond.
• A yield curve graphically shows the relationship between the time to
maturity and yields for debt in a given risk class
Bond Valuation: Bond Fundamentals
• A noted earlier, bonds are long‐term debt instruments used by
businesses and government to raise large sums of money, typically
from a diverse group of lenders.
• Most bonds pay interest semiannually at a stated coupon interest
rate, have an initial maturity of 10 to 30 years, and have a par value of
$1,000 that must be repaid at maturity.
• Bond C has a $1,000 face value and provides an 8% annual coupon for
30 years. The appropriate discount rate is 10%. What is the value of
the coupon bond?
• V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)
= $80 (9.427) + $1,000 (.057)
= $754.16 + $57.00
= $811.16.
Bond Valuation:
Bond Fundamentals (cont.)
• Table 6.7 Bond Values for Various Required Returns
• (Mills Company’s 10% Coupon Interest Rate, 10‐Year Maturity, $1,000
Par, January 1, 2010, Issue Paying Annual Interest)
Time to Maturity and Bond Value
1. Whenever the going rate of interest, rd, is equal to the coupon rate, a
fixed‐rate bond will sell at its par value.
2. Interest rates do change over time, but the coupon rate remains fixed
after the bond has been issued. Whenever the going rate of interest rises
above the coupon rate, a fixed‐rate bond’s price will fall below its par value.
Such a bond is called a discount bond.
3. Whenever the going rate of interest falls below the coupon rate, a fixed‐
rate bond’s price will rise above its par value. Such a bond is called a
premium bond.
4. Thus, an increase in interest rates will cause the prices of outstanding
bonds to fall, whereas a decrease in rates will cause bond prices to rise.
Zero Coupon Bond
• A zero coupon bond is a bond that pays no interest but sells at a deep
discount from its face value; it provides compensation to investors in
the form of price appreciation.
• Zero‐coupon bond=MV/(1+kd )n

• Bond Z has a $1,000 face value and a 30 year life. The appropriate
discount rate is 10%. What is the value of the zero‐coupon bond?
V = $1,000 (PVIF10%, 30)
= $1,000 (.057)
= $57.00