CHAPTER 6: Valuation of

Bond and Stock

Valuation:
The process of determining the present
value of a financial asset by discounting
future cash flows to be generated by that
asset at an expected discount rate is called
valuation.
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 CHAPTER 6: Valuation of
Bond and Stock

Bond:
A long-term debt instrument in which a
borrower agrees to make payments of
principal and interest, on specific dates, to
the holder of the instrument by securing
sufficient collateral is called bond.
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Key Features of a Bond
 Par value – face amount of the bond, which
is paid at maturity (assume $1,000).
 Coupon interest rate – stated interest rate
(generally fixed) paid by the issuer. Multiply
by par to get dollar payment of interest.
 Maturity date – years until the bond must be
repaid.
 Issue date – when the bond was issued.
 Market rate of interest is the current interest
rate available at the market. (suppose, r)
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 Valuation of Bond
Value of bond equals to the present value of all
future payments of interest and the principal
amounts. Since all the interest figures are equal so it
is the same as the present value of annuity and the
future value can be converted in the present value
as:
C 1  F
PV  1  T 

r  (1  r )  (1  r ) T

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Example 1. Bond valuation
 A 10%, Tk.1000, 10 year bond was issued that
pays interest on July 1 and December 1 every
year. Already 7 payments made. If the current
interest rate is 12%, what is the current price?

 So, t=(20-7)=13
 VB=$50 (PVIFA, n=13, i=6%)+PV(1000)
=[50*(8.8527)]+ 468.84=$ 911.47

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 Valuation of Stock
Method 1: Zero Growth
 Share price is the present value of all future dividends.

Po   PV ( D )
t 1
t

D1 D2 D3 D
    .... 
1 k (1  k ) 2
(1  k ) 3
(1  k ) 

 Where, D is dividends and k is the cost of capital.

 Zero growth means dividends remain at the same level

forever, So, D1  D2  D3  .....  D

D
Then, P0 
k 7-6
 Method 2: Constant Growth
If dividends grow at a constant rate for ever, then:
D1=D0(1+g), similarly, D2=D1(1+g)=D0(1+g)2
In that case: D1
P0 
kg
Example: ABC Co. paid Tk.15 as the dividend of the
current year. The dividends are expected to grow at
constant rate of 4 percent forever. The cost of equity is
11 percent. What should be the price today?
D0 (1  g ) Tk .15(1.04)
P0    Tk .222.86
ks  g .11  .04 7-7
 Investment Decision
 Investment decision can be:
1. To buy: If market price is less than theoretical price
2. To sell: If market price is more than theoretical price
3. No change: If market price is equal to theoretical price

For example: In the previous example, if the current

market price of ABC stock is Tk.205 then the
investment decision is to buy ABC stock. If the market
price is Tk.230, then the investment decision is to sell
the stock. If the market price is Tk.222.86 then neither
buy nor sell.

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 Case 3: No-constant Growth
 The constant growth model is not applicable when ‘g’ is quite
high. No-constant growth or super growth model is then the
only choice to estimate stock price.
 1. Calculate the present value of dividends of super growth
rate separately, sum it up,
 2. Calculate the future price of the stock based on constant
growth rate,
 3. Make the present value of the price,
 4. Add the two streams of present value.
 Example: If dividend grows at a super rate for 3 years and
then, at a constant rate for perpetuity, then:
 Po=PV(D1)+PV(D2)+PV(D3)+PV(P3),
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where, P3=D4/(k-g)
 Problem:
No-constant Growth model

Suppose, a high growth mobile firm paid a dividend of

Tk. 22 in the current year. It is expected that dividend will
grow at the rate of 20% for the next 3 years and then at a
constant rate of 3% for ever. If the cost of equity or the
required return of the firm is 15% then what should be the
price of the stock today?
Summarized Answer:
Po=PV(D1)+PV(D2)+PV(D3)+PV(P3)
=PV(26.4)+PV(31.68)+PV(38.02)+PV(39.16/(.15-.03))
=22.95+23.95+25+214.55
=286.46
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 Detail worksheet of the
Answer (contd.)
n Div PV (Div)
1 D1=Do(1+gs)=22(1.2)= 26.4 D1/(1+k)=26.4/1.15= 22.9565
2 D2=D1(1+gs)=26.4(1.2)= 31.68 D2/(1+k)2=31.68/(1.15)2 = 23.9546
3 D3=D2(1+gs)=31.68(1.2)= 38.016 D3/(1+k)3=38.016/(1.15)3 = 24.9961
4 D4=D3(1+g)=38.016(1.03)= 39.156
PV(D1)+PV(D2)+PV(D3)= 71.9073

Po=PV(D1)+PV(D2)+PV(D3)+PV(P3)
Where, P3=D4/(k-g)=39.156/(.15-.03)=326.304
and, PV(P3)=P3/(1+k)3=326.3/(1.15)3=214.55
P0=PV(D1)+PV(D2)+PV(D3)+PV(P3)=71.9+214.55=286.46
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H.W.
Questions:
6-1, 6-2, 7-1, 7-2, 7-3, 7-4
Problems:
6-1, 6-3, 6-4, 6-9, 6-15, 7-3, 7-4, 7-5, 7-25

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