CHAPTER THREE

VALUATION OF STOCK, BONDS

AND OTHER DEBT
INSTRUMENTS

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 Legal Rights and Privileges of Common
Stockholders
• Ownership in a corporation is evidenced by a stock
certificate, a serially numbered document that
indicates the number of shares owned and the par
value (if any).
• Many corporations employ an independent
transfer agent (such as a bank) to handle the
issuance of stock certificates, as well as a registrar
to maintain the stockholder records.

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Sample Stock Certificate: Coca-Cola

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 Stockholders‘ Legal Rights
 The right to share in the profits when a dividend is declared,

 The right to elect directors and to establish corporate

policies,

 The right (called a pre-emptive right) to maintain a

proportionate interest in the ownership of the corporation
by purchasing a proportionate (pro rata) share of additional
capital stock, if more stock is issued, and

 The right to share in the distribution of the assets of the

corporation if it is liquidated.
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 Legal Rights
• A corporation may issue two basic classes of stock,
generally designated as common stock and preferred
stock. Common stock is capital stock that carries
all of the preceding rights. Some corporations,
however, issue more than one type of common
stock such as Class A and Class B common stock.
• In this situation, usually one type of common stock
has greater voting rights than the other to maintain
control over the corporate activities. In exchange
for certain other privileges, preferred stock usually
is not granted all of the common stock’s rights. 5
 BONDS AND BOND VALUATION
• 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.

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 Bond Features and Prices

• A bond is normally an interest-only loan, meaning that

the borrower will pay the interest every period, but
none of the principal will be repaid until the end of the
loan.
• For example, suppose Awash Bank wants to borrow
Birr 1,000,000 for 30 years. The interest rate on similar
debt issued by similar corporations is 12 percent.
Awash will thus pay 12% of Birr 1,000,000 = Birr
120,000 in interest every year for 30 years. At the end
of 30 years, Awash will repay the Birr 1,000,000. As
this example suggests, a bond is a fairly simple
financing arrangement. 7
 Bond Values and Yields

• As time passes, interest rates change in the marketplace. The

cash flows from a bond, however, stay the same. As a result, the
value of the bond will fluctuate.

• 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.

• To determine the value of a bond at a particular point in

time, we need to know the number of periods remaining
until maturity, the face value, the coupon, and the
market interest rate for bonds with similar features.
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 Bond…
• The interest rate required in the market on a bond is
called the bond’s yield to maturity (YTM).
• This rate is sometimes called the bond’s yield for
short. Given all this information, we can calculate
the present value of the cash flows as an estimate of
the bond’s current market value.

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 Bonds …
• For example, suppose Oda Trading was to issue a
bond with 10 years to maturity.
• The Oda Trading bond has an annual coupon of
$80.
• Similar bonds have a yield to maturity of 8 percent.
• Based on our preceding discussion, the Oda
Trading bond will pay $80 per year for the next 10
years in coupon interest.
• At the end of 10th year, Oda Trading will pay
$1,000 to the owner of the bond.
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 Bonds …
• Oda Trading bond’s cash flows have an annuity
component (the coupons) and a lump sum (the
face value paid at maturity).
• We thus estimate the market value of the bond
by calculating the present value of these two
components separately and adding the results
together.

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 Cash flow for Oda Trading bond

• As shown, Oda Trading bond has an annual coupon of $80 and a

face, or par, value of $1,000 paid at maturity in 10 years.

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 Bond Price Computations: Illustrations
  Eg 1 Eg2 Eg 3
settlement date 1/1/2011 1/1/2000 1/1/2005
maturity date 1/1/2025 1/1/2022 1/1/2030
coupon rate 0.1 0.08 0.08
yield rate 0.09 0.09 0.08
face value (%of par) 100 100 100
coupon per year 2 2 4
bond price(% of Par) 107.8714 90.49 100.00
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 Conclusions
If yield rate is greater than coupon rate the bond
will be sold at discount.
YR>CR=discount
If yield rate is Less than coupon rate the bond will
be sold at Premium.
YR<CR =Premium
If yield rate is equals to coupon rate the bond will
be sold at par/Face value.
YR=CR=Face value

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 COMMON STOCK VALUATION

• A share of common stock is more difficult to value in

practice than a bond, for at least three reasons.
– First, with common stock, not even the promised cash
flows are known in advance.
– Second, the life of the investment is essentially forever,
since common stock has no maturity.
– Third, there is no way to easily observe the rate of return
that the market requires.
• Nonetheless, as we will see, there are cases in which
we can come up with the present value of the future
cash flows for a share of stock and thus determine its
value. 16
 Cash Flows

• Imagine that you are considering buying a share of

stock today. You plan to sell the stock in one year.
You somehow know that the stock will be worth
$70 at that time.
• You predict that the stock will also pay a $10 per
share dividend at the end of the year. If you require
a 25 percent return on your investment, what is the
most you would pay for the stock?
• In other words, what is the present value of the $10
dividend along with the $70 ending value at 25
percent?
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 Cash flow

• More generally, let P0 be the current price of the stock,

and assign P1 to be the price in one period. If D1 is the
cash dividend paid at the end of the period, then:
P0 = (D1+ P1)/(1+ R)
• Where R is the required return in the market on this
investment.
• What is the price in one period, P1? Suppose we
somehow knew the price in two periods, P2. Given a
predicted dividend in two periods, D2, the stock price
in one period would be:
P1 = (D2+ P2)/(1 + R)
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 Cash flow
• If you buy the stock today and sell it at the end
of the year, you will have a total of $80 in cash.
At 25 percent:
• Present value =($10 +70)/1.25= $64
• Therefore, $64 is the value you would assign to
the stock today.

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Class Activity
• Assume an investor is considering the purchase of
Stock A at the beginning of the year. The dividend
at year-end is expected to be Birr 3, and the
market price by the end of the year is expected to
be Birr 80. If the investor’s required rate of return
is 15 percent, the value of the stock would be:

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Thank you
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