Chapter 4

The
The Valuation
Valuation of
of
Long-Term
Long-Term Securities
Securities
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
 What is Value?
 Liquidation value represents the amount of money
that could be realized if an asset or group of assets
is sold separately from its operating organization.

 Going-concern value represents the amount a firm could be

sold for as a continuing operating business.
 These two values are rarely equal, and sometimes a company
is actually worth more dead than alive.
 What is Value?
 Market value represents the
market price at which an asset
trades.(in an open market place)
 For an actively traded security, it would be the
last reported price at which the security was sold.
 For a firm, market value is often viewed as being
the higher of the firm’s liquidation or going-
concern value.
 Intrinsic value represents the price a security “ought to have” based on
all factors bearing on valuation.
 Intrinsic value is what the price of a security should be if properly
priced based on all factors bearing on valuation – assets, earnings,
future prospects, management and so on.
 In short, the intrinsic value of a security is its economic value.
 If markets are reasonably efficient and informed, the current market
price of a security should fluctuate closely around its intrinsic value.
 Important
Important Bond
Bond Terms
Terms
 A bond is a long-term debt
instrument issued by a
corporation or government.
 A bond is a security that pays a stated amount of interest to the investor,
period after period, until it is finally retired by the issuing company.
 A bond has a face value. Face value is the stated value of
an asset.
 The maturity value (MV) [or face value] of a bond is the
stated value. In the case of a U.S. bond, the face value is
usually $1,000.
 The bond almost always has a stated maturity, which is the
time when the company is obligated to pay the bondholder
the face value of the instrument.
 In valuing a bond, or any security for that matter, we are
primarily concerned with discounting, or capitalizing, the
cash-flow stream that the security holder would receive
over the life of the instrument.
 The discount, or capitalization, rate applied to the cash-
flow stream will differ among bonds depending on the risk
structure of the bond issue.
 In general, however, this rate can be thought of as being
composed of the risk-free rate plus a premium for risk.
 Perpetual bonds
 A perpetual bond is a bond that never matures. It has an
infinite life.
 The present value of a perpetual bond would simply be
equal to the capitalized value of an infinite stream of
interest payments.
 If a bond promises a fixed annual payment of ‘I ‘
forever, its present (intrinsic) value, V, at the investor’s
required rate of return for this debt issue, kd, is
 Valuation of perpetual Bonds

I I I
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)¥
¥ I
=S (1 + kd)t
t=1

V = I / kd [Reduced Form]
 Perpetual Bond Example
Bond P has a $1,000 face value and provides an 8%
annual coupon. The appropriate discount rate is 10%.
What is the value of the perpetual bond?

I = $1,000 ( 8%) = $80.

kd = 10%.
V = I / kd [Reduced Form]
= $80 / 10% = $800.
 Bonds with finite maturity
 A non-zero coupon-paying bond is a coupon paying bond with a finite
life.
 If a bond has a finite maturity, then we must consider not only the
interest stream but also the terminal or maturity value (face value) in
valuing the bond.
 Different Types of Bonds

I I I + MV
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)n
n I MV
=S (1 + kd) t
+
t=1 (1 + kd)n
 Where n is the number of years until final maturity and MV is the
maturity value of the bond(face value)
 Coupon Bond Example
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)
[Table IV] [Table II]
= $754.16 + $57.00 = $811.16.
 FV= $ 1000
 Coupon rate= 10%
 Years to maturity = 9
 Required rate of return on
bond= 8%
 V= $ 1124.70
 In this case, the present value of the bond is in excess of its $1,000 par
value because the required rate of return is less than the coupon rate.
 Investors would be willing to pay a premium to buy the bond.
 In the previous case, the required rate of return was greater than the
coupon rate. As a result, the bond has a present value less than its par
value.
 Investors would be willing to buy the bond only if it sold at a discount
from par value.
 Now if the required rate of return equals the coupon rate, the bond has
a present value equal to its par value, $1,000.
 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.
 Why buy a bond that pays no interest?
 This return consists of the gradual increase (or
appreciation) in the value of the security from its
original, below-face-value purchase price until it is
redeemed at face value on its maturity date.
 Zero coupon bond
 The valuation equation for a zero-coupon bond is
a truncated version of that used for a normal
interest-paying bond.
 The “present value of interest payments”
component is lopped off, and we are left with
value being determined solely by the “present
value of principal payment at maturity,”
 Zero coupon Bonds

MV
V=
(1 + kd)n
 Zero-Coupon
Zero-Coupon Bond
Bond
Example
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 (PVIF
10%, 30 ) = $1,000 (.057 )
= $57.00
 Semiannual Compounding

Most bonds in the U.S. pay interest

twice a year (1/2 of the annual
coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2
 Semiannual Coupon Bond
Example
Bond C has a $1,000 face value and provides
an 8% semiannual coupon for 15 years. The
appropriate discount rate is 10% (annual rate).
What is the value of the coupon bond?
V = $40 (PVIFA5%, 30) + $1,000 (PVIF5%, 30) = $40
(15.373) + $1,000 (.231)
[Table IV] [Table II]
= $614.92 + $231.00 = $845.92
 Preferred Stock Valuation
 Preferred Stock is a type of stock that promises a (usually)
fixed dividend, but at the discretion of the board of directors.
 Preferred stock has no stated maturity date and, given the
fixed nature of its payments, is similar to a perpetual bond.

Preferred Stock has preference over

common stock in the payment of
dividends and claims on assets.
 Preferred Stock Example
Stock PS has an 8%, $100 par value
issue outstanding. The appropriate
discount rate is 10%. What is the value
of the preferred stock?
DivP = $100 ( 8% ) = $8.00. kP = 10%.
V = DivP / kP = $8.00 / 10%
= $80
 Common stock valuation
 When valuing bonds and preferred stock, we determined
the discounted value of all the cash distributions made by
the firm to the investor.
 In a similar fashion, the value of a share of common stock
can be viewed as the discounted value of all expected cash
dividends provided by the issuing firm until the end of
time.
 Common Stock Valuation

What cash flows will a shareholder receive

when owning shares of common stock?

(1) Future dividends

(2) Future sale of the common
stock shares
 Adjusted Dividend Valuation
Model

The basic dividend valuation model adjusted for

the future stock sale.

Div1 Div2 Divn + Pricen

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + k )n
e

n: The year in which the firm’s shares

are expected to be sold.
Pricen: The expected share price in year n.
 This also assumes that investors will be willing to buy our stock ‘n’ years
from now.
 In turn, these future investors will base their judgments of what the stock is
worth on expectations of future dividends and a future selling price (or
terminal value). And so the process goes through successive investors.
 Note that it is the expectation of future dividends and a future selling price,
which itself is based on expected future dividends, that gives value to the
stock.
 Cash dividends are all that stockholders, as a whole, receive from the
issuing company.
 Consequently, the foundation for the valuation of common stock must be
dividends.
 Constant Growth Model

The constant growth model assumes that dividends

will grow forever at the rate g.

D0(1+g) D0(1+g)2 D0(1+g)¥

V = (1 + k )1 + (1 + k )2 + ... + (1 + k ) ¥
e e e

D1: Dividend paid at time 1.

D1
= g: The constant growth rate.
(ke - g) ke: Investor’s required return.
 Constant Growth Model
Example
Stock CG has an expected dividend growth rate
of 8%. Each share of stock just received an
annual $3.24 dividend. The appropriate
discount rate is 15%. What is the value of the
common stock?
D1 = $3.24 ( 1 + .08 ) = $3.50

VCG = D1 / ( ke - g ) = $3.50 / ( .15 - .08 ) =

$50
 Zero
Zero Growth
Growth Model
Model

The zero growth model assumes that dividends will

grow forever at the rate g = 0.

D1 D2 D
VZG = + + ... +
¥

(1 + ke)1 (1 + ke)2 (1 + ke)¥

D1 D1: Dividend paid at time 1.

=
ke ke: Investor’s required return.
 Zero Growth
Model Example
Stock ZG has an expected growth rate of 0%.
Each share of stock just received an annual
$3.24 dividend per share. The appropriate
discount rate is 15%. What is the value of the
common stock?

D1 = $3.24 ( 1 + 0 ) = $3.24

VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )

= $21.60
 Growth Phases Model

The growth phases model assumes that

dividends for each share will grow at two or
more different growth rates.

n D0(1+g1) t ¥ Dn(1+g2)t
V =S + S (1 + ke)t
t=1 (1 + ke)t
t=n+1
 Growth Phases Model
Example
Stock GP has an expected growth rate of 16% for the first 3 years and 8%
thereafter. Each share of stock just received an annual $3.24 dividend per
share. The appropriate discount rate is 15%. What is the value of the
common stock under this scenario?
 Growth Phases Model
Example

0 1 2 3 4 5 6

D1 D2 D3 D4 D5 D6

Growth of 16% for 3 years Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%, starts at time
t=0 for 3 years and is followed by 8% thereafter starting at time
t=3. We should view the time line as two separate time lines in the
valuation.
 Growth Phases Model
Example

0 1 2 3 Growth Phase
#1 plus the infinitely
long Phase #2
D1 D2 D3
0 1 2 3 4 5 6

D4 D5 D6
Note that we can value Phase #2 using the Constant Growth
Model
 Growth Phases Model
Example

V3 = D 4
We can use this model because
dividends grow at a constant 8%
k-g rate beginning at the end of Year 3.

0 1 2 3 4 5 6

D4 D5 D6
Note that we can now replace all dividends from year 4 to
infinity with the value at time t=3, V3! Simpler!!
 Growth Phases Model
Example

0 1 2 3 New Time
Line
D1 D2 D3
0 1 2 3 D4
Where V3 =
V3 k-g
Now we only need to find the first four dividends to
calculate the necessary cash flows.
 Growth Phases Model
Example

0 1 2 3 Actual
Values
3.76 4.36 5.06
0 1 2 3 5.46
Where $78 =
.15-.08
78
Now we need to find the present value of the
cash flows.
 Growth Phases Model
Example
We determine the PV of cash flows.
PV(D1) = D1(PVIF15%, 1) = $3.76 (.870) = $3.27

PV(D2) = D2(PVIF15%, 2) = $4.36 (.756) = $3.30

PV(D3) = D3(PVIF15%, 3) = $5.06 (.658) = $3.33

P3 = $5.46 / (.15 - .08) = $78 [CG Model]

PV(P3) = P3(PVIF15%, 3) = $78 (.658) = $51.32

 Growth Phases
Model Example

Finally, we calculate the intrinsic value by

summing all of cash flow present values.

V = $3.27 + $3.30 + $3.33 + $51.32

V = $61.22
3 D (1+.16)t 1 D4
V=S
0
+
t=1 (1 + .15) t (1+.15)n (.15-.08)
 Yield to maturity(YTM) on bonds
 The expected rate of return on a bond if bought at its current market
price and held to maturity.
 It is also known as the bond’s internal rate of return(IRR).
 Yield to maturity is the discount rate at which the sum of all future
cash flows from the bond (coupons and principal) is equal to the price
of the bond.
 Mathematically, it is the discount rate that equates the present value of
all expected interest payments and the payment of principal (face
value) at maturity with the bond’s current market price.
 Behavior of bond prices
 When the market required rate of return is more
than the stated coupon rate, the price of the bond
will be less than its face value.
 Such a bond is said to be selling at a discount
from face value. The amount by which the face
value exceeds the current price is the bond
discount.
 Behavior of bond prices
 When the market required rate of return is less
than the stated coupon rate, the price of the bond
will be more than its face value.
 Such a bond is said to be selling at a premium
over face value. The amount by which the current
price exceeds the face value is the bond premium.
 Behavior of bond prices
 When the market required rate of return equals the stated coupon rate,
the price of the bond will equal its face value. Such a bond is said to
be selling at par.
 Bond Price-Yield Relationship

When interest rates rise, then the

market required rates of return rise
and bond prices will fall.
Assume that the required rate of return on a 15
year, 10% annual coupon paying bond rises from
10% to 12%. What happens to the bond price?
 Bond Price - Yield
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
 Bond Price-Yield Relationship
(Rising Rates)

The required rate of return on a 15 year,

10% annual coupon paying bond has
risen from 10% to 12%.

Therefore, the bond price has fallen from

$1,000 to $864.
($863.78 on calculator)
 Bond Price-Yield Relationship

When interest rates fall, then the

market required rates of return fall
and bond prices will rise.
Assume that the required rate of return on a 15 year, 10% annual coupon paying
bond falls from 10% to 8%. What happens to the bond price?
 Bond Price - Yield
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
 Bond
Bond Price-Yield
Price-Yield Relationship
Relationship
(Declining
(Declining Rates)
Rates)

The required rate of return on a 15 year,

10% coupon paying bond has fallen
from 10% to 8%.

Therefore, the bond price has risen from

$1000 to $1171.
($1,171.19 on calculator)
 The Role of Bond Maturity
The longer the bond maturity, the
greater the change in bond price for a
given change in the market required
rate of return.
Assume that the required rate of return on both
the 5 and 15 year, 10% annual coupon paying
bonds fall from 10% to 8%. What happens to
the changes in bond prices?
 The Role of Bond Maturity
The required rate of return on both the 5 and 15
year, 10% annual coupon paying bonds has fallen
from 10% to 8%.

The 5 year bond price has risen from $1,000 to $1,080 for the 5 year bond
(+8.0%).
The 15 year bond price has risen from $1,000 to $1,171 (+17.1%). Twice as
fast!
 The
The Role
Role of
of the
the Coupon
Coupon
Rate
The lower the coupon rate, the price of a bond will change by proportionally more,
for a given change in the market required rate of return.
 In other words, bond price volatility is inversely related to coupon rate.
 The reason for this effect is that the lower the coupon rate, the more return to
the investor is reflected in the principal payment at maturity as opposed to
interim interest payments.
 Put another way, investors realize their returns later with a low-coupon-rate
bond than with a high-coupon-rate bond.