FAR EASTERN UNIVERSITY

Bonds and Stocks Valuation

A bonds is a long-term contract which a borrower agrees to make payments of interest and principal, on specific dates, to
the holders of the bond.

Example: On January 3, 2019, Allied Foods Products borrowed $50 million by issuing $50 million of bonds. In any event,
Allied received the $50 million, and in exchange it promised to make annual interest payments and to repay $50 million on
a specific date.

Bonds are classified into four main types:

1. Treasury bonds – bonds issued by the government, sometimes referred to as government bonds.
2. Corporate bonds – bonds issued by corporations.
3. Municipal bonds – bonds issued by local government.
4. Foreign bonds – bonds issued by either foreign government or foreign corporation.

Key Characteristics of Bonds

1. Par value is the stated face value of the bond. The par value generally represents the amount of money the firm
borrows and promise to repay on the maturity date.
2. Coupon interest rate the stated annual interest rate on a bond.
3. Maturity date a specific date on which the par value of a bond must be repaid.
4. Call provision a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms
prior to the normal maturity date.
5. Sinking fund a provision in a bond contract that requires the issuer to retire a portion of the bonds issue each year.

Bond Valuation
The value of any financial assets – a stock, a bond, lease, or even a physical asset is simply the present value of the cash
flows the assets expected to produce.

Key point
1. Whenever the going rate of interest, is equal to the coupon rate, a fixed-rate bond will sell at its par value.
2. Interest rates do change over time, but 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. (Discount bond a bond that sell below its par value; occurs whenever the going
rate of interest is above the coupon rate)
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 called a premium bond. (Premium bond a bond that sells above its par value; occurs
whenever the going rate of interest is below the coupon rate)
4. Thus, an increase in interest rates will cause the price of outstanding bonds to fall, whereas a decrease in rates
will cause bond price to rise.

Yield to Maturity (YTM)

The rate of return earned on a bond if it is held to maturity. The yield to maturity is generally the same as the market rate
of interest.
Formula:
Price−Par Value
Coupon Rate interest +
t
YTM =
Price+ Par value/2

Illustration 1:
Suppose you are offered a 10-year, 8 percent coupon, P1,000 par value bond at a price of P877.60. What rate of return
could you earn if you bought the bond and held it to maturity?

Illustration 2:
You were offered a 14-year, 10% annual coupon, P1,000 par value bond at a price of P1,494.93. What rate of interest
would you earn on your investment if you bought the bond and held to maturity?

Illustration 3:
Halley’s Enterprises’ bonds currently sell for P975. The bonds have a seven-year maturity, pay an annual coupon of $90,
and have a par value of $1,000. What is the Yield to Maturity? and Current Yield? (9.48%; 9.23%)

Instructor: Melziel Andag Emba

FAR EASTERN UNIVERSITY

Yield to Call (YTC)

The rate of return earned on a bond if it is called before its maturity date.
Formula:
Call Price−Market Value
Coupon Interest Payment +
Number of yearsuntill call
YTC =
Call Price+ Market Value/2

Current Yield (CY)

Provides information regarding the amount of cash income that a bond will generate in a given year. The computation is
the annual interest payment on a bond divided by the bond’s current price.
Formula:
Annual Interest Payment
CY =
Bond ' sCurrent Price
Illustration 4:
Henderson Company bonds currently sell for $1,275. These bonds can be called in five years at a call price of $1,120 and
pay annual coupon of $120. What is their yield to call?

Stock and their Valuation

Common stockholders are the owner of a corporation, and such they have certain rights and privileges.

Definition of terms used in Stock Valuation Model

Common stocks provide an expected future cash flow stream, and stock’s value is found in the same manner as the value
of other financial assets – namely, as the present value of the expected future cash flow stream. The expected cash flows
consist of two elements: (1) the dividends expected in each year and (2) the price investors expect to receive when they
sell the stock. The expected final stock price includes the return of the original investment plus an expected capital gain.

 Dividend the stockholder expects to receive at the end of year. ( D t ¿

 Actual market price of the stock today. ( P0 ¿
 Expected price of the stock at the end of each year. ( Pt ¿
 Expected growth rate in dividends as predicted by a marginal investor. (g)
 Minimum acceptable, or required rate of return on the stock. (k s ¿
 Expected rate of return that an investor who buys the stock expects to receive in the future. ( k s)
 Actual or realized rate of return. (k s ¿
D1
 Expected dividend yield on the stock during the coming year. ( ¿
P0
P 1−P0
 Expected capital gains yield on the stock during the coming year. ( ¿
P0
 Expected total return is expected dividend yield plus expected capital gains yield.

Value of stock = Present Value (PV) of expected future dividends

Constant Growth Stocks

The stream dividends is expected to grow at a constant rate. Using the Gordon Model (popularize by Myron J. Gordon).
D1
Value of stock=
k s−g
For a constant growth stock, the following conditions must hold:
1. The dividend is expected to grow forever at a constant rate.
2. The stock price is expected to grow at this same rate.
3. The expected dividend yield is a constant.
4. The expected capital gains yield is also a constant, and it is equal to growth rate.
5. The expected total rate of return is equals to the expected dividend yield plus the expected growth rate.

Illustration 5:
Allied Food Products just paid a dividend of $1.15. its stock has a required rate of return of 13.4 percent, and investors
expected dividend to grow at a constant 8 percent in the future.

Instructor: Melziel Andag Emba

FAR EASTERN UNIVERSITY
Dividend and Earning Growth
Growth in dividends occurs primarily as a result of growth in earning per share (EPS). Earning growth, in turn result from a
number of factors, including (1) inflation, (2) the amount of earnings the company retains and reinvests, and (3) the rate of
return of the company earns on its equity (ROE).

When can the constant growth model be used?

The constant growth model is often appropriate for mature companies with a stable history of growth. Expected growth
rate somewhat among companies, but dividend growth for most mature firms is generally expected to continue in the
future at about the same rate as nominal gross domestic product (real GDP plus inflation). Note that constant growth
stock is sufficiently general to handle the case of zero growth stock, where the dividends is expected to remain constant
over time. If growth rate is zero the formula will be:
D
Actual Market Price of today=
ks

Expected Rate of Return on a Constant Growth Stock

The computation will be expected rate of return is equal to expected dividend yield plus expected growth rate, or capital
gains yield. Formula:
D1
Expected rate of return= +g
P0
Illustration 6:
If you buy a stock for a price of $23, and if you expect the stock to pay a dividend $1.242 one year from now and to grow
at a constant rate of 8 percent in the future, then the expected rate of return will be?

Illustration 7:
Suppose this analysis had been conducted on January 1, 2019:
a. $23 is the January 1, 2019, stock price;
b. 13.4% is the expected rate of return;
c. $1.242 is the dividend expected at the end of 2019; and
d. 8% a constant growth rate in the future.
Required:
1. What is the expected stock price at the end of 2019?
2. Capital gains yield of 2019?
3. Dividend yield of 2020?

Preferred Stock
Preferred stock is a hybrid – it is similar to bonds in some respect and to common stock in others. The hybrid nature of the
preferred stock becomes apparent when we try to classify it in relation to bonds and common stock. Like bonds, preferred
stock has a par value and a fixed amount of dividends that must be paid before the dividends can be paid on the common
stock. However, if the preferred dividends is not earned, the directors can omit (or “pass”) it without throwing the company
into bankruptcy. So although preferred stock has a fixed payment of bonds, failure to make this payment will not lead to
bankruptcy.

As noted above, a preferred stock entitles its owners to regular, fixed dividend payments. Most of the preferred stocks are
perpetuities. The value of preferred stock is:
Preferred Dividends
Value of Preferred Stock=
Required Rate of Return
Illustration 8:
Allied Food Products has preferred stock outstanding that pays a divided of $10 per year. If the required rate of return on
this preferred stock is 10 percent, then the value of preferred stock is?

Capital Asset Pricing Model (CAPM)

• A model based on the proposition that any stocks required rate of return is equal to the risk free rate of return plus a risk
premium that reflect only the risk remaining after diversification.
• An import tool used to analyze the relationship between risk and rates of return.

The Concept of Beta

• The tendency of a stock to move up and down with the market is reflected in its Beta Coefficient.
• Beta is a key element of CAPM
Instructor: Melziel Andag Emba
FAR EASTERN UNIVERSITY

Formula:
Expected Return=Risk−free rate+ Beta ( Expected Return on Market −Risk −free rate )

Risk Premium = Expected return on market less Risk-free rate

Assessment Task
Yield-to-Maturity
Issued at a Discount
1. The Spade Company’s bonds have 4 years remaining to maturity. Interest is paid annually; the bonds have a P1,000,
face value; and the coupon interest rate is 9%. What is the estimated yield to maturity of the bonds at their current
market price of P829?
A. 8.20% C. 13.10%
B. 10.86% D. 14.80% Pol Bobadilla
2. A 5-year bond with 5% coupon rate and $1,000 face value is selling for $852.10. Calculate the yield to maturity of the
bond. (Assume annual interest payments.)
A. 9.23% C. 8.78%
B. 5% D. None of the above B&M
3 A coupon bond that pays interest of $100 annually has a par value of $1,000, matures in 5 years, and is selling today at a
$72 discount from par value. The yield to maturity on this bond is .
a. 6.00% c. 12.00%
b. 8.33% d. 60.00% Bodie
4. What is the yield to maturity, to the nearest percent, for the following bond: current price is $908, coupon rate is 11
percent, $1,000 par value, interest paid annually, eight years to maturity?
A. 11 percent. C. 13 percent.
B. 12 percent. D. 14 percent. Gitman

Issued at a Premium
5. A 5-year bond with 10% coupon rate and $1,000 face value is selling for $1,054.30. Calculate the yield to maturity on
the bond assuming annual interest payments.
A. 10.53% C. 10%
B. 8.62% D. None of the above B&M
6. Mugwump Industries has issued a bond which has a $1,000 par value and a 15 percent annual coupon interest rate.
The bond will mature in ten years and currently sells for $1,250. Using the approximation formula to calculate the
yield to maturity (YTM) of this bond results in a YTM of
A. 11.11 percent. C. 27.78 percent.
B. 15.00 percent. D. 42.22 percent. Gitman

Present Value of Face Value

7. In calculating the total value of a bond, how much does the $1,000 to be received upon a bond's maturity in 4 years
add to the bond's price if the discount rate is 6%?
A. $207.91 C. $762.90
B. $747.26 D. $792.09 Gleim

Annual interest payment

8. A 5-year treasury bond with a compound rate of 8% has a face value of $1000. What is the annual interest payment?
A. $80 C. $100
B. $40 D. None of the above B&M

Bond Price
9. A corporation has promised to pay $10,000 20 years from today for each bond sold now. No interest will be paid on
the bonds during the twenty years, and the bonds are said to offer a 9% interest rate. Approximately how much should
an investor pay for each bond?
A. $10,000 C. $1,784
B. $9,174 D. $900 Gleim
10. A 3-year bond with 10% compound rate and $1,000 face value yields 8% APR. Assuming annual compounding
payment, calculate the price of the bond.
A. $1051.54 C. $1,000.00
B. $951.96 D. $857.96 B&M
11. A three-year bond has 8.1% compound rate and face value of $1000. If the yield to maturity on the bond is 10%,
calculate the price of the bond assuming that the bond makes semi-annual compound interest payments.
A. $949.24 C. $1057.54
B. $857.96 D. $1000.00 B&M
Instructor: Melziel Andag Emba
FAR EASTERN UNIVERSITY

COST OF PREFERRED CAPITAL

Market Value
12. A firm has an issue of preferred stock outstanding that has a stated annual dividend of $4. The required return on the
preferred stock has been estimated to be 16 percent. The value of the preferred stock is _____.
A. $64 C. $25
B. $16 D. $50 Gitman

Dividend per Share Given

13. What is the after-tax cost of preferred stock that sells for $5 per share and offers a $0.75 dividend when the tax rate is
35%?
A. 5.25% C. 10.50%
B. 9.75% D. 15% Gleim
14. A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share,
and annual dividends of $10 per share. If the tax rate is 40%, the cost of funds (capital) for the preferred stock is
A. 6.2% C. 10.4%
B. 10.0% D. 5.2% CMA 0692 1-14
15. Global Company Press has $150 par value preferred stock with a market price of $120 a share. The organization
pays a $15 per share annual dividend. Global's current marginal tax rate is 40%. Looking to the future, the company
anticipates maintaining its current capital structure. What is the component cost of preferred stock to Global?
a. 4% c. 10%
b. 5% d. 12.5% Gleim
16. Maloney Inc.'s $1,000 par value preferred stock paid its $100 per share annual dividend on April 4 of the current year.
The preferred stock's current market price is $960 a share on the date of the dividend distribution. Maloney's marginal
tax rate (combined federal and state) is 40%, and the firm plans to maintain its current capital structure relationship.
The component cost of preferred stock to Maloney would be closest to
A. 6% C. 10%
B. 6.25% D. 10.4% Gleim

Dividend Rate Given

17. Acme Corporation is selling $25 million of cumulative, non-participating preferred stock. The issue will have a par
value of $65 per share with a dividend rate of 6%. The issue will be sold to investors for $68 per share, and issuance
costs will be $4 per share. The cost of preferred stock to Acme is
A. 5.42%. B. 6.00%.B. C. 5.74%. D. 6.09%. CMA 0690 1-12
18. Mars Company plans to issue some P100 preferred stock with an 11% dividend. The stock is selling on the market
for P97, and Mars must pay flotation costs of 5% of the market price. The company is under the 40% corporate tax
rate. The cost of preferred stock for Mars Company is
A. 7.16% C. 11.34%
B. 6.80% D. 11.94% Pol Bobadilla

Dividend Growth Model – Common Stock

Zero-growth Stock – Current Price
19. Universal Air is a no growth firm and has two million shares outstanding. It is expected to earn a constant 20 million
per year on its assets. If all earnings are paid out as dividends and the cost of capital is 10%, calculate the current
price per share for the stock.
A. $200 C. $150
B. $100 D. $50 B&M
20. A firm has an expected dividend next year of $1.20 per share, a zero growth rate of dividends, and a required return
of 10 percent. The value of a share of the firm's common stock is ______.
A. $120 C. $12
B. $10 D. $100 Gitman

Growth Rate
21. Given that the cost of common stock is 18 percent, dividends are $1.50 per share, and the price of the stock is $12.50
per share, what is the annual growth rate of dividends?
A. 4 percent C. 6 percent
B. 5 percent D. 8 percent Gitman

Current Desired Price

22. Casino Co. is expected to pay a dividend of $6 per share at the end of year one and these dividends are expected to
grow at a constant rate of 8% per year forever. If the required rate of return on the stock is 20%, what is current value
of the stock today?
A. $30 C. $100
B. $50 D. $54 B&M

Instructor: Melziel Andag Emba

FAR EASTERN UNIVERSITY
23. A firm has experienced a constant annual rate of dividend growth of 9 percent on its common stock and expects the
dividend per share in the coming year to be $2.70. The firm can earn 12 percent on similar risk involvements. The
value of the firm's common stock is ______.
A. $22.50/share C. $90/share
B. $9/share D. $30/share Gitman

Past Dividend Given

24. Suppose that Nefertiti recently purchased a share of stock for $45. The most recent dividend was $3, and dividends
are expected to grow at a perpetual rate of 5% indefinitely. What should be her required return on the stock?
A. 12.67% C. 6.67%
B. 12.00% D. 5.00% Gleim
25. A company just paid a $2.00 per share dividend on its common stock (D 0 = $2.00). The dividend is expected to grow
at a constant rate of 7 percent per year. The stock currently sells for $42 a share. If the company issues additional
stock, it must pay its investment banker a flotation cost of $1.00 per share. What is the cost of external equity, k e?
a. 11.76% d. 12.22%
b. 11.88% e. 12.30%
c. 11.98% Brigham
26. Your company’s stock sells for $50 per share, its last dividend (D 0) was $2.00, its growth rate is a constant 5 percent,
and the company will incur a flotation cost of 15 percent if it sells new common stock. What is the firm’s cost of new
equity, ke?
a. 9.20% d. 11.75%
b. 9.94% e. 12.30%
c. 10.50% Brigham

Expected Dividends Given

27. By using the dividend growth model, estimate the cost of equity capital for a firm with a stock price of $30.00, an
estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10%.
A. 21.1% C. 10.0%
B. 11.0% D. 20.0% CMA 1294 1-28

* Under the dividend growth model, the cost of equity equals the
expected growth rate plus the quotient of the next dividend and the current market price.
Thus, the cost of equity capital is 20% [10% + ($3 ÷ $30)]. This model assumes that the
payout ratio, retention rate, and the earnings per share growth rate are all constant.

Capital Asset Pricing Model

Beta
28. If the risk-free rate is 6%, the expected return on the market is 12%, and the expected return on Pookie stock is 12%,
what is the beta of Pookie stock?
A. 1.0 C. 2.0
B. 1.5 D. 2.5 Gleim

Required rate of return (Given – Risk Premium)

29. If Treasury bills yield 4.0%, and the market risk premium is 9.0%, then a portfolio with a beta of 1.5 would be expected
to yield
A. 9.0% C. 17.5%
B. 15.0% D. 19.5% Gleim

Required rate of return (Given – Market Return)

30. Using the Capital Asset Pricing Model (CAPM), the required rate of return for a firm with a beta of 1.25 when the
market return is 14% and the risk-free rate is 6% is
A. 6.0%. C. 17.5%.
B. 7.5%. D. 16.0%. CMA 0692 1-5
31. Assume that the risk-free interest rate is 8%, the required rate of return on the market portfolio (containing all stocks)
is 15%, and the beta coefficient of a particular stock is .9. According to the capital asset pricing model, the required
rate of return on that particular stock is
A. 6.3% C. 15.0%
B. 14.3% D. 21.5% CIA 1191 IV-52

Market Return
32. The following data are related to ABC stock:
Instructor: Melziel Andag Emba
FAR EASTERN UNIVERSITY
Required return on ABC common 15%
Beta coefficient 1.5
Risk-free rate 9%
The required market return is
A. 13.0% C. 25.0%
B. 18.0% D. 16.0% Pol Bobadilla

Instructor: Melziel Andag Emba