FINA2010 Financial Management

Lecture 6: Bond and Stock Valuation

Instructor: Prof. Si Cheng

CUHK Business School

1
 Last Lecture
• Relevant Cash Flows
• Pro Forma Financial Statements and Project
Cash Flows
• Some Special Cases
– Cost-cutting investments
– Set a bid price
– Unequal life projects

2
 Lecture Outline
• Bond Features
• Bond Valuation
• Common Stock Valuation
• Features of Common and Preferred Stocks

3
 Learning Objectives
• Recognize the important bond features and bond
types
• Understand bond values and be able to compute
the bond price
• Understand how stock prices depend on future
dividends and dividend growth
• Be able to compute stock prices using dividend
growth models
• Understand the features of common and
preferred stocks

4
 Valuation Generally
• Finance is a discipline concerned with
determining values and making optimal decisions
based on those values.
• Valuation involves comparing the benefits and
costs on a proposed project decision or asset.
• Assessing an asset’s value today requires
discounting its expected future cash flows to the
present.
• Apply these principles to value bonds and stocks
5
 What is a Bond?
• A bond is the long-term debt instrument sold
to raise money.
• Government, municipalities and companies
can turn to the public to borrow money by
issuing bonds.
• One who buys a corporate bond is a creditor
of the company, NOT an owner (unlike
stockholders who are owners).

6
 Some Basic Terminology
• Coupon: the stated interest payment made on a bond.
• Face value: the principal amount of a bond that is repaid
at the end of the term. Also called par value.
• Coupon rate: the stated annual coupon interest rate of
the bond, equal to the annual coupon divided by the face
value of a bond.
• Maturity: the specified date on which the principal
amount of a bond is paid. Also refer to the lifetime itself.
– Unlike stocks, bonds have finite lifetimes.
• Yield to maturity (YTM): the rate required in the market
on a bond. Also called the bond’s yield.

7
Origin of Coupon Terminology

8
Putting the Main Bond Characteristics Together

• If you buy a bond, the issuer (i.e., the

borrower) promises to pay you back:
– The “par value” (assume $1,000) on a particular
day (the “maturity date”), and
– Periodic “coupons” at a predetermined rate of
interest based on the stated “coupon rate” and
the number of coupon payments per year.

9
Putting the Main Bond Characteristics Together

• Suppose a bond has 5-year maturity, 8% annual

coupon rate, annual coupons, and $1,000 face value
0 1 2 3 4 5 Year

80 80 80 80 1,080
• Fixed-income investments: you are assured a steady
payout or yearly income.
• This regular income makes bond returns inherently
less volatile than stock returns.

10
 Example
• You buy a bond with $1,000 face value, 10-year
maturity and semiannual coupon payments. The
bond has an annual stated coupon rate of 5%.
What will the coupon payments be on your
bond? How many coupon payments will be
made?
• Coupon payment = Coupon rate × Face
value/Number of coupon payments per year
= 5% × 1,000/2 = $25
• Number of coupon payment = 10 × 2 = 20
11
 More Bond Terminology
• Collateral: securities (e.g., bonds and stocks) that
are pledged as security for payment of debt.
• Debenture: a bond backed by the issuer’s general
credit and ability to repay and not by an asset or
collateral (unlike a secured bond).
• Seniority: preference in lender position over
other lenders and debts are sometimes labelled
as senior or junior (subordinated) to indicate
seniority.
12
 More Bond Terminology
• Call provision: an agreement giving the
corporation the option to repurchase a bond at a
specified price prior to maturity. A bond with this
feature is a callable bond.
• Protective covenants: part of the indenture or
loan agreement that limits certain actions a
company might otherwise wish to take during the
term of the loan.
– E.g., limit the amount of additional debt, require a
minimum working capital ratio, etc.

13
Bond Characteristics and Required Returns

• Which bond will have the higher required

return, all else equal?
– Secured debt vs. Debenture
– Senior debt vs. Subordinated debt
– Callable bond vs. Non-callable bond

14
 Bond Valuation

0 r 1 2 3 4 5 Year

PV Coupon Coupon Coupon Coupon Coupon

Bond Face Value

• Bond value = PV of coupons + PV of face value

• Bond value = PV of annuity + PV of lump sum
• As market interest rates increase, present values
decrease, bond prices decrease and vice versa.

15
 The Bond Pricing Equation
1− 1/(1+𝑟)𝑡 𝐹
• 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 (1+𝑟)𝑡

PV of the coupons PV of the

face value
– where 𝐶 is the coupon paid per period
– 𝐹 is the face value paid at maturity
– 𝑟 is the yield to maturity (market interest rate) per
period
– 𝑡 is the number of periods

16
 Yield to Maturity (YTM)
• The rate earned if a bond is held to maturity
• The rate which discounts all future bond cash
flows to their current value (price)
• The ‘market’ rate for the bond, i.e., the
interest rate required in the market on the
bond
• YTM, required return, and market rate are
used interchangeably.

17
 Example: Valuation of a Bond
• Suppose the Star Co. were to issue a bond with 10
years to maturity. The Star bond has an annual
coupon of $80 and $1,000 face value. Similar bonds
have a yield to maturity of 8 percent. What would
this bond sell for?

18
 Example: Valuation of a Bond
1− 1/(1+𝑟)𝑡 𝐹
• 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 (1+𝑟)𝑡
1−1/1.0810 1,000
= 80 × + = $1,000
0.08 1.0810
• The bond sells at its face value, as coupon rate =
YTM.
Inputs 10 8 80 1,000
N I/Y PV PMT FV
Compute −1,000
19
 Example: Valuation of a Bond
• Suppose one year later, the interest rate in the
market has risen to 10 percent.

Inputs 9 10 80 1,000
N I/Y PV PMT FV
Compute −884.82

• The bond sells for less than its face value (discount
bond), as coupon rate < YTM.
20
 Example: Valuation of a Bond
• Suppose one year later, the interest rate in the
market has dropped to 6 percent.

Inputs 9 6 80 1,000
N I/Y PV PMT FV
Compute −1,136.03

• The bond sells for more than its face value (premium
bond), as coupon rate > YTM.
21
 Current Yield vs. Yield to Maturity
• Current yield is the annual interest paid by a bond,
expressed as a percentage of its current market price.
• Example: 8% coupon bond, with annual coupons, face
value of $1,000, 9 years to maturity, 6% YTM, $1,136.03
price.
• Current yield = annual coupon/price = 80/1,136.03 =
7.04%
• Assuming no change in YTM, price in one year = $1,124.2
– Enter N = 8, I/Y = 6%, PMT = 80, FV = 1,000
– <CPT> <PV> −1,124.2

22
 Current Yield vs. Yield to Maturity
• 9 years to maturity, Price = $1,136.03
• 8 years to maturity, Price = $1,124.2
• Capital gains yield = (End bond price − Beg. bond
price)/Beg. bond price = (1,124.2 – 1,136.03)/1,136.03 =
−1.04%
• Yield to maturity (YTM) = current yield + capital gains
yield = 7.04% – 1.04% = 6%, confirms 6% YTM
• Weakness of current yield: not account for any capital
gain or loss associated with the principal to be paid at
maturity.

23
 A Summary
• In our previous example, if maturity = 10 years
Coupon Rate YTM Bond Price Current Yield
8% 8% $1,000 80/1,000 = 8%
8% 10% $877.11 80/877.11 = 9.12%
8% 6% $1,147.2 80/1,147.2 = 6.97%

• Par value bond: Coupon Rate = Current Yield = YTM

• Discount bond: Coupon Rate < Current Yield < YTM
• Premium bond: Coupon Rate > Current Yield > YTM

24
Graphical Relationship: YTM and Bond Prices
Long-term bond is more sensitive to
changes in interest rates.

25
 Example: Flight-to-Safety
• Investors’ Retreat To Safety Sees Bonds Hit New Highs
• Global markets suffered a second week of volatility that
pushed the yields on government bonds to record lows
on fears the coronavirus would spread further.
• Demand for haven assets sank the yield on 10-year
government debt to below 0.7 percent — a record low.
This compares with a yield of 1.9 percent at the start of
2020.
• The sharp slide has taken aback investors, reflecting
“pure fear” in the market. Yields fall when prices rise.
• Source: 7 March 2020, Financial Times

26
Example: Flight-to-Safety

27
 Quick Review MCQ
• Which one of the following terms is most
associated with the ranking of a debt should a
firm declare bankruptcy?
A. Seniority
B. Collateral
C. Debenture
D. Call provisions
E. Protective covenants

28
 Stockholders: Ways To Receive
Cash Return
• If you buy a share of stock, you can receive
cash in two ways.
– The company pays dividends (cash paid out of
earnings).
– You sell your shares, either to another investor in
the market (secondary market) or back to the
company (when a firm repurchases shares).
• As with bonds, the value of the stock is the
present value of these expected cash flows.
29
 Dividend Characteristics
• Firms are not required to pay dividends to their
shareholders.
• The decision to pay a dividend rests in the hands
of the Board of Directors of the corporation.
• Dividends are NOT a liability of the firm until a
dividend has been declared by the Board.
• Dividend payments are not considered a business
expense, therefore, they are not tax deductible.

30
 Value: Several Kinds
• Book Value: the price paid to acquire the asset, less
accumulated depreciation.
• Market Value: the price of an asset as determined in a
competitive marketplace.
• Intrinsic Value: what an asset is really worth. In finance,
estimated by the present value of the expected future
cash flows discounted at the decision maker’s required
rate of return. Determined by:
– Size and timing of the expected future cash flows
– Individual’s required rate of return (riskiness)

31
 Stock Value: 1-Period Example
• Suppose you are thinking of purchasing the stock of Moore
Oil, Inc. and you expect it to pay a $2 dividend in 1 year and
you believe that you can sell the stock for $14 at that time. If
you require a return of 20% on investments of this risk, what
is the maximum you would be willing to pay?
• Use a timeline
0 1
20%

P0 D1 = 2
P1 = 14
2+14
• 𝑃0 = = $13.33 → Value of the stock at time 0
1+0.2

32
 Stock Value: 2-Period Example
• Now what if you decide to hold the stock for 2 years? In
addition to the dividend in one year, you expect a dividend of
$2.1 and a stock price of $14.7 at the end of year 2. Now how
much would you be willing to pay?
• Use a timeline
0 1 2
20%

P0 D1 = 2 D2 = 2.1
P2 = 14.7

2 2.1+14.7
• 𝑃0 = + = $13.33
1+0.2 1+0.2 2

33
Stock Value: Developing The Model
• You could continue to delay when you would sell the
stock.
• You would find that the price of the stock is really
just the present value of all expected future
dividends.
𝐷1 𝐷2 𝐷3 𝐷4 𝐷5
• 𝑃0 = + + + + +⋯
(1+𝑅)1 (1+𝑅)2 (1+𝑅)3 (1+𝑅)4 (1+𝑅)5
– where 𝐷𝑡 is the dividend in time 𝑡, 𝑅 is the required return
• But how can we estimate all future dividend
payments?
34
Estimating Dividends: Special Cases
Constant Dividend (Zero Growth Dividend)
• The firm will pay a constant dividend forever (like preferred stock).
• The price is computed using the perpetuity formula.
Constant Dividend Growth (Constant Growth)
• The firm will increase the dividend by a constant percent every
period.
• The price is computed using the growing perpetuity model.
Supernormal Growth (Nonconstant Growth)
• Dividend growth is not constant initially, but settles down to
constant growth eventually.
• The price is computed using a multistage model.

35
 Scenario 1: Constant Dividend
• If dividends are expected at regular intervals
forever, then this is like preferred stock and is
valued as a perpetuity.
• Formula for perpetuity:
𝐷
𝑃0 =
𝑅
– where D is the constant dividend
– R is the required return

36
 Example: Constant Dividend
• Suppose stock is expected to pay a $0.5
dividend every quarter and the annual
required return is 10% with quarterly
compounding. What is the price?
• R = 10%/4 = 0.025
• P0 = D/R = 0.5/0.025 = $20

37
Scenario 2: Constant Dividend Growth
• Dividends are expected to grow at a constant percent
per period, g. Let D0 be the dividend just paid, then:
– 𝐷1 = 𝐷0 × 1 + 𝑔
– 𝐷2 = 𝐷1 × 1 + 𝑔 = 𝐷0 × 1 + 𝑔 2
– 𝐷𝑡 = 𝐷𝑡−1 × 1 + 𝑔 = 𝐷0 × 1 + 𝑔 𝑡

• Formula for growing perpetuity:

𝐷1 𝐷0 × 1+𝑔
𝑃0 = = (Dividend Growth Model)
𝑅−𝑔 𝑅−𝑔
– where D1 is the next dividend (1 period later)
– R is the required return
– g is the growth rate in dividends

38
 Constant Dividend Growth
• The constant dividend growth model (stable
model) is best suited for firms experiencing
long-term stable growth.
• Generally, stable firms are assumed to grow at
the rate equal to the long-term nominal
growth rate of the economy (inflation plus real
growth in GDP).
𝐷1
• Limitation: 𝑃0 = requires 𝑅 > 𝑔
𝑅−𝑔
39
 Example: Constant Dividend Growth
• The next dividend for the Gordon Growth
Company will be $4 per share. Investors
require a 16 percent return on companies
such as Gordon. Gordon’s dividend increases
by 6 percent every year. Based on the dividend
growth model, what is the value of Gordon’s
stock today?
𝐷1 4
• 𝑃0 = = = $40
𝑅−𝑔 0.16−0.06

40
 Example: Constant Dividend Growth
• For the same company, what is the price
expected to be in year 4?
𝐷1 𝐷0 × 1+𝑔
• At time 0: 𝑃0 = =
𝑅−𝑔 𝑅−𝑔
𝐷𝑡+1
• The price of the stock as of time t is: 𝑃𝑡 =
𝑅−𝑔
𝐷5 𝐷1 ×(1+𝑔)4 4×(1+0.06)4
• 𝑃4 = = = = $50.5
𝑅−𝑔 𝑅−𝑔 0.16−0.06

41
 Example: Constant Dividend Growth
• What is the implied return on the price
appreciation of the stock, given the change in
price during the four years?
• 50.5 = 40 × (1 + r)4 → r = 6%
• The price grows at the same rate as the
dividends.

42
 Scenario 3: Nonconstant Growth
• Dividend growth is not constant initially, but settles
down to constant growth eventually.
• Remember that we have to find the PV of all
expected future dividends.

• The required return is 10 percent. What is the value

of the stock today?
43
 Example: Nonconstant Growth

+
P3 = ?
𝐷4 2.5×1.05
• Dividend Growth Model: 𝑃3 = = = $52.5
𝑅−𝑔 0.1−0.05
𝐷1 𝐷2 𝐷3 +𝑃3 1 2
• 𝑃0 = + + = + +
1+𝑅 (1+𝑅)2 (1+𝑅)3 1+0.1 (1+0.1)2
2.5+52.5
3 = $43.88
(1+0.1)

44
Required Return in Dividend Growth Model
𝐷1
• Dividend Growth Model: 𝑃0 =
𝑅−𝑔
𝐷1
• Rearrange and solve for R: 𝑅 = +𝑔
𝑃0
• Total return = dividend yield + capital gains yield
– Dividend yield: a stock’s expected cash dividend
divided by its current price.
– Capital gains yield: the dividend growth rate, or the
rate at which the value of an investment grows.

45
 Example: Required Return
• Suppose a firm’s stock is selling for $20. The next
dividend will be $1 per share and dividends are
expected to grow at 10% per year indefinitely.
What return does this stock offer?
𝐷1 1
• 𝑅= +𝑔 = + 10% = 15%
𝑃0 20
• Dividend yield = 1/20 = 5%
𝐷2 𝐷1 ×(1+𝑔) 1×1.1
• 𝑃1 = = = = $22
𝑅−𝑔 𝑅−𝑔 0.15−0.1
• Capital gains yield = (22 − 20)/20 = 10% = g
46
Reading Stock Quotes
Ex-Dividend Value per
Payable Date
Date share
Sep 07, 2020 Sep 24, 2020 0.3500
Jun 03, 2020 Jun 19, 2020 0.9330
Sep 09, 2019 Sep 26, 2019 0.3330
May 21, 2019 Jun 06, 2019 0.9430
Sep 10, 2018 Sep 28, 2018 0.2920
May 23, 2018 Jun 08, 2018 0.7438
Aug 14, 2017 Aug 31, 2017 0.2562
May 16, 2017 May 31, 2017 0.6375
Aug 12, 2016 Aug 31, 2016 0.2190
May 10, 2016 May 27, 2016 0.5100

47
Reading Stock Quotes

48
 Proportion of Dividend Payers

• Source: Kahle and Stulz, “Is the US Public Corporation in Trouble?” Journal of Economic
Perspectives, 2017

49
 No-Dividend Firm
• Most Internet firms, such as Amazon.com, Google, and
eBay, pay no dividends.
• Consider Microsoft Corporation. The company started in
1975 and grew rapidly for many years. It paid its first
dividend in 2003, though it was a billion-dollar company
(in both sales and market value of stockholders’ equity)
prior to that date.
• A firm with many growth opportunities is faced with a
dilemma. Pay out dividends now, or make investments to
generate even greater dividends in the future?
• Why aren’t no-dividend stocks selling at zero?

50
 Features of Common Stock
• Voting rights: vote for the board of directors and
other important issues
• Proxy voting: shareholders can transfer their
voting rights to another party.
• Classes of stock: often differ in voting rights
• Other rights
– Share proportionally in declared dividends
– Share proportionally in remaining assets during
liquidation
– Preemptive right: first shot at new stock issue to
maintain proportional ownership if desired

51
 Example: Facebook Dual Classes
• Facebook had 2 classes of stock at its IPO in 2012. Each
class A stock has 1 vote. Each class B stock has 10
votes. Further, whenever any class B share is sold, it is
converted to a class A share.
• Post-IPO, Mark Zuckerberg owns about 28% of
Facebook but 57% voting rights.
• Zuckerberg did this to ensure that Facebook could live
up to his vision, which he outlined in the IPO filing:
“Simply put: we don’t build services to make money;
we make money to build better services. And we think
this is a good way to build something.”

52
 Dual-Class Structure
• Founders have absolute control so they can focus
on the long-term strategic development.
– High-tech firms have to take huge risks in their R&D
expenditures → disliked by short-term shareholders.
• More agency problems by founders or managers
– Dual-class stock structure creates a significant
divergence between founders’ voting rights and cash
flow rights → lack of disciplinary control and financial
consequences.

53
 Example: Practice in HK
• Hong Kong Adds Dual-Class Shares, Paving Way for
Tech Titans
• Hong Kong Exchanges & Clearing Ltd. approved the
biggest change to its initial public offering rules in
two decades, putting it in a position to battle New
York for some of the world’s hottest companies.
• Technology firms that have shares with different
voting rights will now be allowed to go public in
Hong Kong, overturning rules that barred the likes of
Alibaba Group Holding Ltd. Businesses will be able to
apply under the new regime starting April 30.
• Source: 24 April 2018, Bloomberg
54
Top 10 Largest Hong Kong IPOs in 2018

• TMT: Telecommunications, Media and Technology

55
Top 10 Largest Hong Kong IPOs in 2017

56
Example: Global IPOs

57
 Features of Preferred Stock
• Preferred Dividends
– Stated dividend must be paid before dividends can
be paid to common stockholders.
– Not a liability of the firm and can be deferred
indefinitely
– Most are cumulative: any missed preferred
dividends have to be paid before common
dividends can be paid
• Preferred stock generally do not carry voting
rights.
58
 Summary
• Bond Valuation: PV(Coupons) + PV(Face Value)
1− 1/(1+𝑟)𝑡 𝐹
– 𝐵𝑜𝑛𝑑 𝑣𝑎𝑙𝑢𝑒 = 𝐶 × +
𝑟 (1+𝑟)𝑡

• Stock Valuation
𝐷
– Constant Dividend: 𝑃0 =
𝑅
𝐷1 𝐷0 × 1+𝑔
– Constant Dividend Growth: 𝑃0 = =
𝑅−𝑔 𝑅−𝑔
– Nonconstant Growth: multistage

59
Appendix (Not Examinable)

60
 Appendix: Derive Constant Dividend
Growth Model
• Recall sum of a geometric series:
1−𝑏𝑛
• σ𝑛−1
𝑘=0 𝑎𝑏
𝑘 = 𝑎 + 𝑎𝑏 + 𝑎𝑏 2 + ⋯+ 𝑎𝑏 𝑛−1 = 𝑎
1−𝑏
– where 𝑎 is the first term, 𝑏 is the common ratio, 𝑛 is the number of
terms
𝐷1 𝐷2 𝐷3 𝐷1 𝐷1 × 1+𝑔
• 𝑃0 = + + +⋯= + +
(1+𝑅)1 (1+𝑅)2 (1+𝑅)3 (1+𝑅)1 (1+𝑅)2
𝐷1 × 1+𝑔 2
+⋯
(1+𝑅)3
𝐷1 1+𝑔
• In this case, 𝑎 = ,𝑏 = ,𝑛→∞
1+𝑅 1+𝑅
1+𝑔 𝑛
𝐷1 1− 1+𝑅 𝐷1 1 𝐷1
• 𝑃0 = × 1+𝑔 = × 1+𝑔 =
1+𝑅 1−1+𝑅 1+𝑅 1−1+𝑅 𝑅−𝑔
1+𝑔 𝑛 1+𝑔
– As → 0 given 𝑅 > 𝑔, <1
1+𝑅 1+𝑅
61