CHAPTER FOUR

BOND AND STOCK VALUATION AND COST OF CAPITAL

Introduction
The valuation of assets is a critical as well as challenging task. In this chapter, we examine the
concepts and procedures for valuing assets, especially financial assets (securities) such as bonds,
preferred stocks, and common stocks. Since the goal of the financial manager is to maximize the
value of the firm’s common stock, we need to understand the constructs that underlie value.
Book value: is the value of all assets as shown on the firm’s balance sheet. It represents a
historical value rather than a current worth. For example, the book value for common stock is the
sum of the stocks par value, the paid - in capital, and the retained earnings.
Liquidation Value: - is the amount that could be realized if an asset were sold individually and
not as part of a going concern. For example, if a product line is discontinued, the machinery used
in its production might be sold. The sale price would be its liquidation value and would be
determined independently of firm’s value.
Market Value: - is the observed value for the asset in the market place. This value is determined
by the supply and demand forces working together in the market place, where buyers working
together in the market place, where buyers and sellers negotiate a mutually acceptable price for
the asset. In theory, a market price exists for all assets. However, many assets have no readily
observable market price because trading seldom occurs.
The Intrinsic Value: the present value of the assets expected future cash flows. This value is
also called the fair value, as perceived by the investor, given the amount, timing, and risky ness
of future cash flows. In essence, intrinsic value is like the value in the eyes of the investor, given
the amount, timing, and risky ness of future cash flows. Given the risk, the investor determines
the appropriate discount rate to use in computing the present or intrinsic value of the assets. Once
the investor can compare with its market value. If the intrinsic value is greater than the market
value, the security is undervalued in the eyes of the investor. If the market value exceeds the
investors intrinsic value the security is overvalued.

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4.1. Valuation an Overview:-
For our purposes the value of an asset is its intrinsic value, which is the present value of its
expected future cash flows, where these cash flows are discounted back to the present value
using the investor’s required rate of return. Thus, value is a function of three elements.
1. The amount and timing of the assets expected cash flows.
2. The risky ness of these cash flows.
3. The investor’s required rate of return for undertaking the investment.
4.2. Valuation: - The Basic Process
The valuation process can be described as assigning value to an asset (bond, preferred stock, and
common stock) by calculating the present value of its expected future cash flows.
Using the investor's required rate of return as the discount rate thus value (V) is computed as
follows:-
n
V = CF1 + CF2 + CF3 + CF3 + …. …+ CFn or V= ∑ CFt
(1+k) 1 (1+k) 2 (1+k) 3 (1+K) 4 (1+k) n t=1 (1+K)t
Where:
V = the intrinsic value of an asset producing expected future cash flows, CFt, in years 1 through
n.
CFt= Cash flows to be received in year t.
K = the investor’s required rate of return.

4.3. Bond Valuation

Bond: is a long term promissory note that promises to pay the bond holder a predetermined,
fixed amount of interest each year until maturity. At maturity, the principal will be paid to the
bond holder. In the case of a firm’s insolvency, a bond holder has a priority of claim to the firm’s
assets before the preferred and common stock holders. Also, bondholders must be paid interest
due them before dividends can be distributed to the stockholders. The process of valuing a bond
requires first that we understand the terminologies and institutional characteristics of a bond.
Terminologies
Par Value: - The par value is the stated face value of the bond at the end of the life of the bond,
it is usually set at $ 1000. This amount, defined as the par value or face value, can not be altered
after the bond has been issued. The par value is essentially independent of the intrinsic value of

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the bond. Thus, although the price of the bond fluctuates in response to changing economic
conditions, the par value remains constant.
Coupon Interest Rate: - The rate which is generally fixed determines the periodic coupon or
interest payments. It is expressed as a percentage of bonds face value. It also represents the
interest cost of the bond to the issuer.
Coupon Payments: - The coupon payments represent the periodic interest payments from the
bond issuer to the bond holder. The annual coupon payments are calculated by multiplying the
coupon rate by the bond’s face value. Since most bonds pay interest semi -annually, generally
one half of the annual coupon is paid to the bond holders every six-month.
Maturity Date: - The maturity date represents the date on which the bond matures, i.e. the date
on which the face value is repaid. The last coupon payment is also paid on the maturity date.
Call Date: - for bonds which are callable, i.e. bonds which can be redeemed by the issuer prior
to maturity, the call date represents the earliest date at which the bond can be called.
Call Price: - The amount of price the issuer has to pay to call a callable bond (there is a premium
for calling the bond early). When a bond first callable, i.e. on the call date, the call price is often
set to equal the face value plus one year’s interest.
Required Return: the rate of return that investors currently require on a bond
Yield-to-Maturity: the rate of return that an investor could earn if he bought the bond at its
current market price and held it until maturity. Alternatively, it represents the discount rate which
equates the discounted value of bonds future cash flows to its current market rice.
Valuation Procedure:
The value of the bond is the present value of both interest to be received and the par or maturity
value of the bond. This may be expressed as:

N
It $M
Vb = ∑¿¿t=1 (1+ Kb)t + (+kb ) N or Vb = (It x PVIFA k b,n ) + (Mx PVIFkb,n)
Where
It = the dollar interest to be received in each payment
M= the par value of the bond
Kb = the required rate of return for the bond holder
N = the number of periods to maturity
The valuation process for a bond requires knowledge of three essential elements.
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1. The amount of the cash flows to be received by the investor
2. The maturity date of the loan
3. The investors required rate of return. The amount of cash flow is dictated by the periodic
interest to be received and the par value to be paid at maturity. Given these elements, we can
compute the intrinsic value of the bond.
Example 1. Consider that Habesha cement, on Jan1, 2010 issued a 10% coupon interest rate,
10-year bond with Br 1000 par value that pays interest annually. If the investor requires a 10%
rate of return on this bond. What is the value of the bond to such an investor?
Solution:
I (interest) = M x Kc
= Br 1000* 10%
= Br 100
n
I M
Vb = ∑¿¿t=1 (1+ Kb)t + (1+kb )N or I (PVIFA kb,n) + M (PVIF kb,n)
10
100 1000
= ∑¿¿t=1 (1.1)10 + (1.1)10
= (Br 100 * 6.1446) + (Br 1000 X0.38 55)
= Br 1000.

Example 2: Assume that another investor viewed the bond of Habasha cement to be riskier and
thus requires 12% rate of return on this bond. Find the value.
Solution:

n
I M
Vb = ∑¿¿t=1 (1+ Kb)t + (1+kb )N or I (PVIFA kb,n ) + M (PVIF kb,n)

10
100 1000
= ∑¿¿t=1 (1.12)10 + (1.12)10 = (Br 100 X 5.650) + 1000 (0.322) = Br 887

Example 3:- Further assume that an investor requires 8% return on this bond. Find its value
Solution:
n
I M
Vb = ∑¿¿t=1 (1+ Kb)t + (1+kb )N

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 10
100 1000
= ∑¿¿t=1 (1.12)10 + (1.1)10 = (100 X 6.710) + (1000 0.463) = Br 1,134

Note: - The bond’s coupon rate is fixed by its nature and the coupon rate and required rate of
return moves in the opposite direction.
Semi-Annual Interest Payments
For bonds that pay interest semi annually, we need to adjust the size of interest payments as the
coupon interest amount is to be paid in two semiannual installments rather than a one time
annual payments. The valuation equation becomes,
I /2
N (1+
Kb
)2t
M
2 kb
Vb = ∑¿¿t=1 +
(1+ )2t
2 or Vb= (
(
I
2
XPVIFA Kb / 2 , 2 t )
+
( MxPVIF kb/2 ,2t )
Example 4: - Suppose a bond has $ 1000 face value, a 10 percent coupon (paid semiannually),
five years remaining to maturity, and is priced to yield 8 percent. What is its value?
I = MC = $1000 x 10% = 100
I
N 2
Kb
M
(1+ )at kb 100 /2 1000
Vb = ∑¿¿t=1 2
+
(1+ )t
2 or Vb= (1+8%/ 2)10 + (1+8%/ 2)10
= $ 405 .54 + $ 675. 60 = $1,081.14

4.3.1. Bond holders Expected Rate of Return (Yield to Maturity, YTM )

The bond holder’s expected rate of return is the rate the investor will earn if the bond is held to
maturity, provided of course, that the company issuing the bond does not default on the
payments.
Computation of Yield –to- Maturity all the Bond (YTM)
Assumption: YTM is the bonds annual average rate of return to the investor if
1. The bond is held to maturity and
2. The dollar coupon interest payments are reinvested at the rate kd (reinvestment
assumption).

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 YTM can be computed as follows:

( M−Vb )
I+
YTM = n
M +Vb
2
Where
I= Periodic dollar coupon payments (Kc X M)
M = the dollar principal payment at maturity (Fv)
Vb = the value (present value) of bond
n = the number of periods until maturity of the bond
Kc = the fixed coupon interest rate on the bond
Note: - the investor uses the bond’s computed YTM by comparing it to his/her required rate
of return on the bond after considering all risk factors;
1. If the investors required return is greater than the YTM, the investor should not buy
the bond
2. If the investor’s required return is less than the YTM, the investor should buy the
bond.
Example 1:- suppose a zero – coupon with five years remaining to maturity and a face value of $
1,000 has a price of $ 800. What is the yield to maturity on this bond?

I +( M−Vb ) $ 1000 − $ 800 40

0+
5 $ 1000 + 800 ¿
YTM = n YTM = 2 = 900 = 4.4.%
M +Vb
2

4.3.2. Required Returns and Bond Values

Whenever the required return and bond differs from the bonds coupon interest rate, the bond’s value will
differ from its par value or face value.
Three Important Relationships
First Relationship: - A decrease in interest rates (required rates of return) will cause the bond to increase
value. The change in value caused by changing interstates rata is called interest rate risk.

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Second Relationship
1. If the bond holders required rate of return (current interest rate) equals the coupon interest rate, the
bond will be sold at par, or maturity value.
2. If the current interest rate exceeds the bond’s coupon rate; the bond will be sold below par
value or at a discount.
3. If the current interest rate is less than the bond’s coupon rate, the bond will be sold above    par
value or at a “premium”

3.Third Relationship
A bond holder owning a long-term bond is exposed to greater interest rate – risk than when
owning short – term bonds.

Relationship on the YTM

Since the bonds coupon rate (kc) is fixed for the life of the bond, the following (YTM) bond
price relationship is expected.
 If YTM > Kc the bond sells at discount below par value
 If YTM < kc the bond sells at premium above par value
 If YTM = kc the bound sells at par value.

4.4 Preferred Stock Valuation

Preferred stock is defined as equity with priority over common stock with respect to the payment
of dividends and the distribution of assets in liquidation. Preferred stock is a hybrid security
which shares features with both common stock and debt. Preferred stock is similar to common
stock in that it entitle its owners to receive dividends which the firm must pay out of after – tax
in come.
Moreover, the use of preferred stock as a source of financing does not increase the profitability
of bankruptcy for the firm. However, like the coupon payments on debt, the dividends on
preferred stock are generally fixed. Also, the claims of the preferred stock holders against the
assets of the firm are fixed as are the claims of the debt holders.
Preferred Dividend/Preferred Dividend Rate: The preferred dividend rate is expressed as a
percentage of the par value of the preferred stock. The annual preferred dividend is determined
by multiplying the preferred dividend rate times the par value of the preferred stock. Since the
preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock

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with a dividend growth rate equal to zero. Thus, the price of a share of preferred stock can be
determined using the following equation.
Dp
Vp = Kp Where
Vp = the preferred stock price
Dp = the preferred dividend and
 Kp = the required return on the stock

Example: - Find the price of a share of preferred stock given that the par value is $100 per
share, the preferred dividend rate is 8% and the required return is 10%.
Dp $8
Solution: - Vp = Kp but Dp = Mx Dr = 100x0.8=$8, Vp = 0.1 = $80

4.5 Common Stock Valuation

Like bonds and preferred stocks, a common stock’s value is equal to the present value of all
future cash flows expected to be received by the stock holder. However, in contrast to bonds,
common stock does not promise its owners interest income or a maturity payment at some
specified time in the future. Nor does common stock entitle the holder to a predetermined
constant dividend as does preferred stock. For common stock, the dividend is based on the
profitability of the firm and on managements’ decision to pay dividends or to retain the profits
for reinvestment purposes. As of consequence dividend streams tend to increase with the growth
in corporate earnings. Thus, the growth of future dividends is a prime distinguishing feature of
common stock. This does not mean that divided will always increase in the future. Let’s develop
common stock valuation process by steps starting with a one – period horizon and progressing to
a multiple period horizon.
4.5.1 One Period Valuation Model
For an investor holding a common stock for only one year, the value of the stock would be the
present value of both the expected cash dividend to be received in one year (D1) and the
expected market price per share of the stock at year end (P1) .If ks represents an investors
required rate of return, the value of common stock (po) would be:
D1 p1
Po = 1+ks + 1+ks

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Example: - Assume kuku Company is considering the purchase of stock at the beginning of the
year. The divided at year end is expected to be Br 3 and the market price by the end of the year is
expected to be Br 80. If the investor’s required rate of return is 15 percent. What would be the
value of the stock?

Given:- Required solution

D1 P1 Br 3
D1= Br 3 Po=? Po= 1+ks + 1+ks = (1.15)1 +
Br 80
1.15
P1= Br 80 Br 3 (0.870) + Br 80 (0.870)
Ks = 15% Br2. 61 + Br 69.6
Br 72.21

Interpretation; - The implication of Br 72.21 is that if the investor buys this stock for Br 72.21
today, receives a Br 3 dividend, and sells the stock for Br 80 one year from now, the investor will
earn the 15% rate of return that was required to invest.
4.5.2. Two Period Valuation Models

Now, suppose the investor plans to hold a stock for two years before selling. How is the value of
the stock determined when the investment horizon changes? The answer is to incorporate the
additional years in formation be.
D1 D2 P2
Po= (1+ks)1 + (1+ks)2 + (1+ks)2
Example 1:-Assume the expected dividend for KUKU Company in the second year be Br 4, the expected
price at the end of the second year be Br100, and the required rate of return remains 15%. Find the value
of the common stock.
Value of the Common Stock
Given Required Solution
D1 D2 D2
D1 = Br 3 Po= ? Po = (1+ks) + (1+ks)2 + (1+ks)2
D2 = Br 4
P2= Br 100
4 100
3 +
(1+15)2 (1 .15)2
Ks = 15% = (1+15)1 +
3 (0.870) + 4 (0.7561) + 100 (0.7561) = Br 79.38

4.5.3. Multiple Period Valuation Model

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Since common stock has no maturity date and is held for many years, a more general, multi period model
is needed. The general formula for common stock valuation model is defined as follows:

∞
Dt Pn
Po = ∑¿¿t=1 (1+ Ks)n
+ (1+ks)n
D1 D2 Dn Pn
Po = (1+ Ks)1 + (1+ks)2 + D3 + …………. + (1+ks)n + (1+ks)n
Example: - Assume that an investor expects Br 3 dividend for each of 10 years and a selling
price of Br 50 at the end of 10 years. What would be the value of the common stock to day?

Given Required Solution

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Br 3 Br 50
D1, D 2.......D 10=Br 3 Po=? Po = ∑¿¿t=1 (1.1)10 + (1.1)10 = 3 (6.15) + Br 50 (0.38)
n=10Years
P = Br 50
10 Br 8.4 5 + Br. 19.30 = Br37.75

4.6 Dividend Discount Model

Many investors do not contemplate selling their stock in the near future but are long term
holders. Since a common stock held with such intention has an infinite life, we need to
accommodate the potentially endless series of dividends that may be received in the future on the
stock. The value of such stock is:
D1 D2 D3 Dn D∞
Po = (1+ks) + (1+ks)2 + (1+ks)3 + ……….. (1+ks)n + (1+ks)∞
This equation is a more general form of the stock valuation model. It is often referred to as the
dividend discount model because it shows the current price of the stock as determined by the
discounted future expected dividends. It is an extremely important.
To implement the dividend valuation model which requires that we discount the entire future
stream of expected dividends, we must model the expected growth rate of dividends. There are
three cases of growth in dividends. They are
1. Zero growth
2. Constant growth and
3. Non constant or super normal growth

4.6.1. Zero Growth (No Growth)

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Suppose dividends are not expected to grow at but to remain constant. Here, we have a zero
growth stock for which the dividends expected in future years are equal to some constant amount

that is D1=D 2=D 3. ...... .. .D ∞= D. Notice the two conditions implied here (1) un changing
cash flows (2) this continues for ever .when these conditions occur, the dividend discount model
mathematically reduces to a much simpler form called the constant dividend or no-growth
model:
Do
Po = Ks
Po = the current market price
Do= unchanging dividend
Ks = required rate of return
Example: - If dividends for MM Company are expected to be constant at Br 2.50 per share
forever and if the required rate of return on equity is 10 percent. Compute the value of the stock.

Given Required Solution

Do
Do = Br 2.50 Po =? Po= Ks
Br2.50
Ks = 10% = 0 .1               = Br 25

4.6.2. Normal or Constant Growth (Gordon Growth Model)

Many companies have expected dividend streams that can be roughly described as growing at
constant rate for along period of time. Thus, if a normal, or constant, growth company’s last
dividend, which has already been paid was Do , its dividend in any future year t may be
forecasted as Dt = Do (1+g)t ,where is the constant expected rate of growth. The value of a stock
whose dividend is expected to increase at constant rate is given as:

Ks−g¿ Ks−g ¿
Do(1+g)¿ ¿ D1¿ ¿
Po= ¿ or, equivalently since D1= Do (1+g), Po= ¿ in, general, Dt = Do
(1+g) t
Where
Do = Current dividend (Dividend just paid by the firm)

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D1= Expected dividend in one year
Ks = required rate of return
g= Expected percent growth in dividends
Assumptions in Constant (Gordon Growth) Growth Model
 The expected dividend growth rate, g, is constant from year to year.
 The constant growth is forever (g = ∞ )
 Ks > g.
Example: Consider a common stock that paid a $ 5 dividend per share at the end of the last year
and is expected to pay cash divided every year at a growth rate of 10 percent. Assume the
investor’s required rate of return is 12% .what would be the value of the stock?
Given Required Solution

Do(1+g) $5.5
Do = $5, g = 10% Ks = 12% Po =? Po= ks−g = 0.02 = $ 275
4.6.3. Non Constant or Supernormal Growth Model

Many firms enjoy periods of rapid growth. These periods may result form the introduction of a
new product, a new technology, or an innovative marketing strategy. However, the period of
rapid growth can not continue indefinitely. Eventually, competitors will enter the market and
catch up with the firm.
These firms cannot be valued properly using the constant growth stock valuation approach. This
section presents a more general approach which allows for the dividends/ growth rates during the
period of rapid growth to the dividends/ growth rates during the period of rapid growth to be
forecasted. Then it assumes that dividends will grow form that point on at a constant rate reflects
the long-term growth rate in the economy. Stock which are experiencing the above pattern of
growth rate are called non constant, supernormal, or erratic growth stocks. The value of a non
constant growth stock can be determined using the following equation.

T
DT DT+1
Po = ∑¿¿t=1 (1+ks)t +
( Ks−gc ) ( 1+ks )−T
Where
Po = the stock price at time 0
Dt = Expected dividend at time t.

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T = the number of years of non constant growth
Ks = the required return on the stock, and gc < Ks
Example: - The current dividend on stock is Br 2 per share and investors required rate of return
of 12%. Dividends are expected to grow at rate of 20% per year over the next three years and
then a rate of 5% per year form that point on .Find the price of the stock.

Solution
There are 3 years of non constant growth, thus, T = 3. Before substituting in to the formula given
above, it is necessary to calculate the expected dividends for year 1 though year 4 using the
provided growth rates.
D1=Br 2 (1−20)=Br 2. 40
D 2=Br 2 . 40 (1 .20 )=Br 1 . 88
D3 =Br 2. 88 (1 .20 ) =Br 3. 456
D 4 =Br 3 . 456 (1 . 05) =Br 3 . 6288
Using the formula
Br 2.40 Br 2.88 Br 3. 456 Br 3.6288
Po= (1.12)1 + (1.12)2 + (1.12 )3 + (0.12−0.05 ) (1.12)−3 = Br 43.80

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