TCH302

Bodie (2000), Chapter 7, 8, 9

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Financial Mathematics
• A quick review from previous session
𝑃𝑉 = 𝑪𝑭𝒕 1 + 𝑖

• Some small modifications to the notation for this lecture:

1. Calculating a price today, P0
2. Future cash flows noted as CFt
3. Start from t=1, because if you purchase a stock or bond today you are generally
not entitled to CF0.
4. The discount rate will be noted as r, ke or kd.
𝒏
𝒕
𝑷𝟎 = 𝑪𝑭𝒕 𝟏 + 𝒓
𝒕 𝟏

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Valuation fundamentals
⦁Valuation is the process that links risk and return to estimate the worth of an asset
or a firm.
Book value is the accounting value of a firm or an asset. Be an historical value
rather than a current value. Reported in the financial statement.
Market value is the price that the owner can receive from selling an asset in the
market place. The key determinant of market value is supply and demand for the
asset.
Intrinsic value, also called fundamental value, is a measure of the theoretical
value of an asset. Because determining the intrinsic value requires estimates,
we may never know the “actual” or “true” intrinsic value of some financial
assets. Nonetheless, intrinsic value serves as a basis for determining whether to
buy or sell a financial asset when compared to its market value or price.

⦁In efficient capital market, the fundamental value = its market value.
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Discounted Cash Flow Valuation
Valuation is the process that links risk and return to estimate the worth of an asset
or a firm.
The valuation of any financial asset is a function of the:

•amount of the expected cash flows (returns) generated by the asset over its life;
•timing of the cash flows; and

•riskiness associated with these cash flows as measured by the required rate of return.

3 step:
1. Estimate the future cash flows expected over the life of the asset.
2. Determine the appropriate required rate of return on the asset.
3. Calculate the present value of the estimated cash flows using the required
rate of return as the discount rate.

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⦁Discounted Cash Flow Valuation:
Estimating the required rate of return
The required rate of return consists of three major components:
•Real risk-free rate of interest (RRFR) is a default free rate in which investors
know the expected returns with certainty.
•Expected inflation rate premium (INF) is an adjustment to the real risk-free
rate to compensate investors for expected inflation. The nominal risk-free rate
(NRFR) is the combination of the real risk-free rate and the expected inflation
rate premium.
•Risk premium (RP)

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Discounted Cash Flow Valuation
Standard financial securities entitle the owner to a stream of payments in the
future. The value/price of such a security is the present value of its future payments
(cash flows).

• Debt: Interest/Coupon (C) + Repayment of Face Value (FV)

𝒏
𝒕
𝑃 = 𝐶 1+𝑟 + 𝐹𝑉 1 + 𝑟 = 𝑪𝑭𝒕 𝟏 + 𝒓
𝒕 𝟏

• Equity: Dividends

𝒕
𝑃 = 𝐷 1+𝑟 = 𝑪𝑭𝒕 𝟏 + 𝒓
𝒕 𝟏

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Capital market instruments – Bond
Bonds are long-term debt securities:
• issued by corporations and government agencies to support their operations
• which the issuers promise to repaid to bondholders in some date in the future
Maturity: The period from the date of issuing to expired date
Par value/ face value: the amount that the issuer must pay to maturity

By issuer: Corporate bonds & Treasury bonds

By interest payment: Coupon bonds & Discount bonds

By coupon rate: Plain – vanilla bonds & floating rate bonds

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Capital market instruments – Coupon bond
Coupon bond: bond that the issuer promises:
• to make periodic payments of interest – called coupon payments *
– to the bondholder for the life of the bond,
• to pay the face value of the bond when the bond matures
* Coupon payments: at coupon rate – the interest rate applied to the face value
E.g. A bond with a face value of $100 that makes annual coupon payment at
a coupon rate of 10% and its maturity is 10 years.

 The issuer has to pay (every year)

 At the end of 10 years, the issuer pays

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⦁Coupon Bond
0 1 2 3 ... n-2 n-1 n

Coupons C C C C C C
Face Value F
Coupons are an annuity, price
𝐶 using PV of Annuity Formula
(1 + 𝑟)
…… ……
𝐶+𝐹
Required rate (r)
(1 + 𝑟)

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⦁Coupon Bond
Example 1:
$100 bond, 10% annual coupon and 10 years to maturity. Value of bond with kd = 8%
0 1 2 3 ... 8 9 10

Coupons 10 10 10 10 10 10
Face Value 100
𝟏 𝒏
𝑃 = 𝐶𝐹 1 + 𝑘 =𝑪 𝟏− 𝒏
/𝒌𝒅 + 𝑭𝑽𝒏 𝟏 + 𝒌𝒅
𝟏 + 𝒌𝒅
CF= $10

= 10 1 + 0.08 + 10 1 + 0.08 + ⋯ + 110 1 + 0.08

=125* (1-1/
1
= 10 1 − /0.08 + 100 1 + 0.08
1 + 0.08

= 113.420

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⦁Coupon Bond

Example 2:
Corporation A issued an annual-pay bond with a 10 percent coupon rate and a
$1,000 par value 25 years ago. The bond now has 20 years remaining until
maturity. Due to changing interest rates and market conditions, the required rate of
return on this bond is 8 percent. That is, the discount rate on the bond is 8 percent.
What is the intrinsic value of the annual-pay bond?

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Capital market instruments – Discount bond (zero-coupon bond)
(Pure) discount bonds (zero – coupon bonds): bonds that promise a single payment
of cash at some date in the future, called the maturity date.
 The interest earned by investors:
the face value – the price

E.g. A pure discount bond with a face value of $1000 maturing in one year and
a purchase price of $950

 During this 1 year, it does not make any payment

 At the end of 1 year, the holder receives the amount of $1000 (face value)

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⦁Zero-coupon Bond
0 1 2 3 ... n-2 n-1 n

Face Value F

Required rate (r)

r or kd represents the market required rate of return given the current economic cost of funds,
default risk, time-to-maturity and coupon of a particular bond.

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⦁Zero-coupon Bond
Example 3:
Suppose Corporation A has a 20-year zero coupon bond with a maturity value of
$1,000. If investors require an 8 percent rate of return, what is the value of this
zero-coupon bond?

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⦁Bond pricing relationships
Example 4:
Required rate/ Yield
Par value Coupon rate Maturity
8% 10% 12%
1,000 10% 10 $1134,2 $1000 $887

• Something to note about bond prices.

• if P0 < FV, bond is selling at a discount,
• if P0 = FV, bond is selling at a par,
• if P0 > FV, bond is selling at a premium,

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⦁Bond pricing relationships
Example 5:
Required rate
Par value Coupon rate Maturity
8% 10% 12%

1,000 10% 10 $1134,2 $1000

1,000 10% 8 $1114,9

1,000 10% 6 $1092,4

1,000 10% 4 $1066,2

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⦁Bond pricing relationships

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⦁Bond yields
⦁Yield to maturity (YTM), also known as promised yield, is the rate of
return that investors expect to earn if they buy a bond at its market price and
hold it until maturity.
Yield to maturity involves three embedded assumptions:
1. Investors will hold the bond to maturity.
2. Investors will receive all coupon payments in a prompt and timely fashion.
3. Investors will reinvest all coupons to maturity at a rate of return that
equals the bond’s YTM.
Rate of return

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⦁Bond yields
Example 6:
Suppose a 15-year, $1,000 par value, 10 percent annual-pay bond is currently
trading at a price of $1,100. What is the bond’s yield to maturity? If an investor
requires a 5.5 percent return, would this bond be attractive? YTM= 8,7%

Example 7:
A 5- year, 10% coupon bond with a face value of 1000 USD, payment annually is
selling for 965 USD. Calculate the YTM ? 10,95%

Example 8:
A discount bond with a face value of 1000 USD is currently selling for 850 USD,
maturing in 2 years. Calculate the yield to maturity? 8,465%

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 C= 900k
Example 9: C= 900k
A 10-year, 9%-coupon bond with a face value of 10 million VND is currently
bought for 9.5 million VND and you intend to sell one year later for the
price P’. YTM= 9,81%
a. Write down a formula used to calculate yield to maturity.
b. Use a calculator or Excel to calculate the yield?
YTM= 9,81% RoR= (900k-500k)/9500k
c. P’= 9 million VND, YTM and the rate of return?
d. P’= 8.5 million VND, YTM and the rate of return?

RoR= (Coupon + Psell - Pbuy)/ Coupon Price Pbuy

= (0,9m + 9m-9,5m)/ 9,5m
= 0,4m/9,5m = 4,21%

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⦁Interest rate risk
⦁Interest rate risk, which is the sensitivity of bond prices to changes in interest rates

Required rate
Par value Coupon rate Maturity
8% 10% 12%
1,000 10% 10 $1134,2 $1000 $887

1,000 10% 4 $1066,2 $1000 $939,25

Required rate
Par value Coupon rate Maturity
8% 10% 12%
1,000 10% 10 $1134,2 $1000 $887

1,000 5% 10 $798,7 $692,77 $604,5

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Coupon bond has: F= 1,000
C=117,46

n YTM0 P0 YTM1 P1 R

20 10% CR= 11,746 1,000 15%

15 10% 1,000 15%
5 10% 1,000 15%
1 10% 1,000 15%
15 10% 1,000 8%
5 10% 1,000 8%
1 10% 1,000 8%
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⦁Coupon Bond

BBB Corp.
A Corp.
AAA Corp. AA QLD GOV
AA Corp.

AAA AUS GOV

(Sean Wu , 2022) 23
⦁Coupon Bond

(Sean Wu , 2022)

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⦁Coupon Bond

(Sean Wu , 2022)

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⦁Stock - Shares
• An owner of a share is entitled to future dividend payments.
• Share value = present value of these dividends

where ke = cost of equity capital

• We start at t = 1
• If you purchase a stock that will pay a dividend soon (let’s call it D0), you are not entitled to
that dividend if you purchased the stock on or after the ‘ex-dividend date’, which is
generally about a month before the actual dividend is paid

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⦁Stock - Shares
• Remember the perpetuity formula

• We can apply it (and some variants) to shares

• We’ll need to make some assumptions, watch timing of cash flows and come up
with an appropriate discount rate.

• Basic models
• Perpetuity (constant dividend)
• Constant growth (dividend that grows at a constant rate)
• Standard model (non-constant dividends at the start)

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⦁Stock - Shares
• Perpetuity
• Assume dividends are constant

𝟎
𝒆

Where D = constant dividend (to be received in one-period’s time)

“ke” cost of equity capital

• This approach can realistically be applied to non-redeemable preference shares

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⦁Stock - Shares
Example 11
What is price of a non-redeemable preference share that pays a constant dividend
of 90 cents per year if the discount rate (required rate of return) is 15%? The
dividend has just been paid.

P0= D/ke = 90%/15% = 6

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⦁Stock - Shares
• Constant Growth Model
• Assume dividend grows at a constant rate (g) 𝑫𝟏 𝑫𝟎 × (𝟏 + 𝒈)
𝑷𝟎 = =
𝒌𝒆 − 𝒈 𝒌𝒆 − 𝒈

where g = constant growth rate of dividends to ∞

• Advantages
• potentially more realistic than constant dividend
• relatively easy to calculate
• is an important part of the standard model (covered next)
• Limitation
• unlikely to find shares with growth pattern demanded by the model

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⦁Stock - Shares

Example 12
What is the value of a share that just paid a 90-cent dividend, where dividends
are expected to grow at 10% p.a. forever and the required rate is 15%?

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⦁Stock – Shares – Standard Model
•Assume particular dividend values until a certain date and from then make one
of the previous two simplifying assumptions
𝒏
𝒕 𝒏
𝟎 𝒕 𝒏 where
𝒆 𝒆
𝒕 𝟏

Valuing Valuing
non-constant constant
dividends dividends

•Advantage - More flexible

•During the business cycle you find that firms grow at different rates during
the cycle.
•Typically, new firms will grow rapidly in early years then level out to some
lower growth rate as their market matures.

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⦁Stock - Shares
Example 13
A stock’s current dividend of $1.00 has just been paid. Dividends are expected
to grow by 12% for the next five years and 6% forever after that. The required
rate of return is 10%. What is the price of the share?

To start, let’s do a timeline of dividends

g = 12% g = 6%

0 1 2 3 4 5 6 7 …

$1.12 $1.25 $1.40 $1.57 $1.76 $1.87 $1.98

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⦁Stock - Shares
g = 12% g = 6%

0 1 2 3 4 5 6 7 …

1
$1.12 $1.25 $1.40 $1.57 $1.76 $1.87 $1.98

2 Determine the period of constant

3 1 dividend growth
𝐷 𝑃 Calculate PV of dividends in the 1st
𝑃 = + 2 growth stage
1+𝑘 1+𝑘
4 3 Calculate PV of dividends in the
5 constant growth stage at n, PVn (Pn)

4 Discount Pn to 0 using (1+ke)n

𝐷
𝑃 = PV0 = PV of non-constant dividends
𝑘 −𝑔 5
+ PV of constant dividends

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⦁Stock - Shares
• Example 13 cont.
g = 12% g = 6%

0 1 2 3 4 5 6 7 …

1
$1.12 $1.25 $1.40 $1.57 $1.76 $1.87 $1.98

2 3

5
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⦁Stock - Shares
Example 14
A commencing company is expected to pay the following dividends: $0.12 in year 3,
$0.18 in year 4 and $0.25 in year 5. All further dividends will grow at 5% indefinitely.
Investors require a return of 15%. What do you think that the share price should be?

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