FINA2203

Spring 2022‐23

Tutorial 9

Topic Review
• Chapter 6 con’t: Bonds
• Chapter 7: Stock Valuation

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6.5 Corporate Bonds
Question 10
Your firm has a credit rating of A. You notice that the credit spread for
five‐year maturity A debt is 85 basis points (0.85%). Your firm’s five‐
year semiannual coupon debt has a coupon rate of 6%. You see that
new five‐year semiannual coupon Treasury notes are being issued at
par with a coupon rate of 2.0%. What should the price of your
outstanding five‐year bonds be per $100 of face value?

6.5 Corporate Bonds

• You see that new five‐year semiannual coupon Treasury notes are
being issued at par with a coupon rate of 2.0%. ‐> YTM for five‐
year semiannual coupon Treasury notes is 2.0%. It is the same as
coupon rate because they are issued at par.
• The appropriate YTM for the corporate bonds is the comparable
Treasury plus the credit spread, which is 2.0% + 0.85% = 2.85%.
• Using formula:
PV= 1 = 114.58
. % . % . %

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7.3 The Dividend‐Discount Model
• Dividend Discount Model
Dividend Discount Model (DDM) is the value of a stock which is
equal to the present value of the dividends and future sale price
the investor will receive. (If it is never acquired, the stock price
equals the PV of all future dividends.)

7.3 The Dividend‐Discount Model

Question 1
Valorous Corporation will pay a dividend of $1.75 per share at this
year's end and a dividend of $2.35 per share at the end of next year.
It is expected that the price of Valorous' stock will be $41 per share
after two years. If Valorous has an equity cost of capital of 9%, what
is the maximum price that a prudent investor would be willing to pay
for a share of Valorous stock today?

0 1 2 3 4 5
A) $32.38 ...
B) $36.19 D1 = $1.75 D2 = $2.35
P2 = $41

C) $38.09 $ . $ $ .
D) $39.99 P = + $38.09 per share
. .

Answer: C 6

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7.4 Estimating Dividends in the DDM
Constant Dividend Growth Model
• Constant Dividend Growth Model has two assumptions.
• Common stock dividends will grow at a constant rate into the future
indefinitely.
• Value of a stock is the present value of the future dividends expected to
be generated by the stock.

7.4 Estimating Dividends in the DDM

Question 2
The constant growth model:
I. assumes that dividends increase at a constant rate forever.
II. can be used to compute a stock price at any point in time.
III. can be used to value zero‐growth stocks.
IV. requires the growth rate to be less than the required return.

A) I and III only

B) II and IV only
C) I, II, and IV only
D) I, III, and IV only
E) I, II, III, and IV

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7.4 Estimating Dividends in the DDM
• Item I is correct. Given a dividend per share that is payable in one year, and the
assumption the dividend grows at a constant rate in perpetuity, the model
solves for the present value of the infinite series of future dividends.

• Item II is correct. It can compute a stock price at any point in time.

7.4 Estimating Dividends in the DDM

• Item III is correct. Assume the growth rate is 0, the constant growth model can
compute a stock price.

• Item IV is correct. The constant growth model requires the growth rate to be
less than the required return. Recall the formula.

If the growth rate is “higher” than the required rate of return, the stock price is very
“unrealistic”.

Answer: E 10

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7.4 Estimating Dividends in the DDM
Question 3
Marcel Co. is growing quickly. Dividends are expected to grow at a 30
percent rate for the next three years, with the growth rate falling off
to a constant 6 percent thereafter. If the required return is 13 percent
and the company just paid a $1.80 dividend, what is the current
share price?

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7.4 Estimating Dividends in the DDM

• The stock begins constant growth in Year 4, so we can find the price of the stock
in Year 3, one year before the constant dividend growth begins as:
$ . . .
P $59.88
. .
• The price of the stock today is the PV of the first three dividends, plus the PV of
the Year 3 stock price. The price of the stock today will be:
P + + +
$ . . $ . . $ . . $ .
P + + +
. . . .
P $48.7 per share

0 1 2 3 4 5 N N+1
...
1.8(1+g1) 1.8(1+g1)2 1.8(1+g1)3 1.8(1+g1)3(1+g2)
P3

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 Q&A

Thank You!