4,5,6,7

By the end of this lecture you should be able to:
•Explain what a bond is and who issues bonds

•Understand basic bond terminology
•Calculate the value of a bond given the coupon rate, required return,
and time to maturity of the bond
•Estimate the value of a zero-coupon bond
•Explain the concept of yield to maturity and how it can be calculated.
•Describe the behaviour of bond prices, yield to maturity versus coupon
rate concept
© Irina Mateus 2023 2

Introduction
Imagine a company needs to invest in new plant or equipment
Options:
• use accumulated earnings
• sell additional shares of stock
• obtain cash from borrowing
Borrowing:
• from a bank (if cash is needed for a short-term)
• issue bonds (if cash is needed for long-term investments)

Issuer of the debt security - entity that promises to make the
payment
• governments (i.e. government bonds, treasure notes – issuers i.e. US
government, French government)
• regions and municipalities (municipal bonds – issuers i.e. the state of
New York)
• supranational entities (global entities that are not based in a specific
nation, i.e. - World Bank or the European Investment Bank)
• government-related agencies of a central government (i.e. Fennie Mae,
Freddie Mac)
• companies (corporate bonds – i.e. Coca-Cola, Apple)
The issue of the bond is called the borrower

The investor who purchases the bond – the lender or creditor.
What is Bond?
Bonds are fixed-income securities that are issued by corporations and

governments to raise capital.
A bond is a debt obligation. It is a financial obligation of an entity that promises to

pay a specified sum of money at specified future dates.
The promised payments consist of two components:

• Interest on the principal
• principal (paid at maturity, also called par value, face value)
Many bonds pay a fixed rate of interest throughout their term.
Other bonds offer floating rates that are reset periodically, such as every six
months. adjust their interest payments to changes in market interest rates.
(Based on a bond index or other benchmark, i.e. treasury bond plus 1%.).

Capital Market Trading
Occurs in either primary market or the secondary market
Primary market: where new issues of stocks and bonds are introduced.
Investment funds, corporations, and individual investors can all purchase
securities offered in the primary market. (IPO – initial public offering).
Secondary market: where the sale of previously issued securities takes

place, and it is important because most investors plan to sell long-term
bonds before they reach maturity.
While some bonds are traded publicly through exchanges, most trade
over-the-counter between large broker-dealers acting on their clients’ or
their own behalf.

Bond terminology
Bond indenture (also trust indenture or deed of trust) - the bond contract
Document which details the legal obligation of the corporation to the

bondholders. The indenture lists all the terms and conditions of the bond
(i.e. interest rate, maturity date, convertibility, promises, covenants)
Bond Covenant
Designed to limit credit risk. Negative or restrictive covenants forbid the
issuer from undertaking certain activities; positive or affirmative covenants
require the issuer to meet specific requirements.
Bonds are Securities that represent a debt owned by the issuer to the
investor.
Bonds obligate the issuer to pay a specified amount at a given date,
generally with periodic payments

If the repayment terms of a bond are not met, the holder of a bond has a claim on
the assets of the issuer
Par Value (the principal, face value)

It refers to the initial amount borrowed in a loan. The amount that the issuer
agrees to repay the bondholder at or by the maturity date (principal value, face
value, redemption value or maturity value).
Coupon - the regular interest payment received by the buyer. It is expressed as

a percentage of the bond's face value. It also represents the interest cost of the
bond to the issuer.
Coupon Rate (nominal rate, APR)

The coupon rate determines the amount of each coupon payment. Is the interest
rate that the issuer agrees to pay each year. This rate is usually fixed for the
duration of the bond and does not fluctuate with market interest rates.
𝑪𝒐𝒖𝒑𝒐𝒏 𝑹𝒂𝒕𝒆 𝒙 𝑷𝒂𝒓 𝑽𝒂𝒍𝒖𝒆

𝒄𝒐𝒖𝒑𝒐𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒄𝒐𝒖𝒑𝒐𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕𝒔 𝒑𝒆𝒓 𝒚𝒆𝒂𝒓
Example:
6% coupon rate and a par value of $1,000
Coupon (interest payment) = $60
United States (semi-annual instalments), Mortgage and Asset Backed

Securities typically pay interest monthly.
Maturity
Maturity date: The expiration date of the bond on which the final coupon
and the principal value are paid by the issuer.
The term of the bond: the time remaining until the repayment date
Type Maturity
Short-term 1 to 5 years
Intermediate-term 5 – 12 years
Long-term More than 12 years

Original Maturity -The time from when the bond was issued until its maturity
date.
Remaining Maturity -The time currently remaining until 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 money the issuer has to pay to call a callable
bond (there is a premium for calling the bond early). When a bond first
becomes 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 would earn if he/she
bought the bond at its current market price and held it until maturity.
Current Yield: yield of the bond at the current moment. It is equal to the
annual interest payment divided by the bond’s price. It does not reflect the
total return over the life of the bond and the fact that bonds usually mature
at par value, which can be an important component of a bond's return.
Treasury Securities
Type Maturity
Treasury Bill Less than 1 year
Treasury Note 1 to 10 years
Treasury Bond 10 to 20 years
The Valuation Principle
The price of a security today is the present value of all future expected
cash flows discounted at the “appropriate” required rate of return (or
discount rate)
The valuation variables are

1. Current price
2. Future expected cash flows - Face value and/or coupons
3. Yield or required rate of return
Valuation problems:
1. To estimate the price; given the future cash flows and required rate
of return, or
2. To estimate the required rate of return; given the future cash flows
and price

Zero Coupon Securities
Zero coupon bond is a bond that pays no interest and trades at a discount to its
face value (Example: US Treasury bills with a maturity of up to one year).
• Pays the face value at maturity

• Issued at deep discount to face value
• No coupons (interest payments)
• The difference between the purchase price of a zero-coupon bond and the
par value, indicates the investor's return
Example: a one-year Treasury bill with a $1,000 face value and an initial price
of $ 986.13.

Yield to Maturity: Zero-Coupon Bond
Yield to maturity (YTM) – the IRR of the investment opportunity.
It is a discount rate that equates the present value of a bond's future cash flows to
its current market price.
Example: a one-year Treasury bill with a $1,000 face value and an initial price of $
986.13. Estimate the yield to maturity.
𝐹𝑉
𝑃𝑉 = 𝑛
1+𝑖
1,000 1,000
986.13 = ; 𝑌𝑇𝑀 = − 1 = 0.014; 14%
1 + 𝑌𝑇𝑀 986.13
Yield to Maturity , Zero-Coupon Bond, n-Year

𝟏ൗ
𝒏
𝐹𝑉 𝑭𝑽
𝑃𝑉 = 𝑛; 𝒀𝑻𝑴 = −𝟏
1 + 𝑌𝑇𝑀 𝑷𝑽

Pricing Zero Coupon Securities
Example: Consider a zero coupon bond which matures in 5 years with a face
value of $1,000
a) If the bond has a yield to maturity of 8% what price should it be selling for
today?
b) b) Suppose interest rates change suddenly and the price of these bonds
rises to $700. What has happened to the yield to maturity of the bonds and
why?
a) Given: P₁ = $1,000, n = 5 years, and YTM = 8%
𝐹𝑉 1000
𝑃𝑉 = 𝑛
= 5
= $680.58
1+𝑖 1 + 0.08
b) The price has risen so you'd expect the YTM to be lower

1ൗ 1ൗ
𝑛 5
1000 𝐹𝑉 1000
700 = ; 𝑌𝑇𝑀 = −1= − 1 = 7.39%
1+𝑖 5 𝑃𝑉 700

Risk-Free Interest Rates
Risk-free interest rate – the yield to maturity on a
default-free zero-coupon bond
The default-free, zero-coupon yields are also

referred to as spot interest rates.
The yield curve is also referred to as the zero-

coupon yield curve.
Example: Based on the information about the current trading prices for zero-
coupon bonds, determine the corresponding spot interest rates required to build
a zero-coupon yield curve. Assume $100 FV.
𝟏ൗ Maturity Price
𝒏
𝑭𝑽 100
𝒀𝑻𝑴 = − 𝟏; 𝑌𝑇𝑀1 = − 1 = 0.0275 1 year $97.32
𝑷𝑽 97.32
𝟏ൗ 𝟏ൗ
100 𝟐 100 𝟑 2 year $94.26
𝑌𝑇𝑀2 = − 1 = 0.03 ; 𝑌𝑇𝑀3 = − 1 = 0.035
94.26 90.19 3 year $90.19
𝟏ൗ
100 𝟒 4 year $86.31
𝑌𝑇𝑀3 = − 1 = 0.0375
86.31
Valuing Discount Securities
The face value (Pn) is promised at a pre-specified date – no other payment
promised
Interest earned is “implicit” in the difference between the face value and current
market price, P0
Examples: Treasury Bills, Commercial Paper, Bank Bills. Face value is typically
$100,000 or its multiple
The price is computed as the present value at a specified yield
The interest rate for maturity of less than 1 year is:
Example: Consider two Treasury bills, each with a face value of $100,000 and
maturing in 180 and 90 days, respectively. Assume the yield is 6% p.a. What are
their prices today? What happens to T-bill prices as they approach maturity?
Valuing Discount Securities

Coupon Bonds
The bonds that make fixed coupon payment, typically every six months
and repay face value at maturity.
Examples: Treasury notes (maturities from 1 to 10 years), Treasury bonds

(maturities above 10 years)
Market price depends on the rate of return required by investors

Pricing a Bond
Equal to the present value of the expected cash flows from the financial
instrument. Determining the price requires:
• An estimate of the expected cash flows
• An estimate of the appropriate required yield
The price of the bond is the present value of the cash flows, it is
determined by adding these two present values:
i) The present value of the coupon payments (often semi-annual)
ii) The present value of the par or maturity value at the maturity date
𝐶 𝐶 𝐶 𝐶 𝐹𝑉
𝑃0 = + + … + 𝑛+
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 1+𝑟 (1 + 𝑟)𝑛

𝑛
𝐶𝑛 𝐹𝑉
𝑃𝑉 = ෍ 𝑡
+ 𝑛
1+𝑟 1+𝑟
𝑡=1
PV = Price
n = number of periods (nr of years times 2, if semi-annual)
C = semi-annual coupon payment
r = periodic interest rate (required annual yield divided by 2, if semi-
annual)
t = time period when payment is to be received

Because the semi-annual coupon payments are equivalent to an ordinary
annuity, applying the equation for the present value of an ordinary annuity
gives the present value of the coupon payments:
Consider a 20 year 10% coupon bond with a par value of $1,000. The required
yield on this bound is 11%.
The PV of the par or maturity value of $1,000 received 40 six-month periods

from now, discounted at 5.5%, is $117.46, as follows:
Price = PV coupon payments + PV of par (maturity value)

$802.31 + $117.46 = $919.77
Yield to Maturity on bonds
The YTM for a bond is the IRR of investing in the bond and holding it to maturity.
It is a single discount rate that equates the present value of a bond's future cash
flows to its current market price.
𝐶 𝐶 𝐶 𝐶 𝐹𝑉
𝑃0 = + + … + 𝑛+
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 1+𝑟 (1 + 𝑟)𝑛
If 𝑃0 , 𝐶, 𝐹𝑉 are known you can estimate r (YTM). The precise calculate will require
a sophisticated handheld calculator, or a computer. If you do manually, use
Interpolation method (a trial-and-error procedure) estimate an unknown
number that lies somewhere between two known numbers.
When you calculate YTM based on the formula above, the computed yield will be
the rate per coupon interval (6 months yield if semi-annual interest). But should be
converted to an APR with the corresponding compounding period.

Example: Estimate the yield to maturity of the five-year bond paying a 6% coupon
rate that is currently trading at a price of $ 965.32. The coupons are paid semi-
annually, and the face value of the bond is $1000.
Solution:
Because the bond pays coupons semi-annually, it has 10 remaining coupon
payments (5*2), the coupon rate per period = 6/2=3%,
the coupon = 0.03*1000=30
𝐶 1 𝐹𝑉
𝑃𝑉𝑂𝐴 = 1− +
𝑟 (1 + 𝑟)𝑛 1+𝑟 𝑛
30 1 1000
965.32 = 1− + ; 𝑟 = 0.03415 3.415%
𝑟 (1 + 𝑟)10 1 + 𝑟 10
r= the yield for a six-month period
To convert to APR multiply the rate per coupon interval by the number of coupon
payments per year
Thus, 3.415*2 = 6.83% YTM equal to 6.83% APR with semi-annual
compounding
The price of each bond can be converted into a yield and vice versa
Prices and yields are often used interchangeably.
Following the previous example, the bond can be quoted as having a yield of
6.83% or a price of $965.32 per $1000 face value.
Very often bond traders quote bond yields instead of bond prices.
When prices are quoted in the bond market, they are typically quoted as a
percentage of the face value.
Following the previous example, 96.532 will indicate the actual price of $ 965.32
per $1000 face value of the bond.

Bond prices, Rates, and Yields
At Par: YTM = coupon rate
At discount: YTM > coupon rate
At Premium: coupon rate > YTM

Yields to Maturity on a 10% Coupon rate Bond Maturing in 10 years
(Face Value = $ 1,000)
Price of Bond (4) Yield to Maturity
1200 7.13
1100 8.48
1000 10.00
900 11.75
800 13.81
1. When the coupon bond is priced at is face value, the YTM equals the coupon
rate
2. The price of a coupon bond and the YTM are negatively related; that is, as
the YTM rises, the price of the bond falls. If the YTM falls, the price of the
bond rises
3. The YTM is greater than the coupon rate when the bond price is below its
face value
Yield to Maturity on bonds vs Current Yield
Yield to maturity (YTM) is the expected rate of return on a bond if bought at its
current market price and held to maturity; it is also known as the bond’s internal
rate of return (IRR).
Mathematically, it is an interest rate that equates the present value of cash flows
received from a bond with its current market price.
YTM is the yield promised to the bondholder on the assumption that the bond will
be held to maturity, that all coupon and principal payments will be made and
coupon payments are reinvested at the bond's promised yield at the same rate as
invested.
A bond’s yield to maturity is commonly referred to as the market required rate of

return on the bond.

The current yield is an approximation of the yield to maturity on coupon bonds
that is often reported, because, in contrast to YTM it is easily calculated.
It is defined as the yearly coupon payment divided by the price of the security,
𝐶
𝑟𝑐 =
𝑃
where 𝑟𝑐 - current yield
P - price of the coupon bond
C - yearly coupon payment
The formula is identical to the YTM for a consol (perpetual CF).
The current yield - a close approximation of the yield to maturity for a long-term
coupon bond, not a good approximation for short-term bonds.

The current yield is equal to the coupon rate when the bond price is at par.
the closer the bond price is to the bond’s par value, the better the current
yield will approximate the yield to maturity.
At Par: YTM = current yield = coupon yield.

At Discount: YTM > current yield > coupon yield
At Premium: coupon yield > current yield > YTM
The current yield and the yield to maturity always move together
A rise in the current yield signals that the yield to maturity has also risen.
Regardless of whether the current yield is a good approximation of the yield to

maturity, a change in the current yield always signals a change in the same
direction of the yield to maturity.
Time and bond prices
Assuming YTM are constant. The price of zero-coupon bond rises smoothly as it
approaches it’s maturity date.
The price of a coupon bond rises before each coupon and tumbles on the coupon
date (by the amount of coupon). Ultimately, approach the FV at maturity.
Source: Berk J. and DeMarzo P., Corporate Finance, 5th Edition, Pearson

By the end of this lecture you should be able to:
• Distinguish risks associated with investing in bonds
• Explain price/yield relationship for an option-free bond
• Explain the impact of maturity and coupon rate on bond’s price sensitivity
• Explain the concept of Duration
• Compute Macauley, Modified and Effective Duration
• Understand the concept of convexity
• Understand the intuition behind the arbitrage-free approach to bond
valuation

The arbitrage-free Approach to Bond Valuation
Stripping and Reconstituting Bonds
STRIPS (Separate Trading of Registered Interest and Principal of Securities).

STRIPS - “zero-coupon” securities Can be used to replicate a coupon bond
let investors hold and trade the individual interest and principal components
of eligible Treasury notes and bonds as separate securities.
Example: replicate a three-year, $1000 bond that offers 10% annual coupons
using three zero-coupon bonds.
Source: Berk J. and DeMarzo P., Corporate Finance, 5th Edition, Pearsonc
The Law of One price states that the price of portfolio of zero-coupon bonds must
be equal to the price of the coupon bond. Otherwise arbitrage opportunities.
By looking at the prices/yields of default-free zero-coupon bonds (spot interest
rates), we can determine the price of an equivalent reconstituted default-free
bond.
Based on the above, the price of the three-year, $1000 bond that offers 10%
annual coupons must be $1,153.00
100 100 100 + 1000
𝑃0 = + + = $1153
(1.035) (1.04)2 (1.045)3

100 100 100 + 1000
𝑃0 = + + = $1153
(1.035) (1.04)2 (1.045)3
Where 𝑟1 , 𝑟2 , 𝑟3 −the spot rates or the yields for zero-coupon bonds
100 100 100 + 1000

$1153 = + + ; 𝑌𝑇𝑀 = 4.44%
(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)2 (1 + 𝑌𝑇𝑀)3
YTM - is a weighted average of the yields of the zero-coupon bonds of equal or

shorter maturities
If the parity does not hold:

If the price of the coupon bond is higher make an arbitrage profit by
selling the coupon bond and buying the zero-coupon bond portfolio.
If the price of the coupon bond is lower buy the coupon bond and short
sell the portfolio of zero-coupon bonds.

Risks Associated with Investing in Bonds
Credit Risk
Credit or default risk is the risk that a company will fail to timely make interest or
principal payments and thus default on its bonds (corporate and sovereign bonds).
The prospects of default reduce the price investors are willing to pay for a bond
The expected return of a corporate bond – risk-free rate plus a risk premium.
If risk of default: the bond’s expected return is less than YTM
A higher YTM does not imply that a bond’s expected return is higher.

Bond ratings
Downgrade Risk: Risk that the bond issue or issuer
credit rating will change.
Companies Moody’s, R&P and Fitch rate the
creditworthiness of bonds
Bonds in the top 4 categories – investment-grade
bonds, lower - speculative or junked bonds.
Sometimes called high-yield bonds.
Credit spread is the difference between the yield

(return) of two different debt instruments with the
same maturity but different credit ratings.
Credit spreads commonly use the difference in yield

between a same-maturity Treasury bond and a
corporate bond.
Credit spread - yield spread or the risk premium

attributable to default risk. © Irina Mateus 2023 7
Credit spread risk
The spread reflects the additional yield required by an investor for taking on
additional credit risk
The spread is the difference in returns due to different credit qualities.
Credit spreads are not static – they can tighten and narrow over time.
Driven by economic conditions.
Source: CFI

Sovereign Bonds
Sovereign Bonds are bonds issued by national governments.
Sovereign bond yields reflect investor expectations of inflation, currency and

default risk.

Interest-rate risk or market risk
As interest rates rise, the price of a bond fall (vice-versa)
The prices of bonds move in the opposite direction of interest rates.
This is because newer bonds will be issued paying higher coupons, making the
older, lower-yielding bonds less attractive.
If an investor has to sell a bond prior to the maturity date, an increase in interest
rates will mean the realization of a loss (i.e. selling the bond below the purchase
price) – which is the major risk faced by investors.
Interest rate risk is common to all bonds, even U.S. treasury bonds
Example:
Consider a 6% 20-year bond with a face value of $100. if the yield investors
require to buy this bond is 6%, the price of this bond would be $100 (selling at
par).
If required yield increase to 6.5%, the price of this bond would decline to $94.4479.
Thus, for a 50 basis point increase in yield, the bond’s price declines by 5.5%. If,
instead, the yield declines from 6% to 5.5%, the bond’s price will rise by 6.02% to
$106.0195. © Irina Mateus 2023 10
Price Volatility Characteristics of Bonds
The price of a bond will fall if market interest rates rise and vice versa.
The percentage price change is not the same for all bonds
Instantaneous Percentage Price Change for Four Hypothetical Bonds
(Initial yield for all four bonds is 6.%)
Percentage Price Change
Yield (%) 6%/ 5 year 6%/20 year 9%/5 year 9%/20 year
4.00 8.98 27.36 8.57 25.04

5.00 4.38 12.55 4.17 11.53
5.50 2.16 6.02 2.06 5.54
5.90 0.43 1.17 0.41 1.07
5.99 0.04 0.12 0.04 0.11
6.01 -0.04 -0.12 -0.04 -0.11
6.10 -0.43 -1.15 -0.41 -1.06
6.50 -2.11 -5.55 -2.01 -5.13
7.00 -4.16 -10.68 -3.97 -9.89
8.00 -8.11 -19.79 -7.75 -18.40
Interest Rate Risk and Bond Features
A bond’s maturity and coupon rate generally affect its sensitivity to changes in
market interest rates.
The impact of maturity

The longer the bond’s maturity, the greater the bond’s price sensitivity to changes
in interest rates
Thus, from the previous example: The 50 basis points yield increase resulted in
5.55% price decline for a 6% 20- year bond and in 2.11% for a 6% 5-year bond
The impact of coupon rate

The lower the coupon rate, the greater the bond’s price sensitivity to changes in
interest rates.
Thus, from the previous example: The 50 basis points yield increase resulted in
5.13% price decline for a 9% 20- year bond versus 5.55% price decline for a 6%
20- year bond
Important to consider when purchasing bonds in a low-interest rate environment!!

Duration
Duration is a measure of risk in bond investing.
It is a tool used in the assessment of the price volatility of a fixed-income security.
Two bonds with the same term to maturity do not mean that they have the same
interest-rate risk
It is an important measure for investors to consider, as bonds with higher durations

(given equal credit, inflation and reinvestment risk) may have greater price volatility
than bonds with lower durations.
Duration is commonly used in the portfolio and risk management of fixed income
instruments.

Macaulay Duration
It is a measure of the time required for an investor to be repaid the bond’s price by
the bond’s total cash flows.
The Macaulay duration is measured in units of time (e.g., years).

It is a weighted average of the times until the cash flows of a fixed income
instrument are received.
Source: Corporate Finance Institute

Macaulay Duration
It is a measure of the time required for an investor to be repaid the bond’s price by
the bond’s total cash flows (in years).
𝑛
𝑃𝑉𝑖
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = ෍ 𝑡𝑖 x
𝑉
𝑖
where 𝑡𝑖 - the time until the ith cash flow from the asset will be received,
𝑃𝑉𝑖 - the present value of the ith cash flow from the asset,
𝑉 - the present value of all cash flows from the asset
The Macaulay duration for coupon-paying bonds is always lower than the bond’s
time to maturity. For zero coupon bonds, the duration equals the time to
maturity.
The Macaulay duration of a bond can be impacted by the bond’s coupon rate,
term to maturity, and yield to maturity.
Calculating Macaulay Duration on a $1,000 ten-year 10% Coupon Bond
𝑃𝑉
when its Interest Rate is 10%. 𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = σ𝑛𝑖 (𝑡𝑖 x 𝑖)
𝑉
(1) (2) (3) (4) (5)
Year Cash Payments Present Value of Cash Weights Weighted Maturity
(Zero-Coupon Bonds) Payments (% of total) (1×4)
1 100 90.91 0.09091 0.09091
2 100 82.64 0.08264 0.16528
3 100 75.13 0.07513 0.22539
4 100 68.30 0.06830 0.27320
5 100 62.09 0.06209 0.31045
6 100 56.44 0.05644 0.33864
7 100 51.32 0.05132 0.35924
8 100 46.65 0.04665 0.37320
9 100 42.41 0.04241 0.38169
10 100 38.55 0.03855 0.38550
10 1000 385.54 0.38554 3.85540
Total 1,000.00 1.00 6.7589 (years)

Modified Duration
Modified duration identifies the sensitivity of the bond price to the change in interest
rate. It is thus measured in percentage change in price.
Is an adjusted measure of the Macaulay duration that produces a more accurate

estimate of how much the percentage change in the price of a bond will be per 100
basis points change in the interest rate.
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
𝑌𝑇𝑀
1+
𝑛
Where
YTM - is the yield to maturity of a bond
n - is the number of periodic payment (compounding) periods per year

Effective Duration
The drawback of modified duration is that it does not consider that interest rate
movements can change a bond’s cash flows. Example, the cash flows of bonds with
optionality (i.e. callable bonds: The issuer of a callable bond can ‘call’ the bond prior
to maturity, thereby returning principal to the bondholder earlier than expected)
When bonds offer an uncertain cash flow, the effective duration is the best way to
calculate the volatility of interest rates.
Effective duration further refines the modified duration calculation and is particularly
useful when a portfolio contains callable securities.
It captures the sensitivity of bonds to changes in interest rates, while also factoring
in a bond’s call structure. effective duration is called option-adjusted duration.
The difference between the modified and effective duration for option-free (i.e., non-
callable) bonds is very small. However, for some bonds with optionality, the
difference can be substantial.

Effective Duration
If the yield increased by a small amount r, from r0 to r+, the price of the bond will
decrease from P0 to P-.
Effective duration incorporates a bond’s yield, coupon, final maturity and call
features into one number that indicates how price-sensitive a bond or portfolio is to
changes in interest rates.
𝑃−Δ𝑟 − 𝑃+Δ𝑟
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
2𝑃0 Δ𝑟
𝑃−Δ𝑟 – The bond’s value if the yield falls by a certain percentage

𝑃+Δ𝑟 – The bond’s value if the yield rises by a certain percentage
𝑃0 – The present value of cash flows (i.e. the bond’s price)
Δ𝑟 – The change in the value of the yield

Example:
A 7% coupon, 5-year bond, yielding 6% is priced at 104.265. If its yield declines by

25 basis points to 5.75%, the bond’s price will increase to 105.366. On the other
hand, if its yield increases by 25 basis points to 6.25%, the price of the bond will
decline to 103.179. Compute the effective duration of the bond under these
conditions.
P- -P+ 105.366 − 103.179

DE= = = 4.2
2P0 Δr 2(104.265)(.0025)
If this bond’s yield increases by 1% (apparently because interest rates have

increased by 100 basis points), the price of the bond will fall by approximately 4.2%.

Calculating Bond Portfolio Duration
𝐷𝑝 = 𝑊1 𝐷1 + 𝑊2 𝐷2 + ⋯ + 𝑊𝑛 𝐷𝑛
Where:
wi = market value of bond i / market value of portfolio
Di = duration of bond i
n = number of bonds in portfolio
Example:
A barbell portfolio is constructed with 60% of its value invested in a 4-year bond
with an effective duration of 3.0 and 40% of its value invested in a 15-year bond
with an effective duration of 10.0. What is the effective duration of the portfolio?
𝐷𝑝 = 𝑊1 𝐷E1 + 𝑊2 𝐷E2 = 0.6 ∗ 3 + 0.4 ∗ 10 = 5.8

Effective Duration
It is an essential tool for assessing the interest rate risks of bonds with optionality,
such as callable municipal bonds and mortgage-backed securities (MBS).
Effective duration is a more complete measure vs. the Macauley or Modified

duration measures but it still falls short because it is a linear approximation for small
changes in yield.
Therefore, effective duration becomes a less accurate estimation of price

sensitivity to interest rates for larger changes in rates.
Price/yield relationship for a
hypothetical option-free bond
1) Although the price moves in the opposite
direction from the change in the yield,
percentage change is not the same for all
bonds
Price
2) For small changes in the yield, the

percentage price changes for a given
bond is roughly the same, whether the
yield increases or decreases.
3) For large changes in yield, the percentage
price change is not the same for an
increase in yield as it is for a decrease in
Yield yield
4) For a given large change in yield, the
percentage price increase is greater than
the percentage price decrease.

Convexities: Positive versus Negative
Bond A is more convex than Bond B even though they both have the same
duration, and hence Bond A is less affected by interest rate changes.

Convexity
Duration is important – is the first-order measure of yield sensitivity of a bond (can
be used for small changes in yield)
Convexity - more accurate measure – the second-order measure of yield

sensitivity of a bond
Convexity adjustment is used to adjust the accuracy of the price impact on a bond
given changes in yields.
𝐶ℎ𝑎𝑛ge in price % = 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝑒𝑓𝑓𝑒𝑐𝑡 + 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 𝑎𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡

1
= −Modified duration ∗ Change in yield + ( ∗ 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 ∗ 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑦𝑖𝑒𝑙𝑑 2 )
2

Effective convexity
𝑃−Δ𝑟 − 𝑃+Δ𝑟 − 2𝑃0

𝐸𝑓𝑓𝑒𝑐𝑡𝑣𝑒 𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦 =
2𝑃0 Δ𝑟 2
Where:
P0 is the initial price of the bond
P- is the price if the yields decline by r
P+ is the price if the yields increases by r
r is the change in the bond’s yield, which can also be viewed as being a
change in interest rates if the bond’s yield spread is assumed to be constant

Other risks:
Call Risk or Prepayment Risk
Issuer can retire or “call” all or part of the issue before the maturity date (Issuer
usually retains this right in order to have flexibility to refinance the bond in the future
if the market interest rate drops below the coupon rate).
Disadvantages from the investor’s perspective:

1) The cash flow pattern of a callable bond is not known with certainty because it
is not known when the bond is called.
2) Because the issuer is likely to call the bonds when interest rates have declined
below the bond’s coupon rate, the investor is exposed to reinvestment risk (will
have to reinvest the proceeds at a lower interest rate than the bond’s coupon
rate)
3) The price appreciation potential of the bond will be reduced relative to an
otherwise comparable option-free bond (price compression)
The same disadvantages apply to mortgage-backed/asset-backed securities where

the borrow can prepay principal prior to scheduled principal payment dates
(prepayment risk).
Liquidity Risk
liquidity is the ability to sell an asset, such as a bond, for cash when the owner
chooses. Bonds can be traded frequently and at high volumes - stronger liquidity
other bonds may trade less frequently.
The risk that the investor will have to sell a bond below its indicated value, where the
indication is revealed by a recent transaction.
If you own a bond that is not traded on an exchange, you may have to go to a broker
when you want to sell it.
The primary measure of liquidity is the size of the spread between the bid price (the
price at which the dealer is willing to buy a security) and the ask price (the price at
which a dealer is willing to sell a security).
The wider the bid-ask spread, the greater the liquidity risk.
Exchange Rate or Currency Risk

Risk of receiving less of the domestic currency when investing in a bond issue that
makes payments in a currency other than the investor’s domestic currency.

Inflation Risk
Risk of decline in the value of a security's cash flows due to inflation, which is
measured in terms of purchasing power (purchasing power risk).
Sovereign Risk:
1) Unwillingness of a foreign government to pay, or,
2) Inability to pay due to unfavourable economic conditions in the country
Event Risk
1) Natural disaster (earthquake or hurricane) or an industrial accident.
2) Takeover or corporate restructuring that impairs an issuer’s ability to meet its
obligation
3) Regulatory risk
Changes in regulation may require a regulated entity to divert itself from certain
types of investments.

Content
• Estimated value and market price
• Overview of equity valuation models
• The Dividend-Discount Model (a one-year investment, a multi-year
investment)
• Constant Dividend Growth Model
• Multistage Dividend Discount Model
• Preferred Stock Valuation
• Total Payout model

The Dividend-Discount Model
A One-Year Investment Horizon
There are two potential sources of cash flows from owning a stock:
• Payout in the form of dividends
• Choice to sell shares at a future date (P1).
The total amount received depends on the investor’s investment horizon.
To buy a stock an investor will pay a current market price for a spare P0. In one
year time he/she will be entitled to any dividends
Today (-P0) – In one year time (entitled to dividends Div1, P1 – price to sell)

These cash flows are risky (not guaranteed with certainty). Thus, risk-free interest
rate cannot be applied to estimate PV0.
Equity cost of capital (rE) must be used. It is the expected return of other
investments available in the market with equivalent risk to the firm’s shares.
𝐷𝑖𝑣1 + 𝑃1
𝑃0 =
1 + 𝑟𝐸
𝐷𝑖𝑣1 + 𝑃1 𝐷𝑖𝑣1 𝑃1 − 𝑃0
𝑟𝐸 = −1= +
𝑃0 𝑃0 𝑃0
𝐷𝑖𝑣1
– Dividend Yield
𝑃0
Dividend Yield – the percentage return from the dividend.

It is a stock's annual dividend payments to shareholders expressed as a
percentage of the stock's current price

𝐷𝑖𝑣1 𝑃1 − 𝑃0
𝑟𝐸 = +
𝑃0 𝑃0
𝑃1 −𝑃0
- Capital Gain Rate - the percentage return from the capital gain or loss
𝑃0
The sum of the dividend yield and the capital gain rate is called the total return of
the stock
It the expected return that the investor will earn for a one-year investment in the
stock.
The stock’s total return should equal the equity cost of capital

Pricing Ordinary Shares
Example: The price and dividend per share for OzCo Ltd next period are expected
to be $5.00 and $0.50, respectively. If the expected return on these shares is 10%
p.a. what is OzCo’s current stock price? If the current price changes to $4.80 what
has happened to the expected return on these shares? Why?
Given: Pt+1 = $5.00, Dt+1 = $0.50 and ke = 10%
If the current price changes to $4.80, the expected return rises to
!!!!Note that prices and expected returns are inversely related

A Multiyear Investment
Assume the investment horizon of 2 years

PV (share of stock) = PV (expected future cash flows)
Total cash received from the investment includes any dividends received and the
proceeds when shares are sold.
If investment horizon is extended from a year to two years

𝐷1 + 𝑃1 𝐷1 𝑷𝟏 𝑫𝟐 + 𝑷𝟐
𝑃𝑉0 = = + 𝑃1 =
(1 + 𝑟𝐸 )1 (1 + 𝑟𝐸 ) (1 + 𝑟𝐸 ) (𝟏 + 𝒓𝑬 )
𝑃1 – the expected price per share at t=1, 𝑃2 - The expected price at t=2

From
𝐷1 + 𝑃1 𝐷1 𝑷𝟏 𝑫𝟐 + 𝑷𝟐
𝑃𝑉0 = = + 𝑃1 =
(1 + 𝑟𝐸 )1 (1 + 𝑟𝐸 ) (1 + 𝑟𝐸 ) (𝟏 + 𝒓𝑬 )
𝑃1 – the expected price per share at t=1, 𝑃2 - The expected price at t=2
Substituting P1 in the PV0 equation results in
𝑫𝟏 𝑫𝟐 + 𝑷𝟐
𝑷𝑽𝟎 = +
(𝟏 + 𝒓𝑬 ) (𝟏 + 𝒓𝑬 )𝟐
PV value for n holding periods
𝐷1 𝐷2 𝐷𝑛 𝑃𝑛
𝑃𝑉0 = + +⋯+ 𝑛 + (1 + 𝑟 )𝑛
(1 + 𝑟𝐸 ) (1 + 𝑟𝐸 )2 1 + 𝑟𝐸 𝐸
The Dividend-Discount Model

𝒏
𝑫𝒕 𝑷𝒏
𝑷𝑽𝟎 = ෍ +
(𝟏 + 𝒓𝑬 )𝒕 (𝟏 + 𝒓𝑬 )𝒏
𝒕=𝟏
!!!The equation holds for any horizon
If an investor holds shares forever

If the value of the stock is the same independently on the investment horizon,
then it is irrelevant whether they collect their return in the form of dividends or
capital gains
PV (share of stock) = PV (expected future dividends per share)

∞
𝐷𝑡
𝐻 ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 → ∞ ; 𝑃𝑉0 = ෍
(1 + 𝑟𝐸 )𝑡
𝑡=1
Where PV0 – present value of stock today, at t=0

Dt – expected dividend in year t, assumed to be paid at the end of the year
𝑟𝐸 - equity cost of capital

Constant Dividend Growth
It is difficult to estimate expected future dividends
A common assumption – dividends will grow at a constant rate (g); company’s
business model is stable (no significant changes in its operations)
Constant Dividend Growth Model (The Gordon Growth Model)
∞ ∞ ∞
𝐷𝑡 𝐷0 (1 + 𝑔)𝑡(1 + 𝑔)𝑡
𝑃𝑉0 = ෍ → 𝑉0 = ෍ = 𝐷0 ෍
(1 + 𝑟𝐸 )𝑡 (1 + 𝑟𝐸 )𝑡 (1 + 𝑟𝐸 )𝑡
𝑡=1 𝑡=1 𝑡=1
∞
(1 + 𝑔)𝑡 (1 + 𝑔)
෍ 𝑡 → ∞ ; 𝑟𝐸 > 𝑔
(1 + 𝑟𝐸 )𝑡 𝑟𝐸 − 𝑔
𝑡=1
The above expression simplifies to

𝐷0 (1 + 𝑔) 𝐷1
𝑃𝑉0 = =
𝑟𝐸 − 𝑔 𝑟𝐸 − 𝑔
Constant Dividend Growth
𝐷0 (1 + 𝑔) 𝐷1
𝑃𝑉0 = 𝑃0 = =
We can rearrange the above equation as follows:
𝐷1
𝑟𝐸 = +𝑔
𝑃0
𝐷𝑖𝑣1 𝑃1 − 𝑃0
𝑟𝐸 = +
𝑃0 𝑃0
Following the above g is equal to the expected capital gain rate
If expected dividend growth is constant, the expected growth rate of the

share price matches the growth rate of dividends

Investment and Growth
𝐷0 (1 + 𝑔) 𝐷1
𝑃𝑉0 = 𝑃0 = =
To maximise its share price the firm needs to increase the expected growth rate
and the current dividend
To grow the firm needs to invest but the earnings spent on investments reduce
dividends. ???
𝐷𝑡 = 𝐸𝑃𝑆𝑡 𝑥 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒𝑡
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑡
𝑤ℎ𝑒𝑟𝑒 𝐸𝑃𝑆𝑡 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔𝑡
What are the three ways to increase dividends?

Growth rate estimation
Assuming the number of shares outstanding is fixed:
2 options: increase earnings or increase dividend payout rate
If no investment – the level of earnings is constant
Investment drives change in earnings
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑁𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑥 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑅𝑂𝐼)
𝑁𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑥 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
= 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝑥 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝑥 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Where, 𝑔 = dividend growth rate; =earnings growth rate if dividend payout is
constant - firm’s sustainable growth rate
If a firm wants to increase its share price, should it cut its dividend and
invest more, or should it cut investment and increase its dividend?
Example: Cutting Dividends for Profitable Growth
ABC corp. expects to have earnings per share of $6 in the coming year. Rather
than reinvest these earnings and grow, the firm plans to pay out all of its earnings
as a dividend. With these expectation of no growth, ABC’s current share price is
$60.
Suppose ABC could cut its dividend payout rate to 75% of the foreseeable future
and use the retained earnings to open new stores. The return on its investment in
these stores is expected to be 12%. Assuming its equity cost of capital is
unchanged, what effect would this new policy have on ABC’s stock price?
ABC’s equity cost of capital (D=EPS, no expected growth)
𝐷𝑖𝑣1
𝑟𝐸 = + 𝑔 = 10% + 0% = 10%
𝑃0
The expected return for similar risk stocks must be 10%

New policy:
Dividend payout rate =75%, Return on investment=12%
ABC’s new dividend 𝐷𝐼𝑉1 = 𝐸𝑃𝑆1 ∗ 75% = $6 ∗ 0.75 = $4.50
𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝑥 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡(𝑅𝑂𝐼) = 0.25 ∗ 0.12 = 3%
Assuming that ABC can continue to grow at this rate, the new share price under
the new policy is:
𝐷𝑖𝑣1 $4.50
𝑃0 = = = $64.29
𝑟𝐸 − 𝑔 0.10 − 0.03
Thus, ABC’s share price should rise from $60 to $64.29.
ABC has created value for its shareholders since the company invested in projects
that offered a rate of return (12%) greater than its equity cost of capital (10%).

Example: Unprofitable Growth
Suppose ABC decided to cut its dividend payout to 75% to invest in new stores, as
in the previous example. But now suppose that the return on these new
investments is 8%, rather than 12%. Given its expected earnings per share this
year of $6 and its equity cost of capital of 10%, what will happen to ABC’s current
share price in this case?
ABC’s new dividend= 𝐸𝑃𝑆1 ∗ 75% = $6 ∗ 0.75 = $4.50
𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 𝑥 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑛𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡(𝑅𝑂𝐼) = 0.25 ∗ 0.08 = 2%
𝐷𝑖𝑣1 $4.50
𝑃0 = = = $56.25
𝑟𝐸 − 𝑔 0.10 − 0.02
Thus, ABC’s share price will fall from $60 to $56.25 if it cuts its dividend to make
new investments with a return of only 8% when its investors can earn 10% on
other investments with comparable risk.
Hence: The answer to cut dividends or not will depend on the profitability of the
firm’s investment !!!!
Constant Dividend Growth Model
Example 1: Assume that year 0 is the end of 2022. Telstra Ltd is expected
to pay annual dividends of $0.26 in 2023 (year 1). Assume that this
dividend grows at an annual rate of 5% in the foreseeable future and
investors require a return of 10% p.a.
a) Estimate Telstra’s stock price today

b) What is Telstra’s price expected to be at the end of 2023?
c) Based on Telstra’s current price of $4.75, what is the constant dividend
growth rate implied?
d) How sensitive is the price estimate to different assumptions regarding
the growth in dividends over time?
e) How sensitive is the price estimate to different assumptions regarding
the required rate of return?

Given: D1 = 0.26, g = 0.05 and 𝑟𝐸 = 0.10
a) P0 = 0.26/(0.10 - 0.05) = $5.20

b) P1 = D2/(𝑟𝐸 - g) = 0.26(1.05)/(0.10 - 0.05) = $5.46 (a 5% rise)
c) 𝑟𝐸 = D1 /P0 + g or g = 𝑟𝐸 - D1 /P0
g = 0.10 - 0.26/4.75 = 0.0453 or 4.5%
d) Sensitivity of Telstra’s price to changes in expectations of g
g = 3%:P0 = 0.26/(0.10 - 0.03) = $3.71 (-28.7%)

g = 4%:P0 = 0.26/(0.10 - 0.04) = $4.33 (-16.7%)
g = 5%:P0 = 0.26/(0.10 - 0.05) = $5.20
g = 6%:P0 = 0.26/(0.10 - 0.06) = $6.50 (+25.0%)
g = 7%:P0 = 0.26/(0.10 - 0.07) = $8.67 (+66.7%)

Sensitivity of Telstra’s price to changes in 𝑟𝐸
𝑟𝐸 = 8%: P0 = 0.26/(0.08 - 0.05) = $8.67 (+66.7%)
𝑟𝐸 = 9%: P0 = 0.26/(0.09 - 0.05) = $6.50 (+25.0%)
𝑟𝐸 = 10%: P0 = 0.26/(0.10 - 0.05) = $5.20
𝑟𝐸 = 11%: P0 = 0.26/(0.11 - 0.05) = $4.33 (-16.7%)
𝑟𝐸 = 12%: P0 = 0.26/(0.12 - 0.05) = $3.71 (-28.7%)
• Price estimates are very sensitive to assumptions regarding future

dividends, growth in dividends and required rate of return (equity cost of
capital)
• It is often more realistic to assume a variable growth rate in dividends

with higher initial growth in dividends followed by subsequent lower (or
zero) growth in dividends

Multistage Dividend Discount Model
Used to model rapidly growing companies
The two-stage DDM assumes that at some point the company will begin to pay
dividends that grow at a constant rate, but prior to that time the company will
pay dividends that are growing at a higher rate that can be sustained in the long
run.
Two periods: finite period of high growth and infinite period of sustainable
growth
The two stage DDM can be extended to as many stages as deemed appropriate.
Practitioners often assume three-stage DDM for publicly traded companies:
1. Growth (high growth rate for an initial finite period)
2. Transition (a lower growth rate for a finite second period)
3. Maturity (a lower sustainable growth rate into perpetuity)
Two growth rates.
𝑛
𝐷0 (1 + 𝑔𝑆 )𝑡 𝑽𝒏
𝑉0 = ෍ +
(1 + 𝑟𝐸 )𝑡 (1 + 𝑟𝐸 )𝑛
𝑡=1
The equation above values the dividends over the short-term period of
high growth and the terminal value at the end of the period of high
growth. The short-term growth period 𝑔𝑆 lasts for n periods
𝑉𝑛 - year n value of the dividends received during the sustainable growth
period or the terminal value at the time n.
𝐷𝑛+1
𝑽𝒏 =
𝑟𝐸 − 𝑔𝐿
Where 𝑔𝐿 is the long-term or sustainable growth rate.
𝐷𝑛+1 = 𝐷0 (1 + 𝑔𝑆 )𝑛 (1 + 𝑔𝐿 )

Variable Dividend Growth Model
Example 2: In the previous application, assume that Telstra’s current
dividend of $0.25 grows at 10% for 3 years and then stabilizes at 5%
thereafter. What price should Telstra shares sell for today if the required
rate of return remains at 10%?
Three step procedure to estimate P0

Step 1: Compute the dividends up to the point where g becomes
constant (over years 1 to 4 in this case)
Step 2: Compute the price at the end of the year after which dividends
grow at a constant rate (year 3 in this case)
Step 3: Add the present value of dividends from Step 1 to the present
value of the price from Step 2 to get P0

Variable Dividend Growth Model
Given: D0 = $0.25, g1 = 10% over years 1 - 3,
g2 = 5% from year 4 onwards, 𝑟𝐸 = 10%
Step 1: Obtain dividends up to where g becomes constant

D1 = 0.2500(1.10) = $0.2750
D2 = 0.2750(1.10) = $0.3025
D3 = 0.3025(1.10) = $0.3328
D4 = 0.3328(1.05) = $0.3494
Step 2: Obtain Pn (after which dividend growth is constant)

P3 = D4 /(𝑟𝐸 - g2 ) = 0.3494/(0.10 - 0.05) = $6.988
Step 3: Add the present values of dividends and Pn to get P0
P0 = D1/(1 + 𝑟𝐸 ) + D2 /(1 + 𝑟𝐸 )2 + (D3 + P3)/(1 + 𝑟𝐸 )3
P0 = 0.2750/1.1 + 0.3025/1.12 + (0.3328 + 6.988)/1.13 = $6.00

Preferred Stock Valuation
Preferred stock is a form of equity (generally, non-voting) that has priority over
common stock in the receipt of dividends and on the issuer’s assets in the event
of a company liquidation.
It may have a stated maturity date or it may be perpetual, it may be callable or
convertible.
For a non-callable, non-convertible perpetual share, assuming a constant
required rate of return over time
𝐷0
𝑉0 =
𝑟
For a non-callable, non-convertible preferred stock with maturity at time n
𝑛
𝐷𝑡 𝐹
𝑉0 = ෍ +
(1 + 𝑟)𝑡 (1 + 𝑟)𝑛
𝑡=1
Where F – preferred stock’s par value

Total Payout
In recent years , an increasing number of firms have replaced dividend payouts
with share repurchases – when the firm uses excess cash to buy back its own
shares.
2 consequences for the DDM
- the more cash the firm uses to repurchase shares, the less it has available to
pay dividends.
- by repurchasing shares, the firm decreases its share count, which increases its
earnings and dividends on a per-share basis.
From DDM 𝑃0 = 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒)

Total payout model – an alternative method that may be more reliable
Values all of the firms equity, rather than a single share.

To calculate, we discount the total payout to shareholders, the total amount spent
on both dividends and share repurchases. Then, we divide by the current number
of shares outstanding to determine the share price.
Difference with DDM – forecast the growth of the firm’s total payout.
- discount total dividends and share repurchases at the growth rate of total
earnings (not EPS)
𝑃𝑉 (𝐹𝑢𝑡𝑢𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠)

𝑃0 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔0

Example: XYZ industries has 217 million shares outstanding and expects
earnings at the end of this year of $860 million. XYZ plans to pay out 50% of its
earnings in total, paying 30% as a dividend and 20% to repurchase shares. If
XYZ earnings are expected to grow by 7.5% per year and these payout rates
remain constant, determine XYZ’s share price assuming an equity cost of capital
of 10%.
Total payouts this year of 50%x$860 million=$430 million.
𝑟𝐸 = 10%, 𝑔 = 7.5%
𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

$430 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
= = $17.2 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
0.10 − 0.075
This PV represents the total value of XYZ’s equity (i.e. its market capitalisation)
$17.2 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
𝑃0 = = $79.26 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
217 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠

Content:
Free Cash Flow valuation
FCFF and FCFE
WACC
Valuation Multiples
Comparable Company Analysis

Limitations of the Dividend-Discount Model
DDM – estimates value per share based on a forecast of the future dividends
paid to shareholders.
Expected cash flows are not certain
Future earnings depend on interest expenses (depends on capital structure)
Dividend payout ratio and Future share count – are subject to management’s
decisions.
It can be difficult to forecast reliably
Free cash flow models are used when

(1) the firm doesn’t pay dividends at all or pays out fewer dividends than dictated
by its cash flow, (2) free cash flow tracks profitability or (3) the analyst takes a
corporate control perspective.
Free Cash Flow valuation
The premise of the DCF model is that the value of a business is purely a
function of its future cash flows.
𝑉0 = 𝑃𝑉 (Future Free Cash Flow of Firm)

There are two common approaches to calculating the cash flows.
Unlevered DCF approach
Forecast and discount the operating cash flows. Based on Unlevered Free Cash
Flow (also known as Free Cash Flow to the Firm or FCFF for short)
Levered DCF approach

Forecast and discount the cash flows that remain available to equity
shareholders after cash flows to all non-equity claims (i.e. debt) have been
removed (Free Cash Flow to Equity - FCFE).
Common equity can be valued directly by using FCFE or indirectly by first using
an FCFF model to estimate the value of the firm and then subtracting the value
of non-common-stock capital (usually debt) from FCFF to arrive at an estimate
of the value of equity. © Irina Mateus 2023 4
Free Cash Flow to the Firm
(FCFF) is a theoretical cash flow
figure for a business, the
operating cash flow. It is the
cash flow available to all equity
holders and debtholders after all
operating expenses (e.g., salaries
and taxes, but not interest
expense, which is a financing and
not an operating expense), capital
expenditures, and investments in
working capital have been made.
Free Cash Flow to Equity (FCFE)

is the cash available to common
shareholders after funding capital
requirements, working capital
needs, and debt financing Source: CFA Kaplan Schweser
requirements. © Irina Mateus 2023 5
First Principle of Valuation
Never mix and match cash flows and discount rates.
Because FCFF is the after-tax cash flow going to all suppliers of capital to the
firm, the value of the firm is estimated by discounting FCFF at the weighted
average cost of capital (WACC).
∞
𝐹𝐶𝐹𝐹𝑡
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑉0 = ෍
(1 + 𝑊𝐴𝐶𝐶)𝑡
𝑡=1
Firm value = Enterprise Value is the measure of a company’s total value. It looks
at the entire market value rather than just the equity value, so all ownership
interests and asset claims from both debt and equity are included.
𝐸𝑉 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡– 𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠
𝐸𝑉0 −𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡0 +𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠0

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 =
First Principle of Valuation
The value of equity can also be estimated directly via FCFE
The value of the firm’s equity is the present value of the expected future FCFE
discounted at the required return on equity:
∞
𝐹𝐶𝐹𝐸𝑡
𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒 = ෍
(1 + 𝑟𝐸 )𝑡
𝑡=1
Avoid mismatching cashflows and discount rates!!!
discounting FCFE at the weighted average cost of capital will lead to an

upwardly biased estimate of the value of equity,
discounting FCFF at the cost of equity will yield a downward biased estimate of
the value of the firm.

The advantage of the DCF
DCF allows valuing a firm without explicitly forecasting its dividends, share
repurchases, or use of debt.
Used when
• a company has negative FCFE and significant debt outstanding
• a levered company with a changing capital structure.
Why is Capital Structure Ignored?

There are two main reasons capital structure is ignored when performing a
valuation:
1.It makes firms comparable
2.Capital structure is somewhat discretionary, and owners/managers could
theoretically place a different capital structure of their choosing on the firm
Free Cash Flow to the Firm estimation
There are important differences between earnings and cash flow
Earnings include non-cash charges, such as depreciation but do not include

expenditures on capital investment.
𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

= 𝐸𝐵𝐼𝑇 𝑥 1−𝑡𝑐 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑖𝑛 𝑁𝑊𝐶
where EBIT (1-t) – Unlevered Net Income
Noncash charges - expenses that reduced taxable earnings but didn’t actually
result in an outflow of cash. If depreciation is ignored EBIT would be too high, the
taxes would be too high, the incremental Free Cash Flow will be too low
Net working capital reflects a short-term investment that ties up cash flow that
could be used elsewhere.
Capital expenditures (i.g. outflow from purchasing a required equipment in year

0) should be recognised. © Irina Mateus 2023 9
Example: Calculation of HomeNet’s Free Cash Flow
J.Berk and P.DeMarzo “Corporate Finance”, 5th ed. Pearson
The free cash flows differ from unlevered net income by reflecting the cash flow
effects of capital expenditures on equipment, depreciation, and changes in net
working capital.
Free Cash Flow to Equity estimation
FCFE method is based on the free cash flow available to equity holders after
taking into account all payments to and from debt holders.
The cash flows to equity holders should be discounted at the equity cost of
capital.
The FCFE is the free cash flow that remains after adjusting for interest payments,
debt issuance, and debt repayment.
Difference to the FCFF estimation

For FCFF - Unlevered net income is calculated, Depreciation is added back, and
Capital Expenditures and changes in NWC are subtracted.
For FCFE - deduct interest expenses from EBIT before taxes to estimate the
Incremental net income.
Depreciation, Capital Expenditures and changes in NWC are treated similarly.
The proceeds from the firm’s borrowing activity should be added.
Example: Calculation of Free Cash Flow to Equity

FCFF and FCFE
The main difference between the FCFF and FCFE is the impact of interest
expenses and their tax shields. Therefore, the FCFE can be calculated using the
FCFF formula:
FCFE = FCFF + Net Borrowing – Interest Expense (1 – t)
Where net borrowing = long- and short-term new debt issues minus long- and
short-term debt repayments
Hence to estimate FCFE from FCFF adjust the calculations for the two cash flows
to bondholders: the after-tax interest expense and any new long- or short-term
borrowings.
FCFE shows the amount of cash the firm will have available to pay dividends (or
conduct share repurchases) each year.
Generic DCF Valuation Model Firm is a stable growth
Grows at constant rate
forever
Cash Flows Expected Growth
Firm: Pre-debt cash flows Firm: Growth in Operating Earnings
Equity: After-debt cash flows Equity: Growth NI/EPS
Value
CF1 CF2 CF3 CF4 CF5 CFn Terminal Value
Firm: Value of Firm Forever
Equity: Value of Equity
Length of period of High Growth

Discount Rate
Firm: Cost of Capital
Equity: Cost of Equity
The Discounted Free Cash Flow model
Thus, we estimate a firm’s current enterprise value 𝐸𝑉0 by computing PV of the

firm’s free cash flow
𝐸𝑉0 = 𝑃𝑉 (Future Free Cash Flow of Firm)
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3 𝐹𝐶𝐹𝑁 + 𝑉𝑁

𝐸𝑉0 = + + + ⋯+
(1+𝑟𝑊𝐴𝐶𝐶 ) (1+𝑟𝑊𝐴𝐶𝐶 )2 (1+𝑟𝑊𝐴𝐶𝐶 )3 (1+𝑟𝑊𝐴𝐶𝐶 )N
𝐹𝐶𝐹𝑁+1 𝐹𝐶𝐹𝑁 (1 + 𝑔𝐹𝐶𝐹 )

𝑉𝑛 = =
𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹 𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹
where 𝑔𝐹𝐶𝐹 - a constant long-run growth rate for free cash flows beyond year N
𝐹𝐶𝐹𝑛 - free cash flows to firm for each period
𝑟𝑊𝐴𝐶𝐶 - weighted average cost of capital
𝐸𝑉0 + 𝐶𝑎𝑠ℎ0 − 𝐷𝑒𝑏𝑡0

𝑃0 =
Example: Valuing the firm using Free Cash Flow
Nike had sales of $25.3 billion in 2012. Suppose you expected its sales to grow
at a rate of 10% in 2013, but then slow by 1% per year to the long-run growth
rate that is characteristic of the apparel industry—5%—by 2018.
Based on Nike’s past profitability and investment needs, you expected EBIT to be
10% of sales, increases in net working capital requirements to be 10% of any
increase in sales, and capital expenditures to equal depreciation expenses. If
Nike had $3.3 billion in cash, $1.2 billion in debt, 893.6 million shares
outstanding, a tax rate of 24%, and a weighted average cost of capital of 10%,
what would have been your estimate of the value of Nike stock in early 2013?
J.Berk, P.DeMarzo and J.Harford “Fundamentals of Corporate Finance”, 2019,. Pearson

A simplified Pro Forma for Nike is presented below
Because capital expenditures are expected to equal depreciation, lines 7 and 8

cancel out (set to 0)
J.Berk, P.DeMarzo and J.Harford “Fundamentals of

Corporate Finance”, 2019,. Pearson

The Weighted Average Cost of Capital (WACC)
The biggest difference between DDM, FCFE and FCFF is the discount rate.
DDM, FCFE discounts the cash flows to equity holders, uses the firm’s equity
cost of capital, 𝑟𝐸 .
FCFF uses the firm’s weighted average cost of capital (WACC) as the free cash
flow will be paid to both debt and equity holders.
What is WACC?
A firm’s WACC is the blended cost of capital across all funding sources, including
common shares, preferred shares and debt.
The cost of each type of capital is weighted by its percentage of total capital and
they are added together.
If the firm has no debt 𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸

The Weighted Average Cost of Capital (WACC)
𝑟𝑊𝐴𝐶𝐶 – the average cost of capital the firm must pay to all of its investors
WACC reflects the average risk of all the firm’s investments.
Estimation:
The main steps involved in the estimation of the WACC are…
• Identify the financing components
• Estimate the current (or market)
values of the financing components
• Estimate the cost of each financing
component
• Estimate the WACC

WACC estimation
The WACC is a blend of a company’s equity and debt cost of capital based on
the company’s debt and equity capital ratio.
Hence, the first step in calculating WACC is to estimate the debt-to-equity mix
(capital structure).
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝑘𝑑 × 1 − 𝑡𝑐 𝑥 + 𝑘𝑒 𝑥
𝑉 𝑉
Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt (net of cash)
V = total value of capital (equity plus debt) or (equity plus debt plus preferred stock if
a firm has preferred stock)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
𝑘𝑒 = cost of equity (required rate of return)
𝑘𝑑 = cost of debt (yield to maturity on existing debt)
𝑡𝑐 = marginal corporate tax rate
𝑘𝑑 × 1 − 𝑡𝑐 = after-tax cost of debt because interest on debt is tax deductible
WACC estimation
For companies that have preferred stock, an extended version of the
WACC formula should be used, which includes the cost of Preferred Stock
𝐷 𝐸 𝑃
𝑊𝐴𝐶𝐶 = 𝑘𝑑 1 − 𝑡𝑐 𝑥 + 𝑘𝑒 𝑥 + 𝑘𝑝 𝑥
𝑉 𝑉 𝑉
Where:
P = market value of the firm’s preferred stock
V = total value of capital (equity plus debt plus preferred stock)
P/V = percentage of capital that is preferred stock
Rp = cost of preferred stock
It can be written as
𝑊𝐴𝐶𝐶
= cost of debt 𝑥 % debt x 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 + 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑥 % 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
+ cost of preferred stock 𝑥 % 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘

Identify the Financing Components
Source: CFI Institute

The Equity Cost of Capital
The cost of capital is the best-expected return available in the market on
investments with similar risk.
It is common to use CAPM to estimate the cost of equity capital,
𝐸[𝑅𝑖 ] = 𝑟𝑓 + 𝛽𝑖 (𝐸[𝑅𝑀 ] − 𝑟𝑓 )
Investments have similar risk if they have the same sensitivity to the market risk,
as measured by their beta with the market portfolio.
𝐸[𝑅𝑖 ] – required rate of return on share i

𝛽𝑖 (𝐸[𝑅𝑀 ] − 𝑟𝑓 ) – risk premium for security i
𝐸[𝑅𝑀 ] − 𝑟𝑓 – expected market risk premium
𝐸[𝑅𝑀 ]– expected return of the market
𝑟𝑓 – risk free rate
𝛽𝑖 – equity beta (a measure of non-diversifiable
risk)

The Equity Cost of Capital
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝐵𝑒𝑡𝑎 𝑥 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
Investors will require a risk premium comparable to what they would earn taking
the same market risk through an investment in the market portfolio.
Steps:
1 - Determine the risk-free rate, typically by using the yield on Treasury bills or
bonds
2 - Estimate the firm’s beta of equity
3 - Estimate the market risk premium, typically by comparing historical returns on
a market proxy to historical risk-free rates.

Cost of Ordinary Shares
Example:
Assume that the risk free rate is 6 percent, the expected market risk premium is 8
percent and the equity beta of XYW Ltd’s equity is 1.2. What is the firm’s cost of
equity capital?
Using the CAPM, we have…
𝐸[𝑅𝑖 ] = 𝑟𝑓 + 𝛽𝑖 (𝐸[𝑅𝑀 ] − 𝑟𝑓 )
𝐸[𝑅𝑖 ] = 𝑘𝑒 = 0.06 + 0.08 𝑥 1.2 = 15.6%
Note: Can also use the dividend discount model (but not commonly used by
managers…)
𝐷1 𝐷𝑖𝑣1
𝑉0 = 𝑟𝐸 𝑜𝑟 𝑘𝑒 = +𝑔
𝑟𝐸 − 𝑔 𝑃0

Taxes and the Cost of Debt
The return an investor receives on debt is not the same as the cost to the company
The difference – taxes interest paid on debt is a tax-deductible expense.
The effective cost of the debt – a firms net cost of interest on its debt after taxes
The effective cost of debt = 𝑘𝑑 × 1 − 𝑡𝑐
Example: Suppose that a company issues bonds with a pretax cost of 10%.
If the company’s tax rate is 40%, what is its effective cost of debt?
𝑘𝑑 = 10% × 1 − 0.4 = 6%
𝑤ℎ𝑒𝑟𝑒, 𝑡𝑐 = corporate tax rate

The impact of the effective cost of debt
Pretax weighted average cost of capital (unlevered cost of capital)
Weighted average cost of capital

Cost of Debt
Example:
The bonds of ABD LTd have a face value of $1,000 with one year remaining to
maturity. The bonds pay coupons at the rate of 10 percent p.a. If the current
market price of the bonds is $1,018.50, what is the firm’s cost of debt?
The annual interest (coupon) paid on the debt is:
𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 𝐶𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒

𝐶𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 1,000 𝑥 0.10 = $100
𝑛
𝐶𝑛 𝐹𝑉
𝑃𝑉 = ෍ 𝑡+ 𝑛
1 + 𝑘𝑑 1 + 𝑘𝑑
𝑡=1
(1,000 + 100) 1,100

1,018.50 = 𝑘𝑑 = − 1 = 8.0%
(1 + 𝑘𝑑 ) 1,018.50

The Debt Cost of Capital
A firm’s cost of debt is the interest rate it would have to pay to refinance its
existing debt, such as through new bond issues.
It is the yield to maturity of its existing debt, which is the promised return its
lenders currently demand.
If there is a significant risk that the firm will default on its obligations, YTM
(promised return) will overstate investors’ expected return.
better to adjust the YTM for expected losses to get an estimate of

investors’ actual expected return.
𝑘𝑑 = 𝑌𝑖𝑙𝑒𝑑 𝑡𝑜 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 − 𝑃𝑟𝑜𝑏 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑥 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐿𝑜𝑠𝑠 𝑅𝑎𝑡𝑒

The Debt Cost of Capital
Current prices of bonds are quoted together with their implied yields to maturity.
Note: a firm’s cost of debt differs from the coupon rate on the firm’s existing
debt.
The average loss rate for unsecured debt is about 60%.
Table: Annual Default Rates by Default Ratings
Thus, the expected return to debtholders of BB bond during average times

would be approximately 0.022 x 0.60 = 1.32% lower than the implied YTM

Cost of Preference Shares
𝐷𝑝
𝑃0 =
𝑘𝑝
𝐷𝑝
𝑘𝑝 =
𝑃0
𝑤ℎ𝑒𝑟𝑒 𝑘𝑝 - cost of preference shares; 𝐷𝑝 - dividend
Example
The preference shares of DBB Ltd pay a dividend of $0.50 p.a. If the preference
shares are currently selling for $4.00 per share , what is the cost of these shares
to the firm?
The cost of preference shares is given as:
𝐷𝑝 0.50
𝑘𝑝 = = = 12.5%
𝑃0 4.00

Valuation Multiples
A valuation multiple – is a ratio of the value to some measure of the firm’s scale.
Types of Valuation Multiples

There are two main types of valuation multiples:
1.Equity Multiples
2.Enterprise Value Multiples
The Price-Earnings ratio

Assuming that price equals intrinsic value (𝑃0 = 𝑉0 )
𝐷1
𝑃0 =
𝑟𝐸 − 𝑔
If we divide both sides of this equation by 𝐸𝑃𝑆1 , we have
𝑃 𝑃0 𝐷1/ 𝑬𝑷𝑺𝟏 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 = = =
𝐸 𝑬𝑷𝑺𝟏 𝑟𝐸 − 𝑔 𝑟𝐸 − 𝑔
Enterprise value to EBITDA
EV/EBITDA –can be used as a substitute of free cash flows; is the most used
enterprise value multiple
The enterprise value represents the entire value of the firm before the firm pays
its debt scaled by earnings or cash flows before interest payments are
made.
If expected free cash flow growth is constant then
𝑉0 𝐹𝐶𝐹1 /𝐸𝐵𝐼𝑇𝐷𝐴1
=
𝐸𝐵𝐼𝑇𝐷𝐴1 𝑟𝑊𝐴𝐶𝐶 − 𝑔𝐹𝐶𝐹
Other Enterprise value multiples include: EV/Revenue, EV/EBITDAR,

EV/Invested capital

Comparable Company Analysis
It is a valuation methodology that looks at ratios of similar public companies and
uses them to derive the value of another business.
- Comps - relative form of valuation

- DCF - intrinsic form of valuation.
Steps in Performing Comparable Company Analysis

1. Find the right comparable companies
2. Gather financial information
3. Set up the comps table (outline main values for multiples)
4. Calculate the comparable ratios
5. Use the multiples from the comparable companies to value the company

Example: Suppose manufacture KLJ, Inc., has earnings per share of $2.59. If the
average P/E of comparable company stocks is 27.5, estimate a value for KLJ
using the P/E as a valuation multiple. What are the assumptions underlying this
estimate?
You need to estimate a share price for KLJ by multiplying its EPS by the P/E of
comparable firms.
P = $2.59 * 27.5 = $71.23.
This estimate assumes that KLJ will have similar future risk, payout rates, and
growth rates to comparable firms in the industry.
Comps can be viewed as a “shortcut” to the DCF

Comps do not take into account differences between firms in future growth rate,
risk, profitability, etc.

Example: Comparable Company Analysis
Source: wallstreetprep.com

All valuation models require assumptions or forecasts
No single technique provides a final answer regarding a stock’s true value.
Most real-world practitioners use a combination of these models and gain
confidence if the results are consistent across a variety of methods

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By the end of this lecture you should be able to:

•Explain what a bond is and who issues bonds

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The issue of the bond is called the borrower

Bonds are fixed-income securities that are issued by corporations and

A bond is a debt obligation. It is a financial obligation of an entity that promises to

The promised payments consist of two components:

Many bonds pay a fixed rate of interest throughout their term.

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Secondary market: where the sale of previously issued securities takes

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Document which details the legal obligation of the corporation to the

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Par Value (the principal, face value)

Coupon - the regular interest payment received by the buyer. It is expressed as

Coupon Rate (nominal rate, APR)

𝑪𝒐𝒖𝒑𝒐𝒏 𝑹𝒂𝒕𝒆 𝒙 𝑷𝒂𝒓 𝑽𝒂𝒍𝒖𝒆

United States (semi-annual instalments), Mortgage and Asset Backed

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The valuation variables are

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• Pays the face value at maturity

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Yield to Maturity , Zero-Coupon Bond, n-Year

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a) Given: P₁ = $1,000, n = 5 years, and YTM = 8%

b) The price has risen so you'd expect the YTM to be lower

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The default-free, zero-coupon yields are also

The yield curve is also referred to as the zero-

The price is computed as the present value at a specified yield

The interest rate for maturity of less than 1 year is:

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Examples: Treasury notes (maturities from 1 to 10 years), Treasury bonds

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The PV of the par or maturity value of $1,000 received 40 six-month periods

Price = PV coupon payments + PV of par (maturity value)

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Prices and yields are often used interchangeably.

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A bond’s yield to maturity is commonly referred to as the market required rate of

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The formula is identical to the YTM for a consol (perpetual CF).

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At Par: YTM = current yield = coupon yield.

Regardless of whether the current yield is a good approximation of the yield to

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STRIPS (Separate Trading of Registered Interest and Principal of Securities).

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Where 𝑟1 , 𝑟2 , 𝑟3 −the spot rates or the yields for zero-coupon bonds

100 100 100 + 1000

YTM - is a weighted average of the yields of the zero-coupon bonds of equal or

If the parity does not hold:

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