07 33172

Corporate Finance
Topic 4 – Valuation of Financial
Assets

Objective
Explain and use valuation models for
financial assets (bonds and common
stocks)

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 Basic Building Blocks of Bond
Valuation: Pure Discount Bonds
(1)
• A pure discount bond is a security that
promises to pay a specified single cash
payment (face value or par value) at a specified
date called its maturity date
• There is no regular cash flow associated with
interest (i.e. no coupon payments)
• Pure discount bonds are purchased at a
discount from their face or par value
• We can always analyze any fixed income
contract as a sum of pure discount bonds (zero-
coupon bonds)
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07 33172 – Topic 4
 Basic Building Blocks of Bond
Valuation: Pure Discount Bonds (2)
Information needed for valuing pure discount
bonds:
– Time to maturity or investment period (T) = Maturity
date minus today’s date
– Face or future value (FV)
– Discount rate (r)
$0 $0 $0 $F

0 1 2 T 1 T
Present value (PV) of a pure discount bond or its price
at time 0:
FV
PV 
07 33172 – Topic 4
(1  r )T 3
 Basic Building Blocks of Bond
Valuation: Pure Discount Bonds
(3)
• The pure discount bond is an example of the
present value of a lump sum cash flow
• The yield-to-maturity is the discount rate that
makes the present value of the cash flows from
the bond equal to the current price of the bond
• Solving for this, the yield-to-maturity (i) on a
pure discount bond is given by the relationship:
1
 FV 
FV  PV1 i
T T
 i    1
 PV  4
07 33172 – Topic 4
 Basic Building Blocks of Bond
Valuation: Pure Discount Bonds
(4)
• Example
– You can purchase a pure discount bond for
$9,000, and it matures in two years with a
face value of $10,000
– What is the yield-to-maturity?

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07 33172 – Topic 4
 Basic Building Blocks of Bond
Valuation: Pure Discount Bonds
(5)
1 1
 FV  T 10,000  2
i   1     1  5.41%
 PV   9,000 

T i PV PMT FV

2 ? -9,000 0 10,000
5.41%

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 SHOWS POSITIVE RELATIONSHIP B/W RISK AND MATURITY CUZ
EXPECTED RETURN ALSO INCREASES WITH MATURITY
INCREASSING

US Treasury Yield Curve

7.50

7.00
Annualized Yield (%)

6.50

6.00

5.50

5.00

4.50
0 5 10 15 20 25 30

Years to Maturity

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07 33172 – Topic 4
 Coupon Bonds (1)
• A coupon bond obligates the issuer to
– make periodic payments of interest (called
coupon payments) to the bond holder until
the bond matures
– at which time the face value of the bond is
also paid to the bond holder
– and the contract is satisfied

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 Coupon Rate

• The coupon rate is the interest rate

applied to the face value to compute the
coupon payment
– A bond with a face value of $1,000 and a
coupon rate of 10% pays an annual coupon
of $100
– At maturity, the payment is $1,000 + $100

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 Price of a Coupon Bond

• The price of a coupon bond is the sum of

the present value of the coupon payment
annuity plus the present value of the face
value

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 Coupon Bonds (2)
Information needed to value coupon bonds:
– Coupon payment dates, and time to maturity (T)
– Coupon payment per period (C) and face value (FV)
– Discount rate (r)

$C $C $C $C  $ FV

0 1 2 T 1 T
Present value (PV) of a coupon bond or its price at time 0:

C 1  FV
PV  1  
r  (1  r )T  (1  r )T 11
07 33172 – Topic 4
 Coupon Bonds: Example
Find the present value (as of January 1, 2004) of a 6-3/8 percent
Treasury coupon bond, with semi-annual payments, a maturity
date of December 31, 2009 and a face value of $1,000, if the
yield-to-maturity is 5-percent.
– On January 1, 2004 the size and timing of cash flows are:

$31.875 $31.875 $31.875 $1,031.875


1 / 1 / 04 6 / 30 / 04 12 / 31 / 04 6 / 30 / 09 12 / 31 / 09 BOND PRICES
GO UP WHEN
INTEREST RATE
FALSE= YTM

$31.875  1  $1,000
PV  1  12 
 12
 $1,070.52
.05 2  (1.025)  (1.025) 12
07 33172 – Topic 4 do seperately in calculator
 Bond Prices Rise (Fall) as
Interest Rates Fall (Rise)
• Basic principle in evaluating known cash
flows
– A change in market interest rates causes a
change in the opposite direction in the
market values of all existing contracts
promising fixed payments in the future

• Volatile market rates imply volatile

market values
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 Behavior of Bond Prices Over
Time

• The expected price of pure discount

bonds rises exponentially to the face
value with time, and the actual price
never exceeds par
• Coupon bonds are more complex, and
their price may exceed their par value,
but at maturity they reach their par value
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 20-Year Coupon Bond Value Over Time

1060

1040

1020
with no volatility = theoretical journey
1000

Value
980

theoretical journey of discount bond

960

940
REALISTIC JOURNEY OF DISCOUNT BOND
920
20 15 10 5 0
Time to Maturity 15
07 33172 – Topic 4
 Coupon Bonds Trading at Par

• Coupon Bond Pricing Principle #1: Par

Bonds
– If a bond’s price equals its face value, then
its yield-to-maturity = current yield =
coupon rate.

– Current yield = Annual coupon / Price

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 Coupon Bond Pricing Principles
#2 and #3

• Coupon Bond Pricing Principle #2: Premium

Bonds
bond price > face value
 yield-to-maturity < current yield < coupon rate

• Coupon Bond Pricing Principle #3: Discount

Bonds
bond price < face value
 yield-to-maturity > current yield > coupon rate

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 Valuation of Common Stocks:
Discounted Dividend Model
(DDM)
• The DDM is a model that computes the
value of a share of a stock as the present
value of the expected future cash
dividends
• Notation:
– Pj is the stock value per share in year j
– Dj is the cash dividend per share in year j
– k is the required rate of return on the stock
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 Present Value of Dividends
• Current stock price based only on the first year’s
dividend is the present value of the expected
dividend for the year and end-of-year price, both
discounted at the required rate of return:
D1  P1
P0 
1 k
• Current stock price with perpetual dividends
growing at a constant rate g:

D1 D1(1 g) D1(1 g)2 D1(1 g)3 D1

P0      ... 
1 k1 1 k2 1 k3 1 k4 k g
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 Capital Gains Yield
D2 D (1  g ) D1
P1   1  (1  g )  P0 (1  g )
kg kg kg
P P
g 1 0
P0
=> The DDM implies that the capital gains
yield is equal to the dividend growth rate

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 DDM Examples
• No-Growth Stock
E1=D1=$15, k=15%, g=0%
P0=D1/(k – g)=$15/(0.15 – 0)=$100

• Growth Stock equivalent

• 60% of first year earnings reinvested at 20%
E1=$15, D1=$6 ($15 * 40%), k=15%,
g=12% (60% * 20%)
P0=D1/(k – g)=$6/(0.15 – 0.12)=$200

• Normal Profit Stock equivalent

• 60% of first year earnings reinvested at 15%
E1=$15, D1=$6 ($15 * 40%), k=15%,
g=9% (60% * 15%)
P0=D1/(k – g)=$6/(0.15 – 0.09)=$100
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 DDM Parameter Estimates

• Growth Rate
– g = earnings retention ratio * return on
equity
– How large should/can g be?
– What are the underlying assumptions?

• Discount Rate
– k : cost of equity capital (how can/should it
be estimated we will see later in the module)
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 Equivalently

• P0 = E1/k + NPV of future investments

(NPVGO)

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