Chapter - 3

BOND VALUATION
 Time values of money
Finance involve choices of receiving or paying cash at
different time periods.

The time value of money is that money received now is

better than the same amount of money received some time
later because there is an opportunity to invest the money
have now and earn a return on it.

The time value of money is a very important concept in

financial management.
 Cont.….
The time value of money concept is essential for a financial
manager to achieve the wealth maximization goal of a firm.

Interest is the cost of using money (capital) over a specified

time period.

There are two basic types of interest:

A. simple interest and

B. compound interest.
 A. simple interest
Simple interest can be understood in two different
ways.
v An interest computed for just a period or computed for one
period only.
v An interest computed for two or more periods whereby only
the principal (original) value would earn interest.

In simple interest the previously earned interests do not

produce another interest.
 Cont.…..

TIME allows you the opportunity to postpone consumption and earn

INTEREST.
Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
 Cont.……
Example 1. Assume that you deposit $1,000 in an account earning
7% simple interest for 2 years. What is the accumulated interest at
the end of the 2nd year?

SI = P0(i)(n)

= $1,000(.07)(2)

= $140

Future Value is the value at some future time of a present amount of

money, or a series of payments, evaluated at a given interest rate.

FV = P0 + SI = $1,000 + $140 = $1,140

 B. Compound Interest
An interest computed for a minimum of two periods
whereby the previous interests produce another interest for
subsequent or next periods.

The principal and previous interests bring additional

interest.
The present value (pv) means the value money today.
PV = FV /(1+r)^n
FV=pv (1+r)^n
The future value (FV) means the value of money in the future.
 Cant…….
Present Value is the current value of a future amount of
money, or a series of payments, evaluated at a given interest
rate.

Future Value is the value at some future time of a present

amount of money, or a series of payments, evaluated at a
given interest rate.
Example: what is the future if present value of Br, 10,000, 20
years and 6% interest rate?
1. FV= pv (1+r)^n
= 10,000(1.06)^20 = 32,071.35
 Cont.……

FV1 = P0 (1+i)1 You earned an EXTRA $4.90

= $1,000 (1.07)
in Year 2 with compound
= $1,070
over simple interest.
FV2 = FV1 (1+i)1
FV1 = P0(1+i)1
FV2 = P0 (1+i)(1+i)
FV2 = P0(1+i)2
= $1,000(1.07)(1.07)
General Future Value Formula:
= P0 (1+i)2
FVn = P0 (1+i)n
= $1,000(1.07)2
or FVn = P0 (FVIFi,n)
= $1,144.90
 Future Value of an Annuity
An annuity is a series of equal periodic rents (receipts, payments,
withdrawals, deposits) made at fixed intervals for a specified number of
periods.
For a series of cash flows to be an annuity four conditions should be
fulfilled.
Ø The cash flows must be equal.

Ø The interval between any two cash flows must be fixed.

Ø The interest rate applied for each period must be constant.

Ø Interest should be compounded during each period.

If any one of these conditions is missing, the cash flows cannot be an
annuity.
 Types of Annuities
1. Ordinary Annuity: Payments or receipts occur at the end of each period.
2. Annuity Due: Payments or receipts occur at the beginning of each period.

Examples of Annuities

v Student Loan Payments

v Car Loan Payments
v Insurance Premiums
v Mortgage Payments
v Retirement Savings
Cont.…….
Julie Miller wants to know how large her deposit of
$10,000 today will become at a compound annual interest
rate of 10% for 5 years.

Calculation based on general formula:

FVn = P0 (1+i)n

FV5 = $10,000 (1+ 0.10)5

= $16,105.10
Cont.……
Cont.…..
The future value of an ordinary annuity can be
viewed as occurring at the end of the last cash
flow period.

The future value of an annuity due can be

viewed as occurring at the beginning of the
last cash flow period.
Cont.…..
 Cont.…..
The present value of an ordinary annuity can
be viewed as occurring at the beginning of
the first cash flow period.

The future value of an annuity due can be

viewed as occurring at the end of the first
cash flow period.
 Quiz
1. What’s the difference between an ordinary
annuity and an annuity due?

2. Why would you prefer to receive an annuity

due for $10,000 per year for 10 years than
an otherwise similar ordinary annuity?
 Long-Term Debt, Preferred Stock, and
Common Stock
• Bonds and Their Features
• Types of Long-Term Debt Instruments
• Retirement of Bonds
• Preferred Stock and Its Features
• Rights of Common Shareholders
• Dual-Class Common Stock
v Bond
A long-term debt instrument with a final maturity generally
being 10 years or more.
Debt security issued by a corporation or government entity.
Bonds pay a fixed rate of interest and return the face amount
on the maturity date.
Can be bought and sold before maturity.
Market trading prices are based on current interest rates in
relation to the fixed rate a bond pays
 Cont.…..
• If the discount rates rise above the interest rate that the bond pays,
its price goes down;

• If discount rates drop below the bond's rate, its price rises.

• When Bond Issued at par value(Par Bond),

Market Price = face value and Coupon Rate = market interest rate

• When a bond trades at a premium (premium Bond), Market Price

> face value and Coupon Rate > market interest rate.

• When a bond trades at Discount (Discount Bond), Market Price <

face value
and Coupon Rate < market interest rate.
 Basic Terms

Par Value Coupon Rate

Maturity Bond Ratings
 Trustee and Indenture
Trustee – A person or institution designated by a
bond issuer as the official representative of the
bondholders. Typically, a bank serves as trustee.

Indenture – The legal agreement, also called the

deed of trust, between the corporation issuing
bonds and the bondholders, establishing the terms
of the bond issue and naming the trustee.
 Cant…..
Debenture – A long-term, unsecured debt instrument.
• Investors look to the earning power of the firm as their primary
security.
• Investors receive some protection by the restrictions imposed in
the bond indenture, particularly any negative-pledge clause.
• A negative-pledge clause precludes the corporation from pledging
any of its assets (not already pledged) to other creditors.
 Types of Long-Term Debt Instruments
• Subordinated Debenture – A long-term, unsecured debt
instrument with a lower claim on assets and income than other
classes of debt; known as junior debt.

• Income Bond – A bond where the payment of interest is

contingent upon sufficient earnings of the firm.

• Junk Bond – A high-risk, high-yield (often unsecured) bond rated

below investment grade.

•
 Types of Long-Term Debt Instruments

• Mortgage Bond – A bond issue secured by a mortgage

on the issuer’s property.

The issue is secured by a lien on specific assets of the

corporation.

The market value of the collateral should exceed the

amount of the bond issue by a reasonable margin of safety
to help protect bondholders.
 Types of Long-Term Debt Instruments

• Equipment Trust Certificate – An intermediate-

to long-term security, usually issued by a
transportation company such as a railroad or
airline, that is used to finance new equipment.
 Asset Securitization
Asset Securitization – The process of packaging a pool of assets
and then selling interests in the pool in the form of asset-
backed securities.

Asset-backed Security – Debt securities whose interest and

principal payments are provided by the cash flows coming
from a discrete pool of assets.
 Common Stock Shares
• Common stock represents equity ownership in a corporation.

• Allows its holders to make a profit through rising share prices and
dividend payments.

• Get to vote on corporate issues, such as electing new directors to

the corporation's board.

• Should the company end up in bankruptcy; holders of common

stock are last on the list to get their money back (after regular
creditors, bondholders, and holders of preferred stock.
 Cont.…..

• Dividends are not guaranteed and a company can reduce

or eliminate dividends at any time

• Aside from dividends, however, the share value of

common stocks tends to rise and fall with market
conditions and with the financial results of the
underlying company.

• Dividend yields on common stocks are typically lower

than the yields available from bonds or preferred
shares.
 Cont.…..
• Common Stock represents the owner’s fund, as
equity shareholders jointly own the company.
• The stockholders are entitled to both risk and
rewards of ownership, but their liability is
limited to the capital contributed by them.
 Generally Common stockholders have
Ø Right to Income: Common stockholders have a residual claim on
the earnings of the firm.

Ø Right to Vote: Common stockholders, has the right to elect firm’s

board of directors and vote on various corporate policies, at the
general meeting.

Ø Pre-emptive Right: The pre-emptive rights allow the existing

stockholders to buy the company’s stock before they are
publicly available, so as to maintain their proportional
ownership.
 Cont.…….

Right in Liquidation: Common Stockholders are entitled to receive

the leftover amount and assets of the firm in the event of liquidation,
once all the creditors, debenture holders, preferred stock holders are
paid off, the amount and assets remained are distributed to common

stockholders in the ratio of their ownership in the company.

 Preferred Stock
• Preferred stock represents owning a share of the company, but it
works a bit differently than common stock.

• Holders do not get a vote on company matters but enjoy

preference in certain matters, as to the payment of fixed
amount of dividend and repayment of capital in the event of
liquidation or bankruptcy.

• It is a fixed income bearing investment vehicle, which may or

may not have a maturity period.
 Cont.……
• Preferred shares have a fixed dividend rate, which will not change
unless the issuing company does not earn enough money to pay
the dividend.

• Nature of dividend is cumulative that if the payment of dividend is

skipped in a particular year, then the dividend is carried
forward to next year and arrears of dividend have to be paid by
the company.
 Valuation
Valuation is the process of determining the worth of any asset whose
value is obtained from future cash flows.

Ø The intrinsic value of any asset in finance

v present value of all future cash flows.

v Expected to provide over the relevant time period.

 Cont.……
• The intrinsic value of an asset is determined based on three basic inputs:
cash flows (returns), time pattern of the returns, and the discount rate.

The value of an asset is determined by discounting the expected cash flows

to their present value.

To determine the present value use a discount rate appropriate based on the
asset’s risk.

• Value can be determined for any kind of asset like buildings, machineries,
factories, bonds, stocks etc. But in this unit, we will discuss the value
of three financial assets: bonds, preferred, and common stocks.
 The General Valuations Model
Value of a security is a fundamental variable and depends on its
promised return, risk and the discount rate.

The basic understanding of present value concept, with the mention

of fundamental factors like returns and discount rate.

In fact the basic valuation model is none else than present value
procedure.

Given a risk adjusted discount rate and the future expected earnings
flow of security in the form of interest, dividend, earnings, or cash
flow.
PV =
Determine the
CF1 + CF2
present value of follows.
+ CF3 + ……. CFn
1+r (1 + r)2 (1 + r)3 (1 + r)n

PV = Present value

CF = Cash flow interest, dividend, earnings per time period

up to ‘n’ number of year

r = Risk adjusted discount rate

 Bond Valuation
Bond is a long-term debt instrument or security issued by businesses
and governmental units to raise large sums of money.

Investment in a bond provides two types of cash flows.

v The periodic interest payment by the issuing party.

v The price paid to the investor upon maturity.

The interest payment is based on the par value of the bond and the
coupon interest rate.
 Cont.…….
The par value is the face value of the bond which will be paid to
the investor upon maturity.

The coupon interest rate is the rate which the issuer pays to the

investor on the par value of the bond.

Interest paid on bonds is usually referred to as coupon.

 Bonds may be classified in to four types

v Treasury (government) bonds:- Bonds issued by the

government.

v Corporate bonds:- bonds issued by the corporation

v Municipal bonds:- bonds issued by state and local

government.

v Foreign bonds:- bonds issued by the foreign government

and corporations.
 Types of Corporate Bonds

1. Convertible Bonds A convertible bond may be exchanged for

shares of stock of the issuing corporation at the bondholder’s option.

2. Income bonds: - A long term debt security in which the issuer is

required to pay interest only when interest is earned.

3. Term bond:-bonds whose principal is repaid on specific maturity

date in the future.

4. Serial bonds: -bonds whose principal is paid on a periodic basis

on certain period.
 Cont.………

5. Callable /Redeemable Bonds:-

v Contain a provision that gives the issuer the right to call (buy
back) the bond before its maturity date, similar to the call
provision of some preferred stocks.

v The exercise of the call provision normally requires the company

to pay the bondholder a call premium.

v A call premium is the price paid in excess of face value that the
issuer of bonds must pay to redeem (call) bonds before their
maturity date.
 Cont.……….
6. Puttable /Put Bond
Bonds that are issued with a specific feature where the bondholder
has the right to return back the bonds at a pre-fixed date before
maturity are called as puttable bonds.

Bonds allow a benefit to the bondholders to ask for the principal

repayment before maturity.

Bonds usually offer a coupon rate lower than a normal straight

coupon-bearing bond.
7. Zero Coupon Bonds

• A zero coupon bond is a type of bond.

There are no coupon payments made.

It is not that there is no yield.

It is issued at a price lower than the face value (say 950$) and then pay the face
value on maturity ($1000).

8. Secured and Unsecured Bonds

• Secured bond is a bond for which a company has pledged specific property to
ensure its payment.

• Unsecured bond is a bond backed only by the general creditworthiness of the

issuer, not by a lien on any specific property. More easily issued by a
company that is financially sound.
The value of Basic
a bond Bond Valuation
is the present Model
value of the periodic interest
payments plus the present value of the par value.

The value of a bond can be computed using the following

equitation:

Bond value (VB) = PV of the coupon payment + PV the face vale

N
=  INT  FV
t 1
t
1  k d  1  K d N
 1 
 1  N 
= INT (1  k d )   FV
 kd  (1  k d ) N
 
 
 When Interest is paid semiannually:
2N
INT/2 FV
VB   1  k 

 d /2 
t 2N
t 1 d /2 1  k
 1 
 1 
 (1  k d /2) 2N  FV
 (INT/2)
 k d /2  (1  k d /2) 2N
 
 

PV (VB) = Present value of the bond today (value of the bond)

INT= Coupon interest payment =Par Value x Coupon interest rate (i)

FV = Face Value (the par value of the bond, principal payment at maturity)

Kd = Appropriate discount rate or market yield

N = Number of years to maturity

(PVIF kd,n) = The present value interest factor for an annuity at interest rate of
kd per period for n periods = 1
1
(1  kd )n
=
kd
Illustration:
Ex 1. A 10% bond of Birr 1,000 issued with a
maturity of five years at par. The discounted rate of
marketing 10%. The interest is paid annually. What
would be the bond value.
PV =100 + 100 + 100+ 100+ 100+
(1 + .10) (1 + .10)2 (1 + .10)3 (1 + .10)4 (1 + .10)5
= 100 x .9091 + 100x .8264 + 100 x .7513 + 100x .6830 + 1100
x .620
= 90.91 +| 82.64 + 75.13 + 68.30 + 682.99
= 999.97
 Cont.……..

2. A bond of Birr 1,000 at 6% is issued at par. The bond had a

maturity period of five years. As of today five more years are left for
final repayment at par. The current discount rate is 10 percent. What
is the present value?
PV = 60__ + 60___ + 60 __ + 60 60 + 1000
2 3 4 5
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)
= 60 x .9091 + 60 x .8264 + 60 x .7513 + 60 x .683 + 1060 x .6209
= 54.55 + 45.08 + 40.98 + 658.15
= 847.35
 B. Interest Rate on a Bond

To determine the value of a bond if are given,,,,,

v The par value.

v The coupon interest rate.

v The number of periods.

v The interest rate on the bond.

Yield to Maturity (YTM) is the rate of return investors earn if they

buy a bond at a specific price Bo, and hold it until maturity.

The approximate YTM can be found using the following

approximation formula:
 Approximate YTM =

Example: Zebra Company has a Br. 1,000 par value, 10% coupon
interest rate, and 15 years to maturity. The bond is currently selling
at Br. 1,090. Compute the YTM.

Solution:

Given: FV = Br. 1,000; I = Br. 100 (Br. 1,000 x 10%); n = 15; Bo =

Br. 1,090; YTM = ?
 Approximate YTM=

Yield to call (YTC) is the rate of return earned by an investor if he

buys a bond at a specified price, Bo, and the bond is called before its
maturity date.

YTC is computed only for callable bonds. A callable bond is a bond

which is called and retired prior to its maturity date at the option of
the issuer.

A bond is called by an issuer when the market interest rate falls

below the coupon interest rate. The YTC can be found by solving the
following equation.
 Approximate YTC =

Example: X Company is intending to purchase Y

Company’s outstanding bond which was issued on January
1, 1997. Y bond is a Br. 1,000 par value, has a 10% annual
coupon, and a 30 year original maturity. There is a 5-year
call protection, after which time the bond can be called at
108. X Company is to acquire the bond on January 1, 1999
when it is selling at Br. 1,175.
Required: Determine the yield to call in 1999 for Y
company bond.

Solution:

Given: I = Br. 100 (Br. 1,000 x 10%); VB = Br. 1,175;

call price = Br. 1,080 (Br. 1,000 x 108%);

n = 3 (call protection – 2 years elapsed since the

bond was issued); YTC =?

Approximate YTC =
 PREFERRED STOCK VALUATION

• Preferred stock is a type of equity security that provides its owners

with limited or fixed claims on a corporation’s income and
assets. Preference shares are those, which enjoy the following
two preferential rights:

• Dividend at a fixed rate or a fixed amount on these shares before

any dividend on equity shares.]

Return of preference share capital before the return of equity share

capital at the time of winding up of the company.
Preference shares also have a right to participate or in part in excess
profits left after been paid to equity shares, or has a right to
participate in the premium at the time of redemption. But these
shares do not carry voting rights.

Preferred stock has similarities to both a bond and a common stock.

As to similarities to a bond, preferred dividends are fixed in amount
and are like interest payments. As to a common stock, the preferred
dividends are paid for an indefinite time period. Specifically the
following are the major types of preference shares.
 The major types of preference shares.
1.Redeemable and Irredeemable

Redeemable preference share is very commonly seen preference

share which has a maturity date on which date the company will
repay the capital amount to the preference shareholders and
discontinue the dividend payment thereon.

Irredeemable preference shares are little different from other types

of preference shares.
 2. Cumulative and Non cumulative
A preference share is said to be cumulative when the arrears of dividend are
cumulative and such arrears are paid before paying any dividend to equity
shareholders.

In the case of non-cumulative preference shares, the dividend is only payable out
of the net profits of each year.

If there are no profits in any year, the arrears of dividend cannot be claimed in the
subsequent years.

If the dividend on the preference shares is not paid by the company during a
particular year, it lapses.

Preference shares are presumed to be cumulative unless expressly described as

non-cumulative.
 3. Convertible and Non convertible
The owner of these preference shares has the option,
but not the obligation, to convert the shares to a
company's common stock at some conversion ratio.

The owners of preference shares can realize

substantial gains by converting their shares. Non
convertible are those shares which do not carry the
right of conversion into equity shares.
 4. Participative and Non participative

Participating preference shares are entitled in

addition to preference dividend at a fixed rate, to
participate in the balance of profits with equity
shareholders after they get a fixed rate of dividend
on their shares.
 Preferred Stock Valuation Model
is the present value of all future preferred dividends
it is expected to provide over an infinite time
horizon.

Most preferred stocks entitle their owners to regular

and fixed dividend payments.

If the payments last forever, the issue is perpetuity.

Example: Abebe wishes to estimate the value of its
outstanding preferred stock. The preferred issue has a Br. 80
par value and pays an annual dividend of Br. 6.40 per share.
Similar-risk preferred stocks are currently earning a 9.3%
annual rate of return. What is the value of the outstanding
preferred stock?
Given: Dps = Br. 6.40;
Kps = 9.3%;
Vps =?
 Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a
preferred stock in comparison to other investment
opportunities, should be able to compute the rate of
return on a preferred stock.

If know the current price of a preferred stock

and its dividend, can compute the expected rate
of return on the preferred stock.
 Kps =

Kps = The expected rate of return on the preferred

stock

Dps = Preferred stock dividends

Vps = Value or current price of the preferred stock

Example: A preferred stock pays an annual
dividend of Br. 9 and the current market price is Br.
81. Compute the required rate of return from the
preferred stock.

Solution:

Given: Dps = Br. 9;

Vps = Br. 81;

Kps =? = 11.11%
 COMMON STOCK VALUATION
The value of a share of common stock is the present
value of the common stock’s dividend expected over an
infinite time horizon.

The value of a share of common stock is equal to the sum

of the present value of the expected dividends and the
present value of the expected selling price of the stock.

The selling price in turn will depend on the dividends to be

received by the purchasing party.
To understand the value of a common stock we should keep in mind two points.
The dividends are expected for an infinite time period.
The dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of
annual dividends.

Where:
Po = Value of the common stock at time zero (as of today)
D1, D2, …, D = Per share dividend expected at the end of each year
Po =
Ks = the required rate of return on the common stock.
The common stock valuation equation can be simplified by redefining
each year’s dividend.

The dividends are defined in terms of anticipated dividends growth.

Generally, there are three cases accordingly.

1. Zero growth common stock,

2. Constant growth common stock, and

3. Variable growth common stock.

 A. Zero Growth Stock

A zero growth stock is a common stock whose future

dividends are not expected to grow at all.

The expected growth rate (g) is zero.

This is the simplest model to common stock valuation.

It assumes a constant, non-growing annual dividend.

So here the annual dividends are all equal.

That is D1 = D2 = … = D = D.
 Po =
Example:- The most recent common stock dividend of Shalom
Manufacturing Corporation was Br. 3.60 per share. Due to the firm’s
maturity as well as stable sales and earnings, the dividends are
expected to remain at the current level of the foreseeable future.

Required: Determine the value of Shalom’s common stock for an

investor whose required return is 12%.

Solution: Given: D = Br. 3.60; Ks = 12%; Po =?

Po = = Br. 30
 B. Constant Growth Stock
Constant growth stock is a common stock whose future dividends
are expected to grow at a constant dividend growth rate (g).

It is sometimes called normal growth stock.

The constant growth common stock valuation model is the most

widely cited approach to common stock valuation.

The value of a constant growth stock is the present value of the

expected future dividends growing at a constant rate of g.
 Po = = ks > g

Where:-

D1 = the expected dividend at the end of year 1.

g = the expected growth rate in dividends.

Ks = required return

D1 = Do(1+g)

where Do is the most recent dividend.

Example: Zeila Motor Corporation’s common stock
currently pays an annual dividend of Br. 5.40 per share. The
dividends are expected to grow at a constant annual rate of
5% to infinity. Estimate the value of Zeila’s common stock
if the required return is 12%.

Solution:

Do = Br. 5.40; g = 5%; Ks = 12%; Po =?

D1 = Do (1+g0) = Br. 5.40 (1.05) = Br. 5.67

Po = D1/Ks – g = 5.67/12- 5% = Br. 81

 C. Variable Growth Stock

• Variable growth stock is a stock whose dividends are

expected to grow at variable or non-constant rates.

• The model of common stock valuation that allows for a

change in the dividend growth rate is called Variable
(non constant) Growth Model.

• It sometimes is also called supernormal growth model.

The value of a share of variable growth stock is determined by
following 4 procedures.

1. Find the value of the dividends at the end of each year during
the initial growth period.

2. Find the present values of the dividends found in step 1.

3. Find the value of the stock at the end of the initial growth
period

4. Add the present value of the dividends found in step 2 and the
present value of the value of the stock found in step 3 to determine
the value of the stock at time zero, i.e. po.
Example: Addis Company’s most recent annual dividend, which was
paid yesterday, was Br. 1.75 per share. The dividends are expected to
experience a 15% annual growth rate for the next 3 years. By the end
of 3 years growth rate will slow to 5% per year to infinity.

Stockholders require a return of 12% on Addis’ stock

Required: Calculate the value of the stock today.

Solution:

Given: Do = Br. 1.75; g1 = 15% for 3 years; g2 = 5% from year 3

to infinity; k5 = 12%; p0 =?
 end
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