Bond Valuation & Stock Valuation

Bonds
 A long term debt instrument in which a borrower agrees to make payment of
principal and interest, on specific dates, to the holders of the bond
Bond Market
 Primarily traded in the over-the-counter (OTC) market
 Most bonds are owned by and traded amount large financial institutions
 The wallstreet journal reports key developments in the treasury, corporate,
and municipal markets
Key Components of the Bond
1. Issuer
- The entity that borrows the money
2. Investor
- The individual or institution lending the money
3. Par Value
- Face amount of the bond, which is paid at maturity
- Also called as Principal
4. Coupon Interest Rate
- Stated interest rate (generally fixed) paid by the issuer
- Multiply by par value to get payment of interest
5. Coupon Payments
- Regular interest payments made to the investor
6. Maturity Date
- Years until the bond must be repaid
7. Issue Date
- When the bond was issued
8. Yield To Maturity
- Rate of return earned on a bond held until maturity (also called as the
promised yield)
Key Points
1. Risk and Return
- Bonds are generally considered less risky than stocks, as they offer a
fixed return. However, the risk of default (the issuer not being able to
repay the principal) is a factor to consider.
2. Interest Rates
- Bond prices and interest rates have an inverse relationship. When
interest rates rice, bond prices tend to fall and vice versa.
3. Types of Bonds
- There are many different types of bonds, including government bonds,
corporate bonds, municipal bonds, and more.
4. Bonds are an important part of a diversified investment portfolio, offering a
balance between potential growth and stability.
Effect of a Call Provision
1. Allows issuer to refund the bond issue if rates decline (helps the issuer but
hurts the investors).
2. Bonds investors require higher yields on callable bonds.
3. In many cases, callable bonds include a deferred call provision and a
declining call premium.
Sinking Fund
 Provision to pay off a loan over its life rather than all at maturity.
 Similar to amortization on a term loan.
 Reduces risk to investor, shortens average maturity but not good with
investors if rate decline after issuance.
How are sinking funds executed?
1. Call x% of the issue at par, for sinking und purposes
- Likely to be used if r d is below the coupon rate and the bond sells at a
premium
2. Buy bonds in the open market
- Likely to be used if rd is above the coupon rate and the bond sells at a
discount
Types of Bonds
A. By Issuer
1. Government Bonds – issued by national, state, or local governments to
finance public projects or operations. These bonds are generally
considered to be less risky than corporate bonds due to the backing of
the government.
2. Corporate Bonds – issued by companies to raise capital for operations,
expansion, or other purposes. These bonds carry more risk than
government bonds because they are backed by the financial health of
the company.
B. By Maturity
1. Short-Term Bonds – mature in less than a year. These bonds are
typically less volatile than long-term bonds and are often used by
investors seeking to preserve capital.
2. Medium-Term Bonds – mature in 1to 10 years. These bonds offer a
balance between risk and return.
3. Long-Term Bonds – mature in more than 10 years. These bonds offer
higher potential returns but also carry more risk due to their longer
maturity.
C. By Interest Payment
1. Coupon Bonds – pay a fixed interest rate at regular intervals (typically
semi-annually_. These bonds are the most common type of bond.
2. Zero-Coupon Bonds – do not pay periodic interest payments. Instead,
they are sold at a discount to their face value, and the difference
 between the purchase price and the face value represents the interest
earned.
D. By Security
1. Secured Bonds – backed by specific assets of the issuer, which can be
used to repay the debt if the issuer defaults.
2. Unsecured Bonds – not backed by any specific assets and are
considered riskier than secured bonds. These bonds are also known as
debentures.
E. By Other Features
1. Callable Bonds – allows the issuer to redeem the bonds before
maturity, typically at a predetermined price. This option gives the
issuer flexibility, but it can be detrimental to investors if interest rates
fall.
2. Convertible Bonds – allows the bondholder to convert their bonds into
shares of the issuer’s stock at a predetermined price. This feature
provides investors with the potential for higher returns if the
company’s stock price increases.
3. Inflation-Indexed Bonds – adjust the principal amount and interest
payments to account for inflation. This feature protects investors from
the erosion of their investment due to rising prices.
4. Warrant – long-term option to buy a stated number of shares of
common stock at a specified price.
5. Putable Bond – allows holder to sell the bond back to the company
prior to maturity.
6. Income Bond – pays interest only when interest is earned by the firm.
7. Indexed Bond – interest paid is based upon the rate of inflation.
Bonds Value Over Time
 At maturity, the value of any bond must equal its par value.
 If rd remains constant:
o The value of a premium bond would decrease over time, until it
reached $1,000.
o The value of a discount bond would increase over time, until it reached
$1,000.
o A value of a par bond stays at $1,000.
 The price of bonds moves inversely to the direction of prevailing interest
rates. If rates move higher, then bond prices move lower, all else equal.
Conversely, if rates move lower, then bond prices move higher, all else equal.
Reinvestment Rate Risk
 Reinvestment rate risk is the concern that r d will fall, and future CFs will have
to be reinvested at lower rates, hence reducing income.

Short-term AND/OR High Long-term AND/OR Low

Coupon Bonds Coupon Bonds
Interest Rate Risk Low High
Reinvestment Rate Risk High Low
Default Risk
 If an issuer defaults, investors receive less than the promised return.
Therefore, the expected return on corporate and municipal bonds is less than
the promised return.
 Influenced by the issuer’s financial strength and the terms of the bond
contract.
Factors affecting default risk and bond ratings
1. Financial performance
a. Debt ratio
b. TIE ratio
c. Current ratio
2. Qualitative factors: bond contract provisions
a. Secured vs Unsecured debt
b. Senior vs Subordinated debt
c. Guarantee and sinking fund provisions
d. Debt maturity
3. Miscellaneous qualitative factors
a. Earnings stability
b. Regulatory environment
c. Potential antitrust or product liabilities
d. Pension liabilities
e. Potential labor problems
f. Accounting policies
Sports Industry
 Major League Baseball (MLB) team, the “New York Knights,” is looking to
finance a new stadium construction project. To raise capital, they decide to
issue bonds to investors.
 Face Value: The Knights issue bonds with a face value of $1,000 each. This is
the amount the team promises to repay investors at maturity.
 Coupon Rate: The bonds offer a 5% annual coupon rate, meaning investors
will receive $50 in interest payments each year ($1,000 x 0.05)
 Maturity Date: The bonds have a maturity date of 10 years. After 10 years,
the team will repay the principal amount ($1,000) to each bondholder.
 Yield to Maturity (YTM): The YTM is the annual rate of return an investor can
expect if they hold the bond until maturity. Let’s assume the current market
interest rate for similar bonds is 6%. This means the YTM for the Knights’
bonds is 6%.
Challenges of Bonds in Sports Business
1. Interest Rate Risk – bondholders require a return on their investment,
meaning teams must pay interest, which can impact their profitability.
 2. Regulatory Requirements – issuing bonds can be complex and require
compliance with various regulations, adding to the administrative burden.
3. Market Volatility – the value of bonds can fluctuate based on market
conditions, potentially impacting a team’s financial stability.
Stock Valuation
Facts about common stock
1. Represents ownership
2. Ownership implies control
3. Stockholders elect directors
4. Directors elect management
5. Management’s goal: maximize the stock price
Intrinsic Value and Stock Price
 Outside investors, corporate insiders, and analysts use a variety of
approaches to estimate a stock’s intrinsic value (P 0).
 In equilibrium we assume that a stock’s price equals its intrinsic value.
o Outsiders estimate intrinsic value to help determine which stcks are
attractive to buy and/or sell.
o Stocks with a price below (above) its intirinsic value are undervalued
(overvalued).
Different approaches for estimating the intrinsic value of a common stock
1. Discounted Dividend Model
2. Corporate Valuation Model
3. P/E Multiple Approach
4. EVA Approach

a. Dividend Growth Model – value of a stock is the present value of the future
dividends expected to be generated by the stock.
b. Constant Growth Stock – a stock whose dividends are expected to grow
forever at a constant rate, g.
What happens if g > rs?
 If g>rs, the constant growth formula leads to a negative stock price, which
does not make sense.
 The constant growth model can only be used if:
o rs>g
o g is expected to be constant forever

Corporate Value Model

 also called the free cash flow method. Suggests the value of the entire firm
equals the present value of the firm’s free cash flows
  remember, free cash flow is the firm’s after-tax operating income less the net
capital investment
Issues regarding the corporate value model
1. often preferred to the dividend growth model, especially when considering
number of firms that don’t pay dividends or when dividends are hard to
forecast.
2. Similar to dividend growth model, assumes at some point free cash flow will
grow at a constant rate.
3. Terminal Value represents value of firm at the point that growth becomes
constant.
Preferred Stock
 Hybrid security
 Like bonds, preferred stockholders receive a fixed dividend that must be paid
before dividends are paid to common stockholders.
 However, companies can omit preferred dividend payments without fear of
pushing the firm into bankruptcy.