Topic Bonds and
Stocks Valuation
Introduction to Financial
Management course
By Dr. Nguyen Thu Hien
Modified from slides by Ross, Westerfield, Jordan, 0
“Fundamentals of Corporate Finance”, 7th ed., McGraw-Hill Irwin
Chapter Outline
l Bonds and Bond Valuation
l Determinants of Bond Yields
l Valuation of Stocks: three models
l Characteristics of Common stock, Preferred
stocks
l Reading quotes
1
Bond Definitions
l Bond
l Par value (face value)
l Coupon rate (interest rate of bond)
l Coupon payment (interest pmts of bond)
l Maturity date (expiration date)
l Yield or Yield to maturity (YTM)
(or Annual Effective Rate of Bond)
2
Cash Flows for Bondholders
l If you buy a share of coupon bond, you can
receive cash in 2 ways:
l Receive the periodic coupon payments
l Receive the face value of bond at maturity
l Price of the bond is the present value of
above future cash flows.
3
Present Value of Cash Flows as
Rates Change
l Bond Value = PV of coupons + PV of par
l Bond Value = PV annuity + PV of lump sum
l Remember, as interest rates increase
present values decrease
l So, as interest rates increase, bond prices
decrease and vice versa
4
The Bond-Pricing Equation
é 1 ù
1 -
ê (1 + r) t ú F
Bond Value = C ê ú+
ú (1 + r)
t
ê r
êë úû
5
Valuing a Discount Bond with
Annual Coupons
l Consider a bond with a coupon rate of 10% and
annual coupons. The par value is $1000 and the
bond has 5 years to maturity. The yield to maturity is
11%. What is the value of the bond?
l Using the formula:
l B = PV of annuity + PV of lump sum
l B = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5
l B = 369.59 + 593.45 = 963.04
l Using the calculator:
l N = 5; I/Y = 11; PMT = 100; FV = 1000
l CPT PV = -963.04
6
Valuing a Premium Bond with
Annual Coupons
l Suppose you are looking at a bond that has a 10%
annual coupon and a face value of $1000. There are
20 years to maturity and the yield to maturity is 8%.
What is the price of this bond?
l Using the formula:
l B = PV of annuity + PV of lump sum
l B = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
l B = 981.81 + 214.55 = 1196.36
l Using the calculator:
l N = 20; I/Y = 8; PMT = 100; FV = 1000
l CPT PV = -1196.36
7
Graphical Relationship Between
Price and Yield-to-maturity
1500
1400
1300
1200
Bond Price
1100
1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
Yield-to-maturity
8
Bond Prices: Relationship
Between Coupon and Yield
l If YTM > coupon rate, then bond price < par value
l Why?
l Selling at a discount, called a discount bond
l If YTM < coupon rate, then bond price > par value
l Why?
l Selling at a premium, called a premium bond
l If YTM = coupon rate, then bond price = par value
9
Example
l A bond has following information: YTM = 16%;
Maturity = 7 years; Par value = $1000; Coupon rate
14%; Coupons are paid semiannually
l Find present values based on the payment period
l How many coupon payments are there?
l What is the semiannual coupon payment?
l What is the semiannual yield?
l B = 70[1 – 1/(1.08)14] / .08 + 1000 / (1.08)14 = 917.56
l Or PMT = 70; N = 14; I/Y = 8; FV = 1000; CPT PV = -
917.56
10
Computing Yield-to-maturity
l Yield-to-maturity is the rate implied by the
current bond price
l Finding the YTM requires trial and error if you
do not have a financial calculator and is
similar to the process for finding r with an
annuity
11
YTM with Annual Coupons
l Consider a bond with a 10% annual coupon
rate, 15 years to maturity and a par value of
$1000. The current price is $928.09.
l Will the yield be more or less than 10%?
l N = 15; PV = -928.09; FV = 1000; PMT = 100
l CPT I/Y = 11%
12
YTM with Semiannual
Coupons
l Suppose a bond with a 10% coupon rate and
semiannual coupons, has a face value of
$1000, 20 years to maturity and is selling for
$1197.93.
l Is the YTM more or less than 10%?
l What is the semiannual coupon payment?
l How many periods are there?
l N = 40; PV = -1197.93; PMT = 50; FV = 1000;
CPT I/Y = 4% (Is this the YTM?)
l YTM = 4%*2 = 8%
13
Table 7.1
14
Zero-Coupon Bonds
l Make no periodic interest payments (coupon rate =
0%)
l The entire yield-to-maturity comes from the
difference between the purchase price and the par
value
l Cannot sell for more than par value
l Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
l Treasury Bills and principal-only Treasury strips are
good examples of zeroes
15
Floating Rate Bonds
l Coupon rate floats depending on some index value
l Examples – adjustable rate mortgages and inflation-
linked Treasuries
l There is less price risk with floating rate bonds
l The coupon floats, so it is less likely to differ
substantially from the yield-to-maturity
l Coupons may have a “collar” – the rate cannot go
above a specified “ceiling” or below a specified
“floor”
16
Corporate Bonds Quotations
l The quote of Goldman Sachs Group (in Figure 5.2)
for the trading date Jan. 19, 2006
l 4.500 June 15,2010 97.984 5.016 71 5 116,790
l What is the coupon rate on the bond?
l When does the bond mature?
l What is the bid price? What does this mean?
l What is the ask price? What does this mean?
l How much did the price change from the previous day?
l What is the yield based on the ask price?
17
Bond Ratings – Investment
Quality
l High Grade
l Moody’s Aaa and S&P AAA – capacity to pay is
extremely strong
l Moody’s Aa and S&P AA – capacity to pay is very
strong
l Medium Grade
l Moody’s A and S&P A – capacity to pay is strong, but
more susceptible to changes in circumstances
l Moody’s Baa and S&P BBB – capacity to pay is
adequate, adverse conditions will have more impact on
the firm’s ability to pay
18
Bond Ratings - Speculative
l Low Grade
l Moody’s Ba, B, Caa and Ca
l S&P BB, B, CCC, CC
l Considered speculative with respect to capacity to pay.
The “B” ratings are the lowest degree of speculation.
l Very Low Grade
l Moody’s C and S&P C – income bonds with no interest
being paid
l Moody’s D and S&P D – in default with principal and
interest in arrears
19
Interest Rate Risk
(or Price risk)
l Price Risk
l Change in price due to changes in interest rates
l Long-term bonds have more price risk than short-term
bonds
l Low coupon rate bonds have more price risk than high
coupon rate bonds
l Bond A : coupon rate 5% - reduce in price when interest rate
increases à price reduction higher?
l Bond B: coupon rate 8% - reduce in price when interest rate
increases à price reduction higher?
l Now interest rate (YTM) increase from 6% to 9% - increase by
3%
l Which bond has higher price risk? 20
Figure 7.2
21
The Bond-Pricing Equation
é 1 ù
1 -
ê (1 + r) t ú F
Bond Value = C ê ú+
ú (1 + r)
t
ê r
êë úû
C: coupon payment = Face * Coupon rate
r: market interest rate / interest rate/ required return by investor/ YTM
22
Inflation and Interest Rates
l Real rate of interest – change in purchasing
power
l Nominal rate of interest – quoted rate of
interest, change in purchasing power and
inflation
l Real rate= 2%
l Forecasted inflation rate = 5%
l Quote rate/Nominal rate = 2% + 5% = 7%
l The ex ante nominal rate of interest includes
our desired real rate of return plus an 23
The Fisher Effect
l The Fisher Effect defines the relationship
between real rates, nominal rates and
inflation rates
l (1 + R) = (1 + r)*(1 + h), where
l R = nominal rate
l r = real rate
l h = expected inflation rate
l Approximation
l R ~= r + h
24
Example 7.6
l If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
l R = (1.1)(1.08) – 1 = .188 = 18.8%
l Approximation: R = 10% + 8% = 18%
l Because the real return and expected
inflation are relatively high, there is significant
difference between the actual Fisher Effect
and the approximation.
25
Term Structure of Interest
Rates
l Term (maturity) structure is the relationship between time to maturity
and yields, all else equal
l It is important to recognize that we pull out the effect of default risk,
different coupons, etc. (securities-specific risks)
l Term structure of interest rate includes only fundamental factors:
real rate, inflation rate and interest rate risk.
l Yield curve – graphical representation of the term structure
l Normal – upward-sloping, long-term yields are higher than short-
term yields
l Inverted – downward-sloping, long-term yields are lower than short-
term yields
26
Upward-Sloping Yield Curve
(Interest rate curve)
3mth 6mth 9mth 12mth
27
Downward-Sloping Yield Curve
Expect to see
a recession!
28
3mth 6mth 9mth 12mth
Figure 7.7
29
Factors Affecting Required
Return
l Default risk premium – remember bond
ratings
l Liquidity premium – bonds that have more
frequent trading will generally have lower
required returns
l Anything else that affects the risk of the cash
flows to the bondholders will affect the
required returns
30
Quick summary
1. How do you find the value of a bond and why do
bond prices change?
2. What are bond ratings and why are they
important?
3. What factors determine the required return on
bonds?
31
Stock Valuation
32
Cash Flows for Stockholders
l If you buy a share of stock, you can receive
cash in two ways
l The company pays dividends
l You sell your shares, either to another investor in
the market or back to the company – selling price
l As with bonds, the price of the stock is the
present value of these expected cash flows
33
One Period Example
l Suppose you are thinking of purchasing the
stock of Moore Oil, Inc. and you expect it to
pay a $2 dividend in one year and you
believe that you can sell the stock for $14 at
that time. If you require a return of 20% on
investments of this risk, what is the maximum
you would be willing to pay?
l Compute the PV of the expected cash flows
l Price = (14 + 2) / (1.2) = $13.33
l Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33
34
Two Period Example
l Now what if you decide to hold the stock for
two years? In addition to the dividend in one
year, you expect a dividend of $2.10 in two
years and a stock price of $14.70 at the end
of year 2. Now how much would you be
willing to pay?
l PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33
35
Three Period Example
l Finally, what if you decide to hold the stock for three
years? In addition to the dividends at the end of
years 1 and 2, you expect to receive a dividend of
$2.205 at the end of year 3 and the stock price is
expected to be $15.435. Now how much would you
be willing to pay?
l PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 =
13.33
36
Developing The Model
l You could continue to push back when you
would sell the stock
l You would find that the price of the stock is
really just the present value of all expected
future dividends
l So, how can we estimate all future dividend
payments?
37
Estimating Dividends:
Special Cases
1. Constant dividend Model
l The firm will pay a constant dividend forever
l This is like preferred stock
l The price is computed using the perpetuity formula
2. Constant dividend growth Model
l The firm will increase the dividend by a constant
percent every period
3. Supernormal growth Model
l Dividend growth is not consistent initially, but settles
down to constant growth eventually
38
l PV = D/R
D1
D2= D1 * (1+g)
D3= D2 * (1+g) = D1 * (1+g)2
D4= D3 * (1+g) = D1 * (1+g)3
…..
Price of stock = PV (D1, D2, D3…. Dinfinity)
= D1/(1+r) + D1 *(1+g)/((1+r)2 + D1*(1+g)2/(1+r)3+ ………
39
P0 = D1 / (R-g)
l D1
l D2
l D3
l D4 to Dìnfinity: cónstant growth model!
l Price of stock today = P0
= PV (D1,D2,D3) + PV[ D4/(R-g)]
40
1. Constant dividend Model
(Zero Growth)
l If dividends are expected at regular intervals forever,
then this is a perpetuity and the present value of
expected future dividends can be found using the
perpetuity formula
l P0 = D / R
l Suppose stock is expected to pay a $0.50 dividend
every quarter and the required return is 10% with
quarterly compounding. What is the price?
l P0 = .50 / (.1 / 4) = $20
41
2. Constant Growth Model
l Dividends are expected to grow at a constant
percent per period.
l P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
l P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
l With a little algebra and some series work,
this reduces to:
D 0 (1 + g) D1
P0 = =
R -g R -g
42
DGM – Example 1
l Suppose Big D, Inc. just paid a dividend (D0)
of $.50. It is expected to increase its dividend
by 2% per year (i.e. every year until infinity).
If the market requires a return of 15% on
assets of this risk, how much should the
stock be selling for?
l You invest today: time0
l You wait for 1 year and receive dividend: D1
l P0 = D1/R-g = D0*(1+g) / R-g =3.92$
43
DGM – Example 2
l Suppose TB Pirates, Inc. is expected to pay a
$2 dividend in one year (D1). If the dividend
is expected to grow at 5% per year and the
required return is 20%, what is the price?
l P0 = 2 / (.2 - .05) = $13.33
l Why isn’t the $2 in the numerator multiplied by
(1.05) in this example?
44
Stock Price Sensitivity to Dividend
Growth, g
250
D1 = $2; R = 20%
200
Stock Price
150
100
50
0
0 0.05 0.1 0.15 0.2
Growth Rate
45
Stock Price Sensitivity to Required
Return, R
250
D1 = $2; g = 5%
200
Stock Price
150
100
50
0
0 0.05 0.1 0.15 0.2 0.25 0.3
Rate of required return
46
Example - Gordon Growth
Company - I
l Gordon Growth Company is expected to pay
a dividend of $4 next period and dividends
are expected to grow at 6% per year. The
required return is 16%.
l What is the current price?
l P0 = 4 / (.16 - .06) = $40
l Remember that we already have the dividend
expected next year, so we don’t multiply the
dividend by 1+g
47
Example – Gordon Growth
Company - II
l What is the price expected to be in year 4?
l P4 = D4(1 + g) / (R – g) = D5 / (R – g)
l P4 = 4(1+.06)4 / (.16 - .06) = 50.50
l What is the implied return given the change
in price during the four year period?
l 50.50 = 40(1+return)4; return = 6%
l PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
l The price grows at the same rate as the
dividends
48
3. Supernormal Growth-
Example
l Suppose a firm is expected to increase
dividends by 20% in first year (g1) and by
15% in second year (g2). After that dividends
will increase at a rate of 5% per year infinitely
(g3). If the last dividend was $1 (D0) and the
required return is 20%, what is the price of
the stock?
l Remember that we have to find the PV of all
expected future dividends.
49
Nonconstant Growth –
Example Solution
l Compute the dividends until growth levels off
l D1 = 1(1.2) = $1.20 à PV
l D2 = 1.20(1.15) = $1.38 à PV
l D3 = 1.38(1.05) = $1.449
l Find the expected future price (D3à D.infinity
– Constant growth model)
l P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66 à PV
l Find the present value of the expected future
cash flows
l P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
50
Quick Quiz – Part I
l What is the value of a stock that is expected
to pay a constant dividend of $2 per year if
the required return is 15%?
l What if the company starts increasing
dividends by 3% per year, beginning with the
next dividend? The required return stays at
15%.
51
Using the DGM to Find R
l Start with the DGM:
D 0 (1 + g) D1
P0 = =
R -g R -g
rearrange and solve for R
D 0 (1 + g) D1
R= +g= +g
P0 P0
52
Finding the Required Return -
Example
l Suppose a firm’s stock is selling for $10.50.
They just paid a $1 dividend and dividends
are expected to grow at 5% per year. What is
the required return?
l R = [1(1.05)/10.50] + .05 = 15%
l What is the dividend yield?
l 1*(1.05) / 10.50 = 10%
l What is the capital gains yield?
l g = 15% - 10% = 5%
l Dividend, Selling price: 53
Table 8.1 - Summary of Stock
Valuation
54
Features of Common Stock
l Voting Rights
l Other Rights
l Share proportionally in declared dividends
l Share proportionally in remaining assets during
liquidation
l Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired
55
Dividend Characteristics
l Dividends are not a liability of the firm until a
dividend has been declared by the Board
l Consequently, a firm cannot go bankrupt for not
declaring dividends
l Dividends and Taxes
l Dividend payments are not considered a business
expense; therefore, they are not tax deductible
l The taxation of dividends received by individuals
depends on the holding period
l Dividends received by corporations have a minimum
70% exclusion from taxable income
56
Features of Preferred Stock
l Dividends
l Stated dividend that must be paid before
dividends can be paid to common stockholders
l Dividends are not a liability of the firm and
preferred dividends can be deferred indefinitely
l Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid
l Preferred stock generally does not carry
voting rights
57
Reading Stock quotes in VN
markets
Kết quả giao dịch chứng khoán ngày 13-10-2008
TTO - * Chỉ số VN-Index: 371,67 điểm, giảm 7,39 điểm (-1,94%)
Khối lượng giao dịch: 13.693.350 đơn vị;
Giá trị giao dịch: 416,968 tỉ đồng
Mã CK Giá khớp Thay đổi (+/-) Khối lượng GD
ABT 30.4 0 777
ACL 33.1 -1.4 1200
AGF 20.9 FL-1 5525
ALP 11.3 -0.4 3896
ALT 27.9 FL-1.4 160
ANV 31 -0.2 6551
ASP 11.8 0.3 3368
BBC 17.1 FL-0.9 5167
BBT 5.5 FL-0.2 2184
BHS 15.4 0.1 559
BMC 90 FL-4.5 7941
BMI 21.5 FL-1.1 3265 59
Quick Quiz – Part II
l You observe a stock price of $18.75. You
expect a dividend growth rate of 5% and the
most recent dividend was $1.50. What is the
required return?
l What are some of the major characteristics of
common stock?
l What are some of the major characteristics of
preferred stock?
60
