Interest Rates and Bond Valuation

Chapter 8
Copyright 2010 by the McGraw-Hill Companies, I nc. All rights reserved.
McGraw-Hill/I rwin
8-1
8.1 Bonds and Bond Valuation
A bond is a legally binding agreement between
a borrower and a lender that specifies the:
Par (face) value
Coupon rate
Coupon payment
Maturity Date
The yield to maturity is the required market
interest rate on the bond.

8-2
Bond Valuation
Primary Principle:
Value of financial securities = PV of expected
future cash flows
Bond value is, therefore, determined by the
present value of the coupon payments and par
value.
Interest rates are inversely related to present
(i.e., bond) values. Price Yield Relationship
8-3
The Bond-Pricing Equation
T
T
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(

+
=
8-4
Bond Example
Consider a U.S. government bond with as 6 3/8%
coupon that expires in December 2013.
The Par Value of the bond is $1,000.
Coupon payments are made semiannually (June 30 and
December 31 for this particular bond).
Since the coupon rate is 6 3/8%, the payment is $31.875.
On January 1, 2009 the size and timing of cash flows are:

09 / 1 / 1
875 . 31 $
09 / 30 / 6
875 . 31 $
09 / 31 / 12
875 . 31 $
13 / 30 / 6
875 . 031 , 1 $
13 / 31 / 12
8-5
Bond Example
On January 1, 2009, the required yield is 5%.
The current value is:
17 . 060 , 1 $
) 025 . 1 (
000 , 1 $
) 025 . 1 (
1
1
2 05 .
875 . 31 $
10 10
= +
(

= PV
8-6
Bond Example: Calculator
PMT
I/Y
FV
PV
N
PV
31.875 =
5%/2=2.5
1,000
1,060.17
10
1,0000.06375
2
Find the present value of a 6 3/8% coupon bond with semi-annual
payments, and a maturity date of December 2013 if the YTM is
5% and there are 10 payment periods left.
8-7
Bond Example
Now assume that the required yield is 11%.
How does this change the bonds price?
69 . 825 $
) 055 . 1 (
000 , 1 $
) 055 . 1 (
1
1
2 11 .
875 . 31 $
10 10
= +
(

= PV
8-8
YTM and Bond Value
800
1000
1100
1200
1300
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
Discount Rate
B
o
n
d

V
a
l
u
e

6 3/8
When the YTM < coupon, the bond
trades at a premium.
When the YTM = coupon, the
bond trades at par.
When the YTM > coupon, the bond trades at a discount.
8-9
Bond Concepts
Bond prices and market interest rates move
in opposite directions.
When coupon rate = YTM, price = par
value
When coupon rate > YTM, price > par
value (premium bond)
When coupon rate < YTM, price < par
value (discount bond)

8-10
Interest Rate Risk
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can be
reinvested
Short-term bonds have more reinvestment rate risk than long-term
bonds.
High coupon rate bonds have more reinvestment rate risk than low
coupon rate bonds.
8-11
Maturity and Bond Price Volatility
C
Consider two otherwise identical bonds.
The long-maturity bond will have much more
volatility with respect to changes in the
discount rate.
Discount Rate
B
o
n
d

V
a
l
u
e

Par
Short Maturity Bond
Long Maturity
Bond
8-12
Computing Yield to Maturity
Yield to maturity is the rate implied by the
current bond price.
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.
If you have a financial calculator, enter N, PV,
PMT, and FV, remembering the sign
convention (PMT and FV need to have the
same sign, PV the opposite sign).
8-13
YTM with Annual Coupons
Consider a bond with a 10% annual coupon
rate, 15 years to maturity, and a par value of
$1,000. The current price is $928.09.
Will the yield be more or less than 10%?
N = 15; PV = -928.09; FV = 1,000; PMT = 100
CPT I/Y = 11%
8-14
YTM with Semiannual Coupons
Suppose a bond with a 10% coupon rate and
semiannual coupons has a face value of
$1,000, 20 years to maturity, and is selling for
$1,197.93.
Is the YTM more or less than 10%?
What is the semi-annual coupon payment?
How many periods are there?
N = 40; PV = -1,197.93; PMT = 50; FV = 1,000;
CPT I/Y = 4% (Is this the YTM?)
YTM = 4%*2 = 8%

8-15
Current Yield vs. Yield to Maturity
Current Yield = annual coupon / price
Yield to maturity = current yield + capital gains yield
Example: 10% coupon bond, with semi-annual
coupons, face value of 1,000, 20 years to maturity,
$1,197.93 price
Current yield = 100 / 1197.93 = .0835 = 8.35%
Price in one year, assuming no change in YTM = 1,193.68
Capital gain yield = (1193.68 1197.93) / 1197.93 =
-.0035 = -.35%
YTM = 8.35 - .35 = 8%, which is the same YTM computed
earlier
8-16
Zero Coupon Bonds
Make no periodic interest payments (coupon rate =
0%)
The entire yield to maturity comes from the
difference between the purchase price and the par
value
Cannot sell for more than par value
Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips are
good examples of zeroes
8-17
Pure Discount Bonds
Information needed for valuing pure discount bonds:
Time to maturity (T) = Maturity date - todays date
Face value (F)
Discount rate (r)

T
r
F
PV
) 1 ( +
=
Present value of a pure discount bond at time 0:

0
0 $
1
0 $
2
0 $
1 T
F $
T
8-18
Pure Discount Bonds: Example
Find the value of a 15-year zero-coupon bond
with a $1,000 par value and a YTM of 12%.

11 . 174 $
) 06 . 1 (
000 , 1 $
) 1 (
30
= =
+
=
T
r
F
PV
0
0 $
1
0 $
2
0 $
29
000 , 1 $
30

0
0 $
1
0 $
2
0 $
29
000 , 1 $
30
8-19
8.2 Government and Corporate Bonds
Treasury Securities
Federal government debt
T-bills pure discount bonds with original maturity less
than one year
T-notes coupon debt with original maturity between one
and ten years
T-bonds coupon debt with original maturity greater than
ten years
Municipal Securities
Debt of state and local governments
Varying degrees of default risk, rated similar to corporate
debt
Interest received is tax-exempt at the federal level
8-20
After-tax Yields
A taxable bond has a yield of 8%, and a
municipal bond has a yield of 6%.
If you are in a 40% tax bracket, which bond do
you prefer?
8%(1 - .4) = 4.8%
The after-tax return on the corporate bond is 4.8%,
compared to a 6% return on the municipal
At what tax rate would you be indifferent between
the two bonds?
8%(1 T) = 6%
T = 25%
8-21
Corporate Bonds
Greater default risk relative to government
bonds
The promised yield (YTM) may be higher than
the expected return due to this added default
risk
8-22
Bond Ratings Investment Quality
High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong
Medium Grade
Moodys A and S&P A capacity to pay is strong, but
more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more impact on
the firms ability to pay
8-23
Bond Ratings - Speculative
Low Grade
Moodys Ba and B
S&P BB and B
Considered speculative with respect to capacity to pay.
Very Low Grade
Moodys C
S&P C & D
Highly uncertain repayment and, in many cases,
already in default, with principal and interest in
arrears.
8-24
8.3 Bond Markets
Primarily over-the-counter transactions with
dealers connected electronically
Extremely large number of bond issues, but
generally low daily volume in single issues
Makes getting up-to-date prices difficult,
particularly on a small company or municipal
issues
Treasury securities are an exception
8-25
Clean versus Dirty Prices
Clean price: quoted price
Dirty price: price actually paid = quoted price plus accrued
interest
Example: Consider T-bond in previous slide, assume today is
July 15, 2009
Number of days since last coupon = 61
Number of days in the coupon period = 184
Accrued interest = (61/184)(.04*1,000) = 13.26
Prices (based on ask):
Clean price = 1,327.50
Dirty price = 1,327.50 + 13.26 = 1,340.76
So, you would actually pay $1,340.76 for the bond.
8-26
8.4 Inflation and Interest Rates
Real rate of interest change in purchasing
power
Nominal rate of interest quoted rate of
interest, change in purchasing power and
inflation
The ex ante nominal rate of interest includes
our desired real rate of return plus an
adjustment for expected inflation.
8-27
Real versus Nominal Rates
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
Approximation
R = r + h
8-28
Inflation-Linked Bonds
Most government bonds face inflation risk
TIPS (Treasury Inflation-Protected Securities),
however, eliminate this risk by providing
promised payments specified in real, rather
than nominal, terms
8-29
The Fisher Effect: Example
If we require a 10% real return and we expect
inflation to be 8%, what is the nominal rate?
R = (1.1)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
8-30
8.5 Determinants of Bond Yields
Term structure is the relationship between time
to maturity and yields, all else equal.
It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
Yield curve graphical representation of the
term structure
Normal upward-sloping, long-term yields are
higher than short-term yields
Inverted downward-sloping, long-term yields are
lower than short-term yields
8-31
Factors Affecting Required Return
Default risk premium remember bond ratings
Taxability premium remember municipal
versus taxable
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns (remember bid-ask spreads)
Anything else that affects the risk of the cash
flows to the bondholders will affect the
required returns.
Stock Valuation
Chapter 9
Copyright 2010 by the McGraw-Hill Companies, I nc. All rights reserved.
McGraw-Hill/I rwin
8-33
9.1 The PV of Common Stocks
The value of any asset is the present value of its
expected future cash flows.
Stock ownership produces cash flows from:
Dividends
Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth
8-34
Case 1: Zero Growth
Assume that dividends will remain at the same level
forever
R
P
R R R
P
Div
) 1 (
Div
) 1 (
Div
) 1 (
Div
0
3
3
2
2
1
1
0
=
+
+
+
+
+
+
=
= = =
3 2 1
Div Div Div
- Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:
8-35
Case 2: Constant Growth
) 1 ( Div Div
0 1
g + =
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
of a growing perpetuity:
g R
P

=
1
0
Div
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
2
0 1 2
) 1 ( Div ) 1 ( Div Div g g + = + =
3
0 2 3
) 1 ( Div ) 1 ( Div Div g g + = + =
.
.
.
8-36
Constant Growth Example
Suppose Big D, Inc., just paid a dividend of
$.50. It is expected to increase its dividend by
2% per year. If the market requires a return of
15% on assets of this risk level, how much
should the stock be selling for?
P
0
= .50(1+.02) / (.15 - .02) = $3.92
8-37
Case 3: Differential Growth
Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
To value a Differential Growth Stock, we need
to:
Estimate future dividends in the foreseeable future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
8-38
Case 3: Differential Growth
) (1 Div Div
1 0 1
g + =
- Assume that dividends will grow at rate g
1
for N
years and grow at rate g
2
thereafter.
2
1 0 1 1 2
) (1 Div ) (1 Div Div g g + = + =
N
N N
g g ) (1 Div ) (1 Div Div
1 0 1 1
+ = + =

) (1 ) (1 Div ) (1 Div Div
2 1 0 2 1
g g g
N
N N
+ + = + =
+
.
.
.
.
.
.
8-39
Case 3: Differential Growth
) (1 Div
1 0
g +
Dividends will grow at rate g
1
for N years and grow
at rate g
2
thereafter
2
1 0
) (1 Div g +
N
g ) (1 Div
1 0
+
) (1 ) (1 Div
) (1 Div
2 1 0
2
g g
g
N
N
+ + =
+

0 1 2


N N+1

8-40
Case 3: Differential Growth
We can value this as the sum of:
a T-year annuity growing at rate g
1

(

+
+

=
T
T
A
R
g
g R
C
P
) 1 (
) 1 (
1
1
1
plus the discounted value of a perpetuity growing at
rate g
2
that starts in year T+1
T
B
R
g R
P
) 1 (
Div
2
1 T
+
|
|
.
|

\
|

=
+
8-41
Case 3: Differential Growth
Consolidating gives:
T T
T
R
g R
R
g
g R
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 T
1
1
+
|
|
.
|

\
|

+
(

+
+

=
+
Or, we can cash flow it out.
8-42
A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.
8-43
With the Formula
3
3
3
3
) 12 . 1 (
04 . 12 .
) 04 . 1 ( ) 08 . 1 ( 2 $
) 12 . 1 (
) 08 . 1 (
1
08 . 12 .
) 08 . 1 ( 2 $
|
|
.
|

\
|

+
(

= P
| |
( )
3
) 12 . 1 (
75 . 32 $
8966 . 1 54 $ + = P
31 . 23 $ 58 . 5 $ + = P 89 . 28 $ = P
8-44
With Cash Flows
08) . 2(1 $
2
08) . 2(1 $

0 1 2 3 4
3
08) . 2(1 $ ) 04 . 1 ( 08) . 2(1 $
3
16 . 2 $
33 . 2 $
0 1 2 3
04 . 12 .
62 . 2 $
52 . 2 $

+
89 . 28 $
) 12 . 1 (
75 . 32 $ 52 . 2 $
) 12 . 1 (
33 . 2 $
12 . 1
16 . 2 $
3 2
0
=
+
+ + = P
75 . 32 $
08 .
62 . 2 $
3
= = P
The constant
growth phase
beginning in year 4
can be valued as a
growing perpetuity
at time 3.
8-45
9.2 Estimates of Parameters
The value of a firm depends upon its growth
rate, g, and its discount rate, R.
Where does g come from?
g = Retention ratio Return on retained earnings


8-46
Where Does R Come From?
The discount rate can be broken into two parts.
The dividend yield
The growth rate (in dividends)
In practice, there is a great deal of estimation
error involved in estimating R.
8-47
Using the DGM to Find R
Start with the DGM:
g
P
D
g
P
g) 1 ( D
R
g - R
D
g - R
g) 1 ( D
P
0
1
0
0
1 0
0
+ = +
+
=
=
+
=
Rearrange and solve for R:
8-48
9.3 Growth Opportunities
Growth opportunities are opportunities to
invest in positive NPV projects.
The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100% of its earnings as dividends plus the net
present value of the growth opportunities.
NPVGO
R
EPS
P + =
8-49
NPVGO Model: Example
Consider a firm that has forecasted EPS of $5,
a discount rate of 16%, and is currently priced
at $75 per share.
We can calculate the value of the firm as a cash cow.


So, NPVGO must be: $75 - $31.25 = $43.75

25 . 31 $
16 .
5 $ EPS
0
= = =
R
P
8-50
Retention Rate and Firm Value
An increase in the retention rate will:
Reduce the dividend paid to shareholders
Increase the firms growth rate
These have offsetting influences on stock price
Which one dominates?
If ROE>R, then increased retention increases firm
value since reinvested capital earns more than the
cost of capital.

8-51
9.4 Price-Earnings Ratio
Many analysts frequently relate earnings per share to
price.
The price-earnings ratio is calculated as the current
stock price divided by annual EPS.
The Wall Street Journal uses last 4 quarters earnings

EPS
share per Price
ratio P/E =
8-52
PE and NPVGO

Recall,

Dividing every term by EPS provides the following description
of the PE ratio:



So, a firms PE ratio is positively related to growth
opportunities and negatively related to risk (R)

NPVGO
R
EPS
P + =
EPS
NPVGO
R
PE + =
1
8-53
9.5 The Stock Markets
Dealers vs. Brokers
New York Stock Exchange (NYSE)
Largest stock market in the world
License Holders (formerly Members)
Entitled to buy or sell on the exchange floor
Commission brokers
Specialists
Floor brokers
Floor traders
Operations
Floor activity
8-54
NASDAQ
Not a physical exchange computer-based
quotation system
Multiple market makers
Electronic Communications Networks
Three levels of information
Level 1 median quotes, registered representatives
Level 2 view quotes, brokers & dealers
Level 3 view and update quotes, dealers only
Large portion of technology stocks