Lecture 3 –Valuation : Bonds, Equity

and Projects
BDS : Chapters 6 ,7
Continuous Time Rate
• Last Lecture we discussed compounding frequency (m) and how by increasing the frequency the
effective rate tends to increase relative to the APR .
• Could compounding frequency exceed daily ?? YES !
• We could have continuously compounded rates of return
• Where ,

• For example , Assume you borrow $ 2000 , at a continuous compounded rate of return of 16 %
per annum , how much would you owe after 1 year ? After 7 Month ?
Sol . = $ 2, 347.02 after 1 year
Sol 2000 after 7 month
Computing a Rate of Return
• To compute a return on any asset, investment or on equity , you will need the original value , the
ending value and the loan value if needed .
• For example , you buy an asset for $20,000 and borrow 10,000 from a friend at no interest to
make the purchase. Suppose that after 4 month the value of the asset becomes $40,000 and that
you can sell it at that price .
• So, The asset price originally is $20,000 , the loan value is $10,000 , making the equity value at T=
0 equal to $10,000 .
• However , your equity value after a couple of month is now $ 30,000 (40,000-10,000)
• So, =3
• We can annualize these rates of return by taking the powers as
• ROA = =8 , 800 % gross or 700% net , while ROE = 2700 % gross or 2600% Net
Project Valuation
• Remember NPV ??
• An asset ( Project ) is a set of Future Cash flow stream.
• Cash flow estimation may include ( maintenance , replacement , legal , construction , initial
investment ,…) as cash outflows , while ( Rental income , operational , selling ,…) are cash inflows .
• Some Projects may deplete , while others are sustainable through the lifetime of the project .
• Example 1 :
Assume that an oil field will generate a CF of $ 15 Million next year . If you estimate that the CF will
decline by 5% per year and that the discount rate is 10 % , what would be the value of this oil field ?
Solution :
Remember the growing perpetuity ??
 Fiscal Versus Monetary Policy –
Interest Rates
• As Discussed Last week, The monetary policy is used as a mechanism to raise or lower central bank rates .
• Raising rate environments ( as what has been happening in 2022 and 2023 ) is considered or known as a
tightening monetary policy. The main objective here is to moderate inflation and GDP growth, and an
eventual slowing down to the economy .
• Lowering rate environments ( as what happened after 2008 economic collapse ) is considered or known as a
loosening monetary policy . The main objective here is stimulating the economy
• While these are options for the short run , long run impact can be conducducted via the fiscal policy

• The Fiscal Policy is used as a mechanism to counteract fluctuations in the economy . The two main forces
used by governments to do that are Government spending and Taxation .
Bond Valuation

Bond Valuation

- Bonds are usually interest-only loans interest is paid by the borrower every period, and
the principal/face/maturity value is repaid at the end of the loan.
- They could be issued by corporations or government agencies(ex: Municipal Bonds, War
Bonds )

Terminology :

- Coupon Rate

- Coupon Payment

- Face/Par/Maturity Value

- Maturity

- Yield or Yield to maturity

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Bond Valuation

- Coupon Rate : The annual Coupon divided by the face value of the bond .

Corporations promise to pay regular interest payments , these are called coupons .

The Coupon is constant and paid every year. This type of bond is called level coupon
bond.

- Face Value/Par Value : The amount repaid at the end of the loan.

Taking these to terms into consideration we can calculate the value of a bond by :

Bond Value = PV of coupons + PV of face

So, Bond Value = PV annuity + PV of lump sum

7
Bond Valuation

- Yield or Yield to maturity: The required market rate or rate that makes the discounted cash
flows from a bond equal to the bond's price.
- As time passes, interest rates change, but coupon payments on the bond remain the
same.
- Interest rate changes will have an impact on the value of the bond.
- Quoted market interest rate: yield to maturity (YTM) a semiannually compounded APR type
rate
- Example: quoted rate of 8% implies a six month (i.e. semiannual) interest rate of r = 8% 
2 = 4%

- Important relation between interest rates and the bond’s value:

1) When interest rates rise, the present value of the bond’s remaining cash flows declines , and the
bond is worth less.
2) When interest rates fall, the present value of the bond’s remaining cash flows increases , and the
bond is worth more.
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Bond Valuation

• We will demonstrate this relationship through Three different types of bonds and three
examples .
• Case I ( YTM=CR) and (Price = Par value)

Assume a bank was to issue a bond with 10 years to maturity . The annual coupon is $56. Similar
bonds have a yield to maturity of 5.6%. In 10 years the bank pays $1000 to the owner of the bond.

What would this bond sell for ?

- The bond’s cash flow has an annuity component and a lump sum. As stated :

Present value = $1000/

Annuity present value= $56*(1-1/

= $ 420.09

Adding up these values , total bond value is $1000.

The bond sells for its exact face value

9
Interest Rates and Bond Valuation

• Case II ( YTM>CR) and ( Price< Par Value)

We now assume that a year has passed by. Now the bond has nine years to maturity . If
interest rates rise to 7.6%, what would the bond be worth ?

Again,

Present value = $1000/

The bond offers $56 per year for nine years, so the present value of the annuity stream is :

Annuity present value :

$56*(1-1/$355.71

Adding the two values we get the bond’s value is $ 872.96 <1000 But Why ?

- The bond pays less than the going rate , investors are only willing to lend something less
than the $1000 promised repayment . This is an example of a discount bond .

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Bond Valuation

• Case III (CR>YTM) and (Price> Par value)

What would the bond sell for if interest rates had dropped by 2% ?

In this case the bond has a coupon rate of 5.6% and the market rate is only 3.6%.

Again,

Present value = $1000/

Annuity present value = $56*(1-1/)/0.036=$424.08

So, total bond value is $1151.46

The bond sells for more than $1000, we call this a premium bond .

Investors are willing to pay a premium to get the extra coupon .

- Bond prices and interest rates always move in opposite directions .

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Bond Valuation

Suppose you have an 8% semiannual-pay bond with a face value of $1,000 that matures
in 7 years. If the yield is 10%, what is the price of this bond?
 1 
1 - 1.0514  1,000
Bond Price 40   14
901.01
0.05 1.05

Or PMT = 40; N = 14; I/Y = 5; FV =

1000; CPT PV = -901.01

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Bond Valuation

Interest Rate Risk:

The risk that arises for bond owners from fluctuating interest rates( market yields) is
called interest rate risk. The sensitivity of prices to interest rate changes depends on
two things :

1- The time to maturity

The longer the time to maturity , the greater the interest rate risk.

2- The coupon rate

- The lower the coupon rate , the greater the interest rate risk.

13
Bond Valuation

14
Bond Valuation

• Consider bonds A and B

• Coupon rate: rCoupon A = rCoupon B = 10%
• Annual coupons
• Maturity in years: TA = 20; TB = 10
• Interest rate: 10%
 Both bonds sell for $1000
• Interest rate drops to 4%
 What happens to the prices of bonds?
 Which bond is more sensitive to a change in the
interest rate?
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Bond Valuation

 1  1  1
A
P $100  
 1 
20  
 $1,000 $1,815.42
 0.04  1  0.04    1  0.04
0 20

 1  1  1
B
P $100   1  
10  
 $1, 000 $1,486.65
 0.04  1  0.04    1  0.04
0 10

% A 81.54%
% B 48.66%
Longer term bond is more sensitive.
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Equity Valuation
• We already started this a bit last week when we covered the PV of a perpetuity
and a growing perpetuity
• Motivational Question :

How is the valuation of a share of common stock different from the valuation of a bond?

It is different in 3 ways :

1) Cash Flows are not known in advance

2) There isn’t a clear maturity

3) We cant easily observe the market rate of return

These factors make equity valuation more difficult .

The main difference in calculating the PV's of stocks rather than bonds is the in the profiles of earnings .
As with bonds, the price of the stock is the present value of these expected cash flows

The Payoff from stocks come in two forms : Cash Dividends and Capital gains and loses
Equity Valuation
• The Price of a stock today is equal to the present value of the dividend plus the
present value of the price expected to obtain .

Terminology :

r - is the opportunity cost of the expected return on similar securities

0 1
P1  D1
P0 P0 
(1  r ) P1 + D 1
 Equity Valuation
• But What determines next year’s price ?

If we knew the dividend and price in two periods , the stock price in one period would
equal :

Substituting for

If we continue similarly, then for H periods

How many future dividends are there ? How can we estimate them ?
Equity Valuation
Three Special cases : (In each case , we make some assumptions about the
future pattern of dividends)

• Constant dividend (Zero growth)

 The firm will pay a constant dividend forever
 This is like preferred stock
 The price is computed using the perpetuity formula

• Constant dividend growth

 The firm will increase the dividend by a constant percent every period

• Supernormal growth
 Dividend growth is not consistent initially, but settles down to constant
growth eventually
Equity Valuation
Three Special cases : (In each case , we make some assumptions about the
future pattern of dividends)

1- Zero Growth

One assumption we can make is that the company has a constant dividend stream Ex: A
preferred stock .

D1= D2=D3=D4=D= constant

So, + ……

The stock in this case can be viewed as an ordinary perpetuity , so this can be reduced
to (chapter 6) :

= D/r
 Equity Valuation
2- Constant Growth

Here we assume that dividend grows at a steady rate. We call that rate , the growth rate
(g). So, if we know the dividend now , or ( , then we can calculate any future dividend .

So, (1+g ) or the general case

So, (1+g) , Plugging into this equation we get =(1+g ) (1+g)

So, = or the general case =

(1+g )

0 1 2 3

This is a growing perpetuity , so we can use the following formula :

Equity Valuation
• This formula reflects the Dividend growth model of the Gordon Growth Model

Definition : The dividend growth model is a model that determines the current price of a
stock as the dividend next period , divided by the discount rate less the dividend
growth rate .

Why do we need this model ?

This model comes in handy went we want to value a company that offers a steady
growth in dividends . Ex : The TSX Canadian dividend aristocrats index

As long as the growth rate is less than the discount rate , the model could be used.
Equity Valuation
3- Non-Constant Growth

We use this model if we want to allow supernormal growth rates for some finite period of time .

Example : Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years.
After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the
required return is 20%, what is the price of the stock?

Solution:
• Compute the dividends until growth levels off
 D1 = 1(1.2) = $1.20
 D2 = 1.20(1.15) = $1.38
 D3 = 1.38(1.05) = $1.449

• Find the expected future price

 P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66

• Find the present value of the expected future cash flows

 P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
Equity Valuation
• Models could be very sensitive to your inputs or estimates .
250

200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate
Equity Valuation
• Other techniques of Stock Valuation :

Relative Valuation Models ( Using Multiplies )

- A problem with the dividend based approach is that many companies don’t pay
dividends. In this case we use price multiplies like the P/E ratio.
- Price at time t =
- The benchmark PE ratio could be based on the company’s own historical values or on
an industry average or median .
- Example : Twitter !

- In other case , some companies are not yet profitable, meaning that earnings are
negative . We could use the Price-sales ratio in this case .
• Using the Constant DGM to find r

Using the DGM and rearranging the formula , we can solve for r .

Since so,

Then = + g

r has two components here, the first is the dividend yield and the second is the growth
rate . Since we have the same growth rate for earnings , dividends , and stock price ,
growth rate here can be interpreted as the capital gains yield.

Definition: The capital gains yield is the dividend growth rate or the rate at which the
value of an investment grows.

Example :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?
- Solution

r = [1(1.05)/10.50] + .05 = 15%

What is the dividend yield?
1(1.05) / 10.50 = 10%

What is the capital gains yield?

g =5%

Important

We need to be very careful when stocks are valued about when the first dividend is
paid . If a question states that( the dividend has just been paid ), then this is Do , and
the next dividend payment will be D1.