Bond Valuation
Bond Valuation
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What is Bond ?
A long-term debt instrument in which a borrower agrees to
make payments of principal and interest, on specific dates,
to the holders of the bond.
A bond is a security that obligates the issuer to make
specified interest and principal payments to the holder on
specified dates.
Bonds are sometimes called fixed income securities.
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Key Features of a Bond
Par value or face value – face amount of the bond, which
is paid at maturity (assume $1,000).
Maturity Date : The length of time until the bond issuer
returns the par value to the bondholder and terminates or
redeems the bond.
Coupon interest rate – stated interest rate (generally fixed)
paid by the issuer.
Rate of interest paid as a percentage of the par value.
Issue date – when the bond was issued.
Indenture: An Indenture is the legal agreement between
the firm issuing the bonds and the bond trustee who
represents the bondholders.
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Bond Valuation
In general, Valuation is the process of determining the intrinsic
value of any asset whose value is obtained from future cash flows
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 a bond is a function of:
» Par value
» Term to maturity
» Coupon rate
» Investor’s required rate of return (discount rate is also known as the
bond’s yield to maturity)
Can the intrinsic value of an asset differ from the
market value?
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Bond Value
General Formula
1
1 ( 1 k )n 1
[ 6-1] B I b
F
kb ( 1 k b ) n
Where:
I = interest (or coupon ) payments
kb = the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
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Bond Valuation: Example
1 1 kb n F
B I
b
n
k b
1 k
1 1.06 10 1, 000
50
10
0.06
1.06
$926.40
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Example 1
Consider a 10 year, 12 % coupon bond compounded
annually with a par value of Birr 1000. Let the required
yield on this bond is 13%.
The cash flows for this bond are as follows:
10 annual coupon payment of Birr 120
Birr 1000 principal repayment 10 years from now
45 45 45 45 1045
0 1 2 3 ... 20
Period/Yr = 1
N = 20
r% per year = 12
FV = 1,000
Coupon = 120
Solution:
P = $1,000
Note: If the coupon rate = yield, the bond will
sell for par value.
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Exercise (contd…)
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Period/Yr = 1
N = 20
r% per Year = 10
Coupon = 120
FV = 1000
Solution:
P = $1,170.27
Note: If the coupon rate > yield, the bond will sell
for a premium.
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Exercise (contd…)
12
Period/Yr = 1
N = 20
r% per year = 14
Coupon = 120
FV = 1000
Solution:
P = $867.54
Note: If the coupon rate < yield, the bond will sell
for a discount.
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Relationship Between Bond Prices
and Yields
The relationship between the coupon rate and the bond’s
yield-to-maturity (YTM) determines if the bond will sell at a
premium, at a discount, or at par
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Relationship Between Bond Prices
and Yields
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Rate of return on Bond
Yield To Maturity (YTM): The average annual rate of
return investors expect to receive on a bond if they hold it to
maturity.
Mathematically:
YTM of a bond is the interest rate that makes the present value
of the cash flows receivable from owning the bond equal to the
price of the bond. M-P
I n
P = $A (PVIFA r, n) + $M (PVIF r, n) Approx YTM
MP
»just solve for r = YTM !!! 2
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YTM Example
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1.2 Valuation of Stocks
Two types:
– Preferred stock and
– Common stock
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Hybrid nature of
Preferred stocks
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Valuing Preferred Stock
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Valuing Preferred Stock
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2. Common Stock
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Common Stock: in-brief
Status: Owners
Life: No maturity date
Rights to votes and assets: In proportion to number of
shares held
Liability: Limited to amount of investment
Source of Return: Dividends (if paid) and Capital gain (if
sold at a higher price)
Dividends: Neither fixed nor guaranteed.
Seniority: In the event of bankruptcy, common
stockholders will not receive any payment until all the
creditors, including the bondholders and preferred
stockholders, have been satisfied.
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Features of Common Stocks
Voting rights
Preemptive rights
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Voting Rights
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Preemptive Rights
Preemptive right entitles the common shareholder to
maintain a proportionate share of ownership in the firm.
» Thus, if a shareholder currently owns 5% of the
shares, s/he has the right to purchase 5% of the shares
when new shares are issued.
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Valuing Common Stock
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Stock Valuation Models: The Basic Stock
Valuation Equation
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Stock Valuation Models:
The Zero Growth Model
The zero dividend growth model assumes that the stock will
pay the same dividend each year, year after year.
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Stock Valuation Models:
The Zero Growth Model (cont.)
The dividend of Denham Company, an established
textile manufacturer, is expected to remain constant at
$3 per share indefinitely. What is the value of
Denham’s stock if the required return demanded by
investors is 15%?
P0 = $3/0.15 = $20
Note that the zero growth model is also the appropriate
valuation technique for valuing preferred stock
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Stock Valuation Models:
Constant Growth Model
The constant dividend growth model assumes that the stock will
pay dividends that grow at a constant rate each year—year after
year forever.
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An Example
Find the stock price given that the current dividend is $2 per
share, dividends are expected to grow at a rate of 5% in the
foreseeable future, and the required return is 10%
P0 = D1/(r – g)
P0 = $2.10/5% = $2.10/0.05 = $42
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Stock Valuation Models:
Variable-Growth Model
The non-constant dividend growth or variable-
growth model assumes that the stock will pay
dividends that grow at one rate during one period,
and at another rate in another year or thereafter.
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Stock Valuation Models:
Variable-Growth Model (cont.)
Step 1. Find the value of the cash dividends at the end of each year, Dt,
during the initial growth period, years 1 though N.
2. Find the present value of the dividends expected during the initial
growth period.
Step 3. Find the value of the stock at the end of the initial growth period,
PN = (DN+1)/(ks-g2), which is the present value of all dividends expected
from year N+1 to infinity, assuming a constant dividend growth rate,
Step 4. Add the present value components found in Steps 2 and 3 to find
the value of the stock, P0,
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Stock Valuation Models:
Variable-Growth Model (cont.)
The most recent annual (2016) dividend payment of Warren Industries,
a rapidly growing boat manufacturer, was $1.50 per share. The firm’s
financial manager expects that these dividends will increase at a 10%
annual rate, g1, over the next three years. At the end of three years
(the end of 2009), the firm’s mature is expected to result in a slowing
of the dividend growth rate to 5% per year, g2, for the foreseeable
future. The firm’s required return, ks, is 15%.
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Stock Valuation Models:
Variable-Growth Model (cont.)
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Stock Valuation Models:
Variable-Growth Model (cont.)
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