Lecture 04 Bonds and Stocks Valuation

LECTURE 4
BONDS AND
STOCKS
VALUATION

Copyright 2012 Pearson Prentice Hall. All rights reserved.
LEARNING OBJECTIVES
Review bond terminology and how to
compute the price and yield to maturity of
a zero-coupon bond and a coupon bond
Have look at stock basics, the Dividend-
Discount Model and the Total Payout Model
to evaluate the stock
Experience some problems
CHAPTER OUTLINE
4.1 BONDS VALUATION
- Bond Terminology
- Zero- coupon Bond
- Coupon Bond
- Bond prices
4.2 STOCKS VALUATION
- Common and preferred stock basics
- The Dividend- Discount Model
- Share Repurchases and the Total Payout
Model

4.1 BOND VALUATION
4.1.1 Bond Terminology
4.1.2 Zero- coupon Bond
4.1.3 Coupon Bond
4.1.4 Bond prices

4.1.1 BOND TERMINOLOGY
Bond: a long-term debt security
(promissory note).
Bond certificate
Terms of the bond
Amounts and dates of all payments to be made.
Term: the time remaining until the
repayment date

Face value (aka par value or principal
amount)
Notional amount used to compute interest
payments
Usually standard increments, such as $100
Typically repaid at maturity
Maturity date: final repayment date of
bond. Payments continue until this date.

Copyright 2012 Pearson Prentice Hall. All rights reserved. 7
Copyright 2012 Pearson Prentice Hall. All rights reserved. 8
Coupon rate: set by the issuer and stated
on the bond certificate
Coupon payment (CPN)

Coupon Rate Face Value
Number of Coupon Payments per Year
CPN

=
(Eq. 4.1)
EXAMPLE 4.1
The Beck Corporation wants to borrow
$1,000 for 30 years. The interest rate on
similar debt issued by similar corporations
is 12%.
Beck will thus pay .12 x $ 1,000 = $120 in
interest every year for 30 years
At the end of 30 years, Beck will repay the
$1,000
4.1.2 ZERO- COUPON BONDS
Bonds without coupons
Always trade at a discount (aka pure
discount bonds)
Only two cash flows
The bonds market price at the time of purchase
The bonds face value at maturity
Treasury bills
Yield to Maturity (YTM, a rate of return
of a bond) of a Zero-Coupon Bond
The discount rate that sets the present value of
the promised bond payments equal to the
current market price of the bond
Yield to Maturity of an n-Year Zero-Coupon
Bond:

1/
1
n
n
Face Value
YTM
Price
| |
+ =
|
\ .
(Eq. 4.2)
Price of a Zero- coupon bond: compute
the present value of the face amount using
the bonds yield to maturity.

n
YTM) (
value Face
P
+
=
1

(Eq. 4.3)
4.1.3 COUPON BONDS
Coupon bonds
Pay face value at maturity
Also make regular coupon interest payments
Two types of U.S. Treasury coupon securities
are currently traded in financial markets:
Treasury notes
original maturities from one to ten years
Treasury bonds
original maturities of more than ten years

Table 4.1: Existing U.S. Treasury
Securities
Bonds Cur YLD VOL CLOSE NET CHG
ATT 6s15 6.4 177 93 7/8 + 1/4
4.1.3 COUPON BONDS
Return on a coupon bond comes from:
The difference between the purchase price and the
principal value
Periodic coupon payments
To compute the yield to maturity of a
coupon bond, we need to know the coupon
interest payments, and when they are
paid.

4.1.3 COUPON BONDS
YTM of a coupon bond: the interest rate y
that solves the following equation
Annuity Factor using the YTM ( )
Present Value of the
Present Value of all of the periodic coupon payments
Face Value repayment
using the YTM (
1 1
1
(1 ) (1 )
y
N N
y
FV
P CPN
y
y y
| |
= +
|
|
+ +
\ .
)
(Eq. 4.4)
OTHER TYPES of BONDS
Income bonds: coupon payments are
dependent on company income
A convertible bond: can be swapped for
a fixed number of shares of stock anytime
before maturity at the holders option
A put bond: allow the holder to force the
issuer to buy the bond back at a stated
price.
4.1.4 BOND PRICES
Coupon bonds may trade at a discount or
at a premium
Most issuers of coupon bonds choose a
coupon rate so that the bonds will initially
trade at, or very close to, par.

Figure 4.1 A Bonds Price vs. Its Yield
to Maturity
Discount Bond: Priced
below Par
YTM > Coupon Rate
Premium Bond:
Priced above Par
YTM < Coupon Rate
Par Value
Coupon Rt = YTM
Table 4.2 Bond Prices Immediately
After a Coupon Payment
INTEREST RATE RISK
The risk that arises for bond owners from
fluctuating interest rates. With all the other
things being equal:
- The longer the time to maturity, the
greater the interest risk
- The lower coupon rate, the greater the
interest rate risk.
Risk- free interest rate: equals the YTM
on a default- free zero- coupon bond

INTEREST RATE RISK and BOND PRICE
Example 4.2: We compute and plot prices
under different interest rate scenarios for
10% coupon bonds with maturities of 1
year and 30 years
INTEREST RATE RISK and BOND PRICE
With the coupons and time to maturity
equal, the higher interest rate leads to the
smaller bond price
The longer- term bonds have greater
interest rate sensitivity to bond price (The
slope of the line connecting the prices is
much steeper for the 30-year maturity
than it is for the 1- year maturity)
Coupon and interest rate sensitivity
A bond with the lower coupon price will
fluctuate more as interest rate change
A bond with the higher coupon price is
less sensitive to changes in the discount
rate

Example 4.3 Coupons and Interest Rate
Sensitivity
Consider two bonds, each pays semi-
annual coupons and 5 years left until
maturity.
One has a coupon rate of 5% and the other
has a coupon rate of 10%, but both
currently have a yield to maturity of 8%.
How much will the price of each bond
change if its yield to maturity decreases
from 8% to 7%?
Sensitivity
Solution
We need to compute the price of each bond
at 8% and 7% yield to maturities and then
compute the percentage change in price.
Each bond has 10 semi-annual coupon
payments remaining along with the
repayment of par value at maturity.
The cash flows per $100 of face value for the
first bond are $2.50 every 6 months and
then $100 at maturity.
CPN = (.05 x 100)/2 = $2.50

Coupon Rate Face Value
Number of Coupon Payments per Year
CPN

=
Sensitivity
Solution
The cash flows per $100 of face value for the second
bond are $5 every 6 months and then $100 at
maturity. [CPN = (.10 x 100)/2 = $5.00]
Since the cash flows are semi-annual, the
yield to maturity is quoted as a semi-
annually compounded APR, so we convert
the yields to match the frequency of the cash
flows by dividing by 2.
With semi-annual rates of 4% (for 8%) and
3.5% (for 7%), we can compute the prices.
Sensitivity
The 5% coupon bonds price changed from $87.83 to
$91.68, or 4.4%, but the 10% coupon bonds price
changed from $108.11 to $112.47, or 4.0%.
4.2 STOCK VALUATION
4.2.1 Common and preferred stock basics
4.2.2 The Dividend- Discount Model
4.2.3 Share Repurchases and the Total
Payout Model
4.2.1 Common Stock Basics
Stock Market Reporting: Stock Quotes
Common Stock (CS) is a certificate that
indicates ownership in a corporation. When you
buy a share, you buy a part/share of the
company and attain ownership rights in
proportion to your share of the company.
Common stockholders are the true owners of
the firm. Bondholders and preferred stock
holders can be viewed as creditors.
Ticker Symbol is the designated 3 or fewer
characters symbol of publicly traded company
listed on NYSE.

7-34
4.2.1 Common Stock Basics
Common Stock
Shareholder Voting
Straight Voting-voting power goes to shareholder
(S/H) with majority ownership (aka majority vote)
Cumulative Voting (total VOTE allocation for all
directors = # of open spots x # of shares owned)
Classes of Stock (different types of CS with different
voting rights)
Shareholder Rights
Annual Meeting to answer questions from S/H
Proxy is giving a party temporary power of
attorney to vote. Proxy Contest are battles
between rival groups for proxy votes.

7-35
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
Income: Dividends (if paid) and Capital gain (if sold
at a higher price)
Dividends: Dividends are 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.
4.2.1 Preferred Stock Basics
Preferred Stock (PS) is often referred to as a
hybrid security because it has many
characteristics of both common stock and bonds.
PS has preference over CS in the distribution of
div. or cash in BK.
Like common stocks, preferred stocks
Have no fixed maturity date
Failure to pay dividends can not force the firm to file bankruptcy
Dividends are not a tax-deductible expense
No voting rights
Like Bonds
Dividends are fixed in amount
7-37
4.2.1 Preferred Stock Basics
Cumulative PS is where unpaid dividends
are carried forward, almost all PS are
cumulative
Non-Cumulative PS is when missed
dividends do not accumulate
Preferred Stock is treated as equity, not a
debt
Is preferred stock really debt?

7-38
4.2.2 The Dividend-Discount Model
A One Year Investor
Two potential sources of cash flows from
owning a stock:
Dividends
Selling Shares
7-39
P
0
= current market price for a share of stock
Div
1
= total dividends paid per share

P
1
= sell price

A One Year Investor
Since the cash flows are not risk-less, they
must be discounted at the equity cost of capital

7-40
(Eq. 4.5)
Dividend Yields, Capital Gains, and Total
Returns
Dividend Yield
Capital Gain
Capital Gains Rate
Total Return

7-41
(Eq. 4.5)
r
E
= equity Cost of Capital

(Eq. 4.6)
Dividend-Discount Model Equation

Dividend Discount Model determines the
price of stock by taking the PV of all future
dividends that the firm will pay

7-42

P
0
=
Div
1
1+ r
E
+
Div
2
1+ r
E
( )
2
+L +
Div
N
1+ r
E
( )
N
+
P
N
1+ r
E
( )
N
(Eq. 4.8)

Some special cases
A share of common stock in a company with a
constant dividend is much like a share of
preferred stock.

r
E
Div
=
P
0
Zero dividend growth

(Eq. 4.9)
Example 4. 5 Valuing a firm with zero
dividend growth
Suppose the Paradise Protyping Company
has a policy of paying a $10 per share
dividend every year. If this policy is to be
continued, what is the value of a share of
stock if the equity cost of capital is 20%?
Some special cases
Constant Dividend Growth
Assumes that dividends will grow at a constant
rate, g, forever
The value of the firm depends on the dividend
level of next year, divided by the equity cost of
capital adjusted by the growth rate

7-45

P
0
=
Div
1
r
E
g
(Eq. 4.10)
Example 4.6 Valuing a firm with
constant dividend growth
The Gordon Corporation will pay dividend
of $4 per share for the next year. The
dividend of this company grows at a steady
rate of 6% per year. Based on the dividend
growth model, what is the value of Gordon
stock today? What is the value in four
years? If the cost of equity if 16%.
Some special cases
Nonconstant dividend growth
Example 4.7: Suppose that you have come
up with the dividend forecasts for the next
three years are $1, $ 2 and $2.5
respectively. After the third year, the
dividend will growth at a constant rate of
5% per year. The required return is 10%.
What is the value of the stock today?
Payout Model
Share Repurchases
The firm uses excess cash to buy back its own
stock
Consequences:
The more cash the firm uses to repurchase shares, the
less cash it has available to pay dividends
By repurchasing shares, the firm decreases its share
count, which increases its earnings and dividends on a
per-share basis.

7-48
Payout Model
Share Repurchases
In the dividend-discount model, a share is
valued from the perspective of a single
shareholder, discounting the dividends the
shareholder will receive:

7-49
( )
0
Future Dividends per Share P PV =
(Eq. 4.11)
Payout Model
Total Payout Model
Values all of the firms equity, rather than a
single share
To use this model, discount the total payouts that the
firm makes to shareholders, which is the total amount
spent on both dividends and share repurchases

7-50
(Eq. 4.12)
( )
0
0
Future Total Dividends and Repurchases
Shares Outstanding
PV
P =

Lecture 04 Bonds and Stocks Valuation

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