FINA5530 - Managerial Finance

Week 3
Valuation
Objectives for Week 3

You should be able to:

– discuss the key features of the discounted cash flow (DCF)
valuation model

– apply the discounted cash flow (DCF) valuation model to valuing

different types of bonds and stocks
Discounted cash flow valuation

The discounted cash flow (DCF) valuation model values a security as

the present value of the expected future cash flows accruing to the
owner of the security.

The two inputs to the DCF model are:

– the expected future cash flows (CF1, CF2, ….. )
– the discount rate (k).

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑇

𝑉𝑎𝑙𝑢𝑒 = + + ⋯+ (10.1)
(1+𝑘)1 (1+𝑘)2 1+𝑘 𝑇

In Week 3 we apply the DCF model to valuing bonds and stocks.

We can also apply the DCF model to valuing capital projects (Week 8)
and business units and businesses (Week 9).
Valuing a coupon bond

Corporations and governments issue bonds to raise long-term funding.

The bond price represents the present value of future coupon

payments (CP) and the face value (F) discounted at investors’ yield to
maturity (y):

𝐶𝑃1 𝐶𝑃2 𝐶𝑃𝑇 +𝐹

𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = + + ⋯+ (10.2)
(1+𝑦)1 (1+𝑦)2 1+𝑦 𝑇

We can also value a bond by decomposing the cash flows into an

annuity (the coupon stream) and a single sum (the face value):

1
1−
(1+𝑦)𝑇 𝐹
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = 𝐶𝑃 × +
𝑦 1+𝑦 𝑇

NB. Formula assume there is a full period (one year) to the first coupon.
Problem 1

What is the price of a two-year bond with a $100 face value and 8%
p.a. coupon when the yield to maturity is 7% p.a.?
Yield to maturity

The yield to maturity (y) represents the discount rate that makes the
bond price equal to the present value of the bond’s future cash flow
stream i.e. the future coupon payments (CP) and the face value (F).

The yield to maturity is a promised yield. The investor will only earn
the promised yield if three conditions hold:
1. the bond is held to maturity date
2. all intermediate coupons are reinvested at the promised yield
3. all coupons and the face value are received in full and on time

The investor’s actual yield or realised yield may be higher or lower

than the promised yield.

Be very wary about buying a bond with a high (promised) yield such as
17%. You will be fortunate to realise this high yield!
The yield to maturity on a bond is analogous to the internal rate of
return (IRR) on a project.

You need a financial calculator or EXCEL to determine the yield to

maturity!

In EXCEL you can use the RATE function or the IRR function.

You will NOT be required to calculate the yield to maturity in the final
examination in FINA5530.
The price/yield relationship

Inverse price/yield relationship

Rise in yield Fall in bond price
Fall in yield Rise in bond price

Price/Yield Relationship:
Five year bond, 5% coupon, $100 face value
140.00

130.00

120.00
Price 110.00
($) 100.00

90.00

80.00

70.00

60.00
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0

Yield (%)

Price/yield relationship is convex.

Semi-annual coupon bonds

Most bonds pay a semi-annual coupon. To price a semi-annual

coupon bond, we modify the bond pricing formulae as follows:
– halve the periodic coupon payment
– halve the annual yield to maturity
– double the number of coupon periods

𝐶𝑃1ൗ 𝐶𝑃2ൗ 𝐶𝑃𝑇ൗ

2 2 2 +𝐹
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = 𝑦 1+ 𝑦 2 + ⋯+
(1 + ൗ2) (1 + ൗ2) 𝑦 𝑇
1 + ൗ2

1
1− 𝑦ൗ 𝑇
𝐶𝑃Τ (1+ 2) 𝐹
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = 2 × 𝑦 +
ൗ2 (1+𝑦ൗ2)𝑇

NB. These formulae assume there is a full period (six months) to the
first coupon.
Problem 2

What is the price of a two-year bond with a $100 face value and 8%
p.a. coupon, paid semi-annually, when the yield to maturity is 7% p.a.?
Perpetual bonds

The issuer of a perpetual bond is not obligated to redeem the bond (i.e.
repay the face value) at some point in the future.

The bond price represents the present value of a perpetual coupon

stream i.e. a perpetuity:

𝐶𝑃 𝐶𝑃 𝐶𝑃
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = + + ⋯ =
(1 + 𝑦)1 (1 + 𝑦)2 𝑦

The most famous example is the consol first issued by the UK

Government in 1751.
https://en.wikipedia.org/wiki/Consol_(bond)
Problem 3

What is the price of a perpetual bond with a $100 face value and 4%
p.a. coupon when the yield to maturity is 3% p.a.?
Zero coupon bonds

Zero coupon bonds do not pay a coupon.

The bond price represents the present value of the face value of the
bond:

𝐹𝑇
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 =
(1 + 𝑦)𝑇

Zero coupons are issued at a deep discount to their face value and
appreciated in value as time passes.

Institutional investors often prefer zero coupon bonds because they do

not involve any reinvestment risk.
Problem 4

What is the price of a five-year bond with a $100 face value zero
coupon bond when the yield to maturity is 6% p.a.?
Valuing a stock

According to the dividend discount model (DDM), the stock price

represents the present value of future dividends per share (DPS)
discounted at the investors’ cost of equity capital.
𝐷𝑃𝑆1 𝐷𝑃𝑆2 𝐷𝑃𝑆𝑡
𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 = 1
+ 2
+ ⋯+ + ⋯ (10.9)
(1+𝑘𝑒 ) (1+𝑘𝑒 ) (1+𝑘𝑒 )𝑡

The stream of future dividends continues in perpetuity because the firm

is assumed to be a ‘going concern’.

The cost of equity capital is often estimated using the Capital Asset
Pricing Model (CAPM) – see Weeks 4 and 5.
Constant dividend model

The constant dividend model assumes dividends are expected to be

constant in the future.

The value of the firm’s stock is the present value of a perpetuity:

𝐷𝑃𝑆1
𝑃=
𝑘𝑒

where 𝐷𝑃𝑆1 is the expected dividend per share.

This formula should only be used to value the stocks of ‘no growth’
companies.
Problem 5

A stock of a mature company is expected to pay an annual dividend of

$0.50 per share for the foreseeable future. What is the fair value of the
stock if investor’s cost of equity capital is 9%?
Constant dividend growth model

The constant dividend growth model (aka Gordon model) assumes

dividends are expected to grow forever at a constant rate g.

The value of the firm’s stock is the present value of a growing

perpetuity:

𝐷𝑃𝑆1 𝐷𝑃𝑆0 1+𝑔

𝑃= = with 𝑘𝑒 > 𝑔 (10.10b)
𝑘𝑒 −𝑔 𝑘𝑒 −𝑔

where 𝐷𝑃𝑆0 is the current dividend per share.

This formula should only be used to value the stocks of stable growth
or relatively mature companies.
Problem 6

PEC has just paid an annual dividend of $0.80 per share. What is the
fair value of PEC stock if dividends per share are expected to grow at
3.5% p.a. indefinitely and the firm’s cost of equity capital is 9%?
Reverse engineering

We can use either the constant dividend or constant dividend

growth models to ‘reverse engineer’ critical variables such as the
cost of equity or the growth rate implied by the market’s valuation of a
stock.

Assume that dividends are expected to grow forever at constant rate g.

𝐷𝑃𝑆1
If 𝑃 = , then we can write
𝑘𝑒 −𝑔
𝐷𝑃𝑆1 𝐷𝑃𝑆1
𝑘𝑒 = +𝑔 or 𝑔 = 𝑘𝑒 −
𝑃 𝑃

i.e. given data on P, DPS1 and g, we can estimate the implied cost of
equity capital, and given data on P, DPS1 and ke, we can estimate the
implied growth rate.
Problem 7

At close of trading on 04/02/2022, ANZ’s stock price was $27.09.

Bloomberg forecasts dividends of $0.75 in July 2022 and $0.77 in
December 2022 and projects three-year dividend growth of 2.07% p.a.
What is the implied cost of equity capital for ANZ?
Two-stage dividend growth model

How do we value a stock when the dividend grows a high rate for
several years before dropping to a lower long-run growth rate?

The two-stage dividend growth model values the stock using a four-
step process:
1. calculate the PV of the dividends paid during the high-growth
phase
2. calculate the selling price of the stock at the end of the high-growth
phase using the Gordon Model
3. calculate the PV of the selling price
4. add the PVs calculated at steps 1 and 3.

An alternative is to use formula 10.12.

Problem 8

TEC has just paid a dividend of $1.00 per share. What is the fair value
of TEC stock if dividends per share are expected to grow at 10% p.a.
for two years and at 4% p.a. thereafter and the cost of equity capital is
9%?
Estimating the long-run growth rate

Firm data:
– historical growth rate of dividends, adjusted for future expectations
– sustainable growth formula
𝑔 = 𝑅𝑂𝐸 × 𝑏
where ROE = return on equity, b = retention ratio = 1 – payout ratio
Industry data:
– Industry reports e.g. IBIS World
Economy-wide data:
– growth rate of nominal GDP.

For a domestic-oriented company, be wary of using a growth rate much

in excess of the growth rate of nominal GDP.
Why? A company growing faster than the economy will eventually
swallow it up!
Problem 9

GLOCO has a return on equity of 15% and a target payout ratio of

70%. What is GLOCO’s estimated sustainable growth rate?
For the adventurous ….

Chapter 10:

Review Questions – 10
Pricing bonds in Australia

The following formula is used in Australia to price a semi-annual

coupon bond traded between coupon dates:

𝑓ൗ
1 𝑑 1 − (1+𝑦1Τ2)𝑇 𝐹
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = 𝐶𝑃Τ2 × 1 + + 𝑇
1 + 𝑦Τ2 𝑦Τ2 1 + 𝑦Τ2

where f = no. of days till the next coupon, d = no. of days in the current
coupon period, T= no. of full coupon periods remaining.

This formula prices the bond on the day just before the next coupon is
paid, then discounts this value back to a value today.

https://www.aofm.gov.au/securities/treasury-bonds
See the worked examples under ‘Pricing Formulae’.

This slide is not examinable!

Pricing stocks in Australia

Franking credits are usually attached to dividends paid by Australian

companies.

𝑡𝑐
𝐹𝑟𝑎𝑛𝑘𝑖𝑛𝑔 𝑐𝑟𝑒𝑑𝑖𝑡 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × × 𝐹𝑟𝑎𝑛𝑘𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜
1 − 𝑡𝑐

Franking credits are valuable to investors because they reduce tax

payable on dividends.

One simple model incorporating franking credits:

𝐷𝑃𝑆1 + 𝐹𝐶 𝐷𝑃𝑆2 + 𝐹𝐶 𝐷𝑃𝑆𝑡 + 𝐹𝐶

𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 = 1
+ 2
+ ⋯+ 𝑡
+⋯
1 + 𝑘𝑒 (1 + 𝑘𝑒 ) (1 + 𝑘𝑒 )

This slide is not examinable!