Bonds, Stock and

Their Valuation
Presented by :
Irwan Rizki Basir
Neela Osman
Yuningsih
7-1

Bonds and Their

Valuation
7-2

What is a 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.

7-3

Bond markets
Primarily traded in the over-the-counter (OTC)
market.

Most bonds are owned by and traded among

large financial institutions.

Full information on bond trades in the OTC

market is not published, but a representative

group of bonds is listed and traded on the
bond division of the NYSE.

7-4

Key Features of a Bond

Par value face amount of the bond, which
is paid at maturity (assume $1,000).

Coupon interest rate stated interest rate

(generally fixed) paid by the issuer. Multiply by

par to get dollar payment of interest.

Maturity date years until the bond must be

repaid.

Issue date when the bond was issued.

Yield to maturity - rate of return earned on
a bond held until maturity (also called the
promised yield).

7-5

What is a sinking fund?

Provision to pay off a loan over its

life rather than all at maturity.

Similar to amortization on a term

loan.

Reduces risk to investor, shortens

average maturity.

But not good for investors if rates

decline after issuance.

7-6

How are sinking funds

executed?
Call x% of the issue at par, for sinking
fund purposes.

Likely to be used if kd is below the coupon

rate and the bond sells at a premium.

Buy bonds in the open market.

Likely to be used if kd is above the coupon

rate and the bond sells at a discount.

7-7

The value of financial

assets
0

k
Value

...
CF1

CF2

CFn

CF1
CF2
CFn
Value

...
1
2
(1 k)
(1 k)
(1 k)n

7-8

What is the value of a 10year, 10% annual coupon

bond, if kd = 10%?
0

k
VB = ?

...
100

100

100 + 1,000

$100
$100
$1,000
VB
...

1
10
(1.10)
(1.10)
(1.10)10
VB $90.91 ... $38.55 $385.54
VB $1,000
7-9

Using a financial
calculator to value a bond
This bond has a $1,000 lump sum due at t
= 10, and annual $100 coupon payments
beginning at t = 1 and continuing through
t = 10, the price of the bond can be found
by solving for the PV of these cash flows.

INPUTS
OUTPUT

10

10

I/YR

PV

100

1000

PMT

FV

-1000
7-10

An example:
Increasing inflation and kd

Suppose inflation rises by 3%, causing kd

= 13%. When kd rises above the coupon
rate, the bonds value falls below par,
and sells at a discount.

INPUTS
OUTPUT

10

13

I/YR

PV

100

1000

PMT

FV

-837.21
7-11

An example:
Decreasing inflation and kd

Suppose inflation falls by 3%, causing

kd = 7%. When kd falls below the
coupon rate, the bonds value rises
above par, and sells at a premium.

INPUTS
OUTPUT

10

I/YR

PV

100

1000

PMT

FV

-1210.71
7-12

The price path of a

bond
What would happen to the value of this
VB

bond if its required rate of return remained

at 10%, or at 13%, or at 7% until maturity?

1,372
1,211

kd = 7%.
kd = 10%.

1,000
837
775

kd = 13%.
30

25

20

15

10

Years
to Maturity
7-13

Bond values over time

At maturity, the value of any bond

must equal its par value.

If kd remains constant:

The value of a premium bond would decrease over

time, until it reached $1,000.

The value of a discount bond would increase over

time, until it reached $1,000.

A value of a par bond stays at $1,000.

7-14

What is the YTM on a 10-year, 9%

annual coupon, $1,000 par value
bond, selling for $887?

Must find the kd that solves this model.

INT
INT
M
VB
...

1
N
N
(1 kd )
(1 kd )
(1 kd )
90
90
1,000
$887
...

1
10
(1 kd )
(1 kd )
(1 kd )10
7-15

Using a financial
calculator to find YTM
Solving for I/YR, the YTM of this bond
is 10.91%. This bond sells at a
discount, because YTM > coupon
rate.

INPUTS

10
N

OUTPUT

I/YR

- 887

90

1000

PV

PMT

FV

10.91
7-16

Find YTM, if the bond price was

$1,134.20.

Solving for I/YR, the YTM of this bond

is 7.08%. This bond sells at a
premium, because YTM < coupon
rate.

INPUTS

10
N

OUTPUT

I/YR

-1134.2

90

1000

PV

PMT

FV

7.08
7-17

Definitions
Annual coupon payment
Current yi
eld(CY)
Currentprice
Changein price
Capitalgainsyield(CGY)
Beginningprice
Expected
Expected

Expectedtotalreturn YTM
CY CGY

7-18

An example:
Current and capital gains
yield

Find the current yield and the capital

gains yield for a 10-year, 9% annual

coupon bond that sells for $887, and has
a face value of $1,000.
Current yield

= $90 / $887

= 0.1015 = 10.15%
7-19

Calculating capital
gains yield
YTM = Current yield + Capital gains yield
CGY = YTM CY
= 10.91% - 10.15%
= 0.76%
Could also find the expected price one year
from now and divide the change in price by the
beginning price, which gives the same answer.
7-20

Semiannual bonds
1.

Multiply years by 2 : number of periods = 2n.

2.

Divide nominal rate by 2 : periodic rate (I/YR) =

kd / 2.

3.

Divide annual coupon by 2 : PMT = ann cpn / 2.

INPUTS

2n

kd / 2

OK

cpn / 2

OK

I/YR

PV

PMT

FV

OUTPUT
7-21

What is the value of a 10-year, 10%

semiannual coupon bond, if kd =
13%?
1.

Multiply years by 2 : N = 2 * 10 = 20.

2.

Divide nominal rate by 2 : I/YR = 13 / 2 = 6.5.

3.

Divide annual coupon by 2 : PMT = 100 / 2 =

50.

INPUTS
OUTPUT

20

6.5

I/YR

PV

50

1000

PMT

FV

- 834.72
7-22

Would you prefer to buy a 10-year, 10%

annual coupon bond or a 10-year, 10%
semiannual coupon bond, all else equal?
The semiannual bonds effective rate is:

i
EFF% 1 Nom
m

0.10
1 1
1 10.25%
2

10.25% > 10% (the annual bonds

effective rate), so you would prefer the
semiannual bond.
7-23

If the proper price for this semiannual

bond is $1,000, what would be the proper
price for the annual coupon bond?

The semiannual coupon bond has an

effective rate of 10.25%, and the annual

coupon bond should earn the same EAR.
At these prices, the annual and semiannual
coupon bonds are in equilibrium, as they
earn the same effective return.

INPUTS
OUTPUT

10

10.25

I/YR

PV

100

1000

PMT

FV

- 984.80
7-24

A 10-year, 10% semiannual coupon bond

selling for $1,135.90 can be called in 4 years
for $1,050, what is its yield to call (YTC)?

The bonds yield to maturity can be

determined to be 8%. Solving for the YTC

is identical to solving for YTM, except the
time to call is used for N and the call
premium is FV.

INPUTS

8
N

OUTPUT

I/YR

- 1135.90

50

1050

PV

PMT

FV

3.568
7-25

Default risk
If an issuer defaults, investors

receive less than the promised

return. Therefore, the expected
return on corporate and municipal
bonds is less than the promised
return.

Influenced by the issuers financial

strength and the terms of the bond

contract.
7-26

Types of bonds

Mortgage bonds
Debentures
Subordinated debentures
Investment-grade bonds
Junk bonds

7-27

Evaluating default risk:

Bond ratings
Investment Grade

Junk Bonds

Moody
s

Aaa Aa A Baa

Ba B Caa C

S&P

AAA AA A BBB

BB B CCC
D

Bond ratings are designed to reflect

the probability of a bond issue going

into default.
7-28

Stocks and
Their
stock
Features of common
Valuation

Determining common stock

values
Efficient markets
Preferred stock

7-29

Facts about common

stock

Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Managements goal: Maximize the
stock price

7-30

Social/Ethical
Question
Should management be equally

concerned about employees,

customers, suppliers, and the
public, or just the stockholders?

In an enterprise economy,

management should work for

stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
7-31

Types of stock market

transactions

Secondary market
Primary market
Initial public offering market
(going public)

7-32

Different approaches
for valuing common
stock

Dividend growth model

Corporate value model
Using the multiples of
comparable firms

7-33

Dividend growth model

Value of a stock is the present value of
the future dividends expected to be
generated by the stock.

D3
D1
D2
D
P0

...
1
2
3

(1 ks ) (1 ks ) (1 ks )
(1 ks )
^

7-34

Constant growth stock

A stock whose dividends are expected to
grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

If g is constant, the dividend growth formula

converges to:
^
D0 (1 g)
D1
P0

ks - g
ks - g

7-35

Future dividends and

their present values
$

Dt D0 ( 1 g )

Dt
PVDt
t
(1 k )

0.25

P0 PVDt
0

Years (t)
7-36

What happens if g > ks?

If g > ks, the constant growth

formula leads to a negative stock

price, which does not make sense.

The constant growth model can

only be used if:

ks > g
g is expected to be constant forever
7-37

If kRF = 7%, kM = 12%, and = 1.2,

what is the required rate of return
on the firms stock?

Use the SML to calculate the required

rate of return (ks):

ks = kRF + (kM kRF)

= 7% + (12% - 7%)1.2
= 13%
7-38

If D0 = $2 and g is a constant 6%,

find the expected dividend
stream for the next 3 years, and
their PVs.
0

g = 6%

D0 = 2.00
1.8761
1.7599

2.12

2.247

3
2.382

ks = 13%

1.6509
7-39

What is the stocks

market value?
Using the constant growth model:
D1
$2.12
P0

ks - g 0.13- 0.06
$2.12

0.07
$30.29

7-40

What is the expected market

price of the stock, one year
from now?

D1 will have been paid out already.

So, P1 is the present value (as of
year 1) of D2, D3, D4, etc.
^
D2
$2.247
P1

ks - g 0.13- 0.06
$32.10

^
Could
also
expected
P1 as:

P1 Pfind
(1.06)

$32.10
0

7-41

What is the expected dividend

yield, capital gains yield, and total
return during the first year?

Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%

Capital gains yield

= (P1 P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%

Total return (ks)

= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
7-42

What would the expected

price today be, if g = 0?

The dividend stream would be a

perpetuity.

ks = 13%

...
2.00

2.00

2.00

PMT $2.00
P0

$15.38
k
0.13
^

7-43

Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?

Can no longer use just the constant

growth model to find stock value.

However, the growth does become

constant after 3 years.

7-44

Valuing common stock

with nonconstant
growth
0 k = 13% 1
s
g = 30%

D0 = 2.00

2
g = 30%

2.600

3
g = 30%

3.380

...

g = 6%

4.394

4.658

2.301
2.647
3.045

46.114
54.107

= P0

4.658
0.13 0.06

$66.54
7-45

Find expected dividend and capital

gains yields during the first and
fourth years.

Dividend yield (first year)

= $2.60 / $54.11 = 4.81%

Capital gains yield (first year)

= 13.00% - 4.81% = 8.19%

During nonconstant growth, dividend yield

and capital gains yield are not constant,
and capital gains yield g.

After t = 3, the stock has constant growth

and dividend yield = 7%, while capital
gains yield = 6%.

7-46

Nonconstant growth:
What if g = 0% for 3 years before
long-run growth of 6%?
0 k = 13% 1
s
g = 0%

D0 = 2.00

2
g = 0%

2.00

3
g = 0%

2.00

...

g = 6%

2.00

2.12

1.77
1.57
1.39

20.99
25.72

= P0

2.12
0.13 0.06

$30.29
7-47

Find expected dividend and

capital gains yields during
the first and fourth years.
Dividend yield (first year)
= $2.00 / $25.72 = 7.78%

Capital gains yield (first year)

= 13.00% - 7.78% = 5.22%

After t = 3, the stock has constant growth

and dividend yield = 7%, while capital gains

yield = 6%.

7-48

If the stock was expected to have

negative growth (g = -6%), would
anyone buy the stock, and what is its
value?

The firm still has earnings and pays

dividends, even though they may be

declining, they still have value.

D0 ( 1 g )
D1
P0

ks - g
ks - g
^

$2.00(0.94) $1.88

$9.89
0.13- (-0.06) 0.19
7-49

Find expected annual

dividend and capital
gains yields.
Capital gains yield
= g = -6.00%

Dividend yield
= 13.00% - (-6.00%) = 19.00%

Since the stock is experiencing constant

growth, dividend yield and capital gains

yield are constant. Dividend yield is
sufficiently large (19%) to offset a
negative capital gains.
7-50

Corporate value model

Also called the free cash flow method.

Suggests the value of the entire firm equals

the present value of the firms free cash flows.

Remember, free cash flow is the firms aftertax operating income less the net capital
investment

FCF = NOPAT Net capital investment

7-51

Applying the
corporate value
model
Find the market value (MV) of the firm.

Find PV of firms future FCFs

Subtract MV of firms debt and preferred

stock to get MV of common stock.

MV of
= MV of MV of debt and
common stock firm
preferred

Divide MV of common stock by the

number of shares outstanding to get

intrinsic stock price (value).

P0 = MV of common stock / # of shares

7-52

Issues regarding the

corporate value model
Often preferred to the dividend growth model,

especially when considering number of firms that

dont pay dividends or when dividends are hard to
forecast.

Similar to dividend growth model, assumes at some

point free cash flow will grow at a constant rate.

Terminal value (TVn) represents value of firm at the

point that growth becomes constant.

7-53

Given the long-run gFCF = 6%, and

WACC of 10%, use the corporate
value model to find the firms
intrinsic value.
0 k = 10%

1
-5

-4.545
8.264
15.026
398.197
416.942

2
10

20

g = 6%

...

21.20

21.20

530 =

0.10

0.06

= TV 3
7-54

If the firm has $40 million in debt

and has 10 million shares of stock,
what is the firms intrinsic value per
share?

MV of equity

= MV of firm MV of debt

= $416.94m - $40m
= $376.94 million

Value per share = MV of equity / # of

shares

= $376.94m / 10m
= $37.69
7-55

Firm multiples method

Analysts often use the following
multiples to value stocks.

P/E
P / CF
P / Sales

EXAMPLE: Based on comparable

firms, estimate the appropriate P/E.

Multiply this by expected earnings to
back out an estimate of the stock
price.
7-56

What is market
equilibrium?
In equilibrium, stock prices are stable
and there is no general tendency for
people to buy versus to sell.

In equilibrium, expected returns must

equal required returns.

D1
ks
g
P0
^

ks kRF (kM kRF )

7-57

Market equilibrium
Expected returns are obtained by

estimating dividends and expected

capital gains.

Required returns are obtained by

estimating risk and applying the
CAPM.

7-58

How is market
equilibrium established?
If expected return exceeds required return

The current price (P ) is too low

0

and offers a bargain.

Buy orders will be greater than sell

orders.

will be bid up until expected

return equals required return
0

7-59

Factors that affect stock

price
Required return (k ) could change
s

Changing inflation could cause kRF to change

Market risk premium or exposure to market risk ()
could change

Growth rate (g) could change

Due to economic (market) conditions

Due to firm conditions

7-60

What is the Efficient

Market Hypothesis
(EMH)?
Securities are normally in equilibrium and are
fairly priced.

Investors cannot beat the market except

through good luck or better information.

Levels of market efficiency

Weak-form efficiency
Semistrong-form efficiency
Strong-form efficiency
7-61

Weak-form efficiency
Cant profit by looking at past trends.
A recent decline is no reason to think
stocks will go up (or down) in the
future.

Evidence supports weak-form EMH,

but technical analysis is still used.

7-62

Semistrong-form
efficiency

All publicly available information

is reflected in stock prices, so it
doesnt pay to over analyze
annual reports looking for
undervalued stocks.

Largely true, but superior

analysts can still profit by finding

and using new information
7-63

Strong-form efficiency
All information, even inside information, is
embedded in stock prices.

Not true--insiders can gain by trading on

the basis of insider information, but thats

illegal.

7-64

Is the stock market

efficient?
Empirical studies have been conducted to
test the three forms of efficiency. Most of
which suggest the stock market was:

Highly efficient in the weak form.

Reasonably efficient in the semistrong form.
Not efficient in the strong form. Insiders
could and did make abnormal (and
sometimes illegal) profits.

Behavioral finance incorporates

elements of cognitive psychology to

better understand how individuals and
markets respond to different situations.
7-65

Preferred stock

Hybrid security
Like bonds, preferred stockholders

receive a fixed dividend that must be

paid before dividends are paid to
common stockholders.

However, companies can omit

preferred dividend payments without

fear of pushing the firm into
bankruptcy.

7-66

If preferred stock with an annual

dividend of $5 sells for $50, what is
the preferred stocks expected
return?
Vp

= D / kp

$50 = $5 / kp
kp

= $5 / $50

= 0.10 = 10%

7-67

THANK YOU
7-68