3

VALUING BONDS
VALUING BONDS

• What is a bond?

• What are the different types of bonds?

• What are the relevant cash flows?

• What is the relevant discount rate?

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PRESENT VALUE OF A COUPON PAYING BOND
Coupon Payments

C1 C2 C N 1 C N  FaceValue

0 1 2 N 1 N
Maturity

C1 C2 C N  FaceValue
PV0    ... 
(1  r ) (1  r )
1 2
(1  r ) N

Price
Yield to Maturity
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VALUING A BOND WITH ANNUAL COUPONS
• What is the price of an IBM bond that has a 10% annual
coupon and a face value of $1000. There are 20 years to
maturity and the yield to maturity is 8%.
100 100 100 100  1,000

........... 20
0 1 2 3
100 100 100  1000
PV0    ... 
(1  0.08)1 (1  0.08) 2 (1  0.08) 20

• PV0 = PV of coupons+ PV of face value

• PV0 = 100[1 – 1/(1.08)20] / 0.08 + 1000 / (1.08)20
• PV0 = 981.81 + 214.55 = 1196.36
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VALUING BONDS WITH
SEMI-ANNUAL PAYMENTS

• What is the price (as of January 1, 2006), of a 6.375%

coupon bond with semi-annual payments, $1,000 face
value and a maturity date of December 2013 if the YTM
is 5-percent.

$31.875 $31.875 $31.875 $1,031.875


1/1/06 6/30/06 12/31/06 6/30/13 12/31/13

𝑃𝑉 =
31.875
0.05 /2
1−
[
1
(1.025 ) 16
+
]
1,000
(1.025 ) 16
=1,049.30
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VALUING BONDS
• What if there are no coupon payments (i.e., a zero
coupon bond)?
Face Value
Face Value
PV0 
(1  r ) t
0 1 2 3 ........... t

• What about deferred payments?

C3 C4 C10  Face Value

1 1  Face Value
0 1 2 3 4 ...... 10 PV2  C   8

 r r 1  r   1  r 8

1
PV0  PV2
1  r 2

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PRICE & RATE OF RETURN
Clean vs Dirty Price

𝑫𝒊𝒓𝒕𝒚 𝒑𝒓𝒊𝒄𝒆 =𝐶𝑙𝑒𝑎𝑛 𝑝𝑟𝑖𝑐𝑒+ 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡

What is the dirty price of an IBM bond that has a 10% annual coupon
and a face value of $1,000? There are 20 years to maturity, the yield
to maturity is 8% and there are 6 months to the next coupon payment.

Clean price = $1,196.36

Accrued interest = 100(6/12) = $50
Dirty price = $1,246.26

𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑐𝑜𝑚𝑒+ 𝑝𝑟𝑖𝑐𝑒 𝑐h𝑎𝑛𝑔𝑒

𝑹𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏=
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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DURATION

𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑴𝒐𝒅𝒊𝒇𝒊𝒆𝒅 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏=
1+𝑦𝑖𝑒𝑙𝑑

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BOND RATINGS: DEFAULT RISK
Sovereign Foreign Currency Ratings (Long Term)

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BOND RATINGS: DEFAULT RISK

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TERM STRUCTURE OF INTEREST RATES

• Relationship
between time to
maturity and yields,
all else equal
• Yield curve is the
graphical
representation of
the term structure

1-11
 4

VALUING STOCKS
VALUING STOCKS

• What is a stock?

• What are the different types of stocks?

• What are the relevant cash flows?

• What is the relevant discount rate?

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VALUING STOCKS

Value of a
= PV (Future cash flows)
dividend paying
stock
Div1  P1 Div1  Div2  P2
 ? ? ...else
1  r  1  r 2

Price

 PVExpected future dividends 

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VALUING STOCKS

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PRESENT VALUE OF A DIVIDEND PAYING STOCK
Constant Dividend Payments
D D ……... D

8
PV0 
r
0 1 2
Dividend Payments Growing at a Constant Rate g
D3 .....…..
D2
8
D1
D
PV0 
0 1 2 3 rg
Differing Dividend Payments
D4
D2
D3 …..
8

D1

0 1 2 3 PV0  PV1  PV2  ...  PVH

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EXAMPLE
What is the value of Apple stock if it is expected to
pay a $3.00 dividend next year, and then increase
the dividend at a rate of 8% per year, indefinitely?
Assume a 12% expected return.

3 3.24

8
0 1 2 3 ....…..

Div1 $3.00
P0    $75.00
r  g .12 .08

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QUESTION
GM will pay dividends of $3, $3.24 and 3.56 over the
next three years. Then the dividend payments will
settle down to constant growth rate of 5%. What is the
price of stock given 12% expected return?

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ESTIMATING A SUSTAINABLE GROWTH RATE
Long-run sustainable dividend growth rate
g = Return on equity × Plowback ratio

Earnings per share (EPS) Fraction of earnings

ROE 
Book equity per share retained by firm

If firm pays lower dividend and reinvests funds,

stock price may increase due to higher future
dividends

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EXAMPLE
GM plans a $8.33 perpetuity dividend next year (100% of
earnings). Instead, the company may plow back 40% of
earnings at firm’s current return on equity (ROE) of 25% and
pay the rest as a perpetuity dividend.
What is the stock value without and with the plowback
decision if the investors expect 15% return on this
investment?
Pay 100% of Earnings Plow back 40% of
Earnings
8.33 g  .25  .40  .10
P0   $55.56
.15 5.00
P0   $100.00
.15  .10
PVGO  100.00  55.56  $44.44
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 VALUING A BUSINESS
• Valuing a Business or Project
• Usually computed as discounted value of FCF to
valuation horizon (H)
• Valuation horizon sometimes called terminal value
and calculated like PVGO

++...++

PV (free cash flows) PV (horizon value)

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 VALUING A BUSINESS
• Valuing a Business or Project
• Usually computed as discounted value of FCF to
valuation horizon (H)
• Valuation horizon sometimes called terminal value
and calculated like PVGO

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r )1
(1  r ) 2
(1  r ) H
(1  r ) H

PV (free cash flows) PV (horizon value)

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