Chapter 4

The
The Valuation
Valuation of
of
Long-Term
Long-Term
Securities
Securities
1
 The Valuation of
Long-Term Securities
 Distinctions Among Valuation
Concepts
 Bond Valuation
 Preferred Stock Valuation
 Common Stock Valuation
 Rates of Return (or Yields)
2
 What is Value?
 Liquidation value represents the
amount of money that could be
realized if an asset or group of
assets is sold separately from its
operating organization.
 Going-concern value represents the
amount a firm could be sold for as a
continuing operating business.
3
 What is Value?
 Book value represents either
(1) an asset: the accounting value
of an asset -- the asset’s cost
minus its accumulated
depreciation;
(2) a firm: total assets minus
liabilities and preferred stock as
listed on the balance sheet.
4
 What is Value?
 Market value represents the
market price at which an asset
trades.
 Intrinsic value represents the price a
security “ought to have” based on all factors
bearing on valuation including assets,
earnings, future prospects, management etc.
AKA Economic Value. In efficient markets,
M.V. should be near the I.V.
5
 Bond Valuation
 Important Terms
 Types of Bonds
 Valuation of Bonds
 Handling Semiannual
Compounding

6
 Important Bond Terms
 A bond is a security or a long-term debt
instrument issued by a corporation or
government.

 The maturity value (MV) [or face value] of a bond

is the stated value. In the case of a U.S. bond, the
face value is usually $1,000.
 The maturity of a bond is the stated time after
which the company is obligated to pay the
bondholder the face value of the instrument.

7
 Important Bond Terms
 The bond’s coupon rate* is the stated rate of interest
of the bond i.e The annual interest payment divided by
the bond’s face value.
 E.g coupon rate is 12% on a 1000$ face value bond,
the company pays the holder 120$ each year until
maturity.

 The discount rate or capitalization rate (applied to the

CF stream) is dependent on the risk of the bond. It
consists of risk-free rate (basic yield of Treasury
Bonds) plus a premium for risk (for non-T-Bonds)

8
 Different Types of Bonds
A perpetual bond is a bond that never matures. It has an
infinite life.
E.g CONSOLS (consolidated annuities)
issued by the Great Britain.
The PV of a perpetual bond is equal to the Capitalized Value of an
infinite stream of Interest Payments.

I I I
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)¥
¥ I
=S (1 + kd)t or I (PVIFA k )
t=1 d, ¥

V = I / kd [Reduced Form]
9
 Perpetual Bond Example
Bond P has a $1,000 face value and
provides an 8% coupon. The appropriate
discount rate is 10%. What is the value of
the perpetual bond?

I = $1,000 ( 8%) = $80

kd = 10%
V = I / kd Interest Payment/Required rate
= $80 / 10% = $800
10
 Different Types of Bonds
A non-zero coupon-paying bond is a coupon-paying bond
with a finite life. So the Interest Stream PLUS the terminal
or Maturity Value both are considered during valuation

I I I + MV
V= (1 + kd)1 + (1 + kd)2 + ... + (1 + kd)n
n I MV
=S (1 + kd) t
+
t=1 (1 + kd)n
V = I (PVIFA k ) + MV (PVIF kd, n)
11
d, n
 Coupon Bond Example
Bond C has a $1,000 face value and provides
an 8% annual coupon for 30 years. The
appropriate discount rate is 10%. What is the
value of the coupon bond?
V = $80 (PVIFA10%, 30) + $1,000 (PVIF10%, 30)
= $80 (9.427) + $1,000 (.057)
[Table IV] [Table II]
= $754.16 + $57.00
= $811.16.
12
 Different Types of Bonds

A zero-coupon bond is a bond that

pays no interest but sells at a deep
discount from its face value; it provides
compensation to investors in the form
of price appreciation.

MV
V= = MV (PVIFk )
(1 + kd)n d, n

13
 Zero-Coupon
Bond Example
Bond Z has a $1,000 face value and
a 30-year life. The appropriate
discount rate is 10%. What is the
value of the zero-coupon bond?
V = $1,000 (PVIF10%, 30)
= $1,000 (.057)
= $57.00
14
 Semiannual Compounding
Most bonds in the U.S. pay interest
twice a year (1/2 of the annual
coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2
15
 Semiannual Compounding

A non-zero coupon bond adjusted for

semiannual compounding.
I / 2 I / 2 I / 2 + MV
V =(1 + k /2 )1 +(1 + k /2 )2 + ... + 2 n
d d (1 + kd/2 ) *
2*n I/2 MV
=S (1 + kd /2 ) t
+
t=1 (1 + kd /2 ) 2*n
= I/2 (PVIFAk
d /2 ,2*n ) + MV (PVIFkd /2 , 2*n)
16
 Semiannual Coupon
Bond Example
Bond C has a $1,000 face value and provides
an 8% semiannual coupon for 15 years. The
appropriate discount rate is 10% (annual rate).
What is the value of the coupon bond?
V = $40 (PVIFA5%, 30) + $1,000 (PVIF5%, 30)
= $40 (15.373) + $1,000 (.231)
[Table IV] [Table II]
= $614.92 + $231.00
= $845.92
17
 Preferred Stock Valuation
Preferred Stock is a type of stock
that promises a (usually) fixed
dividend, but at the discretion of
the board of directors.
Preferred Stock has preference over
common stock in the payment of
dividends and claims on assets.
18
 Preferred Stock Valuation

DivP DivP DivP

V= (1 + kP)
+ (1 + k + ... +
P) (1 + kP)¥
1 2

¥ DivP
=S or DivP(PVIFA k )
t=1 (1 + kP) t
P, ¥

This reduces to a perpetuity!

V = DivP / kP
19
 Preferred Stock Example
Stock PS has an 8%, $100 par value
issue outstanding. The appropriate
discount rate is 10%. What is the value
of the preferred stock?
DivP = $100 ( 8% ) = $8.00.
kP = 10%.
V = DivP / kP = $8.00 / 10%
= $80

20
 Common Stock Valuation
Common stock represents a
residual ownership position in the
corporation. Pro-rata is used to describe a proportionate allocation. A method of
assigning an amount to a fraction, according to its share of the whole

 Pro rata share of future earnings

after all other obligations of
the firm (if any remain).
 Dividends may be paid out of
the pro rata share of earnings.
21
 Common Stock Valuation

What cash flows will a shareholder

receive when owning shares of
common stock?
(1) Future dividends
(2) Future sale of the
common stock shares
22
 Dividend Valuation Model

Basic dividend valuation model accounts

for the PV of all future dividends.

Div1 Div2 Div¥

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + ke)¥
¥ Divt Divt: Cash dividend
=S (1 + ke)t at time t
t=1
ke: Equity investor’s
23 required return
 Adjusted Dividend
Valuation Model
The basic dividend valuation model
adjusted for the future stock sale.

Div1 Div2 Divn + Pricen

V= (1 + ke)1 + (1 + ke)2 + ... + (1 + k )n
e

n: The year in which the firm’s

shares are expected to be sold.
Pricen: The expected share price in year n.
24
 Dividend Growth
Pattern Assumptions
The dividend valuation model requires the
forecast of all future dividends. The
following dividend growth rate assumptions
simplify the valuation process.
Constant Growth
No Growth
Growth Phases
25
 Constant Growth Model

The constant growth model assumes that

dividends will grow forever at the rate g.

D0(1+g) D0(1+g)2 D0(1+g)¥

V = (1 + k )1 + (1 + k )2 + ... + (1 + k ) ¥
e e e

D1: Dividend paid at time 1.

D1
= g: The constant growth rate.
(ke - g) ke: Investor’s required return.
26
 Constant Growth
Model Example
Stock CG has an expected growth rate of
8%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What
is the value of the common stock?
D1 = $3.24 ( 1 + .08 ) = $3.50
(since D1 = D0(1+g)
VCG = D1 / ( ke - g ) = $3.50 / ( .15 - .08 )
27 = $50
 Zero Growth Model

The zero growth model assumes that

dividends will grow forever at the rate g = 0.

D1 D2 D
VZG = + + ... +
¥

(1 + ke)1 (1 + ke)2 (1 + ke)¥

D1 D1: Dividend paid at time 1.

=
ke ke: Investor’s required return.
28
 Zero Growth
Model Example
Stock ZG has an expected growth rate of
0%. Each share of stock just received an
annual $3.24 dividend per share. The
appropriate discount rate is 15%. What
is the value of the common stock?

D1 = $3.24 ( 1 + 0 ) = $3.24

VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )

= $21.60
29
 Calculating Rates of
Return (or Yields)
Steps to calculate the rate of
return (or yield).
1. Determine the expected cash flows.
2. Replace the intrinsic value (V) with
the market price (P0).
3. Solve for the market required rate of
return that equates the discounted
30 cash flows to the market price.
 Determining Bond YTM

Determine the Yield-to-Maturity

(YTM) for the coupon-paying bond
with a finite life.
n
I MV
P0 = S (1 + kd )t
+
(1 + kd )n
t=1

= I (PVIFA k ) + MV (PVIF kd , n)
d,n
kd = YTM
31
 Determining the YTM
Julie Miller want to determine the YTM
for an issue of outstanding bonds at
Basket Wonders (BW). BW has an
issue of 10% annual coupon bonds
with 15 years left to maturity. The
bonds have a current market value of
$1,250.
What is the YTM?
32
 YTM Solution (Try 9%)
$1,250 = $100(PVIFA9%,15) +
$1,000(PVIF9%, 15)
$1,250 = $100(8.061) +
$1,000(.275)
$1,250 = $806.10 + $275.00
= $1,081.10
[Rate is too high!]
33
 YTM Solution (Try 7%)
$1,250 = $100(PVIFA7%,15) +
$1,000(PVIF7%, 15)
$1,250 = $100(9.108) +
$1,000(.362)
$1,250 = $910.80 + $362.00
= $1,272.80
[Rate is too low!]
34
 YTM Solution (Interpolate)

.07 $1,273
X $23
.02 IRR $1,250 $192
.09 $1,081

X $23
.02 = $192

35
 YTM Solution (Interpolate)

.07 $1,273
X $23
.02 IRR $1,250 $192
.09 $1,081

X $23
.02 = $192

36
 YTM Solution (Interpolate)

.07 $1273
X $23
.02 YTM $1250 $192
.09 $1081

($23)(0.02)
X= $192 X = .0024

YTM = .07 + .0024 = .0724 or 7.24%

37
 Determining Semiannual
Coupon Bond YTM
Determine the Yield-to-Maturity
(YTM) for the semiannual coupon-
paying bond with a finite life.
2n
I/2 MV
P0 = S
t=1 (1 + kd /2 )
t
+
(1 + kd /2 )2n

= (I/2)(PVIFAk ) + MV(PVIFkd /2 , 2n)

d /2, 2n
[ 1 + (kd / 2) ]2 -1 = YTM
38
 Determining the Semiannual
Coupon Bond YTM
Julie Miller want to determine the YTM
for another issue of outstanding
bonds. The firm has an issue of 8%
semiannual coupon bonds with 20
years left to maturity. The bonds have
a current market value of $950.
What is the YTM?

39
 Determining Semiannual
Coupon Bond YTM
Determine the Yield-to-Maturity
(YTM) for the semiannual coupon-
paying bond with a finite life.
[ 1 + (kd / 2) ]2 -1 = YTM

[ 1 + (.042626) ]2 -1 = .0871
or 8.71%

40
 Determining Semiannual
Coupon Bond YTM
This technique will calculate kd.
You must then substitute it into the
following formula.
[ 1 + (kd / 2) ]2 -1 = YTM

[ 1 + (.0852514/2) ]2 -1 = .0871
or 8.71% (same result!)

41
 Bond Price-Yield
Relationship
Discount Bond -- The market required
rate of return exceeds the coupon rate
(Par > P0 ).
Premium Bond -- The coupon rate
exceeds the market required rate of
return (P0 > Par).
Par Bond -- The coupon rate equals the
market required rate of return (P0 = Par).
42
 Bond Price-Yield
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
43
 Bond Price-Yield
Relationship
When interest rates rise, then the
market required rates of return rise
and bond prices will fall.
Assume that the required rate of
return on a 15-year, 10% coupon-
paying bond rises from 10% to 12%.
What happens to the bond price?
44
 Bond Price-Yield
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
45
 Bond Price-Yield
Relationship (Rising Rates)

The required rate of return on a 15-

year, 10% coupon-paying bond
has risen from 10% to 12%.

Therefore, the bond price has fallen

from $1,000 to $864.

46
 Bond Price-Yield
Relationship
When interest rates fall, then the
market required rates of return fall
and bond prices will rise.
Assume that the required rate of
return on a 15-year, 10% coupon-
paying bond falls from 10% to 8%.
What happens to the bond price?
47
 Bond Price-Yield
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
48
 Bond
Bond Price-Yield
Price-Yield Relationship
Relationship
(Declining
(Declining Rates)
Rates)

The required rate of return on a 15-

year, 10% coupon-paying bond
has fallen from 10% to 8%.

Therefore, the bond price has

risen from $1,000 to $1,171.

49
 The Role of Bond Maturity

The longer the bond maturity, the

greater the change in bond price for a
given change in the market required rate
of return.
Assume that the required rate of return
on both the 5- and 15-year, 10% coupon-
paying bonds fall from 10% to 8%. What
happens to the changes in bond prices?
50
 Bond Price-Yield
Relationship
1600
BOND PRICE ($)

1400

1200
1000
Par 5 Year
600
15 Year
0
0 2 4 6 8 10 12 14 16 18
Coupon Rate
MARKET REQUIRED RATE OF RETURN (%)
51
 The Role of Bond Maturity
The required rate of return on both the
5- and 15-year, 10% coupon-paying
bonds has fallen from 10% to 8%.
The 5-year bond price has risen from
$1,000 to $1,080 for the 5-year bond
(+8.0%).
The 15-year bond price has risen from
$1,000 to $1,171 (+17.1%). Twice as fast!
52
 The Role of the
Coupon Rate
For a given change in the
market required rate of return,
the price of a bond will change
by proportionally more, the
lower the coupon rate.

53
 Example of the Role of
the Coupon Rate
Assume that the market required rate
of return on two equally risky 15-year
bonds is 10%. The coupon rate for
Bond H is 10% and Bond L is 8%.

What is the rate of change in each of

the bond prices if market required
rates fall to 8%?
54
 Example of the Role of the
Coupon Rate
The price on Bonds H and L prior to the
change in the market required rate of
return is $1,000 and $848, respectively.

The price for Bond H will rise from $1,000

to $1,171 (+17.1%).
The price for Bond L will rise from $848 to
$1,000 (+17.9%). It rises faster!
55
 Determining the Yield on
Preferred Stock

Determine the yield for preferred

stock with an infinite life.
P0 = DivP / kP

Solving for kP such that

kP = DivP / P0

56
 Preferred Stock Yield
Example
Assume that the annual dividend on
each share of preferred stock is $10.
Each share of preferred stock is
currently trading at $100. What is
the yield on preferred stock?

kP = $10 / $100.
kP = 10%.
57
 Determining the Yield on
Common Stock

Assume the constant growth model

is appropriate. Determine the yield
on the common stock.
P 0 = D 1 / ( ke - g )

Solving for ke such that

ke = ( D 1 / P 0 ) + g
58
 Common Stock
Yield Example
Assume that the expected dividend
(D1) on each share of common stock
is $3. Each share of common stock
is currently trading at $30 and has an
expected growth rate of 5%. What is
the yield on common stock?
ke = ( $3 / $30 ) + 5%

59
ke = 15%