Chapter 5

Valuation of Bonds and Stock

First Principles:
 Value of financial securities = PV of expected

future cash flows

To value bonds and stocks we need to:

 Estimate future cash flows:

size (how much) and timing (when)

 Discount future cash flows at an appropriate

rate
Jacoby, Stangeland and Wajeeh, 2000 1
 Bond Features
 What is a bond -
 debt issued by a corporation or a governmental body.
 A bond represents a loan made by investors to the issuer.
 In return for his/her money, the investor receives a legal claim on
future cash flows of the borrower.

 The issuer promises to:

 make regular coupon payments every period until the bond
matures, and
 pay the face (par) value of the bond when it matures.

 Default
 an issuer who fails to pay is subject to legal action on behalf of the
lenders (bondholders).
Jacoby, Stangeland and Wajeeh, 2000 2
 Pure-Discount (Zero-Coupon) Bonds
Information needed for valuing pure discount bonds:
 Time to maturity (T):

T = Maturity date - today’s date

 Face value (F)

 Discount rate (r)

0 1 2… T
|-------------------|-------------------|------ … ------|
F
Value of a pure discount bond:

PV = F / (1 + r)T 3
 Examples - Pure Discount Bonds
Q1. Consider a zero-coupon bond, with a face value of $1,000,
maturing in 5 years. Suppose that the appropriate discount rate
is 8%. What is the current value of the bond?
A1. This is a simple TVM problem:
Year: 0 1 2 3 4 5
(r = 8%)
PV0 1,000
Use the above PV equation to solve:
PV = F / (1 + r)T = 1,000 / (1.08)5 = $

Q2. Suppose 6 months have past. What is the bond value now?
A1. Again, use the above PV equation to solve:
PV = F / (1 + r)T = 1,000 / (1.08)4.5 = $
Note: As we get closer to maturity(T), the z.c. bond value increases
(PVm), since we have to wait less time to receive $1,000
4
 Level-Coupon Bonds
Information needed to value level-coupon bonds:
 Coupon payment dates and Time to maturity (T)

 Coupon (C) per payment period and Face value (F)

 Discount rate

0 1 2… T
|----------------|------------------|------- … ------|
Coupon Coupon Coupon + F

Value of a Level-coupon bond:

PV= C/(1+r) + C/(1+r)2 + .. + C/(1+r)T + F/(1+r)T
= C (1/r){1 - [1 / (1 + r)T]} + F/(1 + r)T
= PV of coupon payments + PV of face value 5
 Example - Coupon Bonds
Q1. Consider a coupon bond paying a 4% coupon rate annually, with a
face value of $1,000, maturing in 10 years. Suppose that the
appropriate discount rate is 6%. What is the current value of the bond?
A1. The time line:
0 1 2 9 10 (Years)
… (r = 6%)

Define:
c = annual coupon rate (%)
C = dollar periodic coupon payment = c%F
In the above example:
c = % C = c%F = =$
F=$ T= years r= %
Use the above PV equation to solve:
PV= C (1/r){1 - [1 / (1 + r)T]} + F/(1 + r)T
= 40(1/0.06){1 - [1 / (1.06)10]} + 1,000/(1.06)10 = $ 6
 PV of a Bond in your HP 10B Calculator
First, clear previous data, and check that your calculator is set to 1 P/YR:

C
Yellow C ALL
The display should show: 1 P_Yr
Input data (based on above bond example)
Key in coupon
40 PMT
payment

Key in face value

1,000 FV
(paid at maturity)

Key in discount
rate 6 I/YR

Key in number of
periods to maturity 10 N

Compute PV of
Display should show:
the bond PV
-852.79825897
7
 Example - Discount, Premium and Par Bonds
Q2. For the above coupon bond: when discount rate is 6% and
coupon rate is 4% (c < r), the value of the bond is $852.80, less
than its face value (PV < F). In this case we say that the bond is
priced at discount. Recalculate the PV of the above bond with
discount rates of 2% and 4%.
A2. r = 2%
We have: r = 2% < 4% = c.
Use the above PV equation to solve:
PV= C (1/r){1 - [1 / (1 + r)T]} + F/(1 + r)T
= 40(1/0.02){1 - [1 / (1.02)10]} + 1,000/(1.02)10 = $1,179.65
We see that when c > r, the bond is priced at premium (PV > F).
r = 4%
We have: r = c = 4%.
Use the above PV equation to solve:
PV= 40(1/0.04){1 - [1 / (1.04)10]} + 1,000/(1.04)10 = $1,000
We say that when c = r, the bond is priced at par (PV = F). 8
 Some Tips on Bond Pricing

Bond prices and market interest rates move in

opposite directions.


 When coupon rate = market rate (r) => price = par value.
(par bond)
 When coupon rate > market rate (r) => price > par value
(premium bond)
 When coupon rate < market rate (r) => price < par value
(discount bond)

Jacoby, Stangeland and Wajeeh, 2000 9

 Discount, Premium, and Par Bonds

Premium Bond
(r < c , and PV>F)
PV
($)
Par Bond
(r = c , and PV=F)

1,000 = F
Discount Bond
(r > c , and PV<F)

r (%)
2 4=c 6

Jacoby, Stangeland and Wajeeh, 2000 10

 Yield-To-Maturity
The bond’s indenture provides: F, c, and T
The bond price (B) is set by the market
Given F, c, T, and B, what return (y) does the
market demand for holding the bond?
To find y, solve the following equation:
B C
 C
 C
 F
, or
(1 y )1 (1 y ) 2 (1 y )T (1 y )T

BC  1  
1
y
1
(1 y )T
 F
(1 y )T

There is no analytical solution (use calculator)

11
 Example - Bond’s YTM
Q. Consider a coupon bond paying a 7% coupon rate annually, with a
face value of $1,000, maturing in 20 years. The current market price
of the bond is $1,072.93. What is the yield to maturity (YTM) of the
bond?
A. We have:
c = % C = c%F = =$
F=$ T= B=$
Use your HP 10B Financial Calculator:

C
Yellow C ALL
3) Key in the 1,072.93 +/- PV
bond price (PV)
4) Key in number of
1) Key in coupon 20 N
70 PMT periods to maturity
payment

2) Key in face value 1,000 FV 5) Compute YTM Display should show:

I/YR
6.346178%
Jacoby, Stangeland and Wajeeh, 2000 12
 Canadian Bonds
Canadian bonds usually pay coupons every six months (semiannually)
Q. Consider a GofC bond paying semiannual coupons at an annual rate of
6%, with a face value of $1,000, maturing in 8 years. The bond’s YTM is
7% per year compounded semiannually. What is the value of the bond?
A. The time line:
0 1 2 15 16 (6-month Periods)
… (y1/2 = 7% per year comp. s.a.)
Define:
c = (stated) annual coupon rate (%) = 6%
C = dollar periodic coupon payment = (c/2)%F= =$
We also have:
F = 1,000 N= s.a. periods y1/2 = 7% per year comp. s.a.
Use the following PV equation to solve:
 1   1  F
 
PV  c y1 / 2  1   y1 / 2 N  

 2   (1  2 )  (1  y1 / 2 N
2 )

 30 0.107  
1   1    1,000  $939 .53

 2    (1 0.207 )16   (1 0.207 )16 13
 PV of a S.A. Coupon Bond in your HP 10B Calculator
First, clear previous data, and check that your calculator is set to 1 P/YR:
C
Yellow C ALL

The display should show: 1 P_Yr

Input data (based on above bond example)
Key in the s.a.
30 PMT
coupon payment

Key in face value

1,000 FV
(paid at maturity)

Key in the effective 3.5

s.a. discount rate I/YR

Key in number of 6-month

16
periods to maturity N

Compute PV of
Display should show:
the bond PV
-939.52941596
14
 Finding the YTM of Canadian Bonds
Q. Consider a GofC bond paying semiannual coupons at an annual rate of
12%, with a face value of $1,000, maturing in 25 years. The bond’s market
value is $1,057.98. What is the yield to maturity (YTM) of the bond per
year compounded semiannually?
A. We have: c = 12% C = (c/2)%F= =$
F = 1,000 N= s.a. periods B= 1,057.98
Use your HP 10B Financial Calculator:
3) Key in the 1,057.98
C +/- PV
Yellow C ALL bond price (PV)
4) Key in number of s.a.
1) Key in s.a. coupon 50 N
60 PMT periods to maturity
payment
5) Compute the Display should show:
2) Key in face value 1,000 5.649995%
FV effective YTM I/YR
PER 6 MONTHS
Since (y1/2/2) = 5.649995%, the YTM of the bond per year compounded
semiannually is given by: y1/2 = 2%5.649995% = 11.299990% 15
 Finding the Maturity of Canadian Bonds
Q. Consider a GofC bond paying semiannual coupons at an annual rate of 7%,
with a face value of $1,000. The bond’s market value is $1,026.82, with a
YTM of 6.6% per year compounded semiannually. What is the time to
maturity of this bond in years?
A. We have: c = 7% C = (c/2)%F= =$

F = 1,000 (y1/2 /2) = = % B=$

Use your HP 10B Financial Calculator:

3) Key in the 1,026.82

C +/- PV
Yellow C ALL bond price (PV)
4) Key in the effective
1) Key in s.a. coupon 3.3 I/YR
35 PMT YTM per 6 months
payment
5) Compute the number
2) Key in face value 1,000 FV Display should show:
of 6 MONTHS N
17.99806470
PERIODS to maturity
Thus, T = 0.5%(# of 6-month periods to maturity)
= 0.5% 17.99806470 = 8.99903235 years to maturity 16
 Finding the Coupon Rate of Canadian Bonds
Q. Consider a 30-year GofC bond paying semiannual coupons, with a face value
of $1,000. The bond’s market value is $912.83, with a YTM of 8.4% per year
compounded semiannually. What is the the bond’s annual coupon rate?

A. We have: F = 1,000 (y1/2/2) = = %

B= 912.83 N= s.a. periods

Use your HP 10B Financial Calculator:
3) Key in the 912.83
C +/- PV
Yellow bond price (PV)
C ALL
4) Key in the effective
1) Key in number of s.a. 4.2 I/YR
60 N YTM per 6 months
periods to maturity
5) Compute the SEMI
2) Key in face value 1,000 FV Display should show:
ANNUAL DOLLAR PMT
38.00001999
coupon payment

Since: C = (c/2)%F, we get:

c = (C/F)%2 = (38.00001999/1,000)%2 = 7.600004% per annum 17
 The Yield Curve

From the financial Post, November 28, 1997

Years to Bond
Maturity maturity yields (%)
1-Dec-97 0.00 0.00
1-Nov-98 0.92 4.57
1-Mar-99 1.25 4.70 6.5
1-Dec-99 2.00 4.98
1-Mar-00 2.25 5.02
6

Bond yields (%)

1-Sep-00 2.75 5.09
1-Mar-01 3.25 5.16
1-Dec-01 4.00 5.24 5.5
1-Apr-02 4.33 5.25
1-Jun-03 5.50 5.37
5
1-Dec-03 6.00 5.41
1-Jun-04 6.50 5.42
1-Dec-04 7.01 5.47 4.5
1-Dec-05 8.01 5.53
1-Dec-06 9.01 5.56 4
1-Jun-10 12.51 5.73 0 5 10 15 20 25 30
1-Mar-11 13.25 5.76
15-Mar-14 16.30 5.84 Years to maturity
1-Jun-21 23.52 5.93

Jacoby, Stangeland and Wajeeh, 2000 18

 The Term Structure of Interest Rates

Four theories:

I. Expectations theory

t f t 1  spot rate expected over year t

 E  t rt 1 

e.g. if investors expect next years yield to be 12%, then

the forward rate will also be 12%: 1f2 = 12%

Example: two alternative investments

 B1: a zero coupon bond with: T = 1, YTM: 0r1 = 8%
 B2: a zero coupon bond with: T = 2, YTM: 0r2 = 9%,
19
 The Term structure of Interest Rates

The following investments of $1 must be equivalent:

(i) investing in B2 for 2 years. At t = 2, receive: 1.092

(ii) investing in B1 for 1 year. At t = 1, investing in a new

1-year bond at a rate 1f2. At t = 2, receive: 1.08(1+1f2)

The forward rate (1f2) must take a value such that:

(1.09 ) 2  1.08  (11f 2 )

Jacoby, Stangeland and Wajeeh, 2000 20

This implies the following forward rate for year-2:
(1 0 r2 )2
1 f2  (1 0 r1 ) 1  1.09 2
1.08  1  10.01%
(1 0 rt 1 )t 1
The general case:
t f t 1  1
(1 0 rt )t

Note: This formula can be used only for zero-coupon bonds

Example: 3 alternative zero-coupon bonds, with the following spot rates:

0r1 = 8%

0r2 = 10%

0r3 = 12%
Calculating 1f2 and 2f3:
(1 0 r2 )2
1 f2  1 1  1.102
1.08  1  12.037%
(1 0 r1 )

(1 0 r3 )3
2 f3  1  1.123
 1  16.110%
(1 0 r2 )2 1.102 21
 Example - Using the Term Structure
Q1. You observe the above spot rates for GofC zero-coupon bonds for
different maturities: 0r1 = 8%, 0r2 = 10%, and 0r3 = 12%. A zero-
coupon bond has a face value of $1,000 and maturity of 2 years.
What must be its price today?
A1. Since: (1+0r2)2 = (1+0r1)(1+1f2), we can use either spot rates or
forward rates (same result) to find B:
Spot : B 1, 000
 1, 000
 $826 .45, or :
(1 0 r2 )2 (1.1) 2

Forward : B  (1 1r,000

)(1 f )
0 1
 1.081.12037  $826 .45
1 2
1, 000

Q2. Assume that the Pure Expectations Hypothesis (PEH) holds, what do
you expect the bond price to be one year from today?
A2. One year from today, the bond will have one year remaining to
maturity. Based on the PEH:
E 1 r2  expected spot rate for second year = 1f2
Thus, the expected bond price in a year is:
E[ B1 ]  (11,000f )  1.112037
1 2
,000
 $892.56 22
II. Liquidity Premium Theory
If you invest for (t+1) years, you commit to reinvest in every
year after the 1st year, and thereby lose liquidity and ask
for a liquidity premium:
t f t 1  spot rate expected over year (t  1)  Lt 1
 E  t rt 1   Lt 1
III. Augmented Expectations Theory
Combines the pure expectations theory with the liquidity premium theory:
Example - Suppose: 0r1 = 8% and 0r2 = 9%. By the Expectations Theory:
1.09 2  1.08(11f 2 )
By the Liquidity Premium Theory, when L2 =1%, we get:
1f2= E[1r2] + L2. = E[1r2] + 1%
Both theories together, give:

1.09 2  1.08(1  E 1 r2   0.01)

 1f 2  E 1 r2  23
Shapes of the Term Structure under the Liquidity Premium Theory & the
Augmented Expectations Theory
The shape of the term structure depends on the magnitude of the premium:
 when there exist constant expectations:
% f

L
E[trt+1]

 when there exist decreasing expectations:

% f`

f ``

E[trt+1]
t

Jacoby, Stangeland and Wajeeh, 2000 24

IV. Market Segmentation Theory

 Different segments of investors choose to invest in assets with different

investment horizons:
e.g. mutual funds that commit to invest in long term bonds.

 Thus, demand and supply in each segment could set different rates:

%
Medium
Short Term Long
Term Bonds Term
Bonds Bonds

t
25
 Common Stocks
 What are stocks -
 legal representation of of ownership in a corporation (equity)
 a stock holder is entitled to receive profit distributions of the
corporation (dividends)

 Dividends:
 cash payments made by the corporation to stockholders
 since stocks have no expiration date, we assume that dividends will
be paid forever

 Valuation
 the value of stocks at any point in time equals the present value of
all future dividends

Jacoby, Stangeland and Wajeeh, 2000 26

 Common Stock Valuation

 The value of a stock = PV of all expected future cash flows

 Thus, the information needed to value common stocks:

 Common Stock Dividends (Dt)

 Discount rate (r)

 PV0 = D1/(1 + r)1 + D2/(1 + r)2 + D3/(1 + r)3 + . . . forever. .

 We have to estimate future dividends

Jacoby, Stangeland and Wajeeh, 2000 27

 Case 1: Zero Growth

Assume that dividends will remain at the same

level forever, i.e. D1 = D2 =…= Dt = D

Since future cash flows are constant, the value of a

zero growth stock is the present value of a
perpetuity:
Pt = Dt+1 / r

Jacoby, Stangeland and Wajeeh, 2000 28

Example - Valuation of Common Stocks with Zero Growth
Q. ABC Corp. is expected to pay $0.75 dividend per annum, starting a
year from now, in perpetuity. If stocks of similar risk earn 12%
annual return, what is the expected price of a share of ABC stock?

A. The stock price is given by the the present value of the perpetual
stream of dividends:
0 1 2 3 4

$ $ $ $

P0 = D1 / r

= =

Jacoby, Stangeland and Wajeeh, 2000 29

 Case 2: Constant Growth
Assume that dividends will grow at a constant
rate, g, forever, i. e.,
D1 = D0 x (1+g)
D2 = D1 x (1+g) = D0 x (1+g)2

Dt = D0 x (1+g)t

Since future cash flows grow at a constant rate
forever, the value of a constant growth stock is the
present value of a growing perpetuity:
Pt = Dt+1 / (r - g)
Jacoby, Stangeland and Wajeeh, 2000 30
Examples - Valuation of Common Stocks with Constant Growth
Q1. XYZ Corp. has a common stock that paid its annual dividend this
morning. It is expected to pay a $3.60 dividend one year from now,
and following dividends are expected to grow at a rate of 4% per
year into the foreseeable future (forever)in perpetuity. If stocks of
similar risk earn 16% effective annual return, what is the price of a
share of XYZ stock?
A1. The stock price is given by the the present value of the perpetual
stream of growing dividends:
0 1 2 3 4

forever . . .

$3.60 $3.60% $3.60% $3.60%

P0 = D1 / (r-g)

= =
Jacoby, Stangeland and Wajeeh, 2000 31
Q2. In the above example, assume that XYZ’s common stock that paid its
quarterly dividend two months ago. It is expected to pay a $0.90 dividend
in one month, and following quarterly dividends are expected to grow at
a rate of 1% per quarter into the foreseeable future. Recall that the
effective annual required rate of return on XYZ stock is 16%. What is the
price of a share of XYZ stock now?
A2. Time line of the quarterly dividends:
0 1 month 4 months 7 months 10 months

forever . . .
$0.90 $0.90% $0.90% $0.90%
We first need to calculate EPR1/4 and EPR1/12:
Using: EPRn = (1+EAR)n - 1, we get:
EPR1/4 = 3.780199% and EPR1/12 = 1.244514%
The stock price in one month (after D1 month is paid):
P1 month = D4 months / (EPR1/4 - g)
= (0.90%1.01)/(0.03780199 - 0.01) = $32.69550129
The stock price today:
P0 = (D1 month + P1 month) / (1+EPR1/12) 32
= (0.90+ 32.69550129) / 1.01244514 = $33.18
Q3. Manitoba Network Operators (MNO) is expected to pay a dividend
next year of $8.06 per share. Both sales and profits for Pale Hose
are expected to grow at a rate of 2% per year indefinitely. Its
dividend is expected to grow by the same amount. If an investor is
currently willing to pay $62.00 per one MNO share, what is her
required return for this investment?
A3. We have: P0=$62.00, D1=$8.06, and g=0.02. We are looking for r.
The stock price is given by:
P0 = D1/(r-g)

=
Rearranging, we get:

r= =
In general:
r = (D1/P0) + g 33
Q4. Vandalay Industries Corp. (VIC) is expected to pay a dividend
next year of $4.32 per share. Its current stock price is $36. If the
required return for this stock is 15%, what is the constant dividend
growth rate expected for VIC’s stock starting from the second year
forever?
A4. We have: P0=$36.00, D1=$4.32, and r=0.15. We are looking for g.
The stock price is given by:
P0 = D1/(r-g)

=
Rearranging, we get:

g= =
In general:
g = r - (D1/P0)
34
Q5. MT&T Inc. has a common stock that paid its annual dividend this
morning. You expect future annual dividends to grow at a rate of
2% per year into the foreseeable future (forever). The required
return for this stock is 20%, and its current price is $25.50. What is
the dividend that was paid this morning?
A5. We have: P0=$25.50, r=0.20, and g=0.02. We are looking for D0.
The stock price is given by:
P0 = D1/(r-g)
25.5 = D1/(0.20-0.02)

Rearranging, we get:
D1 = 25.5(0.20-0.02) = $4.59

We are looking for D0. Since D1=D0(1+g), D0 is given by:

D0 = D1/(1+g) = =$
Jacoby, Stangeland and Wajeeh, 2000 35
 Case 3: Differential Growth

Assume that dividends will grow at different rates

in the foreseeable future and then will grow at a
constant rate thereafter.

To value a Differential Growth Stock, we need to:

 Estimate future dividends in the foreseeable

future.
 Estimate the future stock price when the stock

becomes a Constant Growth Stock (case 2).

 Compute the total present value of the

estimated future dividends and future stock

price at the appropriate discount rate. 36
 Examples - Differential Growth
Q1. Whizzkids Inc. is experiencing a period of rapid growth. Earnings and
dividends are expected to grow at a rate of 8 percent during the next three
years, and then at a constant rate of 4% thereafter. Whizzkids’ last dividend,
which has just been paid, was $2 per share. If the required rate of return on
the stock is 12 percent, what is the price of the stock today?
A1. It is given that:
r = 12%, D0 = $2, g1 = g2 = g3 = 8%, and g4 = g* = 4% (forever)
We calculate:
D1=$2% =$ , D2= =$ ,

D3= =$
With g4=g* =4%, we have:
D4= =$
Since constant growth rate applies to D4, we use Case 2 (constant
growth) to compute P3:
P3 = =$ 37
Expected future cash flows of this stock:

0 1 2 3
|----------|---------|---------| (r = 12%)
D1 D2 D3 + P3
2.16 2.33 2.52 + 32.75

The current (time 0) value of the stock:

P0 = D1/(1+r) + D2/(1+r)2 + (D3+P3)/(1+r)3

= + +

= $
Jacoby, Stangeland and Wajeeh, 2000 38
Q2. An investor has just paid $141.75 for the purchase of one share of UMB
Corp. stock. UMB just paid a $9 dividend per share. Annual dividends paid
at the end of the first, second and third years will grow at a rate of 10% per
annum, and then grow at a constant annual rate of g* forever. Given the risk
inherent in UMB Corp., the investor requires an effective annual rate of
10% on his/her investment. What is the value of g*?

A2. We calculate:
D1=$9% =$ , D2=
=$ ,

D3= =$
With g4=g*, we have:
D4=
UMB’s current stock price is given by:
P0 = D1/(1+r) + D2/(1+r)2 + (D3+P3)/(1+r)3
39
Where: P3 = D4/(r-g*)
With the above data:
141.75 = 9.9/1.1 + 10.89/(11)2 + 11.979/(11)3 + P3/(1.1)3
Thus, the expected stock price in three years is P3 = 152.73225

Since, this price is given by:

P3 = D4/(r-g*) = [D3(1+g*)]/(r-g*)

We have

152.73225 =

Rearranging, we get:

g* = %

Jacoby, Stangeland and Wajeeh, 2000 40