Chapter 3

BOND AND STOCK

VALUATION
 Bond Valuation
 A bond is a contract that requires the borrower to
pay the interest income to the lender.
 It can also be defined as a certificate issued by a
firm (or government) that states the holder of the
certificate is owed money by the firm.
 Thus, a bond is simply a form of debt. If a firm (or
government) wishes to borrow money to finance its
activities, an alternative to a loan from a bank is a
sale of bonds.
 It resembles the promissory note and issued by the
government and corporate. The par value of bond
indicates the face value of the bond, i.e., the value
stated on the bond paper.
 Most of the bonds make fixed interest payment till
the maturity period. This specific rate of interest is
known as coupon rate. Coupons are paid quarterly,
semi-annually and annually. At the end of the
maturity period, the value is repaid.
 Most bonds are distinguished from bank loans by the
existence of a secondary market.
 Bonds are bought and sold among individual
investors after they are initially issued by the firm.
 Thus if the holder of a corporate bond no longer
wishes to keep the bond (i.e., no longer wishes to be
a creditor of the firm), then he can simply sell the
bond to another investor in the bond market.
 Terms to be defined
 Par Value: It is the price at which the bond will be
redeemed by the issuing company at the end of the
life of the bond.
 Coupon interest rate: The periodic interest rate that
is expressed as a percentage of the face value of the
bond.
 Maturity date: is the date a note is to be paid.
 Market Value: is the bond’s current price or it is the
amount that is due at the maturity or due date of the
note. In short, it is the price at which bonds are
trading in the market place.
 Yield to maturity. It is the single discount factor that
makes present value of future cash flows from a
bond equal to the current price of the bond.
Intuitively, it is the bond’s required rate of return,
which an investor can expect to earn if the bond is
held till maturity.
 Types of Bonds
 Debenture bonds. Debenture bonds are bonds that are not secured by
specific property. Their marketability is based on the general credit
rating of the company. Generally, a company must have a long-period of
earnings and continued favorable predictions of future earnings and
liquidity to sell debenture bonds. Debenture bondholders are
considered to be general creditors, with the same rights as other
creditors if the issuer fails to pay the interest or principal and declares
bankruptcy.
 Mortgage Bonds. Mortgage bonds are bonds that are secured by a lien
against specific property of the company. If the company becomes
bankrupt and is liquidated, the holders of these bonds have first claim
against the proceeds of the sale of the assets that secured their debt. If
the proceeds from the sale of pledged assets are not sufficient to repay
the debt, mortgage bondholders become general creditors for the
balance of the unpaid debt.
 Characteristics of Bonds
 Registered Bonds. Registered bonds are bonds whose ownership
is registered with the company. That is, the company maintains a
record of the holder of each bond. Therefore, on each interest
payment date, interest is paid to the individuals listed on the
corporate records as owners of the bonds. When an owner sells
registered bonds, the issuer or transfer agent must be notified so
that interest will be paid to the proper person.

 Coupon Bonds. Coupon bonds are unregistered bonds on which

interest is claimed by the holder presenting a coupon to the
company. These bonds can be transferred between individuals
without the company or its agent being notified.
 Characteristics of Bonds
 Zero-Coupon Bonds. Zero-coupon bonds (also called deep-
discount bonds) are bonds on which the interest is not paid until
the maturity date. That is, the bonds are sold at a price
considerably below their face value, interest accrues until
maturity, and then the bondholders are paid the interest along
with the principal at maturity.

 Callable Bonds. Callable bonds are bonds that are callable by the
company at a predetermined price for a specified period. That is,
the company has the right to require the bondholders to return
the bonds before the maturity date, with the company paying the
predetermined price and interest to date.
 Characteristics of Bonds
 Convertible Bonds. Convertible bonds are bonds that are
convertible into a predetermined number of shares. That is, the
owner of each bond has the right to exchange it for a
predetermined number of shares of the company. Thus, upon
conversion, the bondholder becomes a stockholder of the
company.
 Serial Bonds. Serial bonds are bonds issued at one time, but
portions of the total face value mature in periodic installments at
different future dates. Bonds with several maturities.
 Term Bonds. Term bonds are bonds that pay the entire principal
on one date, i.e. at the maturity date. Bonds with single maturity.
 Income (Revenue) Bonds. These are bonds whose payment of interest
is conditional on income.
 Other classifications include:
 Treasury bonds
 Corporate bonds
 Municipal bonds
 Foreign bonds
 1). Coupon Bonds
 These give a fixed interest payment each period as
well as paying the face value at maturity.
 We are interested in determining the price that a
bond would sell for in the bond market.
 If an investor was going to buy a bond, he would not
pay more for it than the present value of the cash
flows it provided to him.
 Similarly, if an investor was going to sell a bond, he
would not sell it for less than the present value of the
cash flows.
 Thus, the present value of the bond’s cash flows
must be the price of the bond in the market.
 Example
 The bonds of the Nordy Company have a coupon
interest rate of 9%. The interest on the bonds is paid
semiannually, the bonds mature in 8 years, and their
par value is $1,000. If the required rate of return is
8%, what is the value of each bond? What is the
value of each bond if the interest is paid annually?
 2) Zero-Coupon Bonds (or Strip Bonds)
 Bonds of this type make no interest payments; they
simply pay the face value at maturity. The holder of
this type of bond still earns interest because zero-
coupon bonds always sell at a discount to face
value.
 Example :
 A government Treasury bill is a zero-coupon bond. If
the term to maturity is one year and the government
wants to issue them at 8%, what is the price of a birr
1,000,000 Treasury bill?
 Bond issues
 When a bond sells at a price below its face value, it
is said to sell at a discount; selling at a price above
face value is selling at a premium; selling at face
value is selling at par.
 Coupon rate  interest rate in the market  bonds
sell at a discount
 Coupon rate  interest rate in the market  bonds
sell at premium
 Coupon rate  interest rate in the market  bonds
sell at a par
 In general, if the market rate of interest raises then
the price of a bond falls and vice versa.
 Yield to Maturity (YTM)
 YTM is the measure of a bond’s rate of return that
considers both the interest income and any capital
gain or loss. It is a bond’s internal rate of return.
 Example:
 Suppose that the market price of a bond is $883.40
(with a face value of $1,000). The bond will pay
interest at 6% per annum for 5 years, after which it
will be redeemed at par. What is the bond’s rate of
return?
 Yield to Call (YTC)
 A number of companies issue bonds with buy back
or call provision. Thus, a bond can be redeemed or
called before maturity.
 Example:
 Suppose the 10% 10 year $1,000 bond is
redeemable (callable) in 5 years at a call price of
$1,050. The bond is currently selling for $950. What
is bond’s YTC. The bond’s YTC is
 Current Yield CY
 It is the annual interest (coupon) payment on a bond
divided by the bond’s current market price.
 Example:
 The annual interest is $60 on the current investment
of $883.4. What is the current yield?
 Common Stock
 Common stock represents a part ownership of a firm
and entitles the holder to receive part of any profits that
are paid out to the owners in the form of dividends.
 A common stock’s value is equal to the present value
of all future cash flows expected to be received by the
stockholder.
 However, in contrast to bonds, common stock does not
promise its owners interest income or a maturity
payment at some specified time in the future.
 When buying a stock, one cares about two things:
1. the dividends that one gets while the stock is held
2. the price for which the stock can be sold (capital
gains)
 Expected Dividends as a Basis for Valuation

 The value of the stock today is determined by

discounting an infinite stream of dividends. Unless it
is liquidated or sold to another corporation.
 Valuation of Zero-Growth Stock
 Zero growth stock is a common stock whose future
dividends remain constant, g = 0. So, all future
expected dividends will be equal, called perpetuity.
 Valuation of Constant Dividend Growth Stock

 It is also known as normal growth model or Gorden

Model in which future dividends expected to be grow
at a uniform rate, g. Hence, Dt =D0(1+g)t . Based on
this, P0 will be determined as follows.
 Valuation of a Stock With Non-constant or Supernormal Growth

 Firms that encounter dividend growth that is non-

constant and inconsisten in their life have
supernormal growth stock.
 The steps to determine value of the stock is:
1. Find the present value of the dividends during the
supernormal period,
2. Find the price of the stock at the end of the
nonconstant growth period and discount it back that
price by the same period,
3. Finally, add the above two components to find the
intrinsic value of the stock, P0.
 Example: Suppose the stock’s last dividend paid
shows $1.15 and expected to grow at 30% for the
first 3 years and at 8% constantly then after. The
required rate of return is 13.4% per annum.
Determine the value of the common stock?
 Preferred stock Valuation
 Preference share is something of a hybrid security
with features that are part debt and part equity in
nature.
 Preference shareholders receive dividends, which
are discounted at the required rate of return on the
preference.
 Preference shareholders have prior claim over the
equity holders on the firm’s income in normal times
and on the firm’s assets in bankruptcy. Therefore,
preference share is safer than ordinary shares.
 Since preference share provides a fixed income
return; the equation adopted to find out the value is
given below:

 Example: Assume that a preferred stock’s annual

dividend is Birr 50 and the required rate of return is
10 pre cent, what is its worth today?
 Cost of Capital
 Cost of capital is the minimum rate of return that a
company must earn on equity financed portion of its
investment.
 In other words, cost of capital is the minimum return
expected by the investors on their investment to
invest the money in the proposal under
consideration.
 Thus, it is the minimum rate of return which a firm
requires as a condition for undertaking any
investment.
 #
Importance of Cost of Capital
1. The concept of cost of capital is the criterion in
capital budgeting decision. Capital budgeting
decision involves the consideration of the cost of
capital.
2. The cost of capital decides about the method of
financing.
3. The cost of capital serves as a basic for evaluating
the financial performance.
4. The cost of capital can be conveniently employed
as a tool in making decision in dividend policy.
5. It acts as determinant of capital mix in the designing
of a balanced and appropriate capital structure.
 Factors Determining the Cost of Capital

 General Economy Conditions

 Risk and Cost of Capital:
 Business Risk
 Purchasing Power Risk
 Money rate Risk
 Market (Liquidity) Risk
 Amount of Financing Required:
 Floatation Costs
 Components of Cost of Capital
 The overall cost of capital of a firm is comprised of
the costs of the various components of financing.
Techniques for determining the specific costs of
each of these sources, i.e., debt, preferences
shares, equity shares and retained earnings are
presented as follows: