Lecture 3

Bonds
Valuation
FIN 2102 25 April 2016

Agenda:
1.
2.
3.

4.

Revision. Discounting factor, FV, PV,

NPV, annuities
What is a bond?
Definitions: Coupon rate, Current yield
n Yield to maturity, Market / Discount/
Interest Rate.
Definitions: Face Value, Market Value,
Fair value

AGENDA (2)
5.
6.
7.
8.
9.

Valuation of Bonds
What is Stock /Shares?
Valuation of Stocks.
Main role of stock exchange
Efficient Market Hypothesis.

REVISIONS:
FV = PV (1 + i )n
1
PV =
(1+ i)n
FV
Annuities:

PVA = A
x
FVA = A
x

1
(1+ i)n

i
(1+ i)n 1
i

 What

if a company sells you a certificate

for RM 1,000 and promises to pay the
buyer 5% of RM 1,000 (i.e. RM50) every
year for 3 years?
And promises to pay back the whole RM
1,000 at the end of 3 years.
This

is a Bond

1,000 is the Face Value

5% of the Face Value (RM 1,000) is the
RM

Coupon Rate

 What

if, after the company sells it to the

original buyer for RM 1,000, the original
buyer sells it for RM 913?
Is the bond value RM 1,000 or RM 913?
Both. RM 1,000 is the Face Value and
RM 913 is the Market Value
Face Value will always be the same
for the bond.
Market Value is the price where there
is a willing buyer and seller for the
bond.

 The

new owner will receive RM 50 for

the remaining 2 years of the bond. (i.e.
up to maturity of the bond)
Is he getting 5% return on the bond like
the previous owner?
No. His return is RM50 / RM 913 =
0.0548 or 5.48%
Is the coupon rate still 5%? Then what is
5.48%?
Coupon rate (5%) does not change. It is
dependent on Face Value.
This (5.48%) is the Current Yield and
dependent on Market Value

 If

the new owner bought the bond at the

beginning of year 2 (i.e. end of year 1)
for RM 913, he will still receive RM 50
for the remaining 2 years
AND RM 1,000 at maturity;
What is the % profit (return) for the new
owner?

RM 913
=

RM 50
(1 + i)

Solve for i for rate of

return

RM 50
(1 +
i)2

RM 1,000
(1 +
i)2

is found to be 10%. So what is this

value? The new coupon rate?

The

new current yield?

No.

It is called Yield-to-maturity or just

Yield

It

is the discount rate where the price of

a bond equates to the present value of
all benefits arising from the bond.

 What

if the banks outside are giving

interest rates of 4% on deposits?
This is the Market / Discount / Interest
Rate
So

from this example.

Coupon Rate = 5%
Current yield = 5.48%
Yield-to-maturity = 10%
Discount rate = 4%
Face Value = RM 1,000
Market Value = RM 913

VALUE OF BOND
To

obtain the Fair value of bond, use

Bank interest rate
Bank interest rate
fair value of bond
value
- inverse relationship.
and the length of time to maturity.

Yield-to- Maturity
Usually

taken to e the rate of return of

the bondholder.
It is made up of :

The real rate of return (the opportunity

cost or financial rent the investor
charges for using his funds
Inflation premium
Risk premium a special risk associated
with the specific investment.

 If

the now owner wishes to have a

return of say 12%, (i.e. yield to maturity
of 12%) what is the price he is will to
pay for the bond?

Price of
the
bond

RM 50
(1 +
0.12)

RM 50
(1 +
0.12)2

RM 1,000
(1 +
0.12)2

Valuation of stock /
shares

DIVIDEND VALUATION MODEL

Works on the premise that the value of a

share to the shareholder is the promise of
receiving future dividends.

So if the common stock pays a constant

dividend each year then the price of the stock
will be:

P0 =

D1
Ke

where P0 = price of the stock today,

D1 = Dividend paid
Ke = Required rate of return of share

DIVIDEND VALUATION MODEL

If

dividends are in constant growth the

price of the share is found by:

P0 =

D1
Ke g

where P0 = price of the stock today,

D1 = Dividend paid
Ke = Required rate of return of share
g = Constant growth rate in dividends

STOCK EXCHANGE
Financial

markets exist to allocate

capital from households to corporations
and government units, with financial
institutions acting as intermediaries.

Stock

exchanges is an example of
financial markets.

Examples:

NYSE ; NASDAG

IMPORTANCE OF
STOCK EXCHANGE
Provides

liquidity in two ways:

1.

Enable corporations to raise funds by

selling new issues of securities at fair,
competitive prices.

2.

Allows the investor who purchases

securities to sell them at relative ease
and speed.

MARKET EFFICIENCY
Markets

are generally said to be efficient

when:
1.

Prices adjusts rapidly to new information;

2.

After each transaction, the next

transaction occurs at a price close to the
previous price

3.

The market can absorb large dollar

amounts of securities without
destabilizing the prices.

EFFICIENT MARKET
HYPOTHESIS
States

that if stock markets are efficient,

it will be difficult for investors to select
portfolios of common stock that can
outperform the stock market in general.

categories of efficient stock markets:

Weak

Semi-strong

Strong

EFFICIENT MARKET
HYPOTHESIS
Weak

Here past price information is unrelated to

future prices;
Trends cannot be predicted and taken
advantage of by investors.

Semi-strong

Prices currently reflect all public

information

Strong

All information is immediately reflected in

stock prices

RESULTS OF STUDIES
Stock

exchanges found to be mainly

weak and semi-strong but not strong

Private,

insider information is
valuable for quick profits but it is
illegal.

CHANGES:
As

communication systems improve,

information get disseminated faster and

securities law are forcing fuller

disclosure of corporate data.

Securities

markets getting more efficient

and stock prices are reacting faster to
new information

REFERENCE
Block,

Hirt and Danielson, Foundations

of Financial Management, 15th Edition ,
McGraw Hill Education (2011); Chapters
10 and 14