8 Bonds Valuation

Bonds are long-term debt securities that are issued by corporations and government
entities. Purchasers of bonds receive periodic interest payments, called coupon payments,
until maturity at which time they receive the face value of the bond and the last coupon
payment. Most bonds pay interest semiannually. The Bond Indenture or Loan Contract
specifies the features of the bond issue. The following terms are used to describe bonds.

8.1 Par or Face Value

The par or face value of a bond is the amount of money that is paid to the bondholders at
maturity. For most bonds the amount is $1000. It also generally represents the amount of
money borrowed by the bond issuer.

8.2 Coupon Rate

The coupon rate, which is generally fixed, determines the periodic coupon or interest
payments. It is expressed as a percentage of the bond's face value. It also represents the
interest cost of the bond issue to the issuer.

8.3 Coupon Payments

The coupon payments represent the periodic interest payments from the bond issuer to
the bondholder. The annual coupon payment is calculated be multiplying the coupon rate
by the bond's face value. Since most bonds pay interest semiannually, generally one half
of the annual coupon is paid to the bondholders every six months.

8.4 Maturity Date

The maturity date represents the date on which the bond matures, i.e., the date on which
the face value is repaid. The last coupon payment is also paid on the maturity date.

8.5 Original Maturity

The time remaining until the maturity date when the bond was issued.

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8.6 Remaining Maturity
The time currently remaining until the maturity date.

8.7 Call Date

For bonds which are callable, i.e., bonds which can be redeemed by the issuer prior to
maturity, the call date represents the date at which the bond can be called.

8.8 Call Price

The amount of money the issuer has to pay to call a callable bond. When a bond first
becomes callable, i.e., on the call date, the call price is often set to equal the face value
plus one year's interest.

8.9 Required Return

The rate of return that investors currently require on a bond.

8.10 Yield to Maturity

The rate of return that an investor would earn if he bought the bond at its current market
price and held it until maturity. Alternatively, it represents the discount rate which
equates the discounted value of a bond's future cash flows to its current market price.

8.11 Yield to Call

The rate of return that an investor would earn if he bought a callable bond at its current
market price and held it until the call date given that the bond was called on the call date.

The figure below illustrates the cash flows for a semiannual coupon bond with a face
value of $1000, a 10% coupon rate, and 15 years remaining until maturity. (Note that the
annual coupon is $100 which is calculated by multiplying the 10% coupon rate times the
$1000 face value. Thus, the periodic coupon payments equal $50 every six months.)

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8.12 Bond Cash Flows

Because most bonds pay interest semiannually, the discussion of Bond Valuation
presented here focuses on semiannual coupon bonds.

8.13 Bond Price

The price or value of a bond is determined by discounting the bond's expected cash flows
to the present using the appropriate discount rate. This relationship is expressed for a
semiannual coupon bond by the following formula:

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where

• B0 = the bond value,

• C = the annual coupon payment,
• F = the face value of the bond,
• r = the required return on the bond, and
• t = the number of years remaining until maturity.

Bond Valuation Example

Find the price of a semiannual coupon bond with a face value
of $1000, a 10% coupon rate, and 15 years remaining until
maturity given that the required return is 12%.

Solution:

8.14 Par Bonds

A bond is considered to be a par bond when its price equals its face value. This will occur
when the coupon rate equals the required return on the bond.

8.15 Premium Bonds

A bond is considered to be a premium bond when its price is greater than its face value.
This will occur when the coupon rate is greater than the required return on the bond.

8.16 Discount Bonds

A bond is considered to be a discount bond when its price is less than its face value. This
will occur when the coupon rate is less than the required return on the bond.

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8.17 Yield to Maturity
The yield to maturity on a bond is the rate of return that an investor would earn if he
bought the bond at its current market price and held it until maturity. It represents the
discount rate which equates the discounted value of a bond's future cash flows to its
current market price. This is illustrated by the following equation:

where

• B0 = the bond price,

• C = the annual coupon payment,
• F = the face value of the bond,
• YTM = the yield to maturity on the bond, and
• t = the number of years remaining until maturity.

The yield to maturity usually cannot be solved for directly. It generally must be
determined using trial and error or an iterative technique. Fortunately, financial
calculators make the task of solving for the yield to maturity quite simple.

Yield to Maturity Example

Find the yield to maturity on a semiannual coupon bond with
a face value of $1000, a 10% coupon rate, and 15 years
remaining until maturity given that the bond price is $862.35.

Solution:

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8.18 Yield to Call
Many bonds, especially those issued by corporations, are callable. This means that the
issuer of the bond can redeem the bond prior to maturity by paying the call price, which
is greater than the face value of the bond, to the bondholder. Often, callable bonds cannot
be called until 5 or 10 years after they were issued. When this is the case, the bonds are
said to be call protected. The date when the bonds can be called is refered to as the call
date.

The yield to call is the rate of return that an investor would earn if he bought a callable
bond at its current market price and held it until the call date given that the bond was
called on the call date. It represents the discount rate which equates the discounted value
of a bond's future cash flows to its current market price given that the bond is called on
the call date. This is illustrated by the following equation:

where

• B0 = the bond price,

• C = the annual coupon payment,
• CP = the call price,
• YTC = the yield to call on the bond, and
• CD = the number of years remaining until the call date.

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Like the yield to maturity, the yield to call usually cannot be solved for directly. It
generally must be determined using trial and error or an iterative technique. Fortunately,
financial calculators make the task of solving for the yield to maturity quite simple.

Yield to Call Example

Find the yield to call on a semiannual coupon bond with a
face value of $1000, a 10% coupon rate, 15 years remaining
until maturity given that the bond price is $1175 and it can be
called 5 years from now at a call price of $1100.

Solution:

8.19 Bond Valuation Equations

Semiannual Coupon Bonds

Bond Price:

Yield to Maturity:

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Yield to Call:

Annual Coupon Bonds

Bond Price:

Yield to Maturity:

Yield to Call:

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9 Stock Valuation
Firms obtain their long-term sources of equity financing by issuing common and
preferred stock. The payments of the firm to the holders of these securities are in the form
of dividends. Unlike interest payments on debt which are tax deductible, dividends must
be paid out of after-tax income.

The common stockholders are the owners of the firm. They have the right to vote on
important matters to the firm such as the election of the Board of Directors. Preferred
stock, on the other hand, is a hybrid form of financing, sharing some features with debt
and some with common equity. For example, preferred dividends like interest payments
on debt are generally fixed. In addition, the claims against the assets of the firm of the
preferred stockholders, like those of the debtholders, are also fixed.

The common stockholders have a residual claim against the assets and cash flows of the
firm. That is, the common stockholders have a claim against whatever assets remain after
the debtholders and preferred stockholders have been paid. Moreover, the cash flow that
remains after interest and preferred dividends have been paid belongs to the common
stockholders.

The priority of the claims against the assets of the firm belonging to debtholders,
preferred stockholders, and common stockholders differ. The owners of the firm's debt
securities have the first claim against the assets of the firm. This means that the
debtholders must receive their scheduled interest and principal payments before any
dividends can be paid to the equity holders. If these claims are not paid, the debtholders
can force the firm into bankruptcy. The preferred stockholders have the next claim. They
must be paid the full amount of their scheduled dividends before any dividends may be
distributed to the common stockholders.

The value of these securities, as with other assets, is based upon the discounted value of
their expected future cash flows. In this section, Time Value of Money principles are
applied to value common and preferred stock. Two approaches are presented for the
valuation of common stock. The first approach illustrates the valuation of a constant

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growth stock, i.e., a stock whose dividends are growing at a rate which mirrors the long-
term growth rate of the economy. The second approach is a more general approach which
can be applied to value stocks whose growth is not constant in the near term.

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10 Constant Growth Stock Valuation
Stock Valuation is more difficult than Bond Valuation because stocks do not have a
finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the
techniques used for stock valuation must make some assumptions regarding the
structure of the dividends.

A constant growth stock is a stock whose dividends are expected to grow at a constant
rate in the foreseeable future. This condition fits many established firms, which tend to
grow over the long run at the same rate as the economy, fairly well. The value of a
constant growth stock can be determined using the following equation:

where

• P0 = the stock price at time 0,

• D0 = the current dividend,
• D1 = the next dividend (i.e., at time 1),
• g = the growth rate in dividends, and
• r = the required return on the stock, and
• g < r.

Constant Growth Stock Valuation Example

Find the stock price given that the current dividend is $2 per
share, dividends are expected to grow at a rate of 6% in the
forseeable future, and the required return is 12%.

10.1 Dividend Yield and Capital Gains Yield

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