CHAPTER 5

BONDS AND STOCKS

VALUATION
NURUL SUHADA BINTI RAMLI (817159)
NOOR RAFIDAH BINTI KAMARUDIN (815512)
YUSNIZA BINTI YAAKUB (817269)
EVE CHEN BAO LIN (815754)
SIVARANJINI(815652)

5.1
HOW TO VALUE BONDS

How to value Bonds

Definition of bond a bond is a fixed
interest financial asset issued by
governments, companies, banks,public
utilities and other large entities.
Legally binding agreement between a
borrower and a lender that specifies the
a) Par (face) value
b) Coupon rate
c) Coupon payment
d) Maturity Date

Type of Bonds

Secured Bonds
Callable Bonds
Convertible Bonds
Agency Bonds
Municipal Bonds
Corporate Bonds
Zero Coupon Bond used in United States
bonds markets and is the biggest in the
world

Pure Discount Bonds

Make no periodic interest payments (coupon
rate= 0%). Pure discount bond that will make
only one payment of principal and interest.
Entire yield maturity = purchase price par
value (FV)
Cannot sell for more than par value
Sometimes called zeroes, deep discount
bonds, or original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury
strips are good example of zeroes.

Pure Discount Bonds: (Fixed future date)

- Pure discount bond that will make only one
payment of principal and interest. Also called
a zero-coupon bomd or single-payment bond.
Simplest kind of bonds coupon rate = 0.
- Zero-coupon bonds are bonds that do not pay
interest during the life of the bonds.
- The bond is said to mature or expire on the
date of its final payment.
- Face value (par value): is the payment at
maturity or expire of bond.

$
0
$
0
$
0
$
F

2
T
01P
T

1
F
V

(1
R
)T

Pure Discount Bonds

Information needed for valuing pure discount

bonds:
Time to maturity (T) = Maturity date
Face value (F)
Discount rate (R)

Present value of a pure discount bond at time 0:

$
0
$
0
$
0
$
1
,
0

3
0
2
0P
2
9
1
F
$
1
,
0
V

$
1
7
4
.
T
3
0
(1
R
)(.6)

Pure Discount Bonds:

Example
Find the value of a 30-year zero-

coupon bond with a $1,000 par

value and a YTM of 6%.

0$0,1$

2930
2
1
0

Level Coupon Bonds

Coupon bonds are type of bond issue
that offers the benefit of receiving an
interest payment on a semi-annual
basis.
The coupon is paid every six months
and is the same throughout the life
of the bond.
The face value of the bond is paid at
maturity in end the final year.

$
C
$
C
$
C
$
C

2
T
0P
1
T

1
V
R
C
1
F

1
(
T
T
R
) (1R
)

Level-Coupon Bonds

Information needed to value level-coupon bonds:

Coupon payment dates and time to maturity
(T)
Coupon payment (C) per period and Face
value (F)
Discount rate

Value of a Level-coupon bond= PV of coupon payment annuity + PV of face value

.P
$
3
1
8
7
5
$
3
1
.
8
7
5
$
3
1
.
8
7
5
$
1
,
0
3
.
8
7
5

/V
1
0
2
1
2
/
3
0
2
/
6
3
0
2
6
/
3
0
9
1
2
/
3
0
9
(.025)6($.12,05)6
$301.82751
1
$1,049.3
Level-Coupon Bonds: Example

Find the present value (as of January 1, 2002), of a 63/8 coupon T-bond with semi-annual payments, and a
maturity date of December 2009 if the YTM is 5percent.
On January 1, 2002 the size and timing of cash
flows are:

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

Example of Yield to
Maturity
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.

5.2
BONDS CONCEPTS

Bond Concepts
1.

Bond prices and interest rates move in opposite

directions.

2.

When coupon rate = YTM, price = par value.

When coupon rate > YTM, price > par value
(premium bond)
When coupon rate < YTM, price < par value
(discount bond)

3.

A bond with longer maturity has higher relative (%)

price change than one with shorter maturity when
interest rate (YTM) changes. All other features are
identical.

4.

A lower coupon bond has a higher relative price

5-16
change than a higher coupon bond when
YTM

Bond Value

YTM and Bond Value

$1400

When the YTM < coupon, the bond

trades at a premium.

1300
1200

When the YTM = coupon, the

bond trades at par.

1100
1000
800

0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
6 3/8
Discount Rate

When the YTM > coupon, the bond trades at a discount.

5-17

Bond Value

Maturity and Bond Price

Volatility
Consider two otherwise identical
bonds.
The long-maturity bond will have
much more volatility with respect to
changes in the discount rate

Par
Short Maturity Bond

Discount Rate

Long Maturity Bond

5-18

Bond Value

Coupon Rate and Bond Price

Volatility
Consider two otherwise identical bonds.
The low-coupon bond will have much more
volatility with respect to changes in the
discount rate

High Coupon Bond

Discount Rate
Low Coupon Bond
5-19

5.3
THE PRESENT VALUE
OF COMMON STOCKS

Dividends VS. Capital Gains

Securities
representing
equity
ownership in a corporation, providing
voting rights, and entitling the holder
to a share of the company's success
through dividends and/or capital
appreciation.
The price of a share of common stock
to the investor is equal to the present
value of all expected future dividends.

Valuations of Different Stock

Types
1. Zero Growth
2. Constant Growth
3. Differential Growth

NOTES
= the expected dividend paid
= the expected price at years end
= the present value of the common
stock investment
r = the appropriate discount rate for
the stock

ZERO GROWTH
Assume that dividends will remain at the same
level forever
Div 1
Div 2
Div 3

L
P0
1
2
3
(1 r )
(1 r )
(1 r )
Div
P0
r

Example
D0 = 2.00, R = 13%
Div
P0 =
r
=

RM2
0.13

= RM15.38

CONSTANT GROWTH
Assume that dividends will grow at a constant
rate, g, forever

P0

Div
1

r g

Example
D0 = 2.00, R = 13%, g = 6%.
Constant growth
model:
D0(1+g)
P0 =
R-g
=

RM2.12
0.13 - 0.06

D1
=
R-g
=

RM2.12
0.07

= RM30.29.

DIFFERENTIAL GROWTH
Assume that dividends will grow at
different rates in the foreseeable
future and then will grow at a
constant rate thereafter.

Example
A common stock just paid a dividend of
RM2.
The dividend is expected to grow at
8% for 3
years, then it will grow at 4% in
perpetuity.
The discount rate is 12%.

 Div N 1

C
(1 g1 )T R g 2
P

1
T
N
R g1
(1 R )
(1 R )
$2(1.08) 3 (1.04)

3
.12 .04
RM 2 (1.08)
(1.08)

P
1

3
3
.12 .08
(1.12)
(1.12)

$32.75
P RM 54 1 .8966
3
P RM 5.58 $23.31

(1.12)
P RM 28.89

5.4
ESTIMATES OF PARAMETERS
IN THE DIVIDEND-DISCOUNT
MODEL

 The value of firms depends upon its

growth rate (g) and its discount rate
(R)
Where does g come from?
Where does R come from?

Growth Rate (g)

The amount of increase that specific
variable has gained within specific
area
Annualized rate of growth of
company earning and dividend.
Formula:
g = Retention Ratio x Return on
retained earning (ROE)

Example for Firms Growth

Rate (g)
Firm plans to retain 40% of earning all year
forward (retention ratio)
The ROE = 0.16 expected to continue into
future (historical)
The calculation
g = 0.4 x 0.16 = 0.64
Because of dividend to earning, its payout
out ratio is constant growth forward
0.64 is growth rate for earning and dividend.

Required Return or Discount Rate

(R)
Required return is return on assets
with the same risk as the firm share.
The formula:
From P = Div/(R g)
Rearrange the equation to solve R,
we get:
R g = Div/P
R = Div/P + g

Example Calculating the Required

Return
Earning = $2,000,000
Share of stock outstanding= 1,000,000
Stock Selling at $10
Retention Ratio = 40%
Payout Ratio = 60% (1 Retention Ratio)
1) Calculate the Earning = $2,000,000 x 1.064
= $2,128,000
2) Calculate the dividends = 0.6 (payout) x $2,128,000
= $1,276,800
3) Dividend per share = ($1,276,800 x 1,000,000) = $1.28
4) g = 0.064
5) R = $1.28/$10.00 + 0.064
= 0.192

5.5
GROWTH
OPPORTUNITIES

Growth Opportunities (GO)

GO = Investment chances in +ve
NPV projects.
A firms value can be determined as
the total of a firms value that pays
out ALL profits as dividends and the
EPSvalue.
net equal Pto GO
NPVGO
r

5.6
THE DIVIDENDS GROWTH
MODEL AND THE NPVGO
MODEL

Two ways to value a stock:

1. The dividend discount model
2. The price of a share of stock
Sum of its price as a cash cow
plus the per-share value of its
growth opportunities.

Example:
Consider a firm that has EPS of $5 at
the 1st year end, a dividend-payout
ratio of 30%, a discount rate of 16%,
and a return on retained earnings of
20%.
The dividend at year one = $5 30% =
$1.50 per share.
The retention ratio is 70% implying a
growth rate in dividends of 14% = 70%
20%

Option 1: Dividend growth

model
The price of a share is:
P0

Div
1

r g

$1. 50
0. 16 0. 14

$ 75

Option 2: NPVGO Model

S1. Calculate the value of the firm as a cash cow.

Div1 $5
$31.25

P0
r 0.16
S2. Calculate the value of the growth opportunities.

.20
3
.
50

3
.
50

$.875
0.
16

P0
$43.75

0.16 0.14
r g

S3.

P0 31.25 43.75 $75

5.7
PRICE-EARNING RATIO

Price to Earning Ratio

To figure out the price to earnings ratio,
divide the price of stock, by the
earnings per share.
Price Of a Stock/Earnings per share

Computing PE Ratios :
Need to know the price of the stock
Need to know the annual earnings
per share
Divide price of the stock by the
earnings

What happens to the price to

Earnings Ratios if only :
The Stock Price Goes Higher? - The P/E ratio goes
higher
The Stock price goes lower? - The P/E ratio goes
lower
The Earnings Go higher? The P/E ratio goes lower
The Earnings Go Lower? The P/E ratio goes higher

Understanding the Ratio

High P/E Ratio
The stock price maybe over-valued or
the company is growing rapidly
Low P/E Ratio
The stock price maybe under-valued or
the company is in mature industry

Example
1. Take Yahoo!, for example. As of August 23, 2013,
Yahoo!'s stock was trading at 27.99.
1.We have the first part of our equation, the
numerator, or 27.99.
2.As of August 23, 2013, Yahoo!'s EPS was $.35
per share.
3.Divide 27.99 by .35 to get 79.97. Yahoo!'s
price-earnings ratio is approximately 80.

THE END
THANK YOU