Bond Valuation, Risk and

Cost of Capital and

capital structure

Where does the discount

rate come from?

FIN 819: lecture 4&5

Today’s plan
 Bond valuation
• Yield to maturity
• Term structure of interest rates and yield curve
 Risk and returns
• How to measure risk
• Individual security risk
• Portfolio risk
• Diversification
• Unique risk
• Systematic risk or market risk
• Measure market risk: beta

FIN 819: lecture 4&5

Today’s plan (continue)
 Portfolio rules and diversification
 Measure market risk: beta
 CAPM
 WACC
 Levered betas and unlevered betas

FIN 819: lecture 4&5

 Bonds

 Bond – a security or a financial instrument that

obligates the issuer (borrower) to make
specified payments to the bondholder during
some time horizon.
 Coupon - The interest payments made to the
bondholder.
 Face Value (Par Value, Principal or Maturity
Value) - Payment at the maturity of the bond.
 Coupon Rate - Annual interest payment, as a
percentage of face value.
FIN 819: lecture 4 &5 4
Bonds
 A bond also has (legal) rights attached to
it:
• if the borrower doesn’t make the required
payments, bondholders can force bankruptcy
proceedings
• in the event of bankruptcy, bond holders get
paid before equity holders

FIN 819: lecture 4 &5 5

An example of a bond
 A coupon bond that pays coupon of 10%
annually, with a face value of $1000, has a
discount rate of 8% and matures in three
years.
• The coupon payment is $100 annually
• The discount rate is different from the coupon rate.
• In the third year, the bondholder is supposed to get
$100 coupon payment plus the face value of $1000.
• Can you visualize the cash flows pattern?

FIN 819: lecture 4 & 5 6

Bonds

WARNING
The coupon rate IS NOT the discount
rate used in the Present Value
calculations.
The coupon rate merely tells us what cash flow
the bond will produce.
Since the coupon rate is listed as a %, this
misconception is quite common.

FIN 819: lecture 4 & 5 7

Bond Valuation

The price of a bond is the Present Value

of all cash flows generated by the bond
(i.e. coupons and face value) discounted
at the required rate of return.

cpn cpn 1,000  cpn

PV    ... 
(1  r )1 (1  r ) 2 (1  r ) N

FIN 819: lecture 4 &5 8

Zero coupon bonds

 Zero coupon bonds are the simplest type of bond

(also called stripped bonds, discount bonds)
 You buy a zero coupon bond today (cash outflow)
and you get paid back the bond’s face value at
some point in the future (called the bond’s maturity )
 How much is a 10-yr zero coupon bond worth today
if the face value is $1,000 and the effective annual Face
rate is 8% ? value

PV

Time=0 Time=t

FIN 819: lecture 4 &5 9

Zero coupon bonds (continue)
 P0=1000/1.0810=$463.2
 So for the zero-coupon bond, the price is
just the present value of the face value
paid at the maturity of the bond
 Do you know why it is also called a
discount bond?

FIN 819: lecture 4 & 5 10

Coupon bond

The price of a coupon bond is the

Present Value of all cash flows
generated by the bond (i.e. coupons and
face value) discounted at the required
rate of return.
cpn cpn (cpn  par )
PV    .... 
(1  r )1 (1  r ) 2 (1  r )t
1 1 

 cpn    par  PV (annuity)  PV ( par )
 r r (1  r )t  (1  r )t
 

FIN 819: lecture 4 & 5 11

Bond Pricing

Example
What is the price of a 6 % annual coupon
bond, with a $1,000 face value, which matures
in 3 years? Assume a required return of 5.6%.

FIN 819: lecture 4 & 5 12

Bond Pricing

Example
What is the price of a 6 % annual coupon
bond, with a $1,000 face value, which matures
in 3 years? Assume a required return of 5.6%.
60 60 1,060
PV  1
 2

(1.056) (1.056) (1.056)3
PV  $1,010.77

FIN 819: lecture 4 13

Bond Pricing

Example (continued)
What is the price of the bond if the required
rate of return is 6 %?
60 60 1,060
PV  1
 2
 3
(1.06) (1.06) (1.06)
PV  $1,000

FIN 819: lecture 4 & 5 14

Bond Pricing

Example (continued)
What is the price of the bond if the required
rate of return is 15 %?
60 60 1,060
PV  1
 2

(1.15) (1.15) (1.15)3
PV  $794.51

FIN 819: lecture 4 15

Bond Pricing

Example (continued)
What is the price of the bond if the required
rate of return is 5.6% AND the coupons are
paid semi-annually?

FIN 819: lecture 4 16

Bond Pricing

Example (continued)
What is the price of the bond if the required
rate of return is 5.6% AND the coupons are
paid semi-annually?
30 30 30 1,030
PV  1
 2
 ...  
(1.028) (1.028) (1.028) (1.028)6
5

PV  $1,010.91

FIN 819: lecture 4 17

Bond Pricing

Example (continued)
Q: How did the calculation change, given semi-
annual coupons versus annual coupon
payments?

FIN 819: lecture 4 18

Bond Yields

 Current Yield - Annual coupon

payments divided by bond price.
 Yield To Maturity (YTM)- Interest rate
for which the present value of the
bond’s payments equal the market
price of the bond.
cpn cpn (cpn  par )
P   .... 
(1  y )1 (1  y ) 2 (1  y )t

FIN 819: lecture 4 19

An example of a bond
 A coupon bond that pays coupon of 10%
annually, with a face value of $1000, has
a discount rate of 8% and matures in
three years. It is assumed that the
market price of the bond is the present
value of the bond at the discount rate of
8%.
• What is the current yield?
• What is the yield to maturity.
FIN 819: lecture 4 20
My solution
 First, calculate the bond price
 P=100/1.08+100/1.082+1100/1.083
 =$1,051.54
 Current yield=100/1051.54=9.5%
 YTM=8%

FIN 819: lecture 4 21

Bond Yields

Calculating Yield to Maturity (YTM=r)

If you are given the market price of a
bond (P) and the coupon rate, the yield
to maturity can be found by solving for r.

cpn cpn (cpn  par )

P   .... 
1 2
(1  r ) (1  r ) (1  r )t

FIN 819: lecture 4 22

Bond Yields

Example
What is the YTM of a 6 % annual coupon
bond, with a $1,000 face value, which matures
in 3 years? The market price of the bond is
$1,010.77
60 60 1,060
PV   
(1  r ) (1  r ) (1  r ) 3
1 2

PV  $1,010.77

FIN 819: lecture 4 23

Bond Yields

 In general, there is no simple formula

that can be used to calculate YTM
unless for zero coupon bonds
 Calculating YTM by hand can be very
tedious. We don’t have this kind of
problems in the quiz or exam
 You may use the trial by errors
approach get it.

FIN 819: lecture 4 24

Bond Yields (3)

 Can you guess which one is the

solution?
(a) 6.6%
(b) 7.1%
(c) 6.0%
(d) 5.6%
 My solution is (d).

FIN 819: lecture 4 25

The rate of return on a bond
Coupon income + price change
Rate of return =
investment or bond price
profit
Rate of return =
cost of investment

Example: An 8 percent coupon bond has a price of $110 dollars

with maturity of 5 years and a face value of $100. Next year, the
expected bond price will be $105. If you hold this bond this
year, what is the rate of return?

FIN 819: lecture 4 26

My solution
 The expected rate of return for holing the
bond this year is (8-5)/110=2.73%
• Price change =105-110=-$5
• Coupon payment=100*8%=$8
• Profit=8-5=$3
• The investment cost or the initial price=$110

FIN 819: lecture 4 27

Some new terms
 So far, we consider one discount rate for all the
cash flows
 In fact, the discount rate for one period cash
flows can be different from the discount rate for
two-period cash flows.
 Spot interest rate: the actual interest rate
available today (t=0)
 Future interest rate: the spot rate in the future
(t>0)

FIN 819: lecture 4 28

Example
 Spot rates (r)
 Investment Horizon r
 1 6%
 2 6.5%
 3 7%
 4 7.2%

FIN 819: lecture 4 29

The Yield Curve

Term Structure of Interest Rates: is the

relationship between the spot rates and
their maturity dates
Yield Curve - Graph of the term structure.

FIN 819: lecture 4 30

The term structure of interest
rates (Yield curve)

FIN 819: lecture 4 31

Value the bond (revisit)
 If we are given the term structure of interest
rates, we know the discount rates for cash
flows in different time periods.
 Then
cpn cpn (cpn  par )
PV    .... 
(1  r1 ) (1  r2 )
1 2
(1  rt ) t
 Here r1, r2, …, rt are spot rates for period 1, 2,
…, t, respectively.

FIN 819: lecture 4 32

Question
 Which kind of the yield curve can make
you use a single discount rate for the
bond valuation?
 For what kind of bonds, YTM is the same
as spot rates?

FIN 819: lecture 4 33

Example
 Please use the following information to
value a 10%, four years coupon bond, if
the spot rates are:
Year Spot rate

1 5%

2 5.4%

3 5.7%

4 5.9%
FIN 819: lecture 4 34
Solution
 The interest payment is $100 every year.
100 100 100 (100  1,000)
PV    
(1  .05)1 (1  .054) 2 (1  .057)3 (1  .059) 4
 $1,144.5

FIN 819: lecture 4 35

A problem
 A 6 percent six-year bond yields 12%
and a 10 percent six year bond yields 8
percent. Please calculate six-year spot
rate.

FIN 819: lecture 4 36

How to measure the
performance of your investment
 Suppose you buy one share of IBM at
$74 this year and sell it at the expected
price of $102. IBM pays a dividend of
$1.25 for your investment
• What profit do you expect to make for your
investment?
• What profit do you expect to make for one
dollar investment?

Financial Management: lecture 8

Solution
 Profit in total =102-74+1.25=$29.25
 Profit per one dollar=29.25/74=0.395 or
39.5%

Financial Management: lecture 8

Measuring Risk

In financial markets, we use the volatility of

a security return to measure its risk.
Variance – Weighted average value of squared
deviations from mean.
Standard Deviation – Weighted average value
of absolute deviations from mean and is also
the square root of the variance

FIN 819: lecture 5

Risk premium
 The risk premium is the difference
between the expected rate of return on a
risky security and the expected rate of
return on risk-free government bonds or
T-bills.
 Over the last century, the average risk
premium is about 7% for stocks.
 Why is this risk premium so high?

FIN 819: lecture 5

Calculating the risk of a security
 There may be two approaches for calculating
the risk of a security. Specifically,
• Using the basic definition of expectation and
variance for both individual securities and
securities that are portfolios.
• Using the portfolio rule for only the security
that is a portfolio.
 In fact, these two approaches are exactly the
same, but the second one can omit some
calculation details.

FIN 819: lecture 5

Some basic concepts
 Before we go on to show how to use two
approaches to calculate risk, let’s first
review some basic formula for
Expectation and Variance
 Let X be a return of a security in the next
period. Then we have
N N
X  E[ X ]   p (i ) X (i ) Var [ X ]   p (i )( X (i )  X ) 2
i 1 i 1

FIN 819: lecture 5

Portfolio
 A portfolio is a set of securities and can
be regarded as a security.
 If you invest W US dollars in a portfolio
of n securities, let Wi be the money
invested in security i, then the portfolio
weight on stock i is n
Wi
xi  , with property  xi  1
W i 1

FIN 819: lecture 5

Example 1
 Suppose that you want to invest $1,000
in a portfolio of IBM and GE. You spend
$200 on IBM and the other on GE. What
is the portfolio weight on each stock?

FIN 819: lecture 5

Solution

xIBM  200 / 1000  0.2

xGE  800 / 1000  0.8

FIN 819: lecture 5

Example 2
 Suppose that you have $1,000 and
borrow another $1,000 from the bank to
invest in IBM and GE. You spend $500
on IBM and the other on GE. What is the
portfolio weight on each stock?

FIN 819: lecture 5

Three portfolio rules
A: The return of a portfolio is the weighted
average of the returns of the securities in the
portfolio.
B: The expected return of a portfolio is the
weighted average of the expected returns of
the securities in the portfolio.
C: The Beta of a portfolio is the weighted
average of the Betas of the securities in the
portfolio.

FIN 819: lecture 5

 Portfolio return and risk of two
stocks

Expected Portfolio Return  (x1r1 )  ( x 2 r2 )

Portfolio Variance  x σ  x σ  2( x 1x 2ρ 12σ 1σ 2 )

2
1
2
1
2
2
2
2

FIN 819: lecture 5

Portfolio risk with two stocks
The variance of a two stock portfolio is the sum of these
four boxes

Stock 1 Stock 2
x 1x 2σ 12 
Stock 1 x 12σ 12
x 1x 2ρ 12σ 1σ 2
x 1x 2σ 12 
Stock 2 x 22σ 22
x 1x 2ρ 12σ 1σ 2

FIN 819: lecture 5

Portfolio risk for N securities

1
2
3
4
5
6

N
1 2 3 4 5 6 N

FIN 819: lecture 5

Example
 Consider a portfolio of two stocks: IBM and GL.
 I  0.1, G  0.3
rI  0.08, rG  0.12
 IG  0.8
x I  0.4, xG  0.6
 What is the expected return and standard deviation of the
portfolio?

FIN 819: lecture 5

Solution

R  x I rI  xG rG  0.4 * 0.08  0.6 * 0.12  10.4%

 IG   IG  I G  0.024
 2R  xI2 2I  xG
2 2
G  2 xI xG  IG  0.02248
 R  15%

FIN 819: lecture 5

Two types of risks

Unique Risk - Risk factors affecting only that

firm. Also called “firm-level risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”

Financial Management: lecture 8

Diversification
 What have your observed from the
above example
• Risk for each individual stock
• Risk for your portfolio
 Diversification: put a lot of different
assets in a portfolio to reduce risk
 Why can diversification be used to
reduce risk?

FIN 819: lecture 5

Diversification and risk

FIN 819: lecture 5

Market risk and Beta

Market Portfolio - Portfolio of all assets in

the economy. In practice a broad stock
market index, such as the S&P 500, is
used to represent the market portfolio.
Beta - Sensitivity of a stock’s return to the
return on the market portfolio.
Beta- measures systematic risk

FIN 819: lecture 5

Beta and market risk
 im
Bi  2
m
Covariance with the
market

Variance of the market

FIN 819: lecture 5

Some true or false questions
1. A market index is used to measure performance of a
broad-based portfolio of stocks.
2. Long-term corporate bonds are riskier than common
stocks.
3.If one portfolio's variance exceeds that of another
portfolio, its standard deviation will also be greater
than that of the other portfolio.
4. Portfolio weights are always positive.

FIN 819: lecture 5

Some true or false questions
5. Standard deviation can be calculated as the square
of the variance.
6. Market risk can be eliminated in a stock portfolio
through diversification.
7. Macro risks are faced by all common stock investors.
8. The risk that remains in a stock portfolio after efforts
to diversify is known as unique risk.
9. We use the standard deviation of future stock prices
to measure the risk of a stock.

FIN 819: lecture 5

Measuring Market Risk

 Market Portfolio
• It is a portfolio of all assets in the economy.
In
practice a broad stock market index, such as the
S&P 500 is used to represent the market portfolio.
The market return is denoted by Rm
 Beta (β)
• Sensitivity of a stock’s return to the return on the
market portfolio, Cov (ri , Rm )
i 
• Mathematically, Var ( Rm )

FIN 819: lecture 5

An intuitive example for Beta

Turbo Charged Seafood has the following

% returns on its stock, relative to the
listed changes in the % return on the
market portfolio. The beta of Turbo
Charged Seafood can be derived from
this information.

FIN 819: lecture 5

Measuring Market Risk
(example, continue)

Month Market Return % Turbo Return %

1 + 1 + 0.8
2 + 1 + 1.8
3 + 1 - 0.2
4 -1 - 1.8
5 -1 + 0.2
6 -1 - 0.8

FIN 819: lecture 5

Measuring Market Risk
(continue)

 When the market was up 1%, Turbo average % change was +0.8%
 When the market was down 1%, Turbo average % change was -0.8%
 The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8. β=1.6/2=0.8

FIN 819: lecture 5

CAPM (Capital Asset Pricing
Model)
 CAPM describes the relationship
between the expected return of a
security and the risk premium of the
market portfolio as follows


ri  r f  i ( Rm  r f )

FIN 819: lecture 5

Security Market Line
 The graph used to describe CAPM is
called the security market line
 In the security market line is drawn in
the expected-return-beta plane.
 Do you know the name of the line drawn
in the expected-return-standard-
deviation?

FIN 819: lecture 5

Security Market Line
Return
A

Market Return = rm . B

Efficient Portfolio
Risk Free
Return = rf

1.0 BETA

FIN 819: lecture 5

Apply CAPM and portfolio theory
in capital budgeting
 So far, we have discussed portfolio
diversification theory and the relation
between expected returns and risk.
 Our objective is to use these theories to
calculate the discount rate for a project a
firm may be interested in.
 Now how can we approach this
question?

FIN 819: lecture 5

The risk of a project
 One simple approach to calculate the discount
rate of a project to assume that the project to
be taken has the same risk as the existing
business or assets of the firm
 Then we can decided what is the required
return of the existing business or assets.
 Then use this rate of return on the existing
assets as the discount rate of the project

FIN 819: lecture 5

Example
Suppose a company has the following
assets:
2/3 New Ventures B=2.0
1/6 Expand existing business B=1.3
1/6 Plant efficiency B=0.6

B of assets = 2.0*(2/3)+1.3/6+0.6/6=

FIN 819: lecture 5

The cost of capital
 To calculate the cost of capital, let’s
consider an imaginary portfolio that has
100% of the equity and debt of the
company. Certainly the risk of the
portfolio is the same as the risk of the
asset of the company, why?
 Now, we can calculate the risk of the
portfolio and then the risk of the asset of
the company.

FIN 819: lecture 5

Cost of capital
 If the firm has two securities: debt (D)
and equity, with the tax rate of Tc, the
cost of capital is
D E
WACC  rdebt (1  Tc )  requity
DE DE

FIN 819: lecture 5

How does debt financing affect
the risk of equity?
 When firms issue debt, the introduced
financial risk impacts the risk of equity

 To understand how financing affects

equity risk, we will introduce several
variables.

FIN 819: lecture 6

Some terminology
 D: the market value of debt
 E: the market value of equity
 UA: the value of the unlevered asset of the
firm ( the value of the asset when D=0)
 V: the value of the levered asset of the firm
when D >0.
 TX: the present value of the tax shield

FIN 819: lecture 6

Some terminology (continues)
  D : the beta of debt
  E : the beta of equity
 UA : The beta of the unlevered asset
 A : the beta of the levered asset
 TX : the beta of the tax-shield

FIN 819: lecture 6

Some terminology (continues)
 rD : the cost of debt
 rE : the cost of equity
 rUA : the cost of the unlevered asset
 rA : the cost of the levered asset
 rTX : the cost of the tax-shield

FIN 819: lecture 6

Balance sheet
Asset Liabilities and equity

Debt Tax shield (TX) Debt (D)

Unlevered asset value Equity (E)

(UA)

FIN 819: lecture 6

The relationship among all kinds
of values
 From the balance sheet, we can have
the following relationships

V  UA  TX
V  DE

FIN 819: lecture 6

The present value of tax-shield
 If the tax-shield is as risky as debt, and
the firm issues risk-free perpetual debt,
then the present value of the tax-shield
can be regarded as a simple perpetuity
with the amount of level cash flow as
Dr f Tc
 Clearly,
TX  Dr f Tc / r f  DTc

FIN 819: lecture 6

The beta of equity
 Still using portfolio theory and the results
in the previous two slides, we have
 D
 E  1  1  Tc  UA
 E
 In this text book, we can assume that
UA is not affected by firms’ capital
structure, but decided by firms’ business
risk.

FIN 819: lecture 6

The betas of equity and asset
(continues)
 Thus, for firms with the same business
line, UA should be the same
theoretically.
 Two questions?
• Is this making sense?
• Why are we interested in the betas of
unlevered assets?

FIN 819: lecture 6

An important question to think?
 In the textbook, the authors also
introduce a way to calculate the
unlevered and levered betas or costs,
how do you like their idea? Why or why
not?

FIN 819: lecture 6

An example
 Firm D has the same business as firms
A, B and C, whose betas and market
values of debt and equity are given in the
table in the next slide. Suppose all the
firms have the risk-free debt and the risk
free rate is 4%, the risk premium on the
market portfolio is 8.4% annually and the
corporate tax rate is 34%, what is the
WACC for firm D?

FIN 819: lecture 6

Information
Firm Beta Debt Equity
A 0.75 4 96
B 1.0 230 770
C 1.08 210 790
D 150 800

FIN 819: lecture 6