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Long Long- -Term Term

Securities Securities

The Valuation of The Valuation of

Long Long- -Term Term

Securities Securities

2009 Financial Management

Fundamentals of Financial Management, 11/e

Prepared by: Amyn Wahid

Bond & Stock Bond & Stock

Valuation Valuation

Bond & Stock Bond & Stock

Valuation Valuation

2

The Valuation of The Valuation of

Long Long- -Term Securities Term Securities

The Valuation of The Valuation of

Long Long- -Term Securities Term Securities

Distinctions Among Valuation

Concepts

Bond Valuation

Preferred Stock Valuation

Common Stock Valuation

Rates of Return (or Yields)

Distinctions Among Valuation

Concepts

Bond Valuation

Preferred Stock Valuation

Common Stock Valuation

Rates of Return (or Yields)

3

What is Value? What is Value? What is Value? What is Value?

Going Going- -concern concern value value represents the

amount a firm could be sold for as a

continuing operating business.

Going Going- -concern concern value value represents the

amount a firm could be sold for as a

continuing operating business.

Liquidation Liquidation value value represents the

amount of money that could be

realized if an asset or group of

assets is sold separately from its

operating organization.

Liquidation Liquidation value value represents the

amount of money that could be

realized if an asset or group of

assets is sold separately from its

operating organization.

4

In general, the value of an asset is

the price that a willing and able buyer

pays to a willing and able seller

Note that if either the buyer or seller

is not both willing and able, then an

offer does not establish the value of

the asset

What is Value? What is Value? What is Value? What is Value?

Several Kinds of Value Several Kinds of Value

There are several types of value, of which we

are concerned with three:

Book Value - The assets historical cost less

its accumulated depreciation

Market Value - The price of an asset as

determined in a competitive marketplace

Intrinsic Value - The present value of the

expected future cash flows discounted at

the decision makers required rate of return

6

Bond Valuation Bond Valuation Bond Valuation Bond Valuation

Important Terms

Types of Bonds

Valuation of Bonds

Handling Semiannual

Compounding

Important Terms

Types of Bonds

Valuation of Bonds

Handling Semiannual

Compounding

7

Bonds Bonds

A bond is a tradeable instrument that

represents a debt owed to the owner by the

issuer. Most commonly, bonds pay interest

periodically (usually semiannually) and then

return the principal at maturity.

Most corporate, and some government,

bonds are callable. That means that at the

companys option, it may force the

bondholders to sell them back to the

company.

(Refer to the bonds valuation handout)

8

Bond Terminology Bond Terminology

There are several terms with which you must be

familiar to solve bond valuation problems:

Coupon Rate - This is the stated rate of interest on the bond.

It is fixed for the life of the bond. Also, this rate time the face

value determines the annual interest payment amount.

Discount Rate - (capitalization rate or market required rate of

return) is dependent on the risk of the bond and is

composed of the risk-free rate plus a premiumfor risk.

Face Value - This is the principal amount (nominally, the

amount that was borrowed). This is the amount that will be

repaid at maturity

Maturity Date - This is the date after which the bond no

longer exists. It is also the date on which the loan is repaid

and the last interest payment is made.

9

Calculating the Value of a Bond Calculating the Value of a Bond

There are two types of cash flows that are

provided by a bond investments:

Periodic interest payments (usually every six

months, but any frequency is possible)

Repayment of the face value (also called the

principal amount, which is usually $1,000) at

maturity

The following timeline illustrates a typical bonds

cash flows:

0 1 2 3 4 5

100 100 100 100 100

1,000

10

We can use the principle of value additivity to find

the value of this stream of cash flows

Note that the interest payments are an annuity,

and that the face value is a lump sum

Therefore, the value of the bond is simply the

present value of the annuity-type cash flow and

the lump sum:

)

)

V Pmt

k

k

FV

k

B

d

N

d

d

N

=

+

+

1

1

1

1

Calculating the Value of a Bond Calculating the Value of a Bond

(Cont) (Cont)

Discussed

In the

subsequent

slides

11

Different Types of Bonds Different Types of Bonds Different Types of Bonds Different Types of Bonds

Perpetual Bond

Non-Zero Coupon Bond

Zero Coupon Bond

Perpetual Bond

Non-Zero Coupon Bond

Zero Coupon Bond

12

Different Types of Bonds Different Types of Bonds Different Types of Bonds Different Types of Bonds

A perpetual bond perpetual bond is a bond that never

matures. It has an infinite life.

A perpetual bond perpetual bond is a bond that never

matures. It has an infinite life.

(1 + k

d

)

1

(1 + k

d

)

2

(1 + k

d

)

gg

V =

+ + ... +

I I I

= 7

gg

t=1

(1 + k

d

)

t

I

or I (PVIFA

k

d

, gg

)

V = II / k k

dd

[Reduced Form]

13

Perpetual Bond Example Perpetual Bond Example Perpetual Bond Example Perpetual Bond Example

Bond P has a $1,000 face value and

provides an 8% coupon. The appropriate

discount rate is 10%. What is the value of

the perpetual bond perpetual bond?

Bond P has a $1,000 face value and

provides an 8% coupon. The appropriate

discount rate is 10%. What is the value of

the perpetual bond perpetual bond?

II = $1,000 ( 8%) = $80 $80.

k k

dd

= 10% 10%.

VV = II / k k

dd

[Reduced Form]

= $80 $80 / 10% 10% = $800 $800.

II = $1,000 ( 8%) = $80 $80.

k k

dd

= 10% 10%.

VV = II / k k

dd

[Reduced Form]

= $80 $80 / 10% 10% = $800 $800.

14

Different Types of Bonds Different Types of Bonds Different Types of Bonds Different Types of Bonds

A non non- -zero coupon zero coupon- -paying bond paying bond is a

coupon-paying bond with a finite life.

A non non- -zero coupon zero coupon- -paying bond paying bond is a

coupon-paying bond with a finite life.

(1 + k

d

)

1

(1 + k

d

)

2

(1 + k

d

)

nn

V =

+ + ... +

I I + MV I

= 7

nn

t=1

(1 + k

d

)

t

I

V = I (PVIFA

k

d

, nn

) + MV (PVIF

k

d

, nn

)

(1 + k

d

)

nn

+

MV

15

Bond C has a $1,000 face value and provides

an 8% annual coupon for 30 years. The

appropriate discount rate is 10%. What is the

value of the coupon bond?

Bond C has a $1,000 face value and provides

an 8% annual coupon for 30 years. The

appropriate discount rate is 10%. What is the

value of the coupon bond?

Coupon Bond Example Coupon Bond Example Coupon Bond Example Coupon Bond Example

VV = $80 (PVIFA

10%, 30

) + $1,000 (PVIF

10%, 30

)

= $80 (9.427) + $1,000 (.057)

[ [Table IV Table IV] ] [ [Table II Table II] ]

= $754.16 + $57.00

= $811.16 $811.16 (D to R)

VV = $80 (PVIFA

10%, 30

) + $1,000 (PVIF

10%, 30

)

= $80 (9.427) + $1,000 (.057)

[ [Table IV Table IV] ] [ [Table II Table II] ]

= $754.16 + $57.00

= $811.16 $811.16 (D to R)

16

Coupon Bond Example Coupon Bond Example

( Ms Excel Approach) ( Ms Excel Approach)

Present Value Calculations

Future Value 1000.00

Years 30

Rate 10%

Present Value $57.31

Present Value of an Annuity

Payment 80

Interest Rate 10%

Number of Payments 30

Present Value $754.15

VALUE $811.46

17

Different Types of Bonds Different Types of Bonds Different Types of Bonds Different Types of Bonds

A zero zero- -coupon bond coupon bond is a bond that

pays no interest but sells at a deep

discount from its face value; it provides

compensation to investors in the form

of price appreciation.

A zero zero- -coupon bond coupon bond is a bond that

pays no interest but sells at a deep

discount from its face value; it provides

compensation to investors in the form

of price appreciation.

(1 + k

d

)

nn

V =

MV

= MV (PVIF

k

d

, nn

)

18

VV = $1,000 (PVIF

10%, 30

)

= $1,000 (.057)

= $57.00 (D to R) $57.00 (D to R)

VV = $1,000 (PVIF

10%, 30

)

= $1,000 (.057)

= $57.00 (D to R) $57.00 (D to R)

Zero Zero- -Coupon Bond Coupon Bond

Example Example

Zero Zero- -Coupon Bond Coupon Bond

Example Example

Bond Z has a $1,000 face value and

a 30-year life. The appropriate

discount rate is 10%. What is the

value of the zero-coupon bond?

Bond Z has a $1,000 face value and

a 30-year life. The appropriate

discount rate is 10%. What is the

value of the zero-coupon bond?

19

Non Non- -Zero Coupon Bond Example Zero Coupon Bond Example

( Ms Excel Approach) ( Ms Excel Approach)

Present Value Calculations

Future Value 1000.00

Years 30

Rate 10%

Present Value $57.31

VALUE $57.31

20

Semiannual Compounding Semiannual Compounding Semiannual Compounding Semiannual Compounding

(1) Divide k k

dd

by 2 2

(2) Multiply nn by 2 2

(3) Divide II by 2 2

(1) Divide k k

dd

by 2 2

(2) Multiply nn by 2 2

(3) Divide II by 2 2

Most bonds in the U.S. pay interest

twice a year (1/2 of the annual

coupon).

Adjustments needed:

Most bonds in the U.S. pay interest

twice a year (1/2 of the annual

coupon).

Adjustments needed:

21

(1 + k

d

/2 2 )

2 2

*

nn

(1 + k

d

/2 2 )

1

Semiannual Compounding Semiannual Compounding Semiannual Compounding Semiannual Compounding

A non non- -zero coupon bond zero coupon bond adjusted for

semiannual compounding.

A non non- -zero coupon bond zero coupon bond adjusted for

semiannual compounding.

V = + + ... +

I / 2 2 I / 2 2 + MV

= 7

2 2*nn

t=1

(1 + k

d

/2 2 )

t

I / 2 2

= I/2 2 (PVIFA

k

d

/2 2 ,2 2*nn

) + MV (PVIF

k

d

/2 2 , 2 2*nn

)

(1 + k

d

/2 2 )

2 2

*

nn

+

MV

I / 2 2

(1 + k

d

/2 2 )

2

22

VV = $40 (PVIFA

5%, 30

) + $1,000 (PVIF

5%, 30

)

= $40 (15.373) + $1,000 (.231)

[ [Table IV Table IV] ] [ [Table II Table II] ]

= $614.92 + $231.00

= $845.92 ( D to R) $845.92 ( D to R)

VV = $40 (PVIFA

5%, 30

) + $1,000 (PVIF

5%, 30

)

= $40 (15.373) + $1,000 (.231)

[ [Table IV Table IV] ] [ [Table II Table II] ]

= $614.92 + $231.00

= $845.92 ( D to R) $845.92 ( D to R)

Semiannual Coupon Semiannual Coupon

Bond Example Bond Example

Semiannual Coupon Semiannual Coupon

Bond Example Bond Example

Bond C has a $1,000 face value and provides

an 8% semiannual coupon for 15 years. The

appropriate discount rate is 10% (annual rate).

What is the value of the coupon bond?

Bond C has a $1,000 face value and provides

an 8% semiannual coupon for 15 years. The

appropriate discount rate is 10% (annual rate).

What is the value of the coupon bond?

23

Semi Annual Coupon Bond Example Semi Annual Coupon Bond Example

( Ms Excel Approach) ( Ms Excel Approach)

Present Value Calculations

Future Value 1000.00

Years 30

Rate 5%

Present Value $231.38

Present Value of an Annuity

Payment 40

Interest Rate 5%

Number of Payments 30

Present Value $614.90

VALUE $846.28

24

Different Types of Stocks Different Types of Stocks

Preferred Stock

Common Stock

25

Preferred Stock Preferred Stock is a type of stock that

promises a (usually) fixed dividend, but at

the discretion of the board of directors.

Preferred Stock Preferred Stock is a type of stock that

promises a (usually) fixed dividend, but at

the discretion of the board of directors.

Preferred Stock Valuation Preferred Stock Valuation Preferred Stock Valuation Preferred Stock Valuation

Preferred Stock has

preference over common

stock in the payment of

dividends and claims on

assets.

Preferred Stock has

preference over common

stock in the payment of

dividends and claims on

assets.

26

Preferred Stock Valuation Preferred Stock Valuation Preferred Stock Valuation Preferred Stock Valuation

This reduces to a perpetuity perpetuity! This reduces to a perpetuity perpetuity!

(1 + k

P

)

1

(1 + k

P

)

2

(1 + k

P

)

gg

VV =

+ + ... +

Div

P

Div

P

Div

P

= 7

gg

t=1

(1 + k

P

)

t

Div

P

or Div

P

(PVIFA

k

P

, gg

)

VV = Div

P

/ k

P

27

Preferred Stock Example Preferred Stock Example Preferred Stock Example Preferred Stock Example

Div Div

PP

= $100 ( 8% ) = $8.00 $8.00.

k k

PP

= 10% 10%.

VV = Div Div

PP

/ k k

PP

= $8.00 $8.00 / 10% 10%

= $80 $80

Div Div

PP

= $100 ( 8% ) = $8.00 $8.00.

k k

PP

= 10% 10%.

VV = Div Div

PP

/ k k

PP

= $8.00 $8.00 / 10% 10%

= $80 $80

Stock PS has an 8%, $100 par value

issue outstanding. The appropriate

discount rate is 10%. What is the value

of the preferred stock preferred stock?

Stock PS has an 8%, $100 par value

issue outstanding. The appropriate

discount rate is 10%. What is the value

of the preferred stock preferred stock?

Similar to

Perpetual

Bonds

28

Common Stock Valuation Common Stock Valuation Common Stock Valuation Common Stock Valuation

Pro rata share of future

earnings after all other

obligations of the firm

(if any remain).

Dividends may may be paid

out of the pro rata share

of earnings.

Pro rata share of future

earnings after all other

obligations of the firm

(if any remain).

Dividends may may be paid

out of the pro rata share

of earnings.

Common Common stock stock represents a residual

ownership position in the corporation.

Common Common stock stock represents a residual

ownership position in the corporation.

29

Common Stock Valuation Common Stock Valuation Common Stock Valuation Common Stock Valuation

(1) Future dividends

(2) Future sale of the

common stock shares

(1) Future dividends

(2) Future sale of the

common stock shares

What cash flows will a shareholder

receive when owning shares of

common stock common stock?

30

Dividend Valuation Model Dividend Valuation Model Dividend Valuation Model Dividend Valuation Model

Basic dividend valuation model accounts

for the PV of all future dividends.

Basic dividend valuation model accounts

for the PV of all future dividends.

(1 + k

e

)

1

(1 + k

e

)

2

(1 + k

e

)

gg

V =

+ + ... +

Div

1

Divgg

Div

2

= 7

gg

t=1

(1 + k

e

)

t

Div

t

Div

t

: Cash dividend

at time t

k

e

: Equity investors

required return

Div

t

: Cash dividend

at time t

k

e

: Equity investors

required return

31

Adjusted Dividend Adjusted Dividend

Valuation Model Valuation Model

Adjusted Dividend Adjusted Dividend

Valuation Model Valuation Model

The basic dividend valuation model

adjusted for the future stock sale.

The basic dividend valuation model

adjusted for the future stock sale.

(1 + k

e

)

1

(1 + k

e

)

2

(1 + k

e

)

nn

V =

+ + ... +

Div

1

Divnn + Pricenn Div

2

nn: The year in which the firms

shares are expected to be sold.

Price

nn

: The expected share price in year nn.

nn: The year in which the firms

shares are expected to be sold.

Price

nn

: The expected share price in year nn.

32

Dividend Growth Dividend Growth

Pattern Assumptions Pattern Assumptions

Dividend Growth Dividend Growth

Pattern Assumptions Pattern Assumptions

The dividend valuation model requires

the forecast of all future dividends.

The following dividend growth rate

assumptions simplify the valuation

process.

Constant Growth Constant Growth

No Growth No Growth

The dividend valuation model requires

the forecast of all future dividends.

The following dividend growth rate

assumptions simplify the valuation

process.

Constant Growth Constant Growth

No Growth No Growth

33

Constant Growth Model Constant Growth Model Constant Growth Model Constant Growth Model

The constant growth model constant growth model assumes that

dividends will grow forever at the rate g.

The constant growth model constant growth model assumes that

dividends will grow forever at the rate g.

(1 + k

e

)

1

(1 + k

e

)

2

(1 + k

e

)

g

V =

+ + ... +

D

0

(1+g) D

0

(1+g)

g

=

(k

e

- g)

D

1

D

1

: Dividend paid at time 1.

g: The constant growth rate.

ke: Investors required return.

D

1

: Dividend paid at time 1.

g: The constant growth rate.

ke: Investors required return.

D

0

(1+g)

2

34

Constant Growth Constant Growth

Model Example Model Example

Constant Growth Constant Growth

Model Example Model Example

Stock CG has an expected growth rate of

8%. Each share of stock just received an

annual $3.24 dividend per share. The

appropriate discount rate is 15%. What

is the value of the common stock common stock?

D D

1 1

= $3.24 $3.24 ( 1 + .08 ) = $3.50 $3.50

VV

CG CG

= D D

1 1

/ ( k k

e e

- g ) = $3.50 $3.50 / ( .15 .15 - .08 )

= $50 $50

Stock CG has an expected growth rate of

8%. Each share of stock just received an

annual $3.24 dividend per share. The

appropriate discount rate is 15%. What

is the value of the common stock common stock?

D D

1 1

= $3.24 $3.24 ( 1 + .08 ) = $3.50 $3.50

VV

CG CG

= D D

1 1

/ ( k k

e e

- g ) = $3.50 $3.50 / ( .15 .15 - .08 )

= $50 $50

k

e e

= D1/V + g

35

Zero Growth Model Zero Growth Model Zero Growth Model Zero Growth Model

The zero growth model zero growth model assumes that

dividends will grow forever at the rate g = 0.

The zero growth model zero growth model assumes that

dividends will grow forever at the rate g = 0.

(1 + k

e

)

1

(1 + k

e

)

2

(1 + k

e

)

g

V

ZG

=

+ + ... +

D

1

D

g

=

k

e

D

1

D

1

: Dividend paid at time 1.

k

e

: Investors required return.

D

1

: Dividend paid at time 1.

k

e

: Investors required return.

D

2

36

Zero Growth Zero Growth

Model Example Model Example

Zero Growth Zero Growth

Model Example Model Example

Stock ZG has an expected growth rate of

0%. Each share of stock just received an

annual $3.24 dividend per share. The

appropriate discount rate is 15%. What

is the value of the common stock common stock?

Stock ZG has an expected growth rate of

0%. Each share of stock just received an

annual $3.24 dividend per share. The

appropriate discount rate is 15%. What

is the value of the common stock common stock?

D D

1 1

= $3.24 $3.24 ( 1 + 0 ) = $3.24 $3.24

VV

ZG ZG

= D D

1 1

/ ( k k

e e

- 0 ) = $3.24 $3.24 / ( .15 .15 - 0 )

= $21.60 $21.60

D D

1 1

= $3.24 $3.24 ( 1 + 0 ) = $3.24 $3.24

VV

ZG ZG

= D D

1 1

/ ( k k

e e

- 0 ) = $3.24 $3.24 / ( .15 .15 - 0 )

= $21.60 $21.60

37

Practice Questions Practice Questions

1. Beta Budget Brooms will pay a big $2 dividend next year on

its common stock, which is currently selling at $50 per share.

What is the market's required return on this investment if the

dividend is expected to grow at 5%forever?

2. What is the intrinsic value of a $1,000 face value, zero-

coupon bond that matures in 20 years if an investor's

required rate of return for the bond is 8%? (Assume annual

discounting.)

3. What is the intrinsic value of a $1,000 face value, 8% coupon

paying perpetual bond if an investor's required rate of return

is 6%? (Assume annual interest payments and discounting.)

4. A $250 face value share of preferred stock, pays a $20 annual

dividend and investors require a 7% return on this

investment. If the security is currently selling for $276, what

is the difference (overvaluation) between its intrinsic and

market value (rounded to the nearest whole dollar)?

38

Practice Questions Practice Questions

5. You have just purchased a 15-year, $1,000 par value bond. The

coupon rate on this bond is nine percent (9%) annually, with

interest being paid each six months. If you expect to earn a 12

percent nominal rate of return on this bond, how much did you

pay for it?

6. WeeWiggly Woodcarvers (WWW) common stock is currently

expected to maintain its current earnings level indefinitely

(earnings will stay at the current $4.00 per share). Investors in

WWW expect to earn 10% on this investment since the firm

anticipates retaining only 10% of earnings. What is the

intrinsic value of a share of WWW?

7. You have been asked to determine the intrinsic value of a

share of Quick Quilters, Inc. (QQ) common stock. The stock

most recently paid a $2.00 annual dividend (D

0

). You expect

dividends to grow at a supernormal rate of 15% for the next

three years. You then expect that dividends will grow at a

normal 5%rate thereafter (indefinitely). As a potential investor,

you would expect to earn 10% on this investment. What is the

intrinsic value of a share of QQ?

39

ANSWERS ANSWERS

1. 9%

2. $214.55

3. $1333.33

4. $9.71; Hence $10 ( due to rounding)

5. $793.53

6. $36.00

7. $54.55

40

41

Bonds

&

Stocks

Yields (Rates of Return ) Yields (Rates of Return )

42

Yield to Maturity Yield to Maturity

The yield to maturity is an

important number in bond

valuation.

It is the rate which

equates the market price

of the bond with the value

of the discounted cash

flows.

That is, YTM is the k

d

such that the bond

equation holds.

43

Determining Bond YTM Determining Bond YTM Determining Bond YTM Determining Bond YTM

Determine the Yield-to-Maturity

(YTM) for the coupon-paying bond

with a finite life.

Determine the Yield-to-Maturity

(YTM) for the coupon-paying bond

with a finite life.

P

0

=

7

nn

t=1

(1 + k

d

)

t

I

= I (PVIFA

k

d

, nn

) + MV (PVIF

k

d

, nn

)

(1 + k

d

)

nn

+

MV

k

d

= YTM

44

45

Determining the YTM Determining the YTM Determining the YTM Determining the YTM

Julie Miller want to determine the YTM

for an issue of outstanding bonds at

Basket Wonders (BW). BWhas an

issue of 10% annual coupon bonds

with 15 years left to maturity. The

bonds have a current market value of

$1,250 $1,250.

What is the YTM? What is the YTM?

Julie Miller want to determine the YTM

for an issue of outstanding bonds at

Basket Wonders (BW). BWhas an

issue of 10% annual coupon bonds

with 15 years left to maturity. The

bonds have a current market value of

$1,250 $1,250.

What is the YTM? What is the YTM?

46

YTM = INT + {(FV C.P)/n}

(FV + C.P)/2

= 100 + {(1000 1250)/15}

(1000+1250)/2

= 0.074 = 7.4%(Approximate)

Yield Approximation Formula Yield Approximation Formula Yield Approximation Formula Yield Approximation Formula

47

YTM Formula YTM Formula

(interpolation) (interpolation)

YTM = LR + (Difference of 2 rates)(LRV)

LRV + HRV

LR = Lower Rate

HR = Higher Rate

LRV = Lower Rate Value

HRV = Higher Rate Value.

48

Solution Solution (by interpolation) (by interpolation)

Data:-

CR = 10%

N = 15 years

M.P = $1,250

YTM (k

d)

V

b

10% $1000

YTM

?

1250

5% $1519

$250

$269

LR

HR

HRV

LRV

49

Solution Solution

(interpolation) (interpolation)

LR = 5%

HR = 10%

LRV = $269

HRV = $250

269 + 250

YTM = 0.05 +

(0.05)(269)

= 0.0759 = 7.59 %

Note:- The lower the difference between the two rates, the better is the

approximation. Maximumdifference allowed is 5%.

Actual answer

= 7.22%

50

YTM Solution ( Ms Excel Approach) YTM Solution ( Ms Excel Approach)

YTM (kd) of a NON-ZERO COUPOIN BOND

Present Value Calculations (PVIF) for "M.V."

Future Value $1,000.00

Years 15

YTM (k

d

) 7.22%

Present Value $351.45

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 7.22%

Number of Payments 15

Present Value $898.27

VALUE $1,249.72

51

Practice Question Practice Question (Interpolation) (Interpolation)

Xen Cooper wants to determine the YTM for

an issue of outstanding bonds at Small

Wonders (SW).

a. 10%annual coupon bonds, 15 years & market value of $1,150.

b. 12%annual coupon bonds, 20 years & market value of $820.

c. 9%annual coupon bonds, 18 years & market value of $737.

d. 10% semi annual coupon bonds, 10 years & market value of

$1,194.

e. 8% semi annual coupon bonds, 12 years & market value of

$700.

52

Answers Answers

a. 8.22%.

b. 14.85%

c. 12.8%

d. 7.37%

e. 13.42%

53

Determining Semiannual Determining Semiannual

Coupon Bond YTM Coupon Bond YTM

Determining Semiannual Determining Semiannual

Coupon Bond YTM Coupon Bond YTM

P

0

=

7

2nn

t=1

(1 + k

d

/2 )

t

I / 2

= (I/2)(PVIFA

k

d

/2

, 2nn

) + MV(PVIF

k

d

/2

, 2nn

)

+

MV

[ 1 + (k

d

/ 2) ]

2

-1 = YTM

Determine the Yield-to-Maturity

(YTM) for the semiannual coupon-

paying bond with a finite life.

Determine the Yield-to-Maturity

(YTM) for the semiannual coupon-

paying bond with a finite life.

(1 + k

d

/2 )

2nn

54

Determining the Semiannual Determining the Semiannual

Coupon Bond YTM Coupon Bond YTM

Determining the Semiannual Determining the Semiannual

Coupon Bond YTM Coupon Bond YTM

Julie Miller want to determine the YTM

for another issue of outstanding

bonds. The firm has an issue of 8%

semiannual coupon bonds with 20

years left to maturity. The bonds

have a current market value of $950 $950.

What is the YTM? What is the YTM?

Julie Miller want to determine the YTM

for another issue of outstanding

bonds. The firm has an issue of 8%

semiannual coupon bonds with 20

years left to maturity. The bonds

have a current market value of $950 $950.

What is the YTM? What is the YTM?

55

Determining Semiannual Determining Semiannual

Coupon Bond YTM Coupon Bond YTM

Determining Semiannual Determining Semiannual

Coupon Bond YTM Coupon Bond YTM

[ 1 + (k

d

/ 2) ]

2

-1 = YTM

Determine the Yield-to-Maturity

(YTM) for the semiannual coupon-

paying bond with a finite life.

Determine the Yield-to-Maturity

(YTM) for the semiannual coupon-

paying bond with a finite life.

[ 1 + (.042626) ]

2

-1 = .0871

or 8.71%

56

Determining Semiannual Determining Semiannual

Coupon Bond YTM Coupon Bond YTM

Determining Semiannual Determining Semiannual

Coupon Bond YTM Coupon Bond YTM

[ 1 + (k

d

/ 2) ]

2

-1 = YTM

This technique will calculate k

d

.

You must then substitute it into the

following formula.

This technique will calculate k

d

.

You must then substitute it into the

following formula.

[ 1 + (.0852514/2) ]

2

-1 = .0871

or 8.71% (same result!)

57

YTM Solution ( Ms Excel Approach) YTM Solution ( Ms Excel Approach)

YTM (kd) - Semi Annual Compounding

Present Value Calculations (PVIF) for "M.V."

Future Value $1,000.00

Years 40

YTM (k

d

/2) 4.263%

Present Value $188.31

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 4%

Payment $40.00

YTM (k

d

/2) 4.263%

Number of Payments 40

Present Value $761.70

VALUE $950.00

58

Note: The investor uses the bond's

computed YTM by comparing it to his/her

required rate of return on the bond after

considering all risk factors.

1) If the investor's required return is

greater than the YTM, the investor

should not buy the bond

2) If the investor's required return is

less than the YTM, the investor should

buy the bond

Guideline to YTM Guideline to YTM

59

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Discount Bond Discount Bond -- The market required rate of

return exceeds the coupon rate (Par > P

0

).

Premium Bond Premium Bond -- -- The coupon rate exceeds the

market required rate of return (P

0

> Par).

Par Bond Par Bond -- -- The coupon rate equals the market

required rate of return (P

0

= Par).

Discount Bond Discount Bond -- The market required rate of

return exceeds the coupon rate (Par > P

0

).

Premium Bond Premium Bond -- -- The coupon rate exceeds the

market required rate of return (P

0

> Par).

Par Bond Par Bond -- -- The coupon rate equals the market

required rate of return (P

0

= Par).

60

Bond Price Par Bond Price Par ( Ms Excel Approach) ( Ms Excel Approach)

Bond Price (Par)

Coupon Rate = 10%

Present Value Calculations (PVIF) for "M.V."

Future Value 1,000.00 $

Years 15

YTM (k

d

) 10.00%

Present Value $239.39

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 10.00%

Number of Payments 15

Present Value $760.61

VALUE $1,000.00

61

Bond Price Discount Bond Price Discount ( Ms Excel Approach) ( Ms Excel Approach)

Bond Price (Discount)

Coupon Rate = 10%

Present Value Calculations (PVIF) for "M.V."

Future Value 1,000.00 $

Years 15

YTM (k

d

) 12.00%

Present Value $182.70

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 12.00%

Number of Payments 15

Present Value $681.09

VALUE $863.78

62

Bond Price Premium Bond Price Premium ( Ms Excel Approach) ( Ms Excel Approach)

Bond Price (Premium)

Coupon Rate = 10%

Present Value Calculations (PVIF) for "M.V."

Future Value 1,000.00 $

Years 15

YTM (k

d

) 8.00%

Present Value $315.24

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 8.00%

Number of Payments 15

Present Value $855.95

VALUE $1,171.19

63

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

B

O

N

D

P

R

I

C

E

(

$

)

1000

Par

1600

1400

1200

600

0

0 2 4 6 8 10 10 12 14 16 18

5 Year 5 Year

15 Year 15 Year

64

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Assume that the required rate of

return on a 15-year, 10% coupon-

paying bond rises rises from 10% to 12%.

What happens to the bond price?

Assume that the required rate of

return on a 15-year, 10% coupon-

paying bond rises rises from 10% to 12%.

What happens to the bond price?

When interest rates rise rise, then the

market required rates of return rise rise

and bond prices will fall fall.

When interest rates rise rise, then the

market required rates of return rise rise

and bond prices will fall fall.

65

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

B

O

N

D

P

R

I

C

E

(

$

)

1000

Par

1600

1400

1200

600

0

0 2 4 6 8 10 10 12 14 16 18

15 Year 15 Year

5 Year 5 Year

66

Bond Price Bond Price- -Yield Yield

Relationship (Rising Rates) Relationship (Rising Rates)

Bond Price Bond Price- -Yield Yield

Relationship (Rising Rates) Relationship (Rising Rates)

Therefore, the bond price has

fallen fallen from $1,000 to $864.

Therefore, the bond price has

fallen fallen from $1,000 to $864.

The required rate of return on a 15-

year, 10% coupon-paying bond

has risen risen from 10% to 12%.

Refer

Slide #

55

67

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Assume that the required rate of

return on a 15-year, 10% coupon-

paying bond falls falls from 10% to 8%.

What happens to the bond price?

Assume that the required rate of

return on a 15-year, 10% coupon-

paying bond falls falls from 10% to 8%.

What happens to the bond price?

When interest rates fall fall, then the

market required rates of return fall fall

and bond prices will rise rise.

When interest rates fall fall, then the

market required rates of return fall fall

and bond prices will rise rise.

68

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

B

O

N

D

P

R

I

C

E

(

$

)

1000

Par

1600

1400

1200

600

0

0 2 4 6 8 10 10 12 14 16 18

15 Year 15 Year

5 Year 5 Year

69

Bond Price Bond Price- -Yield Relationship Yield Relationship

(Declining Rates) (Declining Rates)

Bond Price Bond Price- -Yield Relationship Yield Relationship

(Declining Rates) (Declining Rates)

Therefore, the bond price has

risen risen from $1,000 to $1,171.

Therefore, the bond price has

risen risen from $1,000 to $1,171.

The required rate of return on a 15-

year, 10% coupon-paying bond

has fallen fallen from 10% to 8%.

Refer

Slide #

56

70

The Role of Bond Maturity The Role of Bond Maturity The Role of Bond Maturity The Role of Bond Maturity

Assume that the required rate of return

on both the 5- and 15-year, 10% coupon-

paying bonds fall fall from 10% to 8%. What

happens to the changes in bond prices?

Assume that the required rate of return

on both the 5- and 15-year, 10% coupon-

paying bonds fall fall from 10% to 8%. What

happens to the changes in bond prices?

The longer the bond maturity, the

greater the change in bond price for a

given change in the market required rate

of return.

The longer the bond maturity, the

greater the change in bond price for a

given change in the market required rate

of return.

71

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Bond Price Bond Price- -Yield Yield

Relationship Relationship

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

Coupon Rate Coupon Rate

MARKET REQUIRED RATE OF RETURN (%)

B

O

N

D

P

R

I

C

E

(

$

)

1000

Par

1600

1400

1200

600

0

0 2 4 6 8 10 10 12 14 16 18

15 Year 15 Year

5 Year 5 Year

72

Bond Maturity Bond Maturity ( Ms Excel Approach) ( Ms Excel Approach)

Coupon Rate = 10%

Present Value Calculations (PVIF) for "M.V."

Future Value 1000.00

Years 5

YTM (k

d

) 8.00%

Present Value $680.58

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 8.00%

Number of Payments 5

Present Value $399.27

VALUE $1,079.85

5-YEAR MATURITY

73

Bond Maturity Bond Maturity ( Ms Excel Approach) ( Ms Excel Approach)

Coupon Rate = 10%

Present Value Calculations (PVIF) for "M.V."

Future Value 1000.00

Years 15

YTM (k

d

) 8.00%

Present Value $315.24

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 8.00%

Number of Payments 15

Present Value $855.95

VALUE $1,171.19

15-YEAR MATURITY

74

The Role of Bond Maturity The Role of Bond Maturity The Role of Bond Maturity The Role of Bond Maturity

The 5-year bond price has risen risen from

$1,000 to $1,080 for the 5-year bond

(+8.0%).

The 15-year bond price has risen risen from

$1,000 to $1,171 (+17.1%). Twice as fast Twice as fast! !

The 5-year bond price has risen risen from

$1,000 to $1,080 for the 5-year bond

(+8.0%).

The 15-year bond price has risen risen from

$1,000 to $1,171 (+17.1%). Twice as fast Twice as fast! !

The required rate of return on both the

5- and 15-year, 10% coupon-paying

bonds has fallen fallen from 10% to 8%.

75

The Role of the The Role of the

Coupon Rate Coupon Rate

The Role of the The Role of the

Coupon Rate Coupon Rate

For a given change in the

market required rate of return,

the price of a bond will change

by proportionally more, the

lower lower the coupon rate.

For a given change in the

market required rate of return,

the price of a bond will change

by proportionally more, the

lower lower the coupon rate.

76

Example of the Role of Example of the Role of

the Coupon Rate the Coupon Rate

Example of the Role of Example of the Role of

the Coupon Rate the Coupon Rate

Assume that the market required rate

of return on two equally risky 15-year

bonds is 10%. The coupon rate for

Bond H is 10% and Bond L is 8%.

What is the rate of change in each of

the bond prices if market required

rates fall to 8%?

Assume that the market required rate

of return on two equally risky 15-year

bonds is 10%. The coupon rate for

Bond H is 10% and Bond L is 8%.

What is the rate of change in each of

the bond prices if market required

rates fall to 8%?

77

Example of the Role of the Example of the Role of the

Coupon Rate Coupon Rate

Example of the Role of the Example of the Role of the

Coupon Rate Coupon Rate

The price for Bond H will rise from $1,000

to $1,171 (+17.1%).

The price for Bond L will rise from $848 to

$1,000 (+17.9%). It rises faster It rises faster! !

The price for Bond H will rise from $1,000

to $1,171 (+17.1%).

The price for Bond L will rise from $848 to

$1,000 (+17.9%). It rises faster It rises faster! !

The price on Bonds H and L prior to the

change in the market required rate of

return is $1,000 and $848, respectively.

78

Lower Coupon Rate Lower Coupon Rate ( Ms Excel Approach) ( Ms Excel Approach)

Present Value Calculations (PVIF) for "M.V."

Future Value 1000.00

Years 15

YTM (k

d

) 10.00%

Present Value $239.39

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 10%

Payment $100.00

YTM (k

d

) 10.00%

Number of Payments 15

Present Value $760.61

VALUE $1,000.00

BOND H (COUPON RATE = 10%)

79

Lower Coupon Rate Lower Coupon Rate ( Ms Excel Approach) ( Ms Excel Approach)

Present Value Calculations (PVIF) for "M.V."

Future Value 1000.00

Years 15

YTM (k

d

) 10.00%

Present Value $239.39

Present Value of an Annuity for "INTEREST"

Future Value $1,000.00

Coupon Rate 8%

Payment $80.00

YTM (k

d

) 10.00%

Number of Payments 15

Present Value $608.49

VALUE $847.88

BOND L (COUPON RATE = 8%)

80

Determining the Yield on Determining the Yield on

Preferred Stock Preferred Stock

Determining the Yield on Determining the Yield on

Preferred Stock Preferred Stock

Determine the yield for preferred

stock with an infinite life.

P

0

= Div

P

/ k

P

Solving for k

P

such that

k

P

= Div

P

/ P

0

Determine the yield for preferred

stock with an infinite life.

P

0

= Div

P

/ k

P

Solving for k

P

such that

k

P

= Div

P

/ P

0

Recall

from

slide #

26

81

Preferred Stock Yield Preferred Stock Yield

Example Example

Preferred Stock Yield Preferred Stock Yield

Example Example

k

P

= $10 / $100.

k k

PP

= 10% 10%.

k

P

= $10 / $100.

k k

PP

= 10% 10%.

Assume that the annual dividend on

each share of preferred stock is $10.

Each share of preferred stock is

currently trading at $100. What is

the yield on preferred stock?

Assume that the annual dividend on

each share of preferred stock is $10.

Each share of preferred stock is

currently trading at $100. What is

the yield on preferred stock?

82

Determining the Yield on Determining the Yield on

Common Stock Common Stock

Determining the Yield on Determining the Yield on

Common Stock Common Stock

Assume the constant growth model

is appropriate. Determine the yield

on the common stock.

P

0

= D

1

/ ( k

e

- g )

Solving for k

e

such that

k

e

= ( D

1

/ P

0

) + g

Assume the constant growth model

is appropriate. Determine the yield

on the common stock.

P

0

= D

1

/ ( k

e

- g )

Solving for k

e

such that

k

e

= ( D

1

/ P

0

) + g

Recall

from

slide #

34

83

Common Stock Common Stock

Yield Example Yield Example

Common Stock Common Stock

Yield Example Yield Example

k

e

= ( $3 / $30 ) + 5%

k k

e e

= 15% 15%

k

e

= ( $3 / $30 ) + 5%

k k

e e

= 15% 15%

Assume that the expected dividend

(D

1

) on each share of common stock

is $3. Each share of common stock

is currently trading at $30 and has an

expected growth rate of 5%. What is

the yield on common stock?

Assume that the expected dividend

(D

1

) on each share of common stock

is $3. Each share of common stock

is currently trading at $30 and has an

expected growth rate of 5%. What is

the yield on common stock?

84

End of Chapter End of Chapter

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