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The Valuation of The Valuation of


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