Finance & Financial Management

Bond, Equity & Firm Valuation

Lecture 7

Lecture slides are based on the textbook and accompanying slides of

Hillier, Ross, Westerfield, Jaffe, and Jordan “Corporate Finance”.
European Edition, 3rd Edition, McGraw-Hill, 2016, (Copyright © The
McGraw-Hill Companies 2016)
Bond, Equity & Firm Valuation
- Be able to value coupon and pure discount bonds of any maturity.
- Be familiar with the different types of bonds.
- Know what is meant by yield to maturity and how to calculate it.
- Be able to value equity.
- Understand how to arrive at a measure of growth and its main
determinants.
- Be familiar with the concept of ‘net present value of growth opportunities’
and how to value equities with it.
- Know what is meant by a price-earnings ratio and its main determinants.
 Definition of a Bond

To repay the money, the

A bond is a certificate borrower has agreed to
showing that a borrower make interest and
owes a specified sum principal payments on
designated dates
 Example of A Bond

Kreuger Enterprises just issued 100,000 bonds for 10,000

Rand each, where the bonds have a coupon rate of 5 percent
and a maturity of two years. Interest on the bonds is to be paid
yearly.

The firm must

The firm must pay both R50
R1 billion has
pay interest of million of interest
been borrowed
R50 million at the and R1 billion of
by the firm.
end of one year. principal at the
end of two years.
Table 1: International Bond
Issues – October 2011
 How to Value Bonds

Three Types
Pure Level
Discount Coupon Consols
Bonds Bonds
 Bond Valuation:
Comparison of Cash Flows
 Bond Valuation:
Pure Discount Bonds
F
PV 
(1  R)
r

• Example: Suppose that the interest rate is 10 percent.

What is the value of a bond with face value of €1 million
that matures in 20 years?

€1 million
PV  20
(1.1)
 €148, 644
 Bond Valuation:
Level Coupon Bond
C C C €1, 000
PV    ...  
1  R (1  R) 2
(1  R)
T
(1  R)
T

€1, 000
PV  C  T
AR 
(1  R)
T
 Example 1: Bond Prices

• Consider the EIB bond from Table 1 that was

issued on October, 2011. The coupon is 2.5
percent and the face value is €1,000.
• The coupon of €25 is paid annually in October
• The face value is paid out in October 2018,
seven years from the issue date.
• If the stated annual interest rate in the market is
2.53 percent per year, what is the present value
of the bond?
Example 1: Bond Prices
 Bond Valuation:
Consols

Consols Other Uses

• Same as • Same cash

Perpetuity flow stream
• Use as preference
perpetuity shares
formula
 Bond Valuation:
Consols
• If the market-wide interest rate is 10
percent, What is the value of a consol with
a yearly interest payment of €50?

€50
 €500
0.10
 Bond Concepts

Interest
Yield to
Rates and
Maturity
Bond Prices
 Example 2: Bond Valuation

A Two Year Bond with a 10% Annual

Coupon. r = 10%, 12%, 8%

£10 £100  £10 £10  £100  £10 £10 £100  £10

 2 2 
1.10 (1.10) 1.12 (1.12) 1.08 (1.08)
2

 £100  £96.62  £103.567

 Example 2: Bond Valuation

Par Bond Discount Premium

• Coupon Bond Bond
rate equals • Coupon • Coupon
interest rate rate is less rate is more
than than
interest rate interest rate
 Yield to Maturity

£10 £100  £10

£103.567  
1 y (1  y)
2

y is the Yield to Maturity

What is the Yield to Maturity? (Use trial and error)
Yield to Maturity is 8 percent
 The Present Value of
Equity
Div1 P1 1   Div 2  P2  
P0   P0   Div1 +  
1 R 1 R 1 R  1  R  
Div1 Div 2 P2
Div2 P2  + 
P1 = + 1  R (1  R) 2
(1  R)
2

1+ R 1+ R


Div1 Div2 Div3 Divt
P0  
1  R (1  R)
  ...  
(1  R) (1  R)
2 3 t
t 1
 Equity Valuation

Three Scenarios

Zero Constant Differential

Growth Growth Growth
Equity Valuation:
Three Scenarios
 Equity Valuation:
Zero Growth
• Simple Perpetuity

Div1 Div2 Div1

P0  + + ... 
1  R (1 + R) 2
R
 Example 3:
Projected Dividends
Hampshire Products will pay a dividend of £4 per share a
year from now. Financial analysts believe that dividends
will rise at 6 percent per year for the foreseeable future.
What is the dividend per share at the end of each of the
first five years?

1 2 3 4 5
£4.00 £4 x (1.06) £4 x (1.06)2 £4 x (1.06)3 £4 x (1.06)4
= £4.24 = £4.4944 = £4.7641 = £5.0499
 Example 4:
Share Valuation
Suppose an investor is considering the purchase
of a share of the Avila Mining Company. The
equity will pay a €3 dividend a year from today.
This dividend is expected to grow at 10 percent
per year (g = 10%) for the foreseeable future. The
investor thinks that the required return (R) on this
equity is 15 percent, given her assessment of Avila
Mining’s risk.
What is the share price of Avila Mining Company?
 Example 4:
Share Valuation

€3
€60 
.15  .10
 Example 5:
Differential Growth
Consider the equity of Mint Drug Company, which
has a new massage ointment and is enjoying rapid
growth. The dividend per share a year from today
will be €1.15. During the following four years the
dividend will grow at 15 percent per year (g1 =
15%). After that, growth (g2) will equal 10 percent
per year.
Can you calculate the present value of the equity if
the required return (R) is 15 percent?
 Example 5:
Differential Growth
Step 1
Calculate the present value of the dividends growing
at 15 percent per annum

Step 2
Calculate the present value of the dividends that
begin at the end of year 6
 Example 5:
Differential Growth
• Calculate the present value of the first five dividends

Future Growth Expected Present

Year Rate (g1) Dividend Value
1 .15 €1.15 €1
2 .15 1.3225 1
3 .15 1.5209 1
4 .15 1.7490 1
5 .15 2.0114 1
Years 1–5 The present value of dividends = €5
 Example 5:
Differential Growth
Calculate the present value of the dividends beginning at
end of year 6
6 7 8 9

Div5 x (1 + g2) Div5 x (1 + g2)2 Div5 x (1 + g2)3 Div5 x (1 + g2)4

€2.0114 x (1.10) €2.0114 x (1.10)2 €2.0114 x (1.10)3 €2.0114 x (1.10)4
= €2.2125 = €2.4338 = €2.6772 = €2.9449

Div6 €2.2125
P5 = = P5 €44.25
R  g 2 .15  .10 = = €22
5 5
= €44.25 (1 + R) (1.15)
 Example 5:
Differential Growth
Step 1
Present Value of First Five
€5
Dividends

Step 2
Present Value of Dividends
€22
beginning end of year 6

Step 3
Value of Equity €5 + €22 = €27
 Estimates of Parameters in
Dividend Growth Model

Where does Where does

g come r come
from? from?
 Where Does g Come
From?

Earnings next year Earnings this year  Re tained earnings this year 
  
Earnings this year Earnings this year  Earnings this year
× Return on retained earnings

1 + g = 1 + (Retention ratio × Return on retained earnings)

g = Retention ratio × Return on retained earnings

 Example 6:
Earnings Growth
Pagemaster plc just reported earnings of £2
million. It plans to retain 40 percent of its earnings.
The historical return on equity (ROE) has been 16
percent, a figure that is expected to continue into
the future.
How much will earnings grow over the coming
year?

g = Retention ratio × ROE

g = .4 × .16 = .064
 Where Does R Come
From?
P0 = Div1/(R - g)
Rearrange:
R – g = Div1 /P0
R = Div1 / P0 + g

R = Dividend Yield + Capital Gains Yield

 Example 7:
Calculating the Required Return
Pagemaster plc, the company examined in the previous
example, has 1,000,000 shares outstanding. The equity is
selling at £10. What is the required return on the shares?
Because the retention ratio is 40 percent, the payout ratio is
60 percent (=1 - retention ratio).
The payout ratio is the ratio of dividends/earnings.
Because earnings one year from now will be £2,128,000 (=
£2,000,000 × 1.064), dividends will be £1,276,800 (= .60 ×
£2,128,000).
Dividends per share will be £1.28 (= £1,276,800/1,000,000).
 Example 5.7:
Calculating the Required Return

Given our previous result that g = .064, we

calculate R as follows:

£1.28
.192   .064
10.00
 Growth Opportunities

Value of a Share of Equity When a Firm

Acts as a Cash Cow:
EPS Div

R R

where R is the discount rate on the firm’s

equity.
Why?
 Growth Opportunities
Share price after Firm Commits to New Project:

EPS
 NPVGO
R
Where NPVGO = Net Present Value of Growth
Opportunities
 Example 8:
Growth Opportunities
Sarro Shipping plc expects to earn £1 million per year in
perpetuity if it undertakes no new investment opportunities.
There are 100,000 shares of equity outstanding, so
earnings per share equal £10 (= £1,000,000/100,000).
The firm will have an opportunity at date 1 to spend
£1,000,000 on a new marketing campaign. The new
campaign will increase earnings in every subsequent
period by £210,000 (or £2.10 per share). This is a 21
percent return per year on the project. The firm’s discount
rate is 10 percent.
What is the share price before and after deciding to accept
the marketing campaign?
 Example 8:
Growth Opportunities
Share Price of Sarro When Firm Acts as a Cash Cow:
EPS £10
  £100
R .1
Value of Marketing Campaign at Date 1:
£210, 000
£1, 000, 000   £1,100, 000
.1

Value of Marketing Campaign at Date 0:

£1,100,000
 £1,000,000
1.1
NPVGO per share is £10 (= £1,000,000/100,000).
The share price is EPS/R + NPVGO = £100 + 10 = £110
 Growth in Earnings and Dividends
versus Growth Opportunities

• Grows with investments with positive NPVGO

Firm Value • Falls with negative NPVGO investments

• Can grow or fall with negative NPVGO

Dividends investments

• Can grow or fall with negative NPVGO

Earnings investments
 Example 9:
NPV versus Dividends
Lane Supermarkets, a new firm, will earn €100,000 a year
in perpetuity if it pays out all its earnings as dividends.
However, the firm plans to invest 20 percent of its earnings
in projects that earn 10 percent per year. The discount rate
is 18 percent. What is the growth rate of dividends?
g = Retention ratio × Return on retained earnings
= .2 × .10 = 2%
However, note that the policy reduces value because the
rate of return on the projects of 10 percent is less than the
discount rate of 18 percent.
 The Dividend Growth Model
and the NPVGO Model

Both Models are Equivalent

Dividend
NPVGO
Growth
Model
Model
 The Dividend Growth Model
and the NPVGO Model
Suppose Manama Books has EPS of
€10 at the end of the first year, a
dividend payout ratio of 40 percent, a
discount rate of 16 percent, and a
return on its retained earnings of 20
percent.
What is the value of the firm?
 The Dividend Growth Model
and the NPVGO Model
The Dividend Growth Model:
The dividends at date 1 are .40 x €10 = €4 per share.
The retention ratio is .60 (1 - 40),
This implies a growth rate in dividends of .12 (= .60 × .20).
The price today is

Div1 €4
  €100
R  g .16  .12
 The Dividend Growth Model
and the NPVGO Model
The NPVGO Model
Step 1

Calculate NPV of all Growth Opportunities

Step 2

Calculate Share Price if Firm acts like a Cash Cow

Step 3

Value of Firm is the sum of values from Steps 1 and 2

 The Dividend Growth Model
and the NPVGO Model
Step 1:
Value per share of a single growth opportunity:
Out of the earnings per share of €10 at date 1, the
firm retains €6 (= .6 x €10) at that date.
The firm earns €1.20 (= €6 X .20) per year in
perpetuity on that €6 investment.
Per-Share NPV Generated from Investment of
Date 1: €1.20
€6 +  €1.50
.16
 The Dividend Growth Model
and the NPVGO Model
Step 1 (continued)
Value per share of all opportunities: As pointed out earlier,
the growth rate of earnings and dividends is 12 percent.
This means that the stream of investments leads to a
growing perpetuity.
The present value of this perpetuity is:

€1.50
NPVGO   €37.50
.16  .12
 The Dividend Growth Model
and the NPVGO Model
Step 2
Value per share if the firm is a cash cow: We now assume
that the firm pays out all of its earnings as dividends. The
dividends would be €10 per year in this case.
The Value per share is:

Div €10
  €62.50
R .16
 The Dividend Growth Model
and the NPVGO Model
Step 3
Share price is the value of a cash cow plus
the value of the growth opportunities. This is

€100 = €62.50 + €37.50

Same result as Dividend Growth Model

 The Price-Earnings Ratio

EPS
Price per share  + NPVGO
R

Pr ice per share 1 NPVGO

= +
EPS R EPS
The Price-Earnings Ratio increases with growth opportunities