BM/2018/275

V.R.Mahakumara

Bond and Stock Valuation

Learning Outcomes
At the end of the summary I will be able to;

 Identify of bond and stock valuation

 Determine value of a bond
 Identify stock valuation models
 Compute value of stocks based on valuation models

Abstract
Through this chapter, I hope to gain an understanding of bonds. Explains how bonds are
calculated and how they relate to each other. It then recognizes the interrelationship between
bonds and risk. I hope to discuss later how to calculate yield to maturity. Then the objective is to
gain a basic understanding of the differences between debt and equity and identify stock
valuation. Finally, an extensive study is carried out under estimating dividends.

Definition of Bond
When a corporation or government wishes to borrow money from the public on a long term
basis, issuing or selling debt securities that is called bonds.

Related words of bond

 Par value (Face value)

- The principal amount of bond
 Coupon rate
- The annual coupon rate of the bond
 Coupon payment
- The stated interest payment made on a bond
 Maturity date
- The specified interest payment made on a bond
 Yield or Yield To Maturity (YTM)
- The required rate of return

1|Page BM/2018/275
Bond market

The bond market is the buying and selling of various loan instruments that are widely issued by
different institutions.

Issuer / Promised CFs Lender 1 /

Borrower Buyer 1

Certificate of
ownership

The benefits of invested in bonds

 Bonds provide income

 Bonds offer diversification
 Bonds preserve principal
 Predictability
 Liquidity

The Bond pricing Equation

Bond value = PV of coupons + PV of par

= PV of annuity + PV of lump sum

** When interest rates increase, present values and bond prices decrease and vice versa

Relationship between Coupon and Yield

If ,

 YTM = Coupon rate , Par value = Bond price

 YTM > Coupon rate , Par value > Bond price Discount bond
 YTM < Coupon rate , Par value < Bond price
Premium bond
** When YTM increase, bond value decreases
When YTM decrease, bond value increases

2|Page BM/2018/275
Bonds and Risk

Bond related interest rates also change as interest rates change frequently due to events in the
economy. Therefore the market price also changes.

Thus, it can be said that there is a negative relationship between bonds and risks.

Interest rate risk

 Price Risk
- Change in price due to changes in interest rates
- Long-term bonds have more price risk than short-term bonds
- Low coupon rate bonds have more price risk than high coupon rate bonds
 Reinvestment Rate Risk
- Uncertainty concerning rates at which cash flows can be reinvested
- High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

Differences between Debt and Equity

Debt Equity
Ownership interest No Yes
Return Interest Dividend
Voting rights Do not have voting rights Have voting rights for the board
of directors and other issues
Cost & tax Interest is a cost Dividends are not a cost
Tax is deductible Tax are not deductible
Excess debt Can lead to financial distress and Can not go bankrupt merely due
bankruptcy to debt since it has no debt

The Bond Indenture

The long-term contract between the borrower and the bond holder is called the bond indenture.

That includes ;

 The basic terms of the bonds

 The total amount of bonds issued
 A description of property used as security, if applicable
 Call provisions
 Details of protective covenants

3|Page BM/2018/275
Stock Valuation
There are two major ways in which you can make money buying shares in the stock market

1. The company pays dividends

2. From selling shares to market or back to the company

Issues in share valuation

- Uncertainty of cash flows

- Indefinite life

Developing the model

Po = D1 / ( 1+R ) + P1 / ( 1+R ) One period

Po = D1 / ( 1+R ) + D2 / ( 1+R )2 + P2 / ( 1+R )2 Two period

Po = D1 / ( 1+R ) + D2 / ( 1+R )2 + D3 / ( 1+R )3 + P3 / ( 1+R )3 Three period

Estimating dividends

1. Constant dividend
The price is computed using the perpetuity formula

P 0 = D1 / R
2. Constant dividend growth
The firm will increase the dividend by a constant percent every period

P0 = D1 / ( R – g )
3. Supernormal growth

Pt = D1 * ( 1 + g ) / ( R – g )

4|Page BM/2018/275
Summary
 Bond is a corporation or government wishes to borrow money from the public on a long
term basis, issuing or selling debt securities.
 Bond equation

 YTM = coupon rate, par value = bond price

YTM > coupon rate, par value > bond price Discount bond
YTM < coupon rate, par value < bond price Premium bond
 Bond and risk have negative relationship
 The bond indenture is contract between the company and the bond holders
 If you buy a share of stock, you can receive cash in two ways
1) The company pays dividends
2) From selling shares to the market or back to the company
 Developing the model
Po = D1 / ( 1+R ) + P1 / ( 1+R ) One period
Po = D1 / ( 1+R ) + D2 / ( 1+R ) + P2 / ( 1+R )2
2
Two period
Po = D1 / ( 1+R ) + D2 / ( 1+R ) + D3 / ( 1+R ) + P3 / ( 1+R )3
2 3
Three period
 Estimating dividends
- Constant dividend / Zero growth

P 0 = D1 / R
- Constant dividend growth

P0 = D1 / ( R – g )
- Super normal growth

Pt = D1 * ( 1 + g ) / ( R – g )

References
A.Ross, S. (n.d.). Fundamentals of Corporate Finance. Jordan: McGrow - Hill/Irwin.

5|Page BM/2018/275