Bonds, Stocks

and Their Valuation

Lecturer Daniel Iskandar
Presented for
 Bonds and Their Valuation

• It is a general obligation or debt instrument issued by a

limited liability company (which stated an indebtedness
amount, coupon rate and maturity date among others)
and negotiable/tradable/transferable.

• Key features of Bonds

• Bond Valuation
• Measuring Yield
• Assessing Risk

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 Key Features of a Bond
1. Par value: Nominal value or Face amount; paid at
maturity. Assume $1,000.

2. Coupon interest rate: Stated interest rate (%).

Multiply by par value to get dollars amount.
Generally fixed till maturity and coupon payable
quarterly or semi-annually.

3. Maturity: Years until the bond must be repaid.

4. Issue date: Date when bond was issued.

5. Default risk: Risk that issuer will not make interest or

principal re-payments as reflected on the Bond’s rating.

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Sweeteners/Provisions in Bonds

•Call and Put Options

•Single maturity or Series or Tranche or even Extendable
•Fixed and Variable Interest rates
•Convertible, Exchangeable and Others

•Generally the provisions functions as sweetener in the Bond

structure to make it more palatable/attractive to investors
and the issuer has therefore may make concessions on the
other terms to make it fair

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 How does adding a Call provision
affect a bond?

• If a Call Option resides in the Issuer of Bond, then

Issuer can call or buy back the Bonds at pre-
determined terms prior to maturity;
• Issuer can repurchase if interest rates decline
normally; this helps the issuer but may hurts the
investor as yield is capped;
• Therefore, borrowers are willing to pay more, and
lenders or bond investor require more than Nominal
Value, on callable Bonds to make up the expected yield.

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 What’s a Sinking Fund?

• An percentage amount of bonds issued being set aside at

Custodian Bank/ Wali Amanat as small collateral;
• Function as Provision to pay off a portion of the loan or
interest rates over its life;
• Similar to amortization on a term loan;
• Reduces risk to investor, shortens average maturity;
• But not good for investors if rates decline after issuance
since it will put bargaining power to Issuer.

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 Financial Asset Valuation

0 1 2 n
k ...

Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + +…
(1+k)1 (1+k)2 (1+k)n

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 K1= Required Rate of Return

• The discount rate (ki) is the opportunity cost of

capital, i.e., the rate that could be earned by investor
on alternative investments of equal risk.

ki = k* + IP + LP + MRP + DRP
for debt securities.

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 What’s the value of a 10-year,
10% coupon bond if kd = 10%?

0 1 2 10
10%
V = ? 100 100 100 + 1,000

$100 $100 $1,000

VB  +… …+
(1+Kd)1 (1+Kd)5 (1+Kd)10

= $90.91 + . . . + $38.55 + $385.54

= $1,000.

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Suppose the bond was issued 20 years ago
and now has 10 remaining years to
maturity.

What would happen to its value over time if

the required rate of return remained at
10%, or at 13%, or at 7%?

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Bond Value ($)
1,372 kd = 7%

1,211

kd = 10%
1,000 M

837 kd = 13%
775

30 25 20 15 10 5
Years remaining to Maturity

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• At maturity, the value of any bond must equal its par
value.
• The value of a premium bond would decrease to $1,000.
• The value of a discount bond would increase to $1,000.
• A par bond stays at $1,000 if kd remains constant.

September 07 Bonds & Stocks Valuations 12

 What’s the YTM on a 10-year,
9% annual coupon, $1,000 par value bond
that sells for $887?

0 1 9 10
kd=?
...
90 90 90
PV1 1,000
.
.
.
PV10 887
PVM Find kd that “works”!

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 Yield To Maturity

• Annual Yield of a Bond = annual coupon rates/acquisition value

• Simple Yield = coupon/ purchase price = $90/$887 = 10.14%

• Gain upon the Bond redemption = $1000 - $887 = $113

• Yield to Maturity = {(10yr x $90) + $113}/ $887 = 11.42%

• The difference between the acquisition price against the nominal

value represent the capital gain or loss and should be
incorporated with the coupon received over the remaining life of
the bond to maturity

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 Find kd
i i M
VB = ------ +….------- + -------
(1+kd) 1 (1+kd) n (1+kd) M
90 90 1,000
887 = ------ + … ------ + --------
(1+kd) 1 (1+kd) 10 (1+kd) M

INPUTS 10 -887 90 1000

N I/YR PV PMT FV

OUTPUT 11.42%

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 Risk: Interest Rates Movement

^ in Kd affects Long Term Bonds more than Short One

Kd 1yr Tenor Changes 10yr Tenor Change

5% $1,048 + 4.8% $1,386 +38.6%
10% $1,000 $1,000
15% $ 956 -4.4% $ 749 -25.1%

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 Bond Value
1,500
10-year

1,000 1-year

500

kd
0
0% 5% 10% 15%

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 Bond Ratings

Investment Grade High Yield/ Junk Bond

Moody’s Aaa Aa A Baa Ba B Caa D

S & P AAA AA A BBB BB B CCC D

Fitch

Pefindo

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 Factors affect Bond ratings?

• Financial performance
– Debt ratio
– TIE, FCC ratios
– Current ratios
• Provisions in the bond contract
– Secured versus unsecured debt
– Senior versus subordinated debt
– Guarantee/Insurance provisions
– Sinking fund provisions
– Debt maturity

(More…)

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 Factors affect Bond ratings?

• Other factors
– Earnings stability
– Regulatory environment
– Potential product liability
– Accounting policies
– Industry trends and substitute products
– Management changes

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 Stocks and Their Valuation

• Features of common stock

• Determining common stock values
• Efficient markets
• Preferred stock

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 Facts about Common Stock

• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors hire professional management.
• Management’s goal: Maximize shareholders’ value.

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 What’s classified stock?
How might classified stock be used?

• Classified stock has special provisions.

• Could classify existing stock as founders’ shares, with voting
rights but dividend restrictions.
• New shares might be called “Class A” shares, with voting
restrictions but full dividend rights.

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 Different Approaches for
Valuing Common Stock

• Dividend growth model

• Using the multiples of comparable firms
• Free cash flow method (covered in Chapter 12)

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 Stock Value = PV of Dividends

  D1 D2 D3 D
P   . . .
0
1  k  s
1
1  k 
s
2
1  k  s
3
1  k 
s


What is a constant growth stock?

One whose dividends are expected to grow forever at a

constant rate g.

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For a constant growth stock,

D1  D 0 1  g
1

D 2  D 0 1  g
2

D t  D t 1  g
t

If g is constant, then:
D 1  g  D1
Pˆ0  0 
ks  g ks  g

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 $
D t  D 0 1  g
t

0.25 Dt
PVD t 
1  k  t

If g > k, P0  !
P0   PVD t

0 Years (t)
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Assume beta = 1.2, kRF = 7%, and kM = 12%.
What is the required rate of return on
the firm’s stock?

Use the SML to calculate ks:

ks = kRF + (kM - kRF)bFirm

= 7% + (12% - 7%) (1.2)
= 13%.

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 D0 was $2.00 and g is a constant 6%. Find the expected
dividends for the next 3 years, and their PVs. ks = 13%.

0 1 2 3 4
g=6%

D0=2.00 2.12 2.2472 2.3820

1.8761 13%

1.7599

1.6508

September 07 Bonds & Stocks Valuations 29

What’s the stock’s market value?
D0 = 2.00, ks = 13%, g = 6%.

Constant growth model:

P  D 0 1  g  D1 =
ks  g ks  g
0

$2.12 $2.12
= $30.29.
0.13 - 0.06 0.07

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Using the Multiples of Comparable Firms to
Estimate Stock Price

• Analysts often use the following multiples to value stocks:

– P/E
– P/CF or P/EBITDA
– P/Sales
– P/Customer
• Example: Based on comparable firms, estimate the appropriate P/E.
Multiply this by expected earnings to back out an estimate of the
stock price.

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In equilibrium, expected returns must
equal required returns:

^
ks = D1/P0 + g = ks = kRF + (kM - kRF)b.

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 Preferred Stock

• Hybrid security.
• Similar to bonds in that preferred stockholders receive a fixed
dividend which must be paid before dividends can be paid on
common stock.
• However, unlike bonds, preferred stock dividends can be
omitted without fear of pushing the firm into bankruptcy.

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 What’s the expected return on
preferred stock with Vps = $50 and
annual dividend = $5?

$5
Vps  $50  
k ps

 $5
k ps   0.10  10.0%.
$50

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