Advanced Financial management class

BY
ATAKELT HAILU ,
MBA,M.COM & Ph.D.
DEPT. OF MANAGEMEN
 Chapter three

valuation of bond and stock

 What is Bond?
 A bond is a security that is issued in
connection with a borrowing arrangement.
 It is a long-term contract under which a
borrower agrees to make payments of
interest and principal, on specific dates, to
the holders of the bond.
 The borrower issues (i.e., sells) a bond to the
lender for some amount of cash.
 The arrangement forces the issuer to make
specified payments to the bondholder on specific
dates.
Advanced Financial Management 3
 Bond Terminology
 Bond: A long-term debt instrument
 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.
 Face Value (Par Value, Principal or Maturity Value) - Payment at the maturity of
the bond. 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.
 Current Yield: Stated interest payment divided by the current bond
price.
 Coupon Rate: Stated interest payment divided by the par value.
 Yield to maturity - rate of return earned on a bond held until maturity
(also called Required Return or IRR).
 rate at which the present value of all future interest payments and the
principal payment is equal to the current bond price
 ………..Bond Terminology
 Call Provision
 A provision in a bond contract that gives the issuer the right to redeem
the bonds under specified terms prior to the normal maturity date
 Example: :-Assume Company XYZ issues a $1,000 callable bond with a 5% 
coupon rate and a maturity date of December 31, 2015. The bond's call date is
January 1, 2014 and its call price is $1,050. 
 Call Date: - for bonds which are callable, i.e. bonds which can be redeemed by the
issuer prior to maturity,
 Call Price:
 The amount of money the issuer has to pay to call a callable bond
(there is a premium for calling the bond early). When a bond first
becomes callable, i.e., on the call date, the call price is often set to
equal the face value plus one year's interest.
 Call Price= Par Value + Call Premium
 Call Premium=One year’s interest
 Issuers tend to call bonds when interest rates fall. That can be a
disaster for an investor who thought he had locked in an interest rate
and a level of safety.
 Types of Bond
 Treasury bonds, sometimes referred to as government
bonds, are issued by the government. These bonds have no
default risk.
 However, Treasury bond prices decline when interest rates rise, so
they are not free of all risks
 Corporate bonds, as the name implies, are issued by
corporations.
 Unlike Treasury bonds, corporate bonds are exposed to
default risk
 Different corporate bonds have different levels of default risk,
depending on the issuing company’s characteristics and on the
terms of the specific bond.

6
 Municipal bonds are issued by state and
local governments.
 Like corporate bonds, these bonds have
default risk.
 However, these bonds offer one major
advantage over all other bonds:
 The interest earned on these bonds is exempt from
taxes, if the holder is a resident of the issuing state.
 Consequently, these bonds carry interest rates that are
considerably lower than those on corporate bonds with
the same default risk.

Wednesday, June 02, 2021 Advanced Financial Management 7

 Zero Coupon Bonds: Do not pay any interest over the life of
the bond (Sold at a deep discount).
 Called Pure /deep Discount :- Pay no coupons prior to maturity

and . Pay the bond’s face value at maturity.

 Junk Bonds: High risk, high yield bonds. (often unsecured) bond
rated below investment grade.
 Issued by risky companies and pay high interest rates
 Coupon Bonds
 Pay a stated coupon at periodic intervals prior to maturity.
 Pay the bond’s face value at maturity.
Perpetual bond: they have no maturity date. The most famous of
these are UK consols, issued back in 1988 and still trade today.
 Floating-Rate Bonds:- A bond whose interest rate
fluctuates with shifts in the general level of interest rates
 Pay a variable coupon, reset periodically to a reference rate.

 Pay the bond’s face value at maturity.

8
 War bond: is a bond issued by a country to fund a war.
 Serial bond: is a bond that matures in installments over a
period of time. If bond par value of 100,000 with 5 year serial
bond would mature in a 20,000 annuity over a 5 year interval.
(100,000/5=20,000 annuity pyt)
 Mortgage Bond -- A bond issue secured by a mortgage
on the issuer’s property.
 Debenture -A long-term, unsecured debt instrument.
Not Backed by property as collateral
 Investors look to the earning power of the firm as

their primary security.

 Subordinated Debenture: There is a hierarchy of payout in
case of insolvency.
 Claims honored after the claims of secured debt and

unsubordinated debentures have been satisfied.

9
 Convertible Bond: Provides for
conversion into common stock at a
fixed price.
 Callable Bond: Issuer has the right to call in
the bonds prior to maturity. Usually, a premium
that declines over time (e.g., one year’s interest
initially) must be paid to bondholders. Most
bonds contain some kind of call provision.

Wednesday, June 02, 2021 Advanced Financial Management 10

 Eurobonds are bonds denominated in one or
more currencies other than the currency of the
country in which they are sold.
 For example,

 bonds denominated in a currency other than the

Japanese yen sold in Japan would be called
Eurobonds.
 a bond issued by an American corporation in
Japan that pays interest and principal in dollars.
 If Ethiopian govt / foreign corporation issue US.
Dollar denominated bond and sell in Ethiopia
 Foreign bond :- A bond denominated in the currency of the
country in which it is sold, but issued by an entity from a foreign
country, is called a foreign bond.
 For example, if a U.S. company were to sell yen
denominated bonds in Japan, it would be classified as a
foreign bond.(issuer should be foreigner)
 if IBM were to issue yen denominated bonds in Japan, it

would come under the category of a foreign bond. This is

because the issuer is from a foreign country even though
the currency is local.
 Finally, if either IBM(foreign com.) or Sony com. (local com.)

were to issue U.S. dollar-denominated bonds in Japan, it

would be categorized as a Eurobond issue. This is because
the currency is foreign regardless of e nationality of the
issuer.
Advanced Financial Management 12
 Bond Issuers

 Treasury Bonds
 Issued by the federal government.
 Municipal Bonds
 Issued by state and local governments.
 Corporate Bonds
 Issued by corporations.
 Foreign Bonds
 Issued by foreign governments or foreign
corporations.
 CHARACTERISTICS OF BONDS
 Long-term debt instrument or security.
 Can be secured or unsecured.

Claims on Assets and Income

•Seniority in claims

 In the case of insolvency, claims of debt, including bonds, are

generally honored before those of common or preferred stock.

 Par Value
 Par value is the face value of the bond, returned to the bondholder at

maturity.
 In general, corporate bonds are issued at denominations or par value of

$1,000.
 Coupon Interest Rate:-Interest Rate or coupon rate is fixed
 The percentage of the par value of the bond that will be paid periodically

in the form of interest.

 Example: A bond with a $1,000 par value

and 5% annual coupon rate will pay $50 annually (=0.05*1000) or $25 (if
interest is paid semiannually).
 A fixed maturity date:- specified date on which the principal amount of a bond is
paid.
14
• Generally, Most bonds share certain basic characteristics
– First, a bond promises to pay investors a fixed amount of interest,
called the bond’s coupon.
– Second, bonds typically have a limited life, or maturity.
– Third, a bond’s coupon rate equals the bond’s annual coupon
payment divided by its par value.(coupon rate=coupon pyt/par v.)
– Fourth , Current yield—annual interest payment divided by bond’s
current price
An Example of a Bond
A coupon bond that pays coupon of 10% annually, with a face value of
$1000, has a discount rate of 8% and matures in three years.
• The coupon payment is $100 annually(100/1000=coupon rate
• The discount rate is different from the coupon rate.
• In the third year, the bondholder is supposed to get $100 coupon payment
plus the face value of $1000.
 What is Value?
• 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
 Several Kinds of “Value”
 Book value: value of an asset as shown on a firm’s
balance sheet; historical cost.
 Liquidation value: amount that could be received
if an asset were sold individually.
 Market value: observed value of an asset in the
marketplace; determined by supply and demand.
 Intrinsic value: economic or fair value of an asset;
the present value of the asset’s expected future
cash flows.
 Security Valuation
• In general, the intrinsic value of an asset = the
present value of the stream of expected cash
flows discounted at an appropriate required
rate of return.

n
$CFt
B.V =S
t=1 (1 + k)t
 CFt = cash flow to be received at time t.
 k = the investor’s required rate of return.
 B.V = the intrinsic value of the asset.
Bond Valuation—Basic Ideas

 Adjusting to interest rate changes

 Bonds are sold in both primary (original sale)
and secondary markets (subsequent trading
among investors)
 Interest rates change all the time

 Most bonds pay a fixed interest rate

• What happens to the price of a bond paying a fixed
interest rate in the secondary market when interest
rates change?

19
Bond Valuation—Basic Ideas
 You buy a 20-year, $1,000 par bond today for par (meaning you
pay $1,000 for it) when the coupon rate is 10%
 This implies that your required rate of return was 10%
 For that purchase price, you are promised 20 years of coupon
payments of $100 each, and a principal repayment of $1,000 in 20
years
 After you’ve held the bond investment for a week, you decide that
you need the money (cash) more than you need the investment
 You decide to sell the bond
 Unfortunately, interest rates have risen
 Other investors now have a required rate of return of 11%
• They can buy new bonds with an 11% coupon rate in the market for
$1,000
• Will they buy your bond from you for $1,000?
• NO! They’ll buy it for less than $1,000

20
Determining the Price of a
Bond
 The Bond Valuation Formula
 The price of a bond is the present value of a
stream of interest payments plus the present
value of the principal repayment
PB = PV(interest payments) + PV(principal repayment)
Interest payments are Principal repayment is a lump
annuities—can use the sum in the future—can use
present value of an annuity the future value formula:
formula: PMT[PVFAk,n] FV[PVFk,n]

21
Determining the Price of a Bond

 Two Interest Rates

 Coupon rate
• Determines the size of the interest payments
 K—the current market yield on comparable bonds
• The appropriate discount rate that makes the present value
of the payment equal to the price of the bond in the market
• yield to maturity (YTM)

22
 Ways of Bond Valuation

 Value of Bond with finite maturity period

 Value of bond with semiannual coupon payment
 Value of zero coupon bond
 Value of bond with infinite maturity period
 YTM

23
 Bond Valuation with finite maturity period
Bonds are valued using time value of money concepts.
• The cash flows promised by a bond are:
• The coupon payment stream (an annuity).
• The par value payment (a single sum).(maturity value (MV)
•The value of a bond is determined by finding the present value (PV) of
future cash flows:
• the PV of the interest payment annuity (at the stated or coupon rate of
interest), plus the PV of the redemption (face, par) value,

n
Vb = $IIt + $MV
S
t=1 (1 + k b)t
(1 + kb)n
Vb = $It (PVIFA kb, n) + $MV (PVIF kb, n)
 Cash Flow Pattern of a Bond

0 1 2 3 4 n

Purchase Coupon Coupon Coupon Coupon Coupon +

Price Face Value

Cash Outflows Cash Inflows

to the Investor to the Investor

The Purchase Price or Market Price of a bond is simply the present

value of the cash inflows, discounted at the bond’s yield-to-maturity
25
 Bond Value:- with maturity period
General Formula of bond Value= VB
• The coupon/interest, payments are treated like an equal cash flow
stream (annuity and lump sum /Maturity value/MV ).
• The face value/par value of bond is treated like a lump sum /Maturity
value/MV.

 1 
1 
 (1 n
k) 1

VB 
PMT  
MV
 k  (1 n
k)

 


Where:
PMT = interest (or coupon ) payments
k= the bond discount rate (or market rate)
n = the term to maturity
MV =maturity valu/ Face (or par) value of the bond
Bond Valuation: An Example
 Assume that you are interested in purchasing a bond with
5 years to maturity and a 10% coupon rate. If your
required return is 12%, what is the highest price that you
would be willing to pay? 1,000
100 100 100 100 100

0 1 2 3 4 5

1001 100 2 1003 100 4 1005 10005

VB      
1.12 (1.12) (1.12) (1.12) (1.12) (1.12)5
2 3 4 5

 89.3  79.745  71.18  63.53  56.744  567.44  927.9

 1  1 
1 
5
  0 .1 2  1 , 0 0 0
V  1 0 0     9 2 7 . 9 0
1 
B 5
 0 .1 2   0 .1 2
 

2
 Example
 Assume XY company buys a 10-year bond from the ABC
corporation on January 1, 2010. The bond has a face value
of $1000 and pays an annual 10% coupon. The current
market rate of return is 12%. Calculate the price of this
bond today.

1. Draw a timeline
$1000

$100 $100 $100 $100 $100

$100 $100 $100 $100 $100 +

?
?
Advanced Financial Management 28
  You can find the PV of a cash flow stream and
per value
 PV = $100/(1+.12)1 + $100/(1+.12)2 +
$100/(1+.12)3+$100/(1+.12)4
+$100/(1+.12)5+ $100/(1+.12)6 +
$100/(1+.12)7+$100/(1+.12)8
+$100/(1+.12)9+ $100/(1+.12)10
 + $1000/(1+.12)10
 PV = $565.02 + $321.97 = $886.99

Wednesday, June 02, 2021 Advanced Financial Management 29

 Or 1st you can fined PV of annuity  2nd you can fined PV of annuity
Find the PV of the face value as
 1  lump sum amount
 1  1  k  n 
B A  PMT 


k



PV = CF / (1+r) t
t

1 

1 

PV = $1000/
 1  0 . 12 
10
BA  100 
 0 . 12


(1+.12)10
  PV = $321.97
 1 
 1  
B A  100 
 1  0 . 12 
10

 0 . 12   1 
   1  ( 1  k) n
VB  PMT  

  MV 
1
 k  ( 1  k )n
 
B A  100 5 . 6502

B A  565 . 02

PV = $565.02 + $321.97 = $886.99

Wednesday, June 02, 2021 30
 Alternatively, we can calculate the PV by
using the PV formula
PMT = 100
FV = 1000  1 
 1  
n = 10 VB  PMT  
( 1  k) n
  MV 
1
 k  ( 1  k )n
i = 12  
PV = ?
1  1 
 1  0.12 10   1000 
BA  100  10 
 0.12   1  0.12  
 
BA  100 5.6502    321.97
BA  886.99

Wednesday, June 02, 2021 Advanced Financial Management 31

 Semiannual Coupon pymt
• Most bonds in the U.S. pay interest
twice a year (1/2 of the annual
coupon).
Adjustments needed:
(1) Divide kd by 2
(2) Multiply n by 2
(3) Divide I by 2

32
 Bond Valuation: Semi-Annual Coupons
• So far, we have assumed that all bonds have annual pay
coupons. However, most bond issues, which have coupons
that are paid semi-annually. If interest was paid, say,
quarterly, we would have divided the annual amount by
four.
• To adjust for semi-annual coupons, we must make three
changes:
– Size of the coupon payment (divide the annual coupon
payment by 2 to get the cash flow paid each 6 months )
– Number of periods (multiply number of years to maturity(3)
by 2 to get number of semi-annual periods(6))
– Finally, we also must adjust annual required return/YTM
(7%) (divide (7%) by 2 to get the semi-annual Return (3.5%).
Prepared by Sewale Abate (Ph.D) 33
 A bond adjusted for semiannual compounding.

I/2 I/2 I/2

B.V = + + ... + +
MV
(1 + kd/2 )1 (1 + kd/2 )2 (1 + kd/2 )nx2 (1 + k /2 ) 2*n
d
Where I is coupon payment
Kd is required rate of return
Mv is maturity value /par value
2*n + MV
=S I/2
t=1
(1 + kd /2 )t (1 + kd /2 ) 2*n

= I/2 (PVIFA kd /2 ,2*n) + MV (PVIF kd /2 , 2*n)

 Example:-Semi-Annual Coupons :
• Suppose that you are interested in purchasing a 3-year bond with a 10% semiannual coupon rate
and a face value of $1,000. If your required return is 7%, what is the intrinsic value of this bond?
• Note :-
• An annuity, the interest payments, paid every six months. This is calculated as:
• coupon payment==0.1x1000=100 but 100/2=50
• Time=nx2=6
• K=7%/2= 1000
50 50 50 50 50 50

0 1 2 3 4 5 6

 1 
 1  6 
 1   0 . 07 
 1    1   
V B  Pmt 
 1  kd 
N

MV 
 50   2   1000
 kd  1  k d 
N
0 . 07  1  0 . 07 / 2  6  1,079.93

   2 
   
  the second is the
the first term is present value of a
the present value lump sum
of an annuity
• Do the math, and you’ll find that the bond is worth $1,079.93.
 EXERCISE :-Semi annual coupon
Suppose XYZ corporation issues a 7 percent coupon interest rate bond paid
semi annually with a maturity of 20 years. The face value of the bond, payable at
maturity, is $1,000. what is the value of XYZ corporation bond.
: Annual Basis Semi-annual Basis
Coupon Interest Payments = $70 ÷ 2 = $35 per six-month period
Maturity period = 20 yrs × 2 = 40 six-month periods
Required Rate of Return = 8% ÷ 2 = 4% semi- annual rate

 1 
 1  40 
 1   0 . 08 
1 
 1  k  N   1   
MV   2   1000
V B  Pmt  d
  35    901.04


kd  1  k d 

N

0.08
2


 1
0.08
2
 40

   
 

36
Some Notes About Bond Valuation
• The value of a bond depends on several factors such
as time to maturity, coupon rate, and required
return
• We can note several facts about the relationship
between bond prices and these variables (ceteris
paribus):
– Higher required returns lead to lower bond prices, and
vice-versa
– Higher coupon rates lead to higher bond prices, and vice
versa
– Longer terms to maturity lead to lower bond prices, and
vice-versa
 Bond Rules
1. Coupon rate = required rate of interest, Bond sells
at PAR
2. coupon rate < required rate of interest, Bond sells
at a discount
3. coupon rate > required rate of interest, Bond sells
at a premium
4. required rate of interest increases, Value of Bond
decreases
5. required rate of interest decreases, Value of Bond
increases

Wednesday, June 02, 2021 Advanced Financial Management 38

 Example 1: 1st case when (coupon rate = required
rate)
 If coupon rate(10%) = required rate(10%))
 Assume a five year $1000 bond pay coupons at

10% rate, Market rate (discount rate) (required rate

of return) is 10%
 Define Terms
 C = coupon payment = coupon rate x $1000
= 10% x $1,000 = $100
 M.V= face amount or maturity value = $1000
 n = payments to maturity = 5
 k = required rate of return = 10%
 BV = bond value = ?
 K = 10%
Year 1 Year 2 Year 3 Year 4 Year 5

$100 $100 $ 100 $100 $100

MV0=1000
N= 5
COUPON = 1O% $1000
K=10%
MV= 1,000
PMT = 100
•PV of coupon annuity = $379.08
•PV of lump sum maturity value = $620.92
•BV = $379.08 + $620.92 = $1,000.00
 1 
 1  5 
pv  100 
1  0 . 1     1000 
 5 
 1  0 . 1  
B
 0 .1 
 
pv B  100 ( 3 . 7908 )  620 . 92
Pv B  1000

Note: If the coupon rate = discount rate, the bond will sell for par
value.
Example 2 (coupon rate > required rate)
 If coupon rate(12%) > required rate(10%))
 Assume that the Five year $1000 bond pay coupons at
12% rate, market rate is 10%. What should be the price
of Bond?
 PMT= C = 120
 MV = 1000
 Coupon rate=12%
 k = 10%
 N=5
BV= 454.89+ 620.92 = $1,075.81
 In this case coupon rate > k so BV > MV, we are getting
more in coupon than we demand through required rate
of return.
 Premium = $75.81

41
Example 3. (coupon rate < required rate)
 If coupon rate(8%) < required rate(10%))
 Assume that the Five year $1000 bond pay

coupons at 8% rate, market rate is 10%. What

should be the price of the bond?
 PMT = 80
 MV /maturity value= 1000
 k = 10%
 N=5
 P0 = 303.26 + 620.92 = $924.18
 In this case coupon rate < K so BV < MV, we are getting
less in coupon than we demand through required rate of
return.
 Discount = $75.82 42
 BOND YIELDS TO MATURITY
The Yield to Maturity = Investor’s Required Rate of Return

 The expected rate of return on a bond.

 The rate of return (required rate of return) that an
investor would earn if he bought the bond at its current
market price and held it until maturity.
 Alternatively, it represents the discount rate which equates the discounted
value of a bond's future cash flows to its current market price.

S
$It $MV
BV = +
t=1
(1 + k)t (1 + k)n
Solving for YTM
 The yield to maturity is that discount rate that causes the
sum of the present value of promised cash flows to equal
the current bond price.
 To solve for YTM, solve for YTM in the following formula:

 1 
 1  
BV  I * 
1  YTM n   MV *
1
 YTM  1  YTM n
 

 The YTM calculation takes into account the bond’s current

market price, par value, coupon interest rate and time to
maturity.
 But, there is a Problem to calculate easily:
 You can’t solve for YTM easily algebraically; therefore, we must

either use a trial & error or approximation formula.

Wednesday, June 02, 2021 Advanced Financial Management 44

 Approximation formula of YTM
 I  (MV  BV) / n  or  I  ( MV  BV ) / n 
YTM    YTM   
 (MV  BV) / 2   (0.4 xMV )  (0.6 xBV ) 
Where
I= Periodic coupon payments (CR*mv=Coupon rate * MV)
MV =Maturity /par value :- the dollar principal payment at maturity
Vb = the value ob bond (present value) of bond
n = the number of periods until maturity of the bond
CR = the fixed coupon interest rate on the bond
Note: - the investor uses the bond’s computed YTM by
comparing it to his required rate of return on the bond after
considering all risk factors;
1. If the investors 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.
Solving for YTM
Example 1: Consider a $1000 par value Bond, carrying a coupon
rate of 9% (annual pay coupons), maturing after 8 years. The bond
is currently selling for $800. What is the YTM on this Bond?
coupon rate of 9%
FV/MV = 1,000
BV= 800
PMT= 90
N= 8
YTM ?

 I  ( MV  BV ) / n  90  ( 200 ) / 8
YTM      115 / 900  12 .7 %
 ( MV  BV ) / 2  (1800 ) / 2
or
 I  ( MV  BV ) / n 
YTM     115 / 880  13.1%
 (0.4 xMV )  (0.6 xBV ) 
 The computation of trial and error procedure
MV = 1,000, BV= 800 , coupon rate =9%, PMT= 90 , N= 8, YTM?
Rule :-If bond price(800) is lower than maturity value(1000), YTM
must be higher than coupon rate . If not , YTM is lower than CR
 1 
1  1  YTM ?  n  MV
BV  pmt     800
 YTM ?  1  YTM ? n
 

Let us begin with a discount rate of 12%

 1 
1   1  YTM 8  1000
800  90   
 YTM  ( 1  YTM )8
 
 1 
 1  
800  90 
 1  . 12 8  
1000
 0 . 12   1  . 12  8
 
Since this value is higher than
800  $ 851 . 00
$800, let us try to take A higher
value of discount rate =14%
Let us take a discount rate of 14%

 1 
1 
 1  YTM  8  1000
800  90 
 (1  YTM )
8
 YTM
 

 1 
1 
 1  .14 8  1000
800  90  
 0. 14   1  .14  8

 
800  $768.10 Since this value is less than $800, let us take a lower value
of discount rate

Wednesday, June 02, 2021 Advanced Financial Management 48

Let us take a discount rate of 13%
 1 
1 
 1  YTM  8  1000
800  90  
 YTM  (1  YTM ) 8

 

1  1  When discount rate is 12%, VB=851

 1  .13 8  1000 When discount rate is 13%, VB=808
800  90  When discount rate is 14%, VB=768.1
 .13   1  .13 8

  lies between 13% and 14%.

$800  $808
Thus, discount rate lies between 13% and 14%.
Using a linear interpolation in the Rage 13% to 14%,
we can find that Discount rate is equal to 13.2%
Wednesday, June 02, 2021 Advanced Financial Management 49
 linear interpolation
Interpolation is a method of finding new value for any function using the given set of Valu
The unknown value at a particular point can be found using  two given points

When discount rate is 12%, VB=851

When discount rate is 13%, VB=808
When discount rate is 14%, VB=768.10
Where
lies between 13% and 14%.
UKd= upper limit of discount rate
VBLKd  BV 0
YTM  Lk d  * (UK d  Lk d ) lkd = lower limit of the discount rate
VBLKd  VBUKd
VBukd = value of bond with the upper
808  800 limit discount rate
YTM  13%  * (14%  13%)
808  768.10 VBlkd = value of the bond with the
lower limit of the bond
8
YTM  0.13  * (0.14  0.13) BV0= current price of the bond
39.90
YTM  0.13  0.2005(0.01)
YTM  0.13  0.002
YTM  0.132
YTM  13.2% 50
Alternative formula
2
where:
 MV - BV  MV=Maturity /par value/face value of bond
  I 
YTM  1  n BV=current price of Bond
 1
 MV  BV  I= coupon payment
  n= number of payment periods

2 2
 MV - BV   $1,000  $800 
  I    $90 
YTM  1  n 8
  1  1   1
 MV  BV   $1000  $800 
   
2 2
 $25  $90   $115 
YTM  1    1  1    1   1  0 .06389  2
1
 $1800   $1800 
YtM  1.06389  1  1.1319  1  0.1319  13.19%
2

Wednesday, June 02, 2021 Advanced Financial Management 51

Example 2
. the yield-to-maturity of a 5 year 6% coupon bond $1000
Find
that is currently priced at $850. The coupon interest is paid
annually.)
2 2
 MV- BV   $1,000$850 
  I    $60
YTM 1 n 5
 1 1  1
 MV BV   $1000$850 
   
2 2
 $30$60  $90 
1 1 0.04865 1
2
YTM 1  1 1 
 $1850   $1850
YtM 1.04865 11.099661 0.09967 9.97%
2

The actual answer is 9.87%...so of course, the

approximation approach only gives us an approximate
 Perpetual bond
• A perpetual bond is a bond that never
matures. It has an infinite life.
• Here Bond has constant amount of Coupon
payment(I) for infinite life
I I I
BV = + + ... +
(1 + kd)1 (1 + kd)2 (1 + kd)¥
I
¥
=S
(1 + kd) t or I (PVIFA kd, ¥)
t=1
Plugging constant Coupon payment into the bond valuation
formula reduces to simple equation for a perpetuity: I/K

BV = I / K Reduced Form]
To find K(YTM) I
Just adjust the above valuation model:
K = VB
 Example:-
Example:- Perpetual
Perpetual Bond
Bond

Bond of ABC co. 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?

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

kd = 10%.
B.V = I / kd [Reduced Form]
4 = $80 / 10% = $800.
 Zero-Coupon Bond
A zero-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.

MV
BV = = MV (PVIFkd, n)
(1 + kd)n
 Example :-Zero-Coupon Bond
Bond of ABC co. 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?

B. V=
1000 1000 = 57.3
=
(1 + 0.1)30 17.449
Or B.V = $1,000 (PVIF10%, 30) = $1,000
(.057)= $57.00

What about YTM of zero-coupon bond?

1000
57.3= = (1 + YTM)30 = 10%
(1 + YTM)30
 Different Types of Stocks

Preferred Stock
Common Stock

7
 Preferred Stock

Preferred Stock is a type of stock that

promises a (usually) fixed dividend

Preferred Stock has

preference over common
stock in the payment of
dividends and claims on
assets.

8
Preferred Stock Valuation
 Preferred stock is defined as equity with priority over
common stock with respect to the payment of dividends
and the distribution of assets in liquidation.
 Preferred stock is a hybrid security which shares
features with both common stock and debt.
 Preferred stock is similar to common stock in that it
entitle its owners to receive dividends which the firm
must pay out of after – tax in come and having
ownership right.
 like the coupon payments on debt, the dividends on
preferred stock are generally fixed.
Cont
 Preferred Dividend/Preferred Dividend Rate:
The preferred dividend rate is expressed as a
percentage of the par value of the preferred
stock.
 Since the preferred dividends are generally fixed,
preferred stock can be valued as a constant
growth stock with a dividend growth rate equal to
zero.
 Thus, the price of a share of preferred stock can
be determined using the following equation.
Vp = Dp Vp = the preferred stock price

Kp Dp = the preferred dividend and

Kp = the required return on the stock
Cont…

 Example: - Find the price of a share of

preferred stock given that the par value is
$100 per share,                     the preferred
dividend rate is 8% and the required return is
10%.
 Common Stock

Common stock represents a residual

ownership position in the corporation.

2
 Common Stock
What cash flows will a shareholder
receive when owning shares of
common stock?

(1) Future
dividends
(2) Future sale of
3
the common
Common Stock Valuation
 common stock does not promise its owners interest
income or a maturity payment at some specified time in
the future.
 Nor does common stock entitle the holder to a
predetermined constant dividend as does preferred stock.
 As of consequence dividend streams tend to in crease
with the growth in corporate earnings.
 Thus, the growth of future dividends is a prime
distinguishing feature of common stock.
 This does not mean that divided will always increase in
the future.
 Let’s develop common stock valuation process by steps
starting with a one – period horizon and progressing to a
multiple period horizon.
One Period Valuation Model
 For an investor holding a common stock
for only one year, the value of the stock
would be the present value of both the
expected cash dividend to be received in
one year (D1) and the expected market
price per share of the stock at year end
(P1) .If ks represents an investors required
rate of return, the value of common stock
(po) would be:
One Period Valuation Model
 Po = D1 + P1
(1+ks)
(1+ks)
 Example: - Assume kuku Company is
considering the purchase of stock at the
beginning of the year. The divided at year
end is expected to be Br 3 and the market
price by the end of the year is expected to
be Br 80. If the investor’s required rate of
return is 15 percent. What would be the
value of the stock?
Two Period Valuation Models
 Now, suppose the investor plans to hold a stock
for two years before selling. How is the value of
the stock determined when the investment
horizon changes? The answer is to in corporate
the additional years in formation be.
 Po = D1 + D2 + P2

(1+ks)1 (1+ks)2 (1+ks)2

 Example 1:-Assume the expected dividend for
KUKU Company in the second year be Br 4, the
expected price at the end of the second year be
Br100, and the required rate of return remains
15%. Find the value of the common stock.
Multiple Period Valuation Model
 Since common stock has no maturity date and is
held for many years, a more general, multi
period model is needed. The general formula for
common stock valuation model is defined as
follows:
 Po = D1 + D2 + D3 …+…. + Pn

(1+ks)1 (1+ks)2 (1+ks)n

 Example: - Assume that an investor expects Br
3 dividend for each of 10 years and a selling
price of Br 50 at the end of 10 years. What
would be the value of the common stock to day?
Dividend Discount Model
 Many investors do not contemplate selling their stock in
the near future but are long term holders.
 Since a common stock held with such intention has an
infinite life, we need to accommodate the potentially
endless series of dividends that may be received in the
future on the stock. The value of such stock is:
p = D1 + D2 + D3 +…. Dn+ + D∞
(1+ks) 1 (1+ks) 2 (1+ks) 3 (1+Ks) n (1+ks) ∞
. This equation is a more general form of the stock
valuation model. It is often referred to as the dividend
discount model because it shows the current price of the
stock as determined by the discounted future expected
dividends. It is an extremely important.
Cont…
 To implement the dividend valuation model
which requires that we discount the entire
future stream of expected dividends, we must
model the expected growth rate of dividends.
There are three cases of growth in dividends.
They are
 Zero growth
 Constant growth and
 Non constant or super normal growth
Zero Growth (No Growth)
 Suppose dividends are not expected to grow at but to remain
constant.
 Here, we have a zero growth stock for which the dividends

expected in future years are equal to some constant amount

that is Notice the two conditions implied here;
1. un changing cash flows
2. this continues for ever .
 when these conditions occur, the dividend discount model

mathematically reduces to a much simpler form called the

constant dividend or no-growth model:
po = Do
Ks
Example: - If dividends for MM Company are expected to be
constant at Br 2.50 per share forever and if the required rate of
return on equity is 10 percent. Compute the value of the stock.
Normal or Constant Growth (Gordon
Growth Model)
 Many companies have expected dividend streams that can be
roughly described as growing at constant rate for along period
of time.
Assumptions in Constant (Gordon Growth) Growth Model
 The expected dividend growth rate, g, is constant from year to

year.
 The constant growth is forever (g =∞ )

 The required rate of return must greater than growth rate;Ks >

g.
po = D1 = Do (1+g) Dt= Do(1+g)t
Ks –g ks – g
Example: Consider a common stock that paid a $ 5 dividend per
share at the end of the last year and is expected to pay cash
divided every year at a growth rate of 10 percent. Assume the
investor’s required rate of return is 12% .what would be the
value of the stock?
The Cost of Capital
 Concept of Cost of Capital
• The cost of capital is the rate that the firm must
earn on its investment in order to satisfy the
required rate of return of the firm’s investors
• It can be defined from two points of view, that
of a company and that of an investor.
– From an investor's point of view, the cost of capital
is the required rate of return an investment must
provide in order to be worth undertaking.
– From a company's point of view, the cost of capital
refers to the cost of obtaining funds —debt or
equity—to finance an investment.
 Components of Cost of Capital
• Component of cost of capital is the individual cost of
each source of financing.
• It is also known as the specific cost of capital which
includes the individual cost of debt, preference shares,
ordinary shares and retained earning.
• Components of cost of capital are
A. Cost of Debt
B. Cost of Preference Share
C. Cost of ordinary/ common stock
D. Cost of retained earning
 The Cost of Debt
• The cost of debt is the rate of return the firm’s
lenders demand when they loan money to the
firm.
– Note, the rate of return is not the same as coupon
rate, which is the rate contractually set at the time
of issue.
• We can estimate the market’s required rate of
return by examining the yield to maturity on
the firm’s debt.
• After-tax cost of debt = Yield (1-tax rate)
 Example:-
• What will be the yield to maturity on a debt
that has par value of $1,000, a coupon
interest rate of 5%, time to maturity of 10
years and is currently trading at $900?

• What will be the cost of debt if the tax rate is

30%?
 2
 F -B 
  I 
YTM  1  n 1
F  B 
 
 
2 2
 F-B   $1,000  $900 
  I    $ 50 
YTM  1  n 10
  1  1   1
 FB   $1000  $900 
   
2 2
 $10  $50   $60 
YTM  1    1  1    1   1  0 . 0316  2
1
 $1900   $1900 
YtM  1.0316  1  1.0642  1  0.0642  6.42%
2

After tax cost of debt  YTM 1  Taxrate 

K d  6 .42 % 1  30 %   0 .0449  4 .49 %
 The Cost of Preferred Equity
 The cost of preferred equity is the rate of
return investors require when they purchase
firms’ preferred stock.
 The cost is not adjusted for taxes since
dividends are paid to preferred stockholders
out of after-tax income.
 The cost of preferred stock can be inferred
from its trading price and the fixed dividend:
 Example:-
Consider the preferred shares of ABC Company
that are trading at $25 per share. What will be the
cost of preferred equity if these stocks have a par
value of $35 and pay annual dividend of 4%?

D ps
R ps 
Pi Dividend =$35x4%=$1.4
where:
Rps=required rate of return
Cost of preferred equity =
Dps = preferred dividends
Pi = net issuing price Dividend/price=1.4/25=5.6%.
 The Cost of Common Equity
 The cost of common equity is the rate of return investors expect
to receive from investing in firm’s common stocks.
 This return comes in the form of cash distributions of dividends
and cash proceeds from the sale of the stock.
 Cost of common equity is harder to estimate since common
stockholders do not have a contractually defined return similar to
the interest on bonds or dividends on preferred stock.
• A new common stock is raised in two ways:
1. By retaining some of the current year’s
earnings (internal common equity) and
2. By issuing new common stock (external
common equity)
– equity raised by issuing stock has a somewhat
higher cost than equity raised as retained
earnings due to the flotation costs involved with
new stock issues
– Cost of Internal Equity = opportunity cost of
common stockholders’ funds

82
 There are two approaches to estimate the cost of common
equity:

• Dividend Growth Model

• Capital Asset Pricing Model

83
 The Dividend Growth Model
 Using this approach, we estimate the expected stream of
dividends as the source of future estimated cash flows.
 We use the estimated dividends and current stock price to
calculate the internal rate of return on the stock investment.
This return is used as an estimate of cost of equity.
 Originally, we use the dividend growth model to estimate the stock value.
 Thus, take the market price of the stock as the fair value, and learn what
the discount rate (required rate of return) should be if the market price is
the fair value.
 The constant growth case
 If we assume that the dividend grows at a constant rate, g,
the stock can be valued as
D1
P0 =
Ks- g
where ks is the cost of common equity or required rate of return on
the equity and
P0 is the fair value.
Then, we can infer the cost of common equity as,

D1
kS = + g
P0
 Dividend Growth Model
• Cost of Internal Common Stock Equity:The reason
we must assign a cost of capital to retained
earnings involves the opportunity cost principle

D1
kS = + g
P0

Example:
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is
10%.

86
• Cost of Internal Common Stock Equity

D1
kS = + g
P0

kS = 3(1+0.10) + .10
60

=.155 = 15.5%

87
 The Capital Asset Pricing Model
 CAPM is used to determine the expected or required rate
of return for risky investments.

 Cost of equity is determined by three key ingredients:

 The risk-free rate of interest,
 The beta or systematic risk of the common stock returns, and
 The market risk premium.
 ..\Simple steps to calculate Beta.doc
• Cost of Internal Common Stock Equity
– Capital Asset Pricing Model

kS = kRF + (kM – kRF)

Example:
The estimated Beta of a stock is 1.2. The risk-free rate is 5%
and the expected market return is 13%.

kS = 5% + 1.2(13% – 5%) = 14.6%

89
Compute Cost of New Common Equity

• Cost of New Common Stock

– We must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.

D1
kns = + g
P0 (1- F)

Where, Kns= New common stock

P0= current price of common stock
F = Flotation Cost (The percentage cost of issuing
new common stock)
g = Growth rate
D = dividend

90
 Example:
 If additional shares are issued floatation costs will be
12%. D0 = $3.00 and estimated growth is 10%, Price is
$60 as before.

D1
kns = +g
P0 (1- F)

3(1+0.10)
kns = + .10
60.00 (1– 0.12)

3.30
kns = + .10
52.80 = .1625 = 16.25%
91
End of Chapter