Principles of Managerial Finance: Bond & Stock Valuation

Principles of Managerial
Finance
9th Edition
Chapter 7
Bond & Stock Valuation

Learning Objectives
• Describe the key inputs and basic model used in the
valuation process.
• Apply the basic bond valuation model to bonds and

describe the impact of required return and time to
maturity on bond values.
• Explain yield to maturity (YTM), its calculation, and the

procedure used to value bonds that pay interest
semiannually.
Learning Objectives
• Understand the concept of market efficiency and basic
common stock valuation under each of three cases:
zero growth, constant growth, and variable growth.
• Discuss the use of book value, liquidation value, and

price/earnings (PE) multiples to estimate common
stock values.
• Understand the relationships among financial

decisions, return, risk, and the firm’s value.
Nominal or Actual Rate of Interest
Nominal><Real interest rate

• Inflationary expectation (IP)
• Issuer Characteristic such default risk,
contractual provisions (RP)
• Nominal rate (ki):
ki=k*+IP+RP
Example
Fund $10, cost of candy $ 0.25/piece,

interest 7%, inflation 4%.
Real interest rate:
Fund after 1 year = $10+(7%*$10)=$10,7
Cost of candy=1.04*$0.25=$0.26
Total candy $10.7/0.26=$41.2
Theory of Term Structure
• Expectation theory (future interest rate,
inflation rate)
• Liquidity preference theory (ST-security
lower risk than LT-security, pay a higher
rate for LT than ST)
• Market Segmentation Theory (based on
maturity, supply and demand, type such
Aaa-Aa, A-Baa, Ba-C)
Corporate Bonds
 Coupon interest rate
 Bond indenture
 Standard debt provision
 Restrictive covenants:
 Minimum of liquidity
 Prohibit the sale of A/R
 Impose fixed assets restriction
 Constrain subsequent borrowing
 Limited cash dividend
• Subordination (wait until all claims of the
senior debt are satisfied)
• Sinking-fund requirement (providing for
systematic retirement of bonds prior
their maturity)
General Features of a Bond Issue
• Conversion feature
• Call feature
• Call price
• Call premium
• Stock purchase warrant
Interpreting Bond Quotations
• Example IBM 7s25

• 7 is coupon interest rate
• 25 is mature in the year 2025
• CurYld is current yield (coupon rate
divided by closing price
• Vol is actual number of bond that traded
on the given day
Valuation Fundamentals
• The (market) value of any investment asset is simply
the present value of expected cash flows.
• The interest rate that these cash flows are discounted
at is called the asset’s required return.
• The required return is a function of the expected rate
of inflation and the perceived risk of the asset.
• Higher perceived risk results in a higher required
return and lower asset market values.
Basic Valuation Model
V0 = CF1 + CF2 + … + CFn

(1 + k)1 (1 + k)2 (1 + k)n
Where:
V0 = value of the asset at time zero
CFt = cash flow expected at the end of year t
k = appropriate required return (discount rate)
n = relevant time period
What is a Bond?
A bond is a long-term debt instrument that

pays the bondholder a specified amount of
periodic interest over a specified period of
time.
(note that a bond = debt)

General Features of Debt
Instruments
• The bond’s yield to maturity is the yield (expressed as
a compound rate of return) earned on a bond from the
time it is acquired until the maturity date of the bond.
• A yield curve graphically shows the relationship

between the time to maturity and yields for debt in a
given risk class.
General Features of Debt
Instruments
• The bond’s principal is the amount borrowed by the
company and the amount owed to the bond holder on
the maturity date.
• The bond’s maturity date is the time at which a bond
becomes due and the principal must be repaid.
• The bond’s coupon rate is the specified interest rate
(or $ amount) that must be periodically paid.
• The bond’s current yield is the annual interest
(income) divided by the current price of the security.
Bonds with Maturity Dates
Annual Compounding
B0 = I1 + I2 + … + (In + Pn)
(1+i)1 (1+i)2 (1+i)n
For example, find the price of a 10% coupon bond
with three years to maturity if market interest rates
are currently 10%.
B0 = 100 + 100 + (100+1,000)

(1+.10)1 (1+i)2 (1+.10)3
Annual Compounding
Using Excel

are currently 10%.
Finding the Value of a Bond
Coupon Interest ($) $ 100

Note: the equation
Maturity (periods) 3
for calculating
Face Value ($) $ 1,000
price is
Market Interest Rate (%) 10%
=PV(rate,nper,pmt,fv)
Market Price ($) ($1,000.00)
Annual Compounding
Using Excel

are currently 10%.

When the coupon
Coupon Interest ($) $ 100 rate matches the
Maturity (periods) 3 discount rate, the
Face Value ($) $ 1,000 bond always sells
Market Interest Rate (%) 10% for its par value.
Market Price ($) ($1,000.00)
Annual Compounding
Using Excel
What would happen to the bond’s price if interest

rates increased from 10% to 15%?

When the interest
rate goes up, the
bond price will
always go down.
Market Price ($) ($885.84)
Annual Compounding
Using Excel
What would happen to the bond’s price it had a 15

year maturity rather than a 3 year maturity?
Coupon Interest ($) $ 100 And the longer the

Maturity (periods) 15 maturity, the greater
Face Value ($) $ 1,000 the price decline.
Market Price ($) ($707.63)
Annual Compounding
Using Excel
What would happen to the original 3 year bond’s

price if interest rates dropped from 10% to 5%?
Coupon Interest ($) $ 100 When interest rates

Maturity (periods) 3 go down, bond
Face Value ($) $ 1,000 prices will always
Market Interest Rate (%) 5% go up.
Market Price ($) ($1,136.16)
Annual Compounding
Using Excel
What if we considered a similar bond, but with a 15

year maturity rather than a 3 year maturity?
Coupon Interest ($) $ 100 And the longer the

Maturity (periods) 15 maturity, the greater
Face Value ($) $ 1,000 the price increase will
Market Interest Rate (%) 5% be.
Market Price ($) ($1,518.98)
Graphically
Effect of Changes in Interest Rates on Price
$1,600
Bond prices go down

$1,400
$1,200
$1,000
3 yr bond
$800
15 yr bond
$600
$400
$200 As interest rates go up
$-
5% 10% 15%
Semi-Annual Compounding
Using Excel
If we had the same bond, but with semi-annual coupon

payments, we would have to divide the 10% coupon rate by
two, divided the discount rate by two, and multiply n by two.
For the original
Coupon Interest ($) $ 50 example, divide the 10%
Maturity (periods) 6 coupon by 2, divide
Face Value ($) $ 1,000 the 15% discount rate
Market Interest Rate (%) 3% by 2, and multiply
Market Price ($) ($1,137.70) 3 years by 2.
Semi-Annual Compounding
Using Excel
If we had the same bond, but with semi-annual coupon

payments, we would have to divide the 10% coupon rate by
two, divided the discount rate by two, and multiply n by two.
Finding the Value of a Bond Thus, the value is
slightly larger than the
Coupon Interest ($) $ 50 price of the annual
Maturity (periods) 6 coupon bond (1,136.16)
Face Value ($) $ 1,000 because the investor
Market Interest Rate (%) 3% receives payments
Market Price ($) ($1,137.70) sooner.
Coupon Effects on Price Volatility
• The amount of bond price volatility depends on three
basic factors:
– length of time to maturity
– risk
– amount of coupon interest paid by the bond
• First, we already have seen that the longer the term to
maturity, the greater is a bond’s volatility
• Second, the riskier a bond, the more variable the
required return will be, resulting in greater price
volatility.
• The amount of bond price volatility depends on three
basic factors:
– length of time to maturity
– risk
– amount of coupon interest paid by the bond
• Finally, the amount of coupon interest also impacts a
bond’s price volatility.
• Specifically, the lower the coupon, the greater will be
the bond’s volatility, because it will be longer before
the investor receives a significant portion of the cash
flow from his or her investment.
10 Year Bond
Interest Price Price
Rate 5% Coupon 15% Coupon
0% $ 1,500 $ 2,500
10% $ 693 $ 1,307
20% $ 371 $ 790
$3,000
$2,500
$2,000
5% Coupon
$1,500
15% Coupon
$1,000
$500
$-
0% 10% 20%
Price Converges on Par at Maturity
• It is also important to note that a bond’s price will
approach par value as it approaches the maturity date,
regardless of the interest rate and regardless of the
coupon rate.
10% Coupon Bond

Interest Price Price
Rate 20 Years 1 Year
0% $ 3,000 $ 1,100
10% $ 1,000 $ 1,000
20% $ 513 $ 917
Price Converges on Par at Maturity
• It is also important to note that a bond’s price will
approach par value as it approaches the maturity date,
regardless of the interest rate and regardless of the
coupon rate.
$3,500
$3,000
$2,500
$2,000 20 Years
$1,500 1 Year
$1,000
$500
$-
0% 10% 20%
Yields
• The Current Yield measures the annual return to an
investor based on the current price.
Current = Annual Coupon Interest

Yield Current Market Price
For example, a 10% coupon bond which is currently
selling at $1,150 would have a current yield of:
Current = $100 = 8.7%

Yield $1,150
Yields
• The yield to maturity measures the compound annual
return to an investor and considers all bond cash
flows. It is essentially the bond’s IRR based on the
current price.
PV = I1 + I2 + … + (In + Pn)
(1+i)1 (1+i)2 (1+i)n
Notice that this is the same equation we saw earlier

when we solved for price. The only difference then is
that we are solving for a different unknown. In this
case, we know the market price but are solving for
return.
Yields
current price.
Using Excel
For Example, suppose we wished to determine the YTM
on the following bond.
Finding Yield to Maturity
Market Price ($) ($1,000.00)

Market Interest Rate (%) ?
Yields
current price.
Using Excel
Finding Yield to Maturity Period Cash Flow
0 ($1,000.00)
To compute the Market Price ($) ($1,000.00) 1 $ 100
yield on this bond Coupon Interest ($) $ 100 2 $ 100
we simply listed Maturity (periods) 10 3 $ 100
all of the bond Face Value ($) $ 1,000 4 $ 100
cash flows in a Market Interest Rate (%) 10% 5 $ 100
column and 6 $ 100
7 $ 100
computed the 8 $ 100
IRR =IRR(d10:d20) 9 $ 100
10 $ 1,100
Yields
current price.
• Note that the yield to maturity will only be equal if the
bond is selling for its face value ($1,000).
• And that rate will be the same as the bond’s coupon
rate.
• For premium bonds, the current yield > YTM.
• For discount bonds, the current yield < YTM.
Yields
• The yield to call is the yield earned on a callable bond.
• To calculate the yield to call, simply substitute the call
date for the maturity date plus the call premium if there
is one.
For Example, suppose we wished to determine the yield
to call (YTC) on the following bond where the call
premium is equal to one year extra coupon interest.
Finding Yield to Call
Market Price ($) ($1,000.00)

Call Premium $ 100
Market Interest Rate (%) ?
Yields
• The yield to call is the yield earned on a callable bond.
• To calculate the yield to call, simply substitute the call
date for the maturity date plus the call premium if there
is one. Finding Yield to Call Period Cash Flow
0 ($1.000,00)
Market Price ($) ($1.000,00) 1 $ 100
Coupon Interest ($) $ 100 2 $ 100
Maturity (periods) 10 3 $ 100
Face Value ($) $ 1.000 4 $ 100
Call Premium $ 100 5 $ 100
Market Interest Rate (%) 11% 6 $ 100
7 $ 100
8 $ 100
9 $ 100
10 $ 1.200
Risk and Yield Fluctuations
Bond Ratings and Yields for Bonds Maturing in 2007
S&P Bond Yield to

Bond Issue Rating Maturity
AT&T, 7 3/4, 07 AA 7.08%
Seagram & Sons, 8 5/8, 07 AA 7.16%
Long Island Lighting, 7 1/2, 07 BB+ 9.23%
Inland Steel, 9.9, 07 BB- 9.64%
Risk and Yield Fluctuations
Moody's Aaa versus Baa Yield Spread
17%
15%
13%
Aaa
Baa
11%
9%
7%
5%
1965 1970 1975 1980 1985 1990 1995 2000 Year
The Reinvestment Rate Assumption
• It is important to note that the computation of the YTM
implicitly assumes that interest rates are reinvested at
the YTM.
• In other words, if the bond pays a $100 coupon and
the YTM is 8%, the calculation assumes that all of the
$100 coupons are invested at that rate.
• If market interest rates fall, however, the investor may
be forced to reinvest at something less than 8%,
resulting a a realized YTM which is less than
promised.
• Of course, if rates rise, coupons may be reinvested at
a higher rate resulting in a higher realized YTM.
Differences Between Debt and Equity
Capital
Characteristic Debt Equity
Voice in management NO Yes
Claim on income and Senior to equity Subordinate to debt
assets
Maturity Stated None
Tax treatment Interest deduction No deduction
Common and Preferred Stock
Owner:
• Privately owned
• Closely owned (small group)
• Publicly owned (broad of group)
• Preemptive Rights (maintain proportionate
ownership)
• Dilution of ownership
• Right (purchase additional shares)
• Authorized shares
• Outstanding shares
• Treasury stock
• Issued stock
Voting Rights
• Super voting shares (multiple votes per share)
• Nonvoting common stock
• Proxy statement (giving the votes to another party)
• Proxy battle (attempt by a non management group)
Going Public
• Public Offering
• A right Offering
• Private placement
• Prospectus (key aspects of issue, issuer,
management and financial)
• Red herring (a preliminary prospectus
made available to prospective investors)
The selling process for large security
issue
Interpreting Stock Quotations
YTD 52 Weeks YLD vol Net

% CHG Hi Lo Stock (SYM) Div % PE 100s Last CHG
-5.6 15.70 9.40 Masisa ADS Mys .41e 3.4 …. 361 12.20 -0.05
+8.5 31 24.75 Mc Donalds MCD .23f 0.8 23 59195 28.72
+0.57
Common Stock Valuation
Stock Returns are derived from both dividends and
capital gains, where the capital gain results from the
appreciation of the stock’s market price.due to the
growth in the firm’s earnings. Mathematically, the
expected return may be expressed as follows:
E(r) = D/P + g
For example, if the firm’s $1 dividend on a $25

stock is expected to grow at 7%, the expected
return is:
E(r) = 1/25 + .07 = 11%

Stock Valuation Models
The Zero Growth Model
• The zero dividend growth model assumes that the

stock will pay the same dividend each year, year after
year.
• For assistance and illustration purposes, I have

developed a spreadsheet tutorial on Excel.
• A non-functional excerpt from the spreadsheet

appears on the following slide.
The Basic Stock Valuation Equation
D1 D2 D
PO    ... 
(1  k ) (1  k )
1 2
(1  k ) 
Using Excel
1. Zero Growth (Constant Dividend) Model
A. Solving for Price: V = D/k, where D = dividend and k = required return
What would an investor be willing to pay for a stock if she expected to receive
a dividend of $2.50 each year indefinitely and her required return is 15%?
D $ 2.50
k 15.00%
V? $ 16.67
Using Excel
B. Solving for Return: k = D/V
What rate of return would an investor expect if the current price of a stock
is $119 and she expected the firm to pay a constant dividend of $4/year?
V $ 119.00
D $ 4.00
k? 3.4%
The Constant Growth Model
• The constant dividend growth model assumes that the

stock will pay dividends that grow at a constant rate
each year -- year after year.

developed a spreadsheet tutorial using Excel

Using Excel
Valuation
(Note: The tables below have been w ritten using form ulas w hich allow you to alter the information or assum ptions.)
1. Constant Growth Model
A. Solving for Price: V = D0(1+g)/k-g = D1/(k-g) , where D0 = current dividend, k = required return,
and g = growth rate
What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividneds
to grow at a rate of 5% per year.
D0 $ 2.50
k 15.00%
g 5.00%
V? $ 26.25
Using Excel
B. Solving for Return: k = D0(1+g)/V + g = D1/V + g
What is my expected return on a stock that costs $26.50, just paid a

dividend of $2.50, and has an expected growth rate of 5%?
D0 $ 2.50
V $ 26.25
g 5.00%
k? 15.00%
Variable Growth Model
• The non-constant dividend growth model assumes
that the stock will pay dividends that grow at one rate
during one period, and at another rate in another year
or thereafter.
developed a spreadsheet tutorial available under the
heading “Course Materials” on Course Web-Page.
Using Excel
Valuation
(Note: The tables below have been w ritten using formulas
w hich allow you to alter the informatins or assumptions.)
1. Non-Constant Growth Model
A. Solving for Price: This model involves the computation of year-to-year dividends which
are then dicounted at the investors required rate of return.
to grow at a rate of 10% per year for the first two years, and then at a rate of
5% thereafter.
5% thereafter.
Step 1: Compute the expected dividends during the first growth period.
g 10.0%
D0 $ 2.50
D1 $ 2.75
D2 $ 3.03
5% thereafter.
Step 2: Compute the Estimated Value of the stock at the end of year 2
using the Constant Growth Model
D2 $ 3.03
k 15.00%
g 5.00%
V 2? $ 31.76
5% thereafter.
Step 3: Compute the Present Value of all expected cash flows
to find the price of the stock today.
Cash PV at
Flow 15%
1 D1 $ 2.75 $ 2.39
2 D2 $ 3.03 $ 2.29
3 V 2? $ 31.76 $ 20.88
V0 ? $ 25.56
Other Approaches to Stock Valuation
Book Value
• Book value per share is the amount per share that
would be received if all the firm’s assets were sold for
their exact book value and if the proceeds remaining
after paying all liabilities were divided among common
stockholders.
• This method lacks sophistication and its reliance on
historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship to
the firm’s value in the marketplace.
Liquidation Value
• Liquidation value per share is the actual amount per
share of common stock to be received if al of the firm’s
assets were sold for their market values, liabilities
were paid, and any remaining funds were divided
among common stockholders.
• This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
• However, it still fails to consider the earning power of
those assets.
Valuation Using P/E Ratios
• Some stocks pay no dividends. Using P/E ratios are
one way to evaluate a stock under these
circumstances.
• The model may be written as:
– P = (m)(EPS)
– where m = the estimated P/E multiple.
For example, if the estimated P/E is 15, and a

stock’s earnings are $5.00/share, the estimated
value of the stock would be P = 15*5 =
$75/share.
Weaknesses of Using P/E Ratios
• Determining the appropriate P/E ratio.

– Possible Solution: use the industry average P/E
ratio
• Determining the appropriate definition of earnings.
– Possible Solution: adjust EPS for extraordinary
items
• Determining estimated future earnings
– forecasting future earnings is extremely difficult
Decision Making and Common Stock Value
• Valuation equations measure the stock value at a
point in time based on expected return and risk.
• Any decisions of the financial manager that affect
these variables can cause the value of the firm to
change as shown in Figure 8.3 below.
Changes in Dividends or Dividend Growth
• Changes in expected dividends or dividend growth
can have a profound impact on the value of a stock.
Price Sensitivity to Changes in Dividends and Dividend Growth
(Using the Constant Growth Model)
D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00

g 3.0% 3.0% 3.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.58 $ 3.09 $ 2.06 $ 2.12 $ 2.18
kS 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
P $ 29.43 $ 36.79 $ 44.14 $ 29.43 $ 53.00 $ 218.00
Changes in Risk and Required Return
Price Sensitivity to Changes Risk (Required Return)

D0 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00

g 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
D1 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P $ 103.00 $ 45.78 $ 29.43 $ 21.68 $ 17.17 $ 14.21
Changes in Risk and Required Return
Price Sensitivity to Changes in Both Dividends and Required Return

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.50 $ 3.00

g 3.0% 6.0% 9.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.65 $ 3.27 $ 2.06 $ 2.65 $ 3.27
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P $ 103.00 $ 176.67 $ 327.00 $ 21.68 $ 29.44 $ 38.47

Principles of Managerial Finance: Bond & Stock Valuation

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Principles of Managerial

Bond & Stock Valuation

• Apply the basic bond valuation model to bonds and

• Explain yield to maturity (YTM), its calculation, and the

• Discuss the use of book value, liquidation value, and

• Understand the relationships among financial

Nominal><Real interest rate

Fund $10, cost of candy $ 0.25/piece,

• Example IBM 7s25

V0 = CF1 + CF2 + … + CFn

A bond is a long-term debt instrument that

(note that a bond = debt)

• A yield curve graphically shows the relationship

B0 = 100 + 100 + (100+1,000)

For example, find the price of a 10% coupon bond

Finding the Value of a Bond

Coupon Interest ($) $ 100

For example, find the price of a 10% coupon bond

Finding the Value of a Bond

What would happen to the bond’s price if interest

Finding the Value of a Bond

Coupon Interest ($) $ 100

What would happen to the bond’s price it had a 15

Finding the Value of a Bond

Coupon Interest ($) $ 100 And the longer the

What would happen to the original 3 year bond’s

Finding the Value of a Bond

Coupon Interest ($) $ 100 When interest rates

What if we considered a similar bond, but with a 15

Finding the Value of a Bond

Coupon Interest ($) $ 100 And the longer the

Bond prices go down

If we had the same bond, but with semi-annual coupon

If we had the same bond, but with semi-annual coupon

Effect of Changes in Interest Rates on Price

10% Coupon Bond

Current = Annual Coupon Interest

Current = $100 = 8.7%

Notice that this is the same equation we saw earlier

Market Price ($) ($1,000.00)

Market Price ($) ($1,000.00)

Bond Ratings and Yields for Bonds Maturing in 2007

S&P Bond Yield to

YTD 52 Weeks YLD vol Net

For example, if the firm’s $1 dividend on a $25

E(r) = 1/25 + .07 = 11%

• The zero dividend growth model assumes that the

• For assistance and illustration purposes, I have

• A non-functional excerpt from the spreadsheet

1. Zero Growth (Constant Dividend) Model

A. Solving for Price: V = D/k, where D = dividend and k = required return

B. Solving for Return: k = D/V

• The constant dividend growth model assumes that the

• For assistance and illustration purposes, I have

• A non-functional excerpt from the spreadsheet

1. Constant Growth Model

B. Solving for Return: k = D0(1+g)/V + g = D1/V + g

What is my expected return on a stock that costs $26.50, just paid a

1. Non-Constant Growth Model

For example, if the estimated P/E is 15, and a

• Determining the appropriate P/E ratio.

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00

Price Sensitivity to Changes Risk (Required Return)