Financial Management

For
MBA Program

Banbul Shewakena
(Assistant Professor of Financial Management)

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 Chapter 4

Bond and Stock

Evaluation

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4.1.1 What is bond and Who issue a bond?

• A bond is a debt contract that specifies a

fixed set of cash flows which the issuer has
to pay to the bondholder.
• The cash flows consist of a coupon (interest)
payment until maturity as well as
repayment of the par value of the bond at
maturity.

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 4.1.2. Types of a Bond
Investors have many choices when investing in
bonds, but bonds are classified into four main
types:
 Treasury,
 Corporate,
 Municipal, and
 Foreign.
Each type differs with respect to expected
return and degree of risk.
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 1. Treasury Bonds
• Treasury bonds, sometimes referred to as
government bonds, are issued by the U.S. federal
government.
• It is reasonable to assume that the federal
government will make good on its promised
payments, so these bonds have almost no
default risk.
• However, Treasury bond prices decline when
interest rates rise, so they are not free of all risks.
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 2. Corporate Bonds
• Corporate bonds, as the name implies, are issued by
corporations.
• Unlike Treasury bonds, corporate bonds are
exposed to default risk—if the issuing company gets
into trouble, it may be unable to make the
promised interest and principal payments.
• Different corporate bonds have different levels of
default risk, depending on the issuing company’s
characteristics and the terms of the specific bond.
• Default risk is often referred to as “credit risk,” and
the larger the credit risk, the higher the interest rate
the issuer must pay. 6
 3. Municipal bonds
• Municipal bonds, or “munis,” are issued by state
and local governments.
• Like corporate bonds, munis have default risk.
However, munis offer one major advantage:
• The interest earned on most municipal bonds is
exempt from federal taxes and also from state
taxes if the holder is a resident of the issuing
state.
• Consequently, municipal bonds carry interest
rates that are considerably lower than those on
corporate bonds with the same default risk.
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 4. Foreign bonds
• Foreign bonds are issued by foreign governments or
foreign corporations.
• Foreign corporate bonds are, of course, exposed to
default risk, and so are some foreign government
bonds.
• An additional risk exists if the bonds are denominated
in a currency other than that of the investor’s home
currency.
• For example, if a U.S. investor purchases a corporate
bond denominated in Japanese yen and if the yen
subsequently falls relative to the dollar, then the
investor will lose money even if the company does not
default on its bonds. 8
 4.1.3. Some Concepts about Bond
Par Value
• The par value is the stated face value of the bond;
for illustrative purposes, we generally assume a
par value of $1,000.
• In practice, some bonds have par values that are
multiples of $1,000 (for example, $5,000) and
some have par values of less than $1,000 (Treasury
bonds can be purchased in multiples of $100).
• The par value generally represents the amount of
money the firm borrows and promises to repay on
the maturity date.
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 Some concepts…
Coupon Interest Rate
• Bonds require the company to pay a fixed number of
dollars of interest every year (or, more typically, every
6 months).
• When this coupon payment, as it is called, is divided
by the par value, the result is the coupon interest
rate. For example, bonds have a $1,000 par value, and
they pay $100 in interest each year.
• Then bond’s coupon interest is $100/$1,000 = 10%.
• The coupon payment, which is fixed at the time the
bond is issued, remains in force during the life of the
bond.
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 Some concepts…
Maturity Date
• Bonds generally have a specified maturity date on
which the par value must be repaid.
• Most bonds have original maturities (the maturity
at the time the bond is issued) ranging from 10 to
40 years, but any maturity is legally permissible.
• Of course, the effective maturity of a bond
declines each year after it has been issued. A
bonds which have a 15-year original maturity, but
a year later, they will have a 14-year maturity, and
so on.
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4.1.4. Valuing Bonds Using Present Value
Formulas
•The value of a bond is equal to the present
value of the future cash flows:
1.Value of bond = PV(cash flows) =
PV(coupons) + PV(par value)
•Since the coupons are constant over time and
received for a fixed time period the present
value can be found by applying the annuity
formula.
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 4.1.4. Valuing Bonds Using Present Value
Formulas
Example
11. Suppose ABC company issues 3years bond
with par value of 1000 ETB, that pays 4%
interest rate annually, which is also prevailing
market interest rate. What is the PV of the
payment?

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4.1.4. Valuing Bonds Using Present Value
Formulas
• Solution
• Value of the bond= VPV= c1/(1+i)n +C2/(1+i)n+
…..+ Cn/(1+i)n
= 40/(1+0.04)1 + 40/(1+0.04)2 + 1040/(1.0.04)3
=

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 Valuing Bonds…

• Bond prices change when the interest rate

changes, the rate of return earned on the bond
will fluctuate with the interest rate.
• Thus, the bond is subject to interest rate risk.
• All bonds are not equally affected by interest
rate risk, since it depends on the sensitivity to
interest rate fluctuations.
• The interest rate required by the market on a
bond is called the bond's yield to maturity.
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 Valuing Bonds…

• Yield to maturity is defined as the discount rate

that makes the present value of the bond equal
to its price.
• Moreover, yield to maturity is the return you
will receive if you hold the bond until maturity.
• Note that the yield to maturity is different from
the rate of return, which measures the return
for holding a bond for a specific time period.

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 Valuing Bonds…

•The yield to maturity required by

investors is determined by:
1.Interest rate risk
2.Time to maturity
3.Default risk

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 Valuing Bonds…

Generally, there exist five important relationships related to a

bond's value:
1. The value of a bond is inversely related to changes in the
interest rate. Is it true?
• PV= c1/(1+i)n C2/(1+i)n+…..+ Cn/(1+i)n
2. Market value of a bond will be less than par value if
investor’s required rate is above the coupon interest rate.
3. As maturity approaches the market value of a bond
approaches par value.
4. Long-term bonds have greater interest rate risk than do
short-term bonds .
5. Sensitivity of a bond’s value to changing interest rates
depends not only on the length of time to maturity, but also on
the patterns of cash flows provided by the bond. 18
 BONDS WITH SEMIANNUAL COUPONS
• Although some bonds pay interest annually, the vast majority
actually pay interest semiannually.
• To evaluate semiannual payment bonds, we must modify the
valuation model as follows.
1. Divide the annual coupon interest payment by to determine
the dollars of interest paid every 6 months.
2. Multiply the years to maturity, N, by 2 to determine the
number of semiannual periods.
3. Divide the nominal (quoted) interest rate, rd, by 2 to
determine the periodic (semiannual) interest rate.
• By making these changes, we obtain the following equation
for finding the value of a bond that pays interest
semiannually: 19
• PV= c1/2 + C2/2+……. + M
(1+i/2)n (1+i/2)n+…..+ Cn/(1+i)2n

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 4.2. Stock Valuation
What is stock?
• Stock is an equity instrument.
• It is a major source of financing.
• Is an asset that is expected to generate benefit in the
future.
• If you buy a bond and stock you will become investor.
What is the d/ce b/n bond and stock?
• Bond is debt instrument
• If you buy a bond you will get interest and principal
 Stock is an equity instrument
 If you buy a stock you will get dividend
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 Types of stock

1. Common
2. Preferred stock.

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 The difference between
preferred and common stock 
• Common • have no voting right
• Dividend is paid first
stock provides voting
• Fixed or regular dividend
rights to payment
shareholders. • Preferred shareholders have
priority over a company's
 Dividend is variable income, meaning they are paid
dividends
before common shareholders.
• Have x’s of both bond and
stock.
• When the business ceases
come first to get the cash
distribution
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 Valuing stock
 A share of common stock is more difficult to value
in practice than a bond, for at least three reasons.
 1st, with common stock, not even the promised cash
flows are known in advance.
 2nd, the life of the investment is essentially forever,
since common stock has no maturity.
 3rd, there is no way to easily observe the rate of return
that the market requires.
• Nonetheless, as we will see, there are cases in
which we can come up with the present value of
the future cash flows for a share of stock and thus
determine its value.
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 4.2.2. Valuing Stocks Using Present Value Formulas:
The Dividend Discount Model
• The price of a stock is equal to the present value
of all future dividends. The intuition behind this
insight is that the cash payoff to owners of the
stock is equal to cash dividends plus capital gains
or losses. Thus, the expected return that an
investor expects from investing in a stock over a
set of period of time is equal to:

• At the limit, the current stock price, P0 , can be

expressed as the sum of the present value of all
future dividends. 25
 Special circumstance
• There are a few very useful special circumstances
under which we can come up with a value for the
stock.
• What we have to do is make some simplifying
assumptions about the pattern of future dividends.
• The three cases we consider are the following:
(1) the dividend has a zero growth rate,
(2) the dividend grows at a constant rate, and
(3) the dividend grows at a constant rate after some
length of time.
We consider each of these separately.
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 Case1: Zero Growth
• A share of common stock in a company with a
constant dividend is much like a share of
preferred stock.
• we know that the dividend on a share of
preferred stock has zero growth and thus is
constant through time.
• For a zero growth share of common stock, this
implies that:
D1 = D2 = D3 = D constant
• So, the value of the stock is:
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 Case1: Zero Growth …
P0= D/R
where R is the required return.
• For example, suppose the Paradise Prototyping
Company has a policy of paying a $10 per share
dividend every year. If this policy is to be
continued indefinitely, what is the value of a share
of stock if the required return is 20 percent?
Solution
• The stock in this case amounts to an ordinary
perpetuity, so the stock is worth $10/.20 $50 per
share. 28
 Case2: Constant Growth Model
Discounted Dividend Growth Model:
The Gordon Growth Model
• In cases where firms have constant growth
in the dividend a special version of the
discounted dividend model can be applied.
• If the dividend grows at a constant rate, g,
the present value of the stock can be found
by applying the present value formula for
perpetuities with constant growth.
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Case2: Constant Growth Model…

Example 1
• The next dividend for the Gordon Growth
Company will be $4 per share. Investors
require a 16 percent return on companies
such as Gordon. Gordon’s dividend increases
by 6 percent every year. Based on the
dividend growth model, what is the value of
Gordon’s stock today? What is the value in
four years?
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 Case2: Constant Growth Model…
• The only tricky thing here is that the next
dividend, D1, is given as $4, so we won’t multiply
this by (1 + g). With this in mind, the price per
share is given by:
P0 = D1/(R - g)
where, D1 = D0(1+g), but D1 is already given
= $4/(.16 - .06)
= $4/.10
= $40
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 Case3: Differential Growth
• It is where there is a different growth is observed
• Algebric formula would be too un-widely. Thus
lets present with example

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Two-stage dividend growth
• Consider a share of common stock whose dividend
is currently $2.00 per share and is expected to
grow at a rate of 10 percent per year for two years
and afterward at a rate of 4 percent per year.
• Assume a required rate of return of 6 percent.
• To tackle this problem, identify the cash flows for
the first stage, calculate the price at the end of the
first stage, and then assemble the pieces:
• P =$2.0755+2.1538+112.00=$116.23
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• Solution
• PV of each cash flow stream
• PV=

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 Case3: Differential Growth
Example
This is a tricky one, so again, let’s do an example.
Consider a firm that just paid a dividend of
$2.60. They plan to increase dividends by 5% in
year one, 10% in year two, 20% in year three,
20% in year four, and then 3% per year
thereafter. You feel that a 16% required return is
appropriate. What is this stock worth to you?

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Step 1 — Forecast the Dividends
D1 = $2.60*(1.05) = $2.73
D2 = $2.73*(1.10) = $3.00
D3 = $3.00*(1.20) = $3.60
D4 = $3.60*(1.20) = $4.32
D5 = $4.32*(1.03) = $4.45

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• Note: We stop in year five because that is the
first year of constant growth. There is no need
to forecast dividends any further since once
they are growing at a constant rate (in the
timeline below, you can see that after year 4,
all dividends are growing at 3% per year
through infinity), we can apply the Constant
Growth Model discussed above which leads to
Step 2.
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• Step 2 — Use the Constant-Growth Model to Forecast
Price

P{4}={$4.45}/{.16-.03}=$34.23

Note: Be careful here as this is a confusing, but critical

detail. When we apply the constant-growth model we use
next year’s dividend to get this year’s price. Since we are
using year five’s dividend, the first dividend of the
constant-growth stage, it will tell us the price in year four –
not year five. This price represents the present value of all
dividends paid from year five and beyond as of year four.
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THANK
YOU

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