VALUATION AND

RATES OF RETURN
 VALUATION CONCEPTS

• VALUATION OF A FINANCIAL ASSET IS BASED ON

DETERMINING THE PRESENT VALUE OF FUTURE CASH
FLOWS
• THE DISCOUNT RATE USED IS INVESTORS’ REQUIRED RATE
OF RETURN, BASED ON THE MARKET’S ESTIMATES OF RISK,
EFFICIENCY, AND EXPECTED FUTURE RETURNS
• A BOND PROVIDES AN ANNUITY STREAM OF INTEREST
PAYMENTS AND A PRINCIPAL PAYMENT AT MATURITY.

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 VALUATION OF BONDS (CONT’D)

• TO DETERMINE THE VALUE/PRICE OF BOND WE NEED

PV OF INTEREST PAYMENT AND PV OF FACE VALUE OF
BOND. AS INTEREST PAYMENT IS AN ANNUITY WE HAVE
TO CALCULATE PRESENT VALUE ANNUITY TO
CALCULATE ITS PV.
1
1-
(1+Y)n FV
Bond value = It +
Y (1+Y)n

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 VALUATION OF BONDS (CONT’D)

• ASSUMING INTEREST RATE IS 10%. INTEREST PAYMENTS ( ) = $100;

PRINCIPAL PAYMENTS AT MATURITY ( ) = $1,000; YIELD TO
MATURITY (Y) = 6% AND TOTAL NUMBER OF PERIODS (N) = 20.
THUS, THE PRICE OF BONDS ( );
• WHERE:
• = PRICE OF THE BOND; = INTEREST PAYMENTS; =
PRINCIPAL PAYMENT AT MATURITY; T = NUMBER CORRESPONDING
TO A PERIOD (RUNNING FROM 1 TO N); N = NUMBER OF PERIODS; Y
= YIELD TO MATURITY (OR REQUIRED RATE OF RETURN)
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 1. Answer:

1 FV = Face value
1- $1,000
Bond price = $100 (1+.06)20 + i = interest rate = 10%
(1+.06)20 It = interest payment= ($1000*
0.06
0.10) = $100
Y = yield to maturity = 6%
n = no. of periods = 20 years
Bond value = ($100 * 11.470) + $311.82
= $1,147 + $311.82
= $1,458.82
CONCEPT OF YIELD TO MATURITY

• THE YIELD TO MATURITY OR THE DISCOUNT RATE IS THE

REQUIRED RATE OF RETURN REQUIRED BY BONDHOLDERS
• THREE FACTORS INFLUENCE THE REQUIRED RATE OF
RETURN:
• REQUIRED REAL RATE OF RETURN
• INFLATION PREMIUM
• RISK PREMIUM

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 DETERMINING YIELD TO MATURITY
FROM THE BOND PRICE
• THE YIELD TO MATURITY (Y), THAT WILL EQUATE THE
INTEREST PAYMENTS ( ) AND THE PRINCIPAL
PAYMENTS ( ) TO THE PRICE OF THE BOND ( )

• ASSUMING THAT A 15 YEAR BOND PAYS $110 PER YEAR (11%) IN

INTEREST AND $1,000 AFTER 15 YEARS IN PRINCIPAL
REPAYMENT
• CHOOSING AN INITIAL PERCENTAGE TO TRY AS A DISCOUNT
RATE, WE HAVE:

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 FORMULA FOR BOND YIELD

• WEIGHTED AVERAGE IS USED TO GET THE AVERAGE

INVESTMENT OVER 15 YEAR HOLDING PERIOD

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 VALUATION AND PREFERRED STOCK

• WHERE,
- THE PRICE OF THE PREFERRED STOCK; = THE ANNUAL
DIVIDEND FOR THE PREFERRED STOCK (CONSTANT = REQUIRED
RATE OF RETURN (DISCOUNT RATE) APPLIED TO PREFERRED STOCK
DIVIDENDS
• ASSUMING, THE ANNUAL DIVIDEND IS $10, AND THE STOCKHOLDER
REQUIRES A 10% RATE OF RETURN, THE PRICE OF THE PREFERRED
STOCK WOULD BE:

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 Valuation of Common Stock
NO GROWTH IN DIVIDENDS
• THE COMMON STOCK PAYS A CONSTANT DIVIDEND AS IN THE CASE OF A
PREFERRED STOCK
• THIS IS NOT A VERY POPULAR OPTION

• WHERE,
• = PRICE OF THE COMMON STOCK; = CURRENT ANNUAL COMMON
STOCK DIVIDEND (CONSTANT); = REQUIRED RATE OF RETURN FOR
COMMON STOCK

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• ASSUMING = $1,86 AND = 12%, THE PRICE OF THE STOCK WOULD BE:
 Valuation
CONSTANT ofDIVIDEND
GROWTH Common Stock
VALUATION
MODEL
• WHERE:

= PRICE OF THE STOCK TODAY

• = DIVIDEND AT THE END OF THE FIRST YEAR
• = REQUIRED RATE OF RETURN (DISCOUNT RATE)
• G = CONSTANT GROWTH RATE IN DIVIDENDS
• BASED ON THE CURRENT EXAMPLE; = $2.00; = .12; G = .07. IS
COMPUTED AS:
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 DETERMINING THE REQUIRED RATE
OF RETURN FROM THE MARKET
PRICE
• DETERMINING THE REQUIRED RATE OF RETURN, KNOWING THE FIRST YEAR’S
DIVIDEND, THE STOCK PRICE, AND THE GROWTH RATE (G):

• ASSUMING;
= REQUIRED RATE OF RETURN (TO BE SOLVED)
• = DIVIDEND AT THE END OF THE FIRST YEAR, $2.00
• = PRICE OF THE STOCK TODAY, $40
• G = CONSTANT GROWTH RATE 7%, WE HAVE:

= $2.00 + 7% = 5% + 7% = 12%
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$40