Chapter IV(Suplimentary) : Valuation of Stock and Bonds

3.1 Legal Rights and Privileges of Common Stockholders

The common stockholders are the real owners of the company, and as such they have certain
rights and privileges. These rights and privileges of common stockholders are established by the
term of the charter and laws of the state in which the company is registered. Common
stockholders have some specific rights as individual owners. Some important rights are as
follows:

1. Right to Share Income and Assets

Common stockholders have the right to share company's earnings equally on a per-share basis.
Similarly, in the event of liquidation, stockholders have claim on assets that remain after meeting
the obligation to accrued taxes, accrued salary and wages, creditors including bondholders and
preferred stockholders. Thus, common stockholders are residual claimants of the firm's income
and assets.

2. Control of the Firm

Common stockholders control the firm through their right to elect the company's board of
directors, which appoints management. In a small firm, the largest stockholder typically holds
the position of president or chairperson of the board of directors. In a large publicly owned firm,
the managers have some stock, but their personal holdings are insufficient to provide voting 1
control. Thus, the shareholders remove the management if they do not perform effectively.
 Cont …
3. Preemptive Right
• Preemptive right is a privilege offered to existing shareholders for buying a
specified number of shares of the company's stocks before the stocks are
offered to outsiders for sale. It is a provision in company's charter or by-laws
that gives the existing shareholders right to purchase new shares at a
subscribed price on pro-rate basis. Each stockholder receives one right for
each share of stock owned. If the company sells new shares to the existing
stockholders, it is called right offering.

4. Voting Right
Common stockholders can attend at annual general meeting to cast vote or use a
proxy. A proxy is a legal document given one person the authority to cast vote
and represent on behalf of others. Generally, each share of stock has one vote
for each director at the general meeting. Thus, the owner of 1,000 shares has
1,000 votes for each director to be elected.

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 3.2. Common stock valuation

• A fundamental assertion of finance holds that a security’s value is based on

the present value of its future cash flows. Accordingly, common stock
valuation attempts the difficult task of predicting the future. Valuing a
firm’s equity involves the same ideas introduced for valuing a firm’s debt
instruments
To value a firm’s stock
1. Determine the expected cash flows
2. Calculate the present value of the cash flows
Valuing stock, however, is more complicated than valuing bonds because the
cash flows are not contractually specified or fixed.

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 Cont …
Note:
A stock’s cash flow consists of:
• Stream of dividend payments received during ownership of stock
• The sale price for the stock upon deciding to sell
• The dividend stream may continue indefinitely
• The dividend stream may be finite
• The dividend stream may change over time
• There may be no dividend stream

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 Cont…
Let’s calculate the rate of return for holding a stock for one Period (holding
period return). Given the following facts;
P0 = today’s price of the stock
P1 = next year’s price
D1 = next year’s dividend
HPR = r = [P1 + D1 - P0]/P0
Example1
Given P0 = 100, P1 = 110, and D1 = 5. Solve for r:

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 Stock valuation models

Reading Assignment

1.Dvidend Discount models (DDM)

-Zero growth model
-Constant growth Model

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 3.3. Bond valuation

What is bond and Who issues Bond ?

• A bond 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.
• 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.
• 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.

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 Cont …

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.

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 Cont…
Municipal bonds, or “munis,” are issued by state and local
governments. Like corporate bonds, munis have no 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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 Cont …
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.

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 Cont …
note
The issuance and marketing of bonds to the public does not happen
overnight. It usually takes weeks or even months. First, the
issuing company must arrange for underwriters that will help
market and sell the bonds. Then, it must obtain the Securities and
Exchange Commission’s approval of the bond issue, undergo
audits, and issue a prospectus (a document which describes the
features of the bond and related financial information). Finally,
the company must generally have the bond certificates printed.
Frequently, the issuing company establishes the terms of a bond
indenture well in advance of the sale of the bonds. Between the
time the company sets these terms and the time it issues the
bonds, the market conditions and the financial position of the
issuing corporation may change significantly. Such changes affect
the marketability of the bonds and thus their selling price.
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 Value of bond

The selling price of a bond issue is set by the supply and demand of
buyers and sellers, relative risk, market conditions, and the state
of the economy. The investment community values a bond at the
present value of its expected future cash flows, which consist
of (1) interest and (2) principal. The rate used to compute the
present value of these cash flows is the interest rate that provides
an acceptable return on an investment commensurate with the
issuer’s risk characteristics. The interest rate written in the terms
of the bond indenture (and often printed on the bond certificate)
is known as the stated, coupon, or nominal rate. The issuer of
the bonds sets this rate. The stated rate is expressed as a
percentage of the face value of the bonds (also called the par
value, principal amount, or maturity value).

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 Cont …
• If the rate employed by the investment community (buyers)
differs from the stated rate, the present value of the bonds
computed by the buyers (and the current purchase price) will
differ from the face value of the bonds. The difference
between the face value and the present value of the bonds
determines the actual price that buyers pay for the bonds. This
difference is either a discount or premium.1
• If the bonds sell for less than face value, they sell at a discount.
• If the bonds sell for more than face value, they sell at a
premium.

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 Cont…

• The rate of interest actually earned by the bondholders is called

the effective yield or market rate. If bonds sell at a discount,
the effective yield exceeds the stated rate. Conversely, if bonds
sell at a premium, the effective yield is lower than the stated
rate. Several variables affect the bond’s price while it is
outstanding, most notably the market rate of interest. There is an
inverse relationship between the market interest rate and the
price of the bond.
Note :
• Like any financial asset, the value of a bond is the present value
of the cash flows that the bond is expected to produce.
• Bond value = Sum of Present value of the coupons + Present
value of the face amount
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 Cont …

Example 1
• Assume that ServiceMaster issues $100,000 in bonds, due in five years
with 9 percent interest payable annually at year-end. At the time of issue,
the market rate for such bonds is 11 percent.
• Determine the value of the bond
• VB(sp) = PV of the principal + PV of periodic interest payments
= 100,000/ (1+0.11)5 + R ( PVF-OAn,i)
Where
• R= periodic interest payment= $9000

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 Cont …

Thus, PV of principal =$59,345

PV of periodic interest =9000(1- ____1__=$33,263.10
(1+0.11)5
0.11
• Value of the bond = $92,608.10
Reading Assignment:
Try to understand how to Determine the value of bond when
periodic interest payment is semi
annual ,quarterly ,monthly ,and daily .

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Changes in Bond Values over Time

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 Cont …
1. Whenever the going rate of interest, rd, is equal to the coupon rate, a
fixed rate bond will sell at its par value. Normally, the coupon rate is set
equal to the going rate when a bond is issued, causing it to sell at par
initially.
2. Interest rates do change over time, but the coupon rate remains fixed
after the bond has been issued. Whenever the going rate of interest rises
above the coupon rate, a fixed-rate bond’s price will fall below its par
value. Such a bond
is called a discount bond.
3. Whenever the going rate of interest falls below the coupon rate, a fixed-
rate bond’s price will rise above its par value. Such a bond is called a
premium bond.
4. Thus, an increase in interest rates will cause the prices of outstanding
bonds to fall, whereas a decrease in rates will cause bond prices to rise.
5. The market value of a bond will always approach its par value as its
maturity date approaches, provided the firm does not go bankrupt. 18
 Cont …

• These points are very important, for they show that bondholders
may suffer capital losses or make capital gains, depending on
whether interest rates rise or fall after the bond was purchased.

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 Assessing Risk of Bond

Interest Rate Risk

• Interest rates go up and down over time, and an increase in
interest rates leads to a decline in the value of outstanding
bonds. This risk of a decline in bond values due to rising interest
rates is called interest rate risk. rising rates cause a loss of
value for bondholders. Thus, people or firms who invest in
bonds are exposed to risk from changing interest rates.

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 Cont …

• Another important risk associated with bonds is default risk. If

the issuer defaults, investors receive less than the promised
return on the bond. Therefore, investors need to assess a
bond’s default risk before making a purchase. Note that the
quoted interest rate includes a default risk premium (DRP),the
greater the default risk, the higher the bond’s yield to
maturity. The default risk on Treasury securities is zero, but
default risk can be substantial for corporate and municipal
bonds.

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 Summary on Stock Valuation
Theories and Models of Stock Valuation

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 Cont …
The Dividend Discount Model: estimate the intrinsic value for the
stock and compare it with the market price to determine if the
stock in the market is over-priced or under-priced.
• (1) Zero growth model (the dividend growth rate, g = 0) It is a
perpetuity model:
• P = D/Rs
For example, if D = $2.00 and rs = 10%,then po =$20
• If the market price (P0) is $22, what should you do? You should
not buy it because the stock is over-priced

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 Cont …
The Growth rate g is expected rate of growth in dividends
g = ROE * retention ratio
Retention ratio = 1 - dividend payout ratio
• The growth rate (g) plays an important role in stock valuation
(2) Constant growth model (the dividend growth rate, g =
constant)
Po=D1/rs-g= Do*(1+g)
rs-g

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 Cont …
Class Activity
D0 = $2.00, g = 5%, rs = 10%, then Po=?
po=$42
If the market price is $40, what should you do? You should buy it
because the stock is under-priced

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