Group 06
Habiba Mustafa Sumaiya Nishan Muhammad Kashif Hafiz Aamir Sohail Altaf Hussain

BOND VALUATION

BOND: long term debt
A security that pays a stated amount of interest to the investor, period after period until its maturity. Face value Coupon maturity

BOND VALUE  PV(bond)=PV(coupon payments)+PV(final payment) PV= PMT(1-1/(1+i)^n)/i + MV/(1+i)^n .

Factors affecting Bond prices Credit Quality Interest Rate Yield Tax Status .

Interest rate .

yield Yield is a figure that shows the return you get on a bond. Simplest version Yield= coupon amount/price .

prices of outstanding bonds rise.YIELD (Linking price and yield) • Most important thing to remember!!!! **When prevailing interest rates rise. . prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues **When prevailing prices fall. until the yield of older bonds is low enough to match the lower interest rate on new issues.

BOND VOLATILITY Volatility refers to the amount of uncertainty or risk about the size of changes in security’s value. Volatility=Duration/1+yield .

duration takes into account interest payments that occur throughout the course of holding the bond.BOND DURATION • Duration is a weighted measure of the length of time the bond will pay out. • Unlike maturity. .

Cont’d… .

Term structure/Yield Curve A "term structure of interest rates. . ranging from shortest to longest.“ also known as yield curve is a graph that plots the yield/spot rates of bonds against their maturities.

Forms of yield curve .

Cont’d… .

EXPECTATION THEORY The expectation theory says that: “Bonds are priced so that an investor who holds a succession of short bonds can expect the same return as another investor who holds a long bond.” .

select strategy offering highest return.INTRODUCING RISK In expectation theory risk factor must be considered. . If predicted future level of interest rates.

Inflation and Term structure • Suppose u are saving for your retirement. which of the following strategies is the more risky? • Invest in one-year or invest in 20-year bond? .

Inflation and nominal interest rates • How does inflation affect the nominal rate of interest? .

FISHER’S THEORY “A change in the expected inflation rate will cause the same proportionate change in the nominal interest rate. no effect on the required real interest rate”. 1+rnominal=(1+rreal)(1+i) .

. Inflation rate higher real return will be lower.REAL & NOMINAL INTEREST RATE In Real interest rate no inflation factor while in Nominal interest rate inflation factor exists.

0620=\$342.000 in a 20-year bond with a 10% coupon.99 .NOMINAL INTEREST RATE Real cash flowt=nominal cash flowt/1+inflation rate)t FOR EXAMPLE: If u were to invest \$1.100/1. if inflation rate=6% then real value would be =1.100. final payment would be \$1.

.INDEXED BONDS Bonds promised you a fixed nominal rate of interest.

Valuation of common stock .

How Common Stocks are Traded • Primary Market Trading through bank and OTC • Secondary Market Trading through Stock Exchange .

How Common Stocks are valued • PV(stock) = PV(expected future dividends) • Today’s Price The cash payoff to the owners of common stocks comes in two forms • Cash dividends • Capital gains or losses .

They also expect stock to sell for \$110 a year (p1=110) .Conti…d • Expected return = r = Divi1 + p1-p0/p0 Example Suppose Fledgling Electronics stock is selling for \$100 a share (p0=100). Investors expect a \$5 cash dividend over the next year (Div1=5).

Price = po = Div1+p1/(1+r) . if you are given investors forecasts of dividend and price and the expected return is same then you can predict today’s price.Conti’d Expected return = r = 5+(110-100)/100 r = 0.15 or 15% On the other hand.

Conit’d • If DIV1=5 and p1=110 and r=15%.15 =\$100 . then today's price should be 100: P0 = 5+110/1.

thus we can forecast p1 by forecasting DIV2 and p2 and we can express po in terms of DIV1. and p2: . DIV2. a year from now investor will be looking out at dividends in year 2 and price at the end of year 2.But what determines the Next Year’s Price • P1 = DIV2 + P2/(1+r) That is.

that implies a price at the end of the year 1 of P1 = 5.50+121/1.15 = \$110 .Conit…’d • Po=1/1+r(DIV1+p1)=1/1+r(DIV1+DIV2+p2/1+r) =DIV1/(1+r) + DIV2+p2/(1+r)*2 Example Suppose they are looking today for dividends of \$5.5 in year 2 and subsequent price of \$121.

15)*2 = \$100 .50+121/(1.Conti…d • From our expended formula P0 = 5/1.15 + 5.

Estimating the Cost of Equity Capital • Po = DIV1/ (r-g) • r = (DIV 1/p0) + g .

Danger lurk in Constant-Growth formula • Dividend growth rate = plowback ratio*ROE .

The link between stock price and Earning per share • Growth stock • Income stock Expected return =dividend yield=earning-p ratio If dividend is \$10 a share and stock price is \$100 then: Expected return=DIV1/P0 = 10/100 = .10 .

Conti.PVGO/Po) It will underestimate r if PVGO is +ve and overestimate it if PVGO is -ve .d The price equals P0= DIV1/r = EPS1/r = 10/. EPS/Po= r ( 1..10 =100 Po =EPS1/r+PVGO So.

Calculating PV of Growth Opportunities • Po= DIV1/r-g • Payout ratio = DIV1/EPS1 • Growth rate= g = plowback ratio*ROE • Present value of level stream of earnings= EPS/r • PVGO = NPV1/r-g • Share price = EPS1/r +PVGO .

• Value today always equals future cash flow discounted at the opportunity cost of capital .Valuing a Business by Discounting Cash Flow • In this you forecast dividend per share or total free cash flow of a business.

Valuing the Concatenator Business • PV= FCF/1+r + FCF2/(1+r)^2 +….+FCF/(1+r)^H + PV/(1+r)^H .

• It can also be calculated normal price-earnings or market-book ratios at the horizon date . which allow us to growing-perpatuity DCF formula.Estimating Horizon Value • Forecasting reasonable horizon is particularly difficult. The usual assumption is moderate long rum growth after the horizon.