# FI 3300 – Chapter 9 Valuation of Stocks and Bonds  2018-09-29 3K 3 0 0

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Instructor: Ryan Williams. Learning Objectives. Value a bond given its coupon rate, par value, yield-to-maturity, time to maturity and payment frequency.. Given all but one of the factors of a bond’s value, find the remaining factor.. ID: 682017 Download Presentation

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## FI 3300 – Chapter 9 Valuation of Stocks and Bonds

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### Presentations text content in FI 3300 – Chapter 9 Valuation of Stocks and Bonds

Slide1

FI 3300 – Chapter 9Valuation of Stocks and Bonds

Instructor: Ryan Williams

Slide2

Learning Objectives

Value a bond given its coupon rate, par value, yield-to-maturity, time to maturity and payment frequency.

Given all but one of the factors of a bond’s value, find the remaining factor.

Value a stock using the dividend discount model under assumptions of constant growth and non-constant growth.

Given all but one of the factors of a stock’s value, find the remaining factor.

Slide3

Remember – different words for the same thing

Cost of capital (from firm’s point of view) = required rate of return (from investor’s point of view) = interest rate in problems.

Cost of debt = investor’s required rate of return on debt

Cost of equity = investor’s required rate of return on equity.

Slide4

What is a financial security?

It’s a contract between the provider of funds and the user of funds.

The contract specifies the:

amount of money that has been provided

terms & conditions of how the

user

is going to repay the

provider

Provider: you (ordinary investor), the bank, venture capitalist, etc.

User: entrepreneur or firm with good business idea/product but no (or not enough) money to execute the idea.

Slide5

TVM and valuing financial securities

To an investor who owns a financial security (a stock or a bond), the security is a stream of future expected cash flows.

The value of any security is the Present Value of all the future expected cash flows from owning the security, discounted at the appropriate discount rate (required rate of return).

When we learn to value stocks and bonds later, we are just applying TVM concepts we already know.

Slide6

Common financial securities

Debt security

Equity security

1) Holder is a creditor of the firm.

No say in running of the firm.

1) Holder is an owner of the firm.

Have a say in running of the firm (by voting).

2) Fixed payment.

2) Payment is not fixed. No guaranteed cash flow from firm.

3) Receives payment before anything is paid to equity holders.

3) Receives what’s left over after all debt holders/creditors are paid.

4) If firm cannot pay, debt holders will take over ownership of firm assets.

4) If firm cannot pay debt holders, loses control of firm to debt holders.

5) Limited liability.

5) Limited liability.

Slide7

Types of debt securities

Fixed-coupon bonds

Zero-coupon bonds

Consols

(Perpetual bonds)

Variable-rate bonds

Income bonds

Convertible bonds

Callable bonds

Slide8

Fixed coupon bonds

Firm pays a

fixed amount (‘coupon’)

to the investor every

period

until bond matures.

At maturity, firm pays

face value

of the bond to investor.

Face value also called par value. Most common face value is \$1000.

Period:

can be year, half-year (6 months), quarter (3 months).

Slide9

General Motors 30 year bond

Par Value = \$1000

Interest paid Semi-annual

Interest Rate = 8%.

Slide10

Zero coupon and consul bonds

Zero-coupon bond

Zero coupon rate, no coupon paid during bond’s life.

Bond holder receives one payment at maturity, the face value.

Consol bond

Pays a fixed coupon every period forever.

Has no maturity.

Slide11

Other types of bonds

Variable-rate bond: Coupon rate is not fixed, but is tied to a specific interest rate.

Income bond: pays the coupon only when borrower’s earnings are high enough.

Convertible bond: allows holder to convert it to another security, usually issuer’s common stock.

Callable bond: issuer has the right to buy back the bond (before maturity) at a predetermined price.

Slide12

Equity securities

Equity security means common stock.

Common stock holders have control privileges, i.e., have a say in firm’s operating decisions.

Exercise control privileges by

voting

on matters of importance facing the firm. Voting takes place during shareholder meetings.

Board of directors: Elected by shareholders to make sure management acts in the best interests of shareholders.

Common stock holders can expect two types of cash flows:

Dividends

Slide13

Preferred Stock

Owners of preferred stock are paid after payment to debt holders, but before payment to equity holders.

No maturity.

Has stated par value and stated dividend.

Firm can omit paying preferred stock dividend without going into default.

Usually non-voting.

Slide14

Stock/Bond payoffs

Pretend a firm only exists for one year, and debt has face value of \$600,000. The distribution of funds is as follows:

Total

Profit

\$1,000,000

\$800,000

\$600,000

\$400,000

Profit to

debt holders

\$600,000

\$600,000

\$600,000

\$400,000

Profit to equity holders

\$400,000

\$200,000

\$0

\$0

Slide15

Securities Markets

Securities markets: markets for the trading of financial securities.

Primary market:

Markets in which companies raise money by selling securities to investors.

Every security sells only once in the primary market.

Initial public offering market: firms become publicly owned by issuing (selling) shares to investors for the first time.

Secondary market:

Trading is primarily among investors. Issuers are usually not involved.

Slide16

Securities Markets

Money market: markets for trading of debt securities with less than one-year maturity.

Capital markets: market for trading of intermediate-term and long-term debt and common stock.

Spot markets: securities are bought and sold for ‘on-the-spot’ delivery.

Futures markets: trading takes place now, but full payment and delivery of the asset takes place in the future, e.g., 6 months or 1-year.

Slide17

Console is just a perpetuity!

Price of consol

=

Slide18

All debt securities have similar form

Will list a “par value” and a coupon rate.

Par value is NOT Present Value, and

Coupon rate is NOT the cost of debt/required rate of return

Slide19

Consol problem

Problem 9.2

ABC Corp. wants to issue perpetual debt in order to raise capital. It plans to pay a coupon of \$90 per year on each bond with face value \$1,000.

Consols

of a comparable firm with a coupon of \$100 per year are selling at \$1,050. What is the cost of debt capital for ABC? What will be the price at which it will issue its

consols

?

Slide20

Consol problem

Problem 9.3

If ABC (from the problem above) wanted to raise \$100 million dollars in debt, how many such

consols

would it have to issue (to nearest whole number)?

Slide21

Consol problem

Problem 9.4

If ABC wanted to issue it’s

consols

at par, that is, at a price of \$1,000, what coupon must it pay?

Slide22

Zero coupon bond

Zero coupon rate, no coupon paid during bond’s life.

Bond holder receives one payment at maturity, the face value (usually \$1000).

Most common example are government bonds

How does investor get a return?

Slide23

Zero coupon bond - 2

This is just a lump sum problem!

You have a Future Value (par value)

Present Value (today’s price or market price)

Rate

Slide24

Example problems – zero coupon bonds

Find the price of a zero coupon bond with 20 years to maturity, par value of \$1000 and a required rate of return of 15% p.a.

XYZ Corp.’s zero coupon bond has a market price of \$ 354. The bond has 16 years to maturity and its face value is \$1000. What is the cost of debt for the ZCB (i.e., the required rate of return).

Slide25

Fixed-coupon bonds

Firm pays a

fixed amount (‘coupon’)

to the investor every

period

until bond matures.

At maturity, firm pays

face value

of the bond to investor.

Face value also called par value. Unless otherwise stated, always assume face value to be \$1000.

Period: can be year, semi-annual (6 months), quarter (3 months). Most common are semi-annual.

Slide26

This is just a lump-sum + annuity!

PV is today’s price or market price

FV is the par value lump sum

PMT is the period coupon payments.

Slide27

Example problem - FCB

A \$1,000 par value bond has coupon rate of 5% and the coupon is paid semi-annually. The bond matures in 20 years and has a required rate of return of 10%. Compute the current price of this bond.

Slide28

Useful relationships

Coupon rate < discount rate

Price < face value

Bond is

selling at a discount

Coupon rate = discount rate

Price = face value

Bond is

selling at par

Coupon rate > discount rate

Price > face value

Bond is

Slide29

Useful relationship example

A 10-year annual coupon bond was issued four years ago

at par

. Since then the bond’s yield to maturity (YTM) has decreased from 9% to 7%. Which of the following statements is true about the current market price of the bond?

The bond is selling at a discount

The bond is selling at par

The bond is selling at a premium

The bond is selling at book value

Insufficient information

Slide30

Example - 2

One year ago Pell Inc. sold 20-year, \$1,000 par value, annual coupon bonds at a price of \$931.54 per bond. At that time the market rate (i.e., yield to maturity) was 9 percent. Today the market rate is 9.5 percent; therefore the bonds are currently selling:

at a discount.

at par.

above the market price.

not enough information.

Slide31

Other types of FCB problems

Finding yield-to-maturity. THIS IS IDENTICAL TO SOLVING FOR R.

Finding coupon rate

Slide32

Other FCB problems

1)A \$1,000 par value bond sells for \$863.05. It matures in 20 years, has a 10 percent coupon rate, and pays interest semi-annually. What is the bond’s yield to maturity on a per annum basis (to 2 decimal places)?

2) ABC Inc. just issued a twenty-year semi-annual coupon bond at a price of \$787.39. The face value of the bond is \$1,000, and the market interest rate is 9%. What is the annual coupon rate (in percent, to 2 decimal places)?

Slide33

Two part FCB problem

HMV Inc. needs to raise funds for an expansion project. The company can choose to issue either zero-coupon bonds or semi-annual coupon bonds. In either case the bonds would have the SAME required rate of return, a 20-year maturity and a par value of \$1,000. If the company issues the zero-coupon bonds, they would sell for \$153.81. If it issues the semi-annual coupon bonds, they would sell for \$756.32. What annual coupon rate is Camden Inc. planning to offer on the coupon bonds? State your answer in percentage terms, rounded to 2 decimal places.

Slide34

Stocks/equity

All of these are related to perpetuities

Slide35

Preferred stock

You have a constant dividend (or cash flow) and assume it will go forever.

Slide36

Common stock

With debt, cash flows can come from coupon payments + repayment of par.

With common stock, cash flows come from dividends or selling your stock. However, expected future dividends are the only thing that matters. Why?

Three different ways to make assumptions when we value:

Common dividend stream

Constant growth in dividends

Uneven growth (non-constant) in dividends

Slide37

How do we price a stock? Constant Dividend

<= dividend

stock price=>

<= required

return on equity

Comment – where does required return on equity come from?

Slide38

How do we price a stock? Constant dividend growth

Assume that dividends grow at constant growth rate, g, to infinity:

D

0

= Dividend that the firm

just

paid

Dividend growth rate

Required rate of return on equity

Don’t panic.

D

1

= D

0

(1 + g)

Slide39

How do changes in these affect Stock Price?

Slide40

Algebra – rearrange to solve for growth

Note that we can find rate by using this formula (if we have dividend, price, and growth).

If we don’t have this info – what do we use?

Dividend yield

Capital gains yield

Required rate of return on equity

Slide41

Example problem – constant growth

Jarrow

Company will pay an annual dividend of \$3 per share one year from today. The dividend is expected to grow at a constant rate of 7% permanently. The market requires 15% What is the current price of the stock (to 2 decimal places)?

Slide42

Example problem 2 – constant growth

Johnson Foods Inc. just paid a dividend of \$10 (i.e., D

0

= 10.00). Its dividends are expected to grow at a 4% annual rate forever. If you require a 15% rate of return on investments of this risk level, what is Johnson

Foods’s

current stock price? (to 2 decimal places)

Slide43

Example problem 3 – constant growth

The price of a stock in the market is \$62. You know that the firm has just paid a dividend of \$5 per share (i.e., D

0

= 5). The dividend growth rate is expected to be 6 percent forever. What is the investors’ required rate of return for this stock (to 2 decimal places)?

Slide44

Example problem 4 – constant growth

A firm is expected to pay a dividend of \$5.00 on its stock next year. The price of this stock is \$40 and the investor’s required rate of return is 20%. The firm’s dividends grow at a constant rate. What is this constant dividend growth rate (g)?

Slide45

Example problem 5

A stock’s expected growth rate is 4% and they just paid a dividend yesterday of \$10 per share. This stock has a beta of 1.5, the risk free rate is 2% and the market premium is 7%. What is the price of this stock?

Slide46

Non-constant growth

With this assumption, dividends grow at different rates for different periods of time. Eventually, dividends will grow at a constant rate forever.

Time line is very useful for valuing this type of stocks.

To value such stocks, also need the constant growth formula.

Best way to learn is through an example.

Slide47

From book

in valuing the stock of ABC Corp. suppose that you forecast that dividends will be \$2, \$3, and \$3.50 in the next three years, respectively. After that you expect dividends to grow at a rate of five percent per year forever. Let us suppose that the appropriate discount rate for ABC's stock is 15 percent. The projected future dividends are: D1 = \$2.00, D2 = \$3.00, D3 = \$3.50, D4 = \$3.50 x (1.05) = \$3.675, and so on.

Slide48

Non-constant dividend growth 2

Consider ABC Co.’s dividend stream:

Discount rate is 15%.

WORK BACKWARDS!!!!!

T = 0

\$2.00

\$3.00

\$3.50

Dividends grow at 5% forever

T =1

T = 2

T = 3

T = 4

Slide49

Another example

Malcolm Manufacturing, Inc. just paid a \$2.00 annual dividend (that is, D

0

= 2.00). Investors believe that the firm will grow at 10% annually for the next 2 years and 6% annually forever thereafter. Assuming a required return of 15%, what is the current price of the stock (to 2 decimal places)?

Use timeline to ‘see’ the problem better.

Verify that stock price = \$25.29

Slide50

Summary

Consol bonds

Zero coupon bonds

Fixed coupon bonds

Preferred Stock

Common stock – constant dividend

Common stock – constant growth

Common stock – non-constant growth