FI 3300 Chapter 9 Valuation of Stocks and Bonds

FI 3300 Chapter 9Valuation of Stocks and BondsInstructor: Ryan WilliamsLearning ObjectivesValue 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 bonds 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 stocks value, find the remaining factor.

Remember different words for the same thingCost of capital (from firms point of view) = required rate of return (from investors point of view) = interest rate in problems.

Cost of debt = investors required rate of return on debt

Cost of equity = investors required rate of return on equity.What is a financial security?Its a contract between the provider of funds and the user of funds.The contract specifies the:amount of money that has been providedterms & 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.

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.

Common financial securitiesDebt 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 whats 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.Types of debt securitiesFixed-coupon bondsZero-coupon bondsConsols (Perpetual bonds)Variable-rate bondsIncome bondsConvertible bondsCallable bonds

Fixed coupon bondsFirm 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).

How to read a bondGeneral Motors 30 year bond

Par Value = $1000

Interest paid Semi-annual

Interest Rate = 8%.Zero coupon and consul bondsZero-coupon bondZero coupon rate, no coupon paid during bonds life. Bond holder receives one payment at maturity, the face value. Consol bondPays a fixed coupon every period forever.Has no maturity.

Other types of bondsVariable-rate bond: Coupon rate is not fixed, but is tied to a specific interest rate. Income bond: pays the coupon only when borrowers earnings are high enough.Convertible bond: allows holder to convert it to another security, usually issuers common stock. Callable bond: issuer has the right to buy back the bond (before maturity) at a predetermined price.

Equity securitiesEquity security means common stock.Common stock holders have control privileges, i.e., have a say in firms 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:DividendsMoney received from selling shares

Preferred StockOwners 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.

Stock/Bond payoffsPretend 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$400,000Profit to debt holders$600,000$600,000$600,000$400,000Profit to equity holders$400,000$200,000$0$0Securities MarketsSecurities 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:Markets in which already issued securities trade. Trading is primarily among investors. Issuers are usually not involved.

Securities MarketsMoney 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.

Console is just a perpetuity!Price of consol =

All debt securities have similar formWill 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 returnConsol problemProblem 9.2ABC 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?

Consol problemProblem 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)?

Consol problemProblem 9.4If ABC wanted to issue its consols at par, that is, at a price of $1,000, what coupon must it pay?

Zero coupon bondZero coupon rate, no coupon paid during bonds life. Bond holder receives one payment at maturity, the face value (usually $1000).

Most common example are government bondsHow does investor get a return?

Zero coupon bond - 2This is just a lump sum problem!

You have a Future Value (par value)

Present Value (todays price or market price)

RateExample problems zero coupon bondsFind 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).Fixed-coupon bondsFirm 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.

This is just a lump-sum + annuity!PV is todays price or market priceFV is the par value lump sumPMT is the period coupon payments.Example problem - FCBA $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.

Useful relationshipsCoupon rate < discount ratePrice < face valueBond is selling at a discount Coupon rate = discount ratePrice = face valueBond is selling at parCoupon rate > discount ratePrice > face value Bond is selling at a premiumUseful relationship exampleA 10-year annual coupon bond was issued four years ago at par. Since then the bonds 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 discountThe bond is selling at parThe bond is selling at a premiumThe bond is selling at book valueInsufficient information

Example - 2One 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 a premium.at par.above the market price.not enough information.

Other types of FCB problemsFinding yield-to-maturity. THIS IS IDENTICAL TO SOLVING FOR R.

Finding coupon rateOther FCB problems1)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 bonds 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)?Two part FCB problemHMV 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.

Stocks/equityAll of these are related to perpetuitiesPreferred stockYou have a constant dividend (or cash flow) and assume it will go forever.

Common stockWith 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 streamConstant growth in dividendsUneven growth (non-constant) in dividends

How do we price a stock? Constant Dividend