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Bond Valuation
What is a bond?
When a corporation wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities called bonds. A bond is normally an interest-only loan, meaning that the borrower will pay the interest every period, but none of the principal will be repaid until the end of the loan.
Bond terminology
- Par value (face value) : Stated face value of the bond. It is usually $1,000.
- Maturity date : The date on which the par value must be repaid.
- Interest payment (coupon payment) : The fixed amount of interest usually paid every 6 months.
- Coupon rate : The interest payment divided by the par
value. e.g. 80 1 000,
- Call provision : The provision whereby the issuer may pay bonds off prior to maturity.
The bond market is huge. At the end of 1994, the face value of bonds outstanding in the 22 largest international markets totaled $18.5 trillion, according to Salomon Brothers. That was 38% larger than the $13.4 trillion value of stocks outstanding worldwide.
- If market interest rate (r) increases to 12% right after the bond has been issued, how does this affect the bond price?
PV=100× 5.6502+1,000× 0.322=$887<$1, A discount bond (the bond is sold below par).
Bondholders earn less than that offered by the market, hence the bond must sell at a lower price.
Discount=$1,000-887=$113.
- If r decreases to 8% right after the bond has been issued, how does this affect the bond price?
PV=100× 6.7101+1,000× 0.4632=$1,134.20>$1, A premium bond (the bond is sold above par).
Bondholders earn more than that offered by the market, hence the bond must sell at a higher price.
Premium=$1,134.20-1,000=$134.20.
- Bond interest rate risk: bond prices fluctuate as the interest rate changes – increase when interest rates decrease , and vice versa (inverse, convex price-yield relationship).
Bonds with semiannual coupons
- Convert C, n, and r into C/2, 2n, and r/2.
PV=C/2[PVIFA(r/2,2n)]+F[PVIF(r/2,2n)]
Example : A bond has an annual coupon rate of 15%, but coupons are paid semiannually. If the required rate of return on the bond is 10%, and the bond has 15 years to maturity, what is the bond price today?
PV = 75[PVIFA(5%,30)]+1,000[PVIF(5%,30)] = 75 × 15.3725+1,000× 0. = $1,384.34.
Other Yield Measures
- YTM : The compounded interest rate that makes the present value of the cash flows equal to its price. - assumes all coupon interest payments are reinvested at the Yield to Maturity (reinvestment rate risk).
- Current Yield : Annual dollar coupon interest per unit price of the bond. E.g. 15-yr 7% coupon bond, $1000 par, selling for $769. 9. 10 % $ 769. 40
current − yield = =
- ignores capital gain/loss
- ignores time value of money
- Yield to Call : For bonds that may be called prior to the stated maturity date, YTC is the yield of the bond assuming it’s called on its first call date, at the call price.
( 1 ) ( 1 )^2 ....... ( 1 ) n *^ ( 1 r ) n
M
r
C
r
C
r
C
P
E.g. 18-yr 11% (semi-annual) coupon bond, $ par, selling for $1168.97. Suppose first call date is 13 yrs from now, and the call price is $1055. here, YTC = 9.2%
- YTM assuming bond is called on first call date.
How are bond prices reported?
- Most Corporate bonds are traded in the OTC (Over-The- Counter) markets.
- Government Bonds (Treasury securities) are auctioned, and then traded in secondary markets by dealers.
Common Stock Valuation
Common stocks are the units of ownership of a public corporation. Owners are entitled to receive dividends and capital appreciation as well as voting powers.
What is the difference between a bond and a stock?
- Ownership
- Voting rights
- Dividends
- Residual claim
- Limited liability
The general model
Cash payoff from stocks (in terms of future cash flows):
- cash dividends,
- capital gains/losses (upon selling the stock).
Expected return by holding a stock for one period is:
r = DIV^ P^ P P
1 1 0 0
hence, P 0 = DIV^ P r
1 1 1
In the same way, the price at the end of the first period can be expressed as:
P 1 = DIV^ P r
2 2 1
By iteratively substituting for P 1, P 2, etc., we get:
P 0 =
DIV DIV^ P r r
1 2 2 1 1
= DIV r
1 1 +
+ DIV^ P
r
2 2 1 2
( + ) = DIV r
1 1 +
+ DIV
r
2 ( 1 + )^2 +^
DIV r
3 ( 1 + )^3 +............ = DIV r
t t = 1 ( 1 + ) t
∞ ∑.
Thus, the value of a stock is equal to the present value of all expected future dividends.
How do you estimate g****?
It’s a billion-dollar question in valuation!
Can estimate by the following ways:
- Historical (past) growth as a measure of expected growth,
- Trust analysts and their projections,
- Put your faith in fundamentals.
What determines a firm’s growth rate?
- Firm’s reinvestment policy,
- Firm’s project quality.
Expected growth in earnings = Reinvestment Rate x Return on Investment = Retention Ratio x ROE = (1-payout ratio) x ROE = (1- DPS EPS
) x EPS BPS ( Why should this hold? Why ROE? )
Now, the growth rate in dividends equals the growth rate in earnings if the payout ratio is constant ( is it? ).
So what we need is assumptions about (and estimates of):
- Reinvestment rates,
- Marginal returns on equity.
How do you estimate how long the expected growth will last?
- The greater the current growth rate in earnings of the firm, relative to the stable growth rate (that can be sustained forever ), the longer the high growth period.
- The larger the current size of the firm, the shorter the high growth period – size pushes firms towards stable growth.
- The greater the barriers to entry in a business, the longer the length of the high growth period for the firm.
At the end, you have to make a judgement call – as much an art as it is a science!
What should be the stable growth rate?
- No firm, in the long term, can grow faster than the economy it is in ( why not? ).
- So, stable growth rate cannot be greater than the growth rate of the economy.
- Stable growth rate cannot be greater than the discount rate, because the riskfree rate that is embedded in the discount rate will also build on these same factors – real growth in the economy and the expected inflation rate.
- Empirical fact: Very few firms ( Microsoft? ) are able to sustain high growth periods longer than 10 years.
Why discount Dividends, why not earnings?
- Investors receive dividends, not earnings!
- Some part of earnings has to be retained and invested, to generate future returns. Discounting earnings would ignore the investment needed to generate these returns.
How do you value no-dividend firms? As per the Gordon Model, they should be valued at zero!
- A firm with many attractive growth opportunities may not want to declare dividends, and invest all earnings into projects.
- This would increase the value of the firm.
- Hence, investors would buy the stock at positive prices with the hope of: - selling it for higher later, as the increase in firm valuation would increase stock price. - receiving cash or shares of stock of the acquirer, if the firm is acquired (if it has attractive growth opportunities, it could be an attractive acquisition candidate!). - receiving bonus shares if the stock splits.
These hypotheses are borne out by empirical evidence:
- High growth firms pay lower dividends (Microsoft?).
- Utility firms have high payout ratios, as they do not have many growth opportunities.
Present value of growth opportunities (PVGO)
- Without growth opportunities (all earnings are paid out): r = DIV P
1 0
= EPS
P
1 0
, P 0 = EPS
r
- With growth opportunities:
P 0 = EPS r
1 + NPVGO.
Price of the stock equals the sum of the stock price of an equivalent firm with no growth opportunities, and the net present value (per share) of the growth opportunities.
How is the stock price affected if the firms accept negative NPV projects?
Some examples
- Fledgling Electronics has a market capitalization rate of 15%. The company is expected to pay a dividend of $ in the first year, and thereafter, the dividend is predicted to grow indefinitely at 10% per year.
P 0 = DIV
r g
1 −
- − 010.
Suppose EPS=$8.33, then
payout ratio= DPS EPS
8 33.
Plowback ratio=1-0.6=0.4. If ROE=0.25, then growth rate g = plowback ratio× ROE = 0.4× 0. = 0. If there is no growth,
share price= EPS r
015
. .
Therefore, PVGO=$100-55.56=$44.44.
- The YTM on a bond is the interest rate you earn on your investment if interest rates don’t change. If you actually sell the bond before it matures, your realized return is known as the holding period yield (HPY).
a. Suppose you buy a 10% coupon bond making annual payments today for $1,100. The bond has 10 years to maturity. What rate of return do you expect to earn on your investment?
b. Two years from now, the YTM on your bond has declined by 2.5%, and you decide to sell. What price will your bond sell for? What is the HPY on your investment? Compare this yield to the YTM when you first bought the bond. Why are they different?
