CHAPTER 4:
INTEREST RATE AND BOND
VALUATION
1.1 Bonds and Bonds Valuation
1
What is Bond ?
A long-term debt instrument in which a borrower agrees to
make payments of principal and interest, on specific dates,
to the holders of the bond.
A bond is a security that obligates the issuer to make
specified interest and principal payments to the holder on
specified dates.
Bonds are sometimes called fixed income securities.
2
Key Features of a Bond
Par value or face value – face amount of the bond, which
is paid at maturity (assume $1,000).
Maturity Date : The length of time until the bond issuer
returns the par value to the bondholder and terminates or
redeems the bond.
Coupon interest rate – stated interest rate (generally fixed)
paid by the issuer.
Rate of interest paid as a percentage of the par value.
Issue date – when the bond was issued.
Indenture: An Indenture is the legal agreement between
the firm issuing the bonds and the bond trustee who
represents the bondholders.
3
Bond Valuation
In general, Valuation is the process of determining the intrinsic
value of any asset whose value is obtained from future cash flows
The intrinsic value of an asset is determined based on three basic
inputs: cash flows (returns), time pattern of the returns, and the
discount rate.
The value of a bond is a function of:
» Par value
» Term to maturity
» Coupon rate
» Investor’s required rate of return (discount rate is also known as the
bond’s yield to maturity)
Can the intrinsic value of an asset differ from the
market value?
4
Bond Value
General Formula
1
1 ( 1 k )n 1
[ 6-1] B I b
F
kb ( 1 k b ) n
Where:
I = interest (or coupon ) payments
kb = the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
5
Bond Valuation: Example
What is the market price of a ten-year, $1,000 bond with a
5% coupon, if the bond’s yield-to-maturity is 6%?
1 1 kb n F
B I
b
n
k b
1 k
1 1.06 10 1, 000
50
10
0.06
1.06
$926.40
6
Example 1
Consider a 10 year, 12 % coupon bond compounded
annually with a par value of Birr 1000. Let the required
yield on this bond is 13%.
The cash flows for this bond are as follows:
10 annual coupon payment of Birr 120
Birr 1000 principal repayment 10 years from now
P 120 PIVFA13%,10 yrs 1000 PVIF13%,10 yrs
Birr 946.1
7
Example 2
What is the market price of a U.S. Treasury bond that has a
coupon rate of 9%, a face value of $1,000 and matures
exactly 10 years from today if the required yield to
maturity is 10% compounded semiannually?
0 6 12 18 24 ... 120 Months
45 45 45 45 1045
P 45 PVIFA 5%, 20 1000 PVIF5%, 20 $937.69
8
1000
120 120 120 ... 120
0 1 2 3 ... 20
Period/Yr = 1
N = 20
r% per year = 12
FV = 1,000
Coupon = 120
Solution:
P = $1,000
Note: If the coupon rate = yield, the bond will
sell for par value.
9
Exercise (contd…)
Suppose interest rates fall immediately after we
issue the bonds. The required return on bonds
of similar risk drops to 10% i.e. Yield falls to
10 %
What would happen to the bond price?
10
Period/Yr = 1
N = 20
r% per Year = 10
Coupon = 120
FV = 1000
Solution:
P = $1,170.27
Note: If the coupon rate > yield, the bond will sell
for a premium.
11
Exercise (contd…)
Suppose interest rates rise immediately after we
issue the bonds. The required return on bonds of
similar risk rises to 14%.
What would happen to the bond price?
12
Period/Yr = 1
N = 20
r% per year = 14
Coupon = 120
FV = 1000
Solution:
P = $867.54
Note: If the coupon rate < yield, the bond will sell
for a discount.
13
Relationship Between Bond Prices
and Yields
The relationship between the coupon rate and the bond’s
yield-to-maturity (YTM) determines if the bond will sell at a
premium, at a discount, or at par
If Then Bond Sells at a:
Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium
14
Relationship Between Bond Prices
and Yields
Bond prices are inversely related to interest rates
(or yields).
A bond sells at par only if its coupon rate equals
the required yield.
A bond sells at a premium if its coupon rate is
above the required yield.
A bond sells at a discount if its coupon rate is
below the required yield.
15
Rate of return on Bond
Yield To Maturity (YTM): The average annual rate of
return investors expect to receive on a bond if they hold it to
maturity.
Mathematically:
YTM of a bond is the interest rate that makes the present value
of the cash flows receivable from owning the bond equal to the
price of the bond. M-P
I n
P = $A (PVIFA r, n) + $M (PVIF r, n) Approx YTM
MP
»just solve for r = YTM !!! 2
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YTM Example
Suppose we paid $898.90 for a $1,000 par 10% coupon
bond with 8 years to maturity and semi-annual coupon
payments.
What is our yield to maturity?
M-P
Period/YR =m= 2 I n
Approx YTM
MP
n = m*t= 16
2
p = 898.90 1000 - 898.9
50
Approx YTM 16
Coupon per period = 50 1000 898.9
2
M = 1000
= 11.21%
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For Callable Bond
Call Price - P
C
Approx YTC n
Call Price P
2
C = annual coupon payment
n = term to call
Call price can be on premium sometimes.
Eg. Call to premium of 9% means, bond will be called at the value 9%
greater than the face value
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1.2 Valuation of Stocks
Two types:
– Preferred stock and
– Common stock
– Preferred stock is often referred to as a hybrid security
because it has many characteristics of both common
stock and bonds.
19
Hybrid nature of
Preferred stocks
Like common stocks, preferred stocks
» Have no fixed maturity date
» Failure to pay dividends does not lead to
bankruptcy
» Dividends are not a tax-deductible expense
Like Bonds
» Dividends are fixed in amount (either as a Birr
amount or as a % of par value)
20
Valuing Preferred Stock
The economic or intrinsic value of a preferred stock
is equal to the present value of all future dividends.
Value of preferred stock:
= Annual dividend/required rate of return
(PV of perpetuity equation)
22
Valuing Preferred Stock
Example: Assume AIB’s preferred stock pays an
annual dividend of $3.75 and the investors required
rate of return is 6%.
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2. Common Stock
Common stock is a certificate that indicates ownership
in a corporation. When you buy a share, you buy a
“part/share” of the company and attain ownership
rights in proportion to your “share” of the company.
Common stockholders are the true owners of the firm.
Bondholders and preferred stock holders can be
viewed as creditors.
24
Common Stock: in-brief
Status: Owners
Life: No maturity date
Rights to votes and assets: In proportion to number of
shares held
Liability: Limited to amount of investment
Source of Return: Dividends (if paid) and Capital gain (if
sold at a higher price)
Dividends: Neither fixed nor guaranteed.
Seniority: In the event of bankruptcy, common
stockholders will not receive any payment until all the
creditors, including the bondholders and preferred
stockholders, have been satisfied.
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Features of Common Stocks
Voting rights
Preemptive rights
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Voting Rights
Most often, common stockholders are the only
security holders with a vote.
» Majority of shareholders generally vote by
proxy.
Common shareholders are entitled to:
» elect the board of directors
» approve any change in the corporate charter
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Preemptive Rights
Preemptive right entitles the common shareholder to
maintain a proportionate share of ownership in the firm.
» Thus, if a shareholder currently owns 5% of the
shares, s/he has the right to purchase 5% of the shares
when new shares are issued.
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Valuing Common Stock
Like bonds and preferred stock, the value of
common stock is equal to the present value of all
future expected cash flows (i.e. dividends in this
case).
However, dividends are neither fixed nor
guaranteed, which makes it harder to value
common stocks compared to bonds and preferred
stocks.
29
Stock Valuation Models: The Basic Stock
Valuation Equation
30
Stock Valuation Models:
The Zero Growth Model
The zero dividend growth model assumes that the stock will
pay the same dividend each year, year after year.
31
Stock Valuation Models:
The Zero Growth Model (cont.)
The dividend of Denham Company, an established
textile manufacturer, is expected to remain constant at
$3 per share indefinitely. What is the value of
Denham’s stock if the required return demanded by
investors is 15%?
P0 = $3/0.15 = $20
Note that the zero growth model is also the appropriate
valuation technique for valuing preferred stock
32
Stock Valuation Models:
Constant Growth Model
The constant dividend growth model assumes that the stock will
pay dividends that grow at a constant rate each year—year after
year forever.
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An Example
Find the stock price given that the current dividend is $2 per
share, dividends are expected to grow at a rate of 5% in the
foreseeable future, and the required return is 10%
P0 = D1/(r – g)
P0 = $2.10/5% = $2.10/0.05 = $42
34
Stock Valuation Models:
Variable-Growth Model
The non-constant dividend growth or variable-
growth model assumes that the stock will pay
dividends that grow at one rate during one period,
and at another rate in another year or thereafter.
We will use a four-step procedure to estimate the
value of a share of stock assuming that a single
shift in growth rates occurs at the end of year N.
We will use g1 to represent the initial growth rate
and g2 to represent the growth rate after the shift.
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Stock Valuation Models:
Variable-Growth Model (cont.)
Step 1. Find the value of the cash dividends at the end of each year, Dt,
during the initial growth period, years 1 though N.
2. Find the present value of the dividends expected during the initial
growth period.
Step 3. Find the value of the stock at the end of the initial growth period,
PN = (DN+1)/(ks-g2), which is the present value of all dividends expected
from year N+1 to infinity, assuming a constant dividend growth rate,
Step 4. Add the present value components found in Steps 2 and 3 to find
the value of the stock, P0,
36
Stock Valuation Models:
Variable-Growth Model (cont.)
The most recent annual (2016) dividend payment of Warren Industries,
a rapidly growing boat manufacturer, was $1.50 per share. The firm’s
financial manager expects that these dividends will increase at a 10%
annual rate, g1, over the next three years. At the end of three years
(the end of 2009), the firm’s mature is expected to result in a slowing
of the dividend growth rate to 5% per year, g2, for the foreseeable
future. The firm’s required return, ks, is 15%.
37
Stock Valuation Models:
Variable-Growth Model (cont.)
Steps 1 and 2. See Table 7.3 below.
Table 7.3 Calculation of Present Value of
Warren Industries Dividends (2010–2012)
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Stock Valuation Models:
Variable-Growth Model (cont.)
This example can be summarized using the time line below:
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