Chapter –Five Long-term Investment

Decision Making
Bonds and Stock Valuation And Cost of
Capital
Introduction
 It must be noted that all classes of investors
are interested in knowing the values of
securities i.e.
 Common stock, Preference stock and
Bonds.
 It is important to weigh the risk and return,
which affect the valuation process
 Hence, the valuation is the key concept for
investment decisions.
 No buy-sell action will take place
The Valuation Process
 The basic valuation and constantly exercised
is rationality with cost, benefits, and
uncertainty as important variables.
 The valuation process will be examined in
view of;
 The performance of a firm in relation to
the performance of industry to which it
belongs; and
 The performance of the economy and the
market in general.
 The three sequential steps in the valuations
process would be as follows:
 Economy analysis
 Industry analysis
The basic valuations model
 Value of a security is;
 A fundamental variable and
 Depends on its promised return, risk and the
discount rate.
 In fact the basic valuation model is present
value procedure with the mention of
fundamental factors like returns and discount
rate.
 You can always determine the present value as
follows.

PV + + --- +
+
=

PV = Present value
CF = Cash flow (interest, dividend, earnings per time
period) up to ‘n’ number of years
r = Risk adjusted discount rate
1.Valuation of Bonds
 Bonds represent loans extended by
investors to corporations and/or the
government.
 Bonds are issued by the borrower, and
purchased by the lender.
 The legal contract underlying the loan
is called a bond indenture.
 A bond is an instrument or
acknowledgement issued by a business
unit or government by specifying the
amount of loan, rate of interest and the
terms of loan repayment.
 When the bond is purchased, the bond holder
(owner) receives two things:
i. Interest payments, which are a series of
equal payments and
ii. Repayment of the full principal at its
maturity.
 Par value. It is the amount or value stated on
the face of the bond.
 It represent the amount of the firm
borrows and promises to repay at the time
of maturity.
 Coupon Rate of Interest. A bond carries a
specific interest rate, called coupon rate.
 The interest payable is simply par value
multiplied by the coupon rate.
 Maturity period. Every bond will have maturity
period.
 On completion of the maturity period the
principal amount has to be repaid.
 Sometimes bonds may be issued under a
provision that the business will have an option to
pay back the bond amount before the maturity
period. These are known as callable bonds.
 The intrinsic value of a bond. is the present
value (PV) of the cash flow stream (CF) provided to
the investor, discounted at a required rate of return
appropriate for the risk involved.
C TV

n
PV = 
t 1
(1  r ) t (1  r ) n

VB (PVB)
] +
=C[
 PV = Present value of the bond today
C = Coupon rate of interest
TV = Terminal value repayable
r = Appropriate discount rate or market yield
n = Number of years to maturity

a) Valuation of perpetual bond; bond that never mature

Where; C= coupon rate of interest,
VB (pv) = r = Appropriate discount rate or
market yield
b) Valuation of zero-coupon bond

VB =

Example. A 10% bond of Birr 1,000 issued with a

maturity of five years at par. The discounted rate of
marketing is 10%. The interest is paid annually.
What would be the bond value?
 Solution, the intrinsic value of bond is its NPV of cash flow

PV = 100 __+ 100__ + 100___ + 100___ + 100+

1000
(1 + .10) (1 + .10)2 (1 + .10)3 (1 + .10)4 (1
+ .10)5
= 100 x .9091 + 100x .8264 + 100 x .7513 + 100x .6830 +
1100 x .620
= 90.91 + 82.64 + 75.13 + 68.30 + 682.99
= 999.97
Or;
VB (PVB) = 100 [ ]+

= 100 [ ]+

= 100 ]+
[
= 100(3.79) + 620.92
= 999.97
2. Valuation of Preferred Stock
 Preference shares are hybrid security. They
have some features of bonds and some of
equity shares.
 Theoretically, preference shares are
considered a perpetual security but there
are convertible, callable, redeemable and
other similar features, which enable issuers
to terminate them within the finite time
horizon.
 Preference dividends are specified like
bonds.
 Claims of preferred stockholders are junior
to claims of debt holders, but senior to
those of common stockholders.
 They have limited voting rights
compared to common stock.
 Preferred stock has a par value and a
dividend rate.
 Preference shares are less risky than
equity because their dividends are
fixed and all arrears must be paid
before equity holders get their
dividends.
 They are however, more risky than
bonds because the second enjoy
priority in repayment and in
liquidation.
Since dividends from preference shares are assumed to
be perpetual payments, the intrinsic value of such
shares will be estimated from the following equations.
Vps =
Where; Vp = Value of preferred stock
D = Constant dividends
received
K = required rate of return
Example. A preference share of Birr 100 each
with a specified dividend of Birr 11.5 per share. Now,
if the investors’ required rate of return corresponding
to the risk level of a company is 10%, what would be
the value of share today?
Vps = = 11.5/0.10 = Br 115
3. Valuation of Common Stock
 Common stock represents residual
ownership of the firm.
 Common stockholders have important voting
rights.
 The issuer may pay dividends to common
stockholders.
 However, there is no pre-set dividend rate.
 The valuation of common stock has three
methods.
a) zero growth model
b) constant growth model
c) super-normal growth model
 a)Zero growth models
Under this the assumption is the growth of dividend is zero or
constant.
Vc =
Where; Vc = Value of common stock
D = Dividend paid
K = the required rate of return
Example. A company pays a cash dividend of Birr 9 per share
on common share for an indefinite period of future. The required
rate of return is 10% and the market price of the share is Birr 80.
Would you buy the share at its current price?

Vs =

= 9/0.10
= Br 90
Yes, you would consider buying the share.
 b)Constant Growth Model
The dividend payable to common stock holders will grow
at a uniform rate in the future.
It can be written as below.

V =
c=
D1 = Do + (Do+g) = Do (1+g),
D2 = Do (1+g) 2,
Dn = Do (1+g) n, so
Vcn = Do (1+g) n/ (k-g)

Where Do = Dividend paid

g = growth rate
k = desired rate of return.
Example. Alfa Company paid a dividend of Birr 2 per share on
common stock for the year ending March 31, 2003. A constant
growth of dividend 10% per share has been forecast for an
indefinite future. Investors required rate of return is 15%. You
want to buy the share at market price quoted on July 31, 2003 is
stock market at Birr 60. what would be your decision?
 Vc = = = =

= Br 44
decision; Value is less than price, so you do not buy.

c) Supper-normal growth model:

 The multiple growth assumption has to be made in
a vast number of practical situations. The infinite
future time period is viewed as divisible into two
or more different segments.
 The investor must forecast the time ‘T’ up to
which growth would be variable and after which
only the growth rate would show a pattern and
would be constant. This mean that present value
calculations will have to be spread over two
phases viz. one phase would last until time ‘T’ and
the other would begin after ‘T’ to maturity.
 VT (1) = Dt
(1 + k) t
VT (2) = DT + 1___
(k – g) (1 + k)T
Combined equation for VT(1) + VT(2)
= Dt___+ DT + 1______
(1 + k)t (k – g) (1 + k)T
Exmple. Ethio-Power Corporation paid dividend of 1.15 Br per
share during the last year. At this time, the forecast is that
dividends will grow at 30% for the next two years and by 8% for
the third year. The required rate of return is 13.4% for the next
three years.
Solution
Vs = Dt___+ DT + 1______ D3 = 1.15(1.30)3=2.5266
(1 + k)t (k – g) (1 + k)T Dt+1 = 2.5266(1.08) = 2.7287

= 2.5266 / (1.134)3 = 1.7326

= 2.7287 / (13.4%-8%) (1+13.4%) = 34.6512
= 1.7326 + 34.6512 = 36.3838
Cost of capital
What is cost of capital?
 Cost of capital is the required rate of return that a
firm must achieve in order to cover the cost of
generating funds in the marketplace.
 The firm must earn a minimum of rate of return to
cover the cost of generating funds to finance
investments.
 Based on their evaluation of the
riskiness of each firm, investors will
supply new funds to a firm only it pays
them the required rate of return to
compensate them for taking the risk of
investing in the firms bonds and
stocks.
 If the firm does not achieve the return
investors expect, investors will not
invest in the firms debt and equity.
 As a result the firms value (both
their debt and equity) will decline.
Cost of specific source of capital
1. Cost of debt
It is the cost associated with raising one or more
dollar by issuing debt.
Kd = Ki (1-T)
Where; Kd = after tax cost of debt
Ki = before tax cost of debt
T = tax rate
Example; suppose the palm computer company can
issue debt with a yield 6%. If the palms marginal tax
rate is 40%, what is the cost of debt?
Solution; Kd = Ki (1-T)
= 0.06 (1-0.4) = 0.0360 = 3.6%
The interpretation is that the firm must earn 3.6%
on debt investment to satisfy the bondholders interest.
2. Cost of preferred stock
 It is the cost associated with raising one or more dollar of
capital by issuing shares of preferred stock.
 It is the rate of return that must be earned on the preferred
stock holder’s investment to satisfy their requirements.
 In order to express this dividend cost as a yearly rate the firm
uses the selling price it receives after deducting whatever
costs incurred in issuing the pr. stocks.

Kp = = =
Example; a preferred stock selling for Br 500 with an annual
stated dividend of Br 50 require a flotation cost of Br 10 per
share. Determine the specific cost of preferred stock if the
corporate tax rate is 40%?
Solution ; Kp = = = 10.20%

The interpretation is that the firm must earn 10.20% on

preferred stock investment to satisfy the preferred stockholders
interest.
3. Cost of common stock
The specific cost of common stock is a minimum rate of return
that the firm must earn for its common stock holders in order to
maintain the market value of the firm’s equity.
Kc =
Example; Millie Company’s common stock has recent divided
per share of Br 12. It is found that the company dividend per share
should continue to increase at 6% growth rate in to the indefinite
future.
What is the specific cost of the common stock if a market price
of Br 100 with a flotation cost per share Br 8 is expected up on
selling the stocks?
Solution
Given; Np = market price-flotation cost
= Br 100-8 = Br 92/share
Do = Br 12/share
Soln Kc g
= = 6% =
= 0.138+0.06 = 19.8%
4. Weighted Average Cost of Capital
 In the previous cost computation we assume that firms finance
its assets from only one source.
 A firm can also finance its assets by using different financing
alternative available to it.
 It may use bonds, stocks or retained earnings.
 And the specific cost of capital will not answer the amount that
should be earned from the asset which is financed from
different sources.
 So we have to compute weighted average cost of capital.
 It is the composite of the individual cost of financing.

WACC = Wd*Rd (1-T) + Wps*Rps + Wc*Rc

Steps to determine WACC of the firm
i. Calculate the specific cost of funds for all source of finance
ii. Multiply the cost of specific funds by the proportion of cash
funds
iii. Add the product
 Example; Imagine that you went to finance your assets with 100,000 birr and you
get this amount from the following different sources. From debt= Br 40,000 has
specific cost of 8%, preferred stock = Br 20,000 has specific cost of 11%, and
common stock 40,000 has specific cost of 18%.
Compute the firms WACC?

Solution;

Source of finance Amount Specific cost of capital (1st) Proportion

Debt 40,000 8% 40000/100000 = 40%
Pref. stock 20,000 11% 20000/100000 = 20%
Comm. Stock 40,000 18% 40000/100000 = 40%
Total 100,000 100%
 2rd step; multiply the cost of specific funds by the proportion of cash funds
Debt = Wd*Rd = 40%*8% = 0.032
Pref. stock = Wp*Rp = 20%*11% = 0.022
Comm. Stock = Wc*Rc = 40%*18% = 0.072
3rd step; add the product
WACC = Wd*Rd + Wp*Rp + Wc*Rc
= 0.032+0.022+0.072
= 0.126
= 12.6%
The company should earn at least 12.6% annual return from its assets worth of
100,000 to satisfy capital providers interest.