Applied Corporate Finance

Session 3:
Interest Rates, Bond Valuation
and Stock Valuation
1. Know the important bond features and bond
types
2. Understand bond values and why they fluctuate
3. Understand bond ratings and what they mean
4. Understand the impact of inflation on interest
rates
5. Understand the term structure of interest rates
and the determinants of bond yields
6. Understand how stock prices depend on future
dividends and dividend growth
7. Be able to compute stock prices using the
dividend growth model
Learning outcomes
ACF 2013
7-1
Bond Value = PV of coupons + PV of par
Bond Value = PV of annuity + PV of lump
sum
As interest rates increase, present values
decrease
So, as interest rates increase, bond prices
decrease and vice versa
Present Value of Cash Flows
as Rates Change
ACF 2013
7-2
Consider a bond with a coupon rate of 10% and annual
coupons. The par value is $1,000, and the bond has 5
years to maturity. The yield to maturity is 11%. What is
the value of the bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 1/(1.11)
5
] / .11 + 1,000 / (1.11)
5

B = 369.59 + 593.45 = 963.04
Suppose you are reviewing a bond that has a 10%
annual coupon and a face value of $1000. There are
20 years to maturity, and the yield to maturity is 8%.
What is the price of this bond?
Using the formula:
B = PV of annuity + PV of lump sum
B = 100[1 1/(1.08)
20
] / .08 + 1000 / (1.08)
20

B = 981.81 + 214.55 = 1196.36
Valuing a Discount Bond with
Annual Coupons
ACF 2013
7-3
Relationship Between Price and Yield-
to-maturity (YTM)for 8% bond
600
700
800
900
1000
1100
1200
1300
1400
1500
0% 2% 4% 6% 8% 10% 12% 14%
ACF 2013
B
o
n
d

P
r
i
c
e

Yield-to-maturity (YTM)
7-4
If YTM = coupon rate, then par value = bond price
If YTM > coupon rate, then par value > bond price
Why? The discount provides yield above coupon rate
Price below par value, called a discount bond
If YTM < coupon rate, then par value < bond price
Why? Higher coupon rate causes value above par
Price above par value, called a premium bond
Bond Prices: Relationship
Between Coupon and Yield
ACF 2013
7-5
The Bond Pricing Equation
ACF 2013
t
t
r) (1
FV
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(

+
=
7-6
Find present values based on the payment
period
How many coupon payments are there?
What is the semiannual coupon payment?
What is the semiannual yield?
B = 70[1 1/(1.08)
14
] / .08 + 1,000 / (1.08)
14
=
917.56
Example 7.1
ACF 2013
7-7
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-term bonds
(see page 223 for an example)
Low coupon rate bonds have more price risk than high
coupon rate bonds
Price risk is greater when the yield-to-maturity is low than
when the yield-to-maturity is high (Why? Look at the slope of
the price and yield-to-maturity graph)
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can be
reinvested
Short-term bonds have more reinvestment rate risk than
long-term bonds
High coupon rate bonds have more reinvestment rate risk
than low coupon rate bonds
Interest Rate Risk
ACF 2013
7-8
Figure 7.2
ACF 2013
7-9
Yield to Maturity (YTM) is the rate implied by
the current bond price
Finding the YTM requires trial and error if you do
not have a financial calculator and is similar to
the process for finding r with an annuity
If you have a financial calculator, enter N, PV,
PMT, and FV, remembering the sign convention
(PMT and FV need to have the same sign, PV the
opposite sign)
See examples 7.2 & 7.3 in text
Computing Yield to Maturity
ACF 2013
7-10
Suppose a bond with a 10% coupon rate
and semiannual coupons, has a face
value of $1,000, 20 years to maturity and
is selling for $1,197.93.
Is the YTM more or less than 10%?
What is the semiannual coupon payment?
How many periods are there?
Using a financial calculator:
N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT
I/Y = 4% (Is this the YTM?)
YTM = 4%*2 = 8%

YTM with Semiannual
Coupons
ACF 2013
7-11
Table 7.1
ACF 2013
7-12
Bonds of similar risk (and maturity) will be
priced to yield about the same return,
regardless of the coupon rate
If you know the price of one bond, you can
estimate its YTM and use that to find the
price of the second bond
This concept of pricing an asset based on
the price of a similar asset can be used to
value other assets besides bonds

Bond Pricing Theorems
ACF 2013
7-13
There is a specific formula for finding
bond prices on a spreadsheet
PRICE(Settlement,Maturity,Rate,Yld,Redemption,
Frequency,Basis)
YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
Settlement and maturity need to be actual dates
The redemption and Pr need to be input as % of par
value
Bond Prices with a
Spreadsheet
ACF 2013
7-14
Differences Between
Debt and Equity
Debt
Not an ownership interest
Creditors do not have
voting rights
Interest is considered a
cost of doing business and
is tax deductible
Creditors have legal
recourse if interest or
principal payments are
missed
Excess debt can lead to
financial distress and
bankruptcy

Equity
Ownership interest
Common stockholders
vote for the board of
directors and other issues
Dividends are not
considered a cost of doing
business and are not tax
deductible
Dividends are not a liability
of the firm, and
stockholders have no legal
recourse if dividends are
not paid
An all equity firm cannot
go bankrupt merely due to
debt since it has no debt
ACF 2013
7-15
Contract between the company and
the bondholders that includes
The basic terms of the bonds
The total amount of bonds issued
A description of property used as
security, if applicable
Sinking fund provisions
Call provisions
Details of protective covenants
The Bond Indenture
ACF 2013
7-16
Registered vs. Bearer Forms
Security
Collateral secured by financial securities
Mortgage secured by real property, normally
land or buildings
Debentures
Unsecured debt (in US)
Secured debt (in UK)
Notes unsecured debt with original maturity
less than 10 years
Seniority
Bond Classifications
ACF 2013
7-17
The coupon rate depends on the risk
characteristics of the bond when issued
Which bonds will have the higher coupon,
all else equal?
Secured debt versus an unsecured debt
Subordinated debt versus senior debt
A bond with a sinking fund versus one without
A callable bond versus a non-callable bond
Bond Characteristics and
Required Returns
ACF 2013
7-18
The following are considered Investment Grade bonds
1. High Grade
Moodys Aaa and S&P AAA capacity to pay is extremely
strong
Moodys Aa and S&P AA capacity to pay is very strong
2. Medium Grade
Moodys A and S&P A capacity to pay is strong, but more
susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is adequate,
adverse conditions will have more impact on the firms ability
to pay
Anything below that are called Junk Bonds
Bond Ratings
Investment Quality
ACF 2013
7-19
Low Grade
Moodys Ba and B
S&P BB and B
Considered possible that the capacity to pay will
degenerate.
Very Low Grade
Moodys C (and below) and S&P C (and below)
income bonds with no interest being paid, or
in default with principal and interest in arrears
Page 234 shows the rating agencies in
Asia
Malaysia: RAM and MARC

Bond Ratings Speculative
ACF 2013
7-20
Treasury Securities
Federal government debt
T-bills pure discount bonds with original maturity of
one year or less
T-notes coupon debt with original maturity between
one and ten years
T-bonds coupon debt with original maturity greater
than ten years
In Malaysia, they are known as MGS
Municipal Securities (common in US, Canada etc)
Debt of state/provincial and local governments
Varying degrees of default risk, rated similar to
corporate debt
Interest received is tax-exempt at the federal level in the
USA
Government Bonds
ACF 2013
7-21
Make no periodic interest payments (coupon rate
= 0%)
The entire yield-to-maturity comes from the
difference between the purchase price and the
par value
Cannot sell for more than par value
Sometimes called zeroes, deep discount bonds,
or original issue discount bonds (OIDs)
Treasury Bills and principal-only Treasury strips
are good examples of zeroes
Zero-coupon bonds have no reinvestment
rate risk.
Zero Coupon Bonds
ACF 2013
7-22
Coupon rate floats depending on some index
value
Examples adjustable rate mortgages and
inflation-linked Treasuries
There is less price risk with floating rate bonds
The coupon floats, so it is less likely to differ
substantially from the yield-to-maturity
Coupons may have a collar the rate cannot go
above a specified ceiling or below a specified
floor
Floating-Rate Bonds
ACF 2013
7-23
Disaster bonds
often issued by insurance companies
Income bonds
Convertible bonds
bonds with warrant-like feature
Put bonds
There are many other types of provisions
that can be added to a bond and many
bonds have several provisions
it is important to recognize how these
provisions affect required returns
Other Bond Types
ACF 2013
7-24
Primarily over-the-counter transactions
with dealers connected electronically
Extremely large number of bond issues,
but generally low daily volume in single
issues
Makes getting up-to-date prices difficult,
particularly on small company or municipal
issues
Treasury securities are an exception
Bond Markets
ACF 2013
7-25
Highlighted quote in Figure 7.4

15 Nov 21 8.000 148.5000 148.5469 0.2656 2.59

What is the coupon rate on the bond?
When does the bond mature?
What is the bid price? What does this mean?
What is the ask price? What does this mean?
How much did the price change from the
previous day?
What is the yield based on the ask price?
Treasury Quotations
ACF 2013
7-26
Clean price: quoted price
Dirty price: price actually paid = quoted price plus
accrued interest
Example: Consider a T-bond with a 4%
semiannual yield and a clean price of $1,282.50:
Number of days since last coupon = 61
Number of days in the coupon period = 184
Accrued interest = (61/184)(.04*1000) = $13.26
Dirty price = $1,282.50 + $13.26 = $1,295.76
So, you would actually pay $ 1,295.76 for the
bond
Clean vs. Dirty Prices
ACF 2013
7-27
Real rate of interest change in buying
power
Nominal rate of interest quoted rate of
interest, change in actual number of
dollars
The ex ante nominal rate of interest
includes our desired real rate of return plus
an adjustment for expected inflation
Inflation and Interest Rates
ACF 2013
7-28
The Fisher Effect defines the relationship
between real rates, nominal rates, and
inflation
(1 + R) = (1 + r)(1 + h), where
R = nominal rate
r = real rate
h = expected inflation rate
R = r + h + rh
Approximation
R r + h
The Fisher Effect
ACF 2013
7-29
If we require a 10% real return and we
expect inflation to be 8%, what is the
nominal rate?
R = (1.10)(1.08) 1 = .188 = 18.8%
Approximation: R = 10% + 8% = 18%
Because the real return and expected
inflation are relatively high, there is
significant difference between the actual
Fisher Effect and the approximation.
Example 7.5
ACF 2013
7-30
Term structure is the relationship between time to
maturity and yields, all else equal
It is important to recognize that we pull out the
effect of default risk, different coupons, etc.
Yield curve graphical representation of the term
structure
Normal upward-sloping; long-term yields are higher
than short-term yields
Inverted downward-sloping; long-term yields are lower
than short-term yields
Term Structure of
Interest Rates
ACF 2013
7-31
Figure 7.6 Downward-
Sloping Yield Curve
ACF 2013
7-32
In addition to the above 3 factors, the
following are additional factors:
1.Default risk premium remember bond
ratings
2.Taxability premium remember municipal
versus taxable
3.Liquidity premium bonds that have more
frequent trading will generally have lower
required returns
Anything else that affects the risk of the cash flows
to the bondholders will affect the required returns
Factors Affecting Bond
Yields
ACF 2013
7-33
Valuation of Shares
If you buy a share of stock, you can
receive cash in two ways
The company pays dividends
You sell your shares, either to another
investor in the market or back to the
company
As with bonds, the price of the stock
is the present value of these
expected cash flows
8-34
One-Period Example
Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. You expect it to pay a $2 dividend in
one year, and you believe that you can sell the
stock for $14 at that time. If you require a return of
20% on investments of this risk, what is the
maximum you would be willing to pay?

Compute the PV of the expected cash flows
Price = (14 + 2) / (1.2) = $13.33
8-35
One-Period Example: Using a Timeline
0 1
2 3
20%
P
1
=14

P
0
D
1
=$2

Expect to sell stock at this
price
+
PVIF
20%,1
$16

expect a $2 dividend in 1
year and sell the stock for
$14
Developing The Model
You could continue to push back the year in
which you will sell the stock
You would find that the price of the stock is really
just the present value of all expected future
dividends



So, how can we estimate all future dividend
payments?
8-37

+
+
+
+
+
+
+
+ +
+
+
+
+
+
=
) r (1
D
...
) r (1
D

) r (1
D

) (1
D
P
s
3 t
s
3 t
2 t
s
2 t
1 t
s
1 t
t
r
Estimating Dividends: Special Cases
Constant dividend
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
Constant dividend growth
The firm will increase the dividend by a constant percent
every period
The price is computed using the growing perpetuity
model
Supernormal growth
Dividend growth is not consistent initially, but settles
down to constant growth eventually
The price is computed using a multistage model
8-38
Zero Growth
If dividends are expected at regular intervals
forever, then this is a perpetuity and the present
value of expected future dividends can be found
using the perpetuity formula
P
0
= D / R

Suppose stock is expected to pay a $0.50
dividend every quarter and the required return is
10% with quarterly compounding. What is the
price?
P
0
= .50 / (0.1 / 4) = $20
8-39
Constant Dividend Growth Model
Dividends are expected to grow at a constant percent
per period.
P
0
= D
1
/(1+R) + D
2
/(1+R)
2
+ D
3
/(1+R)
3
+
P
0
= D
0
(1+g)/(1+R) + D
0
(1+g)
2
/(1+R)
2
+ D
0
(1+g)
3
/(1+R)
3
+

With a little algebra and some series work, this
reduces to:
g - R
D
g - R
g) 1 ( D
P
1 0
0
=
+
=
8-40
Constant Dividend Growth Model
Example 1
Suppose Big D, Inc., just paid a dividend of $0.50
per share. It is expected to increase its dividend by
2% per year. If the market requires a return of 15%
on assets of this risk, how much should the stock be
selling for?

8-41
92 . 3
0.02 - 0.15
0.50(1.02)
g - R
g) 1 ( D
P
0
0
= =
+
=
Constant Dividend Growth Model
Example 2
Suppose TB Pirates, Inc., is expected to pay a $2
dividend in one year. If the dividend is expected to
grow at 5% per year and the required return is 20%,
what is the price?



Why isnt the $2 in the numerator multiplied by
(1.05) in this example?
8-42
33 . 13
0.05 - 0.2
2
g - R
D
g - R
g) 1 ( D
P
1 0
0
= = =
+
=
Stock Price Sensitivity to Dividend
Growth Rate, g
D
1
= $2; R = 20%
8-43
Stock Price Sensitivity to
Required Return, R
D
1
= $2; g = 5%
8-44
Gordon Growth Company - I
Gordon Growth Company is expected to pay a
dividend of $4 next period, and dividends are
expected to grow at 6% per year. The required
return is 16%. What is the current price?




Remember that we already have the dividend
expected next year, so we dont multiply the
dividend by 1+g
8-45
40
0.06 - 0.16
4
g - R
D
g - R
g) 1 ( D
P
1 0
0
= = =
+
=
Gordon Growth Company - II
What is the price expected to be in year 4?




What is the implied return given the change in price during
the four year period?




Using financial calculator: -40 PV; 50.50 FV; 4 N; CPT I/Y
= 6%

The price grows at the same rate as the dividends
8-46
50 . 50
0.06 - 0.16
0.06) 4(1
g - R
g) 1 ( D
g - R
D
P
4 4
1 5
4
=
+
=
+
= =
6% 0.06 r r) 40(1 50.50
r) (1 P P
4
4
0 4
= = + =
+ =
Constant DGM: Price Grows at
Same Rate as Dividends
dividends the as rate same at the grows price the
g 1
g r
g) (1 D
g r
g) (1 D
P
P
g r
g) (1 D
P
g r
g) (1 D
P
1 t
0
2 t
0
t
1 t
2 t
0
1 t
1 t
0
t

+ =

+

+
=

+
=

+
=
+ +
+
+
+
+
8-20
Nonconstant Growth
Problem Statement
Suppose a firm is expected to increase dividends
by 20% for one year and then by 15% in the year
following. After that, dividends will increase at a
rate of 5% per year indefinitely. If the dividend at
time 0, D
0
, was $1 and the required return is
20%, what is the price of the stock?
Remember that we have to find the PV of all
expected future dividends.
8-48
Nonconstant Growth
Example Solution
Compute the dividends until growth levels off
D
1
= 1(1.2) = $1.20
D
2
= 1.20(1.15) = $1.38
D
3
= 1.38(1.05) = $1.449

Find the expected future price
P
2
= D
3
/ (R g) = 1.449 / (.2 - .05) = 9.66

Find the present value of the expected future cash
flows





8-49
8.67
0.2) (1
9.66 1.38
0.2 1
1.2
R) (1
P D
R 1
D
P
2 2
2 2 1
0
=
+
+
+
+
=
+
+
+
+
=
Quick Quiz Part I
A company has just paid a dividend of $2. What is
the value of its stock if it expects to maintain this
level of dividend every yea. Assume that the
required return is 15%.
$2/ ????
What if the company starts increasing dividends
by 3% per year, beginning with the next dividend?
The required return stays at 15%.
$2 ( ????
Why is the second value higher?
8-50
See example 8.4 in pg. 267
Two-stage growth: p.268 & example
8.5
Try Problems 12 to 16 for interesting
variations of the standard model

Supernormal growth
ACF 2013
Using the Constant DGM to Find
Required Return, Dividend Yield,
Capital Gains Yield
Start with the Constant DGM:
g
P
D
g
P
g) 1 ( D
R
g - R
D
g - R
g) 1 ( D
P
0
1
0
0
1 0
0
+ = +
+
=
=
+
=
8-52
Finding the Required Return,
Dividend Yield, Capital Gains Yield -
Example
Suppose a firms stock is selling for $10.50. It just
paid a $1 dividend, D
0
, and dividends are expected
to grow at 5% per year.
What is the required return?


What is the dividend yield, D
1
/P
0
?


What is the capital gains yield?
g =5%
8-53
% 15 05 . 0
10.50
) 05 . 0 1 ( 1
g
P
g) 1 ( D
R
0
0
= +
+
= +
+
=
10%
10.50
0.05) 1(1
P
g) (1 D
P
D
yield div
0
0
0
1
=
+
=
+
= =
Table 8.1 - Stock Valuation
Summary
8-54
Equity Valuation using Peer Multiples
1. P/E (Price-to-earnings) ratio
trailing vs forward PE ratios
often used to value IPO shares:
Based on comparable firms, estimate the appropriate
P/E.
Multiply this by expected earnings to obtain an estimate
of the stock price.
see pg. 272 for examples
What are problems with PE method?
Often hard to find comparable firms.
The average ratio from a sample of comparable firms
can have a wide range.
Example: The average P/E ratio of comparable firms is 20 but the
range is from 10 to 50.
when profits are ve, PE ratio is meaningless


Equity Valuation using Peer Multiples
2. Price-to-Sales Multiples
P/S ratio = price per share/ sales per share
focuses on operating revenue so not
influenced by one-off gains

3. Price-to-Cash Flow Multiple
useful to compare across countries
see airline example in pg 273
Features of Common Stock
Voting Rights:
Cumulative vs. straight voting
Proxy voting
Classes of stock
Other Rights
Share proportionally in declared dividends
Share proportionally in remaining assets during
liquidation
Preemptive right first shot at new stock issue to
maintain proportional ownership if desired
8-57
Dividend Characteristics
Dividends are not a liability of the firm until a
dividend has been declared by the Board
Consequently, a firm cannot go bankrupt for not
declaring dividends
Dividends and Taxes
Dividend payments are not considered a business
expense; therefore, they are not tax deductible
The taxation of dividends received by individuals varies
across countries
see pg 277 for examples in US and Singapore.
Malaysia follows the same single tier system as in
Singapore
imputation system vs. single payer system
8-58
Features of Preferred Stock
Dividends
Preferred dividend must be paid before
dividends can be paid to common stockholders
Dividends are not a liability of the firm.
Preferred dividends can be deferred
indefinitely
Most preferred dividends are cumulative any
missed preferred dividends have to be paid
before common dividends can be paid
Preferred stock generally do not carry voting
rights
Similar to a perpetuity from a valuation point
Is Preferred stock really Debt?
8-59
Stock Market
Dealers vs. Brokers
New York Stock Exchange (NYSE)
Largest stock market in the world
License holders (1,366)
Commission brokers
Specialists
Floor brokers
Floor traders
Operations
Floor activity
8-60
NASDAQ
Not a physical exchange computer-based
quotation system
Multiple market makers
Electronic Communications Networks
Three levels of information
Level 1 median quotes, registered representatives
Level 2 view quotes, brokers & dealers
Level 3 view and update quotes, dealers only
Large portion of technology stocks
8-61
Bursa Malaysia and
The Singapore Exchange
Visit www.bursamalaysia.com
Be familiar with the main features
Source of much useful information
Visit www.sgx.com.sg
Select Prices from the menu on the left
Click on the following stocks to find the buy and sell
quotes for selected stocks
SGX
Wilma
DBS Bank