FM I Bond Valuation
FM I Bond Valuation
FM I Bond Valuation
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different levels of default risk, depending on the issuing company’s characteristics and on the
terms of the specific bond. Default risk is often referred to as “credit risk,” and the larger the
default or credit risk, the higher the interest rate the issuer must pay.
Municipal bonds, or “munis,” are issued by state and local governments. Like corporate bonds,
munis have default risk. However, munis offer one major advantage over all other bonds: the
interest earned on most municipal bonds is exempt from federal taxes and also from state taxes if
the holder is a resident of the issuing state. Consequently, municipal bonds carry interest rates
that are considerably lower than those on corporate bonds with the same default risk.
Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate
bonds are, of course, exposed to default risk, and so are some foreign government bonds. An
additional risk exists if the bonds are denominated in a currency other than that of the investor’s
home currency. For example, if you purchase corporate bonds denominated in Japanese yen, you
will lose money, even if the company does not default on its bonds, if the Japanese yen falls
relative to Birr.
1.2. Bond valuation
The valuation process for a bond requires knowledge of three basic elements.
i. The amount of the cash flows to be received by the investor, which is equal to the
periodic interests to be received and the par value to be paid at maturity.
ii. The maturity date of the loan.
iii. The investor’s required rate of return.
The periodic interest can be received annually or semiannually. The value of a bond is simply the
present value of these cash flows. Two versions of the bond valuation model are presented
below.
® If the interest rate payments are made annually, then;
= I (PVIFAi,n) + M(PVIFi,n)
Where; I= Interest payment each year=coupon rate × par value
M=par value or maturity value
I= investor’s required rate of return
n=number of years to maturity
PVIA=present value interest factor of an annuity of Birr 1
PVIF= present value interest factor of a lump sum of Birr 1
Eg: Consider a bond, maturing in 10 years and having a coupon rate of 8 percent. The par value
is Birr 1,000. Investors consider 10 percent to be an appropriate required rate of return in view of
the risk level associated with this bond. The annual interest payment is Birr 80(8% X Birr l,000).
The present value of this bond is:
Solution: V= I (PVIFAi,n) + M(PVIFi,n)
V= 80×(PVIFA10%,10yrs) + 1000×(PVIF10%10yrs)
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V= =80(6.1446) + 1,000(0.3855) = 491.57 + 385.50 = Birr 877.07
If the interest is paid semiannually, then;
Here, solve for YTM by try and error. You will get approximately 10%.
1.2.2. Yield To Call
The rate of return earned on a bond if it is called before its maturity date. A number of
companies issue bonds with buy back or call provision. Thus a bond can be redeemed or called
before maturity. The call period is different from maturity and the call value could be different
from the maturity value.
If current interest rates are well below an outstanding bond’s coupon rate, then a callable bond is
likely to be called, and investors will estimate its expected rate of return as the yield to call
(YTC) rather than as the yield to maturity. To calculate the YTC, solve this equation for i:
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; Then calculate for i, by try and error, so as to calculate YTM.
Where, V=is the value of the bond; i=is the investor’s required rate of return;
n=number of periods and M=maturity value
Eg: A zero coupon bond with a face value of Birr10,000 which will mature at 30 years, has a
current yield on the bond 9%, then the value of the pure discount bond will be:
Solution:
Features of stocks
® Claims: preference share holders have a claim on assets and income prior to ordinary
share holders. Ordinary share holders have a residual claim on a company’s income and
assets. They are legal owners of the company.
® Dividend: dividends for preference share holder are fixed. Preference share holders’ can
be cumulate. Ordinary share holders have neither fixed dividend receipts nor accumulate
dividends.
® Redemption: for preference shares, redeemable and irredeemable shares can be issued.
But, for ordinary shares there is no maturity date stated.
® Conversion: a company can issue a convertible preference share, on which such shares
can be converted in to ordinary shares.
Like bonds, the value of stock is the present value of all future cash inflows expected to
receive by the investor. The cash inflows expected to be received are dividends and the future
price at the time of sale of the stock.
2.1. Preference stock valuation
¥ For valuation of preference shares which has maturity date: we can use the following
formula.
OR Po=PD×(PVIFAi,n) + Pn×(PVIFi,n)
Where, Po= value of preference shares, PD= preference dividend per share, Pn= maturity value
of the preference shares, i=the required rate of return of the preference share, and n= maturity
period of the preference share.
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Eg: suppose an investor is considering the purchase of a 12 year, 10% dividend for Rs100 par
value preference share. The redemption value of the preference share on maturity is Rs 120. The
investor’s required rate of return is 10%. What amount should he/she willing to pay for the share
now?
Solution: the dividend is 10% of the par value=100×0.1=10, the present value of the P/share is
=120Rs, the maturity period =12years, required rate of return=11%
Po=10 (PVIFA11%, 12yrs) + 120 (PVIF11%, 12yrs) =10 (6.492) + 120 (0.286) = Rs 99.24
¥ Valuation of preference shares without maturity, we can use the following formula;
Eg: assuming a company issues Rs 100 irredeemable preference shares which it pays a dividend
of 9%. Assume also, this type of preference share is currently yielding a dividend of 11%. What
is the value of the preference share?
Solution:
OR
Eg: Assume an investor is considering the purchase of stock A at the beginning of the year. The
dividend at year-end is expected to be Birr1.50, and the market price by the end of the year is
expected to be Birr 40. If the investor's required rate of return is 15 percent, the value of the
stock would be:
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There are three cases of growth in dividends. They are (1) zero growth; (2) constant growth; and
(3) Non-constant, or supernormal, growth.
In the case of zero growth, if
DO= D1= …= D
Then the valuation model;
Eg: Assuming D equals Birr 2.50 and i equal 10 percent, then the value of the stock is:
In the case of constant growth, if we assume that dividends grow at a constant rate of g every
year [i.e., D, = Do (l + g)'], then the above model is simplified to:
Eg: Consider a common stock that paid a Birr 3 dividend per share at the end of the last year and
is expected to pay a cash dividend every year at a growth rate of 10 percent. Assume the
investor's required rate of return is 12 percent. The value of the stock would be:
Solution: D1 = Do (l + g) = 3(1 + 0.10) = Birr 3.30
; = Birr 165
Finally, consider the case of non-constant, or supernormal growth. Firms typically go through
life cycles, during part of which their growth is faster than that of the economy and then falls
sharply. The value of stock during such supernormal growth can be found by taking the
following steps:
1. Compute the dividends during the period of supernormal growth and find their present
value;
2. find the price of the stock at the end of the supernormal growth period and compute its
present value; and
3. Add these two PV figures to find the value (PO ) of the common stock.
Eg: Consider a common stock whose dividends are expected to grow at a 25 percent rate for 2
years, after which the growth rate is expected to fall to 5 percent. The dividend paid last period
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was Birr 2. The investor desires a 12 percent return. To find the value of this stock, take the
following steps:
Solution:
Step-1: Compute the dividends during the supernormal growth period and find their present
value. Assuming Do is Birr 2, g is 25 percent, and i is 12 percent:
D1 = Do (1 + g) = 2(1 + 0.25) = Birr 2.50
D2 = Do (1 +g)2 = 2(1.563) = Birr 3.125 OR
D2 = D1 (1 + g) = 2.50(1.25) = Birr 3.125
Step-2: Find the price of the stock at the end of the supernormal growth period. The dividend
for the third year is:
D3 = D2 (1+ g’), where g’ = 5%
= 3.125(1 + 0.05) = Birr3.28
The price of the stock is therefore:
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3. Cost of capital
Cost of capital refers to the rate of return a firm must earn on its investment project to increase
the market value of its common shares. Or it is the rate of return required by market suppliers of
capital to attract funds to the firm.
The opportunity cost of capital for a project is the discount rate for discounting its cash flows.
The project’s cost of capital is the minimum required rate of return on funds committed to the
project which depends on the riskiness of its cash flows.
A firm’s cost of capital will be the overall, or average, required rate of return on the aggregate of
investment projects.
Cost of capital can be useful as a standard of; evaluating investment decisions, designing debt
policy, and appraising the financial performance of top management.
The items on the right side of a firm’s balance sheet, which includes; various types of debts,
preferred stocks and common stock (equity) are called the capital components. Any increase in
total assets must be financed by an increase in one or more of these capital components.
1. Cost of debt
Companies may raise debt through borrowings from financial institutions or public deposits on
bonds for a specified period of the time at a certain rate of return. The before-tax cost of debt
can be found by determining the internal rate of return (or yield to maturity) on the bond cash
flows.
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V = value or net proceeds from the sale of a bond
n = term of the bond in years
Since the interest rate payments are tax-deductible, the cost of debt must be stated on after tax
basis. The after-tax cost of debt is:
, where t= tax rate
If the debt is issued at par, the cost of debt will be calculated using:
; Where, I=interest payment, and M=par value or issue price of the bond
Eg: Assume that the Carter Company issues a $l, 000, 8 percent, 20-year bond whose net
proceeds are $940.The tax rate is 40 percent. Then, the before-tax cost of debt, ki, is:
Solution:
Therefore, the after-tax cost of debt is: Kd = Ki(l -t) = 8.56%(1 -0.4) = 5.14%
Interest paid on debt is tax deductible. The higher the interest charged, the lower will be the
amount of tax payable by the firm. The cost of debt will be less, when it is after tax.
2. Cost of preferred shares
The cost of preferred stock, Kp, is found by dividing the annual preferred stock dividend, dp, by
the net proceeds from the sale of the preferred stock, p , as follows:
Since preferred stock dividends are not a tax-deductible expense, these dividends are paid out
after taxes.
Eg1: Suppose that the Carter Company has preferred stock that pays a $13 dividend per share
and sells for $100 per share in the market. The flotation (or underwriting) cost is 3 percent, or $3
per share. What is the cost of preferred stock?
Solution:
Eg2: firm A intends to issue a 10% annual dividend preferred share with an expected value of
$100. Floatation costs amount to 5.6% per share. What is the cost of preferred equity?
Solution:
For preferred stocks which have maturity, cost of preferred stock can be calculated as;
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Where: Kp=the cost of preferred stock, dp=dividends to preferred stockholders, Pn=maturity
value of the preferred share, and P=net proceed from the sale of the stock.
Calculate for Kp by try and error, so as to get the cost of preferred stock with maturity.
3. Cost of equity capital
Cost of equity is the shareholders’ required rate of return, which equates the present value of the
expected dividends with market value of the share.
Measuring cost of equity has two difficulties: one is the difficulty to estimate the expected
dividends and the other one is the future earnings and dividends are expected to grow over time
and estimation of the growth of dividends is very difficult.
Three techniques can be used so as to measure the cost of common stock equity capita1.
(1) The Gordon’s growth model; (2) the capital asset pricing model (CAPM) approach; and
(3) the bond plus approach.
i. Growth model: as we have seen on the valuation of common stock, there are three
growth models.
a. Zero growth model: in case of zero growth model, the valuation equation was:
, here growth of dividends, g, will be zero, if the firm doesn’t retained some of its
earnings.
So as to calculate the cost of equity, calculate for i, in the above equation.
b. Constant growth model: the value of the stock in case of constant growth of dividends
is:
model.
Eg: Assume that the market price of the Carter Company’s stock is $40. The dividend to be paid
at the end of the coming year is $4 per share and is expected to grow at a constant annual rate of
6 percent. Then the cost of this common stock is:
Solution:
The cost of new common stock, or external equity capital, is higher than the cost of existing
common stock because of the flotation costs involved in selling the new common stock.
If f is flotation cost in percent, the formula for the cost of new common stock is:
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Eg: consider the above example, except, the firm is trying to sell new issues of stock A and its
flotation cost is 10%. Then,
c. Supernormal growth model: the present value of the common stock in addition to the
three steps that we have seen , can be calculated by using:
gn=the perpetual growth rate (normal growth of dividends after the supernormal).
To get the cost of common stock under supernormal growth of dividends, solve for Ke by try
and error.
ii. The Capital Asset Pricing Model (CAPM) Approach:
An alternative approach to measuring the cost of common stock is to use the CAPM, which
involves the following steps:
1. Estimate the risk-free rate, rf.
2. Estimate the stock’s beta coefficient, β, which is an index of systematic (or non
diversifiable market) risk.
3. Estimate the rate of return on the market portfolio, rm.
4. Estimate the required rate of return on the firm’s stock, using the CAPM (or SML)
equation:
CAPM is a model that is used to determine the required rate of return on asset and indicates the
relationship between return and risk of the asset.
Ke = rf+ β(rm – rf)
Where; rf=risk free rate of return, rm=rate of return on the market, β=the stock’s beta coefficient
Eg: Assuming that rf is 7 percent, β is 1.5, and rm is 13 percent, then:
Ke = rf+ βb(rm – rf) = 7% + 1.5(13% -7%) = 16%
This 16 percent cost of common stock can be viewed as consisting of a 7 percent risk-free rate
plus a 9 percent risk premium, which reflects that the firm’s stock price is 1.5 times more volatile
than the market portfolio to the factors affecting non diversifiable, or systematic, risk.
iii. The Bond-plus Approach: in this approach, the cost of common stock is the firm’s cost
of long term debt plus a risk premium to it.
Ke = long-term bond rate +risk premium
Ke= ki(1-t) +risk premium
A risk premium of about 4 percent is commonly used with this approach.
Eg: consider the example that we have seen in cost of debt, the cost of common stock using the
bond plus approach is:
Ke = long-term bond rate + risk premium
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Ke= ki(1 - t) + risk premium
Ke= 5.14% + 4% = 9.14%
Cost of Retained Earnings
The cost of retained earnings, ks, is closely related to the cost of existing common stock, since
the cost of equity obtained by retained earnings is the same as the rate of return investors require
on the firm’s common stock. Therefore,
ks = ke=D1/P0+g
Measuring the overall cost of capital (weighted average cost of capital (WACC))
The firm’s overall cost of capital is the weighted average of the individual capital costs, with the
weights being the proportions of each type of capital used. Let K0, be the overall cost of capital.
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