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There are two distinct aspects of this topic: (1) pricing securities, & (2) calculating a

securitys expected rate of return. (1) involves calculating a securitys intrinsic value

(IV) based on the valuers required rate of return. (2) involves calculating a securitys

expected return based on its current market price (P

0

). Note that: (1) a securitys

current market price may not be the same as its intrinsic value, and (2) a securitys

expected return may not be the same as its required rate of return. These differences

lead to the flowing decision rules:

If P

0

< IV security is underpriced, therefore buy

If P

0

> IV security is overpriced, therefore sell.

If expected return > required return, security is underpriced, therefore buy

If expected return < required return, security is overpriced, therefore sell.

The golden rule is buy low, sell high.

Pricing bonds

A bond has a: par value = face value = redemption value = nominal value;

coupon rate of interest applied to its par value; maturity date.

Bond interest is typically paid twice-yearly.

PV of a bond = (1) PV of the interest payments (an annuity) +

(2) PV of the par value (future value).

See text pages 277-281.

Note that the price of a bond is inversely related to its yield or discount rate; ie the

higher the yield on a bond, the lower will be its price, and vice-versa.

When the yield on a bond is lower than its coupon rate, its price will be higher than its

par value.

When the yield on a bond is higher than its coupon rate, its price will be lower than its

par value.

return of rate required r

Example

A bond has a par value of $100, a coupon rate of 10.75% and matures in 5 years. If

interest is paid annually and the required rate of return is 10%, what is the bonds IV?

Answer

PV of the annuity: $10.75 [1 (1.1)

-5

] / 0.1 = $40.75

PV of par value: $100 / (1.1)

5

= 62 .09

Total PV = IV = $102 .84

Pricing preference shares

IV = annual dividend required rate of return = D

p

/ RROR = D

p

/R

p

Example

A preference share has a par value of $100 and a dividend rate of 10.75%. If the

required rate of return is 10%, what is the shares IV?

Answer

PV = IV = $10.75 / 0.1 = $107.50

Pricing ordinary shares

D

1

= D

0

(1 + g)

g = expected growth rate. Can be defined in terms of growth in the book value (BV)

of shareholders funds

= BV

1

/ BV

0

1

= return on equity (ROE) profit retention ratio.

Example

A share has just paid an annual dividend of $0.54. The book value of shareholders

funds is currently $11,020,801. One year ago the book value of shareholders funds

was $10,699,807. During the past year there were no changes to paid-up capital. The

risk-free rate of return is currently 5%. A risk premium of 8% is required for investing

in the share. What is its PV?

Answer

Required rate of return = 5% + 8% = 13%

Growth rate = 11,020,801/10,699,807 1 = 0.03

D

0

= $0.54 D

1

= $0.54 1.03 = $0.5562, or

2

g r

D

PV

1

D

1

= $0.54 11,020,801/10,699,807 = $0.5562

PV = $0.5562 / (0.13 0.03) = $5.56

Expected rates of return

Shares

= D

1

/ P

0

+ g

Example

If the share in the previous example has a current market price of $5.02, what is its

expected rate of return?

Answer

D

1

/ P

0

+ g

= 0.5562/5.02 + 0.03

= 14.08%

Is this share worth buying?

Yes: its market price is below its intrinsic value and its expected rate of return is

higher than its required rate of return.

Bonds

Expected return = yield to maturity = internal rate of return (IRR - interest symbol i

on the calculator).

The IRR is the discount rate that equates the PV of a bonds future cash flows with its

current market price. This rate can be identified either through a process of iteration or

by using an electronic device such as a financial calculator or an Excel spreadsheet.

Note that if the price of a bond is below its par value, its yield will be higher than its

coupon rate, and vice-versa.

Example

A bond has a par value of $100, a coupon rate of 10.5% payable semi-annually and has

4.5 years to maturity. If its current price is $117.52, what is its expected rate of return?

3

return of rate ected exp r

g yield dividend r +

Answer

Because the current market price is above par value, we know that the expected return

must be less than the coupon rate.

This calculation is best done using a financial calculator (or spreadsheet).

The key strokes are:

9 n 117.52 +/- PV 5.25 PMT 100 FV COMP i x 2 = 6.00%

Calculating bonds yields without a financial calculator

If we know the price of a bond, we can calculate its yield to maturity (YTM); i.e. the

discount rate that equates the present value of the bonds future cash flows with its

current price. The textbook sometimes refers to a bonds YTM as the bondholders

expected rate of return. However, whether or not a bonds YTM will be the rate of

return actually realised by the bondholder will depend on the rate at which the bonds

coupons can be reinvested. Remember that a bond YTM is an annual percentage rate

(APR), as opposed to an effective annual rate (EAR).

Example

What is the YTM of a three-year bond with a face value of $100 and a 14% coupon

paid twice per year, if the price of the bond is $110.15?

Solution

The time line is shown below.

-110.15 7 7 7 7 7 107

0 1 2 3 4 5 6

We need to find the value of i such that:

110.15 =

6

6

) m i 100(1

2 i

) 2 i (1 1

7

+ +

,

_

+

For equations of this type there is no algebraic solution for i when the exponent is

greater than 4. In all such cases an approximation method needs to be used for

determining the value of i. The routine is a two-part process involving first using an

equation for determining an approximate value of i and then using a solution

algorithm to bring the approximate value of i closer and closer to its true value

through successive iterations. This is the solution method used by electronic devices

and may also be used manually.

Using a financial calculator, the YTM in this example is easily found to be 10.00%.

Using the Sharp EL-735, the key-strokes are: 6 n 110.15 +/- PV 7 PMT 100 FV

COMP i 2 =

4

Without a financial calculator, the following equation defines an approximate bond

YTM:

Bond YTM

a 6 . 0 1

n a c

+

(8)

Where a = V

b

/M 1

Applied to the current example, a = 110.15/100 1 = 0.1015. Equation (8) then defines

an approximate yield of 10.007%, as follows:

Bond YTM

( ) 1015 . 0 6 . 0 1

3 1015 . 0 14 . 0

+

0609 . 1

106167 . 0

0.100072

10.0072%

In this case the approximation equation has yielded a reasonable result. But if we do

not know that 10.00% is the actual YTM, we cannot assess the accuracy of 10.0072%.

However, in all cases such as this we can obtain a better approximation of the actual

YTM by using an appropriate solution algorithm, such as Newton's Method.

Alternatively, if we designate the first approximation as i

a

, a second approximation,

designated i

b

, can be defined in either of the following two ways:

(1) i

b

= i

a

a

PV

a

+ 1

(2) i

b

=

m

a

FV nm

a

1

1

1

]

1

,

_

+

1

1

1

where PV

a

= the present value of the bonds cash flows per dollar

of bond when discounted at i

a

FV

a

= the future value of the bonds cash flows per dollar of

bond when compounded at i

a

Using the first method, we find:

PV

a

= $

( )

1

1

]

1

+

a

nm

a

i

m i

c

1 1

+ $1(1 + i

a

/m)

-nm

= $

( )

1

1

]

1

+

100072 . 0

2 100072 . 0 1 1

14 . 0

6

+ $1(1 + 0.100072/2)

-6

= $0.355257543 + $0.746061907

= $1.1013

5

i

b

= 10.0072%

1015 . 1

1013 . 1

= 10.0054%

Using the second method (which was developed by Chris Deeley in

2005), we find:

FV

a

= FV of coupons per dollar of bond + $1

= $

( )

1

1

]

1

+

a

nm

a

i

m i

c

1 1

+ $1

= $0.14

1

1

]

1

100072 . 0

1 050036 . 1

6

+ $1

= $0.14 3.4012645 + $1

= $1.476177

i

b

=

2 1

1015 . 1

476177 . 1

6 1

1

1

]

1

,

_

= 0.10001466 = 10.001466%

Either of the foregoing methods can be repeated until the actual YTM

is identified when i

n

= i

n1

to the required degree of accuracy. The

second method (Deeleys Method) is recommended, despite its

greater complexity, on the grounds that it approaches the actual

YTM far more quickly than the first method.

Using Deeleys Method, the second iteration gives us a YTM of 10.0006%, calculated

as follows:

FV

b

= FV of coupons per dollar of bond + $1

= $

( )

1

1

]

1

+

b

nm

b

i

m i

c

1 1

+ $1

= $0.14

1

1

]

1

10001466 . 0

1 05000733 . 1

6

+ $1

= $0.14 3.401019135 + $1

= $1.47614268

i

c

=

2 1

1015 . 1

47614268 . 1

6 1

1

1

]

1

,

_

= 0.100006 = 10.0006%

6

Repeating this routine with 10.0006% as the reinvestment rate will confirm that the

actual YTM is 10.00% (to two decimals). The following equation also confirms

10.00% as the actual YTM:

V

b

=

( )

( )

nm

nm

m i M

m i

m i

C

+ +

1

1

]

1

+

1

1 1

= $7

( )

( )

6

6

05 . 1 100

5 . 0 . 0

05 . 1 1

+

1

1

]

1

= $7 5.075692 + $100 0.7462

= $35.53 + $74.62

= $110.15 = the given price of the bond.

Note that although the method just demonstrated is of a type often described as one of

trial and error, it is nevertheless a systematic routine of repetition or iteration. Each

repetition of the routine will always generate a more accurate approximation of the

YTM until the actual YTM is identified to the required degree of accuracy. It is, of

course, your understanding of the concepts that is important, not that you can

necessarily calculate the precise answer. Depending upon the nature of the question, it

is often sufficient to calculate a range within which the YTM falls. Nevertheless, now

that youve seen the hassles involved in calculating a YTM without a financial

calculator, you may appreciate the value of having one, and knowing how to use it.

Preference shares

Expected return = D / P

0

Example

A preference share has a par value of $100 and a dividend rate of 10.5% payable

annually. If its current price is $117.52, what is its expected rate of return?

Answer

10.5 / 117.52 = 8.9%

Financial calculations without using a financial calculator

Rate of interest

If $1 grows to $10 over 10 years, what is the rate of interest?

Ans. i = 10

1/10

1 = 0.2589 = 25.89%

Check: $1 (1.2589)

10

= $1 9.998 = $10.00

7

Number of periods

If $1 grows to $10 at 10% pa, how long does it take?

Ans. n = log 10/ log 1.1 = 24.16 years

Check: $1 (1.1)

24.16

= $1 10.0011 = $10.00

Calculating periodic payments when paying off a debt or saving for a

future amount, without using a financial calculator or tables

Paying off a debt

A debt which is paid off in equal periodic instalments may be referred to as a credit

foncier loan. It is a present value (PV) that needs to be paid off and the amount of each

instalment (or payment) can be calculated by dividing the PV by equation 4-12a,

which is on page 79 of the text. Note that this is a double-decker equation in which i

is the denominator. Because the PV (the numerator) is to be divided by this equation,

the equation should be inverted and then multiplied by the PV.

Example

See problem 4-15 at page 98.

Payment (PMT) = 60,000 0.09/(1 1.09

-25

)

= 60,000 0.10180625

= $6,108.38

Saving for a future amount

It is a future value (FV) that needs to be saved for and the amount of each instalment

(or payment) can be calculated by dividing the FV by equation 4-11a, which is on page

81 of the text. Note that this is a double-decker equation in which i is the

denominator. Because the FV (the numerator) is to be divided by this equation, the

equation should be inverted and then multiplied by the FV.

Example

See problem 4-18 at page 98.

Payment (PMT) = 100,000 1.05

10

0.1/(1.1

10

1)

= 162,889.46 0.62745394

= $10,220.56

Note that the first part of this answer calculates the expected future value of the

property, which is expected to increase in value at the rate of 5% per year for 10 years.

Note also that with this sort of calculation, you should not round-off until completion

of the calculation.

8

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