CHAPTER 4:

INTEREST RATE AND BOND

VALUATION

1.1 Bonds and Bonds Valuation

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 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.

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 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.

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 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?
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 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

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 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

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 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
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 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

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 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.
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 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?

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 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.
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 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?

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 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.
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 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

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 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.

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 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   
MP
 
»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  
MP 
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.

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 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)

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 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)

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 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.

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 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.

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Stock Valuation Models: The Basic Stock
Valuation Equation

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 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.

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 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
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 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

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 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,
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 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%.

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 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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