FI3300

Corporation Finance – Chapter 9

Bond and Stock Valuation

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Learning objectives
 Describe the concepts underlying the cost of
capital.
 Compute the price of a consol and a preferred
stock.
 Compute the price of a zero-coupon bond.
 Compute the price of a fixed-coupon bond.
 Know the pricing properties of a fixed-coupon
bond.
 Compute the price of common stock under
various assumptions about dividend growth.
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Cost of capital 1

 Cost of capital
• How much the firm is willing to pay to get
funds from investors
• In other words, it is the cost to the firm for
acquiring money from investors
• Usually expressed as a percentage

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Cost of capital 2

• An investor will provide funds to the firm only if

she earns her required rate of return
• If investor provides funds to the firm (i.e., a financial
security was bought and sold), the following must be
true:
• Investor earns her required rate of return from the
transaction
• Firm pays just its cost of capital for the funds

• Thus investor’s required rate of return = firm’s

cost of capital

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Cost of capital 3

Capital can be provided either by issuing debt

(e.g., bonds) or equity (common stock).
 If debt is issued,
Investor’s required rate of return on debt security
= firm’s cost of debt

 If equity is issued,
Investor’s required rate of return on equity security
= firm’s cost of equity
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Blast from the past: last lecture

 Required rate of return on debt security

is also known as:
• Cost of debt
• Yield-to-maturity (YTM for short)
• Discount rate
 Required rate of return on equity security
is also known as:
• Cost of equity
• Discount rate
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Bond Valuation

 Consols, Preferred stock

 Zero-coupon bonds
 Fixed-coupon bonds

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Consols 1
 Pays a fixed coupon every period forever.
 Has no maturity.
 Investor who buys a consol is buying the perpetuity of the
fixed coupon.
So, use PV formula of a perpetuity to find the
present value/price of the consol
Price of consol
= fixed coupon in dollar ter ms
investor' s required rate of return on consol
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Consols 2

 Remember earlier that cost of capital =

investor’s required rate of return. So, we can
re-arrange the equation to find the firm’s cost
of consol capital.
fixed coupon in dollar ter ms
 Cost of consol capital 
price of consol
 We can apply the same ideas to value
preferred stocks. This is because the cash
flows from a preferred stock is also a
perpetuity!
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Preferred stock

Pays a fixed dividend forever.

Price of preferred stock is simply the present
value of a perpetuity. Preferred stock
dividend
D
Price of
preferred stock
Pps 
rp Required rate of
return on preferred
stock/ cost of
capital for preferred
Required rate of return on preferred stock. stock
D
rp 
Pps
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Consol problem 1
 Problem 9.2 ABC Corp. wants to issue perpetual
debt in order to raise capital. It plans to pay a coupon
of $90 per year on each bond with face value $1,000.
Consols of a comparable firm with a coupon of $100
per year are selling at $1,050. What is the cost of debt
capital for ABC? What will be the price at which it will
issue its consols?

 Verify that cost of debt = 0.0952 or 9.52%

 Use cost of debt from above to find price of consol.
Verify that price of consol = 90/0.0952 = 945.38

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Consol problem 2
 Problem 9.3 If ABC (from the problem above)
wanted to raise $100 million dollars in debt, how many
such consols would it have to issue (to nearest whole
number)?
 No. of consols = 100 million/ consol price = 105,778

 Problem 9.4 If ABC wanted to issue it’s consols at

par, that is, at a price of $1,000, what coupon must it
pay?
 Use coupon = price x required rate of return
 Verify that coupon = $95.20 per year
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Zero-coupon bond (ZCB) 1
 Call this ZCB for short.
 Zero coupon rate, no coupon paid during bond’s life.
 Bond holder receives one payment at maturity, the
face value (usually $1000).
 Price of a ZCB, PZCB F = face value of the bond

F
PZCB 
1  r d
ZCB N
 N = number of years
cost of ZCB to maturity
debt capital
(in decimals)
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Zero-coupon bond (ZCB) 2

 As long as interest rates are positive, the

price of a ZCB must be less than its face
value.
 Why? With positive interest rates, the
present value of the face value (i.e., the
price) has to be less than the face value.

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 These problems are just basic TVM problems where you receive
one lump sum in the future.
ZCB Problems
1) Find the price of a ZCB with 20 years to
maturity, par value of $1000 and a required
rate of return of 15% p.a.
N=20, I/Y=15, FV=1000, PMT=0. Price = $61.10
2) XYZ Corp.’s ZCB has a market price of $ 354.
The bond has 16 years to maturity and its face
value is $1000. What is the cost of debt for the
ZCB (i.e., the required rate of return).
PV=-354, FV=1000, N=16, PMT=0.
Required rate of return/ Cost of debt =6.71% p.a.
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Fixed-coupon bond (FCB) 1
 Call this FCB for short.
 Firm pays a fixed amount (‘coupon’) to the
investor every period until bond matures.
 At maturity, firm pays face value of the bond to
investor.
 Face value also called par value. Unless
otherwise stated, always assume face value to
be $1000.
 Period: can be year, half-year (6 months),
quarter (3 months).
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Fixed-coupon bond (FCB) 2

 FCB gives you a stream of fixed payments

plus a lump sum payment (face value) at
maturity.
 This cash flow stream is just an annuity plus a
lump sum at maturity.
 Therefore, we calculate the price of a FCB by
finding the PV of the annuity and lump sum.
 We use the financial calculator to compute the
price of the FCB.

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Fixed-coupon bond (FCB) 2

Price of the FCB, PFCB

Fixed periodic
Number of Face value
coupon
periods to
maturity
N
C F
PFCB  
t 1 1  rd  1  rd 
t N

Cost of debt capital

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Find FCB price

 A $1,000 par value bond has coupon

rate of 5% and the coupon is paid semi-
annually. The bond matures in 20 years
and has a required rate of return of 10%.
Compute the current price of this bond.
 PMT = 25. Why?
FV=1000, PMT =25, I/Y=5, N=40. CPT, then PV.
PV = -571.02. Thus, price = $571.02 < par value

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Useful property 1

Go back to the bond in the last problem.

 Suppose annual coupon rate = 10%.
 Verify that price = $1000 = par value

 Suppose annual coupon rate = 12%

 Verify that price = $1,171.59 > par value.

It turns out that the following property is true.

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 Note: discount rate = cost of debt = required rate of return = yield to maturity
Useful property 2

Coupon rate < discount rate Price < face value Bond is
selling at a
discount

Coupon rate = discount rate Price = face value Bond is

selling at
par

Coupon rate > discount rate Price > face value Bond is
selling at a
premium

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Apply what we learnt
 A 10-year annual coupon bond was issued four years
ago at par. Since then the bond’s yield to maturity
(YTM) has decreased from 9% to 7%. Which of the
following statements is true about the current market
price of the bond?

 The bond is selling at a discount

 The bond is selling at par
 The bond is selling at a premium
 The bond is selling at book value
 Insufficient information

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Try one more
 One year ago Pell Inc. sold 20-year, $1,000 par value,
annual coupon bonds at a price of $931.54 per bond.
At that time the market rate (i.e., yield to maturity) was
9 percent. Today the market rate is 9.5 percent;
therefore the bonds are currently selling:
 at a discount.
 at a premium.
 at par.
 above the market price.
 not enough information.

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Find YTM, Coupon rate
1)A $1,000 par value bond sells for $863.05. It matures in
20 years, has a 10 percent coupon rate, and pays
interest semi-annually. What is the bond’s yield to
maturity on a per annum basis (to 2 decimal places)?
Verify that YTM = 11.80%
2) ABC Inc. just issued a twenty-year semi-annual coupon
bond at a price of $787.39. The face value of the bond is
$1,000, and the market interest rate is 9%. What is the
annual coupon rate (in percent, to 2 decimal places)?
Verify that annual coupon rate = 6.69%
What happens if bond pays coupon annually? Quarterly?

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Long FCB question
 HMV Inc. needs to raise funds for an expansion
project. The company can choose to issue either zero-
coupon bonds or semi-annual coupon bonds. In either
case the bonds would have the SAME nominal
required rate of return, a 20-year maturity and a par
value of $1,000. If the company issues the zero-
coupon bonds, they would sell for $153.81. If it issues
the semi-annual coupon bonds, they would sell for
$756.32. What annual coupon rate is Camden Inc.
planning to offer on the coupon bonds? State your
answer in percentage terms, rounded to 2 decimal
places.
 Verify that annual coupon rate = 7.01%
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Common stock
For common stock, the future cash flows are:
 Dividends
 Selling price
These cash flows are highly uncertain.
 To find the value of common stock, we make
assumptions about how dividends evolve in
the future. We look at 3 set of assumptions:
 Constant dividend stream
 Dividends grow at constant rate (constant
dividend growth model)
 Non-constant dividend growth

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Constant dividend stream
 Same amount of dividend is paid for ever.
 Cash flow stream resembles a perpetuity.
 Thus, we value the common stock in the same way as
we value the preferred stock.
Common
 Common stock price, Pe stock
D
Pe  dividend
re
Cost of equity
 Cost of equity capital, re capital or
D required rate
re  of return on
Pe equity

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Dividends grow at constant rate 1

 Assume that dividends grow at a

constant rate, g, per period forever.
 Given this assumption, the price of
common stock equals
D0 = Dividend Don’t panic.
that the firm just
D0 1  g  D1 D1 = D0(1 + g)
paid
Pe  
re  g re  g
Required rate
of return on Dividend
equity growth rate
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Dividends grow at constant rate 2

Useful properties.
 All other things unchanged,
• If D0 increases (decreases), Pe increases
(decreases).
• If g increases (decreases), Pe increases
(decreases).
• If re increases (decreases), Pe decreases
(increases).

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Dividends grow at constant rate 2

 By rearranging the above equation, we

can find the required rate of return on
equity
D1
Required rate re  g Capital gains
of return on Pe yield
equity

Dividend yield

 For the constant growth model to work,

re > g.
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Constant growth problems 1

 Jarrow Company will pay an annual dividend

of $3 per share one year from today. The
dividend is expected to grow at a constant rate
of 7% permanently. The market requires 15%
What is the current price of the stock (to 2
decimal places)?

In this question D1 is already given to you.

Verify that Price = $37.5

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Constant growth problems 2

 Johnson Foods Inc. just paid a dividend of $10

(i.e., D0 = 10.00). Its dividends are expected
to grow at a 4% annual rate forever. If you
require a 15% rate of return on investments of
this risk level, what is Johnson Foods’s current
stock price? (to 2 decimal places)

Straightforward application of price formula.

Verify that price = $94.55

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Constant growth problems 3

 The price of a stock in the market is $62. You

know that the firm has just paid a dividend of
$5 per share (i.e., D0 = 5). The dividend
growth rate is expected to be 6 percent
forever. What is the investors’ required rate of
return for this stock (to 2 decimal places)?

Use re = (D1/P) + g.
Verify that re = 14.55%

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Constant growth problems 4

A firm is expected to pay a dividend of

$5.00 on its stock next year. The price of
this stock is $40 and the investor’s
required rate of return is 20%. The firm’s
dividends grow at a constant rate. What
is this constant dividend growth rate (g)?
use re = (D1/P) + g
Verify that g = 7.5%

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Non-constant dividend growth 1

 With this assumption, dividends grow at

different rates for different periods of
time. Eventually, dividends will grow at a
constant rate forever.
 Time line is very useful for valuing this
type of stocks.
 To value such stocks, also need the
constant growth formula.
 Best way to learn is through an example.
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Non-constant dividend growth 2

 Consider ABC Co.’s dividend stream:

Dividends grow
$2.00 $3.00 $3.50 at 5% forever

T=0 T =1 T=2 T=3 T=4

 Discount rate is 15%.

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What to do?

 Use constant growth formula to find

stock price at the end of year 3. Call this
stock price P3.
 Add P3 to dividend received at t=3. This
sum is the cash flow for t=3. Find PV of
this cash flow.
 Find PV of dividends at t=1, t=2.
 Current stock price = sum of 2 and 3.

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Apply the method to
find ABC’s stock price
 P3 = (3.5 x (1.05))/(0.15 – 0.05) = 36.75
 Find cash flow at t=3
 36.75 + 3.50 = 40.25
Current stock price, P0
2 3 40.25
P0     $30.47
1.15 1.152
1.153

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Another type of non-constant growth
problem
Malcolm Manufacturing, Inc. just paid a $2.00
annual dividend (that is, D0 = 2.00). Investors
believe that the firm will grow at 10% annually for
the next 2 years and 6% annually forever
thereafter. Assuming a required return of 15%,
what is the current price of the stock (to 2
decimal places)?
Use timeline to ‘see’ the problem better.
Verify that stock price = $25.29

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Summary
 Find the price/ present value of debt and
equity securities
 Consols, preferred stock are valued using the
same techniques.
 Fixed-coupon bonds are valued as an annuity
plus a lump sum (face value at maturity)
 Common stocks are valued under 3 different
assumptions about dividends
• Constant dividends
• Dividends grow at constant rate
• Dividends grow at different rates

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