MANAGERIAL FINANCE: FTX1005

WEEK 8
SHARE AND BOND VALUATIONS

Nomthandazo Jwara
[email protected]
Property of the University of Cape Town 1
 Learning Objectives:
❑ Explain what an efficient capital market is and why efficient efficiency is important to financial
managers
❑ Describe the market for corporate bonds and three types of corporate bonds
❑ Explain how to calculate the value of a bond and why bond prices vary negatively with interest rate
movements
❑ Distinguish between a bond’s coupon rate, yield to maturity and effective annual yield and be able to
calculate their values
❑ Explain why many financial analyst treat preference shares as a special type of bond rather than as
an equity security
❑ Describe how the general dividend-valuation model values ordinary shares
❑ Explain why g must be less than R in the constant-growth dividend model
❑ Explain how valuing preference shares with a stated maturity differs from valuing preference shares
with no maturity date and be able to calculate the price of both types of preference shares.
 BACKGROUND
We will use the DCF technique
Time Value of Money Vs. Basic Valuations[DCF Technique]
Similarities
➢ The same thing, [no new formulas],
➢ We are applying the present value techniques.
➢ That PV is going to be our intrinsic price/fair value. that’s a VALUATION.
New stuff
➢ Focus is now on specific financial instruments [Bonds, Ordinary Shares, Prefs]
➢ New names and new definitions to what you know already [e.g PV,FV,I/PMT, i, n]
➢ It comes down to the present valuing & timing of cash flows for each instrument.
important
➢ Bring your TVM Module every day to the lectures
➢ We will analyse the valuation from the investor’s perspective
3
 1. INTRODUCTION TO VALUATIONS

▪ Security markets, such as the bond and stock markets, help bring buyers and sellers of securities
together.
▪ The supply and demand for securities are better reflected in organized markets. Investors would like
financial markets to price securities at their true (intrinsic ) value.
➢ A security’s true value is the present value of the cash flows an investor who owns that security
can expect to receive in the future.
➢ This present value reflects all available information about the size, timing, and riskiness of the
cash flows at the time the price was set.
➢ As new information becomes available, investors adjust their cash flow estimates through buying
and selling, and the price of security adjusts to reflect this information.
What is valuation?
▪ Valuation is the process of determining how much an asset is worth.

What do you get from the valuations?

▪ Fair value or fair price
▪ Intrinsic value or intrinsic price

Why do we value securities?

▪ To determine the intrinsic value of a security,
▪ Discount all its future cash flows.

What is the Role of Valuations?

▪ To determine whether an asset is overvalued or undervalued by the market.

Techniques of valuing financial assets

▪ Discounted Cash flow techniques: the process involves finding the present value of the future benefits
1.2. Difference between market price and intrinsic price

Market price vs intrinsic price

Market price(MP) Compare Intrinsic price (IP)

the two
➢ Observed from the market + other ➢ Self-assigned value
➢ Is the consensus price of all factors ➢ Varieties of models
traders used for estimation.
➢ Find it in newspapers

MP<IP=BUY, security is underpriced

MP>IP=SELL, security is overpriced
MP=IP=HOLD, security is correctly priced

Note:
➢ Value investors look for under-priced assets
❖ prices that are unjustifiably low based on their intrinsic worth.
3.2 Role of a valuation
▪ Assist investors in making investment decisions :

Let’s assist John the novice investor

➢ On the JSE MTN, ordinary shares are trading at a price of R195.40. John has done his
valuation and came up with an intrinsic price of R250.
Analyse Intrinsic value > Market price Which means? asset is under-priced decision Buy

b) John holds Vodacom shares, the shares are trading at R120.79 on the JSE. The intrinsic price
according to John’s model is R95.10
Analyse Intrinsic value < Market price Which means? asset is over-priced decision Sell

c) John holds Vodacom shares, the shares are trading at R300 on the JSE. The intrinsic price
according to John’s model is R300
Analyse Intrinsic value = Market price Which means? asset is fairly priced decision Hold
1.3 Market conditions.

▪ Efficient markets
➢ Market prices fully reflect all information, knowledge & expectations of all investors.
❖ Low costs and easy to transact (market participants are knowledgeable)
❖ If markets are efficient, investors have no reason to believe securities are not priced at or
near their true value their true value

Efficient Market Outcome Market price=intrinsic price.

▪ Inefficient markets
➢ The opposite of conditions under efficient markets
❖ Market prices deviate from the intrinsic prices by huge margins

Inefficient Market Outcome Over and underpriced securities.

EFFICIENT MARKET HYPOTHESIS

A theory concerning the extent to which information is incorporated
into security prices.
1.4 Techniques of valuing financial assets:

1.4.1 Discounted Cash flow technique

▪ The process involves finding the present value of the future benefits (cash flows) of the
asset.

0 1 2 3 4

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4

Discount rate = Required
PV of Cash flows = rate of return (RRR)
Intrinsic Value

9
1.4.2 Techniques of valuing financial assets: Discounted Cash flow

Variations to the formula depending on the pattern of cash flows

Cash flow type C.

1. Perpetuity Annuity+lumpsum at the end D. A+L, with SaC
2.Annuity+LS 𝑽𝟎 = 𝑪𝒙𝑷𝑽𝑰𝑭𝑨𝒏,𝒓 + 𝑷𝒙𝑷𝑽𝑰𝑭𝒏,𝒓 𝑉0
𝟏
3.Growing perpetuity 𝟏−
(𝟏 + 𝒓)𝒏 𝟏 = 𝐶𝑥𝑃𝑉𝐼𝐹𝐴𝑛𝑋2,𝑟/2
4.Lump sum 𝑽𝟎 = 𝑪
𝒓
+ 𝑭𝑽
(𝟏 + 𝒓)𝒏 + 𝑃𝑥𝑃𝑉𝐼𝐹𝑛𝑋2,𝑟/2
5.2 stage cashflow

A E.
Perpetuity 𝟏 𝟏 Growing
𝑪 𝑽𝟎 = 𝑪𝑭𝟏 𝒙[ ] + 𝑪𝑭 𝟐 𝒙[ ] … perpetuity
𝑽𝟎 = (𝟏 + 𝒓)𝟏 (𝟏 + 𝒓)𝟐 𝑪𝟏
𝒓 𝑽𝟎 =
𝒓−𝒈
B
Lumpsum
𝟏
𝑽𝟎 = 𝑪 𝒙
(𝟏 + 𝒓)𝒏 E.
Two-stage growth cashflow
𝑪𝒙𝑷𝑽𝑰𝑭𝒏,𝒓 𝑛 𝑪𝟑
𝐶0 (1 + 𝑔1 ) 𝐶1 (1 + 𝑔2 ) 𝒓−𝒈
𝑉0 = ෍ + +
(1 + 𝑟)𝑡 (1 + 𝑟)𝑡 (1 + 𝑟)𝑛
𝑡=1
 SHARE VALUATION

❖ PREFERENCE SHARES
❖ ORDINARY SHARES
 4. THE MARKET FOR SHARES

4.1 Secondary market and their efficiency

▪ Shares are bought and sold among investors
▪ Markets are efficient when current market prices of securities traded reflect all available information
relevant to the security
▪ Types of Secondary Markets
a) Direct search: Individuals bear the full cost of locating and negotiating. It is too costly to conduct
a thorough search to locate the best price. Securities that sell in direct market search markets
are normally bought and sold infrequently

b) Broker: Brokers bring buyers and sellers together and charge a commission fee that is less
than a cost of a direct search. The presence of active brokers increases market efficiency

c) Dealer: If the trading in security has sufficient volume, market efficiency is improved if there is
someone in the marketplace to provide continuous bidding for the security. Dealers earn profits
from the spread of the securities they trade. Difference between the bid price and the offer price
 5. PREFERENCE SHARE VALUATION

▪ Regarded as fixed income securities because dividend is fixed

▪ Preference shareholders:
➢ have preferential rights over ordinary shareholders with regards to receipt of dividends
➢ Receive their dividend before the ordinary shareholder
➢ Have preference on the sharing of surplus assets on liquidation before ordinary shareholders
➢ They do not have a right to vote at shareholders meetings
▪ Ranked ahead ordinary shares in the event of liquidation but behind debt finance :
➢ have a debt characteristic and consequently referred to as hybrid instruments (mix instrument)
Understanding preference share transaction

At Pref Issuance Date

Companies Prefs Selling Price Investors
(In need of Pref Certificate (got cash, seek
finance) investment
Subsequent periods opportunities)
Selling/Issuing
Prefs
dividends

Principal is repaid at End Buying Prefs

of term

Secondary trading is
huge. The company
is not involved
5.1 Redeemable and Non-redeemable preference shares

▪ Pref in perpetuity/non-redeemable preference shares

➢ [Normal perpetuity]
➢ Non-redeemable + cumulative preference shares
➢ Non-redeemable +non cumulative preference shares

▪ Redeemable preference shares

5.2 Valuation of Preference shares

▪ To determine the intrinsic value of preference shares,

▪ Discount all the future cash flows (dividends) using the required rate of return (dividend yield for
similar preference) as the discount rate.

𝑃𝑆0 = 𝑃𝑉 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 + 𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒

5.2.1 Preference share in perpetuity: Non-redeemable preference share
▪ A permanent form of financing with no obligation on the part of the company to repay the capital amount
𝑫𝒑
▪ Pay an infinite series of equal and periodic cash flows. Valued using perpetuity formulae: 𝑷𝑺𝟎 =
𝒊
𝑫𝒑 = the annual preference share dividend
𝒊 = the yield to maturity of the preference share

Class Example 1
Many years ago, MJ’s ltd. issued non-redeemable preference shares. The shares pay an annual dividend
equal to R6.80. If the required rate of return on similar risk investments is 8 percent.
Required: What should be the market value of ’MJs preference shares?

Class Example 1 Suggested Solution

Dp
PS0 =
i
Dp = R6,80, I = 8%

𝑅6.80
=
0.08

= 𝑅85
5.2.2 Redeemable preferences shares
1
1−
(1+𝒊)𝑛 1
𝑃𝑆0 = 𝐷𝑥 + 𝑃𝑥((1+𝒊)𝑛 )
𝒊
𝐷= the annual preference share dividend payment
𝑃= the stated (par) value of the preference share
𝑖 = the yield to maturity of the preference share
𝑛 = the number of years to maturity
Class Example 2
The company issued redeemable preference shares that value R10 000, these shares pay a dividend of
8%. The required rate of return on similar preference shares (dividend yield) is 10%. The shares are
redeemable in full after 5 years. Required: Determine the market value of these shares

Class Example 2 Suggested Solution

1
1−
(1+𝒊)𝑛 1
𝑃𝑆0 = 𝐷𝑥 + 𝑃𝑥( )
𝒊 (1+𝒊)𝑛
D = R10 000 x 0,08 = R800, P = R10 000, I =0,10, N=5

1
1−
(1+0,10)5 1
𝑃𝑆0 = 800 + 10 000 ((1+0,10)5 )
𝟎,𝟏𝟎
1
1− 1
(1,6105
𝑃𝑆0 = 800 + 10 000 ( )
0,10 1,6105
𝑃𝑆0 = 3032,8 +6209
𝑃𝑆0 = 9241,8
Class Example 2 Suggested Solution continued …

Vp = DxPVIFAn,r + PxPVIFn,r
• PS0 = D x PVIFA5,10% + P x PVIF5,10%
• PS0 = 800x 3.791 + 10,000 x 0.621
• PS0 = R9,242.80

Cash flow pattern of the bond

0 1 2 3 4 5
R800 R800 R800 R800 R10,000+800

PV=Pref value=𝑽𝒑

18
 6. ORDINARY SHARE VALUATION
a) Listed Ordinary shares
▪ Enjoy all the residual benefits of company ownership, but are exposed to the primary risks are
difficult financial instruments to value.
▪ Unlike bonds, shares represents an ownership interest in a company and shareholders are
entitled to: voting rights (at the AGM) and dividends (when declared). share surplus on assets on
liquidation of the company.
▪ Shares may be listed on a Stock Exchange : stock exchange act as both primary and a
secondary market
- Advantages: In the long-term, they outperform bonds and money market instruments, easy to
buy and sell (being listed), information is easily available (annual reports and share prices),
hundreds of firms to choose from.
- Disadvantages: The risk is higher than that of bonds and money markets instruments.
Dividends are not guaranteed and you could loose the original investment.
Understanding the ordinary share transaction
(Initial Public Offer -selling shares to the public through a listing of the shares on a stock exchange)

At IPO, Issuance Date

Companies Investors
Selling IPOPrice
(In need of share Certificate (got cash, seek
finance) investment
Subsequent periods opportunities)
Selling/Issuing
Ordinary
shares Dividends-discretion of firm

Buying Shares

Secondary trading is
huge. The company is
not involved
JSE is the trading
6.1 Valuing Ordinary Share: Dividend discount model (DDM)

▪ Based on the DDM, the intrinsic value of equity or the stock price should equal the present value of all
expected future dividends to perpetuity
DDM The dividend discount model is a method of valuing a company's stock price based on the theory that its
stock is worth the sum of all of its future dividend payments, discounted back to their present value

▪ General Formula
𝑃0 = 𝑃𝑉(𝐴𝑙𝑙 𝑓𝑢𝑡𝑢𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠)

Valuation process using DDM, the steps

▪ Determine/Project future dividends of the firm-More detail
▪ Determine the RRR in more detail under WACC.
▪ Discount the dividends to the valuation date at the required rate of return

Dividend discount model versions

▪ Zero growth in dividend
▪ Constant growth model/Gordon/Dividend Growth Model
▪ Non-constant growth model/2 stage model (for advanced Finance courses)

NB: These models suit different types of companies and industries.

6.1.1 Ordinary Share: Zero Growth model
▪ The model assumes that dividend will have a growth rate of zero
▪ The dividend payment pattern remains constant over time
▪ Question: Given that companies are regarded as going concerns, which TVM formula do we apply?
D
So we are simply valuing perpetuity. Value P0 =
R
𝑃0 = the current value, price or present value of the share
𝐷 = the constant cash dividend received in each time period
𝑅 = the required return on the shares or discount rate

Class Example 3
Assume a company pays a constant dividend of R0.80 to perpetuity, and the investors require a rate of
11%.
Required: Calculate the fair price of each ordinary share.

Class Example 3 – Solution

D
Value P0 =
R
D = R0,80; R = 11%

0.80
P0 =
0.11
= R7.27
6.1.2 Ordinary Share: Constant growth model

▪ The model assumes dividends grow at the same average rate from one period to the next period
forever (-ve/+ve)
▪ It is the appropriate assumption for mature companies with a history of stable growth
▪ We assume a constant growth in dividends to infinite. We apply the growing perpetuity formula.

D1 D0 (1 + g)
P0 = =
R−g R−g

P0 = the current value, or price of the share

D1 = the next year’s dividend,
D0 = is the last dividend paid
R = required rate of return for ordinary shareholders,
g = the constant growth rate for dividends / estimated future growth rate in dividends,
The constant growth model continues….

▪ Dividend growth curve Companies go through life cycles and as a result, exhibit
different dividend patterns over time
▪ During the early part of their lives, successful businesses experience mixed/supernormal rates of
growth in earnings pay lower dividends or no dividends, reinvest earnings

TAKE NOTE:

▪ You may be given the current dividend that is D0 , you will then need to calculate D1 using D0 and g.
➢ -To determine whether the dividend given is D0 /D1 , watch out for words like current/next dividend
OR just paid or expect to pay, this year they paid, next year they will pay.
▪ Growth rate may be positive, negative, or zero
▪ You may be required to compute the growth given a set of information. Use the sustainable growth
formula or historical compounded growth in dividends if you are given data for past dividends
▪ You may be required to calculate the required rate of return for ordinary shares. Use the Capital Asset
pricing model (CAPM)
Class Example 4
Harvey ltd expects to pay an R2.15 dividend in the next period. The dividend has been increasing at a
6% annual rate and is expected to continue at this rate.
Required:
What is the maximum price you are willing to pay for this stock if your required rate of return is 11%?

Class Example 4 – Solution

D1
P0 =
R−g
D1 = R2,15
R = 11%
G= 6%

D1
P0 =
R−g

2.15
P0 =
0.11 − 0.06

P0 = R43
Class example 5
Lively Limited paid the R3 dividend this year. The firm expects the dividends to grow at a constant of
5% each year, forever. Investors require a 12% return to invest in this stock.
Required: What is the intrinsic price of this share?

Class Example 5 - Solution

𝐷1
𝑃0 =
𝑅−𝑔
D1 = ?; D0 = R3 ; R = 12% ; G = 5%

the next year’s dividend (not given, therefore, calculate it)

𝐷1
𝑃0 =
𝑅−𝑔
is the last dividend paid
𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒 𝐷1 = 𝐷0 𝑋 1 + 𝑔

𝐷1 = 3 1.05 = 𝑅3.15

3.15
𝑃0 =
0.12−0.05

= 𝑅45
 Class example 6
Kid Ltd. paid a dividend of R2 in the last period. Due to lagging sales, the firm’s dividends have been
reduced each year by 4%. This trend is expected to continue in the future.
Required: What is the most price you are willing to pay for this stock if your required rate of return is
10%?

Class Example 6 - Solution

𝐷1
𝑃0 =
𝑅−𝑔
D1 = ? ; D0 = R2; R= 10%; G = - 4%
D
P0 = 1 the next year’s dividend (not given, therefore, calculate it )
R−g
𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒 𝐷1 = 𝐷0 𝑋 1 + 𝑔

dividend is reduced by 4%, therefore, (1-g) instead of 1 +g

D1 = 2(1- 0,04) = 1,92

1,92
𝑃0 =
0.10−(−0.04)
1.92
=
0.14
= R13.71
CORPORATE BONDS
 7. CORPORATE BONDS
7.1 What is a bond?
▪ These are financial securities issued by companies, governments, or municipalities in order to
borrow from the public (e.g., government and corporate bonds).
▪ A bond is a long-term debt instrument used for raising finance.
▪ Two parties to a bond;
➢ One party borrows - Borrower/issuer/seller
➢ The other party lends - Lender/Investor/Buyer
▪ The borrower is obligated to pay periodic interest and the principal amount at a specific date
▪ Interest paid is called a coupon payment
➢ Interest payments are made to the bondholder
▪ Bond issuers have an obligation to pay bondholders (a) fixed interest amounts (or coupons) annually
or semi-annually; & (b) the principal sum on maturity.
➢ Advantages: Are safer (less risky) than shares (interest & capital sum guaranteed).
➢ Disadvantages: The return on bonds is less than the return on shares.
Understanding bond transaction

At Bond Issuance Date

Borrower Lenders
Bond Selling Price
Issuers Bond Certificate Investors
(In need of (got cash, seek
finance) Subsequent periods investment
opportunities)
Selling/Issuing Coupon/interest Payments
Bonds
Principal is repaid at End Buying Bonds
of Bond Term.

Secondary trading is
huge
7.2 Types of Corporate Bonds

a) Plain Vanilla Bonds /Straight bonds

➢ Coupon payments are fixed for the life of the bond
➢ The entire original principal is paid at maturity
b) Zero-coupon Bonds
➢ There are no coupon payments
➢ A single payment at maturity
➢ Interest paid to the bondholder is the difference between the principal amount paid current
amount received at maturity
c) Convertible Bonds
➢ Converted into ordinary shares at some predetermined ratio at the discretion of the bondholder
d) Callable, Puttable, and Perpetual Bonds
➢ A company issuing a bond may include a special provision that allows an issuer to redeem the
bond at a present price
7.3 Basic bond features
ABC Limited raised R123,000 by selling a bond. The bond has a face value of R100 000. It pays a 15%
coupon, paid annually. The bond is redeemable in 5 years time. Similar bonds have a market yield of 9%
Bond feature Details
Face Value ▪ Paid/received when bond matures. Principal amount owed to the bondholder
▪ R100 000 at maturity
▪ Determine coupon payment
▪ Set by company & fixed
Coupon rate/ payment ▪ It determines the coupon payments
▪ 15%/R15 000 ▪ Coupon rate x face value
(R100 000 x 15%) ▪ Set by company and is fixed
Time to maturity ▪ Shows the lifespan of the bond
▪ 5 years ▪ Set by the company & fixed
Yield to maturity ▪ Represents the return required by investors on the particular bond
▪ 9% ▪ Used as a discount rate
▪ Fluctuates with market conditions Rate is determined from the market prices of
bonds that have features similar to those of the bond being valued.

Price ▪ The amount you (the investor) pay to buy the bond
▪ R123million ▪ It’s a function of the cash flows & YTM
▪ It is not fixed, it fluctuates
Bond interpretation

Bond feature Details

Par -value Bonds sell at face value – coupon rate is equal to the market rate of
interest on similar bonds
Discount bonds Bond sells at below face value

Premium bonds Bond sells at above face value

Valuation of corporate bonds continued…..

Non-redeemable AND Redeemable bonds

a) Bond in perpetuity/non-redeemable bond

▪ No fixed life span i.e. no redemption date
▪ Pays coupons indefinitely
▪ The principal is not paid back
𝑪
Apply the perpetuity formula: 𝑷𝑩 =
𝒊

b) Redeemable bond
▪ Has a fixed lifespan
▪ Pays coupons up to the maturity date[annuities]
▪ Pays the principal at maturity [lumpsum]
𝟏
𝟏−(𝟏+𝒊)𝒏 𝟏
𝑷𝑩 = 𝑪𝒙 + 𝑭𝒙(
𝒊 (𝟏+𝒊)𝒏
OR
𝑷𝑩 = 𝑪𝒙𝑷𝑽𝑰𝑭𝑨𝒏,𝒊 + 𝑭𝒙𝑷𝑽𝑰𝑭𝒏,𝒊

“These are the two types of bonds that we will be dealing with. There are more bond types including convertible bonds but they
are outside our syllabus.”
7.5 Bond Valuation

▪ To determine the intrinsic value of a bond,

▪ Discount all its future coupons using yield to maturity as the discount rate.

PB = PV all future cashfl𝑜𝑤𝑠 (𝑐𝑜𝑢𝑝𝑜𝑛𝑠 + 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑝𝑎𝑦𝑚𝑒𝑛𝑡

𝑃𝐵 = the price of the bond

C = Coupon payment
I = required rate / the interest rate for n periods
F = principal amount / the amount of the cash payment at maturity ( face value)
n= number of periods to the bond maturity
m= the number of times interest is compounded each year
Bond in Perpetuity/ Non-Redeemable bond
Class Example 7
A non-redeemable bond has a face value of R100 and pays a coupon rate of 15% pa. The current yield
to maturity for similar bonds is 9%.
Required
How much will you pay for this bond?

Class Example 7 - Solution

𝑪
Apply the perpetuity formula: 𝑷𝑩 =
𝒊
C = Coupon payment (face value x coupon rate)
i= required rate

C= R100 x 15% = R15

i= 9%

𝑅15
𝑃𝐵 =
9%

=R166.67

Q: Are you willing to pay R166.67 for this bond?

Redeemable bond: Annual coupons
Class Example 8
Q Ltd issued a bond with a Face Value of R100 and pays an annual coupon of 15%, and it is
redeemable in 5 years’ time. Similar bonds have a market yield of 9%. Required: How much will you be
willing to pay for this bond?

Class Example 8 - Solution

1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛

C = R100 x 15% =R15, i= 0,09, F =100, N=5

1
1−
(1+0.09)5 1
𝑃𝐵 = 𝑅15( )+ 100𝑥( )
0.09 (1+0.09)5
1
1−(1,538623955 1
= 𝑅15 ( ) + 100𝑥( )
0.09 1,538623955
1−0,649931386
= 𝑅15 ( ) + 100𝑥(0,649931386)
0.09
= 58,34476896 + 64,9931386
=R123.34
Q : Are you willing to pay R123,33 for a bond with an face value of R100?
Class Example 8 Solution continued

Using interest factor tables

PB= R15 xPVIFA5; 9% + R100 x PVIF5; 9%

= R15 x 3.890 + R100 x 0.650
= R 58,35 + R65
= R123.35
7.5.3 Redeemable bond: Semi-annual compounding:
Class example 9
BDC Limited issued a bond with a face value of R100 and a coupon rate of 15%p.a. The bond pays
coupons on a semi-annual basis, and it is redeemable in 5 years’ time. Similar bonds have a market yield
of 10%.
Required: How much will you be willing to pay for this bond?

Class Example 9 Suggested Solution

1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛
C= R100 x 15% =15/2= R7.50, i=10%/2=5%, n=5X2=10, F=R100
1
1−
(1+0.05)10 1
𝑃𝐵 = 7,5 ( ) +100 (1+0.05)10
0.05
1
1−1,628894627 1
= 7,5 ( ) + 100𝑥
0.05 1,628894627
1−0,613913253
= 7,5 ( ) + 100𝑥 0,613913253
0.05
= 57,91301198 + 61,3913253
=R119.30
Will you pay R119,30 for a bond with a face value of R100?
Class Example 9 - Solution continued

Using interest factor tables

PB= R15/2 xPVIFA5X2; 10%/2 + R100 x PVIF5X2; 10%/2
= R7.5 x 7.722+ R100 x 0.614
= R57,915 + R61,40
= R119.32

C= R100 x 15%
I = 10%
N=5
F = R100
M=2
1
1−
൫1+iΤm)nm 1
PB = CΤm + F(൫1+i/m)nm)
iΤm

1
1−
(1+0.10/2)5X2 1
PB = R15/2( )+100x
0.10/2 (1+0.10/2)5X2
=R119.30
7.6 Relationship between yield to maturity and bond price

Class Example 10
TYM Ltd issued a bond that has a par value of R1,000 and is now left with 15 years to maturity. The
bond pays a coupon rate of 10%.
Required:
a) Calculate the price of the bond today assuming similar bonds are trading at a yield of 10%
b) Value the bond again assuming a yield of 8%
c) Value the bond again assuming a yield of 12%

Class Example 10- Solution

1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛

N=15
C=R1,000 x10%=R100
I=10%,8%,12%
FV=R1,000
Class Example 10- Solution continued….
1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛

a) Calculate the price of the bond today assuming similar bonds are trading at a yield of 10%.

1
1− 1
(1 + 0.10)15
𝑃𝐵 = 𝑅100 + 𝑅1,000𝑥
0.10 (1 + 0.10)15
1
1− 1
4,177248169
= 𝑅100 + 𝑅1,000𝑥
0.10 4,177248169
1 − 0,239392049
= 𝑅100 + 𝑅1,000𝑥 0,239392049
0.10
=760,6079506 + 239, 392049
= 𝑅1,000
Class Example 10- Solution continued….
1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛

b) Value the bond again assuming a yield of 8%

1
1− 1
(1 + 0.08)15
𝑃𝐵 = 𝑅100 + 𝑅1,000𝑥
0.08 (1 + 0.08)15
1
1− 1
3,172169114
= 𝑅100 + 𝑅1,000𝑥
0.08 3,172169114
1 − 0,315241705
= 𝑅100 + 𝑅1,000𝑥 0,315241705
0.08
= 855,9478688 + 315,541705
= 𝑅1,171,19
Class Example 10- Solution continued….
1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛

c) Value the bond again assuming a yield of 12%

1
1− 1
(1 + 0.12)15
𝑃𝐵 = 𝑅100 + 𝑅1,000𝑥
0.12 (1 + 0.12)15
1
1− 1
5,473565759
= 𝑅100 + 𝑅1,000𝑥
0.12 5,473565759
1−, 182696261
= 𝑅100 + 𝑅1,000𝑥 0,182696261
0.12
= 681,0864489 + 182,696261
= 𝑅863.78
Class Example 10 continued… A summary and interpretation of our calculations
Question Coupon rate Face Value YTM Price (R)

a 10% R1,000 8% R1,171,19 Premium

b 10% R1,000 10% R1,000.00 Par

c 10% R1,000 12% R863,78

Discount
Observations :
b) When a bond’s YTM=coupon rate, the bond’s price = face value. The bond is trading at par.
Par: bond’s coupon rate is equal to the market rate of interest on similar bonds

a) When a bond’s YTM < coupon rate, the bond’s price becomes greater than face value. The bond is
trading at a premium.
Premium: bonds that sell at above par (face) value

c) When a bond’s YTM > coupon rate, the bond’s price becomes less than face value. The bond is
trading at a discount. The bond is trading at a discount.
Discount: bonds that sell at below par (face) value

Do you notice the inverse relationship that exists between a bond’s price and YTM??
Non-mathematical explanation of the inverse relationship between bond prices and yields
Non-mathematical explanation: negative r/ship bond price & YTM

▪ The negative relationship exists to ensure that existing bonds continue to offer the return that is
demanded by investors/the return equal to similar bonds.

▪ A change in YTM or interest rates, without a corresponding change in price means existing bonds will
offer a return that differs from (1) what investors want and (2) what similar NEW bonds are offering.
➢ That creates either more demand or less demand which then pushes the price up/down.

▪ An increase in YTM means investors now want a higher return on that bond given its features, which
means.
➢ There will be less demand for the bond, Hence the price drops till the return (YTM) is equal to
the higher yield that investors want.

▪ A decrease in YTM means investors now expect a lower return on that bond given its features, which
means
➢ There will be a huge demand, Hence the price increases till the return (YTM) is equal to the
lower yield that investors want
Preference share features vs bonds
Preference shares[Equity] Bonds/Debentures[Debt]

▪ Its an equity position- operates more like a bond ▪ It’s a debt position

▪ Receives, in most cases, a fixed dividend ▪ Receive a fixed interest/coupon

▪ Dividends payment can be postponed or even ▪ Coupons/interest have to be paid at the stipulated
foregone forever. time/date or else its default.

▪ Rank second priority ▪ Rank first priority

▪ Basic features the same, names differ: dividend ▪ Coupon, DR is kd (cost of debt)-yield to maturity
, DR/RRR = cost of preference shares

▪ Redeemable and perpetuity ▪ Redeemable and perpetuity

Q: What is the significant difference so far as cash flows are concerned?
Q: Which one is more riskier than the other, why ?
 Ordinary share features vs bonds
Ordinary shares[Equity] Bonds/Debentures & Preference shares
▪ It’s a debt position, preference shares are an
▪ Its an equity (ownership) position, participate in equity position but no claim on the underlying
the governance process entity.

▪ Receipt of dividend & proceeds on liquidation-

▪ Rank last on the receipt of dividend & proceeds on Debt-First priority and Preference shares-
liquidation Second priority

▪ No fixed cash flow-Company not obliged to pay a ▪ Coupons/interest & dividends are fixed.
dividend.

▪ No fixed lifespan-perpetuities ▪ Have a fixed term-sometimes

▪ Basic features different from Bonds & Preference
shares. ▪ Basic features different from Ordinary shares

Q: What is the significant difference so far as cash flows are concerned?

Q: Which one is more riskier than the other, why ?
 8. BOND MARKETS AND BOND RATINGS

8.1 Bond markets and reporting

▪ The Financial markets are where participants buy and sell debt securities.

8.2 Bond ratings

▪ Rated according to the creditworthiness of the issuing entity.
➢ The entity is Rated by independent agencies in terms of its likelihood of defaulting on payments.
➢ Entity’s coupons are dependent on their ratings.

▪ The lower the risk, the lower the return rate

▪ AAA: has no risk of defaulting
▪ BBB: has a greater risk of defaulting
▪ D in default
Property of the University of Cape Town 49
 BOND MARKERTS AND BOND RATINGS

Source: Wolf Street, 2020 Property of the University of Cape Town 50

Bond ratings continued……
▪ NOTE: all bonds with a rating of BB and less can be rated as junk bonds
➢ Non- investment quality and speculative

RATING AGENCIES

➢ Moody’s,
➢ Standard & Poor’s (S&P)
➢ Fitch.

Question: What is the current credit rating for South Africa?

Property of the University of Cape Town 51
 9. WHAT DETERMINES BOND RETURNS
▪ Investors want compensation for the risk they are prepared to take.
➢ The return an investor receives consists of compensation for the following mix of variables:-

9.1 Real interest rate and expected inflation rate

▪ Nominal interest rate/coupon rate is dependent on the expected inflation rate and real interest rate.
▪ When the real interest rate is added to the inflation rate, it provides an accurate estimate of the
coupon rate.
➢ If either or both increase, it would increase the coupon rate and vice versa; this relationship is
called inflation premium

9.2 Interest Rate and Time to Maturity

▪ The longer the maturity, the higher the financial compensation for the investor.
▪ Long-term bonds have more interest rate risk than short-term bonds.
➢ Extra compensation required by the investor in long-term bonds is referred to as the interest-rate
Property of the University of Cape Town 52
premium
what determines bond returns continued…..

9.3 Default risk

▪ The issuer may not be able to make payments.
➢ The bond rating indicates if a bond is of high quality or if the risk of default is high.
➢ The higher the risk of default, the higher compensation for the investor, and this is called the
credit risk premium.

9.4 Lack of liquidity

▪ Bonds not traded regularly are not very liquid. Investors might struggle to convert it into cash. the
investor will require compensation called liquidity premium

Property of the University of Cape Town 53

 END OF WEEK 8

Recommended textbooks
▪ Moles P., Parrion R and Kidwell D. Corporate Finance , John Wiley &Sons Ltd. United Kingdom. 2011
▪ D Flynn, Understanding Finance & Accounting , 2019,
▪ Alsemgeest, du Toit, Ngwenya and Thomas. 2020. Corporate Finance: A South African perspective. Chapter 8
 CLASS EXERCISE
1. A non-redeemable bond has a face value of R 5000 and pays a coupon rate of 15% p.a. The
current yield to maturity for similar bonds is 7%. How much will you pay for this bond?

2. Cookie Ltd issued a bond with a face value of R 4 000, and it pays an annual coupon rate of 10%. It
is redeemable in 5 years’ time. Similar bonds have a market yield of 12%. Calculate the price that you
will pay for this bond.

3. Sweet Ltd has issued a bond with a face value of R1000. This is a three-year bond that pays a
coupon of 6.10%. Coupon payments are made semi-annually. The yield to maturity is 5.8%.
3.1 How much will you be willing to pay for this bond?
3.2 Based on your calculations above, is this bond selling at premium, discount, or par? Motivate
your answer

4. Candy Ltd issued a bond with a face value of R35 000 that pays annual coupon payments of
R2 300. The bond is redeemable in 3 years’ time. You have calculated the price of the bond and found
it to be R 43 000. Is this a good investment? Motivate your answer

Property of the University of Cape Town 55

 CLASS EXERCISE SOLUTIONS

1. C = R5 000 x 7% = R750, i= 7%
𝑪
𝑷𝑩 =
𝒊
𝑅750
𝑃𝐵 =
0.07
=R10 714.29

2. C = R 4 000 x 10% =R400, i= 12%, F =4 000, N=5

1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ 𝑛
]
𝑖 (1 + 𝑖)
1
1−
(1+0.12)5 1
𝑃𝐵 = 400 ( ) + 4000 ( )
012 (1+0.12)5

1
1−1.762341683 1
𝑃𝐵 = 400 ( )+4 000𝑥( )
0.12 (1.762341683
= 400(3.604776202 + 4000 (0.567426855)
= 1441.91 + 2269.71
= 3711.62 Property of the University of Cape Town 56
 Class exercise solutions continued…….
3.1
C = R 1 000 x (0.061/2) = R30.50; I 5.8%/2 = 0.029; N= 3; C = 6.1%; M=2
1
1− 1
(1 + 𝑖)𝑛
𝑃𝐵 = 𝐶 +𝐹[ ]
𝑖 (1 + 𝑖)𝑛
1
1−
(1.029)6 1
PB = 30.50 +1000
0.029 (1.029 ) 6

= R165.77 + R842.38
= R1008.15

3.2. Bond is selling at a premium. The company is offering a high coupon payment that is greater than
the required rate. OR The selling price is higher than the face value.

4. No. My total return will be R41 900 (R2 300 x 3 + R35 000), which is less than the purchase price of
R43 000

Property of the University of Cape Town 57