Lecture 2

FINM7007 Financial Management

Valuation of Bonds and Shares

BD Ch 8,9

1
Zero-Coupon Bonds

• Zero-Coupon Bond
 Does not make coupon payments
 Always sells at a discount (a price lower than face
value), so they are also called pure discount bonds
 Treasury Bills are U.S. government zero-coupon
bonds with a maturity of up to one year.

2
Zero-Coupon Bonds (cont'd)

• Suppose that a one-year, risk-free, zero-coupon

bond with a $100,000 face value has an initial
price of $96,618.36. The cash flows would be:

 Although the bond pays no “interest,” your

compensation is the difference between the initial price
and the face value.

3
Zero-Coupon Bonds (cont'd)

• Yield to Maturity
 The discount rate that sets the present value of the
promised bond payments equal to the current market
price of the bond.
• Price of a Zero-Coupon bond

FV
P 
(1  YTM n ) n

4
Zero-Coupon Bonds (cont'd)

• Yield to Maturity
 For the one-year zero coupon bond:
100,000
96,618.36 
(1  YTM 1 )

100,000
1  YTM 1   1.035
96,618.36

• Thus, the YTM is 3.5%.

5
Zero-Coupon Bonds (cont'd)

• Yield to Maturity
 Yield to Maturity of an n-Year Zero-Coupon Bond
1
 FV  n
YTM n     1
 P 

6
Example 8.1

7
Example 8.1 (cont'd)

8
Zero-Coupon Bonds (cont'd)

• Risk-Free Interest Rates

 A default-free zero-coupon bond that matures on
date n provides a risk-free return over the same period.
Thus, the Law of One Price guarantees that the
risk-free interest rate equals the yield to maturity on
such a bond.
 Risk-Free Interest Rate with Maturity n

rn  YTM n

9
Coupon Bonds

• Coupon Bonds
 Pay face value at maturity
 Pay regular coupon interest payments

• Treasury Notes
 U.S. Treasury coupon security with original maturities
of 1–10 years
• Treasury Bonds
 U.S. Treasury coupon security with original maturities
over 10 years

10
Example 8.2

11
Example 8.2 (cont'd)

12
Coupon Bonds (cont'd)

• Yield to Maturity
 The YTM is the single discount rate that equates the
present value of the bond’s remaining cash flows to its
current price.

 Yield to Maturity of a Coupon Bond

1  1  FV
P  CPN  1  N 

y  (1  y )  (1  y ) N
13
Interest Rate Changes and Bond Prices

• There is an inverse relationship between

interest rates and bond prices.
 As interest rates and bond yields rise,
bond prices fall.
 As interest rates and bond yields fall,
bond prices rise.

14
8.3 The Yield Curve and Bond Arbitrage

• Using the Law of One Price and the yields of

default-free zero-coupon bonds, one can
determine the price and yield of any other
default-free bond.
• The yield curve provides sufficient information
to evaluate all such bonds.

15
Valuing a Coupon Bond
Using Zero-Coupon Yields

• The price of a coupon bond must equal the

present value of its coupon payments and
face value.
 Price of a Coupon Bond

PV  PV (Bond Cash Flows)

CPN CPN CPN  FV
    
1  YTM 1 (1  YTM 2 ) 2
(1  YTM n )n

100 100 100  1000

P   2
 3
 $1153
1.035 1.04 1.045
16
Coupon Bond Yields

• Given the yields for zero-coupon bonds, we can

price a coupon bond.
100 100 100  1000
P  1153   
(1  y ) (1  y ) 2
(1  y ) 3

100 100 100  1000

P   2
 3
 $1153
1.0444 1.0444 1.0444

17
Treasury Yield Curves

• Treasury Coupon-Paying Yield Curve

 Often referred to as “the yield curve”

• On-the-Run Bonds
 Most recently issued bonds
 The yield curve is often a plot of the yields on
these bonds.

18
8.4 Corporate Bonds

• Corporate Bonds
 Issued by corporations

• Credit Risk
 Risk of default

19
Corporate Bond Yields

• Investors pay less for bonds with credit risk

than they would for an otherwise identical
default-free bond.
• The yield of bonds with credit risk will be higher
than that of otherwise identical default-free bonds.

20
Figure 8.3 Corporate Yield Curves for
Various Ratings, September 2005

21
Valuation of Shares

22
9.1 Stock Prices, Returns,
and the Investment Horizon

• A One-Year Investor
 Potential Cash Flows
• Dividend
• Sale of Stock
 Timeline for One-Year Investor

• Since the cash flows are risky, we must discount them at the
equity cost of capital.
23
9.1 Stock Prices, Returns,
and the Investment Horizon (cont'd)

• A One-Year Investor
 Div1  P1 
P0   
 1  rE 

 If the current stock price were less than this amount,

expect investors to rush in and buy it, driving up the
stock’s price.
 If the stock price exceeded this amount, selling it would
cause the stock price to quickly fall.

24
Dividend Yields, Capital Gains,
and Total Returns

Div1  P1 Div1 P1  P0
rE   1  
P0 P0 P0
 
Dividend Yield Capital Gain Rate

• Dividend Yield
• Capital Gain
 Capital Gain Rate
• Total Return
 Dividend Yield + Capital Gain Rate
• The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk.
25
A Multi-Year Investor (cont'd)

• What is the price if we plan on holding the stock

for N years?
Div1 Div2 DivN PN
P0      
1  rE (1  rE ) 2
(1  rE ) N
(1  rE ) N

 This is known as the Dividend Discount Model.

26
A Multi-Year Investor (cont'd)


Div1 Div2 Div3 Divn
P0 
1  rE

(1  rE ) 2

(1  rE ) 3
   
n 1 (1  rE ) n

• The price of any stock is equal to the present

value of the expected future dividends it will pay.

27
9.2 The Discount-Dividend Model

• Constant Dividend Growth

 The simplest forecast for the firm’s future dividends
states that they will grow at a constant rate, g, forever.

28
9.2 The Discount-Dividend Model (cont'd)

• Constant Dividend Growth Model

Div1
P0 
rE  g

Div1
rE   g
P0

 The value of the firm depends on the current dividend

level, the cost of equity, and the growth rate.

29
Dividends Versus Investment and Growth

• A Simple Model of Growth

 Dividend Payout Ratio
• The fraction of earnings paid as dividends each year

Earningst
Divt   Dividend Payout Ratet
Shares Outstanding
       t
EPSt

30
Dividends Versus Investment
and Growth (cont'd)

• A Simple Model of Growth

 Assuming the number of shares outstanding is
constant, the firm can do two things to increase
its dividend:
• Increase its earnings (net income)
• Increase its dividend payout rate

31
Dividends Versus Investment
and Growth (cont'd)

• A Simple Model of Growth

 A firm can do one of two things with its earnings:
• It can pay them out to investors.
• It can retain and reinvest them.

32
Dividends Versus Investment
and Growth (cont'd)

• A Simple Model of Growth

Change in Earnings  New Investment  Return on New Investment

New Investment  Earnings  Retention Rate

 Retention Rate
• Fraction of current earnings that the firm retains

33
Dividends Versus Investment
and Growth (cont'd)

• A Simple Model of Growth

Change in Earnings
Earnings Growth Rate 
Earnings
 Retention Rate  Return on New Investment

g  Retention Rate  Return on New Investment

 If the firm keeps its retention rate constant, then

the growth rate in dividends will equal the growth rate
of earnings.

34
Dividends Versus Investment
and Growth (cont'd)

• Profitable Growth
 If a firm wants to increase its share price, should it cut
its dividend and invest more, or should it cut investment
and increase its dividend?
• The answer will depend on the profitability of the
firm’s investments.
 Cutting the firm’s dividend to increase investment will raise
the stock price if, and only if, the new investments have a
positive NPV.

35
Example 9.3

36
Example 9.3 (cont'd)

37
Changing Growth Rates

• We cannot use the constant dividend growth

model to value a stock if the growth rate is
not constant.
 For example, young firms often have very high initial
earnings growth rates. During this period of high
growth, these firms often retain 100% of their earnings
to exploit profitable investment opportunities. As they
mature, their growth slows. At some point, their
earnings exceed their investment needs and they begin
to pay dividends.

38
Changing Growth Rates (cont'd)

• Although we cannot use the constant dividend

growth model directly when growth is not
constant, we can use the general form of the
model to value a firm by applying the constant
growth model to calculate the future share
price of the stock once the expected growth
rate stabilizes.

39
 Changing Growth Rates (cont'd)

DivN  1
PN 
rE  g
• Dividend-Discount Model with Constant Long-
Term Growth
Div1 Div2 DivN 1  DivN  1 
P0        
1  rE (1  rE ) 2
(1  rE ) N
(1  rE ) N  rE  g 

40
Example 9.5

41
Example 9.5 (cont'd)

42