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CHAPTER 5 BONDS AND STOCKS VALUATIONNURUL SUHADA BINTI RAMLI (817159)NOOR RAFIDAH BINTI KAMARUDIN (815512)YUSNIZA BINTI YAAKUB (817269)EVE CHEN BAO LIN (815754)SIVARANJINI(815652)

5.1 HOW TO VALUE BONDS

How to value BondsDefinition of bond a bond is a fixed interest financial asset issued by governments, companies, banks,public utilities and other large entities.Legally binding agreement between a borrower and a lender that specifies the Par (face) valueCoupon rateCoupon payment Maturity Date

Type of BondsSecured BondsCallable BondsConvertible BondsAgency BondsMunicipal BondsCorporate BondsZero Coupon Bond used in United States bonds markets and is the biggest in the worldPure Discount BondsMake no periodic interest payments (coupon rate= 0%). Pure discount bond that will make only one payment of principal and interest. Entire yield maturity = purchase price par value (FV)Cannot sell for more than par valueSometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)Treasury Bills and principal-only Treasury strips are good example of zeroes. Pure Discount Bonds: (Fixed future date)

Pure discount bond that will make only one payment of principal and interest. Also called a zero-coupon bomd or single-payment bond. Simplest kind of bonds coupon rate = 0.Zero-coupon bonds are bonds that do not pay interest during the life of the bonds.The bond is said to mature or expire on the date of its final payment. Face value (par value): is the payment at maturity or expire of bond.Pure Discount BondsInformation needed for valuing pure discount bonds:Time to maturity (T) = Maturity dateFace value (F)Discount rate (R)

Present value of a pure discount bond at time 0:

8Pure Discount Bonds: ExampleFind the value of a 30-year zero-coupon bond with a $1,000 par value and a YTM of 6%.

9Level Coupon BondsCoupon bonds are type of bond issue that offers the benefit of receiving an interest payment on a semi-annual basis.The coupon is paid every six months and is the same throughout the life of the bond.The face value of the bond is paid at maturity in end the final year.Level-Coupon BondsInformation needed to value level-coupon bonds:Coupon payment dates and time to maturity (T) Coupon payment (C) per period and Face value (F) Discount rate

Value of a Level-coupon bond= PV of coupon payment annuity + PV of face value

11Level-Coupon Bonds: ExampleFind the present value (as of January 1, 2002), of a 6-3/8 coupon T-bond with semi-annual payments, and a maturity date of December 2009 if the YTM is 5-percent.On January 1, 2002 the size and timing of cash flows are:

12Yield to MaturityThe yield to maturity on a bond is the rate of return that an investor would earn if he bought the bond at its current market price and held it until maturity. It represents the discount rate which equates the discounted value of a bond's future cash flows to its current market price. This is illustrated by the following equation:

Example of Yield to MaturityFind the yield to maturity on a semiannual coupon bond with a face value of $1000, a 10% coupon rate, and 15 years remaining until maturity given that the bond price is $862.35.

5.2 BONDS CONCEPTS

Bond ConceptsBond prices and interest rates move in opposite directions.

2.When coupon rate = YTM, price = par value.When coupon rate > YTM, price > par value (premium bond)When coupon rate < YTM, price < par value (discount bond)

A bond with longer maturity has higher relative (%) price change than one with shorter maturity when interest rate (YTM) changes. All other features are identical.

4. A lower coupon bond has a higher relative price change than a higher coupon bond when YTM changes. All other features are identical.5-16YTM and Bond Value5-17When the YTM < coupon, the bond trades at a premium.When the YTM = coupon, the bond trades at par.When the YTM > coupon, the bond trades at a discount.8001000110012001300$140000.010.020.030.040.050.060.070.080.090.1Discount RateBond Value6 3/8Maturity and Bond Price Volatility5-18Consider two otherwise identical bonds.The long-maturity bond will have much more volatility with respect to changes in the discount rateCDiscount RateBond ValueParShort Maturity BondLong Maturity BondCoupon Rate and Bond Price Volatility5-19Consider two otherwise identical bonds.The low-coupon bond will have much more volatility with respect to changes in the discount rateDiscount RateBond ValueHigh Coupon BondLow Coupon Bond

5.3THE PRESENT VALUE OF COMMON STOCKS

Dividends VS. Capital GainsSecurities representing equity ownership in a corporation, providing voting rights, and entitling the holder to a share of the company's success through dividends and/or capital appreciation.The price of a share of common stock to the investor is equal to the present value of all expected future dividends.

Valuations of Different Stock TypesZero GrowthConstant GrowthDifferential GrowthNOTESZERO GROWTHAssume that dividends will remain at the same level forever

rPrrrP Div)1(Div)1(Div)1(Div03322110=++++++=LExampleD0 = 2.00, R = 13%

= = RM15.380.13 RM2P0 = DivrCONSTANT GROWTHAssume that dividends will grow at a constant rate, g, forevergrP-=10DivExampleD0 = 2.00, R = 13%, g = 6%.

Constant growth model:= = = RM30.29.0.13 - 0.06RM2.12RM2.120.07P0 = D0(1+g)R - g=D1R - gDIFFERENTIAL GROWTHAssume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter.

ExampleA common stock just paid a dividend of RM2.The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in perpetuity. The discount rate is 12%.

5.4 ESTIMATES OF PARAMETERS IN THE DIVIDEND-DISCOUNT MODELThe value of firms depends upon its growth rate (g) and its discount rate (R)Where does g come from?Where does R come from?

Growth Rate (g)The amount of increase that specific variable has gained within specific areaAnnualized rate of growth of company earning and dividend.Formula: g = Retention Ratio x Return on retained earning (ROE)

Example for Firms Growth Rate (g)Firm plans to retain 40% of earning all year forward (retention ratio)The ROE = 0.16 expected to continue into future (historical)The calculationg = 0.4 x 0.16 = 0.64Because of dividend to earning, its payout out ratio is constant growth forward0.64 is growth rate for earning and dividend.

Required Return or Discount Rate (R)Required return is return on assets with the same risk as the firm share.The formula:From P = Div/(R g)Rearrange the equation to solve R, we get:R g = Div/P R = Div/P + g

Example Calculating the Required ReturnEarning = $2,000,000Share of stock outstanding= 1,000,000 Stock Selling at $10Retention Ratio = 40%Payout Ratio = 60% (1 Retention Ratio)Calculate the Earning = $2,000,000 x 1.064 = $2,128,000Calculate the dividends = 0.6 (payout) x $2,128,000 = $1,276,800Dividend per share = ($1,276,800 x 1,000,000) = $1.28g = 0.064 R = $1.28/$10.00 + 0.064 = 0.192

5.5GROWTH OPPORTUNITIES

Growth Opportunities (GO)GO = Investment chances in +ve NPV projects.A firms value can be determined as the total of a firms value that pays out ALL profits as dividends and the net equal to GO value.

NPVGOrEPSP+=

5.6 THE DIVIDENDS GROWTH MODEL AND THE NPVGO MODELTwo ways to value a stock:The dividend discount modelThe price of a share of stock Sum of its price as a cash cow plus the per-share value of its growth opportunities.

Example: Consider a firm that has EPS of $5 at the 1st year end, a dividend-payout ratio of 30%, a discount rate of 16%, and a return on retained earnings of 20%.

The dividend at year one = $5 30% = $1.50 per share. The retention ratio is 70% implying a growth rate in dividends of 14% = 70% 20%Option 1: Dividend growth modelThe price of a share is:

75$140.160.50.1$Div10=-=-=grPOption 2: NPVGO Model S1. Calculate the value of the firm as a cash cow.25.31$160.5$Div10===rP75.43$140.160.875$.160.20.50.350.30=-=-+-=grP75$75.4325.310=+=P S2. Calculate the value of the growth opportunities.S3.

5.7 PRICE-EARNING RATIO

Price to Earning RatioTo figure out the price to earnings ratio, divide the price of stock, by the earnings per share.Price Of a Stock/Earnings per share

Computing PE Ratios :Need to know the price of the stockNeed to know the annual earnings per shareDivide price of the stock by the earnings

What happens to the price to Earnings Ratios if only :The Stock Price Goes Higher? - The P/E ratio goes higherThe Stock price goes lower? - The P/E ratio goes lowerThe Earnings Go higher? The P/E ratio goes lowerThe Earnings Go Lower? The P/E ratio goes higherUnderstanding the RatioHigh P/E RatioThe stock price maybe over-valued or the company is growing rapidly

Low P/E RatioThe stock price maybe under-valued or the company is in mature industry

ExampleTake Yahoo!, for example. As of August 23, 2013, Yahoo!'s stock was trading at 27.99. We have the first part of our equation, the numerator, or 27.99.As of August 23, 2013, Yahoo!'s EPS was $.35 per share.Divide 27.99 by .35 to get 79.97. Yahoo!'s price-earnings ratio is approximately 80.THE END

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