8/13/2019 ACF2013 Session 03

1/63

Applied Corporate Finance

Session 3:Interest Rates, Bond Valuation

and Stock Valuation

8/13/2019 ACF2013 Session 03

2/63

1. Know the important bond features and bondtypes2. Understand bond values and why they fluctuate3. Understand bond ratings and what they mean4. Understand the impact of inflation on interest

rates5. Understand the term structure of interest rates

and the determinants of bond yields6. Understand how stock prices depend on future

dividends and dividend growth7. Be able to compute stock prices using the

dividend growth model

Learning outcomes

ACF 2013 7-1

8/13/2019 ACF2013 Session 03

3/63

8/13/2019 ACF2013 Session 03

4/63

Consider a bond with a coupon rate of 10% and annualcoupons. The par value is $1,000, and the bond has 5years to maturity. The yield to maturity is 11%. What isthe value of the bond? Using the formula:

B = PV of annuity + PV of lump sum B = 100[1 1/(1.11) 5] / .11 + 1,000 / (1.11) 5 B = 369.59 + 593.45 = 963.04

Suppose you are reviewing a bond that has a 10%annual coupon and a face value of $1000. There are20 years to maturity, and the yield to maturity is 8%.What is the price of this bond? Using the formula:

B = PV of annuity + PV of lump sum B = 100[1 1/(1.08) 20] / .08 + 1000 / (1.08) 20 B = 981.81 + 214.55 = 1196.36

Valuing a Discount Bond with Annual Coupons

ACF 2013 7-3

8/13/2019 ACF2013 Session 03

5/63

Relationship Between Price and Yield-to-maturity (YTM)for 8% bond

600

700

800

900

1000

1100

1200

1300

1400

1500

0% 2% 4% 6% 8% 10% 12% 14%

ACF 2013

B o n

d P r i c e

Yield-to-maturity (YTM)

7-4

8/13/2019 ACF2013 Session 03

6/63

If YTM = coupon rate, then par value = bond price If YTM > coupon rate, then par value > bond price

Why? The discount provides yield above coupon rate Price below par value, called a discount bond

If YTM < coupon rate, then par value < bond price Why? Higher coupon rate causes value above par Price above par value, called a premium bond

Bond Prices: RelationshipBetween Coupon and Yield

ACF 2013 7-5

8/13/2019 ACF2013 Session 03

7/63

8/13/2019 ACF2013 Session 03

8/63

Find present values based on the paymentperiod How many coupon payments are there?

What is the semiannual coupon payment? What is the semiannual yield? B = 70[1 1/(1.08) 14] / .08 + 1,000 / (1.08) 14 =

917.56

Example 7.1

ACF 2013 7-7

8/13/2019 ACF2013 Session 03

9/63

Price Risk Change in price due to changes in interest rates Long-term bonds have more price risk than short-term bonds

(see page 223 for an example) Low coupon rate bonds have more price risk than high

coupon rate bonds Price risk is greater when the yield-to-maturity is low than

when the yield-to-maturity is high (Why? Look at the slope ofthe price and yield-to-maturity graph)

Reinvestment Rate Risk Uncertainty concerning rates at which cash flows can be

reinvested Short-term bonds have more reinvestment rate risk thanlong-term bonds

High coupon rate bonds have more reinvestment rate riskthan low coupon rate bonds

Interest Rate Risk

ACF 2013 7-8

8/13/2019 ACF2013 Session 03

10/63

Figure 7.2

ACF 2013 7-9

8/13/2019 ACF2013 Session 03

11/63

Yield to Maturity (YTM) is the rate implied bythe current bond price Finding the YTM requires trial and error if you do

not have a financial calculator and is similar tothe process for finding r with an annuity

If you have a financial calculator, enter N, PV,PMT, and FV, remembering the sign convention

(PMT and FV need to have the same sign, PV theopposite sign)

See examples 7.2 & 7.3 in text

Computing Yield to Maturity

ACF 2013 7-10

8/13/2019 ACF2013 Session 03

12/63

Suppose a bond with a 10% coupon rateand semiannual coupons, has a facevalue of $1,000, 20 years to maturity and

is selling for $1,197.93. Is the YTM more or less than 10%? What is the semiannual coupon payment? How many periods are there?

Using a financial calculator: N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT

I/Y = 4% (Is this the YTM?) YTM = 4%*2 = 8%

YTM with SemiannualCoupons

ACF 2013 7-11

8/13/2019 ACF2013 Session 03

13/63

Table 7.1

ACF 2013 7-12

8/13/2019 ACF2013 Session 03

14/63

Bonds of similar risk (and maturity) will bepriced to yield about the same return,regardless of the coupon rate

If you know the price of one bond, you canestimate its YTM and use that to find theprice of the second bond

This concept of pricing an asset based onthe price of a similar asset can be used tovalue other assets besides bonds

Bond Pricing Theorems

ACF 2013 7-13

8/13/2019 ACF2013 Session 03

15/63

There is a specific formula for findingbond prices on a spreadsheet PRICE(Settlement,Maturity,Rate,Yld,Redemption,

Frequency,Basis) YIELD(Settlement,Maturity,Rate,Pr,Redemption,Frequency,Basis)

Settlement and maturity need to be actual dates The redemption and Pr need to be input as % of par

value

Bond Prices with aSpreadsheet

ACF 2013 7-14

8/13/2019 ACF2013 Session 03

16/63

Differences BetweenDebt and Equity

Debt Not an ownership interest Creditors do not have

voting rights Interest is considered a

cost of doing business andis tax deductible Creditors have legal

recourse if interest orprincipal payments aremissed

Excess debt can lead tofinancial distress andbankruptcy

Equity Ownership interest Common stockholders

vote for the board ofdirectors and other issues

Dividends are notconsidered a cost of doingbusiness and are not taxdeductible

Dividends are not a liabilityof the firm, and

stockholders have no legalrecourse if dividends arenot paid

An all equity firm cannotgo bankrupt merely due todebt since it has no debt

ACF 2013 7-15

8/13/2019 ACF2013 Session 03

17/63

Contract between the company andthe bondholders that includes The basic terms of the bonds

The total amount of bonds issued A description of property used as

security, if applicable

Sinking fund provisions Call provisions Details of protective covenants

The Bond Indenture

ACF 2013 7-16

8/13/2019 ACF2013 Session 03

18/63

Registered vs. Bearer Forms Security

Collateral secured by financial securities

Mortgage secured by real property, normallyland or buildings

Debentures Unsecured debt (in US)

Secured debt (in UK) Notes unsecured debt with original maturity

less than 10 years

Seniority

Bond Classifications

ACF 2013 7-17

8/13/2019 ACF2013 Session 03

19/63

The coupon rate depends on the riskcharacteristics of the bond when issued

Which bonds will have the higher coupon,all else equal? Secured debt versus an unsecured debt Subordinated debt versus senior debt

A bond with a sinking fund versus one without A callable bond versus a non-callable bond

Bond Characteristics andRequired Returns

ACF 2013 7-18

8/13/2019 ACF2013 Session 03

20/63

The following are considered Investment Grade bonds1. High Grade

Moodys Aaa and S&P AAA capacity to pay is extremelystrong

Moodys Aa and S&P AA capacity to pay is very strong

2. Medium Grade Moodys A and S&P A capacity to pay is strong, but more

susceptible to changes in circumstances

Moodys Baa and S&P BBB capacity to pay is adequate,adverse conditions will have more impact on the firms abilityto pay

Anything below that are called Junk Bonds

Bond Ratings Investment Quality

ACF 2013 7-19

8/13/2019 ACF2013 Session 03

21/63

Low Grade Moodys Ba and B S&P BB and B Considered possible that the capacity to pay will

degenerate.

Very Low Grade Moodys C (and below) and S&P C (and below)

income bonds with no interest being paid, or in default with principal and interest in arrears

Page 234 shows the rating agencies in Asia Malaysia: RAM and MARC

Bond Ratings Speculative

ACF 2013 7-20

8/13/2019 ACF2013 Session 03

22/63

8/13/2019 ACF2013 Session 03

23/63

Make no periodic interest payments (coupon rate= 0%)

The entire yield-to-maturity comes from thedifference between the purchase price and thepar value

Cannot sell for more than par value Sometimes called zeroes, deep discount bonds,

or original issue discount bonds (OIDs) Treasury Bills and principal-only Treasury strips

are good examples of zeroes Zero-coupon bonds have no reinvestment

rate risk.

Zero Coupon Bonds

ACF 2013 7-22

8/13/2019 ACF2013 Session 03

24/63

Coupon rate floats depending on some indexvalue

Examples adjustable rate mortgages andinflation-linked Treasuries

There is less price risk with floating rate bonds The coupon floats, so it is less likely to differ

substantially from the yield-to-maturity

Coupons may have a collar the rate cannot goabove a specified ceiling or below a specifiedfloor

Floating-Rate Bonds

ACF 2013 7-23

8/13/2019 ACF2013 Session 03

25/63

Disaster bonds often issued by insurance companies

Income bonds Convertible bonds

bonds with warrant-like feature Put bonds There are many other types of provisions

that can be added to a bond and manybonds have several provisions it is important to recognize how these

provisions affect required returns

Other Bond Types

ACF 2013 7-24

8/13/2019 ACF2013 Session 03

26/63

Primarily over-the-counter transactionswith dealers connected electronically

Extremely large number of bond issues,

but generally low daily volume in singleissues Makes getting up-to-date prices difficult,

particularly on small company or municipal

issues Treasury securities are an exception

Bond Markets

ACF 2013 7-25

8/13/2019 ACF2013 Session 03

27/63

Highlighted quote in Figure 7.4

15 Nov 21 8.000 148.5000 148.5469 0.2656 2.59

What is the coupon rate on the bond? When does the bond mature? What is the bid price? What does this mean? What is the ask price? What does this mean?

How much did the price change from theprevious day? What is the yield based on the ask price?

Treasury Quotations

ACF 2013 7-26

8/13/2019 ACF2013 Session 03

28/63

Clean price: quoted price Dirty price: price actually paid = quoted price plus

accrued interest Example: Consider a T-bond with a 4%

semiannual yield and a clean price of $1,282.50: Number of days since last coupon = 61 Number of days in the coupon period = 184 Accrued interest = (61/184)(.04*1000) = $13.26 Dirty price = $1,282.50 + $13.26 = $1,295.76

So, you would actually pay $ 1,295.76 for thebond

Clean vs. Dirty Prices

ACF 2013 7-27

8/13/2019 ACF2013 Session 03

29/63

Real rate of interest change in buyingpower

Nominal rate of interest quoted rate of

interest, change in actual number ofdollars The ex ante nominal rate of interest

includes our desired real rate of return plus

an adjustment for expected inflation

Inflation and Interest Rates

ACF 2013 7-28

8/13/2019 ACF2013 Session 03

30/63

The Fisher Effect defines the relationshipbetween real rates, nominal rates, andinflation

(1 + R) = (1 + r)(1 + h), where R = nominal rate r = real rate h = expected inflation rate

R = r + h + rh Approximation

R r + h

The Fisher Effect

ACF 2013 7-29

8/13/2019 ACF2013 Session 03

31/63

If we require a 10% real return and weexpect inflation to be 8%, what is thenominal rate?

R = (1.10)(1.08) 1 = .188 = 18.8% Approximation: R = 10% + 8% = 18% Because the real return and expected

inflation are relatively high, there issignificant difference between the actualFisher Effect and the approximation.

Example 7.5

ACF 2013 7-30

8/13/2019 ACF2013 Session 03

32/63

Term structure is the relationship between time tomaturity and yields, all else equal

It is important to recognize that we pull out theeffect of default risk, different coupons, etc.

Yield curve graphical representation of the termstructure Normal upward-sloping; long-term yields are higher

than short-term yields

Inverted downward-sloping; long-term yields are lowerthan short-term yields

Term Structure ofInterest Rates

ACF 2013 7-31

8/13/2019 ACF2013 Session 03

33/63

Figure 7.6 Downward-Sloping Yield Curve

ACF 2013 7-32

8/13/2019 ACF2013 Session 03

34/63

In addition to the above 3 factors, thefollowing are additional factors:1.Default risk premium remember bond

ratings2.Taxability premium remember municipalversus taxable3.Liquidity premium bonds that have morefrequent trading will generally have lowerrequired returns

Anything else that affects the risk of the cash flowsto the bondholders will affect the required returns

Factors Affecting BondYields

ACF 2013 7-33

8/13/2019 ACF2013 Session 03

35/63

Valuation of Shares

If you buy a share of stock, you canreceive cash in two ways The company pays dividends You sell your shares, either to another

investor in the market or back to thecompany

As with bonds, the price of the stockis the present value of theseexpected cash flows

8-34

8/13/2019 ACF2013 Session 03

36/63

8/13/2019 ACF2013 Session 03

37/63

8/13/2019 ACF2013 Session 03

38/63

Developing The Model

You could continue to push back the year inwhich you will sell the stock

You would find that the price of the stock is really just the present value of all expected futuredividends

So, how can we estimate all future dividendpayments?

8-37

)r (1D

...)r (1

D

)r (1D

)(1

D P

s3t

s

3t2t

s

2t1t

s

1tt

r

8/13/2019 ACF2013 Session 03

39/63

Estimating Dividends: Special Cases Constant dividend

The firm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula

Constant dividend growth The firm will increase the dividend by a constant percent

every period The price is computed using the growing perpetuity

model Supernormal growth

Dividend growth is not consistent initially, but settlesdown to constant growth eventually

The price is computed using a multistage model

8-38

8/13/2019 ACF2013 Session 03

40/63

Zero Growth

If dividends are expected at regular intervalsforever, then this is a perpetuity and the presentvalue of expected future dividends can be foundusing the perpetuity formula P 0 = D / R

Suppose stock is expected to pay a $0.50dividend every quarter and the required return is

10% with quarterly compounding. What is theprice? P 0 = .50 / (0.1 / 4) = $20

8-39

8/13/2019 ACF2013 Session 03

41/63

Constant Dividend Growth Model

Dividends are expected to grow at a constant percentper period. P 0 = D1 /(1+R) + D 2 /(1+R) 2 + D3 /(1+R) 3 + P 0 = D0(1+g)/(1+R) + D 0(1+g) 2/(1+R) 2 + D0(1+g) 3/(1+R) 3 +

With a little algebra and some series work, thisreduces to:

g-R Dg-R g)1(DP100

8-40

8/13/2019 ACF2013 Session 03

42/63

8/13/2019 ACF2013 Session 03

43/63

Constant Dividend Growth Model Example 2

Suppose TB Pirates, Inc., is expected to pay a $2dividend in one year. If the dividend is expected togrow at 5% per year and the required return is 20%,what is the price?

Why isnt the $2 in the numerator multiplied by(1.05) in this example?

8-42

33.130.05-0.2

2g-R

Dg-R

g)1(DP 100

8/13/2019 ACF2013 Session 03

44/63

Stock Price Sensitivity to DividendGrowth Rate, g

D1 = $2; R = 20%

8-43

8/13/2019 ACF2013 Session 03

45/63

Stock Price Sensitivity toRequired Return, R

D1 = $2; g = 5%

8-44

8/13/2019 ACF2013 Session 03

46/63

Gordon Growth Company - I

Gordon Growth Company is expected to pay adividend of $4 next period, and dividends areexpected to grow at 6% per year. The requiredreturn is 16%. What is the current price?

Remember that we already have the dividendexpected next year, so we dont multiply thedividend by 1+g

8-45

400.06-0.16

4g-R

Dg-R

g)1(DP 100

8/13/2019 ACF2013 Session 03

47/63

Gordon Growth Company - II

What is the price expected to be in year 4?

What is the implied return given the change in price duringthe four year period?

Using financial calculator: -40 PV; 50.50 FV; 4 N; CPT I/Y= 6%

The price grows at the same rate as the dividends

8-46

50.500.06-0.16

0.06)4(1g-R g)1(D

g-R D

P44

154

6%0.06r r)40(150.50

r)(1PP4

404

8/13/2019 ACF2013 Session 03

48/63

8/13/2019 ACF2013 Session 03

49/63

N t t G th

8/13/2019 ACF2013 Session 03

50/63

Nonconstant GrowthExample Solution

Compute the dividends until growth levels off D1 = 1(1.2) = $1.20 D2 = 1.20(1.15) = $1.38 D3 = 1.38(1.05) = $1.449

Find the expected future price P 2 = D3 / (R g) = 1.449 / (.2 - .05) = 9.66

Find the present value of the expected future cashflows

8-49

8.670.2)(1

9.661.380.21

1.2R)(1

PDR 1

DP 22221

0

8/13/2019 ACF2013 Session 03

51/63

Quick Quiz Part I

A company has just paid a dividend of $2. What isthe value of its stock if it expects to maintain thislevel of dividend every yea. Assume that therequired return is 15%.

$2/ ???? What if the company starts increasing dividendsby 3% per year, beginning with the next dividend?The required return stays at 15%. $2 ( ????

Why is the second value higher?

8-50

8/13/2019 ACF2013 Session 03

52/63

See example 8.4 in pg. 267 Two-stage growth: p.268 & example

8.5 Try Problems 12 to 16 for interesting

variations of the standard model

Supernormal growth

ACF 2013

8/13/2019 ACF2013 Session 03

53/63

Using the Constant DGM to FindRequired Return, Dividend Yield,

Capital Gains Yield Start with the Constant DGM:

gPD

gP

g)1(D R

g-R D

g-R g)1(D

P

0

1

0

0

100

8-52

Finding the Required Return

8/13/2019 ACF2013 Session 03

54/63

Finding the Required Return,Dividend Yield, Capital Gains Yield -

ExampleSuppose a firms stock is selling for $10.50. It justpaid a $1 dividend, D 0, and dividends are expectedto grow at 5% per year.

What is the required return?

What is the dividend yield, D 1/P 0?

What is the capital gains yield?g =5%

8-53

%1505.010.50

)05.01(1 g

Pg)1(D

R 0

0

10%10.50

0.05)1(1P

g)(1DPD

yielddiv0

0

0

1

bl k l

8/13/2019 ACF2013 Session 03

55/63

Table 8.1 - Stock ValuationSummary

8-54

8/13/2019 ACF2013 Session 03

56/63

Equity Valuation using Peer Multiples

1. P/E (Price-to-earnings) ratio trailing vs forward PE ratios often used to value IPO shares:

Based on comparable firms, estimate the appropriateP/E.

Multiply this by expected earnings to obtain an estimateof the stock price.

see pg. 272 for examples What are problems with PE method?

Often hard to find comparable firms. The average ratio from a sample of comparable firms

can have a wide range. Example: The average P/E ratio of comparable firms is 20 but the

range is from 10 to 50.

when profits are ve, PE ratio is meaningless

8/13/2019 ACF2013 Session 03

57/63

Equity Valuation using Peer Multiples

2. Price-to-Sales MultiplesP/S ratio = price per share/ sales per sharefocuses on operating revenue so notinfluenced by one-off gains

3. Price-to-Cash Flow Multiple

useful to compare across countriessee airline example in pg 273

8/13/2019 ACF2013 Session 03

58/63

Features of Common Stock

Voting Rights: Cumulative vs. straight voting

Proxy voting Classes of stock Other Rights

Share proportionally in declared dividends Share proportionally in remaining assets during

liquidation

Preemptive right first shot at new stock issue tomaintain proportional ownership if desired

8-57

8/13/2019 ACF2013 Session 03

59/63

8/13/2019 ACF2013 Session 03

60/63

Features of Preferred Stock

Dividends Preferred dividend must be paid before

dividends can be paid to common stockholders Dividends are not a liability of the firm. Preferred dividends can be deferred

indefinitely Most preferred dividends are cumulative any

missed preferred dividends have to be paidbefore common dividends can be paid

Preferred stock generally do not carry votingrights

Similar to a perpetuity from a valuation point Is Preferred stock really Debt?

8-59

8/13/2019 ACF2013 Session 03

61/63

Stock Market

Dealers vs. Brokers New York Stock Exchange (NYSE) Largest stock market in the world License holders (1,366)

Commission brokers Specialists Floor brokers Floor traders

Operations Floor activity

8-60

8/13/2019 ACF2013 Session 03

62/63

NASDAQ

Not a physical exchange computer-basedquotation system Multiple market makers Electronic Communications Networks

Three levels of information Level 1 median quotes, registered representatives Level 2 view quotes, brokers & dealers Level 3 view and update quotes, dealers only

Large portion of technology stocks

8-61

Bursa Malaysia and

8/13/2019 ACF2013 Session 03

63/63

Bursa Malaysia andThe Singapore Exchange

Visit www.bursamalaysia.com Be familiar with the main features Source of much useful information Visit www.sgx.com.sg Select Prices from the menu on the left

Click on the following stocks to find the buy and sellquotes for selected stocks

SGX

Wilma DBS Bank

http://www.bursamalaysia.com/http://www.sgx.com.sg/http://www.sgx.com.sg/http://www.bursamalaysia.com/