Lecture 10: 07.04.

2011
Security Valuation Bond valuation: Bond is an interest bearing loan on long-term basis issued by corporations and the government. The borrower pays interest every period and the principle amount is repaid at the maturity. There are two parts of bond: a. Cash flow from interest b. Principle amount Coupon rate is the annual interest rate on a bond. Coupon amount is the interest amount on a bond each period. Coupon payment is constant and payable every year or half year. Maturity is the original life of a bond after which the principle amount is repaid.

Valuation Method: Value of a bond at particular point of time depends on four factors: 1. 2. 3. 4. Face value of the bond Coupon amount Number of periods until maturity The market interest on bonds with similar features

If, C = coupon amount P = principle amount t = number of periods until maturity i = market interest rate Then, Value of the bond, V = +

e.g. A bond with a face value of $ 1000 at a coupon rate of 6% has 10 years to maturity. What is the market price of this bond if the market interest rate is 10%? Ans. V= + = $ 754.21

e.g. A company issued $ 1000 bond with 10 years to maturity. The coupon amount is $ 80 per year for the next 10 years. The market interest rate is 8%. What is the face value of the bond? Ans.: $ 1000. If the coupon rate and market interest rate are equal, then the value of the bond will be equal to the face value of the bond. e.g. A company issued $ 1000 bond with 10 years to maturity. The coupon amount is $ 80 per year for the next 10 years. The market interest rate is 10%. What is the face value of the bond? Ans.: $ 877.1086579 The value of the bond fluctuates with market interest rate; they have inverse relationship between market interest rate and the bond price. When the interest rate rises, the present value of the bonds remaining cash flows decline and the bond is worth less. When the interest rate falls, the bond is worth more.

Interest rate risk:

It is the risk that arises for the bond holders from changes in market interest rate. This risk depends on how sensitive its market price depends on market price. Sensitivity depends on two things: 1. All other things be equal, the longer the time to maturity, the greater the interest rate risk. 2. All other things be equal, the lower the coupon rate, the greater is the interest rate risk. e.g. Face value of the Bond = $ 1000, Coupon rate = 10% 1 year maturity 30 year maturity 5% 10% 15% 20%
2000 1 year maturity 30 year maturity 0 5% 10% 15% 20%

1047.619048 1000 956.5217391 916.6666667

1768.622551 1000 671.7010182 502.1063601

Formatted: Font: (Default) Calibri, Font color: Black

1000

Lecture 11: 11.04.2011

Observations: The slope of the curve for 30 years maturity is much steeper than the curve for 1-year maturity. It shows that a relatively small change in the interest rate would cause a substantial change in bonds value. In comparison, the 1-year bond is relatively insensitive to interest rate changes. If two bonds have the same maturity but with different coupon rates, the value of the bond with lower coupon is relatively more dependent on the face value of the bond to be received at the maturity. The bond with higher coupon rate has larger cash flows early in its life. So its value is less sensitive to changes in the discount rate/market interest rate.

If, R = nominal interest rate = stated rate of return from an investment h = It is the inflation rate, and r = real rate of return then, Fisher effect on interest rate will be: (1 + R) = (1 + r)(1 + h) 1 + R = 1 + r + h + rh R=r+h r=R-h

;[as r, h are small, rh is negligible]

Stock Valuation
Dividends from preferred share are constant per period. These dividends are annuity. Present value of preferred stock = Share valuation is more difficult than bond valuation for number of reasons. They are: 1. Uncertainty of promised cash flows 2. Shares have no definite maturity 3. Observing the market rate of return on shares is difficult. Growth of dividends: 1. Zero growth = dividends are same each period.

2. Constant growth = dividends grow at a constant rate. 3. Non constant growth = dividends are different each period and grow at different rates.

2. Constant growth of dividends: Dividends grow by the same percent each period. e.g. g = growth rate D0 = current dividend t = time period then, Dt = D0 (1 + g)t To calculate the market price of a share when the dividends grow at a constant rate, the Dividend Growth Model is used. Pt = Here, Pt is price of the bond at time t, Return and g is Growth Rate So, P0 = e.g. A company just paid a dividend of $ 0.15 per share which is expected grow at 5% per year. What price should you pay for the share now if the required rate on your investment is 10%? Ans. D0 = $ 0.15 per share r = 10% g = 5% then, D1 = $ 0.15 * 1.05 = $ 0.1575 so, P0 = = = $ 3.15 is dividend at the next period, r is Required Rate of

What will be the price of the share in year 6? D7 = 0.15 (1 + 0.05)7 = 0.211 P6 = = = $ 4.22

Non constant growth: It allows for super normal growth rates over some finite length of time. When g > r, it is super normal growth. The constant growth rate rule cannot be applied in such cases. This growth rate cannot exceed the required rate of return indefinitely, but can do so for a number of periods. After that the growth rate will have to grow at a constant rate for indefinite period. e.g. a company just paid dividend of $ 0.15 per share and it is expected to grow at a rate of 20% per year for the next 3 years and after that itll grow at a rate of 5% per year forever. Calculate the current market price of the share if required rate of return is 10%? Ans. Do = 0.15, D1 = 0.18, D2 = 0.216, D7 = 0.2592, D4 = 0.27216 P3 = = = $ 5.4432

..