Chapter 4

The Valuation of
Long-Term Securities
Presented By:
Syed Ahsan Aman

The Valuation of
Long-Term Securities
Distinctions Among Valuation Concepts
Time Value of Money [Revision]
Bond Valuation
Preferred Stock Valuation
Common Stock Valuation
Rates of Return (or Yields)
What is Value?
Going-concern value represents the amount
a firm could be sold for as a continuing
operating business.
Liquidation value represents the amount of
money that could be realized if an asset or
group of assets is sold separately from its
operating organization.
What is Value?
(2) a firm: total assets minus liabilities and
preferred stock as listed on the balance
sheet.
Book value represents either
(1) an asset: the accounting value of an
asset -- the assets cost minus its
accumulated depreciation;
What is Value?
Intrinsic value represents the price a
security ought to have based on all
factors bearing on valuation.
Market value represents the market price at which an asset
trades.
What is Time Value?
We say that money has a time value because that money
can be invested with the expectation of earning a positive
rate of return
In other words,

That is because todays dollar can be invested so that we
have more than one dollar tomorrow

Interest Rates & Required Returns
7
The interest rate or required return represents
the price of money.
Interest rates represent the compensation that a
demander of funds must pay a supplier.
When funds are lent, the cost of borrowing is the
interest rate.
When funds are raised by issuing stocks or
bonds, the cost the company must pay is called
the required return, which reflects the suppliers
expected level of return.
The Terminology of Time Value
Present Value - An amount of money today, or the current
value of a future cash flow
Future Value - An amount of money at some future time
period
Period - A length of time (often a year, but can be a
month, week, day, hour, etc.)
Interest Rate - The compensation paid to a lender (or
saver) for the use of funds expressed as a percentage for a
period (normally expressed as an annual rate)
Abbreviations
PV - Present value
FV - Future value
Pmt - Per period payment amount
N - Either the total number of cash flows or
the number of a specific period
i - The interest rate per period
10
Introduction to the Timeline
Time Value of Money (TVM) problems involve
identifying the payment or receipt of cash over
time.
A useful tool in the analysis of these problems is
the timeline illustrated below.
Years or Periods
Cashflows
0
1 2 3 4
CF
0
CF
1 CF
2
CF
3
CF
4
5
CF
5
Calculating the Future Value
Suppose that you have an extra $100 today that you wish
to invest for one year. If you can earn 10% per year on
your investment, how much will you have in one year?
0 1 2 3 4 5
-100 ?
( )
FV
1
100 1 010 110 = + = .
n
r PV FV ) 1 ( + =
12
Present Value
0 1 2 3 4
Present
Value

5
Future
Value

Years
Since receiving money in the future is
less valuable than having cash today, we
say the the present value of a future
cashflow is at a discount.
Calculating the Present Value involves
quantifying this discount.
n
r
FV PV
) 1 (
1
+
=
Discount Factor
13
Testing Our Intuition
Future Value
Increase (Decrease) in Interest Rate
Increase (Decrease) in Investment Horizon

Present Value
Increase (Decrease) in Interest Rate
Increase (Decrease) in Investment Horizon
Annuities
An annuity is a series of nominally equal payments equally
spaced in time
Annuities are very common:
Rent
Mortgage payments
Car payment
The timeline shows an example of a 5-year, $100 annuity
0 1 2 3 4 5
100 100 100 100 100
( ) ( ) ( ) ( )
PV
Pmt
i
Pmt
i
Pmt
i
Pmt
i
A
t
t
t
N
N
N
=
+
=
+
+
+
+ +
+
=

1 1 1 1
1
1
1
2
2
( )
( )
PV
Pmt
i
Pmt
i
i
A
t
t
t
N
N
=
+
=

+

(
(
( =

1
1
1
1
1
THE FUNDAMENTALS &
VALUATIONS OF BOND
A Deeper Understanding of a Major
Economic Market


16
Outline
Bond Definitions
Valuation of Bonds
Yield to Maturity (YTM)
Rate of Return
Interest Rate Risk
Default Risk
17
What is a BOND?

A Bond is an agreement ( or financial asset ) in
which an issuer is required to repay to the investor
the amount borrowed plus interest over a specified
period of time.

Principal borrowed by government(corporation)
from investor
Principal returned to investor
Principal

Regular
interest
payments
Bond Vs Stock
Corporate bonds differ from common stock in
three fundamental ways.



Corporate Bonds Common Stock
Represent a creditors claim on
the corporation
Represents an ownership claim
on the corporation
Promised cash flows (coupons
and principal) are stated in
advance
Amount and timing of
dividends may change
at any time
Mostly callable Almost never callable
19
Example
In the beginning of 1994 U.S. government borrowed
$100 million at 9% yearly rate by issuing 100,000
bonds for $1,000 each. Each bond promised to pay its
holder $90 (9% of $1,000) at the end of year for 10
years and repay $1,000 at the end of 2003.


$90 $90 $90
Years 1994 1995 2002 2003



You pay price of the bond
coupons
principal+
last coupon
$1,000+
$90=
$1,090
20
FOUR COMPONENTS OF A
BOND
Issuer The organization responsible for ensuring that
interest and principal payments are made to bondholder.

Principal The amount of money denominated in a specific
currency that the issuer wishes to borrow and agrees to
repay the investor. (Face Value, Par value, Maturity value)

Coupon (rate) The rate of interest the issuer agrees to pay
the investor. Usually stated as a percentage of the Face V.

Maturity date The date on which the issuer of a bond must
repay the principal due and the final interest rate payment.
21
Bond Valuation ???
Pricing a bond is a simple two step process:
1. Define the cash flows.
2. Calculate the aggregate present value of the cash flows
using appropriate discount rate (r).
Note: Generally discount rate IS NOT EQUAL to
coupon rate!!!








c c c
Years 1 2 t-1 t



You pay price of the bond
coupons
principal+
last coupon
FaceValue+
c
22
What is appropriate discount rate
(r)?
It is an interest rate on similar bonds on
financial markets.

What does similar mean?
Similar features!!! (ALL)
Similar risk!!!
23
Yield to Maturity (YTM)
Yield to Maturity (YTM) - The single
discount rate (internal rate of return) used to
calculate the market price of the bond.

Reflects the required market interest rate for the
bond.
Assumes the bond is held to maturity.
Different than the coupon rate.
24
Yield to Maturity (YTM)
In other words:
If you plan to hold the bond until maturity n years from
today:
The yield to maturity is the discount rate at which the
bonds price is the present value of the bonds payments
(coupons and face value).



YTM is the required return on the bond assuming it will be
held until maturity.
( ) ( ) ( )
n
r
Par C
r
C
r
C
r
C
bond PV ice
+
+
+ +
+
+
+
+
+
=
1
...
1 1 1
= ) ( Pr
3 2
25
Bond Valuation (using YTM)







c c c
Years 1 2 t-1 t



You pay price of the bond
coupons
principal+
last coupon
FaceValue+
c
t
r
FaceV C
r
C
r
C
Bond PV
) 1 (
.
...
) 1 ( ) 1 (
) (
2 1
+
+
+ +
+
+
+
=
26
Example
Five year 9% coupon bond offers these cashflows.
Discount rate (YTM) is 9% .
What is the present value of this bond?


$90 $90 $90
Years 1999 2000 2002 2003


$1,000+
$90=
$1,090
$90
2001
1998
5 4 3 2 1
) 1 (
.
) 1 ( ) 1 ( ) 1 ( ) 1 (
) (
r
FaceV C
r
C
r
C
r
C
r
C
Bond PV
+
+
+
+
+
+
+
+
+
+
=
000 , 1
) 09 . 1 (
090 , 1
) 09 . 1 (
90
) 09 . 1 (
90
) 09 . 1 (
90
) 09 . 1 (
90
) (
5 4 3 2 1
=
+
+
+
+
+
+
+
+
+
= Bond PV
27
What happens if the discount rate (YTM)
drops to 5.3%?
87 . 158 , 1
) 053 . 1 (
090 , 1
) 053 . 1 (
90
) 053 . 1 (
90
) 053 . 1 (
90
) 053 . 1 (
90
) (
5 4 3 2 1
=
+
+
+
+
+
+
+
+
+
= Bond PV
I f the interest rate on similar bonds was 5.3%
the value of 9% Treasures increases to $1,158.87.
What happens if the interest rate on similar bonds
was 10%?
09 . 962
) 1 . 1 (
090 , 1
) 1 . 1 (
90
) 1 . 1 (
90
) 1 . 1 (
90
) 1 . 1 (
90
) (
5 4 3 2 1
=
+
+
+
+
+
+
+
+
+
= Bond PV
The value of 9% Treasures decreases to $962.09.
28
Bond Valuation
Using the Annuity Formula

Value a Bond with a combination of the Annuity
and the Present Value formulas.





( ) ( )
n n
r + 1
Amount Par
r + 1 r
1
r
1
Coupon = Bond of Value +
(

29
Example
Suppose investors demand an interest rate of 5 percent on a
10-year 6 percent bond. How much should investors pay to
acquire the bond? (Alternatively, whats the price of the
bond?)
Solution: coupon rate is 6%, this means we are going to
receive $60 each year for 10 years and another $1,000 in
the end of year 10. The discount rate is 5%.
( ) ( )
22 . 077 , 1 $
05 . 1
1000
05 . 1 * 05 .
1
05 .
1
60
r + 1
par
r + 1 r
1
r
1
cpn PV
10 10
= +
(

=
+
(

=
t t
30
Semiannual Coupon Bond
In the Bond Market, most bonds make coupon
payments semiannually.
A bond has a coupon rate of 6 percent, with
coupon payment made semiannually. This means
the bond makes payment of $1,000*(6%/2)=$30
every 6 months.
Accordingly, the quoted interest rate is APR and
has to be compounded semiannually.
31
Semiannual Coupon Bond
What is the value of a bond with a face value of
$1000, coupon rate of 10% and maturity of 10
years? Assume semiannual coupon payments and
an annual interest rate of 8% compounded
semiannually.
1136 $
) 04 . 0 1 (
) 000 , 1 50 (
....
) 04 . 0 1 (
50
) 04 . 0 1 (
50
Price
20 2 1
0
=
+
+
+ +
+
+
+
=
0 1 2 3 4 5 20
$1000
$50 $50 $50 $50 $50 $50
Semiannual Coupon payments=(1000*0.10)/2
32
Semiannual Coupon Bond
t
bond coup Sem
r
FaceV C
r
C
r
C
PV
2 2 1
. .
) 2 / 1 (
.
...
) 2 / 1 ( ) 2 / 1 ( +
+
+ +
+
+
+
=
2
. * . Rate Coupon Value Face
C =
Semiannual payment :
Present Value of Semiannual Coupon Bond:
Where: r is annual discount rate (YTM)
33
Using Financial Functions
FV=Par
Yearly discount Rate = I/YR

PMT PMT PMT
Years 0 1 2 N

PV = Price
Given any four of the variables
(N, I, PV, PMT,FV) your
financial calculator can solve
for the fifth.
34
Examples
$1,000 bond for 10 years with 9% interest and 9%
yearly coupons
PMT=90 FV=1000 N=10 I/Y=9% PV=?
$1,000 bond for 5 years with 5% interest and 9%
semiannual coupons
PMT=45 FV=1000 N=5*2 I/Y=5/2 PV=?
$1,000 bond for 10 years with 9% interest and 9%
yearly coupons .What happens after five years if
the interest rate changes to 5% then? 11%?

35
How can we calculate YTM?
Find r so present value of payments is equal
to price.
Use financial calculator.
Example: $1,000 face value, $90 annual
coupons for 5 years, $1,100 price
FV=1000 PMT=90 N=5 PV=-1100 I/Y=?
Note: PV is equal to price!!!
36
More Examples
Example 1: C = $90, t = 10 years, Po = 1050.
FV=1000 PMT=90 N=10 PV=-1050
YTM=8.25%

Example 2: C = $90, t = 10 years, Po = 900.
FV=1000 PMT=90 N=10 PV=-900
YTM=10.67%

37
How do Bond Prices Vary with
Interest?
What happens if the coupon rate is equal to
the interest rate? (see slide 11)
What happens to bond prices if the interest
rate goes up? (see slide 12)
What happens to bond prices if the interest
rate goes down? (see slide 12)
38
Bond Prices and Interest Rates
(YTM)
Int.rate=
Coupon rate
Bond Price=
Face Value
Interest Rate
B
o
n
d

P
r
i
c
e

39
Conclusion/Observation:
When the market interest rate equals the coupon
rate, bonds sell for the face value.

When the market interest rate exceeds the
coupon rate, bonds sell for less than face value.

When the market interest rate is below the
coupon rate, bonds sell for more than face value.
40
Price vs. Face Value
If P < Face V. the bond is said to be sold at a discount
If P > Face V. the bond is said to be sold at a premium
If P = Face V. the bond is said to be sold at par
Ex 1: If a bond with a face value FV = 100 would be sold in the
market for P = 99.5 we would say it is sold at a discount, as in this
case the price is smaller than the face value.
Ex 2: Suppose you are told that a bond with a face value of $50
is sold at par. What can you say about the price of this bond?
41
Interest Rates or Yields Up (Down)
= Prices Down (Up)
As interest rates increase, the value of a bond decreases;
conversely as interest rates decrease, the value of a bond
increases. Therefore generally the following holds:

coupon rate < required yield, then price < face value
bond is said to be selling at a discount.
coupon rate = required yield, then price = face value
bond is said to be selling at par.
coupon rate > required yield, then price > face value
bond is said to be selling at a premium.
MEMORIZE!!!
42
Bond Prices Over Time
Bond
Price
time
1 2 3

$1000
Premium Bond
Discount Bond
Maturity
?
43
Rate of Return
We define Rate of Return over a specified period of time as:







The price change divided by the bond price today is called
Capital Gain (or Loss).



today Price
change price + income Coupon
= return of Rate
investment
income total
= return of Rate
44
Rate of Return
Expected vs. Realized return.
P
0
price paid for a bond,
P
1
expected bond price at time 1 , when you sell the
bond,
C coupon payments received between buying and selling


0
0 1
) (
Return of Rate
P
P P C +
=
45

Example 1:You pay $900 for a bond which
has an annual coupon of $120. You sell it for
$930 after one year. What is your rate of
return?

$900
$900) - ($930 + $120
= return of Rate
Rate of return=16.67%
46
More Definitions
Current Yield - The annual coupon of the bond
divided by price.




This return ignores the effect of price changes
(capital gain or loss).

The current yield is a rough approximation of the
expected return on the bond.
Price
Coupon Annul
eld Current Yi =
47
Example 1: C = $90, t = 10 years, Po = 1050.

Current yield =

Example 2: C = $90, t = 10 years, Po = 900.

Current yield =

% 57 . 8
1050 $
90 $
=
% 10
900 $
90 $
=
48
Rate of Return versus YTM
Is the rate of return higher than or lower
than the YTM?

What can we say if the YTM does
not change?
49
Rate of Return versus YTM
Example 1: John buys a bond when its time to maturity is
9 years, r is 12% and sells after a year when r is 10%. The
coupon rate is 8%. Find the rate of return from this
investment.


Example 2: A bond pays annual coupon of $100. Ann
bought the bond 1 year back when YTM was 9%. If Ann
sells the bond today, YTM now being 9.5%, find the
annual rate of return on her bond. This bond will mature
in another 5 years.

50
Rate of Return versus YTM

The above examples illustrate:

1. If YTM decreases (ex.1), the rate of return is
higher then the initial YTM. Why? (Price of
the bond grows)
2. If YTM increases (ex.2), the rate of return is
lower then the initial YTM. Why? (Price of
the bond goes down)
3. If YTM does not
change_____________________.
51
Interest Rate Risk
Bond price fluctuates as interest rate
changes.
If interest rate suddenly goes up, will your
bond be worth more or less? What if
interest rate goes down?
Will a 3-year bond or a 30-year bond be
subject to more interest rate risk?
52
Interest Rate Risk
Two bonds: a 6% coupon bond with 3 years to
maturity and a 6% coupon bond with 30 years to
maturity. Both sell at face value today ($1,000).
What is the discount rate?

What would be the price of each bond today if the
discount rate
drops to 4%?

jumps to 8%?

PV3=1055.5 ;% change=5.6%
PV30 =1345.84 ; % change=34.6%
PV30=774.84 ; % change= -22.5%
PV3 =948.46 ; % change= -5.1%
53
Interest Rate Risk
-
500
1,000
1,500
2,000
2,500
3,000
0 2 4 6 8 10
Discount Rate
$

B
o
n
d

P
r
i
c
e
30 yr bond
3 yr bond
When the discount
rate(yield) equals the 6%
coupon rate, both bonds
sell at face value
54
Interest Rate Risk
The fluctuations in price due to changes in interest
rates is called interest rate risk. This risk is
presented in a bond even if the future cash flows
are risk free or will be received with certainty.
This risk increases as maturity increases. In
another word, long term bond prices are more
sensitive to the interest rate than prices of short-
term bonds.
Interest rate risk increases as coupon rate
decreases.
55
Yield Curve / Term Structure
The relationship between yields and time to maturity is
called a yield curve







The Yield curve for Treasury Bonds is in the Wall Street
Journal every day.
These yields are influenced by the expectations of future
interest rates and inflation.
2%
3%
4%
5%
6%
7%
5Yr 10Yr 15Yr 20Yr 25Yr 30Yr
Yield
56
Default Risk
Coupons and principal will always be repaid if
U.S. government is the borrower.
What about corporations?
Because there is a default risk, there is a default
premium.
Default premium is the difference between yield
on corporate bond and on U.S. government bond
of same coupon and maturity.
The two largest rating agencies are Moodys and
Standard & Poors.
57
Ratings
Moodys S&P
Aaa
Aa
A
Baa
Ba
B
Caa
Ca
C
AAA
AA
A investment grade
BBB bonds

BB junk bonds or
B speculative grade
CCC
Cc
C

D bonds in default

58
Example
A bonds credit rating provides a guide to its risk.
Long-term bonds rated Aa currently offer yield to
maturity of 7.5 percent. A-rated bonds sell at yield
of 7.8 percent. If a 10-year bond with a coupon
rate of 7 percent is downgraded by Moodys from
Aa to A rating, what is the likely effect on the
bond price?
59
Questions
Are all bonds subject to default risk?

Are all bonds subject to interest rate risk?

Is a default-free bond risk-free?
60
Other Types of Bonds
Floating Rate Bonds - Bonds where the coupon rate
can change over time.
Convertible Bonds - Bonds where a right (option) is
granted to the investor to exchange the bond for some
other specified security, usually common stock, before
the Maturity Date.
Zero-Coupon Bonds - Bonds that pay only the face
value at maturity, no coupons.
Callable Bonds - Can be bought back early.
Put Bond -allows holder to redeem for par.
61
Government
Bonds
Treasury bills:bonds with maturity of one
year or less
Treasury notes:bonds with maturity from 1
year to 10 years
Treasury bonds:maturity more than 10 years

62
What you should know about bonds
Distinguish among the bonds coupon rate, current yield,
and yield to maturity.

Find the market price of a bond given its yield to maturity,
find a bonds yield given its price, and demonstrate why
prices and yields vary inversely.

Show why bonds exhibit interest rate risk.

Understand why investors pay attention to bond ratings
and demand a higher interest rate for bonds with low
ratings.
Characteristics of Bonds
Bonds: debt securities that pay a rate of interest based upon the face
amount or par value of the bond.
Price changes as market interest changes

Interest payments are commonly
semiannual

Bond investors receive full face amount
when bonds mature

Zero coupon bonds no periodic payment
(no interest reinvestment rate)
Originally sold at a discount
63
64