Valuing Stocks and Bonds

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Valuing Stocks and Bonds

• Lecture 4
• RWJ Chapters 78

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Key Concepts and Skills

• Understand bond values and why they fluctuate
• Understand the term structure of interest rates
  and the determinants of bond yields
• Be able to compute stock prices using the
  dividend growth model
• Differences between debt, equity and preferred
  equity

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Dividend Growth Model

• Dividends are expected to grow at a constant
  percent per period.
• P0 D1 /(1R) D2 /(1R)2 D3 /(1R)3
• P0 D0(1g)/(1R) D0(1g)2/(1R)2
  D0(1g)3/(1R)3
• With a little algebra, this reduces to

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Dividend Growth Model cont.

• Chriss Carbonation Pill Inc., has a dividend at
  T1 of 5 which is expected to grow at 4 per
  year. The required return is 12.
• What is the price youd be willing to pay?
• Erics Carbonation Pill Inc., also has a dividend
  at T1 of 5 which is expected to grow at 4.
  However, the market is pricing the stock at 50.
• How can it have a different price?

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Chriss Pills cont.

• Find the price of CCP, Inc. immediately after
  paying the dividend at T1.
• Find the NPV and the return from buying at T0,
  waiting until I get the dividend at T1, and
  immediately selling.

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Cash Flows for Stockholders

• If you buy a share of stock, you can receive cash
  in two ways
• The company pays dividends
• You sell your shares, either to another investor
  in the market or back to the company
• As with bonds, the price of the stock is the
  present value of these expected cash flows

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DGM Example 1

• Suppose Big D, Inc. just paid a dividend of .50.
  It is expected to increase its dividend by 2 per
  year. If the market requires a return of 15 on
  assets of this risk, how much should the stock be
  selling for?

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DGM Example 2

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

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Nonconstant Growth Problem Statement

• Suppose a firm is expected to increase dividends
  by 20 in one year and by 15 in two years. After
  that dividends will increase at a rate of 5 per
  year indefinitely. If the last dividend was 1
  and the required return is 20, what is the price
  of the stock?
• Remember that we have to find the PV of all
  expected future dividends.

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Finding the Required Return - Example

• Suppose a firms stock is selling for 10.50.
  They just paid a 1 dividend and dividends are
  expected to grow at 5 per year. What is the
  required return?
• What is the dividend yield?
• What is the capital gains yield?

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Zero-Coupon Bonds

• Make no periodic interest payments
• Sometimes called zeroes, or deep discount bonds
• Treasury Bills and principal only Treasury strips
  are good examples of zeroes

• http//www.smartmoney.com/onebond

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Interest Rate Risk Example

• Assume the yield curve is flat at 5.
• I buy 1000 worth of 1 year discount bonds, and
  1000 worth of 30 year discount bonds.
• Immediately after my purchase, interest rates
  rise to 6.
• What happens to the value of my bonds?

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Determinants of the Yield Curve

• Interest Rate Risk
• Yield curve should usually slope upward
• Liquidity Premium
• Yield curve should usually slope upward
• Future Movement of Interest Rates
• Yield curve will slope upward if we expect
  interest rates to rise.
• Yield curve will slope upward if we expect
  interest rates to rise.

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The Bond-Pricing Equation

• Typical bonds pay coupons, in which case

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Yield to Maturity

• Bonds of similar risk (and maturity) will be
  priced to yield about the same return, regardless
  of the coupon rate
• If you know the price of one bond, you can
  estimate its YTM and use that to find the price
  of the second bond
• YTM is an annual number, despite the fact that
  coupons are often paid every six months.

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The most common mistake when pricing bonds

• The appropriate six-month rate to use in the bond
  pricing formula?
• NOT the yield-to-maturity divided in half!

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Does it really matter?

• You are looking at a 1000 face value 20 year
  bond with an 8 YTM. It is described as a 10
  coupon bond which means that it pays 50 every
  six months.
• What is the bond worth?
• Suppose the bond above paid annual coupons of
  100. What is it worth?

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Differences Between Debt and Equity

• Debt
• Not an ownership interest
• Creditors do not have voting rights
• Interest is considered a cost of doing business
  and is tax deductible
• Creditors have legal recourse if interest or
  principal payments are missed
• Excess debt can lead to financial distress and
  bankruptcy

• Equity
• Ownership interest
• Common stockholders vote for the board of
  directors and other issues
• Dividends are not considered a cost of doing
  business and are not tax deductible
• Dividends are not a liability of the firm and
  stockholders have no legal recourse if dividends
  are not paid
• gt a firm cannot go bankrupt due to unpaid
  dividends