How to Value Bonds and Stocks Bonds (0 coupon, level coupons & Consols), constant/non-constant growth C/S, and GROWTH.

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How to Value Bonds and Stocks Bonds (0 coupon, level coupons & Consols), constant/non-constant growth C/S, and GROWTH

Chhachhi/519/Ch. 52 Valuation-- Bonds Value of any Asset: PV of all future cash flows (FCFs) need estimate of FCFs & discount rate Bond:a long-term IOU Discount (0 coupon) bonds FCF is face value (F) to be received in ‘T’ yrs. Bond Value = F/(1+r) T

Chhachhi/519/Ch. 53 Bonds-- Continued Level Coupon Bonds. FCFs: 1. coupons every period till maturity (annuity) 2. face value at maturity (lump-sum) 012 … T | | | … | CouponCouponCoupon + F Consols: Coupon bonds with no maturity; I.e., Perpetuity

Chhachhi/519/Ch. 54 Additional Bond Concepts r: YTM (Yield to Maturity) rate of return required by the investors as r, P ??? Coupon rate fixed at the time of the issue; ‘r’(discount rate/YTM) changes with time 10% coupon, 20 yrs. maturity r = 12%, value =?;Discount bond; YTM>C r = 8%, value =?;Premium bond; YTM<C

Chhachhi/519/Ch. 55 Bond Concepts-- Contd. r=10%, value = ?;Par; YTM = C 7% coupon, 10 Y. bond for $ YTM = ?? Semiannual Coupons 14s of December 2014 selling for 110 on July 1, 2003

Chhachhi/519/Ch. 56 Maturity and Bond Price Volatility C Consider two otherwise identical bonds. The long-maturity bond will have much more volatility with respect to changes in the discount rate Discount Rate Bond Value Par Short Maturity Bond Long Maturity Bond

Chhachhi/519/Ch. 57 Coupon Rate and Bond Price Volatility Consider two otherwise identical bonds. The low-coupon bond will have much more volatility with respect to changes in the discount rate Discount Rate Bond Value High Coupon Bond Low Coupon Bond

Chhachhi/519/Ch. 58 Common Stock Valuation What are the FCFs? P 0 is a function of D 1 and P 1 P 1 is a function of D 2 and P 2 SO P 0 is a function of D 1, D 2, and P 2 …….. P 0 is a function of D 1, D 2, D 3 … PV of all expected future dividends Zero growth: PerpetuityP t = D t+1 / r

Chhachhi/519/Ch. 59 Common Stock valuation--contd. Constant growth: Assume that dividends will grow at a constant rate, g, forever. D T = D 0 (1 + g) T Growing perpetuity P t = D t+1 / (r - g) ‘g’ cannot be > ‘r’; WHY?

Chhachhi/519/Ch. 510 Differential Growth Differential growth: g 1 for T periods and g 2 (constant growth) thereafter Valuation of a Differential Growth Stock: Estimate future dividends in the foreseeable future. Estimate the future stock price when the stock becomes a Constant Growth Stock Compute the total present value of the estimated future dividends and future stock price

Chhachhi/519/Ch. 511 A Differential Growth Example … The constant growth phase beginning in year 4 can be valued as a growing perpetuity at time 3.

Chhachhi/519/Ch. 512 Stock Market Reporting Gap has been as high as $25.72 in the last year. Gap has been as low as $16.99 in the last year. Gap pays a dividend of 9 cents/share 6,214,400 shares traded hands in the last day’s trading Gap ended trading at $20.15, down $0.71 from yesterday’s close Given the current price the P/E is 17

Chhachhi/519/Ch. 513 Growth? A function of # and quality of investment opportunities How do you add value to a firm? Identify +NPV projects that lead to Growth Dividend Growth model and NPVGO approach lead to identical valuations Skip Sec. 5.7 H.W , 9, 13, 17, 19, 25, 26, 29