CHAPTER 4

SECURITY VALUATION AND THE COST OF CAPITAL

• Valuation is the process of determining the worth of any asset whose value is

obtained from future cash flows. The value of any asset in finance is the present

value of all future cash flows. it is expected to provide over the relevant time

period. This value is called intrinsic value.

4.1 Bond Valuation

• Governments and corporations borrow money by selling bonds to

investors. The money they collect when the bond is issued, or sold
to the public, is the amount of the loan. In return, they agree to make
specified payments to the bondholders, who are the lenders. When
you own a bond, you generally receive a fixed interest payment each
year until the bond matures.
Investment in a bond provides two types of cash flows

• The periodic interest payment by the issuing party and=COUPON PAYMENT

• The price paid to the investor upon maturity=MV

Features of Bonds

• Par value: It is the amount or value stated on the face of the bond. It

represents the amount of the firm borrows and promises to repay at

the time of maturity. It can be any denomination.

• Coupon Rate of Interest: A bond carries a specific interest rate, which

is called the coupon rate. The interest payable to the bondholder is

simply par value of bond multiplied by the coupon rate

• Maturity period: Every bond will have maturity period. On
completion of the maturity period the principal amount has to be
repaid as per the agreed terms.

• The intrinsic value of a bond is equal to the present value of its

expected cash flows. The coupon interest payments and principal
payments are known and the present value is determined by
discounting these future payments from the issuer at an appropriate
discount rate or market yield.

• Zero-Coupon Bonds. Corporations sometimes issue zero-coupon

bonds. In this case, investors receive face value at the maturity date
but do not receive a regular coupon payment.
• Floating-Rate Bonds. Sometimes the coupon rate
can change over time. For example, floating-rate
bonds make coupon payments that are tied to some
measure of current market rates.

• Convertible Bonds. If you buy a convertible bond,

you can choose later to exchange it for a specified
number of shares of common stock
• Put Bond - allows the holder to force the issuer to buy
back the bond at a stated price.

• The Call Provision: A call provision allows the

company to repurchase or “call” part or all of the bond
issue at stated prices over a specific period. Corporate
bonds are usually callable. The difference between the
call price and the stated value is the call premium.

• The Indenture: is the written agreement between the

corporation (the borrower) and its creditors.
Investors have many choices when investing in Bonds,
but bonds are classified into four main types: treasury,
corporate, municipal, and foreign.
• Treasury Bonds: sometimes referred to as government
bonds, are issued by the federal government. It is
reasonable to assume that the federal government will
make good on its promised payments, so these bonds have
no default risk. However, Treasury bond prices decline
when interest rates rise, so they are not free of risks.
• Corporate Bonds: as the name implies, are issued by corporations.
Unlike Treasury bonds, corporate bonds are exposed to default risk- if
the issuing company gets into trouble, it may be unable to make the
promised interest and principal payments.

• Municipal Bonds: or “minis,” are issued by state and local

governments. Like corporate bonds, munis have default risk. However,
munis offer one major advantage over all other bonds. The interest
earned on most municipal bonds is exempted for federal taxes, and also
from state taxes if the holder is the resident of the issuing state.
Consequently, municipal bonds carry interest rates that are considerably
lower than those on corporate bonds with the same default risk.
• Foreign Bonds: are issued by foreign governments or
foreign corporations. Foreign corporate bonds are, of
course, exposed of default risk, and so are sometimes
foreign government bonds.
• Basic Bond Valuation Model
• The value of a bond is the present value of the periodic
interest payments plus the present value of the par value. The
value of a bond can be computed using the following
equitation:
Bo = I (PVIFA kd,n) + M(PVIF kd,n) Where:
Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
• Illustration: Tebaber Corporation has a Br. 1,000
par value bond with an 8% coupon interest rate
outstanding. Interest is paid semiannually and the
bond has 12 years remaining to its maturity date.

Required: What is the value of the bond if the

required return on the bond is 8%?
We see a relation developing between the coupon rate, the yield, and the value of a debt
security:

• If the coupon rate is more than the yield, the security is worth more than its maturity value
—it sells at a premium and it is called premium bond.

• If the coupon rate is less than the yield, the security is less than its maturity value—it sells
at a discount and it is called discount bond.

• If the coupon rate is equal to the yield, the security is valued at its maturity value and it is
called par value.

Generally, the relationship among a Bond’s price and its coupon rate, current yield and
yield to Maturity

• Bond Price<Face Value: Coupon rate<Current yield<YTM

• Bond Price=Face Value: Coupon rate=Current yield=YTM

• Bond Price>Face Value: Coupon rate>Current yield>YTM

• Yield to Maturity (YTM) is the rate of return
investors earn if they buy a bond at a specific price
Bo and hold it until maturity.

• Example: Zebra Company has a Br. 1,000 par value,

10% coupon interest rate, and 15 years to maturity.
The bond is currently selling at Br. 1,090. Compute
the YTM.
4.2 Stock Valuation

4.2.1 Preferred Stock Valuation

• Preferred stock is a type of equity security that provides its owners

with limited or fixed claims on a corporation’s income and assets.

Investment in a preferred stock provides a single cash flow, i.e.,

constant periodic dividend payments.

• Preferred stock has similarities to both a bond and a common stock.

As to similarities to a bond, preferred dividends are fixed in amount

and are like interest payments. As to a common stock, the preferred

dividends are paid for an indefinite time period.

Preferred Stock Valuation Model

• The value of a preferred stock is the present value of all future

preferred dividends it is expected to provide over an infinite time
horizon.

• The intrinsic value of such shares will be estimated from the

following equations.

Vps = C_ + C__ + Cn__

(1 + k) (1 + k) 2 (1 + k) n

Vp = Value of perpetual today

C = Constant dividends received

Kps = Required rate of return appropriate

Example: Abebe wishes to estimate the value of its
outstanding preferred stock. The preferred issue has a
Br. 80 par value and pays an annual dividend of Br.
6.40 per share. Similar-risk preferred stocks are
currently earning a 9.3% annual rate of return. What is
the value of the outstanding preferred stock?
Rate of Return on a Preferred Stock

• To evaluate the worthiness of investment in a

preferred stock in comparison to other investment
opportunities, we should be able to compute the rate
of return on a preferred stock. If we know the current
price of a preferred stock and its dividend, we can
compute the expected rate of return on the preferred
stock.
• Example: A preferred stock pays an annual dividend
of Br. 9 and the current market price is Br. 81.
Compute the required rate of return from the
preferred stock.
4.2.2 Common Stock Valuation

• The value of a share of common stock is the present

value of the common stock’s dividend expected over
an infinite time horizon. The value of a share of
common stock is also equal to the sum of the present
value of the expected dividends and the present
value of the expected selling price of the stock.
To understand the value of a common stock we should
keep in mind two points. First, the dividends are
expected for an infinite time period. Second, the
dividends are not constant. Therefore, the value of a
common stock is found by summing the present
values of annual dividends.

Po =
The common stock valuation equation can be
simplified by redefining each year’s dividend. The
dividends are defined in terms of anticipated dividends
growth. Generally, there are three cases accordingly.
These are:

• Zero growth common stock,

• Constant growth common stock, and

• Variable growth common stock.

• Zero Growth Stock

A zero-growth stock is a common stock whose future

dividends are not expected to grow at all. The expected
growth rate (g) is zero. This is the simplest model to
common stock valuation. It assumes a constant, non-
growing annual dividend. So here the annual dividends
are all equal.

That is D1 = D2 = … = D = D.
• Example: The most recent common stock dividend of
Shalom Manufacturing Corporation was Br. 3.60 per
share. Due to the firm’s maturity as well as stable
sales and earnings, the dividends are expected to
remain at the current level of the foreseeable future.

Required: Determine the value of Shalom’s common

stock for an investor whose required return is 12%.
• Constant Growth Stock

Constant growth stock is a common stock whose

future dividends are expected to grow at a constant
dividend growth rate (g). It is sometimes called
normal growth stock. The constant (normal) growth
common stock valuation model is the most widely
cited approach to common stock valuation.
• Example: Zeila Motor Corporation’s common stock
currently pays an annual dividend of Br. 5.40 per
share. The dividends are expected to grow at a
constant annual rate of 5% to infinity. Estimate the
value of Zeila’s common stock if the required return
is 12%.
• Variable Growth Stock

Variable growth stock is a stock whose dividends are expected to grow at variable or

non-constant rates. The model of common stock valuation that allows for a change in the

dividend growth rate is called Variable (Non constant) Growth Model. It sometimes is

also called supernormal growth model.

The value of a share of variable growth stock is determined by following 4 procedures.

1. Find the value of the dividends at the end of each year during the initial growth period.

2. Find the present values of the dividends found in step 1.

3. Find the value of the stock at the end of the initial growth period

4. Add the present value of the dividends found in step 2 and the present value of the

value of the stock found in step 3 to determine the value of the stock at time zero, i.e. po.
• Example: Addis Company’s most recent annual
dividend, which was paid yesterday, was Br. 1.75 per
share. The dividends are expected to experience a 15%
annual growth rate for the next 3 years. By the end of
3 years growth rate will slow to 5% per year to
infinity. Stockholders require a return of 12% on
Addis’ stock

Required: Calculate the value of the stock today.

Thanks