Lecture 4: Bond and Stock Valuation

4.1 Bonds and Bond Valuation

• Definition of Bonds:

  • A bond is a type of debt security issued by corporations or governments to borrow money from the public on a long-term basis.

• Characteristics of a Bond:

  1. Interest-Only Loan: The borrower pays interest periodically but does not repay the principal until maturity.
  2. Coupons: Regular interest payments promised by the issuer to the bondholder.
  3. Face (Par) Value: The amount to be repaid to bondholders at maturity.
  4. Par Value Bond (P): A bond selling at its face value.
  5. Coupon Rate (c): The annual coupon divided by the face value of the bond.
  6. Time to Maturity (T): The number of years until the face value of the bond is paid.
  7. Yield to Maturity (YTM, r): The current market interest rate required on the bond.
  8. Current Yield: A bond's annual coupon divided by its price.

• Cash Flow Formula for Bonds:

  • Bond Value formula:
    $Bond Value = cP imes \frac{1 - (1 + r)^{-T}}{r} + \frac{P}{(1 + r)^T}$

• Example Calculation for a $1,000 Bond with 8% Coupon:

  • First few terms of the cash flow noted;
    $Bond Value = 0.08(1000) \frac{1 - (1 + 0.08)^{-10}}{0.08} + 1000(1 + 0.08)^{-10}$

Questions on Bond Value

1. Semiannual Coupons:
   • Calculate bond value if Star Co. Bond has semiannual coupons.
2. Effect of Interest Rate Changes on Bond Value:
   • What happens if the interest rate decreases to 4%?
   • What happens if it increases to 12%?

4.2 More about Bond Features

• Types of Securities:
  • Debt Securities: Represents borrowing that must be repaid; involves creditors and debtors.
  • Equity Securities: Represents ownership in a firm; generally does not provide tax-deductible advantages.
• Impact on Financial Statements:
  • Interest payments are tax-deductible, whereas dividends are not.
  • Unpaid debt constitutes a liability; creditors can claim assets upon default, which may lead to liquidation or reorganization.

Specific Features of Debt Securities:

• Maturity Classification:
  • Short-term: Maturity of one year or less.
  • Long-term: Maturity of more than one year; often called notes (≤ 10 years) or bonds (>10 years).
• Public vs. Private Issues: Categorizes bonds based on how they are made available to the public.
• Indenture:
  • Legal agreement detailing terms between bond issuer and debt holder; can be extensive.

Roles of a Trustee:

• Appointed by the corporation to represent bondholders and ensure compliance with indenture terms including managing sinking funds and addressing defaults.

Types of Bonds:

• Registered Bonds: Require the owner to send a coupon to claim interest.
• Bearer Bonds: Ownership evidenced by possession; hard to recover if lost.
• Collateral: Refers to pledged securities for debt; can involve common stock or real property.
• Debenture: Unsecured bond; claims only on residual property.
• Seniority: Determines the order of claim in case of default; debts are often labeled as senior or junior.

Covenant Types:

• Negative Covenant: Limits company actions (restricts dividends, pledging assets, etc.).
• Positive Covenant: Mandates company actions (maintaining working capital, asset condition, etc.).

4.3 Bond Rating

• Significance: Evaluates creditworthiness and possibility of default for corporate issuers.
• Rating Scale: Ranges from AAA (best quality, lowest risk) to lower grades like junk bonds.
• Investment-Grade Bonds: Bonds rated BBB or higher.
• Credit rating Dynamics: Ratings can fluctuate with the issuer’s financial strength.

4.4 Types of Bonds

• U.S. Government Bonds: Largest borrower globally; no default risk.
  • As of January 2015, total U.S. debt was $18.1 trillion.
• Municipal Bonds: State/local issues; coupons are typically exempt from federal income tax, making them appealing to high-income investors.
• Zero Coupon Bonds: No periodic coupons; sold at a discount.
• Floating-Rate Bonds: Adjustable coupon payments based on a base rate, may include inflation adjustments.
• Inflation-linked Bonds (TIPS): Specifically designed to protect against inflation.

4.5 Common Stock Valuation

• Challenges in Valuing Common Stock:

  1. Unknown future cash flows.
  2. Perpetual investment life.
  3. Difficulty in observing the market-required return rate.

• Stock Valuation Formula:
  $Stock Value = D<em>1/(1 + r) + D</em>2/(1 + r)^2 + D_3/(1 + r)^3 + …$

• Dividend Growth Cases:

  1. Zero growth rate.
  2. Constant growth rate.
  3. Constant growth after a period.

Constant Growth Model:

• Similar to preferred stock valuation.
  $Stock Value = D/r$ where D is a constant dividend.

• Example: Constant Dividend of $10 at a 20% return.

  • Value: $\frac{10}{0.20} = 50$

Growth Rate Adjustments:

• General Growth Model:
  $D<em>1 = (1 + g)D</em>0$
  $Stock Value = \frac{(1 + g)D_0}{r - g}$
• Example: Stock with $10 dividend growing at 5%, calculated value: $\frac{10(1 + 0.05)}{0.20 - 0.05} = 70$

Non-Constant Growth Model:

• Supernormal Growth Limitations:
  • Growth rate cannot exceed required return indefinitely.
  • Example of variable growth rates over a fixed period with calculations.

4.6 Suggested Questions for Analysis

• Bond Information: Questions related to price changes based on interest rate shifts and bonds' characteristics.
• Stock Valuation Questions: Involves calculating expected returns and analyzing performance across given periods.