Chapter 9 Stocks and Bonds Essay

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FI 3300 – Chapter 9
Valuation of Stocks and Bonds
Instructor: Ryan Williams

Learning Objectives
Value a bond given its coupon rate, par value,

yield-to-maturity, time to maturity and payment frequency.
Given all but one of the factors of a bond’s value, find the remaining factor.
Value a stock using the dividend discount model under assumptions of constant growth and non-constant growth.
Given all but one of the factors of a stock’s value, find the remaining factor.

Remember – different words for the same thing Cost of capital (from firm’s point of view) =

required rate of return (from investor’s point of view) = interest rate in problems.
Cost of debt = investor’s required rate of

return on debt
Cost of equity = investor’s required rate of

return on equity.

What is a financial security?
It’s a contract between the provider of

funds and the user of funds.
The contract specifies the:

amount of money that has been provided
terms & conditions of how the user is going to

repay the provider

 Provider: you (ordinary investor), the bank,

venture capitalist, etc.
 User: entrepreneur or firm with good business idea/product but no (or not enough) money to execute the idea.

TVM and valuing financial securities
To an investor who owns a financial security (a

stock or a bond), the security is a stream of future expected cash flows.
The value of any security is the Present Value of all the future expected cash flows from owning the security, discounted at the appropriate discount rate (required rate of return).
When we learn to value stocks and bonds later, we are just applying TVM concepts we already know. Common financial securities
Debt security
1) Holder is a creditor of the firm.
No say in running of the firm.

Equity security
1) Holder is an owner of the firm.
Have a say in running of the firm
(by voting).

2) Fixed payment.

2) Payment is not fixed. No guaranteed cash flow from firm.

3) Receives payment before anything is paid to equity holders.

3) Receives what’s left over after all debt holders/creditors are paid.

4) If firm cannot pay, debt holders will take over ownership of firm assets. 4) If firm cannot pay debt holders, loses control of firm to debt holders. 5) Limited liability.

5) Limited liability.

Types of debt securities
Fixed-coupon bonds
Zero-coupon bonds
Consols (Perpetual bonds)
Variable-rate bonds
Income bonds
Convertible bonds
Callable bonds

Fixed coupon bonds
Firm pays a fixed amount (‘coupon’) to the

investor every period until bond matures.
At maturity, firm pays face value of the bond to investor.
Face value also called par value. Most common face value is $1000.
Period: can be year, half-year (6 months), quarter (3 months).

How to read a bond
General Motors 30 year bond
Par Value = $1000
Interest paid Semi-annual
Interest Rate = 8%.

Zero coupon and consul bonds
Zero-coupon bond
Zero coupon rate, no coupon paid during bond’s life.
Bond holder receives one payment at maturity, the face value.
Consol bond
Pays a fixed coupon every period forever.
Has no maturity.

Other types of bonds
Variable-rate bond: Coupon rate is not fixed, but is

tied to a specific interest rate.
Income bond: pays the coupon only when borrower’s earnings are high enough.
Convertible bond: allows holder to convert it to another security, usually issuer’s common stock.
Callable bond: issuer has the right to buy back the bond (before maturity) at a predetermined price.

Equity securities
Equity security means common stock.
Common stock holders have control privileges,

i.e., have a say in firm’s operating decisions.
 Exercise control privileges by voting on matters of

importance facing the firm. Voting takes place during shareholder meetings.

Board of directors: Elected by shareholders to

make sure management acts in the best interests of shareholders.
Common stock holders can expect two types of cash flows:
 Dividends
 Money received from selling shares…