UNIT-IV

BOND AND STOCK VALUATION AND THE COST OF CAPITAL

The concept of bond

A bond is a long-term debt of a government or corporation. When you own a bond, you
receive a fixed interest payment each year until the bond matures. This payment is known as the
coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond’s
face value. At maturity the bond’s face value is repaid. The current yield is the annual coupon
payment expressed as a fraction of the bond’s price. The yield to maturity measures the average
rate of return to an investor who purchases the bond and holds it until maturity, accounting for
coupon income as well as the difference between purchase price and face value.
A bond is a long-term contract under which a borrower agrees to make payments of
interest and principal, on specific dates, to the holders of the bond. Bond A long-term debt
instrument. For example, imagine that Kreuger Enterprises just issued 100,000 bonds for $1,000
each, where the bonds have a coupon rate of 5 percent and a maturity of two years. Interest on
the bonds is to be paid yearly. This means that:
1. $100 million (100,000 _ $1,000) has been borrowed by the firm.
2. The firm must pay interest of $5 million (5% _ $100 million) at the end of one year.
3. The firm must pay both $5 million of interest and $100 million of principal at the end of two
years.
Types of Bonds:
Investors have many choices when investing in bonds, but bonds are classified into four
main types: Treasury, corporate, municipal, and foreign. Each type differs with respect to
expected return and degree of risk.
Treasury bonds: sometimes referred to as government bonds, are issued by the federal
government.1 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 all 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. Different corporate bonds have
different levels of default risk, depending on the issuing company’s characteristics and on the
terms of the specific bond. Default risk is often referred to as “credit risk,”
Municipal bonds, or “munis,”: These 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 exempt from federal taxes and also from state
taxes if the holder is a 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: These are issued by foreign governments or foreign corporations. Foreign
corporate bonds are, of course, exposed to default risk, and so are some foreign government
bonds. An additional risk exists if the bonds are denominated in a currency other than that of the
investor’s home currency. For example, if you purchase corporate bonds denominated in
Japanese yen, you will lose money—even if the company does not default on its bonds—if the
Japanese yen falls relative to the dollar.
Key characteristics of bonds:
Although all bonds have some common characteristics, they do not always have the same
contractual features. For example, most corporate bonds have provisions for early repayment
(call features), but these provisions can be quite different for different bonds. Differences in
contractual provisions, and in the underlying strength of the companies backing the bonds, lead
to major differences in bonds’ risks, prices, and expected returns. To understand bonds, it is
important that you understand the following terms.
PAR VALUE
The par value is the stated face value of the bond; for illustrative purposes we generally assume
a par value of $1,000, although any multiple of $1,000 (for example, $5,000) can be used. The
par value generally represents the amount of money the firm borrows and promises to repay on
the maturity date.
Coupon Payment
The specified number of dollars of interest paid each period, generally each six months.
Coupon Interest Rate
The stated annual interest rate on a bond.
Floating Rate Bond
A bond whose interest rate fluctuates with shifts in the general level of interest rates.
Zero Coupon Bond
A bond that pays no annual interest but is sold at a discount below par, thus providing
compensation to investors in the form of capital appreciation.
Original Issue Discount Bond
Any bond originally offered at a price below its par value.
Maturity Date
A specified date on which the par value of a bond must be repaid.
Original Maturity
The number of years to maturity at the time a bond is issued.
Call Provision
A provision in a bond contract that gives the issuer the right to redeem the bonds under specified
terms prior to the normal maturity dates.
Sinking Fund Provision
A provision in a bond contract that requires the issuer to retire a portion of the bond issue each
year.
Other features:
Convertible Bond
A bond that is exchangeable, at the option of the holder, for common stock of the issuing firm.
Warrant
A long-term option to buy a stated number of shares of common stock at a specified price.
Income Bond
A bond that pays interest only if the interest is earned.
Indexed (purchasing power) Bond
A bond that has interest payments based on an inflation index so as to protect the holder from
inflation.
HOW TO VALUE BONDS
For the purpose of valuation, bonds may be classified into 2 categories.
1. Bonds with a maturity period
2. Bonds in perpetuity
Bonds with a maturity period: When the bonds have a definite maturity period, its valuation is
determined by considering the annual interest payments plus its maturity value.
The following formula can be used to determine the value of a bond.

Vd = value of bond or debt M= maturity value of bond

R1,R2…… =annual interest n= number of years to maturity
Kd =required rate of return

Illustration: An investor is considering the purchase of a 8%, $1,000 bond redeemable after 5
years at par. The investor’s required rate of return is 10%. What should be willing to pay now to
purchase the bond?
Sol:

Bonds Redeemable in Installments:

A company may issue a bond or debenture to be redeemed periodically. In such a case,
principal amount is repaid partially each period instead of a lump sum at maturity and hence cash
outflows each period include interest and principal. The amount of interest goes on decreasing
each period as it is calculated on the outstanding amount of bond/debenture.
The formula for calculating the value of bond:
Illustration: A company is proposing to issue a 5 year debenture of $1,000 redeemable in equal
installments at 14%rate of interest per annum. If an investor has a minimum required rate of
return of 12%, calculate the debenture’s present value for him. What should be willing to pay
now to purchase the debenture?

Bonds in perpetuity: Perpetuity bonds are the bonds which never mature or have infinitive
maturity period. Value of such bonds is simply the discounted value of infinite streams of
interest flows.
The formula for calculating the value of bond is:

Illustration: Mr. David has a perpetual bond of the face value of $1,000. He receives an interest
of $60 annually. What would be its value if the required rate of return is 10%?

Yield to Maturity or Bond’s Internal/Rate of Return:

We have so far assumed that the investor’s required rate of return also called the discount
rate is given for calculating the value of the bond/debenture. However, in many cases, we may be
required to calculate the required rate of return when the cash inflows and the current value/price
of the bond is given. This rate also known as ‘yield to maturity’ or the ‘internal rate of return’ for
the bond.
It can be calculated by using the following formula:

Illustration: The current value of an 8% debenture, of $1,000 redeemable after 5 years at par, is
how much?

Valuation of zero coupon bonds/deep discount bonds:

The deep discount bond does not carry any interest but it is sold by the issuer company at
deep discount from its eventual maturity value.
The following formula can be used to calculate the value:

Illustration: A deep discount bond is issued for a maturity period of 20 years and having a face
value of $100,000. Find out the value of the DDB if the required rate of return is 10%.
Preferred Stock Valuation:
Preferred stock is a hybrid security having features of both equity and debt. A fixed rate
of dividend is paid on preference shares. Dividend on preference share is payable out of profits
after paying interest on debt but before paying dividend on equity shares. A preference share is
also preferred in repayment as compared to equity share.
Preferred stock or share can be with a maturity period or redeemable after a certain
period or with perpetuity having no maturity period.
The following formula is used to calculate redeemable preference share

Illustration: Mr. Daniel is considering the purchase of a 7% preference share of $1,000

redeemable after 5 years at par. What should he willing to pay now to purchase the share
assuming that the required rate of return is 8%?

Value of a perpetual preference share: If the preference share has no maturity date or is
irredeemable and the future dividends are expected to be constant, the value can be calculated as
below:

Illustration: Mr. Riaz has a irredeemable preference share of $1,000. He receives an annual
dividend of $80 annually. What will be its value if the required rate of return is 10%?
STOCK VALUATION

A shareholder is a part-owner of the firm. For example, there were 1,471 million shares
of PepsiCo outstanding at the beginning of 1999, so if you held 1,000 shares of Pepsi, you would
have owned 1,000/1,471,000,000 = .00007 percent of the firm. You would have received .00007
percent of any dividends paid by the company and you would be entitled to .00007 percent of the
votes that could be cast at the company’s annual meeting.
Firms issue shares of common stock to the public when they need to raise money. We
use the terms “shares,” “stock,” and “common stock” interchangeably, as we do “shareholders”
and “stockholders.”

PRIMARY MARKET
Market for newly-issued securities, sold by the company to raise cash.
a) There are two types of primary market issues. In an initial public offering, or IPO, a
company that has been privately owned sells stock to the public for the first time.
b) Established firms that already have issued stock to the public also may decide to
raise money from time to time by issuing additional shares. Sales of new shares by
such firms are also primary market issues and are called seasoned offerings. When a
firm issues new shares to the public, the previous owners share their ownership of the
company with additional shareholders. In this sense, issuing new shares is like having
new partners buy into the firm.

SECONDARY MARKET
Market in which already issued securities are traded among investors.

The two major exchanges in the United States are the New York Stock Exchange
(NYSE) and the NASDAQ market. At the NYSE trades in each stock are handled by a specialist,
who acts as an auctioneer. The specialist ensures that stocks are sold to those investors who are
prepared to pay the most and that they are bought from investors who are willing to accept the
lowest price.
The NYSE is an example of an auction market. By contrast, Nasdaq operates a dealer
market, in which each dealer uses computer links to quote prices at which he or she is willing to
buy or sell shares. A broker must survey the prices quoted by different dealers to get a sense of
where the best price can be had.

DIVIDEND : Periodic cash distribution from the firm to its shareholders.

PRICE-EARNINGS (P/E) MULTIPLE: Ratio of stock price to earnings per share.

These terms needs clarification.

• Book value records what a company has paid for its assets, with a simple, and often
unrealistic, deduction for depreciation and no adjustment for inflation. It does not capture
the true value of a business.
• Liquidation value is what the company could net by selling its assets and repaying its
debts. It does not capture the value of a successful going concern.
• Market value is the amount that investors are willing to pay for the shares of the firm.
This depends on the earning power of today’s assets and the expected profitability of future
investments.
Valuation of Equity shares:
a) One period Valuation Model:
Suppose an investor plans to buy an equity share to hold it for one year and then sell.
The formula is:

Illustration: Mr.X is planning to buy an equity share, hold it for one year and then sell it. The
expected dividend at the end of year 1 is $7 and the expected sale proceeds $200 after 1 year.
Determine the value of the share to the investor assuming the discount rate of 15%.
 b) Two-period valuation model: Suppose now that the investor plans to hold the share for
two years and then sell it. The formula is:

Illustration: Mr.X is planning to buy an equity share, hold it for 2 years and then sell it. The
expected dividend at the end of year 1 is $7 and $7.50 at the end of year 2. The expected selling
price of the share at the end of year 2 is $220. Calculate the value of the share today taking 15%
discount rate.

c) N-period Valuation Model: Similarly, if the investor plans to hold the share for n years
and then sell, the value of the share would be:

Illustration: An investor expects a dividend of $5 per share for each of 10 years and a selling
price of $80 at the end of 10 years. Calculate the present value of share if his required rate of
return is 12%.
Dividend Valuation Model: Dividend valuation model is the generalized form of common stock
valuation. The concept of this model is that many investors do not contemplate selling their share
in the near future. They want to hold the share for a very long period.
a). No growth case: If the dividends constant, the value of the share shall be the capitalization of
perpetual stream of constant dividends.

Illustration: A company is presently paying a dividend of $6 per share and is expected not to
deviate from this in future. Calculate the value of the share if the required rate of return is 15%.

d) Constant Growth Rate: If the dividends of a firm are expected to grow at a constant rate
forever, the value of the share can be calculated as:

Illustration: A company is expected to pay a dividend of $6 per share next year. The dividends
are expected to grow perpetually at a rate of 9%. What is the value of its share if the required rate
of return is 15%?

Earnings capitalization model: When the earnings of the firm are stable the value of an equity
share can be determined by capitalization of earnings.
Illustration: Calculate the price of an equity share from the following data:
Earnings per share $20
Internal rate of return 20%
Equity capitalization rate 20%

Rate of return of an equity share:

Illustration: The equity share of a company is currently selling at $80. It is expected that the
company will pay a dividend of $4 at the end of one year and the share can be sold at a price of
$88. Calculate the return on share. Should an investor buy it, if his capitalization rate is 12%?

COST OF CAPITAL
The cost of capital is the measurement of the sacrifice made by an investor in order to
capital formation with a view to get a fair return as his investment as a reward is the
measurement of disutility of funds in the present as compared to the return expected in future.
The cost of capital is the required rate of return to justify the use of capital so that the
expected rate of return can be maintained on equity share and market value per share remain
unchanged or should not be reduced at least.
Definition: James C Van Horne: “The cost of capital is the cut-off rate for the allocation of
capital to investments of projects. It is the rate of return on a project that will leave unchanged
the market price of the stock”.
Soloman Ezra: “The cost of capital is the minimum required rate of earnings or the cut-off rate
of capital expenditures.”
 The above definitions indicate that it is a leading rate which the firms could be earned if
they invested and is the borrowing rate to acquire funds to finance the project.
CAPITAL STRUCTURE:
The capital structure decision is a significant managerial decision which influence and
return of the investors. The firm has to decide the way-in which capital project will be financed.
The company will have to plan its capital structure at the time of promotion itself and also
subsequently whenever it has to raise additional fund for various new projects. Whenever the
company needs to raise finance, it involves a capital structure decision because it has to decide
amount of finance to be raised as well as the source it is to be raised. The capital structure
decision influence the value of the firm through shareholders.
SPECIFIC/COMPONENT COST OF CAPITAL:
Specific cost refers to the cost of a specific source of capital while composite cost is
combined cost of various sources of capital. It is the weighted average cost of capital. In case
more than one form of capital is used in the business, it is the composite cost which should be
considered for decision-making and not the specific cost. But where only one type of capital is
employed the specific cost of that type of capital may be considered.
Importance of the overall cost of capital:
The cost of capital is a very important concept in financial management decision making.
The concept, is however a recent development and has relevance in almost every financial
decision making but prior to the development, the problem was or by passed. There are almost 5
important reasons for management to aware the cost of capital.
a. In the context of capital budgeting, cost of capital is of supreme importance. The
usefulness of evaluation of investment depends on cost of capital.
b. It is a measure of financial performance and hence it is called the hurdle rate, target rate,
cut off rate and required rate of return.
c. The cost of capital is useful in inter-company and intra company performance.
d. There is an empirical evidence to show that the market value of the firm and cost of
capital are related and cost of capital is useful in determining the market value of the
firm.
e. The cost of capital is a guide in timing and issue of capital.
MARGINAL COST OF CAPITAL:
Marginal cost of capital may be defined as the cost of raising an additional rupee of
capital. The weighted average cost of capital is the overall cost of existing capital fund where as
the marginal cost of capital is the weighted average cost of new or incremental capital.
Marginal cost of capital is relevant in the capital budgeting process, as the firm is
concerned with the selection of new projects with the new investments. Hence, the cost of raising
new funds is to be worked out for deciding the investment pattern.
In the capital budgeting process, the firm concerned with the selection of new projects.
Therefore, the relevant cost is the cost of raising new funds to finance the projects on the
historical cost. Thus, the weighted average cost of incremental capital is known as the marginal
cost of capital.
The marginal cost of capital may be define as the cost of raising an additional rupee of
capital since the capital is raised in lump sum in practice, the marginal cost of capital in finance
as referred to the cost incurred in raising the new fund.

QUESTIONS FOR STUDY:

1. What is meant by a bond?
2. What are the types of bonds?
3. How will you value the bonds?
4. What is meant by preferred stock?
5. What is common stock?
6. How will you value different types of stock?
7. Explain the concept of cost of capital.
8. What is the importance of overall cost of capital?
9. Describe marginal cost of capital.
10. Explain book value, liquidation value and market value.
11. What is primary market and what is secondary market?