Chapter 4: The valuation of long-

term securities
Study objectives
Distinctions among valuation concepts
Bond valuation
Preferred stock valuation
Common stock valuation
Rates of Return

chapter 4 1
 What does it mean?
What is a cynic? A man who knows the
price of everything and the value of
nothing.---Oscar Wilde

chapter 4 2
Why shall we know the valuation
of long-term securities?
Make investment decisions
Determine the value of the firm

chapter 4 3
 Distinctions among valuation
concepts
Liquidation value versus going-concern value
Liquidation value is the amount of money that could be
realized if an asset or a group of assets (e.g., a firm) is
sold separately from its operating organization.
Going-concern value is the amount a firm could be sold
for as a continuing operating business
The computation of liquidation value and going-
concern value is very different
As in accounting, the security valuation models that we
will discuss in this chapter will generally assume that
we are dealing with going-concern

chapter 4 4
 Book value versus market value
The book value of an asset is the accounting value
of the asset---the assets cost minus its
accumulated depreciation.
The book value of a firm is equal the dollar
difference between the firms total assets and its
liabilities and preferred stock as listed on its
balance sheet
Because book value is based on historic values and
estimations, it may not be accurate after a long period
of time

chapter 4 5
 Book value versus market value
In general, the market value of an asset is simply
the market price at which the asset (or a similar
asset) trades in an open market place.
For a firm, market value often viewed as being the
higher of the firms liquidation or going concern
value
Market value often outrival book value as to decision
relevance, because market value takes risk, future
opportunity, current cash flow in account.

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 Market value versus intrinsic
value
For an actively traded security, the market value would be
the last reported price at which the security was traded.
For an inactively traded security, an estimated market price
would be needed
The intrinsic value of a security is what the price of a
security should be if properly priced based on all factors
bearing on valuation---assets, earnings, future prospects,
management, and so on.
If markets are reasonably efficient and informed, the current
market price of a security should fluctuate closely around its
intrinsic value

chapter 4 7
 The valuation approach
The valuation approach taken in this
chapter is one of determining a securitys
intrinsic value. This value is the present
value of the cash flow stream provided to
the investor, discounted at a required rate of
return appropriate for the risk involved

chapter 4 8
 Bond valuation
A bond is a security that pays a stated amount of
interest to the investor, period after period, until it
is finally retired by the issuing company
In China, bond interest may not be paid annually, but
until the retirement of the bond
Face value is the stated value of an asset. In the
case of a bond, the face value is usually $1000
The face value is supposed to be paid back to the
bondholders as the principal, no matter what the
purchasing price of the bond

chapter 4 9
 Bond Valuation
Coupon rate: the stated rate of interest on a bond;
the annual interest payment divided by bonds face
value
The factors that affect the valuation of bond
Face value
Coupon rate
Required rate of return
Maturity

chapter 4 10
The Model of Bond Valuation

n
Vb MV
(1 r ) n (1 r )t It

t 1

chapter 4 11
 Perpetual Bonds
A bond that never matures (rarely exists
now)
n
Vb t 1
I
(1 r ) t
I /r

chapter 4 12
 Bonds with a Finite Maturity
Typical coupon bonds (limited outstanding
period, annually paid interest)
V=I(PVIFAr,n)+MV(PVIFr,n)

chapter 4 13
 Example
The Brothers determines to issue 10000
$1000-par-value bonds with 10% coupons.
The bonds will be retired in 9 years. The
Brothers decides to issue the bond at $1020.
If Mr. White wants to buy the bond and his
required rate of return is 8%, should Mr.
White buy the bond?

chapter 4 14
 Example
V=$100(PVIFA8%,9)+
$1000(PVIF8%,9)=$1124.70
Because V>P, Mr. White should buy the
bond

chapter 4 15
 Zero-coupon bond
A zero-coupon bond is a bond that pays no
interest but sells at a deep discount from its
face value; it provides compensation to
investors in the form of price appreciation
The interest of a zero-coupon bond is the
remainder of the face value less issuing
price
V=MV/(1+r)n

chapter 4 16
 Example
Suppose that Pace Enterprises issues a zero-
coupon bond having a 10-year maturity and
a $1000 face value. If the investors
required return is 12%, then
V=$1000/(1+12%)10=$322

chapter 4 17
Seminal compounding of interest
Although some bonds (typically those issued in
European Markets) make interest payments once a
year, most bonds issued in America pay interest
twice a year. As a result, it is necessary to modify
our bond valuation model
V=(I/2)(PVIFAr/2,2n)+MV(PVIFr/2,2n), here I is the
nominal interest of the bond and n is the years that
the bond exists

chapter 4 18
 Example
To illustrate, if the 10% coupon bonds of the U.S.
Blivet Corporation have 12 years to maturity and
our nominal annual required rate of return is 14%,
the value of one $1000-par-value bond is
V=($50/2)(PVIFA14/2,24)+MV(PVIF14/2,24)=$770.45
Why V<par value? Because required
return>coupon rate

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 Preferred Stock Valuation
Preferred stock is a type of stock that promises a
(usually) fixed dividend, but at the discretion of
the directors. It has preference over common stock
in the payment of dividends and claims on assets
Cumulative and noncumulative preferred stock
A cumulative preferred stock is a stock whose
dividend not paid out is deferred to later years

chapter 4 20
 Example
To illustrate the payment of different types
of dividends, the following data from the
Boston Lakers Basketball Team will be
used. Assume that outstanding stock
includes: preferred stock (5%, $10 par value
6000 shares issued and outstanding)
$60000, common stock ($5 par value, 8000
shares issued and outstanding) $40000
chapter 4 21
 Example
case Preferred Years Total Preferred Common
dividend in dividend dividend dividend
feature arrears
1 noncumula --- 2000 2000 0
tive
2 noncumula --- 4000 3000 1000
tive
3 cumulative 2 7000 7000 0
4 cumulative 2 11000 9000 2000

chapter 4 22
 The valuation of preferred stock
The payment of preferred stock is similar to an annuity, so
the valuation model of a preferred stock is :
Vp=Dp/R
If Margana Cipher Corporation had a 9%, $100-par-value
preferred stock issue outstanding and your required return
was 14% on this investment, its value per share to you
would be Vp=Dp/R=$64.29
In China, no listed company has issued preferred stock

chapter 4 23
 Common stock valuation
Common stock is the security that represent
the ultimate ownership (and risk) position in
a corporation
The difficult issues of valuation: uncertainty
and payment of stock dividend, different
risk levels, etc.

chapter 4 24
 Are dividends the foundation
Case 1: hold the stock for a long time
n
V D1
(1 r ) (1 r ) 2 ... (1 r ) n (1 r )t
D2 Dn Dt

t 1

chapter 4 25
 Are dividends the foundation
Case 2: hold the stock for a short time (e.g.,
2 years)
Note: D1, D2Dn and P2 are all estimates

V D1
(1 r ) (1 r ) 2 (1 r ) 2
D2 P2

chapter 4 26
 A logical question to the models
The logical question to raise at this time is: why do the
stocks of companies that pay no dividends have positive,
often quite high, values?
The answer is: investors expect to sell the stock in the
future at a price higher than they paid for it.
Terminal value depends on the expectations of the
marketplace viewed from the terminal point. The ultimate
expectation is that the firm will eventually pay dividends,
either regular or liquidating, and that future investors will
receive a company-provided cash return on their
investment

chapter 4 27
 Dividend Discount Models
Constant Growth
Assume that dividends grow at a constant rate. But
in real life, few companies do this. We shall learn
this in corporate finance---dividend policy
Assume that D0 is the present dividend per share
and g is the growth rate of dividend, so D1 is (1+g)
D0 , D2 is D0 (1+g)2,Dn is D0 (1+g)n
According to the valuation model, constant growth
stock is valuated as:

chapter 4 28
 Constant Growth
D0 (1 g ) D0 (1 g ) 2
V (1 r ) (1 r ) 2

D0 (1 g ) n
...... (1 r ) n
D0 (1 g )
(r g ) D1
(r g )

chapter 4 29
 Constant Growth
Tip: a common mistake made in using the above
equation is to use, incorrectly, the firms most
recent annual dividend for the variable D1 instead
of the annual dividend expected by the end of the
coming year
g can never be larger than r, why?
Suppose that LKN, Inc.s dividend per share at t=1
is expected to be $4, that it is expected to grow at a
6% rate forever, and that the appropriate discount
rate is 14%. The value of one share of LKN stock
would be V=$4/(0.14-0.06)=$50
chapter 4 30
 Conversion to an earnings
multiplier approach
Assume that a company retains a constant
proportion of its earnings each year; call it b,
then (1-b)=D1/E1, D1=E1(1-b), V=(1-b)E1/(r-
g), V/E1=(1-b)/(r-g), (1-b)/(r-g) is called
earnings multiplier (EM). V=E1(EM)
Why we should know earnings multiplier?
Because it bring together value and earnings
of a stock
chapter 4 31
 No Growth
Assume that dividends will be maintained at
their current level forever ( a kind of
dividend policy)
V=D1/r==D0/r. like a preferred stock

chapter 4 32
 Growth phases
Firms may exhibit above-normal growth for a
number of years (g may even be larger than r
during this phase), but eventually the growth rate
will taper off.
Assume that dividends per share are expected to
grow at f compound rate for m years and thereafter
at g, the valuation model is:
m n
V Dm1 (1 g ) t m
t
D0 (1 f )
(1 r ) t (1 r ) t
t 1 t m 1

chapter 4 33
 Example
If dividends per share are expected to grow
at 10% compound rate for 5 years and
thereafter at 6%, the required rate is 14%,
how to value the stock?

chapter 4 34
 Example
5

t 1
$2 (1.10 ) t
(1.14 ) t $8.99

[$2 (1.10 ) 5 (1.06 ) /( 0.14 0.06 )]

(1.14 ) 5 $22.13
$22.13 $8.99 $31.12
chapter 4 35
 Rates of Return
If we replace intrinsic value in our valuation
equations with the market price (p0) of the
security, we can then solve for the market
required rate of return.
This rate, which sets the discounted value of
the expected cash inflows equal to the
securitys current market price, is also
referred to as the securitys market yield
chapter 4 36
 Rate of return
It is important to recognize that only when the
intrinsic value of a security to an investor equals
the securitys market value (price) would the
investors required rate of return equal the
securitys (market) yield
Market yields serve an essential function by
allowing us to compare, on a uniform basis,
securities that differ in cash flow provided,
maturities, and current prices
chapter 4 37
 Yield to maturity (YTM) on
bonds
Yield to maturity (YTM) is the expected rate of
return on a bond if bought at its current market
price and held to maturity; it is also known as the
bonds internal rate of return (IRR)
Mathematically, it is the discount rate that equates
the present value of all expected interest payments
and the payment of principal (face value) at
maturity with the bonds current market price

chapter 4 38
 Yield to maturity
n
P0 (1YTM
I
)t
MV
(1YMT ) n
t 1

The difficult issue is: it is not a linear

function, more complex

chapter 4 39
 Interpolation---Example
Consider a $1000-par-value bond with the
following characteristics: a current market price of
$761; 12 years until maturity, and 8% coupon rate
(with interest paid annually)
Suppose we start with a 10% discount rate and
calculate the present value of the bonds expected
future cash flows. V=$80(PVIFA10%.12)+
$1000(PVIF10%.12)=$684.12>761, so YTM>10%

chapter 4 40
 Interpolation---Example
Try a 15% discount rate
V=$80(PVIFA15%.12)+$1000(PVIF15%.12)=$620.68<761, so
YTM<15%
X/0.05=(864.12-761)/(864.12-620.68)
X=0.0212
YTM=X+10%=12.12%
It is important to keep in mind that interpolation gives only
an approximation of the exact percentage; the relationship
between the two discount rate is not linear with respect to
present value

chapter 4 41
 Behavior of bond price
When the market required rate of return is more
than the stated coupon rate, the price of the bond
will be less than its face value---bond discount
When the market required rate of return is less
than the stated coupon rate, the price of the bond
will be more than its face value---bond premium
When the market required rate of return equals the
stated coupon rate, the price of the bond will equal
its face value---selling at par
chapter 4 42
 Behavior of bond price
If interest rates rise so that the market required rate
of return increases, the bonds price will fall. If
interest rates fall, the bonds price will increase
For a given change in market required return, the
price of a bond will change by a greater amount, the
longer its maturity
Bond price volatility is inversely related to coupon
rate
Figure 4-1 relation between bond price and market
required rate of return
chapter 4 43
 YTM and Semiannual
Compounding

2n
P0 I /2
(1 r / 2 ) t
MV
(1 r / 2 ) 2 n
t 1

chapter 4 44
 Yield on preferred stock and
common stock
P0=Dp/r
P0=D1/(r-g)

chapter 4 45