Yield-to-Maturity and Credit Rating Relationship in Corporate Securities

This document discusses the relationship between yield-to-maturity and credit rating in corporate securities, the impact of coupon rate and maturity period on bond prices, the CAPM approach for calculating required rates of return for stocks, and the use of the Gordon Growth Model and P/E ratio to estimate stock prices.

PART-1
The table is as per the question provided (Morningstar, 2018a, 2018b, 2018c)
Bond
Company/
Rating
Face Value
(FV)
Coupon
Rate
Annual
Payment
(PMT)
Time-to
Maturity
(NPER)
Yield-to-
Maturity
(RATE)
Market Value
(Quote)
Premium
Discount
A-
Rated
Oracle $1,000 4.20% 41 18.5 Yrs 4.45% 1180 Premium
B-
Rated
Verizon
Communica
tion
$1,000 4.32% 38.72 19.8 Yrs 5.02% 1018 Discount
C-
Rated
KLA
Tencor
$1,000 6.05% 65.2 17.9 Yrs 6.01% 921 Premium
Yield to maturity and credit rating are inversely related to each other in nature.This is in turn
very important as because corporate securities which have a low credit rating are also
continuously under exposure towards default, and subsequently, there exists risk on the higher
side for the financial specialists. Hence, there will be a definite expectations of the financial
investors to expect the yield on these securities on to be on the higher side which might have

foreseen as fixed expense to the additional risk which is already on the assumption list of the
specialists in finance (Damodaran, 2018).
The rate of the coupon along with the YTM, characterizes if at all the security lies with the
option for trade at higher cost than average, inflated, or deflated rate. Eventually, when the
correlation between YTM and the coupon rate is considered, then the securities will in general be
traded at par also keeping in mind that the rate of coupon offered is equivalent to the speculators’
expectations of the yield. Suppose if YTM is below the rate of the coupon rate, then at that point
undertaken security might be traded in the cost, higher than the assumptions as because the
security which offers the coupon is highly required taking into account the reasonable outcome
from the underlying security. This makes it more noteworthy to earn interest in the market in
terms of these securities. Vice-versa, when the maturity yield (YTM) is higher than the yield on
the bond, then at that point, underlying coupon is expected to be traded at a discount. The coupon
rate of the bond is less than the financial investors expectations. (Kane and Marcus, 2013).
Downfalling maturity period will result in a general decline of the YTM and accordingly also
build the estimated costs of the bond. Although the postponing of the maturity date to a later date
will, in general, lead to an increment in the YTM and in this manner a reduction in the costs of
the bond can be seen. (Parrino and Kidwell, 2011).

PART- II
CAPM Approach
The table below shows CAPM approach with 5 year Risk and Return (Yahoo Finance, 2018).
Company 5-year Risk-Free
Rate of Return
Beta (β) 5-Year Return
on Top 500
Stock
Required Rate of
Return (CAPM)
Intel 2.13% 1.20 9.25% 10.67% pa
Dell 2.13% 1.16 9.25% 10.39% pa
Microsoft 2.13% 0.82 9.25% 7.97% pa
The yield on the US treasury is the Risk-free rate, being the 5 – year bond which is calculated as
2.13% per annum. (Brealey, Myers & Allen, 2018) We have used the CAPM model for the
calculation of beta of different stocks.
Required rate of return Risk free rate + Beta*(Market return – Risk free rate)
Intel 2.13 + 1.20*(9.25-2.13) 10.67% pa

Dell 2.13 + 1.16*(9.25-2.13) 10.39% pa
Microsoft 2.13 + 0.82*(9.25-2.13) 7.97% pa
PART-III
Valuation of stock Price Using Gordon Model
Company Current
Dividend
($)
Projected
Growth Rate
(next year)
Required Rate
of Return
(CAPM)
Estimated
Stock Price
(Gordon
Model)
Current Stock
Price
Over/Under
Priced
Intel 3.24 4% 10.67% pa $54.08 58.80 Over
Dell 4.08 4.5% 10.39% pa $ 72.38 96.30 Over
Microsoft 5.2 3.5% 7.97% pa $ 120.4 119.56 Under
Stock Price Estimation

Intel 3.24*1.04/(0.1023-0.04) $54.08
Dell 4.08*1.045/(0.1039-0.045) $ 72.38
Microsoft 5.2*1.035/(0.0797-0.035) $ 120.4
Valuation of Stock Price Using P/E Ratio
Company Estimated
Earning
(next year)
P/E Ratio Estimated
Stock Price
(P/E)
Current Stock
Price
Over/Under Priced
Intel 3.12 33.51 $59.08 58.80 Under
Dell 10.49 10.35 $ 98.38 96.30 Under
Microsoft 15.01 8.97 $ 128.4 119.56 Under
Yahoo Finance (2018) is the source for all the relevant information for the date written and
derived in the above table.The Gordon’s Dividend Growth Model illustrates as under:
Price of the stock as estimated = Dividend next year / (Required return – dividend growth rate)

Therefore, it is observed that both the evaluated stock price and the required profit for stock are
inversely proportional to each other whereas it is legitimately relative to the inclined rate of
dividend which might turn out to the basic idea as there would be an expansion in the numerator
by the exceeded growth rate of dividend and similarly the denominator will also be reduced, and
also result in higher assessed stock cost. To add, direct relationship would exist between the
greater dividend paying stock and also a greater worth accepting that denominator is kept stable
similarly like more expensive rate of an increased coupon paying security, expecting the yield to
maturity as consistent. Gordon Profit model specifies that the stock at present and the immediate
value of the profits amount is to be considered, this might be covered by paying expected stock
price throughout the life span. (Kane and Marcus, 2013).
Advantages of Gordon Growth Model
It is a strategy that is quite useful to compliment the estimation of any particular organization
irrespective of the industry which it pertains to. (Parrino and Kidwell, 2011).
Disadvantages Of Gordon Growth Model
Gordon’s model of Growth cannot be applied to derive the stock price of those organizations
which are not paying and neither are obliged to distribute dividends.(Marcus and Kane, 2013).
The model is not accountable for the constants beyond dividends at the assurance of stock price,
specifics are, the intangible resources which turn out to be crucial in the current tutorial
economical environment (Parrino and Kidwell, 2011).
The inclination of dividend is constantly fluctuating, notwithstanding for mature stocks.

Required rate of equity must be considerably higher than the dividend growth rate, but not in all
cases as then the prices of stocks might not be predicted accurately. (Damodaran, 2018). What
basically is based on the EPS calculation is the P/E approach in the subsequent year and
gradually growing with the current profit/Earning ratio to stress on the estimated stock price in
the subsequent years with the underlying expectation that the profit/Earning ratio might be
stagnant.(Parrino and Kidwell, 2011).
Therefore, the estimated value of stock = Analysed EPS in the Subsequent year*Current profit-
earning ratio
The estimation of the stock prices are decided with the help of the P/E model, reason being that
the prices derived as per the dividend growth model of Gordon are extensively reactive to the
growth rate of dividend. Although, there is no anticipation on the accuracy of the data.
Accordingly, the estimates resulted from the profit/Earning ratio analysis, reflect closely the
current market price of the commodities. (Brealey, Myers and Allen, 2018).
Assuming that there is a stable growth rate of the organization, then, the stock analysis might
increase as there might be an increase in the dividend in the subsequent years to come, while the
lower constant of the Gordon growth model may reduce. Stock worth would be lowered down
by the expansion in the expected return pace. Further, the cost of the underlying stock may be
expanded by an elevation in the dividends as per the Gordon growth model in which the cost of
the said stock is correlated to the dividend distribution. Stock pricing would build higher
probability of increasing the cost of the stock considering the income to increase as per the
price-earning ratio method (Damodaran, 2018).

REFERENCES
Brealey, R., Myers, S. & Allen, F. (2018), Principles of Corporate Finance, New York: McGraw
Hill Publications
Damodaran, A. (2018), Corporate Finance, London: Wiley Publications
Kane, B.Z. & Marcus, A.J. (2013). Essentials of Investment, Singapore: McGraw-Hill
International
Morningstar (2018a), Verizon Communications Inc, MorningStar Website, Retrieved on
January 12, 2016 https://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=vz
Morningstar (2018b), KLA-Tencor Corp, MorningStar Website, Retrieved on January 12, 2016
ttp://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=KLAC&country=USA
Morningstar (2018c), Oracle Corp, MorningStar Website, Retrieved on January 12, 2016
https://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=ORCL&country=USA
Parrino, R. & Kidwell, D. (2011), Fundamentals of Corporate Finance, London: Wiley
Publications
Yahoo Finance (2016), Historical prices, Yahoo Finance, Retrieved on September 02, 2019
https://finance.yahoo.com/