Comprehensive Analysis: Bond and Stock Valuation in Corporate Finance

This report provides a comprehensive analysis of bond and stock valuation, essential concepts in corporate finance. It begins by defining bonds, detailing important terms like par value, coupon rate, and yield to maturity (YTM), and explaining the cash flows associated with bonds. The report then explores the valuation of bonds, including the relationship between coupon rate and YTM, and the risks associated with bonds like price risk and reinvestment risk. It also covers how to compute YTM using the trial and error method. The report contrasts debt and equity, and explains the bond indenture. Subsequently, it delves into stock valuation, outlining cash flows for shareholders, and different dividend estimation models, including constant dividend, constant dividend growth, and non-constant growth models. It also examines the components of required return. The report concludes by summarizing key takeaways, emphasizing the inverse relationship between bond value and interest rates, and the importance of understanding dividend-based stock valuation.

Bond and Stock valuation
Abstract
Bond and stock valuation are most important concepts in corporate finance. Investors may
benefit from bonds, stocks or a mix of both in their portfolios. Ability to esteem each sort of
investment is important, on the grounds that various components decide the worth of each.
You can look for the best price if you know those variables. Make sure to keep the method
for esteeming a bond separate from our technique for esteeming stocks, on the grounds that
the two methods are not interchangeable. Therefore valuation is a significant concept for
investment decisions. Basically, this chapter will cover how to value bonds and stocks
separately.
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01.Bonds
01.1.What is a Bond?
Simply a bond is a loan from an investor to a borrower such as company or government
01.2.Important terms in bond
 Par value – the principle amount of a bond that is repaid at the end of the term
 Coupon rate – the annual coupon divided by par value of bond
 Coupon payment – the stated interest payment made on a bond
 Maturity – the specific date on which the principal amount of bond paid
 Yield to maturity (YTM) – the required rate in the market on bond
(Ross, Westerfield, & Jordan )
01.3.Cash flows of bonds
 Coupon payment and Par value
01.4.Valuation of bonds
Price of bond is the present value of cash flows
01.5.Relationship between coupon rate and YTM
 When Coupon rate = YTM Par value = Bond price
 When Coupon rate < YTM Par value > Bond price Discount bonds
 When Coupon rate > YTM Par value < Bond price Premium bonds
01.6.Bonds and Risks( (Bond Risk, n.d.))
 Price risk - Risk that the market price of the bond will fluctuate due to fluctuates in
the market interest
 Reinvestment risk - Reinvestment risk is the risk that a bond is reimbursed early, and
a investor needs to track down another spot to invest with the risk of lower returns.
01.7.Computing YTM
 Can use financial calculators or trail and error method(similar to process that we use
to find annuity)
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Bond value = {Coupon payment * [1-(1+r)-n]/r} + [Par value of the bond / (1+r)n]
r = Yield to maturity
n = time period in years

Illustration(trial and error method)
Consider bond with 10% annual coupon rate ,15 year to maturity & par value of
Rs.1000.The current price Rs.928.09.What is the YTM?
In here directly we can say YTM is greater than coupon rate.(928.09<1000)Fistly we
apply 12% as YTM and get the price of the bond as 863.78.It is too low.Therefore
YTM must be in between 10% and 12%.Now we apply 11% as the YTM and
calculate the price of bond.Now we get the price as 928.09.Therefore YTM is 11%
 When calculating YTM with semiannual coupon we must be careful about coupon
payment and compounding periods
Illustration
Suppose a bond with a 20% coupon rate & semiannual coupons,has a par value
1000 ,20 years to maturity & selling for 1197.93.In here semi annual coupon is 100
and compounding period is 2*20=40.
01.8.Current yield of a bond
02.Difference between debt and equity
Debt Equity
 Not an ownership interest  Ownership interest
 Borrowed fund  Owned fund
 Interest is considered as a cost of
doing business
 Dividends are not considered as cost
of doing business
 Can be secured or unsecured  Always unsecured
(Difference Between Debt and Equity, n.d.)
03.Bond indenture
Contract between the company and the bond holders.Also known as “deed of trust”.It Include
 Basic terms of bond
 Total amount of bond issued
 Repayment arrangement
 The call provision
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Current yield = Annual interest payment / Bond current price

04.Stock valuation
04.1.Cash flows for shareholders
 Dividend and From selling shares to market or to company
 Price of stock is present value of these cash flows
04.2.Estimating dividends-Special events
04.2.1.Constant dividend
Firm pay constant dividend forever.Price is calculated using perpetuity
04.2.2.Constant dividend growth
Firm will increase the dividend by a constant percent every period
04.2.3.Non constant growth
Dividend growth is not consistence initially but settles down to constant growth eventually
If we take two different divided in first 2 years and then from 3rd year has constant growth
04.3.Components of required return
(D1/ P0) = Dividend yield
g = Capital gainyield (Ross, Westerfield, & Jordan )
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Price of stock(1 year )
P0 = [D1 / (1+r)]+[selling price / (1+r)]
Price of stock(2 year )
P0 = [D1 / (1+r)]+ [D2 / (1+r)2] +[selling price / (1+r)2]
Price of stock
P0 = [D1 / (1+r)]+ [D2 / (1+r)2]+ [D3 / (1+r)3]+ [D4 / (1+r)4]+……………………………..
P0 = [D1 / R]
P0 = [D1 / R-g] Pt = [Dt+1 / R-g]
P0 = [D1 / (1+r)]+ [D2 / (1+r)2]+ [P2 / (1+r)2]
P2 = [D3 / R-g]
P = price of stock
R = required return
g = growth rate
R = (D1/ P0) + gP0 = [D1 / R-g]

Summary
 Determine the price of a bond using the basic application of discounted cash flow
principle.
 Determine risks associated with bonds.
 The relationship between bond value and interest rate is inverse, leading to potential
gain or losses for bond investors.
 Determine the difference between debt and equity
 Cash flows for owning stocks is coming in form of future dividend.
 Determine the price of stock in special events.(constant dividend,contant dividend
growth,nonconstant growth)
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