Module 2

Module 2 - Bonds and their Valuation (Chapter 6) and Stocks and their Valuation (Chapter 7)

All  page numbers are references to Fundamentals of Corporate Finance, 7th  edition by Brealey, Myers, and Marcus (McGraw-Hill, 2012)

Chapter 6 applies Time Value of Money techniques to the valuation of bonds, defines some new terms, and discusses how interest rates are determined.  Chapter 7 applies Time Value of Money techniques to the valuation of common stock and preferred stock. While for quiz and exam purposes, you must know everything from both chapters, you should focus on computing returns as we use that later in the course.

Things to Absorb.  From Chapter 6, know everything.  Additionally you need to practice with your financial calculator or spread sheet.  This chapter develops the valuation techniques of fixed income securities.  Bonds are valued similar to an ordinary annuity.  You already know the valuation techniques from Time Value of Money.  The most difficult part of this chapter is the terminology and learning the interrelationships between the various bond components.  The most important relationship is that "If the  market price decreases, this implies that the yield to maturity has increased," and this is often expressed as "rate up implies price down." 

Things to Read - You will need to read the chapter. 

Things to Do - Make 100 on the quiz.  Also, since most bonds make coupon payments twice per year, make sure you can compute the price and yield to maturity on semiannual coupon bonds.  You should be able to answer all of the end of chapter Questions and Problems.

Our book, for reasons I do not understand, make all computations assuming annual coupons. Real world, most bonds are semi-annual.   Thus you should solve/answer most of the problems assuming semi-annual payments. Note, I have used variations on every one of the end of chapter Questions and Problems in past semester’s quizzes and exams.

Calculator links

Note, that your calculator is probably set to 12 payments per year and 2 decimal places.  You need to change this to 1 payment per year and at least 4 decimal places.

1. Watch the Chapter 6 Overview video. The Powerpoints for all of this chapter’s videos are located here.

2. Watch the Chapter Lecture for an in depth review of the chapter. The Powerpoints for this video begin at about slide 4.

3. Read the chapter.

4.  If you feel the need, watch the following lectures on Bonds.

a. Watch the Bond Pricing. The Powerpoints for this video begin at about slide 10.

b. Watch the Bond Yield’s to  Maturity and Interest Rate Determinants.. The Powerpoints for this video begin at about slide 18.

4. The is a chapter where you should spend most of your time solving problems.  The only way to learn this material is to do this material.  In later chapters, we will make many calculations involving bond returns and prices. The list of suggested questions/ problems is at the top of the page.  Here are audio solutions to common bond valuation problems.

a. Audio solution to: You are considering buying bonds in ACBB, Inc. The bonds have a par value of $1,000 and mature in 37 years. The annual coupon rate is 10.0% and the coupon payments are annual. If you believe that the appropriate discount rate for the bonds is 13.0%, what is the value of the bonds to you?

b. Audio solution to: XZYY, Inc. currently has an issue of bonds outstanding that will mature in 31 years. The bonds have a face value of $1,000 and a stated annual coupon rate of 20.0% with annual coupon payments. The bond is currently selling for $890. The bonds may be called in 4 years for 120.0% of the par value. What is your expected quoted annual rate of return if you buy the bonds and hold them until maturity?

c. Audio solution to: Again, Inc. bonds have a par value of $1,000, a 33 year maturity, and an annual coupon rate of 12.0% with annual coupon payments. The bonds are currently selling for $923. The bonds may be called in 4 years for 112.0% of par. What quoted annual rate of return do you expect to earn if you buy the bonds and company calls them when possible?

d. Audio solution to: Within Year, Inc. has bonds outstanding with a $1,000 par value and a maturity of 17 years. The bonds have an annual coupon rate of 17.0% with semi-annual coupon payments. You would expect a quoted annual return of 14.0% if you purchased these bonds. What are the bonds worth to you?

e. Audio solution to: Yes They May, Inc. has a bond issue outstanding with a $1,000 par value and a maturity of 40 years. The bonds have an annual coupon rate of 15.0% with quarterly coupon payments. The current market price for the bonds is $1,035. The bonds may be called in 4 years for 115.0% of par. What is the quoted annual yield-to-maturity for the bonds?

f. Audio solution to: Yes They Can, Inc. has a bond issue outstanding with a $1,000 par value and a maturity of 20 years. The annual coupon rate is 9.0% with semi-annual coupon payments. The bonds are currently selling for $859. The bonds may be called in 3 years for 109.0% of par. What is the quoted annual yield-to-call for these bonds?

g. Audio solution to: You are considering buying bonds in AZYX, Inc. The bonds have a par value of $1,000 and mature in 13 years. The annual coupon rate is 11.0% and the coupon payments are annual. The bonds are currently selling for$1,442.63 based on a yield-to-maturity of 6.0%. What is the bond's current yield?

h. Audio solution to: You are considering buying bonds in AZYX, Inc. The bonds have a par value of $1,000 and mature in 13 years. The annual coupon rate is 11.0% and the coupon payments are annual. The bonds are currently selling for $1,442.63 based on a yield-to-maturity of 6.0%. What is the bond's expected capital gain/loss if the bonds are held until maturity?

h. Audio solution to: Panther Enterprises has outstanding zero coupon bonds that have a face value of $1000 and mature in exactly 18 years. The market price of the bonds is $179.86. What will be the percentage change in the market price of the bonds if the yield to maturity falls by half?

5. If you find yourself making general errors, rather than bond specific errors, you should watch the video, Hints on Solving Time Value of Money Problems.

6. Be prepared for a 60 minute quiz, with roughly 14 questions. The name of the quiz is Chapter 6.

Need to Absorb - For Chapter 7, everything.  This includes the attributes of common stocks including the rights of shareholders, how to use the Constant Growth Model, how to value non-constant growth stocks, and the attributes and valuation of preferred stock.  Also, from BA 530, you learned the Capital Assets Pricing Model (CAPM).  On exams, this chapter typically has recurring calculations to include a CAPM problem, a constant growth stock valuation problem, a non-constant growth valuation problem.  Have a higher focus on computing returns, rather than price, as we will use this in later chapters.

Need to Read - Read the Chapter.

Need to Do - Make 100 on the quiz.

Calculator links

1. Watch the Chapter 7 Overview video. The Powerpoints for all of this chapter’s videos are located here.

2. Watch the Chapter Lecture. The Powerpoints for this video begin at about slide 4.

3. Read about valuing Constant Growth Stocks on pages 94-110.

4. If you feel the need, watch the Terms and Terminology video (hint, you can probably learn this faster by reading).  Then watch the Chapter Valuing Constant Growth Stocks video.  Powerpoints  for the first video start about slide 8 and the second video at about slide 15.

5. Read from page 110-116 on valuing non-constant growth stock.

6. Watch the Valuing Non-Constant Growth Stocks video.  Powerpoints start about slide 29. 

7. Read the rest of the chapter.  If you feel the need, watch the Methods of Analysis video.  Powerpoints start about slide 35. 

8. Solve the remaining problems listed at the top of the page. You can find the solutions to these problems in our E-book.  If you need additional instruction, here are audio solutions to the most common types of stock valuation problems:

a. Audio solution to: Timeless Corporation issued preferred stock with a par value of $700. The stock promised to pay an annual dividend equal to 19.0% of the par value. If the appropriate discount rate for this stock is 10.0%, what is the value of the stock?

b. Audio solution to: Forever, Inc's preferred stock has a par value of $1,000 and a dividend equal to 13.0% of the par value. The stock is currently selling for $907.00. What discount rate is being used to value the stock?

c. Audio solution to: Here and After Corporation plans a new issue of preferred stock. Similar risk stock currently offers an annual return to investors of 17.0%. The company wants the stock to sell for $569.00 per share. What annual dividend must the company offer?

d. Audio solution to: You are considering buying common stock in Grow On, Inc. The firm yesterday paid a dividend of $5.20. You have projected that dividends will grow at a rate of 8.0% per year indefinitely. If you want an annual return of 20.0%, what is the most you should pay for the stock now?

e. Audio solution to: You are considering buying common stock in Grow On, Inc. You have projected that the next dividend the company will pay will equal $4.00 and that dividends will grow at a rate of 5.0% per year thereafter. If you would want an annual return of 13.0% to invest in this stock, what is the most you should pay for the stock now?

f. Audio solution to: Growing, Inc. is a firm that is experiencing rapid growth. The firm yesterday paid a dividend of $7.50. You believe that dividends will grow at a rate of 24.0% per year for two years, and then at a rate of 5.0% per year thereafter. You expect an annual rate of return of 18.0% on this investment. If you plan to hold the stock indefinitely, what is the most you would pay for the stock now?

g. Audio solution to: Growing, Inc. is a firm that is experiencing rapid growth. The firm yesterday paid a dividend of $5.60. You believe that dividends will grow at a rate of 24.0% per year for three years, and then at a rate of 10.0% per year thereafter. You expect an annual rate of return of 18.0% on this investment. If you plan to hold the stock indefinitely, what is the most you would pay for the stock now?

h. Audio solution to: Growing, Inc. is a firm that is experiencing rapid growth. The firm yesterday paid a dividend of $8.00. You believe that dividends will grow at a rate of 22.0% per year for years one and two, 15.0% per year for years three and four, and then at a rate of 9.0% per year thereafter. If you expect an annual rate of return of 21.0% on this investment, what is the most you would pay for the stock now?

i. Audio solution to: You are considering buying common stock in Grow On, Inc. You have calculated that the firm's free cash flow was $8.10 million last year. You project that free cash flow will grow at a rate of 6.0% per year indefinitely. The firm currently has outstanding debt and preferred stock with a total market value of $9.22 million. The firm has 1.20 million shares of common stock outstanding. If the firm's cost of capital is 25.0%, what is the most you should pay per share for the stock now?

j. Audio solution to: You are considering buying common stock in Super Growth, Inc. You have calculated that the firm's free cash flow was $6.20 million last year. You project that free cash flow will grow at a rate of 20.0% per year for the next three years, and then 6.0% per year indefinitely thereafter. The firm currently has outstanding debt and preferred stock with a total market value of $26.60 million. The firm has 1.68 million shares of common stock outstanding. If the firm's cost of capital is 19.0%, what is the most you should pay per share for the stock now?

k. Video solution to: Kanine Corp recently reported earnings of $1.5 million. The firm plans to retain 30% of its earnings. The historical return  on equity for the firm has been 12%, and this figure is expected to continue in future also. If the firm has 1,000,000 shares outstanding,  calculate the price of each share. Assume the company's beta is 1.2, the risk-free rate is 4% and the market risk premium is 11%. (Hint: The 30% of the company's earnings that are being retained have some implications for the growth of the company)

9. Be prepared for a 60 minute quiz, with roughly 14 questions. The name of the quiz is Chapters 7.

Revised October 18, 2014

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