BADM 7090 IC 2011 - Basic Concepts (The Valuation of Stocks and Bonds)

# BADM 7090 IC 2011 - Basic Concepts (The Valuation of Stocks and Bonds)

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BADM 7090 Financial Management Unit I.C Basic Concepts: The Valuation of Bonds and Stocks Text material: GSM, Ch. 4 D. Chance

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Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 2 of 57 Questions How are bond prices determined? What factors affect their values? How are stock prices determined? What factors affect their values? How do companies grow?
Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 3 of 57 The Concept of Valuation of Corporate Securities Corporations receive the capital from creditors and owners who hold, respectively, bonds (and other debt securities) and stock. It is important, therefore, to understand how these securities obtain their values. In general, the value of any asset is the present value of the cash flows it will pay to its owner.

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Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 4 of 57 Valuing Bonds A bond makes promised payments of coupon and principal. The value of a bond is found as the present value of these payments, using a discount rate that is equivalent to that used on comparable bonds.
Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 5 of 57 Valuing Bonds (cont.) Example Problem I.C.(1) : Consider a four-year government bond with \$1,000 face value and annual coupons of 6%. What is this bond worth if the discount rate on comparable bonds is 6%? Note that this bond makes annual payments of \$60 and returns its face value of \$1,000 in four years.

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Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 6 of 57 Valuing Bonds (cont.) \$60 0 1 2 3 4 \$60 \$60 \$60 + \$1,000 Here are the cash flows paid by the bond: If holders of the bond require a return of 6% on comparable bonds, what is this bond worth?
Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 7 of 57 Valuing Bonds (cont.) 2 3 4 4 \$60 \$60 \$60 \$60 \$1,000 (1.06) (1.06) (1.06) (1.06) (1.06) \$56.60 \$53.40 \$50.38 \$47.53 \$792.09 \$1,000.00 + + + + = + + + + = Summing the present values of each payment individually: Using the annuity shortcut: - - + = + = ÷ 4 4 1 (1.06) \$1,000 \$60 \$207.91 \$792.09 \$1,000 0.06 (1.06)

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Version: 1/3/11 D. Chance – BADM 7090 – Unit IC p. 8 of 57 Valuing Bonds (cont.) The rate r is sometimes called the yield to maturity or just yield . The use of a single rate for discounting all cash flows is not technically correct but is acceptable and can be interpreted as the single discount rate that makes the value of the bond’s cash flows equal the price it is trading at in the market.
1/3/11 D. Chance – BADM 7090 – Unit IC p. 9 of 57 Bond Prices When Yields Change Bond yields change for a variety of reasons. One reason is overall changes in the level of interest rates in the economy. We are interested in what happens to the

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## This note was uploaded on 02/28/2012 for the course BADM 7090 taught by Professor Staff during the Fall '08 term at LSU.

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BADM 7090 IC 2011 - Basic Concepts (The Valuation of Stocks and Bonds)

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