CHAPTER -FOUR

BOND AND STOCK VALUATION AND THE COST OF CAPITAL

4.1 Introduction
As you have seen in the previous accounting courses, the value of an asset is determined
based on its cost (historical cost). That means all the necessary expenditures incurred
from the time the asset is acquired until it is placed in operation will be the cost of the asset.
However, in financial management, the value of an asset is quite different.
Since finance is interested more on decision making rather than recording, the value of an
asset is determined before it is purchased. The purpose is to decide whether to acquire or
not to acquire the asset. Therefore, here the historical cost cannot be used as the value of
the asset. Rather, the value of the asset is determined by valuation.
Valuation is the process of determining the worth of any asset whose value is obtained
from future cash flows. Look, the value here is not historical cost. The value of any asset
in finance is the present value of all future cash flows it is expected to provide over the
relevant time period. This value is called intrinsic value. In the remainder of this unit, we
shall emphasize the intrinsic value of an asset.
The intrinsic value of an asset is determined based on three basic inputs: cash flows
(returns), time pattern of the returns, and the discount rate. The value of an asset is,
therefore, determined by discounting the expected cash flows to their present value. To
determine the present value, we use a discount rate appropriate based on the asset’s risk.
Value can be determined for any kind of asset like buildings, machineries, factories, bonds,
stocks etc. But in this unit, we will discuss the value of three financial assets: bonds,
preferred, and common stocks.
4.2 Bond Valuation
Bond is a long-term debt instrument or security issued by businesses and governmental
units to raise large sums of money. Investment in a bond provides two types of cash flows.
One is the periodic interest payment by the issuing party. Another is the price paid to the
investor upon maturity. The first, i.e., the interest payment is based on the par value of the
bond and the coupon interest rate. The par value is the face value of the bond which will be
paid to the investor upon maturity. Par value is also called maturity value.

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For instance, if the par value of a bond is Br. 1,000, the issuer should pay the investor
Br.1,000 when the maturity date of the bond arrives. The coupon interest rate is the rate
which the issuer pays to the investor on the par value of the bond. If A Company invests in
a Br. 1,000 par value, 10-year, 8% coupon bonds of B Company, A shall receive Br.
80 (Br. 1,000 x 8%) per year for 10 years.
4.2.1 Basic Bond Valuation Model
The value of a bond is the present value of the periodic interest payments plus the present
value of the par value. The value of a bond can be computed using the following equitation:
Bo = I (PVIFA kd,n) + M(PVIF kd,n)
where: Bo = the value of the bond
I = interest paid each period = Par Value x Coupon interest rate
Kd = the appropriate interest rate on the bond
n = The number of periods before the bond matures
M = the par value of the bond
(PVIF kd,n) = The present value interest factor for an annuity at interest rate of kd per
period for n periods.

(PVIFkd,n) = The present value interest factor at interest rate of kd per period for n periods.

Notice that we have used kd instead of i. This is because, generally, in financial

management k designates rate of return and the subscript d denotes debt security. So kd
designates the rate of return on a debt security.

Illustration: Tebaber Berta Corporation has a Br. 1,000 par value bond with an 8%
coupon interest rate outstanding. Interest is paid semiannually and the bond has 12 years
remaining to its maturity date.
Required: What is the value of the bond if the required return on the bond is 8%?
Solution:

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Given: M = Br. 1,000; kd = 8% per year or 4% (8%/2) per semiannual period; I = Br. 40
(Br. 1,000 x 4%); n = 24 semiannual periods (12 x 2); Bo =?
Bo = I (PVIFA kd, n) + M (PVIF kd, n)
= Br. 40(PVIFA4%, 24) + Br. 1,000(PVIF4%, 24)
= Br. 40 (15.2470) + Br. 1,000 (0.3901)
= Br. 1,000
If the appropriate discount rate (kd) remains constant at 8% (4% per semiannual period),
the value of the bond will not be changed. It will remain Br. 1,000. Suppose the appropriate
discount rate is 8% 2 years from now, what would be the value of the bond?
Solution: now n is reduced to 20[24-(2 x 2)]
Bo = Br.40 (PVIFA4%, 20) + Br. 1,000 (PVIF4%, 20)
= Br. 40 (13.5903) + Br. 1,000 (0.4564)
= Br. 1,000
Suppose the interest rate in the economy when Tebaber Berta’s bonds were issued was 6%
rather than 8%, what would be the value of the bond? Since Tebaber Berta’s bond now will
be paying more interest than do other bonds in the market, the company’s bond will be
selling at a larger price. Such bonds which are selling more than their par value are called
premium bonds. Here, kd is 6% (3% per semiannual payment), but other things
are not changed. So
Bo = Br. 40 (PVIFA3%, 24) + Br. 1,000 (PVIF 3%, 24)
= Br. 40 (16.9355) + Br. 1,000 (0.4919)
= Br. 1,169.32
So, when the market interest rate (kd) is less than the coupon interest rate, the value of a
bond is always larger than the par value. An investor by deciding to invest his money on
Tebaber Berta’s bond, he will receive a 1% (4% - 3%) more interest payment than he
would receive if he invested somewhere else. This allows the investor to receive Br. 10
[Br. 1,000 x (4% - 3%)] more every semiannual period.
4.3 Preferred Stock Valuation
Preferred stock is a type of equity security that provides its owners with limited or fixed
claims on a corporation’s income and assets. Investment in a preferred stock provides a
single cash flow, i.e., constant periodic dividend payments. Preferred stock has similarities

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to both a bond and a common stock. As to similarities to a bond, preferred dividends are
fixed in amount and are like interest payments. As to a common stock, the preferred
dividends are paid for an indefinite time period.
4.3.1 Preferred Stock Valuation Model
The value of a preferred stock is the present value of all future preferred dividends it is
expected to provide over an infinite time horizon. Most preferred stocks entitle their owners
to regular and fixed dividend payments. If the payments last forever, the issue is a
perpetuity. Therefore, the value of a preferred stock is found by the following formula:

Where:
Vps = Value of the preferred stock
Dps = Preferred stock dividends
Kps = The required rate of return on the preferred stock
Example: Abebe wishes to estimate the value of its outstanding preferred stock. The
preferred issue has a Br. 80 par value and pays an annual dividend of Br. 6.40 per share.
Similar-risk preferred stocks are currently earning a 9.3% annual rate of return. What is
the value of the outstanding preferred stock?

So, the Br. 6.40 annual dividend an investor receives for an infinite year is equal to today’s
Br. 68.82 if the required rate of return is 9.3%.
4.3.2 Rate of Return on a Preferred Stock
To evaluate the worthiness of investment in a preferred stock in comparison to other
investment opportunities, we should be able to compute the rate of return on a preferred
stock. If we know the current price of a preferred stock and its dividend, we can compute
the expected rate of return on the preferred stock. This can be done using the following
Formula

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Example: A preferred stock pays an annual dividend of Br. 9 and the current market
price is Br. 81. Compute the required rate of return from the preferred stock.

For an investor to invest Br.

81 in this preferred stock and to receive an annual dividend of Br. 9, his minimum
required rate of return is 11.11%.
4.4 Common Stock Valuation
The value of a share of common stock is the present value of the common stock’s dividend
expected over an infinite time horizon. The value of a share of common stock is also equal
to the sum of the present value of the expected dividends and the present value of the
expected selling price of the stock. The selling price in turn will depend on the dividends to
be received by the purchasing party.
To understand the value of a common stock we should keep in mind two points. First, the
dividends are expected for an infinite time period. Second, the dividends are not constant.
Therefore, the value of a common stock is found by summing the present values of
annual dividends.

Where:
Po = Value of the common stock at time zero (as of today)
D1, D2, …, D∞ = Per share dividend expected at the end of each year
Ks = the required rate of return on the common stock.
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The common stock valuation equation can be simplified by redefining each year’s
dividend. The dividends are defined in terms of anticipated dividends growth. Generally,
there are three cases accordingly. These are:
1. Zero growth common stock,
2. Constant growth common stock, and
3. Variable growth common stock.
Hence, common stock valuation approaches are developed under each of the above
dividend growth models. Next sections will discuss each model one by one
4.4.1 Zero Growth Stock
A zero-growth stock is a common stock whose future dividends are not expected to grow at
all. The expected growth rate (g) is zero. This is the simplest model to common stock
valuation. It assumes a constant, non-growing annual dividend. So here the annual
dividends are all equal. That is D1 = D2 = … = D∞ = D0
A common stock with zero growth rate is a security that is expected to provide a fixed
dividend each year. Hence, a zero-growth common stock is a perpetuity. Therefore, the
value of a zero-growth stock is given as:

Example: The most recent common stock dividend of Shalom Manufacturing

Corporation was Br. 3.60 per share. Due to the firm’s maturity as well as stable sales and
earnings, the dividends are expected to remain at the current level of the foreseeable future.
Required: Determine the value of Shalom’s common stock for an investor whose
required return is 12%.

The maximum price the investor would be willing to pay for a share of Shalom’s common
stock is Br. 30 for he to receive a Br. 3.60 annual dividend for an indefinite year.

4.4.2 Constant Growth Stock

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Constant growth stock is a common stock whose future dividends are expected to grow at a
constant dividend growth rate (g). It is sometimes called normal growth stock. The constant
(normal) growth common stock valuation model is the most widely cited approach to
common stock valuation.
The value of a constant growth stock is the present value of the expected future dividends
growing at a constant rate of g. Here the value can be found by using the following
formula:

Where:
D1 = The expected dividend at the end of year 1.
g = The expected growth rate in dividends.
D1 = Do(1+g), where Do is the most recent dividend. Similarly, D2 = D1 (1+g) and so on.
To find the value of a common stock (constant growth) at one year, first, find the expected
dividend at the end of next year.
Example: Zeila Motor Corporation’s common stock currently pays an annual dividend of
Br. 5.40 per share. The dividends are expected to grow at a constant annual rate of 5% to
infinity. Estimate the value of Zeila’s common stock if the required return is 12%.
Solution:

For an investor to receive an annual dividend of Br. 5.40 growing at 5% constantly to

infinity, the maximum price he would pay today is Br. 81.

If we are given the value of a constant growth stock, the most recent dividend, the
expected dividend growth rate, we can compute the expected rate of return as follows.

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Example: Assume the above example except that you are given the value of common
stock of Br. 81 instead of the required return. Compute the expected rate of return?

4.4.3 Variable Growth Stock

Variable growth stock is a stock whose dividends are expected to grow at variable or
non-constant rates. The model of common stock valuation that allows for a change in the
dividend growth rate is called Variable (non constant) Growth Model. It sometimes is
also called supernormal growth model.
The value of a share of variable growth stock is determined by following 4 procedures.
1. Find the value of the dividends at the end of each year during the initial growth period.
2. Find the present values of the dividends found in step 1.
3. Find the value of the stock at the end of the initial growth period.
4. Add the present value of the dividends found in step 2 and the present value of the
value of the stock found in step 3 to determine the value of the stock at time zero, i.e.
po.
Example: Addis Company’s most recent annual dividend, which was paid yesterday,
was Br. 1.75 per share. The dividends are expected to experience a 15% annual growth rate
for the next 3 years. By the end of 3 years growth rate will slow to 5% per year to infinity.
Stockholders require a return of 12% on Addis’ stock.

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