Bonds, equities and interest rates
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Bonds, equities and interest rates

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Bonds, equities and interest rates

Bonds, equities and interest rates

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Bonds, equities and interest rates Bonds, equities and interest rates Presentation Transcript

  • Finance Lecture:Bonds, Equities and Interest Rates Brad Simon
  • Lecture Overview  Bonds  Definitions  Issuers and holders  Example  Valuation  Interest Rates  Conclusions (bonds and interest rates)  Equities  Definition  Stock Markets  Valuation  Conclusion2
  • Bonds – Definition3 View slide
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)4 View slide
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:5
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:  A principal amount to be repaid on a specific date in the future6
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:  A principal amount to be repaid on a specific date in the future  The principal amount is also known as the face value or par value7
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:  A principal amount to be repaid on a specific date in the future  The principal amount is also known as the face value or par value  The payment date is known as the maturity date8
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:  A principal amount to be repaid on a specific date in the future  The principal amount is also known as the face value or par value  The payment date is known as the maturity date  Many bonds have regular coupon payments which are paid-out annually, semi-annually or quarterly.9
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:  A principal amount to be repaid on a specific date in the future  The principal amount is also known as the face value or par value  The payment date is known as the maturity date  Many bonds have regular coupon payments which are paid-out annually, semi-annually or quarterly.  The coupon rate is the interest rate used to calculate the coupon payment and is a percentage of the principal amount10
  • Bonds – Definition  A bond is a type of security instrument used to raise capital by an issuing party (an issuer)  A bond typically has the following characteristics:  A principal amount to be repaid on a specific date in the future  The principal amount is also known as the face value or par value  The payment date is known as the maturity date  Many bonds have regular coupon payments which are paid-out annually, semi-annually or quarterly.  The coupon rate is the interest rate used to calculate the coupon amount and is a percentage of the principal amount  Coupon Payment = Coupon Rate x Principal11
  • Bonds – Definition12
  • Bonds – Definition  A bond is a legal debt obligation. Failure to make payments as required can result in legal recourse by the holders of the bonds.13
  • Bonds – Definition  A bond is a legal debt obligation. Failure to make payments as required can result in legal recourse by the holders of the bonds.  A bond may be callable by the issuer14
  • Bonds – Definition  A bond is a legal debt obligation. Failure to make payments as required can result in legal recourse by the holders of the bonds.  A bond may be callable by the issuer  After some specified amount of time or some specified event, the issuer can purchase the bonds back from the market.15
  • Bonds – Definition  A bond is a legal debt obligation. Failure to make payments as required can result in legal recourse by the holders of the bonds.  A bond may be callable by the issuer  After some specified amount of time or some specified event, the issuer can purchase the bonds back from the market.  Typically the issuer will have to pay some type of penalty for this early re-call.16
  • Bonds – Definition  A bond is a legal debt obligation. Failure to make payments as required can result in legal recourse by the holders of the bonds.  A bond may be callable by the issuer  After some specified amount of time or some specified event, the issuer can purchase the bonds back from the market.  Typically the issuer will have to pay some type of penalty for this early re-call.  Other features can also exist.17
  • Bonds – Definition18
  • Bonds – Definition  Issuing Party or Issuer – the party who has made the payment promises19
  • Bonds – Definition  Issuing Party or Issuer – the party who has made the payment promises  The issuance of bonds is known as a bond offering20
  • Bonds – Definition  Issuing Party or Issuer – the party who has made the payment promises  The issuance of bonds is known as a bond offering  Holding Party or Holder – the party who currently has possession of the bond21
  • Bonds – Definition  Issuing Party or Issuer – the party who has made the payment promises  The issuance of bonds is known as a bond offering  Holding Party or Holder – the party who currently has possession of the bond  The holding party receives the payments from the issuer22
  • Bonds – Definition  Issuing Party or Issuer – the party who has made the payment promises  The issuance of bonds is known as a bond offering  Holding Party or Holder – the party who currently has possession of the bond  The holding party receives the payments from the issuer  Often, the holding party can freely sell the bond to a third-party and all rights will transfer23
  • Bonds – Definition  Issuing Party or Issuer – the party who has made the payment promises  The issuance of bonds is known as a bond offering  Holding Party or Holder – the party who currently has possession of the bond  The holding party receives the payments from the issuer  Often, the holding party can freely sell the bond to a third-party and all rights will transfer  Effectively, a bond is a loan.24
  • Bonds – Definition Recap25
  • Bonds – Definition Recap  Principal or Face Value26
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date27
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date  Coupon Rate, Coupon Payment28
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date  Coupon Rate, Coupon Payment  Legal debt obligation29
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date  Coupon Rate, Coupon Payment  Legal debt obligation  Callable30
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date  Coupon Rate, Coupon Payment  Legal debt obligation  Callable  Issuing Party or Issuer31
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date  Coupon Rate, Coupon Payment  Legal debt obligation  Callable  Issuing Party or Issuer  Bond offering32
  • Bonds – Definition Recap  Principal or Face Value  Maturity Date  Coupon Rate, Coupon Payment  Legal debt obligation  Callable  Issuing Party or Issuer  Bond offering  Holding Party or Holder33
  • Bonds – Issuers34
  • Bonds – Issuers  Bonds are issued by various types of parties:35
  • Bonds – Issuers  Bonds are issued by various types of parties:  Federal governments36
  • Bonds – Issuers  Bonds are issued by various types of parties:  Federal governments  State and municipal governments37
  • Bonds – Issuers  Bonds are issued by various types of parties:  Federal governments  State and municipal governments  Corporations38
  • Bonds – Issuers  Bonds are issued by various types of parties:  Federal governments  State and municipal governments  Corporations  Money Markets39
  • Bonds – Issuers  Bonds are issued by various types of parties:  Federal governments  State and municipal governments  Corporations  Money Markets  Mortgage-backed and Asset-backed securities40
  • Bonds – Bondholders41
  • Bonds – Bondholders  Bonds are held by various types of parties:42
  • Bonds – Bondholders  Bonds are held by various types of parties:  Pension funds43
  • Bonds – Bondholders  Bonds are held by various types of parties:  Pension funds  Insurance companies44
  • Bonds – Bondholders  Bonds are held by various types of parties:  Pension funds  Insurance companies  University endowments45
  • Bonds – Bondholders  Bonds are held by various types of parties:  Pension funds  Insurance companies  University endowments  Bond funds46
  • Bonds – Bondholders  Bonds are held by various types of parties:  Pension funds  Insurance companies  University endowments  Bond funds  Individuals47
  • Bonds – Magnitude48
  • Bonds – Magnitude  The bond market is enormous49
  • Bonds – Magnitude  The bond market is enormous  As of 2009, the face value of total bonds outstanding globally was $82 trillion. Sources: Asset Allocation Advisor and World Economic Outlook Database50
  • Bonds – Magnitude  The bond market is enormous  As of 2009, the face value of total bonds outstanding globally was $82 trillion.  By comparison  The total value of all global equities (stocks) was $44 trillion. Sources: Asset Allocation Advisor and World Economic Outlook Database51
  • Bonds – Magnitude  The bond market is enormous  As of 2009, the face value of total bonds outstanding globally was $82 trillion.  By comparison  The total value of all global equities (stocks) was $44 trillion.  Total global GDP in 2010 was roughly $62 trillion. Sources: Asset Allocation Advisor and World Economic Outlook Database52
  • Bonds – Magnitude  The bond market is enormous  As of 2009, the face value of total bonds outstanding globally was $82 trillion.  By comparison  The total value of all global equities (stocks) was $44 trillion.  Total global GDP in 2010 was roughly $62 trillion. o US GDP was $14.5 trillion or nearly 25% of total GDP Sources: Asset Allocation Advisor and World Economic Outlook Database53
  • Bonds – Magnitude54
  • Bonds – Magnitude Sources: Asset Allocation Advisor and World Economic Outlook Database55
  • Bonds – An Example56
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds57
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:58
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,00059
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,000  Maturity Date is 5 years from issuance60
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,000  Maturity Date is 5 years from issuance  Coupon Rate is 5%61
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,000  Maturity Date is 5 years from issuance  Coupon Rate is 5%  Coupon Payments are made annually at end of year62
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,000  Maturity Date is 5 years from issuance  Coupon Rate is 5%  Coupon Payments are made annually at end of year  Coupon Payment is:63
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,000  Maturity Date is 5 years from issuance  Coupon Rate is 5%  Coupon Payments are made annually at end of year  Coupon Payment is:  Principal x Coupon Rate64
  • Bonds – An Example  A company wants to raise money for a new project and decides to do so by issuing bonds  The characteristics of the bonds are as follows:  Principal is $1,000  Maturity Date is 5 years from issuance  Coupon Rate is 5%  Coupon Payments are made annually at end of year  Coupon Payment is:  Principal x Coupon Rate  $1,000 x 5% = $5065
  • Bonds – An Example66
  • Bonds – An Example  Note, we are discussing the characteristics at an individual bond level. The company has likely issued a number of these bonds in the offering.67
  • Bonds – An Example  Note, we are discussing the characteristics at an individual bond level. The company has likely issued a number of these bonds in the offering.  For example, the company may be issuing $1 million of face value bonds of this characteristic.68
  • Bonds – An Example  Note, we are discussing the characteristics at an individual bond level. The company has likely issued a number of these bonds in the offering.  For example, the company may be issuing $1 million of face value bonds of this characteristic.  This means the company is issuing 1,000 bonds, each with a face value of $1,000.69
  • Bonds – An Example70
  • Bonds – An Example  When issued, some bonds simply sell for their face value.71
  • Bonds – An Example  When issued, some bonds simply sell for their face value.  In this case, the company would convey the bond to the buyer in exchange for receiving $1,000.72
  • Bonds – An Example  When issued, some bonds simply sell for their face value.  In this case, the company would convey the bond to the buyer in exchange for receiving $1,000.  Assuming the buyer holds the bond to maturity he would receive 5 annual payments of $50 and a final payment of $1,000 after 5 years.73
  • Bonds – An Example  When issued, some bonds simply sell for their face value.  In this case, the company would convey the bond to the buyer in exchange for receiving $1,000.  Assuming the buyer holds the bond to maturity he would receive 5 annual payments of $50 and a final payment of $1,000 after 5 years.  In other words, the buyer receives annual interest payments and finally the return of his principal.74
  • Bonds – Valuation75
  • Bonds – Valuation  In the previous slide I said that some bonds are issued at a price equal to their face value.76
  • Bonds – Valuation  In the previous slide I said that some bonds are issued at a price equal to their face value.  Many bonds, however, are issued at a price higher or lower than their face value.77
  • Bonds – Valuation  In the previous slide I said that some bonds are issued at a price equal to their face value.  Many bonds, however, are issued at a price higher or lower than their face value.  Ultimately, the market (i.e. supply and demand) determines a bond’s price. Sometimes it is willing to pay more than face value, other times less.78
  • Bonds – Valuation  In the previous slide I said that some bonds are issued at a price equal to their face value.  Many bonds, however, are issued at a price higher or lower than their face value.  Ultimately, the market (i.e. supply and demand) determines a bond’s price. Sometimes it is willing to pay more than face value, other times less.  We can make sense of this by applying the Time- Value-of-Money concept:79
  • Bonds – Valuation  In the previous slide I said that some bonds are issued at a price equal to their face value.  Many bonds, however, are issued at a price higher or lower than their face value.  Ultimately, the market (i.e. supply and demand) determines a bond’s price. Sometimes it is willing to pay more than face value, other times less.  We can make sense of this by applying the Time- Value-of-Money concept:  The issuing party specifies how much and when they will make payments.80
  • Bonds – Valuation  In the previous slide I said that some bonds are issued at a price equal to their face value.  Many bonds, however, are issued at a price higher or lower than their face value.  Ultimately, the market (i.e. supply and demand) determines a bond’s price. Sometimes it is willing to pay more than face value, other times less.  We can make sense of this by applying the Time- Value-of-Money concept:  The issuing party specifies how much and when they will make payments.  The market then applies an interest rate to discount the specified payments to the present81
  • Bonds – Valuation82
  • Bonds – Valuation  Let’s look at our prior example:83
  • Bonds – Valuation  Let’s look at our prior example:  Face Value of $1,000, payment to be made in 5 years84
  • Bonds – Valuation  Let’s look at our prior example:  Face Value of $1,000, payment to be made in 5 years  Coupon rate of 5%85
  • Bonds – Valuation  Let’s look at our prior example:  Face Value of $1,000, payment to be made in 5 years  Coupon rate of 5%  Annual coupon payments of $50 for five years86
  • Bonds – Valuation  Let’s look at our prior example:  Face Value of $1,000, payment to be made in 5 years  Coupon rate of 5%  Annual coupon payments of $50 for five years Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,05087
  • Bonds – Valuation88
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,05089
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5%90
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5%91
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5% Year Payment PVIF PV 0 $ - 1 $ 50 0.952 $ 48 2 $ 50 0.907 $ 45 3 $ 50 0.864 $ 43 4 $ 50 0.823 $ 41 5 $ 1,050 0.784 $ 823 Present Value: $ 1,00092
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5% Year Payment PVIF PV 0 $ - 1 $ 50 0.952 $ 48 2 $ 50 0.907 $ 45 3 $ 50 0.864 $ 43 4 $ 50 0.823 $ 41 5 $ 1,050 0.784 $ 823 Present Value: $ 1,00093
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5% Year Payment PVIF PV 0 $ - 1 $ 50 0.952 $ 48 2 $ 50 0.907 $ 45 3 $ 50 0.864 $ 43 4 $ 50 0.823 $ 41 5 $ 1,050 0.784 $ 823 Present Value: $ 1,00094
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5% Year Payment PVIF PV 0 $ - 1 $ 50 0.952 $ 48 2 $ 50 0.907 $ 45 3 $ 50 0.864 $ 43 4 $ 50 0.823 $ 41 5 $ 1,050 0.784 $ 823 Present Value: $ 1,00095
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 5% Year Payment PVIF PV 0 $ - 1 $ 50 0.952 $ 48 2 $ 50 0.907 $ 45 3 $ 50 0.864 $ 43 4 $ 50 0.823 $ 41 5 $ 1,050 0.784 $ 823 Present Value: $ 1,00096
  • Bonds – Valuation97
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $1,000 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 5%.98
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $1,000 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 5%.  When the bond valuation (i.e. the price) is equal to the face value we say the bond is “selling at par value.”99
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $1,000 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 5%.  When the bond valuation (i.e. the price) is equal to the face value we say the bond is “selling at par value.”  Now, what happens if the market applies an interest rate of 7%? How much would the previous bonds be valued at?100
  • Bonds – Valuation101
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050102
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 7%103
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 7%104
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Year Payment PVIF PV i = 7% 0 $ - 1 $ 50 0.935 $ 47 2 $ 50 0.873 $ 44 3 $ 50 0.816 $ 41 4 $ 50 0.763 $ 38 5 $ 1,050 0.713 $ 749 Present Value: $ 918105
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Year Payment PVIF PV i = 7% 0 $ - 1 $ 50 0.935 $ 47 2 $ 50 0.873 $ 44 3 $ 50 0.816 $ 41 4 $ 50 0.763 $ 38 5 $ 1,050 0.713 $ 749 Present Value: $ 918106
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Year Payment PVIF PV i = 7% 0 $ - 1 $ 50 0.935 $ 47 2 $ 50 0.873 $ 44 3 $ 50 0.816 $ 41 4 $ 50 0.763 $ 38 5 $ 1,050 0.713 $ 749 Present Value: $ 918107
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Year Payment PVIF PV i = 7% 0 $ - 1 $ 50 0.935 $ 47 2 $ 50 0.873 $ 44 3 $ 50 0.816 $ 41 4 $ 50 0.763 $ 38 5 $ 1,050 0.713 $ 749 Present Value: $ 918108
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Year Payment PVIF PV i = 7% 0 $ - 1 $ 50 0.935 $ 47 2 $ 50 0.873 $ 44 3 $ 50 0.816 $ 41 4 $ 50 0.763 $ 38 5 $ 1,050 0.713 $ 749 Present Value: $ 918109
  • Bonds – Valuation110
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $$918 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 7%.111
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $$918 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 7%.  When the bond valuation is below the face value we say the bond is “selling at discount to par value.”112
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $$918 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 7%.  When the bond valuation is below the face value we say the bond is “selling at discount to par value.”  Now, what happens if the market decides the interest rate should be 3%? How much would the previous bonds be valued at?113
  • Bonds – Valuation114
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050115
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 3%116
  • Bonds – Valuation Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 i = 3% Year Payment PVIF PV 0 $ - 1 $ 50 0.971 $ 49 2 $ 50 0.943 $ 47 3 $ 50 0.915 $ 46 4 $ 50 0.888 $ 44 5 $ 1,050 0.863 $ 906 Present Value: $ 1,092117
  • Bonds – Valuation118
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $$1,092 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 3%.119
  • Bonds – Valuation  Based on the TVM, we would be willing to pay $$1,092 to receive five annual payments of $50 and a final payment of $1,000 after five years, assuming an interest rate of 3%.  When the bond valuation is below the face value we say the bond is “selling at premium to par value.”120
  • Bonds – Valuation Summary121
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050122
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5%123
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000124
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000 i = 3%125
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000 i = 3% Bond price today is $1,092126
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000 i = 3% i = 5% Bond price today is $1,092127
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000 i = 3% i = 5% Bond price Bond price today is today is $1,092 $1,000128
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000 i = 3% i = 5% i = 7% Bond price Bond price today is today is $1,092 $1,000129
  • Bonds – Valuation Summary Y 0 ear Y 1 ear Y 2 ear Y 3 ear Y 4 ear Y 5 ear ? $50 $50 $50 $50 $1,050 Coupon Rate = 5% Face Value = $1,000 i = 3% i = 5% i = 7% Bond price Bond price Bond price today is today is today is $918 $1,092 $1,000130
  • Bonds – Valuation Conclusions131
  • Bonds – Valuation Conclusions  We use the TVM to value a bond’s price today132
  • Bonds – Valuation Conclusions  We use the TVM to value a bond’s price today  The time-frame, coupon payments and the final principal payment are specified by the bond issuer. These represents a future cash flow.133
  • Bonds – Valuation Conclusions  We use the TVM to value a bond’s price today  The time-frame, coupon payments and the final principal payment are specified by the bond issuer. These represents a future cash flow.  The numerator of the TVM134
  • Bonds – Valuation Conclusions  We use the TVM to value a bond’s price today  The time-frame, coupon payments and the final principal payment are specified by the bond issuer. These represents a future cash flow.  The numerator of the TVM  The market will then apply an interest rate to the above cash flow to calculate their present value (the bond’s price today)135
  • Bonds – Valuation Observations136
  • Bonds – Valuation Observations  Valuing a bond is the same as calculating the present value of an annuity + and the PV of a single payment137
  • Bonds – Valuation Observations  Valuing a bond is the same as calculating the present value of an annuity + and the PV of a single payment  5 annual payments of $50 at a given interest rate138
  • Bonds – Valuation Observations  Valuing a bond is the same as calculating the present value of an annuity + and the PV of a single payment  5 annual payments of $50 at a given interest rate  A payment of $1,000 in 5 years at a given interest rate139
  • Bonds – Valuation Observations  Valuing a bond is the same as calculating the present value of an annuity + and the PV of a single payment  5 annual payments of $50 at a given interest rate  A payment of $1,000 in 5 years at a given interest rate  PV(Bond) = PVA(Coupon Payments) + PV(Face Value)140
  • Interest Rates141
  • Interest Rates  I keep using the term, “interest rate” and it appears to mean different things depending on the use.142
  • Interest Rates  I keep using the term, “interest rate” and it appears to mean different things depending on the use.  Unfortunately, there are many terms for the same concept143
  • Interest Rates  I keep using the term, “interest rate” and it appears to mean different things depending on the use.  Unfortunately, there are many terms for the same concept  And there are many concepts that use the same name144
  • Interest Rates  I keep using the term, “interest rate” and it appears to mean different things depending on the use.  Unfortunately, there are many terms for the same concept  And there are many concepts that use the same name  Back in our bond calculations, the market interest rate which was the denominator of our TVM analysis is also known as the “yield to maturity” (YTM) or simply “yield”.145
  • Interest Rates  I keep using the term, “interest rate” and it appears to mean different things depending on the use.  Unfortunately, there are many terms for the same concept  And there are many concepts that use the same name  Back in our bond calculations, the market interest rate which was the denominator of our TVM analysis is also known as the “yield to maturity” (YTM) or simply “yield”.146  People will also use the term “discount rate” or
  • Interest Rates147
  • Interest Rates  To make it even more confusing, there are many different interest rates in an economy148
  • Interest Rates  To make it even more confusing, there are many different interest rates in an economy  The interest rate the government is charged to borrow money is lower than the interest rate I am charged on my credit card149
  • Interest Rates  To make it even more confusing, there are many different interest rates in an economy  The interest rate the government is charged to borrow money is lower than the interest rate I am charged on my credit card  Companies with good investment opportunities and lots of cash have lower interest rates for their corporate debt than companies few growth opportunities and no cash.150
  • Interest Rates  To make it even more confusing, there are many different interest rates in an economy  The interest rate the government is charged to borrow money is lower than the interest rate I am charged on my credit card  Companies with good investment opportunities and lots of cash have lower interest rates for their corporate debt than companies few growth opportunities and no cash.  Interest rates for the exact same security will change over time151
  • Interest Rates  To make it even more confusing, there are many different interest rates in an economy  The interest rate the government is charged to borrow money is lower than the interest rate I am charged on my credit card  Companies with good investment opportunities and lots of cash have lower interest rates for their corporate debt than companies few growth opportunities and no cash.  Interest rates for the exact same security will change over time  Interest rates of identical securities except their152 times to maturity will have different interest rates
  • Interest Rates153
  • Interest Rates  But in all these cases, the interest rate will increase when a given risk increases and decrease when a given risk decreases.154
  • Interest Rates  But in all these cases, the interest rate will increase when a given risk increases and decrease when a given risk decreases.  The logic is simple:155
  • Interest Rates  But in all these cases, the interest rate will increase when a given risk increases and decrease when a given risk decreases.  The logic is simple:  In the face of multiple investment or lending opportunities, if we are not compensated for additional risk we will always put our money in the least risky opportunity.156
  • Interest Rates  But in all these cases, the interest rate will increase when a given risk increases and decrease when a given risk decreases.  The logic is simple:  In the face of multiple investment or lending opportunities, if we are not compensated for additional risk we will always put our money in the least risky opportunity.  We need to be induced to invest or lend to the riskier situation by the promise of higher returns.157
  • Interest Rates158
  • Interest Rates  The interest rate is a function of a number of factors:159
  • Interest Rates  The interest rate is a function of a number of factors:  The prevailing market interest rates (including the “real” interest rate)160
  • Interest Rates  The interest rate is a function of a number of factors:  The prevailing market interest rates (including the “real” interest rate)  Inflation risks161
  • Interest Rates  The interest rate is a function of a number of factors:  The prevailing market interest rates (including the “real” interest rate)  Inflation risks  Repayment or default risks expectations162
  • Interest Rates  The interest rate is a function of a number of factors:  The prevailing market interest rates (including the “real” interest rate)  Inflation risks  Repayment or default risks expectations  Liquidity risk163
  • Interest Rates  The interest rate is a function of a number of factors:  The prevailing market interest rates (including the “real” interest rate)  Inflation risks  Repayment or default risks expectations  Liquidity risk  Other risk factors164
  • Interest Rates165
  • Interest Rates  Back in our example of the 5 year bond we calculated the price using three different interest rates, 3%, 5% and 7%.166
  • Interest Rates  Back in our example of the 5 year bond we calculated the price using three different interest rates, 3%, 5% and 7%.  We can interpret the difference in interest rates as different risk assessments related to the bond’s cash flows.167
  • Interest Rates  Back in our example of the 5 year bond we calculated the price using three different interest rates, 3%, 5% and 7%.  We can interpret the difference in interest rates as different risk assessments related to the bond’s cash flows.  For example, we might apply a higher rate of 7% if we are concerned the company might not actually make the payments (default risk).168
  • Interest Rates  Back in our example of the 5 year bond we calculated the price using three different interest rates, 3%, 5% and 7%.  We can interpret the difference in interest rates as different risk assessments related to the bond’s cash flows.  For example, we might apply a higher rate of 7% if we are concerned the company might not actually make the payments (default risk).  Or maybe we are concerned that inflation will increase and so we need extra compensation.169
  • Conclusions170
  • Conclusions  The lower the interest rate, the higher a bond’s (or any security’s) price today.171
  • Conclusions  The lower the interest rate, the higher a bond’s (or any security’s) price today.  Conversely, the higher the interest rate, the lower the bond’s price today.172
  • Conclusions  The lower the interest rate, the higher a bond’s (or any security’s) price today.  Conversely, the higher the interest rate, the lower the bond’s price today.  Higher interest rates have built-in “additional compensation” compared to lower interest rates.173
  • Conclusions  The lower the interest rate, the higher a bond’s (or any security’s) price today.  Conversely, the higher the interest rate, the lower the bond’s price today.  Higher interest rates have built-in “additional compensation” compared to lower interest rates.  The additional compensation will relate to some type of additional perceived risk related to the underlying cash flow.174
  • Equities175
  • Equities  Equity securities (stocks) represent ownership in a corporation176
  • Equities  Equity securities (stocks) represent ownership in a corporation  Common stockholders are residual claimants177
  • Equities  Equity securities (stocks) represent ownership in a corporation  Common stockholders are residual claimants  They have a claim on cash flows only after all other claimants (employees, suppliers, debtholders, the government) have been paid178
  • Equities  Equity securities (stocks) represent ownership in a corporation  Common stockholders are residual claimants  They have a claim on cash flows only after all other claimants (employees, suppliers, debtholders, the government) have been paid  At any point in time the market value of a firm’s common stock depends on many factors including:179
  • Equities  Equity securities (stocks) represent ownership in a corporation  Common stockholders are residual claimants  They have a claim on cash flows only after all other claimants (employees, suppliers, debtholders, the government) have been paid  At any point in time the market value of a firm’s common stock depends on many factors including:  The company’s profitability (cash flows)180
  • Equities  Equity securities (stocks) represent ownership in a corporation  Common stockholders are residual claimants  They have a claim on cash flows only after all other claimants (employees, suppliers, debtholders, the government) have been paid  At any point in time the market value of a firm’s common stock depends on many factors including:  The company’s profitability (cash flows)  The company’s growth potential181
  • Equities  Equity securities (stocks) represent ownership in a corporation  Common stockholders are residual claimants  They have a claim on cash flows only after all other claimants (employees, suppliers, debtholders, the government) have been paid  At any point in time the market value of a firm’s common stock depends on many factors including:  The company’s profitability (cash flows)  The company’s growth potential  Current market interest rates182
  • Stock Markets183
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.184
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.  This liquidity allows buyers and sellers the means to transact with each other and gives people the confidence to buy shares in the first place.185
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.  This liquidity allows buyers and sellers the means to transact with each other and gives people the confidence to buy shares in the first place.  New York Stock Exchange (NYSE)186
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.  This liquidity allows buyers and sellers the means to transact with each other and gives people the confidence to buy shares in the first place.  New York Stock Exchange (NYSE)  NASDAQ187
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.  This liquidity allows buyers and sellers the means to transact with each other and gives people the confidence to buy shares in the first place.  New York Stock Exchange (NYSE)  NASDAQ  London Stock Exchange188
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.  This liquidity allows buyers and sellers the means to transact with each other and gives people the confidence to buy shares in the first place.  New York Stock Exchange (NYSE)  NASDAQ  London Stock Exchange  Private trading floors (the major banks).189
  • Stock Markets  Stock exchanges provide liquidity: the ability for owners of common stock to convert their shares into cash at any time.  This liquidity allows buyers and sellers the means to transact with each other and gives people the confidence to buy shares in the first place.  New York Stock Exchange (NYSE)  NASDAQ  London Stock Exchange  Private trading floors (the major banks).  Largest private trading floor in the world is at UBS (a Swiss Bank), located in Stamford, CT.190
  • Stock Markets  UBS Trading floor – Stamford, CT191
  • Stock Markets  UBS Trading floor – Stamford, CT Your Instructor192
  • Stock Valuation193
  • Stock Valuation  We would like to use our TVM tool to value stocks.194
  • Stock Valuation  We would like to use our TVM tool to value stocks.  For example, when valuing bonds we discounted the promised future payments of the bond by an appropriate interest rate (discount rate) to arise at the present value (i.e. the market price) of bond.195
  • Stock Valuation  We would like to use our TVM tool to value stocks.  For example, when valuing bonds we discounted the promised future payments of the bond by an appropriate interest rate (discount rate) to arise at the present value (i.e. the market price) of bond.  Unfortunately, for stocks the issuer has not promised any specific payments so it is not obvious what values we should use for our future cash flows (i.e. the numerator of the TVM analysis).196
  • Stock Valuation  We would like to use our TVM tool to value stocks.  For example, when valuing bonds we discounted the promised future payments of the bond by an appropriate interest rate (discount rate) to arise at the present value (i.e. the market price) of bond.  Unfortunately, for stocks the issuer has not promised any specific payments so it is not obvious what values we should use for our future cash flows (i.e. the numerator of the TVM analysis).  This makes it harder to value stocks.197
  • Stock Valuation  We would like to use our TVM tool to value stocks.  For example, when valuing bonds we discounted the promised future payments of the bond by an appropriate interest rate (discount rate) to arise at the present value (i.e. the market price) of bond.  Unfortunately, for stocks the issuer has not promised any specific payments so it is not obvious what values we should use for our future cash flows (i.e. the numerator of the TVM analysis).  This makes it harder to value stocks.  But not impossible.198
  • Stock Valuation – A First Cut199
  • Stock Valuation – A First Cut  Let’s we are trying to value a company’s stock in which we expect a dividend to be paid.200
  • Stock Valuation – A First Cut  Let’s we are trying to value a company’s stock in which we expect a dividend to be paid.  We can look at historic dividend payments to get a sense of how much the dividend in the future might be.201
  • Stock Valuation – A First Cut  Let’s we are trying to value a company’s stock in which we expect a dividend to be paid.  We can look at historic dividend payments to get a sense of how much the dividend in the future might be.  Let’s assume the company is “mature” and the dividends are expected to be the same, forever.202
  • Stock Valuation – A First Cut  Let’s we are trying to value a company’s stock in which we expect a dividend to be paid.  We can look at historic dividend payments to get a sense of how much the dividend in the future might be.  Let’s assume the company is “mature” and the dividends are expected to be the same, forever.  If we assume a dividend of $2.00 (based on our historic analysis of dividends paid-out by this company) then what we are really saying is every year we expect a $2.00 dividend payment,203 forever.
  • Stock Valuation – Dividend Discount Model204
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity:205
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00206
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00207
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00208
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever209
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:210
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:  PV = Annual Payment / Discount Rate211
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:  PV = Annual Payment / Discount Rate  Let’s Assume a discount rate of 12%212
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:  PV = Annual Payment / Discount Rate  Let’s Assume a discount rate of 12%  PV = $2.00 / 0.12213
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:  PV = Annual Payment / Discount Rate  Let’s Assume a discount rate of 12%  PV = $2.00 / 0.12 = $16.67214
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:  PV = Annual Payment / Discount Rate  Let’s Assume a discount rate of 12%  PV = $2.00 / 0.12 = $16.67  The value of such a stock is $16.67215
  • Stock Valuation – Dividend Discount Model  A $2.00 dividend in perpetuity: Year 1: $2.00 Year 2: $2.00 Year 3: $2.00 Continue forever  Valuing this is simply valuing a perpetuity:  PV = Annual Payment / Discount Rate  Let’s Assume a discount rate of 12%  PV = $2.00 / 0.12 = $16.67  The value of such a stock is $16.67  The Dividend Discount Model216
  • Stock Valuation – Dividend Discount Model217
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.218
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.219
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.  If we can estimate (or assume) a constant growth rate (g) we could value the stock using a perpetuity with constant growth:220
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.  If we can estimate (or assume) a constant growth rate (g) we could value the stock using a perpetuity with constant growth:  PV = Dividend this year x (1 + g) / (r – g)221
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.  If we can estimate (or assume) a constant growth rate (g) we could value the stock using a perpetuity with constant growth:  PV = Dividend this year x (1 + g) / (r – g)  Let’s say our growth rate is 3%222
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.  If we can estimate (or assume) a constant growth rate (g) we could value the stock using a perpetuity with constant growth:  PV = Dividend this year x (1 + g) / (r – g)  Let’s say our growth rate is 3%  PV = $2.00 x (1.03) / (12% - 3%)223
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.  If we can estimate (or assume) a constant growth rate (g) we could value the stock using a perpetuity with constant growth:  PV = Dividend this year x (1 + g) / (r – g)  Let’s say our growth rate is 3%  PV = $2.00 x (1.03) / (12% - 3%)  PV = $2.06 / 9%224
  • Stock Valuation – Dividend Discount Model  We could build on this model to make it more versatile.  For example, we might assume that this is an established but growing company.  If we can estimate (or assume) a constant growth rate (g) we could value the stock using a perpetuity with constant growth:  PV = Dividend this year x (1 + g) / (r – g)  Let’s say our growth rate is 3%  PV = $2.00 x (1.03) / (12% - 3%)  PV = $2.06 / 9%225  PV = $22.89
  • Stock Valuation – Comparison226
  • Stock Valuation – Comparison  Let’s compare the values to see the difference:227
  • Stock Valuation – Comparison  Let’s compare the values to see the difference:  Constant Dividend: $16.67228
  • Stock Valuation – Comparison  Let’s compare the values to see the difference:  Constant Dividend: $16.67  Constant Growth: $22.89229
  • Stock Valuation – Comparison  Let’s compare the values to see the difference:  Constant Dividend: $16.67  Constant Growth: $22.89  The growth assumption gave us an extra $6.22 per share of value (or 37% more).230
  • Stock Valuation – Comparison  Let’s compare the values to see the difference:  Constant Dividend: $16.67  Constant Growth: $22.89  The growth assumption gave us an extra $6.22 per share of value (or 37% more).  Growth is good!231
  • Stock Valuation – Comparison  Let’s compare the values to see the difference:  Constant Dividend: $16.67  Constant Growth: $22.89  The growth assumption gave us an extra $6.22 per share of value (or 37% more).  Growth is good!  This is why managers of companies are constantly trying (encouraged) to grow their businesses.232
  • Stock Valuation – Extensions233
  • Stock Valuation – Extensions  There are many extensions to this basic model.234
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:235
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend236
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend  An estimation of growth237
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend  An estimation of growth  For example, a common extension is to split our time horizon into two parts:238
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend  An estimation of growth  For example, a common extension is to split our time horizon into two parts:  A high-growth phase in the early years239
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend  An estimation of growth  For example, a common extension is to split our time horizon into two parts:  A high-growth phase in the early years  A slow but steady growth phase from then on out240
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend  An estimation of growth  For example, a common extension is to split our time horizon into two parts:  A high-growth phase in the early years  A slow but steady growth phase from then on out  High Growth Period + Steady Growth Period241
  • Stock Valuation – Extensions  There are many extensions to this basic model.  But the essential ingredients involve what we have just seen:  An estimated dividend  An estimation of growth  For example, a common extension is to split our time horizon into two parts:  A high-growth phase in the early years  A slow but steady growth phase from then on out  High Growth Period + Steady Growth Period  We can value each period separately using the prior242 methods and simply add each component together
  • Conclusion - Equities243
  • Conclusion - Equities  If there is any residual value after paying back all outstanding obligations (payroll, taxes, loans, etc.), it is owned by the shareholders.244
  • Conclusion - Equities  If there is any residual value after paying back all outstanding obligations (payroll, taxes, loans, etc.), it is owned by the shareholders.  Equities are bought and sold in stock markets just like bonds are bought and sold in bond markets.245
  • Conclusion - Equities  If there is any residual value after paying back all outstanding obligations (payroll, taxes, loans, etc.), it is owned by the shareholders.  Equities are bought and sold in stock markets just like bonds are bought and sold in bond markets.  We can value stocks by taking the present value of any future estimated dividends, accounting for growth, and using an appropriate discount rate.246
  • Conclusion - Equities  If there is any residual value after paying back all outstanding obligations (payroll, taxes, loans, etc.), it is owned by the shareholders.  Equities are bought and sold in stock markets just like bonds are bought and sold in bond markets.  We can value stocks by taking the present value of any future estimated dividends, accounting for growth, and using an appropriate discount rate.247