Valuing bonds and stocks

1. Valuing bonds and stocks Yields and growth

2. Exam (sub) question • r = 6%, compounded monthly. • Save $100 at the end of each month for 10 years. • Final value, in dollars of time 120?

3. Answer in two steps • Step 1. Find PDV of the annuity. • .005 per month • 120 months • PVAF = 90.073451 • PVAF*100 = 9007.3451 • Step 2. Translate to money of time 120. • [(1.005)^120]*9007.3451 = 16387.934

4. Present value of annuity factor

5. Example: Cost of College • Annual cost = 25000 • Paid when? • Make a table of cash flows

6. Timing • Obviously simplified

7. Present value at time zero • 25+25*PVAF(.06,3) • =91.825298

8. Spreadsheet confirmation

9. Saving for college • Start saving 16 years before matriculation. • How much each year? • Make a table.

10. The college savings problem

11. Solution outlined • Target = 91.825 dollars of time 16. • Discount to dollars of time 0. • Divide by (1.06)16 • Result 36.146687… , the new target • PV of savings =C+C*PVAF(.06,16) • Equate and solve for C.

12. Numerical Solution • PV of target sum = 36.146687 • PV of savings = C+C*10.105895 • Solve C*11.105695 = 36.14667 • C = 3.2547298

13. Confirmation in an excel spread sheet.

14. Confirmation in an excel spread sheet.

15. Apply the formula to a Bond This is a bond maturing T full years from now with coupon rate 2C/1000

16. Yield • Yield is the market rate now. • Coupon rate is written into the bond. • It is near the market rate when issued. • Yield and coupon rate are different.

17. Given the yield, r • Yield r for a bond with semi-annual coupons means r/2 each 6 months. • Value of the bond is • P = C*PVAF(r/2,2T) + 1000/(1+r/2)^2T

18. Given the price of the bond, P • Yield is the r that satisfies the valuation equation • P=C*PVAF(r/2,2T) + 1000/(1+r/2)^2T

19. A typical bond

20. Value at yield of 5% • Pure discount bond (the 1000): Value =1000/(1.025)3=928.599… • Strip: ( the coupon payments)60*(1/.025)(1-1/(1.025)3) • =171.3614… • Total market value of bond =1099.96

21. Facts of bonds • They are called, • at the option of the issuer when interest rates fall. • or retired in a sinking fund, • as required to assure ultimate repayment.

22. More Facts • Yield > coupon rate, bond sells at a discount (P<1000) • Yield < coupon rate, it sells at a premium(P>1000)

23. Growing perpetuities • Thought to be relevant for valuing stocks • Present value of growing perpetuity factor PVGPF • g = growth rate (decimal) • r = interest rate (decimal) • PVGPF(r,g) = 1/(r-g)

24. Growing perpetuity

25. Riddle • What if the growth rate is above the discount rate? • Formula gives a negative value. • Correct interpretation is infinity.

26. More riddle: market response • An investment with growth rate above the interest rate. • Others copy the investment until competition drives the growth rate down • or until … • the opportunity drives the interest rate up.

27. Review question • A bond has a coupon rate of 8%. • It sells today at par, that is, for $1000. • What is the yield? • Prove it.

28. Answer one • yield = coupon rate. • You must know that.

29. Answer two: proof • 1000/(1.04)^20 + 40*(1/.04)[1-1/(1.04)^20] = 456.3869462+543.6130537 = 1000

30. Answer two: deeper proof • 1000/(1.04)^20 + 40*(1/.04)[1-1/(1.04)^20] • 1000/(1.04)^20 + 1000-1000/(1.04)^20 • End terms cancel. Answer = 1000.