Chapter 5  How to Value Stocks and Bonds
Ross, Westerfield, Jaffe (8th edition) Corporate Finance.
There are two quizzes from this chapter; one quiz focuses on Bonds and the other quiz focuses on Stocks.
Need to know – This chapter develops the valuation techniques of stocks and fixed income securities (a.k.a. Bonds). Our focus is on sections 5.1 to 5.5.
Bonds are valued either as an ordinary annuity or as a perpetuity (consols only). You already know the valuation techniques from Jordan Chapter 6. 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, price down." 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.
Stocks are valued as a growing perpetuity. You will need to know how to use the Constant Growth Model (aka Dividend Discount), how to value nonconstant/differential growth stocks, and valuation of preferred stock (0% growth). This chapter has very little information about stocks that can be used as concept questions, the discussion in section 5.8 on the PriceEarnings Ratio is probably useful but not testable.
Don't need to know  From Chapter 5, the First OneHour Exam will not require you to make any calculations using material from section 5.65.8.
This textbook has no instruction to assist in using calculators and spreadsheets. You will need to be able to use a financial calculator for the quizzes and exams. Here are calculator links to assist you in learning to use the calculator.
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 5 Overview video. Here is a link to the powerpoint slides used in this video. Read the chapter.
2. The is another chapter where you should spend you time solving EndofChapter problems. The only way to learn this material is to do this material. Below are audio solutions to various types of stock and bond valuation problems.
Bond Valuation
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 semiannual 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 yieldtomaturity 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 semiannual 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 yieldtocall 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 yieldtomaturity 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 yieldtomaturity of 6.0%. What is the bond's expected capital gain/loss if the bonds are held until maturity?
Stock Valuation
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. Audio solution to:
3. Our textbook has only a limited discussion of the terms and teminology of bonds. If you want more information, you might want to view this optional Bond Video Material.
4. Our textbook has only a limited discussion of stocks terms and concepts. If you want more information, you might want to view this optional Stock Video Material
4. If you still find yourself missing problems, you should listen to the Hints on Solving Time Value of Money Problems.
5. Be prepared for a longish quiz on stock and bond valuation with a few concept questions.
