Acca Afm (P4)

Session 2
Security Valuation and

the Cost of Capital
FOCUS
This session covers the following content from the ACCA Study Guide.
C. Advanced Investment Appraisal

3. Impact of financing on investment decisions and adjusted
present values
b) Calculate the cost of capital of an organisation including the cost of equity
and cost of debt, based on the range of equity and debt sources of finance.
d) Assess an organisation's debt exposure to interest rate changes using the
simple Macaulay duration method.
e) Discuss the benefits and limitations of duration including the impact of
convexity.
4. Valuation and the application of free cash flows
a) Apply appropriate models, including term structure of interest rates, the
yield curve and credit spreads, to value corporate debt.
Session 2 Guidance
Understand that the theoretical market price of a security is the present value of its future cash flows
discounted at the investor's required return (s.1).
Understand the Dividend Valuation Model; i.e. the theoretical share price is the present value of
future dividends discounted at the shareholder's required return (s.2).
Learn how to reconfigure the DVM to infer the required return of shareholders and hence the firm's
cost of equity finance (s.3).
(continued on next page)

P4 Advanced Financial Management Becker Professional Education | ACCA Study System
Ali Niaz - ali.niaz298@gmail.com

VISUAL OVERVIEW
Objective: To develop a valuation model for shares and bonds that facilitates estimation
of equity and debt costs, and to consider the relationship between short- and long-term
interest rates.
CAPITAL MARKET EFFICIENCY

• Introduction
• Efficient Market Hypothesis
• Implications for Financial
Managers
DIVIDEND VALUATION MODEL BOND VALUATION AND

COST OF DEBT
• General Model
• Terminology
• Constant Dividend
• Irredeemable Bonds
• Constant Dividend Growth
• Redeemable Bonds
• Assumptions
• Semi-annual Interest
• Uses
• Convertible Bonds
• Practical Factors
• Bond Duration
COST OF EQUITY TERM STRUCTURE OF

INTEREST RATES
• Required Rate of Return
• Yield Curve Theory
• Dividend With Constant
Growth • Spot Yield Cure
• Growth From Past Dividends • Corporate Bonds Valuation
• Gordon's Growth Model
• Project Appraisal
• Preference Shares
Session 2 Guidance
Understand application of discounted cash flow to bond valuation, recognise the difference
between bondholders' required return v firm cost of debt and learn the calculations to assess how
interest rate changes affect bond price (s.4).
Learn how to derive the spot yield curve using "bootstrapping" (s.5).
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 2-1

Session 2 • Security Valuation and the Cost of Capital P4 Advanced Financial Management
1 Capital Market Efficiency
1.1 Introduction
An efficient market is one in which the market price of all
securities traded on it reflects all the available information.
A perfect market is one which responds immediately to the
information made available to it.
An efficient and perfect market will ensure that quoted share
prices are as fair as possible, in that they accurately and quickly
reflect a company's financial position with respect to both current
and future profitability.
Efficiency can be looked at in four ways:
1. Allocative efficiency:
Does the market attract funds to the best companies?
2. Operational efficiency:
Does the market have low transaction costs and a convenient
trading platform? These promote a "deep" market with high
liquidity (i.e. a high volume of transactions).
3. Informational efficiency:
Is all relevant information available to all investors at low cost?
4. Pricing efficiency:
Do share prices quickly and accurately reflect all known
information about the company? This is also referred to as
information-processing efficiency.
Most research on market efficiency has focused on pricing
efficiency. The most well-known model is the Efficient Market
Hypothesis.
1.2 Efficient Market Hypothesis

The value of a share is based on expectations of future cash flows
from that share in the form of dividends or share buybacks (see
Session 12).
The strength of the link between the performance of the company
and the share price will depend upon the pricing efficiency of the
capital markets.
The Efficient Market Hypothesis (EMH) considers three potential
levels of efficiency:
1. Weak-form efficiency:
Share prices reflect all the information contained in the record
of past prices. Share prices therefore follow a "random walk"
and will move up or down depending on what information next
reaches the market.
If this level of efficiency has been achieved it should not be
possible to forecast price movements by reference to past
trends (i.e. "chartists" (also known as technical analysts)
should not be able to consistently out-perform the market).
The way to consistently "beat" a weak-from efficient market is
by analysis of publicly available information such as financial
statements (i.e. fundamental analysis).
2-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

P4 Advanced Financial Management Session 2 • Security Valuation and the Cost of Capital
2. Semi-strong form efficiency:

Share prices reflect all information currently publicly available.
Therefore the price will alter only when new information is
published.
If this level of efficiency has been reached, price movements
can only be forecast by using "inside" information (i.e.
significant non-public information). This is known as insider
trading which is illegal in most markets and is unethical in any
market.
3. Strong-form efficiency:
Share prices reflect all information, published and unpublished,
that is relevant to the company.
If this level of efficiency has been reached, share prices cannot
be predicted and gains through insider dealing are not possible
as the market already knows everything!
In major markets (e.g. the London or New York Stock Exchanges)
there are strict rules outlawing insider dealing. Therefore such
markets are regarded as semi-strong efficient.
1.3 Implications for Financial Managers

The level of efficiency of the stock market has implications for
financial managers:
 The timing of new issues:
Unless the market is fully efficient the timing of new issues
remains important. This is because the market does not
reflect all the relevant information, and hence advantage could
be obtained by making an issue at a particular point in time
just before or after additional information becomes available
to the market.
 Project evaluation:
If the market is not fully efficient, the price of a share is
not fair, and therefore the rate of return required from that
company by the market cannot be accurately known. If this is
the case, it is not easy to decide what rate of return to use to
evaluate new projects.
 Creative accounting:
Unless a market is fully efficient creative accounting can still
be used to mislead investors.
 Mergers and takeovers:
Where a market is fully efficient, the price of all shares is fair.
Hence, if a company is taken over at its current share value
the purchaser cannot hope to make any gain unless economies
can be made through scale or rationalisation when operations
are merged. Unless these economies are very significant an
acquirer should not be willing to pay a significant premium
over the current share price.
 Validity of current market price:
If the market is fully efficient, the share price is fair. In other
words, an investor receives a fair risk/return combination for
his investment and the company can raise funds at a fair cost.
If this is the case, there should be no need to discount new
issues to attract investors.

2 Dividend Valuation Model
2.1 General Model
The dividend valuation model implies that the market value of a

share or other security is equal to the present value of the future
expected cash flows from the security discounted at the investor's
required rate of return.
 A security is any traded investment (e.g. shares and bonds).

2.2 Constant Dividend
 The formula for share valuation can be developed as follows:
Present value of the future dividends discounted at
Ex-div market value at time 0 =
the shareholders' required rate of return
 Ex-div market value is the market value assuming that a

dividend has just been paid.
 Let:
P0 = Current ex-div market value
Dn = Dividend at time n
ke = Shareholders' required rate of return/company's cost
of equity
 The model then becomes:
D1 D2 D3 Dn
P0 = + + .....
(1 + ke) (1 + ke) 2
(1 + ke) 3
(1 + ke)n
 If the dividend is assumed to be constant to infinity, this

becomes the present value of a perpetuity, which simplifies to:
D
P0 =
ke
 This version of the model can be used to determine the

theoretical value of a share which pays a constant dividend
(e.g. a preference share or an ordinary share in a zero growth
company).

2.3 Constant Dividend Growth

 If dividends are forecast to grow at a constant rate in
perpetuity, where g = growth rate:
Do(1 + g) D1
P0 = =
ke – g ke – g
where Do = most recent dividend

D1 = dividend in one year
The formula is published in the exam in the following format:
Do(1 + g)
P0 =
(re – g)
Where re = required return of equity investors (i.e. ke)
2.4 Assumptions Behind the Dividend

Valuation Model
 Rational investors.
 All investors have the same expectations and therefore the
same required rate of return.
 Perfect capital market assumptions including:
 no transactions costs;
 large number of buyers and sellers of shares;
 no individual can affect the share price; and
 all investors have all available information.
 Dividends are paid just once a year and one year apart.
 Dividends are either constant or are growing at a constant rate.
2.5 Uses of the Dividend Valuation Model
 The model can be used to estimate the theoretical fair value of
shares in unlisted companies where a quoted market price is
not known.
 However if the company is listed, and the share price is
therefore known, the model can be used to estimate the
required return of shareholders (i.e. the company's cost of
equity finance).

Illustration 1 Dividend Valuation Model

A share has a current ex-div market value of 80 cents, and investors expect a dividend of 10 cents
per share to be paid each year, as has been the case for the past few years.
Using the dividend valuation model, the investors' required return can be determined:
D
P0 =
ke
10c
80c =
ke
10c
ke =
80c
ke = 12.5%
Investors will all require this return from the share, as the model assumes they all have the same
information about the risk of this share and they are all rational.
If investors think that the dividend is due to increase to 15 cents each year, then at a price of 80
cents the share is giving a higher return than 12.5%. Investors will therefore buy the share and
the price will increase until, according to the model, the value will be:
15c
P0 = = 120 cents
0.125
Alternatively, suppose that the investors' perception is that the dividend will remain at 10 cents
per share but that the risk of the share has increased and so requires a 15% return. If the share
only gives a return of 12.5% (on an 80 cents share price), then investors will sell and the price
will fall. The fair value of the share according to the model will be:
10c
P0 = = 66.7 cents
0.15
2.6 Practical Factors Affecting Share Prices

 The dividend valuation model gives a theoretical value, under
the assumptions of the model, for any security.*
 In practice there will be many factors other than the present
value of cash flows from a security that play a part in its
valuation. These are likely to include: *Share prices change,
often dramatically,
 interest rates;
on a daily basis. The
 market sentiment; dividend valuation
 expectation of future events; model will not predict
 inflation;
this, but will give
an estimate of the
 press comment; underlying fair value of
 speculation and rumour; the shares.
 currency movements;
 takeover and merger activity;
 Political issues.
The dividend valuation model helps us to understand how a change

in these variables should affect the market value of the security.

3 Cost of Equity
3.1 Shareholders' Required Rate of Return

 The basic dividend valuation model is:
D
P0 = Many relatively easy
ke marks are often
available in the
 This can be rearranged to find ke: Paper P4 exam for
performing cost of
D capital calculations.
ke =
p0
 If ke is the return required by the shareholders in order for the

share value to remain constant, then ke is also the return that
the company must pay to its shareholders. Therefore, ke also
equates to the cost of equity of the company.
 Therefore, the cost of equity for a company with a constant
annual dividend can be estimated as the dividend divided into
the ex-div share price (i.e. the dividend yield).
 The ex-div market value is the market value of the share,
assuming that the current dividend has just been paid.
A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value
is given, then this must be adjusted to an ex-div market value
by taking out the current dividend.
Example 1 Cost of Equity
A company's shares have a market value of $2.20 each. The company is just about to
pay a dividend of 20 cents per share as it has every year for the last 10 years.
Required:
Calculate the company's cost of equity.
Solution

3.2 Dividend With Constant Growth

 The model can also deal with a dividend that is growing at a
constant annual rate of g.
 The formula for valuing the share is as seen earlier:
D0(1 + g) D1
P0 = =
ke – g ke – g
where D0 = most recent dividend

D1 = dividend in one year
 Rearranged, this becomes:
D0(1 + g)
ke = +g
P0
where g = growth rate (assumed constant in perpetuity)

P0 = ex-div market value
 Therefore, the cost of equity = dividend yield + estimated
growth rate.
Illustration 2 Dividend With

Constant Growth
D0 = 12c, P0 (ex-div) = $1.75, g = 5%.
What is ke?
0.12(1.05)
ke = + 0.05 = 12.2%
1.75
 The growth rate of dividends can be estimated using either of

two methods.
Two Methods
Extrapolation of Gordon's growth

past dividends model

3.3 Growth From Past Dividends

 Look at historical growth and use this to predict future growth.
If specific information about future growth is given, use it.
 If dividends have grown at 5% in each of the last 20 years,
predicted future growth = 5%.
 Uneven but steady growth—take an average overall growth
rate.
 Discontinuity in growth rate—take the most recent evidence.
 New company with very high growth rates—take care! It is
unlikely to produce such high growth in perpetuity.
 No pattern—do not use this method (i.e. dividends up one
year, down the next).
Example 2 Growth Using Extrapolation
A company has paid the following dividends over the last five years:
Cents per share

20X0 100
20X1 110
20X2 125
20X3 136
20X4 145
Required:
Estimate the growth rate and the cost of equity if the current (20X4)
ex-div market value is $10.50 per share.
Solution
g= %
ke = %

3.4 Gordon's Growth Model

 Gordon's growth model states that growth is achieved by
retention and reinvestment of funds.
g = bre
b = proportion of profits retained
re = return on equity
 Take an average of r and b over the preceding years to
estimate future growth.
Profit after tax Profit after tax
re = =
Shareholders' funds Net assets
Retained profit
b=
Profit after tax
 These figures can be obtained from the statement of financial
position (balance sheet) and statement of profit or loss
(income statement).
Example 3 Gordon's Growth Model
A company has 300,000 ordinary shares in issue with an ex-div market value of $2.70
per share. A dividend of $40,000 has just been paid out of Post-tax profits of $100,000.
Net assets at the year end were $1.06m.
Required:
Estimate the cost of equity.
Solution
b= %
re = %
g= %
ke = %

3.5 Cost of Equity and Project Appraisal
Illustration 3 Impact of Project on Value

Apple is all equity financed and has 1m shares quoted at $2 each (ex-div). It
pays constant annual dividends of 30 cents per share.
It is considering a project which will cost $500,000 and which is of the same
risk as its existing activities. The cost will be met by a rights issue. The project
will produce inflows of $90,000 per annum in perpetuity. All inflows will be
distributed as dividends.
What is the new value of the equity in Apple and what is the gain to the
shareholders? Ignore tax.
0.30
ke = = 15%
2.00
New dividend
$
Existing total dividend 300,000
Dividends from the project 90,000
New total dividend 390,000
390,000
Value of equity =
0.15
= $2,600,000
Shareholders' gain = $(2,600,000 – 2,000,000) – $500,000

= $100,000
90,000
Project NPV = ($500,000) + = $100,000
0.15
Therefore, new value of equity
= Existing value + Equity outlay + NPV
= Existing value + PV of additional dividends
 Therefore the NPV of a project increases the value of the

company's shares (i.e. the NPV of a project shows the increase
in shareholders' wealth).
 This proves that NPV is the correct method of project appraisal
—it is the only method consistent with the assumed objective
of maximising shareholders' wealth.
3.6 Cost of Preference Shares

 By definition, preference shares have a constant dividend:
D
ke =
p0
where D = constant annual dividend

 Preference dividends are normally quoted as a percentage (e.g.
10% preference shares). This means that the annual dividend
will be 10% of the nominal value.

Example 4 Cost of Preference Shares
A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
Required:
Calculate the cost of the preference shares.
Solution
4 Bond Valuation and Cost of Debt
4.1 Terminology
A bond is a written acknowledgement of a company's debt.
A bond usually pays a fixed rate of interest and it may be secured
or unsecured. It may be traded on the bond market and will
reach a market price. The terms bond, debenture and loan stock
all basically refer to the same thing (i.e. traded corporate debt).
They are unlike bank loans which are not traded.
 The coupon rate is the interest rate printed on the bond
certificate.
Annual interest = coupon rate × nominal value In the exam the
nominal value of one
 Nominal value is also known as par or face value. bond is usually $100.
 Market value (MV) is normally quoted as the MV of a block of
$100 nominal value.

Illustration 4 Bond Terminology
10% bonds quoted at $95 means that a $100 block is selling for
$95 and annual interest is $10 per $100 block.
 Market value (ex-int) is where interest has just been paid.

 Market value (cum-int) includes the value of accrued interest
which is just about to be paid.
4.2 Irredeemable Bonds

4.2.1 Valuation of Irredeemable Bonds
The market value of any bond should equal the present value
of the future payments to investors discounted at their required
return.
In the case of irredeemable (undated) bonds there will be a fixed
annual payment of "coupon" interest into perpetuity, with no
repayment of principal.
I
P0 =
re
Where:
P0 = Ex-interest market price
I = Annual interest payment
re = Bondholders' required return
I
Note that the required return = = current yield, which could
P0
also be described as the interest yield, running yield or the firm's
pre-tax cost of irredeemable bonds.
Example 5 Valuation of
Irredeemable Bonds
A firm has in issue 7% undated bonds each with $100 nominal value.
The current yield is quoted as 7.42%.
Required:
Calculate the market price of each bond.
Solution
Annual coupon =
Required return =
P0 =
4.2.2 Cost of Irredeemable Bonds

Although the interest yield is the firm's pre-tax cost of
irredeemable debt, the post-tax cost will be lower due to "tax
shield" on the coupon payments.

Illustration 5 Tax Shield of

Debt Interest
Consider two companies with the same earnings before interest and
tax (EBIT). The first company uses some debt finance, the second
uses no debt.
$ $
EBIT 100 100
Debt interest (10)
Profits before tax 90 100
Tax @ 33% 29.70 33
$3.30 difference
Therefore
Effective cost of debt $
Debt interest 10.00
Less: tax shield (3.30)
Effective cost of debt 6.70
 Because of tax relief, the cost to the company is less than the
required return of the bondholders.
Unless told otherwise, tax relief is assumed to be instant (in
practice, there will be a minimum time lag of nine months under
the UK tax system).
 If the debt is irredeemable, then:
Cost of debt to the company Return required by the
(also known as the post-tax = bondholders × (1 – T )
c
cost of debt)
= Interest yield × (1 – Tc)
Where Tc = corporate tax rate as a decimal

 Kd can be used to denote the cost of debt—but care is needed
as to whether it is stated pre-tax or post-tax.

Example 6 Cost of Irredeemable Debt
12% undated bonds with a nominal value of $100 are quoted at $92 cum- interest.
The rate of corration tax is 33%
Required:
Calculate
(a) the return required by the bondholders; and
(b) the cost to the company.
Solution:
(a) Return required by bondholders
Required return by bondholders = %
(b) Cost to the company
4.3 Redeemable Bonds*

4.3.1 Valuation of Redeemable Bonds
The market value of a redeemable bond should equal the present *Also called dated
value of the coupon interest (paid each year until maturity) bonds.
and the redemption price (paid at maturity), discounted at the
investors' required rate of return.
The required return on a redeemable bond is referred to as its
Yield to Maturity, Gross Redemption Yield or the firm’s pre-tax
cost of the redeemable bond.

Example 7 Valuation of Redeemable Bonds
A company has in issue 8% $100 nominal value bonds redeemable at a 5%

premium in 10 years' time. 4% $100 treasury notes are trading at $98 and are
redeemable at face value after one year; the yield curve is flat and the corporate
credit spread is 388 basis points.
Required:
Calculate the market price of each bond.
Solution:
Yield to maturity on risk-free treasuries =
Yield to maturity on corporate bond =
Annual coupon =
Present value of the coupon =
Redemption price =
Present value of redemption price =
Market price of bond =
4.3.2 Cost of Redeemable Bonds

 The cash flows are not a perpetuity because the principal will
be repaid. However, the following general rule can be applied:
The cost of any source of funds is the IRR of the cash flows
associated with that source.
 Looking at the return from an investor's point of view, interest

payments are included gross.
 Looking at the cost to the company, interest payments are
included net of corporation tax. (Assume instant tax relief.)
 Assume that the final redemption payment does not have any
tax effects.
 To find the cost of debt for a company, find the IRR of the
following cash flows:
Time $
0 Market value (ex-interest) x
1–n Post-tax coupon interest (x)
n Redemption value (x)
 The IRR is found as usual using linear interpolation.

Example 8 Cost of Redeemable Debt
A company has in issue $200,000 7% bonds redeemable at a premium of 5% on

31 December 20X6. Interest is paid annually on 31 December. It is currently 1
January 20X3 and the bonds are trading at $98 ex-interest. Corporation tax is
33%.
Required:
Calculate the cost of debt for this company.
Solution:
Time Cash flow PV @ 10% PV @ 5%
$ $
1–4
IRR =
kd = %
 Care should be taken not to confuse the required return of the

bondholders with the cost of debt of the company.
Required return of the IRR of pre-tax cash flows

= = Gross redemption yield
redeemable bondholder from the bond
 Gross Redemption Yield is also referred to as the Yield to

Maturity (YTM)

4.4 Semi-annual Interest Payments

 In practice, bond interest is usually paid every six months
rather than annually. This practical aspect can be built into
calculations for the cost of debt.
 If interest payments are being made every six months, the IRR
of the bond's cash flows should be calculated on the basis of
each time period being six months.
 The IRR, or cost of debt, will then be a six-month cost of debt
and must be adjusted to determine the annual cost of debt.
Effective annual cost = (1 + semi-annual cost)2 – 1
Example 9 Effective Annual Cost
A company has in issue 6% bonds, the interest on which is paid on 30 June and 31
December each year. The bonds are redeemable at par on 31 December 20X9. It is
now 1 January 20X7 and the bonds are quoted at $96 per $100 nominal value.
Required:
Calculate the effective annual cost of debt for the company. Ignore
corporation tax.
Solution:
Cash flow PV @ 3% PV @ 5%
Time $ $ $
1–6
IRR =
Effective annual cost of debt = %

4.5 Convertible Bonds

4.5.1 Valuation of Convertible Bonds
 Convertible bonds allow the investor to choose between MV (ex-interest) =
redeeming them at some future date or converting them into a present value of future
predetermined number of ordinary shares in the company. interest payments and
the higher of:
 To estimate the market value, it is first necessary to predict (i) redemption value:
whether the investor will choose redemption or conversion. or
The redemption value will be known with certainty, but the (ii) forecast conversion
future share price can only be estimated. value,
discounted at the
 Other amounts that may be calculated for convertibles: bondholder's required
 Floor value = the value assuming redemption; rate of return.
 Conversion premium = market value – current
conversion value.
Example 10 Valuation of Convertible Debt
A company has in issue 9% bonds which are redeemable at their par value of $100
in five years' time. Alternatively, each bond may be converted on that date into 20
ordinary shares. The current ordinary share price is $4.45, and this is expected to
grow at a rate of 6.5% per year for the foreseeable future. Bondholders' required
return is 7% per year.
Required:
Calculate the following values for each $100 convertible bond:
(i) market value;
(ii) floor value; and
(iii) conversion premium.
Solution
(i) Market value
(ii) Floor value
(iii) Conversion premium

4.5.2 Cost of Convertible Bonds

 To find the post-tax cost of convertible debt for a company,
find the IRR of the following cash flows:
Time $
0 Market value (ex-interest) x
1–n Post-tax interest (x)

Higher of redemption value/
n (x)
forecast conversion value
Example 11 Post-Tax Cost of Convertible Debt
A company has in issue some 8% convertible loan stock currently quoted at $85 ex-interest.
The loan stock is redeemable at a 5% premium in five years' time, or can be converted into 40
ordinary shares at that date. The current ex-div market value of the shares is $2 per share and
dividend growth is expected at 7% per annum. Corporation tax is 33%.
Required:
Calculate the cost to the company of the convertible loan stock.
Solution
DF @ 5% PV DF @ 10% PV
$ $
t0
t1–5
t5
IRR =
Therefore, cost to the company = %

4.6 Bond Duration

 When market interest rates (yields) fall the market price of
bonds rises (because the present value of the bonds' fixed
future cash flows rises). When yields rise the price of bonds
falls.
 The change in bond price is approximately the same in either
direction for a small rise/fall in yield. For larger changes in
yield the change in price is greater for falls in yield than for
rises in yield. Therefore the relationship between yields and
bond prices is not linear, but convex.
 Duration measures the average time it takes for a bond to pay
its coupons and principal. It recognises that bonds which pay
higher coupons effectively mature earlier compared to bonds
which pay lower coupons, even if the redemption dates of the
bonds are the same.
 This is because a higher proportion of the higher coupon
bonds' income is received sooner. Therefore these bonds are
less sensitive to interest rate changes and will have a lower
duration.
 Duration is often expressed in years – known as Macaulay's
duration.
 Macaulay's duration = the weighted average of the number
of years in the bond's life, with the weighting factor being the
present value of the flows in each year (discounted at the yield
to maturity).
 Higher Macaulay's duration indicates higher bond price
volatility.
 Modified duration – gives the approximate percentage price
change in a bond for a 1% change in yield.
Macaulay's duration
 Modified duration =
1 + YTM
where YTM = bond's yield to maturity.
 However modified duration is not totally accurate as it
assumes a linear relationship between yield and price (i.e.
ignores convexity).
 Therefore duration will predict a lower price than the actual
price and for large changes in interest rates this difference can
be significant.
 If interest rates fall duration will understate the rise in bond
prices, whereas if interest rates rise duration will over-state
the fall in bond prices.

Bond Value
Actual relationship
Relationship predicted
by duration
Interest Rates
 Therefore the price change predicted by modified duration

needs to be adjusted by the convexity measure to make the
calculation more accurate.
 Total % price change = ± change due to duration + change
due to convexity
 Even after correcting for convexity duration can only measure
the change in bond price if the change in interest rates does
not lead to a change in the shape of the yield curve. This is
because duration is an average measure based on the bond's
gross redemption yield (yield to maturity).
 If there is a non-parallel shift in the yield curve (i.e. the shape
of the yield curve changes) duration can no longer be used to
assess the change in bond value.
 Factors affecting duration:
 Term to maturity—longer dated bonds have longer durations
and hence higher price volatility.
 Coupon—lower coupon bonds have longer durations and
hence higher price volatility (the duration of a zero-coupon
bond equals its term to redemption).
 Yield—bonds with low yields have longer durations and
hence higher price volatility.

Example 12 Duration
6% coupon bond (paid annually) with three years to maturity. Yield to maturity is 10%, $1,000
par value.
Calculate:
(a) Macaulay's duration;
(b) Modified duration;
(c) The actual % change in bond price for a 1% rise/fall in yield.
Solution
(a) Macaulay's duration
Year $ DF PV Year x PV
1
Macaulay duration = years
(b) Modified duration

Modified duration =
(c) Actual % change in bond price for a 1% rise/fall in yield
Recalculate bond price if yield rises to 11%:
Year $ DF PV
1
% fall in bond price = % ≈ modified duration
Recalculate bond price if yield falls to 9%:
Year $ DF PV
1
rise in bond price = % ≈ modified duration

5 Term Structure of Interest Rates
5.1 Yield Curve Theory

The return provided by a security will alter according to the length
of time before the security matures.
If, for example, a graph is drawn showing the yield to maturity/
redemption yield of various government securities against the
number of years to maturity, a "yield curve" such as the one
below might result.
Yield
Years to maturity
It is important for financial managers to be aware of the shape

of the yield curve, as it indicates to them the likely future
movements in interest rates and hence assists in the choice of
finance for the company.
The shape of the curve can be explained by the following:
 Expectations theory:
If interest rates are expected to increase in the future, a
curve such as that above may result. The curve may invert if
interest rates are expected to decline.
 Liquidity preference theory:
Yields will need to rise as the term to maturity increases, as
by investing for a longer period the investor is deferring his
consumption and needs higher compensation.
 Segmentation theory:
Different investors are interested in different segments of the
yield curve. Short-term yields, for example, are of interest to
financial intermediaries (e.g. banks). Hence the shape of the
yield curve in that segment is a reflection of the attitudes of
the investors active in that sector.
Where two sectors meet there is often a disturbance or
apparent discontinuity in the yield curve as shown in the
above diagram.

This can also be referred to as "preferred habitat theory" (i.e.

different investors have a preference for being in different
segments of the yield curve).
Pension fund managers often have a preference for investing
in long-dated bonds—to match against the long-term liabilities
of the fund. This can drive up the price of long-dated bonds
which brings down their yield, possibly resulting on an
"inversed" (falling) yield curve.
 Risk:
On high-quality government/sovereign debt (e.g. UK Gilt-
Edged Securities ("Gilts")) the risk of default is not significant
even for long-dated bonds.
However, default risk may be more significant on corporate
debt, therefore the corporate yield curve may rise more
steeply than the government yield curve.
5.2 Deriving the Spot Yield Curve

A "spot interest rate" is the rate for borrowing a sum of money
today to be repaid by a single sum on a specific future date.
For example, the one-year spot rate is the rate for borrowing
money today to be repaid with a single "bullet" after one year;
the two-year spot rate is the rate for borrowing money today to
be repaid with a single sum after two years (i.e. with zero coupon
paid during the loan's life).
Ideally, spot interest rates could be found directly as the quoted
yield to maturity (gross redemption yield) of zero-coupon bonds
of various maturities.
However, in practice most government (and corporate) bonds pay
coupon (i.e. are not repaid as a single sum). In this case spot
rates cannot be directly observed and have to be implied using a
process known as "bootstrapping":
 First find the YTM on a one-year government bond. Assuming
coupon is paid annually (as opposed to semi-annually) this
one-year bond is in fact repaid by a single sum (i.e. its YTM is
by definition the one-year spot rate).
 Then find the market price of a two-year government bond.
The market price should theoretically equal the present value
(PV) of the first-year coupon (discounted at the one-year spot
rate) plus the PV of the second-year coupon and redemption
value (discounted at the two-year spot rate). As the one-year
spot is known the two-year spot can be implied.
 Then find the market price of a three-year government bond.
This should equal:
 the PV of the first-year coupon (discounted at the one-year
spot rate) plus
 the PV of the second-year coupon (discounted at the two-
year spot rate) plus
 the PV of the third-year coupon and redemption value
(discounted at the three-year spot rate, which can now be
implied).
 The process continues for as long as required.

Example 13 Spot Rates
The following data has been collected on government treasury notes (annual coupon, $100 face
and redemption value):
Years to redemption Coupon Market Price
One 7% $103
Two 6% $102
Three 5% $98
Required:
Calculate the one-year, two-year and three-year treasury spot rates.
Solution
One-year spot rate: S1 =
Two-year spot rate: S2 =
Three-year spot rate: S3 =
5.3 Valuing Corporate Bonds Using Spot Rates

An accurate approach to bond valuation is to "strip" a bond into
its constituent cash flows and discount each cash flow separately
at its related spot rate.
Once the theoretical market value of the bond has been found
then its YTM can be estimated (i.e. the equal annual rate that
would discount the bond's cash flows to the market price).
It can then be observed that a bond's YTM is a weighted average
of the underlying spot rates, the weighting being the proportion of
returns generated in each year.

Example 14 Spot Curve Valuation

A three-year, 5% coupon corporate bond ($100 face and redemption value) has the following
spread above the treasury spot rates from example 12 (bps = basis points):
Year Spread (bps)
One 29
Two 41
Three 55
Required:
(a) Value the bond based on the corporate spot curve.
(b) Estimate the bond's yield to maturity.
Solution
(a) Corporate Spot Curve
Spread Treasury Corporate Present

Year (bps) spot spot $ value
1
2
(b) YTM
Time $ 6% DF PV $ 7% DF PV $
0
1-3
YTM = IRR = %

Summary
The Efficient Markets Hypothesis deals with the pricing efficiency of the capital markets (i.e.
what information is included in the price of securities).
The rise of "dark pool trading" (i.e. off-market private trading) may be a challenge to the
pricing efficiency of public markets.
If capital markets are perfect the sale/purchase of any security must be a zero NPV
transaction (i.e. market price = present value of future cash flows discounted at investors'
required return).
This general rule can be specifically applied to shares to develop the Dividend Valuation
Model (DVM) and also applied to bond valuation.
If the market price of a security is already known then the model can be rearranged to find
the required return of investors' (i.e. the company's cost of equity and debt finance).
Care must be taken with the cost of debt as interest, unlike dividends, is a tax allowable
expense for the company.
Bond duration measures the sensitivity of a bond's price to a change in yield.
The term structure of interest rates deals with the relationship between short- and long-
term interest rates. Everything else being equal, long-term rates should be higher to
compensate investors for locking their money away and deferring consumption. However,
other factors (e.g. expectations or preferred habitat) can produce an inverted yield curve.
A spot interest rate refers to the rate that would apply if money borrowed today is to be
repaid by a single sum.
As spot interest rates cannot usually be directly observed they have to be implied through
the process of bootstrapping.

Session 2
Session 2 Quiz
Estimated time: 30 minutes
1. Distinguish between the following types of financial market efficiency: allocative, operational,
informational, pricing. (1.1)
2. State what information is reflected in share prices under each of the three levels of the
Efficient Markets Hypothesis. (1.2)
3. State how the theoretical value of a share is calculated. (2.1)
4. State what future growth in dividends is a function of under Gordon's growth model. (3.4)
5. State the ratio that measures the required return of investors in irredeemable bonds. (4.2)
6. Explain why a company's cost of debt is lower than the required return of its debt
investors. (4.2)
7. State which cash flows should be used to find IRR as an estimate of the post-tax cost of
redeemable debt. (4.3)
8. State how the cost of convertible debt can be estimated. (4.5)
9. State why duration only gives the approximate price change for a bond for a change in
interest rates (4.6)
10. State the theories or factors that can be used to explain the shape of the interest rate yield
curve. (5.1)
11. Name the technique used to infer spot interest rates. (5.2)
Study Question Bank

Estimated time: 30 minutes
Priority Estimated Time Completed
Q3 Cost of capital 30 minutes

Additional
Q4 Gaddes
Q5 Stock market efficiency

EXAMPLE SOLUTIONS
Solution 1—Cost of Equity
P0 (cum-div) = $2.20
P0 (ex-div) = $2.00
ke = D/P0(ex-div) = 20/200 × 100%
ke = 10%
Solution 2—Growth Using Extrapolation

20X0–20X4—four changes in dividend.
100 (1 + g)4 = 145
(1 + g)4 = 145/100
145
1+g = 4 = 1.097
100
g = 9.7%
ke = D1/P0 + g
= 145(1.097)/1,050 + 0.097
ke = 24.8%
Solution 3—Gordon's Growth Model

Growth rate g = bre
b = % profit retained
= 60,000/100,000 = 60%
re = Return on equity*
= Profit after tax/Opening net assets *Return on average

equity could be used
= 100,000/1,060,000 – 60,000 × 100% rather than return on
opening equity.
re = 10%
g = 0.6 × 0.1 = 0.06
g = 6%
k = D1/P0 + g
ke = 40,000(1.06)/300,000 x 2.70 + 0.06
ke = 11.2%
Solution 4—Cost of Preference Shares

12% preference shares: dividend is 12% × nominal value
ke = D/P0
= 12/115 × 100%
ke = 10.4%

Solution 5—Valuation of Irredeemable Bonds
Annual coupon = 7% × $100 = $7
Required return = 7.42% = 0.0742

$7
P0 = = $94.34
0.0742
Solution 6—Cost of Irredeemable Debt

(a) Return required by debt holders
r = Int/MV ex int
= 12/92 – 12 × 100% = 15%
Return required by bondholders = 15%.
(b) Cost to the company:

kd = Int(1 – T)/MV ex int
= 12(1 –0.33)/92 – 12
kd = 10.05%
Solution 7—Valuation of Redeemable Bonds
Yield to maturity on risk-free treasuries = (104/98) − 1 = 6.12%
Yield to maturity on corporate bond = 6.12% + 3.88% = 10%
Annual coupon = 8% × $100 = $8
Present value of the coupon

(applying a 10-year annuity factor at = $8 × 6.145 = $49.16
10% discount rate)
Redemption price = $105
Present value of redemption price

(applying a 10-year discount factor at = $105 × 0.386 = $40.53
10% discount rate)
Market price of bond = $49.16 + $40.53 = $89.69
Solution 8—Cost of Redeemable Debt

0 (98) (98) (98)
1–4 (7) × 0.67 = (4.69) 14.87 16.63
4 (105) 71.72 86.42
(11.41) 5.05
IRR = 5 + 5.01/5.01 + 11.41 × (10 – 5) = 6.5%
kd = 6.5%

Solution 9—Effective Annual Cost
Time 0 is 1 January 20X7. Interest payments are due:
30 June X7 Time 1
31 Dec X7 Time 2
30 June X8 Time 3
31 Dec X8 Time 4
30 June X9 Time 5
31 Dec X9 Time 6
Each interest payment will be just half of the coupon rate, $3 each 6
months.

0 (96) (96) (96)
1–6 3 16.25 15.23
6 100 83.75 74.62
4.00 (6.15)
IRR = 3 + 4.00/4.00 + 6.17 x (5 – 3) = 3.79%
This is the semi-annual cost of debt.
Effective annual cost of debt = 1.03792 – 1 = 7.7%
Solution 10—Valuation of Convertible Debt

(i) Market value
Expected share price in five years' time = 4.45 x 1.0655 = $6.10
Forecast conversion value = 6.10 x 20 = $122
Compared with redemption at par value of $100, conversion will be
preferred.
Today's market value is the PV of future interest payments, plus the PV of
the forecast conversion value:
MV0 = (9 x 4.100) + (122 x 0.713) = $123.89
(ii) Floor value
Floor value is the PV of future interest payments, plus the PV of the
redemption value:
FV0 = (9 x 4.100) + (100 x 0.713) = $108.20
(iii) Conversion premium
Current conversion value = 4.45 x 20 = $89.00
Conversion premium = $123.89 – 89.00 = $34.89
This is often expressed on a per share basis (i.e. 34.89/20 = $1.75
per share).

Solution 11—Post-Tax Cost of Convertible Debt
First decide whether the loan stock will be converted or not in five years.
To do this compare the expected value of 40 shares in five years' time
with the cash alternative.
Assuming that the MV of shares will grow at the same rate as the
dividends:
MV/share in five years = 2(1.07)5 = $2.81
MV of 40 shares × $2.81 = $112.40
Cash alternative = $105
Therefore all loan stockholders will choose the share conversion.
To find the cost to the company, find the IRR of the Post-tax flows.
DF @ 5% PV DF @ 10% PV
$ $
t0 (85) 1 (85.00) 1 (85.00)
t1–5 8(1 – 0.33) 4.329 23.20 3.791 20.32
t5 112.4 0.784 88.12 0.621 69.80
26.32 5.12
IRR = 5 + 26.32/26.32 – 5.12 × (10 – 5) = 11.2%
Therefore, cost to the company = 11.2%.

Solution 12—Duration
(a) Macaulay's duration

Year $ DF PV Year x PV
1 60 0.909 54.54 54.54
2 60 0.826 49.56 99.12
3 1,060 0.751 796.06 2,388.18
900.16 2,541.84
2,541.84
Macaulay duration = = 2.82 years
900.16
(b) Modified duration
Modified duration = 2.82/1.10 = 2.56
(c) Actual % change in bond price for a 1% rise/fall in yield
Recalculate bond price if yield rises to 11%:
Year $ DF PV
1 60 0.901 54.06
2 60 0.812 48.72
3 1,060 0.731 774.86
877.64
% fall in bond price = (900.16 – 877.64)/900.16 = 2.5% ≈ modified duration
Recalculate bond price if yield falls to 9%:
Year $ DF PV
1 60 0.917 55.02
2 60 0.842 50.52
3 1,060 0.772 818.32
923.86
rise in bond price = (923.86 – 900.16)/900.16 = 2.63% ≈ modified duration*
*Note how duration overstates falls in bond prices when interest

rates rise but understates rises in bond prices when interest rates
fall. This is because duration assumes a linear relationship between
yields and bond prices, whereas the true relationship is convex.

Solution 13—Spot Rates
S1 = (107/103) – 1 = 3.88%
The two-year spot rate can be implied by "stripping" the two-year
treasury note into its constituent cash flows and discounting each at the
relevant spot rate (where s = two-year spot rate):
102 = (6/1.0388) + ((106/(1 + s2)2)
96.22 = ((106/(1 + s2)2)
S2 = √(106/96.22) – 1 = 4.96%
98 = (5/1.0388) + (5/1.04962) + ((105/(1 + s3)3)
88.65 = ((105/(1 + s3)3)
S3 = (105/88.65)1/3 – 1 = 5.8%
Solution 14—Spot Curve Valuation
(a) Corporate Spot Curve
Spread Treasury Corporate Present

Year (bps) spot spot $ value
1 29 388 4.17% 5 5/1.0417 = 4.80
2 41 496 5.37% 5 5/1.05372 = 4.50
3 55 580 6.35% 105 105/1.06353 = 87.29
96.59
(b) YTM
Time $ 6% DF PV $ 7% DF PV $
0 (96.59) 1 (96.59) 1 (96.59)
1-3 5 2.673 13.36 2.624 13.12
3 100 0.84 84 0.816 81.60
0.77 (1.87)
YTM = IRR = 6% + 0.77/(0.77 + 1.87) = 6.29%

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Session 2

Security Valuation and

C. Advanced Investment Appraisal

(continued on next page)

Ali Niaz - ali.niaz298@gmail.com

CAPITAL MARKET EFFICIENCY

DIVIDEND VALUATION MODEL BOND VALUATION AND

COST OF EQUITY TERM STRUCTURE OF

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1 Capital Market Efficiency

1.2 Efficient Market Hypothesis

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2. Semi-strong form efficiency:

1.3 Implications for Financial Managers

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2 Dividend Valuation Model

2.1 General Model

The dividend valuation model implies that the market value of a

 A security is any traded investment (e.g. shares and bonds).

 Ex-div market value is the market value assuming that a

 If the dividend is assumed to be constant to infinity, this

 This version of the model can be used to determine the

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2.3 Constant Dividend Growth

where Do = most recent dividend

Where re = required return of equity investors (i.e. ke)

2.4 Assumptions Behind the Dividend

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Illustration 1 Dividend Valuation Model

2.6 Practical Factors Affecting Share Prices

The dividend valuation model helps us to understand how a change

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3.1 Shareholders' Required Rate of Return

 If ke is the return required by the shareholders in order for the

Example 1 Cost of Equity

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3.2 Dividend With Constant Growth

where D0 = most recent dividend

where g = growth rate (assumed constant in perpetuity)

Illustration 2 Dividend With

 The growth rate of dividends can be estimated using either of

Extrapolation of Gordon's growth

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3.3 Growth From Past Dividends

Example 2 Growth Using Extrapolation

Cents per share

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3.4 Gordon's Growth Model

Example 3 Gordon's Growth Model

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3.5 Cost of Equity and Project Appraisal

Illustration 3 Impact of Project on Value

Shareholders' gain = $(2,600,000 – 2,000,000) – $500,000