Module 2 – Case

Stock and Bond Valuation

Assignment Overview

Before starting on this assignment, make sure to thoroughly review the required background materials. This assignment will require you to use the various discounted cash flow methods and dividend models to make computations. In addition to knowing the computational steps involved in stock and bond valuation, make sure you also understand the basic concepts.

Submit your answers in a Word document. Make sure to show your work for all quantitative questions, and make sure to fully explain your answers using references to the background readings for any conceptual questions. Questions 1 and 3 will require Excel, so submit an Excel file that shows your computational steps as a separate file in addition to your Word file. Question 4 is purely conceptual; no computations are necessary, but make sure to apply and reference concepts from the required readings in your answers to each of the scenarios.

Case Assignment

1. Suppose you buy a bond that will pay $1000 in 10 years along with an annual coupon payment of $50. The interest rate is 4%. Answer the following questions:
   1. What is the value of this bond?
   2. Now suppose the bond has no coupon payments (it is a “zero coupon” bond) but still pays $1000 in 10 years. What is the value of this bond?
   3. What would happen to the value of the bond if the inflation rate unexpectedly goes up? What if the bond value increases or decreases?
   4. Now suppose the bond still pays an annual coupon of $50 but the interest rate drops to 2%. What is the new value of this bond?
2. The XYZ Corporation pays a dividend of $1 for each share, and its required rate of return is 8%. Answer the following questions:
   1. Assuming zero growth in dividends, what is the value of each share?
   2. Now assume a 4% annual growth rate in the dividend paid. What is the value of each share?
   3. Assume the growth rate is still 4%, but the required rate of return drops to 6%. What is the new value of each share?
3. Acme Medical Corp. is expecting the cash flows from 2018-2022 shown in the table below. After 2022, it is expecting growth in cash flow at an annual rate of 3%. The firm has determined that its weighted average cost of capital (discount rate) is 7%. Using the table below, calculate the following:
   1. What is the present value of Acme’s future cash flows using the discounted cash flow model?
   2. If the firm has 200,000 common shares outstanding, zero preferred shares, and debt with a market value of $10,000,000, what would be the value of each share?
   3. Now suppose the discount rate increases to 10%. How would your answers to a) and b) above change based on the new discount rate?

Year	Cash flow
2018	500,000
2019	550,000
2020	620,000
2021	700,000
2022	800,000

1. Suppose the Alpha Manufacturing Corporation is experiencing extreme financial difficulties and is considering bankruptcy. Its shareholders are currently almost equally divided about whether or not the company should go bankrupt, with one outspoken faction pushing for bankruptcy and the other strongly opposing it. The company has $50 million in debt—all in the form of bonds—and bondholders are pretty well united in wanting the firm to declare bankruptcy.
   1. The CEO announces that he is leaning against bankruptcy. This means one faction of shareholders is happy, but another faction of shareholders is very upset, and the bondholders are also unhappy. Can the unhappy faction of shareholders team up with the bondholders to vote out the CEO? Explain your reasoning using references from the background readings.
   2. Suppose Alpha ends up declaring bankruptcy. The company has no cash in the bank but owns $60 million worth of real estate and has only one type of shareholder—common shareholders. If Alpha sells the real estate, how much of the money will bondholders get, and how much with shareholders get? Explain your reasoning using references from the background readings.
   3. Now suppose that Alpha has two classes of shareholders—common shareholders and preferred shareholders. Preferred shareholders are owed $20 million in dividends that have been unpaid in the past two years. If Alpha goes bankrupt and sells its $60 million worth of real estate, how much will bondholders get, how much will common shareholders get, and how much will preferred shareholders get? Explain your reasoning using references from the background readings.

Assignment Expectations

• Answer the assignment questions directly.
• Stay focused on the precise assignment questions. Do not go off on tangents or devote a lot of space to summarizing general background materials.
• For computational problems, make sure to show your work and explain your steps.
• For short answer/short essay questions, make sure to reference your sources of information with both a bibliography and in-text citations. See the Student Guide to Writing a High-Quality Academic Paper, including pages 11-14 on in-text citations. Another resource is the “Writing Style Guide,” which is found under “My Resources” in the TLC Portal.

Module 2 – Background

Stock and Bond Valuation

Required Reading

Start off with these two tutorials that will give you an overview of the basic methods of valuing stocks and bonds from Subjectmoney:

Subjectmoney. (2013, January 2). How to price/value bonds – formula, annual, semi-annual, market value, accrued interest [Video file]. Retrieved from https://www.youtube.com/watch?v=7zCqoED8MVk

Subjectmoney. (2013, January 3). Dividend discount model (DDM) – constant growth dividend discount model – how to value stocks [Video file]. Retrieved from https://www.youtube.com/watch?v=n76Pz3HOBPo

Now dig much deeper into bond and stock valuation with the following books chapters. They cover not only the computational methods but also provide a general overview of stock and bond markets:

Ross, S., Westerfield, R., & Jordan, B. (2007). Chapter 6: Interest rates and bond valuation. Essentials of Corporate Finance. McGraw Hill. Retrieved from http://novellaqalive2.mhhe.com/sites/dl/free/007000000x/484691/Part4_Chap6.pdf [If this link is down, click Interest Rates and Bond Valuation for an alternative link.]

Fabozzi, F. J., & Peterson Drake, P. (2009). Chapter 7: Asset valuation: Basic bond and stock valuation models. Finance: Capital markets, financial management, and investment management. Wiley. Available in the Trident Online Library.

Finally, for some examples of valuation calculations in Excel see the following videos:

Moy, M. (2014). Bond valuation in Excel. Retrieved from https://www.youtube.com/watch?v=H-_NP0UxX_U

Girvin, M. (2010). Stock valuation with dividend growth model. ExcellsFun. Retrieved from https://www.youtube.com/watch?v=cbRIhwkGAnQ

Girvin, M. (2010). Stock value based on present value of future dividend cash flows. ExcellsFun. Retrieved from https://www.youtube.com/watch?v=G2VIY5E3I3s&t=163s

Optional Reading

Davis, A. (2016). Bond pricing. Retrieved from https://www.youtube.com/watch?v=-DnARyndirI

Ahmad, A. (n.d.). Bonds part II: Pricing. Coursera. Retrieved from https://www.coursera.org/learn/finance-markets/lecture/EpByC/bonds-part-ii-pricing

Ozoguz, A. (n.d.) Basics of equity valuation. Coursera. Retrieved from https://www.coursera.org/learn/global-financial-markets-instruments/lecture/vHPRN/basics-of-equity-valuation

Vishwanath, S. (2007). Chapter 24: Debt markets. Corporate finance: Theory and practice. SAGE Publications India. Available in the Trident Online Library.