BFF2140 Chap.2 Bond and Equity Valuation
Bond and Equity Valuation
Bond and Equity Valuation applies discounted cash flow to financial securities. A bond combines coupon payments with face value, while an ordinary share represents uncertain residual cash flows. The chapter connects bond yield to price, separates current dividends from next-period dividends, and makes the assumptions behind constant-growth equity valuation explicit.
Bond price is built from two pieces: the present value of coupons and the present value of face value. When the required yield rises, both pieces fall, creating the inverse price-yield relation. A coupon rate below the yield produces a discount, a coupon above the yield produces a premium, and equal rates produce par. Payment frequency must be reflected in both the periodic coupon and the discount rate.
Equity valuation shifts from promised payments to expected distributions. The constant-growth model uses next period's dividend and requires a return greater than sustainable growth. Its estimate becomes highly sensitive when those two rates are close, so the assumptions deserve as much attention as the calculation. Comparing estimated value with market price gives a conditional investment signal, not certainty.
The chapter therefore trains two related skills: mapping a security into dated cash flows and explaining how required return, maturity, growth and cash-flow risk transmit into price.
What this chapter covers
- 01
Bond coupon and face value
- 02
Yield to maturity
- 03
Premium and discount pricing
- 04
Zero-coupon bonds
- 05
Dividend discount valuation
- 06
Constant dividend growth
- 07
Price sensitivity to required yield, maturity, coupon size, sustainable growth and the distinction between the current and next dividend
Worked example · free
Price a coupon bond and a growing dividend share
- 4Discount the eight $45 coupons and the $1,000 face value at 6% to obtain $906.85.
- 4Compute D1 as $3.20 multiplied by 1.04, then divide $3.328 by 0.095 less 0.04 to obtain $60.51.
Key terms
- Coupon rate
- The stated annual coupon divided by bond face value.
- Required yield
- The market return used to discount a bond's promised cash flows.
- Dividend growth
- The assumed continuing rate at which dividends increase in a constant-growth model.
Bond and Equity Valuation FAQ
Why do bond price and yield move inversely?
The promised coupons and face value are fixed. When investors require a higher yield, those same cash flows are discounted more heavily, so present value falls. A lower required yield raises present value.
When does a bond trade below face value?
A bond trades at a discount when its coupon rate is below the required yield, because its coupon cash flows are less attractive than newly priced alternatives with similar risk.
When is constant growth unsuitable?
It is unsuitable when dividends are absent, unstable or expected to grow at a rate that cannot persist. The required return must also exceed perpetual growth for the denominator to be economically meaningful.
Exam move
Build security valuation from the promised or expected cash-flow pattern. For every bond, write the face value, coupon rate, payment frequency, maturity and required yield in separate rows. Convert the coupon rate into a cash coupon and convert the annual yield into a rate per coupon period before discounting.
Decompose price into the present value of coupons and the present value of face value; this makes a missing redemption payment or an incorrect number of periods obvious. Use the coupon-yield comparison as an independent diagnostic: coupon below yield implies a discount, coupon above yield implies a premium, and equality implies par.
Reprice the same bond at several yields and explain why longer maturity and lower coupon generally increase interest-rate sensitivity. For zero-coupon bonds, recognise that all value comes from the final payment and that there is no annuity component. Equity questions need a different cash-flow discipline.
Label the most recent dividend as D0, calculate D1 explicitly, and confirm that required return exceeds perpetual growth before applying the constant-growth model. Explore sensitivity by changing growth and required return separately, then explain why a small denominator makes the estimate unstable.
Write down what the model assumes about dividend policy, growth persistence and risk; reject the shortcut when those assumptions do not fit the company. Compare security values at a common date and do not confuse a book figure with a market price. When a question asks whether a security is attractive, distinguish model value from observed price and state the conditional trading implication without claiming certainty.
During timed practice, reserve a final minute for three checks: all cash-flow dates included, all rates expressed per matching period, and price direction consistent with the economics. Record errors under cash-flow omission, period conversion, D0-versus-D1, or interpretation. Repeat a fresh problem of the same error type immediately.
The aim is not merely to reach a price but to explain which cash flows created it, which return discounted them and which assumption would cause the estimate to change most.
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