CHAPTER FORTY
Valuation of Bonds and Stocks
Valuation IS THE process of determining the worth (or value) of an asset. Just like a company’s investors, the company’s financial managers must have a good understanding of how to value its stocks, bonds, and other securities to judge whether they are good buys or not. The failure to understand the concepts and computational procedures in valuing a security may preclude sound financial decisions. This fact is evident in the company’s objective of maximizing the value of its common stock.
In this chapter, we use the concept of the time value of money to analyze the values of bonds and stocks. Basic bond valuation and stock valuation models under varying assumptions are discussed. In all cases, bond and stock values are found to be the present value of the future cash flows expected from the security.
HOW TO VALUE A SECURITY
The process of determining security valuation involves finding the present value of an asset’s expected future cash flows using the investor’s required rate of return. Thus, the basic security valuation model can be defined mathematically as:
where
V = intrinsic value or present value of a security
n = number of periods
Ct = expected future cash flows in period t = 1, … , n
r = investor’s required rate of return
HOW TO VALUE BONDS
A bond is a certificate or security showing funds loaned to a company in return for ...
