Question

1. What makes bonds sell at a premium, par value, or discount? Please show and describe the dividend discount model of common stock valuation. Are the costs of debt and equity observable in the capital markets? If not how do you estimate that cost of capital? The expected annual cash flow on a restaurant is $300,000 (assume growth = 0%), and my cost of equity capital for restaurants if 33.3% (restaurants are very risky!). What is the maximum price I am willing to pay for that business? A stock has a current dividend of $2.00, a forecasted growth rate of 10%, a beta = 2, market return = 12.4% and the risk-free rate (30 year US T-Bond YTM) = 4%. The current stock price on the NYSE is $15. What is the value of the stock and is the stock over- or under-valued?

Answer 1

1]

Price of a bond is the present value of its cash flows. The cash flows are the periodic coupon payments and the maturity value. The discount rate used is the bond's YTM.

A bond sells at a discount if YTM > coupon rate

A bond sells at a premium if YTM < coupon rate

A bond sells at par if YTM = coupon rate

2]

As per dividend discount model,

Price of stock = next year dividend per share / (required return - growth rate).

The required return is the cost of equity.

3]

The cost of debt is usually observable directly in the capital markets. Pretax cost of debt = yield on bonds of company.

However, cost of equity is not observable directly in the capital markets. It can be estimated by the following methods :

• CAPM
• Dividend growth model
• Bond yield plus risk premium approach

4]

present value of perpetuity = perpetual payment / discount rate

Maximum price to pay for restaurant = $300,000 / 33.3%

Maximum price to pay for restaurant = $900,900.90