Valuation of Financial Instruments

Apply the time value of money in making financial decisions.

Determine the relationship between risk and return by calculating stock and portfolio variance.

Apply valuation formulas to assess the value of stocks and bonds.

Use effective communication, team and problem-solving skills to collaborate on a project.

After engaging in a dialogue with your colleagues on valuation, you will now be given an opportunity to apply principles that were presented in this phase. Using a Web site that provides current stock and bond pricing and yield information, complete and analyze the tables illustrated below. Your mentor suggests using a Web site similar to this one.

To fill out the first table, you will need to select 3 bonds with maturities between 10 and 20 years with bond ratings of “A to AAA,” “B to BBB” and “C to CC” (you may want to use bond screener at the Web site linked above). All of these bonds will have these values (future values) of $1,000. You will need to use a coupon rate of the bond times the face value to calculate the annual coupon payment. You should subtract the maturity date from the current year to determine the time to maturity. The Web site should provide you with the yield to maturity and the current quote for the bond. (Be sure to multiply the bond quote by 10 to get the current market value.) You will then need to indicate whether the bond is currently trading at a discount, premium, or par.

Bond

Company/
Rating

Face Value (FV)

Coupon Rate

Annual Payment (PMT)

Time-to Maturity (NPER)

Yield-to-Maturity (RATE)

Market Value (Quote)

Discount, Premium, Par

A-Rated

$1,000

B-Rated

$1,000

C-Rated

$1,000

Explain the relationship observed between ratings and yield to maturity.
Explain why the coupon rate and the yield to maturity determine why the bonds would trade at a discount, premium, or par.
Based on the material you learn in this Phase, what would you expect to happen to the yield to maturity and market value of the bonds if the time to maturity was increased or decreased by 5 years?
In this step, you have been asked to visit a credible Web site that provides detailed information on publicly traded stocks and select 1 that has at least a 5-year history of paying dividends and 2 of its closest competitors.

To fill up the first table, you will need to gather information needed to calculate the required rate of return for each of the 3 stocks. You will need to calculate the risk-free rate for this assignment. You will need the market return that was calculated in Phase 2, and the beta that you should be able to find on the Web site.

Company

5-year Risk-Free Rate of Return

Beta (β)

5-Year Return on Top 500 Stocks

Required Rate of Return (CAPM)

To complete the next table, you will need the most recent dividends paid over the past year for each stock, expected growth rate for the stocks, and the required rate of return you calculated in the previous table. You will also need to compare your results with the current value of each stock and determine whether the model suggests that they are over- or underpriced.

Company

Current Dividend

Projected Growth Rate (next year)

Required Rate of Return (CAPM)

Estimated Stock Price (Gordon Model)

Current Stock Price

Over/Under Priced

In the third table, you will be using the price to earnings ratio (P/E) along with the average expected earnings per share provided by the Web site. You will also need to compare your results with the current value of each stock to determine whether or not the model suggests that the stocks are over- or underpriced.

Company

Estimated Earning
(next year)

P/E Ratio

Estimated Stock Price (P/E)

Current Stock Price

Over/Under Priced

After completing the 3 tables, explain your findings and why your calculations coincide with the principles related to bonds that were presented in the Phase. Be sure to address the following:

Explain the relationship observed between the required rate of return, growth rate and the dividend paid, and the estimated value of the stock using the Gordon Model.
Explain the value and weaknesses of the Gordon model.
Explain the how the price-to-earnings model is used to estimate the value of the stocks.
Explain which of the 2 models seemed to be the most accurate in estimating the value of the stocks.
Based on the material that you learn in this Phase, what would you expect to happen to the value of the stock if the growth rate, dividends, required rate of return, or the estimated earnings per share were to increase or decrease? Be sure to explain each case separately.
Note: You can find information about the top 500 stocks at this Web site.

References

S&P 500 index chart. (2014). Retrieved from the Yahoo! Finance Web site: http://finance.yahoo.com/echarts?s=%5egspc+interactive#symbol=^gspc;range=1y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=;

Yahoo! Finance. (n.d.). Retrieved from http://finance.yahoo.com/

Be sure to document your paper with in-text citations, credible sources, and a list of references used in proper APA format.