Free «Vanilla Stock Valuation» UK Essay Sample

Vanilla Stock Valuation

Any given stock valuation is significant to a variety of users. It is therefore, necessary to value stock whether common stock or vanilla bonds. Determination of vanilla bond value requires consideration of various aspects. For instance, the maturity period of the stock is essential in calculating the yield to maturity.

A vanilla bond has a maturity period, which is predetermined. The value of the bond at the date of issue is recoverable together with the interest accruing as of that date. When looking at a company’s balance sheet it is not easy to understand the direct or indirect implications of the figures that appear. It is essential to be able to interpret and understand the meaning of each figure and its effect on decision-making.

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A company facing financing difficulties may result to using debt financing to enable it continue its operations or to expand. Such a company may result to issuing a vanilla bond. When a company is issuing a bond it determines the fair value of the bond and its rate of interest. Investors in such a company will weigh their options and decide whether purchasing the bond is viable to them or not. Therefore, in an attempt to make the optimal decisions, it is necessary to make calculations relating to the bond.

In determining the coupon price of the bond, the interest rate of the coupon is known, the maturity period is also known (Advanced bond concepts). The price of a bond is given by the present value of the payments to be made up to the maturity period plus the bond value at the date of maturity i.e.

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Coupon price = C/ (1+r) + C/ (1+r) ^2 +…+ C/ (1+r) ^n + CM/ (1+r) ^n

Where; C is the bond payments, r is the interest rate, CM is par value at maturity date (Advanced Bond Concepts: Bond Pricing).

A bond has a given length to maturity. The period between the issue of the bond and the date the bond is redeemable is the length to maturity. At times it may be necessary to calculate the duration to maturity of a given bond. This may be at a time other than the date of issue of the bond and therefore; the following may be put into consideration when calculating the bonds duration to maturity. The bond duration is essentially the degree in which the bonds value shifts when there is a change in the yield to maturity of the bond by one percent (Baaquie, 2009).

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It is possible to compute the length to maturity using the formula;

Effective length= (v2 – v1) / {2(v0) (change in yield)}

Where, v2 is the bonds value as a result of a decrease in its yield to maturity by 0.5 percent, v1 is the bonds value as a result of an increase in its yield to maturity by 0.5 percent and v0 is the current yield of the bond(The finance tutor).

The determination of the yield to maturity is significant. It is necessary in making other relevant calculations that enable an individual to adequately make a decision. Therefore, the yield to maturity is the given internal rate if return of a bond when held until it matures and is recouped by the issuer (yield to maturity).

Yield to maturity is given by, YTM = {[C+ (F-P)/n] / (F+P)/2}

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Where C is coupon payment, F is par value of the bond, P is the price and n are number of years to maturity of the coupon. Yield to maturity calculates the bonds value rate using the prevailing market rates.

In the event of credit worthiness of a company the bonds yield plays a significant role. For instance in the case of two companies; company A and company B. both with the same maturity period. Company A has a yield to maturity of 8.5% while company B has a yield to maturity of 15%. The credit worthiness of the two companies will not be the same. A bond with a higher yield to maturity may have the consideration of high risk and hence a low credit rating. A bond with a lower yield to maturity will have the consideration of low risk and hence a higher credit rating

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When a bank is issuing a loan to a company, the company’s yield to maturity is essential in determining whether a loan will be issued or not. A company with a very high yield to maturity may not receive the loan. This is a result of its high yield is an indicator of low credit rating; hence the banks cannot afford to issue a loan. A company with a low yield to maturity is an indicator of its high credit rating and therefore, a bank will feel comfortable issuing a loan.

In the event that both companies receive the loan, then the company with a higher yield to maturity will have a higher interest on loan. This is because of it s low credit rating. The bank feels that since the company’s credit rating the chances of default on loan repayments are high. The bank imposes high interest rates to motivate the company to repay the loan promptly to avoid extra additional costs in interest repayments.

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An investor willing to invest in both companies will opt to choose the company with a higher yield to maturity since it will earn him more in terms of interest. Future growth of the companies will significantly be influenced by the investor confidence in it, the strategic managerial techniques, and the market forces. Given the yield to maturity of the companies the company with a lower yield to maturity will experience more growth since it is spending less in interest repayments (Yield to Maturity). The company with a higher yield to maturity will spend more in terms of interest repayments hence it will experience a low growth rate, since most of its earnings are spent in interest repayments.

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