Stock Valuation

Chapter: 10 Stock Valuation

Section: 4 Valuing an Asset with Uncertain Cash Flows

If we want to value a corporate bond, the certainty of cash flows would be less than the government bond. Hence we need to add a risk premium to the required rate of return. This risk premium would depend on that particular bond’s credit rating. For example, suppose that the following risk premiums are priced into the market above the risk free rate:

 

Credit Rating

AAA

AA

A

Premium above the Risk Free Rate

1%

2%

3%

 

The valuation of a corporate bond with ‘A’ credit rating, 3 years to maturity, SR 1,000 par value and 6% annual coupon rate would be as follows:

 

Risk free rate of return = 4.00%
Premium above the risk free rate = 3.00%
Expected rate of return = 7.00%
Value of Corporate Bond =

      60                         60                 60 + 1000

____________   +   ___________   +   __________

  (1 + 0.07)              (1 + 0.07)2           (1 + 0.07)3

 

=

SR 984.78

 

 

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