Vanilla Stock Evaluation

Key Assignment Final Draft 

Part I  Deliverable Length: 700-1000 words

Understanding how to properly value a vanilla bond is essential for finance. Find a company with debt and that pays dividends. You can use the following stock screener to find a company:

http://www.google.com/finance/stockscreener

. Add the criteria of long-term debt to assets to ensure the company has debt. Add the criteria of dividend per share. Find the company’s financial pages at:

http://www.sec.gov/edgar.shtml

. Look at the long-term debt on the balance sheet. Determine the coupon price, the length until maturity and the yield to maturity. Calculate today’s price of the bond. 

• List the pertinent information on the bond you chose and then calculate the price of one bond from both companies.
• Which bond is receiving the higher price? Explain your answer.
• From a time value of money frame of mind, what does each rate say about the viewpoint on the time value of money?
• Which company has a better credit rating? Explain your answer.
• Based on the credit rating, which company do you believe the bank feels more secure will pay back the loan? Explain your answer.
• Why does the bank charge more interest for one company than another?
• What does the credit rating say to an investor?
• Which bond looks is more financially attractive? Explain why you chose the answer you did. 

Part II  Deliverable Length: 700-1000 words

Understand how to properly find the value of a stock using the dividend growth rate is a fundamental building block in valuation. Find two companies and evaluate each stock using a constant dividend growth model. Please use a standard long-term economic growth rate of 3% in your calculations.

• Calculate the future growth rate for both companies.
• Which stock has the better growth rate? Do you agree with this assessment? Explain. Support your answer with either a description of a new product growth or from past growth performance.
• Calculate the future stock price for both companies.
• From a time value of money point of view stand point what does the calculated stock price say about the market’s view on the time value of money for each stock?
• Compare the calculated stock price with the current stock price for both companies.
• Is either stock underpriced or overpriced? Explain.
• Should an investor purchase either of those stocks?
• Should one stock outperform the other?
• Based on the ratings found in Phase 4, does one stock seem more financially healthy? Explain.
• Does this financial health make a stronger case to invest in the stock? Explain.

Phase 4- Vanilla Bond Valuation

Professor Angela Garrett

FINC390-1303A-04

CTU Online

Evelyn Green

August 07, 20113

PepsiCo Inc Corporate Bond

(“PEP debt, bond, rates, quotes, yields – Morningstar”, n.d.)

The bond price is calculated using the Price formula in Excel:

This represents the bond price per $100 of face value.

Johnson & Johnson Corporate Bond

(“JNJ debt, bond, rates, quotes, yields – Morningstar”, n.d.)

The bond Price is calculated using Price function in Excel:

This represents the bond price per $100 of face value.
a) Based on the bond price calculation it is evident that Johnson & Johnson 5.55% 2017 bond is receiving higher price. Now the credit rating of a corporate bond indicates the investment grade of a bond in terms of investment risk involved for the bond. In other words the credit rating of a bond indicates the ability of the corporate to repay the debt issued.
Now the price of a corporate bond is influenced by several factors like the maturity, the credit rating of the company issuing the bond and the general level of interest rates. The yield of a corporate bond fluctuates to reflect changes in the price of the bond caused by shifts in interest rates and the markets’ perception of the issuer’s credit quality.
Typically higher the credit rating of a corporate bond, lower is the default premium paid by an investor for such a bond. At the same time corporate bonds with higher credit rating will be perceived as more safe investments and hence investors will be willing to pay a higher price/premium to purchase such bonds. This fact is also reflected in the higher yield required by investors to invest in bonds with lower credit rating.
Based on their credit ratings, bonds are classified as investment grade or non-investment grade. Investment-grade bonds are considered more likely than non-investment grade bonds to be paid on time. Non-investment grade bonds, which are also called high-yield or speculative bonds, generally offer higher interest rates to compensate investors for greater risk (“What Are Corporate Bonds?”, 2013).
As given above Johnson & Johnson 5.55% 2017 bond has the highest credit rating of AAA implying the lowest investment risk for an investor buying this bond issue. Hence the market price of this bond is higher compared to PepsiCo Inc 4.5% 2020 bond.
b) The Time Value of money represents the fact that a dollar today is worth more than a dollar received in future. In other words it represents the opportunity cost of giving up consumption today.
Now any bond investment essentially means a series of cash flows to be received in future during the tenure of the bond. The cash flows involved for a bond are the coupon payments and the face value of the bond which is redeemed on maturity of the bond.
At the same time the risk of investing in any bond is the event risk i.e. the issuer fails to repay the debt. The risk associated with any bond investment is reflected in the discount factor known as the Yield to Maturity. Typically bonds with lower credit ratings (implying higher probabilities of default) will require a higher YTM for investors as they are perceived more risky.
The price of a bond essentially represents the time value of money as it indicates the Present Value of Future cash flows.

Thus the price of Johnson & Johnson 5.55% 2017 bond i.e. $115.708 indicates that the expected future cash flows from this bond are worth $115.708 today per $100 of face value.

Similarly all the future cash flows from PepsiCo Inc 4.5% 2020 bond are worth $113.930 per $100 of face value when discounted with the appropriate discount rate.

c) As given in the corporate bond details for Johnson & Johnson it has a credit rating of AAA whereas the corporate bond details for PepsiCo Inc indicate that it has a credit rating of AA-.
Credit ratings are forward-looking opinions about credit risk. Credit ratings speak about the credit quality of an individual debt issue, such as a corporate note, a municipal bond or a mortgage-backed security, and the relative likelihood that the issue may default (“Credit Ratings Definitions & FAQs”)
The table below shows the credit ratings and the corresponding level of investment risk (“What Is A Corporate Credit Rating?”, 2009)

Hence based on this table it is evident that Johnson & Johnson 5.55% 2017 corporate bond has a better credit rating and hence a lower investment risk. In fact as its rating is AAA it indicates that this bond has the lowest default risk also.
d) Credit or default risk is the risk that a company will fail to make timely interest or principal payments and thus default on its bonds. Credit ratings try to estimate the relative credit risk of a bond based on the company’s ability to pay. Credit rating agencies periodically review their bond ratings and may revise them if conditions or expectations change.
Credit ratings provide objective, consistent and simple measures of creditworthiness. As such, they improve the flow of information between institutional borrowers (issuers) and lenders (investors). Ratings also reduce investors’ costs of gathering, analyzing, and monitoring the financial positions of borrowers (“Understanding Moody’s Corporate Bond Ratings And Rating Process”, 2002).
Now companies with higher credit rating are perceived to have lower default risk i.e. the probability of default on the debt obligations is lower and companies with lower credit ratings are perceived to have higher default risk.
Thus banks will feel more secure in lending money to companies with higher credit rating as the default risk is lower. And typically banks will charge a much higher interest rate (default premium) for lending to companies with lower credit ratings.
As Johnson & Johnson has the highest credit rating of AAA whereas PepsiCo Inc has a rating of AA-, comparatively banks will feel more secure in lending to Johnson & Johnson as it has a lower default risk.
e) Typically the interest charged by a bank for lending to a corporate comprises the risk-free rate and the default premium corresponding to the corporate. The default premium is charged to compensate the bank for taking on a higher risk by investing in a corporate which has a default risk (i.e. probability of default) compared to government bonds which are perceived to be risk free.
Again as the credit rating is an indicator of the degree of default risk in a corporate debt issue, hence corporate bonds having lower credit rating will attract a higher default premium as they are perceived to have higher probability of default.
Here as PepsiCo Inc has a credit rating of AA- which is lower than the credit rating of Johnson & Johnson hence lending to PepsiCo Inc will be perceived comparatively riskier. Thus the banks will charge a higher interest rate for lending to PepsiCo Inc compared to Johnson & Johnson.
f) The credit rating of a bond/debt does not indicate whether to buy, hold or sell a bond. However it indicates the probability of default risk by the corporate issuing the debt and hence the default premium which should be built into the total return required by the investor. Typically bonds with higher credit ratings are classified as investment-grade whereas the bonds with lower credit ratings are classified as non-investment grade. Also the credit rating indicates the degree of investment risk involved in a particular debt issue. The table below shows the credit rating categories and the corresponding investment risk level

Based on the risk tolerance and investment objectives of the investor he can then choose a particular bond from a given range of debt securities.
g) The selection of any bond for investment typically depends on the following factors:
1. Credit Rating of the bond – The credit rating of a bond indicates the default risk of the issuer and hence the degree of investment risk for an investor. Typically investors looking for capital protection invest in bonds with higher credit ratings.
2. Interest Rate – The duration of the bond indicates the sensitivity of a bond price to changes in interest rates. Typically when investors expect the interest rate to fall they invest in bonds with higher duration so as to get a substantial capital appreciation when the interest rates fall. On the other hand if the interest rates are expected to rise, investors will invest in bonds with lower duration. Thus coupon rates and time to maturity become important selection factors.
Again the Yield to Maturity of a bond indicates the rate of return from an investment in a bond. Typically bonds with higher risk in the form of lower credit rating will have a higher Yield and hence investors with higher risk tolerance will prefer such bonds for investment.
3. Diversification – In case the investment objective is diversification of portfolio investors consider a portfolio of bonds with different maturities and from different industries. Typically capital protection is the objective behind such a strategy. In such a case coupon rates as well as taxable status become important factors too.
Although Johnson & Johnson 5.55% 2017 bond has a higher credit rating of AAA, PepsiCo Inc 4.5% 2020 bond has higher duration as well as higher Yield to Maturity. Hence if my objective is to achieve a higher return on investment (assuming I have a higher risk tolerance) I’ll prefer PepsiCo Bond as it has higher Yield to Maturity.
Again if I expect the interest rates to fall (let’s say to give stimulus to the economy) I’ll prefer the PepsiCo Inc bond as it has higher modified duration and hence a higher potential capital appreciation when the interest rates fall.

References
Credit Ratings Definitions & FAQs. (n.d.). Retrieved from http://www.standardandpoors.com/ratings/definitions-and-faqs/en/us
What Is A Corporate Credit Rating? (2009, September 26). Retrieved from http://www.investopedia.com/articles/03/102203.asp
What Are Corporate Bonds? (2013, June). Retrieved from http://www.investor.gov
Understanding Moody’s Corporate Bond Ratings And Rating Process. (2002).
JNJ debt, bond, rates, quotes, yields – Morningstar. (n.d.). Retrieved from http://quicktake.morningstar.com
PEP debt, bond, rates, quotes, yields – Morningstar. (n.d.). Retrieved from http://quicktake.morningstar.com
Corporate Bond Details
Issue Details
Issue Size in Billion dollars1.0
Par Value1,000$
Coupon Rate4.50%
Coupon TypeFixed
Coupon FrequencySemi-Annually
Day Count Basis30/360
First Payment Date7/15/2010
Accrual Start Date1/14/2010
Maturity Date1/15/2020
CallableNo
PuttableNo
ConvertibleNo
Current Yield4.09%
Yield to Maturity2.17%
Modified Duration5.6
Credit Rating (Moody’s)AA-
Johnson and Johnson

Corporate Bond Details
Issue Details Settlement Date 8/7/13
Issue Size in Billion dollars 1 Maturity Date 8/15/17
Par Value $ 1,000 Coupon Rate 5.55%
Coupon Rate 5.55% Yield to Maturity 1.51%
Coupon Type Fixed Final Redemption % 100
Coupon Frequency Semi-Annually Coupons per Year 2
Day Count Basis 30/360 Day Count Basis 30/360
First Payment Date 2/15/08
Accrual Start Date 8/16/08 Bond Price $ 115.708
Maturity Date 8/15/17
Callable No
Puttable No
Convertible No
Current Yield 4.80%
Yield to Maturity 1.51%
Modified Duration 3.6
Credit Rating (Moody’s) AAA

PepsiCo Inc

Corporate Bond Details
Issue Details Settlement Date 8/7/13
Issue Size in Billion dollars 1.0 Maturity Date 1/15/20
Par Value $ 1,000 Coupon Rate 4.50%
Coupon Rate 4.50% Yield to Maturity 2.17%
Coupon Type Fixed Final Redemption % 100
Coupon Frequency Semi-Annually Coupons per Year 2
Day Count Basis 30/360 Day Count Basis 30/360
First Payment Date 7/15/10
Accrual Start Date 1/14/10 Bond Price $ 113.930
Maturity Date 1/15/20
Callable No
Puttable No
Convertible No
Current Yield 4.09%
Yield to Maturity 2.17%
Modified Duration 5.6
Credit Rating (Moody’s) AA-

Sheet3

Corporate Bond Details
Issue Details
Issue Size in Billion dollars1
Par Value1,000$
Coupon Rate5.55%
Coupon TypeFixed
Coupon FrequencySemi-Annually
Day Count Basis30/360
First Payment Date2/15/2008
Accrual Start Date8/16/2008
Maturity Date8/15/2017
CallableNo
PuttableNo
ConvertibleNo
Current Yield4.80%
Yield to Maturity1.51%
Modified Duration3.6
Credit Rating (Moody’s)AAA
Johnson and Johnson

Corporate Bond Details
Issue Details
Issue Size in Billion dollars 1
Par Value $ 1,000
Coupon Rate 5.55%
Coupon Type Fixed
Coupon Frequency Semi-Annually
Day Count Basis 30/360
First Payment Date 2/15/08
Accrual Start Date 8/16/08
Maturity Date 8/15/17
Callable No
Puttable No
Convertible No
Current Yield 4.80%
Yield to Maturity 1.51%
Modified Duration 3.6
Credit Rating (Moody’s) AAA

Microsoft

Corporate Bond Details
Issue Details
Issue Size in Billion dollars 1.0
Par Value $ 1,000
Coupon Rate 4.20%
Coupon Type Fixed
Coupon Frequency Semi-Annually
Day Count Basis 30/360
First Payment Date 12/1/09
Accrual Start Date 5/18/09
Maturity Date 6/1/19
Callable No
Puttable No
Convertible No
Current Yield 3.75%
Yield to Maturity 2.02%
Modified Duration 5.2
Credit Rating (Moody’s) AAA

Sheet3

2

>INTRO

303A-04
CTU Online
Evelyn Green
August 07, 20113

Phase 4- Vanilla Bond Valuation Professor Angela Garrett FINC390-

1

Johnson and Johnson

1

Coupon Rate 5.55%

2

Day Count Basis 30/360

Maturity Date 8/15/17

No

No

Yield to Maturity 1.51%

	Corporate Bond Details
	Issue Details		Settlement Date		8/7/13
	Issue Size in Billion dollars
			Maturity Date		8/15/17
	Par Value		$ 1,000				Coupon Rate		5.55%
			Yield to Maturity		1.51%
	Coupon Type		Fixed		Final Redemption %		100
	Coupon Frequency		Semi-Annually		Coupons per Year
			Day Count Basis				30/360
	First Payment Date	2/15/08
	Accrual Start Date	8/16/08		Bond Price	$ 115.708
	Callable						No
	Puttable
	Convertible
	Current Yield	4.80%
	Modified Duration	3.6
	Credit Rating (Moody’s)	AAA

PepsiCo Inc

Corporate Bond Details
Issue Details Settlement Date 8/7/13

Issue Size in Billion dollars

Maturity Date

Par Value $ 1,000 Coupon Rate

Coupon Rate 4.50%

Yield to Maturity

Coupon Type Fixed Final Redemption % 100
Coupon Frequency Semi-Annually Coupons per Year 2
Day Count Basis 30/360 Day Count Basis 30/360

First Payment Date

Accrual Start Date

Bond Price

Maturity Date 1/15/20
Callable No
Puttable No
Convertible No

Current Yield

Yield to Maturity 2.17%

Modified Duration

Credit Rating (Moody’s)

1.0
	1/15/20
	4.50%
	2.17%
7/15/10
1/14/10	$ 113.930
4.09%
5.6
AA-