FinancialManagement

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Unit4
4.1 Introduction 4.2 ValuationofBonds TypesofBonds 4.2.1 IrredeemableorPerpetualBonds

ValuationOfBondsAndShares

4.2.2 RedeemableorBondswithMaturityPeriod 4.2.3 ZeroCouponBond BondyieldMeasures 4.2.1 HoldingPeriodRateofReturn 4.2.2 CurrentYield 4.2.3 YieldtoMaturity(YTM) 4.2.4 BondValueTheorems 4.3 ValuationofShares 4.3.1 ValuationofPreferenceShares 4.3.2 ValuationofOrdinaryShares 4.4 Summary SolvedProblems TerminalQuestions AnswerstoSAQsandTQs

4.1

Introduction

Valuationistheprocessoflinkingriskwithreturnstodeterminetheworthofanasset.Assetscanbe realorfinancialsecuritiesarecalledfinancialassets,physicalassetsarerealassets.Theultimate goal of any individual investor is maximization of profits. Investment management is a continuous processrequiringconstantmonitoring.Thevalueofanassetdependsonthecashflowitisexpected toprovide over the holdingperiod. Thefact thatas ondate there isno method by which prices of shares and bonds can be accurately predicted should be kept in mind by an investor before he decides to take an investment decision. The present chapter will help us to know why some

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securities are priced higher than others.We can design our investment structure by exploiting the variablestomaximizeourreturns. Ordinarysharesareriskierthanbondsordebenturesandsomesharesaremoreriskythanothers. Theinvestorwouldthereforecommitfundsonashareonlyifheisconvincedabouttherateofreturn beingcommensuratewithrisk.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1. KnowthemeaningofvalueasusedinFinanceTheory. 2. UnderstandthemechanicsofBondvaluation,and 3. Understandthemechanicsofvaluationofequityshares.

Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest paymentsreceivableoveraperiodoftime.Inotherwords,asecuritycanbedefinedasthepresent valueofthefuturecashstreamstheintrinsicvalueofanassetisequaltothepresentvalueofthe benefits associated with it. The expected returns (cash inflows) are discounted using the required returncommensuratewiththerisk.Mathematically,itcanberepresentedby:
1 2 3 n V0=C1/(1+i) +C2/(1+i) +C3/(1+i) +Cn/(1+i) n =Cn/(1+i)

WhereV0=Valueoftheassetattimezero(t=0) P0=Presentvalueoftheasset Cn=Expectedcashflowattheendofperiodn i=Discountrateorrequiredrateofreturnonthecashflows n=Expectedlifeofanasset.

Example: Assuming a discount rateof10%and thecashflows associated with2 projectsA and Bovera3 yearperiod,determinethevalueoftheassets.

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Year 1 2 3 Solution:

Cashflows Cashflows ofA(Rs.) ofB(Rs) 20000 20000 20000 10000 20000 30000

ValueofassetA=20000PVIFA(10%,3y) =20000*2.487 =Rs.49470 ValueofassetB=10000PVIF(10%,1)+20000PVIF(10%,2)+30000PVIF(10%,3) =10000*0.909+20000*0.826+30000*0.751 =9090+16520+22530 =Rs.48140 Example: CalculatethevalueofanassetiftheannualcashinflowisRs.5000peryearforthenext6yearsand thediscountrateis16%. Solution:
n Valueoftheasset=Cn/(1+i) 6 =5000/(1+0.16)

Or

=5000PVIFA(16%,6y) =5000*3.685 =Rs.18425

4.1.1ConceptsofValue Bookvalue:Bookvalueisanaccountingconcept.Valueiswhatanassetisworthtodayintermsof theirpotentialbenefits.Assetsarerecordedathistoricalcostandthesearedepreciatedoveryears. Bookvaluemayincludeintangibleassetsatacquisitioncostminusamortizedvalue.Thebookvalue ofadebtisstatedattheoutstandingamount.Thedifferencebetweenthebookvalueofassetsand liabilities is equal to the shareholders net worth. (Net worth is the sumtotalofpaidup capital and reservesandsurplus).Bookvalueofashareiscalculatedbydividingthenetworthbythenumberof sharesoutstanding.
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Replacementvalueistheamountacompanyisrequiredtospendifitweretoreplaceitsexisting assetsinthepresentcondition.Itisdifficulttofindcostofassetspresentlyusedbythecompany. Liquidationvalueistheamountacompanycanrealizeifitsoldtheassetsafterthewindingupofits business.Itwillnotincludethevalueofintangiblesastheoperationsofthecompanywillceaseto exist. Liquidation value is generally the minimum value the company might accept if it sold its business. Going concern value is theamount a company can realize if it sells its businessasanoperating one.Thisvalueishigherthantheliquidationvalue. Marketvalueisthecurrentpriceatwhichtheassetorsecurityisbeingsoldorboughtinthemarket. Marketvaluepershareisgenerallyhigherthanthebookvaluepershareforprofitableandgrowing firms. 4.2

ValuationofBonds

Bonds are long term debt instruments issued by government agencies or big corporate houses to raiselargesumsofmoney.Bondsissuedbygovernmentagenciesaresecuredandthoseissuedby privatesectorcompaniesmaybesecuredorunsecured.Therateofinterestonbondsisfixedand theyareredeemableafteraspecificperiod.Someimportanttermsinbondvaluation: Facevalue:Alsoknownasparvalue,thisisthevaluestatedonthefaceofthebond.Itrepresents theamountthattheunitborrowswhichistoberepaidatthetimeofmaturity,afteracertainperiodof time.AbondisgenerallyissuedatvaluessuchasRs.100orRs.1000. Couponrateisthespecifiedrateofinterestinthebond.Theinterestpayableatregularintervalsis theproductoftheparvalueandthecouponratebrokendowntotherelevanttimehorizon. Maturity period refers to the number of years after which the par value becomes payable to the bondholder.Generally,corporatebondshaveamaturityperiodof710yearsandgovernmentbonds 2025years. Redemptionvalueistheamountthebondholdergetsonmaturity.Abondmayberedeemedatpar, atapremium(bondholdergetsmorethantheparvalueofthebond)oratadiscount(bondholder getslessthantheparvalueofthebond).

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Marketvalueisthepriceatwhichthebondistradedinthestockexchange.Marketpriceistheprice at which the bonds can be bought and sold and this price may be different from par value and redemptionvalue. TypesofBonds Bondsareofthreetypes:(a)IrredeemableBonds(alsocalledperpetualbonds)(b)Redeemable Bonds(i.e.,Bondswith finitematurityperiod)and(c)ZeroCouponBonds. 4.2.1 IrredeemableBondsorPerpetualBonds Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies Actsrestrictstheissueofsuchbondsandthereforetheseareveryrarelyissuedbycorporatesthese days.Incaseofthesebondstheterminalvalueormaturityvaluedoesnotexistbecausetheyarenot redeemable.Thefacevalueisknowntheinterestreceivedonsuchbondsisconstantandreceived at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the intrinsicvalue)iscalculatedas: V0=I/id IfacompanyofferstopayRs.70asinterestonabondofRs.1000parvalue,andthecurrentyieldis 8%,thevalueofthebondis70/0.08whichisequalto Rs.875 4.2.2 RedeemableBonds: There are two types viz.,bonds withannual interestpaymentsandbonds with semiannual interest payments. Bondswithannualinterestpayments BasicBondValuationModel: The holder of a bond receives a fixed annual interest for a specified number of years and a fixed principalrepaymentatthetimeofmaturity.Theintrinsicvalueorthepresentvalueofbondcanbe expressedas:
n n n V0orP0= t=1 I/(I+kd) +F/(I+kd)

Whichcanalsobestatedasfolloows V0=I*PVIFA(kd,n)+F*PVIF(kd,n) WhereV0=Intrinsicvalueofthebond

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P0=PresentValueofthebond I=AnnualInterestpayableonthebond F=Principalamount(parvalue)repayableatthematuritytime n=Maturityperiodofthebond Kd=Requiredrateofreturn Example:AbondwhosefacevalueisRs.100hasacouponrateof12%andamaturityof5years. Therequiredrateofinterestis10%.Whatisthevalueofthebond? Solution: Interestpayable=100*12%=Rs.12 PrincipalrepaymentisRs.100 Requiredrateofreturnis10% V0=I*PVIFA(kd,n)+F*PVIF(kd,n) Valueofthebond=12*PVIFA(10%,5y)+100*PVIF(10%,5y) =12*3.791+100*0.621 =45.49+62.1 =Rs.107.59 Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years coupledwithanominalinterestrateof8%.Therequiredrateofreturnis10%.Whatisthepricehe shouldbewillingtopaynowtopurchasethebond? Solution: Interestpayable=1000*8%=Rs.80 PrincipalrepaymentisRs.1000 Requiredrateofreturnis10% V0=I*PVIFA(kd,n)+F*PVIF(kd,n)

Valueofthebond=80*PVIFA(10%,5y)+1000*PVIF(10%,5y) =80*3.791+1000*0.621 =303.28+621 =Rs.924.28

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ThisimpliesthatthecompanyisofferingthebondatRs.1000butisworthRs.924.28attherequired rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond today. BondValueswithSemiAnnualInterestpayment: Inreality,itisquitecommontopayinterestonbondssemiannually.Withtheeffectofcompounding, the value of bonds with semiannual interest is much more than the ones with annual interest payments.Hence,thebondvaluationequationcanbemodifiedas:
n n 2n V0orP0= t=1 I/2/(I+id/2) +F/(I+id/2)

WhereV0=Intrinsicvalueofthebond P0=PresentValueofthebond I/2=SemiannualInterestpayableonthebond F=Principalamount(parvalue)repayableatthematuritytime 2n=Maturityperiodofthebondexpressedinhalfyearlyperiods kd/2=Requiredrateofreturnsemiannually. Example:AbondofRs.1000valuecarriesacouponrateof10%,maturityperiodof6years.Interest ispayablesemiannually.Iftherequiredrateofreturnis12%,calculatethevalueofthebond. Solution:

n n 2n V0orP0= t=1 (I/2)/(I+kd/2) +F/(I+kd/2) 6 6 =(100/2)/(1+0.12/2) +1000/(1+0.12/2)

=50*PVIFA(6%,12y)+1000*PVIF(6%,12y) =50*8.384+1000*0.497 =419.2+497 =Rs.916.20 Itistobekeptinmindthattherequiredrateofreturnishalved(12%/2)andtheperioddoubled(6y*2) astheinterestispaidsemiannually. 4.2.3 ValuationofZeroCouponBonds. InIndiaZerocouponbondsarealternativelyknownasDeepDiscountBonds. Forclosetoa decade,thesebondsbecameverypopularinIndiabecauseofissuanceofsuchbondsatregular intervalsbyIDBIandICICI. Zerocouponbondshavenocouponrate,i.e.thereisnointeresttobe

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paidout.Instead,thesebondsareissuedatadiscounttotheirfacevalue,andthefacevalueisthe amountpayabletotheholderoftheinstrumentonmaturity.Thedifferencebetweenthediscounted issuepriceandfacevalueiseffectiveinterestearnedbytheinvestor.Theyarecalleddeepdiscount bondsbecausethesebondsarelongtermbondswhosematurity sometimeextendsupto25to30years. Example: RiverValleyAuthorityissuedDeepDiscountBondofthefacevalueofRs.1,00,000payable25years later,atanissuepriceofRs.14,600.Whatistheeffectiveinterestrateearnedbyaninvestorfrom thisbond? Solution: Thebondinquestionisazerocouponordeepdiscountbond.Itdoesnotcarryanycouponrate. Therefore,theimpliedinterestratecouldbecomputedasfollows: Step1. PrincipalinvestedtodayisRs.14600atarateofinterestofr%over25yearstoamountto Rs.1,00,000.
n Step2. Itcanbestatedas A=P0(1+r) 25 1,00,000=14,600(1+r)

Solvingforr,weget

25 1,00,000/14600=(1+r) 25 6.849 =(1+r)

Readingthecompoundvalue(FVIF)table,horizontallyalongthe25yearline,wefindrequals8%. Therefore,bondgivesaneffectivereturnof8%perannum.

4.2.4

BondyieldMeasures

4.2.4.1 CurrentYield: Current yield measures the rate of return earned ona bond if it ispurchasedat its current market priceandthecouponinterestreceived. CurrentYield=CouponInterest/CurrentMarketPrice Example: Continuing with thesame example above calculate the CY ifthe current market price is Rs.920

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Solution: CY=CouponInterest/CurrentMarketPrice =80/920 =8.7% 4.2.4.2YieldtoMaturity(YTM) Itistherateearnedbyaninvestorwhopurchasesabondandholdsittillitsmaturity.TheYTMisthe discountrateequalingthepresentvaluesofcashflowstothecurrentmarketprice. Example:AbondhasafacevalueofRs.1000witha5yearmaturityperiod.Itscurrentmarketprice isRs.883.4.Itcarriesaninterestrateof6%.Whatshallbetherateofreturnonthisbondifitisheld tillitsmaturity?

Solution:
n n n V0orP0= t=1 I/(I+kd) +F/(I+kd)

OR V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =60*PVIFA(Kd,10)+1000*PVIF(Kd,10)=883.4 Weobtain10%forkd Example:AbondhasafacevalueofRs.1000witha9yearmaturityperiod.Itscurrentmarketprice isRs.850.Itcarriesaninterestrateof8%.Whatshallbetherateofreturnonthisbondifitisheldtill itsmaturity? Solution:

n n n V0orP0= t=1 I/(I+kd) +F/(I+kd)

OR V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =80*PVIFA(Kd%,9)+1000*PVIF(Kd%,9)=850 TofindoutthevalueofKd,trialanerrormethodistobefollowed.Letusthereforestartthevalueof Kdtobe12%andtheequationnowlookslike =80*PVIFA(12%,9)+1000*PVIF(12%,9)=850 LetusnowseeifLHSequalsRHSatthisrateof12%.LookingatthetableswegetLHSas

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80*5.328+1000*0.361=Rs.787.24 SincethisvalueislessthanthevaluerequiredontheRHS,wetakealesserdiscountrateof10%.At 10%,theequationis =80*PVIFA(10%,9)+1000*PVIF(10%,9)=850 LetusnowseeifLHSequalsRHSatthisrateof11%.LookingatthetableswegetLHSas 80*5.759+1000*0.424=Rs.884.72 WenowunderstandthatKdclearlyliesbetween10%and12%.Weshallinterpolatetofindoutthe truevalueofKd. 10%+{(884.72850)/(884.72787.24)}*(12%10%) 10%+(34.72/97.48)*2 10%+0.71 ThereforeKd=10.71% Anapproximation:ThefollowingformulamaybeusedtogetaroughideaaboutKdasTrialand ErrorMethodisaverytediousprocedureandrequireslotsoftime.Thisformulacanbeusedasa readyreferenceformula. YTM={I+(FP)/n}/{(F+P)/2} WhereYTM=YieldtoMaturity I=Annualinterestpayment F=Facevalueofthebond P=Currentmarketpriceofthebond n=Numberofyearstomaturity. Example:Acompanyissuesabondwithafacevalueof5000.ItiscurrentlytradingatRs.4500.The interestrateofferedbythecompanyis12%andthebondhasamaturityperiodof8years.Whatis YTM? Solution: YTM={I+(FP)/n}/{(F+P)/2} =600+{(50004500)/8}/{(5000+4500)/2} ={600+62.5}/4750 =13.94%

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4.2.5 BondValueTheorems Thefollowingfactorsaffectthebondvalues: Relationshipbetweentherequiredrateofinterest(Kd)andthediscountrate. Numberofyearstomaturity. YTM

Relationshipbetweentherequiredrateofinterest(Kd)andthediscountrate: WhenKdisequaltothecouponrate,theintrinsicvalueofthebondisequaltoitsfacevalue,that is,ifKd=couponrate,thenvalueofbond=facevalue. When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face value,thatis,ifKd>couponrate,thenvalueofbond<facevalue. When Kd is lesser thanthe coupon rate,the intrinsic value of thebond is greater than itsface value,thatis,ifKd<couponrate,thenvalueofbond>facevalue. Example:SugamindustrieswishestoissuebondswithRs.100asparvalue,couponrate12%an YTM5years.Whatisthevalueofthebondiftherequiredrateofreturnofaninvestoris12%,14% and10% IfKdis12%, V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =12*PVIFA(12%,5)+100*PVIF(12%,5) =12*3.605+100*0.567 =43.26+56.7 =Rs.99.96orRs.100 IfKdis14%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =12*PVIFA(14%,5)+100*PVIF(14%,5) =12*3.433+100*0.519 =41.20+51.9 =Rs.93.1 IfKdis10%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =12*PVIFA(10%,5)+100*PVIF(10%,5) =12*3.791+100*0.621 =45.49+62.1 =Rs.107.59
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Numberofyearstomaturity When Kd is greater than the coupon rate, the discount on the bond declines as maturity approaches. When Kd is less than the coupon rate, the premium on the bond declines as maturity approaches. To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a couponrateof11%andamaturityof7years. IfKdis13%,then,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(13%,7)+100*PVIF(13%,7) =11*4.423+100*0.425 =48.65+42.50 =Rs.91.15 After1year,thematurityperiodis6years,thevalueofthebondis V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(13%,6)+100*PVIF(13%,6) =11*3.998+100*0.480 =43.98+48 =Rs.91.98. Weseethatthediscountonthebondgraduallydecreasesandvalueofthebondincreaseswiththe passageoftimeatKdbeingahigherratethanthecouponrate. Continuingwiththesameexampleabove,letusseetheeffectonthebondvalueifrequiredrateis 8%. IfKdis8%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(8%,7)+100*PVIF(8%,7) =11*5.206+100*0.583 =57.27+58.3 =Rs.115.57 Oneyearlater,Kdat8%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n) =11*PVIFA(8%,6)+100*PVIF(8%,6) =11*4.623+100*0.630

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=50.85+63 =Rs.113.85 Forarequiredrateofreturnof8%,thebondvaluedecreaseswithpassageoftimeandpremiumon bonddeclinesasmaturityapproaches. YTM:YTMdeterminingthemarketvalueofthebond,thebondpricewillfluctuatetothechangesin marketinterestrates.AbondspricemovesinverselyproportionaltoitsYTM. 4.3

ValuationofShares

Acompanyssharesmaybecategorizedas(a)OrdinaryorEquitysharesand(b)Preferenceshares. Thereturnstheseshareholdersgetarecalleddividends.Preferenceshareholdersgetapreferential treatmentastothepaymentofdividendandrepaymentofcapitalintheeventofwindingup.Such holdersareeligibleforafixedrateofdividends.Someimportantfeaturesofpreferenceandequity shares. Dividends:Rateisfixedforpreferenceshareholders.Theycanbegivencumulativerights,that is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity shareholders.Theychangewithanincreaseordecreaseinprofits.Duringyearsofbigprofits,the management may declare a high dividend. The dividends are not cumulative for equity shareholders, that is, they cannot be accumulated and distributed in later years. Dividendsare nottaxable. Claims: In the event of the business closing down, the preference shareholders have a prior claimontheassetsofthecompany.Theirclaimsshallbesettledfirstandthebalanceifanywill be paid off to equity shareholders. Equity shareholders are residual claimants to the company incomeandassets. Redemption: Preference shares have a maturity dateon which day the company pays off the facevalueofthesharetotheholders.Preferencesharescanbeoftwotypesredeemableand irredeemable. Irredeemable preference shares are perpetual. Equity shareholders have no maturitydate. Conversion: A company can issue convertible preference shares and not vice versa. After a particular period as mentioned in the share certificate, thepreference shares canbeconverted intoordinaryshares.

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4.3.1 ValuationofPreferenceShares: Preference shares, like bonds carry a fixed rate of dividend/return. Symbolically, this can be expressedas:
n n P0=Dp/{1+Kp) }+Pn/{(1+Kp) }

OR P0= Dp*PVIFA(Kp,n)+Pn*PVIF(Kp,n) WhereP0=Priceoftheshare Dp=Dividendonpreferenceshare Kp=Requiredrateofreturnonpreferenceshare n=Numberofyearstomaturity 4.4

ValuationofOrdinaryShares

Peopleholdcommonstocksfortworeasonstoobtaindividendsinatimelymannerandtogeta higheramountwhensold.Generally,sharesarenotheldinperpetuity.Aninvestorbuystheshares, holdsthemforsometimeduringwhichhegetsdividendsandfinallysellsitofftogetcapitalgains. Thevalueofasharewhichaninvestoriswillingtopayislinkedwiththecashinflowsexpectedand risksassociatedwiththeseinflows.Intrinsicvalueofashareisassociatedwiththeearnings(past) andprofitability(future)ofthecompany,dividendspaidandexpectedandfuturedefiniteprospectsof the company. It is the economic value of a company considering its characteristics, nature of businessandinvestmentenvironment. 4.4.1 DividendCapitalizationModel Whenashareholderbuysashare,heisactuallybuyingthestreamoffuturedividends.Thereforethe valueofanordinaryshareisdeterminedbycapitalizingthefuturedividendstreamatanappropriate rate of interest. So under the dividend capitalization approach, the value of an equity share is the discountedpresentvalueofdividendsreceivedplusthepresentvalueoftheresalepriceexpected whentheshareisdisposed.Twoassumptionsaremadetoapplythisapproach: Dividendsarepaidannually. Firstpaymentofdividendismadeafteroneyeartheequityshareisbought.

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4.4.1.1 Singleperiodvaluationmodel Thismodelholdswellwhenaninvestorholdsanequityshareforoneyear.Thepriceofsuchashare willbe: P0= D1 + P1 (1+Ke)(1+Ke) WhereP0=Currentmarketpriceoftheshare D1=Expecteddividendafteroneyear P1=Expectedpriceoftheshareafteroneyear Ke=Requiredrateofreturnontheequityshare Example:GammonIndiaLtd.sshareisexpectedtotouchRs.450oneyearfromnow.Thecompany isexpectedtodeclareadividendofRs.25pershare.Whatisthepriceatwhichaninvestorwouldbe willingtobuyifhisrequiredrateofreturnis15%? Solution: P0=D1/(1+Ke)+P1/(1+Ke) {25/(1+0.15)}+{450/(1+0.15)} =21.74+391.30 =Rs.413.04isthepriceheiswillingtopaytoday

4.4.1.2 Multiperiodvaluationmodel: Anequitysharecanbeheldoranindefiniteperiodasit hasnomaturitydate,inwhichcasethevalueofapriceattimezerois:

1 2 3 P0=D1/(1+Ke) +D2/(1+Ke) +D3/(1+Ke) +..+D/(1+Ke)

Or

P0= t=1

Dn

n {(1+Ke) }

WhereP0=Currentmarketpriceoftheshare D1=Expecteddividendafteroneyear P1=Expectedpriceoftheshareafteroneyear D=Expecteddividendatinfiniteduration Ke=Requiredrateofreturnontheequityshare. Theaboveequationcanalsobemodifiedtofindthevalueofanequityshareforafiniteperiod.

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1 2 3 n P0=D1/(1+Ke) +D2/(1+Ke) +D3/(1+Ke) +..+D/(1+Ke) +Pn/(1+Ke) n n =P0= t=1Dn/{(1+Ke) }+Pn/(1+Ke)

Unit4

Wecancomeacrossthreeinstancesofdividendsincompanies: Constantdividends Constantgrowthofdividends Changinggrowthratesofdividends.

Valuation with constant dividends: If constant dividends are paid year after year, then
1 2 3 P0=D1/(1+Ke) +D2/(1+Ke) +D3/(1+Ke) +..+D/(1+Ke)

SimplifyingthiswegetP=D/Ke Valuation with constant growth in dividends: Here we assume that dividends tend to increase with time as and when businesses grow over time. If the increase in dividend is at a constant compoundrate,thenP0=D1/Keg,wheregstandsforgrowthrate. Example:Sagarautomobilesltd.sshareistradedatRs.180.Thecompanyisexpectedtogrowat 8%perannumandthedividendexpectedtobepaidoffisRs.8.Iftherateofreturnisexpectedtobe 12%,whatisthepriceoftheshareonewouldbeexpectedtopaytoday? Solution: P0=D1/Keg =8/0.120.08 =Rs.200. Example:MonicalabsisexpectedtopayRs.4asdividendpersharenextyear.Thedividendsare expected to grow perpetually@8%. Calculate the share price today if the market capitalization is 12%. Solution: P0=D1/Keg P0=4/(0.120.08) =Rs.100 Valuationwithvariablegrowthindividends:Somefirmsmaynothaveaconstantgrowthrateof dividendsindefinitely.Thereareperiodsduringwhichthedividendsmaygrowsupernormally,thatis, thegrowthrateisveryhighwhenthedemandforthecompanysproductsisveryhigh.Afteracertain periodoftime,thegrowthratemayfalltonormallevelswhenthereturnsfallduetofallindemandfor

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products(withcompetitionsettinginorduetoavailabilityofsubstitutes).Thepriceoftheequityshare ofsuchafirmisdeterminedinthefollowingmanner: Step1.Expected dividendflowsduringperiodsof supernormal growth is tobe considered and presentvalueofthisistobecomputedwiththefollowingequation:
n P0= t=1 Dn/(1+Ke)

Valueoftheshareattheendoftheinitialgrowthperiodiscalculatedas: Pn=(Dn+1)/(Kegn)(constantgrowthmodel).Thisisdiscountedtothepresentvalueandwe get:

n (Dn+1)/(Kegn)*1/(1+Ke) Add both the present value composites to find the value P0 of the share, that is, P0= t=1 n n Dn/(1+Ke) +(Dn+1)/(Kegn)*1/(1+Ke)

Example: Souparnika Pharmas currentdividend is Rs. 5.It expects to have a supernormalgrowth periodrunningto5yearsduringwhichthegrowthratewouldbe25%.Thecompanyexpectsnormal growth rate of 8% after the period of supernormal growth period. The investors required rate of returnis15%.Calculatewhatthevalueofoneshareofthiscompanyisworth. Solution:D0=5,n=5y,ga(supernormalgrowth)=25%,gn(normalgrowth)=8%,Ke=14%
n StepI:P0= t=1 Dn/(1+Ke) 1 D1=5(1.25) 2 D2=5(1.25) 3 D3=5(1.25) 4 D4=5(1.25) 5 D5=5(1.25)

Thepresentvalueofthisflowofdividendswillbe:
2 2 3 3 4 4 5 5 5(1.25)/(1.15)+5(1.25) /(1.15) +5(1.25) /(1.15) +5(1.25) /(1.15) +5(1.25) /(1.15)

5.43+5.92+6.42+6.98+7.63=32.38

StepII:Pn=(Dn+1)/(Keg) P5=D6/Kegn =D5(1+gn)/Kegn

5 ={5(1.25) (1+0.08)}/(0.150.08)

=15.26(1.08)/0.07
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=16.48/0.07 =235.42
5 Thediscountedvalueofthispriceis235.42/(1.15) =Rs.117.12 n n StepIII:P0= t=1 Dn/(1+Ke) +(Dn+1)/(Kegn)*1/(1+Ke)

ThevalueoftheshareisRs.32.38+Rs.117.12=Rs.149.50 Otherapproachestoequityvaluation In addition to thedividend valuation approachesdiscussed in the previous section, there areother approachestovaluationofsharesbasedonRatioApproach. Bookvalueapproach:Thebookvaluepershare(BVPS)isthenetworthofthecompanydividedby thenumberofoutstandingequityshares.Networthisrepresentedbythesumtotalofpaidupequity shares,reservesandsurplus.Alternatively,thiscanalsobecalculatedastheamountpershareon the sale of the assets of the company at their exact book value minus all liabilities including preferenceshares. Example: AOneLtd.hastotalassetsworthRs.500Cr.,liabilitiesworthRs.300Cr.,andpreferenceshares worthRs.50Cr.andequitysharesnumbering10lakhsTheBVPSisRs.150Cr/10lakhs=R.150 BVPS does not give a true investment picture. This relies on historical book values than the companysearningpotential. Liquidationvalue:Theliquidationvaluepershareiscalculatedas: {(Valuerealizedbyliquidatingallassets)(AmounttobepaidtoallCrsandPreSH)}divided byNumberofoutstandingshares. Intheaboveexample,iftheassetscanbeliquidatedatRs.450Cr.,theliquidationvaluepershareis (450Cr350Cr)/10lakhshareswhichisequaltoRs.1000pershare.

4.4.2 PriceEarningsRatio:Thepriceearningsratioreflectstheamountinvestorsarewillingto payforeachrupeeofearnings. Expected earning per share = (Expected PAT) (Preference dividend) / Number of outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit

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margin,depreciationandinterestandtaxrate.TheP/Eratioisalsotoconsiderfactorslikegrowth rate,stabilityofearnings,companysize,companymanagementteamanddividendpayoutratio. P/Eratio=(1b)/r(ROE*b) Where1bisdividendpayoutratio risrequiredrateofreturn ROE*bisexpectedgrowthrate. SelfAssessmentQuestions1 1. ______________________istheminimumvaluethecompanyacceptsifitsolditsbusiness. 2. ______________per share is generallyhigher than the book valueper shareforprofitableand growingfirms. 3. Bondsissuedby____________aresecuredandthoseissuedbyprivatesectorcompaniesmay be_________or___________. 4. ___________istherateearnedbyaninvestorwhopurchasesabondandholdsittillitsmaturity. 5. WhenKdislesserthanthecouponrate,thevalueofthebondis_________thanitsfacevalue. 6. ___________of a share is associated with the earnings (past) and profitability (future) of the company,dividendspaidandexpectedandfuturedefiniteprospectsofthecompany. 7. The _______________is the net worth of the company divided by the number of outstanding equityshares.

4.5

Summary

Valuationistheprocesswhichlinkstheriskandreturntoestablishtheassetworth.Thevalueofa bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a periodoftime.Thediscountrateistherateofreturnwhichtheinvestorsexpectfromthesecurities. In case of bonds, the stream of cash flows consists of annual interest payment and repayment of principal(whichmaytakeplaceatpar,atapremiumoratadiscount).Thecashflowswhichoccurin eachyearisafixedamount. Cashflowsforpreferencesharearealsoafixedamountandthesesharesmayberedeemedatpar, atapremiumoratadiscount. The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits. Thereforetheriskofholdinganequityshareishigherthanholdingapreferenceshareorabond.
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Solvedproblems 1. ThecurrentpriceofaAshokLeylandshareisRs.30.Thecompanyisexpectedtopayadividend of Rs. 2.50 per share which goes up annually at 6%. If an investors required rate of return is 11%,shouldhebuythisshareornot?Advise. Solution:P=D1(1+g)/Keg=2.5(1+0.06)/0.110.06=Rs.53.Theinvestorshouldcertainly buythisshareatthecurrentpriceofRs.30asthevaluationmodelsaystheshareisworthRs. 53. 2. A bond withaface value of Rs. 100 providesan annual return of8%andpays Rs. 125 at the timeofmaturity,whichis10yearsfromnow.Iftheinvestorsrequiredrateofreturnis12%,what shouldbethepriceofthebond? Solution:P=Int*PVIFA(12%,10y)+Redemptionprice*PVIF(12%,10y) =8*PVIFA(12%,10y)+125*PVIF(12%,10y) =8*5.65+125*0.322 =45.2+40.25=Rs.85.45 ThepriceofthebondshouldbeRs.85.45 3. ThebondofSiliconEnterpriseswithaparvalueofRs.500iscurrentlytradedatRs.435.The couponrateis12%withamaturityperiodof7years.Whatwillbetheyieldtomaturity? Solution:r=I+{(FP)/n}/(F+P)/2 =60+{(500435)/7}/(500+435)/2 =15.03% 4. The share of Megha Ltd is sold at Rs. 500 a share. The dividend likely to be declared by the companyisRs.25pershareafteroneyearandthepriceoneyearhenceisexpectedtobeRs. 550.Whatisthereturnattheendoftheyearonthebasisoflikelydividendandpricepershare? Solution:Holdingperiodreturn=(D1+Pricegain/loss)/purchaseprice =(25+50)/500=15% 5. AbondoffacevalueofRs.1000andamaturityof3yearspays15%interestannually.Whatis themarketpriceofthebondifYTMisalso15%? Solution:P=Int*PVIFA(15%,3y)+Redemptionvalue*PVIF(15%,3y) P=150*2.283+1000*0.658 P=342.45+658=Rs.1000.45
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1. AperpetualsharepaysanannualdividendofRs.15onafacevalueofRs.100andtherateof returnrequiredbyinvestorsonsuchinvestmentsis20%.Whatshouldbethemarketpriceofthe preferenceshare? Solution:Expectedyield=Expectedincome/currentmarketprice Expectedyield=15/0.2=Rs.75

TerminalQuestions
1. WhatshouldbepriceofabondwhichhasaparvalueofRs.1000carryingacouponrateof8% andhavingamaturityperiodof9years?Therequiredrateofreturnoftheinvestoris12%. 2. A bond of Rs.1000 value carriesa coupon rate of10% and has a maturity period of6 years. Interestispayablesemiannually.Iftherequiredrateofreturnis12%,calculatethevalueofthe bond. 3. AbondwhoseparvalueisRs.500bearingacouponrateof10%andhasamaturityof3years. Therequiredrateofreturnis8%.Whatshouldbethepriceofthebond? 4. IfthecurrentyearsdividendisRs.24,growthrateofacompanyis10%andtherequiredreturn onthestockis16%,whatistheintrinsicvalueofthestock? 5. IfastockispurchasedforRs.120andheldforoneyearduringwhichtimeRs.15dividendper shareispaidandthepricedecreasestoRs.115,whatisthenominalreturnontheshare? AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Liquidationvalue 2. Marketvalue 3. Governmentagencies,securedorunsecured 4. YieldtoMaturity 5. Greater 6. Intrinsicvalue 7. Bookvaluepershare(BVPS)

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AnswerstoTerminalQuestions 1. P=Int*PVIFA(12%,9y)+Redemptionprice*PVIF(12%,10y) 80*PVIFA(12%,9)+1000*PVIF(12%,9y) 80*5.328+1000*0.361 426.24+361=Rs.787.24 2. 50*PVIFA(6%+12y)+1000*PVIF(12%,6y) 50*8.384+1000*0.497 Rs.916.2 3. P=Int*PVIFA(8%,3y)+Redemptionprice*PVIF(6%+12y) 50*2.577+500*0.794 128.85+397=Rs.525.85 4. Intrinsicvalue=24{(1+0.1)}/0.160.1=Rs.440 5. Holdingperiodreturn=(D1+Pricegain/loss)/purchaseprice {15+(5)}/120=8.33%

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