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Chapter 7

VALUATION OF BONDS AND STOCKS


1.
P =

t=1

11

100
+

(1.15)t

(1.15)5

= Rs.11 x PVIFA(15%, 5 years) + Rs.100 x PVIF (15%, 5 years)


= Rs.11 x 3.352 + Rs.100 x 0.497
= Rs.86.7
2.(i)

When the discount rate is 14%


7
12
100
P =
+
t=1
(1.14) t (1.14)7
= Rs.12 x PVIFA (14%, 7 years) + Rs.100 x PVIF (14%, 7 years)
= Rs.12 x 4.288 + Rs.100 x 0.4
= Rs.91.46

(ii)

When the discount rate is 12%


7
12
100
P =
+
= Rs.100
t
7
t=1
(1.12)
(1.12)

Note that when the discount rate and the coupon rate are the same the value is
to par value.
3.

equal

The yield to maturity is the value of r that satisfies the following equality.
7 120
1,000
Rs.750 =
+
t
t=1 (1+r)
(1+r)7
Try r = 18%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (18%, 7 years) + Rs.1,000 x PVIF (18%, 7 years)
=
Rs.120 x 3.812 + Rs.1,000 x 0.314
=
Rs.771.44
Try r = 20%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (20%, 7 years) + Rs.1,000 x PVIF (20%, 7 years)
= Rs.120 x 3.605 + Rs.1,000 x 0.279
= Rs.711.60
Thus the value of r at which the RHS becomes equal to Rs.750 lies between 18% and

20%.

Using linear interpolation in this range, we get


771.44 750.00
Yield to maturity = 18% + 771.44 711.60

x 2%

= 18.7%
4.
80 =

10 14
100

+
t=1 (1+r) t
(1+r)10

Try r = 18%. The RHS of the above equation is


Rs.14 x PVIFA (18%, 10 years) + Rs.100 x PVIF (18%, 10 years)
=
Rs.14 x 4.494 + Rs.100 x 0.191 = Rs.82
Try r = 20%. The RHS of the above equation is
Rs.14 x PVIFA(20%, 10 years) + Rs.100 x PVIF (20%, 10 years)
= Rs.14 x 4.193 + Rs.100 x 0.162
= Rs.74.9
Using interpolation in the range 18% and 20% we get:
Yield to maturity

82 - 80
= 18% + ----------- x 2%
82 74.9
= 18.56%

4.
P =

12

t=1

100
+

(1.08) t

(1.08)12

= Rs.6 x PVIFA (8%, 12 years) + Rs.100 x PVIF (8%, 12 years)


= Rs.6 x 7.536 + Rs.100 x 0.397
= Rs.84.92

5.

The post-tax interest and maturity value are calculated below:


Bond A

Bond B

Post-tax interest (C )

12(1 0.3)
=Rs.8.4

Post-tax maturity value (M) 100 [ (100-70)x 0.1]


=Rs.97

10 (1 0.3)
=Rs.7
100 [ (100 60)x 0.1]
=Rs.96

The post-tax YTM, using the approximate YTM formula is calculated below
Bond A :

Post-tax YTM =
=

Bond B :

Post-tax YTM =
=

8.4 + (97-70)/10
-------------------0.6 x 70 + 0.4 x 97
13.73%
7 + (96 60)/6
---------------------0.6x 60 + 0.4 x 96
17. 47%

6.
P =

14

t=1

100
+

(1.08) t

(1.08)14

= Rs.6 x PVIFA(8%, 14) + Rs.100 x PVIF (8%, 14)


= Rs.6 x 8.244 + Rs.100 x 0.341
= Rs.83.56
7.

Do = Rs.2.00, g = 0.06, r = 0.12


Po = D1 / (r g) = Do (1 + g) / (r g)
=
=

Rs.2.00 (1.06) / (0.12 - 0.06)


Rs.35.33

Since the growth rate of 6% applies to dividends as well as market price, the market
price at the end of the 2nd year will be:

9.

P2

=
=

Po x (1 + g)2 = Rs.35.33 (1.06)2


Rs.39.70

Po

=
=

D1 / (r g)
=
Do (1 + g) / (r g)
Rs.12.00 (1.10) / (0.15 0.10)
=

Rs.264

10.

11.

Po

D1 / (r g)

Rs.32 =
g
=

Rs.2 / (0.12 g)
0.0575 or 5.75%

Po
Do
So
8

D1/ (r g) = Do(1+g) / (r g)
Rs.1.50, g = -0.04, Po = Rs.8

=
=

= 1.50 (1- .04) / (r-(-.04)) = 1.44 / (r + .04)

Hence r = 0.14 or 14 per cent


12.

The market price per share of Commonwealth Corporation will be the sum of three
components:
A:
B:
C:

Present value of the dividend stream for the first 4 years


Present value of the dividend stream for the next 4 years
Present value of the market price expected at the end of 8 years.

A=

1.50 (1.12) / (1.14) + 1.50 (1.12)2 / (1.14)2 + 1.50(1.12)3 / (1.14)3 +


+ 1.50 (1.12)4 / (1.14)4
=
=

B=

1.68/(1.14) + 1.88 / (1.14)2 + 2.11 / (1.14)3 + 2.36 / (1.14)4


Rs.5.74

2.36(1.08) / (1.14)5 + 2.36 (1.08)2 / (1.14)6 + 2.36 (1.08)3 / (1.14)7 +


+ 2.36 (1.08)4 / (1.14)8
=
=

2.55 / (1.14)5 + 2.75 / (1.14)6 + 2.97 / (1.14)7 + 3.21 / (1.14)8


Rs.4.89

P8 / (1.14)8
P8 = D9 / (r g) =

3.21 (1.05)/ (0.14 0.05) = Rs.37.45

So
C

Thus,
Po
=
=
13.

Rs.37.45 / (1.14)8 = Rs.13.14


A + B + C = 5.74 + 4.89 + 13.14
Rs.23.77

Let us assume a required rate of return of 12 percent. The intrinsic value of the equity
share will be the sum of three components:

A:

Present value of the dividend stream for the first 5 years when the
growth rate expected is 15%.

B:

Present value of the dividend stream for the next 5 years when the
growth rate is expected to be 10%.

C:

Present value of the market price expected at the end of 10 years.

A=

2.00 (1.15) 2.00 (1.15)2 2.00 (1.15)3 2.00(1.15)4 2.00 (1.15)5


------------- + ------------- +-------------- + ------------- + ------------(1.12)
(1.12)2
(1.1.2)3
(1.1.2)4
(1.12)5

=
=

2.30 / (1.12) + 2.65 / (1.12)2 + 3.04 / (1.12)3 + 3.50 / (1.12)4 + 4.02/(1.12)5


Rs.10.84

B=

4.02(1.10) 4.02 (1.10)2 4.02(1.10)3 4.02(1.10)4 4.02 (1.10)5


------------ + ---------------- + ------------- + --------------- + --------------(1.12)6
(1.12)7
(1.12)8
(1..12)9 (1.12)10

4.42
--------(1.12)6

Rs.10.81

C=
=

4.86
5.35
5.89
6.48
+ -------------- + --------------- + ------------- + ------------(1.12)7
(1.12)8
(1.1.2)9 (1.12)10

D11
1
6.48 (1.05)
-------- x --------------- = ------------------- x 1/(1.12)10
rg
(1 +r)10
0.12 0.05
Rs.97.20

The intrinsic value of the share = A + B + C


=
10.84 + 10.81 + 97.20 =
Rs.118.85
14.

Terminal value of the interest proceeds


=
140 x FVIFA (16%,4)
=
140 x 5.066
=
709.24
Redemption value = 1,000
Terminal value of the proceeds from the bond = 1709.24
Define r as the yield to maturity. The value of r can be obtained from the equation
900 (1 + r)4

= 1709.24

r
15.

= 0.1739 or 17.39%

Intrinsic value of the equity share (using the 2-stage growth model)
(1.18)6
2.36 x
1 - ----------2.36 x (1.18)5 x (1.12)
(1.16)6
=
--------------------------------- + ----------------------------------0.16 0.18
(0.16 0.12) x (1.16)6

16.

2.36 x

Rs.74.80

- 0.10801
----------- + 62.05
- 0.02

Intrinsic value of the equity share (using the H model)


=

4.00 (1.10)
4.00 x 4 x (0.10)
-------------- + --------------------0.18 0.10
0.18 0.10

=
=

55 + 20
Rs.75

17.
Po =

Po
=

D1
rg
Rs. 8

Rs. 266.7

0.15-0.12
Po =

E1
r

+ PVGO

Po =

Rs. 20 +
PVGO
0.15
Rs. 266.7 = Rs. 133.3 + PVGO

So, PVGO = Rs. 133.4