In finance, valuation is the process of determining the present value (PV) of an asset.

Valuations can be done on

Security Valuation
assets (for example, investments in marketable securities such as stocks, options, business enterprises, or
5 intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company).
Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition
Old New
transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
Syllabus Syllabus

Overview Return Concepts Valuation Equity Valuation Preference Valuation Bond Valuation

Dividend Based Single Period Holding

Redeemable Irredeemable
Required Rate of Return Discount Rate Internal Rate of Return Multi Period Holding
No Growth Constant Growth

1. Required rate of return is 1. Discount Rate is the rate at which present value of future 1. The internal rate of return Two Stage
the minimum rate of return cash flows is determined.
Model
sometime known as yield on
that the investor is expected 2. Discount rate is normally the required rate of return project is the rate at which Three Stage
to receive while making an which is also called as cost of capital an investment project Model
investment in an asset over promises to generate a
a specified period of time.
(1+ Nominal Rate) = (1+ Real Rate)(1+Inflation rate) return during its useful life.
Gordon’s
2. T h i s i s a l s o c a l l e d We can form some principle based on the above formula
2. It is the discount rate at Earnings Based Growth Model
Walters Model PE Multiple
opportunity cost or cost of which
11
1. If projected cash flows are in real terms, the discount rate
capital because it is the PV of CIF = PV of COF

highest level of expected used should be real discount rate.

MP = EPS x PE Multiple
Or

return forgone which is 2. If projected cash flows are in money terms, the discount Convertible Bonds
NPV=0
available elsewhere from rate used should be money discount rate.

investment of similar risks.

Market Market Market Cash & 1. Conversion Ratio:

3. Where there are more than one inflation rates, then Situation Result Minority
3. Many times, required rate of Enterprise Value = Value of + Value of + Value of + - Cash The number of shares each convertible bond
convert the cash flows in which the discount rate is.
Interest
return and expected return Equity Preference Debt Equivalent converts into. It may be expressed per bond.

IRR > Ko Acceptable

are used interchangeably. 4. The depreciation charge remains the same irrespective of
But, that is not the case. the inflation rate and hence it should be considered as EV Multiple 2. Conversion Value:
IRR < Ko Not Acceptable
CV= Market price per share x Conversion
Zero Inflation item. Ratio

= Net
Capital Asset Pricing Model is Capital 🔺 Non Cash New Debt Debt
used widely to calculate Cash Flows Discount Stock Valuation Cash Flow Based FCFE +
Income Depreciation - - +
Expenditure Working Capital Issued
- Repayment 75+50-20-5+15-10 = 105
3. Conversion Premium:

required Return on Equity Rate The amount by which the price of a

Stock is undervalued as it is
Expected Return > EBITDA Capital 🔺 Non Cash convertible security exceeds the current
Equity Ke Buy expected that return will be FCFF
Based on = EBITDA*(1-tax) + Depreciation*(tax) - Expenditure - 260*(1-0.50)*+50*(0.50)-20-5=130
Working Capital market value of the common stock into
CAPM Return higher than required.
Preference Kp Capital 🔺 Non Cash which it may be converted.

Based on EBIT = EBIT*(1-tax) + Depreciation - Expenditure - 210*(1-0.50)+50-20-5=130 CP = MP - CV

where
Working Capital
Stock is correctly valued
Rx = expected return on Debt Kd(1-t) Expected Return = MP = Market Price of Convertible Bond

Hold hence we should hold and Capital 🔺 Non Cash

investment in "x"(company x)
CAPM Return Based on EAT = EAT+ Interest*(1-tax) + Depreciation - Expenditure - 75+60*(1-0.50)-20-5=130 CV = Conversion Value

Bonds YTM wait to buy or sell in future. Working Capital

CA Mayank Kothari
Rf = risk-free rate of return

βx = beta of "x"
= FCFE + Interest*(1-tax) + New Debt Preference 4. Conversion Premium Ratio:
Mix Ko Stock is overvalued as it is Based on FCFE Principal Prepaid - Issued + 105+60*(1-0.50)+10-15+0=130
Expected Return < Dividend Ratio which shows at what premium the
Rm = expected return of market
Sell expected that return will be
CAPM Return convertible bond is trading in the market

Rm-Rf = Market Risk Premium

less than required.
βx(Rm-Rf) = Equity Risk Premium
Rights Share Announcement of Ex-Right Date
1 2 3 4 Right Issue 2:1
5. Straight Value of the Bond:

Po=£50 P1=£46
It is the price where the bond would trade if it
Structure Types Yield Valuation S=£40 were not convertible to stock. Its then is
equivalent to non-convertible bond.

1. Face Value
1. Fixed Rate Bonds
1. Current Yield
2. Coupon Rate
2. Floating Rate Bonds

BV=Theoretical Value of Bond

6. Minimum Value of the Convertible Bond:
3. Maturity
3. Zero Coupon Bonds
£3
Rights Value £3.33 A convertible bond should at the lowest
4. YTM
4. Convertible Bonds
I = Annual Interest/Coupon Amount
46-40 3 trade at the higher of either the conversion
5. Market Price
5. Covered Bond
PVAF=Present Value Annuity Factor

value or straight value.

6. Redemption Value 6. Deep Discount Bonds

2. Yield To Maturity YTM= Yield to Maturity (Investors
7. Callable Bonds
a. Average Method Required Rate of Investors
8 9 10 7. Downside Risk:

8. Putable Bonds
PVF= Present Value Factor Downside risk is the % premium over the
Immunization Forward Rates Term Structure Theories straight value of the bond.

CY = Current Yield

YTM= Yield to Maturity

We k n o w t h a t w h e n An investor can purchase a two- The term structure theories explains the
C= Coupon Amount
interest rate goes up year Treasury bill (say rate is 10%) relationship between interest rates or bond
b. IRR or Discounted Cash Flow RV= Redemption Value
although return on or buy a one- year bill (say rate is yields and different terms or maturities:
8. Conversion Parity Price or Market Conversion
Method MV= Market Value(purchase price)

investment improves but 9%) and roll it into another one- Price:

N= No. of periods to expiry

value of bond falls and year bill once it matures.
1. Unbiased Expectation Theory: As per this Price at which the investor will neither gain
vice versa. Thus, the price theory the long-term interest rates can be used nor lose on buying the bond and exercising
5 6 7 of Bond is subject to The investor will be indifferent if to forecast short-term interest rates in the it.

following two risk:

they both produce the same future on the basis of rolling the sum invested
Duration Volatility Convexity result. An investor will know the for more than one period.

1. Price Risk
spot rate for the one-year bill 2. Liquidity Preference Theory: As per this 9. Favourable Income Differential Per Share
Macaulay Duration Modified Duration (Volatility) Modified Duration is a good approximation of the percentage of price change 2. Reinvestment Rate Risk
(10%) and the two-year bond theory forward rates reflect investors’ It represents extra income earned in Bond
attempts to estimate how the for a small change in interest rate. However, the change cannot be estimated (9%), but he or she will not know expectations of future spot rates plus a over dividend income in shares.

price of the bond will change in so accurately of convexity effect as duration base estimation assumes a linear Further, with change in the value of a one-year bill that is liquidity premium to compensate them for
response to a change in interest relationship
interest rates these two purchased one year from now.
exposure to interest rate risk. Positive slope
(ytm) and is stated in terms of % This estimation can be improved by adjustment on account of ‘convexity’ risks move in opposite
Year Cash PVF PV PV may be a result of liquidity premium.

Flows x Yr change in price direction. Through the Given these two rates though, the
PV+ = Bonds Price on increase in 🔺 Yield
3. Preferred Habitat Theory: Premiums are 10. Premium Payback Period
process of immunization forward rate on a one-year bill will related to supply and demand for funds at It represents the time in which we recover
1 C PV- = Bonds Price on increase in 🔺 Yield

selection of bonds shall be be the rate that equalizes the various maturities not the term to maturity and premium paid (to purchase the Convertible
PVo = Initial Bond Price

2 C+RV AnnModDur = Annual Modified Duration in such manner that the rupee return between the two hence this theory can be used to explain Bon) using extra income of Interest

effect of above two risks types of investments mentioned almost any yield curve shape.
shall offset each other. earlier.

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