BAF 361 INTRODUCTION TO CORPORATE FINANCE

AND BANKING

LECTURE 5- Valuation of Securities

Samuel Gameli Gadzo

2 Learning objectives

By the end of the lecture; you

should understand
´Debt valuation
´Preference share valuation
´Stock valuation
3 Factors to Consider when raising finance

´Accessibility of the source to the

organization
´Cost of the source
´The effect of the source on gearing
´Effect of its redemption on cash flow
´Duration of the source
 Valuation of Bonds
4
´ A bond is a long-term contract under which the borrower agrees to make payments of
interest and principal, on specific dates to the holders of the bond.
´ Bonds are promissory notes that represent long-term sources of borrowing, usually between
20 and 30 years. The issues promises to pay a fixed amount of interest periodically and to
repay the principal on a specific date of maturity.
General Characteristics of bonds are:
´ Par-value. This is the principal (face amount) of the bond. It is denoted as Mn. This is the
amount at which the issuing company will redeem a bond (that is pay) on its maturity
date.
´ Coupon rate. This is the periodic stated rate of interest paid on the par-value of the bond.
The bond’s annual coupon (interest) equals the coupon rate times the value (some bonds,
called zero coupon bonds, do not pay interest. They only the principal at maturity).
´ Maturity. This refers to the length of time the bond will be outstanding.
´ Yield to Maturity. It is the discount rate that equals the bond’s market value with the
present value of the future interest payments and repayment of principal.
5 Bond Valuation Cont.
´ Bond Valuation
The value of a bond is the present value of all the cash flows that it is
expected to produce. The value would depend on the contractual
features.
What do you need to value a bond?
´ The par/face value: This represents the amount the firm borrows
and promises to repay at the maturity date.
´ The coupon/coupon interest rate:This interest payment on the bond
– may be fixed or floating
´ The yield – the market interest rate required for the bond
´ Number of year to maturity
6 BOND VALUATION CONT’D
Steps
´ Find the present value for the par value
´ Find the present value of each coupon paid
´ Add answers from 1 and 2 above.

Possible Outcome
´ The present value is equal to par value – an indication that the coupon
rate is equal to the yield
´ The present value is less than par value – an indication that the bond is at a
discount.
´ Present value is more than the par value – an indication that the bond is at
a premium
7
BOND VALUATION CONT’D

´ Bond Value = PV of coupons + PV of face

´ Bond Value = PV annuity + PV of lump sum
é 1 ù
ê1 - (1 + r) t ú F
Bond Value = C ê ú+
ê r ú (1 + r) t

ê
ë ú
û
Where
C= Coupon = coupon rate * face value of bond
R = current yield on bond
t = Remaining maturity period of bond
F = face value of bond on maturity
8
Valuing a Discount Bond with Annual Coupons
Question
Consider a bond with a coupon rate of 10% and coupons
paid annually. The par value is GH¢1000 and the bond has
5 years to maturity. The yield to maturity is 11%. What is the
value of the bond?
Solution
´Price of Bond = PV of annuity + PV of lump sum
´Price of Bond = 100[1 – 1/(1.11)5] / .11 + 1000 / (1.11)5
´Price of Bond = 369.59 + 593.45 = 963.04
 Valuing a Premium Bond with Annual
9
Coupons
Question
Suppose you are looking at a bond that has a 10%
annual coupon and a face value of GH¢1000.
There are 20 years to maturity and the yield to
maturity is 8%. What is the price of this bond?
solution
Price of Bond = PV of annuity + PV of lump sum
Price of Bond = 100[1 – 1/(1.08)20] / .08 + 1000 / (1.08)20
Price of Bond = 981.81 + 214.55 = 1196.36
10
Bond Prices: Relationship Between Coupon
and Yield

If Then

Kd > Coupon rate Bond will sell at a discount

Kd= Coupon rate Bond will sell at par

Kd< Coupon rate Bond will sell at a premium

11 Semi-Annual Coupon Payments
´ Up to this point, the examples for bond price calculations assumed
that interest was paid annually. Many bonds pay interest on a semi-
annual basis. The procedure used to value bonds in this situation is
similar to that studied in “frequency of compounding interest”.
The process involves three steps:
´ Convert annual interest It to semi-annual interest by dividing it by 2
i.e. It/2.
´ Convert the remaining number of years to maturity n, to the number
of six-month periods to maturity by multiplying n by 2 i.e. n x 2.
´ Convert the required return from an annual rate Kd, to a semi-
annual rate by dividing it by 2 that is. Kd/2.
 Example – Semiannual Coupons
12
Suppose you have an 8% semiannual-pay bond with a
face value of GH¢1,000 that matures in 7 years. If the
yield is 10%, what is the price of this bond?
Solution
´The bondholder receives a payment of GH¢40 every six months (a
total of GH¢80 per year)
´The market automatically assumes that the yield is compounded
semiannually
´The number of semiannual periods is 14

é 1 ù
êë1 - 1.0514 úû 1,000
Bond Price = 40 ´ + 14
= 901.01
0.05 1.05
13 Zero- Coupon Bonds
´ These do not make periodic interest payments
´ The return to the investor consists of the difference between the
redemption or facevalue of the security on maturity date and
the “below face value” at which he or she purchased it
´ Since no interest is to be received, its value is equivalent to
discounted value of the facevalue on maturity only.

´
14 Preference Share Valuation
Preference share is a hybrid security in that it has some characteristics similar to both
ordinary share and debenture. Legally, it represents a part of ownership in a company.
On the other hand, it has only limited claim on a company’s earnings and assets
compared to debenture (bond).
General Characteristics of Preference Share
´ Preference. The preference shareholders have preference over ordinary shareholders
in the distribution of dividends and in the company’s assets in the event that the
company fails and/or is in liquidation, hence the term “ preference”.
´ Par Value. Preference shares have a fixed amount of dividend which is usually
expressed as a percentage of par-value (its dividend yield)
´ This preference dividend yield is set when the share are issued and is paid on a certain
date every year. The dividend is usually cumulative.
´ If they are not paid on time, the cumulative unpaid dividends must be paid out before
ordinary shareholders can receive any dividends.
´ No maturity. Preference shares have no maturity date, however, some preference
shares may include the call provision which allows the firm to redeem (retire) the
shares, at a pre-determined time and price.
15 Formula for valuation OF Preference shares
´
16 Stocks and Their Valuation
´Features of common stock
´Determining common stock values
´Efficient markets
´Preferred stock
Facts about Common Stock
´Represents ownership.
´Ownership implies control.
´Stockholders elect directors.
´Directors elect management.
´Management’s goal: Maximize stock price.
17 Initial Public Offering (IPO)
This involves selling of some of a company’s shares to outside
investors for the first time. The company becomes a public
company once the process is complete.
Implications of obtaining a listing
´ The company would need to comply with the listing rules of the
exchange
´ Shares can be traded on the exchange
´ Value of the shares increases due to marketability of the shares
´ Raising funding becomes easier
´ Shares would be held by larger number of investors –
vulnerability to takeover
18 Information required for IPO issue
Information would be required about the
following broad areas:
´General Historical information about
organization
´Historical financial information
´Information about management e.g.
competence
´Plan for future
19 Advantages of Going Public
´Increase liquidity of investors and company.
´Establishes reliable value for the business
´It facilitates mergers/takeovers
´Enhanced reputation/prestige
´Increase of market
´Access to cheaper capital
´Risk diversification for investors
20 Disadvantages of Going Public
´Disclosure and loss of privacy
´Cost of reporting
´Cost of listing
´Possibility of loss of control
´Impact of Price volatility
´Management of investor relations
Because most of these securities are issued on
the stock exchange let’s under stand the stock
exchange
21 Stock Exchange
´ Stock exchange is an organized market for buying and selling corporate and other
securities.
´ Stock Exchange (also called Stock Market or Share Market) is one important constituent
of capital market.
´ A stock exchange is a form of exchange which provides services for stock brokers and
traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities
for issue and redemption of securities and other financial instruments, and capital events
including the payment of income and dividends.
Role of Stock Exchange
1. Raising capital for businesses 6. Mobilizing savings for investment
2. Facilitating company growth 7. Profit sharing
3. Corporate governance 8. Creating investment opportunities for small investors
4. Government capital raising for development projects
5. Barometer of the economy
 Membership and listing regulations of the Ghana
22
stock exchange
Membership:
´ The Ghana Stock Exchange as a public company limited by guarantee has no
owners or shareholders as such, but members are either corporate bodies or
individuals.
There are three categories of members, namely
´ Licensed Dealing Members: An LDM is a corporate body licensed by the Exchange
to deal in all securities.
´ An Associate member is an individual or corporate body which has satisfied the
Exchange's membership requirements but is not licensed to deal in securities.
´ Government Security Dealer: A PD is a corporate body, which is approved by the
Bank of Ghana and registered by the Exchange to deal only in government
securities
 Membership and listing regulations of the Ghana
23
stock exchange
´ Regulatory Framework
GSE operates within a set of Rules, including membership, listing, trading, clearing &
settlement and depository. These are collectively referred to as the GSE Rule Book.
´ Membership Rules
These deal with the criteria for membership of the GSE, code of conduct or ethics for
members, among others.
´ Listing Rules
These prescribe, among others, criteria for listing securities (local and external),
continued obligations of the listed companies as well as Take-over and merger
procedures.
´ GSE Automated Trading (GATS) Rules
These govern electronic trading done by the brokers whether on the Floor, from
Dealers offices or through the secured internet.
 Membership and listing regulations of the Ghana
24 stock exchange
´ Clearing and Settlement House Rules
These are to ensure timely clearing and settlement of trades electronically.
´ Trading Method
GSE uses an electronic trading platform called the GSE Automated Trading System GATS
´ Trading Days: Trading takes place every working day.
´ Trading Hours: Pre-opening period: 9:30 to 10:00 hrs (GMT)
´ Surveillance: The Securities and Exchange Commission (SEC) carries out regular
inspection of Licensed Dealing Members' operations and books. Brokers are also required
to submit returns to GSE.
´ Listing: GSE has two categories of listing. These are 1st and 2nd. The second list is
essentially aimed at small and medium sized enterprises (SMEs)
´ Types of Securities that can be listed: shares (preference or equities); debt in the form of
corporate bonds (and notes), municipal bonds (and notes), & government bonds (and
notes); and close-end unit trusts and mutual funds
25 Share/Stock Valuation
´
26 Share/Stock Valuation Cont.
´
27 Share/Stock Valuation Cont.

2. Constant Dividend Growth

´ Perhaps a more realistic assumption about dividends for many companies is that
dividends will increase at a constant growth rate

! D0 (1+ g) D1
P0 = =
ks - g ks - g
´ Where g is the constant rate of growth in dividends. ; Ks is the cost of share D0 =
Currently or past year dividend and D1= Next year dividend
28
What happens if g > ks?
D1
P! 0 = requires k s > g.
ks - g

´If ks< g, get negative stock price, which is

nonsense.
´We can’t use model unless (1) g < ks and (2) g is
expected to be constant forever. Because g
must be a long-term growth rate, it cannot be >
ks .
29
D0 was GH¢2.00 and g is a constant 6%. Find the
expected dividends for the next 3 years, and
their PVs. ks = 13%.
0 1 2 3 4
g=6%
D0=2.00 2.12 2.2472 2.3820

1.8761 13%

1.7599

1.6508
30 What’s the stock’s market value?
D0 = 2.00, ks = 13%, g = 6%.
Constant growth model:

! =
P
D0 (1 + g) =
D1
0
ks - g ks - g
GH¢2.12 GH¢2.12
= = GH¢30.29.
0.13 - 0.06 0.07
31
What would P0 be if g = 0?

The dividend stream would be a perpetuity.

0 1 2 3
ks=13%
2.00 2.00 2.00

PMT GH¢2.00
^ P0 = = = GH¢15.38.
k 0.13
 If we have supernormal growth of
32

30% for 3 years, then a long-run

constant g = 6%, what is P0? k is
still 13%.

´Can no longer use constant growth

model.
´However, growth becomes constant after
3 years.
33
Valuation of Share for Non-constant growth followed
by constant growth

0 k =13% 1 2 3 4
s

g = 30% g = 30% g = 30% g = 6%

D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
$4.6576
P̂3 = = $66.5371
46.1135 0.13 - 0.06
^
54.1067 = P0
34
What is the expected dividend yield
and capital gains yield at t = 0? At t
= 4?
D1 GH¢2.60
Dividend yield = = = 4.8%.
P0 GH¢54.11

CG Yield = 13.0% - 4.8% = 8.2%.

 ´During non-constant growth, dividend yield
35
and capital gains yield are not constant.

´If current growth is greater than g, current

capital gains yield is greater than g.

´After t = 3, g = constant = 6%, so the t t = 4

capital gains gains yield = 6%.

´ Because ks = 13%, the t = 4 dividend yield =

13% - 6% = 7%.
36 Is the stock price based on
short-term growth?
´The current stock price is GH¢54.11.
´The PV of dividends beyond year 3 is
GH¢46.11 (P3 discounted back to t = 0).
´The percentage of stock price due to
“long-term” dividends is:
GH¢46.11
GH¢54.11 = 85.2%.
 If most of a stock’s value is due to long-
37
term cash flows, why do so many
managers focus on quarterly earnings?

´Sometimes changes in quarterly

earnings are a signal of future changes
in cash flows. This would affect the
current stock price.
´Sometimes managers have bonuses tied
to quarterly earnings.
38
Suppose g = 0 for t = 1 to 3, and then
g is a constant 6%. What is P0?^

0 1 2 3 4 ...
ks=13%
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861 2.12
20.9895 P3 = = 30.2857
25.7118 0.07
39 If g = -6%, would anyone buy the stock? If
so, at what price?
Firm still has earnings and still pays
dividends, so P^0 > 0:

D0 (1+ g) D1
P̂0 = =
ks - g ks - g
GH¢2.00(0.94) GH¢1.88
= = = GH¢9.89.
0.13 - (-0.06) 0.19
40 Expansion Plan
´Finance expansion by borrowing GH¢40 million
and halting dividends.
´Projected free cash flows (FCF):
´Year 1 FCF = -GH¢5 million.
´Year 2 FCF = GH¢10 million.
´Year 3 FCF = GH¢20 million.
´FCF grows at constant rate of 6% after year 3.
´The corporate cost of capital, kc, is 10%.
´The company has 10 million shares of stock.
41
Find the value of operations by discounting the free cash
flows at the cost of capital.

0 k =10% 1 2 3 g = 6% 4
c

FCF= -5.00 10.00 20.00 21.2

-4.545
8.264
15.026
Vop at 3 GH¢21.2
398.197 = = GH¢530.
0.10 - 0.06
416.942 = Vop
42
Find the price per share of
common stock.
Value of equity = Value of operations
- Value of debt
= GH¢416.94 - GH¢40
= GH¢376.94 million.

Price per share = GH¢376.94/10 = GH¢37.69.

43

END OF
LECTURE