T-IVv | Learning Objectives This unit provide introduction to Bond, Equity and Derivative Analysis. After studying this unit, one should be able to: « Understand the concept of equity shares with its valuation techniques. « Explain bond and bond theorems. + Evaluate valuation of bonds/debentures, bond yield and term structure of interest rates. + Discuss about derivative analysis and clearing house. Chapter 7: Equity, Bond & Derivative Analysisx Chapter 7) Equity, Bond & Derivative Analysis 7.4. CONCEPT OF VALUATION 7. EQUITY SHARES ys 7.1.1. \Anitroduction Valuation is quite necessary for determining the suitable security value. It is estimated by determining the willingness of the buyer to pay a seller provided that both involved parties agree to transact with each other freely. The market value of a bond or stock is evaluated by the buyers and sellers when security is traded in the exchange. In simple words, the present worth of all the expected cash flows which can be accumulated by the security ‘over a certain time period is known as the value of a certain security. copk wet incepts of Value > ‘The security valuation refers to the way of estithating the fair price of security. The following concepts of value are explained below: 1) Book value is the historical value, synonymous to shareholders’ equity, net worth, and net book value. Itis the difference between total assets and the total liabilities appearing in the balance sheet ‘a company on a particular date. Market value is the price at which the property would change hands between a willing buyer and a willing seller, where both are not under any compulsion to buy and sell ‘and they have reasonable knowledge of relevant facts and information. This means that representative price would not work if it affects buyer's or seller’s unique motivations Liquidation value is the net amount that can be realized if the business is terminated and the sets are sold piece-meal Antrinsic value is defined as the present value of all ash proceeds to the investor in the stock. It is an ‘estimate of the true value of a company. 7.1.2, Valuation of Securities Valuation of Securities H, 2» 3) Shares Bond/Debenture Concept of Equity Shares ‘also termed as Ordinary shares o, common shares. Holders of equity shares are the Gwners of the company as they have invested in the company, they have voting rights and are par of decision-making process on major issues relati the affairs of the company. The shareholders’ r ‘on the funds invested by them in the company is in the form of ‘Dividend 7.2.1. Equity shares are Depending upon the performance of « company, ie net profit eared by it during a particular year, the Board of Directors of a company decide the quantum of dividend to be distributed amongst the shareholders. In case of loss incurred during a Board may decide against the distribution of dividend. This is precisely the reason why equity shares are described as “Variable Income Security’. In case of liquidation of a company, equity shareholders are the last one to get their money back. arateme shares means such equity shares as are issued by a company to its directors or employees at 4 discount or for consideration, other than cash, for providing their know-how or making available rights in the nature of intellectual property rights or value additions. Sweat equity shares are issued to the employees or directors in lieu of their contribution towards the development of the company. particular year, 7.2.2. Valuation of Equity Shares ‘The various model used for equity valuation are 3s follows: ‘Valuation of Equity Shares] Balance Sheet Valuation Intrinsic Value Approach [Eamings Muliplier Apreosch {other Comparative Valuation Rts [Discounted Cashflow Technique Dividend Discount Models Dividend Valuation Method ‘Market Price PIE Ratiogoo & Desvatve Analysis (Chapter 7 723: piscounted Cash-flow Technique S of evaluation of any asset class Ti ding shares- whether equity or preference) is (ocludi ne level of the expected future cashflows, rien are subject to appropriate discount to arrive at a mnt value. This method of discounting fre cashinflows is derived from the concept of “the fur alue of money’. which envisages that the pesent values of all the future cashflows are always ffs then their furure values. For example, a fancial instrument matures, after one year from Mrith maturity value at £100, its present value toad be less than €100. Appropriate discounting is, erefore necessary, which depends upon the nity cost of the capital and is expressed in terms of percentage Valuation of a share under this method involves following steps: 1) Assessment of the future cash-inflows of the shares: 2) An appropri basis of: 3). Riskiness of the said cash-inflows; and ii) Prevailing rate of interest in the capital market. 43) Present value of all the future cash-inflows is arrived at after allowing the appropriate discount rate (cf. 2 above) to the future cash-inflows; 4) Other expenses like tax liabilities, payment of smterest / principal, ete. which affect the cost OF equity preference shares, are taken into consideration. fate discount rate is decided on the Following formula is relevant in this regard: 3 CFIoEquity, a 5 CFO Bauitys, Value of Equity an CF to Equity , = Expected ‘cashflow to equity in period t and r= Cost of equity Example 1: Mr. °X" js expected to rceeive camming 2 Mr. eae per share of £100 every year for 1A yeas Mineo of equity is 12%, what 16 the curren! shares? 159 7.2.4. Balance Sheet Valuation Analysis of the balance sheet of a company may also provide a basis for the valuation of its shares. There are basically three approaches for measuring the value of a company’s shares, which are book value approach, liquidation value approach and replacement cost approach. 1) Book Value Approach: Book value of a company's share may be obtained by dividing the company's net-worth (paid-up capital. reserves and surpluses) with the number of outstanding shares. Example 2: The net worth of a company "XYZ Lid.’ is 230,00,000 and the number of its outstanding shares is %2,00,000. Calculate the book value of a share. Solution: Book Value of one share of “XYZ Ltd e Net Worth of XYZ __ No.of Outs tan ding Equity Shares 215 per share 2) Liquidation Value Approach: This type of approach is applicable only in the case when a company goes into liquidation. Liquidation Value per Share ‘Value realized from the process of liquidation — Amount to be paid to all the preference shareholders and other creditors No.of outs tan ding equity shares Example 3: ‘ABC Ltd." a company under liquidation (i) is expected to realise €45,00,000 from the liquidation of its assets, (ii) payment of %18,00,000 is required to be made to its preference shareholders and other creditors in full and final settlement of their claims, and (iii) the number of outstanding equity shares happens to be 15,00,000, What would be the liquidation value per share? Solution: The liquidation value per share ‘Value realized from the process of liquidation — Amount to be paid to all the preference shareholders and other creditors No.of outs tan ding equity shares = 45,00,000-18,00,000_ 27,00,000 Tn eon es Pee sae160 (nit-1v) 3) Replacement Cost Approach: This is yet ‘another approach, which is used for measurement Walvation of shares by arriving at_ the replacement cost of the company’s assets, from which the liabilities of the company are reduced to get the company’s net worth. The net-worth so obtained is then divided by the number of outstanding shares to get the value per share of the company. 7.25. idend Discount Models/ Dividend Valuation Method Dividend Discount Model’ is one of the most commonly used models for ascertaining the present value of an equity share. According to this model, the value of an equi e is equal to the sum of the present value of: 1) The cash inflows expected in the form of dividends, and 2) The sale price expected at the time of sale of the equity share. Following presumptions are made before applying the “Dividend Discount Model’: 1) Distribution of dividends is made at every year- end until infinity; and 2). First dividend in respect of a share is received on completion of one year from the date of purchase of the equity share. 7.25.1. Single-Period Valuation Model If the investor in the share of a company expects to retain the equity share atleast for one year, the share price would be computed with the help of following formula: Dea (+n +p Value/Current price of the equity share, Po Price of the share expected a year hence, Required rate of return. ‘The share price obtained by applying the above formula is considered as the ‘Fair’ or ‘Reasonable’ ne, as it reveals the present value (PV) of the share. ‘An investor may be willing to buy the share if the ‘market price of such share happens to be less than its present value and willing to sell the share when its ‘market price is more than its present value. Example 4: Calculate the present value of an equity share from the following data: i) An investor's XYZ equity share is expected to provide a dividend of 2.00. in MBA Third Semester davestment Analysis and Portfolio Management) aKry the share expected after a year is 218,09 i). Price of | iit) Required rate of return on the share is 12% 5 DP Solution: Value of Share (PO)= 5+ 7 Where, (D,) = 22.00 Dividend expected a year hence Price of the share expected a year hence (P;) =218,09 Rate of return required on the equity share (r) = 12%, p, = 20. 4 18.00 °° a2) (12) 22,0(PVIFo 2, :) + 218.00 (PVIFo 12.1) 2,0(0.893) + 218.00(0.893) = 1,786 + 216.074 = 717.86 7.2.5.2. Multi-Period Valuation Model ‘Single Period Method’ of share valuation is the fundamental framework of the equity share valuation, on the basis of which other techniques have evolved. ‘Multi-Period Evaluation’ method is advancement over the ‘Single Period Method’, which is more realistic as well as more complex. Presumption made under this method of valuation is that the equity shares have no maturity period and the vidend stream is of infinite duration. The value of fan equity share may be computed by applying the following formula: Dime) De D, = to a5” Geo dae! PR (+n) Where, Po = Value/Price of the equity share today, D, = Dividend expected a year hence, Dividend expected two years hence, ividend expected at the end of infinity. = Required rate of return, For illustration, Let us consider valuation of equity shares of a company held by an investor, who plans to sell the share for a price of P, after holding it for ‘n’ number of years. The value of the equity shar held by him would be: Deep! D, P, R= ae ite Pa Gro dent Gen ato D, (+n! d+n*ee Band Desvave Anas (Chapter 7 eseple 5: Calculate the present value of common Beek from the following data: gerkn investor gets G34 as dividend by the company continuously for five years jj Maturity period of the stock is 5 years, i Selling price of the shares at the end of the fifth year is €60, jx) Required rate of retum is 10% solution: Present Value of the Share Zep P, Pa): ec Where, Dividend expected five years hence (D) = 3.44 Price of the share at the end of five years (P, Required rate of retum (r) = 10% = T3.44(PVIFA 105, sya) + T60(PVIF ios, 55) %3.44x (0.621) + %60x (0.621) = 2.136 + €37.26 = 739.396 7253. Constant Dividend Growth Model (Gordon Model) The most popular and widely used amongst all the “Dividend Discount Models’ is the ‘Normal or Constant Growth Model’. This method was xiginally proposed by Myron J. Gorden and as sach also known as Gordon model. This model presumes that the actual growth of “Dividend per Share’ is at a constant rate (g) which is less than the required rate. Let us presume that “pividend per Share’ of a t rate to infinity. If the company ‘0’, then dividend at the end of first (D.) yea" Di=Do(1 +8)! Similarly ‘Dividend’ at the end of the second year (D;) will be: Ds=Di(1 +8)+ Doll +8) Dividend at the end of third and subsedu ay also be formulated in the similar manner- Therefore, when the dividend of a company | Constantly, the formula for its ‘Share Valuation may be worked out as follows: will be: rent years 1+) 161 When the above formula is applied for the total of a geometric progression, it is simplified as under, Doll+e) p _ Value of Share: stimated dividend for next period; Required rate of return: G = Growth rate; and Da= Present dividend Limitations of Constant Growth Model The constant growth model, developed by Myron J Gordon, is an easy and simple method of valuation of shares. However, its shortcoming lies in the fact that due to its sensitivity to the inputs for the growth rate, any minor mistake in its application may lead to distorted results. As the growth rate converges on the discount rate, the value may go upto infinity Example 6: Calculate the present value of share from the following data: i) A company paid a dividend of %3.70 in the previous year. ) Growth rate of dividend is 8%. iii) Required rate of return on dividend at 12%. ol +8) 8 Solution: Value of Share (Po) = ‘Where, Present dividend (Do) = 3.70, Required rate of return (r) = 12%, Growth rate (g) = 8% ‘The value of share: _3.7001+.08) Example 7: Dividend on a share during current year 20, the face value 7100. Dividends are expected to grow at a constant rate 10.9% for 5 years and then 8% infinitely. An investor expects a return of 25% p.a. Suggest him at what price he should buy it? Solution: Calculation of Present Value of the Dividend during the Period of Supernormal Growth Dividends (D,(1 + g3)'] Present Year | (R20(1+ 0.109) PVIFs, | Value @ © T | 2od+o1o'=2a1e | 0800 | 7739 2 | 2+0109%=2560 | ost | is744 3 | 20109 =2728 | osi2 | 13967 4 | 200-+0109'=3025 | 0410 | r2a02 s_| mo cuopieass_| os! > | ios Present Value of ‘during Supernormal | 70.827 Growth Period yall (er p,=Dollte) , Dol+s) , dsp). (+n a162 (Unity) Calculation of Present Value of Dividend after Period of Supernormal Growth 1) Calculation of Stock Value at Beginning at Constant Growth Period De +g))5(1+8)! p= Pe — Pallr gry) Te 1-8 where, Dividend of the previous period (L Growth rate of dividend for n year (g)) = Rate of retum (5) = 25% Growth rate (g) = 8% = 40+0.109)51+-0.08)! _ (4>x1,677)(1.08) 10.9% P, 0.25-0.08 4 O17 6.708x1.08 _ 7.245 a = 142.62 017 O17 2) Calculation of Present Value of Constant Growth Dividend Po = Ps(PVIFis5 5 yeu) = 42,62(0.327) = 213.94 Calculation of Present Value of Share P) = Value during supernormal growth period + Value during normal growth period = 70,827 + 13.94 = 884.767 or 84.77 7.2.5.4. Zero Growth Model The ‘Zero Growth Model’ is the most basic model amongst all the “Dividend Discount Models’. The underlying presumption in this model is that over a period of time, the dividend will remain constant (with the result that there is ‘Zero’ growth) as also the investor's required rate of return. Valuation of “Equity Share’ in this model would also be as under: Deen, D D + soa Gen d+ (+n den* Present value of share, ‘Constant dividend per share, Required rate of return. Considering ‘Zero Growth Equity Share’ to be of perpetual duration implies that an investor would hold the share forever. Thus, the above formula may be simplified as follows: D Pee ky Example 8: A stock pays dividends of €1.80 per year and the required rate of return for the stock is 8%. Calculate the value of stock. Solution: Value of Share/Stock (P,) = 2 MBA Third Semester (Investment sis and Portfolio Managemen) ysis and F mH Ay Given, Dividend per share (D) = 81.80, Requireg urn (¢) = 8% or 0.08 1.80 0.08 rate of rel = 222.50 Value of Share/Stock (Po) Example 9: A company expects the earnings of x5 per share and because they do not expect to grow, Camings are paid out as dividends. So, all futyy dividends are expected to be %5 per share. ‘Thy investors required rate of return is 10% ¢ the value of stock. i) Cale ii) Calculate the present value of stock, if the investor expects to receive a %5 dividend for ech, of 2 years and then sell the stock for 250 in 7 years. Solution: i) Value of Share/Stock (Pp) Given, Constant dividend per share (D) = %5, Required rate of return (r) = 10% % 250 Present Value of Sha e/Stock (B,) = ii) Present Value of Stock P PD os ee 9G aan den a Given, Constant dividend per share (D) = *5 Dividend at the end of 2" year (D) = %0, Required rate of return (r) = 10% 85 aba 85) 250 @¥10% | a+10%)? — @+10%)* = V(PVIFioc, yn) + &5(PVIFios, 20) * %50(PVIF 10%, 279) 5(0.909) + %5(0.826) + €50(.0826) 4.545 + 84.13 + €41.3 = 749.975 or 850 » 7.2.5.5. Non-Constant Growth Dividend Valuation/Multistage Models ‘The growth-phase concept provides the intuition for multistage discounted cash flow (DCF) models of a types, including multistage dividend discount models Multistage models are a staple valuation discipline of investment management firms using DCF valuation models, Under the multistage model, changing gro* rates are applied to different time periods. Stoel which are experiencing the above pattern of £7 are called non-constant, supernormal, or erratic 8° stocks,maltstage growth models are: oa Dividend Growth model, » poe Hamed! (2 Oye of (wo-stage model), and B Fp aeeescge Dividend Growth made! aps TreStage Growth Model fe eat of ‘Drvidead Growth’ of a company may Bete Be sume for etemity. Companies, at times, we a phase of extreontinary dividend Seed woh is 2 temporary phenomenon. as the oe & generally Bot sustainable in the long run. Gren such 2 phase gets over, the rate of ‘Dividend Groat! settles down at a reasonable/constant level. 3 sus, terefore, be concloded that companies face a Feo-stage growth situation, which dow each other ahiernatively je Ge first stage. the growth of dividend may be at wm exzzortinay pace (super-normal growth rate), ssisch generally takes place when the company’s pedo xt in high demand and the company is in ip afvaniazeous position to extract premium from its cesomers. In the second stage, the demand for the conguay’s products may come down at a normal level which leads wo the normal camings for the cuapeny end rate of “Dividend Growth’ may also become normal (normal growth rate). ‘The share value of 2 company experiencing “Extra- cemxry Growth’ in its dividend pay-out (like companies with zero or constant dividend growth) is equal to the present value of the company’s expected ferme dividends. The value of a company with variable rate of Gividend growth as mentioned above may be caicaized by applying the following equation: = pyle, $ Delizesl? meh bel att Where, P,= Current price of the equity share, 2: = Growth rate of dividends for n year, Re see of dividends for years 0 +1 and D, expected hence, , = Dividend a year P= Price of the equity share atthe end of Year 1= Required rate of return. 2 p,litef, Paws feral P= Md Get eal? 163 The first term shown on the right hand side in the above equation is the present value of a growing annuity, the value of his equal I l Example 10: Calculate the present value of the stock from the following formula. 1) A stock is expected to experience supernormal growth in dividend of 10 percent, gi over the next five Years. 2). Following this period, dividends are expected to ‘grow at a constant rate of 4 percent, g 3). The stock paid a dividend of @4 last year. 4) The required rate of return on the stock is 15% Solution: Step 1: Calculation of present value of the dividend during the period of supernormal growth: Year | Dividends (Dy(1+2,)) | PVIFisx, | Present (1+ 0.1)" Value ®@ © T sa+00 0870 3.828 2 | 4a+0n 0.756 3.659 3 | 4a+0n'=5324 0.658 3.503 4 | sa+0n'=5.56 0372 3.350 s_| s0+01'=6442 0.497 3.202 Present Value of Dividends during 17542 ‘Supernormal Growth Period Step 2: Calculation of present value of dividend after period of supernormal growth: 1) Calculation of stock value at beginning of constant growth period: Dg _ Doll +g, rg Where, Dividend of the previous period (Dy Growth rate of dividend for n year (gi) = 10% Rate of retumn (1) = 15%. 40+0.)°0+0.04)' _ 644211.04) _ 6.70 015-004 ou Oar = 860.91 2) Find — present r+)! 8 Ps value of constant growth Ps (PVIFise, s) = 60.91 (0.497) = Step 3: Ste? & Calculation of present value of stock: ‘Value during Supernormal Growth Peri i Period _Yalue during Normal Growth Period * = 817.542 + 930.272 = 847.814164 CnittV) 7.2.5.7. Three-Stage Growth Model/Three Phase Model ‘The three-phases model consists of three stages of dividend growth which is as follows 1) The starting time period of high growth, 2) The transition period in which the growth decreases, and 3) The final stable growth phase which is. present forever, | Phase 1 Phase 2 Figure 7.1: Three-Phase Dividend Growth Model ‘The dividend growth rate g, is referred to be stable for a period of A years. In the A + 1 years the growth rate gs, decrease for phase B while in third phase there will be stable growth rate ga SD.(1+2,)! ite.) , Dy(l+e,) Pen (ent rg, (141) where, Dp = Dividend in the next year ‘8. = Growth rate in first phase, i.e., for period “A” ‘8 = Growth rate in second phase, i.e., for period ‘B’ ‘ga = Growth rate in the third phase Dp = Dividend at the beginning of the third phase Example 11: A company listed in NSE has estimated growth ratc of 18 per cent. After four years the growth rate is expected to decline to 13 per cent. ‘After eight years the firm is expected to grow at the rate of 13 per cent infinitely. The company has planned to pay dividend at the rate €10 per share. If the required return is 15 per cent, what would be the value of the company's stock? Dividend forthe next year (Ds) Required Rate of Returns, (F) Growab rate in Phase 1 (8) Growah rate in Phase 3 (ga) Dividend atthe | 018 | 017] 016] 0.15] 014 | O13 beginning ofthe 3% Phase Begining of | & Phase (Byers) MBA Third Semester (avestment Analysis and Portfolio Management) ax, Solution: 10.08)! _, 1011.08)? _, 1001.08)", 1041 08)* G+015) 040.15 140.15" +015 118 , 13924 , 16.8303 , 19.3877 = [as 13225 1.5209 * 1-7490_ 0.261 + 10.528 + 10.803 + 10.850 42.442, ¥. b, (+8) tep 2: S Date) Step 4s 2 ata! 100.135, 10 100.13)”, 1001.13)" (140.15) 0.15) (140.15) 1+0.15)" 4243 , 208195 | 23.5261 , 26.5844 N14 * 2.3131 * 2.6600 ~ 3.0590. 1599 + 9.0007 + 8.8444 + 8.6906 = €35.6956 Step 3: Dy(1 + ge)/(r—ga)(1 +1)” toa +0.18)* ,_@.13)* 015-013 (1+0.15)* = SST 26584 _ 249.44 0.02 “3.0590 725.8. H-Model H Model is a model used for Two Stage Model. In this model the Dividend Growth begins with a high rate and decreases slowly in a linear manner for certain period of time for calculating and balancing the normal rate in the end. The various assumptions for “H Model’ of equity valuation are as follows: 1) The present rate of dividend growth is more than the rate of dividend growth in the normal long- run (gq). So, the decrease in the growth rate is planned and decreases in a linear manner for 2H years. 2) The rate of dividend growth decreases linearly and stabilises at g, after 2H years. 3) The rate of dividend growth is the half between 2 and gain the time scale at point "H’ years. Growth Rate 8 Figure 7.2: Dividend Growth Rate Pattern for H Modeleee ee) se Sigur 7-2 shows the dividend growth rate pattem Te stmode'. The valuation equation for “H-Mode!’ is Gaple as compared to the *H-Model’, The formula is ssfollows He, ~£,) pe Dole te (g, —8,)) it Ps ten ‘Where, y= Intrinsic value of the share, Current dividend per share, += Required rate of return by investors, g.=Normal long-run growth rate. ‘urrent above-normal growth rate, ‘One-half of the period during which g, will level-off to g Equation (1) may be simplified as under: G+g,) , DoHG a) + 8, T= By 2, (2) In the above equation (2), the H-model is given in a simple and unplanned manner which is as follows: 1) The first term on the right hand side of the above Pol*#) shows the value of T- 8. equity share according to the normal rate, and DoH(g.~ £5) sepresents the TS, premium due to abnormal growth rate. equation (2) 2) The second term Example 12: From the following information: i) The current dividend on an equity share of JKI- Limited is %6.00. ab ii) The present growth rate is 25%. Bie ii) After a period of 10 years the growth rate decline and then stabilizes at 6%. iv) The required rate of retum is 8%. the Calculate the intrinsic. value per. share from following data: Solution: igeon Current dividend per share (Do) = ee Rate of return expected by investor Normal long-run growth rate (Bs) "© _ 95% See above nots rach ga will level off One-half of the period dur Gi =5 years (4) ue of the share (Po) Ba) , Doles “Bs? r- Be 165 Putting these inputs in the H-model, the intrinsic Value estimate as: _6.00{(1.06) + 6%5(0.25 ~ 0.06) 0.08 - 0.06 _ 6.00(1.06) + 6%5(0.19)) = 2 2 6.36+5.7 _ 12.06 = 2603 2 002 0.02 7.2.6.'_Attrinsic Value Approach Intrinsic value of a security denotes its value, which is inbuilt in its nature. It is also referred to as the fundamental value, and is arrived at by summing up all the future incomes projected to earn through the underlying assets as per the criterion of present value. According to ‘Graham’ and ‘Dodd’, “Intrinsic value is the value which is justified by assets, carnings, dividends, definite prospects and the factor ‘of management”. Example 13: A limited company’s earnings and dividends have been growing at a rate of 18 per cent per annum which is expected to continue for 4 years. ‘After that the growth rate is expected to fall to 12 per cent for the next 4 years. Thereafter, the growth rate is expected to be at 6 per cent forever. If the last dividend per share was ®2 and the investor's required rate of return on company equity is 15 per cent, what is the intrinsic value per share? Solution: For the computation of the intrinsic velue per share of a limited company, following procedure involving three distinct steps need to be followed: Step 1: The dividend stream during the first eight, years, when a limited company would enjoy a relatively high rate of growth (first four years @ 18% and second four years @ 12%), will be as follows: Particulars 001.18) 001.18)" 001.18)" 001.18)" 00 (118)$ (1.12) .00 1.18) 1.12)? (las 2y Dy= 2000 4.18)" (1 ‘The present value of this dividend stream may be calculated as under; = 2.36 (PVIFisx, 1s) + 2.78 (PVIFisa, 2 yn) + 3.29 VIF on 3 ym) + 3.88 (PVIF sa, 4 yn) + 4.34 (PVIFise, 5 yn) + 4.87 (PVIFisa, 6 5.) + 5:45 (PVIF 5,9 yr) + 6.10 (PVIF sx, syn) GeO Se 78 (0.756) + 3.29 (0.658) + 3.88 . 34(0.497) + 4.86(0. (0.376) + 6.10 (0, 327) ara n =2.05 +2. FE eroga Ot 216+ 2.22 +2.16+2.10+ 205 + 1.99 if.166 (Uait-¥) Step 2: The price of the share at the end of 8 years, applying the constant growth model at that point of time, will be: _D, _ Dita.) P, Bas TB, 2.00(1.18)*(1.12)$ (0.06) _6.1011.06) _ 6.466 0.15-0.06 009 009 = P7184 The present value of this price is: Pp = Ps (PVIF sx.syn) 71.83 (0.322) 23.49 Step 3: The sum of the above components is: Po = 216.83 + 723.49 = 740.32 The intrinsic value per share of the limited company = 840.32 7.2.7. Market Price ‘The market value of securities is not the same as the book value, as the market value considers the future chances of growth. The fundamental analysis is used by various investors for selecting a stock for analysing the market value of the company, and then estimating, if the market value is proper or if there is undervaluation as compared to the book value, net assets, or the various other methods. ‘The market value is referred to as the last provided sales price or present bid and ask prices which is the price provided by the buyers and sellers in the open market. International Valuation Standards defines market, price as, “The estimated amount for which a property, should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion”. Features of Market Price ‘The features of market price are as follows: 1). Itis the price at which the investors purchase or sell a share of stock or bond at the specified time and quoted price. 2) The total market value refers to the total of ‘market capitalisation and market value of debt, 3) The market should have proper and full information and unbiased belief should exist for the market price to be same as market value, 4) Market price can be used in place of open market value, fair value, fair market value, but these words have different standard and meaning in different situations. MBA Third Semester nvestment Analysis and Ponto Manageme ayy, Intrinsic Value versus Market Price ‘The model used for determining the Value of gj concer firm will take analysis of an investor ine Teaving a tetur including cash dividends and capt profit or loss. For example, there is 1 year holy time and the stock of the company has an expect dividend per share E(D;), of 8, the presen pre of share is (Pa) is £96 and the expected price atthe eng of year E(P)), is 104 The holding period return that the investor witl ge total of E(D,) and the expected price appreciation 3.) — Pj, all dividend by the present price P, ED) +1ER)-Po) PB Expected HPR = E(t)= _ 8+ (104-96) Tet 96 Note, that E(D,) denotes an expected future value Thus E(P,) represents the stock price I year from now. E(t) is referred to as the stock's expe holding period return. It is the sum of the expected dividend yield, E(D,)/Po, and the expected rate of price appreciation, the capital gains, (E(P)) ~ Ps) 0.167 = 16.7% Where, E(D,) = Expected Future Value E(P,) = Stock Price of | year E(t) = Expected Holding Period Return of Stock The total of the the expected dividend yield, E(D,)/Po, and the expected rate of price appreciation, the capital gains, [E(P;) - Po] To compare the intrinsic value, Vo, of a share of stock to its current market price: y= E@i+P) I+k The intrinsic value of the company is set according © the present value of expected cash flows to the stockholder of the company is: It can also be said that the intrinsic value is tbe present value of the expected future cash inflow which means the total of dividend and terminal price ‘of the selling of stock provided discount by required rate of return, The stock is undervalued if the intrinsic value (determination by the investor © the value of the stock) is more than the market price ‘The stock is undervalued by the market if the company has Vo> Po (850>R48). The investors Woo! adopt a passive strategy and will buy more shares the company.<< lll er) the investor will buy few numbers of ‘nthe passive strategy, because the intrinsie ll be less than the present market price. This to shortage of the stock of the compan sHiqganegative numberof shares of «fim, any tafe thatthe individual investor having intrinsic Waray not be same with the market price Py and it Neidio differ with the market consensus estimates AD, Pork. 728, Earnings Multiplier Approach Te PIE ratio is a commonly utilized tool for equity tgaiysis. The Earnings Multiplier Approach is a eas to forecast future earnings of a company, and Samequently the estimated P/E ratio. To calculate the tamings multiplier, multiply the aggregate earings ty the PIE to market value To derive the P/E estimate, we use the Dividend Discount Model (DDM): (PoE) = (DVE\(Re - 8) ice of security ,= projected earnings in the next year D, =dividend estimated for the next year required return on equity capital = growth rate Eaming multiplier = P/E ratio x Aggregate Eamings Steps in Calculating Earning Multiplier Approach Following are the different steps in calculating caming multiplier ich: Step I: Estimate Sales per Share: Start with the cstimate of GDP forecasted for the coming year. This information is usually provided by governments, banks and economists. Given the GDP estimate We can now estimate the firm’s expected sales per share forthe coming year. To do so, must assess the stock ‘market series based on the historically strong relation n sales and GDP using regression analysis. Step 2: Estimate Profits: Once the sales estimate tas ben obtained of the company. profit margins 1° be calculated based on recent earning trends, THT ‘lomation is usually offered on 8 quately and basis by all publically traded companite t (ited by the SEC. However: it should be 1 bey fit are carnings nel ng allon and amortization and interest POY rates will change frequently, dependi# Oy y's depreciable assets utes, earnings and taxes owed: A sal : Mrnis usually resus revenues are ty, even if 167 constant. Therefore, Earnings Before Interest, Taxes and Depreciation (EBITDA) should be used first (© Measure operating profits Step 3: Estimate Depreciation, Amortization: Depreciation is a tricky component, since most companies generally increase their capital expenditures over Depreciation estimates can be found by using time series analysis with Capital Expenditures (CAPEX) as the independent variable. If the CAPEX is currently high, the depreciation is expected to grow above average. Alternatively, depreciation can be estimated by using the Plant Property and Equipment and applying the appropriate depreciation rate to that PP&E amount. The main reason of not including depreciation in the previous step, is that depreciation should not be calculated as a percentage of sales, since it is dependent upon the level of capital investment. Step 4: Estimate Interest Expense per Share: Interest expense is a function of the outstanding debt and expected market interest rates. These debt levels n be used to estimate the firm’s asset levels However, the debt outstanding and current market interest rates are not the only relevant factors for a borrowing firm. The credit rating of the company, the overall trend of their credit history are also major factors that impact the firm's cost of borrowing, and should be given equal credence when developing. expectations. Similar to Depreciation and, Amortization, interest expense should not be estimated as a percentage of sales, as it is more tied to the firm's credit rating, debt levels and market interest rates. Step 5: Estimate Corporate Tax Rates: Estimation of the corporate tax rate should be fairly straight forward, but consideration to the current and future political environment should be noted. Taxes should be adjusted for any possible tax legislation due going forward. Taxes should be calculated as a percentage of sales. Step 6: Putting it All Together: When the relevant factors of a company’s income statement are combined, its become casy to estimate the predicted EPS of the company with the following equation EPS = [(Sales Per share estimate) (EBITDA) ~ Dep. & Amort, — Interest] (1 = Taxes) Using the EPS estimate, company’s stock price relative to its earnings can be evaluated, then Earning Multiplier is calculated, It is-a tool to determine if a company is trading “cheap” or “tich” to its peers, ‘The earnings multiplier approach is a useful tool for those who already use the P/E ratio,a meser(Unvesunent Analysis and Portotio Management) ayy, 168 (Unit-V) MBA Thint Seu AE eK na From she company's | 0K, HE ong Despite a) number’ of positive features anid information has been culled Ou mee convenience of various methods under the dividend Profit after tax at 60% 2709 discount models, many of the financial analysts ewe paid | pa prefer a simple procedure by using ‘Price ea ice of Euity share w0| Ratios’ (P/E Ratios) for the va | oars of ae —— 20 Shares’ of a company. The direct relationship oi te the price earnings ratio of the company, Caleutate the pr between the earnings and value of a share is known as the price per earnings ratio, or P/E, The P/E ratio of a company shows the price being paid for each rupee of its earnings. It is calculated by dividing the ‘Current Market Price” of the company’s ‘equity share with the ‘Earnings Per Share’ P/E Ratio Market price/Eamings per share For example, Market price of a share of 810 is &50. The profits available for equity shareholders are %2,00,000 and number of equity shares is 50,000. Profits available for MarketPrice EamingsPerShare Lower the P/E ratio, the better it is for an investor. ‘Among various alternatives, that stock with the lowest P/E ratio may be selected. ‘There is a major role of P/E ratio in a buy/sel decision. A high P/E ratio may indicate a share is overpriced, in which case the investor may decide to sell it on the expectation that its inflated price will soon collapse and it will fall back to its real value. Conversely, a low P/E ratio may indicate that a share is underpriced or cheap, in which case the investor ‘may decide to buy it on the expectation that other investors will soon become aware of its fundamental strengths and its share price will rise to its real value, Example 14: The capital structure of a limited company is as follows: Particulars z "80,000 Equity Shares of €10 each 8,00,000, 9% 30,000 Preference Shares of 810 each |_3,00,000 11,00,000 Solution: ‘ngs Ratio = Market Price Per Share Price Earnings Ratio = Per Share =A eis 3.04 Note: Earnings Per Share (EPS) Profit After Tax & Preference Dividend ie ‘No. of Shares Outstanding 27,00,000 —(3,00,000 x9 /100) 380,000 __27,00,000=27,000 _ 2.43.00 _ , y4 és 80,000 80,000 7.2.10. Other Comparative Valuation Ratios ‘There are two more comparative valuation ratios, viz price-book ratio and price-sale ratio. ‘Other Comparative Valuation Ratios PricerBook (P7B) Value or Rai} Price/Sales (PS) Ratio 7.2.11. Price/Book (P/B) Value or Ratio This is a preferred and popular choice of equity analysts. It is the ratio of market value of 4 company's equity to book value of the same company's equity. Book value of a company’s equit) is the total of its paid-up capital, reserves and surplus / retained earnings of the company as disclosed by i$ balance sheet. Application of this method involves comparison of the market price of one share with that of its book value, Book value of one share is the ‘company’s net-worth (book value) divided by the ‘number of shares issued, The market price of a shee is determined by the market forces, i.e. demand supply factors, It reflects the market perception of the ‘company's earning potentials. PBVRatio=Price/ Book ValueRatio = Market price per share at time (1) Book value per share at time (0)pond & Derivative Analysis (Chapter 7) 72.12. Price/Sales (P/S) Ratio Te pe ratio of market price of a company’s share to company's sales pet share. This ratio (P/S Ratio) gn edge over the price to eamings ratio (P/E Ratio), ach as in case of « company’s earnings being nil, IeAO(E ratio approach will ead to a dead end (an jnconclusive result), whereas P/S ratio approach sures comparison of even the companies without any eamings. P/S ratio is computed by dividing the railing market price of a company's share with the etapany’s annual sales / revenue per share: ails p/S Ratio=Pr ice / Sales Ratio Market price per share at time (0) Sales /Re venue at time (t) 7.2.13. Economic Value Added (EVA) Economic Value Added (EVA) is a valve-based financial performance evaluation technique, which is ted to evaluate the performance of a company. It may also be used as an investment decision tool, myn reflects the absolute value created for Hurcholders. Almost all companies have embraced EVA as an indicator of their performance, 25 4% analytical device for creating, selecting and management of a portfolio. Henge value added (EVA) is)8 mes of a company's financial performance, ‘which is based on the weeidual wealth calculated by deducting © cost of capital (both equity and debt deploye? the business) from its operating profit after taxes: EVA can also be reread te as economic profit, as it MAKES Xe attempt to capture the true economic Prom ‘of a company. It reveals the value addition to the shareholders’ eat by computing operating profit in excess (0 the © capital invested in the business: The formula for calculating EVA is: ‘Taxes EVA] Net Operating Profit after (NOPAT) - Teeied| Capital x Weighted Average Cost of Capital (WACO) The notion of EVA wa management consulting Management, originally Stewart & Co. mate of Stern by which earnings ¢%* minienura rate of TOUUIB:. To investing in other securities © ind EVA “ ‘The basic concept behind EV) A thinking that shareholders of is ae good ‘compensated appropriate ly il 169 retums for the investment made and risk taken by them. In any case, the earnings from equity capital should not be less than the earnings from similar risky investments at equity markets. If it is not so. then there is no real profit in the business and from the shareholders’ perspective the company is operating at a loss. Even if the EVA of a company is zero, it may be considered as satisfactory ‘accomplishment because the shareholders were able to get an adequate retum in liew of the risk taken by them by investing in the company. This kind of approach use average risk-adjusted market return 25 a minimum benchmark, may be viewed as acceptable fas such returns are casily possible, if well-diversifics investments are made in stock market on basis, Such retums (average long-term stock market returns) represent the returns generally gen the public companies from their actions, a long-term jerated by ‘Less: Opera (Operating Profit (EBIT) Less: Taxes Net Operating Profit after Tax (NOPAT) Less: Capital Charges (Invested Capital x Cost of Capital) Economic Value Added (EVA) EE) Note: Calealation of Company's Net Operating Profit after Tax (NOPAT) NOPAT is derived from NOP simply by deducting ‘calculated taxes from NOP, ie NOPAT = NOP x (1 Tax rate) 2) Calculation of Economic Value Added (If not in Tabular Format) ‘The EVA can be calculated by subtracting capital charges from NOPAT as follows: EVA = NOPAT — Capital Charges = NOPAT-C x COC where, = Invested Capital; and COC = Cost of Capital Positive EVA indicates value creation while negative EVA indicates value destruction for the ‘company’s owners. 7.2.13.2. Advantages of EVA The concept and implementation of EVA is beneficial for a company in following ways: 1) EVA facilitates the identification of various problem areas prevailing in a company, which can subsequently be monitored and eventually corrective measures can be taken to sort out those problems.170 (Unit-tv) 2) Itean bring about considerable improvement in corporate governance of a company, A higher EVA is likely to result in rewands to the Managervstaft in the form of higher bonuses, which in tam motivates them to work hart in sincere manner. Such an atmosphere is conducive for the growth of the company. 3) BVA reveals a true image of a company’s performance before the such as owners, creditors, different from the various par accounting profit used in assess ‘company’s performance, like EBIT, Net Income, EPS, etc. The EV concept that while assessing the performance of company, the operating costs and the capital costs are needs t0 be taken into account. 4) Ithelps in recognising the best performer of the company or the most suitable individual who run the company in proficient and effective manner. Before taking a decision with regard to the execution of a project, a company may use EVA as a tool to evaluate the project independently 7.2.13.3. Disadvantages of EVA EVA suffers from certain shortcomi which are as follows: 1) Some of the experts opine that EVA is not suitable for all categories of companies. They are of view that it is an appropriate measure for evaluation of performance of established companies which has minimum requirements. of capital expenditures. Capital is an important element in the EVA equation. For other companies, itis not considered as a good measure for evaluation. 2) The basis for computation of EVA is financial statements of a company which subjected to any deliberate change in crucial factors by the accountants that may impact the resultant figure of EVA. 3) EVA and similar other metrics encourages managers of a company to have a short-sighted ‘approach, inasmuch as they are more inclined to focus on immediate benefits in the form of better EVA by making necessary positive changes in present time, rather than keeping an eye on the projects that may not prove beneficial in the immediate future. 4) Another shortcoming of EVA, as a performance measure of a company, it is relates 0 “result orientation”, which implies that it is not a supportive tool to “point towards the root causes ‘of operational inefficiencies me of a MBA Thint SesnesterClnvestinent Analysis ant RtiOtio Management) Ay 7.3.1. Meaning of Bond A bond refers t the instrament which obli issuer to pay pre-defined interest to the buy The face value of the bond is its par value and it is mentioned on the bond document. Bonds are generally issued in denominations of 1000, 2000 ane! so forth The specific rate of interest payable on a bond i¢ called its coupon rate, Mostly the interest payments of bonds are fixed till the maturity periox!, The interest payment on a bond may be quarterly, semi-annually oe nnually. The value of the bond is repaid at the end of maturity period, A bond shares many characteristics with a debenture and. these terms may be used and refers to public debt instruments issued by government or public sector units, Bonds in| India generally refer to long-term debt securities of government and financial institutions. ‘An instrament issued by a company using its common seal is known as debenture, It acknowledges indebtedness of the company to the holder of the bond. In India, a public limited company may issue | debentures for the purpose of raising debt capital However, it needs to obtain certificate of commencement of business f Section 2(12) of the Companies Act, 1956 states that “debenture” includes debenture stock, bonds, and any other security of a company whether constituting & charge on the assets of the company or not. 7.3.2. Nature of Bonds ‘The nature of bonds are as follow: 1) Par Value: Par value is a value. Par value is used for specifying the valve of bonds in balance sheet. A bond may be issue aa price higher or lower than the Par valuc. Pat ue is payable at the expiry of bond tenure 2) Coupon Rate: Coupon rate is also known 3 coupon interest rate, it is the interest rate payable fon the par value of a bond, It is specified it relation to the par value of the bon. Interest my be payable quarterly, semi-annually or annually Further, a bond may be a floating rate bow! where interest rate fluctuates. in relation © general interest rate, A zero coupon bord is O° which is issued below its par value and does 1t offer any interest, 3) Maturity Date: It is the date when par vale ot” bond! is repayable. This is specified acconling the terms of issue.‘Equity, Bond & Derivative Analysis (Chapter 7) 4) Call Provision: Some bonds sion where the issuer may the bond before its orginal maturity dave, Howecee the issuer needs to fulfil specified term neal conditions for this purpose. This righ is genera exercised in the case of fall in general interest ete Thus, these bonds have early provision ny redeeming the bonds before its maturity dag Therefore itis known as callable bond I. 133. Types of Bonds Following figure shows different kind. of bonds: ‘Types of Bonds Premium Bonds LY ors Comic | Tacomas — +H High Yield Bonds Government Bonds come with call choose to redeem, “Municipal Bonds }) Premium Bonds: A premium bond is sold at a Price higher than its par value, For example, if « ‘bond with face value of %100 is sold at 2130 in the market, it will be termed as a premium bond, ‘The premium in this case would be 230. 2Aaiabie Bonds: Callable bonds are also called as redeemable bond. It is a bond that can be redeemed before the maturity date by the issuer. Callable bonds are called when interest rates decline appreciably and have a call price that declines as time passes. 3) Convertible Bonds: These bonds bestow a right ‘on the holders to convert them into equities, a6 specified by te terms of the issue. The ratio of conversion is. generally pre-determined: Once converted, these bonds ae ie ears re, the proce tometer Se ny pre-determined ratio is termed as Cony rsion Ratio. Bond is also. i: A Zero Coupon i ee enema aay thar is soldat 8 eo, Pe ied ingens mer Pa ta ss or ess a s ‘make coupon Pi At a ayer ours Fra periodic sree them be redeemed a is FEE ‘lowing te bono tae 2 ON m 5) Mortgage Bo Assets stich as 1 this, these bonds hy These bonds are backed by ichinery or real estute, Due 10 ave low risk profile 6) High Yield Bonds: Also known as junk bonds, these bonds come with higher interest rite 10 compensate for their high eredit risk, These bonds are deemed speculative by grading agencies and ‘re not considered investment grade. This bond is ‘ot worth to make investments because the money Bets blocked for pre-determined period and would ot inerease more. 7) Fixed Income Bonds: These bonds generate fixed amount of income for their holders. The interest rate is lower as risk associated with these bonds is less. These bonds may be issued by the government as well. Government Bonds and Guaranteed Income Bonds are a type of Fixed Income Bonds, 8) Government Bonds: These bonds are generally issued by the government to their residems. These bonds are considered to have lowest default risk as the government generally does not 80 bankrupt. Consequently, the interest rate Payable on such bonds is also lower than other debt instruments. It gives a fixed yield to the holder of this bond. 9) Corporate Bonds: Bonds issued by companies are known as corporate bonds. In India, such instruments are generally called debentures, whether these are secured or unsecured. Internationally, secured corporate debt instrument is referred to as a ‘corporate bond’ while an unsecured instrument is called a ‘corporate debenture’, 10) Municipal Bonds: These bonds are city or state corporations. These may Purpose bonds or specific purpose, where the funds are raised for particular projects. Narmada Sarovar Bonds issued bs y central government are an example of such bonds. Another example of such bonds is the fundin, is 1g of railway project by issue of municipal bonds by the Konkon Railway Development Corporation Limited for the public. 7.3.4. Valuation of Bonds/ Debentures Determination of present value of bond is related to finding its fair Price and this process is known as pond Valuation’. The fai price of a bond equates te eset salts of future cashflow to be generated y it. Future cashflow is discounted usi Cc eye bas; ‘ounted using applicable issued by be general emer eles. Seaaage G172 Waiv Vy Following are the various assumptions made for this purpose: 1) The coupon interest rate re entire tenure of the bond. 2). The coupon payments are annual in th The next interest payment is due only af 3) The bond is redeemable at par on the expiry of fi Based on these assumptions, the future cashflow on rnon-callable bond equates to an annuity consisting of an annually payable fixed coupon interest rate, while the principal amount is payable atthe end of the te Therefore, the present value of a bond can be iculated as below eG M PES eee Sen +n" where, P= Value (in rupees), n= Number of yeats, interest payment (in rupees), © = Annual coupon r= Periodic required return rate, M_= Maturity value/Principal repayment at the end of m years {= Time period when the payment is received Thus, the discounted present value of future cashflow constitutes the intrinsic value of the bond. The two components of present value of a bond are the present value of principal repayment and the present ‘Value of future interest payments. For the purpose of calculating present value of interest payments, the formula applicable for the present value of a regular annuity is used. The present value of the bond may be calculated as below P where. PVIFA = Present value of interest annuity factor. PVIF = Present value of interest factor at required rate for number of years. > x PVIFA, + M x PVIB ea For example, consider a 10 year, 12 percent coupon bond with a par value of 81,000. The required yield fon this bond is 13 percent. The cashflows for this bond are as follows: 1) 10 annual coupon payments of €120. 2) 21,000 principal repayment 10 years from now. P=Cx PVIFAcat Mx PVIF where, Value of bond (P) Annual coupon payment (C) = €120 (81,000 of 12%) MBA Thied Semester (lavestnent Ans alysis and Portfolio Managemen) aK (n= 10 at the Number of y' al repayment re (M) = £1,000 Periodic required retu n rate (0) = 134 we of the bond is ~The valu PVIFAive, om + 1,000 PVIF 99, P= 120 120 x (5.426) + 1,000 x (0.295) = 651.12 + 295 = 7946.12 ¢ the value of a bond from the xample 15: Calcula following data: i). The par value of the bond is 1,000. ii) Ivbears a coupon rate of 14% iii) The bond will mature after 5 years iv) The required rate of retu non the bond is 13% Solution: P = C x PVIFA, «+ M x PVIF rn Value of bond (P) = ‘Annual coupon payment (C) = €140 (&1,000 of 14%) Number of years (n) = 5 years Principal repayment at the end of 5 years/Maturity value (M) = ®1,000 Periodic required return rate (r) = 13% *. The value of bond is: Z140(PVIFAss, sys) + €1,000(PVIF i, 5) £140 x (3.517) + £1,000 x (0.543) 492.38 + £543 = €1,035.4 following data: i) The par value of the bond is €1,000. fi) Itbears a coupon rate of 12%. iii) Its maturity period is 3 years, iv) The required rate of return on the bond is 10% Solution: P = C x PVIFA, «+ M x PVIF.. where, ‘Value of bond (P) 120 (€1,000 ‘Annual interest/coupon payment (C) Anna -oupon payment (C) = Number of years (n) = 3 years Principal repayment at the end of 3 yearvMatus®) value (M) = 71,000 : Periodic required return rate (t) = 10% 2. The value of bond is: P= 2120 (PVIFA jog, yn) + £1,000 (PVIF 1.2 2120 x (2.487) + 1,000 x (0.751) = 2298.44 + 8751= 1,040.44gin Bond & Derivative Analysis (Chapter 7) sample 17: Calculate the value of a bond from the slowing data: The par value of the bond is 2100. ) Itbears a coupon rate of 12% twill mature after 8 years, }) The required rate of return on the bond is 14% olution; P = C x PVIFA,.+ Mx PVIF, yhere, Value of bond (P) = annual interesUcoupon payment (C) = 812 (8100 of 12%) Number of years (n) = 8 years Principal repayment at the end of 8 years/Maturity value (M) = 7100 Periodic required return rate (r) = 14% . The value of bond is: T2(PVIFA jax, yr:) + TLOO(PVIF 4,550) = 212 x (4.639) + 100 x (0.351) 55.67 + 235.1= 290.77 Bond Value with Semi-Annual Interest While most of the bonds state annual rate of interest, the payment is actually made on semi-annually basis. In such cases, following steps are taken to calculate the value of bond: 1) Semi-annual interest payment is calculated by dividing the annual interest payment by 2 2) The number of years to maturity are multiplicd by 2to get the totalnumber of half-yearly period. 3) The discount rate is divided by 2 1 eae appropriate discount rate of semi-annual period: ‘cations, the formula for ronual interest is given as After making above mi valuing the bond with sem below: pa Ss. GY, Maw tari a+” = Sf, x PVIPAra ant M * PVIF., 2» Example 18; Calculate the prevent valve of from the following data: 1}. A bond has a par valve of is payable semi-annually. fa bond 00 on which interest ; 2 perce 1 bea coupe id aa iv) The required sate of return 0” ne HS Solution; P= Sf x VIA" MoBNFe™ a ” s/matrily a ax the end of 8 Yew ) = £100 1B Semi-annually receipt of interest/coupon rate (C/2) = 6 (2100 of 12%/2) Semi-annually required rate of interest (1/2) = 7% (14%)2) No. of periods (2n) = 16 years (Byears%2) ‘Time period when the payment is received (t) = 16 years 2. The value of bond is: P= 26% (PVIFA 1x, soyn) + 8100 x (PVIF ia. son) = 86 x (9.447) + 2100 % (0.339) = 256.7 + 733.9 = 290.6 Example 19: A bond of 21,000 bearing a coupon rate of 12% p.a. payable half-yearly is redeemable after five years at par. Find out the value of the bond given that the required rate of return is 14%. Solution: Given, Value of bond (P) =? Principal payment at the end of 5 years (M) = 71,000 Half-yearly receipt of Interest /coupon rate (C/2) = 260 (1,000 of 12%/2) Half-yearly required rate of interest (1/2) = 7% (14% / 2), No of period (2n) = 10 years (5 years x 2) ai) -. Value of bond (P) =) -— fi +1/2) e__ 60 1,000 P= aL Zoro 0 (1+0.07)" = 60 x (PVIFAys, 1Oyrs) + 1,000 x (PVIP; = (60 x 7.024) + (1,000 x 0,508) = 421.44 + 508 = 8929.44 Example 20: Calculate the value of the bond with semi: ‘annual and annual interest from the following data: i) Abond has a par value of € 1,000. ) It bears a coupon rate of 10 percent ‘The bond's maturity period is after 10 years iv) The required rate of return on the bond is 12% ¥) Payment of interest is semi-annually. , 1Oyrs) Solution: Interest pald Semi-Annually: P= O &PVIPA vo, ant MX PVIB yn oy where, Value of bond (P) =? Principal repayment sas iment at the end of ‘Semi-annually. receii payment(C/2) = %50, 1.000 ShOK Seimi-annuall ) Tam ANnally required rate Of interest (2) = 6% No. of periods (21) = 20 years (1Oyears x 2) 10 years (M) = Pah MS eK 2) > ee174 (Unit-tv) ©. The value of bond is: E50(PVIFAg, 20 yn) + 1,000(PVIF yn, 25) = 250 x (11.470) + 21,000 x (0.312) 573.5 + F312 = 2885.5 Interest paid Annually: P=C x (PVIFA,,,)+ M x (PVIF, ,) ae | Tals or bond @) eee at value (M) = 71,000 Feta Hesses of incrtveraban payeaaiOy's 7100 (21,000 of 10%) Oe cer Ree ss he oye 100(PVIFA\ 25,10 yn) + €1,000(PVIF 2, 10s) 100 x (5.650) + 1,000 x (0.3220) 565 + £322 = 2887 The investor would be willing to pay 2887 for the bond. Exafiple 21: An investor finds. the following -fosition in respect of two bonds I and Il Face Value] Coupon Rae[Life [Market Prise] BoaaT] 3000 | 850% [year] 9900 [Bona | “10000 [875% —[s year] 4950 Given that Coupon interest is payable annually and the required rate is 90%. Find out the value of both bonds. Which one is better to invest in? fg = 1 (PVIFA a. «) + F (PV IF a, 2) Solution: Bond I ‘Annual interests payable +. The value of the Bond, 5,000 x 8.5% = 8425 425(PVIFAga, 3yn) + 5,000(PV IF 9s, s ys) 425(2.531) + 5,000(0.772) = 1,075.675 + 3,860 = 4,935.68 Vv, Bond IL ‘Annual interest payable = 10,000 x 8.75% = €875 ©. The value of the Bond, Vo = 875(PVIFAgs, yn) + 10,000(PVIF 9, 4) = 875(3.240) + 10,000(0.708) 2,835 + 7,080 = 09.915, Conclusion: Since the market price of Bond I (9,900) is higher than the estimated price of Bond I (4,935.68). So, Bond I is better to invest in, MBA Third Semester (Investment Analysis and Portfolio Mana 7.3.5. Bond Yield Yield is one of the most important terms related to 4 bond, Bonds are normally compared on the basis of their yields as their prices vary significantly due tp differences in cashflow and other features. Following are the four main types of yields: ond Viel Curent Yield ied o Maturity (VT ie wo Call VTC) Realized Yield Current Yield 7351. ‘The current yield is obtained by dividing annual interest by market price of the bond and thus it relates annual coupon rate to the market price Annual Interest (Is) 599 Market Price (P,) Current Yield ‘This concept does not take time value of money into account. It also does not take into account the actual purchase price and hence till the expiry period it cannot be used to calculate capital gain or loss iculate the current yield from the Example 23 following data: 1) A bond with a par value of 21,000 2) Itbears a coupon rate of 12%. 3) The bond's maturity period is after 10 years. 4) Its market price for selling is £950. PBoauall interes! 1))<100, Market Price (P,) Solution: Current Yiel Where, Annual Interest (I,) = 8120 (81,000 of 12%) Market Price (Po) = 7950 Current Yield = #29 199 = 0.1263 oF 12.63% 950 Example 23: Calculate the current yield for 115% GOI series 2015 with face value of %1,000 am ‘current market price of €1,010. ‘Annual interest(Is 199 Solution: Current Yield Market Price (Py) where, Annual Interest (I Market Price (Ps) R115 (1,000 x 11.5%) 1,010