Financial Management

Lecture 3
Valuation of Securities

Course leader : Dr. Asnake Minwyelet (Ph.D.))

Contents in this chapter

3.1 Bonds Values and Yields – computational methods

3.2 Valuation of Preference Shares
3.3 Valuation of Equity Shares
 Bond valuation
• Bonds represent debt obligation to
the issuer (borrower).
• The creditor (s) are referred to as bond
holders, or investors
• Bonds are assets to the creditors
(holders) or investment in financial
assets
 Bonds cont’d

Bond Features
Bonds have the following features that affect their
values
• Pa r ( s t a t e d va l u e ) – re p re s e n t t h e p r i n c i p a l
amount promised to be paid at maturity by the
issuer
• Coupon interest rate – annual or semi annual
interest payment stated as percentage of par
value
• Coupon payments – specified number of
payments attached to bonds
 Cont’d
• Maturity date – specified date on which par value is repaid
• Call provisions – terms of contract or clause attached to bond
providing for possibility of retiring the bonds before maturity
date at the option of the issuer
• New issues vs outstanding bonds
• Bond contract- indenture

Other features of bond include:

• Mortgage bonds
• Debenture bonds
• Convertible bonds
• Zero coupon bonds
Basic bond valuation model

• Bond value is the price an investor ( bond holder) is willing to

pay for the bond
• The value depends on the stream of interest and principal
cash flows expected from the bond
• Thus, we need to know
– The interest cash flows to the holder
– Principal amount to be collected at maturity (term bonds)
– Risk adjusted discount rate at which these amounts are
discounted to present value
INT1 + INT2 +INT3 + …+ (M+INTn)
1 2 3 … n

(discounted at kd )
discount rate (market interest rate on
similar/comparable investments)
Value of bonds
Thus, Bo= INT1 + INT2+ INT3+…+ INTn + M
(1+k d) (1+kd)2 (1+kd)3 … (1+kd)n (1+kd)n

n
Bo = ∑ INTt + M
t=1 (1+kd)t (1+kd)n

Where : INT= amount of interest paid in each period

M = Par ( stated value) collected at maturity
n = number of periods involved
kd = the appropriate discount rate
 Bond valuation illustrated

• Assume the following;

ABC corporation issued 10% coupon 50,000
bonds ( Birr 1000 par) on 1st January
2007. The bond matures on 31st
December 2016. Interest is computed
annually. Calculate value (Vo) of the bond
if market interest rate ( kd ) is :
–A) 12 % per annum (Br. 887 each)
–B) 8% per annum (Br. 1134 .2 each)
–C) 10% per annum ( same as coupon
rate) (Br. 1,000 each)
Valuation of Equity Security
 Common Stock:
• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors hire management.
• Preemptive right.
• Since managers are “agents” of shareholders,
their goal should be: Maximize stock price.
Different Approaches for Valuing Common Stock
• Dividend growth model
– Constant growth stocks
– Nonconstant growth stocks
• Free cash flow method
• Using the multiples of comparable firms
 Constant Growth Approach to Equity Valuations

– Po = (D1 / R – g)
– Discounting the Dividends (or CFs) by R-g (return adjusted for
constant growth)
• Constant growth model: works when g is constant rate (%) &
R>g
– If we need R (required return) to use as discount factor, we can
use SML relationship from CAPM
• SML: Ri = rRF + (RM - rRF)bi .
 Stock Value = PV of Dividends

^ D1 D2 D3 D∞
P0 = + + +…+
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞

What is a constant growth stock?

One whose dividends are expected to grow

forever at a constant rate, g.
 For a constant growth stock:

D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t

If g is constant and less than rs, then:

^P = D0(1 + g) D1
0 =
rs – g rs – g
 What happens if g > rs?

^ D0(1 + g)1 D0(1 + g)2 D0(1 + rs)∞

P0 = + +…+
(1 + rs)1 (1 + rs)2 (1 + rs)∞
(1 + g)t ^
If g > rs, then > 1, and P0 = ∞
(1 + rs)t

So g must be less than rs for the constant growth

model to be applicable!!
Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%.

Use the SML to calculate rs:

rs = rRF + (RPM)bFirm
= 7% + (5%)(1.2)
= 13%.
 Projected Dividends
• D0 = $2 and constant g = 6%

• D1 = D0(1 + g) = $2(1.06) = $2.12

• D2 = D1(1 + g) = $2.12(1.06) = $2.2472
• D3 = D2(1 + g) = $2.2472(1.06) = $2.3820
Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)

0 g = 6% 1 2 3

2.12 2.2472 2.3820

1.8761 13%

1.7599
1.6508
Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6%
Constant growth model:

^ D0(1 + g) D1
P0 = =
rs – g rs – g

$2.12 $2.12
= = =$30.29.
0.13 – 0.06 0.07
 Expected value one year from now:
• D1 will have been paid, so expected dividends are
D2, D3, D4 and so on.

^ D2 $2.2472
P1 = = = $32.10
rs – g 0.07
 Return = Dividend Yield + Capital Gains Yield

D1
Dividend yield =
P0

^
P1 – P0 New - Old
Capital G Yield = =
P0 Old
 Expected Dividend Yield and Capital Gains Yield (Year 1)

D1 $2.12
Dividend yield = = = 7.0%.
P0 $30.29

^
P1 – P0 $32.10 – $30.29
CG Yield = =
P0 $30.29
= 6.0%.
 Total Year 1 Return
• Total return = Div yield + Cap gains yield.
• Total return = 7% + 6% = 13%.
• Total return = 13% = rs.
• For constant growth stock:
– Capital gains yield = 6% = g.
Rearrange model to rate of return
form:
^ D1 ^r D1
P0 = to s = + g.
rs – g P0

Then, r^s = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.
If g = 0, the dividend stream is a
perpetuity.
0 r = 13% 1 2 3
s

2.00 2.00 2.00

^ PMT $2.00
P0 = = = $15.38.
r 0.13
 Preferred Stock

• Hybrid security.
• Similar to bonds in that preferred stockholders
receive a fixed dividend which must be paid before
dividends can be paid on common stock.
• However, unlike bonds, preferred stock dividends
can be omitted without fear of pushing firm into
bankruptcy.
 Expected return =?,
given Preferred stock share trading at $50 & pays annual dividend = $5

= $50 = $5
Vps
^rps

^rps = $5 = 0.10 = 10.0%

$50
End of Chapter Three