Chapter 6: Valuation of bonds and shares

End of Chapter Questions

6.5 What is the intrinsic value of a security and why do we focus on intrinsic
values in finance?

The intrinsic value of a security is the present value of expected future cash flows. Cash
flows are forecast and then discounted at the investor’s required return. Intrinsic value
is the appropriate value for finance because it applies the principles of the time value of
money.

6.12 If dividends are paid semi-annually on a preference share and we adjust

the required return to reflect this, is the intrinsic value any different to a
share with the same total dividend paid annually and an annual required
return? Use an annual dividend of $1 and a required return of 9% to
demonstrate your understanding.

The cash flows of a preference share form a perpetuity. As shown by the following
calculations, there is no difference in the intrinsic value of a preference share paying
and annual dividend of $1 compared to a semi-annual dividend of $0.50 for a given
investor.
1 0.50
Vp   $11.11 Vp   $11.11
0.09 0.045
If we were looking at a security with a finite life, we would find that the security with
more frequent cash inflows would have a higher intrinsic value.

6.18 What is the most difficult aspect of valuing ordinary shares?

The most difficult aspect of valuing ordinary shares is making reliable forecasts for
dividends over the infinite life of the security. While it is not too difficult make
reasonable (i.e. fairly accurate) forecasting in the shorter term (say one to two years),
analysts don’t always get it right. Forecasting in the longer term (over two years) with
much degree of accuracy is extremely difficult. Most analysts confine their earnings
and dividend forecasts to a two-year horizon.

6.19 Explain why you should not use a PE multiple from the financial press to
value a share.

The PE multiples in the financial press are calculated as the most recent price divided
by the last period reported earnings per share for the company. Our definition of the PE
ratio is the relationship of price to forecast earnings. Unless the past EPS is a perfect
predictor of next period’s EPS, we would not find that the PE ratios in the newspaper
are able to help us ascertain the intrinsic value of the share. As with all of our valuation
models, the intrinsic value you calculate from them is only as good as the forecasts you
put into them!
 Chapter 6: Valuation of bonds and shares

6.20 Is there a theoretical relationship between the constant growth model and
the PE method of valuation? What does the relationship depend on?

The theoretical relationship between the constant growth model and the PE method of
valuation is that both will give the same valuation for a share when you use the same
assumptions in your forecasts of dividends and earnings.

Financial Problems
6.1 You have been offered an investment with the following cash flows:
End year $
1 50
2 80
3 300
If you have a discount rate of 7% p.a., how much is this investment worth
to you?

n
CFt
V 
t 1 (1  r )
n

50 80 300
V   
1  0.07 1  0.07 1  0.073
1 2

V  46.73  69.88  244.89  $361.49

6.7 Vision Systems bonds have a face value of $500 000, a coupon of 7.75% and
7 years to maturity. Coupons are paid semi-annually. If your required
return is 11% p.a., what is the intrinsic value of this bond?

0.0775 0.11
Ct   500,000  19,375 rb   0.055
2 2
1  (1  rb )  n  F
Vb  C  
 (1  rb )
n
 rb
1  (1  0.055) 14  500,000
 19,375  
 (1  0.055)
14
 0.055
500000
 19375 9.5897 
2.1161
= 185 799.43 + 236 283.73
= $422 083.16
 Chapter 6: Valuation of bonds and shares

6.17 Calliope Ltd has been listed for the last 20 years. Over this time, investors
have enjoyed a steady stream of dividends. You expect the current annual
growth rate of about 1% to be maintained into the foreseeable future.
Dividends are paid semi-annually and the dividend paid last week was 13c
per share. If your required return for Calliope is 5% p.a., what is the
intrinsic value of a share?

D1
Using equation 6.7 Ve 
re  g
D (1  g )
Ve 
re  g
0.13(1  0.005)

0.025  0.005

The last dividend would have been a semi-annual one. The growth rate and required
return, however, are annual so need to be divided by two.

0.13065
 = $6.53
0.02

6.18 You have forecast an annual growth rate of 3% for MOP Ltd. Dividends
are paid annually and the last dividend was 50c. If your required return is
12% p.a., what is the value of an MOP share?

D1
Ve 
re  g
0.50(1  0.03)
Ve   $5.72
0.12  0.03
6.20 Shares in Cochlear Ltd have been trading on the ASX for about 12 years. Over that time, the company has experienced
a phenomenal growth rate in dividends of about 25% p.a. This growth has been achieved by expanding into overseas
markets and, to a lesser extent, by new product development. You expect that growth in US sales will support the current
growth in dividends for a further 5 years. After that time, you expect dividend growth to slow to about 10% p.a. and the
new growth rate to be maintained for many years to come. Total dividends last year were 51 cents. The next dividend
payment is due 6 months from now and dividends are paid semi-annually. What is the intrinsic value of a Cochlear share
if your required rate of return is 16% p.a.?

D(1  g1 ) D(1  g1 ) 2 D(1  g1 )10 D(1  g1 )10 (1  g 2 ) 1

Ve    .....   
(1  re ) (1  re ) 2
(1  re )10
re  g (1  re )10

0.255(1  0.125) 0.255(1  0.125) 2 0.255(1  0.125)10 0.255(1  0.125)10 (1  0.05) 1

   .....   
(1  0.08) (1  0.08) 2
(1  0.08)10
0.08  0.05 (1  0.08)10

0.2869 0.3227 0.3631 0.4085 0.4595 0.517 0.5816 0.6543 0.7361 0.8281 0.86947  1 
            
1.08 1.1664 1.2597 1.3605 1.4693 1.5869 1.7138 1.8509 1.999 2.1589 .03  2.1589 

= 0.2656 + 0.2767 + 0.2882 + 0.3003 + 0.3127 + 0.3258 + 0.3393 + 0.3535 + 0.3682 + 0.3836 + 13.4244

= $16.64
6.27 (a) The last dividend on an ordinary share was $0.50. You expect the
dividends to grow at 2% per annum for the foreseeable future. What is
the value of the share if the required return is 10% p.a.?

D1
Ve 
re  g

0.50(1  0.02)
Ve   $6.38
0.10  0.02

(b) The next dividend on an ordinary share is expected to be $0.50. You

expect the dividends to grow at 2% per annum for the foreseeable future.
What is the value of the share if the required return is 10% p.a.?

0.50
Ve   $6.25
0.10  0.02

© John Wiley and Sons Australia, Ltd 2008 5.5