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- Introduction to Accounting - 1st Edition - Anthony Webster
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You are on page 1of 54

FINANCIAL ASSETS

Valuation

Is a process of determination of

worth of an asset.

Different concepts of Valuation

Book Value

Market Value

Going concern Value

Liquidating Value

Capitalizes value

Book value

the Balance sheet will be treated as historical value or book

value.

In case of equity shares Book Value = Net worth / No. of equity

Shares.

Market Value

The price at which the shares & debentures are sold. In case of

the financial assets which are listed in a recognized stock

exchange, the price prevailing at the stock exchange is the

market value.

It refers to the value of the business, as an operating, performing

and run by business unit. This is the value, which a prospective

buyer of a business may be ready to pay.

Liquidating value

L.V. represents to the net difference between the realizable

value of all assets and the sum total of external, liabilities.

This net difference belongs to the shareholders.

Capitalized Value

C.V. defined as the sum of present value of cash flows,

from an asset discounted at the required rate of return

(i.e.) to find out C.V. the future expected benefits are

discounted for time value of money.

BOND VALUATION

Bond is a long term financing used

by firms, which upon issuing,

promise to make some future cash

inflows interest/ repayment of the

bond.

Bond Terminology

Coupon Rate - This is the stated rate of interest

on the bond. It is fixed for the life of the bond.

Also, this rate time the face value determines the

annual interest payment amount.

Face Value - This is the principal amount

(nominally, the amount that was borrowed). This

is the amount that will be repaid at maturity

Maturity Date - This is the date after which the

bond no longer exists. It is also the date on

which the loan is repaid and the last interest

payment is made.

Bond Risk

Bond Return

Bond Yield to Maturity

Bond Risk

Interest Rate Risks: The return expected from bond will

vary as per the variation in the interest rate in the market.

This is known as interest rate risk. Market Interest is inversely

related to the price of the bond.

agreed value of debt Instrument in full/ on time or both, this

is default risk.

selling the bonds in the market at its face value without giving

any discount, this is marketability risk.

issues to call the bond at any time & this creates an

uncertainty in the return of investor, this is called as callability risk.

Bond Return

Holding Period Return

Current Yield

Current Price

Purchase Price

Where,

Price = Selling Price Purchase

Price

Yield to maturity means

the expected rate of return,

which an investor can

expect to earn if the bond is

held till maturity.

Rv Bo

I

n

Ytm

Rv Bo

2

Yield to maturity is a

single discount factor that

makes the present value of

future cash flows from a

bond equals to the current

price of bond.

I

= coupon interest

Rv = Redemption value

Bo = Bond Price

n

= years to maturity

Value of Bond

n

Ii

Fv

VB

i

n

(1 r )

i 1 (1 r )

I = Interest

receivable per year

Rv = Redemption

Value

Fv = Face value

Bond/Zero Coupon Bond r = Required rate of

VDD B

Fv

n

(1 r )

return

n = No. of years

Decision

(Value of the Bond)

is greater than the

current market price,

then Investors can buy

(Value of the Bond)

is smaller than the

current market price

then investor should sell

Theorem 1- If the Market Price of bond

increases the yield will decreases and vice versa.

Based on Concept that if the required rate of

return and the coupon rate are equal then the

bond will be equal to the par value. So, if the

required rated return is greater then the coupon

rate, the bond value is less the par value.

Theorem 2- If the bond yields remain same over

its life, the discount premium depends on

maturity period.

Bond with a short term maturity sells at a lower

discount than the bond with long term maturity.

over its life , the discount or premium amount will

decreases at an increasing rates at its life gets

shorter.

Bond with shorter maturity has more present

value i.e. less discount.

Theorem 4 A raise in the bonds price for a

decline in the bonds yield is greater than the falls

in the bonds price for a raise in the yield.

The fall in the yield results in greater raise in

bond price than the raise in the yield results in

decrease in Bond price.

lesser for a percentage change in bonds yield of

its coupon rate is higher.

When the yield to maturity changes by 1% then

the bond with higher coupon rate has a lower %

of change in price than bond with lower coupon

rate.

Convexity

Bond Price and YTM are inversely related

The rise in the price results in a fall in the yield

and vice versa.(Theorem-1)

This relationship is not linear. i.e., A raise in the

bonds price for a decline in the bonds yield is

greater than the falls in the bonds price for a

raise in the yield and vice versa.(Theorem-4)

This refers to Bond convexity.

Differs from bond to bond depending upon the

size of the bond, years to maturity and the

current market price.

Yield Curve

Term structure of Interest rate is the relationship

between the yield and time to maturity.

This is know as Yield Curve

The general perception is that the curve will be

upward moving up to a point and then becomes

flat.

This is explained through three theories

Expectation theory

Liquidity preference theory

Segmentation theory

Expectation theory

Based on Investors Expectation

A rising yield curve- investors

expectation of continuous rise in

interest rate.

A flat yield curve- investors expect

interest rate to remain constant.

A declining yield curve- investors

expectation of decline in interest rate

The investors prefer to invest in the

short term bonds than to long term

bonds because of the uncertainty of

the future and of greater liquidity in

short term.

So the investors have to be

motivated through premium to be

paid to them.

Segmentation theory

This theory is based on the supply and

demand of the funds segmented in sub

markets because of the preferred habits of

the individuals.

Insurance company prefers Long term

bonds, whereas the commercial banks and

corporates may prefer liquidity to meet

their short term requirements through

short term bonds.

Duration

Measures the time structure of a bond and

the bonds interest rate risk.

Measures the average time taken for all

interest coupons and the principal to be

recovered.

This is called Macaulays duration.

It is the weighted average of periods to

maturity, with the weights being present

values of the cash flow in each period.

Pv (Ct )

D

xt

Po

t 1

D Duration

C Cash flow

t number of years

Pv (Ct ) present value of the cash flow

Po sum of the present value of cash flows

General rule

Higher coupon rate, lower duration-less

volatile bond price

Longer term of maturity, longer durationmore volatile bond

Higher YTM, lower duration-more bond

volatility and vice versa.

In case of a zero coupon bond, the bonds

term to maturity and duration are the

same. It repays at the time of maturity the

principal and the interest at the same

time.

Immunization

The coupon rate risk and the price risk can

be made to offset each other.

Whenever there is a increase in the

market interest rate, the price of the bond

falls. At the same time, the newly issued

bonds offer higher interest rate. The

coupon can be reinvested in the bond

offering higher interest rate and losses

that occur due to fall in price of the bond

can be offset and the portfolio is

immunised.

interest rate and price risks by

matching the outflow duration with

cash inflow duration from bond

investment.

Investment outflow = (X1 x duration

of bond 1) + (X2 x duration of bond 2)

Where X1 and X2 refers to proportions

of investment in bond 1 and bond 2

Four strategies used to manage bond

portfolio:

Passive strategy

Quasi-passive strategy

Immunization or quasi-active

strategy

Active strategy

Passive strategy

Buy and hold

Buy the bonds and hold till the

maturity

Reinvestment of the coupons.

Quasi-passive strategy

Ladders-portfolio of individual bond

with various maturity dates.

Laddered Portfolio

(contd)

29

Bullets

Staggered purchase of several bonds

that mature at the same time.

Maturity matching strategy

Barbell strategy

The barbell strategy differs from

the laddered strategy in that less

amount is invested in the middle

maturities

32

Active Strategy

Valuation strategy- depends upon

the portfolio managers ability to

identify and purchase the

undervalued bonds and avoid the

overvalued bonds.

Bond swap startegies

Bond swap

In a bond swap, a portfolio manager

exchanges an existing bond or set of

bonds for a different issue

Bond swaps are intended to:

Increase current income

Increase yield to maturity

Improve the potential for price appreciation

with a decline in interest rates

Establish losses to offset capital gains or

taxable income

Substitution Swap

In a substitution swap, the investor

exchanges one bond for another of

similar risk and maturity to increase

the current yield

E.g., selling an 8% coupon for par and

buying an 8% coupon for Rs.980

increases the current yield.

35

Substitution Swap

(contd)

Profitable substitution swaps are

inconsistent with market efficiency

Obvious opportunities for

substitution swaps are rare

36

Intermarket or

Yield Spread Swap

The intermarket or yield spread swap

involves bonds that trade in different

markets

E.g., government versus corporate bonds

can cause similar bonds to behave

differently in response to changing

market conditions

37

Intermarket or

Yield Spread Swap (contd)

In a flight to quality, investors

become less willing to hold risky

bonds

As investors buy safe bonds and sell

more risky bonds, the spread between

their yields widens

using the confidence index

The ratio of the yield on AAA bonds to

the yield on BBB bonds

38

Bond-Rating Swap

A bond-rating swap is really a form

of intermarket swap

If an investor anticipates a change in

the yield spread, he can swap bonds

with different ratings to produce a

capital gain with a minimal increase

in risk

39

In a rate anticipation swap, the

investor swaps bonds with different

interest rate risks in anticipation of

interest rate changes

Interest rate decline: swap long-term

premium bonds for discount bonds

Interest rate increase: swap discount

bonds for premium bonds or long-term

bonds for short-term bonds

40

Valuation of Convertible

Debentures (CD)

In case of CD, the debenture holder get interest

at a specified rate for a specified period, after

which a part of / full value of the CD is converted

into specific number of equity shares.

Again in case of partial conversion, the nonconvertible portion continues to earn interest for

the remaining period, after which it is redeemed.

The cash flows associated with this transaction are:

Periodic interest receivable from the company.

Expected market price of the shares received on

conversion.

Redemption amount if any.

VCD

Ii

Rv

MxPt

i

n

t

(1 Kd ) (1 Ke)

i 1 (1 Kd )

Vcd = Value of CD

I = Interest receivable per year

Kd = Rate of discount

Ke = Required rate of return on equity

M = No. of shares received on conversion

Rv = Redemption value of debenture

N= Life of debenture

Pt = Share price at the time of conversion

t= n + 1 year

Valuation of preference

shares

Returns / Benefits of preference

share investment are:

A dividend at a fixed rate.

Redemption amount at the time of

happens in case of redeemable

preference share only).

n

Di

Rv

Po

i

n

(1 Kp )

i 1 (1 Kp )

Irredeemable Preference Share

Po

i 1

Di

D

i

(1 Kp )

kp

Di = Dividend

Kp = Required rate of return

Rv = Redemption Value

n = Life of Preference Share

Valuation of equity share is most

typical because of its residual

ownership character. The equity

shareholders receive, the residual

profits and also the residual assets in

case of liquidation.

Valuation Approaches

Valuation of equity shares based on

accounting intermediaries.

Valuation of equity share based on

dividend.

Valuation of equity shares based on

earnings.

per Dividend discount model

Two basis factors

Expected growth pattern of future

dividend

Appropriate discount rate / required rate

of return.

concerned, growth may be as:

No growth

Constant growth

Varied growth.

(Perpetuity case)

The dividend per share remains constant year after year

Ve

i 1

Di

D

i

(1 Ke )

ke

The dividend per share grows at a constant rate.

Ve

i 1

D0 (1 g )

i

(1 Ke)

D1

ke g

g = Growth rate, Ke = Required rate of return

n = No. of years

The extraordinary growth continues for a

finite no. of years and there after

normal growth rate will prevail infinitely.

D0 (1 g1 ) i NextyearDividend

1

Ve

x

i

n

(

1

Ke

)

Ke

g

(

1

Ke

)

i 1

2

n

D0 (1 g1 ) i D0 (1 g1 ) n (1 g 2 )

1

x

i

n

(

1

Ke

)

Ke

g

(

1

Ke

)

i 1

2

n

rate, g2 = Above normal growth rate

Ke = Required rate of return, n = Period of Normal

growth

Decision

Calculated Rate of Return > Required

Rate of Return Buy

Calculated Rate of Return < Required

Rate of Return Sell

E0 xd / e(1 g1 ) i E0 xP / E (1 g ) n

Ve

i

n

(

1

Ke

)

(

1

Ke

)

i 1

E0 EPS

n

d / e dividend payout

g growth rate

P/E Price earning ratio

Ke required rate of return

n expected holding period of the investor

Graham-Dodd model

Whitbeck- Kisor model

Graham-Dodd model

P/E= 8.5 + (2 x Growth%)

Price = EPS (8.5 + (2 x Growth%))

If the calculated price is more than the

current price, then the stock is

considered to be underpriced and

placed in the buy list.

Model suggested to consider a stock if

the actual price was 80% or less than

the calculated price to reduce the risk

P/E = 8.2 + 1.5g + 0.067 D/E - 0.2

g= growth rate %

D/E =dividend payout

=standard deviation in growth rate

Decision

Theoretical P/E > actual P/E Sell

Theoretical P/E < actual P/E - Buy

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