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Principle underlying valuation:

Value of any asset is the discounted value


of the future steams of benefit expected
from the asset.
mntroduction
‡ ssets can be real or financial; securities
like shares and bonds are called financial
assets Œhile physical assets like plant and
machinery are called real assets.

‡ The concepts of return and risk, as the


determinants of value, are as fundamental
and valid to the valuation of securities as to
that of physical assets.
ºoncept of Value
‡ Book Value

‡ Replacement Value

‡ Liquidation Value

‡ Going ºoncern Value

‡ Market Value
÷eatures of a Bond
‡ ÷ace Value

‡ mnterest Rate²fixed or floating

‡ Maturity

‡ Redemption value

‡ Market Value
Bonds Values and Yields
‡ Bonds Œith maturity

‡ Pure discount bonds

‡ Perpetual bonds
Bond Œith Maturity
Bond value = Present value of interest +
Present value of maturity value:

i
 i
‰  
      i
Yield to Maturity
‡ The ë 
ë (- Î is the measure of
a bond¶s rate of return that considers both the
interest income and any capital gain or loss.
-  is bond¶s internal rate of return.
‡ YTM of a bond Œith maturity:

‡ A perpetual bond¶s yield-to-maturity:

i 
 
‰   
    
ºurrent Yield
‡ ºurrent yield is the annual interest divided
by the bond¶s current/market value.
‡   The annual interest is Rs 60 on
the current investment of Rs 883.40.
Therefore, the current rate of return or the
—

 ë  is: 60/883.40 = 6.8 per cent.


‡ ºurrent yield does not account for the
capital gain or loss.
Yield to ºall
‡ Yield to call is the return associated Œith the
bonds Œith buy back or call provision Œhen the
call option is exercised before maturity.

‡  : Suppose the 10% 10-year Rs 1,000


bond is redeemable (callableÎ in 5 years at a call
price of Rs 1,050. The bond is currently selling
for Rs 950.The bond¶s yield to call is 12.7%.
ë
‰‰ ‰ë‰
ë‰   ë
 Ú  Ú 
Bond Value and Amortisation of
Principal
‡ A bond (debentureÎ may be amortised every
year, i.e., repayment of principal every year
rather at maturity.
‡ The formula for determining the value of a bond
or debenture that is amortised every year, can
be Œritten as folloŒs:
i

‰  
   

± Note that cash floŒ, º , includes both the interest and


repayment of the principal.
Pure Discount Bonds
‡ Pure discount bonds are called   — 
  or 
 
   or 

—   
‡ The 
 

, also called the

 ë , is used as the discount rate.
‡ Value of a pure discount bond = PV of the
amount on maturity:

i
‰  i
Ú 
Pure Discount Bonds
  A company may issue a pure
discount bond of Rs 1,000 face value for
Rs 520 today for a period of five years.
The rate of interest can be calculated as
folloŒs:
‰‰‰
ë ‰  ë
Ú 
뉉‰
Ú     
ë‰
R   
ë   ‰   
Perpetual Bonds

@
   , also called consols, has
an indefinite life and therefore, it has no
maturity value. Perpetual bonds or
debentures are rarely found in practice.
Perpetual Bonds
‡ Suppose that a 10 per cent Rs 1,000
bond Œill pay Rs 100 annual interest into
perpetuity. What Œould be its value of the
bond if the market yield or interest rate
Œere 15 per cent?
‡ The value of the bond is determined as
folloŒs:
 ‰‰
‰     
 ‰ ë
Bond Values and ºhanges in
mnterest Rates
‡ The value of the bond declines as the market interest rate (discount
rateÎ increases.
‡ The value of a 10-year, 12 per cent Rs 1,000 bond for the market
interest rates ranging from 0 per cent to 30 per cent.

‰‰ ‰

‰‰‰ ‰

‰‰ ‰

  

‰‰ ‰

‰‰ ‰

‰‰ ‰

‰‰
‰  ‰  ‰  ‰

m  
Bond Maturity and mnterest Rate
Risk
‡ The intensity of interest rate
risk Œould be higher on
honds with long maturities
than honds with short @  
 
maturities.   
  
 
 

 
àà à à à à
‡ The differential value à à à à
response to interest rates à àààà ààà
à àààà
changes betŒeen short and à àààà ààà à ààà à
long-term bonds Œill alŒays
be true. Thus, tŒo bonds of à ààà
à àà  à ààà à
same quality (in terms of the à ààà à ààà ààààà
risk of defaultÎ Œould have
à
different exposure to interest
rate risk.
Bond Maturity and mnterest Rate
Risk
Bond Duration
mn finance, the duration of a financial asset measures the
sensitivity of the asset's price to interest rate
movements. Duration is a measurement of hoΠlong, in
years, it takes for the price of a bond to be repaid (i.e.
recovery of PV of cash floŒsÎ by its internal cash floŒs. mt
is an important measure for investors to consider, as
bonds Œith higher durations carry more risk and have
higher price volatility than bonds Œith loŒer durations.

he units of duration are years, and duration is always hetween 0


years and the time to maturity of the hond, with duration equal to
time to maturity if and only if the hond is a zero-coupon hond.
ÿ— ë
 
ÿ— ë 
  , named for ÷rederick
Macaulay Œho introduced the concept, is the
Œeighted average maturity of a bond Œhere the
Œeights are the relative discounted cash floŒs in
each period.

— —  ÿ 


ÿ— ë

  

@
— 
Duration of Bonds
m 
 
Let us consider the 



8.5 per cent rate  




bond of Rs 1,000  

 
face value that has a    
 
  
current market value ë   ‰ ‰ ‰ ‰
of Rs 954.74 and a ë ‰ ë ‰ ‰ ‰ 
YTM of 10 per cent,  ë   ‰ ‰ ‰ ‰
and the 11.5 per cent  ë ë ‰ ‰ ‰ ‰ 
rate bond of Rs 1,000 ë ‰ë  ‰ ‰    ë
face value has a   ‰‰‰  ë
current market value  
 
of Rs 1,044.57 and a 



yield to maturity of  




 
   
 
10.6 per cent. Table     
  


shoŒs the calculation ë ‰  ‰ ‰ ‰ ‰
of duration for the ë  ‰ ‰ ‰ ‰ 
tŒo bonds.  ë ë ‰‰ ‰ ‰ ‰ 
 ë   ‰ ‰ ‰ 
ë  ë  ë ‰ ë  ë
‰ ‰ ‰‰‰  ‰

Volatility
The r  ë or the interest rate sensitivity of a bond is
given by its duration and YTM. A bond¶s volatility,
referred to as its    
  , is given as
folloŒs:  
    
  
The volatilities of the 8.5 per cent and 11.5 per cent
bonds are as folloŒs:
 ë
   ë     
 ‰‰
 ‰
  ë     
 ‰
mf YTM increases by 1%, this Œill result in 3.87% decrease in the
price of the 8.5% bond and a 3.69% decrease in the price of 11.5%
bond.
Valuation of Shares
‡ A company may issue tŒo types of shares:
± ordinary shares and
± preference shares
‡ ÷eatures of Preference and Ordinary
Shares
± ºlaims
± Dividend
± Redemption
± ºonversion
Valuation of Preference Shares
‡ The value of the preference share Œould be the
sum of the present values of dividends and the
redemption value.
‡ A formula similar to the valuation of bond can be
used to value preference shares Œith a maturity
period:
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‰  
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Value of a Preference Share-
Example
Ô  
    
    
       
  
    


 
      
 
 
 
  
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 "# 
 "  $

   
            

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      "   "     "    

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  ( 

 
  
   )) 
 
  
  
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(
 
 
     


 
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Valuation of Ordinary Shares
The valuation of ordinary or equity shares
is relatively more difficult.
± The rate of dividend on equity shares is not
knoŒn; also, the payment of equity dividend is
discretionary.
± The earnings and dividends on equity shares are
generally expected to groŒ, unlike the interest on
bonds and preference dividend.
Dividend ºapitalisation
‡ The value of an ordinary share is determined by
capitalising the future dividend stream at the
opportunity cost of capital
‡ Single Period Valuation:
± mf the share price is expected to groŒ at g per cent, then
P1 = Po(1 + gÎ
± Po = (DmV1 + P1Î/(1 + keÎ
± We obtain a simple formula for the share valuation as
folloŒs:

‰ 
O

Multi-period Valuation
‡ mf the final period is n, Œe can Œrite the general
formula for share value as folloŒs:
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‰  
  O   O  i
‡ GroŒth in Dividends
è#$ % &&   &   &' 

 ()
± Normal GroŒth
*
‰ 
O 
± Super-normal GroŒth
Ô$& + &  !  + &  , &  &-. ,#$ &
!  + &  ,  && . ,#$ &
Earnings ºapitalisation
Under tŒo cases, the value of the share
can be determined by capitalising the
expected earnings:
± When the firm pays out 100 per cent dividends;
that is, it does not retain any earnings.
± When the firm¶s return on equity (ROEÎ is equal
to its opportunity cost of capital.
Equity ºapitalisation Rate

÷or firms for Œhich dividends are expected


to groΠat a constant rate indefinitely and
the current market price is given

O 

ºaution in Using ºonstant-GroŒth
÷ormula

‡ Estimation errors

‡ Unsustainable high current groŒth

‡ Errors in forecasting dividends


Valuing GroŒth Opportunities
The value of a groŒth opportunity is given
as folloŒs:

 
O 

 /  O 

O O  
Price-Earnings (P/EÎ Ratio: HoŒ
Significant?
‡ @ 
  is calculated as the price of a
share divided by earning per share.
‡ Some people use P/E multiplier to value
the shares of companies.
‡ Alternatively, you could find the share
value by dividing EPS by E/P ratio, Œhich
is the reciprocal of P/E ratio.
Price-Earnings (P/EÎ Ratio: HoŒ
Significant?
‡ The share price is also given by the
folloŒing formula:
/
‰  
O

‡ The earnings price ratio can be


derived as folloŒs:
/  
 O   
   
Price-Earnings (P/EÎ Ratio: HoŒ
Significant?
ºautions:
± E/P ratio Œill be equal to the capitalisation rate
only if the value of groŒth opportunities is zero.
± A high P/E ratio is considered good but it could
be high not because the share price is high but
because the earnings per share are quite loŒ.
± The interpretation of P/E ratio becomes
meaningless because of the measurement
problems of EPS.
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