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Principle underlying valuation:

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 hile physical assets like plant and

machinery are called real assets.

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

Market Value

÷eatures of a Bond

÷ace Value

Maturity

Redemption value

Market Value

Bonds Values and Yields

Bonds ith maturity

Perpetual bonds

Bond ith 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 ith 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

ºurrent yield does not account for the

capital gain or loss.

Yield to ºall

Yield to call is the return associated ith the

bonds ith buy back or call provision hen the

call option is exercised before maturity.

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 ritten as follos:

i

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

follos:

ë ë

Ú

ë

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 ill pay Rs 100 annual interest into

perpetuity. What ould be its value of the

bond if the market yield or interest rate

ere 15 per cent?

The value of the bond is determined as

follos:

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 ould 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 beteen short and à àààà ààà à ààà à

long-term bonds ill alays

be true. Thus, to bonds of à ààà

à àà à ààà à

same quality (in terms of the à ààà à ààà ààààà

risk of defaultÎ ould 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 ho long, in

years, it takes for the price of a bond to be repaid (i.e.

recovery of PV of cash flosÎ by its internal cash flos. mt

is an important measure for investors to consider, as

bonds ith higher durations carry more risk and have

higher price volatility than bonds ith loer durations.

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 ho introduced the concept, is the

eighted average maturity of a bond here the

eights are the relative discounted cash flos in

each period.

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

shos the calculation ë

of duration for the ë

to 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

follos:

The volatilities of the 8.5 per cent and 11.5 per cent

bonds are as follos:

ë

ë

ë

mf YTM increases by 1%, this ill 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 to 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 ould 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 ith a maturity

period:

i

! i

i

Value of a Preference Share-

Example

Ô

!"

"#

" $

%

&

"

!

" "

" " "

'

(

))

()*

"

(

"
!!

!

Valuation of Ordinary Shares

The valuation of ordinary or equity shares

is relatively more difficult.

± The rate of dividend on equity shares is not

knon; also, the payment of equity dividend is

discretionary.

± The earnings and dividends on equity shares are

generally expected to gro, 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 gro at g per cent, then

P1 = Po(1 + gÎ

± Po = (DmV1 + P1Î/(1 + keÎ

± We obtain a simple formula for the share valuation as

follos:

O

Multi-period Valuation

mf the final period is n, e can rite the general

formula for share value as follos:

i

i

O O i

Groth in Dividends

è#$%&& & &'

()

± Normal Groth

*

O

± Super-normal Groth

Ô$&+ & ! + & ,& &-.,#$&

! + & , &&.,#$&

Earnings ºapitalisation

Under to 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

to gro at a constant rate indefinitely and

the current market price is given

O

ºaution in Using ºonstant-Groth

÷ormula

Estimation errors

Valuing Groth Opportunities

The value of a groth opportunity is given

as follos:

O

/ O

O O

Price-Earnings (P/EÎ Ratio: Ho

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, hich

is the reciprocal of P/E ratio.

Price-Earnings (P/EÎ Ratio: Ho

Significant?

The share price is also given by the

folloing formula:

/

O

derived as follos:

/

O

Price-Earnings (P/EÎ Ratio: Ho

Significant?

ºautions:

± E/P ratio ill be equal to the capitalisation rate

only if the value of groth 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 lo.

± The interpretation of P/E ratio becomes

meaningless because of the measurement

problems of EPS.

to get a copy of this presentation visit

.slideshare.net/jairajgupta

hy

jairaj gupta

e-mail: jairajgupta@aol.com

mobile: (91Î 9007202650

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