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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 hile 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 ith maturity

##  Pure discount bonds

 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:

##  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 ith the
bonds ith buy back or call provision hen 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 ritten as follos:
i

  
   

## ± Note that cash flo, 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
follos:

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
follos:
 
     
  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 àààà ààà
à àààà
changes beteen short and à àààà ààà à ààà à
long-term bonds ill alays
be true. Thus, to bonds of à ààà
à àà  à ààà à
same quality (in terms of the à ààà à ààà ààààà
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 flosÎ by its internal cash flos. 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 loer 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 ho introduced the concept, is the
eighted average maturity of a bond here the
eights are the relative discounted cash flos 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     
  


shos the calculation ë      
of duration for the ë      
to 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
follos:  
    
  
The volatilities of the 8.5 per cent and 11.5 per cent
bonds are as follos:
 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 to 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
knon; 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
follos:

 
O

Multi-period Valuation
 mf the final period is n, e can rite the general
formula for share value as follos:
i
 i
  
  O   O  i
 Groth in Dividends
è#\$ % &&   &   &' 

 ()
± Normal Groth
*
 
O 
± Super-normal Groth
Ô\$& + &  !  + &  , &  &-. ,#\$ &
!  + &  ,  && . ,#\$ &
Earnings ºapitalisation
Under to 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 hich dividends are expected

to gro at a constant rate indefinitely and
the current market price is given

O 

ºaution in Using ºonstant-Groth
÷ormula

 Estimation errors

##  Errors in forecasting dividends

Valuing Groth Opportunities
The value of a groth opportunity is given
as follos:

 
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
folloing formula:
/
  
O

##  The earnings price ratio can be

derived as follos:
/  
 O   
   
Price-Earnings (P/EÎ Ratio: Ho
Significant?
ºautions:
± E/P ratio ill be equal to the capitalisation rate
only if the value of groth 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.
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jairaj gupta
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