CHAPTER 5

VALUATION OF BONDS AND SHARES

Features of a Bond

2
Long-term debt instrument or security.
 Can be secured or unsecured.
 Interest Rate or coupon rate is fixed
 Face Value or par value of Rs 100 or Rs 1,000, and interest is paid
on face value.
 Maturity is fixed.
 Redemption value - may be redeemed at par or premium.
 Market Value- may be different from par value or redemption
value as it is traded in the market.
 Types of Bonds
3

 Bonds with maturity

 Pure discount bonds -The bond discount is the
difference between the par value and the selling
price.
 Perpetual bonds
 Bond with Maturity
4
 Yield to Maturity
5
 6

Yield to Maturity of Redeemable Bond

YTM = [I + (M – V)/N] / (M + V)/2

I = Annual Interest
M = Face Value or Maturity Value of Bond
V = Selling Price of Bond
N = Number of Years to Maturity
 Bond Values and Semi-annual Interest Payments
7
 Example
8
 Pure Discount Bonds
9

 Pure discount bond do not carry an explicit rate of

interest.
 It provides for the payment of a lump sum amount at
a future date in exchange for the current price of the
bond.
 The difference between the face value of the bond
and its purchase price gives the return or YTM to the
investor.
 Pure Discount Bonds
10
 Pure Discount Bonds
11
 Valuation of Shares
12

 A company may issue two types of shares:

 ordinary shares and
 preference shares
 Features of Preference and Ordinary Shares
 Claims
 Dividend
 Redemption
 Conversion
 Valuation of Preference Shares
13
 Valuation of Ordinary Shares
14

 The valuation of ordinary or equity shares is

relatively more difficult.
 The rate of dividend on equity shares is not known; also,
the payment of equity dividend is discretionary.
 The earnings and dividends on equity shares are generally
expected to grow, unlike the interest on bonds and
preference dividend.
 Dividend Capitalisation
15
 Multi-period Valuation
16
 Multi-period Valuation
17
 18

 Return on equity (ROE) is a ratio that provides investors with

insight into how efficiently a company (or more specifically, its
management team) is handling the money that shareholders
have contributed to it.
 It measures the profitability of a corporation in relation to
stockholders’ equity.
 The higher the ROE, the more efficient a company's
management is at generating income and growth from its
equity financing.
 19

ROE = Net Income/Shareholders’ Equity

 The net income is the bottom-line profit—before common-

stock dividends are paid—reported on a firm’s income
statement.

 Shareholder equity is assets minus liabilities on a firm’s

balance sheet and is the accounting value that's left for
shareholders should a company settle its liabilities with its
reported assets.
20
 Normal Growth
21

 If a totally equity financed firm retains a constant

proportion of its annual earnings (b) and reinvests it
at its internal rate of return, which is its return on
equity (ROE), then it can be shown that the dividends
will grow at a constant rate equal to the product of
retention ratio and return on equity; that is,
g = b × ROE.
 Perpetual Growth Model
22
 Super-normal Growth
23

 The dividends of a company may not grow at the same

constant rate indefinitely. It may face a two-stage growth
situation.
 In the first stage, dividends may grow at a super-normal
growth rate when the company is experiencing very high
demand for its products and is able to extract premium from
customers.
 Afterwards, the demand for the company’s products may
normalize and therefore, earnings and dividends may grow at
a normal growth rate.
 Super-normal Growth
24

The share value in a two stage growth situation can be

determined in two parts.

 First,we can find the present value of constantly growing

dividend annuity for a definite super-normal growth period.

 Second, we can calculate the present value of constantly

growing dividend, indefinitely (in perpetuity), after the super-
normal growth period.
 25

Earnings Capitalisation Model

• When earnings of the firm are stable (when firm pays
dividends) or when there is an expansion situation (new
investment avenues available), the value of an equity share
can be determined by capitalization of earnings.

1. The earnings of the firm will be stable if it neither retains

earnings nor employs any external financing (pays all earnings
as dividends).
• In such a situation, the retention rate ‘b’ is zero and the
growth rate ‘br’ would be zero because g=br.
 26

Earnings Capitalisation Model

As there is no retention, dividends D0 will be equal to earnings
E0.

The value per share in such a case can be determined as:

P0 = [E0(1-b)]/(Ke-br) or

P0 = E0/Ke (as b=0) or

P0 = D0/Ke (as E0=D0)

 27

Earnings Capitalisation Model

2. The expansion situation in a firm is when it has investment
opportunities which will generate internal rate of return ‘r’ equal
to the equity capitalization rate Ke
r = Ke
In such a situation also
P0 = E0/Ke