Introduction to Security

Valuation
Applying the time value of money to security valuation
Sub Topics
• Introduction
• Financial asset valuation under certainty
• Valuation of Shares
• Valuation of debt Securities
• Interest Rate Risk
• The term structure of interest rates
• The default risk structure of interest rates
• Other factors affecting interest rate structures
Learning Objective
• Define overvaluation and undervaluation
• Understand and explain overvalued and undervalued shares
• Define the concept of intrinsic value
• Use the tools of financial mathematics to value debt and equity securities.
• Apply the dividend growth model to value ordinary shares;
• Explain the main difference between the valuation of ordinary shares based on
dividends and on earnings;
• Explain the nature of interest rate risk;
• Understand the theories that are used to explain the term structure of interest
rates
• Apply the concept of duration to immunize a bond investment.
Introduction
• The previous chapters you were introduced to the concept of time
value of money. In the proceeding chapter, you were presented with
some key tools to analyzing problems involving time value of money.
• In this chapter, we apply those tools to the valuation of DEBT and
EQUITY securities.
Financial Asset Valuation Under Certainty.
• The benefits of owning an asset are the present and future
consumption opportunities attributable to it. For a financial asset,
these benefit are in the form of cash.
• For example an investor who holds a government bond until maturity
receives cash in the form of interest payments during the bond’s life
and at maturity, in the form of payment of the face value.
• In the case of shares, the investor receives cash in the form of
dividends and, on sale of the shares, in the form of the price obtained
for the shares.
Financial Asset Valuation Under Certainty
• A decision to invest by purchasing an asset implies a simultaneous
decision to forgo current consumption.
• It is assumed that, at any time, investors prefer more consumption to
less consumption, other things being equal.
• The principal to understand is that, when all other factors are same,
investors prefer earlier cash inflows than later cash inflows – This
observation is summarised as discussed in earlier topic by the phrase
“Money has a time value”
Financial Asset Valuation Under Certainty
• Money has a Time Value,

• An illustration.

K100.00
Received now K100.00
To receive later
after one year

A rational person will always wants to receive K100.00 now. The reason offcourse is that earlier cash-
flow can be invested. This will enable even greater consumption later.
Financial Asset Valuation Under Certainty
• Example. If the K100.00 received now is invested at 12% per annum for
1 year, at the end of the year have K112.00 available for consumption.
• Clearly, it is better to have K112.00 after one year compared to
K100.00.
• Suppose if you have a RIGHT to receive K100 in one year time, what is
the maximum price the investor should offer for that price?
• The right to receive K100.00 in 1 year’s time is worth as present; Po =
K100/1.12 = K89.29
Financial Asset Valuation Under Certainty
• The amount K89.29 is referred to as present value of K100.00 to be
received in one year’s time is the DISCOUNT Rate is 12 percent per
annum.
• Therefore the Interest Rate has two functions; It is the rate at which
the present sums can be converted to equivalent future sums and it is
also the rate at which promised future sums can be converted to
equivalent present values every future c
• Where there are many cash flows from the same asset, the present
value of the asset is the sum of the present values of every future
cash flows.
 Financial Asset Valuation Under Certainty
• Thus, the formula is;
n
• Po = C1/1+I + C2/(1+i) 2……+Cn/(1+i)
• Po = t

• Where; Po = Present Value of the Asset

• Ct = Dollar return (cash flow) at time t.
• n = term of the investment
• i = Interest rate per time period
• t = 1, 2,……n
Financial Asset Valuation under Certainty
• Suppose that an asset returns K100.00 per annum for 5 years and that
an investor requires an annual interest rate of 3.6% percent as
compensation for forgoing current consumption, using above
equation we find that;
2 3
• Po = K100/(1+0.036) + K100/(1+0.036) + K100/(1+ 0.036) + +
• Po = K450.23.

• There this investor would be prepared to pay K450.23 for the asset.
Valuation of Shares Assuming Certainty
• If future cash-flows are known with certainty, equation discussed
above can be used to value shares. The periodic cash flows from an
investment in shares are called “DIVIDENDS.
• Unless, there is possibility of liquidation, the dividend payment maybe
considered to flow indefinitely. Therefore the equation may be
rewritten Po
• Dt = Dividend per share in period t. It can be seen that the market
interest rate is the discount rate that equates future dividend with
the current market price of the shares.
Valuation of Shares
• It may appear that Po ignores a second potential sources of return
from an investment in shares – that is, the capital gain from selling the
shares at a price greater than the price at which they were purchased.
This impression is incorrect. Suppose that an individual purchases
shares with the intention of selling them in 5 years’ time. The above can
be expanded as such;
• Po = t + P5/(1+ i)5 where P5 = Share price at the end of the 5th year.
• The capital gain or loss is the difference between P5 and Po. The price of
the shares when they are sold is the discounted value of all future
dividends from year 6.