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Financial Management I

7. Valuation of Securities



















Dr. Suresh
suresh.suralkar@gmail.com
Phone: 40434399, 25783850
Course Content - Syllabus







































































*Book preference
Sr Title ICMR Ch. PC Ch. IMP Ch.
1 Introduction to Financial Management 1* 1 1
2 Overview of Financial Markets 2* 2 -
3 Sources of Long-Term Finance 10* 17 20, 21
4 Raising Long-term Finance - 18* 20, 21, 23
5 Introduction to Risk and Return 4* 8, 9 4, 5
6 Time Value of Money 3* 6 2
7 Valuation of Securities 5* 7 3
8 Cost of Capital 11* 14 9
9
Basics of Capital Expenditure
Decisions
18* 11 8
10 Analysis of Project Cash Flows - 12* 10, 11
11
Risk Analysis and Optimal Capital
Expenditure Decision
- 13* 12
2 / 53
3 / 53
Valuation of Securities



Reference Books
1. Financial Management, ICMR Book, Chapter 5
2. Financial Management, Prasanna Chandra, 7
th
Edition,
Chapter 7
3. Financial Management, I. M. Pandey, 9
th
Edition,
Chapter 3
4 / 53
Syllabus Valuation of Securities




1. Concept of Valuation
2. Bond Valuation
3. Equity Valuation: Dividend Capitalization Approach
and Ratio Approach
4. Valuation of Warrants and Convertibles
5 / 53
1. Concept of Valuation






Investments in bonds and equity
Valuation is based on time value of money, risk and
returns.
Finance manager needs to have knowledge of valuation
Needs the understanding of the company over a time
span
Estimation of future profitability and growth
6 / 53
1. Concept of Valuation






Concept of Valuation
Security can be regarded as a series of dividends or
interest payments receivable over a period of time.
Therefore value of any security can be defined as the
present value of these cash streams. This present value is
also called as intrinsic value of an asset. It is expressed as
below
7 / 53
1. Concept of Valuation











Where V
0
= Value of the asset at time 0, which is P
0
,
present value of an asset
C
t
= Expected cash flow at the end of period t
k = Discount rate or required rate of return on
the cash flows
n = Expected life of an asset
n
n
2
2 1
0 0
k) (1
C
...
k) (1
C
k) (1
C
) P (or V
+
+ +
+
+
+
=

=
+
=
n
1 t
t
t
k) (1
C
8 / 53
1. Concept of Valuation





Example
Calculate the value of an asset if the annual cash flow is
Rs. 2000 per year for next 7 years and the discount rate
is 18%.
Solution
Present value of an asset



= 2000 x PVIFA
(18%,7year)
= 2000 x 3.812
= Rs. 7624

=
+
=
n
1 t
t
t
0
k) (1
C
V

=
+
=
7
1 t
t
) 18 . 0 (1
2000
9 / 53
1. Concept of Valuation





Concepts of Value
Book value
Replacement value
Liquidation value
Going concern value
Market value
10 / 53
1. Concept of Valuation





Book Value: This is an accounting concept. Assets are
recorded at historical costs and they are depreciated over
years. Book value may include intangible at acquisition
cost minus amortized value. Book value of debt is stated
at the outstanding amount. The difference between the
book value of assets and liabilities is equal to
shareholders funds or net worth (which is equal to paid-
up equity capital plus reserves and surplus).

Replacement value: is an amount required to replace an
existing assets in the current condition.
11 / 53
1. Concept of Valuation





Liquidation value: is an amount that a company can
realize if it sells its assets after terminating its business. It
is generally a minimum value which a company may
accept if it sells its business.

Going concern value: is an amount a company can realize
if it sells its business as an operating one. Its value would
always be higher than the liquidation value.

Market value: of an asset or security is the current price at
which the asset or security is being sold or bought in the
market.
12 / 53
2. Bond Valuation





Bond are negotiable promissory notes that can be used by
governments, government agencies, business firms or
individuals. Bonds issued by the government or public
sector companies in India are generally secured. Private
sector companies issue secured or unsecured bonds. In
case of bonds, the rate of interest is fixed. A bond is
redeemable after a specific period.
Face value: is the value stated on the face of he bond and is
also known as par value. It is an amount specified to
repay after a time o maturity. Bond is generally issued at
face value usually Rs. 100 and sometimes Rs. 1000.
13 / 53
2. Bond Valuation





Coupon Rate or Interest: is payable on the face value of
the Bond.
Maturity: Bond is issued for a specific period of time. It is
repaid on maturity. Typically corporate bonds have a
maturity of 7-10 years, whereas government bonds have
maturity period up to 20-25 years.
Redemption value: is a value which a bondholder gets on
maturity is called redemption value.
Market value: Bond may be traded in a stock exchange.
Market value is the price at which the bond is usually
bought or sold.
14 / 53
2. Bond Valuation




Basic Bond Valuation Model
Bondholder receives a fixed annual interest payment for
a certain number of years an a fixed principal payment
(face value or par value) at the time of maturity.
Therefore the present value or the intrinsic value of bond


V
0
= I x PVIFA
(kd,n)
+ F x PVIF
(kd,n)
Where V
0
= Present value P
0
or intrinsic value of a bond
I = Annual interest payable on the bond
F = Face value or the par value or the principle
amount payable on maturity
n = Maturity period of bond
k
d
= Required rate of return

=
+
+
+
=
n
1 t
n
d
t
d
t
0 0
) k (1
F
) k (1
C
) P (or V
15 / 53
2. Bond Valuation




Example
A bond with face value Rs. 1000 bears a coupon rate of
12% and has a maturity period of 3 years. The required
rate of return on the bond is 10%. Calculate the value of
this bond?
Solution
Annual interest payable = Rs. 1000 x 12% = Rs. 120
Principal repayable at the end of 3 years = Rs. 1000
Value of the bond

=Rs.120x PVIFA
(10%, 3trs)
+Rs.1000x PVIF
(10%,3yrs)
= 120 x 2.487 + 1000 x 0.751 = Rs. 1049.44

=
+
+
+
=
n
1 t
n
d
t
d
t
0
) k (1
F
) k (1
C
V
16/53
2. Bond Valuation




Example
A bond with face value Rs. 1000 bears a coupon rate of 7%
and has a maturity period of 5 years. The required rate
of return on the bond is 8%. What should an investor be
willing to pay now to buy the bond if it matures at par?
Solution
Annual interest payable for 5 yrs = Rs. 1000x7% =Rs. 70
Principal repayable at the end of 5 years = Rs. 1000
Present value of the bond

=Rs.70x PVIFA
(8%, 5trs)
+Rs.1000x PVIF
(8%,5yrs)
= Rs. 70 x 3.993 + Rs. 1000 x 0.681 = Rs. 960.51

=
+
+
+
=
n
1 t
n
d
t
d
t
0
) k (1
F
) k (1
C
V
17 / 53
2. Bond Valuation





Bond values with Semi-annual Interest
Some of the bonds carry interest payment semi-annually.
Hence bond valuation equation is modified as


= I / 2 x PVIFA
(kd/2,2n)
+F x PVIF
(kd/2,2n)
Where I/2 = Semi-annual interest payment
k
d
/2= Required rate of return for the half-
year period
2n = Maturity period expressed in half-yearly
periods

=
+
+
+
=
2n
1 t
2n
d
t
d
0
/2) k (1
F
/2) k (1
I/2
V
18 / 53
2. Bond Valuation





Example
A bond of Rs. 1000 value carries a coupon rate of 10%and
a maturity period of 6 years. Interest is payable semi-
annually. If the required rate of return is 12%, calculate
the value of the bond.
Solution



= Rs. 50 x PVIFA
(6%,12yrs)
+1000 x PVIF
(6%,12yrs)
= 50 x 8.384 + 1000 x 0.497 = Rs. 916.20

=
+
+
+
=
2n
1 t
2n
d
t
d
0
/2) k (1
F
/2) k (1
I/2
V

=
+
+
+
=
12
1 t
12 t
0.12/2) (1
1000
0.12/2) (1
100/2
19 / 53
2. Bond Valuation





Bond Yield Measures
One Period Rate of Return
If a bond is purchased and then sold one year later, its
rate of return over this single holding period can be
defined as one period rate of return.



The holding period can be calculated on a daily, monthly
or annual basis. If the bond price falls by an amount that
exceeds coupon interest, the rate of return assumes
negative values.
period) holding the of beginning at the price (Purchase
paid) if interest (Coupon period) holding during loss or gain (Price +
=
20 / 53
2. Bond Valuation





Example
Mr. X purchased Rs. 1000 par value bond for Rs. 900. The
coupon payment on this bond is Rs. 80 i.e. 8%. One year
later he sells the bond for Rs. 800. Calculate the rate of
return to Mr. X for this one year period.
Solution
Holding period return



period) holding the of beginning at the price (Purchase
paid) if interest (Coupon period) holding during loss or gain (Price +
=
900
80 900) - (800 +
= 2.22% or 0.0222
900
20
900
80 100 -
=

=
+
=
21 / 53
2. Bond Valuation





Current Yield
Current yield measures the rate of return earned on a
bond if it is purchased at its current market price and if
the coupon interest is received.


In earlier example
Coupon interest is Rs. 80
Current market price is Rs. 800
Current yield = 80 / 800 = 0.10 or 10%
Coupon rate and current yield are two different measures.

Price Market Current
Interest Coupon
Yield Current =
22 / 53
2. Bond Valuation





Yield to Maturity (YTM)
It is the rate of return earned by an investor who
purchases a bond and holds it till maturity. YTM is the
discount rate which equals the present value of promised
cash flows to the current market price / purchase price.



Where k
d
= YTM

=
+
+
+
=
n
1 t
n
d
t
d
t
0 0
) k (1
F
) k (1
C
) P (or V
23/53
2. Bond Valuation





Example
Consider a Rs. 1000 par value bond whose current
market price is Rs. 850. The bond carries a coupon rate
of 8% and has a maturity period of 9 years. Calculate
the rate of return an investor earns if he purchases the
bond and holds till maturity.
Solution



=Rs.80x PVIFA
(kd%,9yrs)
+ Rs.1000x PVIF
(kd%,9yrs)

=
+
+
+
=
n
1 t
n
d
t
d
t
0 0
) k (1
F
) k (1
C
) P (or V

=
+
+
+
=
9
1 t
9
d
t
d ) k (1
1000
) k (1
80
850 Rs.
24 / 53
2. Bond Valuation





To find out the value of k
d
in the above equation, several
values of k
d
will have to be tried out in order to reach the
input value. Therefore to start, consider a discount rate
of 12% for k
d
. The expression becomes

Rs.80 x PVIFA
(12%,9yrs)
+ Rs.1000 x PVIF
(12%,9yrs)
= Rs. 80 x 5.328 + Rs. 1000 x 0.361
= Rs. 426.24 + 361 = Rs. 787.24

Since the above value is less than Rs. 850 market price, we
have to try with a less discounting rate k
d
. So let k
d
=
10%, then
25 / 53
2. Bond Valuation





Rs.80 x PVIFA
(10%,9yrs)
+ Rs.1000 x PVIF
(10%,9yrs)
= Rs. 80 x 5.759 + Rs. 1000 x 0.424
= Rs. 460.24 + 424 = Rs. 884.72

From above, it is clear that k
d
lies between 10% and 12%.
We have to use linear interpolation between 10% and
12%.



= 10% + 0.71 = 10.71%
Yield to maturity is 10.71%
787.24 - 884.72
850 - 884.72
x 10%) (12% 10% kd + =
26 / 53
2. Bond Valuation






Bond Value Theorems
Based on the bond valuation models, several bond value
theorems have been derived, based on the effects of
following factors on bond values.
Relationship between required rate of return and the
coupon rate
Number of years to maturity
Yield to maturity

=
+
+
+
=
n
1 t
n
d
t
d
t
0 0
) k (1
F
) k (1
C
) P (or V
27 / 53
2. Bond Valuation





Theorem 1
When the required rate of return is equal to the coupon
rate, the value of the bond is equal to its par value.
i.e. id k
d
= coupon rate,
then value of a bond = par value

Example
Consider a bond with par value Rs. 100, coupon rate
12% and years to maturity 5 years. Calculate the value
of a bond if required rate of return is 12%.
Solution

28 / 53
2. Bond Valuation








V
o
= I x PVIFA
(kd,n)
+ F x PVIF
(kd,n)
= 12 x PVIFA
(12%,5)
+ 100 x PVIF
(12%,5)
= 12 x 3.605 + 100 x 0.567
= 43.26 + 56.7
= Rs. 100

=
+
+
+
=
n
1 t
n
d
t
d
t
0 0
) k (1
F
) k (1
C
) P (or V
29 / 53
2. Bond Valuation





Theorem 2
When the required rate of return k
d
is greater than the
coupon rate, the value of the bond is less than its par
value.

Theorem 3
When the required rate of return k
d
less than the coupon
rate, the value of the bond is greater than its par value.
30 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach






Equity valuation models are used to determine the
intrinsic value (also called as real value or the fair value)
of the stock. This value is compared with market price of
stock to determine whether the stock is under valued or
over valued. Accordingly investment decisions, buy or
sell of the stocks are decided.
According to dividend discount model, value of an equity
share is discounted present value of dividends received
plus the present value of the sale value expected when
the equity stock is sold.
31 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach







For applying the dividend discount model, we will make
following assumptions.
Dividends are paid annually.
First dividend is received one year after the equity
stock is bought.
32 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Single-period Valuation Model
This model is for an equity stock where an investor holds
it for one year. The price of such equity stock will be


Where, P
0
= Present value of the share or current
market price of the share
D
1
= Expected dividend a year hence
P
1
= expected price of the share a year hence
k
e
= required rate of return on the equity share

) k (1
P
) k (1
D
P
e
1
e
1
0
+
+
+
=
33 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Example: A company is expected to declare a dividend of
Rs. 2.50 and reach a price of Rs. 35 a year hence. What is
the price at which the share would be sold to the
investors now if required rate of return is 13%?
Solution
The present value of the share


) k (1
P
) k (1
D
P
e
1
e
1
0
+
+
+
=
) 13 . 0 (1
35
) 13 . 0 (1
2.50
+
+
+
=
31 2.21+ =
33.21 Rs. =
34 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





If the price of the equity share is expected to grow at a rate
of g percent annually, the present price P
0
becomes
P
0
(1+g) a year hence, we get


Simplifying above, we get
) k (1
g) (1 P
) k (1
D
P
e
0
e
1
0
+
+
+
+
=
g) - (k
D
P
e
1
0 =
35 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Example: The expected dividend per share on the equity
share of a company is Rs. 2. The dividend per share of a
company has grown at a rate of 5% per year and this
growth is expected to continue in future. Market price of
equity share is also expected to grow at the same rate.
Calculate the present value of the stock if the required
rate of return is 15%.
Solution:
g) - (k
D
P
e
1
0 =
20 Rs.
0.05) - (0.15
2
= =
36 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Multi-period Valuation Model
This is more realistic model for an equity valuation.
Since equity shares have no maturity period, they may
be expressed to bring a dividend stream of infinite
duration.
(1)

Where, P
0
= present value of the share or current
market price of the share
D
1
= expected dividend a year hence
D2 = expected dividend two years hence
D = expected dividend at the end of infinity
k
e
= required rate of return on the equity share

+
=
+
+ +
+
+
+
=
1 t
t
e
t
e
2
e
2
e
1
0
) k (1
D
) k (1
D
...
) k (1
D
) k (1
D
P
37 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach




Above equation is for valuation of equity share of infinite
duration. For finite duration, same equation can be
applicable, if the investor holds the stock for n years and
then sells it at a price P
n
. The value of equity share for
finite duration would be


(2)

Applying dividend discounting principle, value of P
n
would
be the present value of the dividend stream beyond the
n
th
year, evaluated at end of n
th
year. This means

=
+
+
+
=
n
1 t
n
e
n
t
e
t
) k (1
P
) k (1
D
n
e
n
n
e
n
2
e
2
e
1
0
) k (1
P
) k (1
D
...
) k (1
D
) k (1
D
P
+
+
+
+ +
+
+
+
=
38 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach






Substituting this value of P
n
in equation (2) we get





(3)
This is same as equation (1) which may be regarded as a
generalized multi-period valuation formula.

+ +
+
+ +
+
+
+
=
) k (1
D
...
) k (1
D
) k (1
D
P
e
2
e
2 n
e
1 n
n
|
|
.
|

\
|
+
+ +
+
+
+ +
+
+
+ +
+
+
+
=

+ +
) k (1
D
...
) k (1
D
) k (1
D
) k (1
1
) k (1
D
...
) k (1
D
) k (1
D
P
e
2
e
2 n
e
1 n
n
e
n
e
n
2
e
2
e
1
0

+
+
+
+ +
+
+
+
+ +
+
+
+
=
) k (1
D
...
) k (1
D
) k (1
D
...
) k (1
D
) k (1
D
e
1 n
e
1 n
n
e
n
2
e
2
e
1

=
+
=
1 t
t
e
t
) k (1
D
39 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Equation (1) is general enough to permit any dividend
patterns: constant, rising, declining or randomly
fluctuating. Such cases are as below
1. Constant dividends
2. Constant growth of dividends
3. Changing growth rates of dividends
40 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





1. Valuation with constant dividends
We assume that dividend per share is constant year
after year, at a value of D. Then equation (1) becomes



On simplification, this equation becomes
(4)

This is a present value of perpetuity formula, used in
earlier chapter.

+
+ +
+
+
+
=
) k (1
D
...
) k (1
D
) k (1
D
P
e
2
e e
0
e
0
k
D
P =
41 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





2. Valuation with constant growth in dividends
It is assumed that dividends tend to increase at a
constant growth rate (g), because business firms
usually grow over time. Equity share valuation under
this assumption is


Applying the formula for the sum of geometric
progression, this equation simplifies to
...
) k (1
n
g) (1 D
...
) k (1
g) (1 D
) k (1
D
P
1 n
e
1
2
e
1
e
1
0 +
+
+
+ +
+
+
+
+
=
+
g - k
D
P
e
1
0 =
42 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Example: A company is expected to grow at a rate of 7%
per annum and dividend expected a year hence is Rs. 5.
If the required rate of return for this stock is 12%,
calculate the valuation of this stock.
Solution
g - k
D
P
e
1
0 =
0.07 - 0.12
5
=
100 Rs.
0.05
5
= =
43 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





3. Valuation with variable growth in dividends
Some forms have a super normal growth rate followed
by a normal growth rate. Valuation of share will be


During super normal growth period the stock valuation


At the end of super normal growth period, followed by
constant growth period. The valuation in this period
n
e
n
n
e
1 n
a 1
3
e
2
a 1
2
e
a 1
e
1
0
) k (1
P
) k (1
) g (1 D
...
) k (1
) g (1 D
) k (1
) g (1 D
) k (1
D
P
+
+
|
|
.
|

\
|
+
+
+ +
+
+
+
+
+
+
+
=

=
+
=
n
1 t
t
e
t
) k (1
D
44 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach







This is discounted to get the present value. Therefore
discounted valuation is


Addition of valuations of both periods, we get
n
e n e
1 n
n
1 t
t
e
t
0
) k (1
1
x
) g (k
D
) k (1
D
P
+
+
+
=
+
=

n e
1 n
n
g k
D
P

=
+
n
e n e
1 n
) k (1
1
x
) g (k
D
+
=
+
45 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach




Example: A company having current dividend per share
Rs. 3. Super normal growth period of 5 years with a
growth rate of 25%. After this, normal growth is 7%.
Investors required rate of return is 14%. Calculate the
valuation of this equity stock.
Solution: 1. Dividends stream during super normal
growth period: D
1
= Rs. 3 (1.25)
D
2
= Rs. 3 (1.25
2
)
D
3
= Rs. 3 (1.25
3
)
D
4
= Rs. 3 (1.25
4
)
D
5
= Rs. 3 (1.25
5
)
46 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Present value of above stream of dividends is




2. At the end of 5 years, applying a constant growth model
5
5
4
4
3
3
2
2
(1.14)
3(1.25)
(1.14)
3(1.25)
(1.14)
3(1.25)
(1.14)
3(1.25)
(1.14)
3(1.25)
+ + + + =
n e
n 5
n e
6
5
g k
) g (1 D
g - k
D
P

+
= =
4.76 4.34 3.96 3.61 3.29 Rs. + + + + =
19.96 Rs. =
0.07 - 0.14
) 07 . 1 ( 3(1.25)
5
= 140 Rs.
0.07
9.8
= =
47 / 53
3. Equity Valuation: Dividend Capitalization
Approach and Ratio Approach





Discounted value of this price is


Sum of values of both the periods is



Valuation of the share P
0
= Rs. 92.67
72.71 Rs.
(1.14)
140
5
+ =
72.71 Rs. 19.96 Rs. P0 + =
92.67 Rs. =
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3. Equity Valuation: Ratio Approach






This is also known as multiplier approach or the relative
valuation approach. This approach is useful in
comparing the stocks in a particular industry sector.
Widely used ratios are
1. Price / Earning ratio (P/E ratio)
2. Price / Book Value ratio (P/BV ratio)
3. Price / Liquidation value ratio (P/L ratio)
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3. Equity Valuation: Approach






Price / Earnings Ratio
P/E model is used more frequently than P/B or P/L
models.
Expected earnings per share is


P/E ratios may have wide variations over a time period
depending on the variability of earnings.
shares equity g outstandin of Number
dividend Preferred - PAT Expected
=
50 / 53
3. Equity Valuation: Ratio Approach






Book Value
Book value per share is the net worth of the company
(paid-up equity capital plus reserves and surplus)
divided by the number of outstanding equity shares.

Liquidation Value
Liquidation value per share is the value realized from
liquidating all assets of the firm minus amount to be paid
to all the creditors and preference shareholders divided
by number of outstanding equity shares.
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4. Valuation of Warrants and Convertibles






Warrants and convertible debentures are commonly used
instruments of financing.

Warrant is a call option to buy a stated number of shares.
They entitle the holder to buy a fixed number of shares
at a predetermined price during some specified period of
time. It gives the holder the right to subscribe to the
equity shares of a company. Warrants expire at certain
date. They may also be a perpetual warrants, which
never expire. Warrants are issued to sweeten the
offering. For example, a debenture or a bond is issued by
a company along with warrant.
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4. Valuation of Warrants and Convertibles






Warrant Price
Exercise price of warrants is always greater than the
current market price. Price may be fixed for the entire
life of the warrant or increased periodically. Terms are
specified for number of shares that can be purchased for
each warrant. Usually the ratio is 1:1 i.e. one share for
each warrant.

Convertible Debentures
Convertible debentures are convertible partly or fully
into equity shares.
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4. Valuation of Warrants and Convertibles






Conversion Ratio and Conversion Value
Conversion ratio gives the number of shares to be
received for each convertible security. Conversion value
represents the market value of the convertible if it were
converted into stock.

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