Financial Management for Policy Makers

Valuation of Bonds and Shares

Valuation
Involves determining the theoretical value of an asset. Using the fundamental analysis principles; the intrinsic value of an asset is determined as the present value of all the cash flows expected from the asset

Bond valuation Bond – A debt instrument issued by the government (treasury bond) or a corporate body (corporate bond) .

Payment of interest is an obligation to the issuer 5.Features of the Bonds 1. the issuer pays the coupon interest to the investor. Have a coupon rate of interest that is fixed 3. Principle is refunded at the end of the maturity period . Within the term of the bond. Bond may be trading in the secondary market at par. Have a maturity period otherwise it will be a perpetual bond 4. Have a face value (par value) (registered value) 2. at a premium or at a discount 6.

Valuation of bonds .

Valuation of Bonds Determine the value of a bond with the following characteristics. Par value – Sh. 100 Coupon rate of interest – 8% per annum Maturity – 3 years Interest is paid on annual basis and the expected rate of return is 10% .

Valuation of bonds Determine the value of a bond with the following characteristics. Par value – Sh. 100 Coupon rate of interest – 10% per annum Maturity – 3 years Interest is paid on semi-annual basis and the expected rate of return is 16% .

1000 Coupon rate of interest – 8% per annum Maturity – 8 years Interest is paid on annual basis and the expected rate of return is 10% . Par value – Sh.Valuation of Bonds Determine the value of a bond with the following characteristics.

1000 Coupon rate of interest – 8% per annum No Maturity – It is a perpetual bond Interest is paid on annual basis and the expected rate of return is 10% . Par value – Sh.Valuation of Bonds Determine the value of a bond with the following characteristics.

Valuation of ordinary shares Share – A unit of capital • Has voting rights • Earns dividends • Payment of dividends = not an obligation to the firm • Grows with profitability • Holders are residual claimants • Market value is determined by the market forces .

• If you require a return of 20% on investments of this risk.One-period example • Suppose you are thinking of purchasing the a share of Sameer Africa and you expect it to pay a Sh.2) = 13. 14 at that time.33 . 2 dividend in one year and you believe that you can sell the stock for Sh. what is the maximum you would be willing to pay? – Compute the PV of the expected cash flows – Price = (14 + 2) / (1.

14.70) / (1.2.10 + 14.Two-Periods Now what if you decide to hold the stock for two years? In addition to the dividend in one year.2)2 = 13.33 .70 at the end of year 2.2) + (2. Now how much would you be willing to pay? PV = 2 / (1. you expect a dividend of Sh.10 in and a stock price of Sh.

15.435) / (1.2 + 2.33 . 2.205 + 15. you expect to receive a dividend of Sh.435.205 at the end of year 3 and a stock price of Sh.Three periods What if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2. Now how much would you be willing to pay? – PV = 2 / 1.2)2 + (2.2)3 = 13.10 / (1.

You would find that the price of the stock is really just the present value of all expected future dividends • So.Developing the Model • You could continue to push back when you would sell the stock. how can we estimate all future dividend payments? .

but settles down to constant growth eventually .Estimating Dividends – Special Cases • Constant dividend – The firm will pay a constant dividend forever – This is like preferred stock – The price is computed using the perpetuity formula • Constant dividend growth – The firm will increase the dividend by a constant percent every period • Supernormal growth – Dividend growth is not consistent initially.

What is the price? – P0 = .1 / 4) = 20 .Zero growth • If dividends are expected at regular intervals forever. then this is like preferred stock and is valued as a perpetuity • P0 = D / R • Suppose stock is expected to pay a Sh. 0.50 dividend every quarter and the required return is 10% with quarterly compounding.50 / (.

Dividend Growth Model D 0 (1  g) D1 P0   R -g R -g .

how much should the stock be selling for? • P0 = . It is expected to increase its dividend by 2% per year.15 .50(1+.02) / (.92 .02) = 3.50. If the market requires a return of 15% on assets of this risk..Illustration • Suppose a company just paid a dividend of Sh.

33 – Why isn’t the 2 in the numerator multiplied by (1. If the dividend is expected to grow at 5% per year and the required return is 20%..Illustration • Suppose a company is expected to pay a $2 dividend in one year. what is the price? – P0 = 2 / (.05) = 13.2 .05) in this example? .

Illustration • A Company is expected to pay a dividend of Sh. 4 next period and dividends are expected to grow at 6% per year. The required return is 16%. • What is the current price? • What will be the price if the investor holds the share for six years? .

If the last dividend was Sh. what is the price of the stock? . After that dividends will increase at a rate of 5% per year indefinitely. 1 and the required return is 20%.Illustration • Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years.

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