Valuation of Securities

Rationale
General Valuation Model
Valuing Bonds
Bond yields
Valuing Preference Stock
Valuing Common Stock
Rate of Return
Rationale
Value of an asset is derived from the cash
flows associated with that asset.
This applies whether the asset is a financial
asset or a real asset.
The cash flows must be evaluated on a
present value basis.
Thus the value of any asset at time 0 would
then be the discounted value of net cash
flows over a relevant time horizon.
General Valuation Model

C1 C2 Cn
V0 = + ++
(1 + i)1 (1 + i)2 (1 + i)n

V0 = Value at time 0
C = Year's cash flow
i = Annual interest rate
n = Number of years
Example
A three-year asset with cash flows of Rs 2000
in year one, Rs 3000 in year two and Rs 5000
in year three would be valued at Rs 9144 if
interest is 4% as follows :

Year CF x PVIF@4% = DCF

1 2000 .962 = Rs 1924
2 3000 .925 = Rs 2775
3 5000 .889 = Rs 4445

Rs 9144
Example contd.
What it means if the current price is more or
less than Rs 9144
What shall be market behavior for
equilibrium
Efficient vs. Inefficient markets
Overview of Cost of Capital

The cost of capital has two important

definitions
The rate of return a firm must earn on its
projects or investments to maintain the
market value of its stock, assuming
constant risk
The rate of return required by the market
suppliers of capital to attract their funds
to the firm
Basic Assumptions

Business Risk
likelihood that a company will have lower
than anticipated profits or experience
loss instead of profit.
Financial Risk
likelihood of a company going bankrupt
and its inability to pay its debts
After-Tax Costs
Risk

Risk
Composition of Financing Cost
The general relationship between risk and
financing costs can be explained by the following
equation:
kl = RF + bp + fp
WHERE:
kl = specific cost of a given source of long-
term financing
RF = risk-free cost of a given type of financing
bp = business risk premium
fp = financial risk premium
Basic Concept
Cost of capital is measured at a given point in time
Cost of capital reflects the interrelatedness of
financing activities
Cost of capital assumes a deliberate financing mix
called a target capital structure
Given the target capital structure, the firms overall
cost of capital - often measured as the "weighted
average cost of capital" - is of greatest importance
Example
A firm that has a target capital structure of 40% debt
and 60% equity should consider the long run overall
cost of capital when making capital budgeting
decisions. If, for example, debt financing is available
at a cost of 8% (after tax) and equity financing is
available at a cost of 15%, the weighted average
long-term cost of capital is [(.40 x 8%) + (.60 x 15%)]
= 12.2%, reflecting the interrelatedness of financing
decisions. Decisions made with the weighted
average cost of capital in mind generally are in the
best interests of the firm and its shareholders.
The Cost of Specific Sources of
Capital
There are four basic sources of long-term funds
Long-term debt
Preferred stock
Common stock
Retained earnings

The specific cost of each source of financing is the

after-tax cost of obtaining the financing today
The techniques used to determine specific costs of
capital generate rough approximations due to their
numerous assumptions and underlying forecasts
Valuing Bonds
Bonds are corporate security representing
debt of the company.
Can be easily valued since the cash flows
are easy to identify.
The cash flows associated with bonds are
the coupon payments on the bond for each
coupon period and the maturity value or
face value of the bond.
Most bonds pay coupons semi-annually
Cost of Bond
Example - 2
Price a 5% coupon, Rs1000 bond with 5
years to maturity if other bonds of similar
quality are sold to yield 8%.

Periods CF x PVIF@4% = DCF

1-10 Rs 25 8.111 = Rs 202.78
10 Rs1000 .676 = Rs 676.00

Rs 878.78
Example 3 Post Tax Cost
Example 3 Post Tax Cost

Calculate the Pre Tax Cost - ????

Valuing Preferred Stock
Preferred stock is an equity instrument
Technically it is a perpetuity.
The annual return in dollars for a share of
preferred stock would be the dividend rate
To value a perpetuity, simply take the
annual return in dollars and divide by the
appropriate discount rate
Valuing Preferred Stock

D
P0 =
kp
D = Annual dividend in Rs
Kp = Investors required rate of return
Valuing Preferred Stock - Example

An issue of preferred stock was sold for $78

per share. The stock will pay $8 per year in
dividends. Flotation costs of $3 per share
were incurred by the firm. Find kp

k
p = $8 = $ 8 = .1067 or 10.67%
$78-$3 $75
Valuing Equity Stock

Common stock is not so easy to value.

The cash flows are not stable or easily
identified.
One simple model that is sometimes used
to value common stock is the Gordon
Dividend Valuation Model.
Valuing Equity Stock

D 1

k =
e + g
P0
D1 = Annual dividend of next year in Rs
Ke = Investors required rate of return
P0 = Current Price
g = Dividend growth rate
Example

A firm's stock is currently selling for $22 per share,

it expects to pay a dividend of $1.76 per share
next year, and dividends have been growing at a
compound annual rate of 5%. Find ke?

$1.76
ke = + .05 = .08 + .05 = .13 or 13%
$ 22
Capital Asset Pricing Model

Beta Computation
Capital Asset Pricing Model
Beta Computation

Covariance Variance method

Slope Method
Regression Method
Example

If a firm's Beta is 1.25, the risk-free rate is 6%, and

the market return is 11.5%, find ks.

ks = .06 + [1.25 x (.115 - .06)] = .06 + .06875

=12.875%
WACC

The weighted average cost of capital

(WACC) is computed with the use of the
corporation's existing capital structure
Determine the percentage composition of each
source of capital in the capital structure (The
"Weight")
Multiply the specific cost of each source of
capital by its weight
Sum the products and you have the WACC
WACC
ka = (wi x kd) + (wp x kp) + (ws x ke or kn)

WHERE:

wi = Proportion of L-T debt in the capital

structure
wp = Proportion of preferred stock in the capital
structure
ws = Proportion of common equity in the capital
structure
Note: wi + wp + ws = 1.0
Example
The Axis Company seeks a target capital structure
of 40% long-term debt, 20% preferred stock, and
40% common stock equity. Assuming that Axis
can obtain long-term financing at the after tax
costs of 7.32% for debt, 10.67% for preferred
stock, and 13% for common stock equity, find ka

ka = (.40 x .0732) + (.20 x .1067) + (.40 x .1300) =

.02928 + .02134 + .052 = .10262 or 10.26%
END