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VALUATION OF SECURITIES

Learning objectives; Basic valuation models to value bonds / debentures, preference shares, equity shares. Apply the basic valuation model to bonds/Deb. To evaluate the relationship between both return and time to maturity & bond values. Understand YTM, its calculations and procedure to value Bonds that pay interest semi-annually. Learn the valuation of perpetual and redeemable preference shares. Learn basic share valuation under each of three cases/. Zero growth model, constant growth model and variable growth model. Understand and learn three other approaches- Book value, liquidation value and P/E /multiples-that are used to estimate share values. Review the relationship between the impact of financial decision on both expected return and risk and their combined effect on the value of the firm.

VALUATION
Valuation is the process that links risk and return to determine the worth of an asset. To value them, we have to use TV techniques and risk and return framework. The key inputs to the valuation process are Expected returns in terms of cash flows together with their timings. Risk in terms of required rate of return or return. The value of an asset depends on the return (CFs) expected over the holding/ownership period. The CFs can be annually, intermittent and even one time. The level of risk associated with a given CF/ return has a significant bearing on its value. The greater the risk the lower the value & vice versa. Higher risk can be incorporated into the valuation analysis by using a higher required / capitalization/discount rate to determine the PV. While studying CAP,M model we found that greater the Beta, the higher the required ROR. It is against this back ground, the valuation of Bonds/ PS /ES is determined.

BONDS
Basic valuation model: The value of an asset /security is the present/discounted values of all future CFs (return) associated with it over the relevant/specified period. The expected return (CFs) are discounted V= A1/ (1+k) 1 + A2/ (1+k) 2 + + An / (1+k) n V= Value of an asset / security At = Cash streams expected at the end of year t K = appropriate required /capitalization / discount rate. Alternatively, if expected CF is a mixed stream, then V = [(A1 x PVIF (k, 1) + (A2 x PVIF (k, 2) +. + (An x PVIF (k, n) )] If expected CF is an annuity, then V= A x PVIFA (k, n)

BONDS
EXAMPLE: Assuming a discount rate of 10% and CFs are given

Year

Cash Flows Security X

Cash Flows Security Y

10000

5000

10000

10000

10000

15000

BONDS
Value of asset X = 10000 x PVIKA (10, 3) Value of asset Y = 5000 x PVIF (10, 1) + 10000X PVIF (10, 2) + 15000 XPVIF (10, 3) VALUATION OF BOND / DEBENTURE A bond is a long term debt instrument used by Govt. / Govt. bodies / Business enterprises to raise large sum of money/ funds /resources. Basic Bond Valuation The value of a bond is the PV of the contractual payments its issuer is obliged to make from the beginning till maturity. The appropriate discount rate would be, Required Rate of Return

B = I [Summation of [1 / (1+Kd) t] + M x [1 / (1+Kd) n = I x (PVIFA (kd, n)) + M x PVIF (kd, n) B = Value of the Bond at t = 0 I = Annual rate of interest paid n = No. of years to maturity (term of Bond) M= par/maturity value of Bond Example: 10% rate of interest, maturity 10 years maturity of Rs 1000 i.e. par value. RROR = 10%, 8% and 12% B = 100 x PVIFA (10, 10) + 1000 X PVIF (10, 10) = 100 X 6.145 + 1000 X 0.386 = 614.50 + 386 = 1000.50 = 1000

IMPACT OF MATURITY ON BOND VALUE When the required ROR is different from the coupon rate (CR) of interest, the time to maturity would affect value of bonds even though the RROR remains constant till maturity. Constant required return In such situation the value of bond would approach its par value as the passage of time mover the value of bond closer to maturity. Changing required return Short maturity has less interest rate risk In other words short maturities have less interest rate risk than to long maturities when all other features, namely CR par value and frequency of interest payments are same

Bond values for various required return


Required returns kd Bond value B Status

12

887

Discount

10

1000

At par

1134

premium

Yield to Maturity (YTM) YTM is the ROR that investors earn if they purchase a bond at a specific price and hold it until maturity. The YTM on a bond whose current price equals its par/face value (i.e. purchase price = maturity value) would always be equal to its CR interest. If bond value differs from par value, the YTM would differ from CR. EXAMPLE: The bond of PC Ltd is currently quoted at 10800. Assuming CR of 10%, par value 10000, year to maturity 10 years and Annual interest payments. Ans: V = 1000 x PVIFA kd, 10 + 10000 x PVIF 9,1 IF kd is 10%, that is, equal to CR, the value of bond would be Rs 10000. Since the value of bond is 10800, the kd must be less than 10%. Using 9% discount kd we get:

V = 1000 PVIFA 9,10 + 10000 x PVIF 9,10 = 1000 X 6.418 + 10000 X 0.422 = 6418 + 4220 = 10638 SINCE value of bond (10638) at kd=9% is less than Rs 10800, we try a lower rate of discount using 8% =1000x6.710 + 10000x0.463 = 6710+4630 = 11340 Since the bond value is higher than 10800, the kd (YTM) must be between 8 and 9%. The exact value The difference between bond value at 8% and 9% = 11340-10638=702 Difference between desired value (10800) and the value with lower kd is 11340-10800 =540, Percentage of the difference across discount range 89 % is 540/702 = .77

VALUATION OF SHARES
P.S, like debentures, is usually subject to fixed rate of return / dividend. In this case valuation is similar to valuation of bonds. Po = D / (1+rp) t + M / (1+rp) n Po = Current price of P.S. D = Annual dividend N= life of the preference share Rp= required rate of return M= maturity

VALUATION OF SHARES
The ES holders buy/hold shares in expectation of periodic cash dividend and an increasing share value. They would buy a share when it is undervalued ( i.e. its true value is more than its market price) and sell it when market price is more than its true value (i.e. when it is overvalued) The value of a share is equal to the PV of all future dividends it is expected to provide over an infinite time horizon. P= D1/(1+ke)1 + D 2/(1+ke)2 +.+ D/(1+ke) On simplification, the above equation becomes P=D / Ke EXAMPLE: Poland Ltd has declared a dividend of Rs 6 per share this year. It is expected that the dividend would remain constant over a period of time. Calculate the intrinsic value of the stock if the required rate of return for equity owner is 18.5%. P= D / ke = 6 / 0.185 = Rs 32.43

VALUATION WITH CONSTANT GROWTH MODEL


It is assumed that dividend tend to increase over time because business firms usually grow over time. Therefore, if the growth of the dividends is at a constant compound rate then, D1 = D o (1+g) where, D1 = dividend for year 1 Do = Dividend for year 0 G = Constant compound growth rate. The valuation of the share where dividend increases at a constant, compound rate is given as: Po = D1 / (1+ke) + D1 (1+g) 2 / (1+ke) + D1 / (1+ke) 3 Po = D1 / ke g

VALUATION WITH CONSTANT GROWTH MODEL


EXAMPLE Chill Soft Ltd is expected to grow at the rate of 7% per annum and dividends expected a year hence is Rs 5. If the required rate of return is 12%, what is the price of the share today? Po = 5 / 0.12 0.07 = 5 / 0.05 = Rs 100 EXAMPLE: The Premier Instruments Ltd had paid the following dividends per share:
Year 1 2 3 4 5 6 Dividend per share 2.00 2.10 2.24 2.40 2.58 2.80 5 6.67 7.14 7.5 8.53 Growth in %age

VALUATION WITH CONSTANT GROWTH MODEL


Assuming a 16% required return, and Rs 3 share dividend in year 7 (D1). Compute the value of the shares of PIL. Number of years of growth = year 6 year 1 =5 years G = D6 = D1 x (1+g) 5 2.80 = 2 x (1+g) 5 D1 / D6 = 1/ (1+g) 5 2 / 2.80 = 1/ (1+g) 5 and (1/ (1+g) 5 = PVIF g, 5 PVIF g, 5 = 2/2.80 = 0.714 the PVIF close to 0.714 is 7% Therefore, P = D7 / (ke g) 3 / (0.16 0.07) = 33.3

VALUATION WITH VARIABLE GROWTH MODEL


VALUATION WITH VARIABLE GROWTH IN DIVIDEND This approach incorporates a change in the dividend growth rate. Assuming g= initial growth rate and g2 = the subsequent growth rate occurs at the end of year N. EXAMPLE Consider the equity share of Metlife Ltd. Do = current dividend per share of Rs 3. N = duration of the period of super normal growth = 5 years Ga = growth rate during the period of super normal growth = 25% Gn = normal growth rate after super normal growth period is over = 7% Ke= investors required rte of return = 14%

VALUATION WITH VARIABLE GROWTH MODEL


STEP I-Dividend streams during super Normal growth period; D1=Rs 3 (1.25) = 3.75 D2=Rs 3(1.25) = 4.69 D3= Rs 3(1.25) =5.86 D4= Rs3 (1.25) =7.32 D5=Rs 3(1.25) =9.16 The PV of the above stream of dividend is 3.75 /1.14 + 4.69/ (1.14)2 + 5.86/(1.14)3 + 7.32/(1.14)4 + 9.16 / (1.14)5 =3.29+3.60+3.96+4.33+4.76 = 19.94

VALUATION WITH VARIABLE GROWTH MODEL


STEP II The price of share at the end of 5 years, applying the constant growth model at that point of time will be P5 = D6 / ke gn = D5 (1+gn) / (ke gn) = 3 (1.25)5 (1.07) / 0.14 -.07 =140 The discount value of the price is 140 / (1.14)5 = 140 / 1.9254 = 72.71 STEP III The sum of these component is Po 19.94+72.71 = 92.6

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