RAJARATA UNIVERSITY OF SRI LANKA FACULTY OF MANAGEMENT STUDIES POSTGRADUAATE DIPLOMA IN MANAGEMENT (PGDM) LEADING TO THE DEGREE IN MBA. PGDM 1213

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RAJARATA UNIVERSITY OF SRI LANKAFACULTY OF
MANAGEMENT STUDIESPOSTGRADUAATE DIPLOMA IN
MANAGEMENT (PGDM) LEADING TO THE DEGREE IN
MBA.PGDM 1213 FINANCIAL MANAGEMENTVALUATION
CONCEPTSESSION 05

• KGA UDAYA KUMARA
• SENIOR LECTURER
• DEPT. OF ACCOUNTANCY FINANCE
• FACULTY OF MANAGEMENT STUDIES
• RAJARATA UNIVERSITY OF SRI LANKA

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Session Objectives

• To understand
• The valuation of bonds
• The valuation of preferred stocks
• The valuation of common stocks
• The stock valuation models
• The characteristics of different types of stocks

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Fundamental Rule of Valuation

• Value/Price Present Value of the Future Cash
  Flows
• The fundamental asset valuation model (FVM)
  defines the value of an asset in terms of the
  present value of all its expected future cash
  flows discounted at an appropriate rate of
  return.

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To construct a valuation model for any asset
three critical components are required

• 1 Estimates of the size or volumes of the
  expected future cash flow returns which the
  asset is expected to generate, and the bigger the
  expected cash flows are the better.
• 2 Estimates of the timings of the future cash
  flows as this will also affect their respective
  valuesthe sooner cash flows are received the
  more valuable they will be. Cash flows may occur
  over any time period, days, weeks, months or
  years and their patterns may be regular or
  erratic.
• 3 An estimate of the investors required rate of
  return from the prospective investment. This is
  the minimum rate of return that will entice the
  investor to undertake an investment given its
  level of risk. Required rates of return, as we
  know, can be determined using the capital asset
  pricing model (CAPM).

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• Assumptions
• All the cash flows are known before hand
• All the cash flows will occur with certainty
• There are no information asymmetries
• There is no default

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The value of an asset can be expressed in present
value equation form as
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Which from the time value of money concept you
will remember is the same as V0CF1(PVIFr,1)
CF2(PVIFr,2)CF3(PVIFr,3) ...
CFn(PVIFr,n)
V0 value of the asset at the present time,
time zero CFt cash flow expected at end of
year t t any year (t1, 2,, n) r
required rate of return/appropriate discount
rate n assets expected life
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Characteristics of Bond

• A bond is a security that obligates the issuer to
  make specified interest and principal payments to
  the holder on specified dates.
• Coupon rate
• Face value (or par value or redemption price)
• Maturity date(or term)
• Term to maturity (remaining time period to
  redeem)
• Required rate of return (expected return r k
  Kb)

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Bond Valuation

• It is understood that the value of an asset is
  the present value (PV) of the future cash flows
• Cash flows of a bond
• Coupon Payments
• Maturity Payment
• Hence value of bond/debenture is based on the PV
  of its coupon payments and maturity value (
  redemption payment)

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Bond Valuation Cont.
where n Number of periods to
maturity, CFt Cash flow (interest and
principal) received in period t, kb
Required rate-of-return for bond.
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Bond Valuation (Redeemable Bonds) .

• It Coupon payment, coupon rate X face value,
• P Principal amount (face value) of the bond,
• n Number of periods to maturity.
• Kb Required rate of return

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Example

• Suppose a 20 coupon bond with par value of Rs.
  1,000 is trading for Rs. 1,100. It matures in six
  years from now and pays the coupon annually. What
  would be the Bond price today if the annual
  expected rate of return on similar investment is
  16, 20 and 24

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Bond with semiannual coupon

• What would be the price of the bond, if the bond
  receives its coupon semiannually in the above
  example ?

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Bond Valuation (Irredeemable Bonds)
PV I/ Kb
where, PV Value of the bond at time zero I
Annual interest or coupon payment in time
period t (t1, 2, , n.) Kb required rate of
return/appropriate discount rate
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Example 1 Valuing an irredeemable bond If a bond
has a par value of Rs.100, pays a coupon interest
rate of 10 per cent per year and the return
currently required by investors in the market on
similar risk bonds is 8 per cent, the bonds
value will be calculated as
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Why bond prices vary?

• Bond prices can and do change frequently over
  their life spans
• Bond prices can fluctuate quite dramatically
• Most corporate bonds frequently traded in the
  markets
• Buying and selling activities and market
  expectations will cause prices and yields to
  change.
• The price or value of bonds is influenced by two
  main factors
• 1. Changes in the required rate of return which
  are in turn related to changes in the general
  level of interest rates and
• 2. The time to maturity of the bond.

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Bond values and the required rate of return

• Inverse relationship between a bonds price and
  the required rate of return
• as the required rate of return decreases, the
  bonds value increases and
• as the required rate of return increases, the
  bonds value decreases

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Graphical Illustration Bond values and the
required rate of return
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Relationship between bond value and the required
rate of return
Coupon rate () Required rate of return () Bond value (Rs.) (Trading position)
12 14 87.70 (Discount)
12 12 100.03 (Par)
12 10 115.17 (Premium)
12 09 124.23 (Premium)
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Bond values and the time to maturity
Required Rate of Return Time to Maturity
10 15 20
(1) 9 124.23 119.22 111.68
(2) 12 100.00 100.00 100.00
(3) 14 87.70 89.59 93.10
(4) Change in Value (1) (2) 36.53 29.63 18.58
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Graphical Illustration Bond values and the time
to maturity
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Yield To Maturity (YTM)
The yield to maturity is that interest rate that
equates the present discounted value of all
future payments to bondholders to the market
price.
If an investor buys a bond today at a quoted
price in the secondary market and holds it until
maturity, the compound rate of return the
investor would earn on the investment is known as
the bonds yield to maturity (YTM).
Ex Suppose the price of a bond with Rs. 1,000
par value, which matures in 10 years with a
coupon of 8, is Rs. 875. What is YTM?
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Trial and error method If the bond is selling at
a discount, YTM gtcoupon rate If the bond is
selling at a premium, YTM lt coupon rate

• Since selling at a discount, YTM gt coupon rate
• Try 10,
• PV of Interests 491.56
• PV of Par value 385.54
• Price 877.10
• Try a higher rate, say 11,
• PV of Interests 471.14
• PV of Par value 352.18
• Price 849.83
• Repeat rate, between 10 and 10.5