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Bonds Valuation

Preferred share is share that has a claim against income and assets before ordinary
share but after debt. Often, preferred share considered a hybrid security because it
possesses characteristics of both debt and equity. Generally, preferred share is
considered similar to ordinary (common) equity share because they do not have
maturity and similar to debt in that both securities have fixed payments, dividends for
preferred share and interest for debt.
Preferred share valuation is relatively simple if the firm pays fixed dividends at the end
of each year. If this condition holds, then the stream of dividend payments can be
treated in perpetuity and be discounted by the investors required rate of return on a
preferred share has high risk, investors normally require a higher rate of return. This is
because creditors have priority over preferred shareholders in their claims to both
income and investors.
Thus, the intrinsic value of a share of preferred share (Po) is the sum of the present
value of future dividends discounted at the investors required rate of return. This also
can be determined using the following valuation model.
Po= Dp
Kp
Where: Dp= Per share cash dividend
Kp= Investors required rate of return on preferred share

For example, Federal Electric Company has an issue of preferred share outstanding
that pays a yearly dividend of P 10.80. Investors require a 12 % return on this preferred
share.
Determine the intrinsic value of the preferred share.
Solution:
Po = P 10.80
12 %

P90.00

Ordinary (Common) Equity Share


Ordinary equity shares (traditionally known as common stock) are a form of long
term equity that represents ownership interest of the firm. Ordinary equity shareholders
are called residual owners because their claim to earnings and assets is what remains
after satisfying the prior claims of various creditors and preferred stock holders.
Ordinary (common) equity shareholders are the true owners of the corporation and
consequently bear the ultimate risk and rewards of ownership.
Business firms organized as a corporation may choose to issue publicly traded stock
(publicly owned corporation) or keep ownership only among the original organizers
(closely held corporation). As owners of the firm, ordinary shareholders are
considered to be residual domains. This means that ordinary shareholders have the
right to claim any cash flows or value after all other claimants have received what they
are owed. These profits can be used to reinvest in the firm to foster growth, pay out
dividends to shareholders, or a combination of the two.
Shareholders assume a limited liability because their risk of potential loss is limited to
their investment in the corporations equity shares.

VALUATION OF ORDINARY EQUITY SHARES AS A SOURCE OF FUNDS


Ordinary Equity Share Valuation
Ordinary equity shares are shares held by the owners of the firm. Ordinary equity share
valuation is complicated by the uncertainty of future returns. These returns may be in
the form of cash dividend payments and/ or changes in the shares price (gains or
losses) over the holding period. Dividends are uncertain because there is no legal
requirement to pay them unless they are declared. Furthermore, ordinary equity share
dividends may increase, remain constant, or decrease. Future share prices are also
uncertain. Thus, equity shares are generally riskier than bonds because the cash flows
must be estimated. Although there are numerous ordinary equity shares valuation
models, the following discussion focuses on models that assume varying holding
periods (the length of time that an investor expects to own or hold a security) and rates
of dividend growth.
Ordinary Equity Share Valuation Models Based on Holding Periods
A. Finite- Period Dividend Valuation
B. Infinite- Period Dividend Valuation

A. Finite- Period Dividend Valuation


This model is one in which an investor plans to purchase an ordinary equity
share and hold it for a specific length of time. For example, the holding period
may be for one or more periods. During the holding period, the investor
expects to receive cash dividends and to sell the stock for a price at the end
of the holding period. The equation to estimate the value of ordinary equity
share is:

Po=

Where: Dt= Per share cash dividend paid on ordinary equity in period t
Pn= Per share price of ordinary equity in period n
Kr= Investors required rate of return on ordinary equity share

Illustrative Case: CALCULATIONS OF INTRINSIC VALUE OF ORDINARY EQUITY


SHARE UNDER THE FINITE- PERIOD DIVIDEND VALUATION
An investor plans to but ordinary share of Holy land Farms and to sell it at the end of
one year. The investor expects Holy Land to pay P. 5.20 cash dividend and to sell for P
50.00 at the end of the year. If the investors required rate oid return is15 %, the value of
the stock to this investor would be computed as follows:
P= P 5.20
1 + 0.15

P 50

P 55.20

1 + 0.15

P 48.00
1.15

This indicate that the investor should pay no more than P 48 per share for a share of
Holy Lnads share to realize an expected return of 15 %.

B. Infinite- Period Dividend Valuation

This model assumes that an investor plans to purchase an ordinary share and hold it
indefinitely. Hence, the returns are only I the form of dividends over multiple periods.
The following equation is an infinite period model that shows the intrinsic value of a
share of ordinary share is equal to the expected stream of dividends discounted at the
investors required rate of return.

The above equation can be simplified into the following valuation model:
Pn=

Dp
Ks

Where: Dp= per share dividend paid on perpetuity


Ks= investors required rate of return on ordinary equity share
= sign for infinity

Illustrative Case: Calculations of the Intrinsic Value of Ordinary Equity Share Under the
Infinite- period Dividend Valuation
Using the data, determine the intrinsic value of oordinary equity share under the infinite
period dividend valuation
Answer: P = D p
Ks
P = P 5.20
15 %
= P 34.67

Ordinary Equity Share Valuation Model Based on Dividend Growth Rate

The valuation models to determine the value of ordinary equity shares based on
dividends growth rates include the following:
A. Zero Growth Dividend Model
B. Constant Growth Dividend Model
C. Supernatural Growth Dividend Model

A. Zero Growth Dividend Model


A zero growth dividend model assumes dividends remain a fixed amount over
time.
Pn =
Dp
Ks
Illustrative Example: Calculations of Share Value Using the Zero Growth Dividend
Model
XYZ Company expects to pay a P 3.00 cash dividend at the end of the year indefinitely
into the future. If investors in this stock require a 15 percent return, the value of a share
of XYZ would be computed as by substituting D p = P 3.00 and ks= 0.15
Pn

= P 3.00

= P 20.00

1.15

B. Gordon Constant Growth Model


A Gordon constant growth dividend model assumes that dividends frow at a constant
rate each period. The formula is :

Pn=

D1
ks - g

Where: D1 = Expected dividend


ks = Investors required rate of return on common equity share

g = Constant dividend growth rate


Illustrative Case: Calculations of Share Value Using the Gordon Constant Growth
Dividend Model
RST Corporation currently pays P 2.00 per share in ordinary equity share dividends.
The firms dividends are expected to grow at a constant rate of 5 percent per year.
Investors require a 15 percent return on RSTs ordinary equity share.
D1 is calculated by using Do (1 + g) 1
D1 ( P 2.00 ) ( 1 + 0.05 ) 1 = P 2.10
Substituting D1 = P 2.10, ks = 0.15 and g= 0.05 in the above equation produces an
ordinary share value of P 21.00

Pn

P 2.10
1.15 - 0.05

P 21.00

C. Supernormal Growth Dividend Model


A supernormal growth dividend model assumes the dividends grow at an above
normal rate over some tie period and then grow at a normal rate thereafter. This twostage model is more flexible than the zero or constant growth rate models and can be
adjusted to allow for any number of different expected growth rate. This model states
that the value of the firms ordinary equity share equal the present plans the present
value of the sale price at the end of the above normal growth period.

Where: gn= Supernatural growth rate


m = Period of supernatural growth

Illustrative Case: Calculations of Share Value Using the Supernatural Growth Dividend
Model

QC Company expects dividends to grow at a rate of 10 percent a year for the next five
years and 6 percent a year there after. The firms current dividend is P 2.00 per share.
An investor who requires a 16 percent rate of return would compute the value of QCs
ordinary shares in four steps.
Step 1 :
Find the present value of the dividends during the above normal growth model.
Year
1
2
3
4
5

Dividend
P2.00 (1.100) - P2.20
P2.00 (1.210)-2.42
2.00 (1.331)- 2.66
2.00 (1.464)- 2.93
2.00 (1.611)-3.22

Present Value of
Intrinsic Factor
0.862
0.763
0.641
0.552
0.476

Present Valueof Dividend


P 1.90
1.80
1.71
1.62
1.53
P 8.56

Step 2: Find the present value of the stock price in year 5. This step involves calculating
the share value at the end of year 5.
P5= P3.22 x 0.06

10 %
= P 3.413
10 %
= P 34.13
Step 3 : Discount the share value at the end of year 5 to the present at the 16 %
required rate of return.
PV (P5) = P 34.13(0.40 %)
=

P 16.25

Step 4: Add the present value of the 5 years dividends and the present value of the
share in tear 5 to get the value of the share at the end of the above normal growth
model.

Po = P 8.56 + P 16.25
= P 24.81