FINAL PROJECT

BUSINESS FINANCE

Madam Umara Noreen

Date
20/5/2009
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• Hasan Asghar Sipra

• Kashif Rashid

• Qazi Yasir Irshad

• Maaz Javed Sheikh

• Jazib Sarwar

• Ahsan Kaleem

• Amjad Iqbal
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Table of
Contents
Table of Contents.......................................................................................................3

DISTINCTIONS AMONG VALUATION CONCEPTS..................................................5

Liquidation Value................................................................................................................5

Going-concern Value..........................................................................................................5

Book Value.........................................................................................................................5

Market Value.......................................................................................................................5

Intrinsic Value.....................................................................................................................5

BOND VALUATION.....................................................................................................6

Types of Bonds...................................................................................................................6

Perpetual Bonds..............................................................................................................6

Example..........................................................................................................................7

Nonzero coupon bonds...................................................................................................7

Example .........................................................................................................................8

Zero-coupon bonds.........................................................................................................8

Example .........................................................................................................................9

Semi-annual compounding of Interest.................................................................................9

Example .........................................................................................................................9

PREFERRED STOCK VALUATION..........................................................................10

Example ........................................................................................................................10

COMMON STOCK VALUATION...............................................................................10

Are dividends the Foundation?.........................................................................................11

Dividend Discount Models.................................................................................................12

Constant Growth...........................................................................................................12
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Example .......................................................................................................................13

No Growth.....................................................................................................................13

Earning multiplier Approach..........................................................................................13

Example.....................................................................................................................14

Growth Phases..............................................................................................................14

RATES OF RETURN (or YIELDS)............................................................................16

Ytm on bonds....................................................................................................................16

Behaviour of Bond Prices..............................................................................................16

YTM & Semi-annual Compounding...............................................................................17

Yield on Preferred Stock...................................................................................................17

Example............................................................................................................................18

Yield to common Stock.....................................................................................................18

Example............................................................................................................................18
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DISTINCTIONS AMONG VALUATION

CONCEPTS
Liquidation Value
 The Amount of Money that could be realized if an asset or
group of assets(e.g. firms)is sold separately from its operating
organization

 It has a major role in determining the value of the firms'

financial securities

Going-concern Value
 The Amount the firm could be sold for as a continuing
operating business

 In the upcoming security valuation models ,it will generally

assume that we are dealing with going concern

 It is not appropriate for impending bankruptcy

Book Value
 BV of an asset is the accounting value of the asset

 BV=Cost-Accumulated Depreciation

 It can be compute as calculating difference b/w total assets

and total liabilities of a firm

Market Value
 MV of an asset is simply the market price at which the asset
trades in an open market place

 It is being viewed as the higher of the firm’s liquidation or

going concern value

Intrinsic Value
 IV is what the price of security should be if properly priced
based on all factors bearing on valuation-assets, earnings,
future prospects, management and so on.
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 It’s a economic value

 We will use this value throughout the chapter

BOND VALUATION

 Bond is a security that pays a stated amount of interest to the

investor period after period until it finally retired by the issuing
company

 Bond always has face value(the stated value of an asset)

 The Bond always has stated maturity which is the time when the
company is obliged to pay the bondholder the face value of the
instrument

 The Bond also has a coupon rate the stated rate of interest on bond
( CR=I/FV)

 In valuing a security the primary concern is with discounting or

capitalizing the cash flow stream that the security holder would
receive over the life of the instrument

 Discounting vary among securities depending on the risk structure

of the bond issue

Types of Bonds
 Perpetual Bonds

 Nonzero Coupon Bonds

 Zero Coupon Bonds

Perpetual Bonds
 The valuation of this bond is with a unique class of
bonds that never matures
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 It is easy to valuate and originally issued by Great

Britain after Napoleonic wars to consolidate debt issues,
the British Consol (consolidated annuities) is one such
example.

 A consol is a bond that never matures ,a perpetuity in

the form of bond

 The present value of it is equal to the capitalized value

of an infinite stream of interest payments.

 If a bond promises a fixed annual payment of INT

forever ,its present(Intrinsic)Value V at the Investor’s
required rate of return for this debt issue kd,

Example
Suppose you could buy a bond that paid $50 a year
forever. Assuming that rate of return is 12%, the present
value would be

V=$50/0.12 =$416.67

It is the amount that you would be willing to pay for this

bond if market price is greater than this amount then
you would not want to buy it

Nonzero coupon bonds

It is a bond of finite life, so we must consider not only
the interest stream but also the terminal or maturity
value(face value)in valuation process
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Example
Assume that face value (MV) is $1000 with a 10%
coupon and nine years to maturity. The coupon rate
corresponds to interest payments of $100 per year. If
our required rate of return on bond is 12%, then

V=$100/(1+0.12)^1+$100/(1+0.12)^2+...$100/
(1+0.12)^9..+$1000/(1+0.12)^9 =$100/(1.12)^1+
$100/(1.12)^2+…$100/(1.12)^9…+$1000/(1.12)^9

=$100(5.328)+$1000(0.361)

=$532.80+$361.00

=$893.80

So, from the example we can see that PV of Interest

payment is 532.80 and PV of maturity payment is
361.00.

If we reduce the discount rate to 8% from 12%

V=$100/ (1.08) ^1+$100/ (1.08) ^2+…$100/ (1.08) ^9

+… $1000/(1.08)^9

=$624.70+$50 = $1124.70

In this case PV >FV because rate of return <coupon rate i.e. 8%

<10%

Zero-coupon bonds
It is a bond which makes no periodic interest payments
but instead is sold at a deep discount from its face
value.

Why we buy such a bond which pays no interest?

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Because the gradual increase (0r appreciation) in the

value of security from its original

Example
Suppose that Sipra enterprises issue a zero-coupon
bond having a 10-year maturity and a $1000 face value.
if your required return is 12%

V=$1000/ (1+0.12) ^10

=$1000/ (1.12) ^10

=$1000(0.322)

=$322

(If you could purchase this bond for $322and redeem it 10years later for
$1000,so you would get 12% rate of return)

Semi-annual compounding of Interest

SO, for we calculating the intrinsic value by compounding
annual interest rate but most bonds in USA pay interest twice
a year.

Example
Assume that 10% coupon bonds of Sipra Enterprise have
12years to maturity and our required rate of return is
14%,the face value of bond is $1000

V= ($100/2)/ (1+0.14/2) ^12 +$1000/ (1+0.14/2)

^12x2
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= $50/ (1.07) ^12+$1000/ (1.07) ^24

=$50(11.469) +$1000(0.197)

=$770.45

PREFERRED STOCK VALUATION

• Most preferred stocks pay a fixed dividend at regular intervals.

• It has no stated maturity date

• It is similar to a perpetual bond.

• It has preference over common stock in the payment of dividends

and claims on assets

• Its Intrinsic Value can be found as follow

• V=Dp / Kp

Dp=stated annual dividend per share of preferred stock

Kp=it is appropriate discount rate

Example
If SHK corporation had a 9% , $100 face value preferred
stock issue outstanding and your required return was 14%
on this investment then its value would be

V=$9/0.14

=$64.29

COMMON STOCK VALUATION

 It’s a security that represents the ultimate ownership and risk

position in a corporation

 It’s a controversial subject and no one method for valuation is being

accepted universally

 The growing acceptance of idea that individual common stocks

should be analyzed as apart of total portfolio of common stocks
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 Simple is that, investors are not concerned

whether particular stock goes up or down as they are with what
happens to the overall value of their portfolio.

 And the other important thing is that common stock are much more
uncertain about the future stream of returns as compared to the
bonds and preferred stocks. at the investor might hold

Are dividends the Foundation?

 V=D1/(1+Ke)^1+D2/(1+ke)^2+….+D inf/(1+ke)^inf
(derived from preferred stock and bond)

D is the cash dividend

Ke is the investor’s required return

 But, if we plan to own the stock for two years then..

V=D1/(1+Ke)^1+D2/(1+ke)^2+P2/(1+ke)^2

 P2 is the expected sales price of our stock after two years

 Note that it is the expectation of future dividends and a

future selling price which itself is based on expected future
dividends that gives value to the stock.

 Cash dividends are all that stockholders as a whole receive

from the issuing company

 Consequently, the foundation for the valuation of the

common stock must be dividend.

 P=MV

 Why do stocks of companies that pay no dividend

have positive, often quite high values????
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It is because investors expect to sell the stock in the future at

a price higher then they paid for it...

Dividend Discount Models

 Constant growth

 Conversion to an earnings Multiplier Approach

 No Growth

 Growth Phases

Constant Growth
• If the dividends are expected to grow at constant rate
then we will modify the basic stock valuation approach

V=Do(1+g)^1/(1+ke)^1 +D0(1+g)^2/
(1+ke)^2……Do(1+g)^n/(1+ke)^n

• (Do=present dividend per share; (1+g) =compound

growth factor)

• Assuming ke >g because dividend growth rate

>capitalization rate

• Multiply the whole term by (1+ke)/(1+g) and subtract it

• V x {(1+ke)/ (1+g)} =Do (1+g) ^1/ (1+ke) ^1 x

{(1+ke)/ (1+g)}

• V (1+ke)/ (1+g) =Do……………………. A

• Now, subtract the original equation from A ,we get

• V(1+ke)/(1+g)-V=Do-Do(1+g)/(1+ke)

As we assume that ke>g then right hand would get to zero

 V[(1+ke)/(1+g)-1]=Do

 V[(1+ke)-(1+g)]=Do(1+g)

 V(ke-g)=Do(1+g)=D1
 V=D1/ (ke-g)…………………… reduced equation
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Example
Suppose SOKS corp. dividend share at t=1 is expected to
be $4that it is expected to grow at a 6% rate forever and
the appropriate discount rate is 14%. The Value of one
share of SOKS stock would be

V= $4/ (0.14-0.06)

=$50

No Growth
Its statement is like an expected growth rate is equal to
zero.

The dividends will be maintained at their current level

forever.

Its equation would be like as follow

V=D1/ (ke-g)

As g=0 so,

V=D1/ke…………….. NO Growth Equation

It is used when the stable dividend for long time is expected

to be maintained

Earning multiplier Approach

It is totally based upon the idea that investors often think in
terms of how many dollars they are willing to pay for a
dollar of future expected earnings.

Now assume that a company retains a constant proportion

of its earnings each year call it b the dividend payout ratio
(D/E) would also be constant,

(1-b)=D1/E1

(1-b)E1=D1…………………… A

Now, putting A into the constant growth equation we get

V= (1-b) E1/ (ke-g)……………..B

By rearranging the equation B we get,

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V/E1= (1-b)/(ke-g)……….. Earnings Multiplier

Example
Suppose now SOKS has retention rate of 40% and
earning per share for period 1 expected to be $6.67

B-> V= [(0.60) $6.67]/ [(0.14-0.6)]

=$50

EM=V/E1= (1-0.40)/(0.14-0.6)

=7.5times

Note, that $6.67x7.5=$50(alternative approach to find $50)

Growth Phases
A number of Valuation models are based on the premise
that firms may exhibit above-normal growth for number of
years (g>ke) but eventually the growth will taper off.

For example if dividends per share are expected to grow at

10% compound rate for five years and thereafter at a 6 %

V=Do(1.10)^1/(1+ke)^1+Do(1.10)^2/(1+ke)^2+..
+D5(1.06)^6-5/(1+ke)^6..

Note that growth in dividends in the second phase uses the

expected dividend in period 5 as its foundation. Therefore,
the growth term exponent is t-5 which means that the
exponent in period 6 equals 1 in period 7 it equals to 2 and
so forth.

We can rewrite the equation as

V=Do(1.10)^1/(1+ke)^1+Do(1.10)^2/(1+ke)^2+……….+[1/(1+ke)^5]
[D6/(ke-0.06)]….. n

If current dividend Do=$2, ke is 14%, then

V=$2(1.10)^1/(1.14)^1+$2(1.10)^2/(1.14)^2+
………………………………….+$2(1.10)^5/(1.14)^5+[1/
(1.14)^5][$3.41/(.14-.06)]

=$8.99+$22.13
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=$31.12

So, this can be clearer from the upcoming tables……

PHASE: 1
PV of Dividends to be Received Over First 5 years

End of
Dividend X PVIF(14%,t) = PV of Dividend
year

1 $2(1.10)^1 =$2.20 X .877 = $1.93

2 $2(1.10)^2 =$2.42 X .769 = $1.86

3 $2(1.10)^3 =$2.66 X .675 = $1.80

4 $2(1.10)^4 =$2.93 X .592 = $1.73

5 $2(1.10)^5 =$3.22 X .519 = $1.67

Total $8.99

PHASE: 2
Present Value of Constant Growth Component

Dividend at the end of =$3.22(1.06)=$3.41

year 6

Value of stock at the end of =Do/(ke-g)=$3.41/(.14-.06)=$42.63

year 5
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Present Value of $42.63 at =($42.63)(PVIF 14%,5)

end of year 5

=($42.63)(.519)=$22.13

Present Value of Stock $8.99+$22.13=$31.12

RATES OF RETURN (or YIELDS)

If we replace the intrinsic value (V) with the market price (P0) of the
security, we can solve the market required rate of return (yield)

 Yield to Maturity on Bonds

 Yield on Preferred stocks

 Yield on Common Stocks

Ytm on bonds
 YTM is the expected rate of return on a bond if bought at its
current market price and held to maturity ,it is also known as
Internal rate of return (IRR)

 Basically, it is the discount rate that equates the present value

of all expected interest payments and the payment of
principal amount at maturity with the bond’s current market
price

 P0=I/(1+kd)^1+…nth…+MV/(1+kd)^n

(KD=YTM)

Behaviour of Bond Prices

 Kd>coupon rate

Price
of
Bond < Face Value of Bond
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 Kd<coupon rate

Price of Bond >Face Value of Bond

 Kd=coupon rate

Pr
ice of
Bond =Face Value

YTM & Semi-annual Compounding

As we mentioned most domestic bonds pay interest
twice a year so for determining YTM we can replace the
Intrinsic Value (V) with Current Market Price (Po) in bond
Valuation

Po=(I/2)/(1=kd/2)^1 +….. (I/2)/(1+kd/2)^n +…..+MV/

(1+kd/2)^2n

Yield on Preferred Stock

Remember…… V=Dp/Kp (PSV equation)

Replace V with Po….

Po=Dp/Kp

Dp= it is same the dividend

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Kp= it is here becomes market rate of return for stock

By rearranging ……

Kp=Dp/Po

Example
Assume that the current market price per share of Red Chilies
Entertainment is 10 %,$100-par-value preferred stock is
$91.25, so, priced to yield of

Kp=$10/$91.25

=$10.96%E

Yield to common Stock

Remember …… V=D1/ (ke-g)

Replace V with Po

Po=D1/ (ke-g)

Poke –P0g=D1

Ke-g=D1/Po

Ke=D1/p0 +g

Example
P0=$40; g=9%; D=$2.40 for 1st year; ke =?

Ke=D1/Po + g

=$2.40/$40 + 0.09

= 0.06 + 0.09

= 0.15 or 15%