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Lecture Number: 04

Course: PGDM (IInd Semester). Subject: Financial Management

Topic: Valuation of Securities. Faculty: Vikash Sharma


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Introduction: Valuation is the process of determining the worth of an asset. Broadly, the assets can be
classified into two parts, Physical assets and Financial assets. The physical assets refer to the assets like
Land, Building, Stock, Furniture, Machineries, etc. the financial assets refer to the financial claims such
as bonds (Debentures), Preference shares, equity shares etc. Every investor and finance manager must
understand how to value the financial assets to judge whether to invest in these securities or not.

A. Valuation of Bonds (Debentures): A bond or a debenture is a debt security issued by a borrower and
purchased by an investor. Bond is a usual source of long term financing.

(i) Par Value: The par value is also called the face value, the original value or the nominal value
of a bond. However, the issue price may be more than, may be less than, or may be equal to
the face value of the bond.

(ii) Coupon Rate: Coupon rate is the interest rate on a bond’s par value. A 10% debenture
implies that the firm has to pay 10% interest on the par value of the same debenture.

(iii) Maturity Period: The maturity period refers to the life of a bond in a firm. In other words, it
refers to the period from the date of issue till the redemption date. Generally, the firms issue
bonds of maturity period up to 10 years only.

• Valuation model for Redeemable Bonds: The value of a redeemable bond is the sum of the
present value of all the interest earnings and the redemption value of the same bond. So for
calculating the total value of a bond, we need to first calculate the present value of each year’s
interest, using the discounting factor (required rate of return) and present value of the Redemption
value, using the same discount rate.

• Valuation model for Irredeemable Bond: The value of irredeemable bond can be calculated by
dividing the Annual Interest payment (in rupee terms) by the Cost of bonds (required rate of
return on bonds).

Annual interest payment (in rupee terms)


Value of each bond =
Cost of bonds (Kd)

In case of Semi-Annual Interest: In case, the firm decides to pay the interest on half-yearly
intervals, then the need valuation needs to be modified as follows:

(i) Find out the half-yearly amount of interest by dividing the annual interest by 2.
(ii) The number of years to maturity is to be multiplied by 2.
(iii) The annual required rate of return (discount rate) is also to be divided by 2.

B. Valuation of Preference Shares:


There are two types of preference shares, Redeemable preference shares and Irredeemable preference
shares. An investor holding Redeemable preference shares is entitled to receive a dividend at a fixed rate
for a given period and a redemption amount at the time of redemption of preference share. An investor
holding Irredeemable preference shares is entitled to receive a dividend at a fixed rate perpetually till the
liquidation of the company. Since there is no Redemption of the Irredeemable Shares, therefore the
shareholder will get only Dividend.

• Valuation model for Redeemable Preference Shares: The valuation of the Redeemable
preference shares can be done using the same steps as we did in case of Bond Valuation. Only
one change has to be made and that is of Dividend in place of Interest as the shareholders are
entitled to receive dividend on shares.

• Valuation model for Irredeemable Preference Shares: The value of irredeemable preference
share can be calculated as dividing the Dividend per share (in rupee terms) by the Cost of
preference shares (required rate of return on preference shares).

Dividend per share (in rupee terms)


Value of each share =
Cost of Preference Share Capital (Kp)

C. Valuation of Equity Shares:

Every company must have equity share capital as it represents the real ownership interest. The valuation
of the equity share is the most typical because of its residual ownership character. The equity shareholders
receive the residual profits if any after charging Interest on debt capital (debentures and long term loans),
and paying Dividend to preference shareholders

Valuation Models

Accounting Basis Dividend Basis Earning Basis

Zero Growth Model Constant Growth Model Variable Growth Model

Gordon’s Model Walter’s Model

1. ACCOUNTING BASIS: The value of an equity share is simply the value of firm’s ownership (based
on Balance Sheet values) divided by the number of equity shares.
2. DIVIDEND BASIS:

• Zero Growth Model: This is the simplest type of a dividend pattern in which the dividend
amount remains constant over years. The value of equity share can be calculated as dividing the
Dividend per share (in rupee terms) by the Cost of equity shares (required rate of return on equity
shares).

Dividend Per Share (in rupee terms)


Value of each share =
Cost of Equity Share Capital (Ke)

• Constant Growth Model: In this type of dividend pattern the dividend grows constantly at a rate
“g” every year. The value of equity share can be calculated as dividing the Dividend per share (in
rupee terms) by the Cost of equity shares (required rate of return on equity shares) less annual
growth rate in dividend.

Dividend per share (in rupee terms)


Value of each share =
Cost of Equity Share Capital (Ke) – Dividend Growth Rate (g)

3. EARNING BASIS:

• Gordon’s Model: The model is based on Earnings for equity shareholders and can be
represented as follows:

EPS (1-b)
Value of each share =
Ke – br
Where;

EPS = Earning Per Share.


b = Retention ratio i.e. % of earnings being retained (not distributed as
dividend).
Ke = Cost of Equity Share Capital or the required rate of return on equity
share capital, and
r = Internal rate of return for the firm.

• Walter’s Model: This model is also based on Earnings for equity shareholders and can be
represented as follows:

D + (r / Ke) (E – D)
Value of each share = --------------------------
Ke

Where,

D = Dividend per share.


E = Earning per share
r = Internal rate of return for the firm.
Ke = Cost for Equity Share Capital or the required rate of return on equity
share capital.