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Principle underlying valuation:
Replacement Value
Liquidation Value
Market Value
÷eatures of a Bond
÷ace Value
Maturity
Redemption value
Market Value
Bonds Values and Yields
Bonds ith maturity
Perpetual bonds
Bond ith Maturity
Bond value = Present value of interest +
Present value of maturity value:
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Yield to Maturity
The ë
ë (- Î is the measure of
a bond¶s rate of return that considers both the
interest income and any capital gain or loss.
- is bond¶s internal rate of return.
YTM of a bond ith maturity:
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ºurrent Yield
ºurrent yield is the annual interest divided
by the bond¶s current/market value.
The annual interest is Rs 60 on
the current investment of Rs 883.40.
Therefore, the current rate of return or the
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Pure Discount Bonds
A company may issue a pure
discount bond of Rs 1,000 face value for
Rs 520 today for a period of five years.
The rate of interest can be calculated as
follos:
ë ë
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ë
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ë
R
ë
Perpetual Bonds
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, also called consols, has
an indefinite life and therefore, it has no
maturity value. Perpetual bonds or
debentures are rarely found in practice.
Perpetual Bonds
Suppose that a 10 per cent Rs 1,000
bond ill pay Rs 100 annual interest into
perpetuity. What ould be its value of the
bond if the market yield or interest rate
ere 15 per cent?
The value of the bond is determined as
follos:
ë
Bond Values and ºhanges in
mnterest Rates
The value of the bond declines as the market interest rate (discount
rateÎ increases.
The value of a 10-year, 12 per cent Rs 1,000 bond for the market
interest rates ranging from 0 per cent to 30 per cent.
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Bond Maturity and mnterest Rate
Risk
The intensity of interest rate
risk ould be higher on
honds with long maturities
than honds with short @
maturities.
àà à à à à
The differential value à à à à
response to interest rates à àààà ààà
à àààà
changes beteen short and à àààà ààà à ààà à
long-term bonds ill alays
be true. Thus, to bonds of à ààà
à àà à ààà à
same quality (in terms of the à ààà à ààà ààààà
risk of defaultÎ ould have
à
different exposure to interest
rate risk.
Bond Maturity and mnterest Rate
Risk
Bond Duration
mn finance, the duration of a financial asset measures the
sensitivity of the asset's price to interest rate
movements. Duration is a measurement of ho long, in
years, it takes for the price of a bond to be repaid (i.e.
recovery of PV of cash flosÎ by its internal cash flos. mt
is an important measure for investors to consider, as
bonds ith higher durations carry more risk and have
higher price volatility than bonds ith loer durations.
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Valuation of Ordinary Shares
The valuation of ordinary or equity shares
is relatively more difficult.
± The rate of dividend on equity shares is not
knon; also, the payment of equity dividend is
discretionary.
± The earnings and dividends on equity shares are
generally expected to gro, unlike the interest on
bonds and preference dividend.
Dividend ºapitalisation
The value of an ordinary share is determined by
capitalising the future dividend stream at the
opportunity cost of capital
Single Period Valuation:
± mf the share price is expected to gro at g per cent, then
P1 = Po(1 + gÎ
± Po = (DmV1 + P1Î/(1 + keÎ
± We obtain a simple formula for the share valuation as
follos:
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Multi-period Valuation
mf the final period is n, e can rite the general
formula for share value as follos:
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Groth in Dividends
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± Normal Groth
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± Super-normal Groth
Ô$&+ & ! + & ,& &-.,#$&
! + & , &&.,#$&
Earnings ºapitalisation
Under to cases, the value of the share
can be determined by capitalising the
expected earnings:
± When the firm pays out 100 per cent dividends;
that is, it does not retain any earnings.
± When the firm¶s return on equity (ROEÎ is equal
to its opportunity cost of capital.
Equity ºapitalisation Rate
Estimation errors
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Price-Earnings (P/EÎ Ratio: Ho
Significant?
@
is calculated as the price of a
share divided by earning per share.
Some people use P/E multiplier to value
the shares of companies.
Alternatively, you could find the share
value by dividing EPS by E/P ratio, hich
is the reciprocal of P/E ratio.
Price-Earnings (P/EÎ Ratio: Ho
Significant?
The share price is also given by the
folloing formula:
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