Valuation of bonds and shares - MBA Online Presentation

Valuation of bonds and shares

1. Financial Management Valuation of Bonds and Stocks

2. Valuation of Bonds and Stocks

3. Recall Financial Assets… What are financial assets? Intangible assets like equity shares, preference shares, bonds, debentures, derivatives etc. 10-year bond issued by Government of India @7%, 7-year debenture issued by Reliance Industries @8% Equity shares issued by NIIT through an initial public offering

4. The (market) value of any financial asset is simply the present value of its expected cash flows So How To Value Any Financial Asset?

5. Bonds Government Businesses Individuals Businesses Gives money to Govt. to buy Bonds Gets yearly Interest, gets Principal after Bond expires

6. A security that obligates the issuer to make specified interest and principal payments to the holder on specified dates Bonds are sometimes called Fixed Income Securities A Bond is

7. Government – state as well as central governments Corporate For example, Government of India issues 8% savings bond with Rs 1000 minimum investment amount and 8 years duration Sovereign Gold Bonds issued at 2.75% with 8 years duration and minimum investment amount of 1 gram of gold Who Issues Bonds

8. Face Value : Value stated on the bond. Also known as the face amount/par value. It represents the amount the firm borrows and promises to pay at maturity Coupon interest rate : Stated interest rate. Multiply by par value to get interest in rupee terms Maturity : time to return the principal Issue date : Date when bond was issued Default risk : Risk that the issuer will not make the interest or principal payment Bond Terminology

9. So how do we find the value of a bond? We calculate the Present value of its future expected cash flows! Bond sample

10. The price of the bond can be written as Bond value= Present value of interest + Present value of maturity value Where P = price of the bond C = coupon payment(interest payment) k d = required rate of return of bond M = Principal repayment (Maturity Value) N = payment period Bond Valuation

11. Assume a company ’ s bonds have a Rs.1,000 face value The promised annual coupon is 10% The bonds mature in 10 years The market ’ s required return on similar bonds is 10% What is the value of the bond? Bond Value

12. 1. Calculate the present value of the face value(maturity value) = Rs.1,000 x [1/1.10 10 ] = Rs.1,000 x 0.3855 = Rs.385.50   2. Calculate the present value of the coupon payments = Rs.100 x (1+0.10) 10 -1 = Rs.100 x 6.1446 0.10 ( (1+0.10) 10 = Rs. 614.46  3. The value of each bond = Rs. 1,000 (approx.) Bond Value

13. A Government bond is issued at a face value of Rs 1000. The bond promises to pay a coupon of 12% at the end of 5 years along with the face value. What is the price of the bond if the rate of return on the bond is 8%? Ans- Rs 1159.71 Practice question:-

14. Zero Coupon Bonds or deep-discount bonds. Interest paid at the end of the bond period Value of a pure discount bond= PV of the amount on maturity For example, the IDBI bond with a face value of Rs 500000 with a maturity of 30 years. Suppose the current market yield on similar bonds is 9%. The value of the IDBI pure-discount bond today is :- B o = 500000/(1.09) 30 = Rs 37685.57 Regular Coupon Bonds Interest paid on a regular basis The Two Types of Bonds

15. Let’s go back to our previous example Assume a company’s bonds have a Rs.1,000 face value The promised annual coupon is Rs.100 The bonds mature in 10 years The market’s required return on similar bonds is 10% We know the value of the bond is Rs 1000. What is the current value of the bond if the expected return on the bond is 11%? What is the current value of the bond if the expected return on the bond is 9%? Bond Value

16. We see that when the bond return goes up, the price goes down and when the return goes down, the price goes up. Thus the Bond Price follows an inverse relation with Bond Expected Return. Bond Value 10% Coupon Bond Rate of Return Price 9% 1064 10% 1000 11% 941

17. Bond prices are inversely related to interest rates (or yields) A bond sells at par only if its coupon rate equals the required return A bond sells at a premium if its coupon is above the required return A bond sells at a discount if its coupon is below the required return Price vs Bond Returns

18. Let’s look at another case now What happens to the price of the bond as we move closer to the maturity period? We see that the Price of the bond gets closer to par value of Rs 1000 as we move closer to our maturity date This happens irrespective of the expected rate of return Bond Value 10% Coupon Bond Rate of Return Price (time to maturity 10 yrs) Price (time to maturity 5 yrs) Price (time to maturity 1 yr) Price (time to maturity 0 yr) 9% 1064 10% 1000 11% 941

19. In actual life, most bonds pay interest semi-annually. A 8 year, 12% coupon bond with a par value of Rs 100. If the required return on the bond is 14%, what is the value of the bond if the interest is paid semi-annually. Ans= Rs 90.54 Now solve this!

20. Valuation of Preference Stock is much the same as valuation of a Bond Value of the stock is given as Consider an 8 year 10% preference stock with a par value of Rs 1000. The required return on the stock is 9% The annual dividend expected from the stock, D = Rs 100 Maturity value = Rs 1000 Valuation of Preference Stock

21. Similar to Bonds and Preference Stock, price of Equity would be present value of all the future expected dividends Since Equity stock has no end date, the dividends may go on forever The price of the equity would then be given as: P is the price of equity D is the annual dividend per share offered by the company k e is the required rate of return of Equity Valuation of Equity

22. Now to find out the price of a stock in this situation, the following cases arise: The dividend per share remains constant forever (zero growth model) The dividend per share grows at a constant rate per year forever (constant growth model) The dividend per share grows at an extraordinary rate for a few years , followed by a constant normal rate of growth forever thereafter (two-stage model) Valuation of Equity

23. Let’s look at them one by one Zero Growth Model Since D 1 is constant, we get This is a perpetuity, hence the stock price becomes Ex: Prestige’s equity share is expected to provide a dividend of Rs 2.00 a year hence. What price would it sell now if the investors’ required rate of return is 10 %? Rs 20 Valuation of Equity

24. Constant Growth Model/Gordon Model Here, the dividend per share grows at a constant growth rate of g percent per year (very popular) This is the case of a growing perpetuity, the stock price becomes For eg - Ramesh Engg Ltd is expected to grow at the rate of 6% pa. The dividend expected on Ramesh’s equity share a year hence is Rs 2.00. If you require a return of 14%, what price will you be willing to pay for this stock? Ans- Rs 25.00 Valuation of Equity

25. Two Stage Growth Model Here, the company is expected to grow at an extraordinary growth rate for a few years and then at a normal growth rate hence forth, We follow the basic PV principles to find out the stock price. Let’s look with an example, The current dividend on an equity share of Vertigo Ltd is Rs 2.00. Vertigo is expected to enjoy above normal growth rate of 20% for a period of 3 years. Thereafter the growth rate will fall and stabilize at 10% for two year. Investors expect a return of 15%. What is the value of the equity share? Ans- Rs 56.38

26. Here, g 1 = 20% g 2 = 10% n = 5 years r = 15 % D 1 = D (1+g) = 2*1.2 = Rs 2.4 Let’s look at this on a timeline

27. Calculate PV of these cash flows. Calculate terminal value = dividend of 5 th year*(1.1)/r-g Then calculate PV of terminal value. Add both of them. 1 2 2*1.2 2*1.2 2 2*1.2 3 2*1.2 3 *1.10 3 4 5 2*1.2 3 *1.10 2 2

28. Vardhman Ltd’s earnings and dividends have been growing at a rate of 18% per annum. This growth rate is expected to continue for 4 years. After that the growth rate is expected to be 6% forever. If the last dividend per share was Rs 2.00 and investor’s required rate of return on Vardhman’s equity is 15%, what is the intrinsic value per share? Ans: Rs 34.57 Practice Question