VALUATION OF BONDS AND STOCKS

PROF S N RAO 1
WHAT IS A BOND?
A long-term debt instrument in which a borrower agrees to make
payments of principal and interest, on specific dates, to the
holders of the bond.
KEY FEATURES OF A BOND
Par value – face amount of the bond, which
is paid at maturity (assume Rs.1,000).
Coupon interest rate – stated interest rate (generally fixed)
paid by the issuer. Multiply by par value to get rupee
payment of interest.
Maturity date – years until the bond must be repaid.
Issue date – when the bond was issued.
Yield to maturity - rate of return earned on
a bond held until maturity (also called the “promised yield”).
BOND VALUATION
Fundamental Principle of Valuation:
Value of a bond or any financial asset is equal to the present value of the cash flows
expected from it

PROF S N RAO 4
THE VALUE OF FINANCIAL ASSETS

0 1 2 n
r% ...
Value CF1 CF2 CFn

CF1 CF2 CFn

Value  1
 2
 ... 
(1  r) (1  r) (1  r)n
 BOND PRICING (VALUATION)

C M
P0 =  +
t=1 (1+r)t (1+r)n

2n C/2 M
P0 =  +
t=1 (1+r/2)t (1+r/2)2n

PROF S N RAO 6
BOND VALUE THEOREMS
When the required rate of return equals the coupon rate, the bond sells at its
par value
When the required rate of return exceeds coupon rate, the bond sells at a
discount, however the discount declines as maturity approaches
When the required rate of returns is less than coupon rate, the bond sells at
premium, however the premium declines as maturity approaches
The longer the maturity of a bond, the greater is its price change in response
to a given change in the required rate of return

PROF S N RAO 7
 PRICE - YIELD RELATIONSHIP
PRICE

YEILD

PRICE CHANGES WITH TIME

VALUE OF
BOND PREMIUM BOND: rd = 11%

A
PAR VALUE BOND: rd = 13%
B
DISCOUNT BOND: rd = 15%

8 7 6 5 4 3 2 1 0

YEARS TO MATURITY

PROF S N RAO 8
 Yield to Maturity (YTM)

SOMEONE WHO INVESTS IN A COUPON - PAYING

BOND WILL EARN THE YTM PROMISED ON THE
PURCHASE DATE IF AND ONLY IF ALL OF THE
FOLLOWING THREE CONDITIONS ARE
FULFILLED
• THE BOND IS HELD UNTIL IT MATURES RATHER
THAN BEING SOLD AT A PRICE WHICH DIFFERS
FROM ITS FACE VALUE BEFORE ITS MATURITY
• THE BOND DOES NOT DEFAULT
• ALL CASHFLOWS ARE RE-INVESTED AT AN
INTEREST RATE EQUAL TO THE PROMISED YTM

PROF S N RAO 9
EXAMPLE-1
Garnet Corporation issued a 10%,Rs.1000 FV bond with the maturity period of 6
years. Interest is paid annually. If your required rate of return is 11% at what price
you would be willing to buy the bond?

PROF S N RAO 10
EXAMPLE-2
Find the YTM of a debenture with FV of Rs.100, market price of Rs.80, term to
maturity of 5 years and coupon rate of 14% (coupon paid annually).

PROF S N RAO 11
EQUITY STOCK VALUATION
Single Period Valuation Model
Multi-period Valuation Model
 Zero growth Model
 Constant growth Model
-Two stage growth Model

P/E Approach

PROF S N RAO 12
EQUITY STOCK VALUATION
•Price-Earnings (P/E) approach
Value of stock = (P/E) * Expected EPS
•Determinants of P/E ratio
 Payout ratio or retention ratio
 Required rate of return (linked to int rate & risk)
 Expected growth
 Liquidity
 Size of the firm
 Reputation of management

PROF S N RAO 13
EQUITY STOCK VALUATION
Impact of growth on price, returns, and P/E ratio
 Higher growth rate makes capital gains as significant
component of expected returns
 Higher the growth rate, higher will be the P/E ratio
 High DY and low P/E ratio imply limited growth prospects
 Low DY and high P/E ratio imply considerable growth prospects

PROF S N RAO (SJMSOM/IITB) 14

EXAMPLE-3
A stock is quoting at Rs.50. A Financial Analyst reports that expected dividend on the
stock is Rs.5 and the price is expected to reach Rs.60 within a year. If your required
rate of return is 20% at what price would you be willing to buy the stock for one
year holding period? Is the stock over/under valued compared to your valuation?

PROF S N RAO 15
EXAMPLE-4
ABC Ltd declared DPS of Rs.0.95 for 2017-18. Stock price on
31 March 2018 was Rs.108.55.If the dividend is expected to
grow at constant rate of 10% and your required rate of
return on this stock is 18%, would you buy the stock?
What would be your decision if the dividend is expected to
grow at 15% for first five years and at 12% thereafter?
What would be the target price based on P/E ratio and
expected EPS. Current EPS is Rs.1.37

PROF S N RAO 16
RISK AND RETURN

PROF S N RAO 17
RISK AND RETURN
How to compute return for a single asset?
How to compute risk for a single asset?
Estimation of returns based on
 Historical Returns
 Relationship between risk and Return

PROF S N RAO 18
RETURN OF A SINGLE ASSET
Rate of return = capital gain/loss + dividend yield
Logarithmic returns = natural log (end price/beginning price)

PROF S N RAO 19
METHODS OF COMPUTING RETURNS
Probability distribution approach:
Expected rate of return =
Sum (rate of return X corresponding prob)

PROF S N RAO 20
METHODS OF COMPUTING RETURNS
Historical Approach
Arithmetic Mean of Logarithmic Returns

PROF S N RAO 21
MEASURE OF RISK
Risk refers to the dispersion of a variable OR deviation of value of a variable from
its expected value
Risk is commonly measured by variance or standard deviation

PROF S N RAO 22
RISK-RETURN PROFILE OF ASSETS

R
Smallcap stocks
E
Midcap stocks
T
U
R Index Stocks
N
Corp Bonds

Govt Bonds
RISK
PROF S N RAO 23
RELATIONSHIP BETWEEN RISK AND RETURN

Capital Asset Pricing Model/Security Market Line

Market Model/Characteristic Line
Bond-yield plus premium model

PROF S N RAO 24
CAPITAL ASSET PRICING MODEL
Assumptions
Individuals make investment decisions based on risk-return assessment
Stocks are infinitely divisible
Individuals can not affect prices (perfect competition)
Perfect market (no taxes, no transaction costs)
Individuals can borrow/lend any amount at risk free rate
Investors have identical expectations

PROF S N RAO 25
CAPITAL ASSET PRICING MODEL
Expected return on stock = Risk Free Return + Beta of the stock (Exp return on market
portfolio – Risk free return)

= Risk free return + risk premium for systematic risk

PROF S N RAO 26
MARKET MODEL

Expected Return= alpha + Beta (Mean Market Return)

PROF S N RAO 27
BOND-YIELD PLUS RISK PREMIUM
Expected return
= Bond yield + Risk premium

PROF S N RAO 28
CAPITAL BUDGETING

PROF S N RAO 29
 CAPITAL BUDGETING PROCESS
1.Identification of potential investment opportunities
Monitor external environment regularly
Formulate well defined corporate strategy
Share corporate strategy and perspectives with persons involved in
capital budgeting
Motivate employees to make suggestions

PROF S N RAO 30
CAPITAL BUDGETING PROCESS
2.Assembling of investment proposals
Route investment proposals of various departments through several
persons/departments to ensure that the proposal is viewed from different angles
It also helps on creating a climate for coordination of interrelated activities

PROF S N RAO 31
CAPITAL BUDGETING PROCESS
3. Decision making
Limits for approval of investment proposals at various levels in organization
 Plant superintendent
 Works manager
 Managing Director
 Board of directors

PROF S N RAO 32
CAPITAL BUDGETING PROCESS
4. Preparation of Capital Budget and Appropriation
 To ensure the availability of funds at the time of implementation of the project
 To review the project at the time of implementation

PROF S N RAO 33
CAPITAL BUDGETING PROCESS
5. Implementation
 Adequate formulation of projects
 Defining accountability
 Use of network techniques

6. Performance Review
 Comparison of actual with projections
 Provides inputs for future decision making

PROF S N RAO 34
PROJECT CLASSIFICATION
1.Mandatory investments
 Statutory investments
 Welfare investments
 Non-revenue generating investments
 Focus on most cost effectiveness

PROF S N RAO 35
PROJECT CLASSIFICATION
2.Replacement projects
 To reduce costs: labour, raw material, power
 To increase yield
 To improve quality
 Straightforward evaluation

PROF S N RAO 36
PROJECT CLASSIFICATION
3.Expansion Projects
 To increase capacity/widen distribution network
 Needs forecast of growth
 Risky and complex
 Needs detailed analysis
 Decided by top management

PROF S N RAO 37
 PROJECT CLASSIFICATION
4.Diversification projects
 To produce new products/services
 To enter new markets
 Substantial risk
 Involve large capital investment
 Require considerable managerial effort and attention
 Needs thorough evaluation of quantitative and non-quantitative aspects
 Need involvement of board of directors

PROF S N RAO 38
PROJECT CLASSIFICATION
5.R & D Projects
 Involves numerous uncertainties
 Sequential decision making
 Evaluation tools: decision tree, option analysis

PROF S N RAO 39
PROJECT CLASSIFICATION
6.Miscellaneous Projects
 Interior decoration
 Recreational facilities
 Executive aircrafts
 Landscaped gardens
 Decisions based on the personal preferences of top management

PROF S N RAO 40
INVESTMENT CRITERIA
Discounting criteria
 NPV
 IRR
 BCR

Non-discounting criteria
 Payback period
 Accounting rate of return

PROF S N RAO 41
INVESTMENT CRITERIA
1. Net Present Value (NPV)
• Sum of present values of all cash flows (both negative and positive cash flows) related to an
investment/project
• Difference between PV of CIFs and PV of COFs

Decision Rule
 If NPV > 0 accept the investment proposal
 The project earns higher than cost capital
 If NPV = 0 indifferent
 The project earns just cost of capital
 If NPV < 0 reject the investment proposal
 The project earns less than cost of capital

PROF S N RAO 42
INVESTMENT CRITERIA
Properties of NPV Method
 NPVs are additive
 Assumes that intermediate CIFs are invested at cost of capital
 Allows time varying discount rates

Limitations of NPV Method

 Does not consider scale of investment
 Does not consider project life

PROF S N RAO 43
INVESTMENT CRITERIA
2. Internal Rate of Return (IRR)
 It is the discount rate which makes NPV zero OR Which makes PV of CIFs equal to PV of COFs

Decision criteria
 If IRR > k, accept the project
 If IRR = k, indifferent
 If IRR < k, reject the project

PROF S N RAO 44
INVESTMENT CRITERIA
Properties of IRR
 Assumes that intermediate cash inflows are invested at IRR
 Considers scale of investment
Limitations of IRR
 Does not allow time varying discount rate
 Does not allow for intermediate cash outflows/investments (not suitable for evaluation of un-
conventional projects)
 Not suitable for ranking mutually exclusive projects of different scales

Despite its limitations, IRR is most popular investment evaluation technique

PROF S N RAO 45
INVESTMENT CRITERIA
3. Benefit Cost Ratio (BCR)
= (PV of Benefits/I)
= (PV of CIFs/PV of COFs)
Decision Rule with BCR:
 If BCR > 1 accept the project
 If BCR = 1 indifference
 If BCR < 1 reject the project

BCR measure NPV per rupee of outlay, it can discriminate between

large and small investments
BCR are not additive

PROF S N RAO 46
INVESTMENT CRITERIA
4. Payback Period
It is the length of time period required to recover the initial cash outlay
on the project
Decision Rule:
 Shorter the payback period, more desirable the project
 Payback period should be less than the defined payback period, for the project to be
accepted

Advantages
Simple to understand and to compute
It is rough method for dealing with risk
Suitable for firms facing liquidity problem
PROF S N RAO 47
INVESTMENT CRITERIA
Limitations
Does not consider time value of money
Ignores cash flows beyond payback period
It is a measure of project’s capital recovery, not profitability
It measures liquidity of project, it does not indicate the liquidity of firm
as a whole

PROF S N RAO 48
INVESTMENT CRITERIA
4 (a). Discounted Payback Period
It is payback period based on discounted cash flows
It is an improved version of payback period
It considers time value of money
It measures profitability and capital recovery

PROF S N RAO 49
INVESTMENT CRITERIA
5. Accounting Rate of Return (ARR)
= (Avg PAT)/(Avg BV of Investment)
Simple to calculate
Based on accounting information and not cash flow
Does not consider time value of money

PROF S N RAO 50
INVESTMENT APPRAISAL IN PRACTICE
Discounted cash flow methods are used, IRR is most popular
Multiple evaluation methods are used
ARR and Payback Period are widely used as supplementary methods
WACC is the most commonly used discount rate

PROF S N RAO 51