Valuation of Bonds & Shares

BOND A Bond is a type of debt or long term promissory note, issued by the borrower,
promising to pay its holder a predetermined and fixed amount of interest per year.
Some other Instruments with almost similar features but with different names : 1. Debentures 2. Subordinated Debentures 3. Mortgage Bonds 4. Eurobonds 5. Zero and very low coupon Bond 6. Junk Bond.

Issuers of Bonds 1. Central Government 2. State Government 3. Municipalities 4. PSUs 5. Private Sector Companies

Terminology
Par Value The Value Stated on the face of Bond is called as Face Value. Coupon Rate Bond carries a specific interest rate which is called the coupon rate. Maturity Period The maturity of a bond indicates the length of time until the bond issuer returns the par value to the bond holder and terminates or redeems the bond. Current Yield The current yield on a bond refers to the ratio of the annual interest payment to the current market price . Bonds with Call Option The bonds issued by some companies give the right to the company to redeem entire/part of the bond issue prior to maturity are called as callable bond or bond with call option. Yield to Maturity This is the rate of return that investors earn if they buy the bond at a specific price and hold it until maturity. Yield to Call This is the rate of return that investors earn if they buy the bond with a call option at a specific price and hold it till the company exercises its call option.

Types of Risks associated with Bonds Interest Rate Risk

The interest rate in market changes over time, and an increase in interest rate leads to a decline in the value of outstanding bonds. This risk of a decline in bond values due to rising interest rate is called Interest Rate Risk.

Reinvestment Rate Risk

As Interest rate in market changes over time, any decrease in interest rate may cause a company to exercise its call option for the bonds issued with call option. The bond holders will have to replace his high income bonds with low income bonds. This risk of fall in income due to fall in market interest is called as Reinvestment Rate Risk.

Default Risk
This risk occur when issuer of bonds default either in payment of Interest or Principal amount.

Types of Bonds & their Valuation 1. Bonds with Maturity. 2. 3. Pure Discount/Zero Coupon/Zero Interest Bonds. Perpetual Bond.

Bond Valuation with Semiannual Interest Computation of Yield to Maturity Computation of Yield to Call

Bond Valuation : Five important relationship 1. The value of a bond is inversely related to changes in the investors present required rate of return (the current interest rate). The market value of a bond will be less than the par value if the investors required rate is above the coupon interest rate; but it will be valued above par value if the investors required rate of return is below the coupon interest rate. As the maturity date approaches, the market value of a bond approaches its par value. Long term bonds have greater interest rate risk than do short term bonds. The sensitivity of a bonds value to changing interest rates depends not only on the length of time to maturity, but also on the pattern of cash flows provided by the bond.

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3. 4. 5.

Concept of Duration
Duration of a Bond is simply a measure of the responsiveness of its price to a change in interest rates. The greater the relative percentage change in a bond price in response to a given percentage change in the interest rate ,the longer the duration.
In assessing a bonds sensitivity to changing interest rates ,the bonds duration is one more appropriate measure.

Valuation of Shares
Valuation of Preference Shares
1.Perpetual Preference Shares The valuation model is same as the one followed while valuing Perpetual Bond with only change of Dividend replacing Interest. 2.Redeemable Preference Shares The valuation model is same as the one followed while valuing Bond with maturity with only change of Dividend replacing Interest.

Valuation of Equity Shares

Equity share valuation is comparatively a difficult task because of following reasons 1. Rate of dividend is not known and certain. Dividend payment is discretionary. Therefore the forecast of cash flows is not certain and difficult to make. 2. Earnings & Dividends on equity shares are expected to grow.

Valuation Models for Equity Share Valuation

Dividend Discount Model Under this model ,the price paid for shares today will be the present value of dividend stream receivable in Future and any amount which will be realised after sale of shares. SINGLE PERIOD VALUATION ASSUMPTIONS Dividends are paid annually. The first dividend will be received one year after the equity share is purchased. The share is held only for one year. Valuation Model for Single Period Valuation

MULTI PERIOD VALUATION With no fixed ,pre determined maturity period ,dividend stream may be of infinite duration. In this case P0 will be computed differently. Valuation Model for Multi Period Valuation This Equation may go on for a long period. This period or time horizon n could be very large. Infact ,It can be assumed to approach to (infinity). If time horizon ,n approaches to infinity ,then the PV of future price of share will approach to Zero. Hence if n = ,PV of price of share = 0. Dividend Growth Models 1.Zero Growth Model 2.Constant Growth Model 3.Two stage Growth Model Q A company earned Rs 6 per share and paid Rs 3.48 per share as dividend in the previous year. Its earnings and dividends are expected to grow at 15% for 6 years and then at a rate of 8% indefinitely. The discount rate is 18%.What is the price of the share today?