CHAPTER 4

VALUATION OF BONDS
AND SHARES
 • Long term debt instrument.
WHAT IS A • Fixed income securities.
BOND? • Bonds are traded on exchanges, some
are traded over the counter (OTC).
• Bonds issued at par value are traded
in market price, influenced by factors
such as quality of issuer, length of
time until expiration, coupon rate etc.
 FEATURES OF A BOND
• Face Value: this is the par value of the bond.
• Interest rate: it is fixed and known to investors. Mentioned as coupon
rate. This interest is tax deductible.
• Maturity: specific time period and repaid on maturity.
• Redemption value: the value that bondholder gets on maturity. It may
be redeemed at par or premium or discount when traded before
maturity.
• Market value: Traded in stock exchange. It is not necessary that market
value will same as par or redemption value.
 Bond Values and Yields
• Total expected cash flow (discounted) is the combination
of annual interest payments and principal.
• 3 categories of bonds:
– Bonds with maturity.
– Pure discount bond.
– Perpetual bond.
 Bond with Maturity
• Bond with a fixed maturity period and specific interest rate.
• The most common type.
• Calculation will be the discounted cash flows, which include
annual interest payments and terminal or maturity value.
• Firstly, from the investor point of view we will calculate the Bond
value (PV) given the required rate of return and bond coupon
rate.
Bond with • Secondly, we will compare the
Maturity present value with the bond’s
market value, to make sound
(Cont.) investment decision.

• From investors point of view.

• If Overvalued - ?
• If Undervalued - ?
 Calculation
••  
Bond value = Present value of annual interest + Present value of maturity
value/terminal value

• B0 = +

• Example: Suppose an investor is considering the purchase of a five

year, 1000 par value bond, bearing a nominal rate of interest of 7%
per annum. The investor’s required rate of return is 8%. What
should he be willing to pay now to purchase the bond if it matures
at par?
 Yield-to-Maturity
••  
If we know the present value and cash flows of a bond, we can find the rate of
return.
• This required rate of return is the YTM.
• YTM is the measure of a bond’s rate of return that consider both the interest
income and any capital gain or loss.
• The calculation we do for YTM is trial and error basis.

• B0 = +
 Example
••  
Suppose market price of a bond is 950 (present value). Face value being
1000, bond will pay interest at 6% per annum for 5 years. What is the bond’s
YTM?

• We will use the trial and error basis.

• 950 = + + ++
 Yield-to-Call
• Bond can be redeemed or called before maturity if bought with call
provision.
• Concern is to find out the required rate of return for the bond if redeemed
before maturity.
• Therefore, the calculation is same as YTM, only difference is the time period.
• Example: Bond par value is 1000, 10 year tenure, 10% coupon rate, and
callable in 5 years at a call price of 1050. Current price/market price/PV of the
bond is 950. What is bond’s yield-to-call?
 Calculation
•  
• 950 = + + + +

• Same trial and error method. (if answer is lower than PV, decrease
the rate vice versa)

• Now, if the bond is redeemed at 1050 on maturity?

• Or, if the bond is redeemed at face value on maturity?
 Bond and Amortization of Principal
• Here, the bond value is amortized every year.
• Meaning, each year cash outflow will be uneven and includes
both the interest and partial repayment of principal.
• Each year principal will decline and next year’s interest will be
calculated based on the reduced principal.
Example • The government is proposing
to sell a 5 year bond of BDT
1000 at 8% coupon rate. The
bond amount will be
amortized equally over its life.
If the minimum required rate
of return is 7%, what is the
bond’s current value?
 •  
• B0= + + + +
Calculation
= 261.80 + 230.47 + 202.37 + 177.02 +
154.00

= BDT 1025.66
 Bond values and semi-annual interest
Payment
••  
Changes will be made on the time period (n), Interest amount and required
interest rate (k).
• B0 = +

• Example: A 10 year bond of BDT 1000 has an annual rate of interest of 12%.
The interest is paid half-yearly. What is the value of the bond if the required
rate of return is 16%?
 Pure Discount Bonds
• Pure discount bond also know as deep-discount bond or zero-interest
bond or zero-coupon bond.
• They do not carry an explicit rate of interest rather purchased at
current price of the bond to get the par value after maturity.
• Thus, the difference between the price is the return from investment.

• Example: company issued a pure discount bond of BDT 1000 face

value for BDT 520 today for a period of 5 years. What will be the rate
of interest?
 Perpetual Bonds
••  From the name we can understand it is for infinite time period, therefore, no
maturity value.
• Value of the bond will be the discounted value of the infinite steam of interest flows.

• Example: 10% bond BDT 1000 bond will pay 100 annual interest into perpetuity.
What would be the value of bond if the interest rate/ market yield/ required rate is
15%?
• B0 = = 100/0.15 = BDT 667

• Bond value will decrease with increasing RRR and vice versa.
 Some Relationships
• Bond value decreases if market int. rate/ RRR increases and vice versa.
• Bond value decreases if maturity period increases and vice versa.
• These relationships have consequences over the market price of the bond. For
example, if the market int. rate goes up (bond coupon rate is unchanged), the
current price of bond will decrease and vice versa. The risk coming from interest
rate fluctuation is called the interest rate risk (bond investors are exposed to
this risk)
• The bond is more sensitive to interest rate risk, if the maturity is longer and vice
versa.
END of part one, BOND
 • Shareholders contribution is called the share

Basic capital of firm.

• Two types: A) Ordinary shares B) preference
Concepts of shares.
Shares • Redeemable preference shares have maturity
and irredeemable ones do not have maturity.
• Preference shares can be issued with
cumulative features. In Cumulative preference
shares unpaid dividends accumulated and are
payable in the future.
 Features of Preference and Ordinary Shares
• Claims: – Dividends on both are not tax
– Over company income and deductible.

Preference shares
assets. • Redemption
– Residual claim. – Redeemable – has maturity
– Legal/Voting rights. (bought back by the company)
• Dividend – Irredeemable – perpetual.
– Fixed dividend rate. • Conversation
Preference shares

– Cumulative rights. – Convertible preference shares

– after certain period
converted into ordinary shares.
 •• Suppose
  an investor is considering the purchase of a 12
Valuation of year, 10%, BDT 100 par value preference share. The
redemption value of the preference share on maturity is
preference BDT 120. The investor’s required rate of return is 10.5%.
shares What should she be willing to pay for the share now?

P0 = PDIV * [] +

• Here, PDIV = preference dividend per share in period

• k = required rate of return
• Pn = Maturity amount
 •  
• P0= 10 * [] +
Solution
• = 10 * 6.506 + 120 * 0.302
• = 101.30
 ••  
Example: company has issued BDT 100
Valuing irredeemable preference shares on which it
pays a dividend of BDT 9. Assume that this
Irredeemable type of preference share is currently yielding
Preference a dividend of 11%. What is the value of the

Share preference share?

• P0 =

• P0 = = BDT 81.82
 ••  
Here we will calculate the yield/rate of the
Yield on irredeemable preference shares.
Irredeemable • It is the same formula.

Preference
• P0 =
Share
• 81.82 = = 11%
 ••  
Suppose an investor is considering the purchase
YTM on of a 12 year, 10%, BDT 100 par value preference
Redeemable share. The redemption value of the preference
share on maturity is BDT 120. Investor be willing
preference to pay BDT 101.30 for the share now. The
shares investor’s required rate of return is?

P0 = PDIV * [] +

• Here, PDIV = preference dividend per share in period

• k = required rate of return
• Pn = Maturity amount
 •  
• P0 = PDIV * [] +
Calculation
• 101.30 = 10 *[ ] +

• Can be found by trial and error method. It is the

same process we used while calculating the YTM for
Bonds.
Valuation of • Valuation of ordinary or equity

Ordinary shares is relatively more difficult.

Because –
Shares – Payment is discretionary, on
boards discretion (estimates of
the timing of cash flow).
– The earning and dividends on
equity shares are expected to
grow (earning not fixed like
bonds).
 Dividend Capitalization
• Dividend capitalization model is a valid share valuation model.

• SINGLE PERIOD VALUATION:

If we assume that investor will buy and hold the share for one year;
expects a dividend of BDT 2 next year and to sell the share at BDT
21. The opportunity cost of capital is 15%. How much would he be
paying for this share?
Calculation
•  
• P0 =

• Here, P0 is the price the investor willing to pay today.

• DIV = expected dividend of that year.
• P1 = Expected selling price of share.
• K = required rate of return.
Calculation
•  
• P0 =

P0 = BDT 20

• Multi-period Valuation
Growth in • In practice dividend can rise, fall,
Dividends remain constant, or fluctuate
randomly.

• Four growth consideration:

– Normal growth
– Perpetual growth
– Super normal growth
– Zero growth
 • ROE = how efficient a company is in generating
profit.
Normal • Growth in dividend = Retention ratio * Return on
Growth Equity (g = b * ROE)
• It is noted that the growth in dividend will be
more if the firm retains higher portion of earnings.
However, the current dividend will be reduced.
• If the dividends grow at a constant rate to infinity,
and firm pays dividend DIV0 at this year. Then the
next year dividend would be DIV1.
 Multi-period •  
• DIV0 = Current year’s dividend
valuation with • DIV1 = DIV0 (1+g)1; for next year
normal growth • DIV2= DIV0 (1+g)2 ; for second year
• Thus, when dividend grow constantly,
the share valuation formula would be:

• P0 = +
 ••  
From the previous formula, we can get the
Perpetual value of share if a time period is given.
• With the perpetual growth model / Gordon
Growth growth model, we can determine the value
Model /GGM of share based on perpetuity concept.
• Formula:

• P0
• here, DIV1 = Dividend after a year,
capitalization rate = K, and g = growth rate.
 • Some assumptions we hold while considering
Assumptions GGM to calculate the price of share:
of GGM – K>G
– Initial dividend per share must be grater than
zero. Otherwise, initial price will be zero.
– Relationship between K and G is assumed to
remain constant and perpetual.

Formula:
EPS = Book value per share * ROE
Example • A company has a book value
per share of BDT 137.80. Its
return on equity is 15% and
follows a policy of retaining
60% of its earning. If the
opportunity cost of capital
were 18%, what would be the
price of the share today?
 • If the growth pattern is in two stages (super normal
growth rate and normal growth rate), we will use
this method of calculation.
Super • Company life cycle concept.
Normal
Growth • Example: A company earned BDT 6 per share and
paid BDT 3.48 per share as dividend in the previous
year. Its earning and dividend are expected to grow
at 15% for six years and then at a rate of 8%
indefinitely. The capitalization rate is 18%. What is
the price of the share today?
 •  
• P0 =

Calculation • P0= + + + + +

• P0 = Y
 •  
• P6
• = = ?
Calculation
• PV (P6) =

So, value of the share today P = Y + Z

0
 ••  
When there is not growth in dividend, we consider
that to be zero growth situation.
• Formula would be the same:

Zero • P0
Growth
• Example: If the dividend per share paid BDT 3.48
with zero/no growth and capitalization rate is 18%,
what is the price of share today?
END of the Chapter