Valuation of Bonds and

Shares

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© Tata McGraw-Hill Publishing Company Limited, Financial Management 4-1
VALUATION OF BONDS AND SHARES

Basic Valuation Model

Valuation of Bonds/Debentures

Valuation of Preference Shares

Valuation of Ordinary Shares

Other Approaches to Valuation of Shares

Relationship Among Decisions, Return,

Risk and Share Values

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 Types of Bonds

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Features of Bonds and Debt

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Features of Bonds and Debt

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VALUATION OF BONDS/DEBENTURES
A bond/debenture is a long-term debt instrument used by the
government/government agency (ies) and business enterprises to raise a large
sum of money. Most bonds, particularly corporate bonds (i) pay interest half-
yearly (semi-annually) at a stated coupon interest rate, (ii) have an initial
maturity of 10-years and (iii) have a par/face value of Rs 1,000 that must be
repaid at maturity.

To illustrate, a firm has issued a 10 per cent coupon interest rate, 10-year bond
with a Rs 1,000 par value that pays interest semi-annually. A bondholder would
have the contractual right to (1) Rs 100 annual interest (0.10, coupon rate
interest × Rs 1,000, par value) paid as Rs 50 (½ × Rs 100) at the end of every 6
months and (2) Rs 1,000 par value at the end of the 10th year.

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 (1) Basic Bond Valuation

The value of a bond is the present value of the contractual payments its issuer
(corporate) is obliged to make from the beginning till maturity. The appropriate
discount rate would be the required return commensurate with risk and the
prevailing interest rate. Symbolically,
n 1   1 
B  I    M   n 
(3)
 t 1 1  k d    1  k d  
t

 
 I  PVIFA k n  M  PVIFk n
d
 d
 (3  A)

where
B = value of the bond at t = 0
I = annual interest paid
n = number of years to maturity (term of the bond)
M = par/maturity value
kd = required return on the bond

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Example 2 For the data given above and assuming interest is paid annually,
compute the value of the bond.
Solution
B0 = [Rs 100 × (PVIFA10,10) + Rs 1,000 (PVIF10,10)]
= (Rs 100 × 6.145) + (Rs 1,000 × 0.386)
= Rs 614.5 + Rs 386 = Rs 1,000
The bond value is equal to the par value. As a general proposition, when the
required return is equal to the coupon rate, the bond value equals the par value. We
discuss below the impact of two factors on bond values, namely,
(1) Required return and
(2) Time to maturity.
Impact of Required Return on Bond Values
When the requried return on a bond differs from its coupon rate, the value of a bond
would differ from its par/face value. The reason for the differences in the required
return and the coupon interest rate may be (i) change in the basic cost of long-term
funds or (ii) change in the basic risk of the firm. When the required return (RR) is
more than the coupon rate of interest (CR), the bond value would be less than its
par value, that is, the bond would sell at a discount equal to (M – B). Conversely, in
case the RR is less than CR, the bond value would be more than the par value, that
is, the bond would sell at a premium equal to (B – M). Consider Example 3.

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Example 3
Assuming for the facts in Example 2 the required return is (i) 12 per cent and
(ii) 8 per cent, find the value of the bond.
Solution
(i) B = [Rs 100 × (PVIFA12,10) + Rs 1,000 × (PVIF12,10)]
= [(Rs 100 × 5.650) + (Rs 1,000 × 0.322)
= Rs 565 + Rs 322 = Rs 887
The bond would sell at a discount of Rs 113 (Rs 887 – Rs 1,000)
(ii) B = [Rs 100 × (PVIFA8,10) + Rs 1,000 × (PVIF8,10)]
= [(Rs 100 × 6.710) + (Rs 1,000 × 463)
= Rs 671 + Rs 463 = Rs 1,134
The bond would sell at a premium of Rs 134 (Rs 1,134 – Rs 1,000).

Impact of Maturity on Bond Value

When the required return (RR) is different from the coupon rate of interest (CR),
the time to maturity would affect value of bonds even though the RR remains
constant till maturity. The relationship among (i) time to maturity, (ii) the RR
and (iii) the bond value are related to (a) constant RR and (b) changing RR.

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Constant Required Returns
In such a situation the value of the bond would approach its par value as the
passage of time moves the value of the bond closer to maturity.
Changing Required Returns
The shorter the time period until a bond’s maturity, the less responsive is its
market value to a given change in the required return. In other words, short
maturities have less “interest rate risk” than do long maturities when all other
features, namely, CR, par value and frequency of interest payment, are the
same.
To illustrate, the results relating to the bonds values for various required
returns of the computations in Examples 2 and 3 are summarised in Table 1 and
graphically depicted in Figure 1.

Table 1: Bond Values for Various Required Returns

Required returns (kd) Bond value (B) Status
12 Rs 887 Discount
10 1,000 At Par
8 1,134 Premium

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 1400

1300
Market Value of Bond, B0 (Rs)

1200
1134
Premium 1100

Par 1000

Discount 900
887
800

700

0 2 4 6 8 10 12 14 16

Required Return, kd (%)

Figure 1: Bond Values and Required Returns

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 Valuation of Ordinary Shares
The ordinary/equity shareholders buy/hold shares in expectation of periodic
cash dividends and an increasing share value. They would buy a share when
it is undervalued (i.e. its true value is more than its market price) and sell it
when its market price is more than its true value (i.e. it is overvalued). The
value of a share is equal to the present value of all future dividends it is
expected to provide over an infinite time horizon. symbolically,

D D
P 1  2  ...  D Equation 8

1 k e
1
 1 k e
2
 
1 k e


whereP  value of shares
D  per share dividend expected at the end of year, t
t
K e  required return on share
We illustrate below the computation of value of shares with reference to
(i) zero growth, (ii) constant growth and (iii) variable growth.
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 (i) Zero Growth Model
Zero growth model is an approach to dividend valuation that assumes a
constant, non-growing dividend stream.

1 1 D1
 

P  D1    D PVIFA  D   ( 9)
t 1 1  k 
t 1 ke, 1
e
ke ke
whereD 1  constant dividend per share
K e  required return of investors

Example 6 The per share dividend of Premier Instruments Ltd (PIL) remains
constant indefinitely at Rs 10. Assuming a required rate of return of 16 per
cent, compute the value of the PIL’s shares.
Solution D1 Rs 10
P   Rs 62.5
ke 0.16

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 (ii) Constant Growth
Model/Gordon Model
Constant growth model assumes that dividend will grow at a
constant rate that is less than the required rate.
Gordon Model is the common name for the constant growth modal
widely cited in dividend valuation
Required rate/return is a specified return required by investors for a
given level of risk.

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Example

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 (iii) Variable Growth Model
Variable growth model is a dividend valuation approach that allows
for a change in the dividend growth rate.
Assuming g1 = initial growth rate and g2 = the subsequent growth
rate occurs at the end of year N, the value of the shares can be
determined as follows:
Step 1: Compute the value of cash dividends at the end of each year (Dt)
during the initial growth period (years 1 – N). Symbolically,
Dt = D0 × (1 + g1)t = D0 × PVIFg1, t

Step 2: Compute the present value of the dividends expected during the
initial growth period. Symbolically,
D 0  1  g 
t
N N
Dt N

 1  k     D t  PVIFk e , t 
t 1 e
t
t 1 1  k e 
t
t 1

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 Liquidation Value
Liquidation value per share is the actual amount per share if all assets are
sold, liabilities including preference shares paid and any remaining money is
divided among the ordinary shareholders.
 Value realised from   Amount to be paid to all creditors
 liquidating all assets  and preference shareholders 
LVPS 
Number of oustanding shares

If the total assets of Alert Ltd can be liquidated for Rs 52.5 crore, its LVPS =
(Rs 52.5 crore – Rs 45 crore) ÷ 10,00,000 = Rs 75. The minimum value of the
firm would be Rs 75 per share. The LVPS is a more realistic measure than
book value. But it ignores the earnings power of the assets of the firm.
Moreover, it is difficult to estimate the liquidation value of a going concern.
For these reasons, the LVPS is also not a true proxy of the true investment
value.

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