Valuation of Bonds and

Shares– Chapter 3
Lecture 4
(Based on IM Pandey’s book on Financial Management)

MSESPM
Prof. Amrit Nakarmi
24 Dec 2019

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Chapter Objectives
Explain the fundamental characteristics of ordinary
shares, preference shares and bonds (or debentures).
Show the use of the present value concepts in the
valuation of shares and bonds.
Learn about the linkage between the share values,
earnings and dividends and the required rate of
return on the share.
Focus on the uses and misuses of price-earnings
(P/E) ratio.

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Introduction
Assets can be real or financial; securities like shares
and bonds are called financial assets while physical
assets like plant and machinery are called real
assets.
The concepts of return and risk, as the
determinants of value, are as fundamental and
valid to the valuation of securities as to that of
physical assets.

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Concept of Value
Book Value
Replacement Value
Liquidation Value
Going Concern Value
Market Value

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Features of a Bond
Face Value
Interest Rate—fixed or floating
Maturity
Redemption value
Market Value

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Bonds Values and Yields
Bonds with maturity
Pure discount bonds
Perpetual bonds

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Bond with Maturity
Bond value = Present value of interest + Present value of
maturity value:

n
INTt Bn
B0   
t 1 (1  kd ) (1  k d ) n
t

7
Yield to Maturity
The yield-to-maturity (YTM) is the measure of a
bond’s rate of return that considers both the
interest income and any capital gain or loss. YTM is
bond’s internal rate of return.
A perpetual bond’s yield-to-maturity:

n 
INT INT
B0   
t 1 (1  kd )t kd

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Current Yield
Current yield is the annual interest divided by the
bond’s current value.
Example: The annual interest is Rs 60 on the
current investment of Rs 883.40. Therefore, the
current rate of return or the current yield is:
60/883.40 = 6.8 per cent.
Current yield does not account for the capital gain
or loss.

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Yield to Call
For calculating the yield to call, the call period would
be different from the maturity period and the call (or
redemption) value could be different from the
maturity value.
Example: Suppose the 10% 10-year Rs 1,000 bond is
redeemable (callable) in 5 years at a call price of Rs
1,050. The bond is currently selling for Rs 950.The
bond’s yield to call is 12.7%.
5
100 1,050
950   
 1  YTC   1  YTC 
t 5
t 1

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 Bond Value and Amortisation of Principal
A bond (debenture) may be amortised every year, i.e.,
repayment of principal every year rather at maturity.
The formula for determining the value of a bond or
debenture that is amortised every year, can be written
as follows:
n
CFt
B0  
t 1 (1  k d )
t

Note that cash flow, CF, includes both the interest and
repayment of the principal.

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Pure Discount Bonds
Pure discount bond do not carry an explicit rate of
interest. It provides for the payment of a lump sum
amount at a future date in exchange for the current
price of the bond. The difference between the face
value of the bond and its purchase price gives the
return or YTM to the investor.

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Pure Discount Bonds
Example: A company may issue a pure
discount bond of Rs 1,000 face value for Rs 520
today for a period of five years. The rate of
interest can be calculated as follows:

1, 000
520 
 1  YTM 
5

1, 000
 1  YTM 
5
  1.9231
520
i  1.92311/ 5  1  0.14 or 14%

13
Pure Discount Bonds
Pure discount bonds are called deep-discount
bonds or zero-interest bonds or zero-coupon
bonds.
The market interest rate, also called the market
yield, is used as the discount rate.
 Value of a pure discount bond = PV of the amount
on maturity:

Mn
B0 
 1  kd 
n

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Perpetual Bonds
Perpetual bonds, also called consols, has an
indefinite life and therefore, it has no maturity value.
Perpetual bonds or debentures are rarely found in
practice.

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Perpetual Bonds
Suppose that a 10 per cent Rs 1,000 bond will pay Rs
100 annual interest into perpetuity. What would be its
value of the bond if the market yield or interest rate
were 15 per cent?
The value of the bond is determined as follows:

INT 100
B0    Rs 667
kd 0.15

16
Bond Values and Changes in Interest
Rates
The value of the bond
declines as the market 1200.0

interest rate (discount 1000.0

rate) increases. 800.0

Bond Value
The value of a 10-year, 12 600.0

400.0
per cent Rs 1,000 bond
200.0
for the market interest
0.0
rates ranging from 0 per 0% 5% 10% 15% 20% 25% 30%
cent to 30 per cent. Interest Rate

17
Bond Maturity and Interest Rate Risk
 The intensity of interest rate
risk would be higher on
bonds with long maturities Present Value (Rs)
than bonds with short Discount rate (%) 5-Year bond 10-Year bond Perpetual bond
maturities.
5 1,216 1,386 2,000
 The differential value 10 1,000 1,000 1,000
response to interest rates 15 832 749 667
changes between short and 20 701 581 500
long-term bonds will always 25 597 464 400
be true. Thus, two bonds of 30 513 382 333
same quality (in terms of the
risk of default) would have
different exposure to interest
rate risk.

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Bond Maturity and Interest Rate Risk
2000
5-year bond
1750
10-year bond
1500 Perpetual bond
Value (Rs)

1250
1000
750
500
250
0
5 10 15 20 25 30
Discount rate (%)

19
 Bond Duration and Interest Rate
Sensitivity
The longer the maturity of a bond, the higher will
be its sensitivity to the interest rate changes.
Similarly, the price of a bond with low coupon rate
will be more sensitive to the interest rate changes.
However, the bond’s price sensitivity can be more
accurately estimated by its duration. A bond’s
duration is measured as the weighted average of
times to each cash flow (interest payment or
repayment of principal).

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Duration of Bonds
 Let us consider the 8.5 8.5 Percent Bond
per cent rate bond of Year Cash Flow
Present Value
at 10 %
Proportion of
Bond Price
Proportion of
Bond Price x Time
Rs 1,000 face value that 1
2
85
85
77.27
70.25
0.082
0.074
0.082
0.149
has a current market 3 85 63.86 0.068 0.203
4 85 58.06 0.062 0.246
value of Rs 954.74 and a 5 1,085 673.70 0.714 3.572
943.14 1.000 4.252
YTM of 10 per cent, and 11.5 Percent Bond
the 12 per cent rate Year
Cash
Flow
Present Value
at 10.2%
Proportion of
Bond Price
Proportion of Bond
Price x Time
bond of Rs 1,000 face 1
2
115
115
103.98
94.01
0.101
0.091
0.101
0.182
value has a current 3 115 85.00 0.082 0.247
4 115 76.86 0.074 0.297
market value of Rs 5 1,115 673.75 0.652 3.259
1,033.60 1.000 4.086
1,044.57 and a yield to
maturity of 10.8 per
cent. Table shows the Durati
on
calculation of duration
for the two bonds.

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Volatility
The volatility or the interest rate sensitivity of a bond
is given by its duration and YTM. A bond’s volatility,
referred to as its modified duration, is given as
follows:
Duration
Volatility of a bond 
(1  YTM)

The volatilities of the 8.5 per cent and 11.5 per cent
bonds are as follows:
4.252
Volatility of 8.5% bond   3.87
(1.100)
4.086
Volatility of 11.5% bond   3.69
(1.106)
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 The Term Structure of Interest Rates
Yield curve shows the relationship between the yields
to maturity of bonds and their maturities. It is also
called the term structure of interest rates.
Yield Curve (Government of India Bonds)
Yield (%)
7.5%
7.18%
7.0%

6.5%

6.0%
5.90%
5.5%
Maturity
5.0% (Years )
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10

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 The Term Structure of Interest Rates
The upward sloping yield curve implies that the
long-term yields are higher than the short-term
yields. This is the normal shape of the yield curve,
which is generally verified by historical evidence.
However, many economies in high-inflation
periods have witnessed the short-term yields being
higher than the long-term yields. The inverted
yield curves result when the short-term rates are
higher than the long-term rates.

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The Expectation Theory
The expectation theory supports the upward
sloping yield curve since investors always expect
the short-term rates to increase in the future.
This implies that the long-term rates will be higher
than the short-term rates.
But in the present value terms, the return from
investing in a long-term security will equal to the
return from investing in a series of a short-term
security.

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The Expectation Theory
The expectation theory assumes
 capital markets are efficient
 there are no transaction costs and
 investors’ sole purpose is to maximize their returns
The long-term rates are geometric average of current
and expected short-term rates.
A significant implication of the expectation theory is
that given their investment horizon, investors will earn
the same average expected returns on all maturity
combinations.
Hence, a firm will not be able to lower its interest cost
in the long-run by the maturity structure of its debt.

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The Liquidity Premium Theory
Long-term bonds are more sensitive than the prices
of the short-term bonds to the changes in the market
rates of interest.
Hence, investors prefer short-term bonds to the
long-term bonds.
The investors will be compensated for this risk by
offering higher returns on long-term bonds.
This extra return, which is called liquidity
premium, gives the yield curve its upward bias.

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The Liquidity Premium Theory
The liquidity premium theory means that rates on
long-term bonds will be higher than on the short-
term bonds.
From a firm’s point of view, the liquidity premium
theory suggests that as the cost of short-term debt
is less, the firm could minimize the cost of its
borrowings by continuously refinancing its short-
term debt rather taking on long-term debt.

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The Segmented Markets Theory
The segmented markets theory assumes that the
debt market is divided into several segments based
on the maturity of debt.
In each segment, the yield of debt depends on the
demand and supply.
Investors’ preferences of each segment arise
because they want to match the maturities of assets
and liabilities to reduce the susceptibility to
interest rate changes.

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The Segmented Markets Theory
The segmented markets theory approach assumes
investors do not shift from one maturity to another in
their borrowing—lending activities and therefore,
the shift in yields are caused by changes in the
demand and supply for bonds of different maturities.

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Default Risk and Credit Rating
Default risk is the risk that a company will default
on its promised obligations to bondholders.
Default premium is the spread between the
promised return on a corporate bond and the
return on a government bond with same maturity.

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Crisil’s Debenture Ratings
High Inves tme nt Gr ades
AAA (Triple A): Highest Safety Debentures rated `AAA' are judged to offer highes t s afety of
timely payment of interes t and principal. Though the
circu mstances providing this degree of s afety are like ly to
change, such changes as can be envis aged are mos t unlikely to
affect advers ely the fundamentally s trong pos ition of s uch iss ues .
AA (Double A): High Safety Debentures rated 'AA' are judged to offer high s afety of time ly
payment of interest and principal. They differ in s afety fro m
`AAA' is sues only margina lly.
Inves tment Gr ades
A: Adequate Safety Debentures rated `A' are judged to offer adequate s afety of time ly
payment of interes t and principal; however, changes in
circu mstances can advers ely affect s uch iss ues more than thos e in
the higher rated categories .
BBB (T rip le B): Moderate Safety Debentures rated `BBB' are judged to offer sufficient s afety of
timely payment of interes t and principal for the pres ent; however,
changing circumstances are more like ly to lead to a weakened
capacity to pay interest and repay principal than for debentures in
higher rated categories .
Speculati ve Gr ades
BB (Double B): Inadequate Safety Debentures rated `BB' are judged to carry inadequate s afety of
timely pay ment of interes t and principal; wh ile they are les s
s us ceptible to default than other speculative grade debentures in
the immediate future, the uncertainties that the is suer faces could
lead to inadequate capacity to ma ke timely interes t and principal
payments .
B: High Risk Debentures rated `B' are judged to have greater susceptibility to
default; while currently interes t and principal payments are met,
advers e bus iness or economic conditions would lead to lack of
ability or willingness to pay interest or principal.
C: Substantial Risk Debentures rated `C' are judged to have factors pres ent that make
them vulnerable to default; time ly payment of interes t and
principal is pos s ible only if favourable c ircu ms tances continue.
D: In De fault Debentures rated `B' are judged to have greater susceptibility to
default; while currently interes t and principal payments are met,
advers e bus iness or economic conditions would lead to lack of
ability or willingness to pay interest or principal.
Note:
1. CRISIL may apply "+" (plus) or " -" (minus) signs for ratings from AA to D to reflect comparative standing
within th e category.
2. The contents within parenth esis are a guide to the pronuncia tion of the rating symbo ls.
3. Preference share rating symbols are identical to deben ture rating symbols except that th e letters "pf" are
prefixed to the d ebenture rating symbols, e.g. pfAAA (" pf Triple A" ).

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Valuation of Shares
A company may issue two types of shares:
ordinary shares and
preference shares
Features of Preference and Ordinary Shares
Claims 
Dividend 
Redemption
Conversion 

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 Valuation of Preference Shares
The value of the preference share would be the sum
of the present values of dividends and the
redemption value.
A formula similar to the valuation of bond can be
used to value preference shares with a maturity
period: n
PDIV1 Pn
P0   
t 1 (1  k p ) (1  k p ) n
t

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 Value of a Preference Share-Example
Suppose an investor is considering the purchase of a 12-year, 10% Rs 100 par value preference share. The
redemption value of the preference share on maturity is Rs 120. The investor’s required rate of return is
10.5 percent. What should she be willing to pay for the share now? The investor would expect to receive
Rs 10 as preference dividend each year for 12 years and Rs 110 on maturity (i.e ., at the end of 12 years).
We can use the present value annuity factor to value the constant stream of preference divi dends and the
present value factor to value the redemption payment.
 1 1  120
P0  10    12 
 12
 0.105 0.105  (1.105)  (1.105)
 10  6.506  120  0.302  65.06  36.24  Rs101.30

Note that the present value of Rs 101.30 is a composite of the present value of dividends, Rs 65.06 and
the present value of the redemption value, Rs 36.24.The Rs 100 preference share is worth Rs 101.3 today
at 10.5 percent required rate of return. The investor would be better off by purchasing the share for Rs 100
today.

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 Valuation of Ordinary Shares
The valuation of ordinary or equity shares is
relatively more difficult.
The rate of dividend on equity shares is not known;
also, the payment of equity dividend is discretionary.
The earnings and dividends on equity shares are
generally expected to grow, unlike the interest on
bonds and preference dividend.

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Dividend Capitalisation
The value of an ordinary share is determined by
capitalising the future dividend stream at the
opportunity cost of capital DIV1  P1
P0 
Single Period Valuation: 1  ke
P1  P0 (1  g )
If the share price is expected to grow at g per cent,
then P1:
We obtain a simple formula for the share valuation as
follows: DIV1
P0 
ke  g
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Multi-period Valuation
If the final period is n, we can write the general formula
for share value as follows:
n
DIVt Pn
P0   
Growth in Dividends t 1 (1  ke ) (1  ke ) n
t

Growth = Retention ratio  Return on equity

Share value  PV of
Super-normal dividends during finite super-normal growth period
Growth
 PV of dividends during indefinite normal growth period
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Earnings Capitalisation
Under two cases, the value of the share can be
determined by capitalising the expected earnings:
When the firm pays out 100 per cent dividends; that
is, it does not retain any earnings.
When the firm’s return on equity (ROE) is equal to
its opportunity cost of capital.

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Equity Capitalisation Rate
For firms for which dividends are expected to grow
at a constant rate indefinitely and the current
market price is given

DIV1
ke  g
P0

40
 Caution in Using Constant-Growth
Formula

Estimation errors 
Unsustainable high current growth 
Errors in forecasting dividends 

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Valuing Growth Opportunities
The value of a growth opportunity is given as
follows:

NPV1
Vg 
ke  g
b  EPS1(ROE  ke )

ke ( k e  g )

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 Price-Earnings (P/E) Ratio: How
Significant?
P/E ratio is calculated as the price of a share divided
by earning per share.
Some people use P/E multiplier to value the shares
of companies.
Alternatively, you could find the share value by
dividing EPS by E/P ratio, which is the reciprocal of
P/E ratio.

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Price-Earnings (P/E) Ratio: How
Significant?
The share price is also given by the following
formula:
EPS1
P0   Vg
ke
The earnings price ratio can be derived as follows:

EPS1  Vg 
 ke 1  
Po  Po 

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 Price-Earnings (P/E) Ratio: How
Significant?
Cautions:
E/P ratio will be equal to the capitalisation rate only
if the value of growth opportunities is zero.
A high P/E ratio is considered good but it could be
high not because the share price is high but
because the earnings per share are quite low.
The interpretation of P/E ratio becomes
meaningless because of the measurement problems
of EPS.

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Assignments
Page 72: 1,3,5,7,11,12,14,20,21,25,27,29.
Case study:3.1

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