Valuation of Shares and Bonds (1)

8/2/2019 Valuation of Shares and Bonds (1)

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Financial Management for Policy

Makers

Valuation of Bonds and Shares


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Valuation

Involves determining the theoretical value of an

asset.

Using the fundamental analysis principles; the

intrinsic value of an asset is determined as the

present value of all the cash flows expected

from the asset


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Bond valuation

Bond A debt instrument issued by thegovernment (treasury bond) or a corporate

body (corporate bond)


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Features of the Bonds

1. Have a face value (par value) (registered value)

2. Have a coupon rate of interest that is fixed

3. Have a maturity period otherwise it will be a

perpetual bond4. Payment of interest is an obligation to the issuer

5. Bond may be trading in the secondary market atpar, at a premium or at a discount

6. Within the term of the bond, the issuer pays thecoupon interest to the investor. Principle isrefunded at the end of the maturity period


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Valuation of bonds


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Valuation of Bonds

Determine the value of a bond with the followingcharacteristics;

Par value Sh. 100Coupon rate of interest 8% per annum

Maturity 3 years

Interest is paid on annual basis and the expectedrate of return is 10%


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Valuation of bonds



Maturity 3 years

Interest is paid on semi-annual basis and theexpected rate of return is 16%


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Valuation of Bonds



Maturity 8 years



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Valuation of Bonds



No Maturity It is a perpetual bond



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Valuation of ordinary shares

Share A unit of capital

Has voting rights

Earns dividends

Payment of dividends = not an obligation to thefirm

Grows with profitability

Holders are residual claimants

Market value is determined by the market forces


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One-period example

Suppose you are thinking of purchasing the ashare of Sameer Africa and you expect it to pay aSh. 2 dividend in one year and you believe thatyou can sell the stock for Sh. 14 at that time.

If you require a return of 20% on investments ofthis risk, what is the maximum you would bewilling to pay?

Compute the PV of the expected cash flows

Price = (14 + 2) / (1.2) = 13.33


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Two-Periods

Now what if you decide to hold the stock for two

years? In addition to the dividend in one year,

you expect a dividend of Sh.2.10 in and a

stock price of Sh. 14.70 at the end of year 2.

Now how much would you be willing to pay?

PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33


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Three periods

What if you decide to hold the stock for three periods?

In addition to the dividends at the end of years 1 and

2, you expect to receive a dividend of Sh. 2.205 atthe end of year 3 and a stock price of Sh. 15.435.

Now how much would you be willing to pay? PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3

= 13.33


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Developing the Model

You could continue to push back when you

would sell the stock; You would find that the

price of the stock is really just the present

value of all expected future dividends

So, how can we estimate all future dividend

payments?


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Estimating Dividends Special Cases

Constant dividend

The firm will pay a constant dividend forever

This is like preferred stock

The price is computed using the perpetuity formula Constant dividend growth

The firm will increase the dividend by a constantpercent every period

Supernormal growth Dividend growth is not consistent initially, but settles

down to constant growth eventually


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Zero growth

If dividends are expected at regular intervalsforever, then this is like preferred stock and isvalued as a perpetuity

P0 = D / R Suppose stock is expected to pay a Sh. 0.50

dividend every quarter and the requiredreturn is 10% with quarterly compounding.

What is the price?

P0 = .50 / (.1 / 4) = 20


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Dividend Growth Model

g-R

D

g-R

g)1(DP 100


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Illustration

Suppose a company just paid a dividend of

Sh.50. It is expected to increase its dividend by

2% per year. If the market requires a return of

15% on assets of this risk, how much shouldthe stock be selling for?

P0 = .50(1+.02) / (.15 - .02) = 3.92


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Illustration

Suppose a company is expected to pay a $2

dividend in one year. If the dividend is

expected to grow at 5% per year and the

required return is 20%, what is the price?

P0 = 2 / (.2 - .05) = 13.33

Why isnt the 2 in the numerator multiplied by

(1.05) in this example?


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Illustration

A Company is expected to pay a dividend of

Sh. 4 next period and dividends are expected

to grow at 6% per year. The required return is

16%.

What is the current price?

What will be the price if the investor holds the

share for six years?


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Illustration

Suppose a firm is expected to increase

dividends by 20% in one year and by 15% in

two years. After that dividends will increase at

a rate of 5% per year indefinitely. If the lastdividend was Sh. 1 and the required return is

20%, what is the price of the stock?

Documents

Valuation of Shares and Bonds (1)