UNIT 10 VALUATION OF SECURITIES Structure 10.1 Objectives 10.2 Introduction 10.3 The Basic Valuation Model 10.4 Valuation of Bonds/Debentures 10.5 Valuation of Preference Shares 10.6 Valuation of Equity Shares 10.7 Valuation of Convertible Debentures 10.8 Let Us Sum Up 10.9 Key Words 10.10 Answers to Check Your Progress 10.11 Self-Assessment Questions/Exercises 10.1| OBJECTIVES After studying this unit, you should be able to: «explain the basic valuation model; * discuss the method for valuation of bonds; * understand the method for valuation of preference shares; and * comprehend the methods for valuation of equity shares and convertible debentures. 10.2. INTRODUCTION The purpose of investment is a commitment of funds for a particular period for return, The investor forgoes its present consumption, therefore, requires some return from the investment, The future value of money will change, so the return is required to compensate for the change in the value of money. It is always suggested that all investment selections are to be done on a scientific analysis of the value of a security. Therefore, to know how to value securities is always better for an investor. Investors attempt to make gains by buying under-priced securities and sell over-priced securities. And this again points out the importance of understanding the valuation of securities. In valuation process, three types of analyses are to be done. These are: 1) Economic Analysis 2) Industry analysis 3) Company Analysis 159Financing Decisions 160 Economic Analysis As all businesses are part of the economic system, thus, it is important to analyse the general economic environment for the valuation of securities in economic analysis, An analyst is required to analyse the general economic factors affecting the economy. Thus, to analyse Fiscal and Monetary policy and the economic environment it is important for any investor to predict Recession and Boom. Industry Analysis All industries are not equally affected by the change in the economic conditions. Some industries are affected more and some less. Industry analysis is a tool that businesses use to assess the market, It is also used by market analysts, as well as by business owners, to find out how the industry dynamics work for the specific industry studied. Industry analysis helps the analyst develop a strong sense of what is going on in the industry. The following problems can be addressed through Industry analysis. ‘© What are the similariti systems? and differences among industry classification ‘+ How does an analyst go about choosing a peer group of companii ‘© What are the key factors to consider when analysing an industry? * What advantages are enjoyed by companies in strategically well- positioned industries? Company Analysis Company analysis is done after the analyst has done industry analysis. It facilitates in understanding the company’s extemal environment and how the company will respond to the threats and opportunities by the external environment. Thus, the intended response is the individual company’s competitive strategy. A checklist for company analysis includes a thorough investigation of: + Company detail * Characteristics of industry ‘© Demand and supply of goods and services ‘© Financial statement analysis, ‘© Company investment policy 10.3 THE BASIC VALUATION MODEL The time value of money affects the valuation of the securities. The current value of any asset is equal to the present price of its predicted returns. Thus, the present value of expected returns to be provided by a security in a length of time will help to estimate the value of that security. This definition of valuation applies to the value of the security.To estimate the value, you must discount the stream of money flows at required rate of return. Thus, from this discussion we can understand that, the technique of estimation of value requires a) the estimated money flows or returns from that security and b) the required rate of return on the investment, ‘The required return rate is simply a return that an investor would accept as consideration for a given level of risk associated with owning the stock of a company. Financial security has the potential to generate some additional return above its face value in the future. Thus, the value of a security is the present value of the future benefits or future cash flows like interest, dividend, or earnings per period. There are various kinds of securities with, various terms and conditions. While talking about the returns, some securities have fixed returns like bonds and some have variable returns like equity. Let us assume that that risk-adjusted discount rate is ‘r’, and it is expected that the security will give cash flow for n years. In this case, the present value of the security can be determined as follow: orl, cr. cra Grn | Genz | Gens Ginn ‘Where PV = present value of security 1= risk-adjusted discount rate CF = cash flow (expected cash inflow from a particular security) But here it is to be noted that all investors may not value the same shares. equally. They may have different expectations about the returns from security. Also, the risk complexity of the securities may change with time in this dynamic environment. Illustration 1: Compute the value of assets of Company ‘A’ from the information given below: Year Cash Flow (Rs.) 1 10,000 2 10,000 3 10,000 4 10,000 Discount rate is 10%, Value of Asset = 10,000 x PVIFAjo4 = 10,000 x 3.170 = Rs. 31,700 Vata Secu on of 161Hinauciag Dexia 10.4. VALUATION OF BONDS/DEBENTURES Bonds are long-term debt instruments used by both firms and the government to raise money. The most common type of bond is the one in which investors carn periodic interest and the face value at maturity. Types of Bonds Convertible bonds: Convertible bonds can be converted into stock after a predetermined time at the predetermined ratio. Thus, the holder has an option of converting the bond into shares of a company at a predetermined price. Non-convertible bonds: Bonds that cannot be converted into shares are known as non-convertible bonds. The bondholder receives the redemption value at the time of maturity, Zero-Coupon Bond: A zero-coupon bond is one where no coupon is paid.It is purchased at a discounted price and does not pay any periodic interest rates, to the bondholder. The return on these bonds is calculated as the difference between the face value and issue price, which is the discounted price. Bearer Bonds: It is a Bond certificate issued without recording the name of the holder. The risk associated with these bonds are they can be either lost or stolen, Registered Bonds: It is a bond whose ownership is recorded by the issuer or by a transfer agent Term Bonds: The bonds issued for a specific term of years and then become due and payable. Most of the corporate bonds are term bonds Serial Bonds: The bonds whose specific principal amounts become due on specified dates before maturity. They are termed as serial bonds. Mortgage Bonds: A bond that is secured against the property of the firm is known as a mortgage bond The valuation of a Bond is also based on the concept of the basic valuation model. The value of a bond is obtained by discounting the bond's expected cash flows to the present value using an appropriate discount rate. So, if there is a bond on which a periodic interest is received and also the amount equal to the bond’s face value at maturity then-current value of the bond will be calculated by discounting the cash inflows in terms of periodic interest and the maturity value of the bond at a required rate of return on the bond, The basic equation for the present value of a bond on which annual interest is received will be as follows: 1 1 1 eve Gena * Tea? * Tea aKa Bo= Where By= present value of the bond at time zero kd= required rate of return on bond a I= annual interest on a bondFVB= face value of a bond n number of years to maturity The above equation can also be represented as: Bor Diy rye aay + Gear ‘The valuation for a bond can be understood with the following example: Illustration 2: XYZ Ltd. issues a bond with a face value of Rs. 1,000 with the maturity of five years at par to yield 10%, Interest is paid annually on this bond. Calculate the present value of the bond. Solution: Here, Face Value = 71000, kg (required return on bond) = 10%, n (number of years to maturity) = 5 years To calculate the value of the bond, we use the formula given below rve 6 Bodh saat (+kay” ‘Where Bo= present value of the bond at time zero Substituting the given values in the above formula, we get, 100 1000 thant + Gra0F = 100 (PVAF) + 1,000 (PVIF) Here, Bo= = 100 (10,5) + 1,000 (10,5) = 100 (3.791) + 1000 (.621) = 379.1 + 621 = 21,000 Before you lea, the methods of valuation of bonds let us understand some important basic terms: 1) Face Value/Par Value: It is the value of on the face of the bond. 2) Coupon Rate: It is the specified interest rate on the bond. The interest is, paid to the bond holder which is calculated as : par value x coupon rate 3) Maturity period : It is the number of years after which face value is paid to the holder of the bond. 4) Issue Price: It is that price at which bond is issued to the investor in primary market. 5) Market Price: It is that price of the bond at which buying and selling of the bond is done between investors in the secondary market. 6) Redemption Value: It is that value at which the bond is redeemed. 163Financing Decisions 164 Yield to Maturity Yield to maturity (YTM) is the discount rate at which the sum of all future ash flows from the bond is equal to the price of the bond. The YTM is based on the belief or understanding that an investor purchases the security at the current market price and holds it until the security has matured, and that all interest and coupon payments are made in a timely fashion. YTM is usually an annual percentage rate, The following formula is used to get YTM: I= Interest payment FV = Face Value PV = present Value (current price of the bond) years to maturity Mlustration 3 Assume that there is a bond in the market priced at % 700 and that the bond has a face value of %1,000, Yearly coupons for this bond are € 150. The coupon rate for the bond is 15% and the bond will reach maturity in 6 years. Determine YTM. Solution: We are given, Market price of bond = 7700 Face Value = %1000 Interest = @150 Ka(required return on bond) = 15% We use the formula below to calculate YTM. Where, I = Interest payment FV = Face Value PV = present Value (current market price of the bond) t fears to maturity Substituting the given values in the above formula, we get, aso 1200-700 YTM=YTM = 23.53% Debt valuation Illustration 4: Mr. A has invested in 8% debentures of Rs. 500 which are redeemable after 5 years at par. Calculate the value of bond if the required rate of return is 14% and 7%, Solution: We are given Redeemable Value (RV) = 500 Interest = 8% Required rate of return kd = 14% years to maturity n =5 years Annual interest = 8% of 500 = 40 Bond Value at 14% at 5 years Bond value = I (PVAF i,2) + RV (PVF ta,2) 10 (PVAF 12.3) + 500 (PVFi4s) = 40 x 3.4331 + 500 0.5194 = 137.324 + 259.7 =Rs. 397.024 Bond Value at 7% at 5 years Bond Value = 40 (PVAF;s) + 500 (PVF) = 40 (4.1002) + $00 (0.7130) = 164.008 + 356.6 =Rs. 510 Illustration 5: Mr. A has invested in 10% debentures of Rs. 1000 which are redeemable after 4 years at par. Calculate the value of bond if interest is paid a) annually b) semi-annually c) quarterly basis. Assume that the required rate of return is, 12% Solution: We are given Redeemable Value = 1000 Interest, = 10% Required rate of return = 12% years to maturity n years 165Financing Decisions 166 Annual interest = 10% of 1000 = 2100 a) Bond value = I (PVAF jan) + RV (PVF kaa) = 100 x 3.0373 + 1000 x 0.6355 03.73 + 635.5 =Rs. 939.23 ‘Ans. The value of the bond is 939.23 b) Bond value = 1/2 (PVAF 4a,2,0¢2) + RV (PVF xa, 02) = 100/2(6.2098) +1000 (0.6274) = 310.49 + 627.4 937.89 Ans. The value of the bond is $937.89 ©) Bond value = 1/4 (PVAF kaa, es) + RV (PVF yas, ors) = 100/4(12.561) +1000(0.6232) = 314,025 + 623.2 = 937.22 Ans, The value of the bond is 7937.22 Mlustration 6: Mr. A has invested in 6% debentures of Rs. 1000 which are redeemable after 7 years at premium for Rs, 1100. Calculate the value of bond if the required rate of retum is 15%, Solution: We are given Redeemable Value = €1100 Interest = 6% Required rate of retum = 15% Annual interest = 6% of 1000 = 60 Bond value = I (PVAF ta, RV (PVF kan) = 60 x 4.1604 + 1100 x 0.3759 = 249.624 + 413.49 = Rs. 663.114 ‘Ans. The value of the bond is & 663.114 Mlustration 9% debentures of Rs. 800 which is redeemable after 5 years at par. Calculate the value of the bond if the required rate of return is 15%. Also, state whether Mr. A should buy the debentures if the current market price is Rs.600, and will your answer be the same if the current market price is Rs.650?Solution: We are given Valuation of Securities Redeemable Value =%800 Interest = 9% Required rate of return = 15% Annual interest = 9% of 800 = 72 Bond value = I (PVAF ig,n) + RV (PVF ta.n) = 72x 3,3522+ 800 x 0.4972 = 241.35 + 397.76 = Rs, 639.11 Ans. The value of the bond is %639.11. If the current market price is Rs.600 then Mr. A should buy the bonds as the fair value is more than the market price. However if the current market price is Rs.650 then Mr. A should not buy the bonds as the fair value is less than the market price. 10.5 VALUATION OF PREFERENCE SHARES Preference shares are a kind of hybrid securities in which some features of bonds and some features of equity shares are present. The rate of dividend on such shares is usually specified. ‘Thus, at the time of buying such shares, an investor knows about the rate of dividend. There are many types of preference shares. Preference shares can be convertible or non-convertible, redeemable or irredeemable, participating or non-participating, Cumulative and Non- Cumulative, and shares with callable options Dividends on preference shares are specified like bonds. Preference shareholders get preference over equity shareholders when it comes to the payment of dividends. In the case of cumulative preference shares, if a company is not able to pay dividends in a particular year, then dividends on them may accumulate over time. And before paying the dividend to equity shareholders it is required that arrears of preference dividends are cleared first Thus, preference shares are less risky in comparison to equity shares. But when it comes to comparison between preference shares and bonds then preference shares are riskier as there is a priority in payment and liquidation, towards bonds. Bonds are usually secured and thus enjoy the protection of the principal, The value of a redeemable preference share is the present value of all the future expected dividend payments and the maturity value, discounted at the required return on preference shares. 167Financing Decisions 168 v: lue of Redeemable Preference Shares ‘The value of Redeemable preference share can be ascertained as follows: Reedemption Value VR ‘Gang! ark Where, Dj=Dividend in the year | K, = required rate of retum n /ears to maturity Mlustration 8: The face value of the preference share is €1000 and the stated dividend rate is 9%, The shares are redeemable at par after 5 years period. Calculate the value of preference shares if the required rate of return is 13%, Solution: We know the value of preference share can be calculated with the help of the formula below ReedemptionVatue V=Rie Rapa ate" Where, Dj jvidend in the year 1 = 1000 x 9% kp = required rate of return on preference shares = 13% n years to maturity = 5 years Substituting the given values in the above formula, we get, 2000 Gas Here, VDE t+ = Rs. 859.31 (approx.) Value of Irredeemable Preference Shares In this case dividends from preference shares are assumed to be perpetual payments. Intrinsic value or the present value of such shares can be calculated as follows: a ep) Where D = Dividend on preference shares Kp = required rate of return Illustration 9: A firm issued preference shares of Rs, 800 each with a specified dividend of Rs, 125 per share. The investors! required rate of retum is 10%. What will be the value of the preference shares today? We know,Dj=Dividend in the year 1 =8125 kp = required rate of return on preference shares = 10% = (kp) 2s (0.10) Value of preference share =Rs, 1250 Illustration 10: Mr. ‘A’ wants to purchase a 7% preference share of Rs. 2000 redeemable after 5 years at par. What should he be willing to pay now to purchase the share? Assume that the required rate of return is 10%. Solution: Value of preference share will be calculated with the help of the following formula- =D (PVAF ,2) + Pa (PVF ip.) Where, D;=Dividend in the year i = 2000x7%=140 kp = required rate of return on preference shares = 10% n= years to maturity = 5 years Substituting the given values in the above formula, we get, = 140 x 3.7908 + 2000 x 0.6209 530.712 + 1241.8 = Rs, 1772.512 Ans. The value of preference share is Rs. 1772.512 Illustration 11: Mr. A wants to purchase a 9% preference share of Rs. 1000 redeemable after 3 years at a premium for Rs. 1050, What is the value of preference shares assuming that the required rate of return is 15% Solution: Value of preference share will be calculated as follows- =D (PVAF ip,2) + Pa (PVF ip,n) Dj =Dividend in the year 1 = 1000%9% = 90 kp = required rate of return on preference shares = 15% n= years to maturity =3 years Substituting the given values in the above formula, we get, ‘V= 90%2,2832 + 1050 x0.6575 = 205.488 + 690.375 169Financing Decisions 170 = Rs. 895.863 Ans, The value of preference share is Rs. 895.863 Mlustration 12: Mr. A has invested in an irredeemable preference share of Rs. 1000. He receives a dividend of Rs. 80 annually. What is the value of preference shares assuming that the required rate of return is 10%? Solution: Value of irredeemable preference share will be calculated as follows- V=DiK, Where D =Dividend= 80 K, = required rate of return on preference shares =10% Substituting the given values in the above formula, we get, = 80/.10 = Rs. 800 Ans, The value of preference share is Rs. 800 Check Your Progress A QL. What is the formula of yield to maturity method? Q2. What are the different types of bonds? Q3. Mr. A purchased a bond whose face value is € 1000which is redeemable after 5 years at par. The coupon (interest) rate is 7%.At what price will the investor be willing to purchase the bond today if the required rate of return is 8%.Q4. An investor purchases a bond of value % 1000 having a coupon rate of 12% Calculate the value of the bond if the required rate of return on the bond is 10% and it matures at par after a period of 3 years? 10.6| VALUATION OF EQUITY SHARES Ordinary shares are also called equity shares or common shares. Investors would like to invest in equity shares with an expectation to earn dividends and to get the benefit of capital gains arising out of selling such shares. The equity shareholders usually buy the shares when they find that the market value is lower than its intrinsic value and sell it when the market value is ‘more than its intrinsic value, This is how they realize a capital gain on the transaction. Some investors expect that the company would grow well in the future and in anticipation of that, they retain their shares for a longer time. Methods for Valuation of Shares Earning Basis Dual Method Earning Capacity Method Dividend Yield Method A Net Asset Method The net asset method is also called as Asset Backing method or Intrinsic Value method or break up value method. Under this method, the stress is on the protection of investment because the investors always need safety for his or her investments. Under this method, the net assets of the corporate are divided by the number of shares to reach the net asset value of each share. That is, the value per share is arrived at by first valuing the assets of the company and then deducting the value of liabilities and claims of preference shareholders, from the value of assets. Many times, people have confusion regarding the inclusion of Goodwill in the net assets. For this, one must know that unless otherwise stated goodwill is included in the net assets, Thus, the following points are to be considered: © The value of goodwill will be ascertained, © Fixed assets will be considered at their realizable value. ‘Valuation of Securities 7Financing Decisions 172 ‘* Floating assets are to be taken at market value. ‘* The stock of finished goods is to be taken at their market value whereas other stocks such as raw materials, stores, and spare parts or stock in the process may be taken at their cost. ‘+ Fictitious assets are not to be taken into consideration. * Provision for depreciation, bad debts provision, etc. must be considered, * Find out the extemal liabilities of the company payable to outsiders including contingent liabilities © Ifcum dividend price of shares is required then the proposed dividend is not deducted as a liability. But if an ex-dividend price is desired then the proposed dividend is deducted as a liability B Earning Basis Method ‘The earning basis of share valuation is expressed through: 1) Yield method or Dividend yield method 2) Earning Capacity Method 1) Yield Method or Dividend Yield Method Investors are interested in income. They value the share based on expected dividends. The value of a share under this method is determined by comparing the expected rate of the dividend of a company with the Normal rate of Dividends as prevailing in the industry. Rate of dividend expected Normal rate of dividend Profit Available for Dividend Total paid up capital Value of Shares = X Paid up value of share And, Rate of dividend expected = x 100 Mlustration 13: XYZ Ltd. has issued shares of 8100 each, 890 paid up. The rate of dividend is declared by the company as 10%. The normal rate of return is 9%, Find the value of the share. Solution: To find the value of share we will use: Rateofdividendexpected Normalrateofdividend Value of Shares = x Paidup value of share Where the Expected rate of dividend = 10%, Normal rate = 9%, Paid-up value = 890 Substituting the given values in the above formula, we get, Value of Shares = “2 X 90 = 100 2) Earning Capacity Method ‘When somebody is interested to own the bulk of shares of a corporation, he makes use of earning capacity method for valuation of shares. Thus, profits earned by the corporate are compared with the quantity of capitalemployed within the business, and the rate of earning is discovered in Valuation of the following manner: Securities Profit earned Capital employed Rate of earning Rate of Earning = xX 100 Value of Shares = x Paid up value of share Normal rate of dividend Here profit eamed means the profits that are available after payment of interest to debenture holders and dividends to preference shareholders. Illustration 14: A company has employed equity capital of &5,00,000 of 850 each fully paid up. It is an all-equity firm. The average profits of the company are 750, 000 and the estimated rate of capitalization is 20%, Find the value of shares as per earning capacity method Solution: Valuation of share under Equity Capacity Method can be done as follows- Average profit = 50,000 ‘We use the formula below to calculate the rate of earning Profit earned Capital employed Where Profit earned = % 50000, Capital employed = %5,00,000 Rate of Earning = 100 Substituting the given values in above formula, we get, 50.000 500,000 Rate of Eaming = x 100 =10% The value of shares can be calculated as follows: Rate of earning Value of Shares = rat rate of dividend X Paid up value of share Where Normal rate of return = 20% Substituting the given values in the above formula, we get, 0 Value of equity share =" x 50 =%25 20 Fair Value Method fair value method is also called as Dual method, Some accountants don't prefer to use Intrinsic Value or Yield Value to determine the correct value of the shares. However, they prescribe the Fair Value Method which is the mean of the values derived from the method of Intrinsic Value and Yield Value, and the same gives a better indication of the value of the shares. The value of share under this method can be calculated as follows: Value of share on earning basis+Value of share on Net Assets Basls Value per share = “ 173Financing Decisions 174 Mlustration 15: If the value of the share as per the Intrinsic value method is %200.50 and as per the Yield method is 99.50 then the value as per the fair value method will be calculated as follows: Value as per fair value method _ Value of share on earning basis+Value of share on Net Assets Basis 2 Substituting the given values in the above formula, we get, _9950420050_, 2150 Dividend discount model The valuation of Equity shares with the help of the dividend discount model is also based on the concept of the basic valuation model, The value of an equity share is obtained by discounting the expected dividends to the present value using an appropriate discount rate. So, if there is a share on which a periodic dividend is received and also the expected price of a share is known then the value of the shares will be calculated by discounting the dividend streams and expected price of the share at a required rate of return. If the value of share computed using the dividend discount model is higher than the current market price of shares, then we can say that the share is undervalued or underpriced and that the investor should buy the share as its intrinsic or fair value is more than the price prevailing in the market. On the other hand, if the value of share computed using the dividend discount model is lower than the current market price of shares, then we can say that the share is overvalued or overpriced and that the investor should not buy the share as its intrinsic or fair value is less than the price prevailing in the market The basic equation for calculating the present value of an equity share on which annual dividend is received will be as follows: Dy a Px Ore)” Tek” OHO ane 9 = Where Po= present value of the share at time zero <= required return on share D) = expected dividend after one year P,= expected price of shares after n years n_ =number of years to maturity The above equation can also be represented as: Di b, Por ea Gene > Taney The formula for calculating the fair value of equity share using the Dividend Discount Model under various casesb) i. For one year holding period Valuation of Securities The value of equity share Dish Po= 1+ Ke where Po= present value of the share at time zero k= required return on share Dj = expected dividend after one year P= Expected price of shares after | year id For the multi-year holding pe The value of equity share is: Dy Dy Pa Geka * Teka” Tek? aKa Po Po= D (PVFAke,nj+Pa(PVFie, 2) where Po= present value of the share at time zero k.= required return on share D = expected dividend/future dividend payments P,= Expected price of shares after n years n=number of years to maturity Indefinite holding period No growth in dividends If there is no growth in the dividends then the value of the share will be calculated as: sya: s) 2k) Pome where Po= present value of the share at time zero k.= required return on share D = expected dividend/future dividend payments Constant growth in dividends If there is constant growth in the dividends then the value of the share will be calculated as: Dy 7) Po where Po= present value of the share at time zero k= required return on share D) = expected dividend after one year g= growth rate176 ili, Multiple growth rates If there are multiple growths in the dividends then the value of the share will be calculated as: Dy, Gta) , DiC ‘ Ds (tga) Gtk)” Gtk)? ” rk tke)” aner where Po= present value of the share at time zero k.= required return on share D, = expected dividend after one year g= first growth rate g1 = second growth rate Equity valuation Mlustration 16: PQR Lid. has issued shares of €200 each, €192 paid up. The rate of dividend is declared by the company as 10%. The normal rate of return is 8%. Find the value of the share. Solution: To find the value of share we will use Rate of dividend expected Value OE Shares = mal rate f dieidend X Paid up value of share Where, the Expected rate of dividend = 10%, Normal rate = 8%, and Paid-up value = 7192 Substituting the given values in the above formula, we get, Value of Shares == X 192 = 2240 ‘Ans.The value of share is 2240 Illustration 17: ‘A company has employed equity capital of 10,00,000 of 2100 each fully paid up. It is an all-equity firm. The average profits of the company are %1,00,000 and the estimated rate of capitalization is 20%. Find Value as per eaming capacity method. Solution: Valuation of share under Equity Capacity Method Here, Average profit = 1,00,000, Capital employed = %10,00,000 Rate of Earning = —72Mtearned_y 199 Capital employed Substituting the given values in above formula, we get, Rate of Earning = _— X 100 =10%Value of Shares = —2#e2/ coming _y paid up value of share Valuation of Normal rate of dividend Securities Where Normal rate of return = 20% Substituting the given values in the above formula, we get, Value of equity share = 3 X 100 =%50 Ans. The value of share is Rs. 50 Illustration 18: If the value of the share as per the Intrinsic value method is €160 and as per the Yield method is € 140 then the value as per the fair value method will be calculated as follows: Solution: Value as per fair value method _ Value of share on earning basis+Value of share on Net Assets Basis z Substituting the given values in the above formula, we get, 260 4140_ 150 Ans.The value of share is 7150 Illustration 19: The current market price of a share is Rs. 100, The expected dividend is Rs. 5 per share and the expected price of share after one year is Rs. 110. Calculate the value of the share and should it be bought at the current market price if the required rate of retum is 10 %? Solution: We are given expected dividend= D; = Rs. 5 Expected Price = P; = Rs.110 Required rate of retum = K.~ 10% Therefore, the value of equity share Substituting all the values in the formula above, = SEM 8 _e104.5 1010 43 Ans. The value of equity is Rs. 104.5 and hence the investor should buy it at the current market price of Rs. 100. Illustration 20: ‘The current market price of a share is Rs. 140. The expected dividend is Rs. 10 per share and the expected price of share after one year is Rs. 150. Calculate the value of the share and should it be bought at the current market price if the required rate of return is 20%? Solution: We are given, Expected dividend= Dj = Rs. 10 V7Financing Decisions 178 Expected Price = P; = Rs.150 Required rate of return = K.= 20% ‘Therefore, the value of equity share = a Substituting the given values in the above formula, we get, 104 150 _ 160 Ans. The value of equity is Rs. 133.33 and hence the investor should not buy it at the current market price of Rs. 140. Mlustration 21: Mr. A wants to invest in the shares of ABC Co. for the next 7 years. The company is expected to declare a dividend of Rs. 10 per share at the end of every year for the next 7 years. The projected price of the share at the end of the seventh year is Rs. 200. Calculate the value of the share and should it be bought now at the current market price of Rs. 160, if the required rate of retum is 10%? Solution: We know that the Dy = D)= Ds= Dy= Ds=Ds=Dy=Rs. 10, Where, D; = Expected dividend after one year And expected price after seven years =P; = Rs.200 Required rate of return = K.= 10% ‘Therefore, the value of equity share = DPVFAe yt Pa(PVFec. 2) Substituting the given values in above formula, we get, = 10 (PVFA 10%,7)+ 200(PVF j0%,7) = 10 (4,868) + 200 (0.513)= 48.68 + 102.6 8151.28 Ans. The value of equity is Rs. 151.28 and hence the investor should not buy it at the current market price of Rs. 160. Mlustration 22: Mr. A wants to invest in the shares of XYZ Co, The company declared a dividend of Rs. 10 per share last year. Calculate the value of a share if the required rate of return is 15% and there is no growth in dividends, Solution: Last dividend declared= Dp = Rs. 10 Since there is no growth in dividends, Therefore, expected dividend after one year = Dj = Do= 10 Required rate of return = K,= 15%If there is no growth in the dividends then the value of the share will be calculated as: Substituting the given values in the above formula, we get, = 10/.15 = Rs. 66.67 Ans. The value of equity share is Rs. 66.67 when there is no growth in the dividends. Illustration 23: Mr. A wants to invest in the shares of a company. The company declared a dividend of Rs. 20 per share last year. Calculate the value of a share if the required rate of return is 20% and the dividends are expected to grow at a constant rate of 15%? Solution: Last dividend declared= Dy = Rs. 20 Required rate of return = Ke = 20% Growth rate = g= 15% Since dividends are expected to grow at constant rate of 15%, Expected dividend after one year =D; = Do (1+ g) Dy = 20(1+0.15) =23 The value of share will be calculated as — Ds keg Po= Substituting the given values in the above formula, we get, 23 = 460 30-015 Ans. The value of equity share is Rs. 460 when there is constant growth at the rate of 15% in dividends. Ilustration 24: Mr. A wants to invest in the shares of PQR Co. The company declared a dividend of Rs. 10 per share last year. The dividends of the company are expected to grow at a rate of 15% for the next five years and thereafter it is expected to grow at a rate of 18% p.a. forever. Calculate the value of the equity if the required rate of return is 15% Solution: Last dividend declared= Do = Rs. 10 Required rate of return =K. = 20% Growth rate = g= 15% for the first 5 years and then g; = 18% forever Vata Secu on of 179180 Since dividends are expected to grow at rate of 15% for first 5 years Expected dividend after one year = D; = Do (1+ g) Dy = 10 (140.15) =11.5 Similarly, Expected dividend after two-years = D2 =Do (1 + g) = 13.225 Expected dividend after three years = D3 = Dp (1 + g)'= 15.208 Expected dividend after four years = Dy = Do (1 + g)*= 17.490 Expected dividend after five years = Ds = Dp (1 + g)'= 20.11 Now we calculate the Present value of dividends for the first 5 years Dividends PVF20%,0 Pv 1S 0.833 9.5795 13.225 0.694 9.17815 15.208 0.579 8.805432 17.49 0.482 8.43018 20.11 0.402 8.08422 Total 44.0748 From 6" year onwards, g1 = 18% Therefore, expected dividend after six years = Dg = Ds (I+ gi) = 23.729 20.11(1.18) Now, since after 5 years the dividend grows at a constant rate of 18%, Ds Price of share after five years = Ps = 77% Substituting all the values in the formula above, = 23.729/ (0.20-0.18) = Rs. 1186.45 And, Present value of Ps= 1186.45 1/(1+ 0.20)* =1186.45*0,402 = 476.95 Therefore, the value of eq =i, DiGita) | Betas) DiGtg" , Dn Gta), 1 GK) +k)? | G+ke)* Gk" hemga) Uke Po i.e., Rs 44,077 + 476.95 = Rs. $21.03 Ans. The value of equity share is Rs. $21.03.Illustration 25: The current market price of a share is Rs. 60. The expected dividend is Rs. 5 per share and the growth rate is 7%. Calculate the value of the share and should it be bought at the current market price if a) market retum is 10% b) Risk-free rate is 5% ©) Beta of the company is 2 Solution: We are given, Market return = Ry = 10% Risk free rate of return = Rr= 5% Beta=p=2 Growth rate = g= 7% According to capital asset pricing model K= Rr* (Ro ROB Where, k. = the required rate of return on equity Ry = Market return, Re Risk free rate of return Therefore, k, = 0.05 + (0.1-0.05) x2 =0.15 Now, we calculate the value of the share Where, D, = Expected dividend after one year k. = the required rate of return on equity g= growth rate Substituting the given values in above formula, we get, = 5/ (0.15-0.07) =%62.5 Ans. Since the fair value of share i.e., Rs. 62.5, is higher than the current market price i.e., Rs. 60, the investor should buy the shares. 181Financing Decisions 182 10.7 VALUATION OF CONVERTIBLE DEBENTUR A convertible debenture/bond refers to fixed-income debt security that generates interest payments and can be converted into a pre-set or fixed number of equity shares. The debenture/bond can be converted into stock at a specific time during the life of the bond, usually at the preference of the bondholder. If an investor chooses to keep the bond and not convert it into shares then he will receive the face value at the time of maturity. A convertible bond presents an investor with a form of hybrid security and a flexible financing opportunity for issuing companies. It has characteristics of a bond for instance maturity date, coupon rate, face value, and payment of interest to the investors during the life of a bond in addition to offering the investor a chance to own an equity share. Conversion ratio refers to the number of shares the bondholder will from converting one bond. For example, a ratio of 1:10 means that one bond can be converted to 10 equity shares. The conversion price is the price of each share or per share at which a convertible bond can be converted into equity shares, It is calculated by dividing the face value of the bond by the conversion ratio, The conversion price and ratio are set at the time of the issuance of debenture and can be obtained from the bond indenture The conversion value refers to the value of equity shares obtained after the bonds have been converted. Conversion value can be determined by the product of the conversion ratio and the current market price of the equity share. The conversion premium is the excess of the convertible bond's price today over its intrinsic value. It is calculated by subtracting the convertible bond’s intrinsic value from its price today. Illustration 26: A company issued 1000, 10% debentures of 7100 each redeemable after 5 years, At maturity, the bondholder has on option to convert the debentures into equity shares of the company. The conversion ratio is 1:10, and the current market price of a share is @8 per share. The current price of the debenture is 795, Solution: We are given that the conversion ratio is 1: 10 ie., the investor will receive 10 shares for each debenture, Then the number of shares a bondholder will receive from converting the bonds will be 10,000 shares. 1) The conversion price will be = Face Value / Conversion ratio ie., %100/10 = €10 per share. 2) The conversion value will be = Conversion Ratio x Current market price of share i.e., 10 x 78 = 7803) The conversion premium = Bond Price toady — Intrinsic value i.e., 295 — 0 =%5 The valuation of convertible debentures is quite similar to the valuation of redeemable debentures. At the time of maturity of the debentures, the debenture holder will have an option to convert the bonds into equity shares of the company. It is assumed that the debenture holder will go with the option only if it gives a higher value. Straight bond valueis the value of a convertible bond if it was not converted into equity shares. This value is calculated in a similar manner as of a regular redeemable debenture i.e., by discounting the cash inflows in terms of periodic interest and the maturity value of the bond to present value at a required rate of return on the bond. ‘The value of convertible debenture in such ca between the is taken as the higher value 1, Straight Bond value and 2. Conversion value Another way of determining the value of the convertible bond will be to compare the current market price of a share with the conversion price. If the current market price of a share is higher than the conversion price then it is, likely that the investor will go for the conversion of the bonds into equity share and, in such case, the value of the bond will be equal to the conversion value. Whereas if the current market price of shares is less than the conversion price then it is unlikely that the investor will opt for converting their debentures into the shares the value of the convertible bond will be equal to the straight bond value Illustration 27: A company issued 1000, 10% debentures of 7100 each redeemable at par after 5 years. At maturity, the bondholder has on option to convert the bonds into equity shares of the company. The conversion ratio is, 1:10, the current market price of a share is €8 per share and the current price of the bond is €95. The rate of discount is $%, Determine the price of the convertible bond Solution: We are given Redeemable Value = 100 Interest = 10% Required rate of retumn = 5% 1 (years to maturity) = 5 years Annual interest = 10% of 100 = €10 The current market price of a share is @8 ‘The current market price of bond = 95 Vata Secu on of 183Financing Decisions 184 The value of Straight Bond =I (PVAF kd, n) + RV (PVF kd, n) = 10%4,3295+ 100 x 0.7835 = 43.295 + 78.35 = Rs, 121.645 the conversion value = Conversion Ratio x Current market price of share i.e, 10x88 = 880 Ans.Since the straight bond value is higher than the conversion value, the investor will not opt for converting the bonds into equity shares Ilustration 28: A company issued 1000, 15% debentures of 7100 each redeemable at par after 10 years. At maturity, the bondholder has on option to convert the bonds into equity shares of the company. The conversion ratio is 1:5, the current market price of a share is €22 per share and the current price of the bond is = 95, The rate of discount is 15%. Determine the price of the convertible bond, Solution: We are given Redeemable Value = %100 Interest = 15% Required rate of return = 10% 1 (years to maturity) = 10 years Annual interest = 15% of 100 = %15 ‘The current market price ofa share is €10 The current market price of bond = 795 The value of Straight Bond = I (PVAF kd, n) + RV (PVE kd, n) = 15 x 5.0188+ 100 x 0,2472 = 75,282 + 24.72 =Rs. 100.002 the conversion value = Conversion Ratio x Current market price of share ie., 5 x822=2110 Ans.Since the straight bond value is less than the conversion value, the investor will opt for converting the bonds into equity shares Check Your Progress B QU. What are convertible debentures?Q2. What do you mean by conversion premium? Q3. Mr. A wants to invest in the shares of ABC Co. The company declared a dividend of Rs. 15 per share last year. Calculate the value of a share if the required rate of return is 15% and there is no growth in dividends? Q4. Mr. A wants to invest in the shares of PQR Co. The company declared a dividend of Rs. 40 per share last year. Calculate the value of a share if the required rate of return is 20% and the dividends are expected to grow at a constant rate of 15%? 10.8 LET US SUM UP This unit introduces you to the purpose of investment and relevance of valuation of different securities using three step valuation process. It presents the significance and implication of the basic valuation model which states that the value of any security is simply the present value of the future benefits ‘or future cash flows like interest, dividend, or earnings per period ie., we discount the stream of cash flows at required rate of return. The chapter first discusses the valuation of bond or debenture including estimation of yield to maturity followed by valuation of redeemable and irredeemable preference share, Different methods of equity valuation have been explained such as Net, asset value method, earning basis method which includes-Dividend yield method and earning capacity method, and dual method, Dividend discount model has been included covering one year holding period, multi-year holding period and indefinite holding period with no growth, constant growth and multiple growth rates. The concept and the valuation of convertible bond have also been discussed, 10.9 KEY WORDS Securities: It includes shares, stock, bonds, debentures, debenture stock or other marketable securities of a like nature. Debenture/Bond: It is an acknowledgement of a debt. Rate of Return: It is also called ‘Discount Rate’. It is a rate used to calculate present value of future cash flows. Dividend Capitalization Approach: Model used to value equity shares. According to it, the current price of a share is equal to the discounted value of all future dividends. Intrinsic Value: The present value of the stream of benefits expected from an asset. Yield to Maturity: The discount rate that equates the present value of interest payment and redemption value with the present price of a bond. Vata Secu on ofFinancing Decisions 186 10.10 ANSWERS TO CHECK YOUR PROGRESS A 3.The bond is worth 960,51 today. Therefore, the investor will be willing to pay a price of equal to or less than 960.51 for the bond today. 4. The value of the bond is 71049, B 3. The value of equity is Rs. 100 when there is no growth in the dividends. 4, The value of equity is Rs. 920. 10.11 SELF-ASSESSMENT QUESTIONS/EXERCISES 1) What do you understand by Basic Valuation Model? 2) Explain various methods for the valuation of equity shares. 3) How will you calculate the value of a preference share? 4) Explain the Dual method for the valuation of shares. 5) How will you find the value of a perpetual bond? 6) what is meant by yield to maturity 7) What are the features of Bonds and explain them in detail, 8) What is the three-step valuation process 9) Define Bond and Types of bonds. 10) What Types of investors are interested in investing in debentures? Practical Problems 1. Mr. B wants to purchase a 9% preference share of Rs. 2000 redeemable after 3 years at a premium for Rs. 2500. What is the value of preference shares assuming that the required rate of return is 15% (Ans, €2054,726) 2. Mr, A has invested in an iredeemable preference share of Rs, 850. He receives a dividend of Rs. 60 annually. What is the value of preference shares assuming that the required rate of return is 10%? (Ans, 600) 3. PQR Ltd. has issued shares of 7150 each, 144 paid up. The rate of dividend is declared by the company as 10%. The normal rate of return is 8%. Find the value of the share. (Ans. 7180) 4, A company has employed equity capital of 20,00,000 of 100 each share fully paid up. It is an all-equity firm, The average profits of the company are %2,00,000 and the estimated rate of capitalization is 25%, Find Value as per earning capacity method. (Ans. 840)If the value of the share as per the Intrinsic value method is %350and as per the Yield method is 550 then find the value as per the fair value method. (Ans, 7450) The current market price of a share is Rs. 200, The expected dividend is Rs. 10 per share and the expected price of share after one-year of Rs. 220. Calculate the value of the share and should it be bought at the current market price if the required rate of return is 10%? Ans, The value of equity is Rs. 209.0909 and hence the investor should buy it at the current market price of Rs. 200 Mr. A wants to invest in the shares of XYZ Co. for the next 7 years. The company is expected to declare a dividend of Rs. 20 per share at the end of every year for the next 7 years. The projected price of the share at the end of the seventh year is Rs. 400. Calculate the value of the share and should it be bought now at the current market price of Rs. 360, if the required rate of return is 10%? Ans. The value of equity is Rs. 302.56 and hence the investor should not buy it at the current market price of Rs. 360. Mr. A wants to invest in the shares of PQR Co. The company declared a dividend of Rs. 25 per share last year, The dividends of the company are expected to grow at a rate of 15% for the next five years and thereafter it is expected to grow at a rate of 17% p.a. forever. Caleulate the value of the equity if the required rate of return is 15% ‘Ans. The value of equity shares is Rs. 898.5483 (approx.) NOTE: These questions will help you to understand the unit better. Try to answer them but do not submit the answers to the University. These questions are for practice only, Vata Secu on of 187