Chapter_3

Financial Management
VALUATION OF LONG-TERM
SECURITIES
1
Copyright © 2014 by McGraw Hill Education ( India ) Pvt.
Ltd.
Introduction
• Long-term securities mainly include bonds (also called debentures),

preference shares and ordinary equity shares.
• The value of a long-term security is the present value of cash flows

expected by the holder of security discounted at the required rate of
return.
• Valuation is a process of estimating the intrinsic value or right value

of an asset (security).
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Concept and Types of Value
• Value of an asset represents its present worth and future potential.
• Most common methods of defining value are:
– Book Value
– Replacement Value
– Liquidation Value
– Going Concern Value
– Market Value

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Concept of Bonds and Bond Terminology
• Bonds are known as fixed-income securities because the exact
amount of return expected if security is held until maturity is known.
• The important terminologies of a bond are as follows:
Face Value:
Face Value represents the nominal value of a bond and is also
mentioned in the bond document.
Coupon Rate:
Coupon Rate is in effect the interest rate applicable on the
bond.
Maturity Period:
The Maturity Period represents the total duration of the bond.
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Concept of Bonds and Bond Terminology
Redemption Value:
The Redemption Value is the value that the investor will get at the
time it is redeemed, i.e. on maturity.
Redemption may be on par, at premium or at discount as per its

terms of issue.
Market Value:
Market Value is the price at which a bond is being traded at (i.e.
bought and sold) in the stock exchanges.

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Bond Valuation
• Bond Valuation involves converting all cash flows to the present

value using a discount rate.
• The discount rate would depend upon the category of risk of the
bond.
• The discount rate is composed of two parts, one a risk free rate and
the other rate as premium for the risk.
• Bonds are of four types:

1. Bonds with maturity
2. Bonds with amortisation of principal
3. Bonds without coupon rate or zero interest bonds
4. Perpetual bonds
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Bond Yields
• Yield refers to the percentage rate of return paid on a stock, as

dividends, or the effective rate of interest paid on a bond.
• Yield-to-Maturity (YTM):
– It is the percentage rate of return paid on a bond, if the bond is bought
and held till its maturity date.
• Yield to Call:
– If bonds are issued with a call provision then the yield to call is same as
yield to maturity except that the period and maturity value are different.
• Current Yield:
– It is the annual interest divided by the current market price of the bond.

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Bond Values and Interest Rates
• When the prevailing rate of interest goes up, the discount rate also
increases, resulting in lower present value of the bond and vice
versa.
• The relationship between the interest rate and the present value of
the bond depends upon the characteristics of the bond.
• For a given Face Value, coupon rate and time to maturity, the
present value of bond would change with varying interest rates.
• If the interest rate goes up, the bond holders lose value. Thus, the
bond holders are exposed to ‘interest rate risk’.

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Duration of the Bonds
• Duration is time weighted average of cash flows divided by total

value.
• Bonds with higher duration are more risky as it takes longer to get
repaid.
• The value of the duration changes as coupon payments are made.
• The formula used to calculate duration is given by Frederick

Macaulay and is known as Macaulay Duration.

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Modified Duration and Convexity of the Bonds
• Modified version of Macaulay Duration that takes into account the

changes in interest rates is known as Modified Duration.
• Modified Duration indicates how much the duration changes for

each percentage change of yield.
• For a bond, the graph of Price vs Yield is convex. This means the
relationship is not linear.
• The extent to which the graph is curved shows how much yield
would change for a given change in price.
• The bond with greater convexity is less affected by interest rates

than bond with less convexity.
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Term Structure of Interest Rates
• The relationship between the interest rate and the period of

investment is known as the “term structure of interest rates”.
• It is technically inappropriate to use the same discount rate for all

years.
• The prevailing interest rates on debts keep changing from time to

time due to various factors.
• The future is uncertain and so are the likely future interest rates.
The interest rates may go up or go down due to uncertainty.
• The rate built into the long duration bond rates for subsequent
periods is called implied forward rate.

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• The issuers of bonds make an assessment of future interest rates

and accordingly offer interest rates on bonds of different maturities.
• If the outlook in future is that the interest rates are expected to rise
with time periods, the yield curve (Normal Yield Curve) would slope
upwards.
• If the future interest rates are likely to drop, the yield curve (Inverted
Yield Curve) would slope downwards.
• Estimated future interest rates based on the prevailing interest rates

on bonds of different maturities are called forward rates.
• Theories of term structure of interest rates give reasoning for

implied forward rates and expected rates.
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• Expectation Hypothesis of Term Structure states that expected

interest rates in future would be equal to implied forward rates.
• As per liquidity preference theory, the long-term bonds must provide

higher rate of interest to compensate for loss of liquidity and extra
risk due to longer period of investment.
• Preferred Habitat Theory states that different investors have

different investment horizons according to their other needs for
funds.
• The theory further states that investors select the maturity period to
suit their requirements, i.e. they follow the maturity matching
strategy.

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Valuation of Preference Shares
• Preference shares like bonds have a fixed rate of return. In case of

irredeemable preference shares, their valuation is like those of
perpetual bonds.
• In case of irredeemable preference shares:
• Where; Dp is dividend of reference share and Kp is cost of

preference share.
• In case of redeemable preference shares:

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Valuation of Ordinary Equity Shares
• The valuation of ordinary equity shares is far more complex

compared to valuation of bonds and preference shares.
• Following methods are used for valuation of ordinary equity shares:
• Dividend Capitalisation Method:

– Intrinsic Value (P0) of the share today, is the present value of all future
cash inflows to the investor. This includes dividends as well as proceeds
from the sale of stock, discounted at the required return.
• Gordon Growth Model:

– If the dividend of a firm has a constant growth rate g, then The value of
the share would be:

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Valuation of Ordinary Equity Shares
• Two stage growth in dividends:

– Present share value of two stage growth in dividend case can be
worked out by treating the first stage as annuity and the second as
perpetuity.
• Earnings Capitalisation Method:

– Earnings Capitalisation Method is another approach to find out the value
of a share, but it is applicable under two specific situations:
 The firm maintains 100 per cent dividend payout ratio.

 The firm’s internal rate of return or return on equity is equal to its opportunity
cost of capital.

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Equity Capitalisation Rate
• Required rate of return depends upon the risk of the share.
• For growth firms in which dividends are expected to grow at constant

rate for indefinite period and current market price is known, the required
rate of return can be calculated by the formula:
Dividend growth rate is called capital gain yield
• Required rate of return = Dividend yield + Capital gain yield

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Price-Earnings (P/E) Ratio
• Price-earnings ratio is defined as market price of a share divided by

the recent earnings per share.
• It represents how much price the market is willing to pay per rupee
of earnings.
• The shares of a growing firm sell at a high PE ratio.
• PE ratio varies from industry to industry and from country to country.
• Identical firms of same size, doing similar type of work in same

industry may have similar.
• Limitation of PE ratio method to assess the value of a firm’s share.

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Financial Management

• Long-term securities mainly include bonds (also called debentures),

• The value of a long-term security is the present value of cash flows

• Valuation is a process of estimating the intrinsic value or right value

Copyright © 2014 by McGraw Hill Education ( India ) 2

• Most common methods of defining value are:

– Going Concern Value

Copyright © 2014 by McGraw Hill Education ( India ) 3

• The important terminologies of a bond are as follows:

Redemption may be on par, at premium or at discount as per its

Copyright © 2014 by McGraw Hill Education ( India ) 5

• Bond Valuation involves converting all cash flows to the present

• Bonds are of four types:

Copyright © 2014 by McGraw Hill Education

• Yield refers to the percentage rate of return paid on a stock, as

Copyright © 2014 by McGraw Hill Education

Copyright © 2014 by McGraw Hill Education

• Duration is time weighted average of cash flows divided by total

• The value of the duration changes as coupon payments are made.

• The formula used to calculate duration is given by Frederick

Copyright © 2014 by McGraw Hill Education

• Modified version of Macaulay Duration that takes into account the

• Modified Duration indicates how much the duration changes for

• The bond with greater convexity is less affected by interest rates

• The relationship between the interest rate and the period of

• It is technically inappropriate to use the same discount rate for all

• The prevailing interest rates on debts keep changing from time to

Copyright © 2014 by McGraw Hill Education

• The issuers of bonds make an assessment of future interest rates

• Estimated future interest rates based on the prevailing interest rates

• Theories of term structure of interest rates give reasoning for

• Expectation Hypothesis of Term Structure states that expected

• As per liquidity preference theory, the long-term bonds must provide

• Preferred Habitat Theory states that different investors have

Copyright © 2014 by McGraw Hill Education

• Preference shares like bonds have a fixed rate of return. In case of

• In case of irredeemable preference shares:

• Where; Dp is dividend of reference share and Kp is cost of

• In case of redeemable preference shares:

Copyright © 2014 by McGraw Hill Education

• The valuation of ordinary equity shares is far more complex

• Following methods are used for valuation of ordinary equity shares:

• Dividend Capitalisation Method:

• Gordon Growth Model:

Copyright © 2014 by McGraw Hill Education

• Two stage growth in dividends:

• Earnings Capitalisation Method:

 The firm maintains 100 per cent dividend payout ratio.

Copyright © 2014 by McGraw Hill Education

• Required rate of return depends upon the risk of the share.

• For growth firms in which dividends are expected to grow at constant

Dividend growth rate is called capital gain yield

• Required rate of return = Dividend yield + Capital gain yield

Copyright © 2014 by McGraw Hill Education

• Price-earnings ratio is defined as market price of a share divided by

• The shares of a growing firm sell at a high PE ratio.

• PE ratio varies from industry to industry and from country to country.

• Identical firms of same size, doing similar type of work in same

• Limitation of PE ratio method to assess the value of a firm’s share.

Copyright © 2014 by McGraw Hill Education