CHAPTER FOUR

VALUATION OF FINANCIAL ASSETS

Overview

Assets may be classified in to physical assets and financial assets. Physical assets
include buildings, furniture, equipment, inventory etc. On the other hand, financial
assets include notes, bonds, commercial paper, Treasury bill, common stock,
preferred stock etc. Financial assets are bought and sold in the financial market.
Issuer and buyer (investor) are the major participants in financial asset transactions.
This chapter is concerned with the valuation of financial assets, especially, common
stock, preferred stock, and bonds from the perspective of the investor.

At the end of this chapter, you will be able to:

 Understand the major concepts of value
 Identify the major inputs to financial assets valuation models
 Determine the current value of common stock using various valuation models
 Determine the current value of preferred stock
 Determine the current value of bonds
 Determine the cost of Capital

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The concept of Value

The term value has different meanings in different situations. The major concepts of
value are explained below:
1. Liquidation value Vs Going Concern value
Liquidation value – the amount of money that could be realized if an asset or a
group of assets is sold off separately from its operating organization.
Going concern value – the amount the firm could be sold for as a continuing
operating business.
2. Book value
Book value of an asset – the accounting value of an asset (i.e. Original Cost –
Accumulated Depreciation)
Book value of a firm –Total assets minus liabilities and preferred stock as listed
on the balance sheet
3. Market Value
Market value of an asset – the price at which the asset trades in the open market
Market value of a firm – the higher of the firm’s liquidation value or going
concern value
4. Intrinsic value
 Is the price a security “out to have” based on all factors bearing on valuation
such as earnings, future prospects, management etc.
 Is what the price of a security should be if properly priced based on all factors
bearing on valuation
 Is the value of the asset that is justified by the facts in the mind of the investor
 Is also called theoretical or economic value
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Inputs to the Valuation Model

The major inputs to the valuation model are:

1. Cash flows – timing and size
2. Discount rate
The present value technique is used in the valuation of financial assets. The
current value of financial asset (to the prospective investor) is the present value
of future cash benefits at a given discount rate. This technique is known as
Discounted Cash Flow Model

COMMON STOCK VALUATION

 The major benefits of holding common stock are:

1. Dividend
2. Capital gain (appreciation in stock price)
 The cash flows associated with investment in common stock are influenced by
much uncertainty
 Basic concepts in common stock valuation include:
1. Market price – the price at which a stock sells in the market
2. Growth rate (g) – the expected rate of growth in dividend per share
3. Required Rate of Return (Ks)– the minimum rate of return that a
stockholder considers acceptable.
 Required Rate of Return has three components:
a. Real Rate of Return – the rate of return the investor demands for
giving up current use of the fund on a non-inflation adjusted basis.

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 b. Inflation premium –compensation for the eroding effect of inflation on
the value of money

Risk-free rate of return = a + b

c. Risk Premium – a compensation for assuming certain level of risk

Ks = a + b + c

4. Expected Rate of Return – the rate of return that the shareholder expects to
receive on common stock
5. Actual (Realized) Rate of Return – the rate of return the investor actually
received on common stock. It is also called After-the fact rate of return.
6. Dividend Yield (DY) –Expected dividend divided by stock price
7. Capital Gain Yield (CGY) - capital gain divided by stock price at the
beginning of the period
8. Expected Total Return – Expected dividend yield plus Expected capital gain
yield

Common Stock Valuation Models

 Present value techniques are used in the valuation of common stock

 The value of common stock (Po) is determined as the present value of a stream of
dividends and the expected sale price. i.e.

Po = PV of Future Dividends + PV of expected sale price

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 There are different common stock valuation models depending on the timing of
cash flows:
1. Limited periods valuation model
Assumption: The investor will hold the stock for limited period of time

Example 1: Assume that the investor is considering holding the stock for two years
and sells it thereafter. Dividends are expected to be Br. 60 and Br. 90 at the end of
year 1 and year 2 respectively. The stock is expected to be sold at Br. 200 after two
years. The required rate of return is 10%. What is the value of stock today?
Answer:

=294.08
Where, Po = current stock price

Example 2: Assume the investor is considering holding the stock for eight years
and sells it thereafter for Br. 500. Annual dividend is expected to be Br. 100 per
share. The required rate of return is 6%. What is stock price today?
Answer:

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 Po = 100 (6.210) + 500 (0.627)
= 934.50

2. Unlimited Period Valuation Model

Assumptions:
 The investor will hold the stock for indefinite period of time
 Annual dividend is expected to be constant
N.B. The only cash flow is annual dividend. There is no sale price.

Example: Assume that the investor expects to hold the stock for unlimited period
of time. Annual dividend is expected to be Br. 100 per share. If the required rate of
return is 10%, what is current stock price?
Answer:

D = Annual Dividend i= required rate of return

= 1000
Where,
D = Annual dividend per share
i = Required Rate of Return

3. Constant Growth Stock Valuation (Gordon) Model

Assumptions:
 The stock will be held forever
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  Dividend will grow at a constant rate per year forever

or

Where,
D1 = Expected dividend per share for year 1
Do = Current dividend per share
i = Required Rate of Return
g = Dividend growth rate

Example: Assume that the investor is considering holding the stock forever.
Current dividend is Br. 100 per share. Dividend is expected to grow at the rate of
2%. The required rate of return is 5%. What is the current stock price?

Answer:

= 3400

4. Delayed No growth in Dividends Model

Assumptions:
 The stock will be held forever
 No dividend for the first few years and once started dividend will remain
constant forever
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Example: Assume that the investor expects to hold the stock forever. No dividend
is expected for the first four years. The first dividend is expected to occur at the end
of year 5 in the amount of Br.100 and is expected to continue forever. The required
rate of return is 10%. What is stock price today?

Answer: The following steps may be used to compute the value of the stock:
Step 1: Compute the price of the stock at the end of year 4 (P4)
 Using present value of perpetuity

= 1000
Step 2: Compute the present value of P4

= 1000 (0.683)
= 683
5. Delayed Constant Growth in Dividends Model
Assumptions:
 The stock will be held forever
 No dividend for the first few years and once started dividend will grow at
a constant rate forever

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Example: Assume that the investor expects to hold the stock forever. No dividend
is expected for the first four years. The first dividend is expected to occur at the end
of year 5 in the amount of Br.100 and is expected to grow at the rate of 4% a year
forever. The required rate of return is 10%. What is stock price today?

Answer: The following steps may be used to compute the value of the stock:
Step 1: Compute the price of the stock at the end of year 4 (P4)
 Using Gordon model

P4 = 1667

Where,
D5 = Expected dividend per share for year 5

Step 2: Compute the present value of P4

= 1667 (0.683)
= 1139
6. Non-constant (Super normal) growth Model

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  Arises when the firm’s growth rate is greater than the growth of the economy
 Growth rate is unusual for some earlier years, then it becomes normal
 May be terminating or perpetual

Example: Assume that the investor is considering holding the stock forever. The
current dividend per share is Br. 100. Dividend is expected to grow at a super
normal growth rate of 10% per year for the next three years and then will grow at a
normal rate of 4% a year forever. The required rate of return is 12%. What is the
current stock value?

Answer
Step 1: Compute dividend at the end of each year during the supernormal growth
period
D1 = Do (1+g)
= 100 (1.10) = 110
D2 = 110 (1.10) = 121
D3 = 121 (1.10) = 133.1
Step 2: Compute the present value of dividends during the super normal growth
period

Year Dividend Discount factor Present value

1 110 0.893 98.23
2 121 0.797 96.437
3 133.1 0.712 94.7672

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 Present value of 1st three years dividends 289.4342
Step 3: Compute stock price at the end of the super normal growth period i.e. end
of year 3 (using Gordon model)
D4 = 133.1 (1.04) = 138.424

P3 = 1730.30
Step 4: Compute the present value of P3 (using present value of a single amount
model)
Pv of P3 = 1730.30 (0.712) = 1231.97
Step 5: Determine the current stock price (Po)
Po = Step 2 + step 4
= 289.4342 + 1231.97
= 1521.4042
Determining the Required Rate of Return on Common Stock
The following methods may be used to determine the required rate of return on
common stock:
1. Gordon model

Where, i = Required Rate of Return on common stock

= Expected Dividend yield
g = Expected Capital Gain Yield

Example: Suppose that the expected dividend per share for year 1 of ABC
Corporation is Br. 80. Dividend is expected to grow at the rate of 3% per annum.

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The current stock price is Br. 800. What is the required rate of return on common
stock?

Answer:

= 13%
Using Gordon model, one can also determine price at the end of each year, dividend
yield, and capital yield. Accordingly, using the above data, they are determined as
follows:

Stock price at the end of each year for three years:

P1 = Po (1+g) = 800 (1.03) = 824

P2 = P1 (1+g) = 824 (1.03) = 848.72
P3 = P2 (1+g) = 848.72 (1.03) = 874.18

Dividend at the end of each year for three years:

D1 = 80
D2 = D1 (1+g) = 80(1.03) = 82.4
D3 = D2 (1+g) = 82.4 (1.03) = 84.872

Dividend Yield for the first three years:

Capital Gain Yield for the first three years:

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 2. Capital Asset Pricing Model (CAPM)
K = Krf + (Km – Krf) 
Where,
K = Required Rate of Return on common Stock
Krf = Risk free rate of return
Km = Average market return
 = Beta coefficient (represents the level of risk)
Km – Krf = Market Risk Premium

Example: Suppose the risk free rate of return and the average market return are
10% and 13% respectively. Determine the required rate of return if  is:
a. 1.2 b. 2 c. 3.5
Answer:
a.  = 1.2
K = Krf + (Km – Krf) 
K = 10% + (12% – 10%) 1.2
= 0.124
b.  = 1.2

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 K = Krf + (Km – Krf) 
K = 10% + (12% – 10%) 2
= 0.14
c.  = 3.5
K = Krf + (Km – Krf) 
K = 10% + (12% – 10%) 3.5
= 0.17

VALUATION OF PREFERRED STOCK

Preferred stock is a hybrid security. It is similar with bonds in some respects and to
common stock in others. Like bonds, preferred stock has a par value and a fixed
dividend amount. On the other hand, like common stock, failure to pay dividend on
preferred stock does not lead to bankruptcy. Basically, preferred stock is perpetual,
paying the owner a constant dividend forever. The value of preferred stock is
determined as follows:

Where,
Vp = Value of preferred stock
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Bp = Preferred dividend 14
Kp = Required rate of return on preferred stock
Example 1: The preferred stock of the company pays an annual dividend of Br. 120
per share. The investor expects to hold the stock forever. If the required rate of
return is 8%, what is the value of the stock today?
Answer:
Using present value of perpetuity concept, the value of preferred stock is computed
as follows:

= 1500
Example 2: The preferred stock of the company pays an annual dividend of Br.
400 per share. The investor expects to hold the stock forever. The current value of
the stock is Br.8000. what is the required rate of return on the stock (Kp)?
Answer:
Solving preferred stock valuation model for Kp results in the following formula:

= 5%

VALUATION OF BONDS
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Meaning and Characteristics of Bonds

A bond is a long-term contract under which a borrower agrees to make payments of

interest and principal, on specific dates, to the holder of the bond. Bonds are debt
securities. They are issued by the borrower. Purchasers of bonds (bondholders or
investors) receive periodic interest payments (called coupon payments) until
maturity at which time they receive the face amount of the bond and the last coupon
payment. Bonds may pay interest monthly, quarterly, semiannually or annually.
However, most bonds pay interest semiannually. Bonds may be issued by
governments and corporations.

Bonds have the following characteristics:

1. Par or face value: The amount of money that is paid to the bondholder at
maturity.
2. Coupon (stated) interest rate: The interest cost of the bond issue to the issuer.
It is the interest rate stated on the face of the bond. It is used to compute periodic
interest (coupon) payment.
3. Coupon payments: The periodic interest payments from the bond issuer to the
bondholder. It is computed by multiplying the coupon rate by the face value.
4. Maturity date: The date on which the face value is repaid.
5. Original maturity: The time remaining until the maturity date when the bond
was issued.
6. Remaining maturity: The time currently remaining until the maturity date.

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7. Call date: The date at which the bond can be called (for callable bonds). A
callable bond is a bond which can be redeemed by the issuer prior to maturity.
8. Call price: The amount of money the issuer has to pay to call a callable bond.
9. Required Rate of Return: The rate of return that investors currently require on
a bond. It is also called effective interest rate, market interest rate, or Yield to
maturity. It is used to discount the future cash flows of the bond to determine the
bonds current value.
10. Yield to maturity: The rate of return that an investor would earn if s/he
bought the bond at its current market price and held it until maturity. It represents
the discount rate that equates the discounted value of a bond’s future cash flows
to its current market price.
11. Yield to call: The rate of return that the investor would earn if s/he bought a
callable bond at its current marked price and held it until the call date given that
the bond was called on the call date.
12. Premium on bonds: The difference between the bond’s market price and its
face value. Premium on bonds occurs when market price exceeds face amount.
13. Discount on bonds: Discount on bonds occurs when the bond’s face amount
is greater than its market price.

Types of Bonds

Generally, bonds may be classified in to four types:

1. Treasury (government) bonds: Bonds issued by the government
2. Corporate bonds: Bonds issued by corporations

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 3. Municipal bonds: Bonds issued by state and local governments
4. Foreign bonds: Bonds issued by foreign governments or corporations
Types of Corporate Bonds
There are various types of corporate bonds. Some of them are discussed below:
1. Zero-coupon bonds: Bonds issued at a discount. They do not have stated
interest rate
2. Floating rate bonds: Bonds whose interest rate fluctuates with shifts in general
level of interest rate
3. Callable Bonds: Bonds which can be redeemed by the issuer prior to maturity
4. Convertible bonds: Bonds that are exchangeable for common stock at the
option of the holder.
5. Income bonds: Bonds which pay interest only if the interest is earned.
6. Indexed (purchasing power) bonds: Bonds whose interest payments are based
on inflation index.
7. Term bonds: Bonds whose principal is repaid on specific maturity date in the
future
8. Serial bonds: Bonds whose principal is paid on a periodic basis over certain
period.

Determining the Value of Term Bonds

 The major cash benefits from investment in bonds are:

1. Periodic interest payment
2. Principal repayment at maturity
 The present value technique is used in the valuation of bonds.

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 The value of a bond is equal to the present value of periodic interest payments
plus the present value of principal repayment at maturity.

Where,
VB = the value of a bond
INT = Periodic interest payment
M = Principal repayment at maturity
kd = Required rate of return on bonds
n = Number of periods to maturity

Bond Valuation When Interest is Paid Annually

 The value of the bond may be:
1. equal to its face amount,
2. greater than its face amount, or
3. less than its face amount
 If coupon interest rate is less than market interest rate, the value of the bond is
less than its face amount. The bond is said to be issued at a discount. Discount is
the difference between face amount and value of the bond
 If coupon interest rate is greater than market interest rate, the value of the bond is
more than its face amount. The bond is said to be issued at a premium. Premium
is the difference between the value of a bond and its face amount.
 If coupon interest rate is equal to market interest rate, the value of the bond is the
same as its face amount.
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Example: The investor is considering investing in a Br. 250,000, 10%, 10 years
term bonds of ABC Corporation. Interest is paid annually. Determine the value of
the bonds if the market interest rate is:
a. 8% b. 14% c. 10%
Answer:
a. Kd = 8%
Annual interest payment (INT) = 250,000 X 10% = 25,000
N = 10
Kd = 8%

=25000(6.710) + 250,000(0.463)
=283,500
Premium on bonds = 283,500 – 250,000 = 33,500
b. Kd = 14%
Annual interest payment (INT) = 250,000 X 10% = 25,000
N = 10
Kd = 14%

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 = 25,000 (5.216) + 250,000(0.270)
= 197,900
Discount on bonds = 250,000 – 197,900 = 52100

c. Kd = 10%
Annual interest payment (INT) = 250,000 X 10% = 25,000
N = 10
Kd = 10%

= 25,000 (6.145) + 250,000(0.386)

= 250,125
The value of the bond is approximately equal to its face amount.

Bond Valuation when interest period is less than a Year

Example: The investor is considering investing in a Br. 500,000, 14%, 5 years term
bonds of XYZ Corporation. The market interest rate is 12%. Determine the value of
the bonds if interest is paid:
a. Annually b. Semiannually c. Quarterly

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Answer
a. Interest paid annually
Annual interest payment = 500,000 x 0.14 = 70,000
N=5
Kd = 12%

= 70,000 (3.605) + 500,000(0.567)

= 537,850
b. Interest paid semiannually
Annual interest payment = 500,000 x 0.14 x 6/12 = 35,000
N = 5 x 2 = 10

= 35,000 (7.360) + 500,000(0.558)

= 536,600
c. Interest paid quarterly

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 Annual interest payment = 500,000 x 0.14 x 3/12 = 17500
N = 5 x 4 = 20

= 17,500 (14.88) + 500,000(0.554)

= 537,400

Yield to Maturity and Yield to Call

Yield to maturity (YTM) refers to the rate of return that an investor would earn if
s/he bought the bond at its current market price and held it until maturity. It
represents the discount rate that equates the discounted value of a bond’s future cash
flows to its current market price. Yield to maturity may be computed in two ways:
1. Trial and error. Trial and error involves a lot of computations and, thus, is
not recommended.
2. Formula. The yield to maturity may be computed using the following
formula:

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 Where,
F = Periodic interest payment
P = Principal
VB = The value of bonds
N = Number of periods to maturity
Example: Assume that the current price of a Br. 5000, 10%, 10 years term bonds is
Br. 4500. Determine yield to maturity if interest is paid:
a. Annually b. Semiannually
Answer
a. Interest is paid annually
F = 5000 x 10% = 500
VB = 4500
N = 10
P = 5000

= 0.117
b. Interest paid semiannually
F = 5000 x 10%x 6/12 = 250
VB = 4500
N = 10 x 2 = 20

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 P = 5000

= 0.0585
Exercise
Assume that the current price of a Br. 20,000, 6%, 10 years term bonds is Br.
22,000. Determine yield to maturity if interest is paid annually.

Yield to call (YTC) is the rate of return that the investor would earn if s/he bought
a callable bond at its current marked price and held it until the call date given that
the bond was called on the call date.
The value of a callable bond is the sum of the present value of periodic interest
payments and the present value of call price. Its yield to call is computed as
follows:

Where,
F = Periodic interest payment N = Call protection period
CP = Call price YTC = Yield to call
VB = the value of bonds

Example: Assume that the current price of a Br. 2000, 10%, 10 Years term bonds is
Br. 1900. These bonds can be called five years from now at a call price of Br. 2100.
Interest is paid annually.

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a. Call premium = Call price – Face amount
= 2100 – 2000
= 100
b. Yield to Call
F = 2000 x 0.10 = 200
N= 10

= 12.12%
Exercise
Assume that the current price of a Br. 10,000, 8%, 10 Years term bonds is Br.
10,400. These bonds can be called fours years from now at a call price of Br.
10,250. Interest is paid annually. Determine call premium and Yield to call.

Call premium = Call price – Face value

= 10,250 – 10,000 = 250

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