Chapter 3 VALUATION OF BONDS Dr Neetu Bhardwaz Faculty in Finance and Research OUTLIN * Bonds valuation Terminologies + Bond Valuation * Bond Yields * Bond Market + Preferred Stock Valuation + Equity Valuation : Dividend Discount Model + Equity Valuation : PE Ratio Approach + Earnings-Price Ratio, Expected Return, and Growth + Stock Market17-Aug-22 BONDS VALUATION Bondidebenture is a fixed income securities which allows lenders to lend a pre determined amount of funds and be eligible for interest on those funds. Most bonds, particularly corporate bonds (i) pay interest half-yearly (semi-annually) at a stated coupon interest rate, (ii) have an initial maturity of 10-years and (iii) have a Pariface value of Rs 1,000 that must be repaid at maturity. WHENEVER YOU PURCHASE ANY BOND PLEASE CHECK -y™ * Coupan rates + Minimum amount required. ‘Taxation (tax free income, No tax on interest + and TDs . Eg Public bonds) + Ratings (ICRA, CARE, CRISIL) + Interest payment frequency + TimeTERMINIOLOGIES Par value is the value on the face of the bond. It represents the amount the entity borrows and promises to repay at the time of maturity. Coupon rate is the specified interest rate. The interest Payable to the bondholder is equal to par value x coupon rate. Maturity period refers to the number of years after which the par value is payable to the bondholder. Redemption — Payment done by the lender depending upon the tenure. e Coupan Payment - Payment made by the issuer to bond holder, Issue Price - The price at which bond has been issued Market Price- Once the bond is floated it will be available in the secondary market. Maturity Date- A pre decided date by which it should get mature. Intrinsic value/ Desired rate/ Expected rate — Present value of all the future cash flows receivable to bond holde PY of Interest + PV of Redemption value. @ 17-Aug-22*Collable and Puttable bonds. C. to take back its bonds before mat «When seller has the ri becomes puttable bonds ompany has a right urity. ight to sell to company it *Zero Coupons Bonds : No coupons payments. “Annuity Bonds: Interest and repayment of principal is arranged in such a manner that you get in form of annuity. (No coupon payment no redemption) VALUE OF A BO. TOM OFA BOND a Bo = It RV ter (+kd7ry + (+key = Annual interest (1+kdy= Annual interest till the maturity period (iskdy= At the date of ‘maturity period P=IxPVAF,, + RV& PVF,,ILLUSTRATION 1 *A Rs. 1,000 par value bond carries coupan rate 6%p.@ and is redeemable after 3 yrs at ee The required rate Feturn 1s. 1200 Wy Solution : Given F.V 1,000, Coupan rate 6% , N= 3 yrs Step 1 : Annual Interest 6% of 1,000 kd orr= 12% First year annual interest rate 60 Redemption value ~ 1,000 AS PER FIRST FORMULA * BO/(1+.12)"" + 60/(14.12)8 + 607 (1+12)° F1000/¢1412)? "= 53.57 + 47.83 + 42.70 +712 "= 144.1+712 *856.1 PV of Bond 17-Aug-22STEP 2 Intrinsic value / True value is always compare with the market value + LV> MV (Investors should BUY) * Getual worth is more) OTHER FORMULA (NEED TO USE TABLE FOR PV ANNUITY FACTOR TABLE AND PV FACTOR) +50 + GO(PVAP 2,3) + 1000 (PVF (1,3) + 60 (2.402) + 1000 (0.712) +1462 +712 + ANSWER : 856.12 17-Aug-2217-Aug-22 BUY SELL (indifferent, Fairly price) =Q2 A 1,00 Bond, 15% bond is available at a price of Rs. 900 in the market. The Bond is redeemable at par after 10 yrs. Interest is payable annually should an investor buy this bond. If his required rate of return is 16%ILLU TRATION 3 To illustrate how to compute the price of a bond, consider a 10-year, 12 [percent coupon bond with a par value of 1,000. Let us assume that the Tequired yield on this bond is 13 percent. The cash flows for this bond are as follows: + 10 annual coupon payments of Rs. 120 + Rs, 1000 principal repayment 10 years The value of the bond is: P=IxPVAF,, + RVx PVF, P= 120 x PVAF 394, 10ys + 1,000 X PVF 1356, = 120 x 5.426 + 1,000 x 0.295 = 651.1 +295 =Rs, 946.1 loys ILLUSTRATION 3 * A= 1,000 , 16 % bond is available at a price of Rs 900 in the market. The bond is redeemable at par after 10 yrs. Interest is payable annually should an investor buy this bond. If his required rate of return is 16% * Solution: 27? * Face value 1,000 coupan rate 15% so 1000 18% 17-Aug-22(1+4/2" or 2. P=V/2x PVFA,), + M(PVIE, 22») ILLUSTRATION As an illustration, consider an 8 year, 12 percent coupon bond with a par! value of Rs. 100 on which interest is payable semi-annually. The required return on this bond is 14 percent. Applying Eq.(7.2) the value of the bond is: 16 On mas 100 “t=1 (L707) = 6(PVIFA 94.46) + 100 (PVIF 9616) = Rs. 6(9.447) + Rs.100 (0.339) = Rs, 90.6 1017-Aug-22 ~ PRICE-YIELD RELATIONSHIP Price Premium, P; Discount Coupon rate > Required yield > Price > Par (Premit Coupon rate > Required yield —+Price = Par Coupon rate < Required yield —»Price < Par (Discount bol nuPRICE - YIELD RELATIONSH PRICE, VALUE OF BOND 1. Bond prices & yields mor directions 2. Bond Prices Are More Sensitive To Changes The Longer Their Maturities 3. The price sensitivity of bonds to yield changes increases at a decreasing rate with maturity 4. High coupon bond prices are less sensitive id changes than low coupon bond prices 5, With a change in yield of a given number of basis points, the associated percent gain is larger than the percent loss. 17-Aug-22 12BOND Yr SOND YIELDS + CURRENT YIELD ANNUAL INTEREST PRICE ELD TO MATURITY ¢ c c CON iris we : (yen (trae 8 90 1,000 We ke Ly (nt avr 13%... RUS = 808 Avr 14% RUS = 768.1 808-800 YTM = 13% + (14% - 13%) —— = 132% 808 768.1 C+O-P)/n Can se eal 0.4M+0.6 P + YIELD TO CALL, pees C. ae P= 3 a 1 (ery ay [SED YIELD TO MATURITY | sINVESTMENT. * ANNUAL INTEREST 150 150 + REINVESTMENT PERIOD (IN YEARS) 4 3 + COMPOUND FACTOR (AT 16 PERCENT) 181 186 135 + FUTURE VALUE OF INTERMEDIATE CASH FLOWS 271.5 234.0 202.8 1744 + MATURITY VALUE + TOTAL FUTURE VALUE. = 2715+ 2340+ 202.54 1740+ 150.0 1000 = 2032 (1+) = 2032 /850 = 2.391 r* = 0.19 OR 19 PERCENT 17-Aug-22ILLUSTRATIVE QUOTATION An illustrative quotation from the WDM segment of NSE no —Te] IR) trades on 31/12/2014 in 8.40% government securities (GS) issued by-entral government (CG) and 9.85% bank bonds (BB) issued by SBI is given pertaining to Dae] Seay | fee estes ey | Same feesisnslees|sia== The retail trade in corporate debt securitit market segment of the National Stock Excl the Bombay Stock Exchange. tly on the capital segment of| Since the stream of dividends is an ordinary annuil formula for the present value of an ordinary annuity. the preference stock is: P, = Dx PVIFAt yp, + MX PVIFY py To illustrate how to compute the value of a preference stock, c 8 year, 10 percent preference stock with a par value of Rs. 10\ required return on this preference stock is 9 percent. 17-Aug-22SS ee VALUATION OF PREFEREN The value of the preference stovkis P= 100 x PVIFA 99, gy, + 1000 x 9%, 8 yrs 100 x 5.535 x 1000 x 0.502 Rs. 1110.5 D, Pet aaa + (I+r) (147) + MULTI - PERIOD VALUATION MODEL. o dD Pyne act 1 (14 + ZERO GROWTH MODEL D Py . r + CONSTANT GROWTH MODEL dD, R= rag 17-Aug-2217-Aug-22 D, (1+g,"! a i (i+r)" T-8)PRICE DIVWEND — CAPITAL, price GAINS EARNINGS YIELD RATIO 1,000 + SO shares + Value-weighted index Centre for Fnac Management angle ISIN stands for International Securities IdentificNQyy Number. 1817-Aug-22 + The term value is used in different value, going concern value, book val intrinsic value are the most commonly value. + The intrinsie value of any asset, rea ot financial, to the present value of the cash flows expected from Hence, determining the value of an asset requires an estimate of expected cash flows and an estimate of the * The value of a bond is: f= ee Gay = (Hy “© Centre for Financial Management Bangalore + A basic property of a bond is that its price varies inversely with yield. + The relationship between coupon rate, reyyired yield, and bond price is as follows: Coupon rate < Required yield Price Required yield ~+Price > Par (Premium + The current yield on a bond is defined as: Annual inter Price. {© Centre for Financial Management, Bangalore 192 P-Aug-22 |. The yield to maturity (YT) 4 bond is the [Tt rate of | investor eams when he buys the Bond and holds it ‘il rig, It is the value ofr in the bond valuatid iodel, For estimatin; ; YTM readily, the following approximatio yim= Ct(EPyn 0.4M + 0.6P - According to the dividend discount model, the val equity share is equal to the present value of dividends ed from its ownership. If the dividend per share remains constant rate, the value share is: Po=D/r Ifthe dividend per share grows at a constant rate, the value of the share is: Po=D,/(r~8) The two key drivers of dividend growth a%w(g) ploughback ratio and (b) return on equity. The value per share, according to the H model is D, (1+8y) : H(BarBn) 18, 18 An approach to valuation, practised widely by investment an the P/E ratio approach. The value of an equity share, under thi approach, is estimated as follows: Po= Ex Po/ EyyA 17-Aug-22