Chapter – 3

VALUATION OF BONDS
AND SHARES

- Dr. Geetika Gahlot

 BOND AND ITS FEATURES
• A bond is a long-term debt instrument or security.
• It represents a contract under which a borrower
promises to pay interests and principal on specific dates
to the holders of the bond.
• Bonds are issued by a variety of organizations. The
principal issuers of bonds in India are the central
government, state government, public sector
undertakings, and private sector companies.
• Bonds issued by the central government are called
Treasury Bonds. These are bonds which typically have
maturities ranging from 3 to 20 years. These bond
generally pay interest semi-annually.
• State government bonds are issued by the state
governments. These bonds also have maturities that
generally range from 3 to 20 years and pay interest
semi-annually.
• Bonds issued by companies are classified into two types:
PSU (public sector undertakings) bonds and private
sector bonds. Both kind of bonds have maturity ranging
1 – 15 years and pay interest semi-annually.
✓ PSU bonds are bonds issued by companies in which the
central or state governments have an equity stake in
excess of 50%.
✓ Private sector bonds are bonds issued by private sector
companies.
The main features of a bond are as follows:
✓ Face value – Face value is called as par value. A bond is
generally issued at par value of Rs 100 or Rs 1,000, and
interest is paid on this.
✓ Interest rate – Interest rate is fixed and known to the
bondholders. Interest paid on a bond is tax deductible. It is
also called as coupon rate.
✓ Maturity – A bond is generally issued for a specified period of
time. It is repaid to maturity.
✓ Redemption value – The value that a bondholder will get on
maturity is called redemption, or maturity value. A bond may
be redeemed at par or at premium or at discount.
✓ Market value – A bond may be traded in a stock exchange.
The price at which it is currently sold or bought is called the
market value of the bond. It may be different from the par
value or redemption value.
 BOND VALUATION
• The value of a bond – or any asset, real or financial – is
equal to the present value of the cash flows expected
from it.
• Hence determining the value of a bond requires:
✓ An estimate of expected cash flows
✓ An estimate of the required rate of return.
• To simplify the analysis of bond valuation, following
assumptions are made:
✓ The coupon interest rate is fixed for the term of the
bond.
✓ The coupon payments are made annually and the next
coupon payment is receivable exactly a year from now.
✓ The bond will be redeemed at par on maturity.

• Therefore, the cash flow for a non-callable bond (a bond

that cannot be prematurely retired) comprises of an
annuity of a fixed coupon interest payable annually and
the principal amount payable at maturity.
• Hence the value of the bond is:
P = Ʃ [C/(1+r)t + M/(1+r)n
Where, P is the value of the bond,
C is the annual coupon payment,
M is the maturity value,
r is the periodic required return,
n is the number of years to maturity,
t is the time when the payment is received.
• Since the stream of coupon payments is an ordinary
annuity, the formula for the present value can be
applied.
P = [C × PVIFAr,n] + [M × PVIFr,n]
Q. Consider a 10-year, 12% coupon bond with a par value of
₹ 1,000. The required yield on this bond is 13%. The
cash flows of this bond are as follows:
- 10 annual coupon payments of ₹ 120
- ₹ 1,000 principal repayment 10 years from now.
What is the value of the bond?

➢ P = [C × PVIFAr,n] + [M × PVIFr,n]
P = [120 × PVIFA(13%,10yrs)] + [1,000 × PVIF(13%,10yrs)]
P = (120 × 5.426) + (1,000 × 0.295)
P = ₹ 946.10
 Bond Values with Semi-Annual Interest
• Most of the bonds pay interest semi-annually. This means
that the bond valuation equation has to be modified
along the following lines:
✓ The annual interest payment, C, must be divided by 2 to
obtain the semi-annual interest payment.
✓ The number of years to maturity must be multiplied by 2
to get the number of half-yearly periods.
✓ The discount rate has to be divided by 2 to get the
discount rate applicable to half-yearly periods.
P = Ʃ [(C/2)/(1+r/2)t] + [M/(1+r/2)2n
P = C/2(PVIFAr/2,2n) + M(PVIFr/2,2n)
Q. Consider a 2 year, 12% coupon bond with a par value of
₹ 100 on which interest is payable semi-annually. The
required rate of return on this bond is 14%. What is the
value of the bond.

➢ P = [6 × PVIFA(7%,4)] + [100 × PVIF(7%,4)]

➢ P = Ʃ [6/(1+0.07)4] + [100/(1+0.07)4]
= 6/(1+0.07)1 + 6/(1+0.07)2 + 6/(1+0.07)3 +
6/(1+0.07)4 + 100/(1+0.07)4
 BOND YIELD
• Current Yield – The current yield relates the annual
coupon interest to the market price.
Current Yield = Annual Interest / Price

• Yield to Maturity – The yield to maturity (YTM) of a bond

is the interest rate that makes the present value of the
cash flows from owning the bond equal to the price of
the bond.
P = C/(1+r) + C/(1+r)2 + … + M/(1+r)n [Trial and error]
An approximation,
YTM = [C+{(M–P)/n}] / (0.4M+0.6P)
• Yield to Call – Some bonds carry a call feature that
entitles the issuer to call (buy back) the bond prior to
the stated maturity date in accordance with a call
schedule. For such bonds, it is a practice to calculate the
yield to call (YTC) as well YTM.
Mathematically, the YTC is the value of r in the following
equation:
P = Ʃ C/(1+r)t + M/(1+r)n
 EQUITY VALUATION: Dividend Discount
Model (DDM)
• A firm’s internal equity consists of its retained earnings.
• The opportunity cost of the retained earnings is the rate
of return forgone by equity shareholders.
• It is that discount rate that equates the present value of
the stream of expected future dividends with the
current market price/issue price.
P0 = [D1/(1+r)1] + D2/(1+r)2 + … + D∞/(1+r)∞
P0 = Ʃ Dt/(1+r)t
where, Po = CMP of the Equity Share at time ‘to’
Dt = Expected Dividend per share at time ‘t’
r = expected rate of return
 Single-Period Valuation Model
• When the investor expects to hold the equity share for
one year, the price of the equity share will be:

P0 = [D1/(1+r)] + [P1/(1+r)]

where, P0 is the current price of the equity share,

D1 is the dividend expected a year hence,
P1 is the price of the share expected a year hence,
r is the rate of return required on the equity share.
 DDM – Normal Growth

• If the dividends are expected to grow at a constant rate

‘g’, and r > g, then,
P0 = D1/(r-g) ‘or’ r = (D1/P0) + g

• Assumptions:
✓ The market price of the ordinary share, P0 is a function of
expected dividends.
✓ The dividend, D1 is positive (D1>0).
✓ The dividends grow at a constant growth rate g, and the
growth rate is equal to the return on equity, ROE, times the
retention ratio, b (g=ROE×b).
✓ The dividend payout ratio (1-b) is constant.
 DDM – Zero Growth

• The dividend discount model can also be used to

estimate the expected rate of return of no-growth
companies.
• The expected rate of return of a share on which a
constant amount of dividend is expected perpetually is
follows:
r = D1/P0
• The growth rate g will be zero if the firm does not retain
any of its earnings, i.e., the firm follows a policy of 100%
payout. Under such case, dividends will be equal to
earnings.
r = D1/P0 = EPS1/P0 (since g=0)
 Two-Stage Growth Model
• The simple extension of the constant growth model
assumes that the extraordinary growth (good or bad) will
continue for a finite number of years and thereafter a
normal growth rate will prevail indefinitely.
1+g1 n
P0 = D1 1 - 1+r + D1(1+g1)n-1(1+g2) 1
r – g1 r – g2 (1+r)n
where, P0 is the current price of the equity share,
D1 is the dividend expected a year hence,
g1 is the extraordinary growth rate applicable for n years,
g2 is the growth rate in the second period,
r is the rate of return required on the equity share.
 H Model
The H model of equity valuation is based on the following
assumptions:
• While the current dividend growth rate, ga, is greater
than gn, the normal long-run growth rate, the growth
rate declines linearly for 2H years.
• After 2H years, the growth rate becomes gn.
• At H years, the growth rate is exactly half-way between
ga and gn.
1. What is the current yield of a 10 year, 12% coupon bond with
a par value of ₹ 1000 and selling for ₹ 950?

2 . Consider a ₹ 1,000 par value bond, carrying a coupon rate of

9%, maturing after 3 years. The bond is currently selling for
Rs 800. What is the YTM on this bond?

3. Ramesh Engineering Ltd. is expected to grow at the rate of

6% per annum. The dividend expected on Ramesh’s equity
share a year hence is ₹ 2.00. What price will you put on it if
your required rate of return for this share is 14%?

4. A ₹ 100 par value bond bearing a coupon rate of 12% will

mature after 5 years. What is the value of the bond, if the
discount rate is 15%?
5. The market price of a ₹ 1,000 par value bond carrying a
coupon rate of 14% and maturing after 5 years is ₹
1,050. What is the yield to maturity (YTM) on this bond?

6. A ₹ 100 par value bond bears a coupon rate of 14% and

matures after 2 years. Interest is payable semi-annually.
Compute the value of the bond if the required rate of
return is 16%.

7. The equity stock of Wax Ltd. is currently selling for ₹ 30

per share. The dividend expected next year is ₹ 2.00. the
investor’s required rate of return on this stock is 15%. If
the constant growth model applies to Wax Limited,
what is the expected growth rate?
8. The current dividend on an equity share of Zio Ltd. is ₹ 3.
Zio Ltd. is expected to enjoy an above-normal growth rate
of 40% for 5 years. Thereafter, the growth rate will fall and
stabilize at 12%. Equity investors require a return of 15%
from Zio’s stock. What is the intrinsic value of equity share
of Zio Ltd.?

9. The current dividend on an equity share of National

Computers Ltd. is ₹ 5. The present growth rate is 50%.
However, this will be decline linearly over a period of 8
years and then stabilize at 10%. What is the intrinsic value
per share of National Computers, if investors require a
return of 18% from its stock?