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
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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

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 similarities and differences among industry classification

systems?
How does an analyst go about choosing a peer group of companies?
What are the key factors to consider when analysing an industry?
What advantages are enjoyed by companies in strategically
wellpositioned industries?

Company Analysis
Company analysis is done after the analyst has done industry analysis. It
facilitates in understanding the company's external 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

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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:
CFI CF2 CF3 CFn

(1+r)n

Where PV present value of security r =

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

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3 10,000
4 10,000
Discount rate is 10%.

Value of Asset 10,000 x PVIFA10,410,000 x 3.170Rs. 31,700

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
earn 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 [Link] 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

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basic equation for the present value of a bond on which annual interest is
received will be as follows:

Where present value of the bond at time zero kd=

required rate of return on bond
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:

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 = ? 1000,
kd (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

Where present value of the bond at time zero

Substituting the given values in the above formula, we get,

100 1000

Here,
(1+.10)1 (1+.10)5

100 (PVAF) + 1,000 (PVIF)

100 (10,5) + 1,000 (10,5)
100 (3.791) + 1000 (.621)

= 379.1 + 621 =

Before you learn, 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
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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.

Yield to Maturity
Yield to maturity (YTM) is the discount rate at which the sum of all future
cash 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 [Link] is usually
an annual percentage rate. The following formula is used to get YTM:
FV-PV
YTM =
2
Where:
I = Interest payment

FV = Face Value

PV = present Value (current price of the bond)

t years to maturity
Illustration 3
Assume that there is a bond in the market priced at 700 and that the bond has
a face value of 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 ? 700
Face Value = a 000
Interest = 50

Kd(required return on bond) = 15%

We use the formula below to calculate YTM

FV-PV

YTM
2

Where, I — Interest payment

Face Value

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PV — present Value (current market price of the
bond) t — years to maturity
Substituting the given values in the above formula, we get,
150+ 1000—700

YTM 1000+7006
2
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
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 - of 500 -
40
Bond Value at 14% at 5 years
Bond value = 1 (PVAF n) + RV (PVF n)

40 (PVAF 14,5) + 500 (PVF14,5)

- 40 x 3.4331 + 500 x 0.5194

137.324 + 259.7

- Rs. 397.024
Bond Value at 7% at 5 years

Bond Value 40 (PVAF7,5) + 500 (PVF7,5)

40 (4.1002) + 500 (0.7130)

164.008 + 356.6

- Rs. 510
Illustration 5:

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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
120/6

Solution: We are given

Redeemable Value

Interest

Required rate of return 120//0

years to maturity n 4 years Annual

interest — of 1000 =

a) Bond value 1 (PVAF n) + RV (PVF kd, n)

100 x 3.0373 + 1000 x 0.6355
- 303.73 + 635.5
Rs. 939.23
Ans. The value of the bond is 039.23
b) Bond value = 1/2 (PVAF kd/2, n*2) + RV (PVF kd/2, n*2)
100/2(6.2098) +1000 (0.6274)
310.49 + 627.4

037.89
Ans. The value of the bond is 037.89
c) Bond value = 1/4 (PVAF kd/4, n*4) + RV (PVF kd/4, n*4)
100/402.561) +1000(0.6232)

- 314.025 + 623.2
- 937.22
Ans. The value of the bond is 037.22
Illustration 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 return is 15%.

Solution: We are given

Redeemable Value ? 1100
Interest 6%

Required rate of return = 15%

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 Valuation of
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Annual interest = 6% of 1000 = 60

Bond value = 1 (PVAF kd,n) + RV (PVF n)

60 x 4.1604 + 1100 x 0.3759
249.624 + 413.49
Rs. 663.114

Ans. The value of the bond is 663.114

Illustration 7:
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

Redeemable Value

Interest = 9%

Required rate of return = 15%

Annual interest = 9% of 800 = 72

Bond value = 1 (PVAF n) + RV (PVF n)

- 72 x 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.

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 Financing Decisions
Preference shares can be convertible or non-convertible, redeemable or
irredeemable, participating or non-participating, Cumulative and
Noncumulative, 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.

Value of Redeemable Preference Shares

The value of Redeemable preference share can be ascertained as follows:

Reedemption Value
n
V =y -l
Where, Di =Dividend in the year 1

KP = required rate of return n

= years to maturity

Illustration 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

ReedemptionValue
(1 + kp)i

Where, DI =Dividend in the year I 1000 x 9% kp =

required rate of return on preference shares n

years to maturity 5 years
Substituting the given values in the above formula, we get,

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 Valuation of
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90 1000
Here,
V
(1 -F. 13) (1+.13)5

V = 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:

(kp)

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 return is 10%. What will be
the value of the preference shares today?

We know,

DI =Dividend in the year 1 kp = required rate of return

on preference shares

(kp)
125
(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 n) + Pn (PVF kp, n),

Where, Di =Dividend in the year i = 2000><7%=140
kp = required rate of return on preference shares —
n = years to maturity = 5 years
Substituting the given values in the above formula, we get,
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140 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 n) + Pn (PVF kp, n)

Di =Dividend in the year 1 = 90

kp = required rate of return on preference shares —

n = years to maturity = 3 years
Substituting the given values in the above formula, we get,

+ 1050

- 205.488 + 690.375

Rs. 895.863

Ans. The value of preference share is Rs. 895.863

Illustration 12:
Mr. A has invested in an irredeemable preference share of Rs. 1000. He
receives a dividend ofRs. 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 D/Kp

Where D =Dividend= 80

KP = 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

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 Valuation of
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Check Your Progress A
What is the formula of yield to maturity method?

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
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 Financing Decisions
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.

A Net Asset Method

The net asset method is also called as Asset Backing method or Intrinsic
Value method or breakup 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.

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 external liabilities of the company payable to outsiders

including contingent liabilities.
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If cum 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:

l) 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
Value of Shares x Paid up value of
share
Normal rate of dividend
Profit Available for Dividend
And, Rate of dividend expected = x 100 Total
paid up capital

Illustration 13:
XYZ Ltd. has issued shares of each, 00 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
Value of Shares —
Paidup value ofshare
Normalrateofdividend
Where the Expected rate of dividend = 10%,
Normal rate = 9%,
Paid-up value =

Substituting the given values in the above formula, we get,

10
Value of Shares x 90 =
9

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
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employed within the business, and the rate of earning is discovered in
Securities the following manner:
Profit earned
Rate of Earning — x 100
Capital employed
Rate of earning
Value of Shares — x Paid up value of share
Normal rate of dividend
Here profit earned 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 of each fully paid up. It
is an all-equity firm. The average profits of the company are ö(), 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 followsAverage

profit = 50,000

We use the formula below to calculate the rate of earning

Profit earned
Rate of Earning x 100
Capital employed

Where Profit earned = 50000, Capital employed

Substituting the given values in above formula, we get,
50.000
Rate of Earning — x 100 =10 0/0
The value of shares can be calculated as follows:
Rate of earning
Value of Shares x Paid up value of share
Normal rate of dividend

Where Normal rate of return = 20%

Substituting the given values in the above formula, we get,
10
Value of equity share x 50=05
20

Fair Value Method

The 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
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 Valuation 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 Basis
Value per share 2

Illustration 15:
If the value of the share as per the Intrinsic value method is ?200.50 and as per the Yield method is 09.50
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,

99.50 +200.50-?150

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:
DI Pn

Where present value of the share at time zero required return on share

DI = expected dividend after one year expected price of shares

after n years n =number of years to maturity

The above equation can also be represented as:

Pn

The formula for calculating the fair value of equity share using the
Dividend Discount Model under various cases

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a) For one year holding period
Securities The value of equity share is:
DI + PI
1+1<e where present value of the share
at time zero required return on share
DI = expected dividend after one year
Expected price of shares after 1 year
b) For the multi-year holding period
The value of equity share is:
DI
or,
D (PVFAke, n)
where present value of the share at time zero required
return on share
D expected dividend/future dividend payments
Expected price of shares after n years
n =number of years to maturity
c) Indefinite holding period
i. No growth in dividends
If there is no growth in the dividends then the value of the share will be calculated
as:

Po-E
ke where present value of the share at time
zero required return on share
D = expected dividend/future dividend
payments ii. Constant growth in dividends
If there is constant growth in the dividends then the value of the share will
be calculated as:

ke-g where present value of the share at

time zero required return on share
DI — expected dividend after one year g
growth rate

iii. Multiple growth rates

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 Valuation of
If there are multiple growths in the dividends then the value of the share will be calculated as:
DI (I DI (1+01)DI (1+02)n
(1+ke)3

where present value of the share at time zero required return on share
DI = expected dividend after one year g = first growth rate gl =
second growth rate

Equity valuation
Illustration 16:
PQR Ltd. 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 of Shares X Paid up value of share
Normal rate of dividend

Where, the Expected rate of dividend = 10%,

Normal rate = 8%, and Paid-up value = 92

Substituting the given values in the above formula, we get,

10
Value of Shares — x 192 = 040
8

[Link] value of share is Q40

Illustration 17:
A company has employed equity capital of of ? 100 each fully paid up. It is an all-equity
firm. The average profits of the company are and the estimated rate of capitalization is 20%.
Find Value as per earning capacity method.

Solution: Valuation of share under Equity Capacity Method

Here, Average profit = 1,00,000, Capital employed =

Profit earned
Rate of Earning x 100
Capital employed

Substituting the given values in above formula, we get,

l,[Link]
Rate of Earning x 100
Rate of earning
Value of Shares — X Paid up value of share
Normal rate of dividend Securities
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 Financing Decisions
Where Normal rate of return = 20%
Substituting the given values in the above formula, we get,
10
Value of equity sharex 100 =
20

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

Substituting the given values in the above formula, we get,

160 +140

[Link] value of share is ? 150

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 return is 10 0/0?

Solution: We are given expected dividend= DI Rs. 5

Expected Price PI Rs.110

Required rate of return = 10%

Therefore, the value of equity share

1+ 1<e

Substituting all the values in the formula above,

5+ 110 115
- ?104.5
I + 0.10 1.1

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 Valuation of
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= DI Rs. 10

Expected Price = PI = Rs. 150

Required rate of return = 20%

Therefore, the value of equity share

1+1<e

Substituting the given values in the above formula, we get,

10+ 150 160
133.33
1+ 0.20 1.2

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.
Illustration 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 return is 10%?

Solution: We know that the

DI Rs. 10,

Where, DI = Expected dividend after one year

And expected price after seven years = P7 = Rs.200

Required rate of return =

Therefore, the value of equity share = D(PVFAke, Pn(PVFke, n)

Substituting the given values in above formula, we get,

10 (PVFA 200(PVF

10 (4.868) + 200 + 102.6

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 Financing Decisions

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.
Illustration 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= Do Rs. 10

Since there is no growth in dividends,

Therefore, expected dividend after one year = DI 10

Required rate of return = Ke = 15%

If there is no growth in the dividends then the value of the share will be calculated as: Securities

ke

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= Do = 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 = Do (l + g)

DI = 200+0.15)
The value of share will be calculated as

ke-g

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 Valuation of
Substituting the given values in the above formula, we get,
23

0.20-0.15

Ans. The value of equity share is Rs. 460 when there is constant growth
at the rate of 15% in dividends.
Illustration 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 = 20%

Growth rate g= 15% for the first 5 years and then gl 18% forever
Since dividends are expected to grow at rate of 15% for first 5 years

Expected dividend after one year = DI = Do (l + g)

DI = 10 (1+0.15) =11.5
Similarly,
Expected dividend after two-years 13.225

Expected dividend after three years DO (1 + 15.208

Expected dividend after four years DO (1 + 17.490

Expected dividend after five years DO (1 + 20.11

Now we calculate the Present value of dividends for the first 5 years
Dividends PVF20%, n PV
11.5 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 44.07748
From 6th year onwards, gl = 18%

Therefore, expected dividend after six years D5 (1+ gl)

20.11(1.18)
= 23.729

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 Financing Decisions
Now, since after 5 years the dividend grows at a constant rate of 18%,

Price of share after five years P5 — Ice-gl

Substituting all the values in the formula above,
- 23.729/ (0.20-0.18) = Rs. 1186.45
And, Present value ofP5= 1186.45 x 1/(1+ 0.20)5

476.95

Therefore, the value of equity is

DI
DI
(1+g2)n Dn (1+01) 1

i.e., Rs 44.077 + 476.95 = Rs. 521.03

Ans. The value of equity share is Rs. 521.03.

Illustration 25:
Securities
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 return is 10 %
b) Risk-free rate is 5% c) Beta of the company is 2

Solution: We are given,

Market return Rm = 10%

Risk free rate of return = Rf

Beta = = 2

Growth rate = g= 7%

According to capital asset pricing model

Where, ke the required rate of return on equity

Rm = Market return

RF Risk free rate of return

Therefore, ke = 0.05 +
(0.1-0.05)

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 Valuation of

- 0.15
Now, we calculate the value of the share

ke-g
Where, DI = Expected dividend after one
year ke = 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.

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 each redeemable after 5 years. At maturity,
the bondholder has on option to convert the debentures into equity shares of the company. The

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 Financing Decisions
conversion ratio is 1:10, and the current market price of a share is per share. The current price of the
debenture is 05.
Solution:
We are given that the conversion ratio is 1: 10 i.e., 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.

l) The conversion price will be = Face Value / Conversion ratio i.e., ?100/10 = ? 10 per share.
2) The conversion value will be = Conversion Ratio x Current market price of share i.e., 10 x =

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 Valuation of
Securities
3) The conversion premium = Bond Price toady — Intrinsic value i.e.,

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 case is taken as the higher value between the

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 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 per share and the current price of the bond
is ?95. The rate of discount is 5%. Determine the price of the convertible bond Solution:
We are given

Redeemable Value

Interest —

Required rate of return = 5% n (years to maturity) = 5

years

Annual interest — of 100 =

The current market price of a share is

The current market price of bond =

The value of Straight Bond = 1 (PVAF kd, n) + RV (PVF kd, n)

100 x 0.7835
43.295 + 78.35

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 Financing Decisions
- Rs. 121.645
The conversion value = Conversion Ratio x Current market price of share i.e., =

[Link] the straight bond value is higher than the conversion value, the investor will not opt for
converting the bonds into equity shares

Illustration 28: A company issued 1000, 15% debentures of ? 100 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 the current market price of a share is 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
Interest —

Required rate of return = 10% n (years to maturity) = 10

years

Annual interest — of 100 = The current market price of a

share is ? 10
The current market price of bond =

The value of Straight Bond = 1 (PVAF kd, n) + RV (PVF 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 i.e., 5 =

[Link] 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

QI. What are convertible debentures?

Q2. What do you mean by conversion premium?

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 Valuation of
Securities
Q3. Mr. A wants to invest in the shares of ABC Co. The company declared a dividend ofRs. 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 i.e., 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.

10.10 ANSWERS TO CHECK YOUR PROGRESS

A [Link] bond is worth 060.51 today. Therefore, the investor will be willing to pay a price of equal to or
less than 060.51 for the bond today.

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 Financing Decisions
4. The value of the bond is
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

l) 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. 0054.726)
2. Mr. A has invested in an irredeemable 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 ? 150 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.

4. A company has employed equity capital of of ? 100 each share fully paid up. It is an
all-equity firm. The average profits of the company are and the estimated rate of
capitalization is 25%. Find Value as per earning capacity method.
(Ans. ?40)

5. If the value of the share as per the Intrinsic value method is ? 350and as per the Yield method is
ö50 then find the value as per the fair value method.

(Ans.

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 Valuation of
Securities
6. 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 0/0?

Ans. The value of equity is Rs. 209.0909 and hence the investor should buy it at the current market
price of Rs. 200

7. 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.

8. 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. Calculate 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.

189