Valuation of Bonds and Equity Shares - Basic Principles and Models

Financial Management Revision Article

Basic Principle

The valuation of any asset, real financial is equal to the present value of cash flows expected from it.

Bond valuation

Valuation of a bond requires an estimate of expected cash flows and a required rate of return specified by the investor for whom the bond is being valued. If it is being valued for the market, the markets expected rate of return is to be determined or estimted.
A simplified bond valuation model or exercise is based on the following features of the bond.
Fixed coupon rate for the term of the bond.
Coupon payments are made annually and the next coupon payment is receivable in year from now.
The bond will be redeemed at par on maturity.
The bond is noncallable. It will not be redeemed before the maturity.
The formula for discounting the associated cash flows is
Sum of all  C/(1+r)t (t = 1 to n)+ P/(1+r)n
Where C = annual coupon payment
r = required rate of return
n = number of years to maturity
P = Par value 
The formula can be modified for various complex features of bond, like half yearly payments, redemption at premium on maturity etc.

Equity Share Valuation

Dividend discount model

Dividend valuation model is conceptually a very sound approach.
According to this approach the value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold.

Simple Model: Constant dividend with no growth

The simple model of equity share valuation has assumption that the dividend per share remains constant year after year at a value D. Dividend will be received at the end one year now from now and required rate of return or that of market is r.
Then Present value of the equity share = V = D/r

Model with growth less than the required rate of return

If there is an expected growth in dividends whch is g constant in all the years in the future and also less than r, the required rate of return, the valuation formula is
V = D/(r-g)

High Current Growth Companies

The simple valuation model proposed for companies that have a high growth in dividends currently is two growth period model. In this model during the first period of n years, the growth g1 is higher than r. In the remaining period growth g is less than r.
The present value of dividends of n years is found out and the present value  terminal value of [D(n+1) /r-g] is added to it to find the value of the share.
More complexities can be added to the model.

References

 
Prasanna Chandra, Financial Management, 5th Ed.,  Tata McGraw Hill, 2001
Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001
 


Originally posted in Knol
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