.

:-=:"

-"

'-

Chapter V

Valuation of Securities
I LeC!rni~g,Goals:

.
.

::A~~rc;~~l!~hlg;.thls'chapter.you wili be conv")rsant'with'.

'Vaiuation 'of Bond'

. ..:.Bond Price Movements

.'

.'

~.':,Caici.rl<ltionofIntrinsic

Value of a Share

.Equity Valuatibn : Ratio Approach.

The ultimate goal of any individual or a firm is

maximization of profits or rate of returns or in other
words market value of one's investments. Thus,
investment management is an on-going process which
needs to be constantly monitored by way of infom1ation
as this may affect the value of securities or rale of
returr.s of such securities. Therefore, a finance manager
needs to have basic knowledge and understanding of
the framework of security valuation which is essentially
based on conceptual understanding of time value of
money and risk-return relationship. Hence. while
making valuation judgments about securities, the
analyst constantly applies a process which may achieve
the following:
a.
A true picture of a company over a representative
time span.
b.

An estimation of current normal earning power

and dividend pay-out.

c.

Estimate of future profitability and growth and

the reliability of such expectations.
Translation of all these estimates into valuation
of the company and its securities.

d.

ll1e concepts of time value of money provide a

fundamental background for the valuation of hond:; and
stocks. The following chapter therefore is divided into
four sections which arc as follows:

= (I

C2

Cn

+k)1 + (I +k)2

+.. + ~k)n

= 1=1(I
where.

( I)

C.
+ k)l

Po

= Value of the
= Present value

C.

= Expected

Vo

asset

at time

zero.

of the asset

cash

flow

at the end

of period t

Example

= Discount

= Expected

ralC of or required rate

. of return on the cash flows
life of an asset.

Calculate the value of an asset if the annual cash inflow

is Rs.2,OOO
per year for the next 7 years and the discount
rate is 18%.

Solution
The value of an asset can he calculated as follows:
n

Vo

I~
1=1

(I + k)1

2,000

1=1 (I + .18)1

Valuation Concept

2.000

2,OO()(PVIFAIK'l.. 7~,,)

1=1 (1.18)1

Bond Valuation
Equity
Valuation:
Approach

C.

Vo(or PO) i

Dividend

Capitalization

Equity Valuation: Ratio Approach.

VALUATION CONCEPT
A security can be regarded simply as a series of
dividends or interest payments receivahle over a period
of time. l'herefore, value of any securit y can he ucfineu
as the present value of these future cash streams i.e.
Ihe IIltnnsic value 0: an asset is equal to the presenl
value of the benefits associateu with it. Symbolically.
it can be represented as

2.000 x 3.S12

Rs.7.624.

Concepts

of Value

Book Value is an accounting concept. Assets arc

recorded at historical costs and they arc depreciated
over years. Book value may include intangihle assets
at acquisition cost minus arnonizeJ value. T~ok
value or debt is stated al the outstanuing arnollnl.111e'lJ.!.lference between the book value of asse~
and liabilities is equal to shareholuer's fund~ or nct
worth (wlllch is equal. to paid-up. equilY cuj)itarp-ius
reserves and surplus).

.
.

Valuation

Re lacelllcnl Value IS the amount that a company

\~()uld he require 10 spcnd .f it were to replace its
c'\isling assets in Ihe current condition.

payment

number

Ll'luidalion Value IS the amuunt !hzl! a company

could realize if it sold its ,Lsselsafter having tenninated
liS business. It is generally a minimum value which
a company 111Ighlaccept if it sells its business.

n,

o(orPo)

G.:2-in!;
(:oncc'rn V~IIIGis Ihe amount that a company
coulJ realize if it sold its business as an op~rating
one. Its value woulJ always be higher than the
liquidation valuc. the difference accounting for the
usefulness ~f assets and value of intangihles.

Vo

Yo
Po

where,

I(PVIFAkd.

=
=
=

c.;:oupo~_Ra~~_.or
Interest: A bond carries a specific rate
of interest which is also called as the coupon rate.. The
interest rate payable is simply the par value of the bond
XcouDon rate. Interest p,lId on a bond IStax dedUCtible.

"-

Maturitv: A bond is issued for a specific period of time.

li'i;~id
on maturity. Typically corporate bonds have
a maturity period of 7-10 years whereas government
bonds have maturity period up 10 20-25 years.
R~dc.ru.plimLY.:il~ The value which a bondholder gets
on maturity is called as redemption value. A bond may
be redeemed at par, at premium (more than par) or at
discount (less than par value).

(I + k,J)!1

II) + F(PVIFkd.

n)

(2)

Intrinsic value of the bono

Present value of the bond
Annual
bond

interest payable

Maturity

kd

Cost of Capial

Principal

Example 2

on the

amount (par value)

repayable

Face Vaiu.k: This is the value stated on the face of the

Dond and is -;Iso known as par value. It r~presents the
amount of borrowing by the firm which it specifies to
repay after a speei fie period of lime i.e. the time of
maturity. A bond is generally issued at face value or
par value which is usually Rs.1 00 and may sometimes
be Rs.I.OOO.

..

1=1 (I + k~J)'

1\1~et Value of an assel or security is the current

price at which the asset or the security is being sold
or bought in the market.

Bonds are negotiable promissory notes that can be used

by individuals. business firms. governments
or
government agencies. Bonds issued by the government
or public sector companies in India are generally
secured. Private sector companies may issue secured
or unsecured bonds. In case of the bond. the rate of
interest is fixed and known to ifivestors. A Qpnd is
redeemable after a specific period. The expected cash
fJows consists of annual interest payments plus
repayment of principal. Before going inro the valuation
of bonds. it is necessary to familiarize with cenain
bond-related terms.

of years and a tixed

principal repayment (e4ual to par value) at the time of

maturity. Therefore. the instrinsic value or the present
value of a bond can now be written as:

BOND VALUATION

for a certain

of Securities

at the maturity
'period

time.

of the bond.

A bond whose par value is Rs.I.OOO bears a COupon

rate of 12% and has a maturity period of 3 years. The
required rate of return on the bond is 10%. What is the
value of this bond?
Solution
Annual interest payable =
Pnncipal

repayment

1 x 12% = Rs.120

at the end of 3 years

= Rs. 1,000

:. The value of the bond

Vo

Rs.: 20(PYIFAIO%.

J yrsJ
JyrsJ

+ RsJ ,000 (PYIF I0%.

=
Example

Rs.12o x (2.487) + 1,000(0.75 I)

Rs.298,44 + Rs.751
Rs.l.049.44.
3

Consider the case where an investor purchases a bond

whose face value is Rs.l.oOo. maturity perod is 5 years
and the nominai (coupon) rate of interest is 7%. The
required rate of return is 8%. What should he be willing
to pay now to purchase the bond if it matures at par.

Solution
Annual interest payable for 5 years

= Rs.70

Principal repayable amount at the end 01'5 years =Rs.1 ,000

:. The intrinsic value or the present value of the

=
=

Rs.7o(PVIFAS%. 5yrsJ + Rs.I.OOO(PYIF8%.5

Rs.7o x 3.993 + Rs.I,OOO x 0.681

279.51 + 681 = Rs.960.51

bOf!d

5'rsJ

Market Value: A bond may he traded in a stock

exchange. Market value is the price at which the bond
is usually hOUgh!or sold. Market value may be different
from [Jar value or redemption value.

The aboveimplies that the bond of Rs.1,000 is worth

Rs.960.51 today if the required rate of return is 8%.
The investor therefore would not be willing to pay

Basic

more than Rs.960.51 for the hond today.

Bond Valuation

Model

Wilh the ahove hackground it is quite clear that the

hold~r of a hond receives a fixed annual inter;;:,!
81

lilt.

.t:

-.. ~----

...

/~
Fine ncial Management

Bond

Values

'C

with Semi-annual

Interest

Some
of the honds carries interest payment
semi-annually. As half-yew'ly interest amounts can be
reinvested the value of such bonds would he more than
the value of the bonds with annual imerest payments.
Hence, the bond valuation equation can he modified
as follows:
i.

Annual interest payment i.e. :. must be divided

by two 10 obtain interest payment semi-anually.

ii.

Number of years :0 maturity will have to be

multiplied by two to get (he number of half-yearly
p~rjods.

iii.

Discount rate has to he divided by (WlIto get the

discount rate for half-yearly period.

'.10

where.

1/2
(I + ku/2)

=
=

kdl2

2n

V2

semi-annual

par value of the bond payable

at maturity
required rate of return for
the half-year period

~urrent

- 900) + 80

(800

-100 + 80
900
-20
900

urrent

"

".

...

..

....

= -2.22%

'"

Yield

Y" Id
Ie

Coupon Interest

= Cun'cnt

Market

Price

(5)

In thc example cited above. if the current market price

of the bond is also Rs.800, then the
Current Yield = 88~O= 10%.

Solution

Yield to Maturity
1,000

100/2

(l + 0.12/2)12

1=1

Rs.50(PVIFA6'7c.
12 yrsJ
+ 1.000(PVIF6'70, 12yrsJ

Rs.50(8.384)
Rs.419.2

Example

+ 1.000 (0.497)

Measures

One Period Rate of Return

If a bond is purchased and then sold one year later, its
rate <?f'Teturn over this single hulding period as given
in the chapter risk and return can be defined as rate of
return.

(
"'"

to.

,.
..

..

,.
..

..

The rate of return earned also referred to as yield to

maturity. is the value of kd in the following equation.

Po

82

,-

Solution

=L
"\'

10

,,:

Consider a Rs.I,OOO par value bond whose current

market price is Rs.850. The bond carries a coupon rate
of 8% and has a maturity period of 9 years. What would
be the rate of return that an investor earns if he purchases
the bond and holds till maturity?

+ 49;]

Rs.916.20

Bond-Yield

(YTM)

1\ is the rate of return earned by an investor who

purchases a bond and holds it till maturity. The YTM
is the discount rate which equals the present value of
promised cash flows to the current market price/
purchase price.

12

~
""

..

'

Coupon rate and current yield are two different

measures. Coupon rate and current yield will be equal
if the bond's market price equals its face value.

A
'"
~

900

A bond of Rs.I,OOO value carries a coupon rate of 10%

and a maturity period of 6 years. Interest is payable
semi-anrmally. If the required rate of return is 12%,
calculate the value of the bond.

Vo

"

"..

,.'"

:.

maturity period expressed in

half-yearly periods

"

,..

X purchased Rs.I,OOOpar value bond for Rs.900. The

coupon paymenl on this bond is Rs.80 i.e.. 8% . One
year later he sells Ihe bond for Rs.800. TIle rate of
return of tvlr. X Ic)rthis one year period is

Curren I Yield measures the rale of return earned on a

bond if il is purchased al its currenl market price and
if the cuupon interest is received.

interest payment

...
.'"

=
..(3)

r
\-

Examp!e5

(l + kd/2)2n

112 (PVIFAkd/2,2n) + F(PVIFkd/2, 2n)

= value of the bond
V

Example

I
t=1

+ r

(i f p:lld)
coupon interest)
=
_.
...(4)
purchase price at the beginning Of
the holding period
]
~
The hol ing period can be calculated on a daily,
monthly or annual basis. If the bond price falls by an
amount Ihal cxceeds coupon interest, rate of return
assumes negalive value:;.

Holding period return

Thus with the above modifications, the bond valuation

equation becomes:
2n

Price gain or loss

during holding period

Ik

1=1(I
. + '<1)

+-

( I + k<l)

..:

~
.:
.;

III
Valuation of Sacuritia~
<)

~;olution

Rs.850 =

80
+ Rs.I.OOG
(I + ku/
( I + kd/

1=1

= Rs.80

(PYlfAkd%.

YTM

<iyr + Rs.l.ooO

(PYlfkd.

I+(F-P)/n
or I+(F-P)/n
O.4F -; 06P
(F + P)/2
60 + (500 - 43)/7

<)yrsJ '

0,4 x 500 + 0.6 x 435

To lind out the value of ku in the above equat}on,

several 'Values of kd will have to be Iried oUI in order
to reach the inpul value. Therefore, to start, consider a
discount rate of 12% for kd for which the expression
becomes cqual to
.

()0+9.2X5
200+ 261

69.285
461

= .150

150/,.

Rs.80(PYIFA 12%,9 yrs) + Rs. I.OOO(PYIFI2%. 9 yrs.)

~OND

= Rs.80 x 5.328 + Rs.I.OOO(0.361)

= Rs.426.24 + 361 = Rs.787.24.

VALUE THEOREMS)

Basedon the bond valu:llion model. several bonn value

theorems have been derived which state the effect of

the following factors on hond values:

Since Ihe above value is less than Rs.850, we have to

10%, then the
try a less value for kd. So, let kd
equation becomes:
,

1.

Relationship bctween the required rate of retun

and the Coupon rale.

Rs.80(PYIFAIO%, 9 yrs,) + Rs. I,000 (PYIFIO%, 9 yrs.)

II.

Number of years to maturity.

III.

Yield to maturity

1.

The following are the theorems which show the

effeci on the bond values intluenced by the
relationship between Ihe required rate of return
and the COupon rate.

= Rs.80 x 5.759 + Rs.1,000 x 0.424

= Rs.460.24 + 424 =Rs.884.72

From the above it is clear that kd lies between 10%

and 12%. Now we have to use linear interpolation in
the range of 10% and 12%. Using it we find that kd is
equal to th~IJowing:
10% + (l2~

=I

0 01
YO

10%) x

884.72 - 850

2% x 0.356

= 10% +
= 10.71%

0.71

then

where, YTM
I
'F

trial and error method

tedious
the
folJowing
be employed to find out
bond.

OAF + 0.6P

= yield

~'r I+(F-P)/n
(F + P)/2
...

..)6)
.

Example

= Par

value

Rs.IOO

Coupon rate

12%

Years to maturity
5 years.
Find out the value of KenStar's bond i I' the
required rate of return is 129c.
If the required rate of return is 1290 (same as the

Couponrate) the value of the bond is

Y = I(PYIFAku. n) + F(PYIFkd. n)

to maturity

= annual interest payment

= par value or redemption

12(PYIFAI2'7c. 5) + IOO(PYIFI2%. 5)

= 12(3.605) + 100(0.567)

value

= 43.26

= current

bond

Par value

of the bond
P
n

of;}

Consider a bO:1dof KenStar Intermediaries Ltd.

with the fOllowingfeatures:

:. The yield to maturity is 10.71%

I+(F-P)/n

value

Example 8
i

An Approximation:
As
calculations
are
too
approximation formula can
the approximate YTM on a

When the required rate.of relurn is equal to

the cCJupon rale. the value of the bond is
equ;:1 to ils p2f va!ue.
i.e. If kd = Coupon rate;

34.72
+ 290 x 97.48

= 10% +

YTM =

i.

market price of the bond

years to maturity.

ii.'

When

+ 56.7

= 99.96 = 100.

the required

rate of return

(kd)

is

greater than the COuponrate. the value of the

bond is less than its par value.

Zeta Industries Ltd. bond a par value of Rs.500 is

currently traded at Rs.435. The COuponrate is 12% and
it has a maturity period of 7 years. What is the yield

to maturity.

83

If kd > COupon rate;

then value of bond < par value.
Consider thc same bond as above except that its
required ratc of rcturn is 14%. Find out Ihe value
of Ihe bond.

~
~:

"''='
/'

Financial Managomont

b.

If the required rate of return is 14% (gr~ater than

the coupon rate). then the value of Ihe bond is

/'/

I(PVIFAkd. n) + F(PYIFkd.n)

12(3.433) + 100(0.519)
41.196 + 51.9
93.1

=
=

iii.

Ir the required rate of return on the bond of Enucon

Limited is 9%, it will have a value of
V

then value of bond>

par value.

+ 62.1
.

III.

1<" i.

,
Years to maturity:
7
If Ihe required rate of return is I3%;then the value
of the bond is

= I(PVIFAkd. n) +
= I 10(PVIFAIW.7)

F(PVIFkd.n)
+ I.OOO(PYIFI:\<k.7)

:;;" .'" '

.
. . .",eV':;"A,.:
4
,','

V alui.1oft)3o:nd;.l_~';:~
. ""

'. ' )
." ..' . .",".:.-;'
. ii>" ..~ .,'

! ~~

1V.
i>,".~"",;.
'{I'.::i~~fI!
1O~' O>\'J~!~~tI
. ('

A bond's price moves inversely proportional

its yield to maturity.

to

The YTM of a Rs. I,000 par value bond bearing

a coupon rate of 10% and maturing in 10 years
is 12%. Thus: the market value of the bond is
Rs.887 (as calculated previously). If the YTM
increases to 14%, the market value of the bond
will drop to Rs.79 I.60. as calculated below

= Rs.1 10(3.998) + 1,000(0.480)

= 439.78 + 480 = 919.78
For a required rate of return of 13%, the .value,of.
the bond will increase with the passage of time,
i.e. untii its maturity.

.....

";"+"'"

";"':"','$,'''
.

As YTM determines a bond's market price and

vice-versa, we can say that the bond's price will
fluctuate in response to Ihe change in market
interest rates in the following ways:

Example

One year from now, when the maturity period

will be 6 years, the value of the bond will be:
Y
= I IO(PYIFA 13%.6) + l,ooo(PVIFI3%.6)

The present value principle states that the present

value of a cash Ilow varies in inverse proportion
to the interest rate used as a discount rate. As such
if the YTM of Ihe bond rises, the bond's market
price drops and if Ihe YTM falls. the bond's market
pnee nses.

= II O(4.423) + 1,000(0.425)
= 486.53 + 425. 9 I1:53. .

Years to maturity

. .'

'~~::Y'I
.,;';~t~":,:,:,~i~"

:,

i 1%

= 1089.46.

;:~;Years'
to :Matttrit c,;"

'. :."'"
.'.

To iIlustrale the above. consider a bond of Enucon

Lid. with the following features:
Par value
:
Rs. 1,000
rate

+ 596

For a required rate of return of 9% the value of

the bond decreases with the passage of time. i.e.
until maturity.

When tbe required rate of return (kd) is

grealer than the coupon rate, the discount
on ihe bond
declines
as maturity

Coupon

6) + J,000(PYIF9%. 6)

110(4.486) + ) ,000(0.596)

= Rs.493.46

= I(PYIFAkd.n) + F(PVIFkd.n)
= 12(PVIFA 10. 5) + lOO(PVIFIO%.5)
= 12(3.791) + 100(0.621)

approaches.

= Rs.IIO(PVIFA9%.

= Rs.

The following theorems show the effect of Ihe

number of years 10 malurity on bond values.

One year hcnce, whcn thc maturity period will be

6 years the value of the bond will be

= 107.59.

a.

I,OOO(PVIFn.7yn;.)
+ 1,000(0.447)
447
1000.63

i.e. if kd < coupor. rate;

= 45.492
II.

= Rs.I IO(PYlFA9%. 7) +

= Rs.IIO(5.033)
= Rs. 553.63 +

When the required ralc of relurn is less than

Ihe coupon rale. Ihe value of the bond is
greater than its par value.

If the required rale of retum is iO% (less than the

coupon rate). Ihen Ihe value of the above bond is
Y

When Ihe required rate of return (kd) is Ie;s than

the coupon rate, the premium on the bond ~..:clip.es
as malurity approaches.

100 (PVIFAI4%.JO) + 1000 (PVIFI4%.tO)

100 x 5.216 + 1000 x 0.270

=
=

Bond Value
929.87
940.14
952.7 I
966.48
982.35
1,000.00

Rs.79 1.60.

If the YTM of the same bond comes down to 8%,

then the market value of the bond rises to Rs. I, I34.
II.

84

For a given difference between YTM and coupon

rate of the bonds. the longer the tcnn to maturity.
the greater will be Ihe change"n price with change,
jn YTM. It is so eecause. in case of long malurity
bonds, a change in YTM is cumulatively applied

_.~

i
;

10 Ihe entire series of the coupon payments and

Ihe principal rayment is discounted at the new

Consider IwO bonds A ann B with the par value

"of Rs.I,OOO, maturing in 4 years and YTM of
10%. Bond A bears coupon rate of 10% whereas
bond B bears coupon rate of 12%.

rale for the entire number of years to mat~ril1;

whereas in case of short-tcrm mattiriiYbonds. the
new YTM is applied to comparatively few Coupon
payments;
and also. principal paymenl is
discounted for only a short period of lime. Thus.
long-Ierm bonds are more variable to changes in
interest rales Ihan shorHem1 bonds.

,
t

Example 10

LeI us take Iwo hYPolheticalbonds differing only

in term to maturilY.

w~t~~;at;;:J:r
:"'0'

.,

,
The market value of the bonds when the YTM
was equai to coupon rate was equal to the face
value of the bonds i.e., Rs. I,000. When however
the YTM increased to II %, the marke~ value of
.he bond with shorter maturity period dropped by
only 2.5% to Rs.975 wherei1s the market value of

the bond with longer malurity period of 6 years

has dropped by 4.2% to Rs.958. Thus, the
long-term bonds' are characteristica!ly more
sensitive to interesl rate changes than short-term
bonds.

f
>

.
,
"

Given the maturity, the change in bond price will

be greater with a decrease in the bond's YTM
than the change in bond price with an equal
increase in the bond's YTM. That is, for equal
sized increases and decreases in the YTM, price
movements are not. symmetrical.
Example

11

Take Rs.I.OOO par value bond with a coupon rate

of 10% and maturity period of 5 years. Let the
YTM be 10%. Market price of the bond will be
equal to Rs.I ,000. A I % increase in YTM to II %
changes price to Rs.963.04 (100 PVIFAll%.S +
1000 PVIFll%.S); a decrease of 3.7%. A decrease
of 1% YTM to 9% changes the price to Rs.I.039
(100 PVIFA9%.5 + 1000 PVIF9%.5) an increase uf
3.9%.
.

"

.
\

Thus, an increase in bond's yield caused a price

decrease that is smaller Ihan the price increase
caused by an equal-size decrease in yield.
IV.

For any given change in YTM, the percentage

price change in case of bonds of high coupon rate
will be smaller than in the case of bonds of low
~oupon rate, other things remaining the same.
85

' , ",

"Bond!e,:

. "'I.'::,

'

,."":',
.

,;\.);~~O.~4:

'." ..,'. .,' 'i"'"

6.03% .'. .'5.92'.

Change in the price with the change in YTM In

case~()f bond B carrying :1 higher coupon ratc of
12% is only 5.92%, whereas in case of bond A
with a coupon rate of 10,%the change in Ihe price
is 6.03%.
A -change in the YTM affects the bonos wilh a
higher YTM more thar. it docs bonds with a lower
YTM.

Consider a Rs. I,000 par value ABC bond with a

coupon rate of 12%, maturity period of 6 years
and YTM of 10%. The markct value of the bond
will be Rs.I,087.

I;

)il

I,
I

i
!

Consider another identical bond XYZ but with

differing YTM of 20%. The market value of this
bond will be Rs.734.
Suppose. Ihere is an increase in YTM by 20% i.e.
YTM of bond ABC rises to 12% (10 x 1.2) and
bond XYZ rises to 24% (i.e. 20 x 1.2). Then the
market value of both bonds will change to Bond ABC:

120 PVIFAI2%.h
+ 1000 PVIF 12%.6
Rs. J,000

Bond XYZ

120 PVIF A24%.6

+ 1000 PVIF24%,6
Rs.638

.i

111.

'.

, i..(~lfY,39.l,'J

"~,'I

v.

':

Change In prlca

eOOd A

. '. (Rsl- 1000.,.!<.10e3~\r

Market prices',t ,v:wroli10%{;'

of Securities

Valuation

Market value of ABC bond with a lower YTM

decreased by 8% whereas in case of XYZ bond
with an higher YTM the decrease is 13%.

EQUITY VALUATION:
CAPITALIZATION

DIVIDEND

APPROACH

{C,I>Yo(:..~~)

People hold common stocks in Iheir portfolios for

two reasons; (i) A representative group of common
stoeks (like growth stocks and blue chips) bought at
a reasona~le price level can be counted to provide a
higher total return than bonds; (ii) Common stocks
can be held as a protective measure during inflation
because unlike equity, a bond's value declines as
inflation rises. However. the safety and attractiveness
of common stock investment would be jeopardized
if stocks were bought at an excessively high general
market value or too much was paid for the promising
prospects of favored issues. Thus, Ihere should be a
standard value for judging whether a stock is under

"'-

~-

'II
I,l
I

"\
I

I'!

~
q

'-

Financial Management

2.50
35.00
-+
(I +0.13)
(I +0.13)
2.50
35.00
= -+1.13
1.13
= 2.21 + 31.00
= Rs.33.

or overpriced in the market place. VIe call this standard

value as the intrin~;c

vnhw

Intrinsic value is the value of a ~tock which is justified

hy assets, earnings. dividends, definite prospects and
.tI1e tactor ot the managcml'ntof
the ISSUingcompany.
'.--

1l1Cmajor components of intrinsic value are:

a.

dividends paid and the ability to pay such

dividends in the future;
~

c.

estimates of the growth of earnings;

stability and predictability of these quantitative

and qualitative projections.
Thus, in essence, the intrinsic value of a firm's shares
is its economic value as a going concern, taking account
of its characteristics, the nature of its business and the
investment environment.
'

01

ii.

The 1st payment of dividend is to be made one

year after the equity share is bought.

where,

=
Po
O.
PI

01
-+(I + Ice)

PI

= current market price

= expected dividend a

+ (I + 1ce)2 + ." + (I + Jr.doo =

... (8)

L
(1 + Ice)'
1=1
where,

Po

DI

D2

Doo

Ice

=
=

current market price of the equity share

expected dividend a year hence
expected dividend two years hence
expected dividend at infinite duration
expected rate of return or requir~-d

rate of return

The above equation is the valuation for an equity share

of infinite duration. The same can be applicable for the
valuation of an equity share with a finite duration
provided the investor holds the same for n years and
then sells it at a price Pn. The value of an equity share
of finite duration would thus he:
Po

DI I +
02 2 + ... +
Dn +
P~
(I + ke)
(I + Ice)
(I + Ice)n (I + Ice)n
n

(7)

(I + ke)

Doo

D(

Single Period Valuation Model

,-,
This model is for an equity share wherein an investor
hold it for one year The price of such equity share
will be:
Po

01

--I
Po- (I+ke)

According to the dividend capitalization approach,

which is a conceplUaliysound approach, the value of
an equity share is the discounted present value of
dividends received plus the present value of the resale
price expected when the equity share is sold. Therefore,
for application of this approach to valuation of equity
stock the following assumptions are to be made'f
Dividends are paid annually which is a common
practice for business firms in India and

Since there is no maturity period for equity share, the

value of an equity share of infinite duration is equal to
the discounted value of the stream of dividends of
infinite duration.
Thus,

d.

Multi Period Valuation Model

earning power and profitability of the management

in the employm~nl of assets;

b.

of the share

L (l +01Ice)! +
1=1

year hence

...(9)

Pn
(l + kn)

Using the dividend capitalization principle, the value

of Pn in the above equation (9) would be the present
value of the stream of dividend beyond the nth period
which is evaluated at the end of nth year. Therefore

= expected price of the share a

year hence
Ice = required rate of return on the
equity share.

Dn+1

Pn

On+'2

-~

.
The current pflce Po

Dt

= (I + Ice)

The above is the same as eqn (8) which is regarded as

generalized multi period formula which can be used
for raising, deeling, constant or randomly fluctuating
dividend str~:im.Three such instances are discussed
below:

+~

(I + Ice)

86

2 +
(I + Ice)

000

. ..(10)
(I + Ice)
(1+1ce)-n
Example 12
.
Mercury India Ltd. is expected to declare a dividend Substituting the value of Pn is the above equation (9)
of Rs.2.50 and reach a price of Rs.35.00 a year hence. and simplyfying it we get,
What is the price at which the share would be sold to
to the investors now if the required rate of return is 13 P -~~
... (II)
percent.
0 - .L. (1 + 1ce)1
t=1
Solution

~
Valu .tion ot Securities'

Where

I.

constant dividends

II.

constant growth of dividends.

iii.
i.

changi~g growth rates of dividends.

Valuation with Constant Dividends

I.

Expected dividend stream during the initial pcrioG

of the super normal growth is to be specifed and
the present value of this dividend stream is to be
computed for which the equation to be used in
n

1=1 (I + ke)t

2.

It is assumed that dividends tend to increase over

time because business finn usually grow over
time. Therefore, if the growth of the dividends is
at a constant compound rate then:
DI

= Do(l

The value of the share at the end of the initial

growth
Pn

period
Dn+1

= Kc -

where,

Dn+1

--

dividend

Do

dividend for year 0

for year

ke

3.

g
= constant compound growth rate
The valuation of the share where dividend increases at
a constant, compound rate becomes

DI
DI(l + g)
D1(1 + g)2
(I + Ice) + (I +1ce)2 + (I +1ce)3 +....

n
10 -- 1:

gn

-(I

Dt

(13)

1
n

+ ke)

..L
' Dn+1

Y-e - gn

..'

= current dividend
.
= d uratlon

per share
.

= Rs.3.00

0 f th e pen 00 super norma I

=5

years

Example 13
Shetkani Solvents Ltd. is expected to grow at the rate
of 6.8% per annum and dividend expected a year hence
is Rs.5.00. If the rate of return is 12%,what is the price
of the share today?

ga

= growth

gn

= normal

Solution

The following are the steps involved.

5.00-

- 5.00

Ill.

ke

=Rs.96

I.

Po
+

= (I

DI (1 + ga)

+ Ice) +

'.'
Dn (I + gn)
(I + ke)n+1

(I + 1ce)2

Dn (I + gn)
(l

=
=

D4

Rs.3.00
Rs.3.00
Rs.3.00
Rs.3.00

D5

Rs.3.00 (1.25)5

. 3.00 (1.25)
IS

(I + Ice)n

(1.14)
4

2
+

Dividend stream during super normal growth period:

(1.25) 2
(1.25)
3
(1.25) 4
(1.25)

The present value of the above stream of dividends

DI (I + g~n-I
+

growth rate after super normal

growth period is over = 7%
= investor's required rate of return = 14%

D2
D3

Some firms have a super normal growth rate followed

by a normal growth rate. If the dividends move in line
with the growth rate, the price of the equity share of
such firm would be
DI

rate during the period of super

normal growth = 25%

DI

Valuation with 'Variable Growth in Dividends

(14)

'

(I + kd

the equity share of Venus Lab LimIted.

growth

The price would be Po = 0.12- 0.068- 0.052

calculated

find the value (Po) of the share which is

Do

P -~
O-ke-g

be

Then add both the present value composites to

1~:.Consider

,.
<i

On simplification

to

(as per the constant growth model)

1=1(i + kd
P

is

gn
which is then discounted' to the present value. The
discounted value therefore is

gi

DI

ihe

= 1:~

...p :,y(12)
Valuation with Constant Growth in Dividends

ii.

For computation of Po in the above equation,

following procedure may be adopted.

'

1=om"

ga
gn

+ (I +kc)2 + ... + (I +ke)oo

Th~ ~W'-:~)PI;fi'al;On

the equity share

dividend a year hence
super normal growth rate of dividends
normal growth rate of dividends

= expected

DI

Assume that the dividend per share is constant year

after year, whose value is D, then eqn.(1) becomes
, D
D
D
PO= (i +ke)1

= price of

Po

3.00 (1.25)
(1.14)2
5

3.00( i ,;~"
(1.14)3

'
r

3.00(1.25) + 3.00(1.25)
( 1.14)4
( 1.14)5

,
+ ......

+ lce)n+2

=Rs.3.29 + 3.6 + 4 + RsA.3 + RsA.75 =Rs.19.94.

87

f
Rnancial Managoment

2.

The price of the share at Ihe end of 5 years,

applying the conSianl growlh model at Ihat poinl
of time will be:

Ps

kc - gn

Looking at Ihe lable. we can say that:

1.

= Ds (I + gn)
kc - gn

3.00 (1.25)5 (1.07) 0.14 - 0.07

- 0.07

= Rs.140

2.

Olher things heing equal. the prit:e-earning ratio

increases as Ihe expected growth rale in dividcnd
increases.

3.

High dividend yield and low price earning ralio

imply limited growlh prospectus.

4.

Low dividend yield and high price earnings ralio

imply considerable growth prospeclus.

The discounted value of this price is

= 140.00 = Rs.72.72
(1.14)5
3.

The sum of the above components is:

Po

=
=

Rs.19.94 + Rs.72.72
Rs.92.66

:. The value of the share Po

EQUITY VALUATION: RATIO

APPROACH

= Rs.92.66.

IMPACT OF GROWTH ON PRICE, RETURNS

PIE RATIO

The ratio approach which is rather simpler to use is

followed by most of the practitioners. The following
is the discussion on some of the rati.osemployed in Ihe
context of valuation.

Different companies have varied expected growlh

rates. While :;ome companies remain stagnanl other
companies show normal growth and still others grow
at a super normal growth rate. Assuming a constant
required rate of return, varying growth rates mean
difference in stock prices, dividend yields, capital gain
yield and price earning ratio.
,'.
To illustrate the. above, three cases can be considered.
Growth rate
(%)
Firm with no growth

()

D,
Nogrowthfinn Po = K
. '
R Rs.4.(X)" Rs25

16%

(PI

PIERatio
(PIE).

Supernormal
growthPo

Amount 10 be paid to aU 1he creditors

and preferenceshareholders.

c.

Price-Earning

Ratio

Earning ratio.
The expected earning per share is:
10%

6%

Expected PAT

- Preference

dividend

Number of oUlstanding equity shares

.-kD,
-9

=0.1~.10
Rs.4.00 c Rs.67

Book Value

Expected earning per share x Appropriate price

Rs.40

a.

Financial analysts have used this PIE model more

frequently than other models. Accounting to Ihis, the
intrinsic value of the share is:

= kD,
-g
' ='

Price/Earnings ratio.

No. 01outstandingequity shares.

s. --o:T6 "'

=0.16-0.06
RS.4.00

c.

This is more realistic than the book value. However,

it has two obslacles (I) It would be difficult to estimate
the amount realized from liquidation of various assets
(2) Liquidation value does not retlect earning capacity.

Normalgrowthfirm Po

Liquidalion value

Valuereafized'rom liquidaling an Ihe

assels 01ihe finn

Po)
0%

b.

b. Liquidation Value
Liquidalionvalue per share is equal to:

Price, Dividend yield, Capital gains yield, &

Price-earnings
ratio under differing growth
assumption for 16% required rate of return.
Capital
Gain Yaeld

Book value

Book Value =Net worth (Paid equity capilal + reserves

+ surplus) + Number of outstanding equity shares.

We can calculate the stock price, dividend yield, capital

gain yield and price-earningratio for all the above cases
with the given informalion.

' Dividend
Yield

a.

The book value p~r share is the nel worth of the

company (paid-up equity capital plus reserves and
surplus) divided by the number of outstanding equity
shares.

.
6
Firm with normal growth rate
Firm with super normal growth rate
i
10
The expected earning per share and dividend per share
of each of the above firms are Rs.5.oo & RsA.OO
respectively. The required rate of return from equity
investments is 16%.

Price,

Other things being equal. as Ihe expct:ted growth

in dividend int:reases, the expct:led return i.e. (the
dividend yield + capital gain yield)
10lal return
depend more on the capital gain yields. less on
the dividend yield.

6%

10"".

Preference dividends and the number of outstanding

equity shares can be defined but the expected PAT is
quite difficult to estimate. Therefore, factors like sales,

13.4

88

l
"..

I.

Valuation 01 Securities

gros!; profit margin, depreciation, interest ~burdenand

tax rate will have to be considered' 'to arrive "at an
appropriate figure for PAT.

..

'E(PIE)

= PV per share
E (EPS)

To establish an appropriate price-earnings ratio for a Substituting the present value per share by the present
given share, to start with, the price-earnings ratio for value formula as per dividend discount model get
the market as a whole and also for the industry will
E(PIE} = -.!L . -L
or D~ (EPS)
have to be considered. Then the PIE ratio applicable
k g E(EPS)
(k - g)
to the particular share under consideration should be
the numerator is nothing but the expected
judged for which the following factors are to be ,where
dividend pay-out ratio.
considered.

I.

Growth rate

2.

Stability of earnings

3.

Size of the company

4.
5.

Quality of management
Dividend.pay-out ratio.

Comparing
Step I

Expected

and Actual PIE Ratios

Estimate the stock's expected price-earning ratio,

E(PIE), by studying fund.:mental facts about the firm.
Step 2

The impact of the 'above'factors in PIE ratio is rather

difficult to quantify. However, qualitative observation
can be made:

Observe the stock's current PIE by checking price and

earnings data in newspapers or investment periodicals.
Step 3

1.

Tne higher the growth rate, the higher the PIE ratio:' . Compare the stock's actuai PIE with its E(PIE) and
The greater the stability of earnings, the higher the PIE
then consult the investment decision rules below:
a.
ratio; the larger the size of the company, the higher the
. If the E(PIE) exceeds the actual PIE, the stock is
PIE ratio; the higher the dividend pay-out ratio, the

higher the PIE ratio.

!"

E(PIE) Ratio

b.

.r>'
,

The E(PIE) ratio is formed by dividing the present value

of the share by the expected earnings per share denoted
,by E(EPS).

c.

currently underpriced and this is the time to buy.

If the E(PIE) is less than the actual PIE, the stock
is currently overpriced and this is the time to sell
(or sell short).

If the E(PIE) equals the actual PIE, the stock is

correctly priced - neither buying nor selling is
desirable.
~-----

;6i
~,I
l'. ~

.r.

/j.:'.

11

89

"

--~~'.,

II

"

Self-Evaluation

Exercises

Section I
Choose the right answer from the alternatives given.

1.

2.

Current yield is
a.

Measured as the rate of return that wil! be earned on a bond if it is purchased at its current market
price and coupon interest is received

b.
c.

Coupon interest divided by previous market price.

d.

Equal to coupon rate if and only if the bonds' market price is greater than its face value
All of the above

e.

None of the above.

Assuming a constant growth rate in dividends, the intrinsic value of a share can be calculated by the
equation where Dt is dividend received a year hence, k is the rate of return required by the shareholders,
g is the constant growth rate.
a.
Dt
k - g
b.
~
k + g
c.
g + k
Dt
d.

k- g
Dt

e.

3.

4.

Dt +

k + g.

Which of the foIlowing is true?

a.

A bond is an instrument of debt issued by a business or governmental

b.

Par value is the value stated on the face of the bond.

c.
d.

A bond carries a specific interest rate which is called coupon rate.

AIl of the above.

e.

None of the above.

unit.

With respect to the effect of the number of years to maturity on bond values, which of the following is
true?

a.

When the required rate of return is less than the coupon rate, the discount on the bond declines
as maturity approaches.

b.

When the required rate of return is less than the coupon rate. the premium on the bond declines
as maturity approaches.

c.
d.

The shorter the maturity of a bond, the greater its price change in response to a given change in
the required rate of return.
AIl of the above.

e.

None of the above.

~
90

I!IIII

Valuation )1 Securttlos

5.

,-.

If I = annual interest payment, F = par value of the bond, P = present price

n

a.

J
d.

= years

to maturity.

YTM

= Yield

(If the bond.

to maturity, which of the following expressions are correct?

YTM = I + (F + P)/ n
(F + P) h
YTM

= I + (F

- P)/ n

(F - P) h

YTM = I + (F P) / n
(F + P) h
YTM = I

(F + P) / n

(F

(F P)h

e.

YTM = I

(F

- P) In

- P) / 2

6.
A Rs.l00 par value bond bearing a coupon rate of iO% will mature after 6 years. If the discount rate is

15%,which of the followingis the valueof the bond?

a.

Rs.115.64

b.

Rs.I02.57

c.

Rs.81.04

d.

Rs.80.42

e.

Rs.67.89

7.
The market price of Rs.l00 par vaiue bond carrying a coupon rate of 15 percent and maturing after 5
years is Rs.ll O. Which of the followingis the yieldto matu~tyon this bond?
a.

22.89

b.

13.65

c.

12.38

d.

10.64

il'.

e.

8.
.

,~

. 8.45

The equity stock of Sands Limited is currently selling for Rs.20 per share. The dividend expected next~
year is Rs.2.00. The investors' required'rate of return on this stock is 12 percent. Which of the following'

is the expected growth rate if the constant growth model applies to Sands Limited?
a.
5.75
b.

4.64

c.

3.25

d.

2.00

e.

None of the above.

Section II
1.
the intrinsic
valuerate
of aasbond
5Calculate
years. Take
the discount
15%.with a face value of Rs.lOO,a Coupon rate of 10% maturing after

2.
A Rs.l00 par value bond, maturing after 8 years bears a Couponrate of 14%. What will be the intrinsic
value of the bond the discount rate is 12%? and 14%?

rr.

Rs.IOOpar
valuethe
bond
is currently selling
for Rs.80. It carries a COuponrate of 10% and matures after
54\. years.
Calculate
YTM.
.

;La
91

9:;b '1 ~r
~
'" ,ceo'1,..--

..

4
q

Financial Management

4.

Markct price

= Rs.95

Par value = Rs.lOO

Coupon rate

= 12%

Maturity

YTM

s.

=8

years

=?

Par value

= Rs.lOO

Coupon rate

Maturity

= 14%

years.

= 12%

compounded
the value of the .bond.
~

semi-annually

You are considering investing in one of following bonds:

~6.

*
Your income-tax rate is 50 percent and your capital gains tax rate is effectively 30 percent. What is your
post-tax yield to maturity from these bonds?

7.
8.

A company's bonds have a par value of Rs.IOO,mature in 8 years, and carry a coupon rate of14 percent
payable semi-annual!y. If the appropriate discount rate is 16 percent, what price should the bond command
in the market place?
k = 12%
Do = Rs.3
g = 8%
PQ..

P2

9.
/10.
II.

(j))f
(J) 13.

=?

=?

Do = RsA
Po = ?

= 12%

= 16%

What is the expectedgrowthrate of a stock currentlysellingfor Rs.32, with an expecteddividendof

RsA and a requiredrate of returnof 16%?Assumethat the constantgrowthmodelapplies.
Do = Rs.5
k =?

Po

= 25

= 8%

x Co. is expected to grow at a rate of 8% for the next 10 years. After that it will grow at a rate of 9%
for the next 5 years. Beyond that it will grow at a rate of 5% forever. If the previous dividend was Rs.3
and the required rate of return is 16%, what should be the current market value of the share?
Previous dividend

RsA

Growth rate for the next 3 years

6%

Growth rate for the years 4 to 6

5%

Growth rate beyond 6 years

4%

Required rate of return

10%

Calculate the current market value.

14.

The shares of X Ltd. are selling for Rs.60 per share. With the following data, advise whether the share
is over or under valued, and also whether it should be bought or sold:
Beta
rr

= lA
= 6%

g = 8%
rm = 10%

D = 4

92

....

p.a. paid semi-annually

Required rate of return

Calculate

= 10

Solutions

Section I
I. a

2. a

3. d

4. b

5. c

6. c

7. c

8. d

Section II

I
I
I
I
,

1.

~~ ~

- 1=1 (1.15)' S + (1.15) 5

~

,f

= Rs.1O x PVIFA(l5.5)+ RsJOO x PVIF(l5.S)

= Rs.1O x 3.352 + 100 x 0.497
= Rs.83-22.

2.

a.

= 12%

Discount rate k

=~ ~+~
1=1(1.12)1

= Rs.14

= Rs.14
= Rs.!

b.

x PVIF(l2.8) + Rs.100 x PVIF(l2.8)

x 4.97 + Rs.IOO x 00404

10.

Discount rate k

'I

=~

'I

"i

3.

.If YTM
Rs.80

",'
.~f

= 14%

I=! (1.14)'

(1.l :2)8

100 8

(1.l4)

= Rs.14 x PVIFA(14.8) +
= Rs.14 x 4.64 +.Rs.100
= Rs.lOO.
= k. then
=~+~+
1=1 (l+k)1

(A)

Let k
(A)

lOOs
(l+k)

= Rs.1O xPVIFA(k.5)

Let k

Rs.IOO x PVIF(l4.8)
x 0.35

+ Rs.IOO x PVIF(k,5)

= 15%, then
= Rs.1O x PVIFA(lS.S) + Rs.IOO x, PVIF(l5.5)
= Rs.1O x 3.352 + Rs.100 x 00497
= Rs.83.24.
= 17%, then
= Rs.1O x PVIFA{I7.s) + Rs.IOO x PVIF{I7.S)
= Rs.1O x 3.2 + Rs.IOO x 0.456
= Rs.77.6

(A)

I,I

!
II"

1'
r

~ k in equation (A) lies between 15% and 17%

Using a linear approximation.
YTM

we get

= 15% + (17 - 15)% x 83.24 - 80

. 83.24 -77.6
= 15% + 1.15%
= 16.15%

93

-~ -,-=c..c-

II

Financial Management

( )
F- P

I
4.

YTM =

+-;f+P
2

SubSliluling

The values. YTM

= 12+ (100; 95)

100+95
2
= 0.1295or 12.95%

5.

The value of a bond if both the couponrate and requiredrate of returnare compoundedsemi-annually
is

2n
L

1/2

+-

1=1 (1+1:;2)1

(1+1:;2)2n

Substituting. we get

6.

20
7 '"'
100
L
1+
20
1=I (I + 0.06)
(1 + 0.06)

=
=
=

Rs.7 x PVIFA(6.20)+ Rs.lOOx PVIF(6.20)

Rs.7 x 11.47 + Rs.l00 x .312
Rs.II 1.49.

The post-tax income and maturity values are calculated as follows:

'1'.
Therefore the value of YTM(ka) for Bond-A can be solved from the following equation.
8

Rs.70

=1=1
L
+
(I + ka)1

91
(1 + ka)

= Rs.5 x PVIFA(ka.8)+ Rs.91 x PVIF(ka.8)

Assigning ka. value of 8% we get

= Rs.5 x 5.74 + Rs.91 x 0.54
= Rs.77.86
if ka = 10%. we get
Rs.5 x 5.33 + Rs.91 x 0.466
= Rs.69.1
Therefore YTM for Bond-A lies between 8% and 10%
Using a linear approximation, we get
77.86 -70
YTM = 8% + (10 - 8)% x
77.86-69.1
= 9.79%

. .
~

=
94

II

\
Valu&tion

.---

For Bond-B. the YTM .(=Kb) can be calculated

10
7 .+
88
Rs.60 = L
1=1(I + kb)t
(I + kb)IO

01 Securities

from the following equz.tion:

For kb

==Rs.7 x PVIFA(kb.lO) + Rs.88 x PVIF(kb.lO)

= 13%

= Rs.63.97

(B)
(8)

.,';::

for kb = 15%
= Rs.56.88

Therefore YTM for Bond B lies between 13% and 15%.

Applying a linear approximation in this interval. we get
63.97 - 60
13% + (15 - 13)% x
63.97 - 56.88
YTM for B = 14.12%
I'

7.

Iii

'The price the bond should command in the market place is given by

'

16
7
100
L
+
16
1=1(I + 0.08)1 (I + 0.08)

= Rs.7
= Rs.7

x PVIFA(8.16) + Rs.l00 x PVIF(8.16)

x 8.85 + Rs.loo x 0.29

= Rs.90.95
8.

Po

DI

--

Ks-g

Do(1 + g)
ks- g

Substituting

the given values

Po

Po

= Rs.81

P2

3(1 + 0.08) - 3 x 1.08

- 0.12- 0.08 D3

-=Do
(ks - g)

0.04
(I + g)3

(ks- g)

3( 1+ 0.08)3
(0.12-0.08)

~t

!I
!I

= Rs.94A8.
9.

We have
Po

-- D.
ks- g

II
II

- Do(1+g) - 4(1+0.12)
- ks-g -0.16-0.12

= Rs.112
10.

Given DI
ks
r, Po

= RsA

= O.16
= Rs.32

D,
We have Po =ks- g

95

Ii

"

.
Financial Management

=>g

01

=ks-- Po
-

"

..i.

- 0.1v - 32
= 0.035
11.

Therefore the expected growth rale is 3.5%

c Rs.5
Po = Rs.25 g = Sra
Given Do

We have Po

==-DI
k-g

Substituting. we get
Rs.25

= Rs.5(
I + O.OS)
k - 0.08
5
=> k = 25 (I + 0.08) + O.OS

= 0,296

12.

or the required rate of return k 29.6%

a.
The present value of the dividend stream for the first 10 years can be given by the formula
n
A

= Do L

= Rs.3

(=:
10

(l + d x PVIF(k,t)

L (l + 0.08)\ x PVIF(16;t)
\=1

= Rs.20.68
b.

The present value of dividend stream for the next 5 years with a growth rate of 9% will be
S
13

= Rs.3

(I + 0.08)

10

\.

x L (I + 0.09) x PVIF(16.\ + 10)

\=1

= Rs.6.476 x 0.943
= Rs.6.11
c.

The market price of the share at the end of 15th year (PIS) is given by
PIS

!b.L

(ks - g)

Where DI6

10.46
0.16 - 0.05

= Rs.95.1.

= 015 (I + g)
= 3 (1.08)10(1.09)s (l

+ 0.05)

= Rs.IO.46

Present yalue of market price (C)

= Rs.95.1 x 0.108
= Rs.10.27

The intrinsic value per share

+ 6.11 + 10.27
= Rs.37.06

= 20.68
13.

=A

= 95.1

x PVIF(l6.IS)

+ B + C

PV if dividend stream for 3 years

= Rs.4[(1 + 0.06) PVIF(lo.l) + (1.06)2 PVIF(l0.2) + (1.06)3

= Rs.4 [1.06x 0.909 + 1.124x 0.826+ 1.191x 0.751]

= RsA [0.964 + 0.928 + 0.894] = RsA(2.786)

= Rs.11.l4

PVIF(lO,3)]

(A)

4
~

96

~
~

..
\I

"
1

Valuation of Securities
/""';

PV of dividend stream for years 4 to 6

= RsA( I + 0.06)3
= RsA.764 [0.717

= RsA.764
= Rs.9.78

(1.05 x PVIF(lO.4) + (1.05)2 x PVif'(lO.5) + (1.05)3 PVIF(lO.6)

+ 0.684 + 0.653)

x 2.054
(B)

Markct valuc of the share at the end of year 6 (P6) is given by

D7
.
P6
=".,5.73/0.1- 0.04

ks- g
= Rs.95.5

Where D7 = D6 (I + g)
= 5.51(1 + 0.04)
= Rs.5.73

P6 x PVIF( 10.6)= Rs.53.86

Therefore the intrinsic value of the share
A + B + C = Rs.1 1.14 + 9.78 + 53.86
= Rs.74.78

. Present value of P6

(C)

14.

The current market value

Given risk free rate rr
Market return rm
f)

= Rs.74.78
= 6%
= 10%
= 1.4

The required rate of return ks is given by

ks rr + 13 (rm - rc)
Substituting. we get

ks

= 0.06

= 0.116

+ 1.4 (0.1 - 0.06)

or 11.6%

.
Th e market pnce

4(1 + 0.08)
= DoKs(I- +gg) = 0.116
= R s.120
- 0.08

The intrinsic price (or the theoretical market price) of the share is Rs.120 which is more than the current
market price of Rs.60. Hence, the share is undervalued and should be bought.

97