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Financial Management I BBPW3103

Chapter 4 Valuation of Securities

Valuation
Is the process to identify the of assets or investment The valuation of assets can be done by several methods:
Book Value : The value of an asset as stated in balance sheet. The market value of the asset is difference with the book value. Liquidation Value : Is the value of asset when an asset is sold Market Value : Value of asset available in the market as determined by supply and demand in the market Intrinsic Value : Is the present value of all the potential cash flow that will be obtained after discounting at the rate of return required by investor

Valuation Process
Is a process to determine the value of asset by using Time Value of Money technique Factor that influence the value of asset
Total cash flow : The value of asset depend on the total cash flow that is expected. Timing : Refer to the period of receiving the cash flow Required Rate of Return : Refer to the return that required by the investor. The higher the risk of the investment, the higher return that will be obtained.

Basic Model Valuation


Os the process to determine the Present Value of asset 3 basic steps in the valuation process
Estimating the amount and timing of cash flow that would be received (CFt) Determine the required rate of return (k) Calculating the intrinsic value of asset that is Present Value (V)

Basic Model Valuation


The early formula of Present Value PV = FV (1 + i)n Then, modified to (for 1 year) V = CF (1 + k)t Present Value for more than one year V = CF1 CF2 .......... .. CFn
(1 k) 1
n

(1 k) 2

(1 k) n

CFn n t 1 (1 k)

Bond
Is the fixed income securities that will be received interest at the fixed rate Figure below is the concept of the bond

Characteristics of Bonds
Claims on Assets and Earning : Bond holder have the priority to claim on the earning and company assets compared to preference share and ordinary share Par Value : Is the value of the bond that stated of the document. This value will be received with interest payment at the maturity date Coupon Rate : Refer to the return to bond holder Indenture : Is the contract between trustee (bond holder) and the company that issued the bond Maturity Date : Is the time that the bond will be redeem Floating Rate : The Coupon Rate may change based on the current interest rate Zero Coupon Bond : The bond sold at the lower price than the par value Embedded Bond : The bond that call back before the maturity date

Rating of Bond
Process to determine the value and grade the bond 2 rating agencies in Malaysia that is
Rating Agency Malaysia (RAM) : For LongTerm Bond, the valuation of AAA indicates a high level of credit trust compare to the AA and BBB. Malaysian Rating Corporation Berhad (MARC) : Use AAA-D grade for long-term bond and use MARC1-MARC4 for short-term bond

Types of Bonds
Mortgage Bond : Is a secured bond backed by tangible asset such as building and land. The secured value is higher than the value of bond issued Debenture : Is the long-term loan that are not secured with assets but depend on the company ability to obtain earning Have a higher risk compare to secured bond High Yield Bonds : Bond that pay interest based on the company surplus earning

Types of Bonds (Cont)


Convertible Bond : Refer to the bond that can be convert to ordinary share at the price determined by the company Zero Coupon Bond : The bond dont pay interest but the bond sold at the lower price than the par value Euro Bond : Bond that were initially issued in the European countries using USD currency by the foreign companies Foreign Currency Bond : Issued in the financial market of a country using its own countrys currency

Valuation of Bond
There are 3 elements that influence the valuation that is:Amount and timing of cash flow that will be received by investors Maturity date of bond Rate of return required by investor

Basic Valuation of Bonds


Bond value is the total present value of payment that must be paid by issuer from now until to maturity date The formula of value bond is

Basic Valuation of Bonds (Cont.)


Dimana :

Vb I n kb M PVIF PVIFA

= Nilai intrinsik atau harga semasa bond = Bayaran kupon = Tempoh bon sehingga matang = Kadar pulangan diperlukan = Nilai muka = Interest factor of Present Value = Interest factor of Present Value Annuity

Basic Valuation of Bonds (Cont.)


Example 4.1 : Bond A has 10 years maturity period. The coupon bond rate is 10% per year and the interest is paid annually. The par value of the bond is RM1,000. The return required is 8% per year. What is the value of the bond?

Basic Valuation of Bonds (Cont.)

Basic Valuation of Bonds (Cont.)

Value of Bond and Required Rate of Return


When the required rate of return different from the coupon bond, the value of the bond is different from the par value. This causes of
Changes in the economic situation that causes the cost of the long-term funds to change as well Change in the company risk

Value of Bond and Required Rate of Return (Cont.)


Required Rate of Return > Coupon Rate (k>i)
Example 4.2 : Bond A has a maturity period of 10 years with the coupon rate of 10% per year and the interest payable every year. The face value is RM1,000 and the required rate of return is 12%. V = I(PVIFAk,n) + M(PVIFk,n) = RM100(PVIFA12%,10) + RM1,000(PVIF12%,10) = RM100 (5.650) + RM1,000(0.322) = RM887.000 The Value of bond < face value of the bond

Value of Bond and Required Rate of Return (Cont.)


Required Rate of Return < Coupon Rate (k<i)
Example 4.3 : Bond A has a maturity period of 10 years with the coupon rate of 10% per year and the interest payable every year. The face value is RM1,000 and the required rate of return is 8%. V = I(PVIFAk,n) + M(PVIFk,n) = RM100(PVIFA8%,10) + RM1,000(PVIF8%,10) = RM100 (6.7101) + RM1,000(0.4632) = RM1,134.21 The Value of bond > face value of the bond

Value of Bond and Required Rate of Return (Cont.)


Required Rate of Return = Coupon Rate (k=i)
Example 4.4 : Bond A has a maturity period of 10 years with the coupon rate of 10% per year and the interest payable every year. The face value is RM1,000 and the required rate of return is 10%. V = I(PVIFAk,n) + M(PVIFk,n) = RM100(PVIFA10%,10) + RM1,000(PVIF10%,10) = RM100 (6.1466) + RM1,000(0.3855) = RM1,000.16 The Value of bond = face value of the bond

Payment of Interest Twice a Year


To calculate the value of bonds that pay interest twice a year
Change the annual interest (I) to interest twice a year by dividing interest with 2 (I 2) Change the number of maturity period (n) by multiplying n with 2 (n x 2) Change annual required rate of return (k) by dividing k with 2 (k 2)

Payment of Interest Twice a Year (Cont.)


The formula is

I = (PVIFAk/2 , 2n ) M(PVIFk/2 , 2n ) 2

Payment of Interest Twice a Year (Cont.)


Example 4.5 : Maya Enterprise Company had issued bonds that have a maturity period 8 years with coupon rate 8% that is payable semiannually. The par value of the bond is RM1,000. If the required rate of return is 10%, what is the value of the bond?

Yield To Maturity (TYM)


Is the expected return that will received by investor There are 2 way to determine the YTM that is

Yield To Maturity (TYM) (Cont.)


Example 4.6 : Orlid Company Bhd issued bonds that have a par value RM1,000 with a coupon rate 10% per year and matured in 10 years. The present price of the bond is RM1,080. What is the YTM for the bond?

Relationship Between Value and YTM

Relationship Between Value and YTM (Cont.)


From the table and figure above
When the required rate of return same as the coupon rate of the bond that is 10%, the value and the par value of the bond is same that is RM1,000 When the required rate of return increase from 10% to 12%, the value of the bond decrease from RM1,000 to RM887 When the required rate of return decrease from 10% to 8%, the value of the bond increase from RM1,000 to RM1,134.21

Change to Required Returns


Change in return required is depend on the period of the bond. The shorter the maturity period of the bond, the lower return to the bond holder. The longer the maturity period of the bond, the higher return to the bond holder as shown below Required Rate of Return (%) Value of Bond 10 Years (RM) Value of Bond 5 Years (RM)

8 10 12

1,134.21 1,000.00 887.00

1,079.87 1,000.00 927.82

Ordinary Share
Ordinary share didnt have maturity period. It will remain forever as long as the company is still in operation Return to the shareholder in form of dividend payment The payment of dividend done after the dividend to the preference share paid

Characteristics of Ordinary Share


Claim on Earning : Ordinary shareholders have right on surplus earnings after the interest for bind holder and dividend for preference shareholder have been paid in form of cash or retained earning Claim on Earning and Assets of Liquidation : The ordinary shareholders will be the last to claim the earning and assets after the claims of bond holders and preference shareholders

Characteristics of Ordinary Share (Cont.)


Voting Right : Ordinary shareholders have right to choose the Board of Director that be done by the shareholders or via a Proxy (giving the right to the third party to vote on behalf of shareholders) Pre-emptive Right : Allow the shareholders to maintain the ownership in hand if the company intends to issue new share Limited Liability : If the liquidation of the company occurs, the liability of the ordinary shareholders is limited to the total invested to the company

Valuation of Ordinary Share


The ordinary shareholders will receive return in 2 forms
Dividend : Profit that are distributed to shareholders Capital Gain : The difference between selling price and the purchase price of the share

The dividend receive by the shareholders is depend on the company profit and the growth rate of the company. Growth rate (g) of the company can be measured using the below formula g = ROE x r

Valuation of Ordinary Share (Cont.)


Example : If the Return on Equity (ROE) is 18% and the profit retained is 50%, the growth (g) is 9% (18% x 50%) Example : If the company retains 25% of its profit, then the value of share will increase to 4.5% (18% x 25%)

Valuation of Ordinary Share Holding in One Period


The valuation process involves 3 steps:Assume the cash flow that is expected to be received in the future (Dividend + Selling Price of the Bond at the end of the Period) Estimate the cash flow required by investor by taking into consideration the risk of expected cash flow Discount the dividend that is expected to be received and the price of share at the end of the period

Valuation of Ordinary Share Holding in One Period (Cont.)


The formula is

Where V = Present value of ordinary share D1 = Cash dividend that is expected to be received at the end of the period P1 = Price of share that is expected at the end of the period K = Required Rate of Return

Valuation of Ordinary Share Holding in One Period (Cont.)


Example 4.7 : Assume an investor plan to buy share in Mercu Company. It expects that the dividend payable will be RM0.15 at the end of the one year. It believes that the share can be sold at the price of RM2.40 for a period of one year holding. What is the value of Mercus share if the required rate of return is 12%? V = [D1 (1 + k)1] + [P1 (1 + k)1] = [RM0.15 (1 + 0.12)1]+[RM2.40 (1 + 0.12)1] = RM0.13 + RM2.14 = RM2.27

Valuation of Ordinary Share Holding in Multiple Periods


Share are holding more than one period such as more than one year. The formula is:-

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Zero Growth
Means that the dividend are not expected to growth (g=0). This means that the dividend receive in the future is the same with the dividend received in the previous year (D1=D2=.=Dn) The formula is V = D1 k

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Zero Growth (cont.)
Rias Company is a company that has been operating for a long time in the fast food industry. Lately, the company had paid dividend for RM0.20 per share. The management expect the dividend to maintain in the future. If the required rate of return is 12%, what is the value of the Rias share? V = D1 k = RM0.20 0.12 = RM1.67

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Constant Growth Rate
The dividend increase from time to time Below is the formula to calculate the share if there are period

Below is the formula to calculate the share if the bond have infinity period V = D1 (k g)

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Constant Growth Rate (Cont.)
BBB Company paid dividend of RM0.20 at the end of last year and is expected to pay cash dividend every year starting from now until forever. The rate of growth for each year is 10% while the rate of return is 15%. The value of bond is Step 1 : Find the dividend D1 = D0(1 + g) = RM0.20 (1 + 0.1) = RM0.22 Step 2 : Find the Present Value V = D1 (k g) = RM0.22 (0.15 0.10) = RM4.40

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Inconstant Dividend Growth
The dividend paid at the inconstant growth There are 3 steps to calculate the value of share
Calculate the present value of the dividends for the entire period of inconstant growth Calculate the share price at the end of the inconstant period of growth and then discount this price at the present value Add the present value obtained from step 1 and step 2 to obtain the intrinsic value

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Inconstant Dividend Growth (Cont.)
Example 4.10 : Assume the following information
K n gs gn D0 = Required rate of return is 12% = Period of inconstant growth is 3 years = Rate of dividend growth is 25% = Fixed rate if 6% = Last dividend paid is RM0.20 per share

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Inconstant Dividend Growth (Cont.)
Calculation :
Step 1 : Calculate the expected dividend for each year D1 = D0(1 + g)1 = RM0.20(1 + 0.25)1 = RM0.25 D2 = D0(1 + g)2 = RM0.20(1 + 0.25)2 = RM0.3125 D3 = D0(1 + g)3 = RM0.20(1 + 0.25)3 = RM0.3906 Step 2 : Calculate the price of the bond D4 = D0(1 + g)4 = RM0.20(1 + 0.25)4 = RM0.414 P3 = D4 (k gn) = RM0.414 (0.12 0.06) = RM6.90

Valuation of Ordinary Share Holding in Multiple Periods (Cont.)


Inconstant Dividend Growth (Cont.)
Calculation :
Step 3 : Discount the cash flow for 3 years Vcs = RM0.25(PVIF12% , 1) + RM0.3125(PVIF12% , 2) + RM0.3906(PVIF12% , 3) + RM6.90(PVIF12% , 3) = RM0.223 + RM0.249 + RM0.278 + RM4.911 = RM5.66

Required Rate of Return for Ordinary Share


The rate of return is calculated based on the value or price of share and the dividend received. The expected rate of return shown for the 2 aspects of growth
Zero Growth Constant Growth Rate

Required Rate of Return for Ordinary Share (Cont.)


Zero Growth
The formula is Kcs = D Vcs Example 4.11 : Cergas Maju Company has just sold its ordinary share at RM2.30 per share. Last year, the company paid dividend RM0.25. The manager expect the company will no growth for a long period of time. What the expected rate of return for the share Kcs = D Vcs = RM0.25 RM2.30 = 10.87%

Required Rate of Return for Ordinary Share (Cont.)


Constant Growth Rate The formula is Kcs = (D1 Vcs) + g Example 4.12 : The ordinary share for Maju Jaya Company sold at RM3.38. The company has just paid dividend of RM0.30 per share and is expected to experience constant growth of 8.5%. What the return that your expect to receive?

Preference Shares
Characteristics of Preference Share
Issuance of Several Classes of Preference Share : Every class of share have different characteristics Claim of Assets and Earning : After bond holder and before ordinary shareholders Cumulative Dividend : If there are dividend arrears, the company must pay those dividend first before the dividend paid to ordinary shareholders

Preference Shares (Cont.)


Characteristics of Preference Share (Cont.)
Provision for Protection : To protect the interest of preference shareholders Convertible Preference Share : The preference share have option to convert it to several units of ordinary share Redeemable Preference Share : Company can call back the share if the interest rate decrease and will issue new preference share at the lower rate

Preference Shares (Cont.)


There are 2 methods to redeem the preference share
Provision for Call Option : Enable company to buy back the share at a price that had been specified and within a period that had been specified Provision for Sinking Fund : Require the company to separate a sum of money for the purposes of redeeming the preference share

Valuation of Preference Share


There are 3 steps to evaluate preference share
Assume the amount and timing of the cash flow that will be received from the investment of preference share Calculate the risk of cash flow that is expected to be received and then determine the rate of return required by the investor Calculate the intrinsic value by discounting all the cash flow

Valuation of Preference Share


The formula is Vps = D kps Example 4.13 : The annual dividend that is expected to be receives is RM0.36 per shares. The rate of return required is 7%. The value of the preference share is Vps = D kps = RM0.36 0.07 = RM5.14

Expected Rate of Return for Preference Share


The formula is kps = D Vps Example 4.14 : Cher Mate Company sold its preference share at RM5.50 and pays dividend of RM0.25 per share. What the expected return of the preference share? kps = D Vps = RM0.25 RM5.50 = 4.54%