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Objectives
The objectives of this chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
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Financial Management
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Financial
Decisions
Investment
Decisions
Financing
Decisions
Dividend
Decisions
Long-term assets: This involves huge investment and yield a return over a period of time in future. It is also
termed as 'capital budgeting' and can be defined as the firm's decision to invest its current funds most efficiently
in fixed assets with an expected flow of benefits over a series of years.
Short-term assets: These are the current assets that can be converted into cash within a financial year without
diminution in value. Investment in current assets is termed as 'working capital management'.
Financing decisions
Financing decisions relate to the acquisition of funds at the least cost. The cost has two dimensions which have been
illustrated in the below mentioned table.
Explicit cost
Implicit cost
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Financial Management
Macroeconomics: It is the environment in which an industry operates, which is not controllable. It is important
for financial managers to understand changes in macroeconomics and their impact on the firm's operating
performance. External environment analysis helps in identifying opportunities and threats.
Microeconomics: It is concerned with the determination of optimum operational strategies. All financial decisions
of a firm are made on the basis of marginal cost, and marginal revenue. Therefore it is necessary to understand
the relationship between finance and economics.
Relationship to accounting
Accounting and finance are closely related. For computation of return-on-investment, earnings per share of various
ratios for financial analysis, the data base will be accounting information. Without proper accounting system, an
organisation cannot administer effectively function of financial management. The purpose of accounting is to report
the financial performance of the business for the period under consideration.
Relationship to HR (Human Resource)
HR activities include recruitment, training, development, fixing compensation and so on for which we need finance.
HR managers need to consult finance managers. Finance managers take decision after studying the impact of HR
activity on organisation.
Relationship to production
Production department is another functional area that involves huge investment on fixed assets. The production
manager and the finance manager need to work closely for effective investment on plant and machinery.
Relationship to marketing
Marketing functions involves selection of distribution channel and promotion policies. These two are the primary
activities of marketing department and involves huge cash outflows. Therefore finance and marketing managers
need to work with coordination to maximise value of the firm.
Formulation of polices for giving effect to the financial plans under consideration
Develop procedures
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Formulation of policies and instituting procedures for elimination of all types of wastages in the process of
execution of strategic plans.
Maintaining the operating capability of the firm through the evolution of scientific replacement schemes for
plant and machinery and other fixed assets.
Flexibility
Government policy
1.6 Capitalisations
Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the firm.
It has two components, viz., debt and equity.
After estimating the financial requirements of a firm, the next decision that the management has to take is to arrive
at the value at which the company has to be capitalised. The two theories of Capitalisation are:
1.6.1 Cost Theory
According to the cost theory of capitalisation, the value of a company is arrived at by adding up the cost of fixed
assets like plants, machinery patents, the capital that regularly required for the continuous operation of the company
(working capital), the cost of establishing business and expenses of promotion. The original outlays on all these
items become the basis for calculating the capitalisation of company.
Merits of cost approach
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Financial Management
1.7 Over-capitalisation
A company is said to be overcapitalised, when its total capital exceeds the true value of its assets. The correct
indicator of overcapitalisation is the earnings capacity of the firm. If the earnings of the firm are less then that of
the market expectation, it will not be in position to pay dividends to its shareholders as per their expectations. It is
a sign of overcapitalisation.
Effects of over-capitalisation
Market value of company's share falls, and company loses investors confidence
Initiating merger with well managed profit making companies interested in taking over ailing company
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1.8 Under-capitalisation
A company is considered to be under-capitalised when its actual capitalisation is lower than its proper capitalisation
as warranted by its earning capacity.
Causes of under-capitalisation
Maintaining very high efficiency through improved means of production of goods or rendering of services
Effects of under-capitalisation
Encouragement to competition
It encourages the management of the company to manipulate the company's share prices
High margin of profit may create among consumers an impression that the company is charging high prices
for its product
Remedies
Splitting up of the shares- This will reduce the dividend per share
Issue of bonus share This will reduce both the dividend per share and earnings per share.
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Financial Management
Summary
Financial management "is the operational activity of a business that is responsible for obtaining and effectively
utilising the funds necessary for efficient operations.
Wealth maximisation refers to maximising the net wealth of the company's share holders.
Financial Planning is a process by which funds required for each course of action is decided.
A financial plan has to consider capital structure, capital expenditure and cash flow.
Capitalisation of a firm refers to the composition of its long-term funds. It refers to the capital structure of the
firm. It has two components, viz., debt and equity.
The earnings theory of capitalisation recognises the fact that the true value (capitalisation) of an enterprise
depends upon its earnings and earning capacity.
A company is said to be overcapitalised, when its total capital exceeds the true value of its assets.
References
Correia, C., Flynn, D. K., Uliana, E. & Wormald, M., 2012. Financial Management, 6th ed., Juta and Company
Ltd.
Financial Planning - Definition, Objectives and Importance, [Online] Available at: <http://www.
managementstudyguide.com/financial-planning.htm> [Accessed 27 May 2013].
2011. Financial Management - Lecture 01, [Video online] Available at: <http://www.youtube.com/
watch?v=iDlFPm3fqbs> [Accessed 27 May 2013].
Recommended Reading
Brigham, E. F., 2010. Financial Management: Theory & Practice. 13th ed., South-Western College Pub.
Shim, J. K., 2008. Financial Management (Barrons Business Library). 3rd ed., Barrons Educational Series.
Brigham, E. F., 2009. Fundamentals of Financial Management. 12th ed., South-Western College Pub.
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Self Assessment
1. Wealth maximisation refers to maximising the ___________ of the company's share
a. profit
holders
b. net wealth
c. assets
d. liabilities
2. A company is said to be ____________, when its total capital exceeds the true value of its assets.
a. under-capitalised
b. capitalised
c. overcapitalised
d. profit maximisation
3. Which of the following statements is false?
a. Capitalisation of a firm refers the composition of its short-term funds.
b. A financial plan has to consider Capital structure, Capital expenditure and cash flow.
c. Wealth maximisation refers to maximising the net wealth of the company's share holders
d. Goal of financial management of a firm is maximisation of economic welfare of its shareholders
4. The earnings theory of Capitalisation recognises the fact that the _________ of an enterprise depends upon its
earnings and earning capacity.
a. false value
b. total value
c. true value
d. half value
5. Which of the following cost is not visible but it may seriously affect the company's operations especially when
it is exposed to business and financial risk.
a. Explicit cost
b. Implicit cost
c. Direct cost
d. Indirect cost
6. Match the following
Concept
A. Explicit cost
B. Financial Planning
C. Long-term assets
D. Short-term assets
a. A-2, B-1, C-4, D-3
Description
1. A process by which funds required for each course of action is decided
2. This involves huge investment and yield a return over a period of time in
future.
3. The current assets that can be converted into cash within a financial year
without diminution in value
4. The cost in the form of coupon rate, cost of floating and issuing the securities
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Financial Management
7. ___________ is the operational activity of a business that is responsible for obtaining and effectively utilising
the funds necessary for efficient operations.
a. Financial planning
b. Financial management
c. Asset management
d. Budget management
8. ______________is a major decision made by the finance manager on the formulation of dividend policy.
a. Investment decision
b. Financing decision
c. Dividend decision
d. Accounting decision
9. Financing decisions relate to the acquisition of funds at the _________ cost.
a. maximum
b. less
c. more
d. least
10. Which among the following is the primary goal of financial management of a firm?
a. Maximisation of economic welfare of its shareholders
b. Encouragement to competition
c. Fall in dividend rates
d. Effective utilisation of funds
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Chapter II
Time Value of Money
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
describe the sinking fund factor with its formula for calculation
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Financial Management
Uncertainty: Future is uncertain and it involves risk. An individual is not certain about future cash inflows.
Hence, the individual would prefer to receive cash toady instead of future.
Current consumption: Most of the people prefer to use the present money for satisfying existing present
needs.
Possibility of investment opportunity: The reason why individuals prefer present money is due to the possibility
of investment opportunity through which they can earn additional cash.
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Financial Management
For instance:
From the following dividend data of a company calculate compound rate of growth for period (1998-2003).
Year
Dividend per share (Rs.)
1998
21
1999
22
2000
25
2001
26
2002
28
2003
31
Solution:
gr= 8%
Note
See compound one rupee Table for 5 years (total years one year) till you find closest value to the compound factor,
at closest value see upward to the table to get growth rate.
Compound Value of Series of cash Flows
Annuity means a series of cash flows (inflow or outflow) of a fixed amount for a specified number of years. Compound
value of a series of cash flows can be calculated by the following formula (uneven cash flows)
Where CVn= Compound value at the end of' 'n' year
P1 = Payment at the end of year 1, P2 = Payment at the end of year 2
Pn = Payment at the end of year 'n', I = Interest rate
CVn = P1 (CVIF I.1) + P2 (CVIF I.2) + Pn (1+I I.n)
For instance
Mr. Shyam deposits Rs. 5,000, Rs. 10,000, Rs. 15,000, Rs. 20,000 and Rs. 25,000 in his savings bank account in
year 1,2,3,4 and 5 respectively. Interest rate of 6 %, he wants to know his future value of deposits at the end of 5
years.
Solution:
Where,
P = Fixed periodic cash flow, I Interest rate
n = duration of the amount
= (CVIFA I.n)
(CVIFA I.n) = Future value for interest fact or annuity at 'I' interest and for 'n' years.
For the example above this formula can be used as below.
= 500(6.975)
= Rs. 3,487.5
Note: See compound value interest factor annuity Table of one rupee Table for 6 years at 6 % interest.
Compound Value of Annuity Due
When the cash flows involves at the beginning of the year compound value of annuity is calculated with the following
formula:
OR
For instance
Suppose you deposit Rs. 2,500 at the beginning of every year for 6 years in a saving bank account at 6 % compound
interest. What is your money value at the end of 6 years?
Solution:
= 2,500 (6.975) (1+0.06)
= Rs. 18, 4863.75
Financial Management
For instance:
If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?
Solution: DP = 72 I = 72 10 = 7.2 years (approx.)
Rule of 69
Rule of 72 may not give exact doubling period, but rule of 69 gives a more accurate doubling period. The formula
to calculate doubling period is
DP =0.35 + 69/I
For instance: If you deposit Rs. 500 today at 10 % of interest in how many years will this amount double?
Solution: 035 + 69/10 = 7.25 years
Effective rate of interest (ERI) in case of doubling period
Effective rate of interest can be defined with the use of following formula.
In case of rule of 72
ERI = 72 Doubling period (DP)
Where ERI = effective rate of interest, DP = Doubling period
In case of rule of 69
For instance
A financial institute has come with an offer to the public, where the institute pays double the amount invested in
the institute at the end of 8 years. Mr. A who is interested to deposit with institute wants to know the effective rate
of interest that will be given by institute.
Solution as per rule of 72: 72 8 years = 9 %
Solution as per rule of 69:
= 9 % (approx.)
PV = Present value
OR
= Rs. 30,040
Note: * Present value of one rupee Table at 3 years for the arte of 10 %
Present value of a series of cash flows
We have calculated the present value of a single amount to be received after a specified period. In many cases, we
may need to calculate present value of series cash flows. For example, in capital budgeting decisions, there is a need
to convert the future cash inflows into present values to take decision and in case of raising funds through debt also
needs to convert the future cash outflows into present values. Cash flows over a period may be even or uneven.
Present Value of Uneven Cash Flows
OR
+ +
PV = Present value
I = Interest rate or discounting factor or cost of capital
n = Duration of the cash inflows stream
t = Year in which cash inflows are receivable
For instance
From the following information, calculate the present value at 10% interest rate.
Year
Cash inflow (Rs.)
2,000
3,000
4,000
5,000
4,500
5,500
Solution:
= 2,000+ 2,727 + 3,304 + 3,755 + 3,073.5 + 3,415.5
= Rs. 18,275
Present Value of even Cash Flows (annuity)
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Financial Management
Solution:
= 1.1038-1
= 0.1038 OR 10.38 %
Convert the series of cash flows into present values at a given discount factor
Add all the present values of series of cash flows to get total PV of a growing annuity
Formula:
PVGA= PV of growing annuity
CIF = Cash inflows
g= Growth rate
I = discount factor
n= Duration of the annuity
For instance: A Real estate Agency has rented out one of their apartment for 5 years at an annual rent of Rs. 6,00,000
with the stipulation that rent will increase by 5% in every year. If the agency's required rate at return is 14%. What
is the PV of expected (annuity) rent?
Solution: Calculate on series of annual rent
Year Amount of Rent (Rs.)
1
6,00,000
2
6,00,000 X (1+0.05) 6,30,000
3
6,30,000 X (1+0.05) 6,61,500
4
6,61,500 X (1+0.05) 6,94,575
5
6,94,575 X (1+0.05) 7,29,303.75
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Financial Management
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Summary
One of the most fundamental concepts in finance is that money has a time value. That is to say that money
in hand today is worth more than money that is expected to be received in the future.
Simple interest is the interest paid on only the original amount, or principle borrowed.
Simple amount is a function of three components such as principle amount borrowed or lent, interest per annum
and the number of years for which the interest rate is calculated.
Doubling period is the period required to double the amount invested at a given rate of interest.
The present value of a future cash inflow (or outflow) is the amount of current cash that is of equivalent value
to the present value.
Effective and nominal rate are equal only when the compounding is done yearly once, but there will be a
difference, that is effective rate is greater than the nominal rate for shorter compounding periods.
Loan is an amount raised from outsiders at an interest and repayable at a specified period. Payment of loan is
known as amortisation.
References
Introduction to the Time Value of Money, [Online] Available at: <https://www.boundless.com/accounting/timevalue-money/introduction-to-time-value-money/> [Accessed 27 May 2013].
Paramasivan, C. & Subramanian, T., 2009. Financial Management, New Age International.
2013. Financial Management: Lecture 2, Chapter 5: Part 1 - Time Value of Money, [Video online] Available
at: <http://www.youtube.com/watch?v=vpJszYCLH3o> [Accessed 27 May 2013].
Prof. Ahmed, M., 2010. Time Value of Money, [Video online] Available at: <http://www.youtube.com/
watch?v=CnRJ6Jypsj4> [Accessed 27 May 2013].
Recommended Reading
Drake, P. P., 2009. Foundations and Applications of the Time Value of Money. Wiley
Benninga, S., 2006. Principles of Finance with Excel. Oxford University Press, USA
Block, S., 2008. Foundations of Financial Management w/S&P bind-in card + Time Value of Money bind-in
card. 13th ed., McGraw-Hill/Irwin.
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Financial Management
Self Assessment
1. Individual prefers ________opportunity to receive money now rather than waiting for one or more years to
receive the same
a. value
b. money
c. interest
d. principle
2. ________ is an amount raised from outsiders at an interest and repayable at a specified period
a. Money
b. Loan
c. Principle
d. Value
3. ________ rate of interest or rate of interest per year is equal
a. Sinking
b. Present value
c. Nominal
d. Principle
4. The present value of a future cash inflow (or outflow) is the amount of _________ cash that is of equivalent
value to the present value
a. current
b. future
c. past
d. lost
5. Which of the following statements is false?
a. Annuity is a series of odd cash flows for a specified duration
b. Simple interest is the interest paid on only the original amount
c. Growing annuity means the cash flows that grow at a constant rate for a specified period of time
d. The processes of determining present value of future cash flows are called discounting
6. Compounding interest is also referred as __________.
a. future value
b. current value
c. asset value
d. amount value
7. ________ period is the period required to double the amount invested at a given rate of interest.
a. Compounding
b. Growth
c. Discounting
d. Doubling
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Financial Management
Chapter III
Valuation of Bonds and Shares
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
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Book value: It is an accounting concept. Assets are recorded in balance sheet at their book values. Book value
of an asset is cost of acquisition less accumulated depreciation. It is determined by the formula below.
Market value: Market value of an asset is the price at which the asset is bought or sold in the market. Market
value per share is generally higher than the book value per share for profitable and growing firms.
Going concern value: It is the value that a firm can be realised if it sells its business as a continuing operating
business. This value would be higher than the liquidation and book value. Valuation of securities is always
considered as going concern, because if the firm is not running, investors would not invest in securities
Liquidation value: Liquidation value is the actual amount that can be realised when an asset is sold. Liquidation
value of a equity stock is the actual amount that would be received if all of the firm's assets were sold at their
market value, liabilities were paid, and the remaining proceeds were by number of equity shares outstanding.
Intrinsic value: Investors invest on equity stock with an expectation of intrinsic cash inflow stream. The present
value of the cash inflows expected from a security over its holding period. Present value is computed by
discounting future cash inflows at an appropriate rate. It is also called economic value.
Par value: The par value (Face Value) is stated on the face of the bond. It is the amount at which a bond is issued
to public, and promises to pay either at the end of maturity period or in pre-decided installments.
Coupon rate: Coupon rate is the interest rate with which a bond is issued. The interest payable at regular intervals
is the product of the par value and the coupon rate broken down to the relevant time horizon.
Maturity period: Refers to the number of years after which the par value becomes payable to the bond-holder.
Redemption value: It is the amount the bond-holder gets on maturity. A bond may be redeemed at par, at a
premium (bond-holder gets more than the par value of the bond) or at a discount (bond-holder gets less than
the par value of the bond)
Market value: It is the price at which the bond is traded in the stock exchange. Market price is the price at which
the bonds can be bought and sold and this price maybe different from par value and redemption value.
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Financial Management
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= Rs.120/.015 = Rs.800
Where,
SP = Sales proceeds a bond (price of bond)
I = Annual Interest payment (Rs.)
M = Maturity value of bond
n= Maturity period
Kd= Yield to maturity
Illustration: XYZ company bond, currently sells for Rs.1, 000 (Face value 900) it has a 10% interest rate, and with
a maturity period of 10 years.
OR
Alternatively
Years
CIFs (Rs.)
DF
10%
6%
1 to 10
90
6.145
7.360
10
900
0.386
0.558
PV (Rs.)
10%
553.05
347.40
900.45
1000.00
(-)99.55
6%
662.4
502.2
1164.6
1000.00
164.6
Yield to maturity:
=
= 6% +
= 6% + 2.49
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Financial Management
= 8.49 %
Yield to Call (YTC)
Yield to call is exactly similar to YTM, but here yield is found till the call of the bond. Some corporate issues bonds
with call feature that allows the company call back the bond before maturity period. In such cases bond holder would
not have the option of holding the bond until the maturity period. Therefore, YTM would not ne earned. YTC is
computed with the following formula:
Where, CP = Call price of bond, n*= Number of years until the assumed call date
For instance: ABC company issues 10 % callable bonds with a face value of Rs. 1000. The bond is currently selling
of Rs. 1,100. Maturity period is 10 years. Determine YTC assuming company calls bonds after 5 years because
interest rate has fallen by 2% at Rs. 1000.
Solution:
Years
CIFs (Rs.)
DF
PV (Rs.)
10%
5%
1 to 5
100
100
3.791
1000
1000
0.621
10%
5%
379.1
621.0
1000.1
1100
432.9
784
1216.9
1100.00
(-)99.55
116.9
Yield to Call =
= 5% +
= 5% + 2.69
= 7.69 %
Current yield
It is the yield that relates to the annual interest to the annual interest to the current market price.
Current Yield = I CMP
Where: I = Annual Interest (Rs.)
CMP = Current market price
For instance: From the following determine current yield on a bond
Face value of bond Rs.1200
Interest Rate 13 %
Maturity 10Years
Current market price Rs. 1000
Solution:
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From the above calculation we can see that yield represents analyse interest rate, it excludes capital gain or loss. It
ignores time value of money. Therefore, it is not a accurate measure of the bonds expected return.
Value of bond when interest-rate equals to required rate of return in this case value of bond is equals to par
value.
For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors
required rate of return is 12%. Determine value of bond.
Solution:
B = (Rs.120 X4.111) + (Rs. 1,000 X 0.507)
= Rs. 493.32 + 507
= Rs. 1,000
Value of bond when required rate of return is higher than the interest- rate in this case value of bond would
be less than par value
For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors
required rate of return is 15%. Determine value of bond
Solution:
B = (Rs.120 X3.784) + (Rs. 1,000 X 0.432)
= Rs. 454.08 + 432
= Rs. 886.08
Value of bond when required rate of return is less than interest rate In this case, value of bond would be above
par value.
For instance: A public lid company issued 2 years ago 12% bond with a face value of Rs. 1,000 for 8 years. Investors
required rate of return is 10%. Determine value of bond
Solution:
B = (Rs.120 X4.355) + (Rs. 1,000 X 0.564)
= Rs. 522.60 + 564
= Rs. 1086.6
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Financial Management
In nutshell the relationship between bond values and required rate of return is given below:
Interest Rate > Required Rate: Bond Value > Par Value
Interest Rate < Required Rate: Bond Value < Par Value
Value of Bond: When I (%) = Kd (%) and change in the time period- In this case value of bond is equals to par
value, whatever may be the maturity period.
For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period
is 10 year. Required rate of return is 10%. Determine value of bond when time period is (i) 5 years, and (ii) 15
years.
Equation
(100 X3.79)+(1000X0.621)
(100 X6.145)+(1000X0.386)
(100 X7.606)+(1000X0.239)
Value of bond remains same (at par value) when interest rate equals to required rate of return, with the change
in time period to maturity.
Value of Bond: When I (%) < Kd (%) and change in the time period - In this case, value of bond decreases
when the time period to maturity increases and vice versa.
For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period
is 10 year. Required rate of return is 12%. Determine value of bond when time period is (i) 5 years, and (ii) 15
years.
Equation
((100 X3.605)+(1000X0.567)
(100 X5.650)+(1000X0.322)
(100 X6.811)+(1000X0.183)
Value of Bond: When I (%) > Kd (%) and change in the time period to maturity In this case value of bond
increases when time period to maturity increases.
For instance: A company issues bond at 10% coupon rate, and with a face value of Rs. 1,000 maturity period
is 10 year. Required rate of return is 6%. Determine value of bond when time period is (i) 5 years, and (ii) 15
years.
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Equation
(100 X4.212)+(1000X0.747)
(100 X7.360)+(1000X0.558)
(100 X9.712)+(1000X0.417)
1,600
1,400
Premium Bond
Required Rate 6%
1297
1,200
1000
1168
800
887
Discount Bond
Required Rate 12%
600
400
200
10 9
4 3
2 1 0
When required rate of return equals to coupon rate, a bond will sell at face value. At the time of issue of bond
interest rate is set at par with required rate of return, to sell bond of par initially.
When required rate of return increases above coupon rate then, the bond value falls below par value. Such bond
is known as 'discount bond'.
When required rate of return falls below the interest rate, then the band values goes above par value. This bond
is called as 'premium bond'
Increase in required rate of return affects bond values (go up or fall below par value).
Market value of bond will always reach its face value by the end of its maturity period, provided the firm does
not go bankrupt.
Preference shares
The returns these shareholders receive are called dividends. Preference shareholders get a preferential treatment
as to the payment of dividend and repayment of capital in the event of winding up. Such holders are eligible for a
fixed rate of dividends. Some important features of preference and equity shares are.
Dividends
Rate is fixed for preference shareholders. They can be given cumulative rights, that is, the dividend can be paid off
after accumulation. The dividend rate is not fixed for equity shareholders. The dividend rate is not fixed for equity
shareholders.
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Financial Management
Claims
In the event of the business closing down, the preference shareholders have a prior claim on the assets of the company.
Their claims shall be settled first and the balance if any will be paid off to equity shareholders.
Redemption
Preference shares have a maturity date on which day the company pays off the face value of the share to the holders.
Preference shares are of two types redeemable and irredeemable.
Conversion
A company can issue convertible preference shares. After a particular period as mentioned in the share certificate,
the preference shares can be converted into ordinary shares.
3.6.1 Valuation of Preference Shares
Preference share gives some preferential rights to preference stockholders. The preferential rights are payment of fixed
rate of dividend and payment of principal amount at the time of liquidation, before paying to equity stockholders.
Value of preference stock is the present value of fixed annual dividends expected and he principal amount.
OR
Where,
= Rs. 85.71
For instance
A company issued 12% preference stock with a face value of Rs. 100, redeemable after 5 years. Required rate of
return is 10%. Determine value of preferred stock.
Solution:
= (Rs.12 X 3.791) + (100x 0.621)
= Rs. 45.492 + 62.1
= Rs. 107.592
3.6.2 Valuation of Equity/Ordinary Shares
People hold common stocks for two reasons:
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The value of a share which an investor is willing to pay is linked with the cash inflows expected and risks associated
with these inflows. Intrinsic value of a share is associated with the earnings (past) and profitability (future) of the
company, dividends paid and expected and future definite prospects of the company.
Basic share valuation model
Stock value is present value of future cash inflows (dividends) that it is expected to provide over an infinite time
horizon. An investor who buys a stock with the intention of holding in forever, on this case the value of equity stock
is the present value of a stream of dividends expected over an infinite period.
Zero growth
Constant growth
Variable growth
Where,
= Value of stock
Zero Growth Model: It is the model under which value of stock is determined assuming dividends are not
expected to grow, (non-growing). Here value of equity stock is the present value of perpetuity of dividends:
Constant Growth (Gorden) Model: In this model value of equity stock is valued assuming that dividends would
growth at a constant rate.
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Financial Management
Variable Growth Model: Growth of the firm should be different life cycle. That is in the early stages growth's much
be faster than that of economy as a whole. Economic growth in the later stages the growth comes down.
Compute the value of the dividends at the end of each year during the super normal growth period.
Compute the present value of the dividends expected during the initial growth period
PV of stock is
Add the PV found in step 2 and step 3 to get intrinsic value of stock. (ESo)
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Summary
Valuation is the process of linking risk with returns to determine the worth of an asset. The value of an asset
depends on the cash flow it is expected to provide over the holding period.
Book value is an accounting concept. Assets are recorded in balance sheet at their book values. Book value of
an asset is cost of acquisition less accumulated depreciation.
Market value of an asset is the price at which the asset is bought or sold in the market. Market value per share
is generally higher than the book value per share for profitable and growing firms.
Liquidation value of a equity stock is the actual amount that would be received if all of the firm's assets were
sold at their market value, liabilities were paid, and the remaining proceeds were by number of equity shares
outstanding.
A bond is a legal document issued by the issuing company under is common seal acknowledging a debt and
setting forth the terms under which they are issued and are to be paid.
Irredeemable bond is the bond which is not repaid till closing of the firm. It is the bond without maturity
period.
References
Shim, J. K. & Siege, J. G., 2008. Financial Management, 3rd ed., Barron's Educational Series.
Prof. Ahmed, M., 2012. Bond Valuation, [Video online] Available at: <http://www.youtube.com/
watch?v=tid0RVUmY3M>[Accessed 28 May 2013].
2012. Value a Bond and Calculate Yield to Maturity (YTM), [Video online] Available at: <http://www.youtube.
com/watch?v=pfhjJ00IuW4>[Accessed 28 May 2013].
Recommended Reading
Staff, I., 2005. Stocks, Bonds, Bills, and Inflation 2005 Yearbook. Ibbotson Associates
Satyaprasad, B.G. & Raghu, G.A. 2010. Advanced Financial Management.Global Media.
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Financial Management
Self Assessment
1. _________ is divided by the number of equity shows outstanding to get book value per share.
a. Net worth
b. Yield
c. Equity stock
d. Premium bond
2. Value of bond equals to __________ value when required rate equals to interest rate.
a. present
b. current
c. par
d. net
3. Which of the following statements is false?
a. Preference stock is also known as hybrid security.
b. Liquidation value equals to value of assets minus value of liabilities
c. Value of bond is less than par value when required rate of return than interest rate.
d. Cash inflows, timing and required return are the three inputs required to value any asset.
4. Bond value equals to par value when it reaches to __________ period.
a. maturity
b. premium
c. value
d. completion
5. Current yield relates to the annual interest to the current________.
a. cost price
b. asset price
c. market price
d. specific price
6. A bond is said to be premium bond when its value is:
a. Higher than the par value
b. Less than the par value
c. Equal to than the par value
d. Higher than the present value
7. Intrinsic value is the __________ value of cash flows expected over a series years of holding an asset.
a. coming
b. going
c. present
d. net
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