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OUTLINE
INTRODUCTION
BOND VALUATION
Bonds
Coupon rate
Current yield
Yield to call
Bond Duration
OUTLINE – CONT’D
EQUITY MARKET
Equity Instruments
SHARE VALUATION
Share Valuation Models
Discount Rate
H-Model
HFIN 4104: Corporate Finance Theory
INTRODUCTION
BOND VALUATION
HFIN 4104: Corporate Finance Theory
BONDS
TYPES OF BONDS
• Callable and putable bonds
• Convertible bonds
• Eurobonds
• Floating rate notes (FRNs)
• Foreign bonds
• Index-linked bonds.
• Junk bonds
• Covered bonds
HFIN 4104: Corporate Finance Theory
Current yield
Yield to call
HFIN 4104: Corporate Finance Theory
COUPON RATE
CURRENT YIELD
• It is the rate of return available from a bond on its
current price in the secondary market.
• It fluctuates depending on the bond price.
• It only measures the annual rate of return accruing
to an investor who purchase the bond from the
secondary market.
Illustration
• A bond has a face value of KShs. 1,000 and a
coupon rate of 9 per annum. The bond is currently
selling in the secondary market at a price of KShs.
800. Calculate the current yield.
HFIN 4104: Corporate Finance Theory
SIR – CONT’D
1
Amount receivable after 4 years hence KShs. 1, 000 *
1 i
1 1
Amount receivable after 3 years hence KShs. 1, 000 *
1 i 1 i
1 1 1
Amount receivable after 2 years hence KShs. 1, 000 *
1 i 1 i 1 i
1 1 1 1
Amount receivable after one year hence KShs. 1, 000 *
1 i 1 i 1 i 1 i
1 1 1 1 1
Pr esent Value KShs. 1, 000 *
1 i 1 i 1 i 1 i 1 i
5
1
KShs. 1, 000 *
1 i
5
1
Thus if the present value is at the end of 5 1,000 ,
1 i
years a sum KShs. 1,000 would be available.
HFIN 4104: Corporate Finance Theory
SIR – CONT’D
Thus:
Present value Discounted price of bond
5
1
600 1, 000 *
1 i
5
1 600
1 i 1, 000
1
5
0.6
1 i
10.76%
HFIN 4104: Corporate Finance Theory
YIELD TO MATURITY
YTM – CONT’D
Cost of bond annual interest receivable plus terminal value of bond
n
Annual Interest receivable Ter min al Value of a Bond
Cost of Bond
t n
t 1 1 i 1 i
where
i yield to maturity
t time period
n no. of years to maturity
Illustration
Bond of face value KShs. 1,000 with a coupon rate of 8% p.a.
and present value of KShs. 700 has a maturity period of 5
years. Calculate the (YTM) on the bond.
HFIN 4104: Corporate Finance Theory
n
Annual Interest receivable Ter min al Value of a Bond
Cost of Bond
1 i
t
1 i
n
t 1
1 1 1 1
1 2 3 4
1 0.18 1 0.18 1 0.18 1 0.18
700 80 1, 000
1 0.18 5
1
1 0.18 5
1, 000
80 0.8474 0.7182 0.6086 0.5158 0.4371
2.2878
250.17 437.10
687.27
HFIN 4104: Corporate Finance Theory
I FV C / n
YTM
FV C / 2
where I annual interest
FV face value of bond
C current price of bond
n bond period
HFIN 4104: Corporate Finance Theory
SHORTCUT … CONT’D
Illustration
Bond of face value KShs. 1,000 with a coupon rate of 8%
p.a. and present value of KShs. 700 has a maturity period
of 5 years. Calculate the Yield To Maturity (YTM) on the
bond using shortcut method.
Solution
YTM
I FV C / n
FV C / 2
80 1, 000 700 / 5
1, 000 200 / 2
80 60
0.1647
850
Appprimate value of YTM 16.47%
HFIN 4104: Corporate Finance Theory
YIELD TO CALL
BOND DURATION
• It is defined as the time period at which the
price risk and the investment risk of the
bond are equal in magnitude but opposite in
direction (Nagarajan and Jayabal, 2011) .
Illustration
• A 5 years bond with a face value of KShs.
100 has a coupon rate of 10%. What is the
terminal value that will be available to the
investor in this bond, if the market interest
rate is 12%?
HFIN 4104: Corporate Finance Theory
n
t. Ct
1 i
t
t 1
D n
Ct
t 1 1 i
t
MACAULAY'S … CONT’D
Illustration
A new bond is issued by a company with a
maturity period of 5 years and a coupon rate of
12%. The face value of the bond is KShs. 100
and the bond is redeemable at par after its
maturity period of 5 years. The market interest
rate is 12%. Prove that the duration of the bond
is less than its period of maturity
HFIN 4104: Corporate Finance Theory
MACAULAY'S … CONT’D
Ct t. Ct
t Ct 1 i
t 1 i
t
MACAULAY'S … CONT’D
Thus:
403.733
Duration
99.999
4.03733 (i.e. 4.04 years)
HFIN 4104: Corporate Finance Theory
EQUITY MARKET
HFIN 4104: Corporate Finance Theory
EQUITY MARKET
• Equity markets are markets which organize trading
nationally and internationally in such instruments,
as common equity, preferred shares, as well as
derivatives on equity instruments.
• The purpose of equity is the following:
a. A new issue of equity shares is an important
source of external corporate financing;
b. Equity shares perform a financing role from
internally generated funds (retained earnings);
c. Equity shares perform an institutional role as a
means of ownership.
HFIN 4104: Corporate Finance Theory
Equity Instruments
a. Common or ordinary share (stock) is an equity share
that does not have a fixed dividend yield. It represent
partial ownership of the company and provide their
holders claims to future streams of income, paid out of
company profits and commonly referred to as
dividends.
b. Preferred share is an equity security, which carries a
predetermined constant dividend payment. It is a
financial instrument, which represents an equity
interest in a firm and which usually does not allow for
voting rights of its owners.
HFIN 4104: Corporate Finance Theory
SHARE VALUATION
HFIN 4104: Corporate Finance Theory
DISCOUNT RATE
where,
S0 present value of the share
D1 dividend expected to be received at the end of the first year
S1 expected selling price of the share at the end of the first year
k rate of return required by the investor also called ‘capitalization rate’
HFIN 4104: Corporate Finance Theory
4.17 58.93
KShs.62.50
Therefore, intrinsic value of the share for the investor KShs. 62.50
HFIN 4104: Corporate Finance Theory
Assumptions
The investor purchases the share now
The investor intends to hold the share for a
certain number of years
The investor will dispose off the share at the
end of the holding period
HFIN 4104: Corporate Finance Theory
MULTIPLE YEAR…CONT’D
where :
S0 present value of the share
D1 , D2 , D3 ,..., Dn annual dividend that will be received in the respective years
Sn expected sales price of the share at the end of the holding period
k rate of return required for the investor
n holding period in years
HFIN 4104: Corporate Finance Theory
MULTIPLE YEAR…CONT’D
Solution
D1 D2 D3 Dn S n
So ...
1 k 1 k 1 k 1 k
1 2 3 n
Assumptions
The investor buys and holds the share forever
The dividends from the share grow at a
constant rate.
The discount rate (used for arriving at the
present value of the share) is greater than the
dividend growth rate.
HFIN 4104: Corporate Finance Theory
CGM – CONT’D
the present value of the share is the sum of
present value of all future dividends.
D1 1 g D2 1 g D3 1 g D3 1 g
1 2 3 n
So ...
1 k 1 k 1 k 1 k
1 2 3 n
as
S
D
o
k – g
CGM – CONT’D
HFIN 4104: Corporate Finance Theory
So
D0 1 g
k – g
4.50 1 0.12
0.18 012
KShs. 84
HFIN 4104: Corporate Finance Theory
MGM – CONT’D
Stage II
DN 1 g
P.V . II
k g 1 k
N
–
Intrinsic value PV
. .I PV
. .II
N Dt DN 1 g
i.e. So t 1
1 k
t
k – g 1 k N
HFIN 4104: Corporate Finance Theory
KShs. 5.78
38.50
1 0.20
3
KShs. 22.80
PV of dividends from Stage I PV
Intrinsic value of the share So
of dividends from Stage II
5.78 22.28
KShs. 28.06
HFIN 4104: Corporate Finance Theory
D
Intrinsic value So
k
HFIN 4104: Corporate Finance Theory
Solution
D
Intrinsic value of the equity share S o
k
20
0.16
KShs. 125
HFIN 4104: Corporate Finance Theory
Assumptions of H-Model
Current above-normal growth rate is g c
The intrinsic value of the share under the above conditions is given by
the following relationship :
D0 1 g f D .H g g
So
0 c f
k – gf k – g f
HFIN 4104: Corporate Finance Theory
Do 1 g Do H gc g f
Intrinsic value of the equity share S o
k – gf k – gf
4.00 1 0.15 4.00 6 0.40 0.15
0.18 – 0.15 0.18 – 0.15
153.33 200
KShs. 353.33
HFIN 4104: Corporate Finance Theory
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