Valuation of Long Term Securities 1
WHAT DOES IT MEANS BY VALUE OF A
SECURITY 2
There are two major types of securities. Bonds and Shares
Value of the security means what the value of a specific security at
present time. It can also be called present value of security.
Here, the value can be divided into two types: Intrinsic value and
market value
WHAT DOES IT MEANS BY VALUE OF A
SECURITY 3
Intrinsic value means the value of security calculated through
present value formulas. This value also means the value which reflect
all fundamentals of company like its dividend.
Market value means the value at which the security is sold last time
in the market. Or it is the value at which the security is currently
traded at stock market.
In reality, in most of the cases, intrinsic value of a security differs
from market value
WHAT DOES IT MEANS BY VALUE OF A
SECURITY 4
Intrinsic value is also a benchmark for investor. If an investor want
to purchase a security of Pepsi corporation, first he will calculate the
intrinsic value of security. Suppose the intrinsic value of the security is
$100. Afterward investor will check the market price of the Pepsi
corporation in stock exchange. If the market value of Pepsi
corporation is $100 or less, the investor will purchase the security. If
the market price is greater than $100, investor will not purchase the
security.
WHAT DOES IT MEANS BY VALUE OF A
SECURITY 5
The security which is selling less than its intrinsic value is called
“undervalued security by the market”. In above example, the true
intrinsic value of Pepsi corporation is $100. If the current market price
(or the price at which the security is currently sold) is $90, than
investor should purchase this security. It is because if investor
purchase it for $90, than in near future, it is assumed that market price
will become equal to true intrinsic value. Like the $90 security market
value will become $100. So investor can purchase the security for $90
and can sale it for $100. By doing so, investor can earn the profit of
$10 in short term
WHAT IS BOND
6
Bonds are issued by governments and corporations when they want to raise money.
By buying a bond, you're giving the issuer a loan, and they agree to pay you back the
face value of the loan on a specific date, and to pay you periodic interest payments
In finance, a bond is a type of security under which the issuer owes the holder a
debt, and is obliged – depending on the terms – to repay the principal of the bond at
the maturity date as well as interest over a specified amount of time.
CHARACTERISTICS OF BONDS
Face value
money amount the bond will be worth at maturity; it is also the reference
amount the bond issuer uses when calculating interest payments.
For example, the face value of bond is $100. When the bond matures, investor
will receive the $100 face value of the bond.
Maturity date
The date on which the bond will mature and the bond issuer will pay the
bondholder the face value of the bond.
CHARACTERISTICS OF BONDS
Coupon rate
The rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage. For example, a 10% coupon rate means that
bondholders will receive 10% x $100 face value = $10 every year
Coupon dates
The Dates on which the bond issuer will make interest payments.
TYPES OF BONDS
Corporate bonds
Issued by companies.
Companies issue bonds rather than seek bank loans because of lower interest
rates.
Municipal bonds
Issued by States, provinces or municipalities.
TYPES OF BONDS
Government bonds
Issued by National Government such as those issued by the U.S. Treasury.
Bonds issued by the Treasury with a year or less to maturity are called “Bills”; bonds
issued with 1–10 years to maturity are called “notes”; and bonds issued with more
than 10 years to maturity are called “bonds.”
The entire category of bonds issued by a government treasury is often collectively
referred to as "treasuries."
Agency bonds
An agency bond is a security issued by a government-sponsored enterprise or by a
federal government department other than the U.S. Treasury.
Issued by government-affiliated organizations such as Federal Housing
Administration (FHA), and the Government National Mortgage Association (GNMA).
TYPES OF BONDS
Coupon Bonds
Coupon bonds provide bondholder periodic/yearly interest rate as well as face value at
the end of maturity
If an investor purchases a $100 ABC Company coupon bond and the coupon rate is
10%, the issuer provides the investor with a 10% interest every year.
Zero-Coupon Bonds
Do not pay coupon payments and instead are issued at a discount to their par value
that will generate a return once the bondholder is paid the full face value when the
bond matures.
For example, face value of bond is $100, Company Issue at discount and Issued at $90.
According to the agreement, company (Bond Issuer) purchase back the Bond after 2 years
at $100. So, the bondholder got the profit of $10 in 2 years
TYPES OF BONDS
Convertible bonds
Debt instruments with an option that allows bondholders to convert their debt into
stock (equity) at some point
Callable Bonds
Can be “called” back by the company before it matures.
Puttable Bond
Allows the bondholders to put or sell the bond back to the company before it has
matured.
TYPES OF BONDS
Convertible bonds
Debt instruments with an option that allows bondholders to convert their debt into
stock (equity) at some point
Callable Bonds
Can be “called” back by the company before it matures.
Puttable Bond
Allows the bondholders to put or sell the bond back to the company before it has
matured.
Finding of Intrinsic Value of a Security 14
Perpetual Bonds
The first (and easiest) place to start determining the value of bonds is with a
unique class of bonds that never matures.
These are indeed rare, but they help illustrate the valuation technique in its
simplest form.
Originally issued by Great Britain after the Napoleonic Wars to consolidate debt
issues, the British consol (short for consolidated annuities) is one such example.
This bond carries the obligation of the British government to pay a fixed interest
payment in perpetuity.
Perpetual Bonds
If a bond promises a fixed annual payment of I forever, its present (intrinsic) value, V, at
the investor’s required rate of return for this debt issue, kd, is
V = Intrinsic Value of the Bond
I = Fixed Annual Payments
Kd = investor’s required rate of return or “Rate of return to calculate present
value” or “Discount Rate
Perpetual Bonds
Suppose you could buy a bond that paid $50 a year forever. Assuming that your
required rate of return for this type of bond is 12 percent, what would be the present
value of this security?
Given Information
I = $50; Kd = 12 percent or 0.12; V=?
Step #1 V = I/ Kd
Step # 2 V = 50/0.12
Step # 3 V= 416.66
Interpretation = 416.66 is the maximum amount that you would be willing to pay
for this bond. If the market price is greater than this amount, however, you would
not want to buy it.
18
Bonds with a Finite Maturity
Bonds with a Finite Maturity 19
VB = Value of the Bond or Intrinsic value of the bond
N = Number of years before the bond matures
INT = Dollars of interest paid each year
Calculated by Coupon Rate x Par Value
For a bond with a 10% coupon and a $1,000 par value, the annual interest is:
0.10 x 1,000 = $100
M = Par value or Face value or maturity value of the bond. This amount must be paid off
at maturity
Bonds with a Finite Maturity 20
VB = Value of the Bond or Intrinsic value of the bond
N = Number of years before the bond matures
INT = Dollars of interest paid each year
Calculated by Coupon Rate x Par Value
For a bond with a 10% coupon and a $1,000 par value, the annual interest is:
0.10 x 1,000 = $100
M = Par value or Face value or maturity value of the bond. This amount must be paid off
at maturity
Bonds with a Finite Maturity
A $100 par value bond, bearing a coupon rate of 12 per cent, will mature after 8 years. The
required rate of return on this bond is 14 per cent. What is the value of this bond?
M = $100; Coupon Rate = 12 percent or 0.12; rd = 0.14; N = 8; VB = ?
INT = Coupon Rate x Par Value = 0.12 x 100 = 12; INT = 12
Step # 1 VB = INT [{1/rd} – {1/rd (1 + rd)N}] + [M/(1 + rd)N] Step # 7 VB = 12 [4.6385] + [35.0569]
Step # 2 VB = 12 [{1/0.14} – {1/(0.14) (1 + 0.14)8}] + [100/(1 + 0.14)8] Step # 8 VB = 55.662+ 35.0569
Step # 3 VB = 12 [{1/0.14} – {1/(0.14) (1.14)8}] + [100/(1.14)8] Step # 9 VB = 90.71
Step # 4 VB = 12 [{1/0.14} – {1/(0.14) (2.8525)}] + [100/2.8525]
Step # 5 VB = 12 [{7.1428} – {1/(0.3993}] + [35.0569]
Step # 6 VB = 12 [{7.1428} – {2.5043}] + [35.0569]
Bonds with a Finite Maturity
A $100 par value bond, bearing a coupon rate of 12 per cent, will mature after 8 years. The
required rate of return on this bond is 14 per cent. What is the value of this bond?
M = $100; Coupon Rate = 12 percent or 0.12; rd = 0.14; N = 8; VB = ?
INT = Coupon Rate x Par Value = 0.12 x 100 = 12; INT = 12
Step # 9 VB = 90.71
Interpretation = A bond having the par value of $100 with 8 years remaining to maturity has a
value (Intrinsic value) of $ 90.71. It will happen in case the required rate of return is 14 percent
23
Value of Zero-coupon bond
Value of Zero-coupon bond 24
V = Intrinsic Value of the Bond
MV = Par value or Face value or maturity value of the bond
Kd = investor’s required rate of return or “Rate of return to calculate present
value” or “Discount Rate
n = Number of years before the bond matures
Value of Zero-coupon bond
Suppose that Espinosa Enterprises issues a zero-coupon bond having a 10-year
maturity and a $1,000 face value. If your required return is 12 percent, then
calculate the value of the bond
n=10; MV= $1000; Kd = 12 percent or 0.12 V=?
Step #1 V = MV/ (1+ Kd)n
Step # 2 V = 1000/(1+0.12)10
Step # 3 V = 1000/(1.12)10
Step # 4 V = 1000/3.1058
Step # 5 V = 321.97
Value of Zero-coupon bond
Suppose that Espinosa Enterprises issues a zero-coupon bond having a 10-year
maturity and a $1,000 face value. If your required return is 12 percent, then
calculate the value of the bond
n=10; MV= $1000; Kd = 12 percent or 0.12 V=?
Step #1 V = MV/ (1+ Kd)n
Step # 2 V = 1000/(1+0.12)10
Step # 3 V = 1000/(1.12)10
Step # 4 V = 1000/3.1058
Step # 5 V = 322
Interpretation = The intrinsic value of a zero-coupon bond having a 10-year maturity
and a $1,000 face value is $322
