financial management i_chapter 4

7/27/2019 Financial Management I_Chapter 4

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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 severalmethods:

Book Value : The value of an asset as stated in balancesheet. The market value of the asset is difference with thebook value.

Liquidation Value : Is the value of asset when an asset issold

Market Value : Value of asset available in the market asdetermined by supply and demand in the market

Intrinsic Value : Is the present value of all the potentialcash 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 assetTotal cash flow : The value of asset depend on

the total cash flow that is expected.

Timing : Refer to the period of receiving thecash flow

Required Rate of Return : Refer to the returnthat required by the investor. The higher the riskof 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 isPresent 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 =

=

n

n

2

2

1

1

k)(1

CF

............k)1(

CF

k)(1

CF

n

1tn

n

k)(1

CF



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 thepriority to claim on the earning and company assetscompared to preference share and ordinary share

Par Value : Is the value of the bond that stated of thedocument. 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 onthe current interest rate

Zero Coupon Bond : The bond sold at the lower pricethan the par value

Embedded Bond : The bond that call back before thematurity date



Rating of Bond

Process to determine the value and gradethe bond

2 rating agencies in Malaysia that is

Rating Agency Malaysia (RAM) : For Long-Term Bond, the valuation of ‘AAA’ indicates ahigh 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 (Cont)

Convertible Bond : Refer to the bond that can beconvert to ordinary share at the price determinedby the company

Zero Coupon Bond : The bond don’t pay interestbut 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 theforeign companies

Foreign Currency Bond : Issued in the financialmarket of a country using its own country’s

currency



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 :

V b = Nilai intrinsik atau harga semasa bond

I = Bayaran kupon

n = Tempoh bon sehingga matang k

b = Kadar pulangan diperlukan

M = Nilai muka

PVIF = Interest factor of Present Value

PVIFA = Interest factor of Present Value Annuity




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 isRM1,000. The return required is 8% per

year. What is the value of the bond?



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

wellChange in the company risk




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 facevalue is RM1,000 and the required rate of returnis 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




Return (Cont.)

Required Rate of Return < Coupon Rate(k<i)Example 4.3 : Bond A has a maturity period of



= RM100 (6.7101) + RM1,000(0.4632)

= RM1,134.21

The Value of bond > face value of the bond




Return (Cont.)

Required Rate of Return = Coupon Rate(k=i)Example 4.4 : Bond A has a maturity period of



= 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) bydividing k with 2 (k ‚ 2)



Payment of Interest Twice a Year (Cont.)

The formula is

= )M(PVIF)(PVIFA2

I2n,k/22n,k/2



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 aboveWhen 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 isRM1,000

When the required rate of return increase from10% to 12%, the value of the bond decreasefrom RM1,000 to RM887

When the required rate of return decrease from10% to 8%, the value of the bond increase fromRM1,000 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 1,134.21 1,079.87

10 1,000.00 1,000.00

12 887.00 927.82



Ordinary Share

Ordinary share didn’t 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 shareholdershave right on surplus earnings after theinterest 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 shareholderswill be the last to claim the earning andassets after the claims of bond holdersand preference shareholders



Characteristics of Ordinary Share (Cont.)

Voting Right : Ordinary shareholders have rightto choose the Board of Director that be done bythe shareholders or via a Proxy (giving the rightto the third party to vote on behalf of

shareholders)

Pre-emptive Right : Allow the shareholders tomaintain the ownership in hand if the companyintends to issue new share

Limited Liability : If the liquidation of thecompany occurs, the liability of the ordinaryshareholders is limited to the total invested tothe company



Valuation of Ordinary Share

The ordinary shareholders will receive return in2 formsDividend : 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 isdepend on the company profit and the growthrate of the company.

Growth rate (g) of the company can bemeasured 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




One Period (Cont.)

The formula is

Where

V = Present value of ordinary share

D1 = Cash dividend that is expected to bereceived at the end of the period

P1 = Price of share that is expected at the endof the period

K = Required Rate of Return




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 Mercu’s 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




Multiple Periods

Share are holding more than one period

such as more than one year.

The formula is:-




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 thedividend received in the previous year

(D1=D2=….=Dn)

The formula is

V = D1 ‚ k





Zero Growth (cont.)Rias Company is a company that has been

operating for a long time in the fast foodindustry. Lately, the company had paid dividendfor RM0.20 per share. The management expectthe dividend to maintain in the future. If therequired rate of return is 12%, what is the valueof the Rias share?

V = D1 ‚ k

= RM0.20 ‚ 0.12

= RM1.67





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 thebond have infinity period

V = D1 ‚ (k – g)





Inconstant Dividend Growth

The dividend paid at the inconstant growth

There are 3 steps to calculate the value of

shareCalculate 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 thepresent value

Add the present value obtained from step 1 and step

2 to obtain the intrinsic value





Inconstant Dividend Growth (Cont.)

Example 4.10 : Assume the following

information

K = Required rate of return is 12%n = Period of inconstant growth is 3 years

gs = Rate of dividend growth is 25%

gn = Fixed rate if 6%

D0 = Last dividend paid is RM0.20 per share





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





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




Required Rate of Return for Ordinary

Share (Cont.)


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 paiddividend of RM0.30 per share and is expected toexperience constant growth of 8.5%. What the returnthat your expect to receive?



Preference Shares

Characteristics of Preference Share

Issuance of Several Classes of Preference

Share : Every class of share have different

characteristicsClaim 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 shareholdersConvertible 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



Valuation of Preference Share

There are 3 steps to evaluate preferenceshare 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 expectedto be received and then determine the rate of return required by the investor

Calculate the intrinsic value by discounting allthe 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

E d R f R f P f



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 paysdividend of RM0.25 per share. What theexpected return of the preference share?

kps = D ‚ Vps = RM0.25 ‚ RM5.50

= 4.54%

financial management i_chapter 4

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