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Valuation of the Financial

Instruments (Bonds/Equities)

Valuation of the Financial

Instruments (Bonds/Equities)

Bond valuation

Zero coupon bond valuation and introduction to interest

rate/bond price changes.
Valuation of coupon paying bonds, annual and semiannual
Yield-to-Maturity (YTM) calculation

Bond terms and types

Basics concerning stock valuation
Valuation of constant growth (mature) stocks.
Valuation of nonconstant growth stocks.
Corporate value or Free Cash Flow model
Functioning of the stock market (Secondary Market)

Sources of Finance

Shares (Shareholders are part owners of a company)

Bonds and Debentures(Unsecured Bonds)
Ordinary Shares (Equities):

Ordinary shareholders have voting rights on important corporate

matters (Directors)

Dividend can vary depending on the performance of the company

Last to be paid back in event of collapse/liquidation of the firm

Share price varies with trade on stock exchange (more liquid)

Preference Shares:

Paid before ordinary shareholders are paid the dividends

Fixed rate of return irrespective of the performance

Cumulative preference shareholders have right to dividend carried
over to next year in event of non-payment

Bond basics

A bond is a debt (fixed income) security, where money/capital

is borrowed and is to be paid back along with interest/coupon.
Bonds are known as fixed income securities as all of the future
payments to be made on the bond are fixed or predetermined, as stated in
the bond contract.

The current value of a bond is defined as the Present Value of

all the future cash flows to be received by the bondholder.

A bond promises to pay a predetermined stream of future cash flows.


The issuer (Corporate, Government)

Principal amount (Face Value)
Specified interest rate (also known as the
coupon rate)
Date of maturity (Time)

Types of Bond

Types and terms of bonds.

Callable bond: the issuer has right to retire the bond

before maturity, at a predetermined price that is
always specified in the bond contract.

Almost all corporate bonds are callable. If interest rates fall

in the future, firms can retire these existing bonds and
replace them with new lower rate bonds.
Callable bonds will command a higher interest rate or yield
(lower price) than a comparable non-callable bond.

Mortgage (Secured) bond : bond is secured or

collateralized by some physical asset in case the issuer

Types and terms of bonds

Convertible bond: bond can be converted into a

predetermined number of shares of common stock.
Investors are willing to accept a lower yield on such
bonds. The right to convert may become very

A convertible bond thus has the opportunity to become an

exciting investment if the firm does unexpectedly well.

Debenture (Unsecured bond): bond is backed by the

issuers ability to generate future cash flow to make
the promised payments. There is no collateral.

Types and terms of bonds,


Subordinated bonds: the bonds claim on the issuer is

junior to one or more senior bond issues. The more
senior bonds have the higher priority in bankruptcy
and/or liquidation.
Sinking fund provision: issuer may be required to
retire a certain amount of an issue each year. For
example, having to retire 10% of a 20 year bond issue
each year from year 11 to year 20.
Bond contract (indenture/deed)): a legal contract
between the issuer and bondholders that specifies all
of the terms and conditions of the bond issue.


Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial
condition and management, economic and debt characteristics, and the specific revenue sources
securing the bond.

Variables that Effect Value

Maturity (Short term, Medium or Long term)

Redemption Features (Callable, Convertible)
Credit Quality (AAA, BB)
Interest Rate
Tax Status (Tax free/exemption)

Example of a three-year zero

coupon bond

Years ago, a 10-year bond was issued which is going to

mature in 3 years. The par value is Rs.100. Currently,
this bond sells for Rs.84.17 in the market. What
annual rate of return do investors currently require on
this three year bond?

This bond must be competitively priced in the market with

similar bonds. This bonds time line appears below:
PV0 = 84.17



FV3 = 100 par

Example of a two-year zero

coupon bond, continued

Using, the time value of money formulas that relate

the PV0 and FVn for multi period applications:

PV0 = FVn/(1+r)n, rearrange as r = [FVn/PV0]1/n 1

For this example, PV0=84.17, FVn=100, and n=3

r = [FVn/PV0]1/n 1 = [100/84.17]1/3 1 = 0.06 or 6.0%

On a financial calculator, enter FV=100, PV=-84.17, N=3,

P/Y=1, and compute the I/Y=6%.

Example of a 10 year bond that

pays annual coupons

Assume that 10 years ago, a 20-year bond was issued and will
mature in 10 years. The par value is Rs.1000. It promises to
pay the owner 9% (fixed rate) coupon interest each year.
What is todays bond price?

This bond will pay (0.09)(Rs.1000) = Rs.90 coupon interest each year,
and will also pay off the Rs.1000 par value at t=10 years from today.
Currently, lets assume that the 10 year market required rate of interest
or return on this and comparable bonds is r=8.5% per year. Anyone
that buys this bond today will expect to earn this rate over the next 10
year. The bonds time line appears below:



PV0 = ?

90 coupon



90 coupon

1000 par
+ 90 coupon

Example of a 10 year bond that

pays annual coupons, continued

The bonds current price or value is thus the PV of all the

promised future cash flows, discounted at r=8.5% per year.
To calculate this bonds current price, add together the PVs of
the annuity of coupons and the PV of the par value lump sum.
The coupon stream annuity PV0=590.52 and the lump sum
PV0=442.29, and both sum up to 1032.81, which is therefore
the bonds current value or price. The TVM formulas are
shown below:










Bond prices and market interest rate

changes, using the ten year bond

Interest rates (yields) and bond prices will change as

time passes and economic conditions change.
What will happen to this ten year bonds price if the
one year market required yield suddenly either (1)
decreases to r=8.0% or (2) increases to r=9.0%?

When market interest rates or yields decrease, the price of

all existing fixed rate coupon bonds will rise.

When market interest rates or yields increase, the price of

all existing fixed rate coupon bonds will fall.

If coupon rate (c) < kd, discount.

If coupon rate (c) = kd, par bond.

If coupon rate (c) > kd, premium.

If kd rises, price falls.

Price = par at maturity.

At maturity, the value of any bond must

equal its par value.
The value of a premium bond would
decrease to Rs.1,000.
The value of a discount bond would
increase to Rs.1,000.
A par bond stays at Rs.1,000 if kd
remains constant.

Bond Values Over Time


Bond Value


k = 10%
k = 8%
k = 6%





12 11 10 9

Time to Maturity

YTM (Yeild to Maturity)

Current Yeild

What is the bonds return over

this year?

Total Rate of Return = Current Yield + Capital Gains

Yield (C.G.Y)
Beg. V = 863.73, End V = 870.10
Annual coupon pmt
Current price

Current yield =
Current Yld = Rs.80/863.73 = 9.26%
Change in price
Beginning price

Capital gains yield =

C.G.Y.=(870.10-863.73)/863.73= 0.74%
Total Return = 9.26% + 0.74% = 10%

Finding a bonds expected rate of


In the marketplace, we know a bonds current

price(PV), but not its return.
Yield to Maturity (YTM) = the rate of return the
bond would earn if purchased at todays price and
held until maturity. Also called promised yield.
Yield to Call (YTC) = the rate of return the bond
would earn if purchased at todays price and held
until could be called.



Common stock basics

Common stock represents the ownership of a corporation.

Stocks are risky investments; therefore the question is how to

price the risk.

The holders of debt or bonds have a senior claim on the firm.

Stockholders have a residual claim, what remains after other obligations
met, including any new asset investment in the firm.

Current stock prices reflect todays expectations of future cash flow

performance of firms and the risk of these cash flows.
Hardly there is any concrete theory to prove the expectations concerning
future performance.

Firms pay out excess (residual) cash to shareholders primarily

as: (1) cash dividends and (2) share repurchases.

Common stock basics

The value of the stock depends on Intrinsic Value.

Intrinsic Value is the Present Value of all future
forecasted cash flows.

We define Free Cash Flow to Equity (FCFE) as the firms

excess cash flow that can be paid out through both
dividends and stock repurchases.
We calculate the PV of all future forecasted FCFE at a
discount rate or cost of equity capital r.

Common stock basics

Many tend to either overcomplicate the mechanics of stock

valuation or unfortunately insert misconceptions and/or
pseudoscience into the analysis.
For simplicity here, we will assume that all the FCFE is paid as
a cash dividend, and thus the stocks intrinsic value today (V0)
is the PV of all future forecasted dividends. The timeline and
TVM valuation equation always resembles the following.

... ..
1 r 1 r 1 r
1 r






V0 = ?






Intrinsic value (V) versus actual

market prices (P)

Intrinsic values are usually privately obtained

estimates of value, here using discounted cash flow
(DCF) analysis.

The term V (usually designated as V0) is used extensively

here since stock valuation is a private effort. V 0 is thus
something we can estimate but not prove.

In efficient capital markets, on average, the market

value or price P0 should equal the intrinsic value V0.
Note: the total value of any firms equity is always the
value per share times the total number of shares.

Most of our analysis here is done on a per share basis.

Valuation of a Constant Growth

common stock

The term constant growth indicates that a firm is

mature and is expected to grow at an assumed
constant rate g throughout the future.

The term growth rate typically refers to the growth of the

firms cash dividends; however, everything associated with
the firm is also assumed to grow at the same rate g.

If a firm is expected to have a variable rate of growth

in the coming years, then constant growth valuation is
not appropriate. However, we will always assume
that constant growth does begin somewhere out in the

Example: valuation of a
Constant Growth common stock

A mature firm just paid a dividend of D0=Rs.5

per share today and is expected to have a
constant growth rate of g=5% per year forever.
Based on the stocks perceived risk, the stock
has a required return of r=14% per year.

Example: valuation of a Constant

Growth common stock, continued

Given the dividend growth rate g=5% per year, now

forecast the dividends for the following years:

D0 = Rs.5.00 (given with example)

D1 = D0(1+g) = (5.00)(1+0.05) = Rs.5.25
D2 = D0(1+g)2 = (5.00)(1+0.05)2 =Rs.5.5125
Dn = D0(1+g)n

The D0=Rs.5.00 per share has already been paid out and
is no longer part of the firm.
The intrinsic value V0 of the stock will be the Present
Value of all the future forecasted dividends, beginning
with D1.

Example: valuation of a Constant

Growth common stock, continued

We use the Constant Growth model (introduced in

Chapter 4) to calculate the Present Value. The
intrinsic value of any currently assumed constant
growth stock or investment is:
V =D /(k-g), plugging in the numbers we have:
V0=D1/(r-g) = 5.25/(0.14 0.05) = 5.25/0.09 = Rs. 58.33
If D =Rs. 5 has not yet been paid out, then the stock value
would be 58.33 + 5.00 =Rs.63.33 per share (cum dividend).
Thus this stock should be worth Rs.58.33 today if the firm is
expected to have a permanent growth rate of 5% per year and
next years dividend at t=1 years is Rs.5.25 per share.

The constant growth model

A more general form of the constant growth model is

given below:
V =D
t+1/(r-g); assuming that capital markets are efficient

we often reexpress this relation as Pt=Dt+1/(r-g)

For the equation to work: (1) r must exceed g and (2) all
dividends following the dividend in the equations numerator
must grow at a constant rate g.
This equation above will always give you the stock value,
exactly one year before the dividend that you plug into the
model. If you plug in the dividend expected at t=30 years,
then the equation gives you the value at t=29 years.

What will be the value of this stock

exactly one year from today?

From previously, we know that r=14%, g=5%, and D 0=Rs.5,

D1=Rs.5.25, and D2=Rs.5.5125.
The constant growth equation, Vt=Dt+1/(r-g), calculates the
stocks value, exactly one year before the dividend that is
plugged into the equation. The dividend exactly two years from
today is estimated to be D2=Rs.5.5125 at t=2 years.
V = D /(r-g) = 5.5125/(0.14-0.05) =Rs.61.25
This stock is predicted to rise in value (or perhaps price) from
Rs.58.33 today to Rs.61.25 in exactly one year (t=1 years).
We thus forecast that in one year (t=1), the stock will be
worth Rs.61.25 per share just after it pays out D 1=Rs.5.25.

What will be the stocks estimated value

in exactly one year? A second approach.

An alternate method to estimate the future

price of a constant growth stock: Everything
associated with the firm is expected to grow at
the rate g=5% per year forever, including the
stocks value!

Therefore, V1 = V0(1+g) = 58.33(1+0.05) =


The two components of a stocks

total return on investment

The return on the stock comes in two components:

Cash dividends
The change in stock price (capital gain or loss)

Lets assume efficient markets for this case (where

on average, P0=V0,): for any constant growth stock
we have the following relation: P0 = D1/(r-g).
Rearrange the equation to yield the following relation
in terms of total return, we have: r = (D1/P0) + g

The first part is D1/P0, the dividend yield

The second part is g, the capital gains yield

The two components of a stocks

total return: r = (D1/P0) + g

We have the following (previously):

D1=Rs.5.25, P0=Rs.58.33, and g=5%. Solving
the above equation, we have a known result:

k = (D1/P0) + g = (5.25/58.33) + 0.05 = 0.09 + 0.05 = 14%

If we pay Rs.58.33 today for this stock, then the

expected 14% return comes to us as:

(1) a 9% dividend yield and (2) a 5% capital gains yield,

which is a 5% increase in stock price from Rs.58.33 to

How todays stock values (or

stock prices) can change

Example 1: Assume that r increases from 14% to 16%

because investors demand a higher risk premium from
the stock.

Example 2: Assume that r decreases from 14% to 12%

because investors demand a lower risk premium from
the stock.

V0=D1/(r-g) = 5.25/(0.16 0.05) = Rs.47.73

V0=D1/(r-g) = 5.25/(0.12 0.05) = Rs.75.00

What really changed above? It was not the future cash

flow amounts, but rather the required return, due to risk
premium changes.

The valuation of nonconstant

growth stocks (most stocks!)

Most stock analysts using an Intrinsic Value analysis will

forecast the following for most stocks that they cover:

Ten (10) future years of individual cash flows that can be paid out to
stockholde Refer to the valuation model at bottom of slide.
A terminal value, i.e., what the stock will be worth in exactly 10 years
(V10), assuming constant growth (maturity) at rate g following year 10.

The stocks intrinsic value is then the sum of the PVs of D1

through D10 and the PV of the terminal value V10=D11/(r-g).
A good approximation for the constant growth g (at maturity)
for a firm is expected future inflation plus the real expected
rate of economic growth in GDP.



1 r 1 1 r 2 1 r 3
1 r 10 r - g 1 r 10

An example of nonconstant
growth valuation

Cirrus Corp. is expected to pay out the following

dividends, per share:

D0=D1=D2=D3=Rs.0, D4=Rs.0.50, D5=Rs.0.65, D6=0.80,

D7=Rs.0.90, ad D8=Rs.1.00. Timeline appears on next slide.
All dividends following year 8 or D8 will grow at g=6%
per year forever. This means that D9 = D8(1+g) =
1.00(1+0.06) = Rs.1.06, although this amount wont be
needed. We are also simplifying the example by assuming
that maturity begins at t=8 years.

Lets just assume here that the firms stock has r=10%
per year.

An example of nonconstant
growth valuation, continued


A timeline of the stocks dividends is shown below.

The salient item here is D8, since all dividend growth
after t=8 years will be at g=6% per year forever. We
can use this information to forecast the stocks value
exactly three years from now (at t=7 years).
V = D /(r-g) = 1.00/(0.10 0.06) = Rs.25.00











D4=0.50 D5=0.65 D6=0.80 D7=0.90 D8=1.00


An example of nonconstant
growth valuation, continued

The current intrinsic value V0 will be the Present

Value of D1, D2, D3, D4, D5, D6, D7 and V7 (Terminal
Value). As given previously, V7 = D8/(r-g) = 1.00/
(0.10-0.06) = Rs.25.00


1 r 1 r 1 r 1 r r - g 1 r 7


1 0.1 1 0.1 1 0.1 1 0.1 0.1 - 0.06 1 0.1 7
V0 0.3415 0.4036 0.4516 0.0.4618 (25)(0.5132)
V0 $14.49 per share

Nonconstant growth: another


XYZ Corp. currently pays no dividends.

XYZs first forecasted dividend is 18 years from today
at t=18 years, and is expected to be D18=Rs.6.00 per
share. Note that D0 through D17 are all forecasted to
be zero. All dividends past t=18 years are forecasted
to grow at g=7% per year.
The stock has a required return r=14%.












Nonconstant growth: another

example, continued

XYZ pays the first dividend at t=18 yea Using the

constant growth formula, we can estimate the value
of XYZ shares at t=17 years, since constant growth
occurs following year 18.

Step 1: V17 = D18/(k-g) = 6.00/(0.14 0.07) = Rs.85.7143

Step 2: V0 = V17/(1+k)17 = 85.7143/(1+0.14)17 = Rs.9.24

The stock is forecasted to be worth Rs.85.71 per share

exactly 17 years from today (t=17). Todays PV0 of
this year 17 value of Rs.85.71 is Rs.9.24

The Corporate Valuation Model

or Free Cash Flow (FCF) Model

Most financial analysts use the FCF model. FCF is the cash
that can be paid out to the firms investors, both the debt and
equity holde
The FCF model will give a value that is the total value of the
firms capital, i.e., the sum of both debt and equity. Note the
following items:

Earnings before interest and taxes: EBIT = Revenues - Costs

Net operating profit after tax: NOPAT = EBIT(1 - Tax Rate)
FCF = NOPAT - net new investment in operating capital.

The appropriate TVM discount rate is the firms total cost of

capital both debt and equity. In Chapter 12, we will cover
the Weighted Average Cost of Capital or WACC.

The Corporate Valuation Model

or Free Cash Flow (FCF) Model

... ..
1 wacc 1 wacc 1 wacc
1 wacc

The above model looks very similar to the dividend

model we covered. However, the V0 estimated here
is the total firm value or enterprise value of the firm.

To obtain the equity value, the debt value (and preferred

stock value) must then be subtracted from the total value.
To obtain value per share, divide by the number of shares.

Many assumptions enter into valuation, so equity

estimates using the FCF method may differ from
those using the FCFE/Dividend model we covered.

How new stock is usually issued

in the Indian capital markets
Primary Market:
Initial Public Offering (IPO): a privately held firm issues publicly
traded stock for the first time.
Private Placement
Rights Offer
The firm usually goes to an Investment Banker such as ICICI Bank,
HDFC Bank.
The investment banker usually underwrites the issue purchasing the
entire stock issuance from the firm and reselling it to the initial
Secondary Market

NSE, BSE, Regional Stock Exchanges.

Functioning of Capital Market Segment

Central Depository Services
(India) Limited (CDSL)&
National Securities Depository
Ltd. (NSDL)


Depositories (DP)





Clearing Banks
Axis Bank Ltd., Bank of India, Canara Bank, Citibank N.A, HDFC Bank, Hongkong &
Shanghai Banking Corporation Ltd., ICICI Bank, IDBI Bank, IndusInd Bank, Kotak

Capital Market (CM)

Wholesale Debt Market (WDM)
Derivative Segment (FO)
Retail Debt market (RDM)

The order matching in an exchange is done based on price-time priority.

The best price orders are matched first.
If more than one order arrives at the same price they are arranged in
ascending time order.
Best buy price is the highest buy price amongst all orders and similarly
best sell price is the lowest price of all sell orders.

Types of Settlement

Account Period Settlement

Rolling Period Settlement

Account Period Settlement:

An account period settlement is a settlement where the trades pertaining to a

period stretching over more than one day are settled e.g. trades for the period
Monday to Friday.
The obligations for the account period are settled on a net basis. Account
period settlement has been discontinued since January 1, 2002, pursuant to
SEBI directives.

Rolling Settlement:

In a Rolling Settlement trades executed during the day are settled based on the
net obligations for the day.

In NSE, the trades pertaining to the rolling settlement are settled on a T+2 day

Types of Market

Normal Market
All orders which are of regular lot size or multiples thereof are traded in the Normal
Market. For shares that are traded in the compulsory dematerialised mode the
market lot of these shares is one. Normal market consists of various book types
wherein orders are segregated as Regular lot orders, Special Term orders,
Negotiated Trade Orders and Stop Loss orders depending on their order attributes.
Odd Lot Market
All orders whose order size is less than the regular lot size are traded in the odd-lot
market. An order is called an odd lot order if the order size is less than regular lot
size. These orders do not have any special terms/attributes attached to them. In an
odd-lot market, both the price and quantity of both the orders (buy and sell) should
exactly match for the trade to take place. Currently the odd lot market facility is
used for the Limited Physical Market as per the SEBI directives.
Auction Market
In the Auction Market, auctions are initiated by the Exchange on behalf of trading
members for settlement related reasons. There are 3 participants in this market

Initiator - the party who initiates the auction process is called an initiator
Competitor - the party who enters orders on the same side as of the initiator
the party who enters orders on the opposite side as of the initiator

Order Books

Regular Lot Book

The Regular Lot Book contains all regular lot orders that have none of the
following attributes attached to them.
- All or None (AON), Minimum Fill (MF), Stop Loss (SL)
Special Terms Book
The Special Terms book contains all orders that have either of the following terms
- All or None (AON), Minimum Fill (MF)

Negotiated Trade Book

The Negotiated Trade book contains all negotiated order entries captured by the
system before they have been matched against their counterparty trade entries.
Stop-Loss Book
Stop Loss orders are stored in this book till the trigger price specified in the order is
reached or surpassed. When the trigger price is reached or surpassed, the order is
released in the Regular lot book.
Auction Book
This book contains orders that are entered for all auctions. The matching process

Trading System - Order Conditions

Price Bands
Daily price bands are applicable on securities as below:

Daily price bands of 2% (either way) on specified securities

Daily price bands of 5% (either way) on specified securities

Daily price bands of 10% (either way) on specified securities

No price bands are applicable on:

scrips on which derivative products are available or scrips included in indices on w
hich derivative products are available.

Price bands of 20% (either way) on all remaining scrips (including debentures,
warrants, preference shares etc).

Circuit Breakers

The Exchange has implemented index-based market-wide circuit breakers in

compulsory rolling settlement with effect from July 02, 2001.

Index-based Market-wide Circuit Breakers The index-based market-wide circuit

breaker system applies at 3 stages of the index movement, either way viz. at 10%,
15% and 20%. These circuit breakers when triggered, bring about a coordinated
trading halt in all equity and equity derivative markets nationwide.

In case of a 10% movement of either of these indices,

there would be a one-hour market halt if the movement takes place before 1:00

In case after 1:00 p.m. but before 2:30 p.m. there would be trading halt for

after 2:30 p.m. there will be no trading halt at the 10% level and market shall
continue trading.

In case of a 15% movement of either index,

there shall be a two-hour halt if the movement takes place before 1 p.m.

after 1:00p.m. but before 2:00 p.m., there shall be a one-hour halt.

If the 15% trigger is reached on or after 2:00 p.m. the trading shall halt for
remainder of the day.
In case of a 20% movement of the index, trading shall be halted for the remainder
of the day.

The pay-in and pay-out days for funds and securities are prescribed as per the
Settlement Cycle. A typical Settlement Cycle of Normal Settlement is given