This chapter discusses the valuation of bonds and shares. It explains the characteristics of different types of bonds and shares and how to value them using present value concepts. The chapter focuses on the linkage between share values, earnings, and dividends. It also covers bond valuation, including the impact of interest rate changes on bond prices. Credit ratings help assess the default risk of different bonds.
What is the 'Time Value of Money - TVM'
The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as present discounted value.
BREAKING DOWN 'Time Value of Money - TVM'
Money deposited in a savings account earns a certain interest rate. Rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. Money earning an interest rate is said to be compounding in value.
BREAKING DOWN 'Compound Interest'
Compound Interest Formula
Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one.The total initial amount of the loan is then subtracted from the resulting value.
time value of money
,
concept of time value of money
,
significance of time value of money
,
present value vs future value
,
solve for the present value
,
simple vs compound interest rate
,
nominal vs effective annual interest rates
,
future value of a lump sum
,
solve for the future value
,
present value of a lump sum
,
types of annuity
,
future value of an annuity
What is the 'Time Value of Money - TVM'
The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as present discounted value.
BREAKING DOWN 'Time Value of Money - TVM'
Money deposited in a savings account earns a certain interest rate. Rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. Money earning an interest rate is said to be compounding in value.
BREAKING DOWN 'Compound Interest'
Compound Interest Formula
Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one.The total initial amount of the loan is then subtracted from the resulting value.
time value of money
,
concept of time value of money
,
significance of time value of money
,
present value vs future value
,
solve for the present value
,
simple vs compound interest rate
,
nominal vs effective annual interest rates
,
future value of a lump sum
,
solve for the future value
,
present value of a lump sum
,
types of annuity
,
future value of an annuity
Discuss the concept of risk in investment decisions.
Understand some commonly used techniques, i.e., payback, certainty equivalent and risk-adjusted discount rate, of risk analysis in capital budgeting.
Focus on the need and mechanics of sensitivity analysis and scenario analysis.
Highlight the utility and methodology simulation analysis.
Explain the decision tree approach in sequential investment decisions.
Focus on the relationship between utility theory and capital budgeting decisions.
This PPT contains the full detail of topic leverage in financial management
it covers following topics :-
Meaning of Leverage
Types of Leverage
Operating Leverage
Financial Leverage
Difference between Operating & Financial Leverage
Combined Leverage
Illustrations
Exercise
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
Discuss the concept of risk in investment decisions.
Understand some commonly used techniques, i.e., payback, certainty equivalent and risk-adjusted discount rate, of risk analysis in capital budgeting.
Focus on the need and mechanics of sensitivity analysis and scenario analysis.
Highlight the utility and methodology simulation analysis.
Explain the decision tree approach in sequential investment decisions.
Focus on the relationship between utility theory and capital budgeting decisions.
This PPT contains the full detail of topic leverage in financial management
it covers following topics :-
Meaning of Leverage
Types of Leverage
Operating Leverage
Financial Leverage
Difference between Operating & Financial Leverage
Combined Leverage
Illustrations
Exercise
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
BONDS, FEATURES OF BONDS, BOND VALUATION, MEASURING YIELD, ASSESSING RISK, TYPES OF LONG- TERM DEBT INSTRUMENTS, SERIAL BONDS, TYPES OF RISK, SEMI- ANNUAL BONDS, YIELD TO CALL, YIELD TO MATURITY, DEFAULT RISK & FACTORS AFFECTING DEFAULT RISK & BOND RATINGS, etc.
W E B E X T E N S I O N 5CA Closer Look at Bond RiskDurat.docxdickonsondorris
W E B E X T E N S I O N 5C
A Closer Look at Bond Risk:
Duration
T his extension explains how to manage the risk of a bond portfolio using the con-cept of duration.
5.1 BOND RISK
In our discussion of bond valuation in Chapter 5, we discussed interest rate and rein-
vestment rate risk. Interest rate (price) risk is the risk that the price of a debt secu-
rity will fall as a result of increases in interest rates, and reinvestment rate risk is the
risk of earning a less than expected return when debt principal or interest payments
are reinvested at rates that are lower than the original yield to maturity.
To illustrate how to reduce interest rate and reinvestment rate risks, we will consider
a firm that is obligated to pay a worker a lump-sum retirement benefit of $10,000 at the
end of 10 years. Assume that the yield curve is horizontal, the current interest rate on all
Treasury securities is 9%, and the type of security used to fund the retirement benefit is
Treasury bonds. The present value of $10,000, discounted back 10 years at 9%, is
$10,000(0.4224) = $4,224. Therefore, the firm could invest $4,224 in Treasury bonds
and expect to be able to meet its obligation 10 years hence.1
Suppose, however, that interest rates change from the current 9% rate immedi-
ately after the firm has bought the Treasury bonds. How will this affect the situation?
The answer is, “It all depends.” If rates fall, then the value of the bonds in the port-
folio will rise, but this benefit will be offset to a greater or lesser degree by a decline
in the rate at which the coupon payment of 0.09($4,224) = $380.16 can be reinvested.
The reverse would hold if interest rates rose above 9%. Here are some examples (for
simplicity, we assume annual coupons).
1. The firm buys $4,224 of 9%, 10-year maturity bonds; rates fall to 7% immediately
after the purchase and remain at that level:
Portfolio value at
the end of 10 years
¼
Future value of
10 interest payments
of $380:16 each
compounded at 7%
þ Maturity
value
¼ $5; 252 þ $4; 224
¼ $9; 476
Therefore, the firm cannot meet its $10,000 obligation, and it must contribute
additional funds.
1For the sake of simplicity, we assume that the firm can buy a fraction of a bond.
1
2. The firm buys $4,224 of 9%, 40-year bonds; rates fall to 7% immediately after the
purchase and remain at that level:
Portfolio value at
the end of 10 years
¼ $5; 252 þ
Value of
30-year
9% bonds
when rd ¼ 7%
¼ $5; 252 þ $5; 272
¼ $10; 524
In this situation, the firm has excess capital at the end of the 10-year period.
3. The firm buys $4,224 of 9%, 10-year bonds; rates rise to 12% immediately after the
purchase and remain at that level:
Portfolio value at
the end of 10 years
¼
Future value of
10 interest payments
of $380:16 each
compounded at 12%
þ Maturity
value
¼ $6; 671 þ $4; 224
¼ $10; 895
This situation also produces a funding surplus.
4. The firm buys $4,224 of 9%, 40-year bonds; rates rise to 12% immediately after the
purchase a ...
The presentation highlights some shortcut formulas that can speed up PV computations if a project have a particular set of cash flow patterns and the opportunity cost of capital is constant
Explain the concept of financial leverage.
Discuss the alternative measures of financial leverage.
Understand the risk and return implications of financial leverage.
Analyse the combined effect of financial and operating leverage.
Highlight the difference between operating risk and financial risk.
Risk and Return: An Overview of Capital Market Theory PANKAJ PANDEY
Discuss the concepts of average and expected rates of return.
Define and measure risk for individual assets.
Show the steps in the calculation of standard deviation and variance of returns.
Explain the concept of normal distribution and the importance of standard deviation.
Compute historical average return of securities and market premium.
Determine the relationship between risk and return.
Highlight the difference between relevant and irrelevant risks.
Real Options, Investment Analysis and Process PANKAJ PANDEY
Understand the capital budgeting process:
Document the policies and practices of companies in India and compare them with that of the companies in developed countries.
Understand the linkage between corporate strategy and investment decisions.
Define strategic real options.
Show the valuation of real options.
Show the application of the NPV rule in the choice between mutually exclusive projects, replacement decisions, projects with different lives etc.
Understand the impact of inflation on mutually exclusive projects with unequal lives.
Make choice between investments under capital rationing.
Illustrate the use of linear programming under capital rationing situation.
DETERMING CASH FLOWS FOR INVESTING ANALYSISPANKAJ PANDEY
Show the conceptual difference between profit and cash flow.
Discuss the approach for calculating incremental cash flows.
Highlight the interaction between financing and investment decisions.
Explain the general concept of opportunity cost of capital.
Distinguish between the project cost of capital and the firm’s cost of capital.
Learn about the methods of calculating component cost of capital and the weighted average cost of capital.
Understand the concept and calculation of the marginal cost of capital.
Recognise the need for calculating cost of capital for divisions.
Understand the methodology of determining the divisional beta and divisional cost of capital.
Illustrate the cost of capital calculation for a real company.
Understand the nature and importance of investment decisions.
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation.
Explain the methods of calculating net present value (NPV) and internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise the superiority of NPV rule.
Discuss the methods of estimating beta.
Explain the market model for calculating beta.
Examine the difference between betas of individual firms and the industry beta.
Highlight the beta instability.
Explain the determinants of beta.
Show the use of beta in determining the cost of equity.
Risk and Return: Portfolio Theory and Assets Pricing ModelsPANKAJ PANDEY
Discuss the concepts of portfolio risk and return.
Determine the relationship between risk and return of portfolios.
Highlight the difference between systematic and unsystematic risks.
Examine the logic of portfolio theory .
Show the use of capital asset pricing model (CAPM) in the valuation of securities.
Explain the features and modus operandi of the arbitrage pricing theory (APT).
Introduction
Why big data is required
Big data
Big data facts
Big data 3 V’s
Why big data is important
Examples where big data is used
Analytics
Approach to analytic development
Analysis of data through senser.
Analytics can help in
Big data analytics
Big data analytics in practice
How big data is used in twitter to get patterns
Human resource cost and risk of big data.
Big data analytics tools and technology
Conclusions
references
Instructions for Submissions thorugh G- Classroom.pptxJheel Barad
This presentation provides a briefing on how to upload submissions and documents in Google Classroom. It was prepared as part of an orientation for new Sainik School in-service teacher trainees. As a training officer, my goal is to ensure that you are comfortable and proficient with this essential tool for managing assignments and fostering student engagement.
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Francesca Gottschalk from the OECD’s Centre for Educational Research and Innovation presents at the Ask an Expert Webinar: How can education support child empowerment?
Read| The latest issue of The Challenger is here! We are thrilled to announce that our school paper has qualified for the NATIONAL SCHOOLS PRESS CONFERENCE (NSPC) 2024. Thank you for your unwavering support and trust. Dive into the stories that made us stand out!
How to Make a Field invisible in Odoo 17Celine George
It is possible to hide or invisible some fields in odoo. Commonly using “invisible” attribute in the field definition to invisible the fields. This slide will show how to make a field invisible in odoo 17.
The Roman Empire A Historical Colossus.pdfkaushalkr1407
The Roman Empire, a vast and enduring power, stands as one of history's most remarkable civilizations, leaving an indelible imprint on the world. It emerged from the Roman Republic, transitioning into an imperial powerhouse under the leadership of Augustus Caesar in 27 BCE. This transformation marked the beginning of an era defined by unprecedented territorial expansion, architectural marvels, and profound cultural influence.
The empire's roots lie in the city of Rome, founded, according to legend, by Romulus in 753 BCE. Over centuries, Rome evolved from a small settlement to a formidable republic, characterized by a complex political system with elected officials and checks on power. However, internal strife, class conflicts, and military ambitions paved the way for the end of the Republic. Julius Caesar’s dictatorship and subsequent assassination in 44 BCE created a power vacuum, leading to a civil war. Octavian, later Augustus, emerged victorious, heralding the Roman Empire’s birth.
Under Augustus, the empire experienced the Pax Romana, a 200-year period of relative peace and stability. Augustus reformed the military, established efficient administrative systems, and initiated grand construction projects. The empire's borders expanded, encompassing territories from Britain to Egypt and from Spain to the Euphrates. Roman legions, renowned for their discipline and engineering prowess, secured and maintained these vast territories, building roads, fortifications, and cities that facilitated control and integration.
The Roman Empire’s society was hierarchical, with a rigid class system. At the top were the patricians, wealthy elites who held significant political power. Below them were the plebeians, free citizens with limited political influence, and the vast numbers of slaves who formed the backbone of the economy. The family unit was central, governed by the paterfamilias, the male head who held absolute authority.
Culturally, the Romans were eclectic, absorbing and adapting elements from the civilizations they encountered, particularly the Greeks. Roman art, literature, and philosophy reflected this synthesis, creating a rich cultural tapestry. Latin, the Roman language, became the lingua franca of the Western world, influencing numerous modern languages.
Roman architecture and engineering achievements were monumental. They perfected the arch, vault, and dome, constructing enduring structures like the Colosseum, Pantheon, and aqueducts. These engineering marvels not only showcased Roman ingenuity but also served practical purposes, from public entertainment to water supply.
2. 2Financial Management, Ninth
Chapter Objectives
Explain the fundamental characteristics of
ordinary shares, preference shares and bonds
(or debentures).
Show the use of the present value concepts in
the valuation of shares and bonds.
Learn about the linkage between the share
values, earnings and dividends and the
required rate of return on the share.
Focus on the uses and misuses of price-
earnings (P/E) ratio.
3. 3Financial Management, Ninth
Introduction
Assets can be real or financial; securities like
shares and bonds are called financial assets
while physical assets like plant and
machinery are called real assets.
The concepts of return and risk, as the
determinants of value, are as fundamental
and valid to the valuation of securities as to
that of physical assets.
7. 7Financial Management, Ninth
Bond with Maturity
Bond value = Present value of interest + Present
value of maturity value:
0
1
INT
(1 ) (1 )
n
t n
t n
t d d
B
B
k k=
= +
+ +
∑
8. 8Financial Management, Ninth
Yield to Maturity
The yield-to-maturity (YTM) is the measure
of a bond’s rate of return that considers both
the interest income and any capital gain or
loss. YTM is bond’s internal rate of return.
A perpetual bond’s yield-to-maturity:
0
1
INT INT
(1 )
n
t
t d d
B
k k
=∞
=
= =
+
∑
9. 9Financial Management, Ninth
Current Yield
Current yield is the annual interest divided by
the bond’s current value.
Example: The annual interest is Rs 60 on the
current investment of Rs 883.40. Therefore,
the current rate of return or the current yield
is: 60/883.40 = 6.8 per cent.
Current yield does not account for the capital
gain or loss.
10. 10Financial Management, Ninth
Yield to Call
For calculating the yield to call, the call period
would be different from the maturity period and
the call (or redemption) value could be different
from the maturity value.
Example: Suppose the 10% 10-year Rs 1,000
bond is redeemable (callable) in 5 years at a call
price of Rs 1,050. The bond is currently selling
for Rs 950.The bond’s yield to call is 12.7%.
( ) ( )
5
5
1
100 1,050
950
1 YTC 1 YTC
t
t=
= +
+ +
∑
11. 11Financial Management, Ninth
Bond Value and Amortisation of
Principal
A bond (debenture) may be amortised every
year, i.e., repayment of principal every year
rather at maturity.
The formula for determining the value of a bond
or debenture that is amortised every year, can
be written as follows:
Note that cash flow, CF, includes both the interest
and repayment of the principal.
0
1 (1 )
n
t
t
t d
CF
B
k=
=
+
∑
12. 12Financial Management, Ninth
Pure Discount Bonds
Pure discount bond do not carry an explicit
rate of interest. It provides for the payment of a
lump sum amount at a future date in exchange
for the current price of the bond. The difference
between the face value of the bond and its
purchase price gives the return or YTM to the
investor.
13. 13Financial Management, Ninth
Pure Discount Bonds
Example: A company may issue a pure
discount bond of Rs 1,000 face value for
Rs 520 today for a period of five years.
The rate of interest can be calculated as
follows:
( )
( )
5
5
1/5
1,000
520
1 YTM
1,000
1 YTM 1.9231
520
1.9231 1 0.14 or 14%i
=
+
+ = =
= − =
14. 14Financial Management, Ninth
Pure Discount Bonds
Pure discount bonds are called deep-
discount bonds or zero-interest bonds or
zero-coupon bonds.
The market interest rate, also called the
market yield, is used as the discount rate.
Value of a pure discount bond = PV of the
amount on maturity:
( )
0
1
n
n
d
M
B
k
=
+
15. 15Financial Management, Ninth
Perpetual Bonds
Perpetual bonds, also called consols, has an
indefinite life and therefore, it has no maturity
value. Perpetual bonds or debentures are rarely
found in practice.
16. 16Financial Management, Ninth
Perpetual Bonds
Suppose that a 10 per cent Rs 1,000 bond will
pay Rs 100 annual interest into perpetuity. What
would be its value of the bond if the market yield
or interest rate were 15 per cent?
The value of the bond is determined as follows:
0
INT 100
Rs 667
0.15d
B
k
= = =
17. 17Financial Management, Ninth
Bond Values and Changes in
Interest Rates
The value of the bond
declines as the market
interest rate (discount
rate) increases.
The value of a 10-year,
12 per cent Rs 1,000
bond for the market
interest rates ranging
from 0 per cent to
30 per cent.
0.0
200.0
400.0
600.0
800.0
1000.0
1200.0
0% 5% 10% 15% 20% 25% 30%
Interest Rate
BondValue
18. 18Financial Management, Ninth
Bond Maturity and Interest Rate Risk
The intensity of interest rate
risk would be higher on
bonds with long maturities
than bonds with short
maturities.
The differential value
response to interest rates
changes between short and
long-term bonds will always
be true. Thus, two bonds of
same quality (in terms of the
risk of default) would have
different exposure to
interest rate risk.
PresentValue(Rs)
Discountrate(%) 5-Yearbond 10-Yearbond Perpetualbond
5 1,216 1,386 2,000
10 1,000 1,000 1,000
15 832 749 667
20 701 581 500
25 597 464 400
30 513 382 333
19. 19Financial Management, Ninth
Bond Maturity and Interest Rate Risk
0
250
500
750
1000
1250
1500
1750
2000
5 10 15 20 25 30
Discount rate (%)
Value(Rs)
5-year bond
10-year bond
Perpetual bond
20. 20Financial Management, Ninth
Bond Duration and Interest Rate
Sensitivity
The longer the maturity of a bond, the higher
will be its sensitivity to the interest rate
changes. Similarly, the price of a bond with
low coupon rate will be more sensitive to the
interest rate changes.
However, the bond’s price sensitivity can be
more accurately estimated by its duration. A
bond’s duration is measured as the weighted
average of times to each cash flow (interest
payment or repayment of principal).
21. 21Financial Management, Ninth
Duration of Bonds
Let us consider the
8.5 per cent rate bond
of Rs 1,000 face
value that has a
current market value
of Rs 954.74 and a
YTM of 10 per cent,
and the 12 per cent
rate bond of Rs 1,000
face value has a
current market value
of Rs 1,044.57 and a
yield to maturity of
10.8 per cent. Table
shows the calculation
of duration for the two
bonds.
8.5 Percent Bond
Year Cash Flow
Present Value
at 10 %
Proportion of
Bond Price
Proportion of
Bond Price x Time
1 85 77.27 0.082 0.082
2 85 70.25 0.074 0.149
3 85 63.86 0.068 0.203
4 85 58.06 0.062 0.246
5 1,085 673.70 0.714 3.572
943.14 1.000 4.252
11.5 Percent Bond
Year
Cash
Flow
Present Value
at 10.2%
Proportion of
Bond Price
Proportion of Bond
Price x Time
1 115 103.98 0.101 0.101
2 115 94.01 0.091 0.182
3 115 85.00 0.082 0.247
4 115 76.86 0.074 0.297
5 1,115 673.75 0.652 3.259
1,033.60 1.000 4.086
22. 22Financial Management, Ninth
Volatility
The volatility or the interest rate sensitivity of a bond
is given by its duration and YTM. A bond’s volatility,
referred to as its modified duration, is given as
follows:
The volatilities of the 8.5 per cent and 11.5 per cent
bonds are as follows:
Duration
Volatility of a bond
(1 YTM)
=
+
4.086
Volatility of 11.5% bond 3.69
(1.106)
= =
4.252
Volatility of 8.5% bond 3.87
(1.100)
= =
23. 23Financial Management, Ninth
The Term Structure of Interest Rates
Yield curve shows the relationship between the
yields to maturity of bonds and their maturities. It is
also called the term structure of interest rates.
Yield Curve (Government of India Bonds)
5.90%
7.18%
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10
Maturity
(Years)
Yield (%)
24. 24Financial Management, Ninth
The Term Structure of Interest
Rates
The upward sloping yield curve implies that
the long-term yields are higher than the short-
term yields. This is the normal shape of the
yield curve, which is generally verified by
historical evidence.
However, many economies in high-inflation
periods have witnessed the short-term yields
being higher than the long-term yields. The
inverted yield curves result when the short-
term rates are higher than the long-term
rates.
25. 25Financial Management, Ninth
The Expectation Theory
The expectation theory supports the upward
sloping yield curve since investors always
expect the short-term rates to increase in the
future.
This implies that the long-term rates will be
higher than the short-term rates.
But in the present value terms, the return
from investing in a long-term security will
equal to the return from investing in a series
of a short-term security.
26. 26Financial Management, Ninth
The Expectation Theory
The expectation theory assumes
capital markets are efficient
there are no transaction costs and
investors’ sole purpose is to maximize their returns
The long-term rates are geometric average of current
and expected short-term rates.
A significant implication of the expectation theory is
that given their investment horizon, investors will earn
the same average expected returns on all maturity
combinations.
Hence, a firm will not be able to lower its interest cost
in the long-run by the maturity structure of its debt.
27. 27Financial Management, Ninth
The Liquidity Premium Theory
Long-term bonds are more sensitive than the
prices of the short-term bonds to the changes
in the market rates of interest.
Hence, investors prefer short-term bonds to
the long-term bonds.
The investors will be compensated for this risk
by offering higher returns on long-term bonds.
This extra return, which is called liquidity
premium, gives the yield curve its upward
bias.
28. 28Financial Management, Ninth
The Liquidity Premium Theory
The liquidity premium theory means that rates
on long-term bonds will be higher than on the
short-term bonds.
From a firm’s point of view, the liquidity
premium theory suggests that as the cost of
short-term debt is less, the firm could
minimize the cost of its borrowings by
continuously refinancing its short-term debt
rather taking on long-term debt.
29. 29Financial Management, Ninth
The Segmented Markets Theory
The segmented markets theory assumes that
the debt market is divided into several
segments based on the maturity of debt.
In each segment, the yield of debt depends
on the demand and supply.
Investors’ preferences of each segment arise
because they want to match the maturities of
assets and liabilities to reduce the
susceptibility to interest rate changes.
30. 30Financial Management, Ninth
The Segmented Markets Theory
The segmented markets theory approach
assumes investors do not shift from one
maturity to another in their borrowing—lending
activities and therefore, the shift in yields are
caused by changes in the demand and supply
for bonds of different maturities.
31. 31Financial Management, Ninth
Default Risk and Credit Rating
Default risk is the risk that a company will
default on its promised obligations to
bondholders.
Default premium is the spread between the
promised return on a corporate bond and the
return on a government bond with same
maturity.
32. 32Financial Management, Ninth
Crisil’s Debenture RatingsHigh Investme nt Gr ades
AAA (Triple A): Highest Safety Debentures rated `AAA' are judged to offer highes t safety of
timely payment of interest and principal. Though the
circu mstances providing this degree of safety are like ly to
change, such changes as can be envisaged are most unlikely to
affect adversely the fundamentally strong position of such iss ues.
AA (Double A): High Safety Debentures rated 'AA' are judged to offer high safety of time ly
payment of interest and principal. They differ in safety fro m
`AAA' issues only margina lly.
Investment Gr ades
A: Adequate Safety Debentures rated `A' are judged to offer adequate safety of time ly
payment of interest and principal; however, changes in
circu mstances can adversely affect such issues more than those in
the higher rated categories .
BBB (T rip le B): Moderate Safety Debentures rated `BBB' are judged to offer sufficient s afety of
timely payment of interest and principal for the present; however,
changing circums tances are more like ly to lead to a weakened
capacity to pay interest and repay principal than for debentures in
higher rated categories.
Speculati ve Gr ades
BB (Double B): Inadequate Safety Debentures rated `BB' are judged to carry inadequate s afety of
timely pay ment of interest and principal; wh ile they are less
susceptible to default than other speculative grade debentures in
the immediate future, the uncertainties that the issuer faces could
lead to inadequate capacity to ma ke timely interest and principal
payments.
B: High Risk Debentures rated `B' are judged to have greater susceptibility to
default; while currently interest and principal payments are met,
adverse business or economic conditions would lead to lack of
ability or willingness to pay interest or principal.
C: Substantial Risk Debentures rated `C' are judged to have factors present that make
them vulnerable to default; time ly payment of interes t and
principal is poss ible only if favourable c ircu ms tances continue.
D: In De fault Debentures rated `B' are judged to have greater susceptibility to
default; while currently interest and principal payments are met,
adverse business or economic conditions would lead to lack of
ability or willingness to pay interest or principal.
Note:
1. CRISIL may apply " +" (plus) or " -" (minus) signs for ratings from AA to D to reflect comparative standing
within the category.
2. The contents within parenthesis are a guide to the pronuncia tion of the rating symbols.
3. Preference share rating symbols are identical to debenture rating symbols except that th e letters " pf" are
prefixed to the debenture rating symbols, e.g. pfAAA ("pf Triple A" ).
33. 33Financial Management, Ninth
Valuation of Shares
A company may issue two types of shares:
ordinary shares and
preference shares
Features of Preference and Ordinary Shares
Claims
Dividend
Redemption
Conversion
34. 34Financial Management, Ninth
Valuation of Preference Shares
The value of the preference share would be
the sum of the present values of dividends
and the redemption value.
A formula similar to the valuation of bond can
be used to value preference shares with a
maturity period:
1
0
1
PDIV
(1 ) (1 )
n
n
t n
t p p
P
P
k k=
= +
+ +
∑
35. 35Financial Management, Ninth
Suppose an investor is considering the purchase of a 12-year, 10% Rs 100 par value preference share. The
redemption value of the preference share on maturity is Rs 120. The investor’s required rate of return is
10.5 percent. What should she be willing to pay for the share now? The investor would expect to receive
Rs 10 as preference dividend each year for 12 years and Rs 110 on maturity (i.e., at the end of 12 years).
We can use the present value annuity factor to value the constant stream of preference dividends and the
present value factor to value the redemption payment.
30.101Rs24.3606.65302.0120506.610
)105.1(
120
)105.1(105.0
1
105.0
1
10P 12120
=+=×+×=
+
×
−×=
Note that the present value of Rs 101.30 is a composite of the present value of dividends, Rs 65.06 and
the present value of the redemption value, Rs 36.24.The Rs 100 preference share is worth Rs 101.3 today
at 10.5 percent required rate of return. The investor would be better off by purchasing the share for Rs 100
today.
Value of a Preference Share-Example
36. 36Financial Management, Ninth
Valuation of Ordinary Shares
The valuation of ordinary or equity shares is
relatively more difficult.
The rate of dividend on equity shares is not
known; also, the payment of equity dividend is
discretionary.
The earnings and dividends on equity shares are
generally expected to grow, unlike the interest on
bonds and preference dividend.
37. 37Financial Management, Ninth
Dividend Capitalisation
The value of an ordinary share is determined
by capitalising the future dividend stream at
the opportunity cost of capital
Single Period Valuation:
If the share price is expected to grow at g per
cent, then P1:
We obtain a simple formula for the share valuation
as follows:
1 1
0
DIV
1 e
P
P
k
+
=
+
1 0 (1 )P P g= +
1
0
DIV
e
P
k g
=
−
38. 38Financial Management, Ninth
Multi-period Valuation
If the final period is n, we can write the
general formula for share value as follows:
Growth in Dividends
Normal Growth
Super-normal Growth
0
1
DIV
(1 ) (1 )
n
t n
t n
t e e
P
P
k k=
= +
+ +
∑
Growth = Retention ratio Return on equity
ROEg b
×
= ×
1
0
DIV
e
P
k g
=
−
Share value PV of dividends during finite super-normal growth period
PV of dividends during indefinite normal growth period
=
+
39. 39Financial Management, Ninth
Earnings Capitalisation
Under two cases, the value of the share can
be determined by capitalising the expected
earnings:
When the firm pays out 100 per cent dividends;
that is, it does not retain any earnings.
When the firm’s return on equity (ROE) is equal to
its opportunity cost of capital.
40. 40Financial Management, Ninth
Equity Capitalisation Rate
For firms for which dividends are expected to
grow at a constant rate indefinitely and the
current market price is given
1
0
DIV
ek g
P
= +
41. 41Financial Management, Ninth
Caution in Using Constant-Growth
Formula
Estimation errors
Unsustainable high current growth
Errors in forecasting dividends
42. 42Financial Management, Ninth
Valuing Growth Opportunities
The value of a growth opportunity is given
as follows:
1
1
NPV
EPS (ROE )
( )
g
e
e
e e
V
k g
b k
k k g
=
−
× −
=
−
43. 43Financial Management, Ninth
Price-Earnings (P/E) Ratio: How
Significant?
P/E ratio is calculated as the price of a share
divided by earning per share.
Some people use P/E multiplier to value the
shares of companies.
Alternatively, you could find the share value by
dividing EPS by E/P ratio, which is the
reciprocal of P/E ratio.
44. 44Financial Management, Ninth
Price-Earnings (P/E) Ratio: How
Significant?
The share price is also given by the following
formula:
The earnings price ratio can be derived as
follows:
1
0
EPS
g
e
P V
k
= +
1EPS
1
g
e
o o
V
k
P P
= −
45. 45Financial Management, Ninth
Price-Earnings (P/E) Ratio: How
Significant?
Cautions:
E/P ratio will be equal to the capitalisation rate
only if the value of growth opportunities is zero.
A high P/E ratio is considered good but it could
be high not because the share price is high but
because the earnings per share are quite low.
The interpretation of P/E ratio becomes
meaningless because of the measurement
problems of EPS.