Bond & Equity Valuation

What is a bond?
Bond is a negotiable instrument which acknowledges the indebtedness of the issuer to the
investor. In this arrangement the investor extends credit to the issuer and in return the
issuer commits to repay the amount back at the end of the pre - determined tenure along
with the interest throughout the life of the bond.

Features
Par value: Face value of the bond which will be paid back at the time of maturity

Coupon rate:  is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage.

Maturity date: the date at which the bond holder will be paid back the principal (par
value)

Redemption value:  is the value paid to the bondholder, at the time of expiry of the term
for which bond is issued.

Types of bonds
Basis of classification Types
Issuer  Government
 Corporate
Coupon rate  Fixed rate
 Floating rate
 Zero coupon
Location  Domestic
 Foreign
 Euro
Bond rating  Investment grade
 High yield bonds
Embedded option  Callable
 Putable
 Convertible
Maturity  Short term
 Medium term
 Long term
 Perpetual
Valuation :
Determining fair price (intrinsic value) of the bond. To be compared with the current market price
for buying decision.

Intrinsic value > Market price, Buy

Intrinsic value < Market price, Sell

n
C M
 1  k   1  k 
t 1
t n
V= d d OR C(PVIFAkd,n) + M(PVIFkd,n)

Illustration : Valuation of a Straight bond

Aseem is considering buying Bond A currently quoting a price of Rs 800. Following are the
salient features of the bond. face value:  Rs 1,000, maturity: 5 years, coupon rate: 6%,
required yield : 12% Advise Aseem if he should invest in the bond.

Every year Rs 60 and Rs 1000 at the end of 5 years.

P0 = 60/1.12^1 + 60/1.12^2 + 60/1.12^3 + 60/1.12^4 + 60/1.12^5 + 1000/1.12^5

P0 = 783.7

60 – annuity for 5 years + 1000 lumpsum

P = 60 (PVIFA 12%,5 yrs) + 1000 (PVIF 12%, 5 yrs)

Solution : Required yield Value (Price)

Coupon Rate
14% 14% 1000 RRR=CR At par
14% 10% 1194.73 RRR<CR At premium
14% 18% 847.5 RRR>CR At discount
CR = 14%
When kd = 14% …. RRR=CR

V = 140 (PVIFA 14%, 7 yrs ) + 1000 (PVIF 14%, 7 yrs)

= 600.32 + 400 = 1000.32…. FV Bond was trading at par

When kd = 10%, RRR < CR

V = 1194 > 1000….Bond is trading at a premium

Kd = 18%, RRR > CR

V = 847 < 1000…. Bond is trading at a discount
 1. Compute the price of a 10-year bond, 12 per cent coupon with par value of Rs.1000. The
required rate of return may be assumed to be 13 per cent.

V = 945,
If MP = 980, overvalued, not buy
If MP = 900, V >MP, underpriced,buy

P0 = Rs 120 interest for 10 years + 1000 at the end of 10 yrs

= 120 (PVIFA 13%, 10yrs) + 1000 (PVIF 13%, 10yrs )

= 651.15 + 294.5

= 945.7

2. Consider an 8-year, 12 per cent coupon bond with par value Rs.100 on which interest is paid
semi-annually. The required rate on the bond is 14 per cent.
Assume that RRR falls by 100 basis points, calculate the new price and analyse the change in
price due to change in RRR. Next assume RRR rises to 15 %, analyse the price change wrt
change in RRR.
1% = 100 basis points

Interest = Rs 6 every 6m …. Rs 6…8*2 = 16 times

C = 6, n*m = 16, Kd = 14/2 = 7%
V = 6 (PVIFA 7%, 16) + 100 (PVIF 7%, 16)
= 6*9.4466 + 100* 0.33873 = 90.549

When RRR falls by 1%, Percentage change in price = (95.12 -90.55)/90.55 * 100 = +5.04%

When RRR rises by 1%, percentage change in price = (-4.71)%

12% CR, 14% RRR, 8 years to maturity, P = 90.55

12% CR, 14% RRR, 3 years to maturity, P = 95.22…

As bond approaches maturity approaches maturity, the discount / premium reduces and bond prices
converge towards the maturity value (which is generally face value)

Interest = Rs 6 semi annually, Kd = 14/2 = 7, period = 8*2 = 16

When RRR = 14%, V = Rs 90.54….if 3 yrs to maturity then V = 95.23

When RRR= 13%, V = 95.11, % increase in price = 5.04%... capital gain

When RRR = 15%, V = 86.29, % fall in price = 4.56%... capital loss

When RRR= 12%, V = 100

3. Consider the following two bonds and advise which one should be invested in

A : FV 1000, CR= 10%, n= 5 yrs, CMP = 900

B : FV 100, CR = 9% n = 8 yrs , CMP = 102

Credit rating A+

YTM : A – 12.63%

YTM – B – 8.66%

Bond yields
Concepts of return (yield) on bond investment

Current yield: Annual interest divided by the current market price of the bond.

CY =Annual interest/ Market price of bond *100

Yield to maturity: Total return anticipated on the bond investment if the bond is held till
maturity. Includes interest income as well as capital gain/loss.

YTM of bond is similar to the internal rate of return of a capital expenditure.

Mathematically, it is the discount rate which equates the present value of all future cash
flows receivable from the bond to the current price of the bond.. Yield to maturity is
considered a long-term bond yield but is expressed as an annual rate. In other words, it is
the internal rate of return of an investment in a bond if the investor holds the bond until
maturity and if all payments are made as scheduled.

Hence in the below equation Kd is the YTM and is calculated through trial and error
n
C M
 1  k   1  k 
t 1
t n
d d

Market price =

YTM (approximation formula)

C  (M  P) / n
YTM ~ ( M  P ) / 2

Illustration : calculating current yield and YTM

A bond of Rs. 10000 bearing coupon rate 12% and redeemable in 8 years at par is trading at
Rs.10,600. Find out the current yield and YTM of the bond.

CY = 1200/10600 * 100 = 11.32%

P = C/1+R + C/1+R^2 +C/1+R^3 +….. M/1+R^N

10600 = 1200/1+kd + 1200/1+kd^2 +… 10000/1+kd^8

10600 = 1200 (PVIFA r, 8y) + 10000(PVIF r, 8Y)

Approx YTM = {1200 + (10000-10600)/8} / (10000+10600)/2

= 1200+ (-75) / 10300 = 1125/10300 = 0.1092* 100 = 10.92%

Assume this bond is trading at case i- 10000, case ii – bond is trading at 9000

12% CR , 8 yrs to maturity

Recalculate CY and YTM

CR MPS CY YTM
12 10600 11.32 10.92 At premium CR>CY>YTM
12 10000 12 12 At par CR = CY = YTM
12 9000 13.33 13.94 At discount YTM >CY>CR
CY = 1200/10600 * 100 = 11.32%

CY = Annual interest / Market price = (1200/10600)*100 = 11.32%

1200  (10000  10600) / 8

(10000  10600) / 2
YTM =

= 1125/10300 = 10.92%...................................YTM

CR MPS CY YTM

12 10600 11.32 10.92 At premium CR>CY>YTM

12 9000 13.33 13.94 At discount CR<CY<YTM

12 10000 12 12 At par CR=CY=YTM

Observe that since the bond is trading at premium to its par value,

CY (11.32) and YTM(10.92) both are lower than the coupon rate(12).

4. Compute the current yield of a 10-year, 12 per cent coupon bond with a par value of Rs.
1000 and selling for Rs.950. What if the price rises to Rs 1000? Or falls to Rs 900?
CY = 120/950 *100 = 12.63%
CY = 120/1000 = 12%
CY = 120/900= 13.33%

5. Consider a Rs.1000 par value bond, carrying a coupon of 9 per cent, maturing after 8 years.
The bond is currently selling for Rs.800. What is the CY and YTM on this bond?
 CY = 11.25%, YTM = 12.77%

Bond Price- yield relationship

https://www.wisdomjobs.com/tutorials/price-yield-relationship.jpg

When interest rates rise, bond prices fall, and when interest rates go down, bond prices
increase. 

Bonds essentially compete against one another on the interest income they provide to
investors. When interest rates go up, new bonds that are issued come with a higher interest
rate and provide more income to investors. When rates go down, new bonds issued have a
lower interest rate and aren’t as attractive as older bonds. 

Unfortunately, when rates go up, the older, lower-rate bonds can’t increase their interest
rates to the same level as the new, higher-interest bonds. The older bond rates are locked
in, based on the original terms.
As a result, the only way to increase competitiveness and value to new investors is to reduce
the price of the bond. But as a result, the original bondholder may be holding an investment
that has decreased in price—and doesn’t pay out as much as they could get for it right now
on the market.

https://www.thebalance.com/why-do-bond-prices-go-down-when-interest-rates-rise-
2388565

Valuation and Yield calculation for a Zero coupon bond and a perpetual
bond

ZERO COUPON BOND : A zero coupon bond, sometimes referred to as a pure discount
bond or simply discount bond, is a bond that does not pay coupon payments and
stead pays one lump sum at maturity. The amount paid at maturity is called the face
value. The term discount bond is used to reference how it is sold originally at a
discount from its face value instead of standard pricing with periodic dividend
payments as seen otherwise.

PV = FV / (1+kd)^n
(FV because that will be the maturity value)

Ex - John is looking to purchase a zero-coupon bond with a face value of $1,000 and 5 years
to maturity. The interest rate on similar bonds is 5% p.a. What price will John pay for the
bond today?
PV = 1000/(1.05)^5 = 783.5
@ 6 %, PV = 1000/1.06^5 = 747.2

Ex – A 1lakh face value zero coupon bond is available at Rs 30000. The bond is due to mature
in 20 years. What yield can the investor expect to earn on this bond?
PV = FV / (1+kd)^n
30000 = 100000/1+kd^20
Kd = 6.2%.....YTM

CY = 0

Reinvestment risk is the risk that an investor will be unable to reinvest a bond’s cash flows
(coupon payments) at a rate equal to the investment’s required rate of return. Zero-coupon
bonds are the only type of fixed-income investments that are not subject to investment risk
– they do not involve periodic coupon payments.
Interest rate risk is the risk that an investor’s bond will decline in value due to fluctuations in
the interest rate. Interest rate risk is relevant when an investor decides to sell a bond before
maturity and affects all types of fixed-income investments.
 PERPETUAL BOND
 Perpetual bonds, also known as perps or consol bonds, are bonds with no maturity date.
 Although perpetual bonds are not redeemable, they pay a steady stream of interest in
forever.
 Because of the nature of these bonds, they are often viewed as a type of equity and not a
debt.

Ex – A 10% perpetual bond with FV of Rs 10000 has an expected yield of 12%, Calculate the
fair value. The market price is Rs 8000.
Pv = 1000/0.12 = 8333.33, so buy

EX – A 12% consol is available in the market at Rs 4500. If the FV is Rs 5000, calculate the
YTM
Annual interest = 12% of 5000 = 600… perpetuity
4500 = 600 / kd
Kd = 13.33% …. YTM
CY = 600/4500= 13.33%

Preference stock valuation

6. Compute the value of an 8-year, 10 per cent preference stock with par value Rs.1000. The
required rate of return on this preference stock is 9 per cent. (To be done exactly like bond
valuation)

Valuation of Equity

Valuation of Equity is more challenging than that of bonds since the returns on equity are
uncertain/variable. Hence there are many models which attempt to arrive at a fair valuation of
equity shares, however all the models have their limitations.
EQUITY VALUATION: DIVIDEND DISCOUNT MODEL

The Dividend Discount Model puts forth that the value of an equity share is the present value
of future expected dividends and the present value of the sale price of the share when sold.

The following assumptions are made while using the Dividend Discount Model:

1. Dividends are paid annually and

2. The first dividend is received one year after the purchase of the equity share.

Single Period Valuation Model

1. The first case is where the investor expects to hold the equity share for one year. The
price of the equity share is:
P0 = D1/(1+r) + P1/(1+r)

Where:

P0 - current price of equity share

D1 - dividend expected one year hence

P1 - price of equity share one year hence

r - rate of return required on equity share

Illustration 1:

Prestige’s equity share is expected to provide a dividend of Rs.2 and fetch a price of Rs.18 a
year hence. What price would it sell for now if investors’ required rate of return is 12 per
cent?

The current price will be: 2.0/ (1.12) + 18.00/ (1.12) = Rs. 17.86.

2. What will be the price of the equity share in case it is expected to grow at a rate of g
percent annually? In case P0 is the current price, in year later the price of the equity
share becomes P0 (1+g).

P0 = D1/(1+r) + P0 (1+g)/(1+r)
P0 = D1/(r - g)
Illustration 2:

The expected dividend per share on the equity share of RK Company Ltd. is Rs.2. The
dividend per share has grown over the past five years at the rate of 5 per cent per year and the
growth rate will continue in future and the market price of the share is expected to grow at the
same rate. What is the fair estimate of the intrinsic value of the share when the required rate
of return is 15 per cent?

The current price will be: 2.0/ (0.15 – 0.05) = Rs. 20.00.

3. What is the rate of return the investor expects given the current market price, and
forecast values of dividend and share price?

The expected rate of return is:

r = D1/ P0 + g

Illustration 3:

The expected dividend per share of Vaibhav Ltd. is Rs.5. The dividend is expected to grow at
the rate of 6 per cent per year. If the price of the share is now Rs.50, what is the expected
return?

The expected rate of return = 5/50 + 0.06 = 16 per cent.

Multi - period Valuation Model

As equity shares have no maturity period, they may be expected to bring dividend steam for
indefinite period in the future.

The assumptions regarding dividend patterns are as follows:

a. The dividend per share remains constant forever, implying that there is zero growth
known as the zero-growth model.

P0 = D /(1+r) + D /(1+r)2 + … + D /(1+r)n …….. ∞

P0 = D / r

Illustration 4:
If we assume that a company would pay Rs.100 as a dividend in the next period and continue
the same in future too, and the required rate of return is 10 per cent; then the price of the
stock would be …...

P0 = 100/0.1 = 1000

Ex – MPS = 25, FV = 5 , Div rate = 50%, RRR = 10%, would u buy the stock.

Po = 2.5/0.1 = 25 Rs

The current price will be: P0 = 100.00 / 0.1 = Rs.1000.

b. The dividend per share grows at a constant rate per year forever known as the
constant-growth model.

P0 = D1/(1+r) + D1 (1+g)/(1+r)2 + …… + D1 (1+g)n+1/(1+r)n + …

P0 = D1/(r - g)

Illustration 5:

Valuation of Equity

Valuation of Equity is more challenging than that of bonds since the returns on equity are
uncertain/variable. Hence there are many models which attempt to arrive at a fair valuation of
equity shares, however all the models have their limitations.

EQUITY VALUATION: DIVIDEND DISCOUNT MODEL

The Dividend Discount Model puts forth that the value of an equity share is the present value
of future expected dividends and the present value of the sale price of the share when sold.

The following assumptions are made while using the Dividend Discount Model:
 1. Dividends are paid annually and

2. The first dividend is received one year after the purchase of the equity share.

1. Prestige’s equity share is expected to provide a dividend of Rs.2 and fetch a price
of Rs.18 a year hence. What price would it sell for now if investors’ required rate
of return is 12 per cent?

P0 = 2/1.12 + 18/1.12 = 17.86…. fair value at which it should be trading in the market.

2. If we assume that a company would pay Rs.100 as a dividend in the next period
and continue the same in future too, and the required rate of return is 10 per cent;
then the price of the stock would be …...

P0 = 100/0.1 = Rs 1000

P0 = D1/r

3. The expected dividend per share on the equity share of RK Company Ltd. is Rs.2.
The dividend per share has grown over the past five years at the rate of 5 per cent
per year and the growth rate will continue in future and the market price of the
share is expected to grow at the same rate. What is the fair estimate of the intrinsic
value of the share when the required rate of return is 15 per cent?

P0 = D1 / r-g

2/0.15 – 0.05 = Rs 20… FV of the stock

 4. The expected dividend per share of Vaibhav Ltd. is Rs.5. The dividend is expected
to grow at the rate of 6 per cent per year. If the price of the share is now Rs.50,
what is the expected return?
50 = 5 / r – 0.06
R = 16%

Ramesh Engineering is expected to grow at the rate of 6 per cent per annum. The dividend
expected a year hence is Rs.2. What is its expected price, if the required rate of return is 14
per cent?

P0 = 25

A stock is currently trading at Rs 50. Expected Div rate is 25%, FV = Rs 10, Growth rate is
5%, RRR= 15%.

P0 = 2.5 / 0.15-0.05 = 25 … Fair value

Overvalued, don’t buy

The expected dividend per share of Vaibhav Ltd. is Rs.5. The dividend is expected to grow at
the rate of 6 per cent per year. If the price of the share is now Rs.50, what is the expected
return?

C. Two – stage Growth Model

Growing Companies generally grow at a fast (supernormal rate) for some years before
settling at a normal (industry) growth rate.

Illustration :
 The current dividend on an equity share of Pioneer Technology is Rs.3. Pioneer is expected
to enjoy an above-normal growth of 40 per cent for the next 5 years. Thereafter the growth
will fall and stabilise at 12 per cent. The equity investors require a rate of return of 15 per
cent. What is the intrinsic value of the share?
D1 = D0 (1+g) = 3(1.4) = 4.2
D2 = D1(1+g) = D0(1+g)^2 = 5.88

Solution:
G1 = 40% , G2 = 12%, r = 15%
D0 = 3
D1 = D0(1+g) =3(1.4) = 4.2
D2 = D0(1+g)2= 3(1.4)2 = 5.88
D3 = D0 (1+g)^3
Similarly calculate D3 = 8.232, D4= 11.52, D5=16.13
D6 = D5 (1+g2) = 16.13(1.12) = 18.07

P0= 4.2/1.15 + 5.88/1.152 + 8.232/1.153 + 11.52/1.154 + 16.13/1.155 + 18.07/(0.15-0.12)

*[1/1.155]
= 3.65 + 4.45 + 5.41 + 6.59 + 8.02 + 299.47 = 327.59

7. Prestige’s equity share is expected to provide a dividend of Rs.2 and fetch a price of Rs.18 a
year hence. What price would it sell for now if investors’ required rate of return is 12 per
cent?
8. The expected dividend per share on the equity share of Roadking Ltd. is Rs.2. The dividend
per share has grown over the past five years at the rate of 5 per cent per year and the
growth rate will continue in future and the market price of the share is expected to grow at
the same rate. What is the fair estimate of the intrinsic value of the share when the required
rate of return is 15 per cent? P0 = 2/0.15-0.05 =20
9. The expected dividend per share of Vaibhav Ltd. is Rs.5. The dividend is expected to grow at
the rate of 6 per cent per year. If the price of the share is now Rs.50, what is the expected
return?
10. Ramesh Engineering is expected to grow at the rate of 6 per cent per annum. The dividend
expected a year hence is Rs.2. What is its expected price, if the required rate of return is 14
per cent?
11. The current dividend on an equity share of Vertigo Ltd. is Rs.2. Vertigo Ltd.is expected to
enjoy an above normal growth rate of 20 per cent for a period of 6 years and thereafter, the
growth rate will fall and stabilize at 10 per cent. What is the intrinsic value of the share if
investors require a rate of return of 15 per cent?
12. A Rs.100 par value bond bearing coupon rate of 12 per cent will mature after 5 years. What
is the value of the bond, if the discount rate is 15 per cent?
 13. The market price of a Rs.1000 par value bond carrying a coupon rate of 14 per cent and
maturing after 5 years in Rs.1050. What is the yield to maturity (YTM) on this bond? What is
approximate YTM?
14. A Rs.100 par value bond bearing coupon rate of 14 per cent will mature after 5 years.
Interest payable semi-annually. What is the value of the bond, if the discount rate is 16 per
cent?
15. The equity stock of Rax Ltd. is currently selling at Rs.30 per share. The dividend expected
next year is Rs.2. The investors’ required rate of return on this stock is 15 per cent. If the
constant growth model applies to Rx Ltd., what is the expected growth rate?
16. Vardhaman Ltd.’s earnings and dividends have been growing at the rate of 18 per cent per
annum. This growth rate is expected to continue for 4 years. After that the growth rate will
fall to 12 per cent for the next 4 years. Thereafter the growth rate is expected to 6 per cent
forever. If the last dividend per share was Rs.2 and the investors required rate of return is 15
per cent, what is the intrinsic value per share?
D4 = 3.88
D5 = D4(1+g2)= 3.88(1.12)= 4.35
D6 = D4(1.12)^2
D8 = 6.1
D9 = 6.1(1.06) = 6.46
17. A stock paid Rs 2 as dividend in the last year(D0). Div is expected to grow at 6 % perpetually.
RRR =12%. How much should the stock sell for now? Assuming everything unchanged, what
should the stock sell for 2 years hence?

P0 = 2(1.06) / 0.12-0.06 = 35.33

P2 = D3/r-g = 2(1.06)^3 / 0.12-0.06 = 39.7

D0 = 2

D1 = D0 (1+g) = 2(1.18) = 2.36

D2 = D0 (1+g)^2 = 2.784

D3 = 2(1.18)^3 = 3.286

D4 = 3.878

D5 = 3.878 (1.12) = 4.343

D6 = D4 (1+g2)^2 = 3.878*1.12^2 = 4.86

D7 = 5.443

D8 = 6.10

D9 = D8(1.06)= 6.467
P0 = 2.36/1.15 + 2.784/1.15^2 + ….. 6.467/0.15-0.06 (1/1.15^8)

D5 = 4.34

D6 = d5*1+g

D7 = d5*1+g^2

D8 = d5*1+g^3

D9 = D8*1.06 = 6.45

P0 = 40.32

18. The current dividend on an equity share of Pioneer Technology is Rs.3. Pioneer is expected
to enjoy an above-normal growth of 40 per cent for the next 5 years. Thereafter the growth
will fall and stabilise at 12 per cent. The equity investors require a rate of return of 15 per
cent. What is the intrinsic value of the share?

D0 = 2

D3 = D0 (1+g)^3 or D2 (1+g) = 2.38

P2 = 2.38/.12-.06 = 39.70

Ans 12 P0 = 2.4/1.15 + 2.88/1.15^2 + 3.456/1.15^3 + 4.14/1.15^4 + 4.97/1.15^5 +5.97/1.15^6 +

6.56/(0.15-0.1) * 1/1.15^6 = 14 + 56.8 = 70.8