LECTURE-4

TOPIC 4: VALUATION OF SECURITIES

Securities are financial assets and include shares of stocks and bonds. Valuation of securities
helps in establishing whether the security is efficiently priced or not.

Reasons for the Valuation of Securities

There are various reasons for the valuation of securities or businesses.

These include:

i. For liquidation purposes- The assets of the company may be valued when the
company is being liquidated in order to determine the amount to be realized from the
sale of the assets and the amount to be attached to the ordinary shares.
ii. For mergers and acquisitions- When mergers and acquisitions take place, there is
need to determine the value of each company in order to establish whether there will
be any additional benefits (synergy) that will come out of the merger.
iii. In order to use the security as collateral- There is need to value an ordinary share or
any other security when the investor intends to use the security as collateral to obtain
loan capital from financial institutions.
iv. For the sale of the security- Investors would require valuing their securities when they
want to sell them in the market in order to determine whether the security is
overvalued, undervalued or is efficiently priced by the market forces.
v. For quotation or listing in stock exchange- A company will value its securities
when it is being listed in the stock exchange for the first time.
vi. For insurance and tax purposes- The assets of the company will have to be valued
for tax purposes especially when granting capital allowances and when they have to
be insured to ensure that the assets are not underinsured or over insured.
vii. For sale of branch/subsidiary- A company will value its securities when it wants to
sell its branch or subsidiary to external parties.

Valuation of Fixed Return Securities

These are securities which have a fixed rate of return determined when the security is
purchased. The fixed rate of return is always shown at the face value of the securities. They
include:

 Preference shares
 Debentures
 Bonds

Note: The fixed rate of return for these securities is called the coupon rate and the benefits
from these securities are based on the coupon rate and par value of the security.

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 1. Valuation of Preferred Stock
Preferred stock is type of stock that promises a fixed dividend. It has preference over
common stock in the payment of dividends and claims on assets. Preferred stock has no
stated maturity date, and given the fixed nature of its payments, is similar to a perpetual bond.
Therefore, the same general approach applied to valuing a perpetual bond is applied to value
preferred stock.

Thus, the present value of preferred stock is:

Where:
Dp is the stated annual dividend per share of preferred Stock
r is the appropriate required rate of return on the preferred stock.

Illustration-1:
An 8% ksh 2,000 pref. stock will pay the annual dividend into perpetuity.

Required:
What would be the value of the pref. stock if the required rate of return is 10%?

Value of pref. stock=Dp/r

Dp =0.08*2000= 160

r = 0.1

160/0.1 = 1,600

Solution:

=ksh 1,600
Anyone buying the stock should pay ksh 1,600.
Explanation:
The 8% dividend is too low for investors to consider for the preference stock in a market that
can give return of 10% unless they are paying a discount for it.
Illustration-2:
A 10% ksh 40,000 pref. stock will pay the annual dividend into perpetuity.

Required:
What would be the value of the pref. stock if the required rate of return is:
a) 10%? Dp= 0.1*40000= 4000
= 4000/0.1 = 40,000 At par since the coupon rate = required rate of return

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8% 4000/0.08 = 50,000 At premium since the coupon rate rate > required rate of return

b) 12% 4000/0.12 = 33,333.33 At discount since the coupon rate rate < required rate
of return

2. Valuation of Debentures/Bonds
A debenture is a long-term debt security that is issued by corporations or the government to
the lender stating the borrower’s indebtedness. It is a legal document which the lender can
use as a supporting document in case the borrower defaults on the payment of interest or the
principal i.e. the debenture forms the basis of a loan agreement.

Terminologies:
Par or Face Value
The par or face value of a bond is the amount of money that is paid to the bondholders at
maturity.
Coupon Rate
The coupon rate, which is generally fixed, determines the periodic coupon or interest
payments. It is expressed as a percentage of the bond's face value. It also represents the
interest cost of the bond issue to the issuer.
Coupon Payments
The coupon payments represent the periodic interest payments from the bond issuer to the
bondholder. The annual coupon payment is calculated be multiplying the coupon rate by the
bond's face value.
Example:
KPLC issues a 12% ksh 50 million bond.
The interest payments that KPLC must give to the bondholders is 12% of ksh 50 million =
ksh 6 million every year until the bond matures if it’s a redeemable bond.
Maturity Date
The maturity date represents the date on which the bond matures, i.e., the date on which the
face value is repaid. The last coupon payment is also paid on the maturity date.
Original Maturity
This is the time remaining until the maturity date when the bond was issued.
Remaining Maturity
This is the time currently remaining until the maturity date.
Call Date
For bonds which are callable, i.e., bonds which can be redeemed by the issuer prior to
maturity, the call date represents the date at which the bond can be called.
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Call Price
The amount of money the issuer has to pay to call a callable bond. When a bond first
becomes callable, i.e., on the call date, the call price is often set to equal the face value plus
one year's interest.

Required Return
This is the rate of return that investors currently require on a bond.

Yield to Maturity
This is the rate of return that an investor would earn if he bought the bond at its current
market price and held it until maturity. Alternatively, it represents the discount rate which
equates the discounted value of a bond's future cash flows to its current market price.
Par Bonds
A bond is considered to be a par bond when its price equals its face value. This will occur
when the coupon rate equals the required return on the bond.
Premium Bonds
A bond is considered to be a premium bond when its issued at a price greater than its face
value. This will occur when the coupon rate is greater than the required return on the bond.

Discount Bonds
A bond is considered to be a discount bond when its price is less than its face value. This will
occur when the coupon rate is less than the required return on the bond.
There are two types of debentures:
 Irredeemable debentures
 Redeemable debentures

Valuation of irredeemable debentures/Bonds

These are those debentures that do not have a definite maturity period i.e. they remain
outstanding as long as the company is a going concern. Their periodical constant interest will
therefore be a constant annuity until perpetuity and hence the intrinsic value of such a
debenture can be calculated using the formula of calculating the present value of an annuity
until perpetuity given as;

Where I is the fixed interest expense per annum in shillings

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r is the required rate of interest on the debentures
Illustration-3
A 10% ksh1,200 bond will pay the annual interest into perpetuity.
Required:
What would be the value of the bond if the required interest rate is 15%?
Soln
I= 0.1*1200= 120 120/ 0.15 = Kshs.800

Solution

Anyone buying the bond should pay ksh 800

Illustration-4
Brookside Dairies issued a 6% ksh 30 million bond. Given that investors require 7.5% return
on this bond, calculate the value of this bond.
Interest Amount = 6% x 30,000,000 = ksh 1,800,000
Value of the irredeemable bond = 1,800,000 ÷ 0.075 = ksh 24,000,000
Illustration-5
KK ltd is issuing a 10% ksh 98 million bond. An investor is willing to pay no more than ksh
68 million for this bond given a required rate of return of 14%.

Required:
Advise this investor
Solution
Interest amount = 10% x 98,000,000 = 9,800,000
Value of the bond = 9,800,000 ÷ 0.14 = ksh 70,000,000

The investor should invest in this bond because the bond is being issued at discount since the
coupon rate is less than the required rate of return

Assuming the required rate of return is 7%

9800000/0.07 = 140,000,000

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The investor should NOT invest in this bond because the bond is being issued at PREMIUM
since the coupon rate is greater than the required rate of return

Valuation of redeemable debentures/Bonds

These are those debentures with a definite maturity period. Their intrinsic value will be equal
to the PV of the Periodic constant interest + Maturity or redemption value (this is a single
amount which comes at the end of the period) and is determined as follows:

V0 = I x PVIFA + Mn x PVIF

Where V0= value of the bond

I = interest = par value x coupon rate

r = required rate of return
Mn = nominal value of the bond i.e. the redemption amount

Illustration-5
Miss Bensouda holds a five-year, 10%, ksh100,000 bond. Determine the value of this bond if
the required return is:
a) 10%
b) 8%
c) 12%

Solution
a) V0 = I (PVIFA) + Mn (PVIF) = 10,000 (3.791) + 100,000(0.621)

V0 = 37,910 + 62,100 = ksh 100,010

b) V0 = 10,000(3.993) + 100,000(0.681)

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 V0 = 39,930 + 68,100 = ksh 108,030

c) V0 = 10,000(3.605) + 100,000(0.567)

V0 = 36,050 + 56,700 = ksh 92,750

Determinants of Bond Prices

The determinants of bond prices include:
i. Term to maturity-The number of years (length of period) before the bond matures.
ii. Yield to maturity-This is the discount rate that makes the present value of all cash flows
equal to the market price of the bond.

Observations:
 If a bond has a market price that is equal to its par value, then its yield to maturity will
be equal to its coupon rate.
 If the market price is less than par value, then the bond will have a yield that is
greater than the coupon rate (i.e. bond is selling at a discount)
 If the market price is greater than par value, then the bond will have a yield that is less
than the coupon rate (i.e. the bond is selling at a premium)

iii. Coupon payment and coupon rate.

The higher the coupon rate the higher the bond price ceteris Paribus (all other things being
constant).

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