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Financial Management for Policy
Makers
Valuation of Bonds and Shares
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Valuation
Involves determining the theoretical value of an
asset.
Using the fundamental analysis principles; the
intrinsic value of an asset is determined as the
present value of all the cash flows expected
from the asset
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Bond valuation
Bond A debt instrument issued by thegovernment (treasury bond) or a corporate
body (corporate bond)
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Features of the Bonds
1. Have a face value (par value) (registered value)
2. Have a coupon rate of interest that is fixed
3. Have a maturity period otherwise it will be a
perpetual bond4. Payment of interest is an obligation to the issuer
5. Bond may be trading in the secondary market atpar, at a premium or at a discount
6. Within the term of the bond, the issuer pays thecoupon interest to the investor. Principle isrefunded at the end of the maturity period
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Valuation of bonds
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Valuation of Bonds
Determine the value of a bond with the followingcharacteristics;
Par value Sh. 100Coupon rate of interest 8% per annum
Maturity 3 years
Interest is paid on annual basis and the expectedrate of return is 10%
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Valuation of bonds
Determine the value of a bond with the followingcharacteristics;
Par value Sh. 100Coupon rate of interest 10% per annum
Maturity 3 years
Interest is paid on semi-annual basis and theexpected rate of return is 16%
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Valuation of Bonds
Determine the value of a bond with the followingcharacteristics;
Par value Sh. 1000Coupon rate of interest 8% per annum
Maturity 8 years
Interest is paid on annual basis and the expectedrate of return is 10%
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Valuation of Bonds
Determine the value of a bond with the followingcharacteristics;
Par value Sh. 1000Coupon rate of interest 8% per annum
No Maturity It is a perpetual bond
Interest is paid on annual basis and the expectedrate of return is 10%
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Valuation of ordinary shares
Share A unit of capital
Has voting rights
Earns dividends
Payment of dividends = not an obligation to thefirm
Grows with profitability
Holders are residual claimants
Market value is determined by the market forces
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One-period example
Suppose you are thinking of purchasing the ashare of Sameer Africa and you expect it to pay aSh. 2 dividend in one year and you believe thatyou can sell the stock for Sh. 14 at that time.
If you require a return of 20% on investments ofthis risk, what is the maximum you would bewilling to pay?
Compute the PV of the expected cash flows
Price = (14 + 2) / (1.2) = 13.33
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Two-Periods
Now what if you decide to hold the stock for two
years? In addition to the dividend in one year,
you expect a dividend of Sh.2.10 in and a
stock price of Sh. 14.70 at the end of year 2.
Now how much would you be willing to pay?
PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33
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Three periods
What if you decide to hold the stock for three periods?
In addition to the dividends at the end of years 1 and
2, you expect to receive a dividend of Sh. 2.205 atthe end of year 3 and a stock price of Sh. 15.435.
Now how much would you be willing to pay? PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3
= 13.33
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Developing the Model
You could continue to push back when you
would sell the stock; You would find that the
price of the stock is really just the present
value of all expected future dividends
So, how can we estimate all future dividend
payments?
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Estimating Dividends Special Cases
Constant dividend
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula Constant dividend growth
The firm will increase the dividend by a constantpercent every period
Supernormal growth Dividend growth is not consistent initially, but settles
down to constant growth eventually
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Zero growth
If dividends are expected at regular intervalsforever, then this is like preferred stock and isvalued as a perpetuity
P0 = D / R Suppose stock is expected to pay a Sh. 0.50
dividend every quarter and the requiredreturn is 10% with quarterly compounding.
What is the price?
P0 = .50 / (.1 / 4) = 20
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Dividend Growth Model
g-R
D
g-R
g)1(DP 100
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Illustration
Suppose a company just paid a dividend of
Sh.50. It is expected to increase its dividend by
2% per year. If the market requires a return of
15% on assets of this risk, how much shouldthe stock be selling for?
P0 = .50(1+.02) / (.15 - .02) = 3.92
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Illustration
Suppose a company is expected to pay a $2
dividend in one year. If the dividend is
expected to grow at 5% per year and the
required return is 20%, what is the price?
P0 = 2 / (.2 - .05) = 13.33
Why isnt the 2 in the numerator multiplied by
(1.05) in this example?
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Illustration
A Company is expected to pay a dividend of
Sh. 4 next period and dividends are expected
to grow at 6% per year. The required return is
16%.
What is the current price?
What will be the price if the investor holds the
share for six years?
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Illustration
Suppose a firm is expected to increase
dividends by 20% in one year and by 15% in
two years. After that dividends will increase at
a rate of 5% per year indefinitely. If the lastdividend was Sh. 1 and the required return is
20%, what is the price of the stock?