Summary
Valuations: Summary for financial management (FBS210)
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this summary provides an introduction to valuations explains through examples how to solve problems
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VALUATIONSOverview
• The value of any security = PV of expected future cash flows (discounted at a rate that reflects
the underlying risk of such a security)
• The higher the certainty of future cash flows, the higher the value of the security, the lower the
required rate of return
• The future cash flows are only an estimate, thus are subject to error although the valuation is
quantitative. However, this estimate still enables us to make the right decision.
• Truth about valuations:
o may be subject to biases (not objective)
o Based on estimates, not precise
o Valuations change over time as new information is used to make estimates
o The process allows understanding the business and what drives the value
o The process links the risks and return of investments
Fundamental building blocks
➢ Cash flows (Cf)
➢ Timing of cash flows
➢ Risk of future cash flows (the higher the risk, the higher the required return)
➢ Required rate of return (discount rate)
o Return required by the investor, given the environment in which the investment is made
If the coupon rate is lower than the return on similar investments, then the investment is worth less
than the price we are paying
Example: the cost of an asset is R10 million, and it gives an annual return of 1 million per
year (10% of the cost per year) while similar investments give a return of 12% then the asset
is not worth R10 million. It is worth R8.33 (R10 mil*10/12). An investor expects to receive the
same return at a lower cost.
Valuation of bonds and debentures
Fixed income securities – Securities such as debentures, bonds and preference shares that pay a
fixed interest amount periodically, usually on a semi-annual or quarterly basis. (Traditional type of
bonds)
Par value = the stated face value of the bond (e.g., R100)
coupon payments = fixed interest payments on the bond (coupon interest rate*par value)
𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
coupon interest rate = ⁄𝑝𝑎𝑟 𝑣𝑎𝑙𝑢𝑒
There is no relationship between the current market yield and the coupon interest rate, except at
time of issue. At the time of issue, the coupon rate = current market yield
Zero coupon bonds – Bonds that do not make any coupon payments (contemporary type of bonds)
maturity date = date that the bond will be redeemed
yield to maturity = implicit return the investor will earn by holding the bond or debenture until the
maturity date.
, VALUATIONS
Debentures and bonds in perpetuity (non-redeemable)
𝑅𝑒𝑡𝑢𝑟𝑛 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 (𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 (𝑃𝑉) =
𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛
Example: par value = R100, coupon rate = 15%, current market rate of similar bonds is 9%
Solution: coupon payment = R100*15%= R15 therefore value of the bond = R15/9% =R166.67
☺ the bond value of R166.67 is higher than the face value of R100, the bond is thus selling at a
premium
Redeemable debentures, redeemable preference shares and bonds
Cash flows involved
➢ Periodic interest payments
➢ Repayment of capital on date of redemption
Example: face value = R100, coupon interest rate 15%, redeemable in 5 yrs, similar bonds have a
market yield of 9%
Solution i= 9% FV = R100 PMT (coupon payment) = R15 n=5 therefore PV =123.34
Bond behavior NB!
If the cost of long-term funds or risk ↑ = required return will ↑ (bond will sell at a discount)
If the cost of long-term funds or risk ↓ = required return will ↓ (bond will sell at a premium)
Things to note
❖ FYI: 100 basis points = 1%.
❖ Remember that if they tell you that it was taken 3 yrs ago, then to calc the PV, n = nr of yrs
remaining from current year to maturity date
❖ If we are told the bond is redeemable at premium/discount of 10%, the FV will be
110 (premium) or 90 (discount). NB: If purchased at a discount, it doesn’t affect the
FV
❖ If the coupon rate = required return; then face value = bond value
❖ When the bond is issued, the coupon rate = required return, then as the risk increases the
required return by the investor will increase.
❖ it doesn’t put you at an advantage when the bond is redeemable at a premium because the
bond value adjusts to reflect the risk in the market. It’s just about how much risk you are
willing to take…
❖ because if it is selling at a premium, it means the risk is lower (the higher the value/worth of
the bond). And if it’s selling at discount the risk is higher (the value/worth is less)
❖ You will still receive the same PMT (return) whether the risk increases (discount) or decreases
(premium)
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