VALUATION OF BONDS AND SHARES Homework Help

VALUATION OF BONDS AND SHARES

INTRODUCTION

Valuation is the process that links risk and return to determine the worth of an asset. It can be applied to expected benefits from real/physical as well as financial assets/securities to determine their worth at a given point of time. This Chapter focusses on valuation of two financial assets, namely, bonds/debentures and shares, ordinary as well as preference. To value them, we have to use the time value techniques and the risk and return framework. The key inputs to the valuation process are (i) expected returns in terms of cash flows together with their timing and (ii) risk in terms of the required return. The value of an asset depends on the return (cash flow) it is expected to provide over the holding/ownership period. The cash flow stream can be (1) annual, (2) intermittent and (3) even one-time. In addition to the total cash flow estimates, their timing/pattern (e.g, amount year-wise) is also required-to identify the return expected from the bond/share. The required return is used in the valuation process to incorporate risk into the analysis/exercise. Risk denotes the chance that an expected outcome (return/cash-flow) would not be realized. The level of risk associated with a given cash flow/return has a significant bearing on its value, that. is, the greater the risk, the lower the value and rice versa. Higher risk can be incorporated into the valuation analysis by using a higher required/capitalization discount rate to determine the present value. With CAPM, the greater the Beta, b the higher the required return. It is against this background that the present chapter dwells on the valuation of bonds/debentures and shares. Section 1 describes the basic valuation model. It can be shown in valuing bonds, preference shares, and ordinary/equity shares. Valuation of bonds is illustrated in Section 2. Valuation of preference shares and ordinary shares is discussed in Sections 3 and 4 respectively. In addition to the basic-stock valuation equation (dividend valuation model), there are other approaches to the valuation of shares. They are briefly covered in Section 4. The relationship among financial decisions, returns, risk and share value are examined in Section 5. The main points are summarized in the last Section.

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