ACC209 Lecture 6

Valuation of Debt and

Financial Management Equity
 At the end of the lecture, students are expected
to:
1. Recognise that, in effect, discounted cash
flow methods can be used in valuing
bonds.
2. Determine, purely based on financial
Objectives returns, whether a given convertible bond
shall be converted or not
3. Understand the basic principles
underlying dividend growth model for
business valuation
4. Distinguish between bonus issue and
rights issue and their impact on share
prices and wealth of the investor.
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 • Bond valuation
• Decisions on convertible debts
• Share prices and market
Contents capitalization
• Impact of bonus and/or rights issue
on share price and market
capitalisation

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 Market capitalisation is the market value of a company's shares
multiplied by the number of issued shares

A takeover is the acquisition by a company of a controlling interest

in the voting share capital of another company

Definitions 4
 • For quoted companies
• Takeover bid
• Liquidation / additional finance / re-
Need for finance
• For unquoted companies
business • To go public
valuation • For merger/takeover
• Shares pledged as security for loans
• For the purpose of taxation

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 • The net assets valuation method can be used as one
of many valuation methods, or to provide a lower
limit for the value of a company. By itself it is
unlikely to produce the most realistic value.

• Using this method of valuation, the value of an

The net assets equity share is equal to the net tangible assets
divided by the number of shares.
method of
• Net tangible assets are the value in the statement of
share financial position of the tangible non-current
assets(net of depreciation) plus current assets,
valuation minus all liabilities.
• Intangible assets (including goodwill) should be
excluded, unless they have a market value (for
example patents and copyrights, which could be sold)

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 A company’s total assets less current liabilities is
$340,000. This included $20,000 in goodwill. The
Example book values of preference shares ($50,000), bonds
($60,000) and deferred taxation ($10,000) were
amongst non-current “liabilities”. No . of ordinary
shares is 80,000.

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 Income based valuation bases
1. The P/E Ratio method
2. The Earnings Yield Valuation Method
 P/E ratios may be used to value equity
shares when a large block of shares, or a
whole business is being valued.
P/E ratio
(earnings)
method of
valuation

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Earnings yield
valuation
method

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Earnings yield
method

This formula is given on your formula sheet as:

Where:
D0 = Current
dividend
Ke = Cost of
equity
g = Growth rate
The second formulae is better known as the Dividend Growth Model

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Value of a company

Required:
Calculate the value of the
company based on the
present value of expected
earnings.

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Solution

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 Dividend growth model is
a method used in the
cash flow valuation.

Valuation of
shares
Dividend growth model:

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 Target paid a dividend of $250,000 this year. The
current return to shareholders of companies in the
same industry as Target is 12%, although it is
expected that an additional risk premium of 2% will
Dividend be applicable to Target, being a smaller and
unquoted company. Compute the expected
growth model valuation of Target, if:

a. The current level of dividend is expected to

- Example continue into the foreseeable future, or
b. The dividend is expected to grow at a rate of
4% pa into the foreseeable future
c. The dividend is expected to grow at a 3% rate
for three years and 2% afterwards.
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 • Dividend $250,000
• Growth rate for part (a) is zero as dividend is to stay constant
• Growth rate for part (b) is 4% as given
• Cost of equity (Ke )= industry average plus beta (risk
premium)

Solution

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 •Dividend $250,000
•Dividend growth rate for part(c) is:
• 3% per annum for first 3 years
• 2% per annum afterwards forever
•Cost of equity (Ke )= industry average plus beta (risk premium)
•Ke= 14%, g = 2%.

Solution

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 Investors act rationally and homogenously.

The D0 figure used does not vary significantly from

the trend of dividends.

Assumptions
of dividend The estimates of Ke are reasonable.

models
The investor preferences in timing of cash flow can
be adjusted using discounting.

Discount rate exceeds the dividend growth rate.

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 Bonds are long-term debt capital raised by a
company for which interest is paid, usually half
Bonds - yearly and at a fixed rate.

definition • Holders of bonds are therefore long-term

payables for the company.
• It’s a major source of financing for PLCs.

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 • Bonds are simply long-term loans
• Holders are entitled to:
– Regular interest(or coupon ) payment
– And at maturity, get back the bond’s face
Bonds value (or principal )

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 • Bonds may be redeemable or irredeemable
• Bonds or loans come in various forms,
including:
– Floating rate debentures
Nature of – Zero coupon bonds
bonds Issued at a discount to their redemption
value, but no interest is paid on them.
– Convertible bonds
bonds that give the holder the right to
convert to other securities

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 • When convertible bonds are traded on a stock
market, its minimum market price will be the
Convertible price of straight bonds with the same coupon
rate of interest.
bonds • If the market value falls to this minimum, it
follows that the market attaches no value to the
conversion rights.

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 Factors that 1. The price of straight debt

determine 2. The current conversion value

3. The length of time before conversion may
market price take place

of convertible 4. The market's expectation as to future equity

returns and the risk associated with these
bonds returns

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 • The bonds give the holder the right to convert to
other securities such as equity shares
Convertible • Decision will depend on:

Debts
– the current value of the bond
– the market price of shares

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Valuation of debt – Irredeemable debt
• For irredeemable bonds where the company will go on paying interest every year in
perpetuity, without ever having to redeem the loan.
• Irredeemable debt only gives interest in perpetuity. The principle amount will not be
returned to the investor.
• For irredeemable debt, the market value is given by:

Where:
i(1-T) is interest received after tax
Kdnet is the net cost of debt

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Valuation of debt – Irredeemable debt
For example, if the cost of debt is 7% before tax and 4.9% after tax, and
the rate of tax is 30%, the market value of irredeemable debt with a
coupon rate of 6% will be:

Market value = 6(1 – 0.30)/0.049 = 85.71

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Valuation of debt – Redeemable debt
• Valued as the total present values of interest payments and the
principal
• Example:
A company has issued some 9% bonds, which are now redeemable
at par in three years time. Investors now require a redemption
yield of 10%. What will be the current market value of each $100
of bond?

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 Example:
A company has issued some 9% bonds, which are
now redeemable at par in three years time. Investors
now require a redemption yield of 10%. What will be
the current market value of each $100 of bond?
Solution

Year Description Cash Discount factor Present

flow (10%) Value
1 Interest 9 0.909 8.18
2 Interest 9 0.826 7.43
3 Interest 9 0.751 6.76
3 Redemption 100 0.751 75.10
value
Market Value of each $100 bond 97.47

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 • The value of any bond is equal to its cash payments
discounted at the spot rates of interest.
• For example, the present value of a 10-year bond
with a 5% coupon paid annually equals:
Valuation of bond
prices

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References

• Gitman, L. J., & Zutter, C. J. (2014).

Principles of Managerial Finance, 14th
Edition. Prentice Hall.
(Chapter 6 & 7)

• BPP Publishers (2016) ACCA - F9: Financial

Management: Study Text
(Chapter 17)
Questions?