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VALUE OF BONDS & SHARES AND COST OF DEBT & EQUITY Session 7

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Value of Bonds & Shares and Cost of Debt & EquitySession 7

Cost of preference shares

COST OF PREFERENCE CAPITAL3Irredeemable Preference Share

Redeemable Preference Share

Example4

Cost of DEBT

Definition of a BondA bond is a legally binding agreement between a borrower and a lender that specifies the:Par (face) valueCoupon rateCoupon paymentMaturity Date

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How to Value Bonds Primary Principle:Value of financial securities = PV of expected future cash flows Bond value is, therefore, determined by the present value of the coupon payments and par value.

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REC- Tax Free Bonds

Pure Discount BondsMake no periodic interest payments (coupon rate = 0%)The entire yield to maturity comes from the difference between the purchase price and the par value.Cannot sell for more than par valueSometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)Pure discount bond do not carry an explicit rate of interest. It provides for the payment of a lump sum amount at a future date in exchange for the current price of the bond. The difference between the face value of the bond and its purchase price gives the return or YTM to the investor.

9Treasury Bills and principal-only Treasury strips are good examples of zeroes.

Pure Discount BondsInformation needed for valuing pure discount bonds:Time to maturity (T) = Maturity date - todays dateFace value (F)Discount rate (r)

Present value of a pure discount bond at time 0:

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Pure Discount Bond: ExampleFind the value of a 30-year zero-coupon bond with a Rs. 1,000 par value and a interest rate of 6%.

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Pure Discount Bonds12

Level Coupon BondsMake periodic coupon payments in addition to the maturity valueThe payments are equal each period. Therefore, the bond is just a combination of an annuity and a terminal (maturity) value.Coupon payments are typically semiannual.Effective annual rate (EAR) = (1 + R/m)m 1

13m is the number of compounding periods during a year.

Example14

Valuing a BondExample continuedIf today is October 1, 2014, what is the value of the following bond? A Reliance Bond pays Rs.115 every September 30 for 5 years. In September 2019 it pays an additional Rs.1000 and retires the bond. The bond is rated AAA (YTM is 7.5%)

Perpetual BondsNot all bonds have a final maturity.British consols pay a set amount (i.e., coupon) every period forever.These are examples of a perpetuity.

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Yield to Maturity17The yield to maturity is the required market interest rate on the bond.The internal rate of return anticipated on a bond if it is held until the maturity date.What is the yield to maturity of a 10 years bond with a coupon rate of 7.16%, par value 100, present price is 87.83?

Interest Rate on 10yr Indian Government Securities

http://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=1956IN00201400458.40% 202428-Jul-201428-Jul-2024

10-year G-sec benchmark yield(source: RBI)- latest

http://www.investing.com/rates-bonds/india-10-year-bond-yield

YTM for last 3yearsGOI 10 year bond

http://www.bloomberg.com/quote/GIND10YR:IND/chart

http://www.bloomberg.com/quote/GIND10YR:IND/chart

Yield to MaturityExampleA Rs.1000 G-Sec expires in 5 years. It pays a coupon rate of 10.5%. If the market price of this bond is 1078.8, what is the YTM?

C0C1C2C3C4C5 -1078.801051051051051105

Calculate IRR = 8.5%

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Yields of Govt sec with various maturities (data source: rbi)http://dbie.rbi.org.in/DBIE/dbie.rbi?site=statistics

Outstanding govt securitieshttp://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=1956http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/183T_SHE130914L.pdf

Current Yield26Current yield is the annual interest divided by the bonds current value. Example: The annual interest is Rs 60 on the current investment of Rs 883.40. Therefore, the current rate of return or the current yield is: 60/883.40 = 6.8 per cent. Current yield does not account for the capital gain or loss.

Yield to Call 27

After tax Cost of DebtA debenture or bond may be issued at par, or at a discount or premium as compared to its face valuehttp://www.investing.com/rates-bonds/india-10-year-bond-yield

The after tax cost of debt is :

http://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=1956

Estimation of the cost of debtThe cost of debt is the rate at which you can borrow at the current time. It incorporates the risk of default and the level of interest rates in the market

Practical Approaches to estimate the cost of debtFind out the YTM of a level coupon bond outstanding from the firm. The limitation of this method is that only a few companies have long term level coupon bonds that are liquid and widely traded

Find out the rating of the firm and estimate the default spread based upon the rating. ( catch: different bonds from the same firm can have different ratings; so you may have to use a median rating for the firm)

If the above 2 methods cant be applied, estimate a synthetic rating for your firm and the cost of debt based upon that rating

synthetic ratingEstimate a synthetic rating: play the role of a ratings agency and assign a rating to a firm based upon its financial ratios; this rating is called a synthetic rating. To make this assessment, we begin with rated firms and examine the financial characteristics shared by firms within each ratings class.

Synthetic rating for Indian companiesSource: https://sites.google.com/a/xlri.ac.in/profmohanty/understanding-valuation/syntheticcreditratingofindiancompanies

Spreads in bps over FIMMDA-PDAI Gilt Curve for Valuation of Corporate BondsFactEntry Daily Valuation Matrix as on 28- January- 2015 PSU / FIs & Banks0.51234567891015AAA294246494847403535373827AA+526878858685777067676553AA8410111111811911911110410110110088AA-122139148154153152143135132132130129A+146162171177178177170164163164163157A177192200206207207201196196198199190A-209223231236237238232227227230231225BBB+253264264265264263258255257262265257NBFCs0.51234567891015AAA668084878582736663646244AA+9010711712312312211310499979369AA123141151157158156146138133130126106AA-160177186192191188178169163161157147A+188205214220220218209200196194191178A221237245251251249241233230229227211A-254269277282282281273265263262261247BBB+299309308308305303296291291295296278CORPORATES0.51234567891015AAA486164666563565049505034AA+718897103103102938581807761AA10412113113713813612812011711611396AA-143160168173173170161152147146143137A+167183191197197196188181179179178166A199214221227227227220214212214213199A-231246253258258258251245244246246235BBB+277287287288285284278273274278281267

Bond ConceptsBond prices and market interest rates move in opposite directions.When coupon rate = YTM, price = par valueWhen coupon rate > YTM, price > par value (premium bond)When coupon rate < YTM, price < par value (discount bond)

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YTM and Bond Value

800100011001200130000.010.020.030.040.050.060.070.080.090.1Discount RateBond Value

6 3/8When the YTM < coupon, the bond trades at a premium.When the YTM = coupon, the bond trades at par.When the YTM > coupon, the bond trades at a discount.

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Debt & Interest Rates

Actual formula

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After tax Cost of DebtThe after tax cost of debt is :

EXAMPLE38

Now,

Cost of the Existing Debt39Sometimes a firm may like to compute the current cost of its existing debt.

In such a case, the cost of debt should be approximated by the current market yield of the debt.

Cost of capital

Weighted Average Cost of Capital WACC is the traditional view of capital structure, risk and return.

42Weighted Average Cost of CapitalRA= RD (1-t) wtD + RP wtP + RE wtE

Where:RA = weighted average cost of capitalRD = cost of debtRP= cost of preferred stockRE= cost of equity (common stock and retained earnings)wtD= weight of debt = D/VwtP= weight of preferred stock = P/VwtE = weight of equity = E/Vt= tax rate

Book Value Versus Market Value Weights-43Market-value weights are theoretically superior to book-value weights: They reflect economic values and are not influenced by accounting policies. They are also consistent with the market-determined component costs. The difficulty in using market-value weights:The market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes.

DIVISIONAL AND PROJECT COST OF CAPITAL44A most commonly suggested method for calculating the required rate of return for a division (or project) is the pure-play technique.The basic idea is to use the beta of the comparable firms, called pure-play firms, in the same industry or line of business as a proxy for the beta of the division or the project

DIVISIONAL AND PROJECT COST OF CAPITAL45The pure-play approach for calculating the divisional cost of capital involves the following steps:Identify comparable firmsEstimate equity betas for comparable firms: Estimate asset betas for comparable firms: Calculate the divisions beta: Calculate the divisions all-equity cost of capitalCalculate the divisions equity cost of capital: Calculate the divisions cost of capital

Firms cost of capital46

The Cost of Capital for Projects47For example, projects may be classified as:Low risk projectsdiscount rate < the firms WACC Medium risk projectsdiscount rate = the firms WACCHigh risk projectsdiscount rate > the firms WACC

Thank you