(88)---VALUATION OF PREFERENCE SHARES

Valuation of Preference Shares

A company may issue two types of shares,

• Preference shares.
• Ordinary shares.

Preference shares have preference over ordinary shares in terms of payment of dividend and repayment of capital.
They may be issued with or without a maturity period.

• Redeemable preference shares with maturity.
• Irredeemable preference shares are shares without any maturity.
• Cumulative preference shares unpaid dividends accumulate and are payable in the future.
• Not cumulative shares do not accumulate dividends.

Features of Preference and Ordinary Shares
Following are the features preference shares,

• Preference shareholders have claim on assets and income prior to ordinary shares.
• The dividend rate is fixed in case of Preference shares.
• A company can issue convertible Preference shares.
• Both redeemable and irredeemable Preference shares can be issued.

We can value Preference shares like below
Po = PDIV {(1/kp) – [1/kp (1+kp)n]} + Pn / (1+Kp)n
Valuation of irredeemable preference shares
Po = PDIV / Kp
Yield on Preference shares
Kp = PDIV / Kp

(87)---DEFAULT RISK AND CREDIT RATING

Default Risk and Credit Rating

Default risk is the risk that a company will default on its promised obligations to bond holders. Bondholders can avoid the default risk by investing their funds in the government bonds instead of the corporate bonds.
Investors invest in corporate bonds if they are compensated for assuming the default risk.
Hence companies in order to induce investors to invest in their bonds, offer a higher return than the return on the government bonds. This difference called default premium.
How do Investors asses the default risk of bonds?
In most countries there are credit rating companies that rate bonds according to their safety (In USA Moody’s and Standards and Poor’s and others provide bond ratings).

1. High Investment Grades
   AAA (Highest Safety)
   Debentures rated “AAA” are judged to offer highest safety of timely payment of interest and principal.AA (High safety)Debentures rated “AA” are judged to offer high safety of timely payment of interest and principal. They differ in safety from “AAA” issues only marginally.
2. Investment GradesA (Adequate safety)Debentures rated “A” are judged to offer adequate safety of timely payment of interest and principal. However changes in circumstances can adversely affect such issues more than those in the higher rated categories.
   BBB (Moderate safety)
   Debentures rated “BBB” are judged to offer sufficient safety of timely payment of interest and principal for the present however changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than for debentures in higher rated categories.
3. Speculative Grades
   BB (Inadequate Safety)
   Debentures rated “BB” are judged to carry inadequate safety of timely payment of interest and principal.B (High Risk)Debentures rated “B” are judged to have greater susceptibility to default while currently interest and principal payments are met adverse business or economic conditions would lead to lack of liability or willingness to pay interest or principal.C (Substantial Risk)Debentures rated “C” are judged to have factors present that make them vulnerable to default.
   D (In Default)
   Debentures rated “D” are judged to have grater susceptibility to default.

(86)---THE TERM STRUCTURE OF INTEREST RATES

The Term Structure of Interest Rates

There are several interest rates in practice, both companies and the government offer bonds with different maturities and risk features.
Debt in a particular risk class will have its own interest rate. Yield curve shows the relationship between the yields to maturity of bonds and their maturities. It is also called the term structure of interest rates.
The upward sloping yield curve implies that the long term yields are higher than the short term yields. This is the normal shape of the yield curve.
However, many economies in high-inflation periods have witnessed the short-term yields being higher than the long term yields. The inverted yield curves result when the short-term rates are higher than the long term rates.

There are three theories that explain the yield curve or the term structure of interest rates,

1. The expectation theory.
2. The liquidity premium theory.
3. The market segmentation theory.

(1).The expectation theory

This theory supports the upwards sloping yield curve since investors always expect the short-term rates to increase in the future. This implies that the long term rates will be higher than the short-term rates.

(2).The liquidity premium theory

The liquidity premium theory provides an explanation for the expectation of the investors. The prices of the long-term bonds are more sensitive than the prices of the short-term bonds to the changes in the market rates of interest.
Hence investors prefer short-term bonds to the long-term bonds. The investors will be compensated for this risk by offering higher returns on long term bonds. This extra return which is called liquidity premium, gives the yield curve its upward bias. However the yield curve could still be inverted if the declining expectations and other factors have more effect than the liquidity premium.

(3).The segmented markets theory

The market segmentation theory assume that the debt market is divided into several segment based on the maturity of debt, in each segment the yield of debt depends on the demand and supply.
Investor’s preferences of each segment arise because they want to mach the maturities of assets and liabilities to reduce the susceptibility to interest rate changes.

(85)---BOND VALUATION AND CHANGES IN INTEREST RATE

Bond valuation and Changes in interest rate

The value of the bond declines as the market interest rate increases, bond values decline with rising fund interest rates because the bond cash flows are discounted at higher interest rates.

Bond Maturity and Interest rate RiskThe value of a bond depends upon the market interest rate. As interest rate changes, the value of a bond also varies. There is an inverse relationship between the value of a bond and the interest rate. The bond value would decline when the interest rate rises and vice verse. Interest rates have the tendency of rising or falling in practice. Thus investors of bonds are exposed to the interest rate risk, which is the risk arising from the fluctuating interest rates.

Bond Duration and Interest Rate Sensitivity

That bond prices are sensitive to changes in the interest rates, and they are inversely related to the interest rates. The intensity of the price sensitivity depends on a bond’s maturity and the coupon rate of interest. The longer maturity of a bond, the higher will be its sensitivity to the interest rate changes. Similarly, the prices of a bond with low coupon rate will be more sensitive to the interest rate changes.

A bond’s maturity and coupon rate provide a general idea of its price sensitivity to interest rate changes. However, the bond’s price sensitivity can be more accurately estimated by its duration. A bond’s duration is measured as the weighted average of times to each cash flow. Duration calculation gives importance to the timing of cash flows, the weight is determined as the present value of cash flow to the bond value. Hence two bonds with similar maturity but different coupon rates and cash flow patterns will have different durations.

The volatility or the interest rate sensitivity of a bond is given by its duration and YTM. A bond’s volatility, referred to as its modified duration,

Volatility of bond = Duration / (1+ YTM)

(84)---VALUATION OF BOND AND SHARES

Valuation of Bond and Shares

IntroductionAsset can be real or financial, like shares and bonds are called financial assets, asset like plant and machinery are called real assets. Real assets can be valued easily but there is no easy way to predict the prices of share and bonds.
The unpredictable nature of the security prices is, in fact, a logical and necessary consequence efficient capital markets.


Concepts of ValueThere are many concepts of value that are used for different purposes,

• Book value-Assets are recorded at historical cost, and they are depreciated over years. Book value may include intangible assets at acquisition cost minus amortized value.
• Replacement value-Ignore the benefits of intangibles and utility of existing assets.
• Liquidation value-If company sold its assets it would be liquidation value.
• Going concern value
• Market value-Price which the asset or security is being sold or brought in the market.

Features of a BondA bond is a long-term debt instrument or securities issued by the government do not have any risk default.
The main features of a bond are

• Face value.
• Interest rate.
• Maturity.
• Redemption value.
• Market value.

Bonds maybe classified into three categories.
(1).Bonds with maturity.
(2).Pure discount bonds.
(3).Perpetual bonds.
(1).Bonds with Maturity
Issue bonds that specify the interest rate and the maturity period.

• Value of bond with maturity
  B0=INT X [(1/Kd)-(1/Kd(1+Kd)n] Bn/(1+Kd)n
  Bond Value = Present value of interest + Present value of maturity value
• Yield to Maturity
  Kd= INT/ B0

(2).Pure Discount Bonds
Bonds do not carry an explicit rate of interest, it provides for the payment of a lump sum amount at a future date.

• B0 = M / (1+Kd)n

(3).Perpetual Bonds
Also called consols, has an indefinite life and therefore, it has no maturity value.

• B0 = INT / Kd

(83)---VALUATION.

Valuation

Concepts- value and return.

Most financial decisions affect the firm’s cash flows in different time periods.
The recognitions of the time value of money and risk is extremely vital in financial decision making.

Time Preference for Money.

Time preference for money is an individual’s preference for possession, of a given amount of money now, rather than the same amount at some future time.
There for reasons attributed for it,

1. Risk
2. Preference for consumption
3. Investment opportunities

Required rate of return

Time preference of money is generally expressed by an interested rate.
Required rate of return = risk free rate + risk premium

• Interest rate will be positive even in the absence of any risk it called risk free rate.
• An investor will be exposed to some degree of risk there fore he would require a rate of return, called risk premium

The risk free rate compensates for time while risk premium compensates for risk. The required rate of return may also be called the opportunity cost of capital of comparable risk.

Future value

• For a single cash flow
  Fn = P (1+i) nFn = Future Sum
  P = Principal
  I = Interest rate
  n = Number of years


• Future value of a lump Sum
  Fn = P X CVFn,iFn = Future Sum
  P = Principal
  CVF = Compound value factor for n periods at I rate of interest


• Future value of an annuity
  Annuity is fixed payment or receipt each year for a specified number of years.
  Fn = A X CVFAn,iFn = Future sum
  CVFAn,I = Compound value factor for annuity = ((1+i)n-1)/i)


• Sinking FundSinking fund is a fund which is created out of fixed payments each period to accumulate to a future sum after a specified period.
  A = Fn X SFFn,i
  SFFn,I = ((i)/(1+i)-1)

Present Value
Present value of a future cash flow is the amount of current cash that is of equivalent value to the decision maker.

• For a single cash flow.
  P = Fn (1/(1+i)n)


• Present value of a lump sum.
  PV = Fn X PVAn,i


• Present value of an annuity.
  PV = A X PVFAn,i
  A = Annuity
  PVFAn,i= Present value annuity factor


• Present value of perpetuity.
  Perpetuity is an annuity that occurs indefinites.
  P = A/ i


• Present value of an uneven cash flow.
  P = (A1 X PVF1) + (A2 X PVF2) +………………………+ (An X PVAFn)

Net Present ValueNet present value of a financial decision is the difference between the present value of cash inflows and the present value of cash outflows.
That the financial objective should be monetize the shareholders wealth. Wealth is defined as net present value.

(82)---NATURE OF FINANCIAL MANAGEMENT.

Nature of financial management

Introduction

Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources.

Finance functions

It may be difficult to separate the Finance factions from production marketing and other functions but the functions them selves can be reading identified

• Long – term asset mix or investment desertions
• Capital – mix or financing decision
• Profit allocation or dividend decision
• Short –term asset mix or liquidity decision

Financial manager’s role
A Financial manager is a person who is responsible in a significant way to carry out the finance functions. These main finance functions are

• Fund raising
• Fund allocation
• Profit planning
• Understanding capital markets

IN THE FUTURE WE COVERED FINANCIAL MANAGEMENT TWO TIMES PER EVERY WEEK.
TOPICS.

1. Valuation.
2. Investment decisions.
3. Financing and dividend decisions.
4. Ling term financing.
5. Financial and profit analysis.
6. Working capital management.
7. Managing value and risk.