## VALUATION OF BONDS AND DEBENTURES

This will depend on expected cash flows consisting of annual interest plus the principal amount to be received at maturity.  The appropriate rate of capitalisation or discount rate to be applied will depend upon the riskiness of the bond e.g. government bonds are less risky and will therefore call for lower discount rates than similar bonds issued by private companies which will call for high rate of discount.

Valuation of bonds with maturity period
When a bond or debenture has reached maturity, its value can be determined by considering annual interest payments plus its terminal or maturity and this is done using the P.V. concept to discount the cash flows and the result will be compared to the market value of the bond to ascertain whether it has overvalued or undervalued.

Where:    Int   = Annual interest
Kd = Required rate of return
M   = Terminal/maturity value
n   = Number of years to maturity

Example
K is contemplating purchasing a 3 year bond worth 40,000/= carrying a nominal coupon rate of interest of 10%.  K required rate of return is 6%.
What should he be willing to pay now to purchase the bond if it matures at par?

Solution

Int    =    10% x 40,000 = 4,000 p.a.
n    =    3 yrs
Kd    =    6%
M    =    40,000

Vd    =
=    4,000 x PVAF6%,3 + 40,000 x PVIF6%,3 = (40,000 x 2.673) + (40,000 x 0.840) = 44,292

REINFORCING QUESTIONS

QUESTION ONE
a)    XYZ Ltd is expected to pay a DPS of Sh.6 in one year’s time.  The dividend payout ratio is 60% and the Return on Equity is 15%.
Determine whether the share is overvalued if the MPS is Sh.40.                    (6 marks)

b)    What is the significance of valuation securities?                             (5 marks)

c)    ABC Ltd has issued a 5 year zero coupon rate bond with maturity value of Sh.100,000.  The bond is issued at a discount of 32%.
Determine the rate of return of the bond.                               (5 marks)

d)    What are the advantages of zero coupon bond?                          (5 marks)
(Total: 19 marks)

QUESTION TWO
Nyakua Limited is contemplating acquiring Uza Limited.
Incremental cash flows arising from the acquisition are expected to be as follows:

Average of years (in Sh.’000’)

1-5
6-10
11-
Cash flow after taxes
Investment required
Net cash flow
100
50
50
150
60
90
200
70
130

Uza Limited has an all equity capital structure.  The required rate of return of Uza Limited is always 5 percent above the risk free rate.  The risk free rate is 9 percent.

Required
a)    Using the information provided, compute the maximum price that Nyakua Limited might pay for Uza Limited.                                                      (14 marks)

b)    What other factors might influence the management of Nyakua Limited in their decision to purchase Uza Limited?                                                      (6 marks)
(Total: 20 marks)

QUESTION THREE
a)    Andreas Company Ltd. currently pays a dividend of Sh.2 per share and this   dividend is expected to grow at an annual rate of 15% for the first 3 years then at a rate of 10% for the next 3 years after which it is expected to grow at a rate of 5% thereafter.
What value would you place on the stock if an 18% rate of return were required?                                              (7 marks)
Would your valuation change if you expected to hold the stock for only 3 years?  Explain.                                   (5 marks)

b) The stream of dividends of XYZ Ltd for the past 4 years was as follows:

Year
1999
2000
2001
2002
DPS Sh.
2.50
2.65
2.76
2.81

The cost of equity is 14%.  Determine the price of a share.        (8 marks)

QUESTION FOUR
a)    The valuation of ordinary shares is more complicated than the valuation of bonds and preference shares.  Explain the factors that complicate the valuation of ordinary shares.                                       (6 marks)

The most recent financial data for the Rare Watts disclose the following:

Dividend per share            Sh.3.00
Expected annual dividend growth rate    6 percent
Current required rate of return        15 percent

The company is considering a variety of proposals in order to redirect the firm’s activities.  The following four alternatives have been suggested:

1. Do nothing in which case the key financial variables will remain unchanged.
2. Invest in venture that will increase the dividend growth rate to 7% and lower the required rate of return to 14%.
3. Eliminate an unprofitable product line.  The action will increase the dividend growth rate to 8% and raise the required rate of return to 17%.
4. Acquire a subsidiary operation from another company.  This action will increase the dividend growth rate to 9% and required rate of return to 18%.

Required
For each of the proposed actions, determine the resulting impact price and recommend the best alternative.

(Total: 14 marks)