CHAPTER THREE

VALUATION OF FINANCIAL ASSETS AND COST OF CAPITAL

After successfully completing this Chapter, you will be able to:

Identify financial assets
Valuation of Financial Assets

Valuation of Bond

Valuation of Preferred Stock

Valuation of Common Stock
Define Cost of capital
Specific Cost of Capital

Specific Cost of debt

Specific cost of Preferred stock

Specific cost of Common stock

Specific cost of retained earning
Weighted average cost of capital

Introduction
Financial asset is a claim against the income or wealth of a business firm, individual, or
unit of government, represented usually by a certificate, receipt, or other legal document.
Familiar examples included stocks, bonds, insurance policies, deposits held in a
commercial bank, credit union or saving bank. Financial assets have no inherent or
intrinsic usefulness. They do have value only because they present claims to something
real-present claims and/or future claims.
Financial assets do not provide a continuing stream of services to their owners as do real
assets. These are sought after because they promise future return to their owner and serve
as a store of value (purchasing power).
A number of other features make financial assets unique. They cannot be depreciated
because they do not wear out like physical assets. Moreover, their physical condition or
form usually is not relevant in determining their market value (price). A stock certificate
is not more or less valuable, for example, because of the size or quality of paper it is
printed on or whether it is frayed around the edges. Because financial assets are generally
represented by a piece of paper (certificate or contract) or by information stored in a
computer file, they have little or no value as a commodity, and their cost of transport and
storage is low.
Finally, financial assets are fungible-they can easily be changed in form and substituted
for other assets. Thus, a bound or a stock usually can be quickly converted into cash at
low cost and then subsequently converted in to any other asset the holder desires.
The value of financial assets rests on the existence of valuable real assets or services,
which the financial asset owner ultimately will receive.. It must be noted that all classes of
investors are interested in knowing the values of financial assets (securities) i.e. common
stock, preference stock and bonds. They plan to hold them for periods ranging from short
to infinity. Since, the investor belongs to special class of goner buyers and sellers, he
would be influenced in his decision to buy/sell by two sets of values. One his own value
and two the value externally determined by the market and known as price. These are the
determinants of the buy – sell decisions of any goods or services in general. It is
important to weigh. The risk and return, which affect the valuation, process both of the
individual investor and the whole constellations of investors that constitute market.

1
Hence, the valuation is the key concept for investment decisions. No buy-sell action will
take place without values.
THE VALUATION PROCESS
The basic valuation is a constant exercise is rationality with cost, benefits, and
uncertainty as important variables. The valuation process will be examined in view of the
performance of a firm in relation to the performance of industry to which it belongs; and
the industry performance in turn, is linked to performance of the economy and the market
is general.
The basic valuations model
Value of a security is a fundamental variable and depends on its promised return, risk and
the discount rate. You may recall the basic understanding of present value concept, with
the mention of fundamental factors like returns and discount rate. In fact the basic
valuation model is none else than present value procedure. Given a risk adjusted discount
rate and the future expected earnings flow of security in the form of interest, dividend,
earnings, or cash flow, you can always determine the present value of follows.
PV = CF1 __ + CF2 + CF3 + ……. CFn
1+r (1 + r)2 (1 + r)3 (1 + r)n
PV = Present value
CF = Cash flow interest, dividend, earnings per time period up to ‘n’ number of
years
r = Risk adjusted discount rate

3.1. VALUATION OF BONDS

Inputs to the Valuation Model
The major inputs to the valuation model are cash flow streams – timing and size, and
Discount rate. Generally the present value technique is used in the valuation of financial
assets. The current value of financial asset (to the prospective investor) is the present
value of future cash benefits at a given discount rate. This technique is known as
Discounted Cash Flow Model
3.1.1. The meaning of Bonds & its characteristics
A bond is a long-term contract under which a borrower agrees to make payments of
interest and principal, on specific dates, to the holder of the bond. Bonds are debt
securities. They are issued by the borrower. Purchasers of bonds (bondholders or
investors) receive periodic interest payments (called coupon payments) until maturity at
which time they receive the face amount of the bond and the last coupon payment. Bonds
may pay interest monthly, quarterly, semiannually or annually. However, most bonds pay
interest semiannually. Bonds may be issued by governments and corporations.
Bonds have the following characteristics:

Par or face value: The amount of money that is paid to the bondholder at
maturity.

Coupon (stated) interest rate: The interest cost of the bond issue to the issuer. It
is the interest rate stated on the face of the bond. It is used to compute periodic
interest (coupon) payment.

Coupon payments: The periodic interest payments from the bond issuer to the
bondholder. It is computed by multiplying the coupon rate by the face value.

Maturity date: The date on which the face value is repaid.

Remaining maturity: The time currently remaining until the maturity date.

2

Call date: The date at which the bond can be called (for callable bonds). A
callable bond is a bond which can be redeemed by the issuer prior to maturity.

Call price: The amount of money the issuer has to pay to call a callable bond.

Required Rate of Return: The rate of return that investors currently require on a
bond. It is also called effective interest rate, market interest rate, or Yield to
maturity. It is used to discount the future cash flows of the bond to determine the
bonds current value.

Yield to maturity: The rate of return that an investor would earn if s/he bought
the bond at its current market price and held it until maturity. It represents the
discount rate that equates the discounted value of a bond’s future cash flows to its
current market price.

Yield to call: The rate of return that the investor would earn if s/he bought a
callable bond at its current market price and held it until the call date given that
the bond was called on the call date.

Premium on bonds: The difference between the bond’s market price and its face
value. Premium on bonds occurs when market price exceeds face amount.

Discount on bonds: Discount on bonds occurs when the bond’s face amount is
greater than its market price.
3.1.2. Types of Bonds
Generally, bonds may be classified in to 4 categories based on the party issuing the bond:
1. Treasury (government) bonds: Bonds issued by the government
2. Corporate bonds: Bonds issued by corporations
3. Municipal bonds: Bonds issued by state and local governments
4. Foreign bonds: Bonds issued by foreign governments or corporations
Moreover, corporate bonds are sub-divided in various groups based on the rights and
obligations associated with each bonds as follows

Zero-coupon bonds: Bonds issued at a discount. They do not have stated interest
rate

Floating rate bonds: Bonds whose interest rate fluctuates with shifts in general
level of interest rate

Callable Bonds: Bonds which can be redeemed by the issuer prior to maturity

Convertible bonds: Bonds that is exchangeable for common stock at the option
of the holder.

Indexed (purchasing power) bonds: Bonds whose interest payments are based
on inflation index.

Term bonds: Bonds whose principal is repaid on specific maturity date in the
future

Serial bonds: Bonds whose principal is paid on a periodic basis over certain
period.
3.1.3 Determining the Value of term Bonds
Whether bonds are perpetual bonds or have finite maturity period, the value of a bond is
the present value of all future cash flow streams expected from the investment.
Discounting of future cash flows depends on whether the bonds are non-zero coupon
bonds or zero-coupon bonds. Zero-coupon bonds do not effect payment of interest being
computed on the principal or face value of the bonds. Rather the bonds are sold at deep
discount from its face value.
The major cash benefits from investment in bonds are:

Periodic interest payment

Principal repayment at maturity

3
The present value technique is used in determining the value of a bond, which is equal to
the present value of periodic interest payments plus the present value of principal
repayment at maturity.
The valuation equation for different types of bonds is explained below:
1. The value of Perpetual bond (bond that never matures)
Vale of the bond (Vb) = discounted future interest payments

Where: Vb= present value of bond ; I= Interest payments

Kd= discount rate; n = number of years or periods
2. Value of Zero-coupon bonds or commonly known as deep discounted bonds (a
bond without having stated coupon interest rate)

3. Value of Bond with finite maturity (Value of term bonds)

Value of the bond = discounted future interest payments + Present value of maturity
value of the bond

 1 
1− 
 (1 + k ) n   
d  1 
V = INT   + M  
B  k   (1 + k ) n 
 d   d 
 
Where,
VB = the value of a bond
INT = Periodic interest payment
M = Principal repayment at maturity
kd = Required rate of return on bonds
n = Number of periods to maturity
3.1.4. Bond Valuation When Interest is paid annually
The value of the bond may be:
1. equal to its face amount,
2. greater than its face amount, or
3. less than its face amount
 If coupon interest rate is less than market interest rate, the value of the bond is
less than its face amount. The bond is said to be issued at a discount. Discount is the
difference between face amount and value of the bond
 If coupon interest rate is greater than market interest rate, the value of the bond is
more than its face amount. The bond is said to be issued at a premium. Premium is
the difference between the value of a bond and its face amount.
 If coupon interest rate is equal to market interest rate, the value of the bond is the
same as its face amount.

4
Example: The investor is considering investing in a Br. 250,000, 10%, 10 years term
bonds of ABC Corporation. Interest is paid annually. Determine the value of the bonds if
the market interest rate is:
a. 8% b. 14% c. 10%
Answer:
a. Kd = 8%
Annual interest payment (INT) = 250,000 X 10% = 25,000
N = 10
Kd = 8%
 1 
1 − 
V B = INT 
(1 + k d ) n  + M  1 

 kd   (1 + k ) n
   d 
 
 1 
1− 10 
( 1 0 . 08 )  1 
= 25 , 000   + 250
+
VB , 000  
 0 . 08   ( 1 + 0 . 08 ) 10 
 
 
=25000(6.710) + 250,000(0.463)
=283,500
Premium on bonds = 283,500 – 250,000 = 33,500
b. Kd = 14%
Annual interest payment (INT) = 250,000 X 10% = 25,000
N = 10
Kd = 14%
 1 
1 − 
VB = INT 
(1 + k d ) n  + M  1 

 kd   (1 + k ) n
   d 
 
 1 
1− 
 (1 + 0 . 14 ) 10  + 250 , 000  1 
VB = 25 , 000  
 0 . 14   (1 + 0 . 14 )
10

 
 
= 25,000 (5.216) + 250,000(0.270)
= 197,900
Discount on bonds = 250,000 – 197,900 = 52100

c. Kd = 10%
Annual interest payment (INT) = 250,000 X 10% = 25,000
N = 10
Kd = 10%
 1 
1− 
V B = 25 , 000 
(1 + 0 . 10 ) 10  + 250 , 000  1 

   (1 + 0 . 10 )10
0 . 10  
 
 
= 25,000 (6.145) + 250,000(0.386)
= 250,000 (The value of the bond is approximately equal to its face amount)

5
 Exercises
1. Assume that you planned to buy a bond that pays Birr 100 per year forever, how
much is the value of the bond if the required rate of return from this investment is
12%?
2. How much is the value of a Birr 1000 par value bond with a 10 % annual coupon rate
and 9 years maturity if the required rate of return from the same investment is 12%?
3. Suppose your company wants to invest on a zero-coupon bond that has a face value
of Birr 1000 with 10 years maturity. If the required rate of return is 12%, how much
is the price of the bond (its value)?
4. Consider a bond, maturing in 10 years and having a coupon rate of 8 percent. The
par value is Birr 1,000. Investors consider 10 percent to be an appropriate required
rate of return in view of the risk level associated with this bond. Calculate the present
value of the bond.
Bond Valuation when interest is paid for less than a Year
Example: The investor is considering investing in a Br. 500,000, 14%, 5 years term
bonds of XYZ Corporation. The market interest rate is 12%. Determine the value of the
bonds if interest is paid:
a. Annually b. Semiannually c. Quarterly
Answer
a. Interest paid annually
Annual interest payment = 500,000 x 0.14 = 70,000
N=5
Kd = 12%
 1 
 1 − 
 + M  
n
(1 + k d ) 1
V B = INT   (1 + k 
 kd   d ) n

 
 
 1 
1− 
V B = 70 , 000 
( 1 + 0 . 12 ) 5  + 500 , 000  1 

   (1 + 0 . 12 ) 5
0 . 12  
 
 
= 70,000 (3.605) + 500,000(0.567)
= 537,850
b. Interest paid semiannually
Annual interest payment = 500,000 x 0.14 x 6/12 = 35,000
N = 5 x 2 = 10
12%
kd = = 6%
2
 1 
1− n 
(1 + k d )   1 
V B = INT  + M  
 kd   (1 + k d ) 
n

 
 
 1 
1− 10 
(1 + 0.06)   1 
VB = 35,000 + 500,000 
 0.06  10
 (1 + 0.06) 
 
 
= 35,000 (7.360) + 500,000(0.558) = 536,600
6
c. Interest paid quarterly
Annual interest payment = 500,000 x 0.14 x 3/12 = 17500
N = 5 x 4 = 20
12%
kd = = 3%
4
 1 
1− 
 (1 + k d ) n  + M  1 
VB = INT
 kd   (1 + k ) n 
   d 
 
 1 
1− 20 
(1 + 0.03)   1 
VB = 17,500 + 500,000 
20 
 0.03   (1 + 0 . 03) 
 
 
= 17,500 (14.88) + 500,000(0.554)
= 537,400

3.1.7. Determining the Bondholder's Expected Rate of Return: Yield to Maturity &
Yield to Call

Yield to Maturity (Required Rate of Return on bond)

Theoretically, each investor could have a different required rate of return for a particular
security. However, the financial manager is only interested in the required rate of return
that is implied by the market prices of the firm's securities. Yield to maturity (YTM)
refers to the rate of return that an investor would earn if s/he bought the bond at its
current market price and held it until maturity. It represents the discount rate that
equates the discounted value of a bond’s future cash flows to its current market price.
To measure the bondholder's expected rate of return, kd, we would find the discount rate
that equates the present value of the future cash flows (interest and maturity value) with
the current market price of the bond. The expected rate of return for a bond is also the
rate of return the investor will earn if the bond is held to maturity or the yield to maturity.
Thus, when referring to bonds, the terms expected rate of return and yield to maturity are
often used interchangeably.
. The yield to maturity may be computed using the following formula:
P −V
F + B
YTM = N
0 . 60 (V ) + 0 . 40 ( P )
B
Where,
F = Periodic interest payment
P = Principal
VB = The value of bonds
N = Number of periods to maturity

7
Example: Assume that the current price of a Br. 5000, 10%, 10 years term bonds is Br.
4500. Determine yield to maturity if interest is paid:
a. Annually b. Semiannually
Answer
a. Interest is paid annually
F = 5000 x 10% = 500
VB = 4500
N = 10
P = 5000
P −V
F + B
YTM = N
0 . 60 (V ) + 0 . 40 ( P )
B
5000 − 4500
500 +
YTM = 10
0.60(4500) + 0.40(5000)
= 0.117
b. Interest paid semiannually
F = 5000 x 10%x 6/12 = 250
VB = 4500
N = 10 x 2 = 20
P = 5000
5000 − 4500
250 +
YTM = 20
0 . 60 ( 4500 ) + 0 . 40 ( 5000 )
= 0.0585 per every six month
Therefore, the annual YTM will be 0.0585*2= 11.7%

Exercise : Assume that the current price of a Br. 20,000, 6%, 10 years term bonds is Br.
22,000. Determine yield to maturity if interest is paid annually.

2. Yield to call (YTC)

YTC is the rate of return that the investor would earn if s/he bought a callable bond at its
current market price and held it until the call date given that the bond was called on the
call date.
The value of a callable bond is the sum of the present value of periodic interest payments
and the present value of call price. Its yield to call is computed as follows:
CP − V
I + B
YTC = N
0 . 60 (V ) + 0 . 40 ( CP )
B
Where,
I = Periodic interest payment N = Call protection period
CP = Call price YTC = Yield to call
VB = the value of bonds

8
 Example: Assume that the current price of a Br. 2000, 10%, 10 Years term bonds is
Br. 1900. These bonds can be called five years from now at a call price of Br. 2100.
Interest is paid annually.
a. Call premium = Call price – Face amount
= 2100 – 2000
= 100 (known as call premium)
b. Yield to Call
F = 2000 x 0.10 = 200
N= 10
2100 − 1900
200 +
YTC = 5 = 12.12%
0 .60 (1900 ) + 0 .40 ( 2100 )
Exercise Assume that the current price of a Br. 10,000, 8%, 10 Years term bonds is Br.
10,400. These bonds can be called four years from now at a call price of Br. 10,250.
Interest is paid annually. Determine call premium and Yield to call.
3 .4 . Valuation of Preferred Stock
Preferred stock is a type of equity security that provides its owners with limited or fixed
claims on a corporation’s income and assets. Investment in a preferred stock provides a
single cash flow, i.e., constant periodic dividend payments. Preference shares are hybrid
security in that it has some features of both bonds and some of equity (common) shares.

Theoretically, preference shares are considered a perpetual security but there are
convertible, callable, redeemable and other similar features, which enable issuers to
terminate them within the finite time horizon.

Preference dividends are characterized like bonds because they rank prior to equity shares
for dividends. However, such characterization doesn’t imply obligation, failure to comply
with which may amount to default and as a result, several preference issues are
cumulative where dividends accumulate over a period of time and equity dividends
require clearance of preference arrears first.

Preference shares are less risky than equity because their dividends are fixed and all
arrears must be paid before equity holders get their dividends. They are however, more
risky than bonds because the latter enjoy priority in repayment and in liquidation. Bonds
are scurried also and enjoy protections of principal which is ordinarily not available to
preference shares. Investor’s required returns on preference shares are more than those on
bonds but less than on equity shares.

Since dividends from preference shares are assumed to be perpetual payments, the
intrinsic value of such shares will be estimated from the following equations.

Vps = C_ + C__ + Cn__

(1 + kps) (1 + kps)2 ( 1 + kps)n
Vps = Value of preferred stock today
C = Constant dividends received
Kps = required rate of return on preferred stock
Dps
∴ VPS =
Kps

9
Example 1: Assume a preference share of Birr 100 each with a specified regular and
fixed dividend of Birr 11.5 per share per period. Now, if the investors’ required rate of
return corresponding to the risk level of a company is 10%, what would be the value of
the preferred share today?

Vps = D_
Kps
= 11.5
.10
= 115.00
If the required rate of return increases to 12%, what would be the value?
Vps = D_
Kps
= 11.50
.12
= 95.83
If the market price of the preference share is Birr 125 what would be the yield?
Vps = D__
Kps
Kps = D_
Vps
= 11.50
125
= 9.2%
Dps
VPS =
Kps

Exercise
1. Assume Mr X wishes to estimate the value of its outstanding preferred stock. The
preferred stock has a Br. 80 par value and pays an annual dividend of Br. 6.40 per
share. Similar-risk preferred stocks are currently earning a 9.3% annual rate of
return. What is the value of the outstanding preferred stock?
2. Assume that you acquired a 9%, $1000 par value preferred stock and your required
rate of return on such investment is 14%. How much is the value of the stock by which
you decide to buy?

3 .5 . VALUATION OF COMMON STOCK

In case of equity shares, the future stream of earnings or benefits pose two problems.
One, it is neither specified nor perfectly known in advance as an obligation. Resulting
this, future benefits and their timing have both to be estimated in a probabilistic frame
work. Two, there are at least three are three elements which are positioned as alternative
measures of such benefits namely dividends, cash flows and earnings.

The valuation of common stock has three methods.

a) zero growth model
b) constant growth model

10
a) Zero growth model
Under this the assumption is the growth of dividend is zero or constant.

Vc = D
K
Vc = Value of common stock
D = Dividend paid
K = The required rate of return

Ex. A company pays a cash dividend of Birr 9 per share on common share for an
indefinite period of future. The required rate of return is 10% and the market price of the
share is Birr 80. Would you buy the share at its current price?

Vs = D= 9_= 90
K .1 0
Yes, the price is more than value, you would consider buying the share.

b) Constant Growth Model

The dividend payable to common stock holders will grow at a uniform rate is future. It
can be written as below.
Vc = Do (1 + g)
k–g
Do = Dividend paid
g = growth rate
k = desired rate of return.

Ex. Alfa Company paid a dividend of Birr 2 per share on common stock for the year
ending March 31, 2003. a constant growth of 10% per annum has been forecast for an
indefinite future. Investors required rate of return is 15%. You want to buy the share at
market price quoted on July 31, 2003 is stock market at Birr 60 what would be your
decision?
Vs = Do (1 + g) = 2 (1 + .10) = 2 (1.10) = 2.20 = 44
k–g 15 - . 10 .0 5 .0 5
Value is less than price, so you do not buy.

Ex. Nissan Ltd paid a dividend of Birr 4 per share for the ending march 31, 2003. The
growth rate is 10% forever. The required rate of return is 15%. You want to buy the share
at a market price of Birr 80 in stock exchange. What would you do?
Vc = Do (1 + g) = 4 (1 + .10) = 4.40 = 88
k–g 15 - . 10 .0 5

11