F9 Financial Management

2 Section G: Business Valuations Designed to give you the knowledge and application of: G2. Models for the valuation of shares G3. The valuation of debt and other financial assets

3 Learning Outcomes G3: The valuation of debt and other financial assets  Apply appropriate valuation methods to: [2] i.irredeemable debt ii.redeemable debt iii.convertible debt iv.preference shares

4 The value of a debt is usually set out in the contract terms that exist between a creditor and debtor. The amount that a debtor owes a creditor at that moment is the nominal value of a debt instrument. Valuation method Classification of debt Irredeemable debt Preference shares Convertible debt Redeemable debt Zero coupon bonds Bonds issued by foreign entities

5 Irredeemable debt  company pays interest every year in perpetuity, without ever having to redeem the loan  irredeemable bonds do not have a maturity date Irredeemable Debt

6 Redeemable debt P 0 = Ex-interest market value I = Annual interest paid K d = Rate of return required by debt investors N = Number of years to maturity RV = Redemption Value Market value of redeemable debt is the discounted present value of future interest receivable, up to year of redemption, plus discounted present value of the redemption payment Redeemable Debt

7 Zero coupon bonds  Coupon is the interest rate on the nominal amount of the bond.  Zero coupon bond do not make any periodic payments  issued at a high discount & pay the full face value at maturity  The price of zero coupon bond is always less than its redemption P= Current MV of ZCB N= Number of periods to maturity Y= Periodic interest rate M = Value at maturity Example A zero coupon bond will be redeemed at par in 3 years. The average annual discount rate is 6%. What is the price of this bond? (Assume that maturity value at par is $100) Zero coupon bonds

8 Example A bondholder has the right to convert the $100 par amount (i.e. conversion value) of his convertible bonds into common shares at $25 per share. In this case, the conversion ratio is 4:1 (four to one). Convertible debt give bondholders the right but not the obligation to convert their bonds into a predetermined number of shares at predetermined dates prior to the bond's maturity Convertible bonds are exchangeable into shares of common stock Conversion is expressed in a “ conversion ratio ” Convertible debt Continued …

9 Convertible bond Actual market value depends on Consists of two assets  the current conversion value  the time of conversion  the expected conversion value  a bond and  a warrant CV = Conversion value P 0 = Current ex-dividend ordinary share price g = Expected annual growth rate of ordinary share price n = Number of years to conversion R = Number of shares received on conversion Conversion value Continued …

10 Example A convertible bond, issued at par value of $1,000, is convertible into 40 shares of a firm's stock, implying a conversion price of $25 per share. If the current stock price is $20, the option to convert is not profitable, and the bondholder will hold the bond and choose not to convert. If the stock price rises to $30, it will become profitable for the bondholder to convert the bond into shares, since each bond can be converted into $1,200 worth of stock, compared to the bond's face value of $1,000. The straight bond value acts as a "floor price," since even if the stock price stays low throughout the holding period, a bondholder can still retain the bond's value. Therefore, a convertible bond provides a safety net for investors. difference in price when a convertible security exceeds the market value of the common stock into which it can be converted. Conversion premium difference between the market value of a convertible bond and its ordinary value as a straight debt Rights premium Continued …

11 Example A convertible bon d which is selling for $950 per unit can be converted into 40 of XYZ shares. The current market price of an XYZ share is $20. The ex-interest market value of ordinary bonds of a similar risk class and maturity is $940. Conversion ratio = 40 unit CV = Current share price x CR = $20 x 40 =$800 Conversion premium = Bond value – CV = $950 - $800 = $150 Current rights premium = $950 - $940 = $10 i.e per share ($10/40shares) Market value of convertible bond V 0 = Ex-interest market value I = Annual interest paid K d = Rate of return required by debt investors n = Number of years to maturity CV = Conversion value at time t Market value of convertible bond

12 Example What would the current market price of a 10% convertible bond of $100 be, if it can be converted, in 3 years’ time, into 20 ordinary shares or redeemed at par on the same date? The required rate of return is 12% and the current market price of the underlying share is $4.50 and this is expected to grow by 6% every year. Step 1: find out conversion value. CV= P 0 (1+ g) n R CV=4.50( ) 3 x 20 = $ Step 2: check whether conversion is likely. Par value is $100 and conversion value is $ which means investor may choose to convert. Step 3: calculate present value of expected cash flow. PV for 3 years is and at the end of 3 rd year is V 0 = (10 x 2.402) + ( x 0.712) = $ Example

13 repayable normally at par without liquidation shareholders participate in an additional dividend plus ordinary dividend or surplus assets on liquidation shareholders have the option to convert into ordinary shares within a given period Preference shares carry preferential rights are valued as perpetuity as it is repaid on liquidation of company Classification of preference shares Redeemable Participating Convertible Preference shares Continued …

14 Example JTL Ltd pays annual dividend of $4 on its preference shares and has required a return of 10%. What will the price of each preference share be? Preference shares P 0 = Ex-dividend market value D = Dividend payable K d = Cost of irredeemable preference share Continued …

15 Recap  Apply appropriate valuation methods to: [2] i.irredeemable debt ii.redeemable debt iii.convertible debt iv.preference shares