Question

1.     Briefly write about the stock valuation methods as discussed in the chapter.

2.     What is a Bond? How is its price calculated?

3.     What is internal rate of return? How is it calculated and used?

4.     What is Going Concern Value? Explain its factors.

5.     Briefly write about the bond risks and how the risks are rewarded for bond holders.

6.     Briefly write about capital rationing and its types with an example each.

Answer 1

Ans) The purpose of shareholders investment in  shares or stock is to earn a stream of dividends.The amount the shareholders would pay to buy the shares is the present value of expected stream of dividends.While calculating the present value of the future dividends the discount rate is taken as the cost of equity.The main methods of stock valuation is 1.Dividend discount model . In this method the present value of expected stream of future dividends equals long term price of share .

Po = D1/(1+ke)+ D1/(1+ke)^2+ D1/(1+ke)^3,,,,,,,infinite terms

Here Po = Equilibrium price of share or value of share

D1 = Dividendv, Ke = Cost of equity .

2.)Terminal Value method : There can be a chance that a perticular shareholder may hold a share for a perticular number of years let take the example as n years .The investor will receive dividends from year 1 to Year N and inaddition he will receive terminal value at the end of year n om the disposal of share .

Po = D1/(1+ke) + D1/(1+ke)^2 +,,,,,,,+ Terminal Value/(1+ke)^n.

Here Po = Price of share

D1 = dividend

Ke = Cost of equity

n =:number of years a share is hold

Ans 2 ) Bond are contracts between the borrowers and lenders.The lender or the bondholder lends the amount which is the bond price in exchange for the borrowers promise to pay interest which is periodic and to repay the principal on maturity.The rate of interest on the bond is also known as the coupon rate.Yields from the bond is the effective rate of return earned by the bondholder.The price of the bond is calculated as below :

B = C /(1+Kd) + C/(1+kd)^2 + C/(1+kd)^3,,,,,,,,,,,+R/(1+kd)^n

B = Priceof bond

C = Coupon rate or interest rate of bond

Kd= Cost of debt

R = Redemption sum at n year.

B is the intrinsic value of bond if market vlue is greter than intrinsic value than the underprice and if the intrinsic value is greater than the market price of the bond , than the bond is overprice

Ans 3) Internal rate of return is the return at which the present value of inflows equals to the Outflow or in other terms it is the rate of earning as an implication of a given cash flow stream or the discount rate at which the Net present value or Present value of inflows minus initial investment is zero .IRR is calculated as follows:

a) Compute NPV at guessed rate Ki %.

Here NPV = Present value of inflow - initial investment.Here Present value of inflows is calculated by discounting cash inflow with the guessed rate Ki %.If NPV is positive we guess another higher rate if NPV is negative , guess another lower rate.At some guess rate Kj% the NPV is zero than IRR = Kj% but if NPV is not zero we need to interpolate .The formula for IRR is as

IRR = R1   + NPV1* (R2-R1)/ (NPV1-NPV2)

R1 and R2 are randomly selected discount rate

NPV1 = Higher Net preaent Value

NPV2 = Lower net present value.

Ans 4) Going concern value is the valuation of the company or firm based on the assumption that the business will be in operation for a long time as against the stoppage of the business by liquidation or selling off.The factors that play important role are basically the goodwill and the operational efficiency which is related to profit earning capacity of the business.

Ans 5) For the company , bonds increase risk because non payment of interest or principal on maturity can lead to liquidation.There is a pressure on the substantial repayment of redemption amount of the bond.Similarly the bondholders are entitled to risk of non payment of interest or  the delay in payment of redemption amount.The priority of bonds refers to a case where the issuer is unable to meet his obligation then the priority payment is to be done to the bondholder.

Ans 6) Capital rationing is the strategy to pick the most profitable projects for the investment.Keeping in mind the availibility of the funds.Capital rationing can be hard or soft.Hard Capital rationing is related to a problem where a company finds hard to raise the external capital and Soft capital rationing is related to a constraint imposed internally in the company for the use of the funds.