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Finance – Bond Valuation

Finance – Bond Valuation

The objective of finance management is to maximize the value of the firm. Hence, managers must know how stocks and bonds are valued. Knowing how to value securities (bonds and stock) is an important task for investors as it is for managers. Current and prospective investors must understand how to value bonds and stocks. Such knowledge is helpful to them in deciding whether they should buy or hold or sell securities at the prices prevailing in the market.

The basic discounted cash flow valuation model and its application to bonds and stocks is divided into:

  • Distinction among valuation concepts
  • Bond Valuation
  • Bond Yields
  • Bond market
  • Preferred stock valuation
  • Equity valuation: dividend discount model
  • Equity valuation: P/E ratio approach
  • E/P ratio, expected return and growth
  • Stock market

Distinction among valuation concepts

The term value is used in different senses. Hence a brief review of the differences that exist among the major concepts of value are

Liquidation Value versus Going Concern Value: The liquidation value is the amount that can be realized when an asset or a group of assets representing a part or even the whole of a firm is sold separately from the operating organization to which it belongs. In contrast, the going concern value represents the amount that can be realized if the firm is sold as a continuing operating entity.

In general, security valuation models assume a going concern, an operating business entity that generates cash flows to its security holders. When the going concern assumption is not appropriate as in the case of an impending bankruptcy, liquidation value of assets is more relevant in determining the worth of the firm’s financial securities.

Book value versus market value: The book value of an asset is the accounting value of the asset, which is simply the historical cost of the asset less accumulated depreciation or amortization as the case may be. The book value of a firm’s equity is equal to the book value of its assets minus the book value of its liabilities. Because book value reflects a historical accounting value it may diverge significantly from the market value.

The market value of an asset is simply, the market price at which the asset trades in the market place. Often the market value is greater than the book value.

Market Value versus Intrinsic Value: As the nomenclature suggests, the market value of a security is the price at which the security trades in the financial market.

The intrinsic value of a security is the present value of the cash flow stream expected from the security, discounted at a rate of return appropriate for the risk associated with the security. Put it differently, intrinsic value is economic value. If the market is reasonably efficient, the market price of the security should hover around its intrinsic value.

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