BONDS AND EQUITY VALUATION COURSE MODULE

                         BOND VALUATION AND EQUITY VALUATION

 Bond valuation is a relatively straight forward process, since future cash returns to the bond holders are always specified in the bond contract. 

The firm issuing the bond is obligated to meet the interest and principal payments as and when due, otherwise the bond will go into default with attendant penalties.

 Defaulting on bond payments can have disastrous consequences for the issuing firm and its shareholders, sometimes resulting in possible bankruptcy and or re-organisation.

As a result of possible default risk, investors normally require a higher rate of return on bonds than the risk-free-rate before agreeing to hold a firm’s bonds. The required rate of return varies among bond issues of different firms, depending on their relative risks of default.

 Under normal conditions, the greater the risk on a given bond issue, the higher the required rate of return.

Valuation of bonds techniques reflect the maturity patterns of various bond issue

In theory, the valuation of common stock is no different from the valuation of other types of securities such as bonds and preferred stock.

The basic procedure involves the same capitalization (i.e discounting) of the expected stream of returns from holding the common stock. Essentially, we value finite bonds ie bonds with maturity dates using present value of annuity while we value bonds without maturity dates which is consols using present value to perpetuity.  However, in the case of common stock, the principle is made more complex by a number of factors.