EAST WEST UNIVERSITY

Final Assignment + Term Paper

FIN 101
Sec: 05

Submitted By

Hossain Mohammad Ibrahim

Id: 2016-2-10-121
Department of

Business Administration

This is a story about two friends called Ibrahim and Rhydom. Ibrahim is doing
his graduation from Business Administration department and Rhydom is in English department.
One day they are talking to each other about their future that what will they do. Then they came
up with a idea that they can invest on share market to do share business. But for doing share
business they need to know many important terms. So as Ibrahim is from BBA department so he
knows about the important term and suddenly Rhydom just said that he read an article on Google
that Mr. Alex faced a huge loss due to having wrong decision about Bond Valuation. And
Rhydom ask Ibrahim that what is Bond Valuation and how it works?
Then Ibrahim started the following discussion to let him understand about the term of Bond
Valuation and Stock valuation, Capital Budgeting also.

Bond Valuation
A corporation’s long-term debt is usually involves interest-only loans. If, for example, a firm
wants to borrow $1,000 for 30 years and the actual interest rate on loans with similar risk
characteristics is 12%, then the firm will pay a total of $120 in interest each year for 30 years and
repay the $1,000 loan after 30 years. The security that guarantees these payments is called a
bond. A bond may involve more than one interest payment during a year. Since bonds are an
essential part of the capital markets, investors and analysts seek to understand how the different
features of a bond interact in order to determine its intrinsic value. Like a stock, the value of a
bond determines whether it is a suitable investment for a portfolio and hence, is an integral step
in bond investing.

A bond is characterized by the following items:

Face Value: The amount of principal to be repaid at the bond’s maturity date.
Coupon Rate: The fraction of F paid in interest each year.
Maturity: The number of years until the face value is repaid.
Number of Payments Per Year: Number of interest payments in a year.
A bond is usually issued at Par, it sells for face value when issued. If, for example the face value
of a bond is $1,000, an investor pays $1,000 for the bond when issued. As time evolves, the
return required by buyers of bonds with similar characteristics changes. This required return
depends on the market interest rates. Market interest rates determine the yield to maturity of a
bond, which is the annual return to an individual buying the bond at its market price and holding
it until maturity. There are different types of yield measures that may be used to represent the
approximate return to a bond. One of them is
# Yield to maturity (YTM):
Annual rate of return earned in a debt security purchased at a given date & held to maturity. To
measure Yield to Maturity (YTM) we need Coupon Payment, Purchase price, Market price,
Time to Maturity. Assume that a company’s annual coupon bond given that the bond price is
$850, coupon rate 15%, Face value $1000 and there are 7 years remaining until maturity. By
using the formula of YTM we can find the approximated YTM on the bond is 18.53%.

Stock Valuation
Consider a stock that promises to pay a $1 dividend one year from now. If the stock price in one
year is expected to be $25, then the overall cash flow to a stockholder one year from now is
expected to be $26. Every investor who wants to beat the market must master the skill of stock
valuation. Essentially, stock valuation is a method of determining the intrinsic value of a stock.
The importance of valuing stocks evolves from the fact that the intrinsic value of a stock is not
attached to its current price. By knowing a stock’s intrinsic value, an investor may determine
whether the stock is over- or under-valued at its current market price. Stock valuation is an
important tool that can help to make informed decisions about trading. It is a technique that
determines the value of a company's stock by using standard formulas. It values the fair market
value of a financial instrument at a particular time. The reason for stock valuation is to predict
the future price or potential market prices for the investors to time their sales or purchase of
investments.
The dividend discount model is one of the basic techniques of absolute stock valuation. The
DDM is based on the assumption that the company’s dividends represent the company’s cash
flow to its shareholders. Essentially, the model states that the intrinsic value of the company’s
stock price equals the present value of the company’s future dividends. Note that the dividend
discount model is applicable only if a company distributes dividends regularly and the
distribution is stable.
The Gordon Growth Model (GGM) helps the investor to determine the intrinsic value of a stock
based on the constant rate of growth of its future dividends. Put simply, the Gordon Growth
Model uses a company’s rate of return and its dividend growth to estimate the fair price of its
stock. Let’s say the investor’s company share is trading at $53 per share. It has paid out a
dividend of $2 per share in the current financial year and the expected dividend growth rate is
5% every year. Investors expect a minimum of 8% return every year from the company. So the
value or price of the company’s share using the Gordon Growth Model is $70.

Capital Budgeting
Capital budgeting is the process that a business uses to determine which proposed fixed asset
purchases it should accept, and which should be declined. This process is used to create a
quantitative view of each proposed fixed asset investment, thereby giving a rational basis for
making a judgment. As part of capital budgeting, a company might assess a prospective project's
lifetime cash inflows and outflows to determine whether the potential returns that would be
generated meet a sufficient target benchmark. The process is also known as investment appraisal.
Some methods of capital budgeting companies use to determine which projects to pursue include
throughput analysis, Net present value (NPV), Internal rate of return (IRR), Modified internal
rate and return (MIRR).
Capital budgets or capital expenditure budgets are a way for a company’s management to plan
fixed asset sales and purchases. Usually these budgets help management analyze different long-
term strategies that the company can take to achieve its expansion goals. In other words, the
management can decide what assets it might need to sell or buy in order to expand the company.
To make this decision, management typically uses these three main analyzes in the budgeting
process: throughput analysis, discounted cash flows analysis, and payback analysis.
Let’s say an example; capital budgeting involves difficult decisions. In most cases buying fixed
assets is expensive and cannot be easily undone. The management has to decide to spend cash in
the bank, take out a loan, or sell existing assets to pay for the new ones. Each one of these
decisions comes with the eternal question: will they receive the proper return on investment?
Because when we think about it, buying new fixed assets is no different than putting money any
other investment. The company is buying equipment hoping that is will pay off in the future.
That is why many managers used the present value of future cash flows when deciding what to
buy. Present value dollars will help them analyze the current and future cash inflows and
outflows equally to come up with the best plan for the future.
So what is Net Present Value actually, Net Present Value (NPV) is the value of all future cash
flows (positive and negative) over the entire life of an investment discounted to the present. NPV
analysis is a form of intrinsic valuation and is used extensively across finance and accounting for
determining the value of a business, investment security, capital project, new venture, cost
reduction program, and anything that involves cash flow.

So the conversation between this two ended up here and Rhydom understand about Bond
Valuation, Stock Valuation and Capital Budgeting. And he realized that these terms are very
important to do share business. Similarly doing discussion about all the term with it they come
up with the decision that they will invest on share market with having good decisions and very
carefully.