Question

Why is share valuation more difficult than bond valuation? Be sure to identify the risks and uncertainties faced by shareholders that do not affect bond holders. (10 marks)

Answer 1

Value of securities, whether shares or bonds, is same in that the value is the PV of the expected cash flows from the security, discounted by the required rate of return.for similar securities.

In the case of bonds, the cash flows are certain as they are the maturity value [which is usually the face value] and the periodic fixed dollar interest [unless of course the bond is a floating rate interest bond]. Only uncertainty is the risk of default in interest payments and repayment of principal on maturity.

In contrast, in the case of shares, the cash flows in the form of dividends are uncertain. Usually some assumption as to the expected dividend streams, is made, such as:

*Constant dividends, with no growth

*Dividends with constant growth

*Dividends having different growth rates for an initial number of years followed by a constant perpetual growth rate.

These predictions as to dividends are uncertain as they depend on earnings after payment of interest on debt and also on the dividend policies of the firm.

Further, in the event of winding up of the firm, the debt holders have priority in receiving the principal. In contrast the shareholders have the last priority.

Thus, the shareholders have the greatest risk in getting their periodic interest and repayment of investment. These risk factors have to be built in the required return which again complicates the issues.