Security Valuation, SFM Notes by CA Mayank Kothari
Security Valuation, SFM Notes by CA Mayank Kothari
Security Valuation, SFM Notes by CA Mayank Kothari
Chapter 5
SECURITY
VALUATION
- CA Mayank Kothari
38 83 39 29 92
Hours Videos Practical Questions Theory Questions Lectures Pages Notes
CA FINAL SFM
अध्याय ५
प्रितभूित मूल्यांकन
- सी.ए. मयंक कोठारी
38 83 39 29 92
घंटे के वीिडयो व्यावहािरक प्रश्न िसद्धांितक प्रश्न व्याख्यान पृष्ठों की पुस्तक
About The Faculty
CA Mayank Kothari
CA, BBA
Co-Founder of Conferenza.in
Achievements
1. Qualified the Chartered Accountancy exam in May 2012 held by ICAI.
2. Secured All India 47th Rank in CA Final and was topper in Nagpur division of
ICAI.
3. Also, he received Gold Medal for securing highest, 88 Marks in Indirect Tax
paper in Nagpur division.
4. He was felicitated with the Best Student Award from the hands of Vice
Chancellor of Nagpur University.
5. He has worked with Deloitte, Haskins and Sells, Pune
6. He has successfully implemented the Lightboard Technology in education
being the First in India.
7. Developed Conferenza MCQs App which has 50000+ Free MCQs for CA
Students
3. Risk Management
Slides of 103 Pages | 11 Practical Questions
To Download Click Here
4. Security Analysis
Notes of 103 Pages | 50 Theory Questions | 8 Practical Questions
To Download Click Here
Content
Question Particulars Page no.
2 What do you mean by Nominal Cash Flows and Real Cash Flow? 8
3 How to select the discount rate in case of Nominal Cash Flows and Real Cash Flows? 8
12 Explain One Stage, Two Stage and Three Stage Model for the Valuation of the firm 19
13 Why FCFE Model of Equity Valuation is better than Dividend Based Model? 20
26 What is Yield Curve? What are the different types of yield curve? 34
29 Why should the duration of a coupon carrying bond always be less than the time to its maturity? 39
33 What is Immunization? 50
35 A portfolio is immunized when its duration equals the investor's time horizon. Explain 52
36 Explain Forward Rates and how to calculate the Theoretical Forward Rates? 53
Chapter 5
Security Valuation
In finance, valuation is the process of determining the present value (PV) of an
asset. Valuations can be done on assets (for example, investments in marketable
securities such as stocks, options, business enterprises, or intangible assets such as
patents and trademarks) or on liabilities (e.g., bonds issued by a company).
Valuations are needed for many reasons such as investment analysis, capital
budgeting, merger and acquisition transactions, financial reporting, taxable events
to determine the proper tax liability, and in litigation.
In this chapter we are going to discuss about the valuation of securities
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2. Discount Rate
✓ Discount Rate is the rate at which present value of future cash flows
is determined.
✓ Discount rate depends on the risk free rate and risk premium of an
investment. Actually, each cash flow stream can be discounted at a
different discount rate.
✓ This is because of variation in expected inflation rate and risk
premium at different maturity levels.This can be explained with the
help of term structure of interest rates.
✓ For instance, in upward sloping term structure of interest rates,
interest rates increase with the maturity. It means longer maturity
period have higher interest rates.
✓ However, in practice, one discount rate is used to determine present
value of a stream of cash flows.
✓ But, this is not illogical. When a single discount rate is applied instead
of many discount rates, many individual interest rates can be replaced
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1st year 2nd year 3rd year 4th year 5th year
Cash Flows `100 `200 `300 `400 `500
Discount Rate 2% 3.2% 3.6% 4.8% 5%
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In our example, the required investment is $8,475 and the net annual cost
saving is $1,500. The cost saving is equivalent to revenue and would,
therefore, be treated as net cash inflow. Using this information, the
internal rate of return factor can be computed as follows:
Internal rate of return factor = $8,475 /$1,500 = 5.650
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After computing the internal rate of return factor, the next step is to
locate this discount factor in “present value of an annuity of $1 in arrears
table“ or the most common method is to apply interpolation method to
find out the IRR.
It is 12%. It means the internal rate of return promised by the project is
12%. The final step is to compare it with the minimum required rate of
return of the VGA Textile Company. That is 15%
Conclusion:
According to internal rate of return method, the proposal is not
acceptable because the internal rate of return promised by the proposal
(12%) is less than the minimum required rate of return (15%).
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where
Rx = expected return on investment in "x"(company x)
Rf = risk-free rate of return
βx = beta of "x"
Rm = expected return of market
Rm-Rf = Market Risk Premium
beta(Rm-Rf) = Equity Risk Premium
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Q2. What do you mean by Nominal Cash Flows and Real Cash Flow?
Answer:
Nominal cash flow is the amount of future revenues the company expects
to receive and expenses it expects to pay out, without any adjustments for
inflation.
For instance, a company which wants to invest in a utility plant wants to
forecast its future revenues and expenses it has to incur while earning its
income (i.e. wages to labour, electricity, water, gas pipeline etc)
On the other hand, Real cash flow shows a company's cash flow with
adjustments for inflation. Since inflation reduces the spending power of
money over time, the real cash flow shows the effects of inflation on a
company's cash flow.
In the short term and under conditions of low inflation, the nominal and
real cash flows are almost identical. However, in conditions of high
inflation rates, the nominal cash flow will be higher than the real cash flow.
From the above discussion, it can be concluded that cash flows can be
nominal or real.
Q3. How to select the discount rate in case of Nominal Cash Flows and Real
Cash Flows?
Answer:
When cash flows are stated in real terms, then they are adjusted for
inflation. However, in case of nominal cash flow, inflation is not adjusted.
For nominal cash flow, nominal rate of discount is used. And, for real cash
flow, real rate of discount is used.
Cash Flows Discount rate
Nominal Cash Flows Nominal Discount Rate
Real Cash Flows Real Discount Rate
While valuing equity shares, only nominal cash flows are considered.
Therefore, only nominal discount rate is considered. The reason is that the
tax applying to corporate earnings is generally stated in nominal terms.
Therefore, using nominal cash flow in equity valuation is the right
approach because it reflects taxes accurately.
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Moreover, when the cash flows are available to equity shareholders only,
nominal discount rate is used. And, the nominal after tax weighted average
cost of capital is used when the cash flows are available to all the
company’s capital providers.
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Do (1 + g1 )1 Do (1 + g1 )2 Do (1 + g1 )𝑛 Pn
Po = [ 1
+ 2
+ ⋯ … + n
]+
(1 + Ke) (1 + Ke) (1 + Ke) (1 + Ke)n
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Where
g n = Normal Growth Rate
g c = Current Growth Rate (Initial short term growth)
H1 = half life of high growth period
Interpretation:
The first component of the valuation in this case is what the value of the shares
would be if there was no high growth period at all. Notice that the formula is
quite similar to the Gordon Growth model formula
The second component is the addition in value resulting from the high growth
period. This component is where the H model differs from other dividend
discount models
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High Growth period is of 4 years during which the growth rate will decline from
12% to 9% equally.
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r
D+ (E − D)
Ke
P=
Ke
3) PE Multiplier
Market Price = EPS x PE Ratio
Now, the question arises how to estimate the PE Ratio. This ratio can
be estimated for a similar type of company or of industry after making
suitable adjustment in light of specific features pertaining to the
company under consideration. It should further be noted that EPS
should be of equity shares.
Accordingly, it should be computed after payment of preference
dividend as follows:
PAT − Preference Dividend
EPS =
No. of Equity Shares
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Q11. Explain how to calculate the change Non Cash working capital?
Answer:
Step 1: Calculate Working Capital for the current year:
Working Capital =Current Asset-Current Liability
Step 2: Calculate Non-Cash Working Capital for the current year:
Non-Cash WC= Working Capital – Cash and Bank Balance
Step 3: In a similar way calculate Working Capital for the previous year
Step 4: Calculate change in Non-Cash Working Capital as:
Non-Cash WC (current year)- Non-Cash WC (previous year)
Step 5:
a) If change in Non-Cash Working Capital is positive, it means an increase in
the working capital requirement of a firm and hence is reduced to derive
at free cash flow to a firm.
b) If change in Non-Cash Working Capital is negative, it means an decrease in
the working capital requirement of a firm and hence is added to derive at
free cash flow to a firm.
Q12. Explain One Stage, Two Stage and Three Stage Model for the Valuation of
the firm
Answer:
(a) For one stage Model:
Intrinsic Value = Present Value of Stable Period Free Cash Flows to Firm
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Q13. Why FCFE Model of Equity Valuation is better than Dividend Based Model?
Answer:
✓ In the dividend discount model the analyst considers the stream of expected
dividends to value the company’s stock.
✓ It is assumed that the company follows a consistent dividend payout ratio
which can be less than the actual cash available with the firm.
✓ Dividend discount model values a stock based on the cash paid to
shareholders as dividend.
✓ A stock’s intrinsic value based on the dividend discount model may not
represent the fair value for the shareholders because dividends are
distributed from cash. In case the company is maintaining healthy cash in its
balance sheet then dividend pay-outs will be low which could result in
undervaluation of the stock.
✓ In the case of free cash flow to equity model a stock is valued on the cash
flow available for distribution after all the reinvestment needs of capex and
incremental working capital are met. Thus using the free cash flow to equity
valuation model provides a better measure for valuations in comparison to
the dividend discount model.
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In other words, for every 10 shares you hold, Wobble is offering you another
three at a deeply discounted price of $3. This price is 45% less than the $5.50
price at which Wobble stock trades.
As a shareholder, you have three options with a rights issue. You can
(1) subscribe to the rights issue in full,
(2) ignore your rights, or
(3) sell the rights to someone else.
Below we explore each option and the possible outcomes.
1. Take Up the Rights to Purchase in Full
To take advantage of the rights issue in full, you would need to spend
`3 for every Wobble share that you are entitled to purchase under the
issue. As you hold 1,000 shares, you can buy up to 300 new shares
(three shares for every 10 you already own) at the discounted price of
`3 for a total price of `900.
However, while the discount on the newly issued shares is 45%, the
market price of Wobble shares will not be `5.50 after the rights issue
is complete.
The value of each share will be diluted as a result of the increased
number of shares issued. To see if the rights issue does, in fact, give a
material discount, you need to estimate how much Wobble's share
price will be diluted.
In estimating this dilution, remember that you can never know for
certain the future value of your expanded shareholding since it can be
affected by business and market factors.
But the theoretical share price that will result after the rights issue is
complete—which is the ex-rights share price—is possible to calculate.
This price is found by dividing the total price you will have paid for all
your Wobble shares by the total number of shares you will own. This is
calculated as follows:
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To determine how much you may gain by selling the rights, you can to
estimate value on the nil-paid rights ahead of time.
Again, a precise number is difficult, but you can get a rough value by taking
the value of the ex-rights price and subtracting the rights issue price.
At the adjusted ex-rights price of `4.92 less `3, your nil-paid rights are
worth `1.92 per share.
n1 (Po − S)
Value of right =
n + n1
Alternatively
Value of right = P0 − P1
Ex Right Price (P1 ) = Market Price before right issue (Po) − Value of the Right
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Covered bond are backed by cash flows from mortgages or public sector
assets.
Perpetual bonds are also often called perpetuities. They have no maturity
date.
Deep Discount Bonds:
✓ A bond that sells at a significant discount from par value. A bond that is
selling at a discount from par value and has a coupon rate significantly
less than the prevailing rates of fixed-income securities with a similar risk
profile.
✓ Typically, a deep-discount bond will have a market price of 20% or more
below its face value.
✓ Deep discount bonds allow investors to lock in a better rate of return for
a longer period of time, since these bonds are not likely to be called.
✓ Investors also enjoy the leverage that comes with such investments.
However, investors must be prepared since these bonds are typically
higher risk.
Options in Bond
✓ Occasionally a bond may contain an embedded option; that is, it grants
option-like features to the holder or the issuer:
✓ Callable Bond: Some bonds give the issuer the right to repay the bond
before the maturity date on the call dates. These bonds are referred to
as callable bonds. Most callable bonds allow the issuer to repay the bond
at par. With some bonds, the issuer has to pay a premium. This is mainly
the case for high-yield bonds.
✓ Putable Bonds: Some bonds give the holder the right to force the issuer
to repay the bond before the maturity date on the put dates. These are
referred to as retractable or putable bonds.
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Formula:
𝐁𝐕 = 𝐈 𝐱 𝐏𝐕𝐀𝐅𝐘𝐓𝐌,𝐧 + 𝐑𝐕 𝐱 𝐏𝐕𝐅𝐘𝐓𝐌,𝐧
Where,
BV=Value of the bond or Theoretical Market Price or Intrinsic Value of the
bond [Present value of all the future cash flows]
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Q26. What is Yield Curve? What are the different types of yield curve?
Answer:
Yield curve is the graphical representation of yields on bond. The yield curve plots
time to maturity on the x-axis and yield on y-axis. The curve shows the relation
between interest rate and the maturity.
The term structure of interest rates, popularly known as Yield Curve, shows how yield
to maturity is related to term to maturity for bonds that are similar in all respects,
except maturity.
Consider the following data for Government securities:
Face Value Interest Maturity Current Yield to
Rate (yrs) Price Maturity
10000 0 1 8897 12.40
10000 12.75 2 9937 13.13
10000 13.50 3 10035 13.35
10000 13.50 4 9971 13.60
10000 13.75 5 9948 13.90
The yield curve for the above bonds is shown in the diagram (Type 1). It slopes
upwards indicating that long-term rates are greater than short-term rates.
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Where,
Weight = Weight of a Present Value of cash flows in Total Present Value
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Alternative 1
∑ 𝐏𝐕 𝐱 𝐘𝐫
𝐌𝐚𝐜 𝐃 =
∑ 𝐏𝐕
Draft Format
Year Cash flows PVF @ Present PV x Year
YTM Value(PV)
1 Interest
2 Interest
3 Interest
4 Interest + Principal
∑ 𝐏𝐕 ∑ 𝐏𝐕 𝐱 𝐘𝐫
Alternative 2
𝟏 + 𝐘𝐓𝐌 (𝟏 + 𝐘𝐓𝐌) + 𝐭(𝐜 − 𝐘𝐓𝐌)
𝐌𝐚𝐜 𝐃 = −
𝐘𝐓𝐌 𝐜[(𝟏 + 𝐘𝐓𝐌)𝐭 − 𝟏] + 𝐘𝐓𝐌
Where
c= coupon rate, t= Time to maturity, YTM = yield to maturity
Alternative 3
𝐭∗𝐜 𝐧∗𝐌
∑ +
(𝟏 + 𝐢) 𝐭 (𝟏 + 𝐢)𝐧
𝐌𝐀𝐂𝐃 =
𝐏
Where,
n= no. of cash flows, c= coupon rate
t= Time to maturity, i= Required yield
M= Maturity Value, P= Bond Price
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Q29. Why should the duration of a coupon carrying bond always be less than the
time to its maturity?
Answer:
Duration is nothing but the average time taken by an investor to collect his/her
investment. If an investor receives a part of his/her investment over the time on
specific intervals before maturity, the investment will offer him the duration which
would be lesser than the maturity of the instrument.
Higher the coupon rate, lesser would be the duration.
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The true relationship between the bond price and the yield-to-maturity is the
curved (convex) line shown in above diagram. This curved line shows the actual
bond price given its market discount rate. Duration (in particular, money
duration) estimates the change in the bond price along the straight line that is
tangent to the curved line. For small yield-to-maturity changes, there is little
difference between the lines. But for larger changes, the difference becomes
significant. The convexity statistic for the bond is used to improve the estimate
of the percentage price change provided by modified duration alone.
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Understanding Convexity (For those who wants to learn the reason behind this
concept, not a part of the syllabus and can be skipped)
What happens if Δy becomes very large? Does this simple relationship (ie, price
will change by MD* Δy) still hold? Well, only upto a point.
As Δy starts becoming larger, MD starts changing too. So to go back to our
example to yields changing from Y1 to Y2, if we could break down the move of
rates from Y1 to Y2 to lots of small Δy, we would see that at every step the MD is
slightly different from the previous one.
We could get an approximation of the price change using just the MD and
multiplying it by ΔY, but we could do better if we can take into account the fact
that the MD itself has changed during the move from Y1 to Y2.
But what about the ‘rate of change’ of the modified duration itself? Assume for
a moment that the modified duration at point Y1 is 10. But as we move from Y1
to Y2, MD starts decreasing. By the time we get to Y2, MD has come down to 4
(hypothetical). So as we estimate the price change based on a rate change from
Y1 to Y2, which MD should we use? The MD at point Y1 (which is 10), or the MD
at point Y2 (which is 4)?
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If you are still with me, great. Now let us talk about how we can use the second
derivative to arrive at the MD of “7” which we thought was intuitively a better
number to use than either 10 or 4. The second derivative represents the ‘rate of
change’ of the modified duration.
How much does the MD change as a result of the yield move from Y1 to Y2? Very
straightforward – it has declined by 6 (=10 – 4). Now Y1 was 3% and Y2 was 5%.
So for a 2% move in interest rates, modified duration has reduced by 6. Can we
express this in terms of a regular 1% move in yields? Sure.
We can say that for a 1% move in yield, the modified duration reduces by 3
(=6/2). This is the rate of change of modified duration.
This is what convexity is from a conceptual perspective – though not from a
formula point of view (we will get there in a second).
Now think about it for a minute – convexity represents the rate of change of
modified duration. Modified duration itself is the rate of change in price in
response to a change in yield.
Substituting, we can say convexity represents the rate of change of the rate of
change in price in response to a change in yield. That sounds very complex, but
in reality that is what it is.
The second derivative is the rate of change of the first derivative. But we prefer
to say it in the first simpler easier to understand way – ie, convexity reflects the
rate of change of modified duration.
With the above intuitive understanding, let us calculate convexity. Convexity can
be defined as ΔMD/ΔY – ie the change in MD divided by the change in yield. Now
MD itself = ΔP/ΔY.
Therefore
∆𝑃
∆( )
Convexity = ∆𝑌
∆𝑌
10 − 4
Convexity = = 300
3% − 5%
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The units of the numerator are ‘PriceChange% / Yield%’. The units of the
denominator are just ‘Yield%’. Therefore the units of convexity are
‘PriceChange% / Yield%2 ’. Now that is not quite easy to interpret – because of
the square term in the denominator.
If modified duration is 10, and convexity is 300, what is the effect of a change in
yield from 3% to 5% on a bond’s price? Looking at just the first derivative, the
answer will be = Modified duration * 2% = -10 * 2% = 20%. But we know that as
we move from 3% to 5%, the modified duration does not stay constant at 10
during this entire range, and we should adjust for that fact. How much do we
adjust? The modified duration at 3% would be too high, that at 5% be too low,
and somewhere in between is just right. If convexity is 300, then by the time the
rates go from 3% to 5% the modified duration would have moved by 300 * 2%.
We should take half of that as the adjustment.
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That is, the modified duration we should use is 10- ½ x (300 x 2%) in other words
Modified Duration – (½ x Convexity x ∆𝒀)
Since this is the new improved modified duration, in order to see the change in
price, we should multiply it by the change in yield, ΔY.
Modified Duration – (½ x Convexity x ∆𝑌) ∆𝑌
Modified Duration x ∆𝒀 – (½ x Convexity x ∆𝒀𝟐 )
This is nothing but the Taylor expansion that you would find in text books as being
the explanation as to how to get to changes in bond prices from a change in yield.
You can get a fairly good estimate of a change in a bond’s price by using only the
first term in the expression above. That will be a first order estimate. You can
improve the estimate by including the second term as well.
Hope the above explanation helps internalize something about modified
duration and convexity.
To summarize:
To interpret a modified duration number, think of it being the percent change in
value from a 1% change in yields. It is the first derivative of the price with respect
to yield. Because prices and yields move in different directions, the first
derivative is negative. Modified duration however skips the minus sign as a
convention.
To interpret a convexity number, think of it as being the percent change in
modified duration from a 1% change in yield. To estimate what the effect of
including convexity in a price change calculation for a 1% change in yield, multiply
the convexity by 1%^2=1%*1%.
If you think about it, convexity reflects the error in the estimation of a bond’s
price if modified duration alone were to be used in such an estimate. You fix part
of that by using the rate of change of the first derivative. (Actually, you could go
on. Even convexity does not stay constant over a range. You could account for
the rate of change of convexity – by using the third derivative! But that would
be quite pointless.)
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Another basic point – one might say that hey, I already know the bond pricing
formula, I can just calculate P1 and P2 and get the exact change in price to the
nth decimal place. I don’t need to do any approximations and mess with
convexity and modified duration. That is a fair point if you are only looking at
one bond. When you have a large portfolio of say thousands of bonds (consider
the Lehman or now Barclays Global Aggregate), then this full calculation of each
bond’s price becomes too intensive an exercise. It is easier to calculate the
duration of the portfolio, and its convexity, and estimate price changes and risk
using these rather than a full computation.
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interest rates. For example, if interest rates rise 1%, a bond with a two-year
duration will fall about 2% in value.
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Q35. A portfolio is immunized when its duration equals the investor's time horizon.
Explain
Answer:
Consider a 15.30% Rs.1000 Bond with 7 years to maturity is currently yielding at 10%
Following table shows the Duration, Bonds Price and Reinvested Coupons at the end of every
year at the original yield of 10% and when the yield increases to 11%
Time 0 1 2 3 4 5 6 7
Maturity 7 6 5 4 3 2 1 0
Coupon 153 153 153 153 153 153 153
Principal 1,000.00
Scenario I YTM 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
Duration 5 4.50 3.94 3.33 2.64 1.87 1.00
Bond Price 1,258.03 1,230.83 1,200.91 1,168.00 1,131.80 1,091.98 1,048.18 1,000.00
Reinv Coupons 153 321.3 506.43 710.073 934.0803 1,180.49 1,451.54
Total 1,258.03 1,383.83 1,522.21 1,674.43 1,841.88 2,026.06 2,228.67 2,451.54
Scenario II YTM 11.00% 11.00% 11.00% 11.00% 11.00% 11.00% 11.00%
Duration 4.95 4.47 3.92 3.32 2.64 1.87 1
Bond Price 1,202.62 1,181.91 1,158.92 1,133.41 1,105.08 1,073.64 1,038.74 1,000.00
Following table shows the Duration, Bonds Price and Reinvested Coupons at the end of every
year at the original yield of 10% and when the yield decreases to 9%
Time 0 1 2 3 4 5 6 7
Maturity 7 6 5 4 3 2 1 0
Coupon 153 153 153 153 153 153 153
Principal 1,000.00
Scenario I YTM 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
Duration 5 4.5 3.94 3.33 2.64 1.87 1
Bond Price 1,258.03 1,230.83 1,200.91 1,168.00 1,131.80 1,091.98 1,048.18 1,000.00
Reinv Coupons 153 321.3 506.43 710.07 934.08 1,180.49 1,451.54
Total 1,258.03 1,383.83 1,522.21 1,674.43 1,841.88 2,026.06 2,228.67 2,451.54
Scenario II YTM 9.00% 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%
Duration 5.05 4.53 3.96 3.34 2.65 1.87 1
Bond Price 1,317.08 1,282.61 1,245.05 1,204.10 1,159.47 1,110.82 1,057.80 1,000.00
Reinv Coupons 153 319.77 501.55 699.69 915.66 1,151.07 1,407.67
Total 1,317.08 1,435.61 1,564.82 1,705.65 1,859.16 2,026.48 2,208.87 2,407.67
: II-I 59.05 51.78 42.61 31.22 17.28 0.42 -19.8 -43.87
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Q36. Explain Forward Rates and how to calculate the Theoretical Forward Rates?
Answer: (This topic has more relevance in Interest Rate Risk Management Chapter)
Forward rates can be defined as the way the market is feeling about the future
movements of interest rates. They do this by extrapolating from the risk-free
theoretical spot rate. For example, it is possible to calculate the one-year forward
rate one year from now. Forward rates are also known as implied forward rates.
To compute a bond's value using forward rates, you must first calculate this rate.
After you have calculated this value, you just plug it into the formula for the
prices of a bond where the interest rate or yield would be inserted.
Example:
An investor can purchase a two-year Treasury bill (say rate is 10%) or buy a one-
year bill (say rate is 9%) and roll it into another one-year bill once it matures. The
investor will be indifferent if they both produce the same result. An investor will
know the spot rate for the one-year bill (10%) and the two-year bond (9%), but
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he or she will not know the value of a one-year bill that is purchased one year
from now. Given these two rates though, the forward rate on a one-year bill will
be the rate that equalizes the rupee return between the two types of
investments mentioned earlier.
2 year bond (10%) 100 110 121
Say S2 is the Spot Rate of 2 year bond and S1 is the Spot Rate of 1 year bond. F2 as
the Forward rate of one year bond one year from now (i.e. for 2nd year)
In the first case, 100 invested becomes 121 at the end of the 2nd year.
100 (1 + S2 )(1 + S2 ) =?
100 (1 + S2 )2 =?
100 (1 + 0.10)2 = 121
Now, in order that the arbitrage opportunity should not exist, what will be the
one year forward rate one year from now if Rs. 100 is invested at the one year
spot rate?
100 (1 + S1 )(1 + F2 ) = 121
Arranging the two equations above we get
100 (1 + S2 )2 = 121 … … … … . . (1)
100 (1 + S1 )(1 + F2 ) = 121 … … … … . . (2)
i.e. (1 + S2 )2 = (1 + S1 )(1 + F2 )
and hence
(1 + S2 )2
F2 =
(1 + S1 )
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Similarly we can find out one year forward rate for year 3 and year 4 and so on
(1 + S1 )
Year 1, F1 = −1
1
(1 + S 2 )2
Year 2, F2 = −1
(1 + S1 )
(1 + S3 )3
Year 3, F3 = −1
(1 + S1 )(1 + F2 )
(1 + S3 )3
Year 4, F4 = −1
(1 + S1 )(1 + F2 )(1 + F3 )
The bondholder keeps the bond for two years and collects a `60 interest
payment each year. At the end of year two, he elects to convert his bond into
20 shares of stock. By this time, the stock price has risen to `75 per share. The
bondholder converts his bond to 20 shares at `75 per share, and now his
investment is worth `1,500.
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2. Conversion Value: The nominal price per share at which conversion takes
place, this number is fixed at the issuance but could be adjusted under
some circumstance described in the issuance prospectus (e.g. underlying
stock split).
Conversion Value = Market price per common share x Conversion ratio
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7. Downside risk: Downside risk is the % premium over the straight value of
the bond. This value helps investors interpret downside risk of a
convertible bond because the convertible bond will not trade below its
straight bond value
Market price of convertible bond
−1
Straight value of the convertible bond
8. Conversion Parity Price or Market Conversion Price: Price at which the
investor will neither gain nor lose on buying the bond and exercising it. We
can find out the parity price by using following formula
Market price of bond
Conversion parity price =
Conversion ratio
Premium payback period explains the time taken to recover the premium
paid on purchase of convertible bonds through the extra returns earned in
the form of Interest per year.
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Practical Questions
1. Starlite Limited is having its share quoted in major stock exchanges. The
company is having a paid up capital of`10 lakh (`10 each share). Dividend is
distributed at the rate of 20% per annum. Annual growth rate in dividend is
expected at 2%. The expected rate of return on its equity capital is 15%.
Calculate the value of the share of Starlite Limited based on Gordon’s model.
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4. Truly Plc presently pay a dividend of £2.00 per share and has a share price of
£40.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever,
what is the firm’s expected or required return on equity using a dividend-
discount model approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected
to grow at a rate of 20% per annum for 5 years and 10% per year thereafter.
Now what is the firm’s expected, or required, return on equity?
5. The shareholders of Yellow pages ltd. have an opportunity cost of capital of 20%.
The company is making a steady profit of `25,00,000 annually and is following
a 100% DP ratio. At present there is an opportunity before the company that the
current income of`25,00,000 may be invested instead of paying out. This
investment will give rise to single pay off after three years. However, the normal
dividend of `25,00,000 p.a. would continue next year onwards.
What extra dividend the company must pay in three years time (out of the
earnings of the fresh investment) so that the equity shareholders are equally
content to wait for 3 years.
6. A company has a book value per share of `137.80. Its return on equity is 15%
and it follows a policy of retaining 60% of its earnings. If the Opportunity Cost
of Capital is 18%, what is the price of the share today?
--------------------------------[May 2002, 6 Marks] ------------------------------------
7. Z Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The
growth rate is likely to fall to 10% for the third year and fourth year. After
that the growth rate is expected to stabilize at 8% per annum. If the last
dividend paid was `1.50 per share and the investors’ required rate of return is
16%, find out the intrinsic value per share of Z Ltd. as of date. You may use
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9. The Beta Co-efficient of Target Ltd. is 1.4. The company has been
maintaining 8% rate of growth in dividends and earnings. The last dividend
paid was `4 per share. Return on Government securities is 10%. Return on
market portfolio is 15%. The current market price of one share of Target Ltd.
is `36.
a) What will be the equilibrium price per share of Target Ltd.?
b) Would you advise purchasing the share?
*[Refer Chapter Portfolio Management for the CAPM and Beta Concept]
10. Two companies A Ltd. and B Ltd. paid a dividend of `3.50 per share. Both are
anticipating that dividend shall grow @ 8%. The beta of A Ltd. and B Ltd. are
0.95 and 1.42 respectively.
The yield on GOI Bond is 7% and it is expected that stock market index shall
increase at an annual rate of 13%. You are required to determine:
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11. With the help of the following figures calculate the market price of the share
using Walter’s model and Dividend Growth model:
Earnings per share (EPS) `10
Retention ratio 60%
Cost of capital (k) 20%
Internal rate of return on investment 25%
Show your calculations under the PE Multiple approach and Earnings Growth
model.
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14. Goldi locks Ltd. was started a year back with equity capital of ` 40 lakhs. The
other details are as under:
Earnings of the Company `4,00,000
Price Earnings Ratio 12.5
Dividend Paid `3,20,000
Number of Shares 40,000
Find the current market price of the share. Use Walter's Model.
16. Zumo & Co. is a watch manufacturing company and is all equity financed and
has paid up capital `10,00,000 (`10 per shares)
The other data related to the company is as follows:
Year EPS Net dividend per share Share price
2004 4.20 1.70 25.20
2005 4.60 1.80 18.40
2006 5.10 2.00 25.50
2007 5.50 2.20 27.50
2008 6.20 2.50 37.20
Zumo & Co. has hired one management consultant, Vidal Consultants to analyze
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the future earnings and other related item for the forthcoming years.
As a Vidal Consultant’s report
(1) The earnings and dividend will grow at 25% for the next two years.
(2) Earnings are likely at rate of 10% from 3rd year and onwards
(3) Further if there is reduction in earnings growth occurs dividend payout ratio
will increase to 50%
Assuming the tax rate as 33% (not expected to change in the foreseeable future)
calculate the estimated share price and P/E Ratio which analysts now expect for
Zumo& Co. using the dividend valuation model.
You may further assume the post tax cost of capital is 18%.
17. Mr. A is thinking of buying shares at `500 each having face value of `100.
He is expecting a bonus at the ratio of 1:5 during the fourth year. Annual
expected dividend is 20% and the same rate is expected to be maintained on
the expanded capital base. He intends to sell the shares at the end of seventh
year at an expected price of `900 each. Incidental expenses for purchase and
sale of shares are estimated to be 5% of the market price. He expects a
minimum return of 12% per annum.
Should Mr. A buy the share? If so, what maximum price should he pay for
each share? Assume no tax on dividend income and capital gain.
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c. If the company’s cost of capital is 20% p.a. and the anticipated growth rate
is 19% p.a., calculate the market price per share.
19. DEF Ltd has been regularly paying a dividend of `19,20,000 per annum for
several years and it is expected that same dividend would continue at this level
in near future. There are 12,00,000 equity shares of `10 each and the share is
traded at par. The company has an opportunity to invest `8,00,000 in one year's
time as well as further `8,00,000 in two year's time in a project as it is estimated
that the project will generate cash inflow of `3,60,000 per annum in three year's
time which will continue forever. This investment is possible if dividend is
reduced for next two years. Whether the company should accept the project?
Also analyze the effect on the market price of the share, if the company decides
to accept the project.
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21. Following Financial data are available for PQR Ltd. for the year 2008 :
(` in lakh)
8% Debentures 125
10% bonds (2007) 50
Equity shares (Rs. 10 each) 100
Reserves and Surplus 300
Total Assets 600
Assets Turnovers ratio 1.1
Effective interest rate 8%
Effective tax rate 40%
Operating margin 10%
Dividend payout ratio 16.67%
Current market Price of Share 14
Required rate of return of investors 15%
price?
---------- [RTP, Nov 11, May 16] [MTP Oct 15, Mar 16, 8 Marks)-------
22. Lockheed Martin (LM ) the aerospace and defense conglomerate, has a stellar
dividend history, with steadily increasing quarterly payments since 1995. In
recent years, however, the rate of dividend growth has declined from a solid
15.6% in 2014 to 10% in 2016. Of course, the 2016 fiscal year has just begun
as of this writing, but the total dividend can be extrapolated from the first
quarter dividend of $1.65 per share and the company’s history of consistent
quarterly payments.
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Based on this steady rate of decline, it can be assumed that dividend growth will
again decrease by 2.8% in 2017 and then stabilize at a healthy 7.2% thereafter.
This example will use LMT’s actual dividend performance for 2013 through
2016, along with a projected decline and stabilization in 2017, to produce a value
estimate for the stock in 2013 using the H model dividend discount calculation.
For the purposes of this example, a 10% expected rate of return is used. The
number of years over which the growth rate will transition is four. calculate the
value estimate using the 2013 dividend payment of $4.60..
23. Consider the data given below and calculate the FCFE and FCFF.
Balance Sheet
Assets 2016 2015
Cash 30 15
Accounts Receivables 90 45
Inventory 120 90
Current Assets 240 150
Gross PPE 1200 900
Accumulated Depreciation 570 420
Total Assets 870 630
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Income Statement
2016 2015
Sales 900 750
COGS 360 300
Gross Profit 540 450
Selling and Admin. Exp. 105 90
EBITDA 435 360
Depreciation 150 120
EBIT 285 240
Interest Expense 45 30
EBT 240 210
Tax (30%) 72 63
Net Income 168 147
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25. An analyst has determined that the appropriate EV/EBITDA for Rainbow
Company is 10.2. The analyst has also collected the following forecasted
information for Rainbow Company:
EBITDA = $22,000,000
Market value of debt = $56,000,000
Cash = $1,500,000
Calculate The value of equity for Rainbow Company?
26. Jorge Zaldys, CFA, is researching the relative valuation of two companies in the
aerospace/defense industry, NCI Heavy Industries (NCI) and Relay Group
International (RGI). He has gathered relevant information on the companies in
the following table
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27. A company offers to its shareholders the right to buy 2 shares at `130 each for
every 5 shares of `100 each held in the company. The market value of the shares
is `200 each. Calculate the value of right.
29. Pragya Limited has issued 75,000 equity shares of `10 each. The current market
price per share is `24. The company has a plan to make a rights issue of one new
equity share at a price of `16 for every four share held.
You are required to :
(i) Calculated the theoretical post right price per share
(ii) Calculate the theoretical value of the right alone.
(iii) Show the effects of the right issue on the wealth of the shareholder who
has 1000 shares assuming he sells entire right.
(iv) Show the effect if the shareholder does not take any action
----------[RTP May 13, May 15, Nov 18] [MTP Feb 14, 5 Marks] ----------
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30. AB Limited’s shares are currently selling at `130 per share. There are
10,00,000 shares outstanding. The firm is planning to raise `2 crores to
Finance new project.
Required
(i) What is the ex-right price of shares and value of a right, if.
(ii) The firm offers one right share for every two shares held.
(iii) The firm offers one right share for every four shares held.
(iv) How does the shareholder’s wealth change from (i) to (ii)? How does
right issue increase shareholder’s wealth.
--------------------------------- [RTP May 2014] -----------------------------------
31. The value of a share of Morton Ltd. after right issue was found to be Rs.75.
The theoretical value of the right is Rs.5. The number of existing shares
required for a rights share is 2. Calculate the subscription price at which rights
were issued.
32. The current price of a share of Ronex Ltd. is Rs.55. The company is planning
to issue one right share for every four equity shares. If the company targets that
the ex-rights value of a share shall not fall below Rs.52, calculate the minimum
subscription price for one rights share.
33. The stock of the Soni plc is selling for £50 per common stock. The company
then issues rights to subscribe to one new share at £40 for each five rights held.
a) What is the theoretical value of a right when the stock is selling rights-on?
b) What is the theoretical value of one share of stock when it goes ex-rights?
c) What is the theoretical value of a right when the stock sells ex-rights at
£50?
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d) John Speculator has £1,000 at the time Soni plc goes ex-rights at £50 per
common stock. He feels that the price of the stock will rise to £60 by the
time the rights expire. Compute his return on his £1,000 if he (1) buys Soni
plc stock at £50, or (2) buys the rights as the price computed in part c,
assuming his price expectations are valid.
Sun Ltd., earns a profit of `32 lakhs annually on an average before deduction
of income- tax, which works out to 35%, and interest on debentures.
(a) Profit after tax covers fixed interest and fixed dividends at least 3
times.
Sun Ltd., has been regularly paying equity dividend of 8%. Compute the
value per equity share of the company.
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35. SAM Ltd. has just paid a dividend of `2 per share and it is expected to grow
@ 6% p.a. After paying dividend, the Board declared to take up a project
by retaining the next three annual dividends. It is expected that this project
is of same risk as the existing projects. The results of this project will start
coming from the 4th year onward from now. The dividends will then be
`2.50 per share and will grow @ 7% p.a.
An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least
`2,000 p.a. from this investment.
Show that the market value of the share is affected by the decision of the
Board. Also show as to how the investor can maintain his target receipt from
the investment for first 3 years and improved income thereafter, given that
the cost of capital of the firm is 8%.
36. A bond of`10000 bearing coupon rate 12% and redeemable in 8 years at par is
being traded at `10,600. Find out the YTM of the bond.
37. If the market price of the bond is `95; years to maturity = 6 yrs: coupon
rate = 13% p.a (paid annually) and issue price is `100. What is the yield to
maturity?
--------------------------[MTP Feb 14, 5 Marks]-----------------------------------
38. Following information is available in respect of a bond
Face value `1000
Coupon Rate 8%
Time to Maturity 10 years
Market Price `1140
Callable in 6 years `1100
Find out the YTM and YTC of the bond?
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39. An investor purchased a 10% bond at par value of`100. The time to maturity is
5 years. However, he sold the bond for `120 after two years. Out of the proceeds,
he immediately purchased a 7% bond which has 3 years maturity redeemable at
`130. Find out his YTM over a period of 5 years.
40. XYZ Ltd.’s bond (Face Value of `1000) with 4 years maturity is currently
trading at `900 carrying a coupon rate of 15%. Assuming that the
reinvestment rate is 16%, you are required to calculate Realized Yield to
Maturity of the bond.
-------------------------[MTP Sept 14, 8 Marks]-------------------------------------
41. There is a 9% 5-year bond issue in the market. The issue price is `90 and the
redemption price `105. For an investor with marginal income tax rate of 30%
and capital gains tax rate of 10% (assuming no indexation), what is the post-tax
yield to maturity?
42. A bond of Face Value of `1000 and Coupon rate of 9% is presently traded at
`750. The time to maturity is 10 years. It is expected that there will not be any
interest default by the issuing company but at the time of maturity, a price of
70% only may be received. Find out the expected YTM of the bond
43. The ELU co. is contemplating a debenture issue on the following terms:
Face Value `100 per debentures
Terms to maturity 7 years
Coupon rate
Year 1-2 8%
Year 3-4 12%
Year 5-7 15%
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The current market rate of interest in similar debentures is 15% p.a. The
company proposes to price the issue so as to yield a (compounded) return of
16% p.a. to the investors. Determine the issue price. Assume the redemption of
debenture at a premium of 5%.
The current market rate on similar debenture is 15% p.a. The company
proposes to price the issue in such a way that a yield of 16% compounded
rate of return is received by the investors. The redeemable price of the
debenture will be at 10% premium on maturity. What should be the issue
price of debenture?
0.862, 0.743, 0.641, 0.552, 0.476, 0.410, 0.354, 0.305, 0.263, 0.227
45. Consider two bonds, one with 5 years to maturity and the other with 20 years to
maturity. Both the bonds have a face value of `1000 and coupon rate of 8%
(with annual interest payments) and both are selling at par. Assume that the
yields of both the bonds fall to 6%, whether the price of bond will increase or
decrease? What percentage of this increase/decrease comes from a change in
the present value of bond’s principal amount and what percentage of this
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b) A bond with 7.5% coupon interest, Face value of `10,000 & term to
maturity of 2 years, presently yielding 6%. Interest payable half yearly.
47. Based on the credit rating of the bonds, A has decided to apply the following
discount rates for valuing bonds:
Credit Rating Discount Rate
AA AAA + 2% spread
A AAA+3% spread
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48. On 31st March, 2013, the following information about Bonds is available:
Name of the Face Maturity Date Coupon Coupon Date
security Value Rate
10% GOI 2018 100 31stMarch 2018 10.00% 31st March and 31st
October
Calculate:
1. If 10 years yield is 7.5% p.a. what price the Zero Coupon Bond would fetch
on 31st March, 2013?
2. What will be the annualized yield if the T-Bill is traded @ 98500?
3. If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price would
it fetch on April 1, 2013 (after coupon payment on 31st March)?
4. If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it
fetch on April 1, 2013 (after coupon payment on 31st March)?
49. ABC Ltd. issued 9%, 5 year bonds of `1,000/- each having a maturity of 3 years.
The present rate of interest is 12% for one year tenure. It is expected that
Forward rate of interest for one year tenure is going to fall by 75 basis points
and further by 50 basis points for every next year in further for the same tenure.
This bond has a beta value of 1.02 and is more popular in the market due to less
credit risk.
Calculate
(i) Intrinsic value of bond
(ii) Expected price of bond in the market
----------------------------------[Nov 18, 5 Marks]-------------------------------------
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51. Pet feed plc has outstanding, a high yield Bond with following features:
Face Value £ 10,000
Coupon 10%
Maturity Period 6 Years
Special Feature Company can extend the life of Bond to 12 years.
Presently the interest rate on equivalent Bond is 8%.
a. If an investor expects that interest will be 8%, six years from now then how
much he should pay for this bond now.
b. Now suppose, on the basis of that expectation, he invests in the Bond, but
interest rate turns out to be 12%, six years from now, then what will be his
potential loss/ gain.
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52. Consider a bond selling at its par value of `1,000, with 6 years to maturity and
a 7% coupon rate (with annual interest payment), what is bond’s duration? If
the YTM of the bond in (b) above increases to 10%, how it affects the bond’s
duration? And why?
54. A 5% bond with face value of `1000 is being traded in the market at`1000. It is
redeemable at par after 10 years. Find out the duration of the bond if the required
rate of return or YTM of the investor is 5%. Also find out the duration by short-
cut method?
55. Mr. A is planning for making investment in bonds of one of the two companies
X Ltd. and Y ltd. The detail of these bonds is as follows:
Company Face Value Coupon Rate Maturity Period
X ltd. `10,000 6% 5 years
Y ltd. `10,000 4% 5 years
The current market price of X Ltd’s bond is `10796.80 and both bonds have
same Yield to Maturity. Since Mr. A considers duration of bonds as the basis of
decision making, you are required to calculate the duration of each bond
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56. XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures
on January 1, 2011. These debentures have a face value of `100 and is
currently traded in the market at a price of `90.
Required :
(i) Estimate the current yield and the YTM of the bond.
(ii) Calculate the duration of the NCD.
------------------------------------[RTP, May-12]-----------------------------------
57. The following data is available for a bond:
Face Value 1000
Coupon Rate 11%
Years to Maturity 6
Redemption Value 1000
Yield to Maturity 15%
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58. Find the current market price of a bond having face value `1,00,000 redeemable
after 6 year maturity with YTM at 16% payable annually and duration 4.3202
years.
Given:1.16 6 = 2.4364
59. A bond is currently trading for 98.722 per 100 of par value. If the bond’s yield-
to-maturity (YTM) rises by 10 basis points, the bond’s full price is expected to
fall to 98.669. If the bond’s YTM decreases by 10 basis points, the bond’s full
price is expected to increase to 98.782. Calculate The bond’s approximate
convexity.
60. A bond has an annual modified duration of 7.020 and annual convexity of
65.180. If the bond’s yield-to-maturity decreases by 25 basis points, what is the
expected percentage price change?
61. A bond has an annual modified duration of 7.140 and annual convexity of
66.200. The bond’s yield-to-maturity is expected to increase by 50 basis
points. What is the expected percentage price change?
62. Based on the following price information for four bonds and assuming that all
four bonds are trading to yield 5%:
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1. Assuming all four bonds are selling to yield 5%, compute the value for C in
the convexity equation for each bond using a 25 basis point rate shock
(0.0025)
2. Using the value for C computed in question 12, compute the convexity
adjustment for the two 25-year bonds assuming that the yield changes by
200 basis points (0.02).
3. Compute the estimated percentage price change using duration 14.19 (5%y
yield, 25 year) & 12.94 (8% yield 25 year) and convexity adjustment if yield
changes by 200 basis points.
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63. The following data are available for three bonds A, B and C. These bonds
are used by a bond portfolio manager to fund an outflow scheduled in 6
years. Current yield is 9%. All bonds have face value of `100 each and will
be redeemed at par. Interest is payable annually.
Bond Maturity (Years) Coupon rate
A 10 10%
B 8 11%
C 5 9%
Present Values 6 7 8 9 10
PVIF0.09,t 0.596 0.547 0.502 0.460 0.4224
----------------------------[Nov 2018, 12 Marks]---------------------------------
64. Firm XYZ is required to make a $5M payment in 1 year and a $4M payment
in 3 years. The yield curve is flat at 10% APR with semiannual compounding.
Firm XYZ wants to form a portfolio using 1-year and 4-year U.S. strips to
fund the payments. How much of each strip must the portfolio contain for it
to still be able to fund the payments after a shift in the yield curve?
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66. XYZ Company has current earnings of `3 Per share with 5,00,000 shares
outstanding. The company plans to issue 40,000, 7% convertible preference
shares of `50 each at par. The preference shares are convertible into 2 shares for
each preference shares held. The equity share has a current market price of `21
per share.
a. What is preference share’s conversion value?
b. What is conversion Premium?
c. Assuming that total earnings remain the same, calculate the effect of the
issue on the basic earnings per share (a) before conversion and (b) after
conversion.
d. If profits after tax increases by`1 million what will be the basic EPS (a)
before conversion and (b) on a fully diluted basis?
------------------------------------[Nov 2009, 8 Marks]-------------------------------
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67. P Ltd. has current earnings of `6 per share with 10,00,000 shares
outstanding. The company plans to issue 80,000, 8% convertible
preference shares of `100 each at par. The preference shares are
convertible into 2 equity shares for each preference share held. The equity
share has a current market price of `42 per share. Calculate:
AAA rated company can issue plain vanilla bonds without conversion option
at an interest rate of 9.5%.
Required: Calculate as of today:
(i) Straight Value of bond.
(ii) Conversion Value of the bond.
(iii) Conversion Premium.
(i) Percentage of downside risk.
(ii) Conversion Parity Price.
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t 1 2 3
PVIF 0.9132 0.840 0.761
69. The following data is related to 8.5% Fully Convertible (into Equity shares)
Debentures issued by JAC Ltd. at `1000.
Market Price of Debenture `900
Conversion Ratio 30
Straight Value of Debenture `700
Market Price of Equity share on the date of Conversion 25
Expected Dividend Per Share `1
You are required to calculate:
(a) Conversion Value of Debenture
(b) Market Conversion Price
(c) Conversion Premium per share
(d) Ratio of Conversion Premium
(e) Premium over Straight Value of Debenture
(f) Favourable income differential per share
(g) Premium pay back period
----------------------------------------[May 2018, 8 Marks]-----------------------------------
70. Saranam Ltd. has issued convertible debentures with coupon rate 12%. Each
debenture has an option to convert to 20 equity shares at any time until the date
of maturity. Debentures will be redeemed at `100 on maturity of 5 years. An
investor generally requires a rate of return of 8% p.a. on a 5-year security. As an
investor when will you exercise conversion for given market prices of the equity
share of (i) `4, (ii) `5 and (iii) `6.
Cumulative PV factor for 8% for 5 years : 3.993
PV factor for 8% for year 5 : 0.681
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71. ABC Ltd. has `300 million, 12 per cent bonds outstanding with six years
remaining to maturity. Since interest rates are falling, ABC Ltd. is
contemplating of refunding these bonds with a `300 million issue of 6 year
bonds carrying a coupon rate of 10 per cent. Issue cost of the new bond will
be `6 million and the call premium is 4 per cent. `9 million being the
unamortized portion of issue cost of old bonds can be written off no sooner
the old bonds are called off. Marginal tax rate of ABC Ltd. is 30 per cent.
You are required to analyse the bond refunding decision. PVIFA (7%, 6
years) 4.766
----------------[RTP Nov 11, May 14] [MTP Mar 18, 8 Marks]---------------
72. Tangent Ltd. is considering calling `3 crores of 30 years, `1,000 bond issued
5 years ago with a coupon interest rate of 14 per cent. The bonds have a call
price of `1,150 and had initially collected proceeds of `2.91 crores since a
discount of `30 per bond was offered. The initial floating cost was `3,90,000.
The Company intends to sell `3 crores of 12 per cent coupon rate, 25 years
bonds to raise funds for retiring the old bonds. It proposes to sell the new
bonds at their par value of `1,000. The estimated floatation cost is `4,25,000.
The company is paying 40% tax and its after tax cost of debt is 8 per cent. As
the new bonds must first be sold and then their proceeds to be used to retire
the old bonds, the company expects a two months period of overlapping
interest during which interest must be paid on both the old and the new bonds.
You are required to evaluate the bond retiring decision. [PVIFA 8%, 25 =
10.675] (8 Marks)
------------------------------ [Nov 18, 8 Marks] -------------------------------------
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CA Final SFM CA Mayank Kothari
73. M/s. Earth Limited has 11% bond worth of `2 crores outstanding with 10
years remaining to maturity.The company is contemplating the issue of a `2
crores 10 year bond carrying the coupon rate of 9% and use the proceeds to
liquidate the old bonds.The unamortized portion of issue cost on the old bonds
is `3 lakhs which can be written off no sooner the old bonds are called. The
company is paying 30% tax and it's after tax cost of debt is 7%. Should Earth
Limited liquidate the old bonds?
You may assume that the issue cost of the new bonds will be `2.5 lakhs and
the call premium is 5%.
----------------------------------- [May 13, 6 Marks] -----------------------------------
74. A Ltd. has issued convertible bonds, which carries a coupon rate of 14%. Each
bond is convertible into 20 equity shares of the company A Ltd. The prevailing
interest rate for similar credit rating bond is 8%. The convertible bond has 5 years
maturity. It is redeemable at par at `100.
The relevant present value table is as follows.
(i) current market price of the bond, assuming it being equal to its
fundamental value,
(ii) minimum market price of equity share at which bond holder should
exercise conversion option; and
(iii) duration of the bond. (5 Marks)
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CA Final SFM CA Mayank Kothari
75. MP Ltd. issued a new series of bonds on January 1, 2010. The bonds were sold at
par (`1,000), having a coupon rate 10% p.a. and mature on 31st December, 2025.
Coupon payments are made semiannually on June 30th and December 31st each
year. Assume that you purchased an outstanding MP Ltd. bond on 1st March, 2018
when the going interest rate was 12%.
Required:
2. What amount you should pay to complete the transaction? Of that amount
how much should be accrued interest and how much would represent bonds
basic value
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CA Final SFM CA Mayank Kothari
77. Suppose Mr. A is offered a 10% Convertible Bond (par value `1,000) which
either can be redeemed after 4 years at a premium of 5% or get converted into
25 equity shares currently trading at `33.50 and expected to grow by 5% each
year. You are required to determine the minimum price Mr. A shall be ready
to pay for bond if his expected rate of return is 11%.
------------------------------------[RTP May 15]-----------------------------------
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CA Final SFM CA Mayank Kothari
(a) What is the expected price of the stock at the end of 2018?
(b) What is the value of the stock, using the two-stage dividend discount
model?
------------------------------------ [RTP May 2019] -----------------------------------
81. The risk-free rate of return Rf is 9 percent. The expected rate of return on the
market portfolio Rm is 13 percent. The expected rate of growth for the
dividend of Platinum Ltd. is 7 percent. The last dividend paid on the equity
stock of firm A was Rs. 2.00. The beta of Platinum Ltd. equity stock is 1.2.
(i) Calculate the equilibrium price of the equity stock of Platinum Ltd.?
(ii) Also, calculate the equilibrium price when
• The inflation premium increases by 2 percent?
• The expected growth rate increases by 3 percent?
• The beta of Platinum Ltd. equity rises to 1.3?
-----------------------------[MTP May 2019, 8 Marks] --------------------------
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CA Final SFM CA Mayank Kothari
82. A hypothetical company ABC Ltd. issued a 10% Debenture (Face Value of
`1000) of the duration of 10 years, currently trading at `850 per debenture.
The bond is convertible into 50 equity shares being currently quoted at `17
per share.
If yield on equivalent comparable bond is 11.80%, then calculate the spread
of yield of the above bond from this comparable bond.
The relevant present value table is as follows.
Present t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
Values
PVIF0.11, t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVIF0.13, t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295
83. The current market price of an equity share of a company is Rs. 120 and the
exercise price of the warrant is Rs. 80. An investor is holding a warrant giving
him the right to buy 2 ordinary shares from the company. Calculate the
minimum theoretical value of the warrant.
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