Security Valuation, SFM Notes by CA Mayank Kothari

CA FINAL SFM
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
For support Call 8448449881 or Mail at support@Conferenza.in

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Content
Question Particulars Page no.
1 Discuss the four basic concepts of Return. 1
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
4 What are the methods used in Equity Valuation? 9
5 Explain Dividend based Equity Valuation Method? 9
6 Explain Earnings based Equity Valuation Method? 15
7 Discuss the free cash flow based valuation model. 15
8 How to calculate free cash flows to firm (FCFF)? 16
9 How to calculate free cash flows to equity (FCFE)? 18
10 How to calculate the Capital Expenditure 18
11 Explain how to calculate the change Non Cash working capital? 19
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
14 What is Enterprise Value? 20
15 Discuss Enterprise Value Multiples. 22
16 Define Issue of Right Shares 23
17 Explain how Right Issues work. 23
18 How to calculate the Ex-Right Price of shares 26
19 How to calculate the value of the right 26
20 How to Value Preference Shares? 28
21 Discuss the structure of Bonds. 28
22 What are the different types of bonds? 29
23 How to value a bond? 31
24 What is the bond value theorem? 32
25 Discuss the types of Yield 32
26 What is Yield Curve? What are the different types of yield curve? 34
27 What do you mean by the Duration of the Bond 37
28 How to calculate the Duration of Bond 37
29 Why should the duration of a coupon carrying bond always be less than the time to its maturity? 39
30 What is convexity and how it is adjusted with the duration? 40
31 Name the types of term structure theories? 46
32 Explain the Term Structure theories? 47
33 What is Immunization? 50
34 Explain the Effects of Bond Immunization? 51
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
37 Write Short notes on Convertible Bonds 54
38 Explain the structure of the convertible bonds. 56
39 How to value warrants? 58
Practical Questions 1-83 59-92

CA Final SFM CA Mayank Kothari
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
Q1. Discuss the four basic concepts of Return.

Answer:
1. Required Rate of Return
✓ Required rate of return is the minimum rate of return that the investor
is expected to receive while making an investment in an asset over a
specified period of time.
✓ This is also called opportunity cost or cost of capital because it is the
highest level of expected return forgone which is available elsewhere
from investment of similar risks.
✓ Many times, required rate of return and expected return are used
interchangeably. But, that is not the case.
✓ Expected return reflects the perception of investors.
✓ If the investors expect a return of a particular share higher than the
required return, then the share is undervalued. The reason is that the
share will sell for less than its intrinsic value.
✓ On the other hand, if the investors expect a return of a particular share
lower than its required rate of return, then the share is overvalued. The
reason is that it will sell for a higher price than its intrinsic value.
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✓ The difference between expected return and required return is called

expected alpha, and the difference between actual holding period
return and contemporaneous required return is called realized alpha.
✓ The source of expected alpha is mispricing. If true mispricing is present
in any security, the price of the security will eventually converge to its
intrinsic value, thus expected alpha will be realized.
✓ We can derive expected return given what we know about required
return and mispricing. Thus, expected return equals the sum of required
return plus return from convergence of the price over the period of time
Example: Suppose that the current price of the shares of ABC Ltd. is Rs.30
per share. The investor estimated the intrinsic value of ABC Ltd.’s share to
be Rs.35 per share with required return of 8% per annum. Estimate the
expected return on ABC Ltd.
Answer: Intel's expected convergence return is (35 - 30)/30 * 100 = 16.67%,
and let's suppose that the convergence happens over one year. Thus,
adding this return with the 8% required return, we obtain an expected
return of 24.67%.
Explanation: The intrinsic value estimate of Rs.35 and required return of
8% imply that you expect the share price to rise to Rs.37.80, which is up by
26.00% (rough estimate of 24.67%) from the current price of Rs.30
Required Return on Equity

✓ If equity risk premium is calculated as indicated above, required rate
of return can be easily calculated with the help of Capital Asset Pricing
Model (CAPM).
✓ The main insight of the model is that the investors evaluate the risk of
an asset in terms of the asset’s contribution to the systematic risk
(cannot be educed by portfolio diversification) of their total portfolio.
✓ CAPM model provides a relatively objective procedure for required
return estimation; it has been widely used in valuation.
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✓ So, the required return on the share of particular company can be

computed as below: Return on share ‘A’ = Risk free return + β x
Market Risk Premium
Example:
Risk free rate 5%,
Beta 1.5
market risk premium 4.5%
Calculate required return on equity.
Solution
Required return on share A = Risk free return + β x market Risk
Premium
= 0.05 +1.5 (0.045)
= 0.1175 or 11.75%
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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with an equivalent single interest rate which eventually gives the

same present value.
✓ Cash flows and discount rates for each year of cash flows at different
maturities have been given as below:-
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%
The present value of this stream of cash flows, by discounting each

cash flow with the respective discount rate, is Rs.1,278.99.
The single discount rate equates the present value of the stream of
cash flows to approximately
Rs.1278.99 at 4.4861% (any difference is due to rounding).
3. Internal Rate of Return
✓ Like net present value method, internal rate of return (IRR)
method also takes into account the time value of money.
✓ It analyzes an investment project by comparing the internal rate of
return to the minimum required rate of return of the company.
✓ The internal rate of return sometime known as yield on project is the
rate at which an investment project promises to generate a return
during its useful life.
✓ It is the discount rate at which the present value of a project’s net
cash inflows becomes equal to the present value of its net cash
outflows.
✓ In other words, internal rate of return is the discount rate at which a
project’s net present value becomes equal to zero
✓ Under this method, If the internal rate of return promised by the
investment project is greater than or equal to the minimum required
rate of return, the project is considered acceptable otherwise the
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project is rejected. Internal rate of return method is also known

as time-adjusted rate of return method
✓ To understand how computations are made and how a proposed
investment is accepted or rejected under this method, consider the
following example:
Example:
The management of VGA Textile Company is considering to replace an old
machine with a new one. The new machine will be capable of performing
some tasks much faster than the old one. The installation of machine will
cost $8,475 and will reduce the annual labor cost by $1,500. The useful
life of the machine will be 10 years with no salvage value. The minimum
required rate of return is 15%.
Required:
Should VGA Textile Company purchase the machine? Use internal rate of
return (IRR) method for your conclusion.
Solution:
To conclude whether the proposal should be accepted or not, the internal
rate of return promised by machine would be found out first and then
compared to the company’s minimum required rate of return.
The first step in finding out the internal rate of return is to compute a
discount factor called internal rate of return factor. It is computed by
dividing the investment required for the project by net annual cash
inflow to be generated by the project. The formula is given below:
Formula of internal rate of return factor:
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%).
4. Equity Risk Premium

✓ Equity risk premium is the excess return that investment in equity
shares provides over a risk free rate, such as return from tax free
government bonds.
✓ This excess return compensates investors for taking on the relatively
higher risk of investing in equity shares of a company.
✓ The size of the premium will change depending upon the level of risk
in a particular portfolio and will also change over time as market risk
fluctuates. Generally, high-risk investments are compensated with a
higher premium.
✓ The equity risk premium is based on the idea of the risk-reward
tradeoff.
✓ However, equity risk premium is a theoretical concept because it is
very difficult to predict that how a particular stock or the stock market
as a whole will perform in the future.
✓ Investment in equity shares of a company is a high risk investment.
✓ If an investor is providing money to invest in equity shares of a
company, he wants some premium over the risk free investment
avenues such as government bonds.
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✓ For example, if an investor could earn a 7% return on a government

bond (which is generally considered as risk free investment), a
company’s share should earn 7% return plus an additional return (the
equity risk premium) in order to attract the investor.
✓ Equity investors try to achieve a balance between risk and return.
✓ If a company wants to pursue investors to put their money into its
stock, it must provide a stimulus in the form of a premium to attract
the equity investors.
✓ If the stock gives a 15% return, in the example mentioned in the
previous paragraph, the equity risk premium would be 8% (15% - 7%
risk free rate).
✓ However, practically, the price of a stock, including the equity risk
premium, moves with the market. Therefore, the investors use the
equity risk premium to look at historical values, risks, and returns on
investments
✓ To calculate the equity risk premium, we can begin with the capital
asset pricing model (CAPM), which is usually written:
𝐑𝐱 = 𝐑𝐟 + 𝐁𝐞𝐭𝐚(𝐑𝐦 − 𝐑𝐟)
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
Page 7 of 92
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.
Q4. What are the methods used in Equity Valuation?

Answer:
There are three methods of Equity Valuation
1. Dividend Based Valuation
2. Earnings Based Valuation
3. Cash Flow Based Valuation
Q5. Explain Dividend based Equity Valuation Method?

Answer:
As we know that dividend is the reward for the provider of equity capital, the
same can be used to value equity shares. Valuation of equity shares based on
dividend are based on the following assumptions:
a. Dividend to be paid annually.
b. Payment of first dividend shall occur at the end of first year.
c. Sale of equity shares occur at the end of the first year and that to at ex-
dividend price.
The value of any asset depends on the discounted value of cash streams expected
from the same asset. Accordingly, the value of equity shares can be determined
on the basis of stream of dividend expected at required rate of return or
opportunity cost i.e. Ke (cost of equity).
Value of equity share can be determined based on holding period
1. Valuation Based One Year Holding Period: If an investor holds the share for
one year then the value of equity share is computed as follows:
D1 P1
Po = +
(1 + K e )1 (1 + K e )1
Page 9 of 92
Example : Share of X Ltd. is expected to be sold at Rs. 36 with a dividend of

Rs. 6 after one year. If required rate of return is 20% then what will be the
share price.
The expected share price shall be computed as follows:
6 36
Po = + = Rs. 35
(1 + 0.20)1 (1 + 0.20)1
2. Valuation Based on Multi Holding Period: In this type of holding following

three types of dividend pattern can be analyzed.
Three models used under Multi Holding Period

1. Zero Growth Model:
This model assumes that the dividend paid every year will remain
same and there will be no growth. Hence the price of the stock will be
dividend divided by the required rate of return. It is similar to
calculating the value of the perpetuity.
𝐃
𝐏=
𝐊𝐞
2. Constant Growth Model:
Also known as Gordon Growth Model assumes that dividends grow by
specific % every year
𝐃 𝟎 ( 𝟏 + 𝐠)
𝐏=[ ]
𝐊𝐞 − 𝐠
Where,
P = Market price of the share
D0 = Current year dividend
g = growth rate of the company
K e = Capitalization rate
Page 10 of 92
3. Variable Growth Model:

This is the extended version of Constant Growth Rate where the growth
rate changes after some years.
Say, 4% for first three years, 6% for next year and 5% there on till
perpetuity. Duration for which the growth rate remains same will be
counted as 1 stage, and then 2nd stage begins.
The calculation of intrinsic value is simple, each phase should be

calculated by using constant growth model and present values of each
stage should be added together to derive the intrinsic value of the
stock.
A) Two Stage Dividend Discount Model
While simple two stage model assumes extraordinary growth (or
supernormal growth) shall continue for finite number of years.
The normal growth shall prevail for infinite period. Accordingly,
the formula for computation of Share Price or equity value shall
be as follows:
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
B) Three Stage Dividend Discount Model

As per one version there are three phases for valuations:
a. explicit growth period,
b. transition period and
c. stable growth period.
 In the initial phase, a firm grows at an extraordinarily high

rate, after which its advantage gets depleted due to
competition leading to a gradual decline in its growth rate.
This phase is the transition phase, which is followed by the
phase of a stable growth rate.
 Accordingly, the value of equity share shall be computed, as
in case of two stage growth mode by adding discounted
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value of Dividends for two growth periods and finally

discounted value of share price at the beginning of
sustainable or stable growth period.
 There is another version of three stage growth model called
H Model. In the first stage dividend grows at high growth
rate, for a constant period then in second stage it declines
for some constant period and finally grow at sustainable
growth rate.
 H Model is based on the assumption that before
extraordinary growth rate reach to normal growth it
declines lineally for period 2H.
 Though the situation is complex but the formula for
calculation of equity share shall be as follows which is sum
of value on the normal growth rate and premium due to
abnormal growth rate:
D0 (1 + g n ) D0 H1 (g c − g n )
P0 = +
ke − gn ke − gn
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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Accuracy of the Model:

Empirical analysis has shown that the H model is most accurate when:
1. The high growth period is shorter i.e. the model would be less accurate if
we assumed a 20 year high growth period instead of a 5 year high growth
period
2. Also, the accuracy of the model increases when the spread between the
long term growth rate and the short term growth rate is less
To conclude, the H model is a significant advancement in the field of equity
valuation. It solves the problem of the abrupt decline in the growth rates that is
assumed by the other models. However, it still provides only an estimate, albeit
a better estimate than dividend discount models regarding the valuation of the
stock.
*These variants of models can also be applied to Free Cash Flow to Equity
Model discussed later
Example: Consider the data given below

Do 5
G1 0.12
Gn 0.08
Ke 0.15
High Growth period is of 4 years during which the growth rate will decline from
12% to 9% equally.
Page 13 of 92
Page 14 of 92
Q6. Explain Earnings based Equity Valuation Method?

Answer:
1) Gordons Model
EPS1 (1−b)
Ke−br
EPS1 = Earning per share for period 1,

b = retention ratio,
Ke = cost of equity,
r = return on investment
2) Walters Model
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
Q7. Discuss the free cash flow based valuation model.

Answer:
 Free cash flow valuation models discount the cash flows available to a firm
and equity shareholders after meeting its long term and short term capital
requirements. Based on the perspective from which valuations are done,
the free cash flow valuation models are classified as:
Page 15 of 92
1. Free Cash Flow to Firm Model (FCFF)

2. Free Cash Flow to Equity Model (FCFE)
 In the case of FCFF model, the discounting factor is the cost of capital (Ko)
whereas in the case of FCFE model the cost of equity (Ke) is used as then
discounting factor.
 FCFE along with DDM is used for valuation of the equity whereas FCFF model
is used to find out the overall value of the firm.
Q8. How to calculate free cash flows to firm (FCFF)?
Answer:
Example: Consider the following data for XYZ Co.
Sales 1000
Cost 700
Gross Profit 300
Other Expenses 40
EBITDA 260
Depreciation 50
EBIT 210
Interest 60
EBT 150
Tax 75
EAT 75
Add: Depreciation 50
Less: Change in Capital Expenditure 20
Less: Change in Non Cash Working 5
Capital
Less: Principal Repayment 10
Add: New Debt issued 15
FCFE 105
Page 16 of 92
(a) Based on its Net Income:

FCFF = EAT + I(1-t) + D -/+ Capex -/+ ∆WC
FCFF= 75+60(1-0.50)+50-20-5 = 130
FCFF= Net Income + Interest expense *(1-tax) + Depreciation -/+
Capital Expenditure –/+ Change in Non-Cash Working Capital
(b) Based on Operating Income or Earnings Before Interest and Tax

(EBIT):
FCFF= EBIT(1-t) + D -/+ Capex -/+ ∆WC
FCFF= 210(1-0.50)+50-20-5 = 130
FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital Expenditure –
/+ Change in Non-Cash Working Capital
(c) Based on Earnings before Interest, Tax , Depreciation and

Amortization (EBITDA):
FCFF= EBITDA(1-t) + D* tax rate -/+ Capex -/+ ∆WC
FCFF=260(1-0.50)+50(0.50)-20-5= 130
FCFF = EBITDA* (1-Tax) + Depreciation*(Tax Rate) -/+ Capital
Expenditure – /+Change in Non-Cash Working Capital
(d) Based on Free Cash Flow to Equity (FCFE):

FCFF= FCFE +I(1-t) + Principal – New Debt + Pref. Dividend
FCFF=105+60(1-0.50)+10-15+0= 130
FCFF = FCFE + Interest* (1-t) + Principal Prepaid - New Debt Issued
+ Preferred Dividend
Page 17 of 92
Q9. How to calculate free cash flows to equity (FCFE)?

Answer:
Free Cash flow to equity is used for measuring the intrinsic value of the stock for
equity shareholders. The cash that is available for equity shareholders after
meeting all operating expenses, interest, net debt obligations and reinvestment
requirements such as working capital and capital expenditure.
It is computed as:
FCFE= EAT + D –/+ Capex -/+ ∆WC + New Debt – Debt Repayment
Free Cash Flow to Equity (FCFE) = Net Income + Depreciation - Capital
Expenditures - Change in Non- cash Working Capital + New Debt Issued - Debt
Repayments
FCFE = 75+50-20-5+15-10 = 105
FCFE can also be used to value share as per multistage growth model approach.
Q10. How to calculate the Capital Expenditure

Answer:
Capital expenditure is the amount spent during the year for creating the capital asset
Debit Amount Credit Amount
Opening Fixed Assets XXXX Depreciation XX
CAPEX XX Sale of Fixed Asset XX
Closing Fixed Asset XXXX
XXXX XXXX
Capex = Closing FA + Fixed Asset Sold + Depreciation – Opening FA
Page 18 of 92
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
(b) For two stage Model:

Intrinsic Value = Present value of Explicit Period Free Cash Flows to Firm +
Present Value of Stable Period Free Cash Flows to a Firm,
or
Intrinsic Value = Present Value of Transition Period Free Cash Flows to Firm
+ Present Value of Stable Period Free Cash Flows to a Firm
Page 19 of 92
(c) For three stage Model:

Intrinsic Value=Present value of Explicit Period Free Cash Flows to Firm +
Present Value of Transition Period Free Cash Flows to Firm
+ Present Value of Stable Period Free Cash Flows to Firm
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.
Q14. What is Enterprise Value?

Answer:
✓ Enterprise value is the true economic value of a company.
✓ It is calculated by adding market capitalization, Long term Debt, Minority
Interest minus cash and cash equivalents. (Also Minus Equity investments
like affiliates, investment in any company and also Long term
investments.)
Page 20 of 92
EV = market value of common stock + market value of preferred

equity + market value of debt + minority interest - cash and
investments.
✓ Often times, the minority interest and preferred equity is effectively zero,
although this need not be the case. In that case the formula of Enterprise
becomes
EV = market value of common stock + market value of debt - cash and
investments.
✓ Enterprise value (EV) can be thought of as the theoretical takeover
price if a company were to be bought.
✓ EV differs significantly from simple market capitalization in several ways,
and many consider it to be a more accurate representation of a firm's
value. The value of a firm's debt, for example, would need to be paid off
by t he buyer when taking over a company, thus, enterprise value
provides a much more accurate takeover valuation because it includes
debt in its value calculation.
✓ Why doesn't market capitalization properly represent a firm's value? It
leaves a lot of important factors out, such as a company's debt on the one
hand and its cash reserves on the other. Enterprise value is basically a
modification of market cap, as it incorporates debt and cash for
determining a company's valuation
✓ For example, let's assume Company XYZ has the following characteristics:
Shares Outstanding: 1,000,000 Current Share Price: $5 Total
Debt: $1,000,000 Total Cash: $500,000
Based on the formula above, we can calculate Company XYZ's enterprise
value as follows:
($1,000,000 x $5) + $1,000,000 - $500,000 = $5,500,000
Page 21 of 92
Q15. Discuss Enterprise Value Multiples.

Answer:
What Is an Enterprise Multiple?
 Enterprise multiple, also known as the EV multiple, is a ratio used to
determine the value of a company.
 The enterprise multiple looks at a firm in the way that a potential acquirer
would by considering the company's debt.
 Stocks with an enterprise multiple of less than 7.5x based on the last 12
months (LTM) is generally considered a good value.
 However, using a strict cutoff is generally not appropriate because this is not
an exact science.
 Investors mainly use a company's enterprise multiple to determine whether
a company is undervalued or overvalued.
 A low ratio indicates that a company might be undervalued and a high ratio
indicates that the company might be overvalued.
1. Enterprise value to EBITDA Multiple
 An enterprise multiple is a ratio used to determine the value of a company.
 The enterprise multiple looks at a firm as a potential acquirer would, taking
into account the company's debt, which other multiples like the price-to-
earnings (P/E) ratio do not include. The multiple, also known as
the EBITDA multiple, is calculated as:
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐕𝐚𝐥𝐮𝐞
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞 =
𝐄𝐁𝐈𝐓𝐃𝐀
Where:
EV = (market capitalization) + (value of debt) + (minority interest) +
(preferred shares) - (cash and cash equivalents); and
EBITDA is earnings before interest, taxes, depreciation, and amortization.
 Also known as the EBITDA Multiple.
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2. Enterprise value to Sales multiple

This multiple is suitable for the corporates who maintain negative cash flows
or negative earnings as cyclical firms. Corporate like technological firms
generally use this multiple. Sales are the least manipulative top line in any
business and least affected by accounting policies.
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐕𝐚𝐥𝐮𝐞
𝐄𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞 =
𝐒𝐚𝐥𝐞𝐬
Q16. Define Issue of Right Shares

Answer:
Cash-strapped companies can turn to rights issues to raise money when they really
need it. In these rights offerings, companies grant shareholders the right, but not
the obligation, to buy new shares at a discount to the current trading price. We
explain how rights issues work and what they mean for the company and its
shareholders.
 A rights issue is an invitation to existing shareholders to purchase additional
new shares in the company.
 This type of issue gives existing shareholders securities called rights.
 With the rights, the shareholder can purchase new shares at a discount to
the market price on a stated future date.
 The company is giving shareholders a chance to increase their exposure to
the stock at a discount price.
Q17. Explain how Right Issues work.

Answer:
So, how do rights issues work? Let's say you own 1,000 shares in Wobble Telecom,
each of which is worth `5.50. The company is in financial trouble and needs to raise
cash to cover its debt obligations.
 Wobble, therefore, announces a rights offering through which it plans to
raise `30 million by issuing 10 million shares to existing investors at a price
of `3 each. But this issue is a three-for-10 rights issue.
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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:
Page 24 of 92
1000 existing shares at `5.50 `5500

300 new shares for cash at `3 `900
Value of 1300 shares `6400
Ex right value per share `4.92 (`6400/1300)
Ex- Right Value per share =

So, in theory, as a result of the introduction of new shares at the deeply
discounted price, the value of each of your existing shares will decline from
`5.50 to `4.92.
But remember, the loss on your existing shareholding is offset exactly by
the gain in share value on the new rights: the new shares cost you `3, but
they have a market value of `4.92.
2. Take Up the Rights to Purchase in Full

You may not have the `900 to purchase the additional 300 shares at `3
each, so you can always let your rights expire. But this is not normally
recommended.
If you choose to do nothing, your shareholding will be diluted thanks to
the extra shares issued by the company. This will result into loss in the
market value of your shareholding
Before Right Issue 1000 existing shares at `5.50 `5500
After Right Issue 1000 existing shares at `4.92 `4920
Loss `580
3. Sell Your Rights to Other Investors

In some cases, rights are not transferable. These are known as non-
renounceable rights. But in most cases, your rights allow you to decide
whether you want to take up the option to buy the shares or sell your
rights to other investors or the underwriter.
Rights that can be traded are called renounceable rights. After they have
been traded, the rights are known as nil-paid rights.
Page 25 of 92
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.
Q18. How to calculate the Ex-Right Price of shares

Answer: Ex-right price is the average price of the shares after the rights expires
nP0 + n1 S
Ex − Right Price (P1 ) =
n + n1
Where,
n = no. of existing shares
P0 = Price of Share Pre − Right Issue
n1 = no. of new shares issued under right issue
S = Subscription price of each right share
P1 = Ex Right Price
nP0 = Value of existing shares

n1 S = funds raised through right issue
n + n1 = No. of shares outstanding after the right issue
Q19. How to calculate the value of the right

Answer:
No. of right shares
Value of right = x (Market price − Subscription price)
Total Holding (Old + New)
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
Page 26 of 92
Page 27 of 92
Q20. How to Value Preference Shares?

Answer:
The value of redeemable preference share is the present value of all the
future expected dividend payments and the maturity value, discounted at
the required return on preference shares
a. Value of the redeemable preference shares
Dividend1 Dividend2 (Dividendn + Maturity Value)
+ + ⋯ +
(1 + r)1 (1 + r)2 (1 + r)n
b. Value of the irredeemable preference shares

𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐌𝐏 =
𝐊𝐩
Q21. Discuss the structure of Bonds.

Answer:
Face Value/Par Value: It is the amount which the borrower promises to repay
at the time of maturity. It is stated on the face of the bond certificate. (Rs.100)
Coupon Rate: It is the specific interest rate expressed as a percentage of face
value of the bond. It also represents the interest cost of the bond to the issuer
(8%). The interest or coupon is payable according to the frequency of the
bond. It may be annually, half yearly, quarterly etc.
Coupon Payments: It is the interest amount which the holder of bond has
right to receive from the issuer as per the frequency of the bond.
(100x8%=Rs.8)
Maturity Period: The maturity date represents the date on which the bond
matures, i.e., the date on which the face value is repaid. The last coupon
payment is also paid on the maturity date.
Market Value of the Bond: This is the bond’s issued price, the price at which
investor purchases the bond.
Redemption: Bullet i.e. one shot repayment of principal at par or premium.
Page 28 of 92
Q22. What are the different types of bonds?

Answer:
There are various types of bonds and some of these are as follows:
Fixed rate bonds
✓ A bond that pays the same amount of interest for its entire term.
✓ The benefit of owning a fixed-rate bond is that investors know with
certainty how much interest they will earn and for how long.
✓ As long as the bond issuer does not default, the bondholder can predict
exactly what his return on investment will be.
✓ An investor who wants to earn a guaranteed interest rate for a specified
term could purchase a fixed-rate treasury bond, corporate bond or
municipal bond.
Floating rate notes
 (FRNs, floaters) have a variable coupon that is linked to a reference rate
of interest, such as MIBOR. For example the coupon may be defined as
three month MIBOR + 2%.
Zero-coupon bonds (zeros)
 It pay no regular interest.
✓ They are issued at a substantial discount to par value, so that the interest
is effectively rolled up to maturity (and usually taxed as such).
✓ The bondholder receives the full principal amount on the redemption
date. Zero-coupon bonds may be created from fixed rate bonds by a
financial institution separating ("stripping off") the coupons from the
principal.
✓ In other words, the separated coupons and the final principal payment of
the bond may be traded separately.
Convertible bonds let a bondholder exchange a bond to a number of shares
of the issuer's common stock. We will discuss about the convertible bonds
in the later parts of the chapter.
Page 29 of 92
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.  
Page 30 of 92
Q23. How to value a bond?

Answer:
 Bond valuation is the determination of the fair price of a bond.
 The theoretical fair value of a bond is the present value of the cash flows it
is expected to generate (2Interest amount and Terminal value).
 Hence, the value of a bond is obtained by discounting the bond's expected
cash flows to the present using an appropriate discount rate which is the
return required by the investor. [YTM or YTC as the case may be]
 Suppose the bond is selling at Rs. 90 and the face value of the bond is Rs.100
with 10% coupon rate. Assuming that the bond will be redeemed at par,
return (YTM) to the investor in this case will be more than 10% as the bond
is selling cheap (i.e. at discount).
 Suppose the bond is selling at Rs. 105 and the face value of the bond is
Rs.100 with 10% coupon rate. Assuming that the bond will be redeemed at
par, return (YTM) to the investor in this case will be less than 10% as the
bond is selling is costly (i.e. at premium).
 Suppose the bond is selling at Rs. 100 and the face value of the bond is
Rs.100 with 10% coupon rate. Assuming that the bond will be redeemed at
par, return (YTM) to the investor in this case will be equal to 10% as the
bond’s price is same as that of face value (i.e. at par).
Summing up,
Face Value Market Value the bond is issued Relationship YTM&CR
100 90 at discount MP<FV YTM>CR
100 100 at par MP=FV YTM=CR
100 105 at premium MP>FV YTM<CR
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]
Page 31 of 92
I=Annual interest payable on the bond

RV=Redemption value of the bond.[May be at par, premium or discount]
n=maturity period of bond
YTM=yield to maturity or required rate of return or going rate on new bond
with same risk
Bond’s Value with semi-annual interest rate
𝐈
𝐁𝐕 = 𝐱 𝐏𝐕𝐀𝐅𝐘𝐓𝐌 + 𝐑𝐕 𝐱 𝐏𝐕𝐅𝐘𝐓𝐌
𝟐 𝟐
,𝟐𝐧
𝟐
,𝟐𝐧
Q24. What is the bond value theorem?

Answer:
CAUSE EFFECT
Required rate of return = coupon rate Bond sells at par value
Required rate of return > coupon rate Bond sells at a discount
Required rate of return < coupon rate Bond sells at a premium
Longer the maturity of a bond Greater the bond price
change with a given change
in the required rate of return.
Q25. Discuss the types of Yield

Answer:
1. Current Yield: The current yield or running yield, which is simply the annual
interest payment divided by the current market price of the bond (often
the clean price).
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐘𝐢𝐞𝐥𝐝 = 𝐱 𝟏𝟎𝟎
𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞
2. Yield to maturity (YTM) or redemption yield, which is a more useful
measure of the return of the bond, taking into account the current market
price, and the amount and timing of all remaining coupon payments and
Page 32 of 92
of the repayment due on maturity. It is equivalent to the internal rate of

return of a bond.
a) Average Method
(𝐑𝐕 − 𝐌𝐏)
𝐂+
𝐘𝐓𝐌 = 𝐧
(𝐑𝐕 + 𝐌𝐏)
𝟐
Where,
YTM= Yield to maturity
C= Coupon amount/interest amount
RV= Redemption value of the bond
MP=Market price of the bond
n= number of years left
b) Discounted Cash Flow Method (IRR Method)

𝐁𝐕 = 𝐈 𝐱 𝐏𝐕𝐀𝐅𝐘𝐓𝐌,𝐧 + 𝐑𝐕 𝐱 𝐏𝐕𝐅𝐘𝐓𝐌,𝐧
Where,
BV=Value of the bond [Present value of all the future cash flows]
I=Annual interest payable on the bond
RV=Redemption value of the bond.[May be at par, premium or
discount]
n=maturity period of bond
YTM=yield to maturity or required rate of return or going rate on new
bond with same risk
3. Yield to call: Annualized rate of return on the investment that the investor
expects to earn from the date of investment to the date of call (in case of
callable bonds). This has to be calculated using the same method as of
YTM, the only difference is ‘RV’ and the factor ‘n’. These two should be
considered for the callable period only.
Page 33 of 92
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.
Types of yield curve
Page 34 of 92
1. Upward Sloping Yield Curve ( Normal Yield Curve)

This is the most common shape for the curve and, therefore, is referred to as the
normal curve. The normal yield curve reflects higher interest rates for 30-year
bonds, as opposed to 10-year bonds. If you think about it intuitively, if you are
lending your money for a longer period of time, you expect to earn a higher
compensation for that.
2. Downward Sloping Yield Curve ( Inverted Yield Curve)

An inverted curve is when long-term yields fall below short-term yields. An
inverted yield curve occurs due to the perception of long-term investors that yields
will decline in the future. This can happen for a number of reasons, but one of the
main reasons is the expectation of a decline in inflation. When the yield curve
starts to shift towards an inverted shape, it is perceived as a leading indicator of
an economic downturn. Such interest rate changes have historically reflected the
market sentiment and expectations of the economy.
Page 35 of 92
3. Flat Yield Curve

A flat curve happens when all maturities have similar yields. This means that the
yield of a 10-year bond is essentially the same as that of a 30-year bond. A
flattening of the yield curve usually occurs when there is a transition between the
normal yield curve and the inverted yield curve.
4. Humped Yield Curve

A humped yield curve is when medium-term yields are greater than both the
short-term yields and long-term yields. A humped curve is rare and typically
indicates a slowing of economic growth. The Humped Yield Curve is quite rare and
rarely occurs.
Page 36 of 92
Q27. What do you mean by the Duration of the Bond

Answer:
 The concept of duration is straightforward. 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.
 It measures how quickly a bond will repay its true cost. The longer the time it
takes the greater exposure the bond has to changes in the interest rate
environment.
 Following are some of factors that affect bond's duration:
(i) Time to maturity: The shorter-maturity bond would have a lower
duration and less price rise and vice versa.
(ii) Coupon rate: Coupon payment is a key factor in calculation of duration
of bonds. The higher the coupon, the lower is the duration and vice
versa.
Q28. How to calculate the Duration of Bond

Answer: Although there are many formulae to calculate the duration. However,
following are commonly used methods:
1. Macaulay’s Duration of bond This formula measures the number of years
required to recover the true cost of a bond, considering the present value of all
coupon and principal payments received in the future. The formula for Macaulay
duration is as follows:
𝐌𝐀𝐂𝐃 = ∑ 𝐖𝐞𝐢𝐠𝐡𝐭 𝐱 𝐘𝐞𝐚𝐫
Where,
Weight = Weight of a Present Value of cash flows in Total Present Value
Page 37 of 92
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
Page 38 of 92
2. Modified Duration (%) or Volatility of the Bond

Another form of the duration is the Modified Duration, unlike Macaulay’s
duration modified duration measures the percentage change in price for a unit
change in yield.
Volatility of the bonds refers to the sensitivity of the bond price to change in
current interest rate. We can find out volatility of bond with the help of
macaulay’s duration:
𝐌𝐚𝐜𝐚𝐮𝐥𝐚𝐲 ′ 𝐬 𝐃𝐮𝐫𝐚𝐭𝐢𝐨𝐧
𝐕𝐨𝐥𝐚𝐭𝐢𝐥𝐢𝐭𝐲 𝐨𝐫 𝐌𝐨𝐝 𝐃 =
𝐘𝐓𝐌
(𝟏 + )
𝐧
Where, n = no. of compounding in a year
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.
Page 39 of 92
Q30. What is convexity and how it is adjusted with the duration?

Answer:
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.
Modified Duration is a good approximation of the percentage of price change

for a small change in interest rate. However, the change cannot be estimated so
accurately without convexity effect as duration base estimation assumes a
linear relationship
This estimation can be improved by adjustment on account of ‘convexity’. The
formula for convexity is as follows
Page 40 of 92
𝐏𝐕+ + 𝐏𝐕− − 𝟐𝐏𝐕𝟎

𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 =
𝟐𝐏𝐕𝟎 𝐱 ∆𝐘 𝟐
Where
PV+ = Bonds price when yield increases
PV− = Bonds price when yield decreases
PV0 = Initial Bond Price at given yield
∆Y = Change in Yield
Change in Market Price of the Bond with Convexity adjustment can be

calculated as follows
%∆𝐏𝐕 ≈ (−𝐀𝐧𝐧𝐌𝐨𝐝𝐃𝐮𝐫 𝐱 ∆𝐘𝐢𝐞𝐥𝐝) + [𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 𝐱 (∆𝐘𝐢𝐞𝐥𝐝)𝟐 ]
AnnModDur = Annual Modified Duration
Understanding Convexity (For those who wants to learn the reason behind this
concept, not a part of the syllabus and can be skipped)
Lets start from the Modified Duration (MD)

MD is a concept which represent the change in Bonds Value in numerator as
compared to change in YTM in Denominator
It can also be stated as ∆𝑃/∆𝑌. Where ∆𝑃 is the Change in Bonds Price and ∆𝑌 is
the change in YTM.
So when we say that the modified duration of a bond is 10, it is easy to
understand if we were to say that a modified duration of 10 means that a 1%
change in yield will cause a 10% change in price
Actually this is not exactly true.
A 1% change in yield is a fairly large change. What we mean really by modified
duration is the effect on price for a very small change in yield. The small change
in yield could be Δy. Modified duration is another way of saying that for a Δy
change in yield, the price will change by MD* Δy.
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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)?
The answer to this question is somewhere roughly in the middle would be a

reasonable approximation. In other words, something close to 7. Note that this
is fairly intuitive – we just took the middle point of the two MDs to be a fair linear
approximation.
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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.
Let us see how we interpret modified duration. Modified duration is the

percentage change in price from a 1% change in yield. So if modified duration is
10, we can say that a 1% change in yield leads to a 10*1% = 10% change in price.
Extending the analogy, what this means is that a convexity of 300 means a 1%
change in yield will lead to a 3% (0.03) change in price resulting from convexity –
in addition to the change in price resulting from the modified duration.
In other words, the convexity adjustment to the price will be over and above
what the modified duration suggests as the price change, and therefore including
convexity improves our estimates of price changes from changes in yield.
Now we come back to our original example. Yields change from 3% to 5%, and
as a result modified duration changes from 10 to 4. Now what is the effect on
price? Recall we had said that intuitively the ‘right’ duration to use as rates move
from Y1 to Y2 would be something in between, ie 7? Now let us look at how we
can get to this 7 if we know duration and convexity at point Y1 (3%).
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.
Q31. Name the types of term structure theories?

Answer:
The term structure theories explains the relationship between interest rates or bond
yields and different terms or maturities. The different term structures theories are as
follows:
1. Unbiased Expectation Theory: As per this theory the long-term interest
rates can be used to forecast short-term interest rates in the future on the
basis of rolling the sum invested for more than one period.
2. Liquidity Preference Theory: As per this theory forward rates reflect
investors’ expectations of future spot rates plus a liquidity premium to
compensate them for exposure to interest rate risk. Positive slope may be
a result of liquidity premium.
3. Preferred Habitat Theory: Premiums are related to supply and demand for
funds at various maturities not the term to maturity and hence this theory
can be used to explain almost any yield curve shape.
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Q32. Explain the Term Structure theories?

Answer: Note- The following text explains the term structure theories logically and is not a part of the ICAI Material.
Students can skip this topic, however it is recommended to go through it if you want to understand the topic as the
text given in ICAI Material for this topic is not sufficient.
1. Unbiased Expectation Theory: (Pure or Local Expectation Theory)

 Unbiased Expectations Theory states that current long-term interest
rates contain an implicit prediction of future short-term interest
rates.
 More specifically, the theory posits that an investor should earn the
same amount of interest from an investment in a single two-year
bond today as that person would with two consecutive investments
in one-year bonds.
 The two one-year bonds would each have a lower interest rate
individually compared with the two-year bond. However, because
of compounding interest, Unbiased Expectations Theory predicts
that the net outcome would be equal.
 If we assume the theory to be true, we can use it to make practical
predictions about the future of bond yields for our own investing.
 For example if you invest in 1 year 9% bond and use the proceeds to
invest for another 1 year 11% bond then it will give the same results
as investment made in 2 year 10% Bond
1. `100 x 1.09 x 1.11 = `121
2. `100 x 1.10 x 1.10 = `121
*This the same concept that we will learn in Forward Rate Topic
2. Liquidity Preference Theory:

 Whereas the unbiased expectations theory leaves no room for risk
aversion, liquidity preference theory attempts to account for it.
 Liquidity preference theory asserts that liquidity premiums exist to
compensate investors for the added interest rate risk they face
when lending long term and that these premiums increase with
maturity.
 Thus, given an expectation of unchanging short-term spot rates,
liquidity preference theory predicts an upward-sloping yield curve.
The forward rate provides an estimate of the expected spot rate that
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is biased upward by the amount of the liquidity premium, which

invalidates the unbiased expectations theory.
 For example, the US Treasury offers bonds that mature in 30 years.
However, the majority of investors have an investment horizon that
is shorter than 30 years.
 For investors to hold these bonds, they would demand a higher
return for taking the risk that the yield curve changes and that they
must sell the bond prior to maturity at an uncertain price. That
incrementally higher return is the liquidity premium.
 Note that this premium is not to be confused with a yield premium
for the lack of liquidity that thinly traded bonds may bear. Rather, it
is a premium applying to all long-term bonds, including those with
deep markets
3. Segment Market Theory:

 Unlike expectations theory and liquidity preference theory,
segmented markets theory allows for lender and borrower
preferences to influence the shape of the yield curve.
 The result is that yields are not a reflection of expected spot rates or
liquidity premiums. Rather, they are solely a function of the supply
and demand for funds of a particular maturity.
 That is, each maturity sector can be thought of as a segmented
market in which yield is determined independently from the yields
that prevail in other maturity segments.
 The theory is consistent with a world where there are asset/liability
management constraints, either regulatory or self-imposed. In such
a world, investors might restrict their investment activity to a
maturity sector that provides the best match for the maturity of
their liabilities. Doing so avoids the risks associated with an
asset/liability mismatch
 In summary, the segmented markets theory assumes that market
participants are either unwilling or unable to invest in anything
other than securities of their preferred maturity.
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 It follows that the yield of securities of a particular maturity is

determined entirely by the supply and demand for funds of that
particular maturity
4. Preferred Habitat Theory:

 The preferred habitat theory is similar to the segmented markets
theory in proposing that many borrowers and lenders have strong
preferences for particular maturities but it does not assert that
yields at different maturities are determined independently of each
other.
 However, the theory contends that if the expected additional
returns to be gained become large enough, institutions will be
willing to deviate from their preferred maturities or habitats.
 For example, if the expected returns on longer-term securities
exceed those on short-term securities by a large enough margin,
money market funds will lengthen the maturities of their assets.
 And if the excess returns expected from buying short-term securities
become large enough, life insurance companies might stop limiting
themselves to long-term securities and place a larger part of their
portfolios in shorter-term investments.
 The preferred habitat theory is based on the realistic notion that
agents and institutions will accept additional risk in return for
additional expected returns.
 In accepting elements of both the segmented markets theory and
the unbiased expectations theory, yet rejecting their extreme polar
positions, the preferred habitat theory moves closer to explaining
real-world phenomena. In this theory, both market expectations
and the institutional factors emphasized in the segmented markets
theory influence the term structure of interest rates
Page 49 of 92
Q33. What is Immunization?

Answer:
We know that when interest rate goes up although return on investment improves
but value of bond falls and vice versa. Thus, the price of Bond is subject to following
two risk:
1. Price Risk (Discussed in next question)
2. Reinvestment Rate Risk (Discussed in next question)
Further, with change in interest rates these two risks move in opposite direction.
Through the process of immunization selection of bonds shall be in such manner
that the effect of above two risks shall offset each other.
Teachers Note:
 Normally, interest rates affect bond prices inversely. When interest rates go
up, bond prices go down. But when a bond portfolio is immunized, the
investor receives a specific rate of return over a given time period regardless
of what happens to interest rates during that time. In other words, the bond
is "immune" to fluctuating interest rates.
 To immunize a bond portfolio, you need to know the duration of the bonds in
the portfolio and adjust the portfolio so that the portfolio's duration equals
the investment time horizon.
 For example, suppose you need to have $50,000 in five years for your child's
education. You might decide to invest in bonds. You can immunize your bond
portfolio by selecting bonds that will equal exactly $50,000 in five years
regardless of interest rate changes.
1. You can buy one zero-coupon bond that will mature in five years to equal
$50,000, or
2. several coupon bonds each with a five year duration, or
3. several bonds that "average" a five-year duration
 Duration measures a bond's market risk and price volatility in response to a
given change in interest rates. Duration is a weighted average of the bond's
cash flows over its life. (𝐌𝐀𝐂𝐃 = ∑ 𝐖𝐞𝐢𝐠𝐡𝐭 𝐱 𝐘𝐞𝐚𝐫). The weights are the present
value of each interest payment as a percentage of the bond's full
𝐏𝐕
price.(𝐖𝐞𝐢𝐠𝐡𝐭𝐬 = ∑ ) . The longer the duration of a bond, the greater its price
𝐏𝐕
volatility. Duration is used to determine how a bond will react to changing

Page 50 of 92
interest rates. For example, if interest rates rise 1%, a bond with a two-year
duration will fall about 2% in value.
Q34. Explain the Effects of Bond Immunization?

Answer:
 Changes to interest rates (∆𝒀) actually affect two parts of a bond's value.
One of them is a change in the bond's price, or price effect (∆𝑷). When
interest rates change before the bond matures, the bond's final value
changes, too. An increase in interest rates means new bond issues offer
higher earnings, so the prices of older bonds decline on the secondary
market.
 Interest rate fluctuations also affect a bond's reinvestment risk. When
interest rates rise, a bond's coupon may be reinvested at a higher rate.
When they decrease, bond coupons can only be reinvested at the new,
lower rates.
 Interest rate changes have opposite effects on a bond's price and
reinvestment opportunities. While an increase in rates hurts a bond's
price, it helps the bond's reinvestment rate. The goal of immunization is to
offset these two changes to an investor's bond value, leaving its worth
unchanged.
Interest Bonds Reinvestment Explanation
Rate Price Rate
Increase Decrease Increase Means the bad part is the decreased
bonds market price and good part is we
can re-invest the coupons at higher rate
Decrease Increase Decrease Means the good part is the increased
bonds market price and bad part is
coupons will be reinvested at lower rate
 A portfolio is immunized when its duration equals the investor's time

horizon. At this point, any changes to interest rates will affect both price
and reinvestment at the same rate, keeping the portfolio's rate of return
the same. Maintaining an immunized portfolio means rebalancing the
portfolio's average duration every time interest rates change, so that the
average duration continues to equal the investor's time horizon.
Page 51 of 92
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
Reinv Coupons 153 322.83 511.34 720.59 952.85 1,210.67 1,496.84
Total 1,202.62 1,334.91 1,481.75 1,644.75 1,825.67 2,026.49 2,249.41 2,496.84

 : II-I -55.4 -48.92 -40.46 -29.69 -16.21 0.43 20.74 45.3
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
Page 52 of 92
From the tables we see that:

 5 years is the duration of the bond at time 0.
 At year 5, whether y goes up or down, our portfolio value suffers only
a minor change in value.
 At time zero, if we set the duration equal to the target date (a point at
which we must fund some known obligation, e.g., `2,026 in 5 years),
and if we set the bond’s future value at the target date equal to the
amount of the obligation (i.e., the bond’s current value equal to the
current value of the obligation), then we are not greatly affected by
changes in y.
 In general, as long as target date = duration, and current value of assets
= current value of liabilities, we are said to be immunized
Summary
Target Period = Duration
PV of Assets = PV of Liabilities
Bond Portfolio Duration = ∑ 𝐖𝐢 𝐃𝐢
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
Page 53 of 92
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
100 109 121

1 year bond (9%) 1 year bond (?)
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 )
Q37. Write Short notes on Convertible Bonds

Answer:
Convertible bond is a type of bond that the holder can convert into a specified
number of shares of equity shares in the issuing company or cash of equal
value.
Example:
Consider an Infosys bond with a `1,000 par value that is convertible into
Infosys’s common stock. It has a coupon of 6%, payable annually. The bond’s
prospectus specifies a conversion ratio, which is the number of shares that the
investor will receive if he chooses to convert. In this example, Infosys’s
convertible bond has a conversion ratio of 20. The investor is effectively
purchasing 20 shares of Infosys stock for `50 per share (`1000 / 20 = `50).
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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What makes this feature attractive to investors is that it allows bondholders

to participate in the appreciation of the underlying security.
The conversion ratio is not the only aspect of a convertible bond to analyze.
Like other bonds, convertible bonds usually offer a coupon, and their prices
are based on prevailing market rates and the credit quality of the issuer.
Q38. Explain the structure of the convertible bonds.

Answer:
To compensate for having additional value through the option to convert the
bond to stock, a convertible bond typically has a coupon rate lower than that
of similar, non-convertible debt. The investor receives the potential upside of
conversion into equity while protecting downside with cash flow from the
coupon payments and the return of principal upon maturity.
From the issuer's perspective, the key benefit of raising money by selling
convertible bonds is a reduced cash interest payment. The advantage for
companies of issuing convertible bonds is that, if the bonds are converted to
stocks, companies' debt vanishes. However, in exchange for the benefit of
reduced interest payments, the value of shareholder's equity is reduced due
to the stock dilution expected when bondholders convert their bonds into
new shares.
Structure of convertible bonds
1. Conversion ratio: The number of shares each convertible bond converts
into. It may be expressed per bond.
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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3. Conversion premium: Difference between the conversion price and the

stock price at the issuance.
Market price of convertible bond − Conversion Value
The amount by which the price of a convertible security exceeds the

current market value of the common stock into which it may be converted.
4. Conversion premium Ratio: Ratio which shows at what premium the
convertible bond is trading in the market
Market price of convertible bond
Conversion Premium Ratio = −1
Conversion value
5. Straight Value of the bond: It is the price where the bond would trade if it
were not convertible to stock. Its then is equivalent to non-convertible
bond.
6. Minimum value of the convertible bond: A convertible bond should at the
lowest trade at the higher of either the conversion value or straight value.
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
9. Favourable Income Differential Per Share
Interest from Bond— (Dividend from Equity x CR)

Conversion Ratio
Page 57 of 92
10. Premium Payback Period

Conversion Premium
PPP =
Favourable Income Differential
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.
Q39. How to value warrants?

Answer:
A warrant is a right that entitles a holder to subscribe equity shares during a
specific period at a stated price. These are generally issued to sweeten the
debenture issue.
Although both convertible Debentures and Warrants appeared to one and same
thing but following are major differences.
1. In warrant, option of conversion is detachable while in convertible it is not
so. Due to this reason, warrants can be separately traded.
2. Warrants are exercisable for cash payment while convertible debenture
does not involve any such cash payment.
3. Theoretical value of warrant can be found as follows: (if Mp > E)
(Mp – E) x n
MP = Current Market Price of Share
E = Exercise Price of Warrant
n = No. of equity shares convertible with one warrant
4. When Mp<E, Theoretical value of Warrant is Zero i.e. its worthless
Page 58 of 92
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.
2. Calculate the implied Growth Rate and Return on Equity

Current stock price = `65
Next year’s dividend =`4
Capitalization rate =12%
Earnings retention ratio =50%
3. X Limited, just declared a dividend of `14.00 per share. Mr. B is planning to

purchase the share of X Limited, anticipating increase in growth rate from 8% to
9%, which will continue for three years. He also expects the market price of this
share to be `360 after three years.
You are required to determine:

(i) The maximum amount Mr. B should pay for shares, if he requires a rate of
return of 13% per annum.
(ii) The maximum price Mr. B will be willing to pay for share, if he is of the
opinion that the 9% growth can be maintained indefinitely and require 13%
rate of return per annum.
(iii) The price of share at the end of three years, if 9% growth rate is achieved
and assuming other conditions remaining same as in (i) above.
Calculate the rupee amount up to two decimal points.
Page 59 of 92
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
Page 60 of 92
the following table:

Years 0 1 2 3 4 5
Discounting Factor at 1 0.86 0.74 0.64 0.55 0.48
16%
8. The following information is collected from the annual reports of J Ltd:
Profit before Tax `2.50 Crores
Tax rate 40%
Retention Ratio 40%
Number of Outstanding Shares 50,00,000
Equity Capitalization Rate 12%
Rate of return on Investment 15%
What should be the market price per share according to Gordon's model of
dividend policy?
---------------------------------[May 2015, 4 Marks] --------------------------------
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:
Page 61 of 92
(a) Value of share of both companies.

(b) Why there is a difference in the value of shares of two companies.
(c) If current market price of share of A Ltd. and B Ltd. are `74 and `55
respectively. As an investor what course of action should be followed?
---------------------------------------[Nov 2015, RTP] ---------------------------------
*[Refer Chapter Portfolio Management for the CAPM and Beta Concept]
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%
12. Given the following information:

Current Dividend `5.00
Discount Rate 10%
Growth rate 2%
(i) Calculate the present value of the stock.
(ii) Is the stock over valued if the price is `40, ROE = 8% and EPS = `3.00.
Show your calculations under the PE Multiple approach and Earnings Growth
model.
13. The following information relates to Maya Ltd.

Earnings of the company `10,00,000
Dividend payout ratio 60%
No. of shares outstanding 2,00,000
Equity capitalization rate 15%
Return on investment 12%
What would be the market value per share as per Walter model?
Page 62 of 92
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.
15. The following information is given for QB Ltd.

Earnings per share `12
Dividend per share `3
Cost of capital 18%
Internal rate of return on investment 22%
Retention ratio 40%
Calculate the market price per share using
a. Gordon’s formula
b. Walter’s formula
---------------------------------[May 2011, 8 Marks] ----------------------------------
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
Page 63 of 92
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.
----------------------------------[May 2010, 4 Marks] ----------------------------------

18. Shares of Voyage Ltd. are being quoted at a price earning ratio of 8 times. The
company retains 45% of its earnings which are `5 per share.
You are required to compute:
a. The cost of equity to the company if the market expects growth rate of 15%
p.a.
b. If the anticipated growth rate is 16% p.a., calculate the indicative market
price with the same cost of capital.
Page 64 of 92
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.
---------------------------------[May 2011, 8 Marks] ----------------------------------
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.
20. Calculate the value of share from the following information

Profit of the company `290 crores
Equity capital of the company `1,300 crores
Par value of share `40 each
Debt Ratio of company 27
Long Run growth rate of the company 8%
Beta 0.1
Risk free interest rate 8.7%
Market returns 10.3%
Capital Expenditure per share `47
Depreciation per share `39
Change in working capital `3.45 per share
Page 65 of 92
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%
You are required to:

(i) Draw income statement for the year
(ii) Calculate its sustainable growth rate
(iii) Calculate the fair price of the Company's share using dividend
discount model, and

(iv) What is your opinion on investment in the company's share at current
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.
Page 66 of 92
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
Liabilities 2016 2015

Accounts Payable 60 60
Short Term Debt 60 30
Current Liabilities 120 90
Long term Debt 342 300
Common Stock 150 150
Retained Earnings 258 90
Total Liabilities and Equities 870 630
Page 67 of 92
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
24. The balance sheet of Hkurp Ltd is as follows

Non Current Assets 1000
Current Asset
Trade Receivables 500
Cash and Cash Equivalents 500
2000
Shareholders Funds 800

Long Term Debt 200
Current Liabilities and Provisions 1000
2000
The shares are actively traded and the current market price is 12 per share.
Shareholders funds represent 70 shares of 10 each and rest is retained earnings.
You are required to find out the Enterprise Value.\
Page 68 of 92
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
Company RGI NCI

Price per share 150 100
Shares Outstanding 5 Million 2 Million
Market Value of the debt 50 100
Book Value of debt 52 112
Cash and Investment 5 2
Net Income 49.5 12
Net Income from continuing operations 49.5 8
Interest Expense 3 5
Depreciation and Amortization 8 4
Taxes 2 3
Using the information in the table, answer the following questions:
a. Calculate P/EBITDA for NCI and RGI.

b. Calculate EV/EBITDA for NCI and RGI.
c. Which company should Zaldys recommend as relatively undervalued?
Justify the selection
Page 69 of 92
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.
28. Progressive Corporation is planning to raise funds by making rights issue of

equity shares to finance its expansion. The existing ordinary share capital of the
company is `1 crore. The par value of its shares is `10 and the market price is
`40.The alternatives under consideration before the management for making
rights issue are given below:
(a) 4 new shares for 5 old shares at par.
(b) 3 new shares for 5 old shares at `15
(c) 2 new shares for 5 old shares at `20
(d) One new share for 5 old shares at `25
You are required to analyse for each alternative:
(i) Theoretical market price after rights issue;
(ii) Value of rights;
(iii) Percentage increase in share capital,
(iv) Percentage increase in total funds.
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] ----------
Page 70 of 92
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?
Page 71 of 92
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.
34. Capital structure of Sun Ltd., as at 31.3.2003 was as under:

(` in lakhs)
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32
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.
Normal return on equity shares of companies similarly placed is 9.6%

provided:
(a) Profit after tax covers fixed interest and fixed dividends at least 3
times.
(b) Capital gearing ratio is 0.75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on

undistributed profits.
Sun Ltd., has been regularly paying equity dividend of 8%. Compute the
value per equity share of the company.
-------------------------------- [RTP May 17]-----------------------------------
Page 72 of 92
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%.
-----------------------[RTP May 18) [May 16, 8 Marks]-----------------------
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?
Page 73 of 92
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?
--------------------------------[May 2004, 5 Marks] ------------------------------------
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%
Page 74 of 92
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%.
44. Bright Computers Limited is planning to issue a debenture series with

a face value of `1,000 each for a term of 10 years with the following coupon
rates:
Years Rates
1-4 8%
5-8 9%
9-10 13%
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?
PVF @ 16% for 1 to 10 years are:
0.862, 0.743, 0.641, 0.552, 0.476, 0.410, 0.354, 0.305, 0.263, 0.227
---------------------------- [May 16, 5 Marks] --------------------------------
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
Page 75 of 92
increase/decrease comes from a change in the present value of bond’s interest

payments?
--------------------------------[Jun 2009, 8 Marks] ----------------------------------
46. Calculate Market Price of:
a) 10% Government of India security currently quoted at `110, but interest
rate is expected to go up by 1%
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.
--------------------------[Nov 2010, 5 Marks] ----------------------------------------
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
AAA 364 day T-bill rate +3% spread
AA AAA + 2% spread
A AAA+3% spread
He is considering to invest in a AA rated`1000 face value bond currently selling

at `1025.86. The bond has five years of maturity and the coupon rate on the
bond is 15% p.a. payable annually. The next interest payment is due one year
from today and the bond is redeemable at par.(Assume the 364 day T-bill rate
to be 9%).
You are required to:
(i) Calculate the intrinsic value of the bond for A. Should he invest in the
bond?
(ii) Calculate the Current Yield and the Yield to Maturity (YTM) of the
bond.
----------------------------[Nov 2011, 8 Marks] --------------------------------------
Page 76 of 92
48. On 31st March, 2013, the following information about Bonds is available:
Name of the Face Maturity Date Coupon Coupon Date
security Value Rate
Zero Coupon 10000 31st March 2023 NA NA
T-Bill 100000 20th June 2013 NA NA
10.71% GOI 100 31st March 2023 10.71% 31st March

2023
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]-------------------------------------
Page 77 of 92
50. John inherited the following securities on his uncle’s death:

Types of security Nos. Annual Maturity Yield
Coupon % years %
Bond A(`1,000) 10 9 3 12
Bond B(`1,000) 10 10 5 12
Preference shares C(`100) 100 11 * 13*
Preference shares D (`100) 100 12 * 13*
* Likelihood of being called at a premium over par.

Compute the current value of his uncle’s portfolio.
-----------------------[May 2000, 8 Marks][RTP May 17]-------------------------
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.
Page 78 of 92
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?
53. The following data are available for a bond

Face value `1,000
Coupon Rate 16%
Years to Maturity 6
Redemption value `1,000
Yield to maturity 17%
What are the current market price, duration and volatility of this bond?
Calculate the expected market price, if increase in required yield is by 75
basis points
-------------------------------[Nov 2005, 8 Marks] ----------------------------------
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
Page 79 of 92
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.
Interest on these NCDs will be paid through post-dated cheques. Interest

payments for the first 3 years will be paid in advance through post-dated
cheques while for the last 2 years post-dated cheques will be issued at the
third year. The bond is redeemable at par on December 31, 2015 at the end
of 5 years.
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%
(Round-off your answers to 3 decimals) Calculate the following in respect of

the bond:
a. Current Market Price.
b. Duration of the Bond.
c. Volatility of the Bond.
d. Expected market price if increase in required yield is by 100 basis points.
e. Expected market price if decrease in required yield is by 75 basis points.
Page 80 of 92
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
--------------------------------[May 2007, 6 Marks] ---------------------------------
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%:
Coupon 5.0% 5.0% 8.0% 8.0%

Yield Maturity 4 25 4 25
3.00% 107.4859 134.9997 118.7148 187.4992
4.00% 103.6627 115.7118 114.6510 162.8472
4.50% 101.8118 107.4586 112.6826 152.2102
4.75% 100.9011 103.6355 111.7138 147.2621
4.90% 100.3593 101.4324 111.1374 144.4042
5.00% 100.0000 100.0000 110.7552 142.5435
5.10% 99.6423 98.5959 110.3746 140.7175
5.25% 99.1085 96.5416 109.8066 138.0421
5.50% 98.2264 93.2507 108.8679 133.7465
6.00% 96.4902 87.1351 107.0197 125.7298
7.00% 93.1260 76.5444 103.4370 111.7278
Page 81 of 92
Percentage price change based on an initial yield of 5%

Coupon 5.00% 5.00% 8.00% 8.00%
Yield maturity 4 25 4 25
3.00% 7.49% 35.00% 7.19% 31.54%
4.00% 3.66% 15.71% 3.52% 14.24%
4.50% 1.81% 7.46% 1.74% 6.78%
4.75% 0.90% 3.64% 0.87% 3.31%
4.90% 0.36% 1.43% 0.35% 1.31%
5.00% 0.00% 0.00% 0.00% 0.00%
5.10% −0.36% −1.40% −0.34% −1.28%
5.25% -0.89% -3.46% -0.86% -3.16%
5.50% -1.77% -6.75% -1.70% -6.17%
6.00% -3.51% -12.86% -3.37% -11.80%
7.00% -6.87% -23.46% -6.61% -21.62%
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.
Page 82 of 92
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%
a. Calculate the duration of each bond.

b. The bond portfolio manager has been asked to keep 45% of the
portfolio money in Bond A. Calculate the percentage amount to
be invested in bonds B and C that need to be purchased to
immunise the portfolio.
c. After the portfolio has been formulated, an interest rate change
occurs, increasing the yield to 11%. The new duration of these
bonds are: Bond A = 7.15 Years, Bond B = 6.03 Years and Bond
C = 4.27 years. Is the portfolio still immunized? Why or why not?
d. Determine the new percentage of B and C bonds that are needed
to immunize the portfolio. Bond A remaining at 45% of the
portfolio.
Present values be used as follows :
Present Values 1 2 3 4 5
PVIF0.09,t 0.917 0.842 0.772 0.708 0.650
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?
Page 83 of 92
65. The data given below relates to a convertible bond

Face Value `250
Coupon Rate 12%
No. of Shares per bond 20
Market price of Share `12
Straight Value of bond `235
Market price of convertible bond `265
You are required to calculate
i) Stock value of the bond
ii) The percentage of downside risk
iii) The conversion premium
iv) The conversion parity price of the stock.
--------------------[Nov 2008, 8 Marks] [RTP Nov 15, Nov 17]-------------------
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]-------------------------------
Page 84 of 92
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:
(i) What is preference share's conversion value?

(ii) What is conversion premium?
(iii) Assuming that total earnings remain the same, calculate the effect of
the issue on the basic earning per share (A) before conversion (B) after
conversion.
(iv) If profits after tax increases by `20 Lakhs what will be the basic
EPS, (A) before conversion and (B) on a fully diluted basis?
------------------------------ [May 17, 8 Marks] -----------------------------------
68. GHI Ltd., AAA rated company has issued, fully convertible bonds on the
following terms, a year ago:
Face value of bond `1000
Coupon (interest rate) 8.5%
Time to Maturity (remaining) 3 years
Interest Payment Annual, at the end of year
Principal Repayment At the end of bond maturity
Conversion ratio (Number of shares per bond) 25
Current market price per share `45
Market price of convertible bond `1175
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.
Page 85 of 92
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
Page 86 of 92
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] -------------------------------------
Page 87 of 92
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.
𝐏𝐕𝐈𝐅𝟎.𝟏𝟒,𝒕 0.877 0.769 0.675 0.592 0.519

𝐏𝐕𝐈𝐅𝟎.𝟏𝟖,𝒕 0.926 0.857 0.794 0.735 0.681
You are required to estimate:(Calculations be made upto 3 decimal places)
(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)
Page 88 of 92
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:
1. What was the YTM of MP Ltd. bonds as on January 1, 2010?
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
76. Calculate the value of share from the following information:

Profit after Tax (PAT) of the company € 2900 million
Equity capital of company € 13,000 million
Par value of share € 40 each
Debt to Equity ratio of the company 1:3
Debt to Equity ratio of the proxy company 1:2
Beta of proxy company 0.20
Long run growth rate of the company 8%
Risk free interest rate 8.7%
Market returns 10.3%
Capital expenditure per share € 47
Depreciation per share € 39
Change in Working capital € 3.45 per share
Assume corporate tax rate to be 30% and Beta of Debt as zero.

-------[RTP Nov 13, May 15] [MTP Feb 15, Oct 15 Aug 16] [May 16, 5 Marks]----
Page 89 of 92
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]-----------------------------------
78. A share of Tension-free Economy Ltd. is currently quoted at a price earnings

ratio of 7.5 times. The retained earning being 37.5% is `3 per share. Calculate
(i) The company’s cost of equity, if investors’ expected rate of return is
12%.
(ii) Market price of share, if anticipated growth rate is 13% per annum with
same cost of capital.
(iii) Market price per share, if the company’s cost of capital is 18% and
anticipated growth rate is 15% per annum, assuming other conditions

remaining the same.
--------------------------------- [Nov 13, 8 Marks] ----------------------------------
79. M/s X Ltd. has paid a dividend of `2.5 per share on a face value of `10 in the
financial year ending on 31st March, 2009. The details are as follows:
Current market price of share `60
Growth rate of earnings and dividends 10%
Beta of share 0.75
Average market return 15%
Risk free rate of return 9%
Calculate the intrinsic value of the share.
Page 90 of 92
80. Seawell Corporation, a manufacturer of do-it-yourself hardware and

housewares, reported earnings per share of € 2.10 in 2013, on which it paid
dividends per share of €0.69. Earnings are expected to grow 15% a year from
2014 to 2018, during this period the dividend payout ratio is expected to remain
unchanged. After 2018, the earnings growth rate is expected to drop to a stable
rate of 6%, and the payout ratio is expected to increase to 65% of earnings.
The firm has a beta of 1.40 currently, and is expected to have a beta of 1.10
after 2018. The market risk premium is 5.5%. The Treasury bond rate is 6.25%.
(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] --------------------------
Page 91 of 92
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
-----------------------------[MTP May 2019, 7 Marks] --------------------------
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.
Page 92 of 92
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Security Valuation, SFM Notes by CA Mayank Kothari

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CA FINAL SFM

For support Call 8448449881 or Mail at support@Conferenza.in

1. Financial Policy & Corporate Strategy

2. Indian Financial System

1 Discuss the four basic concepts of Return. 1

4 What are the methods used in Equity Valuation? 9

5 Explain Dividend based Equity Valuation Method? 9

6 Explain Earnings based Equity Valuation Method? 15

7 Discuss the free cash flow based valuation model. 15

8 How to calculate free cash flows to firm (FCFF)? 16

9 How to calculate free cash flows to equity (FCFE)? 18

10 How to calculate the Capital Expenditure 18

11 Explain how to calculate the change Non Cash working capital? 19

14 What is Enterprise Value? 20

15 Discuss Enterprise Value Multiples. 22

16 Define Issue of Right Shares 23

17 Explain how Right Issues work. 23

18 How to calculate the Ex-Right Price of shares 26

19 How to calculate the value of the right 26

20 How to Value Preference Shares? 28

21 Discuss the structure of Bonds. 28

22 What are the different types of bonds? 29

23 How to value a bond? 31

24 What is the bond value theorem? 32

25 Discuss the types of Yield 32

27 What do you mean by the Duration of the Bond 37

28 How to calculate the Duration of Bond 37

30 What is convexity and how it is adjusted with the duration? 40

31 Name the types of term structure theories? 46

32 Explain the Term Structure theories? 47

34 Explain the Effects of Bond Immunization? 51

37 Write Short notes on Convertible Bonds 54

38 Explain the structure of the convertible bonds. 56

39 How to value warrants? 58

Practical Questions 1-83 59-92

Q1. Discuss the four basic concepts of Return.

✓ The difference between expected return and required return is called

Required Return on Equity

✓ So, the required return on the share of particular company can be

with an equivalent single interest rate which eventually gives the

The present value of this stream of cash flows, by discounting each

project is rejected. Internal rate of return method is also known

4. Equity Risk Premium

✓ For example, if an investor could earn a 7% return on a government

Q4. What are the methods used in Equity Valuation?

Q5. Explain Dividend based Equity Valuation Method?

Example : Share of X Ltd. is expected to be sold at Rs. 36 with a dividend of

2. Valuation Based on Multi Holding Period: In this type of holding following

Three models used under Multi Holding Period

3. Variable Growth Model:

The calculation of intrinsic value is simple, each phase should be

B) Three Stage Dividend Discount Model

 In the initial phase, a firm grows at an extraordinarily high

value of Dividends for two growth periods and finally

Accuracy of the Model:

Example: Consider the data given below

Q6. Explain Earnings based Equity Valuation Method?

EPS1 = Earning per share for period 1,

Q7. Discuss the free cash flow based valuation model.

1. Free Cash Flow to Firm Model (FCFF)

(a) Based on its Net Income:

(b) Based on Operating Income or Earnings Before Interest and Tax