Pir Mehr Ali Shah

Arid Agriculture University, Rawalpindi

Office of the controller of Examinations
Final Exam (Theory) / Spring 2020 (Paper Duration 48 hours)
To be filled by Teacher

Course No.: …MGT-424…………Course Title:……Introduction to Business Finance ………………………………

Total Marks:……….…30…………………Date of Exam:………………07-08-2020…......................................
Degree: ……BBA…………………………………. Semester:………4 th…………… Section:……………………………………
Marks
Q.No. 1 2 3 4 5 6 7 8 9 10 Obtained/
Total Marks
Marks
Obtaine
d
Total Marks in Words:
Name of the teacher: Dr. Ahmed Imran
Who taught the course: Signature of teacher / Examiner:

To be filled by Student

Registration No.: ……..HASSAN JAVED.……… Name:……………18-ARID-5837……………..

Note: i: Plagiarism policy will be strictly followed, ii: Solve the paper in this sheet, iii: Don’t
change the templet, iv: only word document is acceptable to upload at LMS, v: writ your
section, exact name & registration number in particular places, vi: Answer all questions.

Q.No.1. Discuss in detail the important steps of Bond & Stock Evaluation? Elaborate
the major parts of Indenture and Features of Corporate Bond and give at least one
example. (Marks…10)
Answer: Bond & Stock Evaluation is basically the way to direct the theoretical fair value of a
particular bond. There are four steps to evaluate a bond & stock i.e. pricing of bond/stock,
yield to maturity, duration of bond, convexity.
1. Pricing of Bond/stock:
In this very first step of evaluation of bond and stock i.e. pricing, we focus on the
rates that at which rate or price we should buy bond/stock or at what price company should
sell the bond. The price of bond and stock changes with time even with every minute. Bonds
and stocks are often sold at those prices that are incompatible from its face value. In some
cases two or more parties agree on a specific price and can proceed with the sale. Selling of
bonds and stocks are majorly through a public sale or an exchange platform and the prices are
settled by the market so it can vary every time every single minute.
2. Yield to Maturity:
Yield to maturity can be defined as the average rate of return estimated, if the bond is
bought on the normal market rate and kept till its maturity. Yield to maturity varies over the
life of bond whereas coupon remains the same over life of bond. Understanding yield to
maturity in details, it is related to current yield in which cash inflows of the year is being
divided the market price of bond to calculate that how much profit one can make for buying a
bond or stock and keeping it for a year. One dissimilarity between current yield and YTM is
that YTM considerate in the time value of money i.e. the money a person is having right now
have more worth than the value of same amount of money in future, and current yield does
not calculate this.

3. Duration of Bond/Stock:
This is the 3rd step of evaluation of bond/stock. Duration is basically the average life
of bond/stock. It is also the measurement of the sensitivity of the pricing of bond/stock to a
change in the interest rate. The price of bond/stock is inversely proportional to the duration,
more the duration more price will decrease as interest rates rise. Suppose if the bond/stock
duration is 5 years and interest rate increases by 1% the price of the bond/stock will drop by
5% (1%*5years), likewise if the interest rate decrease by 1% the price will be effected by 5%
increase (1%*5years).

4. Convexity:
This is the 4th step of evaluating the bond/stock. Convexity is the sensitivity of the
bond price due to change in the interest rate. Convexity tells us that how much duration of the
bond/stock will change with the change in the interest rate. There are two types of convexity
i.e. negative and positive.
 If the duration of bond/stock increases with the increase in the yield, the bond/stock is
having the negative convexity.
 If the duration of bond/stock increase and there is a decrease in the yield, so the
bond/stock is having a positive convexity.

Indentures: An indenture is the type of legal contract between two or more parties, normally
done for the cases of bond agreements, real estate business etc.
Major parts of Indenture:
1. Coupon Rate:
Interest calculated on the face value of bond it is basically the interest rate that was
paid on the bond by the issuer to make sure the security.
2. Face Value:
Face value is the actual price that is written on the bond by its issuing authority. The
face value of bond is referred as its legal value. It is the amount that is paid to the holder at
the time of maturity.
3. Maturity:
Maturity means the life of a bond after which the bond issue must have to repay the
original bond value to the bond holder.
4. Payment Schedules:
It refers to the cycle of the payment i.e. annually, semi-annually, quarterly, monthly.
These are the cycles when the payment will be made to the bond holder and payment varies
between all the cycles.
5. Callable or Not:
Callable is meant by either the bond is bought back by the company or not before the
due date. An issuer may choose to demand their bond back if rate of interest in the market
goes down, this will make them to re-borrow at very beneficial rates.
6. Convertible or Not:
It means that the bond is convertible into stock at maturity or not. A bond can be
converted into fixed numbers of common stocks.
7. Redemption Value:
Redemption value is that at which the issuer may choose to repurchase the bond
before maturity time if that bond is callable.
8. Security:
The security of the bond refers to either the bond is secured or not. Secured bond is
which is secured by the issuer with an oath of his specific asset so that in case of default bond
issuer will pass the title of that asset to the bond holder. If the bond is secured it is known as
mortgage bond and if the bond is unsecured so we say it as naked bond.

Corporate Bond:
Corporate bond is the bond that is issued by a firm and it has maturity of more than a
year. By issuing of corporate bonds a company/firm can get its capital and in return the bond
holder or investor is paid a pre-determined number of interest payments that is either fixed or
variable rate of interest. There are two types of corporate bonds i.e. Domestic Bond & Global
bonds.
 Domestic Bonds are the bonds that only issued or offered to the local investors.
 Global Bonds are the bond that are normally issued to foreign investors.

Features of the Corporate Bond:

Foreign Bond:
If any US based Company issues the bond in Pakistan in Rs.
Currency will be same as per country.
Euro Bond:
If any US company issues the bond in Pakistan in dollars.
Currency will be different as per the country currency.
Dual Currency Bond:
Dual currency bond refers to the bond that have different currency for coupon and
have different currency for face value.
Currency Option Bond:
In currency option bonds coupon is the choice of the company and face value is the
desire of the company.
Cocktail Bond:
In case of cocktail bond company has choice on face value and coupon is the desire of
the company.
Zero Coupon Bond:
In zero coupon bonds there is no interest charged.
Coupon Payment Bond:
In coupon payment bond there is a fixed rate and floating rate, this rate is issued by
the state bank to other commercial banks for lending/borrowing with in the bank.
Mortgage Bond:
Mortgage bond refers to the bond which is being secured by the issuer in pledge to his
specific asset and in case of default the issuer will title the asset to bond holder.
Naked Bond:
Naked bond refers to an unsecured bond which has no security from the issuer.
Sukkuk Bond:
Sukkuk bond is the bond that is based on the shari laws, sukkuk bonds are Islamic
bond & Shari compliance bond.
Q.No.2. What is the free cash flow model to detect the fair price of a stock? Develop the
arguments why we name the financial assets disputable & undisputable? How we find
the fair price of stock? Discuss all Models in detail. (Marks…
10)
Answer: Free Cash Flow Model:
“Free cash flows are those which are available to distribute among bond holders
after all operating expenses, interest and principal payments have been paid”
Companies like to use free cash flow model when the company is not dividend paying, free
cash flows align with profitability within a reasonable forecast period with which the
company’s analysts are comfortable, or when the investor takes a control perspective. These
are the situations when companies like to propose free cash flows.
Requirements for Free Cash Flow:
 Operating Expenses
 Tax
 Working Capital
 Capital Expenditure

FCF=EBIT (1-Tax) + Depreciation ± NWC ± Capital Expenditures

 EBIT = Earnings Before Interest & Tax
 NWC = Change In Net Working Capital
 NWC = Net Working Capital
 WC = Current Asset
 NWC = CA – CL

Disputable & Undisputable Financial Asset:

Basically bonds are undisputable because they have fixed price written on the bond
and fixed % of face value. Whereas on the other hands stocks are disputable because there are
variations in the prices of shares in the market and dividends are also not fixed so they are
disputable.
 Disputable

Stocks

Market Price of
Dividend
share (MPS)

Variation in share
Not Fixed
price volatility

Undisputable

Bonds

Coupon Face Value

Fixed % of Face Fixed Price Written

Value (FV) on the bond

Calculating Fair Price of Stock:

By using respectable financial news, find out the closing price of the stock that you
are willing to buy. Let’s say that closing price is 25$ and you are willing to buy 100 shares so
the fair value of 100 shares will be 100*25$= 2500$. This is the simplest method of finding
the fair value of the stock. We can also find fair price of stock by using P/E (price to
earnings) ratio. Formula for calculating P/E is:
the current stock price per share / current earning per share
In this method we have to compare the ratios P/E for different companies of same industry.
For example if you want to find out the fair price of stock for utility, then you have to
compare P/E ratio of different companies from this industry. If a company has high ration of
P/E than it means that company is overvalued. And if any company has low ratio of P/E than
it means that company is undervalued. For example if I want to buy shares of a company that
has P/E ratio of 5 and the average P/E ratio of other companies from the same industry has 3
ratio than I can say that the stock I am willing to buy is too expensive or overvalued.
Models of Stock Pricing:
There are four models of pricing of Stock:
 Relative Models
 Cash Based Models
 Dividend Based Models
 Value Added Models

Relative Models: There are many different types of relative pricing ratios i.e. operating
margin, price to cash flow, price to sales (P/S), enterprise value (EV), price to free cash flow.
One of the most popular model used the most is Price to Earnings ratio (P/E). It is normally
calculated by dividing the stock price by earning per share (EPS). If a company has high ratio
of P/E and it is trading at a higher price as compared to other companies of same industry
then it is considered as overvalued. Likewise company having low P/E ratio trading at lower
price is considered as undervalued.

Cash Based Models: There are three models related to cash flow for valuation of stock i.e.
free cash flow approach, residual equity cash flow approach, and adjusted present value
approach. The most popular amongst these methods is free cash flow approach. Free cash
flows are the cash flows that are available for distribution to shareholders. Analysts like to
use free cash flow model when the company is not

 Dividend paying,
 Free cash flows align with profitability within a reasonable forecast period with which
the company’s analysts are comfortable, or
 When the investor takes a control perspective.
These are the situations when companies like to propose free cash flows.

Dividend Based Models:

There are three models falls under the Dividend Based Model. Basically Dividend
growth model is a pricing stock model which calculates the fair price of stock, supposing that
the dividends grow either at a fixed rate or at a variable rate. This model defines that if a
stock is undervalued or overvalued suppose that the company expected dividend grows at a
fixed value let’s say X forever, which will be subtracted from the required rate of return
(RRR). The DVM is used to define the price beyond which there is constant growth. Let's
observe another situation, one during which growth is predicted to alter as time goes on. This
is a common scenario because companies experience a life-cycle phenomena with rise within
the developing stage, slowing growth within the maturing stage, and possibly declining
growth within the finish of its existence. Further, companies may experience changes in their
growth because of acquisitions and divestitures.

Value Added Models: In value added models there are three more methods falls in this
model i.e. Economic value added, market value added, cash value added. From these
methods the most popular most used method by investor is economic value added model.
Economic value added (EVA) may be a measure of a company's financial performance
supported by the residual wealth calculated by subtracting its cost of capital from its
operating profit, adjusted for taxes on cash bases. EVA may also be denoted as economic
profit, because it attempts to capture genuine economic profit of a corporation. Formula for
calculating EVA:
Net Operating profit after taxes – invested capital*weighted average cost of capital.
EVA is the gradual difference in the rate of return over an organization’s cost of capital.
Fundamentally, it's used for the measurement of the value which a corporation generates
from funds invested into it. If a corporation’s EVA is negative, it means the corporation isn't
generating value from the funds invested into the business. Conversely, a positive EVA
shows that the corporation is generating value from the funds invested in it.

Q.No.3. Assume the data (Market Price per Share (MPS), Earning Price per Share
(EPS), Total Sales, Number of Shares) of at least five companies and calculate the fair
price (either from Price to Earnings Ratio or Sales to Price Ratio) of stock and make a
buying or selling decision. (Marks…
10)
Answer:

Company MPS EPS P/E Fair MPS Decision

A 60 35 60/35=1.71 1.51*35=52.85 Overvalued Sell
B 25 16 25/16=1.56 1.51*16=24.16 Overvalued Sell
 C 70 44 70/44=1.59 1.51*44=66.44 Overvalued Sell
D 12 9 12/9=1.33 1.51*9=13.59 Undervalue Buy
d
E 18 13 18/13=1.38 1.51*13=19.63 Undervalue Buy
d

P/E=MPS/EPS
Relative Model:
Price Earnings Ratio
 (P/E) of Company= ∑ (P/E) / No. of companies = 7.57/5 = 1.51
If there is Variation than there will be difference in between the actual and estimated/ Fair
Price.
 Fair MPS = (P/E) of company* EPS
 Overvalued: If Fair price is less than the MPS.
 Undervalued: If Fair price is greater than the MPS.

Thank You