Chapter 4

SECURITY
VALUATION
Space for your notings of Formulae or important points
 | Chapter 4A: Security Valuation: Equity

Question 1(Study Material TYK Q 1)

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%, compute is the
price of the share today using both Dividend Growth Model and Walter’s Model.
Solution
The company earnings and dividend per share after a year are expected to be:

EPS ₹ 20.67

Dividend

The growth in dividend would be: g = 0.6 x 0.15 = 0.09

a) As per Dividend Growth Model,

Perpetual Growth Model Formula:

b) Walter’s approach showing relationship between dividend and share price can be expressed
by the following formula

Where,
Vc = Market Price of the ordinary share of the company.
Ra = Return on internal retention i.e. the rate company earns on retained profits.
Rc = Capitalization rate i.e. the rate expected by investors by way of return from particular
category of shares.
E = Earnings per share.
D = Dividend per share.

Hence,

= ₹ 103.35

Question 2(Study Material TYK Q 3)

MNP Ltd. has declared and paid annual dividend of ₹ 4 per share. It is expected to grow @ 20%
for the next two years and 10% thereafter. The required rate of return of equity investors is
15%. Compute the current price at which equity shares should sell.
Note: Present Value Interest Factor (PVIF) @ 15%:
For year 1 = 0.8696;
For year 2 = 0.7561

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Solution

TV =

P =

= 4.80 x 0.8696 + 5.76 x 0.7561 + 126.72 x 0.7561 = 104.34

Question 3(Study Material TYK Q 5)/MTP Oct’19

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 ₹ 360.00 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 (ii) above
Calculate rupee amount up to two decimal points.
Year-1 Year-2 Year-3
FVIF @ 9% 1.090 1.188 1.295
FVIF @ 13% 1.130 1.277 1.443
PVIF @ 13% 0.885 0.783 0.693
Solution
(i) Expected dividend for next 3 years.

Year 1 (D1) ₹ 14.00 (1.09) = ₹ 15.26

Year 2 (D2) ₹ 14.00 (1.09)2 = ₹ 16.63

Year 3 (D3) ₹ 14.00 (1.09)3 = ₹ 18.13

Required rate of return = 13% (Ke)

Market price of share after 3 years = (P3) = ₹ 360

The present value of share

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P0 = 15.26(0.885) + 16.63(0.783) +18.13(0.693) + 360(0.693)

P0 = 13.50 + 13.02 + 12.56 + 249.48

P0 = ₹ 288.56

(ii) If growth rate 9% is achieved for indefinite period, then maximum price of share should
Mr. A willing to be pay is
= = = ₹ 381.50

(iii) Assuming that conditions mentioned above remain same, the price expected after 3 years
will be:
= =

Question 4(Study Material TYK Q 6)/RTP Nov’18

Piyush Loonker and Associates presently pay a dividend of Re. 1.00 per share and has a share
price of ₹ 20.00.
(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?

Solution
(i) Firm’s Expected or Required Return on Equity

(Using a dividend discount model approach)

According to Dividend discount model approach the firm’s expected or required return on
equity is computed as follows:

Where,

Ke = Cost of equity share capital or (Firm’s expected or required return on equity share
capital)

D1 = Expected dividend at the end of year 1

P0 = Current market price of the share.

g = Expected growth rate of dividend.

Now, D1 = D0 (1 + g) or ₹ 1 (1 + 0.12) or ₹ 1.12, P0 = ₹ 20 and g = 12% per annum

Therefore,

Or,

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(ii) Firm’s Expected or Required Return on Equity

(If dividends were expected to grow at a rate of 20% per annum for 5 years and 10% per
year thereafter)

Since in this situation if dividends are expected to grow at a super normal growth rate g s,
for n years and thereafter, at a normal, perpetual growth rate of gn beginning in the year
n + 1, then the cost of equity can be determined by using the following formula:

Where,

gs = Rate of growth in earlier years.

gn = Rate of constant growth in later years.

P0 = Discounted value of dividend stream.

Ke = Firm’s expected, required return on equity (cost of equity capital).

Now,

gs = 20% for 5 years, gn = 10%

Therefore,

Or po= 1.20 (PVF1, Ke) + 1.44 (PVF2, Ke) + 1.73 (PVF3, Ke) + 2.07 (PVF4, Ke) + 2.49
(PVF5, Ke) +

By trial and error we are required to find out Ke

Now, assume Ke = 18% then we will have

= ₹ 1.017 + ₹ 1.034 + ₹ 1.053 + ₹ 1.068 + ₹ 1.09 + ₹ 14.97= ₹ 20.23

Since the present value of dividend stream is more than required it indicates that Ke is
greater than 18%

Now, assume Ke = 19% we will have.

= ₹ 1.008 + ₹ 1.017 + ₹ 1.026+ ₹ 1.032 + ₹ 1.043 + ₹ 12.76

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= ₹ 17.89

Since the market price of share (expected value of dividend stream) is ₹ 20. Therefore,
the discount rate is closer to 18% than it is to 19%, we can get the exact rate by
interpolation by using the following formula:

Where,

LR = Lower Rate

NPV at LR = Present value of share at LR

NPV at HR = Present value of share at Higher Rate

Δr = Difference in rates

Therefore, the firm’s expected, or required, return on equity is 18.10%. At this rate the
present discounted value of dividend stream is equal to the market price of the share.

Question 5(Study Material TYK Q 8)

ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The company has paid
dividend @ ₹ 3 per share. The rate of return on market portfolio is 12 percent and the risk-free
rate of return in the market has been observed as 8 percent. The Beta co-efficient of
company’s share is 1.5.
You are required to calculate the expected rate of return on company’s shares as per CAPM
model and equilibrium price per share by dividend growth model.
Solution:

CAPM formula for calculation of Expected Rate of Return is:

= 8 + 1.5 (12 – 8)

= 8 + 1.5 (4)

=8+6

=14% or 0.14

Applying Dividend Growth Model for the calculation of per share equilibrium price:

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Per share equilibrium price will be ₹ 82.50.

Question 6(Study Material TYK Q 9)

A Company pays a dividend of ₹ 2.00 per share with a growth rate of 7%. The risk free rate is
9% and the market rate of return is 13%. The Company has a beta factor of 1.50. However, due
to a decision of the Finance Manager, beta is likely to increase to 1.75. Find out the present as
well as the likely value of the share after the decision.
Solution
In order to find out the value of a share with constant growth model, the value of Ke should be
ascertained with the help of ‘CAPM’ model as follows:

Where,
Ke = Cost of equity
Rf = Risk free rate of return
β = Portfolio Beta i.e. market sensitivity index
Km = Expected return on market portfolio

By substituting the figures, we get

Ke = 0.09 + 1.5 (0.13 – 0.09) = 0.15 or 15%

and the value of the share as per constant growth model is

Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke = Cost of equity
g= growth

Alternatively, it can also be found as follows:

However, if the decision of finance manager is implemented, the beta (β) factor is likely to
increase to 1.75 therefore, Ke would be

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= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%

The value of share is

Alternatively, it can also be found as follows:

Question 7(Study Material TYK Q 11)/PP Nov’18

Shares of Voyage Ltd. are being quoted at a price – earning ratio of 8 times. The company
retains ₹ 5 per share which is 45% of its Earning Per Share.
You are required to compute
(i) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(ii) If the anticipated growth rate is 16% per annum, calculate the indicative market price
with the same cost of capital.
(iii) If the company's cost of capital is 20% p.a. & the anticipated growth rate is 19% p.a.,
calculate the market price per share.
Solution

(i) Cost of Capital

Retained earnings (45%) ₹ 5 per share

Dividend (55%) ₹ 6.11 per share

EPS (100%) ₹ 11.11 per share

P/E Ratio 8 times

Market price ₹ 11.11 x 8 = ₹ 88.88

Cost of equity capital

(ii) Market Price

(iii) Market Price

Question 8(Old PM)

A share of Tension-free Economy Ltd. is currently quoted at, a price earnings ratio of 7.5 times.
The retained earnings per share being 37.5% is ₹ 3 per share. Compute

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1) The company’s cost of equity, if investors expect annual growth rate of 12%.
2) If anticipated growth rate is 13% p.a., calculate the indicated market price, with same
cost of capital.
3) If the company’s cost of capital is 18% and anticipated growth rate is 15% p.a., calculate
the market price per share, assuming other conditions remain the same.
Solution
1) Calculation of cost of Capital
Retained Earnings 37.5% ₹3 per share
Dividend* 62.5% ₹5 per share
EPS 100% ₹8 per share
P/E ratio 7.5 times
Market price is ₹ 7.5 x 8 = ₹ 60 per share

Cost of equity capital = (Dividend/ price x 100) + growth %

=(5/60x100) + 12% = 20.33%

2) Market Price = Dividend / (Cost of equity Capital % - growth rate%) = 5 / (20.33% - 13%) =
5 / 7.33% = ₹ 68.21 per share.
3) Market price = Dividend / (Cost of equity Capital % - growth rate%) = 5 / (18% - 15%) = 5
/ 3% = ₹ 166.66 per share

Question 9(Study Material TYK Q 13)

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.

Solution
Intrinsic Value

Using CAPM

k=

Rf = Risk Free Rate

β = Beta of Security

Rm = Market Return

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Question 10(Old PM)/RTP May’19

Seawell Corporation, a manufacturer of do-it-yourself hardware and housewares, reported
earnings per share of € 2.10 in 2003, on which it paid dividends per share of € 0.69. Earnings are
expected to grow 15% a year from 2004 to 2008, during this period the dividend payout ratio is
expected to remain unchanged. After 2008, the earnings growth rate is expected to drop to a
stable rate of 6%, and the pay-out 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 2008. The market risk
premium is 5.5%. The Treasury bond rate is 6.25%.
(i) What is the expected price of the stock at the end of 2008?
(ii) What is the value of the stock, using the two-stage dividend discount model?
Solution
The expected rate of return on equity after 2008 = 0.0625 + 1.10(0.055) = 12.3%

The dividends from 2003 onwards can be estimated as:

Year 2003 2004 2005 2006 2007 2008 2009

Earnings Per Share (€) 2.1 2.415 2.78 3.19 3.67 4.22 4.48
Dividends Per Share (€) 0.69 0.794 0.913 1.048 1.206 1.387 2.91

(i) The price as of 2008 = € 2.91/(0.123- 0.06) = € 46.19

(ii) The required rate of return up to 2008 = 0.0625 + 1.4(0.055) = 13.95%. The dividends up
to 2008 are discounted using this rate as follow:
Year PV of Dividend
2004 0.794 / 1.1395 = 0.70
2005 0.913 / (1.1395)2 = 0.70
2006 1.048 / (1.1395)3 =0.70
2007 1.206 / (1.1395)4 = 0.72
2008 1.387 / (1.1395)5 = 0.72
Total 3.54

The current price = € 3.54 + € 46.19 / (1.1395)5= € 27.58.

* Values have been rounded off.

Question 11(Study Material TYK Q 15)/MTP March’19/Similar PP May’18

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 ₹ 2.00. The beta of Platinum
Ltd. equity stock is 1.2.
(i) What is the equilibrium price of the equity stock of Platinum Ltd.?
(ii) How would the equilibrium price change when
a) The inflation premium increases by 2 percent?
b) The expected growth rate increases by 3 percent?
c) The beta of Platinum Ltd. equity rises to 1.3?

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Solution
(i) Equilibrium price of Equity using CAPM
= 9% + 1.2(13% - 9%)

= 9% + 4.8% = 13.8%

P=

(ii) New Equilibrium price of Equity using CAPM

= 9.18% + 1.3(13% - 9.18%)

= 9.18% + 4.966% = 14.146%

P=

Alternatively, it can also be computed as follows:

= 11% + 1.3(15% - 11%)

= 11% + 5.2% = 16.20%

P=

Alternatively, if all the factors are taken separately then solution will be as follows:

(i) Inflation Premium increase by 2%. This raises Rx to 15.80%. Hence, new equilibrium price
will be:

(ii)Expected Growth rate decreases by 3%. Hence, revised growth rate stands at 10%:

(iii) Beta rises to 1.3. Hence, revised cost of equity shall be:

= 9% + 1.3(13% - 9%)

= 9% + 5.2% = 14.2%

As a result, New Equilibrium price shall be:

Question 12(Study Material TYK Q 16)/RTP May’18/MTP March’18/MTP Oct’20

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

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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%.
Solution
Value of Share at present

However, if the Board implement its decision, no dividend would be payable for 3 years and the
dividend for year 4 would be ₹ 2.50 and growing at 7% p.a. The price of the share, in this case,
now would be:

So, the price of the share is expected to increase from ₹ 106 to ₹ 198.45 after the
announcement of the project. The investor can take up this situation as follows:

Expected market price after 3 years

Expected market price after 2 years

Expected market price after 1 years

In order to maintain his receipt at ₹ 2,000 for first 3 year, he would sell
10 shares in first year @ ₹ 214.33 for ₹ 2,143.30
9 shares in second year @ ₹ 231.48 for ₹ 2,083.32
8 shares in third year @ ₹ 250 for ₹ 2,000.00
rd
At the end of 3 year, he would be having 973 shares valued @ ₹ 250 each i.e. ₹ 2,43,250. On
these 973 shares, his dividend income for year 4 would be @ ₹ 2.50 i.e. ₹ 2,432.50.

So, if the project is taken up by the company, the investor would be able to maintain his receipt
of at least ₹ 2,000 for first three years and would be getting increased income thereafter.

Question 13((Study Material TYK Q 14)/RTP Nov’19/MTP April’19

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.
Solution

Year Divd. /Sale PVF (12%) PV (₹)

1 ₹ 20/- 0.893 17.86

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2 ₹ 20/- 0.797 15.94

3 ₹ 20/- 0.712 14.24
4 ₹ 24/- 0.636 15.26
5 ₹ 24/ 0.567 13.61
6 ₹ 24/ 0.507 12.17
7 ₹ 24/ 0.452 10.85
7 ₹ 1026/- (₹ 900 x 1.2 x 0.95) 0.452 463.75
₹ 563.68
Less: - Cost of Share (₹ 500 x 1.05) ₹ 525.00
Net Gain ₹ 38.68
P.V. of dividend stream and sales proceeds
Since Mr. A is gaining ₹ 38.68 per share, he should buy the share.

Maximum price Mr. A should be ready to pay is ₹ 563.68 which will include incidental expenses.
So the maximum price should be ₹ 563.68 x 100/105 = ₹ 536.84

Question 14(Study Material TYK Q 12)

Following Financial data are available for PQR Ltd. for the year 2008:
(₹ in lakh)
8% debentures 125
10% bonds (2007) 50
Equity shares (₹ 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 of earnings
(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?
Solution
Workings:
Asset turnover ratio = 1.1

Total Assets = ₹ 600

Turnover ₹ 600 lakhs × 1.1 = ₹ 660 lakhs

Effective interest rate

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Liabilities = ₹ 125 lakhs + 50 lakhs = 175 lakh

Interest = ₹ 175 lakhs × 0.08 = ₹ 14 lakh

Operating Margin = 10%

Hence operating cost = (1 - 0.10) ₹ 660 lakhs = ₹ 594 lakh

Dividend Payout = 16.67%

Tax rate = 40%

(i) Income statement

(₹ Lakhs)
Sale 660
Operating Exp 594
EBIT 66
Interest 14
EBT 52
Tax @ 40% 20.80
EAT 31.20
Dividend @ 16.67% 5.20
Retained Earnings 26.00

(ii) SGR = ROE (1-b)

ROE = and NW = ₹100 lakh + ₹ 300 lakh = 400 lakh

ROE =

SGR = 0.078(1 – 0.1667) = 6.5% or

(iii) Calculation of fair price of share using dividend discount model

Dividends

Growth Rate = 6.5% or 6.95%

Hence

(iv) Since the current market price of share is ₹ 14, the share is overvalued. Hence the
investor should not invest in the company.

Question 15(Old PM)

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

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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 earning per share (a) before conversion (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?
Solution
a. Conversion value of preference share

Conversion Ratio x Market Price

2 x ₹ 21 = ₹ 42

b. Conversion Premium

(₹50 / ₹ 42) – 1 = 19.05%

c. Effect of the issue on basic EPS

₹
Before Conversion
Total (after tax) earnings ₹ 3 × 5,00,000 15,00,000
Dividend on Preference shares 1,40,000
Earnings available to equity holders 13,60,000
No. of shares 5,00,000
EPS 2.72
On Diluted Basis
Earnings 15,00,000
No of shares (5,00,000 + 80,000) 5,80,000
EPS 2.59

d. EPS with increase in Profit

₹
Before Conversion
Earnings 25,00,000
Dividend on Pref. shares 1,40,000
Earning for equity shareholders 23,60,000
No. of equity shares 5,00,000
EPS 4.72
On Diluted Basis
Earnings 25,00,000
No. of shows 5,80,000
EPS 4.31

Question 16(Old PM)/RTP Nov’18

ABC Limited’s shares are currently selling at ₹ 13 per share. There are 10,00,000 shares
outstanding. The firm is planning to raise ₹ 20 lakhs to Finance a new project.
Required:

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What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth change from (i) to (ii)? How does right issue increases
shareholders’ wealth?
Solution
(i) Number of shares to be issued: 5,00,000

Subscription price ₹ 20,00,000 / 5,00,000 = ₹ 4

Ex-right Price

Or Value of Right = ₹ 10 - ₹ 4 = ₹ 6

(ii) Subscription price ₹ 20,00,000 / 2,50,000 = ₹ 8

Ex-right Price

Value of Right = ₹ 12 - ₹ 8 = ₹ 4 or

(iii) Calculation of effect of right issue on wealth of Shareholder’s wealth who is holding, say
100 shares.
a) When firm offers one share for two shares held.
Value of Shares after right issue (150 x ₹ 10) ₹ 1,500
Less: Amount paid to acquire right shares (50 x ₹ 4) ₹ 200
₹ 1,300

b) When firm offers one share for every four shares held.
Value of Shares after right issue (125 x ₹ 12) ₹ 1,500
Less: Amount paid to acquire right shares (25 x ₹ 8) ₹ 200
₹ 1,300

c) Wealth of Shareholders before Right Issue ₹1,300

Thus, there will be no change in the wealth of shareholders from (i) and (ii).

Question 17(Old PM)

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) Calculate the theoretical post - rights price per share;
(ii) Calculate the theoretical value of the right alone;
(iii) Show the effect of the rights issue on the wealth of a shareholder, who has 1,000 shares
assuming he sells the entire rights; and
(iv) Show the effect, if the same shareholder does not take any action and ignores the issue.
Solution
(i) Calculation of theoretical post – rights (ex-right) price per share:

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Ex – right value =

Where,
M = Market price,
N = Number of old shares for a right share
S = Subscription price
R = Right share offer

(ii) Calculation of theoretical value of the rights alone:

= Ex-right price – Cost of rights share

= ₹ 22.40 – ₹ 16 = ₹ 6.40

Or =

(iii) Calculation of effect of the rights issue on the wealth of a shareholder who has 1,000
shares assuming he sells the entire rights:
₹
(a) Value of shares before right issue (1,000 shares × ₹ 24) 24,000
(b) Value of shares after right issue (1,000 shares × ₹ 22.40) 22,400
Add: Sale proceeds of rights renunciation (250 shares × ₹ 6.40) 1,600
24,000

There is no change in the wealth of the shareholder even if he sells his right.

(iv) Calculation of effect if the shareholder does not take any action and ignores the issue:
₹
Value of shares before right issue (1,000 shares ×₹ 24) 24,000
Less: Value of shares after right issue (1,000 shares × ₹ 22.40) 22,400
Loss of wealth to shareholders, if rights ignored 1,600

Question 18
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
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.
Solution

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c)

d)
1) £ 1,000 / £ 50= 20 shares × £ 60 = £ 1,200
£ 1,200 - £ 1,000 = £ 200

2) £ 1,000 / £2 = 500 rights x £ 4* = £ 2,000

£ 2,000 - £ 1,000 = £ 1,000
*Rx = (£ 60 - £ 40) / 5 = £ 4

Question 19(Study Material TYK Q 4)

On the basis of the following information:
Current dividend (Do) ₹ 2.50
Discount rate (k) 10.5%
Growth rate (g) 2%

(i) Calculate the present value of stock of ABC Ltd.

(ii) Is its stock overvalued if stock price is ₹ 35, ROE = 9% and EPS = ₹ 2.25? Show detailed
calculation. Using PE Multiple Approach and Earning Growth Model.
Solution
(i) Present Value of the stock of ABC Ltd. is: -

(ii)
A. Value of stock under the PE Multiple Approach
Particulars
Actual Stock Price ₹ 35.00
Return on equity 9%
EPS ₹ 2.25
PE Multiple (1 / Return on Equity) = 1 / 9% 11.11
Market Price per Share ₹ 25.00
Since, Actual Stock Price is higher, hence it is overvalued.

B. Value of the Stock under the Earnings Growth Model

Particulars
Actual Stock Price ₹ 35.00
Return on equity 9%
EPS ₹ 2.25
Growth Rate 2%
Market Price per Share [EPS × (1 + g)] /(Ke – g) = ₹ 2.25 × 1.02 / 0.07 ₹ 32.79
Since, Actual Stock Price is higher, hence it is overvalued.

Question 20
Given the following information:
Current Dividend ₹ 5.00
Discount Rate 10%

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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.
Solution
(i) Present Value of the stock :-

(ii) Value of stock under the PE Multiple Approach

Particulars
Actual Stock Price ₹ 40.00
Return on equity 8%
EPS ₹ 3.00
PE Multiple (1 / Return on Equity) = 1 / 8% 12.50
Market Price per Share ₹ 37.50
Since, Actual Stock Price is higher, hence it is overvalued.

(iii) Value of the Stock under the Earnings Growth Model

Particulars
Actual Stock Price ₹ 40.00
Return on equity 8%
EPS ₹ 3.00
Growth Rate 2%
Market Price per Share [EPS × (1 + g)] / (Ke – g) ₹ 51.00
= ₹ 3.00 × 1.02 / 0.06
Since, Actual Stock Price is lower, hence it is undervalued.

Question 21(Study Material TYK Q 7)

Capital structure of Sun Ltd., as at 31.3.2003 was as under:
(₹ in lakhs)
Equity share capital (100 each) 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 assuming:

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(i) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(ii) 2% for every one time of difference for Capital Gearing Ratio.
Solution
a. Calculation of Profit after tax (PAT)
₹
Profit before interest and tax (PBIT) 32,00,000
Less: Debenture interest (₹ 64,00,000 × 12 / 100) 7,68,000
Profit before tax (PBT) 24,32,000
Less: Tax @ 35% 8,51,200
Profit after tax (PAT) 15,80,800
Less: Preference Dividend
(₹ 40,00,000 × 8 / 100) 3,20,000
Equity Dividend (₹ 80,00,000 × 8 / 100) 6,40,000 9,60,000
Retained earnings (Undistributed profit) 6,20,800

Calculation of Interest and Fixed Dividend Coverage

b. Calculation of Capital Gearing Ratio

Capital Gearing Ratio

c. Calculation of Yield on Equity Shares:

Yield on equity shares is calculated at 50% of profits distributed and 5% on undistributed
profits:
₹
50% on distributed profits (₹ 6,40,000 × 50/100) 3,20,000
5% on undistributed profits (₹ 6,20,800 × 5/100) 31,040
Yield on equity shares 3,51,040

Yield on equity shares %

Calculation of Expected Yield on Equity shares

(i) Interest and fixed dividend coverage of Sun Ltd. is 2.16 times but the industry
average is 3 times. Therefore, risk premium is added to Sun Ltd. Shares @ 1% for
every 1 time of difference. Hence,

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Risk Premium = 3.00 – 2.16 (1%) = 0.84 (1%) = 0.84%

(ii) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75 times.
Therefore, risk premium is added to Sun Ltd. shares @ 2% for every 1 time of
difference.
Risk Premium = (0.75 – 0.93) (2%) = 0.18 (2%) = 0.36%
(%)
Normal return expected 9.60
Add: Risk premium for low interest and fixed dividend coverage 0.84
Add: Risk premium for high interest gearing ratio 0.36
10.80

Value of Equity Share

Question 22(Study Material TYK Q 10)/RTP May’20/MTP Aug’18-Business Valuation

Calculate the value of share from the following information:
Profit after tax of the company ₹ 290 crores
Equity capital of company ₹ 1,300 crores
Par value of share ₹ 40 each
Debt ratio of company (Debt / Debt + Equity) 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
Solution
No. of Shares

EPS

EPS

FCFE = Net income - [(1-b) (capex-deb) + (1-b) (∆WC)]

FCFE= 8.923 - [(1-0.27) (47-39) + (1-0.27) (3.45)]

= 8.923 - [5.84+2.5185] = 0.5645

Cost of Equity = Rf + ß (Rm – Rf)

= 8.7 + 0.1 (10.3 – 8.7) = 8.86%

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Question 23(Study Material-Business Valuation TYK Q 3)/RTP May’20/Similar Q asked in

MTP Nov’21
ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They want to
know the value of the new strategy. Following information relating to the year which has just
ended, is available:
Income Statement ₹
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000

If it adopts the new strategy, sales will grow at the rate of 20% per year for three years. From
4th year onward Cash Flow will be stabilized. The gross margin ratio, Assets turnover ratio, the
Capital structure and the income tax rate will be remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.

Solution
Projected Balance Sheet
Year 1 Year 2 Year 3 Year 4
Fixed Assets (40% of Sales) 9,600 11,520 13,824 13,824
Current Assets (20% of Sales) 4,800 5,760 6,912 6,912
Total Assets 14,400 17,280 20,736 20,736
Equity 14,400 17,280 20,736 20,736

Projected Cash Flows: -

Year 1 Year 2 Year 3 Year 4
Sales 24,000 28,800 34,560 34,560
PBT (10% of sale) 2,400 2,880 3,456 3,456
PAT (70%) 1,680 2,016 2,419.20 2,419.20
Depreciation 800 960 1,152 1,382
Addition to Fixed Assets 2,400 2,880 3,456 1,382
Increase in Current Assets 800 960 1,152 -
Operating cash flow (FCFF) (720) (864) (1,036.80) 2,419.20

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Projected Cash Flows: -

Present value of Projected Cash Flows:-

Cash Flows PVF at 15% PV

-720 0.870 -626.40
-864 0.756 -653.18
-1,036.80 0.658 -682.21
-1,961.79

Residual Value = 2419.20 / 0.15 = 16,128

Present value of Residual value = 16128 / (1.15)3
= 16128 / 1.521 = 10603.55
Total shareholders’ value = 10,603.55 – 1,961.79 = 8,641.76
Pre strategy value = 1,400 / 0.15 = 9,333.33
Therefore, Value of strategy = 8,641.76 – 9,333.33 = – 691.57
Conclusion: The strategy is not financially viable

Question 24(Study Material-Business Valuation TYK Q 7)/PP May’22

Following information are available in respect of XYZ Ltd. which is expected to grow at a higher
rate for 4 years after which growth rate will stabilize at a lower level:
Base year information:
Revenue - ₹ 2,000 crores
EBIT - ₹ 300 crores
Capital expenditure - ₹ 280 crores
Depreciation - ₹ 200 crores
Information for high growth and stable growth period are as follows:
High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure 20% Capital expenditure are
and depreciation offset by depreciation
Risk free rate 10% 9%
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3
For all time, working capital is 25% of revenue and corporate tax rate is 30%. What is the value
of the firm?
Solution
High growth phase:
ke = 0.10 + 1.15 x 0.06 = 0.169 or 16.9%.
kd = 0.13 x (1-0.3) = 0.091 or 9.1%.
Cost of capital = 0.5 x 0.169 + 0.5 x 0.091 = 0.13 or 13%.

Stable growth phase:

ke = 0.09 + 1.0 x 0.05 = 0.14 or 14%.
kd = 0.1286 x (1 - 0.3) = 0.09 or 9%.

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Cost of capital = 0.6 x 0.14 + 0.4 x 0.09 = 0.12 or 12%

Determination of forecasted Free Cash Flow of the Firm (FCFF) (₹ in crores)

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Terminal Year

Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Capital Expenditure 96 115.20 138.24 165.89 -
Less Depreciation
∆ Working Capital 100.00 120.00 144.00 172.80 103.68
Free Cash Flow (FCF) 56.00 67.20 80.64 96.77 375.32

Alternatively, it can also be computed as follows: (₹ in crores)

Yr. 1 Yr. 2 Yr. 3 Yr. 4 Terminal Year

Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Add: Depreciation 240 288 345.60 414.72 456.19
492 590.40 708.48 850.18 935.19
Less: Capital Exp. 336 403.20 483.84 580.61 456.19
∆ WC 100.00 120.00 144.00 172.80 103.68
56.00 67.20 80.64 96.77 375.32

Present Value (PV) of FCFF during the explicit forecast period is:

FCFF (₹ in crores) PVF @ 13% PV (₹ in crores)

56.00 0.885 49.56
67.20 0.783 52.62
80.64 0.693 55.88
96.77 0.613 59.32
₹ 217.38

Terminal Value of Cash Flow

PV of the terminal, value is:

The value of the firm is:

₹ 217.38 Crores + ₹ 11,503.56 Crores = ₹ 11,720.94 Crores

Question 25(Study Material-Business Valuation TYK Q 8)/RTP Nov’20

Following information is given in respect of WXY Ltd., which is expected to grow at a rate of
20% p.a. for the next three years, after which the growth rate will stabilize at 8% p.a. normal
level, in perpetuity.

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For the year ended March 31, 2014

Revenues ₹ 7,500 Crores
Cost of Goods Sold (COGS) ₹ 3,000 Crores
Operating Expenses ₹ 2,250 Crores
Capital Expenditure ₹ 750 Crores
Depreciation (included in Operating Expenses) ₹ 600 Crores

During high growth period, revenues & Earnings before Interest & Tax (EBIT) will grow at 20%
p.a. and capital expenditure net of depreciation will grow at 15% p.a. From year 4 onwards, i.e.
normal growth period revenues and EBIT will grow at 8% p.a. and incremental capital expenditure
will be offset by the depreciation. During both high growth & normal growth period, net working
capital requirement will be 25% of revenues.
The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%.
Corporate Income Tax rate will be 30%.
Required:
Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) & WACC methodology.
The PVIF @ 15 % for the three years are as below:
Year t1 t2 t3
PVIF 0.8696 0.7561 0.6575
Solution
Determination of forecasted Free Cash Flow of the Firm (FCFF) (₹ in crores)
Yr. 1 Yr. 2 Yr. 3 Terminal Year
Revenue 9000.00 10800.00 12960.00 13996.80
COGS 3600.00 4320.00 5184.00 5598.72
Operating Expenses 1980.00* 2376.00 2851.20 3079.30
Depreciation 720.00 864.00 1036.80 1119.74
EBIT 2700.00 3240.00 3888.00 4199.04
Tax @30% 810.00 972.00 1166.40 1259.71
EAT 1890.00 2268.00 2721.60 2939.33
Capital Exp. – Dep. 172.50 198.38 228.13 -
∆ Working Capital 375.00 450.00 540.00 259.20
Free Cash Flow (FCF) 1342.50 1619.62 1953.47 2680.13
* Excluding Depreciation.

Present Value (PV) of FCFF during the explicit forecast period is:

FCFF (₹ in crores) PVF @ 15% PV (₹ in crores)

1342.50 0.8696 1167.44
1619.62 0.7561 1224.59
1953.47 0.6575 1284.41
3676.44
PV of the terminal, value is:

The value of the firm is:

₹ 3676.44 Crores + ₹ 25174.08 Crores = ₹ 28,850.52 Crores

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Question 26 (Business Valuation)

BRS Inc deals in computer and IT hardwares and peripherals. The expected revenue for the
next 8 years is as follows:
Years Sales Revenue ($ Million)
1 8
2 10
3 15
4 22
5 30
6 26
7 23
8 20

Summarized financial position as on 31st March 2012 as follows: $ Million

Liabilities Amount ($ Million) Assets Amount ($ Million)
Equity Stocks 12 Fixed Assets (Net) 17
12% Bonds 8 Current Assets 3
20 20

Additional Information:
Its variable expenses is 40% of sales revenue and fixed operating expenses (cash) are
estimated to be as follows:
Period Amount ($ Million)
1 – 4 years 1.6
5 – 8 years 2

An additional advertisement and sales promotion campaign shall be launched requiring

expenditure as per following details:
Period Amount ($ Million)
1 year 0.50
2 – 3 years 1.50
4 – 6 years 3.00
7– 8 years 1.00

(c) Fixed assets are subject to depreciation at 15% as per WDV method.
(d) The company has planned additional capital expenditures (in the beginning of each year) for
the coming 8 years as follows:
Period Amount ($ Million)
1 0.50
2 0.80
3 2.00
4 2.50
5 3.50
6 2.50
7 1.50
8 1.00

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a) Investment in Working Capital is estimated to be 20% of Revenue.

b) Applicable tax rate for the company is 30%
c) Cost of Equity is estimated to be 16%
d) The Free Cash Flow of the firm is expected to grow at 5% per annum after 8 years. With
above information you are require to determine the:
(i) Value of Firm &
(ii) Value of Equity
Solution
Working Notes
‘a) Determination of Weighted Average Cost of Capital
Sources of funds Cost (%) Proportions Weights Weighted Cost
Equity Stock 16 12/20 0.60 9.60
12% Bonds 12% (1-0.30) = 8/20 0.40 3.36
8.40
12.96 say 13

‘b) Schedule of Depreciation

$ Million
Year Opening Balance of Additional during Total Depreciation
Fixed Assets the year @ 15%
1 17.00 0.50 17.50 2.63
2 14.87 0.80 15.67 2.35
3 13.32 2.00 15.32 2.30
4 13.02 2.50 15.52 2.33
5 13.19 3.50 16.69 2.50
6 14.19 2.50 16.69 2.50
7 14.19 1.50 15.69 2.35
8 13.34 1.00 14.34 2.15

‘c) Determination of Investment $ Million

Investment Required Existing Additional

Year Investment Investment
For Capital CA (20% of Total
in CA required
Expenditure Revenue)
1 0.50 1.60 2.10 3.00 0.00
2 0.80 2.00 2.80 2.50* 0.30
3 2.00 3.00 5.00 2.00** 3.00
4 2.50 4.40 6.90 3.00 3.90
5 3.50 6.00 9.50 4.40 5.10
6 2.50 5.20 7.70 6.00 1.70
7 1.50 4.60 6.10 5.20 0.90
8 1.00 4.00 5.00 4.60 0.40

*Balance of CA in Year 1 ($ 3 Million) – Capital Expenditure in Year 1 ($ 0.50 Million)

** Similarly balance of CA in Year 2 ($2.80) – Capital Expenditure in Year 2 ($ 0.80 Million)

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‘d) Determination of Present Value of Cash Inflows $ Million

Particulars Years
1 2 3 4 5 6 7 8
Revenue(A) 8.00 10.00 15.00 22.00 30.00 26.00 23.00 20.00
Less:
Expenses
-Variable Cost 3.20 4.00 6.00 8.80 12.00 10.40 9.20 8.00
-Fixed Cash Operating 1.60 1.60 1.60 1.60 2.00 2.00 2.00 2.00
Cost
Advertisement Cost 0.50 1.50 1.50 3.00 3.00 3.00 1.00 1.00
Depreciation 2.63 2.35 2.30 2.33 2.50 2.50 2.35 2.15
Total Expenses(B) 7.93 9.45 11.40 15.73 19.50 17.90 14.55 13.15
EBIT C = A-B 0.07 0.55 3.60 6.27 10.50 8.10 8.45 6.85
Less: Taxes @ 30% (D) 0.02 0.16 1.08 1.88 3.15 2.43 2.53 2.06
NOPAT (E) = (C) – (D) 0.05 0.39 2.52 4.39 7.35 5.67 5.92 4.79
Gross Cash Flow (F) = (E) 2.68 2.74 4.82 6.72 9.85 8.17 8.27 6.94
+ Dep
Less: Investment in
Capital Assets
Plus current assets (G) 0 0.30 3.00 3.90 5.10 1.70 0.90 0.40
Free Cash Flow (H) = (F) - 2.68 2.44 1.82 2.82 4.75 6.47 7.37 6.54
(G)
PVF @ 13% (I) 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376
PV (H)(I) 2.371 1.911 1.261 1.729 2.579 3.106 3.132 2.46

Total present value = $ 18.549 million

‘e) Determination of Present Value of Continuing Value (CV)

Present Value of Continuing Value (CV) = $ 85.8376 million x PVF13%,8 = $ 85.96875 million
x 0.376 = $ 32.2749 million

(i) Value of Firm $ Million

Present Value of cash flow during explicit period 18.5490
Present value of Continuing Value 32.2749
Total Value 50.8239

(ii) Value Of Equity $ Million

Total value of Firm 50.8239
Less: Value of Debt 8.0000
Value of Equity 42.8239

Question 27(Business Valuation)

ABC (India) Ltd., a market leader in printing industry, is planning to diversify into defense
equipment businesses that have recently been partially opened up by the GOI for private sector.

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In the meanwhile, the CEO of the company wants to get his company valued by a leading
consultant, as he is not satisfied with the current market price of his scrip.
He approached consultant with a request to take up valuation of his company with the following
data for the year ended 2009:
Share Price ₹ 66 per share
Outstanding debt 1934 lakh
Number of outstanding shares 75 lakh
Net income (PAT) 17.2 lakh
EBIT 245 lakh
Interest expenses 218.125 lakh
Capital expenditure 234.4 lakh
Depreciation 234.4 lakh
Working capital 44 lakh
Growth rate 8% (from 2010 to 2014)
Growth rate 6% (beyond 2014)
Free cash flow 240.336 lakh (year 2014 onwards)

The capital expenditure is expected to be equally offset by depreciation in future and the debt
is expected to decline by 30% in 2014.

Required:
Estimate the value of the company and ascertain whether the ruling market price is undervalued
as felt by the CEO based on the foregoing data. Assume that the cost of equity is 16%, and 30%
of debt repayment is made in the year 2014.
Solution
As per Firm Cash Flow Approach
(i) Computation of Tax rate

EBIT = ₹ 245 lakh

Interest = ₹ 218.125 lakh

PBT = ₹ 26.875 lakh

PAT = ₹ 17.2 lakh

Tax Paid = ₹ 9.675 lakh

Tax Rate = ₹ 9.675/26.875 = 0.36 = 36%

(ii) Computation for increase in working capital

Working capital (2009) = ₹ 44 lakh

Increase in 2010 = ₹ 44 x 0.08 = ₹ 3.52 lakh

It will continue to increase @ 8% per annum.

(iii) Weighted average Cost of capital

Present debt = ₹ 1934 lakh

Interest cost = ₹ 218.125 lakh/ ₹ 1934 = 11.28%

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Equity capital = 75 lakh x ₹ 66 = ₹ 4950 lakh

(iv) As capital expenditure and depreciation are equal, they will not influence the free cash
flows of the company.

(v) Computation of free cash flows upto 2012

Year 2010 2011 2012 2013 2014
₹ ₹ ₹ ₹ ₹
EBIT (1- t) 169.344 lakh 182.89 lakh 197.52 lakh 213.32 lakh 230.39 lakh
Increase in 3.52 lakh 3.80 lakh 4.10 lakh 4.43 lakh 4.78 lakh
working capital
Debt repayment - - - - 1934 x 0.30
= 580.2 lakh
Free cash flows 165.824 lakh 179.09 lakh 193.41 lakh 208.89 lakh -354.59 lakh
PVF @ 13.54% 0.8807 0.7757 0.6832 0.6017 0.53
PV of free cash 146.04 lakh 138.92 lakh 132.14 lakh 125.69 lakh -187.93 lakh
flow @ 13.54%
Present value of free cash flows upto 2014 = ₹ 354.86 lakh

(vi) Cost of capital (2014 Onwards)

Debt =0.7 × ₹ 1934= ₹ 1353.80 lakh

Equity = ₹ 4950 lakh

= 12.56 + 1.55 % = 14.11%

(vii) Continuing value

= ₹ 1570.556 lakh

a) Value of Firm = PV of free cash flows upto 2014 + continuing value

= ₹ 354.86 lakh + ₹ 1570.556 lakh

= ₹ 1925.416 lakh

b) Value per share = (Value of Firm – Value of Debt) / Number of Shares

= (₹ 1925.416 lakh - ₹ 1353.80 lakh) / 75 lakh

= ₹ 7.622 < ₹ 66 (present market price)

Alternatively, following value can also be considered

= (Value of Firm - Value of Debt) / No. of Shares

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= (₹ 1925.416 lakh - ₹ 1934) / 75 lakh

= - ₹ 0.1145 or ₹ 0

Thus, share has zero value, and hence overvalued.

Answer as per Equity Cash Approach

(i) Computation of tax rate

EBIT = ₹ 245 lakh

Interest = ₹ 218.125 lakh

PBT = ₹ 26.875 lakh

PAT = ₹ 17.2 lakh

Tax Paid = ₹ 9.675 lakh

Tax Rate = ₹ 9.675 / 26.875 = 0.36 = 36%

(ii) Computation for increase in working capital

Working capital (2009) = ₹ 44 lakh

Increase in 2010 = ₹ 44 x 0.08 = ₹ 3.52 lakh

(iii) As capital expenditure and depreciation are equal, they will not influence the free cash
flows of the company.

(iv) Computation of free cash flows upto 2014

Year 2010 2011 2012 2013 2014
₹ ₹ ₹ ₹ ₹
EBIT 245.000 264.600 285.768 308.629 333.319
Less : Interest 218.125 218.125 218.125 218.125 218.125
EBT 26.875 46.475 67.643 90.504 180.531
Less: Tax 9.675 16.266 24.351 32.581 65.027
EAT 17.200 30.209 43.292 57.923 115.604
Increase in 3.52 3.80 4.10 4.43 4.78
working capital
Debt Repayment - - - - 1934 x 0.30
= 580.20
Free cash flows 13.68 26.409 39.192 53.493 -469.376
PVF @ 16% 0.8621 0.7432 0.6407 0.5523 0.4761
PV of free cash 11.794 19.627 25.110 29.544 -233.470
flow

Present value of free cash flows upto 2014 = - ₹ 137.395 lakh

(v) Continuing value

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*(115.604 – 4.78) (1.06)

(i) Value of Firm = PV of free cash flows upto 2014 + continuing value

= - ₹ 137.395 lakh + ₹ 559.304 lakh

= ₹ 421.909 lakh

(ii) Value per share = Value of Equity / Number of Shares

= ₹ 421.909 lakh / 75 lakh

= ₹ 5.62 < ₹ 66 (present market value)

Question 28 (Old PM- Business Valuation)

Personal Computer Division of Distress Ltd., a computer hardware manufacturing company has
started facing financial difficulties for the last 2 to 3 years. The management of the division
headed by Mr. Smith is interested in a buy - out on 1 April 2013. However, to make this buy - out
successful there is an urgent need to attract substantial funds from venture capitalists. Ven
Cap, a European venture capitalist firm has shown its interest to finance the proposed buy-out.
Distress Ltd. is interested to sell the division for ₹ 180 crore and Mr. Smith is of opinion that
an additional amount of ₹ 85 crore shall be required to make this division viable. The expected
financing pattern shall be as follows:
Source Mode Amount
(₹ Crore)
Management Equity Shares of ₹ 10 each 60.00
Ven Cap VC Equity Shares of ₹ 10 each 22.50
9% Debentures with attached warrant of ₹ 100 each 22.50
8% Loan 160.00
Total 265.00

The warrants can be exercised any time after 4 years from now for 10 equity shares @ ₹ 120
per share.

The loan is repayable in one go at the end of 8th year. The debentures are repayable in equal
annual installment consisting of both principal and interest amount over a period of 6 years.
Mr. Smith is of view that the proposed dividend shall not be kept more than 12.5% of
distributable profit for the first 4 years. The forecasted EBIT after the proposed buyout is as
follows:
Year 2013-14 2014-15 2015-16 2016-17
EBIT (₹ crore) 48 57 68 82

Applicable tax rate is 35% and it is expected that it shall remain unchanged at least for 5 - 6
years. In order to attract Ven Cap, Mr. Smith stated that book value of equity shall increase by
20% during above 4 years. Although, Ven Cap has shown their interest in investment but are
doubtful about the projections of growth in the value as per projections of Mr. Smith. Further
Ven Cap also demanded that warrants should be convertible in 18 shares instead of 10 as
proposed by Mr. Smith.

You are required to determine whether or not the book value of equity is expected to grow by

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20% per year. Further if you have been appointed by Mr. Smith as advisor then whether you
would suggest to accept the demand of Ven Cap of 18 shares instead of 10 or not.
Solution
Working Notes
Calculation of Interest Payment on 9% Debentures
PVAF (9%,6) = 4.486

Annual Installment = = ₹ 5.0156 crore

Year Balance Outstanding Interest Installment Principal Repayment Balance

(₹ Crore) (₹ Crore) (₹ Crore) (₹ Crore) (₹ Crore)
1 22.5000 2.025 5.0156 2.9906 19.5094
2 19.5094 1.756 5.0156 3.2596 16.2498
3 16.2498 1.462 5.0156 3.5536 12.6962
4 12.6962 1.143 5.0156 3.8726 8.8236

Statement showing Value of Equity

Particulars 2013-14 2014-15 2015-16 2016-17

(₹ Crore) (₹ Crore) (₹ Crore) (₹ Crore)
EBIT 48.0000 57.0000 68.0000 82.0000
Interest on 9% Debentures 2.0250 1.7560 1.4620 1.1430
Interest on 8% Loan 12.8000 12.8000 12.8000 12.8000
EBT 33.1750 42.4440 53.7380 68.0570
Tax* @35% 11.6110 14.8550 18.8080 23.8200
EAT 21.5640 27.5890 34.9300 44.2370
Dividend @12.5% of EAT* 2.6955 3.4490 4.3660 5.5300
18.8685 24.1400 30.5640 38.7070
Balance b/f Nil 18.8685 43.0085 73.5725
Balance c/f 18.8685 43.0085 73.5725 112.2795
Share Capital 82.5000 82.5000 82.5000 82.5000
101.3685 125.5085 156.0725 194.7795
*Figures have been rounded off.

In the beginning of 2013 - 14 equity was ₹ 82.5000 crore which has been grown to ₹ 194.7795
over a period of 4 years. In such case the compounded growth rate shall be as follows:
¼
(194.7795 / 82.5000) - 1 = 23.96%

This growth rate is slightly higher than 20% as projected by Mr. Smith.

If the condition of Ven Cap for 18 shares is accepted the expected shareholding after 4 years
shall be as follows:
No. of shares held by Management 6.00 crore
No. of shares held by Ven Cap at the starting stage 2.25 crore
No. of shares held by Ven Cap after 4 years 4.05 crore
Total holding 6.30 crore

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Thus, it is likely that Mr. Smith may not accept this condition of Ven Cap as this may result in
losing their majority ownership and control to Ven Cap. Mr. Smith may accept their condition if
management has further opportunity to increase their ownership through other forms.

Question 29 (Old PM-Business Valuation)

A valuation done of an established company by a well - known analyst has estimated a value of ₹
500 lakhs, based on the expected free cash flow for next year of ₹ 20 lakhs and an expected
growth rate of 5%.
While going through the valuation procedure, you found that the analyst has made the mistake
of using the book values of debt and equity in his calculation. While you do not know the book
value weights he used, you have been provided with the following information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
(iii) The market value of equity is three times the book value of equity, while the market
value of debt is equal to the book value of debt.
You are required to estimate the correct value of the company.
Solution
Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-

Value of Firm = V0 =

Where –
FCFF1 = Expected FCFF in the year
Kc = Cost of capital
gn = Growth rate forever

Thus, ₹ 500 lakhs = ₹ 20 lakhs / (Kc - g)

Since g = 5%, then Kc = 9%

Now, let X be the weight of debt and given cost of equity = 12% and cost of debt = 6%, then 12%
(1 – X) + 6% X = 9%

Hence, X = 0.50, so book value weight for debt was 50%

Therefore, Correct weight should be 150% of equity and 50% of debt.

Therefore, Cost of capital = Kc = 12% (0.75) + 6% (0.25) = 10.50%

and correct firm’s value = ₹ 20 lakhs / (0.105 – 0.05) = ₹ 363.64 lakhs.

Question 30 (Study Material- Business Valuation TYK Q 6)/RTP May’19

The valuation of Hansel Limited has been done by an investment analyst. Based on an expected
free cash flow of ₹ 54 lakhs for the following year and an expected growth rate of 9 percent,
the analyst has estimated the value of Hansel Limited to be ₹ 1800 lakhs. However, he
committed a mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but you know that Hansel Limited
has a cost of equity of 20 percent and post - tax cost of debt of 10 percent. The value of equity
is thrice its book value, whereas the market value of its debt is nine - tenths of its book value.
What is the correct value of Hansel Ltd?

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Solution
Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:

Value of Firm

Where ,
FCFF1 = Expected FCFF in the year 1
Kc = Cost of capital
gn = Growth rate forever
Thus, ₹ 1800 lakhs = ₹ 54 lakhs / (Kc - g)
Since g = 9%, then Kc = 12%

Now, let X be the weight of debt and given cost of equity = 20% and cost of debt = 10%, then
20% (1 – X) + 10% X = 12%
Hence, X = 0.80, so book value weight for debt was 80%
Therefore, Correct weight should be 60 of equity and 72 of debt.
Therefore, Cost of capital = Kc = 20% (60/132) + 10% (72/132) = 14.5455% and
correct firm’s value = ₹ 54 lakhs / (0.1454 – 0.09) = ₹ 974.73 lakhs.

RTP, MTP & PREVIOUS YEAR QUESTIONS

Question 1 (RTP May’22)
Mr. A is holding 1000 shares of face value of ₹ 100 each of M/s. ABC Ltd. He wants to hold
these shares for long term and have no intention to sell.
On 1st January 2020, M/s XYZ Ltd. has made short sales of M/s. ABC Ltd.’s shares and
approached Mr. A to lend his shares under Stock Lending Scheme with following terms:
(i) Shares to be borrowed for 3 months from 01-01-2020 to 31-03-2020,
(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of the stock
quoted in Stock Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 01-01-2020.
Other Information:
a) Cost of Bank Guarantee is 8% per annum, On 29/02/2020, ABC Ltd. Declared dividend of
25%
b) On 29-02-2020 M/s ABC Ltd.’s share quoted in Stock Exchange on various dates are as
follows:
Date Share Price in Scenario-1 Bullish Share Price in Scenario-1
Bullish
01-01-2020 1000 1000
31-01-2020 1020 980
29-02-2020 1040 960
31-03-2020 1050 940
You are required to find out:
(i) Earning of Mr. A through Stock Lending Scheme in both the scenarios,
(ii) Total Earnings of Mr. A during 01-01-2020 to 31-03-2020 in both the scenarios,
(iii) What is the Profit or loss to M/s. XYZ by shorting the shares using through Stock
Lending Scheme in both the scenarios?
Solution
Earnings of Mr. A through stock lending scheme

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Scenario 1 Scenario 2
(i) Lending fee
31-01-20 1020 x 1% and 980 x 1% 10.20 9.80
29-02-20 1040 x 1% and 960 x 1% 10.40 9.60
31-03-20 1050 x 1% and 940 x 1% 10.50 9.40
Earnings from lending per Share (A) 31.10 28.80
Total No. of Shares 1000 1000
Total Earning from Lending 31,100 28,800
(ii) Dividend income per Share (B) 25.00 25.00
Total earnings per share (A) + (B) 56.10 53.80
Total No. of Shares 1000 1000
Total Earning 56,100 53,800
(iii) Gain on shortening the shares
(1,050 - 1,000) and (1,000 - 940) (50.00) 60.00
Lending fees paid (31.10) (28.80)
Bank guarantee charges @ 8% (20.00) (20.00)
Gain Per Share (101.10) 11.20
Total No. of Shares 1000 1000
Total Gain on shortening the shares (1,01,100) 11,200

Question 2 (RTP May’22)

Following is the information for the options free bond:
Face value of the bond ₹ 1,000
Coupon rate 7%
Terms of Maturity 7 years
Yield to Maturity 8%

You are required to calculate:

(i) Market price of the bound and duration.
(ii) If there is an increase in yield by 35 basis points, what would be the price of bond?
Present t1 t2 t3 t4 t5 t6 t7
Value
PVIF0.07,t 0.935 0.874 0.817 0.764 0.714 0.667 0.623
PVIF0.08,t 0.926 0.857 0.794 0.735 0.681 0.631 0.584
Solution
(i) 1) Market price and duration of Bond

= 70 (PVIAF 8%,7) + 1,000 (PVIF 8%,7)

= 70 (5.208) + 1,000 (0.584) = 364.56 + 584.00 = 948.56

1) Duration of Bond
Period Cash flow (₹) PVF@8% PV (₹) (E)
(A) (B) (C) (D)=(B) (C) =(A) (D)
1 70 0.926 64.82 64.82
2 70 0.857 59.99 119.98
3 70 0.794 55.58 166.74

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4 70 0.735 51.45 205.80

5 70 0.681 47.67 238.35
6 70 0.631 44.17 265.05
7 70 0.584 624.88 4374.16
948.56 5434.87

Duration of the Bond is = 5.73 years

(ii) Price of Bond if increase in yield by 35 basis points

Period Cash flow (₹ ) PVF@8.35% PV (₹ )
1 70 0.923 64.61
2 70 0.852 59.64
3 70 0.786 55.02
4 70 0.726 50.82
5 70 0.670 46.90
6 70 0.618 43.26
7 1,070 0.570 609.90
930.15

Alternatively, if the same increase in yield is linked with duration as computed in sub part (i),
then answer will be computed as follows:

Volatility of Bond = = = 5.306

The expected market price if increase in yield is by 35 basis points.

= ₹ 948.56 x 0.35 (5.306/100) = ₹ 17.62

Hence expected market price is ₹ 948.56 – ₹ 17.62 = ₹ 930.94

Hence, the market price will decrease with increase in the yield.

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Question 31(Study Material TYK Q 19)

Nominal value of 10% bonds issued by a company is ₹ 100. The bonds are redeemable at ₹ 110 at
the end of year 5. Determine the value of the bond if required yield is (i) 5%, (ii) 5.1%, (iii) 10%
and (iv) 10.1%.
Solution
Case (i) Required yield rate = 5%
Year Cash Flow ₹ DF (5%) Present Value ₹
1-5 10 4.3295 43.295
5 110 0.7835 86.185
Value of bond 129.48

Case (ii) Required yield rate = 5.1%

Year Cash Flow ₹ DF (5.1%) Present Value ₹
1-5 10 4.3175 43.175
5 110 0.7798 85.778
Value of bond 128.953
Case (iii) Required yield rate = 10%

Year Cash Flow ₹ DF (10%) Present Value ₹

1-5 10 3.7908 37.908
5 110 0.6209 68.299
Value of bond 106.207
Case (iv) Required yield rate = 10.1%

Year Cash Flow ₹ DF (10.1%) Present Value ₹

1-5 10 3.7811 37.811
5 110 0.6181 67.991
Value of bond 105.802

Question 32(Study Material TYK Q 23)/PP May’18

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
Solution
If Debentures are not converted its value is as under:
PVF @ 8 % ₹
Interest - ₹ 12 for 5 years 3.993 47.916
Redemption - ₹ 100 in 5th year 0.681 68.100
116.016
Value of equity shares:

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Market Price No. Total

₹4 20 ₹ 80
₹5 20 ₹ 100
₹6 20 ₹ 120

Hence, unless the market price is ₹ 6 conversion should not be exercised.

Question 33(Study Material TYK Q 20)

An investor is considering the purchase of the following Bond:
Face value ₹ 100
Coupon rate 11%
Maturity 3 years

(i) If he wants a yield of 13% what is the maximum price, he should be ready to pay for?
(ii) If the Bond is selling for ₹ 97.60, what would be his yield?
Solution
(i) Calculation of Maximum price
B0 = ₹ 11 × PVIFA (13%,3) + ₹ 100 × PVIF (13%,3)
= ₹ 11 × 2.361 + ₹ 100 × 0.693 = ₹ 25.97 + ₹ 69.30 = ₹ 95.27

(ii) Calculation of yield

At 12% the value = ₹ 11 × PVIFA (12%,3) + 100 × PVIF (12%,3)
= ₹ 11×2.402 + ₹ 100×0.712 = ₹ 26.42 + ₹ 71.20 = ₹ 97.62
It the bond is selling at ₹ 97.60 which is more than the fair value, the YTM of the bond
would be less than 13%. This value is almost equal to the amount price of ₹ 97.60.
Therefore, the YTM of the bond would be 12%.

Alternatively

Question 34(Study Material TYK Q 21)

Calculate Market Price of:
(i) 10% Government of India security currently quoted at ₹ 110, but yield is expected to go up
by 1%.
(ii) A bond with 7.5% coupon interest, Face Value ₹ 10,000 & term to maturity of 2 years,
presently yielding 6%. Interest payable half yearly.
Solution
(i) Current yield = (Coupon Interest / Market Price) X 100 = (10/110) X 100 = 9.09%
If current yield go up by 1% i.e. 10.09 the market price would be
10.09 = 10 / Market Price X 100
Market Price = ₹ 99.11
(ii) Market Price of Bond = P.V. of Interest + P.V. of Principal
= ₹ 1,394 + ₹ 8,885 = ₹ 10,279

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Question 35(Old PM)/RTP May’2020

M/s Agfa Industries is planning to issue a debenture series on the following terms:
Face Value ₹ 100
Term of maturity 10 years

Years Yearly Coupon rate

1-4 9%
5–8 10%
9 - 10 14%

The current market rate on similar debentures is 15 percent per annum. The Company proposes to
price the issue in such a manner that it can yield 16 percent compounded rate of return to the
investors. The Company also proposes to redeem the debentures at 5 percent premium on
maturity. Determine the issue price of the debentures.

Solution

Years Cash out flow (₹) PVIF @ 16% PV

1 9 .862 7.758
2 9 .743 6.687
3 9 .641 5.769
4 9 .552 4.968
5 10 .476 4.76
6 10 .410 4.10
7 10 .354 3.54
8 10 .305 3.05
9 14 .263 3.682
10 14 + 105 = 119 .227 3.178 + 23.835
71.327

The issue price of the debentures will be the sum of present value of interest payments during 10
years of its maturity and present value of redemption value of debenture.
Thus the debentures should be priced at ₹ 71.327

Question 36(Old PM)/RTP May’19

Based on the credit rating of bonds, Mr. Z 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 AA rated, ₹ 1,000 face value bond currently selling at ₹ 1,025.86.
The bond has five years to 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 calculate the intrinsic value of the bond for Mr. Z. Should he invest in the

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bond? Also calculate the current yield and the Yield to Maturity (YTM) of the bond.
Solution
The appropriate discount rate for valuing the bond for Mr. Z is:
R = 9% + 3% + 2% = 14%
Time CF PVIF 14% PV (CF) PV (CF)
1 150 0.877 131.55
2 150 0.769 115.35
3 150 0.675 101.25
4 150 0.592 88.80
5 1150 0.519 596.85
∑ PV (CF) i.e. 1033.80
Since, the current market value is less than the intrinsic value; Mr. Z should buy the bond.
Current yield = Annual Interest / Price = 150 / 1025.86 = 14.62%
The YTM of the bond is calculated as follows:
@ 15%
P = 150 × PVIFA 15%, 4 + 1150 × PVIF 15%, 5
= 150 × 2.855 + 1150 × 0.497 = 428.25 + 571.55 = 999.80

@ 14 %
As found in sub part (a) P0 = 1033.80
By interpolation we get,

YTM = 14.23%

Question 37(Old PM)/MTP April’18/MTP May’20

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
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.
Solution
(i) Intrinsic value of Bond
PV of Interest + PV of Maturity Value of Bond

Forward rate of interests

1st Year 12%
2nd Year 11.25%
3rd Year 10.75%

PV of Interest =

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PV of Maturity Value of Bond =

Intrinsic Value of Bond

(ii) Expected Price = Intrinsic Value x Beta Value

= ₹ 948.48 x 1.02 = ₹ 961.33

Question 38(Old PM)

On 31st March, 2013, the following information about Bonds is available:
Name of Security Face Value Maturity Date Coupon Rate Coupon Date(s)
₹
Zero coupon 10,000 31st March, 2023 N.A. N..A.
T-Bill 1,00,000 20th June, 2013 N.A. N.A.
10.71% GOI 2023 100 31st March, 2023 10.71 31st March
10 % GOI 2018 100 31st March, 2018 10.00 31st March & 30th September
Calculate:
(i) If 10 years yield is 7.5% p.a. what price the Zero Coupon Bond would fetch on 31st March,
2013?
(ii) What will be the annualized yield if the T-Bill is traded @ 98500?
(iii) 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)?
(iv) 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)?
Solution
(i) Rate used for discounting shall be yield. Accordingly, ZCB shall fetch:

(ii) The day count basis is actual number days / 365. Accordingly annualized yield shall be:

Note: Alternatively, it can also computed on 360 days a year.

(iii) Price GOI 2023 would fetch:

= ₹ 10.71 PVAF (8%, 10) + ₹ 100 PVF (8%, 10)

= ₹ 10.71 x 6.71 + ₹ 100 x 0.4632
= ₹ 71.86 + ₹ 46.32 = ₹ 118.18

(iv) Price GOI 2018 Bond would fetch:

= ₹ 5 PVAF (4%, 10) + ₹ 100 PVF (4%, 10)
= ₹ 5 x 8.11 + ₹ 100 x 0.6756
= 40.55 + 67.56 = 108.11

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Question 39(Old PM)

a) 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 ₹ 1,000 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 increase / decrease comes from a change in the present value of bond’s
interest payments?
b) 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?
c) If the YTM of the bond in (b) above increases to 10%, how it affects the bond’s duration?
And why?
Solution
a) If the yield of the bond falls the price will always increase. This can be shown by following
calculation.

If yield falls to 6%

Price of 5yr. bond

₹ 80 (PVIFA 6%, 5yrs.) + ₹ 1000 (PVIF 6%, 5yrs.)

₹ 80 (4.212)+ ₹ 1000 (0.747)
₹ 336.96 + ₹ 747.00 = ₹ 1,083.96
Increase in 5 year’s bond price = ₹ 83.96
Current price of 20 year bond
₹ 80 (PVIFA 6%, 20) + ₹ 1,000 (PVIF 6%, 20)
₹ 80 (11.47) + ₹ 1,000 (0.312)
₹ 917.60 + ₹ 312.00 = ₹ 1229.60
So increase in bond price is ₹ 229.60
PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL
5 yrs. Bond

₹ 1,000 (PVIF 6%, 5) – ₹ 1,000 (PVIF 8%, 5)

₹ 1,000 (0.747) – ₹ 1,000 (0.681)
₹ 747.00 – ₹ 681.00 = ₹ 66.00
& change in price due to change in PV of Principal ( ₹ 66 / ₹ 83.96) x 100 = 78.6%

20 yrs. Bond

₹ 1,000 (PVIF 6%, 20) – ₹ 1,000 (PVIF 8%, 20)

₹ 1,000 (0.312) – ₹ 1,000 (0.214)
₹ 312.00 – ₹ 214.00 = ₹ 98.00
& change in price due to change in PV of Principal
(₹ 98 / ₹ 229.60) x 100 = 42.68%

PRICE CHANGE DUE TO CHANGE IN PV OF INTEREST

5 yrs. Bond

₹ 80 (PVIFA 6%, 5) – ₹ 80 (PVIFA 8%, 5)

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₹ 80 (4.212) – ₹ 80 (3.993)
₹ 336.96 – ₹ 319.44 = ₹ 17.52
% change in price =
20 yrs. Bond
₹ 80 (PVIFA 6%, 20) – ₹ 80 (PVIFA 8%,20)
₹ 80 (11.47) – ₹ 80 (9.82)
₹ 917.60 – ₹ 785.60 = ₹ 132
& change in price =
b) Duration in the average time taken to recollect back the investment
Years Coupon Redemption Total PVIF @ 7% (A)x(B)x (C)
(A) Payments (₹) (₹) (₹) (₹) (₹)
(B) (C)
1 70 - 70 0.935 65.45
2 70 - 70 0.873 122.22
3 70 - 70 0.816 171.36
4 70 - 70 0.763 213.64
5 70 - 70 0.713 249.55
6 70 1000 1070 0.666 4,275.72
∑ ABC 5,097.94

Duration = = = 5.098 years

c) If YTM goes up to 10%, current price of the bond will decrease to

₹ 70 x PVIFA (10%,6) + ₹ 1000 PVIF (10%,6)
₹ 304.85 + ₹ 564.00 = ₹ 868.85
Year (A) Inflow (₹) PVIF @ 10% (A)x(B)x (C)
(B) (C) (₹)
1 70 0.909 63.63
2 70 0.826 115.64
3 70 0.751 157.71
4 70 0.683 191.24
5 70 0.621 217.35
6 1070 0.564 3,620.88
∑ ABC 4,366.45
New Duration ₹ 4,366.45/ ₹ 868.85 = 5.025 years
The duration of bond decreases, reason being the receipt of slightly higher portion of one’s
investment on the same intervals.

Question 40(Old PM)

John inherited the following securities on his uncle’s death:
Types of Security Nos. Annual Coupon % Maturity Years Yield %
Bond A (₹ 1,000) 10 9 3 12
Bond B (₹ 1,000) 10 10 5 12
Preference shares C (₹ 100) 100 11 * 13*

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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.
Solution
Computation of current value of John’s portfolio
(i) 10 Nos. Bond A, ₹ 1,000 par value, 9% Bonds maturity 3 years: ₹
Current value of interest on bond A
1-3 years: ₹ 900 x Cumulative P.V. @ 12% (1-3 years)
= ₹ 900 x 2.402 2,162

Add: Current value of amount received on maturity of Bond A

End of 3rd year: ₹ 1,000 x 10 x P.V. @ 12% (3rd year)
= ₹ 10,000 x 0.712 7,120 9,282

(ii) 10 Nos. Bond B, ₹ 1,000 par value, 10% Bonds maturity 5 years:
Current value of interest on bond B
1-5 years: ₹ 1,000 x Cumulative P.V. @ 12% (1-5 years)
= ₹ 1,000 x 3.605 3,605

Add: Add: Current value of amount received on maturity of Bond B

End of 5th year: ₹ 1,000 x 10 x P.V. @ 12% (5th year)
= ₹ 10,000 x 0.567 5,670 9,275

(iii) 100 Preference shares C, ₹ 100 par value, 11% coupon

11% x 100 Nos. x ₹ 100 = 1,100 8,462
13% 0.13

(iv) 100 Preference shares D, ₹ 100 par value, 12% coupon

12% x 100 Nos. x ₹ 100 = 1,200 9,231 17,693
13% 0.13
Total current value of his portfolio [(i) + (ii) + (iii) + (iv)] 36,250

Question 41(Old PM)

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 if the
company extents the life of Bond for another 6 years.

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Solution
a) If the current interest rate is 8%, the company will not extent the duration of Bond and
the maximum amount the investor would ready to pay will be:
= £1,000 PVIAF (8%, 6) + £10,000 PVIF (8%, 6)
= £1,000 x 4.623 + £10,000 x 0.630
= £4,623 + £ 6,300
= £ 10,923

b) If the current interest rate is 12%, the company will extent the duration of Bond. After six
years the value of Bond will be:
= £1,000 PVIAF (12%, 6) + £10,000 PVIF (12%, 6)
= £1,000 x 4.111 + £10,000 x 0.507
= £4,111 + £5,070
= £9,181

Thus, potential loss will be £9,181 - £10,923= £ 1,742

Question 42(Old PM)

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?
Solution

C = Coupon Rate; F = Face Value (Issue Price); P = Market Price of Bond

Question 43(Old PM)

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?
Solution
Calculation of yield to Maturity (YTM)

YTM =

After tax coupon = 9 x (1 – .30) = 6.3%

After tax redemption price = 105 – (15 x .10) or ₹ 103.5

After tax capital gain = 103.50 – 90 = ₹ 13.50

YTM =

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Question 44(Old PM)/RTP May’18

XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1, 2007.
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 dated June 30 and December 31.
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, 2011 at the end of 5 years.
Required:
(i) Estimate the current yield and YTM of the bond.
(ii) Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment calculate
the realised yield on the NCD.
Solution
(i) Current yield = = 0.1555 or 15.55%

YTM can be determined from the following equation

7 × PVIFA (YTM, 10) + 100 × PVIF (YTM, 10) = 90

Let us discount the cash flows using two discount rates 7.50% and 9% as follows:

Year Cash Flows PVF@7.50% PV@7.50% PVF@9% PV@9%

0 -90 1 -90 1 -90
1 7 0.930 6.51 0.917 6.419
2 7 0.865 6.055 0.842 5.894
3 7 0.805 5.635 0.772 5.404
4 7 0.749 5.243 0.708 4.956
5 7 0.697 4.879 0.650 4.550
6 7 0.648 4.536 0.596 4.172
7 7 0.603 4.221 0.547 3.829
8 7 0.561 3.927 0.502 3.514
9 7 0.522 3.654 0.460 3.220
10 107 0.485 51.90 0.422 45.154
6.560 -2.888
Now we use interpolation formula

YTM = 8.541% or 8.54%

Note: Students can also compute the YTM using rates other than 15% and 18%.

The duration can be calculated as follows:

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Year Cash Flow PVF@ 8.54% PV @ 8.54% Proportion of NCD Proportion of NCD value ×
value time
1 7 0.921 6.447 0.0717 0.0717
2 7 0.849 5.943 0.0661 0.1322
3 7 0.782 5.474 0.0608 0.1824
4 7 0.721 5.047 0.0561 0.2244
5 7 0.664 4.648 0.0517 0.2585
6 7 0.612 4.284 0.0476 0.2856
7 7 0.563 3.941 0.0438 0.3066
8 7 0.519 3.633 0.0404 0.3232
9 7 0.478 3.346 0.0372 0.3348
10 107 0.441 47.187 0.5246 5.2460
89.95 7.3654
Duration = 7.3654 half years i.e. 3.683 years.

(ii) Realized Yield can be calculated as follows:

R= for half yearly and 12.76% annually

Question 45(Old PM)

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
semi annually 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:
(i) What was the YTM of MP Ltd. bonds as on January 1, 2010?
(ii) 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.
Solution

(i) Since the bonds were sold at par, the original YTM was 10%.

YTM =

(ii) Price of the bond as on 1st July, 2018 = ₹ 50 х 9.712 + ₹ 1,000 х 0.417
= ₹ 485.60 + ₹ 417
= ₹ 902.60
Total value of the bond on the next = ₹ 902.60 + ₹ 50 interest date = ₹ 952.60
Therefore, Value of bond at purchase date

(by using excel)

†

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The amount to be paid to complete the transaction is ₹ 916.40. Out of this amount ₹ 48.10
represent accrued interest* and ₹ 868.30 represent the bond basic value.

† Alternatively, it can also be calculated as follows:

The amount to be paid to complete the transaction is ₹ 915.96. Out of this amount ₹ 48.08
represent accrued interest* and ₹ 867.88 represent the bond basic value.

*Alternatively, Accrued Interest can also be calculated as follows:

Accrued Interest on Bonds =

Question 46(Study Material TYK Q 25)/Similar Q asked in PP December’21/RTP Nov’22

ABC Ltd. has ₹ 300 million, 12 percent 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 percent. ₹ 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 percent. You are required to analyze the bond refunding decision.
Solution
(i) Calculation of initial outlay:
₹ (million)
(a) Face value 300
Add:- Call premium 12
Cost of calling old bonds 312

(b) Gross proceed of new issue 300

Less: Issue costs 6
Net proceeds of new issue 294

(c) Tax savings on call premium and unamortized cost 0.30 (12 + 9) 6.3
Therefore,Initial outlay = ₹ 312 million – ₹ 294 million – ₹ 6.3 ₹ 11.7million
million

(ii) Calculation of net present value of refunding the bond:-

₹ (million)
Saving in annual interest expenses [300 x (0.12 – 0.10)] 6.00
Less:- Tax saving on interest and amortization {0.30 x [6 + (9-6)/6]} 1.95
Annual net cash saving 4.05
PVIFA (7%, 6 years) 4.766
Therefore, Present value of net annual cash saving 19.30 million

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Less:- Initial outlay 11.70 million

Net present value of refunding the bond 7.60 million

Decision: The bonds should be refunded

Question 47(MTP Nov’21)(PP Nov’18)

M/s Transindia Ltd. is contemplating 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 ₹ 1,140 and had
initially collected proceeds of ₹ 2.91 crores due to a discount of ₹ 30 per bond. The initial
floating cost was ₹ 3,60,000. 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 ₹ 4,00,000. 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
their proceeds, then used to retire old bonds, the company expects a two months period of
overlapping interest during which interest must be paid on both the old and new bonds. What is
the feasibility of refunding bonds?
Solution
NPV for bond refunding

₹
PV of annual cash flow savings (W.N. 2) 37,31,980
(3,49,600 x PVIFA 8%, 25) i.e. 10.675
Less: Initial investment (W.N. 1) 29,20,000
NPV 8,11,980
Recommendation: Refunding of bonds is recommended as NPV is positive.

Working Notes:
1) Initial investment:
(a) Call Premium
Before tax (1,140 – 1,000) X 30,000 42,00,000
Less tax @ 40% 16,80,000
After tax cost of call prem. 25,20,000

(b) Flotation Cost 4,00,000

(c) Overlapping Interest

Before tax (0.14 x 2/12 x 3 crores) 7,00,000
Less: tax @ 40% 2,80,000 4,20,000

(d) Tax saving on unamortised discount on (3,00,000)

old bond 25/30 x 9,00,000 x 0.4

(e) Tax savings from unamortised floatation

Cost of old bond 25/30 x 3,60,000 x 0.4 (1,20,000)
29,20,000

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2) Annual cash flow savings:

(a) Old bond
(i)Interest cost (0.14 x 3 crores) 42,00,000
Less tax @ 40% 16,80,000 25,20,000

(ii)Tax savings from amortisation of discount

9,00,000/30 x 0.4 (12,000)

(iii) Tax savings from amortization of floatation

cost 3,60,000/30 x 0.4 (4,800)
Annual after tax cost payment under old Bond (A) 25,03,200

(b) New Bond

(i)Interest cost before tax (0.12 x 3 crores) 36,00,000
Less tax @ 40% 14,40,000
After tax interest 21,60,000

(ii)Tax savings from amortization of floatation cost

(0.4 x 4,00,000/25) (6,400)
Annual after tax payment under new Bond (B) 21,53,600
Annual Cash Flow Saving (A) – (B) 3,49,600

Question 48(Study Material TYK Q 18)/Similar Q in PP July’21/MTP Sep’22/RTP Nov’22

Rahul Ltd. has surplus cash of ₹ 100 lakhs and wants to distribute 27% of it to the shareholders.
The company decides to buy back shares. The Finance Manager of the company estimates that its
share price after re-purchase is likely to be 10% above the buyback price - if the buyback route
is taken. The number of shares outstanding at present is 10 lakhs and the current EPS is ₹ 3.
You are required to determine:
(i) The price at which the shares can be re-purchased, if the market capitalization of the
company should be ₹ 210 lakhs after buyback,
(ii) The number of shares that can be re-purchased, and
(iii) The impact of share re-purchase on the EPS, assuming that net income is the same.
Solution
(i) Let P be the buyback price decided by Rahul Ltd.

Market Capitalisation after Buyback

1.1P (Original Shares – Shares Bought Back)

= 11 lakhs x P – 27 lakhs x 1.1 = 11 lakhs P – 29.7 lakhs

Again, 11 lakhs P – 29.7 lakhs

or 11 lakhs P = 210 lakhs + 29.7 lakhs

or P =

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(ii) Number of Shares to be Bought Back :-

= 1.24 lakhs (Approx) or 123910 share

(iii) New Equity Shares:-

10 lakhs – 1.24 lakhs = 8.76 lakhs or 1000000 – 123910 = 876090 shares

Therefore, EPS =

Thus, EPS of Rahul Ltd., increases to ₹ 3.43.

Question 49(Same as Q 48)/MTP April’18

Abhishek Ltd. has a surplus cash of ₹ 90 lakhs and wants to distribute 30% of it to the
shareholders. The Company decides to buyback shares. The Finance Manager of the Company
estimates that its share price after re-purchase is likely to be 10% above the buyback price; if
the buyback route is taken. The number of shares outstanding at present is 10 lakhs and the
current EPS is ₹3.
You are required to determine:
a) The price at which the shares can be repurchased, if the market capitalization of the
company should be ₹ 200 lakhs after buyback.
b) The number of shares that can be re-purchased.
c) The impact of share re-purchase on the EPS, assuming the net income is same.
Solution
a) Let P be the buyback price decided by Abhishek Ltd.

Market Capitalisation after Buyback

1.1P (Original Shares – Shares Bought Back)

= 11 lakhs x P – 27 lakhs x 1.1 = 11 lakhs x P – 29.7 lakhs

Market capitalization rate after buyback is 200 lakhs.

Thus, we have

11 lakhs x P -29.7 lakhs = ₹ 200 lakhs

or 11P = 200 + 29.7

or P =

b) Number of Shares to be Bought Back :-

c) New Equity Shares:-

= (10 - 1.29) lakhs = 8.71 lakhs

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Therefore, EPS =

Thus, EPS of Abhishek Ltd., increases to ₹ 3.44.

Question 50(Old PM)

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 earning per share (a) before conversion (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?
Solution
(i) Conversion value of preference share
Conversion Ratio x Market Price
2 ₹ 21 = ₹ 42
(ii) Conversion Premium
(₹ 50/ ₹ 42) – 1 = 19.05%
(iii) Effect of the issue on basic EPS
₹
Before Conversion
Total (after tax) earnings ₹ 3 × 5,00,000 15,00,000
Dividend on Preference shares 1,40,000
Earnings available to equity holders 13,60,000
No. of shares 5,00,000
EPS 2.72
On Diluted Basis
Earnings 15,00,000
No of shares (5,00,000 + 80,000) 5,80,000
EPS 2.59

(iii) EPS with increase in Profit

₹
Before Conversion
Earnings 25,00,000
Dividend on Pref. shares 1,40,000
Earning for equity shareholders 23,60,000
No. of equity shares 5,00,000
EPS 4.72
On Diluted Basis
Earnings 25,00,000
No. of shows 5,80,000
EPS 4.31

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Question 51(Study Material TYK Q 22)

A convertible bond with a face value of ₹ 1,000 is issued at ₹ 1,350 with a coupon rate of 10.5%.
The conversion rate is 14 shares per bond. The current market price of bond and share is ₹ 1,475
and ₹ 80 respectively. What is the premium over conversion value?
Solution
Conversion rate is 14 shares per bond. Market price of share ₹ 80
Conversion Value 14 x ₹ 80 = ₹ 1120

Market price of bond = ₹ 1475

Premium over Conversion Value (₹ 1475 - ₹ 1120) =

Question 52(Study Material TYK Q 24)/MTP April’18/Similar Q asked in PP July’21

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

Calculate:
(i) Stock value of bond.
(ii) The percentage of downside risk.
(iii) The conversion premium
(iv) The conversion parity price of the stock.
Solution

(i) Stock value or conversion value of bond

12 × 20 = ₹ 240

(ii) Percentage of the downside risk

This ratio gives the percentage price decline experienced by the bond if the stock becomes
worthless.

(iii) Conversion Premium

(iv) Conversion Parity Price

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This indicates that if the price of shares rises to ₹ 13.25 from ₹ 12 the investor will
neither gain nor lose on buying the bond and exercising it. Observe that ₹ 1.25 (₹ 13.25 – ₹
12.00) is 10.42% of ₹ 12, the Conversion Premium.

Question 53(Old PM)

Pineapple Ltd has issued fully convertible 12 percent debentures of ₹ 5,000 face value,
convertible into 10 equity shares. The current market price of the debentures is ₹ 5,400. The
present market price of equity shares is ₹ 430.
Calculate:
(i) The conversion percentage premium, and
(ii) The conversion value
Solution
(i) As per the conversion terms 1 Debenture = 10 equity share and since face value of one
debenture is ₹ 5000 the value of equity share becomes ₹ 500 (5000/10).

The conversion terms can also be expressed as:

1 Debenture of ₹ 500 = 1 equity share.

The cost of buying ₹ 500 debenture (one equity share) is:

Market Price of share is ₹ 430. Hence conversion premium in percentage is:

(ii) The conversion value can be calculated as follows:

Conversion value = Conversion ratio X Market Price of Equity Shares

= 10 × ₹ 430 = ₹ 4300

Question 54(Old PM)/MTP Aug’18

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.

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(iii) Conversion Premium.

(iv) Percentage of downside risk.
(v) Conversion Parity Price.
T 1 2 3
PVIF 0.095, t 0.9132 0.8340 0.7617
Solution
(i) Straight Value of Bond
₹ 85 x 0.9132 + ₹ 85 x 0.8340 + ₹ 1085 x 0.7617 = ₹ 974.96

(ii) Conversion Value

Conversion Ratio x Market Price of Equity Share

= ₹ 45 x 25 = ₹ 1,125

(iii) Conversion Premium

Conversion Premium = Market Conversion Price - Market Price of Equity Share

or = ₹ 1,175 - ₹ 45 x 25 = ₹ 50

or

(iv) Percentage of Downside Risk

or

(v) Conversion Parity Price

Question 55(Old PM)/RTP Nov’21

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:
(i) Conversion Value of Debenture
(ii) Market Conversion Price
(iii) Conversion Premium per share
(iv) Ratio of Conversion Premium
(v) Premium over Straight Value of Debenture
(vi) Favourable income differential per share

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(vii) Premium payback period

Solution
(i) Conversion Value of Debenture

= Market Price of one Equity Share x Conversion Ratio

= ₹ 25 X 30 = ₹ 750

(ii) Market Conversion Price

(iii) Conversion Premium per share

Market Conversion Price – Market Price of Equity Share

= ₹ 30 – ₹ 25 = ₹ 5

(iv) Ratio of Conversion Premium

(v) Premium over Straight Value of Debenture

(vi) Favourable income differential per share

(vii) Premium payback period

Question 56(Old PM)

Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of ₹ 90 lakhs.
Its present borrowings are as follows:
₹ In lakhs
12% term loan 300
Working capital borrowings:
From Bank at 15% 200
Public Deposit at 11% 100

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The sales of the company are growing and to support this, the company proposes to obtain
additional borrowing of ₹ 100 lakhs expected to cost 16%. The increase in EBIT is expected to be
15%.
Calculate the change in interest coverage ratio after the additional borrowing is effected and
comment on the arrangement made.

Solution
Calculation of Present Interest Coverage Ratio
Present EBIT = ₹ 90 lakhs

Interest charges (Present) ₹ lakhs

Term loan @ 12% 36.00
Bank Borrowings @ 15% 30.00
Public Deposit @ 11% 11.00
77.00
Present Interest Coverage Ratio

Calculation of Revised Interest Coverage Ratio

Revised EBIT (115% of ₹ 90 lakhs) ₹103.50 lakhs
Proposed interest charges
Existing charges ₹ 77.00 lakhs
Add: Additional charges (16% of additional Borrowings i.e. ₹ 100 lakhs) ₹ 16.00 lakhs
Total ₹ 93.00 lakhs

Revised Interest Coverage Ratio =

Analysis: With the proposed increase in the sales the burden of interest on additional borrowings
of ₹ 100 lakhs will adversely affect the interest coverage ratio which has been reduced. (i.e. from
1.169 to 1.113).

Question 57
The HLL has ₹ 8.00 crore of 10% mortgage bonds outstanding under an open-end scheme. The
scheme allows additional bonds to be issued as long as all of the following conditions are met:
1) Pre – tax interest coverage remains greater than 4
2) Net depreciated value of mortgage assets remains twice the amount of the mortgage debt.
3) Debt-to-equity ratio remains below 0.50
The HLL has net income after taxes of ₹ 2 crores and a 40% tax-rate, ₹ 40 crores in equity and ₹
30 crores in depreciated assets, covered by the mortgage.
Assuming that 50% of the proceeds of a new issue would be added to the base of mortgaged
assets and that the company has no Sinking Fund payments until next year, how much more 10%
debt could be sold under each of the three conditions? Which protective covenant is binding?

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Solution
Let x be the crores of Rupees of new 10% debt which would be sold under each of the three given
conditions. Now, the value of x under each of the three conditions is as follows:

1) Pre – tax interest coverage remains greater than 4

Or

Or

Or ₹ 4.13 crores + 0.10x = 4(₹ 0.80 crores + ₹ 0.10x)

Or ₹ 4.13 crores + 0.10x = ₹ 3.2 crores + ₹ 0.40x

Or ₹ 0.30x = 0.93

Or x = ₹ 0.93/0.30

Or x = ₹ 3.10 crores

Additional mortgage required shall be a maximum of ₹ 3.10 crores

2) Net depreciated value of mortgage assets remains twice the amount of mortgage debt.

(Assuming that 50% of the proceeds of new issue would be added to the base of mortgage
assets.)

i.e.

or ₹ 30 crores + 0.5x = 2(₹ 8 crores + x)

or ₹ 1.5x = ₹ 14 crores

or =

or x = ₹ 9.33 crores

Additional mortgage required to satisfy condition No. 2 is ₹ 9.33 crores

Debt to equity ratio remains below 5

i.e.

or ₹ 8 crores + x = ₹ 20 crores

or x = ₹ 12 crores

Since all the conditions are to be met, the least i.e. ₹ 3.10 crores (as per condition – 1) can
be borrowed by issuing additional bonds.

Thus, binding conditions are met and it limits the amount of new debt to ₹ 3.10 crore.

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Question 58 (Old PM)/MTP April’19

The following data is available for a bond:
Face value ₹ 1,000
Coupon Rate 11%
Years to Maturity 6
Redemption value ₹ 1,000
Yield to maturity 15%
(Round - off your answers to 3 decimals)
Calculate the following in respect of the bond:
(i) Current Market Price.
(ii) Duration of the Bond.
(iii) Volatility of the Bond.
(iv) Expected market price if increases in required yield is by 100 basis points.
(v) Expected market price if decreases in required yield is by 75 basis points.
Solution
(i) Calculation of Market Price:

(ii) Discount or premium – YTM is more than coupon rate, market price is less than Face Value
i.e. at discount.

Let x be the market price

x = ₹ 834.48

Alternatively, it can also be calculated using Tabular Method.

(iii) Duration
Year Cash Flow P.V. @ 15% Proportion Proportion of Bond
of Bond value x times (years)
value
1 110 .870 95.70 0.113 0.113
2 110 .756 83.16 0.098 0.196
3 110 .658 72.38 0.085 0.255
4 110 .572 62.92 0.074 0.296
5 110 .497 54.67 0.064 0.320
6 1110 .432 479.52 0.565 3.39
848.35 1.000 4.570
Duration of the bond is 4.570 years
(iv) Volatility

Volatility of the bond =

The expected market price if increase in required yield is by 100 basis points.

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= ₹ 834.48 x 1.00(3.974/100) = ₹ 33.162

Hence expected market price is ₹ 834.48 - ₹ 33.162 = ₹ 801.318
Alternatively, this can also be calculated as follows:
₹ 848.35 x 1.00 (3.794/100) = 33.71
Hence expected market price is ₹ 848.48 - ₹ 33.71 = ₹ 814.77
Thus, the market price will decrease.

(v) The expected market price if decrease in required yield is by 75 basis points.
= ₹ 834.48 x 0.75(3.974/100) = ₹ 24.87
Hence expected market price is ₹ 834.48 + ₹ 24.87 = ₹ 859.35
Alternatively, this can also be calculated as follows:
848.35 x 0.75 (3.974/100) = ₹ 25.29
Hence, expected market price = 848.35 – 25.29 = ₹ 823.06
Thus, the market price will increase

Question 59 (Study Material TYK Q 26)

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 is 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.
Solution
a) Calculation of Market price:

= 160(PVIAF 17%,6) + 1,000 (PVIF 17%,6)

= 160 (3.589) + 1,000 (0.390) = 574.24 + 390 = 964.24

b) Duration

Year Cash flow P.V. @ 17% Proportion of Proportion of bond value

bond x time
value (years)
1 160 .855 136.80 0.142 0.142
2 160 .731 116.96 0.121 0.246
3 160 .624 99.84 0.103 0.309
4 160 .534 85.44 0.089 0.356
5 160 .456 72.96 0.076 0.380
6 1160 .390 452.40 0.469 2.814
964.40 1.000 4.247
Duration of the Bond is 4.247 years

Alternatively, it can be calculated as follows:

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Year Cash flow P.V @ 17% P.V. x Year

1 160 0.855 136.80 136.80
2 160 0.731 116.96 233.92
3 160 0.624 99.84 299.52
4 160 0.534 85.44 341.76
5 160 0.456 72.96 364.80
6 1160 0.390 452.40 2714.40
7 964.40 4091.20

D=

D= = 4.242 years

Alternatively, as per Short Cut Method

Where YTM = Yield to Maturity

c = Coupon Rate

t = Years to Maturity

D = 4.24 years

c) Volatility
Volatility of the bonds =

d) The expected market price if increase in required yield is by 75 basis points.

= ₹ 960.26 x .75 (3.63/100) = ₹ 26.142

Hence expected market price is ₹ 960.26 – ₹ 26.142 = ₹ 934.118
Hence, the market price will decrease
This portion can also be alternatively done as follows
= ₹ 964.40 x .75 (3.63/100) = ₹ 26.26
then the market price will be = ₹ 964.40 - ₹ 26.26 = ₹ 938.14

Question 60 (Study Material TYK Q 27)/RTP Nov’21/MTP Aug’18/MTP March’22

Mr. A will need ₹ 1,00,000 after two years for which he wants to make one time necessary
investment now. He has a choice of two types of bonds. Their details are as below:
Bond X Bond Y
Face value ₹ 1,000 ₹ 1,000
Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price ₹ 972.73 ₹ 936.52
Current yield 10% 10%

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Advice Mr. A whether he should invest all his money in one type of bond or he should buy both the
bonds and, if so, in which quantity? Assume that there will not be any call risk or default risk.

Solution
Duration of Bond X
Year Cash flow P.V. @ 10% Proportion of bond Proportion of bond value
value x time (years)
1 1070 .909 972.63 1.000 1.000

Duration of the Bond is 1 year

Duration of Bond Y

Year Cash flow P.V. @ 10% Proportion of bond Proportion of bond value
value x time (years)
1 80 .909 72.72 0.077 0.077
2 80 .826 66.08 0.071 0.142
3 80 .751 60.08 0.064 0.192
4 1080 .683 737.64 0.788 3.152
936.52 1.000 3.563
Duration of the Bond is 3.563 years
Let x1 be the investment in Bond X and therefore investment in Bond Y shall be (1 - x1). Since the
required duration is 2 years the proportion of investment in each of these two securities shall be
computed as follows:
2 = x1 + (1 - x1) 3.563

x1 = 0.61

Accordingly, the proportion of investment shall be 61% in Bond X and 39% in Bond Y respectively.

Amount of investment
Bond X Bond Y
PV of ₹ 1,00,000 for 2 years @ 10% x 61% PV of ₹ 1,00,000 for 2 years @ 10% x 39%
= ₹ 1,00,000 (0.826) x 61% = ₹ 1,00,000 (0.826) x 39%
= ₹ 50,386 = ₹ 32,214
No. of Bonds to be purchased No. of Bonds to be purchased
= ₹ 50,386/₹ 972.63 = 51.80 i.e. approx. 52 bonds = ₹ 32,214/₹ 936.52 = 34.40 i.e. approx. 34
bonds
Note: The investor has to keep the money invested for two years. Therefore, the investor can
invest in both the bonds with the assumption that Bond X will be reinvested for another one year
on same returns.

Further, in the above computation, Modified Duration can also be used instead of Duration.

Question 61 (Old PM)

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

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X Ltd. ₹ 10,000 6% 5 Years

Y Ltd. ₹ 0,000 4% 5 Years
The current market price of X Ltd.’s bond is ₹ 10,796.80 and both bonds have same Yield To
Maturity (YTM). Since Mr. A considers duration of bonds as the basis of decision making, you are
required to calculate the duration of each bond and you decision.
Solution
To calculate duration of bond we need YTM, which shall be calculated as follows:

Let us try NPV of Bond @ 5%

= ₹ 571.43 + ₹ 544.22 + ₹ 518.30 + ₹ 493.62 + ₹ 8,305.358 - ₹ 10,796.80 = - ₹ 363.85

Let us now try NPV @ 4%

= ₹ 576.92 + ₹ 554.73 + ₹ 533.40 + ₹ 512.88 + ₹ 712.43 – ₹ 10,796.80 = ₹ 93.56

Let us now interpolation formula

Duration of X Ltd.’ s Bond

Year Cash flow P.V. @ 4.2% Proportion of Proportion of bond value x
bond value time (years)
1 600 0.9597 575.82 0.0533 0.0533
2 600 0.9210 552.60 0.0512 0.1024
3 600 0.8839 530.34 0.0491 0.1473
4 600 0.8483 508.98 0.0472 0.1888
5 10600 0.8141 8,629.46 0.7992 3.9960
10,797.20 1.0000 4.4878

Duration of the Bond is 4.4878 years say 4.49 years.

Duration of Y Ltd.’s Bond

Year Cash flow P.V. @ 4.2% Proportion of Proportion of bond value x
bond value time (years)
1 400 0.9597 383.88 0.0387 0.0387
2 400 0.9210 368.40 0.0372 0.0744

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3 400 0.8839 353.56 0.0357 0.1071

4 400 0.8483 339.32 0.0342 0.1368
5 10400 0.8141 8,466.64 0.8542 4.2710
9,911.80 1.0000 4.6280

Duration of the Bond is 4.6280 years say 4.63 years.

Decision: Since the duration of Bond of X Ltd. is lower and also carrying higher interest rate hence
it should be preferred.

Question 62 (Old PM)

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 1.166 = 2.4364.
Solution
The formula for the duration of a coupon bond is as follows:

Where
YTM = Yield to Maturity
c = Coupon Rate
t = Years to Maturity

Accordingly, since YTM =0.16 and t = 6

4.3202 =

4.3202 = 7.25 −

0.2 + 6c = 4.20836472c + 0.468768

1.79163528c = 0.268768
C = 0.150012674
Therefore, C = 0.15
Where c = Coupon rate
Therefore, current price = ₹ (1,00,000/- x 0.15 x 3.685 + 1,00,000/- x 0.410) = ₹ 96,275/-.
Alternatively, it can also be calculated as follows:
Let x be annual coupon payment. Accordingly, the duration (D) of the Bond shall be
Year CF PVIF 16% PV (CF) PV (CF)
1 X 0.862 0.862x
2 X 0.743 0.743x
3 X 0.641 0.641x
4 X 0.552 0.552x
5 X 0.476 0.476x
6 x +100000 0.410 0.410x + 41000

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3.684x +
41000

4.3202 =

x = ₹ 14,983 i.e. 14.98% say 15%

Accordingly, current price of the Bond shall be:
= 1,00,000 × 0.15 × PVAF (16%, 6) + 1,00,000 × PVF (16%, 6)
= 15,000 × 3.685 + 1,00,000 × 0.410 = ₹ 96,275

Question 63
This question has been shifted to “Security Analysis Q-13”

Question 64
This question has been shifted to “Security Analysis Q-14”

Question 65 (Old PM)

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.
Solution
Intrinsic Value
Using CAPM
K=
= Risk Free Rate
= Beta of Security
= Market Return
= 9% + 0.75 (15% - 9%) = 13.5%
P=

Question 66 (Old PM)/MTP Oct’18

Capital structure of Sun Ltd., as at 31.3.2003 was as under:
(₹ in lakhs)
Equity share capital 80
8% Preference share capital 40

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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 assuming:
(i) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(ii) 2% for every one time of difference for Capital Gearing Ratio.
Solution
a) Calculation of Profit after tax (PAT)

₹
C Profit before interest and tax (PBIT) 32,00,000
Less: Debenture interest (₹ 64,00,000 × 12/100) 7,68,000
a
Profit before tax (PBT) 24,32,000
l
Less: Tax @ 35% 8,51,200
c
Profit after tax (PAT) 15,80,800
u
Less: Preference Dividend
l
(₹ 40,00,000 × 8/100) 3,20,000
a
Equity Dividend (₹ 80,00,000 × 8/100) 6,40,000 9,60,000
t
Retained earnings (Undistributed profit) 6,20,800
i
Calculation on of Interest and Fixed Dividend Coverage
=

b) Calculation of Capital Gearing Ratio

Capital Gearing Ratio =

c) Calculation of Yield on Equity Shares:

Yield on equity shares is calculated at 50% of profits distributed and 5% on undistributed
profits: (₹)
50% on distributed profits (₹ 6,40,000 × 50/100) 3,20,000
5% on undistributed profits (₹ 6,20,800 × 5/100) 31,040
Yield on equity shares 3,51,040
Yield on equity shares % =

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Calculation of Expected Yield on Equity shares

(i) Interest and fixed dividend coverage of Sun Ltd. is 2.16 times but the industry average is 3
times. Therefore, risk premium is added to Sun Ltd. Shares @ 1% for every 1 time of
difference. Hence,
Risk Premium = 3.00 – 2.16 (1%) = 0.84 (1%) = 0.84%

(ii) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75 times. Therefore,
risk premium is added to Sun Ltd. shares @ 2% for every 1 time of difference. Hence,

Risk Premium = (0.75 - 0.93) (2%)

= 0.18 (2%) = 0.36%
(%)
Normal return expected 9.60
Add: Risk premium for low interest and fixed dividend coverage 0.84
Add: Risk premium for high interest gearing ratio 0.36
10.80
Value of Equity Share
=₹ 40.65

Question 67 (Old PM)/MTP Oct’19

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.
Present values t1 t2 t3 t4 t5
PVIF 0.14, t 0.877 0.769 0.675 0.592 0.519
PVIF 0.08, 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.
Solution
(i) Current Market Price of Bond
Time CF PVIF 8% PV (CF) PV (CF)
1 14 0.926 12.964
2 14 0.857 11.998
3 14 0.794 11.116
4 14 0.735 10.290

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5 114 0.681 77.634

∑ PV (CF) i.e. P0 = 124.002

Say ₹124.002
(ii) Minimum Market Price of Equity Shares at which Bondholder should exercise conversion
option:

(iii) Duration of the Bond

Year Cash flow P.V. @ 8% Proportion of Proportion of
bond value bond value x
time (years)
1 14 0.926 12.964 0.105 0.105
2 14 0.857 11.998 0.097 0.194
3 14 0.794 11.116 0.089 0.267
4 14 0.735 10.290 0.083 0.332
5 114 0.681 77.634 0.626 3.130
124.002 1.000 4.028

Question 68 (Old PM)

XYZ Ltd. paid a dividend of ₹ 2 for the current year. The dividend is expected to grow at 40%
for the next 5 years and at 15% per annum thereafter. The return on 182 days T - bills is 11% per
annum and the market return is expected to be around 18% with a variance of 24%.
The co-variance of XYZ's return with that of the market is 30%. You are required to calculate
the required rate of return and intrinsic value of the stock.
Solution

Expected Return = Rf + β (Rm - Rf)

= 11% + 1.25(18% - 11%)

= 11% + 8.75% = 19.75%
Intrinsic Value
Year Dividend (₹) PVF (19.75%,n) Present Value (₹)
1 2.80 0.835 2.34
2 3.92 0.697 2.73
3 5.49 0.582 3.19
4 7.68 0.486 3.73
5 10.76 0.406 4.37
16.36

PV of Terminal Value =

Intrinsic Value = ₹ 16.36 + ₹ 105.77 = ₹ 122.13

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Question 69 (Study Material TYK Q 28)

RBI sold a 91- day T- Bill of face value of ₹ 100 at an yield of 6%. What was the issue price?
Solution
Let the issue price be X

By the terms of the issue of the T- Bills:

0.01496x = 100 – x

Question 70 (Study Material TYK Q 29)

Wonderland Limited has excess cash of ₹ 20 lakhs, which it wants to invest in short term
marketable securities. Expenses relating to investment will be ₹ 50,000.
The securities invested will have an annual yield of 9%.
The company seeks your advice
(i) as to the period of investment so as to earn a pre-tax income of 5%. (discuss)
(ii) the minimum period for the company to breakeven its investment expenditure overtime
value of money.
Solution
(i) Pre-tax Income required on investment of ₹ 20,00,000
Let the period of Investment be ‘P’ and return required on investment ₹ 1,00,000
(₹ 20,00,000 x 5%)
Accordingly,

P = 10 months

(ii) Break-Even its investment expenditure

P = 3.33 months

Question 71 (Study Material TYK Q 30/MTP Nov’21)

Z Co. Ltd. issued commercial paper worth ₹10 crores as per following details:
Date of issue 16th January, 2019
Date of maturity 17th April, 2019
No. of days 91
Interest Rate 12.04% p. an.
What was the net amount received by the company on issue of CP? (Charges of intermediary may
be ignored)

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Solution
The company had issued commercial paper worth ₹10 crores

No. of days Involves = 91 days

Interest rate applicable = 12.04 % p.a.

Interest for 91 days =

= or ₹ 29.14507 Lakhs

Therefore,

Net amount received at the time of issue :- ₹ 10.00 Crores – ₹ 0.29151 Crores

= ₹ 9.70849 Crores

Alternatively, it can also be computed as follows:

Question 72 (Study Material TYK Q 31)

Bank A enter into a Repo for 14 days with Bank B in 10% Government of India Bonds 2028 @
5.65% for ₹ 8 crore. Assuming that clean price (the price that does not have accrued interest) be
₹ 99.42 and initial Margin be 2% and days of accrued interest be 262 days. You are required to
determine.
(i) Dirty Price
(ii) Repayment at maturity. (consider 360 days in a year)
Solution
(i) Dirty Price
= Clean Price + Interest Accrued

(ii) First Leg (Start Proceed)

Second Leg (Repayment at Maturity)

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RTP, MTP & PREVIOUS YEAR QUESTIONS

Question 1 (RTP Nov’19/MTP March’18/MTP April’19)
A hypothetical company ABC Ltd. issued a 10% Debenture (Face Value of ₹ 1000) of the duration
of 10 years is 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
PVIF 0.11, t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVIF 0.13, t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295
Solution
Conversion Price = ₹ 50 x 17 = ₹ 850
Intrinsic Value = ₹ 850
Accordingly the yield (r) on the bond shall be:
₹ 850 = ₹ 100 PVAF (r, 10) + ₹ 1000 PVF (r, 10)
Let us discount the cash flows by 11%
850 = 100 PVAF (11%, 10) + 1000 PVF (11%, 10)
850 = 100 x 5.890 + 1000 x 0.352
= 91
Now let us discount the cash flows by 13%

850 = 100 PVAF (13%, 10) + 1000 PVF (13%, 10)

850 = 100 x 5.426 + 1000 x 0.295
= - 12.40
Accordingly, IRR

= 12.76%
The spread from comparable bond = 12.76% - 11.80% = 0.96%

Question 2 (RTP Nov’20)

Today being 1st January 2019, Ram is considering to purchase an outstanding Corporate Bond
having a face value of ₹ 1,000 that was issued on 1st January 2017 which has 9.5% Annual Coupon
and 20 years of original maturity (i.e. maturing on 31st December 2027). Since the bond was
issued, the interest rates have been on downside and it is now selling at a premium of ₹ 125.75
per bond.
Determine the prevailing interest on the similar type of Bonds if it is held till the maturity which
shall be at per bond.
PV Factors:
1 2 3 4 5 6 7 8 9

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6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500
Solution
To determine the prevailing rate of interest for the similar type of Bonds we shall compute the
YTM of this Bond using IRR method as follows:
M = ₹ 1000

Interest = ₹ 95 (0.095 x ₹ 1000)

n = 9 years
V0 = ₹ 1125.75 (₹ 1000 + ₹ 125.75)
YTM can be determined from the following equation
₹ 95 x PVIFA (YTM, 9) + ₹ 1000 x PVIF (YTM, 9) = ₹ 1125

Let us discount the cash flows using two discount rates 8% and 10% as follows:

Year Cash Flows PVF@6% PV@6% PVF@8% PV@8%

0 -1125.75 1 -1125.75 1 -1125.75
1 95 0.943 89.59 0.926 87.97
2 95 0.890 84.55 0.857 81.42
3 95 0.840 79.80 0.794 75.43
4 95 0.792 75.24 0.735 69.83
5 95 0.747 70.97 0.681 64.70
6 95 0.705 66.98 0.630 59.85
7 95 0.665 63.18 0.583 55.39
8 95 0.627 59.57 0.540 51.30
9 1095 0.592 648.24 0.500 547.50
112.37 -32.36
Now we use interpolation formula

YTM = 7.553% say 7.55%

Thus, prevailing interest rate on similar type of Bonds shall be approx. 7.55%.

Question 3 (RTP Nov’20)

The following data is available for NNTC bond:
Face Value ₹ 1000
Coupon rate 7.50%
Years to maturity 8 years
Redemption Value ₹ 1000
YTM 8%
Calculate:
(i) The current market price, duration and volatility of the bond.
The expected market price if the decrease in required yield by 50 bps

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Solution
(i) Current Market Price of Bond shall be computed as follows:

Year Cash flows PVF@8% PV@8%

1 75 0.926 69.45
2 75 0.857 64.28
3 75 0.794 59.55
4 75 0.735 55.13
5 75 0.681 51.08
6 75 0.630 47.25
7 75 0.583 43.73
8 1075 0.540 580.50
970.97
Thus, the current market price of the Bond shall be ₹ 970.97

Alternatively, using the Short - cut method the Market Price of Bond can also be computed
as follows:
Interest + (Discount / Premium) / Years to maturity
(Face value + market value) / 2

Let market price be x

–
0.08 =

Thus, Value of X i.e. the price of Bond shall be ₹ 969.70

For the duration of the bond, we have to see the future cash flow and discount them as
follows:
Year CF PV @ 8% DCF Proportion Prop* Time
(Yrs)
1 75 0.926 69.45 0.071 0.071
2 75 0.857 64.28 0.066 0.132
3 75 0.794 59.55 0.061 0.183
4 75 0.735 55.13 0.057 0.228
5 75 0.681 51.08 0.053 0.265
6 75 0.630 47.25 0.049 0.294
7 75 0.583 43.73 0.045 0.315
8 1075 0.540 580.50 0.598 4.784
Total 970.97 1.000 6.272
Volatility of the bond = Duration / (1+ Yield) = 6.272/1.08 = 5.81
(ii) If there is decrease in required yield by 50 bps the expected market price of the Bond
shall be increased by:
= ₹ 970.97 x 0.50 (5.81 / 100) = ₹ 28.21
Hence expected market price is ₹ 970.97 + ₹ 28.21 = ₹ 999.18
Alternatively, this portion using Bond Price as per Short-cut method can also be computed
as follows:
= ₹ 969.70 x 0.50 (5.81 / 100) = ₹ 28.17

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then the market price will be = ₹ 969.70 + ₹ 28.17 = ₹ 997.87

Question 4 (RTP May’21/Similar to Q 17 Pragya Ltd))

KLM Limited has issued 90,000 equity shares of ₹ 10 each. KLM Limited’s shares are currently
selling at ₹ 72. The company has a plan to make a rights issue of one new equity share at a price
of ₹ 48 for every four shares held.
You are required to:
a) Calculate the theoretical post – rights price per share and analyse the change
b) Calculate the theoretical value of the right alone.
c) Suppose Mr. A who is holding 100 shares in KLM Ltd. is not interested in subscribing to the
right issue, then advice what should he do.
Solution
a) Calculation of theoretical Post – rights (ex – right) price per share
Ex – right value =
Where,
M = Market price,
N = Number of old shares for a right share
S = Subscription price
R = Right share offer

= = ₹ 67.20
Thus, post right issue the price of share has reduced by ₹ 4.80 per share.
b) Calculation of theoretical value of the rights alone:
= Ex - right price – Cost of rights share

= ₹ 67.20 – ₹ 48 = ₹ 19.20
Or
= = ₹ 4.80
(iii) If Mr. A is not interested in subscribing to the right issue, he can renounce his right
eligibility @ ₹ 19.20 per right and can earn a gain of ₹ 480.

Question 5 (MTP May’20)

A company has an EPS of Rs. 2.5 for the last year and the DPS of Rs. 1. The earnings is expected
to grow at 2% a year in long run. Currently it is trading at 7 times its earnings. If the required
rate of return is 14%, compute the following:
(i) An estimate of the P/E ratio using Gordon growth model.
(ii) The Long-term growth rate implied by the current P/E ratio
Solution
(i) Estimation of P/E Ratio using Gordon Growth Model

P = ₹ 8.50
PE Ratio =

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(ii) Long Term Growth Rate implied

Based on Current PE Ratio, the price per share = Rs. 2.50 x 7 Times = Rs. 17.50

We know that
P = D0 (1+g) / (ke – g)
Rs. 17.50 = Rs. 1(1 + g) / (0.14 – g)
17.50 x 0.14 – 17.50g = 1 + g
g = 0.0784 i.e. 7.84%

Question 6 (MTP March’21)

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 Rs.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%
(i) Calculate the duration of each bond.

(ii) Advise the percentage amount to bond portfolio manager to be invested in bonds B and C
to immunise the portfolio and he has been asked to keep 45% of the portfolio money in
Bond A.

(iii) Evaluate whether the portfolio is still immunized if after the portfolio has been
formulated, an interest rate change occurs, increasing the yield to 11%. The new duration
of bonds are: Bond A = 7.15 Years, Bond B = 6.03 Years and Bond C = 4.27 years.

(iv) Advise 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 t1 t2 t3 t4 t5
PVIF0.09, t 0.917 0.842 0.772 0.708 0.650

Present Values t6 t7 t8 T9 t10

PVIF0.09, t 0.596 0.547 0.502 0.460 0.4224
Solution
(i) Calculation of Bond Duration
Bond A

Year Cash P.V. @ 9% Proportion of bond Proportion of bond value

flow value x time (years)
1 10 0.917 9.17 0.086 0.086
2 10 0.842 8.42 0.079 0.158
3 10 0.772 7.72 0.073 0.219
4 10 0.708 7.08 0.067 0.268
5 10 0.650 6.50 0.061 0.305

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6 10 0.596 5.96 0.056 0.336

7 10 0.547 5.47 0.051 0.357
8 10 0.502 5.02 0.047 0.376
9 10 0.460 4.60 0.043 0.387
10 110 0.4224 46.46 0.437 4.370
106.40 1.000 6.862
Duration of the bond is 6.862 years or 6.86 year

Bond B
Year Cash flow P.V. @ 9% Proportion of Proportion of bond value x
bond value time (years)
1 11 0.917 10.087 0.091 0.091
2 11 0.842 9.262 0.083 0.166
3 11 0.772 8.492 0.076 0.228
4 11 0.708 7.788 0.070 0.280
5 11 0.650 7.150 0.064 0.320
6 11 0.596 6.556 0.059 0.354
7 11 0.547 6.017 0.054 0.378
8 111 0.502 55.772 0.502 4.016
111.224 1.000 5.833
Duration of the bond B is 5.833 years or 5.84 years

Bond C
Year Cash P.V. @ 9% Proportion of bond Proportion of bond
flow value value x time (years)
1 9 0.917 8.253 0.082 0.082
2 9 0.842 7.578 0.076 0.152
3 9 0.772 6.948 0.069 0.207
4 9 0.708 6.372 0.064 0.256
5 109 0.650 70.850 0.709 3.545
100.00 1.000 4.242
Duration of the bond C is 4.242 years or 4.24 years

(ii) Amount of Investment required in Bond B and C

Period required to be immunized 6.000 Year

Less: Period covered from Bond A 3.087 Year
To be immunized from B and C 2.913 Year
Let proportion of investment in Bond B and C is b and c respectively then

b + c = 0.55 (1)
5.883b + 4.242c = 2.913 (2)
On solving these equations, the value of b and c comes 0.3534 or 0.3621 and 0.1966 or 0.1879
respectively and accordingly, the % of investment of B and C is 35.34% or 36.21% and 19.66 %
or 18.79% respectively.

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(iii) With revised yield the Revised Duration of Bond stands

0.45 x 7.15 + 0.36 x 6.03 + 0.19 x 4.27 = 6.20 year

No portfolio is not immunized as the duration of the portfolio has been increased from 6 years
to 6.20 years.
(iv) New percentage of B and C bonds that are needed to immunize the portfolio.
Period required to be immunized 6.0000 Year
Less: Period covered from Bond A 3.2175 Year
To be immunized from B and C 2.7825 Year
Let proportion of investment in Bond B and C is b and c respectively, then
b + c = 0.55
6.03b + 4.27c = 2.7825
b = 0.2466
On solving these equations, the value of b and c comes 0.2466 and 0.3034 respectively and
accordingly, the % of investment of B and C is 24.66% or 25% and 30.34 % or 30.00%
respectively.

Question 7
You are interested in buying some equity stocks of RK Ltd. The company has 3 divisions operating
in different industries. Division A captures 10% of its industries sales which is forecasted to be
Rs. 50 crore for the industry. Division B and C captures 30% and 2% of their respective
industry's sales, which are expected to be Rs. 20 crore and Rs. 8.5 crore respectively. Division A
traditionally had a 5% net income margin, whereas divisions B and C had 8% and 10% net income
margin respectively. RK Ltd. has 3,00,000 shares of equity stock outstanding, which sell at Rs.
250.
The company has not paid dividend since it started its business 10 years ago. However, from the
market sources you come to know that RK Ltd. will start paying dividend in 3 years time and the
pay-out ratio is 30%. Expecting this dividend, you would like to hold the stock for 5 year. By
analysing the past financial statements, you have determined that RK Ltd.'s required rate of
return is 18% and that P/E ratio of 10 for the next year and on ending P/E ratio of 20 at the end
of the fifth year are appropriate. Evaluate:
(i) Whether you will be in purchasing RK Ltd. equity at this time based on your one year
forecast?
(ii) Price you will like to pay for the stock of RK Ltd if you expect earnings to grow @ 15%
continuously.
Ignore taxation.
PV factors are given below:
Years 1 2 3 4 5
PVIF@ 18% 0.847 0.718 0.609 0.516 0.437
Solution
Working Notes:
Computation of Earning Per Share (EPS)
Particulars Amount (Rs.)
Margin of Division A (Rs. 50 crore x 10% x 5%) 25,00,000
Margin of Division B (Rs. 20 crore x 30% x 8%) 48,00,000
Margin of Division C (Rs. 8.5 crore x 2% x 10%) 1,70,000

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74,70,000
No. of Equity Shares 3,00,000
EPS Rs. 24.90
(i) Market Price based on One Year Forecast
Expected Market Price at the end of the year = Rs. 24.90 x 10 = Rs. 249
PV of the Expected Price = Rs. 249 x 0.847 = Rs. 210.90
I would NOT like to purchase the share as the expected market price of shares is less than
its current price of Rs. 250.

(i) If Earning is expected to grow @ 15%

Year EPS (Rs.) Dividend (Rs.) PVF@18% PV (Rs.)
1 28.64 --- 0.847 ---
2 32.93 --- 0.718 ---
3 37.87 11.36 0.609 6.92
4 43.55 13.07 0.516 6.74
5 50.08 15.02 0.437 6.56
20.22

Share Price after 5 years = = Rs. 575.77

PV of the Market Price after 5 years = Rs. 575.77 x 0.437 = Rs. 251.61

Total PV of Inflows = Rs. 20.22 + Rs. 251.61 = Rs. 271.83

Thus, the maximum price I would be willing to pay for the share shall be Rs. 271.83.

Question 8(MTP April’21)

ABC Ltd. wants to issue 9% Bonds redeemable in 5 years at its face value of Rs. 1,000 each. The
annual spot yield curve for similar risk class of Bond is as follows:
Year Interest Rate
1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%
(i) Evaluate the expected market price of the Bond if it has a Beta value of 1.10 due to its
popularity because of lesser risk.
(ii) Interpret the nature of the above yield curve and reasons for the same.
Note: Use PV Factors upto 4 decimal points and value in Rs. upto 2 decimal points.
Solution
(i) For finding expected market price first we shall calculate Intrinsic Value of Bond as
follows:
PV of Interest + PV of Maturity Value of Bond

1st Year 12%

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2nd Year 11.62%

3rd Year 11.33%
4th Year 11.06%
5th Year 10.80%
Forward rate of interests

PV of interest =

= Rs. 90 x 0.8929 + Rs. 90 x 0.8026 + Rs. 90 x 0.7247 + Rs. 90 x 0.6573 + Rs. 90 x 0.5988

= Rs. 80.36 + Rs. 72.23 + Rs. 65.22 + Rs. 59.16 + Rs. 53.89

= Rs. 330.86

PV of Maturity Value of Bond =

= Rs. 1,000 x 0.5988 = Rs. 598.80

Intrinsic value of Bond = Rs. 330.86 + Rs. 598.80 = Rs. 929.66

Expected Price = Intrinsic Value x Beta Value

= Rs. 929.66 x 1.10 = Rs. 1,022.63

(ii) The given yield curve is inverted yield curve.

The main reason for this shape of curve is expectation for forth coming recession when
investors are more interested in Short-term rates over the long term.

Question 9
This question has been shifted to “Risk Management Q-12”

Question 10(MTP Oct’21/Similar Q asked in PP Nov’20)

An investor is considering purchasing the equity shares of LX Ltd., whose current market price
(CMP) is 150. The company is proposing a dividend of ₹ 6 for the next year. LX is expected to
grow @ 18% per annum for the next four years. The growth will decline linearly to 14% per annum
after first four years. Thereafter, it will stabilize at 14% per annum infinitely. The required rate
of return is 18% per annum.
You are required to determine:
(i) The intrinsic value of one share
(ii) Whether it is worth to purchase the share at this price
T 1 2 3 4 5 6 7 8
PVIF (18, t) 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266
Solution

D1 = ₹ 6
D2 = ₹ 6 (1.18) = ₹ 7.08
D3 = ₹ 6 (1.18)2 = ₹ 8.35
D4 = ₹ 6 (1.18)3 = ₹ 9.86
D5 = ₹ 9.86 (1.17) = ₹ 11.54

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D6 = ₹ 9.86 (1.17) (1.16) = ₹ 13.38

D7 = ₹ 9.86 (1.17) (1.16) (1.15) = ₹ 15.39
D8 = ₹ 9.86 (1.17) (1.16) (1.15) (1.14) = ₹ 17.54

TV = = 438.50

= 6.00 x 0.847 + 7.08 x 0.718 + 8.35 x 0.609 + 9.86 x 0.516 + 11.54 x 0.437 + 13.38 x 0.370 + 15.39
x 0.314 + 438.50 x 0.314

= ₹ 172.85

Since the Intrinsic Value of share is ₹ 172.85 while it is selling at ₹ 150 hence it is under - priced
and better to acquire it.

Question 11(PP Nov’20)

The following data are available for a bond:
Face Value ₹ 10,000 to be redeemed at par on maturity
Coupon rate 8.5 per cent per annum
Years to Maturity 5 years
Yield to Maturity (YTM) 10 per cent
You are required to calculate:
(i) Current market price of the Bond,
(ii) Macaulay’s Duration,
(iii) Volatility of the Bond,
(iv) Convexity of the Bond,
(v) Expected market price, if there is a decrease in the YTM by 200 basis points
a) By Macaulay’s Duration based estimate
b) By Intrinsic Value Method.
Given
Years 1 2 3 4 5
PVIF (10%, n) 0.909 0.826 0.751 0.683 0.621
PVIF (8%, n) 0.926 0.857 0.794 0.794 0.681
Solution
(i) Current Market Price of Bond

= ₹ 850 (PVIAF 10%, 5) + ₹ 10,000 (PVIF 10%, 5)

=₹ 850 (3.79) + ₹ 10,000 (0.621) = ₹ 3,221.50 + ₹ 6,210 = ₹ 9,431.5

(ii) Macaulay’s Duration

Year Cash P.V. @ 10% Proportion of Proportion of bond value x

flow bond value time (years)
1 850 0.909 772.65 0.082 0.082

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2 850 0.826 702.10 0.074 0.148

3 850 0.751 638.35 0.068 0.204
4 850 0.683 580.55 0.062 0.248
5 10,850 0.621 6,737.85 0.714 3.57
9431.50 1.000 4.252
Duration of the Bond is 4.252 years

(iii) Volatility of Bond

Volatility of Bonds = = 3.865

(iv) Convexity of Bond

C* x (ΔY) 2 x 100

C* = V+ + V- - 2V0

2V0 (∆Y)2

Year Cash flow P.V. @ 8% P.V @12%

1 850 0.926 787.10 0.892 758.20
2 850 0.857 728.45 0.797 677.45
3 850 0.794 674.90 0.712 605.20
4 850 0.735 624.75 0.636 540.60
5 10,850 0.681 7388.85 0.567 6,151.95
10204.05 8,733.40

= 9.867

Convexity of Bond = 9.867 x (0.02)2 x 100 = 0.395%

(v) The expected market price if decrease in YTM by 200 basis points.

a. By Macaulay’s duration-based estimate

= ₹ 9431.50 x 2 (3.865 / 100) = ₹ 729.05

Hence expected market price is ₹ 9431.50 + ₹ 729.05 = ₹ 10,160.55

Hence, the market price will increase.

b. By Intrinsic Value method

Intrinsic Value at YTM of 10% ₹ 9,431.50
Intrinsic Value at YTM of 8% ₹ 10,204.05
Price increased by ₹ 772.55
Hence, expected market price is ₹ 10,204.05

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Question 12
This question has been shifted to “Security Analysis Q-15”

Question 13
Following are the yields on Zero Coupon Bonds (ZCB) having a face value of ₹ 1,000
Maturity (Years) Yield to Maturity (YTM)
1 10%
2 11%
3 12%

Assume that the term structure of interest rate will remain the same.
You are required to
(i) Calculate the implied one year forward rates
(ii) Expected Yield to Maturity and prices of one year and two-year Zero-Coupon Bonds at the
end of the first year. (4 Marks)
Solution
(i) Calculation of Forward Rates

Maturity YTM (%) PVIF Face value Price Forward rate

1 10 0.909 1,000 909.09
2 11 0.812 1,000 811.62 0.1201 i.e. 12.01%
3 12 0.712 1,000 711.78 0.1403 i.e. 14.03%

(ii) Calculation of Expected Prices and YTM

Maturity Forward rate Face value Price YTM
2 0.1201 1,000 0.1201 i.e. 12.01%

3 0.1403 1,000 0.1302* i.e. 13.02%

= 782.93

= 0.1302

Question 14(MTP May 2023)

The Balance Sheet of M/s. Sundry Ltd. as on 31-03-2020 is follows:(₹ in lakhs)
Liabilities ₹ Assets ₹
Share Capital 300 Fixed Assets 600
Reserves 200 Inventory 500
Long Term Loan 400 Receivables 240
Short Term Loan 300 Cash 60
Payables & Provisions 200
Total 1400 Total 1400
Sales for the year was ₹ 600 lakhs. The sales are expected to grow by 20% during the year. The
profit margin and dividend pay-out ratio are expected to be 4% and 50% respectively.
The company further desires that during the current year Sales to Short Term Loan and Payables

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and Provision should be in the ratio of 4 :3. Ratio of fixed assets to Long Term Loans should be
1.5. Debt Equity Ratio should not exceed 1.5.
You are required to determine:
(i) The amount of External Fund Requirement (EFR)
(ii) The amount to be raised from Short Term, Long Term and Equity funds. (8 Marks)
Solution
(i) External Funds Requirement (EFR): ( ₹ in lakhs)
(₹)
Expected sales (₹ 600 + 20% of ₹ 600) 720.00
Profit margin @ 4% 28.80
Dividend payout ratio @ 50% 14.40
Balance to be ploughed back (A) 14.40
Additional funds required (₹ 1400 - ₹ 200*) x 0.20 (B) 240.00
Balance to be met from external source (B - A) 225.60

* As current liabilities shall also be increased proportionately with increase in sales.

(ii) Amount to be raised from different sources with following conditions:

 Sales to short term loans and payables & provisions 4:3
 Ratio of fixed assets to long term loans 1.5
 Debt equity ratio should not exceed 1.5

1) Amount to be raised from short term funds:

(₹ in lakhs)
New amount of short-term loans and payables & provision 450

Less: Existing Amount of short-term loans and payables & provision 500
Amount to be raised from short term funds Nil
2) Amount to be raised from Long term funds:
(₹ in lakhs)
New fixed assets (₹ 600 + 20% of ₹ 600) 720
New long-term loans (₹ 720 / 1.5) 480
Less: Existing long-term loans 400
Amount to be raised from Long term funds 80

3) Amount to be raised from equity funds:

(₹ in lakhs)
Amount to be raised from external sources 225.60
Less: Amount to be raised from short term funds ----
Less: Amount to be raised from Long term funds 80.00
Balance amount to be raised from equity funds 145.60

Question 15(P P July’21)

Following financial data are available of RK Ltd., for the year ended on 31 -03-2020:

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Particulars ₹ (in Million)

8% Debentures 125
10% Bonds 50
Equity Shares of ₹ 10 each 100
Reserves and Surplus 300
Total Assets 600
Assets Turnover Ratio 1.1
Effective Interest Rate 8%
Effective tax rate 40%
Operating margin 10%
Dividend pay-out ratio 16.67%
Required rate of return by investors 15%
Current market price of share ₹ 14

You are required to:

(i) Prepare the income statement of RK Ltd., for the year ended on 31-03-2020.
(ii) Calculate the sustainable growth rate.
(iii) Find out the fair price of the company's share using dividend discount model.

Advice whether the share is under - priced or overpriced.

Solution
Workings:

Asset turnover ratio = 1.1

Total Assets = ₹ 600 million

Turnover ₹ 600 million × 1.1 = ₹ 660 million

Effective interest rate = = 8%

Liabilities = ₹ 125 million + ₹ 50 million = 175 million

Interest = ₹ 175 million x 0.08 = ₹ 14 million

Operating Margin = 10%

Hence operating cost = (1 - 0.10) ₹ 660 million = ₹ 594 million

Dividend Payout = 16.67%

Tax rate = 40%

(i) Income statement

(₹ Million)
Sale 660
Less: Operating Exp 594
EBIT 66
Less: Interest 14
EBT 52
Less: Tax @ 40% 20.80

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EAT 31.20
Less: Dividend @ 16.67% 5.20
Retained Earnings 26.00

(ii) SGR = ROE (1-b) S

ROE = and NW = ₹ 100 million + ₹ 300 million = ₹ 400 million

ROE = x 100 = 7.8%

SGR = 0.078(1 - 0.1667) = 6.5% or = 6.95%

(iii) Calculation of fair price of share using dividend discount model

PO =

Dividends = = ₹ 0.52 per share

Growth Rate = 6.5% or 6.95%

Hence P0 = = ₹ 6.52 or = ₹ 6.91

(iv) Since the current market price of share is ₹ 14, the share is overvalued. Hence the investor
should not invest in the company.

Question 16(PP Dec’21)

Following are the details of X Ltd. and Y Ltd.:
Particulars X Ltd. Y Ltd.
Dividend per Share ₹4 ₹4
Growth Rate 10% 10%
Beta 0.9 1.2
Current Market Price per Share ₹ 150 ₹ 70

Other Information:
Risk Free Rate of Return 7%
Market Rate of Return 14%
(i) Calculate the price of shares of both the companies.
(ii) Write the comment on the valuation on the basis of price calculated and current market
price.
As an investor what course of action should be followed?
Solution
(i) Calculation of Prices of shares of both companies
X Ltd. Y Ltd.
Beta 0.9 1.20
Cost of Equity using CAPM 7% + 0.9 [14% - 7%] 7% + 1.20 [14% - 7%]
= 13.30% = 15.40%
Growth Rate 10% 10%

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Price of Share

= ₹ 133.33 = ₹ 81.48
(ii) and (iii)
Name of Current Market Value of the Valuation Action of the Investor
Company Price Share
X Ltd. ₹ 150.00 ₹ 133.33 Overvalued / Not to Invest / to be sold
overpriced
Y Ltd. ₹ 70.00 ₹ 81.48 Undervalued / Invest / to be purchased
under-priced

Alternatively, if the given figure of Dividend is considered as Dividend Expected (D1) then
solution will be as follows:
X Ltd. Y Ltd.
Beta 0.9 1.20
Cost of Equity using CAPM 7% + 0.9 [14% - 7%] 7% + 1.20 [14% - 7%]
= 13.30% = 15.40%

Growth Rate 10% 10%

Price of Share

= ₹ 121.21 = ₹ 74.07

(ii) and (iii)

Name of Current Value of the Valuation Action of the Investor

Company Market Price Share
X Ltd. ₹ 150.00 ₹ 121.21 Overvalued / Not to Invest / to be sold
overpriced
Y Ltd. ₹ 70.00 ₹ 74.07 Undervalued / Invest / to be purchased
under-priced

Question 17(MTP April’22)

The following data are available for a bond:
Face Value ₹ 10,000 to be redeemed at par on maturity
Coupon rate 8.5%
Years to Maturity 5 years
Yield to Maturity (YTM) 10%
EVALUATE the change in the expected market price of the Bond, if there is a decrease in the
YTM by 200 basis points based on
(i) By Macaulay’s Duration after making Convexity Adjustment.
(ii) By Intrinsic Value Method.
Given
Years 1 2 3 4 5
PVIF (10%, n) 0.909 0.826 0.751 0.683 0.621

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PVIF (8%, n) 0.926 0.857 0.794 0.735 0.681

Solution
(i) Current Market Price of Bond

= Rs 850 (PVIAF 10%, 5) + Rs 10,000 (PVIF 10%, 5)

= Rs 850 (3.79) + Rs 10,000 (0.621) = Rs 3,221.50 + Rs 6,210 = Rs 9,431.5
(ii) Macaulay's Duration

Year Cash flow P.V. @ 10% Proportion of Proportion of bond

bond value value x time (years)
1 850 0.909 772.65 0.082 0.082
2 850 0.826 702.10 0.074 0.148
3 850 0.751 638.35 0.068 0.204
4 850 0.683 580.55 0.062 0.248
5 10,850 0.621 6,737.85 0.714 3.57
9431.50 1.000 4.252
Duration of the Bond is 4.252 years

(iii) Volatility of Bond

Volatility of Bonds = = 3.865

(iv) Convexity of Bond

C* x (ΔY) 2 x 100

C* =
Year Cash flow P.V. @ 8% P.V @12%
1 850 0.926 787.10 0.892 758.20
2 850 0.857 728.45 0.797 677.45
3 850 0.794 674.90 0.712 605.20
4 850 0.735 624.75 0.636 540.60
5 10,850 0.681 7388.85 0.567 6,151.95
10204.05 8,733.40

= 9.867

Convexity of Bond = 9.867 x (0.02)2 x 100 = 0.395%

(i) The expected market price if decrease in YTM by 200 basis points by Macaulay’s duration
By Macaulay’s duration-based estimate
% Change in Price of Bond 3.865 x 2% + 0.395% = 8.125%
Change in Expected Market Price ₹ 9431.50 x (8.125/100) = ₹ 766.31

Hence expected market price is ₹ 9431.50 + ₹ 766.31 = ₹ 10,197.81

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(ii) The expected market price if there is a decrease in YTM by 200 basis points using Intrinsic
Value method

Intrinsic Value at YTM of 10% ₹ 9,431.50

Intrinsic Value at YTM of 8% ₹ 10,204.05
Price increased by ₹ 772.55
Hence, expected market price is ₹ 10,204.05

Evaluation: Thus, from above it can be evaluated that duration combined with the convexity
adjustment does a better job of estimating the sensitivity of a bond’s price change.

Question 18
This question has been shifted to “Security Analysis Q-16”

Question 19(MTP Sep’22)(Delete)

Mr. X wants to buy shares of A Ltd. (having a Beta of 2) at current market price of ₹ 500 each
having face value of ₹ 100. He is expecting a bonus at the ratio of 1: 4 during the fifth year.
Annual expected dividend is 20% and the same rate is expected to be maintained throughout the
holding period. He intends to sell the shares at the end of 7th year and expect that the market
price shall be doubled during this holding period. Incidental expenses for purchase of shares are
estimated to be 5% of the market price. The risk-free rate of return and market rate of return
are 5% and 7.50% respectively.
ADVISE Mr. X should buy this share or not. If so, then recommend the maximum price should he
pay for each share.
Note: Assume no tax on dividend income and capital gain.
Solution
First, we shall compute the Cost of Equity using CAPM as follows:
ke = Rf + β(Rm – Rf)
= 5% + 2(7.50% - 5.00%)
= 10%
P.V. of dividend stream and sales proceeds
Year Dividend/Sale PVF(10%) PV(₹)
1 ₹ 20/- 0.909 18.18
2 ₹ 20/- 0.826 16.52
3 ₹ 20/- 0.751 15.02
4 ₹ 20/- 0.683 13.66
5 ₹ 25/- 0.621 15.53
6 ₹ 25/- 0.564 14.10
7 ₹ 25/- 0.513 12.83
7 ₹ 1,250/-(₹ 1,000 x 1.25) 0.513 641.25
747.09
Less: Cost of Share (₹ 500 x 1.05) 525.00
Net Gain 222.09

Since Mr. X is gaining ₹ 222.09 per share, he should buy the share.
Maximum price Mr. A should be ready to pay is ₹ 747.09.

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Question 20(MTP Oct’22)

The Bank BK enters into a Repo for 9 days with Bank NE in 6% Government bonds 2022 for an
amount of ₹ 2 crore. The other relevant details are as follows:
First Leg Payment(Start Proceed) ₹ 2,00,06,750
Second Leg Payment (Repayment Proceed) ₹ 2,00,31,759
Initial Margin 1.25%
Days of accrued interest 240
Assume 360 days in a year.
CALCULATE:
1) Repo Rate
2) Dirty Price and
3) Clean Price

Solution
1) Second Leg (Repayment at Maturity)
₹ 2,00,31,759

₹ 1.00125

Repo Rate = 0.05 = 5%

2) First Leg (Start Proceed)

10003.375 = 98.75 x Dirty Price

Dirty Price = ₹ 101.30

3) Dirty Price = Clean Price + Interest Accrued

Question 21(RTP May’23)

From the following information, compute the effective rate of interest per annum as well as the
total cost of funds to Nirmal Ltd., which is planning a Commercial Paper (CP) issue:
Issue Price of CP ₹ 4,87,750
Face Value ₹ 5,00,000
Maturity Period 3 Months
Issue Expenses:
Brokerage 0.15% for 3 months
Rating Charges 0.55% p.a.
Stamp Duty 0.20% for 3 months

Solution

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Nominal Interest or Bond Equivalent Yield =

Where
F= Face Value
P= Issue Price
= = = 0.025115 x 4 x 100 = 10.046 = 10.05% p.a

Effective Interest Rate = = 10.435% p.a.

Cost of Funds to the Company

Effective Interest 10.435%
Brokerage (0.150 x 4) 0.60%
Rating Charge 0.55%
Stamp duty (0.20 x 4) 0.80%
12.385%

Question 22(RTP May’24)

Mr. Amit is happy with the investment in a company as it is paying good dividend for the last
few years. Last year it paid a dividend of ₹ 2 per share. The share is currently trading at
₹ 150 per share. He is of view that if he applies dividend discount model, the share is
undervalued. As a financial expert examine his view that dividend discount model
represents the fair value.
You being an expert is required to evaluate the market value of the share of the company.

Profit after tax of the company ₹ 290 crores

Equity capital of company ₹ 1,300 crores
Par value of share ₹ 40 each
Debt ratio of company (Debt/ Debt + Equity) 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

Note: Round off figures (e.g. EPS etc.) upto 2 decimal points.
Solution
₹
No. of Shares ₹

EPS

₹
EPS ₹

Calculation of value per share using Free Cash Flow to Equity as basis:

FCFE = Net income – [(1-b) (capex – dep) + (1-b) (ΔWC )]

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FCFE = 8.92 – [(1-0.27) (47-39) + (1-0.27) (3.45)]

= 8.92 – [5.84 + 2.52] = ₹ 0.564

Cost of Equity (Ke)= Rf + ß (Rm – Rf)

= 8.7 + 0.1 (10.3 – 8.7) = 8.86%

Calculation of value per share using dividend discount model:

From the above we can see that value per share on the basis of dividend discount model is
more than the value per share on the basis of free cash flow to equity model.
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.

A stock’s intrinsic value based on the dividend discount model may not represent the fair value
for the shareholders because dividends are distributed in the form of cash from profits.
In case the company is maintaining healthy cash in its balance sheet then it means that
dividend pay-out is 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 model provides a better measure for valuations in
comparison to the dividend discount model.
Thus, the view of Mr. Amit that dividend discount model represents the fair value is
incorrect. The share is not under-valued rather it is overvalued if we take “free cash flow
to equity model” into consideration.

Question 23(PP, May’23)

High Growth Ltd. (HGL) was having an excellent growth over a number of years. The Board
of Directors is considering a proposal to reward its shareholders by buying back 20%
shares at a premium. The premium is to be paid by raising a loan from the Bank. The
interest on loan is to be serviced by internal accruals as supported by the financials of
HGL. The company has a market capitalization of ₹ 15,000 crore and the current Earnings
Per Share (EPS) is ₹ 600 with a Price Earnings Ratio (PER) of 25. The Board expects a
post buy back Market Price per Share (MPS) of ₹ 10,000. The PER, post buy back, will
remain the same. The loan can be availed at an interest rate of 16 % p.a.
Applicable corporate tax rate is 30%. You are

required to calculate:

(i) The interest amount which can be paid for availing the bank loan.
(ii) The loan amount to be raised.
(iii) Buy back premium per share.

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Solution
The interest amount which can be paid for availing the bank loan
Current Market Price per Share = ₹ 600 × 25 = ₹ 15,000
No. of Shares before Buyback =
= == 1 crore
No. of Shares proposed to Buyback = 20% of 1 crore = 20 lakh
Total No. of Share after Buyback = 1 crore – 20 lakh = 80 lakh
Post Buy back Market Price per Share = ₹ 10,000
PE Ratio = 25

Post Buyback EPS = = = ₹ 400

EAT before Buyback = ₹ 600 × 1 crore = ₹ 600 crore
EBT before Buyback = = ₹ 857.1429 crore
EAT after Buyback = ₹ 400.00 × 80 lakh = ₹ 320 crore
EBT after Buyback = = ₹ 457.1429 crore

Interest which can be paid for availing bank loan:

EBT before Buyback ₹ 857.1429 crore

(-) EBT after Buyback ₹ 457.1429 crore
₹ 400.0000 crore
Alternatively, it can also be computed as follows:

Pre Buy back Market Capitalization (A) ₹ 15000 crore

Pre Buy back EPS (B) ₹ 600
Pre Buy back PER (C) 25
Pre Buy back Market Price Per Share ( ₹ 600x 5) D = B X C ₹ 15000
Pre Buy back No. of Shares (A)/ (D) 1 Crore
Post Buy back EPS (A) ( ₹ 10000/ 25) ₹ 400
Post Buy back No. of shares (B) 80 Lakh
Post Buy back Earning (C) = (A) X (B) ₹ 320 crore
Pre Buy back Earning 1 Crore X ₹ 600 (D) ₹ 600 crore
Post Tax Earning available for interest payment (D) – (C) ₹ 280 Crore
Pre- Tax amount of Interest 280crore ₹ 400 Crore
1-0.30

(ii) Loan Amount raised = 400 CRORE = ₹ 2500 crore

0.16
(iii) Buyback Premium per Share
Amount of Loan for Buyback of 20 % Shares = ₹ 2500 crore No.
of Shares Buyback = 20 Lakh

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Buyback price per Share = ₹ 2500 Crore/ 20 Lakh = ₹ 12500

Market Price after Buyback = ₹ 10000
Buyback Premium Per Share = ₹ 12500 – ₹ 10000 = ₹ 2500
Alternatively, it can also be computed as follows:

Amount of Loan (A) ₹ 2500 crore

No. of Shares to be bought back (B) 20 Lakh
Price Per Share to be paid (C) = (A)/ (B) ₹ 12,500
Post Buy back Share Price (D) ₹ 10,000
Buy Back Premium per share (C) – (D) ₹ 2,500

Question 24(PP, May’23)

An investor, in the beginning of 2022, has purchased substantial number of 8 year 7.50%, ₹ 1000
bond with 5% premium on maturity at a required Yield to Maturity (YTM) of 8.50 %. However, due
to the continuing war in Europe, the inflation is running very high in the economies of the
countries. The yield on the bonds is decreasing. The risk averse investor wants to protect himself
from further loss and decides to sell the bonds in 2023. He has got a proposal from another
investor who is willing to purchase these bonds by shelling out ₹ a maximum amount of 797.50 per
bond.
Investor follows intrinsic value method for valuation of the Bonds.
You are required to determine
(i) The Market price, Duration and Volatility of the bond.
(ii) Will it be a right decision of the new investor if he is looking for Required Yield to
Maturity (YTM) as 12% p.a. ?
Period 1 2 3 4 5 6 7
PVIF 0.9217 0.8495 0.7829 0.7216 0.6650 0.6129 0.5649
(8.50%,n)
Solution
(i) (A) Market Price of Bond
= 1,000 X 7.50% X (PVIAF 8.50%,7) + 1,050 X (PVIF 8.5%,7)
= 75 X 5.1185 + 1050 X 0.5649
= 383.89 + 593.15 = ₹ 977.04
(B) Duration of Bond
Year Cash Flow P.V. @ 8.5%
1 75 0.9217 69.128 0.071 0.071
2 75 0.8495 63.713 0.065 0.130
3 75 0.7829 58.718 0.060 0.180
4 75 0.7216 54.120 0.055 0.220
5 75 0.6650 49.875 0.051 0.255
6 75 0.6129 45.968 0.047 0.282
7 1125 0.5649 635.513 0.651 4.557
977.035 5.695
Duration of the Bond is 5.695 years.
Alternatively, it can also be calculated as follows:

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1 75 0.9217 69.13 69.13

2 75 0.8495 63.71 127.42
3 75 0.7829 58.72 176.16
4 75 0.7216 54.12 216.48
5 75 0.6650 49.88 249.40
6 75 0.6129 45.97 275.82
7 1125 0.5649 635.51 4448.57
977.04 5562.98

Duration of the Bond = = = 5.69 years

C) Volatility of Bond-
Volatility = Duration/(1+YTM)
= 5.695/ (1+0.085) = 5.249
Or = 5.69/ (1+0.085) = 5.24
(ii) PV of Bond @ 12% YTM
= ₹ 75 PVIAF (12%, 7) + ₹1050 X PVIF (12%, 7)
= ₹ 75 X 4.5637 + ₹ 1050 X 0.4523
= ₹ 342.28 + ₹ 474.92 = ₹ 817.20
Since, Intrinsic Value of Bond is ₹ 817.20 the decision of new investor is right at purchase
price of ₹ 797.50.
Alternatively, it can also be solved as follows:
Price Difference between Current Selling ₹ 179.54
Price & Intrinsic Value
Increase in Yield justified 3.50%

Justified YTM (8.50% + 3.50%) 12%

Thus, the decision of investor is right

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