Chapter 6

Security Analysis And Firm Performance

Numerical

6.1) Suppose an 8 percent coupon, 30-year maturity bond with par value of Rs 1,000 is paying semiannual coupon
payments. Further suppose that the market interest rate is 8 percent. What is the price of this bond? What would happen
to the price of this bond if the market interest rate were 10 percent? If it were 6 percent? What do your calculation reveal
with respect to the relationship between coupon rate and market interest rate, and the bond's price?
Solution
Given:
Annual Coupon (I) = 0.08 × Rs 1,000 = Rs 80
Face value (M) = Rs 1,000
Maturity (n) = 30 years
If the market interest rate kd is 8 percent:

𝐼 𝑅𝑠80
𝑉𝑜 = 2 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 + 𝑀 × 𝑃𝑉𝐼𝐹𝑘𝑑 = × 𝑃𝑉𝐼𝐹𝐴8%,2×30 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹8%,2×30
,2𝑛 ,2𝑛 2 2 2
2 2
= 𝑅𝑠40 × 𝑃𝑉𝐼𝐹𝐴4%,60 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹4%,60
= 𝑅𝑠40 × 22.6234 + 𝑅𝑠1,000 × 0.0951
= 𝑅𝑠904.9 + 𝑅𝑠95.1
= 𝑅𝑠1,000
If the market interest rate (kd) is 10 percent:
𝐼 𝑅𝑠80
𝑉𝑄 2 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 + 𝑀 × 𝑃𝑉𝐼𝐹𝑘𝑑 = 2 × 𝑃𝑉𝐼𝐹𝐴10%,2×30 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹10%,2×30
,2𝑛 ,2𝑛 2 2
2 2
= 𝑅𝑠40 × 𝑃𝑉𝐼𝐹𝐴5%,60 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹5%,60
= 𝑅𝑠40 × 18.9293 + 𝑅𝑠1,000 × 0.0535 = 𝑅𝑠757.17 + 𝑅𝑠53.5
= 𝑅𝑠810.67
If the market interest rate (kd) is 6 percent:
1 𝑅𝑠80
𝑉𝑜 = 2 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 + 𝑀 × 𝑃𝑉𝐼𝐹𝑘𝑑 = 2 × 𝑃𝑉𝐼𝐹𝐴6%,2×30 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹6%,2×30
,2𝑛 ,2𝑛 2 2
2 2
= 𝑅𝑠40 × 𝑃𝑉𝐼𝐹𝐴3%,60 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹3%,60
= 𝑅𝑠40 × 27.6756 + 𝑅𝑠1,000 × 0.1697
= 𝑅𝑠1,107.02 + 𝑅𝑠169.7
= 𝑅𝑠1,276.72

Hence, if the interest rate declines to 6 percent, the bond's price would increase to Rs 1276.72.
Above calculations reveal that if the market interest rate were not equal to the bond's coupon rate: the bond would not sell
at par value. At a higher interest rate, the present value of the payments to be received by the bondholder is lower
Therefore, bond prices fall as market interest rates rise. Conversely, at a lower interest rate: the present value of the
payments to be received by the bondholder is higher: and therefore: bond prices increase as market interest rates decline.
6.2 ) A bond with a coupon rate of 7 percent makes semiannual coupon payments on January 15 and July 15 of each year.
The Journal reports the ask price for the bond on January 30 at 100:02. What ,mat is the invoice price of the bond is the
coupon period has 182 days?
Solution
2
The reported bond price = 100.02 = 100 32 percent of par = Rs 1,000.625
However, 15 days have passed since the last semiannual coupon was paid, so:
15
Accrued interest = Rs 35 × 182 = Rs 2.885
The invoice price is the reported price plus accrued interest = Rs 1,003.51
6.3 )Suppose a bond was issued several years ago when the interest rate was 7 percent. The bond's annual coupon
rate was thus set at 7 percent. For simplicity, suppose that the bond pays its coupon annually. Today, with three years
left in the bond's life, the interest rate is 8 percent per year.
a. What is the bond's fair market price?
b. What is the fair price of bond next year?
c. If an investor had purchased the bond at price calculated in part 'a' and sold at the price calculated in part 'b', what
would be holding period return?
d. Why investor's rate of return is equal to the competitive market interest rate prevailing at the time?
Solution 6.3
Given,
Face value (M) = Rs 1,000
Annual Coupon = 0.07 ×Rs 1,000 = Rs 70
Time to Maturity (n)=3 year
Market Interest rate (kd) =8%
a. The bond's fair market price today when interest rate is 8 percent is given by:
𝑉0 = 𝐼 × 𝑃𝑉𝐼𝐹𝐴8%,3 + 𝑀 × 𝑃𝑉𝐼𝐹8%,3
= 𝑅𝑠 70 × 2.5771 + 𝑅𝑠 1,000 × 0.7938
= 𝑅𝑠 180.40 + 𝑅𝑠 793.80
= 𝑅𝑠 974.20
b. In another year, after the next coupon is paid and remaining maturity falls to two years, the bond would sell at:
𝑉0 = 𝐼 × 𝑃𝑉𝐼𝐹𝐴8%,2 + 𝑀 × 𝑃𝑉𝐼𝐹8%,2
= 𝑅𝑠 70 × 1.7833 + 𝑅𝑠 1,000 × 0.8573
= 𝑅𝑠 124.83 + 𝑅𝑠 857.30
= 𝑅𝑠 982.13
c. If an investor had purchased the bond at Rs 974.20 and sold it for Rs 982.13 after one year after realizing Rs 70 in annual
coupon, the holding period return over the year would be as follows:
𝐼+ 𝑉1 −𝑉0 Rs 70+ Rs 982.13−Rs 974.20
HPR = 𝑉0
= Rs 974.20 = 0.08 or 8%
Hence, the holding period return over the year is 8 percent, exactly the current rate of return available in the market.
d. When bond prices are set according to the present value formula, any discount from par value provides an anticipated
capital gain that will augment a below-market coupon rate just enough to provide a fair total rate of return. Conversely, if
the coupon rate exceeds the market interest rate, the interest income by itself is greater than that available elsewhere in
the market. Investors will bid up the price of these bonds above their par values. As the bonds approach maturity, they will
fall in value because fewer of these above-market coupon payments remain. The resulting capital losses offset the large
coupon payments so that the bondholder again receives only a competitive rate of return.
6.4) Compute the current yield of a 10 percent, 25-years bond that is currently priced in the market at Rs 1,200. Use annual
compounding to find the promised yield on this bond. Repeat the promised yield calculation, but this time use semiannual
compounding to find yield-to-maturity.
Solution
Par value (M) = Rs 1,000 (Assumed)
Annual interest (l) = Rs 100
Maturity period (n) = 25 years
Current yield (cy) = ?
Coupon rate (c)=10%
Current market price = Rs 1200
Promised yield to maturity = ?
Using annual compounding
We have,
Annual Interest 100
Current yield = = 1200 = 8.33%
Current Market Price

Calculation of promised yield

𝐼+ 𝑀−Price /𝑛 100+ 1000−1200 /25 92
Approximate YTM = 𝑀+2×Price /3 = 1000+2×1200 /3 = 1133.3333 = 8.12%

1 1
1− 1000 1−
1.08 25 1.09 25 1000
PV at 8% = 100 + = Rs 1213.4955 PV at 9% = 100 + = Rs 1098.2258
0.08 1.08 25 0.09 1.09 25
Hence: Price of the bond Rs 1200 lies between 1098.2258 and 1213.4955.
By interpolation,
PV −PV
Actual YTM = LR + PVLR−PVTR × HR − LR = 8% + 1213.4955−1098.2258 × 9% − 8%
1213.4955−1200

LR HR
13.4955
= 8% + 115.2697 × 1% = 8.12%
Repetition of the promised yield calculation but this time using semi annual compounding:
𝐼 𝑀−Price 100 1000−1200
+ + 46
2 𝑛×2 2 25×2
Approximate semiannual YTM = 𝑀+2×price = 1000+2×1200 = 1133.33 = 4.06%
3
3
1
1− 1000
1.04 50
PV at 4% = 50 + = Rs 1214.8218
0.04 1.04 50
1
1− 1000
1.05 50
PV at 5% = 50 + = Rs 1000
0.05 1.05 50
Hence, the price of the bond Rs 1200 lies between Rs 1000 and Rs 1214.8218.

By Interpolation,
PV −PV
Actual YTM = LR + PVLR−PVTR × HR − LR
LR HR
1214.8218−1200
= 4% + 1214.8218−1000 × 5% − 4%
14.8218
= 4% + 214.8218 × 1% = 4.07%
Semi annual YTM = 4.07%
Annual YTM = 4.07% × 2 = 8.14%
Effective annual yield = 1 + Semi annual YTM 2 − 1 = 1 + 0.0407 2 − 1 = 8.31%
6.5 ) Suppose an 8 percent coupon, 30-year maturity bond sells for Rs 1,150 and is callable in 10 years at a call price of Rs
1,100.
a. What is its yield to maturity? Whats is its yield to call?
b. In what situation, the bond is likely to call ? Explain.
Solution
Given,
Annual coupon (I) = 0.08 x Rs 1,000 = Rs 80
Selling price of bond = Rs 1.150
Face Value (M) = Rs 1,000
Maturity (n) = 30 years
Call period (t) = 10 years
Call price (CP) = Rs 1,100
𝑎. 𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦:
𝐹𝑖𝑟𝑠𝑡, 𝑤𝑒𝑤𝑜𝑟𝑘 − 𝑜𝑢𝑡𝑡ℎ𝑒𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒𝑌𝑇𝑀𝑜𝑛𝑡ℎ𝑒𝑏𝑜𝑛𝑑𝑎𝑠𝑓𝑜𝑙𝑙𝑜𝑤𝑠:
𝑀−𝑉
𝐼+ 𝑛 0 Rs 80+Rs 1,000−
30
Rs 1,150
Rs 75
Approximate YTM = 𝑀+2𝑉0 = Rs 1,000+2×Rs 1,150 = Rs 1,100
3 3
= 0.0681 or 6.81%
𝑇ℎ𝑒 𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑌𝑇𝑀 𝑖𝑠 6.81 𝑝𝑒𝑟𝑐𝑒𝑛𝑡. 𝐼𝑡 𝑠𝑢𝑔𝑔𝑒𝑠𝑡𝑠 𝑡ℎ𝑎𝑡 𝑡ℎ𝑒 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑙𝑖𝑒𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 6𝑝𝑒𝑟𝑐𝑒𝑛𝑡 7𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑎𝑛𝑛𝑢𝑎𝑙
𝑟𝑎𝑡𝑒. 𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, 𝑤𝑒 𝑤𝑜𝑟𝑘 − 𝑜𝑢𝑡𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 6% 𝑎𝑛𝑑 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒 7% 𝑎𝑠 𝑓𝑜𝑙𝑙𝑜𝑤𝑠:
𝑉𝐿𝑅 = 𝐼 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 ,𝑛 + 𝑀 × 𝑃𝑉𝐼𝐹𝑘𝑑 ,𝑛
= 𝑅𝑠80 × 𝑃𝑉𝐼𝐹𝐴6%,30 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹6%,30
= 𝑅𝑠80 × 13.7648 + 𝑅𝑠1,000 × 0.1741
= 𝑅𝑠1,101.18 + 𝑅𝑠174.1
= 𝑅𝑠1,275.28
Since the value of bond at 6 percent discount rate is higher than its current selling price (Rs 1: 150): we try at higher rate: 7
percent.
𝑉𝐻𝑅 = 𝐼 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 ,𝑛 + 𝑀 × 𝑃𝑉𝐼𝐹𝑘𝑑 ,𝑛
= 𝑅𝑠80 × 𝑃𝑉𝐼𝐹𝐴7%,30 + 𝑅𝑠1,000 𝑃𝑉𝐼𝐹7%,30
= 𝑅𝑠80 × 12.4090 + 𝑅𝑠1,000 × 0.1314
= 𝑅𝑠992.72 + 𝑅𝑠131.4
= 𝑅𝑠1,124.12
Since the current selling price of bond falls between the value of bond at higher rate and lower rate, we interpolate as
follows to work−out YTM.
𝑉LR −𝑉0
YTM = LR + 𝑉 × HR −LR
LR −𝑉HR
Rs 1,275.28−Rs 1,150
= 6% + × 7% − 6%
Rs 1,275.28−Rs 1,124.12
Rs 125.28
= 6% + × 1%
Rs 151.16
= 6% + 0.83% = 6.83%
𝐻𝑒𝑛𝑐𝑒, 𝑡ℎ𝑒 𝑌𝑇𝑀 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑖𝑠 6.83 𝑝𝑒𝑟𝑐𝑒𝑛𝑡.
𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑐𝑎𝑙𝑙:
First, we work-out the approximate YTC on the bond as follows:

𝐶𝑃−𝑉0 Rs 1,100−Rs 1,150

𝐼+ Rs 80+ Rs 75
𝑡 10
Approximate YTC = 𝑉 = Rs 1,150 = Rs 1,133.33 = 0.0662 or 6.62%
𝐶𝑃+2 0 Rs 1,100+2×
3 3
The approximate YTC is 6.62 percent. It suggests that the yield to call lies between 6 percent 7 percent annual rate.
Therefore, we work−out value at lower rate (6%) and higher rate (7%) as follows:
First, let us try at 6%:
𝑉𝐿𝑅 = 𝐼 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 ,𝑡 + 𝐶𝑃 × 𝑃𝑉𝐼𝐹𝑘𝑑 ,𝑡
= 𝑅𝑠80 × 𝑃𝑉𝐼𝐹𝐴6%,10 + 𝑅𝑠1,100 𝑃𝑉𝐼𝐹6%,10
= 𝑅𝑠80 × 7.3601 + 𝑅𝑠1,100 × 0.5584
= 𝑅𝑠588.81 + 𝑅𝑠614.24
= 𝑅𝑠1,203.05
Since the value of bond at 6 percent discount rate is higher than its current selling price (Rs 1,150),
we try at higher rate, 7 percent.

𝑉𝐻𝑅 = 𝐼 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑 ,𝑡 + 𝐶𝑃 × 𝑃𝑉𝐼𝐹𝑘𝑑 ,𝑡

= 𝑅𝑠80 × 𝑃𝑉𝐼𝐹𝐴7%,10 + 𝑅𝑠1,100 𝑃𝑉𝐼𝐹7%,10
= 𝑅𝑠80 × 7.0236 + 𝑅𝑠1,100 × 0.5083
= 𝑅𝑠561.89 + 𝑅𝑠559.13
= 𝑅𝑠1,121.02
Since the current selling price of bond falls between the value of bond at higher rate and lower rate, we
interpolate as follows to work-out YTC.
𝑉 −𝑉
𝑌𝑇𝐶 = 𝐿𝑅 + 𝑉 𝐿𝑅−𝑉 0 × 𝐻𝑅 − 𝐿𝑅
𝐿𝑅 𝐻𝑅
𝑅𝑠1,203.05−𝑅𝑠1,150
= 6% + × 7% − 6%
𝑅𝑠1,203.05−𝑅𝑠1,121.02
𝑅𝑠53.05
= 6% + × 1%
𝑅𝑠82.03
= 6% + 0.65% = 6.65%
Hence, the YTC on the bond is 6.65 percent.

b. When interest rates fall, the present value of the bond's scheduled payments rises, but the call provision allows the
issuer to repurchase the bond at the call price. If the call price is less than the present value of the scheduled
payments, the issuer can call the bond at the expense of the bondholder.
6.6 ) XYZ Company has bonds outstanding with 9 years left to maturity. The bonds have an 8 percent annual coupon rate and,
were issued last year at par value of Rs 1,000, but due to changes in interest rates, each bond's value has fallen to Rs 901.40. The
capital gains yield earned by investors over the last year was - 9.86 percent.
a. What is the expected current yield for the coming year?
b. What is the yield to maturity?
c. What is the expected capital gains yield for the next year if interest rates do not change?
Given,
Par value = Rs 1000
Maturity period = 9 years
Selling price of bond = Rs 901.40
Coupon interest = 8% of Rs 1000 = Rs 80
Capital gain yield= -9.86%
Coupon interest Rs 80
𝑎. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑦𝑖𝑒𝑙𝑑𝑓𝑜𝑟𝑡ℎ𝑒𝑛𝑒𝑥𝑡𝑦𝑒𝑎𝑟 = = Rs 901.40 = 0.0888 = 8.88%
Current market price of bond
b. Yield to maturity (YTM) = ?
To calculate YTM- at first- we have to calculate approximate YTM by using following formula:
𝑀−Price
𝐼+ 𝑛
Approximate YTM = Price
𝑀+2× 3

Rs 80+Rs 1,000 −9 Rs 901.40

=
Rs 1,000+2×Rs 901.40
3
Rs 90.9556
= Rs 934.2667 = 9.74%
𝑁𝑜𝑤,
Price = 𝐼 × PVIFA𝑦,𝑛 + 𝑀 × PVIF𝑦,𝑛
Try at 9%
PV = Rs 80 × PVIFA9%,9 + Rs 1,000 × PVIF9%,9
= Rs 80 × 5.9952 + Rs 1,000 × 0.4604
Try at 10%:
𝑃𝑉 = 𝑅𝑠 80 × 𝑃𝑉𝐼𝐹𝐴10%,9 + 𝑅𝑠 1,000 × 𝑃𝑉𝐼𝐹10%,9
𝑃𝑉 = 𝑅𝑠 80 × 5.7590 + 𝑅𝑠 1,000 × 0.4241
𝑃𝑉 = 𝑅𝑠 460.72 + 𝑅𝑠 424.1 = 𝑅𝑠 884.82
𝐵𝑦 𝑖𝑛𝑡𝑒𝑟𝑝𝑜𝑙𝑎𝑡𝑖𝑜𝑛:
𝑃𝑉 −𝑃𝑉
𝑌𝑇𝑀 = 𝐿𝑅 + 𝑃𝑉 𝐿𝑅−𝑃𝑉 𝑇𝑅 × 𝐻𝑅 − 𝐿𝑅
𝐿𝑅 𝐻𝑅
𝑅𝑠 940.02−𝑅𝑠 901.40
𝑌𝑇𝑀 = 9% + × 10% − 9%
𝑅𝑠 940.02−𝑅𝑠 884.82
𝑅𝑠 38.62
𝑌𝑇𝑀 = 9% + × 1% = 9% + 0.7% = 9.7%
𝑅𝑠 55.20
C. 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑 = 𝑇𝑜𝑡𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 −Current yield
= 9.7% − 8.88% = 0.82%
6.7) Suppose an 8 percent coupon, 30-year bond is selling at Rs 1,276.72. Assume semiannual interest payment on
the bond.
a. What are the semiannual YTM, the nominal annual YTM and the effective annual YTM on this bond?
b. How do you interpret the YTM?
c. What is the current yield on this bond?
d. Why does YTM of this bond differ from the current yield and the coupon rate? What rule does this imply? Explain.
Solution 6.7
Given
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 = 0.08 × 𝑅𝑠 1,000 = 𝑅𝑠 80
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑜𝑛𝑑 = 𝑅𝑠 1,276.72
𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑅𝑠 1,000
𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 (𝑛) = 30
𝑎. 𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀, 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀, 𝑎𝑛𝑑 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀:
𝐹𝑖𝑟𝑠𝑡, 𝑤𝑒 𝑤𝑜𝑟𝑘 𝑜𝑢𝑡 𝑡ℎ𝑒 𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒 𝑌𝑇𝑀 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑎𝑠 𝑓𝑜𝑙𝑙𝑜𝑤𝑠:
𝑀−𝑉
𝐼+ 𝑛 0
Approximate YTM = 𝑀+𝑉0
2
𝑅𝑠 1,000−𝑅𝑠 1,276.72
𝑅𝑠 80+
30
= 𝑅𝑠 1,000+2×𝑅𝑠 1,276.72
3
𝑅𝑠 70.78
= 𝑅𝑠 1,184.48 = 0.0598 or 5.98%
The approximate YTM is 5.98%. It suggests that the yield to maturity lies between 5% and 6% annual rate. Therefore, we
work out the value at a lower rate (5%) and a higher rate (6%) using semiannual compounding.
𝐿𝑒𝑡 𝑢𝑠 𝑡𝑟𝑦 𝑎𝑡 6% 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙3% :
𝐼
𝑉𝐻𝑅 = 2 × 𝑃𝑉𝐼𝐹𝐴𝑘𝑑/2,2𝑛 + 𝑀 × 𝑃𝑉𝐼𝐹𝑘𝑑/2,2𝑛
𝑅𝑠 80
= × 𝑃𝑉𝐼𝐹𝐴6%,2×30 + 𝑅𝑠 1,000 × 𝑃𝑉𝐼𝐹6%,2×30
2
= 𝑅𝑠 40 × 𝑃𝑉𝐼𝐹𝐴3%,60 + 𝑅𝑠 1,000 × 𝑃𝑉𝐼𝐹3%,60
= 𝑅𝑠 40 × 27.6756 + 𝑅𝑠 1,000 × 0.1697
= 𝑅𝑠 1,107.02 + 𝑅𝑠 169.7
= 𝑅𝑠 1,276.72
𝑇ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑎𝑡 𝑎 3 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑖𝑠 𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑’𝑠 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒,
𝑠𝑜 𝑡ℎ𝑒 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑜𝑛 𝑡ℎ𝑖𝑠 𝑏𝑜𝑛𝑑 𝑖𝑠 3 𝑝𝑒𝑟𝑐𝑒𝑛𝑡. 𝑇ℎ𝑎𝑡 𝑖𝑠,
Semiannual YTM = 3%
𝑇ℎ𝑒 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑌𝑇𝑀 𝑜𝑓 3 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑚𝑒𝑎𝑛𝑠 𝑡ℎ𝑎𝑡 𝑡ℎ𝑒 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀 𝑜𝑛 𝑡ℎ𝑖𝑠 𝑏𝑜𝑛𝑑 𝑖𝑠 6 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
. 𝑇ℎ𝑎𝑡 𝑖𝑠,
Nominal annual YTM = Semiannual YTM × 2 = 3% × 2 = 6%
𝐻𝑜𝑤𝑒𝑣𝑒𝑟, 𝑠𝑖𝑛𝑐𝑒 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 𝑝𝑎𝑦𝑠 𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡, 𝑡ℎ𝑒 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀 𝑖𝑠 ℎ𝑖𝑔ℎ𝑒𝑟 𝑡ℎ𝑎𝑛 6 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑏𝑒𝑐𝑎𝑢𝑠𝑒
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑒𝑣𝑒𝑟𝑦 𝑓𝑖𝑟𝑠𝑡 𝑠𝑖𝑥 𝑚𝑜𝑛𝑡ℎ𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑐𝑎𝑛 𝑏𝑒 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 𝑠𝑖𝑥 𝑚𝑜𝑛𝑡ℎ𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟.
𝑇ℎ𝑒 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑌𝑇𝑀 𝑜𝑛 𝑡ℎ𝑖𝑠 𝑏𝑜𝑛𝑑 𝑖𝑠 𝑤𝑜𝑟𝑘𝑒𝑑 𝑜𝑢𝑡 𝑎𝑠 𝑓𝑜𝑙𝑙𝑜𝑤𝑠:
Effective annual YTM = 1 + Semiannual Y TM 2 − 1
= 1 + 0.03 2 − 1 = 1.0609 − 1 = 0.0609 or 6.09%
Hence, the effective average rate of return that an investor earns by purchasing the bond is 6.09 percent.
b. The bond’s yield to maturity is the internal rate of return on an investment in the bond. The yield to maturity can be
interpreted as the compound rate of return over the life of the bond under the assumption that all bond coupons can be
reinvested at that yield. Yield to maturity therefore is widely accepted as a proxy for average return.
c. The current yield is annual coupon payment dividend by bond's price. It is given by:
𝐼 Rs 80
Current yield = 𝑉 = Rs 1,276.72 = 0.0627 or 6.27%
0

d. The YTM differs from the current yield of the bond due to several reasons. For example, this bond is selling at a premium
over par value (that is, selling price is Rs 1,276.72 rather than Rs 1,000), the coupon rate (8%) exceeds the current yield
(6.27%), and which exceeds the yield to maturity (6.09%). The coupon rate exceeds current yield because the coupon rate
divides the coupon payments by par value1 (Rs 1,000) rather than by the bond price (Rs 1,276.72). In turn, the current yield
exceeds yield to maturity because the yield to maturity accounts for the built-in capital loss on the bond; the bond bought2
today for Rs 1,276.72 will eventually fall in value to Rs 1,000 at maturity. This example illustrates a general rule: For
premium bonds, coupon rate is greater than current yield, which in turn is greater than yield to maturity. Conversely, for
discount bonds, these relationships are reversed.
 6.8 ) A 2-year bond selling at Rs 1,000 par value is paying a 10 percent coupon once a year. Suppose the yield to maturity is
also 10 percent.
a. If the coupon payment can be reinvested at an interest rate of 10 percent, What is its realized compound rate?
b. Suppose the interest rate at which the coupon can be invested is only 8 percent. What is its realized compound rate?
c. What relationship do you observe between realized compound rate and coupon reinvestment rate? Explain.
Solution
Given ,
Annual coupon (1) = 0.10 x Rs 1,000 = Rs 100
Time to maturity (n) = 2 years
Face value =Rs 1,000
Bond's price = Rs 1,000
𝑎. 𝐼𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑐𝑎𝑛 𝑏𝑒 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑎𝑡 𝑎𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑟𝑎 𝑒 𝑜𝑓 10 𝑝𝑒𝑟𝑐𝑒𝑛𝑡:
𝑇ℎ𝑒 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑜𝑢𝑝𝑜𝑛𝑠 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑎𝑡 𝑎 10% 𝑟𝑎𝑡𝑒 𝑖𝑠 𝑐𝑜𝑚𝑝𝑢𝑡𝑒𝑑 𝑎𝑠 𝑓𝑜𝑙𝑙𝑜𝑤𝑠:
Future value of coupon = 𝐼 × FVIFA10\%,2 = Rs 100 × 2.1000 = Rs 210
𝑇ℎ𝑒 𝑡𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑖𝑠:
Terminal value = Future value of coupons + Maturity value
Terminal value = Rs 210 + Rs 1,000 = Rs 1,210
Note that we purchased the bond for Rs 1,000 at the time of issue and our total investment grows to Rs 1,210 at the end of
year 2. Thus, our annual realized rate of return (r) is computed as:
Terminal value = 𝑉0 1 + 𝑟 𝑛
Rs 1,210 = Rs 1,000 1 + 𝑟 2
Rs 1,210
1 + 𝑟 2 = Rs 1,000
1 + 𝑟 = 1.2100
𝑟 = 1.10 − 0.10 = 0.10 or 10%
Hence, the realized compound return on the bond is 10%
𝑏. 𝐼𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑐𝑎𝑛 𝑏𝑒 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑎𝑡 𝑎𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 8𝑝𝑒𝑟𝑐𝑒𝑛𝑡:
The future value of coupons reinvested at 8% rate is computed as follows:
Future value of coupon = 𝐼 × FVIFA8%,2 = Rs 100 × 2.0800 = Rs 208
 Problem 6.9.
Suppose you buy a 30-year, 7.5 percent annual payment coupon bond for Rs 980 when its yield to maturity is 7.67 percent.
You plan to hold it for 20 years. Your forecast is that the bond's yield to maturity will be 8 percent when it is sold and that the
reinvestment rate on the coupons will be 6 percent. What is your realized compound rate from this investment?
Given:
Face value = Rs 1,000
Purchase price of bond = Rs 980
Maturity = 30 years
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 = 0.075 × 𝑅𝑠1,000 = 𝑅𝑠750.075 × 𝑅𝑠 1,000 = 𝑅𝑠 75
Coupon reinvestment rate = 6%
Substituting the values:
𝑉20 = 𝑅𝑠75 × 6.7101 + 𝑅𝑠1,000 × 0.4632
𝑉20 = 𝑅𝑠503.26 + 𝑅𝑠463.2
𝑉20 = 𝑅𝑠966.46
We know, the reinvestment rate of 20 annual coupon payments of Rs 75 is 6 percent. Thus, the future value of a 20-year Rs
75 annuity with an interest rate of 6 percent is given by:
Future value of coupon = 𝐼 × FVIFA6%,20
Substituting the values:
Future value of coupon = 𝑅𝑠75 × 36.7856 = 𝑅𝑠2,758.92
And the terminal value is:
Terminal value = Future value of coupons + 𝑉20
Substituting the values:
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 𝑅𝑠2,758.92 + 𝑅𝑠966.46 = 𝑅𝑠3,725.38
We purchased the bond for Rs 980 at the time of issue, and our total investment grows to Rs 3,725.38 at the end of year 20.
Thus, our annual realized rate of return (rr) is computed as:
Terminal value = 𝑉0 × 1 + 𝑟 20
𝑅𝑠3,725.38 = 𝑅𝑠980 × 1 + 𝑟 20
𝑅𝑠3,725.38
1 + 𝑟 20 = 𝑅𝑠980
1/20
1 + 𝑟 = 3.8014
𝑟 = 1.0690 − 1 = 0.0690 or 6.90%
Hence, the realized compound return on the bond is 6.90 percent.
Problem 6.10.
A 25-year, zero-coupon bond was recently being quoted at 11.625 percent of par. Find the current yield and the promised
yield of this issue, given that the bond has a par value of Rs 1,000. Using semiannual compounding, determine how much
an investor would have to pay for this bond if it were priced to yield 12 percent.
Solution
Given:
Maturity period = 25 years
Current price = 11.625% of Rs 1,000 = Rs 116.25
Maturity value = Rs 1,000
We have,
Annual interest 0
Current yield = Current price = 116.25 = 0
1 1
𝑀 𝑛 1000 25
Again, calculation of promised yield (𝑦): = −1= − 1 = 1.0899 − 1 = 0.0899 = 8.99%
𝑃0 116.25
Using semi-annual compounding,
𝑌𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑦 = 12% , 𝑃𝑟𝑖𝑐𝑒 = ?
𝑀 1000
Price = 2𝑛 = = 𝑅𝑠54.29
𝑦
1+2 1.06 50
Problem 6.11.
A newly issued bond pays its coupons once a year. Its coupon rate is 5 percent, its maturity is 20 years, and its yield to
maturity is 8 percent.
After-tax bond return
a. Find the holding-period return for a one-year investment period if the bond is selling at a yield to maturity of 7 percent by
the end of the year.
b. If you sell the bond after one year when its yield is 7 percent, what taxes will you owe if the tax rate on interest income is
40 percent and the tax rate on capital gains income is 30 percent?
c. What is the after-tax holding-period return on the bond?
d. Find the realized compound yield before taxes for a two-year holding period, assuming that (i) you sell the bond after two
years, (ii) the bond yield is 7 percent at the end of the second year, and (iii) the coupon can be reinvested for one year at a 3
percent interest rate.
e. A 9-year bond has a yield of 10 percent and duration of 7.194 years. If the market yield changes by 50 basis points, what
is the percentage change in the bond's price?
Solution 6.11
a. Initial price
𝑃0 = 𝑅𝑠50 × PVIFA8%,20 + 𝑅𝑠1,000 × PVIF8%,20
𝑃0 = 𝑅𝑠50 × 9.8181 + 𝑅𝑠1,000 × 0.2145 = 𝑅𝑠705.41
Next year's price:
𝑃1 = 𝑅𝑠50 × PVIFA7%,19 + 𝑅𝑠1,000 × PVIF7%,19
𝑃1 = 𝑅𝑠50 × 10.3356 + 𝑅𝑠1,000 × 0.2765 = 𝑅𝑠793.28
𝑅𝑠50+ 𝑅𝑠793.28−𝑅𝑠705.41
HPR = = 0.1954 = 19.54%
𝑅𝑠705.41
b. Using OID tax rules, the cost basis and imputed interest under the constant yield method are obtained by discounting
bond payments at the original 8% yield and simply reducing maturity by one year at a time:
Constant yield prices (compare these to actual prices to compute capital gains):
𝑃0 = 𝑅𝑠705.41
𝑃1 = 50 × PVIFA8%,19 + 𝑅𝑠1,000 × PVIF8%,19
𝑃1 = 𝑅𝑠50 × 9.8181 + 𝑅𝑠1,000 × 0.2145 = 𝑅𝑠711.89
⟹ 𝐼𝑚𝑝𝑙𝑖𝑒𝑠Implicit interest over first year = 𝑅𝑠711.89 − 𝑅𝑠705.41 = 𝑅𝑠6.48
𝑃2 = 𝑅𝑠50 × PVIFA8%,18 + 𝑅𝑠1,000 × PVIF8%,18
𝑃2 = 𝑅𝑠718.84 ⟹ 𝐼𝑚𝑝𝑙𝑖𝑒𝑠Implicit interest over second year = 𝑅𝑠718.84 − 𝑅𝑠711.89 = 𝑅𝑠6.95
Tax on explicit interest:
Tax on coupon = 0.40 × 𝑅𝑠50 = 𝑅𝑠20
Tax on implicit interest in first year = 0.30 × 𝑅𝑠6.48 = 𝑅𝑠1.94
Capital gain in first year:
Actual price at first year YTM − constant yield price:𝑅𝑠793.28 − 𝑅𝑠711.89 = 𝑅𝑠81.39
Tax on capital gain:
0.30 × 𝑅𝑠 81.39 = 𝑅𝑠 24.42
Total taxes:
Tax on coupon = 𝑅𝑠22.59 + 𝑅𝑠24.42 = 𝑅𝑠47.01
Rs 50+ Rs 793.28−Rs 705.41 −Rs 47.01
𝑐. 𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥𝐻𝑃𝑅 = = 0.1288 = 12.88%
Rs 705.41

𝑑. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑏𝑜𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑤𝑜 𝑦𝑒𝑎𝑟𝑠 = 50 × PVIFA7%,18 + Rs 1,000 × PVIF7%,18 = Rs 798.82

𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠} = 𝑅𝑠. 50 × 1.03 + 𝑅𝑠. 50 = 𝑅𝑠. 101.50
𝑇𝑜𝑡𝑎𝑙 𝑓𝑢𝑛𝑑𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑤𝑜 𝑦𝑒𝑎𝑟𝑠 = 𝑅𝑠 .798.82 + Rs. 101.50 = 𝑅𝑠 .900.32
Rs 705.41 1 + 𝑟 2 = Rs 900.32 ⇒ 𝑟 = 0.1297 = 12.97%
𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦𝑝𝑒𝑟𝑖𝑜𝑑 𝑛 = 9𝑦𝑒𝑎𝑟𝑠
𝑌𝑖𝑒𝑙𝑑𝑡𝑜𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑦 = 10%
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 𝐷 = 7.194𝑦𝑒𝑎𝑟𝑠
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑌𝑇𝑀 = 50 𝑏𝑎𝑠𝑖𝑠 𝑝𝑜𝑖𝑛𝑡, 𝑖. 𝑒. 0.50%
−𝐷
% change in bond price = 1+𝑦 Δ𝑦
−7.194
= 1+0.10 × 0.005
= −0.0327 = −3.27%

𝐻𝑒𝑛𝑐𝑒, 𝑎 50 𝑏𝑎𝑠𝑖𝑠 𝑝𝑜𝑖𝑛𝑡 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑌𝑇𝑀 𝑤𝑜𝑢𝑙𝑑 𝑟𝑒𝑠𝑢𝑙𝑡 𝑖𝑛𝑡𝑜 3.27 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑑𝑒𝑐𝑙𝑖𝑛𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑 ′ 𝑠 𝑝𝑟𝑖𝑐𝑒.
Problem 6.12
Calculate the YTM and Macaulay's duration for the two Treasury bonds below.

Year Bond 1 Cash Flows Bond 2 Cash Flows

0 -Rs 1,000 -Rs 1,000
1 100 0
2 100 0
3 100 0
4 100 0
5 100 0
6 1,100 1,700
Solution
Bond 1 Bond 2
Yield to maturity (k) ? ?
Macaulay's duration ? ?
(MD)
Purchase price Rs. 1,000 Rs. 1,000
Coupon rate 10% (Rs 100/Rs 1,000) 0
Selling price Rs. 1,000 Rs. 1,700
For Bond 1
Calculation of yield to maturity
First, calculate the approximate yield to maturity (AYTM)
We have,
𝑀−𝑉
𝐶+ 𝑛 0 Rs 100+Rs 1,000−6 Rs 1,000
AYTM = 𝑀+2𝑉0 = Rs 1,000+2×Rs 1,000 = 0.10 or 10%
3 3
After calculating the approximate yield to maturity, it is seems that the actual yield to maturity is lies at 10%. So, try at 10%
first.
Try at
Rs 1,000 = Rs 100 × PVIFA10%,6 + Rs 1,000 × PVIF10%,6
= Rs 100 × 4.3553 + Rs 1,000 × 0.5645
= Rs 435.53 + Rs 564.5 = Rs 1,000.03
NPV = Rs 1,000.03 − Rs 1,000 = 0.03
NPV at 10% is approximately zero; therefore the yield to maturity is 10%.
Calculation of Macaulay duration (D)
We have
1+𝑦 𝑐 1+𝑦 𝑛 −1 𝑛 𝑐−𝑦
𝐷 = − +
𝑦 𝑦 1+𝑦 𝑛 1+𝑦
1+0.10 6
0.10 1+0.10 −1 6 0.10−0.10
= 0.10
− 0.10 1+0.10 6
+ 1+0.10
= 4.79 years
𝐹𝑜𝑟 𝐵𝑜𝑛𝑑 2
𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
𝑊𝑒 ℎ𝑎𝑣𝑒,
𝑀
𝑉0 = 1+𝑌𝑇𝑀 𝑛
Rs 1,700
Rs 1,000 = 1+𝑌𝑇𝑀 6
1/6
Rs 1,700
𝑌𝑇𝑀 = Rs 1,000 − 1 = 0.0925 or 9.25%

Calculation of Macaulay's duration (D-)

It is a zero coupon bond. Zero coupon bonds have no any payment during the period. Therefore the duration of the above
bond is 6 years.
Problem 6.13
A newly issued bond has 8 percent coupon rate and 8 percent yield to maturity. Its maturity is 15 years and the Macaulay's duration
is 10 years.
i. Calculate modified duration using the above information.
ii. Identify the direction of change in modified duration if the coupon of the bond were 4 percent, not 8 percent.
Solution 6.13
Given:
Coupon interest (ii) = 8%
Yield to maturity = 8%
Maturity period = 15 years
Macaulay Duration = 10 years
Modified duration:
𝐷 10
Modified duration = 1+𝑦 = 1+0.08 = 9.26 years
Modified duration when coupon interest rate decreases from 8% to 4%:
1+𝑦 1+𝑦 +𝑛 𝑐−𝑦
Duration (D) =
𝑦 𝑐 1+𝑦 𝑛 −1 +𝑦
1+0.08 1+0.08 +15 0.04−0.08
= 0.08 0.04 1+0.08 15 −1 +0.08
=13.5-2.8760
=10.624 years Now,
10.624
Modified duration = 1+0.08 = 9.84 years
The modified duration increases from 9.26 years to 9.84 years when coupon interest rate decreases from 8% to 4%.
Therefore, modified duration increases as the coupon rate decreases.
Problem 6.14
XYZ Ltd has issued various bonds with the following characteristics.
Bond A carries 8 percent coupon and pays interest semiannually. The bond is selling at Rs 990 in the market.
Bond B is an 8 percent, 5-year maturity bond paying 10 semiannual coupon payments of Rs 40 each. Assume 10 percent
yield to maturity.
Bond C is an 8 percent coupon, 30-year maturity bond and it is selling at Rs 1,276.76.
Bond D is a 3-year zero coupon bond.
a. What will be the invoice price of Bond A if the last coupon was paid 30 days ago? (Use 182 days in a half-year)
b. What is the value of Bond B?
c. What rate of return would be earned by an investor by purchasing Bond C at Rs 1276.76?
d. What is the duration of Bond B if the yield to maturity is 10 percent?
e. Suppose you must make a payment of Rs. 14,641 in four years. The market interest rate is 10 percent, so the present
value of obligation is Rs 10,000. You wish to fund the obligation using Bond B and Bond D (i.e. invest in Bond B and Bond D
now and pay the obligation in four years using the proceeds from bonds). How much you should invest in Bond B and Bond
D to immunize the obligation?
Solution 6.14
a. The invoice price of the bond equals the stated price plus the accrued interest. If the coupon rate of the bond is 8% paid
semiannually and 30 days have passed since the last coupon payment, the accrued interest is calculated as follows:
Annual coupon Days since last coupon payment
𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = ×
2 Days between coupon payments
Substituting values:
𝑅𝑠80 30
Accrued interest = 2 × 182 = 6.59
b. Thus, the invoice price of bond A is:
Invoice price = Quoted price + Accrued interest = Rs 990 + Rs 6.59 = Rs 996.59
The value of Bond B with 8 percent coupon, 5-year maturity bond paying 10 semiannual coupon payments of Rs 40 each is
given by:

𝑉0 = 𝐶 × PVIFA𝑦,𝑛 + 𝑀 × PVIF𝑦,𝑛
= Rs 40 × PVIFA5%,10 + Rs 1000 × PVIF5%,10
= Rs 40 × 7.7217 + Rs 1000 × 0.6139
= Rs 922.77
c. Hence, the value of bond B is Rs 922.77.
The rate of return or yield to maturity that the investor would earn by purchasing Bond C at Rs 1276.76 with S percent
coupon and 30-year maturity is given by:
Step 1: Calculate the approximate yield to maturity (AYTM)
𝑀−𝑉0
𝐶+
𝑛
AYTM = 𝑀+2×𝑉0
3

Rs Rs
80+
1,000−Rs 1,276.76
30
= Rs 1,000+2× Rs 1,276.76
3
Rs 70.7747
= Rs 1184.5067 = 0.0597 or 5.97%
Step 2: Referring AYTM, it seems that the actual yield to maturity lies between 5% and 6%.
Now, we calculate the present value of bond at 5% and 6%.
Trying at 5%:
𝑉𝐿𝑅 = Rs 80 × PVIFA5%,30 + Rs 1,000 × PVIF5%,30
= Rs 80 × 15.3725 + Rs 1,000 × 0.2314 = Rs 1,461.20
𝑇𝑟𝑦𝑖𝑛𝑔 𝑎𝑡 6%
𝑉𝐻𝑅 = Rs 80 × PVIFA6%,30 + Rs 1,000 × PVIF6%,30
= Rs 80 × 13.7648 + Rs 1,000 × 0.1741 = Rs 1275.28
𝑆𝑡𝑒𝑝3: 𝐼𝑛𝑡𝑒𝑟𝑝𝑜𝑙𝑎𝑡𝑒 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒𝑠 𝑎𝑡5% 𝑎𝑛𝑑 6%
𝑊𝑒 ℎ𝑎𝑣𝑒,
𝑉 −𝑉
YTM = LR + 𝑉 𝐿𝑅−𝑉 0 × HR − LR
𝐿𝑅 𝐻𝑅
Rs 1461.20−Rs 1276.76
= 5% + Rs 1461.20−Rs 1275.28 × 6% − 5%
= 5% + 0.99 × 1% = 5.99%
Hence, the investor would earn an annualized yield of 5.99% if the bond is purchased today at Rs 1276.76 and held until 30 years
maturity.
d. The duration of Bond B with 8 percent coupon (c), 5-year maturity (t) bond paying semiannual coupon and 10 percent yield to
maturity (y) is given by:
1+𝑦/2 1+𝑦/2 +2𝑛 𝑐/2−𝑦/2
Duration = −
𝑦/2 𝑐/2 1+𝑦/2 𝑛 −1 +𝑦/2
1+0.10/2 1+0.10/2 +2×5 0.08/2−0.10/2
= −
0.10/2 0.08/2 1+0.10/2 5 −1 +0.10/2

1.05 1.05 +10 0.04−0.05

= −
0.05 0.04 1.05 10 −1 +0.05
0.95
= 21 − =8.36 semiannual period ≈ 4.18 𝑦𝑒𝑎𝑟𝑠
0.07516
Given,
Total outflow in four years = Rs 14,641
Investment duration = 4 years
Duration of Bond B = 4.18
Bond D is a 3-year zero coupon bond so its duration is equal to the maturity, that is,
Duration of Bond D = 3 years
Therefore, the duration of the portfolio must equal to 4 years.
𝐷𝑝 = 𝑊𝐵 𝐷𝐵 + 𝑊𝐷 𝐷𝐷
4 = 𝑊𝐵 × 4.18 + 1 − 𝑊𝐵 × 3
4 = 4.18𝑊𝐵 + 3 − 3𝑊𝐵
1.18𝑊𝐵 = 1
1
𝑊𝐵 = 1.18 = 0.85
𝑊𝐷 = 1 − 𝑊𝐵 = 1 − 0.85 = 0.15
To make Rs 14,641 outflow in four years, the investors must invest 85% in bond B and the 15% in bond D.
Problem 6.15.
Assume that a portfolio manager needs to make only one cash outflow of Rs 1,000,000 from a portfolio of investment in
two years. For this purpose, he has decided to make investment now in two different bond issues. The first bond has a
maturity of 3 years with a coupon rate of 8 percent while the second bond that matures in 1 year with a coupon rate of 7
percent. Both bonds are issued with a face value of Rs 1,000. The yield to maturity of bonds is 10 percent. How much
investment should be made in each of the bonds to fully immunize the interest rate risk?
Solution
Given,
Total outflow in two years = Rs 1
Investment duration or duration of portfolio = 2 years
Bond 1 2
Maturity period 3 years 1 year
Coupon rate 8% 7%
Face value Rs 1,000 Rs 1,000
Yield to maturity 10% 10%
Proportion of wealth (W) ? ?
First, calculate the duration of each bond
For Bond 1
1+𝑦 1+𝑦 +𝑛 𝑐−𝑦
𝐷1 = 𝑦
− 𝑐 1+𝑦 𝑛 −1 +𝑦
1+0.10 1+0.10 +3 0.08−0.10
= −
0.10 0.08 1+0.10 3 −1 +0.10
1.04
= 11 − 0.12648
= 11 − 8.2226 = 2.7774 years
For Bond 2:
Duration of second bond (𝐷2 ) is 1 year because the cash flows received at the end of the period.
Calculation of proportion of wealth invested in each bond
𝐷𝑝 = 𝑊1 × 𝐷1 + 𝑊2 × 𝐷2
𝑜𝑟, 2 = 𝑊1 × 2.7774 + 1 − 𝑊1 × 1
2 = 2.7774𝑊1 + 1 − 𝑊1
1
𝑊1 = 1.7774 = 0.5625
𝑊2 = 1 − 0.5625 = 0.4375
To immunize the interest rate risk, the portfolio manager should invest 56.25% in bond 1 and 43.75% in bond 2.
Problem 6.16.
Delta Company has just paid a cash dividend of Rs 20 per share. Investors require a 15 percent return from investments
such as this. If the dividend is expected to grow at a steady 5 percent per year,
Dividend Growth and Stock Valuation
a. What is the current value of the stock?
b. What will the stock be worth in five years?
c. What would the stock sell for today if the dividend was expected to grow at 10 percent per year for the next three years
and then settle down to 5 percent per year, indefinitely?
Solution 6.16
Current dividend (Do) = Rs 20
Investors required rate (k,) = 15%
Growth rate (g) = 5%
Current value of stock (Po) = ?
𝐷0 1+𝑔 𝑅𝑠20 1+0.05 𝐷0 1+𝑔 6 𝑅𝑠20 1+0.05 6
𝑎. 𝑃0 = = = 𝑅𝑠210 𝑏. 𝑃5 = = = 𝑅𝑠268.02
𝑘−𝑔 0.15−0.05 𝑘−𝑔 0.15−0.05
𝑐. 𝐼𝑓 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 𝑡ℎ𝑟𝑒𝑒 𝑦𝑒𝑎𝑟𝑠 𝑖𝑠 10 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 𝑎𝑛𝑑 𝑡ℎ𝑒𝑟𝑒𝑎𝑓𝑡𝑒𝑟 5% 𝑝. 𝑎. 𝑓𝑜𝑟𝑒𝑣𝑒𝑟.
𝐷 𝐷 𝐷 𝑃
𝑃0 = 1+𝑘1 1 + 1+𝑘2 2 + 1+𝑘3 3 + 1+𝑘3 3
𝐷1 = 𝐷0 1 + 𝑔 = 𝑅𝑠20 1 + 0.10 = 𝑅𝑠22
𝐷2 = 𝐷1 1 + 𝑔 = 𝑅𝑠22 1 + 0.10 = 𝑅𝑠24.2
𝐷3 = 𝐷2 1 + 𝑔 = 𝑅𝑠24.25 1 + 0.10 = 𝑅𝑠26.62 Now,
𝐷3 1+𝑔𝑐 26.62 1+0.05 𝑅𝑠22 𝑅𝑠24.2 𝑅𝑠26.62 𝑅𝑠279.51
𝑃3 = = = 𝑅𝑠279.51 𝑃0 = + + +
𝑘−𝑔𝑐 0.15−0.05 1+0.15 1 1+0.15 2 1+0.15 3 1+0.15 3
= 𝑅𝑠 19.13 + 𝑅𝑠 18.30 + 𝑅𝑠 17.50 + 𝑅𝑠 183.78 = 𝑅𝑠 238.71
Problem 6.17
You are considering an investment in the common stock of Apple Company. The stock is expected to pay a dividend of Rs
14 a share at the end of the year. The stock has a beta equal to 1.5. The risk-free rate is 6 percent, and the market risk
premium is 4 percent. The stock's dividend is expected to grow at some constant rate, g. The stock currently sells for Rs
200 a share. Assuming the market is in equilibrium, what does the market believe will be the stock price at the end of 3
years?
Solution 6.17
Given,
Expected dividend per share (D1) = Rs 14
The stock beta (β) = 1.5
Risk-free rate = 6%
Market risk premium (Rm - RF) = 4%
Current price of stock (Po) = Rs 200
Required rate of return (k) = RF + (RM - RF)β = 6% + 4% × 1.5 = 12%
Now,
𝐷1
𝑃0 = 𝑘 −𝑔
𝑒
𝑅𝑠14
𝑜𝑟, 𝑅𝑠200 = 0.12−𝑔
𝑅𝑠14
0.12 − 𝑔 = 𝑅𝑠200
𝑜𝑟, −𝑔 = 0.07 − 0.12
𝑜𝑟, 𝑔 = 0.05 𝑜𝑟 5%
𝐷3 1+𝑔 𝑅𝑠15.44 1+0.05
𝑁𝑜𝑤, 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 3𝑦𝑒𝑎𝑟 𝑃3 = = = 𝑅𝑠231.53
𝑘𝑒 −𝑔 0.12−0.05
𝑊ℎ𝑒𝑟𝑒, 𝐷3 = 𝐷1 1 + 𝑔 2 = 𝑅𝑠14 1 + 0.05 2 = 𝑅𝑠15.44
Problem 6.18.
You expect the price of MN stock to be Rs 597.7 per share a year from now. Its current market price is Rs 500, and you
expect it to pay a dividend one year from now of Rs 21.5 per share.
Yield and intrinsic value of stock
a. What are the stock's expected dividend yield, rate of price appreciation, and expected holding-period return?
b. If the stock has a beta1 of 1.15, the risk-free rate is 6 percent per year, and the expected rate of return on the market
portfolio is 14 percent per year, what is the required rate of return2 on MN stock?
c. What is the intrinsic value of MN stock, and how does it compare to the current market price?
Solution 6.18
𝑅𝑠21.5
𝑎. 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑦𝑖𝑒𝑙𝑑 = = 4.3%
𝑅𝑠500
597.7−500
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑔𝑎𝑖𝑛𝑠𝑦𝑖𝑒𝑙𝑑 = =
19.54%
500
𝑇𝑜𝑡𝑎𝑙𝑟𝑒𝑡𝑢𝑟𝑛 = 4.3% + 19.54% = 23.84%
𝑏. 𝑘𝑒 = 6% + 1.15 14% − 6% = 15.2%
𝑅𝑠21.5+𝑅𝑠597.7
𝑐. 𝑉0 = = 𝑅𝑠537.5, 𝑤ℎ𝑖𝑐ℎ 𝑒𝑥𝑐𝑒𝑒𝑑𝑠 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒. 𝑇ℎ𝑖𝑠 𝑤𝑜𝑢𝑙𝑑 𝑖𝑛𝑑𝑖𝑐𝑎𝑡𝑒 𝑎 𝑏𝑢𝑦𝑜 𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦.
1.152
 Problem 6.19.
Mid Town Company's stock recently paid a Rs 20 dividend. This dividend is expected to grow by 25 percent for the next 3
years, and then grow forever at a constant rate, g. The current stock price is Rs 588.8. At what constant rate is the stock
expected to grow in the following year if required return is 12 percent?
Solution 6.19
Given, We have,
𝐷 𝐷 𝐷 𝑃
Last dividend paid = Rs 20 𝑃0 = 1+𝑘1 1 + 1+𝑘2 2 + 1+𝑘3 3 + 1+𝑘3 3
𝑠 𝑠 𝑠 𝑠
Growth rate after 3 year will be constant 𝐷1 = 𝐷0 1 + 𝑔 = 𝑅𝑠. 20 1 + 0.25 = 𝑅𝑠. 25
Investments required rate of return = 12% 𝐷2 = 𝐷1 1 + 𝑔 = 𝑅𝑠. 25 1 + 0.25 = 𝑅𝑠. 31.25
Growth rate for next 3 years = 25% 𝐷3 = 𝐷2 1 + 𝑔 = 𝑅𝑠. 31.25 1 + 0.25 = 𝑅𝑠. 39.06
Current price of stock = Rs 588.8 𝐷 1+𝑔𝑐 𝑅𝑠.39.06 1+𝑔𝑐
𝑃3 = 3 =
Constant growth rate = ? 𝑘𝑠 −𝑔𝑐 0.12−𝑔𝑐

𝐴𝑔𝑎𝑖𝑛 𝑤𝑒 ℎ𝑎𝑣𝑒,
𝑁𝑜𝑤,
𝑅𝑠.25 𝑅𝑠.31.25 𝑅𝑠.39.06 𝑅𝑠.39.06 1+𝑔𝑐
𝑅𝑠. 588.8 = + + + 0.12− 𝑔𝑐
1.12 1 1.12 2 1.12 3 3
(1+0.12)
𝑅𝑠.39.06 1+𝑔𝑐
𝑜𝑟, 𝑅𝑠. 588.8 = 𝑅𝑠. 22.32 + 𝑅𝑠. 24.91 + 𝑅𝑠. 27.80 + 0.12 −𝑔
1 1.4049𝑐
𝑅𝑠.39.06 1+𝑔
𝑐
𝑜𝑟, 0.12 − 𝑔𝑐 =
𝑅𝑠.721.80
𝑜𝑟, 0.12 − 𝑔𝑐 = 0.0541 1 + 𝑔𝑐
𝑜𝑟, 0.12 − 𝑔𝑐 = 0.0541 + 0.0541 𝑔𝑐
𝑜𝑟, 0.0659 = 1.0541 𝑔𝑐
𝑔𝑐 = 0.0625 𝑜𝑟 6.25%
Problem 6.20.
Suruchi, an investor, is thinking about buying some shares of ABC Company at Rs 500 per share. She expects the price of
the stock to rise to Rs 750 over the next 3 years. During that time she also expects to receive annual dividends of Rs 50 per
share.
Common stock valuation and expected rate of return
a. What is the intrinsic worth of this stock, given a 10 percent required rate of return?
b. What is its expected return?
Solution 6.20
Given,
Current price (Po) = Rs 500
Price year 3 (P3) = Rs 750
a. Amount dividend = Rs 50 for 3 year period in each year
If required rate of return (ks) 100 0 intrinsic value ?
𝐷1 𝐷2 𝐷3
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐𝑣𝑎𝑙𝑢𝑒 𝑃0 = 1 + 2 + 3 + 𝑃3
1+𝑘 1+𝑘 1+𝑘
50 50 50+750
= + + = 𝑅𝑠. 687.83
1.10 1 1.10 2 1.10 3
𝑏. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖𝑠 𝑅𝑠500, 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑘𝑠 =?
𝑊𝑒ℎ𝑎𝑣𝑒
𝐷 𝐷 𝐷 𝑃
𝑃𝑟𝑖𝑐𝑒 = 1+𝑘1 1 + 1+𝑘2 2 + 1+𝑘3 3 + 1+𝑘3 3
50 50 50 750
500 = + + +
1+𝑘 1 1+𝑘 2 1+𝑘 3 1+𝑘 3
𝑆𝑖𝑛𝑐𝑒, 𝑎𝑡 10% 𝑟𝑒𝑡𝑢𝑟𝑛, 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖𝑠 𝑅𝑠687.83, 𝑤𝑒 𝑡𝑟𝑦 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒.
𝑁𝑜𝑤 𝑡𝑟𝑦 𝑎𝑡15%
50 50 50+750
𝑃𝑉 𝑎𝑡 15% = 1 + 2 + 3 = 𝑅𝑠. 607.2984
1.15 1.15 1.15
50 50 50+750
𝑃𝑉 𝑎𝑡 20% = + + = 𝑅𝑠. 539.3519
1.20 1 1.20 2 1.20 3
50 50 50+750
𝑃𝑉 𝑎𝑡 25% = + + = 𝑅𝑠. 481.6
1.25 1 1.25 2 1.25 3

𝑆𝑖𝑛𝑐𝑒, 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑅𝑠500 𝑙𝑖𝑒𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 481.6 𝑎𝑛𝑑 539.3519.
𝐵𝑦 𝐼𝑛𝑡𝑒𝑟𝑝𝑜𝑙𝑎𝑡𝑖𝑜𝑛, 𝑡ℎ𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑘𝑠 is:
𝑅𝑒
𝑘𝑠 = 𝐿𝑅 + 𝑃𝑉 𝑎𝑡 𝐿𝑅 − 𝑞𝑢𝑖𝑟𝑒𝑑 𝑣𝑎𝑙𝑢𝑒𝑃𝑉 at LR − PV at HR × 𝐻𝑅 − 𝐿𝑅
539.3519−500
= 20% + 539.3519−481.6 × 25% − 20%
196.7595
= 20% + = 23.41%
57.7519
 Problem 6.21.
Nepal Technologies Pvt. Ltd. is a little known company in information technology industry. The earnings and dividend
growth prospects of the company are disputed by financial two analysts- Mr. A, and Mr. B. Mr. A has forecasted 9 percent
annual constant growth in dividends while Mr. B has predicated 21 percent growth in dividends for the next two years,
which has been expected to slow down to 6 percent normal level thereafter. Company's current dividend per share is Rs
15. Stock with similar risk is currently priced to provide a 12 percent expected return.
a. What is the value of company's stock according to Mr. A?
b. What is the value of company's stock according to Mr. B?
c. Assume that the company's stock now sells for Rs. 405 per share. If the stock is fairly priced at the present time, what is
the implied perpetual dividend growth rate? What is the implied price-earnings ratio on next year's earnings, based on this
perpetual dividend growth assumption and assuming a 20 percent payout ratio?
Solution 6.21
𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑏𝑦 𝑀𝑟. 𝐴 𝑔 = 9%
𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑓𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑏𝑦𝑀𝑟. 𝐵:
For first two year 𝑔 = 21%
Growth rate after second year 𝑔𝑎 = 6%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒 𝐷0 = 𝑅𝑠15
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑𝑟𝑎𝑡𝑒𝑜𝑓𝑟𝑒𝑡𝑢𝑟𝑛 𝑘𝑠 = 12%
𝑁𝑜𝑤,
𝑎. 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑃0 , 𝑎𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜𝑀𝑟. 𝐴:
𝐷0 1+𝑔 𝑅𝑠.15 1+0.09
[𝑃0 = = = 𝑅𝑠. 545]
𝑘𝑠 −𝑔 0.12−0.09
 Year Dividend and Price PVIF @ 12% PV
1 D₁ = D₀(1+g) = Rs 15 (1.21) = Rs 18.15 0.8929 Rs 16.21

2 D₂ = D₁(1+g) = Rs 18.15 (1.21) = Rs 21.96 0.7972 17.51

3 𝐷2 1 + 𝑔𝑛 𝑅𝑠. 21.96 1 + 0.06 0.7972 309.28

𝑃2 = =
𝑘𝑠 − 𝑔𝑛 0.12 − 0.06
= 𝑅𝑠. 387.96

P₀ = Rs 343

𝑐. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑠𝑒𝑙𝑙𝑖𝑛𝑔𝑝𝑟𝑖𝑐𝑒𝑜𝑓𝑠𝑡𝑜𝑐𝑘 𝑃0 = 𝑅𝑠. 405

𝐷0 1+𝑔
∴ 𝑃0 = 𝑘𝑒 −𝑔
𝑅𝑠.15 1+𝑔
𝑅𝑠. 405 = 0.12−𝑔
𝑅𝑠. 48.6 – 𝑅𝑠. 405𝑔 = 𝑅𝑠. 15 + 𝑅𝑠. 15𝑔
33.6 = 420𝑔
33.6
∴ 𝑔 = 420 = 0.08 or 8%
Dividend payout 1+𝑔 0.20
𝑃/𝐸𝑟𝑎𝑡𝑖𝑜 = = = 5 times
𝑘 −𝑔
𝑒 0.12−0.08
Problem 6.22.
Ram, Laxman and Bharat are brothers. They’re all serious investors, but each has a different approach to valuing stocks.
Ram, the oldest, likes to use a 1-year holding period to value common shares. Laxman, the middle brother, likes to use
multiyear holding periods. Bharat, the youngest of the three, prefers the dividend valuation model.
As it turns out, right now, all three of them are looking at the same stock- LG Company. The company has been listed on the
NEPSE for over 20 years, and is widely regarded as a mature, dividend-paying stock. The brothers have gathered the
following information about LG’s stock:
Current dividend (Do) = Rs 10/share
Expected growth rate (g) 9.0%
Required rate of return (k) 12.0%
All three of them agree that these variables are appropriate, and they will use them in valuing the stock. Ram and Laxman
intend to use the D&S approach; Bharat is going to use the constant-growth Dividend discounted (DDM) model. Ram will
use a 1-year holding period; he estimates that with a 9 percent growth rate, the price of the stock will increase to Rs 350 by
the end of the year. Laxman will use a 3-year holding period; with the same 9 percent growth rate, he projects the future
price of the stock will be Rs 400 by the end of his investment horizon. Bharat will use the constant-growth DDM, so his
holding period isn’t needed.
a. Use the information provided above to value the stocks first for Ram, then for Laxman, then for Bharat.
b. Comment on your findings. Which approach seems to make the most sense?
Solution 6.22
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷0 = 𝑅𝑠. 10 per share
𝑃𝑟𝑖𝑐𝑒 𝑎𝑡 𝑦𝑒𝑎𝑟 − 𝑒𝑛𝑑 𝑃1 = 𝑅𝑠. 350
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑔 = 9%
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜 𝐿𝑎𝑥𝑚𝑎𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓𝑠 𝑡𝑜𝑐𝑘
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜 𝑅𝑎𝑚 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝐷 𝐷 𝐷3 +𝑃3
𝐷 𝑃 = 1+𝑘1 1 + 1+𝑘2 2 + 1+𝑘
= 1+𝑘1 1 + 1+𝑘1 1 2 2
3
2
2 2
10×1.09 350
= + = 𝑅𝑠. 322.23 10×1.09 10×1.092 10×1.093 +400
1+0.12 1 1+0.12 1 = + 1.12 2 + = 𝑅𝑠. 313.13
1.12 1 1.12 3
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑛𝑜𝑡𝑒
𝐷1 = 10 × 1.09 = 𝑅𝑠. 10.9
𝐷2 = 10 × 1.09 2 = 𝑅𝑠. 11.881
𝐷3 = 10 × 1.09 3 = 𝑅𝑠. 12.95
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔𝑡𝑜𝐵ℎ𝑎𝑟𝑎𝑡𝑝𝑟𝑖𝑐𝑒𝑜𝑓𝑠𝑡𝑜𝑐𝑘:
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜 𝐺𝑜𝑟𝑑𝑜𝑛′ 𝑠 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑚𝑜𝑑𝑒𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑃0
𝐷1 10.9
= 𝑘 −𝑔 = 0.12−0.09 = 𝑅𝑠. 363.33
1
Problem 6.23.
Assume there are three companies that in the past year paid exactly the same annual dividend of Rs 22.5 a share. In
addition, the future annual rate of growth in dividends for each of the three companies has been estimated as follows:
Zero Growth Stock Constant Growth Stock Variable Growth Stock

g=0 g=6% Year

(i.e., dividends are (for the foreseeable future 1 Rs 25.3
expected to remain at 2 Rs 28.5
Rs 22.5/share) 3 Rs 32
4 Rs 36
Year 5 and beyond: g = 6%

Assume also that as the result of a strange set of circumstance, these three companies all have the same required rate of
return of 10 percent.
a. Use the appropriate DDM to value each of these companies.
b. Comment briefly on the comparative values of these three companies. What is the major cause of the differences
among these three valuations?
Solution 6.23
Given,
𝐾𝑠 =10%
𝐷0 = Rs 22.5

𝑎. 𝑍𝑒𝑟𝑜 𝑔𝑟𝑜𝑤𝑡ℎ 𝑠𝑡𝑜𝑐𝑘:

𝐷 22.5
Intrinsic value = 𝑘 = 0.10 = 𝑅𝑠. 225
𝑠
𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑔𝑟𝑜𝑤𝑡ℎ 𝑠𝑡𝑜𝑐𝑘:
𝐺𝑟𝑜𝑤𝑡ℎ𝑟𝑎𝑡𝑒 𝑔 = 6%
𝐷0 1+𝑔 22.5 1+0.06
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐𝑣𝑎𝑙𝑢𝑒 = = = 𝑅𝑠. 596.25
𝑘𝑠 −𝑔 0.10−0.06
𝐷1 𝐷2 𝐷3 𝐷4 𝑃4
Value of stock = + + + +
1+𝑘𝑠 1 1+𝑘𝑠 2 1+𝑘𝑠 3 1+𝑘𝑠 4 1+𝑘𝑠 4
𝐷 1+𝑔𝑐 36 1+0.06
𝑊ℎ𝑒𝑟𝑒, 𝑃4 = 4 = = 𝑅𝑠. 954
𝑘1 −𝑔𝑐 0.10−0.06
25.3 28.5 32 36 954
𝑃0 = 1.10 + 1.102 + 1.103 + 1.104 + 1.104 = 𝑅𝑠. 746.78
Problem 6.24.
New Age (NA) Company’s stock sells at a P/E ratio of 21 times earnings. It is expected to pay dividends of Rs 20 per share in
each of the next 5 years and to generate an EPS of Rs 50 in year 5. Using the dividends-and-earnings model and a 12
percent discount rate, compute the stock’s justified price.
Solution 6.24
𝐺𝑖𝑣𝑒𝑛,

𝑃/𝐸𝑟𝑎𝑡𝑖𝑜 = 21 times
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑡𝑜 𝑝𝑎𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑜𝑓 𝑅𝑠20 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑖𝑛 𝑛𝑒𝑥𝑡 5𝑦𝑒𝑎𝑟𝑠
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒𝑖𝑛𝑦𝑒𝑎𝑟5 = 𝑅𝑠. 50
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑟𝑎𝑡𝑒 𝑘 = 12%
𝑈𝑠𝑖𝑛𝑔 𝑡ℎ𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 − 𝑎𝑛𝑑 − 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑚𝑜𝑑𝑒𝑙 𝑐𝑜𝑚𝑝𝑢𝑡𝑒 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 =?
𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 5:
MPS
𝑃/𝐸𝑟𝑎𝑡𝑖𝑜 = EPS
𝑃
𝑜𝑟, 21 = 5
50
𝑜𝑟, 𝑃5 = 𝑅𝑠. 1,050

𝑁𝑜𝑤, 𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 ′ 𝑠 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑 𝑝𝑟𝑖𝑐𝑒

𝐷 𝐷 𝐷 𝐷 𝐷 𝑃
= 1+𝑘1 1 + 1+𝑘2 2 + 1+𝑘3 3 + 1+𝑘4 4 + 1+𝑘5 5 + 1+𝑘5 5
20 20 20 20 20 1050
= 1.12 + + + + + = 𝑅𝑠. 667.89
1.12 2 1.12 3 1.12 4 1.12 5 1.12 5
Problem 6.25.
Assume a major investment service has just given XYZ Company its highest investment rating, along with a strong buy
recommendation. As a result, you decide to take a look for yourself and to place a value on the company's stock. Here's
what you find: This year, XYZ paid its stockholders an annual dividend of Rs 30 a share, but because of its high rate of
growth in earnings, its dividends are expected to grow at the rate of 12 percent a year for the next 4 years and then to level
out at 9 percent a year. So far, you have learnt that the stock has a beta of 1.80, the risk-free rate of return is 6 percent, and
the expected return on the market is 11 percent. Using the CAPM to find the required rate of return, put a value on this
stock.
Solution 6.25
𝐺𝑖𝑣𝑒𝑛,
𝐷0 = 𝑅𝑠. 30
𝑔 = 12% for next four year and then to level out at 9%
𝐵𝑒𝑡𝑎 β = 1.80
𝑅𝑖𝑠𝑘𝑓𝑟𝑒𝑒𝑟𝑎𝑡𝑒 𝑅𝑓 = 6%
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑𝑟𝑒𝑡𝑢𝑟𝑛𝑜𝑛𝑡ℎ𝑒𝑚𝑎𝑟𝑘𝑒𝑡𝐸 𝑅𝑚 = 11%
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜 𝐶𝐴𝑃𝑀 𝑚𝑜𝑑𝑒𝑙
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑘𝑠 = 𝑅𝑓 + 𝐸 𝑅𝑚 − 𝑅𝑓 β = 6% + 11% − 6% 1.8 = 15%
 𝐷5 51.4541
𝑃4 = 𝑘 = 0.15−0.09 = 𝑅𝑠. 857.5683
𝑠 −𝑔

33.6 37.632 42.1478 47.2056 857.5683

𝑃0 = + + + +
1.15 1 1.15 2 1.15 3 1.15 4 1.15 4

𝑃0 = 602.70
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑖𝑠 𝑅𝑠602.70
Problem 6.26.
The cash dividends per share of the Alpha Company have been growing at an annual rate of 5 percent, and this growth rate
is expected to continue into the foreseeable future. Alpha's current cash dividend is Rs 20 per share. The following two-
factor model is assumed to be appropriate to determine the required rate of return on the shares of Alpha:

𝐸 𝑅Alpha = 5% + 𝑏11 2% + 𝑏12 4%

𝑇ℎ𝑒𝑓𝑎𝑐𝑡𝑜𝑟𝑏𝑒𝑡𝑎𝑠𝑓𝑜𝑟𝐴𝑙𝑝ℎ𝑎𝑠𝑡𝑜𝑐𝑘𝑎𝑟𝑒:
𝑏11 = 1.5 and 𝑏12 = 0.75
a. Use the above information and the dividend discount model to value a share of Alpha's stock.
b. Point out the limitations of dividend discount model.
Solution 6.26
Given,
Growth rate of dividend (g) = 5%
Current cash dividend = Rs 20 per share
𝑎. 𝑊𝑒ℎ𝑎𝑣𝑒,
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑𝑟𝑎𝑡𝑒𝑜𝑓𝑟𝑒𝑡𝑢𝑟𝑛
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑𝑟𝑎𝑡𝑒𝑜𝑓𝑟𝑒𝑡𝑢𝑟𝑛, 𝐸 𝑅𝐴𝐵𝐶 = 5% + 𝑏11 2% + 𝑏12 4%
= 5% + 1.5 2% + 0.75 4% = 11%
𝑉𝑎𝑙𝑢𝑒𝑜𝑓𝑡ℎ𝑒𝑠𝑡𝑜𝑐𝑘 𝑃0 =?
𝐷0 1+𝑔 𝑅𝑠~20 1+0.05
𝑃0 = = = 𝑅𝑠. 350
𝑘𝑠 −𝑔 0.11−0.05
b. Limitations of dividend discount model are as follows:
• The model cannot be used where companies pay very small or no dividends.
• The correct discount rate and growth rate is difficult to estimate for a specific company.
• The model is not definable when g > k, as with growth companies.
• For the variable growth models, small differences in g for the first several years produce large differences the
valuations.
Problem 6.27.
Tinau Steel is run by entrenched management that insists on reinvesting 60 percent of its earnings in projects that provide
an ROE of 10 percent, despite the fact that the firm's capitalization rate is 15 percent. The firm's year-end dividend will be
Rs 20 per share, paid out of earnings of Rs 50 per share. At what price will the stock sell? What is the present value of
growth opportunities? Why would such a firm be a takeover target for another firm?
Solution 6.27
𝑔 = ROE × 𝑏 = 10% × 0.6 = 6%
and the stock price should be
𝑅𝑠.20
𝑃0 = 0.15−0.06 = 𝑅𝑠. 222.22
𝑇ℎ𝑒 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑔𝑟𝑜𝑤𝑡ℎ 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑖𝑒𝑠 𝑖𝑠
𝑃𝑉𝐺𝑂 = Price per share − No−growth value per share
𝐸1 𝑅𝑠,50
= 𝑅𝑠. 222.22 − = 𝑅𝑠. 222.22 − = −𝑅𝑠. 111.11
𝑘 0.15

PVGO is negative. This is because the net present value of the firm’s projects is negative: The rate of return on those assets
is less than the opportunity cost of capital. Such a firm would be subject to takeover, because another firm could buy the
firm for the market price of Rs 222.22 per share and increase the value of the firm by changing its investment policy. For
example, if the new management simply paid out all earnings as dividends, the value of the firm would increase to its no-
growth value, E1= Rs 50/0.15 = Rs 333.33.
Problem 6.28.
The stock of JB Company is currently selling for Rs 100 per share. Earnings per share in the coming year are expected to be
Rs 20. The company has a policy of paying out 50 percent of its earnings each year in dividends. The rest is retained and
invested in projects that earn a 20 percent rate of return per year. This situation is expected to continue indefinitely.
a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM,
what rate of return do JB's investors require?
b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?
c. If JB Company were to cut its dividend payout ratio to 25 percent, what would happen to its stock price? What if JB
eliminated the dividend?
Solution 2.28 𝑏. Since 𝑘 = ROE, the NPV of future investment
𝐷1
opportunities is zero:
𝑎. 𝑘= +𝑔
𝑃0 𝐸1
𝑃𝑉𝐺𝑂 = 𝑃0 − = Rs 100 − Rs 100 = 0
𝑘
𝐷1 = 0.5 × Rs 20 = Rs 10
𝑐. Since 𝑘 = ROE, the stock price would be unaffected by
𝑔 = 𝑏 × ROE = 0.5 × 0.20 = 0.10
cutting the dividend and investing the additional earnings.
Rs 10
Therefore: 𝑘 = Rs 100 + 0.10 = 0.20 = 20%
Problem 6.29.
The risk-free rate of return is 8 percent, the expected rate of return on the market portfolio is 15 percent, and the stock of1
ABC Company has a beta coefficient of 1.2. ABC pays out 40 percent of its earnings in dividends, and the latest earnings
announced were Rs 10 per share. Dividends were just paid and are expected to be paid annually. You expect that ABC will
earn an ROE of 20 percent per year on all reinvested earnings forever.
a. What is the intrinsic value of a share of ABC stock?
b. If the market price of a share is currently Rs 100, and you expect the market price to be equal to the intrinsic value one
year from now, what is your expected one-year holding-period return on ABC stock?
Solution 6.29
𝑎. 𝑘 = 𝑅𝐹 + β 𝐸 𝑅𝑚 − 𝑅𝐹 = 8% + 1.2 15% − 8% = 16.4%
𝑔 = 𝑏 × ROE = 0.6 × 20% = 12%
𝐷1 1+𝑔 Rs 4×1.12
𝑉0 = = 0.164−0.12 = Rs 101.82
𝑘𝑠 −𝑔

𝑏. 𝑃1 = 𝑉1 = 𝑉0 1 + 𝑔 = Rs 101.82 × 1.12 = Rs 114.04

𝐷1 +𝑃1 −𝑃0 Rs 4.48+Rs 114.04−Rs 100
𝐸 𝑟1 = = = 0.1852 = 18.52%
𝑃0 Rs 100
Problem 6.30.
CSE Technology Inc. does not currently pay any dividends but is expected to start doing so in 4 years. That is, CSE will go 3
more years without paying any dividends, and then is expected to pay its first dividend of Rs 30 per share in the fourth year.
Once the company starts paying dividends, it is expected to continue to do so. The company is expected to have a
dividends payout ratio of 40 percent and to maintain a return on equity of 20 percent. Based on the DDM, and given a
required rate of return of 15 percent, what is the maximum price you should be willing to pay for this stock today?

𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒/𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 4

𝐷𝑃𝑅 = 40% ROE = 20%
𝑘𝑠 = 15% Retention ratio (b) = 60%
𝐺𝑟𝑜𝑤𝑡ℎ𝑟𝑎𝑡𝑒 = 𝑏 × ROE = 0.6 × 20% = 12%
𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑣𝑎𝑙𝑢𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 4
𝐷5 33.6
𝑃4 = 𝑘 = 0.15−0.12 = Rs. 1,120
𝑠 −𝑔

𝑁𝑜𝑤, 𝐶𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑖𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑡𝑜𝑑𝑎𝑦

𝐷4 𝑃4 30 1120
𝑃0 = + = + = Rs. 657.52
1+𝑘𝑠 4 1+𝑘𝑠 4 1.15 4 1.15 4
Problem 6.31.
Mrs. Anju Mahat is trying to estimate the intrinsic value per share for a growth stock issued by the Fishtail Corporation. She
estimates that the corporation will grow at 8 percent per year for 10 years and then level off. During this growth period, the
corporation will be more risky than the average company, and Mrs. Mahat thinks 14 percent would be an appropriate
capitalization rate. The corporation's earnings per share are currently Rs 3.00, and the corporation is paying 50 paisa per
share cash dividend. What do you think its stock is worth if the price-earnings ratio is 1.95 times? What is the value using
the dividend discount model?
Solution 6.31
Given:
• Growth rate for 10 years = 8%
• Growth rate after 10th year= level off or 0
• Capitalization rate = 14%
• Earnings per share = Rs 3.00
• Cash dividend per share= Rs 0.50
• Value of stock = ?
Using price earnings model (P/E Model)
We have,
𝑃0 = P/E ratio × EPS = 1.95 × Rs. 3 = Rs. 5.85
𝑈𝑠𝑖𝑛𝑔 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑚𝑜𝑑𝑒𝑙:
𝑊𝑒ℎ𝑎𝑣𝑒,
𝐷1 𝐷2 𝐷3 𝐷4 𝐷5 𝐷6 𝐷7 𝐷8 𝐷9 𝐷10 𝐷10 1+𝑔𝑛 1
𝑉0 = + + + + + + + + + + ×
1+𝑘 1+𝑘 2 1+𝑘 3 1+𝑘 4 1+𝑘 5 1+𝑘 6 1+𝑘 7 1+𝑘 8 1+𝑘 9 1+𝑘 10 𝑘−𝑔𝑛 1+𝑘 10

Rs.0.54 Rs.0.58 Rs.0.63 Rs.0.68 Rs.0.73 Rs.0.79 Rs.1.08 Rs.1.14 Rs.1.21 Rs.1.31
= + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + +
1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 10
Rs.1.31 1+0.00 1
×
0.14−0.00 1+0.14 10

Rs.0.86 Rs.0.93 Rs.1.00 Rs.1.08 Rs.1.14 Rs.1.21 Rs.1.31 Rs.1.41 Rs.1.52 Rs.1.64 Rs~2.08
= + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 +
1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 1+0.14 10

= Rs. 0.47 + Rs. 0.45 + Rs. 0.43 + Rs. 0.40 + Rs. 0.38 + Rs. 0.36 + Rs. 0.34 + Rs. 0.33 + Rs. 0.31 + 𝑅𝑠. 0.29 + Rs. 2.08
= Rs. 5.84
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑛𝑜𝑡𝑒𝑠:
𝐷1 = 𝐷0 1 + 𝑔 = 0.50 1 + 0.08 = 0.54
𝐷2 = 𝐷1 1 + 𝑔 = 0.54 1 + 0.08 = 0.58 and so on
𝑁𝑜𝑡𝑒: 𝑇ℎ𝑒 𝑎𝑛𝑠𝑤𝑒𝑟𝑠 𝑖𝑛 𝑡𝑤𝑜 𝑚𝑒𝑡ℎ𝑜𝑑𝑠 𝑎𝑟𝑒 𝑠𝑙𝑖𝑔ℎ𝑡𝑙𝑦 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡 𝑑𝑢𝑒 𝑡𝑜 𝑟𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑒𝑟𝑟𝑜𝑟.
Problem 6.32.
Big Bazar Limited generated an EPS of Rs 27.50 over the last 12 months. The company's earnings are expected to grow by
25 percent next year, and because there will be no significant change in the number of shares outstanding, EPS should
grow at about the same rate. You feel the stock should trade at a P/E of around 30 times earnings. Use the P/E approach to
set a value on this stock.
Solution 6.32

𝑃/𝐸𝑟𝑎𝑡𝑖𝑜 = 30 times =
𝑃𝑟𝑖𝑐𝑒 𝑡 = P/E ratio × EPS𝑡 = 30 × 34.375 = Rs. 1,031.25
Problem 6.33.
The Mission Corporation's cash flow from operations before interest and taxes was Rs 2 million in the year just ended, and
it expects that this will grow by 5 percent per year forever. To make this happen, the firm will have to invest an amount equal
to 20 percent of pretax cash flow each year. The tax rate is 35 percent. Depreciation was Rs 200,000 in the year just ended
and is expected to grow at the same rate as the operating cash flow. The appropriate market capitalization rate for the
unleveraged cash flow is 12 percent per year, and the firm currently has debt of Rs 4 million outstanding. Use the free-cash
flow approach to value the firm's equity.
Solution 6.33
𝐵𝑒𝑓𝑜𝑟𝑒 − 𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 (𝑅𝑠 2,000,000 × 1.05) = 𝑅𝑠 2,100,000
𝐿𝑒𝑠𝑠: 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 (𝑅𝑠 200,000 × 1.05) = 210,000
𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 = 1,890,000
𝐿𝑒𝑠𝑠: 𝑇𝑎𝑥𝑒𝑠 (@35%) = 661,500
𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 = 1,228,500
𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 = 1,438,500
(𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)
𝑁𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (20% 𝑜𝑓 𝑅𝑠 2,100,000) = 420,000
𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 (𝐹𝐶𝐹𝐹) = 1,018,500
(𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 − 𝑛𝑒𝑤 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
𝐹𝐶𝐹𝐹1 Rs.1,018,500
𝑉0 = = = Rs. 14,550,000
𝑘𝑒 −𝑔 0.12−0.05

𝑇ℎ𝑒𝑣𝑎𝑙𝑢𝑒𝑜𝑓𝑒𝑞𝑢𝑖𝑡𝑦 = Value of the firm − Value of debt

= Rs. 14,550,000 − Rs~4,000,000 = Rs, 10,550,000
𝐻𝑒𝑛𝑐𝑒, 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑠 𝑅𝑠. 10,550,000.
Problem 6.34.
You have been working in an investment advisory company. One of your friends approached you for your advice on the
following:
a. One of the stocks your friend has considered is that of Himalayan Aqua Ltd. The company has just paid its annual
dividend of Rs 3 per share. The dividend is expected to grow at a constant rate of 8 percent indefinitely. The beta of
Himalayan Aqua stock is 1, the risk-free rate is 6 percent, and the market risk premium is 8 percent. Given the information
your friend needs advice on:
i. Should your friend buy the stock if it is trading at Rs 50?
ii. What would be your revised estimate of the value of the stock if you believed that the stock was riskier, with a beta of
1.25?
b. Another stock your friend is interested is that of Generic Genetic (GG) Company. GG pays no cash dividends currently
and is not expected to for the next 4 years. Its last EPS was Rs 5, all of which was reinvested in the company. The firm's
expected ROE for the next 4 years is 20 percent per year, during which time it is expected to continue to reinvest all of its
earnings. Starting 5 years from now, the firm's ROE on new investments is expected to fall to 15 percent per year. What is
the maximum price your friend should pay for GG company stock? Assume 15 percent required return.
c. The third company your friend has selected is The Cooper Company. It had paid dividend of Rs 18 per share over the past
year with a forecast that dividends would grow by 5 percent per year forever. Further assume that the required rate of return
on Copper stock is 11 percent, the current stock price is Rs 400 per share and that the earning per share (Eo) was Rs 27.
i. What is the actual price-earnings ratio?
ii. What is the normal price-earnings ratio?
iii. Is the stock of Cooper Company over-priced or under-priced?
Solution 6.34
𝑎. 𝐺𝑖𝑣𝑒𝑛,
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷0 = Rs. 3 per share
𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑔 = 8%
𝐵𝑒𝑡𝑎 𝑜𝑓 𝐻𝑖𝑚𝑎𝑙𝑎𝑦𝑎𝑛 𝐴𝑞𝑢𝑎 𝑠𝑡𝑜𝑐𝑘 β𝐻 = 1
𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒𝑟𝑎𝑡𝑒 𝑅𝑓 = 6%
𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝐸 𝑟𝑚 − 𝑅𝑓 = 8%
𝑖. 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐻𝑖𝑚𝑎𝑙𝑎𝑦𝑎𝑛 𝐴𝑞𝑢𝑎 𝑠𝑡𝑜𝑐𝑘 = Rs. 50 per share
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑘𝑠 = 𝑅𝑓 + 𝐸 𝑟𝑚 − 𝑅𝑓 β𝐻 = 6% + 8% × 1 = 14%
𝐷1 3.24
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐻𝑖𝑚𝑎𝑙𝑎𝑦𝑎𝑛𝑠𝑡𝑜𝑐𝑘 𝑃0 = 𝑘 = 0.14−0.08 = Rs. 54
𝑠 −𝑔
𝑊ℎ𝑒𝑟𝑒,
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷1 = 𝐷0 1 + 𝑔
= Rs. 3 1 + 0.08 = Rs. 3.24 per share
Market price of stock (i.e. Rs 50) is less than the intrinsic value of stock (i.e. Rs 54). So, the friend should buy the Himalayan
stock because the stock is undervalued in the market.
𝑖𝑖. 𝐼𝑓𝑏𝑒𝑡𝑎𝑜𝑓𝐻𝑖𝑚𝑎𝑙𝑎𝑦𝑎𝑛𝑠𝑡𝑜𝑐𝑘 β𝐻 = 1.25
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑𝑟𝑎𝑡𝑒𝑜𝑓𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑅𝑓 + 𝐸 𝑟𝑚 − 𝑅𝑓 β𝐻
= 6% + 8% × 1.25
= 6% + 10% = 16%
𝐷1 Rs.3.24
𝑃𝑟𝑖𝑐𝑒𝑜𝑓𝐻𝑖𝑚𝑎𝑙𝑎𝑦𝑎𝑛𝑠𝑡𝑜𝑐𝑘 𝑃0 = 𝑘 −𝑔 = 0.16−0.08 = Rs. 40.50
𝑠
Market price of stock (i.e. Rs 50) is more than the intrinsic value of stock (i.e. Rs 40.50). So, the friend should not buy the
stock because the stock is overvalued in the market.
b. Given
Year EPS ROE b DPS g=b×r
0 Rs 5 20% 1 0 20%
1 Rs 6 20% 1 0 20%
2 Rs 7.2 20% 1 0 20%
3 Rs 8.64 20% 1 0 20%

4 Rs 10.368 20% 1 0 20%

5 Rs 12.4416 20% 0 12.4416 0

Note:
• Dividends = 0 for the next four years. So retention ratio (b) = 1.00 (100% plowback ratio)
• Company will pay 100% dividend in fifth year and growth of dividend will be zero.
𝐷5 12.4416
𝑃𝑟𝑖𝑐𝑒𝑜𝑓𝑠𝑡𝑜𝑐𝑘𝑎𝑡𝑡ℎ𝑒𝑒𝑛𝑑𝑜𝑓𝑦𝑒𝑎𝑟4, 𝑃4 = 𝑘 = = 82.944
𝑠 −𝑔 0.15−0
𝑃4 82.944
𝑃𝑟𝑖𝑐𝑒𝑜𝑓𝑠𝑡𝑜𝑐𝑘𝑛𝑜𝑤, 𝑃0 = = = Rs. 47.42
1+𝑘𝑠 4 1+0.15 4
The maximum price that my friend should pay to for GG stock is Rs 47.42 per share,
𝑐. 𝐺𝑖𝑣𝑒𝑛,
𝑃𝑎𝑠𝑡𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷0 = Rs. 18 per share
𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑔 = 5%
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓𝑟𝑒𝑡𝑢𝑟𝑛 𝑘𝑠 = 11%
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑃0 = Rs. 400 per share
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒 𝐸0 = Rs. 27 per share
Intrinsic value of stock Rs.315
𝑖. 𝐴𝑐𝑡𝑢𝑎𝑙𝑃/𝐸𝑟𝑎𝑡𝑖𝑜 = = = 11.11 times
𝐸1 28.35
𝑤ℎ𝑒𝑟𝑒,
𝐸1 = 𝐸0 1 + 𝑔 = Rs. 27 1 + 0.05 = Rs. 28.35
𝐷1 = 𝐷0 1 + 𝑔 = Rs. 18 1 + 0.05 = Rs. 18.90
𝐷1 18.90
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 = 𝑘 −𝑔 = 0.11−0.05 = Rs. 315 per share
𝑠
𝑃0 Rs.400
𝑖𝑖. 𝑁𝑜𝑟𝑚𝑎𝑙 𝑃/𝐸𝑟𝑎𝑡𝑖𝑜 = = = 14.11 times
E1 28.35
𝑖𝑖𝑖. 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖. 𝑒. , 𝑅𝑠400 𝑖𝑠 𝑚𝑜𝑟𝑒 𝑡ℎ𝑎𝑛 𝑡ℎ𝑒 𝑖𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖. 𝑒. , 𝑅𝑠315 . 𝑆𝑜, 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑖𝑠 𝑜𝑣𝑒𝑟
𝑝𝑟𝑖𝑐𝑒𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑚𝑎𝑟𝑘𝑒𝑡.
Problem 6.35.
As an investment advisor, suggest on the following stock valuation problems:
a. The Nepal Electronic Quotation System (NEQS) Corporation pays no cash dividend currently and is not expected to for
the next five years. Its latest EPS was Rs 10, all of which was reinvested in the company. The firm’s expected ROE for the
next five years is 20 percent per year, and during this time it is expected to continue to reinvest1 all of its earnings. Starting
six years from now the firm’s ROE on new investments is expected to fall to 15 percent, and the company is expected to
start paying out 40 percent of its earnings in cash dividends, which it will continue to do forever after.2 NEQS’s market
capitalization rate is 15 percent per year.
i. What is your estimate of NEQS’s intrinsic value per share?
ii. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next
year? The year after?
iii. What effect would it have on your estimate of NEQS’s intrinsic value if you expected NEQS to pay only 20 percent of
earnings starting in year 6?
b. The stock of Almond Corporation is currently selling for Rs 10 per share. Earnings per share in the coming year are
expected to be Rs 2. The company has a policy of paying out 50 percent of its earnings each year in dividends. The rest is
retained and invested in projects that earn a 20 percent rate of return per year. This situation is expected to continue
indefinitely.
i. Assuming the current market price of stock reflects its intrinsic value as computed using the constant-growth DDM, what
rate of return do Almond's investors require?
ii. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?
iii. If Almond were to cut its dividend payout ratio to 25 percent, what would happen to its stock price? What if Almond
eliminated the dividend?
Solution 6.35
Time Et Dt b g
0 Rs 10,000 Rs 0.000 1.00 20.0%
1 Rs 12,000 Rs 0.000 1.00 20.0%
5 Rs 24,883 Rs 0.000 1.00 20.0%
6 Rs 29,860 Rs 11,944 0.60 9.0%

𝑖. 𝑁𝐸𝑄′ 𝑠 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑦𝑒𝑎𝑟 5 𝑖𝑠 𝑔𝑖𝑣𝑒𝑛 𝑏𝑦:

𝐷6 11.944
𝑉5 = 𝑘 −𝑔 = 0.15−0.09 = Rs. 199.07
𝑒
𝑇ℎ𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑜𝑓 𝑁𝐸𝑄′ 𝑠 𝑖𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑖𝑠 𝑔𝑖𝑣𝑒𝑛 𝑏𝑦:
𝑉5 Rs.199.07
𝑉0 = 5 = 5 = Rs. 98.97
1+𝑘𝑒 1.15
ii. The price should rise by 15 percent per year until the end of year 5: because there is no dividend, the entire return must
be in capital gains.
𝑖𝑖𝑖. 𝑔 = 𝑏 × ROE = 0.80𝑡𝑖𝑚𝑒𝑠0.15 = 0.12
NEQ's value per share at the end of 5 is given by
𝐷 11.944
𝑉5 = 6 = = Rs. 398.1333
𝑘𝑒 −𝑔 0.15−0.12
The NEQ's intrinsic value per share is given by
𝑉 398.1333
𝑃0 = 1+𝑘5 5 = 1.15 5 = Rs. 197.94
𝑒
If the retention ratio is increases to 80% from 60%, the value of stock will increase to Rs 197.94 because this is growth
firm.
b. Given,
𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝑠𝑒𝑙𝑙𝑖𝑛𝑔𝑝𝑟𝑖𝑐𝑒𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒 𝑃0 = Rs. 10
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑝𝑒𝑟𝑠ℎ𝑎𝑟𝑒 𝐸1 = Rs. 2
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑝𝑎𝑦𝑜𝑢𝑡𝑟𝑎𝑡𝑖𝑜 1 − 𝑏 = 0.5
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙𝑟𝑎𝑡𝑒𝑜𝑓𝑟𝑒𝑡𝑢𝑟𝑛𝑜𝑛𝑒𝑞𝑢𝑖𝑡𝑦 ROE = 0.20
i. If the current market price reflects the intrinsic value of the stock the required rate of return on equity is given by:
𝐷 𝐸 × 1−𝑏
𝑘𝑒 = 𝑃1 + 𝑔 = 1 𝑃 + 𝑏 × ROE
0 0
Rs2×0.5
= Rs~10 + 0.5 × 0.20 = 0.10 + 0.10 = 0.20 or 20%
ii. If all earnings were paid in dividends and nothing were reinvested, its earnings and dividend would not grow. Therefore,
the value per share of common stock would be:
𝐸 Rs~20
𝑉𝑎𝑙𝑢𝑒 𝑤𝑖𝑡ℎ 𝑛𝑜 𝑔𝑟𝑜𝑤𝑡ℎ = 𝑘1 = 0.20 = Rs. 10
𝑒
Hence, the present value of growth opportunity is given by:
𝐸
𝑃𝑉𝐺𝑂 = 𝑃0 − 𝑘1 = Rs. 10 − Rs. 10 = Rs. 0
𝑒
𝑇ℎ𝑎𝑡𝑖𝑠, 𝑠𝑖𝑛𝑐𝑒𝑘𝑒 = ROE, the NPV of future investment opportunities is zero.
𝑖𝑖𝑖. 𝑆𝑖𝑛𝑐𝑒 𝑘𝑒 = ROE, the stock price would be unaffected by cutting the dividend and investing
𝑡ℎ𝑒 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠.
Problem 6.36.
Calculate the following profitability measures
a. Use the DuPont system and the following data to find the return on equity.
• Leverage ratio (assets/equity) 2.2
• Total assets turnover 2.0
• Net profit margin 5.5%
• Dividend payout ratio 31.8%
b. A firm has an ROE of 3 percent, a debt-to-equity ratio of 0.5, a tax rate of 35 percent, and pays an interest rate of 6
percent on its debt. What is its operating ROA?
c. A firm has a tax burden ratio of 0.75, a leverage ratio of 1.25, an interest burden of 0.6, and a return on sales of 10
percent. The firm generates Rs 2.40 in sales per rupee of assets. What is the firm's ROE?
d. Consider the following financial data for two firms and assume that both firms are in a 20 percent tax bracket.
Solution 6.36
𝑎. 𝑇ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑢𝑠𝑖𝑛𝑔 𝐷𝑢𝑃𝑜𝑛𝑡 𝑠𝑦𝑠𝑡𝑒𝑚 𝑖𝑠 𝑔𝑖𝑣𝑒𝑛 𝑏𝑦:
𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × Total assets turnover × Leverage ratio
= 5.5% × 2 × 2.2 = 24.2
𝑏. 𝐺𝑖𝑣𝑒𝑛,
𝑅𝑂𝐸 = 3%
𝐷𝑒𝑏𝑡 − 𝑡𝑜 − 𝑒𝑞𝑢𝑖𝑡𝑦𝑟𝑎𝑡𝑖𝑜 𝐷𝐸 = 0.5
𝑇𝑎𝑥𝑟𝑎𝑡𝑒 𝑡 = 0.35
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑛 𝑑𝑒𝑏𝑡 𝑖 = 0.06
𝐴𝑠𝑠𝑢𝑚𝑒 𝑡ℎ𝑎𝑡 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑠 𝑅𝑠100, 𝑠𝑜 𝑡ℎ𝑎𝑡
Net income
𝑅𝑂𝐸 = Equity
Net income
0.03 =
Rs 100
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑠3
𝐴𝑔𝑎𝑖𝑛 𝑤𝑒 ℎ𝑎𝑣𝑒,
𝐷𝑒𝑏𝑡 − 𝑒𝑞𝑢𝑖𝑡𝑦𝑟𝑎𝑡𝑖𝑜 = 0.5
Debt Equity = 0.5
Debt Rs 100 = 0.5
𝐷𝑒𝑏𝑡 = 𝑅𝑠50
𝐼𝑓 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 𝑇 𝑖𝑠 35 𝑝𝑒𝑟𝑐𝑒𝑛𝑡, 𝑡ℎ𝑒 𝑝𝑟𝑒 − 𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 𝑖𝑠 𝑔𝑖𝑣𝑒𝑛 𝑏𝑦:
Net income Rs 3
𝑃𝑟𝑒 − 𝑡𝑎𝑥𝑝𝑟𝑜𝑓𝑖𝑡 = = = Rs 4.62
1−𝑇 1−0.35
𝐼𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑖𝑠 6 𝑝𝑒𝑟𝑐𝑒𝑛𝑡, 𝑡ℎ𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = 0.06 × Rs 50 = Rs 3
𝑇ℎ𝑢𝑠,
𝐸𝐵𝐼𝑇 = 𝑃𝑟𝑒 − 𝑡𝑎𝑥𝑝𝑟𝑜𝑓𝑖𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑅𝑠4.62 + 𝑅𝑠3 = 𝑅𝑠7.62
𝐴𝑛𝑑,
𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡𝑠 = 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑅𝑠50 + 𝑅𝑠100 = 𝑅𝑠150
𝑁𝑜𝑤, 𝑡ℎ𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡 𝑖𝑠 𝑔𝑖𝑣𝑒𝑛 𝑏𝑦:
EBIT Rs 7.62
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑅𝑂𝐴 = = = 0.0508 or 5.08%
Total assets Rs 150
𝑐. 𝐺𝑖𝑣𝑒𝑛,
𝑇𝑎𝑥𝑏𝑢𝑟𝑑𝑒𝑛𝑟𝑎𝑡𝑖𝑜 = 0.75,
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑟𝑎𝑡𝑖𝑜 = 1.25
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑏𝑢𝑟𝑑𝑒𝑛 = 0.6
𝑅𝑒𝑡𝑢𝑟𝑛𝑜𝑛𝑠𝑎𝑙𝑒𝑠 = 10𝑝𝑒𝑟𝑐𝑒𝑛𝑡.
Sales Rs 2.4
𝑆𝑎𝑙𝑒𝑠𝑝𝑒𝑟𝑟𝑢𝑝𝑒𝑒𝑜𝑓𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑠𝑠𝑒𝑡𝑠𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = = Rs 1 = 2.4
Total assets
′
𝑇ℎ𝑒 𝑓𝑖𝑟𝑚 𝑠 𝑅𝑂𝐸 𝑖𝑠 𝑔𝑖𝑣𝑒𝑛 𝑏𝑦:
Net income Pretax profits EBIT Sales Assets
𝑅𝑂𝐸 = × × × ×
Pretax profits EBIT Sales Assets Equity

= 𝑇𝑎𝑥𝑏𝑢𝑟𝑑𝑒𝑛 × Interest burden × Return on sales × Assets turnover × Leverage ratio

= 0.75 × 0.6 × 0.1 × 2.4 × 1.25 = 0.135 or 13.5%
d. (i) Calculation of economic value added (EVA):
(1) (2) (3) (4)=(2)×(3) (5) (6)=(4)×(5) Cost of capital (%)
Firm Equity Debt Total operating ROC (%) EBIT = TOC x
(Rs (Rs capital (TOC) (Rs ROC (Rs million)
million) million) million)
A 100 50 150 17% 25.5 9%

B 450 150 600 15% 90 10%

Economic value added assuming no tax is given by:

EVA = EBIT (1 - t) - (TOC) (After-tax cost of capital)
For Firm A:
EVA = Rs 25.5 (1 - 0.2) - (Rs 150 x 0.09) = Rs 6.9 million
For Firm B:
EVA = Rs 90 (1 - 0.2) - (Rs 600 x 0.10) = Rs 12 million
Hence, the Firm B has higher economic value added.
EVA
𝑖𝑖. 𝑇ℎ𝑒 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑎𝑑𝑑𝑒𝑑 𝑝𝑒𝑟 𝑟𝑢𝑝𝑒𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = TOC
For Firm A:
Rs 6.9
𝑇ℎ𝑒 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑎𝑑𝑑𝑒𝑑 𝑝𝑒𝑟 𝑟𝑢𝑝𝑒𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = = Rs 0.046
Rs 150
For Firm B:
Rs 12
𝑇ℎ𝑒 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 𝑎𝑑𝑑𝑒𝑑 𝑝𝑒𝑟 𝑟𝑢𝑝𝑒𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = = Rs 0.02
Rs 600
Hence, the Firm A has higher economic value added per rupee of invested capital.
Problem 6.37.
Miss Sushila is a recently hired analyst. After describing the electronic industry, her first report focuses on two companies,
ABC Company and XYZ Corporation, and concludes: ABC is a more profitable company than XYZ, as indicated by the 40
percent sales growth and substantially higher margins it has produced over the last few years. XYZ's sales and earnings are
growing at a 10 percent rate and produce much lower margins. We do not think XYZ is capable of growing faster than its
recent growth rate of 10 percent whereas ABC can sustain a 30 percent long-term growth rate.
a. Criticize Miss Sushila's analysis and conclusion that ABC is more profitable, as defined by return on equity (ROE), than
XYZ and that it has a higher sustainable growth rate. Use only the information provided in Tables 6A and 6B. Support your
criticism by calculating and analyzing:
• The five components that determine ROE.
• The two ratios that determine sustainable growth: ROE and plowback.
b. Explain how ABC has produced an average annual earnings per share (EPS) growth rate of 40 percent over the last 2
years with an ROE that has been declining. Use only the information provided in Table 6A.
Table A: ABC Company financial statements: yearly data (Rs in '000 except per-share data)
Income Statement December 2016 December 2017 December 2018
Revenue Rs 3,480 Rs 5,400 Rs 7,760
Cost of goods sold Rs 2,700 Rs 4,270 Rs 6,050
Selling, general, and Rs 500 Rs 690 Rs 1,000
admin. expense
Depreciation and Rs 30 Rs 40 Rs 50
amortization
Operating income (EBIT) Rs 250 Rs 400 Rs 660
Interest expense Rs 0 Rs 0 Rs 0
Income before taxes Rs 250 Rs 400 Rs 660
Income taxes Rs 60 Rs 110 Rs 215
Income after taxes Rs 190 Rs 290 Rs 445
Diluted EPS Rs 0.60 Rs 0.84 Rs 1.18
Average shares 317 346 376
outstanding (000)

Financial Statistics December 2016 December 2017 December 2018 3-Year Average
COGS as % of sales 77.59% 79.07% 77.96% 78.24%
General & admin. as 14.37% 12.78% 12.89% 13.16%
% of sales
Operating margin 7.18% 7.41% 8.51% -
Pretax income/EBIT 100.00% 100.00% 100.00% -
Tax rate 24.00% 27.50% 32.58% -
Balance Sheet December 2016 December 2017 December 2018
Cash and cash Rs 460 Rs 50 Rs 480
equivalents
Accounts receivable Rs 540 Rs 720 Rs 950
Inventories Rs 300 Rs 430 Rs 590
Net property, plant, Rs 760 Rs 1,830 Rs 3,450
and equipment
Total assets Rs 2,060 Rs 3,030 Rs 5,470
Current liabilities Rs 860 Rs 1,110 Rs 1,750
Total liabilities Rs 860 Rs 1,110 Rs 1,750
Stockholders’ equity Rs 1,200 Rs 1,920 Rs 3,720
Total liabilities and Rs 2,060 Rs 3,030 Rs 5,470
equity
Market price per share Rs 21.00 Rs 30.00 Rs 45.00
Book value per share Rs 3.79 Rs 5.55 Rs 9.89
Annual dividend per Rs 0.00 Rs 0.00 Rs 0.00
share
Table B: XYZ Corporation financial statements: yearly data .For the month December (Rs in '000 except per-share data)
Income Statement (December) (December) (December)
2016 2017 2018
Revenue Rs 104,000 Rs 110,400 Rs 119,200
Cost of goods sold Rs 72,800 Rs 75,100 Rs 79,300
Selling, general, and Rs 20,300 Rs 22,800 Rs 23,900
admin. expense
Depreciation and Rs 4,200 Rs 5,600 Rs 8,300
amortization
Operating income Rs 6,700 Rs 6,900 Rs 7,700
Interest expense Rs 600 Rs 350 Rs 350
Income before taxes Rs 6,100 Rs 6,550 Rs 7,350
Income taxes Rs 2,100 Rs 2,200 Rs 2,500
Income after taxes Rs 4,000 Rs 4,350 Rs 4,850
Diluted EPS Rs 2.16 Rs 2.35 Rs 2.62
Average shares 1,850 1,850 1,850
outstanding (000)

Financial Statistics 2016 2017 2018 3-Year Average

COGS as % of sales 70.00% 68.00% 66.53% 68.10%
General & admin. as 19.52% 20.64% 20.05% 20.08%
% of sales
Operating margin 6.44% 6.25% 6.46% -
Pretax income/EBIT 91.04% 94.93% 95.45% 94.01%
Tax rate 34.43% 33.59% 34.01% -
Balance Sheet Dec 2016 Dec 2017 Dec 2018
Assets
Cash and cash Rs 7,900 Rs 3,300 Rs 1,700
equivalents
Accounts receivable Rs 7,500 Rs 8,000 Rs 9,000
Inventories Rs 6,300 Rs 6,200 Rs 7,900
Net property, plant, and Rs 12,000 Rs 14,500 Rs 17,000
equipment
Total assets Rs 33,700 Rs 32,100 Rs 35,600

Current liabilities Rs 6,200 Rs 7,800 Rs 6,600

Long-term debt Rs 4,000 Rs 4,300 Rs 4,300
Total liabilities Rs 15,200 Rs 16,100 Rs 15,200
Stockholders’ equity Rs 18,500 Rs 20,000 Rs 22,700
Total liabilities and Rs 33,700 Rs 32,100 Rs 35,600
equity

Market price per share Rs 23.00 Rs 26.00 Rs 30.00

Book value per share Rs 10.00 Rs 10.81 Rs 12.27
Annual dividend per Rs 1.42 Rs 1.53 Rs 1.72
share
Solution 6.37
Given
Year ABC (Rs) XYZ (Rs)
2016 2017 2018 2016 2017 2018
Net Income 190 290 445 4,000 4,350 4,850
Pretax Profit 250 400 660 6,100 6,550 7,350
(Income
before tax)
EBIT 250 400 660 6,700 6,900 7,700
(Operating
Income)
Sales 3,480 5,400 7,760 104,000 110,400 119,200
(Revenue)
Assets 2,060 3,030 5,470 33,700 32,100 33,600
Equity 1,200 1,920 3,720 18,500 20,000 22,700
a. Calculation of ROE and sustainable growth rate
For ABC Company:
Year (1) Tax (2) Interest (3) Operating (4) Assets (5) Leverage (6) =(1×2×3×4×5)
Burden= Burden= Profit Turnover=
𝑆𝑎𝑙𝑒𝑠
Ratio=
𝐴𝑠𝑠𝑒𝑡𝑠 ROE
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝐵𝐼𝑇 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Margin=
𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠
2016 190
= 0.76 250 250 3480 2060 0.1582 or
250 =1 = 0.0718 = 1.6893 = 1.7167
250 3480 2060 1200 15.82%

2017 290 400 400 5400 3030

= 1.5781 0.1511 or
= 0.725 =1 = 0.0711 = 1.782 1920
400 400 5400 3030 15.11%

2018 445 660 660 7760 5470 0.1196 or

= 0.674 =1 = 0.0851 = 1.4186 = 1.4704
660 660 7760 5470 3720 11.96%

15.82%+15.11%+11.96%
Average ROE of ABC = = 14.30%
3
For XYZ Corporation:
Year (1) Tax (2) Interest (3) Operating (4) Assets (5) Leverage (6) =(1×2×3×4×5)
Burden= Burden= Profit Turnover=
𝑆𝑎𝑙𝑒𝑠
Ratio=
𝐴𝑠𝑠𝑒𝑡𝑠 ROE
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝐵𝐼𝑇 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Margin=
𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠

2016 4000
=0.6557
6100
=0.9104
6700
=0.0644
104000
=3.0861
33700
=1.8216 0.2161 or
6100 6700 104000 33700 18500
21.61%

2017 4350
=0.6641
6550
=0.9493
6900
=0.0625
110400
=3.4393
32100
=1.605 0.2175 or
6550 6900 110400 32100 20000
21.75%

2018 4850
=0.6599
7350
=0.9545
7700
=0.0646
1199200
=3.5476
33600
=1.4802 0.2137 or
7350 7700 119200 33600 22700
21.37%

21.61%+21.75%+21.37%
𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑅𝑂𝐸𝑜𝑓𝑋𝑌𝑍 = = 21.58%
3
𝑺𝒖𝒔𝒕𝒂𝒊𝒏𝒂𝒃𝒍𝒆 𝒈𝒓𝒐𝒘𝒕𝒉 𝒓𝒂𝒕𝒆:
𝑭𝒐𝒓𝑨𝑩𝑪𝑪𝒐𝒎𝒑𝒂𝒏𝒚:
(1) (2) (3)=(1)×(2)
Year ROE Plowback ratio Growth rate (g)
(EPS - DPS) / EPS

2016 15.82% 0.60−0

=1 15.82%
0.60

2017 15.11% 0.84−0

=1 15.11%
0.84

2018 11.96% 1.18−0

=1 11.96%
1.18

15.82%+15.11%+11.96%
Average sustainable growth rate of ABC = = 14.30%
3
For XYZ Company
Year (1) (2) (3)=(1)×(2)
ROE Plowback ratio Growth rate (g)
𝐸𝑃𝑆 −𝐷𝑃𝑆
𝐸𝑃𝑆
2016 21.61% 2.16−1.42
=0.3426 7.40%
2.16

2017 21.75% 2.35−1.53

=0.3489 7.59%
2.35

2018 21.37% 2.62−1.72

=0.3435 7.34%
2.62

7.40%+7.59%+7.34%
Average sustainable growth rate of XYZ = = 7.44%
3
a. The average ROE for past 3 year of period for ABC Company is 14.30 percent while that for XYZ Corporation is 21.58
percent. Looking into the return on equity, it cannot be concluded that ABC Company is more profitable than XYZ
Company. ABC has slightly higher profit margin because of lower tax burden. However, its leverage and asset turnover are
lower. Although, its growth in sales seems to be higher than that of XYZ but it is not capable of generating higher rupee of
sales per rupee of assets as indicated by lower assets turnover ratio. Therefore, ROE of ABC is significantly lower.
On the other hand, the average sustainable growth rate for ABC is 14.30 percent while that of XYZ is 7.44 percent. The
higher sustainable growth rates the ABC is maintaining over past three years are primarily due to the higher plowback
ratio. If the plowback ratio of ABC remains lower as to that of XYZ, it cannot maintain this growth rate.
b. ABC's return on equity has been declining primarily due to the use of lower leverage over the past two years. However, its
EPS growth is higher. Higher EPS is determined by lower tax burden and higher profit margin, which are unaffected by the
leverage.