IAPM

Session By:

Dr S G K Sharma
Security Instruments issued by Business Corporates:
1. Common stock ( Ordinary Shares)
2. Preference stock
3. Debentures/Bonds ( Debt Instrument)
Common Stock ( Features)
1. Ownership
2. Voting rights
3. Decision power
4. High risk
5. Permanent Capital
6. Returns are not guaranteed
7. Returns highly fluctuating
Preferred Stock:
1. No ownership
2. No voting right
3. No decision power
4. Low risk
5. Repayment of capital is compulsory
 6. Returns are fixed
7. Returns are almost guaranteed
Debentures/Bonds (Debt Instruments)
1. No ownership
2. No voting right
3. No decision power
4. Low risk
5. Repayment of capital
6. Returns are fixed
7. Returns are guaranteed

Business
100 crores

1. Bipin 10 cr Bank loan 50 cr

2. Avinash 10 cr
3. Pratik 10 cr
4. Prerana 10 cr
40 cr
Equity fund 40 + 15 = 55
Debt fund 50
Capital 105
Estimated amount for the project will be 100 + 5 =105
crores
Risk and Return
Most investors are assumed to be risk averse. This means that investors
are willing to accept a lower return in exchange for the reduction of risk
in an investment.

Because of this risk-aversion of investors, in most cases risky

investments must offer higher expected returns than less risky
investments in order to get investors to purchase them and hold them.
Similarly, an investor must be willing to accept a lower return in order to
have lower risk.
High-risk investments pay high rates of return, but they carry more risk
of loss of principal than lower-risk investments do. Lower-risk
investments have less risk of principal loss, but they pay lower rates of
return.
The Concept of Return
Return is income received by an investor on an investment. Rate of
return is expressed as a percentage of the principal amount invested.

TATA Enterprises 50,000 crores

Different Levels of Profit:
Revenue Revenue
(COGS)
Gross Profit GP
(Administrative exp)
(Selling expenses)
(Distribution expenses)
Cash Profit EBITDA
(Depreciation expenses)
(Amortised expenses)
Operating Profit EBIT Business Return
(Interest) ( Finance cost) Deb Holders
Profit Before Tax EBT
(Tax expenses)
Profit After Tax EAT (Return to SH)

PSH ESH

Pref Dividend EAT – Pref Dividend

The concept of return must be viewed either from the Business
Perspective or Investor’s perspective. The investor in this case means
the owner’s of the business.
The return for any business as an independent legal unit will be nothing
but the Operating Profit (Earnings Before Interest and TAX – EBIT)
which further will be disbursed to outsiders in the form of interest and
the balance to the owners.
From the investor’s perspective, the return will be Earnings before Tax
less Tax expenses for the year which will be nothing but the profit for
the year. As owners, they may not be taking home the entire amount of
profit, but a portion would be retained in the form of retained earnings.
But still for all analysis purpose, the term EBT will be considered as the
return applicable to the owners.
The amount of return on an investment is a function of three things: a)
Amount invested, b) length of time that amount is invested, and c) the
rate of return on the investment. Depending on the type of investment,
all of those things can vary.
When calculating an annual rate of return on an investment, there are
three very important rules that must be followed:
1) When the income received is for an investment that was held for less
than one full year, the amount of income must be annualized.
2) The amount invested used in the calculation must be the average
balance of the amount invested during whatever period of time the funds
were invested, up to one year. The amount invested can vary throughout
the period it is invested. When that happens, the amount of income that
will be received on that investment will vary. But an annual rate of
return can still be calculated by dividing the total amount of income
received by the average balance of the investment during the period the
income was earned.
3) If the funds were invested for less than one full year, we assume that
the average balance during the period the funds were invested was the
average balance for one full year, even though the investment was not
held for a full year.
The Concept of Risk
Risk can be classified as either pure risk or speculative risk.

Pure risk is defined as the chance that an unwanted and detrimental

event will take place. Insurance is designed to address pure risk, because
pure risk yields only a loss.

In investments, the risk is the second classification of risk – speculative

risk. In investing, speculative risk is defined as the variability of actual
returns from expected returns, and this variability may be a gain or a
loss.
The above risks can otherwise be referred as Business risk and Financial
risk
Business risk is something undertaken by the business house as an
artificial, legal personality in not getting the desired operating profit
(EBIT), despite making the investments in the form Non-current assets
and working capital.
The Financial risk is something which is undertaken by the owners of
the business in not getting the returns (EAT), despite taking a call to
invest their money into the shares of a business house. This financial
risk is closely related to speculations
Types of Risks ( Business Risks)
1. Interest rate risk – The risk arising in the financial market due to
fluctuations in the rate of interest can be referred as Interest rate
risk.
2. Re-investment rate risk – The risk of not getting the same return
or a higher return on the amount re-invested into the same project,
when compared to the returns earlier received from the project.
3. Purchasing power risk – The risk which is arising in the market
due to reduction in the purchasing power of the buyers of a country
4. Liquidity rate risk – The risk associated with the liquidity factor
of the investments done by the investors
5. Foreign exchange rate risk – The risk in the international
business, arising due to fluctuations in the exchange rates of the
foreign currencies which invariably be affecting the business
bottom line.
6. Political risk – The risk factors arising due to the changes in the
political environment of a country due to which various changes in
the governmental policies are adopted, which might be create a
risk for certain business ventures
7. Unsystematic risk - Unsystematic risk is risk that is specific to a
particular company or to the industry in which the company
operates. An example of unsystematic risk is a strike that halts
production at one company or at all the companies that employ
members of the union that has gone on strike. Unsystematic risk
can be reduced through appropriate diversification of investments
in a portfolio.
8. Systematic risk - Systematic risk is risk that all investments are
subject to. It is caused by factors that affect all assets. Examples
would be inflation, macroeconomic instability such as recessions,
major political upheavals and wars. Systematic risk cannot be
 diversified away, and so it remains even in a fully diversified
portfolio.
The relationship between risk and return
A simple relationship exists between risk and return: the higher the
potential return, the higher the level of risk involved. Investors are risk
averse. They are willing to undertake additional risk only if they will be
adequately compensated for it by receiving extra return

Current Year an individual invested 5 crores into a specific project

which fetches him a return of 12% per annum. The maturity period
will end at the year end. Hence the principal amount comes back in
the hands of the investor.
This amount can be re-invested else where or in the same project
next year.
CAPITAL ASSET PRICING MODEL (CAPM)
This model conveys the minimum return to be given by an organization
to the shareholders (owners) taking into account their expectations.
Hence in this case, there will be a risk free return and a premium over
and above the risk free return which will constitute the return to the
shareholder. This return will have to be in line the with expectation of
the shareholder.

Risk Free returns (Rf) + Risk Premium = Market returns

The most important element in this case to be considered by any
business organization should be the risk individually undertaken by the
organization. Every industry and each organization within the industry
are not free from the risks. But the risks undertaken by the industry as a
whole or each company within the industry will be different and
accordingly the premium over and above the risk free rate of return must
also be different.
“Beta,” or β, is a measurement of a security’s systematic risk.
Systematic risk is risk that all investments are subject to. Systematic risk
is caused by factors that affect all assets
The beta for the market as a whole is 1.0. An individual security with a
beta of 1.0 has the same systematic risk as the market as a whole
An individual security that has historically been more volatile than the
market will have a beta greater than 1
An individual security that has historically been less volatile than the
market will have a beta less than 1
Explanation of the Model:

Business Industry
Paints & Chem
AMR = 35%
Industrial Risk
Is “1”
AMR – Average Market Return
Risk Free Return prevailing in the market is 8%.
There is an increase in return by 27% when compared to the risk free
investments.
This increase is nothing but the industrial compensation given to the
investors against the risk taken by them. Hence this can be referred to
be the risk premium.
8 + 27 = 35%.
Rf + (Rm-Rf) = 35%
8 + (35-8) = 35% - Industrial Average Return
The minimum return to the investors of British Paints would be:

8 + (35-8) x 1.53 =
8 + 41.31 = 49.31%

Nerolac Paints the return will be:

8 + (35-8) x 0.85 = 30.95%

Rf + (Rm-Rf) x beta = Minimum return

The Business houses within this industry:

 1. Asian Paints - 35% more than the average risk = 1.35
2. Berger 42% more than the average risk = 1.42
3. Nerolac 15% lower than the average risk = 0.85
4. British Paints 53% more than the average risk = 1.53
5. Garware Paints
6. Addisons
7. Surfacoats
8. Casio Paints

A company say British Paints, which is operation in the Paints and

chemicals industries is offering its shares to the public. Last year, the
industrial average return (ie average return of the paints and chemicals
industry) was 35%. The risk free rate of return prevailing as per the
treasury is 8%. The British Paints which operates within this industry is
having a risk 53% more than the industrial average risk of 1
An investor, who is having an allocable surplus decides to invest the
money into this paints and chemicals industry, understanding the charm
of the return which is being provided now. Of course, this will be
funneling more risk on the shoulders of the investor, but since the
investor has decided to go ahead with the investment into this industry
by setting aside the opportunity to invest in a risk free environment to
get a comfortable return of 8%.
It will be now the responsibility of the British Paints to compensate the
return at par with the anticipation of the investor.
In this scenario, the company any way will have pay the minimum return
of 9%, at par with the risk free return. Moreover, the company will have
to compensate the investor for the additional risk taken by him to invest
the money into this industry, and hence a premium over and above this
risk free return of 8% will be given. In this case, the premium is 27%
(35 – 8).
This 27% premium is the industrial premium and the British Paints,
specifically will have give additional premium on account of a higher
risk associated with the company than the industrial average risk of 1.
Hence the risk factor of British Paints will e 1 + 53% of 1 = 1.53. This
will be considered as the Beta factor of British Paints. This means the
British Paints will have give a premium which is higher by 53% than the
industrial average premium of 23%.
The minimum return to the investors of British Paints would be:
8 + (35-8) x 1.53 =
8 + 41.31 = 49.31%
Formula:
Ke = Rf + (Rm – Rf) beta
Rf = Risk free return
Rm = Industrial average return or Market rate of return
(Rm - Rf ) = Industrial Premium

The Security Market Line

The Security Market Line is a regression line formed by doing
regression analysis on investors’ historical required rates of return for
each level of systematic risk in the market portfolio. It summarizes the
systematic, or market, risk versus the return of the whole market at a
certain point in time
 SML (Risk Averse)
Security Market Line
Return
(Rm-Rf)
5 ---------------------------------------------
Risk Free Return (Rf)

Risk

Change in the Risk Free rate

If the risk-free rate changes from 4% to 5%, then the y-intercept of the
SML will change from 4% to 5% and the location of the Security Market
Line will move upward, though its slope will not change.
A Change in the investor’s risk aversion
If the risk aversion of the investors change, then the slope of their
required Security market line will change. When the risk-aversion of
investors increases, the market risk premium increases, and the
investors’ required rate of return at each beta level increases. The more
risk averse the investors, the steeper the SML will be.
PORTFOLIO THEORY
According to portfolio theory, a particular security should not be
evaluated as a standalone investment but rather each individual security
should be evaluated according to how its market value is expected to
vary in relation to the market values of other securities in the portfolio.
The key element with respect to a portfolio is diversification. The
diversification refers to combine securities in such a way so as to reduce
risk on an overall basis. Different types of investments often change in
market value in opposite directions, so when one asset’s market price
decreases, another asset’s market price might increase and offset the
loss.
By properly diversifying the investments in a portfolio, an investor can
minimize risk for a given level of return or maximize return for a given
level of risk. Asset allocation is the process of selecting assets to
combine in a portfolio to achieve the best risk/return tradeoff possible.
The assets can include bonds, stock, real estate, high-risk, low-risk,
long-term, short-term and other types of investments in order to achieve
the correct balance of risk and return. When sufficient number of assets
have been combined to achieve the full benefits of diversification, the
portfolio is called a “fully diversified” or “efficient” portfolio.
The Coefficient of correlation in Portfolio theory
The coefficient of correlation measures the relationship between two
variables. The coefficient of correlation is a number that expresses how
two variables are closely connected and also measures the extent to
which a change in one variable will be resulting into a change in the
other.
THUMB RULES
  A correlation coefficient of +1 means there is a perfect positive
linear relationship between the returns of two securities. When one
security’s returns have increased or decreased by a given
percentage, the returns for the other security will be increased or
decreased by the same percentage.

 If the correlation coefficient is between zero and +1, there is a

positive relationship between the two securities’ returns, though
not a perfect one. If the number is high, for example 0.80, it
indicates a high degree of correlation. If the number is moderate,
generally between 0.30 and 0.49, the correlation is not as strong.

Portfolio 1 Portfolio 2

 A correlation coefficient −1 means there is a negative linear

relationship between the returns of two securities. When the return
of one security have historically increased by a given percentage,
the returns for the other security have historically decreased by the
same percentage.
 If the correlation coefficient is between zero and −1, there is a
negative relationship between the two securities’ returns, though
not a perfect one.
 A coefficient of correlation that is close to zero, for example +0.10
or −0.10, usually means there is very little or no relationship
between the two securities’ historical returns

CAPITAL STRUCTURE
Owner’s Funds – This is referred as Equity otherwise. These funds are
raised by issuing ordinary shares or preferred stock in the market.
External Funds - External funds may be raised through the issuance of
debt securities, or long-term bank financing.
Determining a Capital structure

1. The future prospects of the company

2. The equity market – If the equity market is doing poorly, the cash
received from the issue of stock in an initial public offering will be
less than it would be in a period of a strong market.
3. The composition of the company’s assets – Companies tend to
finance current assets with short-term sources of capital (current
liabilities) and permanent assets (primarily fixed assets) with the
long term capital structure sources.
4. The amount of risk that the company is willing to accept – Debt
sources are inherently more risky to the firm than equity sources
because a default on the debt could put the firm into bankruptcy.
5. The reputation of the issuer
6. The cost of each source of capital

BONDS
Bonds are a means of financing in which a company borrows money by
selling debt securities (bonds) to investors. The bonds represent a loan
by the bondholders (investors) to the issuing company. The
characteristics of the bond are:
1. No Ownership
2. No voting right
3. No decision power
4. Low risk
 5. Repayment of capital
6. Guaranteed return payments
7. Fixed rate of return
Interest is the cost of borrowing paid by a borrower to a lender for the
use of the lender’s funds. Interest rates are always quoted as annual
rates.

The components of interest

The risk-free rate is a theoretical rate that represents the time value of
money when it is invested in a perfectly safe investment

A lender of funds will probably charge more than the risk-free rate,
because the lender will consider several other factors in the process of
determining the interest rate to charge. The other factors are:
 Credit risk or default risk
 Liquidity
 Tax status – Since investors are ultimately interested in what their
after-tax income will be, taxable securities have to offer a higher
before-tax yield than tax-exempt securities
 Term to maturity – The term structure of interest rates defines the
relationship between the maturity of a security and its rate of
return. The relationship between the maturity of a security and its
rate of return is not always the same but rather varies with different
conditions, such as anticipated future inflation

Yield Curve theories:

 1. Pure expectation theory
2. Liquidity Premium theory
3. Segmented Market theory
4. Preferred Habitat theory

Pure expectations theory: The interest rates for each term of

investment in each risk category are governed by the laws of supply and
demand, and supply and demand are determined by the market’s
expectations of future interest rates.
If the market expects that interest rates will be higher in the future,
borrowers will prefer to borrow long-term in order to take advantage of
the currently lower interest rates. At the same time, investors supplying
investment funds will prefer to invest on a short-term basis so they will
be able to reinvest at higher interest rates in the future. The result of this
will be:
• The demand by issuers of securities for short-term borrowings will
decrease while the supply of short-term funds provided by
investors will increase, causing the interest rate for short-term
securities to decrease; and
• The demand by issuers of securities for long-term borrowings will
increase while the supply of long-term funds provided by investors
will decrease, causing the interest rate for longer-term securities to
increase.
If the market expects that interest rates will be lower in the future,
borrowers will prefer to borrow short-term so they can refinance later at
the lower interest rate. At the same time, investors supplying investment
funds will prefer to invest on a long-term basis so they will be able to
lock in the current higher rate of return. As a result,
 • The demand by issuers of securities for short-term borrowings will
increase while the supply of short-term funds provided by
investors will decrease, causing the interest rate for short-term
securities to increase; and
• The demand by issuers of securities for long-term borrowings will
decrease while the supply of long-term funds provided by investors
will increase, causing the interest rate for longer-term securities to
decrease.
Increase in future

Karthik is an investor and has an allocable surplus of 1 crore, which he

can invest. Currently the interest rate prevailing in the market is 9%.
Experts feel that the interest rate will increase to 10% after 10 months
and it will exhibit the increasing trend further.

There are two forms of investments ie short term and long term.

Karthik - Prefer only short term investments

Business - Prefer only long term funds

In the case of long term investments, say for 5 years, when preferred
currently, the interest rate at which the investments are going to be
locked will be 9%. In the case of long term investments, the interest rate
will be consistent till the maturity period.
In the above example, in the case of short term funds, the demand is low
but the supply would be high. In this scenario, the short term interest
rate will decrease.

In the case of long term funds, the demand is high and the supply is low.
In this scenario, the long term interest will increase.

Decrease in future
Currently the interest rate prevailing in the market is 9%. Experts feel
that the interest rate will decrease to 8.5% after 10 months and it will
show the decreasing trend further.

Karthik - Prefer only Long term investments

Business - Prefer only short term funds

Liquidity Premium theory: Liquidity Preference Theory says that if

investors increase their risk of loss of principal by holding long-term
bonds, they will require higher compensation in the form of a higher
interest rate. Thus, the interest rate for a less-liquid security must be
higher than the interest rate for a more liquid security. The difference
between the less-liquid security’s rate and the more liquid security’s rate
is called the liquidity premium.
Segmented Market theory: The Segmented Markets Theory focuses on
cash needs of different groups of investors and borrowers and maintains
that each group chooses securities that meet its forecasted cash needs.
Each group of investors and borrowers determines the term of its
investment or borrowing in light of its cash needs and not because of
expectations of future interest rates.

Preferred Habitat theory: The Preferred Habitat Theory is a

compromise. It agrees with the Segmented Markets Theory and Pure
Expectations Theory.

Uses of Yield curve theories:

To forecast interest rates: The shape of the yield curve can be used to
determine what the general expectations of investors and borrowers are
about future interest rates. An upward-sloping yield curve generally
means that higher interest rates are expected, while a downward-sloping
yield curve generally means the opposite.
To forecast recessions: A flat or inverted yield curve forecasts a
recession, because the yield curves reflect the market’s expectation of
lower interest rates.
To make financing decisions
To make investing decisions

Type of Bonds:
Convertible bonds may be converted by the bondholder into a stated
number of shares of the issuer’s common stock anytime during the
bond’s life.

Debenture bonds are not backed by any specific asset as collateral.

These bonds will most likely have a higher interest rate than bonds
which are having collateral security issued by the same company
Mortgage bonds have specific asset(s) pledged as the collateral for the
loan. The assets pledged as collateral make the bonds less risky to
investors

Subordinated bonds are bonds that will not have the first claim to the
assets of the company in case of a bankruptcy

Income bonds pay interest only if the company achieves a certain level
of income. Income bonds are obviously riskier for the purchaser of the
bonds because the payment of interest by the issuer is not guaranteed.
Therefore, the bonds will carry a higher interest rate.

Serial bonds are bonds issued with varying maturity dates so that they
mature over a period of time.

10000 bonds have been subscribed by Rahul today. Face value is Rs

100/-The redemption to take place after 5 years. The total value to be
redeemed will be 10000 x 100 = 10 lakhs.

1. First 2000 bonds will be maturing on August 2026

2. Second 2000 bonds will be maturing on September 2026

Zero-coupon bonds do not pay any interest, but they sell at a price
significantly less than the face value. The large discount on the sale of
the bonds offsets the fact that no interest is paid.

There would be a deep discount which would invariably be given and

this discount will be replacing the annual interest.

Face value is Rs 100, the company issues the same for a price of Rs 70/-.
After the term of the bond, the company will redeem at a value of Rs
100/- per debenture.
Participating bonds can participate in dividends (the distributions of
profits) of the company during a period of high profits.

FV of Rs 100 with a coupon rate of 9% issued by a business corporation.

If the profitability of the company is found to be very high during the
current year, an additional % is given on the basis of the higher profits as
extra returns to these type of bond holders. This return is purely
variable.

Indexed bonds have an interest rate that is indexed to some other

measure, such as the price index or a general economic indicator.

Callable Bonds
A call provision enables the issuing company to repurchase the bonds
(call the bonds) at their option. A call provision is very beneficial to the
issuer and therefore not beneficial to the investor because the issuer can
call the bonds (retire them) if the market interest rate falls below the rate
that they are paying in interest on the bonds.

X Ltd issues 50,000 bonds in the market. The term is 5 years. But a call
provision has been incorporated in the issue, whereby the issuing
company can repurchase these bonds at any point of time during the
span of this 5 years as per its discretion. The coupon rate of the bond is
11% which is in line the market rates.
After one and half years, the interest rate in the market has fallen down
to 9.8%.

Putable Bonds
In this case, the option to retire the bond belongs to the purchaser of the
bond. If certain events occur, or if the issuing company violates any
bond covenants, an investor can require that the issuer repurchase the
bonds from him. The price that the issuer must pay to repurchase the
bonds will either be specifically established or will be able to be
calculated from the terms in the indenture.

Pricing the Bond:

The price of a bond fluctuates according to the rate of interest prevailing

at various point of time. Normally the coupon rate of a bond will be
fixed during its maturity period. This rate of interest is never going to
change during the span of maturity. The market might witness so many
fluctuations in terms of interest but the coupon rate associated with the
bonds already issued in the market is never be affected by such
fluctuations.
In the case of a bond holder who subscribed the bond two years back,
having maturity of 5 years and having a coupon rate of 8%, is willing to
sell the same in the open market now when the rate of interest is higher,
say 9%, the bond holder will have offer the bond at a discount to
compensate the interest the buyer will lose on account of lower coupon
rate than the market interest rate. In this case as discount is being
offered, the price of the bond will be lower than its face value.
In contrary, the market rate of interest on the date of the sale is only
7.5% which is lower than the coupon rate, the bond holder may charge a
premium on the face value and in this circumstance, the price of the
bond will be higher than its face value.

Example:1
A bond holder, purchased 10,000 numbers of bonds having face value of
$100 per bond, two years back having maturity of 5 years overall and
have a coupon rate of 9%. Two years later, the bondholder intends to
sell these bonds in the market when the rate of interest is 10%. The
bond price in this scenario will be:
Year Return(9%) Discount (10%) PV
1 9 0.909 8.181
2 9 0.826 7.43
3 9 0.751 6.759
3 100 0.751 75.1
Total 127 97.47

The sum of the present value indicates the price of the bond at which the
same need to be sold in the market.
Here the discount which is offered is 100 – 97.47 = $2.53

1. 1/(1+.10)^1 = 0.909

Discounting:
1/(1+i)^n

Example: 2
A bond holder, purchased 10,000 numbers of bonds having face value of
$100 per bond, two years back having maturity of 5 years overall and
have a coupon rate of 9%. Two years later, the bondholder intends to
sell these bonds in the market when the rate of interest is 8%. The bond
price in this scenario will be:
Year Return(9%) Discount (8%) PV
1 9 0.926 8.334
2 9 0.857 7.713
3 9 0.794 7.146
3 100 0.794 79.40
Total 127 102.593
In the above case the bond will be sold at a premium of $2.593, from the
face value. The bond price is 102.593

YIELD TO MATURITY OF A BOND

The term yield to maturity or YTM is usually used to refer to the

effective interest rate or the rate of return on a bond to its holder over its
life, assuming the holder holds the bond to its maturity date. The yield to
maturity is the rate of return over the remaining life of the bond if it is
bought at its current market price and held to its maturity date.

A bond’s yield to maturity is the discount rate that causes the present
value of all expected interest and principal payments to be equal to the
bond’s current market value.

If a bond is sold at a discount, the bond’s price is less than its par, or
face, value, and its YTM to the buyer will be greater than its nominal
interest rate. If the bond is an original issue bond sold by the issuing
company, the interest expense to the issuer will be greater than the
bond’s nominal interest rate because the issuer’s interest expense each
interest period will be the cash payment made plus amortization of the
discount.

If a bond is sold at its par value, with no premium or discount, the

bond’s yield to maturity will be equal to its nominal interest rate. If the
bond is an original issue bond sold by the issuing company, its interest
cost to the issuer will be equal to its nominal interest rate.
If a bond is sold at a premium, the bond’s price is greater than its par
value and its YTM to the buyer will be less than its nominal interest rate.
If the bond is an original issue bond sold by the issuing company, the
interest expense to the issuer will be less than the bond’s nominal
interest rate because the issuer’s interest expense each interest period
will be the cash payment made minus amortization of the premium.

A Bond has a face value of Rs 100 the maturity is 5 years. The coupon
rate is 9%. After 5 years the bond is to be redeemed at a premium of
10%.

On the date of redemption, the amount to be given back to the bond

holder will be 110 (100 + 10% of 100).

For the company which is issuing the bond, the annual interest to be paid
is only 9%. But there is an impact of premium which is to be paid on
the maturity date. Accordingly the interest rate to be reworked.

The premium must be allocated among these five years equally as the
one time payment on the maturity date is being done, as an amount
which is applicable for the entire 5 years period.

Annual cost = 10/5 = Rs 2 per Bond.

% of this amortised premium cost = 2/100 = 2%

Annual interest to be paid = 9%

Additional cost per year = 2%

Effective rate of interest = 11%

DURATION

The amount by which an individual fixed income security will vary in

value with changes in interest rates depends upon its duration.

The duration is also referred as Macaulay Duration. This duration of a

fixed income security is a weighted average of the times until the receipt
of both interest and principal. The weights are given according to the
proportion of the total present value of the bond represented by the
present value of each cash flow to be received.
Example

The $1,000 par value bond with a 5% coupon (nominal interest) rate that
pays interest once a year. The yield-to-maturity (market rate of interest)
is 4.5% and the bond has 3 years to maturity. The duration is calculated
as follows:

Year Inflow Discounting Rate 4.5% PV

1 50 0.9569 47.845
2 50 0.9157 45.785
3 50 0.8763 43.815
3 1000 0.8763 876.30

Year PV Proportion%

1 47.845 0.0472 0.0472

2 45.785 0.0452 0.0904
3 920.115 0.9076 2.7228

Total 1013.745 2.86

2.86 years will be referred as Macalay’s duration.
Modified Duration

The volatility of a bond refers to how much the bond’s price changes
when interest rates change. Modified duration is used to measure a
bond’s volatility. The formula for modified duration is:

Modified duration = Volatility (%) = Duration

---------------------
1 + Yield to Maturity
If the modified duration is 2.5%, this means that for each 1% change in
the bond’s yield to maturity, or market interest rate, the bond’s market
price will change by 2.5%.

• When the market rate increases by 1%, the bond’s market value will
decrease by 2.5%.
• When the market rate decreases by 1%, the bond’s market value will
increase by 2.5%.
Question 1
A company issued bonds in the market having face value of Rs 500/-.
The period of the bond is 5 years and the same has a coupon rate of 8%.
The effective rate of interest is 9% applicable to this Bond. You are
required to calculate the Bond duration and the volatility.
Year 9%
1 40 0.9174 36.696 0.0763 0.0763
2 40 0.8416 33.664 0.0700 0.14
3 40 0.7722 30.888 0.0642 0.1926
4 40 0.7084 28.336 0.0589 0.2356
5 540 0.6499 350.946 0.7303 3.6515
480.526 4.296
Volatility = Duration 4.296
------------------------------ = ---------------- = 3.941%
1 + Yield to Maturity 1+0.09

For each 1% change in the interest rate in the market, the price of the
bond changes by 3.941%.

BOND PORTFOLIO STRATEGIES

Passive strategy
Type of passive strategy – Buy & hold strategy – Indexing strategy

Three different types of investments which can be maintained by any

business.
1. Held till maturity security instruments
2. Available for sale security instruments
3. Held for trading security instruments

Buy & hold strategy•

It simply involve buying a bond & holding it until maturity• A manager

selects a portfolio of bonds based on the objectives of the client with the
intent of holding these bonds to maturity• Investors don’t trade actively
to maximize the return• Hold the bond with a maturity or duration which
is close to their investment horizon.

Examine factor such as quality rating, coupon level, terms to maturity,

call features etc.• Only default-free or very high quality securities should
be held• Also, those securities that are callable by firm (allows the issuer
to buy back the bond at a particular price and time) or putable by holder
(allows bondholder to sell the bond to issuer at a specified price and
time) should not be included . The buy-and-hold strategy minimizes
transaction costs• Suitable for income maximizing investor with low
level of risk• Applicable for pensioners, endowment funds, bond mutual
funds, insurance companies etc.

Indexing strategy•

The objective is to construct a portfolio of bonds that will equal the

performance of a specifies bond index• Investment is done only in the
bond of specific bond index• Performance is measured in terms of total
return realized over the investment horizon
Advantages of indexing strategy include:

 Poor performances of Bond managers can be avoided

 Lower transaction costs
 Higher degree of control can be exercised by the investor

Factors affecting the selection of the index include inevestors risk

tolerance and objective of the investors.

Active management strategies•

Take advantage of market scenario. Requires major time to time
adjustment or changes in portfolio• The goal is to maximize total return
but at increased risk• Requires continuous analysis and observation on
the part of portfolio manager

Types of active management strategies

Interest rate anticipation• This is the riskiest strategy because the

investor must act on uncertain forecasts of future interest rates• When
interest rate rise bond price drop & when interest rate drop bond price
rise• Increase the investment in long duration bonds when interest rates
are expected to decline & vice versa• The risk of misestimating interest
rate movement

Valuation analysis• Select the bond on the basis of their intrinsic values•
What are the factors which affect the bonds intrinsic values?• Bonds
rating, call feature, interest rate etc.• Buy the undervalued bond & sell
the overvalued bonds• If bond rating is higher then interest is low and as
result income is low

Credit analysis• It involves detailed analysis of the bond issuer to

determine expected changes in its default risk• Internal & external
Factors affect the credit rating of the company such as financial ratios,
inflation, etc.• Higher the risk higher the return
Yield spread analysis• Yield spread means difference between the return
of two bonds• Factor affecting yield spread include Business cycle –
Volatility in the market interest rate

Matched-funding techniques• Mixture of passive buy & hold strategy

and active management strategy• Objective is to get higher return at
minimum risk• Require constant monitoring• Could give more return
than buy & hold but not higher than active management strategy

EQUITY:
Equity represents the claims of the owners of the company
In the statement of financial position ( balance sheet), there will be
Assets, Liabilities and Equity.

The total assets (NCA + CA) – Total Liabilities (NCL+CL) = Equity

Equity can otherwise be referred as the amount belong to the owners of
the business.
The total liabilities are referred as debt, which is brought in by outsiders
to the company.

Characteristics of Ordinary share (common stock):

1. Ownership
2. Voting right
3. Decision power
4. High risk
5. No repayment of capital
6. No guaranteed return every year
7. Fluctuating return

Advantages of Issuing common stock:

  Common stock does not have a fixed payment that must be made
to the holders. Dividends need to be paid only when the money to
pay them is available and may also be limited in amount if the
company has other needs for the cash.
 Shares do not mature and do not require a future repayment of the
principal.
 Common stock provides the firm with greater flexibility in its
financial structure because it does not have an obligation to make
interest payments or repay principal.
 The issuance of shares brings additional capital into the firm,
thereby lowering its debt to equity ratio and the perceived riskiness
of its capital structure.

Preferred Stocks:
Preferred stock is a hybrid, or cross, between common stock and bonds.
If one analyses, the characteristics of a preferred stock, this will just at
par with that of a debt instrument.

The characteristics are:

1. No ownership
2. No voting right
3. No decision power
4. Low risk
5. Repayment of capital
6. Almost guaranteed return every year
7. Fixed rate of return

If the preferred stockholder has the option of redeeming the stock, the
stock is mandatorily redeemable and is considered a liability. If the
company has the option of redeeming the stock, the stock is not
mandatorily redeemable and is brought under equity.

Rf + (Rm-Rf) x beta = Ke

Ke can be referred even as Cost of equity.

Dividend Growth Model:

The dividend growth model, consider the annual equity dividend per
share from the company and compare the same with the market price of
the share. As the common stockholder would like to have their returns
growing every year, the growth factor is also taken into account to arrive
the expected return for the year which referred as the cost of common
stock for the year.

Formula:
Ke = (D/MP)+ G
Ke = Cost of common equity (Minimum return to be given)
D = Equity dividend per year per share
MP = Market Price of the share
G = Growth expected by the common stock holder

Face value of a common stock is Rs 10/-. The Market Price prevailing is

Rs 60/- per share. The dividend declared by the corporation last year is
45%. On an average, the common stock holders expect their return to
grow by 20% in the current year.
Dividend per share = 45% of Rs 10 = Rs 4.5
4.5/60 = 0.075 + 0.2 = 0.275 x 100 = 27.5%
Valuation
Valuation of Ordinary shares:
Intrinsic value Method:

The intrinsic value is the internal value generated by the business for its
owners. This will be referred otherwise as the change in the value of the
equity due to change in the fair value of all the assets and the total
liabilities (NCL and CL).
To arrive the intrinsic value, the total assets and the total liabilities will
be revalued. The sum of the fair value of the total liabilities will be
reduced from the sum of the fair value of the total assets (NCA and CA).
If preference share capital is included in the equity, then the same will
be reduced from the value arrived by reducing the total liabilities from
total assets to arrive the intrinsic value applicable to the common
shareholders.
Since, for the companies which are listed in the stock exchanges, the
market price could be determined comfortably, the concept of intrinsic
value will be more applicable in the case of closely held companies.

Example:
(Fair value $mln)
Non-current assets xxxxx
Current Assets xxxxx
Total assets xxxxx
Non-current Liabilities (xxxx)
Current Liabilities (xxxx)
Net Assets xxxxx
Preferred stock (xxxx)
Intrinsic value xxxxx

When this intrinsic value is divided by the number of common stock

available, the intrinsic value per share can be determined.

Total Intrinsic value

-----------------------------
Number of outstanding common shares

Illustration 3

Xylem Co reveals the statement of financial position as on 31.12.2015,

which is as follows:
$mln
Assets
Non-current Assets
Tangible NCA 600
Intangible NCA 200
Long Investments 150
Current Assets
Inventories 200
Receivables 250
Cash & Cash equivalents 100
Total 1500

Equity & Liabilities

Equity
Share Capital 400
Retained Earnings 250
Securities Premium 100
Non-current Liabilities
8% Bonds 250
Long term Loans 200
Current Liabilities
Payables 200
Other liabilities 100
Total 1500

Additional Information:
 The share capital represents ordinary shares of 40 mln
 The Tangible Non-current assets are reflecting a fair value having
appreciation of 40% on one third of the same, appreciation of 15%
on 150 mln and diminution of 10% on the balance.
 75% of the intangible NCA are not having active market and hence
fair value is not assessable. The balance of the intangible NCA is
worth @95%.
 The long term investments are reflecting a fair value @ 105%.
 Inventories are having obsolescence to the extent of 3% of the
current value whereas 4% are estimated as non-collectables against
the receivables.
  The company during the financial year, has not considered a
liability of $25mln in the books, incurred on account of a revamp
of cold room facility used as part of their operations.
 The company will enjoy a waiver of 10% of its long term loan
which was received as a grant from the government.
You are required to calculate the intrinsic value of the share of the
company at the end of the financial year.

Solution:
Fair value of the Tangible NCA – Total value $600mln
a. One third having 40% appreciation = 600x1/3 = 200 + 40% of 200
= $280 mln
b. $150mln TNCA are having appreciation of 15% = 150 + 15% of
150 = $172.5mln
c. Balance $250mln is reflecting a diminution = 250 – 10% of 250 =
$225 mln
The total fair value of the Tangible NCA = 280+172.5+225+25mln
(Cold room) = $702.50mln

Fair value of the Intangible NCA – Total value $200mln

a. 75% do not have active market and hence the value will be
considered as at par with the book value = $150mln
b. 25% of the assets are worth only 95% = 95% of 50mln = $47.5mln
Total fair value of the Intangible NCA = 150+47.5= $197.50mln

Fair value of Investments – Total value $150 mln

a. The fair value is 105% of the Book value = 150x105% =
$157.5mln

Fair value of Current assets:

 a. Inventories – 200 mln less 3% = $194mln
b. Receivables – 250mln less 4% = $240mln
c. Cash & cash equivalents = $100mln
Total fair value of current assets = $534mln

Fair value of current liabilities:

a. Value as per the books = (200+100) = 300 + 25(Cold room)
=$325mln
Fair value of Non-current liabilities:
a. Value of the bonds = $250mln
b. Value of loan = $200mln less 10% = $180mln
Total fair value of NCL = $430mln
Intrinsic value:
Tangible NCA $702.50mln
Intangible NCA $197.50mln
Investments $157.50mln
Current Assets $534.00mln
Current liabilities ($325.00mln)
Non-current liabilities ($430.00mln)

Net Assets $836.50mln

Preferred Stock NIL
Intrinsic value $836.50mln

Number of outstanding common stock = 40mln

Intrinsic value per share = 836.50/40 = $20.91
Valuation based upon Price earnings ratio:
The Price earnings ratio can be calculated by dividing the Market Price
per share by Earnings per share.

PE Ratio = MPS/EPS = 80/12 = 6.67 times

In other words, the market price of a share can calculated when Price
earnings ratio and earnings per share are available. This is arrived by
multiplying the P/E ratio with EPS.

MPS = PE Ratio x EPS

Valuation based upon Earnings Yield

EY = EPS/MPS x 100
If Earnings yield and Earnings per share are available, then Market Price
of a share can be calculated by dividing EPS by EY.

EPS/EY = MP

EAOSH (Profit – PD)/WANOSO = BEPS = 8

Dividend 4 RE 4

Dividend Pay out = DPS/BEPS =

BEPS/DPS = 8/4 = 2 tmes

Valuation based upon dividend yield:

DY = DPS/MPS x 100
If dividend yield and dividend per share are available then the market
price can be calculated by dividing DPS by DY.

DPS/DY = MPS

The total profit of a company is $100 mln

Preference dividend (20 mln)
Balance available to OSH 80 mln

Dividend declared value $40 mln

The above dividend can be distributed in the form of cash
The company decided to issue common stock in lieu of the dividend.
The market price of the share is $50 per share

Number of shares to be issued = $40 mln/50 =

Valuation on the basis of Dividend Growth Approach:

Ke = D/MP + G

Where,
Ke = Cost of common stock/Expected return
D = dividend per share
MP = Market Per share
G = Growth
When all other factors are available other than MP, finding Market price
will be :

MP = D/(Ke-G)

Illustration 4

A company has a number of outstanding shares on 01.01.2016 as 1 mln.

During the year the following transactions took place.

1. On 01.05.2016, issued further 0.30 mln shares in the market

2. On 30.09.2016, bought back 0.15 mln shares out of the opening
lot
The company during the year made the profit after tax of $ 40mln. The
preference dividend obligation is $5 mln. The face value of the share is
$25. The ratio of the earnings and the market price is 6 times where as
the dividend payout is 60% of the earnings You are required to calculate
the dividend yield and market price based upon:
a) Price earnings approach
Solution:
Calculation of WANCSO (Weighted average number of common stock
outstanding)

Opening number of ordinary shares 1000000

Average = 1000000/12 x 4 333333

On 01.05.2016 issued 300000 shares
Total share will be 1300000
Taking an average of 1300000 for 5 months
1300000/12 x 5 541667

On 30.09.2016, the company buys back 0.15 mln

The number of shares will be 1150000
Taking average for 3 months = 1150000/12 x 3 287500
Weighted average number of common stock
Outstanding will be (WANCSO) 1162500
Earnings for the year is $40 mln
Preference dividend is $5 mln
Income available to common stock holders = 40-5= $35mln

Earnings Per share:

IACSH/WANCSO = 35/1.163 = 30.107

PE Ratio = MPS/EPS
6 = MP/30.107
MP = 6x 30.107 = $180

Dividend payout ratio is 60%

So the dividend per share will be 60% of EPS = 60% of 30.107 = $18
So Dividend Per share DPS = $18

Dividend yield = DPS/MPS x 100

18/180 x 100 = 10%

Illustration 5
Fast growth Industries dividend is growing, at an annual rate of 20%.
This growth is expected to continue for three years into the future, after
which the growth is expected to slow down to a more sustainable growth
rate of 7%. Investors’ required rate of return is 15%. The next annual
dividend is expected to be $1.00. Determine the market price.

Solution:

Step 1: We will first calculate the present values of the dividends to be

received during the first three years and sum the results. Each year’s
dividend increases by 20% over the previous year’s dividend.

1 $1.00 0.86957 $ 0.870

2 1.20 0.75614 $ 0.907
3 1.44 0.65752 $ 0.947

Total PV of future dividends - Years 1 through 3: $2.724 or $2.72

Step 2: We next project the dividend for Year 4 by multiplying the Year
3 dividend by (1 + the growth rate for Year 4), which is 1.07.
The Year 4 dividend is therefore projected to be $1.44 × 1.07, or $1.54.

We use the Constant Growth Model to calculate what the value of the
stock will be at the end of Year 3, assuming a required rate of return of
15% and an annual growth in dividends of 7% going forward from the
end of Year 3, beginning with Year 4:

P3 = d4 / (r – g)
P3 = $1.54 / (0.15 – 0.07)
P3 = $19.25

However, this present value of $19.25 occurs at the end of Year 3, not at
Year 0. Therefore, $19.25 must be discounted back 3 years to Year 0.
We will discount it back as if it were a single sum that will be received
in 3 years.
The present value factor for 3 years at 15% is 0.65752, so the present
value of $19.25 three years from now is $19.25 × 0.65752, or $12.66.

Step 3: The final step is to sum the present value of the future dividends
for Years 1 through 3 ($2.72) and the present value of the dividends to
be received from Year 4 to infinity ($12.66) to calculate the value today,
at Year 0, for a share of this stock:

$2.72 + $12.66 = $15.38 – Market Price as on today.