Chapter 1- COST OF CAPITAL, FINANCING

DECISIONS , RISK AND RETURN AND

PORTFOLIO THEORY
Concept of Capital
Capital includes all funds available for long term investment/assets whether debt or
equity.
1. Cost of capital
Cost of capital is the required rate of return of investors on their investments i.e.
opportunity cost of funds. Basic idea to find this cost is that if company raises finance
NOW in its current status, then what return will investors want.
1.1 Cost of Equity
Equilibrium share valuation model
Price= sum of present value of all future streams of dividends. This model forms
the basis of dividend valuation model.

a) Dividend valuation model- No growth

MV= D1/Ke
Where:
MV = the share price ex dividend
D1 = the expected future annual dividend (starting at time 1)
Ke = the cost of equity
Ke= D1/MV
Example-1
Dividend has remained constant for many year at Rs. 12 per share. The current value of
each share is Rs. 150. Calculate the cost of equity.

b) Dividend valuation model- Constant growth

MV= D0 (1+g)/Ke-g
Where:
MV = the share price ex dividend
D0 = current dividend
g = growth rate
Ke = the cost of equity
Ke= (D0 (1+g)/MV) +g OR (D 1/MV) +g
Example-2
A company has just paid a dividend of Rs 4 on its share whose market value is Rs. 37. Past
trend shows that dividend grows at a rate of 5 %. Calculate the cost of equity.

Example-3
A company’s share price is Rs.5.00. The next annual dividend will be paid in one year’s
time and dividends are expected to grow by 4% per year into the foreseeable future. The
next annual dividend is expected to be Rs.0.45 per share. Calculate cost of equity.

c) Dividend valuation model- Variable growth

Step 1- Discount dividend for each year separately
Step 2- For years extending to infinity apply DVM with constant
growth.
Example-4
A company has just paid a dividend of Rs. 10 and dividends are expected to grow by 8%
in year 1, 7% in year 2, 6% in year 3 and 5% from year 4 to infinity. Cost of equity is 20%.
Calculate the share price.

Estimating growth

Growth rate can be estimated in one of two ways:

 Extrapolation of historical growth; and
 Gordon’s growth model

Extrapolation of historical growth

Do= D-n (1+g) ^n (solve for g).

Example-5
A company paid a dividend of Rs. 10 per share 5 years ago and dividend of Rs. 15 for the
current year. Calculate the growth rate.

Gordon’s growth model

g = br
Where:
g = annual growth rate in dividends in perpetuity
b = proportion of earnings retained (for reinvestment in the business)
r = rate of return that the company will make on its investments/equity (book value)
Example-6
A company has equity of Rs. 100,000 with a return of 20%. Profit after for tax for the year
is Rs. 20,000 and the company distributes 50% profits as dividends. Calculate the
expected growth rate in dividend using Gordon’s growth model.

Example-7
You are given with the following information about two companies, both of which are
financed entirely by equity capital:

A Ltd B Ltd
Number of ordinary shares of Rs 1 each 150,000 500,000
Market price per share ex-dividend (Rs.) 3.42 0.65
Total current earnings (Rs,000) 62,858 63,952
Total current dividend (Rs.’000’) 6,158 48,130
Balance sheet value of equity (Rs. ‘000’) 315,000 293,000
Dividend five years ago (Rs. 000) 2,473 37,600

Estimate the growth rate for both the companies using historic method for A and
Gordon’s growth model for B.

Practice question

Zimba plc is a listed all-equity financed company which makes parts for digital cameras.
The company pays out all available profits as dividends.
Zimba plc has a share capital of 15 million ordinary shares.
On 30 September 20X0 it expects to pay an annual dividend of Rs. 20 per share. In the
absence of any further investment the company expects the next three annual dividend
payments also to be Rs. 20per share, but thereafter a 2% per annum growth rate is
expected in perpetuity.
The company’s cost of equity is currently 15% per annum.
The company is considering a new investment which would require an initial outlay of
Rs.500 million on 30 September 20X0.
If this investment were financed by a 1 for 3 rights issue it would enable the share dividend
per share to be increased to Rs. 21 on 30 September 20X1 and all further dividends would
be increased by 4% per annum.
The new investment is, however more risky than the average of existing investments, as a
result of which the company’s overall cost of equity would increase to 16% per annum
were the company to remain all-equity financed.

Required
(a) Assuming the Zimba plc remains all-equity financed and using the dividend valuation
model calculate the expected ex-dividend price per share at 30 September 20X0 if the
new investment does not take place.
(b) Assuming the Zimba plc remains all-equity financed and using the dividend valuation
model calculate the expected ex-dividend price per share at 30 September 20X0 if the
new investment does take place.
(c) Compare the market values with and without the investment and determine whether
the new investment should be undertaken.

d) CAPM method of estimating cost of equity

Formula: Capital asset pricing model (CAPM)

Ke = RF + β (RM – RF)

Where:
Ke = the cost of equity for a company’s shares
RF = the risk-free rate of return: this is the return that investors receive on risk-free
investments such as government bonds
RM = the average return on market investments
β = the beta factor for the company’s equity shares. The nature of the beta factor will be
explained later in another chapter.

Example-8
The rate of return available for investors on government bonds is 4%. The average return
on market investments is 7%. The company’s equity beta is 0.92. Calculate cost of equity
using CAPM.

1.2 Cost of Debt Capital

The market value of debt is the present value of all future cash flows in servicing
the debt. A difference between debt and equity is that interest payments are tax deductible
whereas dividend payments are not.

This means that debt might be valued from two different viewpoints:
 The lenders’ viewpoint: discount the pre-tax cash flows (i.e. ignoring the tax relief
on the interest) at the lenders’ required rate of return (the pre-tax cost of debt.
 The company’s viewpoint: discount the post-tax cash flows (i.e. including the tax
relief on the interest) at the cost to the company (the post-tax cost of debt). This
is the rate that is input into WACC calculations.

a) Cost of irredeemable debt/straight loan

 Pre-tax cost of debt (the lender’s required rate of return)
MV= I/K
 K= I/MV
 Post-tax cost of debt MV= I (1-t)/Kd
Kd= I (1-t)/MV
Where:
Kd = the cost of the debt capital
i = the annual interest payable
t = rate of tax on company profits.
MV = Ex interest market value of the debt
Note that calculations are usually performed on a nominal amount of 100 or 1,000.

Example-9
C Ltd has had an overdraft balance between Rs 1 million and Rs 1.5 million during the
year, the variation being due to short term factors. It pays interest every month of 1.5 %
per month on the balance. Tax rate is 35%. Calculate the cost of debt.

b) Cost of redeemable debt

Apply IRR method
Description Year Amount PV@ 10% PV @20%
(A) (B)
Initial outflow (Ex-interest market 0 (xxx) (xxx) (xxx)
value)
Interest net of tax 1-N xxx xxx xxx
Redemption N xxx xxx xxx

IRR= A+ ____a____ (B-A)

a-b

Where:
A = lower %
B = higher %
a = NPV at lower %
b= NPV at higher %

Important to note: If the debt is non-traded, its market value is measured by

discounting the pre-tax cash flows using the pre-tax opportunity cost of debt as discount
rate (this rate is usually the cost of alternative debt or the Gross yield of similar debt in
the company).

Example-10
C Ltd also has Rs 2 million of non-traded debentures in issue. A similar traded debt has a
yield (gross) of 10% in the economy. These are 8% coupon rate stock but interest is paid
quarterly. They are redeemable in ten years’ time at a premium of 5%. The tax rate is 35
%. Calculate the cost and value of debt.

Also Important to note: if the debt is redeemable at MV it means it will continue till
infinity, in such a case Kd will be calculated in the same way like irredeemable debt.

c) Cost of convertible debt

Convertible debt is debt that gives the holder (the lender) the option of converting it into
equity at an agreed rate and at an agreed time (or during an agreed period) in the future.

The same IRR approach as above is followed with exceptions only that redemption or
conversion proceeds whichever is higher is taken.

Example-11
C Ltd also has Rs 2,000,000 3% convertible loan stock in issue, which can be exchanged
for Rs 50 or 1 share per Rs 100 nominal value in five years’ time. Interest is paid annually
on 1st January and the current cum interest market price is Rs. 25. Tax rate is 35% and
current market value of share is Rs 20 per share which is expected to grow @18% p.a.
calculate the cost and value of convertible.

Example-12
Aay Ltd has in issue 10% bonds that are redeemable @premium of 10% after 5 years.
Current MV of the bond is Rs 105. The bonds can be converted into 10 ordinary shares
per face value after 3 years. Current share price of the company is Rs 9. It is expected to
grow @ 7% p.a. Compute the cost of debt of the bonds assuming that the comparable
market debt yield is 12%. Tax rate is 30%.

d) Foreign currency loans

Example-13
Bee Ltd issued 10% bonds in USA which are redeemable @ premium of 10% after 5 years.
The bonds are issued at current MV of USD 100 which is also the par value. The current
exchange rate is Rs 100/ USD 1. It is expected that Rupee will depreciate against USD by
7 % p.a. Tax rate is 30%. Compute the cost of debt.

1.3 Cost of Preference shares

In case of redeemable preference shares the same method will be applied which we used
for redeemable debt with one exception of tax treatment. Similarly in case of non-
redeemable straight loan method will be applied again with difference of tax treatment.
1.4 Weighted average cost of capital (WACC)
Description Value (Ex-div, Cost % (X) WX
interest (W)
Equity xxx x% xxx
Debt xxx X% xxx
xxx xxx
WACC= sum of WX
Sum of W

Example-13
A company has 20 million shares each with a value of Rs.6.00, whose cost is 9%. It has
debt capital with a market value of Rs.80 million and a before-tax cost of 6%. The rate of
taxation on profits is 30%. Calculate the WACC.

Class practice –
ICMAP - winter 2017 Q no. 5
ICAP - winter 2008 Q no. 6

Suggested Study Material (ICAP CFAP BFD study text Chapter 13)

Practice (ICMA Past papers, ICAP CFAP Practice Kit Chapter 13)
2 Sources of Finance

An important aspect of financial management is the choice of methods of financing for a

company’s assets. Companies use a variety of sources of finance and the aim should be to
achieve an efficient capital structure that provides:
 A suitable balance between short-term and long-term funding
 Adequate working capital
 A suitable balance between equity and debt capital in the long-term capital
structure.

2.1 Equity Finance

Methods of issuing new shares

There are three main methods of issuing new shares for cash:
 Issuing new shares for purchase by the general investing public: this is called a public
offer.
 Issuing new shares to a relatively small number of selected investors: this is called a
placing.
 Issuing new shares to existing shareholders in a rights issue.

Right Issue

A rights issue is an issue of shares for cash, where the new shares are offered to existing
shareholders in proportion to their current shareholding. The share price of the new
shares in a rights issue should be lower than the current market price of the existing
shares. Pricing the new shares in this way gives the shareholders an incentive to subscribe
for them. There are no fixed rules about what the share price for a rights issue should be,
but as a broad guideline the issue price for the rights issue might be about 10% - 15%
below the market price of existing shares just before the rights issue.

The theoretical ex-rights price

When a company announces a rights issue, the market price of the existing shares just
before the new issue takes place is called the ‘cum rights’ price. (‘Cum rights’ means
‘with the rights’).

The theoretical ex-rights price is what the share price ought to be, in theory, after
the rights issue has taken place. The theoretical ex-rights price is the weighted average
price of the current shares ‘cum rights’ and the issue price for the new shares in the rights
issue. Which can be calculated as follows:

MV of old shares + cash from new shares

 Total number of shares (Old +new)

Example

A Ltd announces a 2 for 5 rights issue at a price of Rs.300 per share. The market price of
the existing shares before the rights issue is Rs.370. The theoretical ex-rights price can be
calculated as follows.
Market value of 5 existing shares (5 × Rs.370) =1,850
Issue price of 2 shares in the rights issue (2 × Rs.300)= 600
Theoretical value of 7 shares = 2,450
Theoretical ex-rights price (= Rs.2,450/7) = Rs.350

The value of rights

The holder of five shares in the company in the previous example could buy two new
shares in the rights issue for Rs.300 each, and these two shares will be expected to rise in
value to Rs.350, a gain of Rs.50 for each new share or Rs.100 in total for the five existing
shares. We can therefore say that the theoretical value of the rights is:
Rs.50 for each new share issued; or
Rs.20 (Rs.100/5 shares) for each current share held.

Shareholders are allowed to sell their rights to subscribe for the shares in the rights issue,
and investors who buy the rights are entitled to subscribe for shares in the rights issue at
the rights issue price. The most common way of stating the value of rights is the value
of the rights for each existing share. In the example, the theoretical value of the right
would normally be stated as Rs.20. There is no real gain as the shareholder has paid cash
to the company equal to the amount of the change in share price.

Class Practice Question (ICAP Winter 2009 Q 5)

Shareholder options with respect to Right

A shareholder receiving notification of a rights issue from an entity has a number of

options available. Consider the position of a shareholder in above example having 1,000
shares and, then, being offered 400 shares at Rs 300 each.

Option 1 – Do nothing. In this situation, the market value of the investment could be
expected to fall by Rs.2,000 from Rs 370,000 to Rs. 350,000 (1,000 @ Rs 350). The
company would normally reserve the right to sell any ‘unaccepted’ shares for the best
price available in the market. After having deducted any expenses and, of course, Rs 300
per share, the balance would be sent to the shareholder. This cash balance could fully or
partially compensate the shareholder for the reduction in market value. The shareholder’s
percentage share of the entity will reduce.
Option 2 – Sell the rights. In this situation, the shareholder decides to sell the right to
buy the shares at Rs 300 each to another investor. A rational investor would not be
expected to pay more than Rs 50 per share (TERP – Rs 300) for such a right. The existing
shareholder might receive Rs. 20,000 (R50 @ 400) less any dealing costs incurred. The
shareholder’s percentage share of the entity will be reduced.

Option 3 – Fully subscribe. In this situation, the shareholder will have to increase the
value of the shareholding by paying the entity Rs 120,000 for the 400 new shares. The
shareholder will then own 1,400 shares which, using TERP, will be valued at Rs 490,000.
The shareholder’s percentage share of the entity will be maintained.

Option 4 – Sell some to buy some. In this situation, the shareholder may be unable
or unwilling to invest more funds in the entity. Since the rights can normally be sold in
the market, the shareholder could sell sufficient of the rights to purchase the balance. In
our example, each block of 6 rights sold at Rs 50 raises sufficient cash to purchase one
new share at Rs 300. The shareholder could sell 342 rights @ Rs 50 to raise Rs 17,100
which would be sufficient to purchase 57 @ Rs 300. The value of the investment will be
maintained at Rs 370,000 but the shareholder’s percentage share of the entity will be
reduced.

Yield-adjusted ex-rights price

The calculations of theoretical ex-rights price above assume that the additional funds
raised will generate a return at the same rate as existing funds. If an entity expects (and
the market agrees) that the new funds will earn a different return than is currently being
earned on the existing capital then a ‘yield-adjusted’ TERP should be calculated in the
following manner:

Yield adjusted TERP = ( Pp x N0/N ) + ((Pn x Nn)/N)) x (Yn/Yo)

Pp = Pre-issue price
Pn = New-issue price
Yo = Yield on ‘old’ capital
Yn = Yield on ‘new’ capital
No= Qty of ‘old’ shares
Nn= Qty of ‘new’ shares
N = Total quantity of shares

Example

Using the figures in example above A Ltd and assuming that total number of existing
share are 10,000 shares and:

 the rate of return (yield) on the new funds is 15%

 the rate of return on the existing funds is 12%
Calcualate the yeild adjusted TERP.

Capital or securities market

Capital or securities markets trade in longer-dated securities (usually over twelve months)
such as shares and loan stocks. Examples of capital markets would be the Stock Exchange
and the bond market. Capital markets have two main functions:

1. They provide a primary market for raising new capital for business, usually in the form
of equity (shares) to new shareholders or existing shareholders (via rights issues).

2. They also allow trading in existing securities – the secondary market. This is an
important function as it provides investors with a means of selling their investments
should they wish to.

In Pakistan, Pakistan Stock Exchange is the principal trading market for long-dated
securities.

Scrip dividends

Entities sometimes offer shareholders a choice between a cash dividend and additional
shares worth the same, or approximately the same amount. The dividend paid in
shares is referred to as a scrip dividend and is often offered when the directors feel
they must pay a dividend but would prefer to retain cash funds within the entity. The
presumption is that the retained funds will be invested in projects which can reasonably
be expected to earn an adequate return. As with bonus or scrip issues directors rarely
highlight the fact that once the reserves are capitalised in this way, they become
undistributable.

Example

An entity with 100 million shares in issue, the directors of which decided to declare a
dividend of Rs 1.2 per share. In the ‘normal’ course of events this would mean a cash
outflow of Rs. 120 million to the shareholders. Assuming, for the sake of understanding
that the entity’s shares had been trading at around Rs 36 ex div. the board might offer an
alternative of one new share for every 30 held. There would be rules as to fractional
entitlements, of course, but in simple terms someone who held, say, 3,000 shares could
receive a dividend of Rs 3,600, or 100 shares’ worth – at the contemporary share price –
Rs. 36.

From the point of view of the individual shareholder:

● if he (or she) had been thinking of buying some more shares, and felt that the price was
unlikely to fall below Rs 36 in the near future, he would welcome the opportunity of
obtaining some without having to pay the usual commissions, etc.;

● if he had no wish to increase his holding, he could simply take the dividend as originally
declared;

● if he had no firm views, he could take part dividend and part shares.

Share splits

With a share/stock split, the number of shares is increased through a proportional

reduction in the par value of the share/stock.

Example

Capital structure of a Co before a 2-to-1 stock split was as follows:

Common stock ( 400,000 shares of Rs 10 each ) Rs 4,000,000

Retained earings Rs 8,000,000

Total equity Rs 12,000,000

What would be capital structure after a 2-to-1 stock split??

Share repurchases

The decline in scrip dividend offers in recent years has coincided with an increase in the
number of entities returning capital to investors through share repurchase schemes, or in
some cases by making a special dividend payment.

The repurchase of an entity’s shares may be carried out for a number of reasons:
● return of surplus cash to investors;
● to reduce the entity’s cost of capital;
● to enhance earnings per share in the hope of also increasing market price per share;
● to prevent, or reduce the likelihood of, unwelcome takeover bids;
● to adjust the gearing of the entity to a higher level, closer to the entity’s optimal capital
structure;
● to reduce the amount of cash needed to pay future dividends.

Shares may be repurchased by:

● purchase on the open market;
● individual arrangement with institutional investors;
● a tender offer to all shareholders

With repurchase, fewer shares remain outstanding, and earnings per share and,
ultimately, dividends per share rise. As a result, the market price per share should rise as
well. In theory, the capital gain arising from repurchase should equal the dividend that
otherwise would have been paid. This price can be calculated using the following formula:

Price = Total shares x Price befor repurchase_________

Total shares – number of shares to be repurcased

Signaling Effect

Stock repurchases may have a signaling effect. For example, a positive signal might be
sent to the market if management believed the stock were undervalued and they were
constrained not to tender shares they owned individually. In this context, the premium in
repurchase price over existing market price would reflect management's belief about the
degree of undervaluation. The idea is that concrete actions, such as repurchase, stock
dividends and splits, as well as capital structure changes and cash dividend changes,
speak louder than words.

Class practice

ICMA August 2013 Q 3

The efficient market hypothesis

Investors in securities need to be confident that the price they pay for their securities is a
fair price. For this to happen, stock markets must price shares efficiently. Efficient pricing
means incorporating into the share price all information that could possibly affect it. A
considerable body of finance theory has been built on the hypothesis that, in an efficient
market, prices fully reflect all available information. The efficient market hypothesis
(EMH) is therefore concerned with information and pricing efficiency.

Three levels or forms of efficiency have been defined: these are dependent on the amount
of information available to the participants in the market.

 Weak form efficiency (share prices respond to the publication of historical

information)
 Semi-strong form efficiency (share prices reflect all publicly-available
information about the company and its prospects, in addition to historical
information; and
 Strong form efficiency (Current share prices reflect all relevant information
about the company as soon as it comes into existence, even if it has not been made
publicly-available.

Recommended study Material

ICAP CFAP 04 BFD study text – Chapter 12

Financial Management and Policy 12th edition Chapter 11 – from page 320
onwards
 2.2 Debt Finance

Medium-term financing

The distinction between short-, medium- and long-term finance is not well defined but,
as a guide, short-term is up to 1 year, medium-term is from 1 to 5 years, and long-term is
from 5 years upwards.

The major sources of medium-term financing in recent years have been either term loans
or leasing. Most medium-term finance is used by small entities, as a result of the problems
they face in raising capital.

Term loans

A term loan is for a fixed amount with a fixed repayment schedule. Usually, the interest
rate applied is slightly less than for a bank overdraft. The lender will require security to
cover the amount borrowed and an arrangement fee is payable dependent on the amount
borrowed.

Term loans also have the following qualities:

● They are negotiated easily and quickly.

● Banks may offer flexible repayments.
● Variable interest rates.

Mezzanine finance

Also known as intermediate or subordinated debt, mezzanine finance refers to

unsecured loans that rank after secured or senior debt but ahead of equity in the event of
liquidation. Greater risk brings with it higher interest, and the interest rate on mezzanine
loans will tend to be above interest rates on bank loans

Leasing

Will be covered in a later chapter.

Long-term financing
Long-term finance is usually obtained by issuing bonds. Bonds might also be called loan
stock or debentures. Bonds can be secured or unsecured. Deep-discounted bonds are debt
instruments that are issued at a price well below their nominal value.

Bonds

A bond is a long-term contract under which a borrower agrees to make payments of

interest and principal, on specific dates, to the holders of the bond.

Types of bonds

Bonds are classified into four main types: Treasury, corporate, municipal, and foreign.

KEY CHARACTERISTICS OF BONDS

To understand bonds, it is essential that you understand the following terms.

Par Value

The par value is the stated face value of the bond; for illustrative purposes we generally
assume a par value of Rs. 1,00, although any multiple of Rs1,00 (for example, Rs. 5,00 or
Rs. 5 million) can be used. The par value generally represents the amount of money the
firm borrows and promises to repay on the maturity date.

Coupon rate

A connected issue that is often misunderstood is the relationship of face value to market
value and coupon rate (on debt) to rate of return. When a bond or any fixed-interest debt
is issued, it carries a ‘coupon’ rate. This is the interest rate that is payable on the face, or
nominal, value of the debt. Unlike shares, which are rarely issued at their nominal value,
debt is frequently issued at par, usually Rs 100 payable for Rs 100 nominal of the bond.
At the time of issue the interest rate will be fixed according to interest rates available in
the market at that time for bonds of similar maturity. The credit rating of the entity will
also have an impact on the rate of interest demanded by the market.

Zero-coupon bonds

The lower the issue price of a bond in relation to its nominal value, the greater the
potential for a capital gain on redemption. The interest rate can therefore be reduced until
we reach a stage where no interest is paid on the bond at all during its life. This is referred
to as a zero-coupon bond. With a zero-coupon bond, all of the investor’s return is wrapped
up in a capital gain on redemption.
Bond Ratings

The creditworthiness of a publicly traded debt instrument often is judged by investors in

terms of the credit rating assigned to it by investment agencies

Call Provision

A provision in a bond contract that gives the issuer the right to redeem the bonds under
specified terms prior to the normal maturity date.

Sinking Fund Provision

A provision in a bond contract that requires the issuer to retire a portion of the bond issue
each year.

Bond yield

Bond yield is simply the internal rate of return of a bond. This is also known as yield to
maturity. Given any three of the following four factors-coupon rate, final maturity,
market price, and yield to maturity-we are able to solve for the fourth. If we are
required to calculate the yield to maturity and other factors are available we would
calculate yield to maturity simply using IRR method. Important to note in this respect:

1. When a bond's market price is less than its face value say Rs 100 so that it sells at a
discount, the yield to maturity exceeds the coupon rate.
2. When a bond sells at a premium, its yield to maturity is less than the coupon rate.
3. When the market price equals the face value, the yield to maturity equals the coupon
rate.

Holding-Period Return

The yield to maturity, as calculated above, may differ from the holding-period yield if the
security is sold prior to maturity. The holding period yield is the rate of discount that
equates the present value of interest payments, plus the present value of terminal value
at the end of the holding period, with the price paid for the bond.

Yield to Call
The rate of return earned on a bond if it is called before its maturity date. If you purchased
a bond that was callable and the company called it, you would not have the option of
holding it until it matured. Therefore, the yield to maturity would not be earned. For
example, if A’s 10 percent coupon bonds were callable, and if interest rates fell from 10 to
5 percent, then the company could call in the 10 percent bonds, replace them with 5
percent bonds, and save Rs100 - Rs50 = Rs50 interest per bond per year. This would be
beneficial to the company, but not to its bondholders.
If current interest rates are well below an outstanding bond’s coupon rate, then a callable
bond is likely to be called, and investors will estimate its expected rate of return as the
yield to call (YTC) rather than as the yield to maturity. In that case price of bond will be
calculated as follows:
Value= Interest + call price
(1+i)^n (1+i) ^n

BONDS WITH SEMIANNUAL COUPONS

Although some bonds pay interest annually, the vast majority actually make payments
semiannually. To evaluate semiannual bonds, we must modify the valuation model as
follows:
1. Divide the annual coupon interest payment by 2 to determine the Rupees of
interest paid each six months.
2. Multiply the years to maturity, N, by 2 to determine the number of semiannual
periods.
3. Divide the nominal (quoted) interest rate, i, by 2 to determine the periodic
(semiannual) interest rate.

Class practice
ICMA Winter 2016 Q. 3

Refunding a Bond Issue

By refunding, we mean refinancing the bond issue with a new bond issue at a lower
interest cost. In refunding there is an initial cash outlay followed by future interest
savings. These savings are represented by the difference between the annual cash outflow
required under the old bonds and the net cash outflow required on the new, or refunding,
bonds. Calculating the initial cash outlay is little bit complex.

Example
A company currently has a Rs. 20 million, 10 percent bonds issue outstanding, and the
issue still has 20 years to final maturity. Because interest rates are significantly lower than
at the time of the original offering, the company can now sell a Rs. 20 million issue of 20-
year bonds at a coupon rate of 8 percent that will result in net receipts of Rs 19,600,000.
The old bonds were sold originally at a slight discount from par value, and the
unamortized portion now is Rs. 200,000. There is a 1-month period of overlap. The
period of overlap is the lag between the time the new bonds are sold and the time the old
bonds are called. Moreover, the legal fees and other issuing expenses involved with the
old bonds have an unamortized balance of Rs. 100,000. The call price on the old bonds is
Rs. 109, issuing expenses on the new bonds are Rs. 150,000, and the income tax rate is
30 percent. For income tax purposes, the unamortized issuing expense of the old bonds,
the call premium, and the unamortized discount of the old bonds, if they were sold at a
discount, are deductible as expenses in the year of the refunding. Calculate the initial cash
outflow and the future cash benefits.

Class practice

ICMA August 2015 Q 5.

Convertible bonds/securities

A convertible security is a bond or a share of preferred stock that can be converted at the
option of the holder into common stock of the same corporation. As a result, a company
is able to sell a convertible security at a lower yield than it would have to pay on a straight
bond or preferred stock issue.

Conversion Price/ Ratio

The ratio of exchange between the convertible security and the common stock can be
stated in terms of either a conversion price or a conversion ratio. Suppose ABC
Corporation's 7 percent convertible subordinated debentures (Rs 1,000 face value) have
a conversion price of Rs 43.75. To determine the conversion ratio, we merely divide Rs
1,000 by Rs 43.75 to get 22.86 shares. This is the number of shares of stock a holder will
receive upon converting his or her debenture.
Some convertible issues provide for increases or "step-ups" in the conversion price at
periodic intervals. A Rs 1,000 face value bond might have a conversion price of Rs 40 a
share for the first 5 years, Rs 48 a share for the second 5 years, Rs 56 for the third 5, and
so on.

Conversion value and conversion premium

The relationship between the price of the ordinary share and the convertible bond is
usually expressed in one of two ways as illustrated below.

Example

ABC has in issue a convertible bond with a coupon rate of 10 per cent. Each Rs 100
nominal bond is convertible into 20 ordinary shares. The market price of the convertible
bond is Rs 108, while the current ordinary share price is Rs 4.80.

Calculate (i) the conversion premium and (ii) the conversion value.

Solution
The conversion terms are: Rs 100 bond = 20 ordinary shares. This is known as the
conversion ratio. The conversion terms could also be expressed as: Rs 5 bond = one
ordinary share.

The conversion premium measures how much more expensive it is to buy the
convertible bond than the underlying ordinary share.

The cost of buying Rs. 5 bond is:

Rs 5 x 108 = Rs 5.40
100

compared with the cost of buying one ordinary share, Rs. 4.80.

The conversion premium is therefore:

Rs 5.4 – Rs 4.80 = 12.5%

Rs. 4.8

In this case, it is more expensive to purchase the bond and convert, than to purchase one
ordinary share directly.

The conversion value is calculated as the market value of ordinary shares that is
equivalent to one unit of the convertible bond.

Conversion value = Conversion ratio x MPS (ordinary shares)

20 x Rs 4.8 = Rs 96

Note that from this calculation of conversion value, the conversion premium may also be
stated as:

Rs 108- Rs 96 = 12.5%
Rs 96

Warrants

Warrants are options to buy shares in the entity at a given price within a given period.
They can be traded on the market and are sometimes issued with bonds as a ‘sweetener’.

Share warrants issued in conjunction with a bond will put the holder in an overall position
that is very similar to that of a convertible bond holder. Thus, it follows that the holder
has both debt and equity interest in the issuing firm. However, it may be argued that
investors will find warrants more attractive than a convertible bond since they can sell
warrants separately, whereas the conversion option is an integral part of convertible
bonds.
The warrant, like the conversion option, will enable the coupon rate to be reduced on the
debt. The amount of this reduction will depend upon the value of the warrant.

Unlike a convertible bond, the debt issued with warrants will run to maturity, thus
maintaining the tax deduction. The warrants, if exercised, will also result in new capital
being raised; this may be useful if expansion of the project originally undertaken is being
contemplated. However, the timing of the exercising of warrants is determined by
investors and may not result in extra capital when needed by the entity.

The use of both convertible bonds and warrants represents an attempt to make debt
capital more attractive to investors; they also have characteristics that may make them
useful to an entity as part of its financing.

Example

ABC has equity consisting of 1 million shares of Rs 10 each and retained earnings of Rs
40 million. It just raised Rs 25 million in debt funds with warrants attached. The
debentures carry a 10 percent coupon rate, and with each debenture (Rs 1,000 face value)
investors receive one warrant entitling them to purchase four shares of common stock at
Rs 30 a share. What would be capitalization of the company before financing, after
financing, and after complete exercise of the warrants (in million)?

Valuation of Warrants

The theoretical value of a warrant can be determined by:

= (Ps – E) * N

Where;
N is number of shares that can be purchased with one warrant
Ps is market price of share
E is the exercise price
Warrant’s value assumed to be zero if share price is less than exercise price and in this
case warrant will be “out of the money”. When share is price is greater than exercise price
warrant’s value will be positive and in this case warrant will be “in the money”. When
share price and exercise price is equal then warrant will be “at the money”.

When warrant is issued in conjunction with a bond, its implied price/value can be
determined as follows:

Issue price of the bond – Value of the bond

Class practice

ICMA March 2015 Q 3

Market Risk and Returns

Return is the actual income received (dividend/interest) plus any change in market value
of asset/investment (capital gain).
It can be calculated using following formula:
Dividend + Capital gain
Value at start
Risk
Risk is the variability of actual return from the expected return of an asset/investment.
Risk associated with single asset is assessed from both behavioral and a
quantitative/statistical point of view.

The behavioral view is obtained by using sensitivity analysis or probability distribution.

The statistical is measured by standard deviation using following formula:
SD= √Σp(return-average return)^2

Example

Two investments have the following returns:

Investment-1
Probability .1 .4 .2 .3
Return 10% 30% 40% -20%

Investment-2
Probability .3 .3 .2 .2
Return 10% 20% 30% 0%

Risk and Return in portfolio context

Portfolio is collection/combination of group of assets/securities. Risk is reduced by
making a portfolio having a co-relation of less than +1. This increase the return and /or
reduces the risk and gives better result than individual asset/security.
Diversification to reduce risk: the correlation of investment returns
The extent to which investment risk can be reduced by building a portfolio of different
investments depends on the correlation of the returns from the different investments in
the portfolio.
 When returns from different investments in a portfolio are positively correlated,
this means that when the returns from one of the investments is higher than expected,
the returns from the other investments will also be higher than expected. Similarly,
when returns from one investment are lower than expected, the returns from all the
investments in the portfolio will be lower than expected.
 When returns from two different investments in a portfolio are negatively
correlated, this means that when the returns from one of the investments is higher
than expected, the returns from the other investment will be lower than expected.
 When returns from two investments are neither positively nor negatively
correlated, this means that when the returns from one investment are higher than
expected, the returns from the other investment might be either higher or lower than
expected.
Investment risk is reduced by building up a portfolio of investments whose returns are
negatively correlated, or where correlation is low.
Return of a two assets portfolio = %x.Rx + %y.Ry
Example
A company has invested in two listed securities X and Y. Investment in security X is Rs
150,000 (face value Rs 25,000) and investment in Y amounted to Rs 150,000 (face value
Rs 50,000). During the year both the companies paid 10% dividend. The value of
securities at the end of year was Rs 200,ooo each. Compute the return of securities
separately and return of portfolio.

Risk of a two assets portfolio = √ (𝑾𝑨𝒙𝑺𝑫𝑨)^𝟐 +(WBxSDB) ^2+2(WAxSDA)

(WBxSDB) (CorrelationAB)
Correlation AB= Covariance AB
(SDA)(SDB)

Covariance AB= (SDA) (SDB) (Correlation AB)

OR
∑P (SDA) (SDB)
OR
∑P (A- A) (B-B)
Example
A company has invested in two listed securities X and Y. Investment in security X is 60%
and investment in Y is 40% of total investment. Standard deviation of X is 5% and Y is 3%
and the correlation between X and Y is 0.8. Calculate the risk of portfolio.
Making investment decisions
If the risk return characteristics of a portfolio are compared to those of the portfolio with
a new investment there are a series of possible outcomes. Not all of these would allow a
decision to be made:

Return Risk Conclusion

Improved by new Risk lowered by
investment new investment
Improved by new Stays the same Accept the investment – it improves
investment the risk return position
Stays the same Risk lowered by
new investment
Return reduced by Risk increased by
new investment new investment
Stays the same Risk increased by Reject the investment – it will make
new investment the risk/return position less
Return reduced by Stays the same favourable.
new investment
  Unable to decide. It depends on whether
the fall in return is compensated by the fall
in risk.
  Unable to decide. It depends on whether
the increase in return is thought to be
adequate compensation for the increase in
Risk.

Return of a three assets portfolio = %x.Rx + %y.Ry+%z.Rz

Risk of a three assets portfolio = √ (𝑾𝑨𝒙𝑺𝑫𝑨)^𝟐 +(WBxSDB) ^2+

(WCxSDC)^2+2(WAxSDA) (WBxSDB) (CorrelationAB)+ 2(WAxSDA)
(WCxSDC) (CorrelationAC)+ 2(WBxSDB) (WCxSDC) (CorrelationBC)
Example
A company has invested in three listed securities X, Y and Z. Investment in security X is
20%, investment in Y is 30% and Z is 50% of total investment. Risk of X is 8%, Y is 10%
and Z is 11%. Correlation between X and Y is 0.1, Y and Z is .9 and Z and X is -.2. Calculate
the risk of portfolio.
Systematic and unsystematic risk
There are two types of risk:
 Unsystematic risk, which is risk that is unique to individual investments or securities,
that can be eliminated through diversification.
 Systematic risk, or market risk. This is risk that cannot be diversified away,
because it is risk that affects the market as a whole, and all investments in the market
in the same way.

Return per unit of risk

Another way of assessing the performance of a portfolio is to find out the reward per unit
of risk undertaken.
There are two methods of measuring reward to risk ratio as follows:
i- Sharp ratio
The Sharpe ratio summarizes the risk and return of a portfolio/security into a single
measure that categorizes performance on a risk adjusted basis. It can be calculated using
following formula:
Sharp ratio = Return of security – Risk free return
S.D of security
The larger the ratio, the better the portfolio has performed.

ii- Treynor Ratio

The ratio measures the risk premium of the portfolio where the risk premium is the
difference between the return and the risk free rate. The risk premium is related to the
amount of systematic risk present in the portfolio.

Treynor ratio = Return of security – Risk free return

Beta
Beta of a Security can be calculated as follows:

Covariance of security with market

Variance of market

∑P(x-x) (m-m)
∑P(m-m)^2

∑P(x-x)
∑P(m-m)

SD Security x correlation with market

Market SD
The beta factor of a portfolio

A beta factor for a portfolio is the weighted average value of the beta factors of all the
individual securities in the portfolio. The weighting allows for the relative proportions of
each security in the portfolio.

Beta of portfolio= W%x.Betax+ W%y.Betay+ W%z.Betaz

Class practice

ICMA

November 2013 Q 4(b)

Alpha factor

The beta factor for shares is a measure of systematic risk and it ignores variations in the
equity returns caused by unsystematic risk factors. When shares yield more or less than
their expected return (based on the CAPM), the difference is an abnormal return. This
abnormal return might be referred to as the alpha factor. This is the return over
and above the expected return calculated through CAPM.

Profitability Index

Another method to decide about the investment is profitability index. The ratio of NPV to
capital investment is called the profitability index. The decision rule is therefore to
invest in the projects with the highest profitability index. Profitability Index is calculated
as follows:
PI= Net present value
Investment amount
Coefficient of Variation

The coefficient of variation is a measure of relative dispersion (risk) – a measure of risk

“per unit of expected return. Coefficient of variation is calculated as follows:

Coefficient of variation (CV) = Standard deviation/Return

The larger the CV, the larger the relative risk of the investment. Portfolio with lowest CV
is the efficient portfolio and should be selected.

Attitude towards Risk

  Risk Averse
 Risk neutral
 Risk Taker

Recommended study Material

Financial Management and Policy 12th edition Chapter 2, Chapter 3, Chapter

20 and Chapter 21.
ICAP CFAP 04 BFD study text – Chapter 14

Past papers recommended questions for practice

ICMAP

Attempt Q No in paper
1 February 2013 3
2 August 2013 3
3 November 2013 3 (a&b)
4 November 2013 4(b)
5 May 2014 3
6 August 2014 2
7 August 2014 4
8 March 2015 3
9 August 2015 3
10 August 2015 4
11 August 2015 5
12 August 2016 3
13 February 2017 3
14 February 2017 5
15 September 2017 5
16 February 2018 3
17 February 2018 5
18 May 2018 3 (a&b)
19 August 2018 3 (a&b)
20 August 2018 5 (a&b)

ICAP

Attempt Q No in paper
1 Summer 2008 WACC 2
2 Winter 2008 WACC 6
3 Winter 2009 Right Issue 5
4 Summer 2010 Right Issue 5
5 Summer 2008 Portfolio theory 1
6 Winter 2008 Portfolio theory 1
 7 Winter 2008 Portfolio theory 7
8 Winter 2009 Portfolio theory 1
9 Winter 2010 Portfolio theory 3
10 Summer 2011 Portfolio theory 2
11 Winter 2012 Portfolio theory 5
12 Winter 2013 Portfolio theory 6
13 Summer 2015 Portfolio theory 3
14 Winter 2015 Portfolio theory 4