Security Valuation Chapter Guide

Chapter - 6
SECURITY VALUATION
Contents
1. INTRODUCTION TO SECURITY VALUATION ..................................................................................................................................... 3
(A) FUTURE INFLOWS:................................................................................................................................................................................ 3
(B) FAIR EXPECTED RETURN (OR REQUIRED RETURN): ............................................................................................................ 3
(C) CALCULATION OF FAIR PRICE .......................................................................................................................................................... 4
UNIT-I
BOND / DEBENTURE VALUATION
2. INTRODUCTION TO BOND ......................................................................................................................................................................... 5
3. BASIC TERM OF BOND: ................................................................................................................................................................................ 5
4. VALUE OF DIFFERENT TYPES OF BOND ............................................................................................................................................. 5
(A) VALUE OF ANNUAL EQUAL COUPON BOND: .............................................................................................................................. 5
(B) VALUE OF SEMI-ANNUAL INTEREST BOND: .............................................................................................................................. 5
(C) VALUE OF ZERO COUPON BOND OR VALUE OF DEEP DISCOUNT BOND ....................................................................... 5
(D) VALUE OF VARIABLE COUPON BOND ........................................................................................................................................... 5
(E) VALUE OF PERPETUAL BOND [IRREDEEMABLE BOND]: ..................................................................................................... 6
(F) VALUE OF OUTSTANDING BOND/ VALUE OF OLD BOND/ VALUE OF BOND AFTER ISSUE DATE: .................... 6
(G) VALUE OF BOND ON MID OF TWO INTEREST PAYMENT DATE [DIRTY PRICE]: ....................................................... 6
(H) VALUE OF CONVERTIBLE BOND...................................................................................................................................................... 6
5. EXTENSION OF LIFE OF BOND ................................................................................................................................................................. 7
6. RETURN OF BOND OR YIELD OF BOND ............................................................................................................................................... 7
(A) USING ONE YEAR/ONE PERIOD CASH FLOWS: ......................................................................................................................... 7
(B) USING CASH FLOWS OF MORE THAN 1 YEAR/1 PERIOD: .................................................................................................... 7
7. DIFFERENT TYPES OF RETURN OF BOND ......................................................................................................................................... 8
(A) CURRENT YIELD (CY):................................................................................................................................................................................. 8
(B) HOLDING PERIOD RETURN: ......................................................................................................................................................................... 8
(C) YIELD TO MATURITY (YTM)/ANNUAL REDEMPTION YIELD: .............................................................................................................. 8
(D) YIELD TO CALL (YTC): ................................................................................................................................................................................ 9
8. COMPARISON AMONG COUPON RATE, REQUIRED RETURN AND ACTUAL COMPOUND RETURN (YTM) .......... 9
9. ACTUAL REALISED YIELD OR MODIFIED YTM OR ACTUAL YIELD WHEN RE-INVESTMENT IS MADE AT
SPECIFIED RATE .......................................................................................................................................................................................... 10
10. BOND INDIFFERENCE BETWEEN TAXABLE BOND & TAX-FREE BOND: .......................................................................... 11
11. SOME CONCEPTS RELATED TO CONVERTIBLE BOND .............................................................................................................. 11
(1) CONVERSION PREMIUM: .................................................................................................................................................................. 11
(2) PREMIUM PAYBACK PERIOD:........................................................................................................................................................ 11
(3) PREMIUM DISCOUNTED PAYBACK PERIOD: .......................................................................................................................... 12
(4) CONVERSION PARITY PRICE OF SHARE: .................................................................................................................................. 13
(5) PERCENTAGE OF DOWNSIDE RISK FOR OPTIONAL CONVERTIBLE BOND:.............................................................. 13
(6) PREMIUM OVER FLOOR VALUE OR PREMIUM OVER STRAIGHT VALUE OF BOND: .............................................. 13
// CA NAGENDRA SAH // WWW.FMGURU.ORG

Page 6.2 SFM (CONCEPT SUMMARY)
12. BOND DURATION ........................................................................................................................................................................................ 13
13. BOND VOLATILITY/MODIFIED BOND DURATION ...................................................................................................................... 13
14. EFFECT OF CHANGE IN YTM ON BOND PRICE OF DIFFERENT LIFE .................................................................................. 14
15. BOND IMMUNIZATION ............................................................................................................................................................................. 14
16. BOND REFUNDING ..................................................................................................................................................................................... 14
UNIT-II
SHARE VALUATION
17. ANALYSIS OF FINANCIAL STATEMENT ............................................................................................................................................ 16
(I) WORKING CAPITAL ..................................................................................................................................................................................... 16
(II) CAPITAL EMPLOYED .................................................................................................................................................................................. 16
(III) OPERATING CAPITAL EMPLOYED (OCE) .............................................................................................................................................. 16
18. SOME IMPORTANT RATIOS .................................................................................................................................................................... 17
19. HOW DOES GROWTH GENERATE IN DIVIDEND & EARNINGS? ............................................................................................ 19
20. COST OF CAPITAL ....................................................................................................................................................................................... 20
21. SPECIIFIC COST OF CAPITAL ................................................................................................................................................................. 20
(1) COST OF DEBT (KD) .............................................................................................................................................................................. 20
(2) COST OF BORROWING (KB).................................................................................................................................................................. 21
(3) COST OF PREFERENCE SHARE (KP) ............................................................................................................................................. 21
(4) COST OF EQUITY (KE): ........................................................................................................................................................................ 21
(5) COST OF RETAINED EARNING (KR) .............................................................................................................................................. 22
22. MARGINAL COST OF CAPITAL............................................................................................................................................................... 22
23. VALUATION OF EQUITY SHARE/CALCULATION OF FAIR PRICE OF SHARE ................................................................... 23
24. PRICE EARNINGS RATIO (PE RATIO)................................................................................................................................................. 25
25. CONCEPT OF ADR/ GDR ........................................................................................................................................................................... 25
26. EARNING BASED Model FOR SHARE Valuation............................................................................................................................. 26
(A) GORDON’S MODEL..................................................................................................................................................................................... 26
(B) WALTER MODEL ....................................................................................................................................................................................... 26
(C) P/E MULTIPLE APPROACH ..................................................................................................................................................................... 26
27. INVESTMENT DECISION AND EFFECT OF INVESTMENT DECISION ON SHARE PRICE ............................................. 26
28. RIGHT ISSUE .................................................................................................................................................................................................. 27
29. LEVERAGE ...................................................................................................................................................................................................... 30
30. INCOME STATEMENT ANALYSIS TO UNDERSTAND LOGICS OF LEVERAGE FORMULA ............................................ 31
31. CONVERTIBLE PREFERENCE SHARE ................................................................................................................................................. 32

REVIEWS

SECURITY VALUATION Page 6.3
INTRODUCTION TO SECURITY VALUATION

Calculation of fair price of securities is also known as valuation of securities. Fair price of a security is that value
which buyer wants to pay & seller wants to receive.
Normally, fair price of securities is calculated on current date (i.e. Year 0).
Fair value of any security (i.e. Bond/Debenture, Preference share, Equity share, Commercial paper, T -Bill, etc.
depends upon:
(A) FUTURE INFLOWS &
(B) FAIR EXPECTED RETURN (REQUIRED RETURN) BASED ON RISK
Normally, fair price of a security is calculated from buyer’s point of view. However, it doesn’t matter whether
fair price is calculated from buyer’s point of view or seller’s point of view because fair price is fair for both
buyer and seller.
At fair price, demand and supply becomes equal (i.e. at equilibrium point).
Fair price of a security is also termed as:
www.fmguru.org
(a) Equilibrium price,
CA Nagendra Sah
(b) Intrinsic value, FCA, B. Sc. (H), CFAL1
(c) Theoretical Value,
(A) FUTURE INFLOWS:

Future inflows from different securities are different.
For example:
(i) Inflow from bond/Debenture = Interest or/and redeemable value
(ii) Inflow from Preference Shares = Dividend or/and redeemable value
(iii) Inflow from Equity share = Constant Dividend or Growing Dividend
(iv) Inflow from T-Bill = Maturity value (Equal to face value)
(v) Commercial Paper = Maturity value (Equal to face value)
Short term debt instrument (traded in money market i.e. T-Bill, Commercial paper, certificate of deposit, call
money/Notice money, etc.) are redeemed at face value. They never pay any interest during holding period.
Difference between issue price and redeemable value is earning/int erest.
(B) FAIR EXPECTED RETURN (OR REQUIRED RETURN):

It depends upon risk factor:
High risk  High expected return
Low risk  Low expected return
If risk factor (Beta) of Security is given Calculate fair expected return using CAPM OR APT (Refer Portfolio).
If proxy entity risk factor is given Calculate expected return of Proxy entity and “Assume that return”
as required return of given Security.
If Similar risk Industry return is given Use similar risk industry return as fair expected return.
If nothing is mentioned Use “cost of capital” [% Expenses of company] as fair expected
return of investor.

(C) CALCULATION OF FAIR PRICE
Value of any security/instrument is PV of future inflows calculated using required return as discount rate.
Explanation:
0Y 1Y
Security Inflow = 1000

Face value
1000
Assumed redeemable value is face value
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Fair Price =? FCA, B. Sc. (H), CFAL1
Fair price of this security depends upon types of instrument and issuer credit worthiness (i.e. associated ri sk
factor with 1000 inflow).
Case-(i): Above instrument is T-Bill issued by RBI
It means there is no any uncertainty in 1000 inflow at 1 year end. In other words, it is risk free
securities.
On market research, we find risk free return is 7% (i.e. return on fixed deposit)
Hence,
1000 1000
Fair Price = = = 934.58
(1+𝑖)𝑛 (1+0.07)1
Case-(ii): Above instrument is Bond issued by SBI [Zero coupon bond]
In this case also, there is no risk in 1000
Fair expected return = 7%
1000 1000
Fai price = = = 934.58
(1+𝑖)𝑛 (1+0.07)1
Case-(iii): Above instrument is Bond issued by DHFL (Diwan Housing Finance Limited)
Back Ground: Share Price 52Week High: 691 & 52Week Low Price: 97  It shows High risk
It means there is high uncertainty involved in 1000 inflow.
In this case, buyer expects high return from above securities.
We can calculate fair expected return using CAPM or APT if risk factor is available
Say, Fair Expected Return is 20%. In this case,
1000 1000
Price = = ̅ (Low price due to high required return.)
= 833.𝟑
(1+𝑖)𝑛 (1+0.2)1
Relationship Between Price and Inflow
High future inflows = High price
Low future inflows = Low price
Relationship Between Price and Required Return
High required return = Low price
Low required return = High price
In other words, future inflows are directly related with price but required return are in versely related with
price.
SECURITY VALUATION
Unit-I Unit-II
BOND VALUATION
SHARE VALUATION
DEBENTURE VALUATION

UNIT-I
BOND / DEBENTURE VALUATION
INTRODUCTION TO BOND
Bond/Debenture is a long-term debt instrument which carry fixed interest payable at each year/each 6 month and
maturity value at end of life.
BASIC TERM OF BOND:
A. Face value/par value:
It is the value stated on the face of the bond. Unless otherwise stated, bond is ass umed to be issued at
face value/par value. The face value/par value may be 10 or 100 or 1,000 near to market price.
Coupon interest is calculated on face value irrespective of market price.
B. Redemption value/Maturity value:
The value which the bond holder will get on maturity is called redemption value. If no information
about redeemable value is given, the bond is always assumed to be redeemed at par value. Otherwise
it is redeemed at redeemable value.
C. Coupon rate:
A bond carries a specific interest rate known as the coupon rate. The interest may be paid annually,
semi-annually or even monthly. Coupon rate may be fixed rate (Say 10 % or 12 %)or may be variable
rate (say MIBOR or LIBOR) which fluctuates according to market condition.
Interest payable to bond holder = Par/Face value of bond × Coupon rate
D. Call value:
If bond contains call feature then company can redeem bond before maturity.
Pre-maturity redemption value also termed as call value.
E. Conversion value OR Stock value of Bond:
Convertible bond where bond converted into pre-determined number of equity shares. Value of those
equity shares is known as conversion value.
Conversion Value = Number of Shares per bond × Share price
VALUE OF DIFFERENT TYPES OF BOND

We know,
Value of Bond = PV of future inflows calculated using fair expected return as discount rate (i.e. required return
“RR” as discount rate)
(A) VALUE OF ANNUAL EQUAL COUPON BOND:
It is the bond on which investors are entitled to get equal annual interest at coupon rate and also get maturity value
at end of the bond life (i.e. on maturity date).
Fair Value of bond (B0) = [Annual interest × PVIFA (RR, n)] + [Redeemable value × PVIF (RR, n)]
(B) VALUE OF SEMI-ANNUAL INTEREST BOND:
Semi-annual interest bond is that bond which pay interest semi-annually (i.e. on every 6 month) and Redeemable
value at end of life.
Fair Value of bond (B0)
RR RR
= [Semi Annual interest × PVIFA ( , (life × 2))] + [Redeemable value × PVIF ( , (life × 2))]
2 2
(C) VALUE OF ZERO COUPON BOND OR VALUE OF DEEP DISCOUNT BOND

Zero coupon bonds are those bonds on which investors are not allowed to any interest but are entitled only to
repayment of principal amount on the maturity period.
RV
Fair Value of Zero-coupon bond (B0) = [Redeemable value × PVIF (RR, n)] OR (1+RR)n
(D) VALUE OF VARIABLE COUPON BOND

Annual Interest = Face value × Interest rate prevailing in market
B0 = AI × PVIFA (RR, n) + RV × PVIF (RR, n)

(E) VALUE OF PERPETUAL BOND [IRREDEEMABLE BOND]:
Perpetual bond are those bonds on which interest is paid forever. In other words, we can say that the perpetual
bonds are irredeemable bond.
Annual interest amount
Value of perpetual bond (B0) =
RR(i.e.discount rate)
(F) VALUE OF OUTSTANDING BOND/ VALUE OF OLD BOND/ VALUE OF BOND AFTER ISSUE DATE:
Issue Date NOW 1Y 2Y 3Y Maturity Date
AI AI Price =? AI AI AI AI+RV
PV
These interests are irrelevant = B0
for price because these were
received by previous buyer.
Concept: Current buyer of this bond will receive only four
www.fmguru.org remaining year’s interest & RV. Hence, PV of remaining life
CA Nagendra Sah inflows is considered as price of bond.
FCA, B. Sc. (H), CFAL1
In our example,
Bond Price = [Annual interest × PVIFA (RR, 4)] + [Redeemable value × PVIF (RR, 4)]
(G) VALUE OF BOND ON MID OF TWO INTEREST PAYMENT DATE [DIRTY PRICE]:
1Y 4M Ago 4M Ago 0M 8M 1Y 8M 2Y 8M
AI AI AI
Price= PV
Discount + +RV
@ RR for Value @ RR for 1Y
It includes 4M `
0.667Y at 8M
accrued interest
@ coupon rate. end Discount @ RR for 2Y
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CA Nagendra Sah
Process: FCA, B. Sc. (H), CFAL1
 First calculate price at 8M end excluding interest receivable at 8M end.
 After that, add interest receivable on 8M end. It means, we calculated cum interest price on 8M end.
 Discount it for 0.667 year (8 Months).
(H) VALUE OF CONVERTIBLE BOND

(1) COMPULSORY CONVERTIBLE BOND:
Under compulsory conversion, bond is converted into equity share on maturity date. Investor has no choice.
Inflow of compulsory convertible bond are annual interest and conversion value.
Fair Value (B0) = [Annual interest × PVIFA (RR, n)]+[Conversion value × PVIF (RR, n)]
(2) OPTIONAL CONVERTIBLE BOND:

In this bond, bond holder has choice to convert into equity share on maturity date or take maturity value. It means
inflow to bond holder are:
- Annual interest and
- Redeemable value (RV) or Conversion Value (CV) whichever is higher.
- For optional convertible bond, we can calculate fair value and floor value as follows:
(I) FAIR VALUE:
Fair Value of Optional Convertible Bond (B0)
= [Annual interest × PVIFA (RR, n)] + [{RV or CV whichever is higher} × PVIF (RR, n)]

(II) FLOOR VALUE OR STRAIGHT VALUE BOND:

Floor value/Straight Value of Bond is minimum value of optional convertible bond. In this Bond, when:
(i) RV< CV = Investor opt for CV
(ii) RV>CV = Investor opt for RV
It means minimum inflow on maturity date should be RV. Hence, floor value of bond is calculated using RV.
Floor Value of Optional Convertible bond = [ AI × PVIFA (RR, n)] + [ RV × PVIF(RR, n) ]
NOTE:
Floor Value is calculated for risk analysis only. It is not fair Price but Price that may prevail in bad situation. Hence, we
can say Maximum downside risk = [Bond price – Floor Value]
(I) AMORTISABLE BOND

Under amortizable bond, company repays principle amount equally every year during life time.
In this bond, annual interest amount changes because part of the principle amount repays every year.
Value of Amortisable bond = PV of future inflows
Where,
Future Inflows (p.a.) = Annual interest + Annual Amortizable Value
Value of Bond
Annual Amortizable Value =
Life
EXTENSION OF LIFE OF BOND

If bond contains extension feature then company can extend life of bond for further some years according to terms &
conditions. It means company has choice to extend life of bond.
It is beneficial when outstanding bond coupon rate is lesser than prevailing interest rate on extension/OMD date.
Issue Date OMD (10Y) 20 EMD
Issued bond with Continue old bond

Interest @8% coupon
original life of 10 year
rate 12%
@8% p.a. OR
Special feature:
www.fmguru.org Issue new bond
Life can be extended
CA Nagendra Sah @12% coupon
for further 10Y FCA, B. Sc. (H), CFAL1
Where, It is beneficial for co. to continue old bond @8% coupon.

OMD = Original maturity date
EMD = Extended Maturity Date
RETURN OF BOND OR YIELD OF BOND
Annual Percentage earning in compounded term is known as Yield/Return.
CALCULATION OF RETURN
(A) USING ONE YEAR/ONE PERIOD CASH FLOWS:
There is no question of compounding when investment period.
𝐼𝑛𝑓𝑙𝑜𝑤−𝑂𝑢𝑡𝑓𝑙𝑜𝑤
𝑅𝑒𝑡𝑢𝑟𝑛 = [ × 100]
𝑂𝑈𝑡𝑓𝑙𝑜𝑤
(B) USING CASH FLOWS OF MORE THAN 1 YEAR/1 PERIOD:

0Y 1Y 2Y 3Y 4Y 5Y
(930) 80 80 80 80 80

+1000

930
@ R% (?)

R% is that discount rate where PV of inflows is equal to PV of outflow (i.e. price of bond). We have to use trial
and error assumption (interpolation Technique) to calculate value of R%.
Technique to forecast best assumption of R:
Calculate average annual return & use that return as first assumption of R.
𝑅𝑉−𝐼𝑃
𝐴𝐼+
𝐿𝑖𝑓𝑒
Average 𝑅𝑒𝑡𝑢𝑟𝑛 = [ 𝑅𝑉+𝐼𝑃 × 100] where, AI = Annual Interest; RV =Redeemable Value; IP = Initial Price
2
DIFFERENT TYPES OF RETURN OF BOND

Concepts of all return are same. The only difference is “period “used to calculate return.
Issue Date Purchase Date Conversion Date Sale Date Call Date Maturity Date
CY
HPY
YTM
YTC www.fmguru.org
CA Nagendra Sah
(A) Current yield (CY):
The rate of return over next one year on the amount invested is called current yield.
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐨𝐯𝐞𝐫 𝐨𝐧𝐞 𝐲𝐞𝐚𝐫 𝐏𝐞𝐫𝐢𝐨𝐝

Current yield = × 𝟏𝟎𝟎
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐬𝐡𝐚𝐫𝐞 𝐩𝐫𝐢𝐜𝐞
(B) Holding period return:

Return for the period from purchase date to sale date of an investor is known as holding period return/yield.
(i) If holding period is 1 Year/1 Period:

Holding period return =
Receipt of interest + [Value of bond at end of holding period − Value of bond at begining]
× 100
Bond Value at begining
(ii) If holding period is more than 1 Year/1 Period:
0Y 1Y 2Y 3Y 4Y 5Y
AI AI AI AI AI
P +SV
V
@ R% (?)
HPY
Use interpolation technique to calculate R%
(C) Yield to maturity (YTM)/Annual Redemption Yield:

Return for the period from issue date/purchase date/current date to maturity date is known as YTM.
Read question carefully to find starting date to calculate YTM:
For example:
(i) Current YTM For the period from current date to maturity.
(ii) YTM of an investor From purchase date to maturity date
(iii) YTM as on issue date From issue date to maturity date

For calculation, use same technique as discussed above. First calculate approximate YTM. If PV of inflows is equal to PV
of outflow at that rate then no need to use interpolation otherwise use interpolation.
Redemable Value – IP/PP/CP
Where,
Annual Interest+[ ]
Approximate YTM = Life of bond
Redemable Value+IP/PP/CP × 100 IP= Issue price
2 PP= Purchase Price
CP= Current Price
Note:
In examination, you may calculate approximate YTM instead of calculating exact YTM, if question carry low
mark or you have shortage of time.
When issue price & maturity value are Then coupon rate itself is YTM rate.
face value:
When issue price & maturity value are Then YTM is equal to approximate YTM. In other words,
same but not face value: approx. YTM itself is exact YTM.
(D) Yield to call (YTC):

 Return for the period from issue date/purchase date/current date to call date is known as yield to call.
 Pre-maturity redemption date is also known as call date.
 For calculation, use same technique as discussed above. First calculate approximate YTM. If PV of inflows is
equal to PV of outflow at that rate then no need to use interpolation otherwise use interpolation.
0Y 1Y 2Y 3Y 4Y nY (Call Date)
AI AI AI AI AI
+CV
P
V
Note: In all returns, use “average return” as assumption for interpolation technique.
COMPARISON AMONG COUPON RATE, REQUIRED RETURN AND ACTUAL COMPOUND RETURN
(YTM)
(a) Coupon rate:
It is useful to calculate annual cash flows. Coupon rate is applicable on face value.
(b) Required return:

It is based on risk factor. It is fair expected return. Cash flows are irrelevant for required return.
PV calculated using RR as discount rate may be or may not be equal to actual market price prevailing on
market
0Y 1Y 2Y 3Y 4Y 5Y
AI AI AI AI AI
+RV
P
V
Discount @RR%
May be or may not be equal to (?) www.fmguru.org
Actual price of bond CA Nagendra Sah
(c) YTM or Actual compounded return till maturity period

It is actual compounded return available from bond till maturity date. It depends upon cash flows (i.e.
Actual investment in bond and future inflows).

PV calculated using YTM as discount rate should be equal to actual price of Bond.
0Y 1Y 2Y 3Y 4Y 5Y
AI AI AI AI AI
+RV
P
V
Discount @YTM
Actual price
of bond
Note:
If initial price and redeemable value are face value then “coupon rate” itself is “YTM”.
(a) IF fair price is equal to actual price then “RR = YTM”.
(b) If fair price and actual price both are face value and also RV is face value then “coupon rate = RR = YTM”.
ACTUAL REALISED YIELD OR MODIFIED YTM OR ACTUAL YIELD WHEN RE-INVESTMENT IS

MADE AT SPECIFIED RATE
(1) Assumption of YTM:
Calculation of YTM (or any compounded return) assumes that intermediate period inflows are re-invested at YTM
rate itself otherwise actual compounded return differs.
Example:
Suppose, following are cash flows of amortizable bond:
0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
Calculation of compound return:

0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
PV = ?
@R%
Assume, R = 13% www.fmguru.org
1 1 CA Nagendra Sah
PV = ( + )= 1000.86 FCA, B. Sc. (H), CFAL1
(1+.13) (1+.13)2
It means Return = 13% p.a. compounded annually
[Condition: At 1 year end inflow should be re-invested at 13% itself.]
Verification:
0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
@13%
678
1278
It means, Investment = 1000.86 and Inflow at end = 1278
1000.86 × (1+R)2 =1278
or, (1+R) =
1278
1000.86
∴R = 1.13-1 = 0.13 (13%) Verified.
(2) Actual return if re-investment is made at different rate:

If intermediate period inflows are re-invested at a rate other than YTM rate then return of bond changes and that
changed return is also known as “actual realized yield” or “Modified Yield”

Suppose, in our example above, re-invested rate is 8%. In this case, realized yield of investor should be:
0Y 1Y 2Y
(1000.86) 600 Inflow 600 Inflow
@8%
648
1248
1000.86 × (1+R)2 =1248
or, (1+R) =
1248
1000.86
∴R = 1.1167-1 = 0.1167 (11.67%)
BOND INDIFFERENCE BETWEEN TAXABLE BOND & TAX-FREE BOND:

At indifference point, return of taxable bond and tax-free bond are equal.
Net return of taxable bond = Pre-tax return × (1 – Tax Rate).

It means,
At indifference point:
Return of tax-free bond = Net return of taxable bond
Return of tax-free bond = Pre-tax return of taxable bond × (1 – Tax Rate)
SOME CONCEPTS RELATED TO CONVERTIBLE BOND

(1) CONVERSION PREMIUM:
Extra value of bond over current conversion value is known as conversion premium.
Current bond price (B0) must be higher than current conversion value (CV0) due to interest portion.
Logic:
B0 = PV of interest + PV of conversion or current conversion value
If there is interest, B0 > Current Conversion Value (CV0)
Conversion premium in amount = B0 – CV0

𝐵 – 𝐶𝑉
% Conversion Premium = 0 0 × 100
𝐶𝑉0
Where, 𝐶𝑉0 = Conversion ratio × Current share price
Note:
If question is silent, calculate % premium when question asks for conversion premium.
(2) PREMIUM PAYBACK PERIOD:

It is a time period during which additional investment in bond (i.e. conversion premium) is recovered from
additional earning (i.e. favorable income difference)
Where,
Favourable income difference or additional earning of bond = Annual Interest – Annual Dividend
0Y 1 2Y 3Y 4Y 5Y
B0 = 1200 I = 80 I = 80 I = 80 I = 80 I = 80
CV0 =1000 D =20 D =20 D =20 D =20 D =20
200 60 60 60 60 60
Conversion premium
Favourable Income Difference www.fmguru.org
(Additional investment in bond) CA Nagendra Sah
Where, FCA, B. Sc. (H), CFAL1
I = Interest; D= Dividend equivalent for 1 bond

200 is Conversion premium (i.e. Investor has to pay 200 extra to buy Bond today) for which he/she will receive extra
60 every year.

Premium Payback Period:
Recovery in 3 years = 60+60+60 = 180
Recovery in 4 years = 60+60+60+60 = 240
Required recovery = 200 www.fmguru.org
Using interpolation: CA Nagendra Sah
1Y
?
3Y (?) Y 4Y
180 200 240

20
60
60  1Y
20 
1
× 20 = 0.333 Year
60
Payback period = (3Y + 0.333) = 3.333 Year Ans.
If every year recovery is same then we can calculate it directly by using following formula
Conversion premium 200
Premium payback period = [ In our example, Prem PB Period = = 3.33 years]
n 60
Note:
In premium payback period, we ignore time value of money.
It is also known as Break even period (i.e. no profit, no loss period)
(3) PREMIUM DISCOUNTED PAYBACK PERIOD:

If we consider time value of money in premium payback back period then it becomes premium discounted payback
period.
In same example above, assume discount rate = 10%
0Y 1 2Y 3Y 4Y 5Y
(200) 60 60 60 60 60
54.55 @10%
49.59 @10%
45.08 @10%
40.98 @10%
37.26 @10%
Recovery in 4Y = 54.55+49.59+45.08+40.98 = 190.20

Recovery in 5Y = 54.55+49.59+45.08+40.98+37.26 = 227.46 www.fmguru.org
Required recovery = 200 CA Nagendra Sah
1Y FCA, B. Sc. (H), CFAL1
?
4Y (?) Y 5Y
190.20 200 227.46

9.80
37.26
37.26  1Y
9.80 
1
× 9.80 = 0.263 Year
37.26
Discounted Payback period = (4Y + 0.263) = 4.263 Year Ans.
Analysis:
 If we ignore time value, it is beneficial to buy bond having life more than 3.33 years.
 If we consider time value, it is beneficial to buy bond having life more than 4.263 years.

(4) CONVERSION PARITY PRICE OF SHARE:

At conversion parity,
Current conversion value = Current bond price
or, Conversion ratio × Current share price = B0
∴ Current share price (At parity) B0
= (Conversion
ratio)
In other words, at conversion parity, there is no difference between purchasing share or bond today.
(5) PERCENTAGE OF DOWNSIDE RISK FOR OPTIONAL CONVERTIBLE BOND:

We know, price of optional convertible bond can fall to floor value only (i.e. minimum price of bond).
It means maximum downfall is [Current bond price (B0) – Floor value].
B0 = ₹100 (Say)
Maximum down
fall = ₹20
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Floor value = ₹80 (say) CA Nagendra Sah
𝐵0 – 𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒
% of Downside risk = × 100
𝐵0
100 – 80
In our example, % of Downside risk = × 100 = 20%
100
Note:
For calculation of floor value, refer value of convertible bond concept.
(6) PREMIUM OVER FLOOR VALUE OR PREMIUM OVER STRAIGHT VALUE OF BOND:
𝐵0 – 𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒

% Premium over floor value = × 100
𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒
BOND DURATION
Bond duration is an average time period during which present value of bond is recovered from future inflows. In fact it
is weighted average time period where PV of inflows are used as weight.
Mathematically,
𝚺(𝐘𝐞𝐚𝐫 × 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬) (𝟏×𝑾𝟏 )+(𝟐×𝑾𝟐 )+(𝟑×𝑾𝟑 )+ …
Bond Duration = =
𝚺 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝑾𝟏 +𝑾𝟐 +𝑾𝟑 + …
Where,
W1 = PV-1; W2 =PV-2; W3 = PV-3 and 1,2,3 indicates no. of years.
Note:
 Bond duration of coupon carrying bond is always lesser than its life because of part recovery of bond value during
initial period.
 Bond duration of zero-coupon bond is equal to life because of no recovery of bond value during life time.
 When coupon rate increases, bond duration decreases because of higher part recovery of bond value during initial
period.
 When YTM increases, bond duration decreases because of higher part recover of bond during initial period.
[In other word, Lesser PV of bond value to be recovered from same future inflows.
BOND VOLATILITY/MODIFIED BOND DURATION

𝐵𝑜𝑛𝑑 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝐵𝑜𝑛𝑑 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 =
(1 + 𝑌𝑇𝑀)
Interpretation: Sensitivity of bond price in relation to change in YTM (absolute change) in inverse direction. It means,
if YTM increases by 1% (say from 10% to 11%) then bond price decreases by 2.5% if bond volatility is
2.5 times.

EFFECT OF CHANGE IN YTM ON BOND PRICE OF DIFFERENT LIFE
(i) When YTM or discount rate increases
 Longer life bond price decreases more.
 Shorter life bond price decreases less.
(ii) When YTM or discount rate decreases:

 Longer life bond price increases more.
 Shorter life bond price increases less.
BOND IMMUNIZATION
Bond immunization is an investment strategy used to minimize the interest rate risk of bond by adjusting the portfolio
duration to match the investment time horizon.
 Normally, interest rates affect bond price inversely. But when bond portfolio is immunized, the investor gets a specific
rate of return over a given time period regardless of interest rate.
 Portfolio will be immunized when:
Investment time period = Average bond duration (i.e. weighted average bond duration)
= (BD1×W1)+(BD2×W2)+(BD3×W3)+ ……
BOND REFUNDING
CALL FEATURE:
Call feature allow the bond issuer to redeem the bond and repay them at a pre-determined price before maturity.
Bond issuers use this features to protect themselves from paying more interest.
Some bonds offer “call protection” i.e. it would guaranty not to be called before maturity period and it will affect the
“bond price”.
Example:
 Suppose IDBI had issued 16 Years 1000 bonds 10 year ago @14% p.a. But now interest rate in market is around
9% to 10%.
 If the issuer wants to take the benefit of the call features, it will call back the earlier issued bonds and re-issue it
around 9% to 10% p.a.
 The new proceeds from new bonds may be used to re-pay the existing bonds. In this way, IDBI now enjoy lower
cost for its borrowed money.
EVALUATION OF BOND REFUNDING DECISION:

When bonds redeem before maturity the issuer does not have sufficient cash in hand to repay bond holders. The issuer
can issue new bonds and use the proceeds to redeem the older bonds. This process is called bond defunding.
Implications on bond refunding:

(i) Unamortized floatation cost and Discount on old bond is being debited to P/L Account on which tax saving is
available. However, cost incurred earlier (i.e. at the time of issue of old bond) is not relevant for bond refunding
decision as it is sunk cost.
(ii) Premium on redemption of old bond is outflow and tax saving is also available on this premium.
(iii) Repayment of old bond is also outflow
(iv) Proceeds from new issue of bond is an inflow
(v) Floatation cost on new issue is also outflow on which tax saving will be available over the bond life.
(vi) Coupon rate of old bond is always greater than new bond. Decrease in interest cost on new bond is inflow.
Note:
(i) The face value of new bond is always equal to face value of old bond.
(ii) Life of new bond is equal to remaining life of old bond. If question informs otherwise, then you have to take
decision on the basis of “Annual Equal inflow” (refer capital budgeting)

STEPS FOR EVALUATION OF BOND REFUNDING DECISION:

(1) Calculation of Net initial Outflow:
Particular Amount
(i) Repayment of old bond with premium XXX [Outflow]
(ii) Net proceeds from New issue XXX [Inflow]
(i.e. Value of bond – issue cost –Discount)
(iii) Tax saving on premium of old bond XXX [Inflow]
(iv) Tax saving on unamortized cost of old bond XXX [Inflow]
(v) Overlapping interest net of tax saving on old bond XXX [Outflow]
Net initial out flow XXX [Outflow]
(2) Calculation of Annual Saving:

Particulars Amount
Annual saving in Interest (Existing – New) XXX [Inflow]
Less: Decrease in Tax saving (on interest cost) XXX [Outflow]
Less: Decrease in Tax saving OR XXX [Outflow]

Add: Increase in Tax saving XXX [Inflow]
(on Amortize Discount and floatation cost)
Annual saving XXX [
(3) Calculate net present Value using given discount rate. If discount rate is not given use new interest rate net of
tax as discount rate.
NPV = Annual saving × PVIFA (PIR, n) – Net initial outflow
www.fmguru.org
Decision: CA Nagendra Sah
If NPV is + ve then bond refunding is beneficial. FCA, B. Sc. (H), CFAL1
If NPV is –ve then bond refunding is not beneficial
UNIT-II
SHARE VALUATION

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ANALYSIS OF FINANCIAL STATEMENT
BALANCE SHEET OF ABC LTD.
EQUITY & LIABILITY AMOUNT ASSETS AMOUNT
[Procurement of Fund] () [Utilisation of fund] ()
Capital Equity capital (FV = 10) ₹ 500 Non-Current Assets:
Employed 12% Pref. capital ₹ 200 Plant and Machinery ₹ 800 Capital
Employed
10% Debt ₹ 300 Investment in share of ABC ₹ 120
920 Working
80 Capital
Current Liabilities ₹ 100 Current Assets ₹ 180
TOTAL ₹ 1100 TOTAL ₹ 1100
100
(i) Working Current assets net of current liabilities is known as working capital. In other words, long term
capital capital utilised in day to day working assets is known as working capital.
Formula:
Working capital (WC) = Current Assets (CA)– Current Liabilities (CL) OR
Working capital = Capital Employed – Non-current assets (Including Long term Investment)
In our example, WC = ₹180 – ₹ 100 = ₹ 80 or 1000-920 = 80
(ii) Capital Long term fund raised by company through equity, preference share and debt is called capital
Employed employed.
Formula:
www.fmguru.org Total capital employed = Equity + Pref. + Debt OR
CA Nagendra Sah
FCA, B. Sc. (H), CFAL1 Total capital employed = Non-current assets + long term investment + Working capital
In our example, ₹ 500 + ₹ 300+ ₹ 200 = ₹ 1000 OR ₹ 800 + ₹ 120 + ₹ 80 = ₹ 1000
(iii) Operating That portion of the capital employed which is invested in main business of the company.
capital employed Formula:
(OCE) OCE = Total capital employed – Non-operating investment OR
OCE = Operating non-current asset + working capital
In our example, OCE = ₹ 1000 - ₹ 120=₹ 880 OR (₹ 800 + ₹ 80) = 880
INCOME STATEMENT OF ABC CO.
EH = Equity holder
PARTICULARS AMOUNT (₹)
PH = Preference Holder
Sales ₹ 700
DH = Debt Holder
Less: Operating variable cost (60% of sales) ₹ 420
Contribution ₹ 280 Cost related to Operating activity
Less: Fixed cost (Operating) ₹ 100
EBIT (Operating) ₹ 180 Pre-Tax profit of all investors (EH, PH & DH)
Add: Income from Non-operating investment -
Less: Expense from Non-operating investment -
Total EBIT ₹ 180 Pre-Tax profit of all investors (EH, PH & DH)
Less: Interest on debenture ₹ 30 Share of debenture holder in profit
www.fmguru.org EBT ₹ 150 Pre-Tax profit of 2 investors i.e. EH&PH
Less: Tax @ 30% CA Nagendra Sah ₹ 45
EAT ₹ 105 Post tax profit of two investors (PH & EH)
Less: Pref. dividend (12% of ₹200) ₹ 24 Share of Preference share holder in profit.
Less: Pref. Dividend Tax NIL
EAE ₹ 81 Post tax earning of equity holder
Less: Equity Dividend (20% of 81) ₹ 16.20 Distributed dividend to EH
Less: Equity dividend tax NIL
Earning of EH retained by company for
Retained Earning ₹ 64.80 further investment

SOME IMPORTANT RATIOS

Above Income Statement can be expressed in the following way for better understanding:
EBIT Return on Capital Employed = 18% on ₹ 1000
₹ 180
Pay to Debt Pay to Government Pay to Preference Pay to equity share

(₹ 30) (₹ 45) shareholder (₹24) holder (₹ 81)
Distributed = 20% Retained = 80%

(₹ 16.20) (₹ 64.80)
SUMMARY OF RATIOS
RATIOS FORMULAS IN OUR EXAMPLE

(a) Return on capital Employed Pre-Tax:
𝐄𝐁𝐈𝐓
× 100 OR
180
× 100 =18% or
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝 1000
(Return on Investment) EBIT ( 1−Tax) 180 (1−0.30)
Post-Tax: × 100 ×100 =12.6%
Capital Employed 1000
Post-Tax: Pre Tax ROCE ( 1 − Tax)

www.fmguru.org Explanation: [Reason behind using EBIT ×(1-T)]
CA Nagendra Sah Post-tax profit of all investors
FCA, B. Sc. (H), CFAL1 = EAT + Interest on Debt (1-Tax)
= EBT (1- Tax) + Int. on debt (1-Tax)
= (1-Tax) (EBT + Int. on debt)
= EBIT (1 – Tax)
(b) EPS EAE 81
= ₹ 1.62
No of share 50
(c) DPS Dividend 16.2
= ₹ 0.324
No of share 50
(d) Dividend Payout ratio Dividend
× 100 or
DPS
× 100
16.2
× 100 = 20%
EAE EPS 81
(e) Retention ratio Retained Earning
× 100 or
REPS
× 100
81−16.2
× 100 = 80%
EAE EPS 81
(f) Book value per share (BVPS) Total book value 500
= ₹ 10
No of share 50
(g) Return on equity (ROE) 𝐄𝐀𝐄
× 100 or
𝐄𝐏𝐒
× 100
81
× 100 or 1.62
×100 = 16.2%
𝐄𝐪𝐮𝐢𝐭𝐲 𝐁𝐕𝐏𝐒 500 10
(h) SEGMENT OF ROE DUE TO PRESENCE OF DEBT AND PREFERENCE:
ROE
ROCE Saving from Debt Saving from

preference
EBIT ( 1 − Tax) (𝐑𝐎𝐂𝐄−𝐊𝐝)×𝐃𝐞𝐛𝐭 (𝐑𝐎𝐂𝐄−𝐊𝐩)×𝐏𝐫𝐞𝐟
× 100 × 100
Capital Employed 𝐄𝐪𝐮𝐢𝐭𝐲 𝐄𝐪𝐮𝐢𝐭𝐲

(i) ROCE EBIT ( 1−Tax) 180 (1−0.30)
×100 =12.6%
(Post Tax) Capital Employed 1000
(ii) Saving from (𝐑𝐎𝐂𝐄−𝐊𝐝)×𝐃𝐞𝐛𝐭

× 100
(12.6%−7%)×300
× 100 =3.36%
Debt 𝐄𝐪𝐮𝐢𝐭𝐲 500
Logic:
On investment, company earned 12.6%. But company’s cost of debt net of tax saving is
= 10% × (1- 0.30) = 7%. It means, saving to equity share holder from debt = (12.6%-
16.80
7%) on ₹300 =₹ 16.80. This earning is ( ×100) = 3.36% for equity as investment of
500
equity share holder is ₹500.
(iii) Saving from (𝐑𝐎𝐂𝐄−𝐊𝐩)×𝐏𝐫𝐞𝐟
× 100
(12.6%−12%)×200
× 100 = 0.24%
Preference 𝐄𝐪𝐮𝐢𝐭𝐲 500
Logic:
www.fmguru.org On investment, company earned 12.6%. But company’s cost of preference is 12 %. It
CA Nagendra Sah means, saving to equity share holder from preference = (12.6%- 12%) on ₹200 =₹ 1.20.
FCA, B. Sc. (H), CFAL1 1.2
This earning is ( ×100) % = 0.24% for equity as investment of equity share holder is
500
₹500.
Verification
ROE = 16.2%
ROCE Saving from Saving from

(12.6%) Debt (3.36%) preference (0.24%)
ROCE + Saving from debt + Saving from preference

= (12.6 + 3.36 + 0.24)
= 16.2% (which is equal to ROE)

HOW DOES GROWTH GENERATE IN DIVIDEND & EARNINGS?

BALANCE SHEET OF A COMPANY
SOURCE OF At beg. At 1Y end At 2 Y APPLICATION At beg. At 1Y end At 2 Y
FUND (₹) (₹) end (₹) OF FUND (₹) (₹) end (₹)
Equity capital ₹ 500 ₹ 500 500
(FV=10) Existing non- current 1000 1000 1000
Retained - ₹ 64.80 138 assets & WC
Earning
12% Pref ₹ 200 ₹ 200 200
capital Additional assets 0 64.80 138
10% Debt ₹ 300 ₹ 300 300
TOTAL ₹1000 ₹1064.80 ₹1038 TOTAL ₹1,000 ₹1,064.80 ₹1,138
Fair re-investment rate for Retained earnings
(Additional assets) = Return on ROE (Pre-tax)
16.2
= = 23.1429%
1−0.30
www.fmguru.org
CA Nagendra Sah
PARTICULARS 1Y end (₹) 2Y end (₹) 3Y end (₹)
Total EBIT ₹ 180 195 211.937
Less: Interest on debenture ₹ 30 30 30 Share of debenture holder in profit
EBT ₹ 150 165 181.937
Less: Tax @ 30% ₹ 45 49.5 54.581 Share of Govt in profit
EAT ₹ 105 115.5 127.356
Less: Pref dividend Share of Preference share holder
₹ 24 24 24
(12% of ₹200)
Less: Pref Dividend Tax NIL NIL NIL
EAE ₹ 81 91.5 103.356 Earning of Equity share holder
Less: Equity Dividend ₹ 16.20 18.3 20.671 Distributed profit to EH
Less: Equity dividend tax NIL NIL NIL
Retained Earning ₹ 64.80 73.2 82.685 Co. retains EH’s profit on the
expectation of re-investment at
CALCULATION OF EPS, DPS & ROE min. 16.2% (post-tax) or
PARTICULARS 1Y end (₹) 2Y end (₹) 3Y end (₹) 23.1429% (pre-tax) return
EPS (EAE/No. of shares) 1.62 1.83 2.067
DPS 0.324 0.366 0.4134
SFM CONCEPTS SUMMARY
(Dividend/No. of shares)
ROE (Post tax) 16.2% 16.2% 16.2% BY CA NAGENDRA SAH
𝑬𝑨𝑬 www.fmguru.org
( × 𝟏𝟎𝟎) )
𝑬𝒒𝒖𝒊𝒕𝒚
SUMMARY FOR EPS: SUMMARY OF DPS

0Y 1Y 2Y 3Y 0Y 1Y 2Y 3Y
EPS=1.62 EPS=1.83 EPS=2.067 DPS=.324 DPS=.366 DPS=.4134
% Increase=12.96% % Increase=12.96% % Increase=12.96% % Increase=12.96%

(i.e. Growth) (i.e. Growth) (i.e. Growth) (i.e. Growth)
This growth can also be calculated directly using formula: Retention ratio × ROE = 0.8 × 0.162 = 0.1296 (12.96%).
Notes:
(1) Above annual increase in EPS is also termed as earning growth.
(2) Above annual increase in DPS is also termed as dividend growth.

(3) Earnings growth and dividend growth can also be calculated as:
Fair Growth = Retention ratio × ROE
= 0.80 ×0.162 = 0.1296 (i.e. 12.96%)
(4) Fair reinvestment rate of the retained earnings should be ROE as the retained earning belongs to equity
shareholder and equity holder’s return is ROE. Practically, actual reinvestment rate may differ and hence
actual growth rate may also differ.
(5) Earnings growth and dividend growth remains same if the retention ratio and reinvestment rate remains
same every year.
COST OF CAPITAL
Percentage expenditure of company on fund raised for long term (i.e. capital employed) is known as cost of capital. It
is also known as overall cost of capital (K0) or weighted average cost of capital (WACC).
WACC = (K e×We) +(Kr×Wr) + (K d ×Wd) + (K p × Wp) + (Kb × Wb)

Where,
Ke, Kr, K d & K p are specific cost of capital.
Ke = Cost of equity; K r = Cost of retained earnings; K p = Cost of preference share; K d = Cost of
debenture
𝐄𝐪𝐮𝐢𝐭𝐲 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐃𝐞𝐛𝐭 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝑬𝒂𝒓𝒏𝒊𝒏𝒈
We = ; Wd = ; W p= ; Wr = ;
𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Note:
 Weight may be calculated using book value or market value. www.fmguru.org
 No need to calculate W e and Wr separately if Ke = Kr. CA Nagendra Sah
𝐄𝐪𝐮𝐢𝐭𝐲 𝐜𝐚𝐩𝐢𝐭𝐚𝐥+𝐑𝐞𝐭𝐚𝐢𝐧𝐞𝐝 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 FCA, B. Sc. (H), CFAL1
In this case, calculate only Ke & We = .
𝑻𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
 Calculate We & Wr separately only when Ke ≠ K r [It is due to floatation cost or issue cost on equity.]
Explanation: In our example,

SOURCE OF FUND At beg. (₹) APPLICATION At beg. (₹)
₹81 OF FUND
EH Cost = 16.2% Equity capital (FV=10) 500 Existing non- current
Retained Earning - assets & WC 1000
₹24
PH 12% Pref. capital 200
Cost = 12% Additional assets 0
₹21 10% Debt 300
DH Cost = 7% TOTAL ₹1000 TOTAL ₹1,000
SPECIIFIC COST OF CAPITAL

(1) COST OF DEBT (K d)
I. Cost of Redeemable Debentures 𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 – 𝐍𝐞𝐭 𝐩𝐫𝐨𝐜𝐞𝐞𝐝𝐬
𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐭 ×(𝟏−𝐓𝐚𝐱) +[ 𝐑𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐃𝐞𝐛𝐞𝐧𝐭𝐮𝐫𝐞 ]
Kd = 𝐑𝐞𝐝𝐞𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞+𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 × 100
[ ]
𝟐
II. Cost of Irredeemable Debentures Kd =

𝐀𝐧𝐧𝐮𝐚𝐥 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 × (𝟏−𝐓𝐚𝐱)
× 100
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 𝐟𝐫𝐨𝐦 𝐃𝐞𝐛𝐭
Note:
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(1) Where NP = Issue price – Floating Cost.
CA Nagendra Sah
If question is silent then assume issue price is market price & floating cost is 0. FCA, B. Sc. (H), CFAL1
Hence, NP = Market Price.
(2) If issue price, market price & redeemable value is face value then coupon rate is itself K d [i.e. Kd = Coupon
rate × (1-T)]

(2) Cost of BORROWING (K b) Kb = Interest rate(1 – Tax)
(3) COST OF PREFERENCE SHARE (K P)

I. Cost of Irredeemable Kp =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐞𝐟 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
× 100
Preference 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 𝐟𝐫𝐨𝐦 𝐏𝐫𝐞𝐟.
II. Cost of Redeemable 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐞𝐟 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 +[

𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 – 𝐍𝐞𝐭 𝐩𝐫𝐨𝐜𝐞𝐞𝐝𝐬
]
𝐑𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞
Preference Kp = 𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 + 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 × 100
[ ]
𝟐
Note: www.fmguru.org
(1) Where NP = Issue price – Floating Cost. CA Nagendra Sah
If question is silent then assume issue price is market price & floating cost is 0. FCA, B. Sc. (H), CFAL1
Hence, NP = Market Price.
(2) If issue price, market price & redeemable value is face value then coupon rate itself is K d.
[i.e. Kd = Coupon rate × (1-T)]
III. Cost of Preference share when there is Dividend Tax:
When there is corporate dividend tax, then Annual dividend in above formula will be increase by Tax amount
because both dividend and tax is expense for Company. Dividend tax is calculated on Grossed up Dividend
amount.
Suppose, dividend amount is 100 and tax on dividend is 15%.
In this case,
Grossed Up Dividend =
100
= 117.65
0.85
Dividend Tax = Grossed Up Dividend × 15%
= 117.65 × 15% = 17.65
And total expense for company is (100+17.65) = 117.65.
𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 – 𝐍𝐞𝐭 𝐩𝐫𝐨𝐜𝐞𝐞𝐝𝐬
𝐆𝐫𝐨𝐬𝐬𝐞𝐝 𝐔𝐩 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 +[ ]
𝐑𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐋𝐢𝐟𝐞 𝐨𝐟 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞
In this case, we can use formula: Kp = 𝐑𝐞𝐝𝐞𝐦𝐚𝐛𝐥𝐞 𝐕𝐚𝐥𝐮𝐞 + 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 × 100
[ ]
𝟐
(4) COST OF EQUITY (K e):

I. Dividend Growth Approach Annual dividend with growth is cost to company.
𝐃𝟏
Ke = +𝐠
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬 (𝐍𝐏)
Explanation I:
0 Period 1 Period 2 Period 3 Period 4 Period ∞ Period
D1= 0.324 D2= 0.366 D3= 0.4134 D4= 0.4670

Net
Proceeds
(Say 10)
Discount @ Ke (?)
DERIVATION OF FORMULA In our example, g = 4% (assumed) then,
𝐷
Net Proceeds (NP) = 𝐷1 [i.e. PV of growing perpetuity] 𝐾𝑒 = 1 +𝑔
𝐾𝑒 −𝑔 𝑁𝑃
or, NP × (𝐾𝑒 − 𝑔) =𝐷1 or, 𝐾𝑒 =

0.324
+ 0.1296
10
∴ 𝐾𝑒 =
𝐷1
+𝑔 ∴ 𝐾𝑒 =0.162 (16.2%)
𝑁𝑃
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CA Nagendra Sah
II. Dividend Price Approach Kd =
𝐃𝐏𝐒
×100 FCA, B. Sc. (H), CFAL1
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬

III. Earning Price Approach Kd =
𝐄𝐏𝐒
×100
𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬
Explanation to II & III:

EPS/ DPS=1.62 EPS/ DPS=1.62 EPS/ DPS=1.62 EPS/ DPS=1.62

Net
Proceeds
(Say 10) Discount @ Ke (?)
DERIVATION OF FORMULA In our example,

Net Proceeds (NP) = 𝐸𝑃𝑆 𝑜𝑟 𝐷𝑃𝑆 [i.e. PV of constant perpetuity] 𝐾𝑒 =
𝑬𝑷𝑺 𝒐𝒓 𝑫𝑷𝑺
𝐾𝑒 𝑵𝑷
or, NP × 𝐾𝑒 = EPS or DPS or, 𝐾𝑒 =
𝟏.𝟔𝟐
𝟏𝟎
∴ 𝐾𝑒 =
𝐸𝑃𝑆 𝑜𝑟 𝐷𝑃𝑆
∴ 𝐾𝑒 =0.162 (16.2%)
𝑁𝑃
Note: EPS and DPS of every year remains constant as growth is NIL.
(5) COST OF RETAINED EARNING (K r)

Retained earnings belong to equity holder. Hence, assume cost of equity as cost of retained earnings.
Retained earnings doesn’t attract any floating cost. Hence, use market price to calculate cost (i.e. do not use net
proceeds).
Due to floatation cost, retained earning cost may differ from equity cost.
D EPS or DPS
Formula: 1 + g OR
MP MP
MARGINAL COST OF CAPITAL

New cost to raise additional fund (i.e. new fund) is known as Marginal Cost of Capital.
Marginal Cost of Capital consists:
(i) Marginal cost of equity (MK e)
(ii) Marginal cost of retained earnings (MK r) www.fmguru.org
CA Nagendra Sah
(iii) Marginal cost of preference share (MK P) FCA, B. Sc. (H), CFAL1
(iv) Marginal cost of debenture (MK d)
(v) Marginal cost of borrowing (MK b)
 Formulas are same as studied earlier.

SOURCE OF FUND At beg. (₹) APPLICATION At beg. (₹)
OF FUND
Equity capital 500 Existing non- current
Retained Earnings 100 assets & WC 1100
+
Pref. capital 200 Additional Investment
Debt 300 (Expansion) 900
Equity Share Retained Earning Preference Issue Debenture Issue

₹ 400 ₹ 150 ₹ 125 ₹ 225

Different costs are:

(i) Cost on 400 Marginal cost of equity (MK e)
(ii) Cost on 150 Marginal cost of retained earnings (MK r)
(iii) Cost on 125 Marginal cost of preference share (MK P)
(iv) Cost on 225 Marginal cost of debenture (MK d)
(v) Cost on 900 MWACC (marginal weighted average cost of capital) or (Marginal cost of capital)
(vi) Cost on 500 Existing cost of equity
(vii) Cost on 100 Existing cost of retained earning www.fmguru.org
CA Nagendra Sah
(viii) Cost on 200 Existing cost of preference share FCA, B. Sc. (H), CFAL1
(ix) Cost on 300 Existing cost of debenture
(x) Cost on 1100 Existing WACC or Existing K 0 or Existing cost of capital
(xi) Cost on 2000 Revised cost of capital or Revised WACC or New WACC
Note:
 There is no question of book value weight and market value weight for calculation of marginal WACC as there is no
book value and no market value.
 Use “fund to be raised” to calculate weight.
VALUATION OF EQUITY SHARE/CALCULATION OF FAIR PRICE OF SHARE

We know, value of equity share is PV of future inflow calculated using RR (Required return /Fair expected return)
as discount rate.
Future inflows from equity
(i) Dividend with constant growth; OR
(ii) Dividend with no growth (i.e. 100% payout i.e. EPS = DPS); OR
(iii) Dividend with different growth
Required return of equity:

Fair expected return depends upon risk factor.
High Risk:- High Return
Low Risk:- Low Return
 In different situations, we can calculate required return as mentioned below:
(i) IF risk factor (i.e. β) is given then use CAPM to calculate RR RR = R f + β(R m - Rf)
(ii) IF more than one risk factor is given, use APT RR = R f + β1(Rm1 - Rf)
(Arbitrage pricing theory) to calculate RR. + β2(Rm2 - Rf)
+β3(Rm3 - Rf)+ ……
(iii) If risk factor of similar industry is given Use Similar risk industry’s return as
RR.
(iv) If nothing is available, use cost of equity (K e) as RR. RR = Ke

Calculation of shares price
(1) When there is no Value of Shares (P 0) =
𝐄𝐏𝐒 𝐨𝐫 𝐃𝐏𝐒
𝐑𝐑
growth
Explanation:
EPS or DPS EPS or DPS EPS or DPS EPS or DPS

@ RR
Present @ RR @ RR
Value
(P0) @ RR
Share Price (P0) =

𝐄𝐏𝐒 𝐨𝐫 𝐃𝐏𝐒
It is PV of Constant Perpetuity. (Refer time value of money)
𝐑𝐑
(2) When there is Constant 𝐃𝟏 www.fmguru.org

Value of Shares (P 0) =
growth for indefinite period 𝐑𝐑−𝐠 CA Nagendra Sah
Explanation:
D1 D2 D3 D4
Present
Value
(P0)
@ RR
𝐃𝟏
Share Price (P0) = It is PV of Growing Perpetuity. (Refer time value of money)
𝐑𝐑−𝐠
(3) When there is different First calculate discounted value of cash flows having constant growth for
growth rate indefinite period and then calculate PV of no trend cash flows plus
discounted value.
Explanation:
No Trend cash flows Constant growth cash flows
D1 D2 D3 D4
Present
Value
(P0) @ RR @ RR
P3
𝐷4
P3 = Discounted value of constant growth cash flows i.e. PV of growing perpetuity
𝑅𝑅−𝑔
𝐷1 𝐷2 𝐷3 𝑃3
P0 = + + + www.fmguru.org
(1+𝑅𝑅)1 (1+𝑅𝑅)2 (1+𝑅𝑅)3 (1+𝑅𝑅)3
CA Nagendra Sah

Identification of D 0 and D1 : D1 = D0 × (1+g)

Read question carefully to decide D 0 and D1 as our answer may differs due to different interpretation.
For Instance,
(i) Currently paid dividend D0
(ii) Latest Dividend D0
(iii) Last year dividend D0
(iv) Expected dividend D1
(v) Next year dividend D1
(vi) Current year dividend [Current year dividend to be paid in end of year] D1
(vii) Company pays dividend D0 or D1
(viii) Any confusion D1
PRICE EARNINGS RATIO (PE RATIO)

P/E ratio =
𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞
 Price of share = EPS × P/E ratio
𝐄𝐏𝐒
As price of the share can be calculated using PE ratio it is also called multiplying factor to calculate price. It is
also known as “P/E Multiple Approach” to calculate price.
Fair Price of share
Fair www.fmguru.org
EPS
P/E ratio CA Nagendra Sah
Actual Price of share
Actual
EPS
1
Another formula of fair P/E ratio: Fair P/E ratio =
RR
Explanation:
Fair Price of share EPS
Fair P/E ratio = & Fair Price of share (No Growth Case) =
EPS RR
EPS
1
∴ Fair P/E ratio = RR
=
EPS RR
Summary:
Fair price of share can be calculated using any one of following 2 methods when there is no growth:
𝐸𝑃𝑆
(i) Fair Price of share = OR
𝑅𝑅
1
(ii) Fair price of share = EPS × = EPS × Fair P/E ratio
𝑅𝑅
Note:
Fair P/E ratio may be or may not be equal to actual P/E ratio. Normally, we find actual P/E ratio higher than
fair P/E ratio because actual P/E ratio is derived using actual price of share which considers growth but fair
P/E ratio is derived using fair price of share which ignores growth.
CONCEPT OF ADR/ GDR

ADR ADR is the certificate issued by US depository which represents equity share of Non -US
[American Company. It is denominated in $ currency and listed on US stock exchange.
Depository Receipt] ADR is a negotiable receipt which represents one or more depository shares held by
a US custodian bank, which in turn represent underlying shares of non-US issuer held
by a custodian in the home country.
Non-US company approaches to ADR in order to raise fund in foreign currency and also
to capture foreign investor.
GDR GDR is a certificate issued by a depository bank, which purchases shares of foreign
[Global Depository companies, creates a security on a local exchange backed by those shares.
Receipt]
COST OF ADR/GDR = COST OF EQUITY

Explanation:
Equity Share in (₹)
Infosys Indian
Investors
Equity Sh
in (₹)
BALANCE SHEET Foreign Foreign
Depository Investors
LIABILITY ₹ ASSET ₹
Equity ××× NCA ×××
Current ××× Current ××× www.fmguru.org ADR/GDR in $
Liabilities Assets CA Nagendra Sah
TOTAL ××× TOTAL ×××
ADR & GDR are denominated in foreign currency but when they are incorporated in Balance Sheet, they are
converted in domestic currency and hence not shown separately in Balance Sheet.
EARNING BASED Model FOR SHARE Valuation

(A) Gordon’s Model
(B) Walter Model
(C) P/E Multiple Approach
(A) Gordon’s It is same as dividend growth model.

Model Price of the share can be calculated using following formula:
𝐸𝑃𝑆1 (1−𝑏)
P0 = Where,
𝐾𝑒 −(𝑏×𝑟)
b = Retention ratio
Hence, we can say r = Re-investment rate
P0 = 1
𝐷 (b× r) = Growth
𝐾𝑒 −𝑔
EPS1 (1- b) = D1
(B) Walter Walter provided optimum dividend pay-out theory. According to Walter,
Model (i) If r > Ke Payout ratio should be zero (i.e. Retention 100%)
(ii) If r < Ke Payout ratio should be 100 %
(iii) If r = Ke Pay any dividend www.fmguru.org
Where, CA Nagendra Sah
r = Re-investment rate FCA, B. Sc. (H), CFAL1
Ke = Opportunity cost of equity
r
DPS+(EPS−DPS) ×( )
Price of share = Ke
, [where, EPS-DPS = REPS]
Ke
Note:
r
 If is greater than 1 then keep maximum earning as REPS. In this case, numerator value
Ke
will be maximum and hence the price will be maximum.
r
 If is lesser than 1 then keep Maximum value in DPS for same objective.
Ke
 Ke = discount rate. Dividing by discount rate to calculate PV indicates constant perpetuity.
(C) P/E Price of share (P 0) = EPS × PE ratio
Multiple Where PE ratio = or
1 1
Ke RR
Approach EPS
It is similar to for calculation of price
RR
INVESTMENT DECISION AND EFFECT OF INVESTMENT DECISION ON SHARE PRICE

EVALUATION METHOD 1:
Compare return of project with cost of capital (K0) and take decision.
Case 1: Return of project > K0 (Accept the project)
Case 2: Return of project < K0 (Reject the project)
Case 3: Return of project = K0 (Accept the project)

EVALUATION METHOD 2 :
Compare inflow with outflow and take decision.
Net present value = PV of inflow – PV of outflow
Case 1: NPV = +ve (Accept the project)
Case 2: NPV = -ve (Reject the project)
Case 3: NPV = 0 (Accept the project)
Effect of the investment decision on the price of the share

Case 1: If NPV is positive = Share price will increase by NPV amount.
Case 2: If NPV is negative = Share price will decrease by NPV amount.
Case 3: If NPV is Zero = Share price will remain same.
RIGHT ISSUE
Equity share issued to existing shareholders at concessional rate is known as right issue.
After right issue, price of share decreases.
Balance Sheet of a Company
LIABILITY ₹ ASSET ₹ www.fmguru.org
CA Nagendra Sah
Equity 600 Net Assets of equity holder 600 FCA, B. Sc. (H), CFAL1
(60 share of ₹10)
TOTAL 600 TOTAL 600
For example:
ABC Co. has issued right share in the ratio of 1:4 at issue price of 5. Then,
Right share = 60 ×
1
= 15 Shares
4
New total number of share = 60 + 15 = 75 Shares
Total net assets = (600+ 15×5) = ₹675
Share price after right issue =
675 = ₹ 9 per share (Ex-right price of share)
75
Formula:
(Existing price × Existing no. of share) + (Issue price of right share × Right share)
Ex- right price =
(No. of Existing share + No. of right share)
Note:
 There is no effect of right issue on shareholder’s wealth if investor exercise his right and gets right share.
 If investor ignores right then shareholder’s wealth decreases.
In our example, it decreases by 1% per share.
RIGHT CERTIFICATE AND PRICE OF A RIGHT SHARE AND VALUE OF THE RIGHT
There are three dates associated with right issue. They are:
(i) Right Announcement date
(ii) Record date
(iii) Expiry date
Company issues “right certificate” to all those investors who hold share on record date.
For each share, company issues one certificate and the value of this certificate is known as “value of a right”.

Date when company records the Shareholders’ Date when Right

name to whom Right share to be issued. share to be allotted
Right
Announcement Date Record Date Expiry Date
Share are traded Shares & right are traded

at Cum-right Price separately
Share Right Share Right
www.fmguru.org Traded Separately Traded Separately

Traded at
CA Nagendra Sah at ex-right price at a right price
FCA, B. Sc. (H), CFAL1 Cum- Right Price
NOTE: -
 We assume Pre-Right price and Cum-Right price should be same.
 After record date, if the ex-right price increases due to any good news for the company then the value of the right
certificates will also increase.
Existing Date Record Date
Share ₹10 Share ₹9 R ₹1
Value of the Right

Value of all right certificate out of which investor gets one right share.
Ratio = 1: 4 Record Date Allotment Date
S R Investor gets
one Right
S R share on the
S R basis of these 4
Rights
S R (Certificates)
Value of the Right
Value of the right = Value of a right × No. of right held

Where, R = Right Share
Value of a right = Pre-right price – Post right price

RIGHT SHARE DOESN’T AFFECT THE SHAREHOLDERS EXISTING POSITION.

It is clear from following diagram
Today Future
S 4 Share
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S R CA Nagendra Sah (At Ex-Right
S price) 9 each
S R
S
S R
S
S R 4 Rights 1 Right share
+ Issue Price (5) RS
( 9)
Value of a Right Value of the Right

per share=1 (₹1×4=4)
Existing Value of shareholder = (4 share × 10) = 40
New Value of Shareholder when he sells Right: [In this case he will not receive Right share]
4 Shares at 9 each = 36
Sale Proceeds from 4 rights (right certificates) = 4
Total value after right issue = 40
New Value of Shareholder when he uses Right: [In this case he will receive Right share]
5 Share (Existing 4 and 1 RS) at 9 each = 45
Less: Existing Value = 40
Increase in Value = 5
(for this investor added additional 5 (i.e. Issue Price)
Conclusion:
There is no effect of right issue on shareholder’s wealth if the investor exercises his right or sells right.
However if investors ignores “Right” then shareholder’s wealth gets decreased.
TECHNIQUE TO REMEMBER THE FORMULA:

Cum-Right price (10)
A Right price R
( 1) Ex-Right price ( 9)
R
The Right R
price (4)
R
R www.fmguru.org
Issue price ( 5) CA Nagendra Sah
Above diagram is based on (1:4) ratio as mentioned in our example.
(1) Value of a Right:

(i) Value of a Right = [Cum- Right price] – [Ex- Right price]
(ii) Value of a Right =
[𝐄𝐱−𝐑𝐢𝐠𝐡𝐭 𝐩𝐫𝐢𝐜𝐞]− [𝐢𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞] All formula is based for 1:x Ratio
𝐍𝐨.𝐨𝐟 𝐫𝐢𝐠𝐡𝐭 𝐡𝐞𝐥𝐝
Eg 1:4 or 1:5 etc
(iii) Value of a Right =
𝐜𝐮𝐦 𝐑𝐢𝐠𝐡𝐭 𝐩𝐫𝐢𝐜𝐞−𝐢𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞
Not 2:3 or 3:5
𝐍𝐨.𝐨𝐟 𝐫𝐢𝐠𝐡𝐭 𝐡𝐞𝐥𝐝+𝐍𝐨.𝐨𝐟 𝐫𝐢𝐠𝐡𝐭 𝐬𝐡𝐚𝐫𝐞

(2) Value of the Right:
(i) Value of the Right = Value of a Right × No. of Right held
(ii) Value of the Right = [Ex- Right price] – [issue price]
(3) Ex-Right price:

(i) Ex- right (Cum right price × Existing no. of share) + (Issue price of right share × No. of right share)
price =
(No. of Existing share + No. of new share)
(ii) Ex- right = Cum Right Price – Value of a rights
price
Note: For all above, formula see diagram
LEVERAGE
Risk associated with fixed cost is also known as leverage. There are two types of fixed cost:
 There are 2 types of fixed cost:
FIXED COST
OPERATING FIXED COST FINANCIAL FIXED COST
Fixed cost related to main business. Fixed cost related to financing fund.
E.g.: Depreciation, Rent, Time based E.g.: Interest on deb. & Dividend on
salary, etc. preference
Risk associated with operating fixed Risk associated with financial fixed
cost is known as operating leverage. cost is known as financial leverage.
Risk associated with total fixed cost

is known as combined leverage.

INCOME STATEMENT ANALYSIS TO UNDERSTAND LOGICS OF LEVERAGE FORMULA

Particulars Present Expected
Leverage % Increase/ Decrease
(₹) (₹)
Sales % decrease 10%
100 90
Less: variable cost
60 54
@ 60%
Contribution 40 % decrease 10% 36
𝟒𝟎
OL =
Less: Fixed cost 𝟏𝟔 24 24
= 2.5
% decrease = 25%
EBIT 16 12
i.e. 2.5 times of 10%
Less: Interest on FL due = 𝟏𝟔 8 8
debenture to int. 𝟖
=2 % decrease = 50%
EBT 8 4
i.e. 2 times of 25%
Less: Tax @ 30% 2.40 1.20
EAT % decrease = 50%
5.60 2.80
i.e. 2 times of 25%
FL due 𝟓.𝟔
=
Less: Pref. dividend to Div. 𝟒 1.60 1.60
=1.4
EAE % decrease =70%

4 i.e. 1.4 times of 50% 1.20
EPS www.fmguru.org
( Assume no of CA Nagendra Sah 2 % decrease 70% 0.60
share=2) FCA, B. Sc. (H), CFAL1
1. Degree of operating leverage Contribution % change in EBIT

(i) (ii)
or Operating Leverage EBIT % change in sale or contribution
(i) FL due to interest × FL due to pref. dividend

EBIT EAT EBIT ( 1−tax )
= × =
EBT EAE EAE
EBIT
2. Degree of financial leverage When there is no preference, above formula can be written as because
EBT
or financial leverage EAT = EAE.
EAT
When there is no debenture,
EAE
% change EPS/EAE
(ii)
% change in EBIT
3. Degree of combined leverage % change in EPS / EAE
(i) CL = OL × FL (ii) CL =
or combined leverage % change in sale or contribution
Coverage ratio:
It determines whether the profit of the company is available to cover the claim of investors or not.
1. Instalment coverage ratio or Debt service coverage ratio = 𝐸𝐵𝐷𝐼𝑇
𝐴𝑛𝑛𝑢𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
2. Interest coverage ratio =
𝐸𝐵𝐼𝑇
𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
3. Preference coverage ratio =
𝐸𝐴𝑇
𝐴𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

Techniques to remember formula of coverage ratio:
EBDIT ××× It covers instalments
Less: Depreciation ×××
EBIT ××× It covers interest
Less: Interest on ×××
debenture
EBT ×××
Less: Tax ×××
EAT ××× It covers pref.
dividend
Less: Preference dividend ×××
EAE ×××
ANALYSIS OF LEVERAGE:
 High coverage ratio = High risk
Low coverage ratio = Low risk
 Debt holder uses “Debt service coverage ratio” and “Interest coverage ratio” for risk analysis
 Preference holder uses “preference coverage ratio” for risk analysis.
CONVERTIBLE PREFERENCE SHARE

 Preference share convertible into equity shares.
 All concepts are same as convertible debenture/bond.
P0 – CV0
% Conversion Premium = × 100
CV0
Where,
P0 = Preference share as on today
𝐶𝑉0 = Conversion value as on today

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Chapter - 6

// CA NAGENDRA SAH // WWW.FMGURU.ORG

// CA NAGENDRA SAH // WWW.FMGURU.ORG

// CA NAGENDRA SAH // WWW.FMGURU.ORG

INTRODUCTION TO SECURITY VALUATION

(A) FUTURE INFLOWS:

(B) FAIR EXPECTED RETURN (OR REQUIRED RETURN):

// CA NAGENDRA SAH // WWW.FMGURU.ORG

Security Inflow = 1000

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VALUE OF DIFFERENT TYPES OF BOND

(C) VALUE OF ZERO COUPON BOND OR VALUE OF DEEP DISCOUNT BOND

(D) VALUE OF VARIABLE COUPON BOND

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Issue Date NOW 1Y 2Y 3Y Maturity Date

(H) VALUE OF CONVERTIBLE BOND

(2) OPTIONAL CONVERTIBLE BOND:

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(II) FLOOR VALUE OR STRAIGHT VALUE BOND:

(I) AMORTISABLE BOND

EXTENSION OF LIFE OF BOND

Issue Date OMD (10Y) 20 EMD

Issued bond with Continue old bond

Where, It is beneficial for co. to continue old bond @8% coupon.

(B) USING CASH FLOWS OF MORE THAN 1 YEAR/1 PERIOD:

(930) 80 80 80 80 80

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DIFFERENT TYPES OF RETURN OF BOND

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐨𝐯𝐞𝐫 𝐨𝐧𝐞 𝐲𝐞𝐚𝐫 𝐏𝐞𝐫𝐢𝐨𝐝

(B) Holding period return:

(i) If holding period is 1 Year/1 Period:

(C) Yield to maturity (YTM)/Annual Redemption Yield:

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(D) Yield to call (YTC):

(b) Required return:

(c) YTM or Actual compounded return till maturity period

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ACTUAL REALISED YIELD OR MODIFIED YTM OR ACTUAL YIELD WHEN RE-INVESTMENT IS

Calculation of compound return:

(2) Actual return if re-investment is made at different rate:

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BOND INDIFFERENCE BETWEEN TAXABLE BOND & TAX-FREE BOND:

Net return of taxable bond = Pre-tax return × (1 – Tax Rate).

SOME CONCEPTS RELATED TO CONVERTIBLE BOND

Conversion premium in amount = B0 – CV0

(2) PREMIUM PAYBACK PERIOD:

I = Interest; D= Dividend equivalent for 1 bond

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180 200 240

(3) PREMIUM DISCOUNTED PAYBACK PERIOD:

Recovery in 4Y = 54.55+49.59+45.08+40.98 = 190.20

190.20 200 227.46

// CA NAGENDRA SAH // WWW.FMGURU.ORG

(4) CONVERSION PARITY PRICE OF SHARE:

(5) PERCENTAGE OF DOWNSIDE RISK FOR OPTIONAL CONVERTIBLE BOND:

𝐵0 – 𝐹𝑙𝑜𝑜𝑟 𝑉𝑎𝑙𝑢𝑒 𝑜𝑟 𝑆𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑉𝑎𝑙𝑢𝑒

BOND VOLATILITY/MODIFIED BOND DURATION

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(ii) When YTM or discount rate decreases:

EVALUATION OF BOND REFUNDING DECISION:

Implications on bond refunding:

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STEPS FOR EVALUATION OF BOND REFUNDING DECISION: