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Investment Planning

Module Topics
Overview and Investment Alternatives (Lecture 1) Macroeconomic and Industry Analysis (self study from Prasanna Chandra, IP textbook) Securities Markets (self study from Prasanna Chandra, IP textbook) Risk and Return (Lecture 2) Time Value of Money (already done) Equity Valuations (Lecture 3) Bond Valuations (Lecture 3) Asset allocation, Portfolio Performance & Rebalancing (Lecture 4) Mutual Funds (Lecture 4) Derivatives (Lecture 5) Review of Important Exam questions (Lecture 6)
Financial Planning Academy (FPA) -9322637748

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n)At (1+r)t Financial Planning Academy (FPA) -9322637748 2 .. + An (1+r) (1+r)2 (1+r)n P0 = S(i=1..Investment Evaluation Criteria Rate of Return Risk Marketability Tax shelter Convenience Financial Planning Academy (FPA) -9322637748 Equity Valuations Value of Security (also known as Intrinsic Value) = Present Value of all Cash Flows from that security discounted at an appropriate discount rate P0 = A1 + A2 + ….

Intrinsic Value > Market Value => Underpriced (buy the security) Intrinsic Value < Market Value => Overpriced (sell the security) Intrinsic Value = Market Value => Optimally priced (indifference) Financial Planning Academy (FPA) -9322637748 Equity Valuations In order to determine Intrinsic Value we have 2 variables: Dividend Constant Variable Growing Time horizon Finite Infinite This results in 6 possible cases to determine equity valuations Financial Planning Academy (FPA) -9322637748 3 .Equity Valuations Need to determine Intrinsic Value so that we can understand what to do with the security I.e.

Variable Dividend D1 D2 D3 D4 D5+F r% 0 1 r% 2 r% 3 r% 4 r% 5 P0 = D1 + D2 + ….. CMPD Mode: N. Constant Dividend D D D D D+F r% 0 1 r% 2 r% 3 r% 4 r% 5 P0 = D + D + …. Find NPV Financial Planning Academy (FPA) -9322637748 4 . Find PV Financial Planning Academy (FPA) -9322637748 Equity Valuations Case2: Finite Period. D. I.Equity Valuations Case1: Finite Period. FV.Editor x.. + D + F (1+r) (1+r)2 (1+r)n (1+r)n Using Calculator. Cash Mode: Enter I. + Dn + F (1+r) (1+r)2 (1+r)n (1+r)n Using Calculator. PMT.

. D.. Constant Dividend D D D D r% 0 1 r% 2 r% 3 r% 4 r% ……. + D1(1+g)n-1 (1+r) (1+r)2 (1+r)n + F (1+r)n Using Calculator. Find NPV Financial Planning Academy (FPA) -9322637748 Equity Valuations Case4: Infinite Period. P0 = = D D + D + …. Cash Mode: Enter I.Equity Valuations Case3: Finite Period. Constantly Growing Dividend D1 D1(1+g) D1(1+g)2 D1(1+g)3 D1(1+g)4 +F r% 0 1 r% 2 r% 3 r% 4 r% g 5 P0 = D1 + D1(1+g) + …. + D (1+r) (1+r)2 (1+r)n r $Financial Planning Academy (FPA) -9322637748 5 .Editor x.

¥ (1+r) (1+r)2 (1+r)3 where D1 = D0(1+g) P0 = D1 (r . Constantly Growing Dividend (Gordon’s Constant Growth Formula) D1 D1(1+g) D1(1+g)2 D1(1+g)3 r% 0 1 r% 2 r% 3 r% r% 4 g $……. Variable Dividend D1 D2 D3 D3(1+g) r% 0 1 r% 2 r% 3 r% 4 r% $g …….Equity Valuations Case5: Infinite Period.g) P0 = Financial Planning Academy (FPA) -9322637748 Equity Valuations Case6: Infinite Period. Step 1: Compute Present Value of Dividends received during abnormal growth rate period of n years [Use Cash Mode] Step 2: Compute Present Value of Constantly growing dividends for infinite period [Use formula from Case 5] Step 3: Step 1 + Step 2 [Enter this information in Cash Mode] Financial Planning Academy (FPA) -9322637748 6 . D1 + D1(1+g) + D1(1+g)3 + …….

the individual will get payment only after payments have been made to secured creditors. If individual buys unsecured bond and company defaults. ICRA. Moodys. Risk Category of bond is indicated by Rating from bond rating agency such as CRISIL.Bond Valuations Bond is a fixed income security Future payments are fixed in advance based on coupon and have a limited period of time (maturity) Coupon (C) is regular interest payment from Bond Face Value (or principal or par value) is the amount returned to bondholder on maturity Financial Planning Academy (FPA) -9322637748 Bond Valuations Bonds can be secured or unsecured Secured bonds are bonds in which the promise to pay is backed by specific assets (collaterals) Unsecured bonds have no assets backing them. Unsecured bonds since they are more risky. offer a higher yield than a secured bond of the same risk category. S&P. Varies from ‘AAA’ to D in increasing order of riskiness Financial Planning Academy (FPA) -9322637748 7 . CARE.

. 2 sources of cash flows Coupon payments Principal repayment Value is sum of parts PV (bond) = C + C + ….V (1+r) (1+r)2 (1+r)n (1+r)n C C C C C+Face Value r% 0 1 r% 2 r% 3 r% 4 r% 5 8 .Bond Valuations Bonds are of many types: Pure discount bond(0 coupon bond) pays the bonds face value at maturity Perpetual bond pays stated coupon at periodic intervals and has no maturity date Level coupon bond pays bond’s face value at maturity and a stated coupon at periodic intervals prior to maturity Callable bond gives the issuer the right to buy back the bond before maturity for a specified price on specified date Convertible bond allows the owner to exchange it for a specified number of shares of stock Financial Planning Academy (FPA) -9322637748 Bond Valuations Value of a financial security is the PV of expected cash flows. For bonds. + C + F.

Realized Yield (RY) = While YTM assumes that all the intermediate or annual cash flows can be reinvested at YTM.Yield to Maturity (YTM) = Discounting rate that equates intrinsic value with the current market price is known as yield to maturity 3. Prices of long-term bonds are more sensitive to interest rates changes than prices of short-term bonds Prices of low-coupon bonds are more sensitive to interest rate changes than prices of high-coupon bonds Bond Valuations Bond Returns can be measured as: 1. yield and maturity. a bond that pays a higher coupon will sell at a higher price Bond paying coupon rate exactly equal to its yield will sell at face value.Bond Valuations Price of a bond is inversely proportional to its yield If Price < Par Value => bond selling at discount If Price > Par Value => bond selling at premium If Price = Par Value => bond selling at par 2 bonds of same face value. Current Yield (CY) = Annual coupon interest received per bond / Market price per bond 2. realized yield is computed taking into consideration the reinvestment rate: Step 1: Future value of Interest and Principal repayment using reinvestment rate Step 2: Compute discount rate at which initial cost is equal to future value computed from Step 1 9 .

which considers the size and timing of each cash flow.1 Duration of a coupon bond = 1+y (1+y) + T(c-y) y c[(1+y)T . bonds duration is higher when its coupon rate is lower For a given coupon rate.1] + y Financial Planning Academy (FPA) -9322637748 10 . Duration reflects coupon.Bond Duration Duration is a measure of the weighted average life of a bond. maturity and yield.Number of payments___ yield (1+yield)Number of payments . duration of coupon bond varies inversely with its yield to maturity Duration of a level perpetuity = (1+yield)/yield Bond Duration Duration of level annuity = 1+yield . the 3 variables that determine the response of price to interest rate changes Duration of ‘0’ coupon bond is same as its maturity For a given maturity. a bonds duration increases with maturity Other things being equal.