of MAURITIUS
Financial
Theory & Practice
OUBS002124
OPEN UNIVERSITY
of MAURITIUS
Financial
Theory & Practice
OUBS002124
PROJECT COORDINATION
Open University of Mauritiius
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ii
OPEN UNIVERSITY
of MAURITIUS
Financial
Theory& Practice
OUBS002124
Table of Contents
UNIT 1  THE FINANCIAL SYSTEM
11
21
33
45
55
69
Assignment 83
SOLUTIONS
85
UNIT
Unit Structure
1.0 Overview
1.1 Learning Objectives
1.2 Introduction
1.3 Functions of the Financial System
1.4 Financial Intermediaries
1.5 Primary and secondary markets
1.6 The Relationship between Banks and Companies
1.7 Summary
1.8 Tutorial
1.9 Suggested Reading
1.0 OVERVIEW
This unit lays out the foundation to the understanding of the importance of financial
markets to the economy. The chapter will enable students to appreciate the various
aspects and concepts of financial markets.
1.2 INTRODUCTION
A financial market helps transfer financial assets, real assets and financial risks in
various forms from one entity to another, from one location to another and across time.
The central figure to the whole world of finance is the management of cash as depicted
in Figure 1.
Shareholders
Equity Capital
Employees
Loan
Capital
Lenders
Cash
Government
Government
Customers
Suppliers of Raw
Materials
Figure 1: Uses of Cash
The two main sources of cash are from equity capital and loan capital.
Companies raise money by issuing equity (shares) that is turn bought by individual
and institutional investors. This capital is then invested in various projects that
will bring added profitability to the company. When investors buy a share in a
particular company, they become entitled to future dividends, paid out of profits
by the firm. These investors are also entitled to participate in the management of
the company through their votes in Annual General Meetings (AGMs).
The public, companies and government very often need to spend money now, but do
not have sufficient funds. This loan capital can be obtained by contract a loan with
their banks or other financial institution. The loan is then serviced by meeting interest
payment and capital repayment within the time frame as agreed by both parties.
The Government can also borrow money from investors for various reasons. An
example of the debt contracted by the Government of Mauritius, through the Bank
of Mauritius, is depicted in Illustration 2. Such debts are referred to as Government
Treasury Bills since they have a maturity of less than a year (182 days). Treasury
Notes have a maturity that ranges from 1 year to 10 years. Treasury bonds have
a maturity exceeding 10 years. The Government repays those debts through the
taxes that they collect and from the projects funded by these debts. The following
is an example of a treasury bill issued by Mauritius.
Omnicane Limited
MUR 100,000
Bids Received
MUR 1,000,000,000
Bids Accepted
MUR 920,000,000
Clearing Rate
5.70%
Settlement Date
18 January 2013
Issue Date
18 January 2013
Commencement of Trading
21 January 2013
People always save a portion of their salaries for consumption in future periods.
E.g. Workers who save for their retirement needs move some of their actual
earnings into the future. At retirement, they then use these savings to cater for
their needs. To move money across time, savers have a host of products in which
to invest. Investors need a fair rate of return to compensate them for the use of
their money and in the event that they lose the money. Therefore, a conservative
investor will prefer to invest in Government Treasury Bonds as these as being risk
free. A risk seeking investor will invest in other financial products such as mutual
funds, stocks or even banks. Given the riskiness of these financial instruments, the
return on each of them will differ, with the riskier asset offering more return.
Activity 1
Suppose you are a financial analyst working for a wellknown bank. Currently,
the market is offering the following rates:
Instrument
Return
5%
4%
7%
Stock A (Expected)
10%
Stock B (Expected)
12%
During the day, two potential investors take an appointment with you to discuss
their financial situation and to identify suitable investment opportunities.
Both investors have a capital of Rs 1million to invest.
The first investor is aged 30 and from his personality and subsequent
discussion with him, you find that he is a risk seeking individual. The second
investor has just retired from service and is looking for an investment that
will allow him to have access to the funds at any point in time. Return is not
of a major concern to him and you determine that he is a riskaverse investor.
What are the investments that you will recommend to each of the investors?
Individuals and companies frequently trade one asset for another based on their
usefulness to them at a particular point in time. Investors may trade one currency for
another one or use money to buy a commodity, etc. Consider the following example:
 A Mauritian hotel company e.g. LUX* Resorts pays its Mauritian workers in
Rupees but invoices its services to tourists in Euros. Therefore, it will need to
trade in the foreign exchange markets to exchange Euros for Rupees.
Investors face financial risks which include default risk, a change in foreign
exchange rates, a hike in raw materials, amongst others. These risks can be hedged
by trading different contracts such as forward contracts, futures contracts, swaps,
option contracts, etc. Consider the following:
 Arabica and a coffee manufacturer face different risks related to the price of
coffee. Arabica fears that the price of coffee will increase while the coffee
manufacturer believes that the price of coffee will fall. They can both eliminate
their exposures by entering into a binding agreement referred to as a forward
contract. In such a contract, the coffee manufacturer agrees to sell a fixed quantity
of coffee to Arabica for a specified price and under the contract, Arabica is
obligated to buy the coffee at that specified price. Such an undertaking therefore
eliminates both parties exposure to changing coffee prices.
(c) P
rice discovery of assets at very low costs, thereby aiding liquidity of
financial products trading in different markets
Stock prices and interest rate are valuable information used by different investors
as to their pattern of consuming, saving or dividing their capital among different
asset classes. However, research of these information is timeconsuming and
a costly one for an individual investor. However, when a financial institution
researches the market price/rates, the cost is greatly reduced. The fact that such
information is available at very low cost makes trading easier and hence increases
the liquidity of different assets across different markets.
Open University of Mauritius  Financial Theory & Practice
Secondary markets play a vital role in valuing securities. Any investor buying a certain
financial instrument does not wish to remain invested in that particular asset indefinitely.
Consider the case of a share and a bond. An investor, who has bought a share at a price
of Rs100, will want to realize a profit when the shares price increases to Rs150. Hence,
the importance of a secondary market to provide liquidity (ability to buy or sell a product
in a relatively short period of time and without incurring any loss of value) to sell the
share at Rs150. Comparatively, a bond has a maturity date and a certain redemption
value (price that will be repaid at the end of the maturity period). If an investor holding
a bond wished to hold onto the bond until maturity, he may do so. In other cases, should
he wish to sell the bond before the maturity date, he may do so if a liquid market for
the product exists such that the market will value the security at a certain price at that
particular date.
1.7 SUMMARY
The importance of the financial system to the economy has thoroughly been discussed
in this unit. The key players in the form of financial intermediaries play an important
role and are key to the effective transmission of services and capital. Lastly, we oversaw
the differences between the primary and secondary markets and shedding light on the
relationship between firms and the banking system.
The next unit shall be geared towards capital markets (Stock markets, bond markets,
money markets, derivatives markets, futures markets, forward market, commodities
market, real estate market) and the different financial products traded on those markets.
Close attention shall be paid to the market existing on the Mauritian landscape.
1.8 TUTORIALS
Question 1
How can households, who need to invest their excess funds, reduce their risk?
Question 2
Financial intermediaries can basically be split in two: brokers and market makers.
(a) Discuss the differences between brokers and market makers
(b) In your opinion, should the price earned by market makers be at a premium to the
commission earned by brokers?
Question 3
The evolution of the financial system has contributed massively to the growth of various
economies around the world. Discuss the ways in which the financial system has aided
in this growth with the use of suitable examples.
Question 4
With the use of relevant examples (i.e. recently issued stocks and already trading stocks),
explain the differences existing between the primary and secondary markets?
Question 5
Central Banks across the world have inferred that companies are increasingly dependent
on banks to fund future growth and this relationship has since been under close
supervision due its repercussion on the economy during times of crisis. Discuss the
intricacies of the working relationship between firms and the banking system.
10
UNIT
CAPITAL MARKETS
Unit Structure
2.0 Overview
2.1 Learning Objectives
2.2 Stock Markets
2.2.1 Initial Public Offering
2.2.2 International stock market indexes
2.2.3 The Stock Exchange of Mauritius and the Development Enterprise Market
2.2.4 Measuring the return of a stock
2.3 Bond Markets
2.4 Money Markets
2.5 Derivatives Markets
2.5.1 Futures Market
2.5.2 Forward Market
2.5.3 Swap Market
2.5.4 Options Market
2.6 Commodities Markets
2.7 Real Estate Market
2.8 Summary
2.9 Tutorial
11
2.0 OVERVIEW
After the brief introduction from the previous chapter, Unit 2 explores the world of equities
in detail, spanning from the Mauritian Stock Exchanges to worldwide exchanges. Our
attention to then shift to fixed income markets (bond and money markets). Derivatives
markets (futures, forwards and swaps). An emerging investment trend in the form of
commodities and realestate is also introduced here.
Exchange
Mauritius
United Kingdom
FTSE
France
CAC 40
Germany
U.S.
India
China
South Africa
13
For one particular country, there may exist various exchanges. Any exchange may
possess one index or many indexes. A stock market index is a technique of measuring the
value of a stock market or only a section of the stock market. An index is an important
tool for investors and finance professionals alike in that it describes the evolution of the
market over a certain time period.
Many stock exchanges exist in the U.S. for e.g. NYSE, NASDAQ, S&P500, etc.
Different indices proposes various ways of following these markets e.g. the Wilshire
5000 index computes the market value of all NYSE and American Stock Exchange
including actively traded NASDAQ stocks. On the other hand, the Dow Jones or DJIA
includes 30 bluechip companies. This index has been calculated since 1896.
The stock exchange of Mauritius operates two markets: the Official Market and the
Development and Enterprise Market. There are 42 companies listed on the SEM and
47 companies listed on the DEM. For a company to be able to list on the SEM or the
DEM, it needs to satisfy the exchanges listing requirements. The Official Market of the
SEM has three major indexes: SEMDEX, SEM7 and SEMTRI. On the other hand, the
indexes of the DEM include the DEMEX and the DEMTRI.
Activity 1
Using the official website of the Stock Exchange of Mauritius, find the following
information:
(a) Under which groupings has companies listed on the SEM and the DEM been
categorized?
http://www.stockexchangeofmauritius.com/officialmarketlistedcompanies
(b) W
hat are the listing requirements for a company wishing to list on the SEM
and the DEM?
http://www.stockexchangeofmauritius.com/listingrules
http://www.stockexchangeofmauritius.com/demlistingrules
(c) W
hat are the differences between the SEMDEX, SEM7 and the SEMTRI?
http://www.stockexchangeofmauritius.com/officialmarketindices/index/
semdex/weekly#
(d) W
hat are the difference between the DEMEX and the DEMTRI?
http://www.stockexchangeofmauritius.com/officialmarketindices/index/
semdex/weekly#
Note:
The official website of the stock exchange of Mauritius is:
http://www.stockexchangeofmauritius.com/
A stock market index is used to reflect changes in the average value of a list of
companies which are traded on a particular market. For example, in France the CAC 40
provides such a means. The same goes for the Dow Jones in the U.S. and the SEMDEX
in Mauritius.
The market capitalization is used to measure the size of a company or the size of the
stock market or the size of part of the stock market.
Market Capitalisation of Company A
= (Number of shares of Company A) X (Price of a share of Company at time t)
14
End of Period
Price/MUR
Dividends Per
Share/ MUR
Shares
Outstanding
2,500
2,700
100
5,000
3,500
2,500
150
7,500
1,500
1,600
100
10,000
Security
The Beginning of Period Price column indicates the price of a share at the beginning
of the period under investigation.
The End of Period Price column indicates the price of a share at the end of the period
under investigation.
The Dividends Per Share column indicates the amount of dividends paid to the holder
of one share.
The Shares Outstanding column shows the number of shares held by the company.
Return of Stock A over the period considered
= (Price at end Price at beginning / Price at beginning)
= (27002500 / 2500) * 100%
= 8%
Total Return of Stock A over the period considered
= Price at end + Dividends Paid Price at Beginning
Price at Beginning
= 12%
Carrying out the same calculation for stock B and C will yield:
Stocks
Simple Return
Total Return
28.6%
24.3%
6.7%
13.3%
15
Total Market
Capitalisation of
Index/ MUR
Weight / %
13,500,000
48,250,000
27.98
18,750,000
48,250,000
38.86
16,000,000
48,250,000
33.16
Weight
Return of the
Stock / %
Weighted Return
27.98
12%
3.4%
38.86
24.3%
9.4%
33.16
13.3%
4.4%
Return of Index
100%
1.7%
Convertible Bonds give the bondholder a guaranteed coupon as well as the option
to exchange the bond into a predetermined number of common stocks of the issuing
company. While this feature allows investors to take advantage of favourable movements
in the price of the issuing companys common stocks, it also enables issuers to offer a
lower coupon rate and thereby reducing their cost of financing. However, in the event of
a default by the issuing company, both the bond and the conversion option may become
worthless. Furthermore, the company can also force conversion by calling the bond.
Eurobonds are international bonds which can be issued by both corporations and
governments with the main aim of tapping secured and longterm financing across a
geographical diverse investment clientele. It is generally underwritten by an international
syndicate and sold simultaneously in many countries different from the country of the
currency in which the issue is denominated. Thus, a dollardenominated Eurobond
would be sold outside the United States only. As an example, a Greek corporation
issuing dollardenominated bonds through a consortium of Japanese, Greek and UK
investment banks.
A Futures contract calls for delivery of an asset at a specified delivery or maturity date
for an agreedupon price, called the futures price, to be paid at contract maturity. The
long position is held by the trader who commits to purchasing the asset on the delivery
date. The trader who takes the short position commits to delivering the asset at contract
maturity. The long position, which commits to purchasing, gains if the asset value
increases while the short position, which commits to selling, loses.
17
Unlike a forward contract, however, a futures contract is not a private and customized
transaction but rather a public transaction that takes place on an organised exchange. In
addition, a futures contract is standardised the exchange, rather than the parties, sets
the terms and conditions, with the exception of price. Also, parties to futures contracts
are guaranteed against credit losses resulting from the counterpartys inability to pay. A
clearing house ensures that credit risk is eliminated.
A forward contract is an agreement between two parties in which one party, the buyer
agrees to buy from the other party, the seller, an underlying asset or other derivative, at
a future at a price established at the start of the contract. The global market for forward
contracts is part of a vast network of financial institutions that make markets in these
instruments. Transactions in forward contracts typically are conducted over the phone.
Although swaps were the last of the main types of derivatives to be invented, they are
clearly not the least important. In fact, judging by the size of the swap market, they are
probably the most important. The Bank of International Settlements had estimated the
notional principal of the global overthecounter derivatives market as of 30th June 2001
at $100 trillion. Of that amount, interest rate and currency swaps accounted for about $61
trillion. Swaps are widely used by corporations, financial institutions and Governments.
Swaps are multiperiod extensions of forwards contracts. For example, rather than
agreeing to exchange British Pounds for U.S. dollars at an agreedupon forward price
at one single date, a foreign exchange swap would call for an exchange of currencies
on several future dates. Similarly, interest rate swaps calls for the exchange of a series
of cash flows proportional to a given interest rate corresponding series of cash flows
proportional to a floating interest rate.
A call option gives its holder the right to purchase an asset for a specified price, called the
exercise price or strike price, on or before a specified expiration date. For example, a December
call option on a MCB share with an exercise price of MUR 35 entitles its owner to purchase
the MCB stock for a price of MUR 35 at any time up to and including the expiration date in
December. The holder of the call need not exercise the option; it will be profitable to exercise
only if the market value of the asset that may be purchased exceeds the exercise price. On the
other hand, a put option is the right to sell an asset at some exercise price. Calls increase in
value while puts decrease in value as the price of the underlying asset increases.
2.8 SUMMARY
In this unit, you explored various types of markets and products while appreciating
the financial products on offer on the Stock Exchange of Mauritius and its scope for
development. The attention is now turned onto one of the most important concept in
finance: The Time Value of Money. Going forward in time, the present value and future
value of money is not the same. Unit Three offers further clarification.
2.9 Tutorials
Question 1
With the help of an example, discuss how stocks are issued on the market
Question 2
Question 3
Money markets and bond markets are believed to be the same and are used
interchangeably. Discuss.
19
20
UNIT
Unit Structure
3.0 Overview
3.1 Learning Objectives
3.2 Time Value of Money
3.3 Factors Influencing the Time Value of Money
3.4 Simple and Compound Interest
3.5 Present Value of Future Cash Flows
3.6 Introduction  Annuity
3.7 Future Value of an Annuity
3.8 Summary
3.9 Tutorial
3.10 Suggested Readings
21
3.0 OVERVIEW
This unit focuses on the time value of money. This chapter is of particular importance in
that cash that is received in the future has a different value from the cash that is received
presently. Future cash flows are subject to inflation and risk across time and these
variables need to be factored in the value of any future cash flows arising. Additionally,
this unit will introduce the concept of simple and compound interest.
22
(b) Inflation
If inflation and hence prices do increase, the purchasing power of money declines over
time. Investors will therefore demand compensation in terms of an inflation premium.
Real riskfree rate + inflation premium = Nominal risk free return
(c) Risk
If there are uncertainties over the promised future cash flows, the investor will require a
risk premium. The level of risk and uncertainty (on which the investment is subject to)
will influence the amount of the risk premium.
Nominal risk adjusted return = Nominal riskfree return + risk premium.
Future value
Present value
Proportional rate of interest per period
Number of periods
Compound interest
Note: Interest earned is not fixed to the principal amount invested (i.e. the initial amount
invested) only; subsequent interest payments depend on previous interest payments as well.
Open University of Mauritius  Financial Theory & Practice
23
Illustration 1:
Suppose you want to invest Rs20,000 for 2 years @ 13% compound interest
per annum.
FV
Illustration 2:
You borrow $4,000 from the MCB to further invest in your business. The contract
terms states that you need to pay 10% interest compounded annually. How much
will you owe in 5 years if you return the banks $4,000 plus interest?
Illustration 3:
How much money must be invested today earning an 11% interest rate compounded
annually to have $500,000 in 5 years?
Note: You know that you want to earn $500,000 in 5 years time. Therefore, future value
= $500,000 and n = 5 years since interest is being compounded annually (alternatively,
it could have been said that the money is being compounded monthly, in which case n
would have equaled to [5x12 = 60] and the interest rate would have been [0.11/12]%)
PV = FV [1/(1+r)]t = 500,000 [1/(1.11)5] = $296,725.7
Illustration 4:
Shares in a sugar plant sell for $4,000 today and will be worth $5,500 in 6 years.
What is the rate of return expressed as an annually compounded interest rate?
r = (FV/PV)(1/n)  1
= (5,500/4,000)1/6  1
= 5.45%
Discrete Compounding
In this section, we examine investments paying interest more than once a year. For
instance, many banks offer a monthly interest rate that compounds 12 times a year. In
such an arrangement, they pay interest on interest every month. Financial institutions
often quote an annual interest rate that we refer to as the stated annual interest rate or
quoted interest rate and is denoted by rs.
24
With more than one compounding period per year, the future value formula can be
expressed as:
FVN = PV [ 1+ (rs/m)mN
Where:
rs the stated annual interest rate
m the number of compounding periods per year
N stands for the number of years
Illustration 5
Suppose your bank offers you a certificate of deposit with a twoyear maturity and
a stated annual interest rate of 8 percent compounded quarterly. You decide to
invest $10,000. What will the Certificate of Deposit be worth at maturity?
PV = 10,000
rs = 8%
N = 2 years
m=4
FVN = PV [ 1+ (rs/m)mN
FV2 = 10000 [ 1+ (8%/4)4x2 = $11,716.59
Continuous Compounding
The predecing discussion on compounding periods illustrates discrete compounding,
which credits interest after a discrete amount of time has elapsed. If the number of
compounding periods per year becomes infinite, the interest is said to compound
continuously. The expression for the future value of a sum in N years with continuous
compounding is:
FVN = PVersN
The termersN is the transcendental number e = 2.7182818 raised to the power rsN.
Illustration 6
Suppose a $10,000 investment will earn 8 percent compounded continuously for
two years. Calculate the future value of the investment.
PV = $10,000
rs = 8%
N=2
FVN = PVersN
FVN = 10000e0.08(2) = $11,735.11
With the same interest rate but using continuous compounding, the $10,000 investment
will grow to $11,735.11 in two years, compared with $11,716.59 using quarterly
compounding, as shown in the previous example.
25
FV = PV (1 + r )n
Now, lets turn the question around! Given that interest is 10% compounded annually
how much we need to invest now to obtain:
Rs1,100 after one year?
Simply make PV become subject of the above formula
PV =
FV
1,100
=
= 1,000
n
(1+r)
(1+0.10)1
FV
1,100
=
= 1,000
n
(1+r)
(1+0.10)2
The future cash flows have been discounted. Discounting is therefore a process, which
inverts the compounding process to provide the present value of the future cash flows.
Example:
Given that an investment will produce Rs1,050 at the end of year 1, Rs1,102.50
at the end of year 2 and Rs1,157.63 at the end of year 3, Calculate the present
value of the investment if the investor requires a rate of return of 5% compounded
annually.
PV =
1,050
1,102.50
1,157.63 = 1,000
+
+
1,051
1,052
1,053
By discounting each of the future cash flows occurring at the end of year 1, 2 and 3,
what we are doing is bringing back all future cash flows to the present value so that they
may be compared. Note that the discounting factor in year three (1/1.053 = 0.864) is
greater than the discounting factor in year one (1/1.05 = 0.952). This shows that future
cash flows that are more distant in the future have a greater discounting factor since they
are more uncertain than those arising at the present value or the first few years.
Therefore, if the present worth of this investment taking into consideration the investors
time value of money (5%) is Rs3,000. In effect, Rs3,000 represents the maximum sum
the investor is prepared to pay now for undertaking the investment. The return on the
investment will be exactly 5% if the investor pays Rs3,000 for the investment; if the
investor pays less than Rs3,000, he will be earning a return of more than 5%. However,
if the investor pays more that Rs3,000, a return of less than 5% will be earned.
In conclusion, we can say that the worth of any asset is currently the present value of the
assets future income stream.
26
Let P denote present value, A being the annuity value and let n denote the number
of terms
P=
A
A
A
A
+
+ .................. +
+
(1+r)1 (1+r)2
(1+r)3
(1+r)n
Multiply [1] by
[1]
1 gives:
(1+r)
P
A
A
A
A
A
=
+
+ .................. +
+
+
(1+r)1
(1+r)2 (1+r)3
(1+r)4
(1+r)n
(1+r)n+1
[2]
P
A
=
(1+r)1 (1+r)1
A
(1+r)n+1
[3]
A
(1+r)n
P + Pr  P = A 
A
(1+r)n
Pr = A
P=A
1
A
(1+r)n
1
A
(1+r)n
r
[4]
27
P=
A
r
[5]
A
A
A
A
+
+ .................. +
+
(1+r)1 (1+r)2
(1+r)3
(1+r)n1
1
P=A+A
[6]
A
(1+r)n1
[7]
Illustration 1:
Calculate the present value of an ordinary annuity of Rs20,000 per year for five
years if the interest rate is 12% per year.
1P = 20,000 x
1
(1+0.12)5
= Rs 72,096
0.12
Illustration 2:
Calculate the present value of a due annuity of Rs20,000 per year for five years if
the interest rate is 12% per year.
1P = 20,000 + 20,000 x
1
(1+0.12)51
0.12
= Rs 80,747
The future value (F) of an annuity invested each period (at interest per period r) beginning
one period from now for n periods is:
F = A + A (1+r)1 + A (1+r)2 + A (1+r)3 + ........................ A (1+r)n2 + A (1+r)n1
2nd Annuity
Last annuity
[1]
1St Annuity
Multiply throughout by (1 + r )
F (1+ r) = A (1+r)1 + A (1+r)2 + A (1+r)3 + ................... + A (1+r)n1 + A (1+r)n
28
[2]
Take 2 1
F (1+ r) F = A (1+r)n A
F + Fr F = A (1+r)n A
F=A
(1+r)n  1
r
Illustration 1
What is the future value of a 5 year ordinary annuity, if the annual interest is 10%, and
the annual payment is $3,000?
F= 3000{(1+0.1)51/0.1} = $ 18,315.3
Illustration 2
Assume that an individual plans to retire at the age of 50, with the life expectancy of
30 years. He expects to spend Rs 50,000 at the end of each year during your retirement.
How much money does he need to save by the age of 50 (lump sum) to support his post
retirement consumption expenditure? Assume an interest rate 7%.
Lump sum at P50 = 50,000 + 50,000 + 50,000
+ ......... + 50,000 =
(1 + 0.07) (1 + 0.07)2 (1 + 0.07)3
(1 + 0.07)30
1= 50,000
1
(1.07)30
0.07
= Rs 620,452.1
The future value (F) of an annuity invested each period (at interest per period r) starting
now for n periods is:
F = A (1+ r) = A (1+r)2 + A (1+r)3 + ................... + A (1+r)n
[1]
Multiply throughout by (1 + r )
F(1+r) = A (1+r)2 + A (1+r)3 + A (1+r)4 +................... + A (1+r)n + A (1+r)n+1 [2]
Term before last term
29
Take 2 1
F (1+ r) F = A (1+r)n+1 A (1+r)
F + Fr F = A (1+r)n+1 A (1+r)
F = A(1+ r)
(1+r)n  1
r
Illustration 1
What is the future value of a 5 year due annuity, if the annual interest is 10%,
and the annual payment is $3,000?
F= 3000 (1+0.1) {(1+0.1)51/0.1} = $ 20,146.83
3.8 SUMMARY
For economic progress to be possible, there must be a universally applicable time value
of money, even in a riskfree environment. This fundamental concept introduced in this
chapter gives rise to the techniques of capitalization, discounting and net present value,
described in Unit 4.
3.9 Tutorials
Question 1
On 1 January 2012, Rs400, 000 was borrowed by Mr Nuri from a bank for a period of
10 years at a fixed annual rate of interest of 15%. Mr Nuri will reimburse interest and
principal by equal annual payments. Calculate the annual payment if:
The first annual payment is effected on 31 December 2012.
The first annual payment is effected on 1 January 2012.
Question 2
Compute the size of the fund at the end of the period if a company decides to set up a
fund for its employees with an initial payment of Rs30,000 compounded sixmonthly
over a five year period at a sixmonthly interest of 5%. Also, calculate the effective
annual interest rate.
Question 3
On January 1, 2013, you will deposit $2,000 into a savings account that carries a 10%
interest per annum.
(i) If the bank compounds interest annually, how much will you have in your
account on Jan 1,2017?
30
(ii) What would your Jan 1,2017 balance be if the bank compounds interest on a
semi annual basis?
(iii) Calculate the effective annual rate of interest if the bank compounds interest on
a quarterly basis.
31
32
UNIT
CAPITAL INVESTMENT
APPRAISAL
Unit Structure
4.0 Overview
4.1 Learning Objectives
4.2 Introduction
4.3 Identifying the Projects Cash Flows
4.4 What Does it Mean to Discount a Sum?
4.5 Methods of Investment Appraisal
4.5.1 The Net Present Value (NPV)
4.5.2 The Internal Rate of Return (IRR)
4.5.3 The Payback Period
4.5.4 The Accounting Rate of Return (ARR)
4.6 Summary
4.7 Tutorial
4.8 Suggested Readings
33
4.0 OVERVIEW
Capital Budgeting is the process that companies use for decision making on capital
projects those projects with a life of a year or more. This is a fundamental area of
knowledge for financial analysts for many reasons. Capital Budgeting undergirds the
most critical investments for many corporations their investment in long term assets.
The process of evaluating longterm investment decision is referred to as Investment
Appraisal. The decision whether or not to select a project will usually depend on the
stream of cash flows which are generated over a given time period. These cash flows
will undergo rigorous transformations under different investment appraisal techniques,
namely: the Net Present Value (NPV) method, the Internal Rate of Return (IRR) method,
the Payback method and Accounting Rate of Return (ARR).
4.2 INTRODUCTION
The specific capital budgeting procedures that a manager uses depend on the managers
level in the organization, the size and complexity of the project being evaluated, and the
size of the organization.
The typical steps in the capital budgeting process are as follows:
Step One:
Generating Ideas  Investment ideas can come from anywhere, from the top or the
bottom of the organization, from any department or functional area, or from outside the
company. Generating good investment ideas to consider is the most important step in
the process.
Step Two:
Analysing Individual Proposals This step involves gathering the information to
forecast cash flows for each project and then evaluating the projects profitability.
Step Three:
Planning the capital budget The company must organize the profitable proposals
into a coordinated whole that fits within the companys overall strategies, and it must
also consider the projects timing. Some projects that look good when considered in
isolation may be undesirable strategically. Because of financial and real resource issues,
the scheduling and prioritizing of projects is important.
Step Four:
Monitoring and PostAuditing In a postaudit, actual results are compared to planned
or predicted results, and any differences must be explained. For example, how do
the revenues, expenses, and cash flows realized from an investment compare to the
predictions?
34
A company wishes to replace a machine which will cost Rs150, 000 and has a
three year life. The company decides to finance the purchase of this machine by
undertaking a loan from the bank. The bank charges an interest rate of 12% per
annum with the principal being paid at the end of the third year.
Year
Initial Outlay
Interest
(18,000)
(18,000)
(18,000)
(150,000)
Principal
Repayment
(150,000)
The above representation is wrong since the present value of the loans cash flows is the
machine initial outlay. The interest and principal are financing cash flows and should
be ignored.
Open University of Mauritius  Financial Theory & Practice
35
18,000 18,000
18,000 + 18,000
+
= Rs 150,000
1
2 +
1.12
1.12
1.123
Changes in the level of working capital represent changes in cash flows. Basically, cash
outflows are represented by increases in the working capital requirement such as increase
in debtors or stocks. In fact, the increase in debtors represents an investment in working
capital as payment of sales is not made immediately. Also, increases in stock are due to
lower stock turnover. On the other hand, cash inflows are represented by decreases in
the working capital requirement. For instance, reduction in stocks may be due to greater
stock turnover or reduction in debtors due to earlier settlement of debt by debtors
ake into account all opportunity costs that may arise from undertaking
T
the project
An opportunity cost is what resource is worth in its nextbest use. For example, if a
company uses some idle property, what should it record as the investment outlay: the
purchase price several years ago, the current market price or nothing? If you replace an
old machine with a new one, what is the opportunity cost? If you invest Rs 10million,
what is the opportunity cost? The answers to these questions are respectively: the current
market value, the cash flows the old machine would generate, and Rs 10million (which
you could invest elsewhere)
Taxation
In the appraisal of an investment project, focus is on the cash flows that will be generated
by the project and that which are available for shareholders. As such, we want to assess
the after tax cash flows of the project. It is important to note that the taxation charge is
levied on the taxable profits of the business and not on the net cash flows.
36
Discounting make is possible to compare sums received or paid out at different dates.
Discounting is based on the time value of money. After all, time is money. Any sum
received later is worth less than the same sum received today. Remember that investors
discount they demand a certain rate of return. If a stock pays you Rs110 in one year and
you wish to see a return of 10% on your investment, the most you would pay today for
the security (i.e. the present value) is 100.
Discounting is calculated with the required return of the investor. If the investment
does not meet or exceed the investors expectations, he will forego it and seek a better
opportunity elsewhere.
Discounted Cash Flow Techniques: Takes into account the time value of money
Net present value
Internal Rate of Return.
Discounted payback
We will now explore these four investment appraisal techniques with the help of the
following example:
Glass Company is a manufacturer of plates for the hospitality sector. Currently,
the firm is considering whether to invest in one of the two proposed machines,
Machine A and Machine B. The Management of Glass Company wishes to revamp
its existing operations and firmly believes that such securing such a machine will
automate its processes and contribute to further savings on its production line.
The following information is provided:
Investment Case: Glass Company
Machine A
(MUR)
Investment outlay (payable immediately)
Machine B
(MUR)
250,000
325,000
Year 1
80,000
90,000
Year 2
90,000
91,000
Year 3
100,000
92,000
Year 4
1100,000
93,000
The rate of return that is expected on projects with similar risk is 7%.
Note: The annual cost savings imply that the company will receive these cash flows and as
such are relevant cash flows for the company
Which one of the above machines should be purchased, should the company decide to
move forward with its investment decision?
37
Calculating the NPV of a project is conceptually easy. There are basically two steps
to be followed:
1. Write down the net cash flows that the investment will generate over its life
2. Discount these cash flows at an interest rate that reflects the degree of risk inherent
in the project
The resulting sum of discounted cash flows equals the projects net present value.
The NPV Decision Rule says to invest in projects when the net present value is positive
(greater than zero):
NPV > 0 Invest
NPV < 0
Do Not Invest
The NPV Rule implies that firms should invest when the present value of future cash
inflow exceeds the initial cost of the project. The firms primary goal is to maximize
shareholder wealth. The discount rate r represents the highest rate of return (opportunity
cost) that investors could obtain in the marketplace in an investment with equal risk.
When the NPV of cash flow equals zero, the rate of return provided by the investment is
exactly equal to investors required return. Therefore, when a firm finds a project with a
positive NPV, that project will offer a return exceeding investors expectations
NPV of Machine A project
250,000 +
90,000 91,000
92,000
93,000
+
+
= Rs 15,356.27
+
1.07
1.072
1.073
1.074
38
Disadvantages of NPV
It is difficult to explain to managers. To understand the meaning of the NPV
calculated requires an understanding of discounting. The method is not intuitive as
techniques such as payback;
It requires the knowledge of the cost of capital;
It is relatively complex.
250,000 +
A variety of computer software can be used to solve the above equation. Alternatively,
linear interpolation, a mathematical technique can be used to estimate the IRR. This
consists of determining two discount rates such that one of them produces a positive
NPV and the other produces a negative NPV.
For Machine As project, a discount rate of 15% produces a positive NPV of Rs
16,262.63 whilst a discount rate of 20% produces a negative NPV of Rs 9,915.12. By
linear interpolation, we apply the following formula to estimate IRR:
IRR= LDR +
=15% +
HDR  LDR
x NPVLDR
NPVLDR  NPVHDR
20  15
x 16,262.63 = 18%
16,262.63 + 9,915.12
Where:
39
The IRR only compares the project yield with that of the capital market. In other words,
it answers the question can the project produce a higher return than the capital market.
However, it does not give an indication to judge between alternative projects like the
NPV i.e how much more or less the project is earning relative to the risk equivalent
capital investment alternative.
Another problem arising with the IRR is that this method gives rise to multiple
IRRs when uneven cash flows are considered. Out of these two investment appraisal
techniques, NPV always prevail over IRR.
Advantages of IRR
Considers the time value of money
Is a percentage and is readily understood
Uses cash flows and not profits
Consider the whole life of the project
Means a firm selecting projects where the IRR exceeds the cost of capital, should
increase shareholders wealth
Disadvantages
It is not a measure of absolute profitability
Interpolation only provides an estimate and an accurate estimate requires the use
of spreadsheet program
It is fairly complicated to calculate
Nonconventional cash flows may give rise to multiple IRRs which means the
interpolation method cannot be used.
The payback period measures the number of years it takes to recover the initial cash
outlay on a real asset. A company can also define a cutoff date i.e. set the number of
years over which it wants to recuperate the initial amount invested. E.g. If a certain
company sets its cutoff date to 2 years, it implies that the company wants to recuperate
its investment within two years. In the event that a project offers a payback period of
3 years, the company will refuse the investment since the payback period (3 years) is
greater than the cutoff date of 2 years. In practice, the faster a firm recoups the initial
capital outlay, the less risky are the projects.
The advantages of the payback period method include the following:
Easy to understand and simple to compute
When capital is scarce or in short supply, it could be argued that projects that
returned the expenditure rapidly are the best ones.
It is useful in certain situations (rapidly changing technology and improving
investment conditions)
It favours quick return, which in turn help company growth, minimizes risk and
maximizes liquidity
It uses cash flows, not accounting profits
The drawbacks of this method are:
Ignore the time value of money.
It does not assess the impact of cash inflows arising after the payback period, which
could greatly affect the projects profitability.
It is subjective no definitive investment signal
It ignores project profitability
40
Consider the following table where the payback period for Machine A is considered:
Year
Cash Flow
Cumulative Cash
Flow
Payback Period
(250,000)
(250,000)
80,000
(170,000)
90,000
(80,000)
100,000
20,000
(80,000/100,000) x
(1 year or 12 months)
= 0.8 years or 9.6 months
110,000
Payback period for Machine project A is 2.8 years or 2 years and 10 months.
Payback period for Machine project B is 3.6 years or 3 years and 7 months. (Calculate it!)
Machine A project has the shortest payback period as it recoups initial capital expenditure
earlier that the Machine B project. Hence, management will consider going forward
with the Machine A project under the payback period method.
The Discounted Payback Period method
The Discounted payback period method has been introduced to cater for the time value
disadvantage borne by the payback period. By discounting the future cash flows arising
from the project, you will have taken into consideration the time value of money.
Consider the following example:
Year
Cash Flow
Discounted
Cash Flow
(at 7%)
(250,000)
(250,000)
(250,000)
80,000
74,766
(175,234)
90,000
78,609
(96,625)
100,000
81,629
(14,996)
68,922
14,996/83,918
x 12 Months
= 3 years and 3 Months
110,000
83,918
Cumulative
Cash Flow
Payback Period
Hence, using the discounted payback period, as opposed to the normal payback period,
the payback period has increased from 2 years and 10 months to 3 years and 3 months.
This new method has taken into consideration the riskiness of the cash flows and has
accounted for the risk by applying the time value of money to it. This would reflect a
more conservative approach by management as regards to the payback period method.
41
Year 1
Rs
Year 2
Rs
Year 3
Rs
Year 4
Rs
80,000
90,000
100,000
110,000
(62,500)
(62,500)
(62,500)
(62,500)
17,500
27,500
37,500
47,500
The average profit over the years is: (17,500 + 27,500 + 37,500 + 47,500) / 4 = Rs 32,500
Hence, the accounting rate of return for Machine project A is given by:
(32,500/250,000) x 100 = 13%
Calculate the accounting rate of return for Machine Project B.
The advantages of this method are:
easy to understand and simple to compute
It takes into account the importance of profitability.
The drawback of this method:
It ignore the time value of money
It makes use of accounting data instead of cash flow data
4.6 SUMMARY
Unit 4 presented various techniques for appraising a project, followed by a discussion
of the strengths and weaknesses of each method. Unit 5 will now build further on the
concept of discounting, with a different application. The methodology will now be
applied to the valuation of shares.
42
4.7 Tutorials
Question 1
Rose Company Ltd is considering investment in either project A or project B. The
management of the company has entrusted you the responsibility to determine the
feasibility of the project. Each project has an initial investment of Rs 200m and the
Weighted Average Cost of Capital (or discount rate or opportunity cost of capital) is
22%. Using both discounting and nondiscounting investment appraisal techniques,
determine which project should be selected.
Year
Project B
90M
75M
85M
70M
80M
65M
80M
65M
Question 2
Matt Ltd is about to undertake a new project which entails into investing in a specialised
machine costing Rs155, 000. The project will last for 5 years, after which it is estimated
that the scrap value of the machine will be Rs20,000, to be received at the end of the
sixth year. There is a maintenance cost to ensure that the machine is working properly.
The amount needed at the end of the first year is Rs10,000 and it is estimated that this
amount needs to be increased by 15% at the closing stages of each subsequent year over
the period of the project. Expected revenue through the use of the machine is estimated
at Rs200,000 at the end of the first year, and this will increase by 5% at the end of each
successive year over the period of the project.
(a) Identify the relevant cash flows of the project
(b) Calculate the NPV of the project given that the discount rate of the project is
15 percent.
(c) Estimate the IRR of the project, outlining the disadvantages of using IRR
(d) Calculate the Payback Period of the project assuming a cutoff period of 4 years.
Question 3
A firm is considering two separate capital projects with cash flows as follows:
Year
Project 1
(20,000)
8,000
5,000
5,000
8,000
5,000
Project 2
(30,000)
10,000
10,000
10,000
10,000
11,000
Both projects are of equal risk and the required return on similar risk projects is 10%
(a)
Based on the NPV criterion, which project will capitalize on the wealth of
shareholders?
(b) Estimate the IRR of each project using linear interpolation.
43
44
UNIT
SHARE VALUATION,
RISK AND RETURN
Unit Structure
5.0 Overview
5.1 Learning Objectives
5.2 Measuring Return on a Share
5.3 Major Categories of Equity Valuation Models
5.4 The Dividend Discount Model
5.4.1 The Constant Growth Dividend Discount Model
5.4.2 Multistage Dividend Discount Model
5.5 Free Cash Flow Valuation Model
5.6 Summary
5.7 Tutorial
5.8 Suggested Reading
45
5.0 OVERVIEW
The equity valuation models used to estimate intrinsic value present value models,
multiplier models and assetbased valuation are widely used and serve an important
purpose. The valuation models presented in this unit are a foundation on which to base
analysis and research but must be applied wisely. Valuation is not simply a numerical
analysis. The choice of model and the derivation of inputs require skill and judgment.
This Unit will focus on the present value models Free Cash Flow valuation and the
dividend valuation models. The key to estimation is to find the intrinsic value of the
share and then compare it to the market price.
D1 + (p1  p0)
P0
Example:
BM stock is selling at Rs 100 a share and investors are expecting the company to
pay a cash dividend of Rs 5 over the next year. Investors also have the information
from their analysts that the price of BM stock will be Rs 120 in one years time.
If they decide to purchase the stock, their expected returns will be as follows.
r=
= 0.25 or 25%
This expected return is originated from two parts, the dividend yield and the capital gain.
46
Expected return
D1
D1  P0
= P +
P0
0
Rs5
= Rs100
Rs120  Rs100
Rs100
=
0.05 + 0.20
=
5% + 20%
=
0.25 or 25%
However, the actual return for BM stock may turn out to be greater or less than what
investors expect.
These models estimate the intrinsic value of a security as the present value of the
future benefits expected to be received from the security. In present value models,
benefits are often defined in terms of cash expected to be distributed to shareholders
(Dividend Discount Model) or in terms of cash flows available to be distributed to
shareholders after meeting capital expenditure and working capital needs (Free Cash
Flow Valuation Models).
These models are based chiefly on share price multiples or enterprise value multiples.
The former model estimates intrinsic value of a common share from a price multiple
for some fundamental variable, such as revenues, earnings, cash flows, or book value.
Examples of the multiples include price to earnings (P/E, share price divided by earnings
per share) and price to sales (Share price divided by sales per share). The fundamental
variable may be stated on a forward basis (e.g. forecasted EPS for the next year) or
a trailing basis (e.g. EPS for the past year), as long as the usage is consistent across
companies being examined. Price multiples are also used to compare relative values.
The use of the ratio of share price to EPS that is, the P/E multiple to judge relative
value is an example of this approach to equity valuation.
These models estimate intrinsic value of a common share from the estimated value of the
assets of a corporation minus the estimated value of its liabilities and preferred shares.
The estimated market value of the assets is often determined by making adjustments to
the book value of assets and liabilities. The theory underlying the asset based approach
is that the value of a business is equal to the sum of the value of the businesss assets.
47
D1
D2
D3
D1
+
+ .................. +
+ ..................
+
2
3
(1+r)
(1+r)
(1+r)
(1+r)4
D1
r
2
2.10
2.20
20
+
+
+
2
3
(1 + 0.10) (1 + 0.10)
(1 + 0.10)
(1 + 0.10)3
D1
rg
The above is known as the constantgrowth dividend discount model or the Gordon
Growth Model. Due to its assumption of a constant growth rate, the Gordon growth
model is particularly appropriate for valuing the equity of dividendpaying companies
that are relatively insensitive to the business cycle and in a mature growth phase.
Examples might include an electric utility serving a slowly growing area or a producer
of a staple food product.
48
Note: The growth rate of a company can be estimated using earnings retention rate
and the return on equity of the business. Growth rate, g = b x ROE
Where,
b is the earnings retention rate = (1 Dividend payout ratio);
ROE is the return on equity of the company
Example:
Dividend, to be paid in next year, is estimated at D1 = Rs5, the growth rate of dividends
is g = 20%, and the discount rate is r = 25%. Therefore, the share value will be:
P0 =
D1
rg
P0 =
Rs5
0.25  0.20
= Rs100
The constant growth formula can be rearranged as follows to calculate the expected
rate of return:
P=
D1
+g
P0
r dividendyield + growthrate
For BM share, the expected firstyear dividend is Rs5 and the growth rate is 20%.
With an initial share price of Rs100, the expected rate of return is
r=
D1
+g
P0
r=
Rs5
+ 0.20
Rs100
r = 0.05 + 0.20
r = 0.25 + 25%
Multistage growth models are often used to model rapidly growing companies. The
two stage DDM assumes that at some point the company will begin to pay dividends
that grow at a constant rate, but prior to that time, the company will pay dividends
that are growing at a higher rate than can be sustained in the long run. That is, the
company is assumed to experience an initial, finite period of high growth, prior to the
entry of competitors, followed by an infinite period of sustainable growth. The two
stage DDM thus makes use of two growth rates: a high growth rate for an initial, finite
period followed by a lower, sustainable growth rate into perpetuity.
Consider the following:
The current dividend, D0, is Rs5.00. Growth is expected to be 10 percent a year for
three years and then 5 percent thereafter. The required rate of return is 15 percent.
Estimate the intrinsic value.
49
5.50
6.05
6.655
69.8775
+
= Rs59.68
+
+
2
3
(1 + 0.15) (1 + 0.15)
(1 + 0.15)
(1 + 0.15)4
All these dividends are future expected cash flows and therefore this means that they
are only estimation. Going on this principle, this implies that these future expected cash
flows should be discounted at the required rate of return 15% to account for the time
value of money and returning it back to the present value. This includes value V3 .
50
FCFt
+
(1 + WACC)t
FCFt
+
(1 + WACC)t
FCFn/WACC
(1 + WACC)n
FCFn/( WACC  g)
(1 + WACC)n
2008
2009
2010
2011
2012
2013
2014e
EBIT
185
225
250
271
272
246
235
Tax
68
83
93
100
101
91
87
+Depreciation &
Amortisation
132
133
138
156
159
162
167
134
141
142
163
165
167
169
 Change on
working capital
38
14
12
8
8
8
8
77
148
141
156
157
142
138
 Capital
Expenditure
To calculate the value during this period, the FCFs are discounted at the weighted
average cost of capital (WACC). With a WACC of 10%, the calculation is as follows:
Value of Company, V1
= (77/1.1) + (148/1.12) + (156/1.13) + (157/1.14) + (157/1.15) + (142/1.16) + (138/1.17)
= 653
Terminal Value of Company = (Normalised free cash flow / WACC g) / (1+WACC)n
Assuming a growth rate of 5 percent,
Terminal value = (138 x (1+g)) / (0.10 0.05) = 2,898 / 1.106 = 1,635
Hence, total value of the company = 1,635 + 653 = 2,288
5.6 SUMMARY
The aim of this chapter was to present the key parameters used in analysing stocks and
show how the market estimates the intrinsic value of a share. Analysts then base their
investment decisions on that comparison. The next session presents the foundation to
one of the largest and fastest growing segments of global financial markets Fixed
Income Securities. The chapter will introduce some basic features and then build on it
to describe yields and pricing of bonds
51
5.7 Tutorials
Question 1
Total, one of Frances largest corporations and the worlds fifth largest publicly traded
integrated petroleum company operates in more than 130 countries. To meet growing
energy needs on a longterm basis, Total considers sustainability when making decisions.
Selected financial information is available in table 1 below.
Year
2008
2007
2006
2005
2004
DPS
Dividend Per
Share/$
2.28
2.07
1.87
1.62
1.35
Share price/$
39.91
56.83
54.65
52.37
39.66
The analyst estimates the required rate of return to be 19% from CAPM.
Assume that Totals growth rate will mirror the average growth in dividend over the
period considered (D2008 = D2004 x (1 + g)4)
(a) Use the Gordon Growth Model to estimate Totals intrinsic value
(b) Based on the estimated intrinsic, is the share undervalued or overvalued?
(c) What is the intrinsic value of the growth rate estimate is lowered to 13%?
(d) What is the intrinsic value if the growth rate estimate is lowered to 13% and the
required rate of return is increased to 20%
Question 2
A company does not currently pay a dividend but is expected to begin to do so in five
years (at t = 5). The first dividend is expected to be $4.00 and to be received five years
from today. That dividend is expected to grow at 6% into perpetuity. The required return
is 10%. What is the estimated current intrinsic value?
Question 3
The following are the simplified financial statements for J.S. Company, a renowned
retailer in Europe.
Group Income Statement for the Year to 22 March 2008
$
Revenue
17837
16835
Cost of Sales
Gross Profit
1002
Administrative Expenses
502
Other Income
30
Operating Profit
530
Interest Income
83
Interest Expense
132
2
Share in loss from joint ventures
Profit before tax
479
150
Tax
Profit for the year
329
Note: Operating profit is calculated after charging depreciation of 463 and amortisation of 18
52
2007
7176
175
98
212
7661
590
197
1128
1915
9576
2280
118
6
191
10
2605
2267
373
2
65
14
2721
89
2084
18
321
63
2575
4935
33
2090
43
168
172
2506
4349
499
896
680
494
2366
4935
495
857
670
143
2184
4349
(a) Calculate J.Ss free cash flow for 2008. You may assume effective tax rate of 31.3%
(b) Analysts believe that wholesale food prices will rise by 5% each year for the next
three years, but that supermarkets will be able to raise their prices by only 4% a
year during that time. After that, the future is so uncertain that it is best to assume
zero growth in free cash flows. What is the value of J.S. under these circumstances?
You may assume that J.S weighted average cost of capital is 8%.
53
54
FIXED INCOME
SECURITIES
Unit Structure
6.0 Overview
6.1 Learning Objectives
6.2 Introduction
6.3 Bond Overview
6.4 Bond Pricing
6.5 Bond Riskiness
6.6 Yield to Maturity
6.7 Practitioners perspective
6.8 Summary
6.9 Tutorial
6.10 Suggested Reading
55
6.0 OVERVIEW
This unit builds up the pedestal for students to steepen their knowledge of how fixed
income securities, more specifically bonds, work and their various functions within the
financial sphere.
6.2 INTRODUCTION
Broadly speaking, a fixed income security is one which provides an investor with a
stable, known amount of cash flow at known time intervals in exchange of a principal
which will be paid back at the bond expiry date. In the Unit that follows, emphasis will
be laid on such types of instruments only.
However, it should be noted that the definition of fixed income securities is as crisply
defined as above. A nonexhaustive list of other securities that fall within this category
would be swaps, forward agreements and related options but are beyond the scope of
the syllabus. Nevertheless, students should keep in mind that various companies such as
The Mauritius Commercial Bank and Sun Resorts Limited use interest rate and foreign
currency swaps to hedge their exposure to such risks.
Henceforth, the terms fixed income, bond and debt will be used interchangeably.
A bond is a promise to make periodic coupon payments and to repay principal at maturity
and is issued by corporations and government units. The terms of the bond contract will
specify the amounts and dates at which payments are to be made. Such payments are
made until the final repayment date which is called the maturity date of the bond. The
time remaining until this final payment is made is known as the time to maturity.
Typically, bonds make 2 types of payments to the bond holder. The specified interest
payments are known as coupons and these are typically made on a semiannual basis in
countries with mature debt markets, such as the UK and the US. The principal or the
face value is the final payment that is received and is amount that is used to calculate the
coupon payments to be made. They are usually specified in standard increments such
as $1000 bond.
For example, a $1000 with 4% semiannual coupon payment with maturity in 2 years
will make the following payments to the bond holder. In this case, we assume that the
investor has just received a coupon payment and thus, there is no payment at time 0.
56
Coupons Principal
Time 0: $0 $0
Time 6 months:
$0
Time 12 months:
$0
Time 18 months:
$0
Time 24 months:
$1000
At the end of the 24 months, both the coupon payment of $20 and the $1000 is received
by the investor.
Diagrammatically, the flow of money is depicted as follows:
2. Bond coupon payments are fixed in most cases while dividend payments are at the
discretion of the firm and vary over time.
3. If a company misses its coupon payments, it is in default but a company can stop
paying out dividends without going into financial distress.
4. As opposed to equity holders, bond holders have no voting rights and ownership
in the firm.
5. Bonds have seniority in bankruptcy i.e. bondholders should be paid first and only
residual cash is for equity holders.
6. Debt interest payments are made before making tax payments. So, the tax rate is
applied to a lower amount of earnings (known as Earnings Before Tax EBT) and
this results in a lower cash outflow for the company. This tax deductible feature
is not present for equity financing as dividends are made after tax payments from
the Net Income line.
7. A bond price will converge to its par value known as pull to par as it reaches
maturity but the share price will tend to have an upward drift, primarily owing to
inflation.
57
Similar to the previous example, consider the $1000 bond with semiannual coupon
rate of 4% maturing in 2 years.
The additional information required is the Required Rate of Return.
Let this be 5% (annualised).
Time
Coupons Principal
(months)
($)
($)
0
6
12
18
24
0
20
20
20
20
Total Cash
Flow ($)
0
0
0
0
1000
0
20
20
20
1020
Discount
Factor
0
1/(1+0.025)=
1/((1+0.025)^2)=
1/((1+0.025)^3)=
1/((1+0.025)^4)=
Discounted
Cash Flow ($)
0.000
0.976
0.952
0.929
0.906
Bond Price
0.00
19.51
19.04
18.57
924.07
981.19
As illustrated above, the cash flows are discounted at the required rate of return at each
individual point in time to back out the bond price.
This Required Rate of Return is called the Yield To Maturity (YTM) and the next
section of Unit will further elaborate on the factors that determine the YTM to be
plugged in the pricing formula.
Bond prices and YTM have an inverse relationship. If the YTM increases by 100 basis
points, i.e. 1%, the bond price will decrease by a certain amount as per the pricing
mechanism above.
58
Par Value
Market
Price
Time to Maturity
0
iii) Premium Bond
The price of a premium bond decreases as the bond moves towards maturity and there
are no changes in interest rates. The reason for this is similar as for the discount bond.
In particular, 1) the present value of coupons decreases with time and 2) the present
value of the par value increases for the same reasons as before. However, in the case
of a premium bond, the increase in the present value of par is smaller than the decrease
in the present value of coupons (because coupons for the premium bonds can be quite
large, larger than the interest rate), causing an overall decrease in the price of a bond.
Graphically, this can be presented as follows:
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Price
Market
Price
Par Value
Time to Maturity
0
As it can be seen from the above diagrams, as the bond time to maturity approaches
zero, i.e. the bond is closer to expiry, the market price of the bond approaches par value.
2. Coupon Rate
The lower the coupon rate, the higher the price volatility of a bond. This is because the
price is determined more by the final par value in the discounted cash flow calculation.
For a similar change in YTM, the denominator will fluctuate more for this final payment
than for the coupons to be received in the near future as this final discount rate is raised
to a higher power.
This is the reason that bonds that pay no coupons (known as zero coupon bonds) have
higher volatility.
3. Maturity
Considering 2 bonds with similar characteristics except for their maturities, the bond
with longer maturity will display a higher volatility. Mathematically, the logic behind
this result is that a larger proportion of the cash flows have to be received in a more
distant future. As a result, for a similar change in YTM, the discount factor will change
more for those corresponding cash flows that occur later on.
4. The Level of the YTM
All else equal, a bond with higher yield will have lower volatility than a bond with lower
yield. This is shown graphically below.
Price
The bond price YTM relationship, as mentioned before, is an inverse and, in addition,
a nonlinear one. This is evident from the changing gradient of the graph above as
we move across the xaxis and the polynomial equation of the discounted pricing
calculation.
As the gradient takes on larger absolute values, i.e. as the yield decreases, this implies
that the percentage change in price to % change in YTM increases.
Yield
So, the smaller the YTM becomes, the larger the price volatility. This relates to the
concept of duration that will be discussed further in the Unit.
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As explained in the section above, there are many determinants that affect the value of
a bond. Depending on the characteristics of the bond, taking into account the above 4
factors individually can lead to ambiguous results as to which bond is the more volatile.
So, a more sophisticated approach is required to measure bond price volatility.
The most commonly used measure is duration.
The strict definition of duration, as developed by MaCaulay, is total weighted average
time to recovery of the payments and principal in relation to the current market price of
the bond, the weights being the present value of the cash flows.
When deriving it, duration takes into account the coupon rate, the YTM and the time to
maturity in a single number. The unit of duration is years.
D=
1C
(1 + y)
2C
+
(1 + y)2
nC
(1 + y)n
nF
(1 + y)n
1 n
txPVt
P t1
where,
PVt =
C
(1 + y)t
t = 1,2 ....., n  1
C+F
(1 + y)n
t = 1,2 ....., n  1
and
PVn =
A more intuitive definition of duration is the measure of the sensitivity of bond price
to a change in interest rates. Hence, the alternative way to understand bond volatility is
Modified Duration and is defined as:
MD =
D
1+y
dD
= (MD)dy
P
In words,
Percentage change in bond price =  Modified Duration x
The modified duration can be viewed as a multiplier. A bond with a modified duration
of 4, for example, experiences approximately a 4% change in price for every 100 basis
point (i.e. 1%) change in yield.
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100
=  4.00%
100
100
= 4.00%
100
It is important to tie together the 4 theorems of bond price volatility and duration as to
how each of the 4 factors affect duration. With the duration formula in mind
All else equal,
i) A bond with lower coupon rate will have higher duration as the present value of
cash flows is lower and in turn, the market price of the bond, P, is lower.
ii) A bond with lower yield will have higher duration as decreases in the yield will lead
to higher present value of cash flows i.e the terms in the bracket.
iii) A bond with longer time to maturity, i.e. larger n in the equation above, will exhibit
larger variations in the denominator (1+y)n than a bond with lower n (shorter time
to maturity).
It can be concluded that the 4 theorems and duration match up in terms of measuring
the bond price volatility.
There are special cases that duration of certain bonds collapses to smaller formulas.
For example,
Duration of zero coupon bonds = D = n
We can also show that there is an upper limit in the value of duration by considering an
undated bond, i.e. that even though undated bonds do not have time to maturity, they do
have a duration. An undated bond is a bond whose coupon payments are made at regular
intervals but the principal will never be repaid technically. (N.B. such bonds usually
have options attached to them such that principal repayment does occur. Discussions are
not within the scope of the syllabus)
Duration of Undated bonds = D =
1+y
y
II) CONVEXITY
In spite of its sophistication, there are some problems associated with duration especially
for large changes in interest rates.
62
As it has been mentioned before, the bond price YTM relationship is a nonlinear
one. However, the duration assumes a linear relationship between the two. From a
practitioners perspective, this might not be totally problematic for small changes in
YTM e.g. in the range of 25bps to 50bps; duration is still an appropriate measure and is
rarely the case that yields move by more than this amount in one instance.
However, for larger changes in YTM, another measure known as convexity is required
to fill the gap to accurately measure price sensitivity.
Convexity is defined as the second derivative of bond price with respect to interest rate.
The formula for convexity is given by the following:
C=
1
P
d2P
dy2
Combined with the modified duration formula, the percentage change in bond price is
given by:
dP
1
 MD (y1  y0) +
C(y1  y0)2
P
2
where the first part of the right hand side of the formula is the movement as explained
by the modified duration.
It is important to note that modified duration always works in the favour of the investor
holding the bond! When the interest rate falls, the modified duration model understates
the increase in bond price. On the flipside, when interest rates increase, the model
overstates the losses made on the bond position.
In addition, from the graph and the equation, convexity is always positive as it needs to
increase the price of the bond such that the true value of the bond is obtained.
So far, we have looked at the cash flows and price of the bond. However, it is crucial to
understand the discount rate that needs to be applied to the cash flows.
The yield to maturity is defined as the average weighted yield if:
The bond is held to maturity
Coupons are paid on time and reinvested at the YTM rate.
The YTM is only an approximation of the future bond return as it is known at which rate
the coupons will actually be reinvested in the future. It is the interest rate that makes the
present value of the cash flow equal to the bond price and is subjective.
It can be decomposed into several factors. Intuitively, for any type of security, the higher
the risk associated, the higher the discount rate that will be used to discount the future
cash flows of that security. The same logic applies to bonds.
63
Using Government bonds as an example, the discount rate used will be made up of:
(i) The base rate of the country. Typically, this nominal rate is determined by the real
interest rate and the inflation rate. However, in troubled times, this relationship can
will not hold true as Central Banks shift their focus away from inflation targeting
towards stable GDP growth as is the case today. (0.5% in UK, 0.25% in the US)
(ii) The country default premium measuring the issuing country ability to repay its
debt e.g. Greece has a high sovereign default premium associated to its bonds.
(iii)
Unexpected inflation risk premium is the incremental yield added to Government
bonds to compensate for the fact that despite inflation rate being usually built in the
nominal rate, there is a risk of inflation overshooting nonetheless. Hence, the term
unexpected is used.
(iv) Premium related to price risk/interest rate risk for bonds having higher durations.
(v) Premium related to reinvestment risk because if interest rates fall, the coupons
are reinvested at a lower rate than might have been expected.
There are other sources of risk that an investor will need to be compensated for such as
liquidity premium (to compensate the investor for his inability to unwind his positions
quickly at fair value), event risk, which relate to natural catastrophes and the likes and
foreign exchange risk for investors having positions denominated in currencies other
than their home currency.
Taking the US Treasury bond and the UK Government bond as examples, the largest risk that
needs to be rewarded in the form of the required rate of return will be driven by the nominal
base rate as the other factors tend to be fairly negligible as a result of the developed nature of
the financial system within these countries and the low probability of sovereign default.
In the case of corporate bonds, the above risks hold true as the companies that issue the
bond are domiciled in the country in question. However, in addition, investors need to
take into account corporate credit/default risk.
Credit risk is an important factor in the YTM estimation and needs to be carefully
assessed. It is mainly driven by business deterioration and unfavourable movements in
industry or macroeconomic factors.
Many financial institutions employ credit analysts to determine the repayment ability
of companies. Very often, credit ratings are used to supplement their analysis. Credit
rating agencies such as Moodys and Standard & Poor provide opinions on the future
ability and legal obligation of an issuer to make timely payments of principal and
interest on a specific fixed income security many corporations and Government units
around the globe. (Moodys)
The following table shows the ratings assigned to entities.
Description
Moodys
S&P
Highest quality
High quality
Aaa
Aa
AAA
AA
A
Baa
Ba
B
A
BBB
BB
B
Vulnerable to default
Caa
CCC
Investment Grade
Junk Bond
High Yield
Noninvestment Grade
Empirically, a large price drop is observed when the corporations are downgraded to
noninvestment grade the reason being that pension funds, which are large investors
in bond markets, are not allowed to hold bonds in that category.
64
The yield curve is the depiction of the yields of similar bonds (UK Gilts/ Corporate
bonds issued by Microsoft) with varying time to maturities. Investors use the yield
curve as a reference point for forecasting interest rates and pricing bonds.
As shown in the diagrams below, yield curves generally have an upward slope.
65
iii) The market segmentation theory purports that most bond investors in the market
have short to medium term investment horizons. So, in order to lure these investors
to invest in bonds with longer maturities, additional premium is required.
i)
Many companies use debt on their balance sheet to fund their projects because of the tax
deductibility aspect that leads to reduced cash outflow in the form tax savings.
In addition, leverage can significantly boost the Return on Equity as shown below.
From the diagram above, instead of investing only $100m and obtain a cash inflow of
$200m in year n, the company uses $500m ($400m of additional debt raised), receive a
cash inflow of $1bn and pay off the principal amount of $400 raised and a small interest
amount out of the $600m accruing to the shareholders. Effectively, the boosted the
return to the shareholders by a scale of 3 compared to the previous capital structure.
However, in such levered capital structure, it is of paramount importance for the
company to be able to pay off the interest and debt principal in timely manner. If not,
the firm will default on its debt obligations.
Private equity funds comprise of sophisticated investors that raise debt in order to
fund the purchase of all the equity stake of a public company. If successful, the debt
is put on the previouslypublic company and the asset of the company is pledged as
collateral. Essentially, such funds put in a small amount of their own money to buyout
the company outright from the secondary market and own the company thanks to the
debt raised in the name of the company they acquire.
There a few companies that can sustain the typical leverage of 70% to 80% loaded in the
firm. Such companies should have strong, stable cash flows, leading market positions,
significant growth opportunities, strong asset base and proven management team.
LBO funds earn a typical return of 20%  50% on their investment by paying down the
debt from the large cash flows generated by the company and growing the revenues.
The investment horizon is typically 7 years, after which the company is floated in the
secondary market once the debt to asset ratio reaches the norm in the industry.
66
iii)
iv)
Bond Funds
67
6.8 SUMMARY
This unit represents the building blocks for mastering the analysis, valuation and
management of fixed income securities. In recent years, there has been significant
growth in the fixed income markets of other countries as borrowers have shifted from
funding via banks loans to the issuance of fixed income securities. That is a trend that is
expected to continue. In the next chapter, we will shift our focus to the risk and return
concept and the importance of diversification in this world of uncertainty.
6.9 TUTORIALs
Question 1
Microsoft has issued a 10% Annual Coupon paying Bond maturing on the 20th March
2015. The settlement date is the 20th March 2012 and is sold in denominations of USD
1,000. The yield to maturity is given as 8% and the current market price of the bond is
USD 970. Discuss whether you should buy this bond.
Question 2
You are provided with the following information:
Face value: Rs1000
Maturity: 3 years
Yield: 6.90%
Coupon: 7.5%, semi annual
Settlement date is the same as the coupn date.
Determine the price of the bond.
Question 3
What does the yield curve represent and discuss how the slope should evolve with
reference to the theory underlying the yield curve.
Question 4
Discuss the new trends that are emerging in global bond markets
68
RISK, RETURN
AND DIVERSIFICATION
Unit Structure
7.0 Overview
7.1 Learning Objectives
7.2 Introduction
7.3 Measures of Risk and Return
7.4 Risk of the Investment
7.5 Portfolio of Assets
7.6 The Concept of Minimum Variance Frontier
7.7 Summary
7.8 Tutorial
7.9 Suggested Reading
69
7.0 OVERVIEW
It is important to be able to understand that different assets pay off differently in different
states and these states have a certain probability of occurring. As a result of this inherent
riskiness in the cash flows, investors should be able to assess the expected returns and
volatility of assets.
The concept of portfolio management will be introduced and it will demonstrated
why diversification is considered as the only free lunch in finance, especially when
considered on a riskreturn plane.
7.2 Introduction
Why is it that the US T Bills provide investors a lower return than Microsoft but have
always been one of the most traded assets across the globe? Is it not the case that the
primary aim of an investor is to earn the highest return possible? The answer is no.
By and large, investors are risk averse and require compensation for the risk they take.
It follows that, from the riskreturn relationship, if an asset is riskier, the returns
expected by the investor will be higher. We can interpret that the higher average returns
of Microsoft, or the stock market in general, is to compensate investors for the higher
risk of the investment as compared to the much less riskier T Bill instruments.
E(R) = piRi
i=1
70
Given the following table about nondividend paying stock A, the expected return at the
end of 1 year is given as per the calculation below.
Current Share
Price (Rs)
100
Probability,
p (%)
Expected
Return, R (%)
25%
140
40%
50%
110
10%
25%
80
20%
From its current market price of Rs100, the share can either move up or down since
the future outcome remains uncertain. Therefore, a probability of the expected future
outcome (price) is attached to it. Hence, the share has a 25% probability that it will
increase to Rs140, a 50% probability that it will move to Rs110 and a 25% probability
that it will decrease to Rs80.
The expected return is calculated as follows:
Expected Return = (0.25*40% + 0.5*10% + 0.2*25%) = 10%
(R) = var(R)
The variance is a measure of the spread of the return distribution is. In the case of a riskfree asset, the return is guaranteed; there is no uncertainty about the return. Hence, the
variance of such assets (e.g. US TBills) is zero.
Applying the above formula to calculate the variance of the stock A yields:
Variance = 25%*(0.20.1)2 + 50%* (0.10.1)2 + 25%* (0.40.1)2 = 0.045 = 4.5%
Standard deviation = Variance = 4.5% = 2.12%
Standard deviation is very often referred to as volatility.
71
72
Covariance is the expected product of the deviations of 2 returns from the mean. It is
given by the following formula.
Cov (Rx, Ry) = E[(Rx E[ Rx]) (Ry E[Ry ])]
Intuitively, if 2 stocks move together, their returns will tend to be above or below average
at the same time and the covariance will be positive and vice versa.
Correlation is the covariance divided the product of the standard deviations of the
stocks as per the following formula, and it ensures the sign is from 1 to +1.
Cov (Rx, Ry) = Cov (Rx,Ry) / (x. y)
As opposed to covariance, correlation is standardized and a better measure of degree
of linear comovement. The table below indicates the correlation that exists between
the three instruments: S&P 500, U.S. Long Term Corporate Bonds and MSCI
Emerging Markets
Correlation Matrix
of Returns
S&P 500
U.S. LongTerm
Corporate Bonds
MSCI Emerging
Markets
S&P 500
1.00
0.25
0.45
U.S. LongTerm
Corporate Bonds
0.25
1.00
0.20
0.45
0.20
1.00
As long as security returns are not perfectly correlated, diversification benefits are
possible. Furthermore, the smaller the correlation between security returns, the greater
the costs of not diversifying.
A correlation of 0 (uncorrelated variable) indicates an absence of any linear (straightline) relationship between the variables. Increasingly positive correlation indicates
an increasingly strong positive linear relationship (up to 1, which indicates a perfect
linear relationship). Increasingly negative correlation indicates an increasingly strong
negative (inverse) linear relationship (down to 1, which indicates a perfect inverse
linear relationship).
Example:
Given the following data, find the expected return, covariance, correlation and
variance of a portfolio consisting stock A and B given only the following table and
the weight of each stock being 50%.
Year
Stock Returns
Stock X
Stock Y
2003
21%
9%
2004
30%
21%
2005
7%
7%
2006
5%
2%
2007
2%
5%
2008
9%
30%
73
Applying the formulae from before for individual stocks X and Y, the following answers
are found:
E(Ri)
10.0%
10.0%
Variance
0.018
0.018
Volatility
13.4%
13.4%
In order to compute the covariance and correlation, the following table should be
drawn up.
74
Beta
Portfolio Expected
Return (%)
Portfolio
Volatility (%)
100%
0%
26.0
50.0
80%
60%
40%
20%
20%
40%
60%
80%
22.0
18.0
14.0
10.0
40.3
31.6
25.0
22.3
0%
100%
6.0
25.0
75
The part of the line below the 20% Alpha and 80% Beta weight consists of inefficient
portfolios the reason being that for the same volatility, a better portfolio closer to
the (0.4,0.6) weight allocation can be found to give investors higher returns for the
same risk.
The portfolio lying on the efficient set and that is tangential to the line drawn from the
risk free asset (lying on the vertical axis with coordinates (0,1%) is called the efficient
portfolio. The gradient of this line is equivalent to the Sharpe Ratio and is maximum
at this point.
Given the 2 assets, this portfolio is the best among all other combinations from a riskretun perspective.
E(Rp)
For different levels of correlation, the frontier will change as shown in the graph below
A
C
rxy=1
rxy=+1
For a given asset allocation, correlation has no impact on the expected return as
the correlation is not used in the portfolio expected return calculation. However,
the volatility will change.
When assets are perfectly positively correlated (correlation of +1), the set of portfolios
will be along a straight line and there is no diversification benefit.
When the correlation is less than 1, volatility of the portfolio is reduced due to
diversification and the minimum variance frontier curve bends to the left. This reduction
in volatility is greater as the correlation decreases.
76
O=(Rp)
N
O
P
L
Risk,c
77
7.7 Tutorials
Question 1
Probability
End of period
Share Price
End of period
Dividends
10 %
19.00
1.00
20 %
20.50
2.00
40 %
22.00
3.00
20 %
26.00
4.00
10 %
35.00
5.00
If the current share price of the stock is Rs25.00, find the expected return and the
standard deviation of the asset.
Question 2
A pension fund manager is considering 2 mutual funds and a Government bond for
investment purposes. The probability distribution of the fund returns are shown as
follows.
Expected Return
Standard Deviation
20%
30%
12%
15%
Question 3
The following information is given for two risky assets (an Equity Fund and a Debt
Fund):
Securities
Expected Return
Standard Deviation
0.4
0.25
0.10
0.13
78
Question 4
The following information is given for three risky assets:
Securities
X
Y
Z
Expected Return
0.25
0.35
0.15
Standard Deviation
0.15
0.23
0.20
Question 5
You are given below assets X and Y returns along with their associated probabilities:
Probability
0.2
0.2
0.2
0.2
0.2
Asset X:
Returns in %
10
8
20
6
1
Asset Y:
Returns in %
2
13
3
25
8
79
80
81
82
Assignment
In todays fast evolving world, Mauritian Hospitality Groups rested on past
laurels and lost out. The shift in client base and requirements is proving to be
a lasting phenomenon with both the local and regional operating environment
becoming increasingly competitive. If the hotel industry is to remain sustainable
in the longterm, it will need to reengineer its modus operandi and reduce debt
and the Government will need to realize that clientele diversification cannot
happen without new aerial routes
In light of the above statement, analyse the hotel industry, with a thorough research
and analysis of two or more major hotel groups in Mauritius.
Indicative Marking Scheme
 Introduction (10 Marks)
 Analysis of the tourism industry (SWOT analysis) (30 Marks)
 Analysis of two or more hotels: (30 Marks per Hotel Group)
Background of hotel activities and structure (5 Marks)
Analysis of the company (SWOT analysis) (5 Marks)
Performance of the hotel and its management for period 20052013 (5 Marks)
Analysis of the groups share price performance and explanation thereof
(5 Marks)
The way forward for the company (5 Marks)
Any additional information (5 Marks)
Note:
1. If the student has opted to analyse for example 4 hotel groups, 60% of the marks
will be divided by four and therefore, the student will have a greater opportunity
to earn higher marks.
2. The assignment will be initially marked on 100 and will then be scaled back to 30.
83
84
SOLUTIONS MANUAL
He can diversify his portfolio by buying shares in mutual funds or unit trusts. By doing
so, he will benefit from the advantages of diversification whilst keeping his transactions
costs low since he will not be buying many individual shares.
Question 2
(a) Brokers: They connect buyers and sellers. Trades can only be completed if the
brokers find a buyer for each seller and viceversa. Brokers work on commission.
Market makers: when securities are sold to an investor, market makers buy them at
a given price and try simultaneously or subsequently to sell them at a higher price.
Their earnings are thus the difference between the sell price and the buy price.
(b) Higher, because the risk is higher
Question 3
Question 4
(a) Primary markets new issues of a security; secondary markets subsequent trading
of the shares.
(b) Discussion of the role of investment bankers in the initial public offering process.
(c) Role of brokers and dealers in carrying out trades in primary and secondary markets.
(d) Importance of secondary markets after a share has been issued in the primary market
(e) The aim of the examples is to make the students check out local and international
markets and have a pulse of financial markets. Concrete examples of the stock will
differ across time, but the main aim of this exercise is to make them differentiate
between newly issued stocks and those that are already trading on secondary markets.
Question 5
Discussion of the role of banks as intermediaries between companies and the services
provided by banks:
 Access to equity markets;
 Access to bond markets;
 Mergers and acquisitions;
 Asset management;
 Amongst others.
85
Initial public offerings or IPOs are stocks issued by a formerly privately owned company
that is going public, that is, selling stock to the public for the first time. Seasoned equity
offerings are offered by companies that already have floated equity. For examples, a
sale by IBM of new shares would constitute a seasoned new issue.
Investment bankers normally manage the issue of new securities to the investing
community. Once the Financial and Services Commission has given its approval, the
investment bankers can distribute a prospectus and organize road shows to market the
stock and the company. These road shows are important in that it helps to generate
interest about the company and provide financial and nonfinancial information about
the firm to investors. The latter can also formulate the price at which they would like to
purchase the stock of the company. These indications of interest are referred to as book
and the process of polling potential investors is referred to as bookbuilding.
Use the case of a recently issued stock e.g. Facebook. Discussion should be centred
around where initial public offering price, the banks that were involved in the process,
the marketing process, the performance of the stock since its listing
Question 2
Question 3
1
(1+0.15)10
0.15
Find the value of A.
The first annual payment is effected on 1 January 2012.
1400,000 = A + A x
1
(1+0.15)101
0.15
Find the value of A.
Question 2
Question 3
(i)
FV = PV (1 + r)n = 2,000 (1.10)5
(ii)
FV = PV (1 + r)n = 2,000 (1.10)5*2 = 2,000 (1.10)10
(iii)
FV = PV (1 + r)n = 2,000 (1.10)5*4 = 2,000 (1.10)20
Open University of Mauritius  Financial Theory & Practice
87
Year
Future CF
Depreciation
Profit
3
80
(50)
30
Project B
Depreciation = 200 / 4 = 50m
1
2
75
70
(50)
(50)
25
20
Average Profit = (25+20+15+15) / 4 = 18.75
ARR = (18.75/200) x 100% = 9.4%
Year
Future CF
Depreciation
Profit
4
80
(50)
30
3
65
(50)
15
4
65
(50)
15
Year
0
1
2
Cash Flow
200
90
85
Project A
Cummulative Cash Flow
200
110
25
3
4
80
80
55
135
Time
0
1
2
(25/80) x 1 year or 12 Months = 0.31
or approximately 4 months

Year
0
1
2
Cash Flow
200
75
70
Project B
Cummulative Cash Flow
200
125
55
Time
0
1
2
3
4
65
65
10
75
88
Question 2
(a)
Year
Revenue
Maintenance
Costs
Scrap
Net Cash
Flow
0
(155,000)
1
200,000
2
210,000
3
220,500
4
231,525
5
243,101
6

(10,000)
(11,500)
(13,225)
(15,209)
(17,490)
20,000
(155,000)
190,000
198,500
207,275
216,316
225,611
20,000
Question 3
2.28 = 1.35 x (1 + g) 4
Therefore, g = 14%
Question 2
Value of share five years from now = (4.00 x 1.06) / (0.10 0.06) = $106
Present value of share = 106 x (1/1.105) = $65.82
89
Question 3
(a)
USD
2008
EBIT
Tax
530
150
481
 Capital Expenditure
248
189
424
(b)
Question 2
Question 3
The yield curve is the depiction of the yields of similar bonds (UK Gilts/ Corporate
bonds issued by Microsoft) with varying time to maturities. Investors use the yield
curve as a reference point for forecasting interest rates and pricing bonds. The 3 mains
explanations of the slope of the yield curve are:
i)
The pure expectations hypothesis holds that the slope of the yield curve
reflects only the investors expectations of future short term interest rates.
In good economic times, the interest rate is expected to rise to match a
rise in expected inflation and thus, investors demand a higher return as
compensation. This explains why the yield curve has an upward slope.
However, the yield curve is a leading indicator of recessions when it inverts
as it reflects the expectations of Central Banks to lower interest rates to
shore up the economy and relax any inflation targeting regime.
ii)
90
The liquidity preference theory also assumes that longerterm bonds require
an additional premium for having their capital tied for longer periods of time
and for the higher durations prevalent at the longend of the yield curve.
Open University of Mauritius  Financial Theory & Practice
iii)
The market segmentation theory purports that most bond investors in the
market have short to medium term investment horizons. So, in order to
lure these investors to invest in bonds with longer maturities, additional
premium is required.
Question 4
Risk= sqrt(variance)
(b) Use this formula to find the weight for the min variance portfolio for equity fund (E)
a* =
2d  red e d
2e + 2d  2red e d
(c) Based on the weights in part (b), use the following formula;
E(Rp)=We E(Re ) + Wd E(Rd )
Question 4
91
Question 5
(a)
E(Rx)= 8.6%
E(Ry)=9.4%
(b)
X
0.004624
0.068
Variance
Standard Deviation
(c)
(d)
(e)
92
Y
0.008584
0.0925
Ry E(Ry)
0.114
0.036
0.064
0.156
0.014
Total
COV(XY)
0.0016
0.00022
0.0073
0.00406
0.001344
0.01182
he covariance is negative which imply that assets returns tend to move in the
T
opposite direction such that a loss in asset X will be compensated by a gain in
Asset Y or vice versa.