Capital Market

and
Security Analysis
Scope and Need for Capital Markets and
Portfolio Management
To facilitate effective allocation of funds.

Systematic analysis of different kind of
financial securities.

To determine the price of risky securities in
competitive capital market.

Management of invested fund (portfolio).

Need for Capital Markets and Portfolio
Management.cont
To study the behavior of stock market.

To study the relationship of stock market with other
corporate and economic variables.

Analysis and Management of risk associated with
different financial securities.
Different Types of Investment
Opportunities
Other
Securities
Derivative
Financial
&
Commodity
Money Mkt
Securities
Bonds
Mutual
Funds
Equities
Investment
Oppotunities
Types of Securities
Money market securities
Short-term debt instruments sold by governments,
financial institutions and corporations
They have maturities when issued of one year or
less.
Money market securities includes Treasury Bills,
Commercial papers, Bank deposits etc.

Types of Securitiescont
Capital market securities
Instruments having maturities greater than one year
and those having no designated maturity at all.
It is the market from where long term capital is
raised.
1. Corporate bonds
Fixed income securities like bonds have a specified
payment schedule.
Bonds promise to pay specific amounts at specific
times
Capital Market Securities
2. Common Equity Shares
Ordinary or common shares represents the ownership
position of the company. The holders of ordinary
shares, called shareholders. They are legal owner of
the company.
Capital Market Securities
3. Preference Shares
Preference shares have the preference over the common
equity shares in terms of payments of dividend and repayment
of capital in case of wind up of the company. Preference share
holders get fixed dividends.
Types of Preference shares-
1.Redeemable preference shares-
Redeemable preference shares are available
with certain maturity.
2. Irredeemable preference shares-
Irredeemable preference shares are available
without any maturity period. In India companies
are not allowed to issue irredeemable preference
shares.
Mutual Funds
A Mutual Fund is a trust that pools the savings of a number
of investors who share a common financial goal.
The money thus collected is invested by the fund manager
in different types of securities depending upon the objective
of the scheme. These could range from shares to
debentures to money market instruments.
Mutual
Fund
Stock
Market
Debt
Market
Money
Market
Investors
Community
Types of Mutual Fund
On the basis of Structure-
Open-end Funds

An open-end fund is one that is available for subscription
all through the year. These do not have a fixed maturity.
Investors can conveniently buy and sell units at Net
Asset Value ("NAV") related prices. The key feature of
open-end schemes is liquidity.
Closed-end Funds

A closed-end fund has a stipulated maturity period which
generally ranging from 3 to 15 years. The fund is open
for subscription only during a specified period. Investors
can invest in the scheme at the time of the initial public
issue and thereafter they can buy or sell the units of the
scheme on the stock exchanges where they are listed.
Securities Available in the
International Market
Financial securities which are available in the
international market includes ADR, GDR, Foreign
Bonds, Euro Bonds etc.
Speculation Vs. Investment
Speculation refers to take advantage of short term
fluctuations or development of the stock market.
Speculators are mainly profit oriented and are not
interested in the growth the firm.
Investment on the other hand is made for the long time
period. Along with profit investors are also interested in
the growth the firm.
SEBI also makes discrimination between speculation and
investment for the purpose of tax. Investment which is
made for less than one year is refers as trading and
subject to tax.
On the other hand if investment is made more than one
year it is treated investment and attract no tax.
Risk and Return

Return refers the amount of total monetary benefits a
investors receive from a security.
Return of a financial security consists two component-
periodical cash payments received at specified time
intervals.
And market appreciation/depreciation of the security value
over the investment time period.


Concept of Return
Return refers the amount of total monetary benefits a investors
receive from a security.
Return of a financial security consists two component-
periodical cash payments received at specified time intervals.
And market appreciation/depreciation of the security value
over the investment time period.

urity the of price purchase
period the over change ice ceived Payment Cash
R
i
sec
Pr Re +
=
1
1
) (

+
=
t
t t
i
P
Div P P
R
Where, Pt is price of security in time period t, Pt-1 is price in
last time period, Div is dividends.
Return Calculation
Reliance Ind.
Time Opening Price Closing Price Div.
May-07 1752.0 1760.0 10.0


% 07 . 1 100
1752
10 ) 1752 1760 (
=
+
=
i
R
It indicates that Reliance Ind. has offered 1.07%
return to the investor on 7
th
of May.

The Annualized return will be 1.07X365=390.55%.


Realized Return vs. Expected
Return
Realized return is the return which is realized by
the investor over the investment time period.

Expected return is the return which is expected to
earn over the investment time period by the
investor.

Historical Return
Historical return is that return which has been
offered by the security to the investors during the
past.
Historical return of a security is used to analysis of
risk and return prospectus of that security.

Calculation of Historical Return
Year B S E 100 Dividend Return
1995 1737.91 2 --------
1996 1343.21 3 -22.5386
1997 1481.71 4 10.60891
1998 1401.38 2 -5.28646
1999 1461.52 3 4.505559
2000 2875.37 6 97.14886
2001 2209.31 4 -23.0252
2002 1600.87 6 -27.2682
2003 2946.14 4 84.28355
2004 3521.71 3 19.63824
2005 5224.97 2 48.42136
2006 7145.91 5 36.86031
2007 11154.28 3 56.13519
Absolute Return
Absolute return refers the gross return which is
realized by the investor.
For example on 1 Jan 2010 the price of Infosys
stock was 1500 and it was 2500 on 30 June
2010.
So the absolute return is Rs 500 (2500-1500).
And the relative return will be 33.3% (500/1500).
Average or Airthematic Return
Average return is that return which is on average return
offered by a security to the investors over a particular period
of time. For e.g. in the last slide different level of annual
return is offered by BSE 100 from 1995 to 2007. But the
average return will be-

= + + + + +
+ + +
=
% 28 . 23 ) 13 . 56 37 . 36 42 . 48 63 . 19 28 . 84 20 . 27
02 . 23 14 . 97 50 . 4 28 . 5 60 . 10 53 . 22 (
13
1
i
R
The average return which is offered by BSE 100
from 1995 to 2007 to the investors is 23.28%.
Annual Return Vs Annualized Return
Annual return refers the return which is obtained by the
inventor during a year.
For example, on Jan. 1, 2010 the price of the Infosys
stock was Rs 1000, and on Dec. 31, 2010 it is Rs
1300, and dividend in between is Rs 200, than annual
return is: 50%.
If Infosys price was Rs 1000 on Jan 2010, and 1050 on
Jan 31, 2010. It means the monthly return of Infosys
is: 5%.
Annualized return will be: 5x12=60%.
Risk in Investing Financial Security
Variation in the mean rate of return exhibits risk. Volatility in
the stock market indicates risk which affects the value of the
stocks.
Risk is segregated into two Categories:
Systematic Risk-
Systematic risk refers to that portion of total
probability in return caused by factors affecting the
prices of all securities.
Unsystematic Risk-
Unsystematic risk is the portion of total risk that is
unique to a firm or industry.





Total Risk
Systematic Risk Unsystematic Risk
Business Risk
Financial Risk
Market Risk
Purchasing Power Risk
Interest Rate Risk
Forex Risk
Systematic Risk
Market Risk-
Market risk refers to that portion of total variability in the
return caused by factors affecting the whole market.
Economic, political and sociological changes are sources
of this type risk.

Purchasing Power Risk-
Purchasing risk is associated with inflation and deflation.
If an investor gets 5 percent rate of return and prevailing
inflation is 5.5 percent, it means that investor is realizing
0.5 percent loss on the investment over the period of
time.

Systematic Risk..cont.
Interest Rate Risk-
Interest rate risk is associated with fluctuations in rate of
return caused by variation in general interest rate.
Interest rate risk is becoming prominent as not only
domestic interest rate but also interest rate prevailing in
the international market can cause volatility in the stock
market.

Foreign Exchange Risk-
Foreign Exchange Risk is caused by changes in foreign
exchange rate.

Market risk can not be diversified by enlarging the
portfolio. This risk affects the market as a whole and
each stock seems to co-vary in the same direction with
the emergence of this risk.

Unsystematic Risk
Business Risk-
Business risk, emerges because of operating conditions,
variability in business conditions, dividend decisions etc.
Financial Risk-
Financial risk caused by the way a firm finances its
activities or expansion plans. If a firm raises debt in the
market it increases its obligation to pay fixed amount of
fund, viz., interest to the debtors. Investors perceive it
risky to invest in those stocks whose debt equity ratio is
high.
Non-market risk is specific and associated with individual
stocks. This risk can be eliminated by enlarging and
diversifying the portfolio by holding different stocks of
different industries.
Measurement of Total Risk
Risk of financial security refers the variation in
the rate of return of that financial security.
Standard deviation is used to calculate the total
risk of any financial security.
n
R R
SD


=
2
) (
Where, R is return of the security, n is number of
observations.
Measurement of Systematic Risk -beta
Systematic risk refers to that portion of total risk or variation
in rate of return which are caused by factors affecting the
prices of all securities.
Beta of financial securities is used to measure the
systematic risk. It indicatives the level of sensitiveness of
each security to the market.

( )

=
2
2
X X n
R X XR n
i
|
Where, R is return on security, X is return on Market Index like
Sensex.
A high beta value is the indication of high risk, and low beta
value is the indication of low risk.
Measurement of Systematic Risk -beta
Beta value is widely used by the investors in analyze of the
stocks. A stock with high beta value indicates high risk of
the stock, on the other hand stock with low beta value is
the indication of the low risk of the stocks.
Investor who are looking capital gain should invest in
stocks with high beta value.
On the other hand investors which avoid to take high risk,
should invest in low beta value stocks.
Calculation of beta value
Time Sensex (X) Infosys XR X2
Jan-09 3 5 15 9
Feb-09 2 2 4 4
Mar-09 6 5 30 36
Apr-09 7 6 42 49
May-09 4 7 28 16
Jun-09 2 5 10 4
Jul-09 3 8 24 9
Aug-09 5 3 15 25
Sep-09 3 5 15 9
Oct-09 5 4 20 25
Nov-09 7 6 42 49
Dec-09 4 5 20 16
Total 51 61 265 251
( )

=
2
2
X X n
R X XR n
i
|
16 . 0
) 51 ( 251 * 12
61 * 51 265 * 12
2
=

=
i
|
Beta Value
The beta value of Infosys is 0.16. It means if sensex goes to
1% either side. Infosys return will vary 0.16% accordingly.

Calculation of Alpha value
Alpha of any financial security indicates the minimum level
of return which an investor can expect from that
security.
The income looking investor can invest in the stocks with
high alpha values.
X R
i
2
| o =
Coefficient of variation
Coefficient of variation measures how much variation in the
rate of return of a security comes due to variation in rate
of return of market index like sensex.
All the stocks are the part of the stock market. When there
will be any fluctuations in the rate of return of market
index like sensex, correspondingly fluctuations will occur
in the rate of return of the stock return.

2
2 2
(
. .
|
|
.
|

\
|
=

R X
XR
V C
Where, R is return on security, X is return on Market Index
like BSE 100.
Calculation of Coefficient of Variation
Time Sensex (R) Infosys (X) R2 X2
RX
Jan-09 3 5 25 9
15
Feb-09 2 2 4 4
4
Mar-09 6 5 25 36
30
Apr-09 7 6 36 49
42
May-09 4 7 49 16
28
Jun-09 2 5 25 4
10
Jul-09 3 8 64 9
24
Aug-09 5 3 9 25
15
Sep-09 3 5 25 9
15
Oct-09 5 4 16 25
20
Nov-09 7 6 36 49
42
Dec-09 4 5 25 16
20
Total 51 61 339 251
265
2
2 2
(
. .
|
|
.
|

\
|
=

R X
XR
V C
=0.82
It implies 82% variation in Infosys return are coming due to Sensex
Calculation of expected return and risk using
the probabilities of happening.
% 25 . 7 Pr ). ( ) ( = =

obability R E R E
25 . 13 Pr . = =

obability Risk Risk

Reliance Ind.
stages Return Risk Probability E(R) Risk
Growth 12% 8 25% 12x0.25=3 8x0.25=2
Expansion 10% 12 25% 10x0.25=2.5 12x0.25=3
Stagnation 5% 15 25% 5x0.25=1.25 15x0.25=3.75
Decline 2% 18 25% 2x0.25=0.5 18x0.254.5
Financial Market
Financial Market is the market from where
short and long term financial resources are
raised.

Financial
Market
Capital
Market
Money
Market
Long Term
Loan
Stock
Market
Primary
Market
Secondary
Market
Organized
Banking
Sector
Unorganized
Banking
Sector
Sub
Markets
Call Money
Market
Treasury
Bills
Certificate
of Deposits
Commercial
Papers
Structure of Indian Financial Market
Money Market
Call money market is important segment of money market
from where borrowing and lending is done for a short time
period ranging from overnight to fortnight.

Call Money-
when money is lent or borrowed for overnight.
Notice Money-
when money is lent or borrowed more that one day
and upto fourteen days.
Participants in Call money market
1. Those permitted to operate both as
lenders and borrowers of call loans-
Commercial banks-
State bank of India-
Co-operative banks
Discount & Finance House of India-
Security Trading Corporation of India-
2. Those permitted to operate only as
lenders-
1.LIC, UTI, GIC, IDBI, NABARD.
2. Entities/corporate/mutual funds with bulk
lendable resources subject to approval from RBI.
Treasury Bills
Treasury bills are the promissory notes or a kind of
financial bill issued by RBI on behave of central
government with discount for a fixed period, not
extending beyond one year.
TBs are issued with a promise to pay the amount stated
therein to the bearer of the instruments.
TBs are issued on discount basis.
Periodicity of TBs-
14 days TBs, 91 days TBs, 182 days TBs, 364
days TBs.
Participants in TBs
Reserve Bank of India-
State Bank of India-
Commercial Banks-
State Govts, and other approved bodies-
DFHI, and STCI-
Financial Institutions- IDBI, ICICI, IFCI, LIC, GIC-
Corporate entities-
General public-
FIIs-

Computation of Yield on TBs
100
364

=
days Issueprice
Issueprice Facevalue
Yd
For example, 91 days TBs were issued at fixed price of Rs.
98/- for Rs. 100/- face value. The yield will be-
% 56 . 12 100
91
364
98
98 100
=

= Yd
Commercial Papers
Commercial papers are debt instruments
issued by corporates for raising short term
resources from the money market. CPs
are unsecured debts-no provision is made
behind the CPs.
Corporates having approval from RBI are
eligible to issue CPs.
CPs are issued on interest/discount basis.
Certificates of Deposits
A certificate of deposit is a marketable document
of title to a time deposit for a specified period.
CDs is a receipt given to the depositor by a bank
or any other institution entitled to issue CD.
A CD is issued at a discount and it is negotiable
instrument.
Govt. Dated Securities

Regulation of Indian Financial
Market
Regulation of Money Market
Money market is that market from where capital can be
raised for short time period.
Reserve bank of India (RBI) is the statutory body which is
authorized to regulate the Indian money market.
Regulation of Capital Market
Capital market is that market from where capital can be
raised for long time period.
Securities and Exchange Board of India (SEBI) is the
statutory body which is authorized to regulate the Indian
capital market.

Role of SEBI in Capital Market
Securities exchange board of India (SEBI) is the monitoring
body of the Indian capital market.
Role of SEBI:
1. To promote the healthy transactions in capital market.
2. To promote the investor education.
3. SEBI is working for the development of the capital market.
4. SEBI is protecting the investors.
5. SEBI is promoting the foreign capital in the country.
6. SEBI is monitoring body of stock brokers, mutual funds,
Institutional investors etc.

Types of Market Transactions
Market transactions is process in which stocks are
purchased or sold at particular time and price. Basically two
types of transactions exist-buying orders and sell orders.
Buy Order
Buy order is executed to purchase certain number of stocks
from the stock market. Buy order is used when investors
expected the rise in the price of stocks in near future.
Sell Order
Sell order is executed to sell certain number of stocks into
the stock market. Sell order is used when investors
expected the decline in the price of stocks in near future.

Sell Order..cont.
Sell Order of two types.
Sell long Orders-
This is the order wherein investors orders to sell the stocks
which he owns in the stock market.
Sell short Orders-
This is the order wherein investors orders to sell the stocks
which he does not owns in the stock market. This is kind of
short selling.

Types of orders
Orders which are given on the basis of price
constraints are called Price Limit Orders
Orders which are given on the basis of time
constraints are called Time Limit Orders
Price Limit of Orders
An investor can have his order executed either at the best
prevailing market price on the stock exchange or at a price
he determines.
Market Order
buy or sell at prevailing market price.
Price Limit Order-
buy or sell at specified price suggested by investor.

A maximum price if selling
a minimum price if buying
Price Limit of Orders
Stop Order
A stop order is used to protect the profit and to limit the
loss.
Sell if price falls below the stop price
(A stop-loss is used to lock-in profits)
Buy if price rises above the stop price.
Stop limit Order-
The stop limit order gives the investor the advantage of
specifying the limit price-the maximum price he will pay in
the case of a stop limit to buy, or the minimum price he will
accept in the case of a stop limit to sell.
A minimum price is placed below the stop-price for
a sell
or
A maximum price is placed above the stop-price
for a buy
Time Limit of Orders
Time limit order are placed on the basis of time,
wherein orders are executed on the basis of time
specified by the investor.

Day Order
A day order is that order remain active during a particular
trading day.
Week/Month Order-
A week/month order is that order remain active during a
particular week/month day.
Open Order-
An open order is that order remain active until they are
either executed or cancelled.

Margin Account (Trading)
A margin account with a broker allows for limited
borrowing to purchase assets.
A margin account needs a hypothecation
agreement
A. broker can pledge securities as collateral
B. broker can lend the securities to others
For A. and B., shares are held in street name
Owned legally by brokerage
Dividends, voting rights, reports go to investor
Margin Account
Margin Purchase
Borrow money from broker to invest.
The cost of borrowing is interest plus a service
charge.
Initial margin requirement
The minimum % of investment from investors own
funds
Margin Account
A margin account is marked to market at the end
of each trading day
A daily calculation of actual margin
A margin account is subject to a maintenance
margin requirement
The minimum acceptable value of the actual margin
If actual margin < maintenance margin then a
margin call is issued
The investor is obliged to add cash or securities
to the margin account

Short Sales
A short sale is the sale of a security you do not
own
This is achieved by borrowing share certificates
from someone else
The borrowing process is arranged by a broker
To allow shares to be borrowed the broker either
a. Uses shares held in street name
b. Borrows from another broker
Short Sales
Margin
There is a risk involved so short seller (A)
must make an initial margin advance to the
broker
The broker then calculates the margin each
day
Short sales should be used when prices are
expected to fall
Fixed income securities
Fixed income securities differ from each other in
promised return for several reasons
The maturity of the bonds
The creditworthiness of the issuer
The taxable status of the bond
Income and capital gains are taxed differently in
many countries
Bonds are designed to exploit these differences
Types of Bonds
Based on Issuer
1.Corporate Bonds-
Corporate bonds are issued by private
firms.
2. Govt. Bonds-
Govt. bonds are issued by govt. bodies like
central govt., central bank of the country,
local bodies, state govt. etc.


Types of Bonds
Based on Yield-
1.Interest Bearing Bonds-
Interest bearing bonds gives interest to
the investor after every quarterly or
annually basis.
2. Zero coupon Bond-
Zero coupon bonds give lump sump
amount to the investor at the time of
redemption of the bond.

Types of Bonds.cont.
Based on Conversion-
1.Convertible Debentures-
Convertible bonds are those bonds which are converted into
common equity shares at the time of maturity.
1. Partial Convertible debentures-
2. Fully convertible debentures-
2. Non convertible debentures-
Non Convertible bonds are those bonds which cant be
converted into common equity shares at the time of maturity.

Valuation of Bond
Bonds are marketable instruments. Therefore it is
very important for the investors to find the right
value of the bond. In order to find out the right
value of bond a valuation is done.

Valuation of financial securities refers to find out
the right price of the financial securities. At some
point of time, some financial securities may be
traded at over value or under value. With valuation
we can find out the right price of the financial
securities especially when it is available at market
price.
Valuation of Financial Securities-
Bonds
Some Key Issues in Valuation-
1.Time value of money
Time value of money refers, money which is received in
nearer time period is more preferable that the money
which will be received in distant time period.
2. Opportunity Cost-
Opportunity cost refers, whatever monetary benefits are
sacrificed for the sake of another monetary benefits.
Calculation of Present value of Bond
n n
n
k
Bn
k
Int
k
Int
k
Int
k
Int
Bo
) 1 ( ) 1 (
...
) 1 (
3
) 1 (
2
) 1 (
1
3 2
+
+
(

+
+
+
+
+
+
+
=
(

+ + + + + =
5 5 4 3 2
) 08 . 1 (
1000
) 08 . 1 (
70
) 08 . 1 (
70
) 08 . 1 (
70
) 08 . 1 (
70
) 08 . 1 (
70
Bo
| | | | ofmaturity esentvlaue erest of esentvalue BondValue Pr int Pr + =
Suppose an investor want to purchase a five year bond, Rs.
1,000 par value, bearing the nominal interest rate of 7 percent
per annum. The investor required rate of return is 8 percent.
What should be the value of the bond?
51 . 960 681 51 . 279 = + = BondValue
Calculation of Yield to Maturity
Yield to maturity is worthful to measure when bond is
available at premium or discount.
A bond is said to available at discount when it is available
at less price than the face value.
A bond is said to available at premium when it is available
at more price than the face value.

n n
n
y
Bn
y
Int
y
Int
y
Int
y
Int
Bo
) 1 ( ) 1 (
...
) 1 (
3
) 1 (
2
) 1 (
1
3 2
+
+
(

+
+
+
+
+
+
+
=
Calculation of Yield to Maturity
A bond is available at Rs. 94/- with face value Rs. 100/.
The bond will pay interest at 15 percent per annum for 7
years.
5
7
1
) 1 (
100
) 1 (
15
94
kd kd
t
t
+
+
+
=

=
When kd=17%,
15*PVFA (17%,7)+100*PVF (17%,7)=92.13
When kd=16%
15*PVFA (16%,5)+100*PVF (15%,5)=95.97
It means that the cost of this bond will lie between 17 and
16%.
By Interpolation
Difference
PV required 94.0
1.97
Pv at 16% 95.97
3.84
Pv at 17% 92.13
% 5 . 16
84 . 3
97 . 1
%) 16 % 17 ( % 16 = + = Kd
The cost of this bond will be 16.5%
Calculation of Current Yield
Yield to maturity takes into account present value of interest
payments and capital gain or loss over the bond. But current
yield is takes into account only annual interest and does not
consider capital gain or loss. Current yield is annual interest
divided by bonds current market price.
bond of price market current
nterest i Annual
ld CurrentYie =
A bond is available at Rs. 883/- with face value Rs. 1000/-. The
bond will pay interest at 6 percent per annum for 5 years.

The current yield is 60/883= 6.8%
Calculation of Yield to Call/Put
Corporate bonds are also available with call and put
provisions.
If bond is available with call provision, it means that
company can call back its bond before maturity. On in
other words bond will be redeemed or called before
maturity.
On the other hand if bonds are available with put provision
then investor has the right to redeem the bond before the
maturity period.
A 10 year bond will pay 10% interest, with face value Rs.
1000/- is callable is 5 years at a price of Rs. 1050/- The
bond is currently available at Rs. 950/- What is the yield to
call of the bond?
When bond amortized each year
The govt. is proposing to sell a 5 year bond of 1000 at 8%
interest rate per annum. The bond amount will be amortized
equally over its life. The required rate of return of the investor
is 7%. What will be the present value of the bond?
Interest in the 1
st
year = 1000*0.08=80
2
nd
year= (1000-200)*0.08=64
3
rd
year= (800-200)*0.08=48
4
th
year=(600-200)*0.08=32
5
th
year=(400-200*0.08=16
1025
) 07 . 0 1 (
216
) 07 . 0 1 (
232
) 07 . 0 1 (
248
) 07 . 0 1 (
264
) 07 . 0 1 (
280
5 4 3 2
=
(

+
+
+
+
+
+
+
+
+
= Bo
There fore the present value of this bond is Rs. 1025.
Bond value and Semi annul Interest
Payments
It a practice of many companies in India to pay interest on
bonds semi annually. In such a case the present value of
the bond can be estimated as follow:
n
n
t
t
Kd
Bn
Kd
Int
Bo

=
|
.
|

\
|
+
+
|
.
|

\
|
+
=

2
2
1
2
1
2
1
) ( 2 / 1
Bond value and Semi annul Interest
Payments
A 10 year bond of Rs 1000 has an annual rate of interest of
12%. The interest is paid half yearly. What is the value of the
bond if required rate of return is 12%?
10 2
10 2
1
2
12 . 0
1
1000
2
12 . 0
1
) 120 ( 2 / 1

=
|
.
|

\
|
+
+
|
.
|

\
|
+
=

t
t
Bo
20
20
1
) 06 . 1 (
1000
) 06 . 1 (
60
+ =

= t
t
Bo
= 60x Annuity factor (6%,20)+1000x PV factor (6%,20)
=60x98181+1000x0.2145
=589.09+214.50
=803.59
The present value of this bond is 803.59.
Bond Price and Systematic Risk
Bond is a fixed income security which promises to pay
interest on periodically basis at fixed rate. Certain
systematic factors significantly affects the value of the
bonds. They includes-
1. Purchasing power risk
2. Interest Rate risk
Purchasing Power Risk and Bond
Value
Purchasing power risk arises because of lowering
down of purchasing power of currency due to rise
in inflation level. A rise in inflation lower down the
value of currency.

Suppose a bond is giving 6% interest rate and
prevailing inflation is 7% then nominal rate of return
will be -01%. A result the value of the bond will fall.
Interest Rate Risk and Bond Value
Interest rate which is offered by bank deposits have negative
relation with bond price.
A rise in the interest rate will lower down the value of bond
because investors will be motivated to invest their funds in
bank deposits and vice versa.
Ke
bond over nterest I
ice Bond = Pr
Where, Ke is cost of capital, which is considered equal to
market interest rate offered by banks over the deposits.
A equation indicates the negative relation between bond
price and market interest rate.
Interest Rate Risk and Bond
Value.cont
Interest rate risk has two dimension, the way in
which the market interest rate risk affects the bond
price.
Price Risk
Reinvestment Risk
Price Risk
The price of bond is significantly change with respect
to maturity value, coupon value, and general
economic conditions.
Longer the maturity of the bond, the greater the bond
price volatility.
Lower the coupon value, the greater the bond price
volatility.
Stable the economic condition, the lower the bond price
volatility.
Reinvestment Risk
Reinvestment risk is arises when interest which is
earned over the bond is reinvested further in the
bond.
For example a bond with face value Rs. 100 is
giving 10% interest and market interest rate is 7%.

Suppose when in the second year Rs. 10 is further
invested in the bond and at that time the prevailing
market interest rate is 11%, then it is not worthful
to invest Rs. 10 in the bond. This is called
reinvestment risk.
Asset Securitization
Asset securitization is process in which book debt or mortgage back
securities are converted into marketable securities and these
securities are sold into the market.
For example ICICI bank has given Rs 20 lakh house loan for 20 years
at 10% annual interest rate. Now bank will be able to recover this Rs
20 lakh in next 20 years, but bank needs liquidity to run day to day
business. To recover this loan ICICI bank will create new entity
which is called special purpose vehicle. This special purpuse vehicle
will sell securities into market in the form of pass through certificate.
So ICICI bank can covert these loan into marketable securities which
are know pass through certificate (PTC). These pass through
certificate are sold into the market at some lower interest rate (less
than 10%).
By selling these PTC, ICICI bank has recovered its loan from the
market.
The whole process is called asset securitization.
Asset Securitizationcont
The above diagram explain the process of asset securitization.
The Term Structure of Interest Rate
The term structure of interest rate refers the shape
of yield of bonds with different maturity period is
called term structure of interest rate.

Bond is long term debt instrument, whose price is
significantly affected by prevailing market interest
rate which tends to change frequently.
In doing the valuation of bonds the term structure of
interest rate helps in finding out the right price of the
bonds.
Shape of Term Structure of Interest Rate
0
1
2
3
4
5
6
7
8
9
10
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
In assigning the cost of capital, the term structure of interest
rate are seen i.e. what will be the shape of market interest
rate over the period. It can be of three shapes-
Flat-In future the market interest rate will remain same.
Steep-In future market interest rate will decline.
Inverted-In future market interest rate will rise.
Causes of Term Structure
The term structure of interest rate or yield curve is
determined by number of factors. The commonly
used hypothesis are-
The expectation hypothesis
Liquidity preferences hypothesis
Segmented market hypothesis
The expectation hypothesis
This hypothesis holds that the current structure of
interest rate is determined by common consensus
forecast of future interest rate.

For example if one year bond is giving 7%
interest rate and 2 year bond is giving 8% interest
rate, then investors will start to expect the rise in
the interest rate over the period.
On the other hand, if one year bond is giving 8%
interest rate and 2 year bond is giving 7% interest
rate, then investors will start to expect the fall in
the interest rate over the period.

Liquidity preferences hypothesis
This hypothesis states that the term structure is
determined by liquidity preferences.
If the there will be high demand for liquidity, the
interest rate will be high.
On the other hand if there will be low demand for
liquidity, the interest rate will be low.
Segmented market hypothesis
This hypothesis holds that the group of investors
regularly prefer bonds within particular maturity
ranges in order to hedge their liabilities or to
comply with regularly requirements.

So when the demand for one group of investors
increases relatively others, yields within the
maturity range where demand has risen will fall
relatively to the yields within the maturity range
where demand is less.
Bond Value and Unsystematic Risk
Bond value is largely affected by unsystematic
risk-the inherent factors of the company. There
is a risk of default of the bond. Default is a
situation where issuer fails to meet of the debt
contract.
In other words default refers to the probability that
the return realized will be less than promised,
rather than total cost.
Unsystematic risk is of two types:
1. Financial risk
2. Business risk
Bond and Financial Risk
Financial risk caused by the way a firm finances its
activities or expansion plans. If a firm raises debt
in the market it increases its obligation to pay fixed
amount of fund, viz., interest to the debtors.
Investors perceive it risky to invest in those stocks
whose debt equity ratio is high.
Corporate bonds sell at higher yields than
govt. because of business and financial risk.

Bond and Financial Riskcont.
Business and financial risk are absent from govt.
bonds because of the govt. ability to meet debt
servicing requirements.
Bond and Business Risk
Business risk, emerges because of operating
conditions, variability in business conditions,
dividend decisions etc.
Business risk also affects the possibility of default of
a bond. If the business risk of a company will be very
high, the fear of default of the bond will be high vice
versa.
Bonds and Credit Rating
Credit rating is done on the basis of unsystematic
risk prevailing in the firm.
Credit rating a codified rating assigned to a bond
by an independent credit rating agencies. Credit
rating of a bond indicates the quality and safety of
the bonds. In fact it indicates how much safe it is to
invest in this bond?
Credit Rating of Moody
AAA Best quality.
AA High grade.
A High medium grade.
BAA Lower medium grade.
BA Process speculative elements.
B
Generally lack characteristics of desirable
investment.
CAA Poor standing, may be in default.
Ca Speculative to a higher degree.
C Lower grade.
Credit Rating of Standard & Poor Corp.
AAA Highest Grade
AA High grade.
A Upper medium grade.
BBB medium grade.
BB Lower medium grade.
B Speculative.
CCC-CCC Outright speculative.
C Reserved for income bonds.
DDD-D In default, indicating salvage value.
Credit Rating Agencies in India
Credit Rating and Information Services of
India Ltd (CRISIL).

Investment Information & Credit Rating
Agency of India Ltd (ICRA).

Credit Analysis and Research Ltd (CARE).

Majors Factors in Credit Rating
Credit rating of bonds is assigned on the basis of
number of factors, the most common are.
Indenture provision-
Earning power and leverage-
Liquidity-
Management-

Indenture provision
Indenture provisions refer to provisions which are
maintained by the Issuer for the smooth payment
of interest and principal of the bonds. Indenture
provisions include-
1. Borrower require to maintain certain levels of
retained earning, working capital, debt in relation
to assets.
2. Restriction on sale and lease back of assets.
3. Creation of sunk fund.


Earning power and leverage
Earning power of the firm refers to the level of
earning of the firm over the period of time.
It is seen what is the possibility of earning of the
project where debt capital raised through bonds.
Earning power of the firm is judged through-

Are the return levels indicated sustainable? What has
been the track record?
What is the management plan for future regarding the
acquisition and starting of new venture?
What is the general economic and corporate
environment?
Profit margin are increasing or decreasing over
period?
Liquidity
Liquidity refers to firm ability to meet the current
financial obligations. The firms have mainly three
source of cash generation-
1.Internal Cash generation-
It refers the sale of goods and services.
2. External cash generation-
It refers to raise equity and debt capital.
3. Sale of fixed assets-
It includes sale of old fictitious assets.

Management
Management occupied important role in
determining the credit rating of a bond. How
efficient the management is?
Bond Management Strategies
Value of the bond is subject to change with respect to
systematic and unsystematic factors. Bond investors
may adopt passive or active approaches to the
management of their portfolios. The main bond
management strategies are:
Passive Strategy
Semi Active Strategy: Immunization
Active Strategy
Passive Strategy
Passive strategy are of two types:
Buy and hold strategy
Bond Laddering Strategy
Buy and Hold strategy
Buy & Hold strategy refers to purchasing of bonds
and holding it till the maturity. Passive strategy is
used primarily by income maximizing investors who
are interested in the largest coupon income over a
desired horizon.
This type of investors include retired person, endowment
funds, bond mutual funds, insurance companies.

Bond Laddering Strategy
Bond laddering a building a bond ladder buying bonds
scheduled to come due at different dates in the future, rather
than all in the same year.
Bond laddering strategy is good for income looking investors
who are unaware about the interest changes in the market.
Amount Maturity Yield
5000 2 year 4.25%
5000 3 year 4.65%
5000 5 year 5.55%
5000 7 year 5.89%
5000 10 year 6.06%
The average yield of this ladder is 5.28% which is higher
than yield of short duration bonds.
Semi Active Strategy :Immunization
The value of the bond is very much sensitive to systematic
factors like interest rate and inflation. Value of bonds
change with coming the change in interest rate and
inflation.
A portfolio manager may frame an optimal strategy
which will immunize the portfolio from interest rate
changes.
The immunization techniques attempt to derive a
specified rate of return during a given investment
horizon regardless of what happens to market interest
rates.
Therefore eliminating the impact of interest rate
fluctuations from the bond portfolio is called
immunization.
Semi Active Strategy
:Immunizationcont
The impact of the interest rate fluctuations can be immunized
by calculating the duration of the bond.
Duration of the bond is different from maturity period. If bond
is hold for a particular duration the impact of the interest
rate fluctuations get neutralized and investor can realize
the desired yield from the bond.
The duration of the bond can be calculated as follow:

=
=
+
+
=
N
n
n
n
N
n
n
n
i
C
i
C n
Bo
1
1
) 1 (
) 1 (
) (
Where n is the life of the bond, C is the cash receipt at the
end of year n, i is the yield to maturity.

Semi Active Strategy-calculation of
duration of bond
A 3yearbond of Rs 1000 face value will pay 7% interest per
annum. If market interest rate is 7%, What is the duration
of the bond?
81 . 2
) 07 . 1 (
1070
) 07 . 1 (
70
) 07 . 1 (
70
) 07 . 1 (
1070
) 3 (
) 07 . 1 (
70
) 2 (
) 07 . 1 (
70
) 1 (
3 2
3 2
=
+ +
+
= D
The duration of the bond is 2.81 years. So in order the get
the desired yield of the bond, investor will have to keep
invest for 2.81 years.
Semi Active Strategy-calculation of
duration of bond.cont
In contrast, single payment bonds, which sell at a discount
and do not carry coupon interest, will have duration
exactly equal to their terms to maturity.
For example a 3 years bond currently available at Rs 816,
with face value Rs 1000. What will be the duration of the
bond?
3
) 07 . 1 (
1000
) 07 . 1 (
1000
) 3 (
3
3
= = D
The duration of the bond is 3 years. So in order the get the
desired yield of the bond, investor will have to keep
invest for 3 years.
price of bonds when there is change in
the interest rate
When there will be any change in the market interest rate,
the price of the bond will also change.
( ) yield in change MD price in change % % =
) / 1 ( p r
Duration
MD
+
=
Where, MD is modified duration, BP is change in basis point
in market interest rate. MD can be calculated as follow.
Where, MD is modified duration, r is market interest rate, p
is interest payments per year.
Example
A 1000 par value bond with 3 years maturity, paying an annual coupon
of 6% and 8% is the market interest rate. Present value of the bond is
994.85. What changes will come in the price of the bond if market
interest rate changes from 8% to 9%?
62 . 2 ) 1 / 08 . 0 1 /( 83 . 2 = + = MD
First of all lets calculate the duration of the bond
With change in the interest rate, the modified duration of
the bond is:
83 . 2
) 08 . 1 (
1060
) 08 . 1 (
60
) 08 . 1 (
60
) 08 . 1 (
1060
) 3 (
) 08 . 1 (
60
) 2 (
) 08 . 1 (
60
) 1 (
3 2
3 2
=
+ +
+
= D
( ) 62 . 2 ) 1 ( 62 . 2 % % = = = = eld changeinyi MD ice Changeinpr D
Therefore the price of the bond should reduce to -2.62 and
now it will be 994.85 (1-0.0262)=992.41.
Exercise
Calculate the duration for a three year zero coupon bond
and a three year bond with 9% coupon if both the bonds
have 9% yield to maturity.
Ans. The duration of the zero coupon bond will be equal to
the maturity period of the bond. It is 3 years.
Calculation of the duration of the second bond:
?
) 09 . 1 (
1090
) 09 . 1 (
90
) 09 . 1 (
90
) 09 . 1 (
1090
) 3 (
) 09 . 1 (
90
) 2 (
) 09 . 1 (
90
) 1 (
3 2
3 2
=
+ +
+
= D
Exercise
A bond with 12% coupon issued 3 years ago is redeemable
after 5 years from now at a premium of 5%. The interest
prevailing in the market is 14%. Calculate the duration of
the bond?
Exercise
A 3 year bond with 9%coupon has YTM of10%. What is
the current price of the bond? If yields fall below 50
points basis. Use duration to estimate the new price?
Immunization of Bonds
An investor needs Rs 1 lakh after 2 years and has two bonds in his mind
with YTM of 10%. Bond A has annual coupon rate of 7%, matures in 4
years and is priced at 904.90. bond B has annual coupon of 6%
matures in one year and is priced at 963.64. How many bonds of each
should he buy?
First of all we need to calculate the amount needed today to get Rs 1 lakh
after two years
Money required=100000/1.1^2=82644.63
The next step is to calculate the duration of the bonds:
Duration of A=
(70/1.1+2*70/1.1^2+3*70/1.1^3+3*70/1.1^3+4*1070/1.1^4)/904.9=3.6029
Duration of B will be one year.
We need to combine A and B to get a weighted average duration of 2,
taking X as the proportion to be invested in A and 1-X as the proportion
invested in B we solve the equation:
3.6029X+(1-X)*1=2
Immunization of Bondscont
Proportion in A=X=0.3842, in B=0.6158
Therefore the amount to be invested in
A=82644.63*0.3842=31752.06
And in B=50892.56
No. of bonds that needs to be purchased is the amount to
be invested divided by the price per bond
No of A =31752.06/904.89=35.09
No of B= 50892.56/963.64=52.82
Active bond management strategy
Switching bonds based on rate forecasting can be the most
productive bond portfolio action. The following are key
points in active bond management strategy.
Maturity:
Maturity should be lengthened when interest rates are
expected to fall and price to rise.
Sector:
The yield of the bond largely depend upon sector. Govt.
bonds provides less return in comparison to private sector
bonds.
Quality or grading of bond:
If investor has to invest for long time period then he should
invest only in high grade bonds, on the other hand low
grades bonds are good for short time period investment
horizon.
Active strategy-Yield curve
anticipation
The term structure of the interest rate helps
in forecasting the future interest rate of the
bond.
By looking the historical interest rate,
investor can forecast the future interest
rate.
Industry Analysis
Industry Analysis is done to see the present
and future growth prospects of the industry.
Through Industry Analysis the weaknesses
and strengths of the industry are analyzed.
Types of Industries
1. Transport Services
2. Health Care
3. Diversified
4. FMCG
5. Agriculture
6. Transport Equipment
7. Textile
8.Oil and Natural Gas
9. Chemical and Petroleum
10. Tourism
11. Capital Goods
12. Finance and Banking
13. Power
14. Telecom
15. Metal, Metal Products, &
Mining
16. Information Technology
17. Consumer Durables
18. Media and Publishing
Industries are classified on the basis of nature of
business.
Industry Classification according to
Business Cycles
Growth Industries-
Growth industries are those industry which are growing over
the period of time irrespective of economic growth rate
(GDP). The growth rate of these industries are not much
affected by economic growth rate because of having huge
business opportunities like Software industry, retail industry,
Information technology. Stocks of such industries are called
Growth Stocks.

Cyclical Industries-
Cyclical industries are those industries whose growth rate is
largely affected by economic growth rate (GDP). These
industries expand with high economic growth rate whereas
growth rate decline with the decline of economic growth rate
like Consumer good industry, Aviation, Hotel and Tourism.
Stocks of such industries are called Cyclical Stocks.
Industry Classification according to
Business Cyclescont
Defensive Industries-
Defensive industries are those industries whose growth
rate is not affected by growth rate of economy (GDP) like
Health Care. Stocks of such industries are called
Defensive Stocks or Income Stocks.

Cyclical Growth Industries-
Cyclical growth industries are those industries whose
growth rate fluctuates to lesser degree with economic
growth rate (GDP). Stocks of such industries are called
Cyclical Growth Stocks.

Industry Analysis
Quantitative Analysis-
Quantitative analysis of industry deals with
estimation and comparison of growth and
profitability values of different industries with
each others.

Qualitative Analysis-
Qualitative analysis deals with analysis of
subjective factors with are associated with
different industries.
Quantitative Analysis
1.Forecasting of Present and Future Market
Position and Profitability of the Industry.
Investment Strategy-
Income Objective
High Profitability Ratio
Industries
Growth Objective
High Market Share
Industries
2. Comparative Analysis of Industries in
Stock Market
0
5
10
15
20
25
30
35
40
S
e
p
-
0
1
M
a
r
-
0
2
S
e
p
-
0
2
M
a
r
-
0
3
S
e
p
-
0
3
M
a
r
-
0
4
S
e
p
-
0
4
M
a
r
-
0
5
S
e
p
-
0
5
M
a
r
-
0
6
S
e
p
-
0
6
M
a
r
-
0
7
S
e
p
-
0
7
Sensex P/E Drugs and Pharma P/E Information Tec. P/E
Qualitative Analysis
1. Attitude of the Govt. to the Industry-
2. Attitude of the common Public-
3. Permanence-
4. Labour Conditions-
5. Competitive Advantage
1. Product Differentiation Advantage-
2. Absolute Cost Advantage-
3. Economies of Scale-
Michael E. Porters approach of Industry
Analysis
Threats
of
Potentia
l
Entrants
Buyers
Negotiatio
n
Power
Threats
Of
Substitutes
Suppliers
Negotiation
Power
Industry
Competitors
Michael E. Porters approach of Industry
Analysiscont
Industry Competitors-
In a industry the following types of competition can
be there.
Perfect completion
Imperfect competition
Monopoly
Oligopoly

Michael E. Porters approach of Industry
Analysiscont
Threats from new entrants
In some industries it is easy to make entry while in
some industry it is difficult to make entry. There
are certain barriers which make it difficult to make
entry. These are-
Cost related barriers
Regulation related barriers
Michael E. Porters approach of Industry
Analysiscont
Buyers negotiation power
In some industries buyer have more negotiation
power. Buyers can influence the price of the
product as a result the profit of the firms from such
industry will remain volatile.
Supplier negotiation power
In some industries suppliers have more negotiation
power. Buyers can not influence the price of the
product as a result the profit of the firms from such
industry will remain stable.

Fundamental Analysis
Fundamental Analysis deals with the macro level analysis of
the economy by which the prospective ness of the economy is
analyzed.
Before investing into any stock market Institutional investors
are interested in the present and future growth prospects of
that market.
Therefore fundamental analysis or economic analysis serves
a great purpose to the investors.
Relationship between Economic
Fundamentals and Stock Market
Appreciation
in
domestic currency
Bullish
Stock Market
Strong Economic
Fundamentals
More FIIs
Growth Rate-
GDP is defined as the total market value of all final goods and
services produced within the country in a given period of time.
Whereas Gross National Product is the market value of final
products and earning from abroad.
0
1
2
3
4
5
6
7
8
9
1
9
9
6
-
9
7
1
9
9
7
-
9
8
1
9
9
8
-
9
9
1
9
9
9
-
0
0
2
0
0
0
-
0
1
2
0
0
1
-
0
2
2
0
0
2
-
0
3
2
0
0
3
-
0
4
2
0
0
4
-
0
5
2
0
0
5
-
0
6
Year
G
D
P

G
r
o
w
t
h

R
a
t
e
Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Growth Rate 7.8 4.8 6.5 6.1 4.4 5.8 4.0 8.5 7.5 8.1 9.0 9.5

2. Per Capital Income-
Per capita income means how much each individual
receives, in monetary terms, of the yearly income that is
generated in their country through productive activities. That
is what each citizen would receive if the yearly income
generated by a country from its productive activities were
divided equally among everyone.


3. Attitude of Other Investors-FII and FDI
Trends-
Foreign institutional investment refers investment into
financial securities like equities, mutual funds, derivatives,
bonds. Whereas FDI refers to investment in real assets like
plant, machinery etc.
4. Inflation Rate-
The inflation rate is a measure of inflation, the rate of
increase of a the price of basic goods which is calculated by
some price index (usually some form of consumer price
index). Equivalently, the rate of decrease in the purchasing
power of money. A high inflation will discourage the foreign
investment whereas a low inflation encourage the foreign
investment.
Inflation
Stock Market
5. Interest Rate (Monetary Policy) -
The interest rate which is offered by banks over their
deposits is also major determinate of foreign investment. A
high interest rate will encourage investment in Debt Market,
whereas a low interest rate will encourage the foreign
investment in Capital Market.
Interest rate
Stock Market
-40.00
-20.00
0.00
20.00
40.00
60.00
80.00
M
a
y
-
9
6
M
a
y
-
9
7
M
a
y
-
9
8
M
a
y
-
9
9
M
a
y
-
0
0
M
a
y
-
0
1
M
a
y
-
0
2
M
a
y
-
0
3
M
a
y
-
0
4
M
a
y
-
0
5
M
a
y
-
0
6
Year
R
e
t
u
r
n
6. Capital Market Analysis- Movement of Index
May-96 May-97 May-98 May-99 May-00 May-01 May-02
3709 3724 3673 3835 4434 3623 3136
May-03 May-04 May-05 May-06 May-07 May-08
3172 4760 6666 10679 14451 17000
Comparative Analysis of Difference
Stock Markets Returns
Market/Index March 2006 Dec. 2006
South Korea KOSPI 10.86 12.21
Thailand SET 9.97 9.40
Indonesia JCI 21.68 25.10
Malaysia KLCI 15.33 17.35
Taiwan TWSE 14.62 20.85
BSE SENSEX 20.92 22.76
NSE S & P NIFTY 20.26 21.26
Growth Prospectus of Stock Returns
CAGR for the Period 2000-2007
CAGR isn't the actual return in reality. It's an imaginary
number that describes the rate at which an investment would
have grown if it grew at a steady rate. You can think of CAGR
as a way to smooth out the returns.
S & P 500 Hang Sang Kospi Sensex SSE Com. Index Nikkei 227
Op 1478 15532 943 3972 1535 8340
Cl 1523 27812 1897 20287 5261 15307
CAGR 0.4% 8% 10% 26% 19% 12%
Some Other Important Factors
Internal Political and Social Events-
The internal political and social stability have positive
impact upon the foreign investment. It create a good
climate for investment in the economy and investors are
motivated to invest in the economy.
Budget Analysis-
Budget of the Govt. can be surplus or deficit. Budget deficit
is another important factor which determine the foreign
investment in the country. A high budget deficit in the
indication of govt. excess spending, and govt. owes debt.
Consumer Survey
Consumer survey indicates the trend of consumers
preferences, their income level, their attitude towards a
particular products.
Index of Industrial Production-
Index of industrial production indicates the performance of
manufacturing industries, coal and mining industries and oil
refining industries.
Agriculture Production
Agriculture production also indicates the performance of
the economy. Agriculture of the economy is self reliance or
it is depending upon monsoon. If agriculture is depending
upon monsoon then GDP growth rate of the economy will
be highly unstable.
Company Analysis
Company analysis stands for analyzing the companys strengths and
weaknesses. With the help of the company analysis the growth
prospectus of the company are analyzed.
Internal Analysis of the Company:
Internal analysis of the company can be done by understanding the
income statement and financial statement of the company.
The internal analysis of the company can be done by calculating the
various accounting ratios by using the information given in the
income statement and financial statement of the company.
External Analysis of the Company:
On the other hand the external analysis of the company can be done by
valuing the preference share and common equity share of the
company.

Valuation of Redeemable preference
shares
n n
n
k
Pn
k
Div
k
Div
k
Div
k
Div
Po
) 1 ( ) 1 (
...
) 1 (
3
) 1 (
2
) 1 (
1
3 2
+
+
(

+
+
+
+
+
+
+
=
Suppose an investor is considering the purchase of a 12 years
preference shares, with Rs. 100 par value and 10% dividend rate.
The redemption value of the preference share is Rs. 120/- The
investor required rate of return is 10.5%. What price should investor
pay for this preference share?
12 12 3 2
) 105 . 0 1 (
120
) 105 . 0 1 (
10
......
) 105 . 0 1 (
10
) 105 . 0 1 (
10
) 105 . 0 1 (
10
+
+
(

+
+ +
+
+
+
+
+
= Po
P0=[ value of dividends]+[ value of preference share]
P0=[ 65.06]+[ 36.24]=101.30
Valuation of Irredeemable Preference
shares
Suppose a company has issued Rs. 100 irredeemable
preference share on which it pays a dividend of Rs. 9/-.
Assume that this type of preference share is currently
yielding a dividend of 11%. What should be the price of
this preference share?
82 . 81
11 . 0
9
= = =
K
Div
Po
Valuation of Common Equity shares
The valuation of common equity shares are
more difficult in comparison of bond and
preference shares because of uncertainty of
earning and market price of common
shares.
However, by looking the historical track
record of dividend and market price of
common equity shares we can do valuation.
Valuation of Common equity shares
Single Period Valuation-
Dividend Discount Method-
Suppose an investor is willing to buy a share whose trading is going
at Rs. 19/- suppose the share is expected to pay dividend equal to
Rs. 2/- and year end the price will be Rs. 21/- If the investor
opportunity cost of capital is 15 percent, how much should he pay
for the shares?
20
15 . 1
21 2
) 1 (
1
=
+
=
+
+
=
K
P Div
Po
Rs. 20/- is the present value of the share.
If market price of the share is more than the current price, it means
the share is over valued.
On the other hand if the market price of the share is less than the
current price of share than the share is undervalued.
Valuation of Common equity shares
Multiperiod Valuation-
Dividend Discount Method-
In multiperiod valuation the share is kept hold for number of years, and in
which a series of dividend is received by the investors.
n n
n
k
Pn
k
Div
k
Div
k
Div
k
Div
Po
) 1 ( ) 1 (
...
) 1 (
3
) 1 (
2
) 1 (
1
3 2
+
+
(

+
+
+
+
+
+
+
=
Price of Common equity share when there is
growth in dividend
Suppose an investor is willing to buy a share whose
trading is going at Rs. 20/- . The last dividend paid by the
firm was Rs 2 , and it is expected to growth by the rate of
5% perpetually,. The cost of capital is 10%, then what will
be the price of the of this common share?

42
05 . 0 10 . 0
) 05 . 1 ( 2 1
0 Rs
g K
Div
P =

=
The price of this equity shares will be Rs 42 to the
company.
example
Suppose that dividend per share of a firm is expected to be Rs
1 in the next year, and the expected to grow by 6% per year
perpetually. Determine the cost of equity capital is the current
market price of the share is Rs 25.
% 10 1 . 0 06 . 0
25
1
0
1
or g
P
Div
K = + = + =
The cost of this equity shares will be 10% to the
company. The expected price of the stock can also be
found out-
50 . 26
06 . 0 10 . 0
06 . 1 2
1 =

=
g Ke
Div
P
So the price of this stock in the next year is expected to
be 26.50.
example
A company paid a dividend of Rs 3.70 in the previous year.
The dividends in the future is expected to grow perpetually
at a rate of 8%. Find out the price of capital if capitalization
rate is 12%?.
100
08 . 0 12 . 0
) 08 . 0 1 ( 70 . 3
Rs K =

+
=
So price of this share should be Rs 100
g Ke
Div
g Ke
g Div
Po

+
=
1 ) 1 (
Cost of equity in two stages growth
The fertilizers Ltd has been growing at a rate of 7% per year in recent
years, and it is expected this growth rate will continue in next three
years, then it is likely to grow at the normal growth rate of 6% in next
2 years, after that it will grow at a rate of 5% perpetually. The
required rate of return of the shares of investor is 12%, and the
dividend paid by the company in last year was 3. At what price would
you as an investor be ready to buy this stock in 5th year?
Div in 1
st
year: 3*1.07=3.21
Div in 2nd year: 3.21*1.07=3.43
Div in 3nd year:3.43*1.07=3.67
Div in 4nd year: 3.67*1.06=3.89
Div in 5nd year: 3.89*1.06=4.13
P5=D6/(K-g)=4.13(1+0.05)/(0.12-0.0.5)
P5=Rs 61.95
It means the price of this stock in the 5
th
year will be Rs 61.95.
The last dividend declared by the company Rs 2 per share. For the
next two years the expected growth rate is 15% p.a. and thereafter
9% p.a. forever. The required rate of return is 10%. What price you
should pay for this stock?
D1=2(1+0.15)=2.30
D2=2.30(1+0.15)=2.645

P2=D3/(K-g)=2.645(1+0.09)/(0.15-0.10)
P2=288.30
PV=2.30/(1+0.10)+2.645/(1+0.10)^2+288.30/(1+0.10)^2
PV=2.09+2.18+238.27=242.55
It means investor should be ready to purchase this stock at Rs. 242.55.

X Ltd declared Rs 0.71 dividend in the last year. The dividend is expected to grow
Required rate of return is 16%.Growht rate of dividend is 15% for ten years and 10%
thereafter. What will be the price of the stock in 10
th
year? What price will you pay of
the stock today?
D1=0.71(1+0.15)=0.82
D2=0.82(1+0.15)=0.95
D3=0.95(1+0.15)=1.10
D4=1.10(1+0.15)=1.25
D5=1.25(1+0.15)=1.45
D6=1.45(1+0.15)=1.66
D7=1.66(1+0.15)=1.90
D8=1.90(1+0.15)=2.18
D9=2.10(1+0.15)=2.15
D10=2.15(1+0.15)=2.88
Price of the share in the 10
th
year will be P10=D11/K-g
P10=2.88(1+0.10)/(0.16-0.10)=52.80
The price of the stock today will be:
PV=0.82/(1+0.16)+0.95/(1+0.16)^2+1.10/(1+0.16)^3+1.25/(1+0.16)^4+
1.45/(1+0.16)^5+1.66/(1+0.16)^6+ 1.90/(1+0.16)^7+2.18/(1+0.16)^8+
2.51/(1+0.16)^9+2.88/(1+0.16)^10+52.80/(1+0.16)^10
=6.82+11.93=18.75
The investor should be ready to pay Rs 18.75 for this stock today.


Major Balance Sheet Items
Assets
Current assets:
Cash & securities
Receivables
Inventories
Fixed assets:
Tangible assets
Intangible assets
Liabilities and Equity
Current liabilities:
Payables
Short-term debt
Long-term liabilities
Shareholders' equity
An Example: XYZ Balance Sheet
Assets:
Current Assets: 7,681.00
Non-Current Assets: 3,790.00
Total Assets: 11,471.00
Liabilities:
Current Liabilities: 5,192.00
LT Debt & Other LT Liab.: 971.00
Equity: 5,308.00
Total Liab. and Equity: 11,471.00
Understanding the Income
statement
Sales 25,265.00
Costs of Goods Sold -19,891.00
Gross Profit 5,374.00
Cash operating expense -2,761.00
EBITDA 2,613.00
Depreciation & Amortization -156.00
Other Income (Net) -$6.00
EBIT 2,451.00
Interest -$0.00
EBT 2,451.00
Income Taxes -785.00
Special Income/Charges -194.00
Net Income (EAT) 1,666.00
Major Income Statement Items
Gross Profit = Sales - Costs of Goods Sold
EBITDA
= Gross Profit - Cash Operating Expenses
EBIT = EBDIT - Depreciation - Amortization
EBT = EBIT - Interest
NI or EAT = EBT- Taxes
Net Income is a primary determinant of the firms
cashflows and, thus, the value of the firms
shares
Objectives of Ratio Analysis
Standardize financial information for
comparisons
Evaluate current operations
Compare performance with past
performance
Compare performance against other
firms or industry standards
Study the efficiency of operations
Study the risk of operations
Rationale Behind Ratio Analysis
A firm has resources
It converts resources into profits through
production of goods and services
sales of goods and services
Ratios
Measure relationships between resources and
financial flows
Show ways in which firms situation deviates from
Its own past
Other firms
The industry
All firms-
Types of Ratios
Financial Ratios:
Liquidity Ratios
Assess ability to cover current obligations
Leverage Ratios
Assess ability to cover long term debt obligations
Operational Ratios:
Activity (Turnover) Ratios
Assess amount of activity relative to amount of
resources used
Profitability Ratios
Assess profits relative to amount of resources
used
Valuation Ratios:
Assess market price relative to assets or earnings
Debt ratio
Debt ratio is used to calculate the ratio of debt in the
total capital of the firm.
Debt Ratio=Total Debt/Total Asset
Debt equity ratio
Debt equity ratio is used to calculate the ratio of debt
and equity in firm capital.
Debt equity ratio=debt/equity
Total asset turnover ratio
Total asset turnover ratio is calculated to measure
how efficiently a firm is converting its asset into sale.

Total asset turnover ratio=net sale/total asset
Net asset turnover ratio=Net sale/Net asset

Return on equity ratio
The return on equity ratio is calculated to measure
the rate of return of the equity share holders.
Return on equity ratio=Net income/equity capital
Return on Investment ratio
Return on investment ratio is calculated to measure
the over all return over the capital employed in the
firm.
ROI=EBIT(1-T)/capital employed.