Corporate Finance

Fundamentals of Corporate Finance

Concepts
Finance can be defined as the process of managing money. It involves procurement and proper utilization of funds as capital. So,
financial management is concerned with the process, institutions, markets, and instruments involved in the transfer of money among
individuals, business enterprises, and units of government.
Major Areas in Corporate Finance
The major areas in finance can be summarized by reviewing the career opportunities in finance. These opportunities can broadly be
categorized as financial services and managerial finance:
Financial Services
Financial services are the area of finance concerned with design and delivery of advice and financial products to individuals, business
enterprises, and government units. It involves a variety of interesting career opportunities within the areas of banking and related
institutions, personal financial planning, investment, real estate, and insurance.
Managerial Finance
Managerial finance deals with the decisions that firms make concerning their cash flows. It is concerned with the duties of the
financial manager in the business enterprise. Financial managers actively manage the financial affairs of any type of business. They
perform such varied financial tasks as planning, extending credit to customers, evaluating proposed large expenditures, and raising
money to fund the firm’s operations.
Financial Management Decisions
Financial decision is the process of benefiting the individuals, business firms, and government units from an understanding of finance.
Financial decisions include:
i. Investment decisions: They assert what assets should the firm own? Three major functions in investments area are: a)
selling, b) analyzing individual securities, and c) determining the optimal mix of securities for a given investor. Although
investment decisions cover a wide range of issues, the central focus is on the selection of assets to be held by the firm as
it attempts to generate future cash inflows.
ii. Financing decisions: They assert how should the firm finance the assets? Once the firm has committed itself to new
investments, it must decide how to finance them. Financing decisions comprise both the regular, ongoing need for funds
as well as episodic needs. If the firm obtains funds from owners, it generates equity claims; if the firm borrows, it
generates debt claims.
iii. Dividend decisions:
iv. Liquidity decisions:
Furthermore, financial management decision is basically concerned with the followings:
a) Capital budgeting- It is the process of planning and managing a firm’s long-term investment.
b) Capital structure- It is the mixture or composition of equity and long-term debt maintained by a firm.
c) Working capital- It is the short-term capital requirements by a firm.

Importance of Corporate Finance

Followings are the importance of financial management:
i. Raising of funds:
ii. Allocation of funds:
iii. Forecasting of profit:
iv. Understanding securities markets

Goals of Financial Manager of a Firm/Corporation

The major goals of the financial manager of a firm are:
i. Profit maximization:
ii. Stock price maximization:
iii. Shareholders’ wealth maximization:
iv. Social Responsibilities:
v. Social Welfare:
Agency Costs
To maximize the wealth and to minimize agency problem shareholders’ incur agency costs. There are the costs of maintaining a
corporate governance structure monitoring management behavior ensuring against dishonest acts of management and giving managers
the financial incentives to minimize the price of the shares.
Agency Problem

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There exists the possibility of conflict of interest between the stockholders and management of a firm. It implies that agency problem
is a potential conflict of interest between-
i) the outside shareholders and the manager or
ii) stockholders and creditors
To prevent manager from acting in their own best interests rather than the best interests of the owners of the large firms is really an
actual problem. This is called an agency problem because managers are hired as agents to act on behalf of the owners.

Balance Sheet Model of a Firm

Capital Structure Pie Theory

Determinants of the Value of the Firm

Market factors
● Economic conditions
● Government rules and regulations
● Competitive environment- Domestic and Foreign

Firm specific factors Investor factors

● Revenues and Expenses ● Income/Savings
● Financing policies ● Age /Life style
● Investment policies ● Interest rate
● Dividend policies ● Risk

Net cash flows, FCF Rate of return, k

Value = ∑ FCFt/(1 + k)t

Alternative Approach to Value of the Firm

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 Financing decision
Sales
Revenue
Weighted
Free
Interest rate Average
Operating Cash
Cost and
Taxes Cost of
Flows Firm risk
Capital
Required (FCF)
Investment in Market risk
(WACC)
Operations

N
Po = ∑ FCFt /(1 + WACC)t
t=1

Financial Management

Wealth Maximization

Financial Decisions

Investment decision Financing decision Dividend decision Liquidity decision

Return Risk
Trade off

Corporate Governance
The system used to direct and control a corporation is referred to as corporate governance. It defines the rights and responsibilities of
the key corporate participants such as shareholders, board of directors, officers and managers, and other stakeholders, and the roles
and procedures for making corporate decisions. Corporate governance also specifies the structure through which the corporate sets
objectives, develops plans for achieving them, and establishes procedures for monitoring performance.

Components of Equities
Capital structure refers to long-term sources of financing for a firm. It is consisted of long-tern debt and equities. Shareholders’ equity
is a residual item that is not fixed. It is the difference between the assets and all other liabilities of a firm which is found as:
Assets – Liabilities = Equity
However, the equities of a firm are comprised of the following components:
i. Common stock: The amount of money paid by the owners of the organization measured as the product of par value (face
value) and number of shares outstanding.
ii. Preferred stock: The amount which is measured by the par value of any shares outstanding promising to pay a fixed rate
of return in the form of fixed dividend.
iii. Surplus: The excess amount above each share of stock’s par value paid by the shareholders.
iv. Equity reserves: Representing any fund for contingencies, providing a reserve for dividend expected, and a sinking fund
to retire stock or debt in the future.
v. Undistributed profit: The net earnings after tax that is retained in the business rather than distributing to the shareholders
as dividends

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 vi. Subordinated debentures: Long-term debt carrying a convertible feature. The holders of them have the right to exchange
their debt for shares of stock.
vii. Equity commitment notes: Debt security repayable only from the sale of stock.
viii. Minority interest in consolidated debentures: The holdings of ownership shares of other business enterprises.

Features and Characteristics of Different Securities

Aspects Common stock Preferred stock Bonds
Claim on income:
Priority Last Second First
Amount Residual Fixed Fixed
Claim on assets:
Priority Last Second First
Amount Residual Fixed Fixed
Claim: Discretionary Discretionary Mandatory
Maturity Perpetual Perpetual Fixed

Cash flows between the firm and financial markets

The distribution of the corporate earnings can be done to the following stakeholders.
 To raise capital a firm sells debt and equity to investors in the financial markets through financing decisions.
 The funds raised by the firm is invested in the investment activities of the firm called investment decision or capital
budgeting.
 The invested funds generate cash for the firm through its operation.
 Cash is paid to the debtors for using external funds as the cost of debt like interest if any.
 Cash is paid to the government as taxes.
 Cash is paid to the equity holders as dividends.
 Retained cash flows are invested in the firm sometimes by distributing stock dividend or bonus shares to the existing equity
holders that also increases capital.

Time Value of Money

Time Line
It is an important tool used in time value of money analysis.
Out flow
An investment, cash deposit, cost of project or an amount paid for some purpose. Generally it has a minus sign.
Inflow
An amount to be received. Money comes from different sources to business.
Compounding
A mathematical process by which the terminal value of a cash flow or series of cash flows is/are determined when compounded
interest is applicable.
Discounting
The process of finding present value of a cash flow or a series of cash flows. It is the reversal of compounding.
Future Value
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The amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest
rate.
Present Value
The value today of a flow of cash or a series of cash flows.
Annuity
An annuity is a series of payments of an equal amount at a fixed intervals for a specified number of periods.
Ordinary Annuity
Commonly known as deferred annuity it is an annuity whose payments occur at the end of each period.
Annuity Due
An annuity whose payments occur at the beginning of each period is called annuity due.
Amortized Loans
A loan that is repayable in equal payments over its life is known as amortized loan.

Problem-01: Find out the future value of Tk.120,000 invested for 10 years at a fixed deposit account paying 12% interest per year.
Solution: We know that,
FVn = PV(1 + i)n = Tk. 120,000 (1+.12)10 = Tk. 120,000 (1.12)10
= Tk. 120,000 (3.1058) = Tk. 372,696

Problem-02: Assume that you purchases a 10-year, 8% savings certificate for Tk. 10,000. If interest is compounded annually, what
will be the value of the certificate when it matures?
Solution: We know that,
FVn = PV(1 + i)n = Tk. 10,000 (1+.08)10 = Tk. 10,000 (1.08)10
= Tk. 10,000 (2.1589) = Tk. 21,589

Problem-03: Your friend promises to pay you Tk. 600,000 two years from now if you loan him Tk. 500,000 today. What annual
interest rate is your friend offering?
Solution: We know that,
FVn = PV(1 + i)n
Tk. 600,000 = Tk. 500,000 (1+i)2
or Tk. 500,000 = Tk. 600,000/ (1+i)2
This can be rearranged as:
(1+i)2 = Tk. 600,000/Tk. 500,000
(1+i)2 = 1.2
Therefore = (1+i) = √1.2
1+i = 1.0954
Therefore, i = 1.09541
= .0954
= 9.54%

Prblem-04: You decide to save to purchase a car in five years. If you put Tk. 100,000 at a savings account paying 10% interest
compounded monthly, how much will you accumulate after 5 years.
Solution: We know that,
FVn = PV(1 + i/m)nm
= Tk. 100,000 (1+.18/12)5×12
= Tk. 100,000 (1+.0083)60
= Tk. 100,000 (1.0083)60
= Tk. 100,000 (1.642)
= Tk. 164,200

Problem-05: Find out the present value of Tk. 100,000 to be received after 5 years from now with 8% discount rate.
Solution: PV = FVn[1/(1 + i)n]
= FVn/(1 + i)n
= 100,000/(1+.08)5
= 100,000(1.08)5
= 100,000(1.4693)
= 68,080

Problem-06: Suppose you promise to receive Tk. 5,000 at the end of each of the next 3 years that will pay you 10% rate of interest
annually. How much will you offer today?
Solution: We know that,
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Annuity PV = C× [1PV factor / i]
= C × [{11 /(1+i)n}/i]
= 5,000 × [{11 /(1+.10)3}/.10]
= 5,000 × [{11 /1.331}/.10]
= 5,000 × [(1.7513)/.10]
= 5,000 × [0.2487/.10]
= 5,000 × [2.487]
= 12,435

Problem-07: You have a choice of receiving 30 payments of Tk. 30,000 a year with the first payment to be received one year from
now, or Tk, 150,000 in cash today. If your opportunity cost is 20%, which one would you prefer?
Solution: We know that,
Annuity PV = C× [1PV factor / i]
= C × [{11 /(1+i)n}/i]
= 30,000 × [{11 /(1+.20)30}/.20]
= 30,000 × [{11 /237.3763}/.20]
= 30,000 × [(1.004213)/.20]
= 30,000 × [.9958/.20]
= 30,000 × [4.979]
= 149,370.
The annuity present value is Tk. 149,370. Since the alternative is higher, so it is acceptable.

Problem-08: Suppose you plan to contribute Tk. 2,000 every year to a fund paying 8% interest. If the fund matures after 30 years,
how much would you receive at the maturity period?
Solution:
Given,
Annuity FVn = C× [Annuity PV factor]
= C × [FV Annuity factor1/i]
= C × [{(1+i)n 1} /i]
= 2,000 × [{(1+.08)301}/.08]
= 2,000 × [{10.06271}/.08]
= 2,000 × [9.0627/.08]
= 2,000 × [113.2838]
= 226,568

Problem-09: How much you have to invest each year in a fund to earn Tk. 500,000 after 15 years with 10% interest?
Solution:
Given,
Annuity FVn = C× [Annuity PV factor]
= C × [FV Annuity factor1/i]
= C × [{(1+i)n 1} /i]
So, 500,000 = C × [{(1+.10)151}/.10]
= C × [{4.17721}/.10]
= C × [3.1772/.10]
= C × 31.772
Therefore, C = 500,000/31.772
= 15,737

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 Cost of Capital
Understanding the cost of capital
From the standpoint of the firm using funds, the required rate of return becomes the minimum acceptable rate of to be earned from the
new investment opportunities. Since the required rate of return is an opportunity cost, the suppliers presumably could earn the required
rate of return from comparable alternative elsewhere, and they are going to demand that the firm earn at least this much. Therefore, the
firm should not accept projects earning less. The cost of capital or the required rate of return for a firm can be defined as the composite
cost of the firm’s financing components. One of the most important concepts regarding investment and financing decision is that of
the weighted average cost of capital (WACC). This is the cost of capital for the firm as a whole, and it can be interpreted as the
required return on the overall firm. A firm can raise capital in a variety of forms and different forms of capital may have different cost
associated with them. The important uses of the cost of capital stand out in particular:
 The cost of capital is an important link in achieving the financial goal of the firm- maximizing the stockholders’ wealth by
maximizing the firm’s equity value.
 Maximization of the firm’s value is closely tied to minimization of all input costs, and capital is an important input.
 The cost of capital is used to make capital budgeting decisions.
Required Return vs. Cost of Capital
Required return (RR) is the rate of return that the firm must earn on the investment just to compensate its investors for the use of the
capital needed to finance the project. This why financial practitioners always say that RR is also the cost of capital (CC) associated
with the investment. The concerns in the financial markets generally use the term required return, cost of capital, and appropriate
discount rate (DR) more or less interchangeably, because, they all mean essentially the same thing. The fact is here that the CC
associated with an investment depends on the risk of that investment. This is one of the most important lessons in corporate finance:
The cost of capital depends primarily on the use of funds, not the source of funds
Calculation of CC
Calculation of CC is a three-part process:
i. Estimating the specific CC
ii. Determining the weights or capital structure proportions,
iii. Combining the costs and weights to obtain an estimate of the CC.

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Estimating the specific CC
Specific CC means the costs of capital of each of the various parts, or components, included in the weighted CC. Finding a specific
CC may be thought of as a two-step process:
i. Finding the investor’s required rate of return associated with the capital source.
ii. Adjusting the investor’s required rate of return as found into a specific CC for the firm by considering:
a) The firm’s tax situation.
b) The flotation costs the firm may incur in acquiring the capital.
A specific CC for the firm is basically the rate of return required by investors adjusted for the firm’s tax and flotation cost particulars.
Investors’ Required Rate of Return (RRR):
In present value terms, investors’ required rate of return for capital source-i, is the discount rate that satisfies the equation below:
N Ct
C0 = ∑ ---------
t=1
(1 + ki)t
where,
C0 = cash paid by the investor at time t = 0
Ct = expected cash payment from the firm to the investors in time t
N = life of capital
ki = investors’ required rate of return for capital source i.
Investors’ Required Rate of Return (RRR) on Equity:
The two sources of new equity capital are common stock (external equity) and retained earnings (internal equity). Investors’ required
rate of return (RRR) on equity reflects the opportunity cost that stockholders can earn outside the firm. Investors’ RRR on common
stock (externally provided equity) and on retained earnings (internally provided equity) are equal. Therefore, we may refer to both or
either as the RRR on equity, ke. A good financial analyst has several ways to estimate ke, but two methods are particularly important.
1. Dividend Discount Model (DDM) Approach:
According to the constant growth-version of DDM, the investors’ RRR on equity is (ke):
ke = [D1/P0] + g
where,
D1= next year’s expected dividend per share
P0 = market price of common stock
g = expected constant dividend growth rate.
Investors’ RRR on common stock = Investors’ RRR on retained earnings =
Investors’ RRR on equity = ke
2. The Capital Asset Pricing Model (CAPM) Approach: The firm’s stock is a financial asset, so we can apply CAPM
to determine the RRR on equity, k e as:
K e = rf +  (rmrf)
where,
rf = risk-free rate of interest
rm = expected rate of return on the market index
 = beta (co-variability) risk of the equity.
Cost of equity
Although common stock and retained earnings have the same RRR , they do not have the same cost of capital . By using the constant
growth-version of DDM, cost of new common stock and retained earnings can be estimated as follows:
i. Cost of common stock: When common stock is issued, the firm incurs flotation costs that reduce the cash proceeds the
firm receives. The cost of new common stock (kCS) can be estimated as:
KCS= [D1 / {(1F)P0}] + g
where,
F = flotation costs as percentage of P0.
ii. Cost of retained earnings: When the firm retains earnings, no flotation casts are involved. The cost of retained earnings, kRE is
as follows:
kRE = [D1/P0] + g = ke
Cost of preferred stock
Since the preferred stock is an equity security with constant dividend payments, we can use the perpetuity version of discounting cash
flow equation to estimate investor’s RRR on preferred stock as follows:
K p = d/P0
where,
d = expected preferred dividend
P0 = price of preferred stock
However, the cost of preferred stock (k P) is:
K P = [d/(1f) P0] = k p /(1f)

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Investors’ RRR on Debt:
Adoption of the discounting cash flow equation to the debt situation, we can solve the following equation for the investors’ RRR on
debt:
N
B0 = ∑(It + Bt)/ (1 + kd)t
t=1

where,
kd = investors’ RRR on debt
B0 = initial price of debt
It = interest paid in time t
Bt = principal repayment in time t
N = maturity date.
Cost of Debt: Two adjustments, one major and one minor, need to be made to estimate the firm’s cost of debt (kD):
Cost of debt = (kD) = [(1 T)/ (1F)] kd
Where,
T = corporate tax rate
F= flotation costs as percentage of B0
kd = investors’ RRR on debt.
Determining the weights or capital structure proportions
Weight is the proportion of one component of capital in the capital structure. We can use the market value of the firm’s equity (E) and
the market value of the firm’s debt (D). So, the total value (V) of the firm would become:
V=E+D
If we divide both sides by V, we can calculate the percentages of the total capital represented by the debt and equity:
100% = E/V + D/V
These percentages can be interpreted just like portfolio weights, and they are often called the capital structure weights. Weights can be
book weight and market weight.
Book weight: It is determined by dividing the book value of each capital source by the sum of the book values of all the long-term
capital sources.
Marker weight: It is determined by dividing the market value of each capital source by the sum of the market values of all the long-
term capital sources.
Combining the costs and weights to obtain an estimate of the CC
Once the various costs of capital and their weights are determined, the overall (composite) cost of capital, commonly known as
weighted average cost of capital (WACC), can be calculated as:
N
WACC = kWACC = ∑wi ki
i=1

where,
kWACC = the weighted average cost of capital
wi = percentage of the capital supplied by i th source
ki = cost of capital of the i th source
N = number of the long-term capital sources in the firm’s capital structure.

Marginal Cost of Capital

Marginal cost of capital (MCC) is the weighted average cost of the last taka of capital raised, reflecting higher marginal costs.
Problems and Solutions
Problem-01:
ABC Corporation can sell new common stock at Tk. 75 per share. Find the costs of internal equity and external equity under the
following situations:
a) Stockholders expect that the next dividend will be Tk. 10 and that dividend will grow at 10 % per year. Flotation
costs are 6% of sale price.
b) Stockholders expect that the next dividend will be Tk. 8 and that dividend will not grow. Flotation costs are Tk.5 per
share.
Solution:
Cost of internal equity
We know that,
Cost of internal equity kRE = [D1/P0] + g
Therefore,
for requirement a):
kRE = [10/75] + 0.10 = 0.1333 + 0.10 = 0.2333 = 23.33%
for requirement b):
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 kRE = [8/75] + 0 = 0.1067 = 10.67 %
Cost of external equity
We know that,
Cost of internal equity KCS = [D1/{(1f)P0}] + g
Therefore,
for requirement a):
KCS = [10/{(1.06)75}] + 0.10 = [10/{.94×75}] + 0.10
= 0.1418 + 0.10 = 0.2418 = 24.18 %
for requirement b):
KCS = [8/(15/75)75] + 0 = [8/(10.0667)75] + 0
= [8/0.9333×75] + 0 = 0.1143 + 0 = 11.43 %
Problem-02:
Bigbee has obtained the following information about the new long-term financing:
Source Net proceeds to firm
Common stock, Tk. 100 par Tk. 100 per share
Bonds, Tk. 1000 par @ 7% Tk. 980 per bond
The firm expects earnings would be Tk. 10 per share for the foreseeable future and all the earnings are paid out as dividends.
Corporate tax rate is 40 %. The firm’s balance sheet is given below (in million taka):
Assets:
Current assets Tk. 200
Fixed assets Tk. 400
Total assets Tk. 600
Liabilities:
Current liab. Tk. 100
Long-term debt Tk. 300
Common euity Tk. 200
Tk. 600
Requirements:
Calculate the firm’s cost of capital:
a) Using book weights
b) Using market weights, assuming that the price of common stock is 10 % above the face value and bond price is 5 % above
par value and flotation costs in bond are 2 %.
Solution:
We know that,
Cost of debt (kD):
kD = [(1 T)/ B0(1f)] kd
kd = 1000 × .07= 70
kD = [(1.40)/{(1.02)×1000}] ×70
= [0.60/980] ×70 = 0.0006122×70 = 0.0429 = 4.29 %
Cost of equity (kCS):
kCS = [D1/P0] + g = [10/100] + = 0.10 = 10 %
Again, we know that,
Weighted average cost of capital (WACC) is:
N
WACC = kWACC = ∑wi ki
i=1

For req: a)
Source of capital Book value Weights Cost of wiki
(in million) (wi) source (ki)
Common stock 200 .40 0.1000 0.0400
Long-term debt 300 .60 0.0429 0.0257
WACC 0.0657
Therefore,
N
WACC = kWACC = ∑wi ki
i=1

= 0.0657 = 6.57 %
For req: b)

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 Source of capital Market value Weights Cost of wiki
(in million) (wi) source (ki)
Common stock (1.10×200) = 220 .4112 0.1000 0.0411
Long-term debt (1.05×300) = 315 .5888 0.0429 0.0253
WACC 0.0664
Therefore,
N
WACC = kWACC = ∑wi ki
i=1

= 0.0664 = 6.64 %

Capital Structure and Leverage

Concept
Capital structure is the composition of corporate common stock, preferred stock, And debt with which a firm plans to raise capitaL.
Optimal capital structure strikes a balance between risk an` return to as to maximiZe the firm’s stock price and this generally calls for
a debt ratio that is loWer t`an the one that maximizes expected earnings per share (EPS).
Common stock
Corporate cap. Preferred stock
Debt (debenture/bond)
Capital structure involves a trade-off between risk and return:
 Debt raises risk for the stockholders
 Debt leads to a higher expected rate of return on equity
Factors Affecting Capital Structure Decision
i. Business risk
It refers to the riskiness of the assets if the firm does not use any deBt. Business rIsK is measured by the uncertainty inherent in th%
firm’s Future ex0ected rate of return on ass%Ts (ROA). The greater the business risk, the lower th% optimal debt ratio.
If a high percentage of a firm’s costs are fixed, then thE firm is exposed to a relatively high degree of bUsiness risk.
 A high degree of operating leverage, othe2 factors held constant, implies that a relatively smaLl change in sales results in a
large change in return on equity (ROE).
 The higher a firm’s operating leverage, the higher its business risk as measured by the standard deviation of Its expected
ROE.
ii. Financial risk
Financial risk occurs when a firm uses debt. It is the additional risk placed on the common stockholders as a result of the firm’s
decision to use debt.
 Debt increases the firm’s expected ROE, when ROA exceeds the cost of debt (ROA > kD)
 Standard deviation (σ) of ROE, if the firm uses zero financial leverage, σ ROE(U), is a measure of the firm’s business risk.
 σ ROE at any debt level is a measure of the total risk borne by stockholders.
 If the firm does not use any financial leverage, σ ROE = σ ROE(U).
 If the firm uses debt, then σ ROE > σ ROE(U) as the business risk is being concentrated on shareholders.
 Difference between σ ROE and σ ROE (U) is a measure of risk increasing effect of financial leverage:
Total risk [σ ROE] – Business risk [σ ROE(U)] = Financial risk [σ ROE – σ ROE(U)]
 Both operating leverage and financial leverage normally work in the same way. They increase expected ROE and also
increase the risk to the stockholders.
 Operating leverage alone affects the firm’s business risk whereas financial leverage alone affects the firm’s financial risk,
and they both affect the firm’s total risk.
iii. Tax treatment
Interest is tax deductible which lowers the effective cost of debts.
iv. Financial flexibility
v. Managerial conservatism

Operating Leverage
Operating leverage refers tot eh extent to which fixed costs are used in a firm’s operation. It implies to the magnification of gains and
losses in EBIT by change that occur in sales. This magnification occurs because in employing assets, the firm incurs different types of
costs. Degree of operating leverage (DOL) can be found as:
DOL = Percent Change in EBIT/ Percent Change in Sales

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Anther expression of DOL is:
DOL = 1 + [Fixed operating costs/EBIT]
Financial Leverage
Financial leverage refers to the extent to which fixed income securities are used in the capital structure. Financial leverage is created
by sources of financing that have fixed costs. These financing fixed costs affect the firm’s earnings per share (EPS) in the same way
that operating fixed costs affect EBIT. Degree of financial leverage (DFL) can be found as:
DFL = Percent Change in EPS / Percent Change in EBIT
Another expression of DFL is:
DFL = EBIT/ [{EBIT –I–L– D/(1–T)}]
where, I = interest payment, L =lease payment, D = preferred dividend,
and T = tax rate.
Combined Leverage
It refers to total leverage, consisting of operating leverage and financial leverage. The degree of combined leverage (DCL) is
calculated as:
DCL =(DOL)(DFL)
Degree of combined leverage can alternatively be found as:
DCL = [Percent Change in EBIT/ Percent Change in Sales] ×
[Percent Change in EPS / Percent Change in EBIT]
= [Percent Change in EPS/ Percent Change in EPS]
Problwm-01: ABC Product is considering some changes in the amount of leverage employed by the firm. Two Proposals, A and B
have been suggested to alter the current situation. The following information are related to the proposals:
[Figures in Tk.]
Particulars Current Proposal Proposal
situation A B
Operating data:
Sales 4,000,000 5,000,000 4,000,000
Variable costs/Sales .40 .30 .25
Fixed costs 1,500,000 2,000,000 2,000,000
Financial data:
Interest payments 90,000 110,000 100,000
Lease payments 100,000 60,000 80,000
Preferred dividends 70,000 75,000 60,000

No. of common shares 500,000 600,000 450,000

The firm’s tax rate is 40%.
Requirements:
a) For current situation, Proposal-A and Proposal-B, determine the followings:
i. Degree of operating leverage,
ii. Degree of financial leverage,
iii. Degree of combined (total) leverage
b) Rank the three plans from most risky to lease risky in the following terms:
i. Business risk,
ii. Financial risk,
iii. Overall (total) risk.
Solution:
To solve the problem, we have to calculate EBIT for each alternative by using the basic formula as:
EBIT = Sales revenue – [Fixed costs + Variable costs]
For current situation,
EBIT = Tk. 4,000,000 – [Tk. 1,500,000 + (.40)×(Tk. 4,000,000)]
= Tk. 4,000,000 – [Tk.1,500,000 + Tk. 1,600,000]
= Tk. 4,000,000 – Tk. 3,100,000
= Tk. 900,000
For Proposal -A,
EBIT = Tk. 5,000,000 – [Tk.2,000,000 + (.30) × (Tk. 5,000,000)]
= Tk. 5,000,000 – [Tk. 2,000,000 + Tk. 1,500,000]
= Tk. 5,000,000 – Tk. 3,500,000
= Tk. 1,500,000
For Proposal-B,
EBIT = Tk. 4,000,000 – [Tk. 2,000,000 + (.25) × (Tk. 4,000,000)]

12
 = Tk. 4,000,000 – [Tk. 2,000,000 + Tk. 1,000,000]
= Tk. 4,000,000 – Tk. 3,000,000
= Tk. 1,000,000
Req.: a)
1. We know that,
Degree of operating leverage (DOL) = 1 + [Fixed operating costs/EBIT]
So, current DOL = 1+ [1,500,000/900,000] = 1 + 1.67 = 2.67
DOL for Proposal-A = 1+ [2,000,000/1,500,000] = 1 + 1.33 = 2.33
DOL for Proposal-B = 1+ [2,000,000/1,000,000] = 1 + 2 = 3.00
2. We know that,
Degree of financial leverage (DFL) = EBIT / [{EBIT –I–L– D/(1–T)}]
So current DFL = Tk. 900,000/ Tk. [900,000 – 90,000 – 100,000 – 70,000/(1 – 0.40)]
= Tk. 900,000/Tk. 593,333 = 1.52
DFL for Proposal-A = Tk. 1,500,000/ Tk. [1,500,000 – 110,000 – 60,000 – 75,000/(1 – 0.40)]
= Tk. 1,500,000/Tk. 1,205,000 = 1.24
DFL for Proposal-B = Tk. 1,000,000/ Tk. [1,000,000 – 100,000 – 80,000 – 60,000/(1 – 0.40)]
= Tk. 1,000,000/ Tk. 720,000 = 1.39
3. We now that,
Degree of combined (total) leverage (DCL) = (DOL) ×(DFL)
So, current DCL = (2.67) × (1.52) = 4.06
DCL for proposal-A = (2.33) × (1.24) = 2.89
DCL for proposal-B = (3.00) × (1.39) = 4.17
Req.: b)
1. Proposal-B > Current position > Proposal-A
2. Proposal-B > Current position > Proposal-A
3. Proposal-B > Current position > Proposal-A

Valuation Model:
The value of a firm can be defined as the sum of the value the firm’s debt and the firm’s equity as given below:
V=D+E
If the management of the firm is to make the firm as valuable as possible, the firm should pick the debt-equity ratio that makes the pie
as big as possible. Changes in the capital structure benefit the shareholders if and only if the value of the firm increases.

Modigliani-Miller Model:
MM Propositions-I:
Franco Modigliani and Merton Miller have a convincing argument that a firm can not change the total value of its outstanding
securities by changing the proportions of its capital structure. The market value of a firm is independent of a change in the debt-equity
ratio. That is value of the levered firm is equal to the value of the unlevered firm:
VL = VU
VU = Value of the firm financed by equity only.
VL = Value of the firm financed both by debt and equity.
The value of the firm is always the same under different capital structures. No capital structure any better or worse than any other
capital structure for the firm’s shareholders.
This pessimistic result is the famous MM Propositions-I.
According to MM Proposition;
EBIT
(V U )= k
The value of the unlevered firm e
where, ke = cost of equity of a unlevered firm.
By adding debt to the unlevered firm we get the value of the levered firm as:
EBIT
(V L )= k + D
The value of the levered firm e
Therefore,
VL = VU + D
An increase in D/E ratio results an increase in the required rate of return on equity.
Example:
Suppose the equity of a firm is Tk. 50 million. EBIT is Tk. 10 million with required rate of return of 10%. According to MM
Propositions-I:
The value of the firm:

13
 EBIT Tk . 10 million
V U= ke = =Tk .100 million
.10
Suppose equity is Tk. 25 million and debt is Tk. 25 million, EBIT is Tk. 10 million, required rate of return is 10% and the cost of debt
is 8%.
Thus, According to MM Propositions-I:
The value of the firm:
EBIT − Int .
(V L )= k +D
e
Tk . (10−2) million
= . 10
+Tk . 25 mn=Tk . 105 million
But MM theory says that the market value of the firm is independent of a change in debt-equity ratio. So, it is essential to increase the
cost of equity as the D/E ratio increases. Therefore, a new required rate of return (cost of equity) would become greater than 10%.
This can be calculated as:
keL = keU + (keU – kd)(D/E)

where,
keL = cost of equity of levered firm
keU = cost of equity of unlevered firm
kd = cost of debt
D/E = debt-equity ratio
Based on MM model, the value of the firm remains unchanged at any D/E ratio:
VL = VU
Thus, the value of equity of the levered firm would be:
VE = VL – D = Tk. (100 – 25) million = Tk. 75 million
Therefore,
D/E ratio becomes = Tk. 25 million / Tk. 75 million = 0.33.
Again,
keL = .10 + (.10 – .08)(.33) = 0.1067 = 10.67 %
Accordingly,
The value of the levered firm becomes:
Tk .( 10−2)million
V L= . 1067
+Tk .25 mn=Tk . 100 million

14
 Dividend Policies and Practices
Introduction
Dividend is the amount of profits distributed to the shareholders by the company. A firm’s dividend policies have the effect of
dividing its net earnings into two parts: retained earnings and dividends. Dividends refer to that portion of a firm’s net earnings which
are paid out to the shareholders. The retained earnings, on the other hand, provide funds to finance long-term growth of the firm. That
is why a major decision of financial management is the dividend decision in the sense that the firm has to choose between distributing
the profits to the shareholders and ploughing them back into the business. Thus, a firm’s after-tax net profit can be divided into two
categories:
1. Funds to finance long-term growth: A major portion of net earnings of a firm is to be kept for long-term financing. Such
earnings may be viewed as a source of long-term financing. Dividend will be paid only when the firm does not have profitable
investment opportunities. The firm grows at a faster rate when it accepts highly profitable investment projects.
2. Funds to be distributed to the shareholders: These are represented by the cash dividend declared by the board of directors and paid
to the common stockholders. There is a type of reciprocal relationship between retained earnings for the long-term financing and cash
dividends: larger retention, lesser diviends; smaller retention, larger dividends.

Approaches to Dividend Decisions

Dividend policies affect both long-term financing and the return distributed to shareholders. So, a firm’s decisions to pay dividends
may be shaped by two possible viewpoints mentioned as under:
a) As a long-term financing decision
When dividend decision is treated as long-term financing decision, the net earnings of the firm may be viewed as a long-term source
of financing. The declaration of cash dividends reduces the amount of funds available to finance growth and either restricts growth or
forces the firm to find other financing sources. Thus, the firm might accept a guideline to retain earnings as long as either of two
conditions exists:
i. Sufficient profitable projects are available: The acceptance of highly profitable projects represents a worthwhile growth goal for
most firms. As long as such projects are available the firm can retain earnings to finance them.
ii. Capital structure needs equity funds: The firm has a variety of sources of long-term funds. To avoid the high risk associated with
excessive debt, the firm must have a balance of debt and equity financing. Because of the costs of floating common stock, retained
earnings are preferable as equity financing. Hence, earnings may be retained a part of the long-term financing decision related to the
management of capital structure.
With either of these guidelines, cash dividends will be considered as a remainder.
b) As a wealth maximization decision
With this approach, the firm recognizes that the payment of dividends has a strong influence on the market price of common stock.
Higher dividends increase the value of the stock to many investors. Similarly, low dividends decrease the perceived value of the stock.
In a wealth maximization sense, the firm declares sufficient dividends to meet the expectations of investors and shareholders. The
management of a firm, while evolving a dividend policy, must strike a proper balance between the aforesaid two approaches. When
the firm increases the retained portion of the net earnings, dividends decrease and consequently the market price may be adversely
affected and vice-versa. But according to Merton H. Miller and Franco Modigliani dividends do not affect market price. According to
James E. Walter, on the other hand, dividend policies have profound effects on a firm’s position in the stock market. For the reason we
do not yet have any evidence on whether a maximization of wealth approach correctly deals with the dividend decision.
Why Do Investors Want Dividends?
Most of the investors want two forms of return from their capital investments. These are:
1.Capital gains/Capital appreciation: Capital gain may be defined as the profit resulting from the sale of the capital investments .
Capital appreciation may also be termed as the capital gains. The investors like common stockholders expect an increase in the market
value of the common stock overtime. The increased value of the stock is termed as capital gain. So, the investors always want some
return as capital gain from their investments.
2. Dividends: The investors also expect a distribution of the firm’s earnings. From mature and stable corporations, most investors
expect regular dividends to be declared and paid to the common stockholders. This expectation takes priority over the desire to retain
earnings to finance expansion and growth.
Reasons for Dividend (viewed on investors)
Several factors may be considered and analyzed in explaining investor’s expectation of dividends over capital gains. Followings are
the major factors in this regard.
Reduction of uncertainty: The promise of future capital gains or a future distribution of earnings involves more uncertainty than a
distribution of current earnings. A current dividend represents a present-value cash inflow to the investor that can not be lost if the
firm later experiences operating or financing difficulties. This reduction of uncertainty is only factor explaining investor preference for
current dividends.
15
Indication of strength: The declaration and payment of cash dividends carry information content that the firm is reasonably strong
and healthy. The dividend declaration reveals liquidity since cash is needed to make the dividend payment and this cash must be taken
away from the firm’s operation. The declaration reveals profitability and more importantly, the expectation of future profitability since
the firm would probably conserve its cash if the management were preparing for future difficulties.
Need for current income: Many shareholders require income from their investments to pay for their current living expenses. These
investors may be reluctant to sell their shares in order to gain cash. Cash dividends provide current income to those investors without
affecting their principal and capital.

Alternative Forms of Dividends

The actual practice is to pay dividends in cash. In addition to the declaration of cash dividends, the firm has other options for
distributing profits to shareholders. These options are stock dividends, stock splits, stock repurchases etc.
Cash dividend: Most companies pay dividends in cash. A company should have enough cash when cash dividends are declared. If the
company do not have enough bank balance at the time of paying cash dividend it has to borrow funds . The cash account and reserve
account of a company will be reduced when the cash dividend is paid. Thus, both the total assets and the net worth of the company are
reduced when the cash dividend is distributed. So, the market price of the share drops in most cases by the amount of the cash
dividend distributed.
Stock dividend (Bonus share): A stock dividend specifically known as bonus shares represents a distribution of shares in lieu of or in
addition to the cash dividend to the existing shareholders. This occurs when the board of directors authorizes a distribution of common
stock to existing shareholders. It has the effect of increasing the number of outstanding shares of the firm’s stock . The shares are
distributed proportionately so that an existing shareholder can retain his proportionate ownership of the company.
Stock splits: A stock split is a method to increase the number of outstanding shares through a proportional reduction in the par value
of the share. It affects only the par value and the number of outstanding shares, the capitalization of the company would not be
changed at all.
Stock repurchase: A repurchase of stock occurs when a firm buys back outstanding shares of its own common stock. A firm
repurchases stock for three major reasons as given below:
i. For stock option: A stock option is the right to repurchase a specified number of shares of common
stock during a stated period and at a stipulated price.
ii. For acquisitions: A firm seeking control of another firm may be willing to offer its own common
stock for the stock of other firm.
iii. For retiring the stock: When a firm retires a portion of its stock, the retirement increases the firm’s
earnings per share. The repurchase of sock for the purpose of retiring it is treated a form of cash
dividend by the internal revenue services.
Determinants of Dividend Policy
The factors that determine the dividend policy of a firm, for the purpose of exposition, be divided into:
a) Dividend payout ratio: Dividend payout ratio (D/P ratio) is the rate of dividends to net earnings. A major aspect of dividend
policy of a firm is its dividend payout ratio i.e., the percentage share of the net earnings distributed to the shareholders as
dividends. Hence, dividend policy involves the decision to payout earnings or to retain them for reinvestment in the firm. The
payment of dividends reduces the cash, and therefore, the total assets. Retained earnings, on the other hand, constitute a
source of financing. Since dividends imply outflow of cash, they hamper the longer-term growth of the firm. The payment of
dividends also affect the price of shares: a low D/P ratio may cause a decline in the share price, while a high D/P ratio may
lead to a rise in the market price of the shares. Therefore, D/P ratio is a major determinants of dividend policy
b) Stability of dividends: The second major aspect of dividend policy is the stability of dividends which refers to the
consistency or lack of variability in the stream of dividends. In more precise terms it means that a certain minimum amount
of dividend is paid regularly. The investors favor a stable dividend and there are several reasons why they would prefer a
stable dividend policy and pay a higher price for a firm’s shares which observe stability in dividend payments. So, stability of
dividend plays vital role in dividend policy.
c) Legal, contractual, internal constraints and restrictions: The firm’s dividend policy is also affected by certain legal,
contractual and internal requirements and commitments. The legal factors stem from certain statutory requirements, the
contractual restrictions arise from certain loan covenants and the internal constraints are the result of the firm’s liquidity
position.
d) Owner’s consideration: The dividend policy is also affected by the owner’s considerations of the tax status of the
shareholders, their opportunities of investment and the dilution of ownership. Undoubtedly, it is well-nigh impossible to
establish a policy that will maximize each owner’s wealth. The firm must aim at a dividend policy which has a beneficial
effect on the wealth of the majority of the equity shareholders.
e) Capital market consideration: Another factor that can strongly affect dividend policy is the extent to which the firm has
access to the capital markets. In case the firm has easy access to the capital markets, either because it is financially strong or
large in size, it can follow a liberal dividend policy. On the other hand, if the firm has only limited access to the capital
markets, it is likely to adopt low dividend payout ratio. So, in this way dividend policy is affected by capital market
considerations.

16
 f) Inflation: Finally, inflation is the another factor which affects the firm’s dividend decision. With rising price, funds
generated from depreciation may be adequate to replace absolute equipments. These firms have to rely upon retained
earnings as a source of funds to make up the shortfall. So, dividend payout tends to be low during the period of inflation.
Factors Affecting Dividend Decision
A) Constraints-
i. Bond indenture
ii. Preferred stock restrictions
iii. Impairment of capital rule
iv. Availability of cash
v. Penalty tax on improperly accumulated earnings
B) Investment opportunities-
i. Number of profitable investment opportunities
ii. Possibility of accelerating or delaying projects
C) Alternative sources of capital-
i. Cost of selling new stock
ii. Ability to substitute debt for equity
iii. Control.
D) Effects of dividend policy on required rate of return.
Dividend Payment Procedure (Key dates) (Ross: Ch-17)
i. Declaration date
ii. Holder-of-record date
iii. Ex-dividend date
iv. Payment date

The Irrelevance of Dividend: General Theory

Dividend decision of firm is a crucial area of financial management. The important aspect of dividend policy is to determine the
amount of earnings to be distributed to the shareholders and the amount to be retained in the firm. Retained earnings are the most
significant internal source of financing the growth of the firm. Dividends, on the other hand, are desirable from shareholders’ point of
view as it tends to increase their current wealth. The objective in choosing a dividend policy should be to maximize the value of the
firm to its shareholders.
Since dividend policy is strictly a financing decision, both dividends and retained earnings depend on the available investment
opportunities. This means that when a firm has sufficient profitable investment opportunities, it will retain the earnings to finance
them. To the contrary, if the firm does not have sufficient acceptable/profitable investment opportunities, the earnings would be
distributed to the shareholders.
The test of adequate acceptable investment opportunities is the relationship between the return on investment (r) and the costs of
capital (k). As long as r exceeds k, a firm is said to have acceptable investment opportunities. In other words, if a firm can earn a
return (r) higher than its costs of capital (k), it will retain the earnings to finance the project. If the retained earning fall short of the
total funds required (r>k) it will raise external funds-both equity and debt- to make up the short fall in order to reap huge profits. If,
however, the retained earnings exceed the requirement of funds to finance acceptable investment opportunities, the excess earnings
would be distributed to the shareholders in the form of cash dividends. The amount of dividend will fluctuate from year to year
depending upon the availability of acceptable investment opportunities. With abundant investment opportunities, the dividend payout
ratio would become zero. On the other hand, if there are no profitable investment opportunities, the D/P ratio will range between zero
percent to 100 percent.
In fine so long as the firm is able to earn more than the equity-capitalization rate (k e), the investors would be content with the firm
retaining the earnings. In contrast, if the return is less than the ke, investors would prefer to receive dividends.
Relevance of Dividends: Some Models
There are some theories that consider dividend decisions to be an active valuation in determining the value of a firm. The dividend
decision is, therefore, relevant. We categorically examine below two theories representing this notion: a) Walter’s Model and b)
Gordon’s Model.
Walter’s Model
Professor James E. Walter argues that the choice of dividend policy almost always affects the value of the enterprise. The investment
policy of an enterprise can not be separated from its dividend policy and both are, according to Walter, interlinked. The key argument
in support of the relevance proposition of Walter’s model is the relationship between the return on a firm’s investment or its internal
rate of return (r) and its cost of capital or the required rate of return (k) in determining the dividend policy that will maximize the
wealth of the stockholders. However, Walter’s model is based on the following assumptions:
a) All financing is done through retained earnings i.e., debt or new equity is not issued.
b) With additional investment undertaken, the firm’s internal rate of return, r, and its cost of capital, k, are considered
constant.
c) All earnings are either distributed as dividends or reinvested immediately.

17
 d) Beginning earnings and dividends never change. The values of the earnings per share, E, and the dividend per share, D,
may be changed in the model to determine results, but any givend values of E and D are assumed to remain constant forever in
determining a given value.
e) The firm has perpetual life.
Walter has evolved a mathematical formula to arrive at the appropriate dividend decision. His formula is based on the share valuation
model that states:
P = D/k + r [(ED)/k]/k
where,
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return
k = cost of capital
The above mentioned equation clearly reveals that the market price per share is the sum of the present value of two sources of income:
i) the present value of an infinite stream of constant dividends, D/k
ii) present value of the infinite stream of capital gains, [r(ED)/k]/k. When the firm retains a perpetual sum of (ED) at r rate of
return, its present value will be r(ED)/k. This quantity can be known as capital gain which occurs when earnings are retained within
the firm. If this retained earnings occur every year, the prese
nt value of an infinite number of capital gains, r[(ED)/k will be equal to [r(ED)/k]/k. Thus, the value of a share is the present value
of all dividends plus present value of all capital gains. So, the equation that will give the value of a share is as follows:
P = [D + r/k(ED)]/k
To illustrate the effect of different dividend policies on the value of share respectively for the growth firm, normal firm and declining
firm the following example is made.
Let us assume,
EPS = Tk. 10
Growth firm-A
r = 15 % = .15
(r>k)
k = 10 % = .10
When D/P ratio is 0% i.e., D = Tk. 0, then:
P = [0 + (.15/.10) (10  0)]/ .10 = Tk. 150
When D/P ratio is 40% i.e., D = Tk. 4, then:
P = [4 + (.15/.10) (10  4)]/ .10 = Tk. 130
When D/P ratio is 80% i.e., D = Tk. 8, then:
P = [8 + (.15/.10) (10  8)]/ .10 = Tk. 110
When D/P ratio is 100% i.e., D = Tk. 10, then:
P = [10 + (.15/.10) (10  10)]/ .10 = Tk. 100
Now we assume that,
EPS = Tk. 10
Normal firm-B
r = 10 % = .10
(r = k)
k = 10 % = .10
When D/P ratio is 0 % i.e., D = Tk. 0, then:
P = [0 + (.10/.10) (10  0)]/ .10 = Tk. 100
When D/P ratio is 40 % i.e., D = Tk. 4, then:
P = [4 + (.10/.10) (10  4)]/ .10 = Tk. 100
When D/P ratio is 80 % i.e., D = Tk. 8, then:
P = [8 + (.10/.10) (10  8)]/ .10 = Tk. 100
When D/P ratio is 100 % i.e., D = Tk. 10, then:
P = [10 + (.10/.10) (10  10)]/ .10 = Tk. 100
Again, we assume that,
EPS = Tk. 10
Decline firm-C
r = 8 % = .08
(r<k)
k = 10 % = .10
When D/P ratio is 0% i.e., D = Tk. 0, then:
P = [0 + (.08/.10) (10  0)]/ .10 = Tk. 80
When D/P ratio is 40 % i.e., D = Tk. 4, then:
P = [4 + (.08/.10) (10  4)]/ .10 = Tk. 88
When D/P ratio is 80 % i.e., D = Tk. 8, then:
P = [8 + (.08/.10) (10  8)]/ .10 = Tk. 96
When D/P ratio is 100 % i.e., D = Tk. 10, then:

18
 P = [10 + (.08/.10) (10  10)]/ .10 = Tk. 100
Summary Table:
D/P ratio 0% 40 % 80 % 100 %
Value of firm-A(growing) in Tk 150 130 110 100
Value of firm-B(normal) in Tk. 100 100 100 100
Value of firm-C(declining) in Tk. 80 88 96 100
The calculation of the value of shares according to Walter’s formula yields following conclusions:
a) When the firm is able to earn a return on investment exceeding the required rate of return i.e., r > k, the value of the shares
is inversely related to the D/P ratio: as the payout ratio increases, the market value of the shares declines. Its value is highest when the
D/P ratio is zero. If, therefore, the firm retains its entire earnings, it will maximize the market value of the shares. When all earnings
are distributed, its value is the lowest. In other words, the optimal payout ratio is zero. The firm is called growth firm.
b) When r = k, the market value of the shares is constant irrespective of the D/P ratio i.e., the market value of the shares is not
affected by D/P. Whether the firm retains the profits or distributes dividends is a matter of indifference. In other words, the firm is
called normal firm.
c) When r < k, the firm does not ample profitable investment opportunities and the D/P ratio and the value of the shares are
positively correlated: as the payout ratio increases, the market value of the shares also increases. Its value is highest when the D/P ratio
is 100 % while it is the lowest with D/P ratio being zero. When r < k, the firm would be well-advised to distribute the entire earnings
to the shareholders. In other words, the optimal payout ratio is 100 %. This type of firm is called declining firm.
Gordon’s Model
Another theory which contents that dividends are relevant is the Gordon Model. This model, which opines that dividend policy of a
firm affects its value, is based on the following assumptions:
a) The firm is an all-equity firm. No external financing is used and investment programs are financed exclusively by retained
earnings.
b) r and k are constant.
c) The firm has perpetual life.
d) The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant.
e) k > br.
According to Gordon, the market value of a share is equal to the present value of future streams of dividends. A simplified version of
Gordon’s model can be symbolically expressed as:
P = E(1  b)/ (k  br)
Where,
P = market price per share
E = earnings per share
b = retention ratio
1 b = D/P ratio
k = cost of capital
g= growth rate=br=retention ratio *rate of return
The implication of dividend policy, according to Gordon model, are shown respectively for the growth firm, normal firm and
declining firm:
For growth firm,
Let us assume:
EPS = Tk. 10
Growth firm-A
r = 15 % = .15
(r>k)
k = 10 % = .10
When D/P ratio (1  b) = 40 % i.e., D = Tk. 4, then, b = 60 %,
So, g = br = .15×.60 = .09
Therefore, P = 10(1.60) / (.10.09) = Tk. 400
When D/P ratio (1  b) = 60 % i.e., D = Tk. 6, then, b = 40 %,
So, g = br = .15×.40 = .06
Therefore, P = 10(1.40) / (.10 .06) = Tk. 150
When D/P ratio (1  b) = 90 % i.e., D = Tk. 9, then, b = 10 %,
So, g = br = .15×.10 = .015
Therefore, P = 10(1.10) / (.10.015) = Tk. 106
For normal firm,
We assume that,
EPS = Tk. 10
Normal firm-B
r = 10 % = .10
(r = k)
k = 10 % = .10

19
When D/P ratio (1  b) = 40 % i.e., D = Tk. 4, then, b = 60 % = Tk. 6
So, g = br = .10×.60 = .06
Therefore, P = 10(1.60) / (.10.06) = Tk. 100
When D/P ratio (1  b) = 60 % i.e., D = Tk. 6, then, b = 40 % = Tk. 4
So, g = br = .10×.40 = .04
Therefore, P = 10(1.40) / (.10 .04) = Tk. 100
When D/P ratio (1  b) = 90 % i.e., D = Tk. 9, then, b = 10 % = Tk. 1
So, g = br = .10 ×.10 = .01
Therefore, P = 10(1.10) / (.10.01) = Tk. 100
For Decline firm,
We assume that,
EPS = Tk. 10
Decline firm-C
r = 8 % = .08
(r<k)
k = 10 % = .10
When D/P ratio (1  b) = 40 % i.e., D = Tk. 4, then, b = 60 % = Tk. 6
So, g = br = .08 ×.60 = .048

Therefore, P = 10(1.60) / (.10.048) = Tk. 77

When D/P ratio (1  b) = 60 % i.e., D = Tk. 6, then, b = 40 % = Tk. 4
So, g = br = .08×.40 = .032
Therefore, P = 10(1.40) / (.10 .032) = Tk. 88
When D/P ratio (1  b) = 90 % i.e., D = Tk. 9, then, b = 10 % = Tk. 1
So, g = br = .08 ×.10 = .008
Therefore, P = 10(1.10) / (.10.008) = Tk. 98
Summary Table:
D/P ratio 40 % 60 % 90 %
Value of firm-A(growth) in Tk 400 150 106
Value of firm-B(normal) in 100 100 100
Tk.
Value of firm-C(decline) in 77 88 98
Tk.
It is clearly revealed that under Gordon model:
a) The market value of the share, P, increases with the retention ratio b for firms with growth opportunities (r > k).
b) The market value of the share, P, increases with the payout ratio (1-b) for declining firms (r < k).
c) The market value of the share, P, is not affected by dividend policy when r = k.
Therefore, Gordon’s model concludes about dividend policy are similar to the conclusion of Walter’s model . This similarity is
done to the similarities of assumptions which underlie both the models

Capital Budgeting
Understanding Capital Budget
Capital refers to operating assets used in the production and budget refers to a plan that details projected cash flows during some
period. Therefore, capital budgeting is the process of evaluation of specific investment projects/ decisions.
Capital budget is an outline of planned investment in operating assets. So, capital budgeting is the whole process of analyzing projects
and deciding which ones to include in the capital budget.
Importance of Capital Budgeting
i. Decision of capital budgeting lasts long.
ii. Strategic business decisions.
iii. Timing of capital assets needed.
iv. It improves the quality of asset acquisitions.
20
 v. It involves substantial expenditures.
Steps in Capital Budgeting Process
Step-1: Determination of costs of the project(s).
Step-2: Estimation of expected cash flows.
Step-3: Identification of the riskiness of the projected cash flows
Step-4: Determination of the cost of capital commensurate with the riskiness.
Step-5: Cash flows are converted in to their present values.
Step-6: Comparison of PV of future cash flows with investment.

Problem: You are given two Project- Project-A and Project-B to evaluate. Each of the projects has a cost of capital 10%. The expected
cash flows (in Tk.) are given below:
Time T0 T1 T2 T3 T4 T5
Project-A (120,000) 30,000 50,000 55,000 60,000 70,000
Project-B (150,000) 50,000 60,000 65,000 70,000 80,000
Calculate for both the project:
i. Payback Period,
ii. Discounted Payback Period,
iii. Net Present Value (NPV),
iv. Accounting Rate of Return (ARR),
v. Internal Rate of Return (IRR)
vi. Profitability Index (PI)
Solution:
T Expected cash flows Cumulative Discounted value Cumulative
Proj-A Proj-B Proj-A Proj-B Proj-A Proj-B Proj-A Proj-B
T0 (120,000) (150,000) -------- -------- -------- -------- -------- --------
T1 30,000 50,000 30,000 50,000 27,273 45,455 27,273 45,455
T2 50,000 60,000 80,000 110,000 41,322 49,587 68,595 95,042
T3 55,000 65,000 135,000 175,000 41,322 48,835 109,917 143,877
T4 60,000 70,000 195,000 245,000 40,981 47,811 150,898 191,688
T5 70,000 80,000 265,000 325,000 43,464 49,674 194,362 241,362

1. Payback Period
It refers to the number of years necessary to recover a project’s costs through incremental cash inflows.
The formula for finding out payback period is given as:
Unrecovered cost at the start of yr. (Initial investment - Preceding year cumulative cash flow)
Payback Period = Yr(s). before full recovery + ----------------------------------------
Cash inflow during the yr.

For Project –A:

Payback P = 2 Yrs. + [120,00080,000]/ 55,000 = 2 Yrs. + 40,000/ 55,000
= [2 + .73] Yrs. = 2.73 Yrs.

For Project –B:

Payback P = 2 Yrs. + [150,000110,000]/ 65,000 = 2 Yrs. + 40,000/ 65,000
= [2 + .62] Yrs. = 2.62 Yrs.
Accept-Reject Decision Rule:
# If payback period < required payback standard---project is accepted
# If payback period > required payback standard---project is rejected

2. Discounted Payback Period

Unrecovered cost at the start of yr . (Initial investment - Preceding year cumulative cash
flow)
Discounted Payback Period = Yr(s). before full recovery + -----------------------------------------
Cash inflow during the yr. *all amounts should be discounted
amount.

For Project –A:

Payback P = 3 Yrs. + [120,000109,917]/ 40,981 = 3 Yrs. + .25

21
 = [3 + .25] Yrs. = 3.25 Yrs.

For Project –B:

Payback P = 3 Yrs. + [150,000143,877]/ 47,811 = 3 Yrs. + .13
= [3 + .13] Yrs. = 3.13 Yrs.
Accept-Reject Decision Rule:
# If payback period < required payback standard  project is accepted
# If payback period > required payback standard  project is rejected
3. Net Present Value (NPV)

It is the difference between the discounted cash outflows and discounted cash inflows for an investment project. The formula for
finding NPV Is given below:
N CFt
NPV = ()CF0 + ∑---------
t=1 (1 + k)t

NPV for Project-A:

NPVA = () CF0 + [CF1/(1 + k)1 + CF2/(1 + k)2 + CF3/(1 + k)3 + CF4/(1 + k)4
+ CF5/(1 + k)5]
= () 120,000 + [30,000/(1.10)1 + 50,000/(1.10)2 + 55,000/(1.10)3
+ 60,000/(1.10)4 + 70,000/(1.10)5]
= () 120,000 + [30,000/(1.10) + 50,000/(1.21) + 55,000/(1.331)
+ 60,000/(1.4641) + 70,000/(1.6105)]
= () 120,000 + [27,273 +41,322 + 41,322 + 40,981 + 43,464]
= () 120,000 + 194,362
= 74,362
NPV for Project-B:
NPVB = () CF0 + [CF1/(1 + k)1 + CF2/(1 + k)2 + CF3/(1 + k)3 + CF4/(1 + k)4
+ CF5/(1 + k)5]
= () 150,000 + [50,000/(1.10)1 + 60,000/(1.10)2 + 65,000/(1.10)3
+ 70,000/(1.10)4 + 80,000/(1.10)5]
= () 150,000 + [50,000/(1.10) + 60,000/(1.21) + 65,000/(1.331)
+ 70,000/(1.4641) + 80,000/(1.6105)]
= () 150,000 + [45,455 + 49,587 + 48,835 + 47,811 + 49,674]
= () 150,000 + 241,362
= 91,362
Accept-Reject Decision Rule:
# If NPV > 0  project is accepted
# If NPV < 0  project is rejected
Therefore, project(s) with positive (+) NPV is/are accepted whereas project(s) with negative NPV is/are rejected.

4. Average Accounting Rate of Return (AAR)

The average accounting rate of return is the average project earnings after taxes and depreciation, divided by the average book value
of the investment during its life. The formula for finding out the AAR is given below:
AAR = Average return (income)/ Average investment
AAR for Project-A:
Average return = [30,000 + 50,000 + 55,000 + 60,000 + 70,000] / 5
= 265,000/5 = 53,000-
Average investment = [120,000 + 0]/2 = 60,000
Therefore,
AAR = 53,000/ 60,000 = 0.8833 = 88.33 %
AAR for Project-B:
Average return = [50,000 + 60,000 + 65,000 + 70,000 + 80,000] / 5
= 325,000/5 = 65,000
Average investment = [150,000 + 0]/2 = 0,000
Therefore,
AAR = 53,000/ 60,000 = 0.8833 = 88.33 %
Accept-Reject Decision Rule:
# If the firm had a targeted accounting rate of return greater than the estimated

22
 (actual rate of return, the project is rejected.
# If the firm had a targeted accounting rate of return lower than the estimated (actual
rate of return, the project is accepted.

5. Internal Rate of Return (IRR)

It is a discount rate, required rate of return or cost of capital that equates the cash inflows of an investment project with its cash
outflows. The formula for finding IRR is given below:
N CFt N CFt
CF0 = ∑ ---------  (-)CF0 + ∑ --------- = 0
t = 1 (1 + IRR)t t = 1 (1 + IRR)t

IRR= Lower rate+[(Higher value-Initial outflow)/(Higher value-Lower value)]*(higher rate-Lower rate)

*In this formula when we will use trial and error method by the supposed rate NPV will not be calculated rather present value of
cash inflow will be calculated.
IRR for Project-A:
IRRA = () CF0 = [CF1/(1 + IRR)1 + CF2/(1 + IRR)2 + CF3/(1 + IRR)3 + CF4/(1 + IRR)4
+ CF5/(1 + IRR)5]
The IRR is to be found by trial and error method.
By taking 10 % as IRR, we have the sum of present values of future returns as:
N CFt
∑ ---------
t = 1 (1 + IRR)t

= [30,000/(1.10)1 + 50,000/(1.10)2 + 55,000/(1.10)3 + 60,000/(1.10)4

+ 70,000/(1.10)5]
= + [30,000/(1.10) + 50,000/(1.21) + 55,000/(1.331) + 60,000/(1.4641)
+ 70,000/(1.6105)]
= [27,273 +41,322 + 41,322 + 40,981 + 43,464]
= 194,362
This value is higher than our desired value, 120,000. So, we should try again at a higher IRR say 30 %. At this rate we have:
N CFt
∑ ---------
t = 1 (1 + IRR)t

= [30,000/(1.30)1 + 50,000/(1.30)2 + 55,000/(1.30)3 + 60,000/(1.30)4

+ 70,000/(1.30)5]
= + [30,000/(1.30) + 50,000/(1.69) + 55,000/(2.197) + 60,000/(2.8561)
+ 70,000/(3.7129]
= [23,077 + 29,586 + 25,034 + 21,008 + 18,853]
= 117,558
This value is lower than our desired value, 120,000. So, IRR lies between 10 % and 30 %. It can be estimated by using interpolation as
shown below:
IRRA = 10 + [194,362120,000/194,362117,558] (30-10)
= 10 + [74,362/76,804]×20
= 10 + 19.36
= 29.36 %
IRR for Project-B:
NPVB = () CF0 + [CF1/(1 + k)1 + CF2/(1 + k)2 + CF3/(1 + k)3 + CF4/(1 + k)4
+ CF5/(1 + k)5]
By taking 10 % as IRR, we have the sum of present values of future returns as:
N CFt
∑ ---------
t = 1 (1 + IRR)t

= [50,000/(1.10)1 + 60,000/(1.10)2 + 65,000/(1.10)3 + 70,000/(1.10)4

+ 80,000/(1.10)5]
= [50,000/(1.10) + 60,000/(1.21) + 65,000/(1.331) + 70,000/(1.4641)
+ 80,000/(1.6105)]
= [45,455 + 49,587 + 48,835 + 47,811 + 49,674]
= 241,362
This value is higher than our desired value, 150,000. So, we should try again at a higher IRR say 30 %. At this rate we have:
N CFt

23
 ∑ ---------
t = 1 (1 + IRR)t

= [50,000/(1.30)1 + 60,000/(1.30)2 + 65,000/(1.30)3 + 70,000/(1.30)4

+ 80,000/(1.30)5]
= [50,000/(1.30) + 60,000/(1.69) + 65,000/(2.197) + 70,000/(2.8561)
+ 80,000/(3.7129]
= 38,462 + 35,503 + 29,586 + 24,509 + 21, 546
= 149,606
This value is lower than our desired value, 150,000. So, IRR lies between 10 % and 30 %. It can be estimated by using interpolation as
shown below:
IRRA = 10 + [241,362150,000/241,362149,606] (30-10)
= 10 + [91,362/91,756]×20
= 10 + 19.91
= 29.91 %
Accept-Reject Decision Rule:
# If IRR > k  project is accepted
# If IRR < k  project is rejected
6. Profitability Index (PI)
It is the present value of the future cash inflows for a project divided by its initial investment. So, it is the ratio which is estimated by
using the following formula:
PI = [CFt / (1 + k)t] /CF0
Accept-Reject Decision Rule:
# If PI > 1  project is accepted
# If PI < 1  project is rejected

PI= PV of Cash Inflows / PV of Cash Outflows.

PI for Project-A
N
PI A= [ ∑ CFt / (1 + k)t] /CF0
t=1

= 194,362 / 120,000 = 1.62

PI for Project-B
N
PI B= [ ∑ CFt / (1 + k)t] /CF0
t=1

= 241,362 / 150,000 = 1.61

Therefore, project(s) with PI ratio greater than 1, project(s) is/are accepted whereas project(s) with PI ratio lower than 1, project(s)
is/are rejected.

Distinguishes between NPV and IRR

NPV Subject IRR

In case of NPV, the discount rate which is i. Predetermined Discount rate is not predetermined in
termed as cost of capital or opportunity discount case of IRR.
cost is predetermined
The amount of investment in different ii. Difference in The concept of difference among the
projects is considered in this method investment amount invested in various project is
neglected in IRR.
In case of NPV, the discount rate is easily iii. Co-ordination In IRR, interest rate is not co-ordinated.
co-ordinated by interest rate change. of interest rate.
By this method we can get the idea of asset iv. Calculation of By this method, he amount of asset
increased in the firm. asset increase increase can not be measured but get
the relative idea of fund of a project.
It is easy to make a decision about mutual v. Mutual decision The evaluation of IRR is difficult
project rejection in NPV. of project because IRR may vary in many

24
 rejection situations.
When there is only one project, vi. Independent The acception-rejection decision can
independent decision about acception- method of project not be made only with IRR.
rejection can be made by NPV. evaluation
In this method reinvestment of cash flow is vii. Stated In IRR method, the calculated IRR is
considered with the rate of cost of capital. condition of used or considered in reinvestment of
reinvestment cash flow.
Because of easy calculation this method is viii. Use It’s uses are comparatively less because
widely used. of calculation difficulties.
In case of NPV method, if the NPV of any ix. Acceptance of If the IRR is more than the discount
project is positive, it will be accepted. proposal rate, the project will be accepted.
Cost of capital is essential in case of NPV. x. Cost of capital Cost of capital is not essential to know.
In NPV method, project(s) with negative xi. Proposal If the IRR is less than the discount rate
NPV will be rejected. cancellation project will be cancelled.
In the sense of expense and complexity, xii. Expense and IRR method is more expensive and
NPV method is easier than IRR method. complexity complex than other method.

Analysis of Financial Statements

Many diverse groups of people are interested in the information found in firm’s financial statements; they study the statements
carefully, interpreting the information that relates to their particular interest in the company. Financial analysis typically is associated
with ratio analysis, defined as the analysis of relationships among various financial statement items both at appoint in time and over
time. It uses the financial statements in a unique manner to provide a different perspective about the firm.

Statement of Cash Flows: It is the firm’s financial statement which summarizes its sources and uses of cash over a specified period.
It shows a firm’s cast receipts and cash payments during the period.
Income Statement: Income Statement is the financial statement which summarizes a firm’s performance over period of time. It
shows a firm’s revenues and expenses during a specified period. The income statement equation is:
Sales Revenue – Operating and administrative expenses = Profits (income)
Statement of the Shareholders’ Equity: Is the statement which shows the distribution of the net profits after-tax.
Balance Sheet: A Balance Sheet is the final financial statement which shows the accounting value of a firm on a particular date. It is a
snapshot of a firm. It is the means of organizing and summarizing what a firm owns (its total assets), what a firm owes (its liabilities)
and the difference between the two (firm’s owners’ equity) at a given point in time. The balance equation is:
Asset = Liabilities + Owner’s equity

The followings are the Balance Sheet and Income Statement of Bigbee Ltd. [Figures in Tk. 000’]

Balance Sheet

25
 Assets: Liabilities:
Current Assets: Current Liabilities:
Cash -------------------------Tk. 15,000 Accounts payable -----------Tk. 30,000
Short-term ivst. ------------ 65,000 Notes payables----------------- 60,000
Receivables ------------- 315,000 Accruals ------------------------- 130,000
Inventories----------------- 415,000 Total current liabilities----------------Tk. 220,000
Total Current Assets ---------------Tk. 810,000 Long-term bonds ---------------------------580,000
Plant & Equipments --------------- Tk. 870,000 Total Liabilities ------------------------ Tk. 800,000
Total assets-------------------------Tk. 1,680,000 Preferred stocks (400,000 shares)
========== Tk. 40,000
Equity:
Comn. stock (50,000,000 shares) Tk. 130,000
Retained earnings --------------------Tk. 710,000
Total Equity-----------------------------Tk. 840,000
Total liabilities and equities Tk. 1,680,000
==========

Income Statement
[Figures in ‘000 Tk.]
Sales ---------------------------------------------------------Tk. 2,850,000
(-) Cost of goods sold --------------------------(-) 2,497,000
EBIT including dep. And amrt.---------------------------Tk. 353,000
(-) Depreciations --------------------------------------- 90,000
(-) Amortizations ---------------------------------------- 00
EBIT -----------------------------------------------------------Tk. 263,000
(-)Interest -------------------------------------------------60,000
EBT ------------------------------------------------------------Tk. 203,000
(-) Taxes @ 40 % ------------------------------------- 81,200
Net income before preferred dividends ---------------Tk. 121,800
(-) Preferred dividends ---------------------------------4,000
Net income ---------------------------------------------------Tk. 117,800
(-) Common dividends ------------------------------- 53,000
Addition to retained earnings----- -------------------------Tk. 64,800
=========
Data per share (Absolute figures):
EPS = Net income/ Common stocks outstanding
= 117,800,000/50,000,000 = Tk.2.356
DPS = Tk. 1.06, Book value per share = Tk.16.80
Common stock price = Tk. 26
Cash flow per share = [Net income + Dep. + Amrt.]/ Common stock
= [117,800,000 +90,000 + 00]/50,000,000
= Tk. 4.16

From the information given above calculate the followings:

A] Short-term Solvency or Liquidity Measures:
i. Current ratio = Current assets/ Current liabilities
= Tk. 810,000,000/ Tk. 220,000,000
= 3.68 Times
ii. Quick or Acid test ratio = [Current assets – Inventories] / Current liabilities
= Tk. [810,000,000 – 415,00,000] / Tk. 220,000,000
= 1.80 Times
iii. Cash ratio = Cash/ Current liabilities
= Tk. 15,000,000 / Tk. 220,000,000
= 0.068 Times
iv. Net working capital to total assets = Net working capital / Total assets
= [Current assets- Current liabilities]/ Total assets
= Tk. [810,000,000 – 220,000,000] / Tk. 1,680,000,000
= 0.35 Times.
26
 v. Interval Measures = Current asset/ Average daily operating costs
= Tk. 810,000,000 / [2,497,000,000/365]
= 118 Days.
*Here, depreciation, tax and interest are not included to measure operating costs here.
B] Long-term Solvency or Financial Leverage Ratio:
vi. Total Debt ratio = [Total assets –Total equity]/ Total assets
= Tk. [1,680,000,000 – 840,000,000] / Tk. 1,680,000,000
= 0.50 Times
*Total debt= Total assets – Total equity

vii. Debt-Equity ratio = Debt(Long term debt) / Total equity

= Tk. 580,000,000/ Tk. 840,000,000
= 0.69 Times.
* Total equity = common stock + retained earnings +preferred stock

viii. Equity Multiplier (Leverage) = Total assets / Total equity

= Tk. 1,680,000,000 / Tk. 840,000,000 =
2.00 Times.
ix. Long-term debt ratio = Long-term debt / [Long-term debt + Total equity]
= Tk. 580,000,000 /Tk. [580,000,000 + 840,000,000]
= 0.41 Times.
x Time interest earned ratio = EBIT/ Interest
= Tk. 263,000,000/ Tk. 60,000,000
= 4.38 Times.
xi. Cash coverage ratio = [EBIT + Depreciation] / Interest
= Tk. [263,000,000 + 90,000,000] / Tk. 60,000,000
= 5.88 Times.
xii. Fixed charge coverage = Income before fixed c(arges and taxes / Fixed charges
Fixed charge coverage = [EBIT + Lease payments] /[Lease obligation + Int. Expanses.]
= Tk.[263,000,000 + 00]/Tk. [00 + 60,000,000]
= 4.38 Times.
C] Asset Management or Asset Turn-over ratio:
xiii. Inventory turn over ratio = Cost of goods sold/ Inventory
= Tk. 2,497,000,000 /Tk. 415,000,000 = 6.02 Times.
xiv. Day’s sales in inventory = 365 Days/Inventory turn-over
= 365 Days/ 6.02
= 60.63 Days.

xv. Receivable Turn-over = Sales (credit)/Receivables

= Tk. 2,850,000,000/ Tk. 315,000,000
= 9.05 Times.
xvi. Day’s sales in receivables = 365 Days/Receivable turn-over
= 365 Days/ 9.05
= 40.33 Day

xvii. Average collection period (Days sales outstanding) = Receivables/ Average daily credit sales
= Tk. 315,000,000 / [2,850,000,000/365]
= 40.34 Days.
xviii. Fixed assets turn over ratio = Sales/ Fixed assets
= Tk. 2,850,000,000/ Tk. 870,0 0,000
= 3.28 Times.
xiv. Total assets turn over ratio = Sales/ Total assets
= Tk. 2,850,000,000/ TK. 1,680,000,000
= 1.70 Times.
xx. Net working capital (NWC) turn over = Sales/ NWC
27
 = Tk. 2,850,000,000/ Tk. [810,000,000-220,000,000]
= 4.83 Times.
D] Profitability ratio:
xxi. Profit margin = Net income/ Sales
= Tk.117,800,000 / Tk. 2,850,000,000
= .041
= 4.1 %
xxii. Return on asset (ROA) = Net income/ Total assets
= Tk. 117,800,000/ Tk. 1,680,000,000
= .070 = 7 %.
xxiii. Return on equity (ROE) = Net income/ Common Stockholder’s Equity
= Tk. 117,800,000/ Tk. 840,000,000
= .14 = 14 %.
E] Market Value Measure:
xxiv. Earning per share (EPS) = Net income/ Shares outstanding
= Tk. 117,800,000/ 50,000,000 = Tk. 2.356
xxv. Price earning ratio (P/E) = Price per share/ EPS = Tk. 26/ Tk. 2.356
= 11.04 Times
xxvi. Book value per share (BV) = (Equities-preferred stock)/ No. of shares(common)
= Tk. [840,000,000/ 50,000,000] = Tk. 16.80
xxvii. Market to Book ratio = Market value per share/ Book value per share
= Tk. 26/Tk. [840,000,000/ 50,000,000] = 1.55 Times.
xxviii. Price / Cash flow ratio = Price per share/ Cash flow per share
= Tk. 26/ Tk. 4.16 = 6.25 Times.
Cash flow per share = [Net income + Dep. + Amrt.]/ No. of Common stock outstanding

F] Fundamental Analysis:
Intrinsic value = Po = D1/[k-g]
or
Intrinsic value = Po = [Po/E]1×E1
EPS = ROE ×BV
Break-up of ROE
Return on asset (ROA) = After-tax net income/ Total assets

Pretax and pre-interest profit margin = EBIT/Sales

Asset turnover = Sales/Total assets

Profit margin [EBIT/Sales] ×Asset turnover = [Sales/Total assets]

= EBIT/Total assets
Leverage (L) = Total assets/ Equities
ROE = ROA × Leverage
ROE = ROA × Equity multiplier = ROA × [1 + Debt-Equity ratio]
Alternatively,
ROE = Net income/ Equities
Multiplying this ratio by assets/assets, we have:
ROE = [Net income/ Equities] × [Assets/Assets]
= [Net income/ Asset] × [Assets/Equities]
= ROA × Leverage
Multiplying top and bottom by sales, we have:
ROE = [Net income/ Equities] × [Assets/Assets] × [Sales/Sales]
= [Net income/ Sales] × [Sales/Assets] × [Assets/Equities]
= [Profit margin] × [Asset turnover] × [Equity multiplier]
Furthermore, Multiplying top and bottom by EBIT and EBT, we have:
ROE = [Net income/ Equities] × [Assets/Assets] × [Sales/Sales] ×[EBIT/EBIT] × [EBT/EBT]
ROE = [EBIT/ Sales] × [EBT/EBIT] × [Net income/EBT] × [Sales/Assets] × [Assets/Equities]
ROE = [EBIT efficiency] × [Interest "urden] × [After-tax retention rate] ×
[Asset Turnover] × [Leverage]

Du Pont Analysis
28
 Net Assets/Sales = Profit margin
Sales/Assets = Asset turnover
Profit margin × Asset turnover = ROA
Financing plan = Assets + Debts = 1- [Debt/Assets]
ROE = ROA / [1- (Debt/Assets)
Du Pont identity is the popular expression that breaks ROE into three parts:
i. Operating efficiency measured by profit margin
ii. Asset use efficienCy measured by total asset turnover
iii. Financial leverage measured by equity multiplier
Therefo2e,
ROE = [Profit margin] × [Asset turnover] × [Equity multiplier]
= ROA × [Equity multiplier]

Exercise:
The followings are the Balance Sheet and Income Statement of Evergreen Ltd.
Balance Sheet
Assets:
Cash -------------------------------------Tk. 250,500
Receivables --------------------------------- 336,000
Inventories--------------------------------- 350,500
Current assets-----------------------------------Tk. 937,000
Fixed assets.------------------------------------------500,500
Total assets-------------------------------------Tk. 1437,500
=======
Liabilities:
Accounts payable ----------------------Tk. 250,000
Notes payable -------------------------------184,000
Other current liabilities --------------------247,000
Total current liabilities--------------------------Tk. 681,000
Long-term debt ---------------------------------------395,500
Equity---------------------------------------------------361,000
Total liabilities and equities Tk. 1437,500
==========
Income Statement

Sales ----------------------------------------------Tk. 2,536,500

Cost of goods sold -----------------------------------1,565,500
Selling, General and Administrative exps. ---------845,000
EBIT---------------------------------------Tk. 126,000
Interest ----------------------------------------------------47,500

Earnings before taxes --------------------Tk. 78,500

Corporate income tax 50% ------------------------Tk. 39,250
Net Income -------------------------------------------Tk. 39,250
From the information given above calculate the followings:
ii. Current ratio,
iii. Quick ratio,
iv. Inventory turn over ratio,
v. Days sales outstanding ratio,
vi. Total assets turn over ratio,
vii. Fixed assets turn over ratio,
viii. Debt ratio,
ix. Profit margin ratio,
x. ROA,
xi. ROE.

Return and Risk

29
Concept of Investment Risk
Risk analysis of investment is one of the most complex, controversial and slippery areas in finance. Business decisions are generally
made under conditions of uncertainty rather than under conditions approaching certainty. In fact, both risk and uncertainty are the
extreme end of the same spectrum. The word “risk” shall be used to connote the idea of the twofold possibility of loss or gain. Some
people things that investments are inclined to give emphasis to possibilities of loss but it is a negative pessimistic and depressing
approach. But some people things that investments are inclined to give emphasis to possibilities of gain which is optimistic.
In formal term, risk associated with a project o investment may be defined as the variability that is likely to occur in the future returns
or investment. Therefore, we relate risk to variability of return i.e., the degree to which the return on an investment varies
unpredictably.

Return
Investment implies that investor defers current consumption in order to add to his/her wealth so that he/she can consume more in
future. So, the return on investment is concerned with change in wealth resulting from the investment. Such change in wealth can
either be due to cash inflows in the form of interest or dividends, or caused by a change in the price of the asset. The period during
which an investor deploys funds (wealth) is termed as its holding period and the return for that period is called holding period return
(HPR). HPR is calculated as:
Ending value of the investment
HPR =
Beginning value of the investment
An investor can convert HPR to an annual percentage rate to derive a percentage return commonly known as holding period yield
(HPY). HPY is further being calculated as:
HPY = HPR−1
Again, annual holding period return can be calculated as:
Annual HPR = [HPR]1/N
Where, N is the number of years an investment holds. Suppose an investment is made by Tk. 200 the value of which would become
art Tk.250 after 2 years. The holding period return from the investment is:
Endingvalue
HPR = Beginningvalue
Tk . 250
= Tk . 200 = 1.25
Annual HPR = [1.25]1/N
= [1.25]1/2

= 1.25
√
= 1.1180
Therefore,
Annual HPY = Annual HPR−1
= 1.1180 −1= 0.1180 =11.80%
If the investment is held for a period of 3 years, the holding period yield then would become:
Annual HPR = [1.25]1/N
= [1.25]1/3
3
= √1.25
= 1.08
Therefore,
Annual HPY = Annual HPR−1
= 1.08 −1= 0.08 = 8%.
Alternatively, holding period return can be defined as the capital gains plus dividend per taka invested in the stock like:

Capita lg ain+Dividend
HPR = Investments
HPR = [(Ending price – Beginning price) + Cash dividends]/Beginning price
The ending value of the investment can be the result of a change in the price for the investment. Annual holding period yield assumes
a constant annual yield for each year.
Another calculation of return is called geometric mean which is the nth root of the product of the holding period returns for n years.
Geometric mean, therefore, is:
30
 GM = [πHPR]1/N −1
Where,
π = the product of the annual holding period return calculated as:
[HPR1] × [HPR2] × ------- × [HPRn]
Suppose holding period returns for three consecutive years from an investment are 1.10, 1.15 and 1.20 respectively. The geometric
mean return from the investment can be calculated as:
GM = [(1.10) × (1.15) × (1.20)] 1/3 − 1
= [1.518] 1/3 −1 = 1.1493−1= 0.1493 = 14.93%.

Example-01:
Suppose the market price of a share is Tk. 250. An investor expects that the next dividend will be of Tk. 10 per share and the share can
be sold for Tk. 275 after one year. What would be the expected return from the investment?
Solution:
The expected rate of return from the investment can be calculated as:
Dividend +Endingprice
E(r )= −1
Beginningprice
Tk . 10+Tk .275
= −1
Tk . 250
= 1.14 – 1 = 0.14 + 14%
Example-02:
A share of IBM is currently sellin for Tk. 200. The expected dividend per share of IBM is Tk. 5. The share can be sold for Tk. 210 at
the end of the year. Calculate the expected return of the share of IBM.
Solution:

D+[ P 1−P0 ]
E(r )=
P0
E(r) = Expected return,
D = Dividend from the share during the period,
P1 = Ending price of the share,
P0 = Beginning price of the share,
Therefore, the expected rate of return would be:
Tk . 5+[Tk . 210−Tk . 200]
E(r )= Tk . 200
= 0.075 = 7.5%

Historical vs. Expected Returns

Returns from security consist of income in the form of dividend or interest plus change in capital. Total returns consist of all price
changes and income received during a specific interval. Future returns are the meaningful ones for decision made today. An important
use of expected return is to compare value across asset classes and across time. Some asset allocation decisions are based on the risk
premium differential, which is the difference between the expected return on assets such as stocks, bonds, or real estate and the
expected return on a risk-free asset such as a Treasury bill. An important way to assess return is to compare historical (ex post) and
expected (ex ante) returns. Historical returns are generated by the history of the performance of an investment over a specified time
period. Expected returns, on the other hand, are the best estimates of what returns might be over some future time period. Historical
returns are known with certainty whereas expected returns are fraught with uncertainty i.e., they are probabilistic in nature.

Categories of Risk
Shortly speaking risk is the variability of return from an investment. Returns on investment may vary from the expectation of the
investors. So risk may be defined as the likelihood that the actual return from an investment will be less than the expected return.
Depending upon the elements of risk, it may be broadly divided into two categories like systematic risk and unsystematic risk. Some
elements of risk that are external to the firm cannot be controlled and effect large numbers of securities are the sources of systematic
risk. On the other hand, controllable, internal factors somewhat peculiar to industries and/or firms are referred to as elements of
unsystematic risk. The risk associated with macro, pervasive factor such as a national economy is called systematic risk. On the other
hand, the micro risks associated with factors particular to a company are called unsystematic or unique risk. Investment manager can
do little about systematic risk, although they can do much about unsystematic or unique risk.
Systematic risk

31
Systematic risk refers to that portion of total variability in return on investment caused by factors affecting the prices of all securities
in the portfolio. Economical, political, sociological changes are the sources of systematic risk. Their effect is to cause prices of nearly
all individual common stocks, bonds, and other securities in the market to move together in the same manner. Systematic risk affects
the economic or financial system. Systematic risk some times called as pervasive risk may be categorized under the following means:
Market risk: The price of common stock changes frequently in the process of bought and sold by the investor or speculator
in the market place. The price of a stock may fluctuate daily and cyclically even though earnings maintain unchanged and some
common stocks have a seasonal pattern. Because of the changes in the market prices of the stock the investors can lose money.
Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market
risk. Expectations of lower corporate profits in general may cause the larger body of common stocks to fall in price.
Investment prices vary because investors vacillate in their preference for different forms of investments or simply because they
sometimes have money to invest and sometimes do not have. The extensive vagaries of the stock market, the uncertainty and stowness
of real estate markets and the irregular markets for mortgages and second-grand bond issues all illustrate in the presence of market
risk.
Interest-rate-risk: Interest-rate-risk may be defined as the fluctuation in market price of fixed income securities owing to
changes in levels of interest rate. Fixed income securities mean notes and bonds, mortgage-loans and preferred stocks paying a
definite amount of interest or dividends annually to investors. Interest is the price paid for the use of money and like other prices
fluctuates with demand and supply forces operating in the market. The degree of fluctuation in the market prices of fixed income
securities resulting from interest-rate-risk depends firstly on the amount of change in interest rates. With any change in the market rate
of return on a bond, the market price of stocks changes inversely. The second factor affecting the degree of fluctuation is the length of
period of maturity. Every business or price of property is subject to the possibility that its earning power or usefulness may wane
because of competition, change in demand, uncontrollable costs, managerial error, government action or some similar circumstances.
Purchasing power risk: Purchasing power risk is the uncertainty of purchasing power of the amount to be received. It refers
to the impact of inflation or deflation on an investment. Rising prices on goods and services are normally associated with what is
referred to as inflation. On the other hand, falling prices on goods and services are termed deflation. Purchasing power risk or inflation
risk has received considerable publicity in recent years. When investor holds his surplus funds in the safety deposit box, he suffers
from purchasing power risk. The risk of loss of income or principal because of decreased purchasing power of money is also known as
purchasing power risk. For some investors, purchasing power risk is very important. Individuals or institutions using their income to
buy goods and services are greatly concerned over any changes in the purchasing power of their income. Investors who fear inflation
usually invest partially in common stocks and real estate with the hope that will rise in value. Rationale investors should include in
their estimate of expected return, an allowance for purchasing power risk, in the form of an expected annual percentage change in
prices.
Default risk: Another source of systematic risk is default risk. This type of risk arises because firms may eventually go
bankrupt. Default risk undiversifiable or uncontrollable as it is systematically related to the business cycle affecting all most all
investment even though some default risk may be diversified away in a portfolio of independent investments.
Exchange rate risk: The chance that return will be affected by changes in rates of exchange because investments have been
made in international markets whose promise to pay dividends, interest, or principal is not denominated in domestic currency risk or
exchange risk. Exchange rate risk is the uncertainty due to the determination of an investment in a country other than that of the
investor’s own country. The likelihood of incurring this risk is becoming greater as investor buy and sell assets around the world, as
opposed to only assets within their own countries.
Political risk: Also called country risk, political risk is the uncertainty due to the possibility of major political change in the
country where an investment is located. The chance that returns will be affected by the policies and stability of nations is called
political risk. The danger of debt repudiation or failure to meet debt service, expropriation of assets, differences in taxes, restrictions
on repatriating funds, and the prohibition against exchanging foreign currency into domestic currency are typical political risks.
Liquidity risk: Liquidity risk is the possibility of not being able to sell an asset for fair market value. When an investor
acquires an asset, he expects that the investment will mature or what it could be sold to someone else. In either case, the investor
expects to be able to convert the security into cash and use the proceeds for current consumption or other investment. The more
difficult it is to make this conversion, the greater the liquidity risk.
Real estate risk: Such type of systematic risks is unique and generally not found in most investments rather than real estate.
The specific risk inherited in real estate investments are given below:
 As there is no continuous auction trading market, quoted price may not represent intrinsic value of the property.
 It is more difficult to find a buyer and seller raising the cost of transacting.
 Real estate markets are inefficient as they are likely to be segmented.
 The cost of acquiring information is greater.
 Property value is more influenced by changes in the rates of interest than other equities.
 Returns on real estate assets are determined by the going rates on default-free assets.
 Real estate is less liquid than financial instruments.

Unsystematic risk
A portion of total risk that is unique or peculiar to a firm or an industry above and beyond that affecting securities market in general
may be termed as unsystematic risk. Management capability, consumer preference, labor strikes are the elements of unsystematic risk.
However, the unsystematic risk of an investment consists of two major components: credit risk and sector risk:
32
Credit risk:
Credit risk sometimes called company risk consists of business risk and financial risk. Business risk is the risk inherent in the nature of
the business. On the other hand, financial risk is the risk in addition to business risk arising from using financial leverage. Credit risk
is associated with the ability of the firm that issues securities to meet its promise on those securities. The fundamental promise of
every investment is a return commensurate with its risk. So the credit risk analyzed is the ability to deliver returns that are consistent
with the risk assumed. However, business risk and financial risk are discussed below:
Business risk: The loss or income on capital associated with the ability of some companies to maintain their competitive
position and to maintain their earnings growth is sometimes refers to as the business risk. Common stock and to some extent preferred
stock and bond posses this risk. The risk that results is either temporary or permanent. The business risk is not only associated with the
weaker companies that have suffered a total loss but also happened in the case of some quality companies when a deficit earnings or a
sharp drop earnings sustained which have resulted in substantial losses to investors.
In other words business risk is defined as the change that the firm will not have the ability to compete successfully with the assets that
it purchases. As for example, the firm may acquire a machine that may not operate properly, that may not produce salable products or
that may face other operating or market difficulties that cause losses. Any operational problems are classed as business risk.
Business risk can be divided into two categories: external and internal. Internal business risk is largely associated with the efficiency
with which a firm conducts its operations within the broader operating environment imposed upon it. On the other hand, external
business risk is the result of operating conditions imposed upon the firms by circumstances beyond its control. Each firm faces its own
set of external risk, depending upon the specific operating environment factors that it must deal with.
Financial risk: Financial risk is associated with the way in which a company finances its investment activities. It may be
defined as the change that an investment will not generate sufficient cash flows to cover interest payments on money borrowed to
finance it or principal payments on the debt or to provide profits to the firm. We usually gauge financial risk by looking at the capital
structure of a firm. The presence of borrowed money in the capital structure creates fixed payments in the form of interest that must be
sustained by the firm. The financial risk is avoidable risk to the extent that managements have the freedom to decide to borrow or not
to borrow funds. A firm with no debt financing has no financial risk.
Sector risk:
Sector or industry risk refers to the risk of doing better or worse than expected as a result of investing in one sector of the economy
instead of another. Sector investing implicitly acknowledges that the impact of individual investment decisions is less critical,
certainly to large portfolios, than investing in the proper sector at the proper time. Sector rotation is a portfolio management style
shifting resources to sectors that are expected to be more promising and are overweighted in a portfolio in contrast to other sectors
which are underweighted.
As the number of stocks in the portfolio is increased, the unsystematic or residual risk of the individual securities is diversified away
leaving only the systematic or market-related risk.
We assume that all rationale profit maximizing investors want to hold a completely diversified market portfolio of the risky assets and
they borrow or lend to arrive at a risk level that is consistent with their risk preferences. Under such conditions, the relevant risk
measure for an individual asset is its comovement with the market portfolio. This comovement measured by an asset’s covariance with
the market portfolio is its systematic risk.
Finally, we may draw conclusion as- we can divide total risk into two components viz., a general or market component and a specific
or issuer component. An investor can construct a diversified portfolio and eliminate part of the total risk called diversifiable or
nonmarket risk. The systematic risk known as nondiversifiable or market risk is directly associated with overall movements in the
general market or economy. Table--- summarized different sources of risk.
Categories of risk Sources of risk
 Market risk
 Interest rate risk
 Purchasing power risk
 Exchange rate risk
Systematic risk  Political
 Liquidity risk
 Default risk
 Real estate risk

 Credit risk
Unsystematic risk  Business risk
 Financial risk
 Sector risk
Different connotation of risk can be shown as under:
Total risk = General risk + Specific risk
= Systematic risk + Unsystematic risk
= Nondiversifiable risk + Diversifiable risk
= Market risk + Issuer risk

33
Systematic risk and Unsystematic risk Distinguished
Before identifying the differences between systematic risk and unsystematic risk we should have clear understanding about the
terminologies. However, they are defined as below:
Systematic risk: Nondiversifiable risk is call systematic risk. It is the portion of total risk which can not be eliminated, controlled
through diversification of assets.
Unsystematic risk: Diversifiable risk is called unsystematic risk. It is that portion of total risk which can be eliminated, controlled
through diversification of assets.
The major differences between them can be summarized below:
Systematic risk Unsystematic risk
i. It relates to market risk affecting i. It does relate to market risk.
all the securities in the market.
ii. It can not be diversified away ii. It can be diversified through
through making portfolio of making portfolio of assets.
assts.
iii. It is related to market-wide iii. It is related to business specific
factors. factors.
iv. It arises due to economic iv. It arises due to business
uncertainty phenomenon.
v. It is termed as common risk. v. It is termed as unique risk.
vi. It is measured by the movement vi. Unique risk of the individual
of individual securities with the securities can totally be
changes in the market. eliminated by putting them in a
group.
vii. Security’s beta is the vii. Unsystematic risk is total risk
standardized measure of minus systematic risk.
systematic risk.

Business risk and Financial risk Distinguished

Business risk Financial risk

i. Business risk is uncertainty of i. Financial risk is the uncertainty
expected return on asset if the of return if the company takes
company does not use debt. debt.
ii. It is calculated from the overall ii. It arises if the total debt of the
asset invested in the business. firm is more in the capital
structure.
iii. It is related to the total profit of iii. It is related to the financial profit
the business. of the business.
iv. It is related to the investment iv. It is related to both investment
policy of the firm. policy and capital structure of the
firm.
v. It relates operating leverage. v. It relates financial leverage.
vi. Owners and creditors are vi. Owners of the business are
concerned with this risk. concerned with this risk.
vii. Owners as well as creditors can vii. Only the owners of the business
control this risk. can control this risk.
viii. This is unavoidable risk. viii. This is avoidable risk.
ix. Capital structure is not ix. Capital structure is considered in
considered in analyzing business analyzing financial risk.
risk.
The concluding characteristics of risk can be summarized as below:
 Risk measures the changes in product price.
 The more the debt in the business, the riskier the investment.
 The larger the margin of safety, the lower the risk.
 The more the variability of the return, the more risky the investment.

E(rp )

▪
▪
▪
34
 ▪ Total risk
▪
▪
▪ Unsystematic risk
▪
▪ Systematic risk
▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ ▪ p
Number of securities in the portfolio
Figure: Reduction of risk through diversification of assets.

Measurement of Returns
Investments are made to generate income, to appreciate capital and to preserve capital. An investment periodically generates cash for
the investor in the form of interest, dividends, or rent. The market price or the value of an investment may rise or fall over time. A
capital gain arises when the market value of an asset is above the price what is paid to acquire the asset. Capital loss arises when the
market price fall below what is paid for the asset. In order to measure the return generated by an investment, one should account for
both the income generated by the investment during the period the asset was held and the change in the price. Investors in common
stock consider the change in price and the amount of dividends declared by the company during the holding period of the asset. For
bonds, the holding period return is equal to the price change and interest received. Investors are concerned to measure the return and
choose among alternative investment assets. To meet this, the investors are likely to measure both historical (ex post) and expected (ex
ante) rates of return. Historical returns are often used by the investors with a view to estimating the expected rates of return. The first
measure of return from an individual investment is the historical rate of return during the period the investment is held. The second
measure of return is the measure of expected rate of return for an investment.
The period during which an investor owns an asset is termed as its holding period and the percentage return from the investment and
price changes during this period is called holding period return. For a perpetual security like stock, the holding period return for a
particular period of time is equal to the sum of the price change plus dividends received for that period divided by the price at the
beginning of the time period. For fixed income security like bond, the holding period return is equal to the price change plus interest
received divided by the beginning price. However, in general, the holding period return is calculated as follows:

[( P it − P it−1 )+D it ]
r it =
Pit−1
where,
rit = Return for stock i at time t,
Pit = Price of the stock i at time t,
Pit1 = Price of the stock i at time t1 (previous price) and
Dit = Dividends declared for stock i during t–1 and t
To measure the return generated by an investment, the price change and the cash flow derived from the investment during the period
must be taken into account. To illustrate such return, consider the following data for stock i.
Beginning price Tk.120
Ending price Tk.150
Dividends Tk. 15
Thus, the return for stock i for a particular period would be:
[(150−120)+15 ]
ri = 120
= .375 = 37.5%
The ex post or historical average return for stock i may be calculated as follows:
1
ri = N (ri1 + ri2 + .............. + rin)
N

1 ∑ r it
or ri = N t=1
where, N denotes the number of time periods.
The following Table illustrates data relating to the above formula:

35
 Time 1 2 3 4 5 6 7 8 9 10
Return .09 .12 .03 .04 .14 .02 .10 .15 .04 .05
The historical mean return for stock i is computed as:
1
ri = 10 [(.09) +.12 + (.03) +.04 +.14 + (.02) +.10 +.15 +.04 + (.05)]
1 1
= 10 × [0.59  0.19] = 10 (.40) = .04 = 4 %.

Analysis of Return
Security analysts often use the probability distribution of return to determine expected return and the risk as well. The expected return
is the weighted average of the returns. It can be estimated by multiplying each return by its associated probability and then adding the
results together. The weighted average return called as the expected average return lies at the center of the distribution. Most of the
possible outcomes lie either above or below it.
After calculating the historical rate of return of a security it is essential to calculate its expected (ex ante) return. The expected rate of
return is the ex ante return that an investor expects to earn over some future holding period. An investor determines how certain the
expected rate of return on an investment is by analyzing estimates of expected returns. In this connection, an investor assigns
probability values to all possible returns. These probability values range from zero (zero per cent) indicating no change of the return to
one (hundred per cent) indicating complete certainty that the investment will generate the specific rate of return. For sure, for a fruitful
estimation, these probabilities are based on the historical performance of the investment or similar investments modified by the
investor’s expectations for the future. To describe the outcome from a particular probability distribution, it is essential for an investor
to estimate its expected value. The expected value is the average of all possible return outcomes, where each outcome is weighted by
its respective probability of occurrence. The expected rate of return from an investment is defined as:
N
E(r )=∑ pi r i
i=1
where,
E(r) = the expected return on security in subject,
ri = the i th possible return,
pi = the probability of i th return (ri) and
n = the number of possible returns
Example-03:
From the following information calculate the expected rate of return.
Return Possible (ri) .10 .12 .09 .11 .05 .15
Probability (pi) .15 .20 .25 .10 .12 .18
Solution:
The expected rate of return for the stock can be calculated as:
Return Possible (ri) .10 .12 .09 .11 .05 .15 Total
Probability (pi) .15 .20 .25 .10 .12 .18 1.00
(pi)(ri) .015 .024 .0225 .011 .006 .027 .1055
N
E(r )=∑ hi r i
i=1
= .1055 = 10.55%
The return lies between 5% to 15%.

Example-04:
From the following probability distribution calculated expected rate of return for the stock i:
Possible .0 .12 .0 .04 .14 .0 .10 .15 .04 .05
return (ri) 9 3 2
Probability (pi) .10 .10 .10 .10 .10 .10 .10 .10 .10 .10
Solution:
From the above ex ante data the expected rate of return for stock i may be computed as:
Possible .09 .12 .03 .04 .14 .02 .10 .15 .04 .05
return (ri)

36
 Prob. (pi) .10 .10 .10 .10 .10 .10 .10 .10 .10 .10
(pi)× (ri) .009 . .003 . . .002 .01 . . .005
012 004 014 015 004
Here,
N
∑ pi r i
i=1 = [.10 (.09) +.10 (.12) +.10 (.03) +.10 (.04) +.10 (.14) +
.10 (.02) +.10 (.10) +.10 (.15) +.10 (.04) +.10 (.05)]
= [0.059 0.019] = 0.040 = 4%.
Alternatively,
N
E(r )=∑ pi r i
i=1
= 0.040 = 4%
Therefore, the expected return is 4 % which lies, according to its property, between – 9 % to 15 %.
Example-05:
Suppose the market price of a stock which pays no dividend is Tk. 200. The possible prices of the stock with respective probabilities
are given below:
Expected Price (P1) 210 195 200 211 205 215 220
Probability (pi) .10 .20 .15 .10 .25 .10 .10
Calculate the expected rate of return.
Solution:
Here, the expected rate of return can be calculated through the probability distribution of return. The probable returns for each of the
expected prices can be calculated by using the following formula:
D +[ P 1− P 0 ]
E ( r i )=
Probable return P0 ×100
Current price (P0) 200
Price (P1) 210 195 200 211 205 215 220
[P1 – P0] 10 –5 00 11 5 15 20
E(ri) = .05 –.025 00 .055 .025 .075 .10
[P1 – P0]/P0 × 100

Calculation of expected rate of return:

Probable .05 –.025 00 .055 .025 .075 .10 Total
return (ri)
Probability (pi) .10 .20 .15 .10 .25 .10 .10 1.00
(pi) (ri) .005 –.005 00 .0055 .0063 .0075 .01 0.029
3
Therefore, the expected rate of return is:
N
E(r )=∑ pi r i
i=1
= 0.0293 = 2.93%
Example-06:
Suppose share of IBM is currently selling for Tk. 150 but not pay any dividend. The expected prices of the stock with respective
probabilities by the year end are given below:
Price (P1) 160 175 155 158
Probability (pi) .25 .25 .25 .25
Calculate the expected rate of return if 500 shares of IBM are purchased with 50 % borrowed funds assuming that the cost of
borrowed funds is 10 %.
Solution:
Here, the expected rate of return can be calculated through the probability distribution of return. The probable returns for each of the
expected prices can be calculated by using the following formula:
D +[ P 1− P 0 ]
E ( r i )=
Probable return P0 ×100

37
 Current market price (P0) 150
Year end expected price (P1) 160 175 155 158
[P1 – P0] 10 25 5 8
E(ri) = [{D + (P1–P0)}/P0] × 100 .067 .167 .033 .053

Calculation of expected rate of return:

Probable return E(ri) .067 .167 .033 .053 Total
Probability (pi) .25 .25 .25 .25 1.00
(pi) (ri) .0168 .0418 .0083 .0133 0.0802
Therefore, the expected rate of return is:
N
E(r )=∑ pi r i
i=1
= 0.0802 = 8.02%
Calculation of return:
The investment amount of 500 shares is Tk. 150 × 500 = Tk. 75,000
Borrowed funds are (50% of Tk. 75,000) = Tk. 37,500
Gross return from 500 shares are (Tk. 75,000 × .0802) = Tk. 6,015
Interest payment is (Tk. 37,500 × .10) = Tk. 3,750
Therefore,
Net return is (Tk. 6,015 – Tk. 3,750) = Tk. 2,265
The rate of return on equity investment is Tk. 2,265 /Tk. 37,500 × 100 = 0.0604
= 6.04%

Measures of Risk
Risk arises from the expected volatility in asset’s return over time caused by one or more of the following sources of returns on
investment:
▪ Fluctuations in expected income
▪ Fluctuations in the expected future price of the asset
▪ Fluctuations in the amount an investor can reinvest
▪ Fluctuations in returns an investor can earn from reinvestment.
Under these circumstances, we examine the measures of risk arising from an investment. There are two methods of measuring risk
viz., i) absolute measure and ii) relative measure of risk. The absolute measures of risk for an investment are:
▪ Variance of rates of return (σ2i)
▪ Standard deviation of rates of return (σi)
▪ Covariance (σim)
These measures of risk can be influenced by the magnitude of original numbers. Hence, to compare series with greatly different
values, we need a relative measure of dispersion. The relative/standardized measures of risk for investments are:
▪ Coefficient of variation (CV) of rates of return which is calculated as:
σi

CV = E (r i )
▪ Correlation coefficient (rij), being a statistical measure of the extent to which two variables are associated which is calculate
as:
σ ij
r ij =
σiσj
▪ Covariance of returns with the market portfolio is called beta (i) which is calculated as:
σ im
β i= 2m
σ
or
r im σ i σ m
β i= 2m
σ
Statistical measures allow an investor to compare the return and risk measures for alternative investments directly. Variance and
standard deviation of the estimated distribution of expected returns are, however, two possible measures of uncertainty. Calculation of
the expected return of the probability distribution is essential to calculate the variance and standard deviation.

38
Standard deviation
Standard deviation is a measure of the dispersion of forecasted returns when such returns approximate a normal probability
distribution. It is a statistical concept and is widely used to measure risk from holding a single asset. The standard deviation is derived
so that a high standard deviation represents a large dispersion of return and is a high risk; a low deviation is a small dispersion and
represents a low risk. Standard deviation of the rates of return is simply the square root of the variance of the rates of return which tells
us about the potential for deviation of the return from its expected values.
Variance
Variance is directly related to the standard deviation and is of considerable importance in finance. However, the variance is simply the
standard deviation squared (or the standard deviation is the root of the variance). The following is the formula for calculating the
variance of historical returns (using ex post data):
N
1 ∑
2r = N−1 (rit  ri)2
t=1
Dividing by N1 gives us an unbiased estimate for the variance when the sample is relatively a small size (lower than 30). In case of
historical data the computation of the variance would be as follows:
Time 1 2 3 4 5 6 7 8 9 10
Return .09 .12 .03 .04 .14 .02 .10 .15 .04 .05
The historical mean return for stock i:
ri = 0 .04

Time Return (ri) (rit-¯ri)2

1 .09 (.09 .04)2 (.13)2 = 0.0169
2 .12 (.12.04)2 (.08)2= 0.0064
3 .03 (.03 .04)2 (.07)2 = 0.0049
4 .04 (.04.04)2 (00)2 = 0000
5 .14 (.14.04)2 (.10)2 = 0.0100
6 .02 (.02.04)2 (.06)2 = 0.0036
7 .10 (.06)2 = 0.0036
(.10.04)2
8 .15 (.11)2 = 0.0121
(.15.04)2
9 .04 (00)2 = 0000
(.04.04)2
10 .05 (.09)2 = 0.0081
(.05 .04)2
ri =0.04 = 0.0656

N
1 ∑
r=
2 N−1 t=1 (rit  ri)2
1
r=
2 9 (.0656)
= .0073
Standard deviation is the positive square root of the variance.
2
r = √σ r

= .0073
√
= .085 = 8.5 %
The variance of expected rates of return by using ax ante data can be found as follows:
N
∑
 r = i=1 pi[ri  E(r)]2
2

In case of our example the expected rate of return can be given as below against probability distribution. The variance of the
population by using ex ante data is computed as follows:

39
 Expected E(ri) = pi (ri) pi[ri  E(r)]2
return (ri)
.09 .10 (.09) .10(.09 .04)2 .10(.13)2 = 0.00169
.12 .10 (.12) .10(.12.04)2 .10(.08)2= 0.00064
.03 .10 (.03) .10(.03 .04)2 .10(.07)2 = 0.00049
.04 .10 (.04) .10 (.04.04)2 .10 (00)2 = 0.00000
.14 .10 (.14) .10(.14.04)2 .10(.10)2 = 0.00100
.02 .10(.02) .10(.02.04)2 .10(.06)2 = 0.00036
.10 .10(.10) .10(.10.04)2 .10(.06)2 = 0.00036
.15 .10(.15) .10(.15.04)2 .10(.11)2 = 0.00121
.04 .10(.04) .10(.04.04)2 .10(00)2 = 0.00000
.05 .10(.05) .10(.05 .04)2 .10(.09)2 = 0.00081

= 0.040 = 0.00656
N
∑
 r = i=1 pi[ri  E(r)]2
2

2r = .00656

Also, = .00656
√
= .081 = 8.1%
Thus, the ex ante standard deviation is considered as a weighted average of the potential deviations from the expected returns and a
reasonable measure of risk. Both variance and standard deviation are absolute measures of dispersion. They are influenced by the
magnitude of the original numbers.
Coefficient of variation
A relative measure of dispersion is the coefficient of variation (CV). To compare series with greatly different values, we need a
relative measure of dispersion which can be calculated as:
Standard deviation of Return
Coefficient of variation (CV) =
Expected Rate of Return
The coefficient of variation measures risk per unit of return. A larger value indicates greater dispersion relative to the arithmatic mean
of the series.
Covariance:
The expected rates of return and the variance provide the information about the natures of the probability distribution of a single stock
or a portfolio of stocks indicating nothing about the returns on securities interrelated. Certainly a stock may generate a rate of return
above its expected value. If it is known in advance, will it impact on the expected rate of return on other stock? If one stock generates
a rate of return above its expected value, willl other stock produce the same? A statistical measure giving answer to these questions is
the variance between two stocks. Covariance refers to the measure of the degree of association between the returns of a pair of
securities. It is defined as the extent to which two random variables covary over time. However, the properties of covariance are given
below:
▪ A positive covariance: The returns on two securities tend to move in the same direction at the same time indicating that if
one increases (decreases), the other does the same.
▪ A negative covariance: The returns on two securities tend to move inversely at the same time indicating that if one increases
(decreases), the other decreases (increases).
▪ Zero covariance: The returns on two securities are independent having no tendency to move in the same or opposite
directions together.
To understand the concept of covariance, let us assume that we have two stocks called stock A and stock B. In a period of six months
the stocks produce the following rates of return:
Month Jan Feb Mar Apl May Jun Mean
Stock-A .12 .14 .10 .08 .04 .04 .04
Stock-B .09 .12 .06 .10 .09 .08 .06
We like to estimate the covariance from the sample of the six months returns. As the data given above are historical returns, the
sample covariance may be computed by using the following formula:
N
1 ∑
im = N−1 t=1 [(r,it  ri)( rm,t rm)]

40
Using the data in our example, we can estimate the covariance of the returns from stock A and stock B as follows:

Return
(rAt rA) ( rBt rB) [(rAt rA) ( rBt rB)]
rA rB
.12 .09 (.12  .04) (.09 .06) (.08)(.03) = .0024
.14 .12 (.14 .04) (.12 .06) (.10)(.06) = .0060
10 .06 (10 .04) (.06 .06) (.14)(00) = 0000
.08 .10 (.04)(.04) = .0016
(.08 .04) (.10 .06)
.04 .09 (.08)(.15) = .0120
(.04 .04) (.09 .06)
.04 .08 (00)(.02) = 0000
(.04 .04) (.08 .06)
rA=.04 rB =.06 Total = 0.0220

N
1 ∑
AB = N−1 t=1 [(rA,t  rA)( rB,t rB)]

1
σ AB = 5 (0.022)
=.0044
The above measure is used to calculate the covariance from a sample of paired returns. Now the question arises when the actual
probabilities of getting various pairs of returns at the same time. The probabilities of getting various pairs of returns on two
investments at the same time could be presented in the joint probability distribution. If we have the actual probability distribution
rather than a sample estimate, the population covariance of underlying joint distribution may be estimated by applying the following
formula: N
∑
σ im = t=1 pt [rit  E(ri)][ rmt  E(rm)]
Covariance describes the co-movement of the returns of two securities. Suppose we have the following observation about the expected
rates of return from two stocks A and B. We compute the population covariance as follows:

Probability .20 .25 .30 .15 .10 E (r)

Stock-A .02 .07 .10 .11 .21 .09
Stock-B .24 .18 .10 .01 .12 .10
We can compute the population covariance as follows:

Proba Return
pt× E( rA) pt×E( rB) pt [ rAt E(rA)] [ rBt E(rB)]
bility E(rA) E(rB)
.20 .02 .24 .20×.02 .20×.24 .20(.02 .09)(.24 .10) =
.25 .07 .18 .25×.07 .25×.18 .00196
.30 .10 .10 .30×.10 .30×.10 .25 (.07 .09)(.18 .10) =
.15 .11 -.01 .15×.11 .15×-.01 .0004 .
.10 .21 -.12 .10×.21 .10×-.12 30(.10 .09)(.10 .10) = 0000 .
15(.13 .09)(.01 .10) =
.00066 .10(.21 .09)( .12
.10) = .00264
1.00 N E( rA)=.09 E( rB)=.10 = .00566

∑
σ AB = t=1 pt [rAt  E(rA)][ rBt  E(rB)]

σ AB = .00566
The calculation of covariance is very important since it is a critical input in determining the variance of a portfolio of stocks. However,
it doesn’t accurately describe the nature of the relationship between two investments. Furthermore, we can standardize the covariance
obtaining a better descriptor called the correlation coefficient.
41
Correlation coefficient: Correlation coefficient is a statistical measure of the relative co-movements between returns on securities. It
measures the extent to which the returns on any two securities are related. As the covariance number is unbounded, we can bound it
by dividing it by the product of the standard deviations for the two investments say security A and security B which can be given as
follows: σ AB
r AB =
σ A σB
The resulting number of the above equation is called the coefficient of correlation falling within the range 1 to + 1. With perfect
positive correlation, the returns on securities have a perfect direct linear relationship indicating that the return on one security allows
an investor to forecast perfectly what the other security will result. With perfect negative correlation, the returns on securities have a
perfect inverse linear relationship to each other indicating that the return on one security provides knowledge about the return on the
other security i.e. when return on one security is high, the other is low. With zero correlation, there exists no relationship between the
returns on two securities indicating that the return on one security provides no value in predicting the return on the other security.
However, we can rewrite the covariance as the product of the correlation coefficient and the standard deviations of the two stocks as:
σ AB =r AB ×σ A×σ B
If we square the correlation coefficient we obtain a number called the coefficient of determination. Coefficient of determination (CD)
tells the fraction of the variability in the returns on the one investment that can be associated with the variability in the returns on the
other.
CD = (R2) = (rim)2

Table: Different Aspects of Statistical Measures of Returns and risk on Securities.

Ex post (historical) Ex ante (expected)
Mean return: Expected return:
N N
1 ∑ ∑
ri = N t=1 rit E(r) = i=1 piri
Variance Variance:
N N
1 ∑ ∑
2i = N−1 t=1 (rit  ri)2 2(r) = i=1 ∑ pi [ri  E(r)]2

Standard deviation: Standard deviation:

2 2
i = √σ i
i = √σ i

Covariance(sample): Covariance (population):

N N
1 ∑ ∑
 im = N−1 t=1 [(rit ri)( rmt im = t =1 pt[rit E(ri)][rmt E(rm)]
rm)]

Calculation of a standard deviation using probability distributions involves making subjective estimates of the probabilities and the
likely returns. We cannot avoid such estimates as future returns are uncertain. The prices of the securities are based on investors’
expectations about the future. The relevant standard deviation in this situation is the ex ante standard deviation rather than ex post
based on the realized returns. Although standard deviations based on realized returns could be used as proxies for ex ante standard
deviations, it should be remembered that past may not always be extrapolated into the future without modifications. Though ex post
standard deviations are convenient, they are subject to error.

Individual Stock and Market Portfolio

We have discussed the relationship between the returns on two individual stocks in the preceding discussion. At this stage we like to
discuss about the relationship between the returns on a individual stock and the market portfolio.
Characteristic Line
The pairs of returns can be plotted in figure. The line passing through the observations is the line of best fit. This line helps in
describing the relationship between the return from individual stock and that of market portfolio or market return. If we relate the
return from an individual stock to the market return in this way, the line of best fit refers to as the stock’s characteristic line. The

42
characteristic line shows the return an investor expects the stock to produce, given that a particular rate of return appears for the
market.

Ri
·
·
·
·
rf ·
·
· · · · · · · · · · · Rm

Figure: Relationship between the return of stock i and market portfolio.

The straight line in the figure represents the line of best fit between the return on stock i and market return. In the regression analysis,
the random-error term will have a mean value of zero and is assumed to be uncorrelated with the market returns, the error terms of
other securities, and error terms of the same security over time. The most interesting parameters in the line are the intercept and beta
coefficient.
Systematic risk (Beta factor): Systematic risk is the variability of returns of individual security caused by changes in the economy or
the market. All the securities in the market are affected by such changes. The systematic risk of a security can be measured by relating
the variability of that security with the variability in the market index. The higher the variability, the higher the systematic risk and
vice-versa. The systematic risk of a security can be measured by a statistical weapon called beta. Beta picks up the risk that cannot be
diversified away. As the effective diversification eliminates almost all of an asset’s unique risk, the relative measure of a single asset’s
risk is not its standard deviation, but its beta. Beta indicates an asset’s contribution to the total risk of a portfolio. Since the
characteristic line is a straight line, it can be fully described by its slope and the point where it passes through the vertical axis. The
slope of the characteristic line is commonly known as the stock’s beta factor. The beta factor of an individual stock is an indicator of
the degree to which the stock responds to changes in the return produced by the market. That is , beta measures the covariance of
return on individual stock with market divided by the variance of market return. Since beta indicates the manner in which the returns
on security change systematically with changes in the returns on market, it is frequently referred to as the measure of a security’s
systematic or market risk. The input data required to estimate beta are the historical data of returns of the individual security and the
returns of the market index as well. If the market’s return increased by 10%, then a stock with beta of .75 is expected to increase its
return by 7.5% (.75 × 10%). Two statistical approaches are the appropriate methods of estimating beta. They are; i. correlation method
and/or regression method. From the historical data of returns from both individual security and the market, beta can be calculated by
using correlation method as follows:
σ im
β i= 2
σ m

and
άi = ri  βirm
where,
 i,m = the covariance of return on the stock i with the return on the market,
2 rm = the variance of return on market,
βi = beta factor of stock i,
άi = intercept and
ri ,rm = mean return on stock i and market respectively.
Hence, this formula can be modified to estimate historical beta for individual security as:

43
 σ im
r im =
σi σ m
 i,m = ri,m ×i ×m
Again, βi = ri,m× i× m / 2 m
= rim (i/ m)

The second menthod of calculating beta is the use of regression method. This model postulates a linear relationship between a
dependent variable and an independent variable. This model also helps to calculate the values of two constants viz., ά and β. Beta
measures the change in the dependent variable in response to unit change in the dependent variable. Intercept term (ά) measures the
value of the dependent variable even when the independent variable has zero value. The regression model can be given below:
Y = ά + βX
Where,
Y = Dependent variable,
X = Independent variable
ά and β are constant terms
Where ά and β are given by the following equations respectively;
α=Y−β X
and
N ∑ XY −(∑ X )( ∑ Y )
2 2
β= N ∑ X −∑ (X )
Therefore, for the calculation of beta of individual security, its return is taken as dependent variable and the return of the market index
is taken as independent variable. The regression equation, thus, can be expressed as:
ri = ά + β rm
The beta of stock i is equal to the correlation coefficient for stock i and market portfolio, multiplied by the ratio of the standard
deviation of stock i to the standard deviation of the market return. In another way, the beta of stock i is a function of the correlation of
the returns on stock i with those of the market (r im) and the variability of the returns on stock i relative to the variability of the market
returns (i/ m).
The covariance of market return with itself is the variance of market return:
 mm = 2m
Thus, the beta for the market index would be:
σ mm
β m= 2
m
σ
2
m
σ
= 2m =1
σ
We can, now, classify the systematic or market risk of securities by using the beta of market index into two categories. A stock having
a beta of greater than 1 has above-average market-related or systematic risk and a stock having beta of less than 1 has below-average
market-related or systematic risk. Hence;
β  1: stock holds systematic risk more than average
β  1: stock holds systematic risk less than average
β = 1: Stock holds systematic risk equal to average
β = 0: Stock holds no systematic risk
The standardized measure of systematic risk is commonly known as beta (). The covariance of the subject stock (stock i) with the
market portfolio (im) is the relevant risk measure. Beta defining as im /2m is a standardized measure of risk because it relates this
covariance to the variance of the market portfolio. As a result, the market portfolio has a beta of 1. If the beta of the subject stock is
above 1, the stock has higher normalized systematic risk than the market assuming that it is more volatile than the overall market
portfolio. The notion that individual stock prices may be related to market returns is shown in the following chart:
Beta Description Type of company
Greater than one Stock price moves in the same Volatile/Aggressive
>1 direction, but return move
quickly and higher than market
Less than one Stock moves less quickly than Defensive
<1 market and stock return is less
than market return
Equal to one Stock moves with market and Cyclical
44
 =1 the return is equal to market
return
Equal to zero Stock return is equal to risk free Risk less
=1 return
# A company having beta less than one means that the company’s stock returns do not closely track changes in market
returns and vice-versa.
# The closer the beta to zero, the less relation there is to market returns.
# When the beta of a stock is greater than one, the stock returns for that company move in the same direction, but to a much
greater degree.

Estimating Beta
Beta is a mathematical value that measures the risk of one asset in terms of its effects on the risk of a group of assets called portfolio.
It is concerned solely with market related risk, as would be concern for an investor holding stocks and bonds. It is derived
mathematically so that a high beta indicates a high level of risk, a low beta represents low level of risk. There are different methods of
estimating beta like historical beta using ex post return, ex ante beta using ex ante return, and ex ante beta using adjusted historical
betas. The following Table represents historical returns on stock i and market.
Time
stock-i (ri) .03 .09 .12 -.04 .08 .14
Return
market (rm) .02 -.04 .08 .03 .02 .13

The calculation table:

Return on
(rit ri)( rm t rm) ( rm t rm)2
ri rm
.03 .02 (.03 .07) (.02 .04) = .0008 (.02 .04)2 = .0004
.09 .04 (.09 .07) (.04 .04) =  .0016 (.04 .04)2 = .0064
.12 .08 (.12 .07) (.08 .04) = .0020 (.08 .04)2 = .0016
.04 .03 (.04 .07) (.03 .04) = .0011 (.03 .04)2 = .0001
.08 .02 (.08 .07) (.02 .04) = .0002 (.02 .04)2 = .0004
.14 .13 (.14 .07) (.13 .04) = .0063 (.13 .04)2 = .0081
r i =. r =.
m ∑(rit¯ri)(rm trm) =.0084 ∑( rmt rm)2 = .0170
07 04

The covariance between return on stock i and market portfolio and variance of the return on market are, therefore:
N
1 ∑
 i,m = N−1 t=1 (rit ri)(rmt rm)
1
= 6−1 × 0.0084
= 0.00168

N
1 ∑
m=
2 N−1 t=1 (rmt rm)2
1
= × 0.017
6−1
= 0.0034
Thus, the beta factor and intercept using ex post return can be estimated as:
σ im
β i= 2
σ m
.00168
= .0034
= .49
The intercept is:
αi =ri  βi rm
= .07 .49 (.04) =.07 .0196 =.0504
45
In the above case, the beta factor for stock i is .49 which indicates that if the market return goes to be higher by 1 per cent, the return
for stock i tends to increase by .49 per cent.
The ex ante or expected beta can be estimated from probability distribution. The following information are given to find beta.
Probability .20 .25 .30 .25
Return on stock-i .18 .16 .12 .40
Return on market portfolio .09 .08 .16 .20
From the above information the following estimations are made:

Probability Return
(pi) stock market pi × E(ri) pi × E(rm) pi [ rit E(ri)]2
E(ri) E(rm)
.20 .18 .09 .036 .018 .20(.32)2 =.0205
.25 .16 .08 .040 .020 .25(.02)2 =.0001
.30 .12 .16 .036 .048 .30(.02)2 =.00012
.25 .40 .20 .100 .050 .25(.26)2 =.0169
.140 .098 =.03762

Table contd.
Proba Return
bility stock market pi [ rmt E(rm)]2 pi [ rit E(ri)] [ rmt E(rm)]
(pi) E(ri) E(rm)
.20 .18 .09 .20(.188)2 = .0071 .20(.32) (.188) =.0120
.25 .16 .08 .25(.018)2 = .0008 .25(.02) (.018) = .00009
.30 .12 .16 .30(.062)2 = .0012 .30(.02) (.062) = .00037
.25 .40 .20 .25(.102)2 = .0026 .25(.26) (.102) =.0066
= .01098 = .01814

Expected return:
N
∑
E(ri) = t=1 pi × E(ri)
= .140
N
∑
E(rm) = t=1 pi × E(rm)
= .098
1

Variance:
N
∑
 = t=1 pi [ rit E(ri)]2
2
i
= .03762

N
∑
2m = t=1 pi [ rmt E(rm)]2
= .01098

Standard deviation:
2
i = √σ i

= √0.03762
= 0.1940

46
and
2
m = √σ m

= 0.01098
√
= 0.1048

Covariance:
N
∑
 im = t=1 pi [ rit E(ri)] [ rmt E(rm)]
= .01814
Correlation coefficient:
σ im
r im =
σi σ m
0. 01814
= ( .1940 )(. 1048)
= 0.89
Beta coefficient:
σ im
β i= 2
m
σ
0 . 01814
= 0. 01098 = 1.65
Again,
σi
β i=r im ( )
σm
0 .1940
= .89 × 0 .1048 = 1.65

Problem-07:
Suppose you are given the following observation:
Time T1 T2 T3 T4 T5 T6
Stock-A .02 .04 .02 .08 .04 .04
Stock-B .02 .03 .06 .03 .04 .08
You are required to-
i. find out the sample mean return for each of the stock
ii. find out the variance and standard deviation for the stocks
iii. compute the covariance and correlation coefficient between the return on the stocks
iv. find out the coefficient of determination and comment on the result
Solution:
Time Return on (rAt rA)
(rAt ( rBt
Stock- Stock- (rAt rA)2 ( rBt rB)2 ×
rA) rB)
A B (rBt rB)
T1 .02 .02 00 0000 .01 .0001 0000
T2 .04 .03 .02 .0004 00 0000 0000
T3 .02 .06 .04 .0016 .03 .0009 .0012
T4 .08 .03 .06 .0036 00 0000 0000
T5 .04 .04 .06 .0036 .07 .0049 .0042
T6 .04 .08 .02 .0004 .05 .0025 .0010
.12 .18 .0096 .0084 .0040
Sample mean:
Stock-A

47
 N

1 ∑
rA = N t=1 rAt
1
= 6 × .12 = .02

Stock-B N

1 ∑
rB = N t=1 rBt
1
8 = 6 × .18 = .03

Sample variance:
For Stock-A N
1 ∑
A=
2 N−1 t=1 (rAt rA)2
1
= 6−1 × 0.0096
= 0.00192

For Stock-B N

1 ∑
B=
2 N−1 t=1 (rBt rB)2
1
= 6−1 × 0.0084
= 0.00168

Standard deviation:
For Stock-A
N
1

A =
√ N1 ∑
t=1 (rAt rA)2

1
= √ 6−1
×0 . 0096
= √.00192
= 0.0438 = 4.38%
For Stock-B N
1

B =
√ N−1 ∑
t=1 (rBt rB)2

1
= √ 6−1
×0 . 0084
= .00168
√
=.0410 = 4.10%

48
Covariance:
For stock A and B N

1 ∑
 AB = N−1 t=1 [(rA,t rA)( rB,t rB)]
1
= 6−1 ×.0040
= 0.0008
Correlation coefficient:
For stock A and B σ AB
r AB =
σ A σB
0 . 0008
= ( 0. 0438)( 0 .0410 )
= .45
Again,
 AB = rA,B (A)(B)
= (.45) × (.0438) × (.0410)
= 0.0008
Coefficient od determination:
CD = (rAB)2
= (.45)2 = .20
Problem-08:
Suppose following information are the information about ex ante data:
Probability .20 .25 .30 .15 .10
Stock-A .16 .12 .08 .04 .02
Stock-B .02 .07 .10 .13 .21
You are required to-
i. find out the expected rate of return for each of the stocks
ii. compute the variance and standard deviation for the stocks
iii. compute the covariance and correlation coefficient between the return on the stocks
iv. find out the coefficient of determination of the stocks and comment on the result

Solution:
Calculation of expected rate of return
Prob. Return pi × E(rAi) pi × E(rBi)
(Pi) Stock (rA) Stock (rB)
.20 .16 .02 .20 × .16 = .032 .20 × .02 = .004
.25 .12 .07 .25 × .12 = .030 .25 × .07 = .018
.30 .08 .10 .30 × .08 = .024 .30 × .10 = .030
.15 .04 .13 .15 × .04 = .006 .15 × .13 = .0195
.10 .02 .21 .10 × .02 = .002 .10 × .21 = .021
1.00 .094 .0925
Expected rate of return:
Stock-A
N
∑
E(rA) = i =1 pi × E(rAi)
= .094 = 9.4%

Stock-B
N
∑
E(rB) = i =1 pi × E(rBi)

49
 = .0925 = 9.25%
Contd. Table
Calculation of variance and standard deviation
Prob. Return
(Pi) Stock Stock pi × [rAi  E(rA)]2 pi × [rBi  E(rA)] 2
(rA) (rB)
.20 .16 .02 .20 (.16  .094) = .00087 .20 (.02  .0925) = .00101
.25 .12 .07 .25 (.12  .094) = .00017 .25 (.07  .0925) = .000127
.30 .08 .10 .30 (.08  .094) = .000059 .30 (.10  .0925) = 0000169
.15 .04 .13 .15 (.04  .094) = .00044 .15 (.13  .0925) = .000211
.10 .02 .21 .10 (.02  .094) = .00055 .10 (.21  .0925) = .00138
1.00 .0021 .00274

Variance:
Stock-A
N
∑
2(rA) = i=1 pi [rAi  E(rA)]2
= .0021

Stock-B

N
∑
2(rB) = i=1 pi[rBi  E(rA)] 2
= .00274

Standard deviation:
Stock-A

(rA) = √ σ 2(r A )
= √ 0.0021
= .046 = 4.6%

Stock-B

(rB) = √ σ 2(r B )
= √ 0.00274
= .0523 = 5.23%
Contd. Table
Calculation of covariance
Prob. Return
pi × [rAi  E(rA)][rBi  E(rA)]
(Pi) Stock (rA) Stock (rB)
.20 .16 .02 .20 (.16  .094) (.02  .0925) = .000957
.25 .12 .07 .25 (.12  .094) (.07  .0925) = .000146
.30 .08 .10 .30 (.08  .094) (.10  .0925) = .0000315
.15 .04 .13 .15 (.04  .094) (.13  .0925) = .000295
.10 .02 .21 .10 (.02  .094) (.21  .0925) = .00087
1.00 = .0023

Covariance:

50
 N
∑
AB = i =1 pi × [rAi  E(rA)][rBi  E(rA)]
= 0.0023

Correlation coefficient:
σ AB
r AB =
σ A σB
= 0. 0023 / [(.046)(.0523]
= 0.97
Again,
AB = rA,B (A)(B)
= ( 0.97) (.046)(.0523)
= 0.0023
Coefficient of determination (R2):
CD = (rAB)2
= (0.97)2 = .94
Problem-09:
Suppose you are given the following information:
Probability .20 .25 .30 .15 .10
Return on Stock-i .16 .12 .08 .04 .02
Return on market portfolio-M .02 .07 .10 .13 .21
You are required to-
find out the beta factor for stock i and comment on the result.

Solution:
Calculation of expected rate of return
Prob. Return pt × E(rit) pt × E(rmt)
(Pt) Stock (ri) Market (rm)
.20 .16 .02 .20 × .16 = .032 .20 × .02 = .004
.25 .12 .07 .25 × .12 = .030 .25 × .07 = .018
.30 .08 .10 .30 × .08 = .024 .30 × .10 = .030
.15 .04 .13 .15 × .04 = .006 .15 × .13 = .0195
.10 .02 .21 .10 × .02 = .002 .10 × .21 = .021
1.00 .094 .0925
Expected rate of return:
Stock-i
N
∑
E(ri) = t =1 pt × E(rit)
= .094 = 9.4%
Market portfolio return

N
∑
E(rm) = t =1 pt × E(rmt)
= .0925 = 9.25%

Calculation of covariance covariance

Prob. Return
pt × [rit  E(ri)][rmt  E(rm)]
(Pt) Stock (ri) Market (rm)
.20 .16 .02 .20 (.16  .094) (.02  .0925) = .000957
.25 .12 .07 .25 (.12  .094) (.07  .0925) = .000146
.30 .08 .10 .30 (.08  .094) (.10  .0925) = .0000315
.15 .04 .13 .15 (.04  .094) (.13  .0925) = .000295
51
 .10 .02 .21 .10 (.02  .094) (.21  .0925) = .00087
1.00 = .0023

Covariance between return for stock i and market portfolio:

N
∑
 im = t=1 pt × [rit  E(ri)][rmt  E(rm)]
= . 0023
Calculation of market variance
Prob. (Pt) Return
pt × [rmt  E(rm)] 2
Stock (ri) Market (rm)
.20 .16 .02 .20 (.02  .0925) = .00101
.25 .12 .07 .25 (.07  .0925) = .000127
.30 .08 .10 .30 (.10  .0925) = 0000169
.15 .04 .13 .15 (.13  .0925) = .000211
.10 .02 .21 .10 (.21  .0925) = .00138
1.00 .00274

Variance of market:

N
∑
 (rm) = t =1
2
pt[rmt  E(rm)] 2
= .00274
Therefore,
σ im
2m
βi = σ
−0. 0023
βi = 0. 00274
= 0.84
The beta factor for stock i is negative () 0.84. This indicates that if the market return goes to be higher by 1 per cent, the return for
stock i is expected to decrease by .84 per cent for the next time period and vice versa.
If the market return goes to be higher by 10 per cent, the return for stock i is expected to decrease by 10 (.84) = 8.4 per cent and if the
market return goes to be higher by 100 per cent, the return for stock i is expected to decrease by 100(.84) = 84 per cent for the next
period and vice versa.
Residual variance
Another dimension of the relationship between the return on individual stock and that of market is the propensity of the stock to
produce returns that derive from the characteristic line. The measure describing this propensity is called the residual variance. The
variance of stock describes the stock’s propensity to produce returns that derive from its expected value. The residual variance
describes the propensity of the stock to produce returns that derive from its characteristic line. It is the vertical distance between the
pair of returns and the characteristic line. The residual for a stock can be calculated by using the following formula from the market
model as:
rit = αi + β i (rmt) + εit

and
εit = rit  [αi + βi (rmt)]
Like the variance of stock the residual variance is computed by squaring the deviations from the expected value as:

N
1
N−2 ∑
Residual variance (2 εi) = t=1 2 εit
Problem-10:
From the following information find out the residual variance.
Time T1 T2 T3 T4 T5
Return on Stock-i .02 .03 .06 .04 .08
52
 Return on market portfolio-M .04 .02 .08 .04 .04

Solution:
Calculation table
Time Return on
(rit ri) (rmt rm) (rmt rm)2
Stock-i Market
T1 .02 .04 (.02 .03)(.04 .02) = .0002 .0004
T2 .03 .02 (.03 .03)( .02 .02) = 0000 .0016
T3 .06 .08 (.06 .03)(.08 .02) = .0018 .0036
T4 .04 .04 (.04 .03)( .04 .02) = .0042 .0036
T5 .08 .04 (.08 .03)(.04 .02) = .0010 .0004
ˉri=.03 ˉrm=.02 =.0068 .0096
Covariance Between stock i and market
N
1
N−1 ∑
 i,m = t=1 (ritri)(rm trM)
1
= 5−1 (.0068)
= 0.0017
Market variance
N
1
N−1 ∑
 m=
2 t=1 ( rm t rm)2
1
= 5−1 (.0096)
= 0.0024

Beta factor for stock i:

σ im
2m
βi = σ
0. 0017
= 0 . 0024
= 0.708
Alpha intercept for stock i:
αi =ri  βi(rm)
= .03  (.708)(.02) =.0158
Calculation of residual variance
Conld. table
Time Residual (εit) = rit  [αi + βi (rmt)] Square Residual (ε2it)
T1 .02  [.0158 + .708 (.04)] = .0241 (.0241)2 =.000581
T2 .03  [.0158 + .708 (.02)] =.02836 (.02836)2 =.000804
T3 .06  [.0158 + .708 (.08)] = .0124 (.0124)2 =.000154
T4 .04 [.0158 + .708 (.04)] = .0525 (.0275)2 =.000756
T5 .08  [.0158 + .708 (.04)] = .0359 (.0359)2 =.001289
= .003584

N
1 2
N−2 ∑ ε it
Residual variance (2 εi) = t =1
1
= × 0. 003584
5−2
= 0.001195

53
 Valuation of Fixed-I ncome Securities

Understanding of fixed income securities

9k=9
+gk3Fixed income securities are the investment alternatives generating predetermined fixed income to the investors. Bonds and
debentures offer the investors the opportunity to earn stable nominal returns with low risk of loss of principal if held to maturity.
Nevertheless, bonds also offer investors the chance to earn more returns by speculating on interest rate movements. Although bonds
and debentures are long-term fixed income securities, both of them are debt securities. Generally speaking debt securities issued by
government and public sector units are commonly known as bonds. On the other hand, debt securities issued by private sector joint
stock companies are called debentures. A debenture is also called an unsecured bond backed by general credit of a company.
However, bonds and debentures are often used interchangeably. Bonds can be defined as the long-term debt instruments which
represent a contractual obligation to pay both principal and interest thereon by the issuer to the holder . Two major categories of bonds
54
available in the securities markets are government bonds and corporate bonds. The holder of bonds can sell them off any time before
maturity although no maturity the issuer reimburses to the holder. If a bond is going to be sold before maturity, the price will depend
on the level of interest rates at that time. Therefore, the buyers of the bonds are exposed to interest rate risk. So, on the part of the
buyers and sellers of bonds it is essential to understand the fundamentals of bonds how to price, analyze, and manage them.

Theorems of Bond Pricing

Being fixed income securities bonds are issued with a fixed rate of interest known as coupon rate. The calculation of coupon rate is
based on the face value and maturity of the bond. At the time of issuance, the coupon rate seems to be equal to the prevailing market
interest rate. Based on the market condition, interest rate may change. If the current market interest rate is higher than the coupon rate
of a bond, the bond generates a lower return and becomes less attractive to the investors. Therefore, the price of the bond declines
below its face value. On the other hand, if the market interest rate declines below the coupon rate, bond price will increase and the
bond becomes popular and being sold at a premium on its face value. Thus, the general assumption is that the bond prices vary
inversely with changes in market interest rates.
Burton G. Malkiel identified the relationship between bond prices and changes in market interest rates . He stated five fundamental
principles to relate bond prices to market interest rates which are known as bond pricing theorems. These are discussed as:
1. Bond prices move inversely to market interest changes.
2. The variability in bond prices and term to maturity are positively related. For a given change in the level of market interest
rates, changes in the bond prices are greater for long-term maturities.
3. The sensitivity to changes in market interest rates increases at a diminishing rate as the time remaining until the bond’s
maturity increases.
4. Absolute increases in market interest rates and subsequent bond price changes are not symmetrical. For a given maturity, a
decrease in market interest rate causes a price rise that is larger than the price decline resulting from an equal increase in
market interest rate.
5. Bond price volatility is related to its coupon rate. The percentage change in a bond’s price due to a change in the market
interest rate will be smaller if its coupon rate is higher.
The amount of price variation necessary to adjust to a given change in interest rates is a function of the number of years to maturity. In
the case of long-maturity bond, a change in market interest rate results in a relatively large price change when compared to a short-
maturity bond. Long-term bond is more sensitive to interest rate changes than short-term bond. This is why short-term bonds generally
possess less exposure to interest rate risk.

Bond Risk Analysis

As compare to other financial assets or securities fixed income securities are considered to be less risky. Though they are less risky,
are not entirely risk-free securities. Therefore, the investment in bonds is a function of various types and sources of risk. The actual
return from a bond may differ from the expected return due to defalcation or changes in market interest rate. Both systematic and
unsystematic risk can influence the return from the investments in bond. However, the major risks involved in investments in bond are
default risk and interest rate risk.
Default risk: Default risk refers to the failing of the company to repay principal and/or interest thereon on the stipulated dates .
Inefficient financial performance and management inefficacy lead to default risk. Default risk arises due the nonpayment of whole or a
part of interest and principal. In such a situation, investors in bonds suffer losses which reduce their return from bonds. Through credit
rating such risk can be identified and measured. Credit rating is a process of qualitative analysis of the company’s business and
management and quantitative an analysis of the company’s financial performance.
Interest rate risk:
Since the price of a bond rarely moves in financial markets, the major income from the bond represents the coupon interest rates. An
investor in bond generally receives these interests annually or semi-annually. Hence, the investors can reinvest their interest amounts
at the prevailing market interest rate so that interest on principal begets interest. An investor can do so, so long as he holds the
security. Investor can sell the bond off at a price which may be equal to the face value. During the holding period, market interest rates
may change. If the interest rate increases, the investor would be able to reinvest the annual interest earned from the bond at a higher
rate which will maximize the return. In addition to that bond price will fall below its face value as the market interest rate moves up.
Therefore, investor would suffer a loss if he sells the bond. If the lose on sale exceeds the gain on reinvestment, investor will suffer a
net lose on account of the rise in market interest rate. In contrast, if the interest rate declines, opposite dimension will exist. The
investors have to reinvest the amount of interest at a lower rate than what was expected. Since the market interest declines, the bond
price will move above the face value because the demand of that bond would become high as its rate of return is higher. Under these
circumstances, the investors would incur lose in reinvesting the interest while they will gain on selling the bond. Investors in bond
experience variations in expected rate of return because of the changes in the market interest rate. This variability in return is termed
as interest rate risk. Interest rate risk is the result of two components like reinvestment of annual interest and the capital gains or losses
on the sale of the bond at the end of the holding period. When the market interest rises, there is the possibility of making gains from
reinvestments of interest but there may exist a lose on sale of the bond and vice versa. However, reinvestment risk and price risk are

55
the decompositions interest rate risk. Both reinvestment risk and price risk have an opposite effect on the return of bond. Investor can
eliminate interest rate risk by holding the bond for its duration. If the holding period significantly differs from the duration of the
bond, interest rate risk will exist for the bond.

Term Structure of Interest Rates

The term structure of interest rate refers to the relationship between time to maturity and yields for a particular category of bonds at a
particular point in time. Particular theories are developed to explain the nature of bond yields over time. The following theories are
vital in this regard.
Expectations Theory: Expectations theory of term structure of interest rates states that market participants and the market force as
well will determine the return from holding a security where the return from holding an n-period bond equals the average return
expected from holding a series of one-year bonds over the same n-periods. The long-term rate of interest would be equal to an average
of the present yield on short-term bond plus the expected future yields on short-term bonds which are expected to prevail over the
long-term period. For each period, the total rate of return is expected to be the same on all securities regardless of the time to maturity.
The term structure of interest rate consists of a set of forward rates and spot rate. Spot rate is the rate which is applicable today and the
forward rates are expected to prevail in the future. The rate of return an investor requires to invest is a function of three factors as:
i. risk-free real rate of return,
ii. inflation and
iii. risk premium.
More specifically,
E(r) = risk-free rate + inflation + risk premium
The rate of return for the nth year bond can be estimated by using the following formula:
(1 + trn) = [(1 + t r 1 ) × (1 + t + 1 r 1) ×- - - - - × (1 + t + n –1 r 1)] 1/n 1
where,
(1 + trn) = the rate of return on a n-year bond,
(1 + t r 1) = current rate on a one-year bond,
(1 + t + 1 r 1) = the expected rate on a bond with one-year to maturity beginning one-year from now,
(1 + t + n –1 r 1) = the expected rate on a bond with one-year to maturity beginning n 1-year from now,
n = bond maturity period.
The formula is applicable for any number of periods. Any long-term rate is geometric average of consecutive one-period rate.
Let us consider an example. Suppose one-year bond rate is 10 per cent and two forward rates are 11 per cent and 12 per cent. Find out
the three-year bond.
This problem can be solved by using geometric average of the current one-year rate and the expected forward rates for the subsequent
two years as follows:
(1 + tr3) = [(1 + t r1) (1 + t + 1 r 1) (1 + t + 2 r 1)] 1/3 1.0
= [(1.10) (1.11) (1.12)]1/3  1.0
= [1.3675] 1/3  1.0
3
= √ 1. 3675  1.0
= 1.11 1.0 = 0.11 = 11%
Liquidity Preference Theory: Liquidity preference theory assets that as in the expectations theory, interest rates reflect the sum of
current and expected short rates plus liquidity premium. Because of the uncertainty in future, investors prefer to invest in short-term
bonds. On the other hand, borrowers prefer long-term to invest in capital assets. Under these circumstances, investors are supposed to
receive a liquidity premium to invest in long-term bonds. Therefore, this theory implies that long-term bonds should offer higher
yields.
Preferred Habital Theory: The difference between the expectations theory and liquidity preference theory is the recognition that
future interest rate expectations are uncertain. To compensate this uncertainty, risk-averse investors would like a higher rate for long-
term bonds. Being third theory of term structure of interest rates, preferred habital theory assets that investors usually prefer maturity
sectors or habits. A financial institution with many five-year maturity deposits to pay off will not wish to take the reinvestment rate
risk that would result from investing in one-year Treasury bills. This theory means that the borrowers and lenders can be induced to
shift maturities if they are adequately compensated by an appropriate risk premium.

Bond Yields and Prices

Bond returns can be calculated in many ways though they are prefixed. The followings are general expressions of bond returns which
are usually found in the securities markets.
Coupon Rate

56
It is the fixed annual interest rate affixed on the face of the bond and is calculated on the face value. It is the fixed rate of return at
which income is payable to the bond holder. Suppose a bond of face value of Tk. 500 with 15 per cent coupon rate will generate Tk.
75 to bond holder annually till maturity.
Current Yield
Since a bond can be sold before maturity, it might be performed in the prevailing market price. The current market price of a bond in
the secondary market may differ from its face value. Current yield is the ratio of annual interest receivable on a bond and its current
market price which can be shown mathematically as:

In
Currentyield=
P0
where,
In = amount of annual interest
P0 = current market price of the bond
Current yield can be expressed in percentage term by multiplying the ratio by 100 as:
Current yield (per cent) = [In/P0] ×100
In the earlier example, if the current market price of the bond is Tk. 490, the current yield would become:
Current yield = [In/P0] ×100
= [75/490] ×100 = 15.31 per cent
The properties of current yield are: the lower the selling price of the bond the higher the current yield and higher the market price the
lower the current yield. It implies that there is an adverse relationship between current market price of a bond and its current yield . On
the other hand, if the current yield of the bond is lower than the coupon rate, the bond is selling at a premium and vise versa. The
current yield measures the annual return to a bondholder who purchases the bond from the secondary market and sells before maturity
at the same price at which it was bought. It does not measure the entire returns from a bond held till maturity.
Spot Interest Rate
A zero coupon bond is a bond which is sold with no coupons, no interest to be paid during the life of the bond and is redeemed for
face value at maturity. It is a special type of bond paying no annual interest. Therefore, the return on this bond represents a discount on
issue of the bond. As for example a two-year bond with a face value of Tk. 1000 may be issued for Tk. 800 at discount. The investor
purchasing the bond at Tk. 800 will receive Tk. 1000 after two years from now. This type of bond is called pure discount bond. The
return received from a zero coupon bond expressed on an annualized basis is called spot interest rate. Hence, spot interest rate
represents the annual rate of return on a bond having only one cash inflow. It can be expressed as the discount rate that equates the
redemption value to the discounted value at which the investor purchased it. Thus, the spot interest rate of a two-year bond of face
value Tk. 1000 issued at a discount for Tk. 800 can be estimated as:

1000
800=
(1+k )2
1000
(1+k )2=
800
(1 + k)2 = 1.25

(1 + k) = √ 1.25
= 1.1180
Therefore,
k = 1.1180 1
= .1180 = 11.80 percent
A zero coupon bond with a face value of Tk. 1000 with a maturity period of three years is issued at discount for Tk. 700. The spot
interest rate can be shown as below:

1000
700=
(1+k )3

57
 1000
(1+k )3 =
700
(1 + k)3 = 1.4286
3
(1 + k) = √ 1.4286
= 1.1263
Therefore, k = 1.1263 1
= .1263 = 12.63 percent
The spot interest rate depends on the life of the bond and the difference between the face value and discounted value of the bond.
Yield to Maturity
Yield to maturity (YTM) is the most widely used measure of return on bond. It is the compounded rate of return an investor expects to
receive from a bond purchased at current market price which he holds till maturity. On the other hand, it may be termed as internal
rate of return or discount rate that makes the present value of all the futures cash inflows from the bond equal to the purchase price of
the bond. The relationship among the cash outflow, the cash inflow, and the YTM of a bond can be expressed as:
N
Ct TV n
∑ (1+YTM )t (1+YTM )n
+
MP = t=1
where,
MP = market price of the bond,
Ct = cash inflow from the bond during the whole life of the bond,
YTM = yield to maturity,
TV = terminal value of the bond,
n = total maturity period of the bond.
Hence, it is possible to estimate the YTM equating both the sides of the equation by trial and error method. Let us consider a bond
with a face value of Tk. 1000 having 15 per cent coupon rate which will mature at par. Five years maturity bond can be purchased at
Tk. 800 in the market. The YTM of the said bond can be determined as under:
The relationship among the cash outflow, the cash inflow, and the YTM of a bond can be expressed as:
N
Ct TV n
∑ (1+YTM ) + (1+YTM )
t n
MP = t=1
5
150 1000
∑ ( 1+YTM) + t
(1+YTM )
5
800 = t =1
Since the market price is lower than the face value, the YTM would be higher than the coupon interest rate. This can be estimated by
trial and error method. Firstly, we may consider 20 per cent as YTM. Then the right hand side of the equation becomes-
150 150 150 150 150 1000
[ + + + + + ]
( 1+. 20) ( 1+ .20 ) ( 1+ .20 ) ( 1+ .20 ) ( 1+. 20) ( 1+. 20 )5
2 3 4 5

= [125 + 104.17 + 86.81 + 72.34 + 60.28 +401.88]

= 448.60 + 401.88 = 850.48
Since the estimated value Tk. 850.48 is higher than the desired value Tk. 800, we should try again by a higher discount rate. Taking 25
per cent as YTM, the right hand side of the equation would become-
150 150 150 150 150 1000
[ + + + + + ]
( 1+. 25) ( 1+ .25 ) ( 1+ .25 ) ( 1+ .25 ) ( 1+. 25) ( 1+. 25 )5
2 3 4 5

= [120 + 96 + 76.80 + 61.44 + 49.15 + 327.68]

= 403.39 + 327.68 = 731.07
This value is lower than our desired value Tk. 800. Hence, desired YTM lies between 20 per cent and 25 per cent. It can be estimated
by using interpolation as shown below:
Value at lower YTM –Desired value
YTM = Lower YTM + [ ]×
Value at lower YTM- Value at higher YTM
(Higher YTM  Lower TYM)

58
 850 . 48−800
20+[ ]×(25−20)
= 850 . 48−731. 07
= 20 + (0.4227)(5)
= 20 + 2.1135
= 22.11 per cent.
Alternatively, the present values of the future cash inflows can be estimated by using present value tables like:
Tk. 150 (present value annuity factor for 5 yrs., 20%) + Tk. 1000 (present value factor for 5 yrs., 20%)
= (150 × 2.9906) + (1000 × 0.4019) = 448.59 + 401.90 = 850.49
Again,
Tk. 150 (present value annuity factor for 5 yrs., 25%) + Tk. 1000 (present value factor for 5 yrs., 25%)
= (150 × 2.689) + (1000 × 0.328) = 403.35 + 328 = 731.35

Therefore,
YTM = 20 + [(850.49  800)/(850.49  731.35)](2520)
= 20 + (0.4238)(5) = 20 + 2.119 = 22.12 per cent.

Yield to Call
At the option of the issuer or of the investor, some bonds may be redeemable before their maturity period. If such option is executed,
the subject bond would be called for redemption at the specific call price on the specified call date. For bonds likely to be called, the
yield to maturity calculation is unrealistic. Hence, the better calculation here is termed as yield to call (YTC). The end of the deferred
call period, when a bond can first be called, is often used for the yield-to-call calculation. This is appropriate for the bonds selling at a
premium. In case of redeemable bond, two yields are to be calculated as:
a) Yield to maturity: It asserts that the bond will be redeemed only at the end of full maturity period.
b) Yield to call: It implies that the bond will be redeemed at the call date before the full maturity. Yield-to-call is the discount
rate that makes the present value of cash inflows to call equal to the bond’s current market price.
Let us consider an example. A bond with a face value of Tk. 100 having 15 percent coupon rate will mature at par in 15 years. The
bond is callable in 5 years at Tk. 115. It currently sells for Tk. 105 in the market. The YTC of the said bond can be determined as
under:
The relationship among the cash outflow, the cash inflow, and the YTC of a bond can be expressed as:
N
CtTV n
∑ (1+YTC )t (1+YTC)n
+
MP = t=1
where,
MP = market price of the bond,
Ct = cash inflow from the bond during the whole life of the bond,
YTC = yield to call,
TV = terminal value of the bond,
n = total maturity period of the bond.

By putting the values, we have

5
15 115
105=∑ t + 5
t =1
(1+YTC) (1+YTC )
We have to find the value of YTC that makes the right hand side of the equation equal to Tk. 105. This can be done by trial and error
method. Since the market price is lower than the callable price, the YTC would be higher than the coupon interest rate. Firstly, we
may consider 15 per cent as YTC. Then the right hand side of the equation becomes-
15 15 15 15 15 115
[ + + + + + ]
( 1+. 15) ( 1+. 15 )2 (1+. 15 )3 (1+. 15 )4 ( 1+.15 )5 ( 1+.15 )5
59
 = [13.04 + 11.34 + 9.86 + 8.58 + 7.46] + [57.17]
= 50.28 + 57.17 = 107.45
Since the estimated value, Tk. 107.45 is higher than the desired value, Tk. 105; we should try again by a higher discount rate. Taking
18 per cent as YTC, the right hand side of the equation would become-
15 15 15 15 15 115
[ + + + + + ]
( 1+. 18) ( 1+. 18 )2 (1+. 18 )3 (1+. 18 )4 ( 1+.18 )5 ( 1+.18 )5
= [12.71 + 10.77 + 9.13 + 7.74 + 6.56] + [50.27]
= 46.91 + 50.27 = 97.18
This value is lower than our desired value, Tk. 105. Hence, desired YTC lies between 15 per cent and 18 per cent. It can be estimated
by using interpolation as shown below:

Value at lower YTM –Desired value

YTM = Lower YTM + [ ]×
Value at lower YTM- Value at higher YTM
(Higher YTM  Lower TYM)
107 . 45−105
15+[ ]×(18−15)
= 107 . 45−97 .18
= 15 + (0.2386)(3)
= 15 + 0.7157
= 15.72 per cent.

Bond Duration
A bond will face interest rate risk if holding period differs from duration. For any bond there is a holding period at which the effect of
reinvestment risk and price risk balances each other. The lose on reinvestment of interest can be compensated by a capital gain on the
sale of the bond and vice versa. For this holding period there is no interest rate risk. The holding period at which interest rate risk
disappears is called the duration of the bond. Thus, the duration of bond is required time period at which the price risk and the
reinvestment risk of a bond are of equal magnitude but opposite in direction. Therefore, the bond duration is the weighted average life
of the bond. The various time periods at which the bond generates returns are weighted according to the respective size of the present
value of these returns. The formula for calculating bond duration can be expressed as:
I1 I2 I n +TV n
[
d= 1×
( 1+k )
+2×
(1+ k )2
+−−−−+n×
( 1+k )n P0 ]
This equation requires discounting the series of cash flows, which are multiplied by the time period in which they occur. The sum of
these cash flows is divided by the price of the bond obtained by using present value model. However, the above formula can be
expressed in a more general format as:

N
C
∑ t× ( 1+kt )t
t =1
d= N
Ct
∑
t =1 (1+ k )t

where,
d = bond duration,
Ct = annual cash flow both interest and principal amount,
k = discount rate which is the proxy of market interest rater,
t = time period of each cash flow and
N = number of period.
Let us consider an example. A 5-year bond having 15 per cent coupon rate was issued at a premium of 5 per cent 3 years ago. The
prevailing interest rate in the market is 18 per cent. The calculation of the bond duration can be summarized as:
Assume that the face value of the bond is Tk. 100.
Year Cash flow PV factor Present value PV multiplied by
(Ct) @ 18 % (PV) years
1 15 0.8475 12.7125 12.7125
2 15 0.7182 10.7730 21.5460

60
 3 15 0.6086 9.1290 27.3870
4 15 0.5158 7.7370 30.9480
5 15 0.4371 6.5565 32.7825
5 105 0.4371 45.8955 229.4775
92.8035 354.8535
N
C
∑ t× ( 1+kt )t
t =1
d= N
Ct
∑
Bond duration t =1 (1+ k )t
354 . 8535
= =3 .82 years
92 . 8035
The duration of the 5-year maturity bond is 3.82 years. If the bond is held for 3.82 years, the interest rate risk can be eliminated. The
impact of reinvestment risk and price risk would offset each other to reduce the interest rate risk to zero.

Bond Volatility
Bond volatility is the absolute value of the percentage change in the bond price for a given change in yield to maturity. If we divide
the percentage change in price by the percentage change in yield to maturity, we simply get bond volatility. Therefore, bond volatility
can be expressed by applying the following formula:
ΔP/ P
Bond volatility = Δr
where,
∆P/P = percentage change in price
∆r = percentage change in yield to maturity
To understand bond volatility, let us take an example. Suppose interest rate increases from 10 per cent to 12 per cent and price
changes from Tk. 100 to Tk. 90. Thus, bond volatility can be expressed as:
ΔP/ P
Bond volatility = Δr
(100−90 )/100
=
12−10
10 %
= =5
2%

61
 Valuation of Common Stocks
Introduction
After discussing the fixed income securities in the preceding chapter, it is essential to evaluate and analyze equity securities. Valuation
of common stocks is easier to describe because they do not have the many technical features like fixed income securities. Fundamental
analysis asserts that the intrinsic value of each share depends upon the returns that an investor receives in future from investing in the
share in the form of dividends and capital appreciation. The decision to buy or sell shares is based on a comparison between the
intrinsic value of a share and the price currently prevails in the market. If the market price of a share exceeds its intrinsic or investment
value, the share is suggested to be sold because it is perceived to be overpriced and vice-versa. Specialists believe that the market price
of a share is the reflection of its investment value. Though the market price of a share may differ from intrinsic value in the short-run,
the price would move along with the investment value of the share in the long-run. Therefore, the investment value called intrinsic
value and the market value of shares are the ingredients of investment decisions making in the securities markets. The intrinsic value
is determined by a process of common stock valuation.

The Basic Valuation Model

The general principle of valuation also applies to share or stock valuation. The value of a share today is a function of the cash inflows
expected by the investors and the risk associated with the cash inflows. The cash inflows expected from an equity share will consist of
the dividend expected to be received by the owner while holding the share and the price which he expected to obtain when the share is
sold. The price which the owner is expected to receive when the share is sold will include the original investment plus a capital gain. It
is normally found that a shareholder does not hold the share in perpetuity. He holds the share for some times, receives the dividends,
and finally sells it to obtain capital gains. But when he sells the share, the buyer is also simply purchasing a stream of future dividends
and liquidating price when he sells the share. The logic can be extended further. The ultimate conclusion is that, for shareholders in
general, the expected cash inflows consist only of future dividends and, therefore, the value of a common stock is determined by
capitalizing the future dividend stream discounted by an appropriate discount rate known as investor’s required rate of return (RRR).
Thus, the value of a share is the present value of its future stream of dividends. The formula for calculating the present value of a share
of one year holding period is given as below:
D1 P1
P0 = +
( 1+ k ) ( 1+ k )
D 1+ P 1
=
( 1+k )
where,
P0 = price per share today,
D1= dividend per share at the end of first year,
P1= price per share at the end of first year,
k = investor’s required rate of return.
If a buyer wishes to hold a share for three years and then sell after purchasing it for P1 at the end of first year, the value of the same to
him today will be:
P1 D2 D3 D4 P4
= 2 + 3 + 4 +
( 1+ k ) ( 1+k ) ( 1+k ) ( 1+k ) ( 1+ k )
4

The price at the end of the fourth year and all future prices are determined in a similar manner. The general formula for determining
the value of the share at the present time can be written as follows:
D1 D2 D3 Dn
P0 = + 2 + 3 + .. .. . .+
( 1+ k ) ( 1+ k ) ( 1+ k ) (1+ k )
n

n
Dt
=∑ t
t=1 (1+k )
It is obvious from the above equation that the present value of the share is equal to the capitalized value of an infinite stream of
dividends. It should be noticed here that Dt in the equation are expected dividends. In fact, investors estimate the dividends per share
likely to be paid by the company in future period of time. These estimates are based on their subjective probability distributions. Thus,

62
the Dt are expected values or means of these probability distributions. Obviously, the present value of future sums would be lower
than those future sums (cumulative).

Common Stock Valuation

The fundamental concept of valuation of shares or stocks is that of present value. A study of present value concept is a sine-qua-non
for the evaluation process. Time value of money states that money today is more desirable than those in future. Fundamental security
analysis suggests two basic approaches to the valuation of common stock as given below:
1. Present value or income capitalization approach: Commonly known as capitalization of income method, the present value
approach is similar to the discounting process. The future cash inflows generated from holding of common stock are discounted to the
present value at an appropriate discount rate some times referred to as investor’s required rate of return.
2. Price-earning (P/E) ratio or multiplier approach: The price-earning (P/E) ratio approach is termed as the earnings
multiplier approach. A stock is said to be worth some multiple of its future earnings. It implies that an investor or an analyst
determines the value of a stock by deciding how much money he is willing to pay for every unit of money of estimated earnings.

Present Value Approach

The fundamental analysis suggests that the classic method of estimating intrinsic value involves the present value concept. Under this
method, the value of a share can be determined by a present value process involving the capitalization of expected future cash inflows.
Therefore, the intrinsic value of a share is equal to the sum of the discounted values of the future stream of cash inflows an investor
expects to receive from the share which can be determined as:

n
FCF t
P0 =∑ t
t=1 (1+ k )
where,
P0 = price of a share today (present value),
FCFt = free-cash-inflows at time t and
k = investor’s required rate of return called appropriate discount rate.
The prerequisites to use this model are:
i. Required rate of return: An appropriate discount rate is proxy of investor’s required rate of return. An investor willing to
purchase a share must assess the risk that commensurate the expected return. At a given level of risk, an expected rate of return is
minimum rate of return that will be required to induce the investor to invest. It is also considered as the investor’s opportunity cost.
ii. Expected cash flows: Amount and the timing of the future stream of cash inflows called free-cash-flows are very important
in determining the value of a share. The value of a bond is the present value of any interest payments plus the present value of the
bond’s face value that will be received at maturity. Likewise, the value of a share is the present value of all cash flows to be received
from the issuer. The stream of cash flows from holding a share consists of the cash dividends received and the future price at which
the share can be sold.
i. Dividend discount model: It uses the present value model to determine the value of a share. As cash dividends are the
cash payments a shareholder receives from a firm, they constitute the foundation of valuation for common stock .
Dividend discount model (DDM) asserts that the current price of a share is equal to the discounted value of all future
dividends received by the investors. The value of a share as asserted by DDM can be estimated by the following formula:

D1 D2 D3 D∞
P= + 2 + 3 +. .. .. .+ ∞
( 1+k ) ( 1+k ) ( 1+k ) ( 1+k )
∞ FCFt
=∑ t
t=1 (1+k )
where,
Pcs = intrinsic value of a common stock
kcs = discount rate, investor’s required rate of return or opportunity cost.
D1, D2, …, D∞ = annual dividends expected to be received each year.

63
To use the DDM for share valuation, the investor has to forecast the future dividends during the holding period. It is not possible on
the part of the investor to forecast the expected dividends accurately. This is why modifications of DDM have been developed to
render it useful for the valuation of share.
As in case of most of the shares, the amount of dividends grows because of the growth of earnings of a company; this phenomenon
should be taken into consideration for the valuation purpose. Therefore, the growth rate pattern of dividends should be considered.
Different assumptions regarding the growth rate patterns should be made and incorporated into the valuation model. The assumptions
which are commonly used are:
1. Dividends will not grow at all in future, i.e. the zero growth assumption,
2. Dividends will grow at a constant rate in future, i.e. the constant growth assumption,
3. Dividends will grow at varying rate in future, i.e. the multiple growth assumption.
These assumptions regarding the growth patterns of dividends in future give rise three individual versions of the present value model
of share valuation like:
a) Zero-growth model,
b) Constant-growth model and
c) Multiple-growth model.
Zero-Growth Model
Zero-growth model asserts that dividends will not grow over time. The current dividend shall be remained unchanged . A certain
amount of dividend equal to the current dividend being paid, to be paid every year from now to infinity. This pattern of dividend
payment is referred to as the no-growth rate or zero-growth model. Under this model, the value of the share would be determined as:

D0 D0 D0 D0
P0 = + 2 + 3 +.. .. . .+ ∞
( 1+ k )
1
( 1+ k ) ( 1+ k ) ( 1+ k )
In short,

D0
P0 =
k
where,
P0 = price of share,
D0 = constant dividend expected for all future time periods,
k = required rate of return or opportunity cost.
The value of share with no-growth version is easy to calculate because like a preferred dividend this dividend remains unchanged.
Thus, zero-growth common stock is perpetuity and is easily valued given the required rate of return or investor’s opportunity cost. Let
us take an example: A company pays constant dividend of Tk. 10 per share each year. If investor’s required rate of return is 15 per
cent, the value of the share would be:

D0
P0 =
k
Tk . 10
P0 = =Tk . 66 . 67
.15
Let us take another example. An investor expects to receive Tk. 10, Tk. 12 and Tk. 15 as dividend from a share during the next three
years and hopes to sell it off at Tk. 120 at the end of third year. If his required rate of return is 15 per cent, intrinsic value of the share
can be estimated as:
D1 D2 D3 P3
P0 = 1 + 2 + 3 + 3
( 1+ k ) ( 1+ k ) ( 1+ k ) ( 1+ k )
10 12 15 120
P0 = + 2 + 3 +
( 1+. 15 )1( 1+. 15) ( 1+ .15 ) ( 1+.15 )
3

= 8.70 + 9.07 + 9.86 + 78.90

= Tk. 106.53

Constant-Growth Model

64
The constant-growth model is originated by Myron J. Gordon. This is why this model is known as Gordon’s share valuation model . In
this model, it is assumed that dividends will grow at the same rate upto infinite future and that the investor’s required rate of return
would be greater than the dividend growth rate. It is necessary to compound some beginning dividend into the future.

The higher the growth rate, the higher the value of the share;
The higher the required rate of return, the lower the value of the share;
The longer the time period, the higher the value of the share and vice-
versa.
By applying the growth rate (g) to the current dividend (D 0), the dividend expected to be received after one year (D 1) can be
determined as:
D1 = D0(1 + g)1
The expected dividend of any year thereafter can be determined from the current dividend as:
D2 = D0(1 + g)2 = D1(1 + g)
D3 = D0(1 + g)3 = D2(1 + g)
D4 = D0(1 + g)4 = D3(1 + g)
D10 = D0(1 + g)10 = D9(1 + g)
Dn = D0(1 + g)n = Dn1(1 + g)
The present value model for share valuation can, therefore, be written when the future dividends are expected to grow at a constant
rate over time as follows:

2 n
D 0 ( 1+ g)1 D 0 (1+ g ) D 0 ( 1+ g)
P0 = 1
+ 2
+. .. . ..+ n
( 1+k ) (1+ k ) ( 1+k )
When the holding period, n, approaches infinity, the above formula can be simplified as:
D1
P0 =
( k −g )
D0 (1+g )
=
( k −g )
Thus, the intrinsic value of a share is equal to the next year’s expected dividend divided by the difference between the investor’s
required rate of return and its expected dividend growth rate.
Let us consider some examples.
Example-01: An investor expects to get Tk. 10, Tk. 12 and Tk. 15 as dividend from a share during the next three years. The share is
expected to be sold at Tk. 100 at the end of the third year. If the investor’s required rate of return is 10 per cent, the value of the share
would be:
D1 D2 D3 P3
P0 = 1 + 2 + 3 + 3
( 1+ k ) ( 1+ k ) ( 1+ k ) ( 1+ k )
10 12 15 100
= + 2 + 3 +
( 1+ .10 )1 ( 1+.10 ) ( 1+. 10) ( 1+. 10)
3

= 9.09 + 9.92 + 11.27 + 75.13 = Tk. 105.41

Example-02: Jahan Corporation is currently paying Tk. 10 per share as cash dividends and expects it to grow at 10 per cent a year for
the foreseeable future. If the investor’s required rate of return is 15 per cent, the price of Jahan’s share can be estimated as:
D1
P0 =
( k −g )
D0 (1+g )
=
( k −g )
10( 1+. 10)
= ( .15−. 10)
= 11 / .05 = Tk. 220
If the investor’s required rate of return is 12 per cent with other variables held constant, the price of Jahan’s share can be estimated as:

65
 D1
P0 =
( k −g )
D0 (1+g )
=
( k −g )
10( 1+. 10)
= ( .12−. 10)
= 11/.02 = Tk. 550
When the required rate of return declines with other variables held constant, the price of the share increases.
If the investor’s required rate of return is 18 per cent with other variables held constant, the price of Jahan’s share can be estimated as:
D1
P0 =
( k −g )
D0 (1+g )
=
( k −g )
10( 1+. 10)
= ( .18−. 10)
= 11/.08 = Tk. 137.50
When the required rate of return increases with other variables held constant, the price of the share decreases.
If the dividend growth rate is 12 per cent with other variables held constant, the price of Jahan’s share can be estimated as:
D1
P0 =
( k −g )
D0 (1+g )
=
( k −g )
10( 1+. 12 )
= ( .15−. 12)
= 10(1.12)/.03 = Tk. 373.33
When the growth rate of dividend increases return increases with other variables held constant, the price of the share increases.
If the dividend growth rate is 8 per cent with other variables held constant, the price of Jahan’s share can be estimated as:
D1
P0 =
( k −g )
D0 (1+g )
=
( k −g )
10( 1+.08 )
= ( .15−.08)
= 10(1.08)/.07 = Tk. 154.29
When the growth rate of dividend decreases with other variables held constant, the price of the share decreases. These examples
suggest that the share price constantly fluctuates depending upon the variables. If investors use the constant-growth version of
dividend discount model to estimate the value of a share, a different price will be obtained because of the influence of the variables.
However, the constant-growth model may not become realistic in different situations. The growth of dividends may vary depending
upon the varying situation of the company and the economy as well.
Example-03: Jahan corporation is currently paying a dividend of Tk. 20 per share as dividend and it expects dividend to grow at 10 per
cent a year for the foreseeable future. If the investor’s required rate of return is 15 per cent, the intrinsic value of Jahan’s share will be
calculated by the method described below:

66
 D1
P0 =
(k −g )
D0 (1+g )
=
( k −g )
20( 1+.10 )
= ( .15−.10)
= 20(1.10) / (15 .10)
= 22 /.05 = Tk. 440

Multiple-Growth Model
The financial position of many companies may be that a period of extraordinary growth will prevail for a certain number of years,
after which the dividend growth rate shall become changed to a level at which it is expected to continue indefinitely. The constant-
growth model is unable to deal with these situations. This pattern of dividend can be presented by a two-stage growth model. Such a
variation of the DDM is termed as the multiple-growth model. More specifically, a multiple-growth model can be defined as a
situation in which the expected future growth of dividends shall be shown by two or more growth rates. The basic characteristic of
multiple-growth model is that although two or more growth rates of dividends are to be described in the multiple-growth model, at
least two different growth rates are involved. Under thus circumstances, the value of a share should be the sum of the present values of
two dividend flows. One is the dividends received from period 1 to N and the other refers to the dividends received from N+1 to
infinity. Sum of the total present values represents the intrinsic value or the price of the share. For our understanding we can divide the
period into two parts called first phase and second phase. The growth rates of dividends during the first phase may vary over time. The
expected dividends for each year during the first phase can be forecasted individually irrespecting the constant-growth or varying
growth rates of dividends during the first phase. Therefore, multiple-year holding period valuation model can be used for the first
phase, using expected dividends for each year by the following formula:
D1 D2 DN
P0 = 1 + 2 +.. .. .+ N
( 1+ k ) ( 1+ k ) ( 1+k )
N
Dt
=∑ t
t =1 (1+k )
Since the growth of dividends is assumed to be constant during the second phase at another growth rate, the present value of this phase
would be based on the constant-growth model of DDM. After period N, the investor would enter into the next year at which the
second phase will commence. So, after period N, the expected stream of dividends for time periods N+1, N+2, N+3 and so on which
will grow at an another constant rate, would be considered. The expected dividends after period N can, therefore, be calculated as:
DN+1 = DN(1 + g)1
DN+2 = DN(1 + g)2
DN+3 = DN(1 + g)3
and so on to infinity.
Gordon share valuation model, therefore, can be applied to estimate the present value of the second phase stream of dividends at time
N commencing from period N+1 to infinity as:
D n (1+ gc )
Pn =
( k−g c )
Dn
+1
=
(k −gc )
The value of the share as estimated under the above formulla is assumed to be the present value at time N on today. If this value is to
be considered at time zero, it must be discounted by the required rate of return (1+k) to estimate the present value at time zero for the
second phase of dividend streams. The discounted value of the second phase streams of dividend can be obtained as:
Dn+1
P0 =
( k −g c )(1+ k )n
Pn
=
(1+k )n
67
The present values of two phases estimated above may be added to provide the intrinsic value of the share having a two-stage growth
of dividends as under:
N Dt Pn
P0 = ∑
t =1 [ ( 1+k ) t ][
+
( 1+ k )n ]
From the discussion and expression given above, a well-know multiple-growth model may be assumed to be a two-period model. This
model assumes near-term growth at a rapid rate for some period followed by a suitable steady growth rate. This can be expressed by
the following equation:
N
D0 (1+ g 1 )t D n ( 1+ gc )
P0 = ∑
t =1
[ ( 1+ k )t ][
+
( k −gc )( 1+ k ) n ]
where,
P0 = estimated value of share today,
D0 = current dividend,
g1 = growth rate of dividend at first phase,
gc = constant-growth rate of dividend at second phase,
k = investor’s required rate of return
Dn = dividend at the end of the first phase
N = number of period after which second phase will start.
Let us consider some examples.
Example-01: A company currently pays a dividend of Tk. 10 per share and expects to pay a dividend of Tk. 11 per share during the
next year. Also investors expect dividends of Tk. 12 and Tk. 15 per share respectively during the two subsequent years. After that
(year of receiving dividend of Tk. 15) investors expect that annual dividend will grow at 15 per cent a year upto infinity. If the
investor’s required rate of return is 20 per cent, the intrinsic value of share of that company will be calculated by the method described
below:
The expected dividends for each year during the first phase are given. Therefore, the following multiple-year holding period valuation
model can be used to estimate the present value of the share for the first phase. The sum of the present values of dividends received
upto the year of constant growth can be estimated as:
D1 D2 D3
V 1= 1 + 2 + 3
(1+ k ) (1+ k ) ( 1+ k )
11 12 15
P0 = + 2 +
( 1+ . 20 )1
(1+. 20 ) ( 1+.20 )
3

= 9.17 + 8.33 + 8.68 = 26.18

By using the constant-growth model of DDM, the value of the share at the n th year can be caculated as:

D n (1+ gc )
Pn =
( k−g c )
Dn
+1
=
(k −gc )
15( 1+. 15 )
= (. 20−. 15)
= 345
The present value of second phase at time zero of dividends receivable from fourth year to infinity can be estimated as:
Pn
V 2= n
( 1+ k )
345
=
( 1+.20 )3
= 199.65

68
Therefore, the intrinsic value of the share is sum of the two present values as given below:
P0 = V1 + V2
= 26.18 + 199.65 = Tk. 225.83
Example-02: Suppose a corporation currently pays a dividend of Tk. 10 per share and expects it to grow at 12 per cent a year for next
five years at the end of which the new growth rate is expected to be a constant 8 per cent a year for the foreseeable future. If the
investor’s required rate of return is 15 per cent, the intrinsic value of the share will be calculated by the method described below:
Solution: The first step in the valuation process devotes to determine the amount of dividends of every year of supernormal growth
period in the following way:
The compound of beginning dividend (D0) at supernormal growth rate, 12 per cent for each of the five years are as follows:
D0 = Tk. 10
D1 = D0(1 + g1)1 = Tk. 10(1 + .12)1 = Tk. 11.20
D2 = D0(1 + g1)2 = Tk. 10(1 + .12)2 = Tk. 12.54
D3 = D0(1 + g1)3 = Tk. 10(1 + .12)3 = Tk. 14.05
D4 = D0(1 + g1)4 = Tk. 10(1 + .12)4 = Tk. 15.74
D5 = D0(1 + g1)5 = Tk. 10(1 + .12)5 = Tk. 17.62
Now, the present values of the dividends are estimated by discounting with the required rate of return, 15 per cent, as:
Present value of D1 = Tk. 11.20(.869) = Tk. 9.73
D2 = Tk. 12.54(.756) = Tk. 9.48
D3 = Tk. 14.05(.658) = Tk. 9.24
D4 = Tk. 15.74(.572) = Tk. 9.00
D5 = Tk. 17.62(.497) = Tk. 8.76
=============================
Total present value of D1 to D5 = Tk. 46.21
Sum of the discounted dividends produces the value of the share for its five years only. To evaluate the dividends from year six to
infinity, the constant-growth model, therefore, can be used. After the end of year five the company will enter into year six. The value
of the share at the start of year six can be estimated by using the following model:
Dn+1
Pn =
(k −g c )
where,
DN+1 = D5+1
= D6
= D5 (1+ gc)
= Tk. 17.62(1.08)
= Tk. 19.03
Therefore,
Dn+1
Pn =
(k −g c )
19 .03
= ( . 15−. 08 )
= Tk. 271.86
Thus, Tk. 271.86 is the price of the share which would be received at the beginning of year six (the end of year five). This value is
also to be discounted to get the present value of the share using the present value factor for five years at 15 percent as under:
Discounted value of PN = PN (PV factor for 5 yrs, 15%)
= Tk. 271.86 (.497) = Tk. 135.11
Adding together the two present values, we get the intrinsic value as:
Present value of the first years of dividends = Tk. 46.21
Present value of the share at the end of year five = Tk. 135.11
==========
Present value of the share (P0) = Tk. 181.32

Price-Earning (P/E) Ratio Approach

The ratio of price per share to earnings per share is commonly known as price-earning ratio. Much of the real world discussion of
stock market valuation concentrates on the firm’s price-earning multiple. Earning multiplier approach states that the price of the stock
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is equal to the product of its earnings and a multiplier. It implies that the price of a stock is the product of EPS and P/E multiplier of
that stock. Price-earning (P/E) ratio approach postulates that the current market price of a stock can be determined as under:
P0 = E0 × (P0/E0)
Where E, being the estimated earnings for the next twelve months, refers to the earnings used to calculate P/E ratio. Therefore;
P0 = Estimated earnings × estimated P/E ratio
Determinants of P/E ratio
The constant-growth version of dividend discount model estimates the price of stock as follows:
D1
P0 =
(k −g )
By dividing both the sides of the equation by expected earnings (E1), we get:
P0 D1
= ÷E 1
E 1 (k −g)
P0 P0
=
E1 E1
P0
P0 =
( )E1
×E1

Therefore, the determinants of P/E ratio are;

i. The dividend payout ratio, DPS/EPS
ii. Investor’s required rate of return, k
iii. The expected growth rate of dividend, g.
These can be discussed as:
 The higher the payout ratio, the higher the P/E ratio
 The higher the expected growth rate, the higher the P/E ratio
 The higher the required rate of return, the lower the P/E ratio.
Suppose, payout ratio of a firm is .60. The required rate of return is 15 per cent with an expected growth rate of 7 per cent. If the
expected earnings of the firm for the next year is Tk.10, what would be the price of the share of that firm.
P D 1 / E1
E
=
k−g
.60
= .15−. 07
= 7.50
Therefore, the price for the stock is
P
P0 = ( )E
×E1
= 7.50 × 10 = Tk. 75
If the investor’s required rate of return, k, is 12 per cent and growth rate is being 7 per cent;
P . 60
E
= . 12−. 07
= 12
Therefore, the price for the stock is

P0 = ( PE )×E 1

= 12 × 10 = Tk.. 120
If the investor’s required rate of return, k, is 18 per cent and growth rate is being 7 per cent;
P . 60
E
= . 18−. 07
= 5.45
Therefore, the price for the stock is
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 P0 = ( PE )×E 1

= 5.45 × 10 = Tk. 54.50

We can think of the value of the firm as the sum of the value of assets or the no-growth value of the firm plus the net present value of
the future investments the firm will make. The present value is called present value of growth opportunities, PVGO. Therefore, the
value of the firm is:
P0 = No-growth value per share + PVGO
D0
[ ]
P0 = k + PVGO
Now recall that the dividends represent the earnings which are not retained for reinvestment purpose. The growth rate of dividends is,
therefore, the ratio of earnings reinvested to book value of the firm like:
g = Reinvested earnings/ Book value
If earnings equal to the product of return on equity and book value (ROE × book value), growth of dividend would become:
g = [Reinvested earnings/ Book value] × [Total earnings/ Book value]
g = [b × ROE]
Hence, substituting for expected dividends (D1) and growth of dividend (g) in the constant-growth version of DDM, we find the value
of the firm as:
E 1 (1−b)
P0 =
k−(b×ROE )
Implying the P/E ratio, we get
P0 (1−b )
=
E1 k −(b×ROE )
Assume that risk-free rate is 7 %, risk premium (r m rf) is also 5 %, and retention ratio is 40 %. Therefore, market return would
become:
rm = rf + market risk premium
= 7 % + 5% = 12%.
For a company with beta () equals to 1, the required rate of return of the firm, k, will become equal to 12%. The return on equity
(ROE) of that firm would also become equal to the expected return on the stock (.12). Therefore, the growth of the firm would
become:
g = .12 × .40 = .048 = 4.80%
P (1−. 40 )
=
E (. 12−. 048)
= 8.33.
We may observe that one important implication of stock valuation model is that riskier stock will have lower P/E multiples which can
be expressed as:
P (1−b)
=
E k−g
P/E= (1b) / (kg).
Riskier firm will have higher required rate of return implying higher value of k, therefore, P/E multiple will become lower.

Merger and Acquisition

Concept
Formation of merger
There are three basic legal procedures that one firm can use to acquire another firm:
i. Merger or consolidation
ii. Acquisition of stock
iii. Acquisition of assets.
The firm that acquires another firm is called bidder and the firm that is acquired is called target firm.
Merger or consolidation
A business combination may take the form of either merger or a consolidation.
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 ◘ A merger is defined as a combination of two or more companies in which the resulting firm maintains the identity of the
acquiring firm.
◘ In a consolidation two or more companies are combined to form a new entity. Consolidation might be utilized when the
firms are of equal size and market power.
◘ Merger is the complete absorption of one company by another, wherein the acquiring company retains its identity and the
acquired firm ceases to exist as a separate entity.
◘ A merger is one in which an entirely new firm is created and both the acquired and acquiring firms ceases to exist which is
referred to as consolidation.
Types of merger
Mergers can be categorized into four types as:
1. Horizontal merger
Horizontal merger occurs when one firm combines with another in its same line of business i.e., producing the same product. For
Example, a bank may take the form of merger with another bank.
2. Vertical merger
A vertical merger occurs when a producer acquires one of its suppliers.
3. Congeneric merger
It involves related enterprises but not producers of the same product (horizontal) or the firm in a producer-supplier relationship
(vertical).
4. Conglomerate merger
Conglomerate merger occurs when unrelated enterprises combine to form a new business enterprise.
Acquisition of stock
A second way to acquire another firm is to simply purchase the firm’s voting stock with an exchange of cash, shares of stock, or other
securities. This can be accomplished by a tender offer. A tender offer is a public offer by one firm to directly purchase the shares of
another firm.
Acquisition of assets
A firm can acquire another firm by buying most or all of its assets. This accomplishes the same thing as buying the company.
Types of Acquisition
The major types of acquisition are given below:
1. Horizontal acquisition
This is the acquisition of a firm in the same industry as the bidder.
2. Vertical acquisition
A vertical acquisition involves firms at different steps of the production process. The acquisition by an airline company of a travel
agency would be a vertical acquisition.
3. Conglomerate acquisition
When the bidder and target firm are not related to each other, the merger is called a conglomerate acquisition.
Takeovers
Takeover is a general and imprecise term referring to the transfer of control of a firm from one group of shareholders to another.

Derivatives
Introduction
Financial engineering can be defined as the development and creative application of financial techniques for solving financial
problems, exploiting investment opportunities, and to add value. Financial transactions and investment activities particularly in
securities as well involve uncertainty. Fluctuations in the financial assets expose to risk. The investors particularly dealers are
supposed to hedge risk involved in their financial transactions. Hence, it is necessary for the investors, market makers and financial
management concerned to have basic understanding about proper risk management tools. Financial derivatives are widely used tools
in this regard. Financial derivatives can be defined as instruments for hedging the risk involved in buying, holding, and selling
different types of financial assets like shares, stocks etc. Broadly speaking they refer to financial assets/instruments for the
management of risk arising from the uncertainty prevailing in the transactions of financial assets. Financial derivatives are, therefore,
evolved to hedge the risk while dealing in the financial assets. They are commonly known as derivative securities since their values
are derived from the underlying assets. Finally, financial derivatives are designed help providing financial protection to participants in
the financial markets against adverse movements in the price of the underlying assets. They facilitate in transactions of financial assets
at or within a predetermined future date at the price determined today. The values of the financial derivatives are derived from the
performance of the financial assets, interest rates, currency exchange rate, stock market indices, and what not.
A financial derivative can also be defined as a contract specifying the rights and obligations between the issuer of financial derivatives
and the holder thereof to receive or deliver future cash flows based on some future events. Some derivatives are traded or transacted
on organized stock exchanges which are known as exchange-traded derivatives like options, warrants, futures. Other derivatives

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known as over-the-counter derivatives are not transacted in the organized stock exchange but are privately negotiated between the
parties. These types of derivatives are like the forwards.

Options
An option can be defined as the right to the holder, (but not the obligation) to buy or sell a given quantity of an asset on or before a
given date in future, at prices agreed upon today. Many corporate securities are similar to the stock options that are traded on
organized exchanges. Almost every issue of corporate stocks and bonds has option features. In addition, capital structure and capital
budgeting decisions can be viewed in terms of options. Options are of two types: call options and put options.
Call options
Call options give the holder the right, but not the obligation, to buy a given quantity of some asset within some time in the future
called expiration date, at prices agreed upon today known striking price or exercise price. When exercising a call option, investors
‘call in’ the underlying asset.
Put options
Put options give the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future, at prices
agreed upon today. When exercising a put, investors ‘put’ the asset to someone.
There are two parties in an option contract. The investor getting the right to buy a specific number of shares in case of call option is
called buyer. On the other hand, the investor wishing to sell a specified numbers of shares to the buyer of the option is referred to as
seller. The option contract is initiated by the seller of the option and the seller is called the writer of the option. Let us take an
example: Suppose the current market price of a share of a company is Tk. 200. A call option would give the right to buy the share at a
specified price of Tk. 210 during the next 3 months.

Some vocabularies
The will use exercise the option only if it is profitable, otherwise, the option can be thrown away. Followings are the vocabulary
associated with the option:
Strike price: The fixed price specified in the option contract at which the option holder can buy or sell the underlying asset
can be defined as strike or exercise price.
Exercising the option: The transaction regarding the buying or selling the underlying asset according to the option contract is
called the exercising the option.
Expiration date: The date on or before which the option can be exercised is called expiration date.
American vs. European option: An option can be defined as American option if it may be exercised anytime on or before the
expiration date. A European option, on the other hand, can be defined as one which may be exercised only on the expiration date.

Option Premium
The option premium is the amount called the value of the option paid by the buyer to by the option. Some factors affect the premium
of the option. A call option will yield profit to the option holder if the current market price is greater than the exercise price. The
following outcomes may occur:
In-the-Money
The exercise price is less than the spot price of the underlying asset i.e., the current market price is greater than the exercise price.

At-the-Money
The exercise price is equal to the spot price of the underlying asset i.e., the current market price of the stock is equal to the exercise of
strike price.
Out-of-the-Money
The exercise price is more than the spot price of the underlying asset i.e., the current market price of the stock is less than the exercise
price.
Therefore, for a call option, the following terms are true:
If St > Ep, option is in the money
If St < Ep, option is out of the money
If St = Ep, option is at the money
C0 = Max [St - Ep, 0]
For put options:
If Ep > St, option is in the money
If Ep < St, option is out of the money
If Ep = St, option is at the money
Where,
St is the value of the stock at expiry (time t)
Ep is the exercise price.
C0 is the value of the call option at expiry

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If a call option is in the money, it is exercised immediately and the option holder will earn profit. The positive cash flow or the profit
incurred to the option holder is known as the intrinsic value of the call.
Intrinsic Value
The difference between the exercise price of the option and the spot price of the underlying asset can be termed as intrinsic value of
the call.
Speculative Value
The difference between the option premium and the intrinsic vAlue of the option can be termed as speculative value of the call.
Option premium = Intrinsic value + Speculative value
Suppose, the exercise price of an option is Tk.200 and the market price of the share is Tk. 250. The call option is in The money. If the
owner of the option exercises it he/she will maKe a pbofit equivalent of Tk. 50 (Tk.250-Tk.200). If the market price of the share is Tk.
200, the call is at the money and the holder would get no cash flow. On the other hand, if the market price of te share is less than Tk.
200, the option is out of the money and the holder would experience a negative cash flow. Thus,
The intrinsic value of a call option = St - Ep, if St is greater than Ep
=0 if St is less than or equal to Ep
The above notions indicate that the intrinsic value of a call is always greater than zero or (S t > Ep).
One, who understands this, can become a financial engineer, tailoring the risk-return profile to meet the client’s needs. If we assume
that the option expires at t, then the present value of the exercise price is:
Ep/(1 + rf)t
and the value of the call is:
C0 = S0 − Ep/(1 + rf)t
It is obvious from the above equation that the option value depends on the following factors:
i. The stock price: The higher the stock price, the more the call is worth and vice-versa.
ii. Exercise price: The lower the exercise price, the more the call is worth and vice-versa.
iii. The time to expiration: The longer the time to expire is, the more the option is worth and vice-versa.
v. The risk-free rate: The higher the risk-free rate is, the more the call is worth and vice-versa.
Call Put
Stock price + –
Exercise price – +
Interest rate + –
Volatility in the stock price + +
Expiration date + +
The value of a call option C0 must fall within max (S0 – Ep, 0) < C0 < S0.
The precise position will depend on these factors: market value, time value and intrinsic value for an American call.
The premium of an option is the function of intrinsic value and time value. The time value of an option is the excess of the premium
over the intrinsic value. Consider an example: the premium for a call option with strike price of Tk.200 is Tk.20. If the current market
price of the share underlying the call is Tk. 215, the call option is in the money. The intrinsic value of the call is Tk. 15 (Tk. 215 −Tk.
200). The premium quoted being Tk. 10, the excess of the premium over the intrinsic value Tk. 5 (Tk. 15−Tk. 10) is the time value of
the call option. A call at the money or out of the money has no intrinsic value having only the time value and the entire premium
represents the time value.
Let us consider a case: Suppose the exercise price of an option is Tk. 200 with a premium of Tk. 10. If the price of the share rises
above Tk. 210 (Tk. 200 + Tk. 10) at any time before the expiration date, the option holder can exercise the option to buy share at Tk.
200 and the seller is obligated to make the share available to the option holder at the exercise price (Tk. 200). Assume that the current
market price of the share is Tk.250. The call option holder can make a profit by buying the share at Tk. 200 equal to Tk. 50
(Tk.250−Tk.200) with a net profit of Tk. 40 (Tk.50−Tk.10).

Other Options
◘ Call provision on a bond: A call provision provides the issuer the right, but not the obligation to repurchase the bond at a specified
price.
◘ Put bonds: The owner of a put bond has the right to force the issuer to repurchase the bond for a fixed price for a fixed period of
time.
◘ Green Shoe provision: The right of the underwriter to purchase additional shares from the issuer at the offer price in an IPO.
◘ Insurance: Insurance obligates the insurer (option writer) to purchase the underlying asset at a specified price for a specified period
(the term of the policy).

Stocks and Bonds as Options

Levered Equity is a call option.
The underlying assets comprise the assets of the firm.
The strike price is the payoff of the bond.
If at the maturity of their debt, the assets of the firm are greater in value than the debt, the shareholders have an in-the-money
call, they will pay the bondholders and “call in” the assets of the firm.
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 If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay the bondholders (i.e. the
shareholders will declare bankruptcy) and let the call expire.
The value of a stock option depends on the following factors:
◘ Current price of underlying stock.
◘ Dividend yield of the underlying stock.
◘ Strike price specified in the option contract.
◘ Risk-free interest rate over the life of the contract.
◘ Time remaining until the option contract expires.
◘ Price volatility of the underlying stock.
Much of corporate financial theory can be presented in terms of options.
◘ Common stock in a levered firm can be viewed as a call option on the assets of the firm.
◘ Real projects often have hidden option that enhance value.

Futures Contracts
Futures Contracts commonly known as futures are also financial derivatives constituting instrument for hedging the risk in the
financial markets due to the price fluctuation of the assets. The features of a futures contract are the same as that of a forward contract.
However, these are two different instruments used for risk management. Futures contracts have been designed to remove the
disadvantages of forward contracts. A futures contract can be defined as an agreement between two parties for buying or selling an
asset at a certain time in future at a certain price. Like commodities, financial assets form the underlying assets in futures contracts.
So, Stocks, bonds etc. are the financial assets underlying futures contracts. A futures contract on financial assets is known as financial
future. The fundament idea regarding futures contracts is that for hedging a portfolio with a higher volatility than the market index,
more futures contracts may be required to bring about an effective and efficient hedge. The required number of futures contracts can
be estimated by using the following formula:
F0 = [Vp/ Vf] × βp
Where,
F0 = Required number of futures,
Vp = Value of portfolio to be hedged,
Vf = Value of one futures contract,
βp = Portfolio beta

Forwards
Forward contracts are commitment entered into by two parties to exchange a specific amount of money for a particular commodity at
a specified future time. A forward contract can be described as an agreement to buy or sell an asset at a predetermined fixed price at a
specified future date. In a forward contract, the agreement is initiated at one time but the execution of the contract takes place at a
subsequent date. The terms of the contract, such as price, quality and quantity of the assets, delivery date are specified at the time of
initiating the contract but the actual payment and delivery of the asset occur later.
Under a forward contract, one of the parties of the contract agrees to buy the underlying asset on a certain specified future date at a
certain price. The other party of the contract agrees to sell the underlying asset on the same day at the same price. The following
terms are applicable in a forward contract:
Long position and short position: The buyer of such contract is said to have a long position while the seller have a short position.
Delivery price and delivery date: The price specified in the forward contract is termed as the delivery price and the time specified is
referred to as delivery date.

Warrants
Warrants are financial assets giving the holder the right but not obligation to buy shares of common stocks directly from the issuing
authority at a fixed price for a given period of time. Each warrant specifies the number of shares of common stock a holder can
purchase at the exercise price at the expiration date. Some features of warrants are same as those of call options. From the view point
of the holders call options and warrants like the same. But still there exists a significant difference in contractual features of them. Say
warrants have long maturity period. Some warrants are same as the perpetuals having no expiration date at all. The basic difference
between call options and warrants is that call options are issued by individuals and warrants are issued by the firms. When a warrant is
exercised, a firm must issue new shares of stock. Each time a warrant is exercised, the number of shares outstanding increases. In case
of call options is not necessary i.e., when a call option is exercised, there is no change in the number of shares outstanding.

Convertible Bonds
A convertible bond is same as the bond with warrants. The major difference between convertible bonds and warrants is that warrants
can be separated into distinct securities but convertible bonds are not. Convertible bonds are the fixed income securities which would
be converted into common stocks after certain period of time. Therefore, the convertible bond givers the holder the right to exchange
for it a given number of shares of common stock any time on or before the expiration date. A preferred stock can be converted into
common stock. The convertible preferred stocks and convertible bonds are same except a convertible preferred stock has an infinite
maturity date. The following vocabularies are applicable for convertible bonds.
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 ◘ Conversion premium: The difference between the conversion price and the current stock price, divided by the current stock
price.
◘ Conversion price: The dollar amount of a bond’s par value that is exchangeable for one share of stock.
◘ Conversion ratio: The number of shares per bond received for conversion into stock.
◘ Conversion value: The value a convertible bond would have if it were to be immediately converted into common stock.
◘ Straight bond value: The value a convertible bond would have if it could not be.

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