Security Valuation Section A - Practical Questions Dividend Based Models Question 1 ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The company has paid dividend @ % 3 per share. The rate of return on market portfolio is 12 percent and the risk free rate of return in the market has been observed as 8 percent. The Beta co-efficient of company’s share is 1.5. You are required to calculate the expected rate of return on company’s shares as per CAPM model and equilibrium price per share by dividend growth model. Answer CAPM formula for calculation of Expected Rate of Return is: ER=Re+ B (Ra 9, =84 15 (12-8) -8415(4) B46 = 14% or 0.14 Applying Dividend Growth Model for the calculation of per share equilibrium price: ER= + Po ® 3019) 55.49 Po ot 3.30 0.14-0.10= > 0.04 Po = 3.30 Per share equilibrium price will be € 82.50. Question 2 Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid dividend @ 3 per share, The rate of return on market portfolio is 15% and the risk-free rate of return in the market has been observed as 10%. The beta co-efficient of the company’s share is 1.2. ‘You are required to calculate the expected rate of retum on the company’s shares as per CAPM model and the equilibrium price per share by dividend growth model. Answer SS BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Capital Asset Pricing Model (CAPM) formula for calculation of expected rate of return is, Er= Ret 6 (Rm ~ Re) Where, Ex = Expected Return Beta of Security Ru = Market Return Re= Risk free Rate = 104 [1.2 (15 - 10)] = 10+ 6 = 16% or 0.16 Applying dividend growth mode for the calculation of per share equilibrium price: Di Be= = Po oro.16- 22%) 5 942 0 or P 330 a4 °" 016-0.12 — ‘Therefore, equilibrium price per share will be ¢84. Question 3 ‘A Company pays a dividend of € 2.00 per share with a growth rate of 7%. The risk free rate is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50. However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find out the present as well as the likely value of the share after the decision. Answer In order to find out the value of a share with constant growth model, the value of K. should be ascertained with the help of ‘CAPM’ model as follows: Ke=Re+B (RnR) Where, K,=Cost of equity Rr= Risk free rate of return B= Portfolio Beta ie. market sensitivity index Ru = Expected retum on market portfolio By substituting the figures, we get Ke = 0,09 + 1.5 (0.13 - 0.09) = 0.15 or 15% and the value of the share as per constant growth model is BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation where, Po = Price of a share Dy = Dividend at the end of the year 1 K,= Cost of equity rowth: 2.00 (1.07) (ke~ 8) 2.00 (1.07) 0.15- 0.07 Po= Pp = % 26.75 However, if the decision of finance manager is implemented, the beta (B) factor is likely to increase to 1.75 therefore, K. would be Ke= Ret B(Rm- Re) = 0.09 + 1.75 (0.13 - 0.09) = The value of share is .16 or 16% poet (ke-g) 2.00 (1.07) © 016-007 Po = 823.78 Question 4 M/s Ltd, has paid a dividend of € 2.50 per share on a face value of € 10 in the financial year ending on 31 March, 2022. The details are as follows: Current market price of share 60 Growth rate of earnings and dividends 10% Beta of share 0.75 Average market retum, 15% Risk free rate of return % Calculate the intrinsic value of the share. Answer Intrinsic Value Pp =

78% SGR = 0.078 (1 - 0.1667) = 6.5% (ili) Calculation of fair price of share using dividend discount model Do(1+8) ke-g 35.2 lakhs 10 lakhs Growth Rate= 65% 20.52 (1 + 0.065) (0.15- 0.065 Po Dividends = 0.52 Hence Po = = 2651 (iv) Since the current market price of share is 14, the share is overvalued. Hence the investor should not invest in the company. Question 11 MNP Ltd. has declared and paid annual dividend of % 4 per share. It is expected to grow @ 20% for the next two years and 10% thereafter. The required rate of return of equity investors is 15%. Compute the current price at which equity shares should sell. Note: Present Value Interest Factor (PVIF) @ 15%: For year 1 = 0.8696; For year 2= 0.7561 Answer Do= 84 Di=%4 (1.20) = * 4.80 Dp= %4(1.20)?= 85.76 Dy= 4 (1.20)? (1.10) = 76.336 py- Dt Dy wv °° Crk) rk Ke = De -_ 6336679 ke-g 015-010 6 126.72 (10.15)? * (1+ 0.15)? = 4.80 x 0.8696 + 5.76 x 0.7561 + 126.72 x 0.7561 = % 104.34 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Question 12 The shares of G Ltd. we currently being traded at % 46. The company published its results for the year ended 31% March 2022 and declared a dividend of % 5, The company made a return of 15% on its capital and expects that to be the norm in which it operates, G Ltd. Also expects the dividends to grow at 10% for the first three years and thereafter at 5%. Youare required to advise whether the share of the company is being traded at a premium or discount, PVIF @ 15% for the next 3 years is 0.870, 0.756 and 0.658 respectively. ‘Answer Expected dividend for next three years Year 1(D,)=5(1.1)=5.5 Year 2 (Dp) = 5.5 (1.1) = 6.05 Year 3 (Ds) = 6.05 (1.1) = 6.655 Required Rate (Ks) = 15% Present Value of Dividends. = 5.5 (0.870) + 6.05 (0.756) + 6.655 (0.658) = 4,785.4 4574 44,379 =13.74 Now, PV at growth rate of 5% __Ds ~ (ke=8) _ 6655 (1.05) _ 6.988. 0.15 - 0,05, 0.10 ‘Therefore, Po ~ 69.88 x 0.658 = 45.98 Now, adding the PV of dividend at two different growth rates, we get, 13.74 + 45.98 = 59.72 Ps 69.28 Hence, it is clear that shares are being traded at discount i.e, undervalued because intrinsic value of share is more than the market price, Question 13 XYZ Ltd. paid a dividend of € 2 for the current year. The dividend is expected to grow at 40% for the next 5 years and at 15% per annum thereafter. The return on 182 days T-bills is 11% per annum and the market return is expected to be around 18% with a variance of 24%. The co-variance of XYZ's return with that of the market is 30%. You are required to calculate the required rate of return and intrinsic value of the stock. Answer: = $ovattance of Market Return and Security Return ~ Variance of Market Return Ce BY CA AJAY AGARWAL (AIR-1) AIRACA Career Institute (ACI)Security Valuation 30% _ 2K Expected Retumn = Rr+ B (Ra ~ Ri) = 11% + 1.25 (18% ~ 11%) = 11% + 8.75% = 19.75% Be 1.25 Intrinsic Value Year Dividend () PVF (19.75%n) Present Value (3) 1 2.80 0.835 234 2 3.92 0.697 273 3 5.49 0.582 3.19 4 7.68 0.486 3.73 5 10.76 0.406 4.37 16.36 10.76 (1.15) PV of Terminal Value = x 0.406 = 8105.77 0.1975 - 0.15 Intrinsic Value = % 16.36 + 8 105.77 = € 122.13 Question 14 Seawell Corporation, a manufacturer of do-it-yourself hardware and housewares, reported earnings per share of € 2.10 in 2017, on which it paid dividends per share of € 0.69. Earnings are expected to grow 15% a year from 2018 to 2022, during this period the dividend payout ratio is expected to remain unchanged. After 2022, the earnings growth rate is expected to drop to a stable rate of 6%, and the Payout ratio is expected to increase to 65% of earnings. The firm has a beta of 1.40 currently, and is expected to have a beta of 1.10 after 2022. The market risk premium is 5.5%. The Treasury bond rate is, 6.25%. (a) _ Whatis the expected price of the stock at the end of 20227 (b) Whats the value of the stock, using the two-stage dividend discount model? Note: Consider 2 decimals in amounts and 4 decimals in PV Factor Answer ‘The expected rate of return on equity after 2022 = 0.0625 + 1.10 (0.055) = 12.3% The dividends from 2017 onwards can be estimated as: Year 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 Earnings Per Share(€) | 210 | 242 | 278 | 319 | 367 | 422 | 448 Dividends Pershare(€) | 069 | 0.79 | 091 | 105 [| 121 | 139 | 291 (a) The price as of 2022 = .91/(0.123 - 0.06) = € 46.19 (b) The required rate of return upto 2022 = 0.0625 + 1.4 (0.055) = 13.95% Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation The dividends upto 2022 are discounted using this rate as follow: Year PV of Dividend 2018 0.79/1.1395 = 0.69 2019 0.91/(1.1395)? = 0.70 2020 1.05/(1.1395)5 = 0.71 2021 1.21/(1.1395)4= 0.72 2022 1.39/(1.1395)5 = 0.72 Total 3.54 The current price = 354+ 46,19/(1.1395)5 = € 27.58 Question 15 An investor is considering to purchase the equity shares of LX Ltd., whose current market price (CMP) is € 112, The company is proposing a dividend of ® 4 for the next year. LX Ltd. is expected to grow @ 20 per cent per annum for the first four years. The growth will decline linearly to 16 per cent per annum after first four years. Thereafter, it will stabilise at 16 per cent per annum infinitely. The investor requires a return of 20 per cent per annum, Youare required (i) To calculate the intrinsic value of the share of LX Ltd. (ii) Whether it is worth to purchase the share at this price, Period 1 2 3 4 5 6 7 pviF(20%,n) | 0833 | 0694 | 0579 | o4s2 | oa02 | 033s | 0279 Answer @ pies D2=%4 (1.20) = % 4.80 Ds=%4 (1.20)?= 85.76 4 (1.20) = 26.91 Ds=%6,91 (1.19) = 88.22 De=%6.91 (1.19) (1-18) = %9.70 Dy = % 6.91 (1.19) (1.18) (1.17) = 811.35 Dp=¥ 6.91 (1.19) (1.18) (1.17) (1.16) = 13.17 pe Pe Ds Ds Ds De DV (+k) (+k (+k) Crk)! rks Gtk) (+k) G+ky =e 317 __ 399.95 (k- 020-016 4.00 4.80 5.76 691 822 9.70 1135 329.25 0.20)" Hs O.20) "Hs O20)” Te O20)" * 0.20)" "Cs 0.20)" ” Hs 0.20)" * + 0.2077 SS BY CA AJAY AGARWAL (AIR-1) AIR1CA Career Institute (ACI)Security Valuation 4.00 x 0.833 + 4.80 x 0.694 + 5.76 x 0.579 + 6.91 x 0.482 + 8.22 x 0.402 + 9.70 x 0.335 + 11.35 x 0.279 + 329,25 x 0.279 Intrinsic Value = % 114.91 Gi) _ As Intrinsic Value of the share is higher than its selling price of € 112, it is underpriced and can be acquired. However, other factors need to be taken into consideration since difference is only slightly higher. Question 16 ‘The current EPS of M/s VEE Ltd. is % 4. The company has shown an extraordinary growth of 40% in its earnings in the last few years. This high growth rate is likely to continue for the next 5 years after which growth rate in earnings will decline from 40% to 10% during the next 5 years and remain stable at 10% thereafter. The decline in the growth rate during the five year transition period will be equal and linear. Currently, the company’s pay-out ratio is 10%. It is likely to remain the same for the next five years and from the beginning of the sixth year till the end of the 10% year, the pay-out will linearly increase and stabilize at 50% at the end of the 10" year. The post-tax cost of capital is 17% and the PV factors are given below: Years 1 2 3 4 5 6 7 8 9 10 PviF @ 17% | 0.855 | 0.731 | 0.625 | 0.534 | 0.456 | 0.390 | 0.333 | 0.285 | 0.244 | 0.209 You are required to calculate the intrinsic value of the company's stock based on expected dividend. If the current market price of the stock is % 125, suggest if it is advisable for the investor to invest in the company’s stock or not. Answer Working Notes: (Computation of Growth Rate in Earning and EPS a{[2][3]4 10 40% | 40% | 40% | 40% | 40% | 34% | 28% | 22% | 16% | 10% a o x © 2 5.60 | 7.84 | 10.98] 15.37] 21.51| 28.82 3689] 45.00 | 52.20 | 57.42 (ii) Computation of Payout Ratio and Dividend Year 1[/2]3[4[s[e6f[7][s8]9 [1 Payout Ratio 10% | 10% | 10% | 10% | 10% | 18% | 26% | 34% | 42% | 50% Dividend (2) 056 | 0.78 | 110 | 154 | 25 | 5.9 | 9.59 | 15.30] 21.92 | 28.71 (iil) Calculation of PY of Dividend Year Dividend (2) PVE PV of Dividend (2) 1 0.56, 0.855 0.48 2 0.78 0.731 057 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation 3 1.10 0.625 0.69 4 154 0.534 0.82 5 245 0.456 0.98 6 519 0.390 2.02 7 959 0.333 319 8 15.30 0.285 436 9 21.92 0.244 5.35 18.46 1 ot = % 100.07 Intrinsic Value = € 18.46 + 100.07 = = 118.53 Since the Intrinsic Value of Equity share is less than current market price, it is not advisable to invest in the same. Question 17 You are interested in buying some equity stocks of RK Ltd. The company has 3 divisions operating in different industries. Division A captures 10% of its industries sales which is forecasted to be € 50 crore for the industry. Division B and C captures 30% and 2% of their respective industry's sales, which are expected to be ¥ 20 crore and ¥ 8.5 crore respectively. Division A traditionally had a 5% net income margin, whereas divisions B and C had 8% and 10% net income margin respectively. RK Ltd. has 3,00,000 shares of equity stock outstanding, which sell at < 250. The company has not paid dividend since it started its business 10 years ago. However from the market sources you come to know that RK Ltd, will start paying dividend in 3 years’ time and the pay-out ratio is 30%. Expecting this dividend, you would like to hold the stock for 5 year. By analysing the past financial statements, you have determined that RK Ltd.'s required rate of return is 18% and that P/E ratio of 10 for the next year, Evaluate: (9) Would you will be in purchasing RK Ltd. equity at this time based on your one year forecast? (ii) Price you will like to pay for the stock of RK Ltd if you expect earnings to grow @ 15% continuously. Ignore taxation. PV factors are given below: Years 1 2 3 4 5 PVIF @ 18% 0.847 0.718 0.609 0516 0.437 Answer Working Notes: Computation of Earnings Per Share (EPS) CE] BY CA AJAY AGARWAL (AIR-1) AIRACA Career Institute (ACI)Security Valuation Particulars Amount (2) Margin of Division A (€50 crore x 10% x 5%) 25,00,000 Margin of Division B (% 20 crore x 30% x 8%) 48,00,000 Margin of Division (88.5 crore x 2% x 10%) 1,70,.000 74,70,000 No. of Equity Shares 300,000 EPS 24.90 @ Market Price based on One Year Forecast Expected Market Price at the end of the year = 24.90 x 1 PV of the Expected Price = % 249 x 0.847 = € 210.90 = 3209 I would NOT like to purchase the share as the expected market price of shares is less than its current price of % 250. If Earning is expected to grow @ 15% Year EPS (2) Dividend (®) PVF @18% Pv(®), 1 24.90) - 0.847 - 2 28.64 - 0.718 - 3 32.93 988 0.609 6.02 4 37.87 11.36 0.516 5.86 5 43.55 13.07 0.437 571 17.59 13.07 (1.15) 0.18 0.15 PY of the Market Price after 5 years ~ % 501.02 x 0.437 = 218.95 ‘Total PV of Inflows = 17.59 + 218.95 ~ % 236.54 Share Price after 5 years = € 501.02 ‘Thus, the maximum price | would be willing to pay for the share shall be % 236.54. Question 18 X Limited, just declared a dividend of € 14.00 per share. Mr. B is planning to purchase the share of X Limited, anticipating increase in growth rate from 8% to 9%, which will continue for three years. He also expects the market price of this share to be % 360.00 after three years. Youare required to determine: (the maximum amount Mr. B should pay for shares, if he requires a rate of return of 13% per annum, (ii) the maximum price Mr. B will be willing to pay for share, if he is of the opi growth can be maintained indefinitely and require 13% rate of return per annum, ion that the 9% (ili) the price of share at the end of three years, if 9% growth rate is achieved and assuming other eee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation conditions remaining same as in ({i) above. Calculate rupee amount up to two decimal points. Year-1 Year-2 Year-3 FVIF @ 9% 1.090 1.188 1.295 FVIF @ 13% 1.130 1.277 1.443 PVIF @ 13% 0.885 0.783 0.693 Answer (Expected dividend for next 3 years Year 1 (Di) ~ % 14.00 (1.09) = % 15.26 Year 2 (Dz) = % 14.00 (1.09 = % 16.63 Year 3 (Da) = 14.00 (1.09) = 818.13 Required rate of return = 13% (Ke) Market price of share after 3 years = (P3) = * 360 ‘The present value of share be Ds Ps (tk) Gtk Gk) (+k 15.26 16.63, 18.13, 360 Groagy' (v0a3"' Gs oagp ' s0a3F 5.26 (0.885) + 16.63 (0.783) + 18.13 (0.693) + 360 (0.693) 3.50 + 13.02 + 12.56 + 249.48, Po = % 288.56 (ii) If growth rate 9% is achieved for indefinite period, then maximum price of share should Mr. A willing be to pay is 2381.50 (ii) Assuming that conditions mentioned above remain same, the price expected after 3 years will be: Ds___Ds(1.09)_ _ 18.13% 109 19.76 2 4g, Ps= e—g 013-009 0.04 0.04 Question 19 Mr. A is thinking of buying shares at € 500 each having face value of % 100. He is expecting a bonus at the ratio of 1:5 during the fourth year. Annual expected dividend is 20% and the same rate is expected to be maintained on the expanded capital base. He intends to sell the shares at the end of seventh year at an expected price of € 900 each. Incidental expenses for purchase and sale of shares are estimated to be 5% of the market price. He expects a minimum return of 12% per annum. Should Mr. A buy the share? Ifo, what maximum price should he pay for each share? Assume no tax on Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation dividend income and capital gain. Answer: P.V. of dividend stream and sales proceeds Year Dividend/Sale PVF (12%) PV 1 220 0.893 17.86 2 320 0.797 15.94 3 320 0712 14.24 4 R24 0.636 15.26 5 R24 0.567 13.61 6 R24 0.507 1217 7 24 0.452 10.85 7 21026 0.452 463.75, (%900x1.2%0.95) 563.68 Less: Cost of Share (% 500x 1.05) 2525.00 Net gain 138.68 Since Mr. A is gaining % 38.68 per share, he should buy the share. ‘Maximum price Mr. A should be ready to pay is % 563.68 which will include incidental expenses. So the maximum price should be 563.68 x 100/105 = %536.84 Question 20 SAM Ltd. has just paid a dividend of % 2 per share and it is expected to grow @ 6% pa. After paying dividend, the Board declared to take up a project by retaining the next three annual dividends. It is expected that this project is of same risk as the existing projects. The results of this project will start coming from the 4 year onward from now. The dividends will then be % 2.50 per share and will grow @7%pa. An investor has 1,000 shares in SAM Ltd. and wants a receipt of atleast % 2,000 pa. from this investment. Show that the market value of the share is affected by the decision of the Board. Also show as to how the investor can maintain his target receipt from the investment for first 3 years and improved income thereafter, given that the cost of capital of the firm is 8%. Answer Di Value of share at present = —— 2(1.06) = 2009) <2 106 (0.08 - 0.06 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation However, if the Board implement its decision, no dividend would be payable for 3 years and the dividend for year 4 would be % 2.50 and growing at 7% pa. The price of the share, in this case, now would be: 2.50 0.08 0.07 * (1+ 0.08) P 198.46 So, the price of the share is expected to increase from % 106 to 198.45 after the announcement of the project. The investor can take up this situation as follows: 2.50 Expected market price after 3 years — 7250.00 0.08 - 0.07 d mark fter 2 * + 231.48 ected market price after 2 years —_ x —__ - Eps p ¥ 0.08-0.07 (1 +0.08) 2.50 1 Expected market price after 1 years —_ =« ——_ 2214.33 0.08-0.07 (1 +0.08)? In order to maintain his receipt at % 2,000 for first 3 year, he would sell 10 shares in first year @ % 214.33 for 2,143.30 9 shares in second year @ 231.48 for 2,083.32 8 shares in third year @ 250 for 72,000.00 At the end of 3+ year, he would be having 973 shares valued @ % 250 each ie. 2 2,43,250. On these 973 shares, his dividend income for year 4 would be @ 2.50 Le. % 2,432.50. So, if the project is taken up by the company, the investor would be able to maintain his receipt of at least 2,000 for first three years and would be getting increased income thereafter. Question 21 Shares of Voyage Ltd. are being quoted at a price-earnings ratio of 8 times. ‘The company retains % 5 per share which is 45% of its Earning Per Share. ‘Youre required to compute (The cost of equity to the company if the market expects a growth rate of 15% pa. (ii) If the anticipated growth rate is 16% per annum, calculate the indicative market price with the same cost of capital. (iii) Ifthe company’s cost of capital is 20% p.a. & the anticipated growth rate is 19% pa, calculate the market price per share, Answer @ Cost of Capital Retained earnings (45%) & Sper share Dividend (55%) %6:11 per share EPS (100%) 311.11 per share P/E Ratio 8 times Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Market price 1111 x8 = 788.88 Cost of equity capital = PY 100+ Growth % = +8 x 100 + 15% = 21.87% Price 7a888 (ii) Market Price . Dividend ~ Cost of Capital (%) - Growth Rate (%) 261 ~ Spee ae” £10408 per share (iil) Market Price . Dividend Cost of Capital (%) - Growth Rate (%) TA = Fo io7e ~ 1611.00 per share Question 22 Piyush Loonker and Associates presently pay a dividend of € 1.00 per share and has a share price of 20.00. () Ih this dividend were expected to grow at a rate of 12% per annum forever, what is the firm's expected or required return on equity using a dividend-discount model approach? (ii) _ Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what is the firm's expected, or required, return on equity? The relevant present value table is as follows: Year 1 2 3 4 5 PVIF @ 18% 0.8475 0.7182 0.6086 0.5158 0.4371 PVIF@ 19% 0.8403 0.7061 0.5934 0.4986 0.4190 Answer (Firms Expected or Required Return on Equity (Using a jend discount model approach) According to Dividend discount model approach the firm's expected or required return on equity is computed as follows: Kae eg Po Where, Ke= Cost of equity share capital or (Firm's expected or required return on equity share capital) D1= Expected dividend at the end of year 1 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation wi) ‘urrent market price of the share = Expected growth rate of dividend Now, Dj = Do (14 g) or € 1 (1+ 0.12) or 1.12, Py = 7 20 and g = 12% per annum x42 %20 Or, Ke= 217.6% ‘Therefore, K. = +12% Firm's Expected or Required Return on Equity [if dividends were expected to grow at a rate of 20% per annum for 5 years and 10% per year thereafter) Since in this situation if dividends are expected to grow at a super normal growth rate g,, for n years and thereafter, at a normal, perpetual growth rate of g, beginning in the year n + 1, then the cost of equity can be determined by using the following formula: 5 Do(1+ gs) | Dae p= SEDO He, Poot 1 (1+ KJ Ke ge Where, gs= Rate of growth in earlier years. go = Rate of constant growth in later years. Po= Discounted value of dividend stream. K.= Firm’s expected, required return on equity (cost of equity capital). Now, 85~ 20% for 5 years, ga = 10% Therefore, Pol 40.20" Ds S(T)" e010” (Fa po E20, ee, 173,207,249 249(1 40.10) (rk) Trky Grkp Gtk) Gtk 010 (ks By trial and error we are required to find out Ke Po Now, assume K, = 18% then we will have Po = € 1.20 (08475) + & 1.44 (0.7182) + & 1.73 (0.6086) + & 2.07 (0.5158) + € 2.49 (0.4371) +% 2.74 (0.4371) /(0.18 - 0.10) = 31.017 +3 1.034 + & 1.053 + % 1.068 + % 1.09 + £14.97 = 20.23 Since the present value of dividend stream is more than required it indicates that Ke is greater than 18%, Now, assume K,= 19% we will have Po = ¥ 1.20 (0.8403) + 1.44 (0,7061) + & 1.73 (0.5934) + € 2.07 (0.4986) + ¥ 2.49(0.4190) + 2.74 (0.4190)/(0.19 - 0.10) = % 1.008 + 8 1.017 + % 1026+ F 1.032 + F 1.043 + 812.76 = 317.89 BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Since the market price of share (expected value of dividend stream) is < 20. Therefore, the discount rate is closer to 18% than it is to 19%, we can get the exact rate by interpolation by using the following formula: NPV atLR K,=LR+ ————_" —__ NPV at LR - NPVatHR Where, LR = Lower Rate NPV at LR = Present value of share at LR NPV at HR = Present value of share at Higher Rate r= Difference in rates (8 20.23- 820) 320.23 -%1789 = x1% K,= 18% + z = 10% *e = 18% + 0.10% = 18.10% Therefore, the firm’s expected, or required, return on equity is 18.10%, At this rate the present discounted value of dividend stream is equal to the market price of the share. Earning Based Models Question 23 On the basis of the following information: Current dividend (Do) = % 2.50 Discount rate (k) = 10.5% Growth rate (g) = 2% (i) Calculate the present value of the stock of ABC Ltd. (ii) Is its stock overvalued if stock price is = 35, ROE = 9% and EPS = % 2.25? Show detailed calculation using the PE Multiple Approach and Earnings Growth Model. Answer ()__ Present Value of the stock of ABC Ltd. is: 2.50 (1.02) _ Vor 9.105 - 0.02 30 (A) _ Value of stock under the PE Multi je Approach Particulars ‘Actual Stock Price 35.00 Return on equity % EPS 12.25 Ce BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation PE Multiple (1/Return on Equity) = 1/9% qi Market Price per Share 25.00 Since, Actual Stock Price is higher, hence it is overvalued. (B) Value of the Stock under the Earnings Growth Model Particulars ‘Actual Stock Price 735.00 Return on equity 9% EPS 22.25 Growth Rate 2% Market Price per Share [EPS x (1+ g)]/(ROE - g) 232.79 = % 2.25 x 1.02/0.07 Since, Actual Stock Price is higher, hence it is overvalued. Question 24 Acompany has a book value per share of € 137.80. Its return on equity is 15% and it follows a policy of retaining 60% of its earnings. If the Opportunity Cost of Capital is 18%, compute the price of the share today using both Dividend Growth Model and Walter’s Model. Answer ‘The company earnings and dividend per share after a year are expected to be: BPS = % 137.8 x 0.15 ~ % 20.67 Dividend = 0.40 x 20.67 = 38.27 ‘The growth in dividend would be: B= 0.60.15 = 0.09 (a) Asper Dividend Growth Model Dividend (ke- g) 8.27 0.18 0.09 Perpetual growth model Formmula: Po = Po Po= 91.89 (b) As per Walter's Model Dt (-D) Re Where, Ve = Market Price of the ordinary share of the company. R, = Return on internal retention ie. the rate company earns on retained profits. Ce BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Re = Capitalisation rate fe, the rate expected by investors by way of return from particular category of shares. jarnings per share. D= Dividend per share. Hence, 8.27+ == (20.67-8.27) 19.60 018 0.18 = % 103.35 Question 25 ‘The following information is given for QB Ltd. Earnings per share R12 Dividend per share (Di) 83 Cost of capital (ke) 18% Return on Equity 22% Retention Ratio 73% Calculate the market price per share using (®— Gordon’s formula (ii) Walter's formula Answer (@ Gordon's Formula E(1-b) K.— br Where, Po= Present value of Market price per share Po = Earnings per share Ke= Cost of Capital b= Retention Ratio (%) r= Return on Equity br= Growth Rate 12(1-0.75) 0.18 - (0.75 x0.22) -—_3__ 0.18 - 0.165 Po = % 200 Gi) Walter’s Formula Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation p+=2(E-p) Re Ve Where, Vo= Market Price D= ividend per share Ry= Return on Equity Re= Cost of Capital E= Earnings per share RBH (%12- %3) 0.18) =U77I7 Question 26 Capital structure of Sun Ltd, as at 31.3.2022 was as under: (Zin lakhs) Equity share capital (Paid-up value per share is € 100) 80 8% Preference share capital 40 12% Debentures 64 Reserves 32 Sun Ltd,, earns a profit of © 32 lakhs annually on an average before deduction of income-tax, which works out to 35%, and interest on debentures. Normal return on equity shares of companies similarly placed is 9.6% provide (a) Profit after tax covers fixed interest and fixed dividends at least 3 times. (b) Capital gearing ratio is 0.75. (©) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed profits. Sun Ltd,, has been regularly paying equity dividend of 8%. Compute the value per equity share of the company assuming: (i) 1% forevery one time of difference for Interest and Fixed Dividend Coverage. (ii) 2% forevery one time of difference for Capital Gearing Ratio, Answer (a) Calculation of Profitafter tax (PAT) x Profit before interest and tax (PBIT) 32,00,000 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Less: Debenture interest (% 64,00,000 x 12/100) 7,68,000 Profit before tax (PBT) 24,32,000 Less: Tax @ 35% 851,200 Profit after tax (PAT) 15,60,800 Less: Preference Dividend (% 40,00,000 x 8/100) 3.20.00 Equity Dividend (% 80,00,000 x 8/100) 640,000 9,60,000 Retained earnings (Undistributed profit) 620,800 (b) Calculation of interest and Fixed Dividend Coverage PAT + Debenture Interest Debenture Interest + Preference Dividend 15,80,800 + 7,68,000 _ 23,48,800 7,68,000 ¥ 3,20,000 10,88,000 16 times (©) Calculation of Capital Gearing Ratio Fixed interest bearing funds Equity shareholders’ funds __ Preference Share Capital + Debentures 40,00,000 + 64,00,000 _ 1,04,00,000 ~ ~~“Equity Share Capital + Reserves 80,00,000 + 32,00,000 1,12,00,000 Capital Gearing Ratio = =0,93 (@) Calculation of Yield on Equity Shares: Yield on equity shares is calculated at 50% of profits distributed and 5% on undistributed profits: @ 50% on distributed profits (3 6,40,000 x 50/100) 3,20,000 5% on undistributed profits ( 6,20,800 x 5/100) 31040 Yield on equity shares 351040 Yield on shares Equity share capital = BELO) 100 - 4.39% ~ 80,00,000 - C culation of Expected Yield on Equity shares Calculation of Expected Yield on Equity shar (a) _ Interest and fixed dividend coverage of Sum Ltd. is 2.16 times but the Industry average is 3 times, Therefore, risk premium is added to Sun Ltd. Shares @ 1% for every 1 time of difference. Risk Premium = (3.00 - 2.16) (1%) = 0.84 (1%) = 0.84% Yield on equity shares % = 100 (b) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75 times. Therefore, risk premium is added to Sun Ltd. shares @ 2% for every 1 time of difference. Risk Premium = (0.75 - 0.93) (2%) = 0.18 (2%) = 0.36% (%) Normal return expected 9.60 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Add: Risk premium for low interest and fixed dividend coverage 084 Add: Risk premium for high interest gearing ratio 036 10.80 (0) Value of Equity Share __Actual yield ~ Expected yield 9 x 100 = € 40.65 + Paid-up value of share = 755 Valuation of Rights Question 27 Pragya Limited has issued 75,000 equity shares of ¢ 10 each. The current market price per share is © 24, The company has a plan to make a rights issue of one new equity share at a price of T 16 for every four shares held, Youre required to: () Calculate the theoretical post-rights price per share; (ii) Calculate the theoretical value of the right alone; (iii) Show the effect of the rights issue on the wealth of a shareholder, who has 1,000 shares assuming he sells the entire rights; and (iv) Show the effect, if the same shareholder does not take any action and ignores the issue. Answer (Calculation of theoretical post-rights (ex-right) price per share: erg vue GIN =RD Where, M= Market price, N= Number of old shares fora right share S = Subscription price R= Right share offer (824% 4) + (€16x1) aT 322.40 Ex-right value Calculation of theoretical value of the rights alone: = Excright price - Cost of rights share = 22.40 %16= 6.40 Value of a Right Per Share Basis seas. 160 Calculation of effect of the rights issue on the wealth of a shareholder who has 1,000 shares assuming he sells the entire rights: Ce BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation x (a) _ | Value of shares before right issue (1,000 shares x 24) 24,000 (b) | Value of shares after right issue (1,000 shares x % 22.40) 22,400 Addi Sale proceeds of rights renunciation (250 shares x % 6.40) 1,600 24,000 ‘There is no change in the wealth of the shareholder even if he sells his right. (iv) Calculation of effect if the shareholder does not take any action and ignores the issue: z Value of shares before right issue (1,000 shares x € 24) 24,000 Less: Value of shares after right issue (1,000 shares x € 22.40) 22,400 Loss of wealth to shareholders, if rights ignored 1,600 Question 28 KLM Limited has issued 90,000 equity shares of = 10 each. KLM Limited's shares are currently selling at % 72. The company has a plan to make a rights issue of one new equity share at a price of € 48 for every four shares held. Youre required to: (a) Calculate the theoretical post-rights price per share and analyse the change, (b) Calculate the theoretical value of the right alone. (©) Suppose Mr. A who is holding 100 shares in KLM Ltd. is not interested in subscribing to the right issue, then advice what should he do. Answer (a) Calculation of theoretical post-rights (ex-right) price per share IN+SR Becright value = <-> Where, M = Market price, N= Number of old shares fora right share § = Subscription price R=Rightshare offer R72N44348x1 ae 267.20 ‘Thus, post right issue the price of share has reduced by ¥ 4.80 per share. (b) Calculation of theoretical value of the rights alone: Ex-right price - Cost of rights share OE] BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation 67.20 - €48 = €19,20 167.20 - 148 Value of a Right Per Share Basis = ; 480 (©) If Mr. Ais not interested in subscribing to the right issue, he can renounce his right eligibility @ 19.20 per right and can eam a gain of % 480 (25 shares x € 19.20). Question 29 ABC Limited's shares are currently selling at 13 per share. There are 10,00,000 shares outstanding. The firm is planning to raise < 20 lakhs to Finance a new project. Required: What are the ex-right price of shares and the value of a right, if (i) The firm offers one right share for every two shares held. (i) The firm offers one right share for every four shares held. (iii) How does the shareholders’ wealth (holding 100 shares) change from (i) to (ii) assuming shareholder is exercising the right? How does right issue increase shareholders’ wealth? Answer (@ Number of shares to be issued: 5,00,000 Subscription price % 20,00,000/5,00,000 = %4 %.1,30,00,000 + & 20,00,000 Bxeright Price = = ——— = $10 Value of a Right = €10- %4=%6 210-24 7B Value of a Right Per Share Basis = Gi) Subscription price = ¢ 20,00,000/2,50,000 = °8, 00 + % 2 12, Value of a Right = %12-%8 x Ex-right Price = t12-%8_ Value of a Right Per Share Basis = > a1 (iii) Calculation of effect of right issue on wealth of Sharebolder’s wealth who is holding 100 shares. (a) When firm offers one share for two shares held. Value of Shares after right issue (150 x % 10) 21,500 Less: Amount paid to acquire right shares (50 x % 4) 3200 31,300 (b)_ When firm offers one share for every four shares held. Value of Shares after right issue (125 x 812) 81,500 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Less: Amount paid to acquire right shares (25 x €8) E200 31300 Wealth of Shareholders before Right Issue 21,300 ‘Thus, there will be no change in the wealth of shareholders from (i) and (ii) Bond Pricing Question 30 Nominal value of 10% bonds issued by a company is 100. The bonds are redeemable at % 110 at the end of year 5. Determine the value of the bond if required yield is (i) 5%, (ii) 5.1%, (iii) 10% and (iv) 10.1% Note: Use PV Factors upto 4 decimals Answer: Case (i) Required yield rate = 5% Year Cash Flow & DF (5%) Present Value = 15 10 4.3295 43.295 5 110 0.7835 86.185 Value of bond 129.48 Case (ii) Required yield rate = 5.1% Year Cash Flow & DF (5.1%) Present Value % 15 10 43175 43.175 5 110 0.7798 85.778 Value of bond 128.953 Case (iii) Required yield rate = 10% Year Cash Flow & DF (10%) Present Value 15 10 3.7908 37.908 5 110 0.6209 68.299 Value of bond 106.207 Case (iv) Required yield rate = 10.1% Year Cash Flow & DF (10.1%) Present Value 15 10 3.7811 37811 5 110 0.6181 67.991 Value of bond 105.802 Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Question 31, M/s Agfa Industries is planning to issue a debenture series on the following terms: Face value 100 Term of maturity 10 years Yearly coupon rate Years Coupon Rate 1-4 9% 5-8 10% 9-10 14% ‘The current market rate on similar debentures is 15 per cent per annum. The Company proposes to price the issue in such a manner that it can yield 16 per cent compounded rate of return to the investors. The Company also proposes to redeem the debentures at 5 per cent premium on maturity. Determine the issue price of the debentures. Note: Calculate amount upto 3 decimals Answer: ‘The issue price of the debentures will be the sum of present value of interest payments during 10 years of its maturity and present value of redemption value of debenture. Years Cash out flow (3) PVIF @ 16% Pv 1 9 B62 7.158 2 9 743 6.687 3 9 641 5.769 4 9 552 4.968 5 10 476 4.76 6 10 410 4.10 7 10 354 3.54 8 10 305 3.05 9 4 263 3.682 10 144 105=119 227 3.178 + 23.835 71.327 ‘Thus the debentures should be priced at 71.327 Question 32 Pet feed plc has outstanding, a high yield Bond with following features: Face Value £10,000 Coupon 10% Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Maturity Period 6 Years Special Feature Company can extend the life of Bond to 12 years Presently the interest rate on equivalent Bond is 8%. (a) Ian investor expects that interest will be 8%, six years from now then how much he should pay for this bond now. (b) Now suppose, on the basis of that expectation, he invests in the Bond, but interest rate turns out to be 12%, six years from now, then what will be his potential loss/gain if the company extents the life of Bond for another 6 years. Answer (a) If the current interest rate is 8%, the company will not extent the duration of Bond and the maximum amount the investor would ready to pay will be: = £ 1,000 PVIAF (8%, 6) + £ 10,000 PVIF (8%, 6) = £1,000 x 4.623 + £ 10,000x 0.630 = £4,623 + £ 6,300 = £10923 (b) If the current interest rate is 12%, the company will extent the duration of Bond. After six years, the value of Bond will be = £ 1,000 PVIAF (12%, 6) + £ 10,000 PVIF (12%, 6) = £1,000 x 4.111 + £ 10,000x 0.507 = £4,111 + £5,070 = £9,181 ‘Thus, potential loss will be £ 9,161 - £ 10,923 = £ 1,742 Question 33 ABC Ltd, wants to issue 9% Bonds redeemable in 5 years at its face value of % 1,000 each. The annual spotyield curve for similar risk class of Bond is as follows: Year Interest Rate 1 12% 2 11.62% 3 11.33% 4 11.06% 5 10.80% @ (ii) Not Evaluate the expected market price of the Bond if it has a Beta value of 1.10 due to its popularity because of lesser risk. Interpret the nature of the above yield curve and reasons for the same. Use PV Factors upto 4 decimal points and value in % upto 2 decimal points. BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Answer (For finding expected market price first we shall calculate Intrinsic Value of Bond as follows: PV of Interest + PV of Maturity Value of Bond Forward rate of interests Ast Year 12% 2nd Year 11.62% 3rd Year 11.33% 4th Year 11.06% 5th Year 10.80% PV of interest - 22 290 290 x90, 390 (1+ 0.42) * (1+ 0.1162) * (10.1133) * (1+ 0.1106)" * (1+ 0.1080)5 = € 90x 0.8929 + €90 x 0.8026 + £90.x 0.7247 +X 90x 0.6573 + £90 x 0.5988 = % 80.36 + €72.23 + 65.22 + 759.16 + T 53.89 =%330.86 1,000 (1+ 0.1080) = 21,000 x 0.5988 = % 598.80 PV of Maturity Value of Bond = Intrinsic value of Bond = % 330.86 + & 598.80 = 2 929.66 Expected Price = Intrinsic Value x Beta Value 929.6% 1.10 1,022.63 ‘The given yield curve is inverted yield curve. ‘The main reason for this shape of curve is expectation for forthcoming recession when investors are more interested in Short-term rates over the long term. Question 34 On 31+ March, 2022, the following information about Bonds is available: Name of Security| Face Value | Maturity Date | Coupon Rate Coupon Date(s) ‘Zero coupon 10,000 | 31° March, 2032 NA. NA. Bill 1,00000 | 20% june, 2022 Na. NA, 10.71% GOI 2032 100 31 March, 2032 10.71 31% March. 10% GO1 2027, 100 31" March, 2027 10.00 314 March & 30% September Calculate: () If 10 years yield is 7.5% paa. what price the Zero Coupon Bond would fetch on 31% March, 2022? (ii) What will be the annualized yield if the T-Bill is traded @ 98,5007 (iii) If 10.71% GOI 2032 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2022 (after coupon payment on 31* March)? Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation (iv) If 10% GOI 2027 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2022 (after coupon payment on 31* March)? Note: Consider PV Factor upto 4 decimals Answer (Rate used for discounting shall be yield, Accordingly ZCB shall fetch: _ 10000 | (1 +0.075)" Gi) The day count basisis actual number days/365. Accordingly annualized yield shall be: rice 365 1,00,000 - 98,500 365 viela = Pie, _365 _ = = 6.86% Price» No.of days 98,500 a1 Price GOI 2032 would fetch = % 10.71 PVAF (8%, 10) + € 100 PVF (8%, 10) = 110.71 x 6.71 + € 100 x 0.4632 = 071.86 + 846.32 = 1118.18 (iv) Price GOI 2027 Bond would fetch: = 85 PVAF (4%, 10) + & 100 PVF (4%, 10) = %5xB.11+% 100 x 0.6756 = 40.55 + 67.56 = 108.11 Bond Yield Question 35 Based on the credit rating of bonds, Mr. Z. has decided to apply the following discount rates for valuing bonds: credit Rating Discount Rate AAA 364 day T bill rate + 3% spread AA AAA + 2% spread A AAA + 3% spread He is considering to invest in AA rated, ¢ 1,000 face value bond currently selling at T 1,025.86. The bond has five years to maturity and the coupon rate on the bond is 15% pa. payable annually. The next Interest payment is due one year from today and the bond is redeemable at par. (Assume the 364 day T-bill rate to be 9%). (a) You are required to calculate the intrinsic value of the bond for Mr. Z. Should he invest in the bond? (b) Also calculate the current yield and the Yield to Maturity (YTM) of the bond. ‘The relevant present value table is as follows: Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation Year 1 2 3 4 PVIF @ 14% 0.877 0.769 0.675 0.592 PVIF @ 15% 0.870 56 0.657 0.572 Answer (a) The appropriate discount rate for valuing the bond for Mr. Z is: R= 9% 43% + 2%- 14% Time cr PVIF 14%. Pv (CF) 1 150 0.877 131.55 2 150 0.769 115.35 3 150 0.675 101.25 4 150 0.592 88.80 5 1,150 0.519 596.85 YPV(CE) ie. Py = 1,033.80 Since, the current market value is less than the intrinsic value; Mr. Z should buy the bond. (b) Current yield = Annual Interest/Price = 150/1,025:86 ‘The YTM of the bond is calculated as follows: @15% P= 150 x PVIFA asy.4+ 1,150 x PVIF asx. = 150x 2,855 + 1,150x 0.497 = 428,25 + 571.55 = 999.80 14%, ‘As found in sub part (a) Po = 1,033.80 4.62% By interpolation we get, 7.94 = 14% + x (15% - 14%) = 14% + 7.94 (-26.06) 34 YTM = 14.23% Question 36 An investor is considering the purchase of the following Bond: Face value 2100 Coupon rate 1% Maturity 3years (i) Ihe wants a yield of 13% what is the maximum price, he should be ready to pay for? (i) ithe Bond is selling for € 97.60, what would be his yield? Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)Security Valuation The relevant present value table is as follows: Year 1 2 3 PVIF @ 12% 0893 0.797 0.712 PVIF @ 13% 0.885 0.783 0.693 Answer (@ Calculation of Maximum price Bo=% 11x PVIFA (13%, 3) + € 100 x PVIF (13%, 3) = 311 x 2361 + § 100 x 0.693 = 25.97 + 8 69,30 = 95.27 (i) Calculation of yield At 12% the value= € 11 x PVIFA (12%,3) + 100 x PVIF (12%,3) = X11 2.402 + F100. 0.712 = § 26.42 # ¥ 71.20 = 297.62 It the bond is selling at 97.60 which is more than the fair value, the YTM of the bond would be less than 13%. This value is almost equal to the amount price of £97.60. Therefore, the YTM of the bond would be 12%. Question 37 Today being 1* January 2022, Ram is considering to purchase an outstanding Corporate Bond having a face value of € 1,000 that was issued on 1* January 2020 which has 9.5% Annual Coupon and 11 years of original maturity (i.e. maturing on 31% December 2030). Since the bond was issued, the interest rates have been on downside and it is now selling at a premium of € 125.75 per bond. Determine the prevailing interest on the similar type of Bonds if itis held till the maturity which shall be at Par. PV Factors: 1 2 3 4 5 6 7 8 9 6% 0943 | 0890 | 0840 | 0.792 | 0747 | 0.705 | 0665 | 0627 | 0592 8% 0926 | 0857 | 0.794 | 0.735 | 0.681 | 0630 | 0.583 | 0.540 | 0.500 Answer: ‘To determine the prevailing rate of interest for the similar type of Bonds we shall compute the YTM of this Bond using IRR method as follows: M=%1000 Interest = € 95 (0.095 x 1,000) n 9 years Vo= 21,125.75 (8 1,000 + 8 125.75) YTM can be determined from the following equation Cee BY CA AJAY AGARWAL (AIR-1) AIRICA Career Institute (ACI)