ADVANCED FINANCIAL MANAGEMENT CA.

DINESH JAIN

Topic – Security Valuation

Total Marks: 30 Marks
Time Allowed: 55 Mins
Instruction for candidates:
• Reading time for question paper is 5 minutes
• All questions are compulsory

Question No.1
An analyst is interested in valuing stocks by calculating the present value of its future
dividends. He has compiled the following financial data for TCS:
Earnings per share (EPS)
Year 0 4.00
Year 1 6.00
Year 2 9.00
Year 3 13.50
Note: Shareholders of TCS., require a 20% return on their investment in the high growth stage
compared to 12% in the stable growth stage. The dividend payout ratio of TCS., is expected to
be 40% for the next three years. After year 3, the dividend payout ratio is expected to increase to
80% and the expected earnings growth will be 2%. Using the information contained in the table,
what is the value of share of TCS?
a) Rs.43.04
b) Rs.39.50
c) Rs.82.45
d) Rs.71.38
(3 Marks)
Answer:
Answer to the question is Rs.71.38
WN 1: Computation of dividends till the first year of stabilization phase:
Year EPS Payout Ratio DPS
1 6.00 40% 2.40
2 9.00 40% 3.60
3 13.50 40% 5.40
4 13.77 80% 11.016
[13.50 + 2%]

WN 2: Computation of price at beginning of stabilization phase (Year 3):

D4 11.016
P3 = = = Rs. 110.16
K e − G 12% − 2%

WN 3: Computation of fair market price:

Year Cash flow PVF @ 20% DCF
1 2.40 0.833 2.00
2 3.60 0.694 2.50
3 5.40 0.579 3.13
3 110.16 0.579 63.78
Value of share 71.41 71.38

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Question No.2
A firm has a return on equity of 15%, a current dividend of Rs.1.00 and a sustainable growth
rate of 9%, what are the firm’s current earnings?
a) Rs.1.50
b) Rs.2.50
c) Rs.1.75
d) Rs.1.25
(1 Mark)
Answer:
Answer to this question is Rs.2.50
• Growth rate =ROE x Retention ratio
• 9% = 15% x Retention Ratio
• Retention ratio = 60%
• Payout ratio = 40%
• Hence DPS = 40% of EPS; EPS = 1/40% = Rs.2.50 per share

Question No.3
ABC Limited has a leading price-to-earnings (P/E) ratio of 28 while the median leading P/E of
a peer group of companies within the industry is 38. Based on the method of comparables, an
analyst would most likely conclude that ABC Limited should be:
a) bought as an undervalued stock
b) sold short as an overvalued stock
c) sold as an overvalued stock
d) bought as an overvalued stock
(1 Mark)
Answer:
• Answer to this is bought as an undervalued stock
• The PE ratio is considerably lower than that for the median of the peer group, which
implies that it may well be undervalued

Question No.4
A bond is paying a coupon of 12% and has a face value of Rs.100. It is currently quoting in the
market at Rs.130. What is the likely YTM of the bond?
a) YTM = Coupon Rate
b) YTM > Coupon Rate
c) YTM < Coupon Rate
(1 Mark)
Answer:
• Answer to this is YTM < Coupon Rate
• Bond is quoting at premium and this would mean bond is exceeding expectation of
investors. Hence, we can conclude that in this case YTM < Coupon Rate

Question No.5
ABC Limited is a manufacturer of small refrigerator and other appliances. The following figures
are from the company’s recent financial statement:
Stock Price Rs.30

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Shares outstanding 3,00,000

Market value of long-term debt 8,00,000
Book value of long-term debt 11,00,000
Book value of total debt 26,00,000
Cash and marketable securities 3,00,000
EBITDA 12,00,000
Required:
Calculate the EV/EBITDA multiple.
(4 Marks)
Answer:
Computation of EV/EBITDA Multiple:
Particulars Calculation Amount
Market value of equity 30 x 3,00,000 90,00,000
Market value of long-term debt 8,00,000
Market value of short-term debt Book value and market value 15,00,000
assumed to be same
[26,00,000 – 11,00,000]
Less: Cash and marketable securities (3,00,000)
Enterprise Value 1,10,00,000
EBITDA 12,00,000
EV/EBITDA Multiple 1,10,00,000/12,00,000 9.17 Times

Question No.6
ABC Limited has 11% bond worth of Rs. 2 crores outstanding with 10 years remaining to
maturity. The company is contemplating the issue of a Rs. 2 crores 10-years bond carrying the
coupon rate of 9% and use the proceeds to liquidate the old bonds.

Following are the details about old bond:

• Old bond was issued 15 years ago. The company had incurred floatation cost on issue of
old bond and the same was equally amortized over the life. The company has written off
Rs.4.50 lacs of floatation cost till now
• The old bond was issued at discount. Unamortized discount as on today is Rs.10,00,000
• Old bond was to be redeemed at par. However, it also had a call premium of 5%

Following are the details about new bond:

• Issue cost of the new bonds would be Rs.2.5 lacs
• New bonds must first be sold and their proceeds, then used to retire old bonds, the
company expects a three months period of overlapping interest during which interest
must be paid on both the old and new bonds

The company is paying 30% tax. Should ABC Limited liquidate the old bonds?
(8 Marks)
Answer:

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WN 1: Computation of initial outflow:

Particulars Calculation Amount (in
lacs)
Cash flows relating to old bond:
Value of old bonds redeemed (200)
Call premium on old bonds 200 x 5% (10)
Tax benefit on write off of call premium of old 10 x 30% 3.00
bonds
Tax benefit on write off of issue cost of old bonds 3 x 30% 0.9
(Note)
Tax benefit on write-off of discount of old bonds 10 x 30% 3.00
Cash flows relating to new bond:
Value of issue of new bond 200
Issue cost of new bond (2.5)
Overlapping interest:
Overlapping interest (Note) 3 (3.85)
200 x 11% x ( ) x 70%
12
Net initial outflow 9.45
Note:
❖ The company has amortized Rs.4,50,000 in 15 years. Hence annual amortization is
Rs.30,000. There are ten more years and hence unamortized issue cost on old bonds is
Rs.3,00,000
❖ Overlapping interest is the extra interest to be paid due to delay in redemption of old
bond. During this period, interest would be paid for both old and new bonds. Under
bond refunding, the assumption is that we have redeemed the old bond and replaced
with new bond. Hence any interest paid on old bond will be called as overlapping
interest

WN 2: Computation of in-between cash flows:

Particulars Old bond New bond
Interest outflow 22 18
(200 x 11%) (200 x 9%)
Less: Tax saving on interest (6.6) (5.4)
Less: Tax benefit on w/o off floatation cost (0.09) 0.075
[3 lacs/10 years x 30%] [2.5 lacs/10 years x 30%]
Less: Tax benefit on w/o off discount (0.30)
[10 lacs/10 years x 30%]
Net outflow 15.01 12.525
❖ Net annual savings = 15.01 lacs – 12.525 lacs = 2.485 lacs

WN 3: Computation of NPV of refunding decision:

(in lacs)
Year Cash flow PVF @ 6.30% DCF
0 (9.45) 1.000 (9.45)
1 to 10 2.485 7.257 18.034

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NPV of refunding decision 8.584

Note:
• Discount rate is after-tax cost of debt and the same is missing in this question. Hence, we
will take discount rate as after-tax cost of new debt
• New debt is being issued at 9% and hence discount rate is after-tax cost of debt is 6.3%

Decision: The bond should be refunded as the same generates positive NPV of 8.584 lacs

Question No.7
Which of the following points is/are true about duration of bonds?
(i) The shorter-maturity bond would have a lower duration and vice versa
(ii) The higher the coupon, the lower is the duration and vice versa
(iii) Higher YTM would lead to higher duration and lower YTM would lead to lower
duration
Options:
a) (i) and (ii) is correct
b) (i), (ii) and (iii) is correct
c) (i) and (iii) is correct
d) (ii) and (iii) is correct
(2 Marks)
Answer:
• (i), (ii) is correct
• Shorter-maturity bonds have lower life and accordingly lower duration. Higher coupon
will lead to higher cash flow during initial years and hence will have lower duration.
• High discount rate will lead to lower duration and low discount rate will lead to higher
duration

Question No.8
Wonderland Limited has excess cash of Rs.20 lakhs, which it wants to invest in short term
marketable securities. Expenses relating to investment will be Rs. 50,000. The securities invested
will have an annual yield of 9 %. The company seeks your advice.
a) As to the period of investment so as to earn a pre-tax income of 5 %.
b) The minimum period for the company to break even its investment expenditure over
Time value of money.
(4 Marks)
Answer:
WN 1: Computation of period of investment to earn pre-tax income of 5%:
Particulars Amount
Net return to be earned [20 lacs x 5%] 1,00,000
Expenses relating to investment 50,000
Gross return to be earned 1,50,000
% return to be earned [1,50,000/20,00,000] 7.50%
Return for a year 9%
Period of investment to earn return of 5% 10 months

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𝟕. 𝟓𝟎%
𝐱𝟏𝟐 𝐦𝐨𝐧𝐭𝐡𝐬]
𝟗%

WN 2: Computation of break-even period:

Particulars Amount
Net return to be earned 0
Expenses relating to investment 50,000
Gross return to be earned 50,000
% return to be earned [50,000/20,00,000] 2.50%
Return for a year 9%
Period of investment to break-even 3.33 months
𝟐. 𝟓𝟎%
𝐱𝟏𝟐 𝐦𝐨𝐧𝐭𝐡𝐬]
𝟗%

Question No.9
The face value of the preference share is Rs.10,000 and the stated dividend rate is 10%. The
shares are redeemable after 3 years period. Calculate the value of preference shares if the
required rate of return is 12%.
(2 Marks)
Answer:
Year Cash flow PVF @ 12% DCF
1 1,000 0.893 893
2 1,000 0.797 797
3 11,000 0.712 7,832
Value of preference share 9,522

Question No.10
Eager Ltd. has a market capitalization of Rs. 1,500 crores and the current market price of its
share is Rs. 1,500. It made a PAT of 200 crores and the Board is considering a proposal to buy
back 20% of the shares at a premium of 10% to the current market price. It plans to fund this
through a 16% bank loan. You are required to calculate the post buy back Earnings Per Share
(EPS). The company's corporate tax rate is 30%.
(4 Marks)
Answer:
Particulars Amount
Market capitalization 1,500 crores
Current Market Price 1,500
Existing shares (1,500 crores/1,500) 1 Crore
Shares to be bought back 20 lacs
[1 crore x 20%]
Buy-back price 1,650
[1,500 + 10%]
Buy-back size 330 crores
[1,650 x 20 lacs]
Interest on loan (330 crores x 16%) 52.8 crores

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Post-tax interest cost (52.8 crores x 70%) 36.96 crores

Revised PAT [200 crores – 36.96 crores] 163.04 crores
Revised shares (1 crore – 0.2 crores) 0.8 crores
Post-buyback EPS [163.04/0.8] 203.8

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