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6
Security Analysis
Learning Objective
After going through the chapter student shall be able to understand:
Fundamental Analysis
Dividend Growth Model and the PE Multiple
Economic Analysis
(1)
Factors Affecting Economic Analysis
(2)
Techniques Used in Economic Analysis
Industry Analysis
(1)
Factors Affecting Industry Analysis
(2)
Techniques Used in Industry Analysis
Company Analysis
Technical Analysis
General Principles and Methods of Technical Analysis

(1)
The Dow Theory
(2)
Market Indicators
(3)
Support and Resistance Levels
(4)
Interpreting Price Patterns
(5)
Decision using Data Analysis
(6)
Bollinger Bands
(7)
Momentum Analysis
Evaluation of Technical Analysis
Bond Valuation
(1)
Some Basics of a Bond
(2)
Bond Valuation Model
The Institute of Chartered Accountants of India
Security Analysis
(3)
Bond Value Theorems
(4)
Yield to Maturity
(5)
Bond Values with Semi-Annual Interest
(6)
Price-Yield Relationship
(7)
Relationship between Bond Price and Time
(8)
The Yield Curve
(9)
Duration of Bond
6.2
1. Introduction
Investment decision depends on securities to be bought, held or sold. Buying security is based
on highest return per unit of risk or lowest risk per unit of return. Selling security does not
depend on any such requirement. A security considered for buying today may not be attractive
tomorrow due to management policy changes in the company or economic policy changes
adopted by the government. The reverse is also true. Therefore, analysis of the security on a
continuous basis is a must.
Security Analysis involves a systematic analysis of the risk return profiles of various securities
which is to help a rational investor to estimate a value for a company from all the price
sensitive information/data so that he can make purchases when the market under-prices some
of them and thereby earn a reasonable rate of return.
Two approaches viz. fundamental analysis and technical analysis are in vogue for carrying out
Security Analysis. In fundamental analysis, factors affecting risk-return characteristics of
securities are looked into while in technical analysis, demand/ supply position of the securities
along with prevalent share price trends are examined.
2. Fundamental Analysis
Fundamental analysis is based on the assumption that the share prices depend upon the
future dividends expected by the shareholders. The present value of the future dividends can
be calculated by discounting the cash flows at an appropriate discount rate and is known as
the 'intrinsic value of the share'. The intrinsic value of a share, according to a fundamental
analyst, depicts the true value of a share. A share that is priced below the intrinsic value must
be bought, while a share quoting above the intrinsic value must be sold.
Thus, it can be said that the price the shareholders are prepared to pay for a share is nothing
but the present value of the dividends they expect to receive on the share and this is the price
at which they expect to sell it in the future.
As a first step, to arrive at a compact expression, let us make a simple assumption, that the
company is expected to pay a uniform dividend of ` D per share every year, i.e.,
D(1) = D(2) = D(3) = = D,
(1)
6.3
Strategic Financial Management
The Eq., would then become:

P(0) =
D
D
D
+
+
+ ... + ...
2
(1+ k) (1+ k)
(1+ k)3
(2)
But it is unrealistic to assume that dividends remain constant over time. In case of most
shares, the dividends per share (DPS) grow because of the growth in the earnings of the firm.
Most companies, as they identify new investment opportunities for growth, tend to increase
their DPS over a period of time.
Let us assume that on an average the DPS of the company grows at the compounded rate of
g per annum, so that dividend D(1) at the end of the first period grows to D(1)(1+g),
D(1)(1+g)2, etc, at the end of second period, third period, etc. respectively. So we must have:
P(0) =
D (1)
D (1) (1 + g)
D (1) (1 + g)2
+
+
+ ... + ... (3)
(1 + k)
(1 + k)2
(1 + k)2
which is a perpetual geometric series.

If growth rate in dividends, g, is less than the desired rate of return on share, k, we must have:
P(0) =
D(1)
(k g)
(4)
or
P(0) =
D(0)(1 + g)
(k g)
(5)
Since D(1) may be approximated as D(0)(1+g), D(0) being the DPS in the current period (0).
When growth rate in dividends, g, is equal to or greater than the desired rate of return on
share, k, the above model is not valid, since the geometric series leads to an infinite price.
The condition that g be less than k is not very restrictive, since the long-term growth in
dividends is unlikely to exceed the rate of return expected by the market on the share.
The above result [Eq.(4)] is also known as Gordons dividend growth model for stock
valuation, named after the models originator, Myron J. Gordon. This is one of the most well
known models in the genre of fundamental analysis.
In equation (5), if g is set at zero, we get back equation (2).
2.1
Dividend Growth Model and the PE Multiple
Financial analysts tend to relate price to earnings via the P/E multiples (the ratio between the
market price and earnings per share).
If a company is assumed to pay out a fraction b of its earnings as dividends on an average
(i.e. the Dividend Payout Ratio = b), D(1) may be expressed as b E(1), where E(1) is the
earning per share (EPS) of the company at the end of the first period. Equation (4) then
becomes:
Security Analysis
P(0) =
bE(1)
(k g)
6.4
(6)
or
P(0) =
bE(0) (1 + g)
(k g)
(7)
The fundamental analysts use the above models or some of their variations, for estimating the
fundamental or intrinsic price or the fundamental price-earnings multiple of a security.
Towards this end, they devote considerable effort in assessing the impact of various kinds of
information on a companys future profitability and the expected return of the shareholders. If
the prevailing price or the P/E multiple of a security is higher than the estimated fundamental
value (i.e. if the security appears to be overpriced), they recommend a selling stance with
respect to that security, since once the information becomes common knowledge, the price of
the security may be expected to fall. On the other hand, if the security is under-priced in the
market, the prevailing price (or the P/E multiple) of the security being lower than the estimated
fundamental value, they recommend buying the security, counting upon a price rise.
Because of these inherent complex interrelationships in the production processes, the fortunes
of each industry are closely tied to those of other industries and to the performance of the
economy as a whole. Within an industry, the prospects of a specific company depend not only
on the prospects of the industry to which it belongs, but also on its operating and competitive
position within that industry. The key variables that an investor must monitor in order to carry
out his fundamental analysis are economy wide factors, industry wide factors and company
specific factors. In other words, fundamental analysis encompasses economic, industrial and
company analyses. They are depicted by three concentric circles and constitute the different
stages in an investment decision making process.
Economy Analysis
Industry Analysis
Company Analysis
2.2
Economic Analysis : Macro- economic factors e. g. historical performance of the

economy in the past/ present and expectations in future, growth of different sectors of the
6.5
economy in future with signs of stagnation/degradation at present to be assessed while

analyzing the overall economy. Trends in peoples income and expenditure reflect the growth
of a particular industry/company in future. Consumption affects corporate profits, dividends
and share prices in the market.
2.2.1 Factors Affecting Economic Analysis: Some of the economy wide factors are
discussed as under:
(a) Growth Rates of National Income and Related Measures: For most purposes, what is
important is the difference between the nominal growth rate quoted by GDP and the real
growth after taking inflation into account. The estimated growth rate of the economy would be
a pointer to the prospects for the industrial sector, and therefore to the returns investors can
expect from investment in shares.
(b) Growth Rates of Industrial Sector: This can be further broken down into growth rates
of various industries or groups of industries if required. The growth rates in various industries
are estimated based on the estimated demand for its products.
(c) Inflation: Inflation is measured in terms of either wholesale prices (the Wholesale Price
Index or WPI) or retail prices (Consumer Price Index or CPI). The demand in some industries,
particularly the consumer products industries, is significantly influenced by the inflation rate.
Therefore, firms in these industries make continuous assessment about inflation rates likely to
prevail in the near future so as to fine-tune their pricing, distribution and promotion policies to
the anticipated impact of inflation on demand for their products.
(d) Monsoon: Because of the strong forward and backward linkages, monsoon is of great
concern to investors in the stock market too.
2.2.2 Techniques Used in Economic Analysis: Economic analysis is used to forecast
national income with its various components that have a bearing on the concerned industry
and the company in particular. Gross national product (GNP) is used to measure national
income as it reflects the growth rate in economic activities and has been regarded as a
forecasting tool for analyzing the overall economy along with its various components during a
particular period.
Some of the techniques used for economic analysis are:

(a) Anticipatory Surveys: They help investors to form an opinion about the future state of
the economy. It incorporates expert opinion on construction activities, expenditure on plant
and machinery, levels of inventory all having a definite bearing on economic activities. Also
future spending habits of consumers are taken into account.
In spite of valuable inputs available through this method, it has certain drawbacks:
(i)
Survey results do not guarantee that intentions surveyed would materialize.
(ii) They are not regarded as forecasts per se, as there can be a consensus approach by the
investor for exercising his opinion.
Continuous monitoring of this practice is called for to make this technique popular.
Security Analysis
6.6
(b) Barometer/Indicator Approach: Various indicators are used to find out how the
economy shall perform in the future. The indicators have been classified as under:
(i)
Leading Indicators: They lead the economic activity in terms of their outcome. They
relate to the time series data of the variables that reach high/low points in advance of
economic activity.
(ii)
Roughly Coincidental Indicators: They reach their peaks and troughs at approximately
the same in the economy.
(iii) Lagging Indicators: They are time series data of variables that lag behind in their
consequences vis-a- vis the economy. They reach their turning points after the economy
has reached its own already.
All these approaches suggest direction of change in the aggregate economic activity but
nothing about its magnitude. The various measures obtained form such indicators may give
conflicting signals about the future direction of the economy. To avoid this limitation, use of
diffusion/composite index is suggested whereby combining several indicators into one index to
measure the strength/weaknesses in the movement of a particular set of indicators.
Computation of diffusion indices is no doubt difficult notwithstanding the fact it does not
eliminate irregular movements.
Money supply in the economy also affects investment decisions. Rate of change in money
supply in the economy affects GNP, corporate profits, interest rates and stock prices. Increase
in money supply fuels inflation. As investment in stocks is considered as a hedge against
inflation, stock prices go up during inflationary period.
(c) Economic Model Building Approach: In this approach, a precise and clear relationship
between dependent and independent variables is determined. GNP model building or sectoral
analysis is used in practice through the use of national accounting framework. The steps used
are as follows:
(i)
Hypothesize total economic demand by measuring total income (GNP) based on political
stability, rate of inflation, changes in economic levels.
(ii) Forecasting the GNP by estimating levels of various components viz. consumption
expenditure, gross private domestic investment, government purchases of
goods/services, net exports.
(iii) After forecasting individual components of GNP, add them up to obtain the forecasted GNP.
(iv) Comparison is made of total GNP thus arrived at with that from an independent agency
for the forecast of GNP and then the overall forecast is tested for consistency. This is
carried out for ensuring that both the total forecast and the component wise forecast fit
together in a reasonable manner.
2.3 Industry Analysis: When an economy grows, it is very unlikely that all industries in the
economy would grow at the same rate. So it is necessary to examine industry specific factors,
in addition to economy-wide factors.
First of all, an assessment has to be made regarding all the conditions and factors relating to
6.7
demand of the particular product, cost structure of the industry and other economic and
Government constraints on the same. Since the basic profitability of any company depends
upon the economic prospects of the industry to which it belongs, an appraisal of the particular
industry's prospects is essential.
2.3.1 Factors Affecting Industry Analysis: The following factors may particularly be kept in
mind while assessing the factors relating to an industry.
(a) Product Life-Cycle: An industry usually exhibits high profitability in the initial and growth
stages, medium but steady profitability in the maturity stage and a sharp decline in profitability
in the last stage of growth.
(b) Demand Supply Gap: Excess supply reduces the profitability of the industry because of
the decline in the unit price realization, while insufficient supply tends to improve the
profitability because of higher unit price realization.
(c) Barriers to Entry: Any industry with high profitability would attract fresh investments.
The potential entrants to the industry, however, face different types of barriers to entry. Some
of these barriers are innate to the product and the technology of production, while other
barriers are created by existing firms in the industry.
(d) Government Attitude: The attitude of the government towards an industry is a crucial
determinant of its prospects.
(e) State of Competition in the Industry: Factors to be noted are- firms with leadership
capability and the nature of competition amongst them in foreign and domestic market, type of
products manufactured viz. homogeneous or highly differentiated, demand prospects through
classification viz customer-wise/area-wise, changes in demand patterns in the long/immediate/
short run, type of industry the firm is placed viz. growth, cyclical, defensive or decline.
(f) Cost Conditions and Profitability: The price of a share depends on its return, which in
turn depends on profitability of the firm. Profitability depends on the state of competition in the
industry, cost control measures adopted by its units and growth in demand for its products.
Factors to be considered are:
(i)
Cost allocation among various heads e.g. raw material, labors and overheads and their
controllability. Overhead cost for some may be higher while for others labour may be so.
Labour cost which depends on wage level and productivity needs close scrutiny.
(ii)
Product price.
(iii) Production capacity in terms of installation, idle and operating.

(iv) Level of capital expenditure required for maintenance / increase in productive efficiency.
Investors are required to make a through analysis of profitability. This is carried out by the
study of certain ratios such as G.P. Ratio, Operating Profit Margin Ratio, R.O.E., Return on
Total Capital etc.
(g) Technology and Research: They play a vital role in the growth and survival of a particular
industry. Technology is subject to change very fast leading to obsolescence. Industries which
Security Analysis
6.8
update themselves have a competitive advantage over others in terms of quality, price etc.
Things to be probed in this regard are:
(i)
Nature and type of technology used.
(ii)
Expected changes in technology for new products leading to increase in sales.
(iii) Relationship of capital expenditure and sales over time. More capital expenditure means
increase in sales.
(iv) Money spent in research and development. Whether this amount relates to redundancy
or not?
(v)
Assessment of industry in terms of sales and profitability in short, immediate and long run.
2.3.2 Techniques Used in Industry Analysis: The techniques used for analyzing the
industry wide factors are:
(a) Regression Analysis: Investor diagnoses the factors determining the demand for output
of the industry through product demand analysis. Factors to be considered are GNP,
disposable income, per capita consumption / income, price elasticity of demand. For
identifying factors affecting demand, statistical techniques like regression analysis and
correlation are used.
(b) Input Output Analysis: It reflects the flow of goods and services through the
economy, intermediate steps in production process as goods proceed from raw material stage
through final consumption. This is carried out to detect changing patterns/trends indicating
growth/decline of industries.
2.4 Company Analysis: Economic and industry framework provides the investor with
proper background against which shares of a particular company are purchased. This requires
careful examination of the company's quantitative and qualitative fundamentals.
(a) Net Worth and Book Value : Net Worth is sum of equity share capital, preference share
capital and free reserves less intangible assets and any carry forward of losses. The total net
worth divided by the number of shares is the much talked about book value of a share.
Though the book value is often seen as an indication of the intrinsic worth of the share, this
may not be so for two major reasons. First, the market price of the share reflects the future
earnings potential of the firm which may have no relationship with the value of its assets.
Second, the book value is based upon the historical costs of the assets of the firm and these
may be gross underestimates of the cost of the replacement or resale values of these assets.
(b) Sources and Uses of Funds: The identification of sources and uses of funds is known
as Funds Flow Analysis.
One of the major uses of funds flow analysis is to find out whether the firm has used shortterm sources of funds to finance long-term investments. Such methods of financing increases
the risk of liquidity crunch for the firm, as long-term investments, because of the gestation
period involved may not generate enough surplus in time to meet the short-term liabilities
6.9
incurred by the firm. Many a firm has come to grief because of this mismatch between the
maturity periods of sources and uses of funds.
(c) Cross-Sectional and Time Series Analysis: One of the main purposes of examining
financial statements is to compare two firms, compare a firm against some benchmark figures
for its industry and to analyse the performance of a firm over time. The techniques that are
used to do such proper comparative analysis are: common-sized statement, and financial ratio
analysis.
(d) Size and Ranking: A rough idea regarding the size and ranking of the company within
the economy, in general, and the industry, in particular, would help the investment manager in
assessing the risk associated with the company. In this regard the net capital employed, the
net profits, the return on investment and the sales figures of the company under consideration
may be compared with similar data of other companies in the same industry group. It may also
be useful to assess the position of the company in terms of technical know-how, research and
development activity and price leadership.
(e) Growth Record: The growth in sales, net income, net capital employed and earnings per
share of the company in the past few years should be examined. The following three growth
indicators may be particularly looked into: (a) Price earnings ratio, (b) Percentage growth rate
of earnings per annum, and (c) Percentage growth rate of net block.
The price earnings ratio is an important indicator for the investment manager since it shows
the number of times the earnings per share are covered by the market price of a share.
Theoretically, this ratio should be the same for two companies with similar features. However,
this is not so in practice due to many factors. Hence, by a comparison of this ratio pertaining
to different companies the investment manager can have an idea about the image of the
company and can determine whether the share is under-priced or over-priced.
Consider the following example:
(a)
(b)
(c)
Market price of share of ` 100

Earnings per share
Price earnings ratio [ (a) (b) ]
Company A
150
25
6
Company B
250
25
10
It is obvious that the purchaser of company A's shares pays 6 times its annual earnings while
the purchaser of company B's shares pays 10 times. If other factors (intrinsic value of share,
growth potential, etc.) are quite similar, it is obvious that the shares of company A are
preferable. In practice, however, the other factors are never similar in the case of two
companies. The investment manager must try to ascertain why the EPS in company B is
comparatively low may be some factors are not apparent. EPS calculation cannot be the
sole basis of deciding about an investment. Yet it is one of the most important factors on the
basis of which the investment manager takes a decision to purchase the shares. This is
because it relates the market price of the shares and the earnings per share.
The percentage growth rate of net blocks shows how the company has been developing its
capacity levels. Obviously, a dynamic company will keep on expanding its capacities and
Security Analysis
6.10
diversify its business. This will enable it to enter new and profitable lines and avoid stagnation
in its growth.
In this context, an evaluation of future growth prospects of the company should be carefully
made. This requires an analysis of existing capacities and their utilisation, proposed
expansion and diversification plans and the nature of the company's technology. The existing
capacity utilisation levels can be known from the quantitative information given in the
published profit and loss accounts of the company. The plans of the company, in terms of
expansion or diversification, can be known from the Directors Reports, the Chairmans
statements and from the future capital commitments as shown by way of notes in the balance
sheets. The nature of technology of a company should be seen with reference to technological
developments in the concerned fields, the possibility of its product being superseded or the
possibility of emergence of a more effective method of manufacturing.
Growth is the single most important factor in company analysis for the purpose of investment
management. A company may have a good record of profits and performance in the past; but
if it does not have growth potential, its shares cannot be rated high from the investment point
of view.
(f) Financial Analysis: An analysis of its financial statements for the past few years would
help the investment manager in understanding the financial solvency and liquidity, the
efficiency with which the funds are used, the profitability, the operating efficiency and the
financial and operating leverages of the company. For this purpose, certain fundamental ratios
have to be calculated.
From the investment point of view, the most important figures are earnings per share, price
earning ratios, yield, book value and the intrinsic value of the share. These five elements may
be calculated for the past 10 years or so and compared with similar ratios computed from the
financial accounts of other companies in the industry and with the average ratios for the
industry as a whole. The yield and the asset backing of a share are important considerations
in a decision regarding whether the particular market price of the share is proper or not.
Various other ratios to measure profitability, operating efficiency and turnover efficiency of the
company may also be calculated. The return on owners' investment, capital turnover ratio and
the cost structure ratios may also be worked out.
To examine the financial solvency or liquidity of the company, the investment manager may
work out current ratio, liquidity ratio, debt-equity ratio, etc. These ratios will provide an overall
view of the company to the investment analyst. He can analyse its strengths and weaknesses
and see whether it is worth the risk or not.
(g) Quality of Management: This is an intangible factor. Yet it has a very important bearing
on the value of the shares. Every investment manager knows that the shares of certain
business houses command a higher premium than those of similar companies managed by
other business houses. This is because of the quality of management, the confidence that
investors have in a particular business house, its policy vis-a-vis its relationship with the
investors, dividend and financial performance record of other companies in the same group,
etc. This is perhaps the reason that an investment manager always gives a close look to the
6.11
management of a company in whose shares he is to invest. Quality of management has to be

seen with reference to the experience, skills and integrity of the persons at the helm of affairs
of the company. The policy of the management regarding relationship with the shareholders is
an important factor since certain business houses believe in very generous dividend and
bonus distributions while others are rather conservative.
(h) Location and Labour-Management Relations: The locations of the company's
manufacturing facilities determines its economic viability which depends on the availability of
crucial inputs like power, skilled labour and raw-materials, etc. Nearness to markets is also a
factor to be considered.
In the past few years, the investment manager has begun looking into the state of labourmanagement relations in the company under consideration and the area where it is located.
(i) Pattern of Existing Stock Holding: An analysis of the pattern of existing stock holdings
of the company would also be relevant. This would show the stake of various parties in the
company. An interesting case in this regard is that of the Punjab National Bank in which the
Life Insurance Corporation and other financial institutions had substantial holdings. When the
bank was nationalised, the residual company proposed a scheme whereby those
shareholders, who wish to opt out, could receive a certain amount as compensation in cash. It
was only at the instance and the bargaining strength, of institutional investors that the
compensation offered to the shareholders, who wished to opt out of the company, was raised
considerably.
(j) Marketability of the Shares: Another important consideration for an investment
manager is the marketability of the shares of the company. Mere listing of a share on the stock
exchange does not automatically mean that the share can be sold or purchased at will. There
are many shares which remain inactive for long periods with no transactions being effected.
To purchase or sell such scrips is a difficult task. In this regard, dispersal of shareholding with
special reference to the extent of public holding should be seen. The other relevant factors are
the speculative interest in the particular scrip, the particular stock exchange where it is traded
and the volume of trading.
Techniques Used in Company Analysis: Through the use of statistical techniques the
company wide factors can be analysed. Some of the techniques are discussed as under:
(a) Correlation & Regression Analysis: Simple regression is used when inter relationship
covers two variables. For more than two variables, multiple regression analysis is followed.
Here the inter relationship between variables belonging to economy, industry and company
are found out. The main advantage in such analysis is the determination of the forecasted
values along with testing the reliability of the estimates.
(b) Trend Analysis: The relationship of one variable is tested over time using regression
analysis. It gives an insight to the historical behavior of the variable.
(c) Decision Tree Analysis: Information relating to the probability of occurrence of the
forecasted value is considered useful. A range of values of the variable with probabilities of
occurrence of each value is taken up. The limitations are reduced through decision tree
analysis and use of simulation techniques.
Security Analysis
6.12
In decision tree analysis, the decision is taken sequentially with probabilities attached to each
sequence. To obtain the probability of final out come, various sequential decisions given along
with probabilities, them probabilities of each sequence is to be multiplied and them summed
up.
Thus, fundamental analysis is basically an examination of the economic and financial aspects
of a company with the aim of estimating future earnings and dividend prospects. It includes an
analysis of the macro-economic and political factors which will have an impact on the
performance of the company. After having analysed all the relevant information about the
company and its relative strength vis-a-vis other companies in the industry, the investor is
expected to decide whether he should buy or sell the securities.
Apart from these, the Group Analysis has also become an important factor. SEBI, in particular,
emphasizes the need for disclosure, in public offer documents, of all relevant parameters
especially the financial health and promise versus performance of the group companies. RBI
has also been focusing more and more on the Group Exposure Norms of commercial Banks.
3. Technical Analysis
Technical Analysis is a method of share price movements based on a study of price graphs or
charts on the assumption that share price trends are repetitive, that since investor psychology
follows a certain pattern, what is seen to have happened before is likely to be repeated. The
technical analyst is concerned with the fundamental strength or weakness of a company or an
industry; he studies investor and price behaviour.
A technical analyst attempts precisely that. The two basic questions that he seeks to answer
are: (i) Is there a discernible trend in the prices? (ii) If there is, then are there indications that
the trend would reverse? The methods used to answer these questions are visual and
statistical. The visual methods are based on examination of a variety of charts to make out
patterns, while the statistical procedures analyse price and return data to make trading
decisions.
Technical analysts use three types of charts for analyzing data. They are:
(i) Bar Chart : In a bar chart, a vertical line (bar) represents the lowest to the highest price,
with a short horizontal line protruding from the bar representing the closing price for the
period. Since volume and price data are often interpreted together, it is a common practice to
plot the volume traded, immediately below the line and the bar charts.
6.13
(ii) Line Chart: In a line chart, lines are used to connect successive days prices. The
closing price for each period is plotted as a point. These points are joined by a line to form the
chart. The period may be a day, a week or a month.
(iii) Point and Figure Chart: Point and Figure charts are more complex than line or bar
charts. They are used to detect reversals in a trend. For plotting a point and figure chart, we
have to first decide the box size and the reversal criterion. The box size is the value of each
box on the chart, for example each box could be Re.1, ` 2 or ` 0.50. The smaller the box size,
the more sensitive would the chart be to price change. The reversal criterion is the number of
boxes required to be retraced to record prices in the next column in the opposite direction.
Period
Price
30
24
29
26
28
27
27
Security Analysis
3.1
26
26
28
25
27
24
26
25
26
10
23
23
6.14
22
General Principles and Methods of Technical Analysis
3.1.1 The Dow Theory: The Dow Theory is one of the oldest and most famous technical
theories. It was originated by Charles Dow, the founder of Dow Jones Company in late
nineteenth century. It is a helpful tool for determining the relative strength of the stock market.
It can also be used as a barometer of business.
The Dow Theory is based upon the movements of two indices, constructed by Charles Dow,
Dow Jones Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA). These
averages reflect the aggregate impact of all kinds of information on the market. The
movements of the market are divided into three classifications, all going at the same time; the
primary movement, the secondary movement, and the daily fluctuations. The primary
movement is the main trend of the market, which lasts from one year to 36 months or longer.
This trend is commonly called bear or bull market. The secondary movement of the market is
shorter in duration than the primary movement, and is opposite in direction. It lasts from two
weeks to a month or more. The daily fluctuations are the narrow movements from day-to-day.
These fluctuations are not part of the Dow Theory interpretation of the stock market. However,
daily movements must be carefully studied, along with primary and secondary movements, as
they go to make up the longer movement in the market.
Thus, the Dow Theorys purpose is to determine where the market is and where is it going,
although not how far or high. The theory, in practice, states that if the cyclical swings of the
stock market averages are successively higher and the successive lows are higher, then the
market trend is up and a bullish market exists. Contrarily, if the successive highs and
successive lows are lower, then the direction of the market is down and a bearish market
exists.
Charles Dow proposed that the primary uptrend would have three moves up, the first one
being caused by accumulation of shares by the far-sighted, knowledgeable investors, the
second move would be caused by the arrival of the first reports of good earnings by
corporations, and the last move up would be caused by widespread report of financial wellbeing of corporations. The third stage would also see rampant speculation in the market.
Towards the end of the third stage, the far-sighted investors, realizing that the high earnings
levels may not be sustained, would start selling, starting the first move down of a downtrend,
and as the non-sustainability of high earnings is confirmed, the second move down would be
initiated and then the third move down would result from distress selling in the market.
6.15
3.1.2 Market Indicators

(i) Breadth Index: It is an index that covers all securities traded. It is computed by dividing
the net advances or declines in the market by the number of issues traded. The breadth index
either supports or contradicts the movement of the Dow Jones Averages. If it supports the
movement of the Dow Jones Averages, this is considered sign of technical strength and if it
does not support the averages, it is a sign of technical weakness i.e. a sign that the market
will move in a direction opposite to the Dow Jones Averages. The breadth index is an addition
to the Dow Theory and the movement of the Dow Jones Averages.
(ii) Volume of Transactions: The volume of shares traded in the market provides useful
clues on how the market would behave in the near future. A rising index/price with increasing
volume would signal buy behaviour because the situation reflects an unsatisfied demand in
the market. Similarly, a falling market with increasing volume signals a bear market and the
prices would be expected to fall further. A rising market with decreasing volume indicates a
bull market while a falling market with dwindling volume indicates a bear market. Thus, the
volume concept is best used with another market indicator, such as the Dow Theory.
(iii) Confidence Index: It is supposed to reveal how willing the investors are to take a
chance in the market. It is the ratio of high-grade bond yields to low-grade bond yields. It is
used by market analysts as a method of trading or timing the purchase and sale of stock, and
also, as a forecasting device to determine the turning points of the market. A rising confidence
index is expected to precede a rising stock market, and a fall in the index is expected to
precede a drop in stock prices. A fall in the confidence index represents the fact that lowgrade bond yields are rising faster or falling more slowly than high grade yields. The
confidence index is usually, but not always a leading indicator of the market. Therefore, it
should be used in conjunction with other market indicators.
(iv) Relative Strength Analysis: The relative strength concept suggests that the prices of
some securities rise relatively faster in a bull market or decline more slowly in a bear market
than other securities i.e. some securities exhibit relative strength. Investors will earn higher
returns by investing in securities which have demonstrated relative strength in the past
because the relative strength of a security tends to remain undiminished over time.
Relative strength can be measured in several ways. Calculating rates of return and classifying
those securities with historically high average returns as securities with high relative strength
is one of them. Even ratios like security relative to its industry and security relative to the
entire market can also be used to detect relative strength in a security or an industry.
(v) Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the average
person is usually wrong and that a wise course of action is to pursue strategies contrary to
popular opinion. The odd-lot theory is used primarily to predict tops in bull markets, but also to
predict reversals in individual securities.
3.1.3 Support and Resistance Levels: When the index/price goes down from a peak, the
peak becomes the resistance level. When the index/price rebounds after reaching a trough
subsequently, the lowest value reached becomes the support level. The price is then expected
to move between these two levels. Whenever the price approaches the resistance level, there
Security Analysis
6.16
is a selling pressure because all investors who failed to sell at the high would be keen to
liquidate, while whenever the price approaches the support level, there is a buying pressure
as all those investors who failed to buy at the lowest price would like to purchase the share. A
breach of these levels indicates a distinct departure from status quo, and an attempt to set
newer levels. Let us get a better understanding about these levels by using price data for
about two months for shares of companies A and B given in the following Table:
Date
A
B
Dec. 1, 2005
177
177
5
171
171.5
7
172
175.5
12
174
177
13
177.5
181
14
181
184
15
180
186.5
18
163
176
19
142
162.5
20
127
156
22
123
147
25
124
147
Jan. 3, 2006
107.5
137.5
4
97.5
140
8
105
145
10
102.5
143.75
12
108.75
150
15
100
142.5
25
95
135
26
91.25
133.75
Feb. 1
97.5
138.75
2
106.25
147.5
5
113.75
152.5
6
120
155
7
120
152.5
8
113.75
150
9
113.75
147.5
The line charts for Company A and Company B shares are shown in the graph below. From
the charts, it appears that the support level and resistance level for Company A at that time
were about ` 100 and ` 125, while these levels for Company B were ` 140 and ` 160.
6.17
3.1.4 Interpreting Price Patterns: There are numerous price patterns documented by
technical analysts but only a few and important of them have been discussed here:
(a) Channel: A series of uniformly changing tops and bottoms gives rise to a channel
formation. A downward sloping channel would indicate declining prices and an upward sloping
channel would imply rising prices.
(b) Wedge: A wedge is formed when the tops (resistance levels) and bottoms (support
levels) change in opposite direction (that is, if the tops, are decreasing then the bottoms are
increasing and vice versa), or when they are changing in the same direction at different rates
over time.
(c) Head and Shoulders: It is a distorted drawing of a human form, with a large lump (for
head) in the middle of two smaller humps (for shoulders). This is perhaps the single most
important pattern to indicate a reversal of price trend. The neckline of the pattern is formed by
joining points where the head and the shoulders meet. The price movement after the formation
of the second shoulder is crucial. If the price goes below the neckline, then a drop in price is
indicated, with the drop expected to be equal to the distance between the top of the head and
the neckline.
Security Analysis
6.18
(i)
Head and Shoulder Top Pattern: This has a left shoulder, a head and a right shoulder.
Such formation represents bearish development. If the price falls below the neck line
(line drawn tangentially to the left and right shoulders) a price decline is expected. Hence
its a signal to sell.
(ii)
Inverse Head and Shoulder Pattern: As the name indicates this formation, it is an inverse
of head and shoulder top formation. Hence it reflects a bullish development. The price
rise to above the neck line suggests price rise is imminent and a signal to purchase.
HEAD & SHOULDERS
INVERSE HEAD & SHOULDERS
(d) Triangle or Coil Formation: This formation represents a pattern of uncertainty and is
difficult to predict which way the price will break out.
(e) Flags and Pennants Form: This form signifies a phase after which the previous price
trend is likely to continue.
6.19
TRIANGLE OR COIL
FLAG & PENNANT
(f) Double Top Form: This form represents a bearish development, signals that price is
expected to fall.
(g) Double Bottom Form: This form represents bullish development signaling price is
expected to rise.
DOUBLE TOP
DOUBLE BOTTOM
(h) Gap: A gap is the difference between the opening price on a trading day and the closing
price of the previous trading day. The wider the gap the stronger the signal for a continuation
of the observed trend. On a rising market, if the opening price is considerably higher than the
previous closing price, it indicates that investors are willing to pay a much higher price to
acquire the scrip. Similarly, a gap in a falling market is an indicator of extreme selling
pressure.
Security Analysis
6.20
3.1.5 Decision Using Data Analysis: Technical analysts have developed rules based on
simple statistical analysis of price data. Moving Averages is one of the more popular methods
of data analysis for decision making.
Moving Averages: Moving averages are frequently plotted with prices to make buy and sell
decisions. The two types of moving averages used by chartists are the Arithmetic Moving
Average (AMA) and the Exponential Moving Average (EMA). An n-period AMA, at period t, is
nothing but the simple average of the last n period prices.
AMAn,t = 1/n[Pt + Pt-1 + + Pt-(n-1)]

To identify trend, technical analysts use moving average analysis:
(i)
A 200 days moving average of daily prices or a 30 week moving of weekly price for
identifying a long term trend.
(ii)
A 60 days moving average of daily price to discern an intermediate term trend.
(iii) A 10 days moving average of daily price to detect a short term trend.
For example Moving Average is calculated by considering the most recent observation for
which the closing price of a stock on 10 successive trading days are taken into account for
the calculation of a 5 -day moving average of daily closing prices.
Trading day
Closing prices
1
2
3
4
5
6
7
8
9
10
25.00
26.00
25.50
24.50
26.00
26.00
26.50
26.50
26.00
27.00
Sum of 5 most
recent closing
price
127.00
128.00
128.50
129.50
131.00
132.00
Two-item
Centred Total
Moving Average
255.00
256.50
258.00
260.50
263.00
25.50
25.65
25.80
26.05
26.30
6.21
Buy and Sell Signals Provided by Moving Average Analysis

Buy Signal
Sell Signal
(a)
Stock price line rise through the (a) Stock price line falls through moving
moving average line when graph of
average line when graph of the
moving average line is flattering out.
the moving average line is flattering
out.
(b) Stock price line rises above moving
(b) Stock price line falls below moving
average line which is falling.
average line which is rising.
(c) Stock price line which is slow moving
average line rises but begins to fall
(c) Stock price line which is above
moving average line falls but begins
again before reaching the moving
to rise again before reaching the
average line.
moving average line
Exponential Moving Average: Unlike the AMA, which assigns equal weight of 1/n to each of
the n prices used for computing the average, the Exponential Moving Average (EMA) assigns
decreasing weights, with the highest weight being assigned to the latest price. The weights
decrease exponentially, according to a scheme specified by the exponential smoothing
constant, also known as the exponent, a.
EMAt
= aPt + (1-a)(EMAt-1)
Illustration 1
Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 200X were as
follows :
Days
1
2
3
4
5
6
7
8
9
10
11
12
Date
6
7
8
9
10
11
12
13
14
15
16
17
Day
THU
FRI
SAT
SUN
MON
TUE
WED
THU
FRI
SAT
SUN
MON
Sensex
14522
14925
No Trading
No Trading
15222
16000
16400
17000
No Trading
No Trading
No Trading
18000
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days simple
moving average of Sensex can be assumed as 15,000. The value of exponent for 30 days EMA is 0.062.
Give detailed analysis on the basis of your calculations.
Security Analysis
6.22
Solution
Date
1
Sensex
2
EMA for
Previous day
1-2
30.062
5
EMA
2+4
14522
15000
(478)
(29.636)
14970.364
14925
14970.364
(45.364)
(2.812)
14967.55
10
15222
14967.55
254.45
15.776
14983.32
11
16000
14983.32
1016.68
63.034
15046.354
12
16400
15046.354
1353.646
83.926
15130.28
13
17000
15130.28
1869.72
115.922
15246.203
17
18000
15246.203
2753.797
170.735
15416.938
Conclusion The market is bullish. The market is likely to remain bullish for short term to medium
term if other factors remain the same. On the basis of this indicator (EMA) the investors/brokers can
take long position.
3.1.6 Bollinger Bands: John Bollinger, a long-time technician of the markets developed the
technique of using moving averages with two trading bands, not unlike using envelopes on
either side of a moving average. Unlike using a percentage calculation from a normal moving
average, bollinger bands simply add and subtract a standard deviation calculation. Standard
deviation is a mathematical formula that measures volatility, showing how the stock price can
be spread around it's "true value". The technician can be relatively certain that almost all of
the price data needed will be found between the two bands.
Bollinger bands consist of a centreline and two price channels, one above the centreline and
one below. The centreline is an exponential moving average, and the price channels are
standard deviations of the stock the chartist is studying. The bands will expand and contract
as the price action of an issue becomes volatile (expansion) or becomes bound into a tight
trading pattern (contraction).
A stock may trade for long periods of time in a trend, albeit from time to time with some
volatility. To better see the trend, traders use moving averages to filter the price action. This
way, traders can gather important information regarding how the market is trading. For
example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow
fashion and criss-crossing above and below the moving average. To better monitor this
behavior, traders use price channels, which are designed to encompass the trading activity
around the trend.
We know that markets trade erratically on a daily basis even though they are still trading in an
uptrend or downtrend. We also know that technicians use moving averages with support
and resistance lines to anticipate the price action of a stock. Upper resistance and lower
support lines are first drawn and then extrapolated to form channels within which the trader
expects prices to be contained. Some traders draw straight lines connecting either tops or
bottoms of prices to identify the upper or lower price extremes, respectively, and then add
parallel lines to define the channel within which the prices should move. As long as prices do
6.23
not move out of this channel, the trader can be reasonably confident that prices are moving as
expected.
Traders know that when the stock price continually touches the upper bollinger band, the price
is thought to be overbought and conversely, when they continually touch the lower band, the
prices are thought to be oversold, and a buy signal would thus kick in.
When using Bollinger Bands, designate the upper and lower bands as price targets. If the
price deflects off the lower band and crosses above the 20-day average (which is the middle
line), the upper band comes to represent the upper price target. In a strong uptrend, prices
usually fluctuate between the upper band and the 20-day moving average. When that
happens, a crossing below the 20-day moving average warns of a trend reversal to the
downside.
Source: Tradestation
You can see in this chart of Nortel Networks from the start of 2001 that for the most part the
price action was touching the lower band and the stock price fell from the $40 level in the dead
of winter to its October position of $5.69. There were a couple of instances that saw the price
action cut through the centreline (mid- January and early April), but for many traders, this was
certainly not a buy signal as the trend had not been broken.
Security Analysis
6.24
Source: Tradestation
In the 2001 chart of Microsoft Corporation, you can see the trend reversed to an uptrend in the
early part of January, but look how slow it was in showing the trend change. Before the price
action crossed over the centerline, the stock price had moved from $40 to $47 and then on to
between $48 and $49 before some traders would have confirmation of this trend reversal.
3.1.7 Momentum Analysis: Momentum measures the speed of price change and provides a
leading indicator of changes in trend. The momentum line leads price action frequently enough
to signal a potential trend reversal in the market. Momentum indicators can warn of dormant
strength or weakness in the price well ahead of the turning point. At extreme positive values,
momentum implies an overbought position; at extreme negative values, an oversold position
3.1.7.1 Interpretation of Momentum Line: A strong trending market acts like a pendulum; the
move begins at a fast pace, with strong momentum. It gradually slows down, or loses
momentum, stops and reverses course.
6.25
The momentum line is always a step ahead of the price movement. It leads the advance or
decline in prices and levels off while the current price trend is still in effect. It then begins to
move in the opposite direction as prices begin to level off.
The 10 day momentum line fluctuates on an open scale around a zero line. When the latest
closing price is higher than that of 10 days ago, a positive value is plotted above the zero line.
If the latest close is lower than 10 days previous, a negative value is plotted.
Ten days or periods are usually used in calculating momentum, but any time period can be
employed. The shorter the time frame used the more sensitive momentum becomes to short
term fluctuations with more marked oscillations. Oscillator swings are smoother and more
stable when a longer number of days are used.
(a) Upward Momentum: When an up trending momentum line begins to flatten out it means
that the new gains being achieved by the latest closing prices are the same as the gains 10
days earlier. The rate of upward momentum has leveled off even though prices may still be
advancing. When the momentum line begins to drop further, below the zero line, the uptrend
in prices could still be in force, but the last price gains are less than those of 10 days ago. The
uptrend is losing momentum.
(b) Downward Momentum: When the momentum line moves below the zero line, the latest
close is now under the close of 10 days ago and a short term downtrend is in effect. As
momentum continues to drop farther below the zero line, the downtrend gains momentum. The
downtrend decelerates when the line begins to turn around If loss of momentum is
experienced in a market at the same time as selling resistance is met or when buying power is
temporarily exhausted, momentum and price peak simultaneously.
3.1.7.2 Signals: Momentum is a basic application of oscillator analysis, designated to
measure the rate of price change, not the actual price level. Three common signals are
generated by the momentum oscillator: zero line crossings, trend line violations and extreme
values.
(a) Zero-line Crossings: Although the long term price trend is still the overriding
consideration, a crossing above the zero line could be a buy signal if the price trend is up and
a crossing below the zero line, a sell signal, if the price trend is down.
(b) Trend line Violations: The trend lines on the momentum chart are broken sooner than
those on the price chart. The value of the momentum indicator is that it turns sooner than the
market itself, making it a leading indicator.
(c) Extreme Values: One of the benefits of oscillator analysis is being able to determine
when markets are in extreme areas. At extreme positive values, momentum implies an
overbought position; at extreme negative values, an oversold position.
The absence of a fixed upper and lower boundary presents a difficulty with the momentum
line. To help solve this problem look at the long term history of the momentum line and draw
horizontal lines along its upper and lower boundaries. Adjust these lines periodically,
especially after important trend changes.
Security Analysis
6.26
3.2 Evaluation of Technical Analysis: Technical Analysis has several supporters as well
several critics. The advocates of technical analysis offer the following interrelated argument in
their favour:
(a) Under influence of crowd psychology trend persist for some time. Tools of technical
analysis help in identifying these trends early and help in investment decision making.
(b) Shift in demand and supply are gradual rather then instantaneous. Technical analysis helps
in detecting this shift rather early and hence provides clues to future price movements.
(c) Fundamental information about a company is observed and assimilated by the market
over a period of time. Hence price movement tends to continue more or less in same
direction till the information is fully assimilated in the stock price.
Detractors of technical analysis believe that it is an useless exercise; their arguments are as
follows:
(a) Most technical analysts are not able to offer a convincing explanation for the tools
employed by them.
(b) Empirical evidence in support of random walk hypothesis cast its shadow over the useful
ness of technical analysis.
(c) By the time an up trend and down trend may have been signalled by technical analysis it
may already have taken place.
(d) Ultimately technical analysis must be self defeating proposition. With more and more
people employing it, the value of such analysis tends to decline.
In a nutshell, it may be concluded that in a rational, well ordered and efficient market,
technical analysis may not work very well. However with imperfection, inefficiency and
irrationalities that characterizes the real world market, technical analysis may be helpful. If
technical analysis is used in conjunction with fundamental analysis, it might be useful in
providing proper guidance to investment decision makers.
4. Bond Valuation
A bond or debenture is an instrument of debt issued by a business or government.
4.1
Some Basics of a Bond
(a) Par Value: Value stated on the face of the bond. It is the amount a firm borrows and
promises to repay at the time of maturity.
(b) Coupon Rate and Frequency of Payment: A bond carries a specific interest rate known
as the coupon rate. The interest payable to the bond holder is par value of the bond coupon
rate. If, the annual interest payable on a bond with a par value of ` 100 and a coupon rate of
13.5 percent is ` 13.50 (` 100 13.5 per cent). The frequency of payment of interest also
needs to be specified (e.g. payable annually, semi annually, quarterly or monthly)
(c) Maturity Period: Corporate bonds have a maturity period of 3 to 10 years, while
government bonds can have maturity periods extending up to 30 years.
6.27
(d) Redemption: Bullet i.e. one shot repayment of principal (it could be in installments as
well) at par (could be at some premium also)
4.2
Bond Valuation Model: The holder of a bond receives a fixed annual interest
payment for a certain number of years and a fixed principal repayment (equal to par value) at
the time of maturity. So the value of a bond is:
V=
(1+ k )
t =1
F
(1 + k d )n
V = I(PVIFA kd,n ) + F(PVIFkd,n )

Where,
V = value of the bond
I = annual interest payable on the bond, assuming annual interest payments
F = principal amount (par value) of the bond repayable at the time of maturity,
assuming bullet redemption at par.
n = maturity period of the bond.
Illustration 2
A ` 1,000 par value bond bearing a coupon rate of 14 per cent matures after 5 years, the required rate
of return on this bond is 13 per cent. Calculate the value of the bond.
Solution
The value of the bond is
V
= ` 140(PVIFAss13%, 5yrs) + ` 1,000(PVIF13%,5yrs)

= ` 140(3.517) + ` 1,000(0.543)
= ` 1,035.4
4.3 Bond Value Theorems: Some Basic Rules which should be remembered
with regard to Bonds are:
(a) When the required rate of return equals the coupon rate, the bond sells at par value.
(b) When the required rate of return exceeds the coupon rate, the bond sells at a discount.
The discount declines as maturity approaches.
(c) When the required rate of return is less than the coupon rate, the bond sells at a
premium. The premium declines as maturity approaches.
(d) The longer the maturity of a bond, the greater is its price change with a given change in
the required rate of return.
4.4
Yield to Maturity: If the market price of a ` 1,000 par value bond, carrying a coupon
rate of 9 per cent and maturing after 8 years with a bullet redemption at par, is ` 800. What
Security Analysis
6.28
would be the rate of return, if one buys the bond and holds it till its maturity? The rate of return
one earns is called the Yield to Maturity (YTM). The YTM is defined as that value of the
discount rate (kd) for which the the Intrinsic Value of the Bond equals its Market Price (Note
the similarity between YTM of a Bond and IRR of a Project). If we ignore the issue related
expenses, kd equals the relevant cost of (debt) capital for the company.
= ` 90(PVIFA kd, 8yrs ) + ` 1,000(PVIFkd, 8yrs )
To find the value of kd, several values of kd are considered till the right value is obtained. With
a discount rate of 12 percent and putting a value of 12 per cent for kd the right-hand side
becomes
` 90 (PVIFA12%, 8yrs) + ` 1,000 (PVIF12%, 8yrs) = ` 90 (4.968) + ` 1,000(0.404) = ` 851.00
Since this value is greater than ` 800 a higher value for kd is opted. Let kd = 14 per cent so that
` 90(PVIFA14%,yrs)+ ` 1,000 (PVIF14%,8yrs) = ` 90(4.639) + ` 1,000(0.351) = ` 768.10
Since this value is less than ` 800 a lower value for kd is used. Let us try kd = 13 per cent.
` 90(PVIFA13%,8yrs) + ` 1,000 (PVIF13%,8yrs) = ` 90 (4.800)+ ` 1,000(0.376) = ` 808
Thus kd lies between 13 per cent and 14 per cent. Using linear interpolation in the range of 13
percent to 14 percent, kd is equal to 13.2 per cent
13% + (14% 13%)
808 800
= 13.2%
808 768.1
Illustration 3
If the price per bond is ` 90 and the bond has a par value of ` 100, a coupon rate of 14 per cent, and
a maturity period of 6 years, calculate its yield to maturity.
Solution
6 ` 14
` 100
= ` 14(PVIFA kd, 6yrs ) + ` 100(PVIFkd, 6yrs )
` 90 =
+
t =1 (1 + k )6 (1 + k )6
d
d
To find the value of kd, several values of kd are considered till the right value is obtained. With a
discount rate of 14 percent and putting a value of 14 per cent for kd the right-hand side becomes ` 14
(PVIFA14%, 6yrs) + ` 100 (PVIF14%, 6yrs) = ` 14 (3.889) + ` 100(0.456) = ` 100.046
Since this value is greater than ` 90 a higher value for kd is opted. Let kd = 17 per cent so that
` 14(PVIFA17%,6yrs)+ ` 100 (PVIF17%,6yrs) = ` 14(3.589) + ` 100(0.390) = ` 89.246
Thus kd lies between 14 per cent and 17 per cent. Using linear interpolation in the range of 14 percent
to 17 percent, kd is equal to 16.79 per cent
14% + (17% 14%)
100.046 90
100.046 89.246
6.29
4.5
Bond Values with Semi-Annual Interest: Bonds pay interest semi-annually. This
requires the bond valuation equation to be modified as follows:

(a) The annual interest payment, I, divided by two to obtain the semi-annual interest
payment.
(b) The number of years to maturity is multiplied by two to get the number of half-yearly
periods.
(c) The discount rate divided by two to get the discount rate applicable to half-yearly periods.
The basic bond valuation equation thus becomes:
V=
2n
[(I/2) / {(1+kd/2) }] + [F / (1+kd/2)

t
2n]
t=1
= I/2(PVIFAkd/2,2n) + F(PVIFkd/2,2n)
Where,
V
= Value of the bond
I/2
= Semi-annual interest payment
Kd/2
= Discount rate applicable to a half-year period
= Par value of the bond repayable at maturity
2n
= Maturity period expressed in terms of half-yearly periods.
Illustration 4
If a ` 100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8 years and
interest payable semi-annually then the value of the bond with required rate of return of 14 per cent will
be what?
Solution
V=
16
{6 / (1.07) } + {100 / (1.07)

t
16 }
t =1
= 6(PVIFA7%, 16yrs) + 100(PVIF7%, 16yrs)

= ` 6(9.447) + ` 100(0.339)= ` 90.58
4.6
Price-Yield Relationship: One of the property of a bond is that its price (value)
varies inversely with its yield because as the required yield increases, the present value of the
cash flow decreases; hence the price decreases. On the other hand, when the required yield
decreases, the present value of the cash flow increases; hence the price increases. The
price-yield relationship for any callable bond is shown in the following diagram.
Security Analysis
6.30
Price Yield Relationship
4.7 Relationship between Bond Price and Time: Since the price of a bond must
equal its par value at maturity (assuming that there is no risk of default), bond prices change
with time. For example, a bond that is redeemable for ` 1000 (which is its par value) after five
years when it matures, will have a price of ` 1,000 at maturity, no matter what the current
price is. If its current price is ` 1,100, it is said to be a premium bond. If the required yield
does not change between now and the maturity date, the premium will decline over time as
shown by curve A in the following diagram. On the other hand, if the bond has a current price
of ` 900, it is said to be a discount bond. The discount too will disappear over time as shown
by curve B in the same diagram. Only when the current price is equal to par value in such a
case only the bond is said to be a par bond there is no change in price as time passes,
assuming that the required yield does not change between now and the maturity date. This is
reflected by the dashed line in the diagram.
Price Changes with Time
6.31
4.8
The Yield Curve: The term structure of interest rates, popularly known as Yield
Curve, shows how yield to maturity is related to term to maturity for bonds that are similar in
all respects, except maturity.
Consider the following data for Government securities:
Face Value
Interest Rate
Maturity (years)
Current Price
Yield to Maturity
10,000
0
1
8,897
12.40
10,000
12.75
2
9,937
13.13
10,000
13.50
3
10,035
13.35
10,000
13.50
4
9,971
13.60
10,000
13.75
5
9,948
13.90
The yield curve for the above bonds is shown in the diagram. It slopes upwards indicating that
long-term rates are greater than short-term rates.
Yield curves, however, do not have to necessarily slope upwards. They may follow any
pattern. Four patterns are depicted in the given diagram:
Types of Yield Curve
Security Analysis
6.32
Another perspective on the term structure of interest rates is provided by the forward interest
rates, viz., the interest rates applicable to bonds in the future.
To get forward interest rates, begin with the one-year Treasury bill:
8,897 = 10,000 / (1 + r1)
Where,
r1 is the one-year spot rate i.e. the discount rate applicable to a risk less cash flow
receivable a year hence.
Solving for r1, we get r1 = 0.124.

Next, consider the two-year government security and split its benefits into two parts, the
interest of ` 1,275 receivable at the end of year 1 and ` 11,275 (representing the interest and
principal repayment) receivable at the end of year 2. The present value of the first part is:
1,275 1,275
=
=1,134
(1+r ) 1.124
1
To get the present value of the second years cash flow of ` 11,275, discount it twice at r1 (the
discount rate for year 1) and r2 (the discount rate for year 2)
11,275
11,275
=
(1+r )(1+r ) 1.124(1+r )
1
r2 is called the forward rate for year two, i.e., the current estimate of the next years one-year
spot interest rate. Since r1, the market price of the bond, and the cash flow associated with the
bond are known the following equation can be set up:
9,937 =
1,275
11,275
+
(1.124) (1.124)(I + r2 )
9,937(1.124)(1 + r2) = 1,275 (1 + r2) + 11,275

11,169 + 11,169 r2 = 1,275 + 1,275 r2 + 11,275
11,169 r2 1,275 r2 = 11,275 11,169 + 1,275
9,894 r2 = 1,381
r2 =
1,381
= 0.1396
9,894
Thus solving this equation we get r2 = 0.1396

To get the forward rate for year 3(r3), set up the equation for the value of the three year bond:
6.33
10,035 =
1,350
1,350
11,350
+
+
(1 + r1 ) (1 + r1 )(1 + r2 ) (1 + r1 )(1 + r2 )(1 + r3 )
10,035 =
1,350
1,350
11,350
+
+
(1.124) (1.124)(1.140) (1.124)(1.140)(1+ r3 )
10,035 =
1,350 1,350
11,350
+
+
1.124 1.28136 1.28136(1 + r3 )
10,035 = 1,201 + 1,054 +

7780=
11,350
1.28136(1+ r3 )
11,350
1.28136(1+r )
3
1 + r3 = 1.13839
r3 = 0.13839
Solving this equation we get r3=0.13839. This is the forward rate for year three. Continuing in
a similar fashion, set up the equation for the value of the four-year bond:
9,971 =
1,350
1,350
1,350
11,350
+
+
+
(1 + r1 ) (1 + r1 )(1 + r2 ) (1 + r1 )(1 + r2 )(1 + r3 ) (1 + r1 )(1 + r2 )(1 + r3 )(1 + r4 )
Solving this equation we get r4 = 0.1458. The following diagram plots the one-year spot rate
and forward rates r2, r3, r4. It can be noticed that while the current spot rate and forward rates
are known, the future spot rates are not known they will be revealed as the future unfolds.
Security Analysis
6.34
Thus on the basis of above it can be said that though YTM and Forward Rates are two distinct
measures but used equivalent way of evaluating a riskless cash flows.
Discount at the yield to maturity : (R t ) PV [CF(t)] =
CF( t)
(1+ R t ) t
Discount by the product of a spot rate plus the forward rates

PV [CF(t)] =
CF( t)
(1+ r1 )(1+ r2 )...(1+ rt )
4.9 Duration of Bond: The concept of duration is straightforward. It measures how quickly
a bond will repay its true cost. The longer the time it takes the greater exposure the bond has
to changes in the interest rate environment. It is an important tool in structuring and managing
a fixed income securities. Following are some of factors that affect bond's duration:
(1) Time to maturity: Consider two bonds that each cost ` 1,000 and yield 7%. A bond that
matures in one year would more quickly repay its true cost than a bond that matures in
10 years. As a result, the shorter-maturity bond would have a lower duration and less
price risk. The longer the maturity, the higher the duration.
(2) Coupon rate: Coupon payment is a key factor in calculation of duration of bonds. If two
identical bonds pay different coupons, the bond with the higher coupon will pay back its
original cost quicker than the lower-yielding bond. The higher the coupon, the lower is the
duration.
Duration can also be used to measure risk of investment in bonds. Although there are many
formulae to calculate the duration. However, following are commonly used methods:
(a) Macaulay Duration: This method was developed by Frederic Macaulay. This formula
measures the number of years required to recover the true cost of a bond, considering the
present value of all coupon and principal payments received in the future. Macaulay duration
is calculated by adding the results of multiplying the present value of each cash flow by the
time it is received and dividing by the total price of the security. The formula for Macaulay
duration is as follows:
n
Macaulay Duration =
t*C
(1 + i)
t 1
n* M
(1 + i)n
Where
n = Number of cash flows
t = Time to maturity
C = Cash flows
6.35
i = Required yield (YTM)

M = Maturity (par) value
P = Bond price
This is only the duration which is calculated in years.
(b) Short Cut Method: The duration can also be calculated if figure of Coupon Yield (c),
YTM (y) and Time to Maturity (t) is given the duration shall be calculated as follows:
=
1 + y (1 + y) + t(c - y)
y c [ ( 1 + y) t - 1] + y
(c) Modified Duration: This is a modified version of Macaulay duration which takes into
account the interest rate changes because the changes in interest rates affect duration as the
yield gets affected each time the interest rate varies. In other words it indicates the volatility of
Bond Value consequent upon the change in interest rate.
Normally in coupon bonds, the interest rates and bond price move in opposite directions. This
duration is well suited to measure a particular bonds volatility. There is an inverse relationship
between modified duration and an approximate 1% (100 basis points) change in yield.
The formula for modified duration is as follows:
Macaulay Duration
Modified Duration =
YTM
1+
Where
n = Number of compounding periods per year
YTM = Yield to Maturity
Illustration 5
The following data are available for a bond
Face value
Coupon Rate
Years to Maturity
Redemption value
Yield to maturity
Calculate the duration and volatility of this bond?
Solution
To calculate the duration first the we shall calculate Market price of bond as follows:
160 (PVIFA 17%,6) + 1,000 (PVIF 17%,6)
`1,000
16%
6
` 1,000
17%
Security Analysis
6.36
= 160 (3.589) + 1,000 (0.390)

= 574.24 + 390
= 964.24
1.
Duration
Year
Cash flow
P.V. @ 17%
Proportion of
bond value
Proportion of bond
value x time (years)
160
0.855
160
0.731
136.80
0.142
0.142
116.96
0.121
0.242
160
0.624
99.84
0.103
0.309
160
0.534
85.44
0.089
0.356
160
0.456
72.96
0.076
0.38
1160
0.390
452.40
0.469
2.814
964.40
1.000
4.243
Duration of the Bond is 4.243 years

2.
Volatility
Volatility of the bonds =
Duration
(1 + YTM)
4.243
1.17
= 3.63%
Summary
1. Introduction
Security Analysis involves a systematic analysis of the risk return profiles of various securities.
Two approaches viz. fundamental analysis and technical analysis are in vogue while making
investment decisions.
2. Fundamental Analysis
Based on the assumption that the share prices depend upon the future dividends
expected by the shareholders.
The present value of the future dividends can be calculated by discounting the cash flows
at an appropriate discount rate and is known as the 'intrinsic value of the share'.
The intrinsic value or price of share is calculated as follows:

P(0) =
D(0)(1 + g)
(k g)
The above result is also known as Gordons dividend growth model for stock valuation.
This is one of the most well known models in the genre of fundamental analysis.
A share that is priced below the intrinsic value must be bought, while a share quoting
above the intrinsic value must be sold.
6.37
2.1 Dividend Growth Model and PE Multiple
Relating share price to earnings via the PE(Price Earning Ratio) multiples
Use of the Dividend Grrowth Model or some of its variations like in terms of earning (as
shown below) for estimating the fundamental or intrinsic share price:
P(0) =
bE(1)
bE(0) (1 + g)
Or P(0) =
(k g)
(k g)
Where,
E(1) = EPS at the end of first period
b = Dividend Payout Ratio
Here, D(1) may be expressed as b E(1), where E(1) is the earning per share (EPS) at the
end of the first period and b is dividend payout ratio.
2.2 Economic Analysis
This analysis deals with the macro-economic factors such as historical performance of
economy, growth of different sectors, trends in peoples income etc.
the
2.2.1 Factors Affecting Economic Analysis
Some of the economy wide factors are:

(a) Growth Rates of National Income and Related Measures
(b) Growth Rates of Industrial Sector
(c) Inflation
(d) Monsoon
2.2.2 Techniques Used in Economic Analysis
(a) Anticipatory Surveys
Help investors to form an opinion about the future state of the economy.
Incorporates expert opinion on activities having a definite bearing on economic

activities.
(b) Barometer/Indicator Approach: Various indicators used to find out future economic
performance classified as under:
(i)
Leading Indicators: They relate to the time series data of the variables that reach
high/low points in advance of economic activity.
(ii)
Roughly Coincidental Indicators: They reach their peaks and troughs at

approximately the same in the economy.
(iii) Lagging Indicators: They are time series data of variables that lag behind in their
consequences vis-a- vis the economy.
Security Analysis
6.38
between dependent and independent variables is determined. The steps in this analysis
are pointed as under:
(i)
Hypothesizing total economic demand by measuring GNP
(ii)
Forecasting the GNPs individual components
(iii) After forecasting, add them up to obtain the forecasted GNP.

(iv) Comparison of obtained total GNP with that from an independent agency
(v) Testing of overall forecast.for consistency.
2.3 Industry Analysis
This analysis is necessary to examine industry specific factors, in addition to economy-wide

factors.
2.3.1 Factors Affecting Industry Analysis: The following factors may particularly be kept in
mind while performing industry analysis:
(a) Product Life-Cycle

(b) Demand Supply Gap
(c) Barriers to Entry
(d) Government Attitude
(e) State of Competition in the Industry
(f)
Cost Conditions and Profitability
(g) Technology and Research

2.3.2 Techniques Used in Industry Analysis
The techniques used for analyzing the industry wide factors are:
(a) Regression Analysis:
Diagnosing the factors determining industry output demand through product

demand analysis.
For identifying factors affecting demand, regression analysis and correlation are
used.
(b) Input Output Analysis:
Reflects the flow of goods and services through the economy.
Carried out to detect changing patterns/trends indicating growth/decline of

industries.
2.4 Company Analysis: This analysis requires careful examination of the company's
quantitative and qualitative fundamentals.
(a) Net Worth and Book Value
6.39
(b) Sources and Uses of Funds

(c) Cross-Sectional and Time Series Analysis.
(d) Size and Ranking:
(e) Growth Record
(f)
Financial Analysis
(g) Quality of Management

(h) Location and Labour-Management Relations
(i)
Pattern of Existing Stock Holding
(j)
Marketability of the Shares
Techniques Used in Company Analysis
The statistical techniques for company analysis are discussed as under:

(a) Correlation & Regression Analysis: Simple regression is used when inter relationship
covers two variables. For more than two variables, multiple regression analysis is followed.
(b) Trend Analysis: The relationship of one variable is tested over time using regression
analysis. It gives an insight to the historical behavior of the variable.
(c) Decision Tree Analysis: In this analysis, the decision is taken sequentially with
probabilities attached to each sequence.
3.
Technical Analysis
The two basic questions that technical analyst seeks to answer are: (i) Is there a discernible
trend in the prices? (ii) If there is, then are there indications that the trend would reverse? The
methods used to answer these questions are visual and statistical.
Technical analysts use three types of charts for analyzing data. They are:
(i) Bar Chart: In a bar chart, a vertical line (bar) represents the lowest to the highest price,
with a short horizontal line protruding from the bar representing the closing price for the
period.
closing price for each period is plotted as a point. These points are joined by a line to form the
chart.
charts. They are used to detect reversals in a trend.
3.1 General Principles and Methods of Technical Analysis
3.1.1 The Dow Theory
Oldest and the most famous technical theories.
Helpful tool for determining the relative strength of the stock market.
Security Analysis
6.40
Based upon the movements of two indices, constructed by Charles Dow, Dow Jones
Industrial Average (DJIA) and Dow Jones Transportation Average (DJTA).
The above averages reflect the aggregate impact of all kinds of information on the
market.
The movements of the market are divided into three classifications:
The primary movement,
The secondary movement
The daily fluctuations.
The primary movement is the main trend of the market, which lasts from one year to 36
months or longer. This trend is commonly called bear or bull market.
The secondary movement of the market is shorter in duration than the primary
movement, and is opposite in direction. It lasts from two weeks to a month or more.
The daily fluctuations are the narrow movements from day-to-day. These fluctuations are
not part of the Dow Theory interpretation of the stock market. However, daily movements
must be carefully studied, along with primary and secondary movements, as they go to
make up the longer movement in the market.
3.1.2 Market Indicators

(i)
Breadth Index: An index covering all securities traded.
(ii) Volume of Transactions: Provides useful clues on future market behaviour.

(iii) Confidence Index: Reveals investors willingness to take chance in the market.
(iv) Relative Strength Analysis: Suggests some securities exhibit relative strength.
(v) Odd - Lot Theory: Used primarily to predict tops in bull markets, but also to predict
reversals in individual securities.
3.1.3 Support and Resistance Levels
When the index/price goes down from a peak, the peak becomes the resistance level.
When the index/price rebounds after reaching a trough subsequently, the lowest value
reached becomes the support level.
The price is then expected to move between these two levels.
Whenever the price approaches the resistance level, there is a selling pressure because
all investors who failed to sell at the high would be keen to liquidate.
whenever the price approaches the support level, there is a buying pressure as all those
investors who failed to buy at the lowest price would like to purchase the share.
3.1.4 Interpreting Price Patterns
There are numerous price patterns documented by technical analysts but only a few and
important of them have been discussed here:
6.41
(a) Channel: series of uniformly changing tops and bottoms gives rise to a channel formation.
(b) Wedge: It is Formed when the tops (resistance levels) and bottoms (support levels)
change in opposite direction or when they change in the same direction at different rates over
time.
(c) Head and Shoulders: It is a distorted drawing of a human form, with a large lump (for
head) in the middle of two smaller humps (for shoulders).
(i)
Head and Shoulder Top Pattern: Such formation represents bearish development.
(ii)
Inverse Head and Shoulder Pattern: It reflects a bullish development.
(d) Triangle or Coil Formation: It represents a pattern of uncertainty and is difficult to

predict which way the price will break out.
(e) Flags and Pennants Form: This form signifies a phase after which the previous price
trend is likely to continue.
(f) Double Top Form: This form represents a bearish development, signals that price is
expected to fall.
expected to rise.
(h) Gap: A gap is the difference between the opening price on a trading day and the closing
price of the previous trading day.
3.1.5 Decision Using Data Analysis
Moving Averages is one of the more popular methods of data analysis for decision
making.
The two types of moving averages used by chartists are the Arithmetic Moving Average
(AMA) and the Exponential Moving Average (EMA).
An n-period AMA, at period t, is nothing but the simple average of the last n period
prices.
AMAn,t = 1/n[Pt + Pt-1 + + Pt-(n-1)]
Unlikely the AMA, which assigns equal weight of 1/n to each of the n prices used for
computing the average, the Exponential Moving Average (EMA) assigns decreasing weights
specified by the exponential smoothing constant, also known as the exponent, a.
EMAt = aPt + (1-a)(EMAt-1)
3.1.6 Bollinger Bands
Bollinger bands consist of a centreline and two price channels, one above the centreline
and one below.
The centreline is an exponential moving average, and the price channels are standard
deviations of the stock the chartist is studying.
Security Analysis
6.42
The bands will expand and contract as the price action of an issue becomes volatile
(expansion) or becomes bound into a tight trading pattern (contraction).
3.1.7 Momentum Analysis
Momentum measures the speed of price change and provides a leading indicator of
changes in trend.
The momentum line leads price action frequently enough to signal a potential trend
reversal in the market.
Momentum indicators can warn of dormant strength or weakness in the price well ahead
of the turning point.
At extreme positive values, momentum implies an overbought position; at extreme

negative values, an oversold position.
(a) Interpretation of Momentum Line: A strongly trending market acts like a pendulum; the
move begins at a fast pace, with strong momentum. It gradually slows down, or loses
momentum, stops and reverses course.
(b) Signals: Momentum is a basic application of oscillator analysis, designated to measure
the rate of price change, not the actual price level. Three common signals are as follows:
(i)
Zero-line Crossings
(ii)
Trend line Violations
(iii) Extreme Values

3.2 Evaluation of Technical Analysis
The advocates of technical analysis offer the following interrelated argument in their favour:
(a) Under influence of crowd psychology trend persist for some time.
(b) Shift in demand and supply are gradual rather then instantaneous.
(c) Fundamental information about a company is observed and assimilated by the market
over a period of time.
Detractors of technical analysis present their arguments are as follows:
(a) Most technical analysts unable to offer a convincing explanation for their tools employed
(b) Empirical evidence in support of random walk hypothesis cast its shadow over the useful
ness of technical analysis.
(c) Up trend and down trend signalled by technical analysis may already have taken place.
(d) Technical analysis must be self defeating proposition.
If technical analysis is used in conjunction with fundamental analysis, it might be useful in
providing proper guidance to investment decision makers.
6.43
4.

Bond Valuation
4.1 Some Basics of a Bond

(a) Par Value: Value stated on the face of the bond. of maturity.
(b) Coupon Rate and Frequency of Payment: A bond carries a specific interest rate known
as the coupon rate.
(c) Maturity Period: Total time till maturity.
(d) Redemption: Bullet i.e. one shot repayment of principal at par or premium.
4.2 Bond Valuation Model
The value of a bond is:

V=
(1 + k )
t =1
F
(1 + kd ) n
V = I ( PVIFAkd ,n ) + F ( PVIFkd ,n )
Where,
V = value of the bond
I = annual interest payable on the bond
F = principal amount (par value) of the bond repayable at the time of maturity
N = maturity period of the bond.
4.3 Bond Value Theorems
Some basic rules which should be remembered with regard to bonds are:
CAUSE
EFFECT
Required rate of return = coupon rate
Bond sells at par value
Required rate of return > coupon rate
Bond sells at a discount
Required rate of return < coupon rate
Bond sells at a premium
Longer the maturity of a bond
Greater the bond price change with a given

change in the required rate of return.
4.4 Yield to Maturity (YTM)
The YTM is defined as that value of the discount rate (k d) for which the Intrinsic Value of the
Bond equals its Market Price.
4.5 Bond Values with Semi-Annual Interest
The basic bond valuation equation thus becomes:

V = 2nt=1 [(I/2) / {(1+kd/2)t}] + [F / (1+kd/2)2n]
Security Analysis
6.44
Where,
V
= Value of the bond
I/2
Kd/2 = Discount rate applicable to a half-year period

F
2n
4.6 Price Yield Relationship
A basic property of a bond is that its price varies inversely with yield.
The reason is simple. As the required yield increases, the present value of the cash flow
decreases; hence the price decreases and vice versa.
4.7 Relationship between Bond Price and Time
Since the price of a bond must equal its par value at maturity (assuming that there is no risk of
default), bond prices change with time.
4.8 The Yield Curve
The term structure of interest rates, popularly known as Yield Curve, shows how yield to
maturity is related to term to maturity for bonds that are similar in all respects, except maturity.
4.9 Duration of Bond
The concept of duration is straightforward. It measures how quickly a bond will repay its true
cost. The longer the time it takes the greater exposure the bond has to changes in the interest
rate environment. Following are some of factors that affect bond's duration:
(i)
Time to maturity: The shorter-maturity bond would have a lower duration and less price
risk and vice versa.
(ii) Coupon rate: Coupon payment is a key factor in calculation of duration of bonds.The
higher the coupon, the lower is the duration and vice versa.
Although there are many formulae to calculate the duration. However, following are commonly
used methods:
(a) Macaulay Duration: This formula measures the number of years required to recover the
true cost of a bond, considering the present value of all coupon and principal payments
received in the future. The formula for Macaulay duration is as follows:
n
Macaulay Duration =
t*c
n* M
(1 i) + (1 + i)
t =1
Where,
6.45
C = Cash flows
i = Required yield
P = Bond price
(b) Short Cut Method: The duration can also be calculated if figure of Coupon Yield (c),
YTM (y) and Time to Maturity (t) is given the duration shall be calculated as follows:
1 + y (1 + y) + t(c - y)
y c [ ( 1 + y) t - 1] + y
(c) Modified Duration: This is a modified version of Macaulay duration which takes into
account the interest rate changes because the changes in interest rates affect duration as the
yield gets affected each time the interest rate varies.
The formula for modified duration is as follows:
Macaulay Duration
Modified Duration =
YTM
1 +
Where
n = Number of compounding periods per year
YTM= Yield to Maturity
6
Security Analysis
BASIC CONCEPTS AND FORMULAE
1.
Introduction: Security Analysis stands for the proposition that a well-disciplined investor
can determine a rough value for a company from all of its financial statements, make
purchases when the market inevitably under-prices some of them, earn a satisfactory
return, and never be in real danger of permanent loss.
2.
Approaches of Security Analysis: There are basically two main approaches of security
analysis- Fundamental analysis and Technical analysis.
3.
Fundamental Analysis: Fundamental analysis is based on the assumption that the

share prices depend upon the future dividends expected by the shareholders. The
present value of the future dividends can be calculated by discounting the cash flows at
an appropriate discount rate and is known as the 'intrinsic value of the share'. The
intrinsic value of a share, according to a fundamental analyst, depicts the true value of a
share. A share that is priced below the intrinsic value must be bought, while a share
quoted above the intrinsic value must be sold.
4.
Models of Fundamental Analysis

(a) Dividend Growth Model
P(0) =
D( 0 )( 1 + g )
(k g )
Where,
P(0) = Price of Share
D(0) = Current Dividend
g = Growth Rate
k = Cost of Equity
(b) Dividend Growth Model and the PE Multiple
P(0) =
bE ( 0 ) (1 + g)
(k g )
6.2
Where,
b
= Dividend Pay-out fraction or ratio
E(0) = Current EPS

5.
Types of Fundamental Analysis: There are three types of fundamental analysisEconomic analysis, Industry analysis and Company analysis.
6.
Economic Analysis: Macro- economic factors e. g. historical performance of the

economy in the past/ present and expectations in future, growth of different sectors of the
economy in future with signs of stagnation/degradation at present to be assessed while
analyzing the overall economy. Trends in peoples income and expenditure reflect the
growth of a particular industry/company in future. Consumption affects corporate profits,
dividends and share prices in the market.
7.
Factors Affecting Economic Analysis: Some of the economy wide factors are as
under:
(a) Growth Rates of National Income and Related Measures

(b) Growth Rates of Industrial Sector
(c) Inflation
(d) Monsoon
8.
Techniques Used For Economic Analysis

(i)
Anticipatory Surveys: They help investors to form an opinion about the future
state of the economy.
(ii) Barometer/Indicator Approach: Various indicators are used to find out how the
economy shall perform in the future.
(iii) Economic Model Building Approach: In this approach, a precise and clear
relationship between dependent and independent variables is determined.
9.
Industry Analysis: An assessment regarding all the conditions and factors relating to
demand of the particular product, cost structure of the industry and other economic and
government constraints have to be done.
10. Factors Affecting Industry Analysis: The following factors may particularly be kept in
mind while assessing the factors relating to an industry :
(a) Product Life-Cycle;

(b) Demand Supply Gap;
(c) Barriers to Entry;
(d) Government Attitude;
Security Analysis
6.3
(e) State of Competition in the Industry;

(f)
Cost Conditions and Profitability and
(g) Technology and Research.

11. Techniques Used For Industry Analysis
(a) Regression Analysis: Investor diagnoses the factors determining the demand for
output of the industry through product demand analysis.
(b) Input Output Analysis: It reflects the flow of goods and services through the
economy, intermediate steps in production process as goods proceed from raw
material stage through final consumption.
12. Company Analysis: Economic and industry framework provides the investor with proper
background against which shares of a particular company are purchased. This requires
careful examination of the company's quantitative and qualitative fundamentals.
13. Techniques Used in Company Analysis
(a) Correlation & Regression Analysis: Simple regression is used when inter
relationship covers two variables. For more than two variables, multiple regression
analysis is followed.
(b) Trend Analysis: The relationship of one variable is tested over time using
regression analysis. It gives an insight to the historical behavior of the variable.
(c) Decision Tree Analysis: In decision tree analysis, the decision is taken
sequentially with probabilities attached to each sequence. To obtain the probability
of final outcome, various sequential decisions are given along with probabilities,
then probabilities of each sequence is to be multiplied and then summed up.
14. Technical Analysis: Technical analysis is a method of share price movements based on
a study of price graphs or charts on the assumption that share price trends are repetitive,
that since investor psychology follows a certain pattern, what is seen to have happened
before is likely to be repeated.
15. Types of Charts
(i)
Bar Chart : In a bar chart, a vertical line (bar) represents the lowest to the highest
price, with a short horizontal line protruding from the bar representing the closing
price for the period.
closing price for each period is plotted as a point. These points are joined by a line
to form the chart. The period may be a day, a week or a month.
charts. They are used to detect reversals in a trend.
6.4
16. General Principles and Methods of Technical Analysis: Certain principles underlying
the technical analysis need to be understood and correlated with the tools and
techniques of technical analysis. Interpreting any one method in isolation would not result
in depicting the correct picture of the market.
17. The Dow Theory: The Dow Theory is based upon the movements of two indices,
constructed by Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA). These averages reflect the aggregate impact of all kinds
of information on the market. The movements of the market are divided into three
classifications, all going at the same time; the primary movement, the secondary
movement, and the daily fluctuations. The primary movement is the main trend of the
market, which lasts from one year to 36 months or longer. This trend is commonly called
bear or bull market. The secondary movement of the market is shorter in duration than
the primary movement, and is opposite in direction. It lasts from two weeks to a month or
more. The daily fluctuations are the narrow movements from day-to-day.
18. Market Indicators
(i)
Breadth Index: It is an index that covers all securities traded. It is computed by

dividing the net advances or declines in the market by the number of issues traded.
The breadth index either supports or contradicts the movement of the Dow Jones
Averages. If it supports the movement of the Dow Jones Averages, this is
considered sign of technical strength and if it does not support the averages, it is a
sign of technical weakness i.e. a sign that the market will move in a direction
opposite to the Dow Jones Averages.
(ii) Volume of Transactions: The volume of shares traded in the market provides
useful clues on how the market would behave in the near future. A rising index/price
with increasing volume would signal buy behaviour because the situation reflects an
unsatisfied demand in the market. Similarly, a falling market with increasing volume
signals a bear market and the prices would be expected to fall further. A rising
market with decreasing volume indicates a bull market while a falling market with
dwindling volume indicates a bear market. Thus, the volume concept is best used
with another market indicator, such as the Dow Theory.
(iii) Confidence Index: It is supposed to reveal how willing the investors are to take a
chance in the market. It is the ratio of high-grade bond yields to low-grade bond
yields. It is used by market analysts as a method of trading or timing the purchase
and sale of stock, and also, as a forecasting device to determine the turning points
of the market. A rising confidence index is expected to precede a rising stock
market, and a fall in the index is expected to precede a drop in stock prices. A fall in
the confidence index represents the fact that low-grade bond yields are rising faster
or falling more slowly than high grade yields. The confidence index is usually, but
not always a leading indicator of the market. Therefore, it should be used in
conjunction with other market indicators.
Security Analysis
6.5
(iv) Relative Strength Analysis: The relative strength concept suggests that the prices
of some securities rise relatively faster in a bull market or decline more slowly in a
bear market than other securities i.e. some securities exhibit relative strength.
Investors will earn higher returns by investing in securities which have
demonstrated relative strength in the past because the relative strength of a security
tends to remain undiminished over time.
Relative strength can be measured in several ways. Calculating rates of return and
classifying those securities with historically high average returns as securities with
high relative strength is one of them. Even ratios like security relative to its industry
and security relative to the entire market can also be used to detect relative strength
in a security or an industry.
(v) Odd - Lot Theory: This theory is a contrary - opinion theory. It assumes that the
average person is usually wrong and that a wise course of action is to pursue
strategies contrary to popular opinion. The odd-lot theory is used primarily to predict
tops in bull markets, but also to predict reversals in individual securities.
19. Support and Resistance Levels: When the index/price goes down from a peak, the
peak becomes the resistance level. When the index/price rebounds after reaching a
trough subsequently, the lowest value reached becomes the support level. The price is
then expected to move between these two levels. Whenever the price approaches the
resistance level, there is a selling pressure because all investors who failed to sell at the
high would be keen to liquidate, while whenever the price approaches the support level,
there is a buying pressure as all those investors who failed to buy at the lowest price
would like to purchase the share. A breach of these levels indicates a distinct departure
from status quo, and an attempt to set newer levels.
20. Interpreting Price Patterns
(a) Channel: A series of uniformly changing tops and bottoms gives rise to a channel
formation. A downward sloping channel would indicate declining prices and an
upward sloping channel would imply rising prices.
(b) Wedge: A wedge is formed when the tops (resistance levels) and bottoms (support
levels) change in opposite direction (that is, if the tops, are decreasing then the
bottoms are increasing and vice versa), or when they are changing in the same
direction at different rates over time.
(c) Head and Shoulders: It is a distorted drawing of a human form, with a large lump
(for head) in the middle of two smaller humps (for shoulders). This is perhaps the
single most important pattern to indicate a reversal of price trend. The neckline of
the pattern is formed by joining points where the head and the shoulders meet. The
price movement after the formation of the second shoulder is crucial. If the price
goes below the neckline, then a drop in price is indicated, with the drop expected to
6.6
be equal to the distance between the top of the head and the neckline.
(d) Triangle or Coil Formation: This formation represents a pattern of uncertainty and
is difficult to predict which way the price will break out.
(e) Flags and Pennants Form: This form signifies a phase after which the previous
price trend is likely to continue.
Double Top Form: This form represents a bearish development, signals that price
is expected to fall.
(f)
expected to rise.
(h) Gap: A gap is the difference between the opening price on a trading day and the
closing price of the previous trading day. Wider the gap, stronger is the signal for a
continuation of the observed trend. On a rising market, if the opening price is
considerably higher than the previous closing price, it indicates that investors are
willing to pay a much higher price to acquire the scrip. Similarly, a gap in a falling
market is an indicator of extreme selling pressure.
21. Decision Using Moving Averages: Moving averages are frequently plotted with prices
to make buy and sell decisions. The two types of moving averages used by chartists are
the Arithmetic Moving Average (AMA) and the Exponential Moving Average (EMA).
Buy and Sell Signals Provided by Moving Average Analysis
Buy Signal
(a)
(b)
(c)
Stock price line rise through the (a)

moving average line when graph
of the moving average line is
flattering out.
(b)
Stock price line falls below
moving average line which is (c)
rising.
Stock price line which is above
moving average line falls but
begins to rise again before
reaching the moving average line
Sell Signal
Stock price line falls through moving

average line when graph of the
moving average line is flattering out.
Stock price line rises above moving
average line which is falling.
Stock price line which is slow moving
average line rises but begins to fall
again before reaching the moving
average line.
22. Bollinger Bands: A band is plotted two standard deviations away from a simple moving
average. Because standard deviation is a measure of volatility, Bollinger bands adjust
themselves to the market conditions. When the markets become more volatile, the bands
widen (move further away from the average), and during less volatile periods, the bands
contract (move closer to the average). The tightening of the bands is often used by
Security Analysis
6.7
technical traders as an early indication that the volatility is about to increase sharply.
23. Momentum Analysis: Momentum measures the speed of price change and provides a
leading indicator of changes in trend. The momentum line leads price action frequently
enough to signal a potential trend reversal in the market.
24. Bond Valuation: A bond or debenture is an instrument of debt issued by a business or
government.
(a) Par Value: Value stated on the face of the bond. It is the amount a firm borrows and
promises to repay at the time of maturity.
(b) Coupon Rate and Interest: A bond carries a specific interest rate known as the
coupon rate. The interest payable to the bond holder is par value of the bond
coupon rate.
(c) Maturity Period: Corporate bonds have a maturity period of 3 to 10 years. While
government bonds have maturity periods extending up to 20-25 years. At the time of
maturity the par (face) value plus nominal premium is payable to the bondholder.
25. Bond Valuation Model
Value of a bond is:

n
I
F
+
t
(
k
)
(
kd )n
+
+
1
1
t =1
d
V =
V = I ( PVIFAkd ,n ) + F ( PVIFkd ,n )
Where,
V = Value of the bond
I = Annual interest payable on the bond
F = Principal amount (par value) of the bond repayable at the time of maturity
n = Maturity period of the bond.
Value of a bond with semi-annual interest is:
= 2nt=1 [(I/2) / {(1+kd/2)t}] + [F / (1+kd/2)2n]

Where,
V
= Value of the bond
I/2
Kd/2 = Discount rate applicable to a half-year period

F
6.8
2n
26. Price Yield Relationship: As the required yield increases, the present value of the cash
flow decreases; hence the price decreases. Conversely, when the required yield
decreases, the present value of the cash flow increases, hence the price increases.
27. Relationship between Bond Price and Time: Since the price of a bond must be equal to its
par value at maturity (assuming that there is no risk of default), bond price changes with time.
28. Yield Curve: It shows how yield to maturity is related to term to maturity for bonds
that are similar in all respects, except maturity.
Discount at the yield to maturity : (R t ) PV [CF(t)] =
CF(t )
(1+Rt )t
Discount by the product of a spot rate plus the forward rates :

PV [CF(t)] =
CF(t )
(1 + r1 ) (1 + r2 ) ..... (1 + rt )
29. Bond Duration: Duration can also be used to measure risk of investment in bond. It can be
calculated by any of following methods.
(i)
Macaulay Duration
n
Macaulay Duration =
t*C
(1 + i)
t =1
n* M
(1 + i)n
Where
C = Cash flows
i = Required yield (YTM)
P = Bond price
(ii) Short Cut Method: The duration can also be calculated using short-cut method as follows:
=
1 + y (1 + y) + t(c - y)
y c [ ( 1 + y) t - 1] + y
Security Analysis
6.9
Where
y = Required yield (YTM)

c =Coupon Rate for the period
Question 1
Explain the Efficient Market Theory in and what are major misconceptions about this theory?
Answer
In 1953, Maurice Kendall a distinguished statistician of the Royal Statistical Society, London
examined the behaviour of the stock and commodity prices in search of regular cycles instead of
discovering any regular price cycle. He found each series to be wandering one, almost as if once
a week, the Demon of Chance drew a random number and added it to the current price to
determine next weeks price.
Prices appeared to follow a random walk implying that successive price changes are independent
of one another. In 1959 two interesting papers supporting the Random Walk Theory were
published. Harry Roberts showed that a series obtained by cumulating random numbers bore
resemblance to a time series of stock prices. In the second, Osborne, an eminent physicist,
examined that the stock price behavior was similar to the movements of very small particles
suspended in a liquid medium. Such movement is referred to as the Brownian motion He found a
remarkable similarly between stock price movements and the Brownian motion.
Inspired by the works of Kendall, Roberts & Osbome, a number of researchers employed
indigenous tests of randomness on stock price behaviour. By and large, these tests have indicated
the Random Walk hypothesis.
Search for Theory: When empirical evidence in favour of Random walk hypothesis seemed
overwhelming, researchers wanted to know about the Economic processes that produced a
Random walk. They concluded that randomness of stock price was a result of efficient market that
led to the following view points:
Information is freely and instantaneously available to all market participants.
Keen competition among the market participants more or less ensures that market will
reflect intrinsic values. This means that they will fully impound all available information.
Price change only response to new information that is unrelated to previous information
and therefore unpredictable.
Misconception about Efficient Market Theory: Though the Efficient Market Theory implies that
market has perfect forecasting abilities, in fact, it merely signifies that prices impound all available
information and as such does not mean that market possesses perfect forecasting abilities.
6.10
Although price tends to fluctuate they cannot reflect fair value. This is because the feature is
uncertain and the market springs surprises continually as price reflects the surprises they fluctuate.
Inability of institutional portfolio managers to achieve superior investment performance implies that
they lack competence in an efficient market. It is not possible to achieve superior investment
performance since market efficiency exists due to portfolio mangers doing this job well in a
competitive setting.
The random movement of stock prices suggests that stock market is irrational. Randomness and
irrational are two different things, if investors are rational and competitive, price changes are bound
to be random.
Question 2
Explain the different levels or forms of Efficient Market Theory in and what are various
empirical evidence for these forms?
Answer
That price reflects all available information, the highest order of market efficiency. According to
FAMA, there exist three levels of market efficiency:(i)
Weak form efficiency Price reflect all information found in the record of past prices and
volumes.
(ii)
Semi Strong efficiency Price reflect not only all information found in the record of past
prices and volumes but also all other publicly available information.
(iii) Strong form efficiency Price reflect all available information public as well as private.
Empirical Evidence on Weak form Efficient Market Theory: According to the Weak form
Efficient Market Theory current price of a stock reflect all information found in the record of past
prices and volumes. This means that there is no relationship between the past and future price
movements.
Three types of tests have been employed to empirically verify the weak form of Efficient Market
Theory- Serial Correlation Test, Run Test and Filter Rule Test.
(a) Serial Correlation Test: To test for randomness in stock price changes, one has to look at
serial correlation. For this purpose, price change in one period has to be correlated with
price change in some other period. Price changes are considered to be serially
independent. Serial correlation studies employing different stocks, different time lags and
different time period have been conducted to detect serial correlation but no significant
serial correlation could be discovered. These studies were carried on short term trends
viz. daily, weekly, fortnightly and monthly and not in long term trends in stock prices as in
such cases. Stock prices tend to move upwards.
(b) Run Test: Given a series of stock price changes each price change is designated + if it
represents an increase and if it represents a decrease. The resulting series may be -
Security Analysis
6.11
,+, - , -, - , +, +.
A run occurs when there is no difference between the sign of two changes. When the
sign of change differs, the run ends and new run begins.
To test a series of price change for independence, the number of runs in that series is
compared with a number of runs in a purely random series of the size and in the process
determines whether it is statistically different. By and large, the result of these studies
strongly supports the Random Walk Model.
(c) Filter Rules Test: If the price of stock increases by at least N% buy and hold it until its
price decreases by at least N% from a subsequent high. When the price decreases at
least N% or more, sell it. If the behaviour of stock price changes is random, filter rules
should not apply in such a buy and hold strategy. By and large, studies suggest that filter
rules do not out perform a single buy and hold strategy particular after considering
commission on transaction.
Empirical Evidence on Semi-strong Efficient Market Theory: Semi-strong form efficient
market theory holds that stock prices adjust rapidly to all publicly available information. By
using publicly available information, investors will not be able to earn above normal rates of
return after considering the risk factor. To test semi-strong form efficient market theory, a
number of studies was conducted which lead to the following queries: Whether it was possible
to earn on the above normal rate of return after adjustment for risk, using only publicly
available information and how rapidly prices adjust to public announcement with regard to
earnings, dividends, mergers, acquisitions, stocksplits?
Several studies support the Semi-strong form Efficient Market Theory. Fama, Fisher, Jensen
and Roll in their adjustment of stock prices to new information examined the effect of stock
split on return of 940 stock splits in New York Stock Exchange during the period 1957-1959
They found that prior to the split, stock earns higher returns than predicted by any market
model.
Boll and Bound in an empirical evaluation of accounting income numbers studied the effect of
annual earnings announcements. They divided the firms into two groups. First group consisted
of firms whose earnings increased in relation to the average corporate earnings while second
group consists of firms whose earnings decreased in relation to the average corporate
earnings. They found that before the announcement of earnings, stock in the first group
earned positive abnormal returns while stock in the second group earned negative abnormal
returns after the announcement of earnings. Stock in both the groups earned normal returns.
There have been studies which have been empirically documented showing the following
inefficiencies and anomalies:
6.12
Stock price adjust gradually not rapidly to announcements of unanticipated changes in

quarterly earnings.
Small firms portfolio seemed to outperform large firms portfolio.
Low price earning multiple stock tend to outperform large price earning multiple stock.
Mondays return is lower than return for the other days of the week.
Empirical Evidence on Strong form Efficient Market Theory: According to the Efficient
Market Theory, all available information, public or private, is reflected in the stock prices. This
represents an extreme hypothesis.
To test this theory, the researcher analysed returns earned by certain groups viz. corporate
insiders, specialists on stock exchanges, mutual fund managers who have access to internal
information (not publicly available), or posses greater resource or ability to intensively analyse
information in the public domain. They suggested that corporate insiders (having access to
internal information) and stock exchange specialists (having monopolistic exposure) earn
superior rate of return after adjustment of risk.
Mutual Fund managers do not on an average earn a superior rate of return. No scientific
evidence has been formulated to indicate that investment performance of professionally
managed portfolios as a group has been any better than that of randomly selected portfolios.
This was the finding of Burton Malkiel in his Random Walk Down Wall Street, New York.
Question 3
Explain in detail the Dow Jones Theory?

Answer
As already discussed in the previous chapter, the Dow Jones Theory is probably the most
popular theory regarding the behaviour of stock market prices. The theory derives its name
from Charles H. Dow, who established the Dow Jones & Co., and was the first editor of the
Wall Street Journal a leading publication on financial and economic matters in the U.S.A.
Although Dow never gave a proper shape to the theory, ideas have been expanded and
articulated by many of his successors. Let us study the theory once again but in detail.
The Dow Jones theory classifies the movements of the prices on the share market into three
major categories:
Primary movements,
Secondary movements, and
Daily fluctuations.
(i)
Primary Movements: They reflect the trend of the stock market and last from one year
to three years, or sometimes even more.
If the long range behaviour of market prices is seen, it will be observed that the share
Security Analysis
6.13
markets go through definite phases where the prices are consistently rising or falling.
These phases are known as bull and bear phases.
During a bull phase, the basic trend is that of rise in prices. Graph 1 above shows the
behaviour of stock market prices in bull phase.
Students would notice from the graph that although the prices fall after each rise, the
basic trend is that of rising prices, as can be seen from the graph that each trough prices
reach, is at a higher level than the earlier one. Similarly, each peak that the prices reach
is on a higher level than the earlier one. Thus P2 is higher than P1 and T2 is higher than
T1. This means that prices do not rise consistently even in a bull phase. They rise for
some time and after each rise, they fall. However, the falls are of a lower magnitude than
earlier. As a result, prices reach higher levels with each rise.
Once the prices have risen very high, the b.ear phase in bound to start, i.e., price will
start falling. Graph 2 shows the typical behaviour of prices on the stock exchange in the
case of a bear phase. It would be seen that prices are not falling consistently and, after
each fall, there is a rise in prices. However, the rise is not much as to take the prices
higher than the previous peak. It means that each peak and trough is now lower than the
previous peak and trough.
The theory argues that primary movements indicate basic trends in the market. It states
that if cyclical swings of stock market price indices are successively higher, the market
trend is up and there is a bull market. On the contrary, if successive highs and lows are
successively lower, the market is on a downward trend and we are in a bear market. This
6.14
theory thus relies upon the behaviour of the indices of share market prices in perceiving
the trend in the market.
According to this theory, when the lines joining the first two troughs and the lines joining
the corresponding two peaks are convergent, there is a rising trend and when both the
lines are divergent, it is a declining trend.
(ii) Secondary Movements: We have seen that even when the primary trend is upward,
there are also downward movements of prices. Similarly, even where the primary trend is
downward, there is an upward movement of prices also. These movements are known as
secondary movements and are shorter in duration and are opposite in direction to the
primary movements. These movements normally last from three weeks to three months
and retrace 1/3 to 2/3 of the previous advance in a bull market or previous fall in the bear
market.
(iii) Daily Movements: There are irregular fluctuations which occur every day in the market.
These fluctuations are without any definite trend. Thus if the daily share market price
index for a few months is plotted on the graph it will show both upward and downward
fluctuations. These fluctuations are the result of speculative factors. An investment
manager really is not interested in the short run fluctuations in share prices since he is
not a speculator. It may be reiterated that any one who tries to gain from short run
fluctuations in the stock market, can make money only by sheer chance. The investment
manager should scrupulously keep away from the daily fluctuations of the market. He is
not a speculator and should always resist the temptation of speculating.
Such a temptation is always very attractive but must always be resisted. Speculation is
beyond the scope of the job of an investment manager.
Timing of Investment Decisions on the Basis of Dow Jones Theory: Ideally speaking, the
investment manager would like to purchase shares at a time when they have reached the
lowest trough and sell them at a time when they reach the highest peak.
However, in practice, this seldom happens. Even the most astute investment manager
can never know when the highest peak or the lowest trough has been reached.
Therefore, he has to time his decision in such a manner that he buys the shares when
they are on the rise and sells them when they are on the fall. It means that he should be
able to identify exactly when the falling or the rising trend has begun.
This is technically known as identification of the turn in the share market prices.
Identification of this turn is difficult in practice because of the fact that, even in a rising
market, prices keep on falling as a part of the secondary movement. Similarly even in a
falling market prices keep on rising temporarily. How to be certain that the rise in prices
or fall in the same is due to a real turn in prices from a bullish to a bearish phase or vice
versa or that it is due only to short-run speculative trends?
Dow Jones theory identifies the turn in the market prices by seeing whether the
successive peaks and troughs are higher or lower than earlier. Consider the following
Security Analysis
6.15
graph:
According to the theory, the investment manager should purchase investments when the
prices are at T1. At this point, he can ascertain that the bull trend has started, since T2 is
higher than T1 and P2 is higher than P1.
Similarly, when prices reach P7 he should make sales. At this point he can ascertain that
the bearish trend has started, since P9 is lower than P8 and T8 is lower than T7.
Question 4
Explain the Elliot Wave Theory of technical analysis?

Answer
Inspired by the Dow Theory and by observations found throughout nature, Ralph Elliot formulated
Elliot Wave Theory in 1934. This theory was based on analysis of 75 years stock price movements
and charts. From his studies, he defined price movements in terms of waves. Accordingly, this
theory was named Elliot Wave Theory. Elliot found that the markets exhibited certain repeated
patterns or waves. As per this theory wave is a movement of the market price from one change in
the direction to the next change in the same direction. These waves are resulted from buying and
selling impulses emerging from the demand and supply pressures on the market. Depending on
the demand and supply pressures, waves are generated in the prices.
As per this theory, waves can be classified into two parts:
Impulsive patterns
Corrective patters
Let us discuss each of these patterns.

(a) Impulsive Patterns-(Basic Waves) - In this pattern there will be 3 or 5 waves in a given
direction (going upward or downward). These waves shall move in the direction of the
basic movement. This movement can indicate bull phase or bear phase.
(b) Corrective Patterns- (Reaction Waves) - These 3 waves are against the basic direction
of the basic movement. Correction involves correcting the earlier rise in case of bull
market and fall in case of bear market.
6.16
As shown in the following diagram waves 1, 3 and 5 are directional movements, which
are separated or corrected by wave 2 & 4, termed as corrective movements.
Source: http://elliotwave.net/
Complete Cycle - As shown in following figure five-wave impulses is following by a
three-wave correction (a,b & c) to form a complete cycle of eight waves.
Source: http://elliotwave.net/
One complete cycle consists of waves made up of two distinct phases, bullish and
bearish. On completion of full one cycle i.e. termination of 8 waves movement, the fresh
cycle starts with similar impulses arising out of market trading.
Question 5
Why should the duration of a coupon carrying bond always be less than the time to its
maturity?
Answer
Duration is nothing but the average time taken by an investor to collect his/her investment. If an
investor receives a part of his/her investment over the time on specific intervals before maturity, the
Security Analysis
6.17
investment will offer him the duration which would be lesser than the maturity of the instrument.
Higher the coupon rate, lesser would be the duration.
Question 6
Mention the various techniques used in economic analysis.

Answer
Some of the techniques used for economic analysis are:

(a) Anticipatory Surveys: They help investors to form an opinion about the future state of
the economy. It incorporates expert opinion on construction activities, expenditure on
plant and machinery, levels of inventory all having a definite bearing on economic
activities. Also future spending habits of consumers are taken into account.
(b) Barometer/Indicator Approach: Various indicators are used to find out how the
economy shall perform in the future. The indicators have been classified as under:
(1) Leading Indicators: They lead the economic activity in terms of their outcome. They
relate to the time series data of the variables that reach high/low points in advance
of economic activity.
(2) Roughly Coincidental Indicators: They reach their peaks and troughs at
approximately the same in the economy.
(3) Lagging Indicators: They are time series data of variables that lag behind in their
consequences vis-a-vis the economy. They reach their turning points after the
economy has reached its own already.
All these approaches suggest direction of change in the aggregate economic activity
but nothing about its magnitude.
between dependent and independent variables is determined. GNP model building or
sectoral analysis is used in practice through the use of national accounting framework.
Question 7
Write short notes on Zero coupon bonds.

Answer
As name indicates these bonds do not pay interest during the life of the bonds. Instead, zero
coupon bonds are issued at discounted price to their face value, which is the amount a bond
will be worth when it matures or comes due. When a zero coupon bond matures, the investor
will receive one lump sum (face value) equal to the initial investment plus interest that has
been accrued on the investment made. The maturity dates on zero coupon bonds are usually
long term. These maturity dates allow an investor for a long range planning. Zero coupon
bonds issued by banks, government and private sector companies. However, bonds issued by
corporate sector carry a potentially higher degree of risk, depending on the financial strength
6.18
of the issuer and longer maturity period, but they also provide an opportunity to achieve a
higher return.
Question 8
A company 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%, what is the
price of the share today?
Answer
The company earnings and dividend per share after a year are expected to be:
EPS = ` 137.8 0.15 = ` 20.67
Dividend = 0.40 20.67 = ` 8.27
The growth in dividend would be:
g = 0.6 0.15 = 0.09
Perpetual growth model Formula : P0 =
P0 =
Dividend
Ke - g
8.27
0.18 - 0.09
P0 = ` 91.89
Alternative Solution:
However, in case a student follows Walters approach as against continuous growth model given in
previous solution the answer of the question works out to be different. This can be shown as follow:
Given data:
Book value per share
= ` 137.80
Return on equity
= 15%
Dividend Payout
= 40%
Cost of capital
= 18%
EPS
= ` 137.80 15%
= ` 20.67
Dividend
= ` 20.67 40% = ` 8.27
Walters approach showing relationship between dividend and share price can be expressed by the
following formula
Security Analysis
D+
Vc =
Where,
6.19
Ra
(E - D)
Rc
Rc
Vc = Market Price of the ordinary share of the company.

Ra = Return on internal retention i.e. the rate company earns on retained profits.
Rc = Capitalisation rate i.e. the rate expected by investors by way of return from
particular category of shares.
E
= Earnings per share.
= Dividend per share.
Hence,
Vc =
8.27 +
.15
(20.67 - 8.27)
.18
.18
18.60
.18
= ` 103.35
Question 9
ABC Limiteds 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.
(ii)
The firm offers one right share for every four shares held.
(iii) How does the shareholders wealth change from (i) to (ii)? How does right issue
increases shareholders wealth?
Answer
(i)
Number of shares to be issued : 5,00,000

Subscription price ` 20,00,000 / 5,00,000 = ` 4
Ex-right Pr ice =
` 1,30,00,000 + ` 20,00,000
= ` 10
15,00,000
6.20
Value of right =
` 10 - ` 4
= 3
2
(ii) Subscription price ` 20,00,000 / 2,50,000 = ` 8

Ex-right Pr ice =
` 1,30,00,000 + ` 20,00,000
= ` 12
12,50,000
Value of right =
` 12 ` 8
= ` 1.
4
(iii) Calculation of effect of right issue on wealth of Shareholders wealth who is holding, say
100 shares.
(a) When firm offers one share for two shares held.
Value of Shares after right issue
(150 X ` 10)
Less: Amount paid to acquire right shares (50X`4)
` 1,500
` 200
`1,300
(b) When firm offers one share for every four shares held.
Value of Shares after right issue
(125 X ` 12)
Less: Amount paid to acquire right shares (25X`8)
` 1,500
` 200
`1,300
(c) Wealth of Shareholders before Right Issue
`1,300
Thus, there will be no change in the wealth of shareholders from (i) and (ii).
Question 10
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 ` 16 for every four share held.
You are required to:
(i)
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.
Security Analysis
6.21
Answer
(i)
Calculation of theoretical Post-rights (ex-right) price per share:

MN + S R
Ex-right value =
N+R
Where,
M = Market price,
N = Number of old shares for a right share
S = Subscription price
R = Right share offer
(` 24 4) + ( ` 16 1)
=
= ` 22.40
4 + 1
(ii) Calculation of theoretical value of the rights alone:
= Ex-right price Cost of rights share

= ` 22.40 ` 16 = ` 6.40
(iii) Calculation of effect of the rights issue on the wealth of a shareholder who has 1,000
shares assuming he sells the entire rights:
`
(a)
Value of shares before right issue

(1,000 shares ` 24)
24,000
(b)
Value of shares after right issue

(1,000 shares ` 22.40)
22,400
Add: Sale proceeds of rights renunciation

(250 shares ` 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:
`
Value of shares before right issue
(1,000 shares ` 24)
Less: Value of shares after right issue
(1,000 shares ` 22.40)
Loss of wealth to shareholders, if rights ignored
24,000
22,400
1,600
6.22
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
D0=`4
D1 = ` 4 (1.20) = ` 4.80
D2 = ` 4 (1.20)2 = ` 5.76
D3 = ` 4 (1.20)2 (1.10) = ` 6.336
P=
TV =
P=
D1
D2
TV
+
+
(1+ k e ) (1+ k )2 (1+ k )2
e
e
D3
ke - g
4.80
6.336
0.15 - 0.10
5.76
(1+ 0.15) (1+ 0.15)2
= 126.72
126.72
(1+ 0.15)2
= 4.80 x 0.8696 + 5.76 x 0.7561 + 126.72 x 0.7561 = 104.34

Question 12
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 stock of ABC Ltd.
(ii)
Is its stock overvalued if stock price is ` 35, ROE = 9% and EPS = ` 2.25? Show
detailed calculation.
Security Analysis
6.23
Answer
(i)
Present Value of the stock of ABC Ltd. Is:-
2.50(1.02)
= `30/-.
0.105 0.02
Vo =
(ii) Value of stock under the PE Multiple Approach
Particulars
Actual Stock Price
Return on equity
` 35.00
9%
EPS
` 2.25
PE Multiple (1/Return on Equity) = 1/9%
11.11
Market Price per Share
` 25.00
Since, Actual Stock Price is higher, hence it is overvalued.

(iii) Value of the Stock under the Earnings Growth Model
Particulars
Actual Stock Price
Return on equity
EPS
Growth Rate
Market Price per Share [EPS (1+g)]/(Ke g)
` 35.00
9%
` 2.25
2%
` 32.79
= ` 2.25 1.02/0.07
Question 13
A company has a book value per share of `137.80. Its return on equity is 15% and follows a
policy of retaining 60 percent of its annual earnings. If the opportunity cost of capital is 18
percent, what is the price of its share?[adopt the perpetual growth model to arrive at your
solution].
Answer
The company earnings and dividend per share after a year are expected to be:
EPS = ` 137.80 0.15 = ` 20.67
Dividend = 0.40 20.67 = ` 8.27
6.24
The growth in dividend would be:

g = 0.6 0.15 = 0.09
Dividend
Perpetual growth model Formula : P0 =
Ke - g
P0 =
8.27
0.18 - 0.09
P0 = ` 91.89
Question 14
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.
You are required to determine:
(i)
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 opinion that the
9% growth can be maintained indefinitely and require 13% rate of return per annum.
(iii) the price of share at the end of three years, if 9% growth rate is achieved and assuming
other conditions remaining same as in (ii) 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
(i)
Expected dividend for next 3 years.
Year 1 (D1)
` 14.00 (1.09) = ` 15.26
Year 2 (D2)
` 14.00 (1.09)2 = ` 16.63
Year 3 (D3)
` 14.00 (1.09)3 = ` 18.13
Required rate of return = 13% (Ke)

Market price of share after 3 years = (P3) = ` 360
The present value of share
Security Analysis
P0 =
D3
P3
D1
D2
+
+
+
2
3
(1 + ke) (1 + ke) (1 + ke) (1 + ke)3
P0 =
15.26
16.63
18.13
360
+
+
+
2
3
(1 + 0.13) (1 + 0.13) (1 + 0.13) (1 + 0.13)3
6.25
P0 = 15.26(0.885) + 16.63(0.783) +18.13(0.693)+360(0.693)

P0 = 13.50 + 13.02 + 12.56 + 249.48
P0 = ` 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
P0 =
D1
` 15.26
` 15.26
=
=
= ` 381.50
(ke g) 0.13-0.09 0.04
(iii) Assuming that conditions mentioned above remain same, the price expected after 3
years will be:
P3 =
D4
D 3 (1.09)
18.13 1.09 19.76
=
=
=
= ` 494
k e g 0.13 0.09
0.04
0.04
Question 15
Piyush Loonker and Associates presently pay a dividend of Re. 1.00 per share and has a
share price of ` 20.00.
(i)
If this dividend were expected to grow at a rate of 12% per annum forever, what is the
firms 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 firms
expected, or required, return on equity?
Answer
(i)
Firms Expected or Required Return On Equity

(Using a dividend discount model approach)
According to Dividend discount model approach the firms expected or required return on
equity is computed as follows:
Ke =
D1
+g
P0
Where,
Ke
= Cost of equity share capital or (Firms expected or required return
6.26
on equity share capital)

D1
= Expected dividend at the end of year 1
P0
= Current market price of the share.
= Expected growth rate of dividend.
Now, D1 = D0 (1 + g) or ` 1 (1 + 0.12) or ` 1.12, P0 = ` 20 and g = 12% per annum

Therefore, K e =
` 1.12
+ 12%
` 20
K e = ` 17.6%
Or,
(ii) Firms 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 gs,
for n years and thereafter, at a normal, perpetual growth rate of gn beginning in the year
n + 1, then the cost of equity can be determined by using the following formula:
n
P0 =
Div 0 (1 + gs ) t
(1 + K e ) t
t =1
Div n + 1
1
K e - gn (1 + K e )n
Where,
gs
= Rate of growth in earlier years.
gn
= Rate of constant growth in later years.
P0
= Discounted value of dividend stream.
Ke
= Firms expected, required return on equity (cost of equity capital).
Now,
gs = 20% for 5 years, gn = 10%
Therefore,
n
P0 =
t =1
D0 (1 + 0.20) t
(1 + K e ) t
Div 5 + 1
1
K e - 0.10 (1 + K e ) t
Security Analysis
0P =
1.20
1
(1 + K
e)
1.44
2
(1 + K
e)
1.73
3
(1 + K
e)
2.07
4
(1 + K
e)
2.49
5
(1 + K
e)
6.27
2.49 (1 + 0.10)
1
5
K
0.10
(1 + K
e
e)
or P 0 = ` 1.20 (PVF 1 , K e ) + ` 1.44 (PVF 2 , K e ) + ` 1.73 (PVF 3 , K e ) + ` 2.07

(PVF 4 , K e ) +
` 2.49 (PVF 5 , K e ) +
Rs. 2.74 (PVF5 , K e )

K e - 0.10
By trial and error we are required to find out Ke

Now, assume Ke = 18% then we will have
P0 = ` 1.20 (0.8475) + ` 1.44 (0.7182) + ` 1.73 (0.6086) + ` 2.07 (0.5158) + ` 2.49
1
(0.4371) + ` 2.74 (0.4371)
0.18 - 0.10
= ` 1.017 + ` 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 e = 19% we will have
P 0 = ` 1.20 (0.8403) + ` 1.44 (0.7061) + ` 1.73 (0.5934) + ` 2.07 (0.4986) + ` 2.49
1
(0.4190) + ` 2.74 (0.4190)
0.19 - 0.10
= ` 1.008 + ` 1.017 + ` 1.026+ ` 1.032 + ` 1.043 + ` 12.76
= ` 17.89
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:
K e = LR +
NPV at LR
r
NPV at LR - NPV at HR
Where,
LR
= Lower Rate
NPV at LR
= Present value of share at LR
NPV at HR
= Present value of share at Higher Rate
= Difference in rates
6.28
K e = 18% +
(` 20.23 ` 20)
1%
R` 20.23 ` 17.89
= 18% +
` 0.23
1%
`2.34
= 18% + 0.10% = 18.10%

Therefore, the firms 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.
Question 16
Capital structure of Sun Ltd., as at 31.3.2003 was as under:

(` in lakhs)
Equity share capital
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% provided:
(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is 0.75.
(c) 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.
Answer
(a) Calculation of Profit after tax (PAT)
`
Profit before interest and tax (PBIT)
Less: Debenture interest (` 64,00,000 12/100)

Profit before tax (PBT)
Less: Tax @ 35%

Profit after tax (PAT)
Less: Preference Dividend
32,00,000
7,68,000
24,32,000
8,51,200
15,80,800
Security Analysis
(` 40,00,000 8/100)
6.29
3,20,000
Equity Dividend (` 80,00,000 8/100)
9,60,000
6,40,000
Retained earnings (Undistributed profit)
6,20,800
Calculation of Interest and Fixed Dividend Coverage
PAT + Debenture interest

Debenture interest + Preference dividend
15,80,800 + 7,68,000
7,68,000 + 3,20,000
23,48,800
= 2.16 times
10,88,000
(b) Calculation of Capital Gearing Ratio
Capital Gearing Ratio =

=
Fixed interest bearing funds

Equity shareholders' funds
Preference Share Capital + Debentures

Equity Share Capital + Reserves
40,00,000 + 64,00,000
80,00,000 + 32,00,000
1,04,00,000
1,12,00,000
= 0.93
(c) 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 (` 6,40,000 50/100)
3,20,000
5% on undistributed profits (` 6,20,800 5/100)
31,040
Yield on equity shares

Yield on equity shares %
3,51,040
=
=
Yield on shares
Equity share capital
3,51,040
80,00,000
100
100 = 4.39% or, 4.388%.
Calculation of Expected Yield on Equity shares

Note: There is a scope for assumptions regarding the rates (in terms of percentage for every
one time of difference between Sun Ltd. and Industry Average) of risk premium involved with
respect to Interest and Fixed Dividend Coverage and Capital Gearing Ratio. The below
solution has been worked out by assuming the risk premium as:
(i)
1% for every one time of difference for Interest and Fixed Dividend Coverage.
(ii)
2% for every one time of difference for Capital Gearing Ratio.
6.30
(a) Interest and fixed dividend coverage of Sun 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%
(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
Add: Risk premium for low interest and fixed dividend coverage
Add: Risk premium for high interest gearing ratio
0.84
0.36
10.80
Value of Equity Share
Actual yield
4.39
Paid-up value of share =
100 = ` 40.65
Expected yield
10.80
=
Question 17
Given the following information:

Current Dividend
` 5.00
Discount Rate
10%
Growth rate
2%
(i)
Calculate the present value of the stock.
(ii)
Is the stock over valued if the price is `40, ROE = 8% and EPS = ` 3.00. Show your
calculations under the PE Multiple approach and Earnings Growth model.
Answer
(i)
Present Value of the stock:Vo =
5.00(1.02)
= `63.75/-.
0.10 0.02
Security Analysis
6.31
(ii) Value of stock under the PE Multiple Approach
Particulars
Actual Stock Price
Return on equity
` 40.00
8%
EPS
` 3.00
PE Multiple (1/Return on Equity) = 1/8%
12.50
Market Price per Share
` 37.50

(iii) Value of the Stock under the Earnings Growth Model
Particulars
Actual Stock Price
Return on equity
EPS
Growth Rate
Market Price per Share [EPS (1+g)]/(Ke g)
` 40.00
8%
` 3.00
2%
` 51.00
= ` 3.00 1.02/0.06
Since, Actual Stock Price is lower, hence it is undervalued.
Question 18
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
companys share is 1.5.
You are required to calculate the expected rate of return on companys 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 = Rf + (Rm Rf)
= 8 + 1.5 (12 8)
= 8 + 1.5 (4)
=8+6
=14% or 0.14
6.32
Applying Dividend Growth Model for the calculation of per share equilibrium price:
D1
+g
P0
ER =
0.14=
3 (1.10)
+ 0.10
P0
0.14 0.10 =
3.30
P0
0.04 P0
= 3.30
P0
3.30
= ` 82.50
0.04
Per share equilibrium price will be ` 82.50.

Question 19
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 Ke should be
ascertained with the help of CAPM model as follows:
K e = R f + (K m Rf )
Where,
Ke = Cost of equity
Rf = Risk free rate of return
= Portfolio Beta i.e. market sensitivity index
Km = Expected return 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
P0 =
D1
(k e - g)
Security Analysis
6.33
Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke = Cost of equity
G = growth
P0 =
2.00
(k e - g)
P0 =
2.00
= ` 25.00
0.15 - 0.07
Alternatively it can also be found as follows:

2.00 (1.07)
= ` 26.75
0.15 - 0.07
However, if the decision of finance manager is implemented, the beta () factor is likely to
increase to 1.75 therefore, Ke would be
Ke = Rf + (Km Rf)
= 0.09 + 1.75 (0.13 0.09) = 0.16 or 16%
The value of share is
P0 =
D1
(k e - g)
P0 =
2.00
=`22.22
0.16 - 0.07
Alternatively it can also be found as follows:

2.00 (1.07)
= ` 23.78
0.16 - 0.07
Question 20
Calculate the value of share from the following information:

Profit of the company
Par value of share
` 290 crores
` 1,300 crores
` 40 each
Debt ratio of company
27
Equity capital of company
6.34
Long run growth rate of the company
8%
Beta 0.1; risk free interest rate
8.7%
Market returns
10.3%
Capital expenditure per share
` 47
` 39
` 3.45 per share
Depreciation per share

Change in Working capital
Answer
No. of Shares =
` 1,300 crores
` 40
EPS =
PAT
No.of shares
EPS =
` 290 crores
= ` 8.923
32.5 crores
= 32.5 Crores
FCFE = Net income [(1-b) (capex dep) + (1-b) ( WC )]

FCFE = 8.923 [(1-0.27) (47-39) + (1-0.27) (3.45)]
= 8.923 [5.84 + 2.5185] = 0.5645
Cost of Equity = Rf + (Rm Rf)
= 8.7 + 0.1 (10.3 8.7) = 8.86%
Po =
0.5645(1.08) 0.60966
FCFE(1 + g)
=
=
= ` 70.89
0.0886 .08 0.0086
Ke g
Question 21
XYZ company has current earnings of ` 3 per share with 5,00,000 shares outstanding. The
company plans to issue 40,000, 7% convertible preference shares of ` 50 each at par. The
preference shares are convertible into 2 shares for each preference shares held. The equity
share has a current market price of ` 21 per share.
(i)
What is preference shares conversion value?
(ii)
What is conversion premium?
(iii) Assuming that total earnings remain the same, calculate the effect of the issue on the
basic earning per share (a) before conversion (b) after conversion.
(iv) If profits after tax increases by ` 1 million what will be the basic EPS (a) before
conversion and (b) on a fully diluted basis?
Security Analysis
6.35
Answer
(i)
Conversion value of preference share
Conversion Ratio x Market Price

2 ` 21 = ` 42
(ii) Conversion Premium
(` 50/ ` 42) 1 = 19.05%

(iii) Effect of the issue on basic EPS
Before Conversion
Total (after tax) earnings 3 ` 5,00,000
Dividend on Preference shares
Earnings available to equity holders
No. of shares
EPS
15,00,000
1,40,000
13,60,000
5,00,000
2.72
On Diluted Basis
Earnings
No of shares ( 5,00,000 + 80,000)
EPS
15,00,000
5,80,000
2.59
(iv) EPS with increase in Profit
Before Conversion
Earnings
Dividend on Pref. shares
Earning for equity shareholders
No. of equity shares
EPS
25,00,000
1,40,000
23,60,000
5,00,000
4.72
On Diluted Basis
Earnings
No. of shows
EPS
25,00,000
5,80,000
4.31
6.36
Question 22
Shares of Voyage Ltd. are being quoted at a price-earning ratio of 8 times. The company
retains 45% of its earnings which are ` 5 per share.
You are required to compute
(1) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(2) If the anticipated growth rate is 16% per annum, calculate the indicative market price with
the same cost of capital.
(3) If the company's cost of capital is 20% p.a. & the anticipated growth rate is 19% p.a.,
calculate the market price per share.
Answer
(1) Cost of Capital
Retained earnings (45%)

Dividend (55%)
EPS (100%)
P/E Ratio
Market price
Cost of equity capital
` 5 per share
` 6.11 per share
` 11.11 per share
8 times
` 11.11 8 = ` 88.88
` 6.11
Div
100 + Growth % =
100 +15% = 21.87%
=
` 88.88
Pr ice
(2) Market Price =
=
(3) Market Price =
Dividend
Cost of Capital(%) - Growth Rate(%)

` 6.11
(21.87-16)%
` 6.11
(20-19)%
= ` 104.08 per share
Alternative Solution
As in the question the sentence The company retains 45% of its earnings which are ` 5 per share
amenable to two interpretations i.e. one is ` 5 as retained earnings (45%) and another is ` 5 is
EPS (100%). Alternative solution is as follows:
(1) Cost of capital
EPS (100%)
Retained earnings (45%)
` 5 per share
` 2.25 per share
Security Analysis
6.37
Dividend (55%)
` 2.75 per share
P/E Ratio
8 times
Market Price
` 5 8 = ` 40
Cost of equity capital
` 2.75
Div
=
100 + Growth % =
100 +15% = 21.87%
` 40.00
Pr ice
` 2.75
Dividend
=
(2) Market Price =
Cost of Capital(%) - Growth Rate(%) (21.87 - 16)%
= ` 46.85 per share
(3) Market Price =
` 2.75
(20 - 19)%
Question 23
A share of Tension-free Economy Ltd. is currently quoted at, a price earnings ratio of 7.5
times. The retained earnings per share being 37.5% is ` 3 per share. Compute:
(1) The companys cost of equity, if investors expect annual growth rate of 12%.
(2) If anticipated growth rate is 13% p.a., calculate the indicated market price, with same
cost of capital.
(3) If the companys cost of capital is 18% and anticipated growth rate is 15% p.a., calculate
the market price per share, assuming other conditions remain the same.
Answer
1.
Calculation of cost of capital
Retained earnings
37.5%
` 3 per share
Dividend*
62.5%
` 5 per share
EPS
100.0%
` 8 per share
P/E ratio
7.5 times
Market price is ` 7.5 8 = ` 60 per share

Cost of equity capital = (Dividend/price 100) + growth %
= (5/60 100) + 12% = 20.33%.
`3
*
62.5 = ` 5
37
.
5
2.
Market price = Dividend/(cost of equity capital % growth rate %) = 5/(20.33% 13%) =

5/7.33% = ` 68.21 per share.
6.38
3.
Market price = Dividend/(cost of equity capital % growth rate %) = 5/(18% 15%) =

5/3% = ` 166.66 per share.
Question 24
Following Financial data are available for PQR Ltd. for the year 2008:
(`in lakh)
8% debentures
125
10% bonds (2007)
50
Equity shares (` 10 each)
100
Reserves and Surplus
300
Total Assets
600
Assets Turnovers ratio
1.1
Effective interest rate
8%
Effective tax rate
40%
Operating margin
10%
Dividend payout ratio
16.67%
Current market Price of Share
`14
Required rate of return of investors
15%
You are required to:

(i)
Draw income statement for the year
(ii)
Calculate its sustainable growth rate
(iii) Calculate the fair price of the Company's share using dividend discount model, and
(iv) What is your opinion on investment in the company's share at current price?
Answer
Workings:
Asset turnover ratio
= 1.1
Total Assets
= ` 600
Turnover ` 600 lakhs 11
= ` 660 lakhs
Effective interest rate
Liabilities
= ` 125 lakhs + 50 lakhs = 175 lakh
Interest
= ` 175 lakhs 0.08 = ` 14 lakh
Interest
= 8%
Libilities
Security Analysis
Operating Margin
= 10%
Hence operating cost
= (1 - 0.10) ` 660 lakhs = ` 594 lakh
Dividend Payout
= 16.67%
Tax rate
= 40%
(i)
6.39
Income statement
(` Lakhs)
Sale
660
Operating Exp
594
EBIT
66
Interest
14
EBT
52
Tax @ 40%
20.80
EAT
31.20
Dividend @ 16.67%
5.20
Retained Earnings
26.00
(ii) SGR = G = ROE (1-b)
ROE =
PAT
and NW = ` 100 lakh + ` 300 lakh = 400 lakh
NW
ROE =
` 31.2 lakhs
100 = 7.8%
` 400 lakhs
SGR = 0.078(1 - 0.1667) = 6.5%

(iii) Calculation of fair price of share using dividend discount model
Po =
Do (1 + g)
ke g
Dividends =
` 5.2 lakhs
= ` 0.52
` 10 lakhs
Growth Rate = 6.5%

Hence Po =
` 0.52(1 + 0.065)
` 0.5538
=
= ` 6.51
0.15-0.065
0.085
(iv) Since the current market price of share is ` 14, the share is overvalued. Hence the
investor should not invest in the company.
6.40
Question 25
M/s X Ltd. has paid a dividend of ` 2.5 per share on a face value of ` 10 in the financial year
ending on 31st March, 2009. 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 return
15%
Risk free rate of return
9%
Calculate the intrinsic value of the share.

Answer
Intrinsic Value P0=
D1
kg
Using CAPM
k = Rf + (Rm-Rf)
Rf = Risk Free Rate
= Beta of Security
Rm = Market Return
= 9% + 0.75 (15% - 9%) = 13.5%
P=
2.5 1.1
2.75
=
= ` 78.57
0.135- 0.10 0.035
Question 26
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? If so, what maximum price should he pay for each share?
Assume no tax on dividend income and capital gain.
Security Analysis
6.41
Answer
P.V. of dividend stream and sales proceeds
Year
Divd. /Sale
PVF (12%)
PV (`)
` 20/-
0.893
17.86
` 20/-
0.797
15.94
` 20/-
0.712
14.24
` 24/-
0.636
15.26
` 24/
0.567
13.61
` 24/
0.507
12.17
` 24/
0.452
10.85
` 1026/- (` 900 x 1.2 x 0.95)
0.452
463.75
` 563.68
Less : - Cost of Share (` 500 x 1.05)
Net gain
` 525.00
` 38.68
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 27
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%.
Answer
Case (i) Required yield rate = 5%

Year
Cash
Flow `
DF (5%)
Present
Value `
1-5
10
4.3295
43.295
110
0.7835
86.185
Value of bond
129.48
6.42
Case (ii) Required yield rate = 5.1%

Year
Cash
Flow `
DF
(5.1%)
Present
Value `
1-5
10
4.3175
43.175
110
0.7798
85.778
Value of bond
128.953
Case (iii) Required yield rate = 10%

Year
Cash
Flow `
DF
(10%)
Present
Value `
1-5
10
3.7908
37.908
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 `
1-5
10
3.7811
37.811
110
0.6181
67.991
Value of bond
105.802
Question 28
A convertible bond with a face value of ` 1,000 is issued at ` 1,350 with a coupon rate of
10.5%. The conversion rate is 14 shares per bond. The current market price of bond and
share is ` 1,475 and ` 80 respectively. What is the premium over conversion value?
Answer
Conversion rate is 14 shares per bond. Market price of share ` 80

Conversion Value 14 x ` 80 = ` 1120
Market price of bond = ` 1475
Premium over Conversion Value (` 1475- ` 1120) =
355
x 100 = 31.7%
1120
Question 29
Saranam Ltd. has issued convertible debentures with coupon rate 12%. Each debenture has
an option to convert to 20 equity shares at any time until the date of maturity. Debentures will
be redeemed at ` 100 on maturity of 5 years. An investor generally requires a rate of return of
Security Analysis
6.43
8% p.a. on a 5-year security. As an investor when will you exercise conversion for given
market prices of the equity share of (i) ` 4, (ii) ` 5 and (iii) ` 6.
Cumulative PV factor for 8% for 5 years
3.993
PV factor for 8% for year 5
0.681
Answer
If Debentures are not converted its value is as under: -
PVF @ 8 %
3.993
0.681
Interest - ` 12 for 5 years

Redemption - ` 100 in 5th year
`
47.916
68.100
116.016
Value of equity shares:Market Price

`4
`5
`6
No.
20
20
20
Total
` 80
` 100
` 120
Hence, unless the market price is ` 6 conversion should not be exercised.

Question 30
The data given below relates to a convertible bond :

Face value
` 250
Coupon rate
12%
No. of shares per bond

Market price of share
Straight value of bond
Market price of convertible bond
Calculate:
(i)
Stock value of bond.
(ii)
The percentage of downside risk.
(iii) The conversion premium

(iv) The conversion parity price of the stock.
Answer
(i)
Stock value or conversion value of bond
12 20 = ` 240
20
` 12
` 235
` 265
6.44
(ii) Percentage of the downside risk

` 265 -` 235
= 0.1277 or 12.77%
` 235
This ratio gives the percentage price decline experienced by the bond if the stock
becomes worthless.
(iii) Conversion Premium
Market Pr ice Conversion Value

100
Conversion Value
` 265 -` 240
100 = 10.42%
` 240
(iv) Conversion Parity Price

Bond Pr ice
No. of Shares on Conversion
` 265
= ` 13.25
20
This indicates that if the price of shares rises to ` 13.25 from ` 12 the investor will
neither gain nor lose on buying the bond and exercising it. Observe that ` 1.25 (` 13.25
` 12.00) is 10.42% of ` 12, the Conversion Premium.
Question 31
Pineapple Ltd has issued fully convertible 12 percent debentures of ` 5,000 face value,
convertible into 10 equity shares. The current market price of the debentures is ` 5,400. The
present market price of equity shares is ` 430.
Calculate:
(i)
the conversion percentage premium, and
(ii)
the conversion value
Answer
(i)
As per the conversion terms 1 Debenture = 10 equity share and since face value of one
debenture is ` 5000 the value of equity share becomes ` 500 (5000/10).
The conversion terms can also be expressed as: 1 Debenture of ` 500 = 1 equity share.
The cost of buying ` 500 debenture (one equity share) is:
` 500
5400
5000
=` 540
Security Analysis
6.45
Market Price of share is ` 430. Hence conversion premium in percentage is:

540 - 430
430
100 = 25.58%
(ii) The conversion value can be calculated as follows:
Conversion value
= Conversion ratio X Market Price of Equity Shares

= 10 ` 430 = ` 4300
Question 32
Rahul Ltd. has surplus cash of ` 100 lakhs and wants to distribute 27% of it to the
shareholders. The company decides to buy back shares. The Finance Manager of the
company estimates that its share price after re-purchase is likely to be 10% above the
buyback price-if the buyback route is taken. The number of shares outstanding at present is
10 lakhs and the current EPS is ` 3.
(i)
The price at which the shares can be re-purchased, if the market capitalization of the
company should be ` 210 lakhs after buyback,
(ii)
The number of shares that can be re-purchased, and
(iii) The impact of share re-purchase on the EPS, assuming that net income is the same.
Answer
(i)
Let P be the buyback price decided by Rahul Ltd.
Market Capitalisation after Buyback

1.1P (Original Shares Shares Bought Back)
27% of 100 lakhs
= 1.1P 10 lakhs
P
= 11 lakhs P 27 lakhs 1.1 = 11 lakhs P 29.7 lakhs

Again, 11 lakhs P 29.7 lakhs
or 11 lakhs P = 210 lakhs + 29.7 lakhs
or P =
239.7
= ` 21.79 per share
11
(ii) Number of Shares to be Bought Back :` 27 lakhs

= 1.24 lakhs (Approx.) or 123910 share
` 21.79
6.46
(iii) New Equity Shares :-
10 lakhs 1.24 lakhs = 8.76 lakhs or 1000000 123910 = 876090 shares

EPS =
3 10 lakhs
= ` 3.43
8.76 lakhs
Thus, EPS of Rahul Ltd., increases to ` 3.43.

Question 33
With the help of the following information of Jatayu Limited compute the Economic Value
Added:
Capital Structure
Cost of equity
Financial Leverage
Income Tax Rate
Equity capital ` 160 Lakhs

Reserves and Surplus ` 140 lakhs
10% Debentures ` 400 lakhs
14%
1.5 times
30%
Answer
Financial Leverage = PBIT/PBT

1.5 = PBIT / (PBIT Interest)
1.5 = PBIT / (PBIT 40)
1.5 (PBIT 40) = PBIT
1.5 PBIT 60 = PBIT
1.5 PBIT PBIT = 60
0.5 PBIT = 60
or PBIT =
60
= `120 lakhs
0.5
NOPAT = PBIT Tax = `120 lakhs (1 0.30) = `84 lakhs.

Weighted Average Cost of Capital (WACC)
= 14% (300 / 700) + (1 0.30) (10%) (400 / 700) = 10%
EVA = NOPAT (WACC Total Capital)
EVA = `84 lakhs 0.10 ` 700 lakhs
EVA = ` 14 lakhs
Security Analysis
6.47
Question 34
RST
Ltd.s current financial year's income statement reported its net income as ` 25,00,000.
The applicable corporate income tax rate is 30%.

Following is the capital structure of RST Ltd. at the end of current financial year:
`
Debt (Coupon rate = 11%)
40 lakhs
Equity (Share Capital + Reserves & Surplus)
125 lakhs
Invested Capital
165 lakhs
Following data is given to estimate cost of equity capital:
`
Beta of RST Ltd.
1.36
Risk free rate i.e. current yield on Govt. bonds
8.5%
Average market risk premium (i.e. Excess of return on market portfolio

over risk-free rate)
Required:
(i)
Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii)
Estimate Economic Value Added (EVA) of RST Ltd.
Answer
Cost of Equity as per CAPM

ke = Rf + x Market Risk Premium
= 8.5% + 1.36 x 9%
= 8.5% + 12.24% = 20.74%
Cost of Debt
WACC
kd = 11%(1 0.30) = 7.70%

(ko) = ke x
E
E+D
= 20.74 x
+ kd x
125
165
D
E+D
+ 7.70 x
40
165
= 15.71 + 1.87 = 17.58%

Taxable Income
= ` 25,00,000/(1 - 0.30)
= ` 35,71,429 or ` 35.71 lakhs
9%
6.48
Operating Income
= Taxable Income + Interest

= ` 35,71,429 + ` 4,40,000
= ` 40,11,429
EVA
or
` 40.11 lacs
= EBIT (1-Tax Rate) WACC x Invested Capital

= ` 40,11,429 (1 0.30) 17.58% x ` 1,65,00,000
= ` 28,08,000 ` 29,00,700 = - ` 92,700
Question 35
Tender Ltd has earned a net profit of ` 15 lacs after tax at 30%. Interest cost charged by
financial institutions was ` 10 lacs. The invested capital is ` 95 lacs of which 55% is debt. The
company maintains a weighted average cost of capital of 13%. Required,
(a) Compute the operating income.
(b) Compute the Economic Value Added (EVA).
(c) Tender Ltd. has 6 lac equity shares outstanding. How much dividend can the company
pay before the value of the entity starts declining?
Answer
Taxable Income
Operating Income
EVA
EVA Dividend
` 15 lac/(1-0.30)
` 21.43 lacs
Taxable Income + Interest
` 21,42,857 + ` 10,00,000
` 31,42,857
EBIT (1-Tax Rate) WACC x Invested Capital
` 31,42,857(1 0.30) 13% x ` 95,00,000
` 22,00,000 ` 12,35,000 = ` 9,65,000
` 9,65,000
= ` 1.6083
` 6,00,000
or ` 21,42,857
or
` 31.43 lacs
Question 36
The following information is given for 3 companies that are identical except for their capital
structure:
Orange
Grape
Apple
Total invested capital
1,00,000
1,00,000
1,00,000
Debt/assets ratio
0.8
0.5
0.2
Security Analysis
Shares outstanding
6,100
8,300
10,000
Pre tax cost of debt
16%
13%
15%
Cost of equity
26%
22%
20%
Operating Income (EBIT)
25,000
25,000
25,000
Net Income
8,970
12,350
14,950
6.49
The tax rate is uniform 35% in all cases.

(i)
Compute the Weighted average cost of capital for each company.
(ii)
Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give
reasons.
(iv) If the industry PE ratio is 11x, estimate the price for the share of each company.
(v) Calculate the estimated market capitalisation for each of the Companies.
Answer
(i)
Working for calculation of WACC
Orange
Grape
Apple
Total debt
80,000
50,000
20,000
Post tax Cost of debt
10.4%
8.45%
9.75%
Equity Fund
20,000
50,000
80,000
WACC
Orange:
(10.4 x 0.8) + (26 x 0.2) =
13.52%
Grape:
(8.45 x 0.5) + (22 x 0.5) =
15.225%
Apple:
(9.75 x 0.2) + (20 x 0.8) =
17.95%
(ii)
WACC
EVA [EBIT (1-T)-(WACC x Invested Capital)]
Orange
13.52
2,730
Grape
15.225
1,025
Apple
17.95
-1,700
(iii) Orange would be considered as the best investment since the EVA of the company is
highest and its weighted average cost of capital is the lowest
(iv) Estimated Price of each company shares
EBIT (`)
Orange
Grape
Apple
25,000
25,000
25,000
6.50
Interest (`)
12,800
6,500
3,000
Taxable Income (`)
12,200
18,500
22,000
Tax 35% (`)
4,270
6,475
7,700
Net Income (`)
7,930
12,025
14,300
Shares
6,100
8,300
10,000
1.3
1.448795
1.43
EPS (`)
14.30
15.94
15.73
Stock Price (EPS x PE Ratio) (`)
Since the three entities have different capital structures they would be exposed to
different degrees of financial risk. The PE ratio should therefore be adjusted for the risk
factor.
Alternative Answer
Net Income (Given) (`)

Shares
EPS (`)
Stock Price (EPS x PE Ratio) (`)
Orange
8,970
6,100
1.4705
16.18
Grape
12,350
8,300
1.488
16.37
Apple
14,950
10,000
1.495
16.45
(v) Market Capitalisation
Estimated Stock Price (`)
14.30
15.94
15.73
No. of shares
6,100
8,300
10,000
87,230
1,32,302
1,57,300
Estimated Stock Price (`)
16.18
16.37
16.45
No. of shares
6,100
8,300
10,000
98,698
1,35,871
1,64,500
Estimated Market Cap (`)

Alternative Answer
Estimated Market Cap (`)

Question 37
Delta Ltd.s current financial years income statement reports its net income as
` 15,00,000. Deltas marginal tax rate is 40% and its interest expense for the year was
` 15,00,000. The company has ` 1,00,00,000 of invested capital, of which 60% is debt. In
addition, Delta Ltd. tries to maintain a Weighted Average Cost of Capital (WACC) of 12.6%.
(i)
Compute the operating income or EBIT earned by Delta Ltd. in the current year.
(ii)
What is Delta Ltd.s Economic Value Added (EVA) for the current year?
(iii) Delta Ltd. has 2,50,000 equity shares outstanding. According to the EVA you computed
in (ii), how much can Delta pay in dividend per share before the value of the company
Security Analysis
6.51
would start to decrease? If Delta does not pay any dividends, what would you expect to
happen to the value of the company?
Answer
(i)
Taxable income = Net Income /(1 0.40)

or, Taxable income = ` 15,00,000/(1 0.40) = ` 25,00,000
Again, taxable income = EBIT Interest
or, EBIT = Taxable Income + Interest
= ` 25,00,000 + ` 15,00,000 = ` 40,00,000
(ii) EVA = EBIT (1 T) (WACC Invested capital)
= ` 40,00,000 (1 0.40) (0.126 ` 1,00,00,000)

= ` 24,00,000 ` 12,60,000 = ` 11,40,000
(iii) EVA Dividend = ` 11,40,000/2,50,000 = ` 4.56
If Delta Ltd. does not pay a dividend, we would expect the value of the firm to increase
because it will achieve higher growth, hence a higher level of EBIT. If EBIT is higher, then all
else equal, the value of the firm will increase.
Question 38
Abhishek Ltd. has a surplus cash of `90 lakhs and wants to distribute 30% of it to the
shareholders. The Company decides to buyback shares. The Finance Manager of the
Company estimates that its share price after re-purchase is likely to be 10% above the
buyback price; if the buyback route is taken. The number of shares outstanding at present is
10 lakhs and the current EPS is `3.
(a) The price at which the shares can be repurchased, if the market capitalization of the
company should be `200 lakhs after buyback.
(b) The number of shares that can be re-purchased.
(c) The impact of share re-purchase on the EPS, assuming the net income is same.
Answer
(a) Let P be the buyback price decided by Abhishek Ltd.
Market Capitalisation After Buyback:

1.1 P (Original Shares Shares Bought back)
30% of 90 lakhs
= 1.1P (10 Lakhs
6.52
= 11 Lakhs x P 27 lakhs x 1.1= 11 lakhs x P 29.7 lakhs

Market capitalization rate after buyback is 200 lakhs.
Thus, we have:
11 Lakhs x P 29.7 lakhs = `200 lakhs
or 11P = 200 + 29.7
229.7
= ` 20.88
11
or P =
(b) Number of shares to be bought back:
27 Lakhs
= 1.29 lakhs ( Approximaely )
20.88
(c) New Equity Shares
= (10 1.29) lakhs =
8.71 lakhs
3 10 lakhs 30 L
=
= Rs. 3.44
8.71lakhs 8.71L
EPS =
Thus EPS of Abhishek Ltd., increases to `3.44

Question 39
If the market price of the bond is ` 95; years to maturity = 6 yrs: coupon rate = 13% p.a (paid
annually) and issue price is ` 100. What is the yield to maturity?
Answer
C+
YTM =
YTM =
(F - P)
n
F +P
2
13 +
C= Coupon Rate; F= Face Value (Issue Price) ; P= Market Price of Bond
(100 - 95 )
6
100 + 95
2
= 0.1418 or 14.18%
Question 40
An investors is considering the purchase of the following Bond:

Face value
` 100
Coupon rate
11%
Maturity
3 years
Security Analysis
(i)
If he wants a yield of 13% what is the maximum price he should be ready to pay for?
(ii)
If the Bond is selling for ` 97.60, what would be his yield?
6.53
Answer
(i)
Calculation of Maximum price
Bo
= ` 11 PVIFA (13%,3) + ` 100 PVIF (13%,3)

= ` 11 2.361 + ` 100 0.693 = ` 25.97 + ` 69.30 = ` 95.27
(ii) Calculation of yield
At 12% the value
= ` 11 PVIFA (12%,3) + 100 PVIF (12%,3)
= ` 112.402 + ` 1000.712 = ` 26.42 + ` 71.20 = ` 97.62

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%.
Alternatively
` 11 +
YTM =
( ` 100 - `
97.60 )
3
( ` 100 + ` 97.60)
2
= 0.1194 or 11.94% say 12%
Question 41
Calculate Market Price of:

(i)
10% Government of India security currently quoted at ` 110, but yield is expected to go
up by 1%.
(ii)
A bond with 7.5% coupon interest, Face Value ` 10,000 & term to maturity of 2 years,
presently yielding 6% . Interest payable half yearly.
Answer
(i)
Current yield = (Coupon Interest / Market Price) X 100

(10/110) X 100 = 9.09%
If current yield go up by 1% i.e. 10.09 the market price would be
10.09 = 10 / Market Price X 100
Market Price = ` 99.11
(ii) Market Price of Bond
= P.V. of Interest + P.V. of Principal

= ` 1,394 + ` 8,885 = ` 10,279
6.54
Question 42
Find the current market price of a bond having face value ` 1,00,000 redeemable after 6 year
maturity with YTM at 16% payable annually and duration 4.3202 years. Given 1.166 = 2.4364.
Answer
The formula for the duration of a coupon bond is as follows:

=
1+ YTM (1+ YTM) + t (c - YTM)

YTM
c ( 1+ YTM)t -1 + YTM
Where YTM = Yield to Maturity

c= Coupon Rate
t= Years to Maturity
Accordingly, since YTM =0.16 and t= 6
4.3202 =
1.16 1.16 + 6(c 0.16)

0.16 c ( 1.16)6 -1 + 0.16
4.3202= 7.25 -
1.16 + (6c - 0.96)

1.4364c + 0.16
1.16 + 6c 0.96
= 2.9298
1.4364 c + 0.16
0.2 + 6c = 4.20836472 c + 0.468768
1.79163528c = 0.268768
C = 0.150012674
c = 0.15
Where c = Coupon rate

Therefore, current price = `(1,00,000/- x 0.15 x 3.685 + 1,00,000/- x 0.410) = `96,275/-.
Question 43
There is a 9% 5-year bond issue in the market. The issue price is ` 90 and the redemption
price ` 105. For an investor with marginal income tax rate of 30% and capital gains tax rate of
10% (assuming no indexation), what is the post-tax yield to maturity?
Answer
Calculation of yield to Maturity (YTM)
Security Analysis
YTM =
6.55
Coupon + Pr o - rated discount

(Re demption price + Purchase Pr ice)/2
After tax coupon = 9 (1 .30) = 6.3%

After tax redemption price = 105 (15 .10) or ` 103.5
After tax capital gain = 103.50 90 = ` 13.50
YTM =
6.3 + (13.5/5 )
(103.5 + 90)/2
or
9.00
= 9.30%
96.75
Question
44
ABC Ltd. issued 9%, 5 year bonds of ` 1,000/- each having a maturity of 3 years. The present
rate of interest is 12% for one year tenure. It is expected that Forward rate of interest for one
year tenure is going to fall by 75 basis points and further by 50 basis points for every next year
in further for the same tenure. This bond has a beta value of 1.02 and is more popular in the
market due to less credit risk.
Calculate
(i)
Intrinsic value of bond
(ii)
Expected price of bond in the market
Answer
(i)
Intrinsic value of Bond
PV of Interest + PV of Maturity Value of Bond

Forward rate of interests
1st Year 12%
2nd Year 11.25%
3rd Year 10.75%
PV of interest =
` 90
(1 + 0.12)
` 90
(1 + 0.12)(1 + 0.1125)
PV of Maturity Value of Bond =
` 90
(1 + 0.12)(1 + 0.1125)(1 + 0.1075)
`1000
(1+ 0.12)(1+ 0.1125)(1+ 0.1075)
Intrinsic value of Bond = ` 217.81 + ` 724.67 = ` 942.48

(ii) Expected Price = Intrinsic Value x Beta Value
= ` 948.48 x 1.02 = ` 961.33
= ` 217.81
= ` 724.67
6.56
Question 45
MP Ltd. issued a new series of bonds on January 1, 2010. The bonds were sold at par
(`1,000), having a coupon rate 10% p.a. and mature on 31st December, 2025. Coupon
payments are made semiannually on June 30th and December 31st each year. Assume that
you purchased an outstanding MP Ltd. bond on 1st March, 2018 when the going interest rate
was 12%.
Required:
(i)
What was the YTM of MP Ltd. bonds as on January 1, 2018?
(ii)
What amount you should pay to complete the transaction? Of that amount how much
should be accrued interest and how much would represent bonds basic value.
Answer
(i)
Since the bonds were sold at par, the original YTM was 10%.
YTM =
Interest ` 100
=
= 10%
Pr incipal ` 1,000
(ii) Price of the bond as on 1st July, 2018
= ` 50 9.712 + ` 1,000 0.417

= ` 485.60 + ` 417
= ` 902.60
Total value of the bond on the next
= ` 902.60 + ` 50 interest date = `952.60
Value of bond at purchase date
= ` 952.60
1
(1+ 0.06) 2/3
= ` 952.60 ` 0.9620 (by using excel)

= ` 916.40
The amount to be paid to complete the transaction is `916.40. Out of this amount
` 48.10 represent accrued interest and `868.30 represent the bond basic value.
Question 46
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
AAA + 3% spread
He is considering to invest in AA rated, ` 1,000 face value bond currently selling at

` 1,025.86. The bond has five years to maturity and the coupon rate on the bond is 15% p.a.
Security Analysis
6.57
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%).
You are required to calculate the intrinsic value of the bond for Mr. Z. Should he invest in the
bond? Also calculate the current yield and the Yield to Maturity (YTM) of the bond.
Answer
The appropriate discount rate for valuing the bond for Mr. Z is:
R = 9% + 3% + 2% = 14%
Time
1
2
3
4
5
CF
150
150
150
150
1150
PVIF 14% PV (CF)

0.877
0.769
0.675
0.592
0.519
PV (CF) i.e. P 0 =
PV (CF)
131.55
115.35
101.25
88.80
596.85
1033.80
Since, the current market value is less than the intrinsic value; Mr. Z should buy the bond. Current
yield = Annual Interest / Price = 150 / 1025.86 = 14.62%
The YTM of the bond is calculated as follows:
@15%
P = 150 PVIFA 15%, 4 + 1150 PVIF 15%, 5
= 150 2.855 + 1150 0.497 = 428.25 + 571.55 = 999.80
@14%
As found in sub part (a) P0 = 1033.80
By interpolation we get,
= 14% +
7.94
7.94
(15% - 14%) =14% +
%
34
7.94 - (-26.06)
YTM = 14.23%
Question 47
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
6.58
Years
14
9%
58
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.
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 (` )
PVIF @ 16%
PV
.862
7.758
.743
6.687
.641
5.769
.552
4.968
10
.476
4.76
10
.410
4.10
10
.354
3.54
10
.305
3.05
14
.263
3.682
10
14 + 105 = 119
.227
3.178 + 23.835
71.327
Thus the debentures should be priced at ` 71.327

Question 48
ABC Ltd. has ` 300 million, 12 per cent bonds outstanding with six years remaining to
maturity. Since interest rates are falling, ABC Ltd. is contemplating of refunding these bonds
with a ` 300 million issue of 6 year bonds carrying a coupon rate of 10 per cent. Issue cost of
the new bond will be ` 6 million and the call premium is 4 per cent. ` 9 million being the
unamortized portion of issue cost of old bonds can be written off no sooner the old bonds are
called off. Marginal tax rate of ABC Ltd. is 30 per cent. You are required to analyse the bond
refunding decision.
Security Analysis
6.59
Answer
1.
Calculation of initial outlay:-
`(million)
a.
Face value
Add:-Call premium
b.
12
Cost of calling old bonds
312
Gross proceed of new issue
300
Less: Issue costs
Net proceeds of new issue

c.
300
6
294
Tax savings on call premium

and unamortized cost 0.30 (12 + 9)
6.3
Initial outlay = ` 312 million ` 294 million ` 6.3 million = ` 11.7 million
2.
Calculation of net present value of refunding the bond:-
Saving in annual interest expenses
` (million)
[300 x (0.12 0.10)]
6.00
Less:- Tax saving on interest and amortization
0.30 x [6 + (9-6)/6]
1.95
Annual net cash saving
4.05
PVIFA (7%, 6 years)
4.766
Present value of net annual cash saving
` 19.30 million
Less:- Initial outlay
` 11.70 million
Net present value of refunding the bond
` 7.60 million
Decision: The bonds should be refunded

Question 49
M/s Transindia Ltd. is contemplating calling ` 3 crores of 30 years, ` 1,000 bond issued 5
years ago with a coupon interest rate of 14 per cent. The bonds have a call price of ` 1,140
and had initially collected proceeds of ` 2.91 crores due to a discount of ` 30 per bond. The
initial floating cost was ` 3,60,000. The Company intends to sell ` 3 crores of 12 per cent
coupon rate, 25 years bonds to raise funds for retiring the old bonds. It proposes to sell the
new bonds at their par value of ` 1,000. The estimated floatation cost is ` 4,00,000. The
company is paying 40% tax and its after tax cost of debt is 8 per cent. As the new bonds must
6.60
first be sold and their proceeds, then used to retire old bonds, the company expects a two
months period of overlapping interest during which interest must be paid on both the old and
new bonds. What is the feasibility of refunding bonds?
Answer
NPV for bond refunding
`
PV of annual cash flow savings (W.N. 2)
(3,49,600 PVIFA 8%,25) i.e. 10.675
37,31,980
Less: Initial investment (W.N. 1)
29,20,000
NPV
8,11,980
Recommendation: Refunding of bonds is recommended as NPV is positive.

Working Notes:
(1) Initial investment:
(a) Call premium

Before tax (1,140 1,000) 30,000
Less tax @ 40%
42,00,000
16,80,000
After tax cost of call prem.

(b) Floatation cost
25,20,000
4,00,000
(c) Overlapping interest

Before tax (0.14 2/12 3 crores)
7,00,000
Less tax @ 40%
2,80,000
4,20,000
(d) Tax saving on unamortised discount on

old bond 25/30 9,00,000 0.4
(3,00,000)
(e) Tax savings from unamortised floatation

(1,20,000)
Cost of old bond 25/30 3,60,000 0.4
29,20,000
(2) Annual cash flow savings:
(a) Old bond

(i)
Interest cost (0.14 3 crores)
42,00,000
Less tax @ 40%
16,80,000
25,20,000
Security Analysis
(ii)
Tax savings from amortisation of discount

9,00,000/30 0.4
(iii) Tax
savings
from
amortisation
floatation cost 3,60,000/30 0.4
6.61
(12,000)
of
(4,800)
Annual after tax cost payment under old Bond (A)
25,03,200
(b) New bond

(i)
Interest cost before tax (0.12 3 crores)
36,00,000
Less tax @ 40%
14,40,000
After tax interest

(ii) Tax savings from amortisation of floatation cost
(0.4 4,00,000/25)
Annual after tax payment under new Bond (B)
Annual Cash Flow Saving (A) (B)
21,60,000
(6,400)
21,53,600
3,49,600
Question 50
The following data are available for a bond

Face value
Coupon Rate
Years to Maturity
Redemption value
Yield to maturity
` 1,000
16%
6
` 1,000
17%
What is the current market price, duration and volatility of this bond? Calculate the expected
market price, if increase in required yield is by 75 basis points.
Answer
1.
Calculation of Market price:
Discount or premium
Coupon int erest +
Years left
YTM =
Face Value + Market value
2
Discount or premium YTM is more than coupon rate, market price is less than Face
Value i.e. at discount.
Let x be the market price
6.62
(1,000 - x)
160 +
0.17 =
1,000 + x
2
x = ` 960.26
Alternatively, the candidate may attempt by

160 (PVIAF 17%,6) + 1,000 (PVIF 17%,6)
= 160 (3.589) + 1,000 (0.390) = 574.24 + 390 = 964.24
2.
Duration
Proportion of
bond value
Proportion of bond
value x time (years)
136.80
0.142
0.142
.731
116.96
0.121
0.246
160
.624
99.84
0.103
0.309
160
.534
85.44
0.089
0.356
160
.456
72.96
0.076
0.380
1160
.390
452.40
0.469
2.814
964.40
1.000
4.247
Year
Cash flow
P.V. @ 17%
160
.855
160
Duration of the Bond is 4.247 years

3.
Volatility
Volatility of the bonds =

4.
Duration 4.247
=
= 3.63
(1 + yields) 1.17
The expected market price if increase in required yield is by 75 basis points.
= ` 960.26 .75 (3.63/100) = ` 26.142

Hence expected market price is ` 960.26 ` 26.142 = ` 934.118
Hence, the market price will decrease
This portion can also be alternatively done as follows
= ` 964.40 .75 (3.63/100) = ` 26.26
then the market price will be
= ` 964.40 26.26 = ` 938.14
Security Analysis
6.63
Question 51
XL Ispat Ltd. has made an issue of 14 per cent non-convertible debentures on January 1,
2007. These debentures have a face value of ` 100 and is currently traded in the market at a
price of ` 90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and December
31. Interest payments for the first 3 years will be paid in advance through post-dated cheques
while for the last 2 years post-dated cheques will be issued at the third year. The bond is
redeemable at par on December 31, 2011 at the end of 5 years.
Required :
(i)
Estimate the current yield and YTM of the bond.
(ii)
Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment
calculate the realised yield on the NCD.
Answer
(i)
Current yield =
` 14
= 0.1555 or 15.55%
` 90
YTM can be determined from the following equation

14 PVIFA (YTM, 5) + 100 PVIF (YTM, 5) = 90
Let us discount the cash flows using two discount rates 15% and 18% as follows:
Year
Cash
Flows
PVF@15%
PV@15%
PVF@18%
PV@18%
-90
-90
-90
14
0.870
12.18
0.847
11.86
14
0.756
10.58
0.718
10.05
14
0.657
9.20
0.609
8.53
14
0.572
8.01
0.516
7.22
114
0.497
56.66
0.437
49.82
6.63
Now we use interpolation formula
15% +
6.63
3%
6.63 - (-2.52)
-2.52
6.64
15% +
6.63
3% =15% + 2.17%
9.15
YTM = 17.17%
Note: Students can also compute the YTM using rates other than 15% and 18%.
(ii) The duration can be calculated as follows:
Year
Cash
Flow
PVF@
17.17%
PV @
17.17%
Proportion of
NCD value
Proportion of NCD
value time
14
0.853
11.942
0.1328
0.1328
14
0.728
10.192
0.1134
0.2268
14
0.622
8.708
0.0968
0.2904
14
0.531
7.434
0.0826
0.3304
114
0.453
51.642
0.5744
2.8720
89.918
3.8524
Duration = 3.8524 years.

(iii) Realized Yield can be calculated as follows:
(14 5) + 100
= 90
(1 + R ) 5
1/ 5
(1 + R) 5 =
170
170
R=
- 1 = 0.1356 or 13.56%
90
90
Question 52
GHI
Ltd., AAA rated company has issued, fully convertible bonds on the following terms, a
year ago:
Face value of bond
` 1000
Coupon (interest rate)
8.5%
Time to Maturity (remaining)
3 years
Interest Payment
Annual, at the end of year
Principal Repayment
At the end of bond maturity
Conversion ratio (Number of shares per bond)
25
Current market price per share
` 45
` 1175
Market price of convertible bond
Security Analysis
6.65
AAA
rated company can issue plain vanilla bonds without conversion option at an interest rate
of 9.5%.
Required: Calculate as of today:
(i)
Straight Value of bond.
(ii)
Conversion Value of the bond.
(iii) Conversion Premium.

(iv) Percentage of downside risk.
(v) Conversion Parity Price.
t
PVIF0.095, t
0.9132
0.8340
0.7617
Answer
(i)
Straight Value of Bond
` 85 x 0.9132 + ` 85 x 0.8340 + ` 1085 x 0.7617 = ` 974.96

(ii) Conversion Value
Conversion Ration x Market Price of Equity Share

= ` 45 x 25 = ` 1,125
(iii) Conversion Premium
Conversion Premium = Market Conversion Price - Market Price of Equity Share

=
` 1,175
- ` 45 = ` 2
25
(iv) Percentage of Downside Risk
` 1,175 - ` 974.96
` 974.96
100 = 20.52%
(v) Conversion Parity Price
Bond Price
No. of Share on Conversion
=
` 1,175
= ` 47
25
6.66
Question 53
(a) Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity.
Both the bonds have a face value of ` 1,000 and coupon rate of 8% (with annual interest
payments) and both are selling at par. Assume that the yields of both the bonds fall to
6%, whether the price of bond will increase or decrease? What percentage of this
increase/decrease comes from a change in the present value of bonds principal amount
and what percentage of this increase/decrease comes from a change in the present
value of bonds interest payments?
(b) Consider a bond selling at its par value of ` 1,000, with 6 years to maturity and a 7%
coupon rate (with annual interest payment), what is bonds duration?
(c) If the YTM of the bond in (b) above increases to 10%, how it affects the bonds duration?
And why?
Answer
(a) If the yield of the bond falls the price will always increase. This can be shown by
following calculation.
IF YIELD FALLS TO 6%
Price of 5yr. bond
` 80 (PVIFA 6%, 5yrs.)
+ ` 1000 (PVIF 6%, 5yrs.)
` 80 (4.212)+ ` 1000 (0.747)

` 336.96 + ` 747.00 = ` 1,083.96
Increase in 5 years bond price = ` 83.96
Current price of 20 year bond
` 80 (PVIFA 6%, 20) + ` 1,000 (PVIF 6%, 20)

` 80 (11.47) + ` 1,000 (0.312)
` 917.60 + ` 312.00 = ` 1229.60
So increase in bond price is ` 229.60
PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL
5 yrs. Bond
` 1,000 (PVIF 6%, 5) ` 1,000 (PVIF 8%, 5)

` 1,000 (0.747) ` 1,000 (0.681)
` 747.00 ` 681.00 = ` 66.00
& change in price due to change in PV of Principal
(` 66/ ` 83.96) x 100 = 78.6%
Security Analysis
6.67
20 yrs. Bond
` 1,000 (PVIF 6%, 20) ` 1,000 (PVIF 8%, 20)

` 1,000 (0.312) ` 1,000 (0.214)
` 312.00 ` 214.00 = ` 98.00
& change in price due to change in PV of Principal
(` 98/ ` 229.60) x 100 = 42.68%
PRICE CHANGE DUE TO CHANGE IN PV OF INTEREST
5 yrs. Bond
` 80 (PVIFA 6%, 5) ` 80 (PVIFA 8%, 5)

` 80 (4.212) ` 80 (3.993)
` 336.96 ` 319.44 = ` 17.52
% change in price
` 17.52
x 100 = 20.86%
` 83.96
20 yrs. Bond
` 80 (PVIFA 6%, 20) ` 80 (PVIFA 8%,20)

` 80 (11.47) ` 80 (9.82)
` 917.60 ` 785.60 = ` 132
& change in price =
` 132
x 100 = 57.49%
` 229.60
(b) Duration in the average time taken to recollect back the investment
Years
(A)
1
2
3
4
5
6
Duration =
Coupon
Payments
(`)
70
70
70
70
70
70
Redemption
(`)
1000
ABC
Purchase Price
Total
(`)
(B)
70
70
70
70
70
1070
PVIF @ 7%
(`)
(C)
0.935
0.873
0.816
0.763
0.713
0.666
ABC
(A )x(B)x (C)
(`)
65.45
122.22
171.36
213.64
249.55
4,275.72
5,097.94
6.68
` 5097.94
= 5.098 years
` 1000
(c) If YTM goes up to 10% , current price of the bond will decrease to
` 70 x PVIFA (10%,6) + ` 1000 PVIF (10%,6)

` 304.85 + ` 564.00 = ` 868.85
Year
(A)
1
2
3
4
5
6
Inflow (`)
(B)
70
70
70
70
70
1070
PVIF @ 10%
(C)
0.909
0.826
0.751
0.683
0.621
0.564
ABC
(A )x(B)x (C)
(`)
63.63
115.64
157.71
191.24
217.35
3,620.88
4,366.45
New Duration ` 4,366.45/ ` 868.85 = 5.025 years

The duration of bond decreases, reason being the receipt of slightly higher portion of
ones investment on the same intervals.
Question 54
Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 200X
were as follows:
Days
Date
Day
Sensex
THU
14522
FRI
14925
SAT
No Trading
SUN
No Trading
10
MON
15222
11
TUE
16000
12
WED
16400
13
THU
17000
14
FRI
No Trading
10
15
SAT
No Trading
11
16
SUN
No Trading
12
17
MON
18000
Security Analysis
6.69
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days
simple moving average of Sensex can be assumed as 15,000. The value of exponent for 30
days EMA is 0.062.
Give detailed analysis on the basis of your calculations.
Answer
Date
1
Sensex
2
EMA for
Previous day
1-2
30.062
5
EMA
2+4
14522
15000
(478)
(29.636)
14970.364
14925
14970.364
(45.364)
(2.812)
14967.55
10
15222
14967.55
254.45
15.776
14983.32
11
16000
14983.32
1016.68
63.034
15046.354
12
16400
15046.354
1353.646
83.926
15130.28
13
17000
15130.28
1869.72
115.922
15246.202
17
18000
15246.202
2753.798
170.735
15416.937
Conclusion The market is bullish. The market is likely to remain bullish for short term to
medium term if other factors remain the same. On the basis of this indicator (EMA) the
investors/brokers can take long position.
Question 55
The closing value of Sensex for the month of October, 2007 is given below:
Date Closing
Sensex Value
1.10.07
2800
3.10.07
2780
4.10.07
2795
5.10.07
2830
8.10.07
2760
9.10.07
2790
10.10.07
2880
11.10.07
2960
12.10.07
2990
15.10.07
3200
16.10.07
3300
17.10.07
3450
6.70
19.10.07
3360
22.10.07
3290
23.10.07
3360
24.10.07
3340
25.10.07
3290
29.10.07
3240
30.10.07
3140
31.10.07
3260
You are required to test the weak form of efficient market hypothesis by applying the run test
at 5% and 10% level of significance.
Following value can be used :
Value of t at 5% is 2.101 at 18 degrees of freedom
Value of t at 10% is 1.734 at 18 degrees of freedom
Value of t at 5% is 2.086 at 20 degrees of freedom.
Value of t at 10% is 1.725 at 20 degrees of freedom.
Answer
Date
1.10.07
3.10.07
4.10.07
5.10.07
8.10.07
9.10.07
10.10.07
11.10.07
12.10.07
15.10.07
16.10.07
17.10.07
19.10.07
22.10.07
23.10.07
24.10.07
25.10.07
Closing Sensex
2800
2780
2795
2830
2760
2790
2880
2960
2990
3200
3300
3450
3360
3290
3360
3340
3290
Sign of Price Charge
+
+
+
+
+
+
+
+
+
+
-
Security Analysis
29.10.07
30.10.07
31.10.07
3240
3140
3260
6.71
Total of sign of price changes (r) = 8

No of Positive changes = n1 = 11
No. of Negative changes = n2 = 8
r=
=
r
=
r
2n1n2
+1
n1 + n2
2 11 8
+ 1 = 176/19 + 1 = 10.26
11 + 8
2n1n2 (2n1n2 n1 n2 )
(n1 + n2 )2 (n1 + n2 1)
(2 11 8) (2 11 8 11 8)
=
(11 + 8)2 (11 + 8 1)
176 157
=
(19)2 (18)
4.252 = 2.06
Since too few runs in the case would indicate that the movement of prices is not random. We
employ a two- tailed test the randomness of prices.
Test at 5% level of significance at 18 degrees of freedom using t- table
The lower limit
= t =10.26 2.101 2.06 = 5.932

r
Upper limit
= + t =10.26 + 2.101 2.06 = 14.588

r
At 10% level of significance at 18 degrees of freedom

Lower limit
= 10.26 1.734 2.06 = 6.688
Upper limit
= 10.26 + 1.734 2.06 = 13.832
As seen r lies between these limits. Hence, the market exhibits weak form of efficiency.
*For a sample of size n, the t distribution will have n-1 degrees of freedom.
6.72
Question 56
Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of ` 90 lakhs.
Its present borrowings are as follows:
` In lakhs
12% term loan
300
Working capital borrowings:

From Bank at 15%
200
Public Deposit at 11%
100
The sales of the company are growing and to support this, the company proposes to obtain
additional borrowing of ` 100 lakhs expected to cost 16%.The increase in EBIT is expected to
be 15%.
Calculate the change in interest coverage ratio after the additional borrowing is effected and
comment on the arrangement made.
Answer
Calculation of Present Interest Coverage Ratio

Present EBIT = ` 90 lakhs
Interest charges (Present)
`lakhs
Term loan @ 12%
36.00
Bank Borrowings @ 15%
30.00
Public Deposit @ 11%
11.00
77.00
Present Interest Coverage Ratio
EBIT
Interest Ch arg es
=
` 90 lakhs
= 1.169
` 77 lakhs
Calculation of Revised Interest Coverage Ratio

Revised EBIT (115% of ` 90 lakhs)
`103.50 lakhs
Proposed interest charges

Existing charges
` 77.00 lakhs
Add: Additional charges (16% of additional Borrowings i.e. `100 lakhs)
` 16.00 lakhs
Total
` 93.00 lakhs
Security Analysis
Revised Interest Coverage Ratio =
6.73
` 103.50 lakhs
= 1.113
` 93.00 lakhs
Analysis: With the proposed increase in the sales the burden of interest on additional
borrowings of `100 lakhs will adversely affect the interest coverage ratio which has been
reduced. (i.e. from 1.169 to 1.113).
Question 57
The HLL has ` 8.00 crore of 10% mortgage bonds outstanding under an open-end scheme.
The scheme allows additional bonds to be issued as long as all of the following conditions are
met:
(1)
Income before tax + Bond Interest

Pre - tax interest coverage
remains greater than 4.
Bond Interest
(2) Net depreciated value of mortgage assets remains twice the amount of the mortgage
debt.
(3) Debt-to-equity ratio remains below 5.
The HLL has net income after taxes of ` 2 crores and a 40% tax-rate, ` 40 crores in
equity and ` 30 crores in depreciated assets, covered by the mortgage.
Assuming that 50% of the proceeds of a new issue would be added to the base of
mortgaged assets and that the company has no Sinking Fund payments until next year,
how much more 10% debt could be sold under each of the three conditions? Which
protective covenant is binding?
Answer
Let x be the crores of Rupees of new 10% debt which would be sold under each of the three given
conditions. Now, the value of x under each of the three conditions is as follows:
1.
Income before tax + Bond Interest

Pre - tax interest coverage
remains greater than 4.
Bond Interest
` 2 crores / (1 0.4) + 8 crores 0.1 + x 0.1

=4
(8 crores 0.1) + (x 0.1)
Or
` 3.33 crores + 0.80 crores + 0.10x

=4
(0.80 crores + ` 0.10x)
Or
` 4.13 crores + 0.10x

=4
` 0.80 crores + ` 0.10x
Or ` 4.13 crores + 0.10x = 4 (` 0.80 crores + ` 0.10x)

Or ` 4.13 crores + 0.10x = ` 3.2 crores + ` 0.40x
6.74
Or ` 0.30 x
= 0.93
Or
= ` 0.93/0.30
Or
= ` 3.10 crores
Additional mortgage required shall be a maximum of ` 3.10 crores.

2.
Net depreciated value of mortgage assets remains twice the amount of mortgage debt
(Assuming that 50% of the proceeds of new issue would be added to the base of
mortgaged assets)
i.e.
` 30 crores + 0.5 x
= 2
` 8 crores + x
or ` 30 crores + 0.5x = 2 ( ` 8 crores + x)

or ` 1.5x = ` 14 crores
or x=
` 14 crores
1.5
or x = 9.33 crores
Additional mortgage required to satisfy condition No. 2 is ` 9.33 crores
3.
Debt to equity ratio remains below 5

i.e.
` 8 crores + x
< 5
` 40 crores
or ` 8 crores + x = ` 200 crores

or x = ` 192 crores
Since all the conditions are to be met, the least i.e. ` 3.10 crores (as per condition 1)
can be borrowed by issuing additional bonds.
Note: Since in the question, it is given that Debt to equity ratio remains below 5, the value of
debt is computed by using this condition. However, the new additional debt (x) is exorbitant
and is not comparable with the value of new additional debt (x) computed under conditions 1
and 2. For getting the comparable value of new additional debt x the debt to equity ratio
should be read as 0.5. Accordingly, value of additional debt would be ` 12 crores.
Question 58
John inherited the following securities on his uncles death:

Types of Security
Nos.
Annual Coupon % Maturity Years
Yield %
Bond A (` 1,000)
10
12
Bond B (` 1,000)
10
10
12
Security Analysis
6.75
Preference shares C (` 100)
100
11
13*
Preference shares D (` 100)
100
12
13*
*likelihood of being called at a premium over par.

Compute the current value of his uncles portfolio.
Answer
Computation of current value of Johns portfolio
(i)
10 Nos. Bond A, ` 1,000 par value, 9% Bonds maturity 3 years:
`
Current value of interest on bond A
1-3 years:
` 900 Cumulative P.V. @ 12% (1-3 years)

= ` 900 2.402
2,162
Add: Current value of amount received on maturity of Bond A
End of 3rd year: ` 1,000 10 P.V. @ 12% (3rd year)

= ` 10,000 0.712
(ii)
7,120
9,282
10 Nos. Bond B, ` 1,000 par value, 10% Bonds maturity 5 years:
Current value of interest on bond B

1-5 years:
` 1,000 Cumulative P.V. @ 12% (1-5 years)

= ` 1,000 3.605
3,605
Add: Current value of amount received on maturity of Bond B
End of 5th year: ` 1,000 10 P.V. @ 12% (5th year)

= ` 10,000 0.567
5,670
9,275
(iii) 100 Preference shares C, ` 100 par value, 11% coupon

11% 100 Nos. ` 100
1,100
=
13%
0.13
8,462
(iv) 100 Preference shares D, ` 100 par value, 12% coupon

12% 100 Nos. ` 100
1,200
=
13%
0.13
Total current value of his portfolio [(i) + (ii) + (iii) + (iv)]
9,231
17,693
36,250
6.76
Exercise
Question 1
Phototech plc has in issue 9% bonds which are redeemable at their par value of 100 in five years
time. Alternatively, each bond may be converted on that date into 20 ordinary shares of the company.
The current ordinary share price of Phototech plc is 445 and this is expected to grow at a rate of
65% per year for the foreseeable future. Phototech plc has a cost of debt of 7% per year. You are
required to calculate the following current values for each 100 convertible bond:
(i)
Market value;
(ii)
Floor value; and
(iii) Conversion premium.

Answer: (i) 12389 (ii) 10820 (iii) 3489
Question 2
On 1 June 2003 the financial manager of Gadgets Corporations Pension Fund Trust is reviewing
strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term bonds. Interest
rates are expected to be quite volatile for the next few years.
Among the pension funds current investments are two AAA rated bonds:
1)
Zero coupon June 2018
2)
12% Gilt June 2018 (interest is payable semi-annually)
The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual yield
may be assumed to be 3%. Both bonds have a par value and redemption value of $100. You are
required to estimate the market price of each of the bonds if interest rates (yields):
(i)
increase by 1%;
(ii)
decrease by 1%.
[Given PVF (2.5%, 30) = 0.4767, PVF (3%, 30) = 0.412, PVF (3.5%,30) = 0.3563]
Answer: (i) Zero Coupon Bond-131% (Decrease) & 12% Gilt June 2018- 81% (Decrease) (ii) Zero
Coupon Bond-15.3% (Increase) & 12% Gilt June 2018- 91% (Increase)
Question 3
It is now January 1, 2009, and Mr. X is considering the purchase of an outstanding Municipal
Corporation bond that was issued on January 1, 2007, the Municipal bond has a 9.5 percent annual
coupon and a 30-year original maturity (it matures on December 31, 2037). Interest rates have declined
since the bond was issued, and the bond now is selling at 116.575 % of par, or `1,165.75. Determine
the yield to maturity (YTM) of this bond for Mr. X.
Answer: 8.22%

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6

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