CA Final SFM

Strategic
Financial Management

SFM NEW SYLLABUS

(EXAM ORIENTED)

Volume
2

CA Pavan Karmele Sir

5. Security Valuation

6. Security Analysis

7. Corporate Valuation

8. Merger, Acquisition & Corporate Restructuring

Edition
2022 - 23
 CA FINAL SFM

STRATEGIC FINANCIAL
MANAGEMENT

EXAM ORIENTED BOOK (NEW SYLLABUS)

 Revised & Updated

 ICAI Study Material Coverage
 Includes Examination Question & Answer
 Video Lectures Available in Google Drive

Published By
STRATEGIC FINANCIAL MANAGEMENT

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 CONTENTS

CHAPTER – 05
SECURITY VALUATION
CONCEPTS Page No.

Introduction…………………………………………………………………………… 01

Bond Valuation……………………………………………………………………….. 01

Bond Pricing …………………………………………………………………………... 01

Bond Yield………………………………………………………………………………. 09

Bond Risk………………………………………………………………………........... 22

Bond Portfolio Management………………………………………………………… 45

Convertible Bond………………………………………………………………………. 52

Option Embedded Bond……………………………………………………………… 68

Yield Structure…………………………………………………………………………. 75

Equity Valuation………………………………………………………………........... 82

Dividend Growth Model………………………………………………………………. 82

Multiple Growth Model………………………………………………………………. 109

Buy Back Decision……………………………………………………………………. 127

Valuation of Right…………………………………………………………………….. 133

Money Market Instruments…………………………………………………………. 141

Residual…………………………………………………………………………………. 146
 CONTENTS

CHAPTER – 06
SECURITY ANALYSIS
CONCEPTS Page No.

Fundamental Analysis……………………………………………………………. 01

Technical Analysis…………………………………………………………………. 01

Exponential Moving Average (EMA)…………………………………………….. 02

Dow Theory……………………………………………………………………………

Support & Resistance Level……………………………………………………….

Elliott Wave Theory………………………………………………………………….

Bollinger Band………………………………………………………………………..
 CONTENTS

CHAPTER – 07
CORPORATE VALUATION
CONCEPTS Page No.

Corporate Valuation……………………………………………………………….. 01

Economic Value Added (EVA)……………………………………………………. 01

Valuation of Firm…………………………………………………………………… 17

Value of Equity On The Basis of FCFE………………………………………… 64

Chop Shop/Breakup Value Approach…………………………………………. 65

Gearing of Beta………………………………………………………………………. 67
 CONTENTS

CHAPTER – 08
MERGER, ACQUISITION & CORPORATE
RESTRUCTURING
CONCEPTS Page No.

Introduction…………………………………………………………………………. 01

Merger………………………………………………………………………………... 01

Basics…………………………………………………………………………………. 01

Free Float Market Capitalization……………………………………………….. 46

Demerger……………………………………………………………………………... 65

Leverage Buy Out (LBO)…………………………………………………………… 67

Residual……………………………………………………………………………….. 70
 SECURITY VALUATION

CHAPTER – 05
SECURITY VALUATION

SECURITY VALUATION
In Security Valuation, we have to calculate value of security i.e. real worth &
compare with actual market price & decide whether such security should be
purchased or not?

We divide security valuation chapter in three parts.

1. Bond Valuation.

2. Equity Valuation.

3. Money Market Instruments.

4. Residual

1. Bond Valuation

(I) Bond Pricing or Valuation of Bond

(II) Bond Yield

(III) Bond Risk

(IV) Convertible Bond

(V) Option Embedded Bond

(VI) Yield Structure/Term Structure

(I) Bond Pricing or Bond Valuation

Bond pricing means present value future cash inflows discounted at required
rate of return.

Required rate of return = Yield of similar bond

Intrinsic value of bond = P.V. of future cash flows

Decision Criterion:

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 SECURITY VALUATION

 If value of bond is more than current market price Underpriced

Purchased.
 If value of bond is less than current market price Overpriced Not
purchased.
 If value of bond is equal to current market price Correctly priced Do
nothing.

We divide bonds in 4 categories.

(i) Deep Discount Bonds or Zero Coupon Bonds.

(ii) Plain Vanilla Bonds or Conventional Bonds.

(iii) Non Conventional Bonds.

(iv) Perpetual Bonds.

(i) Deep Discount or Zero Coupon Bonds.

Deep discount bond is issued at discount & redeemed at face value. No coupon
is paid on such bond.

Example – 01

Face value of bond = ₹ 5,000

Life = 5 Years

Current market price = ₹ 2,200

No coupon payment

Yield on similar bond = 15% p.a.

Whether bond should be bought or not?

(ii) Plain Vanilla Bonds

Plain vanilla bond or conventional bond is a regular bond & interest rate is
fixed on such bonds. Such bonds are redeemable n maturity.

Example – 02

Face value = ₹ 1,000

Coupon = 12% p.a.

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Life = 5 Years

Redeemable at 10% premium at the end of year 5

Required rate of return = 15%

Calculate value of bond.

Example – 03

Face value of bond = ₹ 100

Coupon rate = 10% p.a. Semi Annually

Life = 5 Years

Yield on similar bond = 8% p.a.

Redeemable at par

Calculate issue price of bond.

(iii) Non Conventional Bonds

Non Conventional Bonds means where coupon payments are not same each
year & redeemed in part any year.

Example – 04

Face value = ₹ 1,000

Life = 5 Years

Coupon =1–3 10%

=4–5 12%

Redeemable at par

3rd Year = ₹ 500

5th Year = ₹ 500

Yield = 15% Value of bond = ?

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 SECURITY VALUATION

(iv) Perpetual Bonds

Perpetual bonds means only interest is received forever (infinite) & no principal
amount received.

Coupon Payment
Value of bond =
Yeild of Similar Bond
Example – 05

Face value of bond = ₹ 1,000

Coupon = 12%

Yield of similar bond = 10%

Value of perpetual bond = ?

QUESTION – 01

M/s Agfa Industries is planning to issue a debenture series on the following

terms:

Face Value ₹ 100

Term of maturity 10 years

Yearly coupon rate

Years
1–4 9%
5–8 10%
9 – 10 14%

The current market rate on similar debentures is 15 per cent per annum. The
Company proposes to price the issue in such a manner that it can yield 16 per
cent compounded rate of return to the investors. The Company also proposes
to redeem the debentures at 5 per cent premium on maturity. Determine the
issue price of the debentures.

(Study Material & Practice Manual)

SOLUTION:

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 SECURITY VALUATION

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

1 9 0.862 7.758
2 9 0.743 6.687
3 9 0.641 5.769
4 9 0.552 4.968
5 10 0.476 4.76
6 10 0.410 4.10
7 10 0.354 3.54
8 10 0.305 3.05
9 14 0.263 3.682
10 14 + 105 = 119 0.227 3.178 + 23.835
71.327

Thus the debentures should be priced at ₹ 71.327

QUESTION – 02

Bright Computers Limited is planning to issue a debenture series with a face

value of ₹ 1,000 each for a term of 10 years with the following coupon rates:
Years
1–4 8%
5–8 9%
9 – 10 13%

The current market rate on similar debenture is 15% p.a. The company
proposes to price the issue in such a way that a yield of 16% compounded rate
of return is received by the investors. The redeemable price of the debenture
will be at 10% premium on maturity. What should be the issue price of
debenture?

PV @ 16% for 1 to 10 years are: 0.862, 0.743, 0.641, 0.552, 0.476, 0.410,
0.354, 0.305, 0.263, 0.227 respectively.

SOLUTION:

Present Value of Debenture

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 SECURITY VALUATION

Year Cash Outflow (₹) PVF @ 16% Present Value (₹)

1-4 80 2.798 223.84
5-8 90 1.545 139.05
9-10 130 0.490 63.70
10 1100 0.227 249.70
676.29

QUESTION – 03

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%.

(Practice Manual, Study Material)

SOLUTION:

Case (i) Required yield rate = 5%

Year Cash flow ₹ DF (5%) Present Value (₹)

1-5 10 4.3295 43.295
5 110 0.7835 86.185
Value of bond 129.48

Case (ii) Required yield rate = 5.1%

Year Cash flow ₹ DF (5%) Present Value(₹)

1-5 10 4.3175 43.295
5 110 0.7798 85.778
Value of bond 129.48

Case (iii) Required yield rate = 10%

Year Cash flow ₹ DF (5%) Present Value (₹)

1-5 10 3.7908 37.908
5 110 0.6209 68.299
Value of bond 106.207

Case (iv) Required yield rate = 10.1%

Year Cash flow ₹ DF (5%) Present Value (₹)

1-5 10 3.7811 37.811
5 110 0.6181 67.991
Value of bond 105.802

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 SECURITY VALUATION

QUESTION – 04

A company proposes to sell ten-year debentures of ₹ 10,000 each. The

company would repay ₹ 1,000 at the end of every year and will pay interest
annually at 15 percent on the outstanding amount. Determine the present
value of the debenture issue if the capitalization rate is 18 percent.

SOLUTION:

Calculation of Present Value of Bond

Interest + Redeemable Year PVF (18%) Amount Present

Value Value

1,000 + (10,000 × 15%) 1 0.847 2,500 2,117

1,000 + (9,000 × 15%) 2 0.718 2,350 1,687
1,000 + (8,000 × 15%) 3 0.609 2,200 1,340
1,000 + (7,000 × 15%) 4 0.516 2,050 1,058
1,000 + (6,000 × 15%) 5 0.437 1,900 830
1,000 + (5,000 × 15%) 6 0.370 1,750 647
1,000 + (4,000 × 15%) 7 0.314 1,600 502
1,000 + (3,000 × 15%) 8 0.266 1,450 386
1,000 + (2,000 × 15%) 9 0.225 1,300 292
1,000 + (1,000 × 15%) 10 0.191 1,150 220
₹ 9,080

QUESTION – 05

John inherited the following securities on his uncle‟s death:

Types of Security Nos. Annual Maturity Yield %

Coupon % Years
Bond A (₹ 1,000) 10 9 3 12
Bond B (₹ 1,000) 10 10 5 12
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 uncle‟s portfolio.

(Practice Manual)

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 SECURITY VALUATION

SOLUTION:

Computation of current value of John’s 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 7,120 9,282

(ii) 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

= 8,462
13% 0.13

(iv) 100 Preference shares D, ₹ 100 par value, 12% coupon

12% × 100 Nos . × ₹ 100 1,200

= 9,231 17,693
13% 0.13

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 SECURITY VALUATION

Total current value of his portfolio [(i) + (ii) + (iii) + (iv)] 36,250

(II) Bond Yield

There are three types of Bond Yield.

1. Yield to Maturity (YTM)
2. Current Yield
3. Realized YTM

1. Yield to Maturity

Yield to maturity means return from bond till its maturity & it is used for
decision making whether bond should be purchased or not.

Calculation of YTM

F−P
I+
n
(i) YTM of Regular Bond = F+P × 100
2

I = Interest Amount

F = Face Value or Redeemable Value

N = Number of Periods.

(ii) YTM of Perpetual Bond

I
YTM = × 100
P

Decision Criterion

(i) IF YTM is more than required rate of return then bond should be
purchased.

(ii) If YTM is less than required rate of return then bond should not be
purchased.

(iii) If YTM is equal to required rate of return then bond should be

purchased.

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 SECURITY VALUATION

2. Current Yield

 Current Yield is calculated as under

I
Current Yield = × 100
P
 Current Yield is not used in decision making.

Example – 06

Bond A Bond B Bond C

ZCB Conventional Bond Perpetual Bond
Face Value ₹ 5,000 ₹ 1,000 ₹ 100
Coupon Nil 12% 10%
Maturity Period 5 Years 10 Years -
CMP ₹ 2,800 ₹ 920 ₹ 80

Which bond should be purchased?

Example – 07

Face value = ₹ 100

Coupon = 11%

CMP = ₹ 90

Life = 5 Years

R.V. = ₹ 110

Income tax = 30%

Capital Gain = 10%

Calculate post tax YTM

Example – 08

Face value = ₹ 1,000

CMP = ₹ 980

Life = 5 Years

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 SECURITY VALUATION

Redeemable at par

Coupon = 12% p.a. semiannually

Yield of similar bond = 15%

Calculate YTM.

Whether bond should be purchased?

3. Realized YTM

In YTM, we assume that intermediary cash flows are invested at YTM but it
may be possible that actual reinvestment rate is different from YTM. In this
situation we have to calculate realized YTM.

Example – 09

Face value of bonds = ₹ 1,000

Life = 3 years

CMP = ₹ 970

Coupon Rate = 12% p.a.

Calculate YTM & Calculate Realized YTM if reinvestment rate 9% per annum.

Clean Price & Dirty Price

Full price/Dirty price = Value of Bond on Valuation date

Clean price or Bond basic value = Dirty price – Accrued interest

Example – 10

Date of purchase = 31/10/2020

Face value = ₹ 1,000

Coupon = 12% p.a. Half yearly due date 30/06 & 31/12

Maturity date = 31/12/2023

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 SECURITY VALUATION

Redeemable at par

Yield of similar bond = 15% p.a.

Calculate: (i) Clean price

(ii) Dirty price

(ii) Accrued interest.

QUESTION – 06

Based on the credit rating of bonds, Mr. Z has decided to apply the following
discount rates for valuing bonds:
Credit Rating Discount Rate

AAA 364 day T bill rate + 3% spread

AA AAA + 2% spread

A AAA + 3% spread

He is considering to invest in AA rated, ₹ 1,000 face value bond currently

selling at ₹ 1,025.86. The bond has five years to maturity and the coupon rate
on the bond is 15% p.a. 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.

(Practice manual)

SOLUTION:

The appropriate discount rate for valuing the bond for Mr. Z is:

R = 9% + 3% + 2% = 14%

Time CF PVIF 14% PV (CF) PV (CF)

1 150 0.877 131.55
2 150 0.769 115.35
3 150 0.675 101.25
4 150 0.592 88.80
5 150 0.519 596.85

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 SECURITY VALUATION

PV CF i. e. P0 = 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 × PVIFA15%, 4 + 1150 × PVIF 15%, 5

= 150 × 2.855 + 1150 × 0.497 = 428.25 + 571.55 = 999.80

@14%

As found in sub part (a) Po= 1033.80

By interpolation we get,

7.94 7.94
= 14% + × (15% − 14%) = 14% + %
7.94−(−26.06) 34

YTM=14.23%.

QUESTION – 07

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.

(Practice manual & Study Material)

SOLUTION:

(i) Current yield = (Coupon Interest / Market Price) × 100

(10/110) × 100 = 9.09%

If current yield go up by 1% i.e. 10.09 the market price would be

10.09 = 10 / Market Price × 100

Market Price = ₹ 99.11

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 SECURITY VALUATION

(ii) Market Price of Bond = P.V. of Interest + P.V. of Principal

= ₹1,394 + ₹ 8,885 = ₹ 10,279

QUESTION – 08

An investor is considering the purchase of the following Bond:

Face value ₹ 100

Coupon rate 11%

Maturity 3 years

(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?

(Practice manual & Study Material)

SOLUTION:

(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)

= ₹ 11 × 2.402 + ₹ 100 × 0.712

= ₹ 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

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 SECURITY VALUATION

₹ 100 − ₹ 97.60
₹11+
3
YTM = ₹ 100 + ₹ 97.60 = 0.1194 or 11.94% say 12%
2

QUESTION – 09

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?

(Practice manual)

SOLUTION:
F−P
c+
n
YTM = F +P
2

C = Coupon Rate;

F= Face Value (Issue Price);

P= Market Price of Bond

(100 −95)
13 +
6
YTM = 100 +95 = 0.1418 or 14.18%
2

QUESTION – 10

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?

(Practice manual)

SOLUTION:

Calculation of Yield to Maturity (YTM)

Coupon +Pro −Rated Discount

YTM =
(Re demption price +Purchase Price )/2

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After tax coupon = 9 × (1 – 0.30) = 6.3%

After tax redemption price = 105 – (15 × 0.10) or ₹ 103.5

After tax capital gain = 103.50 – 90 = ₹ 13.50

6.3+(13.5/5) 9.00
YTM = or = 9.30%
(103.5+90)/2 96.75

QUESTION – 11

On 31st March, 2013, the following information about Bonds is available:

Name of Security Face Maturity Date Coupon Coupon Date

Value ₹ Rate (s)
Zero coupon 10,000 31st March, 2023 N.A. N.A.
T-Bill 1,00,000 20th June, 2013 N.A. N.A.
10.71% GOI 2023 100 31st March, 2023 10.71 31st March
10% GOI 2018 100 31st March, 2018 10.00 31st March &
30th September

Calculate:

(i) If 10 years yield is 7.5% p.a. what price the Zero Coupon Bond would

fetch on 31st March, 2013?

(ii) What will be the annualized yield if the T-Bill is traded @ 98500?

(iii) If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price
would it fetch on April 1, 2013 (after coupon payment on 31st March)

(iv) If 10% GOI 2018 Bond having yield to maturity is 8%, what price would
it fetch on April 1, 2013 (after coupon payment on 31st March)?

(Practice manual)

SOLUTION:

(i) Rate used for discounting shall be yield. Accordingly ZCB shall fetch:

1000
= =₹ 4,852
(1+0.075)10

(ii) The day count basis is actual number days / 365. Accordingly
annualized yield shall be:

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FV −Price 365 100000 −98500 365

Yield = × × × = 6.86%
Price No .of days 98500 81

Note: Alternatively, it can also computed on 360 days a year.

(iii) Price GOI 2023 would fetch

= ₹ 10.71 PVAF(8%, 10) + ₹ 100 PVF (8%, 10)

= ₹ 10.71 × 6.71 + ₹ 100 × 0.4632

= 71.86 +₹ 46.32 = ₹ 118.18

(iv) Price GOI 2018 Bond would fetch:

= ₹ 5 PVAF (4%, 10) + ₹ 100 PVF (4%, 10)

= ₹ 5 × 8.11 + ₹ 100 × 0.6756

= 40.55 + 67.56 = 108.11

QUESTION – 12

Today being 1st January 2019, Ram is considering to purchase an outstanding

Corporate Bond having a face value of ₹ 1,000 that was issued on 1st January
2017 which has 9.5% Annual Coupon and 20 years of original maturity (i.e.
maturing on 31st December 2027). Since the bond was issued, the interest
rates have been on downside and it is now selling at a premium of ₹ 125.75 per
bond.

Determine the prevailing interest on the similar type of Bonds if it is held till
the maturity which shall be at Par.

PV Factors:

1 2 3 4 5 6 7 8 9
6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592
8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500

(RTP November - 2020)

SOLUTION:

To determine the prevailing rate of interest for the similar type of Bonds we
shall compute the YTM of this Bond using IRR method as follows:

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M = ₹ 1000

Interest = ₹ 95 (0.095 × ₹ 1000)

n = 9 years

V0 = ₹ 1125.75 (₹ 1,000 + ₹ 125.75)

YTM can be determined from the following equation

₹ 95 × PVIFA (YTM, 9) + ₹ 1000 × PVIF (YTM, 9) = ₹ 1125.75

Let us discount the cash flows using two discount rates 8% and 10% as
follows:

Year Cash Flows PVF@6% PV@6% PVF@8% PV@8%

0 -1125.75 1 -1125.75 1 -1125.75
1 95 0.943 89.59 0.926 87.97
2 95 0.890 84.55 0.857 81.42
3 95 0.840 79.80 0.794 75.43
4 95 0.792 75.24 0.735 69.83
5 95 0.747 70.97 0.681 64.70
6 95 0.705 66.98 0.630 59.85
7 95 0.665 63.18 0.583 55.39
8 95 0.627 59.57 0.540 51.30
9 1095 0.592 648.24 0.500 547.50
112.37 -32.36

Now we use interpolation formula

112.37
6.00% + × 2.00%
112.37−(−32.36)

112.37
6.00% + × 2.00% = 6.00% + 1.553%
144.73

YTM = 7.553% say 7.55%

Thus, prevailing interest rate on similar type of Bonds shall be approx. 7.55%.

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Realized YTM

QUESTION – 13

Sushmita acquired at par a bond for ₹ 1,000 that offered a 15% coupon rate. At
the time of purchase, the bond had four years to maturity. Assuming annual
interest payment, calculate Sushmita‟s actual yield-to-maturity if all the
interest payment were reinvested earning 18% p.a. What would Sushmita‟s
realized yield-to-maturity be if all interest payments were spent immediately
upon receipt?

SOLUTION:

1782 .31
1,000 =
(1+YTM )4

1782.31
YTM =
1,000 − 1 × 100

= 15.54% p.a.

Calculation of Realized YTM if Reinvestment is “0”

Cash Inflows = 150 + 150 + 150 + 1150 = ₹ 1,600

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1,600
1,000 = 4
(1+YTM)

1
1,600 4
YTM = − 1 × 100 = 12.47%
1,000

Dirty Price & Clean Price

QUESTION – 14

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, 2010?

(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.

(Practice manual)

SOLUTION:

(i) Since the bonds were sold at par, the original YTM was 10%.

Interest ₹ 100
YTM = = = 10%
Principal ₹ 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

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= ₹ 952.60

1
∴Value of bond at purchase date = ₹ 952.60 +
(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. †

Alternatively, it can also be calculated as follows:

1
= ₹ 952.60 × 2
(1+0.06× )
3

1
= ₹ 952.60 ×
(1+0.04)

=₹ 915.96

The amount to be paid to complete the transaction is ₹915.96. Out of this

amount ₹ 48.08 represent accrued interest* and ₹ 867.88 represent the bond
basic value. *Alternatively, Accrued Interest can also be calculated as follows:

10 2
Accrued interest on Bonds = 1,000 × × =16.67
100 12

(III) Bond Risk

 Default Risk
 Price Risk
 Reinvestment Risk.

1. Price Risk

Bond Duration

There is a inverse relationship between market yield & bond price if market
yield increases then price of bond decreases. It is called bond risk or bond
duration.

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There are two methods to calculate Price Risk.

(I) Effective Duration:

P 2 −P 1
Effective Duration =
2P 0 ∆Y

Effective Duration 2 means if yield changes by 1% then price of bond will

change by 2% in opposite direction.

Example – 11

Face value of bond = ₹ 1,000

Coupon = 10% p.a.

Yield of the bond = 9%

Life = 5 years

(i) Calculate price of bond.

(ii) If yield changes by 2% calculate new price of bond.

(iii) Calculate effective duration.

(II) Modified Duration:

(1) Modified Duration of Regular Bond

 First calculate duration or Macaulay duration.

With the help of Table

wx
Duration =
w

With the help of Formula

C.Y. C.Y.
Duration = × PVAF × (1 + YTM) + 1 − n
YTM YTM

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 After calculation of Macaulay duration,

We calculate modified duration or Volatility of bond.

D
MD =
1+YTM
Example – 12

Face value of bond = ₹ 1,000

Coupon = 10%

Life of bond = 5 years

YTM = 9%

(i) Calculate bond price.

(ii) Calculate Bond duration.

(iii) Calculate modified duration

(iv) If yield increases by 50 basis point calculate new bond price.

(2) Modified Duration of Zero Coupon Bond

Duration = Maturity

(3) Modified Duration of Perpetual Bond

1+YTM
Duration =
YTM

Convexity of Bond

Convexity means change in modified duration, due to change in yield.

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P 2 +P 1 − 2P 0
Convexity =
2P 0 (∆Y)2

Bond Duration

QUESTION – 15

The following data is available for a bond:

Face Value ₹ 1,000

Coupon Rate 11%

Years to Maturity 6

Redemption Value ₹ 1,000

Yield to Maturity 15%

(Round-off your answers to 3 decimals)

Calculate the following in respect of the bond:

(i) Current Market Price.

(ii) Duration of the Bond.

(iii) Volatility of the Bond.

(iv) Expected market price if increase in required yield is by 100 basis points.

(v) Expected market price if decrease in required yield is by 75 basis points.

(Practice manual)

SOLUTION:

(i) Calculation of Market price:

Discount or premium
Co upon interest +
Years left
TM = 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.

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Let x be the market price

1,000 −X
110 +
6
0.15 = 1,000 + X
2

x = ₹ 834.48

Alternatively, it can also be calculated using Tabular Method

(ii) Duration

Year Cash P.V. @ 15% Proportion Proportion bond

flows bond value x time
value (Years)
1 110 0.870 95.70 0.113 0.113
2 110 0.756 83.16 0.098 0.196
3 110 0.658 72.38 0.085 0.255
4 110 0.572 62.92 0.074 0.296
5 110 0.497 52.67 0.064 0.320
6 1110 0.432 479.52 0.565 3.39
848.35 1.000 4.570

Duration of the Bond is 4.570 years

(iii) Volatility

Duration 4.570
Volatility of the bond = = = 3.974
1 + yields 1.15

(iv) The expected market price if increase in required yield is by 100 basis
points.

= ₹ 834.48 × 1.00 (3.974/100) = ₹ 33.162

Hence expected market price is ₹ 834.48 – ₹ 33.162 = ₹ 801.318

Alternatively, this can also be calculated as follows:

₹ 848.35 × 100 (3.794/100) = 33.71

Hence, expected market price is 848.48 – 33.71 = 814.77

Thus, the market price will decrease.

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(v) The expected market price if decrease in required yield is by 75 basis

points.

= ₹ 834.48 × 0.75 (3.974/100) = ₹ 24.87

Hence expected market price is ₹ 834.48 + ₹ 24.87 = ₹ 859.35

Alternatively, this can also be calculated as follows:

848.35 × 0.75 (3.974/100) = 25.29

Hence, expected market price = 848.35 – 25.29 = ₹ 823.06

Thus, the market price will increase.

QUESTION – 16

The following data are available for a bond

Face value ₹ 1,000

Coupon Rate 16%

Years to Maturity 6

Redemption value ₹ 1,000

Yield to maturity 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.

(Practice manual & Study Material)

SOLUTION:

1. Calculation of Market price:

Discount or premium
Coupon interest +
Years left
TM = 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.

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Let x be the market price

1,000 − x
160 +
6
0.17 = 1,000 + x x = ₹ 960.26
2

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

Year Cash P.V. @ 17% Proportion of Proportion of

flow bond value bond value (Years)
1 160 0.855 136.80 0.142 0.142
2 160 0.731 116.96 0.121 0.246
3 160 0.624 99.84 0.103 0.309
4 160 0.534 85.44 0.089 0.356
5 160 0.456 72.96 0.076 0.380
6 1160 0.390 452.40 0.469 2.814
964.40 1.000 4.247

Duration of the Bond is 4.247 years

Alternatively, as per Short Cut Method

1 + YTM 1 + YTM + t(c − YTM )

D= –c
YTM (1 + YTM )t −1 + YTM

Where YTM = Yield to Maturity

C = Coupon Rate

t = Years to Maturity

1.17 1.17 + 6 0.16 − 0.17

= −
0.17 0.16 1.17 t6 − 1 + 0.17

D = 4.24 years

3. Volatility

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Duration 4.247
Volatility of the bonds = = = 3.63
(1 + yields ) 1.17

4.2422
Or, = = 3.6258
1.17
4. The expected market price if increase in required yield is by 75
basis points.

= ₹ 960.26 × 0.75 (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 × 0.75 (3.63/100) = ₹ 26.26

then the market price will be = ₹ 964.40 – 26.26 = ₹ 938.14

QUESTION – 17

Following is the information for the options free bond:

Face value of the bond ₹ 1,000

Coupon rate 7%
Terms of Maturity 7 years
Yield to Maturity 8%

You are required to calculate:

(i) Market price of the bond and duration.

(ii) If there is an increase in yield by 35 basis points, what would be the

price of bond?

Present Value t1 t2 t3 t4 t5 t6 t7
PVIF0.07,t 0.935 0.874 0.817 0.764 0.714 0.667 0.623
PVIF0.08,t 0.926 0.857 0.794 0.735 0.681 0.631 0.584

(RTP May - 2022)

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SOLUTION:

(i) (1) Market price and duration of Bond

= 70 (PVIAF 8%,7) + 1,000 (PVIF 8%,7)

= 70 (5.208) + 1,000 (0.584)

= 364.56 + 584.00 = 948.56

(2) Duration of Bond

Period Cash flow (₹) PVF@ 8% PV (₹) (E)

(A) (B) (C) (D) = (B) × (C) = (A) × (D)
1 70 0.926 64.82 64.82
2 70 0.857 59.99 119.98
3 70 0.794 55.58 166.74
4 70 0.735 51.45 205.80
5 70 0.681 47.67 238.35
6 70 0.631 44.17 265.02
7 1,070 0.584 624.88 4374.16
948.56 5434.87

5434 .87
Duration of the bond is = 5.73 years
948.56
(ii) Price of Bond if increase in yield by 35 basis points

Period Cash Flow PVF @ 8.35% PV (₹)

(₹)
1 70 0.923 64.61
2 70 0.852 59.64
3 70 0.786 55.02
4 70 0.726 50.82
5 70 0.670 46.90
6 70 0.618 43.26
7 1,070 0.570 609.90
930.15

Alternatively, if the same increase in yield is linked with duration as computed

in sub part (i), then answer will be computed as follows:

Duration 5.73
Volatility of Bond = = = 5.306
1+YTM 1+0.08

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The expected market price if increase in yield is by 35 basis points.

= ₹ 948.56 × 0.35 (5.306/100) = ₹ 17.62

Hence expected market price is ₹ 948.56 – ₹ 17.62 = ₹ 930.94

Hence, the market price will decrease with increase in the yield.

QUESTION – 18

The following data is available for NNTC bond:

Face value: ₹ 1000

Coupon rate: 7.50%

Years to maturity: 8 years

Redemption Value: ₹ 1000

YTM: 8%

Calculate:

(i) The current market price, duration and volatility of the bond.

(ii) The expected market price if there is a decrease in required yield by 50

bps.

(RTP November - 2020)

SOLUTION:
(i) Current market price of Bond shall be computed as follows:

Year Cash Flows PVF@8% PV@8%

1 75 0.926 69.45
2 75 0.857 64.28
3 75 0.794 59.55
4 75 0.735 55.13
5 75 0.681 51.08
6 75 0.630 47.25
7 75 0.583 43.73
8 1075 0.540 580.50
970.97

Thus, the current market price of the Bond shall be ₹ 970.97.

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Alternatively, using the Short-cut method the Market Price of Bond can
also be computed as follows:

Interest +(Discount /Premium )/Years to maturity

(Face Value +Market Value )/2

Let market price be X

75+(1,000−X)/8
0.08 =
(1,000+X)/2

Thus, Value of X i.e. the price of Bond shall be ₹ 969.70

For the duration of the bond, we have to see the future cash flow and
discount them as follows:

Year CF PV@8% DCF Proportion Prop* Time

(Yrs)
1 75 0.926 69.45 0.071 0.071
2 75 0.857 64.28 0.066 0.132
3 75 0.794 59.55 0.061 0.183
4 75 0.735 55.13 0.057 0.228
5 75 0.681 51.08 0.053 0.265
6 75 0.630 47.25 0.049 0.294
7 75 0.583 43.73 0.045 0.315
8 1075 0.540 580.50 0.598 4.784
Total 970.97 1.000 6.272

Volatility of the bond = Duration / (1+ Yield) = 6.272/1.08 = 5.81

(ii) If there is decrease in required yield by 50 bps the expected market price
of the Bond shall be increased by:

= ₹ 970.97 × 0.50(5.81/100) = ₹ 28.21

Hence expected market price is ₹ 970.97 + ₹ 28.21 = ₹ 999.18

Alternatively, this portion using Bond Price as per Short-cut method can
also be computed as follows:

= 969.70 × 0.50 (5.81/100) = ₹ 28.17

Then market price will be = ₹ 969.70 + ₹ 28.17 = ₹ 997.87

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QUESTION – 19

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.

(Practice Manual)

SOLUTION:

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

1.16 1.16 + 6 (c−0.16)

4.3202 = − −
0.16 c 1.16 6 −1 +0.16

1.16 + (6c−0.96)
4.3202 = 7.25 − = 2.9298
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/- × 0.15 × 3.685 + 1,00,000/- × 0.410)

= ₹ 96,275/-.

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Alternatively, it can also be calculated as follows:

Let x be annual coupon payment. Accordingly, the duration (D) of the Bond
shall be

Year CF PVIF16%PV(CF) PV(CF)

1 x 0.862 0.862x
2 x 0.743 0.743x
3 x 0.641 0.641x
4 x 0.552 0.552x
5 x 0.476 0.476x
6 X + 1,00,000 0.410 0.410x + 41000
3.684x + 41000

0.862x 0.743X 0.641X

D= ×1+ ×2+ ×3+
3.684x + 41000 3.684X + 41000 3.684X + 41000
0552 x 0.476x (0.410x + 41000 )
×4+ ×5+ ×6
3.684x + 41000 3.684x + 41000 3.684x + 41000

11 319 x + 246000
4.3202 =
3.684x + 41000

x = ₹ 14,983 i.e. 14.98% say 15%

Accordingly, current price of the Bond shall be:

= 1,00,000 × 0.15 × PVAF (16%, 6) + 1,00,000 × PVF (16%, 6)

= 15,000 × 3.685 + 1,00,000 × 0.410 = ₹ 96,275

QUESTION – 20

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.

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Interest on these NCDs will be paid through post-dated cheques dated June 30
and December 31st . 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 realized yield on the NCD.

(Practice manual)

SOLUTION:

₹7 12
(i) Current yield = × = 0.1555 or 15.55%
₹ 90 6
YTM can be determined from the following equation

7 × PVIFA (YTM, 10) + 100 × PVIF (YTM, 10) = 90

Let us discount the cash flows using two discount rates 7.50% and 9%
as follows:

Year Cash PVF @ PVF @ PVF @ PVF @

flows 7.50% 7.50% 9% 9%
0 -90 1 -90 1 -90
1 7 0.930 6.51 0.917 6.419
2 7 0.865 6.055 0.842 5.894
3 7 0.805 5.635 0.772 5.404
4 7 0.749 5.243 0.708 4.956
5 7 0.697 4.879 0.650 4.550
6 7 0.648 4.536 0.596 4.172
7 7 0.603 4.221 0.547 3.829
8 7 0.561 3.927 0.502 3.514
9 7 0.522 3.654 0.460 3.220
10 107 0.485 51.90 0.422 45.154
6.560 -2.888

Now we use interpolation formula

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6.560
7.50% + × 1.50%
6.560 − (2.888)

6.560
7.50% + × 1.50% = 7.50% + 1.041%
9.448
YTM = 8.541% say 8.54%

Note: Students can also compute the YTM using rates other than 15%
and 18%.

(ii) The duration can be calculated as follows:

Year Cash PVF @ PV @ Proportion Proportion

flows 8.54% 8.54% of NCD of NCD value
value × time
1 7 0.921 6.447 0.0717 0.0717
2 7 0.849 5.943 0.0661 0.1322
3 7 0.782 5.474 0.0608 0.1824
4 7 0.721 5.047 0.0561 0.2244
5 7 0.664 4.648 0.0517 0.2585
6 7 0.612 4.284 0.0476 0.2856
7 7 0.563 3.941 0.0438 0.3066
8 7 0.519 3.633 0.0404 0.3232
9 7 0.478 3.346 0.0372 0.3348
10 107 0.441 47.187 0.5246 5.2460
89.95 7.3654

Duration = 7.3654 half years i.e. 3.683 years.

(iii) Realized Yield can be calculated as follows:

7 × 10 + 100
= 90
1 + R 10

170
(1 + R)10 =
90
1
170 10
R= - 1 = 0.06380 or 6.380% for half yearly and 12.76%
90
annually.

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QUESTION – 21

(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 bond‟s
principal amount and what percentage of this increase/decrease comes
from a change in the present value of bond‟s 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
bond‟s duration?

(c) If the YTM of the bond in (b) above increases to 10%, how it affects the
bond‟s duration? And why?

(Practice Manual)

SOLUTION:

(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 5 yrs. 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 year‟s 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

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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) × 100 = 78.6%

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) × 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

17.52
& Change in Price = × 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

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132
& Change in Price = × 100 = 57.49%
229.60
(b) Duration in the average time taken to recollect back the investment

Years Coupon Redemption Total (₹) PVIF (₹) (A)×(B)×(C)

(A) Payment (₹) (₹) (𝐁) (𝐂) (₹)
1 70 - 70 0.935 65.45
2 70 - 70 0.873 122.22
3 70 - 70 0.816 171.36
4 70 - 70 0.763 213.64
5 70 - 70 0.713 249.55
6 70 1000 1070 0.666 4,275.72
ABC 5,097.94

ABC ₹ 5097.94
Duration = = = 5.098 Years
Purchase Price ₹ 1000
(c) If YTM goes up to 10%, current price of the bond will decrease to

₹ 70 × PVIFA (10%,6) + ₹ 1000 PVIF (10%,6)

₹ 304.85 +₹ 564.00 = ₹ 868.85

Years Inflow (₹) PVIF (₹) (A) × (B)×(C)

(A) (B) (𝐂) (₹)
1 70 0.909 65.45
2 70 0.826 115.64
3 70 0.751 157.71
4 70 0.683 191.24
5 70 0.621 217.35
6 1070 0.564 3,620.88
𝐴𝐵𝐶 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 one‟s investment on the same intervals.

QUESTION – 22

Mr. A is planning for making investment in bonds of one of the two companies
X Ltd. and Y Ltd. The detail of these bonds is as follows:

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Company Face Coupon Maturity

Value Rate Period
X Ltd. ₹ 10,000 6% 5 Years
Y Ltd. ₹ 10,000 4% 5 Years

The current market price of X Ltd.‟s bond is ₹10,796.80 and both bonds have
same Yield To Maturity (YTM). Since Mr. A considers duration of bonds as the
basis of decision making, you are required to calculate the duration of each
bond and you decision.

(Practice manual)

SOLUTION:

To calculate duration of bond we need YTM, which shall be calculated as

follows:

Let us try NPV of Bond @ 5%

600 600 600 600 10.600

= + + + + − 10,796.80
(1.05)1 (1.05)2 (1.05)3 (1.05)4 (1.05)5

= ₹ 571.43 + ₹ 544.22 + ₹ 518.30 + ₹ 493.62 + ₹ 8,305.38 – ₹ 10,796.80

= – ₹ 363.85

Let us now try NPV @ 4%

600 600 600 600 10.600

= + + + + −10,796.80
(1.04)1 (1.04)2 (1.04)3 (1.04)4 (1.05)5

= ₹ 576.92 + ₹ 554.73 + ₹ 533.40 + ₹512.88 + ₹ 712.43 – ₹ 10,796.80

= ₹93.56

Let us now interpolation formula

93.56
= 4% + × (5% − 4%)
93.56−(−363.85)

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93.56
= 4% +
93.56−(−363.85)

93.56
= 4% + = 4.20%
457.41

Duration of X Ltd.’ s Bond

Year Cash [email protected]% Proportion Proportion bond

flows bond value value x time
(Years)
1 600 0.9597 575.82 0.0533 0.0533
2 600 0.9210 552.60 0.0512 0.1024
3 600 0.8839 530.34 0.0491 0.1473
4 600 0.8483 508.98 0.0472 0.1888
5 10600 0.8141 8,629.46 0.7992 3.9960
10,797.20 1.0000 4.4878

Duration of the Bond is 4.4878 years say 4.49 years.

Duration of Y Ltd.’s Bond

Year Cash P.V. @ 4.2% Proportion Proportion bond

flows bond value value x time
(Years)
1 400 0.9597 383.88 0.0387 0.0387
2 400 0.9210 368.40 0.0372 0.0744
3 400 0.8839 253.56 0.0357 0.1071
4 400 0.8483 339.32 0.0342 0.1368
5 10400 0.8141 8,466.64 0.8542 4.2710
9,911.80 1.0000 4.6280

Duration of the Bond is 4.6280 years say 4.63 years.

Decision: Since the duration of Bond of X Ltd. is lower and also carrying
higher interest rate hence it should be preferred.

QUESTION – 23

The following data are available for a bond:

Face Value ₹ 10,000 to be redeemed at par on maturity

Coupon rate 8.5 per cent per annum

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Years to Maturity 5 years

Yield to Maturity (YTM) 10 per cent

You are required to calculate:

(i) Current market price of the Bond,

(ii) Macaulay‟s Duration,

(iii) Volatility of the Bond,

(iv) Convexity of the Bond,

(v) Expected market price, if there is a decrease in the YTM by 200 basis
points

(a) By Macaulay‟s Duration based estimate

(b) By Intrinsic Value Method.

Given

Years 1 2 3 4 5
PVIF (10%, n) 0.909 0.826 0.751 0.683 0.621
PVIF (8%,n) 0.926 0.857 0.794 0.735 0.681

(Exam November - 2020)

SOLUTION:

(i) Current Market Price of Bond

= ₹ 850 (PVIAF 10%, 5) + ₹ 10,000 (PVIF 10%, 5)

= ₹ 850 (3.79) + ₹ 10,000 (0.621) = ₹ 3,221.50 + ₹ 6,210 = ₹ 9,431.5

(ii) Macaulay’s Duration

Proportion of Proportion of bond

Year Cash flow P.V. @ 10%
bond value value × time (years)

1 850 0.909 772.65 0.082 0.082

2 850 0.826 702.10 0.074 0.148

3 850 0.751 638.35 0.068 0.204

4 850 0.683 580.55 0.062 0.248

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5 10,850 0.621 6737.85 0.714 3.57

9431.5 1.000 4.252

Duration of the Bond is 4.252 years.

(iii) Volatility of Bond

Duration 4.252
Volatility of Bonds = = = 3.865
1+YTM 1.10

(iv) Convexity of Bond

C* × (∆Y)2 × 100
C* = V+ + V- - 2V0
2V0 (∆Y)2

Cash
Year P.V. @ 8% P.V. @ 12%
flow

1 850 0.926 787.10 0.892 758.20

2 850 0.857 728.45 0.797 677.45

3 850 0.794 674.90 0.712 605.20

4 850 0.735 624.75 0.636 540.60

5 10,850 0.681 7388.85 0.567 6152

10204.05 8733.40

10,204.05+8733 .40−2×9,431.50
C* =
2×9,431.50×(0.02)2
74.45
=
7.5452
= 9.867
Convexity of Bond = 9.867× (0.02)2 ×100 = 0.395%

(v) The expected market price if decrease in YTM by 200 basis points.

(a) By Macaulay‟s duration-based estimate

= ₹ 9431.50×2 (3.865/100) = ₹ 729.05

Hence expected market price is

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₹ 9431.50 + ₹ 729.05 = ₹ 10,160.55

Hence, the market price will increase.

(b) By intrinsic value method

Intrinsic value at YTM of 10% ₹ 9,431.50

Intrinsic value at YTM of 8% ₹10,204.05
Price increased by ₹ 772.55

Hence, expected market price is ₹ 10,204.05

QUESTION – 24

The following data are available for a bond:

Face Value ₹ 10,000 to be redeemed at par on maturity

Coupon rate 8.5%

Years to Maturity 5 years

Yield to Maturity (YTM) 10%

EVALUATE the change in the expected market price of the Bond, if there is a
decrease in the YTM by 200 basis points based on

(i) By Macaulay‟s Duration after making Convexity Adjustment.

(ii) By Intrinsic Value Method.

Given

Years 1 2 3 4 5
PVIF (10%, n) 0.909 0.826 0.751 0.683 0.621
PVIF (8%, n) 0.926 0.857 0.794 0.735 0.681

(MTP April - 2022)

SOLUTION:

Working Notes:

(1) Current Market Price of Bond

= ₹ 850 (PVIAF 10%, 5) + ₹ 10,000 (PVIF 10%, 5)

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= ₹ 850 (3.79) + ₹ 10,000 (0.621) = ₹ 3,221.50 + ₹ 6,210 = ₹ 9,431.5

(2) Macaulay’s Duration

Year Cash P.V. @ 10% Proportion of Proportion of bond

Flow bond value value × time (Years)
1 850 0.909 772.65 0.082 0.082
2 850 0.826 702.10 0.074 0.148
3 850 0.751 638.35 0.068 0.204
4 850 0.683 580.55 0.062 0.248
5 10,850 0.621 6,737.85 0.714 3.57
9431.50 1.000 4.252

Duration of the Bond is 4.252 years.

(3) Volatility of Bond

Duration 4.252
Volatility of Bonds = = = 3.865
(1+YTM ) 1.10

(4) Convexity of Bond

C* × (∆Y)2 × 100

V + +V − −2V 0
C* =
2V 0 (∆Y)2

Year Cash Flow P.V. @ 8% P.V. @ 12%

1 850 0.926 787.10 0.892 758.20
2 850 0.857 728.45 0.797 677.45
3 850 0.794 674.90 0.712 605.20
4 850 0.735 624.75 0.636 540.60
5 10,850 0.681 7388.85 0.567 6,151.95
10204.05 8,733.40

10,204.05 + 8,733.40 – 2 × 9,431.50

C* =
2 × 9,431.50 × (0.02)2

74.45
=
7.5452

= 9.867

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Convexity of Bond = 9.867 × (0.02)2 × 100 = 0.395%

(i) The expected market price if there is a decrease in YTM by 200

basis points using Macaulay‟s Duration

% Change in Price of Bond

= 3.865 × 2% + 0.395% = 8.125%

Change in Expected Market Price

= ₹ 9431.50 × (8.125/100) = ₹ 766.31

Hence expected market price is

= ₹ 9431.50 + ₹ 766.31 = ₹ 10,197.81

(ii) The expected market price if there is a decrease in YTM by 200

basis points using Intrinsic Value method

Intrinsic Value at YTM of 10% ₹ 9,431.50

Intrinsic Value at YTM of 8% ₹ 10,204.05
Price increased by ₹ 772.55

Hence, expected market price is ₹ 10,204.05

Evaluation: Thus, from above it can be evaluated that duration combined

with the convexity adjustment does a better job of estimating the
sensitivity of a bond‟s price change.

Bond Portfolio Management

1. Active Bond Portfolio Management

 It is an interest rate anticipation strategy.

 If we expect that yield will decrease then duration of portfolio should be
shifted from low duration to high.
 If we expect that yield will increase then duration of portfolio should be
shifted from high duration to low.

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Example – 13

BONDS AMT DURATION

A 8,00,000 11 years
B 3,00,000 1 years
C 2,00,000 2 years
D 4,00,000 8 years

(i) Calculate duration of Bond Portfolio.

(ii) Advise if:

(a) Yield will increase.

(b) Yield will decrease.

2. Passive Bond Portfolio Management (Immunization Theory)

 Immunization theory is used when future interest rate can‟t be predicted.

 Macaulay duration is the immunizing period at which whether interest
rates change but no effect on cash flows.

Example – 14

Face Value = ₹ 1,000

Coupon = 12%

Maturity = 5 years

YTM = 14%

Calculate Bond Duration.

Immunization of Liability

How to invest in Bonds so that future liability can be settled whether yield, will
change in future.

Duration of Liability = Duration of Assets

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Bond Immunization (Bond Portfolio)

QUESTION – 25

The following corporate bonds are considered for investment by the portfolio
manager. His aim is to immunize the liability due in 6 years All bonds have
face value of ₹ 1000.

Bonds Maturity (years) Coupon rate Duration(years)

Arvind Mills 10 8 7.35
BILT 8 9 6.15
Cipla 7 7 4.30
If the portfolio manager wishes to invest 50% in Arvind Mills, what is the
proportion of total amount that can be invested in other two bonds to
immunize the portfolio?

SOLUTION:

Calculation of Weight

Duration of Liability = Duration of Assets

6 = (7.35×0.50) + (6.15×WB) + (4.30×(0.5−WB))

6 = 3.675 + 6.15WB + 2.15 – 4.30WB

0.175 = 1.85 WB

0.175
WB =
1.85

= 0.0946

WC = (0.5 – 0.0946) = 0.4054

QUESTION – 26

The following data are available for three bonds A, B and C. These bonds are
used by a bond portfolio manager to fund an outflow scheduled in 6 years.
Current yield is 9%. All bonds have face value of ₹ 100 each and will be
redeemed at par. Interest is payable annually.

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Bond Maturity Coupon rate

(Years)
A 10 10%
B 8 11%
C 5 9%

(i) Calculate the duration of each bond.

(ii) The bond portfolio manager has been asked to keep 45% of the portfolio
money in Bond A. Calculate the percentage amount to be invested in
bonds B and C that need to be purchased to immunize the portfolio.

(iii) After the portfolio has been formulated, an interest rate change occurs,
increasing the yield to 11%. The new duration of these bonds are: Bond A
= 7.15 years, Bond B = 6.03 years and Bond C = 4.27 years.

Is the portfolio still immunized? Why or why not?

(iv) Determine the new percentage of B and Ca bonds that are needed to
immunize the portfolio. Bond A remaining at 45% of the portfolio.

Present values be used as follows:

Present Values t1 t2 t3 t4 t5

PVIF0.09,t 0.917 0.842 0.772 0.708 0.650

Present Values t6 t7 t8 t9 t10

PVIF0.09,t 0.596 0.547 0.502 0.460 0.4224

(MTP March - 2021)

SOLUTION:

(i) Calculation of Bond Duration

Bond A

Year Cash P.V. @ 9% Proportion of Proportion of

flow bond value bond value ×
time (years)
1 10 0.917 9.17 0.086 0.086

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2 10 0.842 8.42 0.079 0.158

3 10 0.772 7.72 0.073 0.219
4 10 0.708 7.08 0.067 0.268
5 10 0.650 6.50 0.061 0.305
6 10 0.596 5.96 0.056 0.336
7 10 0.547 5.47 0.051 0.357
8 10 0.502 5.02 0.047 0.376
9 10 0.460 4.60 0.043 0.387
10 110 0.4224 46.46 0.437 4.370
106.40 1.000 6.862

Duration of the bond is 6.862 years or 6.86 year

Bond B

Year Cash P.V. @ 9% Proportion of Proportion of

flow bond value bond value ×
time (years)
1 11 0.917 10.087 0.091 0.091
2 11 0.842 9.262 0.083 0.166
3 11 0.772 8.492 0.076 0.228
4 11 0.708 7.788 0.070 0.280
5 11 0.650 7.150 0.064 0.320
6 11 0.596 6.556 0.059 0.354
7 11 0.547 6.017 0.054 0.378
8 111 0.502 55.772 0.502 4.016
111.224 1.000 5.833

Duration of the bond B is 5.833 years or 5.84 years.

Bond C

Year Cash P.V. @ 9% Proportion of Proportion of

flow bond value bond value ×
time (years)
1 9 0.917 8.253 0.082 0.082
2 9 0.842 7.578 0.076 0.152
3 9 0.772 6.948 0.069 0.207
4 9 0.708 6.372 0.064 0.056
5 109 0.650 70.850 0.709 3.545
100.00 1.000 4.242

Duration of the bond C is 4.242 years or 4.24 years

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(ii) Amount of Investment required in Bond B and C

Period required to be immunized 6.000 Year

Less: Period covered from Bond A 3.087 Year
To be immunized from B and C 2.913 Year

Let proportion of investment in Bond B and C is b and c respectively

then

b+c = 0.55 (1)

5.883b+ 4.242c = 2.913 (2)

On solving these equations, the value of b and c comes 0.3534 or 0.3621

and 0.1966 or 0.1879 respectively and accordingly, the % of investment
of B and C is 35.34% or 36.21% and 19.66 % or 18.79% respectively.

(iii) With revised yield the Revised Duration of Bond stands

0.45 × 7.15 + 0.36 × 6.03 + 0.19 × 4.27 = 6.20 year

No portfolio is not immunized as the duration of the portfolio has been

increased from 6 years to 6.20 years.

(iv) New percentage of B and C bonds that are needed to immunize the
portfolio.

Period required to be immunized 6.000 Year

Less: Period covered from Bond A 3.2175 Year
To be immunized from B and C 2.7825 Year

QUESTION – 27

Mr. A will need ₹ 1,00,000 after two years for which he wants to make one time
necessary investment now. He has a choice of two types of bonds. Their details
are as below:

Bond X Bond Y
Face value ₹ 1,000 ₹ 1,000
Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price ₹ 972.73 ₹ 936.52
Current yield 10% 10%

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Advice Mr. A whether he should invest all his money in one type of bond or he
should buy both the bonds and, if so, in which quantity? Assume that there
will not be any call risk or default risk.

(PM, SM, MTP March – 2021 & RTP November - 2021)

SOLUTION:

Duration of Bond X

Year Cash P.V. @ 10% Proportion of Proportion of bond

flow bond value value × time (year)
1 1070 .909 972.63 1.000 1.000

Duration of the Bond is 1 year

Duration of Bond Y

Year Cash P.V. @ 10% Proportion of Proportion of bond

flow bond value value × time (year)
1 80 .909 972.63 0.077 0.077
2 80 .826 66.08 0.071 0.142
3 80 .751 60.08 0.064 0.192
4 1080 .683 737.64 0.788 3.152
936.52 1.000 3.563

Duration of the Bond is 3.563 years

Let x1 be the investment in Bond X and therefore investment in Bond Y shall be

(1 − x1 ). Since the required duration is 2 year the proportion of investment in
each of these two securities shall be computed as follows:

2 = x1 + (1 − x1 ) 3.563

x1 = 0.61

Accordingly, the proportion of investment shall be 61% in Bond X and 39% in

Bond Y respectively.

Amount of investment

Bond X Bond Y
PV of ₹ 1,00,000 for 2 years @ 10% × 61% PV of ₹ 1,00,000 for 2 years @ 10%
× 39%
= ₹ 1,00,000 (0.826) × 61% = ₹ 1,00,000 (0.826) × 39%
= ₹ 50,386 = ₹ 32,214

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No. of Bonds to be purchased No. of Bonds to be purchased

= ₹ 50,386/₹ 972.73 = 51.79 i.e. approx. 52 = ₹ 32,214/₹ 936.52 = 34.40 i.e.
bonds approx. 34 bonds

Note: The investor has to keep the money invested for two years. Therefore, the
investor can invest in both the bonds with the assumption that Bond X will be
reinvested for another one year on same returns.

Note: In the above computation, Modified Duration can also be used instead of
Duration.

(IV) Convertible Bonds

 It is a bond in which investor has the option.

 To convert it into shares.
 To consider it as non convertible.
 Valuation of convertible bond.
 Value of convertible bond higher than floor value of bond.
 Floor value is higher of bond two values of bond.

(i) Conversion value or stock value of bond.

Conversion Value = No. of shares per bond × Current share price

(ii) Investment value or straight value of bond.

Investment Value = P.V. of Coupon & P.V. of Redeemable value

discounted at yield of similar non convertible bond.

Example – 15

Face Value = ₹ 1,000

Coupon Rate = 8% p.a.

Years = 5 years

Conversion Ratio = 4 shares

Current share price = ₹ 245

Yield on similar NCD = 11%

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Calculate price of convertible bond if price is more than 10% of floor value.

Example – 16

Consider a convertible bond

Face Value = ₹ 1,000

Coupon = 10% p.a.

Life = 10 years

Conversion Ratio = 20 shares

Market price per share = ₹ 45

Current market price of bond = ₹ 970

Expected dividend per share = ₹ 2

Yield of similar NCD = 14%

Calculate:

(i) Straight value of bond.

(ii) Stock value of bond.

(iii) Percentage of downside risk.

(iv) Premium over conversion value.

(v) Premium over investment value.

(vi) Conversion parity price per share.

(vii) Conversion premium per share.

(viii) Favorable income differential per share.

(ix) Premium pay back period.

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QUESTION – 28

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 share‟s 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?

(Practice Manual)

SOLUTION:

(i) Conversion value of preference share

Conversion Ratio × Market Price

2 × ₹ 21 = ₹ 42

(ii) Conversion Premium

(₹ 50/₹ 42) – 1 = 19.05%

(iii) Effect of the issue on basic EPS

₹
Before Conversion 15,00,000
Total (after tax) earnings ₹ 3 × 5,00,000 1,40,000
Dividend on Preference shares 13,60,000
Earnings available to equity holders 5,00,000
No. of shares 2.72
EPS
On Diluted Basis
Earnings 15,00,000

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No of shares ( 5,00,000 + 80,000) 5,80,000

EPS 2.59

(iv) EPS with increase in Profit

₹
Before Conversion
Earnings 25,00,000
Dividend on Preference shares 1,40,000
Earnings available to equity holders 23,60,000
No. of equity shares 5,00,000
EPS 4.72
On Diluted Basis
Earnings 25,00,000
No of shows ( 5,00,000 + 80,000) 5,80,000
EPS 4.31

QUESTION – 29

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?

(Practice manual & SM)

SOLUTION:

Conversion rate is 14 shares per bond. Market price of share ₹ 80

Conversion Value 14 × ₹ 80 = ₹ 1120
Market price of bond = ₹ 1475
355
Premium over Conversion Value (₹ 1475 − ₹ 1120) = × 100 = 31.7%
1120

QUESTION – 30

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 required a rate of return of 8% p.a. on a 5-year security.

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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

(Practice manual, SM)

SOLUTION:

If Debentures are not converted its value is as under: -

PVF @ 8% ₹
Interest - ₹ 12 for 5 years 3.993 47.916
Redemption - ₹ 100 in 5th year 0.681 68.100
116.016

Value of equity shares:-

Market Price No. Total

₹4 20 ₹ 80
₹5 20 ₹ 100
₹6 20 ₹ 120

Hence, unless the market price is ₹ 6 conversion should not be exercised.

QUESTION – 31

The data given below relates to a convertible bond :

Face Value ₹ 250

Coupon rate 12%
No. of shares per bond 20
Market price of share ₹12
Straight value of bond ₹ 235
Market price of convertible bond ₹ 265

Calculate:

(i) Stock value of bond.

(ii) The percentage of downside risk.

(iii) The conversion premium.

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(iv) The conversion parity price of the stock.

(SM, PM & RTP May - 2019)

SOLUTION:

(i) Stock value or conversion value of bond

12 × 20 = ₹ 240

(ii) Percentage of the downside risk

₹ 265 − ₹ 235
= 0.1277 or 12.77%
₹ 235

Or,

₹ 265 − ₹ 235
= 0.1132 or 11.32%
₹ 235

This ratio gives the percentage price decline experienced by the bond if
the stock becomes worthless.

(iii) Conversion Premium

Make Price −Conversion Value

× 100
Conversion Value
₹ 265 − ₹ 240
× 100 = 10.42%
₹ 240

(iv) Conversion Parity Price

Bond Price
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.

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QUESTION – 32

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

(Practice Manual)

SOLUTION:

(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 become ₹
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:

5400
₹ 500 × = ₹ 540
5000
Market Price of share is ₹ 430. Hence conversion premium in percentage
is:

540 − 430
× 100 = 25.58 %
430
(ii) The conversion value can be calculated as follows:

Conversion value = Conversion ratio × Market Price of Equity Shares

= 10 × ₹ 430 = ₹ 4300

QUESTION – 33

GHI Ltd., AAA rated company has issued, fully convertible bonds on the
following terms, a year ago:

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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
Market price of convertible bond ₹ 1175

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 1 2 3
PVIF0.095, t 0.9132 0.8340 0.7617

(Practice Manual)

SOLUTION:

(i) Straight Value of Bond

₹ 85 × 0.9132 + ₹ 85 × 0.8340 + ₹ 1085 × 0.7617 = ₹ 974.96

(ii) Conversion Value

Conversion Ration × Market Price of Equity Share

= ₹ 45 × 25 = ₹ 1,125

(iii) Conversion Premium

= Market Conversion Price − Market Price of Equity Share

₹ 1,175
= − ₹ 45 = ₹ 2
25

Or = ₹ 1,175 − ₹ 45 × 25 = ₹ 50

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₹ 1,175 − ₹ 1,125
Or = = 4.47%
₹ 1,125

(iv) Percentage of Downside Risk

₹ 1,175 − ₹ 974.96
= × 100 = 20.52%
₹ 974.96
₹ 1,175 − ₹ 974.96
Or = = 17.02
₹ 1,175

(v) Conversion Parity Price

Bond Price
No . of Share on Conversion
₹ 1,175
= = ₹ 47
25

QUESTION – 34

The following data is related to 8.5% Fully Convertible (into Equity shares)
Debentures issued by JAC Ltd. at ₹ 1000.

Market Price of Debenture ₹ 900

Conversion Ratio 30

Straight Value of Debenture ₹ 700

Market Price of Equity share on the date of Conversion ₹ 25

Expected Dividend Per Share ₹1

You are required to calculate:

(a) Conversion Value of Debenture

(b) Market Conversion Price

(c) Conversion Premium per share

(d) Ratio of Conversion Premium

(e) Premium over Straight Value of Debenture

(f) Favorable income differential per share

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(g) Premium pay back period

(Practice Manual & RTP November - 2021)

SOLUTION:

(a) Conversion Value of Debenture

= Market Price of one Equity Share × Conversion Ratio

= ₹ 25 × 30 = ₹ 750

(b) Market Conversion Price

Market Price of Convertible Debenture

=
Conversion Ratio
₹ 900
= = ₹ 30
30

(c) Conversion Premium per share

Market Conversion Price – Market Price of Equity Share

= ₹ 30 – ₹ 25 = ₹ 5

(d) Ratio of Conversion Premium

Conversion premium per share ₹5

= = 20%
Market Price of Equity Share ₹ 25

(e) Premium over Straight Value of Debenture

Market Price of Convertible Bond ₹ 900

−1 = − 1 = 28.6 %
Straight Value of Bond ₹ 700

(f) Favorable income differential per share

Coupon Interest from Debenture − Conversion Ratio × Dividend Per Share

Conversion Ratio
₹ 85−30 × ₹ 1
= ₹ 1.833
30

(g) Premium pay back period

Conversion premium per share 5

= = 2.73 years
Favourable Income Differntial Per Share 1.833

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QUESTION – 35

A Ltd. has issued convertible bonds, which carries a coupon rate of 14%. Each
bond is convertible into 20 equity shares of the company A Ltd. The prevailing
interest rate for similar credit rating bond is 8%. The convertible bond has 5
years maturity. It is redeemable at par at ₹ 100. The relevant present value
table is as follows.

Present Values t1 t2 t3 t4 t5
PVIF0.14,t 0.877 0.769 0.675 0.592 0.519
PVIF0.08, t 0.926 0.857 0.794 0.735 0.681

You are required to estimate:

(Calculations be made upto 3 decimal places)

(i) current market price of the bond, assuming it being equal to its

fundamental value,

(ii) minimum market price of equity share at which bond holder should
exercise conversion option; and

(iii) duration of the bond.

(Practice Manual)

SOLUTION:

(i) Current Market Price of Bond

Time CF PVIF 8% PV (CF) PV (CF)

1 14 0.926 12.964
2 14 0.857 11.998
3 14 0.794 11.116
4 14 0.735 10.290
5 114 0.681 77.634
∑ PV (CF) i.e. P0 = 124.002
Say ₹ 124.00

(ii) Minimum Market Price of Equity Shares at which Bondholder should

exercise conversion option:

124.00
= ₹ 6.20
20.00

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(iii) Duration of the Bond

Year Cash P.V. @ 8% Proportion of Proportion of

flow bond value bond value ×
time (years)
1 14 0.926 12.964 0.105 0.105
2 14 0.857 11.998 0.097 0.194
3 14 0.794 11.116 0.089 0.267
4 14 0.735 10.290 0.083 0.332
5 114 0.681 77.634 0.626 3.130
124.002 1.000 4.028

QUESTION – 36

The following is the data related to 9% Fully convertible (into Equity Shares)
debentures issued by Delta Ltd. at ₹ 1000.

Market Price of 9% Debenture ₹ 1,000

Conversion Ratio (No. of shares) 25
Straight Value of 9% Debentures ₹ 800
Market price of equity share on the date of conversion ₹ 30
Expected Dividend per share ₹1

Calculate:

(a) Conversion value of Debenture;

(b) Market Conversion Price;

(c) Conversion Premium per share;

(d) Ratio of Conversion Premium;

(e) Premium over straight Value of Debenture;

(f) Favorable Income Differential per share; and

(g) Premium pay back period

(Exam May – 2018 & MTP April - 2022)

SOLUTION:

(a) Conversion Value of Debenture

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= Market Price of one Equity Share × Conversion Ratio

= ₹ 30 × 25 = ₹ 750

(b) Market Conversion Price

Market Price of Convertible Debenture

=
Conversion Ratio
1000
= ₹ 40
25

(c) Conversion Premium per share

Market Conversion Price – Market Price of Equity Share

= ₹ 40 – ₹ 30 = ₹ 10

(d) Ratio of Conversion Premium

Conversion premium per share 10

= × 100 = 33.33%
Market price of equity share 30

(e) Premium over Straight Value of Debenture

Market price of Convertible Bond 1000

–1= – 1 = 25%
Straigth Value of Bond 800

(f) Favorable income differential per share

Coupon Interest from Debenture −Conversion Ratio ×Dividend Per Share

Conversion Ratio
90 − 25x1
= ₹ 2.6
25

(g) Premium pay back period

Conversion premium per share 10

= = 3.85 years
Favourable Income Differntial Per Share 2.6

QUESTION – 37

Sabanam Ltd. has issued convertible debentures with coupon rate 11%. Each
debenture has an option to convert to 16 equity shares at any time until the

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date of maturity. Debenture will be redeemed at ₹ 100 on maturity of 5 years.

An investor generally requires a rate of return of 8% p.a. on a 5-year security.
As an advisor, when will you advise the investor to exercise conversion for
given market prices of the equity share of (i) ₹ 5, (ii) ₹ 6 and (iii) ₹ 7.10.

Cumulative PV factor for 8% for 5 years: : 3.993

P.V. factor for 8% for year 5 : 0.681

(Exam May - 2018)

SOLUTION:

If Debentures are not converted its value is as under:

PVF @ 8% ₹
Interest - ₹ 11 for 5 years 3.993 43.923
Redemption - ₹ 100 in 5th year 0.681 68.100
112.023

Value of equity shares:

Market Price No. Total

₹5 16 ₹ 80
₹6 16 ₹ 96
₹ 7.10 16 ₹ 113.60

Hence, unless the market price is ₹ 7.10 conversion should be exercised.

QUESTION – 38

A hypothetical company ABC Ltd. issued a 10% Debenture (Face Value of ₹

1000) of the duration of 10 years, currently trading at ₹ 850 per debenture. The
bond is convertible into 50 equity shares being currently quoted at ₹ 17 per
share.

If yield on equivalent comparable bond is 11.80%, then calculate the spread of

yield of the above bond from this comparable bond.

The relevant present value table is as follows.

Present t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
Values
PVIF0.11,t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVIF0.13, t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295

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(RTP November - 2019)

SOLUTION:

Conversion Price = ₹ 50 × 17 = ₹ 850

Intrinsic Value = ₹ 850

Accordingly the yield (r) on the bond shall be :

₹ 850 = ₹ 100 PVAF (r, 10) + ₹ 1000 PVF (r, 10)

Let us discount the cash flows by 11%

850 = 100 PVAF (11%, 10) + 1000 PVF (11%, 10)

850 = 100 × 5.890 + 1000 × 0.352 = 91

Now let us discount the cash flows by 13%

850 = 100 PVAF (13%, 10) + 1000 PVF (13%, 10)

850 = 100 × 5.426 + 1000 × 0.295 = -12.40

Accordingly, IRR

90.90
11% + × (13% − 11%)
90.90−(−12.40)

90.90
11% +
103.30 × (13% − 11%) = 12.76%
The spread from comparable bond = 12.76% - 11.80% = 0.96%

QUESTION – 39

The data given below relates to convertible bond of Hi-Fi Ltd.:

Face value ₹ 2,500

No. of shares per bond 20

Coupon rate 12%

Market price per share ₹ 120

Market price of convertible bond ₹ 2,650

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Straight value of bond ₹ 2,350

You are required to calculate the following:

(i) Conversion value of bond.

(ii) The percentage of downside risk.

(iii) The conversion premium

(iv) Conversion parity price of the stock and also interpret the results.

(Exam July – 2021)

SOLUTION:

(i) Stock value or conversion value of bond

120 × 20 = ₹ 2,400

(ii) Percentage of the downside risk

₹ 2,650−₹ 2,350
= 0.1277 Or, 12.77%
₹ 2,350

Or,

₹ 2,650−₹ 2,350
= 0.1132 Or, 11.32%
₹ 2,650

This ratio gives the percentage price decline experienced by the bond if
the stock becomes worthless.

(iii) Conversion Premium

Market Price −Conversion Value

× 100
Conversion Value

₹ 2,650 − ₹ 2,400
= 10.42
₹ 2,400

(iv) Conversion Parity Price

Bond Price
No . of Shares on Conversion

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₹ 2,650
= ₹ 132.50
20

This indicates that if the price of shares rises to ₹ 132.50 from ₹ 120 the
investor will neither gain nor lose on buying the bond and exercising it.
Observe that ₹ 12.50 (₹ 132.50 – ₹ 120.00) is 10.42% of ₹ 120, the
Conversion Premium.

(V) Option Embedded Bonds

Bond Refunding

1. Callable Bonds
2. Puttable Bonds
3. Extendable Bonds

1. Collable Bonds

 Callable Bond is long Term fixed coupon rate bond where Company has
right to call such bonds at any time before maturity.
 Call option is exercised when interest rate in market is fall.
Example – 17

Face value of bond = ₹1000

Coupon = 12% p.a.

Life = 15 year

Feature = Callable Bond

1st call after 5 year at ₹1200

2ndcall after 10 year at ₹ 1150

Redeemable Value = ₹ 1000

(i) Calculate yield to call (YTC)

(ii) Yield to Maturity (YTC)

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2. Puttable Bonds

 Puttable Bond means long term fixed coupon rate bond where bond
holders has right to sell Bonds to company at any time before maturity.
 Put option is Exercised when Rate of interest in market is High.

3. Extendable Bond

Extendable bond means long term fixed coupon bonds where company has
right to extend the bond period. Such Extension is made where interest rate in
market is high.

QUESTION – 40

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 analyze the bond refunding decision.

(SM, PM & RTP May - 2020)

SOLUTION:

1. Calculation of initial outlay:-

₹(million)

(a) Face value 300

Add:-Call premium 12

Cost of calling old bonds 312

(b) Gross proceed of new issue 300

Less: Issue costs 6

Net proceeds of new issue 294

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(c) 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 × (0.12 – 0.10)] 6.00

Less:- Tax saving on interest and amortization

0.30 × [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 – 41

M/s Trans India 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 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?

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(Practice Manual)

SOLUTION:

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 42,00,000

Less tax @ 40% 16,80,000

After tax cost of call prem. 25,20,000

(b) Floatation cost 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 unamortized discount on

old bond 25/30 × 9,00,000 × 0.4 (3,00,000)

(e) Tax savings from unamortized floatation

Cost of old bond 25/30 × 3,60,000 × 0.4 (1,20,000)

29,20,000

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(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

(ii) Tax savings from amortization

of discount 9,00,000/30 × 0.4 (12,000)

(iii) Tax savings from amortization

of floatation cost 3,60,000/30 × 0.4 (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 21,60,000

(ii) Tax savings from amortization

of floatation cost (0.4 × 4,00,000/25) (6,400)

Annual after tax payment under new Bond (B) 21,53,600

Annual Cash Flow Saving (A) – (B) 3,49,600

QUESTION – 42

M/s. Earth Limited has 11% bond worth of ₹ 2 crores outstanding with 10
years remaining to maturity.

The company is contemplating the issue of a ₹ 2 crores 10 year bond carring

the coupon rate of 9% and use the proceeds to liquidate the old bonds.

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The unamortized portion of issue cost on the old bonds is ₹ 3 lakhs which can
be written off no sooner the old bonds are called. The company is paying 30%
tax and it's after tax cost of debt is 7%. Should Earth Limited liquidate the old
bonds?

You may assume that the issue cost of the new bonds will be ₹ 2.5 lakhs and
the call premium is 5%.

SOLUTION:

(i) Calculation of initial outlay

₹ (lakhs)
(a) Face value 200.00
Add:- Call premium 10.00
Cost of calling old bonds 210.00
(b) Gross proceed of new issue 200.00
Less: Issue costs 2.50
Net proceeds of new issue 197.50
(c) Tax savings on call premium and unamortized cost 0.30 ₹ 3.90
(10 +3) lakhs

∴ Initial outlay = ₹ 210 lakhs − ₹ 197.50 lakhs − ₹ 3.90 lakhs = ₹ 8.60 lakhs

(ii) Calculation of net present value of refunding the bond

₹ (lakhs)
Saving in annual interest expenses [₹ 200 × (0.11 – 0.09)] 4.000
Less:- Tax saving on interest and amortization 0.30 × [4 + (3 – 1.215
2.5)/10]
Annual net cash saving 2.785
PVIFA (7%, 10 years) 7.024

∴Present value of net annual cash saving = ₹ 19.56 lakhs

Less:- Initial outlay = ₹8.60 lakhs
Net present value of refunding the bond = ₹ 10.96 lakhs

Decision: The bonds should be refunded

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QUESTION – 43

Pet feed plc has outstanding, a high yield Bond with following features:

Face Value £ 10,000

Coupon 10%

Maturity Period 6 Years

Special Feature Company can extend the life of Bond to 12 years.

Presently the interest rate on equivalent Bond is 8%.

(a) If an investor expects that interest will be 8%, six years from now then
how much he should pay for this bond now.

(b) Now suppose, on the basis of that expectation, he invests in the Bond,
but interest rate turns out to be 12%, six years from now, then what will
be his potential loss/ gain if the company extents the life of Bond for
another 6 years.

(Practice Manual)

SOLUTION:

(a) If the current interest rate is 8%, the company will not extent the
duration of Bond and the maximum amount the investor would ready to
pay will be:

= £ 1,000 PVIAF (8%, 6) + £ 10,000 PVIF (8%, 6)

= £ 1,000 × 4.623 + £ 10,000 × 0.630

= £ 4,623 + £ 6,300 = £ 10,923

(b) If the current interest rate is 12%, the company will extent the duration
of Bond. After six years the value of Bond will be

= £ 1,000 PVIAF (12%, 6) + £ 10,000 PVIF (12%, 6)

= £ 1,000 × 4.111 + £ 10,000 × 0.507

= £ 4,111 + £ 5,070

= £ 9,181

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Thus, potential loss will be £ 9,181− £ 10,923 = £ 1,742

(VI) Yield Structure Or, Term Structure of Interest Rate

The relationship between interest rate & maturity is called term structure as
yield curve.

Example – 18

Derive the term structure from the following

Bond Maturity Coupon Rate Price Face Value
(Years)
A 1 0 942 1,000
B 2 0 897 1,000
C 3 0 827 1,000

Example – 19

Derive term structure

Bond Maturity Coupon Rate Price Face Value

(Years)
A 1 10% 990 1,000
B 2 9% 972 1,000
C 3 12% 994 1,000

QUESTION – 44

The following is the Yield structure of AAA rated debenture:

Period Yield (%)

3 Months 8.5%
6 Months 9.25
1 Year 10.50
2 Years 11.25
3 Years and above 12.00

(i) Based on the expectation theory calculate the implicit one-year forward
rates in year 2 and year 3.

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(ii) If the interest rate increases by 50 basis points, what will be the
percentage change in the price of the bond having a maturity of 5 years?
Assume that the bond is fairly priced at the moment at ₹ 1,000.

SOLUTION:

(i) Implicit rates for year 2 and year 3

(1+r 2 )2 (1.1125 )2
For year 2 f2 = –1= – 1 = 12%
1+r 1 1.1050

(1+r 3 )2
For year 3 f3 = –1
(1+r 1 )(1+f 2 )

(1.12)2 1.404928
= –1= – 1 = 13.52%
1.1050 (1.12) 1.2376

(ii) If fairly priced at ₹ 1,000 and rate of interest increases to 12.5% the
percentage charge will be as follows:

1000 (1.12)5 1762 .34168

Price = = = 977.99 or ₹ 978
(1.125)5 1.8020

1000 −978 22
% charge = × 100 = × 100 = 2.2%
1000 1000

QUESTION – 45

ABC Ltd. wants to issue 9% Bonds redeemable in 5 years at its face value of ₹
1,000 each. The annual spot yield curve for similar risk class of Bond is as
follows:

Year Interest Rate

1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%

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(i) Evaluate the expected market price of the Bond if it has a Beta value of
1.10 due to its popularity because of lesser risk.

(ii) Interpret the nature of the above yield curve and reasons for the same.

Note: Use PV Factors upto 4 decimal points and value in ₹ upto 2 decimal
points.

(MTP April - 2021)

SOLUTION:

(i) For finding expected market price first we shall calculate Intrinsic Value
of Bond as follows:

PV of Interest + PV of Maturity Value of Bond

Forward rate of interests

Year Interest Rate

1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%

PV of Interest

₹ 90 ₹ 90 ₹ 90 ₹ 90 ₹ 90
= + 2 + 3 + 4 +
1+0.12 1+0.1162 1+0.1133 1+0.1106 1+0.1080 5

= ₹ 90 × 0.8929 + ₹ 90 × 0.8026 + ₹ 90 × 0.7247 + ₹ 90 × 0.6573 + ₹ 90

× 0.5988

= ₹ 80.36 + ₹ 72.23 + ₹ 65.22 + ₹ 59.16 + ₹ 53.89

= ₹ 330.86

₹ 1,000
PV of Maturity Value of Bond =
1+0.1080 5

= ₹ 1,000 × 0.5988 = ₹ 598.80

Intrinsic value of Bond = ₹ 330.86 + ₹ 598.80 = ₹ 929.66

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Expected Price = Intrinsic Value × Beta Value

= ₹ 929.66 × 1.10 = ₹ 1,022.63

(ii) The given yield curve is inverted yield curve.

The main reason for this shape of curve is expectation for forthcoming
recession when investors are more interested in Short-term rates over
the long term.

QUESTION – 46

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.

(Practice Manual)

SOLUTION:

(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 ₹ 90 ₹ 90
= + +
1+0.12 1+0.12 (1+0.1125) 1+0.12 1+0.1125 (1+0.1075)

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= ₹ 217.81

₹ 1000
PV of Maturity Value of Bond =
1+0.12 1+0.1125 (1+0.1075)

= ₹ 724.67

Intrinsic value of Bond = ₹ 217.81 + ₹ 724.67 = ₹ 942.48

(ii) Expected Price = Intrinsic Value × Beta Value

= ₹ 948.48 × 1.02

= ₹ 961.33

QUESTION – 47

Following are the yields on Zero Coupon Bonds (ZCB) having a face value of ₹
1,000 :

Maturity (Years) Yield to Maturity (YTM)

1 10%
2 11%
3 12%

Assume that the term structure of interest rate will remain the same.

You are required to

(i) Calculate the implied one year forward rates

(ii) Expected Yield to Maturity and prices of one year and two year Zero
Coupon bonds at the end of the first year.

(Exam January - 2021)

SOLUTION:

(i) Calculation of Forward Rates

Maturity YTM PVIF Face Price Forward Rate

(%) Value
1 10 0.909 1,000 909.09
2 11 0.812 1,000 811.62 0.1201 i.e. 12.01%
3 12 0.712 1,000 711.78 0.1403 i.e. 14.03%

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(ii) Calculation of Expected Price and YTM

Maturity Forward Face Price YTM

Rate Value
2 0.1201 1,000 1,000 0.1201 i.e. 12.01%
= 892.78
(1+0.1201)

1,000 0.1302* 13.02%

=
3 0.1403 1,000 1+0.1201 (1+0.1403) i.e.
782.93

1,000
* –1 = 0.1302
782.93

QUESTION – 48

From the following data for Government securities, calculate the forward rates:

Face Value (₹) Interest Rate Maturity (Year) Current Price (₹)
1,00,000 0% 1 91,500
1,00,000 10% 2 98,500
1,00,000 10.5% 3 99,000

SOLUTION:

Consider one-year Treasury bill.

1,00,000
91,500 =
(1+r 1 )

1,00,000
1+ r1 = = 1.092896
91,500

r1 = 0.0929 or 0.093

Consider two-years Government Security

10,000 1,10,000
98,500 = +
1.093 1.093(1+r 2 )

1,10,000
98,500 = 9149.131 +
1.093(1+r 2 )

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10,640.4
⇒ 89,350.87 =
1+r 2

⇒ 1 + r2 = 1.126351

⇒ r2 = 0.12635

⇒ r2 = 0.1263

Consider three-years Government Securities:

10,500 10,500 1,10,500

99,000 = + +
1.093 1.093 × 1.1263 1.093 × 1.1263(1+r 3 )

89,761.07
⇒ 99,000 = 9,606.587 + 8,529.65 +
(1+r 3 )

89,761.07
⇒ 80,863.763 =
1+r 3

⇒ 1 + r3 = 1.1100284

⇒ r3 = 0.1100284 say 11.003%

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2. Equity Valuation

 Value of equity is calculated on the basis of future cash flows.

P0 = P.V. of future cash flows

Or,

P0 = P.V. of dividend + P.V. of future market price.

 Decision Criterion
(1) CMP > P0 Over priced, not purchased.
(2) CMP < P0 Under priced, purchased.
(3) CMP = P0 Correctly priced, Do nothing.

(i) Dividend Growth Model Or, Dividend Discount Model Or, Gorden’s
Model

As per dividend growth model value per share is calculated as under.

D1
P0 =
K e −g

 D1 = Expected Dividend Per Share

If D1 is not given is question, then it is calculated as under.

D1 = D0 (1 + g)

Do = Dividend just paid or current dividend per share.

 g = Growth Rate

If growth rate is not given in question then it is calculated as under.

g =b×r

b = Retention Ratio

r = Return on Equity

 Ke or Re = Cost of Equity

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EPs = Book Value Per Share × Return on Equity

Example – 20

Expected EPS = ₹ 10

Dividend Payout Ratio = 60%

Return on Equity = 20%

Cost of Equity = 15%

Calculate value per share.

QUESTION – 49

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%, compute is the price of the share today using both Dividend
Growth Model and Walter‟s Model.

(Study Material& Practice Manual)

SOLUTION:

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
Dividend
Perpetual growth model formula: P0 =
K e −g
8.27
P0 =
0.18−0.09
P0 = ₹ 91.89
Alternative Solution:

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However, in case a student follows Walter‟s 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

Walter‟s approach showing relationship between dividend and share price can
be expressed by the following formula
R
D + a (E−D)
Rc
Vc =
Rc
Where,
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 = Capitalization rate i.e. the rate expected by investors by way of return
from particular category of shares.
E = Earnings per share.
D = Dividend per share.
Hence,
8.27+ 0.15
0.18
(20.67−8.27)
Vc =
0.18
18.60
=
0.18
= ₹ 103.35

QUESTION – 50

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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.

(Practice Manual)

SOLUTION:

(i) Present Value of the stock of ABC Ltd. is:-

2.50(1.02)
Vo = = ₹ 30/-
0.105 − 0.02

(ii) Value of stock under the PE Multiple Approach

Particulars
Actual Stock Price ₹ 35.00
Return on equity 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 ₹ 35.00
Return on equity 9%
EPS ₹ 2.25
Growth Rate 2%
Market Price per Share [EPS × (1 + g)]/(Ke− g) ₹ 32.79
= ₹ 2.25 × 1.02/0.07

Since, Actual Stock Price is higher, hence it is overvalued.

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QUESTION – 51

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.

(Practice Manual)

SOLUTION:

(i) Present Value of the stock:-

5.00(1.02)
Vo = = ₹ 63.75/-
0.10 − 0.02

(ii) Value of stock under the PE Multiple Approach

Particulars
Actual Stock Price ₹ 40.00
Return on equity 8%
EPS ₹ 3.00
PE Multiple (1/Return on Equity)= 1/8% 12.50
Market Price per Share ₹ 37.50

Since, Actual Stock Price is higher, hence it is overvalued.

(iii) Value of the Stock under the Earnings Growth Model

Particulars
Actual Stock Price ₹ 40.00
Return on equity 8%
EPS ₹ 3.00
Growth Rate 2%
Market Price per Share [EPS × (1 + g)]/(Ke− g) ₹ 51.00

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= ₹ 3.00 × 1.02/0.06

Since, Actual Stock Price is higher, hence it is overvalued.

QUESTION – 52

ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The
company has paid dividend @ ₹3 per share. The rate of return on market
portfolio is 12 percent and the risk free rate of return in the market has been
observed as 8 percent. The Beta co-efficient of company‟s share is 1.5.

You are required to calculate the expected rate of return on company‟s shares
as per CAPM model and equilibrium price per share by dividend growth model.

(Study Material & PM)

SOLUTION:

CAPM formula for calculation of Expected Rate of Return is :

ER = Rf + B (Rm – Rf)

= 8 +1.5 (12 − 8)

= 8 +1.5 (4)

= 6 +8

=14% or 0.14
Applying Dividend Growth Model for the calculation of per share equilibrium
price:

d1
ER =
P0 + g

3 (1.10)
0.14 = + 0.10
P0

3.30
0.14 − 0.10 =
P0

0.04Po = 3.30

3.30
Po =
0.04 = ₹ 82.50
Per share equilibrium price will be ₹ 82.50.

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QUESTION – 53

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.

(Study Material & PM)

SOLUTION:

In order to find out the value of a share with constant growth model, the value
of K e should be ascertained with the help of „CAPM‟ model as follows:

Ke = Rf +β (Km – Rf)

Where,

Ke = Cost of equity

Rf = Risk free rate of return

β = 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

D1
P0 =
(Ke −g)

Where,

P0 = Price of a share

D1 = Dividend at the end of the year 1

Ke = Cost of equity

G = growth

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2.00
P0 =
(Ke −g)
2.00
P0 = = ₹ 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 (β) factor
is likely to increase to 1.75 therefore, K e would be

Ke = Rf + β (Km – Rf)

= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%

The value of share is

D1
P0 =
(K e −g)

2.00
P0 =
0.16−0.07 = ₹ 22.00
Alternatively it can also be found as follows:

2.00 (1.07)
= ₹ 23.78
0.16−0.07

QUESTION – 54

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

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rate is 19% p.a., calculate the market price per share.

(Study Material & PM)

SOLUTION:

(1) Cost of Capital

Retained earnings (45%) ₹ 5 per share

Dividend (55%) ₹ 6.11 per share
EPS (100%) ₹ 11.11 per share
P/E Ratio 8 times
Market price ₹ 11.11 × 8 = ₹ 88.88
Cost of equity capital

Dividend ₹ 6.11
= × 100 + Growth% = × 100 +15% = 21.87%
Price ₹ 88.88

Dividend
(2) Market Price =
Cost of Capital % − Growth Rate %

6.11
= = ₹ 104.08 Per share
21.87−16 %

₹ 6.11
(3) Market Price = = ₹ 611.00 Per share
(20−19)%

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%) ₹ 5 per share

Retained earnings (45%) ₹ 2.25 per share

Dividend (55%) ₹ 2.75 per share

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P/E Ratio 8 times

Market Price ₹ 5 × 8 = ₹ 40

Cost of equity capital

Dividend ₹ 2.75
= × 100 + Growth% = × 100 + 15% = 21.87%
Price ₹ 40.00

Dividend
(2) Market Price =
Cost of Capital % −Growth Rate %

₹ 2.75
= = ₹ 46.85 per share
₹ 21.87−16 %

₹ 2.75
(3) Market Price = = ₹ 275 per share
20−19 %

QUESTION – 55

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 company‟s 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 company‟s 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.

SOLUTION:

(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

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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.

(3) Market price = Dividend/(cost of equity capital % − growth rate %)

= 5/(18% − 15%) = 5/3% = ₹ 166.66 per share.

QUESTION – 56

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.

(Study Material & PM)

SOLUTION:

D1
Intrinsic Value P0 =
K−g
Using CAPM

K = Rf + β (Rm – Rf)

Rf = Risk Free Rate

β = Beta of Security

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Rm = Market Return

= 9% + 0.75 (15% − 9%) = 13.5%

2.5 × 1.1 2.75

P = = = ₹ 78.57
0.135 − 0.10 0.035

QUESTION – 57

The risk free rate of return Rf is 9 percent. The expected rate of return on the
market portfolio Rm is 13 percent. The expected rate of growth for the dividend
of Platinum Ltd. is 7 percent. The last dividend paid on the equity stock of firm
A was ₹ 2.00. The beta of Platinum Ltd. equity stock is 1.2.

(i) What is the equilibrium price of the equity stock of Platinum Ltd.?

(ii) How would the equilibrium price change when

 The inflation premium increases by 2 percent?

 The expected growth rate increases by 3 percent?
 The beta of Platinum Ltd. equity rises to 1.3?

(Study Material & PM)

SOLUTION:

(i) Equilibrium price of Equity using CAPM

= 9% + 1.2(13% − 9%)

= 9% + 4.8% = 13.8%

D1 2.00 (1.07) 2.14

P= = = = ₹ 31.47
K e −g 0.138−0.07 0.068

(ii) New Equilibrium price of Equity using CAPM

= 9.18% + 1.3(13% − 9.18%)

= 9.18% + 4.966% = 14.146%

D1 2.00 (1.10) 2.20

P= = = = ₹ 53.06
K e −g 0.14146 −0.10 0.04146

Alternatively, it can also be computed as follows:

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= 11% + 1.3(15% − 8%)

= 11% + 5.2% = 16.20%

D1 2.00 (1.10)
P= = = ₹ 35.48
K e −g 0.162−0.10

Alternatively, if all the factors are taken separately then solution will be
as follows:

(i) Inflation Premium increase by 3%. This raises RX to 15.80%.

Hence, new equilibrium price will be:

2.00 1.07
= = ₹ 24.32
0.158 − 0.07

(ii) Expected Growth rate decrease by 3%. Hence, revised growth rate
Stands at 10%:

2.00 1.10
= = ₹ 57.89
0.138−0.10
(iii) Beta decreases to 1.3. Hence, revised cost of equity shall be:

= 9% + 1.3(13% − 9%)

= 9% + 5.2% = 14.2%

As a result, New Equilibrium price shall be:

D1 2.00(1.07)
P= = = ₹ 29.72
K e −g 0.142−0.07

QUESTION – 58

XYZ Ltd. paid a dividend of ₹ 2 for the current year. The dividend is expected to
grow at 40% for the next 5 years and at 15% per annum thereafter. The return
on 182 days T-bills is 11% per annum and the market return is expected to be
around 18% with a variance of 24%.

The co-variance of XYZ's return with that of the market is 30%. You are required
to calculate the required rate of return and intrinsic value of the stock.

(Study Material & PM)

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 SECURITY VALUATION

SOLUTION:

Covariance of Market Return andSecurity Return

β =
Variance of Market Return
30%
β = = 1.25
24%

Expected Return = Rf + β (Rm – Rf)

= 11% + 1.25 (18% − 11%)

= 11% + 8.75% =19.75%

Intrinsic Value

Year Dividend (₹) PVF (19.75%, 𝐧) Present Value (₹)

1 2.00 0.835 2.34
2 3.92 0.697 2.73
3 5.49 0.582 3.19
4 7.68 0.486 3.73
5 10.76 0.406 4.37
16.36

10.76 (1.15)
PV of Terminal Value = × 0.406 = ₹ 105.77
0.1975−0.15

Intrinsic Value = ₹ 16.36 + ₹ 105.77 = ₹ 122.13

QUESTION – 59

Sahu & Co. earns ₹ 6 per share having capitalization rate of 10 per cent and
has a return on investment at the rate of 20 per cent. According to Walter‟s
modal, what should be the price per share at 30 per cent dividend payout ratio
? Is this the optimum payout ratio as per Walter ?

SOLUTION:

R
D + a (E−D)
Rc
Walter Model is Vc =
Rc

Whare:

VC = Market value of the share

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Ra = Return on Retained earnings

Rc = Capitalization Rate

E = Earning per share

D = Dividend per share

Hence, if Walter model is applied

0.20
1.80 + (6−1.80)
0.10
Market Value of the Share =
0.10
0.20
1.80 + (4.20)
0.10
P=
0.10

1.80 + 8.40
P=
0.10

P = ₹ 102

This is not the optimum payout ratio because Ra > Rc and there for Vc can
further go up if payout ratio is reduced.

QUESTION – 60

You are requested to find out the approximate dividend payment ratio as to
have the share price at ₹ 56 by using Walter Model, based on following
information available for Company.

Amount ₹
Net Profit 50 lakhs
Outstanding 10% Preference Shares 80 lakhs
Number Equity Shares 5 lakhs
Return on Investment 15%
Cost of Capital (after Tax) (Ke) 12%

SOLUTION:

(i)

₹ in lakhs

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Net Profit 50
Less: Preference dividend 8
Earning for equity shareholders 42
Therefore earning per share ₹ 42 lakhs/5 lakhs ₹ 8.40

(ii) Cost of capital i.e. (ke) 12%

Let, the dividend payout ratio be X and so and so the share price will be:

r (E −D )
D Ke
P= + = where D = Dividend (Rs) and r = 15% and K 𝑒 = 12%
Ke Ke

Here D = 8.40 × ; E = ₹ 8.40; r = 0.15 and K e = 0.12 and P = ₹ 56

8.40X 0.15 (8.40−8.40X)

Hence ₹ 56 = +
0.12 0.12 ×0.12

Or, ₹ 56 = 70x + 87.50 (1-x)

-17.50x = -31.50

X =1.80

Dividend pay-out ratio would be zero, as pay-out is more than 100% of

EPS seems to be illogical.

QUESTION – 61

The following information is collected from the annual reports of J Ltd.

Profit before tax ₹2.50 crore

Tax rate 40 percent
Retention ratio 40 percent
Number of outstanding shares 50,00,000
Equity capitalization rate 12 percent
Rate of return on investment 15 percent

What should be the market price per share according to Gordon‟s model of
dividend policy ?

SOLUTION:

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Gordon’s Formula

E (1−B)
P0 =
K−br
P0 = Market Price per share

E = Earnings per share ( ₹ 1.50 crore/50,00,000) = ₹ 3

K = Cost of Capital = 12%

b = Retention Ratio (%) = 40%

r = IRR = 15%

br = Growth Rate (0.40 ×15%) = 6%

3 (1 − 0.40)
P0 =
0.12 − 0.06

= ₹ 30.00

QUESTION – 62

In December, 2011 AB Co.‟s share was sold for ₹ 146 per share. A long term
earnings growth rate of 7.5% is anticipated. AB co. is expected to pay dividend
of ₹ 3.36 per share.

i. What rate of return an investor can expect to earn assuming that

dividends are expected to grow along with earnings at 7.5% per year in
perpetuity ?

ii It is expected that AB Co. will earn about 10% on book equity and shall
retain 60% of earnings. In this case, whether, there would be any change
in growth rate and cost of Equity ?

SOLUTION:

i. According to Dividend Discount Model approach the firm‟ expected or

required return of equity is computed as follows:

D1
+g
P0

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Where,

Ke = Cost of equity share capital

D1= Expected dividend at the end of year 1

P0 = Current market price of the share.

g = Expected growth rate of dividend.

3.36
Therefore, Ke = + 7.5%
146

= 0.0230 + 0.075 = 0.098

Or, Ke = 9.80%

ii. With rate of return of retained earnings (r) 10% and retention ratio (b)
60%, new growth rate will be as follows:

g = br i.e

= 0.10 × 0.60 = 0.06

Accordingly dividend will also get changed and to calculate this, first we shall
calculate previous retention ratio (b1) and then EPS assuming that rate of
Return on retained earnings (r) is same.

With previous Growth Rate of 7.5% and r = 10% the retention ration comes out
to be:

0.075 = b1 × 0.10

b1 = 0.75 and payout ratio = 0.25

With 0.25payout ration the EPS will be as follows:

3.36
= 13.44
0.25

With new 0.40 (1 – 0.60) payout ratio the new dividend will be

D1 = 13.44 × 0.40 = 5.376

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Accordingly new Ke will be

5.376
Ke =
146 + 6.0%
or, Ke = 9.68%

Alternatively

EPS with 6% growth rate instead of 7.5%.

1.06
13.44 × = 13.25
1.075

With new 0.40 (1−0.60) payout ratio the new dividend will be

D1 = 13.25 × 0.40 = 5.30

Accordingly new Ke will be

5.30
Ke =
146 + 6.0%
or, Ke = 9.63%

QUESTION – 63

Shares of Volga Ltd. are being quoted at a price-earning ratio of 8 times. The
company retains 50% of its Earnings Per share. The Company‟s EPS is ₹ 10.

i. the cost of equity to the company if the market expects a growth rate or
15% p.a.

ii. the indicative market price with the same cost of capital and if the
anticipated growth rate 16% p.a.

iii. the marked price per share if the company‟s cost of capital is 20% p.a.
and the anticipated growth rate is 18% p.a.

(Exam November - 2018)

SOLUTION:

i. Cost of Capital

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Retained earnings (50%) ₹ 5 per share

Dividend (50%) ₹ 5 per share
EPS (100%) ₹ 10 per share (given)
P/E Ratio 8 times (given)
Market price ₹ 10 × 8 = 80 per share

Cost of equity capital

Div ₹5
= × 100 + Growth% = × 100 × 100 + 15% = 21.25%
Price ₹80

Dividend
ii. Market Price =
Cost of Capital % −Growth Rate (%)

₹5
= = 95.24 per share
21.25 − 16 %

₹5
iii. Market Price = = ₹ 250 per share
20 − 18 %

Alternatively, if candidates have assumed the given figure of EPS as of last year
then answer will be as follows:

i. Cost of Capital

Retained earnings (50%) ₹ 5 per share

Dividend (50%) ₹ 5 per share
EPS (100%) ₹ 10 per share (given)
P/E Ratio 8 times (given)
Market price ₹ 10 × 8 = 80 per share

Cost of equity capital

Div ₹ 5 (1.15)
= × 100 + Growth% = × 100 + 15% = 22.19%
Price ₹ 80

Dividend
ii. Market Price =
Cost of Capital % −Growth Rate (%)

₹ 5.75
= = ₹ 92.89 per share
22.19 − 16 %

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₹5
iii. Market Price = = ₹ 295 per share
20−18 %

QUESTION – 64

ABC Limited, just declared a dividend of ₹ 28.00 per share. Mr. A is planning to
purchase the share of ABC 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 ₹ 720.00 after three years.

You are required to determine:

(i) the maximum amount Mr. A should pay for shares, if he requires a rate
of return of 13% per annum.

(ii) the maximum price Mr. A 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.

Note : Calculate rupee amount up to two decimal points and use PVF upto 3
decimal points.

(RTP May - 2021)

SOLUTION:

(i) Expected dividend for next 3 years.

Year 1 (D1) ₹ 28.00 (1.09) = ₹ 30.52

Year 2 (D2) ₹ 28.00 (1.09)2 = ₹ 33.27

Year 3 (D3) ₹ 28.00 (1.09)3 = ₹ 36.26

Required rate of return = 13% (Ke)

Market price of share after 3 years = (P3) = ₹ 720

The present value of share

D1 D2 D3 P3
P0 = + + +
(1+ke ) (1+ke )2 (1+ke )3 (1+ke )3

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30.52 33.27 36.26 720

= + + +
(1+0.13) (1+0.13)2 (1+0.13)3 (1+0.13)3

P0 = 30.52(0.885) + 33.27(0.783) +36.26(0.693) +720(0.693)

P0 = 27.01 + 26.05 + 25.13 + 498.96

P0 = ₹ 577.15

(ii) If growth rate 9% is achieved for indefinite period, then maximum price
of share should Mr. A willing be to pay is

D1 ₹ 30.52 ₹ 30.52
P0 = = = = ₹ 763
(ke −g) 0.13−0.09 0.04

(iii) Assuming that conditions mentioned above remain same, the price
expected after 3 years will be:

D3 D 3 (1.09) 36.26×1.09 39.52

P3 = = = = = ₹ 988
(ke −g) 0.13−0.09 0.04 0.04

QUESTION – 65

The risk free rate of return is 5%. The expected rate of return on the market
portfolio is 11%. The expected rate of growth in dividend of X Ltd. is 8%. The
last dividend paid was ₹ 2.00 per share. The beta of X Ltd. equity stock is 1.5.

(i) What is the present price of the equity stock of X Ltd.?

(ii) How would the price change when:

 The inflation premium increases by 3%.

 The expected growth rate decreases by 3% and
 The beta decreases to 1.3.

(Exam May – 2018)

SOLUTION:

(i) Equilibrium price of Equity using CAPM

= 5% + 1.5(11% − 5%)

= 5% + 9%= 14%

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D1 2.00(1.08) 2.16
P= = = = ₹ 36
k e −g 0.14−0.08 0.06

(ii) New Equilibrium price of Equity using CAPM (assuming 3% on 5% is

inflation increase)

= 5.15% + 1.3(11% − 5.15%)

= 5.15% + 7.61%= 12.76%

D1 2.00(1.05)
P= = = ₹ 27.06
k e −g 0.119−0.05

Alternatively, it can also be computed as follows, assuming it is 3% in

addition to 5%

= 8% + 1.3(11% − 8%)

= 8% + 3.9% = 11.9%

D1 2.00(1.05)
P= = = ₹ 30.43
k e −g 0.119−0.05

Alternatively, if all the factors are taken separately then solution of this part
will be as follows:

(i) Inflation Premium increase by 3%.

This raises RX to 17%. Hence, new equilibrium price will be:

2.00(1.08)
= = ₹ 24
0.17−0.08

(ii) Expected Growth rate decrease by 3%.

Hence, revised growth rate stand at 5%:

2.00(1.05)
= = ₹ 23.33
0.14−0.05

(iii) Beta decreases to 1.3.

Hence, revised cost of equity shall be:

= 5% + 1.3(11% − 5%)

= 5% + 7.8% = 12.8%

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As a result New Equilibrium price shall be:

D1 2.00(1.08)
P= = = = ₹ 45
k e −g 0.128−0.08

QUESTION – 66

A company has an EPS of ₹ 2.5 for the last year and the DPS of ₹ 1. The
earnings is expected to grow at 2% a year in long run. Currently it is trading at
7 times its earnings. If the required rate of return is 14%, compute the
following:

(i) An estimate of the P/E ratio using Gordon growth model.

(ii) The Long-term growth rate implied by the current P/E ratio.

(MTP March - 2021)

SOLUTION:

(i) Estimated of P/E Ratio using Gordon Growth Model

D1
ke = +g
P

1(1.02)
0.14 = + 0.02
P

P = ₹ 8.50

₹ 8.50
PE Ratio = = 3.40
₹ 2.50

(ii) Long Term Growth Rate Implied

Based on Current PE Ratio, the price per share

= ₹ 2.50 × 7 Times = ₹ 17.50

We know that

P = D0(1+g)/ (ke – g)

₹ 17.50 = ₹ 1(1+g)/ (0.14 – g)

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17.50 × 0.14 – 17.50g = 1 + g

g = 0.0784 i.e. 7.84%

QUESTION – 67

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

(Practice Manual & RTP November - 2018)

SOLUTION:

(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

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Required rate of return = 13% (Ke)

Market price of share after 3 years = (P3) = ₹ 360

The present value of share

D1 D2 D3 P3
P0 = + + +
(1 + k e ) (1 + k e )2 (1 + k e )3 (1 + k e )3

15.26 16.63 18.13 360

P0 = + + +
(1 + 0.13) (1 + 0.13)2 (1 + 0.13)3 (1 + 0.13)3

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

D1 ₹ 15.26 ₹ 15.26
P0 = = = = ₹ 381.50
(1−k e ) (0.13−0.09) 0.04

(iii) Assuming that conditions mentioned above remain same, the price
expected after 3 years will be:

D4 D 3 (1.09) 18.13 ×1.09 19.76

P3 = = = = = ₹ 494
ke − g 0.13 −0.09 0.04 0.04

QUESTION – 68

Following are the details of X Ltd. and Y Ltd.:

Particulars X Ltd. Y Ltd.

Dividend per Share ₹4 ₹4
Growth Rate 10% 10%
Beta 0.09 1.2
Current Market Price per Share ₹ 150 ₹ 70

Other Information:

Risk Free Rate of Return 7%

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Market Rate of Return 14%

(i) Calculate the price of shares of both the companies.

(ii) Write the comment on the valuation on the basis of price calculated and
current market price.

(iii) As an investor what course of action should be followed?

(Exam December - 2021)

SOLUTION:

(i) Calculation of Prices of Shares of both companies

X Ltd. Y Ltd.
Beta 0.9 1.20
Cost of Equity using CAPM 7%+0.9[14%−7%] 7%+1.20[14%−7%]
= 13.30% = 15.40%
Growth Rate 10% 10%
4 × 1.10 4.40 4 × 1.10 4.40
= =
Price of Share 0.133 − 0.10 0.033 0.154 − 0.10 0.054
= ₹ 133.33 = ₹ 81.48

(ii) and (iii)

Name of Current Value of Valuation Action of

Company Market Price the Share the Investor
X Ltd. ₹ 150.00 ₹ 133.33 Overvalued/ Not to
overpriced Invest/to be
sold
Y Ltd. ₹ 70.00 ₹ 81.48 Undervalued/ Invest/to be
underpriced purchased

Alternatively, if the given figure of Dividend is considered as Dividend Expected

(D1) then solution will be as follows:

X Ltd. Y Ltd.
Beta 0.9 1.20
Cost of Equity using CAPM 7%+0.9[14%−7%] 7%+1.20[14%−7%]
= 13.30% = 15.40%
Growth Rate 10% 10%
4.00 4.00 4.00 4.00
= =
Price of Share 0.133 − 0.10 0.033 0.154 − 0.10 0.054
= ₹ 121.21 = ₹ 74.07

(ii) and (iii)

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Name of Current Value of Valuation Action of

Company Market Price the Share the Investor
X Ltd. ₹ 150.00 ₹ 121.21 Overvalued/ Not to
overpriced Invest/to be
sold
Y Ltd. ₹ 70.00 ₹ 74.07 Undervalued/ Invest/to be
underpriced purchased

(ii) Multiple Growth Model

Example – 21

D0 =₹5

Growth Rate

First 2 years = 12% p.a.

Next 2 years = 10% p.a.

And there after = 6% p.a. perpetual

Required rate of return = 15% p.a.

Calculate value per share.

QUESTION – 69

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

(Practice Manual)

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SOLUTION:

D0 = ₹ 4

D1 = ₹ 4 (1.20) = ₹ 4.80

D2 = ₹ 4 (1.20)2 = ₹ 5.76

D3 = ₹ 4 (1.20)2 (1.10) = ₹ 6.336

D1 D2 TV
P = + +
1+k e 1+k e 2 1+k e 2

D3 6.336
TV = = = 126.72
ke − g 0.15 − 0.10

4.80 5.76 126.72

P = + +
1 + 0.15 1 + 0.15 2 1 + 0.15 2

= 4.80 × 0.8696 + 5.76 × 0.7561 + 126.72 × 0.7561 = 104.34

QUESTION – 70

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.

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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

(Practice Manual)

SOLUTION:

(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

D1 D2 D3 P3
P0 = + + +
(1 + ke ) (1 + k )2 (1 + k )3 (1 + k )3
e e e

15.26 16.63 18.13 360

P0 = + 2 + 3 + 3
(1 + 0.13) (1 + 0.13) (1 + 0.13) (1 + 0.13)

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

D1 ₹ 15.26 ₹ 15.26
P0 = = =
(1−ke ) (0.13−0.09) 0.04 = ₹ 381.50

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(iii) Assuming that conditions mentioned above remain same, the price
expected after 3 years will be:

D4 D3(1.09) 18.13 × 1.09 19.76

P3 = = = =
ke − g 0.13 −0.09 0.04 0.04 = ₹ 494

QUESTION – 71

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 firm‟s expected or required return on equity using a
dividend-discount model approach?

(ii) Instead of this situation in part (i), suppose that the dividends were
expected to grow at a rate of 20% per annum for 5 years and 10% per
year thereafter. Now what is the firm‟s expected, or required, return on
equity?

(Practice Manual)

SOLUTION:

(i) Firm’s Expected or Required Return On Equity

(Using a dividend discount model approach)
According to Dividend discount model approach the firm‟s expected or
required return on equity is computed as follows:

D1
Ke = +g
P0

Where,

Ke = Cost of equity share capital or (Firm‟s expected or required

return on equity share capital)

D1 = Expected dividend at the end of year 1

P0 = Current market price of the share.

g = Expected growth rate of dividend.

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Now, D1 = D0 (1 + g) or ₹ 1 (1 + 0.12) or ₹ 1.12, P0 = ₹ 20 and g =12% per

annum

Therefore, Ke =
₹ 1.12 + 12%
₹ 20
Or, Ke = ₹ 17.6%

(ii) Firm’s Expected or Required Return on Equity

(If dividends were expected to grow at a rate of 20% per annum for 5
years and 10% per year thereafter)

Since in this situation if dividends are expected to grow at a super

normal growth rate g s , 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:
t
Div0 (1+gs) Divn +1 × 1
P0 = 𝑛
𝑡=1 +
(1+Ke)
l Ke −gn (1+K )ll
e

Where,

gn = Rate of growth in earlier years.

gn = Rate of constant growth in later years.

P0 = Discounted value of dividend stream.

Ke = Firm‟s expected, required return on equity (cost of equity capital).

Now,

gs = 20% for 5 years, g n = 10%

Therefore,

t
n D 0 (1+020) Div5+1 1
P0 = t=1 (1+K )t + Ke −0.10 × t
e (1+Ke )

P0=
1.20 + 1.44 + 1.73 + 2.07 + 2.49 + 2.49(1+0.10) × 1
1 2 3
(1+) (1+) (1+) (1+) (1+)
4 5 −0.10 (1+)
5

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Or P0 = ₹ 1.20 (PVF1Ke) + ₹ 1.44 (PVF2Ke) + ₹ 1.73 (PVF3Ke) + ₹ 2.07

Rs.2.74(PVF5, Ke )
(PVF4Ke) + ₹ 2.49 (PVF5Ke) +
Ke −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)

1
+ ₹ 2.49 (0.4371) + ₹ 2.74 (0.4371)
0.18−0.10
= ₹ 1 .017 + ₹ 1.034 + ₹ 1.053 + ₹ 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 𝐾𝑒 = 19% we will have

P0 = ₹ 1.20 (0.8403) + ₹ 1.44 (0.7061) + ₹ 1.73 (0.5934) + ₹ 2.07 (0.4986) + ₹

1
2.49 (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 × Δr
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

∆r = Difference in rates

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(₹ 20.23 − ₹ 20)
K = 18% + ×1%
₹ 20.23 − 17.89

=18% +
₹023 ×1%
₹2.34
= 18% + 0.10% = 18.10%

Therefore, the firm‟s expected, or required, return on equity is 18.10%. At this rate the
present discounted value of dividend stream is equal to the market price of the share.

QUESTION – 72

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.

(SM, PM & RTP November - 2019)

SOLUTION:

P.V. of dividend stream and sales proceeds

Year Dividend/Sale PVF (12%) PV (₹)

1 ₹ 20/- 0.893 17.86
2 ₹ 20/- 0.797 15.94
3 ₹ 20/- 0.712 14.24
4 ₹ 24/- 0.636 15.26
5 ₹ 24/- 0.567 13.61
6 ₹ 24/- 0.507 12.17
7 ₹ 24/- 0.452 10.85
8 ₹ 1026/- (₹ 900 × 1.2 × 0.95) 0.452 463.75
₹ 563.68
Less: Cost of Share (₹ 500 × 1.05) ₹ 525.00
Net gain ₹ 38.68

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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 × 100/105 = ₹
536.84

QUESTION – 73

Seawell Corporation, a manufacturer of do-it-yourself hardware and house

wares, reported earnings per share of € 2.10 in 2003, on which it paid
dividends per share of €0.69. Earnings are expected to grow 15% a year from
2004 to 2008, during this period the dividend payout ratio is expected to
remain unchanged. After 2008, the earnings growth rate is expected to drop to
a stable rate of 6%, and the payout ratio is expected to increase to 65% of
earnings. The firm has a beta of 1.40 currently, and is expected to have a beta
of 1.10 after 2008. The market risk premium is 5.5%. The Treasury bond rate
is 6.25%.

(a) What is the expected price of the stock at the end of 2008?

(b) What is the value of the stock, using the two-stage dividend discount
model?

(Practice Manual & RTP May - 2019)

SOLUTION:

The expected rate of return on equity after 2008 = 0.0625 + 1.10(0.055) =12.3%

The dividends from 2003 onwards can be estimated as:

Year 2013 2014 2015 2016 2017 2018 2019

Earnings Per Share (€) 2.1 2.415 2.78 3.19 3.67 4.22 4.48
Earnings Per Share (€) 0.69 0794 0.913 1.048 1.206 1.387 2.91

a. The price as of 2008 = €2.91/(0.123- 0.06) = €46.19

b. The required rate of return upto 2008 = 0.0625 + 1.4(0.055) = 13.95%.

The dividends upto 2008 are discounted using this rate as follow:

Year PV of Dividend
2004 0.794/1.139 = 0.70

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2005 0.913/(1.1395)2 = 0.70

2006 1.048/(1.1395)3 = 0.70
2007 1.206/(1.1395)4 = 0.72
2008 1.387/(1.1395)5 = 0.72
Total 3.54

The current price = €3.54 + €46.19/ (1.1395)5 = €27.58.

QUESTION – 74

SAM Ltd. has just paid a dividend of ₹ 2 per share and it is expected to grow @
6% p.a. After paying dividend, the Board declared to take up a project by
retaining the next three annual dividends. It is expected that this project is of
same risk as the existing projects. The results of this project will start coming
from the 4th year onward from now. The dividends will then be ₹ 2.50 per
share and will grow @ 7% p.a.

An investor has 1,000 shares in SAM Ltd. and wants a receipt of at least ₹
2,000 p.a. from this investment.

Show that the market value of the share is affected by the decision of the
Board. Also show as to how the investor can maintain his target receipt from
the investment for first 3 years and improved income thereafter, given that the
cost of capital of the firm is 8%.

(Study Material & PM)

SOLUTION:

D1
Value of share at present =
k e −g

2(1.06)
= = ₹ 106
0.08−0.06

However, if the Board implement its decision, no dividend would be payable for
3 years and the dividend for year 4 would be ₹ 2.50 and growing at 7% p.a. The
price of the share, in this case, now would be:

2.50 1
P0 = × = ₹ 198.46
0.08−0.07 (1+0.08)3

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So, the price of the share is expected to increase from ₹ 106 to ₹ 198.45 after
the announcement of the project. The investor can take up this situation as
follows:

2.50
=
Expected market price after 3 years 0.08−0.07 = ₹ 250.00

2.50 1
= ×
Expected market price after 2 years 0.08−0.07 (1+0.08) = ₹ 231.48

2.50 1
= ×
Expected market price after 1 years 0.08−0.07 (1+0.08)2 = ₹ 214.33

In order to maintain his receipt at ₹ 2,000 for first 3 year, he would sell

10 shares in first year @ ₹ 214.33 for ₹ 2,143.30

9 shares in second year @ ₹ 231.48 for ₹ 2,083.32

8 shares in third year @ ₹ 250 for ₹ 2,000.00

At the end of 3rd year, he would be having 973 shares valued @ ₹ 250 each i.e.
₹ 2,43,250. On these 973 shares, his dividend income for year 4 would be @ ₹
2.50 i.e. ₹ 2,432.50.

So, if the project is taken up by the company, the investor would be able to
maintain his receipt of at least ₹ 2,000 for first three years and would be
getting increased income thereafter.

QUESTION – 75

X Ltd. is a shoes manufacturing company. It is all equity financed and has

paid-up Capital of ₹ 10,00,000 (₹ 10 per share)

X Ltd. has hired Swastika consultants to analyses the future earnings. The
report of Swastika consultants states as follows:

a. The earnings and dividend will grow at 25% for the next two year.

b. Earnings are likely to grow at the rate of 10% from 3rd year and onwards.

c. Further, if there is reduction in earnings growth, dividend payout ratio

will increase to 50%

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The other data related to the company are follows:

Year EPS (₹) Net Dividend per share Share Price (₹)
(₹)
2010 6.30 2.52 63.00
2011 7.00 2.80 46.00
2012 7.70 3.08 63.75
2013 8.40 3.36 68.75
2014 9.60 3.84 93.00

You may assume that the tax rate is 30% (not expected to change is future)
and post tax cost of capital is 15%.

By using the Dividend Valuation Model, calculate

i. Expected Market Price per share

ii. P/E Ratio.

SOLUTION:

i. The formula for the Dividend valuation Model is

D1
P0 =
K e −g

Ke = cost of Capital

G = Growth rate

D1 = Dividend at the end of year 1

On the basis of the information given, the following projection can be made:

Year EPS (₹) DPS (₹) PVF @ PV of

15% DPS (₹)
2015 12.00 = (9.60 × 125%) 4.80 = (3.84 × 125%) 0.870 4.176
2016 15.00 = (12.00 × 125%) 6.00 = (4.80 × 125%) 0.756 4.536
2017 16.50 = (15.00 × 110%) 8.25* = (50% of ₹ 16.50) 0.658 5.429
14.141

* payout ratio changed to 50%.

After 2017, the perpetuity value assuming 10% constant annual growth is:

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D1 = ₹ 8.25 ×110% = ₹ 9.075

Therefore P0 from the end of 2017

9.075
= ₹ 181.50
0.15−0.10

This must be discounted back to the present value, using the 3 year discount
factor after 15%.

₹
Present Value of P0 (₹ 181-50 × 0.658) 119.43
Add: PV of Dividends 2015 to 2017 14.14
Expected Market Price of share 133.57

ii. P/E Ratio

Expected Market Price of share (P 1 )

P/E Ratio =
EPS

₹ 133.57
= = ₹ 13.91
₹ 9.60
QUESTION – 76

Y Ltd., a manufacturer of house wares, reported earnings per share of 4.5 in

2005, on which it paid dividends per share 1.65. Earnings are expected to grow
50% a year from 2005 to 2010, during which period the dividend payout ratio
is expected to remain unchanged. After 2010, the earnings growth rate is
expected to drop to a stable 8% and the payout ratio is expected to increase to
85% of earnings. The firm has a beta of 2 currently, and is expected to have a
beta of 1.50 after 2010. The Treasure bond rate is 5.75%.

i. What is the expected price of the stock at the end of 2010.

ii. What is the value of stock using the two-stage dividend discount model?

SOLUTION:

E0 = 4.5

D0 = 1.65

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1.65
∴ Payout Ratio = × 165 = 36.67%
4.5

Re = Rf (Rm−Rf) β

= 5.75 + 6 × 2

= 17.75%

Stage I – Explicit forecast period (first 5 years)

Years EPS DPS DF@ 17.75% PV

2006 6.75 2.48 0.8493 2.11
2007 10.135 3.71 0.7212 2.68
2008 15.19 5.57 06125 3.41
2009 22.78 8.36 05202 4.35
2010 34.17 12.53 0.4418 5.54
18.09

Stage II – Horizon Period (beyond 5 years)

New Re = 5.75 + 6 ×1.5

= 14.75%

Earnings in 2011 = 34.17 × 1.08

= 36.90

∴ DPS = 36.90 × 85% = 31.37

D 2011 31.37
∴ P2010 = = = 464.74
R e −g 0.1475 −0.08

Present value of P2010 = 464.75 × 0.4419 = 205.32

i. Thus, the expected share price of the sock at the end of 2010 = ₹ 464.74

ii. Value of the stock using the two stage DDM-

= Stage I + Stage II

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18.09 + 205.32 = ₹ 223.41

QUESTION - 77

An investor is considering to purchase the equity shares of LX Ltd., whose

current market price (CMP) is ₹ 112. The company is proposing a dividend of ₹
4 for the next year. LX Ltd. is expected to grow @ 20 per cent per annum for
the next four years. The growth will decline linearly to 16 per cent per annum
after first four years. Thereafter, it will stabilize at 16 per cent per annum
infinitely. The investor requires a return of 20 per cent per annum.

You are required

(i) To calculate the intrinsic value of the share of LX Ltd.

(ii) Whether it is worth to purchase the share at this price.

Period 1 2 3 4 5 6 7
PVIF (20%,n) 0.833 0.694 0.579 0.482 0.402 0.335 0.279

(Exam November - 2020)

SOLUTION:

D1 =₹4

D2 = ₹ 4 (1.20) = ₹ 4.80

D3 = ₹ 4 (1.20)2 = ₹ 5.76

D4 = ₹ 4 (1.20)3 = ₹ 6.91

D5 = ₹ 6.91 (1.19) = ₹ 8.22

D6 = ₹ 6.91 (1.19) (1.18) = ₹ 9.70

D7 = ₹ 6.91 (1.19) (1.18) (1.17) = ₹ 11.35

D8 = ₹ 6.91 (1.19) (1.18) (1.17) (1.16) = ₹ 13.17

D1 D2 D3 D4 D5 D6 D7
P = + + + + + +
1+k e (1+k e )2 (1+k e )3 (1+k e )4 (1+k e )5 (1+k e )6 (1+k e )7
TV
+ 7
(1+ke)

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D8 13.17
TV = = = ₹ 329.25
k e −g 0.20−0.16

4.00 4.80 5.76 6.91 8.22 9.70

P = + + + + + +
(1+0.20) (1+0.20)2 (1+0.20)3 (1+0.20)4 (1+0.20)5 (1+0.20)6
11.35 329.25
+ 7
(1+0.20)7 (1+0.20)

= 4.00 × 0.833 + 4.80×0.694 + 5.76 × 0.579 + 6.91 × 0.482 + 8.22 ×

0.402 + 9.70 × 0.335 + 11.35 × 0.279 + 329.25 × 0.279

(i) Intrinsic Value = ₹ 114.91

(ii) As Intrinsic Value of the share is higher than its selling price of ₹ 112, it
is underpriced and can be acquired. However, other factors need to be
taken into consideration since difference is only slightly higher.

QUESTION – 78

An investor is considering purchasing the equity shares of LX Ltd., whose

current market price (CMP) is 150. The company is proposing a dividend of ₹ 6
for the next year. LX is expected to grow @ 18 per cent per annum for the next
four years. The growth will decline linearly to 14 per cent per annum after first
four years. Thereafter, it will stabilize at 14 per cent per annum infinitely. The
required rate of return is 18 per cent per annum.

You are required to determine:

(i) The intrinsic value of one share.

(ii) Whether it is worth to purchase the share at this price.

Period 1 2 3 4 5* 6* 7* 8*
PVIF (18,t) 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266

* Wrongly got printed as 4, 5, 6 and 7 respectively.

(Exam May - 2019)

SOLUTION:

D1 = ₹ 6

D2 = ₹ 6 (1.18) = ₹ 7.08

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D3 = ₹ 6 (1.18)2 = ₹ 8.35

D4 = ₹ 6 (1.18)3 = ₹ 9.86

D5 = ₹ 9.86 (1.17) = ₹ 11.54

D6 = ₹ 9.86 (1.17)(1.16) = ₹ 13.38

D7 = ₹ 9.86 (1.17)(1.16)(1.15) = ₹ 15.39

D8 = ₹ 9.86 (1.17)(1.16)(1.15)(1.14) = ₹ 17.54

D1 D2 D3 D4 D5 D6 D7
P= + + + + + + +
(1+k e ) (1+k e )2 (1+k e )3 (1+k e )4 (1+k e )5 (1+k e )6 (1+k e )7

TV
(1+k e )7

D8 17.54
TV = = = ₹ 438.50
k e −g 0.18−0.14

6.00 7.08 8.35 9.86 11.54 13.38

P= + 2 + 3 + 4 + 5 + +
(1+0.18) (1+0.18) (1+0.18) (1+0.18) (1+0.18) (1+0.18)6
15.39 438.50
7 +
(1+0.18) (1+0.18)7

= 6.00 × 0.847 + 7.08 × 0.718 + 8.35 × 0.609 + 9.86 × 0.516 + 11.54 × 0.437
+ 13.38 × 0.370 + 15.39 × 0.314 + 438.50 × 0.314

= ₹ 172.85

Since the Intrinsic Value of share is ₹ 172.85 while it is selling at ₹ 150 hence it
is underpriced and better to acquire it.

QUESTION – 79

The shares of G Ltd. are currently being traded at ₹ 46. The company
published its results for the year ended 31st March 2019 and declared a
dividend of ₹ 5. The company made a return of 15% on its capital and expects
that to be the norm in which it operates. G Ltd. also expects the dividends to
grow at 10% for the first three years and thereafter at 5%.

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You are required to advise whether the share of the company is being traded at
a premium or discount.

PVIF @ 15% for the next 3 years is 0.870, 0.756 and 0.658 respectively.

(Exam May - 2019)

SOLUTION:

Expected dividend for next three years

Year 1 (D1) = 5 (1.1) = 5.5

Year 2 (D2) = 5.5 (1.1) = 6.05

Year 3 (D3) = 6.05 (1.1) = 6.655

Required Rate (Ke) = 15%

Present Value of Dividends

= 5.5 (0.870) + 6.05 (0.756) + 6.655 (0.658)

= 4.785 + 4.574 + 4.379

= 13.74

Now, PV at growth rate of 5%

D4
P3 =
k e −g

6.655(1.05) 6.988
= = = 69.88
0.15−0.05 0.1

Therefore, P0 = 69.88 × 0.658 = 45.98

Now, adding the PV of dividend at two different growth rates, we get,

13.74 + 45.98 = 59.72

Hence, it is clear that shares are being traded at discount i.e. undervalued
because intrinsic value of share is more than the market price.

QUESTION – 80

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The current EPS of M/s VEE Ltd. is ₹ 4. The company has shown an
extraordinary growth of 40% in its earnings in the last few year this high
growth rate is likely to continue for the next 5 years after which growth rate in
earnings will decline from 40% to 10% during the nest 5 years and remain
stable at 10% thereafter. The decline in the growth rate during the 5 years
transition period will be equal and linear. Currently, the company‟s pay-out
ratio is 10%. It is likely to remain the same for the next five years and from the
beginning of the sixth year till the end of the 10th year, the pay-out will linearly
increase and stabilize at 50% at the end of the 10th year. The post tax cost of
capital is 17% and the PV factors are given below:

Years 1 2 3 4 5 6 7 8 9 10
PVIF 0.855 0.731 0.625 0.534 0.456 0.390 0.333 0.285 0.244 0.209
@17%

You are required to Calculate the intrinsic value of the company‟s stock based
on expected dividend. if the current market price of the stock is ₹ 125, suggest
if it is advisable for the investor to invest in the company‟s stock or not.

(Exam November - 2019)

SOLUTION:

Working Notes:

(i) Computation of Growth Rate in Earning and EPS

Year 1 2 3 4 5 6 7 8 9 10
Growth 40% 40% 40% 40% 40% 34% 28% 22% 16% 10%
in
Earning
EPS (₹) 5.60 7.84 10.98 15.37 21.51 28.82 36.89 45.00 52.20 57.42

(ii) Computation of Payout Ratio and Dividend

Year 1 2 3 4 5 6 7 8 9 10
Payout 10% 10% 10% 10% 10% 18% 26% 34% 42% 50%
Ratio
Dividend 0.56 0.78 1.10 1.54 2.15 5.19 9.59 15.30 21.92 28.71
(₹)

(iii) Calculation of PV of Dividend

Year Dividend (₹) PVF PV of Dividend (₹)

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1 0.56 0.855 0.48

2 0.78 0.731 0.57
3 1.10 0.625 0.69
4 1.54 0.534 0.82
5 2.15 0.456 0.98
6 5.19 0.390 2.02
7 9.59 0.333 3.19
8 15.30 0.285 4.36
9 21.92 0.244 5.35
10 28.71 0.209 6.00
24.46

(iii) Buy Back Decision

Whenever surplus fund is available & no investment opportunity is available

then such surplus fund can be used for buy back of equity share.

After Buy Back, number of equity shares decreases & earning per share
increases –

MPS After Buy Back = EPS After Buy Back × Post Buy Back P/E Ratio

QUESTION – 81

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.

You are required to determine:

(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.

(Practice manual, SM)

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SOLUTION:

(i) Let P be the buyback price decided by Rahul Ltd.

Market Capitalization 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

239.7
Or P = = ₹ 21.79 Per share
11

(ii) Number of Shares to be Bought Back :-

₹ 27 lakhs
= 1.24. lakhs (approx.) or 123910 share
₹ 21.79

(iii) New Equity Shares :-

10 lakhs – 1.24 lakhs = 8.76 lakhs or 10,00,000 – 1,23,910

= 8,76,090 shares

3 × 10 lakhs
∴EPS = = ₹ 3.43
8.76 lakhs
Thus, EPS of Rahul Ltd., increases to ₹ 3.43.

QUESTION – 82

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.

You are required to determine:

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i. The price at which the shares can be repurchased, if the market

capitalization of the company should be ₹ 200 lakh after buyback.

ii. The number of shares that can be re-purchased.

iii. The impact of share re-purchased on the EPS, assuming the net income
is same.

SOLUTION:

i. Let P be the buyback price decided by Abhishek Ltd.

Market Capitalization After Buyback:

1.1 P (Original Shares – Shares Bought back)

30% of 90 lakhs
= 1.1P 10 lakhs − P

= 11 lakhs × P-27 lakhs × 1.1 = 11 lakhs × P – 29.7 lakhs.

Market Capitalization rate after buyback is 200 lakh.

Thus, we have:

11 lakhs × P − 29 lakhs × ₹ 200 lakhs

Or 11P = 200 + 29.7

229.7
Or P = = ₹ 20.88
11

ii. Number of shares to be bought back:

27 lakhs
= 1.29 lakhs (Approximately)
20.88

iii. New Equity Shares

= (10 – 1.29) lakhs = 8.71 lakhs

3 × 10 lakhs 3 OL
EPS = = = ₹ 3.44
20.88 8.71L

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Thus EPS of Abhiskhek Ltd., increases to ₹ 3.44

QUESTION – 83

ABB Ltd. has a surplus cash balance of ₹ 180 lakhs and wants to distribute
50% of it to the equity share holders. The company decides to buyback equity
shares. The company estimates that its equity share price after re-purchase is
likely to be 15% above the buyback price, if the buyback route is taken.

Other information is as under:

(1) Number of equity shares outstanding at present (Face value ₹ 10 each) is

20 lakhs.

(2) The current EPS is ₹ 5.

You are required to calculate the following:

(i) The price at which the equity shares can be re-purchased, if market
capitalization of the company should be ₹ 400 lakhs after buyback.

(ii) Number of equity shares that can be re-purchased.

(iii) The impact of equity shares re-purchase on the EPS, assuming that the
net income remains unchanged.

(Exam May - 2019)

SOLUTION:

(i) Let P be the buyback price decided by ABB Ltd.

Market Capitalization after Buyback

400 lakhs = 1.15P (Original Shares – Shares Bought Back)

50% of 180 laksh

= 1.15P 20 lakhs – P

= 23 lakhs × P – 90 lakhs × 1.15

= 23 lakhs P – 130.50 lakhs

Again, 23 lakhs P – 130.50 lakhs

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or 23 lakhs P = 400 lakhs + 130.50 lakhs

503.50
or P = = ₹ 21.89 per share
23

(ii) Number of Shares to be Bought Back :-

₹ 90 lakhs/21.89 = 4.111 lakhs (Approx.) or 411147 shares

(iii) Shares after buyback

= 20 lakhs – 4.111 lakhs = 15.889 lakhs

or 20,00,000 – 4,11,147 = 15,88,853 shares

EPS = 5 × 20 lakhs/ 15.889 lakhs = ₹ 6.29

Thus, EPS of ABB Ltd., increases to ₹ 6.29.

So, EPS of ABB Ltd. is increased by ₹ 1.29 (6.29 – 5.00)

QUESTION – 84

Eager Ltd. has a market capitalization of ₹ 1,500 crores and the current market
price of its share is ₹ 1,500. It made a PAT of 200 crores and the Board is
considering a proposal to buy back 20% of the shares at a premium of 10% to
the current market price. It plans to fund this through a 16% bank loan. You
are required to calculate the post buy back Earnings Per Share (EPS). The
company‟s corporate tax rate is 30%.

(MTP March - 2021)

SOLUTION:

₹ 1,500 crore
Existing No. of Equity Shares = = 1 Crore
₹ 1,500

No. of shares to be bought back = 1 Crore × 0.20 = 20 Lakh

Price at which share to be bought back = ₹ 1,500 + 10% of ₹ 1,500 = ₹ 1,650

Amount required for Buyback of Shares = ₹ 1,650 × 20 Lakh = ₹ 330 Crore

Amount of Loan @ 16% = ₹ 330 Crore

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Statement showing Post Buyback EPS

Profit before tax (₹ 200 crore/0.70) ₹ 285.7143 crore

Less: Interest on loan (₹ 330 crore × 16%) ₹ 52.8000 crore
Profit before Tax ₹ 232.9143 crore
Tax ₹ 69.8743 crore
Profit after Tax (PAT) ₹ 163.0400 crore
No. of Shares Post Buyback 80 Lakh
EPS (Post Buyback) (₹ 163.0400 crore/80.00 lakhs) ₹ 203.80

QUESTION – 85

SK Ltd., has a surplus cash of ₹ 150 lakhs and wants to distribute 30% of it to
the shareholders. The company decided to buy-back shares.

The company estimates that its share price after the buy-back is likely to be
15% above the buy-back price. The number of shares outstanding at present is
15 lakhs and the current EPS is ₹ 4.

You are required to determine:

(i) The price at which the shares can be bought-back, if the market
capitalization of the company should be ₹ 400 lakhs after buy back.

(ii) The number of shares that can be bought-back, and

(iii) The impact of this buy-back on the EPS, assuming that the net income
remains the same.

(Exam July – 2021)

SOLUTION:

(i) Let P be the buyback price decided by SK Ltd.

Market Capitalization after Buyback

1.15P (Original Shares – Shares Bought Back)

30% of 150 lakhs

400 lakhs = 1.15P 15 lakhs – P

400 lakhs = 17.25 lakhs × P – 45 lakhs × 1.15

= 17.25 lakhs P – 51.75 lakhs

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Again, 400 lakhs = 17.25 lakhs P – 51.75 lakhs

Or, 17.25 lakhs P = 400 lakhs + 51.75 lakhs

451.75
Or, P = = ₹ 26.19 per
17.25

(ii) Number of Shares to be Bought Back:

₹ 45 lakh
= 1.718 lakhs (approx.) or 1,71,821 share
₹ 26.19

(iii) Impact of Buy Back on the EPS:

No. of equity shares after buy back:

15 lakhs – 1.718 lakhs = 13.282 lakhs or 15,00,000 – 1,71,821

= 13,28,179 shares

4 ×15 lakhs 4 ×15 lakhs

∴ EPS = = ₹ 4.52 or = ₹ 4.52
13.282 lakhs 13,28,179 lakhs

Thus, EPS of SK Ltd. increases to ₹ 4.52 or increases by ₹ 0.52 (4.52 –

4.00).

(iv) Valuation of Right

Following steps are applied to calculate Value of Right.

Step 1: Calculate Theoretical

Ex–Right Price

No .of shares before right × MPS before right +(No .of right shares × Offer price )
=
No of shares before right + No .of right shares

Step 2: Calculate Value of Right

Method I:
Value of right per share = MPS before right – Ex-right price

Method II:

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Value of right = Ex-Right Price – Offer Price

Example – 22

Existing shares of A Ltd. = 1,00,000 shares

Current market price per share = ₹ 40

Right Issue ∆ share for every 5 shares hold

Offer price = ₹ 30

(i) Calculate Ex-Right price.

(ii) Value of Right

(iii) Assuming Ram hold 100 shares, calculate his wealth if he

(a) Buy right shares.

(b) Sell right.

(c) Ignore right.

QUESTION – 86

ABC Limited‟s shares are currently selling at ₹ 13 per share. There are
10,00,000 shares outstanding. The firm is planning to raise ₹ 20 lakhs to
Finance a new project.

Required:

What are the ex-right price of shares and the value of a right, if

(i) The firm offers one right share for every two shares held.

(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?

(Practice Manual)

SOLUTION:

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(i) Number of shares to be issued: 5,00,000

Subscription price ₹ 20,00,000/5,00,000 = ₹ 4

₹ 1,30,00,000 + ₹ 20,00,000
Ex – right Price = = ₹ 10
15,00,000

Or, Value of Right = ₹ 10 −₹ 4 = ₹ 6

₹ 10 − ₹ 4
= =3
2

(ii) Subscription price ₹ 20,00,000/2,50,000 = ₹ 8

₹ 1,30,00,000 + ₹ 20,00,000
Ex-right Price = = ₹ 12
12,50,000

Value of Right = ₹ 12 − ₹ 8 = ₹ 4

₹ 12 − ₹ 8
Or, =1
4

(iii) Calculation of effect of right issue on wealth of Shareholder‟s wealth who

is holding, say 100 shares.

(a) When firm offers one share for two shares held.

Value of Shares after right issue (150 ×₹ 10) ₹ 1,500

Less: Amount paid to acquire right shares (50 ×₹ 4) ₹ 200

₹ 1,300

(b) When firm offers one share for every four shares held.

Value of Shares after right issue (125 ×₹ 12) ₹ 1,500

Less: Amount paid to acquire right shares (25 ×₹ 8) ₹ 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).

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QUESTION – 87

The share Galaxy Ltd. of a face ₹ 10 in being quoted at ₹ 24. The Company has
a plan to make a right issue of one equity share for every four shares currently
held at a premium of 40% per share.

You are required to:

i. Determine the minimum price that can be expected of share after the
issue.

ii. Calculate the theoretical value of the rights alone.

iii. Show the effect of the right issue on the wealth of a shareholder who has
1500 shares, if

a. he sells the entire rights, and

b. he ignores the rights.

SOLUTION:

i. Expected Minimum Price

M × N + Sr 24 × 4 + 14 × 1 96 + 14
P= = = = ₹ 22
N +r N +r 5

Where

P = Theoretical Post right price per share

M = Market price of share

N = No. of existing shares

S = Subscription price

r = No. of right

ii. Post right – Subscription price

₹ 22 − ₹ 14 = 8

Or (M − P) × N

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(₹ 24 – ₹ 22) × 8

iii.

a. Value of 1500 shares before right issue 1500 × ₹ 24 ₹ 36,000

After Right issue 1500 × ₹ 22 ₹ 33,000
Add Sale proceeds of right 375 × ₹ 8 ₹ 3,000
₹ 36,000
b. Value of 1500 shares
Before fights ₹ 36,000
After rights ₹ 33,000
Loss to shareholder ₹ (3000)

QUESTION – 88

KLM Limited has issued 90,000 equity shares of ₹ 10 each. KLM Limited‟s
shares are currently selling at ₹ 72. The company has a plan to make a rights
issue of one new equity share at a price of ₹ 48 for every four shares held.

You are required to:

(a) Calculate the theoretical post-rights price per share and analyze the
change

(b) Calculate the theoretical value of the right alone.

(c) Suppose Mr. A who is holding 100 shares in KLM Ltd. is not interested in
subscribing to the right issue, then advice what should he do.

(RTP May - 2021)

SOLUTION:

(a) Calculation of theoretical Post-rights (ex-right) price per share

MN +SR
Ex-right value =
N+R
Where,

M = Market price,

N = Number of old shares for a right share

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S = Subscription price

R = Right share offer

₹ 72 × 4 + ₹ 48 × 1
= = ₹ 67.20
4 +1
Thus, post right issue the price of share has reduced by ₹4.80 per share.

(b) Calculation of theoretical value of the rights alone:

= Ex-right price − Cost of rights share

= ₹ 67.20 − ₹ 48 = ₹ 19.20

OR

₹ 67.20 − ₹ 48
= = ₹ 4.80
4
(c) If Mr. A is not interested in subscribing to the right issue, he can
renounce his right eligibility @ ₹ 19.20 per right and can earn a gain of ₹
480.

QUESTION – 89

AMKO Limited has issued 75,000 equity shares of ₹ 10 each. The current
market price per share is ₹ 36. The company has a plan to make a rights issue
of one new equity share at a price of ₹ 24 for every four shares held.

You are required to:

(i) Calculate the theoretical post-rights price per share.

(ii) Calculate the theoretical value of the right alone.

(Exam November - 2018)

SOLUTION:

(i) Calculation of theoretical Post-rights (ex-right) price per share:

MN + SR
Ex-right value =
N +R
Where,

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M = Market price,

N = Number of old shares for a right share

S = Subscription price

R = Right share offer

₹ 36 × 4 + ₹ 24 × 1
= = ₹ 33.60
4 +1
(ii) Calculation of theoretical value of the rights alone:

= Ex-right price – Cost of rights share

= ₹ 33.60 − ₹ 24 = ₹ 9.60

Or,

₹ 33.60 − ₹ 24
= = ₹ 2.40
4
QUESTION – 90

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.

(PM & RTP November - 2018)

SOLUTION:

(i) Calculation of theoretical Post-rights (ex-right) price per share:

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MN + SR
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

₹22.40 −₹16
Or = = ₹1.60
4

(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

Value of shares after right issue

(b) (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.

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(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)
24,000
Less: Value of shares after right issue
(1,000 shares ×₹ 22.40)
22,400
Loss of wealth to shareholders, if rights ignored
1,600

3. Money Market Instruments

QUESTION – 91

A bond is held for period of 45 days. The current discount yield is 6 per cent
per annum. It is expected that current yield will increase by 200 basis points
and current market price will come down by ₹ 2.50.

Calculate :

i Face value of the Bond and

ii. Bond Equivalent yield

(Exam May - 2019)

SOLUTION:

i. Face Value of the Bond

a. Current Market Price* 45 days 6 0.9925

b. Current Market Price* 45 days 8 0.9900
c. Difference in price per Unit (a)-(b) 0.0025
d. Difference in price ₹ 2.50
e. Face Value of Bond (d)/(c) ₹ 1,000
f. Current Market Price (a) × (e) 6 ₹ 992.50
g. Current Market Price (a) × (e) 8 ₹ 990.00

*1-[(Discount Rate/100) (45/360)]

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ii. Bond Equivalent yield

At the rate of 6% 1,000−992.50 360 6.05

× × 100 †
992.50 45
At the rate of 8% 1,000−990.00 360 8.08
× × 100 †
990.00 45

Alternative Solution if 365 day year are assumed

i. Face Value of the Bond

a. Current Market Price* 45 days 6 0.9926

b. Current Market Price* 45 days 8 0.9901
c. Difference in price per Unit (a) − (b) 0.0025
d. Difference in price ₹ 2.50
e. Face Value of Bond (d)/(c) ₹ 1,000
f. Current Market Price (a) × (e) 6 ₹ 992.60
g. Current Market Price (b) × (e) 8 ₹ 990.10

*1 − [(Discount Rate/100) (45/360)]

At the rate of 6% 1,000−992.50 360 6.05

× × 100 †
992.50 45
At the rate of 8% 1,000−990.10 360 8.08
× × 100 †
990.10 45

FV −CV 365
× × 100
CV 45

QUESTION – 92

Suppose Govt. Pays ₹ 5,000 at maturity for 91 days Treasury bill. If Mr. Y is
desirous to earn an annualized discount rate of 3.5%, then how he can pay for
it.

SOLUTION:

Suppose X be the maximum amount Mr. Y can pay for Treasury bill. Then,

₹ 5,000−X 360
× = 0.035
₹ 5,000 91

₹ 5,000 − X = ₹ 44.24

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X = ₹ 4,955.76

QUESTION – 93

Suppose Mr. X purchase Treasury bill for Rs. 9,940 maturing in 91 days for
10,000. Then what would be annualized investment rate for Mr. X and
Annualized discount rate for the Govt. Investment.

SOLUTION:

₹ 10,000 − ₹ 9,940 365

Investment Rate = × = 0.02421 i.e. 2.42%
₹ 9,940 91

₹ 10,000 − ₹ 9,940 365

Discount Rate = × = 0.02374 i.e. 2.374%
₹ 10,000 91

QUESTION – 94

Bank A enter into a Repo for 14 days with Bank B in 10% Government of India
Bonds 2018 @ 5.65% for ₹ 8 crore. Assuming that clean price be ₹ 99.42 and
initial margin be 2% and days of accrued interest be 262 days. You are
required to determine.

(i) Dirty Price

(ii) Repayment at maturity. (Consider 360 days in a year)

(MTP March & April - 2021)

SOLUTION:

(i) Dirty Price

= Clean Price + Interest Accrued

10 262
= 99.42 + 100 × × = 106.70
100 360

(ii) First Leg (Start Proceed)

Dirty Price 100−Initial Margin

= Nominal Value × ×
100 100

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106.70 100−2
= ₹ 8,00,00,000 × × = ₹ 8,36,52,800
100 100

Second Leg (Repayment at Maturity)

No. of Days
= Start Proceed × 1 + Repo Rate × 360

14
= ₹ 8,36,52,800 × 1 + 0.0565 × 360 = ₹ 8,38,36,604

QUESTION – 95

From the following particulars, calculate the effective rate of interest p.a. as
well as the total cost of funds to Bhaskar Ltd., which is planning a CP issue:

Issue Price of CP ₹ 97,550

Face Value ₹ 1,00,000

Maturity Period 3 Months

Issue Expenses:

Brokerage 0.15% for 3 months

Rating Charges 0.50% p.a.

Stamp Duty 0.175% for 3 months

(MTP October - 2020)

SOLUTION:

F−P 12
Effective Interest = × × 100
P M

Substituting the given values of F, P and M we get,

1,00,000−97,550 12
Effective Interest = × × 100 = 10.05%
97,550 3

Cost of funds to the company

Effective interest rate = 10.05%

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Brokerage (0.15 × 4) = 0.6%

Rating charges = 0.5%

Stamp duty (0.175 × 4) = 0.75%

Total cost of Funds to Bhaskar Ltd. = 11.9% p.a.

QUESTION – 96

Bank A enters into a Repo for 21 days with Bank B in 8% Government of India
Bonds 2020 @ 6.10% for ₹ 5 crore. Assuming that clean price is ₹ 97.30 and
initial margin is 1.50% and days of accrued interest are 240 days (assume 360
days in a year).

Compute:

(i) The dirty price.

(ii) The repayment at maturity.

(Exam January – 2021)

SOLUTION:

(i) Dirty Price

= Clean Price + Interest Accrued

8 240
= 97.30 + 100 × × = 102.63
100 360

(ii) First Leg (Start Proceed)

Dirty Price 100−Intial Margin

= Nominal Value × ×
100 100

102.63 100−1.50
= ₹ 5,00,00,000 × × = ₹ 5,05,45,275
100 100

Second Leg (Repayment at Maturity)

No .of days
= Start Proceed × (1 + Repo Rate × )
360

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21
= ₹ 5,05,45,275 × (1 + 0.0610 × ) = ₹ 5,07,25,132
360

4. Residual

QUESTION – 97

Capital structure of Sun Ltd., as at 31.3.2003 was as under:

(₹ 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.

(i) 1% for every time of difference for interest and fixed dividend coverage
ratio.

(ii) 2% for every time of difference for capital gearing ratio.

(Study Material & PM)

SOLUTION:

(a) Calculation of Profit after tax (PAT)

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₹
Profit before interest and tax (PBIT) 32,00,000
Less: Debenture interest (₹ 64,00,000 × 12/100) 7,68,000
Profit before tax (PBT) 24,32,000
Less: Tax @ 35% 8,51,200
Profit after tax (PAT) 15,80,800
Less: Preference Dividend
(₹ 40,00,000 × 8/100) 3,20,000
Equity Dividend (₹ 80,00,000 × 8/100) 6,40,000
Retained earnings (Undistributed profit) 9,60,000
6,20,800

Calculation of Interest and Fixed Dividend Coverage

PAT + Debenture interest

=
Debenture interest + Preference dividend
15,80,800 + 7,68,000 23,48,800
= = = 2.16 times
7,68,000 + 3,20,000 10,88,000

(b) Calculation of Capital Gearing Ratio

Fixed interest bearing funds

Capital Gearing Ratio =
Equity shareholders ′ funds

Preference Share Capital + Debentures

=
Equity Share Capital + Reserves

40,00,000 + 64,00,000 1,04,00,000

= = = 0.93
80,00,000 + 32,00,000 1,12,00,000

(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 3,51,040

Yield on shares
Yield on equity shares % = × 100
Equity share capital

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3,51,040
= × 100 = 4.39% or, 4.388%.
80,00,000

Calculation of Expected Yield on Equity shares

(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. Hence,

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. Hence,

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 0.84

Add: Risk premium for high interest gearing ratio 0.36

10.80

Value of Equity Share

Actual yield
= × Paid-up value of share
Expected yield

4.39
= × 100 = ₹ 40.65
10.80

QUESTION – 98

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

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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.

(Practice Manual)

SOLUTION:

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

EBIT
Present Interest Coverage Ratio =
Interest Charges

₹ 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

₹ 103.50 lakhs
Revised Interest Coverage Ratio = = 1.113
₹ 93.00 lakhs

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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 – 99

AB Industries has Equity Capital of ₹ 12 Lakhs, total Debt of ₹ 8 Lakhs, and

annual sales of ₹ 30 Lakhs. Two mutually exclusive proposals are under
consideration for the next year. The details of the proposals are as under:

Particulars Proposal Proposal

No. 1 No. 2
Target Assets to Sales Ratio 0.65 0.62
Target Net Profit Margin (%) 4 5
Target Debt Equity Ratio (DER) 2:3 4:1
Target Retention Ratio (of Earnings) (%) 75 -
Annual Dividend (₹ In Lakhs) - 0.30
New Equity Raised (₹ in Lakhs) - 1

You are required to calculate sustainable growth rate for both the proposals.

(Exam November - 2020)

SOLUTION:

Sustainable Growth Rate under Proposal 1

Sales (Given) ₹ 30 Lakhs

Total Assets ₹ 30 Lakhs × 0.65 ₹ 19.50 Lakhs

Net Profit ₹ 30 Lakhs × 4% ₹ 1.20 Lakhs

Equity 12 lakhs
Equity multiplier = = 0.6
Equity +Debt 12 lakhs +8 lakhs

1.20 lakhs
ROE = × 0.60 × 100 3.69%
19.50 lakhs

Sustainable Growth Rate = ROE × Retention Ratio

= 3.69% × 0.75 = 2.77%

Sustainable Growth Rate under Proposal 2

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New Equity = ₹ 12 lakhs + ₹ 1 lakhs = ₹ 13 lakhs

New Debt = ₹ 13 lakhs × 4 = ₹ 52 lakhs

Total Assets = ₹ 13 lakhs + ₹ 52 lakhs = ₹ 65 lakhs

Target Assets to Sales Ratio (Given) 0.62

Sales ₹ 65 Lakhs / 0.62 ₹ 104.84 Lakhs

Net Profit ₹ 104.84 Lakhs × 5% ₹ 5.242 Lakhs

Equity 13 lakhs
Equity multiplier = = 0.2
Equity +Debt 13 lakhs +52 lakhs

5.242 lakhs
ROE = ×0.20×100 1.613%
65 lakhs

5.242 lakhs −0.30 lakhs

Retention Ratio = 0.943
5.242 lakhs

Sustainable Growth Rate = ROE × Retention Ratio

= 1.613% × 0.943 = 1.52%

QUESTION – 100

In March 2020, XYZ bank sold some 7% interest rate futures underlying
notional 7.50% coupon bonds. The exchange provides following details of
eligible securities that can be delivered:

Security Quoted Price of Bond Conversion Factor

7.96 GOI 2023 1037.40 1.0370
6.55 GOI 2025 926.40 0.9060
6.80 GOI 2029 877.50 0.9195
6.85 GOI 2026 972.30 0.9643
8.44 GOI 2027 1146.30 1.1734
8.85 GOI 2028 1201.70 1.2428

Recommend the Security that should be delivered by the XYZ bank if future
settlement price is 1,000.

(MTP April - 2021)

SOLUTION:

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The XYZ Bank shall choose those CTD (Cheapest-to-Deliver) Bonds from the
basket of deliverable Bonds which gives maximum profit computed as follows:

Profit = Future Settlement Price × Conversion Factor – Quoted Spot Price of

Deliverable bond

Accordingly, the profit of each bond shall be computed as follows:

Security Future Conversion Quoted Price Profit

Settlement Factor (4) = of Bonds
Price (2) × (3)
(1) (2) (3) (5) (6)
7.96 GOI 2023 1,000 1.0370 1037.00 1037.40 - 0.40
6.55 GOI 2025 1,000 0.9060 906.00 926.40 - 20.40
6.80 GOI 2029 1,000 0.9195 919.50 877.50 42.00
6.85 GOI 2026 1,000 0.9643 964.30 972.30 - 8.00
8.44 GOI 2027 1,000 1.1734 1173.40 1146.30 27.10
8.85 GOI 2028 1,000 1.2428 1242.80 1201.70 41.10

Since maximum profit to the Bank is in case of 6.80 GOI 2029, same should be
opted for.

QUESTION – 101

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

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(ii) Calculate its sustainable growth rate of earnings

(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?

(SM, PM & RTP May - 2020)

SOLUTION:

Workings:

Asset turnover ratio = 1.1

Total Assets = ₹ 600

Turnover ₹ 600 lakhs × 11 = ₹ 660 lakhs
Interest
Effective interest rate = = 8%
Libilities
Liabilities = ₹ 125 lakhs + 50 lakhs = 175 lakh
Interest = ₹ 175 lakhs × 0.08 = ₹ 14 lakh
Operating Margin = 10%
Hence operating cost = (1 − 0.10) ₹ 660 lakhs = ₹ 594 lakh
Dividend Payout = 16.67%
Tax rate = 40%
(i) Income statement

(₹ lakh)
Sale 660
Operating Exp 594
EBIT 66
Interest 14
EBT 52
Tax @ 40% 20.80
EAT 31.20
Dividend @ 16.67% 5.20 5.20
Retained Earnings 26.00

(ii) SGR = ROE (1−b)

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PAT
ROE = and NW = ₹ 100 lakh + ₹ 300 lakh = 400 lakh
NW
31.2 lakhs
ROE = 100 = 7.8%
400 lakhs
0.078 × 0.8333
SGR = 0.078 (1 − 0.1667) = 6.5% or = 6.95%
1 − 0.078 × 0.8333
(iii) Calculation of fair price of share using dividend discount model

D 0 (1+g)
P0 =
K e −g

₹ 5.2 lakhs
Dividends = = 0.52
₹ 10 lakhs
Growth Rate = 6.5% or 6.95%
₹ 0.52 1+0.065 ₹ 0.5538 0.52(1 + 0.0695)
Hence P0 = = = ₹ 6.51 or
0.15 − 0.065 0.085 0.15 − 0.0695
0.5561
= = ₹ 6.91
0.0805

(iv) Since the current market price of share is ₹ 14, the share is overvalued.
Hence the investor should not invest in the company.

QUESTION – 102

Following financial information are available of XP Ltd. for the year 2018:

Equity share capital (₹ 10 each) ₹ 200 Lakh

Reserves and Surlus ₹ 600 Lakh

10% Debentures (₹ 100 each) ₹ 350 Lakh

Total Assets ₹ 1200 Lakh

Assets Turnover Ratio 2 times

Tax Rate 30%

Operating Margin 10%

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Dividend Payout Ratio 20%

Current Market Price per Equity Share ₹ 28

Required Rate of Return of Investors 18%

You are required to:

(i) Prepare income statement for the year 2018.

(ii) Determine its sustainable growth rate.

(iii) Determine the fair price of the company‟s share using dividend discount
model.

(iv) Give your opinion on investment in the company‟s share at current price.

(Exam May - 2019)

SOLUTION:

Workings:

Asset turnover ratio = 2 times

Total Assets = ₹ 1200 lakh

Turnover ₹ 1200 lakhs × 2 = ₹ 2400 lakhs

Interest on Debentures = 350 lakh × 10% = 35 lakhs

Operating Margin = 10%

Hence operating cost = (1 − 0.10) 2400 lakhs = ₹ 2160 lakhs

Dividend Payout = 20%

Tax rate = 30%

(i) Income Statement

(₹ Lakhs)
Sale 2,400
Operating Exp 2,160
EBIT 240

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Interest 35
EBT 205
Tax @ 30% 61.5
EAT 143.5
Dividend @ 20% 28.7
Retained Earnings 114.8

(ii) SGR = Return on Equity (1−Dividend Payout Ratio)

= ROE (1 − b)

PAT
ROE = and NW = ₹ 200 lakh + ₹ 600 lakh = ₹ 800 lakh
NW

₹ 143.5 lakhs
ROE = × 100 = 17.94%
₹ 800 lakhs

0.1794 ×0.80 0.14352

SGR = 0.1794 (1 – 0.20) = 14.35% Or, = = 16.76%
1−0.1794×0.80 0.85648

(iii) Calculation of fair price of share using dividend discount model

D 0 (1+g)
P0 =
ke − g

₹ 28.7 lakhs
Dividends = = ₹ 1.435
20 lakhs

Growth Rate= 14.35% or, 16.76%

₹ 1.435(1+0.1435) ₹ 1.64
Hence P0 = = = ₹ 44.93 or, 44.96
0.18−0.1435 0.0365

1.435(1+0.1676) ₹ 1.676
Or, = = ₹ 135.16 or, 135.12
0.18−0.1676 0.0124

(iv) Since the current market price of share is ₹ 28, the share is undervalued.
Hence, the investor should invest in the company.

QUESTION – 103

Following information is available of M/s. TS Ltd.

(₹ in crores)

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PBIT 5.00

Less: Interest on debt (10%) 1.00

PBT 4.00

Less: Tax @ 25% 1.00

PAT 3.00

No. of outstanding shares of ₹ 10 each 40 lakh

EPS (₹) 7.5

Market price of share (₹) 75

P/E ratio 10 Times

TS Ltd. has an undistributed reserves of ₹ 8 crores. The company requires ₹ 3

crores for the purpose of expansion which is expected to earn the same rate of
return on capital employed as present however, if the debt to capital employed
ratio is higher than 35%, then P/E ratio is expected to decline to 8 Times and
rise in the cost of additional debt to 14%. Given this data which of the following
options the company would prefer, and why?

Option (i): If the required amount is raised through debt, and

Option (ii): If the required amount is raised through equity and the new shares
will be issued at a price of ₹ 25 each.

(Exam November - 2019)

SOLUTION:

Working Notes:

(1) Calculation of Return on Capital Employed (ROCE)

(₹ in crores)
Capital Employed:
Share Capital (₹ 10 × 40 lakhs) 4
Reserve
Debt (₹ 1cr. × 100/10) 8
10

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 SECURITY VALUATION

22
PBIT 5
ROCE 22.73%

(2) Revised PBIT

Existing Capital Employed 22

Additional 3
ROI 22.73%
Revised PBIT 5.6825

(3) New Debt/Equity

Existing Debt 10
Additional Under Option (1) 3
Total Debt 13
Total Equity 12

13
New Debt to Capital Employed Ratio = = 0.52
25

So, P/E Ratio to be reduced to 8 times

(4) Debt to Capital Employed Ratio in Option (ii)

10
= = 0.40
25

So, P/E Ratio to be reduced to 8 times in this case also

(5) Number of additional shares to be issued in case of Option (ii)

Funds to be raised ₹ 3 crore

Price per share ₹ 25

No. of additional shares to be issued ₹ 3 crore/ ₹ 25 = 12 lakhs

Particulars Option (i) Option (ii)

PBIT (Revised) (₹ crore) 5.6825 5.6825
Less: Interest on Debt 1.42 1.00
PBT (₹ Crore) 4.2625 4.6825
Tax @ 25% (₹ crore) 1.0656 1.1706
PAT (₹ crore) 3.1969 3.5119

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No. of shares outstanding 40 lakhs 52 lakhs

EPS ₹ 7.99 ₹ 6.75
P/E Ratio 8 8
New Share Price ₹ 63.92 ₹ 54.00

Decision:
Since the MPS is expected to be more in the case of additional financing done
through debt (Option – I) Option – I is preferred.

QUESTION – 104

Following Financial Data for Platinum Ltd.

For The year 2011 (₹ in lakhs)

Equity Shares (10 each) 100
8% Debentures 125
10% Bonds 50
Reserve and Surplus 200
Total Assets 500
Assets Turnover Ratio 1.1
Effective Tax Rate 30%
Operation Margin 10%
Required rate of return of investors 15%
Dividend payout ratio 20%
Current market price of shares ₹ 13

You are required to:

i. Draw income statement for the year

ii. Calculate the sustainable growth rate

iii. Compute the fair price of the company‟s share using dividend discount
model, and

iv. Draw your opinion on investment in the company‟s share at current

price

SOLUTION:

Working:

Asset turnover ratio = 1.1

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Total Assets = ₹ 500 lakhs

Turnover = ₹ 500 lakh × 1.1 = ₹ 550 lakhs

Interest = ₹ 125 lakhs × 0.08 + ₹ 50 lakhs × 0.10 = ₹ 15 lakh

Operation Margin = 10%

Hence operating cost = (1 – 0.10) ₹ 550 lakhs = ₹ 495 lakh

Dividend payout = 20%

Tax rate = 30%

i. Income statement

(₹ Lakhs)
Sale 550.00
Operation Exp 495.00
EBIT 55.00
Interest 15.00
EBT 40.00
Tax @ 30% 12.00
EAT 28.00
Dividend @ 20% 5.60
Retained Earnings 22.40

ii. SGR = G ROE (1-b)

PAT
ROE = and NW = ₹ 100 lakhs + ₹ 200 lakhs = ₹ 300 lakhs
NW

₹ 28 lakhs
ROE = × 100 = 9.33 %
₹ 300 lakhs

SGR = 0.0933 (1 − 0.20) = 7.74%

iii. Calculation of Fair price of share using dividend discount model

D 0 (1+g)
P0 =
K e −g

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₹ 5.6 lakhs
Dividends = = ₹ 0.56
10 lakh

Growth Rate = 7.47%

₹ 0.56 (1 + 0.0747 ) ₹ 0.6018

Hence P0 = = = ₹ 7.99 say ₹ 8.00
0.15 − 0.0747 0.0753

iv. Since the current market price of share is 13.00, the share is overvalued.
Hence the investor should not invest in the company.

QUESTION – 105

AB Industries has Equity Capital of ₹ 12 Lakhs, total Debt of ₹ 8 Lakhs, and

annual sales of ₹ 30 Lakhs. Two mutually exclusive proposals are under
consideration for the next year. The details of the proposals are as under:

Particulars Proposal Proposal

No. 1 No. 2
Target Assets to Sales Ratio 0.65 0.62
Target Net Profit Margin (%) 4 5
Target Debt Equity Ratio (DER) 2:3 4:1
Target Retention Ratio (of Earnings) (%) 75 -
Annual Dividend (₹ In Lakhs) - 0.30
New Equity Raised (₹ in Lakhs) - 1

You are required to calculate sustainable growth rate for both the proposals.
(Exam November - 2020)

SOLUTION:

Sustainable Growth Rate under Proposal 1

Sales (Given) ₹ 30 Lakhs

Total Assets ₹ 30 Lakhs × 0.65 ₹ 19.50 Lakhs

Net Profit ₹ 30 Lakhs × 4% ₹ 1.20 Lakhs

Equity 12 lakhs
Equity multiplier = = 0.6
Equity +Debt 12 lakhs +8 lakhs

1.20 lakhs
ROE =
19.50 lakhs
×0.60×100 3.69%

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Sustainable Growth Rate = ROE × Retention Ratio

= 3.69% × 0.75 = 2.77%

Sustainable Growth Rate under Proposal 2

New Equity = ₹ 12 lakhs + ₹ 1 lakhs = ₹ 13 lakhs

New Debt = ₹ 13 lakhs × 4 = ₹ 52 lakhs

Total Assets = ₹ 13 lakhs + ₹ 52 lakhs = ₹ 65 lakhs

Target Assets to Sales Ratio (Given) 0.62

Sales ₹ 65 Lakhs / 0.62 ₹ 104.84 Lakhs

Net Profit ₹ 104.84 Lakhs × 5% ₹ 5.242 Lakhs

Equity 13 lakhs
Equity multiplier = = 0.2
Equity +Debt 13 lakhs +52 lakhs

5.242 lakhs
ROE = ×0.20×100 1.613%
65 lakhs

5.242 lakhs −0.30 lakhs

Retention Ratio = 0.943
5.242 lakhs

Sustainable Growth Rate = ROE × Retention Ratio

= 1.613% × 0.943 = 1.52%

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 SECURITY ANALYSIS

CHAPTER – 06
SECURITY ANALYSIS
Security Analysis
Technical analysis means, identify market movement with the help of charts &
other technical tools & find out buy & sell signals & decide the time whenever
we should buy stock or sell stock.

Fundamental Analysis

(i) We calculate intrinsic value of share & decide buy or sell. It is pricing
decision.

(ii) 90% Logical & 10% Psychological.

(iii) Generally used in long term investment.

Technical Analysis

(i) In technical analysis, we decide to when should buy or sell shares on the
basis of past price pattern.

(ii) 10% Logical & 90% Psychological.

(iii) Generally used in short term investment.

In this chapter, we will discuss following topics:

(1) Exponential Moving Average (EMA).

(2) Dow Theory.

(3) Support & Resistance level.

(4) Elliott wave theory.

(5) Bollinger Band.

(1) Exponential Moving Average (EMA)

EMA = Previous EMA + (Closing Price – Previous EMA) × Exponent Factor

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 If previous EMA is not given then simple moving Average can be used.
 If Exponent factor is not given, then it is calculated as under.

2
Exponent Factor =
n+1
n = Number of days.

QUESTION – 01

Closing values of BSE Sensex from 6th to 17th day of the month of January of
the year 20XX were as follows:

Days Date Day Sensex

1 6 THU 29,522
2 7 FRI 29,925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 30,222
6 11 TUE 31,000
7 12 WED 31,400
8 13 THU 32,000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 33,000

Compute Exponential moving Average (EMA) of Sensex during the above

period. The 30 days simple moving average of Sensex can be assumed as
30,000. The value of exponent for 30 days EMA is 0.062.

Provide detailed analysis on the basis of your calculations.

(Exam May – 2018)

SOLUTION:

Date 1 2 3 4 5
Sensex EMA for EMA
Previous day 1−2 3 × 0.062 2±4
6 29,522 30,000 (478) (29.636) 29,970.364
7 29,925 29,970.364 (45.364) (2.812) 29,967.55
10 30,222 29,967.55 254.45 15.776 29,983.32
11 31,000 29,983.32 1,016.68 63.034 30,046.354
12 31,400 30,046.354 1,353.646 83.926 30,130.28

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13 32,000 30,130.28 1,869.72 115.922 30,246.202

17 33,000 30,246.202 2,753.798 170.735 30,416.937

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 – 02

Closing values of BSE Sensex from 6th to 17th day of the month of January of
the year 20XX were as follows:

Days Date Day Sensex

1 6 THU 34,522
2 7 FRI 34,925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 35,222
6 11 TUE 36,000
7 12 WED 36,400
8 13 THU 37,000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 38,000

Compute Exponential moving Average (EMA) of Sensex during the above

period. The 30 days simple moving average of Sensex can be assumed as
35,000. The value of exponent for 30 days EMA is 0.064.

Provide detailed analysis on the basis of your calculations.

(Exam November – 2019)

SOLUTION:

Date 1 2 3 4 5
Sensex EMA for EMA
Previous day 1−2 3 × 0.064 2±4
6 34,522 38,000 (478) (30.592) 34,969.408
7 34,925 34,969.408 (44.408) (2.842) 34,966.566
10 35,222 34,966.566 255.434 16.348 34,982.914

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11 36,000 34,982.914 1,017.086 65.094 35,048.008

12 36,400 35,048.008 1,351.992 86.527 35,134.535
13 37,000 35,134.535 1,865.465 119.390 35,253.925
17 38,000 35,253.925 2,746.075 175.749 35,429.674

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 – 03

Closing values of NSE Nifty from 6th to 17th day of the month of January of the
year 2020 were as follows:

Days Date Day Sensex

1 6 THU 14,522
2 7 FRI 14,925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15,222
6 11 TUE 16,000
7 12 WED 16,400
8 13 THU 17,000
9 14 FRI No Trading
10 15 SAT No Trading
11 16 SUN No Trading
12 17 MON 18,000

Calculate Exponential Moving Average (EMA) of Sensex during the above

period. The previous day exponential moving average of Sensex can be
assumed as 15,000. The value of exponent for 31 days EMA is 0.062. Give
detailed analysis on the basis of your calculations.

(Study Material)

SOLUTION:

Date 1 2 3 4 5
Sensex EMA for EMA
Previous day 1−2 3 × 0.062 2±4
6 14,522 15,000 (478) (29.636) 14,970.364
7 14,925 14,970.364 (45.364) (2.812) 14,967.55

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10 15,222 14,967.55 254.45 15.776 14,983.32

11 16,000 14,983.32 1,016.68 63.034 15,046.354
12 16,400 15,046.354 1,353.646 83.926 15,130.28
13 17,000 15,130.28 1,869.72 115.922 15,246.202
17 18,000 15,246.202 2,753.798 170.735 15,416.937

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.

Note: Remaining 4 topics will be discussed in theory class.

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CHAPTER – 07
CORPORATE VALUATION

Corporate Valuation
(1) Economic Value Added (EVA).

(2) Valuation of Firm.

(3) Gearing of Beta.

(1) Economic Value Added (EVA)

 Economic Value Added means, surplus [Remaining Amount] available
after providing cost of capital to capital providers. Capital providers mean
equity share holders, preference share holders & debt holders.

 Following Steps are applied to calculated EVA.

Step 1: Calculate Net Operating PAT (NOPAT)

EBIT xxx

(-) Tax xxx

NOPAT xxx

Step 2: Calculate Weighted Average Cost of Capital

WACC = (ke × wE) + (kd × wd) + (kp × wp)

Step 3: Calculate Economic Value Added

EVA = NOPAT – C/E × WACC

C/E = Capital Employed

Example – 01

ESC (50,000 share @ 10) = ₹ 5,00,000

12 % PSC = ₹ 3,00,000

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10% debentures = ₹ 2,00,000

EBIT = ₹ 2,40,000

Tax = 30%

Rf = 6%

Rm = 11%

Beta = 1.25

Calculate Economic Value Added.

QUESTION – 01

Delta Ltd.‟s current financial year‟s income statement reports its net income as
₹ 15,00,000. Delta‟s 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 would start to decrease? If Delta does
not pay any dividends, what would you expect to happen to the value of
the company?

(Study Material & PM)

SOLUTION:-

(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

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= ₹ 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 – 02

The following data pertains to XYZ Inc. engaged in software consultancy

business as on 31 December 2010.

($ Million)

Income from consultancy 935.00

EBIT 180.00
Less: Interest on Loan 18.00
EBT 162.00
Tax @ 35% 56.70
105.30

Balance Sheet
($ Million)

Liabilities Amount Assets Amount

Equity Stock (10 million 100 Land and Building 200
share @ $ 10 each) Computers &Software‟s 295
Reserves & Surplus 325
Loans 180 Current Assets:
Current Liabilities 180 Debtors 150
Bank 100
Cash 40 290
785 785

With the above information and following assumption you are required to
compute

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(a) Economic Value Added®

(b) Market Value Added.

Assuming that:

(i) WACC is 12%.

(ii) The share of company currently quoted at $ 50 each

(Study Material & PM)

SOLUTION:-

(a) Determination of Economic Value Added (EVA)

$ Million
EBIT 180.00
Less: Taxes @ 35% 63.00
Net Operation Profit after Tax 117.00
Less: Cost of Capital Employed [W.No.1] 72.60
Economic value added 44.40

(b) Determination of Market Value Added (MVA)

$ Million
Market value of Equity Stock [W.no.2] 500
Equity Fund [W.no.3] 425
Market Value Added 75

Working Notes:

(1) Total Capital Employed

Equity Stock $ 100 Million

Reserve and Surplus $ 325 Million

Loan $ 180 Million

$ 605 Million

WACC 12%

Cost of Capital employed $ 605 Million × 12% $ 72.60 Million

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(2) Market Price per equity share (A) $ 50

No. of equity share outstanding (B) 10 Million

Market value of equity stock (A) × (B) $ 500 Million

(3) Equity Fund

Equity Stock $ 100 Million

Reserves & Surplus $ 325 Million

$ 425 Million

QUESTION – 03

Herbal Gyan is a small but profitable producer of beauty cosmetics using the
plant Aloe Vera. This is not a high-tech business, but Herbal‟s earnings have
averaged around ₹ 12 lakh after tax, largely on the strength of its patented
beauty cream for removing the pimples.

The patent has eight years to run, and Herbal has been offered ₹ 40 lakhs for
the patent rights. Herbal‟s assets include ₹ 20 lakhs of working capital and ₹
80 lakhs of property, plant, and equipment. The patent is not shown on
Herbal‟s books. Suppose Herbal‟s cost of capital is 15 percent. What is its
Economic Value Added (EVA)?

(Study Material & PM)

SOLUTION:-

EVA = Income earned – (Cost of capital × Total Investment)

Total Investments

Particulars Amount
Working Capital ₹ 20 lakhs
Property, Plant, and equipment ₹ 80 lakhs
Patent rights ₹ 40 lakhs
Total ₹ 140 lakhs

Cost of Capital 15%

EVA= ₹ 12 lakh – (0.15 × ₹ 140 lakhs) = ₹ 12 lakh – ₹ 21 lakh = -₹ 9 lakh

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Thus, Herbal Gyan has a negative EVA of ₹ 9 lakhs.

QUESTION – 04

Constant Engineering Ltd. has developed a high tech product which has
reduced the Carbon emission from the burning of the fossil fuel. The product is
in high demand. The product has been patented and has a market value of ₹
100 Crore, which is not recorded in the books. The Net Worth (NW) of Constant
Engineering Ltd. is ₹ 200 Crore. Long term debt is ₹ 400 Crore. The product
generates a revenue of ₹ 84 Crore. The rate on 365 days Government bond is
10 percent per annum. Market portfolio generates a return of 12 percent per
annum. The stock of the company moves in tandem with the market. Calculate
Economic Value added of the company.

(SM, PM & Exam May – 2018)

SOLUTION:-

EVA = Income Earned – (Cost of Capital × Total Investment)

Total Investments

Amount ( ₹ Crore)
Net Worth 200.00
Long Term Debts 400.00
Patent Rights 100.00
Totol 700.00

E D
WACC (k0 ) = ke × + kd ×
E +D E+D
300 400
= 12 × + ke ×
700 700

= 5.14% + 5.71% = 10.85%

EVA = Profit Earned – WACC× Invested Capital

= ₹ 84 crore – 10.85% × ₹ 700 crore

= ₹ 8.05 crore

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QUESTION – 05

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
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

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 capitalization for each of the Companies.

(SM, PM & MTP April - 2022)

SOLUTION:-

(i) Working for calculation of WACC

Orange Grape Apple

Total debt 80,000 50,000 20,000
Post tax Cost of debt 10.40% 8.45% 9.75%
Equity fund 20,000 50,000 80,000

WACC
Orange: (10.4 × 0.8) + (26 × 0.2) = 13.52%

Grape: (8.45 × 0.5) + (22 × 0.5) = 15.225%

Apple: (9.75 × 0.2) + (20 × 0.8) = 17.95%

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(ii)

Orange Grape Apple

WACC 13.52 15.225 17.95
EVA [EBIT (1−T) (WACC × Invested Capital)] 2,730 1,025 -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

Orange Grape Apple

EBIT (₹) 25,000 25,000 25,000
Interest (₹) 12,800 6,500 3,000
Texable Income (₹) 12,200 18,500 22,000
Tex 35% (₹) 4,270 6,475 7,700
Net Income (₹) 7,930 12,025 14,300
Shares.. 6,100 8,300 10,000
EPS (₹) 1.30 1.45 1.43
Stock price (EPS PE Ratio) 14.30 15.95 15.73

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.

(v) Market Capitalization

Estimated Stock Price (₹) 14.30 15.95 15.73

No. of shares 6,100 8,300 10,000

Estimated Market Cap (₹) 87,230 1,32,385 1,57,300

QUESTION – 06

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:

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(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?

(Study Material & PM)

SOLUTION:-

Taxable Income = ₹ 15 lac/(1 − 0.30)

= ₹ 21.43 lacs or ₹ 21,42,857

Operating Income = Taxable Income + Interest

= ₹ 21,42,857 + ₹ 10,00,000

= ₹ 31,42,857 or ₹ 31.43 lacs

EVA = EBIT (1-Tax Rate) – WACC × Invested Capital

= ₹ 31,42,857(1 – 0.30) – 13% × ₹ 95,00,000

= ₹ 22,00,000 – ₹ 12,35,000 = ₹ 9,65,000

₹ 9,65,000
EVA Dividend = = ₹ 1.6083
₹6,00,000

QUESTION – 07

With the help of the following information of Jatayu Limited compute the
Economic Value Added:

Capital Structure Equity capital ₹ 160 Lakhs

Reserves and Surplus ₹140lakhs
10% Debentures ₹ 400 lakhs

Cost of equity 14%

Financial Leverage 1.5 times

Income Tax Rate 30%

(Study Material & PM)

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SOLUTION:-

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

60
or PBIT 0.5 = = ₹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

QUESTION – 08

Compute Economic Value Added (EVA) of Good luck Ltd. from the following
information:

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Profit & Loss Statement

Particulars (₹ in Lakh)
(a) Income −
Revenue from Operations 2000
(b) Expenses –
Direct Expenses 800
Indirect Expenses 400
(c) Profit before interest & tax (a − b) 800
(d) Interest 30
(e) Profit before tax (c − d) 770
(f) Tax 231
(g) Profit after tax (e − f) 539

Balance Sheet

Particulars (₹ in Lakh)
Equity and Liabilities :
(a) Shareholder's Fund −
Equity Share Capital 1000
Reserve and Surplus 600
(b) Non- Current Liabilities –
Long Term Borrowings 200
(c) Current Liabilities 800
Total 2600
Assets :
(a) Non - Current Assets 2000
(b) Current Assets 600
Total 2600

Other Information:

(1) Cost of Debts is 15%.

(2) Cost of Equity (i.e. shareholders' expected return) is 12%.

(3) Tax Rate is 30%.

(4) Bad Debts Provision of ₹ 40 lakhs is included in indirect expenses and ₹

40 lakhs reduced from receivables in current assets.

(Exam May – 2019)

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SOLUTION:-

EVA = NOPAT – (Invested Capital × WACC)

NOPAT = EBIT – Tax + Non-Cash Expenses

= 800 lakhs – 231 lakhs + 40 lakhs

= ₹ 609 lakh

(OR)

Operating Income = Taxable Income + Interest + Non-cash Expenses

= 539 + 30 + 40 = ₹ 609 lakh

Invested Capital = 1000 + 600 + 200 = 1800

= 1800 + 40 (Non-cash expenses)

= ₹ 1840 lakhs

1600 200
WACC = × 12% + × 15% (1−0.3)
1800 1800

= 10.67% + 1.17% = 11.84%

Now, EVA = 609 – (1840 ×11.84%)

= 609 – 217.86

= ₹ 391.14 lakhs

OR

1000 200
WACC = × 12% + × 15% (1 − 0.3)
1200 1200

= 10.00% + 1.75% = 11.75%

Now, EVA = 609 – (1840 × 11.75%)

= 609 – 216.20

= ₹ 392.80 lakhs

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QUESTION – 09

Herbal Box is a small but profitable producer of beauty cosmetics using the
plant Aloe Vera. Though it is not a high-tech business, yet Herbal‟s earnings
have averaged around ₹ 18.50 lakhs after tax, mainly on the strength of its
patented beauty cream to remove the pimples.

The patent has nine years to run, and Herbal Box has been offered ₹ 50 lakhs
for the patent rights. Herbal‟s assets include ₹ 50 lakhs of property, plant and
equipment, and ₹ 25 lakhs of working capital. However, the patent is not
shown on the books of Herbal Box. Assuming Herbal‟s cost of capital being 14
percent, calculate its Economic Value Added (EVA).

(Exam November - 2018, 2020 & RTP May-2022)

SOLUTION:-

EVA = Income Earned – (Cost of Capital × Total Investment)

Total Investment

Amount (₹ in lakhs)
Working Capital 25.00
Property, Plant & Equipments 50.00
Patent Rights 50.00
Total 125.00

EVA = Profit Earned – WACC × Invested Capital

= ₹ 18.50 Lakhs – 14% × ₹ 125 Lakhs

= ₹ 1.00 Lakhs

QUESTION – 10

RST Ltd.‟s current financial year's income statement reported its net income
after tax 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:

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₹
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:

Equity 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 9%
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.

(Study Material & PM)

SOLUTION:-

Cost of Equity as per CAPM

ke = Rf + β × Market Risk Premium

= 8.5% + 1.36 × 9%

= 8.5% + 12.24% = 20.74%

Cost of Debt

kd = 11%(1 – 0.30) = 7.70%

WACC

E D
(k0) = ke × + kd ×
E+D E+D
125 40
= 20.74 × + 7.70 × = 15.71 + 1.87 = 17.58%
165 165

Taxable Income = ₹ 25,00,000/(1 − 0.30)

= ₹ 35,71,429 or ₹ 35.71 lakhs

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Operating Income = Taxable Income + Interest

= ₹ 35,71,429 + ₹ 4,40,000

= ₹ 40,11,429 or ₹ 40.11 lacs

EVA = EBIT (1-Tax Rate) – WACC × Invested Capital

= ₹ 40,11,429 (1 – 0.30) – 17.58% × ₹ 1,65,00,000

= ₹ 28,08,000 – ₹ 29,00,700

= - ₹ 92,700

QUESTION – 11

Following is the information of M/s. DY Ltd. for the year ending 31/03/2021:

Particulars
Sales ₹ 1000 Lakh
Operating Expenses Including Interest ₹ 620 Lakh
8% Debentures ₹ 250 Lakh
Equity Share Capital (Face Value of ₹ 10 each) ₹ 250 Lakh
Reserves and Surplus ₹ 250 Lakh
Market Value of DY Ltd. ₹ 900 Lakh
Corporate Tax Rate 30%
Risk Free Rate of Return 7%
Market Rate of Return 12%
Equity Beta 1.4

You are required to

i. Calculate Weighted Average Cost of Capital of DY Ltd.

ii. Calculate Economic Value Added

iii. Calculate Market Value Added

(Exam December – 2021)

SOLUTION:-

(i) Weighted Average Cost of Capital of DY Ltd.

Cost of Equity as per CAPM

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ke = Rf + β × Market Risk Premium

= 7% + 1.4 × [12% − 7%]

= 7% + 7% = 14%

Cost of Debt kd = 8% (1 – 0.30) = 5.60%

E D 500 250
WACC (ko) = ke × + kd × = 14.00 × + 5.60 ×
E+D E +D 750 750

= 9.33% + 1.87% = 11.20%

(ii) Economic Value Added (EVA) of DY Ltd.

₹ Lakhs
Sales 1,000
Operating Expenses (excluding interest) ₹ 620
₹ 20 ₹ 600
₹ 400
Less: Tax @ 30% ₹ 120
Net Operating Profit after Tax (NOPAT) ₹ 280

Calculation of Capital Employed

₹ Lakhs
Equity Share Capital 250
Reserves & Surplus 250
8% Debentures 250
Total Capital Employed 750

EVA = NOPAT – (WACC × Total Capital)

EVA = ₹ 280 Lakh – 0.1120 × ₹ 750 lakhs

EVA = 196.00 lakhs

(iii) Determination of Market Value Added (MVA)

₹ Lakhs
Market value of Equity Stock [₹ 900 Lakh − ₹ 250 Lakh] 650
Equity Fund [₹ 250 Lakh + ₹ 250 Lakh] 500
Market Value Added 150

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Alternatively, it can also be computed as follows:

₹ Lakhs
Market value of DY Ltd. 650
Capital employed [₹ 250 Lakh + ₹ 250 Lakh + ₹ 250 Lakh] 500
Market Value Added 150

(2) Valuation of Firm

(I) There are various methods to find out value of company.

(i) Net Realizable Value Method

Assets (M.V.) xxx

(-) Liability (Payable Value) xxx

Value of Business xxx

(ii) Book Value Method

ESC xxx

(+) R & S xxx

Value xxx

(iii) Dividend Growth Model

Dividend at the end of year

Value of Business = (1 + g)
k e −g

(iv) Price Earnings Method

Value of Business = Earnings × P/E Ratio

(v) Free Cash Flow Approach

 This method is used whenever one company want to take

over another company. In this situation, purchasing
company should focus on earnings of Vender Company not
dividend.
 This method is used whenever track record of dividend is not
available.

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Example – 02

Calculate Value of Business

Free Cash For Firm (FCFF)

Year 1 8,00,000

Year 2 12,00,000

Year 3 20,00,000

FCFF after 3 years = 15,00,000 p.a. perpetual

Ko = 12% g = 4%

Example – 03

Sales 25,00,000 p.a.

VC @ 30%

Fixed Cost = 2,00,000 p.a.

(Excluding depreciation)

Depreciation = ₹ 1,25,000 p.a.

Interest = 1,12,000

Tax = 30%

Example – 04

EBIT = ₹ 3,00,000

Tax = 40%

Capital Expenditure = 75,000

Depreciation = 75,000

Change in working capital = 0

Calculate FCFF.

Example – 05

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Base Year

Sales = ₹ 50,000

Operating Expenditure = ₹ 1,25,000

Tax = 30%

Capital Expenditure = 1,45,000

Depreciation = 3,00,000

Sales & operating expenditure will grow by 20% in next 3 years & there after
10% p.a. perpetual.

Capital Expenditure net of depreciation will grow by 15% in next 3 years &
from 4th year capital expenditure is equal to depreciation.

Working Capital should be 10% of sales

Ko = 15%

Calculated (1) Value of Firm

(2) Value of Equity

(II) Value of Equity

 Calculate FCFF & Discounted with overall cost of capital (ko)

 After Calculate value of firm reduce debt from value of firm.
VE = Vf – Debt

 Calculate FCFE & Discounted with cost of equity (Ke)

QUESTION – 12

The valuation of Hansel Limited has been done by an investment analyst.

Based on an expected free cash flow of ₹ 54 lakhs for the following year and an
expected growth rate of 9 percent, the analyst has estimated the value of
Hansel Limited to be ₹ 1800 lakhs. However, he committed a mistake of using
the book values of debt and equity.

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The book value weights employed by the analyst are not known, but you know
that Hansel Limited has a cost of equity of 20 percent and post tax cost of debt
of 10 percent. The value of equity is thrice its book value, whereas the market
value of its debt is nine-tenths of its book value. What is the correct value of
Hansel Ltd ?

(Study Material & PM)

SOLUTION:

Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-

FCFF 1
Value of Firm = V0 =
K c − gn

Where –

FCFF1 = Expected FCFF in the year 1

KC = Cost of capital

gn = Growth rate forever

Thus, ₹ 1800 lakhs = ₹ 54 lakhs /(K C -g)

Since g = 9%, then Kc = 12%

Now, let X be the weight of debt and given cost of equity = 20% and cost
of debt = 10%, then 20% (1 – X) + 10% X = 12%

Hence, X = 0.80, so book value weight for debt was 80%

∴ Correct weight should be 60 of equity and 72 of debt.

∴ Cost of capital = Kc = 20% (60/132) + 10% (72/132) = 14.5455% and

correct firm‟s value

= ₹ 54 lakhs/(0.1454 – 0.09) = ₹ 974.73 lakhs

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QUESTION – 13

An established company is going to be de merged in two separate entities. The

valuation of the company is done by a well-known analyst. He has estimated a
value of ₹ 5,000 lakhs, based on the expected free cash flow for next year of ₹
200 lakhs and an expected growth rate of 5%. While going through the
valuation procedure, it was found that the analyst has made the mistake of
using the book values of debt and equity in his calculation. While you do not
know the book value weights he used, you have been provided with the
following information:

(i) The market value of equity is 4 times the book value of equity, while the
market value of debt is equal to the book value of debt,

(ii) Company has a cost of equity of 12%,

(iii) After tax cost of debt is 6%.

You are required to advise the correct value of the company.

(Exam May – 2018)

SOLUTION:-

FreeCashFlowatyearend 1
Value of the Company = ,
Kc −g

Where,

Kc = weighted average cost of capital.

200
Value of the company = 5000 =
Kc −5

Kc – 5 = 200/5000 = 4%

Kc = 4% + 5% = 9%

We do not know the weights the analyst had taken for arriving at the cost of
capital. Let w be the proportion of equity. Then, (1−w) will be the proportion of
debt.

Kc = 9 = w × 12 + (1−w) × 6

9 = 6 + 6w

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6w = 3.

Hence w = 3/ 6 = 0.5 = 50 % or 1:1

The weights are equal i.e. 1:1 for equity and debt.

The correct weights should be market value of equity : market value of debts.
i.e. 4 times book value of equity : book value of debts. i.e. 4:1 equity : debt

Revised Kc = 4/5 × 12 + 1/5 × 6= 10.8 %

200
Revised value of the company = = 200/5.8% = 3448.28 lacs.
10.8−5

QUESTION – 14

A valuation done of an established company by a well-known analyst has

estimated a value of ₹ 500 lakhs, based on the expected free cash flow for next
year of ₹ 20 lakhs and an expected growth rate of 5%.

While going through the valuation procedure, you found that the analyst has
made the mistake of using the book values of debt and equity in his
calculation. While you do not know the book value weights he used, you have
been provided with the following information:

(i) Company has a cost of equity of 12%,

(ii) After tax cost of debt is 6%,

(iii) The market value of equity is three times the book value of equity, while
the market value of debt is equal to the book value of debt.

You are required to estimate the correct value of the company.

(RTP May – 2020)

SOLUTION:-

Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-

FCFF 1
Value of Firm = V0 =
K c − gn

Where –

FCFF1 = Expected FCFF in the year 1

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Kc = Cost of capital

gn = Growth rate forever

Thus, ₹ 500 lakhs = ₹ 20 lakhs /(Kc−g)

Since g = 5%, then Kc = 9%

Now, let X be the weight of debt and given cost of equity

= 12% and cost of debt = 6%, then 12% (1 – X) + 6% X = 9%

Hence, X = 0.50, so book value weight for debt was 50%

∴ Correct weight should be 150% of equity and 50% of debt.

∴ Cost of capital = Kc = 12% (0.75) + 6% (0.25) = 10.50%

And correct firm‟s value = ₹ 20 lakhs/(0.105 – 0.05) = ₹ 363.64 lakhs.

QUESTION – 15

Following information are available in respect of XYZ Ltd. which is expected to

grow at a higher rate for 4 years after which growth rate will stabilize at a lower
level:
Base year information:
Revenue - ₹ 2,000 crores
EBIT - ₹ 300 crores
Capital expenditure - ₹ 280 crores
Depreciation - ₹ 200 crores

Information for high growth and stable growth period are as follows:

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High Stable Growth

Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and 20% Capital expenditure are
depreciation offset by depreciation
Risk free rate 10% 9%
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3

For all time, working capital is 25% of revenue and corporate tax rate is 30%.
What is the value of the firm?

(SM & MTP March – 2022)

SOLUTION:

High growth phase :

ke = 0.10 + 1.15 × 0.06 = 0.169 or 16.9%.

kd = 0.13 × (1 − 0.3) = 0.091 or 9.1%.

Cost of capital = 0.5 × 0.169 + 0.5 × 0.091 = 0.13 or 13%

Stable growth phase :

ke = 0.09 + 1.0 × 0.05 = 0.14 or 14%.

kd = 0.1286 × (1 − 0.3) = 0.09 or 9%.

Cost of capital = 0.6 × 0.14 + 0.4 × 0.09 = 0.12 or 12%.

Determination of forecasted Free Cash Flow of the Firm (FCFF)

(₹ in crores)

Yr. 1 Yr.2 Yr.3 Yr.4 Terminal

Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00

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Capital Expenditure 96 115.20 138.24 165.89 -

Less Depreciation
∆ Woking Capital 100.00 120.00 144.00 172.80 103.68
Free Cash Flow (FCF) 56.00 67.20 80.64 96.77 375.32

Alternatively, it can also be computed as follows:

Yr. 1 Yr.2 Yr.3 Yr.4 Terminal

Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Add : Depreciation 240 288 345.60 414.72 456.19
492 590.40 708.48 850.18 935.19
Less: Capital Exp. 336 403.20 483.84 580.61 456.19
∆ WC 100.00 120.00 144.00 172.80 103.68
56.00 67.20 80.64 96.77 375.32

Present Value (PV) of FCFF during the explicit forecast period is:

FCFF(₹ in crores) PVF @ 13% PV (₹ in crores)

56.00 0.885 49.56
67.20 0.783 52.62
80.64 0.693 55.88
96.77 0.613 59.32
₹ 217.38

Terminal Value of Cash Flow

375.32
= ₹ 18,766.00 Crores
0.12−010

PV of the terminal, value is:

1
₹18,766.00Crores × = ₹ 18,700.00 Crores × 0.613 = ₹ 11,503.56 Crores
(1.13)4

The value of the firm is:

₹ 217.38 Crores + ₹ 11,503.56 Crores = ₹ 11,720.94 Crores

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QUESTION – 16

Following information is given in respect of WXY Ltd., which is expected to

grow at a rate of 20% p.a. for the next three years, after which the growth rate
will stabilize at 8% p.a. normal level, in perpetuity.

For the year ended March

31, 2014
Revenues ₹ 7,500 Crores
Cost of Goods Sold (COGS) ₹ 3,000 Crores
Operating Expenses ₹ 2,250 Crores
Capital Expenditure ₹ 750 Crores
Depreciation (included in Operating Expenses) ₹ 600 Crores

During high growth period, revenues & Earnings before Interest & Tax (EBIT)
will grow at 20% p.a. and capital expenditure net of depreciation will grow at
15% p.a. From year 4 onwards, i.e. normal growth period revenues and EBIT
will grow at 8% p.a. and incremental capital expenditure will be offset by the
depreciation. During both high growth & normal growth period, net working
capital requirement will be 25% of revenues.

The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%.

Corporate Income Tax rate will be 30%.

Required:

Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) &WACC
methodology.

The PVIF @ 15 % for the three years are as below:

Year t1 t2 t3
PVIF 0.8696 0.7561 0.6575

(Study Material & PM)

SOLUTION:-

Determination of forecasted Free Cash Flow of the Firm (FCFF)

(₹ in crores)

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Yr. 1 Yr.2 Yr.3 Terminal

Year
Revenue 9000.00 10800.00 12960.00 13996.80
COGS 3600.00 4320.00 5184.00 5598.72
Operating Expenses 1980.00 2376.00 2851.20 3079.30
Depreciation 720.00 864.00 1036.80 1119.74
EBIT 2700.00 3240.00 3888.00 4199.04
Tax @ 30% 810.00 972.00 1166.40 1259.71
EAT 1890.00 2268.00 2721.60 2939.33
Capital Exp.-Dep. 172.50 198.38 228.60 -
∆ Working Capital 375.00 450.00 540.00 259.20
Free Cash Flow (FCF) 1342.50 1619.62 1953.47 2680.13

* Excluding Depreciation. Present Value (PV) of FCFF during the explicit

forecast period is:

FCFF(₹ in crores) PVF @ 13% PV (₹ in crores)

1342.50 0.8696 1167.44
1619.62 0.7561 1224.59
1953.47 0.6575 1284.41
3676.44

PV of the terminal, value is:

2680 .13 1
× = ₹ 38287.57 Crore × 0.6575 = ₹ 25174.08 Crore
0.15−0.08 (1.15)3

The value of the firm is :

₹ 3676.44 Crores + ₹ 25174.08 Crores = ₹ 28,850.52 Crores

QUESTION – 17

Eagle Ltd. reported a profit of ₹ 77 lakhs after 30% tax for the financial year
2011-12. An analysis of the accounts revealed that the income included
extraordinary items of ₹ 8 lakhs and an extraordinary loss of ₹10 lakhs. The
existing operations, except for the extraordinary items, are expected to
continue in the future. In addition, the results of the launch of a new product
are expected to be as follows:

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₹ In Laksh
Sales 70
Material Cost 20
Labour Cost 12
Fixed Cost 10

You are required to:

(i) Calculate the value of the business, given that the capitalization rate is
14%.

(ii) Determine the market price per equity share, with Eagle Ltd.„s share
capital being comprised of 1,00,000 13% preference shares of ₹ 100 each
and 50,00,000 equity shares of ₹ 10 each and the P/E ratio being 10
times.

(Study Material & PM)

SOLUTION:

(i) Computation of Business Value

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(₹ Lakhs)
77 110
Profit before tax
1− 0.30
Less: Extraordinary income (8)

Add: Extraordinary losses 10

112

Profit from new product (₹ Lakhs)

Sales 70
Less: Material costs 20
Labour costs 12
Fixed costs 10 (42) 28
140.00

Less: Taxes @ 30% 42.00

Future Maintainable Profit after taxes 98.00

Relevant Capitalization Factor 0.14

Value of Business (₹ 98/0.14) 700

(ii) Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ₹ 98,00,000

Less: Preference share dividends 1,00,000 shares of ₹ ₹ 13,00,000
100 @ 13%
Earnings available for Equity Shareholders ₹ 85,00,000
No. of Equity Shares 50,00,000
₹ 85,00,000 ₹ 1.70
Earning per share = =
50,00,000
PE ratio
10
Market price per share
₹ 17

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QUESTION – 18

Excellent Ltd. reported a profit of ₹ 154 lakhs after 30% tax for the financial
year 2019- 20. An analysis of the accounts revealed that there is an
extraordinary loss of ₹ 20 lakhs and the income included extraordinary items of
₹ 16 lakhs. The existing operations, except for the extraordinary items, are
expected to continue in the future. In addition, the results of the launch of a
new product are expected to be as follows:

₹ in lakhs

Sales 140

Material costs 40

Labour costs 24

Fixed costs 20

You are required to:

(i) Calculate the value of the business, given that the capitalization rate is
14%.

(ii) Determine the market price per equity share, with Excellent Ltd.'s share
capital being comprised of 2,00,000 at 13% preference shares of ₹ 100
each and 100,00,000 equity shares of ₹ 10 each and the P/E ratio being
12 times. (Ignoring Corporate Dividend Tax).

(Exam July – 2021)

SOLUTION:

(i) Computation of Business Value

(₹ Lakhs)
154 220
Profit before tax
1−0.30
(16)
Less: Extraordinary income 20
Add: Extraordinary losses 224

Profit from new product (₹ Lakhs)

Sales 140
Less: Material costs 40

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Labour costs 24
Fixed costs 20 (84) 56
280.00
Less: Taxes @ 30% 84.00
Future Maintainable Profit after taxes 196.00
Relevant Capitalization Factor 0.14
Value of Business (₹ 196/0.14) 1400

(ii) Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ₹ 1,96,00,000

Less: Preference share dividends 2,00,000 shares of ₹ 26,00,000
₹ 100 @ 13%
Earnings available for Equity Shareholders ₹ 1,70,00,000
No. of Equity Shares 1,00,00,000
₹ 170,00,000 ₹ 1.70
Earnings per share = =
1,00,00,000
PE ratio 12
Market price per share ₹ 20.40

QUESTION – 19

M/s. Roly Ltd. wants to acquire M/s. Poly Ltd. The following is the Balance
Sheet of Poly Ltd. as on 31st March, 2020 :

Liabilities ₹ Assets ₹
Equity Capital (₹ 10 per share) 10,00,000 Cash 20,000
Retained Earnings 3,00,000 Debtors 50,000
12% Debenture 3,00,000 Inventories 2,00,000
Creditors and other liability 3,20,000 Plant & Machinery 16,50,000
Total 19,20,000 Total 19,20,000

Shareholders of Poly Ltd. will get one share of Roly Ltd. at current Market price
of ₹ 20 for every two shares. External liabilities are expected to be settled at a
discount of ₹ 20,000. Sundry debtors and Inventories are expected to realize ₹
2,00,000.

Poly Ltd. will run as an independent unit. Cash Flow After Tax is expected to be
₹ 4,00,000 per annum for next 6 years. Assume the disposal value of the plant
after 6 years will be ₹ 1,50,000.

Poly Ltd. requires a return of 14%

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n 1 2 3 4 5 6
PVIF (14%,n) 0.877 0.769 0.675 0.592 0.519 0.456

Advise the Board of Directors on the financial feasibility of the Proposal.

(Exam January – 2021)

SOLUTION:-

Calculation of Purchase Consideration

₹
Issue of Share 50000 × ₹ 20 10,00,000
External Liabilities settled 3,00,000
12% Debentures 3,00,000
16,00,000
Less: Realization of Debtors and Inventories 2,00,000
Cash 20,000
13,80,000

Net Present Value

= PV of Cash Inflow + PV of Demerger of Roly Ltd. – Cash Outflow

= ₹ 4,00,000 PVAF(14%,6) + ₹ 1,50,000 PVF(14%, 6) – ₹ 13,80,000

= ₹ 4,00,000 × 3.888 + ₹ 1,50,000 × 0.456 – ₹ 13,80,000

= ₹ 15,55,200 + ₹ 68,400 – ₹ 13,80,000

= ₹ 2,43,600

Since NPV of the decision is positive it is advantageous to acquire Poly Ltd.

QUESTION – 20

The closing price of LX Ltd. is ₹ 24 per share as on 31st March, 2019 on NSE
Ltd. The Price Earnings Ratio was 6. It was found that an amount of ₹ 24
Lakhs as income and an extra ordinary loss of ₹ 9 lakhs were included in the
books of accounts. The existing operations except for the extraordinary items
are expected to continue in future. Further the company has launched a new
product during the year with the following expectations:

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(₹ in Lakhs)
Sales 150
Material Cost 40
Labour Cost 34
Fixed Cost 24

The company has 500,000 equity shares of ₹ 10 each and 100,000 9%

Preference Shares of ₹ 100 each. The Price Earnings Ratio is 6 times. Post tax
cost of capital is 10 per cent per annum. Tax rate is 34 per cent. You are
required to determine:

(i) Existing Profit from old operations

(ii) The value of business

(Exam May – 2019)

SOLUTION:-

Price Earnings Ratio 6

Market Price Per Share 24
EPS 4
Number of Shares 5,00,000
Profit After Pref. Dividend ₹ 20,00,000
Pref. Dividend ₹ 9,00,000
Profit After Tax ₹ 29,00,000
29,00,000 ₹ 43,93,939
Profit before tax
1− 0.34
Less: Extraordinary income ₹ 24,00,000
Add: Extraordinary losses ₹ 9,00,000
Existing Profit from Old Operations ₹ 28,93,939
Profit from new product (₹ Lakhs)
Sales 150
Less: Material costs 40
Labour costs 34
Fixed costs 24 (98) ₹ 52,00,000
₹ 80,93,939
Less: Taxes @ 34% ₹ 27,51,939
Future Maintainable Profit after taxes ₹ 53,42,000
Relevant Capitalization Factor 0.10

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Value of Business (₹ 53,42,000/0.10) ₹ 5,34,20,000

Or ₹5.342 crore

QUESTION – 21

Sun Ltd. recently made a profit of ₹ 200 crore and paid out ₹ 80 crore (slightly
higher than the average paid in the industry to which it pertains). The average
PE ratio of this industry is 9. The estimated beta of Sun Ltd. is 1.2. As per
Balance Sheet of Sun Ltd., the shareholder‟s fund is ₹ 450 crore and number of
shares is 10 crore. In case the company is liquidated, building would fetch ₹
200 crore more than book value and stock would realize ₹ 50 crore less.

The other data for the industry is as follows:

Projected Dividend Growth 4%

Risk Free Rate of Return 6%

Market Rate of Return 11%

Calculate the valuation of Sun Ltd. using

(a) P/E Ratio

(b) Dividend Growth Model

(c) Book Value

(d) Net Realizable Value

(RTP May – 2021)

SOLUTION:-

(a) ₹ 200 crore × 9 = ₹ 1800 crore

(b) Ke = 6% + 1.2 (11% − 6%) = 12%

80 crore × 1.04
=
0.12 − 0.04 = ₹ 1,040 crore
(c) ₹ 450 crore

(d) ₹ 450 crore + ₹ 200 crore − ₹ 50 crore = ₹ 600 crore

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QUESTION – 22

ABC Co. is considering a new sales strategy that will be valid for the next 4
years. They want to know the value of the new strategy. Following information
relating to the year which has just ended, is available:

Income Statement ₹
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000

If it adopts the new strategy, sales will grow at the rate of 20% per year for
three years. From 4th year onward Cash Flow will be stabilized. The gross
margin ratio, Assets turnover ratio, the Capital structure and the income tax
rate will remain unchanged.

Depreciation would be at 10% of net fixed assets at the beginning of the year.

The Company‟s target rate of return is 15%.

Determine the incremental value due to adoption of the strategy.

(Study Material, PM & RTP May - 2020)

SOLUTION:

Projected Balance Sheet

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Year 2 Year 2 Year 3 Year 4

Fixed Assets (40% of Sales) 9,600 11,520 13,824 13,824
Current Assets (20% of Sales) 4,800 5,760 6,912 6,912
Total Assets 14,400 17,280 20,736 20,736
Equity 14,400 17,280 20,736 20,736

Projected Cash Flows :-

Year 2 Year 2 Year 3 Year 4

Sales 24,000 28,800 34,560 34,560
PBT (10% of sale) 2,400 2,880 3,456 3,456
PAT (70) 1,680 2,016 2,419.20 2,419.20
Depreciation 800 960 1,152 1,382
Addition to Fixed Assets 2,400 2,880 3,456 1,382
Increase in Current Assets 800 960 1,152 -
Operating cash flow (FCFF) (720) (864) (1,036.80) 2,419.20)

Projected Cash Flows :-

Present value of Projected Cash Flows:-

Cash Flows PVF at 15% PV

-720 0.870 -626.40
-864 0.756 -653.18
-1,036.80 0.658 -682.21
-1,961.79

Residual Value − 2419.20/0.15 = 16,128

Present value of Residual value = 16128/(1.15)3

= 16128/1.521 = 10603.55

Total shareholders‟ value = 10,603.55 –1,961.79 = 8,641.76

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Pre strategy value = 1,400/0.15 = 9,333.33

∴ Value of strategy = 8,641.76 – 9,333.33 = – 691.57

Conclusion: The strategy is not financially viable

QUESTION – 23

(a) Following details are available for X Ltd.

Income Statement for the year ended 31st March, 2018

Particulars Amount
Sales 40,000
Gross Profit 12,000
Administrative Expenses 6,000
Profit Before tax 6,000
Tax @ 30% 1,800
Profit After Tax 4,200

Balance sheet as on 31st March, 2018

Particulars Amount
Fixed Assets 10,000
Current Assets 6,000
Total Assets 16,000
Equity Share Capital 15,000
Sundry Creditors 1,000
Total Liabilities 16,000

The Company is contemplating for new sales strategy as follows :

(i) Sales to grow at 30% per year for next four years.

(ii) Assets turnover ratio, net profit ratio and tax rate will remain the
same.

(iii) Depreciation will be 15% of value of net fixed assets at the

beginning of the year.

(iv) Required rate of return for the company is 15%

Evaluate the viability of new strategy

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(Exam November – 2018)

SOLUTION:-

Projected Balance
Sheet
Year 1 Year 2 Year 3 Year 4 Year 5
Fixed Assets (25% of 13,000 16,900 21,970 28,561.00 28,561.00
Sales)
Current Assets (15% 7,800 10,140 13,182 17,136.00 17,136.00
of Sales)
Total Assets 20,800 27,040 35,152 45,697.60 45,679.60
Equity (37.5% of 19,500 25,350 32,955 42,841.50 42,841.50
sales)
Sundry Creditors 1,300 1,690 2,197 2,856.10 2,856.10
(2.5% of Sales)
Total Liabilities 20,800 27,040 35,152 45,697.60 45,697.60

Projected Cash Flows:-

Year 1 Year 2 Year 3 Year 4 Year 5

Sales 52,000 67,600 87,880.00 1,14,244.00 1,14,244.00
PBT (15% of sales) 7,800 10,140 13,182.00 17,136.60 17,136.60
PAT (10.5% of sales) 5,460 7,098 9,227.40 11,995.62 11,995.62
Depreciation 1,500 1,950 2,535.00 3,295.50 4,284.15
Addition to Fixed 4,500 5,850 7,605.00 9,886.50 4,284.15
Assets
increase in Net 1,500 1,950 2,535.00 3,295.50 --
Current Assets
Operating cash flow 960 1,248 1,622.40 2,109.12 11,995.62

Projected Cash Flows :-

Present value of Projected Cash Flows :-

Cash Flows PVF at 15% PV

960 0.870 835.20
1248 0.756 943.49
1622.40 0.658 1067.54
2109.12 0.572 1206.42
4,052.65

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Residual Value = 11,995.62/0.15 = 79,970.80

Present value of Residual value = 79,970.80 × PVF (15%, 4)

= 79,970.80 × 0.572 = 45,743.30

Total shareholders‟ value = 45743.30 + 4052.65 = 49795.95

Pre-strategy value = 4200/0.15 = 28,000

 Value of strategy = 49795.95 – 28,000 = 21795.95

Conclusion: The strategy is financially viable.

QUESTION – 24

T Ltd. Recently made a profit of ₹ 50 crore and paid out ₹ 40 crore (slightly
higher than the average paid in the industry to which it pertains). The average
PE ratio of this industry is 9. As per Balance Sheet of T Ltd., the shareholder‟s
fund is ₹ 225 crore and number of shares is 10 crore. In case company is
liquidated, building would fetch ₹ 100 crore more than book value and stock
would realize ₹ 25 crore less.

The other data for the industry is as follows:

Projected Dividend Growth 4%

Risk Free Rate of Return 6%

Market Rate of Return 11%

Average Dividend Yield 6%

The estimated beta of T Ltd. is 1.2. You are required to calculate value of T Ltd.
using

(i) P/E Ratio

(ii) Dividend Yield

(iii) Valuation as per:

(a) Dividend Growth Model

(b) Book Value

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(c) Net Realizable Value

SOLUTION:-

(i) ₹ 50 crore × 9 = ₹ 450 crore

0.80
(ii) ₹ 50 crore × = ₹ 666.67
0.06

(iii)

(a) Ke = 6% + 1.2 (11% - 6%) = 12%

40 crore × 1.04
Value of Firm = = ₹ 520 crore
0.12 − 0.4
(b) ₹ 225 crore

(c) ₹ 225 crore + ₹ 100 crore – ₹ 25 crore = 300 crore

QUESTION – 25

XY Ltd., a Cement manufacturing Company has hired you as a financial

consultant of the company. The Cement Industry has been very stable for some
time and the cement companies SK Ltd. & AS Ltd. are similar in size and have
similar product market mix characteristic. Use comparable method to value the
equity of XY Ltd. In performing analysis, use the following ratios:

(i) Market to book value

(ii) Market to replacement cost

(iii) Market to sales

(iv) Market to Net Income

The following data are available for your analysis:

(Amount in ₹)

SK Ltd AS Ltd. XY Ltd.

Market Value 450 400
Book Value 400 300 250
Replacement Cost 600 550 500
Sales 550 450 500

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Net Income 18 16 14

(Exam November – 2019)

SOLUTION:-

Estimation of Reties

Sl. Particulars SK Ltd AS Ltd. Average

No.
(i) Market to Book Value 450 400 1.2290
= 1.125 = 1.333
400 300
(ii) Market to Replacement 450 450 0.7385
= 0.750 = 0.727
Cost 600 550
(iii) Market to Sales 450 400 0.8535
= 0.818 = 0.889
550 450
(iv) Market to Net Income 450 400 25
=25 = 25
18 16

Application of Ratios to XY Ltd.

Sl. Particulars XY Ltd. Average Indicative Value of XY

No (₹) Ltd. (₹)
(i) Book Value 250 1.2290 250 × 1.2290 = 307.25
(ii) Replacement Cost 500 0.7385 500 × 0.7385= 365.25
(iii) Sales 500 0.8535 500 × 0.8535= 426.75
(iv) Net Income 14 25 14 × 25 = 350.00
Average ₹ 363.31.31

Value of XY Ltd. according to the comparable method is ₹ 363.31

QUESTION – 26

You are interested in buying some equity stocks of RK Ltd. The company has 3
divisions operating in different industries. Division A captures 10% of its
industries sales which is forecasted to be ₹ 50 crore for the industry. Division B
and C captures 30% and 2% of their respective industry's sales, which are
expected to be ₹ 20 crore and ₹ 8.5 crore respectively. Division A traditionally
had a 5% net income margin, whereas divisions B and C had 8% and 10% net
income margin respectively. RK Ltd. has 3,00,000 shares of equity stock
outstanding, which sell at ₹ 250.

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The company has not paid dividend since it started its business 10 years ago.
However from the market sources you come to know that RK Ltd. will start
paying dividend in 3 years time and the pay-out ratio is 30%. Expecting this
dividend, you would like to hold the stock for 5 year. By analyzing the past
financial statements, you have determined that RK Ltd.'s required rate of
return is 18% and that P/E ratio of 10 for the next year and on ending P/E
ratio of 20 at the end of the fifth year are appropriate.

Required:

(i) Would you purchase RK Ltd. equity at this time based on your one year
forecast?

(ii) If you expect earnings to grow @ 15% continuously, how much are you
willing to pay for the stock of RK Ltd ?

Ignore taxation.

PV factors are given below :

Years 1 2 3 4 5
PVIF@ 18% 0.847 0.718 0.609 0.516 0.437

(Exam November – 2019 & MTP March – 2021)

SOLUTION:-

Working Notes:

Computation of Earning Per Share (EPS)

Particulars Amount (₹)

Margin of Division A (₹ 50 crore × 10% × 5%) 25,00,000
Margin of Division B (₹ 20 crore × 30% × 8%) 48,00,000
Margin of Division C (₹ 8.5 crore × 2% × 10%) 1,70,000
74,70,000
No. of Equity Shares 3,00,000
EPS ₹ 24.90

(i) Market Price based on One Year Forecast

Expected Market Price at the end of the year = ₹ 24.90 × 10 = ₹ 249

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PV of the Expected Price = ₹ 249 × 0.847 = ₹ 210.90

I would NOT like to purchase the share as the expected market price of
shares is less than its current price of ₹ 250.

(ii) If Earning is expected to grow @ 15%

Year EPS (₹) Dividend (₹) PVF@18% PV (₹)

1 28.64 --- 0.847 ---
2 32.93 --- 0.718 ---
3 37.87 11.36 0.609 6.92
4 43.55 13.07 0.516 6.74
5 50.08 15.02 0.437 6.56
20.22

15.02 (1.15)
Share Price after 5 years = = ₹ 575.77
0.18 − 0 15

PV of the Market Price after 5 years = ₹ 575.77 × 0.437 = ₹ 251.61

Total PV of Inflows = ₹ 20.22 + ₹ 251.61 = ₹ 271.83

Thus, the maximum price I would be willing to pay for the share shall be
₹ 271.83.

QUESTION – 27 ACQUISITION QUESTIONS START

R Ltd. and S Ltd. operating in same industry are not experiencing any rapid
growth but providing a steady stream of earnings. R Ltd.'s management is
interested in acquisition of S. Ltd. due to its excess plant capacity. Share of S
Ltd. is trading in market at ₹ 3.20 each. Other data relating to S Ltd. is as
follows:

Balance Sheet of S Ltd

Liabilities Amount (₹) Assets Amount (₹)

Current Liabilities 1,59,80,000 Current Assets 2,48,75,000
Long Term Liabilities 1,28,00,000 Other Assets 94,00,000
Reserve & Surplus 2,79,95,000 Property Plants
Share Capital & Equipment 3,45,00,000
(80 Lakhs shares of ₹ 1.5 each) 1,20,00,000

Total 6,87,75,000 Total 6,87,75,000

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Particulars R Ltd. (₹) S Ltd. (₹) Combined

Entity (₹)
Profit after Tax 86,50,000 49,72,000 1,21,85,000
Residual Net Cash Flows per year 91,10,000 54,87,000 1,85,00,000
Required return on equity 13.75% 13.05% 12.5%

You are required to compute the following:

(i) Minimum price per share S Ltd. should accept from R Ltd.

(ii) Maximum price per share R Ltd. shall be willing to offer to S Ltd.

(iii) Floor Value of per share of S Ltd., whether it shall play any role in
decision for its acquisition by R Ltd.

(Exam May – 2019)

SOLUTION:-

(i) Calculation of Minimum price per share S Ltd. should accept from R
Ltd.

Residual Cash Flow 54,87,000

Value of S Ltd. = = = ₹ 4,20,45,977
Ke − g 0.1305 − 0

4,20,45,977
Value per share of S Ltd. = = ₹ 5.26
80,00,000

3,99,95,000
Book Value of per share of S Ltd. = = ₹ 4.99 or ₹ 5
80,00,000

Therefore, the minimum price per share S ltd. should accept from R Ltd.
is ₹ 5 (current book value)

(ii) Calculation of Maximum price per share R Ltd. shall be willing to

offer to S Ltd.

Residual Cash Flow 90,10,000

Value of R Ltd. = = = ₹ 6,55,27,273
Ke − g 0.1375 − 0

1,85,00,000
Value of Combined entity = = ₹ 14,80,00,000
0.125−0

Value of synergy

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= Value of Combined entity – Individual values of R Ltd. and S Ltd.

= ₹ 14,80,00,000 – (₹ 4,20,45,977 + ₹ 6,55,27,273)

= ₹ 4,04,26,750

Maximum price per share R Ltd. shall be willing to offer to S Ltd. shall be
computed as follows:

Value of SLtd . as per Residual cash flows + Synergy benefits

=
No . of Shares
4,20,45,977 + 4,04,26,750
= = ₹ 10.31
80,00,000

(iii) Floor value of per share of S Ltd shall be ₹ 3.20 (current market price)
and it shall not play any role in decision for the acquisition of S Ltd. as it
is lower than its current book value.

QUESTION – 28

AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The
valuation is to be based on the recommendation of merchant bankers and the
consideration is to be discharged in the form of equity shares to be issued by
AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists of 80 lakhs
shares of ₹ 10 each. The highest and the lowest market quotation during the
last 6 months were ₹ 570 and ₹ 430. For the purpose of the exchange, the price
per share is to be reckoned as the average of the highest and lowest market
price during the last 6 months ended on 31.3.06.

XY Ltd.‟s Balance Sheet as at 31.3.2006 is summarized below:

₹ lakhs
Sources
Share Capital
20 lakhs equity shares of ₹ 10 each fully paid 200
10 lakhs equity shares of ₹ 10 each, ₹ 5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200
350

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An independent firm of merchant bankers engaged for the negotiation, have

produced the following estimates of cash flows from the business of XY Ltd.:

Year ended By way of ₹ lakhs

31/03/07 After tax earnings for equity 105
31/03/08 Do 120
31/03/09 Do 125
31/03/10 Do 120
31/03/11 Do 100
Terminal Value estimate 200

It is the recommendation of the merchant banker that the business of XY Ltd.

may be valued on the basis of the average of (i) Aggregate of discounted cash
flows at 8% and (ii) Net assets value. Present value factors at 8% for years

1-5: 0.93 0.86 0.79 0.74 0.68

You are required to:

(i) Calculate the total value of the business of XY Ltd.

(ii) The number of shares to be issued by AB Ltd.; and

(iii) The basis of allocation of the shares among the shareholders of XY Ltd.

(Study Material & PM)

SOLUTION:

Price/share of AB Ltd. for determination of number of shares to be issued

= (₹ 570 + ₹ 430)/2 = ₹ 500

Value of XY Ltd based on future cash flow capitalization

(105×0.93)+(120×0.86)+(125×0.79)+(120×0.74)×(300×0.68) ₹ lakhs 592.40
Value of XY Ltd based on net assets ₹ lakhs 250.00
Average value (592.40 + 250)/2 421.20
No. of shares in AB Ltd to be issued ₹ 4,21,20,000/500 Nos. 84240
Basis of allocation of shares
Fully paid equivalent shares in XY Ltd. (20 + 5) lakhs 2500000
Distribution to fully paid shareholders 84240 × 20/25 67392

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Distribution to partly paid shareholders 84240 − 67392 16848

QUESTION – 29

H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The
summarized Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as
follows:

Balance sheet as at 31st March, 2012 (In Crores of Rupees)

Liabilities: H. Ltd B. Ltd.

Paid up Share Capital
-Equity Shares of ₹ 100 each 350.00 --
-Equity Shares of ₹ 10 each -- 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50

H Ltd. proposes to buy out B Ltd. and the following information is provided to
you as part of the scheme of buying:

(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd.
for the last 4 years are ₹ 300 crores and ₹ 10 crores respectively.

(2) Both the companies envisage a capitalization rate of 8%.

(3) H Ltd. has a contingent liability of ₹ 300 crores as on 31st March, 2012.

(4) H Ltd. to issue shares of ₹ 100 each to the shareholders of B Ltd. in

terms of the exchange ratio as arrived on a Fair Value basis. (Please
consider weights of 1 and 3 for the value of shares arrived on Net Asset
basis and Earnings capitalization method respectively for both H Ltd.
and B Ltd.)

You are required to arrive at the value of the shares of both H Ltd. and B Ltd.
under:

(i) Net Asset Value Method

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(ii) Earnings Capitalization Method

(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B

Ltd. on a Fair value basis (taking into consideration the assumption
mentioned in point 4 above.)

(Study Material & PM)

SOLUTION:

(i) Net asset value

H Ltd. ₹ 1300 Crores − ₹ 300 Crores

= ₹ 285.71
3.50 Crores
B Ltd. ₹ 31.50 Crores
= ₹ 48.46
0.65 Crores

(ii) Earning capitalization value

H Ltd. ₹ 300 Crores /0.08

= ₹ 1071.43
3.50 Crores
B Ltd. ₹ 10 Crores 0.08
= ₹ 192.31
0.65 Crores

(iii) Fair value

H Ltd. ₹ 285.71 × 1 + ₹ 1071.43 × 3

= ₹ 857
4
B Ltd. ₹ 48.46 × 1 + ₹ 192.31 × 3
= ₹ 156.3475
4
Exchange radio ₹ 156.3475/₹ 875 = 0.1787

H Ltd should issue its 0.1787 share for each share of B Ltd.

Note: In above solution it has been assumed that the contingent liability will
materialize at its full amount.

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QUESTION – 30

ABC Company is considering acquisition of XYZ Ltd. which has 1.5 crores
shares outstanding and issued. The market price per share is ₹ 400 at present.
ABC's average cost of capital is 12%. Available information from XYZ indicates
its expected cash accruals for the next 3 years as follows:

Year ₹ Crore
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider. (PV factors at 12%
for years 1 to 3 respectively: 0.893, 0.797 and 0.712).

(SM, PM & MTP April - 2021)

SOLUTION:

VALUATION BASED ON MARKET PRICE

Market Price per share ₹ 400

Thus value of total business is (₹ 400 × 1.5 Cr.) ₹ 600 Cr.

VALUATION BASED ON DISCOUNTED CASH FLOW

Present Value of cash flows

(₹ 250 cr × 0.893) + (₹ 300 cr. × 0.797) + (₹ 400 cr. × 0.712 ) = ₹ 747.15 Cr.

Value of per share (₹ 747.15 Cr. / 1.5 Cr) ₹ 498.10 per share

RANGE OF VALUATION

Per Share ₹ Total ₹ Cr.

Minimum 400.00 600.00
Maximum 498.10 747.15

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QUESTION – 31

The Balance Sheet of M/s. Sundry Ltd. as on 31-03-2020 is follows:

(₹ in lakhs)

Liabilities ₹ Assets ₹
Share Capital 300 Fixed Assets 600
Reserves 200 Inventory 500
Long Term Loan 400 Receivables 240
Short Term Loan 300 Cash 60
Payables & Provisions 200
Total 1400 Total 1400

Sales for the year was ₹ 600 lakhs. The sales are expected to grow by 20%
during the year. The profit margin and dividend pay-out ratio are expected to
be 4% and 50% respectively.

The company further desires that during the current year Sales to Short Term
Loan and Payables and Provision should be in the ratio of 4 : 3. Ratio of fixed
assets to Long Term Loans should be 1.5. Debt Equity Ratio should not exceed
1.5.

You are required to determine:

(i) The amount of External Fund Requirement (EFR)

(ii) The amount to be raised from Short Term, Long Term and Equity funds.

(Exam January – 2021)

SOLUTION:-

(i) External Funds Requirement (EFR) :

(₹ in lakhs)

Expected sales (₹ 600 + 20% of ₹ 600) 720.00

Profit margin @ 4% 28.80

Dividend payout ratio @ 50% 14.40

Balance to be ploughed back (A) 14.40

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Additional funds required (₹ 1400 − ₹ 200*) × 0.20 (B) 240.00

Balance to be met from external source (B − A) 225.60

* As current liabilities shall also be increased proportionately with

increase in sales.

(ii) Amount to be raised from different sources with following

conditions:

 Sales to short term loans and payables & provisions 4:3

 Ratio of fixed assets to long term loans 1.5
 Debt equity ratio should not exceed 1.5

(1) Amount to be raised from short term funds;

( ₹ in lakhs)
New amount of short-term loans and payable &
𝟑 450
provision
𝟒 × 𝟔𝟎𝟎
Less: Existing Amount of short-term loans and
payables & provision 500
Amount to be raised from short term funds. Nil

(2) Amount to be raised from long term funds:

( ₹ in lakhs)
New fixed assets (₹ 600 + 20% of ₹ 600) 720
New long-term loans (₹ 720/1.5) 480
Less: Existing long-term loans 400
Amount to be raised from long term funds 80

(3) Amount to be raised from equity funds:

( ₹ in lakhs)
Amount to be raised from external sources 225.60
Less: Amount to be raised from short term funds -----
Less: Amount to be raised from long term funds 80.00
Balance amount to be raised from equity funds 145.60

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QUESTION – 32

The Nishan Ltd. has 35,000 shares of equity stock outstanding with a book
value of Rs.20 per share. It owes debt ₹ 15,00,000 at an interest rate of 12%.
Selected financial results are as follows.

Income and Cash Flow Capital

EBIT ₹ 80,000 Debt ₹ 15,00,000
Interest 1,80,000 Equity 7,00,000
EBT (₹ 1,00,000) ₹ 22,00,000
Tax 0
EAT (₹ 1,00,000)
Depreciation ₹ 50,000
Principal Repayment (₹ 75,000)
Cash Flow (₹ 1,25,000)

Restructure the financial line items shown assuming a composition in which

creditors agree to convert two thirds of their debt into equity at book value.
Assume Nishan will pay tax at a rate of 15% on income after the restructuring,
and that principal repayments are reduced proportionately with debt. Who will
control the company and by how big a margin after the restructuring?

(Practice Manual)

SOLUTION:

Creditors would convert ₹ 10,00,000 in debt to equity by accepting

₹ 1,000,000/₹ 20= 50,000 shares of stock.

The remaining ₹ 500,000 of debt would generate interest of

₹ 500,000 × 0.12 = ₹ 60,000

Repayment of principal would be reduced by two thirds to ₹ 25,000 per year.

The result is as follows

Income and Cash Flow Capital

EBIT ₹ 80,000 Debt ₹ 5,00,000
Interest 60,000 Equity ₹ 17,00,000
EBT ₹ 20,000 ₹ 22,00,000
Tax 3,000
EAT ₹ 17,000
Depreciation ₹ 50,000

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Principal Repayment (₹ 25,000)

Cash Flow (₹ 42,000)

After the restructuring there will be a total of (35,000 + 50,000) 85,000 shares
of equity stock outstanding. The original shareholders will still own 35,000
shares (approximately 41%), while the creditors will own 50,000 shares (59%).
Hence the creditors will control the company by a substantial majority.

QUESTION – 33

BRS Inc deals in computer and IT hardware‟s and peripherals. The expected
revenue for the next 8 years is as follows:

Years Sales Revenue ($ Million)

1 8
2 10
3 15
4 22
5 30
6 26
7 23
8 20

Summarized financial position as on 31st march 2012 was as follows:

Liabilities Amount Assets Amount

Equity Stocks 12 Fixed Assets (Net) 17
12% Bonds 8 Current Assets 3
20 20

Additional Information:

(a) Its variable expenses is 40% of sales revenue and fixed operating
expenses (cash) are estimated to be as follows:

Period Amount ($ Million)

1-4 years 1.6
5-8 years 2

(b) An additional advertisement and sales promotion campaign shall be

launched requiring expenditure as per following details:

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Period Amount ($ Million)

1 years 0.50
2-3 years 1.50
4-6 years 3.00
7-8 years 1.00

(c) Fixed assets are subject to depreciation at 15% as per WDV method.

(d) The company has planned additional capital expenditures (in the
beginning of each year) for the coming 8 years as follows:

Period Amount ($ Million)

1 0.50
2 0.80
3 2.00
4 2.50
5 3.50
6 2.50
7 1.50
8 1.00

(e) Investment in Working Capital is estimated to be 20% of Revenue.

(f) Applicable tax rate for the company is 30%.

(g) Cost of Equity is estimated to be 16%.

(h) The Free Cash Flow of the firm is expected to grow at 5% per annuam
after 8 years.

With above information you are require to determine the:

(i) Value of Firm

(ii) Value of Equity

(Practice Manual)

SOLUTION:

Working Notes:

(a) Determination of Weighted Average Cost of Capital

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Sources of Cost (%) Proportions Weights Weighted

fund Cost
Equity Stock 16 12/20 0.60 9.60
12% Bonds 12%(1-0.30)=8.40 8/20 0.40 3.36
12.96 say 13

(b) Schedule of Depreciation

Year Opening Balance Addition Total Depreciation

of Fixed Assets During the @ 15%
year
1 17.00 0.50 17.50 2.63
2 17.87 0.80 15.67 2.35
3 13.32 2.00 15.32 2.30
4 13.02 2.50 15.52 2.33
5 13.19 3.50 16.69 2.50
6 14.19 2.50 16.69 2.50
7 14.19 1.50 15.69 2.35
8 13.34 1.00 14.34 2.15

(c) Determination of Investment

Year Investment Required Existing Additional

For Capital CA (20% of Total Investment Investment
Expenditure Revenue) in CA required
1 0.50 1.60 2.10 3.00 0.00
2 0.80 2.00 2.80 2.50* 0.30
3 2.00 3.00 5.00 2.00* 3.00
4 2.50 4.40 6.90 3.00 3.90
5 3.50 6.00 9.50 4.40 5.10
6 2.50 5.20 7.70 6.00 1.70
7 1.50 4.60 6.10 5.20 0.90
8 1.00 4.00 5.00 4.60 0.40

* Balance of CA in Year 1 ($3 Million) – Capital Expenditure in Year 1($ 0.50

Million)

** Similarly balance of CA in Year 2 ($2.80) – Capital Expenditure in Year 2($

0.80 Million)

(d) Determination of Present Value of Cash Inflows

Particulars Years
1 2 3 4 5 6 7 8
Revenue (A) 8.00 10.00 15.00 22.00 30.00 26.00 23.00 20.00
Less: Expenses

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Variable Costs 3.20 4.00 6.00 8.80 12.00 10.40 9.20 8.00
Fixed cash
operating cost 1.60 1.60 1.60 1.60 2.00 2.00 2.00 2.00
Advertisement Cost 0.50 1.50 1.50 3.00 3.00 3.00 1.00 1.00
Depreciation 2.63 2.35 2.30 2.33 2.50 2.50 2.35 2.15
Total Expenses (B) 7.93 9.45 11.40 15.73 19.50 17.90 14.55 13.15
EBIT (C) = (A) - (B) 0.07 0.55 3.60 6.27 10.50 8.10 8.45 6.85
Less: Taxes@30% (D) 0.02 0.16 1.08 1.88 3.15 2.43 2.53 2.06
NOPAT (E) = (C) - (D) 0.05 0.39 2.52 4.39 7.35 5.67 5.92 4.79
Gross Cash Flow (F)
= (E) + Dep
2.68 2.74 4.82 6.72 9.85 8.17 8.27 6.94
Less: Investment
in Capital Assets
plus Current Assets
(G)
0 0.30 3.00 3.90 5.10 1.70 0.90 0.40
Free Cash Flow (H)
= (F) − (G) 2.68 2.44 1.82 2.82 4.75 6.47 7.37 6.54
PVF@13% (I) 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376
PV (H)(I) 2.371 1.911 1.261 1.729 2.579 3.106 3.132 2.46

Total present value = $ 18.549 million

(e) Determination of Present Value of continuing Value (CV)

FCF 9 $ 6.54 million (1.05) $ 6.867 million (1.05)

CV = = = = $ 85.8375 M
k−g 0.13−0.05 0.08

Present Value of Continuing Value (CV) = $85.8376 million × PVF13%,8 =

$85.96875 million × 0.376 = $32.2749 million

(i) Value of Firm

$ Million

Present Value of cash flow during explicit period 18.5490

Present Value of Continuing Value 32.2749

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Total Value 50.8239

(ii) Value of Equity

$ Million

Total Value of Firm 50.8239

Less: Value of Debt 8.0000

Value of Equity 42.8239

QUESTION – 34

ABC (India) Ltd., a market leader in printing industry, is planning to diversify

into defense equipment businesses that have recently been partially opened up
by the GOI for private sector. In the meanwhile, the CEO of the company wants
to get his company valued by a leading consultants, as he is not satisfied with
the current market price of his scrip.

He approached consultant with a request to take up valuation of his company

with the following data for the year ended 2009:

Share Price ₹ 66 per share

Outstanding debt 1934 lakh

Number of outstanding shares 75 lakh

Net income (PAT) 17.2 lakh

EBIT 245 lakh

Interest expenses 218.125 lakh

Capital expenditure 234.4 lakh

Depreciation 234.4 lakh

Working capital 44 lakh

Growth rate 8% (from 2010 to 2014)

Growth rate 6% (beyond 2014)

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Free cash flow 240.336 lakh (year 2014 onwards)

The capital expenditure is expected to be equally offset by depreciation in

future and the debt is expected to decline by 30% in 2014.

Required:

Estimate the value of the company and ascertain whether the ruling market
price is undervalued as felt by the CEO based on the foregoing data. Assume
that the cost of equity is 16%, and 30% of debt repayment is made in the year
2014.

(Practice Manual)

SOLUTION:

As per Firm Cash Flow Approach

(i) Computation of tax rate

EBIT = ₹ 245 lakh

Interest = ₹ 218.125 lakh

PBT = ₹ 26.875 lakh

PAT = ₹ 17.2 lakh

Tax paid = ₹ 9.675 lakh

Tax rate = ₹ 9.675 /26.875 = 0.36 =36%

(ii) Computation for increase in working capital

Working capital (2009) = ₹ 44 lakh

Increase in 2010 = ₹ 44 × 0.08 = ₹ 3.52 lakh

It will continue to increase @ 8% per annum.

(iii) Weighted average cost of capital

Present debt = ₹ 1934 lakh

Interest cost = ₹ 218.125 lakh/₹ 1934 = 11.28 %

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Equity capital = 75 lakh × ₹ 66 = ₹ 4950 lakh

4950 1934
Kc = × 16% + × 11.28(1−0.36)
1934+4950 1934+4950

= 11.51 + 2.028 = 13.54

(iv) As capital expenditure and depreciation are equal, they will not influence
the free cash flows of the company.

(v) Computation of free cash flows upto 2012

Year 2010 2011 2012 2013 2014

₹ lakh ₹ lakh ₹ lakh ₹ lakh ₹ lakh
EBIT (1-t) 169.344 182.89 197.52 213.22 230.39
Increase working 3.52 3.80 4.10 4.43 4.78
capital
Debt repayment - - - - 1934 × 0.30
= 580.2
Free cash flows 165.824 179.09 193.41 208.89 -354.59
PVF @ 13.54% 0.8807 0.7757 0.6832 0.6017 0.53
PV of free cash flow @ 146.04 138.92 132.14 125.69 -187.93
13.54%

(vi) Cost of capital (2014 Onwards)

Debt = 0.7 × ₹ 1934 = ₹ 1353.80 lakh

Equity = ₹ 4950 lakh

4950 1353 .80

Kc = × 16% + × 11.28(1−0.36)
4950+1353.80 4950+1353.80

= 12.56 + 1.55% = 14.11%

(vii) Continuing Value

240.336
× (1/1.1354)5
0.1411−0.06

= ₹ 1,570.556 lakh

(a) Value of the firm = PV of free cash flows upto 2014 + continuing value

= ₹ 354.86 lakh + ₹ 1,570.556 lakh

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= ₹ 1925.416 lakh

(b) Value per share = (Value of Firm – Value of Debt)/ Number of Shares

= (₹ 1925.416 lakh – ₹ 1353.80 lakh) / 75 lakh

= ₹ 7.622 < ₹ 66 (present market price)

Alternatively, following value can also be considered

= (Value of Firm – Value of Debt)/No. of Shares

= (₹ 1925.416 lakh − ₹ 1934)/75 lakh

= − ₹ 0.1145 or ₹ 0

Thus, share has zero value, and hence overvalued.

Answer as per Equity Cash Approach

(i) Computation of tax rate

EBIT = ₹ 245 lakh

Interest = ₹ 218.125

PBT = ₹ 26.875 lakh

PAT = ₹ 17.2 lakh

Tax Paid = ₹ 9.675 lakh

Tax rate = ₹ 9.675/26.875 = 0.36 = 36%

(ii) Computation for increase in working capital

Working capital (2009) = ₹ 44 lakh

Increase in 2010 = ₹ l44 lakh × 0.08 = ₹ 3.52 lakh

(iii) As capital expenditure and depreciation are equal, they will not influence
the free cash flows of the company.

(iv) Computation of free cash flows upto 2014

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Year 2010 2011 2012 2013 2014

₹ lakh ₹ lakh ₹ lakh ₹ lakh ₹ lakh
EBIT 245.000 264.600 285.768 308.629 333.319
Less Interest 218.125 218.125 218.125 218.125 152.688
EBT 26.875 46.475 67.643 90.504 180.631
Tax 9.675 16.266 24.351 32.581 65.027
EAT 17.200 30.209 43.292 57.923 115.604
Increase in working 3.52 3.80 4.10 4.43 4.78
capital
Debt repayment - - - - 1934 × 0.30
= 580.20
Free cash flows 13.68 26.409 39.192 53.493 -469.376
PVF @ 16% 0.8621 0.7432 0.6407 0.5523 0.4761
PV of free cash flow 11.794 19.627 25.110 29.544 -223.470

Present value of free cash flows upto 2014 = -₹ 137.395 lakhs

(v) Continuing value

117.473
× (1/1.16)5 = ₹ 559.304 lakh
0.16−0.06

* (115.604 – 4.78) (1.06)

(a) Value of the Equity

= PV of free cash flows upto 2014 + continuing value

= - ₹ 137.395 lakh + ₹ 559.304 lakh = ₹ 421.909 lakh

(b) Value per share

= Value of Equity/Number of Shares

= ₹ 421.909 lakh/75 lakh

= 5.62< ₹ 66 (present market value)

QUESTION – 35

The following is the Balance-sheet of Grape Fruit Company Ltd as at March

31st, 2019.

(₹ in (₹ in
Liabilities Assets
lakhs) lakhs)
Equity shares of ₹ 100 each 600 Land and Building 200

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14% preference shares of ₹ 200 Plant and Machinery 300

100/- each
13% Debentures 200 Furniture and Fixtures 50
Debenture interest accrued 26 Inventory 150
and payable
Loan from bank 74 Sundry debtors 70
Trade creditors 340 Cash at bank 130
Preliminary expenses 10
Cost of issue of debentures 5
Profit and Loss account 525
1440 1440
The Company did not perform well and has suffered sizable losses during the
last few years. However, it is felt that the company could be nursed back to
health by proper financial restructuring. Consequently the following scheme of
reconstruction has been drawn up:

(i) Equity shares are to be reduced to ₹ 25/- per share, fully paid up;

(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal
number of shares of ₹ 50 each, fully paid up.

(iii) Debenture holders have agreed to forgo the accrued interest due to them.
In the future, the rate of interest on debentures is to be reduced to 9
percent.

(iv) Trade creditors will forego 25 percent of the amount due to them.
(v) The company issues 6 lakh of equity shares at ₹ 25 each and the entire
sum was to be paid on application. The entire amount was fully
subscribed by promoters.

(vi) Land and Building was to be devalued at ₹ 450 lakhs, Plant and
Machinery was to be written down by ₹ 120 lakhs and a provision of ₹15
lakhs had to be made for bad and doubtful debts.
Required:

(a) Show the impact of financial restructuring on the company‟s activities.

(b) Prepare the fresh balance sheet after the reconstructions is completed on
the basis of the above proposals.

(Practice Manual)

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SOLUTION:

Impact of Financial Restructuring

(i) Benefits to Grape Fruit Ltd.

(a) Reduction of Liabilities payable

₹ in lakhs
Reduction in equity share capital (6 lakh shares × ₹ 450
75 per share)
Reduction in preference share capital (2 lakh shares 100
× ₹ 50 per share)
Waiver of outstanding debenture Interest 26
Waiver from trade creditors (₹ 340 lakhs × 0.25) 85
661

(b) Revaluation of Assets

Appreciation of Land and Building (₹ 450 lakhs − ₹ 250
200 lakhs)
Total (A) 911

(ii) Amount of ₹ 911 lakhs utilized to write off losses, fictious assets and over
– valued assets.

Writing off profit and loss account 525

Cost of issue of debentures 5
Preliminary expenses 10
Provision for bad and doubtful debts 15
Revaluation of Plant and Machinery 120
(₹ 300 lakhs – ₹ 180 lakhs) _____
Total (B) 675
Capital Reserve (A) – (B) 236

(ii) Balance sheet of Grape Fruit Ltd. as 31st March 2011 (after re-
construction)

Liabilities Amt. Assets Amt.

12 lakhs equity shares of ₹ 25/- 300 Land & Building 450
each Plant & Machinery 180
10% Preference shares of ₹ 50/- 100 Furniture & Fixtures 50
each Inventory 150
Capital Reserve 236 Sundry debtors 7
9% debentures 200 Prov. for Doubtful Debts -15 55
Loan from Bank 74 Cash-at-Bank (Balancing 280
255 figure)*

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Trade Creditors
1165 1165

*Opening Balance of ₹ 130/- lakhs + Sale proceeds from issue of new equity
shares ₹ 150/- lakhs.

Value of Equity on the basis of FCFE

QUESTION – 36

Calculate the value of share from the following information:

Profit after tax of the company ₹ 290 crores

Equity capital of company ₹ 1,300 crores

Par value of share ₹ 40 each

Debt ratio of company (Debt/ Debt + Equity) 27%

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

Depreciation per share ₹ 39

Change in Working capital ₹ 3.45 per shar

(RTP May – 2020)

SOLUTION:-

₹ 1,300 crores
No. of Shares = = 32.5 Crores
₹ 40
PAT
EPS =
No . of shares
₹ 290 crores
EPS = = ₹ 8.923
₹ 32.5 crores

FCFE = Net income − [(1−b) (capex – dep) + (1−b) ( ΔWC )]

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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 + ß (Rm – Rf)

= 8.7 + 0.1 (10.3 – 8.7) = 8.86%

FCFE (1+g) 0.5645(1.08) 0.60966

PO = = = = ₹ 70.89
k e −g 0.0886−0.08 0.0086

Chop Shop Approach or Breakup Value Approach:

In chop shop approach, we calculate value of business on the basis of different
segments & there after we take average. Segment like sales, assets, capital etc.

QUESTION – 37

Using the chop-shop approach (or Break-up value approach), assign a value for
Cranberry Ltd. whose stock is currently trading at a total market price of €4
million. For Cranberry Ltd, the accounting data set forth three business
segments: consumer wholesale, retail and general centers. Data for the firm‟s
three segments are as follows:
Business Segment Segment Segment Segment
Sales Assets Operating Income
Wholesale €225,000 €600,000 €75,000
Retail €720,000 €500,000 €150,000
General € 2,500,000 €4,000,000 €700,000

Industry data for “pure-play” firms have been compiled and are summarized as
follows:
Business Capitalization Capitalization Capitalization/
Segment /Sales /Assets Operating Income
Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4

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(Practice Manual)

SOLUTION:

Business Capital-to- Segment Sales Theoretical Values

Segment Sales
Wholesale 0.85 €225,000 € 191250
Retail 1.2 €720,000 € 864000
General 0.8 € 2,500,000 € 2000000
Total Value € 3055250

Business Capital-to- Segment Theoretical Values

Segment Assets Assets
Wholesale 0.7 € 600000 € 420000
Retail 0.7 € 500000 € 350000
General 0.7 € 4000000 € 2800000
Total Value € 3570000

Business Capital-to Operating Theoretical Values

Segment Operating Income
Income
Wholesale 9 € 75000 € 675000
Retail 8 € 150000 € 1200000
General 4 € 700000 € 2800000
Total Value € 4675000

3055250 + 3570000 + 467500

Average theoretical value = = 37,66,750
3
Average theoretical value of Cranberry Ltd. = €37,66,750

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(3) Gearing of Beta

In this topic, we will discuss risk or beta with respect to gearing of firm. It
means beta depends upon debt-equity combination of firm.

Example – 06

Equity = 3,00,000

Debt = 2,00,000

Assets beta or overall beta = 2

Stock beta or equity beta ?

Example – 07

FCFF1 = ₹ 4,00,000 p.a. perpetual

D/E = 2:3

Assets beta = 1.50

RF = 6%

RM = 10%

Calculate value of firm.

Example – 08

A Ltd. is an Electronic firm

D/E = 1:14

FCFF1 = ₹ 2,50,000

RF = 5%

RM = 12%

Calculate Value of A Ltd.

Assets beta of another electronic firm B Ltd. is 0.9

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Example – 09

A Ltd is an electronic firm

FCFF1 = 1,75,000

RF = 7%

RM = 13%

D/E = 1:3

Calculate Value of A Ltd.

B Ltd. is similar electronic firm

BE = 1.75

D/E = 1:4

Example – 10

D/E = 2:3

BA = 1.20

BD = 0.40

BE =?

Example – 11

FCFF1 = ₹ 80,000

BA = 1.15

D/E = 2:3

RF = 10%

RM = 15%

Tax = 30%

Value of company = ?

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QUESTION – 38

The total market value of the equity share of O.R.E. company is ₹ 60,00,000
and the total value of the debts is ₹ 40,00,000. The treasure estimate that the
beta of the stock is currently 1.5 and that the expected risk premium on the
market is 10%. The treasury bill rate is 8%.

Required:

(1) What is the beta of the company‟s existing portfolio of assets?

(2) Estimate the company‟s cost of capital and the discount rate for an
expansion of the company‟s business.

SOLUTION:

VE VD
(1) βcompany = βequity × βdebt ×
V0 V0

Note : Since βdebtis not given it is assumed that company debt capital is
virtually riskless. If company‟s debt capital is riskless than above
relationship become:

VE
Here βequity = 1.5;βcompany = βequity =
V0

As βdebt =0

VE = ₹ 60 lakhs.

VD = ₹ 40 lakhs.

V0 = ₹ 100 lakhs.

₹ 60 lakhs
βcompany = 1.5 ×
₹ 100 lakhs

= 0.9

(2) Company‟s Cost equity = Rf + βA× Risk premium

Where Rf = Risk free rate of return

βA = Beta of Company assets

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therefore, company‟s cost equity = 8% + 0.9 × 10 = 17% and overall cost

of capital shall be

60,00,000 40,00,000
= 17% × + 8% ×
100,00,000 100,00,000

10.20% + 3.20% = 13.40%

Alternatively it can also be compute as follows:

Cost of Equity = 8% + 1.5 × 10 = 23%

Cost of Debt = 8%

60,00,000 40,00,000
WACC (Cost of Capital) = 23% × 8% ×
100,00,000 100,00,000

= 17%

In case of expansion of the company‟s present business, the same rate of

rete of return i.e 13.40% will be used. However, in case of diversification
into new business the risk profile of new business is likely to be different.
Therefore, different discount factor has to be worked out for such
business.

QUESTION – 39

Equity of KGF Ltd. (KGFL) is ₹ 410 Crores, its debt, is worth ₹ 170 Crores.
Printer Division segments value is attributable to 74%, which has an Asset
Beta (βp) of 1.45, balance value is applied on Spares and Consumables
Division, which has an Asset Beta (βsc) of 1.20 KGFL Debt beta (βD) is 0.24.

You are required to calculate:

(i) Equity Beta (βE),

(ii) Ascertain Equity Beta (βE), if KGF Ltd. decides to change its Debt Equity
position by raising further debt and buying back of equity to have its
Debt Equity Ratio at 1.90. Assume that the present Debt Beta (βD1) is
0.35 and any further funds raised by way of Debt will have a Beta (β D2) of
0.40.

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(iii) Whether the new Equity Beta (β E) justifies increase in the value of equity
on account of leverage?

SOLUTION:

(i) Equity Beta

To Calculate Equity beta first we shall calculate weighted Average of

Asset Beta as follows:

= 1.45 × 0.74 + 1.20 + 0.26

= 1.073 + 0.312 = 1.385

New we shall compute Equity Beta using the following formula:

E D (1−t)
βAsset = βEquit = + βDebt
E + D(1−t) E+D(1−t)

Accordingly,

410 170
1.385 = βEquit + βDebt
410 + 170 410 +170

410 170
1.385 = βEquit + 0.24
580 580

βEquit = 1.86

(ii) Equity Beta on change is Capital structure

Amount of Debt to be raised :

Particulars Value
Total Value of firm (Equity ₹ 410 cr + Debt ₹ 170 cr) ₹ 580 Cr
Desired Debt Equity Ratio 1.90:1.00
Total Value × Debt Ratio ₹ 380 Cr
Desired Dept Level =
DebtRatio + Equity Ratio

Less: Value of Existing Debt

(₹170 Cr)

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Value of Debt to be Raised ₹ 210 Cr

Equity after Repurchase = Total value of firm – Desired Debt value

= ₹ 580 Cr − ₹ 380 Cr

= ₹ 200 Cr

Weighted Average Beta of KGFL:

Source of Investment Weight Beta of Weighted Beta

Finance (₹Cr) Division
Equity 200 0.345 β(E=X) 0.345x
Debt-1 170 0.293 0.35 0.103
Debt-2 210 0.362 0.40 0.145
580 Weighted Average Beta 0.248 + (0.345x)

βKGFL = 0.248 + 0.345x

1.385 = 0248 + 0.345x

0.345x = 1.385 – 0.248

X = 1.137/0.345 = 3.296

βKGFL = 3.296

(iii) Yes, it justifies the increase as it leads to increase in the Value of Equity
due to increase in Beta.

QUESTION – 40

STR Ltd.‟s current financial year's income statement reported its net income
after tax as ₹ 50 Crore.

Following is the capital structure of STR Ltd. at the end of current financial
year:

₹
Debt (Coupon rate = 11%) 80 Crore
Equity (Share Capital + Reserves & Surplus) 250 Crore
Invested Capital 330 Crore

Following data is given to estimate cost of equity capital:

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Asset Beta of TSR Ltd. 1.11

Risk free rate of return 8.5%
Average market risk premium 9%

The applicable corporate income tax rate is 30%.

Estimate Economic Value added (EVA) of RST Ltd. in ₹ lakh.

(RTP November – 2021 & MTP October – 2020)

SOLUTION:-

First of all, to calculate Cost of Equity we shall compute the Equity Beta of STR
Ltd. as follows:

E
βa = βe
E+ D(1− t)

250
1.11 = βe
250 + 80(1− 0.30)

βe = 1.36

then we shall compute the Cost of Equity as per CAPM as follows:

ke = Rf + β × Market Risk Premium

= 8.5% + 1.36 x 9%

= 8.5% + 12.24% = 20.74%

Cost of Debt (kd) = 11% (1 – 0.30) = 7.70%

E D
WACC (ko) = ke × + kd ×
E +D E +D
250 80
= 20.74 × + 7.70 ×
330 330

= 15.71 + 1.87 = 17.58%

Taxable Income = ₹ 50 Crore/(1 − 0.30)

= ₹ 7142.86 lakhs

Operating Income = Taxable Income + Interest

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= ₹ 7142.86 lakhs +₹ 880 lakhs

= ₹ 8022.86 lakhs

EVA = EBIT (1-Tax Rate) – WACC× Invested Capital

= ₹ 8022.86 lakhs (1 – 0.30) – 17.58% ×₹ 330 Crore

= ₹ 5616.00 lakhs – ₹ 5801.40 lakhs = - ₹ 185.40 lakhs

QUESTION – 41

ABC, a large business house is planning to sell its wholly owned subsidiary
KLM. Another large business entity XYZ has expressed its interest in making a
bid for KLM. XYZ expects that after acquisition the annual earning of KLM will
increase by 10%.

Following information, ignoring any potential synergistic benefits arising out of

possible acquisitions, are available:

(i) Profit after tax for KLM for the financial year which has just ended is
estimated to be ₹ 10 crore.

(ii) KLM's after tax profit has an increasing trend of 7% each year and the
same is expected to continue.

(iii) Estimated post tax market return is 10% and risk free rate is 4%. These
rates are expected to continue.

(iv) Corporate tax rate is 30%.

XYZ ABC Proxy entity for

KLM in the same
line of business
No. of shares 100 lakhs 80 lakhs --
Current share price ₹ 287 ₹ 375 --
Dividend pay out 40% 50% 50%
Debt : Equity at 1:2 1:3 1:4
market values
P/E ratio 10 13 12
Equity beta 1 1. 1 1.1

Assume gearing level of KLM to be the same as for ABC and a debt beta of zero.
You are required to calculate:

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(a) Appropriate cost of equity for KLM based on the data available for the
proxy entity.

(b) A range of values for KLM both before and after any potential synergistic
benefits to XYZ of the acquisition.

(Practice Manual)

SOLUTION:

(a) β ungeared for the proxy company = 1.1 × 4/[ 4 + (1 – 0.3) ] = 0.9362

0.9362 = β equity geared × 3/[ 3 + (1 − 0.3)]

β equity geared = 1.1546

Cost of equity = 0.04 + 1.1546 × (0.1 – 0.04) = 10.93%

(b) P/E valuation

(Based on earning of ₹ 10 Crore)

Using proxy Using XYZ‟s

Entity‟s P/E P/E

Pre synergistic value 12 × ₹ 10 Crore 10 × ₹ 10 Crore

= ₹ 120 Crore = ₹ 100 Crore

Post synergistic value 12 × ₹ 10 Crore × 1.1 10 ×₹ 10 Crore × 1.1

= ₹ 132 Crore = ₹ 110 Crore

Dividend valuation model

Based on 50% payout Based on 40% payout

Pre synergistic value 0.5 × 10 × 1.07 0.4 × 10 × 1.07
0.1093 − 0.07 0.1093 − 0.07
= ₹ 136.13 Crore = ₹ 108.91 Crore

Post Synergistic value 0.5 × 10 × 1.1 × 1.07 0.4 × 10 × 1.1 × 1.07

0.1093 − 0.07 0.1093 − 0.07
= ₹ 149.75 Crore = ₹ 119.79 Crore

Range of valuation

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Pre synergistic ₹ 100 Crore ₹ 136.13 Crore

Post synergistic ₹ 110 Crore ₹ 149.75 Crore

QUESTION – 42

Given below is the Balance Sheet of S Ltd. as on 31.3.2008:

Liabilities ₹ (in lakh) Assets ₹ (in lakh)

Share capital Land and building 40
(share of ₹ 10) 100 Plant and machinery 80
Reserves and surplus 40 Investments 10
Long Term Debts 30 Stock 20
Debtors 15
170 Cash at bank 5
170

You are required to work out the value of the Company's, shares on the basis
of Net Assets method and Profit-earning capacity (capitalization) method and
arrive at the fair price of the shares, by considering the following information:

(i) Profit for the current year ₹ 64 lakhs includes ₹4 lakhs extraordinary
income and ₹ 1 lakh income from investments of surplus funds; such
surplus funds are unlikely to recur.

(ii) In subsequent years, additional advertisement expenses of ₹ 5 lakhs are

expected to be incurred each year.

(iii) Market value of Land and Building and Plant and Machinery have been
ascertained at ₹ 96 lakhs and ₹ 100 lakhs respectively. This will entail
additional depreciation of ₹ 6 lakhs each year.

(iv) Effective Income-tax rate is 30%.

(v) The capitalization rate applicable to similar businesses is 15%.

(Practice Manual)

SOLUTION:

₹ lakh
Net Assets Method

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Assets: Land & Buildings 96

Plant & Machinery 100
Investments 10
Stocks 20
Debtors 15
Cash & Bank 5
Total Assets 246
Less: Long Term Debts 30
Net Assets 216
Value per share
1,00,00,000
(a) Number of shares = 10,00,000
10
2,16,00,000
(b) Net Assets ₹ 2,16,00,000 = ₹ 21.6
10,00,000

Profit-earning Capacity Method ₹ lakh

Profit before tax 64.00
Less: Extraordinary income 4.00
Investment income (not likely to recur) 1.00 5.00
59.00
Less: Additional expenses in forthcoming
years 5.00
Advertisement 6.00
Depreciation 11.00
Expected earnings before taxes 48.00
Less: Income-tax @ 30% 14.40
Future maintainable profits (after taxes) 33.60

Value of business

33.60
Capitalization factor = 224
0.15

Less: Long term Debts 30

194

1,94,00,000
Value per share ₹ 19.40
10,00,000

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Fair Price of share ₹

Value as per Net Assets Method 21.60

Value as per Profit earning capacity (Capitalization) method 19.40

21.60 + 19.40 41.00

Fair Price = =
2 2 ₹ 20.50

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CHAPTER – 08
MERGER, ACQUISITION &
CORPORATE RESTRUCTURING

INTRODUCTION:

We will discuss this chapter in four parts .

Part I: Merger

Part II: Demerger

Part III: Leveraged Buy Out (LBO)

Part IV: Residual

Part I: MERGER

1. Basic
Share Exchange Ratio & Stock Deal:-

In order to discuss merger, we have to discuss about synergy. Synergy is the

potential additional value resulting from merger.

Value of Synergy = VAB – (VA + VB)

Value of Synergy in Earnings (PATAB)

= PATA + PATB + Synergy in earnings

If we take over another firm, then there are two methods of payment.

(i) Stock Deal.

(ii) Cash Deal.

(i) Stock Deal

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Whenever we takeover another firm & purchase consideration is paid in the

form of shares to shareholders of vendor Company or Target Company is
called.

Share Exchange Ratio or swap ratio

(i) Share Exchange Ratio on he basis of market price per share

MPS of Vendor Company

Swap Ratio =
MPS of Purchasing Company

(ii) Share Exchange Ratio on the basis of Earning per share

EPS of Vendor Company

Swap Ratio =
EPS of Purchasing Company

(iii) Share Exchange Ration on the basis of value per share

Value per share of Vendor Company

Swap Ratio =
Value per share of Purchasi ng Company

Such value can be intrinsic value per share, Net Asset value per share or
book value per share. If question is spot the swap ratio is calculated on
basis of MPS.

Intrinsic value or net Asset per share

Assets (Move) xxx

(-) outside liab. (M.V.) xxx

(-) PSC xxx

Net Assets xxx

÷ No. of Equity shares xxx

Intrinsic Value per share xxx

Book Value per share

ESC xxx

(+) RRS xxx

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Net Worth xxx

÷ No. of Equity shares xxx

BVPS xxx

Example – 01

A Ltd wants to take over B Ltd.

A Ltd B Ltd.

No of share 1,000 2,000

Paid up value ₹ 100 ₹ 10

ESC ₹ 10,00,000 ₹ 20,000

R&S ₹ 2,00,000 ₹ 4,000

EAT ₹ 1,50,000 ₹ 16,000

EAT
EPS ₹ 15 ₹8
N

MPS ₹ 150 ₹ 32

MPS
T/E Ratio 10 times 4 times
EPS

Net Worth ₹12,00,000 2,400

BVPS ₹ 120 ₹ 12

Calculate share Exchange Ratio

BASIS Weight

MPS 25%

EPS 40%

BVPS 35%

(i) No. of shares to be issued by A Ltd. to shareholder of B Ltd.

(ii) Calculate post merger EPS.

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(iii) Impact on EPS due to merger & Impact on earnings.

(iv) Calculate post merger MPS if post merger P/E ratio is 12 times.

(v) Impact on MPS due to merger.

(vi) Calculate market value of A Ltd. after merger.

(vii) Impact on market value due to merger shareholder.

(viii) Calculate Swap ratio, So that EPS of A Ltd. before merger & after merger
same.

(ix) Calculate swap ratio, So that EPS of B Ltd. Shareholders before merger &
after merger should be same.

Example – 02

A Ltd. wants to take over of B Ltd.

A Ltd. B Ltd.

No. of Share (10) 1,00,000 40,000

EPS ₹15 ₹9

MPS ₹90 ₹27

P/E 6 3

Share Exchange Ratio = 0.5 : 1

EAT ₹ 15,00,000 3,60,000

(i) Maximum exchange ratio acceptable by A Ltd.

(ii) Minimum exchange ratio acceptable by shareholders of B Ltd.

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QUESTION – 01

Long Ltd., is planning to acquire Tall Ltd., with the following data available for
both the companies:

Long Ltd. Tall Ltd.

Expected EPS ₹ 12 ₹5

Expected DPS ₹ 10 ₹3

No. of Shares 30,00,000 18,00,000

Current Market Price of Share ₹ 180 ₹ 50

As per an estimate Tall Ltd., is expected to have steady growth of earnings and
dividends to the tune of 6% per annum. However, under the new management
the growth rate is likely to be enhanced to 8% per annum without additional
investment.

You are required to:

(i) Calculate the net cost of acquisition by Long Ltd., if ₹ 60 is paid for each
share of Tall Ltd.

(ii) If the agreed exchange ratio is one share of Long Ltd., for every three
shares of Tall Ltd., in lieu of the cash acquisition as per (i) above, what
will be the net cost of acquisition?

(iii) Calculate Gain from acquisition.

(Exam July - 2021)

SOLUTION:

(i) Net cost of acquisition shall be computed as follows:

Cash Paid for the shares of Tall Ltd.

(₹ 60 × 18,00,000) ₹ 10,80,00,000
Less: Value of Tall Ltd., as a separate entity
(18,00,000 × ₹ 50) ₹ 9,00,00,000
Net Cost of acquisition of Tall Ltd. ₹ 1,80,00,000

(ii) Net Cost of acquisition in case of exchange of shares:

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Exchange ratio = 1 share of long Ltd for every 3 shares of Tall Ltd.

Number of shares to be issued in Long Ltd.

(18,00,000/3) = 6,00,000 shares

Total no. of shares in Long Ltd. after merger

(30,00,000 + 6,00,000) = 36,00,000

Calculation of cost of Equity of Tall Ltd. = D1/P0+ g

Growth rate under new management

after acquisition = ₹ 3/50 + 0.06

= 12%

Value of Merged company assuming perpetual growth = 8%

Value of merged company

(₹ 180 × 30,00,000) + (₹ 3/(0.12 − 0.08) × 18,00,000 = ₹ 67,50,00,000

= 54,00,00,000 + (75 ×18,00,000)

Value per share of merged company

(67,50,00,000/36,00,000) = ₹ 187.50 per share

Calculation of net cost of acquisition

Gross cost of acquisition (6,00,000 ×187.50) 11,25,00,000

Less: CMP (18,00,000 × 50) 9,00,00,000

Net Cost of acquisition 2,25,00,000

Alternatively, Net Cost of Acquisition can also be computed as follows:

No. of shares issued to shareholders of Tall Ltd. in

the ratio of 1:3 6,00,000

Existing price of one share of Long Ltd. ₹ 180

Value of consideration paid for acquisition of Tall ₹ 10,80,00,000

Ltd.

Less: Existing Value of Tall Ltd., as a separate entity ₹ 9,00,00,000

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Net Cost of acquisition of Tall Ltd. ₹ 1,80,00,000

(iii) Calculation of gain from acquisition:

Total Earnings of Long Ltd. (₹ 12 × 30,00,000) ₹ 3,60,00,000

Total Earnings of Tall Ltd. (₹ 5 × 18,00,000) ₹ 90,00,000

Combined Earnings ₹ 4,50,00,000

PE Ratio of Long Ltd. (180/12) 15

Value of Long Ltd. after acquisition ₹ 67,50,00,000
Less: Value of two companies separately

Long Ltd. (₹ 180 × 30,00,000) ₹ 54,00,00,000

Tall Ltd. (₹50 × 18,00,000) ₹ 9,00,00,000 ₹ 63,00,00,000

Gain from Acquisition ₹ 4,50,00,000

QUESTION – 02

ABC Ltd. is intending to acquire XYZ Ltd. by way of merger and the following
information is available in respect of these companies:

ABC Ltd. XYZ Ltd.

Total Earnings (E) (in lakh) ₹ 1,200 ₹400
Number of outstanding shares (S) (in lakh) 400 200
Price earnings ratio (P/E) 8 7

(a) Determine the maximum exchange ratio acceptable to the shareholders

of ABC Ltd., if the P/E ratio of the combined firm is expected to be 8?

(b) Determine the minimum exchange ratio acceptable to the shareholders

XYZ Ltd., if the P/E ratio of the combined firm is expected to be 10?

Note: Make calculation in lakh multiples and compute ratio upto 4 decimal
points.

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(RTP May – 2021)

SOLUTION:

(a) Maximum exchange ratio acceptable to the shareholders of ABC Ltd.

Market Price of share of ABC Ltd. (₹ 3 × 8) ₹ 24

No. of Equity Shares 400 lakh
Market Capitalization of ABC Ltd. (₹ 24 × 400 lakh) ₹ 9600 lakh
Combined Earnings (₹ 1200 + ₹ 400) lakh ₹ 1600 lakh
Combined Market Capitalization (₹ 1600 lakh × 8) ₹ 12800 lakh
Market Capitalization of ABC Ltd. (₹ 24 × 400 lakh) ₹ 9600 lakh
Balance for XYZ Ltd. ₹ 3200 lakh

Let D be the no. of equity shares to be issued to XYZ Ltd. then,

₹ 3,200 lakh
1600 lakh =D
×8
D +400

D = 133.333 lakh Shares

Exchange Ratio = 133.333 / 200 = 0.6666:1

(b) Minimum exchange ratio acceptable to the shareholders of XYZ Ltd.

Market price of share of XYZ Ltd. ₹ 14.00

No. of equity shares 200 lakh
Market capitalization of XYZ Ltd. (₹ 14.00 × 200 lakh) ₹ 2800 lakh
Combined earnings (₹ 1,200 + ₹ 400) lakh ₹ 1600 lakh
Combined market capitalization (₹ 1600 lakh × 10) ₹ 16000 lakh
Balance for ABC Ltd. ₹ 13200 lakh

Let D be the no. of equity shares to be issued to XYZ Ltd. then,

₹ 2,800 lakh
1600 lakh =D
× 10
D +400

D = 84.8485 lakh Shares

Exchange Ratio = 84.8485/200 = 0.4242:1

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QUESTION – 03

ABC Ltd. is a company operating in the software industry. It is considering the

acquisition of XYZ Ltd. which is also into software industry. The following
information are available for the companies:

ABC Ltd. XYZ Ltd.

Earnings after tax (₹) 9,00,000 2,40,000
Number of equity shares 1,50,000 60,000
P/E ratio (no. of times) 14 10

ABC Ltd. is planning to offer a premium of 25% over the market price of XYZ
Ltd. Required:

(i) What is the swap ratio based on current market price?

(ii) Find the number of shares to be issued by ABC Ltd. to the shareholders
of XYZ Ltd.

(iii) Compute the new EPS of ABC Ltd. after merger and comment on the
impact of merger.

(iv) Determine the market price of the share when P/E ratio remains
unchanged.

(v) Compute the market price when P/E declines to 12 and comment on the
results. Figures are to be rounded off to 2 decimals.

(Exam November – 2019)

SOLUTION:

Computation of Market Price of the Shares

Particulars ABC Ltd. XYZ Ltd.

EAT ₹ 9,00,000 ₹ 2,40,000
No. of Equity Shares 1,50,000 60,000
EPS ₹ 6.00 ₹ 4.00
P/E Ratio 14.00 10.00
Market Price Per Share ₹ 84.00 ₹ 40.00

(i) Exchange Ratio based on Current Market Price

Exchange ratio 40 × 1.25 : 84 = 50 : 84

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that is 50 shares of ABC Ltd. for every 84 shares of XYZ Ltd. or

25 shares of ABC Ltd. for every 42 shares of XYZ Ltd.

(ii) No. of Shares to be issued

50
= 0.596 i.e. 0.60 share for 1 share of XYZ Ltd.
84

60,000 × 0.60 = 36,000

(iii) Computation of EPS and Impact after Merger

Total earnings after merger ₹ 11,40,000

No. of shares post merger (1,50,000 + 36,000) 1,86,000
EPS 6.13

Impact on EPS

For ABC Ltd.’s shareholders ₹

EPS before merger 6.00
EPS after merger 6.13
Increase in EPS 0.13
For XYZ Ltd.’s Shareholders
EPS before merger 4.00
Equivalent EPS after the merger (6.13×0.6) 3.68
Decrease in EPS 0.32

Thus, with the proposed merger while the EPS for shareholders of ABC
Ltd. will improve and EPS for shareholders of XYZ Ltd. will be decreased.

(iv) Market Price of Share after Merger

New EPS ₹ 6.13

PE Ratio 14
New Price of the Share (₹ 6.13 × 14) ₹ 85.82

(v) New Market Price of share if PE Ratio falls to 12

New EPS ₹ 6.13

PE Ratio 12
New Price of the Share (₹ 6.13 × 12) ₹ 73.56

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Gain/ loss from the Merger to the shareholders of ABC Ltd.

Market Price of Share ₹ 73.56

Market Price of Share before Merger ₹ 84.00
Loss from the merger (per share) ₹ 10.44

Gain/ loss from the Merger to the shareholders of XYZ Ltd.

Equivalent Market Price of Share (73.56 × 0.6) ₹ 44.14

Market Price of Share before Merger ₹ 40.00
Gain from the merger (per share) ₹ 4.14

Comments: With the merger there is a decrease in the market price of

shares for the shareholders of ABC Ltd and a gain for shareholders of
XYZ Ltd.

QUESTION – 04

B Ltd. Wants to acquire S Ltd. and has offered a swap ratio of 2:3 (2 shares for
every 3 share of S Ltd.). Following information is available:

Particulars B Ltd. S Ltd.

Profit after tax (in ₹) 21,00,000 4,50,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS (₹) 3.5 2.5
PE Ratio 10 times 7 times
Price quoting per share on BSE before the merger
announcement (₹) 35.00 17.50

Required:

(i) The number of equity shares to be issued by B Ltd. for acquisition of S

Ltd.

(ii) What is the EPS of B Ltd. after the acquisition?

(iii) Determine the equivalent earnings per share of S Ltd. and calculate per
share gain or loss to shareholders of S Ltd.

(iv) What is the expected market price per share of B Ltd. after the
acquisition, assuming its PE Multiple remains unchanged?

(v) Determine the market value of the merged firm.

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(vi) After the announcement of merger, price of shares of S Ltd. rose by 10%
on BSE. Mr. X, an investor, having 10,000 shares of S Ltd. is having
another investment opportunity, which yields annual return of 14% is
seeking your advice whether he needs to offload the shares in the market
or accept the shares from B Ltd.

(RTP May – 2022)

SOLUTION:

(i) The number of shares to be issued by B Ltd.:

The exchange ratio is 2:3

2
So, new shares = 1,80,000 × = 1,20,000 shares.
3

(ii) EPS of B Ltd. after acquisition:

Total Earnings (₹ 21,00,000 + ₹ 4,50,000) ₹25,50,000

No. of Shares (6,00,000 + 1,20,000) 7,20,000

EPS (₹ 25,50,000/7,20,000) ₹ 3.5416 or 3.54

(iii) Equivalent EPS of S Ltd. and gain/loss to shareholders:

2 ₹ 2.36
Equivalent EPS of S Ltd. (₹ 3.54 × )
3
Less: EPS before merger 2.50
Loss (0.14)

(iv) New market price of B Ltd. (P/E remaining unchanged) :

Present P/E Ratio of B Ltd. 10 times

Expected EPS after merger ₹ 3.54
Expected Market Price (₹3.54 × 10) ₹ 35.40

(v) Market value of merged firm:

Total number of shares 7,20,000

Expected market price ₹ 35.40
Total value (7,20,000 × 35.40) ₹ 2,54,88,000

(vi)

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a) Equivalent EPS of S Ltd. ₹ 2.36

b) BSE price per share before merger announcement ₹ 17.50
c) After the merger announcement 10% increase in price ₹ 1.75
of shares.
d) Present market price of share (b + c) ₹ 19.25
e) Return on market price per share (a/d) 12.26

As Mr. X is having another opportunity to earn 14% and expected return on S

Ltd.‘s share is 12.26%, it is advisable to offload in market.

QUESTION – 05

Cauliflower Limited is contemplating acquisition of Cabbage Limited.

Cauliflower Limited has 5 lakh shares having market value of ₹ 40 per share
while Cabbage Limited has 3 lakh shares having market value of ₹ 25 per
share. The EPS for Cabbage Limited and Cauliflower Limited are ₹ 3 per share
and ₹ 5 per share respectively. The managements of both the companies are
discussing two alternatives for exchange of shares as follows:

(i) In proportion to relative earnings per share of the two companies.

(ii) 1 share of Cauliflower Limited for two shares of Cabbage Limited.

Required:

(a) Calculate the EPS after merger under both the alternatives.

(b) Show the impact on EPS for the shareholders of the two companies
under both the alternatives.

(PM & RTP November – 2021)

SOLUTION:

(i) Exchange ratio in proportion to relative EPS

Company Existing No. of EPS Total

shares earnings
Cauliflower Ltd. 5,00,000 5.00 25,00,000
Cabbage Ltd. 3,00,000 3.00 9,00,000
Total earnings 34,00,000

No. of shares after merger 5,00,000 + 1,80,000 = 6,80,000

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3.00
Note: 1,80,000 may be calculated as = 3,00,000 × 5.00

34,00,000
EPS for Cauliflower Ltd. after merger = = 5.00
6,80,000

Impact on EPS

₹
Cauliflower Ltd. ‗s shareholders
EPS before merger 5.00
EPS after merger 5.00
Increase/ Decrease in EPS 0.00
Cabbage Ltd. ‘s shareholders
EPS before merger 3.00
EPS after the merger 5.00 × 3/5 3.00
Increase/ Decrease in EPS 0.00

(ii) Merger effect on EPS with share exchange ratio of 1 : 2

Total earnings after merger ₹ 34,00,000

No. of shares post merger
5,00,000 +1,50,000 (0.5 × 3,00,000) 6,50,000
EPS (34,00,000 ÷ 6,50,000) ₹ 5.23

Impact on EPS

₹
Cauliflower Ltd. ‗s shareholders
EPS before merger 5.00
EPS after merger 5.23
Increase/ Decrease in EPS 0.23
Cabbage Ltd. ‘s shareholders
EPS before merger 3.000
EPS after the merger 5.23 × 0.5 2.615
Decrease in EPS 0.385

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QUESTION – 06

C Ltd. & D Ltd. are contemplating a merger deal in which C Ltd. will acquire D
Ltd. The relevant information about the firms are given as follows:

C Ltd. D Ltd.
Total Earnings (E) (in millions) ₹ 96 ₹ 30
Number of outstanding shares (S) (in millions) 20 14
Earnings per share (EPS) (₹) 4.8 2.143
Price earnings ratio (P/E) 8 7
Market Price per share (P) (₹) 38.4 15

(i) What is the maximum exchange ratio acceptable to the shareholders of C

Ltd., if the P/E ratio of the combined firm is 7?

(ii) What is the minimum exchange ratio acceptable to the shareholders of D

Ltd., if the P/E ratio of the combined firm is 9?

(Exam November – 2018)

SOLUTION:

(i) Maximum exchange ratio acceptable to the shareholders of C Ltd.

Market Price of share of C Ltd. (₹ 4.8 × 8) ₹ 38.40

No. of Equity Shares 20 Million
Market Capitalization of C Ltd. (₹ 38.40 × 20 Million) ₹ 768 Million
Combined Earnings (₹ 96 + ₹ 30) Million ₹ 126 Million
Combined Market Capitalization (₹ 126 Million × 7) ₹ 882 Million
Market Capitalization of C Ltd. (₹ 38.40 × 20 Million) ₹ 768 Million
Balance for D Ltd. ₹ 114 Million

Let D be the no. of equity shares to be issued to D Ltd. then,

₹ 114 Million
126 Million =D
×7
D + 20

D = 2.96875 Million Shares

Exchange Ratio = 2.96875 / 14 = 0.212:1

(ii) Minimum exchange ratio acceptable to the shareholders of D Ltd.

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Market Price of share of D Ltd. ₹ 15.00

No. of Equity Shares 14 Million
Market Capitalization of D Ltd. (₹ 15.00 × 14 Million) ₹ 210 Million
Combined Earnings (₹ 96 +₹ 30) Million ₹ 126 Million
Combined Market Capitalization (₹ 126 Million × 9) ₹ 1134 Million
Balance for C Ltd ₹ 924 Million

Let D be the no. of equity shares to be issued to D Ltd. then,

₹ 210 Million
126 Million =D
D +20
×9

D = 4.54545 Million Shares

Exchange Ratio = 4.54545/14 = 0.325:1

QUESTION – 07

A Ltd., a listed company, is considering merger of B Ltd. which is also a listed

company, with itself by means of a stock swap (exchange). B Ltd. has agreed to
a plan under which A Ltd. will offer the current market value of B Ltd.'s shares.

Additional Information:

Particulars A Ltd. B Ltd.

Earnings after tax (₹) 10,00,000 2,50,000
Number of shares outstanding 4,00,000 2,00,000
Current market price (₹) per share 50 20

On the basis of above information, you are required to calculate the following:

(i) What is the pre-merger Earnings per Share (EPS) and P/E ratio of both
the companies?

(ii) If B Ltd.'s P/E is 10, what is its current market price per share? What is
the exchange ratio? What will A Ltd.'s post-merger EPS be?

(iii) What must the exchange ratio be for A Ltd.'s Pre-merger and Post-merger
EPS to be the same?

(Exam November – 2019)

SOLUTION:

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(i) Before Merger

A Ltd. B Ltd.
Earning after tax (₹) 10,00,000 2,50,000
No. of shares outstanding 4,00,000 2,00,000
EPS ₹ 2.50 ₹ 1.25
Current Market Price/Share ₹ 50 ₹ 20
P/E Ratio 20 16

(ii) If B Ltd.’s P/E Ratio is 10

Then, it‘s Current Market Price = 10 × ₹ 1.25 = ₹ 12.50

Exchange Ratio = 12.50 : 50 i.e. 1 share of A Ltd. for every 4 shares of B

Ltd.

No. of shares to be issued = 50,000

A Ltd. Post-Merger EPS

Post-Merger Earning (10,00,000 + 2,50,000) ₹ 12,50,000

No. of Equity Shares after Merger (4,00,000 + 50,000) 4,50,000

EPS ₹ 2.78

(iii) Calculation of Exchange Ratio for A Ltd.’s pre-merger and post-

merger EPS to be the same

= Total earnings/Pre-merger EPS of A Ltd.

= ₹ 12,50,000/₹ 2.50 = 5,00,000 shares

Now, number of shares to be issue to B Ltd.

= 5,00,000 – 4,00,000 = 1,00,000 shares

Therefore, the share exchange ratio is 1,00,000 : 2,00,000 or 1:2. It

means for every two shares in B Ltd., one share should be issued from A
Ltd.

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QUESTION – 08

Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower Industries

Ltd. (SIL). The particulars of 2 companies are given below:

Particulars Reliable Sunflower

Industries Ltd Industries Ltd.
Earnings After Tax (EAT) ₹ 20,00,000 ₹ 10,00,000
Equity shares O/s 10,00,000 10,00,000
Earnings per share (EPS) 2 1
PE Ratio (Times) 10 5

Required:

(i) What is the market value of each Company before merger?

(ii) Assume that the management of RIL estimates that the shareholders of
SIL will accept an offer of one share of RIL for four shares of SIL. If there
are no synergic effects, what is the market value of the Post-merger RIL?
What is the new price per share? Are the shareholders of RIL better or
worse off than they were before the merger?

(iii) Due to synergic effects, the management of RIL estimates that the
earnings will increase by 20%. What are the new post-merger EPS and
Price per share? Will the shareholders be better off or worse off than
before the merger?

(Study Material & PM)

SOLUTION:

(i) Market value of Companies before Merger

Particulars RIL SIL

EPS ₹2 Re.1
P/E Ratio 10 5
Market Price Per Share ₹ 20 ₹5
Equity Shares 10,00,000 10,00,000
Total Market Value 2,00,00,000 50,00,000

(ii) Post Merger Effects on RIL

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₹
Post-merger earnings 30,00,000
Exchange Ratio (1:4)
No. of equity shares o/s (10,00,000 + 2,50,000) 12.50,000
EPS: 30,00,000/12,50,000 2.4
PE Ratio 10
Market Value 10 × 2.4 24
Total Value (12,50,000 × 24) 3,00,00,000

Gains From Merger: ₹

Post-Merger Market Value of the Firm 3,00,00,000
Less: Pre-Merger Market Value
RIL 2,00,00,000
SIL 50,00,000 2,50,00,000
Total gains from Merger 50,00,000

Apportionment of Gains between the Shareholders:

Particulars RIL (₹) SIL (₹)

Post-Merger Market Value:
10,00,000 × 24 2,40,00,000 --
2,50,000 × 24 - 60,00,000
Less: Pre-Merger Market Value 2,00,00,000 50,00,000
Gains from Merger: 40,00,000 10,00,000

Thus, the shareholders of both the companies (RIL + SIL) are better off
than before

(iii) Post-Merger Earnings:

Increase in Earnings by 20%

New Earnings: ₹ 30,00,000 × (1 + 0.20) ₹ 36,00,000

No. of equity shares outstanding: 12,50,000

EPS (₹ 36,00,000/12,50,000) ₹ 2.88

PE Ratio 10

Market Price Per Share: = ₹ 2.88 × 10 ₹ 28.80

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∴ Shareholders will be better-off than before the merger situation.

QUESTION – 09

R Ltd. and S Ltd. are companies that operate in the same industry. The
financial statements of both the companies for the current financial year are as
follows:
Balance Sheet
Particulars R. Ltd. (₹) S. Ltd (₹)
Equity & Liabilities
Shareholders Fund
Equity Capital (₹ 10 each) 20,00,000 16,00,000
Retained earnings 4,00,000
Non-current Liabilities
16% Long term Debt 10,00,000 6,00,000
Current Liabilities 14,00,000 8,00,000
Total 48,00,000 30,00,000
Assets
Non-current Assets 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
Total 48,00,000 30,00,000

Income Statement

Particulars R. Ltd. (₹) S. Ltd. (₹)

A. Net Sales 69,00,000 34,00,000
B. Cost of Goods sold 55,20,000 27,20,000
C. Gross Profit (A-B) 13,80,000 6,80,00
D. Operating Expenses 4,00,000 2,00,000
E. Interest 1,60,000 96,000
F. Earnings before taxes [C-(D + E)] 8,20,000 3,84,000
G. Taxes @ 35% 2,87,000 1,34,400
H. Earnings After Tax (EAT) 5,33,000 2,49,600

Additional Information:

No. of equity shares 2,00,000 1,60,000

Dividend payment Ratio (D/P) 20% 30%

Market price per share ₹ 50 ₹ 20

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Assume that both companies are in the process of negotiating a merger

through exchange of Equity shares:

You are required to:

(i) Decompose the share price of both the companies into EPS & P/E
components. Also segregate their EPS figures into Return On Equity
(ROE) and Book Value/Intrinsic Value per share components.

(ii) Estimate future EPS growth rates for both the companies.

(iii) Based on expected operating synergies, R Ltd. estimated that the

intrinsic value of S Ltd. Equity share would be ₹ 25 per share on its
acquisition. You are required to develop a range of justifiable Equity
Share Exchange ratios that can be offered by R Ltd. to the shareholders
of S Ltd. Based on your analysis on parts (i) and (ii), would you expect
the negotiated terms to be closer to the upper or the lower exchange ratio
limits and why?

(Study Material & PM)

SOLUTION:

(i) Determination of EPS, P/E Ratio, ROE and BVPS of R Ltd. & S Ltd.

R Ltd. S Ltd.
EAT (₹) 5,33,000 2,49,600
N 200000 160000
EPS (EAT ÷ N) 2.665 1.56
Market Price Per Share 50 20
PE Ratio (MPS/EPS) 18.76 12.82
Equity Fund (Equity Value) 2400000 1600000
BVPS (Equity Value ÷ N) 12 10
ROE (EAT ÷ EF) or 0.2221 0.156
ROE (EAT ÷ EF) × 100 22.21% 15.60%

(ii) Determination of Growth Rate of EPS of R Ltd.& S Ltd.

R Ltd. S Ltd.
Retention Ratio (1-D/P Ratio) 0.80 0.70
Growth Rate (ROE × Retention Ratio) or 0.1777 0.1092
Growth Rate (ROE × Retention Ratio) × 100 17.77% 10.92%

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(iii) Justifiable equity share exchange ratio

(a) Market Price Based = MPSS/MPSR = ₹20/₹ 50 = 0.40:1 (lower limit)

(b) Intrinsic Value Based = ₹ 25/ ₹ 50 = 0.50:1 (max. limit)

Since R Ltd. has higher EPS, PE, ROE and higher growth expectations
the negotiated term would be expected to be closer to the lower limit,
based on existing share price.

QUESTION – 10

BA Ltd. and DA Ltd. both the companies operate in the same industry. The
Financial statements of both the companies for the current financial year are
as follows:
Balance Sheet

Particulars BA Ltd. (₹) DA Ltd. (₹)

Current Assets 14,00,000 10,00,000
Fixed Assets (Net) 10,00,000 5,00,000
Total (₹) 24,00,000 15,00,000
Equity capital (₹10 each) 10,00,000 8,00,000
Retained earnings 2,00,000 --
14% long-term debt 5,00,000 3,00,00
Current liabilities 7,00,000 4,00,000
Total (₹) 24,00,000 15,00,000

Income Statement

Particulars BA Ltd. (₹) DA Ltd. (₹)

Net Sales 34,50,000 17,00,000
Cost of Goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
Operating expenses 2,00,000 1,00,000
Interest 70,000 42,000
Earnings before taxes 4,20,000 1,98,00
Taxes @ 50% 2,10,000 99,000
Earnings after taxes (EAT) 2,10,000 99,000
Additional Information :
No. of Equity shares 1,00,000 80,000
Dividend payment ratio (D/P) 40% 60%

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Market price per share ₹ 40 ₹15

Assume that both companies are in the process of negotiating a merger

through an exchange of equity shares. You have been asked to assist in
establishing equitable exchange terms and are required to:

(i) Decompose the share price of both the companies into EPS and P/E
components; and also segregate their EPS figures into Return on Equity
(ROE) and book value/intrinsic value per share components.

(ii) Estimate future EPS growth rates for each company.

(iii) Based on expected operating synergies BA Ltd. estimates that the

intrinsic value of DA‘s equity share would be ₹ 20 per share on its
acquisition. You are required to develop a range of justifiable equity
share exchange ratios that can be offered by BA Ltd. to the shareholders
of DA Ltd. Based on your analysis in part (i) and (ii), would you expect
the negotiated terms to be closer to the upper, or the lower exchange
ratio limits and why?

(iv) Calculate the post-merger EPS based on an exchange ratio of 0.4:1 being
offered by BA Ltd. and indicate the immediate EPS accretion or dilution,
if any, that will occur for each group of shareholders.

(v) Based on a 0.4: 1 exchange ratio and assuming that BA Ltd.‘s pre-merger
P/E ratio will continue after the merger, estimate the post-merger market
price. Also show the resulting accretion or dilution in pre-merger market
prices.

(SM, PM & Exam January – 2021)

SOLUTION:

Market price per share (MPS) = EPS × P/E ratio or P/E ratio = MPS/EPS

(i) Determination of EPS, P/E ratio, ROE and BVPS of BA Ltd. and DA
Ltd.

BA Ltd. DA Ltd.
Earnings After Tax (EAT) ₹2,10,000 ₹ 99,000
No. of Shares (N) 100000 80000
EPS (EAT/N) ₹ 2.10 ₹ 1.2375
Market price per share (MPS) 40 15

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P/E Ratio (MPS/EPS) 19.05 12.12

Equity Funds (EF) ₹ 12,00,000 ₹ 8,00,000
BVPS (EF/N) 12 10
ROE (EAT/EF) × 100 17.50% 12.37%

(ii) Estimation of growth rates in EPS for BA Ltd. and DA Ltd.

Retention Ratio (1−D/P ratio) 0.6 0.4

Growth Rate (ROE × Retention Ratio) 10.50% 4.95%

(iii) Justifiable equity shares exchange ratio

(a) Intrinsic value based = ₹ 20/₹ 40 = 0.5:1 (upper limit)

(b) Market price based =MPSDA/MPSBA = ₹ 15/₹ 40 = 0.375:1(lower limit)

Since, BA Ltd. has a higher EPS, ROE, P/E ratio and even higher EPS
growth expectations, the negotiable terms would be expected to be closer
to the lower limit, based on the existing share prices.

(iv) Calculation of Post merger EPS and its effects

Particulars BA Ltd. DA Ltd. Combined

EAT (₹) (ii) 2,10,000 99,000 3,09,000
Share outstanding (ii) 100000 80000 132000*
EPS (₹) (i)/(ii) 2.1 1.2375 2.341
EPS Accretion (Dilution) (Re.) 0.241 (0.301***)

(v) Estimation of Post merger Market price and other effects

Particulars BA Ltd. DA Ltd. Combined

EPS (₹) (ii) 2.1 1.2375 2.341
P/E Ratio (ii) 19.05 12.12 19.05
MPS (₹) (i)/(ii) 40 15 44.6
MPS Accretion (₹) 4.6 2.84***

* Shares outstanding (combined) = 100000 shares + (0.40 × 80000)

= 132000 shares

** EPS claim per old share = ₹ 2.34 × 0.4 ₹ 0.936

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EPS dilution = ₹ 1.2375 – ₹ 0.936 ₹ 0.3015

***S claim per old share (₹ 44.60 × 0.4) ₹ 17.84

Less: MPS per old share ₹ 15.00

₹ 2.84

QUESTION – 11

B Ltd. is a highly successful company and wishes to expand by acquiring other

firms. Its expected high growth in earnings and dividends is reflected in its PE
ratio of 17. The Board of Directors of B Ltd. has been advised that if it were to
take over firms with a lower PE ratio than it own, using a share-for-share
exchange, then it could increase its reported earnings per share. C Ltd. has
been suggested as a possible target for a takeover, which has a PE ratio of 10
and 1,00,000 shares in issue with a share price of ₹ 15. B Ltd. has 5,00,000
shares in issue with a share price of ₹ 12.

Calculate the change in earnings per share of B Ltd. if it acquires the whole of
C Ltd. by issuing shares at its market price of ₹12. Assume the price of B Ltd.
shares remains constant.

(SM, PM & RTP November – 2018)

SOLUTION:

Total market value of C Ltd is = 1,00,000 × 15 = ₹ 15,00,000

PE ratio (given) = 10

Therefore, earnings = ₹ 15,00,000 /10

= ₹ 1,50,000

Total market value of B Ltd. is

= 5,00,000 × ₹ 12 = ₹ 60,00,000

PE ratio (given) = 17

Therefore, earnings = ₹ 60,00,000/17

= ₹ 3,52,941

The number of shares to be issued by B Ltd.

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₹ 15,00,000 ÷ 12 = 1,25,000

Total number of shares of B Ltd = 5,00,000 + 1,25,000

= 6,25,000

The EPS of the new firm is =(₹ 3,52,941 + ₹ 1,50,000)/6,25,000

= ₹ 0.80

The present EPS of B Ltd is = ₹3,52,941/5,00,000

= ₹ 0.71

So the EPS affirm B will increase from Re. 0.71 to ₹ 0.80 as a result of
merger

QUESTION – 12

MK Ltd. is considering acquiring NN Ltd. The following information is available:

Company Earning after No. of Equity Market Value

Tax (₹) Shares Per Share (₹)
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00

Exchange of equity shares for acquisition is based on current market value as

above. There is no synergy advantage available.

(i) Find the earning per share for company MK Ltd. after merger, and

(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at a
loss.

(SM, PM & MTP October – 2020)

SOLUTION:

(i) Earning per share of company MK Ltd after merger:-

Exchange ratio 160 : 200 = 4 : 5.

that is 4 shares of MK Ltd. for every 5 shares of NN Ltd.

∴ Total number of shares to be issued = 4/5 × 3,00,000

= 2,40,000 Shares.

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∴ Total number of shares of MK Ltd. and NN Ltd.

=12,00,000 (MK Ltd.)+ 2,40,000 (NN Ltd.)

= 14,40,000 Shares

Total profit after tax = ₹ 60,00,000 MK Ltd.

= ₹ 18,00,000 NN Ltd.

= ₹ 78,00,000

∴ EPS. (Earning Per Share) of MK Ltd. after merger

₹ 78,00,000/14,40,000 = ₹ 5.42 per share

(ii) To find the exchange ratio so that shareholders of NN Ltd. would not be
at a Loss:

Present earning per share for company MK Ltd.

= ₹ 60,00,000/12,00,000 = ₹ 5.00

Present earning per share for company NN Ltd.

= ₹ 18,00,000/3,00,000 = ₹ 6.00

∴ Exchange ratio should be 6 shares of MK Ltd. for every 5 shares of NN

Ltd.

∴ Shares to be issued to NN Ltd.

= 3,00,000 × 6/5 = 3,60,000 shares

Now, total No. of shares of MK Ltd. and NN Ltd.

=12,00,000 (MK Ltd.) + 3,60,000 (NN Ltd.)

= 15,60,000 shares

∴ EPS after merger = ₹ 78,00,000/15,60,000 = ₹ 5.00 per share

Total earnings available to shareholders of NN Ltd.after merger

= 3,60,000 shares × ₹ 5.00 = ₹ 18,00,000.

This is equal to earnings prior merger for NN Ltd.

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∴ Exchange ratio on the basis of earnings per share is recommended.

QUESTION – 13

ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following
information is available in respect of the companies:

ABC Ltd. XYZ Ltd.

Number of equity shares 10,00,000 6,00,000
Earnings after tax (₹) 50,00,000 18,00,000
Market value per share (₹) 42 28

Required:

(i) What is the present EPS of both the companies?

(ii) If the proposed merger takes place, what would be the new earning per
share for ABC Ltd.? Assume that the merger takes place by exchange of
equity shares and the exchange ratio is based on the current market
price.

(iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the earnings
to members are same as before the merger takes place?

(Study Materials & PM)

SOLUTION:

(i) Earnings per share = Earnings after tax /No. of equity shares

ABC Ltd. = ₹ 50,00,000/10,00,000 = ₹ 5

XYZ Ltd. = ₹ 18,00,000 / 6,00,000 = ₹ 3

(ii) Number of Shares XYZ Limited‘s shareholders will get in ABC Ltd. based
on market value per share = ₹ 28/ 42 × 6,00,000 = 4,00,000 shares

Total number of equity shares of ABC Ltd. after merger

= 10,00,000 + 4,00,000 = 14,00,000 shares

Earnings per share after merger

= ₹ 50,00,000+18,00,000/14,00,000 = ₹ 4.86

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(iii) Calculation of exchange ratio to ensure shareholders of XYZ Ltd. to earn

the same as was before merger:

Shares to be exchanged based on EPS

= (₹ 3/₹ 5) × 6,00,000 = 3,60,000 shares

EPS after merger = (₹ 50,00,000 + 18,00,000)/13,60,000 = ₹ 5

Total earnings in ABC Ltd. available to shareholders of XYZ Ltd.

= 3,60,000 ×₹ 5 = ₹ 18,00,000.

Thus, to ensure that Earning to members are same as before, the ratio of
exchange should be 0.6 share for 1 share.

QUESTION – 14

The CEO of a company thinks that shareholders always look for EPS.
Therefore, he considers maximization of EPS as his company's objective. His
company's current Net Profits are ₹ 80.00 lakhs and P/E multiple is 10.5. He
wants to buy another firm which has current income of ₹ 15.75 lakhs & P/E
multiple of 10.

What is the maximum exchange ratio which the CEO should offer so that he
could keep EPS at the current level, given that the current market price of both
the acquirer and the target company are ₹ 42 and ₹ 105 respectively?

If the CEO borrows funds at 15% and buys out Target Company by paying
cash, how much cash should he offer to maintain his EPS? Assume tax rate of
30%.

(SM, PM & MTP – 2020)

SOLUTION:-

(i)

Acquirer Company Target Company

Net Profit ₹ 80 lakhs ₹ 15.75 lakhs
PE Multiple 10.50 10.00
Market ₹ 840 lakhs ₹ 157.50 lakhs
Capitalization ₹ 42 ₹ 105
Market Price 20 lakhs 1.50 lakhs

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No. of Shares ₹4 ₹ 10.50

EPS

Maximum Exchange Ratio 4 : 10.50 or 1 : 2.625

Thus, for every one share of Target Company 2.625 shares of Acquirer
Company.

(ii) Let X lakhs be the amount paid by Acquirer company to Target

Company. Then to maintain same EPS i.e. ₹ 4 the number of shares to
be issued will be:

80 lakhs +15.75 lakhs − 0.70 ×15%×X

=4
20 lakhs
95.75 − 0.105 X
=4
20

X = ₹ 150 lakhs

Thus, ₹ 150 lakhs shall be offered in cash to Target Company to

maintain same EPS.

QUESTION – 15

A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares
for every one share of T Ltd.). Following information is provided:

A Ltd. T. Ltd.
Profit after tax ₹18,00,000 ₹3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS ₹3 ₹2
PE Ratio 10 times 7 times
Market price per share ₹30 ₹14

Required:

(i) The number of equity shares to be issued by A Ltd. for acquisition of T

Ltd.

(ii) What is the EPS of A Ltd. after the acquisition?

(iii) Determine the equivalent earnings per share of T Ltd.

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(iv) What is the expected market price per share of A Ltd. after the
acquisition, assuming its PE multiple remains unchanged?

(v) Determine the market value of the merged firm.

(Study Materials & PM)

SOLUTION:-

(i) The number of shares to be issued by A Ltd.:

The Exchange ratio is 0.5

So, new Shares = 1,80,000 × 0.5 = 90,000 shares.

(ii) EPS of A Ltd. After a acquisition:

Total Earnings (₹ 18,00,000 +₹ 3,60,000) ₹ 21,60,000

No. of Shares (6,00,000 + 90,000) 6,90,000

EPS (₹ 21,60,000)/6,90,000) ₹ 3.13

(iii) Equivalent EPS of T Ltd.:

No. of new Shares 0.5

EPS ₹ 3.13

Equivalent EPS (₹ 3.13 × 0.5) ₹ 1.57

(iv) New Market Price of A Ltd. (P/E remaining unchanged):

Present P/E Ratio of A Ltd. 10 times

Expected EPS after merger ₹ 3.13

Expected Market Price (₹ 3.13 × 10) ₹ 31.30

(v) Market Value of merged firm:

Total number of Shares 6,90,000

Expected Market Price ₹ 31.30

Total value (6,90,000 × 31.30) ₹ 2,15,97,000

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QUESTION – 16

The following information is provided related to the acquiring Firm Mark

Limited and the target Firm Mask Limited:

Firm Mark Firm Mask

Limited Limited
Earning after tax (₹) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5

Required:

(i) What is the Swap Ratio based on current market prices?

(ii) What is the EPS of Mark Limited after acquisition?

(iii) What is the expected market price per share of Mark Limited after
acquisition, assuming P/E ratio of Mark Limited remains unchanged?

(iv) Determine the market value of the merged firm.

(v) Calculate gain/loss for shareholders of the two independent companies

after acquisition

(Study Materials & PM)

SOLUTION:

Particulars Mark Ltd. Mask Ltd.

EPS ₹ 2,000 Lakhs/ 200 lakhs ₹ 400 lakhs / 100 lakhs

= ₹ 10 ₹4

Market Price ₹ 10 × 10 = ₹ 100 ₹ 4 × 5 = ₹ 20

(i) The Swap ratio based on current market price is

₹ 20/₹ 100 = 0.2 or 1 share of Mark Ltd. for 5 shares of Mask Ltd.

No. of shares to be issued = 100 lakh × 0.2 = 20 lakhs.

2000 lakhs + 400 lakhs

(ii) EPS after merger = = ₹ 10.91
200 lakhs 20 lakhs

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(iii) Expected market price after merger assuming P/E 10 times.

= ₹ 10.91 × 10 = ₹ 109.10

(iv) Market value of merged firm

= ₹ 109.10 market price × 220 lakhs shares = 240.02 crores

(v) Gain from the merger

Post merger market value of the merged firm ₹ 240.02 crores

Less: Pre-merger market value

Mark Ltd. 200 Lakhs × ₹ 100 = 200 crores

Mask Ltd. 100 Lakhs × ₹ 20 = 20 crores ₹ 220.00 crores

Gain from merger ₹ 20.02 crores

Appropriation of gains from the merger among shareholders:

Mark Ltd. Mask Ltd.

Post merger value 218.20 crores 21.82 crores
Less: Pre-merger market value 200.00 crores 20.00 crores
Gain to Shareholders 18.20 crores 1.82 crores

QUESTION – 17

XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for each
share of ABC Ltd. Relevant financial data are as follows:

Equity shares outstanding 10,00,000 4,00,000

EPS (₹) 40 28
Market price per share (₹) 250 160

(i) Illustrate the impact of merger on EPS of both the companies.

(ii) The management of ABC Ltd. has quoted a share exchange ratio of 1:1
for the merger. Assuming that P/E ratio of XYZ Ltd. will remain
unchanged after the merger, what will be the gain from merger for ABC
Ltd.?

(iii) What will be the gain/loss to shareholders of XYZ Ltd.?

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(iv) Determine the maximum exchange ratio acceptable to shareholders of

XYZ Ltd.

(SM, Exam November – 2019 & Exam December – 2021)

SOLUTION:-

Working Notes

(a)

XYZ Ltd. ABC Ltd.

Equity shares outstanding (Nos.) 10,00,000 4,00,000
EPS ₹ 40 ₹ 28
Profit ₹ 400,00,000 ₹ 112,00,000
PE Ratio 6.25 5.71
Market price per share ₹ 250 ₹ 160

(b) EPS after merger

No. of shares to be issued (4,00,000 × 0.70) 2,80,000

Exiting Equity shares outstanding 10,00,000
Equity shares outstanding after merger 12,80,000
Total Profit (₹ 400,00,000 + ₹ 112,00,000) ₹ 512,00,000
EPS ₹ 40

(i) Impact of merger on EPS of both the companies

XYZ Ltd. ABC Ltd.

EPS after Merger ₹ 40 ₹ 28
EPS before Merger ₹ 40 ₹ 28*
Nil Nil

* ₹ 40 × 0.70

(ii) Gain from the Merger if exchange ratio is 1: 1

No. of shares to be issued 4,00,000

Exiting Equity shares outstanding 10,00,000
Equity shares outstanding after merger 14,00,000
Total Profit (₹ 400,00,000 + ₹112,00,000) ₹ 512,00,000

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EPS ₹ 36.57
Market Price of Share (₹ 36.57 × 6.25) ₹ 228.56
Market Price of Share before Merger ₹ 160.00
Impact (Increase/ Gain) ₹ 68.56

(iii) Gain/ loss from the Merger to the shareholders of XYZ Ltd.

Market Price of Share ₹ 228.56

Market Price of Share before Merger ₹ 250.00
Loss from the merger (per share) ₹ 21.44

(iv) Maximum Exchange Ratio acceptable to XYZ Ltd. shareholders

₹ Lakhs
Market Value of Merged Entity (₹ 228.57 × 1400000) 3199.98
Less: Value acceptable to shareholders of XYZ Ltd. 2500.00
Value of merged entity available to shareholders of ABC 699.98
Ltd.
Market Price Per Share 250
No. of shares to be issued to the shareholders of ABC 2.80
Ltd. (lakhs)

Thus maximum ratio of issue shall be 2.80 : 4.00 or 0.70 share of

XYZ Ltd. for one share of ABC Ltd.

Alternatively, it can also be computed as follows:

₹ Lakhs
Earning after Merger (40 × 1000000 + 28 ×400000) ₹ 512 lakhs
PE Ratio of XYZ Ltd. 6.25
Market Value of Firm after Merger (512 × 6.25) ₹3200 lakhs
Existing Value of Shareholders of XYZ Ltd. ₹ 2500 lakhs
Value of Merged entity available to Shareholders of ₹ 700 lakhs
ABC Ltd.
Market Price per Share ₹ 250
Total No. of shares to be issued 2.8 lakh

Thus, maximum acceptable ratio shall be 2.80:4.00 i.e. 0.70 share

of XYZ Ltd. for one share of ABC Ltd.

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QUESTION – 18

XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.‘s shares are currently
traded at ₹ 20. It has 2,50,000 shares outstanding and its earnings after taxes
(EAT) amount to ₹ 5,00,000. ABC Ltd., has 1,25,000 shares outstanding; its
current market price is ₹ 10 and its EAT are ₹ 1,25,000. The merger will be
effected by means of a stock swap (exchange).

ABC Ltd., has agreed to a plan under which XYZ Ltd., will offer the current
market value of ABC Ltd.‘s shares:

(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both
the companies?

(ii) If ABC Ltd.‘s P/E ratio is 6.4, what is its current market price? What is
the exchange ratio? What will XYZ Ltd.‘s post-merger EPS be?

(iii) What should be the exchange ratio; if XYZ Ltd.‘s pre-merger and post-
merger EPS are to be the same?

(Study Material & PM)

SOLUTION:

(i) Pre-merger EPS and P/E ratios of XYZ Ltd. and ABC Ltd.

Particulars XYZ Ltd. ABC Ltd.

Earnings after taxes 5,00,000 1,25,000
Number of shares outstanding 2,50,000 1,25,000
EPS 2 1
Market Price per share 20 10
P/E Ratio (times) 10 10

(ii) Current Market Price of ABC Ltd. if P/E ratio is 6.4 = ₹ 1 × 6.4 =₹6.40

₹ 20 ₹ 6.40
Exchange ratio = = 3.125 or = 0.32
₹ 6.40 ₹ 20

Post merger EPS of XYZ Ltd.

₹ 5,00,000 + ₹ 1,25,000
=
2,50,000 + (1,25,000/3.125)

₹ 6,25,000
= = 2.16
2,90,000

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(iii) Desired Exchange Ratio

Total number of shares in post-merged company

Post −merger earnings ₹ 6,25,000

= = = 3,12,500
Pre − merger EPS of XYZ Ltd 2

Number of shares required to be issued

= 3,12,500 – 2,50,000 = 62,500

Therefore, the exchange ratio is

62,500 : 1,25,000

₹ 62,500
= = 0.50
1,25,000

QUESTION – 19

Following information is provided relating to the acquiring company Mani Ltd.

and the target company Ratnam Ltd:

Mani Ltd. Ratnam Ltd.

Earnings after tax (₹ lakhs) 2,000 4,000

No. of shares outstanding (lakhs) 200 1,000

P/E ratio (No. of times) 10 5

Required:

(i) What is the swap ratio based on current market prices?

(ii) What is the EPS of Mani Ltd. after the acquisition?

(iii) What is the expected market price per share of Mani Ltd. after the
acquisition, assuming its P/E ratio is adversely affected by 10%?

(iv) Determine the market value of the merged Co.

(v) Calculate gain/loss for the shareholders of the two independent entities,
due to the merger.

(SM, RTP – November – 2019)

SOLUTION:-

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(i) SWAP ratio based on current market prices:

EPS before acquisition:

Mani Ltd. : ₹2,000 lakhs / 200 lakhs: ₹ 10

Ratnam Ltd.: ₹4,000 lakhs / 1,000 lakhs: ₹4

Market price before acquisition:

Mani Ltd.: ₹10 × 10 ₹ 100

Ratnam Ltd.: ₹ 4 × 5 ₹ 20

SWAP ratio: 20/100 or 1/5 i.e. 0.20

(ii) EPS after acquisition:

₹ 2,000 + 4,000 Lakhs

= ₹ 15.00
200+200 Lakhs

(iii) Market Price after acquisition:

EPS after acquisition : ₹ 15.00

P/E ratio after acquisition 10 × 0.9 9

Market price of share (₹ 15 × 9) ₹ 135.00

(iv) Market value of the merged Co.:

₹135 × 400 lakhs shares ₹ 540.00 Crores

or ₹ 54,000 Lakhs

(v) Gain/loss per share:

₹ Crore

Mani Ltd. Ratnam Ltd.

Total value before Acquisition 200 200

Value after acquisition 270 270

Gain (Total) 70 70

No. of shares (pre-merger) (lakhs) 200 1,000

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Gain per share (₹) 35 7

QUESTION – 20

You have been provided the following Financial data of two companies:

Krishna Ltd. Rama Ltd.

Earnings after taxes ₹ 7,00,000 ₹ 10,00,000
No. of Equity shares(outstanding) 2,00,000 4,00,000
EPS 3.5 2.5
P/E ratio 10 times 14 times
Market price per share ₹ 35 ₹ 35

Company Rama Ltd. is acquiring the company Krishna Ltd., exchanging its
shares on a one-to-one basis for company Krishna Ltd. The exchange ratio is
based on the market prices of the shares of the two companies.

Required:

(i) What will be the EPS subsequent to merger?

(ii) What is the change in EPS for the shareholders of companies Rama Ltd.
and Krishna Ltd.?

(iii) Determine the market value of the post-merger firm. PE ratio is likely to
remain the same.

(iv) Ascertain the profits accruing to shareholders of both the companies.

(Study Material & PM)

SOLUTION:

(i) Exchange Ratio 1:1

New Shares to be issued 2,00,000

Total shares of Rama Ltd. (4,00,000 + 2,00,000) 6,00,000

Total earnings (₹ 10,00,000 + ₹ 7,00,000) ₹ 17,00,000

New EPS (₹ 17,00,000/6,00,000) ₹ 2.83

(ii) Existing EPS of Rama Ltd. ₹ 2.50

Increase in EPS of Rama Ltd (₹ 2.83 – ₹ 2.50) ₹ 0.33

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Existing EPS of Krishna Ltd. ₹ 3.50

Decrease in EPS of Krishna Ltd. (₹ 3.50 – ₹ 2.83) ₹ 0.67

(iii) P/E ratio of new firm (expected to remain same) 14 times

New market price (14 ×₹ 2.83) ₹ 39.62

Total No. of Shares 6,00,000

Total market Capitalization (6,00,000 ×₹ 39.62) ₹ 2,37,72,000

Existing market capitalization

(₹ 70,00,000 +₹ 1,40,00,000) ₹ 2,10,00,000

Total gain ₹ 27,72,000

(iv)

Rama Ltd. Krishna Ltd Total

No. of shares after merger 4,00,000 2,00,000 6,00,000
Market price ₹ 39.62 ₹ 39.62 ₹ 39.62
Total Mkt. Values ₹ 1,58,48,000 ₹ 79,24,000 ₹ 2,37,72,000
Existing Mkt. values ₹ 1,40,00,000 ₹ 70,00,000 ₹ 2,10,00,000
Gain to share holders ₹ 18,48,000 ₹ 9,24,000 ₹ 27,72,000

or ₹ 27,72,000 ÷ 3 = ₹ 9,24,000 to Krishna Ltd. and ₹ 18,48,000 to Rama

Ltd. (in 2 : 1 ratio)

QUESTION – 21

M Co. Ltd. is studying the possible acquisition of N Co. Ltd., by way of merger.
The following data are available in respect of the companies:

Particulars M Co. Ltd. N Co. Ltd.

Earnings after tax (₹) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share (₹) 200 160

(i) If the merger goes through by exchange of equity and the exchange ratio
is based on the current market price, what is the new earning per share
for M Co. Ltd.?

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(ii) N Co. Ltd. wants to be sure that the earnings available to its
shareholders will not be diminished by the merger. What should be the
exchange ratio in that case?

(Study Material & PM)

SOLUTION:

(i) Calculation of new EPS of M Co. Ltd.

No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd.

= 4,00,000 shares × ₹ 160/₹ 200 = 3,20,000 shares

Total no. of shares in M Co. Ltd. after acquisition of N Co. Ltd.

= 16,00,000 + 3,20,000 = 19,20,000

Total earnings after tax [after acquisition]

= 80,00,000 + 24,00,000 = 1,04,00,000

₹ 1,04,00,000
EPS = = ₹ 5.42
19,20,000 equity shares

(ii) Calculation of exchange ratio which would not diminish the EPS of N Co.
Ltd. after its merger with M Co. Ltd.

Current EPS:

₹ 80,00,000
M Co. Ltd. = =₹5
16,00,000 equity shares

₹ 24,00,000
N Co. Ltd. = =₹6
4 00,000 equity shares

Exchange ratio = 6/5 = 1.20

No. of new shares to be issued by M Co. Ltd. to N Co. Ltd.

= 4,00,000 × 1.20 = 4,80,000 shares

Total number of shares of M Co. Ltd. after acquisition

= 16,00,000 + 4,80,000 = 20,80,000 shares

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₹ 1,04,00,000
EPS [after merger] = =₹5
20,80,000 shares

Total earnings in M Co. Ltd. available to new shareholders of N Co. Ltd. =

4,80,000 × ₹ 5 = ₹ 24,00,000

Recommendation: The exchange ratio (6 for 5) based on market shares

is beneficial to shareholders of 'N' Co. Ltd.

QUESTION – 22

Longitude Limited is in the process of acquiring Latitude Limited on a share

exchange basis. Following relevant data are available:

Longitude Latitude
Limited Limited
Profit after Tax (PAT) ₹ in Lakhs 120 80
Number of Shares Lakhs 15 16
Earning per Share (EPS) ₹ 8 5
Price Earnings Ratio (P/E Ratio) 15 10
(Ignore Synergy)

You are required to determine:

(i) Pre-merger Market Value per Share, and

(ii) The maximum exchange ratio Longitude Limited can offer without the
dilution of

(1) EPS and

(2) Market Value per Share Calculate Ratio/s up to four decimal

points and amounts and number of shares up to two decimal
points.

(Study Material & PM)

SOLUTION:-

(i) Pre Merger Market Value of Per Share

P/E Ratio × EPS

Longitude Ltd. ₹ 8 × 15 = ₹ 120.00

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Latitude Ltd. ₹ 5 × 10 = ₹ 50.00

(ii) (1) Maximum exchange ratio without dilution of EPS

Pre Merger PAT of Longitude Ltd. ₹ 120 Lakhs

Pre Merger PAT of Latitude Ltd. ₹ 80 Lakhs
Combined PAT ₹ 200 Lakhs
Longitude Ltd. ‘s EPS ₹8
Maximum number of shares of Longitude after 25 Lakhs
merger (₹ 200 lakhs/₹ 8)
Existing number of shares 15 Lakhs
Maximum number of shares to be exchanged 10 Lakhs

Maximum share exchange ratio 10:16 or 5:8

(2) Maximum exchange ratio without dilution of Market Price Per Shar

PreMerger Market Capitalization of Longitude Ltd. (₹

120 × 15 Lakhs) ₹ 1800 Lakhs
Pre Merger Market Capitalization of Latitude Ltd. (₹ 50
× 16 Lakhs) ₹ 800 Lakhs
Combined Market Capitalization ₹ 2600 Lakhs
Current Market Price of share of Longitude Ltd. ₹ 120
Maximum number of shares to be exchanged of 21.67 Lakhs
Longitude (surviving company) (₹ 2600 Lakhs/₹ 120)
Current Number of Shares of Longitude Ltd. 15.00 Lakhs
Maximum number of shares to be exchanged (Lakhs) 6.67 Lakhs

Maximum share exchange ratio 6.67:16 or 0.4169:1

QUESTION – 23

T Ltd. and E Ltd. are in the same industry. The former is in negotiation for
acquisition of the latter. Important information about the two companies as per
their latest financial statements is given below:

T Ltd. E Ltd.
₹ 10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:

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10% Debentures (₹ Lakhs) 580 --

12.5% Institutional Loan (₹ Lakhs) -- 240
Earning before interest, depreciation and tax (EBIDAT) 400.86 115.71
(₹ Lakhs)
Market Price/share (₹) 220.00 110.00

T Ltd. plans to offer a price for E Ltd., business as a whole which will be 7
times EBIDAT reduced by outstanding debt, to be discharged by own shares at
market price.

E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based
on the market price. Tax rate for the two companies may be assumed as 30%.

Calculate and show the following under both alternatives - T Ltd.'s offer and E
Ltd.'s plan:

(i) Net consideration payable.

(ii) No. of shares to be issued by T Ltd.

(iii) EPS of T Ltd. after acquisition.

(iv) Expected market price per share of T Ltd. after acquisition.

(v) State briefly the advantages to T Ltd. from the acquisition.

Note: Calculations (except EPS) may be rounded off to 2 decimals in lakhs.

(SM, PM & Exam November – 2018)

SOLUTION:

As per T Ltd.’s Offer

₹ In lakhs
(i) Net Consideration Payable
7 times EBIDAT, i.e. 7 × ₹ 115.71 lakh 809.97
Less: Debt 240.00
569.97
(ii) No. of shares to be issued by T Ltd
₹ 569.97 lakh/₹ 220 (rounded off) (Nos.) 2,59,000

(iii) EPS of T Ltd after acquisition

516.57

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Total EBIDT (₹ 400.86 lakh + ₹ 115.71 lakh) 88.00

Less: Interest (₹ 58 lakh + ₹ 30 lakh) 428.57
128.57
Less: 30% Tax 300.00
Total earnings (NPAT) 14.59 lakh
Total no. of shares outstanding (12 lakh + 2.59 lakh) 20.56
EPS (₹ 300 lakh/ 14.59 lakh)

(iv) Expected Market Price:

Pre-acquisition P/E multiple: 400.86
EBIDAT (₹ in lakhs) 58.00
Less: Interest (580 × 10/100)( ₹ in lakhs) 342.86
102.86
Less: 30% Tax (₹ in lakhs) 240.00
EAT (₹ in lakhs) 12.00
No. of shares (lakhs) ₹ 20.00
EPS
220 11
Hence, PE multiple
20
₹ 226.16
Expected market price after acquisition (₹ 20.56 ×11)

As per E Ltd’s Plan

₹ In lakhs
(i) Net consideration payable
6 lakhs shares × ₹ 110 660
(ii) No. of shares to be issued by T Ltd
₹ 660 lakhs ÷ ₹ 220 3 lakh
(iii) EPS of T Ltd after Acquisition
NPAT (as per earlier calculations) 300.00
Total no. of shares outstanding (12 lakhs + 3 lakhs) 15 lakh
Earning Per Share (EPS) ₹ 300 lakh/15 lakh ₹ 20.00
(iv) Expected Market Price (₹ 20 × 11) 220.00

(v) Advantages of Acquisition to T Ltd

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Since the two companies are in the same industry, the following
advantages could accrue:

— Synergy, cost reduction and operating efficiency.

— Better market share.

— Avoidance of competition

2. Free Float Market Capitalization & Promoters Holding

Example – 03
A Ltd. want to take over & Ltd.

A Ltd. B Ltd.

No. of shares 1,00,000 40,000

Paid up Value ₹ 10 ₹ 100

ESC ₹ 10,00,000 ₹ 4,00,000

R&S ₹ 2,00,000 ₹ 50,000

Net worth ₹ 12,00,000 ₹ 4,50,000

Net worth
BVPS ₹ 12 ₹ 11.25
No .of shares

EPS ₹5 ₹2

EAT (EPS × No. of shares) ₹ 5,00,000 ₹ 80,000

P/E Ratio 10 times 6 times

MPS (EPS × P/E Ratio) ₹ 50 ₹ 12

Market Cap. ₹ 50,00,000 ₹ 4,80,000

(No. of shares ×MPS)

Promoter‘s Holding (%) 30% 50%

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Promoter‘s Holding (No) 30,000 shares 20,000 shares

Free float market cap (%) 70% 50%

Free float market cap(shares) 70,000 shares 20,000 shares

Free float market cap (₹) 35,00,000 2,40,000

(i) Calculate Swap Ratio.

(ii) Post merger EPS.

(iii) Post Merger MPS.

(iv) Market Capitalization of A Ltd. after merger.

(v) Book Value per share after merger.

(vi) Promoter‘s holding after merger.

(vii) Free float market capitalization after merger.

QUESTION – 24

The following information is provided relating to the acquiring company E Ltd.,

and the target company H Ltd:

Particulars E Ltd. (₹) H Ltd. (₹)

Number of shares (Face value ₹ 10 each) 20 Lakhs 15 Lakhs
Market Capitalization 1000 Lakhs 1500 Lakhs
P/E Ratio (times) 10.00 5.00
Reserves and surplus in ₹ 600.00 Lakhs 330.00 Lakhs
Promoter's Holding (No. of shares) 9.50 Lakhs 10.00 Lakhs

The Board of Directors of both the companies have decided to give a fair deal to
the shareholders. Accordingly, the weights are decided as 40%, 25% and 35%
respectively for earnings (EPS), book value and market price of share of each
company for swap ratio.

Calculate the following:

(i) Market price per share, earnings per share and Book Value per share;

(ii) Swap ratio;

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(iii) Promoter's holding percentage after acquisition;

(iv) EPS of E Ltd. after acquisitions of H Ltd;

(v) Expected market price per share and market capitalization of E Ltd.;
after acquisition, assuming P/E ratio of E Ltd. remains unchanged; and

(vi) Free float market capitalization of the merged firm.

(Study Material & PM)

SOLUTION:

(i)

E Ltd. H Ltd.
Market capitalization 1000 lakhs 1500 lakhs
No. of shares 20 lakhs 15 lakhs
Market Price per share ₹ 50 ₹ 100
P/E ratio 10 5
EPS ₹5 ₹ 20
Profit ₹ 100 lakh ₹ 300 lakh
Share capital ₹ 200 lakh ₹ 150 lakh
Reserves and surplus ₹ 600 lakh ₹ 330 lakh
Total ₹ 800 lakh ₹ 480 lakh
Book Value per share ₹ 40 ₹ 32

(ii) Calculation of Swap Ratio

EPS 1 : 4 i.e. 4.0 × 40% 1.6

Book value 1 : 0.8 i.e. 0.8 × 25% 0.2

Market price 1 : 2 i.e. 2.0 × 35% 0.7

Total 2.5

Swap ratio is for every one share of H Ltd., to issue 2.5 shares of E Ltd.
Hence, total no. of shares to be issued 15 lakh × 2.5 = 37.50 lakh shares

(iii) Promoter‘s holding = 9.50 lakh shares + (10 × 2.5 = 25 lakh shares) =
34.50 lakh i.e. Promoter‘s holding % is (34.50 lakh/57.50 lakh) × 100 =
60%.

(iv) Calculation of EPS after merger

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Total No. of shares 20 lakh + 37.50 lakh = 57.50 lakh

Total Profit 100 lakh + 300 lakh 400

EPS = = = = ₹ 6.956
No .of shares 57.50 lak h 57.50

(v) Calculation of Market price and Market capitalization after merger

Expected market price EPS 6.956 × P/E 10 = ₹ 69.56

Market capitalization = ₹ 69.56 per share × 57.50 lakh shares

= ₹ 3,999.70 lakh or ₹ 4,000 lakh

(vi) Free float of market capitalization

= ₹ 69.56 per share × (57.50 lakh × 40%) = ₹ 1599.88 lakh

QUESTION – 25

The following information relating to the acquiring Company Abhiman Ltd. and
the target Company Abhishek Ltd. are available. Both the Companies are
promoted by Multinational Company, Trident Ltd. The promoter‘s holding is
50% and 60% respectively in Abhiman Ltd. and Abhishek Ltd.:

Abhiman Ltd. Swabhiman Ltd.

Share Capital (₹) 200 lakh 100 lakh
Free Reserve and Surplus (₹) 800 lakh 500 lakh
Paid up Value per share (₹) 100 10
Free float Market Capitalization (₹) 400 lakh 128 lakh
P/E Ratio (times) 10 4

Trident Ltd. is interested to do justice to the shareholders of both the

Companies. For the swap ratio weights are assigned to different parameters by
the Board of Directors as follows:

Book Value 25%

EPS (Earning per share) 50%

Market Price 25%

(a) What is the swap ratio based on above weights?

(b) What is the Book Value, EPS and expected Market price of Abhiman Ltd.
after acquisition of Abhishek Ltd. (assuming P.E. ratio of Abhiman Ltd.

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remains unchanged and all assets and liabilities of Abhishek Ltd. are
taken over at book value).

(c) Calculate:

(i) Promoter‘s revised holding in the Abhiman Ltd.

(ii) Free float market capitalization.

(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book
Value (B.V.), if after acquisition of Abhishek Ltd., Abhiman Ltd.
decided to :

(1) Issue Bonus shares in the ratio of 1 : 2; and

(2) Split the stock (share) as ₹ 5 each fully paid.

(Study Material & PM)

SOLUTION:

(a) Swap Ratio

AbhimanLtd. Abhishek Ltd.

Share Capital 200 lakh 100 lakh
Free Reserve 800 lakh 500 lakh
Total 1000 lakh 600 lakh
No. of Shares 2 lakh 10 lakh
Book Value per share ₹500 ₹ 60
Promoter‘s holding 50% 60 %
Non promoter‘s holding 50% 40 %
Free Float Market Cap. i.e. 400 lakh 128 lakh
relating to Public‘s holding
Hence Total market Cap. 800 lakh 320 lakh
No. of Shares 2 lakh 10 lakh
Market Price ₹ 400 ₹ 32
P/E Ratio 10 4
EPS 40 8
Profits (₹ 2 × 40 lakh) 80 lakh -
(₹ 8 × 10 lakh) - ₹ 80 lakh

Calculation of Swap Ratio

Book Value 1 : 0.12 i.e. 0.12 × 25% 0.03

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EPS 1 : 0.2 0.20 × 50% 0.10

Market Price 1 : 0.08 0.08 × 25% 0.02

Total 0.15

Swap ratio is for every one share of Abhishek Ltd., to issue 0.15 shares of
Abhiman Ltd. Hence total no. of shares to be issued.

10 Lakh × 0.15 = 1.50 lakh shares

(b) Book Value, EPS & Market Price

Total No of Shares 2 Lakh + 1.5 Lakh = 3.5 Lakh

Total Capital ₹ 200 Lakh + ₹ 150 Lakh = ₹ 350 Lakh

Reserves ₹ 800 Lakh + ₹ 450 Lakh = ₹ 1,250 Lakh

₹ 350 Lakh + ₹ 1,250 Lakh

Book Value = ₹ 457.14 per share
3.5 Lakh

Total Profit ₹ 80 Lakh + ₹ 80 Lakh ₹ 160 Lakh

EPS = =
No .of Share 3.5 Lakh 3.5

= ₹ 45.17

Expected Market Price EPS(₹ 45.71) × P/E Ratio (10) = ₹ 457.10

(c) (i) Promoter‘s holding

Promoter‘s Revised Abhiman 50% i.e. 1.00 Lakh shares

Holding Abhishek 60% i.e. 0.90 Lakh shares

Total 1.90 Lakh shares

Promoter‘s % = 1.90/3.50 × 100 = 54.29%

(ii) Free Float Market Capitalization

Free Float Market = (3.5 Lakh – 1.9 Lakh) × ₹ 457.10

Capitalization = ₹ 731.36 Lakh

(iii) (a) & (b)

Revised Capital ₹ 350 Lakh + ₹ 175 Lakh = ₹ 525 Lakh

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No. of shares before

Split (F.V ₹ 100) 5.25 Lakh

No. of Shares after

Split (F.V. ₹ 5 ) 5.25 × 20 = 105 Lakh

EPS 160 Lakh / 105 Lakh = 1.523

Book Value Cap. ₹ 525 Lakh + ₹ 1075 Lakh

No. of Shares =105 Lakh

= ₹ 15.238 per share

QUESTION – 26

Abhiman Ltd. is a subsidiary of Janam Ltd. and is acquiring Swabhiman Ltd.

which is also a subsidiary of Janam Ltd. The following information is given :

Abhiman Ltd. Swabhiman Ltd.

% Shareholding of promoter 50% 60%
Share capital ₹ 200 lacs 100 lacs
Free Reserves and surplus ₹ 900 lacs 600 lacs
Paid up value per share ₹ 100 10
Free float market capitalization ₹ 500 lacs 156 lacs
Free float market capitalization 10 4

Janam Ltd., is interested in doing justice to both companies. The following

parameters have been assigned by the Board of Janam Ltd., for determining
the swap ratio:

Book value 25%

Earnings per share 50%

Market price 25%

You are required to compute

(i) The swap ratio.

(ii) The Book Value, Earning Per Share and Expected Market Price of
Swabhiman Ltd.,(assuming P/E Ratio of Abhiman remains the same and
all assets and liabilities of Swabhiman Ltd. are taken over at book value.)

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(Study Material & PM)

SOLUTION:

SWAP RATIO

Abhiman Ltd. Swabhiman Ltd.

(₹) (₹)
Share capital 200 lacs 100 lacs
Free reserves & surplus 900 lacs 600 lacs
Total 1100 lacs 700 lacs
No. of shares 2 lacs 10 lacs
Book value for share ₹ 550 ₹ 70
Promoters Holding 50% 60%
Non promoters holding 50% 40%
Free float market capitalization (Public) 500 lacs ₹ 156 lacs
Total Market Cap 1000 lacs 390 lacs
No. of shares 2 lacs 10 lacs
Market Price ₹ 500 ₹ 39
P/E ratio 10 4
EPS 50.00 ₹ 9.75

Calculation of SWAP Ratio

Book Value 1:0.1273 0.1273 × 25% 0.031825

EPS 1:0.195 0.195 × 50% 0.097500

Market Price 1:0.078 0.078 × 25% 0.019500

Total 0.148825

(i) SWAP Ratio is 0.148825 shares of Abhiman Ltd. for every share of
Swabhiman Ltd.

Total No. of shares to be issued = 10 lakh × 0.148825 = 148825 shares

(ii) Book value, EPS & Market Price.

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Total No. shares = 200000 + 148825 = 348825

Total capital = ₹200 lakh + ₹ 148.825 lac = ₹ 348.825 lac

Reserves = ₹ 900 lac + ₹ 551.175 lac = ₹ 1451.175 lac

₹ 348.825 lac + ₹ 1451.175 lac

Book value Per Share = = ₹ 516.02
3.48825 lac

or ₹ 516.02 × ₹ 0.148825 = ₹ 76.80

Total Capital ₹ 1100 lac + 700 lac

or = = = ₹ 516.02
No .of shares 348825 lac

Total Profit ₹ 100 lac + ₹ 97.50 lac

EPS = = = ₹ 56.62
No .of shares 3.48825 lac

or ₹ 56.62 × 0.148825 = ₹ 8.43

Expected market price = ₹ 56.62 × PE Ratio = ₹ 56.62 × 10 = ₹ 566.20

or ₹ 566.20 × 0.148825 = ₹ 84.26

QUESTION – 27

The following information is provided relating to the acquiring company

Efficient Ltd. and the target Company Healthy Ltd.

Efficient Ltd. Healthy Ltd.

No. of shares (F.V. ₹ 10 each) 10.00 lakhs 7.5 lakhs
Market capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus 300.00 lakhs 165.00 lakhs
Promoter‘s Holding (No. of shares) 4.75 lakhs 5.00 lakhs

Board of Directors of both the Companies have decided to give a fair deal to the
shareholders and accordingly for swap ratio the weights are decided as 40%,
25% and 35% respectively for Earning, Book Value and Market Price of share of
each company:

(i) Calculate the swap ratio and also calculate Promoter‘s holding % after
acquisition.

(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?

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(iii) What is the expected market price per share and market capitalization of
Efficient Ltd. after acquisition, assuming P/E ratio of Firm Efficient Ltd.
remains unchanged.

(iv) Calculate free float market capitalization of the merged firm.

(SM, PM & Exam November – 2020)

SOLUTION:

Swap Ratio

Efficient Ltd. Healthy Ltd.

Market capitalization 500 lakhs 759 lakhs
No. of shares 10 lakhs 7.5 lakhs
Market Price per share ₹ 50 100
P/E ratio 10 5
EPS ₹5 20
Profit ₹ 50 lakh ₹ 150 lakhs
Share capital ₹ 100 lakh 75 lakhs
Reserves and surplus ₹ 300 lakh 165 lakhs
Total ₹ 400 lakh 240 lakhs
Book Value per share ₹ 40 ₹ 32

(i) Calculation of Swap Ratio

EPS 1 : 4 i.e. 4.0 × 40% 1.6

Book value 1 : 0.8 i.e. 0.8 × 25% 0.2

Market price 1 : 2 i.e. 2.0 × 35% 0.7

Total 2.5

Swap ratio is for every one share of Healthy Ltd., to issue 2.5 shares of
Efficient Ltd. Hence, total no. of shares to be issued 7.5 lakh × 2.5 =
18.75 lakh shares.

Promoter‘s holding = 4.75 lakh shares + (5 × 2.5 = 12.5 lakh shares) =

17.25 lakh i.e. Promoter‘s holding % is (17.25 lakh/28.75 lakh) × 100 =
60%.

Calculation of EPS, Market price, Market capitalization and free float

market capitalization.

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(ii) Total No. of shares 10 lakh + 18.75 lakh = 28.75 lakh

Total capital 100 lakh + 187.5 lakh = ₹ 287.5 lakh

Total Profit 50 lakh +150 lakh 200

EPS = = = ₹ 6.956
No .of shares 28.75 lakh 28.75

(iii) Expected market price EPS 6.956 × P/E 10 = ₹ 69.56

Market capitalization = ₹ 69.56 per share × 28.75 lakh shares

= ₹ 1,999.85 lakh

(iv) Free float of market capitalization

= ₹ 69.56 per share × (28.75 lakh × 40%)

= ₹ 799.94 lakh

QUESTION – 28

The equity shares of XYZ Ltd. are currently being traded at ₹ 24 per share in
the market. XYZ Ltd. has total 10,00,000 equity shares outstanding in number;
and promoters' equity holding in the company is 40%.

PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The estimated
present value of these synergies is ₹ 80,00,000.

Further PQR feels that management of XYZ Ltd. has been over paid. With
better motivation, lower salaries and fewer perks for the top management, will
lead to savings of ₹ 4,00,000 p.a. Top management with their families are
promoters of XYZ Ltd. Present value of these savings would add ` 30,00,000 in
value to the acquisition.

Following additional information is available regarding PQR Ltd.:

Earnings per share : ₹4

Total number of equity shares outstanding : 15,00,000

Market price of equity share : ₹ 40

Required:

(i) What is the maximum price per equity share which PQR Ltd. can offer to
pay for XYZ Ltd.?

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(ii) What is the minimum price per equity share at which the management of
XYZ Ltd. will be willing to offer their controlling interest?

(Study Material & PM)

SOLUTION:

(i) Calculation of maximum price per share at which PQR Ltd. can offer to
pay for XYZ Ltd.‘s share

Market Value (10,00,000 ×₹ 24) ₹ 2,40,00,000

Synergy Gain ₹ 80,00,000
Saving of Overpayment ₹ 30,00,000
₹ 3,50,00,000

Maximum Price (₹3,50,00,000/10,00,000 ₹ 35

Alternatively, it can also be computed as follows:

Let ER be the swap ratio then,

24 × 10,00,000 + 40 × 15,00,000 + 80,00,000 + 30,00,000 40

40 =
15,00,000 + 10,00,000 × ER

ER = 0.875

40
MP = PE × EPS × ER = × ₹ 4 × 0.875 = ₹ 35
4

(ii) Calculation of minimum price per share at which the management of

XYZ Ltd.‘s will be willing to offer their controlling interest

Value of XYZ Ltd.‘s Management Holding

(40% of 10,00,000 × ₹ 24) ₹ 96,00,000
Add: PV of loss of remuneration to top management ₹ 30,00,000
₹ 1,26,00,000
No. of Shares 4,00,000
Minimum Price (₹ 1,26,00,000/4,00,000) ₹ 31.50

QUESTION – 29

Intel Ltd., promoted by a Trans National Company, is listed on the stock

exchange.

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The value of the floating stock is ₹ 45 crores. The Market Price per Share (MPS)
is ₹ 150.

The capitalization rate is 20 percent.

The promoters holding is to be restricted to 75 per cent as per the norms of

listing requirement. The Board of Directors have decided to fall in line to
restrict the Promoters‘ holding to 75 percent by issuing Bonus Shares to
minority shareholders while maintaining the same Price Earnings Ratio (P/E).

You are required to calculate:

(i) Bonus Ratio;

(ii) MPS after issue of Bonus Shares; and

(iii) Free float Market capitalization after issue of Bonus Shares

(Exam May – 2018)

SOLUTION:

1. No. of Bonus Shares to be issued:

Free Float Capitalization = ₹ 45 crore

Market Price Per Share = ₹ 150

₹ 45 crore
Shares of Minority = = 30 lacs
₹ 150

Minority Share Holding (100% − 80%*) = 20%

30 lacs
Hence Total shares = = 150 lacs
0.20

Promoters holding 80%, = 120 lacs shares

Shares remains the same, but holding % to be taken as 75%

120 lacs
Hence Total shares = = 160 lacs
0.75

Shares of Minority = 160 lacs – 120 lacs = 40 lacs

Bonus 10 lacs for 30 lacs i.e. 1 shares for 3 shares held.

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2. Market price after Bonus issue:

Let us compute PE with given ke as follows:

1 1
PE = = =5
k e 0.20

Market Price Given = ₹ 150

Hence EPS will be (₹ 150/5) = ₹ 30

Total No. of shares before bonus issue = 150 lacs

Accordingly, Total PAT shall be (₹ 30 × 150 lacs) = ₹ 4500 lacs

Total No. of shares after bonus issue = 150 lacs + 10 lacs = 160 lacs

EPS after Bonus Issue = ₹ 4500 lacs/ 160 lacs = ₹ 28.125

Market Price After Bonus Issue = ₹ 28.125 × 5 = ₹ 140.63

3. Free Float Capitalization after Bonus Issue

₹ 140.63 × 40 lacs = ₹ 5,625.20 lacs i.e. ₹ 56.252 crore

Note: Since the information regarding the promoters‘ holding is missing in the
question, above solution is based on assumption of promoter‘s holding as 80%.
However, student can assume any % other than 80% and solve the question
accordingly.

QUESTION – 30

Bank 'R' was established in 2005 and doing banking in India. The bank is
facing DO OR DIE situation. There are problems of Gross NPA (Non Performing
Assets) at 40% & CAR/CRAR (Capital Adequacy Ratio/ Capital Risk Weight
Asset Ratio) at 4%. The net worth of the bank is not good. Shares are not
traded regularly. Last week, it was traded @` 8 per share. RBI Audit suggested
that bank has either to liquidate or to merge with other bank.

Bank 'P' is professionally managed bank with low gross NPA of 5%.It has Net
NPA as 0% and CAR at 16%. Its share is quoted in the market @ ₹ 128 per
share. The board of directors of bank 'P' has submitted a proposal to RBI for
take over of bank 'R' on the basis of share exchange ratio.

The Balance Sheet details of both the banks are as follows:

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Bank ‘R’ Amt. Bank ‘P’ Amt.

in ₹ lacs In ₹ lacs
Paid up share capital (F.V. ₹ 10 each) 140 500
Reserves & Surplus 70 5,500
Deposits 4,000 40,000
Other liabilities 890 2,500
Total Liabilities 5,100 48,500
Cash in hand & with RBI 400 2,500
Balance with other banks - 2,000
Investments 1,100 15,000
Advances 3,500 27,000
Other Assets 100 2,000
Total Assets 5,100 48,500

It was decided to issue shares at Book Value of Bank 'P' to the shareholders of
Bank 'R'. All assets and liabilities are to be taken over at Book Value.

For the swap ratio, weights assigned to different parameters are as follows:

Gross NPA 30%

CAR 20%
Market price 40%
Book value 10%

(a) What is the swap ratio based on above weights?

(b) How many shares are to be issued?

(c) Prepare Balance Sheet after merger.

(d) Calculate CAR & Gross NPA % of Bank 'P' after merger.

(Practice Manual)

SOLUTION:

(a) Swap Ratio

Gross NPA 5 : 40 i.e 5/40 × 30% = 0.0375

CAR 4 : 16 i.e 4/16 × 20% = 0.0500
Market Price 8 : 128 i.e 8/128 × 40% = 0.025
Book Value Per Share 15 : 120 i.e 15/120 × 10% = 0.0125

Thus, for every 1 share of Bank ‗R‘ 0.125 share of Bank ‗P‘ shall be
issued.

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(b) No. of equity shares to be issued:

₹ 140 lac
× 0.125 1.75 lac shares
₹ 10
(c) Balance Sheet after Merger

Calculation of Capital Reserve

Book Value of Shares ₹ 210.00 lac

Less: Value of Shares issued ₹ 17.50 lac

Capital Reserve ₹ 192.50 lac

Balance Sheet

₹ lac ₹ lac
Paid up Share Capital 517.50 Cash in Hand & RBI 2900.00
Reserves & Surplus 5500.00 Balance with other banks 2000.00
Capital Reserve 192.50 Investment 16100.00
Deposits 44000.00 Advances 30500.00
Other Liabilities 3390.00 Other Assets 2100.00
53600.00 53600.00

(d) Calculation CAR & Gross NPA % of Bank ‘P’ after merger

Total Capital
CAR/CRWAR =
Risky Weighted Assets

Bank ‘R’ Bank ‘P’ Merged

CAR (Given) 4% 16%
Total Capital ₹ 210 lac ₹ 6000 lac ₹ 6210 lac
Risky Weighted Assets ₹ 5250 lac ₹ 37500 lac ₹ 42750 lac
₹ 6210 lac
Car = = 14.53%
₹ 42750 lac
Gross NPA
GNPA Ratio = × 100
Gross Deposits

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Bank ‘R’ Bank ‘P’ Merged

GNPA (Given) 0.40 0.5
GNPA R GNPA 𝑆
0.40 = 0.05=
₹ 3500 lac ₹27000 lac

Gross NPA ₹ 1400lac ₹ 1350 lac ₹ 2750 lac

QUESTION – 31

During the audit of the Weak Bank (W), RBI has suggested that the Bank
should either merge with another bank or may close down. Strong Bank (S) has
submitted a proposal of merger of Weak Bank with itself. The relevant
information and Balance Sheets of both the companies are as under:

Particulars Weak Strong Assigned

Bank (W) Bank (S) Weights (%)
Gross NPA (%) 40 5 30
Capital Adequacy Ratio (CAR) 5 16 28
Total Capital/ Risk Weight Asset
Market price per Share (MPS) 12 96 32
Book value 10
Trading on Stock Exchange Irregular Frequent

Balance Sheet
(₹ in Lakhs)
Particulars Weak Bank Strong
(W) Bank (S)
Paid up Share Capital (₹ 10 per share) 150 500
Reserves & Surplus 80 5,500
Deposits 4,000 44,000
Other Liabilities 890 2,500
Total Liabilities 5,120 52,000
Cash in Hand & with RBI 400 2,500
Balance with Other Banks - 2,000
Investments 1,100 19,000
Advances 3,500 27,000
Other Assets 70 2,000
Preliminary Expenses 50 -
Total Assets 5,120 52,500

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You are required to

(a) Calculate Swap ratio based on the above weights:

(b) Ascertain the number of Shares to be issued to Weak Bank;

(c) Prepare Balance Sheet after merger; and

(d) Calculate CAR and Gross NPA of Strong Bank after merger.

(Study Material, PM & Exam May – 2018)

SOLUTION:

(a) Swap Ratio

Gross NPA 5:40 5/40 × 30% 0.0375

CAR 5:16 5/16 × 28% 0.0875
Market Price 12:96 12/96 × 32% 0.0400
Book Value Per Share 12:120 12/120 × 10% 0.0100
0.1750

Thus, for every share of Weak Bank, 0.1750 share of Strong Bank shall
be issued.

Calculation of Book Value Per Share

Particulars Weak Strong

Bank (W) Bank (S)
Share Capital (₹ Lakhs) 150 500
Reserves & Surplus (₹ Lakhs) 80 5,500
230 6,000
Less: Preliminary Expenses (₹ Lakhs) 50 --
Net Worth or Book Value (₹ Lakhs) 180 6,000
No. of Outstanding Shares (Lakhs) 15 50
Book Value Per Share (₹) 12 120

(b) No. of equity shares to be issued:

150
× 0.1750 = 2.625 lakh shares
10

(c) Balance Sheet after Merger

Calculation of Capital Reserve

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Book Value of Shares ₹ 180.00 lac

Less: Value of Shares issued ₹ 26.25 lac

Capital Reserve ₹ 153.75 lac

Balance Sheet

₹ lac ₹ lac
Paid up Share Capital 526.25 Cash in Hand & RBI 2900.00
Reserves & Surplus 5500.00 Balance with other banks 2000.00
Capital Reserve 153.75 Investment 20100.00
Deposits 48000.00 Advances 30500.00
Other Liabilities 3390.00 Other Assets 2070.00
57570.00 57570.00

(d) Calculation CAR & Gross NPA % of Bank ‘S’ after merger

Total Capital
CAR/ CRWAR =
Risky Weighted Assets

Weak Bank Strong Bank Merged

5% 16% ₹ 6180 lac
Total Capital ₹ 180 lac ₹ 6000 lac ₹ 41100 lac
Risky Weighted Assets ₹ 3600 lac ₹ 37500 lac

6180
CAR = × 100 = 15.04%
41100

Gross NPA
GNPA Ratio = × 100
Gross Advances

Weak Bank Strong Bank Merged

GNPA (Given) 0.40 0.05
GNPA R GNPA R
0.40 = 0.40 =
₹ 3500 lac ₹ 27000 lac
Gross NPA ₹ 1400 lac ₹ 1350 lac ₹ 2750 lac

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Part II: DEMERGER

QUESTION – 32

The following information is relating to Fortune India Ltd. having two division,
viz. Pharma Division and Fast Moving Consumer Goods Division (FMCG
Division). Paid up share capital of Fortune India Ltd. is consisting of 3,000
Lakhs equity shares of Re. 1 each. Fortune India Ltd. decided to de-merge
Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2009. Details of Fortune
India Ltd. as on 31.3.2009 and of Fortune Pharma Ltd. as on 1.4.2009 are
given below:

Particulars Fortune Pharma Fortune India

Ltd. (₹) Ltd. (₹)
Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities & Provisions 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh

Board of Directors of the Company have decided to issue necessary equity

shares of Fortune Pharma Ltd. of Re. 1 each, without any consideration to the
shareholders of Fortune India Ltd. For that purpose following points are to be
considered:

(a) Transfer of Liabilities & Assets at Book value.

(b) Estimated Profit for the year 2009-10 is ₹ 11,400 Lakh for Fortune India
Ltd. &₹ 1,470 lakhs for Fortune Pharma Ltd.

(c) Estimated Market Price of Fortune Pharma Ltd. is ₹ 24.50 per share.

(d) Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is
to be expected for both the companies.

Calculate:

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1. The Ratio in which shares of Fortune Pharma are to be issued to the

shareholders of Fortune India Ltd.

2. Expected Market price of Fortune India (FMCG) Ltd.

3. Book Value per share of both the Companies immediately after

Demerger.

(Study Material & PM)

SOLUTION:

Share holders’ funds

Particulars Fortune India Fortune Fortune

Ltd. Pharma Ltd. India
(FMCG) Ltd.
Assets 70,000 25,100 44,900
Outside Liabilities 25,000 4,100 20,900
Net worth 45,000 21,000 24,000

1. Calculation of Shares of Fortune Pharma Ltd. to be issued to

shareholders of Fortune India Ltd.

Fortune Pharma Ltd.

Estimated Profit (₹ in lakhs) 1,470
Estimated market price (₹) 24.5
Estimated P/E 25
Estimated EPS (₹) 0.98
No. of shares lakhs 1,500

Hence, Ratio is 1 share of Fortune Pharma Ltd. for 2 shares of Fortune

India Ltd.

OR for 0.50 share of Fortune Pharma Ltd. for 1 share of Fortune India
Ltd.

2. Expected market price of Fortune India (FMCG) Ltd.

Fortune India (FMCG) Ltd.

Estimated Profit (₹ in lakhs) 11,400
No. of equity shares(₹ in lakhs) 3,000

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Estimated EPS (₹) 3.8

Estimated P/S 42
Estimated Market price (₹) 159.60

3. Book value per share

Fortune Fortune India (FMCG)

Pharma Ltd. Ltd.
Net worth (₹in lakhs) 21,000 24.000
No. of shares (₹ in lakhs) 1,500 3,000
Book value of shares ₹ 14 ₹8

Part III: LEVERAGE BUY OUT (LBO)

QUESTION – 33

Personal Computer Division of Distress Ltd., a computer hardware

manufacturing company has started facing financial difficulties for the last 2 to
3 years. The management of the division headed by Mr. Smith is interested in a
buyout on 1 April 2013. However, to make this buy-out successful there is an
urgent need to attract substantial funds from venture capitalists.

Ven Cap, a European venture capitalist firm has shown its interest to finance
the proposed buy-out. Distress Ltd. is interested to sell the division for ₹ 180
crore and Mr. Smith is of opinion that an additional amount of ₹ 85 crore shall
be required to make this division viable. The expected financing pattern shall
be as follows:

Source Mode Amount

(₹ Crore)
Management Equity Shares of ₹ 10 each 60.00
VenCap VC Equity Shares of ₹ 10 each 22.50
9% Debentures with attached warrant of ₹ 100 each 22.50
8% Loan 160.00
Total 265.00
The warrants can be exercised any time after 4 years from now for 10 equity
shares @ ₹ 120 per share.

The loan is repayable in one go at the end of 8 th year. The debentures are
repayable in equal annual installment consisting of both principal and interest
amount over a period of 6 years.

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Mr. Smith is of view that the proposed dividend shall not be kept more than
12.5% of distributable profit for the first 4 years. The forecasted EBIT after the
proposed buyout is as follows:

Year 2013-14 2014-15 2015-16 2016-17

EBIT (₹ Crore) 48 57 68 82

Applicable tax rate is 35% and it is expected that it shall remain unchanged at
least for 5-6 years. In order to attract VenCap, Mr. Smith stated that book
value of equity shall increase by 20% during above 4 years. Although, VenCap
has shown their interest in investment but are doubtful about the projections
of growth in the value as per projections of Mr. Smith. Further VenCap also
demanded that warrants should be convertible in 18 shares instead of 10 as
proposed by Mr. Smith.

You are required to determine whether or not the book value of equity is
expected to grow by 20% per year. Further if you have been appointed by Mr.
Smith as advisor then whether you would suggest to accept the demand of
VenCap of 18 shares instead of 10 or not.

(Practice Manual)

SOLUTION:

Working Notes

Calculation of Interest Payment on 9% Debentures

PVAF (9%, 6) = 4.486

₹ 22.50
Annual Installment = = ₹ 5.0156 crore
4.486

Year Balance Interest Installment Principal Balance

Outstanding (₹ Crore) (₹ Crore) Repayment (₹ Crore)
(₹ Crore) (₹ Crore)
1 22.5000 2.025 5.0156 2.9906 19.5094
2 19.5094 1.756 5.0156 3.2596 16.2498
3 16.2498 1.462 5.0156 3.5536 12.6962
4 12.6962 1.143 5.0156 3.8726 8.8236

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Statement showing Value of Equity

Particulars 2013-14 2014-15 2015-16 2016-17

(₹ Crore) (₹ Crore) (₹ Crore) (₹ Crore)
EBIT 48.0000 57.0000 68.0000 82.0000
Interest on 9% Debenture 2.0250 1.7560 1.4620 1.1430
Interest on 8% Loan 12.8000 12.8000 12.8000 12.8000
EBT 33.1750 42.4440 53.7380 68.0570
11.6110 14.8550 18.8080 23.8200
Tax* @ 35%
21.5640 27.5890 34.9300 44.2370
EAT
2.6955 3.4490 4.3660 5.5300
Dividend @ 12.5% of EAT* 18.8685 24.1400 30.5640 38.7070
Nil 18.8685 43.0085 73.5725
Balance b/f 18.8685 43.0085 73.5725 112.2795
Balance c/f 82.5000 82.5000 82.5000 82.5000
Share Capital 101.3685 125.5085 156.0725 194.7795

*Figures have been rounded off.

In the beginning of 2013-14 equity was ₹ 82.5000 crore which has been grown
to ₹ 194.7795 over a period of 4 years. In such case the compounded growth
rate shall be as follows:

(194.7795/82.5000)1/4 – 1 = 23.96%

This growth rate is slightly higher than 20% as projected by Mr. Smith.

If the condition of VenCap for 18 shares is accepted the expected share holding
after 4 years shall be as follows:

No. of shares held by Management 6.00 crore

No. of shares held by VenCap at the starting stage 2.25 crore
No. of shares held by VenCap after 4 years 4.05 crore
Total holding 6.30 crore

Thus, it is likely that Mr. Smith may not accept this condition of VenCap as
this may result in losing their majority ownership and control to VenCap. Mr.
Smith may accept their condition if management has future opportunity to
increase their ownership through other forms.

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Part IV: RESIDUAL

QUESTION – 34

ICL is proposing to take over SVL with an objective to diversify. ICL‘s profit
after tax (PAT) has grown @ 18 per cent per annum and SVL‘s PAT is grown @
15 per cent per annum. Both the companies pay dividend regularly. The
summarized Profit & Loss Account of both the companies are as follows:

₹ in Crores

Particulars ICL SVL

Net Sales 4,545 1,500
PBIT 2,980 720
Interest 750 25
Provisions for Tax 1,440 445
PAT 790 250
Dividends 235 125

ICL SVL
Fixed Assets
Land & Building (Net) 720 190
Plant & Machinery (Net) 900 350
Furniture & Fixtures (Net) 30 1,650 10 550
Current Assets 775 580
Less: Current Liabilities
Creditors 230 130
Overdrafts 35 10
Provision for Tax 145 50
Provision for dividends 60 470 50 240
Net Assets 1,955 890
Paid up share capital (₹ 10 per share) 250 125
Reserve and Surplus 1,050 1,300 660 785
Borrowing 655 105
Capital Employed 1,955 890

Market price share (₹) 52 75

ICL‘s Land & Buildings are stated at current prices. SVL‘s Land & Buildings
are revalued three years ago. There has been an increase of 30 per cent per
year in the value of Land & Buildings.

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SVL is expected to grow @ 18 per cent each year, after merger.

ICL‘s Management wants to determine the premium on the shares over the
current market price which can be paid on the acquisition of SVL.

You are required to determine the premium using:

(i) Net Worth adjusted for the current value of Land & Buildings plus the
estimated average profit after tax (PAT) for the next five years.

(ii) The dividend growth formula.

(iii) ICL will push forward which method during the course of negotiations?

Period (t) 1 2 3 4 5
FVIF (30%, t) 1.300 1.690 2.197 2.856 3.713
FVIF (15%,t) 1.15 2.4725 3.9938 5.7424 7.7537

(Exam November – 2020)

SOLUTION:

(i) Computation of premium (Net worth formula) : Amount ₹ in Cr.

Total Assets (Fixed assets + Current Assets) = (550 + 580) 1130

Less: Liabilities (Current Liabilities + Borrowings) = (240 + 345
105) 785
Net asset value 417.43
Current Value of Land after growing for three years @ 30%
= 190 × 2.197 190.00
Less: Book Value 227.43
Increase in the Value of land 1012.43
Adjusted NAV (785 + 227.43) 1938.43
Current Profit after Tax (@15 % for 5 years i.e. 250 × 387.69
7.7537 1400.12
Average Profit for 1 year = 1938.43/5 937.50
Total Value of Firm (1012.43 + 387.69)
462.62
Total Market Value = No of shares ×MPS = 12.50 × 75
Premium (Total Value – Market Value) 49.35%
Premium (%) = 462.62/937.50 * 100

(ii) Computation of premium (Dividend Growth Formula) :

Existing Growth Rate 0.15

DPS = 125/12.50 10
MPS 75

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Cost of Equity (D1/MP + g) = [(10 × 1.15/75) + 0.15] 0.3033

Expected growth rate after merger 0.18
Expected Market Price = 10 × [1.18/ (0.3033 – 0.18)] 95.70
Premium over current market price (95.70 – 75)/75 × 100 27.60%

Alternatively, if given figure of dividend is considered as D1 then premium

over current market price shall be computed as follows:

D
Cost of Equity P1 + g
10
+ 0.15 0.2833
75
Expected growth rate after merger
0.18
Expected market price 10.00/ (0.2833 − 0.18)
96.81
Premium over current market price
29.08%
(96.81 −75)/75 × 100

(iii) During the course of negotiations, ICL will push forward valuation based
on growth rate method as it will lead to least cash outflow.

QUESTION – 35

Mr. X, a financial analyst, intends to value the business of PQR Ltd. in terms of
the future cash generating capacity. He has projected the following after tax
cash flows :

Year : 1 2 3 4 5
Cash flows (₹ in lakh) 1,760 480 640 860 1,170

It is further estimated that beyond 5th year, cash flows will perpetuate at a
constant growth rate of 8% per annum, mainly on account of inflation. The
perpetual cash flow is estimated to be ₹ 10,260 lakh at the end of the 5th year.

Required:

(i) What is the value of the firm in terms of expected future cash flows, if the
cost of capital of the firm is 20%.

(ii) The firm has outstanding debts of ₹ 3,620 lakh and cash/bank balance
of ₹ 2,710 lakh. Calculate the shareholder value per share if the number
of outs tending shares is 151.50 lakh.

(iii) The firm has received a takeover bid from XYZ ltd. of ₹ 225 per share. Is
it a good offer?

[Given: PVIF at 20% for year 1 to Year 5: 0.833, 0.694, 0.579, 0.482, 0.402]

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(Exam November – 2019)

SOLUTION:

(i) Value of Firm

Year Cash Flow PVF PV (₹ in lakhs)

(₹ in lakhs)
1 1760 0.833 1466.08
2 480 0.694 333.12
3 640 0.579 370.56
4 860 0.482 414.52
5 1170 0.402 470.34
PV of Cash flows upto year 5 3054.62

If PV of Terminal Value is considered with the growth rate (at the end of
5th year)

10,260 (1 + 0.08) 11,080,80

= = = ₹ 92,340 lakh
0.20 − 0.08 0.12

Now, PV (at the beginning of the year)

= ₹ 92,340 × 0.402 = ₹ 37,120.68 Lakhs

So, Present Value of the firm

= ₹ 3054.62 + ₹ 37120.68 = ₹ 40175.30 Lakhs

(ii) Value per share

= Value of Firm – Value of Debt / No of shares

= (40175.30 – 3620)/151.50 = ₹ 241.29

(iii) Takeover bid of ₹ 225 per share seems to be not a good offer as it is
lesser than the intrinsic value i.e. value per share of ₹ 241.29.

QUESTION – 36

Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the
companies are dependent on the fluctuating business conditions. The following
information is given for the total value (debt + equity) structure of each of the
two companies.

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Business Condition Probability Simple Ltd. ₹ Dimple Ltd. ₹

Lacs Lacs
High Growth 0.20 820 1050
Medium Growth 0.60 550 825
Slow Growth 0.20 410 590
The current debt of Dimple Ltd. is ₹ 65 lacs and of Simple Ltd. is ₹ 460 lacs.

Calculate the expected value of debt and equity separately for the merged
entity.

(Study Material & PM)

SOLUTION:

Compute Value of Equity

Simple Ltd.
( ₹ in Lacs)
High Growth Medium Growth Slow Growth
Debit + Equity 820 550 410
Less: Debt 460 460 460
Equity 360 90 -50

Since the Company has limited liability the value of equity cannot be negative
therefore the value of equity under slow growth will be taken as zero because of
insolvency risk and the value of debt is taken at 410 lacs. The expected value of
debt and equity can then be calculated as:

Simple Ltd.
(₹ in Lacs)
High Growth Medium Slow Growth Expected
Growth Value
Prob. Value Prob. Value Prob. Value
Debt 0.20 460 0.60 460 0.20 410 450
Equity 0.20 360 0.60 90 0.20 0 126
820 550 410 576

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Dimple Ltd.
(₹ in Lacs)
High Growth Medium Slow Growth Expected
Growth Value
Prob. Value Prob. Value Prob. Value
Equity 0.20 985 0.60 760 0.20 525 758
Debt 0.20 65 0.60 65 0.20 65 65
1050 825 590 823

Expected Values
(₹ in Lacs)
Equity Debt
Simple Ltd. 126 Simple Ltd. 450
Dimple Ltd. 758 Dimple Ltd. 65
884 515

QUESTION – 37

Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the
merged entity are given below:

Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620

Earnings would have witnessed 5% constant growth rate without merger and
6% with merger on account of economies of operations after 5 years in each
case. The cost of capital is 15%.

The number of shares outstanding in both the companies before the merger is
the same and the companies agree to an exchange ratio of 0.5 shares of Yes
Ltd. for each share of No Ltd.

PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497
respectively.

You are required to:

(i) Compute the Value of Yes Ltd. before and after merger.

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(ii) Value of Acquisition and

(iii) Gain to shareholders of Yes Ltd.

(Study Material & PM)

SOLUTION:

(i) Working Notes:

Present Value of Cash Flows (CF) upto 5 years

Year CF of Yes Ltd. PVF PV of CF CF of PV of CF of

End (₹ lakhs) @15% (₹ lakhs) Merged Merged Entity
Entity (₹ lakhs)
(₹ lakhs)
1 175 0.870 152.25 400 348.00
2 200 0.756 151.20 450 340.20
3 320 0.658 210.56 525 345.45
4 340 0.572 194.48 590 337.48
5 350 0.497 173.95 620 308.14
882.44 1679.27

PV of Cash Flows of Yes Ltd. after the forecast period

CF 5 (1+g) 350 (1+0.05) 367.50

TV5 = = = = ₹ 3,675 lakhs
K e −g 0.15−0.05 0.10

PV of TV5 = ₹ 3675 lakhs × 0.497 = ₹ 1826.475 lakhs

PV of Cash Flows of Merged Entity after the forecast period

CF 5 (1+g) 620(1+0.06) 657.20

TV5 = = = = ₹ 7302.22 lakhs
K e −g 0.15−0.06 0.09

PV of TV5 = ₹ 7302.22 lakhs × 0.497 = ₹ 3629.20 lakhs

Value of Yes Ltd.

Before merger After merger

(₹ lakhs) (₹ lakhs)
PV of CF (1-5 years) 882.440 1679.27
Add: PV of TV5 1826.475 3629.20
2708.915

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(ii) Value of Acquisition

= Value of Merged Entity – Value of Yes Ltd.

= ₹ 5308.47 lakhs – ₹ 2708.915 lakhs = ₹ 2599.555 lakhs

(iii) Gain to Shareholders of Yes Ltd.

1
Share of Yes Ltd. in merged entity = ₹ 5308.47 lakhs ×
1.5
= 3538.98 lakhs

Gain to shareholder

= Share of Yes Ltd. in merged entity – Value of Yes Ltd. before merger

= ₹ 3538.98 lakhs − ₹ 2708.915 = ₹ 830.065 lakhs

QUESTION – 38

Company X is contemplating the purchase of Company Y. Company X has

3,00,000 shares having a market price of ₹ 30 per share, while Company Y has
2,00,000 shares selling at ₹ 20 per share. The EPS are ₹ 4.00 and ₹ 2.25 for
Company X and Y respectively. Managements of both companies are discussing
two alternative proposals for exchange of shares as indicated below:

(i) In proportion to the relative earnings per share of two companies.

(ii) 0.5 share of Company X for one share of Company Y (0.5 : 1).

You are required:

(i) To calculate the Earnings Per Share (EPS) after merger under two
alternatives; and

(ii) To show the impact on EPS for the shareholders of two companies under
both the alternatives.

(Practice Manual)

SOLUTION:

(i) Exchange ratio in proportion to relative EPS

(in ₹)

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Company Existing No. of EPS Total Earnings

shares
X 3,00,000 4.00 12,00,000
Y 2,00,000 2.25 4,50,000
Total earnings 16,50,000

No. of shares after merger 3,00,000 + 1,12,500 = 4,12,500

2.25
Note: 1,12,500 may be calculated as = 2,00,000 × 4.00

16,50,000
EPS for Co. X after merger = = ₹ 4.00
4,12,500

Impact on EPS

Equivalent EPS of Co. Y

Before merger ₹ 2.25

After merger (EPS before merger × Share exchange ratio on EPS basis)

₹ 4.00 × 0.5625 = ₹ 2.25

(ii) Merger effect on EPS with share exchange ratio of 0.5 : 1

Total earnings after merger ₹ 16,50,000

No. of shares post merger

(3,00,000 + 1,00,000 (0.5 × 2,00,000) 4,00,000

EPS 16,50,000 ÷ 4,00,000 4.125

Impact on EPS

Co. X‘ shareholders ₹

EPS before merger 4.00

EPS after merger i.e. (16,50,000 ÷ 4,00,000) 4.125

Increase in EPS 0.125

Co. Y' Shareholders

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EPS before merger 2.2500

Equivalent EPS after the merger 4.125 × 0.5 2.0625

Decrease in EPS 0.1875

QUESTION – 39

H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The
summarized Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as
follows:

Balance sheet as at 31st March, 2012 (In Crores of Rupees)

Liabilities: H. Ltd B. Ltd.

Paid up Share Capital
-Equity Shares of ₹100 each 350.00
-Equity Shares of ₹10 each 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50

H Ltd. proposes to buy out B Ltd. and the following information is provided to
you as part of the scheme of buying:

(a) The weighted average post tax maintainable profits of H Ltd. and B Ltd.
for the last 4 years are ₹ 300 crores and ₹ 10 crores respectively.

(b) Both the companies envisage a capitalization rate of 8%.

(c) H Ltd. has a contingent liability of ₹ 300 crores as on 31st March, 2012.

(d) H Ltd. to issue shares of ₹ 100 each to the shareholders of B Ltd. in

terms of the exchange ratio as arrived on a Fair Value basis. (Please
consider weights of 1 and 3 for the value of shares arrived on Net Asset
basis and Earnings capitalization method respectively for both H Ltd.
and B Ltd.)

You are required to arrive at the value of the shares of both H Ltd. and

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B Ltd. under:

(i) Net Asset Value Method

(ii) Earnings Capitalization Method

(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B

Ltd. on a Fair value basis (taking into consideration the assumption
mentioned in point 4 above.)

(Study Material & PM)

SOLUTION:

(i) Net asset value

H Ltd. ₹ 1300 Crores − ₹ 300 Crores

= ₹ 285.71
₹ 3.50 Crores

B Ltd. ₹ 31.50 Crores

= ₹ 48.46
0.65 Crores

(ii) Earning capitalization value

H Ltd. ₹ 300 Crores /0.08

= ₹ 1071.43*
₹ 3.50 Crores

B Ltd. ₹ 10 Crores /0.08

= ₹192.31
0.65 Crores

*Alternatively, Contingent Liability can also be deducted from this

Valuation.

(iii) Fair value

H Ltd. ₹ 285.71 ×1 + ₹ 1071 .43 × 3

= ₹ 875
4

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B Ltd. ₹ 48.46 ×1 + ₹ 192.31 × 3

= ₹ 156.3475
4

Exchange ratio ₹156.3475/ ₹875 = 0.1787

H Ltd should issue its 0.1787 share for each share of B Ltd.

Note: In above solution it has been assumed that the contingent liability will
materialize at its full amount.

QUESTION – 40

AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two companies
are 10,00,000 and 5,00,000 respectively:

(i) Calculate the increase in the total value of BCD Ltd. resulting from the
acquisition on the basis of the following conditions:

Current expected growth rate of BCD Ltd. 7%

Expected growth rate under control of AFC Ltd., (without any additional
capital investment and without any change in risk of operations) 8%

Current Market price per share of AFC Ltd. ₹ 100

Current Market price per share of BCD Ltd. ₹ 20

Expected Dividend per share of BCD Ltd. ₹ 0.60

(ii) On the basis of aforesaid conditions calculate the gain or loss to

shareholders of both the companies, if AFC Ltd. were to offer one of its
shares for every four shares of BCD Ltd.

(iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd.
pays ₹22 for each share of BCD Ltd., assuming the P/E Ratio of AFC Ltd.
does not change after the merger. EPS of AFC Ltd. is ₹ 8 and that of BCD
is `2.50. It is assumed that AFC Ltd. invests its cash to earn 10%.

(Study Material & PM)

SOLUTION:

(i) For BCD Ltd., before acquisition

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The cost of capital of BCD Ltd. may be calculated by using the following
formula:

Dividend
+ Growth%
Price

Cost of Capital i.e., Ke = (0.60/20) + 0.07 = 0.10

After acquisition g (i.e. growth) becomes 0.08

Therefore, price per share after acquisition = 0.60/(0.10−0.08) = ₹ 30

The increase in value therefore is = ₹ (30−20) × 5,00,000 = ₹ 50,00,000/-

(ii) To share holders of BCD Ltd. the immediate gain is ₹ 100 – ₹ 20 × 4 = ₹

20 per share The gain can be higher if price of shares of AFC Ltd. rise
following merger which they should undertake.

To AFC Ltd. shareholders (₹ In lakhs)

Value of Company now 1,000
Value of BCD Ltd. 150
1,150
No. of shares 11,25
∴ Value per share 1150/11.25 = ₹ 102.22

Gain to shareholders of BCD Ltd. = ₹ 102.22 – ₹ (4 × 20) = ₹ 22.22

Gain to shareholders of AFC Ltd. = ₹ 102.22 – ₹ 100.00 = ₹ 2.22

(iii) Gain to shareholders of AFC Ltd:-

Earnings of BCD Ltd. (5,00,000 × 2.50) ₹ 12,50,000/-

Less: Loss of earning in cash

(5,00,000 × ₹ 22 × 0.10) ₹ 11,00,000/-

Net Earning ₹ 1,50,000/-

Number of shares 10,00,000

Net increase in earning per share 0.15

P/E ratio of AFC Ltd. = 100/8 = 12.50

Therefore, Gain per share of shareholders of AFC Ltd.

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= 0.15×12.50 = ₹ 1.88

Gain to the shareholders of BCD Ltd. ₹ (22−20) = ₹ 2/- per share

Alternatively, it can also be computed as follows:

Post-Merger Earnings ₹ 81,50,000

(10,00,000 × ₹ 8 + 5,00,000 × ₹ 2.5 – 11,00,000)
81,50,000
EPS after Merger
10,00,000 ₹ 8.15
PE Ratio
Post Merger Price of Share (₹ 8.15 × 12.50) 12.50
Less: Price before merger ₹ 101.875
₹ 100.00
Say ₹ 1.875
₹ 1.88

QUESTION – 41

AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The
valuation is to be based on the recommendation of merchant bankers and the
consideration is to be discharged in the form of equity shares to be issued by
AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists of 80 lakhs
shares of ₹10 each. The highest and the lowest market quotation during the
last 6 months were ₹570 and ₹430. For the purpose of the exchange, the price
per share is to be reckoned as the average of the highest and lowest market
price during the last 6 months ended on 31.3.06.

XY Ltd.‘s Balance Sheet as at 31.3.2006 is summarized below:

₹ lakhs
Sources
Share Capital
20 lakhs equity shares of ₹10 each fully paid 200
10 lakhs equity shares of ₹10 each, ₹5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150

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Net Current Assets 200

350

An independent firm of merchant bankers engaged for the negotiation, have

produced the following estimates of cash flows from the business of XY Ltd.:

Year ended By way of ₹ lakhs

31.3.07 after tax earnings for equity 105
31.3.08 do 120
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
Terminal Value estimate 200

It is the recommendation of the merchant banker that the business of XY Ltd.

may be valued on the basis of the average of (i) Aggregate of discounted cash
flows at 8% and (ii) Net assets value. Present value factors at 8% for years

1-5: 0.93 0.86 0.79 0.74 0.68

You are required to:

(a) Calculate the total value of the business of XY Ltd.

(b) The number of shares to be issued by AB Ltd.; and

(c) The basis of allocation of the shares among the shareholders of XY Ltd.

(Study Material)

SOLUTION:

Price/share of AB Ltd. for determination of number of shares to be issued

= (₹ 570 + ₹ 430)/2 = ₹ 500

Value of XY Ltd based on future cash flow capitalization

(105 × 0.93) + (120 × 0.86) + (125 × 0.79) + (120 ×
0.74) × (300 × 0.68) ₹ lakhs 592.40
Value of XY Ltd based on net assets ₹ lakhs 250.00
Average value (592.40 + 250)/2 421.20
No. of shares in AB Ltd to be issued ₹ 4,21,20,000/500 Nos. 84240
Basis of allocation of shares

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Fully paid equivalent shares in XY Ltd. (20 + 5) lakhs 2500000

Distribution to fully paid shareholders 84240 × 20/25 67392
Distribution to partly paid shareholders 84240 − 67392 16848

QUESTION – 42

M/s Tiger Ltd. wants to acquire M/s. Leopard Ltd. The balance sheet of
Leopard Ltd. as on 31st March, 2012 is as follows:

Liabilities ₹ Assets ₹
Equity Capital (70,000 shares) 7,00,000 Cash 50,000
Retained earnings 3,00,000 Debtors 70,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors and other liabilities 3,20,000 Plants & Eqpt. 13,00,000
16,20,000 16,20,000

Additional Information:

(i) Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for every two
shares. External liabilities are expected to be settled at ₹ 5,00,000.
Shares of Tiger Ltd. would be issued at its current price of ₹ 15 per
share. Debenture holders will get 13% convertible debentures in the
purchasing company for the same amount. Debtors and inventories are
expected to realize ₹ 2,00,000.

(ii) Tiger Ltd. has decided to operate the business of Leopard Ltd. as a
separate division. The division is likely to give cash flows (after tax) to the
extent of ₹ 5,00,000 per year for 6 years. Tiger Ltd. has planned that,
after 6 years, this division would be demerged and disposed of for ₹
2,00,000.

(iii) The company‘s cost of capital is 16%.

Make a report to the Board of the company advising them about the financial
feasibility of this acquisition.

Net present values for 16% for ₹ 1 are as follows:

Years 1 2 3 4 5 6
PV 0.862 0.743 0.641 0.552 0.476 0.410

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(Study Material & PM)

SOLUTION:

Calculation of Purchase Consideration

₹
Issue of Share 35000 × ₹ 15 5,25,000
External Liabilities settled 5,00,000
13% Debentures 3,00,000
13,25,000
Less: Realization of Debtors and Inventories 2,00,000
Cash 50,000
10,75,000

Net Present Value

= PV of Cash Inflow + PV of Demerger of Leopard Ltd. – Cash Outflow

= ₹ 5,00,000 PVAF(16%,6) + ₹ 2,00,000 PVF(16%, 6) – ₹ 10,75,000

= ₹ 5,00,000 × 3.684 + ₹ 2,00,000 × 0.410 – ₹ 10,75,000

= ₹ 18,42,000 + ₹ 82,000 – ₹ 10,75,000

= ₹ 8,49,000

Since NPV of the decision is positive it is advantageous to acquire Leopard Ltd.

QUESTION – 43

Elrond Limited plans to acquire Doom Limited. The relevant financial details of
the two firms prior to the merger announcement are:

Elrond Limited Doom Limited

Market price per share ₹ 50 ₹ 25
Number of outstanding shares 20 lakhs 10 Lakhs

The merger is expected to generate gains, which have a present value of ₹ 200
lakhs. The exchange ratio agreed to is 0.5.

What is the true cost of the merger from the point of view of Elrond Limited?

(Study Materials & PM)

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SOLUTION:

Shareholders of Doom Ltd. will get 5 lakh share of Elrond Limited, so they will
get:

5 lakh
= = 20% of shares Elrond Limited
20 lakh 5 lakh

The value of Elrond Ltd. after merger will be:

= ₹ 50 × 20 lakh + ₹ 25 × 10 lakh + ₹ 200 lakh

= ₹ 1000 lakh + ₹ 250 lakh + ₹ 200 lakh = ₹ 1450 lakh

True Cost of Merger will be:

(₹ 1450 × 20%) ₹ 290 lakhs – ₹ 250 lakhs = ₹ 40 lakhs

QUESTION – 44

P Ltd. is considering take-over of R Ltd. by the exchange of four new shares in

P Ltd. for every five shares in R Ltd. The relevant financial details of the two
companies prior to merger announcement are as follows:

P Ltd R Ltd

Profit before Tax (₹ Crore) 15 13.50

No. of Shares (Crore) 25 15

P/E Ratio 12 9

Corporate Tax Rate 30%

You are required to determine:

(i) Market value of both the company.

(ii) Value of original shareholders.

(iii) Price per share after merger.

(iv) Effect on share price of both the company if the Directors of P Ltd. expect
their own pre-merger P/E ratio to be applied to the combined earnings.

(Study Material & PM)

SOLUTION:

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P Ltd. R Ltd.
Profit before Tax (₹ in crore) 15 13.50
Tax 30% (₹ in crore) 4.50 4.05
Profit after Tax (₹ in crore) 10.50 9.45
Earning per Share (₹) 10.50 9.45
= ₹0.42 = ₹ 0.63
25 15
Price of Share before Merger ₹ 0.42 × 12 = ₹5.04 ₹ 0.63 × 9 = ₹5.67
(EPS × P/E Ratio)

(i) ∴Market Value of company

P Ltd. = ₹ 5.04 × 25 Crore = ₹ 126 crore

R Ltd. = ₹ 5.67 × 15 Crore = ₹ 85.05 crore

Combined = ₹ 126 +₹ 85.05 = ₹ 211.05 Crores

After Merger

P Ltd. R Ltd.

4
No. of Shares 25 crores 15 × = 12 Crores
5
Combined 37 Crores

25 12
% of Combined Equity Owned ×100 = 67.57% ×100 = 32.43%
37 37

(ii) ∴ Value of Original Shareholders

P Ltd. R Ltd.

₹ 211.05 crore × 67.57% ₹ 211.05 crore × 32.43%

= ₹ 142.61 = ₹ 68.44

Alternatively, it can also be computed as follows:

Combined Value of Entity 211.05 crore

No. of shares after Merger 37 crore
Value of Per Share ₹ 5.70405
Value of P Ltd. Shareholders (25 crores ×₹ 5.70405) ₹142.60 crore
Value of R Ltd. Shareholders (12 crores ×₹ 5.70405) ₹ 68.45 crore

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(iii) ∴ Price per Share after Merger

19.95 Crore
EPS = = ₹ 0.539 per share
37 Crore

P/E Ratio = 12

Market Value Per Share = ₹ 0.539 × 12 = ₹ 6.47

Total Market Value = ₹ 6.47 × 37 crore = ₹ 239.39 crore

Market Value 239.39 crore

Price of Share = = = ₹ 6.47
Number of Shares 37 Crore

(iv) Effect on Share Price

P Ltd.

Gain/loss (-) per share = ₹ 6.47 – ₹ 5.04 = ₹ 1.43

6.47−5.04
i.e. × 100 = 0.284 or 28.4%
5.04

∴ Share price would rise by 28.4%

R Ltd.

4
6.47 × = ₹ 5.18
5

Gain/loss (-) per share = ₹ 5.18 – ₹ 5.67 = (- ₹ 0.49)

5.18−5.67
i.e. × 100 (-) = 0.0864 or (-) 8.64%
5.67

∴ Share Price would decrease by 8.64%.

QUESTION – 45

Trupti Co. Ltd. promoted by a Multinational group ―INTERNATIONAL INC‖ is

listed on stock exchange holding 84% i.e. 63 lakhs shares.

Profit after Tax is ₹ 4.80 crores.

Free Float Market Capitalization is ₹ 19.20 crores.

As per the SEBI guidelines promoters have to restrict their holding to 75% to
avoid delisting from the stock exchange. Board of Directors has decided not to

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delist the share but to comply with the SEBI guidelines by issuing Bonus
shares to minority shareholders while maintaining the same P/E ratio.

Calculate

(i) P/E Ratio

(ii) Bonus Ratio

(iii) Market price of share before and after the issue of bonus shares

(iv) Free Float Market capitalization of the company after the bonus shares.

(Practice Manual)

SOLUTION:

1. P/E Ratio:

% of holding No. of Shares

Promoter‘s Holding 84% 63 Lacs
Minority Holding 16% 12 Lacs
Total Shares 100% 75 Lacs

Free Float Market Capitalization = ₹ 19.20 crores

₹ 19.20 Crores
Hence Market price = ₹ 160 per share
12.00 lacs

EPS (PAT/No. of Shares)

(₹ 4.80 crores /75 lac) = ₹ 6.40 per share

P/E Ratio (₹ 160/ ₹ 6.40) = 25

2. No. of Bonus Shares to be issued:

Promoters holding 84%, = 63 lacs shares

Shares remains the same, but holding % to be taken as 75%

63 Lac
Hence Total shares = = 84 lacs
75%

Shares of Minority = 84 lacs – 63 lacs = 21 lacs

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Bonus 9 lacs for 12 lacs i.e. 3 bonus for 4 held or 0.75 shares for

1 share

3. Market price before & after Bonus:

Before Bonus = ₹160 per share

After Bonus

₹ 4.80 Crores
New EPS = ₹ 5.71
84 lacs

New Market Price (25 ×₹ 5.71) = ₹ 142.75

4. Free Float Capitalization is

₹ 142.75 × 21 lacs = ₹ 29.9775 crores

QUESTION – 46

C Ltd. and P Ltd. both companies operating in the same industry decided to
merge and form a new entity S Ltd. The relevant financial details of the two
companies prior to merger announcement are as follows:

C Ltd. P Ltd.
Annual Earnings after Tax (₹ lakh) 10,000 58,000
No. Shares Outstanding (lakh) 4,000 1,000
PE Ratio (No. of Times) 8 10

The merger will be affected by means of stock swap (exchange) of 3 shares of C

Ltd. for 1 share of P Ltd.

After the merger it is expected that due to synergy effects, Annual Earnings
(Post Tax) are expected to be 8% higher than sum of the earnings of the two
companies individually. Further, it is expected that P/E Ratio of S Ltd. shall be
average of P/E Ratios of two companies before the merger.

Evaluate the extent to which shareholders of P Ltd. will be benefitted per share
from the proposed merger.

(MTP April - 2021)

SOLUTION:

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Exam Oriented Book

CA Pavan Sir

About CA Pavan Sir

CA PAVAN KARMELE is a qualified Chartered Accountant is a

fellow member of ICAI. He is Post graduate in Master of Commerce with
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