Capital Market and

Security Analysis

Scope and Need for Capital Markets and Portfolio Management

To facilitate effective allocation of funds.

Systematic analysis of different kind of financial securities.

To determine the price of risky securities in competitive capital market.

Management of invested fund (portfolio).

Need for Capital Markets and Portfolio Management….cont

To study the behavior of stock market.

To study the relationship of stock market with other corporate and economic variables.

Analysis and Management of risk associated with different financial securities.

Different Types of Investment Opportunities

Other Securities

Derivative Financial

& Commodity

Money MktSecurities

Bonds

Mutual Funds

Equities

Investment Oppotunities

Types of SecuritiesMoney market securities

Short-term debt instruments sold by governments, financial institutions and corporations

They have maturities when issued of one year or less.

Money market securities includes Treasury Bills, Commercial papers, Bank deposits etc.

Types of Securities…cont

Capital market securities – Instruments having maturities greater than one year

and those having no designated maturity at all.– It is the market from where long term capital is

raised.1. Corporate bonds

– Fixed income securities like bonds have a specified payment schedule.

– Bonds promise to pay specific amounts at specific times

Capital Market Securities2. Common Equity Shares

Ordinary or common shares represents the ownership position of the company. The holders of ordinary shares, called shareholders. They are legal owner of the company.

Capital Market Securities3. Preference SharesPreference shares have the preference over the common equity shares in terms of payments of dividend and repayment of capital in case of wind up of the company. Preference share holders get fixed dividends.Types of Preference shares-1.Redeemable preference shares-

Redeemable preference shares are available with certain maturity.

2. Irredeemable preference shares-Irredeemable preference shares are available without any maturity period. In India companies are not allowed to issue irredeemable preference shares.

Mutual FundsA Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is invested by the fund manager in different types of securities depending upon the objective of the scheme. These could range from shares to debentures to money market instruments.

MutualFund

StockMarket

DebtMarket

MoneyMarket

InvestorsCommunity

Types of Mutual FundOn the basis of Structure-Open-end Funds

An open-end fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV") related prices. The key feature of open-end schemes is liquidity.

Closed-end Funds

A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15 years. The fund is open for subscription only during a specified period. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed.

Securities Available in the International Market

Financial securities which are available in the international market includes ADR, GDR, Foreign Bonds, Euro Bonds etc.

Speculation Vs. InvestmentSpeculation refers to take advantage of short term

fluctuations or development of the stock market. Speculators are mainly profit oriented and are not interested in the growth the firm.

Investment on the other hand is made for the long time period. Along with profit investors are also interested in the growth the firm.

SEBI also makes discrimination between speculation and investment for the purpose of tax. Investment which is made for less than one year is refers as trading and subject to tax.

On the other hand if investment is made more than one year it is treated investment and attract no tax.

Risk and Return

Return refers the amount of total monetary benefits a investors receive from a security. Return of a financial security consists two component-periodical cash payments received at specified time intervals.And market appreciation/depreciation of the security value over the investment time period.

Concept of ReturnReturn refers the amount of total monetary benefits a investors receive from a security. Return of a financial security consists two component-periodical cash payments received at specified time intervals. And market appreciation/depreciation of the security value over the investment time period.

uritytheofpricepurchaseperiodtheoverchangeiceceivedPaymentCashRi sec

PrRe

1

1)(

t

tti P

DivPPR

Where, Pt is price of security in time period t, Pt-1 is price in last time period, Div is dividends.

Return Calculation Reliance Ind. Time Opening Price Closing Price Div.May-07 1752.0 1760.0 10.0

%07.11001752

10)17521760(

iR

It indicates that Reliance Ind. has offered 1.07% return to the investor on 7th of May.

The Annualized return will be 1.07X365=390.55%.

Realized Return vs. Expected Return

Realized return is the return which is realized by the investor over the investment time period.

Expected return is the return which is expected to earn over the investment time period by the investor.

Historical Return

Historical return is that return which has been offered by the security to the investors during the past.

Historical return of a security is used to analysis of risk and return prospectus of that security.

Calculation of Historical ReturnYear B S E 100 Dividend Return

1995 1737.91 2 --------

1996 1343.21 3 -22.5386

1997 1481.71 4 10.60891

1998 1401.38 2 -5.28646

1999 1461.52 3 4.505559

2000 2875.37 6 97.14886

2001 2209.31 4 -23.0252

2002 1600.87 6 -27.2682

2003 2946.14 4 84.28355

2004 3521.71 3 19.63824

2005 5224.97 2 48.42136

2006 7145.91 5 36.86031

2007 11154.28 3 56.13519

Absolute Return

Absolute return refers the gross return which is realized by the investor.

For example on 1 Jan 2010 the price of Infosys stock was 1500 and it was 2500 on 30 June 2010.

So the absolute return is Rs 500 (2500-1500).And the relative return will be 33.3% (500/1500).

Average or Airthematic ReturnAverage return is that return which is on average return offered by a security to the investors over a particular period of time. For e.g. in the last slide different level of annual return is offered by BSE 100 from 1995 to 2007. But the average return will be-

%28.23)13.5637.3642.4863.1928.8420.27

02.2314.9750.428.560.1053.22(131

iR

The average return which is offered by BSE 100 from 1995 to 2007 to the investors is 23.28%.

Annual Return Vs Annualized Return

Annual return refers the return which is obtained by the inventor during a year.

For example, on Jan. 1, 2010 the price of the Infosys stock was Rs 1000, and on Dec. 31, 2010 it is Rs 1300, and dividend in between is Rs 200, than annual return is: 50%.

If Infosys price was Rs 1000 on Jan 2010, and 1050 on Jan 31, 2010. It means the monthly return of Infosys is: 5%.

Annualized return will be: 5x12=60%.

Risk in Investing Financial Security

Variation in the mean rate of return exhibits risk. Volatility in the stock market indicates risk which affects the value of the stocks.

Risk is segregated into two Categories:

Systematic Risk-Systematic risk refers to that portion of total

probability in return caused by factors affecting the prices of all securities.

Unsystematic Risk- Unsystematic risk is the portion of total risk that is unique to a firm or industry.

Total Risk

Systematic Risk Unsystematic Risk

Business Risk

Financial Risk

Market Risk

Purchasing Power Risk

Interest Rate Risk

Forex Risk

Systematic RiskMarket Risk-

Market risk refers to that portion of total variability in the return caused by factors affecting the whole market. Economic, political and sociological changes are sources of this type risk.

Purchasing Power Risk- Purchasing risk is associated with inflation and deflation. If an investor gets 5 percent rate of return and prevailing inflation is 5.5 percent, it means that investor is realizing 0.5 percent loss on the investment over the period of time.

Systematic Risk…..cont.Interest Rate Risk-

Interest rate risk is associated with fluctuations in rate of return caused by variation in general interest rate. Interest rate risk is becoming prominent as not only domestic interest rate but also interest rate prevailing in the international market can cause volatility in the stock market.

Foreign Exchange Risk-

Foreign Exchange Risk is caused by changes in foreign exchange rate.

Market risk can not be diversified by enlarging the

portfolio. This risk affects the market as a whole and each stock seems to co-vary in the same direction with the emergence of this risk.

Unsystematic RiskBusiness Risk-

Business risk, emerges because of operating conditions, variability in business conditions, dividend decisions etc.

Financial Risk- Financial risk caused by the way a firm finances its activities or expansion plans. If a firm raises debt in the market it increases its obligation to pay fixed amount of fund, viz., interest to the debtors. Investors perceive it risky to invest in those stocks whose debt equity ratio is high.

Non-market risk is specific and associated with individual stocks. This risk can be eliminated by enlarging and diversifying the portfolio by holding different stocks of different industries.

Measurement of Total Risk

Risk of financial security refers the variation in the rate of return of that financial security.

Standard deviation is used to calculate the total risk of any financial security.

nRR

SD

2)(

Where, R is return of the security, n is number of observations.

Measurement of Systematic Risk -beta

Systematic risk refers to that portion of total risk or variation in rate of return which are caused by factors affecting the prices of all securities. Beta of financial securities is used to measure the systematic risk. It indicatives the level of sensitiveness of each security to the market.

22 XXn

RXXRni

Where, R is return on security, X is return on Market Index like Sensex.A high beta value is the indication of high risk, and low beta value is the indication of low risk.

Measurement of Systematic Risk -beta

Beta value is widely used by the investors in analyze of the stocks. A stock with high beta value indicates high risk of the stock, on the other hand stock with low beta value is the indication of the low risk of the stocks.

Investor who are looking capital gain should invest in stocks with high beta value.

On the other hand investors which avoid to take high risk, should invest in low beta value stocks.

Calculation of beta valueTime Sensex (X) Infosys ® XR X2

Jan-09 3 5 15 9

Feb-09 2 2 4 4

Mar-09 6 5 30 36

Apr-09 7 6 42 49

May-09 4 7 28 16

Jun-09 2 5 10 4

Jul-09 3 8 24 9

Aug-09 5 3 15 25

Sep-09 3 5 15 9

Oct-09 5 4 20 25

Nov-09 7 6 42 49

Dec-09 4 5 20 16

Total 51 61 265 251

22 XXn

RXXRni 16.0

)51(251*1261*51265*122

i

Beta Value

The beta value of Infosys is 0.16. It means if sensex goes to 1% either side. Infosys return will vary 0.16% accordingly.

Calculation of Alpha valueAlpha of any financial security indicates the minimum level

of return which an investor can expect from that security.

The income looking investor can invest in the stocks with high alpha values.

XRi2

Coefficient of variationCoefficient of variation measures how much variation in the

rate of return of a security comes due to variation in rate of return of market index like sensex.

All the stocks are the part of the stock market. When there will be any fluctuations in the rate of return of market index like sensex, correspondingly fluctuations will occur in the rate of return of the stock return.

2

22(..

RX

XRVC

Where, R is return on security, X is return on Market Index like BSE 100.

Calculation of Coefficient of VariationTime Sensex (R) Infosys (X) R2 X2 RXJan-09 3 5 25 9 15Feb-09 2 2 4 4 4Mar-09 6 5 25 36 30Apr-09 7 6 36 49 42

May-09 4 7 49 16 28Jun-09 2 5 25 4 10Jul-09 3 8 64 9 24

Aug-09 5 3 9 25 15Sep-09 3 5 25 9 15Oct-09 5 4 16 25 20Nov-09 7 6 36 49 42Dec-09 4 5 25 16 20Total 51 61 339 251 265

2

22(..

RX

XRVC =0.82

It implies 82% variation in Infosys return are coming due to Sensex

Calculation of expected return and risk using the probabilities of happening.

%25.7Pr).()( obabilityRERE

25.13Pr. obabilityRiskRisk

Reliance Ind.

stages Return Risk Probability E(R) Risk

Growth 12% 8 25% 12x0.25=3 8x0.25=2

Expansion 10% 12 25% 10x0.25=2.5 12x0.25=3

Stagnation 5% 15 25% 5x0.25=1.25 15x0.25=3.75

Decline 2% 18 25% 2x0.25=0.5 18x0.254.5

Financial Market

Financial Market is the market from where short and long term financial resources are raised.

Financial Market

Capital Market

Money Market

Long Term Loan

Stock Market

Primary Market

Secondary Market

Organized Banking Sector

Unorganized Banking Sector

Sub Markets

Call Money Market

Treasury Bills

Certificate of Deposits

Commercial Papers

Structure of Indian Financial Market

Money MarketCall money market is important segment of money market from where borrowing and lending is done for a short time period ranging from overnight to fortnight.

Call Money-when money is lent or borrowed for overnight.

Notice Money- when money is lent or borrowed more that one day

and upto fourteen days.

Participants in Call money market1. Those permitted to operate both as

lenders and borrowers of call loans-Commercial banks-State bank of India-Co-operative banksDiscount & Finance House of India-Security Trading Corporation of India-

2. Those permitted to operate only as lenders-

1.LIC, UTI, GIC, IDBI, NABARD.2. Entities/corporate/mutual funds with bulk lendable resources subject to approval from RBI.

Treasury BillsTreasury bills are the promissory notes or a kind of

financial bill issued by RBI on behave of central government with discount for a fixed period, not extending beyond one year.

TBs are issued with a promise to pay the amount stated therein to the bearer of the instruments.

TBs are issued on discount basis.

Periodicity of TBs-14 days TBs, 91 days TBs, 182 days TBs, 364 days TBs.

Participants in TBs• Reserve Bank of India-• State Bank of India-• Commercial Banks-• State Govts, and other approved bodies-• DFHI, and STCI-• Financial Institutions- IDBI, ICICI, IFCI, LIC, GIC-• Corporate entities-• General public-• FIIs-

Computation of Yield on TBs

100364

daysIssuepriceIssuepriceFacevalueYd

For example, 91 days TBs were issued at fixed price of Rs. 98/- for Rs. 100/- face value. The yield will be-

%56.1210091

36498

98100

Yd

Commercial Papers

Commercial papers are debt instruments issued by corporates for raising short term resources from the money market. CPs are unsecured debts-no provision is made behind the CPs.

Corporates having approval from RBI are eligible to issue CPs.

CPs are issued on interest/discount basis.

Certificates of DepositsA certificate of deposit is a marketable document

of title to a time deposit for a specified period. CDs is a receipt given to the depositor by a bank

or any other institution entitled to issue CD.A CD is issued at a discount and it is negotiable

instrument.

Govt. Dated Securities

Regulation of Indian Financial Market

Regulation of Money MarketMoney market is that market from where capital can be raised for short time period. Reserve bank of India (RBI) is the statutory body which is authorized to regulate the Indian money market.

Regulation of Capital MarketCapital market is that market from where capital can be raised for long time period. Securities and Exchange Board of India (SEBI) is the statutory body which is authorized to regulate the Indian capital market.

Role of SEBI in Capital MarketSecurities exchange board of India (SEBI) is the monitoring

body of the Indian capital market. Role of SEBI:1. To promote the healthy transactions in capital market. 2. To promote the investor education. 3. SEBI is working for the development of the capital market. 4. SEBI is protecting the investors. 5. SEBI is promoting the foreign capital in the country. 6. SEBI is monitoring body of stock brokers, mutual funds,

Institutional investors etc.

Types of Market TransactionsMarket transactions is process in which stocks are purchased or sold at particular time and price. Basically two types of transactions exist-buying orders and sell orders.

Buy OrderBuy order is executed to purchase certain number of stocks from the stock market. Buy order is used when investors expected the rise in the price of stocks in near future.

Sell OrderSell order is executed to sell certain number of stocks into the stock market. Sell order is used when investors expected the decline in the price of stocks in near future.

Sell Order…..cont.

Sell Order of two types.Sell long Orders-This is the order wherein investors orders to sell the stocks which he owns in the stock market.

Sell short Orders-This is the order wherein investors orders to sell the stocks which he does not owns in the stock market. This is kind of short selling.

Types of orders

Orders which are given on the basis of price constraints are called Price Limit Orders

Orders which are given on the basis of time constraints are called Time Limit Orders

Price Limit of OrdersAn investor can have his order executed either at the best prevailing market price on the stock exchange or at a price he determines.

Market Order – buy or sell at prevailing market price.

Price Limit Order-buy or sell at specified price suggested by investor.

A maximum price if sellinga minimum price if buying

Price Limit of OrdersStop Order – A stop order is used to protect the profit and to limit the loss.

• Sell if price falls below the stop price• (A stop-loss is used to lock-in profits)• Buy if price rises above the stop price.

Stop limit Order-The stop limit order gives the investor the advantage of specifying the limit price-the maximum price he will pay in the case of a stop limit to buy, or the minimum price he will accept in the case of a stop limit to sell.

• A minimum price is placed below the stop-price for a sell

or• A maximum price is placed above the stop-price

for a buy

Time Limit of OrdersTime limit order are placed on the basis of time, wherein orders are executed on the basis of time specified by the investor.

Day Order – A day order is that order remain active during a particular trading day.Week/Month Order-A week/month order is that order remain active during a particular week/month day.Open Order-An open order is that order remain active until they are either executed or cancelled.

Margin Account (Trading)A margin account with a broker allows for limited borrowing to purchase assets.•A margin account needs a hypothecation agreement

– A. broker can pledge securities as collateral– B. broker can lend the securities to others

•For A. and B., shares are held in street name– Owned legally by brokerage– Dividends, voting rights, reports go to investor

Margin Account• Margin Purchase

– Borrow money from broker to invest.– The cost of borrowing is interest plus a service

charge.• Initial margin requirement

– The minimum % of investment from investor’s own funds

Margin Account• A margin account is marked to market at the end

of each trading day– A daily calculation of actual margin

• A margin account is subject to a maintenance margin requirement – The minimum acceptable value of the actual margin

• If actual margin < maintenance margin then a margin call is issued

• The investor is obliged to add cash or securities to the margin account

Short Sales• A short sale is the sale of a security you do not

own• This is achieved by borrowing share certificates

from someone else• The borrowing process is arranged by a broker• To allow shares to be borrowed the broker either

– a. Uses shares held in street name– b. Borrows from another broker

Short Sales• Margin

– There is a risk involved so short seller (A) must make an initial margin advance to the broker

– The broker then calculates the margin each day

– Short sales should be used when prices are expected to fall

Fixed income securitiesFixed income securities differ from each other in promised return for several reasons

The maturity of the bondsThe creditworthiness of the issuer The taxable status of the bond

Income and capital gains are taxed differently in many countriesBonds are designed to exploit these differences

Types of BondsBased on Issuer

1.Corporate Bonds-Corporate bonds are issued by private firms.

2. Govt. Bonds-Govt. bonds are issued by govt. bodies like central govt., central bank of the country, local bodies, state govt. etc.

Types of Bonds

Based on Yield-1.Interest Bearing Bonds-

Interest bearing bonds gives interest to the investor after every quarterly or

annually basis.2. Zero coupon Bond-

Zero coupon bonds give lump sump amount to the investor at the time of redemption of the bond.

Types of Bonds….cont.

Based on Conversion-1.Convertible Debentures-Convertible bonds are those bonds which are converted into common equity shares at the time of maturity.

1. Partial Convertible debentures-2. Fully convertible debentures-

2. Non convertible debentures- Non Convertible bonds are those bonds which cant be converted into common equity shares at the time of maturity.

Valuation of Bond Bonds are marketable instruments. Therefore it is very important for the investors to find the right value of the bond. In order to find out the right value of bond a valuation is done.

Valuation of financial securities refers to find out the right price of the financial securities. At some point of time, some financial securities may be traded at over value or under value. With valuation we can find out the right price of the financial securities especially when it is available at market price.

Valuation of Financial Securities- Bonds

Some Key Issues in Valuation-1.Time value of money

Time value of money refers, money which is received in nearer time period is more preferable that the money

which will be received in distant time period.

2. Opportunity Cost-Opportunity cost refers, whatever monetary benefits are sacrificed for the sake of another monetary benefits.

Calculation of Present value of Bond

nn

n

kBn

kInt

kInt

kInt

kInt

Bo)1()1(

...)1(

3)1(

2)1(

132

55432 )08.1(

1000)08.1(

70)08.1(

70)08.1(

70)08.1(

70)08.1(

70Bo

ofmaturityesentvlaueerestofesentvalueBondValue PrintPr

Suppose an investor want to purchase a five year bond, Rs. 1,000 par value, bearing the nominal interest rate of 7 percent per annum. The investor required rate of return is 8 percent. What should be the value of the bond?

51.96068151.279 BondValue

Calculation of Yield to MaturityYield to maturity is worthful to measure when bond is

available at premium or discount. A bond is said to available at discount when it is available

at less price than the face value.A bond is said to available at premium when it is available

at more price than the face value.

nn

n

yBn

yInt

yInt

yInt

yInt

Bo)1()1(

...)1(

3)1(

2)1(

132

Calculation of Yield to MaturityA bond is available at Rs. 94/- with face value Rs. 100/. The bond will pay interest at 15 percent per annum for 7 years.

5

7

1 )1(100

)1(1594

kdkdtt

When kd=17%,

15*PVFA (17%,7)+100*PVF (17%,7)=92.13

When kd=16%

15*PVFA (16%,5)+100*PVF (15%,5)=95.97

It means that the cost of this bond will lie between 17 and 16%.

By InterpolationDifference

PV required 94.01.97

Pv at 16% 95.973.84

Pv at 17% 92.13

%5.1684.397.1%)16%17(%16 Kd

The cost of this bond will be 16.5%

Calculation of Current Yield

Yield to maturity takes into account present value of interest payments and capital gain or loss over the bond. But current yield is takes into account only annual interest and does not consider capital gain or loss. Current yield is annual interest divided by bonds current market price.

bondofpricemarketcurrentnterestiAnnualldCurrentYie

A bond is available at Rs. 883/- with face value Rs. 1000/-. The bond will pay interest at 6 percent per annum for 5 years.

The current yield is 60/883= 6.8%

Calculation of Yield to Call/PutCorporate bonds are also available with call and put

provisions. If bond is available with call provision, it means that

company can call back its bond before maturity. On in other words bond will be redeemed or called before maturity.

On the other hand if bonds are available with put provision then investor has the right to redeem the bond before the maturity period.

A 10 year bond will pay 10% interest, with face value Rs. 1000/- is callable is 5 years at a price of Rs. 1050/- The bond is currently available at Rs. 950/- What is the yield to call of the bond?

When bond amortized each year The govt. is proposing to sell a 5 year bond of 1000 at 8%

interest rate per annum. The bond amount will be amortized equally over its life. The required rate of return of the investor is 7%. What will be the present value of the bond?

Interest in the 1st year = 1000*0.08=80 2nd year= (1000-200)*0.08=64 3rd year= (800-200)*0.08=48 4th year=(600-200)*0.08=32 5th year=(400-200*0.08=16

1025)07.01(

216)07.01(

232)07.01(

248)07.01(

264)07.01(

2805432

Bo

There fore the present value of this bond is Rs. 1025.

Bond value and Semi annul Interest Payments

It a practice of many companies in India to pay interest on bonds semi annually. In such a case the present value of the bond can be estimated as follow:

n

n

tt Kd

BnKdIntBo

2

2

1

21

21

)(2/1

Bond value and Semi annul Interest Payments

A 10 year bond of Rs 1000 has an annual rate of interest of 12%. The interest is paid half yearly. What is the value of the bond if required rate of return is 12%?

102

102

1

212.01

1000

212.01

)120(2/1

t

tBo20

20

1 )06.1(1000

)06.1(60

t

tBo

= 60x Annuity factor (6%,20)+1000x PV factor (6%,20)=60x98181+1000x0.2145=589.09+214.50=803.59The present value of this bond is 803.59.

Bond Price and Systematic RiskBond is a fixed income security which promises to pay interest on periodically basis at fixed rate. Certain systematic factors significantly affects the value of the bonds. They includes-

1. Purchasing power risk2. Interest Rate risk

Purchasing Power Risk and Bond Value

Purchasing power risk arises because of lowering down of purchasing power of currency due to rise in inflation level. A rise in inflation lower down the value of currency.

Suppose a bond is giving 6% interest rate and prevailing inflation is 7% then nominal rate of return will be -01%. A result the value of the bond will fall.

Interest Rate Risk and Bond Value

Interest rate which is offered by bank deposits have negative relation with bond price.A rise in the interest rate will lower down the value of bond because investors will be motivated to invest their funds in bank deposits and vice versa.

KebondovernterestIiceBond Pr

Where, Ke is cost of capital, which is considered equal to market interest rate offered by banks over the deposits. A equation indicates the negative relation between bond price and market interest rate.

Interest Rate Risk and Bond Value….cont

Interest rate risk has two dimension, the way in which the market interest rate risk affects the bond price.

• Price Risk• Reinvestment Risk

Price Risk

The price of bond is significantly change with respect to maturity value, coupon value, and general economic conditions.

Longer the maturity of the bond, the greater the bond price volatility.

Lower the coupon value, the greater the bond price volatility.

Stable the economic condition, the lower the bond price volatility.

Reinvestment RiskReinvestment risk is arises when interest which is earned over the bond is reinvested further in the bond.For example a bond with face value Rs. 100 is giving 10% interest and market interest rate is 7%.

Suppose when in the second year Rs. 10 is further invested in the bond and at that time the prevailing market interest rate is 11%, then it is not worthful to invest Rs. 10 in the bond. This is called reinvestment risk.

Asset Securitization

Asset securitization is process in which book debt or mortgage back securities are converted into marketable securities and these securities are sold into the market.

For example ICICI bank has given Rs 20 lakh house loan for 20 years at 10% annual interest rate. Now bank will be able to recover this Rs 20 lakh in next 20 years, but bank needs liquidity to run day to day business. To recover this loan ICICI bank will create new entity which is called special purpose vehicle. This special purpuse vehicle will sell securities into market in the form of pass through certificate.

So ICICI bank can covert these loan into marketable securities which are know pass through certificate (PTC). These pass through certificate are sold into the market at some lower interest rate (less than 10%).

By selling these PTC, ICICI bank has recovered its loan from the market.

The whole process is called asset securitization.

Asset Securitization…cont

The above diagram explain the process of asset securitization.

The Term Structure of Interest Rate

The term structure of interest rate refers the shape of yield of bonds with different maturity period is called term structure of interest rate.

Bond is long term debt instrument, whose price is significantly affected by prevailing market interest rate which tends to change frequently.

– In doing the valuation of bonds the term structure of interest rate helps in finding out the right price of the bonds.

Shape of Term Structure of Interest Rate

0

1

2

3

4

5

6

7

8

9

10

In assigning the cost of capital, the term structure of interest rate are seen i.e. what will be the shape of market interest rate over the period. It can be of three shapes-

•Flat-In future the market interest rate will remain same.

•Steep-In future market interest rate will decline.

•Inverted-In future market interest rate will rise.

Causes of Term Structure

The term structure of interest rate or yield curve is determined by number of factors. The commonly used hypothesis are-

The expectation hypothesisLiquidity preferences hypothesisSegmented market hypothesis

The expectation hypothesisThis hypothesis holds that the current structure of interest rate is determined by common consensus forecast of future interest rate.

For example if one year bond is giving 7% interest rate and 2 year bond is giving 8% interest rate, then investors will start to expect the rise in the interest rate over the period.On the other hand, if one year bond is giving 8% interest rate and 2 year bond is giving 7% interest rate, then investors will start to expect the fall in the interest rate over the period.

Liquidity preferences hypothesis

This hypothesis states that the term structure is determined by liquidity preferences. If the there will be high demand for liquidity, the interest rate will be high.On the other hand if there will be low demand for liquidity, the interest rate will be low.

Segmented market hypothesis

This hypothesis holds that the group of investors regularly prefer bonds within particular maturity ranges in order to hedge their liabilities or to comply with regularly requirements.

So when the demand for one group of investors increases relatively others, yields within the maturity range where demand has risen will fall relatively to the yields within the maturity range where demand is less.

Bond Value and Unsystematic Risk

Bond value is largely affected by unsystematic risk-the inherent factors of the company. There is a risk of default of the bond. Default is a situation where issuer fails to meet of the debt contract.

In other words default refers to the probability that the return realized will be less than promised, rather than total cost.

Unsystematic risk is of two types:1. Financial risk2. Business risk

Bond and Financial RiskFinancial risk caused by the way a firm finances its activities or expansion plans. If a firm raises debt in the market it increases its obligation to pay fixed amount of fund, viz., interest to the debtors. Investors perceive it risky to invest in those stocks whose debt equity ratio is high.Corporate bonds sell at higher yields than govt. because of business and financial risk.

Bond and Financial Risk…cont.

Business and financial risk are absent from govt. bonds because of the govt. ability to meet debt servicing requirements.

Bond and Business Risk

Business risk, emerges because of operating conditions, variability in business conditions, dividend decisions etc.Business risk also affects the possibility of default of a bond. If the business risk of a company will be very high, the fear of default of the bond will be high vice versa.

Bonds and Credit Rating

Credit rating is done on the basis of unsystematic risk prevailing in the firm. Credit rating a codified rating assigned to a bond by an independent credit rating agencies. Credit rating of a bond indicates the quality and safety of the bonds. In fact it indicates how much safe it is to invest in this bond?

Credit Rating of MoodyAAA Best quality.

AA High grade.

A High medium grade.

BAA Lower medium grade.

BA Process speculative elements.

BGenerally lack characteristics of desirable

investment.

CAA Poor standing, may be in default.

Ca Speculative to a higher degree.

C Lower grade.

Credit Rating of Standard & Poor Corp.AAA Highest Grade

AA High grade.

A Upper medium grade.

BBB medium grade.

BB Lower medium grade.

B Speculative.

CCC-CCC Outright speculative.

C Reserved for income bonds.

DDD-D In default, indicating salvage value.

Credit Rating Agencies in India

Credit Rating and Information Services of India Ltd (CRISIL).

Investment Information & Credit Rating Agency of India Ltd (ICRA).

Credit Analysis and Research Ltd (CARE).

Majors Factors in Credit Rating

Credit rating of bonds is assigned on the basis of number of factors, the most common are.Indenture provision-Earning power and leverage-Liquidity-Management-

Indenture provision

Indenture provisions refer to provisions which are maintained by the Issuer for the smooth payment of interest and principal of the bonds. Indenture provisions include-

1. Borrower require to maintain certain levels of retained earning, working capital, debt in relation to assets.

2. Restriction on sale and lease back of assets.3. Creation of sunk fund.

Earning power and leverageEarning power of the firm refers to the level of earning of the firm over the period of time. It is seen what is the possibility of earning of the project where debt capital raised through bonds. Earning power of the firm is judged through-

Are the return levels indicated sustainable? What has been the track record?

What is the management plan for future regarding the acquisition and starting of new venture?

What is the general economic and corporate environment?

Profit margin are increasing or decreasing over period?

LiquidityLiquidity refers to firm ability to meet the current financial obligations. The firms have mainly three source of cash generation-1.Internal Cash generation-

It refers the sale of goods and services.2. External cash generation-

It refers to raise equity and debt capital.3. Sale of fixed assets-

It includes sale of old fictitious assets.

ManagementManagement occupied important role in determining the credit rating of a bond. How efficient the management is?

Bond Management StrategiesValue of the bond is subject to change with respect to

systematic and unsystematic factors. Bond investors may adopt passive or active approaches to the management of their portfolios. The main bond management strategies are:

• Passive Strategy• Semi Active Strategy: Immunization• Active Strategy

Passive StrategyPassive strategy are of two types:

• Buy and hold strategy• Bond Laddering Strategy

Buy and Hold strategyBuy & Hold strategy refers to purchasing of bonds and holding it till the maturity. Passive strategy is used primarily by income maximizing investors who are interested in the largest coupon income over a desired horizon.

This type of investors include retired person, endowment funds, bond mutual funds, insurance companies.

Bond Laddering StrategyBond laddering a building a bond ladder buying bonds scheduled to come due at different dates in the future, rather than all in the same year.Bond laddering strategy is good for income looking investors who are unaware about the interest changes in the market.

Amount Maturity Yield5000 2 year 4.25%5000 3 year 4.65%5000 5 year 5.55%5000 7 year 5.89%5000 10 year 6.06%

The average yield of this ladder is 5.28% which is higher than yield of short duration bonds.

Semi Active Strategy :ImmunizationThe value of the bond is very much sensitive to systematic

factors like interest rate and inflation. Value of bonds change with coming the change in interest rate and inflation.– A portfolio manager may frame an optimal strategy

which will immunize the portfolio from interest rate changes.

– The immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates.

Therefore eliminating the impact of interest rate fluctuations from the bond portfolio is called immunization.

Semi Active Strategy :Immunization…cont

The impact of the interest rate fluctuations can be immunized by calculating the duration of the bond.

Duration of the bond is different from maturity period. If bond is hold for a particular duration the impact of the interest rate fluctuations get neutralized and investor can realize the desired yield from the bond.

The duration of the bond can be calculated as follow:

N

nn

n

N

nnn

iCiCn

Bo

1

1

)1(

)1()(

Where n is the life of the bond, C is the cash receipt at the end of year n, i is the yield to maturity.

Semi Active Strategy-calculation of duration of bond

A 3yearbond of Rs 1000 face value will pay 7% interest per annum. If market interest rate is 7%, What is the duration of the bond?

81.2

)07.1(1070

)07.1(70

)07.1(70

)07.1(1070)3(

)07.1(70)2(

)07.1(70)1(

32

32

D

The duration of the bond is 2.81 years. So in order the get the desired yield of the bond, investor will have to keep invest for 2.81 years.

Semi Active Strategy-calculation of duration of bond….cont

In contrast, single payment bonds, which sell at a discount and do not carry coupon interest, will have duration exactly equal to their terms to maturity.

For example a 3 years bond currently available at Rs 816, with face value Rs 1000. What will be the duration of the bond?

3

)07.1(1000

)07.1(1000)3(

3

3

D

The duration of the bond is 3 years. So in order the get the desired yield of the bond, investor will have to keep invest for 3 years.

price of bonds when there is change in the interest rate

When there will be any change in the market interest rate, the price of the bond will also change.

yieldinchangeMDpriceinchange %%

)/1( prDurationMD

Where, MD is modified duration, BP is change in basis point in market interest rate. MD can be calculated as follow.

Where, MD is modified duration, r is market interest rate, p is interest payments per year.

ExampleA 1000 par value bond with 3 years maturity, paying an annual coupon

of 6% and 8% is the market interest rate. Present value of the bond is 994.85. What changes will come in the price of the bond if market interest rate changes from 8% to 9%?

62.2)1/08.01/(83.2 MD

First of all lets calculate the duration of the bond

With change in the interest rate, the modified duration of the bond is:

83.2

)08.1(1060

)08.1(60

)08.1(60

)08.1(1060)3(

)08.1(60)2(

)08.1(60)1(

32

32

D

62.2)1(62.2%% eldchangeinyiMDiceChangeinprD

Therefore the price of the bond should reduce to -2.62 and now it will be 994.85 (1-0.0262)=992.41.

ExerciseCalculate the duration for a three year zero coupon bond and a three year

bond with 9% coupon if both the bonds have 9% yield to maturity.Ans. The duration of the zero coupon bond will be equal to the maturity

period of the bond. It is 3 years. Calculation of the duration of the second bond:

?

)09.1(1090

)09.1(90

)09.1(90

)09.1(1090)3(

)09.1(90)2(

)09.1(90)1(

32

32

D

ExerciseA bond with 12% coupon issued 3 years ago is redeemable after

5 years from now at a premium of 5%. The interest prevailing in the market is 14%. Calculate the duration of the bond?

ExerciseA 3 year bond with 9%coupon has YTM of10%. What is

the current price of the bond? If yields fall below 50 points basis. Use duration to estimate the new price?

Immunization of BondsAn investor needs Rs 1 lakh after 2 years and has two bonds in his mind

with YTM of 10%. Bond A has annual coupon rate of 7%, matures in 4 years and is priced at 904.90. bond B has annual coupon of 6% matures in one year and is priced at 963.64. How many bonds of each should he buy?

First of all we need to calculate the amount needed today to get Rs 1 lakh after two years

Money required=100000/1.1^2=82644.63

The next step is to calculate the duration of the bonds:Duration of A= (70/1.1+2*70/1.1^2+3*70/1.1^3+3*70/1.1^3+4*1070/1.1^4)/904.9=3.6029Duration of B will be one year.

We need to combine A and B to get a weighted average duration of 2, taking X as the proportion to be invested in A and 1-X as the proportion invested in B we solve the equation:3.6029X+(1-X)*1=2

Immunization of Bonds…cont

Proportion in A=X=0.3842, in B=0.6158Therefore the amount to be invested in

A=82644.63*0.3842=31752.06And in B=50892.56No. of bonds that needs to be purchased is the amount to

be invested divided by the price per bondNo of A =31752.06/904.89=35.09No of B= 50892.56/963.64=52.82

Active bond management strategySwitching bonds based on rate forecasting can be the most

productive bond portfolio action. The following are key points in active bond management strategy.

Maturity:Maturity should be lengthened when interest rates are

expected to fall and price to rise. Sector:The yield of the bond largely depend upon sector. Govt.

bonds provides less return in comparison to private sector bonds.

Quality or grading of bond:If investor has to invest for long time period then he should

invest only in high grade bonds, on the other hand low grades bonds are good for short time period investment horizon.

Active strategy-Yield curve anticipation

The term structure of the interest rate helps in forecasting the future interest rate of the bond.

By looking the historical interest rate, investor can forecast the future interest rate.

Industry Analysis

Industry Analysis is done to see the present and future growth prospects of the industry. Through Industry Analysis the weaknesses and strengths of the industry are analyzed.

Types of Industries

1. Transport Services2. Health Care3. Diversified4. FMCG5. Agriculture6. Transport Equipment7. Textile8.Oil and Natural Gas9. Chemical and Petroleum10. Tourism

11. Capital Goods12. Finance and Banking13. Power14. Telecom15. Metal, Metal Products, &

Mining16. Information Technology17. Consumer Durables18. Media and Publishing

Industries are classified on the basis of nature of business.

Industry Classification according to Business Cycles

Growth Industries- Growth industries are those industry which are growing over the period of time irrespective of economic growth rate (GDP). The growth rate of these industries are not much affected by economic growth rate because of having huge business opportunities like Software industry, retail industry, Information technology. Stocks of such industries are called Growth Stocks.

Cyclical Industries- Cyclical industries are those industries whose growth rate is largely affected by economic growth rate (GDP). These industries expand with high economic growth rate whereas growth rate decline with the decline of economic growth rate like Consumer good industry, Aviation, Hotel and Tourism. Stocks of such industries are called Cyclical Stocks.

Industry Classification according to Business Cycles…cont

Defensive Industries- Defensive industries are those industries whose growth rate is not affected by growth rate of economy (GDP) like Health Care. Stocks of such industries are called Defensive Stocks or Income Stocks.

Cyclical Growth Industries- Cyclical growth industries are those industries whose growth rate fluctuates to lesser degree with economic growth rate (GDP). Stocks of such industries are called Cyclical Growth Stocks.

Industry Analysis

• Quantitative Analysis-Quantitative analysis of industry deals with estimation and comparison of growth and profitability values of different industries with each others.

• Qualitative Analysis- Qualitative analysis deals with analysis of subjective factors with are associated with different industries.

Quantitative Analysis1.Forecasting of Present and Future Market

Position and Profitability of the Industry.

Investment Strategy-

Income Objective High Profitability RatioIndustries

Growth Objective High Market ShareIndustries

2. Comparative Analysis of Industries in Stock Market

05

10152025303540

Sensex P/E Drugs and Pharma P/E Information Tec. P/E

Qualitative Analysis

1. Attitude of the Govt. to the Industry-2. Attitude of the common Public-3. Permanence-4. Labour Conditions-5. Competitive Advantage

1. Product Differentiation Advantage-2. Absolute Cost Advantage-3. Economies of Scale-

Michael E. Porter’s approach of Industry Analysis

Threatsof

Potential

Entrants

BuyersNegotiatio

nPower

ThreatsOf

Substitutes

Suppliers Negotiation

Power

IndustryCompetitors

Michael E. Porter’s approach of Industry Analysis…cont

Industry Competitors- In a industry the following types of competition can be there.

– Perfect completion– Imperfect competition– Monopoly– Oligopoly

Michael E. Porter’s approach of Industry Analysis…cont

Threats from new entrantsIn some industries it is easy to make entry while in some industry it is difficult to make entry. There are certain barriers which make it difficult to make entry. These are-

• Cost related barriers• Regulation related barriers

Michael E. Porter’s approach of Industry Analysis…cont

Buyers negotiation powerIn some industries buyer have more negotiation power. Buyers can influence the price of the product as a result the profit of the firms from such industry will remain volatile.

Supplier negotiation powerIn some industries suppliers have more negotiation power. Buyers can not influence the price of the product as a result the profit of the firms from such industry will remain stable.

Fundamental Analysis

Fundamental Analysis deals with the macro level analysis of the economy by which the prospective ness of the economy is analyzed. Before investing into any stock market Institutional investors are interested in the present and future growth prospects of that market. Therefore fundamental analysis or economic analysis serves a great purpose to the investors.

Relationship between Economic Fundamentals and Stock Market

Appreciation in

domestic currency

Bullish Stock Market

Strong EconomicFundamentals

More FIIs

Growth Rate- GDP is defined as the total market value of all final goods and services produced within the country in a given period of time. Whereas Gross National Product is the market value of final products and earning from abroad.

0123456789

Year

GD

P G

row

th R

ate

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Growth Rate 7.8 4.8 6.5 6.1 4.4 5.8 4.0 8.5 7.5 8.1 9.0 9.5

2. Per Capital Income-Per capita income means how much each individual receives, in monetary terms, of the yearly income that is generated in their country through productive activities. That is what each citizen would receive if the yearly income generated by a country from its productive activities were divided equally among everyone.

3. Attitude of Other Investors-FII and FDI Trends- Foreign institutional investment refers investment into financial securities like equities, mutual funds, derivatives, bonds. Whereas FDI refers to investment in real assets like plant, machinery etc.

4. Inflation Rate-The inflation rate is a measure of inflation, the rate of increase of a the price of basic goods which is calculated by some price index (usually some form of consumer price index). Equivalently, the rate of decrease in the purchasing power of money. A high inflation will discourage the foreign investment whereas a low inflation encourage the foreign investment.

Inflation Stock Market

5. Interest Rate (Monetary Policy) - The interest rate which is offered by banks over their deposits is also major determinate of foreign investment. A high interest rate will encourage investment in Debt Market, whereas a low interest rate will encourage the foreign investment in Capital Market.

Interest rate Stock Market

-40.00

-20.00

0.00

20.00

40.00

60.00

80.00

Year

Retu

rn

6. Capital Market Analysis- Movement of Index

May-96 May-97 May-98 May-99 May-00 May-01 May-02

3709 3724 3673 3835 4434 3623 3136

May-03 May-04 May-05 May-06 May-07 May-08

3172 4760 6666 10679 14451 17000

Comparative Analysis of Difference Stock Markets Returns

Market/Index March 2006 Dec. 2006

South Korea KOSPI 10.86 12.21Thailand SET 9.97 9.40

Indonesia JCI 21.68 25.10

Malaysia KLCI 15.33 17.35

Taiwan TWSE 14.62 20.85

BSE SENSEX 20.92 22.76

NSE S & P NIFTY 20.26 21.26

Growth Prospectus of Stock Returns

CAGR for the Period 2000-2007

CAGR isn't the actual return in reality. It's an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate. You can think of CAGR as a way to smooth out the returns.

S & P 500 Hang Sang Kospi Sensex SSE Com. Index Nikkei 227

Op 1478 15532 943 3972 1535 8340

Cl 1523 27812 1897 20287 5261 15307

CAGR 0.4% 8% 10% 26% 19% 12%

Some Other Important Factors

Internal Political and Social Events-The internal political and social stability have positive impact upon the foreign investment. It create a good climate for investment in the economy and investors are motivated to invest in the economy.

Budget Analysis-Budget of the Govt. can be surplus or deficit. Budget deficit is another important factor which determine the foreign investment in the country. A high budget deficit in the indication of govt. excess spending, and govt. owes debt.

Consumer SurveyConsumer survey indicates the trend of consumers preferences, their income level, their attitude towards a particular products.

Index of Industrial Production-Index of industrial production indicates the performance of manufacturing industries, coal and mining industries and oil refining industries.

Agriculture ProductionAgriculture production also indicates the performance of the economy. Agriculture of the economy is self reliance or it is depending upon monsoon. If agriculture is depending upon monsoon then GDP growth rate of the economy will be highly unstable.

Company AnalysisCompany analysis stands for analyzing the company’s strengths and

weaknesses. With the help of the company analysis the growth prospectus of the company are analyzed.

Internal Analysis of the Company:Internal analysis of the company can be done by understanding the

income statement and financial statement of the company. The internal analysis of the company can be done by calculating the

various accounting ratios by using the information given in the income statement and financial statement of the company.

External Analysis of the Company:On the other hand the external analysis of the company can be done

by valuing the preference share and common equity share of the company.

Valuation of Redeemable preference shares

nn

n

kPn

kDiv

kDiv

kDiv

kDiv

Po)1()1(

...)1(3

)1(2

)1(1

32

Suppose an investor is considering the purchase of a 12 years preference shares, with Rs. 100 par value and 10% dividend rate. The redemption value of the preference share is Rs. 120/- The investor required rate of return is 10.5%. What price should investor pay for this preference share?

121232 )105.01(120

)105.01(10

......)105.01(

10)105.01(

10)105.01(

10

Po

P0=[ value of dividends]+[ value of preference share]

P0=[ 65.06]+[ 36.24]=101.30

Valuation of Irredeemable Preference shares

Suppose a company has issued Rs. 100 irredeemable preference share on which it pays a dividend of Rs. 9/-. Assume that this type of preference share is currently yielding a dividend of 11%. What should be the price of this preference share?

82.8111.09

KDiv

Po

Valuation of Common Equity shares

The valuation of common equity shares are more difficult in comparison of bond and preference shares because of uncertainty of earning and market price of common shares. However, by looking the historical track record of dividend and market price of common equity shares we can do valuation.

Valuation of Common equity sharesSingle Period Valuation-Dividend Discount Method-Suppose an investor is willing to buy a share whose trading is going at Rs. 19/- suppose the share is expected to pay dividend equal to Rs. 2/- and year end the price will be Rs. 21/- If the investor opportunity cost of capital is 15 percent, how much should he pay for the shares?

2015.1212

)1(1

KPDiv

Po

Rs. 20/- is the present value of the share. If market price of the share is more than the current price, it means the share is over valued.On the other hand if the market price of the share is less than the current price of share than the share is undervalued.

Valuation of Common equity sharesMultiperiod Valuation-Dividend Discount Method-In multiperiod valuation the share is kept hold for number of years, and in which a series of dividend is received by the investors.

nn

n

kPn

kDiv

kDiv

kDiv

kDiv

Po)1()1(

...)1(3

)1(2

)1(1

32

Price of Common equity share when there is growth in dividend

Suppose an investor is willing to buy a share whose trading is going at Rs. 20/- . The last dividend paid by the firm was Rs 2 , and it is expected to growth by the rate of 5% perpetually,. The cost of capital is 10%, then what will be the price of the of this common share?

4205.010.0)05.1(210 Rs

gKDivP

The price of this equity shares will be Rs 42 to the company.

exampleSuppose that dividend per share of a firm is expected to be Rs 1 in the next year, and the expected to grow by 6% per year perpetually. Determine the cost of equity capital is the current market price of the share is Rs 25.

%101.006.0251

01 org

PDivK

The cost of this equity shares will be 10% to the company. The expected price of the stock can also be found out-

50.2606.010.0

06.121

gKe

DivP

So the price of this stock in the next year is expected to be 26.50.

exampleA company paid a dividend of Rs 3.70 in the previous year.

The dividends in the future is expected to grow perpetually at a rate of 8%. Find out the price of capital if capitalization rate is 12%?.

10008.012.0

)08.01(70.3 RsK

So price of this share should be Rs 100

gKeDiv

gKegDivPo

1)1(

Cost of equity in two stages growthThe fertilizers Ltd has been growing at a rate of 7% per year in recent

years, and it is expected this growth rate will continue in next three years, then it is likely to grow at the normal growth rate of 6% in next 2 years, after that it will grow at a rate of 5% perpetually. The required rate of return of the shares of investor is 12%, and the dividend paid by the company in last year was 3. At what price would you as an investor be ready to buy this stock in 5th year?

Div in 1st year: 3*1.07=3.21Div in 2nd year: 3.21*1.07=3.43Div in 3nd year:3.43*1.07=3.67Div in 4nd year: 3.67*1.06=3.89Div in 5nd year: 3.89*1.06=4.13P5=D6/(K-g)=4.13(1+0.05)/(0.12-0.0.5)P5=Rs 61.95It means the price of this stock in the 5th year will be Rs 61.95.

The last dividend declared by the company Rs 2 per share. For the next two years the expected growth rate is 15% p.a. and thereafter 9% p.a. forever. The required rate of return is 10%. What price you should pay for this stock?

D1=2(1+0.15)=2.30D2=2.30(1+0.15)=2.645

P2=D3/(K-g)=2.645(1+0.09)/(0.15-0.10)P2=288.30PV=2.30/(1+0.10)+2.645/(1+0.10)^2+288.30/(1+0.10)^2PV=2.09+2.18+238.27=242.55It means investor should be ready to purchase this stock at Rs. 242.55.

X Ltd declared Rs 0.71 dividend in the last year. The dividend is expected to grow Required rate of return is 16%.Growht rate of dividend is 15% for ten years and 10% thereafter. What will be the price of the stock in 10th year? What price will you pay of the stock today?

D1=0.71(1+0.15)=0.82D2=0.82(1+0.15)=0.95D3=0.95(1+0.15)=1.10D4=1.10(1+0.15)=1.25D5=1.25(1+0.15)=1.45D6=1.45(1+0.15)=1.66D7=1.66(1+0.15)=1.90D8=1.90(1+0.15)=2.18D9=2.10(1+0.15)=2.15D10=2.15(1+0.15)=2.88Price of the share in the 10th year will be P10=D11/K-gP10=2.88(1+0.10)/(0.16-0.10)=52.80The price of the stock today will be:PV=0.82/(1+0.16)+0.95/(1+0.16)^2+1.10/(1+0.16)^3+1.25/(1+0.16)^4+

1.45/(1+0.16)^5+1.66/(1+0.16)^6+ 1.90/(1+0.16)^7+2.18/(1+0.16)^8+ 2.51/(1+0.16)^9+2.88/(1+0.16)^10+52.80/(1+0.16)^10

=6.82+11.93=18.75The investor should be ready to pay Rs 18.75 for this stock today.

Major Balance Sheet Items

Assets• Current assets:

– Cash & securities– Receivables– Inventories

• Fixed assets:– Tangible assets– Intangible assets

Liabilities and Equity• Current liabilities:

– Payables – Short-term debt

• Long-term liabilities• Shareholders' equity

An Example: XYZ Balance Sheet

• Assets:– Current Assets: 7,681.00– Non-Current Assets: 3,790.00– Total Assets: 11,471.00

• Liabilities:– Current Liabilities: 5,192.00– LT Debt & Other LT Liab.: 971.00– Equity: 5,308.00– Total Liab. and Equity: 11,471.00

Understanding the Income statement

Sales 25,265.00Costs of Goods Sold -19,891.00Gross Profit 5,374.00Cash operating expense -2,761.00EBITDA 2,613.00Depreciation & Amortization -156.00Other Income (Net) -$6.00EBIT 2,451.00Interest -$0.00EBT 2,451.00Income Taxes -785.00Special Income/Charges -194.00Net Income (EAT) 1,666.00

Major Income Statement Items

• Gross Profit = Sales - Costs of Goods Sold• EBITDA

= Gross Profit - Cash Operating Expenses• EBIT = EBDIT - Depreciation - Amortization• EBT = EBIT - Interest • NI or EAT = EBT- Taxes• Net Income is a primary determinant of the firm’s

cashflows and, thus, the value of the firm’s shares

Objectives of Ratio Analysis• Standardize financial information for

comparisons• Evaluate current operations• Compare performance with past

performance• Compare performance against other firms

or industry standards• Study the efficiency of operations• Study the risk of operations

Rationale Behind Ratio Analysis• A firm has resources• It converts resources into profits through

– production of goods and services– sales of goods and services

• Ratios– Measure relationships between resources and

financial flows– Show ways in which firm’s situation deviates from

• Its own past• Other firms• The industry• All firms-

Types of Ratios

• Financial Ratios:– Liquidity Ratios

• Assess ability to cover current obligations

– Leverage Ratios• Assess ability to cover long term debt obligations

• Operational Ratios:– Activity (Turnover) Ratios

• Assess amount of activity relative to amount of resources used

– Profitability Ratios• Assess profits relative to amount of resources used

• Valuation Ratios:• Assess market price relative to assets or earnings

• Debt ratioDebt ratio is used to calculate the ratio of debt in the total capital of the firm.

Debt Ratio=Total Debt/Total Asset• Debt equity ratio

Debt equity ratio is used to calculate the ratio of debt and equity in firm capital.

Debt equity ratio=debt/equity• Total asset turnover ratio

Total asset turnover ratio is calculated to measure how efficiently a firm is converting its asset into sale.

Total asset turnover ratio=net sale/total assetNet asset turnover ratio=Net sale/Net asset

• Return on equity ratioThe return on equity ratio is calculated to measure the rate of return of the equity share holders.

Return on equity ratio=Net income/equity capital• Return on Investment ratio

Return on investment ratio is calculated to measure the over all return over the capital employed in the firm.

ROI=EBIT(1-T)/capital employed.