FINANCIAL MANAGEMENT -- PAPER 1

CHAPTER:- INDIAN FINANCIAL SYSTEM

F − P 365
1. T-Bill Yield (k) = ×
P d
Where, F = Face value of T-Bill (If not given assume 100)
P = Price / Issue Price of T-Bill
d = Maturity period in days.

CHAPTER:- TIME VALUE OF MONEY

COMPOUNDING
It is a process to find future value when present value is known.

SITUATION A:- SINGLE CASH FLOW

Compounded Annually Compounded many a times during the year
Method 1:- Method:-
FV = PV[(1+k) n ] (a) Find Effective/Flat rate of Int. (r)
m
 k
r = 1 +  −1
 m
FVIF
Where, k = Interest Rate
Where, FV = Future Value
m = No of times compounding is done
PV = Present Value
k = Interest Rate (b) Then apply FV = PV(1+r) n on annual basis
n = No of Years
(1+k) n = Future Value Interest Factor
(FVIF)
Method 2:-
From the above method 1 we can draw one more
formulae, i.e,
FV = PV x FVIF ( k, n)

SITUATION B:- ANNUITY AT THE END OF THE YEAR

Compounded Annually Compounded many a times during the year
Method 1:- Method:-
 (1 + k ) n −1  (a) Find Effective/Flat rate of Int. (r)
FVA n = A   m
 k   k
r = 1 +  −1
 m
Where, k = Interest Rate
FVIFA m = No of times compounding is done
Where, A = Annuity (1 + r ) n −1
(b) Then apply FVA n = A  on
Method 2:-  r 
From the above method 1 we can draw one more annual basis
formulae, i.e,
FVA n = A x FVIFA ( k, n)

1
SITUATION C:- ANNUITY AT THE BEGINNING OF THE YEAR
Compounded Annually Compounded many a times during the year
Method 1:- Method :-
 (1 + k ) n −1  (a) Find Effective/Flat rate of Int. (r)
FVA n = A(1+k)   m
 k   k
r = 1 +  −1
 m
Where, k = Interest Rate
FVIFA m = No of times compounding is done
(1 + r ) n −1
Method 2:- (b) Then apply FVA n = A(1+r)   on
From the above method 1 we can draw one more  r 
formulae, i.e, annual basis
FVA n = A(1+k) x FVIFA ( k, n)

DISCOUNTING
It is a process to find present value when future value is known.

SITUATION A:- SINGLE CASH FLOW

Compounded Annually Compounded many a times during the year
Method 1:- Method 1:-
We know, FV = PV(1+k) n (a) Find Effective/Flat rate of Int. (r)
m
 1   k
or, PV = FV  n 
r = 1 +  −1
 (1 + k)   m
Where, k = Interest Rate
m = No of times compounding is done
PVIF  1 
(b) Then apply PV = FV  n  on annual
Method 2:-  (1 + r) 
From the above method 1 we can draw one more basis
formulae, i.e,
PV = FV x PVIF ( k, n)

SITUATION B:- ANNUITY AT THE END OF THE YEAR

Compounded Annually Compounded many a times during the year
Method 1:- Method:-
 (1 + k ) n − 1  (a) Find Effective/Flat rate of Int. (r)
PVA n = A  n 
m

 k (1 + k ) 
 k
r = 1 +  −1
 m
Where, k = Interest Rate
m = No of times compounding is done
PVIFA
Method 2:-  (1 + r ) n − 1
(b) Then apply PVA n = A  n  on
From the above method 1 we can draw one more  r (1 + r ) 
formulae, i.e, annual basis
PVA n = A x PVIFA ( k, n)

2
SITUATION C:- ANNUITY AT THE BEGINNING OF THE YEAR
Compounded Annually Compounded many a times during the year
PVA n = Annuity + Annuity at the end of the
year compounded annually for (n-1)
years
Method 1:-
  (1 + k) n -1 − 1
PVA n = A + A ×  n -1 
  k(1 + k) 

PVIFA
Method 2:-
From the above method 1 we can draw one more
formulae, i.e,
PVA n = A + [A x PVIFA ( k, n -1) ]

RELATION BETWEEN NOMINAL INTEREST RATE, REAL INTEREST

RATE, AND INFLATION

(1+r) = (1+R)(1+a)
Where, r = nominal rate of Interest,
R = Real rate of Interest,
a = Inflation rate

EFFECTIVE/FLAT RATE OF INTEREST

Effective/Flat rate of Interest is found when compounding is done many a times during the
year, and the payment is done annually. Thus Effective/Flat rate of Interest is calculated as r =
m
 k
1 +  − 1 .
 m
Again, when payment is made rather than annually (may be monthly, quarterly, semi-
annually), then we will calculate Effective/Flat rate of Interest is calculated as per month, per
quarter, per semi-annual ( r ′) as the case may be. Then we will find FV, FVA, PV, PVA ( r ′)
taking into effect. For calculating it,
m
 k
• First, find Effective/Flat rate of Interest (r), calculated as r = 1 +  −1 .
 m
• Then find Effective/Flat rate of Interest per month, per quarter, per semi-annual ( r ′) ,
1
calculated as, ( r ′) = (1 + r) m −1
• Then we will find FV, FVA, PV, PVA ( r ′) taking into effect.

Example of discounting for Annuity at the beginning of the year compounded annually:-
Problem:- Annuity of Rs. 2000 is deposited at the beginning of the year for full 4 years with a
compound interest of 10% p.a. compounded annually. Find out the present value of the Annuity.

Solution:-
3
 Compounded Interest:- 10% p.a. compounded annually
Annuity is deposited at the beginning of the each year. Thus Annuity of Rs. 2000 deposited
at the beginning of the 1st year will be as same as Rs. 2000 and the Annuity of Rs. 2000 each
deposited at the beginning of the 2nd, 3rd, and 4th year will be calculated on Annuity at the end of the
year at 10% p.a. compounded annually for 3 years.
i.e, PVA n = Annuity + Annuity at the end of the year compounded annually for (n-1) years

Method 1:-
  (1 + k) n -1 − 1
PVA n = A + A ×  n -1 
  k(1 + k) 
  (1 + 0.10) 4-1 − 1 
or, PVA n = 2000 + 2000 ×  4 -1 
  0.10(1 + 0.10) 
  (1.10) 3 − 1 
or, PVA n = 2000 + 2000 ×  3 
  0.10(1.10) 
 0.331 
or, PVA n = 2000 + 2000 ×
 0.1331 

or, PVA n = 2000 + (2000 x 2.487)
∴PVA n = 4973
Method 2:-
PVA n = A + [A x PVIFA ( k, n -1) ]
or, PVA n = A + [A x PVIFA (10%,3) ]
or, PVA n = 2000 + (2000 x 2.487)
∴PVA n = 4973

DOUBLING PERIOD
72
According to Rule 72, Doubling Period =
Interest Rate
69
According to Rule 69, Doubling Period = 0.35 +
Interest Rate

SINKING FUND FACTOR (SFF)

We know, Annuity at the end of the year compounded annually,
 (1 + k ) n −1 
FVA n = A  
 k 
 k 
or, A = FVA n ×  
 (1 + k) −1
n

 k  1
Where,   is known as Sinking Fund Factor i.e. SFF = FVIFA
(1 + k) −1 
n
( k, n )

4
CAPITAL RECOVERY FACTOR (CRF)
We know, Annuity at the end of the year compounded annually,
 (1 + k ) n − 1 
PVA n = A  n 
 k (1 + k ) 
 k (1 + k ) n 
or, A = PVA n ×  
 (1 + k ) − 1 
n

CRF
 k (1 + k ) 
n
1
Where,   is Capital Recovery Factor i.e. CRF = PVIFA
 (1 + k ) − 1 
n
( k, n )

PRESENT VALUE OF A PERPETUITY (P ∞)

I
Present value of Perpetuity (P ∞) =
k
Where, I = Instalment/Annuity
k = Rate of Interest
Net Present value of Perpetuity = Present value of cash inflow - Present value of cash outflow

Problem:- Mr. Farooq is considering to purchase a commercial complex that will generate a net
cash flow of Rs. 4,00,000 at the end of every year till perpetuity. Mr. Farooq’s required rate of
return is 12%. How much should Mr. Farooq pay for the complex if it produces cash flow forever.
I
Solution:- We know, Present value of Perpetuity (P ∞) =
k
Where, I = Instalment/Annuity = Rs. 4,00,000
k = Rate of Interest = 12% = 0.12
4,00,000
∴Present value = 0.12
= 33 ,33,333

PRESENT VALUE OF CASH FLOWS GROWING AT CERTAIN % TILL ∞

Cash flow at the end of one year
∴Present value = ke −g
Where k e = Required rate of return, g = Annual growth rate in cash flows.

Problem:- Mr. Farooq is considering to purchase a commercial complex that will generate a net
cash flow of Rs. 4,00,000 at the end of one year. The future cash flows are expected to grow at the
rate of 4% per annum. Mr. Farooq’s required rate of return is 12%. How much should Mr. Farooq
pay for the complex if it produces cash flow forever.

Cash flow at the end of one year

Solution:- We know, Present value =
ke −g

Where k e = Required rate of return = 12% = 0.12

5
 g = Annual growth rate in cash flows. = 4% = 0.04

4,00,000 4,00 ,000

∴Present value = 0.12 − 0.04
=
0.08
= Rs. 50,00,000

RELATIONSHIP BETWEEN DIFFERENT FACTORS

1
(a). We know, FVIF = (1+k) n and PVIF =
(1 + k) n
1
Thus we can say, PVIF =
FVIF

(1 + k ) n −1 (1 + k ) n − 1
(b). We know, FVIFA = and PVIFA =
k (1 + k )
n
k
FVIFA
Thus we can say, PVIFA =
FVIF
or, PVIFA = FVIFA × PVIF

k
(c). We know, Sinking Fund Factor =
(1 + k) n −1
1
Thus we can say, Sinking Fund Factor =
FVIFA
1
or, Sinking Fund Factor =
PVIFA × FVIF

k (1 + k )
n

(d). We know, Capital Recovery Factor =

(1 + k ) n − 1
1
Thus we can say, Capital Recovery Factor =
PVIFA
FVIF
or, Capital Recovery Factor =
FVIFA

[NOTE:- Relationships are not limited to these only. It can be drawn to any extent. There is no such
limitation of relationship]

CHAPTER:- LEVERAGE
Rs.
Sales ∗∗∗
Less:- Variable Cost ∗∗∗
Contribution ∗∗∗
Less:- Fixed Cost/Operating Cost ∗∗∗
6
 EBIT/Operating Profit ∗∗∗
Less:- Interest ∗∗∗
PBT/EBT ∗∗∗
Less:- Tax ∗∗∗
PAT ∗∗∗
Profit after tax (PAT)
EPS =
No. of outstandin g Equity Shares

DEGREE OF OPERATING LEVERAGE (DOL)

% change in EBIT
(a) Degree of Operating Leverage (DOL) = % change in Quantity

Contributi on
(b) Degree of Operating Leverage (DOL) =
EBIT
Contributi on
or, Degree of Operating Leverage (DOL) =
Contributi on − F

Q(S − V)
or, Degree of Operating Leverage (DOL) =
Q(S − V) − F
Where, Q = Quantity sold, S = Selling Price per unit,
V = Varible Cost per unit, F = Fixed Cost/Fixed Operating Cost.
EBIT = Earning before Interest & Tax/Operating Profit = Contribution – Fixed Cost

OPERATING BREAK EVEN POINT (Q)

Operating Break Even Point is that level of output at which DOL will be undefined (i.e. EBIT = 0)
Contributi on Contributi on
We know, DOL = = = ∞ (Undefined)
EBIT 0
Q(S − V)
Again, DOL=
Q(S − V) − F
DOL is ∞ (undefined) when denominator is zero (0).
i.e. Q(S −V) −F = 0
or, Q(S − V) = F
F
or, Q =
S −V
F
Thus, when Q = , Operating Break Even Point is achieved.
S −V
DEGREE OF FINANCIAL LEVERAGE (DFL)
% change in EPS
(a) Degree of Financial Leverage (DFL) = % change in EBIT

EBIT
(b) Degree of Financial Leverage (DFL) = EBIT − I − D p
(1 − T)

7
 Where, EBIT = Earning before Interest & Tax/Operating profit = Q(S −V) −F ,
I = Interest/Fixed Financing Cost, D p = Preference Dividend
T = Tax rate

FINANCING BREAK EVEN POINT (Rs.)

Financing Break Even Point is that level of output at which DFL will be undefined (i.e.
Denominator is zero)
EBIT
We know, DFL = EBIT − I − D p
(1 − T)
DFL is ∞ (undefined) when denominator is zero (0).
Dp
i.e. EBIT − I − =0
(1 − T)
Dp
or, EBIT = I +
(1 − T)
Dp
Thus, when EBIT = I + , Financial Break Even Point is achieved.
(1 − T)

DEGREE OF TOTAL / COMBINED LEVERAGE (DTL / DCL)

Degree of Total / Combined Leverage (DTL / DCL) = DOL × DFL
% change in EBIT % change in EPS
(a) Degree of Combined Leverage (DTL / DCL) = % change in Quantity × % change in EBIT

% change in EPS
or, Degree of Combined Leverage (DTL / DCL) = % change in Quantity

Contributi on EBIT
×
(b) Degree of Combined Leverage (DTL / DCL) = EBIT Dp
EBIT − I −
(1 − T)

Q(S − V) Q(S − V) − F
×
or, Degree of Combined Leverage (DTL / DCL) = Q(S − V) − F Q(S − V) − F − I −
Dp
(1 − T)
Q(S − V)
or, Degree of Combined Leverage (DTL / DCL) = Q(S − V) − F − I − D p
(1 − T)
Where, Q = Quantity sold, S = Selling Price per unit,
V = Varible Cost per unit, F = Fixed Cost/Fixed Operating Cost.
I = Interest/Fixed Financing Cost, D p = Preference Dividend
T = Tax rate, EBIT = Earning before Interest & Tax/Operating Profit

TOTAL / COMBINED / OVERALL BREAK EVEN POINT (Q)

Total / Combined / Overall Break Even Point is that level of output at which DCL / DTL will be
undefined (i.e. Denominator is zero)

8
 Q(S − V)
We know, DTL / DCL = Q(S − V) − F − I − D p
(1 − T)
DTL / DCL is ∞ (undefined) when denominator is zero (0).
Dp
i.e. Q(S − V) − F − I − =0
(1 − T)
Dp
or, Q(S − V) = F + I +
(1 − T)
Dp
F +I +
or, (1 − T)
Q=
S −V
Dp
F +I +
Thus, when (1 − T) , Total / Combined / Overall Break Even Point is achieved.
Q=
S −V

CHAPTER:- VALUATION OF SECURITIES

VALUATION OF BONDS
(a) Basic Bond Valuation Model:- Sometimes the holder of a bond receives a fixed annual interest
payment for a certain number of years and a fixed principal repayment (equal to par value) at
the time of maturity. Therefore, the intrinsic value or the present value of a bond can now be
written as:
V0 (P0 ) = I(PVIFA k d ,n ) + F(PVIF k d , n )
Where, V 0 = Intrinsic value of the bond / Value of bond
P0 = Present value of the bond, I = Annual interest payable on the bond
F = Principal amount (par value) repayable at the maturity time
n = Maturity period of the bond, kd = Required rate of return/ Capitalisation rate.

(b) Bond Value with Semi-Annual Interest:- Some of the bonds carry interest payment semi-
annually. As half-yearly interest amounts can be reinvested the value of such bonds would be more
than the value of the bonds with annual interest payments. Hence, the bond valuation equation can
be modified as:
i. Annual interest payment i.e., I, must be divided by two to obtain interest payment semi-
anually.
ii. Number of years to maturity will have to be multiplied by two to get the number of half-
yearly periods.
iii. Discount rate has to be divided by two to get the discount rate for half-yearly period.

Thus with the above modifications, the bond valuation equation becomes:
I    
V0 ( P0 ) = PVIFA  + F PVIF k 
2    ,2n 
kd d
2
,2n
  2 
Where, V 0 = Intrinsic value of the bond
P0 = Present value of the bond

9
 I
= Semi-annual interest payable on the bond
2
F = Principal amount (par value) repayable at the maturity time
2n = Maturity period of the bond (i.e total no of payments)
kd
= Required rate of return for half-year period.
2

ONE PERIOD RATE OF RETURN

If a bond is purchased and then sold one year later, its rate of return over this single holding
period can be defined as one period rate of return.

One period rate of return =

∴Real rate of return = One period rate of return – Inflation rate

CURRENT YIELD
Coupon Interest
Current yield:-
Current Market Price

YIELD TO MATURITY(YTM)
It is the rate of return earned by an investor who purchases a bond and holds it till
maturity. The YTM is the discount rate which equals the present value of promised cash flows to
the current market price/purchase price.

F −P
F −P I+
I+ n
Yield to Maturity(YTM) = n or, YTM =
F +P
0.4F + 0.6P
2

Where, I = Interest, F = Redemption Value, P = Issue Price (i.e Market Price), n = No. of years

EQUITY VALUATION
(A) Single Period Valuation Model:- This model is for an equity share wherein an investor holds
it for one year. The price of such equity share will be:-
D1
Year - 1
P0 P1
Now, P0 = PV of Dividend received received during Yr. 1 + PV of price of share after Yr. 1
P0 = D1 × PVIF (k e ,1) + P1 × PVIF (k e ,1)
D1 P1  FV 
or, P0 = +  PV = 
(1 + k e ) (1 + k e )  (1 + k) n 

10
Where, P0 = Current market price of the share, D1 = Expected dividend a year hence
P1 = Expected price of a share a year hence, k e = Required rate of return/Capitalisation
rate

(B) Multi Period Valuation Model:- This model is for an equity share wherein an investor holds it
for more than one year (say 4 years). The price of such equity share will be:-
D1 D2 D3 D4
Yr. 1 Yr. 2 Yr. 3 Yr. 4
P0 P4
Now, P0 = PV of Yr. 1 Dividend + PV of Yr. 2 Dividend + PV of Yr. 3 Dividend + PV of Yr. 4
Dividend + PV of Redemption value of share at the end of Yr.4
D1 D2 D3 D4 P4  FV 
P0 = + + + + We know, PV = 
(1 + k e ) (1 + k e )
1 2
(1 + k e ) 3
(1 + k e ) 4
(1 + k e ) 4  (1 + k) n 

EQUITY VALUATION WITH VARIATION IN DIVIDEND

(A) Valuation with Constant Dividends :- Assume that the dividend per share is constant year
after year (say till infinity), whose value is D, then Value of equity share ( P0 ) is calculated
as:-
D1 D2 D3 D4 D∞
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. ∞
P0
D
∴The value of the stock ( P 0 )=
ke
[ D = D1 = D 2 = D 3 = D 4 = D ∞ ]
Where, k e = Required rate of return / Capitalisation rate.

(C) Valuation with Constant growth in Dividends :- It is assumed that dividends tend to increase
over time because business firms usually grow over time. Therefore, if the growth of the dividends
is at a constant rate, the calculation of dividend for the coming years are calculated as :-
D n = D n -1 (1 + g) (Used to calculate when change in growth rate takes place)
or, D n = D 0 (1 + g) n (Used to calculate when there is constant growth rate)
Where, D n = Dividend for year “n”, D 0 = Dividend for year “0”,
g = constant compound growth rate

D1 D2 D3 D4 D∞
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. ∞
P0

Now, the Value of equity share ( P0 ) is calculated as:-

D1 D 0 (1 + g) 1
[We know, D n = D 0 (1 + g) ]
n
P0 = =
ke −g ke −g
Where, k e = Required rate of return / Capitalisation rate, g = Growth rate,
11
 D n = Dividend for the year “1”

Illustration:- Shetkani Solvents Ltd. Is expected to grow at the rate of 7% per annum and current
year dividend is Rs. 5.00. If the rate of return is 12%, what is the price of the share today?

Solution:-
D0 = 5 D1 = 5.35 D 2 = 5.72 D 3 = 6.12 D 4 = 6.59 D∞
Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. ∞
P0

D1 5.35 5.35
The price of the share would be ( P0 ) = = = = 107
k e − g 0.12 − 0.07 0.05
or,
D 0 (1 + g) 1 5(1 + 0.07) 1 5.00 ×1.07 5.35
The price of the share would be ( P0 ) = = = = = 107
ke − g 0.12 − 0.07 0.05 0.05

(D) Valuation with Variable growth in Dividends:- Some firms have a super normal growth
rate followed by a normal growth rate. If the dividends move in line with the growth rate, the
price of the equity share will be calculated in 3 steps:-

Step 1
Expected dividend stream during the supernormal period of the super normal growth is to be
specified and the present value of this dividend stream is to be computed for which the
equation to be used in
= PV of Dividend of yr. 1 + PV of Dividend of yr. 2 + PV of Dividend of yr. 3 + PV of
Dividend of yr. 4 + ………. PV of Dividend of yr. n
D1 D2 D3 D4 Dn  FV 
= + + + + ......... We know, PV = 
(1 + k e ) 1
(1 + k e ) 2
(1 + k e ) 3
(1 + k e ) 4
(1 + k e ) n  (1 + k) n 

D 0 (1 + g a ) D1 (1 + g a ) D 2 (1 + g a ) D 3 (1 + g a ) D (1 + g a )
= + + + + ....... n -1 [We know,
(1 + k e ) 1
(1 + k e ) 2
(1 + k e ) 3
(1 + k e ) 4
(1 + k e ) n
D n = D n -1 (1 + g)
Where, k e = Required rate of return / Capitalisation rate, D n = Dividend for the year “n”
g a = Growth rate during the period of super normal growth,

Step 2
The value of the share at the end of the initial growth period is to be calculated which as,

12
 D n +1
Pn = (as per the constant growth model)
ke − gn
which is then discounted to the present value. The discounted value is calculated as:-
Pn
∴Discounted value =
(1 + k e ) n
Where, Pn = Price of security at the end of “n” years, k e = Required rate of return,
g n = Normal growth rate after super normal growth period is over.

Step 3
Then add both the present value composites to find the value (Po) of the share which is
= Present value of dividend stream calculated in step 1 + Discounted Value (Price) of the share
at the end of the initial growth period ( Pn -- i.e. super normal growth period)

VALUE OF SECURITIES WHOSE VALUE INCREASES WITH CONSTANT

GROWTH
When value of any security increases with constant growth, its value are shown as :-
Value of the security at the end of year “n” ( Pn ) = P0 (1 + g) n
i.e. P1 = P0 (1 + g) 1
i.e. P2 = P0 (1 + g) 2
i.e. P3 = P0 (1 + g) 3

Illustration :- Price of a car today is Rs. 250000. If the car prices expected to go up by 4% p.a. Find
the value of car in 3rd, 4th, and 5th year.
Solution :-
We know, Pn = P0 (1 + g)
n

∴P3 = 250000 × (1 + 0.04 ) 3 = 281216

∴ P4 = 250000 × (1 + 0.04 ) 4 = 292465
∴P5 = 250000 × (1 + 0.04 ) 5 = 304163

VALUE OF SECURITY BASED ON EARNING

Here Growth (g) = br
Where, g = Growth rate
r = Cost of Equity / Cost of capital / Capitalisation rate / Req. rate of return / Ret on investment
b = Retention ratio = 1 - Dividend Payout Ratio
D1 D (1 + g) 1
Now, Current Value / MP of share ( P0 ) = = 0
ke − g k e − br

SOME IMPORTANT FORMULAE

13
 Dividend per share (DPS)
(a) Dividend Payout Ratio =
Earning per share (EPS)
or, Dividend Payout Ratio = 1 – Retention Ratio

(b) Dividend per share (DPS) :- Earning per share (EPS) x Dividend Payout Ratio
Dividend per share (DPS)
(c) Dividend Yield =
Market price per share (MPS)
DPS EPS
= ×
EPS MPS
= Dividend Payout Ratio ×Capitalisa tion rate

 V r fe al r ai gl oqA ul b mpi u eazmet acit ole dhirl t d eae t dt o i i n t o r s

−
 a a t lo hsfl t fishe ar pe emn str sdhre  s fa e r re e h n o c l ed e
(d) Liquidation value per share =

  
N o o fgoEu s .t qh s uat a ri ten y sd i n
Current Market price − Face Value
(e) Bond Trading (at premium or discount) = ×100
Face Value

Market price per share (MPS)

(f) Price-Earning ratio =
Earning per share (EPS)

Dividend per share (DPS)

(g) Dividend Ratio =
Face Value of share

CHAPTER:- RISK AND RETURN

D t + (Pt − Pt -1 )
(1) Actual Stock rate of return ( k j ) =
Pt -1
Where, D t = Income or cash flows receivable from the security at time ‘t’.

14
( Pt −Pt -1 ) = Capital Appreciation,

P t = Price of the security at time ‘t’ at the end of the holding period = ∑ Prob x Price
Pt -1 = Price of the security at time ‘t-1’ at the beginning of the holding period or purchase
price.

D1
(2) Expected Stock rate of return / Mean ( k j ) = +g
P0
Where, D1 = Income / cash flows / Dividends receivable = D 0 (1 +g) [Here, D 0 = Current
Income]
P 0 = Current Purchase / Market Price of the security.
g = Growth rate during holding period.

(3) Expected Stock rate of return / Mean ( k j ) = ∑Pk j

Where, P = Probability associated with the possible outcome,

k j = Actual Stock rate of return from the possible outcome.

(4) As per Single Index Model,

Expected Stock rate of return / Mean ( k j ) = α + β k m
Where, α = k j − β k m , k j = Expected Stock rate of return / Mean = ∑Pk j

β = Beta Coefficient of security, k m = Expected Market rate of return = ∑Pk m

k j = Actual Stock rate of return, k m = Market rate of return.

(5) Required Stock rate of return :-

It is calculated as per CAPM (Capital Asset Pricing Model), as below,
Required Stock rate of return ( k j ) = Risk-free + Risk-Premium
= R f + β (k m − R f )
Where, R f = Risk-free rate of return, β = Beta Coefficient of security
k m = Market rate of return / Return on market portfolio.

(6) Equilibrium position is achieved when Required rate of return = Expected rate of return.

(7) If Expected rate of return > Required rate of return, then stock is underpriced.
∴Decision BUY
[Note:- Ex. Suppose Required ROR is 12%, and Expected ROR is 16%. Thus here we require
minimum to minimum return of 12%, but above that we are expecting to get 16%. Thus we will be
in benefit of 4% (16% - 12%). Thus our decision will be to buy the security as it is underpriced.]

If Expected rate of return < Required rate of return, then stock is underpriced.
∴Decision SELL

[Note:- Ex. Suppose Required ROR is 16%, and Expected ROR is 12%. Thus here we require
minimum to minimum return of 16%, but we are expecting to get return of 12% only leading to loss
of 4% . Thus whatever the security we are holding we will sell them off to minimise loss as it is
overpriced.]

15
(8) Expected Stock Risk / Standard Deviation ( σj ) = ∑P(k j −k j ) 2

Where, P = Probability associated with the possible outcome,

k j = Actual Stock rate of return, k j = Expected Stock rate of return / Mean =
∑Pk j

(9) Standard Deviation ( σ ) = Variance (VAR)

i.e. σj = VAR j [Where, σj = Standard Deviation of stock]

i.e. σ m = VAR m [Where, σ m = Standard Deviation of market]

Cov. (k j , k m )
(10) Beta Coefficient of Security ( β) =
(σ m ) 2

Here, Cov. (k j , k m ) = ∑P( k j − k j )( k m − k m )

(σ m ) 2 = ∑P( k m − k m ) 2
Where, Cov. (k j , k m ) = Covariance of return between stock and market
σ m = Standard Deviation of market,
k j = Actual Stock rate of return, k j = Expected Stock rate of return / Mean =
∑Pk j

k m = Actual Market rate of return, k m = Expected Market rate of return = ∑Pk m

P = Probability associated with the possible outcome.

% change in stock rate of return % change in k j

(11) Beta Coefficient of Security ( β) = % change in market rate of return =
% change in k m

Cov. (k j , k m )
(12) Coefficient Correlation (r) =
σ j ×σ m
Where, Cov. (k j , k m ) = Covariance of return between stock and market =
∑P(k j − k j )( k m − k m )
σj = Standard Deviation of stock = ∑P(k j −k j ) 2

σ m = Standard Deviation of market = ∑P(k m −k m )2

(13) Expected Portfolio rate of return ( E p ) = W1 E 1 + W2 E 2 + W3 E 3 +.......... ........

Where, W1 = Weight / Proportion of stock 1 in portfolio,
E 1 = Expected return from stock 1,
W2 = Weight / Proportion of stock 2 in portfolio,
E 2 = Expected return from stock 2.

(14) Expected Portfolio rate of return ( E p ) = R f + β (k m − R f )

Where, R f = Risk-free rate of return, β = Beta Coefficient of Portfolio calculated as below,
k m = Market rate of return / Return on market portfolio.

(15) Portfolio Beta ( βp ) = W1 β1 + W2 β2 + W3 β3 +.......... ........

16
Where, W1 = Weight / Proportion of stock 1 in portfolio,
β1 = Beta Coefficient of stock 1,
W2 = Weight / Proportion of stock 2 in portfolio,
β2 = Beta Coefficient of stock 2.

(16) Portfolio Standard Deviation ( σp ) = w 12σ 12 + w 22σ 22 + 2 × w 1 × w 2 × r × σ 1 × σ 2

Where, W1 = Weight / Proportion of stock 1 in portfolio,

σ1 = Standard Deviation of stock 1,
W2 = Weight / Proportion of stock 2 in portfolio,
σ2 = Standard Deviation of stock 2,
r = Coefficient Correlation

(17) CAPITAL ASSET PRICING MODEL (CAPM) :-

As per CAPM Model Required Required Stock rate of return ( k j ) is calculated, as below,
Required Stock rate of return ( k j ) = Risk-free + Risk-Premium
= R f + β (k m − R f )
Where, R f = Risk-free rate of return, β = Beta Coefficient of security,
k m = Market rate of return / Return on market portfolio,
(k m − R f ) = Market Risk Premium / Slope of Security Market Line (SML)
The graphical representation of CAPM Model is known as Security Market Line (SML),
where Market Risk Premium (k m − R f ) is the slope of Security Market Line (SML).

D1
(18) Current Market Price of security ( P0 ) =
k j −g
Where, D1 = Income / cash flows / Dividends receivable from the security during holding period.
= D 0 (1 +g) [Here, D 0 = Current Income / cash flows / Dividends received]
k j = Required stock rate of return, g = Growth during the holding period.

Standard Deviation (σ j )
(19) Coefficient of Variance =
Mean
Where, Stock Standard Deviation ( σj ) = ∑P(k j −k j ) 2

Mean = Expected Stock rate of return ( k j ) = ∑Pk j

Market price per share (MPS)

(20) Price Earning Ratio (P/E Ratio) =
Earning per share (EPS)

(21) As per Du-Pont Analysis,

Return on Equity (ROE) = NP Margin × Asset Turnover Ratio × Debt-Equity Ratio / Asset-Equity
Ratio

[NOTE:- Here in this chapter, in every formulae apply full %, i.e. do not convert % into decimals
for calculations. For Ex. If there is 6%, then take 6 inspite of 0.06]

CHAPTER:- SOURCES OF LONG-TERM FINANCE

17
 NP 0 + S
(a) Ex-Right Value of a share / Value of the share, after the Right issue =
N +1
Where, N = No. of existing shares required for 1 right share
P 0 = Actual Market Price / Existing price of share / Current Price / Cum-Rights price per share
S = Subscription price at which rights shares are issued.

P0 − S
(b) Theoretical Value of a Right share =
N +1

Where, N = No. of existing shares required for a right share

P 0 = Actual Market Price / Existing price of share / Current Price / Cum-Rights price per share
S = Subscription price at which rights shares are issued.

CHAPTER:- COST OF CAPITAL & CAPITAL STRUCTURE THEORY

F −P
I(1 − t) +
n
(a) Cost of Debenture ( k d ) =
F +P
2
Where, k d = Post-tax cost of debenture capital,
I = Annual interest payment per debenture capital,
t = Corporate tax rate, F = Redemption price per debenture,
P = Net amount realized per debenture (MP can be taken if not given),
n = Maturity period.
When the difference between the redemption price and the net amount realized can be written
off evenly over the life of the debentures and the amount so written-off is allowed as tax-deductible
expenses, the above equation change as follows:-
F −P
I(1 − t) + (1 − t)
n
Cost of Debenture ( k d ) =
F +P
2

(b) Cost of Term Loans ( k t ) = I(1 −t)

Where, I = Interest rate, t = Tax rate

F −P
D+
n
(c) Cost of Preference Capital ( k p ) =
F +P
2
Where, k p = Cost of preference capital, D = Preference dividend per share payable annually

18
 F = Redemption price,
P = Net amount realized per share (MP can be taken if not given)
n = Maturity period.
D
Cost of Preference shares which is perpetual or irredeemable ( k p ) =
P
Where, D = Preference dividend per share payable annually,
P = Net amount realized per share (MP can be taken if not given)

(d) Cost of Equity Capital ( k e ) :-

• Dividend Forecast Approach:-
D0 D1

P0 Growth (g)
D1
∴P0 =
ke −g
D1
or, k e = +g
P0
Where, k e = Cost of Equity, D1 = Expected dividend per share at the end of year
one, P0
= Current price, g = Growth rate.

• Capital Asset Pricing Model Approach (CAPM):-

According to this approach, the cost of Equity ( k e ) is reflected by the
following equation:
k e = Rf + β(km – Rf)
Where, kj = Required rate of return on security, Rf = Risk-free rate of return,
β = Beta coefficient of security, km = Return on market portfolio.

• Realized Yield Approach:-

Step 1:- Find the wealth ratio, which is calculated as,
D t + Pt  D1 + P1 D + P2 
Wealth ratio ( Wt ) =
Pt -1  i.e W1 = , W2 = 2 
 P0 P1 

Step 2:- Realized Yield = ( W1 × W2 × W3 .......... × Wn )

1/n
−1
Where, Dt = Dividend per share for year t payable at the end of year,
Pt = Price per share at the end of year t, n = Number of years.

(e) Cost of Retained Earnings / Reserves and Surplus ( k r ) :- Return foregone by Equity
shareholders is known as Cost of Retained Earning ( k r ).
i.e. k e = k r (i.e. Cost of Equity = Cost of Retained Earning)
19
(f) Cost of External Equity :- Cost of Equity when associated with floatation cost it becomes
Cost of External equity ( K ′e )
D1 ke
i.e. K ′e = +g =
P0 (1 − f) 1- f
Where, K ′e = Cost of External equity, D1 = Dividend expected at the end of year 1,
P0 = Current market price per share, g = Constant growth rate applicable to dividends,
f = Floatation costs as a percentage of the current market price.

(g) Weighted Average Cost of Capital (WAC) = We k e + Wp k p + Wr k r + Wd k d + Wt k t

Where, We = Weight of Equity Capital, k e = Cost of Equity / Equity Capitalisation
rate,
Wp = Weight of Preference Capital, kp = Cost of Preference Capital,
Wd = Weight of Debenture, k d = Cost of Debenture,
Wt = Weight of Term Loan, k t = Cost of Term Loan.

 portion of concerned finance 

Weight of any source of finance = Total of all finance 

(h) As per Net Operating Income Approach,

Weighted Average Cost of Capital ( k 0 ) = We k e + Wd k d

When Debt is associated with tax payment, then,

Weighted Average Cost of Capital ( k 0 ) = We k e + Wd k d (1 − t)
Where, We = Weight of Equity Capital, k e = Cost of Equity / Equity Capitalisation rate,,
Wd = Weight of Debt, k d = Cost of Debt,
t = Corporate Tax.

(i ) As per Net Operating Income Approach,

Addition to firm’s Weighted Average Cost of Capital ( k 0 ) = Wd k d (1 −t)
Where, Wd = Weight of Debt, k d = Cost of Debt, t = Corporate tax rate

(j ) As per Net Operating Income Approach,

Net Operating Income / EBIT
Cost of Capital ( k 0 ) = Market Value of firm / Total Assets of the Company

Where, Net Operating Income = Interest on Debt + Equity Earnings,

Market Value of the firm = Market Value of Debt / Debt + Market Value of Equity / Equity,
Interest on Debt = Debt× Cost of Debt ( k ), d

Equity Earnings = Equity × Cost of Equity ( k e ).

20
(k) As per Net Operating Income Approach,
Cost of Equtiy Capital ( k e ) = k 0 + (k 0 − k d ) × Debt - Equity ratio
Where, k 0 = Cost of Capital / Overall Capitalisation rate, k d = Cost of Debt
Debt
Debt-Equity ratio = Equtiy / Asset - Equity Ratio

(l) As per Miller and Modigliani Approach,

Present Value of tax shield = t c B
Where, t c = Corporate tax rate, B = Debt Capital.
(m) Tax advantage of Debt Capital / Tax Shield associated with Debt =
 (1 − t c )(1 − t ps ) 
1 −  ×Β
 (1 − t pd ) 
Where, t c = Corporate tax rate, t ps = Personal tax on Stock / Equity,
t pd = Personal tax on Debt income, B = Debt Capital.

(n) As per Du-Pont Analysis,

Return on Equity (ROE) = NP Margin × Asset Turnover Ratio × Debt-Equity Ratio / Asset-
Equity Ratio

PAT
(o) Rate of return on Equity = Market val ue of Equity

(p) Unlevered firm is a firm who has no debt to pay.

CHAPTER:- DIVIDEND POLICY

(1) As per Traditional Model / Graham Dodd Model,

 E
P = M D + 
 3
Where, P = Market price per share, M = Multiplier,
D = Dividend per share (DPS), E = Earning per share (EPS)

(2) As per Walter Model,

r (E − D)
P= D ke
+
ke ke
Where, P = Market price per share, D = Dividend per share (DPS),
k e = Cost of Equity Capital / Equity Capitalisation Rate,
r = Internal rate of return, E = Earning per share (EPS).

21
(3) As per Gordon Dividend Capitalisation Model,

E (1 − b)
P=
k e − br
Where, P = Market price per share, E = Earning per share (EPS),
b = Retention Ratio, (1 −b) = Dividend Pay-out ratio
k e = Cost of Equity Capital / Equity Capitalisation Rate,
br = Growth rate (g) = b × r = Retention Ratio (b) × Internal rate of return (r).

(4) Rule of Walter Dividend Capitalisation Model,

When, r > k e , then Dividend Pay-out Ratio = 0

When, r < k e , then Dividend Pay-out Ratio = 100%
Where, r = Return on Investment, k e = Cost of Equity Capital / Equity Capitalisation Rate.

(5) As per Miller & Modigliani Model (MM Model),

Calculation of Value of firm is done in 4 steps, such as,

STEP :- 1
Find Current Market Price of the share ( P0 ), such as,
D1 + P1
P0 =
1+ke
Where, D1 = Dividend to be paid at the end of the year,
P1 = Market price of share at the end of the year,
k e = Cost of Equity Capital / Equity Capitalisation Rate.

STEP :- 2
Calculate amount to be raised by the issue of new shares ( n1 P1 ), such as,
n 1 P1 = I − (E − nD 1 )
Where, n1 P1 = Amount to be raised by the issue of new shares / Additional Equity Capital,
I = Total Investment required, E = Earning / Profit during the year,
n = No. of outstanding shares, D1 = Dividend to be paid at the end of the year,
nD 1 = Total Dividends paid, ( E − nD 1 ) = Retained Earnings.

STEP :- 3
Calculate the Number of additional shares ( n 1 ) to be issued, such as,
n 1 P1
n1=
P1
Where, n 1 = Number of additional shares to be issued,

22
 n 1 P1 = Amount to be raised by the issue of new shares / Additional Equity Capital,
P1 = Market price of share at the end of the year.

STEP :- 4
Finally, Calculate Value of the firm ( nP 0 ), such as,
(n + n 1 ) P1 − I + E
nP 0 =
1+ ke
Where, nP 0 = Value of the firm, n = Number of outstanding shares,
n 1 = Number of additional shares to be issued,
P1 = Market price of share at the end of the year, I = Total Investment required,
E = Earning / Profit during the year, k e = Cost of Equity Capital / Equity Capitalisation
Rate.

(6) As per Net Operating Income Approach,

EBIT / Net Operating Income
Market Value of the firm = [Where, k 0 = Cost of Capital]
k0

(7) Market Value of the firm = Market Value of Debt + Market Value of Equity.

23