4s ‘Thakur's MBA Second Semester (Financial Management) Bh.U The Classification of financial markets in India is as follows: 1) Unorganized Markets: In unorganized markets, there are a number of m Araders, etc. who lend money to the public. Indigenous banke fre also private finance companies, chit funds ete whose a has already taken some joney lenders, indigenous bankers, also collect deposits from the public. There ies are not controlled by the RBI. The RBI steps to bring unorganized sector under the organized fold, Organized Markets: In the organized ‘markets, there are standardized rules and regulations governing their financial dealings. There is also a high degree of insttutionalization and instrumentalization, These markets are subject to strict supervision and control by the RBI or other regulatory bodies, 2 ‘These organized markets can be further classified into two markets: i) Capital Market: The capital market is a market for financial assets which have a long or indefinite ity. Generally, it deals with long term securities which have a maturity period of more than one! 8) Equity Market: Shares of public limited company are bought and sold in the equity market. Equity! market is divided into; Primary Market is a place where new offerings by Companies are made either as an Initial Public Offering (IPO) or Rights Issue, Secondary Market is 2 market where Securities are traded after being initially offered to the public in the Primary Market and/or listed on the Stock Exchange. b) Debt Market: Debt iiarket refers to the financial market where investors buy and sell debt securities, mostly in the form of bonds, The debt market is the market where fixed income Securities of various types and features are issued and traded; Debt markets are therefore, markets! for fixed income securities issued by central and state governments, municipal corporations, government bodies, and commercial entities like financial institutions, banks; public sector units, public limited companies, and also structured finance instruments. ii) Money Market: The money market can be defined as a matket for short-term money and financial assets that are near substitutes for money. The term short-term means genetally a period up to one year and near substitutes to money is used to deriote any financial asset which én be qui¢kly converted into money with minimum transaction cost. i ial Assets/Instruments praca eee Sin egal a pltvon 6 a eae N TS he payment at a future date a sum of money andlor a periodic payment inthe form of interest or dividend. Financial instruments help the financial arkets and the financial intermediaries to perform the important rot of channelizing funds from lenders ta ieee instruments differ in terms of marketability, liquidity, reversibility, type of options, return, Bee gaat ‘obsts. The term ‘and/or’ implies that either of the payments will be sufficient but both of] ris coats. them may be promi jal instruments/assets are as follows: ee Seer ee ea : A financial investment whose ptice is vend oes on its pats value, a ti i, bills and anything else that has its own value, By bonds, certificates of deposi, bills an g tls that ee ied derivative instruments, such as options, swaps and futures, is based on the value of, ies ee nee fF holders ofits and prefered stock. The 7 ity: terest in a company of holders of its common and pre! aa ae orem cars adel sa scat th isha ii fe rd; A forward contract is a customized contract between two entities, where settlement takes site a specific date in the future at today’s pre-agreed price, ae ‘A fatures contract is ah agreement between two parties to buy or sell an asset at a certain time iii) Futures: A futures con iog'Futures contract’ aré special types of forward ¢ontracts In the sense that ip ae ested Okchange ded contracts. F ~ calls and puts. Galls give the buyer the right but rot the obligation iv) Options: Options ao ie andeying asta give price ono before a given fue dle Po to ya Ben Fe ih, but not the obligation 0 sella given quantity ofthe underlying asta given give the buyer price on or before a given date.2 } Financial Management and Indian Financial System (Unit 1) : i shange cash flows in the future v) Swaps: Swaps are private agreements between two paities to excl 1 according to a prearranged formula. They can be regarded as portfolios of forward contracts. ; vi) Commercial Paper: A short term promise to repay a fixed amount that is placed on the market either Y Cea caion ey Cera “tis usually issued by companies with iy credit Standing in the form ofa promissory note redemable at par to the holder on maturity an Serene doesn't require any guarantee. Commercial paper is a money market instrument issued normally for tenure of 90 days. vii) Treasury Bills: Short-term (up to 91 days) bearer discount security issued by the Government as a means of financing its cash requirements. ‘ lary Fi 2 It ineludes the fixed income instrument such as’ bonds, debenture, Sea ‘aaa ae fixed “eon. pts stock, etc, as Well as the variable income ji ‘ivati etc. ae ; Sees: ee Teg 25 Gini srr Pelee Fepestenty the form of fractional ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture, The holders of such shares are members of the " <, company and have voting rights. i) Rights Issue /Rights Shares: The issue of new securities to existing shareholders at a ratio to those ~ already held. ii) Bonus Shares: Shares issued by the companies to their shareholders free of cost by capitalization of + accumulated reserves from the profits eamed in the earlier years. JV) Preference Shares: Owners of these kinds of shares are entitled to a fixed dividend or dividend Calculated at a fixed rate to be paid regularly before dividend can be paid in respect of equity share. They also enjoy priority over the equity shareholders in payment of surplus. But in the event of liquidation, their claims rank below the claims of the company’s creditors, bondholders / debenture holders. * . Government Securities (G-Sees): These are sovereign (credit risk-free) coupon bearing instruments ‘Which are issued by the Reserve Bank of India on behalf of Gavernment of India, in lieu of the Central Government's market borrowing programme. These securities have a fixed coupon that is paid on * Specific dates on half-yearly basis. These securities are available in wide range of maturity dates, from Short dated (less than one year) to long dated (up to twenty years). ’ 'V) Debentures: Bonds issued by a company bearing a fixed rate of interest usyally payable half yearly on specifig dates and principal amount repayable on particular date on redemption of the debentures. _ Debentures are normally secured/charged against the asset of the company in favour of debenture holder. i) Bond: A negotiable certificate evidencing indebtedness. It is normally unsecured, A. debt security “is generally issued by a company, municipality or government agency. A bond investor lends ‘money to the issuer and in exchange, the issuer promises to repay the loan amount on a specified Maturity date. The issuer usually pays the bond holder periodic interest payments over the life of the loan. SS iiss? | 4. Indian Financial Services 2 intermediaries provide key financial services such as merchant banking, leasing, hire purchase, credit- and so on. Financial services rendered by the financial intermediaties bridge the Bap between lack of i increasing sophistication of financial instruments and markets, These itms, industrial expansion, and econotnic growth. Financial services adly classified info two categories: Fund/Asset Based Financial Services; When financial services are used for creating assets or are Supported by assets where the funds are Pm fransformed into assets, they are known as asset based financial ‘Mvices. It include 4), Lease Financing: A lease may be defined as a contractual arrangement/transaction in which a party owing an asseVequipment (lessor) provides the asset for use to anotherfransfer the right 10 use the ei2) ‘Thakur's MBA Second Semester (Financial Management) Bh.U equipment to the user (lessee) over a certain/for an agreed period of time for consideration in form offin return for periodic payment (rentals) with or without a further payment (premium), At the end of the period of contract (lease period), the asscvequipment reverts back to the lessor unless there is provision for the renewal of the contract. Hire Purchase: Hire purchase means hiring of an assct for a period of time_and at the end of the period, purchasing the same. Actually, this is time sharing of the asset - the person hiring the asset acquires its possession and the right to use it. As a legal device it is being used for financing o capital goods such as industrial finance, financing of consumer goods and for selling consumer go on hire purchase. iii) Factoring: The word ‘factoring? has its origin from Latin ‘Factor’ which means ‘doer’. The Webster’ New Collegiate Dictionary defines a factor as ‘one that lends money to producers and dealers on t security of accounts receivables’. iv) Forfaiting: Forfaiting is a form of financing of receivables pertaining to international trade. It denot the purchase of trade bills/promissory notes by a bank/financial institution without recourse to th stiller. The purchase is in the form of discounting the documents covering the entire risk of n payment in collection. ¥) Mutual Fund: Mutual fund is an investment vehicle that is made up of a pool of funds collected fro many investors for the purpose of investing in securities such as stocks, bonds, money mark instruments and similar assets. vi) Exchange Traded Funds (ETFs): An exchange-traded fund is an investment fund traded on stod exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trad close to its net asset value over the course of the trading day. Most ETFs track an index, ese as a stoch index or bond index. 4 Consumer Credit / Consumer Finance: The term consumer credit refers to the activities involved j granting credit to consumers to enable them possess own goods meant for everyday use. It is known several names such as credit merchandising, deferred payments, installment buying, hire purcliase, out-of income scheme, pay-as-you earn scheme, easy payment, credit buying, installment credi¢ plan, ete Bill Discounting: A bill discounting or a bill of exchange is a short —term, negotiable and self iquidating money-market instrument. The bill of exchange (B/E) is used for financing a ansaction| goods which means that it is essentially a trade-related instrument. ix) Housing Finance: A set of all financial, arrangements that are made available by Hosing, Fa Companies (HFCs) to meet the requirements of housing is called ‘housing finance’. x) Venture Capital: The term venture capital comprises of two words, namely, ‘venture’ and “capital ‘The term venture literally means a course or proceeding, the outcome of which is uncertain but. which attended by the risk of danger of ‘loss’, On the other hand, the term aril refers to the resources start the enterprise. ~ aay 4 xi) Non-Fund/Fee Based Financial Services: Fee based financial services do flot create immediate ful they enable the creation of funds through their services for which they charge a'fee. Fee-Based Financial Services: Fee based financial services do not create immediate funds; they enable creation of funds through their services for which they charge a fee. It includes: 1 i) Merchant Banking: Merchant banker is an individual or institution who/which facts as an aiden or agent, for corporations and. municipalities. issuing securities. They also. maintain broker/de operations, markets for previously issued securi ies, and offer advisory services to investors. Credit Rating: The process of assigning a symbol with specific reference to the instrument being rat that acts as an indicator of the current opinion on relative capability on the is issuer to service its de * obligation in a timely fashion, is known as credit rating, 4 iii) Stock Broking: The process by which buyers and sellers of stock of sécurities are etait togel under a common platform, the stock exchange, is known as stock broking. .nancial Management and I Financial System (Unit 1) a iv) Securitization of Debt: Securitization means the’ conversion of existing or future cash in-flows of any G Person into tradable security which then may be sold in the market. it it isa writ king issued by the buyer’s (opener) Letters of Credit (LLC): A Letter of Credit (LC) is a written undertal 4 . 4 nee GaN the seller (beneficiary) to reimburse the cost of goods and services supplied to é the buyer by the seller against production of documents stipulated therein within a specific time, at u specified place and up to a specified amount, to a specified bank (reimbursing bank) provided the documents submitted are in strict conformity with the terms and conditions of the LC. is issuing bank and the client in which the bank 5 ¥) Bank Guarantees: A guarantee is a contract between the issuing . bniderakes to riectt claims put forward by the client against the customer on behalf of whom the guarantee is issued. Major Issues in Indian Financial System ~ z : Fthe iro ion of planning. rapid industrialization has taken place, It has in turn led to the growth of the [ mment sector. In order to meet the growing demand of the government and ancial instruments have been introduced. The Indian financial system is now loday than what it was few years ago. Yet it suffers from some issues. llowing are the issues in Indian financial system: : ack of Coordination between Different Financial Instititions: le vital Fis are owned by the government. At the same time, developed and integrated te ie: There are large numbers of Fs. Most of the government is also the controlling lem of coordination arises. As there is there is lack of coordination in the working of In India, some Fls are so large that they: have created a monopolistic . For instance, almost entire life insurance business is in the hands of id delay development of financial system of the country itself. Dominance of Backbone of in Tecent units, debentures The Indian capital market is not is not having faith in the c in financial system... - The dominance of development banks has developed im i The do e prudent financial Bans, So ec orPorate customer. The development banke rovide most of the fi term Toso tte Predominance of debt capital has med, ita coe eae : fe the capital structure of the borrowin, oncer nd lopsided, However in Tecent times, all efforts have been made to activate the capital nat naga also taking place between different Fls, Similarly, the refinance and tediscounting facilities Provided by t strong and dependable. Because of apital markets. The weakness of the TDBI aim at integration. Indian Financial System is undergoing fast changes, to become a well developed on overnment Control, a Statutory and autonomous development & Tegulation of the market and regulatory board with defined Fesponsibi pPositive outcome of the Securities Scam of 1990-91, to independent powers has toy been set up. Paradoxically, this\) 2) eT Ve VC @ G&G 6 wae 2 ‘Thakur's MBA Second Semester (Fnancal Management) BAU 1.4.7.1. Constitution of Management of SEBL The SEBI is managed by a Board consisting of following members: 1) Chairman, ; 2). Two members from among the officials ofthe Ministries of Cer ing with Fi ntral Govemment dealing with Finance and Law. 3) One member from amongst the officials of the Reserve Bank of India. 7% . 4) Two other members to be appointed by the Central Government. The management of SEBI is vested in the Board and Chai f genera superintendence and direction. airman shall have the powers of g 1.4.7.2, Objectives/Purpose of the SEBI Act The purpose of the SEBI Act is to provide for the establishment of a Board called Securities and Exchange Board of India. The purpose of the Board as laid down in its preamble is as below: 1) To provide a degree of protection to the investors and safeguard their rights and to ensure that there is steady flow of funds in the market, 2) To promote fair dealings by the issuer of securities and ensure a market where they can raise funds at relatively low cost. i 3) To regulate and develop a code of conduct for the financial intermediaries and to make them competi and professional. 4) To provide for the matters connecting with or incidental to the above. 1.4.7.3. Powers of SEBI Following powers have been given to SEBI: 1) Power to conduct research and other functions, 2) Power to call for periodical returns from recognized stock exchanges, 3) Power to levy fees, 4) Power to call for any information or explanation from recognized stock exchanges of its members, 5) Power to regulate substantial acquisition of shares and take over of companies, 6) Power to direct inquires to be made in relation to affairs of stock exchanges or its members, 7), Power to promote investors education and trading of intermediaries in capital market, 8) Power to grant approval to bylaws of recognized exchanges, 9) Power to prohibit insider-trading, 10) Power to make or amend bylaws of recognized exchanges, = 11) Power to prohibit fraudulent and unfair trade practices relating to securities, i 12) Power to declare applicability of Section 17 of the Securities Contracts (Regulation) Act in any state or and to grant licenses to dealers in securities, 13) Power to promote and regulate self-regulatory bodies,. 14) Power to compel listing of securities by public companies, 15) Power to control and regulate stock exchanges, 16) Power to register and regulate working of collective investment s : 17) Power to grant registration to market intermediaries. | schemes including mutual funds and 1.4.74, Functions of SEBI Following are the functions of SEBI: 1) Torregister and regulate the working of stock brokers, 2) To register and regulate the working of bankers oan issue, 3) To control and regulate securities market, Es. q 4), To.exercse the powers under Securities Contacts (REgulations) AC. 5) To regulate the working of mutual fands,“* ' | 4 To perform such other functions as may be prescribed, ri “ : To control fraudulent and unfair trade practices relating to securities market, $). To.conduct research for the above purpost3, 9) Tocontrol investment business, Y 10) To regulate issue of securities, MI) To regulate takeovers, and : es 12) To prohibit insiders-trading in securities.Krithnntad ia- Financial Management and indian Financial System (Unit 1) 3 + 14.75. — Role of SEBI in Capital Issues To protect the interest of the investors and to bring back the small investors to the market several measures have » been undertaken by SEBI. Entry and disclosure norms are tightened to prevent the exploitation of investors by the unserupulous promoters. Allocation of shares and promoters’ contribution are regulated. . I), Entry Norms: SEBI has issued guidelines to tighten the entry norms for companies accessing the capital market. i) A company should have a track record of dividend payments for a minimum period of 3 years : * preceding the issue. ‘A company whose shares are already listed would fulfill the entry level requirement only if the post issue net worth becomes more than five times the pre issue net worth. {fa manufacturing company does not have such a track record, it could access the public issue market, Provided its project is appraised by a public financial institution or a scheduled commercial bank. The appraising entity should also participate in the project fund, iv) It would be necessary for a corporate body making a publi holders for every 81 lac of the net capital offer made to the publi ue to have atleast five public share- zPromoters’ Contribution: Promoters’ contribution means contribution by those described in the . " prospectus as promoters, directors, friends, relatives and associates. : i) Promoters’ contribution ‘should not be less than 20% of the issued capital irrespective of the issue size. i) The entire promoters’ contribution should be received before the public issue, Ifthe issue size exceeds "2100 crores, the promoters can bring in not less than 50% of their contribution before opening of the issue and bring in the balance before the calls are made on the shareholders. ; SEBI announced that nt more than 20 per cet of th entire contribution brought in by promoters cumulatively in public or preferential issue would be locked in for 5 years. SEBI lifted the provision of lock in period for . Promoters, contribution incase of listed companies with3 years track record of dividend payment. ') According to the decision taken by the SEBI Board, in case of non underwritten public issue promoters Could bring their own money or procure subscription from elsewhere within 60 days of the closure of the issue subject to such disclosures in the offer document. Disclosure: The draft prospectus filed with SEBI is made as a public document to enhance transparency. _ The draft prospects should provide all the needed information to the investor Tegarding: the present position | ofthe company, the future prospect and the risk factors associated with the investment of the company. ®),, Book Building: Book building hag been accepted as one of the modes of public issue. SEBI issued _Buidelines relating to 100 per cent book-building in an issue of security tothe public through prospectus, 2) Allocation of Shares: To bring back the small investors tothe primary market, the minimum application of j share has been reduced from 500 to 200. Proportionate allotment of shares is made. A reservation of ‘minimum 50 % of net offers to the small investors is being made. Small investors mean those who have applied for 1000 or fewer shares or securities, ) Market Intermediaries: Licensing of merchant bankers or authorization by SEBI was the first step undertaken to regulate the intermediaries, This licensing of merchant bankers is based on the capital ad- €quacy as well as the track record of the capital market related activities. In course of time, other financial y Intermediaries suchas underwriters, registrars and transfer agents came to be licensed, SEBI has the Tight to i inspect the records of the intermediaries. : z VALUATION OF BOND Meaning of Bond : bond is a contract that requires the borrower to pay the interest income to the lender..It resembles the issory note issued by the government and corporate. The par value of the bond indicates the face value of ie bond i.., the value stated on the bond paper. Generally, the face values of bonds are %1,000, 2,000, 5,000 mtd alike. Most of the bonds make fixed interest payment till the maturity period. This specific rate of interest is, sown as coupon rate. Coupons are paid quarterly, semi-annually and annually, At the end of the maturity Petiod, the value is repaid. “ 2w nent) BAU ‘Thahur's MBA Second Semester (Financial Manaue 5 is A bond is more of less the same as a debenture, In India, the two terms are generally interchangeable. me re vd gible. ys Aistinction between the two and the difference if any, is for all practical purposes ines sccurticn bel att 2 bond as an American term for a debenture others reserve the term for PA scat ‘onging to the government and public sector undertakings. In India, it is common to rel or by tem debt secures isued by the Slate Govemments, or by undenakings owned by them evelopment financial institutions, as bonds. ‘ 15.2. Features of Bond Foote niin features of bonds: Indenture: The indenture is a long, complica i ining the restrictions, Promises ofthe contac. Bonded income naren indent oles thee pres. The ist FY the debtor corporation that borrows the money, promises to pay interest, and promises to repay the princiP borrowed. The bond holders are the second party; they lend the money. They automatically accept indenture by acquiring their bonds/ fixed income instrument, The trustee is the third party with whom bond contract is made, The trustee ensures that the corporation Keeps its promises and follows provision coined inthe indenture, In ther words, the tists does the “watchdog” job for all th ndholders. cs 2) Repayment of Principal: Bonds are issued in denominations of £1,000 but there are also bonds of valu of $500 and €100 and of values as high as €5,000 and %10,000. Financial institutions are Known t0 bu corporate bonds bearing higher values, The value of the bond is called the ‘face value, par value or matur value’. The face value of the bond represents the ptomise (o repay the amount 1o the bondholder at the ent ofthe specified petiod, This, in other words, may be called the most important feature of bond, return of principal to the lender on a fixed date specified earlier. 5 3) Maturities/Specified Time Period: Maturities vary widely. Bonds are usually grouped by the maturity classes, Short-term bonds are usually bonds maturing within S years. They may be secured o unsecured. These are common in industrial financing. Medium-term bonds mature in 5 to 10 years. If bond is originally issued on a medium-term bond, it is usually secured by a real estate or equipmen mortgage, or it may be backed by other security. Long-term bonds may run 20 years or more. Capital intensive industries with long expectation of equipment life are the greatest users of this for of bon financing. ’ 4) Interest Payment: Bond! fixed income instrument interest is usually paid semi-annually, though anm payments are also popular. The method of payment depends upon whether the bond/ fixed income instrument is a coupon (bearer) or registered. ‘ note 5) Call: Bonds have an additional feature of ‘call’. This is a privilege to the issuing company to re-purchas bonds 'at a slightly higher price above the par value. 6) Pledge of Security: The issuing company sometimes promises fo pay to the bondholder by offering s security like property. The pledge of security is a promise to the bondholders in writing and signed und seal and presented to the trustee by the company. A simple promise to pay without the proper formalities i not considered as a pledge of security. : pledges and 1.5.3. Types of Bonds Following ae the types of bonds: A 1) Premium Bonds: Premium Bonds are those bonds which are sold atthe price above the par value of ‘same. Suppose, a bond has a par value of 100, Now, if'an investor sells this bond in the market at a rat above the €100, say %150, and then this bond would be regarded as the Premium Bond. In such a case bond would be said to have been sold at a premium of 250, ( 2) Convertible Bonds: Convertible Bonds are the bonds which entitle its holders to convert their bonds to th share equities during particular time span. This conversion from bond to the equity shares can be done the holder on some pre-determined fixed ratio. When these convertible bonds remain as a bond then th give their holders with an income which is fixed. But if these bonds are converted into the shares then the features of the bond changes to those of the equity ones. ; AR isae Financial Management and Indian Financial System (Unit 1 a 3) Discount Bonds: Discount Bonds are those bonds which have been sold by’ a customer at a price below the | face value of the same. One of the examples of such Discount Bonds are the Zero Coupon Bonds where |<. the issuing company offers no coupon rate to the investors. i he same could be real e: Mortgage Bonds: Mortgage bonds are secured bonds and the underlying for tI b state : Pe ea actet ach armcnied As these are secured by the mortgage of the underlying, the risk La associated with such investments arc considered to be low. igh Vi 2 High yi is are the bonds for which the rate of interest offered are higher. These ). Fos creak ied ua Boods, The rick of credit associated with this type of bond is generally er and is rated by the grading agencies as speculative in nature. They also consider this asset type to be below the level of investment because it is not evident that in the long-run or for a specified time period this ' locked money would appreciate. ) Fixed Income Bonds: Fixed income bonds are the types of bonds which generate a fixed income for its investors and are dispersed to the investors at a regular period of interval. These interest payments associated with such a bond is generally low because the risk associated with it is almost nil. The most p< Popular Fixed Income Bonds in the bond market are the ones which are issued by the governments such as the Government Bonds. Another form of the Fixed Income Bonds is the GIBs (i.e., Guaranteed Income Bonds). }= Government Bonds: Government bonds are those debt instruments that are issued by the domestic © goverments for its residents only. Generally, the phenomenon of a government going bankrupt is not Fobserved naturally. Hence, the risk associated with the government bonds are the least. This almost nil fault risk makes this bond a highly secured one. Thus, the compensation for holding such a bond is also ry low in comparison to the other debt instruments. Government issuing this bond offers the prospective Wvestors a fixed yield for holding this bond. ‘orporate Bonds: Companies, like the governments, borrow money by issuing bonds called corporate bonds (also called corporate debentures). Internationally, a secured corporate debt instrument is called corporate bond whereas an unsecured corporate debt instrument is called a corporate debenture. In India, corporate debt instruments have traditionally been referred to as debentures, although typically sfley are secured, For the sake of simplicity, we will refer to all corporate debt instruments as corporate nds. ‘ = Municipal Bonds: Municipal bonds are the bonds issued by states, cities or other corporations. These may be issued for a specific purpose, and necessary funds may be raised. For example, Konkan Railway _ Development Corporation Limited issued bonds to public for raising funds required for its railway line tween Mumbai to Mangalore, Central Government had issued Narmada Sarovar Bond, Jala Nigam Bond f etc. for funding various projects. : Value of a bond— or any asset, real or financial — is equal to the present value of the cashflows e: bm it. Hence determining the intrinsic value of a bond requires: “An estimate of expected cashflows, in estimate of the required return. xpected Simplify the analysis of bond valuation certain assumptions are taken care of: The coupon interest rate is fixed for the term of the bond. The coupon payments are made every year and the next coupon payment is receivable exactly a year from = now. The bond will be redeemed at par on maturity,‘Thahur's MDA Second Semester (Financial Management) Bh. Given these assumptions, the cashflow for a non-callable bond comprises of an annuity of a fixed coupon imerest payable annually and the principal amount payable at maturity, Hence the value of a bond is: eC M Pa ee men! +n" where, P = Value (in rupees), n= Number of years, C = Annual coupon payment (in rupees), r= Periodic required return rate, M = Maturity value, t= Time period when the payment is received. Since the stream of annual coupon payments is an ordinary annuity, we can apply the formula for the present value of an ordinary annuity. Hence the bond value is given by the formula: + P=CXPVIFA,at MX PVIFy. For example, consider a 10 year, 12 pet cent coupon bond with a par value of 21,000. The required yield on. this bond is 13 per cent. The cashflows for this bond are as follows: 1) 10 annual coupon payments of €120, 2) 11,000 principal repayment 10 years from now. The value of the bond is: P= 120 x PVIFAt%, 1mm + 1,000 ¥ PVIFiax.10yn = 120 x 5.426 + 1000 « 0.295 = 651.1 +295 = 8946.1 Example 29: A bond whose par value is €1,000 bears a coupon rate of 12% and has a maturity period of 3 years, The required rate ‘of retum on the bond is 10%. What is the value of this bond? Solution: Annual interest payable = 1,000 x 12% = 120, Principal repayment at the end of 3 years = %1,000 +t. The value of the bond P= £120 (PVIFA so%,3 ym) + €1,000 (PVIF toy, 3 yn) = €120 x (2.487) + 1,000(0.751) = €298.44 + 2751 = $1,049.44 ‘A bond of €1,000 face value, bearing a coupon rate of 12% will mature after 7 years. What is the nd if the discount rates are 14% and 12%? ; Example 39: value of the bo Solu Pom MO PVIFAtM » PVF 21120 PVIFA se 37) 4+ 11,000 (PVIF yoy rym) = #120(4.564) + 1000(0.452) = 0547.68 + 452 = 2999.68 The bond has an annual coupon, ‘Anand owns %1,000 face value bond with five years to maturity. should Anand hold or eam dis cumentl pried al €970. Given an appropriate discount ae of 10%, of £75. The bond is cu sell the bond? ara PVIEA yn) + Principal amoun((PVIF k,n) . {0%, 5 years) + LO00(PVIF 10%, $ years) : Ae sr9os+ 100006209) = £28431 + 6209= "90521 The market price €970 is higher than the estimated price €905.2, It js better for Anand to sell the bond.KrithnalAe a. nani! Management and Indian Financial System (Unit 1) A Bond Value with Semi-annual Interest ; 4 Most of the bonds, although the coupon rate is stated as an annual interest rate, actually pay interest semi- © gnnualy. Valuing bonds that pay interest semi-annually involves following se |) The annual intrest payment, C, must be divided by two to obtain the semi-annual interest payment, 2), The number of years to maturity must be multiplied by two wo get the numberof haf-yearly period, * The discount rate has to be divided by two to get the discount rate applicable to half-yearly period, ith the above modification, the bond valuation formula for a bond paying interest semi-annually is give ; te © Pe aoe 4 Ay +34)" or= Y X PVIFAya,2e+ M * PVIF ya, to Example 32: Find out the present value of an 8 year, 12% coupon bond with a par value of 100 on which eres i payable semi-annually, The required rate of return on this bond is 14%. Scmi-annually receipt of interest = %6, i-annually required rate of interest = 7%, of periods = 16 yrs, 100 PD TOF (1+ 007)" = 290.6 = Z6(PVIFA 1%, 16yn) + 8 100(PVIF 9%, ton) = %6(9.447) + 7100(0.339) ample 33: The face value of a 10 year, 10 per cent bond (with 10 per cent coupon rate) is 21,000, The Interest is payable semi-annually. Assuming 12 per cent required rate of retum of investors, compute the value | Of the bond, What price would an investor be willing to pay, ifthe interest is payable annually, | Solution: Interest paid semi-annually; | __—~ P= I(PVIFA,,,) + M(PVIF,, .) = X50(PVIFAg,20) + 1000(PVIF., 2) = (850 * 11.4699) + (81,000 x 0.3118)= 88853 : Note: 1=%100/2 = 850; n =10 years x 2=20; r= 12 per cent/2 = 6 per cent Interest paid annually: _ P= R100(PVIFAi2 0) +81,000(PVIFi2 1) = (2100 x 5.6502) + (81,000 x 0.3220) = 887,02 yi The investor would be willing to pay €887.02 for the bond, 55, Bond Yield p The word yield is frequently used with regard to investing in bonds. Bonds are generally traded on the basis of their prices. However, they are usually not compared in terms of prices because of significant variations in cash | flow patterns and other features, Instead, they are typically compared in terms of yield, There are four important | fypes of yields is shown in figure with which the investor must be familiar, The commonly employed yield ~ Measures are: Bond Yield Tre m ‘Thakur's MBA Second Semester (Financial Management) Bh.U 1.8.5.1, Current Yield The current yield relates the annual coupon interest to the market Price. Itis expressed as: Current Yield = Annual interest Price Example 34: Face value of a bond 1,000, coupon rate 6%, current market price 2900. Find current yield? Solution: Current Yield = (60/900) x 100 = 6.679% ; Example 35; What is the current yield of a 10 year, 12 i 1,000 satan epant year, 12 per cent coupon bond with a par value of 21,000 an Solution: Current yield = = = 0.1263 or 12.63 per cent 1.5.5.2. Yield to Maturity It is the discount rate that makes the present value of the cash flows receivable from ing the bond equal t ~ the price of the bond. Mathematically, it is the interest rate (r) which satisfies the equation: ’ paiemetiis (ee (+1) (+n) Q+n" den" - where, P = Price of the bond, C = Annual interest (in rupees), M = Maturity Value (in rupees), n= Number of years left to maturity. The yield to maturity can also be calculated by using the alternative formula: W1+(F-P)/n aie ~ 0.4F+0.6P where, 1 = Interest value, F = Face value of bond. Example 36: R.D. Gupta recently purchased a bond with a 1,000 face value, a 10 per cent coupon. rate ani four years to maturity. The bond makes annual interest payments, the first to be received one year from today ‘Mr. Gupta paid %1,032.40 for the bond. What is the bond’s yield-to-maturity? 9 Solution: A bond YTM is that interest rate that equates the bond’s price to the discounted value of its promi; cashflows. In this case: 2100 | z100 | %100 41100 71,032.40 = yt (Gn “Gen? (+r? “Usp! YTM=9 percent Alternatively, ymeleecPy/n 0.4F+0.6P : 100+(1,000-1,032.40)/4 ‘ YIM=———*__ 7 = 9% (0.4(1,000)+0.6(1,032.40)\verage return per year per debenture: [(400 + 100)/(4)] = 125 59 1 Management and Indian Financial System (Unit 1) mple 37: A 4 years debenture with 10% coupon rate, maturity value €1,000, in currently selling at 2900. | i proximate annual rate = (125/900) x 100 = 13.89% NPV (at 13%) is positive, this shows that the return is greater than 13%. We can find the exact return (YTM, sp called as current interest rate) through interpolation. Lower Rate NPV . 1040 Tower Ra No x Difference in Rates =13 + 1 Lower Rate NPV — Higher Rate NPV pee lOO BEET ' 10.40 — (-16.60) . Yield To Call oF x : bonds carry a call feature that entitles the issuer to call (buy back) the bond prior to the stated maturity ae ‘ n accordance with a call schedule (which specifies a call Price for each call date). For such bonds, it is a lice to calculate the Yield To Call (XTC) as well as the YTM. edure for calculating the YTC isthe same as for the YTM. Mathematically the YTC is the value of rin G Re following equation: : clo 2a “ep = call price (in rupees),,. « lumber of years until the assumed calll date. J¢ 38: Continuing example 36 if the bond can be called two years from now at a price of €1,100, what is y the bond can be called in two years for 21,100 its yield-to-eall is found by solving for the YTM ng the receipt of only two coupon payments and a call price of £1,100, Thar in 21,032.40 = 100 | 31,100. 2 (+n! +n? B XTC =125 per cent le 39: Suppose the 10% 10-year ond is currently selling for 8950, What is bond's yield to call? ion: The bonds yield to call is 1,050 pa 05007 (l+Y¥TO)” G+YTO? eld to call, YTC, is 12.7 percent. 11000 bond is redeemable (callable) in 5 years at a call price of = 12.7% can be solved through trial and erro: 950 on ‘maturity. What is the yield to 100 1,050 GHYTO! “GeyTo® OF use @ financial calculator. Suppose the bond will be redeemed ai maturity? It is given as follows: then YTM is 10.9 per cent. 4 Yield to maturity is 11.3 per cent, If the bond is redeemed at par on maturity,= Tamur's MEA Scam Sencar Fmmca Means SRD Eeompe OE A Sumi 5 coertty Taed at TSN bs dace alee s TL. Coupe oar bs 1a BS edema a prcade Syers fom bin. Hee Ge fas ang 3 yexs & a ace srmpany bas an comm of calling fader 3 years fom may at ‘Soto Avene Ream pe Yer pe Bond (ol aa aan] D-H y+ GIS) «as =255 AsNPV fe ION) S aemese, ths Sows Gar ke em S es Ga Less cite NPV a I NOV a 4 = 552 - (0 2362) - GES = +35 As NOW Gar L's positive ths stows ht de nee S Se oem ‘We oun Sind Se ea we (ed YM nt cae? eet mess ee) Groh ee Leese Rae NPV Lose Re NPV - igh Rae NPV = Digeso @ Ress = + Siro Eeangle (1: A reoser boot sling a pr wehe pings 1s cmpen omce a yee The yelp meiys Pre Ee C000 coupon pevmet & eamesed at me oes oe of 10S, Se TL eet ne ba eal poow ser 2 pees w CL200 The coupon paid in Se ies yor oes aa Goss wah Gece crater wabe of (100 which meshes wih Se sean compen pepe md premet of per wake i Seed ge vests i a wal wale of C1700. Cabbaker compoend pooch ome of mead im posd oe diese Saks Soe Sie Se commun sock & GEE pps does ae oy of of Exidend peymens bere ry Grins op on Sn—_— | peecs Miegoet md Inte Fema Sse Tae F a rT PREFERENCE SHARES 4.7.1. Concept of Preference Shares ~ shores represent a kyfeid arvesoment im the sense iat it combines the gemmmrss af buch equity efeeace shares kine preference gins over common Sinck with respect w dividends amd yoseds. In other words, it has proney when Svidead seymeccs and Equdeme SEurioes ‘accrue ag a preesmblished sme and cam be pad om a cumaulithe bess 2 sock my be voeing oF nomacting or excties poco Features of Preference Shares somes mache b ree = e f) Cumsicca of Dividends: Prices Sts = ) fides Bacns a few contees peices Ses nda oy 2 come See 8 SP Gesdends The xpad Gividends on comune preference sharss we camsed forward and psabik wien Se | gsadend s sume cae teens ceecinlies m paricpar i spl Ss (abs ES ater pe = it Tedend at comin rans) coery year and resto assess (ests Kei air meine S= SS paises Sis) nore Gquidsion acorns Da gece ie Tig Riche: A peice hah: een: ect oom ny SE ( Prcipence shrchoisies geal do act hme voting gis ft qe pees dein sia mes Eero ers cma se ces of om =x gy The pefeme: Snidind bes oot bern paid ira pe oft or me = _pean eS E Seam ngpece pend of thre ox mae yes in ie posesing Six yous caine wa SESE Samo vex Geely, peas Shes maak op Shes bepec ae. ie! 5 ‘pot sequined 1 sepa he amount doce fs ES Soe SH Dcomsey bes © reqy Se peioeas Socialis Se mes rs bet here paying back de oY‘7 ae . BU = ‘Thakur’s MBA Second Semester (Financial Managemen”) 9) Claims on Assets: They are not real owners of the ‘company, the preference shareholders, usually; ona have any right in the suplus assets of the company, However, a company may ise partici “preference shares which entitle its holders a right to participate even in the surplus assets of the company af the time of liquidation in agreed ratio, 10) Contra: Ordinarily, preference shareholders do not have any voting rights; so they do not have any S2Y i the management or control ofthe company, 1.7.3. Valuation of Preference Shares ill Since dividends from preference shares are assumed to be perpetual payments, the intrinsic value of shares W! be estimated from the following equation valid for perpetuities in general: vieec c Ne (Kp) (+k, where, ‘Vp the value of a perpetuity today, C= the constant annual payment to be received, Kp the required rate of return appropriate for the perpetuity. Substitute only preference dividend (D) for °C’ and the appropriate required retum (Kis) for ‘Ke’ to obtain following equation for valuing preference shares: D ee , : : = j Y Itis noted that ‘D’ is perpetuity and is known and fixed forever. 1.7.4. Yields on Preference Shares F Preference shareholders as well as equity shareholders ace interested in dividend yields. The computation yield on preference share is similar to the computation of yield on equity shares. Yield on preference ag calculated through the following formula: ; D K, =— nye where, ‘Vp= the value of preference share, D= amount of dividend on preference share per annum, Kp= the required rate of retu on preference share. For example, ifthe curent price of a preference share is 60 and annual dividend is 4, then the yield 0 preference share is calculated in the following ways: D Example 42: What is the value of a preference share where the dividend rate is 18% on 21100 par value? appropriate discount rate fora stock of this risk level is 15%. Solution: Vp=(0.18 x 1000.15 = 1180.15 = 7120 Example 43: The preference shares of RKV Group are selling for %47.50 per share and pay a dividend of €2.3 in dividends, What is the expected rate of retum if we purchase the security at market price? Solution: Expected rate of retum = Dividend/Market Price =%235R47.50=4.95%“Financial Management and Indian Financial System (Unit 1) &. EQUITY SHARES ae Concept of Equity Shares > Equity shares. also known as ordinary shares or common shares represent ¢ holders of these shares are the real owners of the company. They have a pany. Equity: shareholders are paid dividend after paying it to the prefe B "dividend on these shares depends upon the profits of the company. They may be paid or they may not get anything. the owners’ capital in a company. Control over the working of the rence shareholders. The rate of a higher rate of dividend . Features of Equity Shares lowing are the features of equity shares: faturity: Equity shares provide permanent capital to the company, 5 | obligation to refund it during its lifetime, Shareholders can demand their capital only Tiquidation and that too when funds are left after covering all ims. Company can al ain " shareholders to sell back their shares if they were’ fully paid-up and shareholders were not engag A. ir ; iness competitive to the business of the company. Shareholders can, indeed, be persuaded to sell thelr shares. which is not under contractual if the event of Iso not force the D) Claims on Income: Equity shareholders are residual owners whose claim on income arises only when icaims of creditors and preferred stock- owners are met. In many instances, residual owners do not get thing if income of the firm was just sufficient to satisfy the claim of creditors. Even if the company has Sufficient income left meeting after all obligations, equity shareholders can not legally force the company fo individuals to them. Distribution of the profits is left to the discretion of internal management of the company. The management has full right to utilize business income in whatever manner it likes. st of Equity: The cost of equity capital is higher than any other long-term source of finance. Firstly, since the equity dividends are not tax-deductible expenses as the interest is, and secondly the high cost of Issle'and the risk factor associated witht makes the cost of equity higher. ‘Claims on Asset: Being residual owners, equity shareholders are the last claimants to assets of the firm. In the event of winding up of the firm's business assets are disposed off to satisfy the claims of the creditors nd also preferred stockholders prior to equity stockholders. They are, however, entitled to receive all left afler meeting the business obligations. Being last in the priority of claims, “equity shareholders” capital ides a cushion for creditors to absorb losses on liquidation, . Control: The risk of loss associated with equity share is compensated to some extent by controlling power shat rests with residual owners. Equity shareholders have unchallenged Voice in: management. Whatever |Pontrol the stockholders retain is exercised primarily through the voting privilege Every equity shareholders the right to vote on every resolution placed before the company and his voting right on a poll is in ‘Proportions to this share of paid -up capital of the company. Although board of directors who control and” eet the affairs of the organization manages a company, supreme control is endowed |witli equity” Shareholders. It is they who have power to elect the directors of the enterprise and remove or any all of them if they so wish. 3 sr enpaest to : 1 ‘ z ao st Pre-emptive Right: To safeguard the interest of equity shareholders and enable them maintain their Ownership, section 18 of the comp: Act, 1956 provides that whatever a public limited company sProposes to increase its subscribed capital by the allotment of further shares, after the expity:of two” ars from the formation of the company or the expiry of one year from the first allotment of the shares , ein the company, whichever earlier, such shares must be offered to holders of existing equity shares in Proportion, as nearly as circumstances admit, to the capital paid up on these shares. Shares so offered _ 0 ms shareholders are called to right shares and their prior right to such is known as pre-emptive“ : Another distinct feature of equity shares is li lability, Thus, although, equity - eas are the real owners of the company, their liability is limited to the value of shares they haveD | we Sa SFelUMNCOS—lU UN o Thakur’s MBA Second Semester (Financial Management) BRU] 1.8.3. Valuation of Equity Shares ‘The various model used for equity valuation are as follows: Discounted Casheflow Technique Balance Shect Valuation Dividend Capitalization Model Price Eaming Ratio Intrinsic Value Approach Other Comparative Valuation Ratio 1.8.4. Discounted Cash-flow Technique This method estimates the value of an asset based on its expected future cash-flows, which are discounted to present (i.c., the present value). This concept of discounting future monies is commonly known as the tit value of money. For example, an asset that matures and pays €100 in one year is worth less than @100 to ‘The size of the discount is based on an opportunity cost of capital and it is expressed as a percentage. Sor people call this percentage a discount rate. For a valuation using the discounted cash-flow method, following estimations should be done: 1) Estimates the future cash-flows from the investment. 2) Estimates a reasonable discount rate after considering the risk of those cash flows and interest rae capital markets. Next, one makes a calculation to compute the present valve of the future cash flows.’ -s in tl cash-flows to equity, i-e., the residual cash-flows ‘The value of equity is obtained by discounting expected at the cost of equity, ie., the rate meeting all expenses, tax obligations, and interest and principal payments, return required by equity investors in the firm. __€% CFto Equity, WalveofEquiy= ralucof Equity: 2 cn" where, CF to Equity, = Expected cash-flow to equity in period t T= Cost of equity Example 44: Mr. Alok is expected to receive eaming per share of €100 annually for two years. What is value today if cost of equity is 12%. Solution: The present value will be: 1.8.5. Balance Sheet Analysis ‘Analysts often look at the balance sheet ‘of the firm to get a handle on some valuation measures. Three meast derived from the balance sheet are: book value, liquidation value, and replacement cost. 1) Book Value: The book value per share is simply the net worth of the company (which is equal to paid equity capital plus reserves and surplus) divided by the number af outstanding equity shares. : For example, if the net worth of Samsung Limited is ¥30 million and the number of outstanding equi shares of Samsung is 2 million, the book Value, per share works out to €15 (€30 million divided million). 2) Liquidation Value: The liquidation value per share is equal to: Value realised from liquidating - Amount tobe paid to all the creditors all the assets of the firm and preferencesharcholders Number of optstanding equity shares }"Finacial Management and Indian Financial System (Unit 1) 65 for example, assume that Pioneer Industries would realize 845 million from the liquidation of its assets and | sy 818 million to its creditors and preference shareholders in full settlement of their claims. If the number of ae equity shares of Pioneer is 1.5 million, the liquidation value per share works out to: E 245 million-718 million TSmilllion =@18million §) Replacement Cost: Another balance sheet measure considered by analysts in valuing a firm is the replace- ; ment cost of its assets less liabilities. The use of this measure is based on the premise that the market value ‘ofa firm cannot deviate too did so, competitive pressures will tend to align the two. Dividend Valuation Method/Dividend Discount Models @ of the most widely used equity valuation model is the Dividend Discount Model (DDM). According to the iividend discount model, the value of an equity share is equal to the present value of ship plus the present value of the sale price expected when the equity share is sold. sumptions of Dividend Valuation Model ‘he future value of dividend is known by the investor. jends are expected to be distributed at the end of each year until infinity. vidends are the only way investors get money back from the company. This implies that any share yback would be ignored. he implication of the second assumption is that the investor is expected to hold the share for an infinite od: he will not sell it, at any moment. the model may be of some (perhaps significant) theoretical value, these assumptions, at the same time, the limitations of this model. In reality, dividends can vary considerably. Also, few investors have an ite holding period of a particular stock. In general, investors tend to sell a particular stock after a certain for a variety of reasons. These limitations mean that the practical value of the Dividend Discount Model (+r) (+n nt price of the equity share, idend expected a year hence, of the share expected a year hence, _ f= rate of retum required on the equity share. aple 45: Prestige’s equity share is expected to provide a dividend of %2.00 and fetch a price of 718.00 a . What price would it sell for now if investors’ required rate of return is 12 per cent? 2.0 18.00 = 17.86 jon: The current price will be: Py = Macey imple 46; Mercury India Ltd. is expected to declare a dividend of €2.50 and reach a price of €35.00 a year $e. What is the price at which the share would be sold to the investors now if the required rate of retum is 13 r 3 D, PB _ 2.50 35.00 _ 2.50 35.00 j = = 250 ms .00 = 733.21 lon: The current price Po (aca mam rm oe ne 2.21 +31.00