J. K. SHAH CLASSES FINAL C.A. – S. F.M.

SECURITY VALUATION - PART A

HOMEWORK SECTION SOLUTION

Answer 1
(i) Calculation of theoretical Post-rights (ex-right) price per share:
MN+ SR
Ex-right value =
N+R
Where,
M = Market price,
N = Number of old shares for a right share
S = Subscription price
R = Right share offer
  ` 24 × 4  +  ` 16×1  
=   = ` 22.40
 4 +1 

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

= Ex-right price – Cost of rights share
= ` 22.40 – ` 16 = ` 6.40
` 22.40 - ` 16
Or = = ` 1.60
4

(iii) Calculation of effect of the rights issue on the wealth of a shareholder who has
1,000 shares assuming he sells the entire rights :
`
(a) Value of shares before right issue (1,000 shares × ` 24) 24,000
(b) Value of shares after right issue (1,000 shares × ` 22.40) 22,400
Add: Sale proceeds of rights renunciation (250 shares × ` 6.40) 1,600
24,000
There is no change in the wealth of the shareholder even if he sells his right.

(iv) Calculation of effect if the shareholder does not take any action and ignores the
issue:
`
Value of shares before right issue (1,000 shares × ` 24) 24,000
Less: Value of shares after right issue (1,000 shares × ` 22.40) 22,400
Loss of wealth to shareholders, if rights ignored 1,600
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J. K. SHAH CLASSES FINAL C.A. – S. F.M.
Answer 2
D0 = ` 4
D1 = ` 4 (1.20) = ` 4.80
D2 = ` 4 (1.20)2 = ` 5.76
D3 = ` 4 (1.20)2 (1.10) = ` 6.336

D1 D2 TV
P=  
1 +ke  1 +ke  1 +ke 2
2

D3 6.336
TV   =126.72
ke - g 0.15- 0.10

4.80 5.76 126.72

P= + +
1 + 0.15 1 + 0.15 1 + 0.152
2

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

Answer 3

(i) Present Value of the stock:-

5.00 1.02
Vo = =` 63.75 / -
0.10 - 0.02

(ii) Value of stock under the PE Multiple Approach

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

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

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J. K. SHAH CLASSES FINAL C.A. – S. F.M.
(iii) Value of the Stock under the Earnings Growth Model
Particulars
Actual Stock Price ` 40.00
Return on equity 8%
EPS ` 3.00
Growth Rate 2%
Market Price per Share [EPS ×(1+g)]/(Ke – g) ` 51.00
= ` 3.00 × 1.02/0.06

Since, Actual Stock Price is lower, hence it is undervalued.

Answer 4
(i) Let P be the buyback price decided by Rahul Ltd.
Market Capitalisation after Buyback
1.1P (Original Shares – Shares Bought Back)

1.1P  10 lakhs -
27% of 100 lakhs 
P 
 

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

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

`27 lakhs
=1.24 lakhs (Approx.) or 123910 share
`21.79

(iii) New Equity Shares :-

10 lakhs – 1.24 lakhs = 8.76 lakhs or 1000000 – 123910 = 876090 shares
3×10 lakhs
EPS = = ` 3.43
8.76 lakhs

Thus, EPS of Rahul Ltd., increases to ` 3.43.

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J. K. SHAH CLASSES FINAL C.A. – S. F.M.
Answer 5
Calculation of Po
Year DIVIDEND DF@15% PV
1 5.5 0.870 4.785
2 6.05 0.756 4.574
3 6.66 + 69.9 0.658 50.376
Po  59.735
D 6.99
P = 4 =
3 Ke-g 0.15 - 0.05
= 69.9
The expected price of share is `59.735 and the actual price is `46, the share is
currently trading at a discount.

Answer 6
Asset turnover ratio = 1.1
Total Assets = ` 600
Turnover ` 600 lakhs × 11 = ` 660 lakhs
Interest
Effective interest rate = = 8%
Liabilities
Liabilities = ` 125 lakhs + 50 lakhs = 175 lakh
Interest = ` 175 lakhs × 0.08 = ` 14 lakh
Operating Margin = 10%
Hence operating cost = (1 - 0.10) ` 660 lakhs = ` 594 lakh
Dividend Payout = 16.67%
Tax rate = 40%

(i) Income statement

(` Lakhs)
Sale 660
Operating Exp 594
EBIT 66
Interest 14
EBT 52
Tax @ 40% 20.80
EAT 31.20
Dividend @ 16.67% 5.20
Retained Earnings 26.00

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J. K. SHAH CLASSES FINAL C.A. – S. F.M.
(ii) SGR = ROE (1-b)

PAT
ROE = and NW = ` 100 lakh+ ` 300 lakh = 400 lakh
NW

` 31.2 lakhs
ROE = ×100 = 7.8%
` 400 lakhs

SGR = 0.078 (1 – 0.1667) = 6.5 %

(iii) Calculation of fair price of share using dividend discount model

D(1+
0 g)
P0 =
ke - g

` 5.2 lakhs
Dividends = = ` 0.52
` 10 lakhs
Growth Rate = 6.5 %

`0.52 1 + 0.065 ` 0.5538

Hence P0 = = = ` 6.51
0.15- 0.065 0.085

(iv) Since the current market price of share is ` 14, the share is overvalued. Hence
the investor should not invest in the company.

Answer 7
In order to find out the value of a share with constant growth model, the value of K e
should be ascertained with the help of ‘CAPM’ model as follows:

Ke = Rf + β (Km – Rf)
Where,
Ke = Cost of equity
Rf = Risk free rate of return
β = Portfolio Beta i.e. market sensitivity index
Km = Expected return on market portfolio
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J. K. SHAH CLASSES FINAL C.A. – S. F.M.
By substituting the figures, we get
Ke = 0.09 + 1.5 (0.13 – 0.09) = 0.15 or 15%
and the value of the share as per constant growth model is
D1
P0 =
k e - g 
Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke = Cost of equity
G = growth
2.00
P0 =
k e - g 
2.00
P0 = = ` 25.00
0.15- 0.07
Alternatively it can also be found as follows:

2.00 1.07
= ` 26.75
0.15- 0.07
However, if the decision of finance manager is implemented, the beta (β) factor is
likely to increase to 1.75 therefore, Ke would be

Ke = Rf + β (Km – Rf)
= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%
The value of share is
D1
P0 =
k e - g 
2.00
P0 = =` 22.22
0.16 - 0.04

Alternatively it can also be found as follows:

2.00 1.07
= ` 23.78
0.16 - 0.04

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J. K. SHAH CLASSES FINAL C.A. – S. F.M.
Answer 8
1. Calculation of cost of capital
Retained earnings 37.5% ` 3 per share
Dividend* 62.5% ` 5 per share
EPS 100.0% ` 8 per share
P/E ratio 7.5 times
Market price is ` 7.5 × 8 = ` 60 per share
Cost of equity capital = (Dividend/price × 100) + growth %
= (5/60 × 100) + 12% = 20.33%.

 `3
* ×62.5 =` 5 
 37.5 
2. Market price = Dividend/(cost of equity capital % − growth rate %) = 5/(20.33%
− 13%) = 5/7.33% = ` 68.21 per share.

3. Market price = Dividend/(cost of equity capital % − growth rate %) = 5/(18% −

15%) = 5/3% = ` 166.66 per share.

Answer 9
D1
Intrinsic Value P0 =
k - g 
Using CAPM
k = Rf +β (Rm-Rf)

Rf = Risk Free Rate

β = Beta of Security
Rm = Market Return
= 9% + 0.75 (15% - 9%) = 13.5%

2.5×1.1 2.75
P = = =` 78.57
0.135- 0.10 0.035

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