FAQs on Security Valuation | Strategic Financial Management

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FAQ 1. What are Zero Coupon Bonds?

Zero coupon bonds are issued by Banks, Government and Private Sector companies. These bonds do not pay interest during the life of the bonds. Instead, they are issued at discounted price to their face value, which is the amount a bond will be worth when it matures or comes due.

When it matures, the investor receives a lump sum amount equal to the initial investment plus interest that has been accrued on the investment made. The maturity dates on zero coupon bonds are usually long term.

Bonds issued by corporate sector carry a potentially higher degree of risk, depending on the financial strength of the issuer and longer maturity period, but they also provide an opportunity to achieve a higher return.

Check out Taxmann's CA Final Strategic Financial Management Cracker which covers past exam questions (incl. RTPs & MTPs of ICAI) arranged sub-topic wise, with additional solved practice questions. It also includes previous exam trend analysis, chapter-wise marks distribution & ICAI study material comparison.

CA Final | New Syllabus | May 2022 Exams

FAQ 2. What is a Traditional & Walter Approach to Dividend Policy?

Traditional approach:

It is also known as the “The Graham and Dodd model” as it was expounded by him. According to the model, the stock market places considerably more weight on dividends than on retained earnings. This is expressed quantitatively in the following valuation model:

P = m(D + E/3)

Where, P = Market price of the share

D = Dividend per share

E = Earnings per share

m = a multiplier.

This model is based on the following assumptions:

(a) Investors are rational

(b) Under conditions of uncertainty, they turn risk averse.

Under this model, the weight attached to dividends is equal to four times the weight attached to retained earnings. The weights provided by Graham and Dodd are based on their subjective judgment and not derived from any empirical analysis.

Investors discount distant dividends at a higher rate than they discount nearby dividend. This is because nearby dividends are more certain than distant dividends.

Walter approach:

The Walter’s Model propounded in 1963 by John E Walter supports the doctrine that dividends are relevant. The investment policy of the firm cannot be separated from its dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the value of any firm. It is based on the following assumptions:

(a) The firm is an all equity firm.

(b) The firm will use only retained earnings to finance its investments.

(c) The rate of return on investment is constant and so is the cost of equity. This means that with every additional investment, business risk remains unaltered.

(d) All earnings are either distributed or retained internally.

(e) The firm has a perpetual or very long life.

(f) Earnings and dividends don’t change over the life of the firm.

Walter argued that the market price of a share is the sum of the present value of the following two cash flow streams:

i. Infinite stream of constant future dividends.

ii. Infinite stream of capital gains.

Walter model is based on the premise that there is a relationship between the return on a firm’s investment or its internal rate of return (r) and its cost of capital (k_e). The firm would have an optimum dividend policy which will be determined by the relation between (r) and (k_e). If r is greater than k_e, the firm should retain the earnings and if r is less than k_e, it must distribute the earnings.

FAQ 3. Why should the duration of a coupon carrying bond always be less than the time to its maturity?

The concept of duration can be defined as the percentage change in price of a bond for a 100 basis point change in interest rates. However, there is another concept of duration i.e. the time concept of duration according to which duration is nothing but the average time taken by an investor to collect his/her investment. It is the weighted average time to receive the present value of the bond. Therefore, if an investor receives a part of his/her investment over the time on specific intervals before maturity, the investment will offer him the duration which would be lesser than the maturity of the instrument. Higher the coupon rate, lesser would be the duration. The duration of a Zero coupon bond is always equal to its maturity period.

FAQ 4. What is a buy-back of shares by companies?

Buy-Back of Shares: The buy-back of shares means the repurchase of its own shares by a company and to return money to the holders of these shares. The cash is exchanged for a reduction in the number of outstanding shares. Since this process involves outflow of cash resources, it is adopted when the company has sufficient cash resources. The buy-back is a method of financial engineering which enables the company to go back to its shareholders and offers to purchase from them the shares they hold. However, the companies have to fulfil some legal conditions for buy-back of shares.

FAQ 5: What is the impact on P/E Ratio upon the buy of shares by a company?

Impact of Buy-Back on P/E Ratio:

P/E Ratio is given by the following formula :

The buy back of shares by the company reduces the number of shares. In this case if the earnings remain constant, there is a rise in the Earnings Per Share i.e. EPS.

After buy back, the market price of the share generally increases. Thus, there is increase in Market price of share i.e. MPS.

As the numerator and denominator in the formula tend to increase, the impact on P/E will depend upon the quantum of relative increase in the two factors.