PAPER CODE TITLE OF THE PAPER NAME OF THE STUDENT ENROLEMENT NO

DRF 24
Security Analysis and Portfolio Management

DINDIGALA MRUNALINI C0J1316505

1. How will you value the following securities, namely, preference shares and debit Instruments?

Preference Shares: According to Sec 85(1), of the Companies Act, 1956, a preference share is one, whichcarries the following two preferential rights:( a ) T h e p a y m e n t o f d i v i d e n d a t f i x e d r a t e b e f o r e p a y i n g d i v i d e n d t o e q u i t y share holders.( b ) T h e r e t u r n o f c a p i t a l a t t h e t i m e o f w i n d i n g u p o f t h e c o m p a n y , b e f o r e t h e pay ment to the equity share holder.Both the rights must exist to make any share a preference share and should be clearly mentioned in the Articles of Association. Preference shareholders do not have any voting rights, but in the following conditions they can enjoy the voting rights:( 1 ) I n c a s e of cumulative preference shares, if dividend is outstanding for more t h a n two years.( 2 ) I n c a s e o f n o n - c u m u l a t i v e p r e f e r e n c e s h a r e s , i f d i v i d e n d i s o u t s t a n d i n g f o r m o r e than three years.( 3 ) O n a n y resolution of winding up.(4)On any resolution of capital reduction Types of preference shares: I n a d d i t i o n t o t h e a f o r e s a i d t w o r i g h t s , a p r e f e r e n c e s h a r e s m a y c a r r y s o m e o t h e r rights. On the basis of additional rights, preference shares can be classified as follows: Cumulative Preference Shares: Cumulative preference shares are those shares on which the a m o u n t o f d i v i d e d i f n o t p a i d i n a n y y e a r , d u e t o l o s s o r in adequate profits, then such unpaid divided will accumulate and will be paid in t h e s u b s e q u e n t years before any divided is paid to the eq uity share holders. Preference shares are always deemed to be cumulative unless any e x p r e s s provision is mentioned in the Articles.1) Non-Cumulative Preference Shares: Non-cumulative preference shares are those shares on which arrear of dividend do not accumulate. Therefore if divided is not paid on these shares in any year, the right receive the dividend lapses and as such, the arrear of divided is not paid out of the profits of the subsequent years.2) Participating Preference Shares: Participation preference shares are those shares, which, in addition to the basic preferential rights, also carry one or more of the following

rights:( a ) T o r e c e i v e d i v i d e n d , o u t o f s u r p l u s p r o f i t l e f t a f t e r p a y i n g t h e d i v i d e n d t o equity shareholders.( b ) T o h a v e s h a r e i n s u r p l u s a s s e t s , w h i c h r e m a i n s a f t e r t h e e n t i r e c a p i t a l h a s been paid on winding up of the company.4) Non-Participating Preference Shares: Non-participation preference shares are those shares, which do not have the following rights:( a ) T o r e c e i v e d i v i d e n d , o u t o f s u r p l u s p r o f i t l e f t a f t e r p a y i n g t h e d i v i d e n d t o equity shareholders.( b ) T o h a v e s h a r e i n s u r p l u s a s s e t s , w h i c h r e m a i n s a f t e r t h e e n t i r e c a p i t a l h a s been paid on winding up of the company. P r e f e r e n c e s h a r e s a r e a l w a y s d e e m e d t o b e n o n - p a r t i c i p a t i n g , i f t h e A r t i c l e o f t h e company is silent.5) Convertible Preference Shares: C o n v e r t i b l e p r e f e r e n c e s h a r e s a r e t h o s e shares, which can be converted into equity shares on or after the specified date according to terms mentioned in the prospectus.6) Non-Convertible Preference Shares: Non-convertible preference shares, which cannot be converted into equity shares. Preference shares are always being to be non-convertible, if the Article of the company is silent.7) Redeemable Preference Shares: R e d e e m a b l e p r e f e r e n c e s h a r e s a r e t h o s e shares which can be redeemed by the company on or after the certain date after giving the prescribed notice. These shares are redeemed in accordance with the terms and sec. 80 of the Companys Act 1956.2 Irredeemable Preference Shares: Irredeemable preference shares are those shares, which cannot be redeemed by the company during its life time, in other words it can be said that these shares can only be redeemed by the company at the time of winding up. But according to the sec. 80 (5A) of t h e C o m p a n y s (Amendment) Act 1988 no company can issue irredeemable preference shares Preference Shares are issued by corporations or companies with the primary aim of generating funds. A preference share usually carries a fixed stated rate of dividend. The dividend is payable only upon availability of profits. In case of cumulative preference shares, arrears of dividends can be accumulated and in the year of profits common stock holders can be paid dividend only upon settlement of all the arrears of cumulative preference dividends. Preference share holders have preference right over payment of dividend and settlement of principal amount upon liquidation, over common share holders. A preference share can be irredeemable or redeemable. Redeemable preference shares have a fixed maturity date and irredeemable preference shares have perpetual life with only dividend payments periodically upon profit availability. Preference shares can also be cumulative and non-cumulative. Valuation of Preference Shares

Basically, the value of a redeemable preference share is the present value of all the future expected dividend payments and the maturity value, discounted at the required return on preference shares. Redeemable Preference share value

Where:

Dividend 1 to n = Dividends in periods 1 to n. The value of an irredeemable preference share can be expressed as follows:

Defining the "optimal" capital structure is always a challenge for a business. An entrepreneurial company in search of capital can obtain it from various sources, but most come down to choosing between two basic flavors: debt or equity. It's also a challenge for smaller companies to find sources of capital at affordable rates. Affordability with regard to debt refers to the term, interest rate, amortization and penalties for non-payment. In the context of equity, affordability refers to worth (known as "valuation"), dilution of ownership and any special terms or preferences, such as mandatory dividends or redemption rights. Issuing securities is the first option available for obtaining capital. Essentially they come in three basic types: debt, equity and hybrid or convertible. Each type of security has certain fundamental characteristics, variable features and attendant costs. Debt Securities Companies can incur debt by issuing securities, usually in the form of bonds, notes or debentures. Typically, a bond is an obligation secured by a mortgage on some property owned by the company, while a debenture or note is unsecured. Notes and debentures usually carry a higher rate of interest and, therefore, are issued on the strength of the company's reputation, projected earnings and growth potential.

The terms of the debt security and its earnings (referred to as "yield") for the holder will be determined by an evaluation of the level of risk to the holder and the likelihood of default. Growing companies that lack a high bond or credit rating are often faced with restrictive covenants in the debenture purchase agreement or in the bond's indenture (which governs the company's activities during the term of the instrument). For example, the covenants might restrict management's ability to get raises or bonuses, or require that a certain debt-to-equity ratio in the company's capitalization be maintained at all times. The direct and indirect costs of these terms and covenants should be carefully evaluated with the assistance of qualified legal counsel before this option is chosen. Equity Securities The typical growing company--whose value to an investor may be greatly dependent on intangible assets such as patents, trade secrets or goodwill, as well as projected earnings-tends to issue equity securities before incurring additional debt, usually because its balance sheet lacks the assets necessary to secure the debt. Moreover, additional debt is likely to increase the risk of company failure to unacceptably dangerous levels. Equity securities take the form of common stock, preferred stock, and warrants and options. Each type of equity security carries with it a different set of rights, preferences and potential rates of return in exchange for the capital contributed to the company. Common stock offerings, and the related dilution of ownership interest, are often a traumatic experience for founders of growing companies that currently operate as closely-held corporations. The need for additional capital for growth, combined with the lack of readily available personal savings or corporate retained earnings, results in a realignment of the capital structure. Although a common stock offering is generally costly and entails a surrender of some ownership and control, it does give the business an increased equity base and a more secure foundation upon which to build, while the likelihood of obtaining future debt financing is greatly increased Preferred stock is an equity security that has some of the characteristics of debt securities. Preferred stock carries with it the right to receive dividends at a fixed or even an adjustable rate

of return (similar to a debt instrument), with priority over dividends distributed to the holders of the common stock, as well as a preference on the distribution of assets in the event of liquidation. The preferred stock may or may not have certain rights with respect to voting, convertibility to common stock, anti-dilution rights, or redemption privileges which may be exercised either by the company or the holder. Although the fixed dividend payments from preferred stock are not tax-deductible (as interest payments would be) and ownership of the company is still diluted, the balance between risk and reward is still achieved because the principal invested need not be returned (unless there are provisions for redemption). In addition, preferred stockholders' return on investment is limited to a fixed rate of return (unless there are provisions for convertibility), and their claims are subordinated to the claims of creditors and bondholders in the event of a failure to pay dividends upon the liquidation of the company. The use of convertible preferred stock is especially popular with venture capitalists. Warrants and options give the holder a right to buy a stated number of shares of common or preferred stock at a specified price and within a specific period of time. If that right is not exercised, it lapses. If the price of the stock rises above the option price, the holder can essentially purchase the stock at a discount, thereby participating in the company's growth. Convertible Securities In their most typical form, such as convertible notes or convertible preferred stock, these are similar to warrants and options in that the holder has an option to convert them, on specified terms and condition, into common stock. The incentive for conversion is usually the same as for the exercise of a warrant: that the conversion price (that is, the actual price the company will receive for the common stock when a conversion occurs) is more favorable than the current rate of return provided by the security. Convertible securities offer several distinct advantages to a company, including:

an opportunity to sell debt securities at lower interest rates and with less restrictive covenants, in exchange for a chance to participate in the company's success if it meets its projections and objectives.

a means of generating proceeds 10% to 30% above the sale price of common stock at the time the convertible security is issued.

a lower dilution in earnings per share (usually because the company can offer fewer shares when convertible securities are offered than in a "straight" debt or equity offering.

a broader market of prospective purchasers, since certain investors may wish to avoid a direct purchase of common stock but would consider an investment in convertible securities.

Enterprise Value Estimation There are two different methods for estimating the enterprise value. The first one involves the following simple formula: number of shares outstanding x current share price = enterprise value This method is a bit too simplistic and not rigorous enough and for this reason it is less preferred by analysts for enterprise value estimation. A more thorough approach adds market capitalization, debt, preferred stock and cash and cash equivalents to the equation. The following formula is used: market capitalization + preferred stock + outstanding debt - cash & equivalents = enterprise value As it can be seen from the way an enterprise value is calculated, it can be concluded that the latter represents the costs that you will incur if you want to purchase all of the company's common stock, outstanding debt and preferred stock. The cash is subtracted since having purchased the mentioned above shares, you gain full ownerships which automatically makes you a holder of the company's cash. Enterprise Value Components When a company is about to be acquired, its new owner takes on debt (which sometimes can be quite substantial) as well as assets, cash and liquid assets. The more complex formula for enterprise value estimation is more accurate namely because it recognizes that all these factors contribute to value.

Preferred stock can take different functions depending on the specific circumstances. Two of the possibilities are performing as equity or debt. Debt is characterized by the existence of a determined date and price at which a preferred issue should be paid back. Additionally, preferred stocks include the possibility of earning both a fixed dividend and a percentage of the gained profits, known as participating. Whatever the functions of

preferred stocks, their availability requires their inclusion in the enterprise value calculations. Market capitalization is the total market value of a company. The following formula is used for its calculation: market capitalization = number of shares outstanding x current price per share To clarify, consider the following example. Your company includes 1,500,000 shares of outstanding stock. The current price for one stock is $20 for a share. Therefore, the market cap of your company is $30 million (multiply the number of outstanding shares by their price).

Debt represents the owing of the company. For example, you have acquired the outstanding shares of a shoe factory by paying $10 million, which represents the market cap of the company. Throughout its activities, the shoe factory has incurred $3 million in the form of debt. Therefore, you have acquired $13 million. You are responsible for repaying the $3 million in addition to the $10 million you should pay for the acquisition of the factory. The $3 million will be taken out of the company's cash flow, which otherwise could have been allocated for other activities. Cash and cash equivalents become your possession and responsibility with the acquisition of a particular business. You can compensate the costs you have incurred for purchasing the business by withdrawing the specific holdings from the bank. The cash and cash equivalents are subtracted when computing the enterprise value since they have a reduction effect on the price for which you have acquired the business.

Importance of Value Enterprise When deciding whether to purchase a particular business potential buyers compare the enterprise with the cash flow that it generates. If the cash flow represents a big portion of the company's enterprise value, than it is regarded as a preferred purchase. Such investments require little additional investment. As a result, the cash in the company's bank account can be withdrawn and reinvested into other financial opportunities. To get the most out of your money, whether you are interested in mutual funds, stocks, ETFs or options, you need two main things - the knowledge and the right trading platform

Q2. How and why Portfolio Revision carried out? Explain with your examples? PORTFOLIO REVISION The financial markets are continually changing. In the dynamic environment, a portfolio that was optimal when constructed may not continue to be optimal with the passage of time.

It may have to be revised periodically so as to ensure that it continues to be optimal.

the art of changing the mix of securities in a portfolio is called as portfolio revision. The process of addition of more assets in an existing portfolio or changing the ratio of funds invested is called as portfolio revision. The sale and purchase of assets in an existing portfolio over a certain period of time to maximize returns and minimize risk is called as Portfolio revision. Need for Portfolio Revision
An individual at certain point of time might feel the need to invest more. The need

for portfolio revision arises when an individual has some additional money to invest. Change in investment goal also gives rise to revision in portfolio. Depending on the cash flow, an individual can modify his financial goal, eventually giving rise to changes in the portfolio i.e. portfolio revision. Financial market is subject to risks and uncertainty. An individual might sell off some of his assets owing to fluctuations in the financial market. Portfolio Revision Strategies There are two types of Portfolio Revision Strategies. 1. Active Revision Strategy Active Revision Strategy involves frequent changes in an existing portfolio over a certain period of time for maximum returns and minimum risks. Active Revision Strategy helps a portfolio manager to sell and purchase securities on a regular basis for portfolio revision. 2. Passive Revision Strategy Passive Revision Strategy involves rare changes in portfolio only under certain predetermined rules. These predefined rules are known as formula plans. According to passive revision strategy a portfolio manager can bring changes in the portfolio as per the formula plans only. FORMULA PLANS Formula Plans are certain predefined rules and regulations deciding when and how much assets an individual can purchase or sell for portfolio revision. Securities can be purchased and sold only when there are changes or fluctuations in the financial market.
Formula plans help an investor to make the best possible use of fluctuations in the

financial market. One can purchase shares when the prices are less and sell off when market prices are higher. With the help of Formula plans an investor can divide his funds into aggressive and defensive portfolio and easily transfer funds from one portfolio to other.

Aggressive Portfolio (equity shares) Aggressive Portfolio consists of funds that appreciate quickly and guarantee maximum returns to the investor. Defensive Portfolio (bonds and debentures) Defensive portfolio consists of securities that do not fluctuate much and remain constant over a period of time. Formula plans facilitate an investor to transfer funds from aggressive to defensive portfolio and vice a versa. Different formula plans for implementing passive portfolio revision 1 Constant rupee value 2 Constant ratio plan 3 Dollar cost average

1.Constant rupee plan Constructs 2 portfolio-aggressive & defensive. The purpose is to keep the value of aggressive portfolio constant When share value increases aggressive portfolio increases To bring down aggressive portfolio he has to sell some of his shares When share price is falling the aggressive portfolio would also decline To keep the value to the original the investor has to buy some shares from market For this a part of the defensive portfolio will be liquidated to raise the money needed tobuy shares To implement this plan the investor has to decide the action point. 2.Constant ratio plan Construct 2 portfolio The ratio between aggressive and defensive portfolio would be predetermined as 1:1or1.5:1 etc. The purpose is to keep the ratio constant. When share price fluctuates the 2 portfolio sare readjusted to keep the ratio constant.

A revision point will also have to be predetermined 3.Dollar cost average It utilizes the cyclic movement in share prices to construct a portfolio at low cost. The plan stipulates the investor to invest a constant sum in a specified share at periodic intervals. The periodic investment continues for a long period to cover a complete cycle of share price movements It is a technique of building up a portfolio over a period of time. The plan does not envisage withdrawal of funds from the portfolio in between. This plan is suited for investors who have periodic sums to invest.

CONSTRAINTS Transaction cost Taxes Statutory stipulations Intrinsic difficulty