ANVITA SURI

BBA- V (EVE.)

0252111707

FINANCIAL MANGEMENT
Q1. Explain the relationship between the required return and coupon interest rate that would cause a bond to sell
at (a) discount (b) premium (c) at par

A1. BOND - A bond is a long term debt instrument or security. Bonds are issued by the government & do not
have any risk of default. The principle or redeemable bond or bond with maturity is payable after specified
period called maturity period. The government will always honor obligations on its bonds. Bonds of public
company are generally secured in India but they are not free from risk of default. The private sector also issues
bonds which are known as debentures in India. A company in India can issue secured and unsecured
debentures. Incase of bonds or debentures the rate of interest is generally fixed and known to investors.

In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on
the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed
maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals.

Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon
is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case
of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are
considered to be money market instruments and not bonds. Bonds must be repaid at fixed intervals over a
period of time.

Bonds and stocks are both securities, but the major difference between the two is that stockholders have an
equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company
(i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the
bond is redeemed, whereas stocks may be outstanding indefinitely.

COUPON- A fixed amount of interest that a bond promises to pay investors.

COUPON RATE- The rate derived by dividing the bond’s annual coupon payment by its par value.

COUPON YIELD- The amount obtained by dividing the bond’s coupon by its current market price (which does
not always equal its par value). Also called current yield.

REQUIRE RATE OF RETURN (RROR) – it is also known as expected rate of return (EROR) or yield to
maturity (YTM). It is earned by an investor who buys the bond today at the market price, assuming that the
bond will be held until maturity, and that all coupon and principal payments will be made on schedule

NOTE: bond prices and interest rates move in opposite directions. Changes in interest rates have larger impact
on long-term bonds than on short-term bonds.

FEATURES OF THE BOND

1. Face value (par) - face value is also known as par value. A bond is generally issued at par of Rs. 100 or
1000 and interest is paid at par.

2. Interest rate- interest rate is generally fixed and known to investor. Interest rate paid on bond is tax
deductible. The interest rate is also known as coupon rate. Coupons are detachable certificates of
interest.
 3. Redemption value- the value that bond holders will get at maturity is called redemption value or
maturity. A bond may be redeemed at par, premium or discount.

Relationship between coupon interest rate & required rate is as follows:

If the required rate of return is not equal to the coupon rate then, price of the bond will differ from its par
value.

Case Relationship Value of bond yield

redemption CR< RROR VB < FV Discount
Premium CR > RROR VB > FV Premium
Par CR = RROR VB = FV Par

Where,

CR= coupon rate

RROR= required rate of return

VB= value of bond

FV= face value of bond

• If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean) market value of the
bond is greater than the par value (and vice versa).

• If a bond's coupon rate is less than its YTM, then the bond is selling at a discount.

For example, consider a bond selling in 2005 for $10,000 with an annual coupon payment of $1000. What is the
coupon rate? $1000 / 10,000 = 10%

Now suppose that in 2006, the same bond yields only 8% interest payments annually. What is the coupon
payment? 8% x 10,000 = $800 per year.

Which one would you prefer buying? At 10% coupon rate or 8% coupon rate? Since the value of the bond (cash
flows produced) has depreciated from $1000 per year to only $800 per year, this bond will have to be sold at a
cheaper price (or at DISCOUNT).
 • If a bond's coupon rate is more than its YTM, then the bond is selling at a premium.

For example, consider a bond selling in 2005 for $10,000 with an annual coupon payment of $1000. What is the
coupon rate? $1000 / 10,000 = 10%

Now suppose that in 2006, the same bond yields an insane 15% in interest payments annually. What is the
coupon payment? 15% x 10,000 = $1500 per year.

Which one would you prefer buying? At 10% coupon rate or 15% coupon rate? Since the value of the bond
(cash flows produced) has appreciated (gone up) from $1000 per year to a huge $1500 per year, this bond will
have to be sold at a PREMIUM price (higher than its original value).

• If a bond's coupon rate is equal to its YTM, then the bond is selling at par.

For example, consider a bond selling for $10,000 with an annual coupon payment of $1000. Similar type of
bonds is also offering interest payments of $1000 a year. What is the coupon rate?

The coupon rate in this case is $1000 / $10,000 = 10%. Since similar bonds are also offering a 10% interest rate,
this bond is sold at the original price of $10,000 (at Par)

Q2. What is combined leverage? What does it measure? What would be the changes in the degree of combined
leverage assuming other things being equal, in following situations?

(a) The fixed cost increases (b) the EBIT level increases (c) the sale price decreases & (d) the
variable cost decreases?

A2. The term leverage refers to the relation between two interrelated variables. With reference to a business
firm these variables may be cost, output, sales revenue, EBIT, earning per share etc In financial analysis, the
leverage reflects the influence of one financial variable over other financial variable.

OPERATING LEVERAGE- when the sales level increases or decrease, the EBIT also changes. The operating
leverage measures the relation between the sales revenue and the EBIT or in other words, it measures the effect
of change in sales revenue on the level of EBIT. Operating leverage is computed by dividing % change in EBIT
by the % change in sales revenue.

Operating leverage = % change in EBIT

% change in sales revenue

DOL = C/ OP

Where, C= (SALES IN VARIABLE COST)

OP= EBIT
FINANCIAL LEVERAGE- the financial leverage (FL) measures the relation between the EBIT & the EPS & it
reflects the effect of change in EBIT on the levels of EPS. The FL measures the responsiveness of the EPS to a
change in EBIT & is defined as the % change in EPS divided by % change in EBIT. SYMBOLICALLY

Financial leverage = % change in EPS / % change in EBIT

= increase in EPS / EPS

Increase in EBIT / EBIT

Where EPS= (EBIT- Interest) x (1-t)

No. of shares

It may be noted that the EBIT is a dependent variable in the OL & was determined by sales level. However in
case of the FL, the EBIT is an independent variable & now is determining the level of EPS. That is why that
EBIT is called a linking point in the leverage study.

FL= OP/ PBT or FL= EBIT/ (EBIT- I)

Where, OP= operating Profit or EBIT

PBT= profit before tax & after interest.

COMBINED LEVERAGE

The combined leverage (CL) is not a distinct type of leverage analysis; rather it is a product of operating
leverage (OL) & financial leverage (FL).

So far the OL & FL have been analyzed separately. The OL explains the business risk complexion of the firm
whereas the FL deals with the financial risk of the firm. But a firm has to look into the overall risk or total risk
of the firm, which is business risk plus the financial risk. Therefore a financial manager should consider both
the FL & OL simultaneously.

The OL causes a magnified effect of the change in sales level on the EBIT level & if the FL is also considered
simultaneously then the change in EBIT will have a magnified effect on EPS. Thus a firm having both the FL &
OL will have wide fluctuations in the EPS for even a small change in the sales level. This effect of change in
the sales level of EPS is known as combined leverage.

The effect of OL & FL are collectively captured through the concept of combined leverage (CL).
Combined leverage can be described as the capacity of the firm to magnify its EPS as its sales rise. This
magnification is possible because the firm has fixed operating costs in its cost structure & fixed finance charges
in its capital structure.

CL= OL x FL

=C x EBIT

EBIT (EBIT- I)/ NI

= C/NI

WHERE, C= contribution contribution= sales- variable cost

NI= net income after interest

EBIT= operating income

Degree of combined leverage: mathematically, DCL is defined as the change in EPS from the percentage
change in sales.

DCL= DOL * DFL

% change in EBIT x % change in EPS

% change in sales % change in EBIT

Thus, DCL= % change in EPS

% change in sales

Or CL= Cn x OP = Cn

OP PBT PBT

Where, Cn= contribution= (sales- variable cost)

PBT= profit before tax

Illustrations:

Units sold Rs. 1000

Sales @Rs. 10 per unit 10,000

(-) variable cost@7/ unit. (7000)

Contribution 3,000

(-)fixed cost (1000)

EBIT 2,000

(-) interest (200)

PBT 1800

TAX @ 50% 900

Profit after tax 900

CL= C/PBT= 3000/1800

= 1.66

Changes in following situation:

1. Fixed cost increases: if fixed cost increases then it will increase the profit before tax. And thus will
increase combined leverage. Say FC rises to 1200

C- FC= EBIT =1800

Now, PBT= (EBIT-I) = 1800-200= 1600

CL= C/PBT= 3000/1600=1.87

2. The EBIT level increases: increase in EBIT will have no effect on combined leverage. This is because
the formula foe CL is contribution divided by profit before tax. There is no role of EBIT in this.
 3. Sale price decreases:

Contribution = sales – variable cost

If sale price reduces ultimately total sales reduces. This will decrease the contribution. If contribution decreases
then combined leverage also comes down.

Say sale price=@ Rs.11

Units sold Rs. 1000

Sales @Rs. 11 per unit 11,000

(-) variable cost@7/ unit. (7000)

Contribution 4,000

(-)fixed cost (1000)

EBIT 3,000

(-) interest (200)

PBT 2800

CL= 4000/2800= 1.42

4. Variable cost decreases: decrease in variable cost will increase the contribution. This will increase the
combined leverage. Say VC= 8/unit

Units sold Rs. 1000

Sales @Rs. 11 per unit 11,000

(-) variable cost@8/ unit. (8000)

Contribution 2,000

(-)fixed cost (1000)

EBIT 1,000

(-) interest (200)

PBT 800

CL= C/PBT= 2000/ 800

=2.5