CMA Final · Strategic Financial Management

Equity and Bond Valuation and Evaluation of Performance

This chapter of Paper 14 covers how to value shares and bonds, measure bond price risk, read the yield curve and judge a portfolio's returns after adjusting for risk. You solve it by discounting cash flows at the right rate, then applying the correct formula for duration, convexity or a performance ratio.

What this chapter covers

This chapter brings together valuation and performance measurement. You value equity with dividend discount models and earnings-based methods. You value bonds by discounting coupons and principal, and you compute yield measures such as current yield, yield to maturity and yield to call. Then you study how bond prices react to interest rate changes through duration and convexity, how to immunize a liability, and what the term structure of interest rates tells you.

The last part moves from valuing single securities to judging results. Risk-adjusted performance measures such as the Sharpe ratio, Treynor ratio and Jensen's alpha tell you whether a portfolio manager earned enough return for the risk taken. These need standard deviation, beta and the risk-free rate, so they link directly to the portfolio theory and CAPM that you meet elsewhere in the paper.

The chapter connects to the rest of Paper 14 in three ways. Discounting and required return come from the time value of money and the cost of capital. Bond risk ideas feed into interest rate risk management and derivatives. Performance measures feed into portfolio management. Most questions are numerical, so accuracy in workings matters as much as knowing the theory.

Valuation questions are formula-driven and have clear right answers, so a student who practises them can score reliably in both the 2-mark MCQs and the 14-mark written questions. Bond duration, yield and performance ratios are also easy to test as short MCQs, and the same skills support other chapters of the paper. Time spent here pays back through repeated use of the same discounting logic.

Equity and Bond Valuation and Evaluation of Performance: topics in the order to study them

1Equity Valuation ModelsStart here because it builds the habit of discounting cash flows at a required return, which every later topic uses.
2Bond Valuation and Yield MeasuresIt applies the same discounting to fixed cash flows and introduces yield, the base for duration and the yield curve.
3Bond Duration, Convexity and ImmunizationYou need bond price and yield clear first, because duration and convexity measure how price changes when yield changes.
4Term Structure of Interest RatesOnce you know yields and rate risk, you can understand spot rates, forward rates and the shape of the yield curve.
5Risk-Adjusted Performance MeasuresStudy it last as it uses return, risk and beta ideas, and it is a self-contained set of ratios that is easy to revise.

How to prepare Equity and Bond Valuation and Evaluation of Performance

This is a numerical chapter, so you learn it by solving problems, not by reading notes. Use short daily sessions that you can do on a phone for theory and a notebook for workings.

Write each formula once in your own notebook with the condition under which it applies, for example the constant growth model needs the required return to be greater than the growth rate.
Solve at least three problems for each topic, starting with simple ones, and then move to multi-step questions that combine two ideas.
For bonds, practise computing price by discounting each cash flow, and check that price falls when yield rises and that a bond at par has a yield equal to its coupon rate.
Practise the duration and convexity steps in a fixed order: cash flows, present values, weights, then the final measure. Use a table layout so you do not skip a row.
For performance measures, keep a one-line note on what each ratio uses as risk: total risk for Sharpe, beta for Treynor and Jensen's alpha.
Finish with timed MCQs and one full written question per topic. Write a short conclusion at the end, such as which portfolio performed better and why.
Revise from your formula notebook two days before the exam and redo the questions you got wrong.

Common mistakes in Equity and Bond Valuation and Evaluation of Performance

Using D₀ instead of D₁ in the constant growth model.
Fix: Read whether the dividend is already paid or expected next year, and compute D₁ = D₀ × (1 + g) when needed.
Applying the annual yield to half-yearly coupon bonds without adjusting.
Fix: Divide the coupon and yield by the number of payments per year, and multiply the years by the same number.
Mixing up Sharpe and Treynor ratios.
Fix: Remember that Sharpe divides by standard deviation (total risk) and Treynor divides by beta (market risk).
Mixing up the columns in the duration table.
Fix: Build a table with time, cash flow, present value, weight (present value ÷ bond price), and weight × time. Add the last column to get Macaulay duration. Equivalently, add the present value × time column and divide by the bond price.
Giving a number with no conclusion in a written question.
Fix: End every answer with a decision, such as whether to buy a share that is undervalued or which portfolio performed better.
Confusing spot rates with forward rates.
Fix: Write the compounding relation for the years involved and solve for the forward rate step by step.

Last-day revision: Equity and Bond Valuation and Evaluation of Performance

Value of a share is the present value of expected future dividends at the required return.
Constant growth model: P₀ = D₁ ÷ (ke − g), valid only when ke > g.
D₁ = D₀ × (1 + g); do not use D₀ in the numerator by mistake.
Bond price is the present value of coupons plus the present value of the redemption amount.
Bond price moves inversely to yield; a bond sells at par when yield equals coupon rate.
Current yield = annual coupon ÷ current market price.
Yield to maturity is the discount rate that equates the bond price to the present value of its cash flows.
Other things equal, a higher coupon rate and a shorter maturity give a lower Macaulay duration. A zero-coupon bond's Macaulay duration equals its maturity.
Modified duration = Macaulay duration ÷ (1 + yield per period).
Immunization matches the duration of assets with that of the liability.
Sharpe ratio = (Rp − Rf) ÷ σp; Treynor ratio = (Rp − Rf) ÷ βp.
Jensen's alpha = Rp − [Rf + β × (Rm − Rf)]; a positive value means the portfolio beat its required return.

Equity and Bond Valuation and Evaluation of Performance practice questions

Equity and Bond Valuation and Evaluation of Performance in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Equity and Bond Valuation and Evaluation of Performance: frequently asked questions

Is this chapter mostly numerical or theory?

It is mostly numerical. Theory such as the shapes of the yield curve and its explanations is tested in short MCQs or short notes, but equity valuation, bond pricing, duration and performance ratios are tested through calculations.

Which topic should I prioritise if time is short?

Prioritise bond valuation and yield measures and risk-adjusted performance measures, as both rely on a small set of formulas. Then cover equity valuation. Leave convexity and the finer points of the term structure for last.

Do I need to memorise the duration formula?

Yes, but it is easier to learn the table method. Compute the present value of each cash flow, multiply by time, add the column and divide by the bond price. This gives Macaulay duration without relying on a long formula.

How do I decide which performance measure to use?

Decide by the kind of risk that matters. The Sharpe ratio uses total risk (standard deviation), so it suits evaluating a whole or undiversified portfolio. The Treynor ratio and Jensen's alpha use systematic risk (beta), so they suit well-diversified portfolios. The data given in the question is only a practical cue, not the reason for the choice.