Lecture 10

WEALTH PLANNING AND
MANAGEMENT

• LECTURE 10
• TOPIC 5: INVESTMENT IN
SECURITIES

1

CONTENTS
• Introduction
• Types of Securities
• Price Determination
• Risk Elements
• Related Theories
• Laws Relating to Securities
• Questions for Revision
2

INTRODUCTION
• Securities are financial assets that are traded in the
capital markets. Since the fluctuations in securities
prices can be very volatile it is very attractive for people
with surplus funds to buy and sell them hoping to get
dividends and/or capital gains within a short time
• Issuers of securities on the other hand use their
securities to raise funds for future expansion of their
business. Governments too issue securities to raise
funds for development projects.

3

The Islamic Equities Market
• Going by the Shariah, equity financing would be the
preferred financing/investing technique.
• Equity financing has no fixity of return.
• Returns that are tied to the earnings of the
underlying business.
• A risk-profile not detached from that of the business.
• Thus, equity financing is very much profit and loss
sharing with all the business risks thrown in.
• Investment in a stock resembles the provision
of Mudarabah financing.

The Islamic Equities Market
• However, not all stocks listed in an exchange may be
acceptable from a shariah viewpoint.

• The need for a shariah evaluation of stocks and the
identification of shariah compliant stock has led to the
development of shariah filters, shariah indices, shariah
compliant ETFs (Exchange Traded Funds) and an entire
industry of Islamic Mutual Funds.

• All these have meant that there is an Islamic Equities Market
operating in parallel with the conventional equity market.

Components of an Islamic Equities Market

• What would constitute an Islamic Equities
Market?
– Stocks would be the basic component.
– Islamic ETFs (Exchange Trade Funds)
– Islamic REITs (Real Estate Investment Trusts)
– Islamic Mutual Funds
– Others like Islamic Private Equity Funds, Islamic
Structured Products etc.

TYPES OF SECURITIES

• There are two main types of securities
namely:
– Equity instruments
– Debt instruments
• The third type which is increasingly
becoming popular is
– The hybrids. Hybrids are those that have the
characteristics of both equity and debt.

8

TYPES OF SECURITIES

• Difference between debt and equity:
– In terms of claims
– In terms of time
• Debt or borrowing is fixed in time i.e. it is
terminal or has maturity and therefore is
fixed in claim. This means that debt must be
paid in full upon maturity. Once it matures
the firm must pay the creditors the principle
plus interest.
9

TYPES OF SECURITIES

• Equity gives ownership to the holders. The
holders own the firm less the firm’s
obligations. i.e. equity is residual in claim.
Whatever the firm makes belongs to the
equity holders less its obligations.
• Secondly equity being ownership is not
terminal and does not have a fixed maturity.
It is perpetual.
10

TYPES OF SECURITIES

• The most common equity instrument is the
common stock. As long as the stockholder
has the shares he has a residual claim on the
firm.
• The most common debt instrument is the
bond. Generally bonds would provide
holders a fixed annual or semi-annual interest
payments (coupon payments) and full
repayment of principal at maturity.
11

TYPES OF SECURITIES

• Equity instruments – common stocks
– Equity instruments represent ownership in the
company. A public listed company is jointly
owned by its shareholders.
– All public listed companies are limited liability
corporations. The shareholders liability is up to
his investment. Since the corporation is a
separate legal entity the shareholder is
responsible for any losses up to his total
investment.
12

TYPES OF SECURITIES

– As investors, shareholders have certain rights:
• Right to residual value of the firm
• Right to the portions of dividends if announced
• Right to vote in the AGM.
– Since dividend yield is low, shareholders have
the chance to earn capital gain

13

TYPES OF SECURITIES

• Some basic definitions of Common Stocks:
– Authorised capital
– Issued (paid up) capital
– Par Value
– Treasury stocks (usually bought for senior
management)
– Book Value per Share = Common Stockholders
Equity / No. of Shares Outstanding

14

TYPES OF SECURITIES

– Market Value of Firm = Market Price of Share X No. of Shares
Outstanding
– Rights issue: sale of additional stock to existing shareholders
usually to present shareholders at a slight discount
– Bonus issue: issue of additional stocks to existing shareholders
for free
– Stock Dividends: where dividends are paid in terms of stocks
rather than cash
– Earnings per share or EPS: is a key indicator used by
shareholders and market participants
– P/E ratio or Price Earnings ratio: price per share divided by
earnings per share

15

Initial Public Offering (IPO)

• Initial Public Offering (IPO) Process is one
when companies intend to sell stocks to the
investing public
– Must get approval from Securities Commission
to become a public listed company and have its
shares listed in the Stock Exchange
– To get the approval the firm must have
• Good track record of earnings
• Good management
• Fulfil basic statutory requirements
16

Initial Public Offering (IPO)

• After getting approval the firm will appoint a merchant
bank to prepare for the IPO
• The initial issue price is determined by merchant bank
based on the company’s financial health and track
record, market conditions; investor sentiments etc.
• Post-listing prices are determined by market conditions
• IPO market is considered as Primary market but once
listed it is traded in the Secondary market. This is
because the IPO is normally offered to shareholders,
corporations, etc. before it goes public through the stock
market
17

Screening of Stocks for Shariah Compliance

• Malaysia was the first Muslim country with a conventional
stock market to have come up with a formal evaluation for
shariah compliant stocks and a shariah stock index.

• Following this in 1999, Dow-Jones, the US based publisher of
the Wall Street Journal and financial information provider,
designed the Dow-Jones Islamic World Market Index
(DJIWM).The DJIWM is a global index of shariah compliant
stocks.
• In determining whether a stock is a shariah compliant a
screening procedure is used.

Shariah Screening of Stocks in Malaysia

• Shariah screening of listed stocks in Malaysia are based on
parameters established by the Securities Commissions’,
Shariah Advisory Council (SAC).
• The SAC was established by the Securities Commission (SC) in
1996.
• The SAC’s screening process as with the DJIWM begins with
looks at two broad categories:

– i) The line of business or core business of the underlying
company.
– ii) The company’s finances.

Stock Screening Process

• Halal Stocks and Shariah Index
– Security Commission is responsible for
determining the Shariah compliant stocks and the
Shariah Index through its very own Shariah
Advisory Council (SAC)
– In principle the first level of screening is to focus
on core business. Companies whose core
businesses are Shariah compliant will form the
universe.

20


– Securities excluded are those involved in
• Financial services based on riba;
• Gambling and gaming
• Manufacture or sale of non-halal products or related products;
• Conventional insurance
• Entertainment activities that are not permissible by Shariah
• Manufacture or sale of tobacco-based products or related
products;
• Stock broking or share-trading in Shariah non-compliant
securities;
• Other activities deemed non-permissible by Shariah

22


• The SAC also considers amount of interest
income received by the company from
conventional fixed deposits or other interest
bearing financial instrument. In Addition
dividends received from investment in
shariah non-compliant securities are also
considered in the analysis.

23


• For companies with activities comprising both
permissible and non-permissible elements the SAC uses
two other criteria:
– The public perception or image of the company
– The core activities of the company are important and
considered maslahah (beneficial) and the non-permissible
element is very small and involves matters such as umum
balwah (common plight and difficult to avoid); ‘uruf (custom)
and the rights of non-Muslim community which are accepted
by Islam

24


• While the above criteria are all subjective, in order to translate these
subjective criteria into actionable filters, the SAC uses a two phase
analysis/screening procedure. These being;

– Phase One :Quantitative Method
– Phase Two :Qualitative Method

• Phase One: Quantitative Method
– In phase one, the objective is to compute the percentage contribution
of non permissible activities to the company’s income and profit before
tax. The income and profit before tax would be for the latest fiscal year
as shown in the company’s Profit & Loss or Income Statement.


 The computation of percentage is carried out as follows:
 Step 1 : Determine the earnings (Total Income/Revenue) and Profit
before tax of the company.
 Step 2 : Identify and measure the income/earnings and profit
before tax from the non permissible activities.
 Step 3 : Determine the percentages as follows:

(i) Earnings from non-halal activities X 100
Total Earnings of Firm

(ii) PBT from non-halal activities X 100
PBT all activities of firm

 Step 4: Compare the percentage earnings and PBT with the two
threshold level marks.
(see below)


• To determine the tolerable level or
benchmark of mixed contributions from
permissible and non-permissible activities,
the SAC came out with four levels:
– 5% benchmark – when the non-permissible are
clearly prohibited (riba; gambling; liquor; pork)
– 10% benchmark – involve element of umum
balwah prohibited element affecting most people
and difficult to avoid
27


– 20% benchmark – mixed rental payment from
Shariah non-compliant activities such as rental
from premises used for gambling; sale of liquor
etc
– 25% benchmark – activities that are generally
permissible and beneficial (maslahah) but
contains elements that may affect the Shariah
status of these activities. Among these activities
are hotel and resort; share trading; stock broking
and others
28


Phase Two: Qualitative Method

 The qualitative method is essentially used on a case-by-case
method. Again this is applicable for situations where the core
activity of the company has importance and maslahah (benefit
in general) to the ummah but includes a small element that
may be haram. The non permissible activity could also be
driven by custom or involve the rights of non-muslims. In
analyzing such companies on a case-by-case basis, the SAC
allows for threshold levels anywhere from 10% to 25%.


 Since businesses are dynamic and conditions change rapidly,
a company that passes the threshold at a point in time may
exceed it at a future date. For example, a manufacturer of
home appliances may have interest earnings below 5%
currently but could exceed it at a later point. The opposite
situation may also be possible. Thus, the SAC reviews the list
periodically. An updated list is issued every 6 months.
Currently about 85% of the listed stocks in Malaysia are
deemed shariah compliant, based on the SAC criteria.

Shariah Compliant Listing
• For companies with mixed contribution from Shariah permissible and
non-permissible activities, they are deemed Shariah-compliant should
the following thresholds are complied with:

– Income from activities which are clearly prohibited (like conventional
financial business, insurance, gambling, pork and alcohol is less than 5% of
total turnover (TO) and profit before tax (PBT);

– Mixed rental income from Shariah non-compliant activities (like rental
payments from premises used in gambling, sale of liquor) is less than 20% of
total TO and PBT

– Interest income from fixed deposits and income from tobacco business is
less than 10% of total TO and PBT;

– Income from hotel and resort business, share trading and stock broking of
Shariah non-compliant stocks is less than 25% of total TO and PBT.

Stock Screening for the Dow Jones Islamic Index

• The stock screening procedure used by Dow Jones for its Islamic Index is
more elaborate and tighter than that of Malaysia’s SAC. As is the case
with the Malaysian criteria, there are two broad categories, the nature of
the business and financial aspects.

• The Dow Jones criteria involves both financial statements, especially the
Balance Sheet.

• Dow Jones begins with an initial step that involves eliminating stocks of all
companies involved in an exhaustive list of activities. These are industries
related to alcohol, liquor, pork related, conventional financial services (banking,
insurance, merchant banking etc), hotels, entertainment (including cinema, music
etc), tobacco, defense, weapons manufacturing etc. While this first step is
qualitative, the second step involves the quantitative analysis of the
firm’s financial ratios.

 This numerical analysis is really aimed at two things,
 identify firms with “excessive” leverage in the capital structure and;
 identify firms with unacceptable levels of interest income. This is generally
done by applying the following three key ratios.

(i) Debt to Trailing Twelve Month Average Market Capitalization
Debt to TTMAMC

Computed as: =
Total Interest Bearing Debt X 100
12 months Average Market
Cap
Threshold: 33%

Thus, any firm with a Debt to TTMAMC exceeding 33% will be excluded. The
rationale being that such a firm is paying a substantial portion of its earning
as interest on its debts.

• (ii) Liquid Assets to TTMAMC
computed as: =
Cash deposits + Marketable Securities + Interest X 100
Bearing Instruments
TTMAMC

Threshold: 33%

• (iii) Receivables to TTMAMC

computed as : = Recievables +Trade Notes + Other receivables
X 100
TTMAMC
Threshold: 33%
These latter two ratios are intended to capture the extent of interest earned by the
firm from its liquid assets and its receivables. It is common practice in developed
markets such as the US, for firms to charge an interest on all trade receivables
outstanding beyond a certain period.

Comparison of Stock Screening Techniques
• Though the philosophy and intended objective is the same, a comparison
of the stock screening techniques of the Dow Jones Islamic Index (DJII)
with that of the Malaysian SAC pints to obvious differences. The two key
differences are;

– The tolerance for mixed businesses by the SAC.
– The more stringent use of Balance Sheet based
financial ratios by Dow Jones.

• Malaysia’s SAC also does not evaluate a firm’s Balance Sheet. Thus, the
firm’s capital structure and the extent of its financial leverage is not a
consideration.

Comparison of Stock Screening Techniques

• Since the SACs criteria is Malaysia specific, using a stringent filter will
result in a smaller group of eligible stocks and therefore a much narrower
investible spectrum for Muslim investors in Malaysia.
• One might ask, what is wrong with having a smaller but ‘purer’ group of
investible stocks?
• There are several problems with this:
– From a portfolio theory viewpoint, a smaller investible group of stocks restricts
diversification and limits the benefits of diversification.
– One cannot form efficient portfolios or superior risk-return portfolios if the
group of investible stocks is restricted.
– By implication one cannot be on the ‘optimal’ efficient frontier or get close to
such a frontier.

• As with everything else in economics, there is a trade off. The cost may be
less efficient portfolios.

36


• Shariah compliant securities which are
subsequently considered Shariah non-
compliant:
– If the price of the securities is more than its cost:
must sell immediately. If not the proceeds should
go to charity
– If the price is lower than cost: then wait until the
price is equal to cost and then sell. If dividends
are declared during the holding period the
dividend may be accepted
37

Debt Instruments (bonds)

• Debt Instruments – are normally called bonds
which are promissory notes that are traded in
the market
• Bonds are categorised by the issuer; tenor;
coupon type
• By issuer: government or corporate

38


ISSUER TENOR
Long term Short term

Government Govt Bond Treasury bills

Corporations Corp Bond Commercial papers

39


• Bonds also differ by coupon type
– Coupon bonds pay periodic interest based on
coupons
– Zero coupon bonds pay no interest on maturity
but only the face value. The purchaser will buy at
discount.
– Interest can be fixed or floating. Floating
interests are determined in reference to say
KLIBOR + x%. If KLIBOR is 10% and x is 2
then for a bond of RM1000 the interest is RM120
40

BONDS – Some basic definitions

• Par Value
• Coupon rate
• Sinking fund – amount paid by issuer periodically to
equal redemption amount
• Coupon yield
• Yield-to-maturity – total returns of bond
• Duration of the bond
• Unsecured bond
• Collateralized bond
• Speculative grade – lower quality bond

41

Different types of bonds

• Callable bond – callable by issuer at a
predetermined price before maturity. Investor
is normally paid higher than straight bonds
• Convertible bond – allows holder to redeem
at face value or convert it to a predetermined
number of stocks

42

Islamic Debt Securities

• Islamic Interbank Money markets (IIMM) was
established in 1994. This is to allow Islamic banks to
manage their liquidity and price discovery. Several new
instruments were introduced
– Mudharabah Interbank Investment (MII)
– Islamic Accepted Bills (IABs)
– Negotiable Islamic Debt Certificates (NIDC)
– Bank Negara Negotiable Notes (GII) and
– Other Islamic short term Private Debt Securities

43

Key Islamic Money Market Instruments
i) Government Investment Issue (GII)
• To meet the need for a liquidity management instrument that is also
shariah compliant, the Malaysian Parliament passed the Government
Investment Act in 1983. This act, enabled the Malaysian government to
issue a non-interest bearing money market instrument, known as
Government Investment Certificates (GIC) {now replaced with
Government Investment Issues (GII)}. The GII was introduced in July
1983 under the concept of Qard al- Hasan.

• Since a Qard al- Hasan, based instrument would not have a
predetermined fixed “face value” at maturity, it would not be suited for
secondary market trading . Thus, beginning with a 15 June 2001, issue,
GII’s are now issued under a new concept of of Bai Al-Inah. This, added
depth and liquidity to the IIMM as the GII is now tradable in the
secondary market via the concept of Bay ad- Dayn (debt trading).

ii) Bank Negara Negotiable Notes (BNNN)

• Bank Negara Negotiable Notes (BNNN) are a short-term, money
market instrument issued by BNM. The underlying contract is that of
Bai Al Inah. First introduced to the IIMM on 29 November 2000, It is
now popularly traded in the secondary market. The price of the
BNNN is determined on a discounted basis. Tenor is typically up to
one year. The BNNN is designed as a liquidity management tool .

ii) Cagamas Mudharabah Bonds (Sukuk Mudarabah
Cagamas)

• The Cagamas Mudharabah Bond, was introduced in March 1994 by
Cagamas Berhad, the National Mortgage Corporation, to finance the
purchase of Islamic housing debts from financial institutions. As the
name suggests, the bond is structured using the concept of
Mudharabah. Bondholders and Cagamas will share the profits
accrued according to the predetermined profit-sharing ratios.

iv) Islamic Accepted Bills (IAB)

• The Islamic Accepted Bill (IAB), was introduced in 1991. The objective
was to provide a shariah compliant instrument to conventional BAs,
particularly for trade financing . The IAB is formulated on the Islamic
principles of Al-Murabahah (deferred lump-sum sale or cost-plus). The
secondary market trading of the instrument is based on Bai ad-Dayn
(debt-trading).

• Murabahah is based on a cost-plus profit margin or mark up agreed to
by both parties. Bai Al-Dayn refers to the sale of a debt arising from a
trade transaction in the form of a deferred payment sale.

Islamic Debt Securities (Sukuk)

• Sukuk is a long term IDS whose underlying
contractual framework could be a BBA;
Murabahah; Istisna (purchase of
manufactured products on order) or Ijarah
(leasing). BBA is most popular and known as
BAIDS but not popular among Middle East
Shariah scholars
• The ijarah sukuk are more acceptable
globally.
48

Type of Sukuk, Characteristics, and Underlying Contracts
Type of Sukuk Characteristics Underlying Contract
Pure Ijarah Sukuk • Issued on stand-alone assets identified on Ijara
the balance sheet.
• The rental rates of returns on these Sukuk
can be both fixed and floating.
Hybrid/Pooled Sukuk • The underlying pool of assets can Istisna’, Murabahah
comprise of Istisna’, Murabahah receivables and Ijarah.
receivables as well as Ijarah
• The return on these certificates can only
be a pre-determined fixed rate of return.
Variable Rate Redeemable • Redeemable in nature. Musharakah
Sukuk or Musharakah Term • Has relatively stable rate as compared to
Finance Certificates dividend payouts.
(MTFCs) • The floating rate of return on these
certificates would not depend on
benchmarking with market references
such as LIBOR but would instead be
contingent on the firm’s balance sheet
actualities.
Zero-coupon non-tradable • The primary asset pools to be generated Istisna’
Sukuk would be of the nature warranted by
Istisna and installment purchase/sale
contracts that would create debt
obligations.
• Non-tradable
Embedded Sukuk • These could be Sukuk whether zero- pure-Ijara or hybrid
coupon, pure-Ijara or hybrid.
• Has embedded option to convert into
other asset forms depending on specified
conditions.
Source: summarized from Tariq, 2004. Managing Financial Risks of Sukuk Structures.A dissertation at
Loughborough University, UK.

Typical Sukuk Structure

COMPANY
4 1
I
Periodic payment SUKUK N
A V
S 3 $ E
SPV
S S
E T
T O
2
4 R
S

VENDOR/MANUFACTURER

50

In order to have the required underlying sale/purchase of Islamic financing
modes, companies issuing sukuks typically have a Special Purpose Vehicle (SPV).
For example, suppose a company wants to finance the use of an asset, it can
do so by means of issuing a Sukuk Al Ijarah. The company would first establish
a bankruptcy remote SPV. The SPV issues the sukuks to investors and uses the
proceeds to buy the asset from the vendor / manufacturer. The SPV then
“leases” the asset to the company in return for periodic lease payments. The
lease payments received from the company are passed thru to investors as
their returns on the sukuk.

Other Sukuk Structures
• The are several different sukuk structures.
• As the underlying contract changes, the structure changes.
• In addition to straight forward “plain vanilla” structures,
there are increasingly exotic ones.
• The need for exotic sukuk structures arises from the need
to;
• avoid fixity in income/ cash flows
• the need/ desire for specific cash flows
• to alter risk profiles

Structure of An Asset Backed Securitization of
sukuk
2 Sukuk Sold 3
ABS Sukuk
1 4
Asset Payment for subscription $
Mudarib SPV Sukuk
(Originator) Investors
Payment $ 6 Periodic payments
5

Trustees

Note: Trustees are the ‘owners’ of the SPV which
undertakes to service the sukuk.

Sukuk Vs Bonds
Item Bond Sukuk

Tenor Short, Medium and Long Short and Med-Term (≤5
Term yrs)

Financing Category Debt No debt but ownership of
specific asset and its cash
flows

Underlying Not necessary, unless Necessary underlying
collateralized asset, usually tangible
asset

Claim Fixed in time, and Ownership claim on
amount specific asset and its
cash- flows

Pricing Depends on rating, yield Use of indicative yields-
environment and demand benchmarked on
(book-building) reference rates

Total Returns Fixed income No guarantee in returns
(known/predetermined
cash flows)

Funding Purpose Unrestricted Restricted for use in
Shariah compliant assets,
in a predetermined
manner.

Hybrid Instruments
• Hybrids are instruments that have the
features of both debt and equity. We shall
consider four types only:
• Preference shares
• Warrants / Transferable Subscription Rights
(TSR)
• Call Warrants; and
• Irredeemable Convertible Unsecured Loan
Stocks
55

Preferred Stocks or
Preference Shares
• Preferred stock is a true hybrid instrument. It
has a par value, fixed dividend amounts and
terminal maturity.
• In US it requires sinking funds which means
a terminal maturity period
• Dividends on preferred stocks may be missed
and are not tax deductible

56

Preferred Stocks or
Preference Shares
• In Malaysia there are other variants
– Participating Preferred Shares can have higher dividends if
company does well. Non-participating Preference Shares
cannot get dividends
– Further, there are cumulative and non-cumulative Preference
shares.
– For Cumulative Preference Shares, missed dividends must be
made up by cumulating the dividends
– For Non-cumulative Preference Shares, missed dividends need
not be made up.

57

Warrants/Transferable
Subscription Rights (TSR)
• A warrant or TSR can be thought of as a long dated call
option on the issuing company’s stock. They are
typically attached to loan-stocks or bonds issued by a
company. The idea is to make bonds or stocks more
attractive and marketable. The warrants/TSRs can be
detached from the bonds and traded separately in a
secondary market (stock market)
• A warrant/TSR gives the holder the right but not
obligation to buy the company’s stock at a
predetermined market price

58

Warrants/Transferable
Subscription Rights (TSR)

• Equity options will not dilute the ownership
of the share holders but warrants when
exercised dilutes the ownership. This is
because when the warrant is exercised the
company must issue a new stock to the
warrant holders. This has effect on the price
of warrants.

59

Call Warrants vs TSR

• Call warrants are call • TSR issued by company
options issued usually by
merchant bank • Dilutes ownership
• Does not dilute
ownership
• Can be exercised any
• To be exercised on
time until maturity
maturity

• Attached to stock and for
• Stand alone and shorter
longer period (10 years)
period (18 months)

60

Irredeemable Convertible
Unsecured Loan Stock (ICULS)
• It is a fixed income debt instrument until
converted into equity at some date or upon
maturity
• Irredeemable for cash
• Must be converted to underlying stock
• Carry fixed interest coupons payable
annually or semi-annually
• Unsecured
• ICULS result in full dilution
61

PRICE DETERMINATION

• Many factors influence price of stocks
– Firm specific factors
– Industry specific factors
– Macro-economic factors
– Investor psychology
– Sentiments
– Performance of other regional stock markets
– International events etc. (Iraq war)

62

PRICE DETERMINATION

• Dividend Discount Model
• Zero Growth Model
• The Constant Growth Model
• The Accelerated Growth Model

63

DIVIDEND DISCOUNT METHOD (DDM)

DDM is based on the logic that a stock’s price
today should equal the present value of future
dividends that one could get by investing in
the stock.
e.g. Suppose we buy stock A that gives
dividend of RM2.00 per year. We plan to
hold it for 3 years and expect the price at end
of 3 years to be Rm60.00.
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If the required return is 10%, then
2.00 2.00 2.00 60
Po = + + +
(1.10) (1.10) 2 (1.10) 3 (1.10) 3
Po = 4.97 + 45.08 = 50.05

Thus, valuing the stock as present value
of future cash flows:
n
dt Pn
Po = ∑ +
t = (1 + K) (1 + K ) n
t
1

65


where d t is dividend in year t
Pn is the expected price in year n
K is the appropriate discount rate
or required return on asset
This example requires us to assume the
expected price in year 3 (or n) which is
very difficult.
66


To avoid having to make this assumption,
DDM concentrates on earnings from the stock,
i.e. dividends which comes in three forms :
1. Zero growth
2. Constant growth
3. Accelerated growth

67


1. Zero growth model
This model assumes that dividends are the
same from year to year. Since shares have no
maturity, the zero growth model is in fact a
perpetuity with equal cash flow so that

68


n
dt 2.00
Po = ∑ ⇒ = RM 20
t =1 K t (0.10)
where d t is dividend received at time t and K
is the discount rate

2. The Constant Growth Model
This model takes into consideration only the dividends again,
but allows constant (same) rate of dividend growth. So in terms
of cash flows the cash flow pattern is as follows:

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The rate of growth g is constant. This means
that ∆ = g so that d1 = d o (1 + g )1
d 2 = d o (1 + g) 2
d10 = d o (1 + g)10
d o (1 + g)1 d o (1 + g) 3
Hence Po = + ... +
(1 + K) 1
(1 + K )3
d1
which becomes Po = ...Gordon Model
K -g

70


So for a share with next year’s expected
dividend
of RM2.00, g = 5 % and K = 10%
the dividend is
2.00 2.00
= = 40.00
10% - 5% 0.05
Here because the dividend is growing each year the price
will also increase each year at a steady rate equal to the
dividend growth rate
71


So, the expected increase in price is :
d1 2.00
Po = = = 40.00
K - g .10 − .05
d2 2.10
P1 = = = 42.00
K - g .10 − .05
d3 2.2050
P2 = = = 44.10
K - g .10 − .05

72

Note that if K does not change over time the value
of the share increases at the same rate as the dividend
growth. Since price increases gradually over time would the
Investment return depend on how long you hold the stock?
the answer is no. Please read page 195.

For accelerated growth model please read 199

73

RISK ELEMENTS
• Business risk – uncertainty of income flows of firm’s
• Financial risk – uncertainty form methods of financing
• Liquidity risk- uncertainty in secondary market investment
or thinly traded assets
• Currency risk – exchange rate risk
• Country risk – political risk;
• tax risk e.g. Pakistan imposed 10% capital gain tax on shares
held for less than 6 months; 7.5% holding between 6 months
and 1 year.
• Bond risks and rating – different risk class and yield curves
• Default risk – risk of non payment due bankruptcy
• Interest rate risk – changes in bond prices
• Inflation risk – loss in purchasing power

74

LAWS RELATING TO
SECURITIES
• Banking AND financial Institutions Act 1989
(BAFIA)
• Securities Commission Act 1993
• Securities Industry Act 1983
• Securities Industries (Central Depositories)
Act 1991
• Futures Industry Act 1993

75

REVISION QUESTIONS

• Compare and contrast the debt and equity instruments
• What makes securities so attractive that shareholders are
willing to part with their ownership when they go
public?
• Identify risk elements inherent in the investment in
securities
• Explain the stock screening process adopted by the
Shariah Advisory Council of the Securities Commission
• Explain how an ijarah sukuk is structured

76

Lecture 10

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Lecture 10