Mutual Funds
1. 1 Recurring expense
r2 = r1 + in percentage terms
1 – Initial expense
in decimals
1
= x 13% + 1.8%
1 – 0.05
= 15.48%
2. 1 Recurring expense
r2 = r1 + in percentage terms
1 – Initial expense
in decimals
1 Recurring expense
16.5% = x 14% + in percentage terms
1 – 0.06
Recurring expense in
16.5% = 0.1489 + percentage terms
1.
2.
Share Price in Price in Price No .of Market Market
base year year t Relative outstanding capitalisation capitalisatio
(Rs.) (Rs.) shares in the base n in year t
year (1 x 4) (2 x 4)
1 2 3 4 5 6
X 80 100 125 15 1200 1500
Y 40 30 75 20 800 600
Z 30 50 1500
3500
The value weighted index for year t is: Market capitalisation in year t
x 100
3500
Market capitalisation in year t
115 = x 100
3500
115 x 3500 = Market capitalisation in year t x 100
115 x 3500
Market capitalisation in year t =
100
= 4025
Market capitalisation of z = 4025 – (500 + 600)
= 1925
1925
Price of share z in year t =
50
= 38.5
Chapter 5
RISK AND RETURN
Chapter 6
THE TIME VALUE OF MONEY
1. Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:
4. Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent
to saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15.
(5.000 – 4.411) x 2%
r = 16% + = 17.4%
(5.234 – 4.411)
8. The present value of Rs.10,000 receivable after 8 years for various discount rates (r )
are:
r = 10% PV = 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670
r = 12% PV = 10,000 x PVIF (r = 12%, 8 years)
= 10,000 x 0.404 = Rs.4,040
r = 15% PV = 10,000 x PVIF (r = 15%, 8 years)
= 10,000 x 0.327 = Rs.3,270
10. The present value of an annual pension of Rs.10,000 for 15 years when r = 15% is:
Obviously, Mr. Jingo will be better off with the annual pension amount of Rs.10,000.
14. To earn an annual income of Rs.5,000 beginning from the end of 15 years from
now, if the deposit earns 10% per year a sum of Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this sum is:
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165
5.019 – 5.00
r = 15% + ---------------- x 3%
5.019 – 4.494
= 15.1%
= Rs.2590.9
Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1
20. Investment required at the end of 8th year to yield an income of Rs.12,000 per
year from the end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, ∞ )
To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited now is:
Rs.100,000 Rs.100,000
= = Rs.40,388
PVIF(12%, 8 years) 2.476
21. The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
Rs.5,000 now is:
Rs.20,000
FVIF (r,10 years) = = 4.000
Rs.5,000
If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in terms of
the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283
23. A constant deposit at the beginning of each year represents an annuity due.
PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should be
Rs.50,000
A =
FVIFA(12%, 10 years) x (1.12)
Rs.50,000
= = Rs.2544
17.549 x 1.12
24. The discounted value of Rs.20,000 receivable at the beginning of each year from
2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:
If A is the amount deposited at the end of each year from 1995 to 2000 then
Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is
1%, the discounted value of an annuity of Rs.180 receivable at the end of each month for
180 months (15 years) is:
(1.01)180 - 1
Rs.180 x ---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)60 = Rs.14,998
P x 1.817 = Rs.14,998
Rs.14,998
P = ------------ = Rs.8254
1.817
21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18,914
= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%
28. The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at
the end of the 5th year is:
29. Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000
31. Define n as the maturity period of the loan. The value of n can be obtained from the
equation.
32. Expected value of iron ore mined during year 1 = Rs.300 million
Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron
1 – (1 + g)n / (1 + i)n
= Rs.300 million x
i-g
1 – (1.06)15 / (1.16)15
= Rs.300 million x
0.16 – 0.06
MINICASE
This means that his savings in the next 15 years must grow to :
3. How much money would Ramesh need when he reaches the age of 60 to meet his
donation objective?
46
1 2 15
15
1.12
1–
1.08
= 400,000
0.08 – 0.12
= Rs.7,254,962
Chapter 7
Financial Statement Analysis
1.
(a) Assets Rs.
- Fixed assets ( Net ) 150 million
- Cash and bank 20
- Marketable securities 10
- Receivables 70
- Inventories 110
- Prepaid expenses 10
Liabilities
- Equity capital 90
- Preference capital 20
- Reserves and surplus 50
- Debentures (secured) 60
- Term loans (secured) 70
- Short term bank borrowing (unsecured) 40
- Trade creditors 30
- Provisions 10
Liabilities Assets
2.
(a)
Sources & Uses of Cash Statement for the Period 01.04.2000 to 31.03.2001
(Rs. in million)
----------------------------------------------------------------------------------------------------------
Sources Uses
(b)
Classified cash flow statement for the Period 01.04.2000 to 31.03.2001
(Rs. in million)
----------------------------------------------------------------------------------------------------------
A. Cash flow from operating activities
- Net profit before tax and extraordinary items 100
- Adjustments for
Interest paid 30
Depreciation 20
- Operating profit before working capital changes 150
- Adjustments for
Inventories 10
Debtors (10)
Short term bank borrowings 10
Trade creditors 10
Provisions (5)
Increase in other assets (5)
- Cash generated from operations 160
Income tax paid (20)
- Cash flow before extraordinary items 140
Extraordinary item (50)
- Net cash flow from operating activities 90
B. Cash flow from investing activities
- Purchase of fixed assets (30)
- Net cash flow from investing activities (30)
C. Cash flow from financing activities
- Interest paid (30)
- Repayment of term loans (15)
- Dividends paid (20)
Net cash flow from financing activities (65)
Note : It has been assumed that “other assets” represent “other current assets”.
Net profit
3. Return on equity =
Equity
1
= 0.05 x 1.5 x = 0.25 or 25 per cent
0.3
Debt Equity
Note : = 0.7 So = 1-0.7 = 0.3
Total assets Total assets
So PBIT = 6 x Interest
PBIT – Interest = PBT = Rs.40 million
6 x Interest = Rs.40 million
Hence Interest = Rs. 8 million
420,000
So Profit before tax = = Rs. 1,050,000
(1-.6)
Interest charge = Rs.150,000
6. CA = 1500 CL = 600
CA+BB
= 1.5
CL+BB
1500+BB
= 1.5
600+BB
BB = 1200
7. Accounts receivable
ACP =
Sales / 365
120,000
= = 43.8 days
1,000,000 / 365
So the receivables must be collected in 43.8 days
Current assets
8. Current ratio = = 1.5
Current liabilities
Inventories
1.5 - = 1.2
800,000
Inventories
= 0.3
800,000
Inventories = 240,000
Sales
=5 So Sales = 1,200,000
2,40,000
9. Debt/equity = 0.60
Equity = 50,000 + 60,000 = 110,000
So Debt = 0.6 x 110,000 = 66,000
Hence Total assets = 110,000+66,000 = 176,000
Total assets turnover ratio = 1.5
So Sales = 1.5 x 176,000 = 264,000
Gross profit margin = 20 per cent
So Cost of goods sold = 0.8 x 264,000 = 211,200
Day’s sales outstanding in accounts receivable = 40 days
Sales
So Accounts receivable = x 40
360
264,000
= x 40 = 29,333
360
Cash + 29,333
= = 1.2
66,000
So Cash = 49867
Balance Sheet
Equity capital 50,000 Plant & equipment 54,560
Retained earnings 60,000 Inventories 42,240
Debt(Current liabilities) 66,000 Accounts receivable 29,333
Cash 49,867
176,000 176,000
Sales 264,000
Cost of goods sold 211,200
42,500,000
= = 1.42
30,000,000
12,500,000 + 30,000,000
= = 1.31
10,000,000 + 22,500,000
15,100,000
= = 3.02
5,000,000
365
(vi) Average collection period =
Net sales/Accounts receivable
365
= = 57.6 days
95,000,000/15,000,000
PBIT 15,100,000
(x) Earning power = = = 20.1%
Total assets 75,000,000
The comparison of the Omex’s ratios with the standard is given below
Omex Standard
MINICASE
Debtors turnover ratio = net credit sales / average debtors = 57.4 / ( 2.9+2.0) / 2 = 23.43
Average collection period = 365 / debtors turnover = 365 / 23.43 = 15.6 days
Fixed assets turnover = net sales/average total assets = 57.4/ ( 34 + 38) / 2 = 1.59
Gross profit margin = gross profit / net sales = 11.6 / 57.4 = 20.21 %
Net profit margin = net profit / net sales = 3.0 / 57.4 = 5.22 %
Return on assets = net profit / average total assets = 3.0/ ( 34+38) /2 = 8.3 %
Earning power = PBIT / average total assets = 5.0/ ( 34+38) /2 = 13.89 %
Return on equity = Net profit / average equity = 3.0 / ( 13.9 +15.8)/2 = 20.20 %
Net profit
3.0 —
Net profit
margin
÷ Total costs
54.8
5.22%
Net sales
57.4
Return on
total assets
8.3%
X
Net sales
57.4
Average
current
assets 12.05
c. Common size statements
Balance sheet
d.
Financial strengths : leverage position is satisfactory.
Interest repayment capacity is good.
Inventory is efficiently managed.
Credit management is efficient.
Margin on sales is satisfactory.
Financial weaknesses : liquidity position is very bad.
return on assets is low.
fixed assets do not seem to be efficiently employedl.
f. The qualitative factors relevant for evaluating the performance and prospects of a
company are mainly the following:
• Are the company’s revenues tied to one key customer?
• To what extent are the company’s revenues tied to one key product ?
• To what extent does the company rely on a single supplier ?
• What percentage of the company’s business is generated overseas ?
• Competition.
• Future prospects.
• Legal and regulatory environment.
Chapter 8
PORTFOLIO THEORY
1. (a)
E (R1) = 0.2(-5%) + 0.3(15%) + 0.4(18%) + .10(22%)
= 12%
E (R2) = 0.2(10%) + 0.3(12%) + 0.4(14%) + .10(18%)
= 13%
σ(R1) = [.2(-5 –12)2 + 0.3 (15 –12)2 + 0.4 (18 –12)2 + 0.1 (22 – 12)2]½
= [57.8 + 2.7 + 14.4 + 10]½ = 9.21%
σ(R2) = [.2(10 –13)2 + 0.3(12 – 13)2 + 0.4 (14 – 13)2 + 0.1 (18 – 13)2] ½
= [1.8 + 0.09 + 0.16 + 2.5] ½ = 2.13%
(b) The covariance between the returns on assets 1 and 2 is calculated below
State of Probability Return Deviation Return on Deviation Product of
nature on asset of return asset 2 of the deviation
1 on asset 1 return on times
from its asset 2 probability
mean from its
mean
(1) (2) (3) (4) (5) (6) (2)x(4)x(6)
1 0.2 -5% -17% 10% -3% 10.2
2 0.3 15% 3% 12% -1% -0.9%
3 0.4 18% 6% 14% 1% 2.4
4 0.1 22% 10% 18% 5% 5
Sum = 16.7
Thus the covariance between the returns of the two assets is 16.7.
(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 16.7
= = 0.85
σ1 x σ2 9.21 x 2.13
2. (a) For Rs.1,000, 20 shares of Alpha’s stock can be acquired. The probability distribution of
the return on 20 shares is
Economic Condition Return (Rs) Probability
Standard deviation of the return = [(1,100 – 1,150)2 x 0.3 + (1,000 – 1,150)2 x 0.3 +
(1,200 – 1,150)2 x 0.2 + (1,400 – 1,150)2 x 0.2]1/2 = Rs.143.18
(b) For Rs.1,000, 20 shares of Beta’s stock can be acquired. The probability distribution of
the return on 20 shares is:
Economic condition Return (Rs) Probability
Expected return = (1,500 x 0.3) + (1,300 x 0.3) + (1,000 x 0.2) + (800 x 0.2)
= Rs.1,200
(c ) For Rs.500, 10 shares of Alpha’s stock can be acquired; likewise for Rs.500, 10
shares of Beta’s stock can be acquired. The probability distribution of this
option is:
d. For Rs.700, 14 shares of Alpha’s stock can be acquired; likewise for Rs.300, 6
shares of Beta’s stock can be acquired. The probability distribution of this
option is:
Option `d’ is the most preferred option because it has the highest return to risk ratio.
5. (i) Since there are 3 securities, there are 3 variance terms and 3 covariance terms. Note that
if there are n securities the number of covariance terms are: 1 + 2 +…+ (n – 1) = n (n –1)/2.
In this problem all the variance terms are the same (σ2A) all the covariance terms are the same
(σAB) and all the securities are equally weighted ( wA = ⅓)
So,
σ2p = [3 w2A σ2A + 2 x 3 σAB]
σ2p = [3 w2A σ2A + 6 wA wB σAB]
1 2 1 1
=3x x σ A+ 6 x
2
x x σAB
3 3 3
1 2
= σ2A + σAB
3 3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covariance
terms. Note that if the number of securities is n, the number of covariance
terms is n(n – 1)/2.
In this case all the variance terms are the same (σ2A), all the covariance terms are
1
the same (σAB) and all the securities are equally weighted wA =
9
So,
n(n-1)
σ p= 9 w Aσ A t 2 x
2 2 2
wA wB σAB
2
2
1 1 1
= 9x x σ A + 9(8) x
2
x σAB
9 9 9
1 72
= σA+
2
σAB
9 81
4 8 14
3 9 15
5 10 20
1 11 21
7 12 21
2 14 24
8 14 28
6 16 32
Examining the above we find that (i) portfolio 7 dominates portfolio 1 because it offers a higher
expected return for the same standard deviation and (ii) portfolio 2 dominates portfolio 8 as it
offers the same expected return for a lower standard deviation. So, the efficient set consists of all
the portfolios except portfolio 1 and portfolio 8.
7. The weights that drive the standard deviation of portfolio to zero, when the returns are
perfectly correlated, are:
σB 35
wA = = = 0.614
σA + σ B 22 + 35
wB = 1 - wA = 0.386
1. Define RA and RM as the returns on the equity stock of Auto Electricals Limited a
and Market portfolio respectively. The calculations relevant for calculating the
beta of the stock are shown below:
RA = 15.09 RM = 15.18
∑ (RA – RA)2 = 1116.93 ∑ (RM – RM) 2 = 975.61 ∑ (RA – RA) (RM – RM) = 935.86
∑ (RM – RM) 2
= 935.86 = 0.96
975.61
Alpha = RA – βA RM
RA = 0.52 + 0.96 RM
σ2M
Σ (RB - RB) (RM – RM) 320
Cov (RB, RM) = = = 16.84
n –1 19
3.
a. The slope of the capital market line is:
E(RM) – Rf 15 – 8
λ= = = 0.28
σM 25
The expected return of a portfolio which has 60% of market portfolio and 40% of riskless
asset is :
0.6 x 13 + 0.4 x 7 = 10.6%
The standard deviation of a portfolio which has 60% of market portfolio and
40% of riskless asset is :
0.6 x 20 + 0.4 x 0 = 12%
(b) The expected return of a portfolio which has 125% of market portfolio and –25% of
riskless asset is :
1.25 x 13 – 0.25 x 7 = 14.5%
The standard deviation of a portfolio which has 125% of market portfolio and –125% of
riskless portfolio is:
1.25 x 20 – 0.25 x 0 = 25%
6.
(a) The beta of the aggressive stock is:
40% - (-5%) 45%
= = 2.25
25% - 5% 20%
Defensive Stock
Expected return = 13.0%
Beta = 0.50
Required return = 8 + 0.5 x 7 = 11.5%
Alpha = 13.0 – 11.5 = 1.5%
MINICASE
a. For stock A :
Expected return = ( 0.2x 15) +( 0.5x20) +( 0.3x 40) =3+10 +12 =25
Standard deviation= [ 0.2( 15-25)2 + 0.5( 20-25)2 + 0.3(40-25)2]1/2
= [ 20 + 12.5+67.5] ½ = 10
For stock B:
Expected return = ( 0.2x 30) + ( 0.5x 5) + [ 0.3x (-) 15] = 6+2.5- 4.5= 4
(-) 140
c. Coefficient of correlation between the returns of A and B =------------- = (-)0.90
10x15.62
85
. Coefficient of correlation between the returns of A and C =------------- = 0. 81
10x 10.44
g. The linear relationship between expected return and standard deviation for efficient
portfolios is called the Capital Market Line ( CML) and the same is given by the
equation
E (Rm-Rf)
E ( Rj) = Rf + [ ---------- ] σj
σm
where E(Rj) = expected return on portfolio j
Rf = risk-free rate
E(Rm) = expected return on the market portfolio
σm =standard deviation of the market portfolio
σj = standard deviation of the portfolio j
Linear relationship between expected return and standard deviation of individual
securities and inefficient portfolios is called Security Market Line (SML) and the
equation for it is
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] Ci,m
σ2m
where E(Ri) and E(Rm) are the expected returns on the security/ portfolio i and
market respectively.
Rf = risk-free rate
σm =standard deviation of the market portfolio
Ci,m = Covariance of the return on security/ portfolio i with the market portfolio.
CML is a special case of SML as seen from the following.
As per SML
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] Ci,m
σ2m
Since Ci,m = ρi,m σi σm ,the above equation can be rewritten as
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] ρi,m σi
σm
For efficient portfolios , as returns on i and m are perfectly positively
correlated, ρi,m =1
Therefore,
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] σi , which is nothing but the CML.
σm
h. Systematic risk refers to the risk associated with the responsiveness of the return of
the investment arising from economy-wide factors, which have a bearing on the
fortunes of all firms.
Unsystematic risk refers to the risk associated with the responsiveness of the return of
the investment arising from firm-specific factors.
Systematic risk is usually represented by beta ( β), which is given by the formula
σi,m
βi = ------------
σ2m
where
βi = beta of the security/ portfolio i
σi,m = covariance between the returns on investment i and the market portfolio
σ2m = variance of the return on the market portfolio.
Unsystematic risk: Being firm specific there is no generalised formula for this risk.
i. CAPM assumes that return on a stock/ portfolio is solely influenced by the market
factor whereas the APT assumes that the return is influenced by a set of factors called
risk factors.
Chapter 12
BOND PRICES AND YIELDS
1. 5 11 100
P = ∑ +
t=1 (1.15) (1.15)5
Note that when the discount rate and the coupon rate are the same the value is equal
to par value.
3. The yield to maturity is the value of r that satisfies the following equality.
7 120 1,000
Rs.750 = ∑ + = Rs.100
t 7
t=1 (1+r) (1+r)
Try r = 18%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (18%, 7 years) + Rs.1,000 x PVIF (18%, 7 years)
= Rs.120 x 3.812 + Rs.1,000 x 0.314
= Rs.771.44
Try r = 20%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (20%, 7 years) + Rs.1,000 x PVIF (20%, 7 years)
= Rs.120 x 3.605 + Rs.1,000 x 0.279
= Rs.711.60
Thus the value of r at which the RHS becomes equal to Rs.750 lies between
18% and 20%.
771.44 – 750.00
Yield to maturity = 18% + 771.44 – 711.60 x 2%
= 18.7%
4.
10 14 100
80 = ∑ +
t=1 (1+r) t (1+r)10
82 - 80
Yield to maturity = 18% + ----------- x 2%
82 – 74.9
= 18.56%
5.
12 6 100
P = ∑ +
t=1 (1.08) t (1.08)12
= Rs.6 x PVIFA (8%, 12 years) + Rs.100 x PVIF (8%, 12 years)
= Rs.6 x 7.536 + Rs.100 x 0.397
= Rs.84.92
The post-tax YTM, using the approximate YTM formula is calculated below
8.4 + (97-70)/10
Bond A : Post-tax YTM = --------------------
0.6 x 70 + 0.4 x 97
= 13.73%
7 + (96 – 60)/6
Bond B : Post-tax YTM = ----------------------
0.6x 60 + 0.4 x 96
= 17. 47%
7.
14 6 100
P = ∑ +
t
t=1 (1.08) (1.08)14
3 13.21
4 13.48
5 13.72
Graphing these YTMs against the maturities will give the yield curve
1,00,000
- 1 = 12.36 %
89,000
To get the forward rate for year 2, r2, the following equation may be set up :
12500 112500
99000 = +
(1.1236) (1.1236)(1+r2)
To get the forward rate for year 3, r3, the following equation may be set up :
To get the forward rate for year 4, r4 , the following equation may be set up :
113,500
+
(1.1236)(1.1394)(1.1349)(1+r4)
13,750
+
(1.1236)(1.1394)(1.1349)(1.1454)
113,750
+
(1.1236)(1.1394)(1.1349)(1.1454)(1+r5)
9. The pre-tax rate to the debenture holder is the value of the r in the following
equation:
n It ai Pi n Fj
Subscription = ∑ + + ∑
t i
price t=1 (1+r) (1+r) j=m (1+r) j
where: It = interest receivable at the end of period t
n = life of the debenture
a = number of equity shares receivable when part-conversion occurs at the end
of period i
Pi = expected price per equity share at the end of period i
Fj = instalment of principal repayment at the end of period j
60 40 40 40 40 20
600 = + + + + +
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)6
Since the present market price of the bond is Rs.1020, the realised yield to
maturity is the value of r* in the following equation.
1464.1
4
(1+r*) = = 1.435
1020
MINICASE
a. Value of a bond is calculated as the present value of all future cash flows
associated with it.
Value of a bond (V) carrying an annual coupon payment of C ( in rupees) maturing
after n years with maturity value of M is given by
n C M
V = Σ -------- + --------
t=1 ( 1+r)t (1+r)n
where r is the required periodic rate of return and t is the time period for receipt of periodic
payments.
g. If future cash flows are reinvested at 8% p.a. the terminal value will be
100 PVIFA 8%, 6 yrs + 1000 = 100x 7.336 + 1000 = 1733.6
Let r* be the realized yield to maturity.
We have 1050 ( 1+ r *)6 = 1733.6
( 1+r*) 6 = 1733.6/ 1050 = 1.6510
1+r* = 1.0872 r* = 0.0872 or 8.72 %
i. Annual percentage rate of a bond refers to the stated coupon rate per annum.
If m is the frequency of coupon payment per year,
annual parentage rate
Effective annual coupon interest rate = (1+ --------------------------- )m - 1
m
Effective annual coupon interest rate x maturity value
Effective annual yield= -----------------------------------------------------------------
Current market price
j. Interest rate risk: Interest rates tend to vary over time, causing fluctuations in
bond prices. A rise in interest rates will depress the market price of outstanding bonds.
This is called interest rate risk.
Reinvestment risk: When a bond pays periodic interest, there is a risk that these
interest payments may have to be reinvested at a lower interest rate. This is called
reinvestment risk.
k. Key financial ratios that have a bearing on debt rating are:
Interest coverage ratio = EBIT/ Interest
EBIT + Depreciation
Fixed charges coverage ratio = ---------------------------------------
Interest + Repayment of loan
------------------------
1 – tax rate
Chapter 13
BOND PORTFOLIO MANAGEMENT
9+( 100-105)/5 8
1. Yield to maturity =--------------------------------- = --------- = 0.0767 or 7.77 %
( 0.4x100) + ( 0.6x 105) 40+63
Rs.10,000
Issue price = = Rs.4670
(1.10)8
b. The duration of the bond is 8 years. Note that the term to maturity and the
6 duration of a zero coupon bond are the same.
d. The percentage change in the price of the bond, if the yield declines by 0.5 percent is:
∆P/ P = - Modified duration x 0.5
= - 3.637 percent
6. The liability has a duration of ten years. The duration of the zero coupon bond is 6 years
and the duration of the perpetuities is : 1.07/ 0.07 = 15.29 years.
As the portfolio duration is 10 years, if w is the proportion of investment in zero coupon
bonds, we have
( wx6) + ( 1-w)x 15.29 = 10
6w + 15.29 – 15.29= 10
w=0.569 and 1-w= 0. 431
Therefore the amount to be invested in zero coupon bonds is
100,000 x 0.569 =Rs. 56,900 and the amount to be invested in perpetuities
is Rs. 43,100
Po = D1 / (r – g) = Do (1 + g) / (r – g)
Since the growth rate of 6% applies to dividends as well as market price, the market
price at the end of the 2nd year will be:
2. Po = D1 / (r – g) = Do (1 + g) / (r – g)
= Rs.12.00 (1.10) / (0.15 – 0.10) = Rs.264
3. Po = D1 / (r – g)
4. Po = D1/ (r – g) = Do(1+g) / (r – g)
Do = Rs.1.50, g = -0.04, Po = Rs.8
So
8 = 1.50 (1- .04) / (r-(-.04)) = 1.44 / (r + .04)
5. The market price per share of Commonwealth Corporation will be the sum of three
components:
C= P8 / (1.14)8
6. The intrinsic value of the equity share will be the sum of three components:
A: Present value of the dividend stream for the first 5 years when the
growth rate expected is 15%.
B: Present value of the dividend stream for the next 5 years when the
growth rate is expected to be 10%.
7. Intrinsic value of the equity share (using the 2-stage growth model)
(1.18)6
2.36 x 1 - ----------- 2.36 x (1.18)5 x (1.12)
(1.16)6
= +
0.16 – 0.18 (0.16 – 0.12) x (1.16)6
- 0.10801
= 2.36 x + 62.05
- 0.02
= Rs.74.80
= 60 + 20
= Rs.80
9.
Price Po = D1 / (r – g) Dividend yield Capital yield Price
D1/ Po (Po - Po)/ Po earnings
ratio Po/ E1
Low growth Po = 2 / (0.16 - .04) = 16.67 12.0% 4.0% 4.17
firm
Normal Po = 2 / (0.16 - .08) = 25.00 8.0% 8.0% 6.25
growth firm
Supernormal Po = 2 / (0.16 - .12) = 50.00 4.0% 12.0% 12.5
growth firm
10.
E1/Po = 2.50/30.00
r = 0.16
PVGO
E1/Po = r 1 -
Po
2.50 PVGO
= 0.16 1-
30.00 Po
PVGO
= 0.48
30.00
MINICASE
∞ Dr
a. The general formula is P0 = Σ ------------------
t=1 ( 1+ r)t
5 x 1.10 x 1.10
d. (i) Expected value of the stock a year hence = 0.142 – 0.10 = Rs. 144.05
5.50
Expected dividend yield = ---------- = 0.042 or 4.2 %
130.95
5x 1.10x 1.10
Expected price of the stock one year hence=P1 = ----------------- = Rs. 144.05
0.142- 1.10
144.05-130.95
Capital gains yield in the first year = ------------------- = 10 %
130.95
j. The question is incomplete. Let us assume that the decline in growth rate to 10
percent will occur linearly over 4 years.
1.
Return on equity = Profit after tax / Shareholders’ funds
Book value per share = Shareholders’ funds / Number of shares
EPS = Profit after tax / Number of shares
1/4
EPS for 20X5
CAGR in EPS = -1
EPS for 20X1
1/4
EPS for 20X5
CAGR in EPS = -1
EPS for 20X1
3.06 1/4
CAGR of EPS = -1 = 0.171 = 17.1%
1.63
23 – 20.4
Volatility of ROE = = 0.12
21.8
(d) PBIT Sales Profit before tax Profit after tax Assets
ROE = x x x x
Sales Assets PBIT Profit before tax Net worth
The decomposition of ROE for the last two years, viz., 20X4 and 20X5 is
shown below:
1/4
EPS for 20X5
CAGR in EPS = -1
EPS for 20X1
1/4
EPS for 20X5
CAGR in EPS = -1
EPS for 20X1
(a)
20X1 20X2 20X3 20X4 20X5
Return on 60/ 500 60/ 540 110/ 620 150/ 730 240/ 920
equity
= 12% = 11.1% = 17.7% = 20.5% = 26.1%
PB ratio 20/ 16.7 22/ 18 45/ 20.7 56/ 24.3 78/ 30.7
(retrospective)
= 1.2 = 1.2 = 2.2 = 2.3 = 2.5
(b)
1/4
1780
CAGR of sales = -1 = 0.229 = 22.9%
780
1/4
8
CAGR of EPS = -1 = 0.414 = 41.4%
2
26.1 – 11.1
Volatility of ROE = = 0.86
17.5
(d) The decomposition of ROE for the last two years, viz., 20X4 and 20X5 is
shown below:
(f) Average retention ratio for the period 20X3 – 20X5 was 0.75. So the average
payout ratio was 1 – 0.75 = 0.25
Required rate of return
= 10% + 1.1 x 8% = 18.8%
1. S = 100 , uS = 150, dS = 90
u = 1.5 , d = 0.9, r = 1.15 R = 1.15
E = 100
Cu – Cd 50
∆ = = = 0.833
(u-d)S 0.6 x 100
u Cd – d Cu 0 – 0.9 x 50
B = = = - 65.22
(u-d)R 0.6 x 1.15
2. S = 60 , dS = 45, d = 0.75, C = 5
r = 0.16, R = 1.16, E = 60
Cu – Cd 60u – 60 u–1
∆ = = =
(u-d)S (u – 0.75)60 u – 0.75
C = ∆S+B
(u – 1) 60 45 (1 – u)
5 = +
u – 0.75 1.16 (u – 0.75)
45
5(u – 0.75) = (u – 1) 60 + (1 – u)
1.16
3. E
C0 = S0 N(d1) - N (d2)
ert
S0 = 70, E = 72, r = 0.12, σ = 0.3, t = 0.50
S0 1
ln + r+ σ2 t
E 2
d1 =
σ t
70
ln + (0.12 + 0.5 x .09) x 0.50
72
=
0.30 0.50
- 0.0282 + 0.0825
= = 0.2560
0.2121
N (d1) = 0.6010
N (d2) = 0.5175
E 72
= = 67.81
rt 0.12x 0.50
e e
4. E
C0 = S0 N(d1) - N (d2)
rt
e
E = 50, t = 0.25, S = 40, σ = 0.40, r = 0.14
S0 1
ln + r+ σ2 t
E 2
d1 =
σ t
40
ln + (0.14 + 0.5 x 0.16) 0.25
50
d1 =
0.40 0.25
- 0.2231 + 0.055
= = - 0.8405
0.20
N (d1) = 0.2003
N (d2) = 0.1491
E 50
= = 48.28
rt 0.14 x 0.25
e e
Cu – Cd
∆ =
(u – d) S
45 – 0 45 9
∆ = = = = 0.6429
0.7 x 100 70 14
u.Cd – d.Cu
B =
(u-d) R
= -36 = -45.92
0.784
C = ∆S+B
= 0.6429 x 100 – 45.92
= Rs.18.37
6. S = 40 u=? d = 0.8
R = 1.10 E = 45 C=8
We will assume that the current market price of the call is equal to the fair value
of the call as per the Binomial model.
∆ Cu – Cd R
= x
B u Cd – d Cu S
∆ Cu – 0 1.10
= x
B -0.8Cu 40
= (-) 0.034375
∆ = - 0.34375 B (1)
C = ∆S+B
8 = ∆ x 40 + B (2)
8 = (-0.034365 x 40) B + B
8 = -0.375 B
or B = - 21.33
or
u x 40 x 0.7332 – 23.46 = 0
u = 0.8
7.
E
C0 = S0 N(d1) - N (d2)
ert
S0 = 120, E = 110, r = 0.14, t = 1.0, σ = 0.4
S0 1
ln + r+ σ2 t
E 2
d1 =
σ t
120 1
ln + 0.14 + x 0.42 1
110 2
d1 =
0.4 1
.0870 + 0.22
= = 0.7675
0.4
8.
E
C0 = S0 N(d1) - N (d2)
rt
e
S0 = Rs.80, E = Rs.82, ert = 1.1503, σ = 0.20, t = 1, r = ln (1.1503) = 0.14
S0 1
ln + r+ σ2 t
E 2
d1 =
σ t
80 1
ln + 0.14 + x 0.4 1
82 2
d1 =
0.20 1
- 0.0247 + 0.1600
= = 0.6765
0.20
C0 = S0 + P0 – E/ ert
S0 = Rs.75, P0 = Rs.0.70, E = Rs.80, r = 0.08, t = 0.25
So C0 should be
80
Rs.75 + Rs.0.70 - = - 2.716
0.08 x 0.25
e
C0 is given to be Rs.7.
Clearly the put-call parity is not working in this case.
10.
S0 = Rs.60, u = 1.30, d = 0.95, r = 8%, E = Rs.50
Since Bharat’s stock can either rise by 30 percent to Rs.78 or fall by 5 percent to
Rs.57, we can calculate the probability of a price rise in the hypothetical risk-
neutral world.
If the stock price rises the call option has a value of Rs.28 (Rs.78 – 50) and if the
stock price falls the call option has a value of Rs.7 (Rs.57 – 50).
Hence, if investors are risk-neutral, the call option has an expected future value of:
Probability of rise x Rs.28 + (1- Probability of rise) x Rs.7
= 0.3714 x 28 + (1 – 0.3714) x 7
= 10.40 + 4.40 = Rs.14.80
The current value of the call option is:
Expected future value 14.80
= = Rs.13.70
1 + Risk-free rate (1.08)
MINICASE
a. Call option : A call option gives the option holder the right to buy an asset at a fixed
price during a certain period.
Put option : : A put option gives the option holder the right to sell an asset at a fixed
price during a certain period.
Strike price ( exercise price ) : The fixed price at which the option holder can buy and
/or sell the underlying asset is called the strike price or the exercise price .Expiration
date : The date when the option expires is called the expiration date.
b. Call options with strike prices 280, 300 and 320 and put options with strike prices 340
and 360 are in - the - money .
Call options with stike prices 340 and 360 and put options with strike prices 280, 300
and 320 are out of – the – money.
c. (i) If Pradeep Sharma sells Jan/340 call on 1000 shares, he will earn a call premium of
Rs.5000 now. However, he will forfeit the gains that he would have enjoyed if the
price of Newage Hospitals rises above Rs.340.
(ii) If Pradeep Sharma sells Mar/300 call on 1000 shares, he will earn a call
premium of
Rs.41,000 now. However, he will forfeit the gains he would have enjoyed if the
price of Newage Hospital remains above Rs.300.
d. Let s be the stock price, p1 and p2 the call premia for March/ 340 and March/ 360 calls
respectively. When s is greater than 360, both the calls will be exercised and the profit
will be { s-340-p1} – { s-360-p2 } = Rs. 11
The maximum loss will be the initial investment , i.e. p1-p2 =Rs. 9
The break even will occur when the gain on purchased call equals the net premium paid
i.e. s-340 = p1 – p2 =9 Therefore s= 349
e. If the stock price goes below Rs.300, Mr. Sharma can execute the put option and ensure
that his portfolio value does not go below Rs. 300 per share. However , if stock price
goes above Rs. 340, the call will be exercised and the stocks in the portfolio will have to
be delivered/ sold to meet the obligation, thus limiting the upper value of the portfolio to
Rs. 340 per share. So long as the share price hovers between R. 300 and Rs. 340, Mr.
Sharma will be gainer by Rs. 8 ( net premium received ).
f.
Pay off
Profit
E
C0 = S0 N(d1) - ------ N (d2)
ert
S0 σ2
ln ----- + r + ---
E 2
d1 =
σ t
d2 = d1 - σ √¯t¯¯
j. S0 = 325 E =320 t =0.25 r = 0.06 σ =0.30
325 (0.30)2
ln + 0.06 + x 0.25
320 2
d1 =
0.30 x √ 0.25
k. A collar is an option strategy that limits the value of a portfolio within two bounds.
For example the strategy adopted in ( e ) above is a collar.
Chapter 19
FUTURES
1.
Cash flow to the buyer
March 2 1128 – 1125 = 3
March 3 1127 – 1128 = -1
March 4 1126 – 1127 = -1
March 5 1128 – 1126 = 2
2. F0 = S0 (1+rf)t
= Rs.40 (1.08)0.25 = Rs.40.78
3. F0 = S0 (1+rf - d)t
= 1200 (1 + 0.10 - .03)1 = 1284
4. If the 6-months futures contract for gold is $432.8 and the interest rate is 8 percent;
the appropriate value for the one-year gold futures contract is :
$432.8 (1.08) 0.5 = $449.8
If the one-year gold futures has a price of $453 it means that it is over-priced relative
to the 6-months futures contract.
A profitable strategy would be to :
• Sell a one-year futures contract for $453
• Buy a 6-months futures contract for $432.8
• Take delivery of the 6-months futures contract after 6-months with the help of borrowed
money, hold the gold for 6 months, and give delivery of the one-year futures contract.
Chapter 20
PORTFOLIO MANAGEMENT FRAMEWORK
1.
Rp – Rf
Treynor Measure:
βp
15 – 10
Fund P: = 5.55%
0.9
17 – 10
Fund Q: = 6.36%
1.1
19 – 10
Fund R: = 7.50%
1.2
16 – 10
Market index: = 6%
1.0
Rp – Rf
Sharpe Measure:
σp
15 – 10
Fund P: = 0.25
20
17 – 10
Fund Q: = 0.29
24
19 – 10
Fund R: = 0.33
27
16 – 10
Market index: = 0.25
20
2.
(a) The arithmetic average return is:
(5 + 12 + 16 + 3)/ 4 = 9%
(b) The time-weighted (geometric average) return is:
[(1.05) (1.12) (1.16) (1.03)]1/4 - 1 = .089
= 8.9%
(c) The rupee-weighted average (IRR) return is computed below:
Period
1 2 3 4
Rate of return earned 5% 12% 16% 3%
Beginning value of assets 200 220 296.4 373.82
Investment profit during the
period (Rate of return x Assets) 10 26.4 47.42 11.21
Net inflow at the end 10 50 30 -
Ending value of assets 220 296.4 373.82 385.03
Time
0 1 2 3 4
Net cash flow -200 -10 -50 -30 385.03
r = 8.81%
Appendix 20A
SOLUTION
APPENDIX 20 B