Complete Strategic Financial Management Formulae

CA FINAL
STRATEGIC FINANCIAL MANAGEMENT (SFM)

Formulae at a Glance
TIME VALUE OF MONEY
SIMPLE INTEREST
Interest = Pnr
Amount = P(1 + nr) or Principal + Interest
Where, P = Principal
R = Rate of Interest per annum
N = Number of years
In Simple Interest, Interest is paid on a fixed Principal Sum.
COMPOUND INTEREST AND FUTURE VALUE
Future value of a single Cash Flow
a. When compounding is done annually

n
⎛ r ⎞
FV = PV ⎜1 + ⎟
⎝ 4 x 100 ⎠
b. When compounding is done half-yearly
nx2
⎛ r ⎞
FV = PV ⎜1 + ⎟
⎝ 2 x 100 ⎠
c. When compounding is done quarterly
nx4
⎛ r ⎞
FV = PV ⎜1 + ⎟
⎝ 4 x 100 ⎠
d. When Compounding is done monthly

n x 12
⎛ r ⎞
FV = PV ⎜I + ⎟
⎝ 12 x 100 ⎠
Future value of an annuity
a. Annuity occurring at the end of the year
⎡ (1 + r )n - 1⎤
FV = A⎢ ⎥
⎣ r ⎦
b. Annuity occurring at the beginning of the year
⎡ (1 + r )n - 1⎤
FV = A⎢ ⎥ (1 + r)
⎣ r ⎦
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A.S. Foundation, Pune CA ‐ FINAL ‐ STRATEGIC FINANCIAL MANAGEMENT
(020 ‐ 24431210, 24498276, 9422365495, 9273096584, 9766921860) SELF PRACTICE PROBLEM& SOLUTION
Present value of Single Cash flow
FV
PV =
(1 + r )n
PV = FV x Present Value Factor (n, r)
Present Value of a Finite Annuity

⎡ (1 + r )n - 1⎤
PV = A ⎢ n ⎥
⎣ r (1 + r) ⎦
PV = A x PV Annuity Factor (n, r)
Present value of an Infinite Annuity
a. For Constant Annuity

A
PV =
r
b. For Annuity growing at a constant rate
A
PV =
r-g
Notations :
FV = Future Value
PV = Present Value
r = rate of interest
n = Number of years
A = Annuity
g = growth rate
EFFECTIVE RATE OF INTEREST

m
⎛ i⎞
Ei= ⎜1 + ⎟ –1
⎝ m⎠
Where,
M = Frequency of compounding
I = Interest rate
FINANCIAL ANALYSIS AND PLANNING (RATIO ANALYSIS)
CASH POSITION RATIOS
RATIO Formula
Cash + Marketable Securities

Absolute Cash Ratio
Current Liabilities

Cash to total Assets Ratio
Total Assets

Interval Measures Average Daily Cash operating expenses
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LIQUIDITY RATIOS
RATIO Formula
Current Ratio Current Assets
Current Liabilities
Liquid Ratio or Quick Ratio or Acid Test Ratio Quick Assets
Quick Liabilities
Current Assets = Inventories + Trade receivables + Cash and Bank Balances + Marketable Securities
+ Advances to MaterialSuppliers + Prepaid Expenses + Advance Income tax (in
excess of provision)
Current Liabilities = Trade Creditors + Creditors for Services + Short term loans + Bank overdraft Cash credit +
outstanding Expenses + Provision for taxation (net of advance tax) + Proposed
dividend + Unclaimed dividend
Quick Assets = Current Assets – Inventories
Note : Often prepaid expenses are not considered as Quick assets.
Quick Liabilities = Current Liabilities – Bank overdraft – cash credit from Bank
CAPITAL STRUCTURE RATIOS :
RATIO Formula
Long Term Debt + Debentures + Preference Share Capital
Capital Gearing Ratio Equity Share Capital + Reserves and Surplus – losses and fictitious
assets
Fixed Assets
Fixed Assets to long term fund ratio Long Term Funds
Proprietary funds
Proprietary Ratio
Total Assets
(1) Owners’ Equity = Equity Share Capital + Pref. Share Capital + Reserves & Surplus.
PROFITABILITY RATIOS
Return on Investment (ROI) is the basic profitability ratio. It is an indicator of overall efficiency.
Net Operating Profit
= x 100
Capital employed
ROI may be calculated on the basis of shareholders capital employed –

Earnings available to Shareholders (PAT)
= x 100
Shareholders Capital Employed
One may also calculate ROI on the basis of equity shareholders capital employed
Earnings available to Equity Shareholders

= x 100
Equity Shareholders Capital Employed
ROI = Net Profit to Sales Ratio x capital Turnover Ratio
Net Operating Profit Sales

= x x 100
Sales Capital Employed
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Profit after tax
ROE =
Net worth
Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier

OTHER IMPORTANT RATIOS
Ratio Formula
Gross Profit Ratio Gross Profit x 100
Sales
P/V Ratio Sales – Variable Cost x 100
Sales
Or
Contribution x 100
Sales
Net Profit Ratio or Operating Profit Ratio Net Operating Profit x 100
Sales
Operating Cost x 100
Operating Ratio Sales
Earning Per Share (EPS) Earnings available to Equity Shareholder / No. of Equity
Shares
Average Equity Share Market price
Price Earning Ratio EPS
Debt Service Coverage Ratio or Debt Earnings available for debt service
Service Ratio Interest on Term Loans + Term loan Instalments
Interest Coverage Ratio* Earnings before interest on Term Loan and taxation.
Interest on Term Loans
TURNOVER RATIOS:
Ratio Formula
Capital Turnover Ratio Sales
Avg. Capital Employed
Fixed Assets Turnover Ratio Sales
Avg. Fixed Assets
Working Capital Turnover Ratio Sales
Avg. Working Employed
Inventory Turnover Ratio Cost of Goods Sold
Average Inventory
Raw Material Inventory Turnover Ratio Raw Material Consumed
Average Raw Material Stock
Debtors Turnover Ratio Credit Sales
Average Accounts receivable
Debtors collection period Average Accounts Receivable

Average daily/monthly credit sales
Creditors Turnover Ratio Credit Purchases

Average Accounts Payable
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FINANCING DECISIONS
COST OF DEBT CAPITAL :
Cost of Irredeemable Debt Cost of Redeemable Debt

Interest X [1 - Tax Rate] Interest X [1 - Tax Rate] + [RV - Net Proceeds]/N
Net Proceeds of Issue [RV + Net Proceeds] / 2
Net proceeds = Face value + Premium – Discount – Issue expenses. If Redemption value is not given, assume
redemption is at par.
If net proceeds is not given, take current market price. If nothing is given , take face value as net proceeds.
COST OF PREFERENCE SHARE CAPITAL :

Cost of Irredeemable PSC Cost of Redeemable PSC
Preference Dividend Preference Dividend + [RV - Net Proceeds)/N
Net Proceeds of Issue [RV + Net Proceeds] / 2
Net proceeds = Face value + Premium – Discount – Issue expenses

If net proceeds is not given, take current market price. If nothing is given , take face value as net proceeds.
If Redemption value is not given, assume redemption is at par.
COST OF EQUITY SHARE CAPITAL:
Dividend Price Approach :[Constant Dividend]
D
Ke = 1
P0
Dividend Price + Growth Approach :[Constant EPS]
Ke= (D1 / P) + G
Earnings Price Approach :

Ke = E
P
Earnings Price + Growth Approach :
Ke = E + G
P
Where,
Realized Yield Approach
Yt =
(
D t + Pt - Pt -1 ) Yt = Yield for the year t
Pt -1 Dt = Dividend for share for end of the year t
Pt = Price per share at the end of the year t
Pt-1 = Price per share at the beginning of year t.
Capital Asset Pricing Model Approach (CAPM) :

Ke= Rf + b (Rm – Rf)
Where,
Ke = Cost of equity capital Rf= Rate of return on security
b = BetacoefficientRm= Rate of return on market portfolio
Rm –Rf = Market risk premium
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COST OF RETAINED EARNINGS
Cost of Retained Earnings or Reserves are generally taken as the same as Cost of Equity.
COST OF EXTERNAL EQUITY

D1
Ke = +g Where, f = floatation cost, g = growth rate,
P0 (1 - f)
P0 = current market price. In the absence of growth, Ke = D

P0 (1 - f)
VALUE OF EQUITY SHARE

D1
Po =
Ke - g
OPERATING, FINANCIAL AND COMBINED LEVERAGE
OPERATING LEVERAGE
% Change in EBIT Contributi on

or
% Change in Sales EBIT
FINANCIAL LEVERAGE
% Change in EPS EBIT

or
% Change in EBIT Pref. Div
EBT -
1- t
COMBINED LEVERAGE
C
o
n
t
r
i
b
u
t
i
o
n
D
C
L
or DCL = Operating leverage x Financial Leverage

P
r
e
f
.-
D
i
v
=
E
B
T
-
1
t
FINANCIAL BREAK-EVEN POINT
Pref - Dividend
Interest +
1 - Tax rate
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CAPITAL BUDGETING / INVESTMENT DECISION
IMPORTANCE OF CAPITAL BUDGETING:
Capital Budgeting Decisions are important due to following reasons
(i) Such decisions have long term implication .
(ii) Huge sums of money are involved .
(iii) These decisions are irreversible .
TYPES OF CAPITAL BUDGETING PROPOSALS

If more than one proposals are under considerations, then these proposals can be categories as follows :
1. Mutually Exclusive Proposals :
Two or more proposals are said to be Mutually Exclusive Proposals when the acceptance of one proposal
implies the automatic rejection of other proposals, mutually exclusive to it.
2. Complementary Proposals: (Dependent Proposals) Two or more proposals are said to be Complementary
Proposals when the acceptance of one proposal implies the acceptance of other proposal complementary to it,
rejection of one implies rejection of all complementary proposals.
3. Independent Proposals:
Two or more proposals are said to be Independent Proposals when the acceptance/rejection of one proposal
does not affect the acceptance/rejection of other proposals.
STEPS IN CAPITAL BUDGETING :

Capital Budgeting decision involves three steps :
(i) Estimation Of Cash Inflows and Cash Outflows
(ii) Estimation Of the Discount Rate.
(iii) Selecting the Techniques Of Evaluation. For Example : Net Present Value ,Profitability Index etc
CASH FLOWS OR ACCOUNTING PROFIT?
In Finance or in particular Capital Budgeting we considered Cash Flows rather than Accounting Profits .We do not
consider Accounting Profits due to the following reasons :
(i) Accounting Profit is affected by the non-cash items i.e depreciation
(ii) Ignores Time Value of Money
TREATMENT OF WORKING CAPITAL
¾ In the absence of information the students are advised to assume Introduction Of Working Capital at the beginning
of the project life. This should be treated as Outflow.
Release Of Working Capital at the end of the project life . This should be treated as Inflow
¾ Note : Changes in items such as Working Capital do not affect taxes.
ADJUSTMENT OF TAX SAVING IN RELATION TO SET OFF & CARRIED FORWARD OF LOSS :
¾ A Loss no doubt is bad . But it has a silver lining. It can be set off against taxable profits .It therefore goes to reduce
or save tax and hence it represents our inflows .Tax Saved ( Inflow ) = Loss x Tax Rate
¾ There are two options before us for setting off the losses :
1. The losses may be set off in the same year in which loss has incurred .It is assumed here that firm has
sufficient profit from other sources. [This Option is preferable]
2. The loss may be carried forward for adjustment in the subsequent year . It is assumed here that the firm
has insufficient profit in the current year.
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TECHNIQUES OF EVALUATION : ACCOUNTING RATE OF RETURN (ARR)
Average Annual Profit After Tax

¾ Formula : ARR or
Average Investment
Average Annual Profit After Tax

Where,
Initial Investment
Total Expected After Tax Profits

Average Annual Profit After Tax =
Number Of Years ;
Original Investment − Scrap Value

Average Investment =
2
+
Additional Net Working Capital + Scrap Value
¾ Accept/Reject Criterion : Higher the ARR better the project
NET PRESENT VALUE (NPV) :
¾ Formula : Net Present Value = Present Value Of Inflows - Present Value Of Outflows
¾ Accept/Reject Criterion :NPV > 0 Accept the proposal ; NPV = 0 Indifference point ; NPV < 0 Reject the proposal
¾ Note : If question has not said specifically that which evaluation technique should be used we will always prefer
NPV Method.
PROFITABILITY INDEX
Present Value of Inflows

¾ Formula :Profitability Index (PI) =
Present Value Of Outflows
INTERNAL RATE OF RETURN
¾ IRR is the discount rate at which NPV of the project is zero.
¾ Formula :IRR = Lower Rate + Lower Rate NPV

Lower Rate NPV - Higher Rate NPV
X
Difference in Rates
¾ Accept/Reject Criterion : IRR > Cost Of Capital Accept the proposal;
¾ IRR = Cost Of Capital Indifferent ;IRR < Cost Of Capital Reject the proposal
PAYBACK PERIOD
¾ Payback Period is the period within which the total cash inflows from the project equals the cost of the project.
¾ Formula :In Case Of Even Cash Flows : Payback Period
= Initial Investment
Annual Cash Inflows
Remaining Amount
¾ Formula :In Case Of Uneven Cash Flows : Payback Period = Completed Years + Available Amount
¾ Decision :The project with the lower payback period will be preferred.
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DISCOUNTED PAYBACK PERIOD
¾ The discounted payback period is calculated in the same way as the payback period except that the future
cash inflows are first discounted and then payback is calculated. It is superior than Payback period as under
this time value of money is also considered.
¾ Decision :The lower the Discounted Payback Period better the project .
NET PROFITABILITY INDEX (NET PI) :
NPV
¾ Formula :Net Profitability Index (PI) =
Present Value Of Outflows
¾ Accept/Reject Criterion Higher the Net PI, better the project.
MODIFIED NPV
¾ When reinvestment rate and Cost of Capital are separately given then in such case Modified NPV is calculated.
¾ Modified Net Present Value
Terminal Value Of Cash Inflow Using Reinvestment Rate

= - Initial Cash Outflow
n
(1 + Cost Of Capital)
MODIFIED IRR, EQUITY NPV, PROJECT NPV, PROJECT IRR AND EQUITY IRR
¾ The Cost Of Capital or Discount Rate at which modified NPV is zero is known as Modified IRR.
¾ Equity NPV:NPV from the point of view of Equity Shareholders is called Equity NPV .This reflects the NPV that
a project earns for the holders of Equity.
¾ Discount Rate :Cost Of Equity or Ke.
Project NPV:NPV computed from the point of view of overall company or project is called Project NPV . This reflects
NPV that a project earns for the Company as a whole.
¾ Discount Rate :
Overall Cost Of Capital or Weighted Average Cost Of Capital ( WACC
¾ Project IRR:Project IRR is the discount rate at which Project NPV is zero. It reflects the overall rate of return
earned by a project ( both for term lenders and shareholders).
¾ Equity IRR:Equity IRR is the discount rate at which Equity NPV is zero. It reflects the rate of return a project
earns forthe holders of equity.
EQUIVALENT ANNUALISED BENEFIT / COST NET PRESENT
¾ If two projects have unequal life ,then the two projects are not comparable . To make them comparable we will
use Equivalent Annual Net Present Value Concept for each project by applying the following formula :
¾ EANPV = Net Present Value Where K % = Discount Rate and n = Total Life of the project
PVAF (K%, n years)
¾ Note : By using this technique we assume that project life is infinite .
TREATMENT OF SUNK / IRRELEVANT COST :
Only Relevant Costs are considered under Capital Budgeting. Irrelevant Costs or Sunk Cost should be ignored .
Example Of Sunk/Irrelevant Cost are Research & Development Cost, Allocated Fixed Cost etc.
TREATMENT OF COST SAVINGS

(ii) Cash Saved are treated as Cash Earned i.e. A reduction in cost represents a Cash Inflows. In other words
Any savings should be treated as Inflow. For example :Tax Saving on Loss, Tax saving on Depreciation etc

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REPLACEMENT DECISION
¾ Under Replacement Decision we will decide:
Whether to Replace the existing machine & Buy new machine OR Whether to Repair Existing Machine
The Option which involve least outflow should be preferred.
RISK ANALYSIS IN CAPITAL BUDGETING
1. Expected Cash Flow = n

∑ p x CFi
i=1 i
2. Standard Deviation of cash flows - when probability is given = σ =
∑p (CF - CF)2
- when probability is not given
= σ = ∑ (CF - CF)2
n
3. Coefficient of Variation = CV = σ [S.D. / Mean]
CF
4. Expected NPV [ENPV] = PV of Expected Cash Inflows– PV of Outflows
5. Standard Deviation of NPV = σNPV, When
a. Cash Flows are dependent Where σt = Std. deviation of Cash flow of each period
k= Cost of Capital
ση σ
σ σ t
σNPV = σ1 + 2 + 3 + …… = n =∑ t
(1 + k) (1 + k)
1+ k
(1 + k)2 (1 + k)3
b. Cash Flows are Independent
2 2 2
(σ ) (σ ) (σ )
1 2 3 2
+ + + ... = σt
σNPV = 2 4 6 ∑
(1 + k) (1 + k) (1 + k) 2
(1 + k)
6. Z value = x -μ where x is Required Value, μ is originally estimated value (mean) and σ is the standard
σ
deviation about the mean
Sensitivity Analysis / Scenario Analysis

Meaning:- Sensitivity Analysis enables managers to assess how responsive the Net Present Value is to change in the
variables or factors which are used to calculate it.
Importance:- It directs the management to pay maximum attention towards the factor where minimum percentage of
adverse changes causes maximum adverse effect.
Decision:- If NPV were to become 0 with 2% change in Initial Investment relative to 10% change in Cash Inflows, Project
is said to be more sensitive to Initial Investment than to Cash Inflows.
Factor Adverse effect
Inflow Decrease
Change Discount Increase
Symbolically: Sensitivity (%) = x 100
Base R t
Outflow Increase
Life Decrease
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STEPS IN CERTAINTY EQUIVALENT APPROACH:
Steps In Certainty Equivalent Approach
Step 1: Estimate the Total future cash flows from the proposal. These cash flows do have some degree of
risk involved.
Step 2: Calculate the Certainty Equivalent Coefficient (CEC) factors for different years.
Certainty Equivalent Factor (CEF) = CCF / UCF,
Where CCF is Certain Cash Flows & UCF is uncertain Cash Flows.
(This value is generally given in question)
Step 3: Multiply Total future cash flows (Step 1) x CEC (Step 2) = Certainty Cash Flows
Step 4: Certainty Cash Flows are discounted at Risk Free Rate to find out the NPV of the proposal.
DECISION TREE APPROACH

Decision Tree is a form of diagram that is useful for decision maker to identify and evaluate various course of action,
possible outcomes etc. A decision tree is a graphic device that shows a sequence of strategic decisions and expected
consequences under each possible set of circumstances.
RISK ADJUSTED DISCOUNTED RATE (RADR):
Under this technique we discount the Cash Flows by a rate higher than Risk Free Rate. Such rate is known as Risk
Adjusted Discount Rate. Such rate is computed in the following manner:
Alternative 1:
Risk Adjusted Discount Rate = Risk Free Discount Rate + Risk Premium
Alternative 2:
It can also be calculated by using CAPM : RADR = Rf + Beta x (Rm – Rf)
Note: The Net Present Value computed by using Risk Adjusted Discount Rate is sometimes known as Risk Adjusted Net
Present Value.
INFLATION AND CAPITAL BUDGETING
Real rate of interest (r) & Nominal rate of interest (n) are equated by
(1 + n) = (1 + i) (1 + r), where i is the inflation rate.
Nominal rate of Discount = (1 + i) (1 + r) - 1
Real Discount Rate = 1+ n - 1

1+ i
Discount real cash flows with real rate of Discount and nominal cash flows with nominal rate of Discount.
Money Cash Flow = Real cashflow (1 + Inflation Rate)n
Real Cashflow = Money cashflow

n
(1 + Inflation rate)
ABANDONMNET OPTION
NPV with abandonment option = NPV without abandonment + Abandonment option value
DIVIDEND POLICY
1. Graham & Dodd Model
E
P = m (D + )
3
Where: P is the market price per share
M is multiplier
D is the dividend per share
E is the earning per share
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2. Walter Model
⎛ r ⎞
⎜ D + (E- D) ⎟
P= ⎝ ⎠
k
k
Where P is the market price per share
D is the dividend per share
E is the earning per share
r is the internal rate of return on the investments and
k is the cost of capital
OPTIMUM DIVIDEND AS PER WALTER MODEL
Nature of Firm Relationship Optimum Dividend Payout Optimum Retention Ratio

Growth Company Ke<r 0% 100%
Declining Company Ke>r 100% 0%
Normal Company Ke = r Indifferent Indifferent
3. Gordon Model
D
⎛ E (1 - b) ⎞ 1
Quantitatively P = ⎜ ⎟ or Po =
⎝ (k - br) ⎠ Ke - g
Where P is the price per share
E is the earnings per share
b is the retention ratio
1– b is the payout ratio
br is the growth rate
r is the return on investment
k is the rate of return required by shareholders(also called capitalization rate)
OPTIMUM DIVIDEND AS PER GORDON MODEL
Nature of Firm Relationship Optimum Dividend Payout Optimum Retention Ratio
Growth Company Ke<r 0% 100%
Declining Company Ke>r 100% 0%
Normal Company Ke = r Indifferent Indifferent
4. M-M Model
The market price of a share after dividend declared is calculated by applying the following formula :
P + D1
P0 = 1
1+ k e
The number of shares to be issued for new projects, in lieu of dividend payments is given by the following formula :
I - (E - nD1 )
ΔN =
P1
(n + ∆ n ) P1 - (I - E)
Value of Firm =
1+ k e
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n – is the number of shares outstanding at the beginning of the period.
ΔN – is no. of new shares issued
I – Total investment amount required for the new project
E – Earnings or net income of the firm during the period.
5. Linter model
Linter expressed corporate dividend behaviour in the form of a following model
Dt = crEPSt + (1 – c) Dt-1
Where, c = Adjustment rate
r = Target dividend payout ratio
EPSt = Earning per share of current year
Dt-1 = Dividend per share of last year.
Residual Dividend Approach
Under this Approach Earnings or Retained Earnings should first be used for beneficial investments and then if any amount
is left should be used for paying dividend.
Example 1: Earnings Available: Rs.1,00,000; Invesment Required : Rs. 20,000.Determine the amount of Dividend to be
paid and external financing required under Residual Approach ?
Dividend to be paid = Rs.80,000; Amount Of External Financing Required =Nil
Example 2: Earnings Available: Rs.1,00,000; Invesment Required : Rs.1,30,000. Determine the amount of Dividend to be
paid and external financing required under Residual Approach ?
Dividend to be paid = Nil; Amount Of External Financing Required =Rs. 30,000
Dividend Payout : measures the percentage of earnings that the company pays in dividends = Dividends /
Earnings.
Dividend Yield : measures the return that an investor can make from dividends alone = Dividends / Stock Price
Earnings Yield : measures how earnings are reflected in the share price.
= Earnings / Stock Price
Dividend per share
Dividend rate = x 100
Face Value per share
Concept of Maximum Dividend
Maximum Dividend is the amount of Retained Earning or Cash Available which ever is lower.
Notes:
i. Dividend is always paid on Face Value and not on Market Value.
ii. Equity dividend must be paid after Preference Dividend has been paid.
S x P0
Post Buy-back price =
S -N
Where,
S = No. of shares outstanding before buy-back.
P0 = Current Market Price
N = No. of Shares bought back
S x P0
Post Bonus Price =
S+N
Where,
S = No. of shares outstanding before bonus issue
P0 = Current Market Price
N = No. of bonus Shares issued
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Growth rate = b x r
Where,
b = Retention ratio (%)
r = Return on equity (%)
Dividend per share = EPS x Dividend Payout
PAT
Return on equity =
Equity Share Capital + Reserve
EPS = ROE X MPS
APPLICATION OF PRICE/EARNING (P/E) RATIO
MPS 1
PRICE EARNING RATIO = ; K =
EPS e
P/E Ratio
VALUE OF DECLINING FIRM OR WHEN GROWTH RATE IS NEGATIVE

Market Price Per Share of a firm whose dividend is declining at a constant rate p.a. forever is given by
D (1 − g)
o
P =
o
K +g
e
CONSTANT DIVIDEND AMOUNT APPROACH
¾ Under this model, a fixed amount of dividend is paid each year irrespective of the earnings.
¾ There would be no reduction in dividend even during the period of losses.
CONSTANT DIVIDEND PAYOUT APPROACH:

¾ Under this approach, Dividend Payout Ratio is kept constant.
¾ There could be zero dividend during the period of losses.
RIGHT SHARES
Right Shares are those shares which are issued to existing equity shareholders at a price which is normally less than
Current Market Price.
Note: Right Shares are first offered by the company to the existing shareholders
NOTE:
CHOICE BEFORE SHAREHOLDER IN RESPECT OF EFFECT IN SHAREHOLDERS WEALTH
RIGHT SHARES
Subscribe to the rights issue in full No change in the wealth of the shareholders
Ignore your rights/Take No Action Decrease in wealth
Sell the rights to someone else No change in the wealth of the shareholders
Subscribe to the rights issue in part & for balance Sell the No change in the wealth of the shareholders
right
SHARE WARRANTS
Theoretical Value of Share Warrants as on Expiry = Maximum of [Actual Market Price on Expiry – Exercise price, 0]
The value of warrant can never be negative. It can be zero or greater than zero.
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BOND MARKETS
IMPORTANT TERMS
a. Face value : It is also called as per value. Interest is paid on face value.
b. Coupon rate : This is also known as interest rate.
c. Coupon Payment : The coupon payments represents the periodic interest payments from the bond issuer to the
bondholder.
d. Maturity date : The maturity date represents the date on which the bond matures.
e. Required Return : The date of return that investors currently require on a bond.
f. Redemption value : the vale which a bond holder will get on maturity is called redemption value. A bond may be
redeemed at par or at premium or at discount.
IMPORTANT TERMS
• Pure Discount or Zero-Coupon Bonds
¾ Pay no coupons prior to maturity
¾ Pay the band’s face value at maturity.
• Coupon Bonds (Also called Straight Coupon Bond)
¾ Pay a Stated coupon at periodic intervals prior to maturity
¾ Pay the bond’s face value at maturity.
• Perpetual Bonds (Irredeemable Bond)
¾ No maturity date
¾ Pay a stated coupon at periodic intervals
• Self- Amortizing Bonds
¾ Pay a regular fixed amount each payment period over
the life of the bond.
¾ Principal repaid over time rather than at maturity.
• Inflation Bonds
Inflation Bonds are the bonds where interest rate is adjusted for inflation. Thus the investor gets an interest which
is free from the effects of inflation.
• Callable Bond
A Callable Bond is one when the issuer/borrower has an option to retire or redeem the bonds prior to the date of
maturity.
• Puttable Bond
A Puttable Bond is one where the holder (investor) has an option to get the bond redeemed prior to the date of
maturity.
VALUATION OF BOND
INT1 INT2 INT3 INTn + B n

1. B0 = + + + …. +
2 3
(1 + k d ) (1 + k d ) (1 + k d ) (1 + k d ) n
B0 = Present Value of a Bond

INT = Amount of interest in period t – paid annually
Kd = required rate of return on Bond (%)
Bn = Terminal / Maturity value of Bond at period n
N = number of years to maturity
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2. If interest is paid semi-annually then
1
(INTt )
B0 = 2n
∑ 2 + Bn
t =1 t 2n
⎛ Kd ⎞ ⎛ Kd ⎞
⎜⎜ 1 + ⎟⎟ ⎜⎜ 1 + ⎟⎟
⎝ 2 ⎠ ⎝ 2 ⎠
Note:- In Semi-annual bond,

(i) Divide interest rate by 2
(ii) Divide discount rate by 2
(iii) Multiply no. of years by 2
3. Perpetual Bonds
INT
B0 =
Kd
Bond Valuation and Time to Maturity

The value of the bond approaches its par value as the time to maturity approaches its maturity date other things
remaining the same.
¾ As the maturity approaches a Premium Bond will decrease in value
¾ As the maturity approaches a Discount Bond will increase in value
¾ As the maturity approaches a Par Value Bond will remain same in value
Note: For the above relationship to be true the maturity value of the bond must be equal to face value.
4. YTM is that Kd, which satisfies the equation,
INT1 INT2 INT3 INTn + B n
B0 = + + + …. +
2 3
(1 + k d ) (1 + k d ) (1 + k d ) (1 + k d ) n
5. Approximate YTM can be given by

C + Pro - rated Discount C + (M - P) / n
= =
(M + P) / 2 (M +P) / 2
where, C is the annual coupon payment
M is the maturity Value of Bond
P is the current price of the Bond
n is the number of years
Yield To Call (YTC):
⎛ Call Value − Issue Value ⎞

Interest + ⎜⎜ ⎟⎟
YTC =
⎝ Calls Years ⎠
Call Value + Issue Value
2
Relationship Between YTM and Coupon Rate
Case Nature of Bond
Coupon Rate = YTM Par Value Bond i.e. Bo = Par Value
Coupon Rate > YTM Premium Bond i.e. Bo > Par Value
Coupon Rate < YTM Discount Bond i.e. Bo < Par Value
Note:For the above relationship to be true the maturity value of the bond must be equal to face value.
354
6. Value of Zero Coupon or Deep Discount Bonds
Bn Face Value
= V= n = n
(1 + K d ) (I + Yield)
7. Current Yield
= Annual Interest / Current Market Price
Note: Current Yield is calculated on Current Market Price and not on Intrinsic Value.
8. Holding period return = [Coupon + Capital Gains] / Initial Investment
C + (P1 − P0 )
=
P0
n t
∑ Pmt t (t) / (1 + kd)
t =1
9. Duration =
Bond Price
Where,
Pmtt = Amount received in period t
n = Number of years to maturity
kd = Required rate of return
Note: Duration of a ZCB is equal to maturity of the bond.
Macaulay' s Duration
10. Modified Duration =
1 + YTM
11. Percentage change in Price = ( – Modified Duration) x Change in yield
DURATION OF AN IRREDEEMABLE BOND

1 + YTM
=
YTM
n
(1 + rn )
• Forward Rate = −1
n-1
(1 + rn-1 )
• OVERPRICED AND UNDERPRICED BONDS

When Current Market Price and Theoretical Market Price i.e. price which we calculate by applying present value
concept are not same we will undertake following decision:
Case Valuation Decision
If Currently Market Price > Present Value Market Price Overvalued Sell
If Currency Market Price < Present Value Market Price Undervalued Buy
If Currency Market Price = Present Value Market Price Correctly Valued Hold
MONEY MARKET
1. Calculation of Yield from a T Bill
Remember T Bills are issued at Discount. Yield on a T-Bill would be
Y = ⎛⎜ F- P ⎞⎟ x 365 x 100
⎝ P ⎠ M
Where Y is the Yield, F is the Face Value of T Bill, P is the issue price (applicable when directly issued during auction) /
purchase price (applicable when purchased in the secondary market), M is Maturity period.
Note:-Use the above formula for calculating interest rate on commercial paper and certificate of deposit.
355
PORTFOLIO MANAGEMENT
1. Return
P -P
Single Period : r = 1 0 Æ r is the return for a period, P1 is the price at the end of the period and P0 is the price at
P0
the beginning of the period.
(P1 - P0 ) + D1
2. Single Period with Dividend : r =
P0
3. Expected Return of a Security

n
E(x) = ∑ X P where Xi represents return under a particular scenario with Probability Pi.
i =1 i i
4. Expected Return of Portfolio of Securities
Ep = W1E1 + W2E2 + W3E3 + …… + WnEn
Where W1, W2 etc. are respective weights of Securities in the portfolio, E1, E2, etc. are Expected return of Security 1
and Security 2 respectively.
5. When Probabilities of returns are given
Expected return : E(ri) = ∑ x i R i

Where, xi = Proportion of portfolio invested in security i
Ri = Expected return on security i
1 n
First, find Arithmetic Mean return :ri = ∑ r where rit is the returns of various periods.
n t=1 it
1 n 2
2 ∑ (r − r i )
Next, find Variance : σ i = Now find Standard Deviation, which is square root of variance.
n t=1 it
6. Covariance (s,m) = ∑ P (Rm - Rm ) (R s - R s )
Or, Covariance = r . σs .σm.
Where, r = Correlation
σs = Std. Deviation of security
σm = Std. Deviation of Market
Or
_ _
∑ (Rm − R )(R S − R )
M S
Covariance =
n
Covariance (s,m)
7. Correlation Coefficient =
σ s x σm
Note:
(i) The value Correlation of Coefficient (r) ranges between + 1 and – 1 and Value of Covariance will range between
–α to +α
(ii) When r = +1
When r = + 1 It is a Perfect Positive Correlated Portfolio
When r = + 1 Portfolio Risk will be Maximum
When r = + 1 Standard Deviation of Portfolio will become (σ A +B ) = σ A x W A + σ B x WB i.e. it
become weighted average risk of individual security consisting a portfolio.
356
(iii) When r =-1
When r = - 1 It is a Perfect Negative Correlated Portfolio
When r = - 1 Portfolio Risk will be minimum
When r = - 1 Standard Deviation of Portfolio will become
(σ A +B ) = σ A x W A − σ B x WB
(iv) When r = 0
When r = 0 It is a No Correlated Portfolio
When r = 0 Out of two security in a portfolio one security must be a risk
free security.
(v) As r decreases risk also decreases. Lesser the correlation, lower the risk. Higher the correlation, greater would
be the risk of the portfolio. When r = + 1Portfolio has its maximum risk and in such case there can be No risk
reduction. When r = -1 Portfolio has Minimum or Lowest Risk.
8. Variance of a Portfolio containing Two Assets
2 2 2 2 2
σ p = W1 σ1 + W2 σ 2 + 2W1W2Cov(1,2)
Where Cov(1,2) is the Covariance.
2 2 2 2
9. σp = W1 σ1 + W2 σ 2 + 2 W1W2 Cov(1,2)
2 2 2 2
= W1 σ1 + W2 σ 2 + 2 W1W2 r σ σ
1 2
Where,
r = Co-rrelation
When r = 1,
σp = W1σ1 + W2σ2
When r = -1
σp = W1σ1 - W2σ2
10. Beta (β)
Cov (s,m)
βi = 2 where, the numerator is the covariance of the stock with respect to market portfolio and the
σm
denominator is the variance of the market portfolio.
r σi σm σ
i
βi = 2 = .r
σm σm
Where,
r = Correlation coefficient
σi = Std. deviation of security
σm = Std. deviation of market
∑ P (R s - R s ) (R m - R m )
Beta =
2
∑ P (R m - R m )
Or
When no. of observations are given,
∑ (R s - R s ) (Rm - Rm )
Beta =
2
∑ (Rm - Rm )
Or
357
Change in Security Return
Beta =
Change in Market Return
11. Beta (β) of Portfolio of Securities :
n
β = ∑ β i . Wi [Simple summation of beta of stocks multiplied by their respective weights]
i=1
Notes:-
(i) Beta of Market Portfolio is always assumed to be 1.
(ii) Beta of government securities is assumed to be Zero.
DECISION BASED ON BETA

A Security with Beta Greater than 1:
Î It means security has a higher volatility than the market. Fluctuation in security price will be more than
fluctuation in the market index.
Î It is termed as Aggressive Security.
A Security with Beta Less than 1
Î It means security has a lesser volatility than the market. Fluctuation in security price will be less than fluctuation
in the market index.
Î It is termed as Defensive Security / Low Beta Security.
A Security with Beta Equal to 1
Î It means volatility in security price & market is same. Security price are expected to move in tandem with the
market index
Î It is termed as Normal Security/ Normal Beta Security.
A Security with Beta less than 0 [ Negative Beta ] :
Beta value less than zero indicates that a negative (inverse) relationship between security return and market return
exists. i.e If market goes up price of the security will fall and vice versa. In reality beta value can hardly take a negative
value. Normally Gold is supposed to have negative beta.
A Security with Betas = 0 [ Zero Beta ] :
If beta value is zero it means there is no systemnatic risk and the share prices have no relationship with the market. In
reality beta value can hardly take a zero value. However Beta of Risk Free Security is assumed to be zero.
PROXY BETA
Proxy Beta is used when the firm has no market listing and thus no Beta of its own. In that case we take the help of
comparable listed firms and make necessary adjustments as required relative to the financial gearing levels. It is better
to take average of two or more than two companies for calculating Proxy Beta.
2
σ y - Cov (x,y)
Minimum Variance Portfolio (when covariance is given) =
2 2
σ x + σ y - 2 Cov (x,y)
Minimum Variance Portfolio (when correlation is given)

2
σy - r .σx .σy
= 2 2
σx + σy - 2 r .σx .σy
When r = 1,
σ
y
Wx =
σ −σ
y x
When r = -1
σ
y
Wx =
σ +σ
y x
Characteristics Line (CL)
358
Equation Of Characteristics Line :Y = a + β x X, Where
Y = Average or Expected Return for the Security; X = Average or Expected Return of the Market Portfolio; β = Beta of
Security; a = Intercept or alpha which can be calculated as Y - β x X
SLOPE OF CHARACTERISTICS LINE —

Beta is a slope of Characteristics Line.
12. CAPM
If E(ri) is the Expected Rate of return of the portfolio, then
E(ri) = rf + β (Rm – Rf) = Risk Free Rate + Market Risk
Premium
Note:-
(1) Market Risk Premium = Rm – Rf
(2) Security Risk Premium = Return on Security – Rf
Or
(3) CAPM considers only Systematic Risk and not total risk.
15. Capital Market Line (CML) :for stocks perfectly positively Correlated (ρ = 1)
σ i,m r σi σm
We Know that βi = 2 = 2
σm σm
Substitute this in CAPM Equation, we get,
{ [E(rm ) - rf } . σ i
E(ri) = rf + [E(rm) – rf] . βi= rf +
σm
Capital Asset Pricing Model (CAPM) Based Decision
Case Calculation Decision
If CAPM Return > Given Return Overvalued or Overpriced Sell
If CAPM Return < Given Return Undervalued or Underpriced Buy
If CAPM Return = Given Return Correctly valued or Correctly priced Hold
Note: Given Return means any return which may be given in question. At most of the times it is referred to
as Expected Return or Average Return
16. Measuring Project Beta (β)

Project Beta, i.e. the business risk of the overall project, containing Debt & Equity is given by (when there is no tax)
⎡ E ⎤ ⎡ D ⎤
βp = ⎢βEquity x ⎥ + ⎢βDebt x D + E ⎥
⎣ D +E⎦ ⎣ ⎦
when there is tax,
⎡ E ⎤ ⎡ D (1 - t) ⎤
βL = ⎢βEquity x D (1 - t) + E ⎥ + ⎢β
Debt x ⎥
⎣ ⎦ ⎣ D (1 - t) + E ⎦
Where βp is the Business Risk of a project used in finding the reqd. return of the project.
βEquity is the Share Market Beta relating to equity shares
βDebt is the Riskiness of the company’s Borrowings
E is the market Value of Equity
D is the market Value of Debt
t = tax rate
Note:-
359
1. Effect in Overall Beta Due to Change in Capital Structure
¾ A school of thought led by Modigliani and Miller's theory believe that Overall Beta of the firm is not affected by
the Change in Capital Structure .It means that overall beta of a company cannot be diversified or reduced by the
firm.
¾ Overall Beta of a company will be same as other company if the two company are similar i.e. if they belong to
the same industry.
2. Effect in Equity & Debt Beta Due to Change in Capital Structure

¾ Change in Capital Structure will only change Equity and Debt Beta not Overall Beta.
3.(i) Equity Beta will always be greater than Debt Beta as risk of Equity Shareholder are higher than Risk of Debenture
holders
(ii) If Debt Beta is not given in question, it is assumed to be zero.
(iii) If silent Risk Free Rate and Debenture Rate of Interest are assumed to be same unless otherwise stated i.e. If
rate of interest on debenture is not given in question then it is assumed to be risk free rate.
(iv) Market Value should be given preference than Book Value for calculating Weights in determination of Overall
Beta.
(v) For Unleveraged Firm / All Equity Firm : Overall Beta / Firm Beta / Project Beta = Equity Beta
(vi) Beta of Equity will always be higher than Overall Asset Beta or Project Beta.
17. Required Rate of Return of Project (RRRp)

RRRp = Rf + βp (Rm – Rf)
BL
18. Unlevered Beta (Bu) =
D (1 - t)
1+
E
⎡ D (1- t) ⎤
19. Levered Beta (BL) = Bu ⎢1 + ⎥⎦
⎣ E
20. Reward to Risk Ratio (using CAPM)
[Expected return - Risk Free rate]
Reward to Risk Ratio =
Beta
E(R) - R f
21. Slope of Capital Market Line = , whereσm = Std. deviation of Market
σm
22. Alpha = Actual Return – CAPM Return
23. Arbitrage Printing Theory Model
Rj = Rf + β1 (Rm - Interest – Rf) + β2 (Rm - inflation – Rf) + β3 (Rm - GNP – Rf)
Understanding Systematic Risk and Unsystematic Risk
Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk or Non-Diversiable Risk or Market Risk
¾ This risk affects all companies operating in the market.
¾ They are beyond the control by the management of entity.
Example: Interest Rate; Inflation; Taxation; Political Development; Credit Policy.
Unsystematic Risk or Diversiable Risk or Specific Risk
¾ This risk affects only a particular security / company.
¾ They can be controlled by the management of entity.
Example: Strikes, change in management, the research & development expert of company leaves;
Kinds of Systematic and Unsystematic Risk :
Types of Systematic Risk (i) Market Risk: (ii) Interest Rate Risk: (iii) Social or Regulatory Risk: (iv) Purchasing Power
Risk:
360
Types of Unsystematic Risk(i) Business Risk: (ii) Financial Risk (iii) Default Risk:
2 2
24. Systematic Risk, when variance is given = β x σm
25. Systematic Risk, when Standard Deviation is given = β x σm
2 2
26. Unsystematic Risk, When Variance is given = σ - β . σm
27. Unsystematic Risk, when Std. Deviation is given= σ - β .σσ
28. If Expected Return > CAPM Return, stock is undervalued, Buy.
29. If expected Return < CAPM Return, Stock is overvalued, Stock should be sold.
30. If expected Return = CAPM Return, Stock is correctlyvalued. Stock should be held.
SINGLE INDEX MODEL/SINGLE FACTOR MODEL/SHARPE INDEX MODEL;
RISK OF A PORTFOLIO:
Total Security Risk = Systematic Risk (or Security Market Risk) + Unsystematic Risk (or Security Residual Risk)
2 2 2 2 2 2
σ =σ β +σ Where σ = Variance of the Return of the Security; β = Beta of a security; σ =
P m s e s s m
Variance of the Market Portfolio; σ = Residual Risk.
e
COEFFICIENT OF DETERMINATION
Coefficient of Determination = (coefficient of correlation)2 = (r2)
Use of Coefficient of Determination in calculating Systematic Risk & Unsystematic Risk
Explained by the index(Systematic Risk) = Variance of Security Return x Co-efficient of Determination of Security or
Variance of Security Return X r2
(Unsystematic Risk) = variance of Security Return x (1 – Co-efficient of Determination of Security) or Variance of
Security Return x (1 – r2)
RULE OF DIVERSIFICATION
¾ Diversification means "Do not put all your eggs in one basket"
¾ Diversification refers to investing in more than one security i.e dividing the security into different stocks and not
investing the money in one particular stock.
¾ Diversification reduces risk. Greater the diversification lower should be the risk
MUTUAL FUNDS
Market Value of Investments + Receivables + AccruedIncome - Liabilities - AccruedExpenses

1. NAV =
Number of shares / units outstanding
Portfolio Return - R f
2. Sharpe Ratio = , σp is the standard deviation of portfolio
σp
Note: Higher the Sharpe ratio, better the performance.
Portfolio Return - R f
3. Treynor Ratio = , βp is the beta of the portfolio
βp
Note: Higher the Treynor Ratio. Better the performance.
4. Jensen’s Alpha = Return of Portfolio – Expected Return (as per CAPM)
Expected Return = Risk Free Return + Beta of portfolio (Return of Market – Risk Free Return)
i.e. αi = Ri – [Rf + βi (Rm – Rf)]
Note: If Alpha is positive, it means portfolio has performed better.
Distributions (dividendsor capital) ± Change in NAV
5. Return % =
NAV at the beginningof the period
361
D1 + C1 + (NAV1 - NAV0 )
=
NAV0
Expenses Per Unit

6. Expenses Ratio =
(NAV0 + NAV1) / 2
Entry Load or Front End Load:

When an investor purchase a unit of a Mutual Fund he has to pay a load in addition to the NAV of the units. Such
load is known as Entry Load.
Exit Load or Back End Load:
When an investor sale his unit to a Mutual Fund he has to pay a load. Such load is known as Exit Load.
FALL IN NAV AFTER DIVIDEND OR ANY DISTRIBUTION

NAV of Mutual Fund Scheme will fall to the extent of any distribution made by the company.
For example: If Existing NAV is Rs. 16 and dividend of Rs. 4 is to be distributed per unit, then in such case NAV after
dividend distribution will be Rs. 12
RELATIONSHIP BETWEEN RETURN OF MUTUAL FUND, RECURRING EXPENSES, INITIAL EXPENSES AND
RETURN DESIRED BY INVESTORS
Relationship Between Return Of Mutual Fund, Recurring Expenses, Initial Expenses and Return Desired By Investors
can be given by using following relation:
Return Required By Investors = (Return Of Mutual Fund - Recurring Expenses) (1 - Issue Expenses)
Sale Price = NAV + Entry Load %
Repurchase = NAV – Exit Load %
Sale Price
NAV =
1 + Entry Load %
Time Weighted Return = [(1 + r1) (1 + r2)1/n] - 1
DERIVATIVES
1. Futures Price = Spot Price + Cost of Carry – Returns (dividends etc.)

t
⎛ r ⎞
2. Annual compounding formula : A = P ⎜1 + ⎟
⎝ 100 ⎠
3. If the compounding is on a continuous basis, then A = P ern
4. If dividend is given in absolute value terms, then A = (P – I) ern
5. If dividend is given in percentage value terms (mostly applicable in the case of index) then A = (P) en(r-y)
6. The Black – Scholes formula calculates the price of a call option to be :

C = S N (d1) – Ee-rT N (d2)
P = E. e-rtN(-d2) – S.N.(-d1)
2
ln (S/E) + (r + σ / 2) T
Where d1 =
σ T
d2 = d1 - σ T
362
C = price of the call option
S = price of the underlying stock
E = option exercise price
r = risk-free interest rate
T = current time until expiration
N (d) = area under the normal curve
ln = Natural log
P = Price of the option
7. Value of call option on expiry date = Higher of [(S – E), 0]
8. Value of Put option on expiry date = Higher of [(E – S), 0]

Difference in option values
9. Option Delta =
Difference in Share Prices
C 2 - C1
Option Delta =
S 2 - S1
Where, C2 = Value of the call option if the share price is S2

C1 = Value of the call option if the share price is S1.
10. Basis = Future Price – Spot Price
11. Put call Parity Theorem = S + P = C + PV of E
12. Value of Put, P = C + PV of E – S
13. Value of Call, C = S + P – PV of E
14. Theoretical minimum Price of European call option
C0 = S – E . e-rt
15. Theoretical Minimum Price of European Put Option
P0= E . e-rt – S
Risk Neutral Model
(a) Calculation of Probability

Expected Return = (Probability of Price increase) x % Increase in price + (1 – Prob. of price decrease) x %
decrease in price = risk-free rate.
(b) Value of call = PV of expected value = Prob x option value on expiry.
Portfolio Replicating Model
Case -1: Stock equivalent approach
Situation-1
Option Finishing only in the money
E
Co = So -
rt
e
Where, So = Current market price
Situation-2
Option Finishing out of the Money
Spread in stock prices
Step-1 – Calls to be bought =
Spread in call option values
Step-2 – So = PV of Lower Stock Price + Calls bought x Co
363
Case-2 – Option Equivalent Approach
C1 - C 2
Step-1 Δ =
S1 - S 2
N (∆∆2 − C2 )
Step-2 PV of Borrowing (B) =
rt
e
Step-3 Co = N x Δx S – B
Where,
C1 = Value of call if the share price is S1
C2 = Value of call if the share price is S2
N = No. of call option
B = Borrowing
R = rate of interest
GAIN OR LOSS UNDER FUTURE CONTRACT:
The profit or payoff position of a futures contract depends on the differences between the contracted future price and
the actual market price prevailing on the maturity date.
Position Actual Price On Expiration Profit/Loss
Long Increase Profit
Long Decrease Loss
Short Increase Loss
Short Decrease Profit
NUMBER OF FUTURE CONTRACTS TO BE SOLD OR PURCHASED FOR INCREASING OR REDUCING BETA TO

A DESIRED LEVEL USING INDEX FUTURE
The number of futures contract to be taken for increasing and reducing beta to a desired level is given by the following
formula:
Current Portfolio Value x [Existing Beta of the Portfolio − Desired Beta of the Portfolio]
Value of one Futures Contract
Note: Buy or Purchase Future if Desired or Target Beta is more than the Existing Beta. [i.e. If Beta is to be increased
than a buying position should again be supplemented by a buying position]
Note: Sale Future if Desired or Target Beta is less than the Existing Beta [i.e. If Beta is to be decreased than a buying
position should be supplemented by a selling position]
BASIS
Basis = Future Price (the actual price that is quoted in the future market) – Spot Price (the price that is quoted in the
cash market)
In a normal market, the spot price is less than the futures price and accordingly the basis would be negative.
Such a market is known as a contango market.
Basis can become positive, i.e., the spot price can exceed the future price. The market under such
circumstances is termed as a backwardation market or inverted market.
Basis will approach zero towards the expiry of the contract, i.e., the spot and futures prices converge as the
date of expiry of the contract approaches. The process of the basis approaching zero is called convergence.
BUYERS AND SELLERS OF OPTION CONTRACT:
¾ Buyer and Seller is determined from the view point of right.
¾ The person who has a right under a contract is known as Buyer. The right may be Right to Buy [Call Buyer]
or right to Sell [Put Buyer].
364
EXPECTATION OF VARIOUS PARTY IN OPTION MARKET:
Long Call: Person buying a Call option They expects Price to increase
Long Put: Person buying a Put option They expects Price to Decrease
Short Call: Person selling a Call option They expects Price to Decrease
Short Put: Person selling a Put option They expects Price to Increase
IN / OUT / AT THE MONEY OPTION-FOR CALL
Market Scenario For Holder or Buyer Of Call Option
Money Price > Strike Price In the Money
Market Price < Strike Price Out of the Money
Market Price = Strike Price At the Money
Note: The above position is reversed for the Writer of the Option.
Note: For finding In/Out/At the money Option, Premium is ignored as it is considered as sunk cost.
IN / OUT / AT THE MONEY OPTION-FOR PUT
Market Scenario For Holder or Buyer Of Call Option
Money Price > Strike Price Out of the Money
Market Price < Strike Price In the Money
Market Price = Strike Price At the Money
Note: The above position is reversed for the Writer of the Option.
Note: For finding In/Out/At the money Option, Premium is ignored as it is considered as sunk cost.
PAY OFF / PROFIT & LOSS OF CALL OPTION:
Pay off means Profit and Loss. In determining the profit and loss we take into consideration the amount of premium.
Call Option:
Profit: When Market Price > Strike Price
In such case he will exercise the Option. Profit = Actual Market Price – Strike Price – Premium
Loss: When Market Price < Strike Price
In such case he will not exercise the option. Loss = Amount of Premium Paid
Note: Position of Call Seller will just be opposite of Position of Call Buyer.
PAY OFF / PROFIT & LOSS OF PUT OPTION:
Pay off means Profit and Loss. In determining the profit and loss we take into consideration the amount of premium.
Put Option:
Profit: When Market Price < Strike Price
In such case he will exercise the option. Profit = Strike Price – Current Market Price – Premium
Loss: When Market Price > Strike Price
In such case he will not exercise the Option. Loss = Amount of Premium Paid.
MAXIMUM & MINIMUM PROFIT & LOSS
FOR CALL BUYER FOR CALL SELLER
Maximum Profit = Unlimited Maximum Profit = Amount Of Premium Received
Maximum Loss = Amount Of Premium Paid Maximum Loss = Unlimited
FOR PUT BUYER FOR PUT SELLER
Maximum Profit + Strike Price – Premium Maximum Profit = Amount Of Premium Received
Paid Maximum Loss = Strike Price – Premium Paid
Maximum Loss = Amount of Premium Paid
365
BREAK EVEN PRICE OF CALL
Breakeven price is the market price at which the option parties neither makes a profit nor incur any losses.
Break-Even Market Price for Buyer and Seller of Call Option: Exercise Price + Premium
BREAK EVEN PRICE OF PUT OPTION

Breakeven prices is the market price at which the option parties neither makes a profit not incur any losses.
Break-Even Market Price for Buyer and Seller of put Option: Exercise Price - Premium
POSITION TO BE TAKEN IN OPTION MARKET
Expectation Call Put
If Expected Market Price > Strike Price or If Market Will go up Buy Call Sell Call
If Expected Market Price < Strike Price or If Market will go down Sell Call Buy Put
If Expected Market Price = Strike Price or If Market will remain same No action No Action
INTRINSIC VALUE AND TIME VALUE OF OPTION

Option Premium is the component of two parts: Intrinsic Value + Time Value of Money
Intrinsic Value
It can’t be negative (always equal to or greater than zero).
Intrinsic Value of Call Option = maximum of (0, Current Market Price – Exercise Price);
Intrinsic Value of Put Option = Maximum of (0, Exercise Price – Current Market Price).
Time Value of Option:
Time Value of Option is the amount by which the option price exceeds the Intrinsic Value. i.e. TVM =
Option Price – Intrinsic Value
On the expiration date, the time value of option is zero and the premium is entirely represented by the
Intrinsic Value.
OPTION STRATEGIES
STRADDLES
Straddle is an offsetting position taken by an investor in the options market. Straddle can be of two types:
1. Long Straddle
Buying a Call and Buying a Put with the same strike price and the same expiry date.
In Long straddle the investor will have to pay premium on the call as well as on put option contract.
2. Short Straddle
Selling a Call and a Selling a Put with the same strike price and the same expiry date.
In Short straddle the investor will receive premium on the call as well as on put option contract.
¾ In case of Long & Short Straddle, an investor breaks even at two points:
(Strike Price – Total Premium) and (Strike Price + Total Premium)
¾ If question is silent always assume Long Straddle.
STRIPS
A strips involves buying one call and buying two puts all with the same exercise price and same expiry
date.
A strip is adopted when decrease in price is more likely than an increase.
STRAPS
A strap involves buying two calls and buying one put all with the same exercise price and same expiry
date.
A strap is adopted when increase in price is more likely than a decrease.
STRANGLE
There are two types of strangle strategies depending on whether you buy options or sell options.
Long Strangle:- where you buy a Call and buy a Put Option on the same underlying, same expiry date but
different strike price.
366
Short Strangle:- where you sell a Call and sell a Put option on the same underlying, same expiry date but
different strike price.
There are 2 break-even points for the strangle position. The breakeven points can be calculated using the
following formulae.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid
BUTTERFLY SPREAD
It can be Long Butterfly Spread and Short Butterfly Spread
LONG BUTTERFLY SPREAD

It involves four options at three different strike prices. One such way of creating Butterfly Spread is as follows:
¾ By a call option with a lower strike price &
¾ Buy another call with a higher strike price.
¾ Then sells two call options with strike rates in between higher strike price and lower strike price.
¾ All the options have same expiry date.
Breakeven Points (s)
There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the
following formulae.
Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
Lower Breakeven Point = Strike Price of Lower Strike Call + Net Premium Paid
SHORT BUTTERFLY SPREAD
Sell 1 Call, Buy 2 Calls and Sell 1 Call in the same manner as Long Butterfly Spread.
If question is silent always assume Long Butterfly Spread.
BULLISH CALL SPREAD
An options strategy that involves purchasing call options at a specific strike price while also selling the same number of
calls of the same used and expiration date but at a higher strike.
A bull call spread is used when a moderate rise in the price of the underlying asset is expected.
The underline price at which break-even is achieved for the bull call spread position can be calculated using the
following formula. Breakeven Point = Strike Price of Long Call + Net Premium Paid
BULL PUT SPREAD STRATEGY
Buy Put at Lower Strike Price & Sell Put at Higher Strike Price
BEAR CALL SPREAD STRATEGY
Buy Call at Higher Strike Price & Sell Put at Lower Strike Price
CALENDAR SPREAD
Purchase & Sell Of two Option of the Same Type, Same Exercise Price But Different Maturity
CAPS, FLOOR AND COLLAR
This is a method of hedging by which the upper limit and lower limit of price to be paid for the underlying asset can be
assured.
Caps: Caps means setting the upper limit. Usually the upper limit is set by Strike Price of a Call purchased
Floor: Floor means setting the lower limit. Usually the lower limit is set by Strike Price of Put sold.
Collar: Combination of Caps and Floor is known as Collars.
367
INTERNATIONAL FINANCE
1. Direct Quote = No. of units of Domestic currency required for one unit of foreign currency.
2. Indirect Quote = No. of units of foreign currency required for one unit of domestic currency.
1
3. Direct Quote =
Indirect Quote
1
Indirect Quote =
Direct Quote
4. Cross Rates
Bid (A/B) = Bid (A/C) x Bid (C/B)
Ask (A/B) = Ask (A/C) x Ask (C/B)
1
Bid (A/B) =
Ask (B/A)
1
Ask (A/B) =
Bid (B/A)
5. Spread = Ask Price – Bid Price
6. Forward premium (Discount)
For Direct Quotes
Forward premium (Discount) = F - S x 12 x 100
S n
Where F = Forward exchange rate
S = Spot exchange rate and
n = Number of months of the forward contract
For Indirect Quotations = Forward Premium / Discount
S -F 12
= x x 100
F n
7. Interest Rate Parity
1 + rD F
= (Direct Quote) = S (Indirect Quote)
1 + rf S F
where,
rD = Domestic interest rate
rF = Foreign Interest rate
F = Future Exchange rate
S = Spot Exchange rate
Purchasing Power Parity (PPP)
1 + iD F S
= (Direct Quote) = (Indirect Quote)
1 + if S F
where, iD = Domestic inflation rate

iF = Foreign inflation rate
DOMESTIC CURRENCY (HOME CURRENCY) & FOREIGN CURRENCY:

Country’s Own Currency is known as Home Currency. For Example:
For India “Rupee” is the domestic currency
For a country, any Currency other than home currency is known as Foreign Currency.
For India “US$” is the foreign currency
368
SPOT RATE & FORWARD RATE:
Spot Rate: Spot Rate is the rate applicable for immediate settlement.
Forward Rate: Forward Rate is the rate applicable for future settlement.
NOSTRO/VOSTRO/LORO ACCOUNT
NOSTRO ACCOUNT:-Nostro account is an account of Indian Bank maintained by a bank abroad. In other words
Nostro Account can be termed as ‘our account with you’.
VOSTRO ACCOUNT:- A foreign bank may open rupee account with an Indian Bank. In other words Nostro Account
can be termed as ‘your account with us’.
LORO ACCOUNT:- Let's say that State Bank of India is having an account with Citibank, New York. When Syndicate
Bank of India likes to refer to this account while corresponding with Citibank, it would refer to it as Loro account,
meaning 'Their account with you', in Latin.
BID AND ASKRATE:
There are two types of rates in a foreign exchange quote:
Bid rate (Banking Buying Rate): Bid Rate is the rate at which Bank Buys Foreign Currency
Ask Rate (Bank Selling Rate / Offer Rate): Ask rate is the Rate at which Bank Sells Foreign Currency
Note: The difference between the two represents the profit for the bank.
Note: Ask rate will always be greater then Bid rate.
Note: The quote of Bid and Ask Rate is quote from the banker’s point of view.
SWAP POINTS / FORWARD MARGIN / FORWARD SPOT DIFFERENTIAL:
The difference between the Forward Rate and Spot Rate is known as Swap Points.
How to Calculate Forward Rate using Spot Rates:
If Swap points are given in ascending order:
¾ It represents premium onForeign currency.
¾ Hence we will Addthe Swap Point in the given Spot Rates to find Forward Rate.
Example:
Spot Rate 1$ = 47.6500-47.6595 & 2 Months Forward Swap Points are 20/26.Calculate Forward Rate ?
Solution:
2 months Forward Rate will be Rs.47.6520-Rs.47.6621.
If Swap Points are given in descending order:

¾ It represents discount on Foreign currency.
¾ Hence we will Deductthe Swap Points from the Spot Rate to find Forward Rate.
Example :
Spot Rate for 1 Pound = $1.4710 - 1.4810 and Swap Points for 1 month forwards are 65/44
Solution :
1 month forward rate will be 1 Pound= $ 1.4645- $ 1.4766 .
EXCHANGE MARGIN:
Exchange Margin is the extra amount or percentage charged by the bank over and above the rate quoted by bank. It
represent commission, transaction related expenses etc.
In case of Buying Rate Quoted bank:
Deduct Exchange Margin: i.e. Actual Buying Rate = Bid Rate (1 – Exchange Margin)
In case of selling Rate Quoted by Bank:

Add exchange Margin: i.e Actual Selling Rate = Ask Rate (1 + Exchange Margin)
369
INTERNATIONAL FISHER EFFECT (IFE)
It analyses the relationship between the Interest Rates and the Expected Inflation. As per IFE we have, (1+Money or
Nominal Interest Rate ) = ( 1+ Real Interest Rate) ( 1+ Inflation Rate )
ARBITRAGE IN FOREIGN EXCHANGE MARKET GEOGRAPHICAL ARBITRAGE

¾ Geographical Arbitrage refers to a situation in which one currency is cheaper in one foreign exchange market
and costlier in the other market.
¾ Under Geographical Arbitrage the rule is Buy Low and Sell High "
COVERED INTEREST ARBITRAGE:

If Interest Rate Parity Theory do not hold, Covered Interest Arbitrage will arise i.e there will be a possibility of Riskless
Profit .This arbitrage occur when there is mismatch of interest rate between two countries.
How To Find Out Whether there is Arbitrage Opportunity or Not

Alt 1 :Calculate Theoretical Interest Rate of Domestic Country .
If Actual Interest Rate = Theoretical Interest Rate No Arbitrage Opportunity
If Actual Interest Rate > Theoretical Interest Rate Arbitrage Opportunity Exists. Invest in Domestic Country and
Borrow From Foreign Country
If Actual Interest Rate < Theoretical Interest Rate Arbitrage Opportunity Exists. Invest in Foreign Country and
Borrow From Domestic Country
Note :Theoretical Interest Rate may be calculated by using IRPT Equation . Actual Interest Rate will be given in the
question
Note :Invest in Home Country means Money will flow into Home Country. Invest in Foreign Country means Money will
flow out of Home Country .
FORWARD CONTRACTS:
Meaning:- A forward transaction is a transaction requiring delivery at a future date of a specified amount of one
currency for a specified amount of another currency. The exchange rate is determined at the time of entering into the
contract, but the payment and delivery take place on maturity.
Purpose:- Forward Exchange contracts are used to protect a company against the adverse movement in exchange
rate.
CURRENCY SWAP/PARALLELLOAN:
— In a currency swap, two parties agree to pay each others debt obligation denominated in different currencies.
— A currency swap involves (i) an exchange of principal amount today. (ii) an exchange of interest payments
during the currency of loan. (iii) a re-exchange of principle amounts at the time of maturity.
CURRENCY FUTURES:
It is a contractual agreement between a buyer and a seller for the purchase and sale of a particular currency at a
specified future date at a predetermined price.
CURRENCY OPTIONS:
Options are contracts that offer the right but not the obligation, to buy or sell foreign currency in the future at a specified
price .Options are of two types (i) Call Options (ii) Put Options. The application of Currency Option is same as Stock
Option.
NETTING / EXPOSURE NETTING:

The adjustment of receivables and payables at a given point of time is called Exposure Netting. In other words Netting
isa process under which debit balances are netted off against credit balances .
Note :By adopting netting process we not only save our costs but also avoid exchange risk .
Note :Netting is possible only in the following cases :

Inflows and Outflows are denominated in same currency
Inflows and Outflows relate to the same period
370
LEADING AND LAGGING:
¾ Leads means advancing the timing of payment or receipt.
¾ Lags means postponing the timing of payment or receipt.
Note: While deciding on Leading & Lagging, we should also take into account Interest Opportunity Cost.
CANCELLATION OF FORWARD CONTRACT-ON DUE DATE:
Action: A forward contract can be cancelled by entering into a reverse contract i.e sale contract by purchase contract
and purchase contract by sale contract .
Applicable Rate: At Spot Rate prevailing on Due Date
Settlement Of Gain or Loss: Customer will be entitled for both Profit and Loss .
CANCELLATION OF FORWARD CONTRACT-BEFORE DUE DATE:

Action: A forward contract can be cancelled by entering into a reverse contract i.e sale contract by purchase contract
and purchase contract by sale contract .
Applicable Rate: At Forward Rate prevailing as on today for due date
Settlement Of Gain or Loss: Customer will be entitled for both Profit and Loss
EXTENSION OF FORWARD CONTRACT:

Extension involves two steps: (i) Cancellation of Original Contract (ii) Entering into a new contract.
EARLY DELIVERY UNDER FORWARD CONTRACT:

Early Delivery involves two steps: (i) Cancellation of Original Contract (ii) Settlement of Currency which is delivered
before due date at the prevailing Spot Rate.
PARTIAL HONOUR FORWARD CONTRACT:
The part of the forward contract which cannot be honoured must be cancelled as per the Rules of Cancellation.
GAIN & LOSS UNDER FOREIGN EXCHANGE MARKET :

When Foreign Currency is to be Paid:
When Forward Contract is Taken:
Amount to be Paid at Forward Rate xxx
Amount to be Paid at Spot Rate xxx
Gain or Loss xxx
When no Forward Cover is Taken:
Amount to be Paid at Expected Spot Rate xxx
Amount to be Paid at Spot Rate xxx
Gain or Loss xxx
Note: Accordingly Gain in Loss can be calculated in case Foreign Currency is to be received.
TREATMENT OF WITHHOLDING TAX RATE UNDER FOREIGN EXCHANGE MARKET :

¾ When a Foreign Company invest in a Home Country the home country charges an additional tax over an above
the normal income tax. Such tax is known as Withholding Tax.
¾ Withholding tax is applicable on surplus amount or profit which is taken back by MNC in their own country.
APPLICATION OF DTAA-DOUBLE TAXATION AVOIDANCE AGREEMENT
It may be noted that the provisions of DTAA override the provisions of the IT Act insofar as they are more beneficial to
the assessee. Both DTAA and Normal Income Tax will not be applicable at the same time.
Note :All Interest Rates in Foreign Exchange Market are given on p.a basis whether stated or not .
Note :LIBOR : London Inter Bank Offering Rate ; MIBOR :Mumbai Inter Bank Offering Rate; PLR: Prime Lending Rate
371
MERGERS & ACQUISITIONS
1. EPS = Total Earnings / No. of Shares

2. P/E = Market price / EPS
3. Market Price = P/E Ratio x EPS
4. CALCULATION OF EPS OF COMBINED ENTITY
PATA + PATB
EPSAB =
Total No. of shares after Merger
CALCULATION COST OF ACQUISITION

Market Value Of Equity issued to various party Xxx
Market Value Of Debentures issued to various party xxx
Market Value Of Preference Shares issued to various party xxx
Payment of Current Liability xxx
Payment of Unrecorded / Contingent Liabilities xxx
Any other expenses paid xxx
Less : Sale proceeds from sale of assets not required in business (xxx)
Less : Cash in hand and bank received (xxx)
Cost Of Acquisition xxx
Note : Current Liability must be paid even if question is silent
Note : Sale of Asset is to be taken only if question requires and the asset is not required in business.
Note : Cash is to be deducted even if question is silent.
SYNERGY GAIN
If Combined Value of companies after merger is greater than sum of the individual company. The extra value is known as
Synergy Gain.
Merger Gain or Synergy Based On Earnings = Total Combined Earning Of Merged Firm - [Earning Of A + Earning Of B]
Merger Gain or Synergy Based On Market Value
= Total Combined Market Value Of Merged Firm -[Market Value Of A + Market Value Of B]
EPS A + B WHEN SYNERGY IS EXPRESSED IN %
⎡ (Earning A + EarningB ) (1 + Synergy Gain) ⎤

EPS A +B = ⎢ ⎥
⎣⎢ NA + NB x ER ⎦⎥
EPS A + B WHEN SYNERGY IS EXPRESSED IN AMOUNT
⎡ (EarningA + EarningB ) Synergy Gain ⎤

EPS A +B = ⎢ ⎥
⎣⎢ NA + NB x ER ⎦⎥
NOTE : ER = Exchange Ratio
EPS A + B WHEN CASH IS PAID OUT OF BORROWED MONEY
⎡ (Earning A + EarningB − Borrowed Amount x Interest Rate x (1 − Tax Rate) ⎤

EPS A +B = ⎢ ⎥
⎢⎣ NA ⎥⎦
372
EPS A + B WHEN CASH IS PAID OUT OF BUSINESS MONEY
⎡ (Earning A + Earning B − Cash paid x Opportunit y Cost of Interest x (1 − Tax Rate) ⎤

EPS A +B = ⎢ ⎥
⎣⎢ NA ⎦⎥
EPS A + B AFTER ONE YEAR WHEN GROWTH RATE IS USED
⎡ (E + E ) (1 + g ⎤
EPS A +B = ⎢ A B A +B ) ⎥
⎢⎣ N A + NB x ER ⎥⎦
E E
Where, g A B
A +B = g A x +g
B
x
E +E E +E
A B A B
MPS A + B IN CASE OF CASH TAKEOVER
Market Value of A + Market Value of B + Synergic Benefit − Cash Payment

MPS After Merger =
No of shares of A
DEMERGER
A corporate strategy to sell off subsidiaries or divisions of a company. The act of splitting off a part of an existing company to
become a new company, which operates completely separate from the original company. The new company issues shares
to the shareholders of the old company.
LEVERAGE BUYOUTS
Meaning:- A Leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is substantially financed
through debt. Typically in the LBO 90% or more of the purchase price is financed with debt.
5. MERGER VALUE =Stand alone value of acquirer + Stand alone value of Target Firm + Synergy value
6. Firm A Acquires / Mergers with Firm B
The cost in a merger of companies A & B is :
a. If settled through CASH
Cost to A = Cash - PVB
b. If the merger is financed by Stock, then
Cost to A = α PVAB – PVB
Where αpresents the fraction of the combined entity received by holders of B.
Where α PVAB = The value of what Firm B’s shareholders get in Firm A
PVAB = PVA + PVB + Synergy
PVB= The value of what Firm B gives up
c. NPV of Firm A = Benefit – Cost
NPV of Firm B = Cost to Firm A
7. Market value after merger if there is no synergy gain,
MVAB = MVA + MVB
EATA + EATB
8. No. of shares after Merger =
Merger EPS
MVAB
9. Market Value after merger =
No. of shares after merger
EPS of Target Company
10. Share exchange Ratio based on EPS =
EPS of AcquiringCompany
373
PE Ratio of Target Company
11. Share exchange Ratio based on PE Ratio =
PE Ratio of Acquiring Company
MPS of Target Co
12. Share exchange Ratio based on Market Price =
MPS of Acquiring Co
Book Value per Share of Target Firm

13. Share Exchange Ratio based on Book Value =
Book Value per Share of Acquiring Firm
PAT PAT
14. Post Merger PE Ratio= PEA x A + PEB x B
PAT + PAT PAT + PAT
A B A B
15. Post Merger MPS = Post merger EPS x Post merger PE Ratio of Acquiring Ratio
Market Price per share

16. EPS =
PE Ratio
17. Post-Merger Equity Ownership %

No.of New shares x 100
(a) Target Co. =
Total No.of shares after Merger
(b) Acquiring Co. = 100% - Target Co.%
18. Total Market Capitalisation after merger
= Total No. of shares after merger x MPS after Merger
19. Free Float Market Capitalisation
= Total Market Capitalisation x Non-Promoter holding %
COMMODITY DERIVATIVES
(1) If Storage Cost is given in Amount,

F = (S + I). ert
F = Forward Price
S = Spot Price
I = PV of Storage Cost
R = Risk-free rate of Interest
T = Time in years
E = 2.7183
(2) If Storage Costs are expressed as a percentage of the spot price,

F = S. e(r + I) x t
(3) If rebate is received from supplier,
F = (Spot Price + PV of storage cost – PV of Rebate ). ert
(4) Future Value with Convenience Yield in %.
F = S.e(r-c).t
(5) Future Value with Convenience Yield expressed in Amt.

F = (S + I – C). ert
374
LEASING AND HIRE PURCHASE
Cost of the Asset
1. Annual Lease Rental =
PV Annuity Factor
(Use Lessor’srequired rate of return)

Amount Borrowed
2. Loan Instalment =
PV Annuity Factor
(Use Bank Interest rate)
3. Discount rate to be used –

1st Priority – After tax cost of borrowing = I (1 – t)
nd
2 Priority – Use WACC
rd
3 Priority – Use the discount rate given in the problem
(In case of lessor, always use WACC)

4. When lease rentals have to be calculated for lessee,
Take lease rental = x and NPV = 0
Solve the equation and find the value of x.
5. Decision for Lessee –
Lower of Borrowing option or Lease option.
6. Indifference Point :Indifference Point is point at which DCF is same under both the alternatives.
7. If Lease Rentals are paid advance, assume Tax shield will at the end of year.
INTERNAL RATE OF RETURN OR IMPLIED INTEREST COST OF LEASE FOR LESSOR

¾ It is the discounting rate at which the net present value of any proposal is zero.
¾ This method relieves us from the task of identifying the discount rate to be used .
¾ Internal Rate Of Return is the discount rate at which Net Present Value ( NPV) is zero . Under this method
we discount the cash flows by two rates. One higher rate and one lower rate . By higher rate we should get
negative NPV and by lower rate we should get positive NPV. Now to find exact discount rate we will use following
equation
Lower Rate NPV
IRR = Lower Rate x Difference in rates.
Lower Rate NPV - Higher Rate NPV
BREAKEVEN LEASE RENTALS
The break even lease rental is the rental at which the lessee is indifferent to a choice between lease financing and
borrowing/buying.
TREATMENT OF SALVAGE VALUE
Salvage Value should be adjusted for Tax in the following two manner.
In Case Of Loss On Sale: Salvage Value + Loss On Sale x Tax Rate
In Case Of Profit On Sale: Salvage Value – Profit On Sale x Tax rate
TREATMENT OF TAXATION OF ITEM ARISING AT THE BEGINNING OF EACH YEAR

Tax Savings on Items Arising at the Beginning of each year can be taken
Alt 1 : Either at the end of each year [Normally preferred in case of Leasing Chapter]
Alt 2 : At the beginning of each year
TREATMENT OF COMMON ITEMS :

Items of income and expense which are common to both the alternative which is being evaluated should be ignored as
they are irrelavent for our decision making.
However if the two options are discounted with different rates then in such case Common Items should be taken
375
TREATMENT OF DEPRECIATION
⎯ Depreciation can be calculated in two ways
(i) Straight Line Method (SLM)
(ii) Written Down Value (WDV).
⎯ Depreciation is charged by the owner of the asset.
⎯ Under Lease Agreement it is the lessor who claims the depreciation and Under Loan Agreement it is charged by
the Borrower. Under Hire Purchase Agreement, it is charged by the Hire Purchaser.
⎯ Depreciation is not an item of Cash Outflow, hence it should not be considered for our analysis.
⎯ However Tax Saving on depreciation is an item of inflow and hence must be recognized.
⎯ Tax Saving On depreciation=Amount Of Depreciation x Tax Rate
VALUATION OF EQUITY SHARES
BALANCE SHEET VALUATION

a. Book Value Approach – Book value per share is simply the net worth of company divided by number of
outstanding shares.
b. Liquidation Value
Liquidation value per share is equal to –
Value realised- from liquidating all - Amount to be paid to all the creditors and preference
the assets of thefirm shareholders
No. of outstanding equity shares
c. Replacement cost – This method takes into account the replacement cost of its assets less liabilities.
DIVIDEND DISCOUNT MODEL
a. Single Period Valuation Model

D1 P1
Price of equity share (Po) = +
1+ r 1+ r
D1 = Dividend expected a year hence

P1 = Price of share expected a year hence
r = Rate of return required on equity share
b. Multi-Period Valuation Model
D1 D2 Dα
Po = + + ……….. +
2 α
1+ r (1+ r) (1 + r)
Po = Price of equity share today

D1 = Dividend expected a year hence
D2 = Dividend expected two years hence
Dα = Dividend expected at the end of infinity
r = expected return
The above equation will be applied for an infinite horizon. In case of finite horizon, the value of equity share will be
calculated as follows :
D1 D2
Po = + + ……….. + D n + Pn
2 n n
1+ r (1 + r) (1 + r) (1 + r)
n Dt Pn
Po = ∑ + n
t = 1 (1 + r) t (1 + r)
376
c. Growth Model
(i) Zero Growth Model
D
Po =
r
Where, D = Constant Dividend Amount
r = expected return percentage
(ii) Constant Growth Model (Gordon Model)
D
Po = 1
r-g
(iii) Two stage growth model :

This model assumes two stages of growth, the first phase in which the growth rate is high and the
second phase in which the growth rate is assumed to be stable.
I EARNINGS MULTIPLIER APPROACH
Under this approach, the value of equity share is estimated as follows:
Po = EPS x P/E Ratio
Where, EPS = Earnings per share
P/E Ratio = Price Earning Ratio.
II. PRICE TO BOOK VALUE RATIO (PBV RATIO)
Market Price per share at time ' t'

Price / Book Value Ratio =
Book Value per share at time ' t'
Value per Equity Share =Book value per share of company being valued x Book value multiple of the
representative company.
Value of Irredeemable Preference Shares

Annual Dividend
Value of Irredeemable Preference Share =
KP
Value of Firm Using Future Maintainable Profits (FMP)
Future Maintainab le Profit

Value of Business =
Relevant Capitaliza tion rate
Calculation of Future Maintainable Profits:
Average Past Year Profits xxxx
Add:
All Actual Expenses and Losses not likely to occur in future xxxx
All Profits likely to arise in Future
Less: All Expenses and Losses expected to arise in future xxxx
Less: All Profits not likely to occur in future (xxxx)
(xxxx)
377

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CA FINAL

STRATEGIC FINANCIAL MANAGEMENT (SFM)

a. When compounding is done annually

d. When Compounding is done monthly

a. Annuity occurring at the end of the year

Present Value of a Finite Annuity

Present value of an Infinite Annuity

a. For Constant Annuity

EFFECTIVE RATE OF INTEREST

CASH POSITION RATIOS

Cash + Marketable Securities

Cash + Marketable Securities

Cash + Marketable Securities

Quick Assets = Current Assets – Inventories

Note : Often prepaid expenses are not considered as Quick assets.

ROI may be calculated on the basis of shareholders capital employed –

Earnings available to Equity Shareholders

Net Operating Profit Sales

Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier

Debtors collection period Average Accounts Receivable

Creditors Turnover Ratio Credit Purchases

Cost of Irredeemable Debt Cost of Redeemable Debt

Net Proceeds of Issue [RV + Net Proceeds] / 2

COST OF PREFERENCE SHARE CAPITAL :

Net proceeds = Face value + Premium – Discount – Issue expenses

COST OF EQUITY SHARE CAPITAL:

Dividend Price Approach :[Constant Dividend]

Dividend Price + Growth Approach :[Constant EPS]

Earnings Price Approach :

Capital Asset Pricing Model Approach (CAPM) :

COST OF EXTERNAL EQUITY

P0 = current market price. In the absence of growth, Ke = D

VALUE OF EQUITY SHARE

OPERATING, FINANCIAL AND COMBINED LEVERAGE

% Change in EBIT Contributi on

% Change in EPS EBIT

or DCL = Operating leverage x Financial Leverage

FINANCIAL BREAK-EVEN POINT

TYPES OF CAPITAL BUDGETING PROPOSALS

STEPS IN CAPITAL BUDGETING :

Average Annual Profit After Tax

Average Annual Profit After Tax

Total Expected After Tax Profits

Original Investment − Scrap Value

Present Value of Inflows

¾ IRR is the discount rate at which NPV of the project is zero.

¾ Formula :IRR = Lower Rate + Lower Rate NPV

¾ Accept/Reject Criterion Higher the Net PI, better the project.

¾ Modified Net Present Value

Terminal Value Of Cash Inflow Using Reinvestment Rate

TREATMENT OF SUNK / IRRELEVANT COST :

TREATMENT OF COST SAVINGS

RISK ANALYSIS IN CAPITAL BUDGETING

1. Expected Cash Flow = n

Sensitivity Analysis / Scenario Analysis

DECISION TREE APPROACH

Real Discount Rate = 1+ n - 1

Money Cash Flow = Real cashflow (1 + Inflation Rate)n

Real Cashflow = Money cashflow

Nature of Firm Relationship Optimum Dividend Payout Optimum Retention Ratio

APPLICATION OF PRICE/EARNING (P/E) RATIO

VALUE OF DECLINING FIRM OR WHEN GROWTH RATE IS NEGATIVE

CONSTANT DIVIDEND PAYOUT APPROACH: