Additional Solved Problems and Minicases

ADDITIONAL
SOLVED PROBLEMS
AND
MINICASES
2
CHAPTER 3
SECURITIES MARKET
1. Consider the data for a sample of 5 shares for two years, the base year and year t.
Price in Price in No. of

Share base year year t outstanding shares
(Rs.) (Rs.) (in million)
A 24 20 15
B 16 22 8
C 42 54 20
D 32 48 46
E 18 12 12
What is the price weighted index, equal weighted index, and value weighted index
for year t?
Solution:
No. of Market Market

Price in Price in
Price outstanding capitalisation capitalisation
Share base year year t
relative shares in the base in year t
(Rs.) (Rs.)
(in millions) year (1x4) (2x4)
1 2 3 4 5 6
A 24 20 83 15 360 300
B 16 22 138 8 128 176
C 42 54 129 20 840 1080
D 32 48 150 46 1472 2208
E 18 12 67 12 216 144
566 3016 3908
The equal weighted index 566

For year t is : = 113
5 (since there are 5 scrips)
The value weighted index 3908

For year t is : x 100 = 130
3016
3
2. Consider the data for a sample of 5 shares for two years, the base year and year t
No. of outstanding
Price in base year Price in year t
Share shares
(Rs.) (Rs.)
(in millions)
1 2 3
P 42 58 26
Q 60 54 18
R 24 36 16
S 52 38 20
T 16 28 32
What is the price weighted index, equal weighted index, and value weighted index
for year t?
Solution:
No. of Market Market

Price in
Price in Price outstanding capitalisation capitalisation
Share base year
year t (Rs.) relative shares in the base in year t
(Rs.)
(in millions) year (1x4) (2x4)
1 2 3 4 5 6
P 42 58 138 26 1092 1508
Q 60 54 90 18 1080 972
R 24 36 150 16 384 576
S 52 38 73 20 1040 760
T 16 28 175 32 512 896
626 4108 4712
The equal weighted index 626

For year t is : = 125
5 (since there are 5 scrips)
The value weighted index 4712

For year t is : x 100 = 115
4108
4

A 25 20 30
B 48 62 24
C 34 ? 16
The value weighted index for year t is given to be 128. What is the price of
share?
C in year t?
Solution:
Price in Market Market

Prince in No. of
base Price capitalisation capitalisation
Share year t outstanding
year Relative in the base in year t
(Rs.) shares
(Rs.) year (1x4) (2x4)
1 2 3 4 5 6
A 25 20 80 30 750 600
B 48 62 129 24 1152 1488
C 34 16 544
2446
The value weighted index for year t is: Market capitalisation in year t
x 100
2446
Market capitalisation in year t
128 = x 100
2446
128 x 2446
Market capitalisation in year t =
100
= 3131
Market capitalisation of C = 3131 – (600 + 1488)
= 1043
1043
Price of share C in year t =
16
= 65.19
5

P 14 30 48
Q 52 60
R 28 48 26
The value weighted index for year t is given to be 142. What is the price of share Q
in year t?
Solution:
Price in Market Market

Price in No. of
base Price capitalisation capitalisation
Share year t outstanding
year Relative in the base in year t
(Rs.) shares
(Rs.) year (1x4) (2x4)
1 2 3 4 5 6
P 14 30 214 48 672 1440
Q 52 60 3120
R 28 48 171 26 728 1248
4520
The value weighted index for year t is: Market capitalisation in year t
x 100
4520
Market capitalisation in year t

142 = x 100
4520
142 x 4520
Market capitalisation in year t =
100
= 6418
Market capitalisation of Q = 6418 – (1440 + 1248)
= 3730
3730
Price of share Q in year t =
60
= 62.17
6
CHAPTER 4
RISK AND RETURN
1. A stock earns the following returns over a five year period: R1 = 0.30, R2 = -0.20, R3
= -0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36. Calculate the following: (a) arithmetic
mean return, (b) cumulative wealth index, and (c) geometric mean return.
Solution:
R1 = 0.30, R2 = - 0.20, R3 = - 0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36
(a) Arithmetic mean
0.30 – 0.20 - 0.12 + 0.38 + 0.42+0.36

= = 0.19 or 19 %
6
(b) Cumulative wealth index
CWI5 = 1(1.30) (0.80) (0.88) (1.38) (1.42) (1.36) = 2.439
(c) Geometric Mean
= [(1.30) (0.80) (0.88) (1.38) (1.42) (1.36)]1/6 – 1 = 0.1602 or 16.02 %
2. A stock earns the following returns over a five year period: R1 = 10 %, R2 = 16%, R3
= 24 %, R4 = - 2 %, R5 = 12 %, R6 = 15%. Calculate the following: (a) arithmetic
mean return, (b) cumulative wealth index, and (c) geometric mean return.
Solution:
R1 = 10 %, R2 = 16%, R3 = 24 %, R4 = - 2 %, R5 = 12 %, R6 = 15 %
(a) Arithmetic mean

10 + 16 + 24 - 2 + 12 + 15
= = 12.5 %
6
(b) Cumulative wealth index

CWI5 = 1(1.10) (1.16) (1.24) (0.98) (1.12) (1.15) = 1.997
(c) Geometric Mean

= [(1.10) (1.16) (1.24) (0.98) (1.12) (1.15)]1/6 – 1 = 0.1222 or 12.22 %
7
3. What is the expected return and standard deviation of returns for the stock described
in 1?
Solution:
The expected return and standard deviation of returns is calculated below
Return in % Deviation Square of deviation

Period
Ri (Ri-R) (Ri-R)2
1 30 11 121
2 -20 -39 1521
3 -12 -31 961
4 38 19 361
5 42 23 529
6 36 17 289
19 SUM= 3782
R=
Expected return = 19 %
Σ (Ri – R)2 3782
Variance = = = 756.4
n–1 6–1
Standard deviation = (756.4)1/2 = 27.50
4. What is the expected return and standard deviation of returns for the stock described in 2?
Solution:
The expected return and standard deviation of returns is calculated below.
Return in % Deviation Square of deviation

Period
Ri (Ri-R) (Ri-R)2
1 10 -2.5 6.25
2 16 3.5 12.25
3 24 11.5 132.25
4 -2 -14.5 210.25
5 12 -0.5 0.25
6 15 2.5 6.25
12.5 SUM= 367.5
R=
Expected return = 12.5 %

Σ (Ri – R)2 367.5
Variance = = = 73.5
n–1 6–1
Standard deviation = (73.5)1/2 = 8.57
8
5. The probability distribution of the rate of return on a stock is given below:
State of the Economy Probability of Occurrence Rate of Return

Boom 0.20 30 %
Normal 0.50 18 %
Recession 0.30 9%
What is the standard deviation of return?
Solution:
Probability Deviation
State of Return in
of (Ri-R) Pi x (Ri – R)2
the % pi x Ri
occurrence
economy Ri
pi
Boom 0.2 30 6 12.3 30.26
Normal 0.5 18 9 0.3 0.05
Recession 0.3 9 2.7 -8.7 22.71
Expected return R = 17.7 SUM= 53.01

Standard deviation = [53.01]1/2 = 7.28
6. The probability distribution of the rate of return on a stock is given below:
State of the Economy Probability of Occurrence Rate of Return

Boom 0.60 45 %
Normal 0.20 16 %
Recession 0.20 - 20%
What is the standard deviation of return?
Solution:
Probability
State of Return in
of Deviation Pi x (Ri – R)2
the % pi x Ri
occurrence (Ri-R)
economy Ri
pi
Boom 0.6 45 27 18.8 212.06
Normal 0.2 16 3.2 -10.2 20.81
Recession 0.2 -20 -4 -46.2 426.89
Expected return R = 26.2 SUM= 659.76
Standard deviation = [659.76]1/2 = 25.69
9
CHAPTER 5
THE TIME VALUE OF MONEY
1. Calculate the value 10 years hence of a deposit of Rs. 20,000 made today if the
interest rate is (a) 4 percent, (b) 6 percent, (c) 8 percent, and (d) 9 percent.
Solution:
Value 10 years hence of a deposit of Rs. 20,000 at various interest rates is as follows:
r = 4% FV5 = 20,000 x FVIF (4%, 10 years)

= 20,000 x1.480
= Rs.29,600
r = 6% FV5 = 20,000 x FVIF (6 %, 10 years)
= 20,000 x 1.791
= Rs.35,820
r = 8% FV5 = 20,000 x FVIF (8 %, 10 years)
= 20,000 x 2.159
= Rs.43,180
r = 9% FV5 = 20,000 x FVIF (9 %, 10 years)
= 20,000 x 2.367
= Rs. 47,340
2. Calculate the value 3 years hence of a deposit of Rs.5,800 made today if the interest
rate is (a) 12 percent, (b)14 percent, (c) 15 percent, and (d) 16 percent.
Solution:
Value 3 years hence of a deposit of Rs. 5,800 at various interest rates is as follows:
r = 12 % FV5 = 5,800 x FVIF (12%, 3 years)

= 5,800 x 1.405
= Rs.8,149
r = 14 % FV5 = 5,800 x FVIF (14%, 3 years)

= 5,800 x 1.482
= Rs.8,596
r = 15 % FV5 = 5,800 x FVIF (15%, 3 years)

= 5,800 x 1.521
= Rs.8,822
r = 16 % FV5 = 5,800 x FVIF (16%, 3 years)

= 5,800 x 1.561
= Rs. 9,054
10
3. If you deposit Rs.2,000 today at 6 percent rate of interest in how many years
(roughly) will this amount grow to Rs.32,000 ? Work this problem using the rule of
72–do not use tables.
Solution:
Rs.32,000 / Rs. 2,000 = 16 = 24
According to the Rule of 72 at 6 percent interest rate doubling takes place

approximately in 72 / 6 = 12 years
So Rs.2,000 will grow to Rs.32,000 in approximately 4 x 12 years = 48 years
4. If you deposit Rs.3,000 today at 8 percent rate of interest in how many years
(roughly) will this amount grow to Rs.1,92,000 ? Work this problem using the rule
of 72–do not use tables.
Solution:
Rs.192,000 / Rs. 3,000 = 64 = 26
According to the Rule of 72 at 8 percent interest rate doubling takes place

approximately in 72 / 8 = 9 years
So Rs.3000 will grow to Rs.192,000 in approximately 6 x 9 years = 54 years
5. A finance company offers to give Rs.20,000 after 14 years in return for Rs.5,000
deposited today. Using the rule of 69, figure out the approximate interest rate
offered.
Solution:
In 14 years Rs.5,000 grows to Rs.20,000 or 4 times. This is 22 times the initial

deposit. Hence doubling takes place in 14 / 2 = 7 years.
According to the Rule of 69, the doubling period is 0.35 + 69 / Interest rate
We therefore have
0.35 + 69 / Interest rate = 7

Interest rate = 69/(7-0.35) = 10.38 %
11
6. Someone offers to give Rs.80,000 to you after 18 years in return for Rs.10,000
deposited today. Using the rule of 69, figure out the approximate interest rate
offered.
Solution:
In 18 years Rs.10,000 grows to Rs.80,000 or 8 times. This is 23 times the initial
deposit. Hence doubling takes place in 18 / 3 = 6 years.
According to the Rule of 69, the doubling period is 0.35 + 69 / Interest rate. We
therefore have
0.35 + 69 / Interest rate = 6
Interest rate = 69/(6-0.35) = 12.21 %
7. You can save Rs.5,000 a year for 3 years, and Rs.7,000 a year for 7 years thereafter.
What will these savings cumulate to at the end of 10 years, if the rate of interest is 8
percent?
Solution:
Saving Rs.5000 a year for 3 years and Rs.6000 a year for 7 years thereafter is equivalent
to saving Rs.5000 a year for 10 years and Rs.2000 a year for the years 4 through 10.
Hence the savings will cumulate to:
5000 x FVIFA (8%, 10 years) + 2000 x FVIFA (8%, 7 years)
= 5000 x 14.487 + 2000 x 8.923

= Rs.90281
8. Krishna saves Rs. 24,000 a year for 5 years, and Rs.30,000 a year for 15 years
thereafter. If the rate of interest is 9 percent compounded annually, what will be the
value of his savings at the end of 20 years?
Solution:
Saving Rs.24,000 a year for 5 years and Rs.30,000 a year for 15 years thereafter is
equivalent to saving Rs.24,000 a year for 20 years and Rs.6,000 a year for the years
6 through 20.
Hence the savings will cumulate to:
24,000 x FVIFA (9%, 20 years) + 6,000 x FVIFA (9 %, 15 years)

= 24,000 x 51.160 + 6, 000 x 29.361
= Rs. 1,404,006
12
9. You plan to go abroad for higher studies after working for the next five years and
understand that an amount of Rs.2, 000,000 will be needed for this purpose at that
time. You have decided to accumulate this amount by investing a fixed amount at
the end of each year in a safe scheme offering a rate of interest at 10 percent. What
amount should you invest every year to achieve the target amount?
Solution:
Let A be the annual savings.
A x FVIFA (10%, 5years) = 2,000,000

A x 6.105 = 2,000,000
So, A = 2,000,000 / 6.105 = Rs. 327,600
10. How much should Vijay save each year, if he wishes to purchase a flat expected to
cost Rs.80 lacs after 8 years, if the investment option available to him offers a rate
of interest at 9 percent? Assume that the investment is to be made in equal amounts
at the end of each year.
Solution:
Let A be the annual savings.
A x FVIFA (9 %, 8 years) = 80,00,000
A x 11.028 = 80,00,000
So, A = 80,00,000 / 11.028 = Rs. 7,25,426
11. A finance company advertises that it will pay a lump sum of Rs.100,000 at the end
of 5 years to investors who deposit annually Rs.12,000. What interest rate is
implicit in this offer?
Solution:
12,000 x FVIFA (r, 5 years) = 100,000
FVIFA (r, 5 years) = 100,000 / 12,000
= 8.333
From the tables we find that
FVIFA (24%, 5 years) = 8.048

FVIFA (28%, 5 years) = 8.700
Using linear interpolation in the interval, we get:
(8.333– 8.048)
r = 24% + x 4% = 25.75%
(8.700 – 8.048)
13
12. Someone promises to give you Rs.5,000,000 after 6 years in exchange for
Rs.2,000,000 today. What interest rate is implicit in this offer?
Solution:
2,000,000 x FVIF (r, 6 years) = 5,000,000
FVIF (r, 6 years) = 5,000,000 / 2,000,000 = 2.5
FVIF (16%, 6 years) = 2.436

FVIF (17%, 6 years) = 2.565
Using linear interpolation in the interval, we get:
(2.5 – 2.436) x 1 %
r = 16% + = 16.5 %
(2.565 – 2.436)
13. At the time of his retirement, Rahul is given a choice between two alternatives: (a)
an annual pension of Rs. 120,000 as long as he lives, and (b) a lump sum amount of
Rs.1,000,000. If Rahul expects to live for 20 years and the interest rate is expected
to be 10 percent throughout, which option appears more attractive?
Solution:
The present value of an annual pension of Rs.120,000 for 20 years when r = 10% is:
120,000 x PVIFA (10%, 20 years)
= 120,000 x 8.514
= Rs.1,021,680
The alternative is to receive a lumpsum of Rs 1,000,000
Rahul will be better off with the annual pension amount of Rs.120,000.
14. A leading bank has chosen you as the winner of its quiz competition and asked you
to choose from one of the following alternatives for the prize: (a) Rs. 60,000 in cash
immediately or (b) an annual payment of Rs. 10,000 for the next 10 years. If the
interest rate you can look forward to for a safe investment is 9 percent, which
option would you choose
14
Solution:
The present value of an annual payment of Rs.10,000 for 10 years when r = 9% is:
10,000 x PVIFA (9 %, 10 years)
= 10,000 x 6.418
= Rs. 64,180
The annual payment option would be the better alternative
15. What is the present value of an income stream which provides Rs.30,000 at the end
of year one, Rs.50,000 at the end of year three , and Rs.100,000 during each of the
years 4 through 10, if the discount rate is 9 percent ?
Solution:
The present value of the income stream is:
30,000 x PVIF (9%, 1 year) + 50,000 x PVIF (9%, 3 years)
+ 100,000 x PVIFA (9 %, 7 years) x PVIF (9%, 3 years)
= 30,000 x 0.917 + 50,000 x 0.772 + 100,000 x 5.033 x 0.0.772 = Rs.454,658.
16. What is the present value of an income stream which provides Rs.25,000 at the end
of year one, Rs.30,000 at the end of years two and three, and Rs.40,000 during each
of the years 4 through 8 if the discount rate is 15 percent ?
Solution:
25,000 x PVIF (15%, 1 year) + 30,000 x PVIF (15%, 2 years)
+ 30,000 x PVIF (15%, 3 years)
+ 40,000 x PVIFA (15 %, 5 years) x PVIF (15%, 3 years)
= 25,000 x 0.870 + 30,000 x 0.756 + 30,000 x 0.658
+ 40,000 x 3.352 x 0.658 = Rs.152,395.
15
17. What is the present value of an income stream which provides Rs.1,000 a year for
the first three years and Rs.5,000 a year forever thereafter, if the discount rate is 12
percent?
Solution:
1,000 x PVIFA (12%, 3 years) + (5,000/ 0.12) x PVIF (12%, 3 years)
= 1,000 x 2.402 + (5000/0.12) x 0.712
= Rs.32,069
18. What is the present value of an income stream which provides Rs.20,000 a year for
the first 10 years and Rs.30,000 a year forever thereafter, if the discount rate is 14
percent ?
Solution:

20,000 x PVIFA (14%, 10 years) + (30,000/ 0.14) x PVIF (14%, 10 years)
= 20,000 x 5.216 + (30,000/0.14) x 0.270
= Rs.162,177
19. Mr. Ganapathi will retire from service in five years .How much should he deposit
now to earn an annual income of Rs.240,000 forever beginning from the end of 6
years from now ? The deposit earns 12 percent per year.
Solution:
To earn an annual income of Rs.240,000 forever , beginning from the end of 6 years
from now, if the deposit earns 12% per year a sum of
Rs. 240,000 / 0.12 = Rs.2,000,000 is required at the end of 5 years. The amount that
must be deposited to get this sum is:
Rs.2,000,000 PVIF (12%, 5 years) = Rs.2,000,000 x 0.567

= Rs. 1,134,000
16
20. Suppose someone offers you the following financial contract. If you deposit
Rs.100,000 with him he promises to pay Rs.50,000 annually for 3 years. What
interest rate would you earn on this deposit?
Solution:
Rs.100,000 =- Rs.50,000 x PVIFA (r, 3 years)

PVIFA (r,3 years) = 2.00
From the tables we find that:

PVIFA (20 %, 3 years) = 2.106
PVIFA (24 %, 3 years) = 1.981
Using linear interpolation we get:
2.106 – 2.00
r = 20 % + ---------------- x 4%
2.106 – 1.981
= 23.39 %
21. If you invest Rs.600,000 with a company they offer to pay you Rs.100,000 annually
for 10 years. What interest rate would you earn on this investment?
Solution:
Rs.600,000 =- Rs.100,000 x PVIFA (r, 10 years)

PVIFA (r, 10 years) = 6.00

PVIFA (10 %, 10 years) = 6.145
PVIFA (11 %, 10 years) = 5.889
Using linear interpolation we get:
6.145 – 6.00
r = 10 % + ---------------- x 1%
6.145 – 5.889
= 10.57 %
17
22. What is the present value of the following cash flow streams?
End of year Stream X Stream Y Stream Z

1 500 750 600
2 550 700 600
3 600 650 600
4 650 600 600
5 700 550 600
6 750 500 600
---------------------------------------------------------------------------------------------
The discount rate is 18 percent.
Solution:
PV( Stream X) = 500 PV( 18%, 1yr) +550 PV( 18%, 2yrs) + 600 PV( 18%, 3yrs) + 650
PV( 18%, 4yrs) + 700 PV( 18%, 5yrs) + 750 PV( 18%, 6yrs)
= 500 x 0.847 +550 x 0.718 + 600 x 0.609 + 650 x 0.516 + 700 x 0.437 + 750 x 0.370
= 2102.6
PV( Stream X) = 750 PV( 18%, 1yr) +700 PV( 18%, 2yrs) + 650 PV( 18%, 3yrs) + 600
PV( 18%, 4yrs) + 550 PV( 18%, 5yrs) + 500 PV( 18%, 6yrs)
= 750 x 0.847 +700 x 0.718 + 650 x 0.609 + 600 x 0.516 + 550 x 0.437 + 500 x 0.370
= 2268.65
PV (Stream X) = 600 PVIFA (18%, 6yrs) = 600 x 3.498 = 2098.8
23. Suppose you deposit Rs.200,000 with an investment company which pays 12
percent interest with compounding done once in every two months, how much will
this deposit grow to in 10 years?
Solution:
FV10 = Rs.200,000 [1 + (0.12 / 6)]10x6

= Rs.200,000 (1.02)60
= Rs.200,000 x 3.281
= Rs.656,200
24. A bank pays interest at 5 percent on US dollar deposits, compounded once in every
six months. What will be the maturity value of a deposit of US dollars 15,000 for
three years?
Solution:
Maturity value = USD 15 ,000 [1 + (0.05 / 2)]3x2

= 15,000 (1.025)6
= 15,000 x 1.1597
= 17,395.50
18
25. What is the difference between the effective rate of interest and stated rate of
interest in the following cases:
Case A: Stated rate of interest is 8 percent and the frequency of compounding is six
times a year.
Case B: Stated rate of interest is 10 percent and the frequency of compounding is
four times a year.
Case C: Stated rate of interest is 12 percent and the frequency of compounding is
twelve times a year.
Solution:
A B C
Stated rate (%) 8 10 12
Frequency of compounding 6 times 4 times 12 times
Effective rate (%) (1 + 0.08/6)6- 1 (1+0.10/4)4 –1 (1 + 0.12/12)12-1
= 8.27 = 10.38 = 12.68
Difference between the

effective rate and stated
rate (%) 0.27 0.38 0.68
26. You have a choice between Rs.200,000 now and Rs.600,000 after 8 years. Which
would you choose? What does your preference indicate?
Solution:
The interest rate implicit in the offer of Rs.600,000 after 8 years in lieu of
Rs.200,000 now is:
Rs.200,000 x FVIF (r,8 years) = Rs.600,000
Rs.600,000
FVIF (r,8 years) = = 3.000
Rs.200,000
FVIF (15%, 8years) = 3.059
This means that the implied interest rate is nearly 15%.

I would choose Rs.600,000 after 8 years from now because I find a return of 15%
quite attractive.
19
27. Ravikiran deposits Rs.500,000 in a bank now. The interest rate is 9 percent and
compounding is done quarterly. What will the deposit grow to after 5 years? If the
inflation rate is 3 percent per year, what will be the value of the deposit after 5 years
in terms of the current rupee?
Solution:
FV5 = Rs.500,000 [1 + (0.09 / 4)]5x4

= Rs.500,000 (1.0225)20
= Rs.500,000 x 2.653
= Rs.780,255
If the inflation rate is 3 % per year, the value of Rs.780,255 5 years from now, in
terms of the current rupees is:
Rs.780,255 x PVIF (3%, 5 years)

= Rs.780,255 x 0. 863
= Rs.673,360
28. A person requires Rs.100,000 at the beginning of each year from 2015 to 2019.
Towards this, how much should he deposit (in equal amounts) at the end of each
year from 2007 to 2011, if the interest rate is 10 percent.
Solution:
The discounted value of Rs.100,000 receivable at the beginning of each year from
2015 to 2019, evaluated as at the beginning of 2014 (or end of 2013) is:
Rs.100,000 x PVIFA (10%, 5 years)

= Rs.100,000 x 3.791
= Rs.379,100
The discounted value of Rs.379,100 evaluated at the end of 2011 is
Rs.379,100 x PVIF (10 %, 2 years)

= Rs.379,100 x 0.826
= Rs.313,137
If A is the amount deposited at the end of each year from 2007 to 2011 then
A x FVIFA (10%, 5 years) = Rs.313,137
A x 6.105 = Rs.313,137
A = Rs.313,137/ 6.105
= Rs.51,292
20
29. You require Rs.250 ,000 at the beginning of each year from 2010 to 2012. How
much should you deposit (in equal amounts) at the beginning of each year in 2007
and 2008? The interest rate is 8 percent.
Solution:
The discounted value of Rs.250,000 receivable at the beginning of each year from
2010 to 2012, evaluated as at the beginning of 2009 (or end of 2008) is:
Rs.250,000 x PVIFA (8 %, 3 years)
= Rs.250,000 x 2.577= Rs.644,250
To have Rs. 644,250 at the end of 2008, let A be the amount that needs to be
deposited at the beginning of 2007 and 2008.We then have
Ax (1+0.08) x FVIFA ( 8%, 2years) = 644,250
A x 1.08 x 2.080 = 644,250 or A = 286,792
30. What is the present value of Rs.120,000 receivable annually for 20 years if the first
receipt occurs after 8 years and the discount rate is 12 percent.
Solution:
The discounted value of the annuity of Rs.120,000 receivable for 20 years,

evaluated as at the end of 7th year is:
Rs.120,000 x PVIFA (12%, 20 years) = Rs.120,000 x 7.469 = Rs.896,290
The present value of Rs. 896,290 is:
Rs. 896,290 x PVIF (12%, 7 years)
= Rs. 896,290 x 0.452
= Rs.405,119
21
31. What is the present value of Rs.89,760 receivable annually for 10 years if the first
receipt occurs after 5 years and the discount rate is 9 percent.
Solution:
The discounted value of the annuity of Rs.89,760 receivable for 10 years, evaluated
as at the end of 4th year is:
Rs. 89,760 x PVIFA (9%, 10 years) = Rs. 89,760 x 6.418 = Rs.576,080
The present value of Rs. 576,080is:
Rs. 576,080x PVIF (9%, 4 years)
= Rs. 576,080x 0.708
= Rs.407,865
32. After eight years Mr. Tiwari will receive a pension of Rs.10,000 per month for 20
years. How much can Mr. Tiwari borrow now at 12 percent interest so that the
borrowed amount can be paid with 40 percent of the pension amount? The interest
will be accumulated till the first pension amount becomes receivable.
Solution:
40 per cent of the pension amount is
0.40 x Rs.10,000 = Rs.4,000
Assuming that the monthly interest rate corresponding to an annual interest rate of
12% is 1%, the discounted value of an annuity of Rs.4,000 receivable at the end of
each month for 240 months (20 years) is:
Rs.4,000 x PVIFA (1%, 240)

(1.01)240 - 1
Rs.4,000 x ---------------- = Rs.363,278
.01 (1.01)240
If Mr. Tiwari borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)96 = Rs. 363,278

P x 2.60 = Rs. 363,278
Rs. 363,278
P = ------------ = Rs.139,722
2.60
22
33. After one year Mr. Khanna will receive a pension of Rs.15,000 per month for 30
years. How much can Mr. Khanna borrow now at 12 percent interest so that the
borrowed amount can be paid with 25 percent of the pension amount? The interest
will be accumulated till the first pension amount becomes receivable.
Solution:
25 per cent of the pension amount is
0.25 x Rs.15,000 = Rs.3,750
Assuming that the monthly interest rate corresponding to an annual interest rate of
12% is 1%, the discounted value of an annuity of Rs.3,750 receivable at the end of
each month for 360 months (30 years) is:
Rs.3,750 x PVIFA (1%, 360)
(1.01)360 - 1
Rs.3,750 x ---------------- = Rs.364,569
.01 (1.01)360
If Mr. Khanna borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)12 = Rs. 364,569

P x 1.127 = Rs. 364,569
Rs. 364,569
P = ------------ = Rs.323,486
1.127
34. You buy a car with a bank loan of Rs.525,000. An instalment of Rs.25,000 is
payable to the bank for each of 30 months towards the repayment of loan with
interest. What interest rate does the bank charge?
Solution:
Rs.25,000 x PVIFA(r, 30 months) = Rs.525,000
PVIFA (r, 30 months) = Rs.525,000 / Rs.25,000= 21
PVIFA (3%, 30) = 19.600
PVIFA (2%, 30) = 22.397
23
Using a linear interpolation
22.397 – 21.000
r = 2% + ---------------------- x 1%
22.397 – 19.600
= 2.50%
Thus, the bank charges an interest rate of 2.50 % per month.

The corresponding effective rate of interest per annum is
[(1.0250)12 – 1] x 100 = 34.49 %
35. You take a bank loan of Rs.174,000 repayable with interest in 18 monthly
instalments of Rs.12,000 What is the effective annual interest rate charged by the
bank ?
Solution:
Rs.12,000 x PVIFA(r, 18 months) = Rs.174,000
PVIFA (r, 18 months) = Rs.174,000 / Rs.12,000= 14.5
PVIFA (2%, 18) = 14.992
PVIFA (3%, 18) = 13.754
Using a linear interpolation
14.992 – 14.500
r = 2% + ---------------------- x 1%
14.992 – 13.754
= 2.397%
Thus, the bank charges an interest rate of 2.397 % per month.
The corresponding effective rate of interest per annum is
[(1.02397)12 – 1 ] x 100 = 32.88 %
24
36. Metro Corporation has to retire Rs.20 million of debentures each at the end of 6, 7,
and 8 years from now. How much should the firm deposit in a sinking fund account
annually for 5 years, in order to meet the debenture retirement need? The net
interest rate earned is 10 percent.
Solution:
The discounted value of the debentures to be redeemed between 6 to 8 years

evaluated at the end of the 5th year is:
Rs.20 million x PVIFA (10%, 3 years)
= Rs.20 million x 2.487
= Rs.49.74million
If A is the annual deposit to be made in the sinking fund for the years 1 to 5, then
A x FVIFA (10%, 5 years) = Rs.49.74 million
A x 6.105 = Rs.49.74 million
A = Rs.8,147,420
37. Ankit Limited has to retire Rs.30 million of debentures each at the end of 7, 8, 9
and 10 years from now. How much should the firm deposit in a sinking fund
account annually for 5 years, in order to meet the debenture retirement need? The
net interest rate earned is 12 percent.
Solution:
The discounted value of the debentures to be redeemed between 7 to 10 years

evaluated at the end of the 6th year is:
Rs.30 million x PVIFA (12%, 4 years)
= Rs.30 million x 3.037
= Rs.91.11 million
If A is the annual deposit to be made in the sinking fund for the years 1 to 6, then
A x FVIFA (12%, 6 years) = Rs.91.11 million
A x 8.115 = Rs. 91.11 million
A = Rs.11,227,357
25
38. Mr. Mehta receives a provident fund amount or Rs.800,000. He deposits it in a bank
which pays 9 percent interest. If he plans to withdraw Rs.100,000 at the end of each
year, how long can he do so ?
Solution:
Let `n’ be the number of years for which a sum of Rs.100,000 can be withdrawn
annually.
Rs.100,000 x PVIFA (9%, n) = Rs.800,000
PVIFA (9%, n) = Rs.800,000 / Rs.100,000 = 8 .000
PVIFA (9%, 14 years) = 7.786

PVIFA (9%, 15 years) = 8.060
Using a linear interpolation we get
8.000 – 7.786
n = 14 + ----------------- x 1 = 14.78 years
8.060 – 7.786
39. Mr. Naresh wants to invest an amount of Rs. 400,000, in a finance company at an
interest rate of 12 percent, with instructions to the company that the amount with
interest be repaid to his son in equal instalments of Rs.100,000, for his education
expenses . How long will his son get the amount?
Solution:
Let `n’ be the number of years for which a sum of Rs.100,000 can be withdrawn
annually.
Rs.100,000 x PVIFA (12%, n) = Rs.400,000
PVIFA (12 %, n) = Rs.400,000 / Rs.100,000 = 4
PVIFA (12%, 5 years) = 3.605
PVIFA (12%, 6 years) = 4.111
4.000 – 3.605
n = 5 + ----------------- x 1 = 5.78 years
4.111 – 3.605
26
40. Your company is taking a loan of 1,000,000, carrying an interest rate of 15 percent.
The loan will be amortised in five equal instalments. What fraction of the
instalment at the end of second year will represent principal repayment ?
Solution:
1,000,000
Annual instalment = = 298,329
3.352
Loan Amortisation Schedule
Year Beg. Instalment Interest Principal Balance

repayment
1 1,000,000 298,329 150,000 148,329 851,671
2 851,671 298,329 127,751 170,578 681,093
170,578 / 298,329 = 0.572 or 57.2%
41. Anurag Limited borrows Rs.2,000,000 at an interest rate of 12 percent. The loan is
to be repaid in 5 equal annual instalments payable at the end of each of the next 5
years. Prepare the loan amortisation schedule.
Solution:
Equated annual installment = 2,000,000 / PVIFA(12%,5)
= 2,000,000 / 3.605
= Rs.554,785
Loan Amortisation Schedule

Beginning Annual Principal Remaining
Year amount installment Interest repaid balance
------ ------------- --------------- ----------- ------------- -------------
1 2,000,000 554,785 240,000 314,785 1,685,215
2 1,685,215 554,785 202,226 352,559 1,332,656
3 1,332,656 554,785 159.919 394,866 937,790
4 937,790 554,785 112,535 442,250 495,540
5 495,540 554,785 59,465 495320 220*
(*) rounding off error
27
42. You want to borrow Rs.3,000,000 to buy a flat. You approach a housing company
which charges 10 percent interest. You can pay Rs.400,000 per year toward loan
amortisation. What should be the maturity period of the loan?
Solution:
Let n be the maturity period of the loan. The value of n can be obtained from
the equation.
400,000 x PVIFA (10%, n) = 3,000,000

PVIFA (10%, n) = 7.5
PVIFA (10%,14 years) = 7.367

PVIFA (10 %, 15 years) = 7.606
7.500 – 7.367
n = 14 + ----------------- x 1 = 14.56 years
7.606 – 7.367
43. You want to borrow Rs.5,000,000 to buy a flat. You approach a housing company
which charges 11 percent interest. You can pay Rs.600,000 per year toward loan
amortisation. What should be the maturity period of the loan?
Solution:
Let n be the maturity period of the loan. The value of n can be obtained from the
equation.
600,000 x PVIFA (11%, n) = 5,000,000
PVIFA (11%, n) = 8.333
PVIFA (11%, 20 years) = 7.963

PVIFA (11 %, 25 years) = 8.422
Using linear interpolation we get
8.333 – 7.963
n = 20 + ----------------- x 5 = 24.03 years
8.422 – 7.963
28
44. You are negotiating with the government the right to mine 160,000 tons of iron ore
per year for 20 years. The current price per ton of iron ore is Rs.3500 and it is
expected to increase at the rate of 8 percent per year. What is the present value of
the iron ore that you can mine if the discount rate is 15 percent
Solution:
Expected value of iron ore mined during year 1= 160,000x3500 x1.08

= Rs.604.8 million
Expected present value of the iron ore that can be mined over the next 20 years
assuming a price escalation of 8% per annum in the price per ton of iron
1 – (1 + g)n / (1 + i)n
= Rs. 604.8 million x ------------------------
i-g
= Rs. 604.8 million x 1 – (1.08)20 / (1.15)20

0.15 – 0.08
= Rs. 604.8 million x 10.2173
= Rs.6,179,423,040
45. You are negotiating with the government the right to mine 300,000 tons of iron ore
per year for 25 years. The current price per ton of iron ore is Rs.3200 and it is
expected to increase at the rate of 7 percent per year. What is the present value of
the iron ore that you can mine if the discount rate is 18 percent
Solution:
Expected value of iron ore mined during year 1= 300,000x3200 x 1.07

= Rs.1027.2 million
Expected present value of the iron ore that can be mined over the next 25 years
assuming a price escalation of 7% per annum in the price per ton of iron
1 – (1 + g)n / (1 + i)n
= Rs. 1027.2 million x ------------------------
i-g
= Rs. 1027.2 million x 1 – (1.07)25 / (1.18)25

0.18 – 0.07
29
= Rs. 1027.2 million x 8.3036
= Rs.8,529,457,920
46. As a winner of a competition, you can choose one of the following prizes:
a. Rs. 800,000 now

b. Rs. 2,000,000 at the end of 8 years
c. Rs. 100,000 a year forever
d. Rs. 130,000 per year for 12 years
e. Rs. 32,000 next year and rising thereafter by 8 percent per year
forever.
If the interest rate is 12 percent, which prize has the highest present value?
Solution:
(a) PV = Rs.800,000
(b) PV = 2,000,000PVIF12%,8yrs = 2,000,000 x 0.0.404 = Rs.808,000
(c ) PV = 100,000/r = 100,000/0.12 = Rs. 833,333
(d) PV = 130,000 PVIFA12%,12yrs = 130,000 x 6.194 = Rs.805,220
(e) PV = C/(r-g) = 32,000/(0.12-0.08) = Rs.800,000
Option c has the highest present value viz. Rs.833,333
47. Oil India owns an oil pipeline which will generate Rs. 20 million of cash income in
the coming year. It has a very long life with virtually negligible operating costs.
The volume of oil shipped, however, will decline over time and, hence, cash flows
will decrease by 4 percent per year. The discount rate is 15 percent.
a. If the pipeline is used forever, what is the present value of its cash flows?
b. If the pipeline is scrapped after 30 years, what is the present value of its cash
flows?
Solution:
(a) PV = c/(r – g) = 20/[0.15 – (-0.04)] = Rs.105.26 million
1+g n
1 - -------
(b) 1+r
PV = A(1+g) ----------------- = 20 x 0.96 x 5.2398 = Rs.100.604 million
r- g
30
48. Petrolite owns an oil pipeline which will generate Rs. 15 million of cash income in
the coming year. It has a very long life with virtually negligible operating costs.
The volume of oil shipped, however, will decline over time and, hence, cash flows
will decrease by 6 percent per year. The discount rate is 18 percent.
a. If the pipeline is used forever, what is the present value of its cash flows?
b. If the pipeline is scrapped after 10 years, what is the present value of its cash
flows?
Solution:
(a) PV = c/(r – g) = 15/[0.18 – (-0.06)] = Rs.62.5 million
1+g n
1 - -------
(b) 1+r
PV = A(1+g) ----------------- = 15 x 0.94 x 3.7379 = Rs.52.704 million
r- g
31
MINICASE
1. As an investment advisor, you have been approached by a client called Vikas for
your advice on investment plan. He is currently 40 years old and has Rs.600,000 in
the bank. He plans to work for 20 years more and retire at the age of 60. His present
salary is Rs.500,000 per year. He expects his salary to increase at the rate of 12
percent per year until his retirement.
Vikas has decided to invest his bank balance and future savings in a balanced
mutual fund scheme that he believes will provide a return of 9 percent per year.
You agree with his assessment.
Vikas seeks your help in answering several questions given below. In answering
these questions, ignore the tax factor.
(i) Once he retires at the age of 60, he would like to withdraw Rs.800,000 per year
for his consumption needs from his investments for the following 15 years (He
expects to live upto the age of 75 years). Each annual withdrawal will be made at
the beginning of the year. How much should be the value of his investments
when Vikas turns 60, to meet this retirement need?
(ii) How much should Vikas save each year for the next 20 years to be able to
withdraw Rs.800,000 per year from the beginning of the 21st year ? Assume that
the savings will occur at the end of each year.
(iii) Suppose Vikas wants to donate Rs.500,000 per year in the last 5 years of his life to a
charitable cause. Each donation would be made at the beginning of the year. Further,
he wants to bequeath Rs.1,000,000 to his son at the end of his life. How much should
he have in his investment account when he reaches the age of 60 to meet this need
for donation and bequeathing?
(iv) Vikas is curious to find out the present value of his lifetime salary income. For the
sake of simplicity, assume that his current salary of Rs.500,000 will be paid exactly
one year from now, and his salary is paid annually. What is the present value of his
life time salary income, if the discount rate applicable to the same is 7 percent?
Remember that Vikas expects his salary to increase at the rate of 12 percent per
year until retirement.
Solution:
(i)
This is an annuity due
Value of annuity due = Value of ordinary annuity (1 + r)
The value of investments when Vikas turns 60 must be:
800,000 x PVIFA (9%, 15 years) x 1.09
= 800,000 x 8.060 x 1.09 = Rs.7,028,320
32
(ii) He must have Rs.7,092,800 at the end of the 20th year.
His current capital of Rs.600,000 will grow to:
Rs.600,000 x FVIF (9%, 20yrs) = 600,000 x 5.604
= Rs.3,362,400
So, what he saves in the next 15 years must cumulate to:
7,028,320 – 3,362,400 = Rs.3,665,920

A x FVIFA (9%, 20 yrs) = Rs.3,665,920
A x 51.160 = 3,665,920
A = 3,665,920/51.160 = Rs.71,656
(iii)
60 69 70 71 72 73 74 75
A A A A A
1,000,000
To meet his donation objective, Vikas will need an amount equal to:
500,000 x PVIFA (9%, 5years) when he turns 69.
This means he will need
500,000 x PVIFA (9%, 5yrs) x PVIF (9%, 9yrs) when he turns 60.
This works out to:
500,000 x 3.890 x 0.460 = Rs.894,700
To meet his bequeathing objective he will need
1,000,000 x PVIF (15%, 9yrs) when he turns 60
This works out to:
1,000,000 x 0.275 = Rs.275,000
So, his need for donation and bequeathing is: 894,700 + 275,000
= Rs.1,169,700
(iv)
(1+g)n
1-
(1+r)n
PVGA = A (1+g)
r–g
Where A(1+g) is the cash flow a year from now. In this case A (1+g) = Rs.500,000,
g = 12%, r = 7%, and n = 20
So,
(1.12)20
1-
(1.07)20
PVGA = 500,000
0.07 – 0.12 MINICASE 2
2. As an investment advisor, you have been approached by a client called Ravi for
= Rs.14,925,065
advice on his investment plan. He is 35 years and has Rs.200, 000 in the bank. He
33
plans to work for 25 years more and retire at the age of 60. His present salary is
500,000 per year. He expects his salary to increase at the rate of 12 percent per year
until his retirement.
Ravi has decided to invest his bank balance and future savings in a balanced
mutual fund scheme that he believes will provide a return of 9 percent per year.
You concur with his assessment.
Ravi seeks your help in answering several questions given below. In answering
these questions, ignore the tax factor.
(i) Once he retires at the age of 60, he would like to withdraw Rs. 900,000 per year
for his consumption needs for the following 20 years (His life expectancy is
80years).Each annual withdrawal will be made at the beginning of the year.
How much should be the value of his investments when he turns 60, to meet his
retirement need?
(ii) How much should Ravi save each year for the next 25 years to be able to
withdraw Rs.900, 000 per year from the beginning of the 26th year for a period
of 20 years?
Assume that the savings will occur at the end of each year. Remember that he
already has some bank balance.
(iii) Suppose Ravi wants to donate Rs.600, 000 per year in the last 4 years of his life
to a charitable cause. Each donation would be made at the beginning of the year.
Further he wants to bequeath Rs. 2,000,000 to his daughter at the end of his life.
How much should he have in his investment account when he reaches the age of
60 to meet this need for donation and bequeathing?
(iv) Ravi wants to find out the present value of his lifetime salary income. For the
sake of simplicity, assume that his current salary of Rs 500,000 will be paid
exactly one year from now, and his salary is paid annually. What is the present
value of his lifetime salary income, if the discount rate applicable to the same is
8 percent? Remember that Ravi expects his salary to increase at the rate of 12
percent per year until retirement.
Solution:
(i)
900,000 x PVIFA ( 9 %, 20 ) x 1.09
900,000 x 9.128 x 1.09
= Rs. 8,954,568
(ii) Ravi needs Rs. 8,954,568 when he reaches the age of 60.
His bank balance of Rs. 200,000 will grow to : 200,000 ( 1.09 )25
= 200,000 ( 8.623 ) = Rs. 1,724,600
This means that his periodic savings must grow to:
Rs. 8,954,568 - Rs. 1,724,600 = Rs. 7,229,968
34
His annual savings must be:
7,229,968 7,229,968
A = =
FVIFA ( 25, 9% ) 84.701
= Rs. 85,359
(iii)
75 76
600 600 600 600

2000
Amount required for the charitable cause:
600,000 x PVIFA ( 9% , 4yrs ) x PVIF ( 9%, 15yrs )

= 600,000 x 3.240 x 0.275
= Rs. 534,600
Amount required for bequeathing
2,000,000 x PVIF (9%, 20yrs )

= 2,000,000 x 0.178
= Rs. 356,000
35
(iv)
A(1+g) A ( 1 + g )n
0 1 n
( 1 + g )n
PVGA = A(1+ g) 1 -
( 1 + r )n
r - g
( 1.12 )25
= 500,000 1 -
( 1.08 )25
0.08 - 0.12
= Rs. 18,528,922
36
CHAPTER 6
FINANCIAL STATEMENT ANALYSIS
1. At 31st March, 20X6 the balances in the various accounts of Dhoni & Company are
as follows:
Rs. in million
Accounts Balance
Equity capital 120
Preference capital 30
Fixed assets (net) 217
Reserves and surplus 200
Cash and bank 35
Debentures (secured) 100
Marketable securities 18
Term loans (secured) 90
Receivables 200
Short-term bank borrowing (unsecured) 70
Inventories 210
Trade creditors 60
Provisions 20
Pre-paid expenses 10
Required: Prepare the balance sheet of Dhoni & Company as per the format
specified by the Companies Act.
Solution:
st
Balance Sheet of Dhoni & Company as at 31 March, 20X6
31st March,
20X6
EQUITY AND LIABILITIES
Shareholders' Funds 350
Share capital 150
Reserves and surplus 200
Non-current Liabilities 190
Long-term borrowings 190
Deferred tax liabilities(net)
Long-term provisions
Current Liabilities 150
Short-term borrowings 70
Trade payables 60
Other current liabilities
Short-term provisions 20
Total 690
ASSETS
Non-current Assets 217
Fixed assets 217
Non-current investments
Long-term loans and advances
37
Current Assets 473
Current investments 18
Inventories 210
Trade receivables 200
Cash and cash equivalents 35
Short-term loans and advances
10
Other current assets
Total 690
Note: As per the balance sheet format in the revised Companies Act 1956
1. The breakup of the capital into equity and preference is to be given in the
schedule forming part of the balance sheet
2. The breakup of long term borrowings into Debentures and Term loans is to be
given in the schedule forming part of the balance sheet
3. Current assets like prepaid expenses are to be included under the heading ‘Other
current assets’ which is an all-inclusive heading to incorporate current assets that do not
fit into any other asset categories
2.
Balance Sheet of Zenith Ltd. as at March 31, 20X2

Rs. in million
20X2 20X1
Shareholders' Funds 860 800
Share capital * 300 300
Reserves and surplus 560 500
Non-current Liabilities 565 530
Long-term borrowings** 420 400
Deferred tax liabilities(net) 75 70
Long-term provisions 70 60
Current Liabilities 318 310
Short-term borrowings 190 200
Trade payables 90 80
Other current liabilities 26 20
Short-term provisions 12 10
Total 1743 1640
ASSETS
Non-current Assets 643 610
Fixed assets 520 500
Non-current investments 101 90
Long-term loans and advances 22 20
Current Assets 1100 1030
Current investments 50 80
Inventories 510 480
Trade receivables 480 420
Cash and cash equivalents 12 10
38
Short-term loans and advances 48 40
Total 1743 1640
* Par value of share Rs. 10
** Out of which Rs.100 million is payable within 1 year
Statement of Profit and Loss for Zenith Ltd. for the year ended March 31, 20X2
Rs. in million
Revenue from operations 1000
@
Other income 30
Total revenues 1030
Expenses
Material expenses 420
Employee benefits expenses 300
Finance costs 70
Depreciation and amortization expenses 50
Other expenses 28
Total expenses 868
Profit before exceptional and extraordinary
items and tax 162
Exceptional items ------
Profit before extraordinary items and tax 162
Extraordinary items ------
Profit before tax 162
Tax expenses 42
Profit( loss for the period) 120
Dividends 60
@ Consists entirely of interest income.
Required: (a) Prepare the sources and uses of cash statement for the period 1-4-
20X1 to 31-3-20X2
(b) Prepare the cash flow statement for the period 1-4-20X1 to 31-3-20X2
(c)
Calculate the following ratios for the year 20X2
Current ratio, acid-test ratio, cash ratio, debt-equity ratio, interest coverage ratio,
fixed charges coverage ratio ( assume a tax rate of 30 percent), inventory turnover
ratio (assume the cost of goods sold to be Rs.580 million), debtor turnover ratio,
average collection period, total assets turnover, gross profit margin, net profit
margin, return on assets, earning power, return on equity
Solution:
39
(a) Rs. in million
Sources Uses
Net profit 120 Dividend payment 60
Depreciation and amortisation
50
Increase in deferred tax liabilities 5 Decrease in short-term borrowings 10
Increase in long-term provisions 10 Purchase of fixed assets 70
Increase in non-current
Decrease in current investments 30 investments 11
Increase in short-term loans and
Increase in other current liabilities 6 advances given 8
Increase in short-term provisions 2 Increase in inventories 30
Increase in trade payables 10 Increase in trade receivables 60

Increase in long-term borrowings
Increase in long-term loans and
20 advances 2
Total sources 253 Total uses 251
Net addition to cash 2
(b)
Cash Flow Statement
Rs. in million
A. CASH FLOW FROM OPERATING ACTIVITIES
PROFIT BEFORE TAX 162
Adjustments for:
Depreciation and amortisation 50
Finance cost 70
Interest income (30)
OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES 252
Adjustments for changes in working capital:
Trade receivables and short-term loans and advances (68)
Inventories (30)
Current investments 30
Trade payables, short-term provisions, other current liabilities and short-term
provisions 18
CASH GENERATED FROM OPERATIONS 202
Direct taxes paid (42)
NET CASH FROM OPERATING ACTIVITIES 160
B.CASH FLOW FROM INVESTING ACTIVITIES
Purchase of fixed assets (70)
Increase in non-current investments (11)
Interest income 30
NET CASH USED IN INVESTING ACTIVITIES (51)
C.CASH FLOW FROM FINANCING ACTIVITIES
Increase in long- term borrowings 20
Increase in long-term loans and advances given (2)
Decrease in short-term borrowings (10)
40
Increase in deferred tax liabilities 5
Increase in long-term provisions 10
Dividend paid (60)
Finance costs (70)
NET CASH USED IN FINANCING ACTIVITIES (107)
NET CASH GENERATED (A+B+C) 2
CASH AND CASH EQUIVALENTS AT THE BEGINNING OF PERIOD 10
CASH AND CASH EQUIVALENTS AT THE END OF PERIOD 12
(c)
1100
Current ratio = = 2.63
318 + 100
1100 - 510
Acid-test ratio = = 1.41
318 + 100
12 + 50
Cash ratio = = 0.15
318 + 100
883
Debt-equity ratio = = 1.03
860
162 +70
Interest coverage ratio = = 3.31
70
(162 +70)+ 50
Fixed charges coverage ratio = = 1.32
70 + 100/(1 – 0.30)
1000
Inventory turnover ratio = = 2.02
(510+ 480)/2
1000
Debtors turnover = = 2.22
(480 + 420)/2
41
365
Average collection period = = 164 days
2.22
1030
Total assets turnover ratio = = 0.61
(1743 +1640)/2
(1030-580)
Gross profit margin = = 43.69 %
1030
120
Net profit margin = = 11.65 %
1030
120
Return on assets = = 7.09 %
(1743 +1640)/2
162+70
Earning power = = 13.71 %
(1743 +1640)/2
120
Return on equity = = 13.95 %
860
3. Premier Company's net profit margin is 8 percent, total assets turnover ratio is 2.5
times, debt to total assets ratio is 0.6. What is the return on equity for Premier?
Solution:
Net profit
Return on equity =
Equity
= Net profit Total revenues Total assets
x x
Total revenues Total assets Equity
1
= 0.08 x 2.5 x = 0.5 or 50 per cent
0.4
42
Debt Equity
Note : = 0.6 So = 1- 0.6 = 0.4
Total assets Total assets
Hence Total assets/Equity = 1/0.4
4. The following information is given for Alpha Corporation

Sales(total revenues) 3500
Current ratio 1.5
Acid test ratio 1.2
Current liabilities 1000
What is the inventory turnover ratio?
Solution:
Current assets = Current liabilities x 1.5
= 1000 x 1.5 = 1500
Quick assets = Current liabilities x 1.2

= 1000 x 1.2 = 1200
Inventories = 300
3500
300
5. The following information is given for Beta Corporation.

Sales (total revenues) 5000
Current ratio 1.4
Inventory turnover 5
ratio
Acid test ratio 1.0
What is the level of current liabilities?
43
Solution:
Inventory = 5000/5 = 1000
Current assets
Current liabilities
Current assets – Inventories

Acid test ratio = = 1.0
Current Liabilities
C.A - 1000
= 1.0
CL
CA 1000
- = 1.0
CL CL
1000
1.4 - = 1.0
CL
1000
0.4 = CL = 2500
CL
6. Safari Inc. has profit before tax of Rs.90 million. If the company's times interest
covered ratio is 4, what is the total interest charge?
Solution:
PBT = Rs.90 million

PBIT
Times interest covered = = 4
Interest
So PBIT = 4 x Interest
PBT = PBIT – interest

= 4 x interest - interest = 3 x interest = 90 million
Therefore interest = 90/3 = Rs.30 million
44
7. A has profit before tax of Rs.40 million. If its times interest covered ratio is 6, what
is the total interest charge?
Solution:
PBT = Rs. 40 million

PBIT
Interest
PBIT – Interest = PBT = Rs.40 million
6 x Interest – Interest = Rs. 40 million

5 x Interest = Rs.40 million
Hence Interest = Rs.8 million
8. McGill Inc. has profit before tax of Rs.63 million. If the company's times interest
covered ratio is 8, what is the total interest charge?
Solution:
PBT = Rs.63 million

PBIT
Interest
PBIT – Interest = PBT = Rs.63 million
8 x Interest – Interest = 7 x Interest = Rs.63 million
Hence Interest = Rs.9 million
9. The following data applies to a firm:
Interest charges Rs.200,000

Sales(total revenues) Rs.6,000,000
Tax rate 40 percent
Net profit margin 5 percent
What is the firm's times interest covered ratio?
45
Solution:
Sales = Rs.6,000,000
Net profit margin = 5 per cent
Net profit = Rs.6,000,000 x 0.05 = 300,000
Tax rate = 40 per cent
300,000
So, Profit before tax = = Rs.500,000
(1-.4)
Interest charge = Rs.200,000
So Profit before interest and taxes = Rs.700,000
Hence 700,000
Times interest covered ratio = = 3.5
200,000
Interest charges Rs.50,000

Sales(total revenues) Rs.300,000
Tax rate 25 percent

Solution:
Sales = Rs.300,000
Net profit = Rs.300,000 x 0.03 = 9,000
9,000
So, Profit before tax = = Rs.12,000
(1-.25)
Interest charge = Rs.50,000
So Profit before interest and taxes = Rs.62,000
Hence 62,000
50,000
46
Interest charges Rs.10,000,000

Sales(total revenues) Rs.80,000,000
Tax rate 50 percent
Solution:
Sales = Rs.80,000,000
Net profit = Rs.80,000,000 x 0.1 = 8,000,000

8,000,000
So, Profit before tax = = Rs.16,000,000
(1-.5)
Interest charge = Rs.10,000,000
So Profit before interest and taxes = Rs.26,000,000

Hence
26,000,000
10,000,000
12. A firm's current assets and current liabilities are 25,000 and 18,000 respectively.
How much additional funds can it borrow from banks for short term, without
reducing the current ratio below 1.35?
Solution:
CA = 25,000 CL = 18,000
Let BB stand for bank borrowing
CA+BB
= 1.35
CL+BB
25,000+BB
= 1.35
18,000+BB
1.35x 18,000 + 1.35 BB = 25,000 + BB
0.35BB = 25,000- 24,300 = 700
BB = 700/0.35 = 2,000
47
13. LNG’s current assets and current liabilities are 200,000 and 140,000 respectively.
How much additional funds can it borrow from banks for short term, without
reducing the current ratio below 1.33?
Solution:
CA = 200,000 CL = 140,000
CA+BB
= 1.33
CL+BB
200,000+BB
= 1.33
140,000+BB
1.33 x 140,000 + 1.33BB = 200,000 + BB
0.33 BB = 200,000- 186,200 = 13,800
BB =13,800/0.33 = 41,818
14. Navneet’s current assets and current liabilities are 10,000,000 and 7,000,000
respectively. How much additional funds can it borrow from banks for short term,
without reducing the current ratio below 1.4?
Solution:
CA = 10,000,000 CL = 7,000,,000
CA+BB
= 1.4
CL+BB
10,000,000+BB
= 1.4
7,000,000+BB
1.4 x 7,000,000 + 1.4BB = 10,000,000 + BB
0.4 BB = 10,000,000- 9,800,000 = 200,000
BB = 200,000/0.40 = 500,000
48
15. A firm has total annual sales(i.e. revenues from operations ) (all credit) of
25,000,000 and accounts receivable of 8,000,000. How rapidly (in how many days)
must accounts receivable be collected if management wants to reduce the accounts
receivable to 6,000,000?
Solution:
25,000,000
Average daily credit sales = = 68,493
365
If the accounts receivable has to be reduced to 6,000,000 the ACP must be:
6,000,000
= 87.6 days
68,493
16 A firm has total annual sales( i.e. revenues from operations) (all credit) of 1,200,000
and accounts receivable of 500,000. How rapidly (in how many days) must
accounts receivable be collected if management wants to reduce the accounts
receivable to 300,000?
Solution:
1,200,000
Average daily credit sales = = 3287.67
365
If the accounts receivable has to be reduced to 300,000 the ACP must be:
300,000
= 91.3 days
3287.67
17. A firm has total annual sales((i.e. revenues from operations) (all credit) of
100,000,000 and accounts receivable of 20,000,000. How rapidly (in how many
days) must accounts receivable be collected if management wants to reduce the
accounts receivable to 15,000,000?
Solution:
100,000,000
Average daily credit sales = = 273,972.6
365
If the accounts receivable has to be reduced to 15,000,000 the ACP must be:
15,000,000
= 54.8 days
273,972.6
49
18. The financial ratios of a firm are as follows.
Current ratio = 1.25

Acid-test ratio = 1.10
Current liabilities = 2000
Inventory turnover ratio = 10
What is the sales(i.e. revenues from operations) of the firm?
Solution:
Current assets = Current liabilities x Current ratio

= 2000 x 1.25 = 2500
Current assets - Inventories = Current liabilities x Acid test ratio
= 2000 x 1.10 = 2200
Inventories = 300
Sales = Inventories x Inventory turnover ratio
= 300 x 10 = 3000
Current ratio = 1.33

Current liabilities = 40,000
Solution:

= 40,000 x 1.33 = 53,200

= 40,000 x 0.80
= 32,000
Inventories = 21,200

= 21,200 x 6 = 127,200
50
Current ratio = 1.6

Current liabilities = 2,000,000
Solution:

= 2,000,000 x 1.6 = 3,200,000

= 2,000,000 x 1.2
= 2,400,000
Inventories = 800,000
= 800,000 x 5 = 4,000,000
21. Complete the balance sheet and sales data (fill in the blanks) using the following
financial data:
Debt/equity ratio = 0.80

Total assets turnover ratio = 2
Days' sales outstanding in
Accounts receivable = 30 days
Cost of goods sold as a
percentage of total revenues = 70 percent
51
Balance Sheet
Equity capital 80,000

Retained earnings 50,000
Debt --------
--------
Plant and equipment --------

Inventories --------
Accounts receivable --------
Cash --------
--------
Revenues from operations ---------

Other income Nil
Solution:
Debt/equity = 0.80
Equity = 80,000 + 50,000 = 130,000
So Debt = Short-term bank borrowings = 0.8 x 130,000 = 104,000
Hence Total assets = 130,000+104,000 = 234,000
Total assets turnover ratio = 2
So total revenues = 2 x 234,000 = 468,000
Revenues from operations = Total revenues – Other income
= 468,000 -0 = 468,000
So Cost of goods sold = 0.7 x 468,000 = 327,600
Day’s sales outstanding in accounts receivable = 30 days
Sales
So Accounts receivable = x 30
360
468,000
= x 30 = 39,000
360
52
Cost of goods sold 327,600
Inventory turnover ratio = = = 6
Inventory Inventory
So Inventory = 54,600
As short-term bank borrowing is a current liability,
Cash + Accounts receivable
Acid-test ratio =
Current liabilities
Cash + 39,000
= = 1.1
104 ,000
So Cash = 75,400
Plant and equipment = Total assets - Inventories – Accounts receivable – Cash
= 234,000 - 54,600 - 39,000 – 75,400
= 65,000
Putting together everything we get

Balance Sheet

Debt 104,000
234,000
Plant and equipment 65,000

Inventories 54,600
Accounts receivable 39,000
Cash 75,400
234,000
Revenues from operations 468,000

Other income Nil
53
financial data:

Total assets turnover ratio = 2.5
Balance sheet

Debt --------
--------

Cash --------
--------

Other income Nil
Solution:
Debt/equity = 0.40
Equity = 160,000,000 + 30,000,000 = 190,000,000
So Debt = Short-term bank borrowings = 0.4 x 190,000,000 = 76,000,000
Hence Total assets = 190,000,000+ 76,000,000 = 266,000,000
So total revenues = 2.5 x 266,000,000= 665,000,000
= 665,000,000 -0 = 665,000,000
So Cost of goods sold = 0.75 x 665,000,000 = 498,750,000

54
Sales
360
665,000,000
= x 25 = 46,180,556
360
Cost of goods sold 498,750,000
Inventory Inventory
So Inventory = 62,343,750
As short-term bank borrowings is a current liability,
Acid-test ratio =
Current liability
Cash + 46,180,556
= = 0.9
76,000 ,000
So Cash = 22,219,444
= 266,000,000 - 62,343,750 - 46,180,556 – 22,219,444
= 135,256,250

Balance Sheet
Equity capital 160,000,000

Retained earnings 30,000,000
Debt 76,000,000
266,000,000
Plant and equipment 135,256,250

Inventories 62,343,750
Accounts receivable 46,180,556
Cash 22,219,444
266,000,000
Revenues from operations 665,000

Other income Nil
55
financial data:

Debt --------
--------

Cash --------
--------

Other income Nil
Solution:
Debt/equity = 1.5
Equity = 600,000 + 100,000 = 700,000
So Debt = Short-term bank borrowings =1.5 x 700,000 = 1050,000
Hence Total assets = 700,000+1050,000 = 1,750,000
So total revenues = 1.9 x 1,750,000= 3,325,000
= 3,325,000 -0 = 3,325,000
So Cost of goods sold = 0.72 x 3,325,000 = 2,394,000

56
Sales
360
3,325,000
= x 25 = 230,903
360
Cost of goods sold 2,394,000
Inventory Inventory
So Inventory = 342,000
As short-term bank borrowings is a current liability,
Acid-test ratio =
Current liabilities
Cash + 230,903
= = 0.3
1050 ,000
So Cash = 84,097
= 1,750,000 – 342,000 – 230,903 – 84,097
= 1,093,000
Balance Sheet

Debt 1,050,000
1,750,000
Plant and equipment 1,093,000

Inventories 342,000
Accounts receivable 230,903
Cash 84,097
1,750,000
Revenues from operations 3,325,000

Other income Nil
57
24. Compute the financial ratios for Acme Ltd.
Balance Sheet of Acme Ltd. as at March 31, 20X2

Rs. in million
20X2 20X1
Share capital * 100 100
Reserves and surplus 340 300
Non-current Liabilities 180 140
Long-term borrowings** 130 100
Deferred tax liabilities(net) 25 20
Long-term provisions 25 20
Current Liabilities 286 208
Short-term borrowings 100 80
Trade payables 152 100
Other current liabilities 24 20
Short-term provisions 10 8
Total 906 748
ASSETS
Non-current Assets 430 410
Fixed assets 355 300
Non-current investments 50 80
Long-term loans and advances 25 30
Current Assets 476 338
Current investments 8 10
Inventories 267 166
Trade receivables 190 150
Cash and cash equivalents 6 5
Short-term loans and advances 5 7
Total 906 748
* Par value of share Rs. 10
** Out of which Rs. 30 million is payable within 1 year
Statement of Profit and Loss for Acme Ltd. for the year ended March 31, 20X2
Rs. in million
Revenue from operations 800
@
Other income 10
Total revenues 810
Expenses
Material expenses 350
Employee benefits expenses 180
Finance costs 60
Depreciation and amortization expenses 50
Other expenses 12
Total expenses 652
Profit before exceptional and extraordinary
items and tax 158
58
Exceptional items ------
Profit before extraordinary items and tax 158
Extraordinary items ------
Profit before tax 158
Tax expenses 48
Profit( loss for the period) 110
Dividends 70
@ Consists entirely of interest income.
Calculate the following ratios for the year 20X2

Current ratio, acid-test ratio, cash ratio, debt-equity ratio, interest coverage ratio,
fixed charges coverage ratio ( assume a tax rate of 31 percent), inventory turnover
ratio (assume the cost of goods sold to be Rs.450 million), debtor turnover ratio,
average collection period, total assets turnover, gross profit margin, net profit
margin, return on assets, earning power, return on equity
Solution:
476
286 +30
476 - 267
Acid-test ratio = = 0.66
286 +30
6 +8
Cash ratio = = 0.04
286 +30
466
Debt-equity ratio = = 1.06
440
158 +60
Interest coverage ratio = = 3.63
60
(158 +60)+ 50
Fixed charges coverage ratio = = 2.59
60 + 30/(1 – 0.31)
800
59
(267+ 166)/2
800
Debtors turnover = = 4.71
(190 + 150)/2
365
Average collection period = = 77 days
4.71
810
Total assets turnover ratio = = 0.98
(906 +748)/2
(800- 450)
Gross profit margin = = 43.75 %
800
110
Net profit margin = = 13.58 %
810
110
Return on assets = = 13.30 %
(906 +748)/2
158+60
Earning power = = 26.36 %
(906 +748)/2
110
Return on equity = = 25 %
440
60
25. The Balance sheets and Profit and Loss accounts of LKG Corporation are given
below.
Prepare the common size and common base financial statements.
Statement of Profit and Loss

Rs. in million
20X1 20X0
Total Revenues 810 700
Expenses excluding financing cost and tax 592 520
Profit before financing cost and tax 218 180

Financing cost 60 50
Proft before tax 158 130
Tax 48 36
Proft(loss) for the period 110 94
Part B : Balance Sheet
Rs. in million
20X1 20X0
Non- current liabilities
- Long-term borrowings 130 100
50 40
- Other non-current liabilities
Current liabilities 286 208
Total 906 748
Non- current assets
- Fixed assets 355 300
- 75 110
Other non-current assets
Current assets 476 338
Total 906 748
61
Solution:
Part A: Profit and Loss Account
Regular(in million) Common Size (%)
20X0 20zX1 20X0 20X1
Total Revenues 700 810 100 100
Expenses excluding financing cost and tax 520 592 74 73
Profit before financing cost and tax 180 218 26 27

Financing cost 50 60 7 7
Proft before tax 130 158 19 20
Tax 36 48 5 6
Proft(loss) for the period 94 110 13 14
20X0 20X1 20X0 20X1
Shareholders' Funds 400 440 53 49
Non- current liabilities 13 14
40 50 5 6
Current liabilities 208 286 28 32
Total 748 906 100 100
Non- current assets 40 37
- 110 75 15 8
Current assets 338 476 45 53
Total 748 906 100 100

Regular(Rs.in Common Base
million) Year (%)
20X0 20X1 20X0 20X1
Tax 36 48 100 133
62
40 50 100 125
Total 748 906 100 121
- 110 75 100 68
Total 748 906 100 121
26. The Balance sheets and Profit and Loss accounts of Zenith Ltd. are given below.
Prepare the common size and common base financial statements.
Statement of Profit and Loss
Rs. in million
20X1 20X0
Total Revenues 1030 950
Expenses excluding financing cost and tax 798 750
Profit before financing cost and tax 232 200

Financing cost 70 60
Proft before tax 162 140
Tax 42 40
Proft(loss) for the period 120 100
Rs. in million
20X1 20X0
Non- current liabilities
145 130
Current liabilities 318 310
Total 1743 1640
Non- current assets
63
- 123 110
Current assets 1100 1030
Total 1743 1640
Solution:
20X0 20X1 20X0 20X1

Tax 40 42 4 4
20X0 20X1 20X0 20X1
130 145 8 6
Total 1640 1743 100 100
- 110 123 7 7
Total 1640 1743 100 100
64
Regular(Rs.in Common Base
million) Year (%)
20X0 20X1 20X0 20X1
Tax 40 42 100 105
130 145 100 112
Total 1640 1743 100 106
- 110 123 100 112
Total 1640 1743 100 106
65
CHAPTER 7
PORTFOLIO THEORY
1. The returns of two assets under four possible states of nature are given below:
State of nature Probability Return on asset 1 Return on asset 2

1 0.40 -6% 12%
2 0.10 18% 14%
3 0.20 20% 16%
4 0.30 25% 20%
a. What is the standard deviation of the return on asset 1 and on asset 2?

b. What is the covariance between the returns on assets 1 and 2?
c. What is the coefficient of correlation between the returns on assets 1 and 2?
Solution:
(a)
E (R1) = 0.4(-6%) + 0.1(18%) + 0.2(20%) + 0.3(25%)
= 10.9 %
E (R2) = 0.4(12%) + 0.1(14%) + 0.2(16%) + 0.3(20%)
= 15.4 %
σ(R1) = [.4(-6 –10.9)2 + 0.1 (18 –10.9)2 + 0.2 (20 –10.9)2 + 0.3 (25 –10.9)2]½
= 13.98%
σ(R2) = [.4(12 –15.4)2 + 0.1(14 –15.4)2 + 0.2 (16 – 15.4)2 + 0.3 (20 –15.4)2] ½
= 3.35 %
(b) The covariance between the returns on assets 1 and 2 is calculated below
State of Probability Return on Deviation Return on Deviation Product of

nature asset 1 of return asset 2 of the deviation
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 0.4 -6% -16.9% 12% -3.4% 22.98
2 0.1 18% 7.1% 14% -1.4% -0.99
3 0.2 20% 9.1% 16% 0.6% 1.09
4 0.3 25% 14.1% 20% 4.6% 19.45
Sum = 42.53
Thus the covariance between the returns of the two assets is 42.53.
66
(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 42.53
= = 0.91
σ1 x σ2 13.98 x 3.35
2. The returns of 4 stocks, A, B, C, and D over a period of 5 years have been as

follows:
1 2 3 4 5
A 8% 10% -6% -1% 9%
B 10% 6% -9% 4% 11%
C 9% 6% 3% 5% 8%
D 10% 8% 13% 7% 12%
Calculate the return on:
a. portfolio of one stock at a time

b. portfolios of two stocks at a time
c. portfolios of three stocks at a time.
d. a portfolio of all the four stocks.
Assume equiproportional investment.
Solution:
Expected rates of returns on equity stock A, B, C and D can be computed as

follows:
A: 8 + 10 – 6 -1+ 9 = 4%
5
B: 10+ 6- 9+4 + 11 = 4.4%

5
C: 9 + 6 + 3 + 5+ 8 = 6.2%
5
D: 10 + 8 + 13 + 7 + 12 = 10.0%
5
(a) Return on portfolio consisting of stock A = 4%
(b) Return on portfolio consisting of stock A and B in equal

proportions = 0.5 (4) + 0.5 (4.4)
= 4.2%
67
(c) Return on portfolio consisting of stocks A, B and C in equal
proportions = 1/3(4 ) + 1/3(4.4) + 1/3 (6.2)
= 4.87%
(d) Return on portfolio consisting of stocks A, B, C and D in equal

proportions = 0.25(4) + 0.25(4.4) + 0.25(6.2) +0.25(10)
= 6.15%
3. A portfolio consists of 4 securities, 1, 2, 3, and 4. The proportions of these

securities are: w1=0.3, w2=0.2, w3=0.2, and w4=0.3. The standard deviations of
returns on these securities (in percentage terms) are: σ1=5, σ2=6, σ3=12, and σ4=8.
The correlation coefficients among security returns are: ρ12=0.2, ρ13=0.6, ρ14=0.3,
ρ23=0.4, ρ24=0.6, and ρ34=0.5. What is the standard deviation of portfolio return?
Solution:
The standard deviation of portfolio return is:
p= [w1212 + w2222 + w3232 + 4242 + 2 w1 w2 12 1 2 + 2 w1 w3 13 1 3 + 2 w1 w4

14 14 + 2 w2 w3 23 2 3 + 2 w2 w4 24 2 4 + 2 w3 w4 34 3 4 ]1/2
= [0.32 x 52 + 0.22 x 62 + 0.22 x 122 + 0.32 x 82 + 2 x 0.3 x 0.2 x 0.2 x 5 x 6

+ 2 x 0.3 x 0.2 x 0.6 x 5 x 12 + 2 x 0.3 x 0.3 x 0.3 x 5 x 8
+ 2 x 0.2 x 0.2 x 0.4 x 6 x 12 + 2 x 0.2 x 0.3 x 0.6 x 6 x 8
+ 2 x 0.2 x 0.3 x 0.5 x 12 x 8]1/2
= 5.82 %
4. Assume that a group of securities has the following characteristics: (a) the standard
deviation of each security is equal to A; (b) covariance of returns AB is equal for
each pair of securities in the group.
What is the variance of a portfolio containing six securities which are equally
weighted?
Solution:
When there are 6 securities, you have 6 variance terms and 6 x 5 = 30 covariance terms.
As all variance terms are the same, all covariance terms are the same, and all securities
are equally weighted, the portfolio variance is:
6wA2 A2 + 30 wA2 AB
68
5. Which of the following portfolios constitute the efficient set:
Portfolio Expected return (%) Standard deviation (%)

1 15 18
2 18 22
3 10 9
4 12 15
5 15 20
6 13 16
7 22 22
8 14 17
Solution:
Let us arrange the portfolio in the order of ascending expected returns.
3 10 9
4 12 15
6 13 16
8 14 17
5 15 20
1 15 18
2 18 22
7 22 22
Examining the above we find that (i) portfolio 7 dominates portfolio 2 because it offers a
higher expected return for the same standard deviation and (ii) portfolio 1 dominates
portfolio 5 as it offers the same expected return for a lower standard deviation. So, the
efficient set consists of all the portfolios except portfolio 2 and portfolio 5.
69
6. Which of the following portfolios constitute the efficient set:

1 10 12
2 8 10
3 20 18
4 15 11
5 22 20
6 18 15
7 15 12
Solution:
Let us arrange the portfolio in the order of ascending expected returns.
2 8 10
1 10 12
4 15 11
7 15 12
6 18 15
3 20 18
5 22 20
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 4 dominates
portfolio 7 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 7.
7. Consider two stocks, P and Q

Expected return (%) Standard deviation (%)
Stock P 18 % 12 %
Stock Q 24 % 17 %
The returns on the stocks are perfectly negatively correlated.

What is the expected return of a portfolio comprising of stocks P and Q when the
portfolio is constructed to drive the standard deviation of portfolio return to zero?
70
Solution:
The weights that drive the standard deviation of portfolio to zero, when the returns are
perfectly correlated, are:
σQ 17
wP = = = 0.586
σ P + σQ 12 + 17
wQ = 1 – wP = 0.414
The expected return of the portfolio is:
0.586 x 18 % + 0.414 x 24 % = 20.484 %
8. Consider two stocks, X and Y

Expected return (%) Standard deviation (%)
Stock X 10 % 18 %
Stock Y 25 % 24 %
The returns on the stocks are perfectly negatively correlated.
What is the expected return of a portfolio comprising of stocks X and Y when the
portfolio is constructed to drive the standard deviation of portfolio return to zero?
Solution:
The weights that drive the standard deviation of portfolio to zero, when the returns
are perfectly correlated, are:
σY 24
wX = = = 0.571
σ X + σY 18 + 24
wY = 1 – wX = 0.429
The expected return of the portfolio is:
0.571 x 10 % + 0.429 x 25 % = 16.435 %
71
9. The following information is available.
Stock A Stock B
Expected return 24% 35%
Standard deviation 12% 18%
Coefficient of correlation 0.60
a. What is the covariance between stocks A and B ?

b. What is the expected return and risk of a portfolio in which A and B are
equally weighted?
Solution:
(a) Covariance (A,B) = PAB x σA x σB

= 0.6 x 12 x 18 = 129.6
(b) Expected return = 0.5 x 24 + 0.5 x 35 = 29.5 %

Risk (standard deviation) = [w2A 2A + w2B 2
B + 2 Cov (A,B)]
½
2 2 ½
= [0.5 x 144 + 0.5 x 324 + 2 x 129.6]
= 27.93%
10. The following information is available.

Stock A Stock B
Expected return 12% 26 %
Standard deviation 15% 21 %
Coefficient of correlation 0.30
a. What is the covariance between stocks A and B?

b. What is the expected return and risk of a portfolio in which A and B are
weighted 3:7?
Solution:
(a) Covariance (A,B) = PAB x σA x σB
= 0.3 x 15 x 21 = 94.5
(b) Expected return = 0.3 x 12 + 0.7 x 26 = 21.8 %
Risk (standard deviation) = [w2A 2A + w2B 2B + 2 Cov (A,B)]½
= [0.32 x 225 + 0.72 x 441 + 2 x 94.5] ½
= 20.62 %
72
CHAPTER 8
CAPITAL ASSET PRICING MODEL AND
ARBITRAGE PRICING THEORY
1. The following table, gives the rate of return on stock of Apple Computers and on
the market portfolio for five years
Year Return on the stock Return

Apple Computers (%) Market Portfolio (%)
1 -13 -3
2 5 2
3 15 8
4 27 12
5 10 7
(i) What is the beta of the stock of Apple Computers?
(ii) Establish the characteristic line for the stock of Apple Computers.
Solution:
Year RA RM RA - RA RM - RM (RA - RA) (RM - RM) (RM - RM)2

1 -13 -3 -21.8 -8.2 178.76 67.24
2 5 2 -3.8 -3.2 12.16 10.24
3 15 8 6.2 2.8 17.36 7.84
4 27 12 18.2 6.8 123.76 46.24
5 10 7 1.2 1.8 2.16 3.24
Sum 44 26 334.2 134.8

Mean 8.8 5.2
134.8 334.2
M = 2
= 33.7 Cov A,M = = 83.55
5-1 5-1
83.55
A = = 2.48
33.7
(ii) Alpha = RA – βA RM
= 8.8 – (2.48 x 5.2) = - 4.1
Equation of the characteristic line is
RA = - 4.1 + 2.48 RM
73
2. The rate of return on the stock of Sigma Technologies and on the market portfolio
for 6 periods has been as follows:
Period Return on the stock Return on the

of Sigma Technologies (%) market portfolio (%)
1 16 14
2 12 10
3 -9 6
4 32 18
5 15 12
6 18 15
(i) What is the beta of the stock of Sigma Technologies.?
(ii) Establish the characteristic line for the stock of Sigma Technologies
Solution:
(i
Year RA (%) RM (%) RA-RA RM-RM (RA-RA) (RM-RM)2

x(RM-RM)
1 36 28 8.8 2.4 21.12 5.76

2 24 20 -3.2 -5.6 17.92 31.36
3 -20 -8 -47.2 -33.6 1585.92 1128.96
4 46 52 18.8 26.4 496.32 696.96
5 50 36 22.8 10.4 237.12 108.16
 RA = 136 RM = 128 2358.4

Cov A,M =
RA = 27.2 RM = 25.6 5-1
 M2 = 1971.2
5–1
(ii) Alpha = 2358.4

RA – βA/ (5-1)
RM
A = -------------------
= = x 25.6)
27.2 – (1.196 1.196 = -3.42
1971.2 / (5-1)
RA = - 3.42 + 1.196 RM
74
3. The rate of return on the stock of Omega Electronics and on the market portfolio for
6 periods has been as follows:
Period Return on the stock Return on the

of Omega Electronics market portfolio
(%) (%)
1 18% 15%
2 10% 12%
3 -5% 5%
4 20% 14%
5 9% -2%
6 18% 16%
(i)What is the beta of the stock of Omega Electronics?
(ii) Establish the characteristic line for the stock of Omega Electronics.
Solution:
RM
Period R0 (%) (R0 – R0) (RM – RM) (R0 –R0) (RM – RM) (RM - RM)2
(%)
1 18 15 6.33 5 31.65 25
2 10 12 -1.67 2 - 3.34 4
3 -5 5 -16.67 -5 83.35 25
4 20 14 8.33 4 33.32 16
5 9 -2 - 2.67 -12 32.04 144
6 18 16 6.33 6 37.98 36
R0 = 70 RM = 60 (R0-R0) (RM-RM) = 215 250
R0 =11.67 RM = 10
250 215
M = 2
= 50 CovO,M = = 43.0
5 5
43.0
0 = = 0.86
50.0
(ii) Alpha = RO – βA RM
= 11.67 – (0.86 x 10) = 3.07
RA = 3.07 + 0.86 RM
75
4. The risk-free return is 8 percent and the return on market portfolio is 16 percent.
Stock X's beta is 1.2; its dividends and earnings are expected to grow at the constant
rate of 10 percent. If the previous dividend per share of stock X was Rs.3.00, what
should be the intrinsic value per share of stock X?
Solution:
The required rate of return on stock A is:
RX = RF + βX (RM – RF)
= 0.08 + 1.2 (0.16 – 0.08)
= 0. 176
Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r – g)
Given Do = Rs.3.00, g = 0.10, r = 0.176

3.00 (1.10)
Intrinsic value per share of stock X =
0.176 – 0.10
= Rs. 43.42
5. The risk-free return is 7 percent and the return on market portfolio is 13 percent.
Stock P's beta is 0.8; its dividends and earnings are expected to grow at the constant
rate of 5 percent. If the previous dividend per share of stock P was Rs.1.00, what
should be the intrinsic value per share of stock P?
Solution:
The required rate of return on stock P is:
RP = RF + βP (RM – RF)
= 0.07 + 0.8 (0.13 – 0.07)
= 0. 118
Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r – g)
Given Do = Rs.1.00, g = 0.05, r = 0.118

1.00 (1.05)
Intrinsic value per share of stock P =
0.118 – 0.05
= Rs. 15.44
76
6. The risk-free return is 6 percent and the expected return on a market portfolio is 15
percent. If the required return on a stock is 18 percent, what is its beta?
Solution:
The SML equation is RA = RF + βA (RM – RF)
Given RA = 18%. RF = 6%, RM = 15%, we have
0.18 = .06 + βA (0.15 – 0.06)
0.12
i.e. βA = = 1.33
0.09
Beta of stock = 1.33
7. The risk-free return is 9 percent and the expected return on a market portfolio is 12
percent. If the required return on a stock is 14 percent, what is its beta?
Solution:
The SML equation is RA = RF + βA (RM – RF)
Given RA = 14%. RF = 9%, RM = 12%, we have
0.14 = .09 + βA (0.12 – 0.09)
0.05
i.e.βA = = 1.67
0.03
Beta of stock = 1.67
8. The risk-free return is 5 percent. The required return on a stock whose beta is 1.1 is
18 percent. What is the expected return on the market portfolio?
Solution:
The SML equation is: RX = RF + βX (RM – RF)
We are given 0.18 = 0.05 + 1.1 (RM – 0.05) i.e., 1.1 RM = 0.185 or RM = 0.1681
Therefore return on market portfolio = 16.81 %
77
9. The risk-free return is 10 percent. The required return on a stock whose beta is 0.50
is 14 percent. What is the expected return on the market portfolio?
Solution:
The SML equation is: RX = RF + βX (RM – RF)
We are given 0.14 = 0.10 + 0.50 (RM – 0.10) i.e., 0.5 RM = 0.09 or RM = 0.18
Therefore return on market portfolio = 18 %
10. The required return on the market portfolio is 15 percent. The beta of stock A is
1.5. The required return on the stock is 20 percent. The expected dividend growth
on stock A is 6 percent. The price per share of stock A is Rs.86. What is the
expected dividend per share of stock A next year?
What will be the combined effect of the following on the price per share of stock?
(a) The inflation premium increases by 3 percent.

(b) The decrease in the degree of risk-aversion reduces the differential between the
return on market portfolio and the risk-free return by one-fourth.
(c) The expected growth rate of dividend on stock A decrease to 3 percent.
(d) The beta of stock A falls to1.2
Solution:
RM = 15% βA = 1.5 RA =20 % g = 6 % Po = Rs.86
Po = D1 / (r - g)
Rs.86 = D1 / (0.20 - .06)
So D1 = Rs.12.04 and Do = D1 / (1+g) = 12.04 /(1.06) = Rs.11.36
RA = Rf + βA (RM – Rf)
0.20 = Rf + 1.5 (0.15 – Rf)

0.5Rf = 0.025
So Rf = 0.05 or 5%.
Original Revised
Rf 5% 8%
RM – Rf 10% 7.5%
g 6% 3%
βA 1.5 1.2
78
Revised RA = 8 % + 1.2 (7.5%) = 17 %
Price per share of stock A, given the above changes is
11.36 (1.03)
= Rs. 83.58
0.17 – 0.03
11. The required return on the market portfolio is 16 percent. The beta of stock A is
1.6. The required return on the stock is 22 percent. The expected dividend growth
on stock A is 12 percent. The price per share of stock A is Rs.260. What is the
expected dividend per share of stock A next year?
What will be the combined effect of the following on the price per share of stock?
(a) The inflation premium increases by 5 percent.

(b) The decrease in the degree of risk-aversion reduces the differential between the
return on market portfolio and the risk-free return by one-half.
(c) The expected growth rate of dividend on stock A decrease to 10 percent.
(d) The beta of stock A falls to 1.1
Solution:
RM = 16% βA = 1.6 RA =22 % g = 12 % Po = Rs. 260
Po = D1 / (r - g)
Rs.260 = D1 / (0.22 - .12)
So D1 = Rs. 26 and Do = D1 / (1+g) = 26 /(1.12) = Rs.23.21
RA = Rf + βA (RM – Rf)
0.22 = Rf + 1.6 (0.16 – Rf)

0.6Rf = 0.036
So Rf = 0.06 or 6%.
Original Revised
Rf 6% 11%
RM – Rf 10% 5%
g 12 % 10 %
βA 1.6 1.1
Revised RA = 11% + 1.1 (5%) = 16.5 %
79
Price per share of stock A, given the above changes is
23.21 (1.10)
= Rs. 392.78
0.165 – 0.10
12. The following information is given:
Expected return for the market = 15%

Standard deviation of the market return = 25%
Risk-free rate = 8%
Correlation coefficient between stock A and the market = 0.8
Correlation coefficient between stock B and the market = 0.6
Standard deviation for stock A = 30%
Standard deviation for stock B = 24%
(i) What is the beta for stock A?
Solution:
Cov (A,M) Cov (A,M)

AM = ; 0.8 =  Cov (A,M) = 600
A M 30 x 25
M2 = 252 = 625
Cov (A,M) 600

A = = = 0.96
M 2
625
(ii) What is the expected return for stock A?
Solution:
E(RA) = Rf + A (E (RM) - Rf)
= 8% + 0.96 (7%) = 14.72%
80
13. The following table gives an analyst’s expected return on two stocks for particular
market returns.
Market Return Aggressive Stock Defensive Stock

5% - 5% 10%
25% 45% 16%
(i) What is the ratio of the beta of the aggressive stock to the beta of the defensive
stock?
Solution:
45 – (-5)
Beta of aggressive stock = = 2.5
25 – 5
16 - 10
Beta of defensive stock = = 0.30
25 – 5
Ratio = 2.5/0.30 = 8.33
(ii) If the risk-free rate is 7% and the market return is equally likely to be 5% and
25% what is the market risk premium?
Solution:
E (RM) = 0.5 x 5 + 0.5 x 25 = 15%

Market risk premium = 15% - 7% = 8%
(iii) What is the alpha of the aggressive stock?
Solution:
Expected return = 0.5 x –5 + 0.5 x 45 = 20%
Required return as per CAPM = 7% + 2.5 (8%) = 27%
Alpha = - 7%
81
14. The following table gives an analyst’s expected return on two stocks for particular
market returns.
Market Return Aggressive Stock Defensive Stock

8% 2% 10%
20% 32% 16%
(i) What is the beta of the aggressive stock?
Solution:
32% - 2%
Beta = = 2.5
20% - 8%
(ii) If the risk-free rate is 6% and the market return is equally likely to be 8% and
20%, what is the market risk premium?
Solution:
The expected return on the market portfolio is:
0.5 x 8% + 0.5 x 20% = 14%
Since the risk-free rate is 6%, the market risk premium is 8%
(iii) What is the alpha of the aggressive stock?
Solution:
Expected return on the aggressive stock = 0.5 x 2% + 0.5 x 32% = 17%

Required return = 6% + 8 x 2.5 = 26%
Alpha = 17 – 26% = – 9%
82
MINICASE 1
Mr. Nitin Gupta had invested Rs.8 million each in Ashok Exports and Biswas Industries
and Rs. 4 million in Cinderella Fashions, only a week before his untimely demise. As per
his will this portfolio of stocks were to be inherited by his wife alone. As the partition
among the family members had to wait for one year as per the terms of the will, the
portfolio of shares had to be maintained as they were for the time being. The will had
stipulated that the job of administering the estate for the benefit of the beneficiaries and
partitioning it in due course was to be done by the reputed firm of Chartered Accountants,
Talwar Brothers. Meanwhile the widow of the deceased was very eager to know certain
details of the securities and had asked the senior partner of Talwar Brothers to brief her in
this regard. For this purpose the senior partner has asked you to prepare a detailed note to
him with calculations using CAPM, to answer the following possible doubts.
1. What is the expected return and risk (standard deviation) of the portfolio?
2. What is the scope for appreciation in market price of the three stocks-are they
overvalued or undervalued?
You find that out the three stocks, your firm has already been tracking two viz. Ashok
Exports (A) and Biswas Industries (B)-their betas being 1.7 and 0.8 respectively.
Further, you have obtained the following historical data on the returns of Cinderella
Fashions(C):
Period Market return (%) Return on
Cinderella Fashions (%)
------------- ------------------------ ---------------
1 10 14
2 5 8
3 (2) (6)
4 (1) 4
5 5 10
6 8 11
7 10 15
On the future returns of the three stocks, you are able to obtain the following forecast
from a reputed firm of portfolio managers.
-------------------------------------------------------------------------------------------------------
State of the Probability Returns (in percentage)
Economy Treasury Ashok Biswas Cinderella Sensex
Bills Exports Industries Fashions
-------------------------------------------------------------------------------------------------------
Recession 0.3 7 5 15 (10) (2)
Normal 0.4 7 18 8 16 17
Boom 0.3 7 30 12 24 26
Required: Prepare your detailed note to the senior partner.
83
Solution:
(1) Calculation of beta of Cinderella Fashions stock from the historical data
Period Return Return Rc-Rc Rm-Rm (Rm-Rm)2 (Rc-Rc)

Rc ( % ) Rm (%) x (Rm-Rm)
1 14 10 6 5 25 30
2 8 5 0 0 0 0
3 (6) (2) (14) (7) 49 98
4 4 (1) (4) (6) 36 24
5 10 5 2 0 0 0
6 11 8 3 3 9 9
7 15 10 7 5 25 35
∑Rc=56 ∑Rm=35 ∑ (Rm-Rm)2= 144 ∑ (Rc-Rc)(Rm-Rm)= 196

2
Rc= 8 Rm= 5 σm = 144/6 =24 Cov(c,m) = 196/6= 32.7
Beta of Cinderella Fashions βc = 32.7/24= 1.36
(2) Calculation of expected returns, standard deviations and covariances

E(A) =[ 0.3x5] + [0.4x18] +[ 0.3x30] = 17.7
E(B)= [0.3x15] + [0.4x8] + [0.3x12] = 11.3
E(C)= [0.3x(-)10] + [0.4x16] +[0.3x24] = 10.6
E(M)= [0.3x(-)2]+ [0.4x17] + [0.3x26] = 14
σA = [0.3(5-17.7)2 +0.4(18-17.7)2+0.3(30-17.7)2 ]1/2

= [48.4 + 0.1+45.4]1/2 = 9.7
σB = [0.3(15-11.3)2 + 0.4(8-11.3)2 +0.3(12-11.3)2]1/2
= [4.11 +4.36+ 0.15]1/2 =2.94
σc = [0.3(-10-10.6)2+0.4(16-10.6)2 + 0.3(24-10.6)2]1/2
= [ 127.31 +11.66+53.87]1/2 = 13.89
σM = [0.3(-2-14)2 +0.4(17-14)2+0.3(26-14)2]1/2
= [76.8 +3.6 +43.2]1/2 = 11.1
Calculation of covariances between the stocks
State of the Prob- RA-RA RB-RB RC-RC (2)x(3) (2)x(4)x(5) (2)x(3)x(5)

Economy ability x (4)
(1) (2) (3) (4) (5)
Recession 0.3 -12.7 3.7 -20.6 -14.1 -22.9 78.5
Normal 0.4 0.3 -3.3 5.4 -0.1 -7.1 0.6
Boom 0.3 12.3 0.7 13.4 2.6 2.8 49.4
σA,B = -11.6 σB,C= -27.2 σA,C= 128.5
84
Expected return and standard deviation of the portfolio
E(P) = (0.4x17.7) + (0.4x11.3) +(0.2x10.6)= 13.7
σp = [ wA2 σA2 + wB2 σB2 + wC2 σC2 + 2 wAwB σA,B +2 wBwC σB,C +2 wAwC σA,C]1/2
= [ 15.1+ 1.4 +7.7-3.7-4.4+ 20.6]1/2 = 6.1
(3) Determining overpricing and underpricing using CAPM
βA =1.7 βB =0.8 βC = 1.36 E(RM) = 14 Rf =7%
SML = 7 + (14 -7)xBeta

= 7 + 7 x Beta
Required return on Ashok Exports = 7 + (7 x 1.7) = 18.9 %
Required return on Biswas Industries = 7 + (7 x 0.8) = 12.6 %
Required return on Cinderella Fashions = 7 + (7 x 1.36) = 16.5 %
As the expected return of 17.7 % on Ashok Exports is slightly less than the required
return of 18.9%, its expected return can be expected to go up to the fair return
indicated by CAPM and for this to happen its market price should come down. So it
is slightly overvalued.
In the case of Biswas Industries stock, as the expected return of 11.3% is again
slightly less than the required return of 12.6 %, its expected return can be expected to
go up and for this to happen its market price should come down. So it is also slightly
overvalued.
In the case of Cinderella Fashions the expected return is 10.6 % against the required
return of 16.5 %. So it is considerably overvalued.
85
MINICASE 2
Mr. Pawan Garg, a wealthy businessman, has approached you for professional
advice on investment. He has a surplus of Rs. 20 lakhs which he wishes to invest in
share market. Being risk averse by nature and a first timer to secondary market, he
makes it very clear that the risk should be minimum. Having done some research in
this field, you recommend to him a portfolio of two shares - stocks of an oil
exploration company ONGD and an oil marketing company BPDL. You tell him
that both are reputed, government controlled companies.
You have the following market data at your disposal.
Period Market return (%) Return (%) on

ONGD BPDL
-------- ------------- -------------------------------
1 10 18 8
2 12 16 10
3 8 12 14
4 -6 (12) 20
5 -4 -7 16
6 10 16 8
The current market price of a share of ONGD is Rs. 1200 and that of BPDL is Rs. 423.
On the future returns of the two stocks and the market, you are able to obtain the
following forecast from a reputed firm of portfolio managers.
-------------------------------------------------------------------------------------------------------
State of the Probability Returns (in percentage) on
Economy Treasury ONGD BPDL Market Index
Bills
-------------------------------------------------------------------------------------------------------
Recession 0.3 7 9 15 (2)
Normal 0.4 7 18 10 14
Boom 0.3 7 25 6 20
The firm also informs you that they had very recently made a study of the ONGD
stock and can advise that its beta is 1.65.
Mr. Garg requests you to answer the following questions:
a. What is the beta for BPDL stock?

b. What is the covariance of the returns on ONGD and BPDL? Use the forecasted
returns to calculate this.
c. If the forecasted returns on ONGD and BPDL are perfectly negatively correlated
(ρ = -1), what will be expected return from a zero risk portfolio?
d. What will be the risk and return of a portfolio consisting of ONGD and BPDL
stocks in equal proportions?
86
e. What is the scope for appreciation for the two stocks?
Solution:
a. Let the returns from the stocks of ONGD, BPDL and the market index be Ro, RB and
RM respectively.
2
Period RB RM RB - RB RM - RM (RM - RM) (RB - RB)(RM -RM)
1 8 10 -4.67 5.00 25.00 -23.33
2 10 12 -2.67 7.00 49.00 -18.67
3 14 8 1.33 3.00 9.00 4.00
4 20 -6 7.33 -11.00 121.00 -80.67
5 16 -4 3.33 -9.00 81.00 -30.00
6 8 10 -4.67 5.00 25.00 -23.33
Mean = 12.67 5.00 SUM = 310.00 -172.00
Beta of BPDL = (-172/5) / (310/5) = -0.55
Expected return on ONGD = 0.3 x 9 + 0.4 x 18 + 0.3 x 25 = 17.4

Expected return on BPDL = 0.3 x 15 + 0.4 x 10+ 0.3 x 6 = 10.3
Expected return on Market index = 0.3 x (-2) + 0.4 x 14+ 0.3 x 20 = 11
Standard deviation of return on ONGD = [0.3(9-17.4)2 + 0.4(18-17.4)2 + 0.3(25-

17.4)2]1/2
= 6.22
Standard deviation of return on BPDL = [0.3(15- 10.3)2 + 0.4(10-10.3)2 + 0.3(6- 10.3)2]1/2

= 3.49
State of
the Probability p[R0-E(RO)] x
economy (p) ONGD(RO)BPDL(RB) [RB - E(RB)]
Recession 0.3 9 15 -11.844
Normal 0.4 18 10 -0.072
Boom 0.3 25 6 -9.804
SUM = -21.72
Covariance of the returns of ONGD and BPDL = -21.72
Coefficient of correlation between the two stocks = - 21.72 / (6.22 x 3.49) =

= - 21.72 / 21.71 = - 1
87
As the two stocks are perfectly negatively correlated, it is possible to construct a
portfolio with almost nil risk.
b. wo = σΒ / ( σ0 + σΒ) = 3.49 / (6.22+ 3.49) = 0.36

Τhe amount to be invested in ONGD = 0.36 x 20,00,000 = Rs. 7,20,000
No. of share of ONGD to be purchased = 720,000/ 1200 = 600
No. of share of BPDL to be purchased = (20,00,000 – 720,000) / 423 = 3026
c. Weight of ONGD in the portfolio = 0.36 and of BPDL =0.64

The portfolio return = 0.36 x 17.4 + 0.64 x 10.3 = 12.86 %
d. E(R) = 0.5 x 17.4 + 0.5 x 10.3 = 13.85 %

σP = [ (0.5)2 x (6.22)2 + (0.5)2 x(3.49)2 - 2x0.5 x 0.5 x 21.72 ]1/2
= 1.36 %
e. Required return on ONGD as per CAPM = 7 + 1.65 x (11 -7) = 13.6 %

Expected return = 17.4
As the expected return is more than the required return, ONGD stock is
underpriced
Required return on BPDL as per CAPM = 7 – 0.55 x (11 -7) = 4.8 %

Expected return = 10.3
As the expected return is more than the required return, BPDL stock is also
underpriced.
So there is good scope for appreciation in the market prices of both the stocks.
88
CHAPTER 11
BOND PRICES AND YIELDS
1. The price of a Rs.1,000 par bond carrying a coupon rate of 8 percent and maturing
after 5 years is Rs.1020.
(i) What is the approximate YTM?

(ii) What will be the realised YTM if the reinvestment rate is 7 percent?
Solution:
(i)
80 + (1000 – 1020) / 5
YTM ~ = 7.51%
0.6 x 1020 + 0.4 x 1000
(ii)
The terminal value will be
80 x FVIFA (7%, 5yrs) + 1000
80 x 5.751 + 1000 = 1460.08
The realised YTM will be:

1/5
1460.08
– 1 = 7.44%
1020
2. The price of a Rs.1,000 par bond carrying a coupon rate of 7 percent and maturing
after 5 years is Rs.1040.
(i) What is the approximate YTM?

(ii) What will be the realised YTM if the reinvestment rate is 6 percent?
Solution:
(i)
The approximate YTM is:
70 + (1000 – 1040)/5
= 0.0605 or 6.05 percent
0.6 x 1040 + 0.4 x 1000
89
(ii)
0 1 2 3 4 5
-1040 70 70 70 70 70
1000
The terminal value at 6 percent reinvestment rate is:
70 x FVIFA (6%, 5yrs) + 1000
70 x 5.637 + 1000 = Rs.1394.59
1394.59 1/5
Realised yield to maturity = – 1 = 6.04%
1040
3. A Rs.1000 par value bond, bearing a coupon rate of 12 percent will mature after 6
years. What is the value of the bond, if the discount rate is 16 percent?
Solution:
6 120 1000
P =  +
t=1 (1.16)t (1.16)6
= Rs.120 x PVIFA(16%, 6 years) + Rs.1000 x PVIF (16%, 6 years)

= Rs.120 x 3.685 + Rs.1000 x 0.410
= Rs. 852.20
4. A Rs.100 par value bond, bearing a coupon rate of 9 percent will mature after 4
years. What is the value of the bond, if the discount rate is 13 percent?
Solution:
4 9 100
P =  +
t
t=1 (1.13) (1.13)4
= Rs.9 x PVIFA(13%, 4 years) + Rs.100 x PVIF (13%, 4 years)

= Rs.9 x 2.974 + Rs.100 x 0.613
= Rs. 88.07
90
5. The market value of a Rs.1,000 par value bond, carrying a coupon rate of 10
percent and maturing after 5 years, is Rs.850. What is the yield to maturity on this
bond?
Solution:
The yield to maturity is the value of r that satisfies the following equality.
5 100 1,000
Rs.850 =  +
t=1 (1+r) t (1+r)5
Try r = 14%. The right hand side (RHS) of the above equation is:
Rs.100 x PVIFA (14%, 5 years) + Rs.1,000 x PVIF (14%, 5 years)
= Rs.100 x 3.433 + Rs.1,000 x 0.519
= Rs.862.30
Rs.100 x PVIFA (15%, 5 years) + Rs.1,000 x PVIF (15%, 5years)
= Rs.100 x 3.352 + Rs.1,000 x 0.497
= Rs.832.20
Thus the value of r at which the RHS becomes equal to Rs.850 lies between 14%
and 15%.
Using linear interpolation in this range, we get
862.30 – 850.00
Yield to maturity = 14% + 862.30 – 832.20 x 1%
= 14.41%
6. The market value of a Rs.100 par value bond, carrying a coupon rate of 8.5 percent
and maturing after 8 years, is Rs.95. What is the yield to maturity on this bond?
Solution:
The yield to maturity is the value of r that satisfies the following equality.
8 8.5 100
95 =  +
t=1 (1+r) t (1+r)8
8.5 x PVIFA (10%, 8 years) + Rs.100 x PVIF (10%, 8 years)
= Rs.8.5 x 5.335 + Rs.100 x 0.467
= Rs.92.05
91
8.5 x PVIFA (9 %, 8 years) + Rs.100 x PVIF (9%, 8years)
= 8.5 x 5.535 + Rs.100 x 0.502
= 47.04 + 50.20 = 97.24
Thus the value of r at which the RHS becomes equal to Rs.95 lies between 9%
and 10%.
Using linear interpolation in this range, we get
97.24 – 95.00
Yield to maturity = 9 % + 97.24 – 92.05 x 1%
= 9.43 %
7. A Rs.1000 par value bond bears a coupon rate of 10 percent and matures after 5
years. Interest is payable semi-annually. Compute the value of the bond if the
required rate of return is 18 percent.
Solution:
10 50 1000
P =  +
t=1 (1.09) t (1.09)10
= 50 x PVIFA (9%, 10 years) + 1000 x PVIF (9%, 10 years)

= 50 x 6.418 + Rs.1000 x 0.422
= Rs. 742.90
8. A Rs.100 par value bond bears a coupon rate of 8 percent and matures after 10
years. Interest is payable semi-annually. Compute the value of the bond if the
required rate of return is 12 percent.
Solution:
20 4 100
P =  +
t=1 (1.06) t (1.06)20
= 4 x PVIFA (6%, 20 years) + Rs.100 x PVIF (6%, 20 years)

= 6 x 11.470 + Rs.100 x 0.312
= Rs.100.02
92
9. You are considering investing in one of the following bonds:
Coupon rate Maturity Price/Rs.100 par value
Bond A 11% 8 yrs Rs.80
Bond B 9% 9 yrs Rs.70
Your income tax rate is 34 percent and your capital gains tax is effectively 10
percent. Capital gains taxes are paid at the time of maturity on the difference
between the purchase price and par value. What is your post-tax yield to maturity
from these bonds?
Solution:
The post-tax interest and maturity value are calculated below:

Bond A Bond B
* Post-tax interest (C ) 11(1 – 0.34) 9 (1 – 0.34)
=Rs.7.26 =Rs.5.94
* Post-tax maturity value (M) 100 - 100 -
[ (100-80)x 0.1] [ (100 – 70)x 0.1]
=Rs.98 =Rs.97
The post-tax YTM, using the approximate YTM formula is calculated below
7.26 + (98-80)/8
Bond A : Post-tax YTM = --------------------
0.6 x 80 + 0.4 x 98
= 10.91%
5.94 + (97 – 70)/9
Bond B : Post-tax YTM = ----------------------
0.6x 70 + 0.4 x 97
= 11.06 %
10. You are considering investing in one of the following bonds:
Coupon rate Maturity Price/Rs.1000 par value

Bond A 12% 7 yrs Rs. 930
Bond B 8% 5 yrs Rs. 860
Your income tax rate is 33 percent and your capital gains tax is effectively 10
percent. Capital gains taxes are paid at the time of maturity on the difference
between the purchase price and par value. What is your post-tax yield to maturity
from these bonds?
93
Solution:
The post-tax interest and maturity value are calculated below:
Bond A Bond B
* Post-tax interest (C) 120(1 – 0.33) 80 (1 – 0.33)

= Rs.80.40 = Rs.53.6
* Post-tax maturity value (M) 1000 - 1000 -

[(1000-930) x 0.1] [ (1000 – 860)x 0.1]
= Rs. 993 = Rs.986
The post-tax YTM, using the approximate YTM formula is calculated below
80.40 + (993-930)/7
Bond A : Post-tax YTM = --------------------
0.6 x 930 + 0.4 x 993
= 9.36 %
53.6 + (986 – 860)/5

Bond B : Post-tax YTM = ----------------------
0.6x 860 + 0.4 x 986
= 8.66 %
11. A company's bonds have a par value of Rs.100, mature in 5 years, and carry a
coupon rate of 10 percent payable semi-annually. If the appropriate discount rate is
14 percent, what price should the bond command in the market place?
Solution:
10 5 100
P =  +
t=1 (1.07) t (1.07)10
= Rs.5 x PVIFA (7%, 10) + Rs.100 x PVIF (7%, 10)

= Rs.5 x 7.024 + Rs.100 x 0.508
= Rs. 85.92
12. A company's bonds have a par value of Rs.1000, mature in 8 years, and carry a
coupon rate of 14 percent payable semi-annually. If the appropriate discount rate is
12 percent, what price should the bond command in the market place?
94
Solution:
16 70 1000
P =  +
t=1 (1.06) t (1.06)16
= Rs.70 x PVIFA(6%, 16) + Rs.1000 x PVIF (6%, 16)

= Rs.70 x 10.106 + Rs.1000 x 0.394
= Rs. 1101.42
13. Assume the following spot rates:
What are the forward rates over each of the five years?
Solution:
By definition, the forward rate for the first rate is equal to the spot rate for 1
year, viz., 7.6%.
The forward rates over the later years are:
14. Assume the following spot rates:
95
15. You can buy a Rs.1000 par value bond carrying an interest rate of 10 percent
(payable annually) and maturing after 5 years for Rs.970. If the re-investment rate
applicable to the interest receipts from this bond is 15 percent, what will be the
yield to maturity?
Solution:
Terminal value of the interest proceeds

= 100 x FVIFA (15%, 5)
= 100 x 6.742
= 674.20
Redemption value = 1,000
Terminal value of the proceeds from the bond = 1,674.20
let r be the yield to maturity. The value of r can be obtained from the equation
970 (1 + r)5 = 1,674.20

r = (1,674.20/970)1/5 -1
= 0.1153 or 11.53 %
96
16. You can buy a Rs.100 par value bond carrying an interest rate of 8 percent (payable
annually) and maturing after 8 years for Rs.90. If the re-investment rate applicable
to the interest receipts from this bond is 10 percent, what will be your yield to
maturity?
Solution:
Terminal value of the interest proceeds

= 8 x FVIFA (10%, 8)
= 8 x 11.436
= 91.49
Redemption value = 100

Terminal value of the proceeds from the bond = 191.49
let r be the yield to maturity. The value of r can be obtained from the
equation
90 (1 + r)8 = 191.49
r = (191.49/90)1/8 -1
= 0.099 or 9.9 %
17. Shivalik Combines issues a partly convertible debenture for Rs.900, carrying an
interest rate of 12 percent. Rs.300 will get compulsorily converted into two equity shares
of Shivalik Combines a year from now. The expected price per share of Shivalik
Combines’s equity a year from now would be Rs.200. The non-convertible portion will
be redeemed in three equal installments of Rs. 200 each at the end of years 4, 5 and 6
respectively. The tax rate for Shivalik is 35 percent and the net price per share Shivalik
would realise for the equity after a year would be Rs. 180.
(a) What is the value of convertible debenture? Assume that the investors’
required rate of return on the debt component and the equity component are
12 percent and 16 percent respectively.
(b) What is the post-tax cost of the convertible debenture to Shivalik?
Solution:
(a) No. of shares after conversion in one year = 2
Value of the shares at the price of Rs.200 = 2 x 200 = Rs.400
PV of the convertible portion at the required rate of 16% = 400/1.16 =
Rs.344.82
Payments that would be received from the debenture portion:
Year Payments PVIF12%,t PV

1 108 0.893 96.44
2 72 0.797 57.38
3 72 0.712 51.26
97
4 272 0.636 172.99
5 248 0.567 140.62
6 224 0.507 113.57
Total= 632.26
Value of the convertible debenture = 344.82 + 632.26 = Rs. 977.08
(b) The cash flow for Shivalik is worked out as under:
Year Cash flow

0 900
1 =-360-108*(1-0.35) -430
2 =-72*(1-0.35) -47
3 =-72*(1-0.35) -47
4 =-200-72*(1-0.35) -247
5 =-200-48*(1-0.35) -232
6 =-200-24*(1-0.35) -216
The post-tax cost of the convertible debenture to Shivalik is the IRR of the above
cash flow stream.
Let us try a discount rate of 10 %. The PV of the cash flow will then be
= 900 – 430/(1.1) -47/(1.1)2 - 47/(1.1)3 -247/(1.1)4-232/(1.1)5-216/(1.1)6

= 0.25 which is very near to zero.
So the post –tax cost of the convertible debenture to Shivalik is 10%
18. Brilliant Limited issues a partly convertible debenture for 1000, carrying an interest
rate of 10 percent. 360 will get compulsorily converted into two equity shares of
Brilliant Limited a year from now. The expected price per share of Brilliant
Limited’s equity a year from now would be Rs.300. The non-convertible portion
will be redeemed in four equal installments of Rs.160 each at the end of years 3, 4,
5 and 6 respectively. The tax rate for Brilliant is 33 percent and the net price per
share Brilliant would realise for the equity after a year would be Rs. 220.
(a) What is the value of convertible debenture? Assume that the investors’ required
rate of return on the debt component and the equity component are 13 percent
and 18 percent respectively.
(b) What is the post-tax cost of the convertible debenture to Brilliant?
Solution:
(a) No. of shares after conversion in one year = 2

Value of the shares at the price of Rs.300 = 2 x 300 = Rs.600
PV of the convertible portion at the required rate of 18% = 600/1.18 = Rs.508.47
98
Payments that would be received from the debenture portion:
Year Payments PVIF13%,t PV
1 100 0.885 88.5
2 64 0.783 50.11
3 224 0.693 155.23
4 208 0.613 127.50
5 192 0.543 104.26
6 176 0.480 84.48
Total= 610.08
Value of the convertible debenture = 508.47 + 610.08 = Rs. 1118.55
(b)
The cash flow for Brilliant is worked out as under:
Year Cash flow

0 1000
1 =-440-100*(1-0.33) -361.80
2 =-64*(1-0.33) -42.88
3 =-160-64*(1-0.33) -202.88
4 =-160-48*(1-0.33) -192.16
5 =-160-32*(1-0.33) -181.4
6 =-160-16*(1-0.33) -170.72
The post-tax cost of the convertible debenture to Brilliant is the IRR of the above
cash flow stream.
Let us try a discount rate of 4 %. The PV of the cash flow will then be
= 1000 – 361.8/(1.04) -42.88/(1.04)2 – 202.88/(1.04)3 -192.16/(1.04)4-
181.4/(1.04)5-170.72/(1.04)6 = -16.17
Trying a discount rate of 5 %. The PV of the cash flow will then be
= 1000 – 361.8/ (1.05) -42.88/(1.05)2 – 202.88/(1.05)3 -192.16/(1.05)4-

181.4/(1.05)5-170.72/(1.05)6 = 13.66
By extrapolation, we have the IRR = 4 + 16.17/(16.17 + 13.66) = 4.54 %
So the post –tax cost of the convertible debenture to Brilliant is 4.54 %
99
CHAPTER 12
BOND PORTFOLIO MANAGEMENT
1. Consider three bonds, A, B and C

Bond A Bond B Bond C
Face value 1,000 1,000 100
Coupon (interest rate)
payable annually 12 percent 13 percent 14 percent
Years to maturity 5 6 7
Redemption value 1,000 1,000 100
Current market price Rs.900 Rs.850 92
What are the (a) yields to maturity (use the approximate formula) (b) durations,
and (c) volatilities of these bonds?
Solution:
(a)
Yield to maturity of bond A, using the approximate formula, is

120 + (1000 – 900)/5
= ------------------------- = 14.89 %
0.4x1000 + 0.6x900
Yield to maturity of bond B, using the approximate formula, is

130 + (1000 – 850)/6
= ----------------------------- = 17.03 %
0.4x1000 + 0.6x850
Yield to maturity of bond C, using the approximate formula, is

14 + (100 – 92)/7
= -------------------------- = 15.91 %
0.4x100 + 0.6x92
(b) Duration of bond A is calculated as under:
Present value at Proportion of the Proportion of the

Year Cash flow 14.89 percent bond's value bond's value x time
1 120 104.45 0.116 0.116
2 120 90.91 0.101 0.201
3 120 79.13 0.088 0.263
4 120 68.87 0.076 0.305
5 1120 559.51 0.620 3.099
Sum = 902.87 Duration = 3.984
100
Duration of bond B is calculated as under:
Present value at Proportion of the Proportion of the bond's

Year Cash flow
17.03 percent bond's value value x time
1 130 111.08 0.130 0.130
2 130 94.92 0.111 0.222
3 130 81.11 0.095 0.284
4 130 69.30 0.081 0.324
5 130 59.22 0.069 0.346
6 1130 439.84 0.514 3.085
Sum = 855.47 Duration= 4.391
Duration of bond C is calculated as under:
Present value at Proportion of the Proportion of the

Year Cash flow
15.91 percent bond's value bond's value x time
1 14 12.08 0.131 0.131
2 14 10.42 0.113 0.226
3 14 8.99 0.097 0.292
4 14 7.76 0.084 0.336
5 14 6.69 0.073 0.363
6 14 5.77 0.063 0.375
7 114 40.56 0.440 3.077
Sum = 92.27 Duration= 4.800
c)
Volatility of bond A Volatility of bond B Volatility of bond C
3.984 4.391 4.8

= 3.47 = 3.75 = 4.14
1.1489 1.1703 1.1591
2. A zero coupon bond of Rs 100,000 has a term to maturity of six years and a market
yield of 8 percent at the time of issue.
(a) What is the issue price?

(b) What is the duration of the bond?
(c) What is the modified duration of the bond?
(d) What will be the percentage change in the price of the bond, if the yield
declines by 0.3 percentage points (30 basis points)
101
Solution:
a. Issue price (1.08)6 = Rs.100,000

Rs.100,000
Issue price = = Rs.63,017
(1.08)6
b. The duration of the bond is 6 years. Note that the term to maturity and the duration
of a zero coupon bond are the same.
c. The modified duration of the bond is:
Duration 6
= = 5.556
(1+ yield) (1.08)
d. The percentage change in the price of the bond, if the yield declines by 0.5 percent
is:
∆P/ P = - Modified duration x 0.3

= - 5.556 x0.3 = - 1.67 percent
3. A zero coupon bond of Rs 10,000 has a term to maturity of seven years and a
market yield of 9 percent at the time of issue.
(a) What is the issue price?

(b) What is the duration of the bond?
(c) What is the modified duration of the bond?
(d) What will be the percentage change in the price of the bond, if the yield
declines by 0.25 percentage points (25 basis points)
Solution:
a. Issue price (1.09)7 = Rs.10,000
Rs.10,000
Issue price = = Rs.5470
7
(1.09)
b. The duration of the bond is 7 years. Note that the term to maturity and the duration
of a zero coupon bond are the same.
c. The modified duration of the bond is:

Duration 7
= = 6.422
(1+ yield) (1.09)
102
d. The percentage change in the price of the bond, if the yield declines by 0.25 percent
is:
∆P/ P = - Modified duration x 0.3

= - 6.422 x 0.25 = - 1.61 percent
4. You are considering the following bond for inclusion in your fixed income
portfolio:
Coupon rate 9%
Yield to maturity 9%
Term to maturity 8 years
(a) What is the duration of this bond?

(b) Why is the bond’s duration less than its maturity?
(c) What will be the effect of the following changes on the duration of the
bond:
(i) The coupon rate is 6% rather than 9 %
(ii) The yield to maturity is 10% rather than 9%
(iii) The maturity period is seven years rather than 8 years.
Consider one change at a time.

Solution:
a. The duration of a coupon bond is:
1+y (1 + y) + T(c –y)

-
y c [(1 +y)T – 1] + y
y = 9 %, c = 9 %, T = 8 years
So, the duration of the bond is:
1.09 (1.09) + 8 (0.09 – 0.09)

-
0.09 0.09 [(1.09)8 – 1] + 0.09
1.09
12.11 - = 6.031
0.1793
b. Because the bond carries a coupon
c. (i) A decrease in coupon rate from 9 % to 6 % will increase the duration.

(ii) An increase in yield from 9 % to 10 % reduces the duration because the duration
of a coupon bearing bond varies inversely with its yield.
103
(iii) A decrease in maturity period from 8 years to 7 years decreases the duration.
5. You are considering the following bond for inclusion in your fixed income
portfolio:
Coupon rate 12 %
Yield to maturity 12 %
Term to maturity 10 years
(a) What is the duration of this bond?
Solution:
The duration of a coupon bond is:
1+y (1 + y) + T(c –y)

-
y c [(1 +y)T – 1] + y
y = 12 %, c = 12 %, T = 10 years
So, the duration of the bond is:
1.12 (1.12) + 10 (0.12 – 0.12)

-
0.12 0.12 [(1.12)10 – 1] + 0.12
1.12
9.33 - = 6.325
0.3727
6. A 10-year level annuity has a yield of 9 percent. What is its duration?
Solution:
The duration of a level annuity is:
1 + yield Number of payments

-
yield (1 + yield) No. of payments – 1
Yield = 9 %; No. of payments = 10, So, the duration is:

1.09 10
-
.09 (1.09) 10 – 1
= 12.11 – 7.31 = 4.8 years
104
7. A 12-year level annuity has a yield of 11 percent. What is its duration?.
Solution:
The duration of a level annuity is:
1 + yield Number of payments

-
yield (1 + yield) No. of payments – 1
Yield = 11 %; No. of payments = 12
So, the duration is:

1.11 12
-
.11 (1.11) 12 – 1
= 10.09 – 4.80 = 5.29 years
8. A 10 percent coupon bond has a maturity of six years. It pays interest semi-
annually. Its yield to maturity is 4 percent per half year period. What is its
duration?
Solution:
The duration is:
1+y (1 + y) + T(c –y)

-
y c [(1 +y)T – 1] + y
1.04 (1.04) + 12 (.05 – .04)

-
.04 .05 [(1.04)12 – 1] + 0.04
= 26 – 16.56 = 9.44 half year periods.
9. An eight percent coupon bond has a maturity of 4 years. It pays interest semi-
annually. Its yield to maturity is 3 percent per half year period. What is its
duration?
105
Solution:
The duration is:
1+y (1 + y) + T(c –y)

-
y c [(1 +y)T – 1] + y
1.03 (1.03) + 8 (.04 – .03)

-
.03 .04 [(1.03)8 – 1] + 0.03
= 34.33 – 27.29 = 7.04 half year periods. / 8%/240,000/13
10. An insurance company has an obligation to pay Rs 652,710 after 13 years. The
market interest rate is 8 percent, so the present value of the obligation is Rs
240,000. The insurance company’s portfolio manager wants to fund the obligation
with a mix of 10 year bonds and perpetuities paying annual coupons. How much
should he invest in these two instruments?
Solution:
The liability has a duration of thirteen years. The duration of the zero coupon bond
is 10 years and the duration of the perpetuities is: 1.08/ 0.08 = 13.5 years.
As the portfolio duration is 13 years, if w is the proportion of investment in zero

coupon bonds, we have
(wx10) + (1-w)x 13.5 = 13

10w + 13.5 – 13.5w= 13
w=0.143 and 1-w= 0. 857
Therefore the amount to be invested in zero coupon bonds is

240,000 x 0.143 = Rs. 34,320 and the amount to be invested in perpetuities is
Rs. 205,680
11. An insurance company has an obligation to pay Rs. 325,784 after 9 years. The
market interest rate is 9 percent, so the present value of the obligation is Rs.
150,000. The insurance company’s portfolio manager wants to fund the obligation
with a mix of seven year bonds and perpetuities paying annual coupons. How much
should he invest in these two instruments?
106
Solution:
The liability has a duration of nine years. The duration of the zero coupon bond is 5
years and the duration of the perpetuities is: 1.09/ 0.09 = 12.11 years.
As the portfolio duration is 9 years, if w is the proportion of investment in zero

coupon bonds, we have
(wx5) + ( 1-w)x 12.11 = 9
5w + 12.11 – 12.11w = 9
w=0.437 and 1-w= 0. 563
Therefore the amount to be invested in zero coupon bonds is
150,000 x 0. 437 =Rs. 65,550 and the amount to be invested in perpetuities is Rs.
84,450.
12. A Rs 1,000,000 par six-year maturity bond with a 8 percent coupon rate (paid
annually) currently sells at a yield to maturity of 7 percent. A portfolio manager
wants to forecast the total return on the bond over the coming four years, as his
horizon is four years. He believes that four years from now, two-year maturity
bonds will sell at a yield of 5 percent and the coupon income can be reinvested in
short-term securities over the next three years at a rate of 5 percent. What is the
expected annualised rate of return over the four year period?
Solution:
Current price = 80,000 PVIFA (7 %, 6 years) + 1,000,000 PVIF (7%, 6 years)
= 80,000 x 4.766 + 1,000,000 x 0. 666
= 381,280 + 666,000
= 1,047,280
Forecast price = 80,000 PVIFA( 5 %, 2 years) + 1,000,000 PVIF ( 5%, 2 years)

= 80,000 x 1.859 + 1,000,000x 0.907 = 148,720 + 907,000
= 1,055,720
Future value of reinvested coupon
= 80,000 ( 1.05)3 + 80,000 ( 1.05)2 + 80,000 ( 1.05) + 80,000

= 344,810
344,810+ (1,055,720-1,047,280)
Four year return = ---------------------------------------- = 0.3373
1,047,280
The expected annualised return over the four year period will be
(1. 3373)1/4 – 1 = 0.0754 or 7.54 %
107
13. A Rs 100,000 par ten-year maturity bond with a 12 percent coupon rate (paid
annually) currently sells at a yield to maturity of 10 percent. A portfolio manager
wants to forecast the total return on the bond over the coming five years, as his
horizon is five years. He believes that five years from now, five-year maturity
bonds will sell at a yield of 9 percent and the coupon income can be reinvested in
short-term securities over the next four years at a rate of 8 percent. What is the
expected annualised rate of return over the five year period?
Solution:
Current price = 12,000 PVIFA (10 %, 10 years) + 100,000 PVIF (10%, 10 years)
= 12,000 x 6.145 + 100,000 x 0. 386
= 73,740 + 38,600
= 112,340
Forecast price = 12,000 PVIFA (9 %, 5 years) + 100,000 PVIF (9%, 5 years)

= 12,000 x 3.890 + 100,000x 0.650
= 46,680 + 65,000
= 111,680
Future value of reinvested coupon
= 12,000 ( 1.08)4 + 12,000 ( 1.08)3 +12,000 ( 1.08)2 +12,000 ( 1.08) + 12,000

= 70,399
70,399+ (111,680-112,340)
Five year return = ---------------------------------------- = 0. 6208
112,340
The expected annualised return over the five year period will be
(1. 6208)1/5 – 1 = 0.1014 or 10.14 %
108
CHAPTER 13
EQUITY VALUATION
1. The share of a certain stock paid a dividend of Rs.3.00 last year. The dividend is
expected to grow at a constant rate of 8 percent in the future. The required rate of
return on this stock is considered to be 15 percent. How much should this stock sell
for now? Assuming that the expected growth rate and required rate of return remain
the same, at what price should the stock sell 3 years hence?
Solution:
Do = Rs.3.00, g = 0.08, r = 0.15
Po = D1 / (r – g) = Do (1 + g) / (r – g)
= Rs.3.00 (1.08) / (0.15 - 0.08)

= Rs.46.29
Assuming that the growth rate of 8% applies to market price as well, the market price at
the end of the 3rd year will be:
P2 = Po x (1 + g)3 = Rs.46.29 (1.08)3

= Rs. 58.31
2. The share of a certain stock paid a dividend of Rs.10.00 last year. The dividend is
expected to grow at a constant rate of 15 percent in the future. The required rate of
return on this stock is considered to be 18 percent. How much should this stock sell
for now? Assuming that the expected growth rate and required rate of return remain
the same, at what price should the stock sell 4 years hence?
Solution:
Do = Rs.10.00, g = 0.15, r = 0.18
Po = D1 / (r – g) = Do (1 + g) / (r – g)
= Rs.10.00 (1.15) / (0.18 - 0.15)
= Rs.383.33
Assuming that the growth rate of 15% applies to market price as well, the market
price at the end of the 4th year will be:
P2 = Po x (1 + g)4 = Rs.383.33 (1.15)4

= Rs. 669.87
109
3. The equity stock of Hansa Limited is currently selling for Rs.280 per share. The
dividend expected next is Rs.10.00. The investors' required rate of return on this
stock is 14 percent. Assume that the constant growth model applies to Max Limited.
What is the expected growth rate of Max Limited?
Solution:
Po = D1 / (r – g)
Rs.280 = Rs.10 / (0.14 – g)
0.14 –g = 10/280 = 0.0357
g = 0.14-0.0357 = 0.1043or 10.43 %
4. The equity stock of Amulya Corporaion is currently selling for Rs.1200 per share.
The dividend expected next is Rs.25.00. The investors' required rate of return on
this stock is 12 percent. Assume that the constant growth model applies to Max
Limited. What is the expected growth rate of Max Limited?
Solution:
Po = D1 / (r – g)
Rs.1200 = Rs.25 / (0.12 – g)
0.12 –g = 25/1200 = 0.0208
g = 0.12-0.0208 = 0.0992 or 9.92 %
5. Sloppy Limited is facing gloomy prospects. The earnings and dividends are
expected to decline at the rate of 5 percent. The previous dividend was Rs.2.00. If
the current market price is Rs.10.00, what rate of return do investors expect from
the stock of Sloppy Limited?
Solution:
Po = D1/ (r – g) = Do(1+g) / (r – g)
Do = Rs.2.00, g = -0.05, Po = Rs.10
So,
10 = 2.00 (1- .05) / (r-(-.05)) = 1.90 / (r + .05)
r +0.05 = 1.90/10 = 0.19
r = 0.19 – 0.05 = 0.14
110
6. Mammoth Corporation is facing gloomy prospects. The earnings and dividends are
expected to decline at the rate of 10 percent. The previous dividend was Rs.3.00. If
the current market price is Rs.25.00, what rate of return do investors expect from
the stock of Mammoth Limited?
Solution:
Po = D1/ (r – g) = Do(1+g) / (r – g)
Do = Rs.3.00, g = -0.10, Po = Rs.25
So,
25 = 3.00 (1- .10) / (r-(-.10)) = 2.7 / (r + .10)
r +0.10 = 2.7/25 = 0.108
r = 0.108 – 0.10 = 0.008 or 0.8 percent
7. The current dividend on an equity share of Omega Limited is Rs.8.00 on an earnings

per share of Rs. 30.00.
(i) Assume that the dividend per share will grow at the rate of 20 percent per year for
the next 5 years. Thereafter, the growth rate is expected to fall and stabilise at 12
percent.
Investors require a return of 15 percent from Omega’s equity shares. What is the
intrinsic value of Omega’s equity share?
Solution:
111
(ii) Assume that the growth rate of 20 percent will decline linearly over a five year
period and then stabilise at 12 percent. What is the intrinsic value of Omega’s
share if the investors’ required rate of return is 15 percent?
Solution:
D0 [ ( 1 + gn) + H ( ga - gn)]
P0 =
r - gn
8 [ (1.12) + 2.5 ( 0.20 - 0.12 )]

=
0.15 - 0.12
= Rs. 352
8. The current dividend on an equity share of Magnum Limited is Rs.4.00.
(i) Assume that Magnum’s dividend will grow at the rate of 18 percent per year for
the next 5 years. Thereafter, the growth rate is expected to fall and stabilise at 10
percent. Equity investors require a return of 15 percent from Magnum’s equity
shares. What is the intrinsic value of Magnum’s equity share?
Solution:
g1 = 18%, g2 = 10%, n = 5 yrs, r = 15%

D1 = 4 (1.18) = Rs.4.72
n
1 + g1
1–
1+r D1 (1 + g1) n – 1 (1 + g2) 1
P0 = D1 + x
r – g1 r – g2 (1 + r)n
5
1.18
1-
1.15 4.72 (1.18)4 (1.10) 1
= 4.72 + x
0.15 – 0.18 0.15 – 0.10 (1.15)5
= 21.62 + 100.12
= 121.74
112
(ii) Assume now that the growth rate of 18 percent will decline linearly over a period
of 4years and then stabilise at 10 percent . What is the intrinsic value per share of
Magnum, if investors require a return of 15 percent ?
Solution:
(1 + gn) + H (ga – gn)

P0 = D0
r – gn
(1.10) + 2 (0.18 – 0.10)

= 4.00
0.15 – 0.10
= Rs.100.8
9. The current dividend on an equity share of Omex Limited is Rs. 5.00 on an earnings
per share of Rs. 20.00.
(i) Assume that the dividend will grow at a rate of 18 percent for the next 4 years.
Thereafter, the growth rate is expected to fall and stabilize at 12 percent. Equity
investors require a return of 15 percent from Omex’s equity share. What is the
intrinsic value of Omex’s equity share?
Solution:
g1 = 18 %, g2 = 12 %, n = 4yrs , r = 15%
D1 = 5 (1.18) = Rs. 5.90

n
1+ g1
1-
Po = D1 1+ r D1 (1 + g1)n - 1 (1 + g2 ) 1
+ x
r - g1 r - g2 ( 1 + r )n
4
1.18
1 -
= 5.90 1.15 5.90 ( 1.18 )3 ( 1.12 ) 1
+ x
0.15 - 0.18 0.15 - 0.12 ( 1.15)4
= 21.34 + 206.92
= Rs. 228.35
113
10. Keerthi Limited is expected to give a dividend of Rs.5 next year and the same
would grow by 12 percent per year forever. Keerthi pays out 60 percent of its
earnings. The required rate of return on Keerthi’s stock is 15 percent. What is the
PVGO?
Solution:
Po = D1
r–g
Po = 5 = Rs. 166.67
0.15-0.12
Po = E1 + PVGO
r
Po = 8.33 + PVGO
0.15
166.67 = 55.53 + PVGO
So, PVGO = 111.14
11. Adinath Limited is expected to give a dividend of Rs.3 next year and the same
would grow by 15 percent per year forever. Adinath pays out 30 percent of its
earnings. The required rate of return on Adinath’s stock is 16 percent. What is the
PVGO?
Solution:
Po = D1
r–g
Po = 3 = Rs. 300
0.16-0.15
Po = E1 + PVGO
r
Po = 10 + PVGO
0.16
300 = 62.5 + PVGO
So, PVGO = 237.5
114
12. The balance sheet of Cosmos Limited at the end of year 0 (the present point of
time) is as follows.
Rs. in crore
Liabilities Assets
 Shareholders’ funds 500  Net fixed assets 550
 Equity capital 200  Net working capital 200
(20 crore shares of
Rs. 10 each)
 Reserves and surplus 300
 Loan funds( rate
10 percent) 250
750 750
The return on assets( NOPAT) is expected to be 18 percent of the asset value at the
beginning of each year. The growth rate in assets and revenues will be 30 percent
for the first three years, 18 percent for the next two years, and 10 percent thereafter.
The effective tax rate of the firm is 34 percent, the pre-tax cost of debt is 10 percent
and the cost of equity is 24 percent. The debt-equity ratio of the firm will be
maintained at 1:2. Calculate the intrinsic value of the equity share.
Free Cash Flow Forecast
Rs. In crore
Year 1 2 3 4 5 6
Asset value (Beginning) 750.0 975.0 1267.50 1647.75 1944.35 2294.33
NOPAT 135.0 175.50 228.15 296.60 349.98 412.98
Net investment 225.00 292.50 380.25 296.60 349.98 229.43
FCF (90.0) (117.0) (152.1) - - 183.55
Growth rate (%) 30 30 30 20 20 10
3. The weighted average cost of capital is:
WACC = (2/3) x 24 + (1/3) x 10 (1-0.34) = 18.2 percent
4. The horizon value of the firm = (183.55 x 1.10) /(0.182-0.10) = 2462.26 crores
5. The enterprise value is:

-90.00 117 152.1 0
EV = - 2 - +
(1.182) (1.182) (1.182)3 (1.182)4
115
0 183.55 2462.26
+ 5 + +
(1.182) (1.182)6 (1.182)6
= Rs. 718.19 crores
6. The equity value is:
Enterprise value - Debt value = 718.19 – 250.0 = Rs. 468.19Crores
7. The value per share is:
Rs. 468.19/ 20 crore = Rs. 23.41
13. The balance sheet of Oriental Limited at the end of year 0 (the present point of
time) is as follows.
Rs. in crore
Liabilities Assets
 Shareholders’ funds 200  Net fixed assets 400
 Equity capital 100  Net working capital 200
(10 crore shares of
Rs. 10 each)
 Reserves and surplus 100
 Loan funds ( rate
10percent) 400
600 600
The return on assets ( NOPAT) is expected to be 15 percent of the asset value at

the beginning of each year. The growth rate in assets and revenues will be 25
percent for the first two years, 15 percent for the next two years, and 8 percent
thereafter.
The effective tax rate of the firm is 32 percent , the pre-tax cost of debt is 11 percent
and the cost of equity is 22 percent. The debt-equity ratio of the firm will be
maintained at 2:1. Calculate the intrinsic value of the equity share.
116
Free Cash Flow Forecast
Rs. In crore
Year 1 2 3 4 5
Asset value (Beginning) 600.0 750.0 937.50 1078.12 1239.84
NOPAT 90.0 112.50 140.62 161.72 185.98
Net investment 150.0 187.50 140.62 161.72 99.19
FCF (60.0) (75.0) ---- --- 86.79
Growth rate (%) 25 25 15 15 8
3. The weighted average cost of capital is:
WACC = (1/3) x 22 + (2/3) x 11 (1-0.32) = 12.32 percent
4. The horizon value of the firm is
FCFH+1 86.79 x 1.08

VH = + = 2169.75
r–g 0.1232 – 0.08
5. The enterprise value is:
-60.00 75 86.79 2169.75

EV = (1.1232 - + + (1.1232)5
(1.1232)2 (1.1232)5
)
= Rs. 1149.42 crores
6. The equity value is:
Enterprise value - Debt value = 1149.42– 400 = Rs. 749.42 Crores
7. The value per share is:
Rs. 749.42 / 10 = Rs. 74.94
117
CHAPTER 15
COMPANY ANALYSIS
1. Modern Industries Limited is a diversified company with a fairly strong position in

certain segments. The financials of the company for the last five years are given
below:
Rs. in crore
Income Statement Summary 20X1 20X2 20X3 20X4 20X5

 Net sales 560 610 630 685 744
 Profit before interest and tax 80 91 100 118 124
 Interest 20 22 23 25 27
 Profit before tax 60 69 77 93 97
 Tax 20 24 25 30 31
 Profit after tax 40 45 52 63 66
 Dividends 10 12 14 16 16
Balance Sheet Summary

 Equity capital (Rs.5 par) 50 50 50 50 50
 Reserves and surplus 200 233 271 318 368
 Loan funds 120 130 135 140 143
 Capital employed 370 413 456 508 561
 Net fixed assets 250 270 306 343 373
 Investments 20 21 25 30 28
 Net current assets 100 122 125 135 160
 Total assets 370 413 456 508 561
 Market price per share (year end) 35 40 51 57 65
The year 20X5 has just ended. The current market price per share is Rs.65.
(a) Calculate the following for the past 2 years : return on equity, book value per share,
EPS, PE ratio (prospective)
(b) Calculate the CAGR of sales and EPS for the period 20X1 - 20X5.
(c) Calculate the sustainable growth rate based on the average retention ratio and the
average return on equity for the past 2 years.
(d) Decompose the ROE for the last two years in terms of five factors.
(e) Estimate the EPS for the next year (20X6) using the following assumptions: (i) Net
sales will grow at 12%. (ii) PBIT / Net sales ratio will improve by 1% over its 20X5
value. (iii) Interest will increase by 8 percent over its 20X5 value. (iv) Effective tax
rate will be 30 percent.
(f) Derive the PE ratio using the constant growth model. For this purpose use the
following assumptions: (i) The dividend payout ratio for 20X6 will be equal to the
average dividend payout ratio for the period 20X4 - 20X5. (ii) The required rate of
118
return is estimated with the help of the CAPM (Risk-free return = 8%, Market risk
premium = 8%, Beta of Modern Industries stock is 0.9). (iii) The expected growth
rate in dividends is set equal to the product of the average return on equity for the
previous two years and the average retention ratio.
Solution:
a.
20X4 20X5
Return on equity 63 66
= 17.1% = 15.8%
368 418
Book value per share 368 418

= Rs.36.8 = Rs.41.8
10 10
EPS 63 66
= Rs.6.3 = Rs.6.6
10 10
Price per share
(year beginning) Rs.51 Rs.57
PE ratio (prospective) 51 57
= 8.1 = 8.6
6.3 6.6
b.
CAGR in sales:
0.25
744
-1 = 7.36%
560
CAGR in EPS:
0.25
6.6
-1 = 13.34%
4
119
c.
20X4 20X5 Average

Retention ratio 47 50
= 0.75 = 0.76 0.755
63 66
Return on equity 17.1% 15.8% 16.45%
Sustainable growth rate based on the average retention ratio and average return on equity:
0.755 x 16.45% = 12.4%
d.
PBIT Sales PBT PAT Assets

x x x x = ROE
Sales Assets PBIT PBT Networth
118 685 93 63 508

20X4 x x x x
685 508 118 93 368
17.2% x 1.348 x 0.788 x 0.677 x 1.380 = 17.1%
124 744 97 66 561

20X5 x x x x
744 561 124 97 418
16.7% x 1.326 x 0.782 x 0.680 x 1.342 = 15.8%
e. EPS for 20X6

20X5 20X6 Remarks
Net sales 744 833.3 Increase by 12%
PBIT 124 147.2 Increase in PBIT/Netsales by
1%. It increases from 16.666%
to 17.666%
Interest 27 29.2 Increase by 8%
PBT 97 118
Tax 31 35.4 Tax rate is 30%
PAT 66 82.6
EPS Rs.8.26
120
f. Payout ratio
PE ratio =
Required return - Sustainable growth rate
Average payout ratio = 0.245

Required return = 8% + 0.9x8%
= 15.2%
= 0.152
Sustainable growth rate (see c) = 0.124
0.245
Value anchor = = Rs.72.28
(0.152 - 0.124)
P/E ratio = 8.75 x 8.26 = 72.28
2. Fenix Corporation was set up fifteen years ago. After few years of initial turbulence
the company found a few market segments in which it had some competitive
advantage. The financials of the company for the last five years are given below:
Rs. in million
Income Statement Summary 20X1 20X2 20X3 20X4 20X5

 Net sales 1200 1320 1400 1510 1630
 Profit before interest and tax 180 195 201 220 242
 Interest 40 44 47 50 56
 Tax 40 43 45 50 54
 Profit after tax 100 108 109 120 132
 Dividends 36 40 40 42 45
 Retained earnings 64 68 69 78 87

 Loan funds 400 445 450 460 505
 Net fixed assets 728 863 870 920 982
 Investments 100 102 90 104 118
 Total assets 1120 1233 1307 1395 1527
 Market price per share (year end) 52 50 55 62 68
121
The year 20X5 has just ended. The current market price per share is Rs.68. The market
price per share at the beginning of 20X1 was Rs.49.
(a) What was the geometric mean return for the past 5 years ?
(b) Calculate the following for the past 2 years : return on equity, book value per share,
EPS, PE ratio (prospective), market value to book value ratio.
(c) Calculate the CAGR of sales and EPS for the period 20X1 - 20X5.
(d) Calculate the sustainable growth rate based on the average retention ratio and the
(e) Decompose the ROE for the last two years in terms of five factors.
(f) Estimate the EPS for the next year (20X6) using the following assumptions : (i) Net
sales will grow at 10%. (ii) PBIT / Net sales ratio will improve by 0.5% over its 20X5
value. (iii) Interest will increase by 9 percent over its 20X5 value. (iv) Effective tax
rate will be 32 percent.
(g) Derive the PE ratio using the constant growth model. For this purpose use the
following assumptions: (i) The dividend payout ratio for 20X6 will be equal to the
average dividend payout ratio for the period 20X4 - 20X5. (ii) The required rate of
return is estimated with the help of the CAPM (Risk-free return = 7%, Market risk
premium = 7%, Beta of Fenix Corporations’ stock = 0.8). (iii) The expected growth
rate in dividends is set equal to the product of the average return on equity and
average retention ratio for the previous two years.
122
123
3. Invensys Tech Ltd was set up 25 years ago. After few years of initial turbulence the
company found a few market segments in which it had some competitive
advantage. The financials of the company for the last five years are given below:
Rs. in million
Income Statement Summary 20 x 1 20 x 2 20 x 3 20 x 4 20 x 5
 Net sales 1800 2160 2500 3010 3800
 Profit before interest & tax 540 610 625 780 1180
 Interest 108 140 150 187 290
 Tax 125 140 142 180 275
 Profit after tax 307 330 333 413 615
 Dividends 108 116 117 165 246
 Retained earnings 199 214 216 248 369
 Loan funds 200 240 250 275 325
 Net fixed assets 800 830 950 1170 1530
 Investments 100 110 120 135 140
1150 1404 1630 1903 2322
 Market price per share(year ended) 120 176 180 270 462
The year 20x5 has just ended. The current market price per share is Rs.462. The market
price per share at the beginning of 20x1 was Rs.82.
(a) What was the geometric mean return for the past 5 years?
(b) Calculate the following for the past 2 years: return on equity, book value per share,
EPS,PE ratio (Prospective), market value to book value ratio.
(c) Calculate the CAGR of Sales & EPS for the period 20 x 1 – 20 x 5.
(d) Calculate the sustainable growth rate based on the average retention ratio and the
(e) Decompose the ROE for the last 2 years in term of five factors.
(f) Estimate the EPS for the next year (20 x 6) using the following assumptions.
(i) Net sales will grow at 30%
(ii) PBIT / Net sales ratio will improve by 1.5% over its 20 x 5 value.
(iii) Interest will increase by 5% over its 20 x 5 value.
(iv) Effective tax rate will be 30%.
(g) Derive the PE ratio using the constant-growth model. For this purpose use the
following assumptions.
124
(i) The dividend pay out ratio for 20 x 6 will be equal to the average dividend pay out
ratio for the period 20 x 4 – 20 x 5.
(ii) The required rate of return is estimated with the help of the CAPM (Risk free
return = 7%, Market risk premium = 10%, Beta of Invensys’s Stock = 1.3).
(iii) The expected growth rate in dividends is set equal to the product of the average
return on equity and average retention ratio for the previous 2 years.
Solution:
(a) 20x1 20x2 20x3 20x4 20x5
108 116 117 165 246
= 7.2 = 7.73 = 7.8 = 11 = 16.4
15 15 15 15 15
Return
7.2 + 120 7.73 + 176 7.8 + 180 11 + 270 16.4 + 462

= 1.55 = 1.53 = 1.06 = 1.56 = 1.77
82 120 176
7 180 270
1
/n
(1 + R1) (1 + R2) ---- (1 + Rn) –1
1
/5
(1.55) (1.53) (1.06) (1.56) (1.77) – 1 = 47.33
(b) 20 x 4 20 x 5
413 615
ROE = 25.37 = 30.80
1628 1997
1628 1997
BVPS = 108.53 = 133.13
15 15
307 413 615
EPS = 20.47 = 27.53 = 41
15 15 15
180 270
PER = 6.53 = 6.58
27.53 41
270 462
MV/BV = 2.48 = 3.47
108.53 133.13
248 369
Retention ratio = 0.60 = 0.60
413 615
125
¼
3800
(c) CAGR of sales = – 1 = 20.54
1800
¼
41
,, EPS = – 1 = 18.96
20.47
0.6 + 0.6 25.37 + 30.80
(d) Sustainable growth rate =
2 2
= 0.6 x 28.09 = 16.85%
(e) PBIT Sales PBT PAT Assets

x x x x
Sales Assets PBIT PBT Networth
20 x 4 0.259 x 1.58 x 0.76 x 0.70 x 1.17

20 x 5 0.310 x 1.64 x 0.75 x 0.69 x 1.16
(f) EPS estimate for 20x6
20x5 20x6
Net sales 3800 4940
PBIT 1180 1608
Interest 290 305
PBT 890 1303
Tax 275 391
PAT 615 912
EPS 41 60.8
(g) (i) Avg retention for past 2 years = 0.60

So Avg pay out ratio = 1 – 0.60 = 0.40
(ii) Required rate of return
= 7% + 1.3 x 10% = 20%
(iii) Expected growth rate in dividends
Avg ROE x Avg retention ratio for 2 years
= 0.6 x 28.09 = 16.85%
PE ratio as per constant growth model is:
0.4
= 12.70
20 – 16.85
126
CHAPTER 17
OPTIONS
1. A stock is currently selling for Rs.80. In a year’s time it can rise by 50 percent or
fall by 20 percent. The exercise price of a call option is Rs.90.
(i) What is the value of the call option if the risk-free rate is 10 percent? Use the
option-equivalent method.
Solution:
S0 = Rs.80 u = 1.5 d = 0.8

E = Rs.90 r = 0.10 R = 1.10
Cu – Cd 30 – 0 30
∆= = =
(u – d) S 0.7 x 80 56
u Cd – d Cu 1.5 x 0 – 0.8 x 30
B= = = - 31.17
(u – d) R 0.7 x 1.10
C = ∆S + B
30
= x 80 – 31.17
56
= 11.69
(ii) What is the value of the call option if the risk-free rate is 6 percent? Use the
risk-neutral method.
Solution:
[P x 50%] + [(1 – P) x – 20%] = 6%
50 P + 20 P = 26  P = 0.37
Expected future value of a call
0.37 x 30 + 0.63 x 0 = Rs.11.10

Rs.11.10
Current value = = Rs.10.47
1.06
127
2. An equity share is currently selling for Rs 100. In a year’s time it can rise by 30
percent or fall by 10 percent. The exercise price of call option on this share is
Rs.110.
(i) What is the value of the call option if the risk – free rate is 7 percent ? Use the
option – equivalent method.
Solution:
S0 = 100, E = 110, u = 1.3, d = 0.9, R = 1.07
Cu – Cd 20 – 0 20
= = = = 0.5
( u – d) S0 0.4 x 100 40
uCd – dCu 1.3 x 0 – 0.9 x 20 - 42.06

B = = =
( u – d) R 0.4 x 1.07
C = S+B = 0.5 x 100 - 42.06 = 7.94
(ii) What is the value of the call option if the risk-free rate is 6 percent? Use the
risk – neutral method.
Solution:
P x 30% + (1-P) x -10% = 6%
30P + 10P - 10 = 6 == P = 0.4
Expected future value of call
0.4 x 20 + 0.6 x 0 = Rs. 8.00
Current value = 8 = Rs. 7.55

1.06
3. An equity share is currently selling for Rs.60. In a year’s time, it can rise by 50
percent or fall by 10 percent. The exercise price of a call option on this share is
Rs.70.
128
a. What is the value of the call option if the risk-free rate is 8 percent? Use the
option-equivalent method.
Solution:
S0 = Rs. 60, E = Rs. 70, u = 1.5, d = 0.9, R = 1.08
Cu - Cd 20 - 0 20
Δ = = =
(u - d ) So (0.6) 60 36
u Cd - d Cu 1.5 x 0 - 0.9 x 20
B = = = - 27.78
(u - d) R 0.6 x 1.08
C = Δ S + B = 20 / 36 x 60 - 27.78 = Rs. 5.55
b. What is the value of the call option, if the risk-free rate is 6 percent? Use
the risk-neutral method.
Solution:
P x 50 % + ( 1 – P ) x -10% = 6 %
50 P + 10P - 10 = 6 P = 0.27
Expected future value of call

0.27 x 20 + 0.73 x 0 = 5.4
5.4
Current value = Rs. 5.09
1.06
4. The following information is available for a call option:

Time to expiration (months) 3
Risk free rate 8%
Exercise price Rs.60
Stock price Rs.70
Call price Rs.14
What is the value of a put option if the time to expiration is 3 months, risk free rate is
8%, exercise price is Rs.60 and the stock price is Rs.70?
129
Hint : Use put-call parity theorem
Solution:
According to put-call parity theorem
P0 = C0 + E - S0
ert
= 14 + 60 - 70
e .08 x .25
= 14 + 60 - 70 = Rs.2.812
1.0202
5. Consider the following data for a certain share:
Price of the stock now = S0 = Rs.80

Exercise price = E = Rs.90
Standard deviation of continuously compounded annual return =  = 0.3
Expiration period of the call option = 3 months
Risk-free interest rate per annum = 8 percent
(i) What is the value of the call option? Use the normal distribution table and
resort to linear interpolation.
Solution:
S0 = Rs. 80, E = Rs. 90, r = 0.08, σ = 0.3 , t = 0.25
E
Co = So N (d1) - N (d2)
ert
So σ2
ln + r + t
E 2
d1 =
σ√t
130
0.09
- 0.1178 + ( 0.08 + ) 0.25
2
= = - 0.577
0.3 √ 0.25
d2 = d1 - σ √ t = - 0.577 - 0.3 √ 0.25 = - 0.727
N (d1) = N (- 0.577) N ( - 0.600) = 0.2743

N (- 0.550 ) = 0.2912
N ( -0.577) = 0.2743 +( 0.023 / 0.050) [0.2912 – 0.2743]
= 0.2821
N(d2) = N ( - 0.727) N (- 0.750) = 0.2264

N (- 0.700) = 0.2420
N (- 0.727) = 0.2264 +(0 .023 /.050) [.2420 - .2264]
= 0.2336
90
Co = 80 x 0.2821 - x 0.2336
e 0.08 x 0.25
= 22.5 7 - 20.61 = Rs. 1.96
(ii) What is the value of a put option?
Solution:
E
Po = C o - So +
e rt
90
= 1.96 - 80 + = Rs. 10.18
0.08 x 0.25
e
131
6. Consider the following data for a certain share.
Current Price = S0 = Rs. 80

Exercise Price = E = Rs. 90

Risk – free interest rate per annum = 6 percent
(i) What is the value of the call option? Use the normal distribution table given at
the end of this booklet and resort to linear interpolation.
Solution:
S0 = Rs. 80 E = Rs. 90
r = 0.06, σ = 0.5, t = 0.25
C0 = S0N(d1) - E N (d2)
ert
d1 = ln S0 r + σ2 t -0.1178 + 0.06 + 0.25 0.25
E + 2 2
=
σ t 0.5 0.25
= - 0.2862
d2 = d1 – σ t = - 0.2862 - 0.5 0.25 = - 0.5362
N(d1) = N ( - 0.2862) N (-0.30) = 0.3821

N (-0.25) = 0.4013
N (-0.2862) = 0.3821 + 0.0138 [ 0.4013 – 0.3821]
0.05
= 0.3874
N(d2) = N( - 0.5362) N (-0.55) = 0.2912
N (-0.50) = 0.3085
N( - 0.5362) = 0.2912 + 0.0138 [ 0.3085 – 0.2912]
0.05
= 0.2960
C0 = 80 x 0.3874 - 90 x0. 2960
e ( .06 x 0.25)
= 30.99 - 26.24
= Rs. 4.75
132
(ii) What is the value of a put option?
Solution:
P0 = C0 – S0 + E
ert
= 4.75 - 80 + 90
.06 x 0.25
e
= Rs. 13.41
7. Consider the following data for a certain stock:
Price of the stock now = S0 = Rs.150

Exercise price = E = Rs.140
Risk-free interest rate per annum = 6 percent
(i) What is the value of the call option? Use normal distribution table and resort to
linear interpolation?
Solution:
C0 = S0 N(d1) – E N(d2)
ert S0 = Rs.150, E = Rs.140, r = 0.06,
ln (S0/E) + (r + 2/2) t  = 0.3, t = 0.25

d1 =
 t
0.069 + (0.06 + 0.09/2) 0.25
= = 0.635
0.30.25
d2 = d1 -  t = 0.485
N (d1) = N (0.635) = 0.7373 N (0.60) = 1 – 0.2743 = 0.7257

N (d2) = N (0.485) = 0.6861 N (0.65) = 1 – 0.2578 = 0.7422
.035
N (0.635) = 0.7257 + (.7422 –.7257)
.05
= 0.7373
140 N (0.45) = 1 – 0.3264 = 0.6736
C0 = 150 x 0.7373 – x 0.6861 N (0.50) = 1 – 0.3085 = 0.6915
.06 x 0.25
e .035
N (0.485) =0.6736 + (.6915 – 0.6736)
.05
=110.60 – 94.62 = Rs.15.98 = 0.6861
133
(ii) What is the value of the put option?
Solution:
E
P0 = C0 – S0 +
ert
140
= 15.98 – 150 +
e.06 x . 25
= Rs.3.90
134
CHAPTER 18
FUTURES
1. Assume that an investor buys a stock index futures contract on February 1 at 5320.
The position is closed out on February 4 at that day’s closing price. The closing
stock index prices on February 1, 2, 3 and 4 were 5310, 5250, 5234 and 5370
respectively. Calculate the cash flow to the investor on a daily basis. Ignore the
margin requirements.
Cash flow to the buyer
February 1 5310 – 5320 = -10

February 2 5250 – 5310 = - 60
February 3 5234 – 5250 = - 16
February 4 5370 – 5234 = 136
2. Assume that an investor buys a stock index futures contract on March 11 at 4800.
The position is closed out on March 14 at that day’s closing price. The closing
stock index prices on March 11, 12, 13 and 14 were 4810, 4850, 4874 and 4770
respectively. Calculate the cash flow to the investor on a daily basis. Ignore the
margin requirements.
Cash flow to the buyer
March 11 4810 – 4800 = 10

March 12 4850 – 4810 = 40
March 13 4874 – 4850 = 24
March 14 4770 – 4874 = - 104
3. A non dividend-paying stock has a current price of Rs 80. What will be the futures
price if the risk-free rate is 10 percent and the maturity of the futures contract is 6
months?
F0 = S0 (1+rf)t
= Rs.80 (1.10)0.5
= Rs.83.90
4. A non dividend-paying stock has a current price of Rs 340. What will be the
futures price if the risk-free rate is 9 percent and the maturity of the futures
contract is 3 months?
F0 = S0 (1+rf)t
= Rs.340 (1.09)0.25
= Rs. 347.40
135
5. Suppose a stock index has a current value of 5120. If the risk-free rate is 8 percent
and the expected dividend yield on the index is 2 percent, what should be the price
of the one year maturity futures contract?
F0 = S0 (1+rf - d)t
= 5120 (1 + 0.08 - .02)1
= 5427
6. Suppose a stock index has a current value of 4985. If the risk-free rate is 7 percent
and the expected dividend yield on the index is 4 percent, what should be the price
of the one year maturity futures contract?
F0 = S0 (1+rf - d)t
= 4985 (1 + 0.07 - .04)1
= 5135
7. The following information about copper scrap is given:

 Spot price : Rs.10,000 per ton
 Futures price : Rs.10,800 for a one year contract
 Interest rate : 12 per cent
 PV (storage costs) : Rs.500 per year
What is the PV (convenience yield) of copper scrap?
Solution:
Futures price
= Spot price + Present value of – Present value
1
(1+Risk-free rate) storage costs of convenience yield
10,800
= 10,000 + 500 – Present value of convenience yield
1
(1.12)
Hence the present value of convenience yield is Rs.857.14 per ton.
8. The following information about gunmetal scrap is given:
 Spot price : Rs.150,000 per ton

 Futures price : Rs.160,000 for a one year contract
 Interest rate : 13 per cent
 PV (storage costs) : Rs.800 per year
What is the PV (convenience yield) of gunmetal scrap?
136
Solution:
Futures price
= Spot price + Present value of – Present value
(1+Risk-free rate)1 storage costs of convenience yield
160,000
= 150,000 + 800 – Present value of convenience yield
1
(1.13)
Hence the present value of convenience yield is Rs.9,207 per ton.
137
CHAPTER 19
MUTUAL FUNDS
1. You can earn a return of 16 percent by investing in equity shares on your own. You
are considering a recently announced equity mutual fund scheme where the exit load
is 2.5 percent and the recurring annual expenses are expected to be 1.6 percent. How
much should the mutual fund scheme earn to provide a return of 16 percent of you?
Solution:
(1+ r2)
(1+ r2) =
(1- ά) (1-β)
(1.16)
=
(1-.025) (1-.016)
= 1.209
r2 = 20.9 percent
2 You can earn a return of 12 percent by investing in equity shares on your own.
You are considering a recently announced equity mutual fund scheme where the exit
load is 1.2 percent. You believe that the mutual fund scheme will earn 15 percent. At
what recurring expense (in percentage terms) will you be indifferent between
investing on your own and investing through the mutual fund.
Solution:
(1+ r2)
(1+ r2) =
(1- ά) (1-β)
(1.12)
(1.15) =
(1- ά ) (1.012)
(1- ά ) = 0.9857
Ά = 0.0143 or 1.43 percent
138
CHAPTER 20
INVESTMENT IN REAL ASSETS
1. Gopal is considering an investment in a commercial property costing Rs. 15

million. Gopal can get a bank loan of Rs. 6 million at the rate of 11 percent per
year, for purchasing the property. The loan will be repaid in 10 equal instalments;
the first instalment will fall due one year from now. Gopal expects that the property
will fetch a rental income of Rs. 1.2 million for the first year; thereafter the rental
income will increase at the rate of 6 percent per year. For the sake of simplicity
assume that the rental income is receivable at the end of the year. After 10 years,
the property is expected to fetch a net salvage value of Rs. 30 million. Gopal’s
required hurdle rate for this project is 15 percent and his tax rate is 30 percent. Is
this a worthwhile proposal?
Solution:
The equated annual instalment of the loan

= 6,000,000 / PVIFA( 11% , 10Yrs)
= 6,000,000 / 5.889 = 1,018,849
Amount
Amount
Outstanding Principal
Year Interest Installment Outstanding
in the Repayment
at the End
Beginning
1 6,000,000 660,000 1,018,849 358,849 5,641,151
2 5,641,151 620,527 1,018,849 398,322 5,242,829
3 5,242,829 576,711 1,018,849 442,138 4,800,691
4 4,800,691 528,076 1,018,849 490,773 4,309,918
5 4,309,918 474,091 1,018,849 544,758 3,765,160
6 3,765,160 414,168 1,018,849 604,681 3,160,478
7 3,160,478 347,653 1,018,849 671,196 2,489,282
8 2,489,282 273,821 1,018,849 745,028 1,744,254
9 1,744,254 191,868 1,018,849 826,981 917,273
10 917,273 100,900 1,018,849 917,949 -676
139
Interest Principal
Year Rental Income Post-tax Post-tax Net Cash
Payment Repayment
Interest
Rental Income Flow
Payment
A B = (0.79A) C D=(0.7C) E F=(B-D-E)
1 1,200,000 948,000 660,000 462,000 358,849 127,151

2 1,272,000 1,004,880 620,527 434,369 398,322 172,189
3 1,348,320 1,065,173 576,711 403,698 442,138 219,337
4 1,429,219 1,129,083 528,076 369,653 490,773 268,657
5 1,514,972 1,196,828 474,091 331,864 544,758 320,206
6 1,605,871 1,268,638 414,168 289,917 604,681 374,039
7 1,702,223 1,344,756 347,653 243,357 671,196 430,203
8 1,804,356 1,425,441 273,821 191,675 745,028 488,739
9 1,912,618 1,510,968 191,868 134,308 826,981 549,679
10 2,027,375 1,601,626 100,900 70,630 917,949 613,047
The expected post-tax rental income (PTRI) =0.7 Rental income (1-0.3) + 0.3 Rental
income = 0.79 Rental income.
IRR is calculated as follows:

127,151 172,189 219,337
9,000,000 = + +
(1+IRR) (1+IRR)2 (1+IRR) 3
268,657 320,206 374,039 430,203

+ + + +
(1+IRR) 4 (1+IRR) 5 (1+IRR) 6 (1+IRR) 7
488,739 549,679 30, 613,047

+ + +
(1+IRR) 8 (1+IRR) 9 (1+IRR) 10
Trying a rate of 15% for IRR, LHS = 8,904,324
By extrapolation,
IRR = 14 + (9,657,822– 9,000,000) /(9,657,822–= 8,904,324)
= 14 + 0.87
= 14.87 %
The IRR (14.87 percent) is lower than the hurdle rate (15.00 percent). So, it is not a
worthwhile investment proposal.
2. In problem 1, assume that Gopal collects a deposit equal to 3 years’ rent, but the
rental income increases by 30 percent every five years. What will be the IRR of the
proposal?
140
Solution:
The net cash flow from the rental income will change as under:
Rental Interest Principal

Post-tax Post-tax Net Cash
Income Payment Repayment
Year
Rental Interest
Income Payment Flow
A B = (0.79A) C D=(0.7C) E F=(B-D-E)
1 1,200,000 948,000 660,000 462,000 358,849 127,151

2 1,200,000 948,000 620,527 434,369 398,322 115,309
3 1,200,000 948,000 576,711 403,698 442,138 102,164
4 1,200,000 948,000 528,076 369,653 490,773 87,574
5 1,200,000 948,000 474,091 331,864 544,758 71,378
6 1,560,000 1,232,400 414,168 289,917 604,681 337,802
7 1,560,000 1,232,400 347,653 243,357 671,196 317,847
8 1,560,000 1,232,400 273,821 191,675 745,028 295,697
9 1,560,000 1,232,400 191,868 134,308 826,981 271,111
10 1,560,000 1,232,400 100,900 70,630 917,949 243,821
127,151 115,309 102,164

5,400,000 = + +
(1+IRR) (1+IRR)2 (1+IRR) 3
57,574 71,378 337,802 317,847

+ + + +
(1+IRR) 4 (1+IRR) 5 (1+IRR) 6 (1+IRR) 7
295,697 271,111 26, 643,821

+ + +
(1+IRR) 8 (1+IRR) 9 (1+IRR) 10

By extrapolation,
IRR = 18 + (5,784,508 – 5,400,000) /(5,784,508- 5,344,397)

= 18 + 0.87
= 18.87 %
141
3. Rahul is considering an investment in a commercial property costing Rs. 35 million.
Rahul can get a bank loan of Rs. 15 million at the rate of 13 percent per year, for
purchasing the property. The loan will be repaid in 8 equal instalments; the first
instalment will fall due one year from now. Rahul expects that the property will
fetch a rental income of Rs. 3.5 million for the first year; thereafter the rental
income will increase at the rate of 8 percent per year. For the sake of simplicity
assume that the rental income is receivable at the end of the year. After 8 years, the
property is expected to fetch a net salvage value of Rs. 50 million. Rahul’s required
hurdle rate for this project is 14 percent. His tax rate is 30 percent.
a) Is this a worthwhile proposal?

b) Assuming that Rahul collects a deposit equal to 2 years’ rent, but the rental
income increases by only 5 percent every year, what will be the IRR of the
proposal?
Solution:
a)
The equated annual instalment of the loan
= 15,000,000 / PVIFA (13% , 8 Yrs)
= 15,000,000 / 4.799 = 3,125,651
Amount
Amount
Outstanding Principal
Year Interest Installment Outstanding
in the Repayment
at the End
Beginning
1 15,000,000 1,950,000 3,125,651 1,175,651 13,824,349
2 13,824,349 1,797,165 3,125,651 1,328,486 12,495,863
3 12,495,863 1,624,462 3,125,651 1,501,189 10,994,675
4 10,994,675 1,429,308 3,125,651 1,696,343 9,298,331
5 9,298,331 1,208,783 3,125,651 1,916,868 7,381,463
6 7,381,463 959,590 3,125,651 2,166,061 5,215,403
7 5,215,403 678,002 3,125,651 2,447,649 2,767,754
8 2,767,754 359,808 3,125,651 2,765,843 1,911
The expected post-tax rental income (PTRI) =0.7 Rental income (1-0.3) + 0.3 Rental
income = 0.79 Rental income.
142
Post-tax Post-tax
Rental Interest Principal Net Cash
Year Rental Interest
income Payment Repayment Flow
Income Payment
A B=(0.79A) C D=(0.7C) E F=(B-D-E)
1 3,500,000 2,765,000 1,950,000 1,365,000 1,175,651 224,349
2 3,780,000 2,986,200 1,797,165 1,258,016 1,328,486 399,699
3 4,082,400 3,225,096 1,624,462 1,137,124 1,501,189 586,784
4 4,408,992 3,483,104 1,429,308 1,005,515 1,696,343 786,245
5 4,761,711 3,761,752 1,208,783 846,148 1,916,868 998,736
6 5,142,648 4,062,692 959,590 671,713 2,166,061 1,224,918
7 5,554,060 4,387,708 678,002 474,602 2,447,649 1,465,457
8 5,998,385 4,738,724 359,808 251,866 2,765,843 1,721,016
IRR is calculated as follows:
224,349 399,699 586,784 1,465,457

20,000,000 = + + +
(1+IRR) (1+IRR)2 (1+IRR) 3 (1+IRR)4
786,245 998,736 1,224,918 51,721,016

+ + + +
(1+IRR) 5 (1+IRR) 6 (1+IRR) 7 (1+IRR) 8
By extrapolation,
IRR = 14 + (21,159,626– 20,000,000) /(21,159,626– 19,817,400)

= 14 + 0.86
= 14.86 %
The IRR (14.86 percent) is more than the hurdle rate (14 percent). So, it is a
worthwhile investment proposal.
143
b) If the rental income increases by only 5 percent every year, the net cash flow from
rent will be as under.
Rental Interest Principal

Post-tax Post-tax Net Cash
Income Payment Repayment
Year
Rental Interest
Flow
Income Payment
A B = (0.79A) C D=(0.7C) E F=(B-D-E)
1 3,500,000 2,765,000 1,950,000 1,365,000 1,175,651 224,349

2 3,675,000 2,903,250 1,797,165 1,258,016 1,328,486 316,749
3 3,858,750 3,048,413 1,624,462 1,137,124 1,501,189 410,100
4 4,051,688 3,200,833 1,429,308 1,000,515 1,696,343 503,974
5 4,254,272 3,360,875 1,208,783 846,148 1,916,868 597,859
6 4,466,985 3,528,919 959,590 671,713 2,166,061 691,145
7 4,690,335 3,705,364 678,002 474,602 2,447,649 783,114
8 4,924,851 3,890,633 359,808 251,866 2,765,843 872,924
224,349 316,749 410,000 503,974

13,000,000 = + +
(1+IRR) (1+IRR)2 (1+IRR) 3 (1+IRR) 4
597,859 691,145 783,114 43,872,924

+ + + +
(1+IRR)5 (1+IRR) 6 (1+IRR)7 (1+IRR) 8
By extrapolation,
IRR = 18 + (13,362,217– 13,000,000) /( 13,362,217– 12,542,436)

= 18 + 0.44 = 18.44 %
144
CHAPTER 21
INTERNATIONAL INVESTING
1. You have just sold shares of Cisco that you purchased a year ago and incurred a
loss of 2 percent in dollar terms on your investment. During the same period, the
dollar appreciated 4 percent against the INR. What is the realised rate of return in
INR terms from this investment?
The realised rate of return in INR terms is:
= (1 - 0.02) (1 + 0.04) – 1
= .0192 – 1 = 1.92 percent
2. Rajesh has just sold shares of Honda that he purchased a year ago and earned a rate
of return of 8 percent in terms of the Japanese yen. During the same period, the
yen depreciated 5 percent against the INR. What is the realised rate of return in
INR terms from this investment?
= 1 + 0.08) (1 -0.05) – 1
= 1. 026 – 1 = 2.60 percent
3. You are considering investment in the shares of Google. The variance of the US
dollar rate of return from Google is 50 percent and the variance of the exchange
rate change is 40 percent. What covariance between the US dollar rate of return on
Google and the exchange rate change will result in a variance of 100 percent on the
rupee rate of return from Google? Ignore the cross-product term.
Let the covariance be C.
We have
50 + 40 + 2C = 100
C = 10/2
= 5 percent
4. Krishna is considering investment in the shares of Microsoft. The variance of the

US dollar rate of return from Microsoft is 120 percent and the variance of the
exchange rate change is 35 percent. What covariance between the US dollar rate of
return on Microsoft and the exchange rate change will result in a variance of 80
percent on the rupee rate of return from Microsoft? Ignore the cross-product term.
145
We have
120 + 35 + 2C = 80
C = – 75/2
= - 37.5 percent
5. Lalita has just sold shares of IBM that she had purchased a year ago and earned a
rate of return of 12 percent in terms of the US dollars. During the same period, the US
dollar appreciated 4 percent against the INR. What is the realised rate of return in INR
terms from this investment?
Solution:
= (1 + 0.12) (1 + 0.04) – 1
= 1. 1648 – 1 = 16.48 percent
6. Wahab is considering investment in the shares of British Telecom. The variance

of the British pound rate of return from British Telecom is 110 percent and the
variance of the exchange rate change is 40 percent. What covariance between the
British pound rate of return on British Telecom and the exchange rate change will
result in a variance of 120 percent on the rupee rate of return from British
Telecom? Ignore the cross-product term.
Solution:

We have
110 + 40 + 2C= 120

C = - 30/2 = - 15 percent
146
CHAPTER 22
PORTFOLIO MANAGEMENT: INVESTMENT POLICY AND STRATEGY
1. Show the pay off from an initial investment of 100,000 when the market moves
from 100 to 60 and back to 100 under the following policies:
 A drifting asset allocation policy.

 A balanced asset allocation policy under which the stock-bond mix is 70:30
A CPPI policy which takes the form:

Investment in stocks = 2 (portfolio value – 60,000).
Solution:
Drifting Asset Allocation Policy

Market level Stocks Bonds Total
100 40,000 60,000 100,000
60 24,000 60,000 84,000
100 40,000 60,000 100,000
Constant Mix Policy

100 70,000 30,000 100,000
60 50,400 21,600 72,000
100 73,920 31,680 105,600
CPPI Policy
100 80,000 20,000 100,000
60 16,000 52,000 68,000
100 37,333 41,333 78,667
2. Show the pay off from an initial investment of 500,000 when the market moves
from 100 to 70 and back to 100 under the following policies:
 A drifting asset allocation policy.
 A balanced asset allocation policy under which the stock-bond mix is 60:40
 A CPPI policy which takes the form: Investment in stocks = 1.5 (portfolio
value – 300,000
147
Drifting Asset Allocation Policy
100 400,000 100,000 500,000
70 280,000 100,000 380,000
100 400,000 100,000 500,000
Constant Mix Policy

100 300,000 200,000 500,000
70 246,000 164,000 410,000
100 309,257 206,171 515,429
CPPI Policy
100 300,000 200,000 500,000
70 165,000 245,000 410,000
100 271,071 209,643 480,714
148
Chapter 23
PORTFOLIO MANAGEMENT: IMPLEMENTATION AND REVIEW
1. A fund begins with Rs 250 million and reports the following results for three
periods:
Period
1 2 3
Rate of return 8% 18% 12%
Net inflow (end of period)
Rs in million 10 18 0
Compute the arithmetic, time-weighted, and rupee-weighted average returns.
Solution
(a) The arithmetic average return is:
(8 + 18 + 12)/3 = 12.67 % per period
(b) The time-weighted (geometric average) return is:
[(1 + .08) x (1 + .18) x (1 + .12]1/3 – 1 = .1260 or 12.6 % per period.
(c) The rupee-weighted average (IRR) return is computed below:
Period
1 2 3
Rate of return earned 8% 18% 12%
Beginning value of assets 250 280 348.40
Investment profit during the
period (Rate of return Assets) 20 50.40 41.81
Net inflow at the end 10 18 –
Ending value of assets 280 348.40 390.21
Time
0 1 2 3
Net cash flow – 250 – 10 – 18 390.21
The IRR of this sequence is
250 10 18 390.21
+ 2 =
+ (1+r) (1+r) (1+r)3
r = 12.6 percent
149
2. A fund begins with Rs. 160 million and reports the following results for three
periods:
Period
1 2 3
Rate of return 12% 24% 15%
Net inflow (end of period)
Rs in million 25 40 0
Compute the arithmetic, time-weighted, and rupee-weighted average returns.
Solution
(a) The arithmetic average return is:
(12 + 24 + 15)/3 = 17 % per period
(b) The time-weighted (geometric average) return is:
[(1 + .12) x (1 + .24) x (1 + .15]1/3 – 1 = 0.169 or 16.9 % per period.
(c) The rupee-weighted average (IRR) return is computed below:
Period
1 2 3
Rate of return earned 12% 24% 15%
Beginning value of assets 160 204.2 293.2
Investment profit during the
period (Rate of return ´ Assets)19.2 49 43.98
Net inflow at the end 25 40 –
Ending value of assets 204.2 293.2 337.18
Time
0 1 2 3
Net cash flow – 160 – 25 – 40 337.18
The IRR of this sequence is
160 25 40 337.18
+ 2 =
+ (1+r) (1+r) (1+r)3
r = 17 percent
150
1. Consider the following information for three mutual funds, L, M, and N, and the
market.
Mean return (%) Standard deviation (%) Beta
L 15 20 1.6
M 12 11 0.8
N 18 15 1.3
Market index 13 14 1.00
The mean risk-free rate was 8 percent. Calculate the Treynor measure, Sharpe measure,
Jensen measure and M2 for the three mutual funds and the market index.
Solution
Rp – Rf
Treynor Measure :
p
15 – 8
Fund L : = 4.37
1.6
12 – 8
Fund M : = 5.00
0.8
18 – 8
Fund N : = 7.69
1.3
13 – 8
Market index : = 5.00
1.0
Rp – Rf
Sharpe Measure :
p
15 – 8
Fund L : = 0.35
20
12 – 8
Fund M : = 0.36
11
18 – 8
Fund N : = 0.67
15
13 – 8
14
Jensen Measure: Rp – [Rf + p (RM – Rf)]
Fund L: 15 – [8 + 1.6 (5)] = - 1
Fund M: 12 – [8 + 0.8 (5)] = 0
Fund N 18 – [8 + 1.3 (5)] = 3.5
Market Index: 0 (By definition)
M2 = rp* - rM
Fund L: ( 0.7 x 15 + 0.3 x 8 ) – 13 = - 0.1
151
Fund M: ( 1.273 x 12 - 0.273 x 8 ) – 13 = 0.092
Fund N ( 0.93 x 18 + 0.07 x 8 ) – 13 = 4.3
Market Index: 0
2. Consider the following information for three mutual funds, X, Y, and Z, and the
market.
Mean return (%) Standard deviation (%) Beta
X 24 22 1.8
Y 16 14 1.2
Z 12 13 0.8
Market index 10 10 1.00
The mean risk-free rate was 7 percent. Calculate the Treynor measure, Sharpe measure,
Jensen measure and M2 for the three mutual funds and the market index.
Solution
Treynor Measure : Rp – Rf
p
24 – 7
Fund X : = 9.44
1.8
16 – 7
Fund Y : = 7.5
1.2
12 – 7
Fund Z : = 6.25
0.8
10 – 7
1.0
Rp – Rf
Sharpe Measure :
p
24 –7
Fund X : = 0.77
22
16 – 7
Fund Y : = 0.64
14
12 – 7
Fund Z : = 0.38
13
Market index 10 – 7
: = 0.30
10
Jensen Measure: Rp – [Rf + p (RM – Rf)]
152
Fund X: 24 – [7 + 1.8 (3)] = 11.6
Fund Y: 16 – [7 + 1.2 (3)] = 5.4
Fund Z 12 – [7 + 0.8 (3)] = 2.6
Market Index: 0 (By definition)
M2 = rp* - rM
Fund X : (0.455 x 24 + 0.545 x 7 ) – 10 = 4.735
Fund Y (0.714 x 16 + 0.286 x 7 ) – 10 = 3.426
Fund Z (0. 769 x 12 + 0.231 x 7 ) – 10 = 0.845
Market Index: 0
5. The return on a mutual fund portfolio during the last few years was 35 %, when the
return on the market portfolio was 20 %. The standard deviation of the
portfolio return was 12% whereas the standard deviation of the market portfolio
return was 18%. The portfolio beta was 1.7. The risk-free rate was 9 %. Decompose
the portfolio return into four components as suggested by Fama
Solution:
The portfolio return is decomposed into four components as follows:
1. Risk- free return, . Rf = 9 %

2. The impact of systematic return, β ( Rm – Rf ): 1.7 ( 20 – 9 ) = 18.7
3. The impact of imperfect diversification,
(σp/σm – βp ) (Rm – Rf ) : ( 12/18- 1.7) ( 20- 9) = - 11.37
4. The net superior return due to selectivity,
Rp – { Rf + σp/σm (Rm – Rf ) }: 35 – { 9 + (12/ 18) ( 11) } = 18.67
6. The return on a mutual fund portfolio during the last few years was 20%, when the
return on the market portfolio was 15%. The standard deviation of the
portfolio return was 12% whereas the standard deviation of the market portfolio
return was 14%. The portfolio beta was 1.6. The risk-free rate was 8%. Decompose
the portfolio return into four components as suggested by Fama
Solution:
The portfolio return is decomposed into four components as follows
1. Risk- free return, . Rf = 8 %

2. The impact of systematic return, β ( Rm – Rf ): 1.6 ( 15 – 8 ) = 11.2
3. The impact of imperfect diversification,
(σp/σm – βp ) (Rm – Rf ) : ( 12/14- 1.6) ( 15- 8) = - 5.2
4. The net superior return due to selectivity,
Rp – { Rf + σp/σm – βp ) (Rm – Rf ) }: 20 – { 8 + (12/ 14) ( 7) } = 6
153
CHAPTER 25
GUIDELINES FOR INVESTMENT DECISIONS
MINICASE
Jai Prakash is 45 years old and has an annual salary income of Rs. 900,000. He expects
his income to increase by 10 percent per year till he retires at the age of 60.
Jai Prakash expects to live till the age of 80. In the post-retirement period, Jai
Prakash would like his annual income from his financial investments to be 50 percent of
his salary income in his last working year. Further, he would like the same to be
protected in real terms.
Jai Prakash owns a house (on which all the mortgage payments have been made) and
has Rs. 700,000 of financial assets. He wants to bequeath the house to his daughter and
Rs. 15,000,000 to his son when he dies.
The current financial assets and the future savings of Jai Prakash are expected to earn
a nominal rate of return of 11 percent per annum. The expected inflation rate for the next
50 years is likely to be 3 percent.
What proportion of his salary income should Jai Prakash save till he retires so that he
can meet his post-retirement financial goals?
Solution:
His salary income at the time of retirement

= 900,000 x (1.10)15
= 3,759,523.
50 percent thereof is Rs. 1,879,762
To have an annuity of Rs. 1,879,762 for 20 years, the amount that should be
accumulated at the time of retirement is
= 1,879,762 PVIFA( Real rate of interest, 20 yrs)

= 1,879,762 PVIFA[ {(1.11/1.03) – 1}, 20 yrs]
= 1,879,762 PVIFA( 7.77%, 20 yrs)
= 1,879,762 x [ 1-1/(1.0777)15]/0.0777
= 1,879,762 x 8.6810
= 16,318,214
To bequeath Rs. 15 million at the age of 80 years, the amount that should be accumulated
at the time of retirement is
= 15,000,000 PVIF( 11 %, 20 yrs)

= 15,000,000 x 0.124
= 1,860,000
154
Therefore the total amount that should be accumulated
= 16,318,214+ 1,860,000 = 18,178,214
Out of the above the amount contributed by the investment of the financial asset of Rs.
700,000 for 15 years
= 700,000 x (1.11)15
= 3,349,213
So the salary savings alone should cumulate to
18,178,214 - 3,349,213
= 14,829,001
We have Present Value Interest Factor for the Growing annuity
= [1-{(1+0.10)/(1+0.11)}15] / ( 0.11 – 0.10)

= 12.6937
Therefore the Future Value Interest Factor for the growing annuity
= 12.6937 x (1+0.11)15 = 60.7341
Let A be the amount that should be saved from the first salary. For the salary savings
annuity to cumulate to Rs. 14,829,001 in 15 years, we should have
A = 14,829,001/ 60.7341
= Rs. 244,163
So the proportion of his salary income that Jai Prakash should save till he retires so that
he can meet his post-retirement financial goals
= 244,163/ 900,000 = 0.2713 or 27.13 %
155

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ADDITIONAL

Price in Price in No. of

No. of Market Market

The equal weighted index 566

The value weighted index 3908

No. of Market Market

The equal weighted index 626

The value weighted index 4712

Price in Price in No. of

Price in Market Market

Price in Price in No. of

Price in Market Market

Market capitalisation in year t

Market capitalisation of Q = 6418 – (1440 + 1248)

R1 = 0.30, R2 = - 0.20, R3 = - 0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36

(a) Arithmetic mean

0.30 – 0.20 - 0.12 + 0.38 + 0.42+0.36

(b) Cumulative wealth index

CWI5 = 1(1.30) (0.80) (0.88) (1.38) (1.42) (1.36) = 2.439

(c) Geometric Mean

= [(1.30) (0.80) (0.88) (1.38) (1.42) (1.36)]1/6 – 1 = 0.1602 or 16.02 %

(a) Arithmetic mean

(b) Cumulative wealth index

(c) Geometric Mean

The expected return and standard deviation of returns is calculated below

Return in % Deviation Square of deviation

Standard deviation = (756.4)1/2 = 27.50

Return in % Deviation Square of deviation

Expected return = 12.5 %

Standard deviation = (73.5)1/2 = 8.57

State of the Economy Probability of Occurrence Rate of Return

What is the standard deviation of return?

Expected return R = 17.7 SUM= 53.01

6. The probability distribution of the rate of return on a stock is given below:

State of the Economy Probability of Occurrence Rate of Return

What is the standard deviation of return?

r = 4% FV5 = 20,000 x FVIF (4%, 10 years)

r = 12 % FV5 = 5,800 x FVIF (12%, 3 years)

r = 14 % FV5 = 5,800 x FVIF (14%, 3 years)

r = 15 % FV5 = 5,800 x FVIF (15%, 3 years)

r = 16 % FV5 = 5,800 x FVIF (16%, 3 years)

Rs.32,000 / Rs. 2,000 = 16 = 24

According to the Rule of 72 at 6 percent interest rate doubling takes place

So Rs.2,000 will grow to Rs.32,000 in approximately 4 x 12 years = 48 years

Rs.192,000 / Rs. 3,000 = 64 = 26

According to the Rule of 72 at 8 percent interest rate doubling takes place

So Rs.3000 will grow to Rs.192,000 in approximately 6 x 9 years = 54 years

In 14 years Rs.5,000 grows to Rs.20,000 or 4 times. This is 22 times the initial

0.35 + 69 / Interest rate = 7

Interest rate = 69/(6-0.35) = 12.21 %

Hence the savings will cumulate to:

5000 x FVIFA (8%, 10 years) + 2000 x FVIFA (8%, 7 years)

= 5000 x 14.487 + 2000 x 8.923

Hence the savings will cumulate to:

24,000 x FVIFA (9%, 20 years) + 6,000 x FVIFA (9 %, 15 years)

A x FVIFA (10%, 5years) = 2,000,000

So, A = 2,000,000 / 6.105 = Rs. 327,600

So, A = 80,00,000 / 11.028 = Rs. 7,25,426