Crack Grade B 1

Annuities

PYQs asked from this chapter:

Q1. Which is true for annuity:

a. Annuities are consols.
b. Annuity is an asset that pays a fixed sum at the end of each year for a specified no of
years.
c. Annuity are bonds which govt. is under no obligation to repay but that offer a fixed income
for each year of perpetuity.
d. Both a and c

Consols are perpetuities. These are bonds that the government is under no obligation to repay
but that offer a fixed income for each year to perpetuity.

Q2. A bond that pays no coupon payment is called: Zero coupon bond

Q3. Bonds which mature in portions over a period of time- Serial bond

Q4. In calculations of internal rate of return, an assumption states that received cash flow
from the project:

a. Should not be earned

b. Should be earned
c. Must be reinvested
d. Must not be reinvested

Q5. A bond that can be paid off early at the issuer's discretion is referred to as
being which one of the following:
a. zero coupon
b. callable
c. discounted
d. collateralized

Q6. The ABC Company has a semi-annual coupon bond outstanding. An increase in the
market rate of interest will have which one of the following effects on this bond?
a. increase the coupon rate
b. decrease the coupon rate
c. increase the market price
d. decreases the market price

Q7. Q. How much will receive Rs 1 lakh at the end of each of next 6 year, If interest rate to
is 8%:
Ans. 21631

Present value of an annuity (PV) = C {1 – 1/ (1+i)n} /i

Here C =?
n = 5 i = 0.05
PV= 100000

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Q8. Calculate the interest if you receive 90 in total in two years based on 45 principle
amount.

As per rule 72 money will be doubled in years = 72/ Interest rate

72 / Interest Rate = 2 so interest rate = 72/2 = 36%

Q9. If Rs. 250 is converted into 1000 in 16 years-identify the rate of return

As per rule 144 money will be quadruple in years = 144/ Interest rate
16 = 144/ Interest rate
Interest Rate = 144/16 = 9%

Q10. If 400 is converted to 800 at the rate of 9%–identify the no. of years it will take.

As per rule 72 money will be doubled in years = 72/ Interest rate = 72/9 = 8 years

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Annuity: An annuity is any series of equal payments that are made at regular intervals. Though
the word "annuity" comes from the Latin for "yearly," the periods between payments in an annuity
can be just about anything -- years, months, weeks; it doesn't matter as long as the interval is
consistent. An annuity can also last for a short period -- say a few months -- or for decades. An
annuity will be either an ordinary annuity or an annuity due. The difference lies in the timing of
each payment relative to the period the payment covers.

Ordinary Annuity: With an ordinary annuity, the payment comes at the end of the covered term.
The typical home mortgage is an example of an ordinary annuity. When you pay your mortgage on
Sept. 1, for example, you're actually paying for the use of your home (and the use of the lender's
money) for August. You'll pay for September on Oct. 1, and so on. Most annuities are ordinary
annuities, which is why they're called "ordinary." Other common examples include interest
payments from bonds and payments on installment loan.

“A mortgage is a loan in which property or real estate is used as collateral. The borrower enters
into an agreement with the lender (usually a bank) wherein the borrower receives cash upfront
then makes payments over a set time span until he pays back the lender in full.”

An Ordinary Annuity has the following characteristics:

 The payments are always made at the end of each interval

 The interest rate compounds at the same interval as the payment interval.

Annuity Due: In an annuity due, the payment comes at the beginning of the term. The most
familiar application of the annuity due is rent. When you pay apartment rent on Sept. 1, you're
paying for the use of the apartment in September. Unlike with a mortgage, when your first payment
typically isn't due until after your first full month in the home, your first rent payment is due when
you move in. Insurance premiums are another common example of an annuity due; you pay today
for coverage in the future.

In an annuity due, the payments occur at the beginning of the payment period.

Generally, in RBI Examination questions are asked on ordinary annuity related only.

If question is asked on annuity due then we can solve the same also using this formula:
Annuity Due = Annuity Ordinary x (1 + i) where I =interest rate

The formula for calculating simple interest is as follows:

Interest = Principal * Rate x Time

'Rate' is the percentage of the principal charged as interest each year. The rate is expressed
as a decimal fraction, so 100 must divide percentages. For an illustration, if the rate is 15
per cent, then use 15/100 or 0.15 in the formula.

Mohan invested Rs. 5,000 in mutual fund with the interest rate of 4.8%. How much interest would
he earn after 2 years?
Answer
P = Rs. 5,000
r = 4.8%
t = 2 years
I=Pxrxt
I = (Rs. 5,000) (4.8%) (2) = Rs. 480
Hence, Mohan would earn Rs. 480 after 2 years.

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Compound interest is paid on the original principal and accumulated part of interest. For
example:
PV = Principal value (Initial amount you borrowed or deposited) or Present value to be invested

r = Annual rate of interest (per cent)

n =Number of year the amount of deposit
FV= (Future value) Amount of money accumulated after n year including interest.
When interest is compounded once in a year FV= PV (1 +r)n

F.V. = P.V (1+ i/m)m*n when interest is compounded m times in a year.

if the interest is paid :

Compounding Annually = P (1 + r)
Compounding Quarterly = P (1 + r/4)4
Compounding Monthly = P (1 + r/12)12

The Rule of 72: Allows you to determine the number of years before your money doubles whether
in debt or investment. Here is how to do it;
Divide the number 72 by the percentage rate you are paying on your debt (or earning on your
investment).

For an illustration: You borrowed Rs. 1,000 at 6 per cent interest. Then, 72 divided by 6 is 12. That
makes 12 the number of years it would take for your debt to double to Rs. 2,000, Similarly, a
saving account with Rs. 500 deposited in it, earning 4 per cent interest, will take 18 years for Rs.
500 to double to Rs. 1,000 if you do not make any further deposit, as 72 divided by 4 is 18.( 3
Questions were asked in RBI 2017)
EMI: The most commonly adopted method of repayment of loan in present day banking is 'Equated
Monthly Installments’ (EMIs). Under this system, the principal and the interest thereon is repaid
through equal monthly installment over the fixed tenure of the loan. The EMI is fixed based on the
loan amount, interest rate and the repayment tenure.

The formula for calculation of EMI given the loan, term and interest rate is:
{P× r×(1 + r)n} /{ (1 + r)n- 1}

Where P = principal (amount of loan), r = rate of interest per installment period, i.e. if the interest is
12% p.a., r = 0.012, n = no. of installments in the tenure,

Eg: For 100000 at 10% annual interest for a period of 12 months

it comes to 100000*0.00833*(1 + 0.00833)12/{(1 + 0.00833)12- 1} = 8792

Type of Interest rates:

There are two different modes of interest. They are

1. Fixed Rates

2. Floating Rates also called as variable rates.

Fixed Rate: In the fixed rate, the rate of interest is fixed. It will not change during entire period of
the loan. For example, if a home loan, taken at an interest rate of 12 per cent, is repayable in 10
years, the rate will remain the same during the entire tenure of 10 years even if the market rate

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increases or decreases. The fixed rate is, normally, higher than floating rate, as it is not affected by
market fluctuations.

Floating Rate: In the floating rate or variable rate, the rate of interest changes, depending upon
the market conditions. It may increase or decrease. For example, if a home loan is taken at an
interest rate of 12 per cent, repayable in 10 years, in April 2006, and if the market rate increases to
12.5 per cent in April, 2007, the interest rate of this loan will also be increased to 12.5 per cent. If
the loan is under an EMI system, depending upon the change in interest rate, the repayment
period varies, but equated
monthly installment remains the same.

Depending on the prevailing market conditions, people may choose between the fixed rate and a
floating rate.

Annuities:
Annuity Due = Ordinary Annuity (1 + i)

Present Value of an Ordinary Annuity:

F.V. = P.V (1+ i/m)m*n

This formula is similar to compound interest formula that we have studied above.
P.V. = Present Value
F.V. = Future value
i = the rate of return or interest rate etc. (expressed as fraction, e.g. 6 per cent = 0.06)
m = number of times per year that interest is compounded
n = number of years invested

Suppose annuity C is paid every year for n years:

Then P.V. of C in 1st year will be :

F.V = P.V. ( 1+ i/m)m*n

Present value Interest factor

Q.1. Rs. 2,000 is invested at annual rate of interest of 10%. What is the amount after 2 years
if the compounding is done?
(a) Annually? (b) Semi annually? (c) Monthly? (d) Daily?
Solution:
(a) The annual compounding is given by:

F.V. = P.V (1+ i)n

N = 1, i= 0.10 and Present Value = 2000

= 2,000 (1.1)2 = 2,000 × 1.21 = 2,420

(b) For Semiannual compounding, n = 2x2 = 4, i = 0.1/2 = 0.05

FV= 2000 (1+ 0.05)4 = 2,000x1.2155 = 2,431

(c) For monthly compounding, n = 12 2 = 24, i = 0.1/12 = 0.00833

FV= 2000 (1+ 0.00833)12 = 2,000x1.22029 = 2440.58

(d) For daily compounding, n = 365 2 = 730, i = 0.1/(365) = 0.00027

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FV= 2,000 (1.00027) = 2,000x1.22135 = 2,442.70

Q.2.Similarly if we have to find out that how much amount is to be invested at present at
annual rate of interest of 10% to get rupees 3630 after 2 years if the compounding is done
annually?
Then
F.V. = P.V (1+ i)n

P.V. = F.V. / (1+ i)n

P.V. = 3630/ (1 + 0.10)2 = 3000

Rs. 3000 have to be invested to get 3630 after 2 years @ 10%.

Future value of an annuity for payment/investment C for n periods and interest i is given
by:
F.V. of an annuity = C{ (1+i)n – 1 } / i

Q.3.Find the amount of an annuity if payment of Rs .500 is invested annually for 7 years at
interest rate of 14% compounded annually.

Here C = 500, n = 7, i = 0.14

F.V. of an annuity = 500 { (1+0.14)7-1} / 0.14 = 5,365.25

Q.4.If we have to find out that how much amount to be invested per year to get Rs 10730.50
after 7 years at a rate of 14% compounded annually.
Then

F.V. of an annuity or CVAF = C{ (1+i)n – 1 } / i

Here F.V. = 10730.50, n = 7, i = 0.14

10730.50= C*{ (1+0.14)7-1} / 0.14

C= 10730.50/10.7305 = 1000

Rs. 1000 are to be invested annually.

Q.5. Determine the present value of an annuity of Rs.700 each paid at the end of each of the
next six years. Assume an 8 per cent of interest per annum.

Present value of an annuity = C{ 1 – 1/ (1+i)n} / i

Here C = 700, n = 6, i = 0.08

Present value = 700{ 1 – 1/ (1+0.08)6} / 0.08 = 700X4.623 = 3236.10

Bond Market

Investments are classified in two types to put it simply:

• Fixed return investments

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• Variable return investments

Investments with a fixed return provide a guaranteed return in exchange for the capital invested.
These investments generally have a lock in period with low liquidity. Variable return investments
are subject to market forces where the exact return on the investment is not guaranteed till the
time the investor exits from the investment. Equities, mutual funds, gold, real estate are variable
return investments.

One of the most popular types of fixed return investments are investment bonds.

Bonds:

Bonds are instruments issued by a borrower to raise capital from investors or the public at large.
Bonds are like loans which mature on a fixed date. In return, the borrower pays interest.
Depending on the terms and conditions of the bond, the interest can be paid either at specified
intervals or on maturity (deep discount bond).

The interest rate is referred to as the coupon. The interest payment (the coupon) is part of the
return that bondholders earn for loaning their funds to the issuer. The interest rate that
determines the payment is called the coupon rate.

The date on which the issuer must repay the amount borrowed also known as face value is called
the maturity date.

The face value (also known as the par value or principal) is the amount of money a holder will get
back once a bond matures. It is also the money which bondholder lends to the Company.

The company or the government who is borrowing money is called Issuer.

Different Types of Bonds:

Bonds in India are generally issued by Government bodies. Having a government backing to the
bonds provides security to the investor that these bonds will be repaid on maturity. However, other
private institutions also issue bonds depending on their need.

These are the different types of bonds available for investment in India:

1. Central Government bonds:

These bonds are issued by the Central Government to raise funds. These bonds are issued by the
RBI on behalf of the Government. The primary purpose of these bonds is to finance fiscal deficit
and meet the shortfall of revenue in the Government budget. These bonds are the safest bonds to
invest in, since they are backed by the Government and will be repaid on maturity.

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2. State Government bonds:

These bonds are issued by the State Government to meet their fiscal deficits. These bonds are
listed on the stock exchange. These bonds are also backed by the Government, making them low
risk investments.

3. Municipal and Local authority bonds:

A municipal corporation or a local authority may raise finance to meet funding for specific goals
such as constructing infrastructure, public water works etc. These bonds are also rated by credit
rating agencies and it is best to go by the rating and past records before investing.

4. Corporate bonds:

These are highly risky bonds since the maturity depends on the track record of the company.
Before investing in such bonds, you must do a complete study into the company and its
performance.

5. Public Sector bonds:

These bonds are issued by highly rated public sector companies for meeting their growth and
expansion needs. These bonds are relatively less risky since PSUs are under the Government.
Generally, these bonds are issued by companies where the Central Government is the majority
shareholder.

6. Tax free bonds:

Companies such as the National Highways Association of India (NHAI), Indian Railways Finance
Corporation, HUDCO, Rural Electrification Corporation (REC) issue these bonds. The interest
earned on these bonds is completely tax free in the hands of the investor.

Types of bond markets:

1. Primary market:

This is the market where the borrower approaches investors to raise capital. The issue price of the
bonds and the coupon rate is fixed at the time of raising capital.

2. Secondary market:

Most of the bonds are traded in the stock market. They can be sold depending on when the
investor wishes to exit from the bond. However, it is to be noted that the price for the bonds

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depends on how close the bond is to interest payment. As the bond nears the interest payment
date, the price goes up. The price and coupon rate of the bond move inversely i.e. if the price goes
up, the interest rate goes down. This is because the net return to the investor stays the same as
when the bond was issued in the primary market.

For example, if the bond is issued at Rs. 1,000 with a coupon rate of 8%, the interest will be Rs.
80. However, if the price goes up to Rs. 1,250, the interest rate goes down to 6.4%. However, the
interest payment to the investor remains the same.

Perpetual Bonds

These are bonds with no maturity date. They don’t expire. The investor doesn’t get the principal he
invested as such, but he gets it in the form of higher interest rates.

There are very few people who opt for it as no one can guarantee such an infinite time for any
entity.

Yield

Yield is the return one gets on the Bond.

Yield (coupon rate) = Coupon amount/Price

In the beginning, when we buy the bond, the yield is equal to the interest rate but When the price
changes, the yield also changes.

Yield to Maturity

Yield is the return we get as interest on the Bonds. If these interest payments are again invested in
buying the bond then extra interest money is earned on the extra investments we make. In such a
case the total yield or the total return is called yield to maturity.

Yield can be understood as Simple interest while Yield to maturity is a compound interest.

Price and Yield and Interest Rate Relation:

A decrease in Interest Rate Results in Increase in Bond Price and vice versa

When price goes up, yield goes down and vice versa

When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the
bonds and When interest rates fall, the prices of bonds in the market rise, thereby decreasing the
yield of the older bonds.

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When a bond is issued at par value, its yield equals the coupon rate. The yield is its rate of return
considering changes in price and after discounting the bond’s cashflows at prevailing market rates.

Bond yield and price are inversely related. Thus, as the price goes up, the yield decreases, and vice
versa. This relationship exists because the bond’s coupon rate is fixed, which requires the price in
secondary markets to change to align with prevailing interest rates in the market.

Market Interest rate vs. bond price Bond prices rise when interest rates fall, and bond prices fall
when interest rates rise. Why is this? Think of it like a price war; the price of the bond adjusts to
keep the bond competitive in light of current market interest rates. Let's see how this works.

Let's look at a case study:

Case Study Facts

You buy a bond for Rs.1,000.

It matures in four years (at which time you get back your Rs.1,000 investment).

Its coupon rate (interest rate) is 4%, so it pays 4% a year, or Rs. 40 a year.

Suppose one year after you purchase the bond interest rates rise to 5% and you decide to sell your
bond. When you enter an order to sell, the order goes to the market, and potential buyers now
compare your bond to other bonds and offer you a price. This all happens very quickly over the
internet.

How does your bond compare to other bonds on the market? Since interest rates went up, a newly
issued Rs.1,000 bond which matures in three years (the time left before your bond matures) is
paying 5% interest or Rs.50 a year. That means your bond must go through a market value
adjustment to be fairly priced when compared to new issues. Let's take a look at how this market
adjustment works.

Market Adjustment to Bond Prices

If an investor buys your bond for Rs.1,000, they will receive Rs.40 x 3, or Rs.120 in interest over
the remaining three years.

If an investor buys a new bond for Rs.1,000, they will receive Rs.50 x 3, or Rs.150 in interest over
the remaining three years.

There is no incentive to buy your bond at its face value of Rs.1,000 since the investor would receive
less interest than the newly issued bonds. Thus the market adjusts the price of your bond to make
it equivalent.

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In this set of circumstances, you may receive an offer of about Rs.970 for your bond.

(When a bond sells for less than its maturity value it is said to trade at a discount.)

An investor who bought your bond for Rs.970 would now receive the Rs.120 of interest, plus the
additional Rs.30 of principal when the bond matures. Because they were able to pay less for the
bond, they would receive the same Rupees amount of profit, over the same time frame, as if they
bought a newly issued bond paying a higher interest rate.

If you hold your bond to maturity, you receive the full Rs.1,000. The current market price of the
bond only matters if you are selling your bond now.

Market Interest rate vs. YTM

A bond’s yield to maturity shows how much an investor’s money will earn if the bond is held until
it matures. For example, let’s say a bond offers a 3% coupon rate, and a year later market interest
rates fall to 2%. The bond will still pay a 3% coupon rate, making it more valuable than new bonds
paying just a 2% coupon rate. If you sell the 3% bond before it matures, you will probably find that
its price is higher than it was a year ago. Along with the rise in price, however, the yield to maturity
of the bond will go down for anyone who buys the bond at the new higher price.

Now suppose market interest rates rise from 3% to 4%. If you sell the 3% bond, it will be competing
with new bonds that offer a 4% coupon rate. The price of the 3% bond may be more likely to fall.
The yield to maturity, however, will rise as the price fall.

YTM or i can be calculated with the help of this formula:

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

we can calculate the value of i.

YTM or i For zero coupon bond, can be calculated with the help of this formula:

PV = M / (1+ i)n {for zero coupon bond C=0 }

Approximate YTM = {C + (F - P)/ n} / {(F + P) / 2}

Where

YTM = Yield to Maturity

C = Coupon or Interest Payment

F = Face Value

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P = Price

n = Years to Maturity

Current yield = Coupon/ Current Price of bond

Nominal yield = Coupon/ Maturity Price of bond

Basic Bond Valuation: The value of bond is the present value of the contractual payments its
issuer is obliged .to make from the beginning till maturity.. The appropriate discount rate would be
the required return matching with risk and the prevailing interest rate. Symbolically,

PV = C x (PVIFA) + M x (PVIF)

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

PV = value of the bond at present or present value

C = annual interest paid or coupon payment

n = number of years' to maturity (term of the bond)

M = Par/maturity value

i = required return on the bond

For a Coupon Rate a % per annum, the coupon value C = F.V. * a /100

For a zero coupon bond: Coupon payment, C= 0 then Present value for a zero coupon bond,

PV = M / (1+ i)n

Impact of required Return (RR) on Bond Value:

• When the required Return (RR) is equal to the coupon rate (CR), the bond value equals the par
value.

• When (RR) is more than (CR), the bond value would be less than its par value, that is, the bond
would sell at a discount equal to (M-PV)

• When (RR) is less than (CR) , the bond value would be more than its par value, that is, the bond
would sell at a premium equals to (PV-M)

Glossary

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Zero Coupon Bond: Zero Coupon Bond is issued at a discount and repaid at face value. No
periodic interest is paid. The difference between the issue price and redemption price represents
the return to the holder.

Convertible Bond: Bond which carries an option to convert the bond into Equity at a fixed
conversion price.

Bearer Bonds: It is an official certificate issued without recording the name of the holder. These
are very risky because they can be either lost or stolen.

Registered Bonds: It is a bond whose ownership is recorded by the issuer or by a transfer agent.

Term Bonds: Most corporate bonds are term bonds, that is, they run for a specific term of years
and then become due and payable.

Serial Bonds: While issuing bonds some corporate arrange them in such a way that specific
principal amounts become due on specified dates prior to maturity. They are termed as serial
bonds.

Puttable Bonds: A puttable bond grants the bondholder the right to sell the issue back to the
issuer at par value on designated dates.

Callable Bonds: These bonds refer to the ability of the issuer to pay off a debt obligation prior to its
maturity at the option of the issuer of debt.

Exchangeable Bonds: It grants the bondholder the right to exchange the bonds for the common
stock of a firm other than that of the issuer of the bond.

Fixed Rate Bonds: These are bonds with a coupon or a stated rate of interest which remains
constant throughout the life of the bond.

High Yield Bonds: They are bonds that are rated below investment grade by the credit rating
agencies. They are also called junk bonds.

Mortgage Bonds: A bond that is secured through a lien against the property of the firm is known
as mortgage bond.

Subordinated Bonds: These bonds have a lower priority than secured debts, debentures and other
bonds and the general creditors of the issuer in case of liquidation.

Guaranteed Bonds: It is an obligation guaranteed by another entity.

Perpetual Bonds: These bonds are also called perpetuities. It has no maturity date.

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Global bonds: Bonds that are designed so as to qualify for immediate trading in any domestic
capital market and in the Euro market are called global bonds.

Easy Exit Bonds: These are bonds which provide easy liquidity and exit route to investors by way
of redemption or buy back facility where investors can get the benefit of ready encashment in case
of need to withdraw before maturity.

Option Bonds: These are cumulative and non-cumulative bonds where interest is payable on
maturity or periodically. Redemption premium is also offered to attract investors. These were
issued by institutions like IDBI, ICICI, etc.

Double Option Bonds: The face value of each bond is `5,000. The bond carries interest at 15% p.a.
compounded half-yearly from the date of allotment. The bond has a maturity period of 10 years.
Each bond has two parts in the form of two separate certificates, one for principal of Rs 5,000 and
other for interest. Both these certificates are listed on all major stock exchanges. The Investor has
the facility of selling either one or both parts at anytime he wishes so.

Floating Rate Bonds: Here, Interest rate is not fixed and is allowed to float depending upon the
market conditions. This is an instrument used by the issuing Companies to hedge themselves
against the volatility in the interest rates. Financial institutions like IDBI, ICICI, etc. have raised
funds from these bonds.

Inflation Bonds: Inflation Bonds are bonds in which interest rate is adjusted for inflation. Thus,
the investor gets an interest free from the effects of inflation. For example, if the interest rate is
10% and the inflation is 2%, the investor will earn 12.20% [i.e. (1 + Interest Rate) X (1 + Inflation
Rate) -1]. This is similar to Floating Rate Bonds, i.e. rate of return varies over a period of time.

Deep Discount Bonds (DDBs): A deep discount bond is a zero coupon bond whose maturity is very
high, say 15 years onwards and is offered at a discount to the face value. The Industrial
Development Bank of India (IDBI) was the first financial institution to offer DDBs in 1992.

Municipal Bonds: They are debt securities issued by the municipal corporation of a city to raise
funds for financing their growing investment needs for a host of infrastructure projects.

Inverse Float Bonds: These bonds are the latest entrants in the Indian capital market. Inverse
float bonds are bonds carrying a floating rate of interest that is inversely related to short-term
interest rates. The floating rate could be the Mibor (Mumbai inter-bank offer rate) or some other
rate.

Numerical

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Q.1 A bond of Rs.1,000 bearing a coupon rate of 12% is redeemable at par in 10 years. Find
out the value of the bond if required rate of return is10%.

Face Value of the Bond = Rs.1000

Coupon Rate, C = 12%

Interest P.a. = Face Value of the Bond*Coupon Rate = Rs.1000*12% = Rs.120 p.a.

Maturity Period = 10 yrs

M = Rs.1000

Present Value of Bond =PV

i= 10%=0.10

PV = C x PVIFA(10 years, 10%) + RV x PVIF(10th years, 10%)

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

PV = 120*{1 – 1/ (1+0.10)10} / 0.10 + 1000 / (1+ 0.10)10

PV = 120*6.144 + 1000*0.386 = Rs.1123

Q.2 Shyam owns an Rs 1000 face value bond with three years maturity. Bond makes an
annual coupon of 7.5%. The first coupon is due one year from now. Bond is selling at Rs
975.48. If the YTM is 10%, should Shyam sell the bond or hold it?

Step I Find Present value/ intrinsic value of bond

Face Value of the Bond = Rs.1000

Coupon Rate, C = 7.5 %

Interest P.a. = Face Value of the Bond*Coupon Rate = Rs.1000*7.5% = Rs.75 p.a.

Maturity Period = 3 yrs

M = Rs.1000

Present Value of Bond =PV

i= 10%=0.10

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PV = C * PVIFA (10%, 3) + M* PVIF (10%,3)

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

PV = 75*{1 – 1/ (1+0.10)3} / 0.10 + 1000 / (1+ 0.10)3

PV = 937.8

Step 2 Compare it with selling value. Actual Market price or selling value is 975.48 Since Market
Price > Present Value, Shyam should sell the bond.

Q.3 Consider a two-year Rs. 1000 face value 10% coupon rate bond which pays coupon
semiannually. Find out the intrinsic value or present value of the bond if the required rate of
return is 14% p.a. Compounded semi-annually.

Face Value of the Bond = Rs.1000

Coupon Rate, C = 10 % = 10/2% =5% in case of semiannual coupon payments

Coupon payment P.a. = Face Value of the Bond*Coupon Rate = Rs.1000*5% = Rs 50 p.a.

Maturity Period = 2 yrs = 2*2=4 in case of semiannual coupon payments

M = Rs.1000

Present Value of Bond =PV

i= 14%=0.14/2= 0.07

Bond Price = Coupon PVIFA ( 14 /2 )%, 2x2) + M x PVIF (( k/ 2 )%, 2x2)

Bond Price = 50 * PVIFA (7%, 4) + 1000* PVIF (7%,4)

Bond price = 50*{1 – 1/ (1+0.07)4} / 0.07 + 1000 / (1+ 0.07)4

Bond Price = 932.25

Q.4 A Deep Discount Bond (DDB) was issued by a financial institution for a maturity period
of 10 years and having a par value of Rs. 25,000. Find out the value of the Bond given that
the required rate of return is 16%.

Face Value of the Bond = Rs.25000

Coupon payment zero in case of deep discount bond

Maturity Period = 10 yrs

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M = Rs.25000

Present Value of Bond =PV

i= 16%=0.16

Since the bond is a zero-coupon bond coupon rate will be zero. C=0

PV = C * PVIFA (16%, 10) + M* PVIF (16%,10)

Bond Price = 0 + 25000* PVIF (16%,10)

Bond price = 0 + 25000 / (1+ 0.16)10

Bond Price = 5667

Q.5 A Rs. 100 perpetual bond is currently selling for Rs. 95. The coupon rate of interest is
14.5 percent and the appropriate discount rate is 16 percent. Calculate the value of the
bond. Should it be bought? What is its yield at maturity?

Intrinsic/Present Value of Perpetual Bond = Coupon / YTM

Intrinsic/ Present Value of Perpetual Bond = 14.5 / 0.16 = 90.625

Since market value>intrinsic/present value we can conclude that the bond is currently overpriced.
Hence the bond should not be purchased.

YTM = 14.5/ 95 = 15.26%

Q.6 Consider three pure discount bonds with maturities of one, two and three years and
prices of Rs930.23, Rs923.79 and Rs 919.54 respectively. Each bond has a face value of
Rs1000. What are the 1 year, 2 year and 3-year interest rates?

Solution: For zero coupon bonds, bond price is calculated using following formula

Price = FV / (1 + S)

1 year bond 930.23 = 1000 /(1 + S1)1 Solving we get S1 = 7.5%

2 year bond 923.79 = 1000 /(1 + S1)2

Solving we get S2 = 4.04%

3 year bond 919.54 = 1000 /(1 + S1)3

Solving we get S3 = 2.84%

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Yield to maturity can be calculated using approximate formula as follows:

Approx. YTM = C + (F − P)/ n

(F + P)/ 2

P = price of the bond or present value

C = coupon payment

F = maturity value

n = years to maturity

Q.7 A bond is issued at 10% discount to its face value of Rs1lakh. Redemption takes place at
the end of 20 years. If the coupon is 12%. what is the YTM as per approximate method?

P = price of the bond or present value = 0.9*100000 = 90000

C = coupon rate = 12 %

Coupon payment = F. V. of the Bond*Coupon Rate = Rs.100000*12% = Rs 12000 p.a.

F = maturity value = 100000

n = years to maturity = 20

Approx. YTM = 12000 + (100000− 90000)/ 20 = 13.15%

(100000+ 90000)/ 2

Rule of thumb or Rule 69:

Acc. to this rule doubling period of an amount is equal to 0.35 + 69 / interest rate.

For example, at the rate of 10%, an amount will be doubled in how many years? Doubling period =
0.35 + 69 / 10 = 7.25 Years

Internal rate of return (IRR): Internal rate of return (IRR) is the discount rate at which the net
present value of an investment becomes zero. In other words, IRR is the discount rate which
equates the present value of the future cash flows of an investment with the initial investment.

The following is the formula for calculating NPV:

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where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

NPV = 0; or PV of future cash flows − Initial Investment = 0; or

Where,

r is the internal rate of return;

CF1 is the period one net cash inflow;

CF2 is the period two net cash inflow,

CF3 is the period three net cash inflow, and so on ...

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate
r, which is here the IRR. Because of the nature of the formula, however, IRR cannot be calculated
analytically, and must instead be calculated either through trial-and-error or interpolation method
as given above.

Q.10 Mr. Mohan bought bonds of the face value of Rs.1000/- each at a discount of 10% on
face value, bearing coupon@ 10% p.a., residual tenure for redemption at par being exactly 2
years from the date of acquisition. What is the IRR? (RBI SAMPLE QUESTIONS)

(1) 11.11%

(2) 18.12%

(3) 12.12%

(4) 16.18%

(5) 15.25%

Maturity = 2 Yrs

Present Value = 90% of Face Value = Rs. 900

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Coupon = 10% Coupon payment= Face Value *Coupon Rate = Rs.1000*10% = Rs 100

Approx. YTM / IRR = 100+ (1000 − 900)/ 2 = 15.78%

(1000+ 900)/ 2

Approx. YTM formula indicates that YTM is closer to 16 %. Now it is difficult to choose one option
from 15.25% and 16.18% as given.

We can use hit and trial method and can calculate PV @ 15.25% and 16.18% using this formula:

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n and can select one option otherwise we can use
interpolation formula as given below:

As approx. YTM is closer to 16 %, now we will calculate PV/price of bond @ YTM of 16%

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

PV = 100*{1 – 1/ (1+0.16)2} / 0.16 + 1000 / (1+ 0.16)2 = 903.68

Now Calculate PV/price of bond @ YTM of 18%

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

PV = 100*{1 – 1/ (1+0.18)2} / 0.18 + 1000 / (1+ 0.18)2 = 874.74

*We have to choose 2nd YTM/IRR so that desired PV must lie between PVs calculated at lower and
higher YTM/IRR rates. (900 is desired PV and it lies between calculated PVs 903.68 & 874.74 @
16% & 18%).

YTM/IRR = Low % + (PV @ Lower − Actual Desired) x (High% − Low %) YTM or IRR

(PV @ Lower − PV @ Higher)

= 16% + (903.68−874.74) x 2% = 16.18%

(903.68−900)

Hence answer will be 16.18%.

Q.11 Mrs. Laxmi bought 10% p.a. Bonds of ABC Limited for Rs.105/- each, the face value
being Rs.100/- each, with maturity date being exactly 3 years after the date of acquisition.
Assuming market rate of return being 12% p.a., the per bond present value of the inflow will
be:

(1) Rs. 130.00

(2) Rs. 95.30

(3) Rs. 102.70

(4) Rs. 87.90

(5) Rs. 114.40

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Solution:

Bond is purchased at Rs 5 Premium @ Rs.105 having face value Rs. 100.

Maturity, n = 3 Yrs

Coupon = 10% Coupon payment= Face Value *Coupon Rate = Rs.100*10% = Rs 10

Face value or maturity value = 100

Market rate of return, i= 12%=0.12

PV = C*{1 – 1/ (1+i)n} / i + M / (1+ i)n

PV = 10*{1 – 1/ (1+0.12)3} / 0.12 + 1000 / (1+ 0.12)3 = 95.30

Hence answer will be Rs. 95.30.

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