Chapter 3

Mutual Funds
1.

1

Recurring expense
r1 + in percentage terms

r2 =
1 – Initial expense
in decimals
1
=

x 13% + 1.8%
1 – 0.05

= 15.48%
2.

1

Recurring expense
r1 + in percentage terms

r2 =
1 – Initial expense
in decimals
1
16.5%

Recurring expense
x 14% + in percentage terms

=
1 – 0.06

16.5%

= 0.1489 +

Recurring expense in
percentage terms

Recurring expense = 0.1650 – 0.1489 = 0.0161
in percentage terms = 1.61%

Chapter 4
SECURITIES MARKET
1.
Share

M
N
O
P
Q

Price in
base year
(Rs.)

Price in
year t
(Rs.)

Price
Relative

1
12
18
35
20
15

2
16
15
60
30
6

3
133
83
171
150
40
577

The equal weighted index
For year t is
:

577

The value weighted index
For year t is
:

1975

No. of
outstanding
shares
(in million)
4
10
5
6
40
30

Market
Market
capitalisation capitalisatio
in the base
n in year t
year (1 x 4)
(2 x 4)
5
6
120
160
90
75
210
360
800
1200
450
180
1670
1975

= 115.4
5 (since there are 5 scrips)
x 100 = 118.3
1670

2.
Share

X
Y
Z

Price in
base year
(Rs.)

Price in
year t
(Rs.)

Price
Relative

No .of
outstanding
shares

1
80
40
30

2
100
30

3
125
75

4
15
20
50

Market
Market
capitalisation capitalisatio
in the base
n in year t
year (1 x 4)
(2 x 4)
5
6
1200
1500
800
600
1500
3500

The value weighted index for year t is: Market capitalisation in year t
x 100
3500
Market capitalisation in year t
115 =

x 100
3500

115 x 3500 =

Market capitalisation in year t x 100
115 x 3500

Market capitalisation in year t

=
100

Market capitalisation of z

= 4025
= 4025 – (500 + 600)
= 1925
1925

Price of share z in year t

=
50
= 38.5

Chapter 5
RISK AND RETURN
1.

R1 = 0.20, R2 = - 0.10, R3 = 0.18, R4 = 0.12, R5 = 0.16
(a) Arithmetic mean
0.20 – 0.10 + 0.18 + 0.12 + 0.16
=
= 0.112 or 11.2%
5
(b) Cumulative wealth index
CWI5 = 1(1.20) (0.90) (1.18) (1.12) (1.16) = 1.656
(c) Geometric Mean
= [(1.20) (0.90) (1.18) (1.12) (1.16)]1/5 – 1 = 0.106 or 10.6%

2. The standard deviation of returns is calculated below
Period
Return in %
Deviation
Ri
(Ri –R)
1
2
3
4
5

20
-10
18
12
16

8.8
21.2
6.8
0.8
4.8
Sum =
Σ (Ri – R)2

Variance =

596.8
=

n–1

Square of
deviations
(Ri – R)2
77.44
449.44
46.24
0.64
23.04
596.8

= 149.2
5–1

Standard deviation = (149.2)1/2 = 12.21
3. The expected rate of return on Alpha stock is:
0.4 x 25 + 0.3 x 12 + 0.3 x –6 = 11.8
The standard deviation of return is calculated below:
Ri
(RI – R)
pi
pi (Ri – R)2
25
13.2
0.40
69.696
12
0.2
0.30
0.012
-6
-17.8
0.30
95.052
Sum = 164.76

Standard deviation of return = [Σ pi (Ri – R)2]1/2 = 12.84%
Chapter 6
THE TIME VALUE OF MONEY
1. Value five years hence of a deposit of Rs.1,000 at various interest rates is as follows:

2.

r

=

8%

FV5

=
=

1000 x FVIF (8%, 5 years)
1000 x 1.469 =
Rs.1469

r

=

10%

FV5

=
=

1000 x FVIF (10%, 5 years)
1000 x 1.611 =
Rs.1611

r

=

12%

FV5

=
=

1000 x FVIF (12%, 5 years)
1000 x 1.762 =
Rs.1762

r

=

15%

FV5

=
=

1000 x FVIF (15%, 5 years)
1000 x 2.011 =
Rs.2011

Rs.160,000 / Rs. 5,000 = 32 = 25
According to the Rule of 72 at 12 percent interest rate doubling takes place
approximately in 72 / 12 = 6 years
So Rs.5000 will grow to Rs.160,000 in approximately 5 x 6 years = 30 years

3.

In 12 years Rs.1000 grows to Rs.8000 or 8 times. This is 23 times the initial
deposit. Hence doubling takes place in 12 / 3 = 4 years.
According to the Rule of 69, the doubling period is:
0.35 + 69 / Interest rate
Equating this to 4 and solving for interest rate, we get
Interest rate = 18.9%.

4.

Saving Rs.2000 a year for 5 years and Rs.3000 a year for 10 years thereafter is equivalent
to saving Rs.2000 a year for 15 years and Rs.1000 a year for the years 6 through 15.
Hence the savings will cumulate to:
2000 x FVIFA (10%, 15 years) + 1000 x FVIFA (10%, 10 years)
=
2000 x 31.772 + 1000 x 15.937
=
Rs.79481.

5.

6.

Let A be the annual savings.
A x FVIFA (12%, 10 years) =
A x 17.549
=

1,000,000
1,000,000

So A = 1,000,000 / 17.549 =

Rs.56,983.

1,000 x FVIFA (r, 6 years)

=

10,000

FVIFA (r, 6 years)

=

10,000 / 1000 = 10

=
=

9.930
10.980

From the tables we find that
FVIFA (20%, 6 years)
FVIFA (24%, 6 years)

Using linear interpolation in the interval, we get:
20% + (10.000 – 9.930)
r=

x 4% = 20.3%
(10.980 – 9.930)

7.

1,000 x FVIF (r, 10 years)
FVIF (r,10 years)

=
=

5,000
5,000 / 1000 = 5

From the tables we find that
FVIF (16%, 10 years) =
FVIF (18%, 10 years) =

4.411
5.234

Using linear interpolation in the interval, we get:
(5.000 – 4.411) x 2%
r = 16% +

= 17.4%
(5.234 – 4.411)

8. The present value of Rs.10,000 receivable after 8 years for various discount rates (r )
are:
r = 10%
PV
= 10,000 x PVIF(r = 10%, 8 years)
= 10,000 x 0.467 = Rs.4,670

r = 12%

PV

r = 15%

PV

= 10,000 x PVIF (r = 12%, 8 years)
= 10,000 x 0.404 = Rs.4,040
= 10,000 x PVIF (r = 15%, 8 years)
= 10,000 x 0.327 = Rs.3,270

9. Assuming that it is an ordinary annuity, the present value is:
2,000 x PVIFA (10%, 5years)
= 2,000 x 3.791 = Rs.7,582
10.

The present value of an annual pension of Rs.10,000 for 15 years when r = 15% is:
10,000 x PVIFA (15%, 15 years)
= 10,000 x 5.847 = Rs.58,470
The alternative is to receive a lumpsum of Rs.50,000.
Obviously, Mr. Jingo will be better off with the annual pension amount of Rs.10,000.

11.

12.

The amount that can be withdrawn annually is:
100,000
100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years)
9.427
The present value of the income stream is:
1,000 x PVIF (12%, 1 year) + 2,500 x PVIF (12%, 2 years)
+ 5,000 x PVIFA (12%, 8 years) x PVIF(12%, 2 years)
= 1,000 x 0.893 + 2,500 x 0.797 + 5,000 x 4.968 x 0.797 = Rs.22,683.

13.

The present value of the income stream is:
2,000 x PVIFA (10%, 5 years) + 3000/0.10 x PVIF (10%, 5 years)
= 2,000 x 3.791 + 3000/0.10 x 0.621
= Rs.26,212

14.

To earn an annual income of Rs.5,000 beginning from the end of 15 years from
now, if the deposit earns 10% per year a sum of Rs.5,000 / 0.10 = Rs.50,000
is required at the end of 14 years. The amount that must be deposited to get this sum is:
Rs.50,000 / PVIF (10%, 14 years) = Rs.50,000 / 3.797 = Rs.13,165

15.

Rs.20,000 =- Rs.4,000 x PVIFA (r, 10 years)

PVIFA (r,10 years) = Rs.20,000 / Rs.4,000 = 5.00
From the tables we find that:
PVIFA (15%, 10 years)
PVIFA (18%, 10 years)

=
=

5.019
4.494

Using linear interpolation we get:
r = 15% +

5.019 – 5.00
---------------5.019 – 4.494

x 3%

= 15.1%
16.

PV (Stream A) = Rs.100 x PVIF (12%, 1 year) + Rs.200 x
PVIF (12%, 2 years) + Rs.300 x PVIF(12%, 3 years) + Rs.400 x
PVIF (12%, 4 years) + Rs.500 x PVIF (12%, 5 years) +
Rs.600 x PVIF (12%, 6 years) + Rs.700 x PVIF (12%, 7 years) +
Rs.800 x PVIF (12%, 8 years) + Rs.900 x PVIF (12%, 9 years) +
Rs.1,000 x PVIF (12%, 10 years)
= Rs.100 x 0.893 + Rs.200 x 0.797 + Rs.300 x 0.712
+ Rs.400 x 0.636 + Rs.500 x 0.567 + Rs.600 x 0.507
+ Rs.700 x 0.452 + Rs.800 x 0.404 + Rs.900 x 0.361
+ Rs.1,000 x 0.322
= Rs.2590.9
Similarly,
PV (Stream B) = Rs.3,625.2
PV (Stream C) = Rs.2,851.1

17.

FV5

=
=
=
=

Rs.10,000 [1 + (0.16 / 4)]5x4
Rs.10,000 (1.04)20
Rs.10,000 x 2.191
Rs.21,910

18.

FV5

=
=
=
=

Rs.5,000 [1+( 0.12/4)] 5x4
Rs.5,000 (1.03)20
Rs.5,000 x 1.806
Rs.9,030

19.

A
Stated rate (%)

B
12

Frequency of compounding 6 times

24
4 times

24
12 times

(1 + 0.12/6)6- 1 (1+0.24/4)4 –1 (1 + 0.24/12)12-1

Effective rate (%)

Difference between the
effective rate and stated
rate (%)
20.

C

= 12.6

= 26.2

= 26.8

0.6

2.2

2.8

Investment required at the end of 8th year to yield an income of Rs.12,000 per
year from the end of 9th year (beginning of 10th year) for ever:
Rs.12,000 x PVIFA(12%, ∞ )
= Rs.12,000 / 0.12 = Rs.100,000
To have a sum of Rs.100,000 at the end of 8th year , the amount to be deposited now is:
Rs.100,000

Rs.100,000
=

PVIF(12%, 8 years)
21.

= Rs.40,388
2.476

The interest rate implicit in the offer of Rs.20,000 after 10 years in lieu of
Rs.5,000 now is:
Rs.5,000 x FVIF (r,10 years) = Rs.20,000
Rs.20,000
FVIF (r,10 years) =

= 4.000
Rs.5,000

From the tables we find that
FVIF (15%, 10 years) = 4.046
This means that the implied interest rate is nearly 15%.

I would choose Rs.20,000 for 10 years from now because I find a return of 15% quite
acceptable.
22.

FV10

= Rs.10,000 [1 + (0.10 / 2)]10x2
= Rs.10,000 (1.05)20
= Rs.10,000 x 2.653
= Rs.26,530

If the inflation rate is 8% per year, the value of Rs.26,530 10 years from now, in terms of
the current rupees is:
Rs.26,530 x PVIF (8%,10 years)
= Rs.26,530 x 0.463 = Rs.12,283
23. A constant deposit at the beginning of each year represents an annuity due.
PVIFA of an annuity due is equal to : PVIFA of an ordinary annuity x (1 + r)
To provide a sum of Rs.50,000 at the end of 10 years the annual deposit should be
Rs.50,000
A

=
FVIFA(12%, 10 years) x (1.12)
Rs.50,000
=

= Rs.2544
17.549 x 1.12

24.

The discounted value of Rs.20,000 receivable at the beginning of each year from
2005 to 2009, evaluated as at the beginning of 2004 (or end of 2003) is:
=

Rs.20,000 x PVIFA (12%, 5 years)
Rs.20,000 x 3.605 = Rs.72,100.

The discounted value of Rs.72,100 evaluated at the end of 2000 is
=

Rs.72,100 x PVIF (12%, 3 years)
Rs.72,100 x 0.712 = Rs.51,335

If A is the amount deposited at the end of each year from 1995 to 2000 then
A x FVIFA (12%, 6 years)
A x 8.115
A = Rs.51,335 / 8.115

= Rs.51,335
= Rs.51,335
= Rs.6326

25.

The discounted value of the annuity of Rs.2000 receivable for 30 years, evaluated as at the
end of 9th year is:
Rs.2,000 x PVIFA (10%, 30 years) = Rs.2,000 x 9.427 = Rs.18,854
The present value of Rs.18,854 is:
Rs.18,854 x PVIF (10%, 9 years)
=
Rs.18,854 x 0.424
=
Rs.7,994

26.

30 per cent of the pension amount is
0.30 x Rs.600 = Rs.180
Assuming that the monthly interest rate corresponding to an annual interest rate of 12% is
1%, the discounted value of an annuity of Rs.180 receivable at the end of each month for
180 months (15 years) is:
Rs.180 x PVIFA (1%, 180)
(1.01)180 - 1
Rs.180 x
---------------- = Rs.14,998
.01 (1.01)180
If Mr. Ramesh borrows Rs.P today on which the monthly interest rate is 1%
P x (1.01)60 =
P x 1.817
=
P

27.

=

Rs.14,998
Rs.14,998
Rs.14,998
------------ = Rs.8254
1.817

Rs.300 x PVIFA(r, 24 months) = Rs.6,000
PVIFA (4%,24)
= Rs.6000 / Rs.300 = 20
From the tables we find that:
PVIFA(1%,24)
=
PVIFA (2%, 24)
=

21.244
18.914

Using a linear interpolation

r = 1% +

21.244 – 20.000
---------------------21.244 – 18,914

x 1%

= 1.53%
Thus, the bank charges an interest rate of 1.53% per month.
The corresponding effective rate of interest per annum is
[ (1.0153)12 – 1 ] x 100 = 20%
28.

The discounted value of the debentures to be redeemed between 8 to 10 years evaluated at
the end of the 5th year is:
Rs.10 million x PVIF (8%, 3 years)
+ Rs.10 million x PVIF (8%, 4 years)
+ Rs.10 million x PVIF (8%, 5 years)
= Rs.10 million (0.794 + 0.735 + 0.681)
= Rs.22.1 million
If A is the annual deposit to be made in the
sinking fund for the years 1 to 5, then
A x FVIFA (8%, 5 years) = Rs.22.1 million
A x 5.867 = Rs.22.1 million
A = 5.867 = Rs.22.1 million
A = Rs.22.1 million / 5.867 = Rs.3.77 million

29.

Let `n’ be the number of years for which a sum of Rs.20,000 can be withdrawn annually.
Rs.20,000 x PVIFA (10%, n) = Rs.100,000
PVIFA (15%, n) = Rs.100,000 / Rs.20,000 = 5.000
From the tables we find that
PVIFA (10%, 7 years) =
PVIFA (10%, 8 years) =

4.868
5.335

Thus n is between 7 and 8. Using a linear interpolation we get
5.000 – 4.868
n = 7 + ----------------- x 1 = 7.3 years
5.335 – 4.868
30.

Equated annual installment

= 500000 / PVIFA(14%,4)
= 500000 / 2.914
= Rs.171,585

Loan Amortisation Schedule

Year
-----1
2
3
4

Beginning
amount
------------500000
398415
282608
150588

Annual
installment
--------------171585
171585
171585
171585

Interest
----------70000
55778
39565
21082

Principal
Remaining
repaid
balance
------------------------101585
398415
115807282608
132020
150588
150503
85*

(*) rounding off error
31.

Define n as the maturity period of the loan. The value of n can be obtained from the
equation.
200,000 x PVIFA(13%, n) =
1,500,000
PVIFA (13%, n)
=
7.500
From the tables or otherwise it can be verified that PVIFA(13,30) = 7.500
Hence the maturity period of the loan is 30 years.

32.

Expected value of iron ore mined during year 1

=

Rs.300 million

Expected present value of the iron ore that can be mined over the next 15 years
assuming a price escalation of 6% per annum in the price per tonne of iron
1 – (1 + g)n / (1 + i)n
= Rs.300 million x
i-g
1 – (1.06)15 / (1.16)15
= Rs.300 million x
0.16 – 0.06
= Rs.300 million x (0.74135 / 0.10)
= Rs.2224 million
MINICASE
1. How much money would Ramesh need 15 years from now?
500,000 x PVIFA (10%, 15years)
+ 1,000,000 x PVIF (10%, 15years)
= 500,000 x 7.606 + 1,000,000 x 0.239
= 3,803,000 x 239,000
= Rs.4,042,000

2. How much money should Ramesh save each year for the next 15 years to be able to meet
his investment objective?
Ramesh’s current capital of Rs.600,000 will grow to :
600,000 (1.10)15 = 600,000 x 4.177 = Rs 2,506,200
This means that his savings in the next 15 years must grow to :
4,042,000 – 2,506,200 = Rs 1,535,800
So, the annual savings must be :
1,535,800

1,535,800
=

FVIFA (10%, 15 years)

= Rs.48,338
31.772

3. How much money would Ramesh need when he reaches the age of 60 to meet his
donation objective?
200,000 x PVIFA (10% , 3yrs) x PVIF (10%, 11yrs)
= 200,000 x 2.487 x 0.350 = 174090
4. What is the present value of Ramesh’s life time earnings?
400,000
46
1

400,000(1.12)
2
1.12

400,000(1.12)14
15

15

1–
1.08
= 400,000
0.08 – 0.12
= Rs.7,254,962

Chapter 7
Financial Statement Analysis

1.
(a)

Assets
-

Rs.
150 million
20
10
70
110
10

Fixed assets ( Net )
Cash and bank
Marketable securities
Receivables
Inventories
Prepaid expenses

Liabilities
Equity capital
Preference capital
Reserves and surplus
Debentures (secured)
Term loans (secured)
Short term bank borrowing (unsecured)
Trade creditors
Provisions

90
20
50
60
70
40
30
10

Balance Sheet of Mahaveer Limited as on March 31, 2001
Liabilities

Assets

Share capital
Equity
Preference
Reserve & surplus

90
20
50

Secured loans
Debentures
Term loans

60
70

Unsecured loans
Short term bank borrowing
Current liabilities & provisions
Trade creditors
Provisions

2.
(a)

Fixed assets
Net fixed assets

150

Investments
Current assets, loans & advances

40
30
10
-----370
------

-

Marketable securities
Pre-paid expenses
Inventories
Receivables
Cash & Bank

10
10
110
70
20
----370
------

Sources & Uses of Cash Statement for the Period 01.04.2000 to 31.03.2001
(Rs. in million)
---------------------------------------------------------------------------------------------------------Sources
Uses
Net profit
Depreciation
Decrease in inventories
Increase in short term
bank borrowings

30
20
10

Dividend payment

20

Purchase of fixed assets

30

10

Increase in trade creditors

10

Increase in debtors
Increase in other assets
Decrease in long term debt
Decrease in provisions

10
5
15
5

Total sources

80

Total uses

85

Net decline in Cash balance

5

(b)
Classified cash flow statement for the Period 01.04.2000 to 31.03.2001
(Rs. in million)
---------------------------------------------------------------------------------------------------------A.
Cash flow from operating activities
Net profit before tax and extraordinary items
100
Adjustments for
Interest paid
30
Depreciation
20
Operating profit before working capital changes
150
Adjustments for
Inventories
10
Debtors
(10)
Short term bank borrowings
10
Trade creditors
10
Provisions
(5)
Increase in other assets
(5)
Cash generated from operations
160
Income tax paid
(20)
Cash flow before extraordinary items
140
Extraordinary item
(50)
Net cash flow from operating activities
90
B.
Cash flow from investing activities
Purchase of fixed assets
(30)
Net cash flow from investing activities
(30)

C.

D.

Cash flow from financing activities
Interest paid
Repayment of term loans
Dividends paid
Net cash flow from financing activities

(30)
(15)
(20)
(65)

Net increase in cash and cash equivalents
Cash and cash equivalents as on 31.03.2000
Cash and cash equivalents as on 31.03.2001

(5)
20
15

Note : It has been assumed that “other assets” represent “other current assets”.
Net profit
3.

Return on equity =
Equity
=

Net profit

Net sales
x

Net sales
=

0.05

Debt
Note :

Total assets
x

1
1.5 x
0.3

= 0.7

So

=

Rs.40 million
PBIT

Times interest covered =

= 6
Interest

So PBIT = 6 x Interest
PBIT – Interest = PBT = Rs.40 million
6 x Interest = Rs.40 million
Hence Interest = Rs. 8 million
5.

= 0.25 or 25 per cent

= 1-0.7 = 0.3
Total assets

Hence Total assets/Equity = 1/0.3
PBT

Equity

Equity

Total assets

4.

Total assets
x

Sales = Rs. 7,000,000

Net profit margin = 6 percent
Net profit = Rs. 7000000 x 0.06 = 420,000
Tax rate = 60 per cent

420,000
So Profit before tax =

= Rs. 1,050,000

(1-.6)
= Rs.150,000

Interest charge

So Profit before interest and taxes = Rs. 1,200,000
Hence
1,200,000
Times interest covered ratio =
= 8
150,000
6.

CA = 1500

CL = 600

Let BB stand for bank borrowing
CA+BB
=

1.5

=

1.5

CL+BB
1500+BB
600+BB
BB = 1200
7.

Accounts receivable
ACP =
Sales / 365
120,000
=

= 43.8 days
1,000,000 / 365
So the receivables must be collected in 43.8 days
Current assets
8.

Current ratio =

= 1.5

Current liabilities
Current assets - Inventories
Acid-test ratio =

= 1.2
Current liabilities

Current liabilities

= 800,000
Sales
Inventory turnover ratio =
= 5
Inventories
Current assets - Inventories
Acid-test ratio =

= 1.2
Current liabilities

Current assets

Inventories

This means

Current liabilities

= 1.2
Current liabilities
Inventories

1.5

-

= 1.2
800,000

Inventories
= 0.3
800,000
Inventories = 240,000
Sales
=5
So Sales = 1,200,000
2,40,000
9.

Debt/equity = 0.60
Equity = 50,000 + 60,000 = 110,000
So Debt = 0.6 x 110,000 = 66,000
Hence Total assets = 110,000+66,000 = 176,000
Total assets turnover ratio = 1.5
So Sales = 1.5 x 176,000 = 264,000
Gross profit margin = 20 per cent
So Cost of goods sold = 0.8 x 264,000 = 211,200
Day’s sales outstanding in accounts receivable = 40 days
Sales
So Accounts receivable =
x 40
360

264,000
=

x 40

= 29,333

360
Cost of goods sold
Inventory turnover ratio =

211,200
=

Inventory

= 5
Inventory

So Inventory = 42,240
Assuming that the debt of 66,000 represent current liabilities
Cash + Accounts receivable
Acid-test ratio =
Current liabilities
Cash + 29,333
=

=

1.2

66,000
So Cash = 49867
Plant and equipment = Total assets - Inventories - Accounts receivable - Cash
= 176,000 - 42240 – 29333 - 49867
= 54560
Pricing together everything we get
Equity capital
Retained earnings
Debt(Current liabilities)

Balance Sheet
50,000
Plant & equipment
60,000
Inventories
66,000
Accounts receivable
Cash

176,000
Sales
Cost of goods sold

54,560
42,240
29,333
49,867
176,000

264,000
211,200

Cash & bank balances + Receivables + Inventories + Pre-paid expenses
10.(i) Current ratio =
Short-term bank borrowings + Trade creditors + Provisions

5,000,000+15,000,000+20,000,000+2,500,000
=
15,000,000+10,000,000+5,000,000
42,500,000
=
30,000,000

=

1.42

Current assets – Inventories
(ii) Acid-test ratio =

22,500,000
=

= 0.75

Current liabilities

30,000,000

Long-term debt + Current liabilities
(iii) Debt-equity ratio =
Equity capital + Reserves & surplus
12,500,000 + 30,000,000
=

= 1.31
10,000,000 + 22,500,000
Profit before interest and tax

(iv) Times interest coverage ratio =
Interest
15,100,000
=

= 3.02
5,000,000
Cost of goods sold

(v) Inventory turnover period

72,000,000

=

=

= 3.6

Inventory

20,000,000

365
(vi) Average collection period =
Net sales/Accounts receivable
365
=

= 57.6 days
95,000,000/15,000,000
Net sales

(vii) Total assets turnover ratio

=

95,000,000
=

Total assets

= 1.27
75,000,000

Profit after tax
(ix) Net profit margin

=

5,100,000
=

Net sales
PBIT

= 5.4%
95,000,000

15,100,000

(x) Earning power =

=
Total assets

=

20.1%

75,000,000

Equity earning
5,100,000
(xi) Return on equity =
=
= 15.7%
Net worth
32,500,000
The comparison of the Omex’s ratios with the standard is given below
Omex
Current ratio
Acid-test ratio
Debt-equity ratio
Times interest covered ratio
Inventory turnover ratio
Average collection period
Total assets turnover ratio
Net profit margin ratio
Earning power
Return on equity

1.42
0.75
1.31
3.02
3.6
57.6 days
1.27
5.4%
20.1%
15.7%

Standard
1.5
0.80
1.5
3.5
4.0
60 days
1.0
6%
18%
15%

MINICASE
cash and bank + receivables + inventories
12.4
----------------------------------------------------- = -------- = 0.67
current liabilities+ short- term bank borrowing 18. 4

a. Current ratio =

Acid-test ratio =

Cash ratio

=

current assets – inventories
--------------------------------- =
current liabilities

12.4 – 9.3
----------- = 0.17
18.4

cash and bank balance + current investments
------------------------------------------------------ =

1.1+0
------- = 0.06

current liabilities

18.4

Debt-equity ratio = debt / equity =( 3.8+ 11.7 ) / 15.8 = 15.5 / 15.8 = 0. 98
Interest coverage ratio = PBIT / Interest = 5.0 / 2.0= 2.5
PBIT + depreciation
Fixed charges coverage ratio = --------------------------------------------------- =
interest + repayment of loan / ( 1- tax rate)

Inventory turnover ratio =

cost of goods sold
45.8
----------------------- = --------------average inventory
( 8.2 + 9.3)/ 2

= 5.23

Debtors turnover ratio = net credit sales / average debtors = 57.4 / ( 2.9+2.0) / 2 = 23.43
Average collection period = 365 / debtors turnover = 365 / 23.43 = 15.6 days
Fixed assets turnover = net sales/average total assets = 57.4/ ( 34 + 38) / 2 = 1.59
Gross profit margin = gross profit / net sales = 11.6 / 57.4 = 20.21 %
Net profit margin = net profit / net sales = 3.0 / 57.4 = 5.22 %
Return on assets = net profit / average total assets = 3.0/ ( 34+38) /2 = 8.3 %
Earning power = PBIT / average total assets = 5.0/ ( 34+38) /2 = 13.89 %
Return on equity = Net profit / average equity = 3.0 / ( 13.9 +15.8)/2 = 20.20 %

b.

net profit
Dupont equation : -------------------------- =
average total assets

net profit
------------- x
net sales

net sales
-------------average total assets

Dupont chart
Net sales +/Non-op. surplus
deficit 57.8

Net profit
margin
5.22%

Net profit
3.0

÷

Total costs
54.8

Net sales
57.4
Return on
total assets
8.3%

X
Net sales
57.4
Total asset
turnover

÷

1.59

Average
fixed assets
21.4

+
Average total
assets
36

Average
other assets
2.55

+
Average
current
assets 12.05

c.

Common size statements
Balance sheet

Shareholder’ funds
Long term debt
Net current liabilities
Total
Fixed assets
Other assets
Total

Regular ( Rs. in million)
20x4
20x5
-----------------------------13.9
15.8
5.2
3.8
3.2
6.0
---------------------------22.3
25.6
-----------------------------19.6
23.2
2.7
2.4
-----------------------------22.3
25.6
------------------------------

Common Size ( %)
20x4
20x5
-------------------------63
62
23
15
14
23
--------------------------100
100
--------------------------88
91
12
9
--------------------------100
100
---------------------------

Profit and loss account

Net sales
Cost of goods sold
Gross profit
PBIT
Interest
PBT
Tax
PAT

Regular ( Rs. in million)
20x4
20x5
-----------------------------39.0
57.4
30.5
45.8
8.5
11.6
4.1
5.0
1.5
2.0
2.6
3.0
---------2.6
3.0

Common base financial statements

Common Size ( %)
20x4
20x5
------------------------100
100
78
80
22
20
11
9
4
7
5
----------7
5

4

Balance sheet

Shareholder’ funds
Long term debt
Net current liabilities
Total
Fixed assets
Other assets
Total

Regular ( Rs. in million)
20x4
20x5
-----------------------------13.9
15.8
5.2
3.8
3.2
6.0
---------------------------22.3
25.6
-----------------------------19.6
23.2
2.7
2.4
-----------------------------22.3
25.6
------------------------------

Common base year( %)
20x4
20x5
-------------------------100
114
100
73
100
187
100

115

100
100

118
89

100

115

Profit and loss account

Net sales
Cost of goods sold
Gross profit
PBIT
Interest
PBT
Tax
PAT

Regular ( Rs. in million)
20x4
20x5
-----------------------------39.0
57.4
30.5
45.8
8.5
11.6
4.1
5.0
1.5
2.0
2.6
3.0
---------2.6
3.0

d.
Financial strengths : leverage position is satisfactory.
Interest repayment capacity is good.
Inventory is efficiently managed.
Credit management is efficient.
Margin on sales is satisfactory.

Common base year ( %)
20x4
20x5
------------------------100
147
100
150
100
136
100
122
100
133
100
115
100

115

Financial weaknesses : liquidity position is very bad.
return on assets is low.
fixed assets do not seem to be efficiently employedl.
e.

The problems in analyzing financial statements are generally as follows:
• lack of underlying theory.
• conglomerate firms.
• window dressing.
• price level changes.
• variations in accounting policies.
• interpretation of results.
• correlation among ratios.
f. The qualitative factors relevant for evaluating the performance and prospects of a
company are mainly the following:
• Are the company’s revenues tied to one key customer?
• To what extent are the company’s revenues tied to one key product ?
• To what extent does the company rely on a single supplier ?
• What percentage of the company’s business is generated overseas ?
• Competition.
• Future prospects.
• Legal and regulatory environment.

Chapter 8
PORTFOLIO THEORY
1.

(a)
E (R1) =
=
E (R2) =
=
σ(R1) =
=
σ(R2) =
=

0.2(-5%) + 0.3(15%) + 0.4(18%) + .10(22%)
12%
0.2(10%) + 0.3(12%) + 0.4(14%) + .10(18%)
13%
[.2(-5 –12)2 + 0.3 (15 –12)2 + 0.4 (18 –12)2 + 0.1 (22 – 12)2]½
[57.8 + 2.7 + 14.4 + 10]½ = 9.21%
[.2(10 –13)2 + 0.3(12 – 13)2 + 0.4 (14 – 13)2 + 0.1 (18 – 13)2] ½
[1.8 + 0.09 + 0.16 + 2.5] ½ = 2.13%

(b) The covariance between the returns on assets 1 and 2 is calculated below
State of
Probability
Return
Deviation Return on Deviation Product of
nature
on asset
of return
asset 2
of the
deviation
1
on asset 1
return on
times
from its
asset 2
probability
mean
from its
mean
(1)
(2)
(3)
(4)
(5)
(6)
(2)x(4)x(6)
1
0.2
-5%
-17%
10%
-3%
10.2
2
0.3
15%
3%
12%
-1%
-0.9%
3
0.4
18%
6%
14%
1%
2.4
4
0.1
22%
10%
18%
5%
5
Sum =
16.7
Thus the covariance between the returns of the two assets is 16.7.
(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12
16.7
=
= 0.85
σ1 x σ2
9.21 x 2.13
2. (a) For Rs.1,000, 20 shares of Alpha’s stock can be acquired. The probability distribution of
the return on 20 shares is
Economic Condition
Return (Rs)
Probability
High Growth
Low Growth
Stagnation
Recession
Expected return

20 x 55 = 1,100
20 x 50 = 1,000
20 x 60 = 1,200
20 x 70 = 1,400

0.3
0.3
0.2
0.2

=

(1,100 x 0.3) + (1,000 x 0.3) + (1,200 x 0.2) +
(1,400 x 0.2)

=
=

330 + 300 + 240 + 280
Rs.1,150

Standard deviation of the return = [(1,100 – 1,150)2 x 0.3 + (1,000 – 1,150)2 x 0.3 +
(1,200 – 1,150)2 x 0.2 + (1,400 – 1,150)2 x 0.2]1/2 = Rs.143.18
(b)

For Rs.1,000, 20 shares of Beta’s stock can be acquired. The probability distribution of
the return on 20 shares is:

Economic condition

Return (Rs)

Probability

High growth
Low growth
Stagnation
Recession

20 x 75 = 1,500
20 x 65 = 1,300
20 x 50 = 1,000
20 x 40 = 800

0.3
0.3
0.2
0.2

Expected return =

(1,500 x 0.3) + (1,300 x 0.3) + (1,000 x 0.2) + (800 x 0.2)
= Rs.1,200

Standard deviation of the return = [(1,500 – 1,200)2 x .3 + (1,300 – 1,200)2 x .3
+ (1,000 – 1,200)2 x .2 + (800 – 1,200)2 x .2]1/2 = Rs.264.58
(c )

For Rs.500, 10 shares of Alpha’s stock can be acquired; likewise for Rs.500, 10
shares of Beta’s stock can be acquired. The probability distribution of this
option is:
Return (Rs)
(10 x 55) + (10 x 75)
(10 x 50) + (10 x 65)
(10 x 60) + (10 x 50)
(10 x 70) + (10 x 40)

=
=
=
=

Expected return

= (1,300 x 0.3) + (1,150 x 0.3) + (1,100 x 0.2) +
(1,100 x 0.2)
=
Rs.1,175

Standard deviation

=
=

d.

1,300
1,150
1,100
1,100

Probability
0.3
0.3
0.2
0.2

[(1,300 –1,175)2 x 0.3 + (1,150 – 1,175)2 x 0.3 +
(1,100 – 1,175)2 x 0.2 + (1,100 – 1,175)2 x 0.2 ]1/2
Rs.84.41

For Rs.700, 14 shares of Alpha’s stock can be acquired; likewise for Rs.300, 6
shares of Beta’s stock can be acquired. The probability distribution of this
option is:
Return (Rs)
(14 x 55) + (6 x 75)
(14 x 50) + (6 x 65)
(14 x 60) + (6 x 50)
(14 x 70) + (6 x 40)

Probability
=
=
=
=

1,220
1,090
1,140
1,220

0.3
0.3
0.2
0.2

Expected return

=
(1,220 x 0.3) + (1,090 x 0.3) + (1,140 x 0.2) +
(1,220 x 0.2)
=
Rs.1,165

Standard deviation

=
[(1,220 – 1,165)2 x 0.3 + (1,090 – 1,165)2 x 0.3 +
(1,140 – 1,165)2 x 0.2 + (1,220 – 1,165)2 x 0.2]1/2
=
Rs.57.66

The expected return to standard deviation of various options are as follows :
Option
a
b
c
d

Expected return
(Rs)
1,150
1,200
1,175
1,165

Standard deviation
(Rs)
143
265
84
58

Expected / Standard
return
deviation
8.04
4.53
13.99
20.09

Option `d’ is the most preferred option because it has the highest return to risk
3.

ratio.

Expected rates of returns on equity stock A, B, C and D can be computed as
follows:
A:

0.10 + 0.12 + (-0.08) + 0.15 + (-0.02) + 0.20 = 0.0783
6

= 7.83%

B:

0.08 + 0.04 + 0.15 +.12 + 0.10 + 0.06
6

= 0.0917

= 9.17%

C:

0.07 + 0.08 + 0.12 + 0.09 + 0.06 + 0.12
6

= 0.0900

= 9.00%

D:

0.09 + 0.09 + 0.11 + 0.04 + 0.08 + 0.16
6

= 0.095

= 9.50%

(a)

Return on portfolio consisting of stock A

(b)

Return on portfolio consisting of stock A and B in equal
proportions =
0.5 (0.0783) + 0.5 (0.0917)
=
0.085 =
8.5%

(c )

Return on portfolio consisting of stocks A, B and C in equal
proportions =
1/3(0.0783 ) + 1/3(0.0917) + 1/3 (0.090)
=
0.0867
= 8.67%

= 7.83%

(d)

Return on portfolio consisting of stocks A, B, C and D in equal
proportions =
0.25(0.0783) + 0.25(0.0917) + 0.25(0.0900) +
0.25(0.095)
=
0.08875 = 8.88%

4. The standard deviation of portfolio return is:
σp = [w12σ12 + w22σ22 + w32σ32 + σ42σ42 + 2 w1 w2 ρ12 σ1 σ2 + 2 w1 w3 ρ13 σ1 σ3 + 2 w1 w4
ρ14 σ1σ4 + 2 w2 w3 ρ23 σ2 σ3 + 2 w2 w4 ρ24 σ2 σ4 + 2 w3 w4 ρ34 σ3 σ4 ]1/2
= [0.22 x 42 + 0.32 x 82 + 0.42 x 202 + 0.12 x 102 + 2 x 0.2 x 0.3 x 0.3 x 4 x 8
+ 2 x 0.2 x 0.4 x 0.5 x 4 x 20 + 2 x 0.2 x 0.1 x 0.2 x 4 x 10
+ 2 x 0.3 x 0.4 x 0.6 x 8 x 20 + 2 x 0.3 x 0.1 x 0.8 x 8 x 10
+ 2 x 0.4 x 0.1 x 0.4 x 20 x 10]1/2
= 10.6%
5. (i) Since there are 3 securities, there are 3 variance terms and 3 covariance terms. Note that
if there are n securities the number of covariance terms are: 1 + 2 +…+ (n – 1) = n (n –1)/2.
In this problem all the variance terms are the same (σ2A) all the covariance terms are the same
(σAB) and all the securities are equally weighted ( wA = ⅓)
So,
σ2p = [3 w2A σ2A + 2 x 3 σAB]
σ2p = [3 w2A σ2A + 6 wA wB σAB]
1 2
1
1
2
=3x
x σ A+ 6 x
x
x σAB
3
3
3
1
2
=
σ2A +
σAB
3
3
(ii) Since there are 9 securities, there are 9 variance terms and 36 covariance
terms. Note that if the number of securities is n, the number of covariance
terms is n(n – 1)/2.
In this case all the variance terms are the same (σ2A), all the covariance terms are
1
the same (σAB) and all the securities are equally weighted wA =
9
So,
n(n-1)
2
2
2
σ p= 9 w Aσ A t 2 x
wA wB σAB
2

1

2

1

x σ A + 9(8) x
2

= 9x
9
1

σA+

72

=
9

σAB

x
9

2

1
9

σAB

81

6. Let us arrange the portfolio in the order of ascending expected returns.
Portfolio

Expected return(%)

Standard deviation(%)

4

8

14

3

9

15

5

10

20

1

11

21

7

12

21

2

14

24

8

14

28

6

16

32

Examining the above we find that (i) portfolio 7 dominates portfolio 1 because it offers a higher
expected return for the same standard deviation and (ii) portfolio 2 dominates portfolio 8 as it
offers the same expected return for a lower standard deviation. So, the efficient set consists of all
the portfolios except portfolio 1 and portfolio 8.
7. The weights that drive the standard deviation of portfolio to zero, when the returns are
perfectly correlated, are:
σB

35

wA =

=

wB =

σA + σ B
1 - wA = 0.386

= 0.614
22 + 35

The expected return of the portfolio is :
0.614 x 14% + 0.386 x 20% = 16.316
8. (a) Covariance (P,Q)

= PPQ x σP x σQ
= 0.4 x 14 x 20 = 112

(b) Expected return
= 0.5 x 14 + 0.5 x 20 = 17%
Risk (standard deviation) = [w2P σ2P + w2Q σ2Q + 2 Cov (P,Q)]½
= [0.52 x 625 + 0.52 x 1600 + 2 x 112] ½
= 27.93%
Chapter 9
CAPITAL ASSET PRICING MODEL AND
ARBITRAGE PRICING THEORY
1. Define RA and RM as the returns on the equity stock of Auto Electricals Limited a
and Market portfolio respectively. The calculations relevant for calculating the
beta of the stock are shown below:
Year
1
2
3
4
5
6
7
8
9
10
11

RA
15
-6
18
30
12
25
2
20
18
24
8.

RA = 15.09

RM
12
1
14
24
16
30
-3
24
15
22
12

RA-RA
-0.09
-21.09
2.91
14.91
0-3.09
9.91
-13.09
4.91
2.91
8.91
-7.09

RM-RM
-3.18
-14.18
-1.18
8.82
0.82
14.82
-18.18
8.82
-0.18
6.82
-3.18

(RA-RA)
0.01
444.79
8.47
222.31
9.55
98.21
171.35
24.11
8.47
79.39
50.27

(RM-RM)
10.11
201.07
1.39
77.79
0.67
219.63
330.51
77.79
0.03
46.51
10.11

RM = 15.18

∑ (RA – RA)2 = 1116.93 ∑ (RM – RM) 2 = 975.61 ∑ (RA – RA) (RM – RM) = 935.86
Beta of the equity stock of Auto Electricals
∑ (RA – RA) (RM – RM)
∑ (RM – RM) 2
=
Alpha =
=

935.86
975.61

=

0.96

RA – βA RM
15.09 – (0.96 x 15.18)=

0.52

RA-RA/RM-RM
0.29
299.06
-3.43
131.51
-2.53
146.87
237.98
43.31
-0.52
60.77
22.55

Equation of the characteristic line is
RA = 0.52 + 0.96 RM
2. The beta for stock B is calculated below:
Period

Return of
stock B,
RB (%)

Return on
market
portfolio,
RM (%)

Deviation of
return on
stock B
from its
mean
(RB - RB)

Deviation
of return
on market
portfolio
from its
mean
(RM – RM)

Product of
the
deviation
(RB – RB)
(RM – RM)

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

15
16
10
-15
-5
14
10
15
12
-4
-2
12
15
12
10
9
12
9
22
13
180
Σ RB = 180
RB = 9%

9
12
6
4
16
11
10
12
9
8
12
14
-6
2
8
7
9
10
37
10
200
ΣRM = 200
RM = 10%

6
7
1
-24
-14
5
1
6
3
-13
-11
3
6
3
1
0
3
0
13
4

-1
2
-4
-6
6
1
0
2
-1
-2
2
4
-16
-8
-2
-3
-1
0
27
0

-6
14
-4
144
-84
5
0
12
-3
26
-22
12
-96
-24
-2
0
-3
0
351
0
Σ(RB – RB)
(RM – RM)
= 320

Beta of stock B is equal to:
Cov (RB, RM)
σ2M
Σ (RB - RB) (RM – RM)

320

Square of
the
deviation
of return
on market
portfolio,
from its
mean
(RM – RM)2
1
4
16
36
36
1
0
4
1
4
4
16
256
64
4
9
1
0
729
0
Σ(RB – RB)2
= 1186

Cov (RB, RM) =

=
n –1

= 16.84
19

Σ (RM – RM)2
1186
σ2M =
=
= 62.42
n –1
19
So the beta for stock B is:
16.84
= 0.270
62.42
3.
a. The slope of the capital market line is:
E(RM) – Rf
15 – 8
λ=
=
= 0.28
σM
25
b. The expected return for various mutual funds is:
Omega: 8 + 0.28 x 16 = 12.48%
Pioneer: 8 + 0.28 x 20 = 13.60%
Monarch: 8 + 0.28 x 24 = 14.72%
Zenith: 8 + 0.28 x 30 = 16.40%
4.

E(RM) = 14% σM = 20%
ρA,M = 0.7 ρB,M = 0.8
σA = 24%
σB = 32%

Rf = 6%

(a) Beta for stock A:
σA,M
ρA,M σA σM
βA =
=
2
σM
σ2M
Beta for stock B:
σB,M
ρB,M σB σM
βB =
=
σ2M
σ2M

0.7 x 24 x 20
=

= 0.84
20 x 20

0.8 x 32 x 20
=

= 1.28
20 x 20

(b) Required return for A = Rf + βA [E(RM) - Rf ]
= 6 + 0.84 [14 – 6] = 12.72%
Required return for B = Rf + βB [E(RM) - Rf ]
= 6 + 1.28[14 – 6] = 16.24%

5. (a) Market portfolio has an expected return of 13% and standard deviation of 20%
5
Riskless asset has an expected return of 7% and standard deviation of 0%
The expected return of a portfolio which has 60% of market portfolio and 40% of riskless
asset is :
0.6 x 13 + 0.4 x 7 = 10.6%
The standard deviation of a portfolio which has 60% of market portfolio and
40% of riskless asset is :
0.6 x 20 + 0.4 x 0 = 12%
(b) The expected return of a portfolio which has 125% of market portfolio and –25% of
riskless asset is :
1.25 x 13 – 0.25 x 7 = 14.5%
The standard deviation of a portfolio which has 125% of market portfolio and –125% of
riskless portfolio is:
1.25 x 20 – 0.25 x 0 = 25%
6.
(a) The beta of the aggressive stock is:
40% - (-5%)
45%
=
= 2.25
25% - 5%
20%
The beta of the defensive stock is:
18% - 8%
10%
=
= 0.50
25% - 5%
20%
(b) The expected return on the two stocks is:
Aggressive stock: 0.5(-5) + 0.5(40) = 17.5%
Defensive stock : 0.5(8) + 0.5(18) = 13.0%
(c) The expected return on the market portfolio is:
0.5 x 5 + 0.5 x 25 = 15%
If the risk-free rate is 8%, the market risk premium is: 15% - 8% = 7%
So, the SML is:
Required returni = 8% + βi x 7%
(d) The alphas of the two stocks are calculated below:
Aggressive Stock
Expected return = 17.5%

Beta
= 2.25
Required return = 8 + 2.25% x 7 = 23.75%
Alpha
= 17 – 23.75 = - 6.75%
Defensive Stock
Expected return = 13.0%
Beta
= 0.50
Required return = 8 + 0.5 x 7 = 11.5%
Alpha
= 13.0 – 11.5 = 1.5%
MINICASE

a. For stock A :
Expected return = ( 0.2x 15) +( 0.5x20) +( 0.3x 40) =3+10 +12 =25
Standard deviation= [ 0.2( 15-25)2 + 0.5( 20-25)2 + 0.3(40-25)2]1/2
= [ 20 + 12.5+67.5] ½ = 10
For stock B:
Expected return = ( 0.2x 30) + ( 0.5x 5) + [ 0.3x (-) 15] = 6+2.5- 4.5= 4
Standard deviation= [ 0.2( 30-4)2 + 0.5(5-4)2 + 0.3(-15-4)2]1/2
= ( 135.2 + 0.5 + 108.3) ½ = 15.62
For stock C:
Expected return = [ 0.2x(-)5] +( 0.5x15) +( 0.3x 25) =-1+7.5 +7.5 =14
Standard deviation= [ 0.2(-5-14)2 + 0.5(15-14)2 + 0.3(25-14)2]1/2
= [ 72.2 + 0.5+36.3] ½ = 10.44
For market portfolio:
Expected return = [ 0.2x(-)10] +( 0.5x16) +( 0.3x 30) =-2+8 +9 =15
Standard deviation= [ 0.2(-10-15)2 + 0.5(16-15)2 + 0.3(30-15)2]1/2
= ( 125+ 0.5 + 67.5)1/2 = 13.89
b. State of the Proba Return on Return on RA-E(RA) RB-E(RB)
Economy -bility(p) A(%) ( RA) B (%) ( RB)
-------------Recession
Normal
Boom

--------- ----------0.2
15
0.5
20
0.3
40

------------- ---------- --------30
-10
26
5
-5
1
-15
15
-19

p
x[RA-E(RA)]
x[RB-E(RB)]
-------------52.0
- 2.5
- 85.5

-----------total = - 140.0
------------Covariance between the returns of A and B is (-) 140
State of the Proba
Return on
Economy -bility(p) A(%) ( RA)

Return on RA-E(RA) RC-E(RC)
p
C (%) ( RC)
x[RA-E(RA)]
x[RC-E(RC)]
-------------- --------- ----------- ------------- ---------- --------- ------------Recession
0.2
15
-5.0
-10
- 19.0
38.0
Normal
0.5
20
15.0
-5
1.0
- 2.5
Boom
0.3
40
25.0
15
11.0
49.5
-----------total =
85.0
------------Covariance between the returns of A and C is 85

(-) 140
c. Coefficient of correlation between the returns of A and B =------------- = (-)0.90
10x15.62
85
. Coefficient of correlation between the returns of A and C =------------- = 0. 81
10x 10.44
d

Portfolio in which stocks A and B are equally weighted:
Economic condition Probability
Overall expected return
----------------------------------------------------Recession
0.2
0.5x15 +0.5x30 = 22.5
Normal
0.5
0.5x20 +0.5x5
=12.5
Boom
0.3
0.5x40 + 0.5x(-)15=12.5

Expected return of the portfolio=( 0.2x22.5)+( 0.5x12.5)+( 0.3x12.5)
= 4.5 +6.25 + 3.75 = 14.5
Standard deviation of the portfolio
= [ 0.2(22.5-14.5)2 + 0.5(12.5-14.5)2 + 0.3(12.5-14.5)2]1/2
= [ 12.8 + 2 + 1.2] ½ = 4
Portfolio in which weights assigned to stocks A , B and C are 0.4, 0.4 and 0.2 respectively:
Expected return of the portfolio = ( 0.4x25) + ( 0.4x4) +( 0.2x14)
= 10 +1.6 +2.8= 14.4
For calculating the standard deviation of the portfolio we also need covariance between

B and C, which is calculated as under:

State of the Proba
Return on
Economy -bility(p) B(%) ( RB)

Return on RB-E(RB) RC-E(RC)
p
C (%) ( RC)
x[RB-E(RB)]
x[RC-E(RC)]
-------------- --------- ----------- ------------- ---------- --------- ------------Recession
0.2
30
-5.0
26
- 19.0 (-)98.8
Normal
0.5
5
15.0
1
1.0
0.5
Boom
0.3
(-)15
25.0
(-)19
11.0 (-)62.7
-----------total = (-)161.0
------------Covariance between the returns of B and C is (-) 161
We have the following values:
wA =0.4 wB = 0.4 wC = 0.2 σA=10
σB =15.62 σC =10.44
σAB=(-)140 σAC= 85
σBC = (-) 161
Standard deviation
=[(0.4x10)2+(0.4x15.62)2+(0.2x10.44)2+{2x0.4x0.4x(-)140}+{2x0.4x0.2x85}
+{ 2x0.4x0.2x(-)161}]1/2
= ( 16+ 39.04 + 4.36 – 44.8 + 13.6 – 25.76)1/2 = 1.56
e.

(i) Risk-free rate is 6% and market risk premium is 15-6= 9%
The SML relationship is
Required return = 6% + βx 9%
(ii) For stock A:
Required return = 6% + 1.2x9% = 16.8 %; Expected return = 25 %
Alpha = 25-16.8 = 8.2 %
For stock B:
Required return =6 %-0.70x9%=(-)0.3% ; Expected return = 4 %
Alpha = 4- (-) 0.3 = 4.3 %
For stock C:
Required return = 6% + 0.9x 9% = 14.1 %; Expected return= 14%
Alpha = 14 – 14.1 = (-) 0.1 %
_
_
_
_
_
2
f. Period RD(%) RM(%) RD-RD RM-RM ( RM-RM) (RD-RD)(RM-RM)
--------- --------- --------- ---------- ------------ ------------- --------------------------1
-12
-5
-18.4
-11.2
125.44
206.08

2
3
4
5

6
4
- 0.4
- 2.2
4.84
0.88
12
8
5.6
1.8
3.24
10.08
20
15
13.6
8.8
77.44
119.68
6
9
-0.4
2.8
7.84
- 1.12
----------------------------------------------------------------------------------------_
_
_
Σ RD=32 Σ RM=31
Σ( RM-RM)2 =218.80 Σ(RD-RD)(RM-RM)=335.6
_
_
RD =6.4 RM =6.2
σ2m =218.8/ 4 = 54.7 Cov( D,M)=335.6/4=83.9
β = 83.9/54.7 = 1.53
Interpretation: The change in return of D is expected to be 1.53 times the
expected change in return on the market portfolio.

g. The linear relationship between expected return and standard deviation for efficient
portfolios is called the Capital Market Line ( CML) and the same is given by the
equation
E (Rm-Rf)
E ( Rj) = Rf + [ ---------- ] σj
σm
where E(Rj) = expected return on portfolio j
Rf = risk-free rate
E(Rm) = expected return on the market portfolio
σm =standard deviation of the market portfolio
σj
= standard deviation of the portfolio j
Linear relationship between expected return and standard deviation of individual
securities and inefficient portfolios is called Security Market Line (SML) and the
equation for it is
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] Ci,m
σ2m
where
E(Ri) and E(Rm) are the expected returns on the security/ portfolio i and
market respectively.
Rf = risk-free rate
σm =standard deviation of the market portfolio
Ci,m = Covariance of the return on security/ portfolio i with the market portfolio.
CML is a special case of SML as seen from the following.
As per SML
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] Ci,m
σ2m
Since Ci,m = ρi,m σi σm ,the above equation can be rewritten as

E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] ρi,m σi
σm
For efficient portfolios , as returns on i and m are perfectly positively
correlated, ρi,m =1
Therefore,
E( Rm)-Rf
E(Ri) = Rf + [ ------------- ] σi , which is nothing but the CML.
σm
h. Systematic risk refers to the risk associated with the responsiveness of the return of
the investment arising from economy-wide factors, which have a bearing on the
fortunes of all firms.
Unsystematic risk refers to the risk associated with the responsiveness of the return of
the investment arising from firm-specific factors.
Systematic risk is usually represented by beta ( β), which is given by the formula
σi,m
βi = -----------σ2m
where
βi = beta of the security/ portfolio i
σi,m = covariance between the returns on investment i and the market portfolio
σ2m = variance of the return on the market portfolio.
Unsystematic risk: Being firm specific there is no generalised formula for this risk.

i. CAPM assumes that return on a stock/ portfolio is solely influenced by the market
factor whereas the APT assumes that the return is influenced by a set of factors called
risk factors.

Chapter 12
BOND PRICES AND YIELDS
1.
P =

5

t=1

11

100
+

(1.15)

(1.15)5

= Rs.11 x PVIFA(15%, 5 years) + Rs.100 x PVIF (15%, 5 years)
= Rs.11 x 3.352 + Rs.100 x 0.497
= Rs.86.7
2.(i)

When the discount rate is 14%
7
12
100
P = ∑
+
t=1
(1.14) t (1.15)7
= Rs.12 x PVIFA (14%, 7 years) + Rs.100 x PVIF (14%, 7 years)
= Rs.12 x 4.288 + Rs.100 x 0.4
= Rs.91.46

(ii)

When the discount rate is 12%
7
12
100
P = ∑
+
= Rs.100
t
7
t=1
(1.12)
(1.12)

Note that when the discount rate and the coupon rate are the same the value is
to par value.
3.

The yield to maturity is the value of r that satisfies the following equality.
7
120
1,000
Rs.750 = ∑
+
= Rs.100
t
7
t=1 (1+r)
(1+r)
Try r = 18%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (18%, 7 years) + Rs.1,000 x PVIF (18%, 7 years)

equal

=
=

Rs.120 x 3.812 + Rs.1,000 x 0.314
Rs.771.44

Try r = 20%. The right hand side (RHS) of the above equation is:
Rs.120 x PVIFA (20%, 7 years) + Rs.1,000 x PVIF (20%, 7 years)
= Rs.120 x 3.605 + Rs.1,000 x 0.279
= Rs.711.60
Thus the value of r at which the RHS becomes equal to Rs.750 lies between
18% and 20%.
Using linear interpolation in this range, we get
771.44 – 750.00
Yield to maturity = 18% + 771.44 – 711.60

x 2%

= 18.7%
4.
80 =

10 14
100

+
t=1 (1+r) t
(1+r)10

Try r = 18%. The RHS of the above equation is
Rs.14 x PVIFA (18%, 10 years) + Rs.100 x PVIF (18%, 10 years)
= Rs.14 x 4.494 + Rs.100 x 0.191 = Rs.82
Try r = 20%. The RHS of the above equation is
Rs.14 x PVIFA(20%, 10 years) + Rs.100 x PVIF (20%, 10 years)
= Rs.14 x 4.193 + Rs.100 x 0.162
= Rs.74.9
Using interpolation in the range 18% and 20% we get:
Yield to maturity

82 - 80
= 18% + ----------- x 2%
82 – 74.9
= 18.56%

5.
P =

12

t=1

6

100
+

(1.08) t

(1.08)12

= Rs.6 x PVIFA (8%, 12 years) + Rs.100 x PVIF (8%, 12 years)
= Rs.6 x 7.536 + Rs.100 x 0.397
= Rs.84.92

6. The post-tax interest and maturity value are calculated below:
Bond A
Bond B
*

Post-tax interest (C )

12(1 – 0.3)
=Rs.8.4

*

Post-tax maturity value (M) 100 [ (100-70)x 0.1]
=Rs.97

10 (1 – 0.3)
=Rs.7
100 [ (100 – 60)x 0.1]
=Rs.96

The post-tax YTM, using the approximate YTM formula is calculated below
Bond A :

Post-tax YTM =
=

Bond B :

Post-tax YTM =
=

8.4 + (97-70)/10
-------------------0.6 x 70 + 0.4 x 97
13.73%
7 + (96 – 60)/6
---------------------0.6x 60 + 0.4 x 96
17. 47%

7.
P =

14

t=1

6

100
+

(1.08)

t

(1.08)14

= Rs.6 x PVIFA(8%, 14) + Rs.100 x PVIF (8%, 14)
= Rs.6 x 8.244 + Rs.100 x 0.341
= Rs.83.56
8.

. The YTM for bonds of various maturities is
Maturity
YTM(%)
1
12.36

2

13.10

3

13.21

4

13.48

5
13.72
Graphing these YTMs against the maturities will give the yield curve
The one year treasury bill rate , r1, is
1,00,000
- 1

=

12.36 %

89,000
To get the forward rate for year 2, r2, the following equation may be set up :
12500
99000

112500

=

+
(1.1236)

(1.1236)(1+r2)

Solving this for r2 we get r2 = 13.94%
To get the forward rate for year 3, r3, the following equation may be set up :
13,000
99,500

=

13,000
+

(1.1236)

113,000

+
(1.1236)(1.1394)

(1.1236)(1.1394)(1+r3)

Solving this for r3 we get r3 = 13.49%
To get the forward rate for year 4, r4 , the following equation may be set up :
13,500
100,050

=

13,500
+

(1.1236)

13,500
+

(1.1236)(1.1394)
113,500

+
(1.1236)(1.1394)(1.1349)(1+r4)
Solving this for r4 we get r4 = 14.54%

(1.1236)(1.1394)(1.1349)

To get the forward rate for year 5, r5 , the following equation may be set up :
13,750
100,100

13,750

=

+
(1.1236)

13,750

+
(1.1236)(1.1394)

(1.1236)(1.1394)(1.1349)

13,750
+
(1.1236)(1.1394)(1.1349)(1.1454)
113,750
+
(1.1236)(1.1394)(1.1349)(1.1454)(1+r5)
Solving this for r5 we get r5 = 15.08%

9. The pre-tax rate to the debenture holder is the value of the r in the following
equation:
n
It
ai Pi
n
Fj
Subscription = ∑
+
+ ∑
t
i
price
t=1
(1+r)
(1+r)
j=m (1+r) j
where: It = interest receivable at the end of period t
n = life of the debenture
a = number of equity shares receivable when part-conversion occurs at the end
of period i
Pi = expected price per equity share at the end of period i
Fj = instalment of principal repayment at the end of period j
For the given problem, r is obtained by solving the following equation:
60
600 =

40

40

+
(1+r)

+

40

(1+r)2

2 x 150
+

200
+

(1+r)1
r works out to 15.5%

+
(1+r)3
200

+
(1+r)5 (1+r)6

40
+

(1+r)4

20
+

(1+r)5

(1+r)6

10.

Annual interest receipt will be Rs.100 for 4 years the future value at the end of 4
years. The future value at the end of 4 years, given the re-investment rate of 9
percent
will be:
100 (1.09) + 100 (1.09) + 100 (1.09) + 100 + 1,000
= 100 x FVIFA (r = 9%, n = 4) + 1,000
= 100 x 4.641 + 1,000 = Rs.1464.1
Since the present market price of the bond is Rs.1020, the realised yield to
maturity is the value of r* in the following equation.
1020 (1+r*)4 = 1464.1
1464.1
4

(1+r*) =

= 1.435
1020

r* = 0.946 or 9.46 percent

MINICASE
a.

Value of a bond is calculated as the present value of all future cash flows
associated with it.
Value of a bond (V) carrying an annual coupon payment of C ( in rupees) maturing
after n years with maturity value of M is given by
n
C M
V = Σ -------- + -------t=1 ( 1+r)t (1+r)n
where r is the required periodic rate of return and t is the time period for receipt of periodic
payments.

b.

c.
d.

V = 100 PVIFA8%,9yrs + 1000 PVIF8%, 9yrs
= 100 x 6.247 + 1000 x 0.5 = 624.7 + 500 = Rs. 1124.7

V= 50 PVIFA 4%, 18 yrs + 1000 PVIF 4 %, 18 yrs
= 50 x 12. 659 +1000 x 0. 494 = 632. 95 + 494 = Rs. 1126. 95
Let the YTM be r % . We have

100 PVIFA r, 6yrs + 1000 PVIFr, 6 yrs = 1050
Trying r = 8%, LHS = 100 x 4. 623 + 1000 x 0. 630 = 1092.3
Trying r= 9%, LHS = 100x 4.486 + 1000 x 0. 596 = 1044.6
By linear interpolation
r= 8% + ( 9-8) ( 1092. 3- 1050) / ( 1092.3 – 1044.6) = 0.8868 i.e. 8.87 %
100+ (1000- 1050)/6
100- 8.33
e. V = --------------------------- = ------------ = 0.089 i.e. 8.9 %
0.4 x 1000 + 0.6 x 1050
1030
f. Let r be the yield to call. We then have
100 PVIFA r%, 3yrs +1050 PVIF r%, 3yrs =1050
Trying r= 9%, LHS = 100x 2.531 + 1050 x 0. 772 =1063.7
Trying r=10%, LHS = 100x 2.487 + 1050x 0.751 = 1037. 25
By linear interpolation,
( 1063.7- 1050)
13.7
r= 9% + ( 10- 9)----------------------- = 9 + ------- =9.52 %
( 1063.7- 1037.25)
26.45
g.

If future cash flows are reinvested at 8% p.a. the terminal value will be
100 PVIFA 8%, 6 yrs + 1000 = 100x 7.336 + 1000 = 1733.6
Let r* be the realized yield to maturity.
We have 1050 ( 1+ r *)6 = 1733.6
( 1+r*) 6 = 1733.6/ 1050 = 1.6510
1+r* = 1.0872
r* = 0.0872 or 8.72 %

h. Stated YTM =

100 + ( 1000 – 1050) / 6
-------------------------------- = 0.089 or 8.9 %
0.4 x 1000 + 0.6 x 1050

100+ ( 900 – 1050)/ 6
75
Expected YTM = ---------------------------- = ----- = 0.0758 or 7.58%
0.4 x 900 + 0.6 x 1050 990
Difference between the expected and stated YTM = 8.9 – 7.58 = 1.32%
i.

Annual percentage rate of a bond refers to the stated coupon rate per annum.
If m is the frequency of coupon payment per year,
annual parentage rate
Effective annual coupon interest rate = (1+ --------------------------- )m - 1
m

Effective annual yield=

Effective annual coupon interest rate x maturity value
----------------------------------------------------------------Current market price

j.
Interest rate risk: Interest rates tend to vary over time, causing fluctuations in
bond prices. A rise in interest rates will depress the market price of outstanding bonds.
This is called interest rate risk.

Reinvestment risk: When a bond pays periodic interest, there is a risk that these
interest payments may have to be reinvested at a lower interest rate. This is called
reinvestment risk.
k. Key financial ratios that have a bearing on debt rating are:
Interest coverage ratio = EBIT/ Interest
EBIT + Depreciation
Fixed charges coverage ratio = --------------------------------------Interest + Repayment of loan
-----------------------1 – tax rate

PAT+ Depreciation+ Other non- cash charges
+Interest on term loans + Lease rentals
Debt Service Coverage Ratio = ---------------------------------------------------------Interest on term loans +Lease rentals+ Repayment
of term loans
l.
Yield curve shows how yield to maturity is related to term to maturity for
bonds that are similar in all respects, excepting maturity.
m.

Factors that determine interest rates are:
a) Short-term risk-free interest rate, which is given by
Expected real rate of return+ Expected inflation
b) Maturity premium: It is the difference between the YTM on a short-term
( one year) risk-free security and the YTM on a risk-free security of a
longer duration and depends on (i) expectation of the market participants,
(ii) liquidity preference of the market participants and (iii) supply and
demand for funds in different maturity ranges( called habitats)
c) Default premium: An additional default premium will have to be paid
when there exists a possibility of default on interest / principal payment.

d) Special features: Interest rates are affected when a bond has some special
features like call or put option, conversion option, floating rate, zero
coupon etc.

Chapter 13
BOND PORTFOLIO MANAGEMENT
9+( 100-105)/5
8
1. Yield to maturity =--------------------------------- = --------- = 0.0767 or 7.77 %
( 0.4x100) + ( 0.6x 105)
40+63
Duration is calculated below
Year

Cash flow

Present Value
at 18%

Proportion of
bond’s value

Proportion of bond’s
Value x Time

1

9

8.35

0.080

0.080

2

9

7.75

0.074

0.148

3

9

7.19

0.068

0.204

4

9

6.67

0.064

0.256

5

109

74.98

0.714

3.570
-----------------------4.258
------------------------

Duration of the bond is 4.258 years.
2. . a. Issue price (1.10)8 = Rs.10,000
Issue price =

6

Rs.10,000
= Rs.4670
(1.10)8

b. The duration of the bond is 8 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

8
=

(1+ yield)

= 7.273
(1.10)

d. The percentage change in the price of the bond, if the yield declines by 0.5 percent is:
∆P/ P = - Modified duration x 0.5
= - 3.637 percent
3. . a. The duration of a coupon bond is:
1+y
(1 + y) + T(c –y)
y
c [(1 +y)T – 1] + y
y = 10%, c = 10%, T = 10 years
So, the duration of the bond is:
1.10
(1.10) + 10 (0.10 – 0.10)
0.10
0.10 [(1.10) – 1] + 0.10
1.10
11 = 6.759
0.2594
b. Because the bond carries a coupon
c. (i) A decrease in coupon rate from 10% to 8% will increase the duration.
(ii) An increase in yield from 10% to 12% reduces the duration because the
duration of a coupon bearing bond varies inversely with its yield.
(iii) A decrease in maturity period from 10 years to 8 years decreases the
duration.
4. The duration of a level annuity is:
1 + yield
Number of payments
yield
(1 + yield) No. of payments – 1
Yield = 8.5%; No. of payments = 15
So, the duration is:
1.085
15
.085
(1.085) 15 – 1

1.085

15

.085

5. The duration is:
1+y

= 12.76 – 6.25 = 6.51 years
3.400 – 1

(1 + y) + T(c –y)
c [(1 +y)T – 1] + y

y
1.05

(1.05) + 10 (.06 – .05)
-

.05

.06 [(1.05)10 – 1] + 0.05
= 7.89 half year periods.

6. The liability has a duration of ten years. The duration of the zero coupon bond is 6 years
and the duration of the perpetuities is : 1.07/ 0.07 = 15.29 years.
As the portfolio duration is 10 years, if w is the proportion of investment in zero coupon
bonds, we have
( wx6) + ( 1-w)x 15.29 = 10
6w + 15.29 – 15.29= 10
w=0.569 and 1-w= 0. 431
Therefore the amount to be invested in zero coupon bonds is
100,000 x 0.569 =Rs. 56,900 and the amount to be invested in perpetuities
is Rs. 43,100
7.

Current price = 9000 PVIFA( 8 %, 8 years) + 100,000 PVIF ( 8%, 8 years)
= 9000 x 5.747 + 100,000 x 0. 540
= 51,723 + 54,000 = 105,723
Forecast price = 9000 PVIFA( 7 %, 5 years) + 100,000 PVIF ( 7%, 5 years)
= 9000 x 4.100 + 100,000x 0.713 = 36,900 + 71,300
= 108,200
Future value of reinvested coupon = 9000 ( 1.065)2 + 9000 ( 1.065) + 9000
= 10,208 + 9585 + 9000 = 28,793
28,793 + ( 108,200- 105, 723)
Three year return = ---------------------------------------- = 0. 2958
105, 723
The expected annualized return over the three year period will be
( 1. 2958 )1/3 – 1 = 0.0902 or 9.02 %

CHAPTER 14
EQUITY VALUATION
1. Do = Rs.2.00, g = 0.06, r = 0.12
Po = D1 / (r – g) = Do (1 + g) / (r – g)
=
=

Rs.2.00 (1.06) / (0.12 - 0.06)
Rs.35.33

Since the growth rate of 6% applies to dividends as well as market price, the market
price at the end of the 2nd year will be:

2.
3.

4.

P2

=
=

Po x (1 + g)2 = Rs.35.33 (1.06)2
Rs.39.70

Po

=
=

D1 / (r – g)
=
Do (1 + g) / (r – g)
Rs.12.00 (1.10) / (0.15 – 0.10)
=

=

D1 / (r – g)

Po

Rs.32 =
g
=

Rs.2 / 0.12 – g
0.0575 or 5.75%

Po
Do
So
8

D1/ (r – g) = Do(1+g) / (r – g)
Rs.1.50, g = -0.04, Po = Rs.8

=
=

Rs.264

= 1.50 (1- .04) / (r-(-.04)) = 1.44 / (r + .04)

Hence r = 0.14 or 14 per cent
5. The market price per share of Commonwealth Corporation will be the sum of three
components:
A:
B:

Present value of the dividend stream for the first 4 years
Present value of the dividend stream for the next 4 years

C:

Present value of the market price expected at the end of 8 years.

A=

1.50 (1.12) / (1.14) + 1.50 (1.12)2 / (1.14)2 + 1.50(1.12)3 / (1.14)3 +
+ 1.50 (1.12)4 / (1.14)4
1.68/(1.14) + 1.88 / (1.14)2 + 2.11 / (1.14)3 + 2.36 / (1.14)4
Rs.5.74
2.36(1.08) / (1.14)5 + 2.36 (1.08)2 / (1.14)6 + 2.36 (1.08)3 / (1.14)7 +
+ 2.36 (1.08)4 / (1.14)8
2.55 / (1.14)5 + 2.75 / (1.14)6 + 2.97 / (1.14)7 + 3.21 / (1.14)8
Rs.4.89

=
=
B=
=
=
C=

P8 / (1.14)8
P8 = D9 / (r – g) = 3.21 (1.05)/ (0.14 – 0.05) = Rs.37.45

So
C=
Rs.37.45 / (1.14)8 = Rs.13.14
Thus,
Po =
=

A + B + C = 5.74 + 4.89 + 13.14
Rs.23.77

6. The intrinsic value of the equity share will be the sum of three components:
A:

Present value of the dividend stream for the first 5 years when the
growth rate expected is 15%.

B:

Present value of the dividend stream for the next 5 years when the
growth rate is expected to be 10%.

C:

Present value of the market price expected at the end of 10 years.
2.00 (1.15)2

2.00 (1.15)
A=

+
(1.12)2

(1.12)
=
=

2.30 / (1.12) + 2.65 / (1.12)2 + 3.04 / (1.12)3 + 3.50 / (1.12)4 + 4.02/(1.12)5
Rs.10.84
4.02 (1.10)2

4.02(1.10)
B=

+
(1.12)
4.42

=

2.00 (1.15)3 2.00(1.15)4 2.00 (1.15)5
+
+
+
3
4
(1.1.2)
(1.1.2)
(1.12)5

6

+
(1.12)
4.86

+

4.02(1.10)3

7

+
(1.12)
5.35

+

4.02(1.10)4

8

+
(1..12)
5.89

+

4.02 (1.10)5

9

(1.12)10
6.48
+

(1.12)6
(1.12)7
(1.12)8
(1.1.2)9
(1.12)10
= Rs.10.81
D11
1
6.48 (1.05)
C=
x
=
x 1/(1.12)10
r–g
(1 +r)10
0.12 – 0.05
= Rs.97.20
The intrinsic value of the share = A + B + C
= 10.84 + 10.81 + 97.20 = Rs.118.85
7. Intrinsic value of the equity share (using the 2-stage growth model)
(1.18)6
1 - ----------(1.16)6

2.36 x

2.36 x (1.18)5 x (1.12)

=

+
(0.16 – 0.12) x (1.16)6

0.16 – 0.18
- 0.10801
=

2.36 x

+ 62.05
- 0.02

=

Rs.74.80

8. Intrinsic value of the equity share (using the H model)
4.00 (1.20)
=
0.18 – 0.10
=
=

4.00 x 4 x (0.10)
+
0.18 – 0.10

60 + 20
Rs.80

9.

Low growth
firm
Normal
growth firm
Supernormal
growth firm

Price Po = D1 / (r – g)

Dividend yield
D1/ Po

Capital yield
(Po - Po)/ Po

Po = 2 / (0.16 - .04) = 16.67

12.0%

4.0%

Price
earnings
ratio Po/ E1
4.17

Po = 2 / (0.16 - .08) = 25.00

8.0%

8.0%

6.25

Po = 2 / (0.16 - .12) = 50.00

4.0%

12.0%

12.5

10.
E1/Po = 2.50/30.00
r = 0.16
PVGO
E1/Po = r 1 Po
2.50

PVGO
= 0.16

30.00

1Po

PVGO
= 0.48
30.00
So, 48 percent of the price is accounted for by PVGO.
MINICASE

Dr
a. The general formula is P0 = Σ -----------------t=1
( 1+ r)t
where Dt = dividend expected t years hence
r= expected return
D1
b. Value of a constant growth stock P0= -----------r- g
where D1 is the dividend expected a year hence, r the expected return and g the
growth rate in dividends.
c. Required rate of return = 7 % + 1.2 x 6 % = 14.2 %
d. (i) Expected value of the stock a year hence =

5 x 1.10 x 1.10
0.142 – 0.10
= Rs. 144.05

( ii) Expected dividend in the first year = 5x 1.10 = Rs.5.50

5x 1.10
Intrinsic price of the stock at present = P0 = ------------ = Rs. 130. 95
0.142- 0.10
5.50
Expected dividend yield = ---------- = 0.042 or 4.2 %
130.95
5x 1.10x 1.10
Expected price of the stock one year hence=P1 = ----------------- = Rs. 144.05
0.142- 1.10
144.05-130.95
Capital gains yield in the first year = ------------------- = 10 %
130.95
e

Let r be the expected rate of return on the stock. We then have
5x1.10
5x 1.10
110 = ---------- i.e. r = ----------- + 0.10 = 0.05 + 0.10 = 0.15 or 15%
r – 0.10
110

f. Let us assume that the required rate of return is 15 percent.
Year
Expected dividend PV factor @15% PV of dividend
1
5x 1.25 = 6.25
0.870
5.44
2
5x ( 1.25)2= 7.81
0. 756
5.90
3
5x ( 1.25)3= 9.77
0. 658
6.43
4
4
5x ( 1.25) = 12.21
0. 572
6.98
-------------total = Rs. 24.75
(A)
-------------Price of the stock at the beginning of the 5th year
12.21x 1.10
= ---------------- = Rs. 268.62
0.15- 0.10
Present value of the above is 268.62x 0.572 = Rs. 153. 65 (B)
Present value of the stock = A+B = 24.75 + 153.65 = Rs. 178. 40
The expected dividend in the second year= Rs. 7.81
Expected price of the stock at the beginning of the second year:

7.81
= -----1.15

9.77
+ ------( 1.15)2

+

12.21
--------- +
( 1.15 )3

268.62
---------( 1.15 )3

=6.7913 + 7.3875 + 8.0283 + 176. 6220 = 198. 8291
Dividend yield in the second year = 7.81/ 198. 8291 = 0.0393
Expected price of the stock at the end of the second year,
9.77
12.21
268.62
=
------- + ------- + -------- = 8.4956 + 9. 2325 + 203.1153 = 220.8434
(1.15) (1.15)2
(1.15)2
220.8434 – 198. 8291
Capital gain in the second year = --------------------------- = 0. 1107
198. 8291
The total return for the second year = 3.93 + 11.07 = 15 %
Expected dividend in the fifth year = 12.21x1.10= Rs. 13.43
Expected price of the stock in the beginning of the 5th year = Rs.268.62
Expected dividend yield in the 5th year = 13.43/268.62 =0.05 or 5 %
Expected price of the stock at the end of 5th year
13.43x1.10
------------- =295.46
0.15-0.10
Expected capital gains yield in the 5th year =(295.46-268.62)/268.62
= 0.10 or 10 %
.
g. .

Year Expected dividend
1
5.00
2
5.00

PV factor @15%
0. 870
0. 756

PV of dividend
4. 35
3.78
-----------total = Rs. 8.13
(A)
-------------

Expected price of the stock at the beginning of the 3rd year
5x 1.10
= ---------- = Rs. 110
0.15-0.10
Present value of which is 110x 0.756 = Rs. 83. 16 ( B)
Present value of the stock = A+B = 8.13 + 83.16 = Rs. 91.29

h.
i.

5 [ ( 1+ 0.10) + 2 ( 0.30- 0.10 ) ]
Present value of the stock = ---------------------------------------- = Rs. 150
0. 15-0.10
5x (1- 0.05)
5x0.95
Present value of the stock= --------------- = --------- = Rs. 23.75
0.15- (-) 0.05
0.20
Dividend expected after one year = 5x0.95 = Rs. 4.75
Dividend yield per year = 4.75/23.75 = 0.2 or 20 %.
Expected price of the stock at the end of the first year
4.75x0.95
= ---------------- = Rs.22.56
0.15-(-)0.05
Capital gains yield per year =( 22.56-23.75) / 23.75 = (-) 0.05 or (-)5%

j. The question is incomplete. Let us assume that the decline in growth rate to 10
percent will occur linearly over 4 years.
Year Expected dividend PV factor @15% PV of dividend
1
5x1.30 = 6.50
0. 870
5.66
2
5x( 1.30)2 =8.45
0. 756
6.39
3
3
5x( 1.30) = 10.98 0.658
7.22
----------total Rs.19.27
( A)
----------Expected price of the stock at the beginning of the 4th year
10.98[ ( 1+ 0.10) + 2 ( 0.30- 0.10) ]
= ------------------------------------------- = Rs. 329.40
0. 15 – 0. 10
Present value of this is 329.40 x 0.658 = Rs. 216.75
( B)
Present value of the stock = A+ B = 19.27 + 216.75 = Rs 236. 02

Chapter 16
COMPANY ANALYSIS
1.
Return on equity = Profit after tax / Shareholders’ funds
Book value per share = Shareholders’ funds / Number of shares
EPS = Profit after tax / Number of shares
Capital after bonus issue
Bonus adjustment factor =
Capital before bonus issue
Price per share at the beginning of the year
PE ratio (prospective)

=
Earnings per share for the year
Price per share at the end of the year

PB ratio (retrospective)

=
Book value per share at the end of the year
Sales for 20X5

CAGR in sales

=

1/4

-1
Sales for 20X1
EPS for 20X5

CAGR in EPS

=

1/4

-1
EPS for 20X1
Range of ROE over the period of 20X1 – 20X5

Volatility of ROE

=
Average ROE over the period 20X1 – 20X5

Sustainable growth rate = Retention ratio x ROE
Return on equity = Profit after tax / Shareholders’ funds
Book value per share = Shareholders’ funds / Number of shares
EPS = Profit after tax / Number of shares
Capital after bonus issue
Bonus adjustment factor =

Capital before bonus issue
Price per share at the beginning of the year
PE ratio (prospective)

=
Earnings per share for the year
Price per share at the end of the year

PB ratio (retrospective)

=
Book value per share at the end of the year
1/4

Sales for 20X5
CAGR in Sales

=

-1
Sales for 20X1
1/4

EPS for 20X5
CAGR in EPS

=

-1
EPS for 20X1
Range of ROE over the period of 20X1 – 20X5

Volatility of ROE

=
Average ROE over the period 20X1 – 20X5

Sustainable growth rate = Retention ratio x ROE
(a)
20X1
26 / 120

20X2
29 / 137

20X3
32 / 157

20X4
42 / 183

20X5
49 / 216

= 21.7%

= 21.2%

= 20.4%

= 23%

= 22.7%

Book value
per share

120/ 16
= Rs.7.5

137/ 16
= Rs.8.6

157/ 16
= Rs.9.8

183/ 24
= Rs.7.6

216/ 24
= Rs.9

EPS

26/ 16
= Rs.1.63

29/ 16
= Rs.1.81

32/ 16
= Rs.2

42/ 24
= Rs.1.75

49/ 24
= Rs.2.04

Return on
equity

Bonus
adjustment
factor
Adjusted EPS
PE ratio
(prospective)

1

1

1

1.5

1.5

Rs.1.63

Rs.1.81
17.50/ 1.81
= 9.7

Rs.2
21/ 2
= 10.5

Rs.2.63
24.5/ 1.75
= 14

Rs.3.06
21.6/ 2.04
= 10.6

PB ratio
(retrospective)

17.50/ 7.5

21/ 8.6

24.5/ 9.8

21.6/ 7.6

24.2/ 9

= 2.3

= 2.4

= 2.5

= 2.8

= 2.7

16/ 26

17/ 29

20/ 32

26/ 42

33/ 49

= 0.62

= 0.59

= 0.63

= 0.62

= 0.67

Retention
ratio
(b)

1/4

520
CAGR of Sales =

-1 = 0.201 = 20.1%
250
3.06 1/4
-1 = 0.171 = 17.1%

CAGR of EPS =
1.63

23 – 20.4
Volatility of ROE =

= 0.12
21.8

(c)

0.63 + 0.62 + 0.67

20.4 + 23 + 22.7

Sustainable growth rate =
3

3

= 0.64 X 22.03 = 14.09%
(d)

PBIT
ROE =

Sales
x

Sales

Profit before tax
x

Assets

Profit after tax
x

PBIT

Assets
x

Profit before tax

Net worth

The decomposition of ROE for the last two years, viz., 20X4 and 20X5 is
shown below:
PBIT

Sales
x

Sales
20X4
20X5

0.167
0.181

Profit before tax
x

Assets
x 1.758
x 1.646

Profit after tax
x

PBIT
x
x

0.70
0.702

Assets
x

Profit before tax
x
x

0.75
0.742

Net worth
x
x

1.492
1.463

MINICASE
Return on equity = Profit after tax / Shareholders’ funds
Book value per share = Shareholders’ funds / Number of shares
EPS = Profit after tax / Number of shares
Capital after bonus issue
Bonus adjustment factor =
Capital before bonus issue
Price per share at the beginning of the year
PE ratio (prospective)

=
Earnings per share for the year
Price per share at the end of the year

PB ratio (retrospective)

=
Book value per share at the end of the year
Sales for 20X5

CAGR in sales

=

1/4

-1
Sales for 20X1
EPS for 20X5

CAGR in EPS

=

1/4

-1
EPS for 20X1
Range of ROE over the period of 20X1 – 20X5

Volatility of ROE

=
Average ROE over the period 20X1 – 20X5

Sustainable growth rate = Retention ratio x ROE
Return on equity = Profit after tax / Shareholders’ funds
Book value per share = Shareholders’ funds / Number of shares
EPS = Profit after tax / Number of shares

Capital after bonus issue
Bonus adjustment factor =
Capital before bonus issue
Price per share at the beginning of the year
PE ratio (prospective)

=
Earnings per share for the year
Price per share at the end of the year

PB ratio (retrospective)

=
Book value per share at the end of the year
Sales for 20X5

CAGR in Sales

=

1/4

-1
Sales for 20X1
EPS for 20X5

CAGR in EPS

=

1/4

-1
EPS for 20X1
Range of ROE over the period of 20X1 – 20X5

Volatility of ROE

=
Average ROE over the period 20X1 – 20X5

Sustainable growth rate = Retention ratio x ROE
(a)
Return on
equity
Book value
per share
EPS

20X1
60/ 500

20X2
60/ 540

20X3
110/ 620

20X4
150/ 730

20X5
240/ 920

= 12%

= 11.1%

= 17.7%

= 20.5%

= 26.1%

500/ 30
= Rs.16.7

540/ 30
= Rs.18

620/ 30
= Rs.20.7

730/ 30
= Rs.24.3

920/ 30
= Rs.30.7

60/ 30
= Rs.2

60/ 30
= Rs.2

110/ 30
= Rs.3.7

150/ 30
= Rs.5

240/ 30
= Rs.8

PE ratio
(prospective)
PB ratio
(retrospective)

20/ 2
= 10

22/ 3.7
= 5.9

45/ 5
=9

56/ 8
=7

20/ 16.7

22/ 18

45/ 20.7

56/ 24.3

78/ 30.7

= 1.2

= 1.2

= 2.2

= 2.3

= 2.5

40/ 60

40/ 60

80/ 110

110/ 150

190/ 240

= 0.67

= 0.67

= 0.73

= 0.73

= 0.79

Retention
ratio
(b)

1/4

1780
CAGR of sales =

-1 = 0.229 = 22.9%
780
1/4

8
CAGR of EPS =

-1 = 0.414 = 41.4%
2
26.1 – 11.1

Volatility of ROE =

= 0.86
17.5

(c)

0.73 + 0.73 + 0.79

17.7 + 20.5 + 26.1

Sustainable growth rate =
3

3

= 0.75 x 21.4 = 16.05%
(d)

The decomposition of ROE for the last two years, viz., 20X4 and 20X5 is
shown below:
PBIT

Sales
x

Sales
20X4
20X5

0.193
0.230

Profit before tax
x

Assets
x 0.979
x 0.937

(e) EPS estimate for 20X6 is

Profit after tax
x

PBIT
x
x

0.704
0.707

Assets
x

Profit before tax
x
x

0.789
0.828

Net worth
x
x

1.959
2.065

Net sales
Cost of goods sold
Operating expenses
Non-operating surplus/deficit
PBIT
Interest
Profit before tax
Tax
Profit after tax
EPS

20X5
1780
1210
170
10
410
120
290
50

20X6
2047
1403.60
204
10
449.4
132
317.4
70.59

240

246.81
8.23

Remarks
Increase by 15%
Increase by 16%
Increase by 20%
Remains same
Increase by 10%
Effective tax
increases by 5%

(f) Average retention ratio for the period 20X3 – 20X5 was 0.75. So the average
payout ratio was 1 – 0.75 = 0.25
Required rate of return
= 10% + 1.1 x 8% = 18.8%
Expected growth rate in dividends
Average retention ratio
Average return on equity
= in the last three years
x in the last three years
Average return on equity in
the last three years

17.7 + 20.5 + 26.1
=

= 21.4%
3

So, the expected growth rate in dividends is:
0.75 x 21.4 = 16.05%

The PE ratio as per the constant growth model is:
0.25
= 9.09
0.188 – 0.1605
(g) The value anchor is:
Expected EPS x PE ratio
= Rs.8.23 x 9.09 = Rs.74.8

rate

Chapter 18
OPTIONS
1.

S = 100 , uS = 150, dS = 90
u = 1.5 , d = 0.9, r = 1.15 R = 1.15
E = 100
Cu = Max (uS – E, 0) = Max (150 – 100,0) = 50
Cd = Max (dS – E, 0) = Max (90 – 100,0) = 0
Cu – Cd
∆ =

50
=

= 0.833

(u-d)S

0.6 x 100

u Cd – d Cu

0 – 0.9 x 50

B =

=
(u-d)R

C =
2.

= - 65.22
0.6 x 1.15

∆ S + B = 0.833 x 100 – 65.22 = 18.08

S = 60 , dS = 45, d = 0.75, C = 5
r = 0.16, R = 1.16, E = 60
Cu = Max (uS – E, 0) = Max (60u – E, 0)
Cd = Max (dS – E, 0) = Max (45 – 60, 0) = 0
Cu – Cd
∆ =

60u – 60
=

(u-d)S

(u – 0.75)60

u Cd – d Cu
B =

45 (1 – u)
=

(u – 0.75) 1.16

∆S+B
(u – 1) 60

u – 0.75

– 0.75 (60u – 60)
=

(u-d)R
C =

u–1
=

45 (1 – u)

1.16 (u – 0.75)

5 =

+
u – 0.75

1.16 (u – 0.75)

Multiplying both the sides by u – 0.75 we get

45
5(u – 0.75) = (u – 1) 60 +

(1 – u)
1.16

Solving this equation for u we get
u = 1.077
So Beta’s equity can rise to
60 x 1.077 = Rs.64.62
3.

E
C0 = S0 N(d1) -

N (d2)
ert
S0 = 70, E = 72, r = 0.12, σ = 0.3, t = 0.50
S0

1

ln

+

r+

E

σ2

t

2

d1 =
σ

t

70
ln

+ (0.12 + 0.5 x .09) x 0.50
72

=
0.30 0.50
- 0.0282 + 0.0825
=

= 0.2560
0.2121

d2 = d1 - σ

t = 0.2560 – 0.30

N (d1) = 0.6010
N (d2) = 0.5175
E

72

0.50 = 0.0439

=
e

= 67.81

rt

e

0.12x 0.50

C0 = S0 x 0.6010 – 67.81 x 0.5175
= 70 x 0.6010 – 67.81 x 0.5175 = Rs.6.98

4.

E
C0 = S0 N(d1) -

N (d2)
rt

e
E = 50, t = 0.25, S = 40, σ = 0.40, r = 0.14
S0

1

ln

+

r+

E

σ2

t

2

d1 =
σ

t

40
ln

+ (0.14 + 0.5 x 0.16) 0.25
50

d1 =
0.40 0.25
- 0.2231 + 0.055
=

= - 0.8405
0.20

d2 = d1 - σ

t = - 0.8405 – 0.40

N (d1) = 0.2003
N (d2) = 0.1491
E
=
rt
e

0.25 = -1.0405

50
= 48.28
e

0.14 x 0.25

C0 = S0 x 0.2003 – 48.28 x 0.1491
= 40 x 0.2003 – 48.28 x 0.1491 = 0.8135
5.

S = 100

u = 1.5

d = 0.8

E = 105

r = 0.12

R = 1.12

The values of ∆ (hedge ratio) and B (amount borrowed) can be obtained as
follows:
Cu – Cd

=
(u – d) S

Cu

=

Max (150 – 105, 0)

=

45

Cd

=

Max (80 – 105, 0)

=

0

45 – 0

45

=

=
0.7 x 100

9
=

70

=

0.6429

14

u.Cd – d.Cu
B

=
(u-d) R

C

=

(1.5 x 0) – (0.8 x 45)
0.7 x 1.12

=

-36
0.784

=
=
=

∆S+B
0.6429 x 100 – 45.92
Rs.18.37

=

-45.92

Value of the call option = Rs.18.37
6.

S = 40
R = 1.10

u=?
E = 45

d = 0.8
C=8

We will assume that the current market price of the call is equal to the fair value
of the call as per the Binomial model.
Given the above data
Cd

=


=

Max (32 – 45, 0)

=

Cu – Cd

R
x

0

B

u Cd – d Cu

Cu – 0
=

1.10
x

B


C
8

S

-0.8Cu

40

=

(-) 0.034375

=
=
=

- 0.34375 B
∆S+B
∆ x 40 + B

(1)
(2)

Substituting (1) in (2) we get
8
8
or B

=
=
=

(-0.034365 x 40) B + B
-0.375 B
- 21.33

=

- 0.034375 (-21.33) = 0.7332

The portfolio consists of 0.7332 of a share plus a borrowing of Rs.21.33 (entailing a
repayment of Rs.21.33 (1.10) = Rs.23.46 after one year). It follows
that when u occurs either
u x 40 x 0.7332 – 23.46 = u x 40 – 45
-10.672 u
=
-21.54
u
=
2.02
or
u x 40 x 0.7332 – 23.46
u
=
0.8

=

0

Since u > d, it follows that u = 2.02.
Put differently the stock price is expected to rise by 1.02 x 100 = 102%.
7.
E
C0 = S0 N(d1) -

N (d2)
ert
S0 = 120, E = 110, r = 0.14, t = 1.0, σ = 0.4
S0
ln

1
+

E

r+
2

σ2

t

d1 =
σ

t

120
ln
110
d1 =

1
+
0.4

x 0.42 1

0.14 +
2
1

.0870 + 0.22
=

= 0.7675
0.4

d2 = d1 - σ

t = 0.7675 – 0.40 = 0.3675

N (d1) = 0.2003
E
=
ert

N (d2) = 0.6434
110
= 99.63
1.1503

C0 = 120 x 0.7786 – 99.63 x 0.6434
= Rs.29.33
8.
E
C0 = S0 N(d1) -

N (d2)
rt

e
S0 = Rs.80, E = Rs.82, ert = 1.1503, σ = 0.20, t = 1, r = ln (1.1503) = 0.14
S0
ln

1
+

r+

E

σ2

t

2

d1 =
σ

t

80
ln

1
+

82
d1 =
0.20

0.14 +
2

x 0.4 1

1

- 0.0247 + 0.1600
=

= 0.6765

0.20
d2 = d1 - σ

t = 0.6765 – 0.20 = 0.4765

N (d1) = 0.751
E
=
e

rt

N (d2) = 0.683
82
= 71.29
1.1503

C0 = Rs.80 x 0.751 – Rs.71.29 x 0.683
= Rs.11.39
9. According to the put-call parity
C0 = S0 + P0 – E/ ert
S0 = Rs.75, P0 = Rs.0.70, E = Rs.80, r = 0.08, t = 0.25
So C0 should be
80
Rs.75 + Rs.0.70 -

= - 2.716
e

0.08 x 0.25

C0 is given to be Rs.7.
Clearly the put-call parity is not working in this case.
10.
S0 = Rs.60, u = 1.30, d = 0.95, r = 8%, E = Rs.50
If investors are risk-neutral, the expected return on the stock is 8%.
Since Bharat’s stock can either rise by 30 percent to Rs.78 or fall by 5 percent to
Rs.57, we can calculate the probability of a price rise in the hypothetical riskneutral world.
Expected return = [Probability of rise x 30%] + [1 – Probability of rise] x – 5%
= 8%
Therefore the probability of rise is 0.3714
If the stock price rises the call option has a value of Rs.28 (Rs.78 – 50) and if the
stock price falls the call option has a value of Rs.7 (Rs.57 – 50).
Hence, if investors are risk-neutral, the call option has an expected future value of:
Probability of rise x Rs.28 + (1- Probability of rise) x Rs.7
= 0.3714 x 28 + (1 – 0.3714) x 7

= 10.40 + 4.40 = Rs.14.80
The current value of the call option is:
Expected future value
14.80
=
1 + Risk-free rate
(1.08)

= Rs.13.70

MINICASE
a. Call option : A call option gives the option holder the right to buy an asset at a fixed
price during a certain period.
Put option : : A put option gives the option holder the right to sell an asset at a
fixed
price during a certain period.
Strike price ( exercise price ) : The fixed price at which the option holder can buy and
/or sell the underlying asset is called the strike price or the exercise price .Expiration
date : The date when the option expires is called the expiration date.
b. Call options with strike prices 280, 300 and 320 and put options with strike prices 340
and 360 are in - the - money .
Call options with stike prices 340 and 360 and put options with strike prices 280, 300
and 320 are out of – the – money.
c.

(i) If Pradeep Sharma sells Jan/340 call on 1000 shares, he will earn a call premium of
Rs.5000 now. However, he will forfeit the gains that he would have enjoyed if the
price of Newage Hospitals rises above Rs.340.
(ii) If Pradeep Sharma sells Mar/300 call on 1000 shares, he will earn a call
premium of
Rs.41,000 now. However, he will forfeit the gains he would have enjoyed if the
price of Newage Hospital remains above Rs.300.
d. Let s be the stock price, p1 and p2 the call premia for March/ 340 and March/ 360 calls
respectively. When s is greater than 360, both the calls will be exercised and the profit
will be { s-340-p1} – { s-360-p2 } = Rs. 11
The maximum loss will be the initial investment , i.e. p1-p2 =Rs. 9
The break even will occur when the gain on purchased call equals the net premium paid
i.e. s-340 = p1 – p2 =9 Therefore s= 349
e. If the stock price goes below Rs.300, Mr. Sharma can execute the put option and ensure
that his portfolio value does not go below Rs. 300 per share. However , if stock price
goes above Rs. 340, the call will be exercised and the stocks in the portfolio will have to
be delivered/ sold to meet the obligation, thus limiting the upper value of the portfolio to

Rs. 340 per share. So long as the share price hovers between R. 300 and Rs. 340, Mr.
Sharma will be gainer by Rs. 8 ( net premium received ).
f.
Profit

Pay off

0

g.

305

340 375

Stock price
Other
things remaining
· constant, value of a call option
increases when the current price of the stock increases.
decreases when the exercise price increases.
increases when option term to maturity increases.
- increases when the risk-free interest rate increases.
- increases when the variability of the stock price increases.

h. The assumptions underlying the Black-Sholes option pricing model are as
follows:
1. The call option is the European options
2. The stock price is continuous and is distributed lognormally.
3. There are no translation costs and taxes.
4. There are no restrictions on or penalties for short selling.
5. The stock pays no dividend.
6. The risk-free interest rate is known and constant.
i. The three equations are
E
C0 = S0 N(d1) - ------ N (d2)
ert
σ2
+ r + --2

S0
ln ----E
d1 =
σ

d2 = d1 - σ √¯t¯¯

t

j.

S0 = 325

E =320 t =0.25 r = 0.06
(0.30)2

325
ln

+ 0.06 +
320

σ =0.30
x 0.25

2

d1 =
0.30 x √ 0.25
= ( 0.0155 + 0.02625 ) / 0.15 = 0. 2783
d2 = 0.2783 -0.30 √¯0.25¯¯ = 0.2783 – 0.15 = 0.1283
Using normal distribution table
N (d1) = 1 – [ 0.3821 + ( 0.4013- 0. 3821) ( 0.30 – 0.2783 ) /( 0.30 – 0.25) ]
=1- [ 0.3821 + 0. 0192 x 0.0217 / 0.05 ] = 0.6096
N ( d2 ) = 1- [ 0. 4404 + ( 0. 4602- 0.4404) ( 0. 15 – 0. 1283 ) / ( 0. 15- 0.10 ) ]
= 1- [ 0.4404 + 0.0198 x 0.0217 / 0.05 ] = 0. 5510
rt
E / e = 320 / e0.06 x 0. 25 = 320 / 1. 0151 = 315. 24
C0 = 325 x 0.6096 – 315.24 x 0. 5510 = 198.12 – 173. 70 = Rs. 24.42

k.

A collar is an option strategy that limits the value of a portfolio within two bounds.
For example the strategy adopted in ( e ) above is a collar.

Chapter 19
FUTURES
1.
March 2
March 3
March 4
March 5
2.

F0

Cash flow to the buyer
1128 – 1125 = 3
1127 – 1128 = -1
1126 – 1127 = -1
1128 – 1126 = 2

= S0 (1+rf)t
= Rs.40 (1.08)0.25 = Rs.40.78

3.

F0

= S0 (1+rf - d)t
= 1200 (1 + 0.10 - .03)1 = 1284

4. If the 6-months futures contract for gold is $432.8 and the interest rate is 8 percent;
the appropriate value for the one-year gold futures contract is :
$432.8 (1.08) 0.5 = $449.8
If the one-year gold futures has a price of $453 it means that it is over-priced relative
to the 6-months futures contract.
A profitable strategy would be to :
• Sell a one-year futures contract for $453
• Buy a 6-months futures contract for $432.8
• Take delivery of the 6-months futures contract after 6-months with the help of borrowed
money, hold the gold for 6 months, and give delivery of the one-year futures contract.
5. The appropriate value of the 3-months futures contract is
1,000 (1.01)3 = Rs.1030.3
Since the 3-months futures price of Rs.1035 exceeds Rs.1030.3, it pays to buy the
share in the spot market with borrowed money and sell the futures contract. Such an action
produces a riskless profit of Rs.4.7 as shown below :
Action
Initial cash flow
Cash flow at time T (3 months)
• Borrow Rs.1,000 now and
+ Rs.1,000
- Rs.1,000 (1.01)3
repay with interest at time T
= - Rs.1030.3
• Buy a share

- Rs.1,000

• Sell a futures contract
(F0 = Rs.1035)

ST

0

Rs.1035 - ST

0

Rs.4.7

Chapter 20
PORTFOLIO MANAGEMENT FRAMEWORK
1.
Rp – Rf
Treynor Measure:
βp
15 – 10
Fund P:

= 5.55%
0.9
17 – 10

Fund Q:

= 6.36%
1.1

19 – 10
Fund R:

= 7.50%
1.2
16 – 10

Market index:

= 6%
1.0
Rp – Rf
Sharpe Measure:
σp
15 – 10

Fund P:

= 0.25
20
17 – 10

Fund Q:

= 0.29
24
19 – 10

Fund R:

= 0.33
27
16 – 10

Market index:

= 0.25
20

Jensen Measure: Rp – [Rf + βp (RM – Rf )]
Fund P:

15 – [10 + 0.9 (6)] = -0.4%

Fund Q:

17 – [10 + 1.1 (6)] = 0.4%

Fund R:

19 – [10 + 1.2 (6)] = 1.8%

Market Index: 0 ( By definition)
2.
(a) The arithmetic average return is:
(5 + 12 + 16 + 3)/ 4 = 9%
(b) The time-weighted (geometric average) return is:

[(1.05) (1.12) (1.16) (1.03)]1/4 - 1 = .089
= 8.9%
(c) The rupee-weighted average (IRR) return is computed below:

1
5%
200

Rate of return earned
Beginning value of assets
Investment profit during the
period (Rate of return x Assets)
10
Net inflow at the end
10
Ending value of assets
220

0
-200

Net cash flow

2
12%
220

Period
3
16%
296.4

4
3%
373.82

26.4
50
296.4

47.42
30
373.82

11.21
385.03

Time
1
-10

2
-50

The IRR of this sequence is
10
50
30
200 +
+
+
=
(1 + r) (1 + r)2 (1 + r)3

3
-30

385.03
(1 + r)4

r = 8.81%

Appendix 20A
SOLUTION

• Buy and Hold Policy
• Constant Mix Policy

Market Level is 100
Portfolio
Stocks
Bonds
60,000
40,000
60,000
40,000

Total
100,000
100,000

4
385.03

• Constant Proportion
Portfolio Insurance Policy

60,000

40,000

100,000

Market Level Falls to 80
Portfolio
Portfolio
(before rebalancing)
(after rebalancing)
Stocks Bonds Total
Stocks Bonds Total
• Buy and Hold Policy 48,000 40,000 88,000 48,000 40,000 88,000
• Constant Mix Policy 48,000 40,000 88,000 52,800 35,000 88,000
• Constant Proportion
Portfolio Insurance
Policy
48,000 40,000 88,000 24,000 64,000 88,000

Market Level Falls to 100
Portfolio
Portfolio
(before rebalancing)
(after rebalancing)
Stocks Bonds Total
Stocks Bonds Total
• Buy and Hold Policy 60,000 40,000 100,000 60,000 40,000 100,000
• Constant Mix Policy 66,000 35,200 101,000 60,720 40,480 101,000
• Constant Proportion
Portfolio Insurance
Policy
28,800 64,000 92,800 38,400 54,400 92,800

APPENDIX 20 B
1. The portfolio return is decomposed into four components as follows
1. Risk- free return, . Rf = 10 %
2. The impact of systematic return, β ( Rm – Rf ): 1.2 ( 18 – 10 ) = 9.6
3. The impact of imperfect diversification,

( σp/σm – βp ) (Rm – Rf ) : ( 14/16- 1.2) ( 18- 10) = - 2.6
4. The net superior return due to selectivity,
Rp – { Rf + σp/σm – βp ) (Rm – Rf ) }: 16 – { 10 + 14/ 16 ( 8) } = - 1.00

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