SFM FAST TRACK KHETAN EDUCATION

VALUATION OF BONDS

I. COMPUTING THE FAIR VALUE OF A BOND.

The value or price of a bond is the present value of expected coupons and redemption
amount discounted at investors required rate of return.
V0 = C × PVA(r,n) + R.A. × PVIF(r,n)

1. Consider a two year ` 1000 face value 10% coupon rate bond which pays coupon semi-
annually. Find out the intrinsic value of the bond if the required rate of return is 14% p.a.
compounded semi-annually. Should the bond be purchased at the current price of ` 965?
Sol. Given : FV = ` 1000
Coupon rate = 10%
ROR = 14% p.a.
Actual price = ` 965
10%
Coupon = ` 1,000 × = ` 50
2
14%
ROR = = 7%
2
Maturity = 2 years × 2 = 4 Semesters
Vo = ` 50 × PVA (7%,4) + ` 1,000 × PVIF (7%, 4)
= 50 × 3.387 + 1,000 × 0.763
= ` 932.35
This means if we buy the bond at ` 932.35 and receive ` 50 for 4 semesters each and
redeem the bond at ` 1,000 at the end of 2nd year, we shall be earning 14% p.a. approx.
Since actual price is > intrinsic value, the bond is relatively overvalued and hence we
should not buy the bond.

II. TYPES OF YIELD MEASURE

The return to a bond investor can be measured in terms of the following.

a. CURRENT YIELD (C.Y.)
Coupon
C.Y. = × 100
Price

b. YIELD TO MATURITY (Y.T.M)

There are two methods for computing YTM:

⇒ Approximation Method/ Shortcut method:

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 KHETAN EDUCATION VALUATION OF BONDS
F-P
C+
YTM = n × 100
F+P
2
Where,
C = Coupon
F = Redemption amount
P = Price
N = No. of years i.e. maturity
In order to use above mentioned equation –
• The coupon rate must be fixed
• The principal repayment should be one shot
If either of the conditions are not met or both are not met, we cannot use Short Cut
Method. Rather we need to use ‘Trial and Error method’ or IRR method.
YTM is actually IRR of Bond. It considers coupon income, capital gain and interest on
reinvested coupon.
V0 = C × PVA(r,n) + R.A. × PVIF(r,n)
Here, solving for YTM means solving for ‘r’ in the above mentioned equation.
So, a YTM indicates that rate at which the present value of inflows from the bonds equates
the outflow (Price).

2. Today being 1st January 2019, Ram is considering to purchase an outstanding Corporate
Bond having a face value of ` 1,000 that was issued on 1st January 2017 which has 9.5%
Annual Coupon and 20 years of original maturity (i.e. maturing on 31st December 2027).
Since the bond was issued, the interest rates have been on downside and it is now selling
at a premium of ` 125.75 per bond.
Determine the prevailing interest on the similar type of Bonds if it is held till the maturity
which shall be at Par.
PV Factors:
1 2 3 4 5 6 7 8 9
6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592
8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500
Sol.
To determine the prevailing rate of interest for the similar type of Bonds we shall compute
the YTM of this Bond using IRR method as follows:
M = ` 1000
Interest = ` 95 (0.095 × ` 1000)
n = 9 years
V0 = ` 1125.75 (` 1,000 + ` 125.75)
YTM can be determined from the following equation

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` 95 × PVIFA (YTM, 9) + ` 1,000 × PVIF (YTM, 9) = ` 1,125.75
Let us discount the cash flows using two discount rates 8% and 10% as follows:
Year Cash Flows PVF@6% PV@6% PVF@8% PV@8%
0 -1125.75 1.000 -1125.75 1.000 -1125.75
1 95.00 0.943 89.59 0.926 87.97
2 95.00 0.890 84.55 0.857 81.42
3 95.00 0.840 79.80 0.794 75.43
4 95.00 0.792 75.24 0.735 69.83
5 95.00 0.747 70.97 0.681 64.70
6 95.00 0.705 66.98 0.630 59.85
7 95.00 0.665 63.18 0.583 55.39
8 95.00 0.627 59.57 0.540 51.30
9 1,095.00 0.592 648.24 0.500 547.50
112.37 -32.36
Now we use interpolation formula
112.37
6.00% + × 2.00%
112.37 - (-32.36)
6.00% + 112.37 × 2.00% = 6.00% + 1.553%
YTM = 7.553% say 7.55%
Thus, prevailing interest rate on similar type of Bonds shall be approx. 7.55%.

3. Consider the following data regarding the bonds issued by Neha Ltd. On March 15, 2003
to be redeemed on March 15, 2010. Face value of the bond ` 100 issued at a discount 10%
Redeemable at a premium of 10% Interest payable Semi-annually 8% p.a. Current market
price as on March 15, 2005 ` 95. Compute:
• YTM
• BEY
• EAY
C F-P
+
Ans. YTM = m n × m × 100 (m = frequency of coupon payment)
F+P
2
8 110 - 95
+
= 2 5 × 2 × 100
110 + 95
2
= 5.37%/semester
BEY = 5.37% × 2
= 10.74%
EAY = [(1 + 0.0537)2 - 1] × 100

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 KHETAN EDUCATION VALUATION OF BONDS
= 11.03% p.a.

4. Mr. X wants to invest ` 1,00,000 in the 7 years 8% bonds in the market (Face Value `
100) which were issued 2 years ago.
(i) You are requested to advise him what is the maximum price for bonds to be paid in
the following scenarios:
(a) If Mr. X is expecting minimum 9% return on the bonds
(b) If Mr. X is expecting minimum 7% return on the bonds
(c) If the present rate of similar bonds issued is 8.25%
(d) If the present rate of similar bonds issued is 7.75%
(ii) If the bonds are available at par and 1% is the transaction cost, what is the effective
yield?
(iii) Find the number of days required to breakeven transaction cost if the bonds are
available at par and 2% is the transaction cost. (8 Marks)
Sol.
(i) The maximum price to be paid for Bond
(a) To have a return of 9% return on Bond.
8
= ` 100 × = = ` 88.89
9
Alternative Answer
8 8 8 8 108
= 1
+ 2
+ 3
+ 4
+
(1.09) (1.09) (1.09) (1.09) (1.09)5
= ` 7.34 + ` 6.73 + ` 6.18 + ` 5.67 + ` 70.19
= ` 96.11

(b) To have a return of 7% return on Bond.

8
= ` 100 × = ` 114.29
7
Alternative Answer
8 8 8 8 108
= 1
+ 2
+ 3
+ 4
+
(1.07) (1.07) (1.07) (1.07) (1.07)5
= = ` 7.48 + ` 6.99 + ` 6.53 + ` 6.10 + ` 77.00
= ` 104.10

(c) If present rate of similar bond issued is 8.25%

8 8 8 8 108
= 1
+ 2
+ 3
+ 4
+
(1.0825) (1.0825) (1.0825) (1.0825) (1.0825)5
= ` 7.39 + ` 6.83 + ` 6.31 + ` 5.83 + ` 72.66
= ` 99.02
Alternative Answer

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8
= 100 ×
8.25
= ` 96.97

(d) If present rate of similar bond is issued is 7.75%

8 8 8 8 108
= 1
+ 2
+ 3
+ 4
+
(1.0775) (1.0775) (1.0775) (1.0775) (1.0775)5
= ` 7.42 + ` 6.89 + ` 6.39 + ` 5.94 + ` 74.36
= ` 101.00
Alternative Answer
8
= 100 ×
7.75
= ` 103.23

(ii) Effective yield if transaction cost is 1%

8
= × 100 = 7.92
101

(iii) No. of Days required for break even

2% × 1,00,000 2000
= = = 90 days
8% 22.22
1,00,000 ×
360
Alternatively, if 365 days used in calculation then answer will be as follows:
2% × 1,00,000 2000
= = = 91.24 days say 91 days.
8% 21.92
1,00,000 ×
365

III. COMPUTATION OF DURATION AND MODIFIED DURATION

• Duration of a bond measures the weighted average time which elapses before all
the cashflows are received. Since the concept was first introduced by Macaulay,
duration as defined above is also called Macaulay’s duration.
• Duration can also be defined as ‘holding period for which interest rate risk
disappears’.
• The sensitivity of Bond price to change in interest rate is called Bond Price
Volatility and it can be measured by “Modified Duration”.

5. An investor has recently purchased substantial number of 7 year 6.75% ` 1,000 bond with
5% premium payable on maturity at a required Yield to Maturity (YTM) of 9%. However,
due to a financial crunch he is looking to sell these bonds and has got a proposal from

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 KHETAN EDUCATION VALUATION OF BONDS
another investor, who is willing to purchase these bonds by shelling out a maximum
amount of ` 897 per bond. Investors follow intrinsic value method for valuation of bonds.
(i) You are required to determine
(1) The Market Price, Duration and Volatility of the bond and
Calculate the expected market price, if there is an increase in required yield by 75 basis
points.
(2) Required YTM of the new investor

(ii) What is relationship between the price of the bond and YTM?
Period (t) 1 2 3 4 5 6 7
PVIF (9%, t) 0.917 0.842 0.772 0.708 0.650 0.596 0.547

(8 Marks)
Sol.
(1) (A) Market Price of Bond
= 1,000 × 6.75% × (PVIAF 9%,7) + 1,050 × (PVIF 9%,7)
= 67.50 × 5.032 + 1050 × 0.547
= 339.66 + 574.35 = ` 914.01
(B) Duration of Bond

Year Cash flow P.V. @ 9% Proportion Proportion

of bond of bond
value value x time
(years)
1 67.50 0.917 61.898 0.0677 0.0677
2 67.50 0.842 56.835 0.0622 0.1244
3 67.50 0.772 52.110 0.0570 0.1710
4 67.50 0.708 47.790 0.0523 0.2092
5 67.50 0.650 43.875 0.0480 0.2400
6 67.50 0.596 40.230 0.0440 0.2640
7 1117.50 0.547 611.273 0.6688 4.6816
914.011 5.7579

Duration of the Bond is 5.758 years

Alternatively, as per Short Cut Method
1 + YTM (1 + YTM) + t(c - YTM)
D= -
YTM c[(1 + YTM) t -1] + YTM
Where YTM = Yield to Maturity
c = Coupon Rate
t = Years to Maturity

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SFM FAST TRACK KHETAN EDUCATION

1.09 1.09 + 7(0.0675 - 0.09)

= - = 5.72
0.09 0.0675 [(1.09)7 - 1] + 0.09

(C) Volatility of Bond -

Volatility = Duration/(1+YTM) = 5.758/(1 + 0.09) = 5.28
This means if interest rate change by 100 bps or 1%, price of the bond would change by
5.28% in the opposite direction.
• The expected market price if yield increases by 75bps
So, if interest increases by 75 bps or 0.75%, the price of the bond should change by
5.28 × 0.75 = 3.96 %
New price = ` 914.011- 3.96 % = ` 877.82
OR,
New YTM = 9.0 + 0.75 =9.75%
∴ New Price = 160 × PVA (9.75%,7) + 1000 × PVIF (9.75%,7)
= ` 938.40

(2) Required yield of new Investor

= 67.50 PVIAF (r, 7) + 1050 × PVIF (r, 7)
Now, let us discount the cash flow by 9%
PV @ 9% = 67.50 × 5.032 + 1050 × 0.547
= 339.66 + 574.35 = 914.01

NPV @ 9% = 914.01 - 897 = `17.01

Since, NPV of bond is positive, We need to increase discount rate say 12%
= 67.50 PVIAF (12%,7) + 1050 × PVIF (12%,7)
= 67.50 × [0.893 + 0.797 + 0.712 + 0.636 + 0.567 + 0.507 + 0.452] + 1050 × 0.452
= 67.50 × 4.564 + 474.60
= 308.07 + 474.60 = 782.67
NPV @ 12% = 782.67 – 897 = - `114.33

Now we use interpolation formula

NPV at LR
Ke = LR + × Dr
NPV at LR - NPV at HR
17.01
= 9% + × 3%
17.01 -(-114.33)
17.01
= 9% + × 3%
131.34
= 9% + 0.39%
= 9.39%

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 KHETAN EDUCATION VALUATION OF BONDS

(ii) Relationship between the price of the bond & YTM is opposite or inverse

IV. Interest Rate Anticipation and Portfolio Churning

Bond prices and interest rates have inverse relationship. If interest rates go up prices of
bonds go down and when rates go down, the prices go up. An added property says that,
when rates go down, prices of all bonds go up , but they go up more for longer maturity
bonds in comparison to short maturity bonds. Similarly when rates go up, all bonds go
down, but long maturity bonds loose value relatively more. This property is exploited by
fund managers for portfolio churning.

6. The Investment portfolio of a bank is as follows:

Government Bond Coupon Rate (%) Purchase rate Duration (years)
(FV= ` 100/ bond)
G.O.I. 2006 11.68 106.50 3.50
G.O.I. 2010 7.55 105.00 6.50
G.O.I. 2015 7.38 105.00 7.50
G.O.I. 2022 8.35 110.00 8.75
G.O.I. 2032 7.95 101.00 13.00

Face value of total investment is ` 5 crores in each bond.

a. Calculate actual investment in Portfolio.
b. What is a suitable action to churn out investment portfolio in the following scenario?
i. Case I : Interest rates are expected to lower by 25 basis points.
ii. Case II : Interest rates are expected to rise by 75 basis points. Also calculate the
revised duration of investment portfolio in each scenario.
Ans. a. Face value of each bond = ` 100
` 5 crore
∴ No. of bonds in each category = = 5 lakhs
` 100
Bonds Rate ` Investment(Wi) Di Wi*Di
` In lakhs ` In lakhs
GOI 2006 106.50 532.5 3.50 1,863.75
[5L × ` 106.50]
GOI2010 105.00 525.0 6.50 3,412.50
GOI2015 105.00 525.0 7.50 3,937.50
GOI2022 110.00 550.0 8.75 4,812.50
GOI2032 101.00 505.0 13.00 6,565.00
Total 2,637.5 20,591.25

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SFM FAST TRACK KHETAN EDUCATION

Actual investment in the portfolio = ` 2,637.5 L

20,591.25
b. Present Duration of the portfolio = = 7.81 years
2,637.5

i. If interest rates lower by 25bps, the prices of all bonds will go up but they will go
up more for longer maturity bonds. The fund manager can shift short term bonds to
long term in order to maximise gains.
We can shift 2006 bonds to 2032 bonds and there are many more options available.
However, we follow the procedure followed by PM. One such sample would be to
shift GOI 2010 to GOI 2032.
20591.25 - 3412.5 + 525 × 13
Revised Dp = = 9.10 years
2637.5
ii. If interest rates go up by 75 bps, the prices of the bonds will go down, but they will
go down more for longer maturity bonds.
The fund manager can shift long term bonds to short term in order to avoid losses.
One such sample would be to shift GOI 2032 to GOI 2010.
20591.25 - 6565 + 505 × 6.5
Revised Dp = = 6.56 years
2637.5

V. DISCOUNTED SECURITIES

There are two ways of computing yields or returns:

a. ADD ON METHOD:
When a security is issued with a basic denomination i.e. face value which is used for
computing coupon amount is called Add on Method.
E.g. A coupon paying bond or Debenture

b. DISCOUNTED METHOD:
When a security is issued much below its price and is redeemed at par, it is called as
Discounted Method. The difference between issue price and face value is the interest
component.
E.g. A T-bill or ZCB.
The discounted securities can be segregated into two categories on the basis of their
maturity.
i. LESS THAN OR MAXIMUM ONE YEAR:
There are a few securities which are issued at discount and redeemed at par, but the
maturity does not exceed 1 year.
The yield of such securities:

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 KHETAN EDUCATION VALUATION OF BONDS
F-P 12 365
Yield = × 100 × ×
P n n
Where, F = face value, P = price, n = maturity of the security
If the equation is used to compute yield of a T-bill, the computed yield would be a
good substitute for Rf.
A T-bill is a short term security issued by RBI. It is issued at discount and redeemed
at par. We have 91 days T-bill, 182 days T-bill, 364 days T-bill and so on.
A Commercial Paper or CP is a security issued by firms and organisations to meet
their working capital requirements.
They are again issued at discount and redeemed at par with a maximum maturity of
one year.

ii. MORE THAN ONE YEAR:

The securities which are issued at discount and redeemed at par but the maturity is
greater than one year.
They are called zero coupons bonds or Deep discount bonds.
FV
Price/Vo =
(1 + r)n
Where, r = IRR of ZCB. If ZCB is issued by Government, then r = Rf.
o The duration of a ZCB is always equal to maturity.

7. Wonderland Limited has excess cash of ` 20 lakhs, which it wants to invest in short term
marketable securities. Expenses relating to investment will be ` 50,000.
The securities invested will have an annual yield of 9%.
The company seeks your advice
i. as to the period of investment so as to earn a pre-tax income of 5%. (discuss)
ii. the minimum period for the company to breakeven its investment expenditure
overtime value of money.
Sol. i. Pre – tax Income required on investment of ` 20,00,000
Let the period of Investment by ‘P’ and return required on investment ` 1,00,000 (` 20,00,000
× 5%)
Accordingly,
9 P
(` 20,00,000 × × ) - ` 50,000 = ` 1,00,000
100 12
P = 10 months
ii. Break – Even its investment expenditure
9 P
(` 20,00,000 × × ) - ` 50,000 = 0
100 12
P = 3.33 months

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VI. TERM STRUCTURE OF INTEREST RATES

A yield curve is a line that plots the interest rates of the bonds having equal credit quality
but different maturity dates.
E.g. We can plot a yield curve with the help of zero coupon sovereign bonds with different
maturities. The yields are plotted on Y-axis and No. of years to maturity can be plotted
on X-axis.
There are 4 types of yield curves:
i. Upward rising/ Normal ii. Inverted / Downward Sloping
iii. Flat yield curve iv. Humped yield curve

VII. SPOT AND FORWARD RATES i.e. BOOTSTRAPPING

The spot rate is the current yield for a given term. Market spot rates for certain terms are
equal to yield to maturity of ZCB with those terms.
Generally, the spot rates increases as the term increases. Using these spot rates, we can
compute implicit forward rates.
The method is called ‘Boot Strapping’.
E.g. If we want to invest for two years, we can either invest directly for 2 years at r02(spot
rate for 2 year investment) or we can invest at r01 and reinvest for one more year.
The implicit rate between year 1 and 2 should be such that we are indifferent to two
options.
(1 + r02)2 = (1 + r01)1 (1 + f12)1
Similarly for a 3 year investment,
(1 + r03)3 = (1 + r02)2 (1 + f23)1
(1 + r03)3 = (1 + r01)1 (1 + f13)2

8. The Following is the yield structure of AAA rated debenture:

Period Yield (%)

3 months 8.5
6 months 9.25

1 year 10.50
2 years 11.25

3 years and above 12.00

Based on the expectation theory calculate the implicit one year forward rates in year 2
and 3. If the interest rate increases by 50 basis points, what will be the percentage change
in the price of the bond having a maturity of 5 years ? Assume bond is fairly priced at the
moment at ` 1000.

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Ans. One year forward rate in year 2 = f12
One year forward rate in year 3 = f23
⇒ (1 + r02)2 = (1 + r01)1 (1 + f12)1
(1.1125)2 = (1.105)1 (1 + f12)1
1.2376
(1 + f12)1 =
1.105
f12 = 12%
(1 + r03)3 = (1 + r02)2 (1 + f23)1
(1.12)3 = (1.1125)2 (1 + f23)1
F23 = 13.52%
b. Since the bond is fairly priced at ` 1,000 it means coupon rate = YTM = 12%
If interest ↑ by 50 bps
New YTM = 12% + 0.50 = 12.5%
V0 = 120 × PVA(12.5%, 5) + 1000 × PVIF(12.5%,5) = 982.2
∴ PV of future cashflows for 5 years discounted @ 12.5% = 982.2
982.2 - 1,000
∴ % ∆ in price = ×100 = -1.78%
1, 000

9. From the following data for Government securities, calculate the forward rates:
Face value (`) Interest rate Maturity (year) Current Price (`)
1,00,000 0% 1 91,500
1,00,000 10% 2 98,500
1,00,000 10.5% 3 99,000
Ans. a. Since the one year maturity is like ZCB.
FV
∴ Price =
(1 + r)n
1,00,000
91,500 =
(1 + r)n
1,00,000
91,500 =
(1 + r)1
∴ r = 9.29% i.e. r01

10,000 1,10,000
b. 98,500 = +
1
(1 + r01) (1 + r02)2
10,000 1,10,000
98,500 = +
1
(1.0929) (1 + r02)2
110,000
98,500 = 9149.968 +
(1 + r02)2

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(1 + r02)2 = 1.23111
⇒ (1 + r02)2 = (1+r01)1 (1+f12)1
1.2311 = (1.0929)1 (1 + f12)1
f12 = 12.65%
10,500 10,500 1,10,500
c. 99,000 = + +
1 2
(1 + r01) (1 + r02) (1 + r03)3
10,500 10,500 1,10,500
99,000 = + +
1 2
(1.0929) (1 + r02) (1 + r03)3
1,10,500
(1 + r03)3 = = 1.366
80,863.58
(1 + r03)3 = (1 + r02)2 (1 + f23)1
1.366 = (1.2311)1 (1 + f23)1
(1 + f23) = 1.1096
f23 = 10.96%

10. ABC Ltd. wants to issue 9% Bonds redeemable in 5 years at its face value of ` 1,000 each.
The annual spot yield curve for similar risk class of Bond is as follows:
Year Interest Rate
1 12%
2 11.62%
3 11.33%
4 11.06%
5 10.80%
(i) Evaluate the expected market price of the Bond if it has a Beta value of 1.10 due to
its popularity because of lesser risk.
(ii) Interpret the nature of the above yield curve and reasons for the same.
Note: Use PV Factors up to 4 decimal points and value in ` up to 2 decimal points. (8 Marks)
Sol.
(i) For finding expected market price first we shall calculate Intrinsic Value of Bond as
follows:
PV of Interest + PV of Maturity Value of Bond
Forward rate of interests
1st Year 12%
nd
2 Year 11.62%
3rd Year 11.33%
4th Year 11.06%
5th Year 10.80%

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 KHETAN EDUCATION VALUATION OF BONDS
Rs. 90 Rs. 90 Rs. 90
PV of interest = + +
2
(1 + 0.12) (1 + 0.1162) (1 + 0.1133)3
Rs. 90 Rs. 90
+ +
4
(1 + 0.1106) (1 + 0.1080)5
= ` 90 × 0.8929 + ` 90 × 0.8026 + ` 90 × 0.7247 + ` 90 × 0.6573 + ` 90 × 0.5988
= ` 80.36 + ` 72.23 + ` 65.22 + ` 59.16 + ` 53.89
= ` 330.86
Rs. 1000
PV of Maturity Value of Bond = = ` 1,000 × 0.5988 = ` 598.80
(1 + 0.1080)5
Intrinsic value of Bond = ` 330.86 + ` 598.80 = ` 929.66
Expected Price = Intrinsic Value × Beta Value
= ` 929.66 × 1.10 = ` 1,022.63

(ii) The given yield curve is inverted yield curve.

The main reason for this shape of curve is expectation for forthcoming recession when
investors are more interested in Short-term rates over the long term.

VIII. CALLABLE BONDS AND PUTTABLE BONDS

CALLABLE BONDS:
The bonds which can be redeemed before maturity but after the lock in period are called
Callable Bonds.
This option is available to an issuer and these bonds are issued in case of falling interest rates.
The schedule of redemption and call prices are mentioned beforehand in the Bond Deed.
PUTTABLE BONDS:
The bonds which can be redeemed before maturity but after the lock in period is called Puttable
Bonds.
This option is available to investor and can be exercised in the rising interest rate scenario.

IX. BOND REFUNDING

11. XL Ltd. has issued callable 10% bonds with 30 years maturity. The issue size is ` 1 crore
with a face value of ` 1,000 per bond. The bonds have been issued at a discount of 1.2%
on the face value of the bonds in the year 2011. The call option is available to XL Ltd. at
the end of 10 years and 20 years from the time of the issue of the bond. the floatation cost
was `1,50,000.
In the year 2021 XL Ltd, has an opportunity to issue 8% bonds at par with 20 years
maturity worth ` 1 crore with a face value of ` 1,000 per bond. The old bonds will be
retired with the proceeds of the proposed issue. The floatation cost of the present issue
will be ` 3,00,000

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There will be an overlapping interest for a period of three months during the course of the
present issue.
Post tax cost of debt for XL Ltd. is 7% p.a.
The applicable tax bracket is 30%
You are required to advise XL Ltd., whether it can proceed with the proposal.
Given: PVIFA (7%,20) = 10.594
Sol.
NPV for bond refunding
Particulars `
PV of annual cash flow savings (W.N. 2)
(1,41,800 x PVIFA 20%,) i.e. 10.594 15,02,229
Less: Initial investment (W.N. 1) 4,21,000
NPV 10,81,229
Recommendation: Refunding of bonds is recommended as NPV is positive.
Working Notes:
(i) Initial investment:
(a) Floatation cost 3,00,000
(b) Overlapping interest
Before tax (0.10 × 3/12 × 1 crore) 2,50,000
Less tax @ 30% 75,000 1,75,000
(c) Tax saving on unamortized discount on old bond
20/30 × 1,20,000 × 0.30 (24,000)
(d) Tax savings from unamortized floatation
Cost of old bond 20/30 × 1,50,000 × 0.30 (30,000)
4,21,000
(2) Annual cash flow savings:
(a) Old bond
(i) Interest cost (0.10 × 1 crore) 10,00,000
Less tax @ 30% 3,00,000 7,00,000
(ii) Tax savings from amortisation of discount
1,20,000/30 × 0.30 (1,200)
(iii) Tax savings from amortization of floatation cost
1,50,000/30 × 0.30 (1,500)
Annual after tax cost payment under old Bond (a) 6,97,300
(b) New bond
(i) Interest cost before tax (0.08 × 1 crore) 8,00,000
Less tax @ 30% 2,40,000
After tax interest 5,60,000
(ii) Tax savings from amortization of floatation cost

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 KHETAN EDUCATION VALUATION OF BONDS
(0.30 × 3,00,000/20) (4,500)
Annual after tax payment under new Bond (b) 5,55,500
Annual Cash Flow Saving (a) - (b) 1,41,800

X. CONVEXITY

12. The following data are available for a bond:

Face Value ` 10,000 to be redeemed at par on maturity
Coupon rate 8.5 per cent per annum
Years to Maturity 5 years
Yield to Maturity (YTM) 10 per cent
You are required to calculate:
(i) Current market price of the Bond,
(ii) Macaulay`s Duration,
(iii) Volatility of the Bond,
(iv) Convexity of the Bond,
(v) Expected market price, if there is a decrease in the YTM by 200 basis points
(a) By Macaulay`s Duration based estimate
(b) By Intrinsic Value Method.
Given
Years 1 2 3 4 5
PVIF (10%, n) 0.909 0.826 0.751 0.683 0.621
PVIF (8%, n) 0.926 0.857 0.794 0.735 0.681
(7 Marks)
Sol.
(i) Current Market Price of Bond
= ` 850 (PVIAF 10%, 5) + ` 10,000 (PVIF 10%, 5)
= ` 850 (3.79) + ` 10,000 (0.621) = ` 3,221.50 + ` 6,210 = ` 9,431.5

(ii) Macaulay's Duration

Year Cash flow P.V. @ 10% Proportion Proportion
of bond of bond
value value x time
(years)

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SFM FAST TRACK KHETAN EDUCATION
1 850 0.909 772.65 0.082 0.082
2 850 0.826 702.10 0.074 0.148
3 850 0.751 638.35 0.068 0.204
4 850 0.683 580.55 0.062 0.248
5 10,850 0.621 6,737.85 0.714 3.57
9431.50 1.000 4.252
Duration of the Bond is 4.252 years

Duration 4.252
(iii) Volatility of Bonds = = = 3.865
(1 + YTM) 1.10

(iv) Convexity of Bond

C* × (DY)2 × 100
C* = V+ + V- - 2V0
2V0 (DY)2
Year Cash flow P.V. @ 8% P.V @12%
1 850 0.926 787.10 0.892 758.20
2 850 0.857 728.45 0.797 677.45
3 850 0.794 674.90 0.712 605.20
4 850 0.735 624.75 0.636 540.60
5 10,850 0.681 7388.85 0.567 6,151.95
10204.05 8,733.40
10,204.05 + 8,733.40 - 2 × 9,431.50
C* =
2 × 9,431.50 × (0.02)2
74.45
=
7.5452
= 9.867
Convexity of Bond = 9.867 × (0.02)2 × 100 = 0.395%

(v) The expected market price if decrease in YTM by 200 basis points.
(A) By Macaulay's duration-based estimate
= ` 9431.50 × 2 (3.865/100) = ` 729.05
Hence expected market price is ` 9431.50 + ` 729.05 = ` 10,160.55
Hence, the market price will increase.

(B) By Intrinsic Value method

Intrinsic Value at YTM of 10% ` 9,431.50
Intrinsic Value at YTM of 8% ` 10,204.05

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 KHETAN EDUCATION VALUATION OF BONDS
Price increased by ` 772.55
Hence, expected market price is ` 10,204.05

XI. CONVERTIBLE SECURITIES

13. The Following data is related to 8.5% Fully convertible (into Equity shares) Debentures
issued by JAC Ltd at `1000.

Market Price of Debenture ` 900

Conversion Ratio 30
Straight Value of Debenture ` 700
Market Price of Equity share on the date of Conversion ` 25
Expected Dividend Per Share `1
You are required to calculate:
i. Conversion Value of Debenture ii. Market Conversion Price
iii. Conversion Premium per share iv. Ratio of Conversion Premium
v. Premium over Straight Value of Debenture
vi. Favourable income differential per share
vii. Premium payback period
Sol. Conversion Value of Debenture
= Market Price of one Equity Share × Conversion Ratio
= ` 25 × 30 = ` 750
i. Market Conversion Price
Market Price of Convertible Debenture
=
Conversion Ratio
` 900
= = ` 30
30

ii. Conversion Premium per share

= Market Conversion Price - Market Price of Equity Share
= ` 30 - ` 25
=`5

iv. Ratio of Conversion Premium

Conversion primium per share
=
Market Price of Equity Share
`5
= = ` 20%
` 25

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SFM FAST TRACK KHETAN EDUCATION
v. Premium over Straight Value of Debenture
Maket Pr ice of Convertible Bond
= -1
Straight Value of Bond
` 900
= - 1 = 28.6%
` 700

vi. Favourable income differential per share

Coupon Interest From Debenture - Conversion Ratio × Dividend Per Share
=
Conversion Ratio
` 85 - 30 × ` 1
=
30
= ` 1.833

vii. Premium pay back period

Conversion primium per share
=
Favourble Income Differntial Per share
`5
=
` 1.833
= ` 1.833
= ` 1.833

14. A hypothetical company ABC Ltd. issued a 10% Debenture (Face Value of ` 1000) of the
duration of 10 years, currently trading at ` 850 per debenture. The bond is convertible into
50 equity shares being currently quoted at ` 17 per share.
If yield on equivalent comparable bond is 11.80%, then calculate the spread of yield of
the above bond from this comparable bond.
The relevant present value table is as follows.
Present t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
Values
PVIF0.11,t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVIF0.13,t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295

Sol. Conversion Price = ` 50 × 17 = ` 850

Intrinsic Value = ` 850
Accordingly the yield (r) on the bond shall be :
` 850 = ` 100 PVAF (r, 10) + ` 1000 PVF (r, 10)
Let us discount the cash flows by 11%
850 = 100 PVAF (11%, 10) + 1000 PVF (11%, 10)
850 = 100 × 5.890 + 1000 × 0.352 = 91

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 KHETAN EDUCATION VALUATION OF BONDS
Now let us discount the cash flows by 13%
850 = 100 PVAF (13%, 10) + 1000 PVF (13%, 10)
850 = 100 × 5.426 + 1000 × 0.295 = -12.40
Accordingly, IRR
90.90
11% + (13% - 11%)
90.90 - (-12.40)
90.90
11% + × (13% - 11% = 12.76%
103.30
The spread from comparable bond = 12.76% - 11.80% = 0.96%

XII. BOND IMMUNISATION

15. The following data are available for three bonds A, B and C. These bonds are used by a
bond portfolio manager to fund an outflow scheduled in 6 years. Current yield is 9%. All
bonds have face value of `100 each and will be redeemed at par. Interest is payable
annually.
Bond Maturity (Years) Coupon rate
A 10 10%
B 8 11%
C 5 9%

i. Calculate the duration of each bond.

ii. The bond portfolio manager has been asked to keep 45% of the portfolio money in
Bond A. Calculate the percentage amount to be invested in bonds B and C that need
to be purchased to immunize the portfolio.
iii. After the portfolio has been formulated, an interest rate change occurs, increasing
the yield to 11%. The new duration of these bonds are: Bond A = 7.15 Years, Bond
B = 6.03 Years and Bond C = 4.27 years.
Is the portfolio still immunized? Why or why not?
iv. Determine the new percentage of B and C bonds that are needed to immunize the
portfolio. Bond A remaining at 45% of the portfolio.
Present values be used follows :
Present Values t1 t2 t3 t4 t5
PVIF0.09,t 0.917 0.842 0.772 0.708 0.650

Present Values t6 t7 t8 t9 t10

PVIF0.09,t 0.596 0.547 0.502 0.460 0.4224

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Sol.
i. Calculation of Bond Duration Bond A
Proportion Proportion
Year Cash flow P.V. @ 9% of bond of
value bond value
× time
(years)
1 10 0.917 9.17 0.086 0.086
2 10 0.842 8.42 0.079 0.158
3 10 0.772 7.72 0.073 0.219
4 10 0.708 7.08 0.067 0.268
5 10 0.650 6.50 0.061 0.305
6 10 0.596 5.96 0.056 0.336
7 10 0.547 5.47 0.051 0.357
8 10 0.502 5.02 0.047 0.376
9 10 0.460 4.60 0.043 0.387
10 110 0.4224 46.46 0.437 4.370
106.40 1.000 6.862

Duration of the bond is 6.862 years or 6.86 year Bond B

Year Cash flow P.V. @ 9% Proportion of Proportion of
bond value bond
value × time
(years)
1 11 0.917 10.087 0.091 0.091
2 11 0.842 9.262 0.083 0.166
3 11 0.772 8.492 0.076 0.228
4 11 0.708 7.788 0.070 0.280
5 11 0.650 7.150 0.064 0.320
6 11 0.596 6.556 0.059 0.354
7 11 0.547 6.017 0.054 0.378
8 111 0.502 55.772 0.502 4.016
111.224 1.000 5.833

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 KHETAN EDUCATION VALUATION OF BONDS

Duration of the bond B is 5.833 years or 5.84 years Bond C

Year Cash P.V. @ 9% Proportion of proportio
flow bond value n of bond
value ×
time
(years)
1 9 0.917 8.253 0.082 0.082
2 9 0.842 7.578 0.076 0.152
3 9 0.772 6.948 0.069 0.207
4 9 0.708 6.372 0.064 0.256
5 109 0.650 70.850 0.709 3.545
100.00 1.000 4.242
Duration of the bond C is 4.242 years or 4.24 years
ii. Amount of Investment required in Bond B and C
Period required to be immunized 6.000 Year
Less: Period covered from Bond A 3.087 Year
To be immunized from B and C 2.913 Year
Let proportion of investment in Bond B and C is b and c respectively then
b + c = 0.55 (1)
5.883b + 4.242c = 2.913 (2)
On solving these equations, the value of b and c comes 0.3534 or 0.3621 and 0.1966 or
0.1879 respectively and accordingly, the % of investment of B and C is 35.34% or 36.21%
and 19.66 % or 18.79% respectively.

iii. With revised yield the Revised Duration of Bond stands

0.45 × 7.15 + 0.36 × 6.03 + 0.19 × 4.27 = 6.20 year
No portfolio is not immunized as the duration of the portfolio has been increased from 6
years to 6.20 years.

iv. New percentage of B and C bonds that are needed to immunize the portfolio.
Period required to be immunized 6.0000 Year
Less: Period covered from Bond A 3.2175 Year
To be immunized from B and C 2.7825 Year

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