Chapter 3

Mutual Funds

1. 1 Recurring expense
r2 = r1 + in percentage terms
1 – Initial expense
in decimals

1
= x 13% + 1.8%
1 – 0.05

= 15.48%

2. 1 Recurring expense
r2 = r1 + in percentage terms
1 – Initial expense
in decimals

1 Recurring expense
16.5% = x 14% + in percentage terms
1 – 0.06

Recurring expense in
16.5% = 0.1489 + percentage terms

Recurring expense = 0.1650 – 0.1489 = 0.0161

in percentage terms = 1.61%
 Chapter 4
SECURITIES MARKET

1.

Share Price in Price in Price No. of Market Market

base year year t Relative outstanding capitalisation capitalisatio
(Rs.) (Rs.) shares in the base n in year t
(in million) year (1 x 4) (2 x 4)
1 2 3 4 5 6
M 12 16 133 10 120 160
N 18 15 83 5 90 75
O 35 60 171 6 210 360
P 20 30 150 40 800 1200
Q 15 6 40 30 450 180
577 1670 1975

The equal weighted index 577

For year t is : = 115.4
5 (since there are 5 scrips)

The value weighted index 1975

For year t is : x 100 = 118.3
1670

2.
Share Price in Price in Price No .of Market Market
base year year t Relative outstanding capitalisation capitalisatio
(Rs.) (Rs.) shares in the base n in year t
year (1 x 4) (2 x 4)
1 2 3 4 5 6
X 80 100 125 15 1200 1500
Y 40 30 75 20 800 600
Z 30 50 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
= 4025
Market capitalisation of z = 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 Square of
Ri (Ri –R) deviations
(Ri – R)2
1 20 8.8 77.44
2 -10 21.2 449.44
3 18 6.8 46.24
4 12 0.8 0.64
5 16 4.8 23.04
Sum = 596.8

Σ (Ri – R)2 596.8

Variance = = = 149.2
n–1 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:

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

2. 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. Let A be the annual savings.

A x FVIFA (12%, 10 years) = 1,000,000

A x 17.549 = 1,000,000

So A = 1,000,000 / 17.549 = Rs.56,983.

6. 1,000 x FVIFA (r, 6 years) = 10,000

FVIFA (r, 6 years) = 10,000 / 1000 = 10

From the tables we find that

FVIFA (20%, 6 years) = 9.930

FVIFA (24%, 6 years) = 10.980

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) = 5,000

FVIF (r,10 years) = 5,000 / 1000 = 5

From the tables we find that

FVIF (16%, 10 years) = 4.411

FVIF (18%, 10 years) = 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 = 10,000 x PVIF (r = 12%, 8 years)
= 10,000 x 0.404 = Rs.4,040
r = 15% PV = 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. The amount that can be withdrawn annually is:

100,000 100,000
A = ------------------ ------------ = ----------- = Rs.10,608
PVIFA (10%, 30 years) 9.427

12. 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) = 5.019

PVIFA (18%, 10 years) = 4.494

Using linear interpolation we get:

5.019 – 5.00
r = 15% + ---------------- x 3%
5.019 – 4.494

= 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 B C

Stated rate (%) 12 24 24

Frequency of compounding 6 times 4 times 12 times

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

= 12.6 = 26.2 = 26.8

Difference between the

effective rate and stated
rate (%) 0.6 2.2 2.8

20. 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
= = Rs.40,388
PVIF(12%, 8 years) 2.476

21. 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) = Rs.51,335

A x 8.115 = Rs.51,335
A = Rs.51,335 / 8.115 = 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 = Rs.14,998
P x 1.817 = Rs.14,998

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

27. 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) = 21.244
PVIFA (2%, 24) = 18.914

Using a linear interpolation

21.244 – 20.000
r = 1% + ---------------------- x 1%
21.244 – 18,914
 = 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) = 4.868
PVIFA (10%, 8 years) = 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

 Beginning Annual Principal Remaining
Year amount installment Interest repaid balance
------ ------------- --------------- ----------- ------------- -------------
1 500000 171585 70000 101585 398415
2 398415 171585 55778 115807282608
3 282608 171585 39565 132020 150588
4 150588 171585 21082 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
= = Rs.48,338
FVIFA (10%, 15 years) 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?

400,000 400,000(1.12) 400,000(1.12)14

46
1 2 15

15
1.12
1–
1.08
= 400,000
0.08 – 0.12

= Rs.7,254,962

Chapter 7
Financial Statement Analysis
1.
(a) Assets Rs.
- Fixed assets ( Net ) 150 million
- Cash and bank 20
- Marketable securities 10
- Receivables 70
- Inventories 110
- Prepaid expenses 10

Liabilities
- Equity capital 90
- Preference capital 20
- Reserves and surplus 50
- Debentures (secured) 60
- Term loans (secured) 70
- Short term bank borrowing (unsecured) 40
- Trade creditors 30
- Provisions 10

Balance Sheet of Mahaveer Limited as on March 31, 2001

Liabilities Assets

Share capital Fixed assets

- Equity 90 - Net fixed assets 150
- Preference 20
Reserve & surplus 50 Investments

Secured loans Current assets, loans & advances

- Debentures 60
- Term loans 70 - Marketable securities 10
- Pre-paid expenses 10
Unsecured loans - Inventories 110
- Short term bank borrowing 40 - Receivables 70
Current liabilities & provisions - Cash & Bank 20
- Trade creditors 30
- Provisions 10
------ -----
370 370
------ ------

2.
(a)
 Sources & Uses of Cash Statement for the Period 01.04.2000 to 31.03.2001
(Rs. in million)
----------------------------------------------------------------------------------------------------------
Sources Uses

Net profit 30 Dividend payment 20

Depreciation 20
Decrease in inventories 10 Purchase of fixed assets 30
Increase in short term
bank borrowings 10 Increase in debtors 10
Increase in other assets 5
Increase in trade creditors 10 Decrease in long term debt 15
Decrease in provisions 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. Cash flow from financing activities
- Interest paid (30)
- Repayment of term loans (15)
- Dividends paid (20)
Net cash flow from financing activities (65)

D. Net increase in cash and cash equivalents (5)

- Cash and cash equivalents as on 31.03.2000 20
- Cash and cash equivalents as on 31.03.2001 15

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

Net profit
3. Return on equity =
Equity

= Net profit Net sales Total assets

x x
Net sales Total assets Equity

1
= 0.05 x 1.5 x = 0.25 or 25 per cent
0.3

Debt Equity
Note : = 0.7 So = 1-0.7 = 0.3
Total assets Total assets

Hence Total assets/Equity = 1/0.3

4. PBT = 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. 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)
Interest charge = Rs.150,000

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
CL+BB

1500+BB
= 1.5
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 - = 1.2
Current liabilities 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 211,200

Inventory turnover ratio = = = 5
Inventory 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

Balance Sheet
Equity capital 50,000 Plant & equipment 54,560
Retained earnings 60,000 Inventories 42,240
Debt(Current liabilities) 66,000 Accounts receivable 29,333
Cash 49,867

176,000 176,000

Sales 264,000
Cost of goods sold 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
= = 1.42
30,000,000

Current assets – Inventories 22,500,000

(ii) Acid-test ratio = = = 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 72,000,000

(v) Inventory turnover period = = = 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 95,000,000

(vii) Total assets turnover ratio = = = 1.27
Total assets 75,000,000
 Profit after tax 5,100,000
(ix) Net profit margin = = = 5.4%
Net sales 95,000,000

PBIT 15,100,000
(x) Earning power = = = 20.1%
Total assets 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 Standard

Current ratio 1.42 1.5

Acid-test ratio 0.75 0.80
Debt-equity ratio 1.31 1.5
Times interest covered ratio 3.02 3.5
Inventory turnover ratio 3.6 4.0
Average collection period 57.6 days 60 days
Total assets turnover ratio 1.27 1.0
Net profit margin ratio 5.4% 6%
Earning power 20.1% 18%
Return on equity 15.7% 15%

MINICASE

cash and bank + receivables + inventories 12.4

a. Current ratio = ----------------------------------------------------- = -------- = 0.67
current liabilities+ short- term bank borrowing 18. 4

current assets – inventories 12.4 – 9.3

Acid-test ratio = --------------------------------- = ----------- = 0.17
current liabilities 18.4

cash and bank balance + current investments 1.1+0

Cash ratio = ------------------------------------------------------ = ------- = 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)

cost of goods sold 45.8

Inventory turnover ratio = ----------------------- = --------------- = 5.23
average inventory ( 8.2 + 9.3)/ 2

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 net profit net sales

Dupont equation : -------------------------- = ------------- x --------------
average total assets net sales average total assets
 Dupont chart
Net sales +/-
Non-op. surplus
deficit 57.8

Net profit
3.0 —

Net profit
margin
÷ Total costs
54.8
5.22%

Net sales
57.4
Return on
total assets
8.3%
X
Net sales
57.4

Total asset Average

turnover
÷ fixed assets
1.59 21.4
+
Average total
assets Average
36 other assets
2.55
+

Average
current
assets 12.05
c. Common size statements

Balance sheet

Regular ( Rs. in million) Common Size ( %)

20x4 20x5 20x4 20x5
------------------------------ --------------------------
Shareholder’ funds 13.9 15.8 63 62
Long term debt 5.2 3.8 23 15
Net current liabilities 3.2 6.0 14 23
---------------------------- ---------------------------
Total 22.3 25.6 100 100
------------------------------ ---------------------------
Fixed assets 19.6 23.2 88 91
Other assets 2.7 2.4 12 9
------------------------------ ---------------------------
Total 22.3 25.6 100 100
------------------------------ ---------------------------

Profit and loss account

Regular ( Rs. in million) Common Size ( %)

20x4 20x5 20x4 20x5
------------------------------ -------------------------
Net sales 39.0 57.4 100 100
Cost of goods sold 30.5 45.8 78 80
Gross profit 8.5 11.6 22 20
PBIT 4.1 5.0 11 9
Interest 1.5 2.0 4 4
PBT 2.6 3.0 7 5
Tax ----- ------ ------ ------
PAT 2.6 3.0 7 5

Common base financial statements

 Balance sheet

Regular ( Rs. in million) Common base year( %)

20x4 20x5 20x4 20x5
------------------------------ --------------------------
Shareholder’ funds 13.9 15.8 100 114
Long term debt 5.2 3.8 100 73
Net current liabilities 3.2 6.0 100 187
----------------------------
Total 22.3 25.6 100 115
------------------------------
Fixed assets 19.6 23.2 100 118
Other assets 2.7 2.4 100 89
------------------------------
Total 22.3 25.6 100 115
------------------------------

Profit and loss account

Regular ( Rs. in million) Common base year ( %)

20x4 20x5 20x4 20x5
------------------------------ -------------------------
Net sales 39.0 57.4 100 147
Cost of goods sold 30.5 45.8 100 150
Gross profit 8.5 11.6 100 136
PBIT 4.1 5.0 100 122
Interest 1.5 2.0 100 133
PBT 2.6 3.0 100 115
Tax ----- ------
PAT 2.6 3.0 100 115

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.
 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) = 0.2(-5%) + 0.3(15%) + 0.4(18%) + .10(22%)
= 12%
E (R2) = 0.2(10%) + 0.3(12%) + 0.4(14%) + .10(18%)
= 13%
σ(R1) = [.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%
σ(R2) = [.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 20 x 55 = 1,100 0.3

Low Growth 20 x 50 = 1,000 0.3
Stagnation 20 x 60 = 1,200 0.2
Recession 20 x 70 = 1,400 0.2

Expected return = (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 20 x 75 = 1,500 0.3

Low growth 20 x 65 = 1,300 0.3
Stagnation 20 x 50 = 1,000 0.2
Recession 20 x 40 = 800 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) Probability

(10 x 55) + (10 x 75) = 1,300 0.3
(10 x 50) + (10 x 65) = 1,150 0.3
(10 x 60) + (10 x 50) = 1,100 0.2
(10 x 70) + (10 x 40) = 1,100 0.2

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 = [(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

d. 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) Probability

(14 x 55) + (6 x 75) = 1,220 0.3

(14 x 50) + (6 x 65) = 1,090 0.3
(14 x 60) + (6 x 50) = 1,140 0.2
(14 x 70) + (6 x 40) = 1,220 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 :

Expected return Standard deviation Expected / Standard

Option (Rs) (Rs) return deviation
a 1,150 143 8.04
b 1,200 265 4.53
c 1,175 84 13.99
d 1,165 58 20.09

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

3. 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 = 7.83%

6

B: 0.08 + 0.04 + 0.15 +.12 + 0.10 + 0.06 = 0.0917 = 9.17%

6

C: 0.07 + 0.08 + 0.12 + 0.09 + 0.06 + 0.12 = 0.0900 = 9.00%

6

D: 0.09 + 0.09 + 0.11 + 0.04 + 0.08 + 0.16 = 0.095 = 9.50%

6

(a) Return on portfolio consisting of stock A = 7.83%

(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%
 (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
=3x x σ A+ 6 x
2
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)
σ p= 9 w Aσ A t 2 x
2 2 2
wA wB σAB
2
 2
1 1 1
= 9x x σ A + 9(8) x
2
x σAB
9 9 9

1 72
= σA+
2
σAB
9 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 = = = 0.614
σA + σ B 22 + 35
wB = 1 - wA = 0.386

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 RA RM RA-RA RM-RM (RA-RA) (RM-RM) RA-RA/RM-RM

1 15 12 -0.09 -3.18 0.01 10.11 0.29
2 -6 1 -21.09 -14.18 444.79 201.07 299.06
3 18 14 2.91 -1.18 8.47 1.39 -3.43
4 30 24 14.91 8.82 222.31 77.79 131.51
5 12 16 0-3.09 0.82 9.55 0.67 -2.53
6 25 30 9.91 14.82 98.21 219.63 146.87
7 2 -3 -13.09 -18.18 171.35 330.51 237.98
8 20 24 4.91 8.82 24.11 77.79 43.31
9 18 15 2.91 -0.18 8.47 0.03 -0.52
10 24 22 8.91 6.82 79.39 46.51 60.77
11 8. 12 -7.09 -3.18 50.27 10.11 22.55

RA = 15.09 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

= 935.86 = 0.96
975.61

Alpha = RA – βA RM

= 15.09 – (0.96 x 15.18)= 0.52

 Equation of the characteristic line is

RA = 0.52 + 0.96 RM

2. The beta for stock B is calculated below:

Period Return of Return on Deviation of Deviation Product of Square of

stock B, market return on of return the the
RB (%) portfolio, stock B on market deviation deviation
RM (%) from its portfolio (RB – RB) of return
mean from its (RM – RM) on market
(RB - RB) mean portfolio,
(RM – RM) from its
mean
(RM – RM)2
1 15 9 6 -1 -6 1
2 16 12 7 2 14 4
3 10 6 1 -4 -4 16
4 -15 4 -24 -6 144 36
5 -5 16 -14 6 -84 36
6 14 11 5 1 5 1
7 10 10 1 0 0 0
8 15 12 6 2 12 4
9 12 9 3 -1 -3 1
10 -4 8 -13 -2 26 4
11 -2 12 -11 2 -22 4
12 12 14 3 4 12 16
13 15 -6 6 -16 -96 256
14 12 2 3 -8 -24 64
15 10 8 1 -2 -2 4
16 9 7 0 -3 0 9
17 12 9 3 -1 -3 1
18 9 10 0 0 0 0
19 22 37 13 27 351 729
20 13 10 4 0 0 0
180 200 Σ(RB – RB) Σ(RB – RB)2
Σ RB = 180 ΣRM = 200 (RM – RM) = 1186
RB = 9% RM = 10% = 320

Beta of stock B is equal to:

Cov (RB, RM)

σ2M
Σ (RB - RB) (RM – RM) 320
Cov (RB, RM) = = = 16.84
n –1 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% Rf = 6%

ρA,M = 0.7 ρB,M = 0.8
σA = 24% σB = 32%

(a) Beta for stock A:

σA,M ρA,M σA σM 0.7 x 24 x 20
βA = = = = 0.84
σM
2
σ2M 20 x 20

Beta for stock B:

σB,M ρB,M σB σM 0.8 x 32 x 20
βB = = = = 1.28
σ2M σ2M 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) p

Economy -bility(p) A(%) ( RA) B (%) ( RB) x[RA-E(RA)]
x[RB-E(RB)]
-------------- --------- ----------- ------------- ---------- --------- -------------
Recession 0.2 15 30 -10 26 -52.0
Normal 0.5 20 5 -5 1 - 2.5
Boom 0.3 40 -15 15 -19 - 85.5
 ------------
total = - 140.0
-------------
Covariance between the returns of A and B is (-) 140

State of the Proba Return on Return on RA-E(RA) RC-E(RC) p

Economy -bility(p) A(%) ( RA) 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 Return on RB-E(RB) RC-E(RC) p

Economy -bility(p) B(%) ( RB) 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 6 4 - 0.4 - 2.2 4.84 0.88
3 12 8 5.6 1.8 3.24 10.08
4 20 15 13.6 8.8 77.44 119.68
5 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. 5 11 100
P = ∑ +
t=1 (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 equal
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)
 = 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.
10 14 100
80 = ∑ +
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:

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

5.
12 6 100
P = ∑ +
t=1 (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) 10 (1 – 0.3)

=Rs.8.4 =Rs.7

* Post-tax maturity value (M) 100 - 100 -

[ (100-70)x 0.1] [ (100 – 60)x 0.1]
=Rs.97 =Rs.96

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

8.4 + (97-70)/10
Bond A : Post-tax YTM = --------------------
0.6 x 70 + 0.4 x 97

= 13.73%

7 + (96 – 60)/6
Bond B : Post-tax YTM = ----------------------
0.6x 60 + 0.4 x 96

= 17. 47%

7.
14 6 100
P = ∑ +
t
t=1 (1.08) (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 112500
99000 = +
(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 13,000 113,000

99,500 = + +
(1.1236) (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 13,500 13,500

100,050 = + +
(1.1236) (1.1236)(1.1394) (1.1236)(1.1394)(1.1349)

113,500
+
(1.1236)(1.1394)(1.1349)(1+r4)

Solving this for r4 we get r4 = 14.54%

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

13,750 13,750 13,750

100,100 = + +
(1.1236) (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 40 40 40 40 20
600 = + + + + +
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)6

2 x 150 200 200

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

r works out to 15.5%

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. V = 100 PVIFA8%,9yrs + 1000 PVIF8%, 9yrs

= 100 x 6.247 + 1000 x 0.5 = 624.7 + 500 = Rs. 1124.7

c. 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
d. 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 %

100 + ( 1000 – 1050) / 6

h. Stated YTM = -------------------------------- = 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 coupon interest rate x maturity value
Effective annual yield= -----------------------------------------------------------------
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 Proportion of Proportion of bond’s

at 18% bond’s value 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

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

b. The duration of the bond is 8 years. Note that the term to maturity and the
6 duration of a zero coupon bond are the same.

c. The modified duration of the bond is:

 Duration 8
= = 7.273
(1+ yield) (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
- = 12.76 – 6.25 = 6.51 years
.085 3.400 – 1

5. The duration is:

1+y (1 + y) + T(c –y)
-
y c [(1 +y)T – 1] + 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:

P2 = Po x (1 + g)2 = Rs.35.33 (1.06)2

= Rs.39.70

2. Po = D1 / (r – g) = Do (1 + g) / (r – g)
= Rs.12.00 (1.10) / (0.15 – 0.10) = Rs.264

3. Po = D1 / (r – g)

Rs.32 = Rs.2 / 0.12 – g

g = 0.0575 or 5.75%

4. Po = D1/ (r – g) = Do(1+g) / (r – g)
Do = Rs.1.50, g = -0.04, Po = Rs.8
So
8 = 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: Present value of the dividend stream for the first 4 years

B: 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
B= 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

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) 2.00 (1.15)2 2.00 (1.15)3 2.00(1.15)4 2.00 (1.15)5

A= + + + +
(1.12) (1.12)2 (1.1.2) 3
(1.1.2) 4
(1.12)5

= 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) 4.02 (1.10)2 4.02(1.10)3 4.02(1.10)4 4.02 (1.10)5

B= + + + +
6 7 8 9
(1.12) (1.12) (1.12) (1..12) (1.12)10
4.42 4.86 5.35 5.89 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
2.36 x 1 - ----------- 2.36 x (1.18)5 x (1.12)
(1.16)6
= +
0.16 – 0.18 (0.16 – 0.12) x (1.16)6

- 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) 4.00 x 4 x (0.10)

= +
0.18 – 0.10 0.18 – 0.10

= 60 + 20
= Rs.80

9.
Price Po = D1 / (r – g) Dividend yield Capital yield Price
D1/ Po (Po - Po)/ Po earnings
ratio Po/ E1
Low growth Po = 2 / (0.16 - .04) = 16.67 12.0% 4.0% 4.17
firm
Normal Po = 2 / (0.16 - .08) = 25.00 8.0% 8.0% 6.25
growth firm
Supernormal Po = 2 / (0.16 - .12) = 50.00 4.0% 12.0% 12.5
growth firm
10.
E1/Po = 2.50/30.00
r = 0.16
PVGO
E1/Po = r 1 -
Po

2.50 PVGO
= 0.16 1-
30.00 Po

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 %

5 x 1.10 x 1.10
d. (i) Expected value of the stock a year hence = 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 9.77 12.21 268.62
= ------ + ------- + --------- + ----------
1.15 ( 1.15)2 ( 1.15 )3 ( 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 PV factor @15% PV of dividend

1 5.00 0. 870 4. 35
2 5.00 0. 756 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
 5 [ ( 1+ 0.10) + 2 ( 0.30- 0.10 ) ]
h. Present value of the stock = ---------------------------------------- = Rs. 150
0. 15-0.10
5x (1- 0.05) 5x0.95
i. 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
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

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 20X2 20X3 20X4 20X5
Return on 26 / 120 29 / 137 32 / 157 42 / 183 49 / 216
equity
= 21.7% = 21.2% = 20.4% = 23% = 22.7%

Book value 120/ 16 137/ 16 157/ 16 183/ 24 216/ 24

per share = Rs.7.5 = Rs.8.6 = Rs.9.8 = Rs.7.6 = Rs.9

EPS 26/ 16 29/ 16 32/ 16 42/ 24 49/ 24

= Rs.1.63 = Rs.1.81 = Rs.2 = Rs.1.75 = Rs.2.04

Bonus 1 1 1 1.5 1.5

adjustment
factor
Adjusted EPS Rs.1.63 Rs.1.81 Rs.2 Rs.2.63 Rs.3.06
PE ratio 17.50/ 1.81 21/ 2 24.5/ 1.75 21.6/ 2.04
(prospective) = 9.7 = 10.5 = 14 = 10.6
PB ratio 17.50/ 7.5 21/ 8.6 24.5/ 9.8 21.6/ 7.6 24.2/ 9
(retrospective)
= 2.3 = 2.4 = 2.5 = 2.8 = 2.7

Retention 16/ 26 17/ 29 20/ 32 26/ 42 33/ 49

ratio
= 0.62 = 0.59 = 0.63 = 0.62 = 0.67
1/4
(b) 520
CAGR of Sales = -1 = 0.201 = 20.1%
250

3.06 1/4
CAGR of EPS = -1 = 0.171 = 17.1%
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 Sales Profit before tax Profit after tax Assets
ROE = x x x x
Sales Assets PBIT Profit before tax Net worth

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

PBIT Sales Profit before tax Profit after tax Assets

x x x x
Sales Assets PBIT Profit before tax Net worth

20X4 0.167 x 1.758 x 0.70 x 0.75 x 1.492

20X5 0.181 x 1.646 x 0.702 x 0.742 x 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
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

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 20X2 20X3 20X4 20X5
Return on 60/ 500 60/ 540 110/ 620 150/ 730 240/ 920
equity
= 12% = 11.1% = 17.7% = 20.5% = 26.1%

Book value 500/ 30 540/ 30 620/ 30 730/ 30 920/ 30

per share = Rs.16.7 = Rs.18 = Rs.20.7 = Rs.24.3 = Rs.30.7

EPS 60/ 30 60/ 30 110/ 30 150/ 30 240/ 30

= Rs.2 = Rs.2 = Rs.3.7 = Rs.5 = Rs.8
PE ratio 20/ 2 22/ 3.7 45/ 5 56/ 8
(prospective) = 10 = 5.9 =9 =7

PB ratio 20/ 16.7 22/ 18 45/ 20.7 56/ 24.3 78/ 30.7
(retrospective)
= 1.2 = 1.2 = 2.2 = 2.3 = 2.5

Retention 40/ 60 40/ 60 80/ 110 110/ 150 190/ 240

ratio
= 0.67 = 0.67 = 0.73 = 0.73 = 0.79

(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 Profit before tax Profit after tax Assets

x x x x
Sales Assets PBIT Profit before tax Net worth

20X4 0.193 x 0.979 x 0.704 x 0.789 x 1.959

20X5 0.230 x 0.937 x 0.707 x 0.828 x 2.065

(e) EPS estimate for 20X6 is

 20X5 20X6 Remarks
Net sales 1780 2047 Increase by 15%
Cost of goods sold 1210 1403.60 Increase by 16%
Operating expenses 170 204 Increase by 20%
Non-operating surplus/deficit 10 10 Remains same
PBIT 410 449.4
Interest 120 132 Increase by 10%
Profit before tax 290 317.4
Tax 50 70.59 Effective tax rate
increases by 5%
Profit after tax 240 246.81
EPS 8.23

(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 17.7 + 20.5 + 26.1

the last three years = = 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
 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 = = = - 65.22
(u-d)R 0.6 x 1.15

C = ∆ S + B = 0.833 x 100 – 65.22 = 18.08

2. 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–1
∆ = = =
(u-d)S (u – 0.75)60 u – 0.75

u Cd – d Cu – 0.75 (60u – 60) 45 (1 – u)

B = = =
(u-d)R (u – 0.75) 1.16 1.16 (u – 0.75)

C = ∆S+B

(u – 1) 60 45 (1 – u)
 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+ σ2 t
E 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 0.50 = 0.0439

N (d1) = 0.6010
N (d2) = 0.5175
E 72
 = = 67.81
rt 0.12x 0.50
e e

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+ σ2 t
E 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 0.25 = -1.0405

N (d1) = 0.2003
N (d2) = 0.1491
E 50
= = 48.28
rt 0.14 x 0.25
e e

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 9
∆ = = = = 0.6429
0.7 x 100 70 14

u.Cd – d.Cu
B =
(u-d) R

= (1.5 x 0) – (0.8 x 45)

0.7 x 1.12

= -36 = -45.92
0.784

C = ∆S+B
= 0.6429 x 100 – 45.92
= Rs.18.37

Value of the call option = Rs.18.37

6. S = 40 u=? d = 0.8
R = 1.10 E = 45 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) = 0

∆ Cu – Cd R
= x
 B u Cd – d Cu S

∆ Cu – 0 1.10
= x
B -0.8Cu 40

= (-) 0.034375

∆ = - 0.34375 B (1)
C = ∆S+B
8 = ∆ x 40 + B (2)

Substituting (1) in (2) we get

8 = (-0.034365 x 40) B + B
8 = -0.375 B
or 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 = 0
u = 0.8

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 1
ln + r+ σ2 t
E 2
 d1 =
σ t

120 1
ln + 0.14 + x 0.42 1
110 2
d1 =
0.4 1

.0870 + 0.22
= = 0.7675
0.4

d2 = d1 - σ t = 0.7675 – 0.40 = 0.3675

N (d1) = 0.2003 N (d2) = 0.6434

E 110
= = 99.63
ert 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 1
ln + r+ σ2 t
E 2
d1 =
σ t

80 1
ln + 0.14 + x 0.4 1
82 2
d1 =
0.20 1

- 0.0247 + 0.1600
= = 0.6765
 0.20

d2 = d1 - σ t = 0.6765 – 0.20 = 0.4765

N (d1) = 0.751 N (d2) = 0.683

E 82
= = 71.29
rt
e 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
0.08 x 0.25
e

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 risk-
neutral 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
= = Rs.13.70
1 + Risk-free rate (1.08)

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.
Pay off
Profit

0 305 340 375 Stock price

g. 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

S0 σ2
ln ----- + r + ---
E 2

d1 =
σ t

d2 = d1 - σ √¯t¯¯
j. S0 = 325 E =320 t =0.25 r = 0.06 σ =0.30

325 (0.30)2
ln + 0.06 + x 0.25
320 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
E / e = 320 / e0.06 x 0. 25 = 320 / 1. 0151 = 315. 24
rt

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.
Cash flow to the buyer
March 2 1128 – 1125 = 3
March 3 1127 – 1128 = -1
March 4 1126 – 1127 = -1
March 5 1128 – 1126 = 2

2. F0 = 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 ST

• Sell a futures contract 0 Rs.1035 - ST

(F0 = Rs.1035)
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:

Period
1 2 3 4
Rate of return earned 5% 12% 16% 3%
Beginning value of assets 200 220 296.4 373.82
Investment profit during the
period (Rate of return x Assets) 10 26.4 47.42 11.21
Net inflow at the end 10 50 30 -
Ending value of assets 220 296.4 373.82 385.03

Time
0 1 2 3 4
Net cash flow -200 -10 -50 -30 385.03

The IRR of this sequence is

10 50 30 385.03
200 + + + =
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4

r = 8.81%

Appendix 20A
SOLUTION

Market Level is 100

Portfolio
Stocks Bonds Total
• Buy and Hold Policy 60,000 40,000 100,000
• Constant Mix Policy 60,000 40,000 100,000
• 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