MERGERS, ACQUISITIONS & RESTRUCTURING

Advanced
Financial
Management
ADDITIONAL PRACTICE
BOOK

Leaders
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Financial Advanced Across Financial
India
Book Code : AFM_Version-2 Education Across India
 MERGERS, ACQUISITIONS & RESTRUCTURING

INDEX
1 MERGERS, ACQUISITIONS & RESTRUCTURING 1

2 SECURITY VALUATION & CORPORATE VALUATION 20

3 PORTFOLIO MANAGEMENT 38

4 RISK MANAGEMENT 65

5 MUTUAL FUNDS 66

6 MANAGEMENT OF BONDS PORTFOLIO 77

7 DERIVATIVES 87
FOREIGN EXCHANGE EXPOSURE &
8 RISK MANAGEMENT 93

9 INTEREST RATES RISK MANAGEMENT 103

10 INTERNATIONAL FINANCIAL MANAGEMENT 105

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 Mergers, MERGERS, ACQUISITIONS & RESTRUCTURING
Acquisition & Restructuring
Ques on 1 Study Material, (8 Marks) CA Final Nov 2003
M. Co. Ltd., is studying the possible acquisi on of N Co. Ltd., by way of merger. The following data are available
in respect of the companies:
Par culars M. Co. Ltd. N. Co. Ltd.
Earnings a er tax (`) 80,00,000 24,00,000
Number of equity shares 16,00,000 4,00,000
Market value per share (`) 200 160
(i) Compute pre-merger EPS and PEM of both companies
(ii) If the merger goes through the exchange of equity and the exchange ra o is based on the current market
price, what is the new earnings per share for M Ltd.?
(iii) What is the gain or loss in (ii) above?
(iv) N Co Ltd., wants to be sure that the earnings available to its shareholders will not be diminished by the
merger. What should be the exchange ra o in that case?

Solu on:
(i)
Par culars M. Co. Ltd. N. Co. Ltd.
Pre-merger EPS (EAT/n) `5 6
Market value per share (`) 200 160
PE Ra o (MP/n) 40 26.67
(ii) Calcula on of new EPS of M Co. Ltd.
No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 shares × ` 1.6/` 2.0 = 3,20,000 shares
Total no. of shares in M Co. Ltd. a er acquisi on of N Co. Ltd.
= 16,00,000 + 3,20,000 = 19,20,000
Total earnings a er tax [a er acquisi on]
= 80,00,000 + 24,00,000 = 1,04,00,000
= ` 5.42

(iii) Par culars M. Co. Ltd. N. Co. Ltd.

Post Merger EPS/Adjusted EPS ₹ 5.42 4.336
(5.42 x 0.8)
Pre Merger EPS 5 6
Gain/(Loss) Per Share 0.42 (1.664)
Number of equity shares 16,00,000 4,00,000
Total Gain/(Loss) (`) 6,72,000 (6,65,600)

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 MERGERS, ACQUISITIONS & RESTRUCTURING

(iv) Calcula on of exchange ra o which would not diminish the EPS of N Co. Ltd. a er its merger with M
Co. Ltd.
Current EPS:

=`5

=`6

Exchange ra o = 6/5 = 1.20

No. of new shares to be issued by M Co. Ltd. to N Co. Ltd.

= 4,00,000 × 1.20 = 4,80,000 shares

Total number of shares of M Co. Ltd. a er acquisi on

= 16,00,000 + 4,80,000 = 20,80,000 shares

=`5

Total earnings in M Co. Ltd. available to new shareholders of N Co. Ltd.

= 4,80,000 × ` 5 = ` 24,00,000

Recommenda on: The exchange ra o (6 for 5) based on market shares is beneficial to shareholders of
'N' Co. Ltd.

Ques on 2 Study Material

A Ltd. is studying the possible acquisi on of B Ltd. by way of merger. The following data are available:
Firm A er-tax earnings No. of equity shares Market price per share
A Ltd. ₹ 10,00,000 2,00,000 ₹ 75
B Ltd. ₹ 3,00,000 50,000 ₹ 60

(i) If the merger goes through by exchange of equity shares and the exchange ra o is set according to the
current market prices, what is the new earnings per share for A Ltd.
(ii) B Ltd. wants to be sure that its earning per share is not diminished by the merger. What exchange ra o is
relevant to achieve the objec ve?

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Solu on:
(i) The current market price is the basis of exchange of equity shares, in the proposed merger, shareholders
of B Ltd. will get only 40,000 shares in all or 4 shares of A Ltd. for every 5 shares held by them, i.e.,
50,000 x 60
= 40,000
75
The total number of shares in A Ltd. will then be 2,40,000 and, ignoring any synergis c effect, the profit
will be ₹ 13,00,000.The new earning per share (EPS) of A Ltd. will be ₹ 5.42, i.e., ₹ 13,00,000/2,40,000.

(ii) The present earnings per share of B Ltd. is ₹ 6/- (₹ 3,00,000 ÷ 50,000) and that of A Ltd. is ₹ 5/-, i.e., ₹
10,00,000 ÷ 2,00,000.If B Ltd. wants to ensure that, even a er merger, the earning per share of its
shareholders should remain unaffected, then the exchange ra o will be 6 shares for every 5 shares.

The total number of shares of A Ltd. that will produce ₹ 3,00,000 profit is 60,000, (3,00,000 ÷ 5), to be
distributed among, shareholders of B Ltd., giving a ra o of 6 shares in A for 5 shares in B.

Proof:
The shareholders of B Ltd. will get in all 60,000 share for 50,000 shares. It means a er merger, their
₹ 13,00,000
earning per share will be ₹ 5 i.e.
2,60,000
In all they will get ₹ 3,00,000, i.e., 60,000 x 5, as before.

Ques on 3 Study Material

MK Ltd. is considering acquiring NN Ltd. The following informa on is available:
Company Earning a er Tax No. of Equity Market Value Per Share
(₹) Shares (₹)
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00

Exchange of equity shares for acquisi on is based on current market value as above. There is no synergy
advantage available.
(i) Find the earning per share for company MK Ltd. a er merger, and
(ii) Find the exchange ra o so that shareholders of NN Ltd. would not be at a loss.

Solu on:
(i) Earning per share of company MK Ltd a er merger:-
Exchange ra o 160 : 200 = 4 : 5.
that is 4 shares of MK Ltd. for every 5 shares of NN Ltd.
∴Total number of shares to be issued = 4/5 × 3,00,000 = 2,40,000 Shares.
∴Total number of shares of MK Ltd. and NN Ltd.=12,00,000 (MK Ltd.)+ 2,40,000 (NN Ltd.)
= 14,40,000 Shares

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Total profit a er tax = ₹ 60,00,000 MK Ltd.

= ₹ 18,00,000 NN Ltd.
= ₹ 78,00,000
∴ EPS (Earning Per Share) of MK Ltd. a er merger = ₹ 78,00,000/14,40,000 = ₹ 5.42 per share

(ii) To find the exchange ra o so that shareholders of NN Ltd. would not be at a Loss:
Present earning per share for company MK Ltd.
= ₹ 60,00,000/12,00,000 = ₹ 5.00

Present earning per share for company NN Ltd.

= ₹ 18,00,000/3,00,000 = ₹ 6.00
∴ Exchange ra o should be 6 shares of MK Ltd. for every 5 shares of NN Ltd.
∴ Shares to be issued to NN Ltd. = 3,00,000 × 6/5 = 3,60,000 shares
Now, total No. of shares of MK Ltd. and NN Ltd. =12,00,000 (MK Ltd.) + 3,60,000 (NN Ltd.)
= 15,60,000 shares
∴ EPS a er merger = ₹ 78,00,000/15,60,000 = ₹ 5.00 per share
Total earnings available to shareholders of NN Ltd. a er merger = 3,60,000 shares × ₹ 5.00 = ₹ 18,00,000.
This is equal to earnings prior merger for NN Ltd.
∴ Exchange ra o on the basis of earnings per share is recommended.

Ques on 4 Study Material

ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following informa on is available in respect of the
companies:
ABC Ltd. XYZ Ltd.
Number of equity shares 10,00,000 6,00,000
Earnings a er tax (₹) 50,00,000 18,00,000
Market value per share (₹) 42 28
Required:
(i) What is the present EPS of both the companies?
(ii) If the proposed merger takes place, what would be the new earning per share for ABC Ltd.? Assume that
the merger takes place by exchange of equity shares and the exchange ra o is based on the current
market price.
(iii) What should be exchange ra o, if XYZ Ltd. wants to ensure the earnings to members are same as before
the merger takes place?

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Solu on:
(i) Earnings per share = Earnings a er tax /No. of equity shares
ABC Ltd. = ₹ 50,00,000/10,00,000 = ₹ 5
XYZ Ltd. = ₹ 18,00,000 / 6,00,000 = ₹ 3

(ii) Number of Shares XYZ Limited's shareholders will get in ABC Ltd. based on market value per share = ₹ 28/
42 × 6,00,000 = 4,00,000 shares
Total number of equity shares of ABC Ltd. a er merger = 10,00,000 + 4,00,000 = 14,00,000 shares
Earnings per share a er merger = ₹ 50,00,000 + 18,00,000/14,00,000 = ₹ 4.86

(iii) Calcula on of exchange ra o to ensure shareholders of XYZ Ltd. to earn the same as was before merger:
Shares to be exchanged based on EPS = (₹ 3/₹ 5) × 6,00,000 = 3,60,000 shares
EPS a er merger = (₹ 50,00,000 + 18,00,000)/13,60,000 = ₹ 5
Total earnings in ABC Ltd. available to shareholders of XYZ Ltd. = 3,60,000 × ₹ 5 = ₹ 18,00,000.

Thus, to ensure that Earning to members are same as before, the ra o of exchange should be 0.6 share
for 1 share.

Ques on 5 RTP Nov 2021

Cauliflower Limited is contempla ng acquisi on of Cabbage Limited. Cauliflower Limited has 5 lakh shares
having market value of ₹ 40 per share while Cabbage Limited has 3 lakh shares having market value of ₹ 25 per
share. The EPS for Cabbage Limited and Cauliflower Limited are ₹ 3 per share and ₹ 5 per share respec vely.
The managements of both the companies are discussing two alterna ves for exchange of shares as follows:

(i) In propor on to rela ve earnings per share of the two companies.

(ii) 1 share of Cauliflower Limited for two shares of Cabbage Limited.

Required:
(i) Calculate the EPS a er merger under both the alterna ves.
(ii) Show the impact on EPS for the shareholders of the two companies under both the alterna ves.

Solu on:
(i) Exchange ra o in propor on to rela ve EPS
(in ₹)
Company Exis ng No. of shares EPS Total earnings
Cauliflower Ltd. 5,00,000 5.00 25,00,000
Cabbage Ltd. 3,00,000 3.00 9,00,000
Total earnings 34,00,000

No. of shares a er merger 5,00,000 + 1,80,000 = 6,80,000

3.00
Note: 1,80,000 may be calculated as = 3,00,000 x
5.00
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 MERGERS, ACQUISITIONS & RESTRUCTURING

34,00,000
EPS for Cauliflower Ltd. a er merger = = 5.00
6,80,000
Impact on EPS
₹
Cauliflower Ltd. ‘s shareholders
EPS before merger 5.00
EPS a er merger 5.00
Increase/ Decrease in EPS 0.00
Cabbage Ltd. 's shareholders
EPS before merger 3.00
EPS a er the merger 5.00 x 3/5 3.00
Increase/ Decrease in EPS 0.00

(ii) Merger effect on EPS with share exchange ra o of 1 : 2

Total earnings a er merger ₹ 34,00,000
No. of shares post merger 5,00,000 + 1,50,000 (0.5 × 3,00,000) 6,50,000
EPS (34,00,000 ÷ 6,50,000) ₹ 5.23

Impact on EPS
₹
Cauliflower Ltd. shareholders
EPS before merger 5.00
EPS a er merger 5.23
Increase in EPS 0.23
Cabbage Ltd. Shareholders
EPS before merger 3.000
EPS a er the merger 5.23 x 0.5 2.615
Decrease in EPS 0.385

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Ques on 6 RTP May 2021, MTP May 2011

ABC Ltd. is intending to acquire XYZ Ltd. by way of merger and the following informa on is available in respect
of these companies:
ABC Ltd. XYZ Ltd.
Total Earnings (E) (in lakh) ₹ 1200 ₹ 400
Number of outstanding shares (S) (in lakh) 400 200
Price earnings ra o (P/E) 8 7
(a) Determine the maximum exchange ra o acceptable to the shareholders of ABC Ltd., if the P/E ra o of
the combined firm is expected to be 8?
(b) Determine the minimum exchange ra o acceptable to the shareholders XYZ Ltd., if the P/E ra o of the
combined firm is expected to be 10?
Note: Make calcula on in lakh mul ples and compute ra o upto 4 decimal points.

Solu on

(a) Maximum exchange ra o acceptable to the shareholders of ABC Ltd.

Market Price of share of ABC Ltd. (₹ 3 x 8) ₹ 24
No. of Equity Shares 400 lakh
Market Capitalisa on of ABC Ltd. (₹ 24 x 400 lakh) ₹ 9600 lakh
Combined Earnings (₹ 1200 + ₹ 400) lakh ₹ 1600 lakh
Combined Market Capitalisa on (₹ 1600 lakh x 8) ₹ 12800 lakh
Market Capitalisa on of ABC Ltd. (₹ 24x 400 lakh) ₹ 9600 lakh
Balance for XYZ Ltd. ₹ 3200 lakh

Let D be the no. of equity shares to be issued to XYZ Ltd. then,

₹ 3200 lakh
=D
1600 Lakh
) D + 400
) x8

D = 133.333 lakh Shares

Exchange Ra o = 133.333 / 200 = 0.6666:1

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 MERGERS, ACQUISITIONS & RESTRUCTURING

(b) Minimum exchange ra o acceptable to the shareholders of XYZ Ltd.

Market Price of share of XYZ Ltd. ₹ 14.00
No. of Equity Shares 200 lakh
Market Capitalisa on of XYZ Ltd. (₹ 14.00 x 200 lakh) ₹ 2800 lakh
Combined Earnings (₹ 1200 + ₹ 400) lakh ₹ 1600 lakh
Combined Market Capitalisa on (₹ 1600 lakh x 10) ₹ 16000 lakh
Balance for ABC Ltd. ₹ 13200 lakh
Let D be the no. of equity shares to be issued to XYZ Ltd. then,
₹ 2800 lakh
=D
1600 Lakh
) D + 400
) x 10

D = 84.8485 lakh Shares

Exchange Ra o = 84.8485 / 200 = 0.4242:1

Ques on 7 CA Final RTP Nov 2011

There are two companies ABC Ltd. and XYZ Ltd. in same industry. In order to increase its size ABC Ltd. made a
takeover bid for XYZ Ltd.

Equity beta of ABC and XYZ is 1.2 and 1.05 respec vely. Risk Free Rate of Return is 10% and Market Rate of
Return is 16%. The growth rate of earnings a er tax of ABC Ltd. in recent years has been 15% and XYZ's is 12%.
Further both companies had con nuously followed constant dividend policy.
Mr. V, the CEO of ABC requires informa on about how much premium above the current market price to offer
for XYZ's shares.
Two sugges ons have been forwarded by merchant bankers.
(i) Price based on XYZ's net worth as per B/S, adjusted in light of current value of assets and es mated a er
tax profit for the next 5 years.
(ii) Price based on Dividend Valua on Model, using exis ng growth rate es mates.

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Summarised Balance Sheet of both companies is as follows. (` In lacs)

ABC Ltd. XYZ Ltd. ABC Ltd. XYZ Ltd.
Equity Share 2,000 1,000 Land & Building 5,600 1,500
Capital
General 4,000 3,000 Plant & 7,200 2,800
Reserves Machinery
Share Premium 4,200 2,200
Long Term Loans 5,200 1,000
Current Current Assets
Liabili es
Sundry Creditors 2,000 1,100 Accounts 3,400 2,400
Receivable
Bank Overdra 300 100 Stock 3,000 2,100
Tax Payable 1,200 400 Bank/Cash 200 400
Dividend 500 400 - -
Payable
19,400 9,200 19,400 9,200
Profit & Loss A/c (` In lacs)
ABC Ltd. XYZ Ltd. ABC Ltd. XYZ Ltd.
To Net Interest 1,200 220 By Net Profit 7,000 2,550
To Taxa on 2,030 820
To Distributable 3,770 1,510 - -
Profit
7,000 2,550 7,000 2,550
To dividend 1,130 760 By Distributable 3,770 1,510
Profit
To Balance c/d 2,640 750 - -
3,770 1,510 3,770 1,510
(1) ABC Ltd. land & building have been recently revalued. XYZ Ltd's have not been revalued for 4 years, and
during this period the average value of land & building have increased by 25% p.a.
(2) The face value of share of ABC Ltd. is ` 10 and of XYZ Ltd. is ` 25 per share.
(3) The current market price of shares of ABC Ltd. is ` 310 and of XYZ Ltd. ` 470 per share.

With the help of above data and given informa on you are required to calculate the Premium per share above
XYZ's current share price by two suggested valua on methods. Discuss which of these two values should be
used for bidding the XYZ's shares.
State the assump ons clearly, you make.
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 MERGERS, ACQUISITIONS & RESTRUCTURING

Solu on:
(a) Net Assets Method
To compute the value of shares as per this method we shall compute the Net Assets.

(i) Value of Land & Building of XYZ Ltd. = ₹ 1,500 lac (1.25)⁴ = ₹ 3,662.11 lac.
Thus, net asset value will be:
₹
Land & Building 3,662.11 lac
Plant & Machinery 2,800.00 lac
Account Receivable 2,400.00 lac
Stock 2,100.00 lac
Bank/Cash 400.00 lac
11,362.11 lac
Less: Bank Overdra 100.00 lac
Sundry Creditors 1,100.00 lac
Tax Payable 400.00 lac
Dividend Payable 400.00 lac
Long Term Loan 1,000.00 lac
8362.11 lac
(ii) Es mated profit for next 5 years
= ₹ 1,510 lac (1.12) + ₹ 1,510 lac (1.12)² + ₹ 1,510 lac (1.12)³ + ₹ 1,510 lac (1.12)⁴ + ₹ 1,510 lac (1.12)⁵

= ₹ 1,691.20 lac + ₹ 1,894.14 lac + ₹ 2,121.44 lac + ₹ 2,376.01 lac + ₹ 2,661.14 lac = ₹ 10,743.93 lac.

The total yield value= ₹ 8,362.11 lac + ₹ 10,743.93 lac = ₹ 19,106.04 lac

XYZ Ltd.s share’s current market value = ₹ 470 x 40 lacs shares = ₹ 1,88,00,00,000 = ₹ 18,800 lac

The premium is thus ₹ 306.04 lac (₹ 19,106.04 lac – ₹ 18,800 lac) i.e. ₹ 7.65 per share or 1.63%
[7.65/470].

This is not a sound basis for valua on as it ignores the me value of money.

The premium of 1.63% above the current market price is very small compared to those achieved in
many real bids.

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 MERGERS, ACQUISITIONS & RESTRUCTURING

(b) Dividend Valua on Model

D₁ D₀ (1 + g)
P₀ = =
Ke - g Ke - g
₹ 760 lac
D₀ = = ₹ 19 per share.
40 lac

Thus D₁ = ₹ 19 (1 + 0.12) = ₹ 21.28

Ke using CAPM
Ke = Rf +βj (Rm - Rf) =10% + 1.05(16% - 10%) = 16.3%
₹ 21.28 ₹ 21.28
P₀ = = = ₹ 494.88 per share
16.3% - 12% 4.3%
The premium is ₹ 24.88 (₹ 494.88 – ₹ 470) i.e. 5.29% above the current market price.
Thus, this method should be used for bidding shares of XYZ Ltd.’s share

Assump ons
Ÿ Valua on is based on a constant growth rate and unchanged dividend policy.
Ÿ It will be more ra onal to assess the value of XYZ Ltd. incorpora ng post merger synergies.

Ques on 8 Study Material

Company X is contempla ng the purchase of Company Y. Company X has 3,00,000 shares having a market
price of ` 30 per share, while Company Y has 2,00,000 shares selling at ` 20 per share. The EPS are ` 4.00 and `
2.25 for Company X and Y respec vely. Managements of both companies are discussing two alterna ve
proposals for exchange of shares as indicated below:
(i) In propor on to the rela ve earnings per share of two companies.
(ii) 0.5 share of Company X for one share of Company Y (0.5 : 1).

You are required:

(i) To calculate the Earnings Per Share (EPS) a er merger under two alterna ves; and
(ii) To show the impact on EPS for the shareholders of two companies under both the alterna ves.

Solu on:
Working Notes: Calcula on of total earnings a er merger
Par culars Company X Company Y Total
Outstanding shares 3,00,000 2,00,000
EPS (`) 4 2.25
Total earnings (`) 12,00,000 4,50,000 16,50,000

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 MERGERS, ACQUISITIONS & RESTRUCTURING

(i)
(a) Calcula on of EPS when exchange ra o is in propor on to rela ve EPS of two companies
Company X 3,00,000
Company Y 2,00,000x2.25/4 1,12,500
Total number of shares a er merger 4,12,500

Company X
EPS before merger `4

EPS a er merger = ` 16,50,000/4,12,500 shares `4

Company Y
EPS before merger ` 2.25

EPS a er merger

= EPS of Merged En ty a er merger x Share Exchange

ra o on EPS Basis
` 2.25

(b) Calcula on of EPS when share exchange ra o is 0.5 : 1

Total earnings a er merger = ` 16,50,000
Total number of shares a er merger = 3,00,000 + (2,00,000 x 0.5)
= 4,00,000 shares
EPS a er merger = ` 16,50,000/4,00,000 = ` 4.125

(ii) Impact of merger on EPS for shareholders of Company X and Company Y

(a) Impact on Shareholders of Company X (b) Impact on Shareholders of Company Y
( `) ( `)
EPS before merger 4.000 Equivalent EPS before merger 2.2500
EPS a er merger 4.125 Equivalent EPS a er merger 2.0625
Increase in EPS 0.125 Increase/ (Decrease) in EPS (0.1875)

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Ques on 9 Study Material

R Ltd. and S Ltd. are companies that operate in the same industry. The financial statements of both the
companies for the current financial year are as follows:
Balance Sheet
Par culars R. Ltd. (₹) S. Ltd. (₹)
Equity & Liabili es
Shareholders Fund
Equity Capital (₹ 10 each) 20,00,000 16,00,000
Retained earnings 4,00,000 -
Non-current Liabili es
16% Long term Debt 10,00,000 6,00,000
Current Liabili es 14,00,000 8,00,000
Total 48,00,000 30,00,000
Assets
Non-current Assets 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
Total 48,00,000 30,00,000

Income Statement
Par culars R. Ltd. (₹) S. Ltd. (₹)
A. Net Sales 69,00,000 34,00,000
B. Cost of Goods sold 55,20,000 27,20,000
C. Gross Profit (A - B) 13,80,000 6,80,000
D. Opera ng Expenses 4,00,000 2,00,000
E. Interest 1,60,000 96,000
F. Earnings before taxes [C - (D + E)] 8,20,000 3,84,000
G. Taxes @ 35% 2,87,000 1,34,400
H. Earnings A er Tax (EAT) 5,33,000 2,49,600
Addi onal Informa on:
No. of equity shares 2,00,000 1,60,000
Dividend payment Ra o (D/P) 20% 30%
Market price per share ₹ 50 ₹ 20
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 MERGERS, ACQUISITIONS & RESTRUCTURING

Assume that both companies are in the process of nego a ng a merger through exchange of Equity shares:

You are required to:

(i) Decompose the share price of both the companies into EPS & P/E components. Also segregate their EPS
figures into Return On Equity (ROE) and Book Value/Intrinsic Value per share components.
(ii) Es mate future EPS growth rates for both the companies.
(iii) Based on expected opera ng synergies, R Ltd. es mated that the intrinsic value of S Ltd. Equity share
would be ₹ 25 per share on its acquisi on. You are required to develop a range of jus fiable Equity Share
Exchange ra os that can be offered by R Ltd. to the shareholders of S Ltd. Based on your analysis on parts
(i) and (ii), would you expect the nego ated terms to be closer to the upper or the lower exchange ra o
limits and why?

Solu on:
(i) Determina on of EPS, P/E Ra o, ROE and BVPS of R Ltd. & S Ltd.
R. Ltd. (₹) S. Ltd. (₹)
EAT (₹) 5,33,000 2,49,600
N 200000 160000
EPS (EAT ÷ N) 2.665 1.56
Market Price Per Share 50 20
PE Ra o (MPS/EPS) 18.76 12.82
Equity Fund (Equity Value) 2400000 1600000
BVPS (Equity Value ÷ N) 12 10
ROE (EAT÷ EF) or 0.2221 0.156
ROE (EAT ÷ EF) x 100 22.21% 15.60%

(ii) Determina on of Growth Rate of EPS of R Ltd.& S Ltd.

R. Ltd. (₹) S. Ltd. (₹)
Reten on Ra o (1 - D/P Ra o) 0.80 0.70
Growth Rate (ROE x Reten on Ra o) or 0.1777 0.1092
Growth Rate (ROE x Reten on Ra o) x 100 17.77% 10.92%
(iii) Jus fiable equity share exchange ra o
(a) Market Price Based = MPSS/MPSR = ₹ 20/ ₹ 50 = 0.40:1 (lower limit)
(b) Intrinsic Value Based = ₹ 25/ ₹ 50 = 0.50:1 (max. limit)

Since R Ltd. has higher EPS, PE, ROE and higher growth expecta ons the nego ated term would be
expected to be closer to the lower limit, based on exis ng share price.
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 14
 MERGERS, ACQUISITIONS & RESTRUCTURING

Ques on 10 Study Material

XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for each share of ABC Ltd.

Relevant financial data are as follows:

Equity shares outstanding 10,00,000 4,00,000
EPS (`) 40 28
Market price per share (`) 250 160

(i) Illustrate the impact of merger on EPS of both the companies.

(ii) The management of ABC Ltd. has quoted a share exchange ra o of 1:1 for the merger. Assuming that P/E
ra o of XYZ Ltd. will remain unchanged a er the merger, what will be the gain from merger for ABC Ltd.?
(iii) What will be the gain/loss to shareholders of XYZ Ltd.?
(iv) Determine the maximum exchange ra o acceptable to shareholders of XYZ Ltd.

Solu on:
Working Notes
(a)
XYZ Ltd ABC Ltd.
Equity shares outstanding (Nos.) 10,00,000 4,00,000
EPS ` 40 ` 28
Profit ` 400,00,000 ` 112,00,000
PE Ra o 6.25 5.71
Market price per share ` 250 ` 160

(b) EPS a er merger

No. of shares to be issued (4,00,000 x 0.70) 2,80,000
Exis ng Equity shares outstanding 10,00,000
Equity shares outstanding a er merger 12,80,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 40

(i) Impact of merger on EPS of both the companies

XYZ Ltd. ABC Ltd.
EPS a er Merger ` 40 ` 28*
EPS before Merger ` 40 ` 28
Nil Nil
*` 40 x 0.70
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 15
 MERGERS, ACQUISITIONS & RESTRUCTURING

(ii) Gain from the Merger if exchange ra o is 1: 1

No. of shares to be issued 4,00,000
Exi ng Equity shares outstanding 10,00,000
Equity shares outstanding a er merger 14,00,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 36.57
Market Price of Share (` 36.57 x 6.25) ` 228.56
Market Price of Share before Merger ` 160.00
Impact (Increase/ Gain) ` 68.56

(iii) Gain/ loss from the Merger to the shareholders of XYZ Ltd.
Market Price of Share ` 228.56
Market Price of Share before Merger
Loss from the merger (per share) ` 21.44

(iv) Maximum Exchange Ra o acceptable ro XYZ Ltd. Shareholders

` Lakhs
Market Value of Merged En ty (` 228.57 x 1400000) 3199.98
Less: Value acceptable to shareholders of XYZ Ltd. 2500.00
Value of merged en ty available to shareholders of ABC Ltd. 699.98
Market Price Per Share 250*
No. of shares to be issued to the shareholders of ABC Ltd. (lakhs) 2.80
Thus maximum ra o of issue shall be 2.80 : 4.00 or 0.70 share of XYZ Ltd. for one share of ABC Ltd.

*Tutorial Note: Do not make the mistake of using 228.57 because 228.57 in itself will
change as we issue different no. of shares to the target under present situa on.
Students may alterna vely solve this part in below manner:-

Alterna vely, it can also be computed as follows:

Earning a er Merger (40 x 1000000 + 28 x 400000) ₹ 512 lakhs
PE Ra o of XYZ Ltd. 6.25
Market Value of Firm a er Merger (512 x 6.25) ₹ 3200 lakhs
Exis ng Value of Shareholders of XYZ Ltd. ₹ 2500 lakhs
Value of Merged en ty available to Shareholders of ABC Ltd. ₹ 700 lakhs
Market Price per Share ₹ 250
Total No. of shares to be issued 2.8 lakhs
Thus, maximum acceptable ra o shall be 2.80:4.00 i.e. 0.70 share of XYZ Ltd. for one share of ABC Ltd.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 16
 MERGERS, ACQUISITIONS & RESTRUCTURING

Ques on 11 (11 Marks) CA Final May 2011

Bank 'R' was established in 2005 and doing banking in India. The bank is facing DO OR DIE situa on. There are
problems of Gross NPA (Non Performing Assets) at 40% & CAR/CRAR (Capital Adequacy Ra o/ Capital Risk
Weight Asset Ra o) at 4%. The net worth of the bank is not good. Shares are not traded regularly. Last week, it
was traded @ ` 8 per share.
RBI Audit suggested that bank has either to liquidate or to merge with other bank.
Bank 'P' is professionally managed bank with low gross NPA of 5%. It has Net NPA as 0% and CAR at 16%. Its
share is quoted in the market @ ` 128 per share. The board of directors of bank 'P' has submi ed a proposal to
RBI for take over of bank 'R' on the basis of share exchange ra o.
The Balance Sheet details of both the banks are as follows:
Bank 'R' Amt. in ` lacs Bank 'P' Amt. in ` lacs
Paid up share capital 140 500
Reserves & Surplus 70 5,500
Deposits 4,000 40,000
Other liabili es 890 2,500
Total Liabili es 5,100 48,500
Cash in hand & with RBI 400 2,500
Balance with other banks - 2,000
Investments 1,100 15,000
Advances 3,500 27,000
Other Assets 100 2,000
Total Assets 5,100 48,500

It was decided to issue shares at Book Value of Bank 'P' to the shareholders of Bank 'R'.
All assets and liabili es are to be taken over at Book Value.
For the swap ra o, weights assigned to different parameters are as follows:
Gross NPA 30%
CAR 20%
Market price 40%
Book value 10%
(a) What is the swap ra o based on above weights?
(b) How many shares are to be issued?
(c) Prepare Balance Sheet a er merger.
(d) Calculate CAR & Gross NPA of Bank 'P' a er merger.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 17
 MERGERS, ACQUISITIONS & RESTRUCTURING

Solu on:
(a) Swap Ra o
Gross NPA 5 : 40 i.e. 5/40 x 30% = 0.0375
CAR 4 : 16 i.e. 4/16 x 20% = 0.0500
Market Price 8 : 128 i.e. 8/128 x 40% = 0.025
Book Value 15 : 120 i.e. 15/120 x 10% = 0.0125
0.125
Thus for every share of Bank 'R' 0.125 share of Bank 'P' shall be issued.

(b) No. of equity shares to be issued:

(c) Balance Sheet a er Merger

Calcula on of Capital Reserve
Book Value of Shares ` 210.00 lac

Value of Shares issued ` 17.50 lac

Capital Reserve ` 192.50 lac

Balance Sheet
` lac ` lac

Paid up Share Capital 517.50 Cash in Hand & RBI 2900.00

Reserves & Surplus 5500.00 Balance with other banks 2000.00
Capital Reserve 192.50 Investment 16100.00
Deposits 44000.00 Advances 30500.00
Other Liabili es 3390.00 Other Assets 2100.00
53600.00 53600.00

(d) Calcula on of CAR & Gross NPA of Bank 'P' a er merger

Bank 'R' Bank 'P' Merged

4% 16%
Total Capital ` 210 lac ` 6000 lac ` 6210 lac

Risky Weighted Assets ` 5250 lac ` 37500 lac ` 42750 lac

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 MERGERS, ACQUISITIONS & RESTRUCTURING

Bank 'R' Bank 'P' Merged

GNPA % 0.40 0.05
Gross NPA ` 1400 lac ` 1350 lac ` 2750 lac

Advances ` 3500 lac ` 27000 lac ` 30500 lac

Gross NPA = 2750 / 30500 = 9.02%

Ques on 12 MTP Oct 2022

Aggressive Ltd. is proposing to fund its expansion plan of ₹ 12 crore by making a rights issue. The current
market price (CMP) is ₹ 40. The Board is willing to offer a discount of 20% on the CMP for the rights issue. The
Board is also desirous that the fall in Ex-right price of the shares be restricted to 10% of CMP.

CALCULATE:
(1) The number of new equity shares to be offered for each rights held,
(2) Theore cal value of right and
(3) The total number of equity shares to be issued.

Solu on:
(1) Number of new equity shares to be offered for each rights held
Subscrip on Price = ₹ 40 × 0.80 = ₹ 32 per share
Ex Right Price to be restricted to = ₹ 40 × 0.90 = ₹ 36
Let R be the ra o in which right share to be issued then
₹ 40 + ₹ 32 x R
₹ 36 =
1+R
36 + 36R = ₹ 40 + 32R
R=1
Thus, 1 equity share be offered for each share held.

(2) Theore cal Value of right = ₹ 36 – ₹ 32 = ₹ 4

₹ 12 crore
(3) No. of equity share to be issued = = 37,50,000 or 0.375 crore shares.
₹ 32
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 Security Valuation
SECURITY VALUATION & CORPORATE VALUATION
& Corporate Valuation
Ques on 1 Study Material, Exam May 14, Prac ce Manual
MNP Ltd. has declared and paid annual dividend of ₹ 4 per share. It is expected to grow @ 20% for the next two
years and 10% therea er. The required rate of equity investors is 15% Compute the current price at which
equity shares should sell.
Note: Present Value Interest Factor (PVIF) @15%:
For year 1 = 0.8696;
For year 2 = 0.7561

Solu on:
D0 = ₹ 4
D1 = ₹ 4 (1.20) = ₹ 4.80
D2 = ₹ 4 (1.20)² = ₹ 5.76
D3 = ₹ 4 (1.20)² (1.10) = ₹ 6.336

= 4.80 × 0.8696 + 5.76 × 0.7561 + 126.72 × 0.7561

= 104.34

Ques on 2 (8 Marks) CA Final May 2019

The shares of G Ltd. were currently being traded at ₹ 46. The company published its results for the year ended
31 March 2019 and declared a dividend of ₹ 5. The company made a return of 15% on its capital and expects
that to be the norm in which it operates. G Ltd. also expects the dividends to grow at 10% for the first three
years and therea er at 5%.
You are required to advise whether the share of the company is being traded at a premium or discount.
PVIF @ 15% for the next 3 years is 0.870, 0.756 and 0.658 respec vely.

Solu on:
Expected dividend for next three years
Year 1 (D1) = 5 (1.1) = 5.5
Year 2 (D2) = 5.5 (1.1) = 6.05
Year 3 (D3) = 6.05 (1.1) = 6.655
Required Rate (Ke) = 15%
Present Value of Dividends
= 5.5 (0.870) + 6.05 (0.756) + 6.655 (0.658)
= 4.785 + 4.574 + 4.379
= 13.74
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 SECURITY VALUATION & CORPORATE VALUATION

Now, PV at growth rate of 5%

Therefore, P₀ = 69.88 x 0.658 = 45.98

Now, adding the PV of dividend at two different growth rates, we get,

13.74 + 45.98 = 59.72

Hence, it is clear that shares are being traded at discount i.e. undervalued because intrinsic value of share is
more than the market price.
Ques on 3 Study Material, N14 (6 Marks), M16 (8 Marks), MTP S15, MTP Mar18, Prac ce Manual

An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being paid by the
company is ₹ 2 per share and the share is being sold at ₹ 25 per share in the market. However, several factors
are likely to change during the course of the year as indicated below:
Exis ng Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares? And why?

Solu on:
On the basis of exis ng and revised factors, rate of return and price of share is to be calculated.

Exis ng rate of return

= Rf + Beta (Rm – Rf) = 12% + 1.4 (6%) = 20.4%

Revised rate of return

= 10% + 1.25 (4%) = 15%
Price of share (original)
D (1 + g) 2 (1.05) 2.10
Po = = = = ₹ 13.63
ke - g .204 - .05 .154

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 SECURITY VALUATION & CORPORATE VALUATION

Price of share (Revised)

2 (1.09) 2.18
Po = = = ₹ 36.33
0.15 - 0.09 .06
In case of exis ng market price of ₹ 25 per share, rate of return (20.4%) and possible equilibrium price of share
at ₹ 13.63, this share needs to be sold because the share is overpriced (₹ 25 – 13.63) by ₹ 11.37. However,
under the changed scenario where growth of dividend has been revised at 9% and the return though
decreased at 15% but the possible price of share is to be at ₹ 36.33 and therefore, in order to expect price
apprecia on to ₹ 36.33 the investor should hold the shares, if other things remain the same.

Ques on 4 Study Material

ABC Ltd. has been maintaining a growth rate of 10 percent in dividends. The company has paid dividend @ ₹ 3
per share. The rate of return on market por olio is 12 percent and the risk free rate of return in the market has
been observed as 8 percent. The Beta co-efficient of company's share is 1.5.

You are required to calculate the expected rate of return on company's shares as per CAPM model and
equilibrium price per share by dividend growth model.

Solu on:
CAPM formula for calcula on of Expected Rate of Return is :
ER = Rf + β (Rm – Rf)
= 8 + 1.5 (12 – 8)
= 8 + 1.5 (4)
=8+6
=14% or 0.14

Applying Dividend Growth Model for the calcula on of per share equilibrium price:

Per share equilibrium price will be ₹ 82.50.

Ques on 5 Study Material
A Company pays a dividend of ₹ 2.00 per share with a growth rate of 7%. The risk free rate is 9% and the market
rate of return is 13%. The Company has a beta factor of 1.50. However, due to a decision of the Finance
Manager, beta is likely to increase to 1.75. Find out the present as well as the likely value of the share a er the
decision.

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 SECURITY VALUATION & CORPORATE VALUATION

Solu on:
In order to find out the value of a share with constant growth model, the value of Ke should be ascertained with
the help of 'CAPM' model as follows:
Ke = Rf + β (Rm – Rf)
Where,
Ke = Cost of equity
Rf = Risk free rate of return
β = Por olio Beta i.e. market sensi vity index
Rm = Expected return on market por olio

By subs tu ng the figures, we get

Ke = 0.09 + 1.5 (0.13 – 0.09) = 0.15 or 15%
and the value of the share as per constant growth model is

Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke = Cost of equity
g = growth

Alterna vely, it can also be found as follows:

However, if the decision of finance manager is implemented, the beta (β) factor is likely to increase to 1.75,
therefore, Ke would be
Ke = Rf + β (Rm – Rf)
= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%
The value of share is

Alterna vely, it can also be found as follows:

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 SECURITY VALUATION & CORPORATE VALUATION

Ques on 6 Study Material

M/s X Ltd. has paid a dividend of ₹ 2.50 per share on a face value of ₹ 10 in the financial year ending on 31st
March, 2009. The details are as follows:
Current market price of share ₹ 60
Growth rate of earnings and dividends 10%
Beta of share 0.75
Average market return 15%
Risk free rate of return 9%
Calculate the intrinsic value of the share.

Solu on:

Using CAPM
k = Rf + β (Rm-Rf)
Rf = Risk Free Rate
β = Beta of Security
Rm = Market Return
= 9% + 0.75 (15% - 9%) = 13.5%

Ques on 7 (8 Marks) CA Final May 2019

Following financial informa on's are available of XP Ltd. for the year 2018:
Equity Share Capital (` 10 each) ` 200 Lakh

Reserves and Surplus ` 600 Lakh

10% Debentures (` 100 each) ` 350 Lakh

Total Assets ` 1200 Lakh

Assets Turnover Ra o 2 mes

Tax Rate 30%
Opera ng Margin 10%
Dividend Payout Ra o 20%
Current Market Price per Equity Share ` 28

Required Rate of Return of Investors 18%

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 24
 SECURITY VALUATION & CORPORATE VALUATION

You are required to:

(i) Prepare Income Statement for the year 2018.
(ii) Determine its Sustainable Growth Rate.
(iii) Determine the fair price of the company's share using Dividend Discount Model.
(iv) Give your opinion on investment in the company's share at current price.

Solu on:
Workings:
Asset turnover ra o = 2 mes
Total Assets = ` 1200 lakh
Turnover ` 1200 lakhs x 2 = ` 2400 lakhs
Interest on Debentures = 350 lakh x 10% = 35 lakhs
Opera ng Margin = 10%
Hence opera ng cost = (1 - 0.10) 2400 lakhs = ` 2160 lakhs
Dividend Payout = 20%
Tax rate = 30%

(i) Income statement

(` Lakhs)
Sale 2400
Opera ng Exp 2160
EBIT 240
Interest 35
EBT 205
Tax @30% 61.5
EAT 143.5
Dividend @20% 28.7
Retained Earnings 114.8

(ii) SGR = Return on Equity (1- Dividend Payout Ra o)

= ROE (1-b)

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 SECURITY VALUATION & CORPORATE VALUATION
(iii) Calcula on of fair price of share using dividend discount model

(iv) Since the current market price of share is ` 28, the share is undervalued. Hence, the investor should
invest in the company.
Ques on 8 Study Material
Mr. A is thinking of buying shares at ` 500 each having face value of ` 100. He is expec ng a bonus at the ra o
of 1:5 during the fourth year. Annual expected dividend is 20% and the same rate is expected to be maintained
on the expanded capital base. He intends to sell the shares at the end of seventh year at an expected price of `
900 each. Incidental expenses for purchase and sale of shares are es mated to be 5% of the market price. He
expects a minimum return of 12% per annum.
Should Mr. A buy the share? If so, what maximum price should he pay for each share?
Assume no tax on dividend income and capital gain.

[Net Gain = 39.03, Max Price = 537.17]

Solu on:
P.V. of dividend stream and sales proceeds
Year Divd. /Sale PVF (12%) PV (₹)
1 ₹ 20 0.893 17.86
2 ₹ 20 0.797 15.94
3 ₹ 20 0.712 14.24
4 ₹ 24 0.636 15.26
5 ₹ 24 0.567 13.61
6 ₹ 24 0.507 12.17
7 ₹ 24 0.452 10.85
7 ₹ 1026 (₹ 900 x 1.2 x 0.95) 0.452 463.75
₹ 563.68
Less : - Cost of Share (₹ 500 x 1.05) ₹ 525.00
Net Gain ₹ 38.68
Since Mr. A is gaining ₹ 38.68 per share, he should buy the share.

Maximum price Mr. A should be ready to pay is ₹ 563.68 which will include incidental expenses. So the
maximum price should be ₹ 563.68 x 100/105 = ₹ 536.84
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 26
 SECURITY VALUATION & CORPORATE VALUATION

Ques on 9 (5 Marks) CA Final Nov 2014

Goldilocks Ltd. was started a year back with a paid up equity capital of ` 40,00,000. The other details are as
under:
Earning of the company ` 4,00,000

Dividend paid ` 3,20,000

Price Earnings ra o 12.5

Number of shares 40,000

Find the current market price of the share. Use Walter's Model.

You are required to find out whether the company's dividend payout ra o is op mal, using Walter's formula?

[Ans: Market Price 131.25, Op mum ra o 0% at which MP = 156.25]

Solu on:
(i) Walter's model is given by

Where,
P = Market price per share.
E = Earnings per share = ` 10
D = Dividend per share = ` 8
r = Return earned on investment = 10%
Ke = Cost of equity capital = 1/12.5 = 8%

(ii) According to Walter's model when the return on investment is more than the cost of equity capital, the
price per share increases as the dividend pay-out ra o decreases. Hence, the op mum dividend pay-out
ra o in this case is nil.

So, at a pay-out ra o of zero, the market value of the company's share will be:

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 27
 SECURITY VALUATION & CORPORATE VALUATION

Ques on 10
The following informa on is given for 3 companies that are iden cal except for their capital structure:
Orange Grape Apple
Total invested capital 1,00,000 1,00,000 1,00,000
Debt/assets ra o 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Pre tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Opera ng Income (EBIT) 25,000 25,000 25,000
The tax rate is uniform 35% in all cases.
(i) Compute the Weighted average cost of capital for each company.
(ii) Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give reasons.
(iv) If the industry PE ra o is 11x, es mate the price for the share of each company.
(v) Calculate the es mated market capitalisa on for each of the Companies.

Solu on:
(i) Working for calcula on of WACC
Orange Grape Apple
Total debt 80,000 50,000 20,000
Post tax Cost of debt 10.40% 8.45% 9.75%
Equity Fund 20,000 50,000 80,000

WACC
Orange: (10.4 x 0.8) + (26 x 0.2) = 13.52%
Grape: (8.45 x 0.5) + (22 x 0.5) = 15.225%
Apple: (9.75 x 0.2) + (20 x 0.8) = 17.95%

(ii)
Orange Grape Apple
WACC 13.52 15.225 17.95
EVA [EBIT (1 - T)-(WACC x Invested Capital)] 2,730 1,025 -1,700

(iii) Orange would be considered as the best investment since the EVA of the company is highest and its
weighted average cost of capital is the lowest.

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 SECURITY VALUATION & CORPORATE VALUATION

(iv) Es mated Price of each company shares

Orange Grape Apple
EBIT (₹) 25,000 25,000 25,000
Interest (₹) 12,800 6,500 3,000
Taxable Income (₹) 12,200 18,500 22,000
Tax 35% (₹) 4,270 6,475 7,700
Net Income (₹) 7,930 12,025 14,300
Shares 6,100 8,300 10,000
EPS (₹) 1.30 1.45 1.43
Stock Price (EPS x PE Ra o) (₹) 14.30 15.95 15.73
Since the three en es have different capital structures they would be exposed to different degrees of
financial risk. The PE ra o should therefore be adjusted for the risk factor.

(v) Market Capitalisa on

Es mated Stock Price (₹) 14.30 15.95 15.73
No. of shares 6,100 8,300 10,000
Es mated Market Cap (₹) 87,230 1,32,385 1,57,300

Ques on 11 Study Material

The following data pertains to XYZ Inc. engaged in so ware consultancy business as on 31 December 2010
($ Million)
Income from consultancy 935.00
EBIT 180.00
Less: Interest on Loan 18.00
EBT 162.00
Less: Tax @ 35% 56.70
105.30

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 SECURITY VALUATION & CORPORATE VALUATION

Balance Sheet ($ Million)

Liabili es Amount Assets Amount
Equity Stock (10 Million share 100 Land and Building 200
@ $ 10 each)
Reserve & Surplus 325 Computers & So ware 295
Loans 180 Current Assets:
Current Liabili es 180 Debtors 150
Bank 100
Cash 40 290
785 785

With the above informa on and following assump on you are required to compute
a. Economic Value Added.
b. Market Value Added.

Assuming that:
(i) WACC is 12%
(ii) The share of company currently quoted at $50 each

Solu on:
a. Determina on of Economic value added (EVA)
$ Million
EBIT 180.00
Less: Taxes @35% 63.00
Net Opera ng Profit a er Tax 117.00
Less: Cost of Capital Employed [W. No.1] 72.60
Economic Value Added 44.40

b. Determina on of Market Value Added (MVA)

$ Million
Market Value of Equity Stock [W. No.2] 500
Equity Fund [W. No.3] 425
Market Value Added 75

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 SECURITY VALUATION & CORPORATE VALUATION

Working Notes:

(1) Total Capital Employed

Equity Stock $ 100 Million
Reserve and Surplus $ 325 Million
Loan $ 180 Million
$ 605 Million
WACC 12%
Cost of Capital employed $ 605 Million x 12% $ 72.60 Million

(2) Market Price per equity share (A) $ 50

No. of equity share outstanding (B) 10 Million
Market value of equity stock (A) x (B) $ 500 Million

(3) Equity Fund

Equity Stock $ 100 Million
Reserve & Surplus $ 325 Million
$ 425 Million
Ques on 12 Study Material
With the help of the following informa on of Jatayu Limited compute the Economic Value Added:

Capital Equity capital ` 160 Lakhs

Reserve and Surplus ` 140 lakhs
10% Debentures ` 400 lakhs
Cost of equity 14%
Financial Leverage 1.5 mes
Income Tax Rate 30%

Solu on:
Financial Leverage = PBIT/PBT
1.5 = PBIT / (PBIT - Interest)
1.5 = PBIT / (PBIT - 40)
1.5 (PBIT - 40) = PBIT
1.5 PBIT – 60 = PBIT
1.5 PBIT – PBIT = 60
1.5 PBIT = 60

NOPAT = PBIT - Tax = ` 120 lakhs (1 – 0.30) = ` 84 lakhs.

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 SECURITY VALUATION & CORPORATE VALUATION

Weighted Average Cost of Capital (WACC)

= 14% (300/700) + (1 – 0.30) x (10%) x (400/700) = 10%

EVA = NOPAT – (WACC x Total Capital)

EVA = ` 84 lakhs – 0.10 x ` 700 lakhs
EVA = ` 14 lakhs
Ques on 13 Study Material, (5 Marks) CA Final May 2018, RTP May 2022
Herbal Gyan is a small but profitable producer of beauty cosme cs using the plant Aloe Vera. This is not a high-
tech business, but Herbal's earnings have averaged around ` 12 lakh a er tax, largely on the strength of its
patented beauty cream for removing the pimples.

The patent has eight years to run, and Herbal has been offered ` 40 lakhs for the patent rights. Herbal's assets
include ` 20 lakhs of working capital and ` 80 lakhs of property, plant, and equipment. The patent is not shown
on Herbal's books. Suppose Herbal's cost of capital is 15 percent. What is its Economic Value Added (EVA)?

Solu on
EVA = Income earned – (Cost of capital x Total Investment)
Total Investments
Par culars Amount
Working capital ` 20 lakhs

Property, plant, and equipment ` 80 lakhs

Patent rights ` 40 lakhs

Total ` 140 lakhs

Cost of Capital 15%
EVA= `12 lakh – (0.15 x `140 lakhs) = `12 lakh – ` 21 lakh = - ` 9 lakh
Thus, Herbal Gyan has a nega ve EVA of ` 9 lakhs.

Ques on 14 Study Material

RST Ltd.'s current financial year's income statement reported its net income a er tax as ` 25,00,000. The
applicable corporate income tax rate is 30%
Following is the capital structure of RST Ltd. at the end of current financial year:
`

Debt (Coupon rate = 11%) 40 lakhs

Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs

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 SECURITY VALUATION & CORPORATE VALUATION

Following data is given to es mate cost of equity capital:

`

Equity Beta of RST Ltd. 1.36

Risk-Free rate i.e. current yield on Govt. Bonds 8.5%
Average market risk premium (i.e. Excess of return 9%
on market por olio over risk-free rate)
Required:
(i) Es mate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Es mate Economic Value Added (EVA) of RST Ltd.

Solu on:
Cost of Equity as per CAPM
Ke = Rf + β x Market Risk Premium
= 8.5% + 1.36 x 9%
= 8.5% + 12.24% = 20.74%
Cost of Debt Kd = 11%(1 – 0.30) = 7.70%
E D
Ke x + Kd x
E+D E+D

= 15.71 + 1.87
= 17.58%

Taxable Income = ` 25,00,000/ (1 – 0.30)

= ` 35,71,429 or ` 35.71 lakhs

Opera ng Income = Taxable Income + Interest

= ` 35,71,429 + ` 4,40,000
= ` 40,11,429 or ` 40.11 lacs

EVA = EBIT (1-Tax Rate) – WACC x Invested Funds

= ` 40,11,429 (1 – 0.30) – 17.58% x ` 1,65,00,000
= 28,08,000 -` 29,00,700
= -` 92,700

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 SECURITY VALUATION & CORPORATE VALUATION

Ques on 15 Study Material

Tender Ltd has earned a net profit of ` 15 lacs a er tax at 30%. Interest cost charged by financial ins tu ons
was ` 10 lacs. The invested capital is ` 95 lacs of which 55% is debt. The company maintains a weighted
average cost of capital of 13%.

Required,
a. Compute the opera ng income.
b. Compute the Economic Value Added (EVA).
c. Tender Ltd. has 6 lac equity shares outstanding. How much dividend can company pay before the value
of the en ty starts declining? If Tender pay any dividends, what would you expect to happen to the value
of the company ?

Solu on
Taxable Income = ` 15 lac/ (1-0.30)
= ` 21.43 lacs or ` 21,42,857

Opera ng Income = Taxable Income + Interest

= ` 21,42,857 + ` 10,00,000
= 31,42,857 or ` 31.43 lacs

EVA = EBIT (1 – Tax rate) – WACC x Invested Capital

= ` 31,42,857(1 – 0.30) – 13% x ` 95,00,000
= ` 22,00,000 - ` 12,35,000 = ` 9,65,000

If Tender ltd does not pay a dividend, we would expect the value of the firm to increase because it will achieve
higher growth, hence a higher, then all else equal, the value of the firm will increase.

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 SECURITY VALUATION & CORPORATE VALUATION

Ques on 16 (8 Marks) Exam Dec 2021

Following is the informa on of M/s. DY Ltd. for the year ending 31/03/2021:
Par culars ₹
Sales ₹ 1000 Lakh
Opera ng Expenses Including Interest ₹ 620 Lakh
8% Debentures ₹ 250 Lakh
Equity Share Capital (Face value of ₹ 10 each) ₹ 250 Lakh
Reserves and Surplus ₹ 250 Lakh
Market Value of DY Ltd ₹ 900 Lakh
Corporate Tax Rate 30%
Risk free Rate of Return 7%
Market Rate of Return 12%
Equity Beta 1.4

You are required to:-

i. Calculate Weighted Average Cost of Capital of DY Ltd.
ii. Calculate Economic Value Added
iii. Calculate Market Value Added

Solu on:
(i) Weighted Average Cost of Capital of DY Ltd.
Cost of Equity as per CAPM
ke = Rf + β x Market Risk Premium
= 7% + 1.4 x [12% - 7%]
= 7% + 7% = 14%
Cost of Debt kd = 8% (1 – 0.30) = 5.60%
E D 500 250
WACC (k0) = ke x + kd x = 14.00 x + 5.60 x
E+D E+D 750 750
= 9.33% + 1.87% = 11.20%

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 SECURITY VALUATION & CORPORATE VALUATION

(ii) Economic Value Added (EVA) of DY Ltd.

₹ Lakhs
Sales ₹ 1,000
Opera ng Expenses (excluding interest) ₹ 620
₹ 20 ₹ 600
₹ 400
Less: Tax @ 30% ₹ 120
Net Opera ng Profit a er Tax (NOPAT) ₹ 280

Calcula on of Capital Employed

₹ Lakhs
Equity Share Capital 250
Reserves & Surplus 250
8% Debentures 250
Total Capital Employed 750

EVA = NOPAT – (WACC x Total Capital)

EVA = ₹ 280 Lakh – 0.1120 x ₹ 750 lakhs
EVA = 196.00 lakhs

(iii) Determina on of Market Value Added (MVA)

₹ Lakhs
Market value of Equity Stock [₹ 900 Lakh - ₹ 250 Lakh] 650
Equity Fund [₹ 250 Lakh + ₹ 250 Lakh] 500
Market Value Added 150

Alterna vely, it can also be computed as follows:

₹ Lakhs
Market value of DY Ltd. 900
Capital employed [₹ 250 Lakh + ₹ 250 Lakh + ₹ 250 Lakh] 750
Market Value Added 150

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 SECURITY VALUATION & CORPORATE VALUATION

Ques on 17 Nov 18, MTP March 21, MTP March 21

Eager Ltd. has a market capitaliza on of ₹ 1,500 crores and the current market price of its share is ₹ 1,500. It
made a PAT of ₹ 200 crores and the Board is considering a proposal to buy back 20% of the shares at a premium
of 10% to the current market price. It plans to fund this through a 16% bank loan. You are required to calculate
the post buy back Earnings Per Share (EPS).

The company's corporate tax rate is 30%.

Solu on:

No. of shares to be bought back = 1 Crore x 0.20 = 20 Lakh

Price at which share to be bought back = ₹ 1,500 + 10% of ₹ 1,500 = ₹ 1,650
Amount required for Buyback of Shares = ₹ 1,650 x 20 Lakh = ₹ 330 Crore
Amount of Loan @ 16% = ₹ 330 Crore
Statement showing Post Buyback EPS
Profit before tax (₹ 200 crore/ 0.70) ₹ 285.7143 crore
Less: Interest on Loan (₹ 330 Crore x 16%) ₹ 52.8000 crore
Profit before Tax ₹ 232.9143 crore
Tax ₹ 69.8743 crore
Profit a er Tax (PAT) ₹ 163.0400 crore
No. of Shares Post buyback 80 Lakh
EPS (Post Buyback) (₹ 163.0400 Crore/ 80.00 Lakh) ₹ 203.80

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 Portfolio
Management
PORTFOLIO MANAGEMENT

Ques on 1 May 17 (8 Marks), Prac ce Manual, Study Material

A Stock cos ng ₹ 120 pays no dividends. The possible prices at which the stock may be sold for at the end of
the year with the respec ve probabili es are:
Price ↓ (in ₹ ) Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1

You are required to:

(i) Calculate the Expected Return,
(ii) Calculate the Standard Devia on of Returns.

Solu on:
Here, the probable returns have to be calculated using the formula

Calcula on of Probable Returns

Possible prices (P1) P1 - P 0 [(P1 - P0)/ P0] x 100
₹ ₹ Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.50
140 20 16.67

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 PORTFOLIO MANAGEMENT

Alterna vely, it can be calculated as follows:

Calcula on of Expected Returns
Possible Return Probability Product
Xi p (Xi) Xi - p (Xi)
-4.17 0.1 -0.417
0.00 0.1 0.000
4.17 0.2 0.834
8.33 0.3 2.499
12.50 0.2 2.500
16.67 0.1 1.667
X = 7.083
Expected return X = 7.083 per

Alterna vely, it can also be calculated as follows:

Expected Price = 115 × 0.1 + 120 × 0.1 + 125 × 0.2 + 130 × 0.3 + 135 × 0.2 + 140 × 0.1 = 128.50

Calcula on of Standard Devia on of Returns

Probable Probability Devia on Devia on Product
Return Xi P (Xi) (Xi - X) squared
2
(Xi - X) (Xi - X)² p (Xi)

-4.17 0.1 -11.253 126.63 12.66

0.00 0.1 -7.083 50.17 5.017
4.17 0.2 -2.913 8.49 1.698
8.33 0.3 1.247 1.56 0.467
12.50 0.2 5.417 29.34 5.869
16.67 0.1 9.587 91.91 9.191
σ² = 34.902

Variance, = 34.902 per cent

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 PORTFOLIO MANAGEMENT

Ques on 2
Securi es A, B, and C have the following characteris cs with respect to expected return, standard devia on
and the correla on between them:
Correla on (ρij)
Company Ret. SD A-B A-C B-C
A .05 .02 .4 .6 -
B .15 .16 .4 - .8
C .12 .08 - .6 .8

What is the expected return and standard devia on of a por olio composed of equal investments in each?

Solu on:
Expected return:
Return Weight (w) Rxw
A 0.05 1/3 .0167
B 0.15 1/3 .05
C 0.12 1/3 .04
Expected return: 10.66% or 10.667%

Standard Devia on σP =

2 2 2
(σA WB) + (σB WB) + (σC WC) + 2σAWA σBWB Corr AB + 2σB WB σ CWC CorrBC
+ 2σCWC σA WA CorrAC

1 2 1 2 1 2 1 1 1 1
(.02 x ) + (.16 x ) + (.08 x ) + 2 x .02 x x .16 x x0.4+ 2 x .16 x x .08 x x .8
3 3 3 3 3 3 3
1 1
+ 2 x .08 x x .02 x x .6
3 3
σP = 7.9833%

Ques on 3
From the following informa on, calculate the expected rate of return of a por olio:
Risk free rate of interest 13%
Expected return of market por olio 19%
Standard devia on of an asset 25%
Market standard devia on 22%
Correla on co-efficient of por olio with market 0.7
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 PORTFOLIO MANAGEMENT

Solu on:
Calcula on of Expected Rate of Return of a Por olio:
Expected Rate of Return of a por olio can be worked by using following formula:
Re = Rf + βj (Rm – Rf)……. (1)
Where
Re = expected rate of return of a por olio
Rf = Risk free rate of interest or return
Rm = Expected return of market por olio
βj = Beta co-efficient of Security j

Since in the ques on, informa on on β is not given, it is essen al to find it. The formula to calculate βj is:
rsm x σs
βj =
σm

Where rsm stands for correla on co-efficient of por olio with market
σs Standard devia on of an asset
σm Market standard devia on
By subs tu ng the available informa on in above formula, (2) we may get:
β = (0.70 x 0.25) ÷ 0.22
= 0.7955
Now we may get expected rate of return by subs tu ng available informa on in equa on (1)
Re = 13 + 0.7955 (19 - 13)
= 17.77%

Ques on 4
T Ltd. and A Ltd., have low posi ve correla on coefficient of +0.5. Their respec ve risk and return profile is
made up as under:
T Ltd. A Ltd.
Return 12.00% 18.00%
Standard Devia on 10.00% 15.00%
Determine the propor on in which the investment should be made in T and A, in order that the total risk in the
por olio is minimum.

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 PORTFOLIO MANAGEMENT

Solu on:
Calcula on of Propor on
VarA - CovAT
WT =
VarA + VarT - 2 CovAT
2
VarianceA = (SDA)
2
= (10)
= 100
2
VarianceT = (SDT)
2
= (15)
= 225

CovAT = CorrAT x σA x σT
= 0.50 x 10 x 15
= 75
225 - 75
WA = = 0.86
100 + 225 - 150
100 - 75
WT = = 0.14
100 + 225 - 150

Ques on 5 Study Material, (8 Marks) CA Final Nov 2012, RTP Nov 2018
Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Por olio Manager. The Por olio
Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Be er Good Very Good Best
Amount (in ` lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50

You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing Methodology:
(i) Expected return on the por olio, if the Government Securi es are at 8% and the NIFTY is yielding 10%.
(ii) Advisability of replacing Security 'Be er' with NIFTY.

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 PORTFOLIO MANAGEMENT

Solu on:
(i) Computa on of Expected Return from Por olio
Security Beta Expected Return (r) as per Amount Weights WxR
(β) CAPM (` Lakhs) (w)
Moderate 0.50 8% + 0.50(10% - 8%) = 9% 60 0.115 1.035
Be er 1.00 8% + 1.00(10% - 8%) = 10% 80 0.154 1.540
Good 0.80 8% + 0.80(10% - 8%) = 9.60% 100 0.192 1.843
Very Good 1.20 8% + 1.20(10% - 8%) = 10.40% 120 0.231 2.402
Best 1.50 8% + 1.50(10% - 8%) = 11% 160 0.308 3.388
520 1 10.208

Thus Expected Return from Por olio 10.208% say 10.21%

Alterna vely, it can be computed as follows:
60 80 100 120 160
Average β = 0.50 x + 1.00 x + 0.80 x + 1.20 x + 1.50 x = 1.104
520 520 520 520 520
As per CAPM
= 0.08 + 1.104(0.10 - 0.08) = 0.10208 i.e. 10.208%
(ii) As computed above the expected return from Be er is 10% same as from Ni y, hence there will be no
difference even if the replacement of security is made. The main logic behind this neutrality is that the
beta of security 'Be er is 1 which clearly indicates that this security shall yield same return as market
return.

Ques on 6
Mr. Tempest has the following por olio of four shares:
Name Beta Investment ₹ Lac.
Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50

The risk-free rate of return is 7% and the market rate of return is 14%.

Required.
(i) Determine the por olio return. (ii) Calculate the por olio Beta.

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 PORTFOLIO MANAGEMENT

Solu on:
Market Risk Premium (A) = 14% – 7% = 7%
Share Beta Risk Premium (Beta Risk Free Return % Return ₹
x A) % Return %
Oxy Rin Ltd. 0.45 3.15 7 10.15 8,120
Boxed Ltd. 0.35 2.45 7 9.45 14,175
Square Ltd. 1.15 8.05 7 15.05 33,863
Ellipse Ltd. 1.85 12.95 7 19.95 89,775
Total Return 1,45,933
Total Investment ₹ 9,05,000
₹ 1,45,933
(i) Por olio Return = x 100 = 16.13%
₹ 9,05,000

(ii) Por olio Beta

Por olio Return = Risk Free Rate + Risk Premium х β = 16.13%
7% + 7β = 16.13%
β = 1.30

Alterna ve Approach
First we shall compute Por olio Beta using the weighted average method as follows:
0.80 1.50 2.25 4.50
BetaP = 0.45 x + 0.35 x + 1.15 x + 1.85 x
9.05 9.05 9.05 9.05

= 0.45 x 0.0884 + 0.35 x 0.1657 + 1.15 x 0.2486 + 1.85 x 0.4972

= 0.0398 + 0.058 + 0.2859 + 0.9198 = 1.3035
Accordingly,
(i) Por olio Return using CAPM formula will be as follows:
RP = RF + BetaP (RM – RF)
= 7% + 1.3035 (14% - 7%) = 7% + 1.3035 (7%)
= 7% + 9.1245% = 16.1245%
(ii) Por olio Beta
As calculated above 1.3035

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 PORTFOLIO MANAGEMENT

Ques on 7
A conserva ve investor is analyzing the shares of PSEL which is currently trading at ` 1,180. For the year 2019 –
2020, the earnings per share (EPS) was ` 40. The investor has generated the following scenarios for the next
year with the corresponding probabili es:
P/E ra o | EPS-> 20 30
50 0.20 0.35
60 0.30 0.15
You are required to calculate the expected risk and return for the share of PSEL

Solu on: 1180

The current price of PSEL is ` 1,180. The EPS is ` 40. Hence, the P/E ra o is 40 = 29.5
The various EPS and P/E ra os are given below:
(1) (2) (3) (4) (5) (6)
EPS P/E Ra o Probability Expected Expected Expected
Price Return Return (%)
50 20 0.20 1000 -180 (15.25)
50 30 0.35 1500 320 27.12
60 20 0.30 1200 20 1.69
60 30 0.15 1800 620 52.54
The expected return will be
E (P) = (-15.25 x 0.2) + (27.12 x 0.35) + (1.69 x 0.30) + (52.54 x 0.15)
= 14.827 or 14.83%

The risk of the stock is found below:

2 2
X X-X (X - X) Prob. (X - X) x Prob.
(15.25) (30.08) 904.81 0.20 180.96
27.12 12.29 151.04 0.35 52.86
1.69 (13.14) 172.66 0.30 51.80
52.54 37.71 1422.04 0.15 213.31
498.93
2 2
σ (P) = 498.93(%) OR s = (498.93)1/2= 22.34%

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 PORTFOLIO MANAGEMENT

Ques on 8
Suppose that the current price of the shares of ABC Ltd. is ` 30 per share. The investor es mated the intrinsic
value of ABC Ltd.'s share to be ` 35 per share with required return of 8% per annum. Es mate the expected
return on ABC Ltd.

Solu on:
ABC’S expected convergence return is (35 - 30)/30 * 100 = 16.67%, and let's suppose that the convergence
happens over one year. Thus, adding this return with the 8% required return, we obtain an expected return of
24.67%.
Explana on: The intrinsic value es mate of ` 35 and required return of 8% imply that you expect the share
price to rise to ` 37.80, which is up by 26.00% (rough es mate of 24.67%) from the current price of ` 30.
Ques on 9 Study Material, RTP Nov 2019, (8 Marks) Exam May 2022
Calculate the Covariance & Correla on Coefficient of the two securi es, from the historical rates of return
over the past 10 years.
Years 1 2 3 4 5 6 7 8 9 10
Security 1: 15 10 12 8 18 16 20 24 16 14
(Return %)
Security 2: 24 20 18 14 22 26 12 28 16 15
(Return %)

Solu on: Calcula on of Covariance

Year R1 Devia on Devia on R2 Devia on Devia on Product of

(R1 - R1) (R1 - R1)² (R2 - R2) (R2 - R2)² devia ons
1 15 -0.3 0.09 24 4.5 20.25 -1.35
2 10 -5.3 28.09 20 0.5 0.25 -2.65
3 12 -3.3 10.89 18 -1.5 2.25 4.95
4 8 -7.3 53.29 14 -5.5 30.25 40.15
5 18 2.7 7.29 22 2.5 6.25 6.75
6 16 0.7 0.49 26 6.5 42.25 4.55
7 20 4.7 22.09 12 -7.5 56.25 -35.25
8 24 8.7 75.69 28 8.5 72.25 73.95
9 16 0.7 0.49 16 -3.5 12.25 -2.45
10 14 -1.3 1.69 15 -4.5 20.25 5.85
153 ∑ = 200.10 195 ∑ = 262.50 94.50
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 PORTFOLIO MANAGEMENT

Alterna vely, Standard Devia on of securi es can also be calculated as follows:

Year R1 R1² R2 R2²
1 15 225 24 576
2 10 100 20 400
3 12 144 18 324
4 8 64 14 196
5 18 324 22 484
6 16 256 26 676
7 20 400 12 144
8 24 576 28 784
9 16 256 22 256
10 14 196 15 225
153 2541 195.00 4065

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 PORTFOLIO MANAGEMENT

Ques on 10 RTP Nov 2021, RTP May 2022

Mr. A is interested to invest 1,00,000 in the securi es market. He selected two securi es B and D for this
purpose. The risk return profile of these securi es are as follows:
Security Risk (σ) Expected Return (ER)
B 10% 12%
D 18% 20%
Co-efficient of correla on between B and D is 0.15.
You are required to calculate the por olio return of the following por olios of B and D to be considered by A
for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.

Also indicate that which por olio is best for him from risk as well as return point of view?

Solu on:
We have Ep = W1E1+ W2E2 + .....................WnEn

And for Standard Devia on

Two asset por olio

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 PORTFOLIO MANAGEMENT

Subs tu ng the respec ve values we get,

(i) All funds invested in B
Ep = 12%
σp = 10%

(ii) 50% of funds in each of B & D

Ep = 0.50 x 12% + 0.50 x 20% = 16%
σ²P = (0.50)² (10%)² + (0.50)² (18%)² + 2(0.50) (0.50) (0.15) (10%) (18%)
σ²p = 25 + 81 + 13.5 = 119.50
σp = 10.93%

(iii) 75% in B and 25% in D

Ep = 0.75% x 12% + 0.25% x 20 = 14%
σ²p = (0.75)² (10%)² + (0.25%)² (18%)² + 2(0.75) (0.25) (0.15) (10%) (18%)
σ²p = 56.25 + 20.25 + 10.125 = 86.625
σp = 9.31%

(iv) All funds in D

Ep = 20%
σp = 18.0%
Por olio (i) (ii) (iii) (iv)
Return 12 16 14 20
σ 10 10.93 9.31 18
In the terms of return, we see that por olio (iv) is the best por olio. In terms of risk we see that por olio (iii) is
the best op on.

Ques on 11 Study Material

An investor has decided to invest ₹ 1,00,000 in the shares of two companies, namely. ABC and XYZ. The
projec ons of returns from the shares of the two companies along with their probabili es are as follows:
Probability ABC (%) XYZ (%)
.20 12 16
.25 14 10
.25 -7 28
.30 28 -2
You are required to
(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Por olio of these shares in equal propor ons.
(iii) Find out the propor on of each of the above shares to formulate a minimum risk por olio.

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 PORTFOLIO MANAGEMENT

Solu on:
(i)
Probability ABC (%) XYZ (%) 1 x 2 (%) 1 x 3 (%)
(1) (2) (3) (4) (5)
0.20 12 16 2.40 3.2
0.25 14 10 3.50 2.5
0.25 -7 28 -1.75 7.0
0.30 28 -2 8.40 -0.6
Average Return 12.55 12.1
Hence the expected return from ABC = 12.55% and XYZ is 12.1%

Probability (ABC - ABC) (ABC - ABC)² 1×3 (XYZ - XYZ) (XYZ - XYZ)² (1) × (6)
(1) (2) (3) (4) (5) (6)
0.20 -0.55 0.3025 0.06 3.9 15.21 3.04
0.25 1.45 2.1025 0.53 -2.1 4.41 1.10
0.25 -19.55 382.2025 95.55 15.9 252.81 63.20
0.30 15.45 238.7025 71.61 -14.1 198.91 59.64
167.75 126.98

σ² = 167.75 (%)² ; σ = 12.95%

σ² = 126.98 (%)² ; σ = 11.27%

(ii) In order to find risk of por olio of two shares, the covariance between the two is necessary here.
Probability (ABC - ABC) (XYZ - XYZ) 2x3 1x4
(1) (2) (3) (4) (5)
0.20 -0.55 3.9 -2.145 -0.429
0.25 1.45 -2.1 -3.045 -0.761
0.25 -19.55 15.9 -310.845 -77.71
0.30 15.45 -14.1 -217.845 -65.35
-144.25

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 PORTFOLIO MANAGEMENT

σ²P = (0.5² × 167.75) + (0.5² × 126.98) + 2 × (-144.25) × 0.5 × 0.5

σ²P = 41.9375 + 31.745 – 72.125
σ²P = 1.5575 or 1.56(%)
σP
E (Rp) = (0.5 × 12.55) + (0.5 × 12.1) = 12.325%
Hence, the return is 12,325% with the risk of 1.25% for the por olio. Thus, the por olio
results in the reduc on of risk by the combina on of two shares.
(iii) For construc ng the minimum risk por olio, the condi on to be sa sfied is

σX = Std. Devia on of XYZ

σA = Std. Devia on of ABC
rAX= Coefficient of Correla on between XYZ and ABC
CovAX = Covariance between XYZ and ABC.
Therefore,

%ABC = 46%, XYZ = 54%

(1 - 0.46) = 0.54

Ques on 12 Study Material

Given below is informa on of market rates of Returns and Data from two Companies A and B:
Year 2015 Year 2016 Year 2017
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5

You are required to determine the beta coefficients of the Shares of Company A and Company B

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 PORTFOLIO MANAGEMENT

Solu on:
Company A:
Year Return % Market Devia on Devia on D Ra × Rm²
(Ra) return % R(a) Rm D Rm
(Rm)

1 13.0 12.0 1.57 1.33 2.09 1.77

2 11.5 11.0 0.07 0.33 0.02 0.11
3 9.8 9.0 -1.63 -1.67 2.72 2.79
34.3 32.0 4.83 4.67

Average Ra = 11.43
Average Rm = 10.67

Company B:
Year Return % Market Devia on Devia on D Rb × Rm²
(Rb) return % R(b) Rm D Rm
(Rm)
1 11.0 12.0 0.67 1.33 0.89 1.77
2 10.5 11.0 0.17 0.33 0.06 0.11
3 9.5 9.0 -0.83 -1.67 1.39 2.79
31.0 32.0 2.34 4.67
Average Rb = 10.33
Average Rm = 10.67

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 PORTFOLIO MANAGEMENT

Ques on 13 Study Material

The distribu on of return of security F' and the market por olio 'P is given below:
Probability Return %
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security 'F' and the market por olio ‘P’, the covariance
between the market por olio and security and beta for the security.

Solu on:
Security F
Prob Rf P x Rf Devia on of F (Devia on)² (Devia on)² PX
(P) (Rf - ERf) of F
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ERf = 17 Varf = 141

Market Por olio, P

RM PM Exp. Dev. of P (Dev. (Dev.)2 (Dev. F) × (Dev. of F) ×
% Return RM (RM - ERM) Of P)2 PM (Dev. of P) (Dev. of P) × P
× ERM

-10 0.3 -3 -24 576 172.8 -312 -93.6

20 0.4 8 6 36 14.4 18 7.2
30 0.3 9 16 256 76.8 -272 -81.6
ERM = 14 VarM = 264 COVpm = -168
σ(M) = 16.25

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 PORTFOLIO MANAGEMENT

Ques on 14 Study Material, RTP Nov 11, Prac ce Manual

Assuming that shares of ABC Ltd, and XYZ Ltd. are correctly priced according to Capital Asset Pricing Model.
The expected return from and Beta of these shares are as follows:
Share Beta Expected return
ABC 1.2 19.8%
XYZ 0.9 17.1%
You are required to derive Security Market Line.

Solu on:
CAPM = Rf + β (Rm – Rf)
Accordingly
RABC = Rf +1.2 (Rm– Rf) = 19.8
RXYZ = Rf+ 0.9 (Rm – Rf) = 17.1
19.8 = Rf+1.2 (Rm – Rf) (1)
17.1 = Rf +0.9 (Rm – Rf) (2)

Deduct (2) from (1)

2.7 = 0.3 (Rm – Rf)
Rm – Rf = 9
Rf= Rm – 9
Subs tu ng in equa on (1)
19.8 = (Rm – 9) + 1.2 (Rm – Rm + 9)
19.8 = Rm - 9 + 10.8
19.8 = Rm + 1.8
Then Rm = 18% and Rf = 9%

Security Market Line = Rf+ β (Market Risk Premium) = 9% + β x 9%

Ques on 15 Study Material

Informa on related to an investment is as follows:
Risk free rate 10%
Market Return 15%
Beta 1.2
(i) What would be the return from this investment?
(ii) If the projected return is 18%, is the investment rightly valued?
(iii) What is your strategy?

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 PORTFOLIO MANAGEMENT

Solu on:
(i) Required rate of Return as per CAPM is given by
Rj = Rf + β (Rm - Rf)
= 10 + 1.2 (15 - 10) = 16%
(ii) Since projected return is 18%, the stock is not rightly valued rather undervalued as return as per CAPM
less than Projected Return.
(iii) Had this Project Return is considered as expected return, the decision should be to BUY the share.
Ques on 16 Study Material
The expected returns and Beta of three stocks are given below
Stock A B C
Expected Return (%) 18 11 15
Beta Factor 1.7 0.6 1.2
If the risk free rate is 9% and the expected rate of return on the market por olio is 14% which of the above
stocks are over, under or correctly valued in the market? What shall be the strategy?

Solu on:
Required Rate of Return is given by
Rj = Rf + β (Rm - Rf)
For Stock A, Rj = 9 + 1.7 (14 - 9) = 17.50%
Stock B, Rj = 9 + 0.6 (14 - 9) = 12.00%
Stock C, Rj = 9 + 1.2 (14 - 9) = 15.00%
Required Return % Expected Return % Valua on Decision
17.50% 18.00% Under Valued Buy
12.00% 11.00% Over Valued Sell
15.00% 15.00% Correctly Valued Hold

Ques on 17 RTP Nov 2019

Consider the following informa on on two stocks, A and B:
Year Return on A (%) Return on B (%)
2016 10 12
2017 16 18
You are required to determine:
(i) The expected return on a por olio containing A and B in the propor on of 40% and 60% respec vely.
(ii) The Standard Devia on of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correla on coefficient between the returns of the two stocks.
(v) The risk of a por olio containing A and B in the propor on of 40% and 60%.
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 PORTFOLIO MANAGEMENT
Solu on:
(i) Expected return of the por olio A and B
E (A) = (10 + 16) / 2 = 13%
E (B) = (12 + 18) / 2 = 15%
N
Rp = ∑ XiRi = 0.4(13) + 0.6(15) = 14.2%
i-1

(ii) Stock A:
Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9
Standard devia on = = 3%

Stock B:
Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9
Standard devia on = 3%

(iii) Covariance of stocks A and B

CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9
(iv) Correla on of coefficient
CovAB 9
rAB = = =1
σAσB 3 x 3
(v) Por olio Risk
= X2 Aσ2A + X2Bσ2B + 2XAXB(σAσBσAB)
2 2 2 2
= (0.4) (3) + (0.6) (3) + 2(0.4)(0.6)(3)(3)(1)

= 1.44 + 3.24 + 4.32

= 3%
Ques on 18
Data for finding out the op mal por olio are given below:
Security Mean Excess Beta Unsystema c Excess Return
Number Return Return Risk to Beta
Ri Ri – Rf β Ri - Rf
βi
1 19 14 1.0 20 14
2 23 18 1.5 30 12
3 11 6 0.5 10 12
4 25 20 2.0 40 10
5 13 8 1.0 20 8
6 9 4 0.5 50 8
7 14 9 1.5 30 6

The riskless rate of interest is 5 per cent and the market variance is 10. Determine the cut-off point.
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 PORTFOLIO MANAGEMENT

Solu on:
Security Ri - Rf (Ri - Rf) x βi ∑ (Ri - R2 f) x βi
N N
∑ Ci
2
βi σ ei i=1
σ ei i=1

1 14 0.7 0.7 0.05 0.05 4.67

2 12 0.9 1.6 0.075 0.125 7.11
3 12 0.3 1.9 0.025 0.15 7.60
4 10 1.0 2.9 0.1 0.25 8.29
5 8 0.4 3.3 0.05 0.3 8.25
6 8 0.04 3.34 0.005 0.305 8.25
7 6 0.45 3.79 0.075 0.38 7.90

Ci calcula ons are given below:

For Security 1
10 x .7
C1 = = 4.67
1 + 10 (.05)
Here 0.7 is got from column 4 and 0.05 from column 6. Since the preliminary calcula ons are over it is easy to
calculate the Ci.
10 x 1.6
C2 = = 7.11
1 + 10 (.125)
10 x 1.9
C3 = = 7.6
1 + 10 (.15)
10 x 2.9
C4 = = 8.29
1 + 10 (0.25)
10 x 3.3
C5 = = 8.25
1 + 10 (0.3)
10 x 3.34
C6 = = 8.25
1 + 10 (0.305)
10 x 3.79
C7 = = 7.90
1 + 10 (0.38)
The highest Ci value is taken as the cut-off point i.e. C*. The stocks ranked above C* have high excess returns to
beta than cut-off C and all the stocks ranked below C* have low excess returns to beta. Here, the cut-off point
is 8.29. Hence, the first four securi es i.e. 1 - 4 are selected and remaining 3 are rejected.

Now we shall compute how much to be invested in each security by calcula ng Zi for these four securi es as
follows:
B Ri - Ro
Zi = 2i
σi
(1Bi
- C* (
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 PORTFOLIO MANAGEMENT

Thus
Z1 =
1.00
20 ( 1.014 - 8.29 ( = 0.05 (5.71) = 0.2855
Z2 =
1.5
30 ( 1.518 - 8.29 ( = 0.05 (3.71) = 0.1855
Z3 =
0.5
10 ( 0.56 - 8.29 ( = 0.05 (3.71) = 0.1855
Z4 =
2
40 ( 2012 - 8.29 ( = 0.05 (1.71) = 0.0855
The propor on of investment in each stock will be computed as follows:
Z
Xi = N i
∑ Zj
i=1

N
Thus∑ Zj = 0.2855 + 0.1855 + 0.0855 = 0.742
i=1

Accordingly, propor on of investment in

0.2855
Security 1 = = 0.3848 i.e. 38.48%
0.742
0.1855
Security 2 = = 0.25 i.e. 25%
0.742
0.1855
Security 3 = = 0.25 i.e. 25%
0.742
0.0855
Security 4 = = 0.1152 i.e. 11.52%
0.742

Thus investment as per following propor on will be the op mal por olio.
Security 1 = 38.48%
Security 2 = 25%
Security 3 = 25%
Security 4 = 11.52%

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 PORTFOLIO MANAGEMENT

Ques on 19 Study Material, (8 Marks) CA Final MTP Oct 2019, RTP Nov 21
Five por olios experienced the following results during a 7 – years period:
Por olio Average Annual Standard Correla on with the
Return (RP) (%) Devia on (SP) market return (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600
Market Risk (σm) 1.2
Market rate of Return (Rm) 14.0
Risk – free Rate (Rf) 9.0

Rank the por olio using (a) Sharpe's method, (b) Treynor's method and (c) Jensen's Alpha

Solu on:
Let por olio standard devia on = σP
Market Standard Devia on = σm
Coefficient of correla on = r
r x σP
Por olio beta (βP) =
σm

Required por olio return (Rp) = Rf + βp (Rm - Rf)

Por olio Beta Return from the por olio (RP) (%)
A 1.75 17.75
B 0.90 13.50
C 0.65 12.25
D 1.25 15.25
E 0.90 13.50

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 PORTFOLIO MANAGEMENT

Por olio Sharpe Method Treynor Method Jensen’s Alpha

Ra o Rank Ra o Rank Ra o Rank
A 4.00 IV 5.71 V 1.25 V
B 3.00 V 6.67 IV 1.50 IV
C 7.50 I 9.23 I 2.75 II
D 4.25 III 6.80 III 2.25 III
E 4.50 II 9.00 I 3.60 I

Ques on 24 Study Material, MTP Sep 2022

The following are the data on five mutual funds:
Fund Return Standard Devia on Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50

You are required to compute Reward to Vola lity Ra o and rank these por olio using:
Ÿ Sharpe method and
Ÿ Treynor's method
Assuming the risk-free rate is 6%.

Solu on:
Sharpe Ra o S = (Rp - Rf) / σp
Treynor Ra o T = (Rp - Rf) / βp
Where,
Rp = Return on Fund
Rf = Risk - free rate
σp = Standard Devia on of Fund
βp = Beta of Fund

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 PORTFOLIO MANAGEMENT

Reward to Variability (Sharpe Ra o)

Mutual Fund Rp Rf Rp - Rf σp Reward to Variability Ranking
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4

Reward to Vola lity (Treynor Ra o)

Mutual Fund Rp Rf Rp - Rf βp Reward to vola lity Ranking
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3

Ques on 25
Goldman Sachs desires to construct a por olio with a 20 percent expected return. The por olio is to consist of
some combina on of Securi es X and Securi es Y, which have the following expected returns, standard
devia ons of returns, and betas:
Security X Security Y
Expected return 15% 26%
Standard devia on 10% 20%
Beta 0.94 1.33
Determine the expected beta of the por olio.

Solu on :
Let the weight of security X be X & Sec Y be (1 - X)
E (RP) = Ri - Wi
20% = 15% x X + 26 % x (1 - X)
0.20 = 0.15X + 0.26 - 0.26X
= 0.11X = 0.06
6
∴X = or 0.545
11
βp = 6 + 1.33 x 5
11 11
= 1.117 ~ 1.12 mes.
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Ques on 26
For the purpose of Valua on of a Pvt Co. in Health Care Industry we have iden fied a Proxy Firm which is listed
and belongs to same Industry. The par culars of the Proxy Firm are as follows:
βE D/E Ra o Tax Rate
2.2 0.8 32%
The Private company under considera on has the D/E Ra o of 0.6 and Effec ve Tax Rate of 30%. Find out the
Equity Capitalisa on rate (Re) for the Pvt. Co. Rf = 6% & Rm – Rf = 8%

Solu on
Calcula on of unlevered β of proxy firm
= 2.2 x ) 1
1 + 0.8 (1 - 0.32) )
= 1.4248

βe of private company
1.428 = βe x ) 1
1 + 0.6 (1 - 0.3) )
∴βe = 2.02
Ke = 6% + 2.02 (8%)
=22.16%

Ques on 27 Exam May 2024, RTP May 2024

An investor has decided to invest ₹ 1,00,000 in the shares of two companies, namely, ABC and XYZ. The
projec ons of returns from the shares of the two companies along with their probabili es are as follows:
Probability ABC (%) XYZ (%)
0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2
Required:
(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Por olio of these shares in equal propor ons.
(iii) Advise the propor on of each of the above shares to formulate a minimum risk por olio.

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 PORTFOLIO MANAGEMENT

Solu on:
(i) Probability ABC (%) XYZ (%) 1X2 (%) 1X3 (%)
(1) (2) (3) (4) (5)
0.20 12 16 2.40 3.20
0.25 14 10 3.50 2.50
0.25 -7 28 -1.75 7.00
0.30 28 -2 8.40 -0.60
Average return 12.55 12.10

Hence the expected return from ABC = 12.55% and XYZ is 12.10%
Probability (ABC- (ABC- 1X3 (XYZ- (XYZ- (1)X(6)
ABC) ABC)2 XYZ) XYZ)2
(1) (2) (3) (4) (5) (6)
0.20 -0.55 0.3025 0.06 3.9 15.21 3.04
0.25 1.45 2.1025 0.53 -2.1 4.41 1.10
0.25 -19.55 382.2025 95.55 15.9 252.81 63.20
0.30 15.45 238.2025 71.61 -14.1 198.81 59.64
167.75 126.98
2 2
σABC = 167.75(%) ; σABC = 12.95%
2
σXYZ = 126.98(%)2; σXYZ = 11.27%

(ii) In order to find risk of por olio of two shares, the covariance between the two is necessary here.
Probability (ABC - ABC) (XYZ - XYZ) 2X3 1X4
(1) (2) (3) (4) (5)
0.20 -0.55 3.9 -2.145 -0.43
0.25 1.45 -2.1 -3.045 -0.76
0.25 -19.55 15.9 -310.845 -77.71
0.30 15.45 -14.1 -217.845 -65.35
-144.25

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 PORTFOLIO MANAGEMENT

σ2P = (0.52 x 167.75) + (0.52 x 126.98) + 2 x (-144.25) x 0.5 x 0.5

2
σ P = 41.9375 + 31.745 – 72.125
σ2P = 1.5575 or 1.56(%)
2
σ P = 1.56 = 1.25%
E (Rp) = (0.5 x 12.55) + (0.5 x 12.10) = 12.325%

Hence, the return is 12.325% with the risk of 1.25% for the por olio. Thus, the por olio results in the
reduc on of risk by the combina on of two shares.

(iii) For construc ng the minimum risk por olio, the condi on to be sa sfied is
σ X2 - rAX σA σX σ X2 - Cov.AX
XABC = 2 2 or = 2 2
σ A + σ X - 2rAX σA σX σ A+ σ X- 2Cov.AX
σX = Std. Devia on of XYZ
σA = Std. Devia on of ABC
rAX= Coefficient of Correla on between XYZ and ABC
Cov.AX = Covariance between XYZ and ABC.
Therefore,
126.98 - (-144.25) 271.23
% ABC = = = 04650 or 46.50%
126.98 + 167.75 - [2x (-144.25)] 583.23

% ABC = 46.50%,
% XYZ = (1 – 0.4650) = 0.5350 = 53.50%

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 RISK MANAGEMENT

RISK
Management

Ques on 1 (4 Marks) Exam Nov 2020

On Tuesday morning (before opening of the capital market) an investor, while going through his bank
statement, has observed that an amount of ₹ 7 lakhs is lying in his bank account. This amount is available for
use from Tuesday ll Friday. The Bank requires a minimum balance of ₹ 1000 all the me. The investor desires
to make a maximum possible investment where Value at Risk (VaR) should not exceed the balance lying in his
bank account. The standard devia on of market price of the security is 1.5 per cent per day. The required
confidence level is 99 per cent.
Given
Standard Normal Probabili es
z 0.00 .01 .02 .03 .04 .05 .06 .07 .08 .09
2.2 .9861 .9864 .9868 .9871 .9875 .9878 .9881 .9884 .9987 .9890
2.3 .9893 .9896 .9998 .9901 .9904 .9906 .9909 .9911 .9913 .9916
2.4 .9918 .9920 .9922 .9923 .9925 .9929 .9931 .9932 .9934 .9936
You are required to determine the maximum possible investment

Solu on
Par culars Amount (₹)
Amount available in bank account 7,00,000
Minimum balance to be kept 1,000
Available amount which can be used for poten al investment for 4 days 6,99,000
Maximum Loss for 4 days at 99% level 6,99,000
Maximum Loss for 1 day at 99 % level = Maximum Loss for 4 days / √No. of days = 699000 √4 3,49,500
Z score at 99% Level 2.33
Vola lity in terms of Rupees (Maximum Loss / Z Score at 99% level) = 349500/2.33 1,50,000
Maximum Possible Investment (Vola lity in Rupees / Std Devia on) = 1500001.015 1,00,00,000

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 Mutual MUTUAL FUNDS
Funds
Ques on 1 Study Material
Mr. Sinha has invested in three Mutual fund schemes as per details below:
Scheme X Scheme Y Scheme Z
Date of Investment 01.12.2008 01.01.2009 01.03.2009
Amount of Investment ` 5,00,000 ` 1,00,000 ` 50,000

Net Asset Value at entry date ` 10.50 ` 10.00 ` 10.00

Dividend received upto 31.03.2009 ` 9,500 ` 1,500 Nil

NAV as at 31.3.2009 ` 10.40 ` 10.10 ` 9.80

You are required to calculate the effec ve yield on per annum basis in respect of each of the three schemes to
Mr. Sinha upto 31.03.2009.

Solu on:
Calcula on of effec ve yield on per annum basis in respect of three mutual fund schemes to Mr. Sinha up to
31-03-2009:
Par culars Mfx Mfy Mfz
(a) Investments ` 5,00,000 ` 1,00,000 ` 50,000

(b) Opening NAV ` 10.50 ` 10.00 ` 10.00

(c) No. of units (a/b) 47,619.05 10,000 5,000

(d) Unit NAV ON 31-3-2009 ` 10.40 ` 10.10 ` 9.80

(e) Total NAV on 31-3-2009 (c x d) ` 4,95,238.12 ` 1,01,000 ` 49,000

(f) Increase / Decrease of NAV (e - a) (` 4,761.88) ` 1,000 (` 1,000)

(g) Dividend Received ` 9,500 ` 1,500 Nil
(h) Total yield (f + g) ` 4,738.12 ` 2,500 (` 1,000)
(i) Number of Days 121 90 31
(j) Effec ve yield p.a. (h/a x 365/I x 100) 2.859% 10.139% (-) 23.55%

Ques on 2 Study Material

An investor purchased 300 units of a Mutual Fund at ₹ 12.25 per unit on 31st December, 2009. As on 31st
December, 2010 he has received ₹ 1.25 as dividend and ₹ 1.00 as capital gains distribu on per unit.

Required :
(i) The return on the investment if the NAV as on 31st December, 2010 is ₹ 13.00.
st
(ii) The return on the investment as on 31 December, 2010 if all dividends and capital gains distribu ons
are reinvested into addi onal units of the fund at ₹ 12.50 per unit.

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 MUTUAL FUNDS

Solu on:
Return for the year (all changes on a per year basis)
Par culars ₹ /Unit
Change in price (₹ 13.00 – ₹ 12.25) 0.75
Dividend received 1.25
Capital gain distribu on 1.00
Total Return 3.00

3.00
Return on investment = x 100 = 24.49%
12.25
Alterna vely, it can also be computed as follows:
(NAV1 - NAV0) + D1 + CG1
x 100
NAV0

(13 - 12.25) + 1.25 + 1.00

= x 100
12.25
= 24.49%

If all dividends and capital gain are reinvested into addi onal units at ₹ 12.50 per unit the posi on would be.
Total amount reinvested = ₹ 2.25 x 300 = ₹ 675
₹ 675
Addi onal units added = = 54 units
12.50
Value of 354 units as on 31-12-2010 = ₹ 4,602

Price paid for 300 units on 31-12-2009 (300 x ₹ 12.25) = ₹ 3,675

₹ 4,602 - ₹ 3,675 ₹ 927
Return = = = 25.22%
₹ 3,675 ₹ 3,675

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 MUTUAL FUNDS

Ques on 3 Study Material

Mr. Y has invested in the three mutual funds (MF) as per the following details:
Par culars MF 'X' MF 'Y' MF 'Z'
Amount of Investment (`) 2,00,000 4,00,000 2,00,000
Net Assets Value (NAV) at the me of purchase (`) 10.30 10.10 10
Dividend Received up to 31.03.2018 (`) 6,000 0 5,000
NAV as on 31.03.2018 (`) 10.25 10 10.20
Effec ve Yield per annum as on 31.03.2018 (percent) (`) 9.66 -11.66 24.15
Assume 1 Year = 365 days
Mr. Y has misplaced the documents of his investment. Help him in finding the date of his original investment
a er ascertaining the following:
(i) Number of units in each scheme;
(ii) Total NAV;
(iii) Total Yield; and
(iv) Number of days investment held.

Solu on:
(i) Number of Units in each Scheme
MF 'X' 19,417.48

MF 'Y' 39,603.96

MF 'Z' 20,000.00

(ii) Total NAV on 31.03.2018

MF 'X' 19,417.48 x ` 10.25 ` 1,99,029.17
MF 'Y' 39,603.96 x ` 10.00 ` 3,96,039.60
MF ‘Z' 20,000.00 x ` 10.20 ` 2,04,000.00
Total ` 7,99,068.77

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 MUTUAL FUNDS

(iii) Total Yield

Capital Yield Dividend Yield Total
MF 'X' ` 1,99,029.17 - ` 2,00,000 ` 6,000 ` 5,029.17
= - ` 970.83
MF 'Y' ` 3,96,039.60 - ` 4,00,000 Nil - ` 3,960.40
= - ` 3,960.40
MF 'Z' ` 2,04,000 - ` 2,00,000 ` 5,000 ` 9,000
= ` 4,000
Total ` 10,068.77

(iv) No. of Days Investment Held

MF 'X' MF 'Y' MF 'Z'
Let No. of days be X Y Z
Ini al Investment (`) 2,00,000 4,00,000 2,00,000
Yield (`) 5,029.17 - 3,960.40 9,000.00
Yield (%) 2.5146 - 0.9901 4.5
Period of Holding
(Days)

Date of Original Investment 27.12.17 01.03.18 23.01.18

Alterna vely, following dates can also be considered:

Date of Original Investment 26.12.17 28.02.18 22.01.18

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 MUTUAL FUNDS

Ques on 4 Study Material, (8 Marks) CA Final May 2019

A mutual fund company introduces two schemes i.e. Dividend plan (Plan-D) and Bonus plan (Plan-B). The face
value of the unit is ` 10. On 1-4-2005 Mr. K invested ` 2,00,000 each in Plan-D and Plan-B when the NAV was `
38.20 and ` 35.60 respec vely. Both the plans matured on 31-3-2010.

Par culars of dividend and bonus declared over the period are as follows:
Date Dividend Bonus Net Asset Value (`)
% Ra o Plan D Plan B
30-09-2005 10 39.10 35.60
30-06-2006 1:5 41.15 36.25
31-03-2007 15 44.20 33.10
15-09-2008 13 45.05 37.25
30-10-2008 1:8 42.70 38.30
27-03-2009 16 44.80 39.10
11-04-2009 1:10 40.25 38.90
31-03-2010 40.40 39.70
What is the effec ve yield per annum in respect of the above two plans?

Solu on:
Plan – D

Date Units Dividend Reinvestment New Total

held % Amount Rate Units Units
5235.60
30.09.2005 5235.60 10 5235.60 39.10 133.90 5369.50
31.03.2007 5369.50 15 8054.25 44.20 182.22 5551.72
15.09.2008 5551.72 13 7217.24 45.05 160.20 5711.92
27.03.2009 5711.92 16 9139.07 44.80 204 5915.92
31.03.2010 Maturity Value (` 40.40 x 5915.92)
Less: Cost of Acquisi on ` 2,00,000.00

Total Gain ` 39,003.17

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 MUTUAL FUNDS

Alterna vely, it can be computed by using the IRR method as follows:

NPV at 4% = -2,00,000 + 1,96,443 = -3,557

NPV at 2% = -2,00,000 + 2,16,473 = 16,473

Plan – B
Date Par culars Calcula on Working No. of units NAV (`)
1.4.05 Investment ` 2,00,000/35.60 = 5617.98 35.60
30.6.06 Bonus 5617.98/5 = 1123.60 36.25
6741.58
30.10.08 “ 6741.58/8 = 842.70 38.30
7584.28
11.4.09 “ 7584.28/10 = 758.43 38.90
8342.71
31.3.10 Maturity Value 8342.71 x ` 39.70 = 3,31,205.59
Less: Investment 2,00,000.00
Gain 1,31,205.59

Alterna vely, it can be computed by using the IRR method as follows:

NPV at 13% = -2,00,000 + 1,79,765 = -20,235
NPV at 8% = -2,00,000 + 2,25,413 = 25,413

Ques on 5 Study Material

SBI mutual fund has a NAV of ₹ 8.50 at the beginning of the year. At the end of the year NAV increases to ₹ 9.10.
Meanwhile fund distributes ₹ 0.90 as dividend and ₹ 0.75 as capital gains.

(I) What is the fund's return during the year?

(ii) Had these distribu ons been re-invested at an average NAV of ₹ 8.75 assuming 200 units were
purchased originally. What is the return?

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 MUTUAL FUNDS

Solu on:
(i) Normal Return for the year (all changes on a per year basis)
Par culars ₹ /Unit
Change in price (₹ 9.10 – ₹ 8.50) 0.60
Dividend received 0.90
Capital gain distribu on 0.75
Total Return 2.25

(ii) If all dividends and capital gain are reinvested into addi onal units at ₹ 8.75 per unit the posi on would
be.
Total amount reinvested = ₹ 1.65 x 200 = ₹ 330

Value of 237.71 units at end of year = ₹ 2,163.16

Price paid for 200 units in beginning of the year (200 × ₹ 8.50) = ₹ 1,700

Ques on 6
Cinderella Mutual Fund has the following assets in Scheme Rudolf at the close of business on 31 March,
2014.
Company No. of Shares Market Price Per Share
Nairobi Ltd. 25000 ₹ 20
Dakar Ltd. 35000 ₹ 300
Senegal Ltd. 29000 ₹ 380
Cairo Ltd. 40000 ₹ 500

The total number of units of Scheme Rudolf are 10 lacs. The Scheme Rudolf has accrued expenses of ₹
2,50,000 and other liabili es of ₹ 2,00,000. Calculate the NAV per unit of the Scheme Rudolf.

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 MUTUAL FUNDS

Solu on:
Shares No. of shares Price Amount (₹)
Nairobi Ltd. 25,000 20.00 5,00,000
Dakar Ltd. 35,000 300.00 1,05,00,000
Senegal Ltd. 29,000 380.00 1,10,20,000
Cairo Ltd. 40,000 500.00 2,00,00,000
4,20,20,000
Less: Accrued Expenses 2,50,000
Other Liabili es 2,00,000
Total Value 4,15,70,000
No. of Units 10,00,000
NAV per Unit (4,15,70,000/10,00,000) 41.57

Ques on 7 Study Material

On 1 April 2009 Fair Return Mutual Fund has the following assets and prices at 4.00 p.m.
Shares No. of Shares Market Price Per Share (₹)
A Ltd. 10000 19.70
B Ltd. 50000 482.60
C Ltd. 10000 264.40
D Ltd. 100000 674.90
E Ltd. 30000 25.90
No. of units of funds 8,00,000
Please calculate:
(a) NAV of the Fund on 1 April 2009.
(b) Assuming that on 1 April 2009, Mr. X, a HNI, send a cheque of ₹ 50,00,000 to the Fund and Fund
Manager immediately purchases 18000 shares of C Ltd. and balance is held in bank. Then what will be
posi on of fund.
(c) Now suppose on 2 April 2009 at 4.00 p.m. the market price of shares is as follows:
Shares (₹)
A Ltd. 20.30
B Ltd. 513.70
C Ltd. 290.80
D Ltd. 671.90
E Ltd. 44.20
Then what will be new NAV.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 73
 MUTUAL FUNDS

Solu on:
(a) B
NAV of the fund

(b) The revised posi on of fund shall be as follows:

Shares No. of Shares Price Amount (₹)
A Ltd. 10000 19.70 1,97,000
B Ltd. 50000 482.60 2,41,30,000
C Ltd. 28000 264.40 74,03,200
D Ltd. 100000 674.90 6,74,90,000
E Ltd. 30000 25.90 7,77,000
Cash 2,40,800
10,02,38,000

(c) On 2ⁿ April 2009, the NAV of fund will be as follows:

Shares No. of Shares Price Amount (₹)
A Ltd. 10000 20.30 2,03,000
B Ltd. 50000 513.70 2,56,85,000
C Ltd. 28000 290.80 81,42,400
D Ltd. 100000 671.90 6,71,90,000
E Ltd. 30000 44.20 13,26,000
Cash 2,40,800
10,27,87,200

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 MUTUAL FUNDS

Ques on 8 (8 Marks) Exam Jan 21

On 1st January, 2020, an open ended scheme of mutual fund had outstanding units of 300 lakhs with a NAV of
₹ 20.25. At the end of January 2020, it had issued 5 lakhs units at an opening NAV plus a load of 2%, adjusted
for dividend equalisa on. At the end of February 2020, it had repurchased 2.5 lakhs units at an opening NAV
less 2% exit load adjusted for dividend equalisa on. At the end of March 2020, it had distributed 70 per cent of
its available income.
In respect of January - March quarter, the following addi onal informa on is available:
` in lakh

Value apprecia on of the Por olio ₹ 460 lakhs

Income for January ₹ 24 lakhs
Income for Fabruary ₹ 36 lakhs
Income for March ₹ 47 lakhs
You are required to calculate
(i) Income available for distribu on
(ii) Issue price at the end of January
(iii) Repurchase price at the end of February
(iv) Closing Value of Net Asset at the end March.

Solu on:
(i) Calcula on of Income available for Distribu on
Units Per Unit Total
(Lakh) (`) (` In lakh)
Income from January 300 0.0800 24.0000
Add Dividend equaliza on collected on issue 5 0.0800 0.4000
305 0.0800 24.4000
Add Income from February 0.1180 36.0000
305 0.1980 60.4000
Less : Dividend equaliza on paid on repurchase 2.50 0.1980 (0.4950)
302.50 0.1980 59.9050
Add Income from March 0.1554 47.0000
302.50 0.3534 106.9050
Less: Dividend Paid 0.2474 (74.8335)
302.50 0.1060 32.0715
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 MUTUAL FUNDS

(ii) Calcula on of Issue Price at the end of January

`

Opening NAV 20.250

Add: Entry Load 2% of ` 20.25 0.405
20.655
Add: Dividend Equaliza on collected on Issue Price 0.080
20.735

(iii) Calcula on of Repurchase Price at the end of February

`

Opening NAV 20.250

Less: Exit Load 2% of ` 20.250 (0.405)
19.845
Add: Dividend Equaliza on paid on Issue Price 0.198
20.043

(iv) Closing NAV at the end of March

` (Lakh)

Opening Net Asset Value (` 20.25 x 300) 6075.000

Por olio Value Apprecia on 460.000
Issue of Fresh Units (5 x 20.735) 103.675
Income Received
(24 + 36 + 47) 107.000
6745.675
Less: Units repurchased (2.5 x 20.043) -50.1075
Income Distributed -74.8335 (-124.941)
Closing Net Asset Value 6620.734
Closing Units (300 + 5 – 2.5) lakh 302.50 lakh
st
Closing NAV as on 31 March ` 21.8867

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 Management of
MANAGEMENT OF BONDS PORTFOLIO
Bonds Portfolio
Ques on 1
The market value of a ` 1,000 par value bond, carrying a coupon rate of 14% and maturing a er 5 years, is `
1050. What is the yield to maturity(YTM) on this bond? What is the approximate YTM? What will be the
realized Yield To Maturity if the reinvestment rate is 6%?

[Ans: Approximate YTM 12.6%, RYTM = 11.25%]

Solu on:
The YTM is the value of r in the following equality:

= 140 (PVIFAr, 5 yrs) + 1,000 (PVIFr, 5 yrs)

Let us try a value of 13 percent for r. The right hand side of the above expression becomes:
= 140 (PVIFA13%, 5 yrs) + 1,000 (PVIF13%, 5 yrs)
= 140 (3.517) + 1,000 (0.543)
= 492.4 + 543.0 = ` 1035.4
Since this is less than ` 1,050, we try a lower value for r. Let us try r = 12 percent.
This makes the right-hand side equal to:
= 140 (PVIFA12%, 5 yrs) + 1,000 (PVIF12%, 5 yrs)
= 140 (3.605) + 1,000 (0.567)
= 504.7 + 567.0 = ` 1071.7

Thus, r lies between 12 percent and 13 percent. Using a linear interpola on in this range, we find that r is equal to:

(b) The approximate YTM works out to:

(c) The realised yield to maturity may be calculated as follows:

Future value of interest and principal repayment
4 3 2 1
= 140 (1.06) + 140 (1.06) + 140 (1.06) + 140 (1.06) + 140 + 1000
= ` 1789.2
5
Present market price (1+r*) = ` 1789.2
5
` 1050 x (1 + r*) = ` 1789.2
5
(1 + r*) = 1.70399
1/5
r* = 1.70399 - 1
= 1.112489 - 1 = 11.2489 percent ~ 11.25%
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 MANAGEMENT OF BONDS PORTFOLIO

Ques on 2
An investor is considering the purchase of the following Bond:
Face value ₹ 100
Coupon rate 11%
Maturity 3 years

(i) If he wants a yield of 13% what is the maximum price, he should be ready to pay for?
(ii) If the Bond is selling for ₹ 97.60, what would be his yield?

Solu on:
(i) Calcula on of Maximum price
B0 = ₹ 11 × PVIFA (13%, 3) + ₹ 100 × PVIF (13%, 3)
= ₹ 11 × 2.361 + ₹ 100 × 0.693 = ₹ 25.97 + ₹ 69.30 = ₹ 95.27
(ii) Calcula on of yield
At 12% the value = ₹ 11 × PVIFA (12%, 3) + 100 × PVIF (12%, 3)
= ₹ 11 × 2.402 + ₹ 100 × 0.712 = ₹ 26.42 + ₹ 71.20 = ₹ 97.62
It the bond is selling at ₹ 97.60 which is more than the fair value, the YTM of the bond would be less than
13%. This value is almost equal to the amount price of ₹ 97.60. Therefore, the YTM of the bond would be
12%.

Alterna vely
(₹ 100 - ₹ 97.60)
₹ 11 +
3
YTM = = 0.1194 or 11.94% say 12%
(₹ 100 - ₹ 97.60)
2
Ques on 3 Study Material
Nominal value of 10% bonds issued by a company is ` 100. The bonds are redeemable at ` 110 at the end of
year 5. Determine the value of the bond if required yield is (i) 5%, (ii) 5.1%, (iii) 10% and (iv) 10.1%

Solu on:
Case (i) Required yield rate = 5%
Year Cash Flow ` DF (5%) Present Value `
1-5 10 4.3295 43.295
5 110 0.7835 86.185
Value of bond 129.48

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 MANAGEMENT OF BONDS PORTFOLIO

Case (ii) Required yield rate = 5.1%

Year Cash Flow ` DF (5.1%) Present Value `
1-5 10 4.3175 43.175
5 110 0.7798 85.778
Value of bond 128.958

Case (iii) Required yield rate = 10%

Year Cash Flow ` DF (10%) Present Value `
1-5 10 3.7908 37.908
5 110 0.6209 68.299
Value of bond 106.207

Case (iv) Required yield rate = 10.1%

Year Cash Flow ` DF (10.1%) Present Value `
1-5 10 3.7811 37.811
5 110 0.6181 67.991
Value of bond 105.802

Ques on 4 Study Material

A conver ble bond with a face value of ` 1,000 is issued at ` 1,350 with a coupon rate of 10.5%. The conversion
rate is 14 shares per bond. The current market price of bond and share is ` 1,475 and ` 80 respec vely. What is
the premium over conversion value?

Solu on:
Conversion rate is 14 shares per bond. Market price of share ` 80
Conversion value 14 x ` 80 = ` 1120
Market price of bond = ` 1475

Ques on 5
A hypothe cal company ABC Ltd. issued a 10% Debenture (Face Value of ₹ 1000) of the dura on of 10 years is
currently trading at ₹ 850 per debenture. The bond is conver ble 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.
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 MANAGEMENT OF BONDS PORTFOLIO

The relevant present value table is as follows.

Present t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
Values
PVF0.11,t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVF0.13,t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295

Solu on:
Conversion Price = ₹ 50 x 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 x 5.890 + 1000 x 0.352
= 91
Now let us discount the cash flows by 13%
850 = 100 PVAF (13%, 10) + 1000 PVF (13%, 10)
850 = 100 x 5.426 + 1000 x 0.295
= -12.40
Accordingly, IRR
90.90
11% + x (13% - 11%)
90.90 -(-12.40)

90.90
11% + x (13% - 11%)
103.30
= 12.76%
The spread from comparable bond = 12.76% - 11.80% = 0.96%

Ques on 6
The following data is related to 8.5% Fully Conver ble (into Equity shares) Debentures issued by JAC Ltd. at `
1000.
Market Price of Debenture ` 900

Conversion 30
Straight Value of Debenture ` 700

Market Price of Equity share on the date of Conversion ` 25

Expected Dividend Per Share `1

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 MANAGEMENT OF BONDS PORTFOLIO

You are required to calculate:

(a) Conversion Value of Debenture
(b) Market Conversion Price
(c) Conversion Premium per share
(d) Ra o of Conversion Premium
(e) Premium over Straight Value of Debenture
(f) Favourable income differen al per share
(g) Premium pay back period

(a) Conversion Value of Debenture

= Market Price of one Equity Share X Conversion Ra o
= ` 25 x 30 = ` 750

(b) Market Conversion Price

(c) Conversion Premium per share

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

(d) Ra o of conversion Premium

(e) Premium over Straight Value of Debenture

(f) Favourable income differen al per share

(g) Premium pay back period

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 MANAGEMENT OF BONDS PORTFOLIO

Ques on 7 Study Material, (8 Marks) CA Final July 2021

The data given below relates to a conver ble bond:
Face value ` 250

Coupon rate 12%

No. of shares per bond 20
Market price of share ` 12

Straight value of bond ` 235

Market price of conver ble bond ` 265

Calculate:
(i) Stock value of bond.
(ii) The percentage of downside risk.
(iii) The conversion premium
(iv) The conversion parity price of the stock and also interpret the results

Solu on:
(i) Stock value or conversion value of bond
12 x 20 = ` 240

(ii) Percentage of the downside risk

This ra o gives the percentage price decline experienced by the bond if the stock
becomes worthless.

(iii) Conversion Premium

(iv) Conversion Parity Price

This indicates that if the price of shares rises to ` 13.25 from ` 12 the investor will neither gain nor loss on
buying the bond and exercising it. Observe that ` 1.25 (` 13.25 - ` 12.00) is 10.42% of ` 12, the
Conversion Premium.
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 MANAGEMENT OF BONDS PORTFOLIO

Ques on 8 (5 Marks) CA Final Nov 2016,CA Final MTP Oct 2019

A Ltd has issued conver ble bonds, which carries a coupon rate of 14%. Each bond is conver ble into 20 equity
shares of the company A Ltd. The prevailing interest rate, for similar credit ra ng bond is 8%. The conver ble
bond has 5 years maturity. It is redeemable at par at ` 100.
The relevant present value table is as follows
Present values t1 t2 t3 t4 t5
PVIF0.14,t 0.877 0.769 0.675 0.592 0.519
PVIF0.08, t 0.926 0.857 0.794 0.735 0.681

You are required to es mate

(Calcula ons be made upto 3 decimal places)
(i) current market price of the bond, assuming it being equal to its fundamental value,
(ii) minimum market price of equity share at which, bond holder should exercise conversion op on; and
(iii) dura on of the bond.

Solu on:
(i) Current Market Price of Bond
Time CF PVIF 8% PV (CF) PV (CF)
1 14 0.926 12.964
2 14 0.857 11.998
3 14 0.794 11.116
4 14 0.735 10.290
5 114 0.681 77.634
∑ PV (CF) i.e. P0 = 124.002

Say ` 124.00
(ii) Minimum Market Price of Equity Shares at which Bondholder should exercise conversion op on:

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 MANAGEMENT OF BONDS PORTFOLIO

(iii) Dura on of the Bond

Year Cash P.V. @ 8% Propor on of Propor on of bond
flow bond value value x me (years)
1 14 0.926 12.964 0.105 0.105
2 14 0.857 11.998 0.097 0.194
3 14 0.794 11.116 0.089 0.267
4 14 0.735 10.290 0.083 0.332
5 114 0.681 77.634 0.626 3.130
124.002 1.000 4.028

Ques on 9
Mr. A has the following liabili es
Years Liability
2 60,000
3 40,000
5 50,000
If opportunity cost of Funds is 10%. He has decided to invest in the following 2 bonds –
1 year ZCB presently yielding 10%
7 year ZCB presently yielding 10%
What propor on of funds should be invested in these 2 bonds, to achieve immuniza on?

Solu on:
Step 1 – Calcula on of DL
Years (X) Liability Amount PV@10% (w) WX
2 60,000 49,587 99,174
3 40,000 30,053 90,159
5 50,000 31,046 155,230
1,10,686 344563

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 MANAGEMENT OF BONDS PORTFOLIO

Step 2 – For immuniza on

DA = DL

Step 3 – w x 1 + (1 - w) 7 = 3.11
W + 7 – 7w = 3.11
- 6w = - 3.89
W = 0.65
So, 1 – w = 0.35

Step 4 – So, propor on funds to be invested –

In the one year ZCB = 65%
In the 7 year ZCB = 35%
Ques on 10 RTP May 2022
Following is the informa on for the op ons free bond:
Face value of the bond ₹ 1000
Coupon rate 7%
Terms of Maturity 7 years
Yield to Maturity 8%
You are required to calculate:
(i) Market price of the Bond and dura on.
(ii) If there is an increase in yield by 35 basis points, what would be the price of bond?
Present Value t1 t2 t3 t4 t5 t6 t7
PVIF0.07,t 0.935 0.874 0.817 0.764 0.714 0.667 0.623
PVIF0.08,t 0.926 0.857 0.794 0.735 0.681 0.631 0.584

Solu on

(i) (1) Market price and dura on of Bond

= 70 (PVIAF 8%,7) + 1,000 (PVIF 8%,7)
= 70 (5.208) + 1,000 (0.584) = 364.56 + 584.00 = 948.56

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 MANAGEMENT OF BONDS PORTFOLIO

(2) Dura on of Bond

Period Cash flow (₹) PVF@ 8% PV ( ₹) (E)
(A) (B) (C) (D) = (B) x (C) = (A) x (D)
1 70 0.926 64.82 64.82
2 70 0.857 59.99 119.98
3 70 0.794 55.58 166.74
4 70 0.735 51.45 205.80
5 70 0.681 47.67 238.35
6 70 0.631 44.17 265.02
7 1,070 0.584 624.88 4374.16
948.56 5434.87
5434.87
Dura on of the Bond is = 5.73 years
948.56
(ii) Price of Bond if increase in yield by 35 basis points
Period Cash flow (₹) PVF @8.35% PV (₹)
1 70 0.923 64.61
2 70 0.852 59.64
3 70 0.786 55.02
4 70 0.726 50.82
5 70 0.670 46.90
6 70 0.618 43.26
7 1,070 0.570 609.90
930.15
Alterna vely, if the same increase in yield is linked with dura on as computed in sub part (i), then
answer will be computed as follows:
Dura on 5.73
Vola lity of Bond = = = 5.306
1 + YTM 1+0.08
The expected market price if increase in yield is by 35 basis points.
= ₹ 948.56 x 0.35 (5.306/100) = ₹ 17.62
Hence expected market price is ₹ 948.56 – ₹ 17.62 = ₹ 930.94
Hence, the market price will decrease with increase in the yield.

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 Derivatives Analysis
DERIVATIVES
& Valuation
UNIT I
FORWARD & FUTURES
Ques on 1
Consider a 4-month forward contract on 500 shares with each share priced at ₹ 75. Dividend @ ₹ 2.50 per
share is expected to accrue to the shares in a period of 3 months. The CCRRI is 10% p.a.

The value of the forward contract is as follows:

Dividend proceeds = 500 x 2.50 = 1250
- (3/12)(0.10)
= 1250e = 1219.13
Value of forward contract = (500 x 75 – 1219.13) e(4/12)(0.10)
0.033
= 36280.87 x e
= ₹ 37498.11
However, in case the income accre on to the securi es is in the form of percentage yield, y, as in the case of
stock indices arising on account of dividend accruals to individual stocks cons tu ng the index, the above
formula will read as follows:
A = Pe n(r–y)
Ques on 2
Suppose that there is a future contract on a share presently trading at ₹ 1000. The life of future contract is 90 days
and during this me the company will pay dividends of ₹ 7.50 in 30 days, ₹ 8.50 in 60 days and ₹ 9.00 in 90 days.

Assuming that the Compounded Con nuously Risk free Rate of Interest (CCRRI) is 12% p.a. you are required to
find out:

(a) Fair Value of the contract if no arbitrage opportunity exists.

(b) Value of Cost to Carry
-0.01 -0.02 -0.03 0.03
[Given e = 0.9905; e = 0.9802; e = 0.97045 and e = 1.03045]

Solu on:
(a) First of all we shall calculate the PV of Dividend Proceed which is as follows:
-0.12 x 30/360 -0.12 x 60/360 -0.12 x 90/360
= ₹ 7.50 * e + ₹ 8.50 * e + 9.00 * e
-0.01 -0.02 -0.03
= ₹ 7.50 * e + ₹ 8.50 * e + ₹ 9.00 * e
= ₹ 7.50 x 0.9905+ ₹ 8.50 x 0.9802 + ₹ 9.00 x 0.97045
= ₹ 7.43+ ₹ 8.33+ ₹ 8.73
= ₹ 24.49
0.12 x 90/360
Fair Value of Future Contract = (₹ 1000 – PV of Dividend Proceeds) x e
= (₹ 1000 – ₹ 24.49 ) x 1.03045 = ₹ 1005.21

(b) Since, Value of Future Contract = Spot Price + Cost to Carry

₹ 1005.21 = ₹ 1000+Cost to Carry
Cost to Carry = ₹ 5.21
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 DERIVATIVES

Ques on 3 (4 Marks) June 09, MTP Sep 2022, RTP Nov 17, Study Material
The share of X Ltd. is currently selling for ₹ 300. Risk free interest rate is 0.8% per month. A three months
futures contract is selling for ₹ 312. Develop an arbitrage strategy and show what your riskless profit will be 3
months hence assuming that X Ltd. will not pay any dividend in the next three months.

Solu on:
The appropriate value of the 3 months futures contract is -
F₀ = ₹ 300 (1.008)³ = ₹ 307.26
Since the futures price exceeds its appropriate value it pays to do the following: -
Ac on Ini al Cash flow at me T
Cash flow (3 months)
Borrow ₹ 300 now and repay with + ₹ 300 - ₹ 300 (1.008)³
interest a er 3 months = - ₹ 307.26
Buy a share - ₹ 300 *Se lement Trade
Sell a futures contract (F₀ = 312) 0 ₹ 312 - ST
Total ₹0 ₹ 4.74
Such an ac on would produce a risk less profit of ₹ 4.74

Ques on 4 (6 Marks) MTP May 2021

Ms. Pree , a school teacher, a er re rement has built up a por olio of ₹ 1,20,000 which is as follow:
Stock No. of shares Market price per share (₹) Beta
ABC Ltd. 1000 50 0.9
DEF Ltd. 500 20 1.0
GHI Ltd. 800 25 1.5
JKL Ltd. 200 200 1.2
Suppose she has been advised to bring down the beta of her por olio to 0.8.

Advise how much risk-free investment should be bought in to reduce the beta to 0.8?

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 DERIVATIVES

Solu on:
Security No. of shares Market Price of (1) x (2) % to total β (x) wx
(1) Per Share (2) (w)
ABC 1000 50 50000 0.4167 0.9 0.375
DEF 500 20 10000 0.0833 1 0.083
GHI 800 25 20000 0.1667 1.5 0.250
JKL 200 200 40000 0.3333 1.2 0.400
120000 1 1.108
(i) Por olio beta 1.108

(ii) Required Beta 0.8

It should become (0.8 / 1.108) 72.2 % of present por olio
If ₹ 1,20,000 is 72.20%, the total por olio should be
₹ 1,20,000 × 100/72.20 or ₹ 1,66,205
Addi onal investment in zero risk should be (₹ 1,66,205 – ₹ 1,20,000) = ₹ 46,205

Revised Por olio will be

Security No. of shares Market Price of (1) x (2) % to total β (x) wx
(1) Per Share (2) (w)
ABC 1000 50 50000 0.3008 0.9 0.271
DEF 500 20 10000 0.0602 1 0.060
GHI 800 25 20000 0.1203 1.5 0.180
JKL 200 200 40000 0.2407 1.2 0.289
Risk free -- -- 46205 0.2780 0 0
asset
166205 1 0.800

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 DERIVATIVES

UNIT II
OPTIONS
Ques on 5
A call op on has been entered into by Arnav for delivery of share of X Ltd. at ₹ 460. The expected future prices
at the me of expiry of contract are as follows:
470 0.20

450 0.25

480 0.35

490 0.05

500 0.15
Determine the premium at which Arnav will break even i.e calculate Fair OP of Call.

Solu on:
Maturity Exercise OP of Call on Expiry Prob Fair Expected
Price Price Max [MPS-EP,0] Premium
470 460 10 0.20 2
450 460 0 0.25 0
480 460 20 0.35 7
490 460 30 0.05 1.5
500 460 40 0.15 6
16.5

Tutorial Note: Remember at Fair OP (Op on Premium), both the par es will be at breakeven.

Ques on 6 Study Material, (8 Marks) CA Final May 2019, RTP May 2022
Mr. John established the following spread on the TTK Ltd.'s stock:
1. Purchased one 3-month put op on with a premium of ₹ 15 and an exercise price of ₹ 900.
2. Purchased one 3-month call op on with a premium of ₹ 90 and an exercise price of ₹ 1100.

TTK Ltd.'s stock is currently selling at ₹ 1000. Calculate gain or loss, if the price of stock of TTK Ltd. -
(i) Remains at ₹ 1000 a er 3 months.
(ii) Falls to ₹ 700 a er 3 months.
(iii) Raises to ₹ 1200 a er 3 months.

Assume the size of op on is 200 shares of TTK Ltd.

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 DERIVATIVES

Solu on:
(i) Total premium paid on purchasing a call and put op on
= (₹ 15 per share x 200) + (₹ 90 per share x 200).
= ₹ 3,000 + ₹ 18,000 = ₹ 21,000

In this case, Mr. John exercises neither the call op on nor the put op on as both will result in a loss for
him.

Ending value = - ₹ 21000 + zero gain = - ₹ 21000

i.e. Net loss = ₹ 21000

(ii) Since the price of the stock is below the exercise price of the call, the call will not be exercised. Only put is
valuable and is exercised.

Net Gain = (Exercise Price - Current Price) x No of Shares - Premium Paid

Total premium paid = ₹ 21000

Ending value = - ₹ 21000 + ₹ [(900 - 700) x 200] = ₹ 19,000

Net gain = ₹ 19,000

(iii) In this situa on, the put is worthless, since the price of the stock exceeds the put's exercise price. Only
call op on is valuable and is exercised.
Total premium paid = ₹ 21000

Ending value = ₹ 21000 + ₹ [(1200 - 1100) x 200] = - ₹ 1000

Net Loss = ₹ 1,000

Ques on 7 Study Material, (8 Marks) CA Final Nov 2012

You as an investor had purchased a 4 month call op on on the equity shares of X Ltd. of ₹ 10, of which the
current market price is ₹ 132 and the exercise price ₹ 150. You expect the price to range between ₹ 120 to ₹
190. The expected share price of X Ltd. and related probability is given below:
Expected Price (₹) 120 140 160 180 190
Probability .05 .20 .50 .10 .15
Compute the following:
1) Expected Share price at the end of 4 months.
2) Value of Call Op on at the end of 4 months, if the exercise price prevails.
3) In case the op on is held to its maturity, what will be the expected value of the call op on?

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 DERIVATIVES

Solu on:
(i) Expected Share Price
= ₹ 120 x 0.05 + ₹ 140 x 0.20 + ₹ 160 x 0.50 + ₹ 180 x 0.10 + ₹ 190 x 0.15
= ₹ 6 + ₹ 28 + ₹ 80 + ₹ 18 + ₹ 28.50 = ₹ 160.50

(ii) Value Of Call Op on

= ₹ 150 - ₹ 150 = Nil

(iii) If the op on is held ll maturity the expected Value of Call Op on

Expected price (X) Value of call (C) Probability (P) Exercise / Lapse CP
₹ 120 0 0.05 Lapse 0
₹ 140 0 0.20 Lapse 0
₹ 160 ₹ 10 0.50 Exercise ₹5
₹ 180 ₹ 30 0.10 Exercise ₹3
₹ 190 ₹ 40 0.15 Exercise ₹6
Total ₹ 14
*If the strike price goes below ₹ 150, op on is not exercised at all.

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 ForeignFOREIGN
Exchange Exposure
& Risk Management
EXCHANGE EXPOSURE & RISK MANAGEMENT

UNIT II
TYPES OF RISKS & RISK MANAGEMENT

Ques on 1 Study Material, May 15 (5 Marks), Prac ce Manual

DEF Ltd. has imported goods to the extent of US$ 1 crore. The payment terms are 60 days interest-free credit.
For addi onal credit of 30 days, interest at the rate of 7.75% p.a. will be charged.
The banker of DEF Ltd. has offered a 30 days loan at the rate of 9.5% p.a. Their quote for the foreign exchange is
as follows:
Spot rate INR/US$ 62.50
60 days forward rate INR/US$ 63.15
90 days forward rate INR/US$ 63.45

Which one of the following op ons would be be er?

(i) Pay the supplier on 60th day and avail bank loan for 30 days.
(ii) Avail the supplier's offer of 90 days credit.

Solu on:
(i) Pay the supplier in 60 days
If the payment is made to supplier in 60 days ₹ 63.15
the applicable forward rate for 1 USD
Payment Due USD 1 crore
Ou low in Rupees (USD 1 crore x ₹ 63.15) ₹ 63.15 crore
Add: Interest on loan for 30 days @ 9.5% p.a. ₹ 0.50 crore
Total Ou low in ₹ ₹ 63.65 crore

(ii) Availing supplier’s offer of 90 days credit

Amount Payable USD 1.00000 crore
Add: Interest on credit period for 30 [email protected]% p.a. USD 0.00646 crore
Total Ou low in USD USD 1.00646 crore
Applicable forward rate for 1 USD ₹ 63.45
Total Ou low in ₹ (USD 1.00646 crore × ₹ 63.45) ₹ 63.86 crores
Alterna ve 1 is be er as it entails lower cash ou low.

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Ques on 2 Study Material, Nov 2014 (8 Marks), MTP Sept 16 (5 Marks), MTP May 20 (4 Marks), Prac ce Manual

Gibralter Limited has imported 5000 bo les of shampoo at landed cost in Mumbai, of US $ 20 each. The
company has the choice for paying for the goods immediately or in 3 months’ me. It has a clean overdra
limit where 14% p.a. rate of interest is charged.

Calculate which of the following method would be cheaper to Gibralater Limited.

(i) Pay in 3 months’ me with interest @ 10% p.a. and cover risk forward for 3 months.
(ii) Se le now at a current spot rate and pay interest of the overdra for 3 months.

The rates are as follows:

Mumbai ₹/$ spot: 60.25 - 60.55
3 months swap Points: 35/25

Solu on:
Op on - I
Import Value $20 x 5000 = $ 1,00,000
Repayment in 3 months’ me = $ 1,00,000 x (1 + 0.10/4) $ 1,02,500
3-months outright forward rate ₹ 59.90/₹ 60.30
Repayment obliga on in ₹ ($ 1,02,500 x ₹ 60.30) ₹ 61,80,750

Op on - II
Overdra ($1,00,000 x ₹ 60.55) ₹ 60,55,000
Interest on Overdra (₹ 60,55,000 x 0.14/4) ₹ 2,11,925
₹ 62,66,925
Op on I should be preferred as it has lower ou low.

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 3 Study Material, (6 Marks) CA Final Nov 2008, RTP Nov 2009, Nov 2012
An Indian expor ng firm, Rohit and Bros., would be cover itself against a likely deprecia on of pound sterling.
The following data is given :
Receivables of Rohit and Bros £ 500,000
Spot rate ₹ 56.00/£
Payment date 3-months
3 months interest rate India : 12 per cent per annum
UK : 5 per cent per annum
What should the exporter do?

[Ans: 2,84,83,941]

Solu on:
Rohit and Bros may cover the risk in the money market. The following steps are required to be taken:

(i) Borrow pound sterling for 3- months. The borrowing has to be such that at the end of three months, the
amount becomes £ 500,000. Say, the amount borrowed is £ X.
Therefore

(ii) Convert the borrowed sum into Rs at the spot rate. This gives: £493,827 x ₹ 56 = ₹ 27,654,312

(iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the end of 3- months:

(iv) The sum of £ 500,000 received from the client at the end of 3-months is used to refund the loan taken
earlier.

From the calcula ons. It is clear that the money market opera on has resulted into a net gain of ₹ 483,941 (₹
28,483,941 – ₹ 500,000 x 56). If pound sterling has depreciated in the mean me. The gain would be even
bigger.

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 4 Study Material

EFD Ltd. is an export business house. The company prepares invoice in customers' currency. Its debtors of US$
10,000,000 is due on April 1, 2015.
Market informa on as at January 1, 2015 is:
Exchange rates US $/INR Currency Futures US $/INR
Spot 0.016667 Contract size: ₹ 24,816,975
1-month forward 0.016529 1-month 0.016519
3-months forward 0.016129 3-months 0.016118

Ini al margin Interest rates in India

1-Month ₹ 17,500 6.5%
3-Months ₹ 22,500 7%

On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate is 0.016134.

Which of the following methods would be most advantageous to EFD Ltd.

(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk

Solu on:
Receipts using a forward contract = $ 10,000,000/0.016129 = ₹ 620,001,240
Receipts using currency futures
The number of contracts needed is = 25
($ 10,000,000/0.016118)/24,816,975
Ini al margin payable is 25 contracts x ₹ 22,500 = ₹ 5,62,500
On April 1, 2015 Close at 0.016134
Receipts = US$ 10,000,000/0.016136 = ₹ 619,732,276

Varia on Margin
(0.016134 - 0.016118) x 25 x 24,816,975]/0.016136 =
OR (0.000016 x 25 x 24,816,975) / = ₹ 615,195
0.016136 = 9926.79/0.016136
Less: Interest Cost - ₹ 5,62,500 x 0.07 x 3/12 ₹ 9,844
Net Receipts ₹ 620,337,627
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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Receipts under different methods of hedging

Forward contract ₹ 620,001,240
Future contract ₹ 620,337,627
No Hedge (US$ 10,000,000/ 0.016136) ₹ 619,732,276
The most advantageous op on would have been to hedge with futures.

Ques on 5 CA Final RTP May 2010

Wenden Co is a Dutch-based company which has the following expected transac ons.
One month: Expected receipt of £ 2,40,000
One month: Expected payment of £ 1,40,000
Three months: Expected receipts of £ 3,00,000
The finance manager has collected the following informa on:
Spot rate (£ per €): 1.7820 + 0.0002
One month forward rate (£ per €): 1.7829 + 0.0003
Three months forward rate (£ per €): 1.7846 + 0.0004

Money market rates for Wenden Co:

Borrowing Deposit
One year Euro interest rate: 4.9 4.6
One year Sterling interest rate: 5.4 5.1
Assume that it is now 1 April.
Required:
(a) Calculate the expected Euro receipts in one month and in three months using the forward market.
(b) Calculate the expected Euro receipts in three months using a money-market hedge and
recommend whether a forward market hedge or a money market hedge should be used.

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Solu on:
(a) Forward market evalua on
Net receipt in 1 month = £ 2,40,000 – £1,40,000 = £ 1,00,000
Wenden Co needs to sell Sterling at exchange rate of (1.7829 + 0.0003) = £1.7832 per €
Euro value of net receipt = 1,00,000/1.7832 = € 56,079
Receipt in 3 months = £ 3,00,000
Wenden Co needs to sell Sterling at exchange rate of 1.7846 + 0.0004 = £1.7850 per €
Euro value of receipt in 3 months = 3,00.000/1.7850 = € 1,68,067

(b) Evalua on of money-market hedge

Expected receipt a er 3 months = £ 300,000
Sterling interest rate over three months = 5.4/ 4 = 1.35%
Sterlings to borrow now to have £ 300,000 liability
a er 3 months = 300,000/1.0135 = £ 296,004
Spot rate for selling Sterling = 1.7820 + 0.0002 = £ 1.7822 per €
Euro deposit from borrowed Sterling at spot = 296,004/1.7822 = €166,089
Euro interest rate over three months = 4.6/ 4 =1.15%
Value in 3 months of Euro deposit = 166,089 x 1.0115 = € 167,999
The forward market is marginally preferable to the money market hedge for the Sterling receipt
expected a er 3 months.

UNIT III
FATE OF FORWARD CONTRACT
Ques on 6 Study Material
You as a banker has entered into a 3 month's forward contract with your customer to purchase AUD 1,00,000
at the rate of ₹ 47.2500. However a er 2 months your customer comes to you and requests cancella on of the
contract.On this date quota on for AUD in the market is as follows:
Spot ₹ 47.3000/3500 per AUD
1-month forward ₹ 47.4500/5200 per AUD
Determine the cancella on charges payable by the customer.

Solu on:
The contract shall be cancelled at the 1-month forward sale rate of ₹ 47.5200 as follows:
AUD bought from customer under original forward contract at ₹ 47.2500
On cancella on it is sold to him at ₹ 47.5200
Net amount payable by customer per AUD ₹ 0.2700

Thus total cancella on charges payable by the customer ₹ 27,000

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

UNIT IV
ARBITRAGE PROSPECTS

Ques on 7 Nov 08 (4 Marks), RTP May 13, Prac ce Manual, Study Material
On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per annum respec vely. The UK £/US
$ spot rate is 0.7570. What would be the forward rate for US $ for delivery on 30th June?

Solu on:
As per interest rate parity
1 + r£
S1 = S0 [ [
1 + r$

[ [
3
1 + (0.075) x
12
S1 = £ 0.7570
3
1 + (0.035) x
12

= £ 0.7570 [ 1.01875
1.00875
[
= £0.7570 × 1.0099
= £0.7645
S1 = UK £0.7645/US $

Ques on 8 (4 Marks), Exam Nov 2020

USD 10,000 is lying idle in your Bank Account. You are able to get the following quotes from the dealers:
Dealer Quote
A EUR/USD 1.1539
B EUR/GBP 0.9094
C GBP/USD 1.2752
Is there an opportunity of gain from these quotes?

Solu on:
The arbitrageur can proceed as stated below to realize arbitrage gains.
(i) Buy € from US$ 10,000 from Dealer A (10,000/ 1.1539) € 8,666.26
(ii) Convert these € to £ by selling to Dealer B (€ 8,666.26 × 0.9094) £ 7,881.09
(iii) Convert £ to US$ by selling to Dealer C (£ 7,881.09 × 1.2752) US$ 10,049.97
There is net gain of US$ 10,049.97 less US$ 10,000 i.e. US$ 49.97 or US$ 50.00.

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Ques on 9 (8 Marks) MTP Oct 2019

Mercy is a Forex Dealer with XYZ Bank. She no ces following informa on rela ng to Canadian Dollar (CAD)
and German Deutschmark (DEM):
Exchange rate - CAD 0.775 per DEM (Spot)
CAD 0.780 per DEM (3 months)
Interest rates- DEM 7% p.a.
CAD 9% pa.
(i) Assuming that there is no transac on cost determine does the Interest Rate Parity holds in above
quota ons.
(ii) If yes, then explain the steps that would be required to make an arbitrage profit if Mercy is authorized to
work with CAD 1 Million for the same purpose. Aso determine the profit that would be made in CAD.

Note: Ignore the decimal points in fre amounts.

Solu on:
(i) For 3 months, rCAD = 225% and rDEM = 1.75%. Since the exchange rate is in CAD/ DEM term the appropriate
equa on for Interest Rate Parity is as follows:
F (1 + rCAD)
=
S (1 + rDEM)
0.780 (1 + 0.0225)
=
0.775 (1 + 0.0175)
1.00645 ≠ 1.00491
Since both sides are not equal, Interest Rate Parity does not hold.

(ii) Since IRP does not hold frere is an arbitrage opportunity.

Interest Differen al = 2.25% - 1.75% = 0.50%
0.780 - 0.775
Premium = x 100 = 0.645%
0.775
Since the interest rate differen al is smaller than the premium, it will be profitable to place money in
Deutschmarks the currency whose 3-months interest is lower

The following opera ons are carried out

(i) Borrow CAD 1 Million at 9 per cent for 3-months;
(ii) Change this sum into DEM at the spot rate
= (1,000,000/0.775) = 1,290,323
(iii) Place DM 1,290,323 in the money market for 3 months to obtain a sum of DM
Principal: 1,290,323
Add: Interest @ 7% for 3 months = 22,581
Total 1,312,904

(iv) Sell DEM at 3-months forward to obtain CAD = (1 ,312,904 x 0.780) = CAD 1,024,065

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

(v) Refund the debt taken in CAD with the interest due on it, i.e.,
CAD
Principal 1,000,000
Add: Interest @9% for 3 months 22,500
Total 1,022,500
Net arbitrage gain = CAD 1,024,065 - CAD 1,022,500 = CAD 1,565

Ques on 10
Price of a commodity in USA is $ 100
In India, the same commodity is priced at ₹ 7000
Spot rate is ₹ 66 / $.

Show the process of commodity arbitrage.

Also indicate the forces which will eliminate the arbitrage.

Solu on:
Based on the Current spot rate, price of the commodity in India should be ₹ 6600 ($ 100 x ₹ 66). Since the
Actual price (₹ 7000) > Fair price (₹ 6600), therefore the commodity is overpriced in India and compara vely
cheaper in USA. An arbitrageur should –
Step 1: Buy commodity from USA
Ou low = $ 100 i.e. ₹ 6600.
Step 2: Sell the commodity in India for ₹ 7000
Inflow = ₹ 7000

Therefore, the Net Arbitrage gain is ₹ 400 per one unit of commodity.

This arbitrage process will con nue un l the Prices in both the countries and the Exchange Rate are in
equilibrium. To be precise,

Price of commodity in USA will Increase (because of Buying pressure)

Price of commodity in India will Decrease (because of Selling pressure)
Exchange Rate i.e. Foreign Currency will Appreciate (because of rise in Dollar demand to buy commodity in
dollars)

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 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Ques on 11 Study Material

XYZ Bank, Amsterdam, wants to purchase ₹ 25 million against £ for funding their Nostro account and they
have credited LORO account with Bank of London, London.

Calculate the amount of ₤'s credited. Ongoing inter-bank rates are per $, ₹ 61.3625/3700 & per £, $
1.5260/70.

Solu on:
To purchase Rupee, XYZ Bank shall first sell £ and purchase $ and then sell $ to purchase Rupee. Accordingly,
following rate shall be used:
(£/₹)ask
The available rates are as follows:
($/£)bid = $ 1.5260
($/£)ask = $ 1.5270
(₹/$)bid = ₹ 61.3625
(₹/$)ask = ₹ 61.3700

From above available rates we can compute required rate as follows:

(£/₹)ask = (£/$)ask X ($/₹)ask
= (1/1.5260) X (1/61.3625)
= £ 0.01068 or £ 0.0107

Thus amount of £ to be credited

= ₹ 2,50,00,000 x £ 0.0107
= £ 2,67,500

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 102
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 Interest Rates
INTEREST RATES RISK MANAGEMENT
Risk Management
UNIT I
SWAPS
Ques on 1 CA Final Nov 2010
A dealer quotes “All-in-Cost” for a generic swap at 8% against six months LIBOR flat. If the no onal principal
amount of swap is ₹ 6,00,000 :-

(i) Calculate semi-annual fixed payment

(ii) Find the first floa ng rate payment for (i) above, if the six-month period from the effec ve date of swap
to the se lement date comprises 181 days and that the corresponding libor was 6% on the effec ve date
of swap.
(iii) In (ii) above, if the se lement is on 'NET' basis, how much the fixed rate payer would pay to the floa ng
rate payer? Generic swap is based on 30/360 days.

Solu on:
(i) Semi-Annual fixed payment = (N) (AIC) (Period)
Where, N = No onal Principal Amount = ₹ 6,00,000
All-in-Cost (AIC) = 8% = 0.08
= ₹ 6,00,000 x 0.08 x 180 / 360
= ₹ 6,00,000 x 0.08 x 0.5
= ₹ 6,00,000 x 0.04 = ₹ 24,000

(ii) Floa ng rate payment = N (LIBOR) (dt / 360)

= ₹ 6,00,000 x 0.06 x 181 / 360
= ₹ 6,00,000 x 0.06 x (0.502777)
= ₹ 18,100

(iii) Net Amount = (i) - (ii)

or = ₹ 24,000 - ₹ 18,100 = ₹ 5,900.

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 INTEREST RATES RISK MANAGEMENT

Ques on 2 (8 Marks) MTP May 2021

IM is an American firm having its subsidiary in Japan and JI is a Japanese firm having its subsidiary in USA: They
face the following interest rates
IM JI
USD Floa ng rate LIBOR + 0.5% LIBOR + 2.5%
JPY Fixed rate 4% 4.25%
IM wishes to borrow USD at floa ng rate and JI JY at fixed rate. The amount required by both the companies is
same at the current Exchange Rate. A financial ins tu on requires 75 basis points as commission for arranging
Swap. The companies agree to share the benefit/ loss equally.
Advise:
(i) How a beneficial swap can be arranged?
(ii) The effec ve interest cost for both IM and JI if swap arrangement is entered into.

Solu on:
(i) IM has overall strong posi on and hence is in a compara ve advantageous posi on in both rates.
However, it has a compara ve advantage in floa ng-rate market.

The differen al between the U.S. dollar floa ng rates is 2.00% per annum, and the differen al between
the JPY fixed rates is 0.25% per annum. The difference between the differen als is 1.75% per annum.
The total poten al gain to all par es f rom the swap is therefore 1.75% per annum, or 175 basis points. If
the financial intermediary requires 75 basis points, each of IM and JI can be made 50 basis points be er
off.

(ii) Since the Net Benefit of 100 Basis Points to be shared equally among IM and JI interest rate for them
shall be as follows:
IM
Borrowing from Market LIBOR + 0.5%
Less: Benefit from Swap 0.5%
Net Interest LIBOR

JI
Borrowing from Market 4.25%
Less: Benefit from Swap 0.5%
Net Interest 3.75%

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 104
 International
INTERNATIONAL FINANCIAL MANAGEMENT
Financial Management

Ques on 1 (8 Marks) Exam May 2022

M/s. Daksh Ltd is planning to import mul purpose machine from USA at a cost of $15000. The company can
avail loans at 19% Interest per annum with quarterly rests with which it can import the machine.
However, there is an offer from New York branch of an Indian based bank extending credit of 180 days at 2%
per annum against opening of an irrevocable le er of credit.

Other Informa on:

Spot rate US$ 1 = ₹ 75
180 days forward rate US $ 1 = ₹ 77
Commission charges for le er of credit at 2% per 12 months.
(i) Jus fy why the offer from the foreign branch should be accepted?
(ii) Based on the present market condi on company is not interested to take the risk of currency
fluctua ons and wanted to hedge with an addi onal expenses of ₹ 30,000, if so, what is your advise to
the company?

Assume 360 days in the year.

Solu on:
(i) Op on I (To finance the purchases by availing loan at 19% per annum):
Amount
Cost of equipment ($ 15,000 at US$ 1 = ₹ 75) ₹ 11,25,000
Add: Interest at 4.75% I Quarter 53,438
Add: Interest at 4.75% II Quarter (on ₹ 11,78,438) 55,976
Total ou low in Rupees 12,34,414
Alterna vely, interest may also be calculated on compounded basis, i.e.,
2
₹ 1,12,5000 × [1.0475] ₹ 12,34,413

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 105
 INTERNATIONAL FINANCIAL MANAGEMENT

Op on II (To accept the offer from foreign branch):

Amount
Cost of le er of credit at 1 % on US$ 15,000 at ₹ 11,250
US$ 1 = ₹ 75
Tutorial Note:
Add: Interest for 180 days (₹ 11,250 × 19% x ₹ 1,069 Ideally interest
180/360) should be added
(A) ₹ 12,319 on quarterly basis
for 2 quarters
Payment at the end of 180 days:
Cost US$ 15,000
Interest at 2% p.a. [15000 × 2/100 × 180/360] US$ 150
US$ 15,150
Conversion at US$ 1 = ₹ 77 [15150 x ₹ 77] ₹ 11,66,550
(B)
Total Cost: (A) + (B) ₹ 11,78,869
Advise: Op on 2 is cheaper by (₹ 12,34,413 – ₹ 11,78,869) lakh or ₹ 55,544. Hence, the offer may be
accepted.

(ii) If company is not interested to take the risk of currency fluctua ons and wanted to hedge with an
addi onal expense of ₹ 30,000 then it can do so because even taking forward posi on is resul ng in
increased cash ou low by the same amount.
Ques on 2 (8 Marks) Exam Nov 2020, May 2023
ICL an Indian MNC is execu ng a plant in Sri Lanka. It has raised ₹ 400 billion. Half of the amount will be
st
required a er six months' me. ICL is looking an opportunity to invest this amount on 1 April,2020 for a
period of six months. It is considering two underlying proposals:
Market Japan US
Nature of Investment Index Fund (JPY) Treasury Bills (USD)
Dividend (in billions) 25 -
Income from stock lending (in billions) 11.9276 -
Discount on ini al investment at the end 2% -
Interest - 5 per cent per annum
Exchange Rate (1st April, 2020) JPY / INR 1.58 USD / INR 0.014
Exchange Rate (30th September, 2020) JPY / INR 1.57 USD / INR 0.013

You, as an Investment Manager, is required to suggest the best course of op on.

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 INTERNATIONAL FINANCIAL MANAGEMENT

Solu on:
Investment in JPY (in billions)
Par culars Currency INR ER Currency JPY
Available amount 200 1.58 316
Dividend Income 25
Stock Lending Income 11.9276
Investment value at the end a er discount @ 2% 309.68
Amount available at the end 346.6076
Conversion as on 30-09-2020 1.57 ₹ 220.7692
Gain ₹ 20.7692

Investment in USD (in billions)

Par culars Currency INR ER Currency USD
Available amount 200 0.014 2.80
Interest for 6 months @ 5% p.a. 0.07
Amount available at the end 2.87
Conversion as on 30-09-2020 0.013 ₹ 220.7692
Gain ₹ 20.7692

The equivalent amount is same in both the op ons so ICL is indifferent.

However, USD is more stable, and Treasury Bills are risk free, so investment in Treasury Bills (USD) is
suggested.

Ques on 3 Study Material, (5 Marks) CA Final May 2012

The price of a bond just before a year of maturity is $5,000. Its redemp on value is $5,250 at the end of the
said period. Interest is $350 p.a. The Dollar appreciates by 2% during the said period. Calculate the rate of
return.

[Ans: If assume USA Investor then 12%; If Non-USA investor then 14.24%]

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 INTERNATIONAL FINANCIAL MANAGEMENT

Ques on 4 (8 Marks) CA Final Nov 2014, RTP May 2021

Right Limited has proposed to expand its opera ons for which it requires funds of $ 30 million, net of issue
expenses which amount to 4% of the issue size. It proposed to raise the funds though a GDR issue. It considers
the following factors in pricing the issue:
(i) The expected domes c market price of the share is ₹ 300 (Face Value of ₹ 10 each share)
(ii) 4 shares underly each GDR
(iii) Underlying shares are priced at 20% discount to the market price
(iv) Expected exchange rate is 70/$
You are required to compute the number of GDRs to be issued and cost of GDR to Right Limited, if 20%
dividend is expected to be paid with a growth rate of 20%.

Solu on:
Net Issue Size = $ 30 million
$ 30 million
Gross Issue = = $ 31.25 million
0.96

Issue Price per GDR in ₹ (300 x 4 x 80%) ₹ 960

Issue Price per GDR in $ (₹ 960 / ₹ 70) ₹ 13.71
Dividend per GDR (D1) (₹ 2 x 4) ₹8
Net Proceeds per GDR (₹ 960 x 0.96) ₹ 921.60

(a) Number of GDR to be issued

$ 31.25 million
= 2.2794 million
$ 13.71

(b) Cost of GDR to Right Ltd.

8
ke = + 0.20 = 20.87%
921.60
Ques on 5 (8 Marks) Exam Dec 2021
DD Ltd. a company based in India manufactures good quality of leather bags and sells to retail outlets in India
and USA. The cost of quality leather in India is very high, the company is reviewing the proposal of impor ng of
leather in bulk from USA supplier. The es mate of net US $ and Indian ₹ Currency Cash Flows in nominal terms
for this proposal is given below:
Net Cash Flow (in Lakh)
Year 0 1 2 3
In US $ (25) 5 7 8
In ₹ 0 60 80 90
If not imported cost of leather to be purchased in India (in ₹) 400 450 500 600

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 108
 INTERNATIONAL FINANCIAL MANAGEMENT

Other informa on:

(i) DD Ltd. evaluates all investments by using discount rate of 9% p.a.
(ii) All US customers are invoiced in US $. US $ Cash flows converted into ₹ at the forward rate and
discounted at Indian Rate.
(iii) Infla on in USA and India are expected to be 9% and 8% respec vely.
(iv) The current exchange rate 1 US $ = ₹ 74
You are required to Calculate Net Present Value and recommend the decision. Present value factor @ 9% are
as under:
1 Year 2 Year 3 Year
0.917 0.842 0.772
Note: Calcula on to be made up to 2 decimal points.

Solu on:
Expected Forward Exchange Rates
Year ₹ /USD
1 (1+0.08) 73.32
₹ 74.00 x
(1+0.09)
2 (1+0.08) 72.65
₹ 73.32 x
(1+0.09)
3 (1+0.08) 71.98
₹ 72.65 x
(1+0.09)

NPV of the proposal if leather is imported from US

0 1 2 3
Cash Flow is US$ (Lakh) (25) 5 7 8
Expected Forward Rates ₹/ US$ 74.00 73.32 72.65 71.98
Cash Flows in ₹ Lakh (1,850.00) 366.60 508.55 575.84
Cost of leather if not imported (400.00) (450.00) (500.00) (600.00)
Cash Flows in ₹ Lakh ---- 60.00 80.00 90.00
Total Cash Flow ₹ Lakh (2,250.00) (23.40) 88.55 65.84
PVF @ 9% 1.000 0.917 0.842 0.772
PV in ₹ Lakh (2,250.00) (21.46) 74.56 50.83
NPV (2,146.07)

Decision: Proposal should not be accepted as NPV is nega ve.

CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 109