investment analysis solution of BBA tu nepal by kiran thapa

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investment analysis solution of BBA tu nepal by kiran thapa

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NUMERICAL PROBLMS

1. Solution

Here given: Face value (FV) = Rs 10,000; Days to maturity (t) = 87 days; Bank discount yield (d) = 3.4%; price of

the bill (P) = ?; Bond equivalent yield (BEY) = ?

We have,

FV − P 360

d = FV × t

Rs 10,000 − P 360

Or,0.034 = × 87

Rs 10,000

Or, Rs 29,580 = 3,600,000 − 360 P

∴P = Rs 9,917.8333

Alternatively,

Discount amount = FV × t/360 × d = Rs 10,000 × 87/360 × 0.034 = Rs 82.1667

Price paid (P) = Face value – Discount amount = Rs 10,000 – Rs 82.1667 = Rs 9,917.8333

We have,

FV − PP 365 10,000 − 9,917.8333 365

BEY = PP × t = × 87 = 0.0348 = 3.48%

9,917.8333

2. Solution

Given,

Days to maturity (t) = 180 days

Purchase price (PP) = Rs 9,600

Face value (FV) = Rs 10,000

Discount yield = 8%

(a) Bond Equivalent Yield (BEY) = ?

We have,

FV − PP 365 10,000 − 9,600 365

BEY = PP × t = × 180 = 0.0845 = 8.45%

9,600

(b) Bond equivalent yield is always higher than the discount rate because bond equivalent yield calculation use of

365-day in a year, purchase price as a based price, and consider the compounding effect.

3. Solution

Given,

Asked discount yield = 6.81%

Bid discount yield = 6.90%

Maturity period = 60 days

Face value (FV) = 100 assumed

a.Bid price =?

We have,

FV − Bid price 360

Bid discount rate = FV × t

or,0.0690 = 100 × 60

∴Bid price = 98.85

Asked price =?

We have,

FV − Asked price 360

Asked discount rate = FV × t

38 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

or,0.0681 = 100 × 60

∴Asked price = 98.865

FV − PP 365 100 − 98.865 365

b.BEY = PP × t = 98.865 × 60 = 0.0698 Or, 6.98%

Working notes:

Ending price − Beginning price 100 − 98.865

1.Periodic rate = Beginning price = 98.865 = 0.0115 or 1.15%

365

2.Compounding period (m) = 60 = 6.0833

4. Solution

Given:

Purchase price of T−bill (PP) = ?

Maturity period (t) = 182 days

Par value = Rs. 100,000

Bank discount yield = 9.18%

We have,

FV − PP 360

Bank discount yield = FV × t

100,000 − PP 360

or, 0.0918 = × 182

100,000

or,1,670,760 = 36,000,000 − 360PP

∴PP = Rs 95,359

5. Solution

Given,

Maturity period (t) = 90 days

Face value (FV) = Rs. 100 (assumed)

Discount yield = 3%

(a)Purchase price (PP) =?

We have,

FV − PP 360

Discount yield = FV × t

100 − PP 360

or,0.03 = 100 × 90

or,270 = 36,000 − 360 × PP

∴PP = 99.25

(b)Holding period return (HPR) = ?

We have,

Ending price − Beginning price 100 − 99.25

HPR = Beginning price = 99.25 = 0.7557%

(c)BEY = ?

FV − PP 365 100 − 99.25 365

BEY = PPP × t = 99.25 × 90 = 0.03065 Or, 3.065%

(d)Effective annual rate (EAR) = ?

EAR = (1+ Periodic rate)m − 1= (1 + 0.007557)4.0556 − 1 = 3.10%

Working note:

365

m = 90 = 4.0556

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 39

6. Solution

Given,

Rate of return = 2%

Price of bill =?

Maturity period (t) = 6 month or 180 days

Face value Rs 10,000

We have, Price (P) = (1 + r) = 1.02 = Rs 9,803.92

7. Solution

a. The remaining maturity period of T-bills is 357 days.

b. Bid and ask quotes are reported using the bank discount method. This means that the bill's discount from its

maturity, or face value is annualized based on a 360 day year.

c. Calculation of bid price (assume face value = 10,000)

FV – P 360 10000 – P 360

Bid yield = FV × t Or, 0.00185 = 10000 × 357 Or, 6,604.5 = 3,600,000 – 360P

Or, P = 9,981.6542

Calculation of ask price

FV – P 360 10000 – P 360

Ask yield = FV × t Or, 0.0018 = 10000 × 357 Or, 6,426 = 3,600,000 – 360P

Or, P or Ask price = Rs 9,982.15

d. Dealer’s spread = Ask price – bid price = Rs 9,982.15– Rs 9,981.6542= Rs 0.4958

e. Change in previous day’s bid price.

f. Ask yield is the annualized yield an investor will receive by purchasing this bill today and holding it to

maturity.

8. Solution

Here given: Yield on municipal bond = 6 ¾ %; Equivalent taxable yield or before tax yield (BTY) = ?; Tax rate (T) =

35%

We have,

After tax yield = Before tax yield (1 – T)

Or, 6 ¾ % = Before tax yield (1 – 0.35)

Or, Before tax yield = 10.3846%

9. Solution

Here given:

Yield on municipal bond = 4%; Yield on taxable bonds = 5%

a.After tax yield = ?

We have,

After tax yield = Before tax yield (1 – T)

At tax rate (T) = 0%: After tax yield = 5% × (1 – 0.00) = 5%

At tax rate (T) = 10%: After tax yield = 5% × (1 – 0.10) = 4.5%

At tax rate (T) = 20%: After tax yield = 5% × (1 – 0.20) = 4%

At tax rate (T) = 30%: After tax yield = 5% × (1 – 0.30) = 3.5%

b. equivalent taxable yield or earnings before tax = ?

we know, After tax yield = Before tax yield (1 – T)

Yield on municipal bond

Or, Equivalent taxable yield or before tax yield = (1 – Tax rate)

4

Tax at 0%: Equivalent taxable yield = (1 – 0) = 4%

4

Tax at 10%: Equivalent taxable yield = (1 – 0.10) = 4.44%

40 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

4

Tax at 20%: Equivalent taxable yield = (1 – 0.20) = 5.00%

4

Tax at 30%: Equivalent taxable yield = (1 – 0.30) = 5.71%

10. Solution

Here given:

Tax rate (T) = 30%; Yield on corporate bond = 9%; After tax yield (ATY) = ?

We have,

After tax yield = Before tax yield (1 – T) = 9% × (1 – 0.30) = 6.30%

Therefore, the municipals must offer at least 6.3% yields.

11. Solution

Here given: Tax rate (T) = 30%; Taxable return = 6%; Tax free return = 4%

After tax yield = BTY (1 – T) = 6% ( 1 – 0.3) = 4.2%

Taxable bond is better than tax free bond since the yield is higher.

Equivalent taxable yield or Before tax yield (BTY) = ?

We have,

ATY = BTY (1 - T)

4% = BTY (1 – 0.30)

Or BTY = 5.71%

12. Solution

a.You would have to pay the asked price of: 98 is the 98% of par = $980.00

b.The coupon rate is 4.25%, implying coupon payments of $42.5 annually or, more precisely, $21.25(= 42.5/2) semiannually.

c.Given the asked price and coupon rate, we can calculate current yield with the formula:

I

Current yield = = 4.25/98 = 0.0434 = 4.34%

P0

13. Solution

a.Bid price = 112.9375% of Rs 1,000 = Rs 1,129.375; Asked price = 113.000% of Rs 1,000 = Rs 1,130. Yield to

maturity is 1.410% based on asked price.

b.Previous day asked price = Today's ask price - (- change) = Rs 1,130 – (- 0.438% of Rs 1,000) = Rs 1,134.38

c.The coupon rate is 4.500%.

d.Current yield = I /Asked price = Rs 45/Rs 1130 = 3.98%

14. Solution

Dividend on preferred stock Rs 4

Rate of return = Price of stock = Rs 40 = 0.10 or 10%

After tax return for corporation after tax return

= Before tax return × (1 − New tax rate) = 10% (1 − 0.09) = 9.10

Working notes:

1. New tax rate = Corporate tax rate × Exemption rate in preferred dividend

= 0.30 × (1 − 0.70) = 0.09 = 9%

2. There is 70 percent dividend income is tax exempt for corporate investor and only 30 percent income is subject

to tax.

15. Solution

a.The closing price today is $75.60, which is $0.97 above yesterday’s price. Therefore, yesterday’s closing price was:

－

$75.60 $0.97 = $74.63.

b.You would buy 66 shares: $5,000/$75.60 = 66.14.

c.Your annual dividend income on 66 shares would be 66 x $1.88 = $124.08.

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 41

d. Earnings per share can be derived from the price-earnings (PE) ratio:

Given price/Earnings = 10.92 and Price = $75.60, we know that Earnings per Share = $75.60/10.92 = $6.92.

16. Solution

Given,

Stock Price

A Rs. 16

B Rs. 30

Current divisor (d) = 2

Rs. 16 + Rs. 30

Then, Current index (I) = 2 = 23

(a) When stock A issues 5% stock dividend,

Rs.16

Price per share of Stock A, after stock dividend = 1 + 0.05 = Rs. 15.24

Total price after stock dividend

Index after stock dividend (I) = Divisor (d)

Rs.15.24 + Rs. 30

Or,23 = divisor (d)

45.27

Now, Divisor (d) = 23 = 1.967

The value of the new divisor after 5% stock dividend in stock A’s price is 1.967.

(b)Stock B undergoes 3-for-1 stock split

1

Price per share after the split = Rs. 30 × 3 = Rs. 10

Total price after split

Now,Index after the split (I) = Divisor (d)

Rs. 16 + Rs. 10

or,23 = Divisor (d)

26

or, Divisor (d) = 23 = 1.130

Hence the value of the new divisor after 3-for-1 stock split in stock B is 1.130.

(c)When stock A undergoes a 4-for-1 split

1

Price per share after the split = Rs. 16 × 4 = Rs. 4

Total price after split

Index after the split (I) = Divisor (d)

Rs. 4 + Rs. 30

or,23 = Divisor (d)

34

or,Divisor (d) = 23 = 1.478

Hence the value of the new divisor after 4-for-1 stock split in stock C is 1.478.

17. Solution

a)

Security Price (P0) Shares outstanding (N) Market value (N × P0)

A Rs. 20 20,000 Rs. 400,000

B 35 40,000 1,400,000

C 30 40,000 1,200,000

Total Rs.3,000,000

Hence, the aggregate value of the market is Rs. 3,000,000.

(b) When securities C’s price increases by 20%

Security Price (P0) Shares outstanding (N) Market value (N × P0)

A Rs. 20 20,000 Rs. 400,000

42 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

B 35 40,000 1,400,000

C 30 (1.20) = 36 40,000 1,440,000

Total Rs.3,240,000

Market value after change − Market value before change

% change in the market’s aggregate value = Market value before change

Rs. 3‚240‚000 − 3‚000‚000

=

Rs. 3‚000‚000 = 8%

In this way, as security C’s price increases by 20% the market's aggregate value increases by 8%.

(c) If security B splits 2-for-1,

After increases prices Shares outstanding Market value (II × III)

Security

(I) (II) (III)

A Rs. 20 20,000 Rs. 400,000

B 35 × ½ = 17.50 80,000 1,400,000

C 30 40,000 1,200,000

Total Rs.3,000,000

Market value after split − Market value before split

% change in the market value = Market value before split

Rs. 3‚000‚000 − Rs. 3‚000‚000

= Rs. 3‚000‚000 = 0%

In this way after 2-for-1 split in stock B, the market’s aggregate value does not change because other things held

same the no. of shares increases and price per share declines to exactly offset each other.

18. Solution

Current market value 4,632,000

Value Weighted Method = Base market value × Base index value = × 100 = 99.5059

4,655,000

Aggregate market value of four indexes is decreased to 99.5059 from the base value of 100.

Working notes:

Current market value = (1,000 × 1,650) + (920 × 1,600) + (1,500 × 790) + (500 × 650)= 4,632,000

Base market value = (1,000 × 1,700) + (920 × 1,500) + (1,500 × 800) + (500 × 750)= 4,655,000

19. Solution

a. Price weighted index (PWI) =?

We have,

Total price Rs 160 + Rs 50 + Rs 240

PWI = = = 150

Divisor 3

b. Price weighted index (PWI) on date 2 = ?

We have,

Total price Rs 220 + Rs 40 + Rs 300

PWI = = = 186.67

Divisor 3

c. By the event of stock split on a particular date, the index of that day is unaffected. Only the index of next day will be affected as we

have to revise the divisor. Therefore, the index on date 2 after 4-for-1 split X is equal to 186.67.

d. Index on date 1 is equal to 100 and the value weighted index for date 2 would be,

Current market value

Value weighted index (VWI) = Base market value × Base index value

Market value on date 2

= × Index on date 1

Market value on date 1

Rs. 60‚000

= × 100 = 120

Rs 50‚000

Working notes:

Market value on date 1 = 100 × Rs 160 + 200 ×Rs 50 + 100 × Rs 240

= Rs 50,000

Market value on date 2 = 100 × Rs 220 + 200 ×Rs 40 + 100 × Rs 300

= Rs 60,000

e. First calculate the rate of return from the investment in Stock Z

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 43

We have,

Price on date 2 – Price on date 1

Rate of return =

Price on date 1

Rs. 300 – Rs 240

= = 0.25 Or, 25%

Rs 240

Second calculate the rate of return on the value weighted index

We have,

VWI on date 2 – VWI on date 1 120 – 100

Rate of return = = = 0.20 Or, 20%

VWI on date 1 100

Investment in stock Z perform better than the market because its rate of return is higher than the rate of return of market.

20. Solution

Price relatives (Today’s

Market prices

Security price/Yesterday’s price)

Date 1 Date 2 Date 3 Date 2 Date 3

A Rs.50 Rs.55 Rs.60 1.1 1.091

B 30 28 30 0.933 1.071

C 70 75 73 1.071 0.973

Total 3.104 3.135

Now,

(a) First calculate the equal weighted index in date 2

We have,

Total price relatives 3.104

EWI on date 2 = n × Previous day’s index = 3 × 100= 103.5

Assuming index on date 1 (I1) is 100,

(b) We have,

Total price relatives 3.135

EWI on date 3 = n × Previous day’s index = 3 × 103.5 = 104.5

I2 − I1 103.5 − 100

(c) Thus, return on index from date 1to date 2 = I1 × 100 = 100 × 100 = 3.5%

I3 − I2 108.16 −103.50

(d)The return on the index from date 2 to date 3= I2 = 103.50 × 100 = 4.5%

21. Solution

Price relatives (Today’s

Market prices

Security price/Yesterday’s price)

Date 1 Date 2 Date 3 Date 2 Date 3

L Rs.20 Rs.23 Rs.30 1.150 1.304

M 27 30 31 1.111 1.033

N 40 35 29 0.875 0.829

a. Index on date 1, (I1) = 200

Geometric mean index on = [Product of price relatives on date 2]1/n × Previous day’s index

Now,

Geometric mean index on date 2, (I2)

= [Product of price relatives on date 2]1/n × Previous day’s index

= [1.15 × 1.111 × 0.875]1/3 × 200 = 207.57 ≈ 207.60

Hence, the geometric mean index on date 2 is 207.60.

b. Geometric mean index on date 3, (I3)

= [Product of price relatives on date 3]1/n × Pervious day’s index

= [1.304 × 1.033 × 0.875]1/3 × 207.60 = 219.29

Hence, the geometric mean index on date 3 is 215.38.

207. 6 - 200

c. The return on index from date 1 to date 2 = 200 = 3.8%

44 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

219.29 - 207. 6

d. The return on index from date 2 to date 3 = 207.6 = 3.75%

22. Solution

90 + 50 + 100

a.At t = 0, the value of the index is: 3 = 80

95 + 45 + 110

At t = 1, the value of the index is: 3 = 83.333

83.333

The rate of return is: 80 − 1 = 0.0417 Or, 4.17%

95 + 45 + 110

b.In the absence of a split, Stock C would sell for 110, so the value of the index would be: 3 = 83.333

After the split, Stock C sells for 55. Therefore, we need to find the divisor (d) such that:

95 + 45 + 55

83.333 = d ⇒ d = 2.340

c.The return is zero. The index remains unchanged because the return for each stock separately equals zero.

d. i. Rate of return on market value index

Assume base index value = 100

We have,

Current market value 40500

VWI = Base market value × Base index value = 39000 × 100 = 103.846

103.846 – 100

Rate of return = 100 = 0.03846 Or, 3.846% ≈ 3.85%

Working note:

Total market value at t = 0 is: (Rs 9,000 + Rs 10,000 + Rs 20,000) = Rs 39,000

Total market value at t = 1 is: (Rs 9,500 + Rs 9,000 + Rs 22,000) = Rs 40,500

ii. The rate of return on equally weighted index (EWI)

We have,

Total price relatives 3.0556

EWI = n × Previous index value = 3 × 100 = 101.8533

Rate of return = (101.8533 – 100)/100 = 0.0185 Or, 1.85%

Working notes:

Assume base index value = 100

95 45 110

Total price relatives = 90 + 50 + 100 = 3.0556

23. Solution

i. Calculation of Dow Jones Industrial Average (DJIA)

We have,

Total price Price of Alpha + Price of Beta + Price of Delta

The DJIA = Divisor = Divisor

Rs. 5 + 40 + 35

The DJIA at 2004 = 3 = Rs. 26.67

Total price Price of Alpha + Price of Beta + Price of Delta Rs. 2 + 40 + 30

The DJIA at 2005 = Divisor = Divisor = 2.87 = Rs. 25.09

Working notes:

After stock split, the new divisor will be changed. New divisor must be determined as follows:

We have,

Price of Alpha + Price of Beta + Price of Delta

The DJIA at 2004 = Divisor

Rs. 1.67 + 40 + 35

Or, Rs. 26.67 = 3

Or, 2.87

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 45

The DJIA at 2006 = Divisor = Divisor = 2.87 = Rs. 27.87

b. The base value for 2004 is calculated as follows:

Aggregate market value = Rs. 5 × 1,000 + Rs. 40 × 3,000 + Rs. 35 × 2,000 = Rs. 195,000

Rs. 195,000

The index for 2004 = × 10 = 10

195,000

(Rs.2 × 3,000) + (Rs.40 × 3,000) +(Rs.30 × 2,000)

The S& P 500 for 2005 = × 10 = 9.54

Rs. 195,000

(Rs.2 × 3,000) + (Rs.45 × 3,000) +(Rs.33 × 2,000)

The S& P 500 for 2006 = × 10 = 10.62

Rs. 195,000

We have,

Ending index – Beginning index

Return for stock = Beginning index

Return based on price-weighted index:

Index in 2005 – Index in 2004 Rs.25.09 – Rs.26.67

In 2005: Return on stock = Index in 2004 = Rs. 26.67 = - 5.92%

Index in 2006 – Index in 2005 Rs.27.87 – Rs.25.09

In 2006: Return on stock = Index in 2005 = Rs. 25.09 = 11.08%

Return based on value-weighted index:

Index in 2005 – Index in 2004 9.54 – 10

In 2005: Return on stock = Index in 2004 = 10 = - 4.6%

Index in 2006 – Index in 2005 10.62 – Rs.9.54

In 2006: Return on stock = Index in 2005 = Rs. 9.54 = 11.32%

24. Solution

a.Price weighted index (PWI)

We have,

Total price

PWI = Divisor

At time T

Rs. 60 + Rs. 20 + Rs. 189

PWIT = 3 = 89.67

At time T+1

Rs. 80 + Rs. 35+ Rs. 25

PWIT+1 = 3 = 46.67

Percentage have in the series = PWIT = 89.67 = −0.4795 = −47.95%

b. Market value weighted index (VWI) = ?

We have,

Current market value

VWI= Base market value × 100

At time T

(1,000,000 × 60) + (10,000,000 × 20) + (30,000,000 × 189) 5,930,000,000

VWIT = × 100= × 100 = 100

(1,000,000 × 60) + (10,000,000 × 20) + (30,000,000 × 189) 5,930,000,000

At time T + 1

(1,000,000 × 80) + (10,000,000 × 35) + (30,000,000 × 25) 1,180,000,000

VWIT + 1 = × 100= × 100 = 19.8988

(1,000,000 × 60) + (10,000,000 × 20) + (30,000,000 × 189) 5,930,000,000

VWIT+1 − VWIT 19.8988 − 100

Percentage change in the series = VWIT = 100 × 100= −80.10%

c.Equal weighted index (EWI)

We have,

46 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

EWI = n × Previous day's index = 3 × 100= 3 × 100 = 107.1867

107.1867 − 100

Percentage change in wealth = 100 = 7.1867%

d.The value of the three different indexes are summarized below:

Stock Percentage price change Index Value of the index

L +33.33% PWI −47.95%

K +75% VWI −80.10%

M −86.77% EWI +7.1867%

The price weighted index suggested the lower rate of price depreciation −47.95% because the price weighted

procedure assigned the prices of the stocks only. The value weighted index suggested the higher rate of price

depreciation −80.10% because the value weighting method assigned the largest weight to the stock M that have

largest price decrease and largest number of shares outstanding. The equally weighted index registered the

positive percentage price gain, because it gave equal weight to the all stocks. Therefore, the index value obtained

from the same data in three methods is different because of the different weighting systems of respective

methods.

♦-♦

CHAPTER 3: SECURITIES MARKETS

NUMERICAL PROBLMS

1. Solution

Given,

Beginning price (P0) = Rs. 2,500

Ending price (P1) = Rs. 3,000

Cash dividend (D1) = Rs. 50

Rate of return =?

We have,

(P1 − P0) + D1 (3,000 − 2,500) + 50

Rate of return = P0 = = 0.22 or 22%

2,500

2. Solution

Given,

Beginning price (P0) = Rs. 2,000

Ending price (P1) = Rs. 2,200

Cash dividend (D1) = Rs. 40

Rate of return =?

We have,

(P1 − P0) + D1 (2,000 − 2,000) − 40

Rate of return (Rt) = P0 = = − 0.12 or −12%

2,000

3. Solution

Given:

Starting price (P0) = Rs.40

Ending price (P1) = Rs.42

Cash dividend (D1) = Rs.2

Holding period (n) = 6 months

a. One-period rates of return (long position)

(P1 − P0) + D1 (Rs.42 − Rs.40) + Rs.2

Rates of return = P0 = Rs.40 = 0.10 or 10%

b.One-period rates of return (short position)

(P0 − P1) − D1 (Rs.40 − Rs.42) − Rs.2

Rates of return = P0 = Rs.40 = – 0.10 or –10%

4. Solution

a.Given:

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 47

Total shares purchases (N) = 500 shares

Price of one share (P0) = Rs.40

Minimum initial margin =?

We have,

Minimum initial margin = N × P0 × IM = 500 × Rs.40 × 0.60 = Rs.12,000

b. If the initial margin requirement were 75 percent:

Given:

Initial margin (IM) = 75 percent

Total shares purchases (N) = 500 shares

Price of one share (P0) = Rs.40

Minimum initial margin =?

We have,

Minimum initial margin = N × P0 × IM = 500 × Rs.40 × 0.75 = Rs.15,000

c. Given:

Initial margin (IM) = 65 percent

Total shares purchases (N) = 100 shares

Price of one share (P0) = Rs.50

Minimum initial margin =?

We have,

Minimum initial margin = N × P0 × IM = 100 × Rs.50 × 0.65 = Rs.3,250

5. Solution

Given:

Number of shares (N) = 500 shares

Starting price (P0) = Rs.35

Initial margin requirement (IM) = 45%

Annual interest on margin loans (i) = 12%

Dividend (D1) = 0

Ending stock price (P1)= Rs.40

Return on investment = ?

We have,

(P1 − P0) + D1 − I1 (Rs.40 − Rs.35) + 0 − Rs.2.31

Return on investment = = = 0.1708 or 17.08%

P0 × IM Rs.35 × 0.45

Working notes: I1 = P0 × (1 − IM) × i = 35 × (1 − 0.45) × 0.12 = Rs. 2.31

6. Solution

Given:

Number of shares purchased on margin (N) = 500 shares

Stock purchase on margin (P0) = Rs.30

Initial margin requirements (IM) = 55%

Interest on margin loan (i) = 13%

Dividends (D1)= Rs.1 per share

We have,

(P1 − P0) − I1 + D1

Rate of return =

P0 × IM

a. If the stock sold at Rs.40

(Rs.40 − Rs.30) − Rs.1.755 + Rs.1

Rate of return = = 0.5603 or 56.03%

Rs.30 × 0.55

b.If the stock sold at Rs.20

(Rs.20 − Rs.30) − Rs.1.755 + Rs.1

Rate of return = = −0.6518 or −65.18%

Rs.30 × 0.55

Working notes:

I1 = P0 × (1 − IM) × i = Rs.30 × (1 − 0.55) × 0.13 = Rs.1.755

Return if the stock is purchase for cash

48 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

(P1 − P0) + D1

Return = P0

(Rs.40 − Rs.30) + Rs.1

Case: 1: Return = Rs.30 = 0.3667 or 36.67%

Case: 2: Return = Rs.30 = – 0.30 or − 30%

7. Solution

Given:

Beginning price (P0) = Rs.70

Ending price (P1) = Rs.75

Cash dividend (D1) = Rs.2

Initial margin(IM) = 50%

Rate of return =?

We have,

(P1 − P0) − D1 (Rs.70 − Rs.75) − Rs.2

Return = = = – 0.20 or − 20%

P0 × IM Rs.75 × 0.5

8. Solution

Given:

Number of shares (N) = 200 shares

Purchase price of the share (P0) = Rs.40

Borrowed amount (Loan) = Rs.3,000

We have,

Collateral = N × P0

a. Collateral at stock price Rs. 40

Collateral = 200 × Rs. 40 = Rs. 8,000

b. Collateral at stock price Rs. 60

Collateral = 200 × Rs. 60 = Rs. 12,000

c. Collateral at stock price Rs. 35

Collateral = 200 × Rs. 35 = Rs. 7,000

Total assets − Loan

d. Actual margin (AM) = Total assets

Rs. 8,000 − Rs. 3,000

At Rs. 40: AM = = 0.625 or 62.5%

Rs. 8,000

Rs. 12,000 − Rs. 3,000

At Rs. 60: AM = = 0.75 or 75%

Rs. 12,000

Rs. 7,000 − Rs. 3,000

At Rs. 35: AM = = 0.5714 or 57.14%

Rs. 7,000

9. Solution

Given:

Market price of stock (P0)= Rs.50

Number of shares (N) = 200 shares

Initial margin (IM) = 45%

We have,

Equity = N × P0 × (1+ IM) − N × P1

a. Equity if price of stock raises to Rs.58

Equity = 200 × Rs.50 × (1+0.45) − 200 × Rs.58 = Rs. 2,900

b. Equity if price of stock falls to Rs.42

Equity = 200 × Rs.50 × (1+0.45) − 200 × Rs.42 = Rs. 6,100

c. Given:

Interest rate (i) = 8%

Initial margin (IM) = 45%

Stock price at beginning (P0) = Rs.50

We have,

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 49

(P1 − P0) + I1

Return =

P0 × IM

(i)Return if the stock prices Rs.58 after a year.

(Rs.50 − Rs.58) + Rs.1.8

Return = = – 0.2756 or − 27.56%

Rs. 50 × 0.45

(ii) Return if the stock prices Rs.42 after a year.

(Rs.50 − Rs.42) + Rs.1.8

Return = = 0.4356 or 43.56%

Rs. 50 × 0.45

Working notes:

Interest = Rs.50 × 0.45 × 0.08 = Rs.1.8

Margin money paid = Rs.50 × 0.45 = Rs.22.5

10. Solution

Given:

Deposit money = Rs.15,000

Initial margin (IM) = 50%

Maximum rupee amount of stock = ?

We have,

Amount of margin = Total purchase price × Initial margin in fraction

Or, Rs. 15,000 = Total purchase price × 0.50

Rs.15,000

Total purchase price = 0.50 = Rs.30,000

Laxman can purchase maximum rupee amount of stock Rs. 30,000 by depositing Rs. 15,000 on margin.

11. Solution

Given:

Number of shares (N) = 200 shares

Stock price (P0)= Rs.75 per share

Initial margin (IM) = 55%

a.If ending price = Rs. 75

Balance sheet

Assets Liabilities and Owner's Equity

Value of stock Rs.15,000 Loan from broker Rs.6,750

Equity Rs.8,250

Total assets Rs.15,000 Total liabilities and owner's equity Rs.15,000

Working notes:

Total assets = N × P0 = 200 shares × Rs.75 per share = Rs.15,000

Loan= N × P0 × (1 − IM) = 200 × Rs. 75 (1 − 0.55) = Rs. 6,750

Equity = N × P0 × IM = 200 × Rs. 75 × 0.55 = Rs. 8,250

b.If ending price = Rs. 50

Balance sheet

Assets Liabilities and Owner's Equity

Value of stock Rs.10,000 Margin loan Rs.6,750

Equity Rs.3,250

Total assets Rs.10,000 Total liabilities and Owner's equity Rs.10,000

Working notes:

Total assets = N × P0 = 200 × Rs. 50 = Rs. 10,000

Loan= N × P0 × (1 − IM) = 200 × Rs. 75 (1 − 0.55) = Rs. 6,750

Equity = Total assets − Loan = Rs. 10,000 − Rs. 6,750 = Rs. 3,250

c.If ending price = Rs. 100

Balance Sheet

Assets Liabilities and Owner's Equity

Value of stock Rs.20,000 Margin loan Rs.6,750

50 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Equity Rs.13,250

Total assets Rs.20,000 Total liabilities and Owner's equity Rs.20,000

Working notes:

Total assets = N × P0 = 200 × Rs. 100 = Rs. 20,000

Loan = N × P0 × (1 − IM) = 200 × Rs. 75 (1 − 0.55) = Rs. 6,750

Equity = Total assets − Loan = Rs. 20,000 − Rs. 6,750 = Rs. 13,250

12. Solution

Given:

Number of shares (N) = 500 shares

Short sell price (P0) = Rs. 25

Initial margin (IM) = 50%

a. Balance Sheet at the time of Rs. 25

Balance Sheet

Assets Liabilities and Owner's Equity

Loan from broker Rs.12,500

Value of stock Rs.18,750 Equity Rs.6,250

Total assets Rs.18,750 Total liabilities and Owner's Rs.18,750

equity

Working notes:

Total assets = N × P0 (1 + IM) = 500 × Rs.25 × (1+ 0.50) = Rs.18,750

Liabilities = N × P0 = 500 × Rs.25 = Rs.12,500

Equity = N × P0× IM = 500 × 25 × 0.50 = Rs. 6,250

b. Balance sheet of ending price (P1) = Rs. 20

Balance Sheet

Assets Liabilities and Owner's Equity

Liabilities Rs.10,000

Value of stock Rs.18,750 Equity Rs.8,250

Total assets Rs.18,750 Total liabilities and Owner's equity Rs.18,750

Working notes:

Total assets = N × P0 (1 + IM) = 500 × Rs.25 × (1+ 0.50) = Rs.18,750

Liabilities = N × P0 = 500 × Rs.20 = Rs.10,000

Equity = Total assets − Liabilities = Rs. 8,750

c. Balance sheet of ending price (P1) = Rs. 30

Balance Sheet

Assets Liabilities and Owner's Equity

Value of stock Rs.18,750 Liabilities Rs.15,000

Equity Rs.3,750

Total assets Rs.18,750 Total liabilities and Owner's equity Rs.18,750

Working notes:

Total assets = N × P0 (1 + IM) = 500 × Rs.25 × (1+ 0.50) = Rs.18,750

Liabilities = N × P0 = 500 × Rs.30 = Rs.15,000

Equity = Total assets − Liabilities = Rs. 3,750

13. Solution

Here given: Loan amount = Rs 20,000; Purchase price (P0) = Rs 80 per share; Initial margin (IM) = 50%;

Maintenance margin (MM) = 35%; Margin call price = ?

We have,

1− IM 1− 0.50

a. Margin call price = × P0 = × Rs 80 = Rs 61.54

1 − MM 1 − 0.35

Since the margin call is lower than the Rs 75, there is no chance of margin call.

b. If the price falls below Rs 61.54, a maintenance call will be made.

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 51

14. Solution

Given: Number of shares (N) = 1,000 shares; beginning price (P0) = Rs 600 per share; Initial margin (IM) = 50%;

Maintenance margin (MM) = 30%; Margin call price = ?

We have,

1− IM 1− 0.50

a. Margin call price = × P0 = × Rs 600 = Rs 428.5714

1 − MM 1 − 0.30

b. If the price falls below Rs 428.5714, a maintenance call will be made.

15. Solution

Given: Number of shares (N) = 500 shares; beginning price (P0) = Rs 450 per share; Initial margin (IM) = 55%;

Maintenance margin (MM) = 35%

a. Margin call price = ?

We have,

1+ IM 1+ 0.55

Margin call price = 1 + MM × P0 = 1 + 0.35 × Rs 450 = Rs 516.6667

b. If the price raises above Rs 516.6667, a maintenance call will be made.

16. Solution

a. The stock is purchased for: 300 × Rs 40 = Rs 12,000

The amount borrowed is Rs 4,000. Therefore, the investor put up equity, or margin, of Rs

8,000.

b. If the share price falls to Rs 30, then the value of the stock falls to Rs 9,000. By the end of the

year, the amount of the loan owed to the broker grows to:

Rs 4,000 × 1.08 = Rs 4,320

Therefore, the remaining margin in the investor’s account is:

Rs 9,000 − Rs 4,320 = Rs 4,680

The percentage margin is now: Rs 4,680/Rs 9,000 = 0.52 = 52%

Therefore, the investor will not receive a margin call.

c. The rate of return on the investment over the year is:

Ending equity in the account − Initial equity Rs 4,680 − Rs 8,000

= Initial equity = = −0.415 or −41.5%

Rs 8,000

17. Solution

Given

Position = Long position (Bullish)

Initial fund (Margin) = Rs. 5,000

Rs. 10,000

Number of shares (N) = Rs.50 = 200 shares

Loan = Rs. 5,000

Interest rate on loan (i) = 8%

a. Rate of return

Ending price (after 10% increase) = Rs. 50 + 10% of Rs. 50 = Rs. 55

Starting price = Rs. 50

(Rs.55 × 200 − Rs.50 × 200) − Rs. 5,000 × 0.08

Return = = 12%

Rs. 5,000

b. Price of the stock

Given:

Initial margin required of investor= 50 percent

Maintenance margin required by brokerage firm = 30

Purchase price on margin = Rs.50 per share

Price of stock that will trigger a maintenance call:

1− IM 1− 0.50

Price of stock = × P0 = × Rs.50 = Rs. 35.7143

1 − MM 1 − 0.30

If the price falls below Rs. 35.7143, a maintenance call will be made.

52 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

18. Solution

a.Initial margin is 50% of Rs 5,000 or Rs 2,500.

b.Total assets are Rs 7,500 (Rs 5,000 from the sale of the stock and Rs 2,500 put up for margin). Liabilities are 100P.

Therefore, net worth is (Rs 7,500 – 100P). A margin call will be issued when:

Rs 7,500 − 100P

100P = 0.30 ⇒ when P = Rs 57.69 or higher

19. Solution

Given

Current selling price (P0)= Rs. 40

(N × P0 − N × P1) − D1

Return =

N × P0

a. Rate of return

Return if the stock prices Rs.44 after a year.

(500 × Rs.40 − 500 × Rs.44) − Rs. 0

Return = = −13.33%

500 × Rs.40

Return if the stock prices Rs.40 after a year.

(500 × Rs.40 − 500 × Rs.40) − Rs. 0

Return = = 0%

500 × Rs.40

Return if the stock prices Rs.36 after a year.

(500 × Rs.40 − 500 × Rs.36) − Rs. 0

Return = = 13.33%

500 × Rs.40

b. Stock margin price

Given:

Initial margin (IM)= 75 percent

Maintenance margin (MM)= 25

Selling price on margin (P0)= Rs. 40 per share

Price of stock that will trigger a maintenance call:

1 + IM 1 + 0.75

Price of stock = 1 + MM × P0 = 1 + 0.25 × Rs.40 = Rs. 56

If the price increases above Rs.56 a maintenance call will be made.

c. Rate of return if dividend is Rs. 2 per share

At Rs. 44

(500 × Rs.40 − 500 × Rs.44) − 500 × Rs. 1

Return = = −16.67%

500 × Rs.40 × 0.75

At Rs. 40

(500 × Rs.40 − 500 × Rs.40) − 500 × Rs. 1

Return = = − 3.33%

500 × Rs.40 × 0.75

At Rs. 36

(500 × Rs.40 − 500 × Rs.36) − 500 × Rs. 1

Return = = 10%

500 × Rs.40 × 0.75

20. Solution

Given:

Current price (P0) = Rs 40 per share

Number of shares purchased (N) = 500 shares

Equity or net worth = Rs 15,000

Interest rate on margin loan (i) = 8%

We know

a. Net worth = Market value of assets − Loan

(i) Net worth increases to (Rs 44 × 500) – Rs 5,000 = Rs 17,000

Rs 2,000

Percentage gain = = 0.1333 or, 13.33%

Rs 15,000

(ii) With price unchanged, net worth is unchanged.

Percentage gain = zero

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 53

–Rs 2,000

Percentage gain = = –0.1333 = –13.33%

Rs 15,000

Working notes:

1.Market value of assets = N × P0 = 500 × Rs 40 = Rs 20,000

2.Market value of assets = Equity or net worth + Loan

or, Net worth = market value of assets – Loan

Rs 15,000 = Rs 20,000 – Loan

or, Loan = Rs 5,000

Market value of assets - loan Rs 20,000 - Rs 5,000

3. Initial margin (IM) = Market value of assets = = 0.75 or, 75%

Rs 20,000

There is positive relationship between the percentage return and the percentage change in the price of the stock.

b.Maintenance margin (MM) = 25%

Initial margin (IM) = 75%

Margin call price =?

1 - IM 1 - 0.75

Margin call price = 1 - MM × P0 = 1 - 0.25 × Rs 40 = Rs 13.33

If the stock price falls below Rs 13.33, the maintenance call will be made.

c. Initial margin deposit = Rs 10,000; margin call price = ?

1 - IM 1 - 0.50

Margin call price = 1 - MM × P0 = 1 - 0.25 × Rs 40 = Rs 26.67

If the stock price falls below the Rs 26.67, the maintenance call will be made. Decrease in initial margin increases

the margin call price.

Working notes:

Market value of assets - loan Rs 10,000 - Rs 5,000

Initial margin (IM) = Market value of assets = = 0.50 or, 50%

Rs 10,000

d.By the end of the year, the amount of the loan owed to the broker grows to:

Rs 5,000 × 1.08 = Rs 5,400 or Rs 40 (1 – 0.75) × 1.08 = Rs 10.8 and I1 = 10.8 × 0.08 = Rs 0.864

We have,

(P1 − P0) + D1 - I1

Rate of return = P0 × IM

(i) If ending price (P1) = Rs 44

(Rs.44 − Rs.40) + Rs. 0 − Rs 0.864

Rate of return = = 0.1045 or, 10.45%

Rs.40 × 0.75

(ii) If ending price (P1) = Rs 40

(Rs.40 − Rs.40) + Rs. 0 − Rs 0.864

Rate of return = = −0.0288 or, − 2.88%

Rs.40 × 0.75

(iii) If ending price (P1) = Rs 36

(Rs.36 − Rs.40) + Rs. 0 − Rs 0.864

Rate of return = = − 0.1621 or, − 16.21%

Rs.40 × 0.75

There is positive relationship between the percentage return and the percentage change in the price stock

e. Margin call price = ?

Loan after one year = Rs 5,000 × 1.08 = Rs 5,400

We have,

1 - IM 1 - 0.73

Margin call price = 1 - MM × P0 = 1 - 0.25 × Rs 40 = Rs 14.40

If the price of stock falls below the Rs 14.40, the maintenance margin call will be made.

Working note:

Market value of assets - loan Rs 20,000 - Rs 5,400

Initial margin (IM) = Market value of assets = = 0.73 or, 73%

Rs 20,000

54 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

1. Solution

a. Given:

Assets = Rs. 100,000,000

Liabilities = Rs. 0

Shares outstanding = 1,200,000

Net asset value (NAV) = ?

We have,

Assets−Liabilities Rs.100,000,000−Rs.0

Net asset value (NAV) = Number of shares = = Rs.83.33 per share

1,200,000 shares

Therefore, the net asset value of Investment Company is Rs. 83.33 per share.

b. Given:

Shares outstanding = 4,000,000

Assets = Rs. 102,000,000

Liabilities = Rs. 2,000,000

Net asset value (NAV) = ?

We have,

Assets−Liabilities Rs.102,000,000−Rs.2,000,000

Net asset value (NAV) = Number of shares = = Rs.25 per share

4,000,000 shares

Therefore, the net asset value of mutual fund is Rs. 25 per share.

c. Given:

Total assets = 1,000 × Rs. 50 + 2,000 × Rs. 40 = Rs. 130,000

Liabilities = Rs. 50,000

Number of shares outstanding = 4,000 shares

Net assets value (NAV) = ?

We have,

Assets−Liabilities Rs.130,000−Rs.50,000

Net asset value (NAV) = Number of shares = = Rs.20 per share

4,000

Therefore, the net asset value of NCM is Rs. 20 per share.

2. Solution

Given:

Number of share sold = 150,000 shares

Management fee obligations = Rs.50,000

Calculation of total market value of shares

Stock Shares Price /share Value

A 50,000 Rs. 10 Rs.500,000

B 20,000 7 140,000

C 35,000 30 1,050,000

D 10,000 100 1,000,000

Total Rs.2,690,000

We have,

Assets−Liabilities Rs.2,690,000−Rs.50,000

NAV = Number of shares = = Rs.17.60 per share

150,000 shares

Therefore, the net asset value of Neptune value fund is Rs. 17.60 per share.

3. Solution

Given:

Total worth of a portfolio of assets = Rs.500 million

Liabilities = Rs.2 million

Number of shares outstanding = 40 million

The fund's NAV

We have,

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 55

NAV = Number of shares = 40 million = Rs.12.45 per share

Market price of the fund's share

Market price = NAV × (1 – discount rate in fraction)= Rs.12.45 × (1 – 0.08) = Rs.11.45

Market price of the fund's share

Market price = NAV × (1 + premium rate in fraction) = Rs.12.45 × (1 + 0.10) = Rs.13.695

4. Solution

Given:

Total value of portfolio (assets) = Rs. 200 million

Liabilities = Rs. 3 million

Shares outstanding = 5 million shares

a.The Net asset value = ?

We have,

Assets−Liabilities Rs. 200 million−Rs.3 million

Net Asset Value = Number of shares = 5 million = Rs. 39.4 per share

b. Premium or discount = ?

We have,

Current market price − Net asset value Rs.36 − Rs.39.4

Premium (Discount) = Net asset value = Rs.39.4 = (0.0863) or (8.63%)

The fund sells at an 8.63 percent discount from the net asset value.

5. Solution

a. Net asset value

We have,

Total assets − Liabilities Rs.69,750,000 − Rs.500,000

NAV = Number of shares outstanding = = Rs. 69.25 per share

1,000,000

Working notes:

Total assets = 50,000 × Rs. 850 + 25,000 × Rs. 650 + 10,000 × Rs. 350 + 5,000 × Rs. 1,500 = Rs. 69,750,000

b. Buy the shares because shares are under priced.

c. Closed-end funds have a fixed number of shares outstanding. The share price is a function of supply and

demand. Since closed-end funds issue a fixed number of shares at one time, which thereafter trade freely on the

market among investors, depending on investor demand, a fund's share price may fall below or rise above its

NAV.

6. Solution

a. Net asset value

We have,

Total assets − Liabilities Rs.1,654,994,445 − Rs.17,628,104.13

NAV = Number of shares outstanding = = Rs. 32.7473 per share

50,000,000

Working notes:

Total assets = Investment in listed securities + Public issue/right share/bonus share + Bank balance +

Other assets

= 1,362,379,421.94 + 48,462,374.63 + 217,462,443.51 + 26,690,205.05

= 1,654,994,445

Total liabilities = Current liabilities + Fund manager and depository fee + Fund supervisor fee

= 1,283,728.21 + 15,010,141.16 + 1,334,234.76

= Rs 17,628,104.13

b. Buy the shares because shares are under priced.

c. NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the Asset Management

Company (AMC) at the end of every business day. Net asset value on a particular date reflects the realisable

value that the investor will get for each unit that he is holding if the scheme is liquidated on that date.

56 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

e. Closed-end funds have a fixed number of shares outstanding. The share price is a function of supply and

demand. Since closed-end funds issue a fixed number of shares at one time, which thereafter trade freely on

the market among investors, depending on investor demand, a fund's share price may fall below or rise above

its NAV.

7. Solution

a. Net asset value

We have,

Total assets − Liabilities Rs.450 − Rs.10

NAV = Number of shares outstanding = 44 = Rs. 10 per share

b. Number of shares outstanding = 44 – 1 = 43 millions shares

Portfolio value = Rs 450 million – 1 million × 10 = Rs 440 million

Total assets − Liabilities Rs.440 − Rs.10

NAV = Number of shares outstanding = 43 = Rs. 10 per share

8. Solution

Given:

Assets = Rs. 100,000 + Rs. 200,000 = Rs. 300,000

Liabilities (Accounts payable) = Rs. 20,000

Number of shares outstanding = 1,000 shares

Assets−Liabilities Rs.300,000−Rs.20,000

a. Net Asset Value = Number of shares = = Rs. 280 per share

10,000

b.Offering price = ?

We have,

NAV = Offering price × (1 – Load)

Or, Rs 280 = Offering price × (1 – 0.03)

∴ Offering price = Rs 288.66

9. Solution

a. Given:

Net asset value (NAV) = Rs 23.40

Selling price or offering price = Rs 25.00

We have,

Load fee as a percent of net assets value

Offering price−net asset value Rs25−Rs.23.40

Load fee = net asset value = Rs 23.40 = 0.0684 Or, 6.84%

Load fee as a percent of offering price

Offering price−net asset value Rs25−Rs.23.40

Load fee = Offering price = Rs 25 = 0.064 Or, 6.4%

b. Given:

Net asset value (NAV) = Rs. 10.70

Front-end load = 6%

Offering price =?

We have,

Net asset value = Offering price × (1 – front end load)

Or, Rs. 10.70 = Offering price × (1 – 0.06)

Or, Offering price = Rs. 11.3830

Therefore, the offering price of the open end fund is Rs. 11.3830.

c. Given:

Offering price = Rs. 12.30

Front-end load = 5 %

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 57

We have,

Net asset value = Offering price × (1 – front end load) = Rs. 12.30 × (1 – 0.05) = Rs. 11.685

Therefore, the net asset value of open-end mutual fund is Rs. 11.685.

10. Solution

Given:

Load fund No load fund

Investment amount Rs. 1,000 Rs. 1,000

Load fee 8% −

Return from investment 15% 12%

Redemption fee − 1%

Better investment ?

We have,

Value of load fund = (Investment amount − Load fee) × (1 + r) = (Rs. 1,000 − Rs. 80) × 1.15 = Rs. 1,058

Value of no-load fund = [Investment amount × (1 + r)] − Redemption fee

= (Rs. 1,000 × 1.12) − 11.20 = Rs. 1,108.80

Working notes:

Redemption fee = Rs. 1,000 × 1.12 × 0.01 = Rs. 11.20

The better investment is load fund and by Rs. 50.80 (Rs. 1,108.80 − Rs.1,058).

11. Solution

Here given:

Beginning NAV(NAV0) = Rs.18.50

End of year NAV(NAV1) = Rs.16.90

Income and capital gain (Div1 + CG1) = Rs.1.25

Holding period return (HPR) =?

We have,

(NAV1− NAV0) + CG1 + Div1 (Rs.16.90−Rs.18.50) + Rs.1.25

HPR = NAV0 = Rs.18.50 = − 0.019 or −1.9%

12. Solution

We have,

(NAV1 − NAV0) + CG1 + Div1

HPR = NAV0

Where,

NAV 1 = the fund's net asset value per share at the end of time period t +1

NAV0 = the fund's net asset value per share at the beginning

CG 1 = the capital gain at the end

Div1 = the dividend at the end

For year 1

(Rs.14.40−Rs.13.89) + 0.12 + 0.29

HPR1 = 13.89 = 0.066 or 6.6%

For year 2

(Rs.15.95 − Rs.14.40) + 0.25 + 0.33

HPR2 = 14.40 = 0.1479 or 14.79%

For year 3

(Rs.15.20 − Rs.15.95) + 0.05 + 0.36

HPR3 = 15.95 = − 0.021 or −2.1%

58 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

13. Solution

Given:

Assets at the start of the year = Rs. 200 million

No. of shares = 10 million

Total Dividend = Rs. 2 million

Increase in price = 8%

12b-1 fee= 1%

NAV at start = ?

NAV at end = ?

Rate of return= ?

Assets at the start of the year Rs.200

a. Start of year NAV = No. of shares = 10 = Rs. 20

End of year NAV is based on the 8% price gain, less the 10% 12b-1 fee:

End of year NAV = NAV0 × (1 + Price gain) × (1 + 12b-1 fee) = Rs. 20 × (1.08) × (1 + 0.01) = Rs. 21.384

∴Rate of return is 7.92%.

Working note:

Total dividend Rs. 2

Dividend per share = No. of shares = 10 = Rs. 0.20

(NAVt +1 − NAV0) + CG1 + Div1 (Rs. 21.384 − Rs. 20) + Rs. 0 + Rs. 0.20

b. Rate of return = NAV0 = Rs. 20 = 0.0792 or 7.92%

14. Solution

Here given:

Fund Class A Class B

Front end load 6% -

12b-1 fee - 0.4%

Redemption fee - 5% at start, 4% for 1 year, 3 % for 2 year, 2% for 3

year, 1% for 4 year and 0% for 5 year and onward

Rate of return 10% 10%

Initial investment Rs 10,000 Rs 10,000

Future value at year 1, 4 ? ?

and 8 year

We have,

Future value (FVn) = PV (1 + r)n

For Class A

Future value at year 1

FV1 = Rs 10,000 (1 – 0.06) (1 + 0.10)1 = Rs 10,340

Future value at year 4

FV4 = Rs 10,000 (1 – 0.06) (1 + 0.10)4 = Rs 13,762.54

Future value at year 8

FV8 = Rs 10,000 (1 – 0.06) (1 + 0.10)8 = Rs 20,149.73

For Class B

Future value at year 1

FV1 = Rs 10,000 (1 + 0.10 – 0.004)1 (1 – 0.04) = Rs 10,521.6

Future value at year 4

FV4 = Rs 10,000 (1 + 0.10 – 0.004)4 (1 – 0.01) = Rs 14,284.9068

Future value at year 8

FV8 = Rs 10,000 (1 + 0.10 – 0.004)8 (1 – 0.00) = Rs 28,820.1778

In the given periods, Class B share provides higher future value at the end of each horizon than the Class B. For

shorter investment horizons, the Class B shares provide the higher proceeds. For longer horizons, the Class A

shares, which impose a one-time commission, are better.

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 59

15. Solution

Here given:

Beginning NAV (NAV0) = Rs 10.40; Beginning market price (P0) = Rs 10.40 (1 – 0.18) = Rs 8.528; Ending NAV

(NAV1) = Rs 11.69; Ending market price (P1) = Rs 11.69 (1 + 0.04) = Rs 12.1576; Dividend (D1) = Rs 0.40; Capital

gains (CG1) = Rs 0.95

a.HPR = ?

We have,

(NAV1 − NAV0) + CG1 + Div1 (Rs. 11.69 − Rs. 10.40) + Rs. 0.40 + Rs. 0.95

HPR = NAV0 = Rs. 10.40 = 0.2538 or 25.38%

b.HPR = ?

We have,

(P1 − P0) + CG1 + Div1 (Rs. 12.1576 − Rs. 8.528) + Rs. 0.40 + Rs. 0.95

HPR = P0 = Rs. 8.528 = 0.5838 or 58.38%

The market discount applied to the purchase price and the market premium applied to the sale. Therefore, the

investor’s return benefited.

c. HPR = ?; Beginning market price (P0) = Rs 10.40 (1 + 0.18) = Rs 12.272; Ending market price (P1) = Rs 11.69 (1 -

0.04) = Rs 11.2224

We have,

(P1 − P0) + CG1 + Div1 (Rs. 11.2224 − Rs. 12.272) + Rs. 0.40 + Rs. 0.95

HPR = P0 = Rs. 12.272 = 0.0244 or 2.44%

Because the premium applied to the purchase price and discount applied to the ending price, the holding period

return is significantly lower. Obviously, both the premium and discount values affect the investor’s holding

period return.

16. Solution

a. The rate of return = ?

Given:

Beginning NAV (NAV0) = Rs. 12.00

Ending NAV (NAV1) = Rs. 12.10

Beginning NAV (NAV0) after 2% premium = Rs. 12.00 × 1.02 = Rs. 12.24

Ending NAV (NAV1) after 7% discount = Rs. 12.10 (1 − 0.07) = Rs. 11.253

Income and capital gains (Div1 and CG1) = Rs. 1.50

We have,

(NAV1− NAV0) + CG1 + Div1 (Rs.11.253−Rs.12.24) + Rs.1.50

HPR = NAV = Rs.12.24 = 0.0419 or 4.19%

0

Therefore, the rate of return to an investor in the fund during the year is 4.19%.

b. Rate of return =?

Given:

Beginning NAV (NAV0) = Rs. 12.00

Ending NAV (NAV1) = Rs. 12.10

Income and capital gains (Div1 and CG1) = Rs. 1.50

We have,

(NAV1− NAV0) + CG1 + Div1 (Rs.12.10−Rs.12.00) + Rs.1.50

HPR = NAV0 = Rs.12.00 = 0.1333 or 13.33%

Therefore, the rate of return to an investor in the fund during the year is 13.33%.

17. Solution

Given:

Current worth of portfolio (Total Assets) = Rs 1,000,000

Number of shares of Microsoft = 1,000

Market price of Microsoft= Rs 80

Number of shares of Ford= 2,000

60 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Share price= Rs 40

Number of shares of IBM= 1,600

Share price= Rs 100

a. Turnover rate =?

We have,

Minimum of purchasing or selling of securities Rs. 160,000

Portfolio turnover = Net assets value = = 0.16 or 16%

1,000,000

Therefore the turnover ratio is 16 percent. This means that on average, 16 percent of the portfolio is sold and

replaced with other securities each year.

Working notes

Value of securities sold = 1,000 × Rs 80 + 2,000 × Rs 40 = Rs 160,000

Value of securities purchased = 1,600 × Rs 100 = Rs 160,000

b. Realized capital gains are Rs 10 × 1,000 = Rs 10,000 on Microsoft and Rs 5 × 2,000 = Rs 10,000 on Ford. The tax

owed on the capital gains is therefore 0.20 × Rs 20,000 = Rs 4,000.

18. Solution

a.The excess of purchases over sales must be due to new inflows into the fund. Therefore, Rs400 million of stock

previously held by the fund was replaced by new holdings. So turnover is: Rs400/Rs2,200 = 0.182 = 18.2%

b.Fees paid to investment managers were: 0.007 × Rs2.2 billion = Rs15.4 million

Since the total expense ratio was 1.1% and the management fee was 0.7%, we conclude that 0.4% must be for other

expenses. Therefore, other administrative expenses were: 0.004 × Rs2.2 billion = Rs8.8 million

19. Solution

Total assets - liabillities 42000000- 30000

a. Net asset value (NAV) = = = Rs 10.4925 per share

shares outstanding 4000000

NAV is the total asset value (net of expenses) per unit of the fund and is calculated by the Asset Management Company (AMC) at the end

of every business day. Net asset value on a particular date reflects the realisable value that the investor will get for each unit that he is

holding if the scheme is liquidated on that date.

Minimum of sale or purchase Rs. 15,000,000

b Portfolio turnover ratio = = = 0.357 Or, 35.7%

Average net asset value Rs. 42,000,000

Therefore, the portfolio turnover ratio is 35.7%. This means that on average, 35.7 percent of the portfolio is sold and replaced with other

securities each year.

Working notes:

Purchase of stock E = 200,000 × Rs. 50 = Rs. 10,000,000

Purchase of stock F = 200,000 × Rs. 25 = Rs. 5,000,000

Total purchase = Rs. 15,000,000

Calculation of Net Asset Value

Stock Shares Price Net Asset Value

A 200,000 Rs.35 Rs. 7,000,000

B 300,000 Rs.40 Rs. 12,000,000

C 400,000 Rs.20 Rs. 8,000,000

D 600,000 Rs.25 Rs. 15,000,000

Total Rs. 42,000,000

c. Rate of return = ?

We have,

(NAV1- NAV0) + D1 + CG1 (12.10- Rs 10.4925) + Rs 1.50

Rate of return = = = 0.2962 Or, 29.62%

NAV0 Rs 10.4925

Therefore the rate of return for this fund is 29.62 percent.

20. Solution

As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and

purchase costs: 12% − 1.2% − 4% = 6.8%

But the precise return is less than this because the 4% load is paid up front, not at the end of the year.

To purchase the shares, you would have had to invest: Rs20,000/(1 − 0.04) = Rs20,833

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 61

The shares increase in value from Rs20,000 to: Rs20,000 × (1.12 − 0.012) = Rs22,160

The rate of return is: (Rs22,160 − Rs20,833)/Rs20,833 = 6.37%

21. Solution

Given:

Fund Loaded Up fund Economy Fund

Front end load - 2%

12b-1 fee 1% -

Expense ratio 0.75% 0.25%

Rate of return 6% 6%

Initial investment Rs 10,000 (assume) Rs 10,000 (assume)

Future value at year 1, ? ?

3 and 10 year

We have,

Future value (FVn) = PV (1 + r)n

Loaded Up fund

Future value at year 1 : FV1 = Rs 10,000 (1 + 0.06 – 0.01 – 0.0075)3 = Rs 10,425

Future value at year 3: FV3 = Rs 10,000 (1 + 0.06 – 0.01 – 0.0075)1 = Rs 11,329.9552

Future value at year 10: FV3 = Rs 10,000 (1 + 0.06 – 0.01 – 0.0075)10 = Rs 15,162.1447

Economy Fund

Future value at year 1: FV1 = Rs 10,000 (1 – 0.02) (1 + 0.06 – 0.0025)1 = Rs 10,363.50

Future value at year 3: FV3 = Rs 10,000 (1 – 0.02) (1 + 0.06 – 0.0025)3 = Rs 11,589.5668

Future value at year 10: FV1 = Rs 10,000 (1 – 0.02) (1 + 0.06 – 0.0025)10 = Rs 17,140.7506

22. Solution

Given:

Fund Class A Class B

Front end load 4% -

12b-1 fee - 0.5%

Redemption fee - 5% at start, 4% for 1 year, 3 % for 2 year, 2% for 3

year, 1% for 4 year and 0% for 5 year and onward

Rate of return 10% 10%

Initial investment Rs 10,000 Rs 10,000

Future value at year 1, 4 and 10 year ? ?

We have,

Future value (FVn) = PV (1 + r)n

For Class A

Future value at year 1 : FV1 = Rs 10,000 (1 – 0.04) (1 + 0.10)1 = Rs 10,560

Future value at year 4: FV4 = Rs 10,000 (1 – 0.04) (1 + 0.10)4 = Rs 14,055.36

Future value at year 10: FV8 = Rs 10,000 (1 – 0.04) (1 + 0.10)10 = Rs 24,899.93

For Class B

Future value at year 1 : FV1 = Rs 10,000 (1 + 0.10 – 0.005)1 (1 – 0.04) = Rs 10,512

Future value at year 4: FV4 = Rs 10,000 (1 + 0.10 – 0.005)4 (1 – 0.01) = Rs 14,232.84

Future value at year 10: FV10 = Rs 10,000 (1 + 0.10 – 0.005)10 (1 – 0.00) = Rs 24,782.28

For a very short horizon such as 1 year, the Class A shares are the better choice. The front-end and back-end loads

are equal but the Class A shares don't have to pay the 12b-1 fees. For moderate horizons such as 4 years, the Class

B shares dominate because the front-end load of the Class A shares is more costly than the 12b-1 fees and the

now-smaller ext fee. For long horizons of 10 years or more, Class A again dominates. In this case, the one-time

front-end load is less expensive than the continuing 12b-1 fees.

23. Solution

62 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

a. Suppose you have Rs1,000 to invest. The initial investment in Class A shares is Rs940 net of the front-end

load. After four years, your portfolio will be worth:

Rs940 × (1.10)4 = Rs1,376.25

Class B shares allow you to invest the full Rs1,000, but your investment performance net of 12b-1 fees will be

only 9.5%, and you will pay a 1% back-end load fee if you sell after four years. Your portfolio value after four

years will be:

Rs1,000 × (1.095)4 = Rs1,437.66

After paying the back-end load fee, your portfolio value will be:

Rs1,437.66 × 0.99 = Rs1,423.28

Class B shares are the better choice if your horizon is four years.

b. With a fifteen-year horizon, the Class A shares will be worth:

Rs940 × (1.10)15 = Rs3,926.61

For the Class B shares, there is no back-end load in this case since the horizon is greater than five years.

Therefore, the value of the Class B shares will be:

Rs1,000 × (1.095)15 = Rs3,901.32

At this longer horizon, Class B shares are no longer the better choice. The effect of Class B's 0.5% 12b-1 fees

accumulates over time and finally overwhelms the 6% load charged to Class A investors.

24. Solution

Here given:

Investment amount = Rs. 1,000

Load fee = 8.5%

Management and other fee = 1.10%

Interest rate = 5%

Set the equation as follows:

Rs. 1,000 (1 – 0.085) (1 + HPR − 0.011) 5 = Rs. 1,000 ( 1 + 0.05) 5

Or, Rs. 915 (0.989 + HPR)5 = Rs. 1,276.2816

Rs.1,276.2816

Or, (0.989 + HPR) 5 = Rs.915

Or, 0.989 + HPR = (1.3948) 1 / 5

Or, 0.989 + HPR = 1.06881

Or, HPR = 1.06881 – 0.989 = 0.07981 = 7.981 % ≈ 8%

Therefore, the annual return approximately 8% to produce equal the value of two investment.

25. Solution

Here given:

Fund

E D N L

Investment amount Rs. 1,000 Rs. 1,000 Rs. 1,000 Rs. 1,000

NAV Rs. 10 Rs. 10 Rs. 10 Rs. 10

Market price Rs. 10 Rs. 8 Rs. 10 Rs. 10

Brokerage fee 2% 2% − −

Load fund − − − 8.5%

No. of shares ? ? ? ?

We have,

Total investable fund

Number of shares = Cost per share

For closed end fund E:

Rs.1,000

Number of shares = Rs. 10.20 = 98.04 shares

Working notes:

Cost per share = Rs. 10 + 2% of Rs. 10 = Rs. 10.2

For closed end fund E:

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 63

Rs.1,000

Number of shares = Rs. 8.16 = 122.55 shares

Working notes:

Cost per share = Rs. 8 + Rs. 0.16 = Rs. 8.16

For closed end fund N:

Rs.1,000

Number of shares = Rs. 10 = 100 shares

For closed end fund L:

Rs.1,000

Number of shares = Rs. 10.93 = 91.50 shares

Working notes:

Rs.1,000 ( 1 − 0.085)

Cost per share = Rs.10 = 91.10 shares

Thus, the largest number of shares would be received when buying the shares of discounted closed end fund D,

the fewest shares would be received when buying the shares of load fund L.

♦-♦

NUMERICAL PROBLEMS

1. Solution

Given: Holding period = 1 year; Purchase price (P0) = Rs 63; Cash dividend (D1) = Rs 3.75; Selling price or ending

price (P1) = Rs 67.50; Total income = ?

Total income = (P1 – P0) + D1 = (Rs 67.50 – Rs 63) + Rs 3.75 = Rs 4.50 + Rs 3.75 = Rs 8.25

Part of the total rupee return includes a Rs 4.50 capital gain, which is the difference between the proceeds of the

sale and the original purchase price (Rs 67.50 – Rs 63.00) of the stock.

2. Solution

Given: Purchase price (P0) = Rs 10,000; Interest (I1) = Rs 300 in every six months; holding period (n) = 18 months;

Selling price or ending price (P1) = Rs 9,500

Total income = (P1 – P0) + I1 = (Rs 9,500 – Rs 10,000) + Rs 900 = (Rs 500) + Rs 900 = Rs 400

Working notes: Total interest for 18 months = Rs 300 × 3 = Rs 900

The investor had interest income of Rs 900 (three payments of Rs 300 each), and a capital loss of Rs 500.

3. Solution

Given: Purchase price (P0) = Rs 9,500; Interest (I1) = Rs 300 in every six months; holding period (n) = 18 months;

Selling price or ending price (P1) = Rs 10,000

a. Current income = Interest income = Rs 900 (three payment of Rs 300 for 18 months holding period)

b. Capital gain = (P1 – P0) = (Rs 10,000 – Rs 9,500) = Rs 500

Working notes: Total interest for 18 months = Rs 300 × 3 = Rs 900

c. (1)Total return in rupees = (P1 – P0) + I1 = Rs 500 + Rs 900 = Rs 1,400

(P1 − P 0) + I1 Rs 500 + Rs 900

(2) Percentage rate of return (HPR) = P0 = = 0.147 or 14.7 %

Rs 9,500

4. Solution

Given:

Number of shares to be purchased = 100 shares

Price of stock one year ago (P0) = Rs. 20

Holding period = 1 year

Dividend during the year (D1) = Rs. 2

64 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

a. Rupee return

Return per share= (P1 − P0) + D1 = (Rs. 21 − Rs. 20) + Rs. 2 = Rs. 3

Total rupee return= Return per share × Number of shares = Rs. 3 × 100 = Rs. 300

b. Holding period return (HPR)

(P1 − P0) + D1 (Rs.21 − Rs.20) + Rs.2

HPR = P0 = Rs.20 = 0.15 or 15 %

c. Partition of the HPR

D1 Rs.2

Dividend yield = P = Rs.20 = 0.10 or 10%

0

Capital appreciation = P0 = Rs.20 = 0.05 or 5%

5. Solution

Given:

Option 1 2

Quarterly dividend Rs 0.50 Rs 0.60

Beginning price Rs 25 per share Rs 27 per share

Selling price Rs 27 Rs 30

Holding period 6 months 1 year

Annualized holding ? ?

period return

We have,

(P1 − P 0) + D1

HPR= P0

(Rs.27− Rs.25) + Rs.1

For option 1: HPR (Total return) = Rs.25 = 0.12 or 12 %.

Since this is a six-month investment, the annualized return is two times the HPR or 12% × 2 = 24%.

(Rs.30 − Rs.27) + Rs.2.40

For option 2: HPR (Total return) = Rs.27 = 0.20 or 20 %

The first investment provides the higher annualized return.

6. Solution

Given:

Investment ABC XYZ

Beginning Market value (P0) Rs 120,000 Rs 155,000

Cash flow (C1) Rs15,000 Rs 16,800

Ending market value (P1) Rs 130,000 Rs 185,000

a. Holding period return =?

We have,

(P1 − P0) + C1

Holding period return = P0

For ABC

(Rs130,000 − Rs120,000) + Rs15,000

HPR = = 0.2083 or 20.83%

Rs120,000

For XYZ

(Rs185,000 − Rs155,000) + Rs16,800

HPR = = 0.3019 or 30.19%

Rs155,000

b. Investment in XYZ should be recommended because this investment provides higher holding period return.

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 65

7. Solution

Given:

Ending price for Vehicle X, (P1) = Rs. 290

Beginning price for Vehicle X, (P0) = Rs. 300

Cash received for Vehicle X, (D1) = Rs. 45 (Rs.10 + Rs.12 + Rs. 0 + Rs.23)

Ending price for Vehicle Y, (P1) = Rs. 560

Beginning price for Vehicle Y, (P0) = Rs. 500

Cash received for Vehicle Y, (D1) = Rs. 20 (Rs. 0 + Rs. 0 + Rs. 0 + Rs. 20)

We have,

(P1 − P 0) + D1

HPR (Total return) = P0

For Investment Vehicle X

(Rs.290− Rs.300) + Rs.45

HPR (Total return) = Rs.300 = 0.1167 or 11.67 %

For Investment Vehicle Y

(Rs.560 − Rs.500) + Rs.20

HPR (Total return) = Rs.500 = 0.16 or 16 %

If the investments are held beyond a year, the capital gain (loss) component would not be realized and would

likely change. Assuming they are of equal risk, Investment Y would be preferred since it offers the higher return

(16.0% for Y versus 11.67% for X).

8. Solution

Given:

Starting price (P0) = Rs 200 per share

Ending price (P2) = Rs 190 per share

Dividend in 2001 (D1) = Rs 20 per share

Dividend in 2002 (D2) = Rs 30 per share

a.Two year holding period return if dividend is not reinvested

(P2 −P0) + D1 + D2 (Rs190 −Rs 200) + Rs20 + Rs30

HPR = P = Rs200 = 0.20 Or, 20%

0

(P2 −P0) + D1 (1+ R) + D2 (Rs190 −Rs 200) + Rs20 (1 + 0.10) + Rs30

HPR= P0 = Rs200 = 0.21 Or, 21%

9. Solution

a. Two-year holding period return

Given:

Year Nepal Bank Ltd. Nabil Bank Ltd. Total price

Jan. 2001, =1,000 shares × Rs 200 = 500 shares × Rs 700 = Rs 550,000

purchase price = Rs 200,000 = Rs 350,000

Dec. 2002, =1,000 shares × Rs 190 = 500 shares × Rs 800 = Rs 590,000

selling price = Rs 190,000 = Rs 400,000

Reinvestment (R) = 10%

Calculation of total dividend

Dividend per share Total dividend in a year

Bank

2001 2002 2001 2002

Nepal bank Rs 0 Rs 0 1,000 × Rs 0 = Rs 0 1,000 × Rs 0 = Rs 0

Nabil bank Rs 20 Rs 30 500 × Rs 20 = Rs 10,000 500 × Rs 30 = Rs 15,000

Total dividend Rs 10,000 Rs 15,000

(P2 −P0) + D1 + D2 (Rs590,000 − Rs550,000) + Rs10,000 + Rs 15,000

We have, 2- year HPR = P0 = = 0.1182 Or, 11.82%

Rs550,000

b. 2 -year holding period return if dividend in 2001 was reinvested at 10 percent

66 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

We have,

(P2 −P0) + D 1 (1+ R) + D2 (Rs590,000 − Rs550,000) + Rs10,000 ( 1 + 0.10) + Rs 15,000

2- year HPR = P0

= Rs550,000

= 0.12 Or, 12%

10. Solution

Here gi ven:

Purchase price on Jan 15, 19X8 (P0) = Rs 40 per share; Selling price on July 15 (P1) = Rs 42; Cash dividend (D1) = Rs

2 per share

a.Single period rate of return or Holding period return (HPR) = ?

(P1 − P0) + D1 (42 - 40) + 2

HPR = P0 = 40 = − 0.10 or 10%

b.Annualized rate or Effective annual rate (EAR) = ?

EAR = (1 + HPR)m – 1 = (1 + 0.10)2 – 1 = 0.21 Or, 21%

11. Solution

a. Nominal interest rate = Real rate + inflation rate = 3% + 8% = 11%

b. Nominal interest rate = 3% + 10% = 13%

12. Solution

(P1 − P0) + D1 (8,0010,000) + 1,000

a.HPR1989 = P0 = = − 0.10 or −10%

10,000

(P1 − P0) + D1 (11,000 + 8,000) + 1,500

b.HPR1990 = P0 = = 0.5625 or 56.25%

8,000

HPR1989 + HPR1990 −10 + 56.25

c.Arithmetic mean HPR = n = 2 = 23.125%

1

d.Geometric mean HPR = [(1 − 0.10) (1 + 0.5625)]2 − 1 = (1.40625)0.50− 1 = 1.1859 − 1 = 0.1859 or 18.59%

13. Solution

Time Cash flow Holding period return

0 3(–Rs 90) = –Rs 270

1 Rs 100 (100–90)/90 = 11.11%

2 Rs 100 0%

3 $100 0%

a.Time-weighted geometric average rate of return =

(1.1111 × 1.0 × 1.0)1/3 – 1 = 0.0357 = 3.57%

b.Time-weighted arithmetic average rate of return = (11.11% + 0 + 0)/3 = 3.70%

The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the

greater the difference.

c.Rupee-weighted average rate of return = IRR = 5.46%

NPV = TPV – NCO

CF1 CF2 CF3

Or, NPV = (1 + IRR)1 + (1 + IRR)2 + (1 + IRR)3 - NCO

Rs 100 Rs 100 Rs 100

Or, 0 = (1 + IRR)1 + (1 + IRR)2 + (1 + IRR)3 - 270

Or, IRR = 5.46%

The IRR exceeds the other averages because the investment fund was the largest when the highest return

occurred.

14. Solution

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 67

Year rA rB

1 10% 14%

2 15 − 10

3 8 30

ΣrA= 33 ΣrB = 34

ΣrA 33 ΣrB 34

rA= n = 3 = 11%, rB = n = 3 = 11.33 %

b. Geometric mean HPR for both investments.

rB = [(1 + r1)(1 + r2)(1 + r3)]1/3 – 1

For Investment –A

rB = [(1+ 0.10) (1+ 0.15) (1+ 0.08)] 1/3 – 1.0

= [1.10 × 1.15 × 1.08]1/3– 1.0 = [1.3662]1/3 –1.0

= 1.1096127 – 1 = 0.1096 or 10.96 %

For Investment –B

rB = [(1+ 0.14) {1+ (−0.10)} (1+ 0.30)]1/3 –1.0

= [1.14 × 0.90 × 1.30]1/3–1.0

= 1.1007708 − 1 = 0.1008 or 10.08 %

c. The geometric mean return is consistent with the assumption of reinvesting or growth of the income when it is

received and arithmetic mean ignores the reinvesting or growth.

The arithmetic mean and geometric mean will only be equal when the holding period returns are constant over

the investment horizon. Large differences in the holding period returns over the investment horizons will cause

the arithmetic rate of return to be misleading.

d. Total value of investments A and B

Investment -A

1st year = Rs. 10,000 (1.10) = Rs. 11,000

2nd year = Rs. 11,000 (1.15) = Rs. 12,650

3rd year = Rs. 12,650(1.08) = Rs. 13, 662

Alternatively,

Total rupee value at the end of year 3

= Investment × (1+r1)(1+r2)(1+ r3)

= Rs. 10,000 × (1+ 0.10) (1 + 0.15) (1 + 0.08) = Rs. 13,662

Investment -B

1st year = Rs. 10,000 (1.14) = Rs. 11,400

2nd year = Rs. 11,400 (0.90) = Rs. 10,260

3rd year = Rs. 10,260 (1.30) = Rs. 13,338

Alternatively,

Total rupee value at the end of year 3

= Investment × (1+r1)(1+r2)(1+ r3) = Rs. 10,000 × (1+ 0.14) [1 + (− 0.10)] (1 + 0.30) = Rs. 13,338

Investment -A's return performance is better than investment - B because the total value of investment A is

greater than the total value of investment -B. (Rs. 13,662 > Rs. 13,338)

15. Solution

Return rj (%) Probability, Pj Pj × rj Pj×[rj – E(rj)]]2

-10 0.10 -1 34.225

0 0.25 0 18.0625

10 0.40 4 0.9

20 0.20 4 26.45

30 0.05 1.5 23.1125

Total 8.5 102.75

Therefore, the expected return, E(rj)= Σrj × Pj = 8.5%

Variance = Var (rj) = σj2 =Σ Pj[rj − E(rj)]2= 102.75

68 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

16. Solution

Here given

Beginning price = Rs. 23.50 (for each of the business condition)

Calculation of HPR for each business condition

EP − BP + DPS

Business condition EP BP DPS HPR = BP

35 − 23.50 + 4.40

High growth Rs. 35 23.50 Rs. 4.40 = 67.66%

23.50

27 − 23.50 + 4

Normal growth 27 23.50 4 = 31.91%

23.50

15 − 23.50 + 4

No growth 15 23.50 4 = − 19.15%

23.50

Business Condition Probability (Pj) Return (rj) rj × Pj [rj − E(rj)]2 × Pj

High growth 0.35 67.66% 23.681% 591.4680

Normal growth 0.30 31.91% 9.73% 8.6141

No growth 0.35 − 19.15% −6.7025% 731.0195

26.5515% 1331.1016

n

E(r) = ∑ rj × Pj = 26.5513%

j=1

n

Standard deviation (σ) = ∑ [rj − E(rj)]2 × Pj = 1331.1016 = 36.76%

j=1

17. Solution

a. Expected rate of return

Probability

State of economy Estimated return (rj) Pj × rj

(Pj)

Strong growth 0.10 25% 2.5

Moderate growth 0.40 15 6.0

Weak growth 0.40 10 4.0

Recession 0.10 − 12 − 1.2

∑ Pj×HPRj =11.3

b. The variance

State of economy Probability [rj −E (rj)]2 Pj[rj −E(rj)]2

Strong growth 0.10 (25−11.3)2 0.1 × 187.69 = 18.769

Moderate growth 0.40 (15−11.3)2 0.4 × 13.69 = 5.476

Weak growth 0.40 (10−11.3)2 0.4 × 1.69 = 0.676

Recession 0.10 (−12−11.3)2 0.1 × 542.89 = 54.28

Σ Pj[rj − E(rj)]2 = 79.21

σj)

c. Standard deviation (σ

σj = σj2 = 79.21 = 8.90 %

d. Coefficient of variation (CVj)

Standard deviation 8.90

CVj = Expected rate of return = 11.3 = 0.7876

e. The expected rate of return of 11.3% is the weighted average of the various estimated rate of return, with the

weights being percentage probability of occurrence of each economy. The variance of 79.21% is the sum of the

squared difference between each return and the expected return, multiplied by the probability. The standard

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 69

deviation of 8.90%, is the square root of the variance. Both variance and standard deviation measures the

dispersion from the expected rate of return. The coefficient of variation of 0.7876 is the standard deviation divided

by expected rate of return. Coefficient of variation measures the risk per unit of return.

18. Solution

a. E (rG) = 0.25 × (−10%) + 0.15 × 0 + 0.35 × 10 + 0.25 × 25 = 7.25%

Calculation of variance (σ2)

Probability rG [rG − E(rG)]2 × prob

0.25 −10 (−10 − 7.25)2 × 0.25 = 74.3906

0.15 0 (0 − 7.25)2 × 0.15 = 7.8844

0.35 10 (10 − 7.25)2 × 0.35 = 2.6469

0.25 25 (25 − 7.25)2 × 0.25 = 78.7656

Σ[rG − E(rG)]2 × prob = 163.6875

2

Variance = σG = Σ[rG − E(rG)]2 × prob = 163.6875

σG = σG = 163.6875 = 12.7940%

b. Standard deviation can be used as a good measure of relative risk between two investments that have the same

expected rate of return.

c.The coefficient of variation must be used to measure the relative variability of two investments of there are

major differences in the expected rates of return.

19. Solution

a. Investment A, with returns that vary widely—from 1% to 26%—appears to be more risky than Investment B,

whose returns vary from 8% to 16%.

b. Calculation of standard deviation and coefficient of variation

For Investment A:

(2) Average (3) (4)

Year (1) Return, r A

rA

Return, rA

rA – (rA– rA)2

2004 19% 12% 7% 49%

2005 1 12 –11 121

2006 10 12 –2 4

2007 26 12 14 196

2008 4 12 –8 64

Σ (rA– rA)2 = 434

Σ (rA– rA)2 434

Variance of stock A = σA2 = n = 5 = 86.8%%

σA 9.3167%

Coefficient of variation (CVA) = r = 12% = 0.7764

A

Investment B:

(1) (2) (3) (4)

Year

Return, r B Average Return, rB rB – rB (rB – rB)2

2004 8% 12% –4% 16%

2005 10 12 –2 4

2006 12 12 0 0

2007 14 12 2 4

2008 16 12 4 16

Σ (rB– rB)2 = 40

Σ (rA– rA)2 40

Variance of stock A = σA2 = n = 5 = 8%%

70 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

σB 2.8284%

Coefficient of variation (CVB) = = 12% = 0.2357

rB

c.Investment A, with a standard deviation of 9.3167%, is considerably more risky than Investment B, whose

standard deviation is 2.8284%. This confirms the conclusions reached in Part a.

d.Because the real benefit of calculating the coefficient of variation is in comparing investments that have different

average returns, but in this case, standard deviation gives clear cut decision.

20. Solution

(a) Calculation of expected rate of return for each bank’s stock

Probability rNCC rNABIL rNCC × Prob rNABIL × Prob

0.1 -12.5 – 20 -1.25 -2.00

0.2 5 0 1.00 0.00

0.4 10 15 4.00 6.00

0.2 25 30 5.00 6.00

0.1 35 36 3.50 3.60

Σ rNCC × Prob =12.25 Σ rNABIL × Prob = 13.6

(b) Calculation of Standard Deviation

Prob. [rNCC –E(rNCC)]2 × Prob [rNabil –E(rNABIL)]2 × Prob

0.1 (–12.5 – 12.25)2 × 0.1 = 61.26 (–20 – 13.6)2 × 0.1 = 112.90

0.2 (5 – 12.25)2 × 0.2 = 10.51 (0 – 13.6)2 × 0.2 = 36.99

0.4 (10 – 12.25)2 × 0.4 = 2.03 (15 – 13.6)2 × 0.4 = 0.78

0.2 (25 – 12.25)2 × 0.2 = 32.51 (30 – 13.6)2 × 0.2 = 53.79

0.1 (35 – 12.25)2 × 0.1 = 51.76 (36 – 13.6)2 × 0.1 = 50.18

Σ[rNCC –E(rNCC)]2 × Prob =158.07 Σ[rNABIL –E(rNABIL)]2 × Prob = 254.64

Variance of NCC’s stock = σNCC2 = Σ[rNCC –E(rNCC)]2 × Prob. = 158.07%%

Standard deviation of NCC’s stock= Σ[rNCC –E(rNCC)]2 × Prob. = 158.07%% = 12.5726 ≈ 12.57%

Variance of Nabil’s stock = σNabil2 = Σ[rNABIL –E(rNABIL)]2 × Prob.

= 254.64%%

Standard deviation of Nabil’s stock= Σ[rNABIL –E(rNABIL)]2 × Prob. = 254.64%% = 15.9374 ≈ 15.94%

(c) Calculation of coefficient of Variation

σNCC 12.57

CVNCC = E(r ) = 12.25 = 1.026

NCC

σNABIL 15.94

CVNabil = E(r )= 13.6 = 1.172

NABIL

Decision: Stock of NCC is preferable for the investment because the coefficient of variation is less than the stock

of NABIL.

21. Solution

Year rT rB (rT − rT)2 (rB − rB)2

1 0.19 0.08 0.0185 0.0041

2 0.08 0.03 0.0007 0.0002

3 − 0.12 −0.09 0.0303 0.0112

4 −0.03 0.02 0.0071 0.00002

5 0.15 0.04 0.0092 0.0006

0.27 0.08 0.0658 0.01612

n rt

(a) Arithmetic mean return ( r) = ∑ n

t=1

0.27 0.08

rT = = 0.054 i.e. 5.4% rB = = 0.016 i.e. 1.60%

5 5

According to this measure, stock T is most desirable as it has higher rate of return.

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 71

(rj − rj)2

σ) =

(b) Standard deviation (σ

n

0.0658 0.0612

σT = = 0.1147 σB = = 0.0568

5 5

According to this measure, stock B is preferable as it has lower standard deviation.

σ

(c) CV =

r

0.1147 0.0508

CVT = = 2.12 CVB = = 3.55

0.054 0.016

CV is the relative measure of risk. It measures the risk associated with each unit of return. According to CV stock T is preferable.

(d) Calculation of arithmetic mean and geometric means.

Arithmetic mean return:

rT = 5.40% rB = 1.60%

n

Geometric mean return (rg) = ∏ (1 + rt)1/n − 1

t=1

For stock R, = [(1 + 0.19) (1 + 0.08) (1−0.12) (1 − 0.03) (1 + 0.15)1/5 − 1

= (1.261603728)1/5 − 1 = 4.75714%

For stock B = [(1 + 0.08) (1 + 0.03) (1 − 0.09) (1 + 0.02) (1.04)]1/5− 1

= (1.073830867)1/5−1 = 1.4348%

The mean return of each stocks is related with their standard deviation by coefficient of variation in part ‘C’.

22. Solution

Pj rA(%) rB(%) Pj × rA Pj × rB

0.10 10 20 1 2

0.25 12 25 3 6.25

0.35 8 33 2.8 11.55

0.20 14 27 2.8 5.4

0.10 19 22 1.9 2.2

Total 11.5% 27.4%

Probability Pj × [rA-E(rA)]][rB-E(rB)]]

0.10 0.10 ( 10 – 11.5)(20 – 27.4) = 1.11

0.25 0.25( 12 – 11.5)( 25 – 27.4) = − 0.30

0.35 0.35(8 – 11.5)(33 – 27.4) = − 6.86

0.20 0.20(14 – 11.5)( 27 – 27.4) = − 0.20

0.10 0.10( 19 – 11.5)( 22 – 27.4) = − 4.05

Total = −10.30

Covariance, between stock A and B, CovAB = ΣPj × [rA− E(rA)][rB− E(rB)] = – 10.30

23. Solution

Pj rL(%) rH(%) Pj × rL Pj × rH

0.15 −10 15 −1.5 2.25

0.20 5 10 1 2

0.30 10 5 3 1.5

0.35 20 0 7 0

Total 9.5% 5.75%

The expected return = ΣPj × rL = 9.5%

The expected return = ΣPj × rH = 5.75%

Probability Pj × [rL-E(rL)]]2 Pj × [rH-E(rH)]]2 Pj × [rL-E(rL)]][rH-E(rH)

0.15 57.04 12.83 −27.056

0.20 4.05 3.61 −3.825

72 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

0.35 38.59 11.57 −21.131

Total 99.76 28.18 −52.125

Variance, σ2L = Σ[rL− E(rL)]2 × Pj = 99.76

Standard deviation (σL) = 99.76 = 9.987 %

Variance, (σ2H) = Σ Pj × [rH− E(rH)]2 = 28.18

Standard deviation (σH) = 28.18 = 5.309%

Covariance, CovLH = Σ Pj × [rL− E(rL)][rH− E(rH)] = – 52.125

CovLH −52.1

Correlation coefficient (ρLH) = = = − 0.98

σL × σH 9.987 × 5.309

24. Solution

State Prob. rB rS [rL-E(rB)][rH-E(rS)] × Pj

Recession 30% 10% -12% (10 – 6.4) (-12 – 8.8) 0.30 = - 22.464

Normal 40% 7 10 (7 – 6.4) (10 – 8.8) 0.40 = 0.288

Boom 30% 2 28 (2 – 6.4) (28 – 8.8) 0.30 = - 25.344

Σ[rL-E(rB)][rH-E(rS)] × Pj = 47.52

Therefore covariance is 47.52.

25. Solution

a. Calculation of covariance

Year (rA - rA) (rB –rB)

1 (10- 14.25) (20 – 13.25) = - 28.69

2 (12 - 14.25) (15– 13.25) = - 3.94

3 (15- 14.25) (10– 13.25) = - 2.44

4 (20- 14.25) (8– 13.25) = - 30.19

n=4 Σ(kA - kA) (kB –kB) = - 65.26

CovAB = Σ(rA - rA) (rB –rB)/ n = - 65.26/4 = - 16.315%%

Correlation between A an B (ρAB) = CovAB /σA ×σB = - 16.315/ 3.7663 × 4.6567 = - 0.9302

Working notes:

1. Calculation of average rate of return

Year rA rB

1 10% 20

2 12 15

3 15 10

4 20 8

n=4 ΣrA = 57% ΣrB = 53%

rA = ΣrA/n = 57%/4 = 14.25%; rB = ΣrB/n = 53%/4 = 13.25%

2. Standard deviation for each stock

Year (rA - rA)2 (rB –rB)2

1 (10- 14.25) 2 =18.06 (20 – 13.25)2 = 45.56

2 (12 - 14.25) 2 =5.06 (15– 13.25)2 = 3.06

3 (15- 14.25) 2 = 0.56 (10– 13.25)2 = 10.56

4 (20- 14.25) 2 = 33.06 (8– 13.25)2 = 27.56

n=4 Σ(rA - rA)2 = 56.74 Σ(rB –rB)2 = 86.74

σA2 = Σ(rA - rA)2/ n = 56.74/4 = 14.185%% or σA = 14.185 = 3.7663%

σB2 = Σ(rB - rB)2/ n = 86.74/4 = 21.685%% or σA = 21.685 = 4.6567%

b. Yes. These stocks offer a good chance of diversification because the correlation is high negative.

♦-♦

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 73

NUMERICAL PROBLEMS

1. Solution

E(rP) = 0.50 × 15% + 0.40 × 10% + 0.10 × 6% = 12.1%

2. Solution

Here given:

Proportion of wealth invested in common stock 1 (W1) = 20%

Proportion of wealth invested in common stock 2 (W2) = 20%

Proportion of wealth invested in common stock 3 (W3) = 20%

Proportion of wealth invested in Treasury bills (WTB) = 40%

Expected return on common stock 1, E (r1) = 12%

Expected return on common stock 2, E (r2 ) = 10%

Expected return on common stock 3, E (r3) = 15%

Expected return on Treasury bills, E (rTB ) = 6%

We have,

Expected return of the portfolio, E(rP)

E(rp) = W1E(r1) + W2 E(r2) + W3 E(r3) + WTB E(rTB)

= 0.210 × 12%× 0.20 × 0.215 + 0.40 × 6

= 9.8%

Therefore, the expected return for this portfolio is 9.8%.

3. Solution

Here given:

Total investable fund = Rs100,000

Investment in stocks (P0) = Rs 40,000

Investment in bonds (D0) = Rs 60,000

After a year stocks worth (P1) = Rs 50,000

After a year bonds worth (D1) = Rs 46,000

Cash dividend on stocks (P1) = Rs 2,000

Coupon payments on the bonds (I1) = Rs 6,000

a. Return on Ray's stock portfolio during the year

(P1 − P0) + D1 (Rs50,000 − Rs40,000) + Rs2,000

HPR = E(rs) = P0 = = 0.30 Or, 30%

Rs40,000

b. Return on Ray's bond portfolio during the year

(P1 − P0) + I1 (Rs46,000 − Rs60,000) + Rs6,000

HPR = E(rB) = P0 = = –0.1333Or,− 13.33%

Rs60,000

c. Return on Ray's total portfolio during the year

We have,

E(rP) = WS × E(rs) + WB × E(rB) = 0.40 × 30% + 0.60 × − 13.33% = 4%

Working Notes:

Rs40,000

Proportion of wealth invested in Stock (WS) = = 0.40

Rs100,000

Rs60,000

Proportion of wealth invested in Bond (WB)= = 0.60

Rs100,000

d. The rational investor should choose bond portfolio because it has higher expected rate of return.

4. Solution

The initial value of Corns's portfolio is:

= (Rs.50 × 100) + (Rs.35 × 200) + (Rs.25 × 50) + (Rs.100 × 100)

= Rs.5,000 + Rs.7,000 + Rs.1,250 + Rs.10,000 = Rs.23,250

The proportion that each security constitutes of Corns's initial portfolio is:

74 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

WA = = 0.2150 WB = = 0.3011

Rs.23,250 Rs.23,250

(Rs.25 × 50) (Rs.100 × 100)

WC = = 0.0538 WD = = 0.4301

Rs.23,250 Rs.23,250

The expected returns on the portfolio securities are:

We have,

Ending price − Beginning price

Expected return, E(rj) = Beginning price

(Rs.60 – Rs.50)

E(rA) = Rs.50 = 0.20 or 20%

(Rs.40 –Rs.35)

E(rB) = Rs.35 = 0.1429 or 14.29%

(Rs.50 –Rs.25)

E(rC) = = 1.00 or 100%

Rs.25

(Rs.110 – Rs.100)

E(rD) = Rs.100 = 0.10 or 10%

The expected return on a portfolio is given by:

E(rP) = WA × E(rA) + WB × E(rB) + WC × E(rC) + WD × E(rD)

= 0.2150 × 20% + 0.3011 × 14.29% + 0.0538 × 100% + 0.4301 × 10%= 18.284%

Therefore, the expected return on the above portfolio is 18.284%.

5. Solution

Here given:

Proportion of portfolio initial market value for stock A (WA) = 19.2%

Proportion of portfolio initial market value for stock B (WB) = 7.7%

Proportion of portfolio initial market value for stock C (WC) = 38.5%

Proportion of portfolio initial market value for stock D (WD) = 34.6%

Calculation of each stock's expected return

We have,

Ending price − Beginning price

Expected return, E(rj) = Beginning price

Rs.700 – 500

For A, E(rA) = Rs.500 = 0.40 or 40 %

Rs.300 – 200

For B, E(rB) = Rs.200 = 0.50 or 50%

Rs.1,000 – 1,000

For C, E(rC) = = 0.00 or 0 %

Rs.1,000

Rs.1,500 – 900

For D, E(RD) = Rs.900 = 0.6667 or 66.67%

Portfolio return, E(rp), is given by:

E(rP) = WA × E(rA) + WB ×E(rB) + WC × E(rC) + WD × E(rD)

= 0.192 × 40% + 0.077 × 50% + 0.385 × 0% + 0.346 × 66.67% = 34.60%

Therefore, the expected return for this portfolio is 34.60%.

6. Solution

a. Expected return and risk of portfolio if there is no correlation

E(rP) = W1 × E(r1) + W2 × E(r2) = 0.50 × 10% + 0.50 × 10% = 10%

σp = W12σ12 + W22σ22 + 2W1W1ρ12σ1σ2

= (0.5)2(20)2 + (0.5)2(20)2 + 2 × 0.5× 0.5 × 0.00 × 20 × 20

= 100 + 100 + 0 = 14.1421%

b. Expected return and risk of portfolio if there is perfect positive correlation (ρ12 = +1)

E(rP) = W1 × E(r1) + W2 × E(r2) = 0.50 × 10% + 0.50 × 10% = 10%

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 75

= (0.5)2(20)2 + (0.5)2(20)2 + 2 × 0.5× 0.5 × 1.00 × 20 × 20

= 100 + 100 + 200 = 20%

c. Expected return and risk of portfolio if there is perfect positive correlation (ρ12 = -1)

E(rP) = W1 × E(r1) + W2 × E(r2) = 0.50 × 10% + 0.50 × 10% = 10%

σp = W12σ12 + W22σ22 + 2W1W1ρ12σ1σ2

= (0.5)2(20)2 + (0.5)2(20)2 + 2 × 0.5× 0.5 × – 1.00 × 20 × 20

= 100 + 100 – 200 = 0%

Correlation does not affect the portfolio return but it affects the portfolio risk. If there is positive correlation,

the portfolio risk cannot be reduced. If there is perfect negative correlation, the portfolio risk can be reduced

to zero. In case of zero correlation there is some risk reduction.

7. Solution

Here given:

Expected return on security A, E(rA) = 10%

Standard deviation of returns on security A, (σA) = 20%

Portfolio proportion of security A (wA) = 0.35

Expected return on security B, E(rB) = 15%

Standard deviation of returns on security B, (σB) = 25%

Portfolio proportion of security B (wB) = 0.65

Markowitz portfolio theory asserts that portfolio of securities with less than perfectly positively correlated can

reduce the portfolio risk. The portfolio standard deviation is maximum when two securities in the portfolio have

perfect positive correlation and it is minimum when they have perfect negative correlation. It can be observed in

the following calculations:

Portfolio standard deviation if correlation is +1:

σP = wB σB + wA σA = 0.65 x 25 + 0.35 x 20 = 16.25 + 7 = 23.25%

Portfolio standard deviation if correlation is -1:

σP = wB σB + wA σA = 0.65 x 25 - 0.35 x 20 = 16.25 - 7 = 9.25%

8. Solution

a. Calculation of expected return

E(rx) = 0.20 × - 20 + 0.50 × 18 + 0.30 × 50 = 20%

E(ry) = 0.20 × - 15 + 0.50 × 20 + 0.30 × 10 = 10%

b. Calculation of standard deviation of stocks X and Y

Prob. rx ry [rx – E(rx)]2 × pro [ry – E(ry)]2 × pro

0.20 -20 -15 (-20-20)2 × 0.20 = 320 (-15-10)2 × 0.20 = 125

0.50 18 20 (18-20)2 × 0.50 = 2 (20-10)2 × 0.50 = 50

0.30 50 10 (50-20)2 × 0.30 = 270 (10-10)2 × 0.30 = 0

Σ[rx – E(rx)]2 × pro = 592 Σ[ry – E(ry)]2 × pro = 175

Variance of stock X, \X2 = Σ[rx – E(rx)]2 × pro = 592 %%

Standard deviation of stock X, \X = = \X2 = 592%% = 24.33%

Variance of stock Y, \Y2 = Σ[ry – E(ry)]2 × pro = 175

Standard deviation of stock Y, \Y = \Y2 = 175%% = 13.23%

c. Expected return, E(rp) = ?

E(rp) = Wx × E(rx) + Wy × E(ry) = 0.90 × 20% + 0.10 × 10% = 19%

9. Solution

a. The expected rate of return of each stock

State of economy Probabilit Stock A Stock B

y (Pj) rA Pj × rA rB Pj × rB

Strong growth 0.10 25% 2.5 15% 1.50

76 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Weak growth 0.40 10 4.0 10 4.00

Recession 0.10 − 12 − 1.2 5 0.50

∑ Pj × rA = 11.3 ∑ Pj × rB = 12.80

On the basis of expected return stock B is preferable because it has higher expected return than stock A.

b. The standard deviation and variance of each stock’s return

State of economy Stock A Stock B

Probability

[rA −E(rA)]2 × Pj [rB −E(rB)]2×Pj

Strong growth 0.10 (25−11.3)2× 0.10 = 18.769 (15−12.8)2× 0.10 = 0.484

Moderate growth 0.40 (15−11.3)2× 0.40 = 5.476 (17−12.8)2× 0.40= 7.056

Weak growth 0.40 (10−11.3)2× 0.40 = 0.676 (10−12.8)2× 0.40 = 3.136

Recession 0.10 (−12−11.3)2× 0.10 = 54.289 (5−12.8)2× 0.10 = 6.084

Σ[rA −E(rA)]2 × Pj = 79.21 Σ[rB −E(rB)]2×Pj =16.76

Variance of stock’s return

For stock A: σA2 = [rA −E(rA)]2 × Pj = 79.21%%

For stock B: σB2 = [rB −E(rB)]2 × Pj = 16.76%%

Standard deviation of stock’s return (σj)

For stock A σA = σA2= 79.21%% = 8.90%

For stock B σB = σB2= 16.76%% = 4.09%

On the basis of variance or standard deviation, stock B is preferable because it has lower variance or standard

deviation.

c. Coefficient of variation for each stock (CVj)

σA 8.90

For stock A: CVA = E(r ) = 11.3 = 0.7876

A

σB 4.09%

For stock B: CVB = E(r ) = 12.80% = 0.3195

B

On the basis of coefficient of variation, stock B is preferable because it has lower coefficient of variation.

d. Portfolio expected return, E(rP) = ?

E(rP) = WA × E(rA) + WB × E(rB) = 0.40 × 11.3% + 0.60 × 12.8% = 12.20%

10. Solution

Given: Weight of bond (WB) = 50%; Weight of stock (WS) = 50%; Standard deviation of bond (\B) = 12%; Standard

deviation of stock (\S) = 25%

a. Standard deviation of portfolio (\P) = 15%; correlation coefficient (pBS) = ?

We have,

\p2 = WB2 \B2 + WS2 \S2 + 2WBWSpBS\B\S

Or, (15)2 = (0.50)2 ×(12)2 + (0.50)2 ×(25)2 + 2× 0.50 ×0.50 × 12 × 25 × PBS

Or, PBS = 0.2183

b. E (rp) = WB × E(rB) + WS × E(rS) = 0.50 × 6% + 0.50 × 10% = 8%

c. On the one hand, you should be happier with a correlation of 0.2183 than with 0.22 since the lower correlation

implies greater benefits from diversification and means that, for any level of expected return, there will be

lower risk. On the other hand, the constraint that you must hold 50% of the portfolio in bonds represents a

cost to you since it prevents you from choosing the risk return trade off suited to your tastes. Unless you

would choose to hold about 50% of the portfolio in bonds anyway, you are better off with the slightly higher

correlation but with the ability to choose your own portfolio weights.

11. Solution

Here given:

Variance of security A, σA2 = 459

Variance of security B, σB2 = 312

Variance of security C, σC2 = 179

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 77

Covariance between Security A and C, CovAC = 112

Covariance between Security B and C, CovBC = 215

Wealth of proportion invested in Security A, WA = 0.50

Wealth of proportion invested in Security B, WB = 0.30

Wealth of proportion invested in Security C, WC = 0.20

Calculation of portfolio standard deviation, σp

We have,

σp = WA2σA2+WB2σB2+WC2σC2+2WAWBCovAB+2WAWCCovAC+2WBWCCovBC

= 114.75 + 28.08 + 7.16 + (− 63.3) + 22.4 + 25.8

= 134.89 = 11.61%

Therefore, the portfolio standard deviation for above three assets portfolio is 11.61%.

12. Solution

Here given: Beginning price (P0) = Rs 40 per share

a. Calculation of expected holding period return

First calculate holding period return for each economic state

We have,

(P1 − P0) + D1

Formula HPR = P0

(Rs 50 − Rs 40) + Rs 2.00

Boom HPR = = 0.30 Or, 30%

Rs 40

(Rs 43− Rs 40) + Rs 1.00

Normal economy HPR = = 0.10 Or, 10%

Rs 40

(Rs 34 − Rs 40) + Rs 0.50

Recession HPR = = - 0.1375 Or, - 13.75%

Rs 40

Expected HPR = 1/3 × 30% + 1/3 × 10% + 1/3 × - 13.75 = 8.75%

Note: Equally likely = probability of each scenario = 1/3

Calculation of standard deviation

State HPR Prob. [rB – E(rB)]2 Prob.

Boom 30% 1/3 (30- 8.75)2 × 1/3 = 150.5208

Normal economy 10% 1/3 (10- 8.75)2 × 1/3 = 0.5208

Recession - 13.75% 1/3 (-13.75 - 8.75)2 × 1/3 = 168.75

[rB – E(rB)]2 Prob. = 319.7916

Variance of stock Business Adventure = σB2 = [rB – E(rB)]2 Prob. = 319.7916

Standard deviation of stock Business Adventure = σB = 319.7916 = 17.8827%

b. Portfolio return and risk of risky and risk free asset

Expected return, E(rP) = WB × E(rB) + (1 – WB) × rf = 0.50 × 8.75% + 0.50 × 4 = 6.375%

Standard deviation of portfolio (σP ) = WB × σB = 0.50× 17.8827% = 8.94135%

13. Solution:

Here given:

Expected risk premium on risky portfolio [E(rP) – rf] = 10%

Standard deviation of the risky portfolio, (σP) = 14%

Risk-free rate (rf) = 6%

Total investment budget = Rs 60,000 + Rs 40,000 = Rs 100,000

Rs 60‚000

Investment proportion in risky asset (y) = Rs 100‚000 = 0.60

The expected rate of return on complete portfolio of the client:

E(rC) = rf + y [E(rP) – rf] = 6 + 0.6 x 10 = 12%

Standard deviation of rate of return on complete portfolio of the client:

78 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

σC = y σP = 0.6 x 14 = 8.4%

14. Solution

a. Investment 3.

For each portfolio: Utility = E(r) – (0.5 × 4 × σ2)

Investment E(r) σ Utility

1 0.12 0.30 -0.0600

2 0.15 0.50 -0.3500

3 0.21 0.16 0.1588

4 0.24 0.21 0.1518

b. We choose the portfolio with the highest utility value. i.e..Investment 4. When an investor is risk neutral, A =

0 so that the portfolio with the highest utility is the portfolio with the highest expected return.

15. Solution

Here given: Ending of year cash flow = Rs 50,000 or Rs 150,000; probability = 0.50; Risk free rate (rf) = 5%

a. Required risk premium = 10 percent, Required rate of return, E(rP) = ?

E(rP) = rf + Risk Premium = 5% + 10% = 15%.

The expected value of the portfolio = 0.50 x Rs 50,000 + 0.5 x Rs 150,000

= Rs 25,000 + Rs 75,000 = Rs 100,000

Therefore the expected year-end value of the portfolio is Rs 100,000. Now, calculate the current value of

portfolio.

Expected cash flow Rs 100‚000

Current value of portfolio = 1 + E(rp) = 1.15 = Rs 86,956.5217

Therefore we can pay maximum of Rs 86,956.5217for this portfolio.

b. Expected rate of return for the portfolio =?

We have,

Expected cash flow - Current value

Expected rate of return = Current value

Rs 100‚000 - Rs 86‚956.5217

= Rs 86‚956.5217 = 0.15 or 15%

Therefore, the expected rate of return is 15% because the portfolio price is set to equate the expected rate or

return with the required rate of return.

c. If required risk premium is 15 percent, the required rate of return is given by:

E(rP) = rf + Risk Premium = 5% + 15% = 20%.

Expected cash flow Rs 100‚000

Current value of portfolio = 1 + E(rp) = 1 + 0.20 = Rs 83,333.3333

Therefore, we can pay maximum of Rs 83,333.3333 for this portfolio.

d. For a given expected cash flow, portfolios that command greater risk premiums must sell at lower prices. The

extra discount in the purchase price from the expected value is to compensate the investor for bearing

additional risk.

16. Solution

a. Allocating 70% of the capital in the risky portfolio P, and 30% in risk-free asset, the client has an expected

return on the complete portfolio calculated by adding up the expected return of the risky proportion (y) and

the expected return of the proportion (1 - y) of the risk-free investment:

E(rC) = y × E(rP) + (1 – y) × rf = (0.7 × 0.17) + (0.3 × 0.07) = 0.14 or 14% per year

The standard deviation of the portfolio equals the standard deviation of the risky fund times the fraction of

the complete portfolio invested in the risky fund:

σC = y × σP = 0.7 × 0.27 = 0.189 or 18.9% per year

b. The investment proportions of the client’s overall portfolio can be calculated by the proportion of risky

portfolio in the complete portfolio times the proportion allocated in each stock.

Investment proportions

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 79

T-bills 30%

Stock A 0.7 × 27% = 18.9%

Stock B 0.7 × 33% = 23.1%

Stock C 0.7 × 40% = 28.0%

c.We calculate the reward-to-variability ratio (Sharpe ratio)

For the risky portfolio:

E(rP) - rf 17 - 0.07

S= σP = 0.27 = 0.3704

For the client’s overall portfolio:

E(rC) - rf 14 - 0.07

S= σC = 0.189 = 0.3704

d. Graph of CAL

E(r)

% CAL ( slope=.3704)

P

17

14

client

σ

18.9 27 %

15 - 0.07

Solving for y, we get y = 0.10 = 0.8

Therefore, in order to achieve an expected rate of return of 15%, the client must invest 80% of total funds in

the risky portfolio and 20% in T-bills.

f. The investment proportions of the client’s overall portfolio can be calculated by the proportion of risky asset

in the whole portfolio times the proportion allocated in each stock.

Investment proportions

T-bills 20%

Stock A 0.8 × 27% = 21.6%

Stock B 0.8 × 33% = 26.4%

Stock C 0.8 × 40% = 28.0%

The standard deviation of the complete portfolio is the standard deviation of the risky portfolio times the

fraction of the portfolio invested in the risky asset:

σC = y × σP = 0.8 × 0.27 = 0.216 or 21.6% per year

17. Solution

E(rM) - rf 13 - 0.07

a. Slope of the CML = σM = 0.25 = 0.24

See the diagram below:

80 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

20

18 CAL (slope=.3704)

16

14 CML (slope=.24)

12

10

8

6

4

2

0

0 10 20 30

σ (%)

b. Your fund allows an investor to achieve a higher expected rate of return for any given standard deviation

than would a passive strategy, i.e., a higher expected return for any given level of risk.

18. Solution:

a. The risk-free asset has a zero variance and has zero covariance with other assets. Thus, examining the

variance-covariance matrix, the third security must be the risk-free asset.

b. Here given:

Expected return on asset 1, E(r1) = 10.1%

Expected return on asset 2, E(r2) = 7.8%

Expected return on asset 3, E(r3) = 5% = RF (that is risk-free rate)

Variance of returns on asset 1, (σ12) = 210

Variance of returns on asset 2, (σ22) = 90

Covariance of returns between asset 1 and 2, Cov12 = 60

If Lily’s risky portfolio is split 50-50 between risky assets 1 and 2, the expected return and standard deviation

of her portfolio is given by:

Expected return on portfolio:

E(rP) = E(r1) w1 + E(r2) w2 = 10.1 x 0.5 + 7.8 x 0.5 = 8.95%

σP = W12 × σ12 + W22 × σ22 + 2 W1W2 Cov12

= (0.5)2 (210) + (0.5)2(90) + (2)(0.5)(0.5)(60)

= 52.5 + 22.5 + 30 = 105 = 10.25%

e. If the risk-free asset makes up 25 percent of Lily’s total portfolio (that is weight of risky portfolio, wP, is 75

percent), the total portfolio’s expected return and standard deviation is given by:

Expected return on total portfolio:

E(rC) = E(rP) wP + rf (1- wP) = 8.95 x 0.75 + 5 x 0.25 = 6.71 + 1.25 = 7.96%

Standard deviation of returns on total portfolio:

σC = wP σP = 0.75 x 10.25 = 7.69%

19. Solution

Here given:

Expected return on debt fund, E(rD) = 8%

Standard deviation of returns on debt fund (σD) = 12%

Expected return on equity fund, E(rE) = 13%

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 81

Covariance between returns on debt and equity fund (CovDE) = 72

Correlation between returns on debt and equity fund (ρDE) = 0.30

a. Calculation of minimum-variance portfolio proportion:

Investment proportion of debt fund:

σE2 – CovDE (20)2 – 72 328

wD = = = = 0.82

σD2 + σE2 – 2 CovDE (12)2 + (20)2 – 2 × 72 400

Investment proportion of equity fund:

wE = 1 – wD = 1 – 0.82 = 0.18

This result indicates that if investor wanted to minimize risk, s/he would have to invest 82 percent of his total

investment in debt and 18 percent investment in stock.

b. Calculation of expected value and standard deviation of rate of return on minimum variance portfolio of two

risky funds are given by:

Expected return on minimum variance portfolio:

E(rp) = wD E(rD) + wE E(rE) = 0.82 x 8 + 0.18 x 13 = 8.9%

c. Standard deviation of returns on minimum variance portfolio:

σP = WD2 × σD2 + WE2 × σE2 + 2 WDWE CovDE

= (0.82)2 × (12)2 + (0.18)2 × (20)2 + 2 × 0.82 × 0.18 × 72

= 96.8256 + 12.96 + 21.2544

= 131.04 = 11.4473 ≈ 11.45%

20. Solution

Since Stock A and Stock B are perfectly negatively correlated, a risk-free portfolio can be created and the rate of

return for this portfolio in equilibrium will always be the risk-free rate. To find the proportions of this portfolio

[with wA invested in Stock A and wB = (1 –wA) invested in Stock B], set the standard deviation equal to zero. With

perfect negative correlation, the portfolio standard deviation reduces to:

Investment proportion of stock A:

σB2 - CovAB (60)2 - (-2,400) 6,000

wA = = = = 0.60 and WB = 1 – WA = 1 – 0.60 = 0.40

σA2 + σB2 - 2 CovAB (40)2+(60)2 _ (2)(-2,400) 10,000

The expected rate of return on this risk-free portfolio is:

Risk free rate = E(rP) = WA × E(rA) + WB × E(rB) = 0.60 × 8% + 0.40 × 13% = 10%

Therefore, the risk-free rate must also be 10.0%.

Working notes: CovAB = σA × σB × ρAB = 40 ×60 × - 1 = - 2,400

21. Solution

a. Calculation of opportunity set

Proportion Proportion Expected Standard

in X asset in M asset return Deviation

0.00 1.00 10 20

0.20 0.80 11 17.09

0.40 0.60 12 21.17

0.60 0.40 13 29.46

0.80 0.20 14 39.40

1.00 0.00 15 50

82 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Weight of stock fund:

[E(rX) - rf] σM2 - [E(rM) - rf] CovxM

wX =

[E(rX) - rf] σM2 + [E(rM) - rf] σx2 - [{E(rX) - rf} + {E(rM) - rf}]CovxM

(15 - 5)(20)2 - (10 - 5) -200 5‚000

= (15 - 5)(20)2 + (10 - 5)(50)2 - (10 + 5) -200 = 19‚500 = 0.2564

Weight of bond fund:

wM = 1 – wX = 1 – 0.2564= 0.7436

Therefore, optimal risky portfolio consists of 25.64 percent investment in X fund and 74.36 percent in M fund.

The expected return and standard deviation of optimal risky portfolio

E(rP) = wX E(rX) + wM E(rM) = 0.2564 x 15% + 0.7436 x 10% = 11.282%

σP = WX2 × σX2 + WM2 × σM2 + 2 WXWM CovXM

= (0.2564)2 × (50)2 + (0.7436)2 × (20)2 + 2 × 0.2564 × 0.7436 × -200

= 164.3524 + 221.1764 - 76.2636

= 309.2652

= 17.5859%

Calculation of minimum variance portfolio

Investment proportion of X fund:

σM2 – CovXM (20)2 – (-200) 600

wx = 2 = = = 0.1818

σX + σM2 – 2 CovXM (20)2 + (50)2 – 2 × -200 3,300

Investment proportion of equity fund:

wM = 1 – wX = 1 – 0.1818 = 0.8182

Expected return on minimum variance portfolio

E(rmin) = wX E(rX) + wM E(rM) = 0.1818 x 15 + 0.8182 x 10 = 10.909%

Standard deviation of returns on minimum variance portfolio:

σP = WX2 × σX2 + WM2 × σM2 + 2 WXWM CovXM

= (0.1818)2 × (50)2 + (0.8182)2 × (20)2 + 2 × 0.1818 × 0.8182 × -200

= 82.6281 + 267.7805 - 59.4995

= 290.9091

= 17.0561%

E(rp) - rf 11.28 - 5

c. Slop of CAL = = 17.59 = 0.357

σp

d. Mean of the complete portfolio, E(rc) = y × E(rP) + (1 – y) × rf

= 0.2222 × 11.28 + 0.7778 × 5% = 6.395%

Standard deviation of compete portfolio (σc) = y × σP

= 0.2222 × 17.58% = 3.91%

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 83

E(rp) - rf 6.395 - 5

Sharpe ratio = = 3.91 = 0.357

σp

22. Solution

Expected return on portfolio, E(r p) = 20%; Risk free rate (rf) = 5%; Expected return of market, E(rm) = 15%

We have,

E(rp) =rf +[E(rM) - rf ]β P

Or, 20% = 5% + [ 15% - 5%]β P

Or, 15% = 10% βP

Or, βP = 1.5

23. Solution

Here given:

Market price of security (P0) = Rs 40; Expected rate of return, E(r) = 13%; Risk free rate (rf) = 7%; Market risk

premium, E(rm) – rf = 8%; Market price of security (P0) = ? if beta is double

If the beta of the security doubles, then so will its risk premium.

The current risk premium for the stock is: (13% – 7%) = 6%.

So the new risk premium would be double i.e. 6%× 2 = 12%

The new discount rate = Risk free rate + New discount rate = 7% + 12% = 19%

If the stock pays a constant dividend in perpetuity, then we know from the original data that the dividend (D)

must satisfy the equation for perpetuity:

We have,

Dividend D

Price = Discount rate Or, Rs 40 = 0.13 Or, D = Rs 5.20

At the new discount rate of 19%, the stock would be worth:

Dividend Rs 5.20

Price = Discount rate = 0.19 = Rs 27.3684

The increase in stock risk has lowered the value of the stock by 31.58%.

24. Solution

Here given:

T-bill rate or risk free rate, (rf) = 4%; Market risk Premium, E(rm) – rf = 6%

E(rA) =rf +[E(rM) - rf ]βA = 4% + 6% × 1.5 = 13%

E(rB) =rf +[E(rM) - rf ]βB = 4% + 6% × 1.0 = 10%

Stock A is overvalued because its forecast return is lower than the required rate of return. Stock B is undervalued

because its forecast return is higher than required rate of return.

25. Solution

Here given:

Expected return on stock XYZ, E(rXYZ) = 12%; Beta coefficient of the stock XYZ (βXYZ) = 1

Expected return on stock ABC, E(rABC) = 13%; Beta coefficient of the stock ABC (βABC) = 1.5

Expected return on market portfolio, E(rM) = 11%; Risk-free rate (rf) = 5%

a. The required return on XYZ

E(rXYZ) = rf + [E(rm) – rf]βXYZ = 5 + [11 – 5] 1 = 11%

The required return on stock ABC

E(rABC) = rf + [E(rm) – rf]βABC = 5 + [11 – 5] 1.5 = 14%

b. Stock XYZ is undervalued because its expected return is greaer than required rate of return. Stock ABC is

overvalued because its expected return is less than required rate of return.

c. Stock XYZ is better to buy because it has been underpriced as its expected return is greater than what

required by the CAPM.

d. The alpha for stock XYZ

αXYZ = Expected return – Required return = 12% - 11% = 1%

The alpha for stock ABC:

αABC = Forecast return – Required return = 13% - 14% = -1%

84 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Graph of the Security Market Line below shows that ABC plots below the SML, while XYZ plots above.

E(rj)

SML

14% •

αABC < 0 • ABC

13% XYZ

12% •

αXYZ > 0

E(rM) = 11% •

Market

rf = 5%

β

1 1.5

26. Solution

Here given:

Expected return on market portfolio, E(rm) = 16%

Risk-free rate (rf) = 8%

Beta coefficient of the project (βA) = 1.3

a. Required rate of return =?

E(rA) = rf + [E(rM) – rF]βA = 8 + [16 – 8] 1.3 = 18.4%

b. IRR of the project is higher than the required rate of return, the project should be accepted.

27. Solution

Here given: Risk free rate (rf) = 8%; Expected return of market, E(rm) = 18%

a. Current price (P0) = Rs 100; Expected dividend (D1) = Rs 9; Beta of stock (β) = 1; Expected price at the end of

year (P1) = ?

Since the stock's beta is equal to 1.0, its expected rate of return should be equal to that of the market, that is,

18%.

We have,

(P1 - P0) + D1

HPR = P0

(P1 - Rs 100) + Rs 9

Or, 0.18 = Rs 100

Or, Rs 18 = (P1 – Rs 100) + Rs 9

Or, Rs 9 = P1 – Rs 100

Or, P1 = Rs 109

b. If beta is zero, the cash flow should be discounted at the risk-free rate, 8%:

Rs 1,000

PV = 0.08 = Rs 12,500

If, however, beta is actually equal to 1, the investment should yield 18%, and the price paid for the firm

should be:

Rs 1,000

PV = 0.18 = Rs 5,555.56

The difference (Rs 6,944.44) is the amount you will overpay if you erroneously assume that beta is zero rather

than 1.

c. Expected return on stock, E(rj) = 6%; Risk free rate (rf) = 8%; Expected return of market, E(rm) = 18%

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 85

We have,

E(rj) =rf +[E(rM) - rf ]βj

Or, 6% = 8% + [ 18% - 8%]βj

Or, -2% = 10% βj

Or, βj = - 0.20

28. Solution

Here given: Average return for first advisor,(r1) = 19%; Average return for second advisor,(r2) = 16%; Beta of the

first advisor (β1) = 1.5; Beta of the second advisor (β2) = 1.5

a. In order to determine which investor was a better selector of individual stocks, we look at the abnormal

return, which is the ex-post alpha; that is, the abnormal return is the difference between the actual return and

that predicted by the SML. Without information about the parameters of this equation (i.e., the risk-free rate

and the market rate of return), we cannot determine which investment adviser is the better selector of

individual stocks.

b. If risk free rate (rf) = 6% and market return, E(rm) = 14%, then (using alpha for the abnormal return):

E(r1) =rf +[E(rM) - rf ]β1 = 6% + 8% × 1.5 = 18%

E(r2) =rf +[E(rM) - rf ]β1 = 6% + 8% × 1.0 = 14%

Abnormal return or alpha of advisor 1 (α1) = Average return – Required return

= 19% - 18% = 1%

Abnormal return or alpha of advisor 2 (α2) = Average return – Required return

= 16% - 14% = 2%

Here, the second investment adviser has the larger abnormal return and thus appears to be the better selector

of individual stocks. By making better predictions, the second adviser appears to have tilted his portfolio

toward under-priced stocks.

c. If risk free rate (rf) = 3% and market return, E(rm) = 15%, then (using alpha for the abnormal return):

E(r1) = rf +[E(rM) - rf ]β1 = 3% + (15% - 3%) × 1.5 = 21%

E(r2) = rf +[E(rM) - rf ]β1 = 3% + (15% - 3%) × 1.0 = 15%

Abnormal return or alpha of advisor 1 (α1) = Average return – Required return

= 19% - 21% = - 2%

Abnormal return or alpha of advisor 2 (α2) = Average return – Required return

= 16% - 15% = 1%

Here, not only does the second investment adviser appear to be a better stock selector, but the first adviser's

selections appear valueless (or worse).

29. Solution

Risk free rate (rf) = 4%; Expected return on market, E(rm) = 12%

a. Expected return on market portfolio, E(rm) = ?

Since the market portfolio, by definition, has a beta of 1.0, its expected rate of return is 12%.

b. β = 0 means the stock has no systematic risk. Hence, the portfolio's expected rate of return is the risk-free

rate, 4%.

c. Using the SML, the fair rate of return for a stock with β = –0.5 is:

E(r) = rf +[E(rM) - rf ]β1 = 4% + (12% – 4%) (–0.5) = 0.0%

The expected rate of return, using the expected price and dividend for next year:

(P1 - P0) + D1 (Rs 41 - Rs 40) + Rs 3

HPR = E(r) = P0 = Rs 40 = 0.10 Or, 10%

Because the expected return exceeds the fair return, the stock must be under-priced.

30. Solution

The cash flows for the project comprise a 10-year annuity of Rs 10 million per year plus an additional payment in

the tenth year of Rs 10 million (so that the total payment in the tenth year is Rs 20 million). The appropriate

discount rate for the project is:

E(rj) = rf +[E(rM) - rf ]βj = 9% + (19% - 9%) × 1.7 = 26%

86 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Calculation of NPV

Year Cash flows PV factor @ 26% PV

0 -20 1.0000 -20

1-9 10 3.3657 33.657

10 20 0.0992 1.984

NPV 15.641

The highest possible beta estimate for the project before its NPV becomes negative i.e. internal rate of return (IRR)

=?

Calculation of IRR

Year Cash flows PV factor @ 49% PV PV factor @ 50% PV

0 -20 1.0000 -20 1.0000 -20

1-9 10 1.9844 19.844 1.9480 19.48

10 20 0.0185 0.37 0.0173 0.346

NPV 0.214 -0.174

Interpolation

NPVLR 0.214

IRR = LR + NPV - NPV × (HR – LR) = 49 + 0.214 - (-0.174) × (50 – 49) = 49.5515%

LR HR

Therefore, the internal rate of return or required rate of return of the project before its NPV becomes negative must

be 49.5515%.

E(rj) = rf +[E(rM) - rf ]βj

Or, 49.5515% = 9% + (19% - 9%) × βj

Or, 40.5515% = 10 × βj

Or, βj = 4.05515

Therefore, the beta of project must be 4.05515 before its NPV becomes negative.

31. Solution

a. Beta of the aggressive stock (β A) = ? Beta of the defensive stock (βD) = ?

∆rA 2-32

βA = ∆m = 5-20 = 2.00

∆rD 3.5-14

and βD = ∆m = 5-20 = 0.70

b. With the two scenarios equally likely, the expected rate of return is an average of the two possible outcomes:

E(rA) = 0.5 × (2% + 32%) = 17%

E(rD) = 0.5 × (3.5% + 14%) = 8.75%

c. The SML is determined by the following: Expected return is the T-bill rate = 8% when beta equals zero; beta

for the market is 1.0; and the expected rate of return for the market is:

0.5 × (20% + 5%) = 12.5%

Thus, we graph the SML as following:

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 87

E ( r)

SM L

M

1 2 .5 %

αD

D

8%

.7 1 .0 2 .0 β

The equation for the security market line is: E(r) = 8% +β (12.5% – 8%)

d. The aggressive stock has a fair expected rate of return of:

E(rA) = 8% + (12.5% – 8%) 2.0 = 17%

The security analyst’s estimate of the expected rate of return is also 17%. Thus the alpha for the

aggressive stock is zero. Similarly, the required return for the defensive stock is:

E(rD) = 8% + (12.5% – 8%) 0.7 = 11.15%

The security analyst’s estimate of the expected return for D is only 8.75%, and hence:

αD = actual expected return – required return = 8.75% – 11.15% = –2.4%

The points for each stock are plotted on the graph above

e. The hurdle rate is determined by the project beta (i.e., 0.7), not by the firm’s beta. The correct discount rate

is therefore 11.15%, the fair rate of return on stock D.

32. Solution

Here given:

Expected return on portfolio A, E(rA) = 11%

Expected return on portfolio B, E(rB) = 14%

Beta of stock A, (β A) = 0.80

Beta of stock B, (βB) = 1.50

T-bill rate, (rf) = 6%

Expected return on the market index, E(rm) = 12%

Standard deviation of stock A, (σA) = 10%

Standard deviation of stock B, (σB) = 31%

Standard deviation of market index, (σm) = 20%

a. First calculate the required rate of return on each portfolio

E(rA) = rf +[E(rM) - rf ]βA = 6% + (12% - 6%) × 0.80 = 10.8%

E(rB) = rf +[E(rM) - rf ]βB = 6% + (12% - 6%) × 1.50 = 15%

Stock A is undervalued and stock B is overvalued. Hence, Portfolio A is desirable and Portfolio B is not.

b. Slope of the CAL = ?

E(rp) - rf

Slop of CAL =

σp

For market

12 - 6

Slop of CAL = 20 = 0.30

11 - 6

For Stock A: Slop of CAL = 10 = 0.50

14 - 6

For Stock B: Slop of CAL = 31 = 0.2581

Hence, portfolio A would be a good substitute for the S&P 500.

88 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

33. Solution

a. Expected return or required rate of return E(rj) = ?

Required rate of reutrn on Stock X, E(rX) = rf +[E(rM) - rf ]βX = 5% + (14% - 5%) × 0.80 = 12.2%

Alpha of stock X, αX = Forecasted return – Required return = 14% - 12.2% = 1.8%

E(rY) = rf +[E(rM) - rf ]βY = 5% + (14% - 5%) × 1.50 = 18.5%

Alpha of stock Y, αY = Forecasted return – Required return = 17% - 18.5% = - 1.5%

b. i.For an investor who wants to add this stock to a well-diversified equity portfolio, Kamal should recommend

Stock X because of its positive alpha, while Stock Y has a negative alpha. In graphical terms, Stock X’s

expected return/risk profile plots above the SML, while Stock Y’s profile plots below the SML. Also,

depending on the individual risk preferences of Kay’s clients, Stock X’s lower beta may have a beneficial

impact on overall portfolio risk.

ii.For an investor who wants to hold this stock as a single-stock portfolio, Kamal should recommend Stock Y,

because it has higher forecasted return and lower standard deviation than Stock X.

Stock Y’s Sharpe ratio is:

E(rp) - rf 17 - 5

Sharpe ratio = = 25 = 0.48

σp

Stock X’s Sharpe ratio is only:

E(rp) - rf 14 - 5

Sharpe ratio = = 36 = 0.25

σp

The market index has an even more attractive Sharpe ratio:

E(rm) - rf 14 - 5

Sharpe ratio = = 15 = 0.60

σm

However, given the choice between Stock X and Y, Y is superior. When a stock is held in isolation, standard

deviation is the relevant risk measure. For assets held in isolation, beta as a measure of risk is irrelevant.

Although holding a single asset in isolation is not typically a recommended investment strategy, some

investors may hold what is essentially a single-asset portfolio (e.g., the stock of their employer company). For

such investors, the relevance of standard deviation versus beta is an important issue.

34. Solution

Here given: Amount of investment in fully diversified portfolio or original portfolio = Rs 900,000; Investment in

ABC company = Rs 100,000; Expected return on original portfolio, E(rOP) = 0.67%; Expected return on ABC

company, E(rABC) = 1.25%; Standard deviation of original portfolio, (σOP) = 2.37%; Standard deviation of ABC

company, (σABC) 2.95%; Correlation between original portfolio and ABC company, (ρOP, ABC) = 0.40

E(rNP) = wOP E(rOP) + wABC E(rABC)

= (0.9 × 0.67) + (0.1 × 1.25)

= 0.7280%

ii. Covariance between original portfolio and ABC company, CovOP , ABC = ?

CovOP , ABC = ρOP,ABC × σOP × σABC

= 0.40 × 2.37 × 2.95

= 2.7966

iii. Standard deviation of new portfolio (σNP) = ?

σNP = (Wop)2 × (σop)2 + (WABC)2 × (σABC)2 + 2 × WOP × WABC × Covop,ABC

= (0.90)2 × (2.37)2 + (0.10)2 × (2.95)2 + 2 × 0.90 × 0.10 × 2.7966

= 4.5497 + 0.0870 + 0.5034

= 5.1401

= 2.2672%

b. Weight of government securities (WGS) = 0.10; Expected return on government securities, E(rGS) = 0.42%

i. Expected return on new portfolio, E(rNP) = ?

E(rNP) = wOP E(rOP) + wGS E(rGS) = (0.9 × 0.67) + (0.1 × 0.42) = 0.6450%

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 89

ii. Covariance between original portfolio and government securities, CovOP , GS = ?; Correlation between

original portfolio and government securities (ρOP,GS) = 0; Standard deviation of government securiteis

(σGS) = 0%

We have, CovOP , GS = ρOP, GS × σOP × σGS = 0 × 2.37 × 0 = 0

iii. Standard deviation of new portfolio (σNP) = ?

σNP = (Wop)2 × (σop)2 + (WGS)2 × (σGS)2 + 2 × WOP × WGS × Covop,GS

= (0.90)2 × (2.37)2 + (0.10)2 × (0)2 + 2 × 0.90 × 0.10 × 0

= 4.5497 + 0 + 0

= 4.5497

= 2.1330%

c. Adding the risk-free government securities would result in a lower beta for the new portfolio. The new

portfolio beta will be a weighted average of the individual security betas in the portfolio; the presence of the

risk-free securities would lower that weighted average.

d. The comment is not correct. Although the respective standard deviations and expected returns for the two

securities under consideration are identical, the correlation coefficients between each security and the original

portfolio are unknown, making it impossible to draw the conclusion stated. For instance, if the correlation

between the original portfolio and XYZ stock is smaller than that between the original portfolio and ABC

stock, replacing ABC stocks with XYZ stocks would result in a lower standard deviation for the portfolio as a

whole. In such a case, XYZ socks would be the preferred investment, assuming all other factors are equal.

e. Gautam clearly expressed the sentiment that the risk of loss was more important to her than the opportunity

for return. Using variance (or standard deviation) as a measure of risk in her case has a serious limitation

because standard deviation does not distinguish between positive and negative price movements.

35. Solution

Here given:

Yield on T-bill money market fund (rf) = 5.5%

Expected return on stock fund, E(rs) = 15%

Expected return on bond fund, E(rB) = 9%

Standard deviation on stock fund, (σs) = 32%

Standard deviation on bond fund, (σB) = 23%

Correlation of stock and bond fund, (ρSB) = 0.15

a. We have, Investment proportion of stock fund (wS)

σB2 - CovSB (23)2 - 110.4 418.6

wS = 2 = = = 0.3142

σS + σB2 - 2 CovSB (32)2+(23)2 _ 2 × 110.4 1‚332.2

Working notes: CovSB = ρSB × σS × σB = 0.15 × 32% × 23% = 110.4

Investment proportion of bond fund (wB) = 1 - wS = 1 – 0.3142 = 0.6858

Calculation of expected value and standard deviation of rate of return on minimum variance portfolio:

Expected return on minimum variance portfolio

E(rmin) = wS E(rS) + wB E(rB) = 0.3142 x 15 + 0.6858 x 9 = 10.8852% ≈ 10.89%

Standard deviation of returns on minimum variance portfolio:

σP = WS2 × σS2 + WB2 × σB2 + 2 WSWB CovSB

= (0.3142)2 × (32)2 + (0.6858)2 × (23)2 + 2 × 0.3142 × 0.6858 × 110.4

= 101.0910 + 248.8001 + 47.5776

= 397.4687

= 19.9366% ≈ 19.94%

b. Calculation of portfolio risk and return at various weights

Proportion Proportion Expected Standard

in stock fund in bond fund return Deviation

0.00 1.0000 9% 23%

0.20 0.8000 10% 20%

0.3142 0.6858 10.89% 19.94% Minimum variance portfolio

90 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

0.60 0.4000 13% 23%

0.6466 0.3534 12.88% 23.34% Tangency portfolio

0.8000 0.2000 14% 27%

1.0000 0.0000 15% 32%

E(r) σ

Minimum variance portfolio 10.89% 19.94%

Tangency portfolio 12.88% 23.3382%

E(rp) - rf 12.88 - 5.5

Sharpe ratio = = 23.34 = 0.3162

σp

d. Expected return, E(rP) = 12%

i.The equation for the CAL is:

E(rp) - rf

E(rC) = rf + × σc

σp

Or, 12% = 5.5 + 0.3162 σc

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 91

Or, σc = 20.5566%

ii. The mean of the complete portfolio as a function of the proportion invested in the risky portfolio (y) is:

E(rC) = rf + [E(rP) − rf] y

Or, 12% = 5.5 + (12.88 − 5.5) y

Or, 6.5% = 7.38% y

Or, y = 0.8808 Or, 88.08%

Therefore the weight of risky portfolio is 88.08%.

Weight of risk free asset = 1 − y = 1 − 0.8808 = 0.1192 Or, 11.92%

Proportion of stocks in complete portfolio (Ws) = 0.6466× 0.8808 = 0.5695

Proportion of bonds in complete portfolio (WB) = 0.3534× 0.8808 = 0.3113

e. Expected return on portfolio, E(rP) = 12%; Proportion of investment = ?

We have,

E(rP) = Ws × E(rs) + WB × E(rB)

Or, 12 = Ws × 15 + (1 – Ws) × 9

Or, 3 = Ws × 6

Or, Ws = 0.50

σP = WS2 × σS2 + WB2 × σB2 + 2 WSWB CovSB

= (0.50)2 × (32)2 + (0.50)2 × (23)2 + 2 × 0.50 × 0.50 × 110.4

= 256 + 132.25 + 55.20

= 443.45

= 21.0583% ≈ 21.06%

The efficient portfolio with a mean of 12% has a standard deviation of only 21.06%. This is considerably greater than

the standard deviation of 20.5566% achieved using CAL

. ♦-♦

NUMERICAL PROBLEMS

1. Solution

Here given:

Ask price = 117% of Rs 1,000; Last interest payment date = One month ago; Coupon rate (i) = 6%; Invoice price = ?

We have,

Annual coupon payment Days since last coupon payment

Accrued interest = 2 × Days separating coupon payment

Rs 60 30

= 2 × 182 = Rs 4.945

Invoice price = Ask price + Accrued interest = Rs 1,170 + Rs 4.945 = Rs 1,174.95

Working notes:

Annual coupon payment = Par value × coupon rate = Rs 1,000 × 0.06 = Rs 60

2. Solution

Here given:

Face value (M) = Rs 1,000; Maturity period (n) = 5 years; Price (V0 or P0) = Rs 746.22; YTM = ?

We have,

M

V0= (1 + y)n

Rs 1,000

Or, Rs 746.22 = (1 + y)5

Or, (1 + y)5 = 1.3401

Or, y = (1.3401)1/5 – 1 = 1.0603 – 1 = 0.0603 Or, 6.03%

If Price (V0 or P0) = Rs 730; YTM = ?

92 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

M

V0= (1 + y)n

Rs 1,000

Or, Rs 730 = (1 + y)5

Or, (1 + y)5 = 1.

Or, y = (1.3699)1/5 – 1 = 1.0650 – 1 = 0.0650 Or, 6.50%

3. Solution

Here given: Annual coupon rate (i) = 4.8%; Market price (P0) = Rs 970; Current yield (CY) = ?

We have,

I Rs 48

Current yield (CY) = P = Rs 970 = 0.0495 Or, 4.95%

0

4. Solution

Here given: Maturity period of bond (n) = 8 years; current yield (CY) = 6%; coupon yield (i) = 6%; The current

yield and the annual coupon rate of 6% imply that the bond price was at par a year ago. i.e. purchase price (P0) =

Rs 1,000;

Now calculate price after one year (P1) = ?

Remaining maturity period after 1 year (n) = 8 -1 = 7 years; YTM after one year (kd) = 7%

We have,

P1 = V1 = I × PVIFAkd, n + M × PVIFkd, n

= Rs 60 × PVIFA7,7 + Rs 1,000 × PVIF7,7

= Rs 60 × 5.3893 + Rs 1,000 × 0.6227

= Rs 323.358 + Rs 622.70 = Rs 946.058

(P1 - P0) + I (Rs 946.058 - Rs 1,000) + Rs 60

HPR = P0 = = 0.006058 Or 0.6058% ≈ 0.61%

Rs 1,000

5. Solution

Here given: Effective annual rate (EAR) =?

a. Days to maturity (t) = 3 months or 3 × 30 = 90 days; Face value (FV) = Rs 100,000; purchase price (P) = Rs

97,645

We have,

EAR = (1 + periodic rate) m – 1 = (1 + 0.02412)4.0556 – 1 = 1.1015 - 1 = 0.1015 Or, 10.15%

Working notes:

(P1 - P0) (Rs 100,000- Rs 97,645)

1. Periodic rate or holding period return = P0 = = 0.02412 Or, 2.412%

Rs 97,645

Days in a year 365

2. Compounding period in a year (m) = t = 90 = 4.0556

b. Here given: Purchase price (P0) = Rs 1,000; Coupon rate (i) = 10% paid semiannually; selling at par , YTM (kd)

= 10%

EAR = (1 + periodic rate) m – 1 = (1 + 0.10/2)2 – 1 = 1.1025 - 1 = 0.1025 Or, 10.25%

Therefore, the coupon bond has the higher effective annual interest rate.

6. Solution

Here given: Coupon rate (i) = 8% semiannual payment, Selling at par i.e. purchase price (P0) = Rs 1,000; Coupon

rate (i) = ? if coupon payment is in annual basis

EAR = (1 + periodic rate)m – 1 = (1 + 0.08/2)2 – 1 = 1.0816 - 1 = 0.0816 Or, 8.16%

If the annual coupon bonds are to sell at par they must offer the same yield, which requires an annual coupon of

8.16%.

7. Solution

Here given:

Coupon rate (c) = 10% semiannually

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 93

Years to maturity (n) = 3 years

a. Bond’s price now (V0) =?

Bond’s price after six month (V1) = ?

We have,

P = C × PVIFAy,n + FV × PVIFy,n

For semiannual bond

Vd = C/2 × PVIFAy/2,2n + M × PVIFy/2,2n

Calculate the value of bond now

V0 = Rs. 100/2 × PVIFA 4, 2×3 + Rs. 1,000 × PVIF 4, 2×3

= Rs. 50 × 5.2421 + Rs. 1,000 × 0.7903

= Rs. 1052.405

Calculation of value of bond after six months

V1 = Rs. 100/2 × PVIFA 4, 5 + Rs. 1,000 × PVIF 4, 5

= Rs. 50 × 4.4518 + Rs. 1,000 × 0.8219

= Rs. 1,044.49

b. Rate of return

(V1 - V0) + C1 (Rs 1,044.49 - Rs 1,052.405) + Rs 50

Rate of return = V0 = = 0.0399 Or 3.99 ≈ 4%

Rs 1,052.405

8. Solution

The nominal rate of return and real rate of return on the bond in each year are computed as follows:

Interest + Price appreciation

Nominal rate of return = Initial price

1 + nominal return

Real rate of return = 1 + inflation –1

Rs 41.01 + Rs 30.60 Rs 41.44 + Rs 10.51

Nominal rate of return = Nominal rate of return =

Rs 1,010 Rs 1,050.60

= 0.071196 Or, 7.1196% = 0.0504 Or, 5.04%

1 + 0.071196 1 + 0.0504

Real rate of return = 1 + 0.03 – 1 Real rate of return = 1 + 0.01 – 1

= 0.04 Or, 4% = 0.04 Or, 4%

The real rate of return in each year is precisely the 4% real yield on the bond.

9. Solution

Bond 1 and 2

Calculation of yield to maturity (y) Calculation of yield to maturity (y)

Here given: Here given:

Price (V0) = Rs 400 Price (V0) = Rs 500

Maturity period (n) = 20 years Maturity period (n) = 20 years

Face value (M)= Rs 1,000 Face value (M) = Rs 1,000

Yield to maturity (y) =? Yield to maturity (y) = ?

We have, We have,

M M

V0 = (1 + y)n V0 = (1 + y)n

Rs 1,000 Rs 1,000

Or, Rs 400 = (1 + y)20 Or, Rs 500 = (1 + y)20

Or, (1 + y)20 = 2.5 Or, (1 + y)20 = 2.5

Or, y = (2.5)1/20 – 1 Or, y = (2)1/20 – 1

Or, y = 1.04688 – 1 = 0.04688 Or, 4.688 % Or, y = 1.0353 – 1 = 0.0353 Or, 3.53 %

Bond 3 and 4

94 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Here given: Here given:

Price (V0) = Rs 500 Price (V0) = ?

Maturity period (n) = 10 years Maturity period (n) = 10 years

Face value (M) = Rs 1,000 Face value (M) = Rs 1,000

Yield to maturity (y) =? Yield to maturity (y) = 10%

We have, We have,

M M

V0= (1 + y)n V0 = (1 + y)n

Rs 1,000 Rs 1,000

Or, Rs 500 = (1 + y)10 = (1 + 0.10)10

Or, (1 + y)10 = 2 Rs 1,000

= 2.5937

Or, y = (2)1/10 – 1

Or, y = 1.07177 – 1 = Rs 385.5496

Or, y = 0.07177 Or, 7.177 %

Bond 5 and 6

Calculation of value of bond (V0) Calculation of maturity period (n)

Here given: Here given:

Price (V0) =? Price (V0) = Rs 400

Maturity period (n) = 10 years Maturity period (n) =?

Face value (M) = Rs 1,000 Face value (M) = Rs 1,000

Yield to maturity (y) = 8% Yield to maturity (y) = 8%

We have, We have,

M M

V0 = (1 + y)n V0 = (1 + y)n

Rs 1,000 Rs 1,000

= (1 + 0.08)10 Or, Rs 400 = (1 + 0.08)n Or, (1 + 0.08)n = 2.5

Rs 1,000 Or, Taking long on both sides: n log 1.08 = log 2.5

= 2.1589 = Rs 463.1989

Log 2.5 0.3979

Or, n = Log 1.08 = 0.0334 = 11.91 years

10. Solution

Here given: Par value (M) = Rs 1,000; Maturity (n) = 10 years; Coupon rate (i) = 8%; Current market price (P0) = Rs

800; Capital gain over the next year =?; Calculation of price at the end of one year i.e. P1 Or V1

First calculate AYTM

We have,

M − P0 Rs. 1‚000 – Rs. 800

I+ n Rs. 80 + 10 Rs100

AYTM = = Rs. 1‚000 + 2 × Rs. 800 = Rs 866.6667 = 0.1154 Or, 11.54%

M + 2 × P0

3 3

Referring AYTM, actual YTM lies between 11% and 12%. Calculate NPV at low and high rate.

NPV = TPV – P0

NPV = [I × PVIFAkd,n + M × PVIFkd,n] – P0

At 11%

NPV = [Rs 80 × PVIFA11,10 + M × PVIF11,10] – Rs 800

= [Rs 80 × 5.8892 + Rs 1,000 ×0.3522] – Rs 800

= Rs 823.336 – Rs 800

= Rs 23.336

At 12%

NPV = [Rs 80 × PVIFA12,10 + M × PVIF12,10] – Rs 800

= [Rs 80 × 5.6502 + Rs 1,000 ×0.3220] – Rs 800

= Rs 774.016 – Rs 800

= - Rs 25.984

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 95

Interpolation

NPVLR

kd = LR + × (HR − LR)

NPVLR − NPVHR

Rs.23.336

= 11 % + Rs.23.336 + Rs. 25.984 × (12% − 11%)

= 11% + 0.4732 × 1%

= 11.4732%

Now calculate the price of bond after one year (P1)

We have,

P1 = I × PVIFAkd, n + Rs 1,000 × PVIFkd, n

= Rs 80 × 5.4367 + Rs 1,000× 0.3762

= 811.136

Capial gain = P1 – P0 = 811.136 – Rs 800 = Rs 11.136

The new price will be 811.136. Thus, the capital gain is Rs 11.136.

11. Solution

Here given:

Coupon rate (i) = 7% semiannual

Coupon payment = Jan 15 and July 15

Price of bond on Jan 30 = 100: 02

Invoice price of bond= ?

Coupon period = 182 days

We have,

Invoice price = Reported price + accrued interest

= Rs 1,000.625 + Rs 2.885 = Rs 1,003.51

Working notes:

1. Reported bond price = [100 + 2/32] % of Rs 1,000 = Rs 1,000.625

2. Accrued interest = Rs 35 × 15/182 = Rs 2.885

12. Solution

Here given:

Years to maturity (n) = 10 years

Par value (M) = Rs. 1,000

Coupon rate (c) = 14% annually

Coupon payment (C)= M × c = Rs. 1,000 × 0.14 = Rs. 140

Selling price of the bond (V0) = Rs. 900

Calculation of stated yield to maturity

Step 1: Calculate the approximate yield to maturity (AYTM)

M − V0 Rs. 1‚000 – Rs. 900

C+ n Rs. 140 + 10 Rs150

AYTM = = Rs. 1‚000 + 2 × Rs. 900 = Rs 933.3333 = 0.1607 or 16.07%

M + 2 × V0

3 3

Step 2: Referring AYTM, it is seems that the actual yield to maturity lies between 16% and 17%. Now, calculate

the present value of bond at 16% and 17%.

At 16%

V0 = Rs. 140 × PVIFA 16%, 10 + Rs. 1,000 × PVIF16%, 10

= Rs. 140 × 4.8332 + Rs. 1,000 × 0.2267

= Rs. 903.348

At 17%

V0 = Rs. 140 × PVIFA 17%, 10 + Rs. 1,000 × PVIF17%, 10

= Rs. 140 × 4.6586 + Rs. 1,000 × 0.2080

= Rs. 860.204

Step 3: Calculate the net present value at 16% and 17%

96 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

We have,

NPV = Total present value − Market price

At 12%: NPV = Rs. 903.348 − Rs. 900 = + Rs. 3.348

At 13%: NPV = Rs. 860.204 − Rs. 900 = − Rs. 39.796

Step 4: Interpolate the values at 16% and 17%

We have,

NPVLR

y = LR + × (HR − LR)

NPVLR − NPVHR

Rs.3.348

= 16 % + Rs.3.348 + Rs. 39.796 × (17% − 16%)

= 16% + 0.0776× 1%

= 16% + 0.0776

= 16.0776%

Therefore, the stated yield to maturity, based on promised payments, equals 16.0776%.

Step 1: Calculate the approximate yield to maturity (AYTM)

M − V0 Rs. 1‚000 – Rs. 900

C+ n Rs. 70 + 10 Rs 80

AYTM = = Rs. 1‚000 + 2 × Rs. 900 = Rs 933.3333 = 0.0857 or 8.57%

M + 2 × V0

3 3

Step 2: Referring AYTM, it is seems that the actual yield to maturity lies between 8% and 9%. Now, calculate the

present value of bond at 8% and 9%.

At 8%

V0 = Rs. 70 × PVIFA 8%, 10 + Rs. 1,000 × PVIF8%, 10

= Rs. 70 × 6.7101 + Rs. 1,000 × 0.4632

= Rs. 932.907

At 9%

V0 = Rs. 70 × PVIFA 9%, 10 + Rs. 1,000 × PVIF9%, 10

= Rs. 70 × 6.4177 + Rs. 1,000 × 0.4224

= Rs. 871.639

Step 3: Calculate the net present value at 8% and 9%

We have,

NPV = Total present value − Market price

At 12%: NPV = Rs. 932.907 − Rs. 900 = + Rs. 32.907

At 13%: NPV = Rs. 871.639 − Rs. 900 = − Rs. 28.361

Step 4: Interpolate the values at 8% and 9%

We have,

NPVLR

y = LR + × (HR − LR)

NPVLR − NPVHR

Rs.32.907

= 8% + Rs.32.907 + Rs. 28.361 × (9% − 8%)

= 8% + 0.5371 × 1%

= 8% + 0.5371

= 8.5371%

Therefore, the expected yield to maturity, based on expected coupon payments of Rs 70 annually, equals

16.0776%.

13. Solution

Here given:

Maturity period (n) = 2 years

Par value (M) = Rs 1,000

Coupon payment (C) = Rs 100

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 97

Yield to maturity (y) =?

a. The bond is selling at par value. Its yield to maturity equals the coupon rate, 10%.

b. Realized compound yield to maturity (yrealized) = ?

(i) If reinvestment rate (r) = 8%

First calculate the terminal value for second year

FV2 = [C × (1 + r)] + [M + C] = [Rs 100 × (1 + 0.08)] + [1,000 + Rs 100] = Rs 1,208

Second calculate the realized yield to maturity

We have,

FV = PV (1 + r) n

Or, Rs 1,208 = Rs 1,000 (1 + yrealized)2

Or, 1 + yrealized = (1.208)1/2

Or, yrealized = 1.0991 – 1 = 0.0991 Or, 9.91%

(ii) If reinvestment rate (r) = 10%

First calculate the terminal value for second year

FV2 = [C × (1 + r)] + [M + C] = [Rs 100 × (1 + 0.10)] + [1,000 + Rs 100] = Rs 1,210

Second calculate the realized yield to maturity

We have,

FV = PV (1 + r) n

Or, Rs 1,210 = Rs 1,000 (1 + yrealized)2

Or, 1 + yrealized = (1.210)1/2

Or, yrealized = 1.10 – 1 = 0.10 Or, 10%

(iii) If reinvestment rate (r) = 12%

First calculate the terminal value for second year

FV2 = [C × (1 + r)] + [M + C] = [Rs 100 × (1 + 0.12)] + [1,000 + Rs 100] = Rs 1,212

Second calculate the realized yield to maturity

We have,

FV = PV (1 + r) n

Or, Rs 1,212 = Rs 1,000 (1 + yrealized)2

Or, 1 + yrealized = (1.212)1/2

Or, yrealized = 1.1009 – 1 = 0.1009 Or, 10.09%

14. Solution

Here given:

Today’s date = April 15

Coupon rate (c) = 10% semiannually

Asked price = 101:04

Price of the bond =?

We have,

Invoice price = Asked price + Accrued interest = Rs 1,011.25 + Rs 25 = Rs 1,036.25

Working notes:

1. Asked price = [101 + 04/32 ]% of Rs 1,000 = Rs 1,011.25

2. Accrued interest = Rs 1,000 × 0.10 × ¼ = Rs 25

15. Solution

Her given:

Maturity period (n) = 20 years

Bond = Zero coupon bond

Yield to maturity (y) = 8%

Face value (M) = Rs 1,000

Interest income in first, second and last year = ?

We have,

98 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

M Rs 1,000 Rs 1,000

Vd = (1 + y)n = (1 + 0.08)10 = 2.1589 = Rs 463.1989

Imputed interest

M

Year Maturity period (n) Vd = (increase in constant

(1 + y)n

yield value)

0 20 years Rs 1,000

(1 + 0.08)20 = Rs. 214.55

1 19 Rs 1,000 Rs 17.16

(1 + 0.08)19 = Rs. 231.71

2 18 Rs 1,000 Rs 18.54

(1 + 0.08)18 = Rs. 250.25

19 1 Rs 1,000

(1 + 0.08)1 = Rs. 925.93

20 0 Rs 1,000 Rs 74.07

16. Solution

Here given:

Maturity period (n) = 10 years; coupon rate (c) = 4% annual; Price (Vd) = Rs 800; Investor’s taxable income = ?

First calculate the yield to maturity of the bond at issued time

We have,

Step 1: Calculate the approximate yield to maturity (AYTM)

M − V0 Rs. 1‚000 – Rs. 800

C+ n Rs. 40 + 10 Rs. 60

AYTM = = Rs. 1‚000 + 2 × Rs. 800 = Rs 866.6667 = 0.0692 or 6.92%

M + 2 × V0

3 3

Step 2: Referring AYTM, it is seems that the actual yield to maturity lies between 6% and 7%. Now, calculate the

present value of bond at 6% and 7%.

At 6%

V0 = Rs. 40 × PVIFA 6%, 10 + Rs. 1,000 × PVIF6%, 10

= Rs. 40 × 7.3601 + Rs. 1,000 × 0.5584

= Rs. 852.804

At 7%

V0 = Rs. 40 × PVIFA 7%, 10 + Rs. 1,000 × PVIF7%, 10

= Rs. 40 × 7.0236 + Rs. 1,000 × 0.5083

= Rs. 789.244

Step 3: Calculate the net present value at 6% and 7%

We have,

NPV = Total present value − Market price

At 6%: NPV = Rs. 852.804 − Rs. 800 = + Rs. 52.804

At 7%: NPV = Rs. 789.244− Rs. 800 = − Rs. 10.756

Step 4: Interpolate the values at 6% and 7%

We have,

NPVLR

y = LR + × (HR − LR)

NPVLR − NPVHR

Rs. Rs. 52.804

= 6% + Rs. Rs. 52.804 + Rs.10.756 × (7% − 6%)

= 6% + 0.83 × 1%

= 6% + 0.83%

= 6.83%

The bond is issued at a price of Rs 800. Therefore, its yield to maturity is 6.83%.

Value of bond after one year assuming unchanged yield

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 99

= Rs. 40 × 6.5626 + Rs. 1,000 × 0.5518

= Rs. 814.304

Capital gain = V1 – V0 = Rs 814.304 – Rs 800 = Rs 14.304

Taxable income = Capital gain + Coupon = Rs 14.304 + Rs 40 = Rs 54.304

17. Solution

Here given:

Coupon rate (i) = 5%

Maturity period (n) = 20 years

Yield to maturity (y) = 8%

a. Holding period return =?; Yield to maturity end of the year = 7%

We have,

Holding period return = Rate of return

(V1 - V0) + C1 (Rs. 793.28 – Rs. 705.405) + Rs. 50

Rate of return = V0 = Rs. 705.405 = 0.1955 Or 19.55%

Working notes:

Vd = C × PVIFAk,n + M × PVIFk,n

At 8%

Vd = Rs. 50 × PVIFA 8, 20 + Rs. 1,000 × PVIF 8, 20

= Rs. 50 × 9.8181 + Rs. 1,000 × 0.2145

= Rs. 705.405

At 7%

V1 = Rs. 50 × PVIFA 7, 19 + Rs. 1,000 × PVIF 7, 19

= Rs. 50 × 10.3356 + Rs. 1,000 × 0.2765

= Rs. 793.28

b. Taxes = ?; Tax rate on interest income (TNG) = 40%;

Tax rate on capital gain (TCG) = 30%

We have,

Total taxes = Tax on interest income + Tax on capital gain

= [Interest income × tax rate on interest] + [Capital gain × Tax rate on capital gain ]

= (Rs 50 × 0.40) + [ (Rs 793.28 – Rs 705.405) × 0.30]

= Rs 20 + Rs 26.3625

= Rs 46.3625

c. After tax HPR = ?

We have,

(P1 - P0) (1 - TCG)+ I1 (1 - TNG)

After tax HPR = P0

For bond 1

(Rs 793.28 – Rs 705.405) (1 - 0.30) + Rs 50 (1 - 0.40)

After tax HPR = Rs 705.405 = 0.1297 Or, 12.97%

d.Find the realized compound yield before taxes for a 2-year holding period, assuming that (1) you sell the

bond after 2 years, (2) the bond yield is 7% at the end of the second year, and (3) the coupon can be reinvested

for year at a 3% interest rate.

Realized compound yield (yrealized) = ?; holding period (n) = 2 years; Bond yield (y) = 7%; Reinvestment rate (r)

= 3%

First calculate the terminal value in second year

FV2 = [I × (1 + r)] + [P2 + I] = [Rs 50 × (1 + 0.03)] + [798.86 + Rs 50] = Rs 900.36

Working note:

1. Price of bond at the end of second year (P2)

P2 = I × PVIFAy,n + M × PVIFy,n

= Rs 50 × PVIFA 7%, 18 + Rs 1,000 × PVIF7%, 18

= Rs 50 × 10.0591 + Rs 1,000 × 0.2959 = Rs 798.86

100 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

We have,

FV = PV (1 + r) n

Or, Rs 900.36 = Rs. 705.405 (1 + yrealized)2

Or, 1 + yrealized = (1.2764)1/2

Or, yrealized = 1.1298 – 1 = 0.1298 Or, 12.98%

Tax on coupon @ 40% – 20.00

Tax on imputed interest (40%× $6.43) – 2.57

Net cash flow in first year $27.43

If you invest the year-1 cash flow at an after-tax rate of:

3% × (1 – 40%) = 1.8%

By year 2, it will grow to:$27.43 × 1.018 = $27.92

You sell the bond in the second year for: P2 = $718.84, so imputed interest over the second year = $6.95

Selling price of the bond in the second year:$798.82

Tax on imputed interest in second year:– 2.78 [40%× $6.95]

Coupon received in second year, net of tax: + 30.00[$50 × (1 – 40%)]

Capital gains tax on sales price–23.99 [30%× ($798.82 – $718.84)]

Using constant yield value:

CF from first year's coupon (reinvested): + 27.92 [from above]

TOTAL $829.97

Thus, after two years, the initial investment of $705.46 grows to $829.97:

705.46 × (1 + r)2 = 829.97 ⇒ r = 0.0847 = 8.47%

18. Solution

a.The maturity of each bond is 10 years, and we assume that coupons are paid semiannually. Since both bonds are

selling at par value, the current yield to maturity for each bond is equal to its coupon rate.

If the yield declines by 1% to 5% (2.5% semiannual yield), the Sentinal bond will increase in value to 107.79 [n=20; i =

2.5; FV = 100; PMT = 3].

The price of the Colina bond will increase, but only to the call price of 102. The present value of scheduled payments

is greater than 102, but the call price puts a ceiling on the actual bond price.

b.If rates are expected to fall, the Sentinal bond is more attractive: Since it is not subject to being called, its

potential capital gains are higher.If rates are expected to rise, Colina is a better investment. Its higher coupon

(which presumably is compensation to investors for the call feature of the bond) will provide a higher rate of

return than that of the Sentinal bond.

c.An increase in the volatility of rates increases the value of the firm’s option to call back the Colina bond. If rates

go down, the firm can call the bond, which puts a cap on possible capital gains. So, higher volatility makes the

option to call back the bond more valuable to the issuer.This makes the Colina bond less attractive to the investor.

19. Solution

a.You would have to pay the asked price of: 107.27 = 107 + 27/32 % of par = Rs 1,078.4375

b.The coupon rate is 5 5/8% implying coupon payments of Rs 56.25 annually or, more precisely, Rs 28.125

semiannually.

c.Current yield = Annual coupon income/price = Rs 56.25/Rs 1,078.4375 = 0.0522 = 5.22%

20. Solution

a. The coupon is 9% indicating an annual rupee coupon of Rs. 90 or Rs. 45 semiannually.

b. The accrued interest would be from January 1 to April 1 or 3 months. This would be 50 percent of the

semiannual coupon or Rs. 22.50.

c. The close quote is 101½ or 1.0150 × Rs. 1,000 = Rs. 1,015

d.The maturity date is 1998.

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 101

Coupon payment 90

e.Current yield = Closing price = 1,015 = 8.87 ≈ 8.9

21. Solution

Here given:

Face value (M) = Rs. 1,000

Coupon rate (i) = 10%

Years to maturity (n) = 4 years

Interest payment = Annual

Current market price (V0) = Rs. 1,032.40

a. Bond's yield to maturity (y) = ?

First, calculate the approximate yield to maturity (AYTM)

M − V0 Rs.1,000 − Rs.1,032.40

C+ n Rs.100 + 4 Rs.91.9

A YTM = = = = 0.0899 or 8.99%

M + 2 × V0 Rs.1,000 + 2 × Rs. 1,032.40 Rs. 1,021.6

3 3

After calculating AYTM, it seems that the actual yield to maturity lies close to 9%. Therefore, try at 9% first.

Try at 9%

Rs.1,032.40 = Rs.100 × PVIFA9%, 4 + Rs.1,000 × PVIF9%, 4

= Rs.100 × 3.2397 + Rs.1,000 × 0.7884 = Rs.1032.37

∴ NPV = 1,032.37 – Rs.1,032.40 = – Rs.0.03

The net present value at 9% is approximately zero; therefore the yield to maturity is 9%.

b. Yield to call (yc) = ?

Given:

Call price (CP) = Rs. 1,100

Call period (n) = 2 years

First, calculate the approximate yield to call (AYTC)

We have,

CP − V0 Rs.1,100 − Rs.1,032.40

C+ n Rs.100 + 2 Rs.133.8

AYTC = = = = 0.1268 or 12.68%

CP + 2 × V0 Rs.1,100 + 2 × Rs. 1,032.40 Rs.1,054.9333

3 3

After calculating AYTC, it seems that the actual yield to call lies between 12% and 13%. Therefore, try at these two

rates.

Try at 12%

Rs.1,032.40 = Rs.100 (PVIFA12%, 2 ) + Rs.1,100 (PVIF12%, 2)

= Rs.100 × 1.6901 + Rs.1,100 × 0.7972 = Rs.1,045.93

NPV = Rs. 1,045.93 – Rs.1,032.40 = Rs.13.53

Try at 13%

Rs.1,032.4 = Rs.100 (PVIFA13%, 2) + Rs.1,100 (PVIF13%, 2)

= Rs.100 × 1.6681 + Rs.1,100 × 0.7831 = Rs.1,028.22

NPV = Rs.1,028.22 – Rs.1,032.4 = – Rs 4.18

Now interpolate between these two rates.

Interpolation

We have,

NPVLR

YTC = Lower rate + NPV - NPV × (High rate – low rate)

LR HR

13.53

= 12% + + 13.53 - (- 4.18) × (13% - 12%) = 12.76%

Yield to call is the rate of return that an investor would earn if he bought a callable bond at its current market

price and held it until the call date given that the bond was called on the call date.

102 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

22. Solution

Here given:

Face value of bond (M) = Rs. 1,000

Life of bond (n) = 5 years

Coupon rate of the bond (c) = 10%

Call period (n) = 2 years

Call price (CP) = Rs. 1,200

Face value of next 3-year bond= Rs. 1,000

Coupon rate (c) = 7%

Actual yield to maturity for five year period (y) = ?

Since, the coupon rate of 5-year bond is 10%, so try at near to this rate or try at 12%.

Try at 12%

Year CF At 12% PV

1 Rs.100 0.8929 Rs. 89.29

2 300 0.7972 239.16

3 70 0.7118 49.826

4 70 0.6355 44.485

5 1,070 0.5674 607.118

Rs.1,029.88

Less:- 1,000

NPV Rs.29.88

Working notes:

Cash inflow in 2nd year is Rs.300 (Rs.1,200 + Rs.100 – Rs.1,000)

Try at 13%

Year CF At 13% PV

1 Rs.100 0.8850 Rs.88.50

2 300 0.7831 234.93

3 70 0.6931 48.517

4 70 0.6133 42.931

5 1,070 0.5428 580.796

TPV Rs.995.674

Less:- 1,000

NPV –Rs.4.326

NPVLR

YTM = Lower rate + NPV - NPV × (High rate – low rate)

LR HR

29.88

= 12% + + 29.88 - (- 4.326) × (13% - 12%) = 12.87%

Therefore, the actual yield to maturity for 5-year period is 12.87%.

23. Solution

Nellie Fox receives four Rs.90 coupon payments from the bond. Assuming that they are reinvested at 15 percent,

those coupon payments plus the principal repayment will, after four years, have grown to an accumulated value

of:

Future value = Rs.90 (1.15)3 + Rs.90 (1.15)2 + Rs.90 (1.15)1 + Rs.90 (1.15)0

= Rs.136.88 + Rs.119.03 + Rs.103.5 + Rs.1,090 = Rs.1,449.41

As the bond has a purchase price of Rs.1,000, Nellie's actual YTM over the four years is:

1 1

( Future value n

Actual yield = Present value ) (

=

Rs.1,449.41 4

Rs.1,000 )

− 1.0 = 0.0972 or 9.72%

If the coupon payments were spends immediately upon receipt, then the effective reinvestment rate is 0 percent.

Thus the accumulated value of the cash flow is:

Future value = Rs.90 + Rs.90 + Rs.90 + Rs. 1,090 = Rs.1,360

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 103

1 1

( Future value n

Actual yield = Present value ) –1 = ( Rs.1,360

Rs.1,000 ) 4

− 1 = 0.0799 or 7.99%

♦-♦

NUMERICAL PROBLEMS

1. Solution

Given:

Current dividend (D0) = Rs 1.00; Growth rate for 2 years (gs) = 20%; Normal growth rate (gn) = 4%; Required rate

of return (ks) = 8.5%; Intrinsic value of stock (P0) =?

We have,

D1 D2 P2

P0 = (1 + k )1 + (1 + k )2 + (1 + k )2

s s s

= (1 + 0.085)1 + (1 + 0.085)2 + (1 + 0.085)2

= Rs 1.1060 + Rs 1.2232 + Rs 28.2699

= Rs 30.5991

Working notes:

D1 = D0 (1 + gs) = Rs 1 (1 + 0.20) = Rs 1.20

D2 = D1 (1 + gs) = Rs 1.20 (1 + 0.20) =Rs 1.44

D3 = D2 (1 + gn) = Rs 1.44 (1 + 0.04) = Rs 1.4976

D3 Rs 1.4976

P2 = k - g = 0.085 - 0.04 = Rs 33.28

s n

2. Solution

Given:

Current dividend (D0) = Rs 1.22; Growth rate (g) = 5%; Price of stock (P0) = 32.03; Required rate of return (ks) = ?

We have,

D1 Rs 1.281

ks = P + g = Rs 32.03 + 0.05 = 0.03999 + 0.05 = 0.08999 Or 8.999% ≈ 9%

0

Working notes:

D1 = D0 (1 + gs) = Rs 1.22 (1 + 0.05) = Rs 1.281

3. Solution

Given:

Current dividend (D0) = Rs 1.00; Growth rate (g) = 5%; Price of stock (P0) = 35; Required rate of return (ks) = ?

We have,

D1 Rs 1.05

ks = P + g = Rs 35 + 0.05 = 0.03 + 0.05 = 0.08 Or 8%

0

Working notes:

D1 = D0 (1 + gs) = Rs 1 (1 + 0.05) = Rs 1.05

4. Solution

Given:

Current market value (P0) = Rs 41 per share ; Earnings per share (E0) = Rs 3.64; Present value of growth

opportunities (PVGO) = ? Required rate of return (ks) = 9%

E1 Rs 3.64

We have, PVGO = P0 – = Rs 41 - = Rs 41 – Rs 40.4444 = Rs 0.5556

ks 0.09

104 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

5. Solution

Given:

Book value of current assets = Rs 10 million; Market value of current assets = Rs 10 million, book value of fixed

assets = Rs 60 million; Market value of fixed assets = Rs 90 million, Book value of debt = Rs 40 million; Market

value of debt = Rs 50 million; Market to book ratio =?

Market value of assets Rs 50 million

Market to book ratio = Book value of assets = rs 30 million = 1.6667 times

Working notes:

Book value of assets = Book value of current assets + Book value of fixed assets

= Rs 10 million + Rs 60 million = Rs 70 million

Market value of assets = Market value of current assets + Market value of current assets

= Rs 10 million + Rs 90 million = Rs 100 million

Book value of equity = Book value of assets – Book value of debt

= Rs 70 million – Rs 40 million = Rs 30 million

Market value of equity = Market value of assets – Market value of debt

= Rs 100 million – Rs 50 million = Rs 50 million

6. Solution

Given:

Market capitalization rate (ks) = Rs 8%;

Return on equity (ROE) = 10%

Expected earnings per share (E1) = Rs 5

Plowback ratio or retention ratio (b) = 0.60

D1 Rs 2

P0 = k - g = = Rs 100

e 0.08 − 0.06

P0 Rs 100

P/E ratio = E = Rs 5 = 20 times

1

Working notes:

1.Growth rate (g) = ROE × b = 10% × 0.60 = 6%

2.Expected dividend (D1) = E1 × (1 – b) = Rs 5 × 0.40 = Rs 2

7. Solution

Given:

Expected dividend (D1) = Rs 4 per share; Growth rate (g) = 4% per year; Risk free rate (rf) = 4%; Expected return

on market portfolio, E(rm) = 12%; Beta of stock (βs) = 0.75; Intrinsic value of stock (P0) = ?

We have,

D1 Rs 4

P0 = k - g = = Rs 66.6667

s 0.10 − 0.04

Working notes:

Required return on stock (ks) = rf + [E(rm) – rf ]βs = 4% + (12 – 4) 0.75 = 10%

8. Solution

Given:

Expected earnings (E1) = Rs 6 per share, Return on equity (ROE) = 15%; Plowback ratio (b) = 60%; Market

capitalization rate (ks) = 10%; Present value of growth opportunities (PVGO) = ?

We have,

E1 Rs 6

PVGO = P0 – k = Rs 240 - 0.10 = Rs 240– Rs 60 = Rs 180 per share

s

Working notes:

1. Growth rate (g) = b × ROE = 0.60 × 15 = 9%

2. Expected dividend (D1) = E1 × (1 – b) = Rs 6 × (1 – 0.60) = Rs 2.4 per share

D1 Rs 2.4

3. Value of stock (P0) = k - g = = Rs 240 per share

s 0.10 − 0.09

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 105

9. Solution

Given:

Annual dividend (D0) = Rs 2.10 per share; Risk free rate (rf) = 7%; Risk premium = 4%; Expected dividend (D1) = Rs 2.10;

Value of stock (P0) =?

We have

D0 Rs 2.10

Value of stock (P0) = k = 0.11 = Rs 19.0909 per share

s

Working notes:

Required return on stock (ks) = rf + [E(rm) – rf ]βs = 7% + 4% = 11%

10. Solution

Given:

Risk free rate (rf) = 5%; Required rate of return on the market, E(rm) = 10%; Bet of stock (βs) = 1.5; Expected dividend (D1)

= Rs 2.50; growth rate (g) = 4%; Price of stock (P0) = ?

We have,

D1 Rs 2.50

Value of stock (P0) = k - g = 0.1250 - 0.04 = Rs 29.4118 per share

s

Working notes:

Required return on stock (ks) = rf + [E(rm) – rf ]βs = 5% + (10 – 5) 1.5 = 12.50%

11. Solution

a. Given,

Equity capitalization rate (ke) = 16%

Expected year-end dividend per share (D1) = Rs 2

Current selling price per share (P0) = Rs 50

The expected growth rate (g) in dividend is given by:

D1

ke =P +g

0

Rs 2

0.16 = Rs 50 + g

g = 0.12 = 12%

b. Given,

Expected growth rate in dividends (g) = 5%

The price of Mercantile stock is given by:

D1 Rs 2

P0 = (k – g) = (0.16 – 0.05) = Rs 18.18

The price falls in response to the more pessimistic dividend forecast. The forecast for current year earnings,

however, is unchanged. Therefore, the P/E ratio falls. The lower P/E ratio is evidence of the diminished optimism

concerning the firm's growth prospects.

12. Solution

Given,

Return on equity (ROE) = 20%

Plowback ratio (b) = 0.30

Next year’s EPS (E1) = Rs 2

Expected dividend (D1) = E1 × DPR = Rs 2 × (1 – 0.30) = Rs 1.40

Expected rate of return on stock (ks) = 12%

a.Price of stock (P0)

D1 Rs 1.40

P0 = = = Rs 23.3333

ke − g 0.12 − 0.06

Working notes:

g = b x ROE = 0.30 × 20% = 6%

106 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

P0 Rs 23.3333

P/E ratio = E = Rs 2 = 11.6667 times

1

E1 Rs 2

PVGO = P0 − k = Rs 23.3333 − 0.12 = 23.3333 - 16.6667 = Rs 6.6666

s

The high P/E ratios and positive PVGO are due to a high ROE (20%) that is higher than the required rate of return

of stock. (12%).

c. P/E ratio = ?; PVGO = ? ; Plowback ratio (b) = 20%

D1 Rs 1.60

Price of stock (P0) = = = Rs 20

ks − g 0.12 − 0.04

Working notes:

g = b x ROE = 0.20 × 20% = 4%

Expected dividend (D1) = E1 × (1- b) = Rs 2 × (1 – 0.20) = Rs 1.60

P0 Rs 20

P/E ratio = E = Rs 2 = 10 times

1

E1 Rs 2

PVGO = P0 − k = Rs 20 − 0.12 = 20 - 16.6667 = Rs. 3.3333

s

13. Solution

a.Given,

Return on equity (ROE) = 16%

Retention ratio (b) = 0.5

Expected earnings per share (E1) = Rs 2

Market capitalization rate of equity (ke) = 0.12

The expected growth rate:

g = ROE × b = 0.16 × 0.5 = 0.08 or 8%

The expected dividend per share:

D1 = E1(1 – b) = Rs 2(1 – 0.5) = Rs 1

Selling price per share is given by:

D1 Rs 1

P0 = (k – g) = (0.12 – 0.08) = Rs 25

e

P3 = P0(1 + g)3 = Rs 25(1.08)3 = Rs 31.49

14. Solution

Given:

Return on equity (ROE) = 9%

Beta coefficient (βs) = 1.25

Plowback ratio (b) = 2/3

Current year’s EPS (E0) = Rs 3

Expected market return, E(rM) = 14%

Risk-free rate (rf) = 6%

a.The required rate of return on Asian stock:

ks = rf + βs[Ε(rM) – rf ] = 6% + 1.25(14% – 6%) = 16%

Expected growth rate in dividends:

2

g = b x ROE = 3 × 9% = 6%

Expected year-end dividend per share:

1

D1 = E0(1 + g) (1 – b) = Rs 3(1.06) × 3 = Rs 1.06

The price at which Asian stock should sell is given by:

D1 Rs 1.06

P0 = = = Rs 10.60

ks − g 0.16 − 0.06

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 107

P0 Rs 10.60

Leading : P/E = E = Rs 3 (1.06) = 3.33

1

P0 Rs 10.60

Trailing: P/E = E = Rs 3 = 3.53

0

E1 Rs 3.18

PVGO = P0 − k = Rs 10.60 − 0.16 = −Rs 9.275

s

The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than the market capitalization rate

(16%).

1

d.Now, if we revise retention ration (b) to 3, the growth rate (g) is given by:

1

g = b x ROE = 3 × 9% = 3%

And expected year-end dividend (D1) is given by:

2

D1 = E0 × (1 +g) x (1 – b) = Rs 3 x 1.03 × 3 = Rs 2.06

Thus, intrinsic value of the stock is given by:

Rs 2.06

V0 = (0.16 – 0.03) = Rs 15.85

V0 increases because the firm pays out more earnings instead of reinvesting at a poor ROE. This information is not

yet known to the rest of the market.

15. Solution

Given,

Expected growth rate (g) = 5%

Expected year-end dividend per share (D1) = Rs 8

Market capitalization rate of equity (ks) = 10%

a.The current stock price is given by:

D1 Rs 8

P0 = k - g = 0.10 - 0.05 = Rs 160

s

b.If the expected earnings per share (E1) were Rs 12, the dividend payout ratio is 8/12 = 2/3, so the plowback ratio

is (b) = 1 – dividend payout = 1 – 2/3 = 1/3. The implied value of ROE on future investments is found by solving:

g = b × ROE

5% = 1/3 x ROE

ROE = 15%

c.If all earnings were paid in dividends and assuming ROE = ke, price would be equal to:

E1 Rs 12

P0 = k = 0.10 = Rs 120

s

E1

PVGO = P0 - k = Rs 160 – Rs 120 = Rs 40 per share

s

16. Solution

Given,

Current selling price per share (P0) = Rs 10

Expected earnings per share (E1) = Rs 2

Dividend payout ratio (1 – b) = 0.5

Internal rate of return on equity (ROE) = 0.20

a.If the current market price reflects the intrinsic value of the stock the required rate of return on equity is given

by:

D1 Rs 1

ks = P + g = Rs 10 + 0.10 = 0.10 + 0.10 = 0.20 or 20%

0

108 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Working notes:

D1 = E1 × (1 – b) = Rs 2 × 0.50 = Rs 1 per share

g = b × ROE = 0.50 × 0.20 = 0.10 Or, 10%

E1 Rs 20

b.Value with no growth = k = 0.20 = Rs 10

s

E1

PVGO = P0 - k = Rs 10 – Rs 10 = Rs 0

s

That is, since ks = ROE, the NPV of future investment opportunities is zero.

c.Since k = ROE, the stock price would be unaffected if Nogro were to cut its dividend payout ratio to 25%.

The additional earnings that would be reinvested would earn the ROE (20%).

Again, if Nogro eliminated the dividend, this would have no impact on Nogro’s stock price since the NPV of the

additional investments would be zero.

17. Solution

Given,

The risk-free rate (RF) = 8%

The expected return on market portfolio, E(RM) = 15%

Beta coefficient of the stock (βe) = 1.2

Dividend payout ratio (1 – b) = 0.4

Latest earnings per share (E0) = Rs 10

Internal rate of return on equity (ROE) = 0.2

a.The required rate of return on equity is given by:

ks = rf + βs[E(rM ) – rf ] = 8% + 1.2(15% – 8%) = 16.4%

The expected growth rate (g) = b × ROE = 0.6 × 20% = 12%

The intrinsic value of a share of XYZ stock is given by:

D0(1 + g) Rs 4 (1.12) Rs 4.48

V0 = k - g = 0.164 - 0.12 = 0.044 = Rs 101.82

e

b. Given the current market price per share (P0) is Rs 100 and it would equal to intrinsic value 1 year from now,

that is, P1 = V1 = V0(1 + g) = Rs 101.82 × 1.12 = Rs 114.04, the expected 1 year holding period return on XYZ stock is

given by:

D1 + P1 - P0 Rs 4.48 + Rs 114.04 - Rs 100

E(Re) = P0 = Rs100 = 0.1852 or 18.52%

18. Solution

a. The industry’s estimated P/E can be computed using the following model:

DPR 0.60

P0/E1 = k - g = 0.12 - 0.10 = 30 times

s

Working notes:

g = ROE × retention rate = 0.25 × 0.40 = 0.10 or 10%

ks = government bond yield + ( industry beta × equity risk premium) = 6 + (1.2 × 5) = 12%

b. (i) Forecast growth in real GDP would cause P/E ratios to be generally higher for Country A. Higher expected

growth in GDP implies higher earnings growth and a higher P/E.

(ii) Government bond yield would cause P/E ratios to be generally higher for Country B. A lower government bond

yield implies a lower risk-free rate and therefore a higher P/E.

(iii) Equity risk premium would cause P/E ratios to be generally higher for Country B. A lower equity risk

premium implies a lower required return and a higher P/E.

19. Solution

a. ks = rf +β[E(rM) –rf ]= 0.045 + 1.15 × (0.145 −0.045) = 0.16 or 16%

b. Calculation of intrinsic value

Year Dividends

2010 Rs 1.72

SOLUTION MANUAL OF INV ES T ME NT AN A LY S IS (KHA NA L PU B L IC A TI ON S) 109

2

2012 Rs 1.72 × (1 + 0.12) = Rs 2.16

2013 Rs 1.72 × (1 + 0.12)3 = Rs 2.42

2014 Rs 1.72 × (1 + 0.12)3 (1 + 0.09) = Rs 2.63

Present value of dividends paid in years 2011 to 2013:

Year Dividends

2011 Rs 1.93 / (1 + 0.16) = Rs 1.66

2012 Rs 2.16 / (1 + 0.16)2 = Rs 1.61

2013 Rs 2.42 × (1 + 0.16)3 = Rs 1.55

Total Rs 4.82

D2014 Rs 2.63

P2013 = = = Rs 37.57

ks - g 0.16 - 0.09

Rs 37.57

PV (in 2010) of P2013 = = Rs 24.07

(1.16)3

Intrinsic value of stock = Rs 4.82 + Rs 24.07 = Rs 28.89

c. The table presented in the problem indicates that QuickBrush is selling below intrinsic value, while we have

just shown that SmileWhite is selling somewhat above the estimated intrinsic value. Based on this analysis,

QuickBrush offers the potential for considerable abnormal returns, while SmileWhite offers slightly below-market

risk-adjusted returns.

d. Strengths of two-stage DDM compared to constant growth DDM:

▪The two-stage model allows for separate valuation of two distinct periods in a company’s future. This approach

can accommodate life cycle effects. It also can avoid the difficulties posed when the initial growth rate is higher

than the discount rate.

▪The two-stage model allows for an initial period of above-sustainable growth. It allows the analyst to make use of

her expectations as to when growth may shift to a more sustainable level.

▪A weakness of all DDMs is that they are all very sensitive to input values. Small changes in k or g can imply large

changes in estimated intrinsic value. These inputs are difficult to measure.

20. Solution

a. The value of a share of Rio National equity using the Gordon growth model and the capital asset pricing model is

$22.40, as shown below.

Calculate the required rate of return using the capital asset pricing model:

ks = rf + (kM – rf) = 4% + 1.8(9% – 4%) = 13%

Calculate the share value using the Gordon growth model:

D0 (1 + g) Rs 0.20 (1 + 0.12)

P0 = = = Rs 22.40

ks - g 0.13 - 0.12

b. The sustainable growth rate of Rio National is 9.97%, calculated as follows:

g = b × ROE = Earnings Retention Rate × ROE = (1 – Payout Ratio) × ROE

= 0.8939 × 11.16% = 9.9759 ≈ 9.58%

Working notes:

Dividend payout ratio (DPR) = Dividends /Net income = Rs 3.20/ Rs 30.16 = 0.1061

Retention ratio (b) = 1 – DPR = 1 – 0.1061 = 0.8939

Return on equity (ROE) = Net income/Equity = Rs 30.16/Rs 270.35 = 0.1116 Or, 11.16%

21. Solution

a. Using a two-stage dividend discount model, the current value of a share of Sundanci is calculated as follows.

We have,

D1 D2 P2

P0 = (1 + k )1 + (1 + k )2 + (1 + k )2

s s s

= (1 + 0.14)1 + (1 + 0.14)2 + (1 + 0.14)2

= Rs 0.3311 + Rs 0.3834 + Rs 43.3287

= Rs 44.0432

110 Solution Manual of I N V E S T M E N T ANALYSIS (KHANAL PUBLICATIONS)

Working notes:

D1 = D0 (1 + gs) = Rs 0.286 (1 + 0.32) = Rs 0.3775

D2 = D1 (1 + gs) = Rs 0.3775 (1 + 0.32) = Rs 0.4983

D3 = D2 (1 + gn) = Rs 0.4983 (1 + 0.13) = Rs 0.5631

D3 Rs 0.5631

P2 = k - g = 0.14 - 0.13 = Rs 56.31

s n

b. The formula for calculating a price earnings ratio (P/E) for a stable growth firm is the dividend payout ratio

divided by the difference between the required rate of return and the growth rate of dividends. If the P/E is

calculated based on trailing earnings (year 0), the payout ratio is increased by the growth rate. If the P/E is

calculated based on next year’s earnings (year 1), the numerator is the payout ratio.

P/E on trailing earnings:

Payout ratio (1 + g) 0.30 (1 + 0.13)

P/E = ks - g = 0.14 - 0.13 = 33.9 times

P/E on next year's earnings:

Payout ratio 0.30

P/E = ks - g =0.14 - 0.13. = 30.0

c. The P/E ratio is a decreasing function of riskiness; as risk increases, the P/E ratio decreases. Increases in the

riskiness of Sundanci stock would be expected to lower the P/E ratio.

The P/E ratio is an increasing function of the growth rate of the firm; the higher the expected growth, the higher the

P/E ratio. Sundanci would command a higher P/E if analysts increase the expected growth rate.

The P/E ratio is a decreasing function of the market risk premium. An increased market risk premium increases the

required rate of return, lowering the price of a stock relative to its earnings. A higher market risk premium would

be expected to lower Sundanci's P/E ratio.

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