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CHAPTER -2:

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

Bond equivalent yield (BEY) = ?


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

100 − Bid pricce 360


or,0.0690 = 100 × 60

or,414 = 36,000 − 360 bid price


∴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)

100 − Asked price 360


or,0.0681 = 100 × 60

or,408.6 = 36,000 − 360 Asked price


∴Asked price = 98.865
FV − PP 365 100 − 98.865 365
b.BEY = PP × t = 98.865 × 60 = 0.0698 Or, 6.98%

EAR = (1 + Periodic rate)m −1= (1 + 0.0115)6.0833 − 1 = 1.0720 − 1 = 0.0720 or 7.20%


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

Total price Price of Alpha + Price of Beta + Price of Delta Rs. 2 + 45 + 33


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

c. The return for stock in 2005 and 2006


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

PWIT+ 1 −PWIT 46.67 − 89.67


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)

Sum of price relative 80/60 + 35/20 +25/189 3.2156


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

Initial margin (IM) = 60 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 × 0.60 = 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%

(Rs.20 − Rs.30) + Rs.1


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

(iii) Net worth falls to (Rs 36 × 500) – Rs 5,000 = Rs 13,000


–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)

CHAPTER 4: MUTUAL FUNDS


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

Assets − Liabilities Rs.500 million − Rs.2 million


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)

d. This is closed end fund because this fund is trading at NEPSE.


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

Net asset value = ?


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.

♦-♦

CHAPTER 5: RISK AND RETURN

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)

Price of stock one year after (P1) = Rs. 21


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

(P1 − P0) Rs.21 − Rs.20


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

b.Two year holding period return if dividend is reinvested


(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

Arithmetic mean r for A & B


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)

Standard deviation = σj = Variance = 102.75 = 10.136567%

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

Calculation of Expected Return and Standard Deviation


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

Expected rate of return, E(rj) = ∑ Pj × rj =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%%

Standard deviation of stock A = σA= σA2 = 86.8%% = 9.3167%


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%%

Standard deviation of stock A = σA= σA2 = 8%% = 2.8284%


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)

0.30 0.075 0.169 −0.113


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

CHAPTERT -6: EFFICIENT DIVERSIFICATION AND CAPM


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)

(Rs.50 × 100) (Rs.35 × 200)


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

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 = 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)

Moderate growth 0.40 15 6.0 17 6.80


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 B, CovAB = − 211


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 %

e. E(rC) = y × E(rP) + (1 – y) × rf = y × 17 + (1 – y) × 7 = 0.15 or 15% per year


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%

Standard deviation of returns on portfolio:


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

Standard deviation of returns on equity fund (σE) = 20%


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)

b. Calculation of weight of the optimal risky portfolio:


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

a. i. Expected return on new portfolio, E(rNP) = ?


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)

0.40 0.6000 11% 20%


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%

The graph approximates the points:


E(r) σ
Minimum variance portfolio 10.89% 19.94%
Tangency portfolio 12.88% 23.3382%

c. The reward-to-variability ratio (Sharpe ratio) of the optimal CAL is:


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, 6.5% = 0.3162 σc


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
. ♦-♦

CHAPTER -7: BOND PRICES AND YIELDS


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

Market interest rate (y) = 4% for half year


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

Second year Third year


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)

Calculation of yield to maturity (y) Calculation of value of bond (V0)


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%.

Calculation of expected yield to maturity


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

Price of bond (Vd) = Rs 1,000


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

V1 = Rs. 40 × PVIFA 6.83%, 9 + Rs. 1,000 × PVIF6.83%, 9


= 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)

Second calculate the realized yield to maturity


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%

e.Coupon received in first year: $50.00


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

Therefore, Nellie's actual YTM over the four year is:


1 1

( Future value n
Actual yield = Present value ) –1 = ( Rs.1,360
Rs.1,000 ) 4
− 1 = 0.0799 or 7.99%

♦-♦

CHAPTER -8: EQUITY VALUATION MODEL


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

Rs 1.20 Rs 1.44 Rs 33.28


= (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

b. The present value of growth opportunity


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

b.The expected selling price of stock in 3 years is given by:


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

b.The price earnings ratio:


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

c.The present value of growth opportunity


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

Therefore, the market is paying Rs 40 per share for growth opportunities.

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

2011 Rs 1.72 × (1 + 0.12) = Rs 1.93


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

Rs 0.3775 Rs 0.4983 Rs 56.31


= (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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