SFM PDF

C.A.
Final
Strategic Financial
Management
CA. Sunil Gokhale’s

Adarsh Classes
A - Bldg., 1st Floor, Office No. 5, Herekar Park,
Next to Kamala Nehru Park,
Off Bhandarkar Road, Deccan.
9765823305
Contents
1. Cost of Capital, Leverage & Economic Value Added - - - - - - - - - - - - - - - - - - - - - - - 1
Capital Employed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
|| Need to ascertain Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Components of Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . 1
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Operating & Financial Leverage . . . . . . . . . . . . . . . . . . . . . . . . . 5
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Economic Value Added . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2. Financial Policy & Corporate Strategy - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 9
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3. Project Planning & Capital Budgeting - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 11
Market Feasibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Technical Feasibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Financial Feasibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
|| Methods of Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
"" Accounting or Average Rate of Return (A.R.R.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
"" Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
"" Payback Reciprocal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
"" Post-payback Profitability Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
"" Discounted Payback Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
"" Net Present Value Method (N.P.V.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
"" Profitability Index or Desirability Index or Benefit-Cost Index . . . . . . . . . . . . . . . . . . . . . . .15
"" Internal Rate of Return (I.R.R.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
• Comparison between I.R.R. and NPV method of evaluating proposals . . . . . . . . . . . . . . . . . 16
• Similar results under I.R.R. and NPV method . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
• Conflict under I.R.R. and NPV method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
"" Modified I.R.R. (M.I.R.R.) or Terminal I.R.R. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
"" Project I.R.R. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
"" Equity I.R.R. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
|| Problems – General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
|| Problems – Selecting an asset where no revenues are generated . . . . . . . . . . . . . . . . . . . . . 21
Replacement of Asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
|| Problems – Replacing an asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Risk Analysis in Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . 26
|| Standard Deviation (S.D.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
|| Standard Deviation – with probability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
|| Hillier’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
|| Co-efficient of Variation (C.V.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
|| Problems – Standard Deviation & Coefficient of Variation . . . . . . . . . . . . . . . . . . . . . . . . 27
|| Problems – Hillier’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Risk Adjusted Discount Rate (RADR) . . . . . . . . . . . . . . . . . . . . . . 30
|| Problems – Applying risk adjusted discounting rate . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Certainty Equivalent Approach . . . . . . . . . . . . . . . . . . . . . . . . . 31
|| Problems – Applying certainty equivalent approach . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
|| Problems – Sensitivity analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
|| Problems – Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
|| Problems – Simulation using Monte Carlo Method . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Decision Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
|| Problems – Decision tree analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Capital Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
|| Problems – Capital rationing situations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
|| Problems – Capital budgeting decisions in inflationary conditions . . . . . . . . . . . . . . . . . . . . . 43
Real Option – Delay, Abandonment, etc. . . . . . . . . . . . . . . . . . . . . . 44
|| Problems – Decision involving real options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Problems & Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
4. Leasing Decisions - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 68
Types of Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Evaluation Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
|| Lessor’s Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
|| Lessee’s Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
"" Present Value of Cash Outflow Method (PVCO Method) . . . . . . . . . . . . . . . . . . . . . . . . 69
"" Net Advantage to Leasing (NAL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
|| Problems – Lessor’s Perspective, Stepped-up or Stepped-down Lease Rental . . . . . . . . . . . . . . . 70
|| Problems – Lease or Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
|| Problems – Deciding break-even lease rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
5. Dividend Decisions - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 76
Related Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Dividend Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Significance of Stability of Dividend . . . . . . . . . . . . . . . . . . . . . . . 77
Dividend Models or Theories of Dividend . . . . . . . . . . . . . . . . . . . . 77
|| Graham & Dodd Model (Traditional Approach) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
|| Walter’s Model (Earnings Growth Model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
|| Gordon’s Model (Dividend Growth Model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
|| Modigliani-Miller Model (Theory of Dividend Irrelevance) . . . . . . . . . . . . . . . . . . . . . . . . 79
|| Lintner’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
|| Radical Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
|| Bird-in-hand Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
|| Residual Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Intrinsic Value of Share . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
|| Dividend Discount Model (DDM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
"" Graham & Dodd Model (Traditional Approach) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
"" Walter’s Model (Earnings Growth Model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
"" Gordon’s Model (Dividend Growth Model) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
"" Modigliani-Miller Model or Dividend Irrelevance Theory . . . . . . . . . . . . . . . . . . . . . . . . 84
"" Lintner’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
"" Dividend Discount Model (DDM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
6. Bond Valuation - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 90
|| Bond Valuation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
|| Current or Flat Yield of a Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
|| Yield to Maturity (YTM) of a Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
|| Bond Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
|| Duration of a Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
|| Volatility or Modified Duration of a Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
|| Yield Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
|| Forward Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
|| Convertible Debentures or Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
|| Refunding of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
"" Valuation, Yield, Duration, etc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
"" Forward Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
"" Convertible Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
"" Refunding of Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
7. Indian Capital Market - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 101

|| Green Shoe Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
|| Book-building Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
|| Distinction between futures and forward contracts: . . . . . . . . . . . . . . . . . . . . . . . . . . 103
|| Short and Long Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
|| Margins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
|| Marking to market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
Valuation of Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
|| Underlying not generating any income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
|| Underlying generating known cash income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
|| Underlying providing a known yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
|| Underlying held for consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Futures Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Hedging with Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
"" Perfect Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
"" Imperfect hedge or Cross hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
"" Using Index futures for hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
"" Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
"" Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
"" Exercise price or Strike price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
"" Parties to an Option: Holder & Writer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
"" American Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
"" European Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
|| Options that are ‘At the money’, ‘Out of the money’ and ‘In the money’ . . . . . . . . . . . . . . . . . . 108
|| Some Important Option Trading Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
|| Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
|| Strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
|| Strips & Straps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
|| Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
|| Value of an Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
"" Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
"" Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
"" Option Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .121
Option Valuation Models . . . . . . . . . . . . . . . . . . . . . . . . . . 122
|| Basic valuation concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
|| Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
"" One-step Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .122
"" Multi-step Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
|| Risk Neutral Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
|| Black & Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
"" Value of Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
"" Value of Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
|| Portfolio Replication Model – Option Strategy or Stock Equivalent . . . . . . . . . . . . . . . . . . . . 126
|| Portfolio Replication Model – Stock Strategy or Option Equivalent . . . . . . . . . . . . . . . . . . . . 126
|| Minimum value or lower bound of an European Call . . . . . . . . . . . . . . . . . . . . . . . . . . 127
"" Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
|| Minimum value or lower bound of an European Put . . . . . . . . . . . . . . . . . . . . . . . . . . 127
"" Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
|| Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
"" Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
"" Futures: Valuation, Trading & Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
"" Margins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
"" Hedging with Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
"" Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
"" Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
"" Risk Neutral Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
"" Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
"" Replication Model: Option Strategy or Stock Equivalent . . . . . . . . . . . . . . . . . . . . . . . . 139
"" Replication Model: Stock Strategy or Option Equivalent . . . . . . . . . . . . . . . . . . . . . . . . 139
"" Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Commodity Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
Over the Counter (OTC) Derivatives . . . . . . . . . . . . . . . . . . . . . . 141
|| Forward Rate Agreement (FRA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
"" Settlement of FRA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
|| Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
"" Types of Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142
"" Concept of Comparative Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
|| Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
|| Caps, Floors & Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
"" Forward Rate Agreement (FRA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
"" Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .144
"" Caps, Floors & Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
8. Portfolio Theory - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 151
Return From a Security . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
|| Current/Realized Return From a Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
|| Expected Return From a Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
Return From a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
|| Measures of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
"" Absolute Measures of Dispersion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
• Variance & Standard Deviation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
"" Relative Measure of Dispersion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
• Co-efficient of Variation (C.V.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Risk of a Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Risk of a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
|| Co-variance & Co-efficient of Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
"" Computation of Co-variance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
"" Computation of Co-efficient of Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
|| Standard Deviation of a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
"" Standard deviation if securities are perfectly positively correlated . . . . . . . . . . . . . . . . . . . 155
"" Standard deviation if two securities are perfectly negatively correlated . . . . . . . . . . . . . . . . . 155
"" Standard deviation in other cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
"" S.D. of a portfolio of ‘n’ securities when beta and error term are given . . . . . . . . . . . . . . . . . 155
|| Concept of Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
|| Beta as a Measure of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
|| Beta of a Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
"" Computation of beta using Correlation Coefficient . . . . . . . . . . . . . . . . . . . . . . . . . . 156
"" Computation of beta using Covariance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
"" Computation of beta using fluctuation in security returns . . . . . . . . . . . . . . . . . . . . . . . 156
|| Beta of a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Beta of Levered and Unlevered Firm . . . . . . . . . . . . . . . . . . . . . . 157
|| Beta of firm with a single project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
|| Beta of firm with multiple projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Risk-Return Trade-off . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Capital Asset Pricing Model (C.A.P.M.) . . . . . . . . . . . . . . . . . . . . . 157
Determining whether a security is under-valued or over-valued . . . . . . . . . . . 158
Alpha of a Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
Decomposition of Total Risk . . . . . . . . . . . . . . . . . . . . . . . . . 158
More models for computing expected return from a security . . . . . . . . . . . . 159
|| Arbitrage Pricing Theory Model (APT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
|| Sharpe Index Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
|| Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Portfolio Management Strategies . . . . . . . . . . . . . . . . . . . . . . . 159
|| Buy & Hold Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
|| Constant Mix/Ratio Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
|| Constant Proportion Portfolio Insurance Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Optimizing a portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Sharpe’s Optimal Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Capital Market Line . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Characteristic Line of a Security . . . . . . . . . . . . . . . . . . . . . . . . 162
Security Market Line . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Markowitz Model (Efficient Frontier) . . . . . . . . . . . . . . . . . . . . . . 163
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
"" Computation of Expected Return, Beta, Standard Deviation & Investment Weights . . . . . . . . . . . . 164
"" Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168
"" Determining whether securities are over- or under-valued . . . . . . . . . . . . . . . . . . . . . . . 169
"" Computation of Covariance & Correlation Co-efficient . . . . . . . . . . . . . . . . . . . . . . . . 170
"" Portfolio Optimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
"" Arbitrage Pricing Theory (APT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
"" Security Market Line & Characteristic Line of a Security . . . . . . . . . . . . . . . . . . . . . . . 173
"" Sharpe’s Optimal Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
"" Portfolio Management Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
"" Project Beta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
9. Financial Services in India - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 178
Investment Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Credit Rating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Consumer Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
Depository Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Factoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
10. Mutual Funds - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 184
|| Organs of Mutual Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
|| Mutual Fund Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Some Important Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Net Assets Value (NAV) . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
|| Entry & Exit Load . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
|| Expense Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
|| Dividend Options for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Computing Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Evaluation of Mutual Fund Performance . . . . . . . . . . . . . . . . . . . . 188
|| Sharpe Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
|| Treynor Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
|| Jensen’s Alpha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
|| Fama’s Net Selectivity or Fama’s Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
11. Money Market Operations - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 196
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
"" Commercial Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
"" Certificate of Deposit (CDs) & Treasury Bills . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
"" Short-term Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
12. Foreign Direct Investment (FDI), Foreign Institutional Investment (FII) & International
Financial Management - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 198
|| Foreign Currency Convertible Bonds (FCCB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
|| Global Depository Receipts (GDRs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
|| American Depository Receipts (ADRs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
|| Euro Convertible Bonds (ECB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
International Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . 200
Multinational Cash Management . . . . . . . . . . . . . . . . . . . . . . . 200
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
|| GDR Issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
"" International Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
|| International Cash Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
13. Foreign Exchange Exposure and Risk Management - - - - - - - - - - - - - - - - - - - - - - 204
Some Currency Codes & Symbols . . . . . . . . . . . . . . . . . . . . . . . 204
Basic Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Computing appreciation or depreciation in a currency . . . . . . . . . . . . . . . 205
Determining Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . 206
|| Exchange Rate Theories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
|| Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
|| Nostro, Vostro & Loro Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
|| Exchange Position & Nostro Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
"" Conversion, Cover rate, Appreciation & Depreciation, etc. . . . . . . . . . . . . . . . . . . . . . . .211
"" Local Borrowing Vs Foreign Letter of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
"" Interest Rate Parity Theory (IRPT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
"" Purchasing Power Parity Theory (PPPT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
"" Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
"" Exchange Position & Nostro Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
"" Foreign Currency Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
14. Mergers, Acquisitions & Restructuring - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 228
Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
Mergers & Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
Valuation of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
Synergy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
Cost & Gain of Merger . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
|| True Cost of Merger/Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
|| Gain to Acquiring Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
|| Determining Exchange Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
"" Valuation of Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
"" Mergers & Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
Demerger, Reconstruction, Buyback, Bonus Shares & Stock Split . . . . . . . . . . 242
|| Buyback of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
|| Bonus shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
|| Split & Reverse split . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
|| Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
"" Demerger & Reconstruction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
"" Buyback of Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
"" Bonus Issue, Stock Split & Reverse Split . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
15. Tables - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 246

Normal Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
Chapter Cost of Capital, Leverage & Economic Value
1 Added
Capital Employed
Liabilities ` Assets `
Equity: Fixed Assets xx
Equity Share Capital xx Working Capital:
Reserves xx Current Assets xx
Preference Share Capital xx – Current Liabilities xx xx
Debt:
le
Term Loan xx
Debentures xx
xx xx
ha
Cost of Capital
Cost of capital refers to the minimum rate of return required to be earned from a project. Actually cost of
ok
capital means the cost at which the funds are obtained by the company. But the funds must be invested to earn
at least the cost of capital so that the company is at least able to bear the cost of such funds. For the purpose
of evaluation of projects, a company may set the cost of capital (the minimum return required) to be more
G
than actual cost at which funds are obtained. This will ensure that the firm has some surplus earnings from the
project. This rate is referred to as the ‘hurdle rate’. This rate is used by the firm for discounting the cash flows
while evaluating projects.
Capital may consist of equity, preference or other long term fund having fixed cost. The cost of each component
il
(equity, debt, etc) is called the specific cost of capital. The average cost of capital is the weighted cost of capital
calculated after giving appropriate weights to each component according to the proportion of each component
un
in the total capital.

Capital may consist of equity, preference or other long term fund having fixed cost. The cost of each component
(equity, debt, etc) is called the specific cost of capital. The average cost of capital is the weighted cost of capital
.S
calculated after giving appropriate weights to each component according to the proportion of each component
in the total capital.
The cost of capital is thus the rate of return which is expected from any investment proposal to be undertaken.
A firm’s cost of capital is made up of three components – (i) return at zero risk level (risk-free rate of return).
A
This is the expected rate of return if the project involves no risk, either business or financial; (ii) premium
for business risk. Business risk means the risk of variation in EBIT (Earning Before Interest & Tax) due to risk
C
of fluctuation in sales. The investors providing capital for the project will expect a higher return for the risk
involved; (iii) premium for financial risk. Financial risk is the risk associated with the structure of financing of
the project. A project may be financed out of either equity or debt or a combination of the two. Financial risk is
higher in case the debt component in the capital structure is more. This is due to the fact that interest on debt
is committed irrespective of profit or loss in any year but dividend on equity is payable only in case of profits. If
debt component is high, the firm will require a high EBIT to service the debt. The risk of financial insolvency is
greater in firms having high debt. The investors providing the funds will expect a higher return for the financial
risk, if any.
Need to ascertain Cost of Capital

The determination of cost of capital of a firm is important for both capital budgeting (investing) decisions as
well as for deciding the capital structure of the firm. Acceptance or rejection of a proposal depends upon the
cost of capital and hence it is necessary to make a reasonably accurate estimate of the same. Cost of capital is
important in deciding the capital structure, i.e. amount of debt, equity, etc. Estimating cost of capital depends
upon the financing decision (capital or debt?) and the dividend policy of the company.
Components of Capital Structure

The capital structure of a firm is determined by the method of financing adopted by it. The sources of long-term
Cost of Capital, Leverage & Economic Value Added Ɩ 1

funds available to a firm are equity share capital, retained earnings, preference share capital or debt. The cost
of each component of the capital structure has to be determined before computing the weighted average cost of
capital. The cost of each source is computed as follows:
(1) Cost of Long-term debt: This is obtained for meeting long term requirement of funds. The cost of long
term debt is calculated in the same manner as the cost of short term funds. However, sometimes there
may be a cost of raising such long term funds in which case the amount of funds available for use will be
the funds raised less the cost of raising the funds. However, interest is payable on the full funds raised
and hence the rate of such funds may be calculated at the interest paid/payable per annum as a % of the
funds available for use. If debentures are issued at a discount the actual funds available for use will reduce
to that extent but the interest will have to be paid on face value and the redemption will be at par. The
difference between amount received and amount payable will mean additional cost of such fund which
should be amortized over the period of debentures. Similarly, if debentures are redeemable at a premium
then the premium should be taken as cost of funds over the period of the debentures. Only the actual rate
of interest is to be adjusted for the tax rate as no tax benefit is available for additional amount paid over
the amount received.
(i) The question of market value does not arise in case of term loan and hence the cost of term loan is
always computed as follows:
Kd (Term loan) = r(1 – t)
Where,
r = rate of interest on loan
es
t = tax rate expressed in decimal
(ii) Where debentures/bonds are issued at par and the debentures are subsequently quoted in the
ss
market at par (remember that cost of capital is dynamic and changes from time to time), or if no market
value is given in the examination question then we assume that the market quote is at par then the
cost is computed in the same manner as that of term loan provided market value is also the same as
la
par value.
Kd (Term loan) = r(1 – t)
C
Where,
r = rate of interest on loan
t = tax rate expressed in decimal
h
(iii) Where market value of debentures is below the par value (as happens in reality) or the debentures
rs
are issued at a discount or there is flotation cost incurred or there is premium payable on redemption
then these ‘losses’ add to the cost of debentures. In such a case the cost of debentures/bonds is
computed as follows:
da
 RP − NP 
I + n  (1 − t )
Kd (Debentures) =   × 100
( NP + RP ) / 2
A
Where,
Kd = Cost of Long-term Debt
I = Interest amount per debenture
t = tax rate (in decimal)
NP = Net Proceeds [net amount received after deducting discount & flotation charges]
RP = Redemption price
n = Period of debt
The denominator is the average capital.
For example, 10% debentures of `100 are issued at a discount of 5% and redeemable at a premium
of 10%. The amount received per debenture is `95 but amount redeemable is `110. If debentures are
redeemable after five years, the additional ‘cost’ of `15 (`110 – `95) should be spread over five years
i.e. `3 per year. This is in addition to the interest cost of `10 per year. If tax rate is 50% then the cost
of debentures will be calculated as follows:
(10 + 155 )(1 − 0.5) 6.50
Kd = × 100 = × 100 = 6.34%
(95 + 110) / 2 102.50
(2) Cost of preference capital: Rate of dividend on preference shares is the cost of such capital. Adjustment
2 Ɩ CA. Sunil Gokhale: 9765823305

for tax rate is not required as dividend is not tax deductible. Dividend is payable on face value but funds
available for use may be adjusted for share issue expenses, discount on issue, brokerage & commission,
etc. If preference shares are issued at discount and redeemable at par or at a premium then the additional
amount paid over the amount received should be amortized over the period of preference shares and
treated as ‘cost’ of preference shares.
(i) Where preference share have been issued at par and are quoted at par then the rate of preference
dividend is the cost of preference shares. Example, the cost of 12% preference share of `10 each
issued & quoted at par will be denoted as follows:
Kp = 12%
(ii) Where preference share are issued at a discount and/or are redeemable at a premium or any flotation
cost is incurred at the time of issue, such discount or premium or flotation cost has to be amortized
over the period of the preference shares and treated an annual cost in addition to the dividend per
year. (This treatment is similar to cost of debentures but with a difference that no tax benefit is available)
 RP − NP 
D+ 
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 n 
Kp = × 100
( NP + RP ) / 2
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Where,
Kp = Cost of preference capital
D = Dividend on preference shares at the fixed rate applicable
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NP = Net Proceeds from debt (market value may be used in some cases)
RP = Redemption price
n = Period of debt
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The denominator is the average capital.
(3) Cost of equity capital: This is the most difficult to compute. Some people are of the opinion that there
is no cost of equity capital as the company is not bound to pay dividend!! But this is a simplistic approach.
Shareholders invest in the company with the expectation of dividend income. Market price of shares is
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also influenced by the dividend expected by the investors, the book value of the firm and the growth in the
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value of the firm. The required rate of return at which the present value (PV) of the expected dividends
equals the market value of shares is the cost of equity capital. Thus, it can be expressed as the minimum
rate of return that must be earned on new equity shares issued for financing new projects to maintain the
earning on the equity shares unchanged. Simply put, cost of equity is the rate of dividend expected by the
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shareholders. It should be noted that a company has to pay dividend distribution tax on the dividend.
The following methods are used to calculate cost of equity capital:
(a) Dividend Discount Model: As per this model the market value of an equity share is the present value
of the future dividends discounted at the expected rate of return ‘r’. Thus,
A
D1 D2 D3
P= + + + ....
(1 + r ) (1 + r ) (1 + r )3
2
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Where,
P = market value of equity share
Dn = dividend received at the end of nth year
r = rate of return expected by the equity shareholder
The above equation is solved to find the value of ‘r’ which is the cost of equity. However, this is
very difficult to solve because the amount of future dividend as also the number of years for which
dividend will be received is unknown.
(b) Dividend Model: This is the dividend yield on the market price of shares. The dividend income that
an investor will earn per share is expressed as a percentage to the current market price of the share
to find out the average expected yield that an investor expects to earn by investing in a share of the
company.
D1
Ke = × 100
P0
Where,
Ke = Cost of equity capital
D1 = Dividend at the end of the year

P0 = Market price of equity share at time 0, i.e. current price
(c) Dividend model with annual growth rate of ‘g’: When dividends are expected to grow at ‘g’ rate
annually, the above formula is modified to include the effect of growth as follows:
D 
Ke =  1 × 100  + g
 P0 
Where,
g = growth rate
(d) Earnings Model: The cost of equity may be expressed as a ratio of earnings per share to market price
of the share. A long-term investor is interested in the EPS of the company more than the dividend per
share.
EPS1
Ke = × 100
P0
(e) EPS with annual growth rate of ‘g’: If the EPS is expected to grow at ‘g’ rate annually the above
formula is modified as follows:
 EPS1 
Ke =  × 100  + g
 P0 
(f) Flotation Cost Model: If flotation cost (i.e. cost of making the issue, e.g. issue expenses, brokerage,
etc. where it is known in %) is considered then the cost of equity capital is calculated as follows:
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D1
Ke = × 100
P0 (1 − f )
Where,
f = flotation cost in decimal
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If the flotation cost per share is known in rupees then the cost of equity is computed as:
D1
Ke = × 100
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Net issue price per share
Where,
Net issue price per share = Issue price per share – Flotation cost per share
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Growth (g), if any, can be added in either case.

(g) Capital Asset Pricing Model (C.A.P.M.): The equity shareholders’ expected rate of return can be
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computed by using C.A.P.M. This takes into consideration the risk premium expected by the investors
which depends on the risk profile of the company.
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Ke = Rf + b(Rm – Rf)
Where,
Rf = risk-free rate of return
A
b = beta co-efficient of the company also called risk index

Rm = rate of return from the stock market
(h) Short-cut to find cost of equity using P/E Ratio: If the PE ratio is available then we can find the cost
of equity quickly by using the following formula:
100
Ke =
PE Ratio
(4) Cost of retained earnings: Retained earnings means the total of the undistributed profits of the
company, i.e. reserves. One school of thought is that the retained earnings are free of cost as the company
does not have to pay any dividend on this source of finance. However, this is not true. The opportunity
cost may be taken as the cost of retained earnings. The opportunity cost of retained earnings will be the
dividend foregone by the shareholders. Generally, the cost of retained earnings is taken as the same as
the cost of equity shares. A firm must earn the same rate of return on retained earnings as on the equity
capital.
Kr = Ke
There are some other methods of computing cost of retained earnings which take personal income tax of
the shareholder into consideration. However, as dividends are tax-free in the hands of the shareholders,
the same are not relevant in India as of today.
Problems
1.1 [C.M.A.] The capital structure of Hindustan Traders Ltd. as on 31.3.2006 is as follows:
Equity capital, 100 lakh shares of `10 `10 crores
Reserves `2 crores
14% Debentures of `100 each `3 crores
For the year ended 31.3.2006 the company paid a equity dividend of 20%. As the company is a market leader
with good future, dividend is likely to grow by 5% every year. The equity shares are now traded at `80 per share
in the stock exchange. Income tax rate applicable is 50%.
Required:
(a) Find the current cost of capital.
(b) The company has plans to raise a further `5 crores by way of long term loan at 16% interest. When this
takes place, the market value of the equity shares is expected to fall to `50 per share. What will be the new
weighted average cost of capital?
[(a) 7.4% (b) 8.45%]
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1.2 [C.A.] XYZ Ltd. has the following capital structure:
Equity Capital (shares of `10 each) `15 crores
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11% Preference Capital (shares of `100 at par) `1 crore
Retained earnings `20 crores
13.5% Debentures (of `100) `10 crores
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15% Term loans `12.5 crores
The expected dividend on equity shares is `3.60 per share and this is expected to grow at 7% p.a. The market
price of the share is `40. The preference shares, redeemable after 10 years, are quoted in the market at `75. The
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debentures, redeemable after six years, are selling at `80. The tax rate for the company is 40%.
(i) Calculate the weighted average cost of capital using:
(a) book value proportions, and
(b) market value proportions.
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(ii) Find the weighted average marginal cost of capital, if it raises `10 crores next year, given the following
information:
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(a) the amount will be raised by equity and debt in equal proportion;
(b) the company will retain `1.5 crores earnings next year;
(c) the additional issue of equity shares will result in the net price per share being fixed at `32;
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(d) the debt capital raised by way of term loan will cost 15% for the first `2.5 crores and 16% for the
next `2.5 crores.
[(i) (a) 13.67% (b) 14.44% (ii) 13.78%]
A
Operating & Financial Leverage

In financial management, leverage refers to the use of fixed costs, both operating & financial, for the purpose
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of increasing profit available to equity shareholders. Leverage may be operating leverage, financial leverage or
combined leverage.
(1) Operating leverage: This involves the use of ‘operating fixed costs’ to ‘leverage’ the operating profit. With
increase in sales, the total cost does not increase proportionately because the total cost includes some fixed
cost. As a result of this, once all costs are recovered, the operating profits rises at a rate faster than the rise
in sales. This happens because some cost like depreciation, rent, etc. remaining fixed despite the increase
in sales. To understand operating leverage we need to divide the costs between fixed and variable. The
variable cost will increase or decrease in proportion to sale, but the fixed cost will be constant for a period.
The difference between sales and variable cost is called contribution. Contribution helps to recover fixed
cost and make profits. If the fixed cost is a large component of total cost, there will be a surge in profits
after the fixed costs have been recovered, i.e. once the break even point has been achieved. However, the
down side it that in case of decrease in sales the profit will rapidly decrease and if the sales fall below the
break even point then there will be rapid increase in losses as the fixed costs are committed and will have
to be incurred irrespective of the sales volume. Therefore, if fixed cost is low then the risk of losses will
be lower but the opportunity of earning large profits is also lost. The operating leverage is calculated as
follows:

Contribution
Operating leverage =
EBIT
This ratio shows the tendency of increase in EBIT to sales. For example, if the leverage is 2 it means that
for every 1% rise/fall in sales there will be 2% rise/fall in EBIT. A high operating leverage is risky.
(2) Financial leverage: This involves use of financing fixed cost to leverage the profit available to equity
shareholders. For this purpose long-term funds with fixed financial cost, e.g. debt, are used to leverage the
earnings of the equity shareholders. If most of the capital has been obtained at a fixed cost and the company
is earning at a rate which is higher than the fixed cost of capital, then it will benefit the shareholders as
only a fixed amount is payable on debt and the remaining profits will be available for shareholders. But
the down side is that in case there is a decrease in earning then the fixed cost of capital becomes a burden
and shareholders may get a return lower than the rate paid on debt or they may not get anything at all.
Financial leverage is also termed as ‘trading on equity’. The financial leverage is calculated as follows:
EBIT
Financial leverage =
EBT
This shows the tendency of the EBT to rise or fall with the variation in EBIT. If the financial leverage is 3
then it means that for every 1% rise/fall in EBIT the EBT will rise/fall by 3%. High financial leverage is
risky but can provide higher return to shareholders. EPS will fluctuate wildly if financial leverage is high. If
a company has no debt then there will be no financial leverage.
If the company has issued preference shares then the EBT has to be adjusted for pre-tax
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preference dividend to arrive at the EBT available for equity shareholders.
(3) Combined or Composite leverage: The operating leverage shows the firm’s ability to meet its operating
fixed costs (rent, depreciation, etc.) and the financial leverage shows the ability to meet the fixed financial
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cost (interest & preference dividend). The composite leverage shows the firm’s ability to meet its total
fixed cost i.e. both operating and financial. This is calculated as follows:
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Composite/Combined leverage = Operating leverage × Financial leverage
OR
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Contribution EBIT Contribution
Composite leverage = × =
EBIT EBT EBT
This shows the tendency of EBT (for equity shareholders) to rise/fall with change in sales.
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Problems
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2.1 [C.A.] The data relating to two companies are as given below:
Company A Company B
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Equity capital `6,00,000 `3,50,000

12% Debentures `4,00,000 `6,50,000
Output (units) p.a. 60,000 15,000
A
Selling price per unit `30 `250

Fixed cost p.a. `7,00,000 `14,00,000
Variable cost per unit `10 `75
You are required to calculate the Operating, Financial & Combined leverage of the two companies.
[A: 2.4, 1.11, 2.66; B: 2.14, 1.07, 2.29]
2.2 [C.S.] The following information is related to Sunrise Ltd. –
`
Sales 4,00,000
Less: Variable expenses 35% 1,40,000
Contribution 2,60,000
Less: Fixed expenses 1,80,000
EBIT 80,000
Less: Interest 10,000
Taxable income 70,000
You are required to submit the following to management of the company.
(i) What percentage will taxable income increase, if the sales increase by 6%? Use combined leverage.
(ii) What percentage will EBIT increase, if there is a 10% increase in sales? User operating leverage.

(iii) What percentage will taxable income increase, if EBIT increases by 6%? Use financial leverage.
2.3 [C.S.] DIGI Computers Ltd. is a manufacturer of computer systems. The company is marketing its products
in domestic as well as global markets. It has a total sales of `1 crore. Its variable and fixed costs amount to `60
lakh and `10 lakh respectively. It has borrowed `60 lakh @ 10% per annum and has an equity capital of `75
lakhs.
(i) What is company’s return on investment?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 1, does it have a high or low asset leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If sales drop to `50 lakh, what will be the new EBIT?
[(i) ROI 22.22% (ii) Yes, as ROI is higher than interest rate on borrowed fund (iii) Asset turnover 0.74, lower asset leverage (iv) OL 1.33, FL 1.25
CL 1.667 (v) EBIT `10,00,000]
2.4 [C.S.] The following details of Alpha Ltd. for the year ended 2010 are furnished:
Financial leverage 2:1
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Operating leverage 3:1
Interest charges per annum `20 lakhs
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Corporate tax rate 40%
Variable cost as percentage of sale 60%
Prepare income statement of the company.
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Economic Value Added
The objective of financial management is to maximize the wealth of the shareholders. The wealth of the
shareholder is maximized by increasing the value of the equity share of the company. The value of the share
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will increase if there is not only increase in current earnings but investors also see a potential for increase in
future earnings of the company. Return on capital employed, return on equity, operating profit margin, net profit
margin, earnings per share, etc. are used to measure a company’s performance. However, all these measure lack
a proper benchmark for comparison. The shareholders require a minimum return on their investment which
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corresponds to the risk in the investments. Stern Stewart & Co., a New York based financial advisory firm,
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came up with the concept of Economic Value Added (EVA) in 1990. It is a modified concept of the residual
income concept. According to this concept a company creates shareholders or adds shareholder value only if
it earns more than the cost of capital. EVA measures whether the after tax operating profit is enough to pay
the cost of capital and leaves any balance to create shareholder value. The economic value added can be used
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for paying dividend and reinvesting in the business for growth. If the after tax operating profit is less than the
cost of capital then the company is, in fact, reducing shareholder value. This concept also allows the company
to decide how much dividend the company can ‘afford’ to pay. The dividend should be paid only out economic
value added. If the dividend exceeds the EVA then the value of the firm would start declining. Economic value is
A
EVA = EBIT (1 – t) – (WACC × Capital employed)
C
Problems
3.1 [C.A.] Tender Ltd has earned a net profit of `15 lacs after tax at 30%. Interest cost charged by financial
Institutions was `10 lacs. The invested capital is `95 lacs of which 55% is debt. The company maintains a
weighted average cost of capital of 13%. Required,
(a) Compute the operating income.
(b) Compute the Economic Value Added (EVA).
(c) Tender Ltd. has 6 lac equity shares outstanding. How much dividend can the company pay before the value
of the entity starts declining?
[(a) `31.43 lacs (b) `9.65 lacs (c) `1.608]
3.2 [C.A.] Delta Ltd.’s current financial year’s income statement reports its net income as `15,00,000. Delta’s
marginal tax rate is 40% and its interest expense for the year was `15,00,000. The company has `1,00,00,000 of
invested capital, of which 60% is debt.
In addition, Delta Ltd. tries to maintain a Weighted Average Cost of Capital (WACC) of 12.6%.
(i) Compute the operating income or EBIT earned by Delta Ltd. in the current year.
(ii) What is Delta Ltd.’s Economic Value Added (EVA) for the current year?

(iii) Delta Ltd. has 2,50,000 equity shares outstanding. According to the EVA you computed in (ii), how much
can Delta pay in dividend per share before the value of the company would start to decrease? If Delta does
not pay any dividends, what would you expect to happen to the value of the company?
[(i) `40,00,000 (ii) `11,40,000 (iii) `4.56]
3.3 [C.A.] RST Ltd.’s current financial year’s income statement reported its net income as `25,00,000. The
applicable corporate income tax rate is 30%.
Following is the capital structure of RST Ltd. at the end of current financial year:
`
Debt (Coupon rate = 11%) 40 lakhs
Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs
Following data is given to estimate cost of equity capital:
Beta of RST Ltd. 1.36
Risk-free rate i.e. current yield on Govt, bonds 8.5%
Average market risk premium (i.e. Excess of return
on market portfolio over risk-free rate) 9%
Required:
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.
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[(i) 17.58% (ii) (`92,700)]
3.4 [C.A.] With the help of the following information of Jatayu Limited compute the Economic Value Added:
Capital Structure Equity capital `160 lakhs

ss
Reserves and Surplus `140 lakhs
10% Debentures `400 lakhs
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Cost of equity 14%
Financial Leverage 1.5 times
C
Income Tax Rate 30%
[`14 lakhs]
3.5 [C.A.] Calculate economic value added (EVA) with the help of the following information of Hypothetical
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Limited:
Financial leverage : 1.4 times
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Capital structure : Equity Capital `170 lakhs

Reserves and surplus `130 lakhs
da
10% Debentures `400 lakhs

Cost of Equity : 17.5%
Income Tax Rate : 30%
A
[`17.5 lakhs]

Chapter
2
Financial Policy & Corporate Strategy
A successful business must have the following three essential ingredients:
(i) A clear and realistic strategy,
(ii) Financial resources to implement the strategy, and
(iii) Management team and processes to implement the strategy
The management is responsible for searching for the best investment opportunities, selecting the best profitable
opportunities, selecting the method of financing these investments, ensuring their correct implementation and
monitoring them on a continuous basis.
A strategy is a long-term direction given to the company. Strategic financial management has four major
components for maximization of returns:
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(1) Investment decision – This involves the use of the funds of the firm in profitable manner.
(2) Dividend decision – This involves the distribution of earnings to the shareholders and retaining earnings for
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reinvestment in the company.
(3) Financing decision – This involves determination of the capital structure of the firm. A balance of debt &
equity not only increases the return to shareholders but also increases the value of the firm.
(4) Portfolio decision – This involves analysis of the various investments from the point of view of their
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contribution to the overall value of the firm.
Strategies can be evaluated by computing the net present value of the expected earnings generated by their
implementation.
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Problems
1) [C.A.] Helium Ltd has evolved a new sales strategy for the next 4 years. The following information is given:
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Income Statement ` in thousands
Sales 40,000
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Gross Margin at 30% 12,000

Accounting, administration & distribution expense at 15% 6,000
Profit before tax 6,000
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Tax at 30% 1,800

Profit after tax 4,200
Balance sheet information:
Fixed Assets `10,000
A
Current Assets `6,000

Equity `15,000
C
As per the new strategy, sales will grow at 30% per year for the next four years. The gross margin ratio will
increase to 35%. The Assets turnover ratio and income tax rate will remain unchanged.
Depreciation is to be at 15% on the value of the net fixed assets at the beginning of the year.
Company’s target rate of return is 14%.
Determine if the strategy is financially viable giving detailed workings.
2) [C.A.] ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They want to know
the value of the new strategy. Following information relating to the year which has just ended, is available:
Income Statement `
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information:
Fixed Assets `8,000
Financial Policy & Corporate Strategy Ɩ 9

Current Assets `4,000
Equity `12,000
If it adopts the new strategy, sales will grow at the rate of 20% per year for three years.
The gross margin ratio, Assets turnover ratio the Capital structure and the income tax rate will remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.
[Value of strategy (`691.57)]
3) [C.M.A.] The income statement for the year 2013-14 and the balance sheet at the end of the year 2013-14
for Exotica Ltd. are as follows:
Income Statement
` lakhs
Sales 1,000
Gross Margin (25%) 250
Selling, General & Administrative Expenses (10%) 100
Profit before tax 150
Tax (40%) 60
Net profit 90
Balance Sheet
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Liabilities ` lakhs Assets ` lakhs
Equity 500 Fixed Assets 300
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Current Assets 200
500 500
Exotica Ltd. is debating whether it should maintain the status quo or adopt a new strategy. If it maintains the
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status quo:
— the sales will remain constant at `1,000 lakhs.
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— the gross margin and selling, general and administrative expenses will remain unchanged at 25% and 10%,
respectively.
— depreciation charges will be equal to 50% of new investments.
h
— the asset turnover ration will remain constant.

— the discount rate will be 16%.
rs
If Exotica Ltd. adopts a new strategy, its sales will grow at a rate of 10% per year for 5 years. The margin, the
turnover ratio, the capital structure and the discount rate, however, will remain unchanged.
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What value will the new strategy create?

The present value factors at 16% discount rate are:
Year 0 1 2 3 4 5
A
P.V. 1.000 0.862 0.743 0.641 0.552 0.476

[`59 lakhs]

Chapter
3
Project Planning & Capital Budgeting
The first step in project planning is preparing a feasibility study. A project has to be evaluated for: (i) market
feasibility, (ii) technical feasibility and (iii) Financial feasibility.
Market Feasibility
This involves conducting a market research for obtaining information about the demand for the product,
consumers’ expectations about the product, the existing manufacturers, demand-supply mismatch, likely changes
in consumer preferences, etc. This study becomes very critical if a new product is to be introduced in a country.
Technical Feasibility
A project also has to be evaluated for its technical feasibility. Some of the factors to be considered are:
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(1) Availability of commercially viable technology.
(2) Alternative technologies.
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(3) The rate at which technology changes.
(4) The availability of resources like raw material, skilled labour, power, water, etc.
(5) The waste/effluents arising from the production and their disposal.
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Financial Feasibility
Financial feasibility of a project is evaluated on the basis of calculations about the revenue & cost forecasts made
on the basis of the data available from market feasibility study. The various financing alternatives with different
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debt-equity mix and company’s ability to repay the debts have to be calculated. Projected P&L a/c, projected
cash flow statements and projected balance sheets have to be prepared for submission to lenders.
Two important ratios showing the firm’s ability to pay the interest on debt and to repay the debt itself are:
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(1) Interest Coverage Ratio: This shows the firm’s ability to pay interest on long-term loans. It is computed
as follows:
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EBIT
Interest cover =
Interest for the year
Ideal ratios as under:
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Type of firm Ideal ratio

Service firm 4
Industrial company 5
A
Small firms (which are risker) 6

but the higher the better.
C
(2) Debt-service Ratio: While the interest cover ratio helps the lender to understand the company’s ability
to pay interest, this ratio helps the lender to find out the company’s ability to repay the installments of the
loan. It is computed as follows:
EBIT
Debt service cover =
Principal repaid in a year
Interest for the year +
(1 - t )
A debt service ratio of 1.5 is satisfactory; but the higher the better. It should never fall below 1 as this
indicates negative cash inflows.
Problems
1.1 [C.A.] Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of `90 lakhs. Its
present borrowings are as follows:
` in lakhs
12% term loan 300
Working capital borrowings:
From Bank at 15% 200
Public Deposit at 11 % 100
Project Planning & Capital Budgeting Ɩ 11

The sales of the company are growing and to support this, the company proposes to obtain additional borrowing
of `100 lakhs expected to cost 16%. The increase in EBIT is expected to be 15%.
Calculate the change in interest coverage ratio after the additional borrowing is effected and comment on the
arrangement made.
[Interest coverage ratio reduced from 1.169 to 1.113]
1.2 [C.A.] Presently a company is working with an earning before interest and taxes (EBIT) of `90 lakhs. Its
present borrowings are as follows:
` in lakhs
12% term loan 300
Working capital borrowings:
Borrowing from bank at 15% 200
Fixed deposits at 11% 90
The sales of the company are growing and to support this, the company proposes to obtain additional borrowing
of `100 lakhs at a cost of 16%. The increase in EBIT is expected to be 18%. Calculate the present and the revised
interest coverage ratio and comment.
[Decrease from 1.19 to 1.16]
Capital Budgeting
Capital budgeting means planning for capital expenditure i.e. investment in fixed assets. This is very important
as this involves long-term commitment of funds. Purchase of new machinery either, as replacement of existing
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machinery or for additional manufacturing capacity, setting up of new project or factory, etc. are all covered by
the scope of capital budgeting. A careful evaluation of such proposals is necessary as it will involve immediate
outlay of cash but inflows may start after one or more years.
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Different techniques are available for evaluation of capital budgeting proposals. Money has time value but not
all methods take time value of money into consideration. Some of the methods are discussed below:
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Methods of Evaluation
The different methods of evaluating the capital budgeting proposals can be broadly classified into two categories:
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(i) the traditional methods, i.e. those which ignore the time value of money, and
(ii) the modern methods, i.e. those which consider time value of money (discounted cash flow techniques)
Capital Budgeting Techniques
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Traditional methods (non-discounting models) Modern methods (discounting models)

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1. Accounting or Average Rate of Return 1. Discounted Payback Period Method

2. Payback Period Method 2. Net Present Value
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3. Payback Reciprocal 3. Profitability Index

4. Post Payback Profitability 4. Internal Rate of Return (I.R.R.)
5. Modified Internal Rate of Return (M.I.R.R.)
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6. Project Internal Rate of Return (P.I.R.R.)

7. Equity Internal Rate of Return (E.I.R.R.)
Accounting or Average Rate of Return (A.R.R.)

This method is also called Return on Investment (R.O.I.) method or Accounting Rate of Return method. It is
calculated as follows:
Average Net Profit
A.R.R. = × 100
Cost of Project
Average net profit means the average profit over the life of the project i.e. total profit over the life of the project
÷ life of the project. In place of ‘Cost of project’ we can also use (a) Average cost of the project i.e. project cost
÷ 2, or (b) net project cost, i.e. initial cost – salvage value.
The project with the highest rate will be accepted. The company may also set a limit of the rate below which no
project will be accepted. This method ignores the time value of money.
Payback Period
This is a very simple technique of evaluation. Payback period refers to the period over which the cost of the
project is recovered through cash inflows. Cash inflow means cash profits, i.e. net profit plus depreciation.

Payback is computed as follows:
(i) When cash flows are constant every year
Cost of Project
Payback period =
Annual Cash Flow
(ii) When cash flows are unequal
In this case, we find the cumulative cash flows from a project to determine the year in which the entire
cost of the project is recovered. Let us call this the nth year. The payback period is then written as:
Balance cost to be recovered in the nth year
Payback period = (n – 1) years +
Cash Flow in the nth year
!! In the payback period computed above decimal places refer to a fraction of the year and not the number of months.
For example, 2.6 years does not mean 2 years & 6 months. If you want to write the payback period in years &
months then the decimals can be converted to months by multiplying the decimal by 12 months; e.g. 0.6 × 12
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months = 7.2 months. Therefore, 2.6 years can be converted to 2 years & 7 months.
While comparing alternative proposals, the proposal with the shortest payback period is chosen.
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The drawbacks of this method are:
(1) It does not take time value of money into consideration.
(2) It focuses more on recovery of cost rather than the earnings.
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(3) It completely ignores the remaining life of the project after recovery of the cost and the period during which
the earnings arise. For example, a project with 4 years payback & 5 years life will get selected over a project
with 6 years payback & 10 years life.
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Payback Reciprocal
A limitation of the payback period method is that it does not indicate the cut off period for the investment
decisions. For example, if three alternative proposals may have payback periods of 6 years, 7½ years and 8
years. Here, the first proposal may be chosen by payback period method as it has the shortest payback period.
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However, the management may have a set cut-off period for payback and will not want to invest in a proposal
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having a payback period of say more than 5 years. In this case all three proposal will be rejected. The cut-off
period is significant as each project has a certain life and therefore the company has to recover its investment
and have some years remaining for additional revenues. The payback reciprocal method is useful in calculating
the rate of return from a project if the life of the project is at least twice its payback period. It is calculated as
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follows:
Average annual cash inflow

Payback reciprocal = × 100
Cost of project
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The project with the highest rate will be accepted. The company may also set a limit of the rate below which no
project will be accepted. However, this method ignores the time value of money.
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Post-payback Profitability Method

This is an improvement over the payback period method because the purpose of the investment is not to just
recover the cost but also to earn from it. This method takes into consideration the profitability of the project
after the recovery of the cost. The profitability over the entire life of the project is considered. It is calculated as
follows:
Post-payback Profitability = Total saving – Investment OR
= Savings per annum (Total life – Payback period)
The project with the highest post-payback profitability will be selected. However, this method ignores the time
value of money.
Discounted Payback Period

This is similar to payback period. The only difference being that discounted cash inflows are used. This
method has the same drawbacks as the payback period method except that it takes time value of money into
consideration.
Net Present Value Method (N.P.V.)

This method is also called Discounted Cash Flow technique. Cash inflows are different from profit because not

all expenses are actually paid in cash, e.g. depreciation or amortization of expenses. Similarly, cash outflows may
not all be expenses. For example, installments of loan paid will consist of both principal & interest. In evaluating
capital budgeting proposals we are concerned with cash flows. Cash outflows are generally for investment in
fixed asset & working capital. Cash inflows are computed as follows:
Cash inflow = Net profit + Depreciation
The cash inflow in the last year of the life of the project would be:
Cash inflow = Net profit + Depreciation + Salvage value of fixed assets + Working capital released
However, not all cash flows are relevant for the purpose of the capital budgeting decisions. Only cash flows
which are relevant to the decision will be taken into consideration. Some examples are:
(i) Amount spent on marketing research to obtain information about probable demand for product which the
company plans to manufacture will be irrelevant cash outflow in evaluating the proposal to invest in a
project to manufacture the product.
(ii) Mere allocation of cost to a product or project is irrelevant as no actual cash flow is involved.
The methods mentioned earlier ignored the fact that money has time value. A rupee received at an earlier point
of time is worth more than a rupee received at a later. This is the opportunity cost of money. NPV method
takes this fact into consideration. Outflow of cash is immediate but inflows will be over a number of years. This
method is considered to be the best method for evaluation of projects. Under this method the present value of
cash flows is calculated. The rate used for discounting is the either the cost of capital or the hurdle rate decided
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by the management which is also the minimum rate the company expects to earn from the project.
NPV = PV of cash inflows – PV of cash outflows.
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A project is accepted if the NPV is positive or at least zero. In case NPV is negative, the project is rejected.
!! Zero NPV indicates that the return from the project is equal to the rate used for discounting. A positive NPV indicates
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that the rate of return from the project will be more than the rate used for discounting but it does not tell us what
the actual return will be. A negative NPV indicates that return will be less than the rate used for discounting. Hence,
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project can be accepted if the NPV is zero or positive.
Limitation of NPV method
NPV method is useful only for different projects having similar life. If projects having unequal life then this
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method is not suitable. If projects have unequal lives, higher NPV may be due to longer life. NPV can be used
for projects with unequal life but a further calculation of equal annualized criterion is required to evaluate &
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compare different projects with unequal life. This gives the annualized benefit so that the projects with unequal
lives can be compared.
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Equal Annualized Criterion

Equal annualized criterion should be used for choosing from projects/assets having different life spans.
(i) Where projects generate revenues & NPVs are computed:
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This is used to calculate equalized annual cash flow from each project/asset and the one with the higher
equalized annual cash flow will be selected.
NPV
Equalized Annual Cash flow =
PVIAF
Where, PVIAF = Present value interest annuity factor
(ii) Where no revenues are generated: Sometimes, two alternative investment options are to be evaluated where
either there is no revenue generated from the investment or it is not to be taken into consideration. Under
these circumstances the investment which has lower PV of cash outflows is selected.
To choose between alternative investments not generating any inflows, e.g. purchase of a car, the PV (and
not NPV) of their total outflows over their life should be computed and the one with lower PV of outflows
is to be chosen. However, this is suitable only if the life is the same in all cases. In case of unequal lives, the
one with lower Equalized Annual Outflow should chosen:
PV of outflows
Equalized Annual Outflow =
PVIAF
Where, PVIAF = Present value interest annuity factor

Profitability Index or Desirability Index or Benefit-Cost Index
This is a variation of the NPV method. It is suitable for evaluation of projects with unequal investments as it is a
relative measure. It is calculated as follows:
PV of inflows
P.I. =
PV of outflows
This shows the inflow for every rupee invested. The project with higher index is selected.
Internal Rate of Return (I.R.R.)

This is the rate of return that the company earns from any project. This method also takes time value of money
into consideration. This is the rate at which the discounted cash outflows and inflows are almost equal. The rate
is not known in advance, but can be calculated as follows:
When cash flows are unequal —
I I2 I3 In
C= + + + .... +
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(1+r) (1 + r )2
(1 + r )3
(1 + r )n
Where,
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C = Cash outflow
I = Cash inflow
n = life of project in years
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The equation is solved to find the I.R.R. However, as this is a tedious process, I.R.R. can be found by trial and
error method by using different rates for NPV. The I.R.R. will be the rate at which the NPV is zero.
When cash flows are constant every year —
Where cash flows are constant every year, it is easier to find the I.R.R. The rate is determined from the payback
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period of the project.
Cost of Project
Payback period =
Annual Cash Flow
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The payback period is the ‘annuity factor’. I.R.R. is the rate that matches, or very closely matches, the
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annuity factor for the life of the project in years. For example, the payback period of a project (with life of 6
years) is 4 years. From the Annuity Table (given at the end of the notes) we find that in the column for 6 years
(the life of the project) the annuity factor of 3.9975 closely matches the payback period and the applicable rate
for this factor is 13%; therefore, the I.R.R. is 13%. If the payback period does not match, or closely match, any
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of the factors given in the annuity table then we use the interpolation method (given below) to determine the
I.R.R.
Interpolation Method – If the payback period does not match, or closely match, any of the factors given in the
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annuity table then we find two rates between which the payback period lies. The I.R.R. lies between these two
rates (lets call these rates RL and RH). NPV of the project is calculated for the lower as well as the higher rate.
NPV at the lower rate will be positive and at the higher rate will be negative. I.R.R. is then found by interpolation
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as follows:
 NPV at RL 
I.R.R. = RL +  × D
 NPV at RL − NPV at RH 
Where
RL = Lower rate of interest
RH = Higher rate of interest
D = Difference in two rates (higher & lower) adopted
!! I.R.R. will be most accurate when the difference between RL and RH is the least, ideally just 1%.
Shortcut to find I.R.R. in case of constant annual cash flows
 AF at RL − AF at I.R.R. 
I.R.R. = RL +  × D
 AF at R L − AF at R H 
Where,
AF = Annuity factor
AF at I.R.R. = payback period

Comparison between I.R.R. and NPV method of evaluating proposals
Both I.R.R. and NPV method use the present value approach for evaluating proposals. However, they are different
in the following ways:
(a) NPV takes a known rate for the purpose of discounting which is usually the cost of capital or the hurdle/
cut-off rate (higher than cost of capital) as decided by the management. In case of I.R.R. rate is an unknown
factor.
(b) NPV method evaluates whether the return from the proposal is enough to pay the cost of capital. On the
other hand, I.R.R. seeks to find out the maximum rate which the company can earn from the project which
will help in the repayment of the cost of the project.
(c) Both methods assume that cash inflows will be reinvested at the discounting rate used. Reinvestment of
funds at the cut-off rate would be possible but reinvestment at I.R.R. would not always be possible as
normally this rate is higher than the cost of capital and hence NPV is a more realistic method of evaluation.
Similar results under I.R.R. and NPV method
Both the methods will give similar results if the cash flows are conventional; i.e. an initial cash outflow is
followed by a series of cash inflows. The results under both methods will also be similar if the projects are
independent; i.e. the projects are not mutually exclusive and therefore both the projects can also be undertaken.
Under I.R.R. method, a project is acceptable only if the I.R.R. is more than cut-off rate, i.e. cost of capital or a
higher cut-off rate decided by the management. Under NPV method we accept the proposal if the NPV is zero
(rate of return is exactly enough to repay the cost of capital) or positive (return in more than cost of capital).
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Thus both methods give same results because under both methods the project will be accepted only when the
rate of return is at least equal to or more than cost of capital or hurdle rate.
Conflict under I.R.R. and NPV method
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This happens because the project may have different initial outlay, unequal lives and also unequal cash inflows.
There may be a conflict even if the projects have similar cost & life but one of the projects has very high initial
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high cash flows followed by lower cash flows. In case of conflict, the NPV method gives more reliable results
because it takes into consideration the absolute present value of each project which helps in maximization of
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owners’ wealth. I.R.R. takes into consideration only the rate of return and not the amount received from each
project. Also, I.R.R. assumes that retained earnings will be reinvested in the business to earn the same rate
(I.R.R.) and as I.R.R. is normally higher than the cost of capital it may not be possible to do so.
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Modified I.R.R. (M.I.R.R.) or Terminal I.R.R.

The biggest criticism of IRR is that it assumes that the retained earnings will earn the same rate as the IRR.
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This may not happen because, where NPV is positive, the IRR is more than the rate used for discounting. NPV
assumes that the retained earnings will earn the same rate that is used for discounting, which is lower than IRR.
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It would be more realistic to assume a return at a lower rate than IRR. The Modified I.R.R. seeks to adjust the
reinvestment rate of I.R.R. The intermediate cash inflows are compounded at the cut-off rate to the last year of
the project. In effect, this means that inflows are reinvested at the cost of capital or cut-off rate and only a single
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large cash inflow will be available at the end of the project life. For this reason this is also known as Terminal
I.R.R. Thus, the total it is assumed that there will be only one cash inflow at the end of the project. The rate at
which the PV of this cash inflow equals the cost of the project is the modified I.R.R. The total cash flow at the
end of the project life is computed as follows:
Total CF = CF1(1+k)n–1 + CF2(1+k)n–2 + . . . + CFi(1+k)n–i + . . . + CFn
Where,
CFi = CF of the ith year
n = life of the project
k = cost of capital/hurdle rate/cut-off rate
The M.I.R.R. is computed as:
Cost of project = PVF (MIRR, n) × Total CF
Solving the above equation gives the PVF at MIRR for n years. The rate can be determined from the PV factor
table & the life of the project. If the PV factor falls between two rates then the M.I.R.R. is found by interpolation.
Project I.R.R.
The return from a project can also be evaluated from the point of view of inflows to pay the providers of long-

term finance to the firm; i.e. lenders & shareholders. This requires the cash inflows before payment of interest,
principal, dividend, capital redemption or buyback. Thus, the cash flows for P.I.R.R. are computed as follows:
CFAT = Net profit + Depreciation + Interest (1 – t) or
= EBIT – Tax + Depreciation
These cash flows may be used to find Project NPV and Project I.R.R. These methods evaluate the project on a
standalone basis and determine its financial feasibility independent of the method of financing.
Equity I.R.R.
In this case the cash inflows available to equity shareholders are used to compute the I.R.R. The cash flows
after the debt servicing payments will be available for the equity shareholders. The I.R.R. computed using these
cash flows is called the Equity I.R.R. This is the return on equity invested in the project. These cash flows are
CFAT = Net Profit + Depreciation – Loan principal repaid
These cash flows are used to compute Equity NPV and Equity I.R.R.
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Problems – General
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2.1 [C.S.] Xpert Engineering Ltd. is considering buying one of the following mutually exclusive investment
projects:
Project A : Buy a machine that requires an initial investment outlay of `1,00,000 and will generate
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cash flows after tax (CFAT) of `30,000 per year for 5 years.
Project B : Buy a machine that requires an initial investment outlay of `1,25,000 and will generate
cash flows after tax (CFAT) of `27,000 per year for 8 years.
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Which project should be undertaken? The company uses 10% cost of capital to evaluate the projects.
Note: PV of `1 @ 10% for 8 years – 0.9091, 0.8264, 0.7513, 0.6830, 0.6209, 0.5645, 0.5132 and 0.4665.
[NPV - A `13,721, B `19,042; Annual equivalent value: A `3,620, B `3,569. Project A is better.]
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2.2 [C.M.A.] A Ltd. is considering the question of taking up a new project which requires an investment of
`200 lakhs on machinery & other assets. The project is expected to yield the following gross profits (before
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depreciation & tax) over the next 5 years:

Year Gross profit (` lakhs)
1 80
2 80
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3 90
4 90
5 75
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The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on ‘Written down
value’ basis. The scrap value at the end of the five-year period may be taken as zero. Income tax applicable to
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the company is 50%.

Calculate the Net Present Value of the project and advise the management whether the project has to be
implemented. Also calculate the Internal Rate of Return of the project.
Note: Present value of `1 at different rates of interest are as follows
Year 10% 12% 14% 16%
1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48
[NPV `19.31 lakhs, IRR 15.61%]
2.3 [C.A.] DL Services is in the business of providing home Services like plumbing, sewerage line cleaning etc.
There is a proposal before the company to purchase a mechanized sewerage cleaning line for a sum of `20 lacs.
The life of the machine is 10 years. The present system of the company is to use manual labour for the job. You
are provided the following information:
Cost of machine `20 lacs

Depreciation 20% p. a. straight line
Operating cost `5 lacs per annum
Present system:
Manual labour 200 persons
Cost of Manual labour `10,000 (ten thousand) per person per annum
The company has an after tax cost of funds of 10% per annum. The applicable rate of tax inclusive of surcharge
and cess is 35%.
Based on the above you are required to:
(i) State whether it is advisable to purchase the machine.
(ii) Compute the savings/additional cost as applicable, if the machine is purchased.
[NPV `45.17 lakhs]
2.4 [C.S. twice] An iron ore company is considering investing in a new processing facility. The company
extracts ore from an open pit mine. During a year, 1,00,000 tons of ore is extracted. If the output from the
extraction process is sold immediately upon removal of dirt, rocks and other impurities, a price of `1,000 per
tonne of ore can be obtained. The company has estimated that its extraction costs amount to 70% of the net
realizable value of the ore.
As an alternative to selling all the ore at `1,000 per tonne, it is possible to process further 25% of the output.
The additional cash cost of further processing would be `100 per tonne. The processed ore would yield 80%
final output and can be sold at `1,350 per ton.
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For additional processing the company would have to install equipment costing `100 lakhs. The equipment is
expected to have the useful life of 5 years with no salvage value. The company follows the straight-line method
of depreciation. Additional working capital requirement is estimated at `10 lakhs. The company’s cut-off rate for
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such investments is 15%. Assume corporate tax rate 30% (including surcharge and education cess).
Should the company install the equipment for further processing of the ore?
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2.5 [C.S.] The management of Techno Craft Ltd. is evaluating the following data of a capital project:
Project ‘GEE’
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Annual cost savings (`) 80,000
Useful life (years) 5
Internal rate of return (%) 12
Profitability index (PI) 1.270457697
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NPV ?
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Cost of capital ?
Cost of project ?
Payback ?
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Salvage value 0
Find the missing values considering the following table of discount factors only:
Discount factor 13% 12% 9% 6% 3%
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1 year 0.885 0.893 0.917 0.943 0.971

2 year 0.783 0.797 0.842 0.890 0.943
3 year 0.693 0.712 0.772 0.840 0.915
4 year 0.613 0.636 0.708 0.792 0.888
5 year 0.543 0.567 0.650 0.747 0.863
3.517 3.605 3.889 4.212 4.580
[Cost of project `2,88,400; Cost of capital 3%; NPV `78,000; Payback period 3.605 years]
2.6 [C.A.] Following are the data on a capital project being evaluated by the management of X Ltd. –
Project M
Annual cost saving `40,000
Useful life 4 years
IRR 15%
Profitability Index (P.I.) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?

Salvage value 0
Find the missing values considering the following table of discount factor only:
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
[NPV `7,309, Cost of capital 12%, Cost of project `1,14,200, Payback period 2 years 11 months]
2.7 [C.A., C.S.] Sagar Industries is planning to introduce a new project with a projected life of 8 years.
The project, to be set in a backward region, qualifies for a one-time (at its starting) tax free subsidy from the
government of `20 lakhs. Initial equipment cost will be `140 lakhs and additional equipment costing `10 lakhs
will be needed at the beginning of the third year. At the end of 8 years, the original equipment will have no
resale value, but the supplementary equipment can be sold for `1 lakh. A working capital of `15 lakhs will be
needed. The sales volume over the eight year period have been forecast as follows:
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Year Units
1 80,000
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2 1,20,000
3-5 3,00,000
6-8 2,00,000
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A sale price of `100 per unit is expected and variable expenses will amount to 40% of sales revenue. Fixed
cash operating costs will amount to `16 lakhs per year. In addition, an extensive advertising campaign will be
implemented, requiring annual outlays as follows:
Year (` in lakhs)
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1 30
2 15
3-5 10
6-8 4
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The company is subjected to 50% tax rate and considers 12% to be an appropriate after-tax cost of capital for
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this project. The company has enough income from its existing products.
Note: Present value of `1 at 12% rate of discount is as follows:
Year PV factor at 12%
1 0.893
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2 0.797
3 0.712
4 0.636
5 0.567
A
6 0.507
7 0.452
C
8 0.404
[NPV `142.26 lakhs]
2.8 [C.S.] Raghu Electronics wants to take up a new project involving manufacture of an electronic device
which has good market prospects. Further details are given below:
(` in lakhs)
(i) Cost of the project (as estimated):
– Land (to be incurred at the beginning of the year 1) 2.00
– Buildings (to be incurred at the end of the year 1) 3.00
– Machinery (to be incurred at the end of the year 2) 10.00
– Working capital (margin money)
(to be incurred at the beginning of the year 3) 5.00
20.00
(ii) The project will go into production from the beginning of year 3 and will be operational for a period of 5
years. The annual working results are estimated as follows:
(` in lakhs)
Sales 24
Variable cost 8

Fixed cost (excluding depreciation) 5
Depreciation of assets 2
(iii) At the end of the operational period, it is expected that the fixed assets can be sold for `5 lakh (without
any profit).
(iv) Cost of capital of the firm is 10%. Applicable tax rate is 33.33% inclusive of surcharge and education cess, etc.
You are required to evaluate the proposal using the net present value approach and advise the firm.
[`10.50 lakhs]
2.9 [C.A.] XYZ Ltd., an infrastructure company is evaluating a proposal to build, operate and transfer a section
of 35 kms. of road at a project cost of `200 crores to be financed as follows:
Equity Share Capital `50 crores, loans at the rate of interest of 15% p.a. from financial institutions `150 crores.
The Project after completion will be opened to traffic and a toll will be collected for a period of 15 years from
the vehicles using the road. The company is also required to maintain the road during the above 15 years
and after the completion of that period, it will be handed over to the Highway authorities at zero value. It is
estimated that the toll revenue will be `50 crores per annum and the annual toll collection expenses including
maintenance of the roads will amount to 5% of the project cost. The company considers to write off the total cost
of the project in 15 years on a straight line basis. For Corporate Income-tax purposes the company is allowed to
take depreciation @ 10% on WDV basis. The financial institutions are agreeable for the repayment of the loan in
15 equal annual installments — consisting of principal and interest.
Calculate Project IRR and Equity IRR. Ignore Corporate taxation.
Explain the difference in Project IRR and Equity IRR.
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[Project IRR 18.43%; Equity IRR 28%]
2.10 [C.A., C.S.] A Company proposes to install a machine involving a Capital Cost of `3,60,000. The life
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of the machine is 5 years and its salvage value at the end of the life is nil. The machine will produce the net
operating income after depreciation of `68,000 per annum. The Company’s tax rate is 45%.
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The Net Present Value factors for 5 years as under:
Discounting Rate 14% 15% 16% 17% 18%
Cumulative factor 3.43 3.35 3.27 3.20 3.13
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You are required to calculate the internal rate of return of the proposal.
[IRR is 15.74%]
2.11 [C.A.] A company is considering which of the two mutually exclusive projects it should undertake. The
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Finance Director thinks that the project with the higher NPV should be chosen whereas the Managing Director
thinks that the one with the higher IRR should be undertaken especially as both projects have the same initial
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outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax cash flows of the
project are as follows:
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Year 0 1 2 3 4 5
Project X (` ‘000) (200) 35 80 90 75 20
Project Y (` ‘000) (200) 218 10 10 4 3
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Required:
(a) Calculate the NPV and IRR of each project.
(b) State, with reasons, which project you would recommend.
(c) Explain the inconsistency in the ranking of the two projects.
The discount factors are as follows:
Year 0 1 2 3 4 5
10% 1 0.91 0.83 0.75 0.68 0.62
20% 1 0.83 0.69 0.58 0.48 0.41
[(a) NPV `29.15, IRR 16.01% (b) Project X]
2.12 [C.A.] A company is considering which of the two mutually exclusive projects it should undertake. The
Finance Director thinks that the project with the higher NPV should be chosen whereas the Managing Director
thinks that the one with the higher IRR should be undertaken especially as both projects have the same initial
outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax cash flows of the
Year 0 1 2 3 4 5
Project X (` ‘000) (200) 35 80 90 75 20
Project Y (` ‘000) (200) 218 10 10 4 3
Required:
(a) Calculate the NPV and IRR of each project.
(b) State, with reasons, which project you would recommend.
(c) Explain the inconsistency in the ranking of the two projects.
The discount factors are as follows:
Year 0 1 2 3 4 5
10% 1 0.91 0.83 0.75 0.68 0.62
20% 1 0.83 0.69 0.58 0.48 0.41
[(a) NPV `29.15, IRR 16.01% (b) Project X]
2.13 [C.A.] Gretel Limited is setting up a project for manufacture of boats at a cost of `300 lakhs. It has to
decide whether to locate the plant in next to the sea shore (Area A) or in a inland area with no access to any
waterway (Area B). If the project is located in Area B then Gretel Limited receives a cash subsidy of `20 lakhs
from the Central Government.
Besides, the taxable profits to the extent of 20% is exempt for 10 years in Area B. The project envisages a
borrowing of `200 lakhs in either case. The rate of Interest per annum is 12% in Area A and 10% in Area B.
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The borrowing of principal has to be repaid in 4 equal installments beginning from the end of the 4th year.
With the help of the following information, you are required to suggest the proper location for the project to the
CEO of Gretel Limited. Assume straight line depreciation with no residual value, income tax 50% and required
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rate of return 15%.
Year Earnings before Depreciation, Interest & Tax (EBDIT)
(` in lakhs)
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Area A Area B
1 (6) (50)
2 34 (50)
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3 54 10
4 74 20
5 108 45
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6 142 100
7 156 155
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8 230 190
9 330 230
10 430 330
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The PVIF@ 15% for 10 years are as below:

Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
A
[NPV: Area A `100.20 lakhs; Area B (`36.04)]
Problems – Selecting an asset where no revenues are generated

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3.1 [C.A.] Company X is forced to choose between two machines A and B. The two machines are designed
differently, but have identical capacity and do exactly the same job. Machine A costs `1,50,000 and will last
for 3 years. It costs `40,000 per year to run. Machine B is an economy model costing only `1,00,000, but will
last only for 2 years and costs `60,000 per year to run. Ignore tax. Opportunity cost of capital is 10%. Which
machine should the company buy?
[PV of outflows: A `2,49,480, B `2,04,160, Annualized equivalent value: A `1,00,314, B `1,17,604. Machine A is better.]
3.2 [C.A.] ABC Chemicals is evaluating two alternative systems for Waste Disposal, System A and System B,
which have lives of 6 years and 4 years respectively. The initial investment outlay and annual operating costs for
the two systems are expected to be as follows:
Particulars System A System B
Initial Investment Outlay `5 million `4 million
Annual Operating Costs `1.5 million `1.6 million
Salvage value `1 million `0.5 million
If the Hurdle Rate is 15%, which system should ABC Chemicals choose?
The PVIF @ 15% for the six years are as below:
Year 1 2 3 4 5 6
PVIF 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
[EAC: Machine A `2.7069 million, Machine B `2.9001]
3.3 [C.A.] S. Engineering Company is considering to replace or repair a particular machine, which has just
broken down. Last year, this machine cost `20,000 to run and maintain. These costs have been increasing in
real terms in recent years with the age of the machine. A further useful life of 5 years is expected, if immediate
repairs of `19,000 are carried out. If the machine is not repaired it can be sold immediately to realize about
`5,000 (Ignore loss/gain on such disposal).
Alternatively, the company can buy a new machine for `49,000 with an expected life of 10 years with no salvage
value after providing depreciation on straightline basis. In this case, running and maintenance costs will reduce
to `14,000 each year and are not expected to increase much in real terms for few years at least. S. Engineering
Company regard a normal return of 10% p.a. after tax as a minimum requirement on any new investment.
Considering capital budgeting techniques, which alternative will you choose? Take corporate tax rate of 50%
and assume that depreciation on straightline basis will be accepted for tax purposes also.
Given cumulative present value of `1 p.a. at 10% for 5 years 3.791, 10 years 6.145.
[AEV: Repairing `12,506; New machine `11,710]
3.4 [C.A.] A manufacturing unit engaged in the production of automobile parts is considering a proposal of
purchasing one of the two plants, details of which are given below:
Particulars Plant A Plant B
Cost `20,00,000 `38,00,000
Installation charges `4,00,000 `2,00,000
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Life 20 years 15 years
Scrap value after full life `4,00,000 `4,00,000
Output per minute (units) 200 400
The annual costs of the two plants are as follows:
Particulars ss Plant A Plant B
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Running hour per annum 2,500 2,500
Costs: (in `) (in `)
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Wages 1,00,000 1,40,000
Indirect materials 4,80,000 6,00,000
Repairs 80,000 1,00,000
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Power 2,40,000 2,80,000

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Fixed Costs 60,000 80,000

Will it be advantageous to buy Plant A or Plant B? Substantiate your answer with the help of comparative unit
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cost of the plants. Assume interest on capital at 10%. Make other relevant assumptions:
Note: 10% interest tables
20 years 15 years
Present value of `1 0.1486 0.2394
A
Annuity of `1 (capital recovery factor

with 10% interest) 0.1175 0.1315
[Plant B. Cost per unit: Plant A `0.0412; Plant B `0.0287]
Replacement of Asset
It is not necessary that an asset is replaced only at the end of its useful life. An existing asset may be in a
working condition and have remaining useful life but whether it would be beneficial to replace it immediately
can be done only after doing careful computation. To replace an existing working asset it is necessary that the
replacement should give incremental benefits. The key word here is ‘incremental’ and hence in computing the
NPV of the replacement decision we take the following into consideration:
(i) the net initial outlay, i.e. the outlay after deducting not only the amount received from the sale of old
assets but also making adjustment for tax effect thereon for (a) tax payable on gain (outflow) or (b) tax
shield on loss (inflow);
(ii) the incremental cash flows after tax after considering the incremental benefits arising in the form of
higher sales, lower operating cost, etc.;
(iii) incremental depreciation for tax savings; and
(iv) incremental salvage value.

If the problem does not specify the life of the new asset then it should be taken as equal to the remaining life of
the existing asset. For example, an existing asset was purchased 4 year ago and has a total life of 10 years. The
life of the new asset to replace this one will be taken as 6 years, i.e. the remaining life of the existing asset.
Problems – Replacing an asset

4.1 [C.A.] A company has an old machine having book value zero-which can be sold for `50,000. The company
is thinking to choose one from following two alternatives:
(i) To incur additional cost of `10,00,000 to upgrade the old existing machine.
(ii) To replace old machine with a new machine costing `20,00,000 plus installation cost `50,000.
Both above proposals envisage useful life to be five years with salvage value to be nil.
The expected after tax profits for the above three alternatives are as under:
Year Old existing Upgrade New
Machine Machine Machine
` ` `
1 5,00,000 5,50,000 6,00,000
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2 5,40,000 5,90,000 6,40,000
3 5,80,000 6,10,000 6,90,000
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4 6,20,000 6,50,000 7,40,000
5 6,60,000 7,00,000 8,00,000
The tax rate is 40%.
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The company follows straight line method of depreciation. Assume cost of capital to be 15%.
P.V.F. of 15%, 5 = 0.870, 0.756, 0.658, 0.572 and 0.497.
You are required to advise the company as to which alternative is to be adopted.
[NPV: Upgrade (`1,91,320); New machine (`2,72,070).Continue with existing machine.]
G
4.2 [C.A., C.S.] Apollo Ltd. manufactures a special chemical for sale at `30 per kg. The variable cost of
manufacture is `15 per kg. Fixed cost excluding depreciation is `2,50,000. Apollo Ltd. is currently operating at
50% capacity. It can produce a maximum of 1,00,000 kgs. at full capacity.
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The production manager suggests that if the existing machines are replaced, the company can achieve maximum
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capacity in the next 5 years gradually increasing the production by 10% a year.
The finance manager estimates that for each 10% increase in capacity, the additional increase in fixed cost
will be `50,000. The existing machines with a current book value of `10,00,000 and remaining useful life of 5
years can be disposed of for `5,00,000. The vice-president (finance) is willing to replace the existing machines
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provided the NPV on replacement is `4,53,000 at 15% cost of capital.

(a) You are required to compute the total value of machines necessary for replacement. For computations, you
may assume the following:
A
(i) All the assets are in the same block. Depreciation will be on straight line basis and the same is
allowed for tax purposes,
(ii) There will be no salvage value for the new machines. The entire cost of the assets will be depreciated
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over a five year period.

(iii) Tax rate is 40%.
(iv) Cash inflows will accrue at the end of the year,
(v) Replacement outflow will be at the beginning of the year (year 0).
(b) On the basis of data given above, the managing director feels that the replacement, if carried out, would at
least yield a post-tax return of 15% in three years provided the capacity build up is 60%, 80% and 100%
respectively. Do you agree? Give reasons.
Year 1 Year 2 Year 3 Year 4 Year 5
Present value factor at 15% 0.87 0.76 0.66 0.57 0.50
Present value annuity factor at 15% 0.87 1.63 2.29 2.86 3.36
[(a) Value of machines to be replaced `6,27,049 (b) The post-tax return is more than 15%]
4.3 [C.A.] Beta Company Ltd. is considering the replacement of its existing machine by a new machine, which
is expected to cost `2,64,000. The new machine will have a life of five years and will yield annual cash revenues
of `5,68,750 and incur annual cash expenses of `2,95,750. The estimated salvage value of the new machine is
`18,200. The existing machine has a book value of `91,000 and can be sold for `45,500 today.
The existing machine as a remaining useful life of five years. The cash revenues will be `4,55,000 and associated
cash expenses will be `3,18,500. The existing machine will have a salvage value of `4,550 at the end of five

years.
The Beta Company is in 35% tax bracket, and rights of depreciation at 25% all written down value method.
The Beta Company has a target debt to value ratio of 15%. The company has in the past has raised debt at 11%
and it can raise fresh debt at 10.5%.
Beta Company plans to follow dividend discount model to estimate the cost of equity capital. The company plans
to pay a dividend of `2 per share in the next year. The current market price of companies equity share is `20.
The dividend per equity share is expected to grow at 8% per annum.
Required:
(i) Compute incremental cash flows of the replacement decision.
(ii) Compute the weighted average cost of capital of the company.
(iii) Find out the net present value of the replacement decision.
(iv) Should the company replace the existing machine? Advise.
[Cost of capital 16.32%; NPV `1,29,258]
4.4 [C.A.] A machine used on a production line must be replaced at least every four years. Costs incurred to
run the machine according to its age are:
Age of the Machine (years)
0 1 2 3 4
Purchase price (in `) 60,000
Maintenance (in `) 16,000 18,000 20,000 20,000
Repair (in `) 0 4,000 8,000 16,000
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Scrap value (in `) 32,000 24,000 16,000 8,000
Future replacement will be with identical machine with same cost. Revenue is unaffected by the age of the
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machine. Ignoring inflation and tax, determine the optimum replacement cycle. PV factors of the cost of capital
of 15% for the respective four years are 0.8696, 0.7561, 0.6575 and 0.5718.
[3 years, equivalent annual cost `43,114]
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4.5 [C.A.] X & Co. is contemplating whether to replace an existing machine or to spend money in overhauling
it. X & Co. currently pays no taxes. The replacement machine costs `95,000 and requires maintenance of `10,000
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every year at the year end for eight years. At the end of eight years, it would have a salvage value of `25,000
and would be sold. The existing machine requires increasing amounts of maintenance each year and its salvage
value falls each year as follows:
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Year Maintenance (`) Salvage (`)

Present 0 40,000
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1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
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4 40,000 0
The opportunity cost of capital for X & Co. is 15%.
You are required to state, when should the firm replace the machine:
A
(Given: Present value of an annuity of `1 per period for 8 years at interest rate of 15% - 4.4873; present value of
`1.00 to be received after 8 years at interest rate of 15% - 0.3269)
[Replace immediately]
4.6 [C.S.] Growell Ltd. has a machine which has been in operation for 2 years and its remaining estimated
useful life is 4 years with no salvage value at the end. Its current market value is `1,00,000.
The management is considering a proposal to purchase an improved model of similar machine, which gives
increased output. The relevant particulars are as follows:
Particulars Existing machine New machine
Purchase price `2,40,000 `4,00,000
Estimated life 6 years 4 years
Salvage value Nil Nil
Annual operating hours 2,000 2,000
Output per hour 15 units 30 units
Material cost per unit `2 `2
Labour cost per hour `20 `40
Consumable stores per year `2,000 `5,000

Repairs and maintenance per year `9,000 `6,000
Working capital `25,000 `40,000
The company follows the written down value method of depreciation @ 25% and is subject to 35% tax. Should
the existing machine be replaced? Assume that the company’s required rate of return is 15% and the company
has several assets in the 25% block.
[NPV `1,28,984]
4.7 [C.S.] A machine purchased 6 year back for `1,50,000 has been depreciated to a book value of `90,000.
It originally had a projected life of fifteen years and zero salvage value. A new machine will cost `2,50,000 and
result in a reduced operating cost of `30,000 per year for the next nine years. The older machine could be sold
for `50,000. The machine also will be depreciated on an straight line method on nine-year life with salvage
value of `25,000. The company’s tax rate is 50% and cost of capital is 10%.
Determine whether the old machine should be replaced.
Given- P.V. of `1 at 10% for 9th year is 0.424; PV of an annuity of `1 at 10% for 9 years is 5.759.
[NPV (`39,822)]
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4.8 [C.S.] Prithvi Ltd. is a manufacturer of variety of electrical equipments. The existing machine is based on
old technology. In order to improve the quality of the product and bring down operating cost, the management is
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planning to replace the existing machine with a new one based on latest technology. Following are the relevant
information:
Existing machine:
Purchased 5 years ago
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Remaining life 5 years
Salvage value `20,000
Depreciation Straight line basis
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Current book value `3,00,000
Realizable market value `3,50,000
Annual depreciation `28,000
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New replacement machine:
Capital cost `10,00,000
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Estimated useful life 5 years

Estimated salvage value `1,00,000
The replacement machine would permit an output expansion. As a result, sales is expected to increase by
.S
`1,00,000 per year, operating expenses would decline by `2,00,000 per year. It would require an additional
inventory of `2,00,000 and would cause an increase in accounts payable by `50,000.
Assuming a tax rate of 30% & cost of capital of 12%, advise the company about replacement of the existing
machine.
A
[NPV `2,51,260]
4.9 [C.M.A.] Satya Corporation is toying with the idea of replacing its existing machine. The following are the
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relevant data:
Existing machine:
Purchased 2 years ago
Remaining life 6 years
Salvage value `500
Depreciation Straight line basis
Current book value `2,600
Realizable market value `3,000
Annual depreciation `350
New replacement machine:
Capital cost `8,000
Estimated useful life 6 years
Estimated salvage value `800
The replacement machine would permit an output expansion. As a result, sales is expected to increase by `1,000
per year, operating expenses would decline by `1,500 per year. It would require an additional inventory of
`2,000 and would cause an increase in accounts payable by `500.
Assuming a tax rate of 40% & cost of capital of 15%, advise the company about replacement of the existing

machine.
[NPV `1,298]
4.10 [C.S.] National Bottling Company is contemplating to replace one of its bottling machines with a new
and more efficient machine. The old machine has a book value of `10 lakhs and a useful life of ten years. The
machine was bought five years back. The company does not expect to realize any return from scrapping the old
machine at the end of ten years but if it is sold to another company in the industry, National Bottling Company
would receive `6 lakhs for it.
The new machine has a purchase price of `20 lakhs. It has an estimated salvage value of `2 lakhs and has useful
life of five years.
The new machine will have a greater capacity and annual sales are expected to increase from `10 lakes to `12
lakhs. Operating efficiencies with the new machine will also produce saving of `2 lakhs a year. Depreciation is
on a straight-line basis over a ten-year life.
The cost of capital is 8% and 50% tax-rate is applicable. The present value interest factor for an annuity for five
years at 8% is 3.993 and present value interest factor at the end of five year is 0.681.
Should the company replace the old machine?
[NPV `2,53,890]
Risk Analysis in Capital Budgeting

Choosing a project simply on the basis of NPV has one serious drawback and that is it does not indicate the risk
involved in the project. Fluctuations arising in cash flows may seriously affect the profitability of the project.
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The accuracy of the NPV depends upon the accuracy with which cash flows can be estimated. Probability theory
can be used to reduce the uncertainty & improve the accuracy of the cash flows thereby improving the reliability
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of the NPV. For each year, different possible cash flows together with their respective probabilities are ascertained
before computing NPV. As we need only one cash flow for each year the average cash flow called the expected
value (EV) is computed for each year. The EV of cash flow for each year is equal to the sum of the products of the
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different cash flows & their probabilities. This show below:
EV of cash flow for any year = (CF1 × P1) + (CF2 × P2) + . . . . . + (CFi × Pi)
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Where, CF1CF2, . . . CFi are the various estimates of the cash flows for the year & P1, P2, . . . Pi are the respective
probabilities of such estimated cash flows.
Several estimates can be made for each year. There may be small or wide fluctuation in these estimates. A set of
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estimated flows with huge deviations from the average cash flow will be more risky compared to one with small
deviations. Statistical measures like standard deviation & co-efficient of variation can be used to determine the
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risk involved in a project to take a more informed decision about it.

Standard Deviation and Co-efficient of Variation
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Standard deviation shows the average deviation of each value from the mean of all the values & is denoted by
s (sigma). It is an absolute measure of dispersion. The higher the value the more the risk. The square of this
measure s2 is the variance of the distribution. Standard deviation is computed as follows:
A
Standard Deviation (S.D.)

Σd 2
s=
n
Where,
d2 = is the square of the deviation of each observation from its expected value, i.e. d = x – x. Here, x is not the
mean but the expected value computed as x = x1p1 + x2p2 + . . . . + xnpn
n = number of observations
Standard Deviation – with probability

s= Σ pi d 2
Where,
pi = probability of the occurrence of each observation
d2 = is the square of the deviation of each observation from its expected value, i.e. d = x – x. Here, x is not the
mean but the expected value computed as x = x1p1 + x2p2 + . . . . + xnpn

!! Standard deviation can be computed for a given set of variables, cash flows or NPVs.
Hillier’s Model
According to F.S. Hillier the expected NPV and the standard deviation of NPV can be computed to evaluate
the project. The two important factors in the evaluation are:
(i) time value of money, &
(ii) the risk.
The two factors should be kept separate. The NPV should be computed at the risk-free rate and the
standard deviation of the NPV should be computed to assesses the risk. The risk-free rate is used for NPV because
if we use a higher rate to compensate for the risk then computing the standard deviation would mean that the
risk factor is considered twice.
The cash flows of the investment may be correlated (dependent) or uncorrelated (independent). The standard
deviation of the NPV is computed as follows:
(i) Where cash flows are independent (cash flows of subsequent years do not depend on cash flows of earlier
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years)
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n
s2
sNPV = ∑ (1 + Rt )2t
t =1 f
Where,
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sNPV = standard deviation of NPV
st = standard deviation of cash flows for each period
Rf = risk-free rate
(ii) Where cash flows are dependent (cash flows of subsequent years are affected by cash flows of earlier years)
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n
s
sNPV = ∑ (1 + tR )t
t =1 f
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Co-efficient of Variation (C.V.)

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Standard deviation is an absolute measure of dispersion and the units of the standard deviation will be the same
as those of the variable to which it relates; i.e. as cash flows are in rupees the standard deviation of a set of cash
flow will also be in rupees. However, S.D. can be effectively used in comparing two or more sets of variables only
if the average of each set is the same. If the set of variables are very different from one another then it is better
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to use a relative measure of dispersion like the co-efficient of variation. C.V. is suitable for comparison because it
converts the standard deviation to a proportion or percentage to the mean. It is computed as follows:
s s
A
C.V. = or × 100
x x
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Problems – Standard Deviation & Coefficient of Variation

5.1 [C.S.] Shamita Ltd. has an opportunity to invest in a project that will last for two years and will cost
`1,00,000 initially. It has the following estimated possible cash flow after tax (CFAT) in the first year:
CFAT in the first year (`) Probability
40,000 0.3
60,000 0.4
80,000 0.3
In the second year, the conditional cash flows are given below:
If CFAT = `40,000 If CFAT = `60,000 If CFAT = `80,000
CFAT (`) Probability CFAT (`) Probability CFAT (`) Probability
20,000 0.2 70,000 0.3 80,000 0.1
50,000 0.6 80,000 0.4 1,00,000 0.8
80,000 0.2 90,000 0.3 1,20,000 0.1
If the marginal cost of capital for the company is 15%, advise with reasons whether project should be accepted.
[NPV `10,412]
5.2 [C.A.] Jumble Consultancy Group has determined relative utilities of cash flows of two forthcoming projects

of its client company as follows:
Cash Flow in ` – 15,000 – 10,000 – 4,000 0 15,000 10,000 5,000 1,000
Utilities – 100 – 60 – 3 0 40 30 20 10
The distribution of cash flows of project A and Project B are as follows:
Project A:
Cash Flow (`) – 15,000 – 10,000 15,000 10,000 5,000
Probability 0.10 0.20 0.40 0.20 0.10
Project B:
Cash Row (`) – 10,000 – 4,000 15,000 5,000 10,000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why?
[Project B with expected utility 17.55]
5.3 [C.M.A.] Pioneer Projects Ltd. is considering accepting one of two mutually exclusive projects X & Y. The
cash flow and probabilities are estimated as under:
Project X Project Y
Probability Cash flow (₹) Probability Cash flow (₹)
0.10 12,000 0.10 8,000
0.20 14,000 0.25 12,000
0.40 16,000 0.30 16,000
0.20 18,000 0.25 20,000
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0.10 20,000 0.10 24,000
Advise Pioneer Projects Ltd.
[Project X: S.D. `2,190; Project Y: S.D. `4,560]
State of market
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5.4 [C.M.A.] Given the following information, find out which project is more risky — A or B.
Probability of occurrence Actual cash flow (`)
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Project A Project B
High 0.2 1,000 1,200
Normal 0.6 800 800
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Low 0.2 600 400
[S.D. - Project A `126.5, Project B `253]
5.5 [C.A.] A company is considering projects X and Y with the following information:
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Project Expected NPV (`) Standard deviation

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X 1,22,000 90,000
Y 2,25,000 1,20,000
(i) Which project will you recommend based on the above data?
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(ii) Explain whether you opinion will change, if you use coefficient of variation as a measure of risk.
(iii) Which measure is more appropriate in this situation and why?
[(i) Project X (ii) Project Y]
A
5.6 [C.A.] Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs `36,000 and
project B `30,000. You have been given below the net present value probability distribution for each period:
Project A Project B
NPV estimates Probability NPV estimates Probability
(`) (`)
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
(i) Compute the expected net present value is of project A and B.
(ii) Compute the risk attached to each project, i.e. standard deviation of each probability distribution.
(iii) Compute the profitability index of each project.
(iv) Which project do you recommend? State with reasons.
[(i) `9,000 for both (ii) `4,450, `3,795 (iii) 1.25, 1.30 (iv) Project B]
5.7 [C.A., C.M.A.] A company is considering two mutually exclusive projects X and Y. Project X costs `30,000
and Project Y `36,000. You have been given below the net present value probability distribution for each project:
Project - X Project - Y

NPV estimate (`) Probability NPV estimate (`) Probability
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
(i) Compute the expected NPV of Projects X and Y.
(ii) Compute the risk attached to each project, i.e. standard deviation of each probability distribution.
(iii) Which project do you consider more risky and why?
(iv) Compute the profitability index of each project.
[(i) EV of X `9,000, EV of Y `9,000 (ii) S.D. – X `3,795, Y `4,450 (iii) Project Y (iv) P.I. – X 1.3, Y 1.25]
Problems – Hillier’s Model

6.1 [C.A.] XYZ Ltd. is planning to procure a machine at an investment of `40 lakhs. The expected cash flow
after tax for next three years is as follows:
` (in lakh)
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Year - 1 Year - 2 Year - 3
CFAT Probability CFAT Probability CFAT Probability
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12 0.1 12 0.1 18 0.2
15 0.2 18 0.3 20 0.5
18 0.4 30 0.4 32 0.2
32 0.3 40 0.2 45 0.1
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The Company wishes to consider all possible risks factors relating to the machine.
The Company wants to know:
(i) the expected NPV of this proposal assuming independent probability distribution with 7% risk free rate of
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interest.
(ii) the possible deviations on expected values.
[(i) `22.849 lakhs (ii) 12.66%]
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6.2 [C.A.] Aeroflot airlines is planning to procure a light commercial aircraft for flying class clients at an
investment of `50 lakhs. The expected cash flow after tax for next three years is as follows:
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(` in lakh)
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
.S
15 .1 15 .1 18 .2
18 .2 20 .3 22 .5
22 .4 30 .4 35 .2
35 .3 45 .2 50 .1
A
The company wishes to consider all possible risk factors relating to an airline.
The company wants to know –
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(i) the expected NPV of this proposal assuming independent probability distribution with 6% risk free rate of
interest, and
(ii) the possible deviation on expected values
[(i) `20.718 lakh (ii) `4.58 lakhs]
6.3 [C.A.] Skylark Airways is planning to acquire a light commercial aircraft for flying class clients at an
investment of `50,00,000. The expected cash flow after tax for the next three years is as follows:
CFAT (`) Probability CFAT (`) Probability CFAT (`) Probability
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The Company wishes to take into consideration all possible risk factors relating to an airline operations. The
company wants to know:
(i) The expected NPV of this venture assuming independent probability distribution with 6% risk free rate of
interest.
(ii) The possible deviation in the expected value.

(iii) How would standard deviation of the present value distribution help in Capital Budgeting decisions?
[(i) `24,974 (ii) 14.37%]
6.4 [C.A.] The Shcrisight Company is attempting to decide whether or not to invest in a project that requires
an initial outlay of `4 lakhs. The cash flows of the project are known to be made-up of two parts, one of which
varies independently over time and the other one which displays perfect positive correlation.
The cash flows of the six year life of the project are:
Year Perfectly Correlated Components Independent Components
Mean Standard Deviation Mean Standard Deviation
1 40,000 4,400 42,000 4,000
2 50,000 4,500 50,000 4,400
3 48,000 3,000 50,000 4,800
4 48,000 3,200 50,000 4,000
5 55,000 4,000 52,000 4,000
6 60,000 4,000 52,000 3,600
(i) Find out the expected value of the NPV and its standard deviation, using a discount rate of 10%.
(ii) Also find the probability that the project will be successful, i.e. P(NPV ≥ 0) and state the assumptions under
which this probability can be determined.
[(i) ENPV `27,285, SD `18,510 (ii) 92.92%]
Risk Adjusted Discount Rate (RADR)
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A project with a high risk need not always be avoided. A high risk project may be undertaken if the returns are
worth the risk. Under this method of computation of NPV the rate used for discounting a project will be adjusted
to compensate for the risk involved. A higher rate is used for discounting cash flows from a risky project and if
the NPV is positive or zero then the project may be undertaken.
Problems – Applying risk adjusted discounting rate ss

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7.1 [C.A. twice, C.S. twice] Determine the risk adjusted net present value of the following projects:
Particulars Project X Project Y Project Z
C
Net cash outlay (`) 2,10,000 1,20,000 1,00,000
Project life (years) 5 5 5
Annual cash inflow (`) 70,000 42,000 30,000
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Coefficient of variation 1.2 0.8 0.4

The company selects the risk adjusted rate of discount on the basis of coefficient of variation:
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Coefficient of Risk adjusted P.V. factor for 5 years

variation rate of discount at risk adjusted rate of discount
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0.0 10% 3.791

0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
A
1.6 18% 3.127

2.0 22% 2.864
More than 2.0 25% 2.689
[NPV: A `19,180, B `24,186, C `8,150]
7.2 [C.A., C.S.] Fast-run Automobiles Spares Ltd. (FASL) is considering investment in one of three mutually
exclusive projects Zeta-10, Meta-10 and Neta-10. The company’s cost of capital is 15% and the risk-free rate of
return is 10%. The income-tax rate for the company is 40%. FASL has gathered the following basic cash-flow
and risk index data for each project:
Project
Zeta-10 Meta-10 Neta-10
` ` `
Initial investment 15,00,000 11,00,000 19,00,000
Cash inflows after-tax for year:
1 6,00,000 6,00,000 4,00,000
2 6,00,000 4,00,000 6,00,000
3 6,00,000 5,00,000 8,00,000
4 6,00,000 2,00,000 12,00,000

Risk Index 1.80 1.00 0.60
Using the risk adjusted discount rate, determine the risk adjusted NPV for each of the projects. Which project
should be accepted by the company? Give reasons.
Note: Present value of `1 for five years –
Year\Rate 1 2 3 4 5
9% 0.9174 0.8417 0.7722 0.7084 0.6499
11% 0.9009 0.8116 0.7312 0.6587 0.5935
13% 0.8850 0.7831 0.6931 0.6133 0.5428
15% 0.8696 0.7561 0.6575 0.5718 0.4972
17% 0.8547 0.7305 0.6244 0.5337 0.4561
19% 0.8403 0.7062 0.5934 0.4987 0.4190
[Project Neta-10 should be accepted as NPV of `2.143 lakhs is highest]
Certainty Equivalent Approach

As risk arises due to uncertainty of the cash flow, this method seeks to remove the uncertain amount from
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the total cash flow thereby leaving only the certain amount of cash flows. Certainty equivalent factor are to
be determined and the uncertain cash flows are multiplied by these factors to obtain the certain cash flows.
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Certainty Equivalent Factor is the ratio between certain cash flows and uncertain cash flows. It is calculated as:
Certain cash flow

Certainty Equivalent Factor (for a year) =
Uncertain cash flow
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!! Uncertain cash flow means the total cash flow as initially estimated and not just that part of the total cash flow
which is uncertain. For example, cash flow of Year 1 is estimated to be `1,00,000 of which `80,000 is certain then
`1,00,000 is the uncertain cash flow and not just `20,000, i.e. the uncertain part of `1,00,000.
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The uncertain cash flows are multiplied by the CE factors to obtain the certain cash flows. Certain cash flows are
then discounted at risk-free rate to find the NPV. The risk-free rate is used for discounting because the risk,
i.e. the uncertain part of the cash flow, has been removed from the cash flows.
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Problems – Applying certainty equivalent approach

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8.1 [C.M.A.] A project requires an initial cash outlay of `50,000 and offers an annual expected cash inflow of
`40,000 for three years and has no salvage value. The risk coefficients for three years are estimated to be 0.80,
0.70 and 0.65 respectively. The risk free rate of interest is estimated to be 15%.
.S
The PV factor @ 15% is 0.87 for 1st year, 0.756 for 2nd year and 0.658 for the 3rd year.
Calculate the NPV of the project.
[`16,116]
A
8.2 [C.S.] Delta Corporation is considering an investment in one of the two mutually exclusive proposals –
Project-A: It involves initial outlay of `1,70,000.
C
Project-B: It requires initial outlay of `1,50,000.

The certainty-equivalent approach is employed in evaluating risky investments. The current yield on treasury
bills is 5% and the company uses this as riskless rate. Expected values of net cash inflow with their respective
certainty-equivalents are:
Project-A Project-B
Cash Inflow Certainty- Cash Inflow Certainty-
Year (`) equivalent (`) equivalent
1 90,000 0.8 90,000 0.9
2 1,00,000 0.7 90,000 0.8
3 1,10,000 0.5 1,00,000 0.6
Answer the following with reasons:
(i) Which project should be acceptable to the company?
(ii) Which project is riskier and why? Explain.
(iii) If the company was to use the risk-adjusted discount rate method, which project would be analyzed with
higher rate?
[(i) NPV– A `9,554, B `44,256 (ii) Project A (iii) Project A]
8.3 [C.A.] The Textile Manufacturing Co. Ltd. is considering one of two mutually exclusive proposals, Projects

M and N, which require cash outlays of `8,50,000 and `8,25,000 respectively. The certainty-equivalent (C.E.)
approach is used in incorporating risk in capital budgeting decisions. The current yield on government bonds
is 6% and this is used as the risk free rate. The expected net cash flows and their certainty equivalents are as
follows:
Project M Project N
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of `1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and 0.840 respectively.
Required: (i) Which project should be accepted? (ii) If risk adjusted discount rate method is used, which project
would be appraised with a higher rate & why?
[(i) NPV– M `10,980, N `1,71,315 (ii) Project M]
8.4 [C.S.] A company is considering two mutually exclusive projects. The company uses certainty equivalent
approach. Estimated cash flows and certainty equivalents for each project are as follows:
Project-1 Project-2
Year Cash Certainty Cash Certainty
Flow Equivalent Flow Equivalent
0 – 30,000 1.00 – 40,000 1.00
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1 15,000 0.95 25,000 0.90
2 15,000 0.85 20,000 0.80
3 10,000 0.70 15,000 0.70
4 10,000 0.65
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10,000
Which project should be accepted, if the risk free discount rate is 15%?
[NPV – Project 1 `351; Project 2 `1,998]
0.60
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Sensitivity Analysis
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Projects normally take more than a year to be completed. The NPV of a project can change due to change in
any one or more factors affecting the NPV. The factors like cost of the project, cost of capital, sales, operating
cost, etc. affect the NPV and an adverse change in any of these will adversely affect the NPV. Sensitivity analysis
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involves computation of change in factor and its impact on the NPV. Sensitivity may be tested in two ways:
(i) Find the change in a particular factor which will reduce the NPV to zero. A zero NPV makes the project a
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borderline case as the NPV can become negative easily. Express the change in the factor as a percentage to
its original value. The project is the most sensitive to the factor which has the lowest percentage change.
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(ii) Compute revised NPV taking a per-determined change in the different factors for which you want to test the
sensitivity. The project is the most sensitive to the factor which has the highest impact on the NPV.
Problems – Sensitivity analysis

A
9.1 [C.A.] The Easygoing Company Limited is considering a new project with initial investment, for a product
“Survival”. It is estimated that IRR of the project is 16% having an estimated life of 5 years.
Financial Manager has studied the project with sensitivity analysis and informed that annual fixed cost sensitivity
is 7.8416%, whereas cost of capital (discount rate) sensitivity is 60%.
Other information available are:
Profit Volume Ratio (P/V) is 70%
Variable cost `60 per unit
Annual Cash Flow `57,500
Ignore Depreciation on initial investment and impact of taxation.
Calculate:
(i) Initial Investment of the Project
(ii) Net Present Value of the Project
(iii) Annual Fixed Cost
(iv) Estimated annual unit of sales
(v) Break Even Units
Cumulative Discounting Factor for 5 years:

8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%
3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127
[(i) `1,88,255 (ii) `29,727.50 (iii) `1,00,000 (iv) 1,125 units (v) 714.285 units]
9.2 [C.M.A.] From the following project details calculate the sensitivity of the project to (a) Project cost, (b)
Annual cash flow and (c) Cost of capital. Which variable is the most sensitive?
Project cost `12,000 Annual cash flow `4,500
Life of the project 4 years Cost of capital 14%
The annuity factor at 14% for 4 years is 2.9137 and at 18% for 4 years is 2.666.
[(a) 9.27% (b) 8.48% (c) 29%]
9.3 [C.M.A. twice] X Ltd. in considering a project with the following cash flows:
Year Initial outlay Running cost Savings
` ` `
0 (7,000)
1 2,000 6,000
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2 2,500 7,000
The cost of capital is 8%. Measure the sensitivity of the project to changes in the levels of project cost, running
costs and savings (considering each factor at a time) such that the net present value becomes zero. To which
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factor is the project most sensitive? The present value factors at 8% are as follows:
Year PV factor
0 1.00
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1 0.93
2 0.86
[Sensitivity: Project cost 8.4%, Running cost 14.7%, Savings 5.1%]
G
9.4 [C.A.] XYZ Ltd. is considering a project for which the following estimates are available:
`
Initial cost of the project 10,00,000
Sales price/unit 60
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Cost/unit 40
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Sales volume –
Year 1 20,000 units
Year 2 30,000 units
Year 3 30,000 units
.S
Discount rate 10% p.a.

You are required to measure the sensitivity of the project in relation to each of the following parameters:
(a) Sales price/unit (b) Unit cost (c) Sales volume (d) Initial outlay and (e) Project life time.
A
Taxation may be ignored.

[(a) 7.9% (b) 11.8% (c) 100% (d) 30.9% (e) 22.2%]
9.5 [C.A.] XYZ Ltd. is considering a project for which the following estimates are available:
C
`
Initial Cost of the project 10,00,000
Sales price/unit 60
Cost/unit 40
Sales volumes:
Year 1 20,000 units
Year 2 30,000 units
Year 3 30,000 units
Discount rate 10% p.a.
You are required to measure the sensitivity of the project in relation to each of the following parameters:
(a) Sales Price/unit
(b) Unit cost
(c) Sales volume
(d) Initial outlay and
(e) Project lifetime
Taxation may be ignored.

[(a) 7.9% (b) 11.85% (c) 23.68% (d) 31.03% (e) 23.6%]
9.6 [C.A.] Red Ltd. is considering a project with the following Cash flows:
Years Cost of Plant Recurring Cost Savings
0 10,000
1 4,000 12,000
2 5,000 14,000
The cost of capital is 9%. Measure the sensitivity of the project to changes in the levels of plant value, running
cost and savings (considering each factor at a time) such that the NPV becomes zero. The P. V. factor at 9% are
as under:
Year Factor
0 1
1 0.917
2 0.842
Which factor is the most sensitive to affect the acceptability of the project?
[(i) 49.14% (ii) 62.38% (iii) 21.56%]
Scenario Analysis
Sensitivity analysis is a popular technique for risk analysis. But its major drawback is that it considers only one
variable at a time. A better assessment of risk can be made by considering the impact of multiple variables at a
time. Scenario analysis considers changes in several key variables and its impact on the viability of the project.
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Normally, three scenarios are visualized as follows:
(1) Base case or most like case – In this case, the most likely set of key variable are taken into consideration
and cash flows are determined for the same.
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(2) Worst case – In this case, the worst possible set of key variable are taken into consideration and cash flows
are determined for the same. These variables could be lowest possible sale, low selling price, highest cost,
lowest demand, etc.
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(3) Best case – In this case, best possible set of key variables are taken for determining the cash flows; e.g.
highest sale, lowest cost, etc.
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This method of evaluation helps in understanding the outcome under different situations that may arise in the
future and their effect on the profitability of the project.
Problems – Scenario Analysis

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10.1 [C.A.] XY Ltd. has under its consideration a project with an initial investment of `1,00,000. Three probable
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cash inflow scenarios with their probabilities of occurrence have been estimated as below:
Annual cash inflow(`) Probability
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20,000 0.1
30,000 0.7
40,000 0.2
The project life is 5 years and the desired rate of return is 20%. The estimated terminal values for the project
A
assets under the three probability alternatives, respectively, are 0, `20,000 and `30,000.
You are required to:
(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability of occurrence of the worst case, if the cash flows are perfectly positively correlated
over time.
[(i) `746.52 (ii) (`4,019), `6,336 (iii) 0.1]
10.2 [C.A.] Cyber Company is considering two mutually exclusive projects. Investment outlay of both the
projects is `5,00,000 and each is expected to have a life of 5 years. Under three possible situations their annual
cash flows and probabilities are as under:
Cash flow (`)
Situation Probability Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7%, which project should be accepted? Explain with workings.
[Project A– NPV `11.4 lakhs, S.D. `1.55 lakhs; Project B– NPV `11.4 lakhs, S.D. `0.77 lakhs]

10.3 [C.M.A. twice] Forward Looking Ltd. is preparing their budget for 2006. In the preparation of the
budget, they would like to take no chances, but would like to envisage all sorts of possibilities and incorporate
them in the budget. Their estimates are as under:
(a) If the worst possible happens, sales will be 8,000 units at a price of `19 per unit. The material cost will be
`9 per unit, the direct labour `2 per unit and the variable overheads will be `1.50 per unit. The fixed cost
will be `60,000 p.a.
(b) If the best possible happens sales will be 15,000 units at a price of `20 per unit. The material cost will be
`7 per unit, direct labour `3 per unit & variable overhead will be `1 per unit. The fixed cost will be `48,000
p.a.
(c) It is most likely however that the sales will be 2,000 units above the worst possible level at a price of `20
per unit. The material cost, direct labour and variable overheads will be respectively `8, `3 and `1 per unit.
The fixed cost will be `50,000 p.a.
(d) There is a 20% probability that the worst will happen, a 10% probability that the best will happen and a
70% probability that the most likely outcome will occur.
What will be the expected value of profit as per the budget for 2006?
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[`28,100]
10.4 [C.A.] Following are the estimates of the net cash flows and probability of a new project of M/s X Ltd.:
ha
Year P=0.3 P=0.5 P=0.2
Initial investment 0 `4,00,000 `4,00,000 `4,00,000
Estimated net after tax cash
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inflows per year 1 to 5 `1,00,000 `1,10,000 `1,20,000
Estimated salvage value (after tax) 5 `20,000 `50,000 `60,000
Required rate of return from the project is 10%.
G
Find:
(i) the expected NPV of the project.
(ii) the best case and the worst case NPVs.
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(iii) the probability of occurrence of the worst case if the cash flows are
(a) perfectly dependent overtime
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(b) independent overtime.

(iv) Standard deviation and coefficient of variation assuming that there are only three streams of cash flow,
which are represented by each column of the table with the given probabilities.
(v) Coefficient of variation of X Ltd. on its average project which is in the range of 0.95 to 1.0. If the coefficient
.S
of variation of the project is found to be less riskier than average, 100 basis points are deducted from the
Company’s cost of Capital.
Should the project be accepted by X Ltd?
A
[(i) `39,813 (ii) Best case `92,060, Worst case (`8,580) (iii) (a) 0.3 (b) 0.00243 (iv) `39,813 (v) `51,851]
10.5 [C.A.] XV Ltd. has under its consideration a project with an initial investment of `1,00,000. Three probable
C
cash inflow scenarios with their probabilities of occurrence have been estimated as below:
Probability 0.1 0.7 0.2
The project life is 5 years and the desired rate of return is 20%. The estimated terminal values for the project
assets under the three probability alternatives, respectively, are 0, `20,000 and `30,000.
(i) Find the probable NPV;
(ii) Find the worst-case NPV and the best-case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly positively correlated over
time.
Simulation
Simulation analysis is used in capital budgeting when the variables involved may have values in different
permutations & combinations. A model is created for solving the problems and usually computers are used to
compute the results from a large number of runs involving different combinations of the variables. The average
of such computations is then used for decision making.
There are different methods of simulation of which Monte Carlo Method is the most popular and easiest to
use. For setting up the model, the parameters and variables are to be identified. Parameters are held constant
for all simulation runs; e.g. initial outlay, discounting rate, life of project, fixed operating cost, etc. Variables
could be: selling price, variable cost per unit, demand in units, etc. Random numbers from 00 to 99 are used in
simulation.
Steps in simulation –
(1) The different values that each variable can have & the probability of that each value are determined.
(2) The cumulative probability is determined for each variable and a range of random numbers is assigned
to each cumulative probability. The total of the probabilities is 1 (i.e. 100%) and the two digit random
numbers range from 00 to 99, i.e. 100 random numbers, is used so that it corresponds to the cumulative
probability. For example, the selling price of a product proposed to be manufactured may be `10, `12 or `15
with probabilities 0.4, 0.4 & 0.2 respectively. This random number range assigned would be as follows:
Selling price Probability Cumulative Random number
probability Range assigned
`10 0.4 0.4 00-39
`12 0.4 0.8 40-79
`15 0.2 1.0 80-99
A random number range is assigned to each variable in the model.
(3) A set is a combination of the variables selected for the simulation. A set of all variables is selected for a run;
e.g. selling price, variable cost, demand in units is a set of variables. Each variable is assigned a random
number. The value of each variable is then determined from the range it falls in and its value corresponding
to the range assigned in step 2 above. For example, selling price in the set is assigned a random number 52,
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it falls in the range 40-79 which corresponds to the selling price `12.
(4) Many runs are conducted with a large number of sets having different combination of variables and the
average of these runs is obtained as the value required for decision making.
Problems – Simulation using Monte Carlo Method

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11.1 [C.A.] The management of ABC company is considering the question of marketing a new product. The
fixed cost required in the project is `4,000. Three factors are uncertain viz., the selling price, variable cost and
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the annual sales volume. The product has a life of only one year. The management has the data on these three
factors as under:
Selling price Probability Variable cost Probability Sales volume Probability
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(`) (`) (units)

3 0.2 1 0.3 2,000 0.3
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4 0.5 2 0.6 3,000 0.3

5 0.3 3 0.1 5,000 0.4
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To consider the following sequence of thirty random numbers:

81, 32, 60, 04, 46, 31, 67, 25, 24, 10, 40, 02, 39, 68, 08, 59, 66, 90, 12, 64, 79, 31, 86, 68, 82, 89, 25, 11, 98,
16.
Using the sequence (First 3 random numbers for the first trial etc.) simulate the average profit for the above
A
project on the basis of 10 trials.

[`2,100]
11.2 [C.A.] A retailer deals in a perishable commodity. The daily demand and supply are variables. The data
for the past 500 days show the following demand and supply:
Supply Demand
Availability (kgs.) No. of days Demand (kgs.) No. of days
10 40 10 50
20 50 20 110
30 190 30 200
40 150 40 100
50 70 50 40
The retailer buys the commodity at `20 per kg. and sells it at `30 per kg. Any commodity remains at the end
of the day, has no saleable value. Moreover, the loss (unearned profit) on any unsatisfied demand is `8 per kg.
Given the following pair of random numbers, simulate 6 days sales, demand and profit: (31, 18) (63, 84) (15,
79) (07, 32) (43, 75) (81, 27).
The first random number in the pair is for supply and the second random number is for demand, viz. in the first
pair (31, 18), use 31 to simulate supply and 18 to simulate demand.

11.3 [C.A.] An investment company wants to study the investment projects based on market demand, profit
and the investment required, which are independent of each other. Following probability distributions are
estimated for each of these three factors:
Annual demand (‘000 units) 25 30 35 40 45 50 55
Probability 0.05 0.10 0.20 0.30 0.20 0.10 0.05
Profit per unit 3 5 7 9 10
Probability 0.10 0.20 0.40 0.20 0.10
Investment required (` ‘000) 2,750 3,000 3,500
Using simulation process, repeat the trial 10 times, compute the investment on each trial taking these factors
into trial. What is the most likely return?
Use the following random numbers: (30, 12, 16) (59, 09, 69) (63, 94, 26) (27, 08, 74) (64, 60, 61) (28, 28, 72)
(31, 23, 57) (54, 85, 20) (64, 68, 18) (32, 31, 87).
In the bracket above, the first random number is for annual demand, the second one is for profit and the last one
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is for the investment required.
[Investment `29.75 lakhs; Return 7.845%]
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11.4 [C.M.A., C.A.] A company uses a high grade raw material. The consumption pattern is probabilistic as
given below and it takes two months to replenish stocks:
Consumption (tonnes per month) 1 2 3 4
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Probability 0.15 0.30 0.45 0.10
The cost of placing an order is `1,000 and the cost of carrying stocks is `50 per month per ton. The average
carrying costs are calculated on the stocks held at the end of each month.
G
The company has two options for the purchase of raw materials as under:
Option I – Order for 5 tons when the closing inventory of the month plus outstanding order is less than 8
tons.
Option II – Order for 8 tons when the closing inventory of the month plus order outstanding is less than 8
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tons.
Currently on 1st April 2014, the company has a stock of 8 tons of raw materials plus 6 tons ordered two months
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ago. The order quantity is expected to be received next month.

Using the random numbers given below, simulate 12 months consumption till 31-3-2015 and advise the company
as to which purchase option should be accepted such that the inventory costs are minimum. Random numbers
.S
are: 88, 41, 67, 63, 48, 74, 27, 16, 11, 64, 49, 21.
[Cost: Option I `7,200, Option II `5,350]
11.5 [C.A.] A company trading in motor vehicle spares wishes to determine the level of stock it should carry
A
for the item in its range. Demand is not certain and replenishment of stock takes 3 days. For one item X, the
following information is obtained:
Demand (units per day) 1 2 3 4 5
C
Probability 0.1 0.2 0.3 0.3 0.1

Each time an order is placed, the company incurs an ordering cost of `20 per order. The company also incurs
carrying cost of `2.50 per unit per day. The inventory carrying cost is calculated on the bash of average stock.
The manager of the company wishes to compare two options for his inventory decision.
A. Order 12 units when the inventory at the beginning of the day plus order outstanding is less than 12 units.
B. Order 10 units when the inventory at the beginning of the day plus order outstanding is less than 10 units.
Currently (on first day) the company has a stock of 17 units. The sequence of random number to be used is 08,
91, 25, 18, 40, 27, 85, 75, 32, 52 using first number for day one.
You are required to carry out a simulation run over a period of 10 days, recommend which option the manager
should chose.
[Cost: Option A `276.25, Option B `228.75]
11.6 [C.A.] For a washing powder manufacturing factory, frequency distribution of contribution (i.e. sale price
– variable cost) per unit, annual demand and requirement of investment were found as follows:
Contribution per unit (`) 3 5 7 9 10
Relative frequency 0.1 0.2 0.4 0.2 0.1
Annual demand (‘000 units) 20 25 30 35 40 45 50

Relative frequency 0.05 0.10 0.20 0.30 0.20 0.10 0.05
Required investment (` ‘000) 1,750
2,000
2,500
Relative frequency 0.25 0.50 0.25
Consider the random numbers 93, 03, 51, 59, 77, 61, 71, 62, 99, 15 for using Monte Carlo simulation for 10
runs to estimate the percentage of return on investment (ROI %) defined as:
Cash inflow
ROI = × 100
Investment
Recommend an optimum investment strategy based on model value of ROI%.
[Invest `20 lakhs, ROI 12.25%]
11.7 [C.A.] A Publishing house has bought out a new monthly magazine, which sells at `37.50 per copy. The
cost of producing it is `30 per copy. A Newsstand estimates the sales pattern of the magazine as follows:
Demand copies Probability
0 < 300 0.18
300 < 600 0.32
600 < 900 0.25
900 < 1200 0.15
1200 < 1500 0.06
1500 < 1800 0.04
The newsstand has contracted for 750 copies of the magazine per month from the publisher.
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The unsold copies are returnable to the publisher who will take them back at cost less `4 per copy for handling
charges.
The newsstand manager wants to simulate of the demand and profitability. The following random number may
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be used for simulation: 27, 15, 56, 17, 98, 71, 51, 32, 62, 83, 96, 69
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(i) Allocate random numbers to the demand pattern forecast by the newsstand.
(ii) Simulate twelve months sales and calculate the monthly and annual profit/loss.
(iii) Calculate the loss on lost sales.
C
[Annual profit `54,000; Loss on lost sales `15,750]
Decision Tree
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A decision tree is a diagram of the problem and the various outcomes that will arise from the different decisions
which can be taken at each decision point. The decision tree itself does not provide a solution to the problem but
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only makes it easier to understand. The symbols used in a decision tree diagram are:
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Symbol Usage
Used for decision node

A
Used for chance node
Problems – Decision tree analysis

12.1 [C.A., C.S.] A firm has an investment proposal, requiring an outlay of `40,000. The investment proposal
is expected to have 2 years’ economic life with no salvage value. In Year-1, there is a 0.4 probability that cash
flow after tax (CFAT) will be `25,000 and 0.6 probability that CFAT will be `30,000. The probabilities assigned
to CFAT for the Year-2 are as follows:
If CFAT = `25,000 If CFAT = `30,000
Amount (`) Probability Amount (`) Probability
12,000 0.2 20,000 0.4
16,000 0.3 25,000 0.5
22,000 0.5 30,000 0.1
The firm uses a 10% discount rate for this type of investment. You are required to –
(i) Present the above information in the form of a decision tree.
(ii) Find out the NPV under (a) the worst outcome; and (b) under the best outcome.

(iii) Find out the profitability or otherwise of the above investment proposal.
[(ii) Worst outcome NPV is (`7,363). The best outcome NPV `12,050, (iii) NPV `3,112]
12.2 [C.A.] Big Oil is wondering whether to drill for oil in Westchester County. The prospects are as follows:
Depth of Well Total cost Cumulative probability PV of oil (if found)
in feet millions of dollars of finding oil in millions of dollars
2,000 4 0.5 10
4,000 5 0.6 9
6,000 6 0.7 8
Draw a decision tree showing successive drilling decisions to be made by Big Oil. How deep should it be prepared
to drill?
[Drill up to 2,000 ft.]
12.3 [C.A.] A firm has an investment proposal, requiring an outlay of `40,000. The investment proposal is
expected to have 2 years’ economic life with no salvage value. In year I, there is a 0.4 probability that cash
inflow after tax will be `25,000 and 0.6 probability that cash inflow after tax will be `30,000. The probabilities
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assigned to cash inflows after tax for the year II are as follows: (`)
Cash inflow Year I 25,000 30,000
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Cash inflow Year II Probability Probability
12,000 0.2 20,000 0.4
16,000 0.3 25,000 0.5
22,000 0.5 30,000 0.1
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The firm uses a 10% discount rate for this type of investment.
Required:
(a) Construct a decision tree for the proposed investment project.
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(b) What net present value will the project yield if worst outcome is realized? What is the probability of
occurrence of this NPV?
(c) What will be the best and the probability of that occurrence?
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(d) Will the project be accepted?
(Discount factor @ 10% 1 year - 0.909; 2 year - 0.826)
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[(b) (`7,363), 8% (c) `12,050, 6% (d) Yes, ENPV `3,112]

12.4 [C.A.] A firm has an investment proposal, requiring an outlay of `80,000. The investment proposal is
expected to have two years economic life with no salvage value. In year 1, there is a 0.4 probability that cash
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inflow after tax will be `50,000 and 0.6 probability that cash inflow after tax will be `60,000. The probability
assigned to cash inflow after tax for the year 2 are as follows:
The cash inflow year 1 `50,000 `60,000
A
The cash inflow year 2 Probability Probability

`24,000 0.2 `40,000 0.4
`32,000 0.3 `50,000 0.5
C
`44,000 0.5 `60,000 0.1

The firm uses a 10% discount rate for this type of investment.
Required:
(i) Construct a decision tree for the proposed investment project & calculate the expected net present value.
(ii) What net present value will the project yield; if worst outcome is realized? What is the probability of
occurrence of this NPV?
(iii) What will be the best outcome and the probability of that occurrence?
(iv) Will the project be accepted?
(Note - 10% discount factor 1 year 0.909, 2 year 0.826)
[(i) `6,224 (b) (`1,178), 0.08 (c) `24,100, 0.06 (d) Yes]
12.5 [C.A.] A businessman has an option of selling a product either in domestic market or in export market.
The available relevant data are given below:
Items Export Market Domestic Market
Probability of selling 0.6 1.0
Probability of keeping delivery schedule 0.8 0.9
Penalty for not meeting delivery schedule (`) 50,000 10,000

Selling price (`) 9,00,000 8,00,000
Cost of third party inspection (`) 30,000 Nil
Probability of collection of sale amount 0.8 0.9
If the product is not sold in foreign market, it can always be sold in domestic market. There are no other
implications like interest and time.
(i) Draw the decision tree using the data given above.
(ii) Should the businessman go for selling the product in the foreign market? Justify your answer.
[(ii) No. Foreign market EMV `6,99,200; Domestic market EMV `7,19,000]
12.6 [C.M.A.] Lucky Computer Stores is making a business plan for the next five years. Sales growth over
the past 2 years has been good. Sales would grow substantially if a major electronics firm is established in the
vicinity as proposed by an investor.
Lucky Computers see 3 options:
(i) to enlarge the current store
(ii) to relocate it at a new site and
(iii) to simply wait and do nothing.
The decision to expand or move would take little time and therefore, the stores would not lose revenue. If nothing
were done in the first year and strong growth occurred, then the decision to expand would be reconsidered.
Waiting longer than one year would allow competition to move in, making expansion no longer feasible.
The assumptions and conditions are:
– Strong growth, emanating from the new electronics firm has a probability of 55%.
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– Strong growth with new site would give annual returns of `1,95,000 p.a.
– Weak growth with a new site would mean annual returns of `1,15,000 p.a.
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– Strong growth with expansion would yield annual returns of `1,90,000 p.a.
– Weak growth with expansion would mean annual returns of `1,00,000 p.a.
– There would be returns of `1,70,000 p.a. at the existing store with no changes in case of strong growth and
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returns of `1,05,000 if growth is weak.
– Expansion at current site would cost `87,000
C
– A shift to the new site would cost `2,10,000
– In case of strong growth, if existing site is enlarged during the 2nd year, the cost would still be `87,000.
Which option should Lucky Computer Stores take, if operating costs for all options are equal?
h
[Do nothing at all.]
Capital Rationing
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Rationing[1] needs to be done for capital available for investment in different projects when the amount available
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for investment is less than the total cost of all the projects available. Under such circumstances, simply choosing
the project with the highest NPV may not be the solution. The capital rationing may be for a single period or
multi-period. The projects could be divisible or indivisible. The following situations may arise:
(a) Single period capital rationing with divisible projects: When funds are in short supply every
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rupee counts and hence the net benefit or NPV for every rupee invested is important. In this case we find the
Net Present Value Index (NPVI) for each project as follows:
NPV
NPVI = [This is also called ‘net benefit index’]
Cost of project
Projects are ranked on the basis of NPVI in descending order. Funds are assigned to the projects on the basis
of ranks and if the cost of any project exceeds the balance available then only a fraction of that project is
undertaken. Profitability Index (PI), instead of NPVI, gives the same result.
(b) Single period capital rationing with indivisible projects: In this case we find the NPV of the
projects and rank the projects from the highest to the lowest NPV. Different combination of projects are
selected to find the highest possible total NPV while ensuring that total cost of selected projects does exceed
the available cost. As far as possible the entire amount of funds should be utilized. However, it is possible
that the combination with the highest total NPV may leave some surplus cash. The surplus cash may be
assumed to be invested at the cost of capital and hence having a zero NPV. However, if it is specified that
surplus cash will be invested at a specified rate which is below or above the cost of capital then the surplus
cash will also have some NPV which may be negative or positive and such amount should also be taken into
consideration.
1 Allotting a limited portion.

The solution to this situation can also be obtained by setting-up a linear programming problem.
(c) Multi-period capital rationing with divisible projects: This is a situation where budget constraints
apply for more than one year and the projects are also divisible in nature. Such a situation is best resolved
by linear programming.
(d) Multi-period capital rationing with indivisible projects: This is a situation where budget
constraints apply for more than one year but the projects are indivisible in nature. Such a situation is also
best resolved by linear programming.
Problems – Capital rationing situations

13.1 [C.M.A.] In a capital rationing situation (investment limit `25 lakhs), suggest the most desirable feasible
combination on the basis of the following data (indicate justification)
Project Initial outlay NPV
` in lakhs ` in lakhs
A 15 6
B 10 4.5
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C 7.5 3.6
D 6 3
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Project B and C are mutually exclusive.
[Project A & B]
13.2 [C.S.] A company is considering three methods of attracting customers to expand its business by
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undertaking – (A) advertising campaign; (B) display of neon signs; and (C) direct delivery service. The initial
outlay for each alternative is as under:
A `1,00,000
B `1,50,000
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C `1,50,000
If A is carried out, but not B, it has an NPV of `1,25,000. If B is done, but not A, B has an NPV of `45,000.
However, if both are done, then NPV is `2,00,000. The NPV of the delivery system C is `90,000. Its NPV is not
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dependent on whether A or B is adopted and the NPV of A or B does not depend on whether C is adopted.
Which of the investments should be made by the company if (i) firm has no budget constraint; and (ii) the
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budgeted amount is only `2,50,000?

[(i) All (ii) A & C]
13.3 [C.S.] The total available budget for a company is `20 crores and the total cost of the projects is `25 crores.
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The projects listed below have been ranked in the order of profitability. There is a possibility of submitting X
project where cost is assumed to be `13 crores and it has the Profitability Index of 140.
Project Cost (` crores) P.I.
A 6 150
A
B 5 125
C 7 120
C
D 2 115
E 5 110
25
Which projects, including X should be acquired by the company?
[Projects X and A]
13.4 [C.A.] Alpha Limited is consider five capital projects for the years 2008 and 2009. The company is financed
by equity entirely and its cost of capital is 12%. The expected cash flows of the projects are as below:
Year end cash flows (` ‘000)
Project 2008 2009 2010 2011
A (70) 35 35 20
B (40) (30) 45 55
C (50) (60) 70 80
D – (90) 55 65
E (60) 20 40 50
Note: Figures in brackets represent cash outflows.
All projects are divisible i.e. size in investment can be reduced if necessary in relation to availability of funds.
None of the projects can be delayed or undertaken more than once.

Calculate which projects Alpha Limited should undertake if the capital available for investment is limited to
`1,10,000 in 2008 and with no limitation in subsequent years. For year analysis, use the following present value
factor:
Year 2008 2009 2010 2011
Factor 1.00 0.89 0.80 0.71
[Projects E, B & C]
13.5 [C.A., C.M.A.] S Ltd. has `10,00,000 allocated for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined:
Project Amount (`) Profitability Index
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and there is no
alternative use of the money allocated for capital budgeting.
[Projects 3, 4 & 5. NPV `1,91,000]
13.6 [C.M.A.] KPR is evaluating six capital investment projects. The company has allocated `20,00,000 for
capital budgeting purposes. The relevant particulars of the projects, which are independent of one another, are
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as follows:
Project Investment Profitability
needed (`) index
P1 10,00,000
P2 3,00,000
1.21
0.94
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P3 7,00,000 1.20
P4 9,00,000 1.18
P5 4,00,000 1.20
C
P6 8,00,000 1.05
If there is strict capital rationing, which of the projects should be undertaken?
[Projects 3, 4 & 5. NPV `3,82,000]
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13.7 [C.A.] Five Projects M, N, O, P and Q are available to a company for consideration. The investment
required for each project and the cash flows it yields are tabulated below. Projects N and Q are mutually
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exclusive. Taking the cost of capital @ 10%, which combination of projects should be taken up for a total capital
outlay not exceeding `3 lakhs on the basis of NPV and Benefit-Cost Ratio (BCR)?
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Project Investment (`) Cash flow p.a. (`) No. of years P.V. @ 10%
M 50,000 18,000 10 6.145
N 1,00,000 50,000 4 3.170
O 1,20,000 30,000 8 5.335
A
P 1,50,000 40,000 16 7.824

Q 2,00,000 30,000 25 9.077
[Projects M, N & P]
Inflation
Inflation reduces the purchasing power of money. For example, what can be purchased today for `1 may be
available for `1.05 after one year and for `1.12 after two years. This is different from time value of money; it
refers to value of money in real terms. In other words, `1.05 after one year has the same purchasing power as `1
today. If there is no inflation then the real value of money will not decrease but money will still have time value.
Cash flows for a project may be expressed in money terms or real terms. For example, a project has cash flows as
follows: Year 1 `1,00,000 and Year 2 `1,00,000. These cash flows are in money terms, i.e. they do not take into
consideration the real value of money at the end of Year 1 and Year 2. The inflow of `1,00,000 at the end of one
year will have less purchasing power as compared to the current purchasing power of `1,00,000. If inflation is
5%, then in real terms CF at the end of one year = 1/1.05 × 1,00,000 = `95,238. Thus, CF given in money
terms can be converted into real term CF and vice versa.
The rate used for discounting CF can be adjusted so as to remove the effect of inflation. A Money Discount Rate
(MDR) can be used to find PV of money CF. A MDR is higher than the normal discount rate so as to take care of

inflation. The normal discounting rate is called Real Discount Rate (RDR). If CF are in real terms then we can
use RDR to find the PV of CF. MDR can be computed as follows for a given Inflation Rate (IR):
1+MDR = (1+RDR) (1+ IR)
!! While solving problems it should be ensured that if CF are in real terms then RDR should be used for discounting.
Whereas, if the CF are in money terms then the MDR should be used for discounting. Usually, in questions, either
the CF or the discounting rate needs to be converted from real term to money term or vice versa. If a single fixed rate
of inflation is given in the problem then either the CF or the discounting rate can be converted. However, inflation
may not be constant over a period of time or different rates of inflation may be applicable to different costs which
affect CF. Under these circumstances it is convenient to convert money term CF to real term CF. See conversion
below.
Converting discounting rate

If there is a constant inflation rate given and cash flows are nominal cash flows then it will be convenient to
convert the real discount rate to nominal/money discount rate. For example, company’s cost of capital is 10%
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and inflation rate is 5% constant. MDR = (1.10)(1.05) – 1 = 1.155 – 1 = 0.155 or 15.5%. The PV factor can
be computed on the calculator as 1 ÷ 1.155 and so on. However, if inflation is 5% in first year & 8% in second
year and so on then it will not be possible to find MDR as we have more than one rate of inflation. In this case
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we have to convert the nominal cash flows to real cash flows and use the RDR for discounting.
Converting cash flows
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You should know how to convert cash flow in any case.
(a) Converting real cash flows to nominal cash flows: Two situations are possible –
(i) Inflation is constant over the years: Lets say inflation is constant 5% and real cash flows are Year 1
`5,000, Year 2 `6,000 then the nominal cash flows will be –
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Year 1 = `5,000 × 1.05 = `5,250
Year 2 = `6,000 × 1.05 × 1.05 = `5,512.50 or `5,513 (rounded)
(ii) Inflation is not constant over the years: Lets say inflation is 5% in first year & 8% in second year and
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real cash flows are Year 1 `5,000, Year 2 `6,000 then the nominal cash flows will be –
Year 1 = `5,000 × 1.05 = `5,250
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Year 2 = `6,000 × 1.05 × 1.08 = `5,670

(b) Converting nominal cash flows to real cash flows: Two situations are possible –
(i) Inflation is constant over the years: Lets say inflation is constant 5% and nominal cash flows are Year
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1 `10,000, Year 2 `12,000 then the nominal cash flows will be –

1
Year 1 = `10,000 × = `9,523.81 i.e. `9,524 (rounded)
1.05
1 1
A
Year 2 = `12,000 × × = `10,884.35 i.e. 10,884 (rounded)

1.05 1.05
(ii) Inflation is not constant over the years: Lets say inflation is 5% in first year & 8% in second year and
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real cash flows are Year 1 `10,000, Year 2 `12,000 then the nominal cash flows will be –
1
Year 1 = `10,000 × = `9,523.81 i.e. `9,524 (rounded)
1.05
1 1
Year 2 = `12,000 × × = `10,582.01 i.e. `10,582 (rounded)
1.05 1.08
Problems – Capital budgeting decisions in inflationary conditions

14.1 [C.A.] Shashi Co. Ltd. has projected the following cash flows from a project under evaluation:
Year 0 1 2 3
` (in lakhs) (72) 30 40 30
The above cash flows have been made at expected prices after recognizing inflation. The firm’s cost of capital is
10%. The expected annual rate of inflation is 5%. Show how the viability of the project is to be evaluated. PVF at
10% for 1-3 years are 0.909, 0.826 and 0.751.
[NPV `3.45 lakhs]
14.2 [C.A.] A firm has projected the following cash flows from a project under evaluation:
Year 0 1 2 3
` (in lakhs) (70) 30 40 30
The above cash flows have been made at expected prices after recognizing inflation. The firm’s cost of capital is
10%. The expected annual rate of inflation is 5%.
Show how the viability of the project is to be evaluated.
[NPV `5.41 lakhs]
14.3 [C.M.A.] A company is considering a cost saving project. This involves purchasing a machine costing
`7,000 which will result in annual savings on wage costs of `1,000 and on material costs of `400.
The following forecasts are made of the rates of inflation each year for the next 5 years:
Wage costs 10%, Material costs 5%, General prices 6%
The cost of capital of the company, in monetary terms, is 15%.
Evaluate the project, assuming that the machine has a life of 5 years and no scrap value.
[NPV (`1,067)]
14.4 [C.M.A.] A firm is considering an investment of `75,000 on a machine with a life of 4 years and nil
residual value. This machine will produce to sell at `60 for a quantity of 1,000 units. The estimated cost of each
unit manufactured would be.
`
Materials 10
Labour (10 hrs @ `2 per hr.) 20
Variable overheads (10 hrs @ `0.50 per hr.) 5
35
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Due to inflationary conditions, material costs, overheads and selling prices are expected to increase at the rate of
15% per annum and labour costs are expected to increase at the rate of 20% per annum.
The discount rate to be used is 20%
Year
1
2
Discount Factor
0.83
0.69 ss
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3 0.59
4 0.48
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Is the purchase of new machine worth in terms of its net present value?
[NPV `7,084]
14.5 [C.S.] Evaluate the feasibility or otherwise of a project keeping in view the following data:
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(i) The nominal rate of return is 14%.

(ii) The expected rate of inflation over life is 7%.
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(iii) Cash flows of the project are as under:

Year 0 1 2 3 4
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Cash flows (`) (10,000) 3,000 3,000 3,000 3,000

Also find out the real rate of return.
[(i) NPV of the project `269, (ii) Real rate of return 6.54%]
A
14.6 [C.M.A.] D Ltd. has under review a project involving the outlay of `55,000 and expected to yield the
following net cash savings in current terms:
Year 1 2 3 4
` 10,000 20,000 30,000 5,000
The company’s cost of capital, incorporating a requirement for growth in dividends to keep pace with cost
inflation is 20%, and this is used for the purpose of investment appraisal. On the above basis the divisional
manager involved has recommended rejection of the proposal.
Having regard to your on forecast that the rate of inflation is likely to be 15% in year 1 and 10%, in each of the
following years, you are asked to comment fully on his recommendation. (Discounting figures at 20% are 0.833,
0.694, 0.579 and 0.482 respectively for year 1 to year 4)
[NPV almost 0. Project may be accepted.]
Real Option – Delay, Abandonment, etc.

Options, as a type of a derivative, is a financial instrument will provides an option to the holder to buy or
sell the asset specified therein. The options available in reality are called real options. The capital budgeting
decisions that we considered earlier were all taken at time 0, i.e. at present. We decided to either accept or reject
a proposal at present. However, in reality, we have options with respect to the project like — delay, adjust the
scale, abandon before expiry of life of the project, etc.
Thus, the capital budgeting proposals can be evaluated from a new perspective as follows:
Project worth = NPV + Option value
Computing option value –
The option value is computed just like NPV but taking only the present values of only outflows & inflows
resulting from the option. If multiple options (say ‘n’) are available then separate value has to be computed for
each option & different project worth will be obtained for each option:
(1) Project worth = NPV + Option 1 value
(2) Project worth = NPV + Option 2 value
[and so on . . . . till]
(nth) Project worth = NPV + Option n value
The combination with the highest project worth will be chosen.
Some examples of computing project worth including options values are:
(1) A firm is evaluating a proposal to manufacture a product which is a completely new product in the country
& so will not face any competition initially. However, the demand for the product is also unknown. After
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conducting a market survey to gauge the consumer’s interest is such a product it makes a conservative
estimate of the likely demand. However, the NPV based on these estimates is negative. Normally, the project
would be rejected. However, if the firm sees a potential future growth and an option to expand its output
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in the future then the NPV of the option to expand should also be calculated. If the NPV of the option is
positive then it is possible that after adding it to the initial NPV the project may be worth taking up.
Project worth = (NPV) + Value of option to expand in future
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(2) A firm has found that a project having a life of 5 years has a negative NPV. It should also take into account
the fact that even if the project is not successful the factory can be sold above its acquisition cost as there
will be appreciation in the value of its land & building. It is even possible to sell it as a going concern to a
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competitor at a profit. If this option is valued then the project may become feasible.
Project worth = (NPV) + Value of option 1 (to sell the factory as going concern)
Project worth = (NPV) + Value of option 2 (to sell the land & building at appreciated value)
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Problems – Decision involving real options
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15.1 [C.A.] Ramesh owns a plot of land on which he intends to construct apartment units for sale. Number
of apartment units to be constructed may be either 10 or 15. Total construction costs for these alternatives are
estimated to be `600 lakhs or `1,025 lakhs respectively. Current market price for each apartment unit is `80
lakhs. The market price after a year for apartment units will depend upon the conditions of market. If the market
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is buoyant, each apartment unit will be sold for `91 lakhs, if it is sluggish, the sale price for the same will be `75
lakhs. Determine the current value of vacant plot of land. Should Ramesh start construction now or keep the
land vacant? The yearly rental per apartment unit is `7 lakhs and the risk free interest rate is 10% p.a.
A
Assume that the construction cost will remain unchanged.

[The land should be kept vacant]
15.2 [C.M.A.] Sumangal Developer, a leading promoter and land developer, intends to construct luxury
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apartments this year or a year hence. The company has already acquired a vacant land in a residential area. Mr.
Mounir, the technical director, along with Mr. Chitto, the financial director, has worked out the following data
to decide on when to construct the apartments:
Current interest rate =12%
Current value of an apartment = `20 lakhs Value of an apartment a year from now:
`26 lakhs under favourable conditions `16 lakhs under unfavourable conditions Construction costs (this year as
well as next year)
For a 8-unit building = `90 lakhs
For a 12-unit building = `120 lakhs
You are required to estimate the value of land using option pricing model approach and decide whether Sumangal
Developer has to construct in the current year or next year, a 8-unit building or a 12-unit building.
[Constructing next year will result in additional income of `13 lakhs.]
15.3 [C.A.] You own an unused Gold mine that will cost `10,00,000 to reopen. If you open the mine, you
expect to be able to extract 1,000 ounces of Gold a year for each of three years. After that the deposit will be
exhausted. The Gold price is currently `5,000 an ounce, and each year the price is equally likely to rise or fall by
`500 from its level at the start of year.

The extraction cost is `4,600 an ounce and the discount rate is 10%.
Required:
(a) Should you open the mine now or delay one year in the hope of a rise in the Gold price?
(b) What difference would it make to your decision if you could costlessly (but irreversibly) shut down the mine
at any stage? Show the value of abandonment option.
[(a) Delay (b) Value of abandonment option `8,538]
15.4 [C.M.A.] Kitkat Ltd. made an investment of `65,000 in a new machine that is expected to bring in the
following cash flows in years 1 and 2:
Particulars Cash flow (`) Cash flow (`) Residual value (`)
Favourable (60%) 52,000 39,000 2,600
Unfavourable (40%) 26,000 19,500 1,300
Should the environment turnout to be unfavourable, the company will dispose of the machine for a value of
`32,500 at the end of year 1. They can nevertheless continue with the machine, if they so choose. Reckoning the
cost of capital at 15%, evaluate the overall investment decision, and decide the course of action for the owner of
the project.
[Note: Discounting/PV factor for Year 1 = 0.870; Year 2 = 0.756]
[If project is unsuccessful & abandoned at the end of: (i) 2 years NPV (`3,649) (ii) 1st year NPV `1,372]
15.5 [C.M.A. twice] The projected cash flows and the expected net abandonment values for a project are
given below:
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Year Cash inflows Abandonment
(`) Value (`)
0 (–) 1,00,000 Nil
ss
1 35,000 65,000
2 30,000 45,000
3 25,000 20,000
la
4 20,000 Nil
Should the project be abandoned and if so, when?
C
Cost of Capital may be taken as 10%.
Given:
Year 0 1 2 3 4
h
PV factor @ 10% 1.000 0.909 0.826 0.751 0.683

[NPV if abandoned at the end of: Year 4 (`10,970), Year 3 (`9,610), Year 2 (`6,235) & Year 1 (`9,100)]
rs
Problems & Solutions

General Problems
da
P-1.1 [C.S. twice] XYZ Ltd. is a manufacturer of high quality running shoes. Devang, President, is considering
computerizing the company’s ordering, inventory and billing procedures. He estimates that the annual savings
A
from computerization include a reduction of 10 clerical employees with annual salaries of `15,000 each, `8,000
from reduced production delays caused by raw materials inventory problems, `12,000 from lost sales due to
inventory stockouts and `3,000 associated with timely billing procedures. The purchase price of the system is
`2,00,000 and installation costs are `50,000. These outlays will be capitalized (depreciated) on a straight line
basis to a zero book salvage value which is also its market value at the end of five years. Operation of the new
system requires two computer specialists with annual salaries of `40,000 per person. Also annual maintenance
and operating (cash) expenses of `12,000 are estimated to be required. The company’s tax rate is 40% and its
required rate of return (cost of capital) for this project is 12%.
You are required to –
(i) find the project’s initial net cash outlay;
(ii) find the project’s operating and terminal value cash flows over its 5-year life;
(iii) evaluate the project using NPV method;
(iv) evaluate the project using PI method;
(v) calculate the project’s payback period;
(vi) find the project’s cash flows and NPV [parts (i) through (iii)] assuming that the system can be sold for
`25,000 at the end of five years even though the book salvage value will be zero; and
(vii) find the project’s cash flows and NPV [parts (i) through (iii)] assuming that the book salvage value for

depreciation purposes is `20,000 even though the machine is worthless in terms of its resale value.
NOTE: (a) Present value of annuity of `1 at 12% rate of discount for 5 years is 3.605.
(b) Present value of `1 at 12% rate of discount, received at the end of 5 years is 0.567.
Soln.
(i) Initial cash outlay
`
Cost of system 2,00,000
Installation cost 50,000
Initial cash outlay 2,50,000
(ii) Computation of operating & terminal value cash flows
Operating cash flows:
`
Savings in salary (10 × `15,000) 1,50,000
Savings due reduction in production delays 8,000
le
Savings by avoiding inventory stockouts 12,000
Savings due to timely billing 3,000
ha
Depreciation (`2,50,000 ÷ 5) – 50,000
Salary of computer specialists (2 × `40,000) – 80,000
Cash operating expenses – 12,000
ok
Savings before tax 31,000
– Tax @ 40% 12,400
Savings after tax 18,600
+ Depreciation 50,000
G
Annual CFAT 68,600
There will be no terminal cash flow as there is no salvage value.
(iii) Computation of NPV
il
Year 12% PV factor CF (`) PV (`)
1-5 3.605 68,600 2,47,303
un
Initial outlay (2,50,000)

NPV – 2,697
The project should be rejected as NPV is negative.
.S
(iv) Computation of Profitability Index

PV of cash inflows 2,47,303
Profitability Index = = = 0.99
Cash outflows 2,50,000
The project is not viable as the P.I. is less than 1.
A
(v) Payback Period

Initial outlay 2,50,000
C
Payback Period = = = 3.65 years

Annual cash inflow 68,600
(vi) Re-computation of cash flow & NPV in case of salvage value of `25,000
Initial outlay will remain unchanged at `2,50,000.
The operating cash flows for the years 1 to 5 will be unchanged at `68,600 p.a.
The terminal cash flow from salvage value will be subject to tax. As book value is nil, the entire sale price
is the profit on sale.
Terminal cash flow:
`
Salvage value 25,000
– Tax @ 40% 10,000
Net terminal cash inflow 15,000
Computation of NPV
1-5 3.605 68,600 2,47,303
5 0.567 15,000 8,505

NPV 5,808
(vi) Computation of cash flows and NPV if terminal book value is `20,000 and market value is nil
Initial outlay will remain unchanged at `2,50,000.
Computation of annual operating cash flows:
`
Savings before tax (as in (ii) above) 31,000
+ Depreciation (as in (ii) above) 50,000
81,000
– Depreciation [(2,50,000 – 20,000) ÷ 5] 46,000
Savings before tax 35,000
– Tax @ 40% 14,000
Savings after tax 21,000
+ Depreciation 46,000
Annual CFAT 67,000
The terminal book value is `20,000. As market value would be nil, it will result in short term capital loss
and tax shield will be the terminal cash inflow.
Tax shield on short term capital loss = 40% of `20,000 = `8,000
Computation of NPV
1-5 3.605 67,000 2,41,535
es
5 0.567 8,000 4,536
Initial outlay
NPV
ss 2,50,000
– 3,929
la
P-1.2 [C.S.] Karishma Ltd. is considering to manufacture a new product which will involve use of a new
machine costing `1,50,000 and an existing machine, which was purchased two year ago at a cost of `80,000,
having current book value of `60,000. There is sufficient under-utilized capacity on this machine. It is also
C
estimated that annual sales of the product will be 5,000 units at `32 per unit with following cost composition:
`
Direct material 7
h
Direct labour (4 hrs per unit @ `2/hr) 8

Fixed cost (including depreciation) 9
rs
24
The project would have a five year life, with residual value of `10,000 for new machine. Direct labour being
da
continuously in short supply, the labour resources would have to be diverted from other work, currently earning
a profit of `1.50 per direct labour hour. Fixed overheads absorption rate would be `2.25 per hour and actual
expenditure on fixed overheads will not change.
A
The requirement of working capital would be `10,000 in the first year, `15,000 in the second and subsequent
years till the end of the project when it will be recovered. The company’s cost of capital is 20%.
Ignoring tax implications, decide if the project is worth accepting.
Soln. Computation of initial outlay
`
Cost of machine 1,50,000
Working capital of 1st year 10,000
Variable cost per unit (material & labour) = 7 + 8 = `15
Contribution per unit = Selling price – Variable cost
= 32 – 15 = `17 per unit
Depreciation per year = (1,50,000 – 10,000) ÷ 5 = `28,000
Cash fixed cost p.a. = Total fixed cost p.a. – Depreciation p.a.
= (`9 × 5,000) – 28,000 = `17,000
Total labour hours required for 5,000 units = 5,000 × 4 hrs = 20,000 hours
Profit foregone as labour is diverted = `1.50 × 20,000 = `30,000
Annual cash flow from operations

Note: Depreciation is irrelevant as tax implications are to be ignored.
`
Total contribution (5,000 × `17) 85,000
Cash fixed cost – 17,000
Profit foregone – 30,000
Net cash flow from operations 38,000
Net cash flow for 1st year
Cash from operations 38,000
Additional working capital required – 5,000
33,000
Cash flow of 5th year
Cash from operations 38,000
Working capital released 15,000
Scrap value of machine 10,000
le
63,000
Computation of NPV
ha
Year 20% PV factors CF (`) PV (`)
1 0.833 33,000 27,489
2 0.694 38,000 26,372
ok
3 0.579 38,000 22,002
4 0.482 38,000 18,316
5 0.402 63,000 25,326
G
Initial outflow 1,60,000
NPV – 40,495
The project should not be undertaken as NPV is negative.
il
P-1.3 [C.S.] Playmates Ltd. manufactures toys and other short-lived fad items. The research and development
un
department has come up with an item that would make a good promotional gift for office equipment dealers.
As a result of efforts by the sales personnel, the firm has commitments for this product. To produce the quantity
demanded, Playmates Ltd. will need to buy additional machinery and rent additional space. It appears that
about 25,000 sq. ft. will be needed; 12,500 sq. ft. of presently unused space, but leased at the rate of `3 per sq.
.S
ft. per year, is available. There is another 12,500 sq. ft. adjoining the facility available at the annual rent of `4
per sq. ft.
The equipment will be purchased for `9,00,000. It will require `30,000 in modifications and `1,50,000 for
A
installation. The equipment will have a salvage value of about `2,80,000 at the end of the third year. It is subject
to 25% depreciation on reducing balance basis. The firm has no other assets in this block. No additional general
overheads costs are expected to be incurred.
C
The estimates of revenues and costs for this product for three years have been developed as follows:
Particulars Year 1 Year 2 Year 3
` ` `
Sales 10,00,000 20,00,000 8,00,000
Less: Costs:
Material, labour & overheads 4,00,000 7,50,000 3,50,000
Overheads allocated 40,000 75,000 35,000
Rent 50,000 50,000 50,000
Depreciation 2,70,000 2,02,500 Nil
Total Cost 7,60,000 10,77,500 4,35,000
Earnings before taxes 2,40,000 9,22,500 3,65,000
Less: Taxes 84,000 3,22,875 1,27,750
Earnings after taxes 1,56,000 5,99,625 2,37,250
If the company sets a required rate of return of 20% after taxes, should-this project be accepted?
NOTE: PV factor @ 20% for Year 1 = 0.833; Year 2 = 0.694; and Year 3 = 0.579.
Soln. Computation of initial outlay
`

Cost of equipment 9,00,000
Modification cost 30,000
Installation cost 1,50,000
Computation of tax rate
84,000
Tax rate for Year 1 = × 100 = 35%
2,40,000
Similar computation for year 2 and 3 show that the tax rate is steady 35%.
Computation of terminal cash flow
Cost of equipment 10,80,000
Depreciation (2,70,000 + 2,02,500) 4,72,500
Book value after 3 years 6,07,500
Scrap value 2,80,000
Loss on sale of equipment 3,27,500
Tax shield on above @ 35% 1,14,625
Terminal cash inflow = 2,80,000 + 1,14,625 = `3,94,625
Computation of cash flows
Earnings before tax (as given) 2,40,000 9,22,500 3,65,000
Overhead allocated (no cash outflow) 40,000 75,000 35,000
es
Loss of rental income (12,500 sq. ft. × `3) – 37,500 – 37,500 – 37,500
Adjusted earnings before tax 2,42,500 9,60,000 3,62,500
ss
– Tax @ 35% 84,875 3,36,000 1,26,875
Earnings after tax 1,57,625 6,24,000 2,35,625
Depreciation 2,70,000 2,02,500 –
la
Terminal cash flow 3,94,625
CFAT 4,27,625 8,26,500 6,30,250
C
Computation of NPV
Year 20% PV factors CF (`) PV (`)
1 0.833 4,27,625 3,56,212
h
2 0.694 8,26,500 5,73,591

3 0.579 6,30,250 3,64,915
rs

NPV 2,14,718
da
The project can be accepted as NPV is positive.

When no revenues are generated
A
2.1 Sell-Well Ltd. plans to install a large stamping machine. Two machines being considered are as follows:
Machine-A : It costs `50,000 and will require cash running expenses of `15,000 per annum. It has a useful life
of 6 years and, thereafter, it is expected to yield `2,000 as salvage value.
Machine-B : It costs `65,000 and its running expenses are `12,000 per annum. It has a useful life of 10 years
and, thereafter, salvage value of `5,000.
Both machines would be depreciated on straight line basis. Corporate tax rate is 50%. Cost of capital is 10%.
Which machine should be bought by the Sell-Well Ltd.?
Soln. Annual cash outflow
Machine A
Depreciation per year = (50,000 – 2,000) ÷ 6 = `8,000
CFAT for first five years:
Cash operating expenses after tax [15,000 (1 – 0.5)] 7,500
Tax shield on depreciation (50% of 8,000) – 4,000
CFAT 3,500
CFAT for the sixth year:
CFAT as above 3,500

Salvage value of machine – 2,000
CFAT 1,500
Machine B
Depreciation per year = (65,000 – 5,000) ÷ 10 = `6,000
CFAT for first nine years:
Cash operating expenses [12,000 (1 – 0.5)] 6,000
Tax shield on depreciation (50% of 6,000) – 3,000
CFAT 3,000
CFAT for the tenth year:
CFAT as above 3,000
– Salvage value of machine 5,000
CFAT – 2,000
Computation of PV of total cash outflows
Year 10% PV factor Machine A Machine B
le
CF PV CF PV
0 1.00 50,000 50,000 65,000 65,000
ha
1-5 3.79 3,500 13,265
6 0.56 1,500 840
1-9 5.76 3,000 17,280
ok
10 0.39 – 2,000 – 780
PV of total cash outflows 64,105 81,500
On comparing the PV of cash outflows it appears that Machine A is better as cash outflow is lower. However,
as the life of the machines is different it is better to evaluate the proposals on the basis of equalized annual
G
outflows as follows:
Equalized annual outflow
Total cash outflows 64,105 64,105
il
Machine A = = = = `14,727
Cumulative total of PVIF 3.79 + 0.56 4.35
un
Total cash outflows 81,500 81,500

Machine B = = = = `13,252
Cumulative total of PVIF 5.76 + 0.39 6.15
On the basis of annualized cash outflows, Machine B is better.
.S
Replacement of Asset
P-3.1 [C.S.] An existing company has a machine which has been in operation for 2 years. Its remaining estimated
useful life is 10 years, with no salvage value at the end. Its current market value is `1,00,000. The management
A
is considering a proposal to purchase an improved model of a similar machine, which gives increased output.
The relevant particulars are as follows:
Particulars Existing machine New machine
C
Purchase price `2,40,000 `4,00,000

Estimated life 12 years 10 years
Salvage value Nil Nil
Annual operating hours 2,000 2,000
Output per hour 15 units 30 units
Material cost per unit `2 `2
Labour cost per hour `20 `40
Consumable stores per year `2,000 `5,000
Repairs and maintenance per year `9,000 `6,000
Working capital `25,000 `40,000
The company follows the straight line method of depreciation and is subject to 50% tax. Should the existing
machine be replaced? Assume that the company’s required rate of return is 15%.
Note:
(i) Present value of annuity of `1 at 15% rate of discount for 10 years is 5.019.
(ii) Present value of `1 at 15% rate of discount, received at the end of 10th year is 0.247.
Soln. Tax shield on sale of old machine:

Cost of old machine 2,40,000
– Deprn. for 2 years (2,40,000 × 2/12) 40,000
W.D.V. on date of sale 2,00,000
Sold for 1,00,000
Short-term capital loss 1,00,000
Tax shield on short-term capital loss (0.5 × 1,00,000) 50,000
Computation of initial outlay
` `
Cost of new machine 4,00,000
Additional working capital 15,000
4,15,000
– Scrap value of old machine 1,00,000
Tax shield on loss on sale 50,000 1,50,000
Computation of incremental cash flows
Existing output = 2,000 hours × 15 units = 30,000 units
Output with new machine = 2,000 hours × 30 units = 60,000 units
Variable cost & contribution per unit:
Existing New
es
machine machine
Material cost 2.00 2.00
Labour (`20 ÷ 15 & `40 ÷ 30) 1.33 1.33
ss
Variable cost per unit 3.33 3.33
Selling price per unit 10.00 10.00
Contribution per unit 6.67 6.67
la
Incremental contribution per year:
`
C
Total contribution with new machine (`6.67 × 60,000) 4,00,000
Total contribution with existing machine (`6.67 × 30,000) 2,00,000
Incremental contribution 2,00,000
h
Fixed cost per annum:

Existing New
rs
machine machine
Consumable stores 2,000 5,000
Repairs & maintenance 9,000 6,000
da
Total fixed cost 11,000 11,000

There is no incremental fixed cost.
Incremental depreciation
A
Depreciation on new machine (4,00,000 ÷ 10) 40,000

Existing depreciation (2,40,000 ÷ 12) 20,000
Incremental depreciation 20,000
Incremental cash inflow per year
`
Incremental contribution 2,00,000
Incremental deprecation – 20,000
Incremental profit before tax 1,80,000
Less: Tax @ 50% 90,000
Incremental profit after tax 90,000
Add: Depreciation 20,000
Incremental CFAT 1,10,000
Computation of NPV
1-10 5.019 1,10,000 5,52,090
10 0.247 15,000 3,705
PV of incremental inflows 5,55,795
Net cash outflow 2,65,000
NPV 2,90,795
The existing machine should be replaced as NPV is positive.
P-3.2 [C.S.] A product is currently being manufactured on a machine that has a book value of `30,000. The
machine was originally purchased for `60,000 ten years ago. The per unit costs of the product are:
Direct labour `8.00, Direct materials `10.00, Variable overheads `5.00, Fixed overheads `5.00, and total cost
is `28.00. In the past year 6,000 units were produced and sold for `50.00 per unit. It is expected that the old
machine can be used indefinitely in the future.
An equipment manufacturer has offered to accept the old machine at `20,000, a trade in for a new version. The
purchase price of the new machine is `1,00,000. The projected per unit costs associated with the new machine
are direct labour `4.00, direct materials `7.00, variable overheads `4.00, fixed overheads `7.00 and total cost is
`22.00.
The management also expects that, if the new machine is purchased, the new working capital requirement of
the company would be less by `10,000. The fixed overheads costs are allocations from other departments plus
le
the depreciation of the equipment. The new machine has an expected life of ten years with no salvage value, the
straight line method of depreciation is employed by the company. It is also expected that the future demand of
ha
the product would remain at 6,000 units per year.
Should the new equipment be acquired? Corporate tax is @ 50%.
Note: (i) Present value of annuity of `1.00 at 10% rate of discount for 9 years is 5.759.
(ii) Present value of `1.00 at 10% rate of discount, received at the end of 10th year is 0.386.
ok
Soln. Initial Outlay
` `
G
Scrap value of old machine 20,000
Tax shield on loss on sale (`10,000 × 0.5) 5,000
Working capital released 10,000 35,000
Cash outflow 65,000
il
Variable cost per unit
Old New
un
machine machine
Total cost 28.00 22.00
– Fixed cost 5.00 7.00
.S
Variable cost per unit 23.00 15.00

Selling price per unit 50.00 50.00
Contribution per unit 27.00 35.00
Incremental contribution
A
`
Expected contribution (6,000 × `35) 2,10,000
C
– Current contribution (6,000 × `27) 1,62,000

Incremental contribution 48,000
`
Deprecation of new machine (1,00,000 ÷ 10) 10,000
– Depreciation of old machine (60,000 ÷ 20) 3,000
Fixed Cost
Fixed costs are not relevant as the same are allocated and no additional cash will be paid for the same.
Computation of incremental cash flows per year
`
Incremental contribution 48,000
Incremental depreciation – 7,000
Incremental profit before tax 41,000
Tax @ 50% 20,500
Add: Depreciation 7,000

Incremental cash inflows per year 27,500
10% annuity factor for 10 years = 5.759 + 0.386 = 6.145
Computation of NPV
1-10 6.145 27,500 1,68,988
Cash outflow 65,000
NPV 1,03,988
The new equipment should be acquired as the NPV is positive
P-3.3 [C.S., C.M.A.] A product is currently manufactured in a machine that is not fully depreciated for tax
purpose and has a book value of `60,000 (it was bought for `1,20,000 six years ago). The cost of the product is
as under:
(unit cost `)
Direct cost 24
Indirect labour 8
Other variable overheads 16
Fixed overheads 16
64
Normally 10,000 units of the product are produced. It is expected that the old machine can be used indefinitely
into the future, after suitable repairing estimated to cost `40,000 annually is carried out.
There is an offer for a new machine with latest improved technology at `3,00,000 after trading off the old
es
existing machinery for `30,000. The projected cost of the product will then be as under:
(unit cost `)
ss
Direct cost 14
Indirect labour 12
Other variable overheads 12
la
Fixed overheads 20
58
The fixed overheads are allocations from other departments plus the depreciation of the plant and machinery.
C
The old machine can be sold in the open market for `40,000. The new machine will last for 10 years at the end
of which it will have a salvage value of `20,000. Assume rate of corporate tax at 50%. For tax purpose the cost of
the new machine and that of the old one may be depreciated in 10 years. The minimum rate of return expected
h
is 10%. It is also expected that the future demand of the product will remain steady at 10,000 units.
rs
Advise whether the new machine should be purchased. Ignore capital gains tax.
Present value of `1 at 10% for 10 years are:
Year 1 2 3 4 5 6 7 8 9 10
da
P.V. 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
Soln. Initial outlay
A
– Sale of old machine 30,000

`
Depreciation on new machine [(3,30,000 – 20,000) ÷ 10] 31,000
Depreciation on existing machine (60,000 ÷ 10) 6,000
Computation of cash inflows
Variable cost per unit with old machine = 64 – 16 = `48
Variable cost per unit with new machine = 58 – 20 = `38
Savings per unit (incremental contribution) = 48 – 38 = `10
`
Incremental contribution (10,000 × `10) 1,00,000
Savings in repairs cost of old machine 40,000
Incremental depreciation – 25,000
Incremental profit before tax 1,15,000
Tax @ 50% 57,500

Add: Incremental depreciation 25,000
CFAT per annum 82,500
Computation of NPV
Year 10% PV factor CF PV
1-10 6.144 82,500 5,06,880
10 (Scrap value) 0.386 20,000 7,720
Cash outflow 3,00,000
NPV 2,14,600
The old machine should be replaced as NPV is positive.
Risk Analysis: S.D., C.V., Hillier’s Model, R.A.D.R., Certainty Equivalent
P-4.1 [C.M.A.] Based on the data given below, ascertain which of the two projects would be more risky based
le
on the criteria of coefficient of variation?
Project - A Project - B
ha
Cash Flow (`) Probability Cash Flow (`) Probability
3,000 0.10 2,000 0.10
3,500 0.20 3,000 0.25
4,000 0.40 4,000 0.30
ok
4,500 0.20 5,000 0.25
5,000 0.10 6,000 0.10
Soln. Computation of EV of cash flows of the projects
Project A
G Project B
Cash flow Probability EV Cash flow Probability EV
3,000 0.10 300 2,000 0.10 200
3,500 0.20 700 3,000 0.25 750
il
4,000 0.40 1,600 4,000 0.30 1,200
4,500 0.20 900 5,000 0.25 1,250
un
5,000 0.10 500 6,000 0.10 600

4,000 4,000
Coefficient of Variation (C.V.) of project A
.S
x = EV = `4 thousand
Cash flow d = x – x d2 p pd2
` ‘000
3.0 – 1.00 1.00 0.10 0.10
A
3.5 – 0.50 0.25 0.20 0.05

4.0 0 0 0.40 0
C
4.5 0.50 0.25 0.20 0.05

5.0 1.00 1.00 0.10 0.10
s2 = 0.30
s = 0.30 = `0.548 thousand or `5,480
s 0.548
C.V. = × 100 = × 100 = 13.7%
x 4
Coefficient of Variation of project Y

x = EV = `4 thousand
ash flows
C d = x – x d2 p pd2
` ‘000
2 – 2 4 0.10 0.40
3 – 1 1 0.25 0.25
4 0 0 0.30 0
5 1 1 0.25 0.25
6 2 4 0.10 0.40
s2 = 1.30

s = 1.30 = `1.140 thousand or `1,140
s 1.14
C.V. = × 100 = × 100 = 28.5%
x 4
The C.V. of project Y is higher and therefore it is more risky.

P-4.2 [C.A.] Project X and Project Y are under the evaluation of XY Co. The estimated cash flows and their
probabilities are as below:
Project X : Investment (year 0 ) `70 lakhs
Probability weights 0.30 0.40 0.30
Years ` lakhs ` lakhs ` lakhs
1 30 50 65
2 30 40 55
3 30 40 45
Project Y : Investment (year 0) `80 lakhs.
Probability weights Annual cash flows through life
` lakhs
0.20 40
0.50 45
0.30 50
(a) Which project is better based on NPV criterion with a discount rate of 10%?
es
(b) Compute the standard deviation of the present value distribution and analyze the inherent risk of the
projects.
Soln. (a) Computation of NPV
Project X
Year Cash flow (` lakhs)
ss PVF PV (` lakhs)
la
1 (30 × 0.3) + (50 × 0.4) + (65 × 0.3) = 48.5 0.909 44.09
2 (30 × 0.3) + (40 × 0.4) + (55 × 0.3) = 41.5 0.826 34.28
C
3 (30 × 0.3) + (40 × 0.4) + (45 × 0.3) = 38.5 0.751 28.91
PV of inflows 107.28
Initial outlay 70.00
h
NPV 37.28
Project Y
rs
Year Cash flow (`) PVF PV (` lakhs)

1-3 (40 × 0.2) + (45 × 0.5) + (50 × 0.3) = 45.5 2.486 113.11
da

NPV 33.11
On the basis of NPV project X is better because of higher NPV.
A
(b) Computation of standard deviation of the PV distribution

Computation of standard deviation of cash flows –
Project X
The mean cash flows for Years 1, 2 & 3 are x1 = `48.5 lakhs, x2 = 41.5 lakhs & x3 = `38.5 lakhs
Year 1 : s = (30 − 48.5)2 + (50 − 48.5)2 + (65 − 48.5)2 = `24.83 lakhs
Year 2 : s = (30 − 41.5)2 + (40 − 41.5)2 + (55 − 41.5)2 = `17.80 lakhs
Year 3 : s = (30 − 38.5)2 + (40 − 38.5)2 + (45 − 38.5)2 = `10.81 lakhs

Project Y
The cash flow for three years is an annuity with average cash flow x = `45.5 lakhs. The standard deviation of
the cash flows is:
s= (40 − 45.5)2 + (45 − 45.5)2 + (50 − 45.5)2 = `7.12 lakhs

Standard deviation of PV distribution using Hillier’s Model
To find the S.D. of the PV distribution (and not the NPV) the Hillier’s Model has been modified to include the
cash flow of Year 0, i.e. the initial outlay.

n
s t2
sPV = ∑ (1 + r )2t
t =0
Project X
− 702 24.832 17.802 10.812 4,900 617 317 117
sPV = + + + = + + +
1.10 2× 0
1.10 2×1
1.10 2× 2
1.102×3 1 1.21 1.464 1.772
= 4,900 + 510 + 217 + 66 = `75.45 lakhs
Project Y
− 802 7.122 7.122 7.122 6,400 51 51 51
sPV = + + + = + + +
1.10 2× 0
1.10 2×1
1.10 2× 2
1.102×3 1 1.21 1.464 1.772
= 6,400 + 42 + 35 + 29 = `80.66 lakhs

The deviation in the PV distribution of project X is lower and therefore it is less risky.
le
Overall, project X is better because of higher NPV and lower risk.
P-4.3 [C.A. twice, C.S.] Determine the risk adjusted net present value of the following projects:
ha
Project-A Project-B Project- C
Net cash outlay (`) 1,00,000 1,20,000 2,10,000
Project life (Years) 5 5 5
ok
Coefficient of variation 0.4 0.8 1.2
The company selects the risk adjusted rate of discount on the basis of coefficient of variation:
Coefficient of Risk Adjusted
Variation Rate of Discount
G
0.0 10%
0.4 12%
0.8 14%
il
1.2 16%
1.6 18%
un
2.0 22%
More than 2.0 25%
Soln. Identification of R.A.D.R. for each project
.S
Project A = 12%
Project B = 14%
Project C = 16%
Computation of NPV of the projects using R.A.D.R.
A
Project A
Year 12% Annuity factor CF PV
C
1-5 3.6048 30,000 1,08,144

NPV 8,144
Project B
1-5 3.4331 42,000 1,44,190
NPV 24,190
Project C
1-5 3.2743 70,000 2,29,201
NPV 19,201
P-4.4 [C.A.] The Globe Manufacturing Co. Ltd. is considering an investment in one of the two mutually
exclusive proposals– Project X and Y, which require cash outlays of `3,40,000 and `3,30,000 respectively. The
certainty-equivalent (C.E.) approach is used in incorporating risk in capital budgeting decisions. The current
yield on government bonds is 8% and this is used as the risk free rate. The expected net cash flows and their
certainty equivalents are as follows:
Project X Project Y
1 1,80,000 0.8 1,80,000 0.9
2 2,00,000 0.7 1,80,000 0.8
3 2,00,000 0.5 2,00,000 0.7
Present value factors of `1 discounted at 8% at the end of year 1, 2 and 3 are 0.926, 0.857 and 0.794 respectively.
Required: (i) Which project should be accepted? (ii) If risk adjusted discount rate method is used, which project
would be appraised with a higher rate & why?
Soln. (i) Computation of NPV
Project X
Year Cash flow (`) CE Certain CF (`) 8% PVIF PV (`)
1 1,80,000 0.8 1,44,000 0.926 1,33,344
2 2,00,000 0.7 1,40,000 0.857 1,19,980
3 2,00,000 0.5 1,00,000 0.794 79,400
PV of inflows 3,32,724
NPV – 7,276
Project Y
es
Year Cash flow (`) CE Certain CF (`) 8% PVIF PV (`)
1 1,80,000 0.9 1,62,000 0.926 1,50,012
2 1,80,000 0.8 1,44,000 0.857 1,23,408
3 2,00,000
PV of inflows
0.7 1,40,000
ss 0.794 1,11,160
3,84,580
la
NPV 54,580
C
Project Y should be accepted because NPV is positive.
(ii) In the Risk Adjusted Discount Rate method, the project with higher risk gets appraised with a higher rate. A
lower certainty would indicate higher risk. The sum total of the certainty equivalent will indicate the certainty of
h
the cash flows from the two projects:

Sum total of certainty equivalents –
rs
Project X = 0.8 + 0.7 + 0.5 = 2.0

Project Y = 0.9 + 0.8 + 0.7 = 2.4
da
Project X is riskier as the sum of its certainty equivalents is lower and therefore it will be appraised at a higher
rate.
Sensitivity Analysis
A
P-5.1 [C.M.A., C.S.] The initial investment outlay for a capital investment project consists of `100 lakhs for
plant & machinery and `40 lakhs for working capital. Other details are summarized below:
Sales : 1 lakh units of output per year for years 1 to 5
Selling price : `120 per unit
Variable cost : `60 per unit
Fixed overhead (excluding depreciation) : `15 lakhs per year for years 1 to 5
Rate of depreciation on plant & machinery : 25% on WDV method
Salvage value of plant & machinery : Equal to WDV at the end of year 5
Applicable tax rate : 40%
Time horizon : 5 years
Post-tax cut off rate : 12%
Required:
(a) Indicate the financial viability of the project by calculating the net present value.
(b) Determine the sensitivity of the project’s NPV under each of the following conditions: (i) Decrease in selling
price by 5%, (ii) Increase in variable cost by 10% & (iii) Increase in cost of plant & machinery by 10%.
Soln. Initial outlay
` lakhs
Plant & machinery 100.00
Working capital 40.00
Computation of depreciation
Year 1 2 3 4 5
` lakhs ` lakhs ` lakhs ` lakhs ` lakhs
Opening bal. 100.00 75.00 56.25 42.18 31.63
Depreciation 25.00 18.75 14.07 10.55 7.91
Closing bal. 75.00 56.25 42.18 31.63 23.72
Computation of CFAT
Contribution per unit = `120 – `60 = `60
Total contribution per annum = 1,00,000 units × `60 = `60 lakhs
Year 1 2 3 4 5
` lakhs ` lakhs ` lakhs ` lakhs ` lakh
Total Contribution 60.00 60.00 60.00 60.00 60.00
le
Less: Fixed cost
Fixed overhead – 15.00 – 15.00 – 15.00 – 15.00 – 15.00
ha
Depreciation – 25.00 – 18.75 – 14.07 – 10.55 – 7.91
Profit before tax 20.00 26.25 30.93 34.45 37.09
Tax @ 40% – 8.00 – 10.50 – 12.38 – 13.78 – 14.84
Profit after tax 12.00 15.75 18.55 20.67 22.25
ok
Add: Depreciation 25.00 18.75 14.07 10.55 7.91
Operating cash flows 37.00 34.50 32.62 31.22 30.16
Salvage value 23.72
G
Working capital released 40.00
CFAT 37.00 34.50 32.62 31.22 93.88
(a) Computation of NPV
Year 12% PVIF CF ` lakhs PV ` lakhs
il
0 1.000 – 140.00 – 140.00
un
1 0.893 37.00 33.05

2 0.797 34.50 27.50
3 0.712 32.62 23.23
4 0.636 31.22 19.86
.S
5 0.567 93.88 53.23

NPV 16.87
(b) Sensitivity of the project’s NPV
A
(i) Sensitivity to decrease in selling price by 5%

Decrease in selling price per unit = `120 × 5% = `6
Decrease in revenue per year = `6 × 1,00,000 units = `6 lakhs
C
Decrease in post-tax revenue per year = `6 lakhs (1 – 0.4) = `3.60 lakhs

PV of decrease in revenue over five years = `3.60 lakhs × 3.605 = `12.98 lakhs
As PV of cash inflows decreases by `12.97 lakhs NPV will decrease by same amount.
12.98
Decrease in NPV = × 100 = 76.94%
16.87
(ii) Sensitivity to increase in variable cost by 10%
Increase in variable cost per unit = `60 × 10% = `6
Annual increase in outflow = `6 × 1,00,000 units = `6 lakhs
This is effectively decrease in cash inflow by `6 lakhs
This is similar to (i) above and therefore decrease in NPV by `12.98 lakhs or 76.94% as computed in
(i) above.
(iii) Sensitivity to increase in cost of plant & machinery cost by 10%
Initial outlay
` lakhs
Plant & machinery (`100 lakhs × 1.10) 110
Working capital 40
Initial outlay 150
Depreciation
Year 1 2 3 4 5
` lakhs ` lakhs ` lakhs ` lakhs ` lakhs
Opening bal. 110.00 82.50 61.87 46.40 34.80
Depreciation 27.50 20.63 15.47 11.60 8.70
Closing bal. 82.50 61.87 46.40 34.80 26.10
Computation of cash flows
Year 1 2 3 4 5
` lakhs ` lakhs ` lakhs ` lakhs ` lakh
Total Contribution 60.00 60.00 60.00 60.00 60.00
Less: Fixed cost
Fixed overhead – 15.00 – 15.00 – 15.00 – 15.00 – 15.00
Depreciation – 27.50 – 20.63 – 15.47 – 11.60 – 8.70
Profit before tax 17.50 24.37 29.53 33.40 36.30
Tax @ 40% – 7.00 – 9.75 – 11.82 – 13.36 – 14.52
Profit after tax 10.50 14.62 17.71 20.04 21.78
Add: Depreciation 27.50 20.63 15.47 11.60 8.70
Operating cash flows 38.00 35.25 33.18 31.64 30.48
Salvage value 26.10
Working capital released 40.00
CFAT 38.00 35.25 33.18 31.64 96.58
es
Computation of NPV
Year 12% PVIF CF ` lakhs PV ` lakhs
0 1.000 – 140.00 – 150.00
1
2
0.893
0.797
38.00
35.25
ss
33.94
28.10
la
3 0.712 33.18 23.63
4 0.636 31.64 20.13
C
5 0.567 96.58 54.76
NPV 10.56
Decrease in NPV = `16.87 lakhs – `10.56 lakhs = `6.31 lakhs
h
6.31
Decrease in NPV = × 100 = 37.41%
16.87
rs
P-5.2 [C.A.] From the following details relating to a project, analyze the sensitivity of the project to changes in
initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (`) 1,20,000
da
Annual Cash Inflow (`) 45,000

Project Life (Years) 4
Cost of Capital 10%
A
To which of the three factors, the project is most sensitive? (Use annuity factors: for 10% 3.169 and 11% 3.109).
Soln. Computation of NPV
`
PV of cash inflows (`45,000 × 3.169 ) 1,42,605
Initial Project Cost – 1,20,000
NPV 22,605
NOTE: Since only the annuity factors given in the question are to be used and cost of capital is one of the factors
for testing the sensitivity, the percentage change in this factor has to be taken into consideration. The annuity
factors for 10% & 11% are given in the question, i.e. an increase of 10%. Hence, the sensitivity of the factors for
a 10% change has been tested.
(i) Sensitivity of the project to project cost
If project cost increases by 10%, i.e. `12,000, the NPV will decrease by `12,000
12,000
Sensitivity to project cost = × 100 = 53.08%
22,605
A reduction of 53.08%.
(ii) Sensitivity of the project to annual cash flow
If the annual cash flow are reduced by 10% then the revised annual cash flow will be:

Revised annual cash flow = 90% × `45,000 = `40,500
Revised NPV –
`
PV of cash inflows (`40,500 × 3.169) 1,28,345
NPV 8,345
Reduction in NPV = 22,605 – 8,345 = `14,260
14,260
Sensitivity to cash flow = × 100 = 63.08%
22,605
A reduction of 63.08%
(iii) Sensitivity of the project to cost of capital
If the cost of capital increases from 10% to 11% then the revised NPV would be –
`
PV of cash inflows (`45,000 × 3.109) 1,39,905
le
NPV 19,905
Reduction in NPV = 22,605 – 19,905 = `2,700
ha
2,700
Sensitivity to cash flow = × 100 = 11.94%
22,605
A reduction of 11.94%.
ok
Of all the factors, a reduction in cash flows causes the maximum reduction in the NPV and hence the project is
most sensitive to cash flows.
Scenario Analysis
G
P-6.1 [C.S.] Surya Manufacturers is planning to start a new manufacturing process. Following are the estimated
net cash flows and probabilities of the new manufacturing process:
Year Net Cash Flows (`)
il
p = 0.2 p = 0.6 p = 0.2
0 – 2,00,000 – 2,00,000 – 2,00,000
un
1 40,000 60,000 80,000

2 40,000 60,000 80,000
3 40,000 60,000 80,000
.S
4 40,000 60,000 80,000

5 40,000 60,000 80,000
5 (Salvage) 0 40,000 60,000
Surya Manufacturers’ cost of capital for an average risk project is 10%.
A
(a) The project has average risk. Find the project’s NPV.
(b) Find the best case and worst case NPVs. What is the probability of occurrence of the worst case if the cash
C
flows are perfectly dependent (perfectly positively correlated) over time and if they are independent over
time?
(c) Assume that all the cash flows are perfectly positively correlated, that is, there are only three possible cash
flows streams over time: (i) the worst case; (ii) the most likely or base case; and (iii) the best case with
probabilities 0.2, 0.6 and 0.2 respectively. These cases are represented by each of the columns in the given
table. Find the expected NPV, the standard deviation and co-efficient of variation.
Soln.
(a) Computation of NPV
Annual Cash flow for Years 1-5 = (0.2 × 40,000) + (0.6 × 60,000) + (0.2 × 80,000)
= `60,000
Cash flow Year 5 (salvage value) = 0 + (0.6 × 40,000) + (0.2 × 60,000) = `36,000
NPV
Year 10% Factor CF (`) PV (`)
1-5 3.791 60,000 2,27,460
5 0.621 36,000 22,356
Initial outlay – 2,00,000

NPV 49,816
(b) Best case and worst case NPV and probability
Best case NPV –
1-5 3.791 80,000 3,03,280
5 0.621 60,000 37,260
NPV 1,40,540
Worst case NPV –
1-5 3.791 40,000 1,51,640
NPV – 48,360
Probability of occurrence of worst case –
If cash flows are dependent (perfectly positively correlated) over time:
Probability of occurrence = 0.2
If cash flows are independent over time:
Probability of occurrence = 0.2 × 0.2 × 0.2 × 0.2 × 0.2
= 0.00032
es
(c) To find the Expected NPV if cash flows are perfectly dependent we need to find the NPV of the project
under each of the three situation: (i) worst, (ii) most likely and (iii) best. Out of these cases (i) and (iii)
ss
are already computed in part (b)
NPV under most likely case
Year 10% Factor CF PV
la
1-5 3.791 60,000 2,27,460
5 0.621 40,000 24,840
C
NPV 52,300
h
The expected NPV

Case Probability NPV Expected NPV
rs
Worst 0.2 – 48,360 – 9,672

Most likely 0.6 52,300 31,380
da
Best 0.2 1,40,540 28,108

Expected NPV 49,816
Computation of Standard Deviation and Co-efficient of Variation
A
x = ENPV = `49,816 or `0.50 lakhs

Case NPV (x) d = (x – x) d2 p pd2
` lakhs
Worst – 0.48 – 0.98 0.9604 0.2 0.19208
Base 0.52 0.02 0.0004 0.6 0.00024
Best 1.41 0.91 0.8281 0.2 0.16562
s2 = 0.35794
Standard deviation (s) = s2 = 0.35794 = `0.59828 lakhs or `59,828
s 59,828
Co-efficient of variation = = = 1.2 or 120%
x 49,817
Simulation
7.1 [C.M.A.] The Everalert Ltd., which has a satisfactory preventive maintenance system in its plant, has
installed a new Hot Air Generator based on electricity instead of fuel oil for drying its finished products. The
Hot Air Generator requires periodicity shutdown maintenance. If the shutdown is scheduled yearly, the cost of
maintenance will be as under:
Maintenance cost (`) 15,000 20,000 25,000

The costs are expected to be almost linear, i.e. if the shutdown is scheduled twice a year the maintenance cost
will be double.
There is no previous experience regarding the time taken between breakdowns. Costs associated with breakdown
will vary depending upon the periodicity of maintenance. The probability distribution of breakdown cost is
estimated as under:
Breakdown costs (` p.a.) Shutdown once a year Shutdown twice a year
75,000 0.2 0.5
80,000 0.5 0.3
1,00,000 0.3 0.2
Simulate the total costs (maintenance and breakdown costs) and recommend whether shutdown overhauling
should be resorted to once a year or twice a year?
Soln. Alternative I – Shutdown once a year
Assigning random numbers to maintenance cost:
le
Cost (`) Probability Cum. probability Random numbers assigned
15,000 0.30 0.30 00 - 29
20,000 0.40 0.70 30 - 69
ha
25,000 0.30 1.00 70 - 99
Assuming random numbers to breakdown costs:
Cost (Rs.) Probability Cum. probability Random numbers
ok
75.000 0.20 0.20 00 - 19
80.000 0.50 0.70 20 - 69
1.00.000 0.30 1.00 70 - 99
Calculation of Average Annual Total Cost:
G
Year Random Maintenance Random Breakdown Total
numbers cost (`) numbers cost (`) cost (`)
1 27 15,000 03 75,000 90,000
il
2 44 20,000 50 80,000 1,00,000
3 22 15,000 73 1,00,000 1,15,000
un
4 32 20,000 87 1,00,000 1,20,000

5 97 25,000 59 80,000 1,05,000
Total 5,30,000
Average annual cost (`5,30,000 ÷ 5) 1,06,000
.S
Alternative II – Shutdown once a year

Assigning random numbers to maintenance cost:
A
30,000 0.30 0.30 00 - 29

40,000 0.40 0.70 30 - 69
50,000 0.30 1.00 70 - 99
C
Assigning random numbers to breakdown costs:

75,000 0.50 0.50 00 - 49
80,000 0.30 0.80 50 - 79
1,00,000 0.20 1.00 80 - 99
Calculation of Average Annual Total Cost
Year Random Maintenance Random Breakdown Total
numbers cost (`) numbers cost (`) cost (`)
1 42 40,000 54 80,000 1,20,000
2 04 30,000 65 80,000 1,10,000
3 82 50,000 49 75,000 1,25,000
4 38 40,000 03 75,000 1,15,000
5 91 50,000 56 80,000 1,30,000
Total 6,00,000
Average annual cost (`6,00,000 ÷ 5) 1,20,000
Shutdown maintenance/overhauling once a year will be more economical as the average annual cost will only
be `1,06,000 compared to `1,20,000 if shutdown is twice a year.

.6) `24,000
e ss (0
A 0)
B
Succ
en t
`12,000

6,00
Failu
r Curr
(` e (0.
4) 3
R 2:
Current Roya
l
0.1) 2 `12,000 ty (`
5,00
da
ure ( Roy 0) `20,000
Fail a lty
) A (`5
,00
0 ,000 Succ 0) `20,000
R1: (`1 ess (
`26,000
0.9)
rs
Current
1 Royalty: (`5,000)
`12,000
h
`20,000 .9) `26,000
e ss (0
Succ
R2 :
(`6,
000
) Succ
ess (0.6) `24,000
C 00 ) D
en t
`12,000
10,0
Failu
r Curr
C (` e (0.
1) 5
Failu R 1:
r Current Roya
l
e (0.
4) 4
la `12,000 ty (`
5,00
Roy 0) `20,000
a lty
(`5
,00
0)
ss
`20,000
es
Decision Tree for P-8.1
P-7.2 [C.M.A.] The top management of a company is considering the problem of marketing a new product.
The investment or the fixed cost, required in the project is `15,000. The three factors that are uncertain are the
selling price, variable cost and the annual sales volume. The product has a life of only one year. The management
has collected the following data regarding the possible levels of these three factors. The factors are independent
of each other:
Selling Probability Variable Probability Sales volume Probability
price/unit (`) cost/unit (`) units
14 0.35 2 0.30 3,000 0.25
15 0.50 3 0.50 4,000 0.40
16 0.15 4 0.20 5,000 0.35
Using the Monte Carlo Simulation, determine the expected profit from the above investment on the basis of 10
trials and using the following 3 series of ten Random numbers each.
Series 1 : 18, 71, 32, 55, 31, 20, 48, 73, 75, 03
Series 2 : 81, 93, 18, 97, 21, 83, 94, 19, 90, 02
Series 3 : 67, 63, 39, 55, 29, 78, 70, 06, 78, 76
le
Soln. Allocation of random numbers to selling price
Selling price (`) Probability Cum. probability Random numbers assigned
ha
14 0.35 0.35 00-34
15 0.50 0.85 35-84
16 0.15 1.00 85-99
Allocation of random numbers to variable cost
ok
Variable cost (`) Probability Cum. probability Random numbers assigned
2 0.30 0.30 00-29
3 0.50 0.80 30-79
G
4 0.20 1.00 80-99
Allocation of random numbers for sales volume
Sales volume Probability Cum. probability Random numbers assigned
3,000 0.25 0.25 00-24
il
4,000 0.40 0.65 25-64
5,000 0.35 1.00 65-99
un
Calculation of Expected Profit using Monte Carlo Simulation on the basis of 10 trails
Trial Series 1 Selling Series 2 Variable Series 3 Sales Fixed Profit
No. R.N. price R.N. cost R.N. volume cost
.S
(`) (`) (units) (`) (`)

1 18 14 81 4 67 5,000 15,000 35,000
2 71 15 93 4 63 4,000 15,000 29,000
3 32 14 18 2 39 4,000 15,000 33,000
A
4 55 15 97 4 55 4,000 15,000 29,000

5 31 14 21 2 29 4,000 15,000 33,000
6 20 14 83 4 78 5,000 15,000 35,000
C
7 48 15 94 4 70 5,000 15,000 40,000

8 73 15 19 2 06 3,000 15,000 24,000
9 75 15 90 4 78 5,000 15,000 40,000
10 03 14 02 2 76 5,000 15,000 45,000
Total 3,43,000
Average profit (`3,43,000 ÷ 10) 34,300
The expected profit from the investment is `34,300.
Decision Tree
P-8.1 [C.A.] A company is currently working with a process, which, after paying for materials, labour, etc.
brings a profit of `12,000. The company has the following alternatives;
(i) The company can conduct research R1 which is expected to cost `10,000 and having 90% probability of
success. If successful, the gross income will be `26,000.
(ii) The company can conduct research R2, expected to cost `6,000 and having a probability of 60% success. If
successful, the gross income will be `24,000.
(iii) The company can pay `5,000 as royalty of a new process which will bring a gross income of `20,000.
Because of limited resources, only one of the two types of research can be carried out at a time.

Draw the decision tree and find the optimal strategy for the company.
Soln. For decision tree refer page 64.
Computation of Expected Monetary Value (EMV)
EMV at
Nodes 3 & 5 = Max [(20,000 – 5,000), 12,000] = `15,000
Node B = (0.4 × 15,000) + (0.6 × 24,000) = `20,400
Node 2 = Max [(20,400 – 6,000), 12,000, (20,000 – 5,000)]
= Max [14,400, 12,000, 15,000] = `15,000
Node A = (0.1 × 15,000) + (0.9 × 26,000) = `24,900
Node D = (0.9 × 26,000) + (0.1 × 15,000) = `24,900
Node 4 = Max [(24,900 – 10,000), 12,000, (20,000 – 5,000)]
= Max [14,900, 12,000, 15,000] = `15,000
Node C = (0.6 × 24,000) + (0.4 × 15,000) = `20,400
Node 1 = Max [(24,900 – 10,000), 12,000, 15,000, (20,400 – 6,000)]
= Max [14,900, 12,000, 15,000, 14,400] = `15,000
Optimal strategy – The company should pay `5,000 as royalty of a new process which will fetch it maximum
expected monetary value of `15,000.
Capital Rationing
es
P-9.1 The Newstar Ltd. is planning its capital expenditure for 2015. Managers from various divisions have
submitted the following projections for consideration:
Project Initial investment (` lakhs) PV of cash flows (` lakhs)
A
B
C
80
40
70 ss 128
90
147
la
D 30 72
E 50 90
C
Project B will start in 2016. The Board of Directors have imposed a budget limit of `140 lakhs for 2015 with no
limit on funds in subsequent years. All projects are divisible but cannot be delayed. Which projects should the
CEO select?
h
Soln. Project B is to start in 2016 and it can be undertaken in that year as there will be no shortage of funds.
Therefore, it need not be considered for selecting projects to be started in 2015.
rs
Computation of NPVI & ranking of projects to be selected in 2015

Project PV of cash flows Cost NPV NPVI Rank
da
` lakhs ` lakhs ` lakhs (NPV ÷ Cost)

A 128 80 48 0.6 IV
C 147 70 77 1.1 II
D 72 30 42 1.4 I
A
E 90 50 40 0.8 III
Projects to be selected in 2015 (on the basis of NPVI)
Cost Cumulative cost
(` lakhs) (` lakhs)
D 30 30
C 70 100
E (partial) 40 140
Inflation
P-10.1 [C.S.] Ash Enterprises Ltd. generated the following forecast in real terms for a capital budgeting project:
(` in ‘000) (` in ‘000) (` in ‘000)
Capital expenditure 1,210 – –
Revenue – 1,900 2,000
Cash expenses – 950 1,000
Depreciation – 605 605
Ash, the President, estimates the inflation to be 10% per year over the next two years. In addition, Ash believes
that the cash flows of the project should be discounted at the nominal rate of 15.5%.

Required (apply tax rate of 30%) –
(i) Workout NPV based on normal cash flow technique.
(ii) Workout NPV based on real cash flow technique.
Soln. (i) NPV on the basis of normal cash flow technique
Nominal cash flows –
Revenue:
Year 1 = 1,900 × 1.10 = `2,090
Year 2 = 2,000 × (1.10)2 = `2,420
Cash expenses:
Year 1 = 950 × 1.10 = `1,045
Year 2 = 1,000 × (1.10)2 = `1,210
Note: Depreciation does not involve cash outflow & therefore not affected by inflation.
Computation of nominal CFAT
Year 1 2
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Revenue 2,090 2,420
Cash expenses – 1,045 – 1,210
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Depreciation – 605 – 605
Profit before tax 440 605
Tax @ 30% 132 182
Net profit 308 423
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+ Depreciation 605 605
CFAT 913 1,028
Computation of NPV
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Year 15.5% PVIF CF (`) PV (`)
0 1.000 – 1,210 – 1,210
1 0.866 913 791
2 0.750 1,028 771
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NPV 352
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(ii) NPV on the basis of real cash flow technique

Computation of real rate –
1 + MDR = (1 + RDR) (1 + IR)
1 + 0.155 = (1 + r) (1 + 0.10)
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1.155 = (1 + r) (1.10)
1.155
1+r =
1.10
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1 + r = 1.05
r = 1.05 – 1 = 0.05 i.e. 5%
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Computation of real CFAT

Year 1 2
Revenue 1,900 2,000
Cash expenses – 950 – 1,000
Depreciation – 605 – 605
Profit before tax 345 395
Tax @ 30% 104 119
Net profit 241 276
+ Depreciation 605 605
CFAT 846 881
Computation of NPV
Year 5% PVIF CF (`) PV (`)
0 1.000 – 1,210 – 1,210
1 0.952 846 805
2 0.907 881 799
NPV 394

Chapter
4
Leasing Decisions
Leasing is an arrangement in which the owner of the asset (lessor) allows another person (lessee) to use the
asset for a pre-defined period for consideration called lease rent. Thus, for using an asset it is not necessary that
it should be purchased. Leasing is an alternative to purchasing the asset.
Advantages to Lessee –
(1) Lease rent is tax deductible and hence results in tax saving.
(2) The lessee is protected against obsolescence.
(3) A financial lease provides finance to acquire an asset but the liability does not appear in the balance sheet
unlike a loan taken for the same purpose.
(4) The lessee may have an option to buy the asset at the end of the lease period at a nominal price.
(5) The lessor may provide 100% finance for the asset but it is not possible to get 100% loan for the asset.
(6) Leasing arrangement takes less time compared to loan approval.
Disadvantages to Lessee –
(1) Lessee cannot claim depreciation for tax benefit as he is not the owner of the asset.
(2) The interest rate on lease is much higher than that of loan.
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(3) Moratorium[1] period is not available as in case of loan. This causes a financial burden on businesses which
are in the process of being set-up.
Advantages to Lessor –
(1) It generates regular income for the lessor.
(2) The yield on lease in more than the yield from pure lending.
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(3) The lessor can claim depreciation on the leased asset and save tax.
(4) The lessor can liquidate the future lease rent receivable by securitization of the debt.
Types of Leasing
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(1) Operating Lease

In this type of lease the period of the lease is relatively small when compared to the life of the asset. The
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lessor does not plan to recover the full cost of the asset from the first lessee. The same asset is leased
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subsequently to other lessees. An operating lease may be cancelled by the lessee at any time. The lessor
usually bears to cost of insurance & maintenance of the asset. The lessee is not given the option to buy the
asset at the end of the lease period. This type of lease is suitable when the lessee is not sure how long the
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asset will be required or the asset is required only for a short period of time or the asset is such that there
are frequent technological changes it becomes obsolete in a short period of time. This method is useful of
leasing computers or office appliances.
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(2) Financial Lease

This type of lease more in the nature of a financing arrangement and is an alternative to taking a loan. The
period of the lease is long, usually almost covering the life of the asset. The lessee cannot cancel the lease
during the initial years where the lessor has to recover the cost of the asset and some income thereon. This
period is called the primary or initial lease period. At the end of the initial lease period an option is given
to the lessee to buy the asset at a very nominal price or he may renew the lease at a very low rental. This is
called the secondary period. The lessee bears the insurance & maintenance cost of the asset. This method
is useful for leasing land, building or large & expensive machinery & equipment.
(3) Buy & Lease Back
In this case, an asset already owned and in use by the lessee is sold to the lessor and the same is then
leased back to lessee under a financial lease. This method helps the lessee to release funds blocked in the
asset.
(4) Leveraged Lease
Normally, the lessor buys an asset with his own funds for earning income in the form of lease rent.
However, in case of very expensive assets, e.g. airplane, the lessor may not have own funds for the purpose
1 Postponement of payment of instalments.

of acquiring an asset. In this case, the lessor acquires the asset by taken a loan from a large financial
institution or bank. This is called leveraged lease.
(5) Sales-Aid Lease
In this case, the lessor has an arrangement with a manufacturer of the asset to market his product and
through his leasing operation. The lessor gets a commission for this purpose. This increases the income of
the lessor though the lessee is not affected.
Evaluation Models
Lessor’s Perspective
From the lessor’s perspective the lease arrangement is a capital budgeting decision. If the NPV of the proposal, at
the cost of capital to the lessor, is zero or positive then the proposal will be acceptable to the lessor. Sometimes,
the lessee may find the borrowing & buying option better than the leasing option. In such a case, the lessor may
reduce the lease rent to match the outflow of the borrowing option in order to convince the lessee to take the
asset on lease. However, the lessor has to ensure that the NPV of such proposal does not become negative. The
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lowest quotation that a lessor can give is the lease rent which will reduce the NPV of the proposal to zero. If the
lease rent is not given in the problem then it can be computed as follows:
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Cost of the asset
Lease rent per annum =
Annuity factor at IRR
Where, IRR is the internal rate of return that is required by the lessor.
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This gives the minimum lease rent acceptable to the lessor.
Lessee’s Perspective
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From the lessee’s perspective the choice between:
(i) borrowing & purchasing [or hire-purchase]; or
(ii) leasing
is to be taken on the basis of the present value of cash outflows.
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There are different methods of evaluation from the lessee’s perspective. Two important models used for
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evaluation are given below:
Present Value of Cash Outflow Method (PVCO Method)

Present value of cash outflow under both options (purchasing vs. leasing) is to be computed and the option with
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lower PV of cash outflows is to be selected. The discounting rate is important.

As leasing is considered as an alternative to buying, the after-tax rate of interest on borrowing should be the
discounting rate. However, if a cost of capital is specified in the problem then it should be used. In any case
discounting of cash outflow for both alternatives is done at the same rate.
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(a) PV of purchasing option: If discounting rate is different from the rate of interest on borrowing then the
amount of loan instalment as well as the break-up of the instalment into principal & interest is important
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because the interest is tax deductible but not the principal. If rate of discounting is the same as the rate of
interest on loan then there is no need to compute the loan instalment because the PV of the instalments is
the loan itself! However, depreciation has to be computed to find the savings due to tax shield which will
reduce the cash outflow. Similarly, the salvage value & the tax on profit/loss on sale of asset will have to be
computed as it reduces the outflow in the last year. Loan instalments may be payable at the beginning or at
the end of each year.
Equated annual instalment including interest is computed as follows:
(i) If loan instalment is payable at the end of the year –
Loan
Equated annual instalment =
Annuity factor @ interest rate on loan
(ii) If loan instalment is payable at the beginning of the year –
Loan
Equated annual instalment =
1 + Annuity factor @ interest rate on loan
!! Normally, loan instalment is payable at the end of the year.
Leasing Decisions Ɩ 69
Net Advantage to Leasing (NAL)
The method presumes that leasing is the preferred choice and hence we proceed to compute the net benefit of
this option. We compute the difference between the benefits and costs of leasing and if this figure is positive
then we accept the leasing alternative. In this method we use different discounting rates:
(i) Lease rent is discounted at the borrowing rate [because it is an alternative to borrowing].
(ii) Tax shield on interest, tax shield on depreciation & net salvage value is discounted at cost of capital.
This computation can be presented as follows:
`
Benefits of Leasing
Savings in initial outlay (cost of asset) xx
PV of tax shield on lease rent [discounted @ cost of capital] xx
Benefits of leasing A xx
Cost of Leasing
PV of lease rent (pre-tax) [discounted @ borrowing rate] xx
PV of tax shield (forgone) on interest [discounted @ cost of capital] xx
PV of tax shield (forgone) on depreciation [discounted @ cost of capital] xx
Benefits of leasing B xx
Net advantage to leasing A – B xx
!! In the above computation the lease rent and the tax shield thereon are discounted at different rates hence the
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pre-tax lease rent is considered in cost of leasing. In examinations, if cost of capital is not given then all figures
should be discounted at the borrowing rate and in this case the after tax lease rent can be used. In such a case,
NAL = Cost of asset – Cost of leasing
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Problems – Lessor’s Perspective, Stepped-up or Stepped-down Lease Rental
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1.1 [C.A.] ABC Leasing Ltd. has been approached by a client to write a five years lease on an asset costing
`10,00,000 and having estimated salvage value of `1,00,000 thereafter. The company has an after tax required
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rate of return of 10% and its tax rate is 50%. It provides depreciation @ 33% on written down value of the asset.
What lease rental will provide the company its after tax required rate of return?
[`3,08,530]
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1.2 [C.A.] Armada Leasing Company is considering a proposal to lease out a school bus. The bus can be
purchased for `5,00,000 and, in turn, be leased out at `1,25,000 per year for 8 years with payments occurring
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at the end of each year:

(i) Estimate the internal rate of return for the company assuming tax is ignored.
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(ii) What should be the yearly lease payment charged by the company in order to earn 20% annual compounded
rate of return before expenses and taxes?
(iii) Calculate the annual lease rent to be charged so as to amount to 20% after tax annual compound rate of
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return, based on the following:

(a) Tax rate is 40%;
(b) Straight line depreciation;
(c) Annual expenses of `50,000; and
(d) Resale value of `1,00,000 after the term.
[(i) 18.63% (ii) `1,30,310 (iii) `2,23,729]
1.3 [C.A.] Fair Finance, a leasing company, has been approached by a prospective customer intending to
acquire a machine whose Cash Down price is `3 crores. The customer, in order to leverage his tax position, has
requested a quote for a three year lease with rentals payable at the end of each year but in a diminishing manner
such that they are in the ratio of 3:2:1.
Depreciation can be assumed to be on straight line basis and Fair Finance’s marginal tax rate is 35%. The target
rate of return for Fair Finance on the transaction is 10%.
Required: Calculate the lease rents to be quoted for the lease for three years.
[`191.54 lakhs, `127.69 lakhs, `63.85 lakhs]
1.4 [C.A.] Classic Finance, a Leasing Company, has been approached by a prospective customer intending to
acquire a machine whose cash down price is `6 crores. The customer, in order to leverage his tax position, has
requested a quote for a three year lease with rentals payable at the end of each year but in a diminishing manner

such that they are in the ratio of 3:2:1. Depreciation can be assumed to be on WDV basis at 25% and Classic
Finance’s marginal tax rate is 35%. The target rate of return for Classic Finance on the transaction is 10%. You
are required to calculate the lease rents to be quoted for the lease for three years.
[`447.59 lakhs, `298.39 lakhs, `149.20 lakhs]
Problems – Lease or Buy

2.1 [C.A.] M/s Gama & Co. is planning of installing a power saving machine and are considering buying or
leasing alternative. The machine is subject to straight-line method of depreciation. Gama & Co. can raise debt at
14% payable in five equal annual instalments of `1,78,858 each, at the beginning of the year. In case of leasing,
the company would be required to pay an annual end of year rent of 25% of the cost of machine for 5 years.
The Company is in 40% tax bracket. The salvage value is estimated at `24,998 at the end of 5 years. Evaluate the
two alternatives and advise the company by considering after tax cost of debt concept under both alternatives.
P. V. factors 0.9225, 0.8510, 0.7851, 0.7242, 0.6681 respectively for 1 to 5years.
[Cost of Machine `6,99,998; PV of buying `4,69,940; PV of leasing `4,14,845]
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2.2 [C.A.] P Ltd. has decided to acquire a machine costing `50 lakhs through leasing. Quotations from 2 leasing
companies have been obtained which are summarized below.
Quote A Quote B
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Lease term 3 years 4 years
Initial lease rent (` lakhs) 5.00 1.00
Annual lease rent (payable in arrears) (` lakhs) 21.06 19.66
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P Ltd. evaluates investment proposals at 10% cost of capital and its effective tax rate is 30%. Terminal payment
in both cases is negligible and may be ignored.
Make calculations and show which quote is beneficial to P Ltd. Present value factors at 10% rate for years 1-4
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are respectively 0.91, 0.83, 0.75 and 0.68. Calculations may be rounded off to 2 decimals in lakhs.
[PV of outflow: A `40.345 lakhs, B `44.357 lakhs. Equated annual payment: A `16.22 lakhs, B `13.97 lakhs]
2.3 [C.A.] X Ltd. had only one water pollution control machine in this type of block of asset with no book
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value under the provisions of the Income Tax Act, 1961 as it was subject to rate of depreciation of 100% in the
very first year of installation.
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Due to funds crunch, X Ltd. decided to sell the machine which can be sold in the market to anyone for `5,00,000
easily.
Understanding this from a reliable source, Y Ltd. came forward to buy the machine for `5,00,000 and lease it
to X Ltd. for lease rental of `90,000 p.a. for 5 years. X Ltd. decided to invest the net sale proceed in a risk free
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deposit, fetching yearly interest of 8.75% to generate some cash flow. It also decided to re-look the entire issue
afresh after the said period of 5 years.
Another company, Z Ltd. also approached X Ltd. proposing to sell a similar machine for `4,00,000 to the latter
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and undertook to buy it back at the end of 5 years for `1,00,000 provided the maintenance were entrusted to
Z Ltd. for yearly charge of `15,000. X Ltd. would utilize the net sale proceeds of the old machine to fund this
machine also should it accept this offer.
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The marginal rate of tax of X Ltd. is 34% and its weighted average cost of capital is 12%.
Which Alternative would you recommend?
Year 1 2 3 4 5
Discounting Factors @ 12% 0.893 0.797 0.712 0.636 0.567
[NPV of leasing `41,675; NPV of buying `53,181]
2.4 [C.A. twice, C.M.A., C.S. thrice] XYZ Ltd. is considering to acquire an additional computer to supplement
its time-share computer services to its clients. It has two options:
(i) To purchase the computer for `22 lakhs.
(ii) To lease the computer for 3 years from a leasing company for `5 lakhs as annual lease rent plus 10% of
gross time-share service revenue. The agreement also requires an additional payment of `6 lakhs at the end
of the third year. Lease rents are payable at the year-end, and the computer reverts to the lessor after the
contract period. The company estimates that the computer under review will be worth `10 lakhs at the end
of the third year. Forecast revenues are:
Year 1 2 3
Amount (` in Lakhs) 22.5 25 27.5
Annual operating costs excluding depreciation/lease rent of computer are estimated at `9 lakhs with an
additional `1 lakh for start-up and training costs at the beginning of the first year. These costs are to be borne by
the lessee. Your company will borrow at 16% interest to finance the acquisition of the computer. Repayments are
to be made as per the following schedule:
Year-end 1 2 3
Principal (` ‘000) 500 850 850
Interest (` ‘000) 352 272 136
852 1,122 986
The company uses straight line method (SLM) to depreciate its assets and pays 50% tax on its income. The
management of XYZ Ltd. approaches you for advice. Which alternative would you recommend and why?
[PV of cash outflow: (i) `8.91 lakhs, (ii) `12.01 lakhs. Computers should be bought]
2.5 [C.A.] ABC Ltd. is contemplating have an access to a machine for a period of 5 years. The company can
have use of the machine for the stipulated period through leasing arrangement or the requisite amount can be
borrowed to buy the machine. In case of leasing, the company received a proposal to pay annual end of year rent
of `2.4 lakhs for a period of 5 years.
In case of purchase (which costs `10,00,000) the company would have a 12%, 5 years loan to be paid in equated
installments, each installment becoming due to the beginning of each years. It is estimated that the machine can
be sold for `2,00,000 at the end of 5th year. The company uses straight line method of depreciation. Corporate
tax rate is 30%. Post tax cost of capital of ABC Ltd. is 10%.
You are required to advice
(i) Whether the machine should be bought or taken on lease.
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(ii) Analyze the financial viability from the point of view of the lessor assuming 12% post tax cost of capital.
Year PV of `1 @ 10% for 5 years PV of `1 @ 12% for 5 years
1 .909 .893
2
3
.826
.751
ss .797
.712
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4 .683 .636
5 .621 .567
[(i) PV of outflows: Purchasing `6,67,297; Leasing `6,36,720 (ii) NPV (`1,07,920)]
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2.6 [C.A., C.S.] Sundaram Ltd. discounts its cash flows at 16% and is in the tax bracket of 35%. For the
acquisition of a machinery worth `10,00,000, it has two options — either to acquire the asset by taking a bank
loan @15% p.a. repayable in 5 yearly installments of `2,00,000 each plus interest or to lease the asset at yearly
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rentals of `3,34,000 for five years.

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In both the cases, the instalment is payable at the end of the year. Depreciation is to be applied at the rate of
15% using ‘written down value’ (WDV) method. You are required to advise which of the financing options is to
be exercised and why.
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Year 1 2 3 4 5
P.V factor @16% 0.862 0.743 0.641 0.552 0.476
[PV of cash outflows: Purchase option `7,31,540, Lease option `7,10,785]
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2.7 [C.A.] ABC Ltd. is considering a proposal to acquire a machine costing `1,10,000 payable `10,000 down
and balance payable in 10 annual equal instalments at the end of each year inclusive of interest chargeable at
15%. Another option before it is to acquire the asset on a lease rental of `15,000 per annum payable at the end
of each year for 10 years. The following information is also available.
(i) Terminal Scrap value of `20,000 is realizable, if the asset is purchased.
(ii) The company provides 10% depreciation on straight line method on the original cost.
(iii) Income tax rate is 50%.
You are required to compute the analyze cash flows and to advise as to which option is better.
[PV of outflows: Purchase `51,336, Lease `37,641]
2.8 [C.A.] ABC Company has decided to acquire a `5,00,000 pulp control device that has a useful life of ten
years. A subsidy of `50,000 is available at the time the device is acquired and placed into service. The device
would be depreciated on straight-line basis and no salvage value is expected. The company is in the 50% tax
bracket. If the acquisition is financed with a lease, lease payments of `55,000 would be required at the beginning
of each year. The company can also borrow at 10% repayable in equal instalments. Debt payments would be due
at the beginning of each year:
(i) What is the present value of cash outflow for each of these financing alternatives, using the after-tax cost of
debt?

(ii) Which of the two alternatives is preferable?
[PV of outflows: Purchase option `2,57,176, Lease `2,33,613]
2.9 [C.A.] Engineers Ltd. is in the business of manufacturing nut bolts. Some more product lines are being
planned to be added to the existing system. The machinery required may be bought or may be taken on lease. The
cost of machine is `20,00,000 having a useful life of 5 years with the salvage value of `4,00,000 (consider short
term capital loss/gain for the Income tax). The full purchase value of machine can be financed by bank loan at
the rate of 20% interest repayable in five equal instalments falling due at the end of each year. Alternatively, the
machine can be procured on a 5 years lease, year-end lease rentals being `6,00,000 per annum. The Company
follows the written down value method of depreciation at the rate of 25%. Company’s tax rate is 35% and cost
of capital is 14%.
(i) Advise the company which option it should choose - lease or borrow.
(ii) Assess the proposal from the lessor’s point of view examining whether leasing the machine is financially
viable at 14% cost of capital.
Detailed working notes should be given.
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[PV of cash outflows: Leasing `13,71,630, Buying `13,67,085]
2.10 [C.A.] ABC Ltd. Sells computer services to its clients. The company has recently completed a feasibility
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study and decided to a acquire an additional computer, the details of which are as follows:
(1) The purchase price of the computer is `2,30,000; maintenance, property taxes & insurance will be `20,000
per year. The additional expenses to operate the computer are estimated at `80,000. If the computer is
rented from the owner, the annual rent will be `85,000, plus 5% of annual billings. The rent is due on the
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last day of each year.
(2) Due to competitive conditions, the company feels that it will be necessary to replace the computer at the
end of three years with a more advanced model. Its resale value is estimated at `1,10,000.
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(3) The corporate income tax rate is 50% and the straight line method of depreciation is followed.
(4) The estimated annual billing for the services of the new computer will be `2,20,000 during the first year,
and `2,60,000 during the subsequent two years.
(5) If the computer is purchased, the company will borrow to finance the purchase from a bank with interest at
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16% per annum. The interest will be paid regularly, and the principal will be returned in one lump sum at
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the end of the year 3.

Should the company purchase the computer or lease it? Assume (i) cost of capital as 12%, (ii) straight line
method of depreciation, (iii) salvage value of `1,10,000 and evaluate the proposal from the point of view of
lessor also.
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[NPV of Buying `92,703, NPV of leasing `81,515. For lessor: NPV `8,420]
2.11 [C.A.] XYZ Ltd. requires an equipment costing `10,00,000; the same will be utilized over a period of 5
years. It has two financing options in this regard:
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(i) Arrangement of a loan of `10,00,000 at an interest rate of 13% per annum; the loan being repayable in 5
equal year end instalments; the equipment can be sold at the end of fifth year for `1,00,000.
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(ii) Leasing the equipment for a period of five years at an yearly rental of `3,30,000 payable at the year end.
The rate of depreciation is 15% on Written Down Value (WDV) basis, income tax rate is 35% & discount rate is
12%.
Advise the XYZ Ltd. that which of the financing options is to be exercised and why.
[PV of outflows: Buying `7,15,313, Leasing `7,71,985]
2.12 [C.S.] Alfa Ltd. is thinking of installing a computer. Decide whether the computer is to be purchased
outright (through 15% borrowing) or to be acquired on lease rental basis. The rate of income-tax may be taken
at 40%. The other data available are as under –
Purchase of Computer:
Purchase price : `20,00,000
Annual maintenance (to be paid in advance) : `50,000 per year
Expected economic useful life : 6 years
Depreciation (for tax purposes) : Straight line method
Salvage value : `2,00,000
Leasing of Computer:
Lease charges to be paid in advance : `4,50,000.
Maintenance expenses to be borne by lessor.
Payment of loan : 6 year-end equal instalments of `5,28,474.
Note: Present value of `1 for six years –
Year PV @ 6% PV @ 9% PV @ 15%
1 0.9434 0.9174 0.8696
2 0.8900 0.8417 0.7561
3 0.8396 0.7722 0.6575
4 0.7921 0.7084 0.5718
5 0.7473 0.6499 0.4972
6 0.7050 0.5963 0.4323
2.13 [C.S.] Diligent Ltd. is considering the lease of an equipment which has a purchase price of `3,50,000.
The equipment has an estimated economic life of 5 years with a salvage value zero. As per the Income-tax
rules, a written down depreciation @ 25% is allowed. The lease rentals per year are `1,20,000. Assume that
the company’s corporate tax rate is 50%. If the before-tax rate of borrowing for the company is 16%, should the
company lease the equipment?
Note - Present value of `1 for 5 years is:
Year 1 2 3 4 5
P.V. @ 8% 0.9259 0.8573 0.7938 0.7350 0.6806
P.V. @ 16% 0.8621 0.7432 0.6407 0.5523 0.4761
[Buy]
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2.14 [C.A.] R Ltd., requires a machine for 5 years. There are two alternatives either to take it on lease or buy.
The company is reluctant to invest initial amount for the project and approaches their bankers. Bankers are
ready to finance 100% of its initial required amount at 15% rate of interest for any of the alternatives.
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Under lease option, upfront Security deposit of `5,00,000 is payable to lessor which is equal to cost of machine.
Out of which, 40% shall be adjusted equally against annual lease rent. At the end of life of the machine, expected
scrap value will be at book value after providing depreciation @ 20% on written down value basis.
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Under buying option, loan repayment is in equal annual installments of principal amount, which is equal to
annual lease rent charges. However, in case of bank finance for lease option, repayment of principal amount
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equal to lease rent is adjusted every year, and the balance at the end of 5th year.
Assume income tax rate is 30%, interest is payable at the end of every year and discount rate is @ 15% p.a. The
following discounting factors are given:
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Year 1 2 3 4 5
Factor 0.8696 0.7562 0.6576 0.5718 0,4972
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Which option would you suggest on the basis of net present values?
Problems – Deciding break-even lease rental

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3.1 [C.A.] M/s ABC Ltd. is to acquire a personal computer with modem and a printer. Its price is `60,000.
ABC Ltd. can borrow `60,000 from a commercial bank at 12% interest per annum to finance the purchase. The
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principal sum is to be repaid in 5 equal year-end instalments.

ABC Ltd. can also have the computer on lease for 5 years.
The firm seeks your advise to know the maximum lease rent payable at each year end.
Consider the following additional information:
(i) Interest on bank loan is payable at each year end.
(ii) The full cost of the computer will be written off over the effective life of computer on a straight-line basis.
This is allowed for tax purposes.
(iii) At the end of year 5, the computer may be sold for `1,500 through a second-hand dealer, who will charge
8% commission on the sale proceeds.
(iv) The company’s effective tax rate is 30%.
(v) The cost of capital is 11 %.
Suggest the maximum annual lease rental for ABC Ltd.:
Year PVF at 11%
1 0.901
2 0.812
3 0.731
4 0.659
5 0.593
[Pre-tax lease rent `16,400]
3.2 [C.A.] A Company is planning to acquire a machine costing `5 lakhs. Effective life of the machine is 5
years. The Company is considering two options. One is to purchase the machine by lease & the other is to
borrow `5 lakhs from its bankers at 10% interest p.a. The principal amount of loan will be paid in 5 equal
annual instalments.
The machine will be sold at `50,000 at the end of 5th year. Following further informations are given:
(a) Principal, interest, lease rentals are payable on the last day of each year.
(b) The machine will be fully depreciated over its effective life.
(c) Tax rate is 30% and after tax.. Cost of Capital is 8%.
Compute the lease rentals payable which will make the firm indifferent to the loan option.
[`1,23,006]
3.3 [C.A.] Alfa Ltd. desires to acquire a diesel generating set costing `20 lakh which will be used for a period
of 5 years. It is considering two alternatives (i) taking the generating set on lease or (ii) purchasing the asset
outright by raising a loan. The company has been offered a lease contract with a lease payment of `5.2 lakh per
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annum for five years payable in advance. Company’s banker requires the loan to be repaid @ 12% p.a. in 5 equal
annual instalments, each installment being due at the beginning of the each year.
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Tax relevant depreciation of the generator is 20% as per WDV method. At the end of 5th year the generator can
be sold at `2,00,000. Marginal Tax rate of Alfa Ltd. is 30% and its post tax cost of capital is 10%.
Determine:
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(a) The Net Advantage of Leasing to Alfa Ltd. and recommend whether leasing is financially viable.
(b) Break Even Lease Rental.
[(a) (`0.99 lakhs) (b) `4.87 lakhs]
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3.4 [C.M.A.] The following data are furnished by the Sigma Leasing Ltd. (SLL):
Investment cost : `99 lakhs
Primary lease term : 3 years
Residual value : Nil
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Pre-tax required rate of return : 22%
The lease can be renewed for an additional period of 3 years (secondary lease period). The lease rental for the
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secondary period will be 5% of the rental charged during the primary period.
The SLL seeks your advice in determining the annual lease rental under the following rental structures:
(a) Equated
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(b) Stepped (annual increase of 12%)

(c) Ballooned (annual rental of `15 lakhs for years 1 and 2)
(d) Deferred (deferment period of 1 year)
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You are required to compute the annual rentals under four rental structures. Show your workings.
[(a) Primary `47,17,800, Secondary `2,35,890 (b) Year 1 `24,66,429 increasing by 12% p.a. (c) Year 3 onwards `1,26,25,075 (d) `77,41,421]
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Chapter
5
Dividend Decisions
Related Terms
(1) Dividend Rate: This is the dividend amount expressed as a percentage of the face value of the share.
(2) Dividend Payout Ratio: This is the dividend amount expressed as a percentage of the earning per share
(EPS) and is computed as follows:
Dividend per share
Dividend Pay out ratio = × 100
EPS
(3) Retention Ratio: The percentage of retained earnings to the earnings of the firm. It is the complement of
the dividend payout ratio. For example, if payout ration is 60% then retention ratio will be 40%.
(4) Dividend Yield: This is the return of the investor from his investment in a share. It is computed as folows –
Dividend per share
Dividend Yield = × 100
Market price per share
(5) Dividend Declaration Date: This is the date on which the Board of Directors declare the dividend.
(6) Record Date: The shareholders of a company change on daily basis because of the buying & selling of
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shares that takes place on the stock exchanges. To determine which shareholders will be entitled to the
dividend the company announces a record date. All shareholders whose name appears in the register of
members on the record date will be entitled to the dividend declared.
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(7) Ex-dividend Date: This is a date declared by the stock exchange which conveys to the investor that if he
buys the share on this date or after this date then he will not be entitled to the dividend declared by the
company because his name will not appear in the register of members on the record date.
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(8) Payment Date: This is the date on which the company pays the dividend to the shareholders.
Dividend Policy
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Dividend is any distribution of accumulated profits, whether capitalized or not, if such distribution involves a
release of the assets of the company.
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Dividend policy refers to the plan of action that a firm decides to adopt for the distribution of the earnings. A
firm has to decide how much of the earnings will be distributed to the shareholders in the form of dividends
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for maximizing the wealth of shareholders. Declaration of dividends will involve the payment of cash and this
will affect the finances of the company. The funds available for investment opportunities will be affected due to
payment of dividend. Hence, financial needs of the company should be considered before dividend is paid. It is
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not legally binding on the Company to declare dividends to Equity Shareholders.

Only the Board of Directors are authorized to declare dividends. Equity shareholders approve the dividend
recommended by Board of Directors in the Annual General Meeting (A.G.M.).
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But there are restrictions on the discretion of the Board of Directors as follows:
(a) Depreciation is to be provided for in accounts,
(b) There should not be any unlawful declaration of dividends by Directors.
(c) The rights of creditors must be protected before the dividends are declared.
(d) Dividends should be paid out of accumulated profits and not out of Capital profits, unless some conditions
are satisfied.
Dividend Policy of a company determines the dividend payout ratio.
The objective of financial management is to maximize the wealth of the shareholders. If the company has
ample investment opportunities then the company may not declare any dividend or declare a very low rate of
dividend so that the retained earnings can be invested in the available opportunities and this will help to further
maximize the wealth of the shareholders by increasing the value of the business and thereby the value of the
shares of the company. However, if the company does not have opportunities to invest then it will be better if the
company distributes a large part of the earnings to the shareholders who may themselves have some investment
opportunities. However, a company cannot distribute its entire earnings in a year as, according to the Companies
Act, 1956, transfer to reserves is compulsory for the purpose of declaration of dividend if the rate of dividend is
more than 10%.
A stable dividend policy is desirable from the point of view of company as well as shareholders. The shares of

a company with a stable dividend policy will find favour with the investors and its market price will be high as
well as stable. Stability of dividends means regularity in payment of some dividend annually, which may vary
from year to year. A company may be declare a fixed amount of dividend per share or as a constant percentage
of net earnings. For example, a company may declare a dividend of `3 per share consistently. The other option
to the company is to have a stable dividend payout ratio. If a company has a payout ratio of 50% then the
dividend paid in any year will be 50% of the earning per share (EPS). Increase or decrease in the EPS will result
in corresponding increase or decrease in the amount of dividend paid.
Some companies may declare small constant final dividend per share which is declared after the accounts are
audited. In addition to that the company may declare interim dividend depending upon the earnings during
the year. In case of unusually large earnings the company may also declare special/extra dividend. This type of
dividend policy signals to the investor that he can expect a small but stable dividend from his investment and a
higher dividend if the company earns a large profit. By calling it special/extra dividend the company indicates
that such dividend may not be paid every year. If the profits in first few months indicate an increasing trend, the
Directors may declare interim dividends depending on the prospects for the year.
There should be an appropriate relationship between earnings, dividend declaration and retained profits. The
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goal of the top management is the stabilization of the Dividend rate.
Significance of Stability of Dividend
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A stable Dividend policy is highly recommended for the following reasons:
A stable dividend policy is advantageous from the point of view of investors as well as the company for the
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following reasons:
(i) The shareholders expect some income from their investment and a regular dividend meets this expectation.
(ii) A stable dividend payment record will result in high and stable market price of the company’s share.
(iii) It will meet the requirements of institutional investors.
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(iv) The company will find it easier to raise additional funds.
However, a stable dividend policy is not without its pitfalls. In case the profits are lower, the Directors may
declare dividend out of reserves just to maintain a stable rate of dividend and this may not be a prudent financial
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management practice.
Dividend Models or Theories of Dividend

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Graham & Dodd Model (Traditional Approach)

According to Graham and Dodd, the investors give more importance to dividend than to retained earnings.
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Therefore, the company should pay liberal dividend to increase the market price of the company’s share.
According to this model, the weight attached to dividend is four times the weight attached to retained earnings.
However, these weights are based on their judgment and not on the basis of any analysis. The market value of a
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share can be computed as follows:

 E
P = m D + 
C
 3
Where,
P = market price of a share
m = the multiplier
D = dividend per share
E = earnings per share
Walter’s Model (Earnings Growth Model)

According to Prof. James E. Walter, the dividend policy of a company influences the market price of its shares.
He devised a formula to find out the value of a company’s share on the basis of the dividend policy, internal rate
of return and the cost of capital of the company. According to this formula there is a relationship between the
internal rate of return (r) and cost of capital (k) of a company and this can be used to determine the optimum
dividend policy which will maximize the value of the shares. Value of a share, by Walter’s formula, is as under:
r
D+ ( E − D)
P = k
k
Dividend Decisions Ɩ 77
Where
P = market price of a share
D = dividend per share
r = internal rate of return (IRR)
k = cost of capital or capitalization rate
E = earnings per share (EPS)
For the purpose of deciding the optimum dividend policy the firms are divided into three categories –
(a) Growing firm, i.e. firms where r > k. These firms have opportunities to invest retained earnings at a rate
higher than k and hence its dividend payout should be as low as possible. The value of the share will be the
maximum when the payout is the lowest; theoretically zero.
(b) Normal/stable firm; i.e. firms where r = k. Normal firms can invest retained earnings at the same rate as
the cost of capital and hence the dividend policy does not affect the value of the shares of such companies.
They can follow any dividend policy as it will not affect the market price of its shares.
(c) Declining firm; i.e. firms where r < k. These firms can invest retained earnings to earn a rate which is
less than the cost of capital and hence such firms should follow a high dividend policy to increase the value
of its shares; theoretically 100% of earnings.
Walter’s formula is based on the following assumptions:
(1) The firm is an all equity firm.
(2) The firms uses only retained earnings to finance its projects and does not resort to debt or fresh issue of
shares.
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(3) The firm’s cost of capital (ke) and internal rate of return (r) remain constant.
(4) The firm’s retention ratio remains constant & therefore the growth rate also remains constant.
(5) The firm has perpetual existence.
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(6) All earnings are either distributed and retained earnings are invested immediately.
(7) There are no corporate taxes.
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Gordon’s Model (Dividend Growth Model)
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Myron Gordon founded a model for valuation of shares of a company based on the dividend policy followed by
the company. According to Gordon, investors are prepared to pay a higher price for a share if they get greater
current dividend. If a company does not distribute a high dividend then they assume that it is due to uncertainty
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and expect a higher return for the higher risk which they associate with such a company. They may even sell
the shares of such companies thereby affecting its market price. If a company retains most of its earnings for
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investment then the expected return from such investment will go on increasing to meet the higher return
expected by the investors. Thus, when the dividend payout ratio is low, the investors will value the share of the
company highly only when the rate of return of the company is more then their expected return and with this
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higher earning rate of the firm they expect a higher dividend. Gordon’s Model, also called the Dividend Growth
Model, for valuation of a company’s share is as under:
D0 (1 + g )
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E(1 − b) D1
P = OR P = OR P =
k − br Ke − g Ke − g
Where,
P = market price per share
E = earning per share
b = ratio of retained earnings
k = cost of capital/market capitalization rate
r = firm’s rate of return on investment
br = growth rate
D1 = expected dividend per share at the end of 1 year
g = firm’s growth rate
D0 = last dividend per share paid
ke = cost of equity
Gordon’s formula is based on the following assumptions:
(1) All firms are equity firms and only retained earnings are used for financing projects.
(2) Internal rate of return is constant.

(3) Cost of equity is constant.
(4) There are no taxes.
(5) The retained earnings ratio is constant.
(6) Growth rate of the firm is the product of retention ratio and internal rate of return.
(7) Growth rate is constant.
(8) Company has perpetual existence.
Modigliani-Miller Model (Theory of Dividend Irrelevance)

While Walter and Gordon were of the opinion that the share price of a company is related to its dividend policy,
Modigliani and Miller argue that the dividend policy is irrelevant for the purpose of valuing the shares of a
company. According to them, the dividend policy followed by the company does not affect the market price of
the company’s share because the investors are indifferent to dividend or capital gain. Their argument is based on
the premise that as the company issues additional shares to finance new projects the dividend gets diluted and
this will offset the increase in value of its shares. This is explained below:
(1) A company pays dividend on its shares and the market price increases in expectation of future prospects.
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(2) Earnings of the company are reduced by the amount of dividend paid out leaving less funds for new
investment.
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(3) The company requires funds to make new investment and hence has to issue new shares.
(4) With increase in total number of shares, the EPS decreases.
(5) Market price decreases due to decrease in EPS and earlier price increase is offset.
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According to their theory, the value of company’s share is determined by the earning capacity of its assets, i.e.
its projects/investments. A high earning capacity of the firm’s assets will mean a higher market value of the
shares. How the earnings are dealt with by the company, i.e. whether the earnings are distributed as dividend
or retained by the company, will have no bearing on the market price of the company’s share. According to this
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theory, the market price of a shares at the beginning of the year is equal to the present value of the dividend to
be paid at the end of the year plus the market value of the share at the end of the year.
The value per share is computed by the following formula:
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1
P0 = (D1 + P1)
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1+c
Where,
P0 = market price at time 0 (current market price)
D1 = dividend to be paid at the end of 1 year
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P1 = market price at the end of 1 year

c = capitalization rate
Formula for computation of new shares to be issued –
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mP1 = I – (E – nD1)
Where,
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m = number of new shares to be issued

P1 = market price at the end of 1 year
I = amount required for investment
E = earnings during the year
n = number of old shares
D1 = dividend (per share) to be paid at the end of 1 year
The M-M theory of dividend irrelevance is based on the following assumptions –
(1) Capital markets are perfect and shares can be freely traded.
(2) All investors behave in a rational manner.
(3) There are no transaction costs.
(4) Information is available to investors free of cost.
(5) There are no taxes on income.
(6) Risk of uncertainty does not exist.
(7) The cost of equity capital is equal to the shareholders’ expectation.
(8) The firm has a fixed investment policy.
(9) No external source of finance other than equity will be considered for financing investments.
(10) There is no flotation cost or time lag involved in the issue of new shares.
(11) Dividend policy has no effect on the cost of equity.
Lintner’s Model
John Lintner conducted interviews of businessmen to find out how they decided on the dividend to be paid.
He observed that funds required for investment was not a major factor affecting the dividend policy. Rather
the dividend payout was decided on the basis of the changes in the earnings in the long run. He found that the
companies tend to set long-term payout ratio targets. An increase in earnings will result in higher payout only
if the earnings can be sustained in the long run. In other words, increase in earnings will result in increase in
dividend but not at the same rate; e.g. if earnings increase by 30% then dividends may be increase by 15% or
20%. On the basis of this study he formed a model to arrive at the amount of dividend that a firm should pay.
Dt = Dt–1 + [(EPS × Target payout) – Dt–1] × AF
Where,
Dt = Dividend for the year [for which the dividend decision is to be taken]
Dt–1 = Dividend paid for the previous year
EPS = Earnings per share
AF = Adjustment factor
Thus, Lintner’s model has two parameters:
(i) The target long-term payout ratio
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(ii) The adjustment factor which is the spread[1] at which the current dividends adjust to the target payout
ratio; i.e. speed at which dividend is increased so as to achieve the target payout ratio.
The target payout ratio as well as the adjustment factor are decided by the firm. This model was criticized for
the following reasons:
(1) It does not offer a market price for the share.
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(2) The adjustment factor is just an arbitrary number and highly subjective[2].
Radical Approach
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Most dividend models ignore tax completely. The Radical[3] Approach considers tax, both corporate as well as
personal. It also takes into account that dividend and capital gain may be taxed at a different rate. The payoff
to an investor may be in the form of dividend and/or capital gain. Generally, a high dividend will mean lower
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capital gain and vice versa. So the payoff to the investor can planned by the company in such a way that it is the
most tax efficient from the point of view of the investor. If there is low or no tax on dividend compared to capital
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gain then the company which declares higher dividend will be highly valued by the investor. Thus, this approach
is the most practical in reality.
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Bird-in-hand Theory
Myron Gordon and John Lintner put forward a theory that investors value a rupee of dividend received today
(a bird in hand) more highly than a rupee of expected capital gain (two in the bush). This happens because
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the capital gain in the future is uncertain. The more distant the future payoff, the more uncertain it will be.
According, if all other things are equal, the share of a company which pays higher dividend will be highly valued
compared to the share of a company with low payout ratio. The expected return will be:
D 
Expected return =  1 × 100  + g
P
 0 
The first term, i.e. the dividend yield, is considered to be less risky than the second term (growth). Companies
with a low payout will be valued highly only if the growth rate (g) is very high.
Residual Model
Companies need funds for investment in new projects and retained earnings is the easiest method of financing.
As per the Residual model, the dividend payout can be planned on the basis of funds required for new projects.
The retained earnings are first used to finance the new projects and thereafter the remaining earnings are used
to pay dividend. Companies may also use only a part of the earnings for new projects so that the debt-equity
ratio is maintained. If the entire retained earnings are required for new investments then the payout will be zero.
1 Difference between two figures.
2 Taking place in the mind and affected by individual bias.
3 Revolutionary or completely new way of thinking.

Intrinsic Value of Share
Dividend Discount Model (DDM)
According to the Dividend Discount Model a stock is worth the present value of all the dividends to be paid
in the future. This model provides an intrinsic value of a share which is not affected by the current market
conditions. This model can be used only after a company has started paying significant amount of its earnings as
dividend. But in theory, it applies to all companies. This model has three variants –
(i) Constant dividend or no growth model: This model assumes that the dividend paid will remain constant
and there will be no growth. The intrinsic value of the share is given by –
D1
Intrinsic value =
Ke
Where, D1 = expected dividend at the end of Year 1
Ke = the expected rate of return
(ii) Constant growth rate model: This is the Gordon’s model and value of the share is given by –
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D1
Intrinsic value =
Ke − g
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Where, D1 = expected dividend at the end of Year 1
g = the constant growth rate
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This model is used to value shares of companies that have a steadily increasing dividend. The actual
growth rate may not be constant but the average growth rate can be used for this purpose. As per this
model, the share price and the dividend amount will increase by the constant growth rate every year. This
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model fails when the growth rate is more than the shareholders’ expected rate of return.
(iii) Variable growth rate model: In reality, growth rate is far from constant. A company may have different
growth rate every year. For convenience, two or three different growth rates may be considered for valuing
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shares. These would represent the different stages of growth for a company — initial high growth rate,
followed by a slower growth rate and finally sustainable steady growth rate.
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The intrinsic value with two growth rates is given by –

 D0 (1 + g1 )t 
n
D (1 + g2 )  1 
Intrinsic value = ∑  t 
+ n
t =1  (1 + K e ) K e − g2 (1 + K e ) 
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
Where, D0 = the latest dividend paid
t = time in years
g1 = the initial growth rate
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g2 = the settled constant growth rate

n = the number of years of the initial growth rate
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!! The expected rate of return Ke is normally taken as a constant but may be changed to take into account the
change in the growth rate! The first term in the equation is the present value of the dividends to be received
during the period (n years) of the initial growth rate. The second term is the present value of the intrinsic value
of the share at the end of the nth year which can be computed on the basis of constant growth rate after the
nth year.
The intrinsic value with three growth rates is given by –

n  D0 (1 + g1 )t  m  Dn (1 + g2 )t  D (1 + g3 )  1 
Intrinsic value = ∑ t 
+ ∑ t 
+ m
K e − g3 (1 + K e ) 
=t 1  (1 + K e )  n +1  (1 + K e ) 
Where, D0 = the latest dividend paid
t = time in years
g1 = the initial growth rate
g2 = the second growth rate
g3 = the finally settled constant growth rate
n = the number of years of the initial growth rate
m = the last year of the second growth rate stage
!! The expected rate of return Ke is normally taken as a constant but may be changed to take into account the
change in the growth rate! The first term in the equation is the present value of the dividends to be received
during the period (n years) of the initial growth rate. The second term in the equation is the present value of
the dividends to be received during the period of the second growth rate starting from (n+1)th year to mth
year. The third term is the PV of the intrinsic value of the share at the end of the mth year which can be
computed on the basis of constant growth rate after the mth year.
Problems
Graham & Dodd Model (Traditional Approach)
1.1 Ventura Ltd. has 1,00,000 ordinary shares of `10 each outstanding. The earnings per share is `5. The
company wants to maintain a payout of 60%. Find the value the share by Graham & Dodd Model if the multiplier
is 9.
[`42]
1.2 The following information is provided by Ace Ltd. –
EPS `18
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Payout 50%
Face value of share `10
Market price of share `72
Find the indicated multiplier as per the Graham & Dodd Model.
[6]
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1.3 The earnings of a company are `70,000. It has outstanding 10,000 equity shares of `100 each. The company
has a payout ratio of 75%. Find the value of the company’s share by Graham & Dodd Model taking the multiplier
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as 11.
[`70]
Walter’s Model (Earnings Growth Model)

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2.1 [C.A.] Sahu & Co. earns `6 per share having capitalization rate of 10% and has a return on investment at
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the rate of 20%. According to Walter’s model, what should be the price per share at 30% dividend payout ratio?
Is this the optimum payout ratio as per Walter?
[`102. Optimum payout ratio is zero.]
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2.2 [C.A.] X Ltd. earns `6 per share having a capitalization rate of 10% and has a return on investment of 20%.
According to Walter’s model, what should be the price of the share at 25% dividend payout?
[`105]
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2.3 [C.A.] Subhash & Co. earns `8 per share having capitalization rate of 10% and has a return on investment
at the rate of 20%. According to Walter’s model, what should be the price per share at 25% dividend payout
ratio? Is this the optimum payout ratio as per Walter?
[`140, `180 with zero payout]
2.4 [C.A.] The earnings per share of a company is `10 and the rate of capitalization applicable to it is 10%. The
company has three options of paying dividend i.e. (i) 50%,(ii) 75% and (iii) 100%. Calculate the market price of
the share as per Walter’s model if it can earn a return of (a) 15%, (b) 10% and (c) 5% on its retained earnings.
[(i)(a) `125 (ii)(a) `112.50 (iii)(a) `100 (i)(b) `100 (ii)(b) `100 (iii)(b) `100 (i)(c) `75 (ii)(c) 87.50 (iii)(c) 100]
2.5 [C.A.] X Ltd has an internal rate of return @ 20%. It has declared dividend @ 18% on its equity shares,
having face value of `10 each. The payout ratio is 36% and Price Earning Ratio is 7.25. Find the cost of equity
according to Walter’s Model and hence determine the limiting value of its shares in case the payout ratio is
varied as per the said model.
[Ke = 16%, `11.25]
2.6 [C.A.] The following information relates to Maya Ltd. –
Earning of the company `10,00,000
Dividend payout ratio 60%

Number of shares outstanding 2,00,000
Rate of return on investment 15%
Equity capitalization rate 12%
(i) What would be the market price per share as per Walters model?
(ii) What is the optimum payout ratio according to Walters model and the market value of the company’s share
at that payout ratio?
[(i) `45.83 (ii) `52.08]
2.7 [C.S. twice] The earning per share of a company is `16. The market capitalization rate applicable to the
company is 12.5%. Retained earnings can be employed to yield a return of 10%. The company is considering
a pay-out of 25%, 50% and 75%. Which of these would maximize the wealth of shareholders as per Walter’s
model?
[Share value: At 25% D/p ratio `108.80; At 50% D/P ratio `115.20; At 75% D/P ratio `121.60]
2.8 [C.S. thrice] ABC Ltd. was started a year back with a paid-up equity capital of `40,00,000. The other
details are as under:
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Earnings of the company `4,00,000
Dividend paid `3,20,000
Price-earnings ratio 12.5
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Number of shares 40,000
Find out whether the company’s dividend payout ratio is optimal, using Walter’s formula.
[Market price per equity share `156.25]
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2.9 [C.S.] The earnings per share (EPS) of a company is `10. It has an internal rate of return of 15% and
capitalization rate of its risk class is 12.5%. If Walter’s Model is used –
(i) what should be the optimum payout ratio of the company?
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(ii) what would be the price of the share at this payout?
(iii) how shall the price of the share be affected if a different payout were employed?
[(i) Zero payout (ii) `96 (iii) Market price decreases]
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2.10 [C.A.] The following information pertains to M/s XY Ltd.
Earnings of the Company `5,00,000
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Dividend Payout ratio 60%

No. of shares outstanding 1,00,000
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(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of Company’s
share at that payout ratio?
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[(i) `45.83 (ii) `52.08]

2.11 [C.S.] From the following information, ascertain whether the firm is following an optimal dividend policy
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as per Walter’s model:

Total earnings `6,00,000
Number of equity shares of `100 each 40,000
Price-Earning (P/E) ratio 10
The firm is expected to maintain its rate of return on fresh investment. What should be the P/E ratio at which
dividend policy will have no effect on the value of the share? Will your decision change if the P/E ratio is 5
instead of 10?
[(i) No, the dividend policy is not optimal (ii) 6.67 (iii) No]
2.12 [C.A.] The following information is supplied to you:
Total earnings `2,00,000
No. of equity shares of `100 20,000
Price/Earning Ratio 12.5
(i) Ascertain whether the company is following an optimal dividend policy.
(ii) Find out what should be the P/E ratio at which the dividend policy will have no effect on the value of the
share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
[(i) The policy is not optimal (ii) 10 (iii) No]
Gordon’s Model (Dividend Growth Model)

3.1 [C.A. twice, C.S.] MNP Ltd has declared and paid annual dividend of `4 per Share. It is expected to grow
at 20% for the next two years and 10% thereafter. The required Rate of Return of Equity Investors is 15%.
Compute the Current Price at which Equity Shares should sell.
Note: Present Value Interest Factor (PVIF) @ 15%, are For Year 1 = 0.8696, and For Year 2 = 0.7561
[`104.34]
3.2 [C.S.] Assuming a rate of return expected by investors to be 11%, internal rate of return is 12% and earning
per share is `15, calculate price per share by ‘Gordon Approach’ method if dividend payout ratio is 10% & 30%.
[`750; `173.08]
3.3 [C.S., C.M.A.] A company has a total investment of `5,00,000 in assets and 50,000 outstanding ordinary
shares at `10 per share (par value). It earns a rate of 15% on its investment and has a policy of retaining 50% of
the earnings. If the appropriate discount rate of the firm is 10%, determine the price of its share using Gordon’s
model. What shall happen to the price per share if the company has a payout of 80% or 20%?
[Share value: At 50% `30, At 80% `17, At 20% Indeterminate]
3.4 [C.S.] The MNC Ltd.’s available information is:
Ke = 15%
E = `30
es
r = (i) 14%; (ii) 15%; and (iii) 16%.
You are required to calculate market price of a share of the MNC Ltd. as per Gordon Model if – (a) b = 40%; (b)
b = 60%; and (c) b = 80%.
ss
[(a)(i) `191.49, (a)(ii) `200, (a)(iii) `209.30 (b)(i) `181.82, (b)(ii) `200, (b)(iii) `222.22 (c)(i) `157.89, (c)(ii) `200, (c)(iii) `272.73]
3.5 [C.A.] The following information is given for QB Ltd.
la
Earning per share `12
Dividend per share `3
Cost of capital 18%
C
Internal rate of return on investment 22%
Retention ratio 40%
Calculate the market price per share using: (i) Gordon’s formula, and (ii) Walter’s formula.
h
[(i) `78.26 if retention ratio is taken as 40% as given/`200 if retention ratio is taken as 75% actual (ii) `77.77]
rs
3.6 [C.A.] The following information is collected from the annual reports of J Ltd.:
Profit before tax `2.50 crore
Tax rate 40%
da
Retention ratio 40%

Number of outstanding shares 50,00,000
A

What should be the market price per share according to Gordon’s model of dividend policy?
[`31.80]
Modigliani-Miller Model or Dividend Irrelevance Theory

4.1 [C.S.] An equity share of `100 is expected to earn an annual dividend of `10 and this share can be sold at
price of `180 at the end of year. If the required rate of return is 12%, calculate the value of equity share.
[`169.64]
4.2 [C.A.] ABC Limited has a capital of `10 lakhs in equity shares of `100 each. The shares are currently
quoted at par. The company proposes to declare a dividend of `15 per share at the end of the current financial
year. The capitalization rate for the risk class of which the company belongs is 10%.
What will be the market price of share at the end of the year, if
(i) a dividend is declared?
(ii) a dividend is not declared?
(iii) assuming that the company pays the dividend and has net profits of `6,00,000 and makes new investment
of `12,00,000 during the period, how many new shares should be issued? Use the MM model.
[(i) `95 (ii) `110 (iii) 7,895 shares]

4.3 [C.A., C.S.] RST Ltd. has a capital of `10,00,000 in equity shares of `100 each. The shares are currently
quoted at par. The company proposes declaration of a dividend of `10 per share. The capitalization rate for the
risk class to which the company belongs is 12%. What will be the market price of the share at the end of the
year, if – (i) no dividend is declared; and (ii) 10% dividend is declared?
Assuming that the company pays the dividend and has net profits of `5,00,000 and makes new investments of
`10,00,000 during the period, how many new shares must be issued? Use the MM Model.
[Market price (i) when dividend is not declared `112, (ii) when dividend is declared `102; Total number of new shares to be issued 5,883 shares]
4.4 [C.A.] ABC Ltd. has 50,000 outstanding shares. The current market price per share is `100 each. It hopes
to make a net income of `5,00,000 at the end of current year. The Company’s Board is considering a dividend
of `5 per share at the end of current financial year. The company needs to raise `10,00,000 for an approved
investment expenditure. The company belongs to a risk class for which the capitalization rate is 10%. Show,
how does the M-M approach affect the value of firm if the dividends are paid or not paid.
[Value of firm `50 lakhs]
4.5 [C.A., C.S.] M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding
le
shares and the current market price is `100. It expects a net profit of `2,50,000 for the year and the Board is
considering dividend of `5 per share.
ha
M Ltd. requires to raise `5,00,000 for an approved investment expenditure. Show, how does the MM approach
affect the value of M Ltd., if dividends are paid or not paid.
[Value of firm `30 lakhs in either case]
ok
4.6 [C.S., C.M.A.] A company belongs to a risk-class for which the appropriate capitalization rate is 10%.
It currently has outstanding 25,000 shares selling at `100 each. The firm is contemplating the declaration of
dividend of `5 per share at the end of the current year. The company expects to have a net income of `2.5 lakhs
& has a proposal for making new investments of `5 lakhs.
G
Show that under the M-M assumptions the payment of dividend does not affect the value of the firm.
[Value of firm under MM Hypothesis is `30,00,000 (whether dividends are paid or not paid)]
4.7 [C.S., C.M.A.] D Ltd. has 10 lakhs equity shares outstanding at the beginning of the accounting year 2013.
il
The current market price of the shares is `150 each. The Board of directors of the company has recommended
`8 per share as dividend. The rate of capitalization, appropriate to the risk-class to which the company belongs,
un
is 12%.
(i) Based on MM Approach, calculate the market price of the share of the company when the recommended
dividend is (a) declared; and (b) not declared,
.S
(ii) How many new shares are to be issued by the company at the end of the accounting year on the assumption
that the net income for the year is `2 crores and the investment budget is `4 crores when (a) the above
dividends are distributed; and (b) dividends are not declared,
(iii) Show that the market value of the shares at the end of accounting year will remain the same whether
A
dividends are distributed or not declared.

[(i) (a) `160, (b) `168; (ii) (a) 1,75,000 shares, (b) 1,19,048 shares (iii) `18.80 crores]
C
4.8 [C.A., C.S.] RST Ltd. has a capital of `10,00,000 in equity shares of `100 each. The shares are currently
quoted at par. The company proposes declaration of a dividend of `10 per share. The capitalization rate for the
risk class to which the company belongs is 12%. What will be the market price of the share at the end of the
year, if – (i) no dividend is declared; and (ii) 10% dividend is declared?
Assuming that the company pays the dividend and has net profits of `5,00,000 and makes new investments of
`10,00,000 during the period, how many new shares must be issued? Use the MM Model.
[Market price (i) when dividend is not declared `112, (ii) when dividend is declared `102; Total number of new shares to be issued 5,883 shares]
4.9 [C.S. twice] Bestbuy Auto Ltd. has outstanding 1,20,000 shares selling at `20 per share. The company
hopes to make a net income of `3,50,000 during the year ended 31st March, 2003. The company is considering
to pay a dividend of `2 per share at the end of current year, The capitalization rate for risk class of this company
has been estimated to be 15%.
Assuming no taxes, answer the questions listed below on the basis of the M-M Dividend Valuation Model:
(i) What will be the price of a share at the end of 31st March, 2003 - (a) if the dividend is paid; and (b) if the
dividend is not paid?
(ii) How many new shares must the company issue if the dividend is paid and company needs (a) `7,40,000 or
(b) `9,50,000 for an approved investment expenditure during the year?
[(i) (a) `21 (b) `23 (ii) (a) 30,000 shares (b) 40,000 shares]
4.10 [C.A.] Buenos Aires Limited has 10 lakh equity shares outstanding at the beginning of the year 2013. The
current market price per share is `150. The company is contemplating a dividend of `9 per share. The rate of
capitalization, appropriate to its risk class, is 10%.
(i) Based on MM approach, calculate the market price of the share of the company when:
(1) Dividend is declared
(2) Dividend is not declared
(ii) How many new shares are to be issued by the company, under both the above options, if the Company is
planning to invest `500 lakhs assuming a net income of `200 lakhs by the end of the year?
[(i) (1) `156 (2) `165 (ii) (1) 2,50,000 shares (2) 1,81,818 shares]
4.11 [C.A.] X Ltd. has 8 lakhs equity shares outstanding at the beginning of the year. The current market price
per share is `120. The Board of Directors of the company is contemplating `6.4 per share as dividend. The rate
of capitalization, appropriate to the risk class to which the company belongs is 9.6%.
(i) Based on the M-M approach, calculate the market price of the share when dividend is – (a) declared & (b)
not declared.
(ii) How many new shares are to be issued by the company, if the company desires to fund an investment
budget of `3.20 crores by the end of the year assuming net income for the year will be `1.60 crores?
[(i) `125.12; `131.52 (iii) 1,68,798 shares; 1,21,655 shares]
4.12 [C.A., C.S.] ABC Ltd. has a capital of `10 lakhs in equity shares of `100 each. The shares currently quoted
at par. The company proposes declaration of dividend of `10 per share at the end of the current financial year.
es
The capitalization rate for the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of the year, if
(i) a dividend is not declared?
(ii) a dividend is declared?
ss
(iii) assuming that the company pays the dividend and has a net profit of `5,00,000 and makes new investment
of `10 lakhs during the period, how many new shares must be issued? Use the M.M. model.
la
[(i) `112 (ii) `102 (iii) 5,883/6,000 shares]
4.13 [C.S.] Mansha Ltd. has outstanding 50 lakh shares selling at `120 per share. The company is thinking of
C
paying a dividend of `10 per share at the end of the current year. The capitalization rate for the risk class of this
company is 10%.
Under the M-M model, you are required to (i) calculate the price of the share at the end of the current year if
h
dividends are paid, and if the dividends are not paid; and (ii) determine the number of shares to be issued if the
company earns `9 crores, pays dividends and makes new investment of `6.60 crores.
rs
[(i) `122, `132 (ii) 2,13,115 shares]

4.14 [C.S.] Horizon Enterprises is a manufacturer and exporter of woolen garments to most of the European
da
countries. Their business is expanding day by day and in the previous financial year, the company has registered
a 25% growth in export business. The company is in the process of considering a new investment project. It is an
all equity financed company with 10,00,000 equity shares of face value of `50 per share. The current issue price
A
of this share is `125 ex-dividend. Annual earnings are `25 per share and in the absence of new investments will
remain constant in perpetuity. All earnings are distributed at present. A new investment is available which will
cost `1,75,00,000 in one year’s time and will produce annual cash inflows thereafter of `50,00,000. Analyze the
effect of the new project on dividend payments and the share price.
[Dividend `7.5 next year. Share price `131.25]
Lintner’s Model
5.1 SMG Ltd. paid a dividend of `3 last year. For the year ended 31st March, 2014 its earnings per share is `8.
What is the amount of dividend that it should pay? The company’s target payout ratio in the long-run is 50%.
Use Lintner’s model with an adjustment factor of 0.6.
[`3.60]
5.2 PQR Ltd. has an EPS of `12.50 for the year ended 31st March, 2014. The company has a target payout ratio
of 70%. For the year ended 31st March, 2013 the company had paid a dividend of `6.75 per share. You are
required to recommend the dividend per share for the year ended 31st March, 2014 by using Lintner’s model
with an adjustment factor of 0.5.
[`7.75]

Dividend Discount Model (DDM)
6.1 Rani has invested in a share whose dividend is expected to grow at 15% for 5 years and thereafter at 5% till
life of the company. Find out value of the share, if current dividend is `4 and investor’s required rate of return
is 6%.
[`657]
6.2 [C.S.] A large sized chemical company has been expected to grow at 14% per year for the next 4 years and
then to grow indefinitely at the same rate as the national economy, i.e., 5%. The required rate of return on the
equity shares is 12%. Assume that the company paid a dividend of `2 per share last year (D0=2).
Determine the market price of the share today.
[`40.62]
6.3 [C.A.] A company pays a dividend of `2 per share with a growth rate of 7%. The risk-free rate is 9% and
the market rate of return is 13%. The company has a beta factor of 1.50. However, due to a decision of the
Finance Manager, beta is likely to increase to 1.75.
le
Find out the present as well as the likely value of the share after the decision.
[`26.75, `23.78]
6.4 [C.A.] A company has a book value per share of `137.80. Its return on equity is 15% and it follows a policy
ha
of retaining 60% of its earnings. If the opportunity cost of capital is 18%, what is the price of the share today?
[adopt the perpetual growth model to arrive at your solution].
[`91.89]
ok
6.5 D Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The growth rate is likely to be
10% for the third and fourth year. After that the growth rate is expected to stabilize at 8% per annum. If the last
dividend was `1.50 per share and the investor’s required rate of return is 16%, determine the current value of
G
equity share of the company.
The P.V. factors at 16%
Year 1 2 3 4
il
P.V. factor 0.862 0.743 0.641 0.552
[`22.43]
un
6.6 [C.A.] Shares of Voyage Ltd. are being quoted at a price-earning ratio of 8 times. The company retains 45%
of its earnings which are `5 per share.
You are required to compute:
.S
(1) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(2) If the anticipated growth rate is 16% per annum, calculate the indicative market price with the same cost of
capital.
(3) If the company’s cost of capital is 20% p.a. & the anticipated growth rate is 19% p. a., calculate the market
A
price per share.

[(1) 21.87% (2) `46.85 (3) `275]
C
6.7 [C.A.] In December, 2011 AB Co.’s share was sold for `146 per share. A long term earnings growth rate of
7.5% is anticipated. AB Co. is expected to pay dividend of `3.36 per share.
(i) What rate of return an investor can expect to earn assuming that dividends are expected to grow along with
earnings at 7.5% per year in perpetuity?
(ii) It is expected that AB Co. will earn about 10% on book Equity and shall retain 60% of earnings. In this case,
whether, there would be any change in growth rate and cost of Equity?
[(i) 9.8% (ii) g = 6%, Ke = 9.68%]
6.8 [C.A.] X Limited, just declared a dividend of `14 per share. Mr. B is planning to purchase the share of
X Limited, anticipating increase in growth rate from 8% to 9%, which will continue for three years. He also
expects the market price of this share to be `360 after three years.
You are required to determine:
(i) the maximum amount Mr. B should pay for shares, if he requires a rate of return of 13% per annum.
(ii) the maximum price Mr. B will be willing to pay for share, if he is of the opinion that the 9% growth can be
maintained indefinitely and requires 13% rate of return per annum.
(iii) the price of share at the end of three years, if 9% growth rate is achieved and assuming other conditions
remaining same as in (ii) above.
Calculate rupee amount up to two decimal points.
Year-1 Year-2 Year-3
FVIF @ 9% 1.090 1.188 1.295
FVIF @ 13% 1.130 1.277 1.443
PVIF @ 13% 0.885 0.783 0.693
[(i) `288.56 (ii) `381.50 (iii) `494]
6.9 [C.A.] A firm had been paid dividend at `2 per share last year. The estimated growth of the dividends
from the company is estimated to be 5% p.a. Determine the estimated market price of the equity share if the
estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also find out the present market price of
the share, given that the required rate of return of the equity investors is 15.5%.
[Current price `20, with 8% growth `28.80, with 3% growth `16.48]

P-1 [C.S.] Calculate the market price of a share of ABC Ltd. under (i) Walter’s formula, and (ii) Dividend
growth model from the following data:
Earning per share `5
Dividend per share `3
Cost of capital 16%
Internal rate of return 20%
Retention ratio 50%
Soln.
es
(i) Value by Walter’s model
r 0.20
D + ( E − D) 3+ (5 − 3)
k 0.16 5.50
ss
P = = = = `34.38
k 0.16 0.16
(ii) Value by Dividend growth model
la
E(1 − b) 5(1 − 0.5) 2.50
P = = = = `41.67
k − br 0.16 − (0.50 × 0.20) 0.06
C
P-2 [C.A., C.S.] The following figures are collected from the annual report of XYZ Ltd.:
Net profit `30 lakhs
Outstanding 12% preference shares `100 lakhs
No. of equity shares 3 lakhs
h
Return on Investment 20%

rs
What should be the approximate dividend payout ratio so as to keep the share price at `42 by using Walter’s
model?
Soln. Earnings = Net profit – Preference dividend
da
= 30 – 12 = `18 lakhs
Computation of cost of equity
Net profit
A
Return on investment = × 100

Capital employed
30
20 = × 100
Capital employed
30
Capital employed = × 100 = `150 lakhs
20
Equity shareholders’ funds = Capital employed – Preference capital
= `150 lakhs – `100 lakhs
= `50 lakhs
Equity capital = 3 lakh shares × `10 = `30 lakhs
Therefore, reserves = 50 lakhs – 30 lakhs = `20 lakhs
EPS = `18 lakhs ÷ 3 lakh shares = `6
EPS
ke = × 100
P
6
= × 100 = 14.29%
42
Weighted average cost of capital

Source ` lakhs Proportion Cost Average cost
Equity capital 30 3/15 14.29% 2.86%
Reserves 20 2/15 14.29% 1.91%
Preference capital 100 10/15 12.00% 8.00%
150 12.77%
The weighted average cost of capital is 12.77% or say 13%
Value of a share by Walter’s model is given by:
r
D + ( E − D)
P = k
k
0.20
D+ (6 − D)
0.13
42 =
0.13
0.20
5.46 = D + (6 − D)
le
0.13
5.46 = D + 9.23 – 1.54D
1.54D – D = 9.23 – 5.46
ha
0.54D = 3.77
3.77
D= = `6.98 or `7 per share
0.54
ok
Dividend 3.77
Dividend payout = × 100 = × 100 = 116.67%
EPS 0.54
P-3 [C.S.] Exponent Ltd. had 50,000 equity shares of `10 each outstanding on 1st April. The shares are being
G
quoted at par in the market. The company intends to pay a dividend of `2 per share for current financial year. It
belongs to a risk class whose appropriate capitalization rate is 15%.
Using Modigliani-Miller Model and assuming no taxes, ascertain the price of company’s share as it is likely to
il
prevail at the end of the year when (i) dividend is declared; and (ii) no dividend is declared.
Also find out number of new equity shares that the company must issue to meet its investment needs of `2,00,000
un
assuming net income of `1,10,000 and assuming that the dividend is paid.
Soln.
(i) When dividend is declared, by M-M formula we have
.S
D1 + P1
P0 =
1+c
2 + P1
10 =
1.15
A
11.5 = 2 + P1
P1 = 11.5 – 2 = `9.50
C
(ii) When dividend is not declared

D1 + P1
P0 =
1+c
0 + P1
10 =
1.15
11.5 = P1
P1 = `11.5
(iii) Number of equity shares to be issued to meet investment need of `2,00,000
mP1 = I – (NP – nD1)
m(9.50) = 2,00,000 – [1,10,000 – (2 × 50,000)]
9.50m = 2,00,000 – 10,000
9.50m = 1,90,000
m = 20,000 equity shares
Chapter
6
Bond Valuation
Bond Valuation Model

Theoretically, the market value of a bond is equal to the present value of the future cash flows expected from the
bond. These are the periodic interest payments and the redemption value which may be at par or at a premium.
These cash flows are discounted at the expected rate of return of the investor to find what an investor would be
willing to pay for the bond.
n
I RP
Market value of bond = ∑ (1 + k)t +
(1 + k )n
t =1
Where,
I = interest income per period (six-monthly, yearly, etc)
k = expected yield on the investor
n = total periods till maturity
!! The expected yield of the investor (k) is always expressed as a rate per annum. However, interest on a bond may be
es
paid yearly or six-monthly. Where interest is paid annually, there the above mentioned formula can be used directly.
However, in case of six-monthly interest payments ‘k’ will have to be taken accordingly. Similarly, ‘n’ refers to the
number of years or six-monthly periods till maturity.
Current or Flat Yield of a Bond

ss
la
This is the rate of return for the immediate year that an investor earns by investing in the bond.
I
× 100
C
Current or flat yield =
P
Where,
I = interest income per annum
h
P = current market price of the bond

rs
Yield to Maturity (YTM) of a Bond

This is the rate of return that the investor will earn over a period of time if he holds the bond till its maturity.
da
I + RP n− P
YTM = 1 ( P + RP)
2
A
Where,
I = interest income per annum
RP = redemption price of the bond
n = years to maturity
Bond Theorems
Market interest rates do not remain constant. Fluctuation in interest rates changes the expected yields from
bonds which affect the market price of bonds. The following are the bond theorems or rules in this respect:
(1) The market price of fixed coupon bonds are inversely related to interest rates. When there is a drop in
interest rates the bond prices will rise and vice versa.
(2) Between two bonds having same coupon rate, the market price of long-term bonds will fluctuate more than
that of short-term bonds.
(3) Between two bonds having same maturity, the market price of low coupon rate bonds will fluctuate more
than that with high coupon rate.

Duration of a Bond
Duration of a bond refers to the period, in years, required to recover the price of the bond from the cash inflows
from the bond. The duration will always be less than maturity period of the bond, except in case of zero coupon
bonds. In case of zero coupon bonds, the inflow is only on maturity and hence duration will be equal to the
maturity period. The duration can be calculated from the ‘Macaulay Duration Formula’ given below:
n
tC nM
∑ (1 + i)t
+
(1 + i)n
t =1
Macaulay Duration =
P
Where,
C = periodic coupon payment (six-monthly/yearly, etc)
i = required yield
n = number of cash flows
M = maturity value
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Duration can be computed in the form of a table as under:
ha
Col. 1 List of serial number of cash inflows
Col. 2 List the cash inflows till maturity
Col. 3 List of PV factors at YTM
ok
Col. 4 List of PV of cash inflows [Col. 2 × Col. 3] (The total of this column gives the present value of the bond)
Col. 5 List of proportion of each PV of inflow to the price of the bond [Col.4 ÷ Total of Col. 4]
Col. 6 List product of serial number of each cash flow & proportion thereof [Col. 1 × Col. 5]. The total of this
column is the duration in years.
G
Alternatively
1+Y (1 + Y ) + P (C − Y )
Duration = −
il
Y C (1 + y )P − 1 + Y
Where,
un
Y = YTM
P = period of bond
C = coupon, i.e. interest rate
.S
Volatility or Modified Duration of a Bond

The value of a bond will fluctuate with changes in the current expected yield. For example, a bond has a coupon
of 9% but the current expected yield is 9.5% then the value of the bond will fall to provide the expected yield. If
A
the expected yield falls below 9% then the value of the bond will be above its par value. The volatility of a bond
can be computed as under:
C
Duration
Volatility [or Modified Duration] =
1 + YTM
The volatility of a bond indicates the percentage of increase/decrease in the market price of a bond for every 1%
change in expected yield.
!! The bond prices always move in the opposite direction of the change in interest rates; i.e. if expected yield rises the
bond prices will fall to provide the expected yield & vice versa. For example, a `100 face value bond is issued at
par when the prevailing interest rate was 9%. The interest paid per bond per year being `9. If the expected interest
yield falls to 8% then the price of the bond would rise to: `9 × 100/8 = `112.50. If the expected interest yield falls
to 10% then the new price of the bond would fall to: `9 × 100/10 = `90. These new prices provide the expected
yield.
Yield Curve
The yield from a bond/debenture over its term when plotted on a graph is called a Yield Curve. If interest rates
are rising then it will be upward sloping. If interest rates are falling then it will be downward sloping. If interest
rates are constant then it will be straight line. If interest rates fluctuate during the term during the term then the
curve will indicate the same. These patterns are given below:
Bond Valuation Ɩ 91
(a) Yield curve with rising interest rates
Yield
Term

(b) Yield curve with falling interest rates
Yield
es

(c) Yield curve with constant interest rate
Term
ss
la
C
h
Yield
rs
da
Term

(d) Yield curve with fluctuating interest rates
A
Yield
Term

Forward Interest Rates

(a) Interest rate of first year
To compute the forward interest rates we start with the current price of the one year treasury bill (T-bill)
price.

FV
One year T-bill price =
(1 + r1 )
Where,
FV = face value of T-bill
r1 = interest rate for the first year [to be determined]
(b) Forward interest rate of second year
For this, we use the current market price of the Government security with a maturity period of two years
and the interest rate computed for the first year (r1). The current price of the security should be equal to the
present value of the cash flow of the two years till maturity, i.e. the interest at the end of year one and the
interest plus the redemption amount at the end of year two.
I I + RP
Price of Govt. security with 2 years to maturity = +
(1 + r1 ) (1 + r1 )(1 + r2 )
Where,
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I = interest per annum
RP = redemption value of security
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r1 = interest rate for the first year [computed earlier]
r2 = interest rate for the second year [to be determined]
(c) Forward interest rate of third year
For this, we use the current market price of the Government security with a maturity period of three years
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and the interest rates computed for the first year (r1) & second year (r2). The current price of the security
should be equal to the present value of the cash flow of the three years till maturity, i.e. the interest at the
end of year one & two and the interest plus the redemption amount at the end of year three.
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I I I + RP
Price of Govt. security with 3 years to maturity = + +
(1 + r1 ) (1 + r1 )(1 + r2 ) (1 + r1 )(1 + r2 )(1 + r3 )
Where,
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I = interest per annum
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RP = redemption value of security

r1 = interest rate for the first year [computed earlier]
r2 = interest rate for the second year [computed earlier]
r3 = interest rate for the third year [to be determined]
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(d) Forward rates for subsequent years

The above method can be extended to compute forward rates for fourth year, fifth year & so on.
Convertible Debentures or Bonds

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These are debentures or bonds are those which are converted into equity shares of the issuing company on the
specified date and at the predetermined price. Sometimes such conversion is at the option of the holder of the
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holder of the bond or debenture. The terms related to convertible debentures/bonds are:
(1) Conversion price – This is the price at which the conversion takes place.
(2) Conversion ratio – This refers to the number of equity shares that each bond or debenture will be converted
into. This can be computed as follows:
Par value of debenture
Conversion ratio =
Conversion price per share
(3) Conversion parity price or Market conversion price – This is the price of the equity share which is in parity
(equality) with the debenture value. This can be computed as follows:
Market price of debenture
Conversion parity price =
Conversion ratio
(4) Conversion premium – If the conversion price per equity share is more than its market value then the
conversion is at a premium and it can be computed as follows:
Conversion premium per share = Conversion parity price – Market price of equity share
This may be expressed at a percentage of the market price of the equity share as follows:
Conversion premium per share
Conversion premium ratio = × 100
Market price per equity share
(5) Conversion value or Stock value of bond/debenture – This is the value of the bond/debenture determine
from the conversion ratio and the market price of the share. This can be computed as follows:
Conversion value = Market value of equity share × Conversion ratio
(6) Straight value of bond/debenture – This is the value of a bond/debenture if it were non-convertible.
(7) Premium over straight value of debenture – This is the excess of the market price of a convertible bond/
debenture over its straight value.
Premium over straight value = Market value of bond/debenture – Straight value of bond/debenture
This may be express as a percentage to its straight value as follows:
Premium over straight value
Premium over straight value = × 100
Straight value
(8) Downside risk – The conversion price of the bond/debenture into equity shares is predetermined. However,
the market price may fall below the conversion price. If the market price of the equity share falls sharply
then the bond/debenture will not be converted to shares (in case it is optional). The market value of a
convertible bond/debenture is higher than its straight value due to the benefit of conversion but if the
bond is not likely to be converted the its value will fall to its straight value. The possibility of this fall in
price is the downside risk that the investor in such a bond/debenture faces. This is computed as follows:
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Market value of bond/debenture − Straight value
Downside risk = × 100
Market value of bond/debenture
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(9) Favourable income differential – Even if the conversion price is slightly more than the market price of the
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equity share it is still worth buying the convertible bond/debenture because of the income differential that
will arise. Buying the bond/debenture will give more income on a per share basis than buying the share
directly. This favourable income differential is computed as follows:
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Interest income per bond/debenture
Favourable income per share = – Dividend per share
Conversion ratio
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(10) Premium payback period – Buying a convertible bond/debenture may result in getting the equity shares at
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a premium over their market price. This premium will be recovered from the favourable income differential
discussed above. The time taken to recover the premium is called the premium payback period and is
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Conversion premium per share

Premium payback period (in years) =
Favourable income per share
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Refunding of Bonds
Callable bonds/debentures are securities which give the issuer an option to redeem them before the expiry of
their term but usually after the expiry of a certain period of time. For example, a company may issue 12% bonds
of `1,000 each at par with a term of 20 years with an option to call @ `1,100 at any time after the expiry of 8
years. Issuers keep this option in case of long-term securities because there may be a fall in interest rates in the
future and the issuer does not want to be locked into a high rate liability for a long period. Usually a premium
is paid to the holder of the bond in case it is called before the expiry of its term and such premium is specified
in the terms at the time of the issue itself. Another reason to issue callable bonds is that it is possible that the
issuer may have enough surplus funds to repay the liability after a certain period and wants to keep the option
to repay its liability at an early date. The decision of refunding such callable bonds should be viewed as a capital
budgeting decision. Two scenarios are possible –
(1) Early repayment without issuing new bonds: This situation arises when the company has surplus funds and
wants to retire its liability. Find NPV from the following initial outlay and cash flows to decide whether
bonds should be refunded.
(a) Initial outlay:
(i) Principal to be paid for redemption of old bonds xx
(ii) After tax premium on old bonds xx
(iii) The tax shield on the unamortized amount of discount on issue, if any – xx
(iv) The tax shield on the unamortized amount of bond issue expenses – xx
Initial outlay xx
(b) Cash flows (savings):
(i) Interest xx
(ii) Annual amortized amount of discount on issue, if any xx
(iii) Annual amortized amount of bond issue expenses xx
Total expenses xx
– Tax xx
Expenses after tax xx
Less: Non-cash items
(i) Annual amortized amount of discount on issue, if any xx
(ii) Annual amortized amount of bond issue expenses xx
CFAT xx
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(2) Refunding old bonds by issuing new bonds: In case interest rates have fallen sharply and are likely to
remain low and the there is substantial unexpired term of existing bonds, the company may consider
refunding the old high interest bearing bonds by issuing bong with a low rate of interest. This should be
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solved like the replacement decision in capital budgeting where all incremental cash flows are taken into
consideration.
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!! Whether specified in the problem or not the term of the new bonds issued will be equal to the unexpired term
of the old bonds. For example, the old bonds had a term of 20 years. They are to be refunded after 12 years.
The term of the new bonds will be 8 years even if not given in the question.
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(a) Initial outlay:
(i) Principal to be paid for redemption of old bonds xx
(ii) After tax premium on old bonds xx
(iii) Proceeds from issue of new bonds – xx
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(iv) After tax interest on old bonds for overlapping period (see tip below) xx
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(v) The tax shield on the unamortized amount of discount on issue, if any – xx
(vi) The tax shield on the unamortized amount of bond issue expenses – xx
Initial outlay xx
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!! New bonds are issued first & the money is used to repay the old bonds. If the problem specifies that
there will be a delay in refund the old bonds then the interest on the old bonds for the period of the delay
should be included in the initial outlay. For example, if the old bonds are refunded 3 months after the
issue of the new bonds then interest on the old bonds for 3 months should be included in initial outlay.
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(b) Cash flows:

(i) Savings in annual interest xx
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(ii) Annual differential amortized amount of discount on issue, if any ± xx

(iii) Annual differential amortized amount of bond issue expenses ± xx
Total expenses xx
– Tax xx
Expenses after tax xx
Non-cash items
(i) Annual differential amortized amount of discount on issue, if any ± xx
(ii) Annual differential amortized amount of bond issue expenses ± xx
CFAT xx
Problems
Valuation, Yield, Duration, etc.
1.1 [C.A.] (a) Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity.
Both the bonds have a face value of `1,000 and coupon rate of 8% (with annual interest payments) and both
are selling at par. Assume that the yields of both the bonds fall to 6%. whether the price of bond will increase
or decrease? What percentage of this increase/decrease comes from a change in the present value of bond’s
principal amount and what percentage of this increase/decrease comes from a change in the present value of
bond’s interest payments?
(b) Consider a bond selling at its par value of `1,000, with 6 years to maturity and a 7% coupon rate (with
annual interest payment), what is bond’s duration?
(c) If the YTM of the bond in (b) above increases to 10%, how it affects the bond’s duration? And why?
(d) Why should the duration of a coupon carrying bond always be less than the time to its maturity?
[(a) Price increase due to change in PV of principal: 5 yr Bond 78.6%, 20 yr Bond 42.68%. Price increase due to change in PV of interest: 5 yr Bond
20.86%, 20 yr Bond 57.49%. (b) 5.098 years (c) 5.025 years]
1.2 [C.A.] XL Ispat Ltd. has made an issue of 14% non-convertible debentures on January 1, 2007. These
debentures have a face value of `100 and is currently traded in the market at a price of `90.
Interest on these NCDs will be paid through post-dated cheques dated June 30 and December 31. Interest
payments for the first 3 years will be paid in advance through post-dated cheques while for the last 2 years post-
dated cheques will be issued at the third year. The bond is redeemable at par on December 31, 2011 at the end
of 5 years.
Required:
(i) Estimate the current yield at the YTM of the bond.
(ii) Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment calculate the realized
yield on the NCD.
[(i) 17.14% (ii) 3.8524 years (iii) 13.56%]
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1.3 [C.A.] An investor is considering the purchase of the following Bond:
Face value `100
Coupon rate
Maturity
11%
3 years
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(i) If he wants a yield of 13% what is the maximum price he should be ready to pay for?
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(ii) If the Bond is selling for `97.60, what would be his yield?
[(i) `95.27 (ii) 12%]
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1.4 [C.A. twice, C.S.] Based on the credit rating of bonds, Mr Z has decided to apply the following discount
rates for valuing bonds:
Credit rating Discount rate
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AAA 364 day T-bill rate + 3% spread

AA AAA + 2% spread
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A AAA + 3% spread
He is considering to invest in AA rated, `1,000 face value bond currently selling at `1,025.86. The bond has 5
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years to maturity and coupon rate of 15% per annum payable annually. The next interest payment is due one
year from today and the bond is redeemable at par. (Assume the 364 day T-bill rate to be 9%).
You are required to calculate the intrinsic value of the bond for Mr Z. Should he invest in the bond? Also
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calculate the current yield and the yield to maturity of the bond.
[Intrinsic value of the bond `1033.80. The bond should be purchased. Current yield 14.62%, YTM 14.3%]
1.5 [C.A.] Calculate Market Price of:
(i) 10% Government of India security currently quoted at `110, but interest rate is expected to go up by 1 %.
(ii) A bond with 7.5% coupon interest, Face Value `10,000 & term to maturity of 2 years, presently yielding 6%.
Interest payable half yearly.
[(i) `99.11 (ii) `10,279]
1.6 [C.A.] Find the current market price of a bond having face value `1,00,000 redeemable after 6 year maturity
with YTM at 16% payable annually and duration 4.3202 years. Given 1.166 = 2.4364.
[`96,275]
1.7 [C.A.] MP Ltd. issued a new series of bonds on January 1, 2000. The bonds were sold at par (`1,000),
having a coupon rate 10% p.a. and mature on 31st December, 2015. Coupon payments are made semiannually
on June 30th and December 31st each year. Assume that you purchased an outstanding MP Ltd. Bond on 1st
March, 2008 when the going interest rate was 12%.
Required:
(i) What was the YTM of MP Ltd. Bonds as on January 1, 2000?

(ii) What amount you should pay to complete the transaction? Of that amount how much should be accrued
interest and how much would represent bonds basic value.
[(i) 10% (ii) Amount paid per bond `952.60. Basic bond value `902.60 & accrued interest `50]
1.8 [RTP] Mr. A is planning for making investment in bonds of one of the two companies X Ltd. and Y Ltd. The
details of these bonds is as follows:
Company Face value Coupon rate Maturity period
X Ltd. `10,000 6% 5 years
Y Ltd. `10,000 4% 5 years
The current market price of X Ltd.’s bond is `10,796.80 and both bonds have same Yield To Maturity (YTM).
Since Mr. A considers duration of bonds as the basis of decision making, you are required to calculate the
duration of each bond and you decision.
[Duration: X Ltd. 4.4878 years, Y Ltd. 4.628 years]
1.9 [C.A.] The Investment portfolio of a bank is as follows:
Government Bond Coupon Rate Purchase rate Duration
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(F.V. `100 per Bond) (Years)
G.O.I. 2006 11.68 106.50 3.50
G.O.I. 2010 7.55 105.00 6.50
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G.O.I. 2015 7.38 105.00 7.50
G.O.I. 2022 8.35 110.00 8.75
G.O.I. 2032 7.95 101.00 13.00
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Face value of total Investment is `5 crores in each Government Bond.
Calculate actual Investment in portfolio.
What is a suitable action to churn out investment portfolio in the following scenario?
(1) Interest rates are expected to lower by 25 basis points.
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(2) Interest rates are expected to raise by 75 basis points.
Also calculate the revised duration of investment portfolio in each scenario.
[Average duration 7.85 years, (1) 9.75 years (2) 6.55 years]
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1.10 [C.A.] If the market price of the bond is `95; years to maturity = 6 yrs; coupon rate = 13% p.a (paid
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annually) and issue price is `100. What is the yield to maturity?

[14.18%]
Forward Interest Rates

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2.1 [C.A.] Consider the following data for Government Securities:

Face value Interest Maturity Current Price
(`) (rate %) (years) (`)
1,00,000 0 1 91,000
A
1,00,000 10.5 2 99,000

1,00,000 11.0 3 99,500
C
1,00,000 11.5 4 99,900

Calculate the forward interest rates.
[9.9%, 12.4%, 11.5%, 12.8%]
2.2 [C.A.] From the following data for Government securities, calculate the forward rates:
Face value Interest Maturity Current Price
(`) (rate %) (years) (`)
1,00,000 0 1 91,500
1,00,000 10 2 98,500
1,00,000 10.5 3 99,000
[9.3%, 12.63%, 11%]
2.3 [C.A.] The following is the Yield structure of AA rated debenture:
Period Yield (%)
3 months 8.50
6 months 9.25
1 year 10.50
2 years 11.25
3 years and above 12.00
(i) Based on the expectation theory calculate the implicit one-year forward rates in year 2 and year 3.
(ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of the bond
having a maturity of 5 years? Assume that the bond is fairly priced at the moment at `1,000.
[(i) 2 yrs 12%, 3 yrs 13.52% (ii) 2.2%]
2.4 [C.A.] On 31st March, 2013, The following information about Bonds available:
Name of security Face Value ` Maturity date Coupon rate Coupon date(s)
Zero coupon 10,000 31st March, 2023 N.A. N.A.
T-bill 1,00,000 20th June, 2013 N.A. N.A.
10.71% GOI 2023 100 31st March, 2013 10.71 31st March
10% GOI 2018 100 31st March, 2018 10.00 31st March &
31st October
Calculate:
(i) If 10 years yield is 7.5% p.a., what price the Zero Coupon Bond would fetch on 31st March, 2013?
(ii) What will be the annualized yield if the T-Bill is traded 98,500?
(iii) If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2013 (after
coupon payment on 31st March)?
(iv) If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it fetch on April 1, 2013 (after,
coupon payment on 31st March)?
Convertible Bonds
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3.1 [C.A.] A convertible bond with a face value of `1,000 is issued at `1,350 with a coupon rate of 10.5%.
The conversion rate is 14 shares per bond. The current market price of bond and share is `1,475 and `80
respectively. What is the premium over conversion value?
[31.7%]
3.2 [C.A.] The data given below relates to a convertible bond:
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Face value `250
Coupon rate 12%
No. of shares per bond 20
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Straight value of bond `235
Market price of convertible bond `265
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Calculate:
(i) Stock value of bond.
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(ii) The percentage of downside risk.

(iii) The conversion premium
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(iv) The conversion parity price of the stock.

[(i) `240 (ii) 12.77% (iii) 10.42% (iv) `13.25]
3.3 [RTP] The following data is related to 8.5% fully convertible (into equity shares) debentures issued by JAC
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Ltd. at `1,000.
Market price of debenture `900
Conversion ratio 30
Straight value of debenture `700
Market price of equity share on the date of conversion `25
Expected dividend per share `1
You are required to calculate:
(a) Conversion value of debenture
(b) Market conversion price
(c) Conversion premium per share
(d) Ratio of conversion premium
(e) Premium over straight value of debenture
(f) Favourable income differential per share
(g) Premium payback period
[(a) `750 (b) `30 (c) `5 (d) 20% (e) 28.6% (f) `1.833 (g) 2.73 years]
3.4 [C.A.] The data given below relates to a convertible bond:
Face value `250

Coupon rate 12%
No. of shares per bond 20
Straight value of bond `235
Market price of convertible bond `265
Calculate:
(i) Stock value of bond.
(ii) The percentage of downside risk.
(iii) The conversion premium
(iv) The conversion parity price of the stock.
[(i) `240 (ii) 12.77% (iii) 10.42% (iv) `13.25]
3.5 [C.A.] GHI Ltd., AAA rated company has issued, fully convertible bonds on the following terms, a year ago:
Face value of bond `1,000
Coupon (interest rate) 8.5%
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Time to Maturity (remaining) 3 years
Interest Payment Annual, at the end of year
Principal Repayment At the end of bond maturity
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Conversion ratio (Number of shares per bond) 25
Current market price per share `45
Market price of convertible bond `1,175
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AAA rated company can issue plain vanilla bonds without conversion option at an interest rate of 9.5%.
Required: Calculate as of today:
(i) Straight Value of bond.
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(ii) Conversion Value of the bond.
(iii) Conversion Premium.
(iv) Percentage of downside risk.
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(v) Conversion Parity Price.
t 1 2 3
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PVIF0.095, t 0.9132 0.8340 0.7617

[(i) `974.96 (ii) `1,125 (iii) `2 (iv) 20.52% (v) `47]
Refunding of Bonds
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4.1 [C.A.] ABC Ltd. has `300 million, 12% bonds outstanding with six years remaining to maturity. Since
interest rates are falling, ABC Ltd. is contemplating of refunding these bonds with a `300 million issue of 6 year
bonds carrying a coupon rate of 10%. Issue cost of the new bond will be `6 million and the call premium is 4%.
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`9 million being the unamortized portion of issue cost of old bonds can be written off no sooner the old bonds
are called off. Marginal tax rate of ABC Ltd. is 30%. You are required to analyze the bond refunding decision.
[Bonds should be refunded. NPV `7.60 million]
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4.2 [C.A.] M/s Earth Limited has 11% bond worth of `2 crores outstanding with 10 years remaining to maturity.
The company is contemplating the issue of a `2 crores 10 year bond earring the coupon rate of 9% and use the
proceeds to liquidate the old bonds. The unamortized portion of issue cost on the old bonds is `3 lakhs which
can be written off no sooner the old bonds are called. The company is paying 30% tax and it’s after tax cost of
debt is 1%. Should Earth Limited liquidate the old bonds?
You may assume that the issue cost of the new bonds will be `2.5 lakhs and the call premium is 5%.
[Bonds should be refunded. NPV `10.96 lakhs]
4.3 [C.A.] M/s Transindia Ltd. is contemplating calling Rs. 3 crores of 30 year’s, `1,000 bond issued 5 years ago
with a coupon interest rate of 14%. The bonds have a call price of `1,140 and had initially collected proceeds of
`2.91 crores due to a discount of `30 per bond. The initial floating cost was `3,60,000. The Company intends to
sell `3 crores of 12% coupon rate, 25 years bonds to raise funds for retiring the old bonds. It proposes to sell the
new bonds at their par value of `1,000. The estimated flotation cost is `4,00,000. The company is paying 40%
tax and its after cost of debt is 8%. As the new bonds must first be sold and their proceeds, then used to retire
old bonds, the company expects a two months period of overlapping interest during which interest must be paid
on both the old and new bonds. What is the feasibility of refunding bonds?
[NPV `8,11,980]
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Chapter
7
Indian Capital Market
The economic development of a country depends on the efficiency with which its financial system operates.
Setting up of industry as well as their future growth depends on easy available of long term funds. The capital
market comprises of institutions and mechanisms through which medium term funds and long term funds are
pooled and made available to business, government, and individuals. To put it simply capital market provides
the resources needed by medium and large scale industries for investment purposes. It is the market for long
term instruments like stocks & bonds.
Capital market can be classified into (a) Primary market (b) Secondary market.
(a) Primary market: This is the market where new securities are bought and sold for the first time and are
referred to as Initial Public Offers or IPOs. The primary market creates long term instruments through
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which corporate entities borrow from the capital market. This market provides the channel for sale of new
securities. This market also includes issue of further capital by companies whose shares are already listed
on stock exchanges; e.g. rights issue.
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(b) Secondary market: Secondary market deals in securities, which have been issued, through primary market.
So this market enables those who hold securities to adjust their holdings in response to changes in their
assessment of risk and return. A common example of secondary market is stock exchange where already
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issued securities are traded.
Intermediaries in the Capital Market
There are different types of intermediaries operating in the capital market and they play an important part in the
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development of the capital market. The following are the intermediaries operating in the capital market:
– stock-broker, sub- broker,
– share transfer agent,
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– banker to an issue,
– trustee of trust deed,
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– registrar to an issue,
– merchant banker,
– underwriter,
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– portfolio manager,
– investment adviser and such other intermediary who may be associated with securities market.
– depository,
– depository participant
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– custodian of securities
– foreign institutional investor,
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– credit rating agency or any other intermediary associated with the securities market as the Board may by
notification in this behalf specify.
Green Shoe Option

There are no restrictions on the pricing of a share in a public issue. When a company makes an initial public
offer (IPO) neither the company nor the investor knows what would a fair price for the share. It has been
observed that the price of a share has risen sharply after its listing in which case the company has missed out
on an opportunity of charging a higher premium. On the other hand, share prices have also fallen sharply after
listing and the investors have felt they paid far too much for the share. Green Shoe Option is a price stabilizing
mechanism that a company can adopt to try to stabilize the price of the share in case it declines after its listing.
Green shoe option is the option available to the company to allot more number of shares than are offered in
the offer document of the public issue. This is possible only in case of over-subscription. The stabilizing process
works as under:
(1) The company appoints one of the merchant bankers or Book Runners as the stabilizing agent (SA), who
will be responsible for the price stabilization process, if required. The SA enters into an agreement with
the issuer company, prior to filing of offer document with SEBI, clearly stating all the terms and conditions
relating to this option including fees charged/expenses to be incurred by SA for this purpose. The SA also
Indian Capital Market Ɩ 101

enters into an agreement with the promoters or pre-issue shareholders who will lend their shares, which
shall not be in excess of 15% of the total issue size.
(2) These shares are allotted pro-rata to all the applicants and the money received is deposited in a separate
bank account called the Green Shoe Option (GSO) bank account.
(3) The stabilization mechanism shall be available for the period disclosed by the company in the prospectus,
which shall not exceed 30 days from the date when trading permission was given by the exchange(s).
(4) If the share price after listing does not fall below the issue price then no stabilizing is required. At the end
of the stabilization period the company will issue fresh shares equal to the number of shares borrowed by
the SA for which payment is made to the company from the GSO bank account. The SA then gives such
shares to the promoters & pre-issue shareholders whom the shares were borrowed.
(5) If the share price falls after listing then the SA intervenes to stabilize the market price of the share. The SA
will purchase the shares from the market thereby creating a demand for the share in an attempt to push
up the price once again. He has 30 days after listing to carry out this stabilizing process which may or may
not be successful. The shares purchased are returned to the shareholders from whom they were borrowed.
If all the shares borrowed are not purchased from the market then the remaining shares are alloted by the
company for which payment is made from the GSO bank account. As the SA buys the shares below the
issue price there will be some balance in the GSO bank account. Such balance has to be deposited in the
Investor Protection Fund.
This mechanism is called the Green Shoe Option because the Green Shoe Company, a US company, was the first
company in the world to use this option.
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Book-building Process
There are no restrictions on the pricing of a share in a public issue. When a company makes an initial public
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offer (IPO) neither the company nor the investor knows what would a fair price for the share. If the company
overprices the share the issue might fail. Thus the company is interest in knowing what is the price at which the
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issue will be successful. More & more companies in the Indian securities market are accessing the capital market
through book building process. “Book Building” is a process where the company does not decide the issue price
of the equity shares in advance but determines it by from the demand for the equity shares at different prices on
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the basis of bids received by it. The offer/issue price is determined after the bid closing date based on certain
evaluation criteria. The company, in its offer document, announces a floor and a cap price which is the minimum
and maximum issue price of the share. The maximum price cannot be more than 20% above the floor price; e.g.
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if the floor price is `200 then the cap price can be `240 or less. The price range `200 to `240 is called the price
band. All applicants must bid for shares within this price band only. Depending on the number of applications
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received and the price at which bids are made the company determines the issue price of the shares. Shares are
issued at the same price to those who bid for the price which is finalized or a higher price. Refund is given to
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those who bid a lower price.
Derivatives
Contracts
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At least one Parties agree to fulfill

party performs their obligation at a
immediately. future date
Spot contracts.
Forward contracts. Derivatives
Exchange traded: Over the Counter (OTC):

(standardized) (customized)
(1) Futures (1) FRA
(2) Options (2) Swaps
(3) Swaptions
(4) Caps, Floors, Collars
A spot contract is a contract where at least one of the parties completes its side of the contract immediately.
For example:
(a) Mr. A sells & delivers goods to be Mr. B today but payment for the goods will be made after a month.

(b) Mr. X pays for a train ticket today for a journey to be undertaken by him after two months.
(c) Mr. Y purchases goods for cash from Mr. Z.
Most business transactions are spot transactions.
As against spot contracts, derivatives are contracts to be to be performed in the future. There are different
types of derivatives: forwards, futures, options, swaps, etc.
To overcome price or quantity risks, a person may enter into a forward contract. A forward contract is one
where both parties agree to fulfill their part of the contract at a predetermined future date at a predetermined
price. A person may want to enter into a forward contract for purchase of goods after two months if he is not
certain about the availability of the goods or he expects the price of the goods to increase. Similarly the supplier
of the goods may enter into a forward contract to be certain that the goods will be sold and also eliminate risks
about the selling price of the goods which may falls if the supply exceed demand after two months. A forward
contract is a customized contract between two parties which will be performed at a future date. However, in
a forward contract there is always a risk that the counter-party may not perform, i.e. there is no performance
guarantee. Under forward contracts, the parties cannot transfer their right or obligation to any other person.
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Futures
Futures are also a type of a forward contract. A futures contract can be defined as an agreement to buy or
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sell a standard quantity of a specific asset at a predetermined future date and at a price agreed between the
parties. The subject matter for which the contract is entered into is called the ‘underlying’ of the contract.
The underlying may be goods, securities, currency, rate of interest or any other thing for which the contract is
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entered into. Futures are an improvement over the forward contract for the following reasons:
(1) Standardization: The quantity as well as the quality of the asset in the futures contract is standardized and
cannot be customized. There can be different futures for different quality of goods. The standard quantity is
determined by the futures exchange. For example, a futures contract may be for 100 Kg. of grade A rice. If a
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person requires 200 Kg of rice he has to purchase two contracts of 100 Kg. There will be a different futures
for 100 Kg of grade B rice. However, there is no possibility of obtaining a futures contract for 150 Kg. This is
a limitation of futures.
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(2) Liquidity: Each futures contract is traded at the exchange and thus it provides a liquidity to the contract. A
person who has purchased a futures contract, but wants to opt out, can sell the contract to any other person
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willing to buy it at any time before the due date.

(3) Performance guarantee: In a forward contract there is a risk of default by the counter-party. However, in a
futures contract there is no such risk because the exchange acts as an intermediary and the performance of
the contract is guaranteed.
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Distinction between futures and forward contracts:

Point Futures contract Forward contract
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1) Location Futures exchange. No fixed location.

2) Size of contract Standardized by the exchange Fixed by the parties.
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3) Maturity Standardized & fixed by the exchange Fixed by the parties.

4) Counter-party Futures exchange Client or client’s bank.
5) Valuation Marked to market every day No special method of valuation.
6) Regulation Regulated by futures exchange Regulated by general laws of contract.
7) Margin Required to be maintained None.
8) Risk No risk of default Risk of default by counter-party.
9) Settlement Through clearing house or futures exchange Depends on the contract.
10) Method of By squaring off positions or cash settlement, or Mostly by actual delivery or by
settlement by actual delivery. cancellation at a cost.
Short and Long Futures

A short futures refers to a contract for sale. ‘Going short’ means selling. Taking a ‘long position’ refers to buying.
Therefore, a short futures contract is contract for sale and a long futures contract is a contract for purchase of
the underlying. A futures contract has a specified day or date on which it is settled. Usually, futures are settled
on a monthly basis and are referred to by the month in which they are to be settled; for example, a June contract
refers to a contract which has to be settled in the month of June. However, futures may have a settlement period
of more than a month which may extend up to one year.
Settlement: The futures contract have to be settled on or before the due date specified in the contract. Generally,
a futures contract can be settled either by taking/giving delivery of the underlying or by taking offsetting
positions. For example, during May, 2014, a person acquires a long futures contract for 100 Kg of grade A rice @
`10/kg having a settlement day being the last Thursday of June, 2014. The contract can be settled by squaring
off by taking a short futures contract for similar quantity on or before the due date. In India, all futures and
options are settled in cash or by taking offsetting positions and never by actual delivery. In any case, a contract
for index futures/options cannot be settled by delivery and hence all such contracts will always be settled in cash.
Margins
The clearing house/futures exchange acts as an intermediary for every contract and guarantees the performance
of each contract. Therefore, there is no risk for the buyer and seller of the futures contract but the clearing house
assumes the risk. To reduce this risk, the clearing house requires that the parties to the contract should maintain
a margin deposit for the contract entered into. Usually the margin is a certain percentage of the value of the
contract, for example, 15% of the value of the contract entered into. The margin is of two types: initial margin
and maintenance margin. The initial margin is the deposit each party has to keep for buying/selling of futures.
For example, if the initial margin is 15% and a person buys/sells a futures contract of the value of `1,00,000
then he has to deposit `15,000 as margin. The value of the contract is adjusted on a daily basis by the exchange
which adds profit to the margin deposit and deducts losses from it. If there are consistent losses then the margin
of the party will decrease gradually. The exchange also requires the parties to ensure that the margin does not
fall below a certain level from the initial margin and this is called maintenance margin. The maintenance margin
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may be a certain percentage of the initial margin, e.g. 75% of initial margin. In case the initial margin is `15,000
then the maintenance margin may be 75% of `15,000 = `11,250. If the party suffers losses consistently then its
margin may fall below the level of maintenance margin, `11,250 in our example. In this case, the party has to
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deposit additional amount to top-up the margin to the original amount, `15,000 in our example.
Marking to market
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The value of the futures contract keeps changing as long as trading continues and there will be daily valuation of
the contract which is done by the futures exchange. The futures contract derives it value due to fluctuation in the
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price of its underlying asset. The futures exchange operates on a daily basis and futures contracts are purchased
and sold at different rates. At the end of each day, the futures exchange determines the ‘settlement price’ of the
contract which is generated by the system using the weighted average of the rates at which the contracts have
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been traded during the last half an hour. A person who has acquired a long futures for 100 kg of rice @ `10/kg
has a contract valued at `1,000. At the end of the day, if the future price of grade A rice increases to `10.20/kg
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then the value of his contract is will be `10.20 × 100 kg = `1,020. The value of his long futures contract is `20
(`1020 – `1,000). However, if the rice is valued at less then `10/kg he will have made a loss. This profit/loss of
each contract is calculated and adjusted against the margin deposited by the parties to the contract on a daily
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basis. The amount of profit is added to the margin of the concerned party and deducted from the margin of the
party making the loss. This process is called marking to market.
Valuation of Futures
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The future price of a commodity will always be higher than its spot price due to storage costs. Theoretically, the
future price of a commodity is usually the spot price plus the cost of financing and holding the commodity till
the date of the maturity of the contract. For example, the future price of a 3-month futures contract for rice will
be the spot price of rice plus the cost of storing rice for 3 months. The financing and holding cost is referred to as
‘cost of carry’. Financial assets have only financing costs.
Future price (or Fair Forward Price) = Spot price + Cost of carry
However, in reality, the future price is also affected by other factors; for example, expected scarcity of the
commodity on the date of maturity of the contract will push up the price of the underlying beyond the theoretical
or fair forward price as computed above. Similarly, recession or excess supply over demand in the future may
actually reduce the future price of the underlying. These fluctuations in future price give the futures contract
their value.
The future value of a contract is determined by compounding the spot price of the underlying at the rate of
the storage & financing cost. The commonly used methods of compounding are monthly, quarterly, yearly, etc.
and this is called Discrete Compounding. However, futures are valued by compounding the spot price by a
process called Continuous Compounding.

With Continuous compounding: F = S.ert
With Simple interest: F = S (1 + rt)

Where, F = future value
S = spot price
e = exponential value, this is the natural value of logarithm, i.e. 2.71828
r = ‘cost of carry’ as a compounding rate per annum
t = time in years till the expiration of the contract
The values for ert are available in the from of a table (like the tables for PV factor, annuity factor, etc.) which give
the value of `1 after continuous compounding at ‘r’ rate for ‘t’ time period. For example, r = 18%, t = 3 months
then
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0.18 ×
ert = e 12
= e0.045
The compounding factor for e0.045 can be ascertained from the table which gives the values of `1 after continuous
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compounding for different combinations of rate and time period.
The value of the futures contract should be determined so as to take a decision on the purchase of such contracts.
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To find the value of a futures contract, the underlying may be divided into following categories:
(a) Underlying asset not generating any income.
(b) Underlying asset generating known cash income.
(c) Underlying providing known yield.
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(d) Underlying held for consumption.
(a) Underlying not generating any income

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If the underlying asset does not generate any income then the future value of such underlying can be
computed from the basic formula given above for finding the future price, which is
With Continuous compounding: F = S.ert
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With Simple interest: F = S (1 + rt)
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(b) Underlying generating known cash income

If the underlying asset will generate a known amount of income then the future value will be computed as
follows:
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With Continuous compounding: F = [S – (Income × e–rt)] × ert
With Simple interest: F = (S – PV of income) (1 + rt)

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Where,
I = known cash income in rupees
e–rt = is the PV factor at the continuously discounted rate
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t = the time, in years expressed in decimal, from current date till the date on which income will be
received.
(c) Underlying providing a known yield

If the underlying asset provides a yield at a known rate then the rate of storage cost will be reduced by the
rate of such known yield and the future value will be computed as follows:
With Continuous compounding: F = S.e(r–y)t
With Simple interest: F = S [1 + (r – y)t]

Where, ‘y’ is the known rate of yield on the underlying asset.
(d) Underlying held for consumption

An underlying asset may be held for consumption and not investment; for example, raw material held for
the purpose of production, food-grain held for personal consumption, etc. Under these circumstances, the
basic formula cannot be used to compute the future price. However, holding such underlying asset will
yield some benefit as the future price will be higher than spot price. Such yield is known as convenience
yield and can be computed for the fair forward price of the underlying.

With Continuous compounding: F = S × e(r – c)t
With Simple interest: F = S [1 + (r – c)t]

Where, ‘c’ is the convenience yield ascertained by solving the above equation. [The value ‘F’ needs to be
known to compute ‘c’]
Futures Trading
If the actual price of the futures is different from the theoretical future price as computed by using the above-
mentioned formulas then there exists an arbitrage opportunity. If the market price of a futures contract is less
than its theoretical forward price then the contract is undervalued and should be purchased and sold later at a
higher price when the market price corrects itself. If the futures contract is overvalued then it should be sold and
purchased later at a lower price when the market price corrects itself.
Hedging with Futures

To hedge means to protect the value of an asset. It is an insurance against change in the value of the asset. A
hedge is not used for gain, but as protection against loss. Trading in futures may also be done as a hedge against
price risk. If an investor has a long position in a particular security in the spot market then he should short
futures. An investor who has a short position in the spot market can hedge his position by taking long futures.
!! Hedging is done by taking a position opposite to the position in the spot market (long or short). For example, if a
person has a long position in the spot market (he has purchased shares) then he should sell futures and vice versa.
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Perfect Hedge
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Sock futures refers to futures contract for a particular security. If the futures contracts are for the same security
an investor’s position in the spot market then he will have obtained a perfect hedge. To obtain a full hedge
the investor has to obtain futures contracts for the same number of shares as his spot position if possible. For
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example, an investor has taken a long position of 300 shares of X Ltd. in the spot market and futures contracts
for X Ltd. are available with a contract size of 100 shares. For a complete hedge, he has to buy 3 short futures
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contracts. However, if futures contracts for X Ltd. are available at a standard size of 200 shares then he will not
be able to get a complete hedge. If he buys one short futures contract of 200 shares then he is under-hedged and
if he buy 2 short futures contracts then he is over-hedged.
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Imperfect hedge or Cross hedge

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Sometimes, futures contracts are not available for the same security but can be obtained for another security or
for the stock market index like, Nifty, Sensex, etc. If the futures contract is for another security or it is an index
futures then the hedge is called an imperfect hedge or cross hedge.
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Using Index futures for hedging

Instead of obtaining a hedge using futures contract for another security, it is better to obtain a hedge using index
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futures (like Nifty futures on NSE and SENSEX futures on BSE). An index futures is a futures contract which
has the stock index as the underlying. The Nifty is an index of 50 shares and likewise the Sensex is made from
30 shares. Nifty futures have the Nifty as the underlying and Sensex futures have the Sensex as the underlying.
Nifty futures are available with a multiplier of 200. This means that one Nifty futures has a value = Current
index × 200. For example, if the Nifty is at 4,500 points then the value of 1 Nifty futures contract will be =
4,500 × 200 = `9,00,000. Therefore, the value of Nifty contracts that can be purchased would be 1 contract =
`9,00,000; 2 contracts = `18,00,000; and so on. It is not possible to purchase fraction of a contract.
!! In reality, Nifty futures are available with a multiplier of 200 and SENSEX futures at a multiplier of 50 and students
are expected to know this. However, in exam problems, the multiplier may be given & it may be any other number.
Similarly, even if it is not possible to purchase futures contracts in fractions, while solving problems students may
consider contracts in fraction to prove perfect hedge. However, generally complete contracts are considered but this
results in under- or over-hedging.
If index futures are used for hedging then the number of contracts to be purchased/sold can be computed as:
* Value of asset requiring hedge

No. of futures contract to be purchased = Hedge Ratio ×
Value of a standardized futures contract
or

* Spot units requiring hedge
No. of futures contract to be purchased = Hedge Ratio ×
No. of units in a standardized futures contract
*
Hedge ratio will be the beta of the security.
Options
An option is a contract where the holder has an option, but not an obligation, to buy/sell the underlying asset.
An option may be call option or put option.
Call Option
A call option is an option available to the option-holder to buy the underlying at a predetermined price.
Put Option
A put option is an option available to the option-holder to sell the underlying at a predetermined price.
Exercise price or Strike price
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The predetermined price in an option at which the underlying will be sold is called the exercise price or strike
price. It is the price at which the option may be exercised by the option-holder.
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Parties to an Option: Holder & Writer
There are two parties to an option: the holder and the writer. The holder of the option is the buyer who buys an
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option to either call (buy) or put (sell) the underlying. The seller of the option is called the writer of the option.
While the buyer of the option has a option or choice, but not an obligation, to buy or sell the underlying,
the writer has no such option; in fact he has an obligation to perform. The writer has an obligation to buy/sell
the underlying. The writer faces a greater risk as he is under an obligation. The writer of the option charges a
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premium for writing the option and this is non-refundable. The options expires on the predetermined date. The
price at which the option to buy/sell can be exercised is called the exercise price or strike price. An option can be
exercised on or before the expiry date depending upon the type of the option.
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American Option
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An American Option is one which can be exercised at any time up to and including the expiry date.
European Option
However, an European Option is one which can only be exercised on the expiry date.
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Following are examples of call/put options:

(1) Mr. A feels that the price of a dollar after two months will be `55. He, therefore, buys a call option (option
to buy) to purchase a standard quantity of dollars @ `54 at a predetermined date. Mr. B, however, feels
that a dollar would be priced below `54 after two months and writes the option to sell the dollars to Mr. A
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at the predetermined date at a price of `54 per dollar for which Mr. B will charge a premium. Mr. B is the
writer of the option. Now, Mr. A (the holder of the option) has the option to buy the dollars @ `54 but he
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is not obliged to buy the dollars. Let us consider the following situations after two months on the date of
maturity of the option:
(i) The market rate of the dollar is `55.20. In this case, Mr. A will exercise his option and Mr. B will be
obliged to sell dollars to Mr. A @ `54.
(ii) The market rate of the dollar is `53.60. In this case, Mr. A will let his option contract lapse and
buy the dollars from the market because they are cheaper than the option price. He is not under an
obligation to buy dollars from Mr. B @ `54, he has an option or choice and in this case he will choose
not to buy the dollars from Mr. B.
(2) Mr. X holds shares of P Ltd. the market price of which is expected to fall below `400 per share after one
month. He, therefore, buys a put option (option to sell) for the shares @ `400 per share at a predetermined
date. Mr. Y, on the other hand, feels that the price of the share is likely to be above `400 per share after
one month and readily agrees to buy the shares @ `400 on the predetermined date. Mr. Y is the writer of
the option whereas Mr. X is the holder of the option. Mr. Y will charge a premium for writing the option.
Mr. X has the option, but not an obligation, to sell the shares to Mr. Y @ `400 each on the expiry date or
earlier, depending on the type of the option (American/European). If the market price of the share is more
than `400 then Mr. X is not obliged to sell the shares to Mr. Y @ `400 each. However, if the market price
falls below `400 then Mr. Y has the obligation to purchase the shares from Mr. X @ `400 each.

Options that are ‘At the money’, ‘Out of the money’ and ‘In the money’
At the money: If the spot price of the underlying of a call option is the same as its exercise price then the
option is said to be ‘at the money’. It means that there will be no gain or loss by exercising the option. Similarly,
if the spot price of the underlying of a put option is same as the exercise price then the put option is said to be
‘at the money’.
Out of the money: If the spot price of the underlying of a call option is less than the exercise price or the spot
price of the underlying of a put option is more than the exercise then the option is said to be ‘out of the money’.
There would be no point in exercising such an option as it will only lead to a loss.
In the money: If the spot price of the underlying of a call option is more than the exercise price or the spot
price of the underlying of a put option is less than the exercise then the option is said to be ‘in the money’. There
will be a gain from the exercise of such options.
Some Important Option Trading Strategies

An investor may trade in options to earn income. A call option is to be exercised when S > E, where S is the spot
price of the underlying and E is the exercise/strike price. A put is to be exercised when S < E. Even if there is a
benefit in exercising the option there will be no profit until the premium paid for the option is recovered. In fact,
if the benefit from exercising the option is equal to the premium paid for the option then the option holder only
achieves break-even. The B.E.P. of a call is the price of the underlying on the expiry date above which the option
holder earns a profit. Similarly, it is the price on expiry of a put option below which the holder of a put earns a
profit. The break-even point of an option is computed as follows:
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B.E.P. of Call option: E + Premium paid and B.E.P. of Put option: E – Premium paid
(1) Straddle

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Straddle means movement over a range. This strategy can be adopted when we know that the value of the
underlying will move in a certain range small or large. For example, (i) we know that a underlying will
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fluctuate or (ii) a underlying will remain stable & move in a narrow very narrow price range. Different
strategies will apply to the two different scenarios — long straddle and short straddle.
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Long Straddle
When used? When the price of the underlying is expected to fluctuate.
Strategy Buy the same number of ATM calls & ATM puts with the same exercise price and same
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maturity date. Both options should have same exercise price.

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Why? If price goes up then there will be payoff from calls. If price goes down then there will
be payoff from puts. Any fluctuation in the spot price from the exercise price beyond
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the B.E.P. will result in payoff. This strategy has limited maximum loss equal to the
premium paid for buying the call & puts but unlimited profit potential.
Cost of strategy Premium paid for buying calls & puts
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Max loss Cost of strategy

Max profit Unlimited
B.E.P. Cost of strategy
Lower: EP – [where EP is exercise price of call]
No. of puts
Cost of strategy
Upper: EC + [where EC is exercise price of call]
No. of calls

Upper limit to
profit if spot Loss if spot price Unlimited profit if
is in this price spot price is above
price is below
range this level
this level
B.E.P.
Net Payoff (`)
E
0 Spot price on expiry (`)
Diminishing loss if spot price falls
below or rises above exercise price
till it reaches the respective B.E.P.
Max loss on either side.
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Price on expiry: Impact:
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S=E Neither option will be exercised and this results in maximum loss equal to the premium
paid for buying the call & put options.
S<E Puts are exercised resulting in decreasing losses up to the B.E.P. and thereafter increasing
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profit will be earned. Lower the spot price higher will be the profit but this is still
limited as the spot price cannot fall below zero.
S>E Calls are exercised resulting in decreasing losses up to the B.E.P. and thereafter
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increasing profit will be earned. Higher the spot price higher will be the profit and this
can be unlimited profit because there is no theoretical upper limit to the spot price.
Short straddle
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When used? When the price of the underlying is expected to move in a narrow range.
Strategy Sell (write) the same number of ATM calls & ATM puts with the same exercise price &
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Why? The price of the underlying is expected to remain stable and if on expiry it is the same
as the exercise price of the options then neither the calls nor the puts will be exercised
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by the counterparty and the entire premium received will be profit. A small payoff is
likely if the spot price moves in a narrow range. Huge loss is possible if the price falls
or rises steeply.
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Cost of strategy Nil

Max loss Unlimited
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Max profit Premium earned by writing the calls & puts

Lower: EP –
No. of puts
Cost of strategy
Upper: EC +
No. of calls

Limited profit
Upper limit to loss
if spot price Unlimited loss if spot price
if spot price is remains in this is above this level
below this level price range
Max profit
Diminishing profit if spot price is
below or is above exercise price till
it reaches the respective B.E.P. on
Net Payoff (`)
either side.
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B.E.P.

S=E Neither option will be exercised and this results in maximum profit equal to the
premium earned from writing the calls & puts.
S<E Puts are exercised by the counterparty resulting in decreasing profits up to the B.E.P.
and thereafter increasing losses will be suffered. Lower the spot price higher will be the
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loss but this is still limited as the spot price cannot fall below zero.
S>E Calls are exercised by the counterparty resulting in decreasing profits up to the B.E.P.
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& thereafter increasing loss will be suffered. Higher the spot price higher will be the loss
& this can be unlimited loss because there is no theoretical upper limit to the spot price.
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(2) Strangle
Just like the straddle, this strategy can be adopted when we know that the value of the underlying will
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move in a certain range small or large. For example, (i) we know that a underlying will fluctuate or (ii) a
underlying will remain stable or move in a narrow very narrow price range. Different strategies will apply
to the two different scenarios — long strangle and short strangle.
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Long Strangle
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Strategy This strategy involves buying the same number of OTM call & OTM puts with the same
expiry date. If E1 is the exercise price for the put & E2 for the call then clearly E1<E2 as
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both are OTM.

Why? If price goes up then there will be payoff from calls. If price goes down then there will
be payoff from puts. Any fluctuation in the spot price from the exercise price beyond
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the B.E.P. will result in payoff. This strategy has limited maximum loss equal to the
premium paid for buying the call & puts but unlimited profit potential.
Lower: E1 –
No. of puts
Cost of strategy
Upper: E2 +
No. of calls

Upper limit to Limited loss Unlimited profit if
profit if spot if spot price spot price is above
price falls remains in this this level
price range
below this level
B.E.P.
Net Payoff (`)
E1 E2
Decreasing loss if
spot price is below
Max Loss E1 or is above E2
till it reaches the
respective B.E.P.
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E1 ≤ S ≤ E2 Neither option will be exercised and this results in maximum loss equal to the premium
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S < E1 Puts are exercised resulting in decreasing losses up to the B.E.P. and thereafter increasing
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S > E2 Calls are exercised resulting in decreasing losses up to the B.E.P. and thereafter
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Short strangle
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Strategy Equal number of OTM calls & OTM puts are written for the same expiry date. If E1
the exercise price for the put & E2 for the call then clearly E1<E2 as both are OTM.
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Why? The price of the underlying is expected to remain stable and if on expiry it is the
same as the exercise price of the options then neither the calls nor the puts will be
exercised by the counterparty and the entire premium received will be profit. A
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small payoff is likely if the spot price moves in a narrow range. Huge loss is
possible if the price falls or rises steeply.
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Max loss Unlimited

Max profit Premium earned by writing the calls & puts
B.E.P. Total premium earned
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Lower: E1 –
No. of puts
Total premium earned
Upper: E2 +
No. of calls

Upper limit Limited profit Unlimited loss if spot
to loss if spot if spot price price is above this
price falls remains in this level
price range
below this level
Decreasing profit if spot

Max Profit price is below E1 or is
above E2 till it reaches the
Net Payoff (`)
respective B.E.P.

E1 E2
B.E.P.

E1 ≤ S ≤ E2 Neither option will be exercised by the counter party and this results in maximum
profit equal to the premium earned from writing the calls & puts.
S < E1 Puts are exercised by the counterparty resulting in decreasing profits up to the B.E.P.
and thereafter increasing losses will be suffered. Lower the spot price higher will be
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the loss but this is still limited as the spot price cannot fall below zero.
S > E2 Calls are exercised by the counterparty resulting in decreasing profits up to the B.E.P. &
thereafter increasing loss will be suffered. Higher the spot price higher will be the loss
(3) Strips & Straps ss

& this can be unlimited loss because there is no theoretical upper limit to the spot price.
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This strategy is used when a wide fluctuation is expected in the price of the underlying. Strategy depends
on whether fall in price is more likely than rise or vice versa.
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Strips
When used? When price of the underlying is more likely to fall.
Strategy Buy two ATM puts for every ATM call purchased with both options having same
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same maturity date. Both options should have same exercise price.
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Why? As price in more likely to fall, more puts are purchased. If price falls below strike
price then puts are exercised and in case the price rises above the exercise price
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then calls are exercised. Fall or rise beyond the B.E.P. will result in payoff. This
strategy has limited maximum loss but unlimited profit potential.
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Lower: EP –
No. of puts
Cost of strategy
Upper: EC +
No. of calls

Upper limit Limited loss Unlimited
to profit if if spot price profit if
spot price is remains in spot price is
below this this price above this
level range level
B.E.P.
Net Payoff (`)
E
Diminishing loss if spot price is
Max loss below or is above exercise price till
either side.
le
ha
ok
G
Strap
When used? When price of the underlying is more likely to rise.
il
Strategy Buy two ATM calls for every ATM put purchased with both options having same
un
Why? As price in more likely to rise, more calls are purchased. If price rises above strike
price then calls are exercised and in case the price falls below the exercise price
then puts are exercised. Fall or rise beyond the B.E.P. will result in payoff. This
.S
strategy has limited maximum loss but unlimited profit potential.

A

Lower: EP –
No. of puts
C
Cost of strategy
Upper: EC +
No. of calls
Upper limit Limited loss Unlimited

to profit if if spot price profit if
spot price is remains in spot price is
below this this price above this
level range level
B.E.P.
Net Payoff (`)
E
Diminishing loss if spot price is
Max loss below or is above exercise price till
either side.

(4) Spread
Basic rules:
(1) A call gives the holder an option to buy and as buying at a lower exercise price is beneficial, a call
option with a lower exercise price will command a higher premium than the one with a higher
exercise price.
(2) A put gives the holder an option to sell and as selling at a higher exercise price is beneficial, a put
option with a higher exercise price will command a higher premium than the one with a lower
exercise price.
Spread refers to difference in prices. Two types of spreads can be created. A bull spread and a bear spread.
es
Bull Spread with Calls
When used? When the price of the underlying is expected to rise moderately.
ss
Strategy Buy ITM call & write OTM call. If the calls are purchased at an exercise of E1 and
written at an exercise price of E2 then clearly E1<E2 as calls bought are ITM and call
written are OTM.
la
Why? If price goes up then there will be payoff from calls bought. As the price is expected to
go up only moderately it is expected that the call written will lapse and calls are written
C
only to reduce the cost of call bought. However, if the price of the underlying rises
steeply then the chances of making a large profit are lost. The profit potential of the
strategy is limited but so is the loss.
h
Cost of strategy Net premium paid

rs

Max profit E2 – E1 – Cost of strategy
da

E1 +
No. of calls bought
A
In this price Fixed profit

Fixed loss equal range: if spot price
to cost of strategy decreasing rises above
if spot price falls loss or E2 level
below E1 level increasing
profit
B.E.P.
Net Payoff (`)
Max profit

E1 E2
Increasing profit if spot price rises
above the B.E.P. till it reaches E2
Max loss Diminishing loss if spot price rises

above E1 till it reaches the B.E.P.

S ≤ E1 Neither calls purchased nor written will be exercised and this results in maximum loss
equal to the net premium paid for buying the calls.

E1 < S ≤ E2 Calls bought are exercised resulting in decreasing losses up to the B.E.P. and thereafter
increasing profit will be earned.
S > E2 Calls purchased as well calls written are exercised resulting in fixed maximum profit
equal to the spread between the two exercise prices less the cost of the strategy.
Bull Spread with Puts
When used? When the price of the underlying is expected to rise moderately.
Strategy Buy OTM puts & write ITM puts. If E1 is the exercise price of puts purchased & E2 of
puts written then clearly E1<E2 as puts bought are OTM & puts written are ITM.
Why? The strategy is to earn premium by writing ITM puts which command higher premium.
If the spot price closes above E2 then put will lapse earning the income equal to the
premium earned. Though the price is expected to rise moderately, if the price falls
steeply then the ITM puts written may cause huge losses. The OTM puts available at a
lower premium are purchased to limit the downside loss at a cost of losing some
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premium income. The profit potential is limited but so is the loss.
ha
Max loss E2 – E1 – Net premium earned
Max profit Net premium earned
B.E.P. Net premium earned
ok
E2 –
No. of puts written
In this price
G
Fixed profit equal
Fixed loss if range: to net premium
spot price falls decreasing earned if spot
below E1 level loss or price rises above
increasing E2 level
il
profit
un
B.E.P.
Net Payoff (`)
Max profit

E1 E2
.S
Max loss Diminishing loss if spot price rises

above E1 till it reaches the B.E.P.

S < E1 Both puts purchased & written will be exercised and this results in maximum loss
C
which is limited.
E1 ≤ S ≤ E2 Puts written are exercised resulting in decreasing losses up to the B.E.P. and thereafter
increasing profit will be earned.
S > E2 Puts purchased as well written will lapse resulting in fixed maximum profit equal to the
net premium earned.
Bear Spread with Calls
When used? When the price of the underlying is expected to fall moderately.
Strategy Buy OTM call & write ITM call. Calls are written at an exercise price of E1 and bought
at an exercise price of E2. Clearly E1<E2 as calls bought are OTM & those written ITM.
Why? The ITM calls will command higher premium and the strategy is to earn premium by
writing them. The price is expected to fall and if it falls below E1 the call written will
lapse and the entire premium earned will be income. In case it rises steeply then there
can be a huge loss. OTM calls available at a lower premium are purchased to limit the
maximum loss at the cost of paying a small premium. Buying the OTM call is to limit

the loss in case the price rises steeply beyond E2. The profit potential is limited but so
is the loss.
E1 +
No. of calls written
Fixed profit equal In this price Fixed loss

to net premium range: if spot price
earned if spot decreasing rises above
price falls below profit or E2 level
E1 level increasing loss
Increasing profit if spot price falls

Net Payoff (`)
Max profit below the B.E.P. till it reaches E1

E1 E2 Diminishing loss if spot price falls
below E2 till it reaches the B.E.P.
B.E.P.
es
Max loss

S ≤ E1
ss
If spot price is at or below exercise price E1 on expiry then both the calls purchased &
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written will lapse resulting in maximum profit equal to the net premium earned.
E1 < S ≤ E2 If spot price on expiry is above the exercise price (E1) then the call options written will
C
be exercised resulting in diminishing profit till the spot price does reaches the B.E.P. If
the spot price has exceeded the B.E.P. then it will result in increasing losses as long as
the spot price has not crossed E2 level.
h
S > E2 Calls purchased as well written will be exercised. The calls written result in a loss but
the calls bought result in payoff resulting in fixed loss.
rs
Bear Spread with Puts

When used? When the price of the underlying is expected to fall moderately.
da
Strategy Write OTM puts & buy ITM puts. If puts are written at an exercise price of E1 and
purchased at an exercise price of E2 then clearly E1<E2 as the puts written are OTM &
the puts bought are ITM.
A
Why? With the expected fall in price the payoff from the ITM put will increase. As only a
moderate fall is expected, writing an OTM put helps to reduce the cost of buying the
ITM put which is more expensive. However, if the price falls steeply then the opportunity
to earn a higher payoff is lost. The profit potential is limited but so is the loss.
Max profit E2 – E1 – Net premium paid
E2 –
No. of puts written

Fixed profit if spot In this price Fixed loss
price is below E1 range: if spot price
level decreasing rises above
profit or E2 level
increasing loss
Decreasing profit if spot price is

Net Payoff (`)
Max profit above E1 till it reaches the B.E.P.

E1 E2 Increasing loss if spot price is
B.E.P.
Max loss

le
S < E1 If spot price is below exercise price E1 on expiry then both the puts purchased & written
will be exercised resulting in the fixed maximum profit: E2 – E1 – Net premium paid
ha
E1 ≤ S < E2 If spot price on expiry is above the exercise price (E1) then the put options purchased
will not be exercised but the counterparty will exercise the put options written. This
will result in decreasing profits till the spot price does not exceed the B.E.P. If the spot
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price has exceeded the B.E.P. then it will result in increasing losses as long as the spot
price does not crossed E2 level.
S ≥ E2 If the spot price goes beyond the E2 level then neither puts purchased nor written will
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be exercised resulting in maximum loss equal to the net premium paid.
Long Call Butterfly
il
Strategy Buy 1 ITM call, write 2 ATM calls, buy 1 OTM call. If the ITM call has an exercise of E1,
the ATM calls written an exercise price of E2 & the OTM call bought an exercise price E3
un
then clearly E1<E2<E3. E2 should be the middle strike price of E1 and E3.
Why? The maximum profit is earned when the price of the underlying is equal to the strike
price of the calls written (E2); in other words it remains steady. The 2 calls written with
.S
strike price of E2 may result in huge losses if there is a steep rise in price. The ITM call
& OTM call bought will result in huge profit & will limit the loss in such a situation.
A

C
B.E.P. Net premium paid

Lower: E1 +
No. of calls bought at E1
Net premium paid
Upper: E3 –
No. of calls bought at E3

Diminishing
loss if spot price Max profit
rises above E1
till it reaches Decreasing profit if spot price rises
the B.E.P. above E2 till it reaches the B.E.P.
Net Payoff (`)
Increasing loss till spot price

reaches E3.
E1 E2 E3
B.E.P.
Max loss Max loss
Fixed loss if the price falls below E1 or
rises above E3.

S ≤ E1 If spot price is at or below exercise price E1 on expiry then all options purchased &
written will lapse resulting in the fixed maximum loss equal to the net premium paid.
E1 < S ≤ E2 If the spot price is in this range then the calls written will lapse but there will be a
payoff from the calls purchased with a strike price of E1 which will result in diminishing
losses till the lower B.E.P. and thereafter increasing profits. The maximum profit is
es
earned if there is no fluctuation in the price of the underlying.
E2 < S ≤ E3 If the spot price is in this range then the calls written will be exercised resulting in a loss
but calls purchased at the lower strike price will result in payoff so the net payoff will
S > E3
ss
still be a profit but diminishing in nature till the higher B.E.P. & increasing loss thereafter.
If the spot price goes beyond the E3 level then there will be a profit from the calls
la
purchased at both low & high exercise price. The call written will result in a loss. The
overall result would be the maximum loss equal to the net premium paid.
C
Long Put Butterfly
h
Strategy Buy 1 OTM put, write 2 ATM puts, buy 1 ITM put. If the ATM put has an exercise of E1,
the ATM puts written an exercise price of E2 & the OTM put bought an exercise price E3
rs
then clearly E1<E2<E3. E2 should be the middle strike price of E1 and E3.
Why? The maximum profit is earned when the price of the underlying is equal to the strike
da
price of the ATM puts written (E2); in other words it remains steady. In case the price
falls steeply, the OTM put & the ITM put bought will help to limit the loss.
A

B.E.P. Net premium paid
Lower: E1 +
No. of puts bought at E1
Net premium paid
Upper: E3 –
No. of puts bought at E3

Diminishing
loss if spot price Max profit
rises above E1
till it reaches Decreasing profit if spot price rises
the B.E.P. above E2 till it reaches the B.E.P.
Net Payoff (`)
Increasing loss till spot price

reaches E3.
E1 E2 E3
B.E.P.
Max loss Max loss
Fixed loss if the price falls below E1 or
rises above E3.

le
S < E1 If spot price is below exercise price E1 on expiry then all options purchased & written
will be exercised resulting in fixed maximum loss equal to the net premium paid.
ha
E1 ≤ S < E2 If the spot price is in this range then the puts bought at the lower strike price will lapse
but there will be a loss from the puts written which will be offset by the gain from puts
bought at the higher strike price. This results in diminishing losses till the lower B.E.P.
ok
and thereafter increasing profits. The maximum profit is earned if there is no
fluctuation in the price of the underlying (S = E2). Thereafter, there will be diminishing
profits till the higher B.E.P. followed by increasing losses.
G
E2 ≤ S <E3 If the spot price is in this range then the calls written will be exercised resulting in a loss
but calls purchased at the lower strike price will result in payoff so the net payoff will
still be a diminishing profit till the higher B.E.P. & increasing loss thereafter.
il
S ≥ E3 If the spot price goes beyond the E3 level then there will be a profit from the calls
purchased at both low & high exercise price. The call written will result in a loss. The
un
overall result would be the maximum loss equal to the net premium paid.
Short Call Butterfly

.S

Strategy Write 1 ITM call, buy 2 ATM calls, write 1 OTM call. If the ITM call has an exercise of
E1, the ATM calls written an exercise price of E2 & the OTM call bought an exercise
price E3 then clearly E1<E2<E3. E2 should be the middle strike price of E1 & E3.
A
Why? The strategy is to earn premium by writing calls. It aims at earning a limited profit by
taking a limited risk. If the spot price falls below the lower strike price then all options
C
lapse and maximum profit is earned. A steep rise in the price beyond the highest
exercise price will also maximize profit as loss from the calls written will be
compensated by the profit from the calls bought. The maximum loss occurs when the
price remains steady.
Lower: E1 +
No. of calls written at E1
Net premium earned
Upper: E3 –
No. of calls written at E3

Fixed profit if the price falls
below E1 or rises above E3.
Max profit Max profit
B.E.P.
Net Payoff (`)
E2
E1 E3
Decreasing profit above the B.E.P. till it reaches E3
if spot price rises Diminishing loss if spot price rises above
above E1 till it E2 till it reaches the B.E.P.
reaches the B.E.P. Increasing loss till spot price
Max loss
reaches E2.

S ≤ E1 If spot price is at or below exercise price E1 on expiry then all options purchased &
written will lapse resulting in fixed maximum profit equal to the net premium earned.
E1 < S ≤ E2 If the prices ends in this range then the calls written at the lower strike price will result
in loss & therefore profit will start diminishing till the price reaches the lower B.E.P.
Thereafter, the calls written at E1 will result in increasing losses. Maximum loss arises
es
if the price remains steady and does not fluctuate at all.
E2 < S ≤ E3 If the prices ends in this range then the calls written at the lower strike price will result
S ≥ E3 ss
in loss. However, the calls bought with a strike price of E2 will start paying off resulting
in diminishing losses till the higher B.E.P. and increasing profit thereafter.
If the price ends beyond E3 then all calls, written & bought, will be exercised but the
la
calls bought at E2 will compensate for the loss from the call written and the net payoff
will be the maximum profit of the strategy.
C
Short Put Butterfly
h
Strategy Write 1 OTM put, buy 2 ATM puts, write 1 ITM put. If the OTM put has an exercise of
E1, the ATM puts bought an exercise price of E2 & the ITM put written an exercise
rs
price E3 then clearly E1<E2<E3. E2 should be the middle strike price of E1 & E3.
Why? The strategy is to earn premium by writing puts. It aims at earning a limited profit by
da
taking a limited risk. If the spot price falls below the lower strike price then all options
will be exercised but the loss from the puts written will be compensated by the profit
from the puts bought resulting in maximum profit equal to net premium earned. A
A
steep rise in spot price beyond the highest exercise price will also maximize profit as all
puts, written & bought, will lapse. The maximum loss occurs when the price remains
steady.
Lower: E1 +
No. of puts written at E1
Net premium earned
Upper: E3 –
No. of puts written at E3

Fixed profit if the price falls
below E1 or rises above E3.
Max profit Max profit
B.E.P.
Net Payoff (`)
E2
E1 E3
Decreasing profit above the B.E.P. till it reaches E3
if spot price rises Diminishing loss if spot price rises above
above E1 till it E2 till it reaches the B.E.P.
reaches the B.E.P. Increasing loss till spot price
Max loss
reaches E2.

le
S < E1 If spot price is below exercise price E1 on expiry then all options purchased and written
will be exercised. The loss from puts written is compensated by the profit from the puts
ha
bought resulting in fixed maximum profit.
E1 ≤ S < E2 If the prices ends in this range then the puts written at the lower strike price will lapse.
The puts written at the higher strike price will result in loss but the puts bought at E2
ok
will also be exercised resulting in profit & the net result will be diminishing profit till
the price reaches the lower B.E.P. Maximum loss arises if the price remains steady and
does not fluctuate at all.
G
E2 ≤ S < E3 If the prices ends in this range then the only the puts written at the higher strike price
will be exercised resulting in diminishing loss till the higher B.E.P. and increasing profit
thereafter.
il
S ≥ E3 If the price ends beyond E3 then all puts, written & bought, will lapse resulting in
maximum profit of the strategy which is the net premium earned.
un
Value of an Option
Intrinsic Value
.S
The intrinsic value of an option is equal to the gain that will be made by exercising it, i.e. the extent to which it
is ‘in the money’. A call option will have intrinsic value only if there is some gain from exercising the option. This
will happen only when the spot price is more than its exercise price. For example, if a person holds a call option
A
on a share with a strike price of `260. If the spot price of the share is `275 then he can gain `15 by exercising
the option. If the spot price was below `260 then there would be no gain from exercising the option as it will be
C
cheaper to buy the share from the stock market. Similarly, a put option will have some intrinsic value only when
the spot price is less than its exercise price. For example, a person holds a put option for a share at a strike price
of `56 and the spot price of the share is `50 then he gains `6 by exercising the option. But if the spot price of the
share is above `56 then there is no benefit in exercising the option as it is beneficial to sell the share in the stock
market at a higher price. The intrinsic value of an option can never be negative.
Time Value
In addition to intrinsic value, an option may have time value. The time value of the option is the risk premium
and the financing cost of the underlying. It can be computed as the difference between the price at which an
option is trading less its intrinsic value. For example, a share is trading at `164 and its call option with a strike
price of `160 is trading at premium of `12. The intrinsic value of the option is `4 and therefore the time value is
`8 (`12 – `4). If an option has no intrinsic value then the entire option premium will be equal to its time value.
The time value of an option will decrease as the expiry date approaches. This is because as the expiry date nears
the cost of financing as well as the risk of price fluctuations also decrease. The time value is zero on the date of
expiry but the option may have intrinsic value. Time value is also called extrinsic value.
Option Premium
The premium charged by the option holder will be equal to the total of its intrinsic value and time value.

Option premium = Intrinsic value + Time value
This can be used to find out the present value of the option. The value of the option on a future date is more
difficult calculate as we cannot accurately predict the spot price on that date. Further, if we want to trade such
an option then we will have to compute the present value of such future value. If we can find the future value of
the option then we can find its PV by using the PV factor at the risk-free rate. Different models are available to
find the value of an option.
Option Valuation Models

(1) Basic valuation concept
The theoretical value of an European option is computed as follows:
(a) Call option
C0 = S0 – (e–rt.E)
Where,
C0 = current value of call
S0 = spot price of share
e–rt = continuous discounting rate
E = exercise or strike price of option
(b) Put option
es
P0 = (e–rt.E) – S0
Where,

P0 = current value of put
e–rt = continuous discounting rate
ss
la
E = exercise or strike price of option
S0 = spot price of share
C
(2) Binomial Model
This model divides the time to expiry of the option into one or many time intervals. Probability is used to
predict the price of the underlying at the end of each time interval. As the time to expiry is divided into
h
intervals, the value of the option can be determined at the end of each interval and not just on expiry. This
is particularly useful in the valuation of American option because such option can be exercised at any time
rs
up to the expiry date.

(I) One-step Binomial Model
da
Value of call option –

A portfolio of shares can be hedged to lock the value of the portfolio at the end of the specified period.
This can be done by writing a call option. As the value of the portfolio at the end of the specified
A
period is locked, there is no risk involved in such a portfolio and hence the expected return from the
portfolio should be the risk-free rate. If this is not true then there will be arbitrage opportunities.
This model assumes that there will be only two possible values of the stock at the end of the specified
period — a high (upper) price (SU) and a low price (SL), one above & other below the current price.
SU
S0
SL

Accordingly, the call option will have two possible values at the end of the period, namely call high
(CU) & call low (CL). The portfolio is to be made up of D (delta) shares purchased for every 1 call
option written. The number of shares to be purchased, called hedge ratio & denoted by D (delta), for
each call option written, will computed as follows:

Spread in call values CU − C L
D (delta) = =
Spread in share values SU − SL
Theoretically, the value of this portfolio should be the same as the value of a portfolio of risk-free
investment, otherwise there will be arbitrage opportunity.
This portfolio will have the same value irrespective of the market price of the share. To find the
value of the call option, find the value of the portfolio which is equal to the market value of shares
purchased less loss on call options written for both share high & low values at the end of the period.
Both values will be the same. The cost of setting-up the portfolio is the spot price of shares
purchased less the premium received on calls written. This cost when compounded at the risk-free
rate will amount to the future value of the portfolio. Solving the following equation gives the value
of the call –
(i) If continuous compounding is used:
[(D shares × S0) – C]ert = FV of the portfolio
le
Where, S0 = spot price of the share
C = premium earned on writing 1 call option
ha
r = risk-free rate
t = time in years
(ii) If simple interest is used:
ok
[(D shares × S0) – C](1 + rt) = FV of the portfolio
Alternatively, on the basis of the above formulae it can be derived that the value of the call option
today is nothing but the present value of the expected value of the call on the expiry date. To find the
G
expected value of the call the expiry date we need to know the probability of its CU and CL.
The probability of the share upper price is computed as follows:
ert − d
p =
il
u− d
Where,
un
ert = continuous compounding factor

SL
d =
S0
.S
SU
u =
S0
The probability of the share lower price is = (1 – p)
A
Solving the following equation gives the value of the call –

(i) If continuous compounding is used:
C
C0 = e–rt [pCU + (1 – p)CL]

Where,
C0 = spot value of the call option
r = risk-free rate
t = time to expiry
e–rt = continuous discounting factor
CU = call high value on expiry
CL = call low value on expiry
(ii) If simple interest is used:
C0 =
[ pCU + (1 − p)C L ]
1 + rt
This model is suitable for valuing an European option because it assumes that only the price
of the underlying on expiry of the period is relevant for valuing the option.
Value of put option –
The holder of shares may sell the shares and write put options to invest the total proceeds in a

risk-free investment with the intention of buying back the shares on the expiry of the option. The
proceeds from the risk-free investment will be equal to the amount required to buy back the shares
sold earlier and pay the loss on the puts written. If this were not so then there would be arbitrage
opportunities. The ratio of shares sold to put options written can be computed as under:
Spread in call values CU − C L
D (delta) = =
Spread in share values SU − SL
The outflow on expiry of the option, for buying D shares and paying the loss on 1 put option, will be
the same irrespective of the share price on expiry of the option and this will be equal to the amount
received on maturity of the risk-free investment.
The value of a put option can be determined in the same way as that of the call option. This model
is suitable for valuing an European option because it assumes that only the price of the
underlying on expiry of the period is relevant for valuing the option.
(II) Multi-step Binomial Model
Under this model, the period of the option is divided into many small periods. There can be a change
in value of the call option at the end of every small period within the option period and accordingly
value of the option can be obtained for each of these periods just like the single period model. The
current value of the option can then be computed as the present value of the different values at
different points of time. The period till expiry can be divided into an infinite number of step periods
and hence computation would be cumbersome.
es
Consider the following two-step binomial tree:
SUU
S0
SU
SUL
ss
la
SL
SLL
C

Theoretically, the period from the current date to the expiry date of the option can be divided into
infinite periods and a multi-step binomial tree created from it. The value of the option at the end of
each period can then be determined to find the current value of the option. However, for obvious
h
reasons this is not practical. Dividing the period up to the expiry into a limited number of shorter
rs
periods is a practical approach to use this model. This model can be used to find the value of an
American option as such an option can be exercised at any time up to the expiry date.
(3) Risk Neutral Model

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This model assumes that the investor is risk-neutral, i.e. he is indifferent to risk. Under this model we
find the probabilities of the high and low price of the underlying on the expiry date. The spot price of the
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underlying is the expected value of the underlying on expiry date discounted at the risk-free rate. The
risk-free rate is used because the investor is risk-neutral and so no risk-premium is expected. To find the
probabilities, we solve the following equation:
S0 = [PU × Upper price + (1 – PU) × Lower price] e–rt
Where,
S0 = spot price of underlying
PU = probability of the underlying having the upper price
1 – PU = probability of the underlying having the lower price
Alternatively
ert − d
p =
u− d
Where,
ert = continuous compounding factor
SL
d =
S0

SU
u =
S0
The probability of the share lower price is = (1 – p)
We then proceed to compute the PV of the call option as follows:
Find the values of the call option on the expiry date for the high and low price of the underlying. Multiply
the two values with the respective probabilities to give the expected value. Discount the EV at the risk-free
rate to find it current value.
Call Option Value = [PU × Option value at high price + (1 – PU) × Option value at low price] e–rt
(4) Black & Scholes Model

This model was created by Fisher Black and Myron Scholes which later won them a Nobel Prize. This
model is suitable only for European Options. The model is based on the following assumptions:
Assumptions
le
(1) The option to be valued in an European Option.
(2) The stock does not pay any dividend
(3) There are no transaction costs.
ha
(4) There are no taxes.
(5) The risk-free rate is known and is constant over the life of the option.
(6) The volatility of the underlying is known and is constant over the life of the option.
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(7) The underlying asset’s continuously compounded rate of return follows a normal distribution.
(I) Value of Call Option
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C = S0 .N(d1) – e–rt .E .N(d2)
S 
Ln  0  + (r + 0.5s 2 )t
 E
il
d1 =
s t
un
S 
Ln  0  − (r + 0.5s 2 ) t
 E OR = d1 − s t
d2 =
s t
.S
Where
C = value of call option
Ln = natural log
A
N(d1, 2) = cumulative area of standard normal distribution at d1 and d2

S 0 = spot price of underlying
E = exercise price of the option
C
r = risk-free rate of interest expressed in decimal

t = time till expiry of option in years but expressed in decimal
s = annualized standard deviation of the continuous compounded rate
If dividend is received –
If dividend will be received from the stock then the spot price (S0) is reduced by the PV of the
dividend which is then replaced in the above formula and the formula will be modified as follows:
C = (S0 – De–rt) N(d1) – E.e–rt .N(d2)
Where,
D = being the amount of dividend income
t = the time, in years, from current date till the date on which dividend will be received and
expressed in decimal.
(II) Value of Put Option
P = E. e–rt .N(– d2) – S0 .N(– d1)
Where

P = price of put option (and other notations as in the call option)
If we have already computed the value of the call option then we have the values of N(d1) and N(d2).
Value of N(– d1) is given by [1– N(d1)] and that of N(– d2) by [1– N(d2)]. In this case we can rewrite
the formula as –
P = E.e–rt [1 – N(d2)] – S0 [1 – N(d1)]
(5) Portfolio Replication Model – Option Strategy or Stock Equivalent

The objective of this model is to match the return from a portfolio of shares by investing in a risk-free asset
and buying call options. This model is also called Option Strategy or Stock Equivalent. To summarize:
Make a portfolio of . . . . To replicate the return from a portfolio of . . . .
Risk-free investment & calls purchase Shares
We need to compute the number of options to buy and the amount of risk-free investment. The number of
options to buy is the hedge ratio.
Let, S = spot or current price of the underlying
SU = the likely forward high price of the underlying
SL = the likely forward low price of the underlying
CU = value of call option at forward high price of underlying
CL = value of call option at forward low price of underlying
E = exercise/strike price of the option
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r = the rate of interest applicable to the period of the option.
Call options to be purchased can be computed as follows:
ss
The hedge ratio (H.R.) gives us the number of calls to purchase.
Spread in share high & low prices SU − SL

H.R. = = = No. of calls to be purchased
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Spread in call high & low values CU − C L
The amount of risk-free investment to be purchased:
C
Risk-free investment = PV of [No. of shares × (E or SL, whichever is lower)]
Theoretically, the spot price of the underlying should be equal to the risk-value asset plus value of calls
purchased to match the return from the stock. If this is not so then there would be an arbitrage opportunity.
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Thus,
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S = Risk-free investment + C [With S & C having co-efficients as per the hedge ratio]
The value of ‘C’ can be ascertained by substituting the other values in the above equation.
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(6) Portfolio Replication Model – Stock Strategy or Option Equivalent

The objective of this model is to match the return from a portfolio of call options by borrowing and
investing in stock. This model is also called Stock Strategy or Option Equivalent. To summarize:
A
Make a portfolio of . . . . To replicate the return from a portfolio of . . . .

Borrowing & shares Call options
We need to compute the number of shares to buy and the amount to be borrowed.
Number of shares to be purchased can be computed as follows:
The number of shares to buy is equal to the hedge ratio.
Spread in call high & low values CU − C L
H.R. = = = No. of shares to be purchased
Spread in share high & low prices SU − SL
Amount to be borrowed is computed as follows:
Borrowings = PV of [(No. of shares bought × SL) – Payoff from Calls at SL]
Theoretically, value of call option (C) should be equal to the difference between the spot price of the share
(S) of borrowing (B). If this is not so then there would be an arbitrage opportunity. Thus,
C=S–B [With S & C having co-efficients as per the hedge ratio]
The value of ‘C’ can be ascertained by substituting the other values in the above equation.

(7) Minimum value or lower bound of an European Call
Let’s see the minimum value or lower bound of an European Call on a non-dividend paying stock.
The minimum value of an European call option on a non-dividend paying stock is given by:
Minimum value or lower bound = S0 – E.e–rt
In other words,
C0 ≥ S0 – E.e–rt
Where
C0 = current value of the call option
S0 = spot price of the stock
r = risk-free rate of interest
t = number of days to expiry ÷ 365
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If this were not so then there would be arbitrage opportunity. [The arbitrage method is given later.]
On rearranging the terms of the equation we get: C0 + E.e–rt ≥ S0.
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In other words, a portfolio of a call option plus a risk-free investment equal to the PV of the exercise price
will be worth more than or will have the same payoff as a portfolio of one share.
Illustration:
Spot price of a share is `110, a call option is available at `10 with expiry after one year and exercise price
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of `105. The risk-free rate is 5% p.a. For convenience, lets take E–rt = `105–0.05×1 = `100.
Currently, the two portfolios are worth the same:
Portfolio 1 = Value of call option purchased + Risk-free investment equal to PV of Exercise price
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= `10 + `100 = `110
Portfolio 2 = A share = `110
After one year –
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(i) If price of share is `120 on expiry then the two portfolios have the following values –
Portfolio 1 = `15 + `105 = `120
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Portfolio 2 = `120
(ii) If price of share is below exercise price on expiry, say `100, then the two portfolios have the following
values –
Portfolio 1 = 0 + `105 = `105
.S
Portfolio 2 = Spot price = `100

It can be observed that value of Portfolio 1 ≥ Portfolio 2.
Hence, we conclude C0 + E.e–rt ≥ S0.
A
Which, on rearranging, proves that: C0 ≥ S0 – E.e–rt

We observe that a portfolio of (C0 + E.e–rt) will be worth Max (S1, E).
C
Arbitrage
If the value of the call in the market falls below the minimum value/lower bound the following arbitrage
opportunity arises: The minimum value of the call is `10. If it is trading at `9 then an arbitrageur can
make a riskless profit by selling the share in the spot market for `110 & buying a call option at `9. After
buying the call he will have cash balance of `101 (`110 – `9). This amount will be invested at the risk-free
rate of 5% for one year. Maturity amount of this investment will be `101(1.05) = `106.05 (note: annual
compounding is used for convenience). If the spot price of the share after one year is above `105 (exercise
price) then the call option will be exercised to buy the share at `105 and make a profit of `106.05 – `105 =
`1.05. If the spot price is below `105 then the call will lapse & the share will be purchased from the market
at a lower price in which case the arbitrageur will make a higher profit. In either case, the arbitrageur gets
his share back and makes an assured profit.
(8) Minimum value or lower bound of an European Put

Let’s see the minimum value or lower bound of an European Put on a non-dividend paying stock.
Minimum value or lower bound = E.e–rt – S0
In other words,

P0 ≥ E.e–rt – S0
Where
P0 = current value of the put option
S0 = spot price of the stock
r = risk-free rate of interest
t = number of days to expiry ÷ 365
If this were not so then there would be arbitrage opportunity. [The arbitrage method given later.]
On rearranging the terms of the equation we get: S0 + P0 ≥ E.e–rt.
In other words, a portfolio of a share & put option will be worth more than or will have the same payoff as
a portfolio of a risk-free investment equal to the PV of the exercise price of the option.
Illustration:
Spot price of a share is `90, a put option is available at `10 with expiry after one year and exercise price of
`105. The risk-free rate is 5% p.a. For convenience, lets take E–rt = `105–0.05×1 = `100.
Currently, the two portfolios are worth the same:
Portfolio 1 = Value of share purchased + Value of put option purchased = `90 + `10 = `10
Portfolio 2 = Risk-free investment equal to PV of exercise price = `100
After one year –
(i) If price of share is `120 on expiry then the two portfolios have the following values –
es
Portfolio 1 = `120 + 0 = `120
Portfolio 2 = `105

values –
Portfolio 1 = `100 + `5 = `105 ss
(ii) If price of share is below exercise price on expiry, say `100, then the two portfolios have the following
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Portfolio 2 = `105
It can be observed that value of Portfolio 1 ≥ Portfolio 2.
C
Hence, we conclude S0 + P0 ≥ E.e–rt.
Which, on rearranging, proves that: P0 ≥ E.e–rt – S0
We observe that a portfolio of (S0 + P0) will be worth Max (S1, E)
h
Arbitrage
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If the value of the put falls below the minimum value/lower bound then the following arbitrage opportunity
arises: The minimum value of the put is `10. If it is trading at `9 then an arbitrageur can make a riskless
profit by taking a loan of `99 (`90 for the share + `9 for the put) @ 5% p.a. & buying a share & a put in
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the spot market. After one year the loan amount to be repaid with interest will be `99(1.05) = `103.95
(note: annual compounding is used for convenience). If the spot price of the share after one year is below
`105 (exercise price) then the put option will be exercised & the share will be sold for `105; after the
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repayment of the loan the arbitrageur will make a profit of `105 – `103.95 = `1.05. If the spot price is
above `105 then the put option will lapse and the share will be sold in the market for a higher price and
the arbitrageur will make a higher profit. In either case, the arbitrageur repays the loan with interest and
makes an assured profit.
(9) Put-Call Parity

From the European call & put minimum price or lower bound we had made the following observations –
A portfolio of:
(i) Call & risk-free investment equal to PV of exercise price of call (C0 + E.e–rt) will be worth Max (S1, E)
on expiry of term.
(ii) Share & a put (S0 + P0) will be worth Max (S1, E) on expiry of term.
If both the portfolios are worth the same on expiry then their present value should also be the same;
otherwise there will be arbitrage opportunity.
Hence we can say that:
C0 + E.e–rt = S0 + P0
This relationship is called the Put-Call Parity. The conditions being that the exercise price of both,
the call & the put, as well as the expiry date have to be the same.

If European call & put with same exercise price & expiry date are available then we can find the value of
put if we know the value of the call & vice versa.
Arbitrage
If the put-call parity does not hold then arbitrage opportunity will arise. Consider the following situation:
S0 = `90, E = `105, expiry after one year, C0 = `10, P0 = `20, Risk-free rate 5%, E.e–0.05×1 = `100. For
put-call parity, the following must hold
C0 + E.e–rt = S0 + P0
`10 + `100 = `90 + `20
(i) If call is quoted at `9 then an arbitrageur will sell a share at `90 & sell (write) a put to earn `20. Out
of the total cash balance of `110, he will purchase a call for `9 & invest `101 in a risk-free investment
@ 5% p.a. After one year, his investment will grow to `101(1.05) = `106.05. If the spot price of the
share is above `105 (exercise price) then the call is exercised. If the spot price of the share is below
`105 (exercise price) then the counter-party will exercise. In either case, the share will be purchased
at `105. After purchase of share the profit will be: `106.05 – `105 = `1.05. Thus, the arbitrageur
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gets his share back after one year with an assured minimum profit of `1.05.
(ii) If put is quoted at `18 then an arbitrageur will buy a share & a put. For this purpose he will sell
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(write) the call & take a loan. The amount of loan will be = S0 + P0 – C0 = `90 + `18 – `10 =
`98. The loan will have to be repaid after one year with interest = `98(1.05) = `102.90. On expiry,
if the market price of the share is above `105 (exercise price) the counter-party will exercise the call.
If the market price of the share is below `105 (exercise price) the counter-party will let the call lapse
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but the arbitrageur will exercise his put option. In either case the share is sold for `105 to repay the
loan of `102.90 leaving a profit of `2.10.
Problems
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Futures: Valuation, Trading & Arbitrage
1.1 [C.A.] The following data relates to ABC Ltd.’s share price:
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Current price per share `180
Price per share in the futures market – 6 months `195
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It is possible to borrow money in the market for securities transactions at the rate of 12% p.a.
Required:
(i) Calculate the theoretical minimum price of a 6 month-forward contract.
.S
(ii) Explain if any arbitraging opportunities exist.

[(i) `190.80 (ii) Yes. Profit of `4.20 per share]
1.2 [C.S.] A futures contract is available on a company that pays an annual dividend of `5 and whose stock
A
is currently priced at `200. Each futures contract calls for delivery of 1,000 shares of stock in one year, daily
marking to market, and initial margin of 10% and a maintenance margin of 5%. The corporate treasury bill rate
is 8%.
C
(i) Given the above information, what should the price of one futures contract be?
(ii) If the company stock price decreases by 7%, what will be the change, if any, in futures price?
(iii) As a result of the company stock price decrease, will an investor that has a long position in 1 futures
contract of this company realize a gain, or a loss? Why? What will be the amount of this gain or loss?
[(i) `2,11,000 (ii) `1,95,880 (iii) `15,120]
1.3 [C.A.] The following data relate to Anand Ltd.’s share price:
Current price per share `1,800
6 months future price per share `1,950
Assuming it is possible to borrow money in the market for transactions in securities at 12% per annum, you are
required:
(i) to calculate the theoretical minimum price of 6-months forward purchase; and
(ii) to explain arbitraging opportunity.
[(i) `1,908 (ii) Arbitrage gain `42]
1.4 [C.A.] The share of X Ltd. is currently selling for `300. Risk free interest is 0.8% per month. A three months
futures contract is selling for `312. Develop an arbitrage strategy and show what your riskless profit will be 3
months hence assuming that X Ltd. will not pay any dividend in the next three months.

[Arbitrage gain `4.74]
1.5 [C.A.] A stock index currently stands at `3,500. The risk free interest rate is 8% per annum and the
dividend yield on the index is 4% per annum. Expiry in four months. Answer the following:
(a) What should the Index futures price be?
(b) What should the Index futures price be if we have continuously compounded rate?
[(a) `3,546.66 (b) `3,546.98]
1.6 A 3 month future contract on Nifty is available at a time when Nifty is quoting 5,500 points. Continuously
compounded risk-free rate is 10%. Continuously compounded yield on the Nifty is 2% per annum. How much
will you pay for Nifty futures. If Nifty forward trades at 5,650, would you prefer to purchase Nifty futures for
your portfolio?
[5,611; No]
1.7 [C.A.] On 31-8-2011, the value of stock index was `2,200. The risk-free rate of return has been 8% per
annum. The dividend yield on this stock index is as under:
Month Dividend paid
January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
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July 3%
August 4%
ss
September 3%
October 3%
November 4%
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December 3%
Assuming that interest is continuously compounded daily, find out the future price of contract deliverable on 31-
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12-2011. Given: e0.01583 = 1.01593.
[`2,235.05]
1.8 [C.S.] A share is currently trading at `125. It is expected to give a dividend of `10 per share after 4 months.
h
Assume that the risk-free rate of return is 10% per annum.

What would be the approximate value of the forward contract (assuming annual compounding) on the share for
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delivery after 3 months?

[`128.01]
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1.9 [C.A. twice] The six months forward price of a security is `208.18. The rate of borrowing is 8% per annum
payable at monthly rates. What will be the spot price?
[`200]
A
1.10 [C.A.] Calculate the price of 3 months PQR futures, if PQR (FV `10) quotes `220 on NSE and the three
months future price quotes at `230 and the one month borrowing rate is given as 15% and the expected annual
dividend yield is 25% per annum payable before expiry. Also examine arbitrage opportunities.
[FF price `225.75. Gain `4.25]
1.11 [RTP] Suppose that there is a future contract on a share presently trading at `1,000. The life of future
contract is 90 days and during this time the company will pay dividends of `7.50 in 30 days, `8.50 in 60 days
and `9.00 in 90 days.
Assuming that the Compounded Continuously Risk-free Rate of Interest (CCRRI) is 12% p.a. you are required to
find out:
(a) Fair Value of the contract if no arbitrage opportunity exists.
(b) Value of Cost to Carry.
Given e–0.01 = 0.9905, e–0.02 = 0.9802, e–0.03 = 0.97045 and e0.03 = 1.03045
[(a) `1,005.96 (b) `5.96]
Margins
2.1 [C.A.] Sensex futures are traded at a multiple of 50. Consider the following quotations of Sensex futures in
the 10 trading days during February, 2009:

Day High Low Closing
4-2-09 3306.40 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
Abhishek bought one sensex futures contract on February, 04 . The average daily absolute change in the value of
contract is `10,000 and standard deviation of these changes is `2,000. the maintenance margin is 75% of initial
margin.
You are required to determine the daily balances in the margin account and payment on margin calls, if any.
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[Call on 7.2.09 `4,210 & on 18.2.09 `5,485]
2.2 [C.M.A.] On Aug. 2, Mr. Tandon buys 5 contracts of December Reliance futures at `840. Each contract
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covers 50 shares. Initial margin was set at `2,400 per contract while maintenance margin was fixed at `2,000
per contract. Daily settlement prices are as follows:
Aug. 2 `818
Aug. 3 `866
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Aug. 4 `830
Aug. 5 `846
Mr. Tandon met all margin calls. Whenever he is allowed to withdraw money from the Margin Account, he
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withdraws half the maximum amount allowed.
Compute for each day:
(i) Margin call;
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(ii) Profit & (Loss) on the contract;
(iii) The balance in the Account at the end of the day.
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[Aug. 2 Margin paid `5,500; Aug. 3 Profit withdrawn `6,000; Aug. 4 Margin paid `3,000 & Aug. 5 Profit withdrawn `2,000]
2.3 [C.M.A.] The settlement price of June Nifty Futures contract on a particular day was 4585. The minimum
trading lot on Nifty Futures is 100. The initial margin is 8% and the maintenance margin is 6%. The index closed
.S
at the following levels on the next five days:

Day 1 2 3 4 5
Settlement price (`) 4,690 4,760 4,550 4,480 4,570
Required:
A
(i) Calculate the mark to market cash flows and daily closing balances in the account of:
(a) an investor who has gone long at 4585
C
(b) an investor who has gone short at 4585

(ii) Calculate the net profit/(loss) on each of the contracts.
[Loss `1,500]
Hedging with Futures

3.1 [C.A. twice] Ram buys 10,000 shares of X Ltd. at `22 and obtains a complete hedge by shorting 400
Nifties at `1,100 each. He closes out his option at the closing price of the next day at which point price of share
of X Ltd. has dropped 2% and the Nifty futures has dropped 1.5%. What is the overall profit/loss of this set of
transactions?
[Profit `2,200]
3.2 [C.S.] The following information is related to stock of Adarsh Ltd. The company has a beta of 0.5 with
Nifty. Each Nifty contract is equal to 100 units. Adarsh Ltd. now quotes at `250 and Nifty futures is 4,000 index
points. You are long on 1,200 shares of Adarsh Ltd. in the spot market.
(i) How may futures contracts will you have to take?
(ii) Suppose the price in the spot market drops by 10%, how are you protected?
[(i) 0.375 (ii) Possible loss of `30,000 is avoided]
3.3 [C.A.] A Mutual Fund is upholding the following assets in ` Crores:

Investments in diversified equity shares 90.00
Cash and bank balances 10.00
100.00
The beta of the portfolio is 1.1. The index future is selling at 4300 level. The fund manager apprehends that
the index will fall at the most by 10%. How many index futures he should short for perfect hedging so that the
portfolio beta is reduced to 1.00? One index futures consists of 50 units.
Substantiate your answer assuming the fund managers apprehension will materialize.
[418.6 contracts. Loss of `90 lakhs is fully hedged.]
3.4 [C.A.] BSE index 500
Value of portfolio `10,10,000
Risk free interest rate 9% p.a.
Dividend yield on index 6% p.a.
Beta of portfolio 1.5
We assume that a futures contract on BSE index with 4 months maturity is used to hedge the value of portfolio
over the next 3 months. One futures contract is for delivery of 50 times the index. Based on the above information
calculate:
(i) Price of future contract.
(ii) The gain on short futures position if index turns out to be 4,500 in 3 months.
[(i) `2,52,500 (ii) `1,61,625]
3.5 [C.S.] Zenith company has a beta of 0.5 with Nifty. Each Nifty contract is equal to 100 units. Zenith
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company now quotes at `250 and the Nifty future is 4,000 index points. X is long on 1,200 shares of Zenith
company in the spot market.
(i) How many futures contracts will X have to take?
ss
(ii) If the price in spot market drops by 10%, how is X protected?
[(i) 0.375 contracts (ii) Loss of `30,000 is fully hedged]
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3.6 [C.A.] On January 1,2013 an investor has a portfolio of 5 shares as given below:
Security Price No. of shares Beta
C
A 349.30 5,000 1.15
B 480.50 7,000 0.40
C 593.52 8,000 0.90
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D 734.70 10,000 0.95

E 824.85 2,000 0.85
rs
The cost of capital to the investor is 10.5% per annum.

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(i) The beta of his portfolio.

(ii) The theoretical value of the NIFTY futures for February, 2013.
(iii) The number of contracts of NIFTY the investor needs to sell to get a full hedge until February for his
portfolio if the current value of NIFTY is 5900 and NIFTY futures have a minimum trade lot requirement of
A
200 units. Assume that the futures are trading at their fair value.
(iv) The number of future contracts the investor should trade if he desires to reduce the beta of his portfolios to
0.6.
No. of days in a year be treated as 365.
Given: ln (1.105) = 0.0998
e(0.015858) =1.01598
[(i) 0.849 (ii) `5,994.28 (iii) 13.35 or 14 contracts (iv) 3.92 or 4 contracts]
3.7 [C.A.] A trader is having in its portfolio shares worth `85 lakhs at current price and cash `15 lakhs. The
beta of share portfolio is 1.6. After 3 months the price of shares dropped by 3.2%.
Determine:
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on `100 lakhs Nifty futures.
[(i) 1.36 (ii) 2.36]
3.8 [C.A.] Which position on the index future gives a speculator, a complete hedge against the following
transactions:
(i) The share of Right Limited is going to rise. He has a long position on the cash market of `50 lakhs on the

Right Limited. The beta of the Right Limited is 1.25.
(ii) The share of Wrong Limited is going to depreciate. He has a short position on the cash market of `25 lakhs
on the Wrong Limited. The beta of the Wrong Limited is 0.90.
(iii) The share of Fair Limited is going to stagnant. He has a short position on the cash market of `20 lakhs of
the Fair Limited. The beta of the Fair Limited is 0.75.
[Short index futures of `25,00,000]
Options
4.1 [C.A.] A call and put exist on the same stock each of which is exercisable at `60. They now trade for:
Market price of Stock or stock index `55
Market price of call `9
Market price of put `1
Calculate the expiration date cash flow, investment value, and net profit from:
(i) Buy 1.0 call
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(ii) Write 1.0 call
(iii) Buy 1.0 put
(iv) Write 1.0 put
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for expiration date stock prices of `50, `55, `60, `65, `70.
4.2 [C.S.] Identify the profit or loss (ignoring dealing cost and interest) in each of the following cases:
(i) A call option with an exercise price of `200 is bought for a premium of `89. The price of underlying share
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is `276 at the expiry date.
(ii) A put option with exercise price of `250 is bought for a premium of `42. The price of underlying share is
`189 at the expiry date.
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(iii) A put option with an exercise price of `300 is written for a premium of `57. The price of the underlying
share is `314 at the expiry date.
[(i) Loss `13 (ii) Profit `19 (iii) Profit `57]
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4.3 [C.A., C.M.A.] The market received rumour about ABC Corporation’s tie-up with a multinational company.
This has induced the market to move up. If the rumour is false, the ABC Corporation stock price will probably
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fall dramatically. To protect from this an investor has bought the call and put options.
He purchased one 3 months call with a striking price of `42 for `2 premium and paid `1 per share as premium
for a 3 months put with a striking price of `40.
.S
(i) Determine the investor’s position if the tie up offer bids the price of ABC Corporation’s stock up to `43 in 3
months.
(ii) Determine the investor’s ending position, if the tie up programme fails and the price of the stock falls to `36
in 3 months.
A
[(i) Loss `2 per share (ii) Net gain `1 per share]

4.4 [C.M.A.] The share of Bangaluree Corporation Ltd. are selling at `105 each. Chandrashekhar wants to
C
chip in with buying a three months call option at a premium of `10 per option. The exercise price is `110. Five
possible prices per share on the expiration date ranging from `100 to `140, with intervals of `10 are taken into
consideration by him. What is Chandrasekhar’s pay-off as call option holder on expiration?
[Pay-off for 5 possible prices: (a) `10 loss (b) `10 loss (c) No profit no loss (d) `10 profit (e) `20 profit]
4.5 [C.A.] The equity share of VCC Ltd. is quoted at `210. A 3-month call option is available at a premium of
`6 per share and a 3-month put option is available at a premium of `5 per share. Ascertain the net payoffs to the
option holder of a call option and a put option, given that:
(i) the strike price in both cases is `220; and
(ii) the share price on the exercise day is `200, `210, `220, `230, `240.
Also indicate the price range at which the call and the put options may be gainfully exercised.
[`9, (`1), (`11), (`1), `9]
4.6 [C.M.A.] Calculate the profits and losses from the following transactions:
(i) Mr. X writes a call option to purchase share at an exercise price of `60 for a premium of `12 per share. The
share price rises to `62 by the time the option expires.
(ii) Mr. Y buys a put option at an exercise price of `80 for a premium of `8.50 per share. The share price falls
to `60 by the time the option expires.
(iii) Mr. Z writes a put option at an exercise price of `80 for a premium of `11 per share. The price of the share
rises to `96 by the time the option expires.
(iv) Mr. XY writes a put option with an exercise price of `70 for a premium of `8 per share. The price falls to
`48 by the expiry date.
[(i) Profit `10 (ii) Profit `11.50 (iii) Gain `11 (iv) Loss `14]
4.7 [C.A. four times, C.S.] Mr. X established the following spread on the Delta Corporation’s stock:
(i) Purchased one 3-month call option with a premium of `30 and an exercise price of `550.
(ii) Purchased one 3-month put option with a premium of `5 and an exercise price of `450.
Delta Corporation’s stock is currently selling at `500. Determine profit or loss, if the price of Delta Corporation’s
share:
(i) remains at `500 after 3 months.
(ii) falls to `350 after 3 months.
(iii) rises to `600 after 3 months.
[(i) Payoff (`3,500) (ii) Payoff `6,500 (iii) Payoff `1,500]
4.8 [C.S.] A share of Deepika Ltd. is currently selling for `120. There are two possible prices of the share after
one year: `132 or `105. Assume that risk-free rate of return is 9% per annum. What is the value of a one-year
call option (European) with an exercise price of `125?
[`6.17]
4.9 Mr A. purchased a three-month call option for 400 shares of XYZ Ltd. at a premium of `30 per-share, with
an exercise price of `550. He also purchased a three-month put option for 400 shares of the same company at
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a premium of `5 per share, with an exercise price of `450. The market price of the share on the date of Mr.A’s
purchase of options, is `500. Calculate the profit or loss that Mr.A would make assuming that the market price
falls to `350 at the end of 3 months.
[Profit `26,000]
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4.10 [C.S.] Internet Services Ltd. is a listed company and the share prices have been volatile. An investor
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expects that the share price may fall from the present level of `1,900 and wants to make profit by a suitable
option strategy. he is short of share at a price of `1,900 and wants to protect himself against any loss. The
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following option rates are available:
Strike price Call option Put option
(`) (`) (`)
1,700 325 65
h
1,800 200 80
1,900 85 120
rs
2,000 70 200
2,100 65 280
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The investor decides to buy a call at a strike price of `1,800 and write a put at a strike price of `2,000. Find
out the profit or loss profile of the investor if the share price on the expiration date is `1,600, `1,700, `1,800,
`1,900, `2,000 or `2,100 respectively.
A
[(`400), (`300), (`200), 0, `200, `300]

4.11 [C.S.] Equity shares of Bright India Ltd. ere being currently sold for `90 per share. Both the call option
and put option for a 3-month period are available for a strike price of `97 at a premium of `3 per share and `2
per share respectively. An investor wants to create a straddle position in this share.
Find out his net pay off at expiration of the option period if the share price on that day happens to be `90 or
`105.
[`2 or `3]
4.12 [C.A.] Mr. A purchased a 3 month call option for 100 shares in XYZ Ltd. at a premium of `30 per share,
with an exercise price of `550. He also purchased a 3 month put option for 100 shares of the same company at
a premium of `5 per share with an exercise price of `450. The market price of the share on the date of Mr. A s
purchase of options, is `500. Calculate the profit or loss that Mr. A would make assuming that the market price
falls to `350 at the end of 3 months.
[Gain `6,500]
4.13 [C.A.] Equity share of PQR Ltd. is presently quoted at `320. The Market Price of the share after 6 months
has the following probability distribution:
Market Price `180 `260 `280 `320 `400
Probability 0.1 0.2 0.5 0.1 0.1

A put option with a strike price of `300 can be written.
You are required to find out expected value of option at maturity (i.e. 6 months)
[`30]
4.14 [C.A.] You as an investor had purchased a 4 month call option on the equity shares of X Ltd. of `10, of
which the current market price is `132 and the exercise price `150. You expect the price to range between `120
to `190. The expected share price of X Ltd. and related probability is given below:
Expected Price (`) 120 140 160 180 190
Probability .05 .20 .50 .10 .15
Compute the following:
(1) Expected Share price at the end of 4 months.
(2) Value of Call Option at the end of 4 months, if the exercise price prevails.
(3) In case the option is held to its maturity, what will be the expected value of the call option?
[(1) `160.50 (2) Nil (3) `14]
4.15 Share of SBI Ltd. are currently quoted at `300. The RBI Governor is expected to announce an interest
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rate cut in the forthcoming credit policy. If the rate cut is announced the share price is expected to move up.
However, the rate cute may be delayed due to inflation worries in which case the share price will fall.
ha
A one month call for SBI Ltd. with a strike price of `310 is available at `10 and a put with the same exercise
price & expiry is available for `5.
An investor buys a call & a put to create a long straddle to benefit from the situation. At what price does he
achieve a break-even on his investment. Calculate his payoff if the share price on expiry turns out to be: `280,
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`290, `295, `300, `305, `310, `315, `320, `325, `330 or `330.
[B.E.P. of call `325, put `295. Payoff: `10, `5, 0, (`5), (`10), (`15), (`10), (`5), 0, `5, `10]
4.16 Power Ltd. has fairly stable revenue & profits and hence its shares remain relatively stable. The share is
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currently traded at `186. A three month call with an exercise price of `190 is available for `12 and a put for the
same exercise price is traded at `8.
An investor writes 50 calls & 50 puts to create a short straddle. What should the market price be on expiry for
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the strategy to break-event. Compute his payoff if the share price on expiry turns out to be: `20, `100, `170,
`175, `180, `190, `195, `200, `210, `350 or `500.
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[B.E.P. of call `210, put `170. Payoff: (`7,500), (`3,500), 0, `250, `500, `1,000, `750, `500, 0, (`7,000), (`14,500)]
4.17 A company’s share is currently traded at `540. It is expected to declare its results shortly. If the profits
exceed market expectations then the share price will rise sharply or else it will fall sharply. A near month call
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with a strike price of `550 is available for `20 and a put with a strike price of `520 is trading at `30.
an investor buys 100 calls & 100 puts to set-up a long strangle. Compute the break-even for the options. Compute
his payoff if the share price on expiry is: `330, `450, `470, `500, `520, `530, `550, `580, `600, `650 or `800.
[B.E.P. of call `600, put `470. Payoff: `14,000, `2,000, 0, (`3,000), (`5,000), (`5,000), (`5,000), (`2,000), 0, `5,000, `20,000]
A
4.18 The share of Steady Ltd. trades at `920 and it is a low beta stock. A call with a strike price of `930 trades
for `10 and a put with a strike price of `910 quotes at `15. An investor writes 100 calls & an equal number of
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puts to set-up a short strangle. Find the break-even of the call & put option. Find the payoff if the share price on
expiry is — `600, `800, `885, `890, `900, `910, `920, `930, `940, `950, `955, `1,200 or `1,500.
[B.E.P. of call `955, put `885. Payoff: (`28,500), (`8,500), 0, `500, `1,500, `2,500, `2,500, `2,500, `1,500, `500, 0, (`24,500), (`54,500)]
4.19 The share price of a company is currently traded at `130. Within a month the price is more likely to fall
than it is likely to rise. A near month call at a strike price of `130 is available for `4 and a put with the same
strike price for `6. An investor buys 200 puts & 100 calls to set up a strip. What is the break-even price for the
options. Compute his payoff if the share price on expiry is: `20, `50, `122, `125, `128, `130, `132, `136, `146,
`200 or `500.
[B.E.P. of call `146, put `125. Payoff: `20,400, `14,400, 0, (`600), (`1,200), (`1,600), (`1,400), (`1,000), 0, `5,400, `35,400]
4.20 The spot price of shares of Momentum Ltd. is `48. There is a high probability that the share price may go
up in the near future. The data for options available for this share are:
Option type Period Strike price Premium
Call 2 months `50 `6
Put 2 months `50 `8
An investor devise a strap strategy by buying 200 calls & 100 puts. Compute his if the share price on expiry is:
`10, `20, `30, `35, `45, `50, `54, `58, `60, `80 or `200.

[B.E.P. of call `60, put `30. Payoff: `2,000, `1,000, 0, (`500), (`1,500), (`2,000), (`1,200), (`400), 0, `4,000, `13,000]
4.21 Bull Ltd.’s share are trading at `100. A far month call with a strike price of `90 is trading at `21 & with a
strike price of `120 at `6. As the price is expected to rise, an investor adopts a bull spread strategy by buying a
call with a strike price of `90 and writing a call with a strike price of `120.
Compute the break even for the strategy. Find the payoff for each price on expiry: `85, `90, `95, `100, `105,
`110, `115, `120, `125 or `130.
[B.E.P. `105. Payoff: (`15), (`15), (`10), (`5), 0, `5, `10, `15, `15, `15]
4.22 The shares of Bear Ltd. are currently trading at `220. There is high chance that the share price will decline.
The data for options available for this share are:
Call 2 month `210 `25
As the price is expected to fall, an investor adopts a bear spread strategy by buying a call with a strike price of
`225 and writing a call with a strike price of `210.
Compute the break even for the strategy. Find the payoff for each price on expiry: `200, `210, `215, `220, `225,
`230, `240 or `250.
[B.E.P. `210. Payoff: `10, `10, `5, 0, (`5), (`5), (`5), (`5)]
4.23 Butterfly Ltd.’s share is currently trading at `480. The price of the share is likely to move in a narrow
range. The data for options available for this share are:
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Call 1 month `500
ss `10
An investor wants to set-up a long butterfly spread by taking a long position in of one call each at a strike price
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of `460 & `500 and a short position in two calls with an exercise price at `480. He wants you to compute the
payoff for the following different possible prices on expiry: `450, `455, `460, `465, `470, `475, `480, `485,
`490, `495, `500, `505 or `510.
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[B.E.P. `465 & `495. Payoff: (`5), (`5), (`5), 0, `5, `10, `15, `10, `5, 0, (`5), (`5), (`5)]
4.24 Fly Ltd.’s share is currently trading at `1,660. The price of the share is likely remain steady for some time.
h

Put 1 month `1,620 `20
rs
Put 1 month `1,660 `30

Put 1 month `1,700 `50
da
An investor wants to set-up a long butterfly spread by taking a long position in of one put each at a strike price
of `1,620 & `1,700 and a short position in two puts with an exercise price at `1,660. He wants you to compute
the payoff for the following different possible prices on expiry: `1,550, `1,600, `1,620, `1,630, `1,650, `1,660,
A
`1,680`1,690, `1,700, `1,750 or `1,800.

[B.E.P. `1,630 & `1,690. Payoff: (`10), (`10), (`10), 0, `20, `30, `10, 0, (`10), (`10), (`10)]
4.25 The spot price of a share of Butter Ltd. is `1,300. Call near month options on the share with strike prices of
`1,250, `1,300 & `1,350 are trading at a premium of `60, `30 & `25 respectively. The share price is expected to
fluctuate significantly. An investor plans a short call butterfly strategy: he writes a call at a strike price of `1,250
& another at `1,350 and at the same time buys two calls at a strike price of `1,300.
Compute his payoff if on expiry the price end up at: `1,100, `1,200, `1,250, `1,260, `1,265, `1,275, `1,285,
`1,290, `1,300, `1,310, `1,320, `1,325, `1,335, `1,345, `1,350, `1,400 or `1,500.
[B.E.P. `1,275 & `1,325. Payoff: `25, `25, `25, `15, `10, 0, (`10), (`15), (`25), (`15), (`5), 0, `10, `20, `25, `25, `25]
Binomial Model
5.1 [C.A.] Consider a two year American call option with a strike price of `50 on a stock the current price of
which is also `50. Assume that there are two time periods of one year and in each year the stock price can move
up or down by equal percentage of 20%. The risk free interest rate is 6%. Using binomial option model, calculate
the probability of price moving up and down. Also draw a two step binomial tree showing prices and payoffs at
each node.
[Probability of up 0.65 & down 0.35. PV of option `8.872]

5.2 [C.A.] Sumana wants to buy shares of EIL which has a range of `411 to `592 a month later. The present
price per share is `421. Her broker informs her that the price of this share can soar up to `522 within a month
or so, so that she should buy a one month call of EIL. In order to be prudent in buying the call, the share price
should be more than or at least `522 the assurance of which could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the probability of attaining the share
price `592 so that buying of a one month call of EIL at the execution price of `522 is justified. Advise her. Take
the risk free interest rate to be 3.6% and e0.036 = 1.037.
[0.1418]
5.3 [C.M.A.] Quickset Company’s equity shares are currently selling at a price of `400 each. An investor is
interested in purchasing Quickset’s shares. The investor expects that there is a 70% chance that the price will go
up to `550 or a 30% chance that it will go down to `350, three months from now. There is a call option on the
shares of Quickset that can be exercised only at the end of three months at an exercise price of `450.
(i) If the investor wants a perfect hedge, what combination of the share and option should he select?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price.
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(iii) If the risk-free rate is 5% for the 3 month period, what is the value of the option at the beginning of the
period?
(iv) What is the expected return on the option?
ha
[(i) 1 share with 2 options (ii) Portfolio of 1 share maintains value of `350 (iii) `33.33 (iv) 110%]
5.4 [C.M.A.] The equity shares of Endalco Ltd. are currently selling at a price of `500 each. An investor is
interested in purchasing shares of Endalco Ltd. The investor expects that there is a 80% chance that the price
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will go up to `650 or a 20% chance that it will go down to `450, three months from now. There is a call option
on the shares of Endalco Ltd. that can be exercised only at the end of three months at an exercise price of `550.
The risk-free rate is 12% per annum.
G
(i) If the investor wants a perfect hedge, what combination of the share and option should he select?
(ii) Explain how the investor will be able to maintain identical position regardless of the share price.
(iii) How much the investor should pay for buying this call option today?
(iv) What is the expected return on the option?
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[(i) 1 share with 2 options (ii) Portfolio maintains value of `450 (iii) `31.55 (iv) 153.57%]
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Risk Neutral Model

6.1 [C.A.] The current market price of an equity share of Penchant Ltd. is `420. Within a period of 3 months,
the maximum and minimum price of it is expected to be `500 and `400 respectively. If the risk-free rate of
.S
interest is 8% per annum, what should be the value of a 3 month’s call option under the ‘Risk Neutral Model’ at
the strike rate of `450? Given e0.02 = 1.0202.
[`13.72]
A
6.2 The spot price of a share of Pan India Ltd. is `125. It is expected that at the end of three months the price
will move up to `150 or it may fall to `100. A three month call, with a strike price of `135, is available. Find the
value of call using the ‘Risk Neutral Model’ if the risk-free rate of interest is 4% p.a. Given e-0.01 = 0.9901.
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[`7.06]
6.3 A three month call, for a share of X Ltd., with a strike price of `220 is available for `6.40. The current price
of the share is `200. After three months the price is expected to rise to `240 or it may fall to `180. An investor
seeks your advice whether he should buy the call. Advise him using the Risk Neutral Model taking the risk-free
rate as 5% p.a. Given that e-0.0125 = 0.98758.
[`5.77]
Black-Scholes Model
7.1 [C.A.] Following information is available for X Company’s shares and Call option:
Current share price `185
Option exercise price `170
Risk free interest rate 7%
Time of the expiry of option 3 years
Standard deviation 0.18
Calculate the value of option using Black-Scholes formula.
[`54.09]

7.2 [C.M.A.] On September 1, 2010 the stock of Amrex Ltd. was trading `120 and call option exercisable in
three months times had an exercise rate of `112. The standard deviation of the continuously compounded stock
price change for Amrex Ltd. is estimated to be 30% per year. The annualized Treasury Bill rate corresponding to
this option life is 7%.
Required:
(i) Compute the value of a three (3) months call option on the stock of Amrex Ltd. using Black-Scholes model.
(ii) What would be the value of put option for the same?
Note:
Extracted from the tables:
(1) Natural Logarithms: Ln (1.071429) = 0.068993. Ln (0.93333) = – 0.06900
(2) Value of e–x : e–0.02 = 0.9802 and e–0.01 = 0.9900
(3) Cumulative standardized normal probability distribution: NCX
When x > 0 : N(0.6516) = 0.7427, N(0.5016) = 0.6921
When x < 0 : N(– 0.6516) = 0.2573, N(– 0.5016) = 0.3079
[(i) `13.14 (ii) `2.92]
7.3 [C.M.A.] On March 9, 2014, Fergusson Systems was trading at `13.62
(a) To value a July, 2014 call option with a strike price of `15, trading on the Board Option Exchange on the
same day for `2. The following are the other parameters of the option:
The annualized standard deviation in Fergusson Systems stock price over the previous year was 81%.
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The option expiration date is Friday, July 23, 2014. There are 103 days to expiration (year = 365 days), and
the annualized Treasury Bill rate corresponding to this option life is 4.63%.
The value using the normal distribution of N(d1) = 0.5085 and N(d2) = 0.3412.
(b) Comment on the trading value as on 23rd July, 2014.
[(a) `1.87 (b) Option is overvalued]
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7.4 [C.M.A.] On April 10, 2005 the stock of Zenith Company (ZC) was trading at `60. The standard deviation
of the continuously compounded stock price change for ZC is estimated 30% per year. The annualized Treasury
Bill rate corresponding to the option life is 7%.
C
Estimate the value of a 3-month call option with a strike price of `56.
Note: Extract from the table:
(i) Natural logarithms: Ln (1.071429) = 0.068993, Ln (0.9333) = – 0.069029
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(ii) Value of e–x : = e–0.02 = 0.9802 and e–0.01 = 0.9901

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(iii) Cumulative standardized Normal Probability Distribution: NCX

when X ≥ 0 : N (0.6516) = 0.7427, N (0.5016) = 0.6921
when X ≤ 0 : N (– 0.6516) = 0.2573, N (– 0.5016) = 0.3079
da
[`6.57]
7.5 [C.A., C.M.A.] From the following data for certain stock, find the value of a call option:
Price of stock now = `80
A
Exercise price = `75

Standard deviation of continuously compounded annual return = 0.40
Maturity period = 6 months
Annual interest rate = 12%
Given:
Number of S.D. from Mean, (z) 0.25 0.30 0.55 0.60
Area of the left or right (one tail) 0.4013 0.3821 0.2912 0.2578
e0.12 × 0.05 = 1.0060
ln 1.0667 = 0.0645
[`11.53]
7.6 [C.M.A.] The stock of Vintex Ltd. is currently trading at `500 and call option exercisable in three months
time and has an exercise rate of `488. The standard of deviation of continuously compounded stock price change
for Vintex Ltd. is estimated to be 20% per year. The annualized treasury bill rate corresponding to this option
life is 6%. The company is going to declare a dividend of `15 and it is expected to be paid in two months time.
Requirements:
(i) Determine the value of a three-month Call option on the stock of Vintex Ltd. (based on Black & Scholes

model).
(ii) What would be worth of Put option if current price of stock is considered to be `485.15?
Note: Extracted from the Tables:
(1) Natural Logarithm: Ln(0.99416) = – 0.005857. Ln( 1.02459) = 0.02429
(2) Value of e–x : e–0.02 = 0.9802, e–0.015 = 0.9851
(3) For N(X): where X ≥ 0 : N(0.1414) = 0.5562
N(0.0414) = 0.5165
where X ≤ 0: N(– 0.1414) = 0.4438
N(– 0.0414) = 0.4835
(4) PVIF (6%, ¼ year) = 0.9852, PVIF (6%, 1/6 year) = 0.9901
[(i) `21.54 (ii) `17.17]
Replication Model: Option Strategy or Stock Equivalent

8.1 A share is currently quoted at `60. A call option is available for the same at an exercise price of `67 after
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one year. The price of the share after one year is expected to be either `80 or `54. The applicable interest rate
is 8% p.a. You are asked to create a portfolio which will replicate the return of 100 shares showing clearly: (i)
hedge ratio (ii) amount of risk-free investment (iii) fair value of call and (iv) prove that the return is replicated.
ha
[(i) 2 (ii) `5,000 (iii) `1,000 (iv) Payoff: `8,000 or `5,400]
8.2 The shares of XYZ Ltd. are currently quoted at `450. At the end of one year it is expected that the price
will be either `480 or `420. A call option (1 year) with a strike price of `460 is available. An investor wants to
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replicate the return from a portfolio of 50 shares.
If the applicable rate of interest is 5% per annum, compute: (i) hedge ratio, (ii) the amount of risk-free
investment, (iii) value of call option and (iv) the payoff after one year.
G
[(i) 3 (ii) `20,000 (iii) `2,500 (iv) `24,000/`21,000]
Replication Model: Stock Strategy or Option Equivalent

9.1 [C.S.] The current market price of the equity shares of Bharat Bank Ltd. is `190 per share. It may be either
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`250 or `140 after a year. A call option with a strike price of `180 (time 1 year) is available. The rate of interest
applicable to the investor is 9%. Rahul wants to create a replicating portfolio in order to maintain his pay off on
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the call option for 100 shares.

Find out:
(i) hedge ratio;
.S
(ii) amount of borrowing;

(iii) fair value of the call; &
(iv) his cash flow position after a year.
A
[(i) 0.64; (ii) `8,220; (iii) `3,940 (iv) `7,000/`0]

9.2 The shares of Supreme Industries Ltd. are quoted at `210. The expected price after one year is likely to
be either `240 or `220. Call option, with expiry after one year, and a strike price of `230 is available. The
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applicable interest rate is 10%.

To replicate the return from a portfolio of call option for 100 shares, you’re asked to calculate the following: (a)
the number of shares to be purchased, (b) amount of borrowing, (c) value of call (d) show that the return is
replicated.
[(a) 50 shares (b) `10,000 (c) `500 (d) `1,000/`0]
Put-Call Parity
10.1 [C.S.] The following quotes are available for 3-months options in respect of a share currently traded at
`31:
Strike price `30
Call option `3
Put option `2
An investor devises a strategy of buying a call and selling the share and a put option. Draw his profit/loss profile
if it is given that the rate of interest is 10% per annum. What would be the position if the strategy adopted is
selling a call and buying the put and the share?
[Strategy 1: net profit = `0.76; Strategy 2: net loss = `0.76]
10.2 A share is currently quoted at `36. A three month call with an exercise price of `38 is available at `2.30.
What do you expect the value of the put, with the same exercise price & expiry, to be? Given that the risk-free
rate is 4% and e–0.01 = 0.9901.
[`3.92]
10.3 The share of Adarsh Ltd. is available for `200. A 6-month call, with an exercise price of `220, is trading
for `8.63. The put with the same exercise price & expiry is trading at `20. Determine if the Put-Call Parity holds.
The risk-free rate is 8% p.a. Given: e– 0.04 = 0.96079.
[Yes.]
10.4 An investor holds 100 shares of Adarsh Ltd. which are currently traded on the NSE at `812. A 3-month
call, with an exercise price of `825, is trading at `11.36. A put with the same exercise price & expiry is available
for `23.24.
Is their any opportunity for arbitrage? If yes, then determine the amount of arbitrage gain to be made.
Assume risk-free rate at 4% p.a.
[Gain `711.88]
10.5 An investor holds 200 shares of X Ltd. having a spot price of `67. A 6-month call on these shares, with
an exercise price of `75, can be purchased for `6.88 each. Whereas, a put for the same period & with the same
exercise price is available for `13.92.
Is their any opportunity for arbitrage? If yes, then determine the amount of arbitrage gain to be made. Take risk-
free rate as 6% p.a.
[Gain `1,669.52]
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10.6 The spot price of a share is `80. A call on the share is trading at `7.62 & a put at `11.58. Both have an an
expiry of 3 months and an exercise price of `90. The risk free rate is 8%.
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Do any arbitrage opportunities exist? If yes, then explain the steps involved using a suitable illustration.
[Gain `4.36]
10.7 A 6-month call, on share currently traded at `135, can be purchased for `14.06. The call has a strike price
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of `152. A put with same expiry & strike price is available for `22.42. The prevailing T-bill rate is 6% p.a.
An investor seeks your advice about how he can profit from this situation. Explain to the investor, with a suitable
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illustration, the steps he needs to take to make a profit from the prevails prices of the securities.
Given: e– 0.03 = 0.97045, e0.03 = 1.0305.
[Gain `4.27]
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Commodity Derivatives
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Derivatives are available for commodities in the same manner as they are for securities. These are available on
the commodity exchanges of which the National Commodity & Derivatives Exchange (NCDEX) is the largest
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commodity derivative exchange in India. Other commodity exchanges are: Multi Commodity Exchange (MCX),
National Board of Trade (NBOT), National Multi-Commodity Exchange of India (NMCE). These exchanges
feature among the world’s best technology driven on-line exchanges in the world. They offer derivatives for
agricultural products, metals, energy, currency, etc.
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Problems
11.1 [C.A.] A company is long on 10 MT of copper @ `474 per kg (spot) and intends to remain so for the
ensuing quarter. The standard deviation of changes of its spot and future prices are 4% and 6% respectively,
having correlation coefficient of 0.75.
What is its hedge ratio? What is the amount of the copper future it should short to achieve a perfect hedge?
[Hedge ratio 0.5, `23,70,000]
11.2 [RTP] A wheat trader has planned to sell 440000 kgs of wheat after 6 months from now. The spot price
of wheat is `19 per kg and 6 months future on same is trading at `18.50 per kg (Contract Size = 2000 kg). The
price is expected to fall to as low as `17.00 per kg 6 month hence. What can the trader do to mitigate his risk of
reduced profit? If he decides to make use of future market then what would be effective realized price for its sale
when after 6 months is spot price is `17.50 per kg and future contract price for 6 months is `17.55.
[Gain from futures `4,18,000. Effective selling price `18.45]
11.3 [C.A.] On 19th April following are the spot rates
Spot EUR/USD 1.2000 USD/INR 44.8000
Following are the quotes of European Options:

Currency Pair Call/Put Strike Price Premium Expiry date
EUR/USD Call 1.2000 $ 0.035 July 19
EUR/USD Put 1.2000 $ 0.04 July 19
USD/INR Call 44.8000 ` 0.12 Sep. 19
USD/INR Put 44.8000 ` 0.04 Sep. 19
(i) A trader sells an at-the-money spot straddle expiring at three months (July 19). Calculate gain or loss if
three months later the spot rate is EUR/USD 1.2900.
(ii) Which strategy gives a profit to the dealer if five months later (Sep. 19) expected spot rate is USD/INR
45.00. Also calculate profit for a transaction USD 1.5 million.
[(i) Loss $ 0.015 per Euro (ii) Gain `1,20,000]
Over the Counter (OTC) Derivatives

Forward Rate Agreement (FRA)
A forward trade agreement is an over-the-counter contract between two parties. Such contracts are not traded
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on the exchange but our customized according to the requirements of the parties. In such contracts, one party
agrees to borrow/lend to the counter party, the notional principal at a predetermined rate for a certain period
which is to commence from a future date. In periods of fluctuating interest rates, such contracts are used to lock
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in a fixed rate of interest on assets or liabilities. On the commencement date the agreed rate is compared with
the reference rate, which is a floating rate like LIBOR or MIBOR. The difference between the agreed rate and the
floating rate is paid by one party to the other depending on which party has bought the FRA which one has sold it.
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Buying an FRA means agreeing to borrow at the agreed rate.
Selling an FRA means agreeing to lend or make a deposit at the agreed rate.
Though the interest on notional principal is payable at the end of the agreed period, in actual practice, the
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payment is made at the beginning of the period for which the notional principal is to be borrowed. The amount
paid is the present value of the difference which is discounted at the reference rate.
Settlement of FRA
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The party buying the FRA can compute its payoff from the FRA as follows –
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 dtm 
N (RR − FR)  
 360 
Payoff =
  dtm  
1 + RR  360  
 
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
Where,
N = Notional principal
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RR = Reference Rate agreed to in the FRA which could be LIBOR, MIBOR, Prime lending rate or any other.
FR = Forward Rate agreed to in the FRA
dtm = days to maturity of the FRA, i.e. the period borrowing or lending
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Notation:
3 × 9 FRA 7% – This implies that interest @ 7% p.a. will be applicable for the FRA for the period
commencing 3 months from today and ending 9 months from today; i.e. for a period
of 6 months starting 3 months form today.
3 - 6 FRA 5% – This implies that interest @ 5% p.a. will be applicable for the FRA for the period
commencing 3 months from today and ending 6 months from today; i.e. for a
period of 3 months starting 3 months form today.
6 - 12 FRA 6% - 7% – a bank/financial institution may quote these rates indicating that it will offer forward
deposit & lending rates for a period of 6 months commencing from a 6 months later.
i0, 6 – spot 6 months rate.
if6, 9 – forward 3 month rate for FRA commencing after 6 months.
Swaps
A swap is an over the counter derivative where two parties agree to exchange cash flows over a period of time on
predetermined dates in the future. Unlike FRAs, payments are made at the end of each period. An intermediary
between the parties may be involved. Involving an intermediary reduces risk of default by counter-party.

Types of Swaps
Swaps market is highly developed in developed countries. Swaps may be for interest rates, currency, commodity,
assets, energy, etc. However, two important categories are: (a) Interest rate swaps & (b) Currency Swaps.
(i) Interest Rate Swaps: These swaps are used to convert a fixed interest liability or asset into one with
floating rate or vice versa. The cash flows are calculated on a notional principal amount, at agreed interest
rates of which the fixed rate is predetermined and the floating rate is the agreed floating benchmark rate
like the LIBOR or MIBOR. There is no exchange of notional principal amount which is used only for the
calculation of the interest. For example, the two parties enter into an interest rate swap to exchange fixed
8% p.a. for MIBOR payable at the end of each six monthly period for the over three years on a notional
principal amount of `5 crores. The fixed rate is already known so only the floating rate at the beginning of
each period is to be determined and the payment is settled at the end of each six-monthly period on ‘net’
basis at the end of each period.
The fixed rate payer is said to be the buyer of the swap and is said to be long on the swap and the floating
rate payer is the seller and said to be short on the swap.
Interest rate swaps can be of the following types –
(1) Plain Vanilla or Generic Swap: This is the most common type of swap where there is an exchange of
cash flows calculated on the basis of fixed for floating interest rate or vice versa.
(2) Overnight Index Swap (OIS): An overnight index swap uses an overnight rate index as the underlying
for its floating leg. Overnight rate is the rate at which credit-worthy financial institutions lend
overnight funds to one another. In this type of swap the periodic floating rate is linked to an overnight
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index and is computed by compounding the daily rate over the payment period.
(3) Basis Swap: This is a swap where parties agree to exchange floating for floating interest rate bases
on different benchmarks rates. A party affected by two different floating rates can use this swap to
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protect itself from rate fluctuations. For example, a bank has advanced loans at prime lending rate
which are financed by deposits on which the bank pays floating rate based on MIBOR. The current
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spread is 3%. Increase in MIBOR and/or decrease in prime lending rate will adversely affect its
spread. It can enter into a basis swap to protect its spread. For example, the bank will enter into a
basis swap where it earns MIBOR + 2.5% and pays prime lending rate. Irrespective of the change in
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MIBOR and prime lending rate the a spread of 2.5% will be ensured. Though the spread falls, it is
maintained at 2.5%.
(4) Forward Swap: It is a swap that starts at a future date.
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(5) Others: There are several other swaps. For example, extendable swap in which a party has the option
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to extend the period of the swap on payment of a fee, cancelable swap in which a party has the option
to cancel the swap on payment of a fee, an accrual swap is a swap in which the interest accrues only
when the interest floating reference rate is within a certain range, etc.
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(ii) Currency Swaps: Where the two parties need to borrow in different currencies they may enter into a
currency swap. This type of swap involves exchange of principal in different currencies between parties at
the commencement of the swap. This is followed by the usual periodic interest payments which are paid
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in full as they are in different currencies. Finally, the principal amount is again exchanged at the end of
the term. Where swaps involve principal amount in different currencies, the initial amount is the same in
both currencies. However, there is a risk of fluctuation in exchange rates that needs to be considered by
the parties involved in the swap. The key feature in this type of swap is the different currency involved and
hence this could be a fixed for fixed interest rate swap or fixed for floating interest rate swap. [Problems
covered in the Chapter: Foreign Exposure and Risk Management]
Concept of Comparative Advantage

The rate of interest at which a company can borrow money depends upon its creditworthiness. Some companies
have a comparative advantage in fixed rate borrowings while others have a comparative advantage in floating
rate borrowing. For example
Fixed rate loan Floating rate loan
X Ltd. 12% MIBOR
Y Ltd. 14% MIBOR + 0.5%
From the above data it is clear that X Ltd. has better creditworthiness. X Ltd. has comparative advantage in fixed
rate borrowing as it can borrow at a rate which is 2% less than what Y Ltd. would have to pay. However, Y Ltd.
has a comparative advantage in floating rate loan. Here, ‘advantage’ does not mean that it has to pay less than
X Ltd. but despite its lower creditworthiness it has to pay ‘only’ 0.5% more than X Ltd. for a floating rate loan

as compared to 2% more than X Ltd. for a fixed rate loan. Y Ltd. pays relatively less more. [Einstein’s Theory of
Relativity!]
This comparative advantage can be used to the benefit of both parties in the swap deal and the benefit can be
shared by the parties to reduce the effective rate of interest on their borrowing.
Swaptions
An interest rate swaption is an option on an interest rate swap. It provides for the rate, the period of the swap,
the start date, etc. An interest rate swaption may be fixed-floating or floating-fixed option. Just like any other
option it may expire worthless on expiry.
Swaptions fall in three categories:
(a) European Swaptions: This can be exercised by the holder only on the maturity date of the option.
(b) American Swaptions: This can be exercised by the holder at any time up to & including the maturity date of
the option.
(c) Bermudan Swaptions: This can be exercised by the holder on specified dates during the option period
including the maturity date of the option.
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Caps, Floors & Collars
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These are interest rate options which are used to manage interest rate risks.
(a) Cap: This is an option which is used to manage the interest cost risk on a floating rate liability. The cap
puts an upper limit to the interest rate on a floating rate liability. A floating rate liability has a reset date
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for the floating rate interest. The reset period is called the tenor. The cap rate is fixed and if the floating
rate exceeds the cap rate on the reset date then the option holder gets a payoff for the tenor. The payoff
is at the end of the period and not on the reset date. There is no payoff to the option holder at the start of
the option. For example, a company has issued 10-year inflation indexed bonds with a coupon of 2% above
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the inflation rate of the preceding year and such coupon to be reset every year. The company can purchase
a cap with a 10% rate so that it will not pay more than 10% on the bonds in the future. In the first year
the interest rate is set at 11% (9% + 2%). There will be no payoff from the option in the first year. In the
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second year, the interest is 13% (11% + 2%). The option payoff at the end of second year will be 3% as the
interest rate has crossed the cap rate of 10%. In the third year the interest is reset to 9% (7% + 2%) there
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will be no payoff from the option and so on. It should be noted that though the option is for 10 year it can
have only a maximum of 9 payoffs because there will be no payoff in the first period.
(b) Floor: This is an option which is used to manage the interest income risk on a floating rate asset. A floor is
an option which ensures a minimum rate of interest earned on an asset which earns interest at a floating
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rate. The option holder gets a payoff when the reference interest rate falls below the floor’s strike rate. For
example, an investor buys a 5-year bond which pays interest at LIBOR which is reset every year. He can
buy a floor to ensure than his income from the bond will not fall below the floor rate. If the LIBOR falls
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below the floor rate then the payoff from the floor will ensure than his income is maintained at the fixed
rate.
(c) Collar: A collar is a combination of a cap & a floor. It involves buying a cap & writing a floor.
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(i) Collar for a liability: A floating rate loan carries a risk of increasing interest rate. This risk can be
hedged by buying a cap for which a premium has to be paid. However, it is generally known that the
interest rate will not fall below a certain level and therefore it may be possible to also sell a floor
at the same time and thereby earn some premium which will help to reduce the cost of buying the
cap. Setting up a collar for a floating rate loan will mean that the interest rate will be within a range
between the floor and the cap.
(ii) Collar for an asset: Fluctuation in interest rates affect bond prices. Consider a 9% bond of face value
of `100 issued at par. If the interest rates rise then the market value of the bond will fall the provide
the expected yield. On the other hand, if the interest rates fall the value of bond will rise. Fluctuation
in the value of the investment in a portfolio of bonds is a risk that needs to be hedged. Collars are
used for this purpose. Buying a cap for an investment means that when the interest rate crosses cap
strike rate there will be a payoff from the option. However, this is to compensate for the loss in the
value of the bonds. Writing the floor means that whenever there is a fall in interest rates a payment
will have to be made to the holder of the floor. However, decrease in interest rate will mean increase
in the value of the bonds. [Note: hedging is not for gain but to stabilize the value of the portfolio.]
If the premium paid for buying a cap is equal to the premium earned from writing a floor then this strategy
can be set up a zero cost.

Problems
Forward Rate Agreement (FRA)
12.1 [C.S.] Ankush Ltd. has a plan to raise an amount of `50 crores for a period of 3 months, 6 months from
now. The current rate of interest is 9%, but it may rise in 6 months’ time. The company wants to hedge itself
against the increase in interest rate. Bank of India has quoted a forward rate agreement (FRA) at 9.1% per
annum.
Find out the effect of FRA and actual interest cost to Ankush Ltd., if the actual rate after 6 months happens to be
either 9.5% or 8.5%.
[Interest rate locked at 9.1%]
12.2 [C.A.] The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) for Yen is Nil.
1. What should be 3 months FRA rate at 3 months forward?
2. The 6 & 12 months LIBORs are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA at 6.50 - 6.75%. Is
any arbitrage opportunity available?
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Calculate profit in such case.
[(1) 5.44% (2) $0.005 for every $1 borrowed]
12.3 [C.A.] M/s Parker & Co. is contemplating to borrow an amount of `60 crores for a period of 3 months in
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the coming 6 month’s time from now. The current rate of interest is 9% p.a., but it may go up in 6 month’s time.
The company wants to hedge itself against the likely increase in interest rate.
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The Company’s Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a.
What will be the effect of FRA and actual rate of interest cost to the company, if the actual rate of interest after
6 months happens to be (i) 9.60% p.a. and (ii) 8.80%) p.a.?
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[(i) Gain `4,39,453 (ii) Loss `7,33,855]
Swaps
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13.1 X Ltd. and Y Ltd. face the following interest rates:

Fixed-rate Floating rate
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X Ltd. 8% MIBOR + 0.5%

Y Ltd. 11% MIBOR + 1%
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X Ltd. would like to borrow at floating-rate and Y Ltd. at fixed-rate. Arrange a swap which will yield the
intermediary 0.5% commission and make the swap equally attractive to both parties. What would be the effective
rate of interest for the two parties.
[X Ltd. MIBOR – 0.5%, Y Ltd. 10%]
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13.2 PQR Ltd. and XYZ Ltd. face the following interest rates:
PQR Ltd. XYZ Ltd.
Fixed-rate 13% 14%
Floating rate MIBOR MIBOR + 2%
PQR Ltd. would like to borrow at fixed-rate and XYZ Ltd. at floating-rate. Arrange a swap which will yield the
intermediary a commission of 20 basis points. The gain to be shared ¾th by PQR Ltd. and ¼th by XYZ Ltd. What
would be the effective rate of interest for the two parties.
[PQR Ltd. 12.4%, XYZ Ltd. MIBOR + 1.8%]
13.3 [C.S.] Two companies Rita Ltd. and Gita Ltd. are considering to enter into a swap arrangement with each
other. Their corresponding borrowing rates are as follows:
Name of Company Floating rate Fixed rate
Rita Ltd. LIBOR 11%
Gita Ltd. LIBOR + 0.3% 12.5%
Rita Ltd. requires a floating rate loan of £8 million while Gita Ltd. requires a fixed-rate loan £8 million.
(i) Show which company has a comparative advantage in floating-rate loans and which company has advantage
in fixed rate loans.

(ii) If Rita Ltd. and Gita Ltd. engage in a swap agreement and the benefits of the swap are equally split, at what
rate will Rita Ltd. be able to opt in floating-rate finance and Gita Ltd. be able to opt in fixed-rate finance?
Ignore bank charges.
[(i) Gita Ltd., Rita Ltd. (ii) Rita Ltd. LIBOR – 0.6%, Gita Ltd. 11.9%]
13.4 [C.A.] Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six month libor flat. If the
notional principal amount of swap is `5,00,000,
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six month period from the effective date of swap to
the settlement date comprises 181 days and that the corresponding Libor was 6% on the effective date of
swap.
In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would pay to the floating rate
payer?
Generic swap is based on 30/360 days basis.
[(i) `20,000 (ii) `15,090]
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13.5 [C.A.] Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap) on a
principal of `10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment on the principal.
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The swap was entered into on Monday 2nd August, 2010 and was to commence on 3rd August, 2010 and run for
a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75%, 8.15%, 8.12%, 7.95%, 7.98%, 8.1%.
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If Derivative Bank received `317 net on settlement, calculate Fixed rate and interest under both legs.
Notes:
(i) Sunday is Holiday.
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(ii) Work in rounded rupees and avoid decimal working.
[Fixed rate 8%]
13.6 [C.A.] A Dealer quotes “All-in-Cost” for a generic swap at 8% against six months LIBOR flat. If the notional
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principal amount of swap is `6,00,000,
(i) Calculate semi-annual fixed payment.
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(ii) Find the first floating rate payment for (i) above, if the six-month period from the effective date of swap to
the settlement date comprises 181 days and that the corresponding LIBOR was 6% on the effective date of
swap.
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(iii) In (ii) above, if the settlement is on ‘NET’ basis, how much the fixed rate payer would pay to the floating
rate payer? Generic swap is based on 30/360 days.
[(i) `24,000 (ii) `18,100 (iii) `5,900]
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13.7 [C.A.] ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + ¼%
for `200 million for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six month LIBOR treating
six months as exactly half a year.
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(a) What will be the “all in cost” funds to ABC Bank?

(b) Another possibility being considered is the issue of a hybrid instrument which pays 7.5% for first three years
and LIBOR – ¼% for remaining two years.
Given a three year swap rate of 8%, suggest the method by which the bank should achieve fixed rate funding.
[(a) `77,50,000 (b) First 3 years 7% & 2 years 7.25%]
Caps, Floors & Collars

14.1 [C.A.] XYZ Limited borrows £15 Million of six months LIBOR + 10.00% for a period of 24 months. The
company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at the strike rate of
8.00%. The lump sum premium is 1.00% for the entire reset periods and the fixed rate of interest is 7.00% per
annum. The actual position of LIBOR during the forthcoming reset period is as under:
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap Option.
For calculation, work out figures at each stage up to four decimal points and amount nearest to £. It should be

part of working notes.
[Savings £2,14,917]
14.2 [RTP] Suppose that a 1-year cap has a cap rate of 8% and a notional amount of `100 crore. The frequency
of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for the next
four quarters is as shown below.
Quarters 3-month MIBOR (%)
1 8.70
2 8.00
3 7.80
4 8.20
You are required to compute payoff for each quarter.
[Payoff: Q1 `17,50,000, Q2 Nil, Q3 Nil, Q4 `5,00,000]
14.3 [RTP] Suppose that a 1-year floor has a floor rate of 4% and a notional amount of `200 crore. The
frequency of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-month MIBOR for
the next four quarters is as shown below.
Quarters 3-months MIBOR (%)
1 4.70
2 4.40
3 3.80
4 3.40
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You are required to compute payoff for each quarter.
[Payoff: Q1 Nil, Q2 Nil, Q3 `10,00,000, Q4 `30,00,000]
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14.4 [RTP] XYZ Inc. issues a £10 million floating rate loan on July 1, 2013 with resetting of coupon rate every
6 months equal to LIBOR + 50 bp. XYZ is interested in a collar strategy by selling a Floor and buying a Cap. XYZ
buys the 3 years Cap and sells 3 years Floor as per the following details on July 1, 2013:
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Notional Principal Amount $ 10 million
Reference Rate 6 months LIBOR
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Strike Rate 4% for Floor and 7% for Cap
Premium 0*
*Since Premium paid for Cap = Premium received for Floor
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Using the following data you are required to determine:

(i) Effective interest paid out at each reset date,
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(ii) The average overall effective rate of interest p.a.

Reset date LIBOR (%)
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31.12.2013 6.00
30.06.2014 7.00
31.12.2014 5.00
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30.06.2015 3.75
31.12.2015 3.25
30.06.2016 4.25
[Effective interest: $3,27,671, $3,47,123, $2,77,260, $2,10,753, $2,01,644, $2,35,548. Effective rate of interest 5.33% p.a.]
14.5 [C.A.] XYZ Limited borrows £15 Million of six months LIBOR + 10.00% for a period of 24 months. The
company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at the strike rate of
8.00%. The lump sum premium is 1.00% for the entire reset periods and the fixed rate of interest is 7.00% per
annum. The actual position of LIBOR during the forthcoming reset period is as under:
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%
You are required to show how far interest rate risk is hedged through Cap Option.
For calculation, work out figures at each stage up to four decimal points and amount nearest to £. It should be
part of working notes.
[Premium payable to bank £40,861. Net amount received from bank: Period 1 £34,139; Period 2 £71,639; Period 3 £1,09,139. Interest rate risk
hedged by cap is £2,14,917]

Long Straddle
P-1 X Ltd. a relatively small pharmaceutical company, is in negotiations with a large pharmaceutical company
for merger. The share of X Ltd. are currently traded at `30. If the merger is announced the share is likely to
move up. If the talks fail the share price will fall.
A two month call with a strike price of `32 is available for `4 while a put for the same period with the same
exercise price is traded for `2.50.
An investor buys 100 calls & 100 puts to create a long straddle. At what price does he achieve a break-even on
his investment. Compute his payoff if the share price on expiry turns out to be: `6, `10, `25, `27, `30, `32, `34,
`36, `39, `52 or `87.
Soln. Premium paid = (100 × `4.50) + (100 × `2.50) = `450 + `250 = `700
700
Lower B.E.P. = `32 – = `32 – `7 = `25
100
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700
Higher B.E.P. = `32 + = `32 + `7 = `39
100
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Payoff from
Expiry Calls bought Puts bought Gross Premium Net
price at `32 at `32 payoff paid payoff
6 – 2,600 2,600 (700) 2,100
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10 – 2,200 2,200 (700) 1,500
25 – 700 700 (700) 0
27 – 500 500 (700) (200)
30 – 200
G 200 (700) (500)
32 – – 0 (700) (700)
34 200 – 200 (700) (500)
36 400 – 400 (700) (300)
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39 700 – 700 (700) 0
52 2,000 – 2,000 (700) 1,300
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87 5,500 – 5,500 (700) 4,800

Short Straddle
P-2 An investor has observed that the shares of Stable Ltd., currently quoted at `683, move in a very narrow
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range. A far month call on the share with a strike price of `680 is available for `20 and a put for the same at `10.
He sets up a short straddle to gain from the situation by writing 100 calls and the same number of puts. What
should be the price of the share for his investment to break even? Compute his payoff if the share price on expiry
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turns out to be: `630, `640, `650, `660, `670, `680, `690, `700, `710, `720 or `730.
Soln. Premium earned = (100 × `20) + (100 × `10) = `2,000 + `1,000 = `3,000
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3,000
Lower B.E.P. = 680 – = `680 – `30 = `650
100
3,000
Upper B.E.P. = 680 + = `680 + `30 = `710
100
Payoff from
Expiry Puts written Puts written Gross Premium Net
price at `680 at `680 payoff earned payoff
630 – (5,000) (5,000) 3,000 (2,000)
640 – (4,000) (4,000) 3,000 (1,000)
650 – (3,000) (3,000) 3,000 0
660 – (2,000) (2,000) 3,000 1,000
670 – (1,000) (1,000) 3,000 2,000
680 – – 0 3,000 3,000
690 (1,000) – (1,000) 3,000 2,000
700 (2,000) – (2,000) 3,000 1,000
710 (3,000) – (3,000) 3,000 0
720 (4,000) – (4,000) 3,000 (1,000)
730 (5,000) – (5,000) 3,000 (2,000)

Long Strangle
P-3 Share of XYZ Ltd. are traded at `60. An investor expects the price to fluctuate. A far month call with a strike
price of `65 is trading at `3 and a put for the same month with a strike price of `50 is trading at `5. He sets-up
a long strangle by buying a call & a put. What is the break even for each option? Also compute his payoff if the
share price on expiry is: `27, `36, `42, `46, `53, `64, `70, `73, `87 or `106.
Soln. Premium paid = `3 + `5 = `8
Lower B.E.P. = `50 – `8 = `42
Upper B.E.P. = `65 + `8 = `73
Payoff from
Expiry Call bought Put bought Gross Premium Net
27 – 23 23 (8) 15
36 – 14 14 (8) 6
42 – 8 8 (8) 0
46 – 4 4 (8) (4)
53 – – 0 (8) (8)
64 – – 0 (8) (8)
70 5 – 5 (8) (3)
73 8 – 8 (8) 0
87 22 – 22 (8) 14
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106 41 – 41 (8) 33
Short Strangle
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P-4 The share of Low Beta Ltd. is currently traded at `160. It is expected to move in a narrow range in the next
few months. A three month call at a strike price of `165 is available for `3 whereas a put for the same period
with a strike price of `155 trades for `4.
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An investor sets-up a short strangle by writing a call and a put. Find the break-even price for the options. Also
compute his payoff if the share price on expiry is: `80, `100, `148, `150, `153, `155, `160, `165, `167, `170,
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`172, `200 or `400.
Soln. Premium earned = `3 + `4 = `7
Lower B.E.P. = `155 – `7 = `148
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Upper B.E.P. = `165 + `7 = `172

Payoff from
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Expiry Call written Put written Gross Premium Net

price at `165 at `155 payoff earned payoff
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80 – (75) (75) 7 (68)

100 – (55) (55) 7 (48)
148 – (7) (7) 7 0
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150 – (5) (5) 7 2

153 – (2) (2) 7 5
155× – – 0 7 7
160 – – 0 7 7
165 – – 0 7 7
167 (2) – (2) 7 5
170 (5) – (5) 7 2
172 (7) – (7) 7 0
200 (35) – (35) 7 (28)
400 (235) – (235) 7 (228)
Strips
P-5 The call option for a company’s share with a strike price of `800 trades at `10 whereas a put with the same
strike price & expiry is available for `15. The price of the share is expected to fluctuate but it is more likely to go
down. To take advantage of this possibility an investor decides to set-up a strip by buying 2 puts & a call.
Compute the price of the share at which the strategy breaks even. Compute his payoff if the share price on expiry
is: `600, `700, `780, `785, `790, `800, `815, `825, `840, `900 or `1,000.
Soln. Premium paid = `10 + (2 × `15) = `40

40
Lower B.E.P. = `800 – = `800 – `20 = `780
2
Higher B.E.P. = `800 + `40 = `840
Payoff from
Expiry Call bought 2 Puts bought Gross Premium Net
600 – 400 400 (40) 360
700 – 200 200 (40) 160
780 – 40 40 (40) 0
785 – 30 30 (40) (10)
790 – 20 20 (40) (20)
800 – – 0 (40) (40)
815 15 – 15 (40) (25)
825 25 – 25 (40) (15)
840 40 – 40 (40) 0
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900 100 – 100 (40) (60)
1,000 200 – 200 (40) 160
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Straps
P-6 The spot price of shares of Uprise Ltd. is `1,794. There is a high probability that the share price may go up
in the near future. The data for options available for this share are:
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Call 1 month `1,800 `30
Put 1 month `1,800 `40
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An investor devise a strap strategy by buying 2 calls & a put. Compute his if the share price on expiry is: `1,000,
`1,500, `1,700, `1,725, `1,775, `1,820, `1,830, `1,850, `1,900, or `2,000.
Soln. Premium paid = (2 × `30) + `40 = `100
Lower B.E.P. = `1,800 – `100 = `1,700
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100
Upper B.E.P. = `1,800 + = `1,850
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2
Payoff from
Expiry 2 Calls bought Put bought Gross Premium Net
price at `1,800 at `1,800 payoff paid payoff
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1,000 – 800 800 (100) 700

1,500 – 300 300 (100) 200
1,700 – 100 100 (100) 0
1,725 – 75 75 (100) (25)
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1,775 – 25 25 (100) (75)

1,800 – – 0 (100) (100)
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1,820 40 – 40 (100) (60)

1,830 60 – 60 (100) (40)
1,850 100 – 100 (100) 0
1,900 200 – 200 (100) 100
2,000 400 – 400 (100) 300
Short Put Butterfly
P-7 BF Ltd.’s share is currently trading at `650. The share price is expected to fluctuate over the next few
months.
Put 2 month `600 `10
An investor set-up a short put butterfly by writing one put at `600 & another at `700 and at the same time
buying two puts at `650. Compute his net payoff if the spot price on expiry is — `450, `550, `600, `610, `615,
`625, `635, `640, `650, `660, `670, `675, `685, `695, `700, `750 or `850.
Soln. Net premium earned = `10 + `45 – (2 × `15) = `25

Lower B.E.P. = E1 + Net premium earned = `600 + `25 = `625
Upper B.E.P. = E3 – Net premium earned = `700 – `25 = `675
Payoff from
Expiry Put sold 2 Puts bought Put sold Gross Premium Net
price at `600 at `650 at `700 payoff earned payoff
450 (150) 400 (250) 0 25 25
550 (50) 200 (150) 0 25 25
600 – 100 (100) 0 25 25
610 – 80 (90) (10) 25 15
615 – 70 (85) (15) 25 10
625 – 50 (75) (25) 25 0
635 – 30 (65) (35) 25 (10)
640 – 20 (60) (40) 25 (15)
650 – – (50) (50) 25 (25)
660 – – (40) (40) 25 (15)
670 – – (30) (30) 25 (5)
675 – – (25) (25) 25 0
685 – – (15) (15) 25 10
695 – – (5) (5) 25 20
700 – – 0 0 25 25
750 – – 0 0 25 25
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850 – – 0 0 25 25
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A

Chapter
8
Portfolio Theory
A portfolio is a collection of investments like bonds, shares, gold, precious stones, real estate, paintings, etc.
Such investments should be selected in such a manner that they provide the best possible return. However,
investments may carry risk. Hence, in order to optimize a portfolio it is important to understand both return as
well as risk.
A portfolio has to be optimized according to each investor’s –
(1) Objective — the purpose of such investment
(2) Risk profile — his ability & willing to take risk
(3) Investment horizon — short- or long-term
Portfolio management has emerged as an important field in financial services sector. It involves not only
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understanding the investor’s requirements but also selecting the appropriate securities for his portfolio and
deciding their proportion in the portfolio; the period evaluation of the performance of the portfolio with that of
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the market; churning the portfolio by selling the non-performing or under-performing securities with others and
so on. Thus, portfolio management is a continuous process.
Return From a Security
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Current/Realized Return From a Security
Return from a security is the income generated by the security expressed as a percentage of the amount invested
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in it. The return from a security includes income not only in the form of dividend/interest but also capital gain/
loss arising from it. The return from a security is computed on per annum basis:
Income ± Capital gain/loss I ± ( P1 - P0 )
Return from a security = × 100 = × 100
Cost/Price at the beginning of the year
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P0
or
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I + P1
Return from a security = − 1
P0
Where,
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I = income earned during the year

P1 = market price at the end of the year
P0 = cost/market price at the beginning of the year
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Expected Return From a Security

The expected return of a security can be computed in different ways. Computing the expected return from the
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security can help us decide whether it is worth investing in the security. Two basic methods are given below –
(1) On the basis of historical returns
Expected return can be computed as the arithmetic mean of the return of the past few years.
(2) On the basis of probabilities
Expected return can be computed on the basis of the different possible expected returns in the forthcoming
year and the probabilities assigned to such returns.
E(Rx) = R1p1 + R2p2 + R3p3 + ...... + Rnpn
Where,
E(Rx) = expected return from security X
R1, R2 ... Rn = the different possible return on the same investment
p1, p2 ... pn = the probability of each possible return
To compute the expected return from a security we can use probability of occurrence. This is computed as
follows:
For example, the probable return from a security could be either 10% or 12% or 15% with corresponding
chance (probability) of occurrence being 30%, 30% and 40%. The expected return will be-
E(Rx) = 10% (0.3) + 12% (0.3) + 15% (0.4)
Portfolio Theory Ɩ 151

= 3% + 3.6% + 6% = 12.6%
!! While solving problems students should understand which type of expected return is given in the question and/or
which is required to be computed in the question. More models are given later.
Return From a Portfolio

The return from a portfolio is the weighted average return of the securities in the portfolio
using the proportion or percentage of investment in each security as the weight.
R p = R 1W 1 + R 2W 2 + R 3W 3 + . . . . . + RnW n
Where,
R p = return from the portfolio
R1, R2 . . . Rn = the return from each security in the portfolio
W1, W2 . . . Wn = the weight of each security in the portfolio, i.e. the cost of investment in each security
!! The entire portfolio can be considered to be one investment.
Risk Analysis
The risk involved in investing in a security is the uncertainty or fluctuation in its return. The fluctuation is
caused due to a number of factors. The total risk of investing in a security may be analyzed as follows:
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Total risk = Systematic risk + Unsystematic risk
The factors contributing to systematic risk are the macro economic factors which are uncontrollable and affect
almost all investments. These are: economic downtrend, political instability, inflation, interest rate risk, stock
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market risk (fluctuations), etc. This risk is also known as non-diversifiable risk because it cannot be reduced or
eliminated by diversification of the portfolio.
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Unsystematic risk in controllable to a great extent and can even be eliminated by diversification. The is also
known as diversifiable risk or unique risk because it is unique to that investment. The factors contributing to
unsystematic risk are: business risk — the type of business undertaken by the company, financial risk — high
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debt-equity ratio of the company, shortage of raw material faced by the company, etc.
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Unsystematic Risk
Total risk (s)
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Systematic Risk
No. of Investments
Measures of Risk
There are different statistical measures of risk. Lets study the basic but commonly used measures first.
Absolute Measures of Dispersion

Variance & Standard Deviation
The most common & popular measures are variance (σ2) and standard deviation (s). Variance shows the spread
in a distribution and the standard deviation the average deviation from its mean. Thus, the variance will show
the variability in the returns and the standard deviation the average deviation in income from the expected/
average income of the security. The higher the value of S.D., the higher the risk of fluctuation in income. This is
an absolute measure of dispersion and its unit of measurement is the same as that of the variable; in case
of return from securities the standard deviation will be in percentage.

(a) Steps to compute Variance and Standard Deviation from historical returns –
(1) Find the average return, i.e. mean (R) of the historical returns.
(2) Find ‘d’ which is the deviation of the actual return for each year from the mean, d = (R – R).
(3) Find the square of the deviation ‘d’, i.e. ‘d2’, for each year under consideration.
(4) Find ∑ d 2.
(5) Find Variance (s2) =

∑ d2
n
(6) Compute Standard deviation (s) =

∑ d2
n
(b) Computation of Variance when S.D. of market as well as error term of security is given
!! You have to know the concept of beta before studying this formula.
s2 = b i2s m2 + s e2i e = Greek alphabet epsilon
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Where
bi = beta of security i
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sm = standard deviation of the market
sei = the random error of security i
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!! Meaning of error term: A population may have a large number of observations which will make computations
tedious. A sample may be drawn from such a population for study. The sample mean and population mean
will almost always differ. The terms ‘residual’ & ‘random error’ or simply ‘error term’ are the deviations of
individual sample observations from such means.
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Residual = Individual sample observation – Sample mean
Random Error = Individual sample observation – Population mean
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(c) Steps to compute Variance and Standard Deviation from future expected returns –
(1) Find expected return E(Rx).
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(2) Find ‘d’ which is the deviation of each possible return from expected return, d = [R – E(Rx)].
(3) Find the square of the deviation ‘d’, i.e. ‘d2’, for each year possible return.
(4) Multiply each value of ‘d2’ with the corresponding probability ‘p’ to get ‘pd2’ for each possible return.
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(5) Find ∑ pd2.

(6) Variance (s2) = ∑ pd2 [Note that you do not divide by the number of observations]
(7) Standard deviation (s) = ∑ pd 2
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Relative Measure of Dispersion

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Co-efficient of Variation (C.V.)

While variance & standard deviation are in themselves good for evaluating the risk of a security, they may
not be useful while comparing the risk & return between two securities because of the different prices & the
average returns from the different securities. That’s when a relative measure of dispersion becomes useful. It is
a useful tool for comparing the risk between two securities as it standardizes the risk to a ratio for the purpose
of comparison. Co-efficient of Variation (C.V.) is a useful relative measure of dispersion for this purpose and it is
simply taking the calculation one step forward after having computed the standard deviation. It is computed as,
a proportion or percentage, as follows:
sj sj
C.V. = or × 100
|x| |x|
Where
sj = standard deviation of the security
|x| = absolute value of mean of the returns from the security
Lower C.V. indicates lower risk.
!! C.V. should be used as a measure when comparing investments even if not specified in the question.

Risk of a Security
Risk of a security can be analyzed by computing its variance and standard deviation. Lower S.D. means lower
risk. Risk of two or more securities can be compared by comparing their C.V. Lower C.V. indicates lower risk.
However, risk & return must be in proportion.
!! A portfolio can be considered as a single security for evaluation.
Risk of a Portfolio
The return from a portfolio is the weighted average return from the securities in the portfolio. However, the same
may not always be true about the risk of the portfolio. This is because the return from different securities in a
portfolio may not move in the same direction. The fluctuation in the return from one or more securities may be
compensated by the fluctuation in the return from some other securities in the portfolio. For this purpose we need
to understand the relationship that exists between the co-movement in the return from the different securities in
the portfolio. Statistical measures like co-variance and co-efficient of correlation are useful for this purpose.
Co-variance & Co-efficient of Correlation

(a) Computation of Co-variance
This helps to understand the co-movement of returns from a pair of securities. This refers to the variation
or fluctuation in the return of two securities taken as a pair. The fluctuation in the income of one security,
in the pair, may have (a) same effect, (b) opposite effect or (c) no effect on the income from the other
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security. We always compute this effect by taking the securities in pairs. If we have three securities, namely
A, B and C, in the portfolio then we can compute the co-variance for the following pairs: AB, AC and BC.

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The co-variance between a pair of securities could be positive, negative or zero. A positive co-variance
indicates that return from the pair of securities will move in the same direction, i.e. both will rise or fall
together. A negative co-variance indicates that return from the pair of securities will be in the opposite
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direction, i.e. increase in return of one will mean a decline in return from the other. A zero co-variance
indicates that there is no distinct relationship between the return from the two securities; in other words,
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they are independent.
For two securities X and Y, the covariance is computed as:
∑ (x − x )(y − y ) ∑ (x − x )(y − y )
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Covxy = or = OR Covxy = Corrxysxsy

n n −1
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OR
Where probabilities are given –
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Covxy = ∑ p ( x − x )(y − y )
Where,
x = return from security x
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x = mean return from security x

y = return from security y
y = mean return from security y
n = number of observations
p = probability of each pair of observations
(b) Computation of Co-efficient of Correlation
Correlation co-efficient is denoted by ‘r’ [Greek alphabet rho].
Corrxy (r) =
Cov xy
or
∑ (x − x )(y − y )
sx sy ∑ (x − x )2 ∑ ((y − y )2
Where,
sx = standard deviation of security x
sy = standard deviation of security y
x = return from security x
x = mean return from security x
y = return from security y

y = mean return from security y
The correlation co-efficient may have a value ranging from – 1 to 1. The values are interpreted as follows:
Correlation Coeff. (r) What it means
–1 Perfect negative correlation. The fluctuation in returns from the pair of
securities will be equal but in the opposite direction; i.e. if the return from one
security increases by 10% then the return from the other will decrease by 10%.
This is possible only in theory but rarely in reality.
1 Perfect positive correlation. The fluctuation in returns from the pair of
securities will be in the same direction; i.e. if the return from one security
increases by 10% then the return from the other will also increase by 10%.
This too is possible only in theory but rarely in reality.
0 No correlation. The returns from the two securities are independent and do not
have any effect on each other.
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0<r<1 Some degree of positive correlation. Returns move in the same direction but
not to the same extent.
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0 > r > –1 Some degree of negative correlation. Returns move in the opposite direction
but not to the same extent.
Standard Deviation of a Portfolio
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Having understood the interrelationship between the securities in a portfolio we can now proceed to evaluate
the risk of the portfolio. The standard deviation of a portfolio can be computed as follows:
(1) Standard deviation if securities are perfectly positively correlated
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In this case the correlation co-efficient is 1. The standard deviation of the portfolio is the weighted average
of the standard deviation of the securities in the portfolio.
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s p = W 1s 1 + W 2s 2 + W 3s 3 + . . . . . Wns n
Where,
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sp = standard deviation of the portfolio

Wn = weight of a security in the portfolio
sn = standard deviation of a security in the portfolio
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(2) Standard deviation if two securities are perfectly negatively correlated

This shortcut method applies only when there are two securities in the portfolio
s p = W 1s 1 – W 2s 2
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If there are more than two securities then formula under (3)(b), given below, is to be
used.
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(3) Standard deviation in other cases

(a) Standard deviation of a portfolio of two securities can be computed as follows:
sp = W12 s 12 + W22 s 22 + 2 W1W2 s 1s 2 Corr12

(b) Standard deviation of a portfolio of three securities can be computed as follows:
sp = W12 s 12 + W22 s 22 + W32 s 32 + 2 W1W2 s 1s 2 Corr12 + 2 W2W3 s 2s 3 Corr23 + 2 W1W3 s 1s 3 Corr13

Where,
s p = S.D. of portfolio
W 1, W 2 & W 3 = proportion of funds invested in the securities and used as weights
s 1, s 2 & s 3 = S.D. of the securities
Corr12, Corr23, Corr13 = Correlation co-efficient between returns of different pairs of securities
(4) S.D. of a portfolio of ‘n’ securities when beta and error term are given
When beta & error term of ‘n’ securities are given then the S.D. of the portfolio can be computed as the
square root of the sum of the variances of the individual securities in the portfolio as follows:

s= ∑ ( bi2s m2 + s e2i )
Where
sei = the error term of security i
Concept of Dominance
The concept of dominance refers to the fact that some stocks will dominate others due to higher return or lower
risk. A dominant stock is one in which investors choose over others. This can be summarized as follows:
(i) In a group of stocks with the same return, the stock with the lowest risk will dominate.
(ii) In a group of stocks with the same risk, the stock with the highest return will dominate.
Beta as a Measure of Risk

Beta is an index of non-diversifiable risk. It is a measure of a security’s volatility relative to that of the market. It
shows the sensitivity of the security to the capital market and hence is also known as ‘Market Sensitivity Index’
or simply ‘Risk Index’.
Beta of a Security
Beta of a security can be computed as follows:
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(a) Computation of beta using Correlation Coefficient
sj
Where,
Beta coefficient (b) = Corrjm ×
sm
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Corrjm = Correlation co-efficient of a security (j) with the market (m)
s j = standard deviation of the security
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s m = standard deviation of the stock market
(b) Computation of beta using Covariance
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Cov jm
Beta coefficient (b) =
s m2
rs
Where,
Covjm = Covariance of the security (j) with the market (m)
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s m2 = variance of the stock market

(c) Computation of beta using fluctuation in security returns
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Fluctuation in security return

Beta coefficient (b) =
Fluctuation in market return
Beta of a Portfolio
There are two ways to determine the beta of a portfolio –
(1) The beta of a portfolio can be computed by considering the portfolio as a single security. To compute the
beta, we need to know the S.D. of the portfolio, S.D. of the stock market and the correlation co-efficient
between the portfolio and the stock market. Using the formula compute beta of a security we can find the
beta of the portfolio.
(2) If we know (or can find out) the beta of each security in the portfolio then the portfolio beta is the average
or weighted average of the securities in the portfolio.
Analysis of Beta coefficient:
Beta coefficient (b) What it means
b<0 Possible in computation but not likely. If beta is negative it means the return from the
security move in the opposite direction to that of the market.

b=0 Security value will not fluctuate with stock market.
0<b<1 Low volatility investment if closer to 0 with increasing volatility if it is closer to 1.
b=1 Volatility of the security matches that of the stock market index, security will rise or
or fall to the same extent as the market.
b>1 Security is more volatile than stock market index, will fluctuate more than stock
market.
Beta of Levered and Unlevered Firm

The beta of a firm depends either upon its capital structure or its projects. However, the beta of its equity and
debt will be influenced by the capital structure. A firm may be equity financed or financed by debt and equity.
The beta of an all equity firm is equal to the beta of the equity. For a firm partly financed by debt, and in the
absence of information, we assume that the beta of debt is 0. However, debt may have a beta and research has
shown this to be between 0.10 to 0.30.
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Beta of firm with a single project
The beta of a firm is the weighted average beta of its equity and debt, i.e., by its capital structure. The beta
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of a levered firm can be computed as follows:
E D
bA = be × + bd ×
E +D E +D
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If tax is considered:
E D
bA = be × + bd ×
E + D (1 − t ) E + D (1 − t )
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Where,
bA = beta of levered firm
be = beta of the firm’s equity
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bd = beta of the firm’s debt
D = value of the firm’s debt
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E = value of the firm’s equity

t = tax rate in decimal
Beta of firm with multiple projects

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The beta of a firm with multiple projects is determined by its projects and not by its capital structure. The
beta of an individual project may be determined from the capital structure used to finance the project. A firm
having many projects will have a beta equal to the weighted average of the beta of all the projects.
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Risk-Return Trade-off
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There will be a trade-off for higher risk undertaken. The market risk-return trade-off can be computed as follows:
Rm − R f
Market risk-return trade-off (l) = [l = Greek alphabet lambda]
sm
In a perfect capital market all securities will have an expected return according to the risk attached to them. If
some securities are under- or over-valued then the demand/supply of such securities will ensure that the price of
the securities will adjust itself to provide the expected return.
If two securities have a different expected return then their risk premium must be in proportion to their betas.
For example, we have two securities A and B having expected return & beta as RA, RB and bA and bB respectively,
then the following must hold true –
RA − R f RB − R f
=
bA bB
Capital Asset Pricing Model (C.A.P.M.)

William F. Sharpe and John Linter developed the Capital Asset Pricing Model (C.A.P.M.). This model explains
how the expected rate of return determines the market value of financial assets based on the risk associated
with that financial asset. It assumes that individuals are averse to risk and will expect a premium for investing in

risky financial assets. The expected return increases with increase in risk. It is a useful tool in valuing investment
in shares of individual companies. This model suggests that as the systematic risk cannot be eliminated by
diversification, the expected return from a security must be the risk-free rate of return plus a risk premium
which is proportionate to its systematic risk.
This model is based on the following assumptions:
(1) Individuals are averse to risk
(2) All individuals have the same expectations about risk and return on securities
(3) Individuals can borrow and lend without limitations at risk-free rate of interest
(4) The stock market is perfect and competitive
(5) There are no transaction costs and taxes
(6) Securities are completely divisible
(7) Securities face no bankruptcy or insolvency
Under CAPM the expected return on a financial asset is computed as under:
Re = Rf + b(Rm – Rf)
Where,
Re = expected return or may be taken as Ke
R f = risk-free rate of return
R m = expected rate of return from investment in stock market
(Rm – Rf) = risk premium
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b = beta, measure of risk of the underlying financial asset
This is the most popular model to compute the theoretical expected return from a security.
Determining whether a security is under-valued or over-valued

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The basic way to determine whether a share is under- or over-valued is to find its theoretical value and compare
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that to its market value. Different share valuation models are available for this purpose: Gordon’s model, Walter’s
model, etc. The selection on the model depends on the data given in the question and sometimes the price can
be determined by more than one model in which case the answer would differ according to the model chosen.
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Also its market price should be given in the question. Comparing the theoretical price with the market price we
can determine whether the share is under- or over-valued.
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Where market price is not given in the question

To determine whether a security is under- or over-valued we need to know both the theoretical expected return
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Re and the current return. The decision is taken as follows:

Current return > C.A.P.M. return – Security is under-valued. Buy/hold the security.
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Current return = C.A.P.M. return – Security is correctly valued. Buy/hold/sell the security.
Current return < C.A.P.M. return – Security is over-valued. Sell the security.
Alpha of a Security
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If the actual return from a security is different from its expected return then the difference is called the ‘Alpha’
of the security and denoted by a.
Alpha (a) = Actual return – Expected return as per C.A.P.M.
Alpha may be positive or negative as actual return may be more or less than expected return.
In the long-run alpha value should be zero as the market value will adjust itself to provide the theoretical
return.
Decomposition of Total Risk

The total risk of a security can be decomposed into systematic & unsystematic risk. Systematic risk is often
referred to as explained risk and the unsystematic risk as the unexplained risk or the residual (remaining) risk.
Variance is a measure of risk. Co-efficient of Determination is a useful measure in statistics denoted by R2 or r2,
where ‘r’ is the Correlation Coefficient. In relation to variance, the Co-efficient of Determination is the ratio of
the explained variance (systematic risk) to total variance (total risk). The total risk can be decomposed as under:
Systematic or market risk can be computed as follows:
Systematic risk = r s i b i2s m2
2 2
or

Unsystematic risk can be computed as follows:
Unsystematic risk = (1 − r 2 )s i2
or
= Variance of security – Systematic risk
More models for computing expected return from a security

A couple of basic methods of computing expected return from a security were given earlier. Some more methods
are as follows:
(1) Arbitrage Pricing Theory Model (APT)

C.A.P.M. model determines the theoretical return from a security by comparing its risk & return with that
of the market. These risks are non-diversifiable risks related to macro economic factors like interest rates,
inflation, foreign currency exchange rates, balance of payments, etc. which are beyond the control of the
investor. However, not all investments are affected by each of these factors. The Arbitrage Pricing Theory
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model takes this fact into consideration and proposes that the expected return from a security should be
computed by taking into consideration the premium only for those factors which affect the security. For
this purpose we need to know the market premium for each of these factors and also the security beta for
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each of these factors. The expected return can then be computed as:
Ri = Rf + l1ib1 + l2ib2 + . . . lnibn [l = Greek alphabet lambda]
Where,
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Ri = expected return from security i
b1, b2, bn = security betas for different factors
l1i, l2i, lni = market premium for each factor for security i
G
However, this method is difficult to apply because there are many economic factors that may affect a
security and it is very difficult to decide which ones are to be selected. It is also very difficult to find the
security beta and the market premium for each factor.
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(2) Sharpe Index Model
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This model was developed by William Sharpe and is also know as Single Index Model. He observed that
stock prices moved with the stock market indices. However, the variation in the market index is only one
of the factors that causes a movement in the stock price. There are also other factors which affect the price
of the stock and such factors are unique to the stock. Thus, movement in the stock price is explained by
.S
movement in the market index as well as other factors. The mean or expected return from a security can be
R i = R f + a i + b iR m + e i [e = Greek alphabet epsilon]
A
Where,
Ri = expected return from the security i
C

ai = alpha co-efficient
ei = error term
(3) Market Model

This is the return from a security that has been observed in the market over the years. It is possible that the
return from a security has regularly been above or below its theoretical return, i.e. it has some alpha value.
The expected return may then be computed as follows:
Re = Rf + b(Rm – Rf) + a
This is an extension of the C.A.P.M. model.
Portfolio Management Strategies

Investments can be made in bonds which provide a fixed but steady income and have very low risk compared
to shares or in shares which are risk but can provide phenomenal returns but can also result in huge losses.
Normally, an investor will have investment in both so that the portfolio is balanced to provide steady income as
well as growth. The securities in the portfolio have to be selected to provide optimum return for a given level of
risk that the investor is ready to take.

!! A bond is considered risk-free when there is a guarantee of repayment of the interest as well as the principal.
Generally, while solving problems, bonds are considered to be risk-free. However, in reality, that is not true as there
is always some risk of default in repayment of the principal amount and is some cases there has also been default in
payment of interest. Even long-term Government securities are not considered risk-free. Only short-term government
securities, like T-bills, are considered risk-free.
There are three ways in which a portfolio can be managed — (1) Buy & Hold Policy, (2) Constant Mix/Ratio
Policy and (3) Constant Proportion Portfolio Insurance Policy.
(1) Buy & Hold Policy

Under this policy, the investor decides the proportion of bonds & shares; for example 60:40 or 50:50 or
70:30, etc. After investing the total amount in this proportion, no further action is taken and the policy is
to just hold the portfolio. The amount invested in the bonds remains more or less steady and the value of
the shares fluctuates with the stock market. The return from the portfolio depends on the performance of
the shares which may either enhance the return or even completely wipe out the return from the bonds.
The proportion of the mix will change with the change in the market value of the shares. This is a passive
strategy because once the investment is made in the desired proportion then no further action is taken and
hence it is also called “Do Nothing” policy.
(2) Constant Mix/Ratio Policy

This policy is similarly to the buy & hold policy but with one important difference. The objective of this
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policy is to maintain the ratio of the mix decided at the commencement. Thus, if the value of the shares
increases then their ratio in the total value of the portfolio will increase. In such a case, some shares are
sold and bonds are purchased to reset the ratio to its original level. For example, a portfolio of `10 lakhs
ss
is set-up with a mix of 50:50; i.e. investment of `5 lakhs in bonds & `5 lakhs in shares. If the value of
the shares increases to `7 lakhs then shares of `1 lakh will be sold and bonds of equal amount will be
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purchased so that the investment mix will be `6 lakhs in each. Similarly, if the value of shares decreases
then some bonds will be sold & shares will be purchased to maintain the mix. This policy results in sale
of shares when the price rises & purchase of shares when price falls. This is an active investment strategy
C
which requires periodic assessment of the performance of the portfolio.
(3) Constant Proportion Portfolio Insurance Policy

h
This strategy is based on maintaining a dynamic mix of risky assets (shares) and riskless assets (bonds).
As per this policy, shares are purchased as they fall and sold when they rise and therefore, it is exactly the
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opposite of the Constant Mix Policy. The objective of selling some shares as their price falls is to limit the
losses. As all shares are not sold, there is potential to earn profit if the shares rise. The amount retained as
investment in the shares is calculated on the basis of a constant multiplier. The amount to be retained in
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equity is computed as follows:

Investment in equity = Multiplier (Current portfolio – Floor value)
A
Where,
Multiplier = any integer > 1 [this is decided by the investor]
Floor value = minimum value set for the portfolio [this is set to be equal to expected fall in equity on the
first evaluation date]
Optimizing a portfolio
A portfolio consisting of two securities X and Y can be optimized by planning carefully the amount to be invested
in each. The amount invested in each will be the weight of the security in the portfolio.
Let weight of security X = Wx
Therefore, weight of security Y = 1 – Wx
(1) Computing weight using Co-variance –
s 2y − Cov xy
Wx =
s x2 + s 2y + 2Cov xy

(2) Computing weight using Correlation Co-efficient –
s 2y − Corrxys xs y
Wx =
s x2 + s 2y + 2Corrxys xs y
Short-cut method:
(i) Where the two securities have a positive correlation:
sy
Wx =
sx − sy
(ii) Where the two securities have a negative correlation:
sy
Wx =
sx + sy
Sharpe’s Optimal Portfolio
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Developed by William Sharpe, the Sharpe Ratio can be used to evaluate the performance of a security or
portfolio. It can also be used for optimizing the portfolio. It is computed as follows:
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Ri − R f
Sharpe ratio of security i =
bi
Where,
ok
Ri = return from security i
Rf = risk-free rate of interest
G
This measures the premium earned per unit of beta. The higher the ratio the better the performance of the
security or portfolio.
Steps for choosing the securities & deciding their weights to optimize a portfolio
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Step 1 Use the Sharpe ratio to find the excess return per unit of beta for all the securities available for
investment. This can be presented as a table as follows:
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Security Excess return Beta Sharpe Ratio Rank

R1 − R f
1 (R1 – Rf) b 1 xx
b1
.S
R2 − R f
2 (R2 – Rf) b 2 xx
b2
. . . . and so on.
Step 2 Rank the securities as per their excess return from highest to lowest and compute the Ci in the form of
A
the following table:

Col. 1 Col 2 Col. 3 Col 4 Col. 5 Col. 6
C

n ( R − R )b
2 i
sm ∑
f i
Securities bi b bi b i =1 s e2i
(Ri – Rf) 2 ∑ (Ri – Rf) 2i ∑ 2i Ci =
as per rank sei sei s e2i sei n
b2
1 + s m2 ∑ i2
i =1 s e i
Each col. value Each col. value Each col. value

is simply is simply is simply
⇓ ⇓ ⇓
[Cumulative [Cumulative  s × Col. 3 
2
m
 
total of Col. 2] total of Col. 4]  1 + (s m × Col. 5) 
2
Step 3 Determine the cut-off point for securities which is the highest value of Ci. This selected value is denoted
as C* which is the cut-off rate for selecting the investments. Only securities having a Sharpe ratio
more than C* are selected for the portfolio.
Step 4 Compute the weights (Xi) of selected securities as follows:

Zi
Xi = n
∑ Zi
i =1
Where,
bi
Zi = (Sharpe Ratio of the security – C*)
s e2i
Capital Market Line

Risk & return can be plotted on a graph to obtain the capital market line. The return is plotted on the y-axis and
the risk (standard deviation) on the x-axis. A line which passes through the risk-free rate & the return of efficient
portfolios (in terms of risk & return) will be the Capital Market Line. This line shows the various portfolios
which provide the equilibrium return to match the risk (standard deviation) of the portfolios.
The equation of the line is:
sp
E(RP) = Rf + (R – Rf)
sm m
Characteristic Line of a Security

The return from a security may be compared with the market return at different points in time. When these
returns are plotted on a graph, with security return on Y-axis and market return on X-axis, we get what is called
es
the characteristic line of the security. It helps to determine the expected return from the security with a change
in market return. The equation of the line is:
E(Rx) = a + bRm
or
ss
la
E(Rx) = a + bRm + ei [if the error term of security i is available]
Security Market Line

C
The expected return from a security depends upon it beta value and can be obtained by using the C.A.P.M.
model. The expected return from a security increases in direct proportion to the beta of the security. The security
h
market line is given by the equation:

E(Ri) = Rf + bi (Rm – Rf)
rs
Where,
E(Ri) = expected return from a security i
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Rm = market return
A
Plotting the returns on the y-axis and the beta values on the x-axis we can obtain a line which is called the
Security Market Line.
Return from
Return %
security
Rf
Beta

Markowitz Model (Efficient Frontier)
Harry Markowitz is considered to be the father of Modern Portfolio Theory. Every investor is aware that there
is a trade-off between risk and return. Once an investor has identified his acceptable level of risk, out of the
different investments available at the same level of risk he will always chooses the investment which provides
the highest return. Similarly, once an investor has identified his expected return, out of the different investments
available which provide his expected rate of return he will always choose the investment with the lowest risk.
According to Markowitz, an investor need not worry about the risk from individual investments. This is because,
by selecting a well diversified portfolio the risk can be reduced to a great extent. Several efficient portfolios can
be found for a given level of risk and return. Therefore, the investment decision for an investor can be divided
into 2 steps: (a) identifying an acceptable level of risk and return, and (b) selecting a portfolio out of different
portfolios which provide the investor’s expected return at his acceptable level of risk.
According to Markowitz, such efficient portfolios can be found on the basis of 3 factors, namely mean, standard
deviation and correlation. Mean refers to the average rate of return expected from the investment; the standard
deviation of each investment showing the fluctuation in the returns from the investment and correlation between
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the different investments which will help in diversification. If such portfolios are plotted on a graph with the
return on the Y-axis and the risk (S.D.) on the X-axis the line joining such portfolios is called the efficiency
frontier. Other portfolios with a return-risk combination above such line would be desirable from the investor’s
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point of view but such portfolios are not available. Portfolio combinations below the line would be available but
not desirable.
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Efficient frontier: arc joining B to D
Expected D
Portfolios above the arc
G
Return are desirable but not C
available
Portfolios below the arc

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Optimal point are available but not
B desirable
E(Ri) E
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.S
F
A
A
C
0 s(R1) s(R2) Risk (s)
In the above diagram A, B, C, D, E & F define the boundary of all possible investments out of which B, C and D
lie on the efficient frontier. The selection of a portfolio on the efficient frontier depends on the risk appetite of
the investor. Moving from point B to point D each portfolio will provide a higher return but at a higher level of
risk. Between portfolios B & A, B would be preferred because for the same level of risk, B gives a higher return.
Between portfolios B & E, B would be preferred because for the same return, B has a lower level of risk.
The Markowitz model is based on the following assumptions:
1) Investors estimate the risk of the portfolio on the basis of variability of expected returns.
2) The investors can visualize a probability distribution of a rates of return.
3) Investors base their decisions solely on expected return and risk.
4) For a given level of risk, investors prefer high returns to low returns. Similarly, for a given level of expected
returns investors preferred less risk to more risk.
Problems
Computation of Expected Return, Beta, Standard Deviation & Investment Weights
1.1 [C.S.] From the following data compute the beta of Security-J:
sj = 12% sm = 9% Corrjm = + 0.72
[0.96]
1.2 [C.A.] Given below is information of market rates or returns and data from two Companies A and B:
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
Determine the beta coefficients of the shares of Company A and Company B.
[A 1.04; B 0.5]
1.3 [C.S.] Security-A offers an expected rate of return of 14% with a standard deviation of 8%. Security-B
offers an expected rate of return of 11% with a standard deviation of 6%. If an investor wishes to construct a
portfolio with the 12.8% expected return, what percentage of the portfolio will consist of Security-A?
[0.6 or 60%]
1.4 [C.S.] Calculate the expected rate of return of the security & interpret the same from the following
information:
es
Beta of a security 0.5
Expected rate of return on market portfolio 15%
Risk-free rate of return 0.06
ss
If another security has an expected rate of return of 18%, what would be its beta?
[1.33]
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1.5 [C.S.] A Portfolio Manager has three stocks in his portfolio. Following information is available in respect of
his portfolio:
Company Investment (`) b
C
X Ltd. 6,00,000 1.3
Y Ltd. 3,00,000 1.4
Z Ltd. 1,00,000 0.9
h
Expected return on the market portfolio is 15% and the risk free rate of interest is 6%. On the basis of Capital
Asset Pricing Model (CAPM), compute the following:
rs
(i) Expected return of the portfolio; and

(ii) Expected b of the portfolio.
da
[(i) 17.61% (ii) 1.29]

1.6 [C.S. twice] From the following information, calculate the expected rate of return of a portfolio:
Risk-free rate of interest 8%
A
Expected return of market portfolio 18%

Standard deviation of an asset 2.8%
Market standard deviation 2.3%
Co-relation co-efficient of portfolio with market 0.8
[17.7%]
1.7 [C.S.] Following information is available in respect of the return from Reliance’s stock under different
economic conditions:
Economic Condition Return Probability
Good 20 0.2
Average 16 0.4
Bad 10 0.2
Poor 4 0.2
Find out the expected return of the stock and risk associated with it.
[Expected Return 13.2%; Risk associated with stock 5.60%.]
1.8 [C.S.] Following information is available in respect of return from Reliance’s stock under different economic
conditions:
Economic condition Return (%) Probability

Good 20 0.2
Average 16 0.4
Bad 10 0.2
Poor 4 0.2
Find out the expected return of the stock and the risk associated with it.
[Expected return 13.2%, Risk 5.6%]
1.9 [C.S.] The market portfolio has a historically based expected return of 0.10 and a standard deviation
of 0.04 during a period when risk-free assets yielded 0.03. The 0.07 risk premium is thought to be constant
through time. Riskless investments may now be purchased to yield 0.09. A security has a standard deviation of
0.08 and a co-efficient of correlation with the market portfolio is 0.85. The market portfolio is now expected to
have a standard deviation of 0.04.
You are required to find –
(i) market’s return-risk trade-off;
(ii) security beta; and
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(iii) equilibrium required expected return of the security.
[(i) 1.75 (ii) 1.7 (iii) 20.90%.]
1.10 [C.M.A.] The market portfolio has a historically based expected return of 0.095 and a standard deviation
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of 0.035 during a period when risk-free assets yielded 0.025. The 0.06 risk premium is thought to be constant
through time. Riskless investments may now be purchased to yield 0.08. A security has a standard deviation of
0.07 and a co-efficient of correlation with the market portfolio is 0.75. The market portfolio is now expected to
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have a standard deviation of 0.035.
You are required to find –
(i) market’s return-risk trade-off;
G
(ii) security beta; and
(iii) equilibrium required expected return of the security.
[(i) 2 (ii) 1.5 (iii) 17%]
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1.11 [C.A.] ABC Ltd. has been maintaining a growth rate of 10% in dividends. The company has paid dividend
@ `3 per share. The rate of return on market portfolio is 12% and the risk free rate of return in the market has
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been observed as 8%. The Beta co-efficient of company’s share is 1.5.

You are required to calculate the expected rate of return on company’s shares as per CAPM model and equilibrium
price per share by dividend growth model.
[CAPM 14%, `82.50]
.S
1.12 [C.A.] Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid dividend
@ `3 per share. The rate of return on market portfolio is 15% and the risk-free rate of return in the market has
been observed as 10%. The beta co-efficient of the company’s share is 1.2.
A
You are required to calculate the expected rate of return on the company’s shares as per CAPM model and the
equilibrium price per share by dividend growth model.
C
[16%, `84]
1.13 [C.A.] Mr. Tempest has the following portfolio of four shares:
Name Beta Investment ` Lac.
Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50
The risk free rate of return is 7% and the market rate of return is 14%.
Required: (i) Determine the portfolio return. (ii) Calculate the portfolio Beta.
[(i) 16.13% (ii) 1.3]
1.14 [C.S.] A Portfolio Manager has three stocks in his portfolio. Following information is available in respect
of his portfolio:
Company Investment (`) b
X Ltd. 6,00,000 1.3
Y Ltd. 3,00,000 1.4
Z Ltd. 1,00,000 0.9
Expected return on the market portfolio is 15% and the risk free rate of interest is 6%. On the basis of Capital

Asset Pricing Model (CAPM), compute the following:
(i) Expected return of the portfolio; and
(ii) Expected b of the portfolio.
[(i) 17.61% (ii) 1.29]
1.15 [C.A.] Mr. Ram is holding the following securities:
Particulars of Securities Cost Dividends Market Price Beta
Equity Shares:
Gold Ltd. 11,000 1,800 12,000 0.6
Silver Ltd. 16,000 1,000 11,200 0.8
Bronze Ltd. 12,000 800 18,000 0.6
G.O.I. Bonds 40,000 4,000 37,500 1.0
Calculate:
(i) Expected rate of return in each case, using the Capital Asset Pricing Model (CAPM).
(ii) Average rate of return, if risk free rate of return is 14%.
[(i) 16.84% (ii) 16.13%]
1.16 [C.A. twice] Your client is holding the following securities:
Particulars of Securities Cost Dividends Market Price Beta
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
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Bronze Ltd. 14,000 700 20,000 0.6
G.O.I. Bonds 36,000 3,600 34,500 1.0
Average return of the portfolio is 15.7%, calculate:
ss
(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
(ii) Risk free rate of return.
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[(i) 15.10%, 15.90%, 15.105, 16.70% (ii) 12.7%]
1.17 [C.S.] Your client is holding following securities as proxy of market portfolio:
C
Particulars of Purchase Dividends Expected Market BETA
securities Price (`) (`) Price after (b)
1 year (`)
Equity shares :
h
Company–A 8,000 800 8,200 0.80

Company–B 10,000 800 10,500 0.70
rs
Company–C 16,000 800 22,000 0.50

PSU bonds 34,000 3,400 32,300 1.00
da
Assume a risk free rate of 15%.

Calculate expected rate of return in each, using capital asset pricing model if shares are held for 1 year.
1.18 [C.S.] The following data is related to Raman Ltd. –
A
Raman Ltd. Nifty Nifty Return on

Average Dividend Average Dividend Government
Year share price per share Index Yield Stock
` `
3 278 14 2,600 4% 8%
2 294 17 2,990 6% 10%
1 326 18 3,040 6.5% 9%
Current 370 20 3,280 6.5% 9%
Calculate –
(i) Expected return on shares of Raman Ltd.; and
(ii) Beta value using Capital Asset Pricing Model (CAPM).
[(i) 17.47% (ii) 1.92]
1.19 [C.A.] A stock costing `120 pays no dividends. The possible prices that the stock might sell for at the end
of the year with the respective probabilities are:
Price (`) Probability
115 0.1
120 0.1

125 0.2
130 0.3
135 0.2
140 0.1
Required:
(i) Calculate the expected return.
(ii) Calculate the Standard deviation of returns.
[(i) 7.08% (ii) 5.91%]
1.20 [C.A.] A has portfolio having following features:
Security b Random Error sei Weight
L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20
You are required to find out the risk of the portfolio if the standard deviation of the market index (sm) is 18%.
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[bP = 1.295; sP = 25.03% or 23.69%]
1.21 [C.A. twice] P Ltd. invested on 1.4.2006 in Equity shares as below:
ha
Company Number of Shares Cost (`)
M Ltd. 1,000 (`100 each) 2,00,000
N Ltd. 500 (`10 each) 1,50,000
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In September, 2006, M Ltd. paid 10% dividend and in October, 2006, N Ltd. paid 30% dividend. On 31.3.2007,
market price of shares of M Ltd. and N Ltd. were `220 and `290 respectively.
P Ltd. have been informed by their investment advisers that:
(i) Dividends from M Ltd. and N Ltd. for the year ending 31.3.2008 are likely to be 20% and 35% respectively.
G
(ii) Probabilities of market quotations on 31.3.2008 are:
Probability Price of share Price of share
Factor of M Ltd. of N Ltd.
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0.2 220 290
0.5 250 310
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0.3 280 330

(i) Calculate the average return from the portfolio for the year ended 31.3.2007.
.S
(ii) Calculate the expected average return from the portfolio for the year 2007-08.
(iii) Advise P Ltd. of the comparative risk of two investments by calculating the standard deviation in each case.
[(i) 7.55% (ii) 17.51% (iii) S.D. - M Ltd. 21%, N Ltd. 14%]
1.22 [C.S., RTP] A portfolio consists of three securities P, Q and R with the following parameters:
A
Security Correlation
P Q R coefficient
C
Expected return (%) 25 22 20

Standard deviation (%) 30 26 24
Correlation coefficient:
PQ – 0.5
QR + 0.4
PR + 0.6
If the securities are equally weighted, how much is the risk and return of the portfolio of these securities.
[Expected return 22.33%, Risk 17.43%]
1.23 [C.A.] Mr. A is interested to invest `1,00,000 in the securities market. He selected two securities B and D
for this purpose. The risk return profile of these securities are as follows:
Security Risk (s) Expected Return (ER)
B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio risk and portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100% investment in B only;

(ii) 50% of the fund invested in B and D both;
(iii) 75% of the fund in B and the rest 25% in D;
(iv) 25% of the fund in B and the rest 75% in D; and
(v) 100% investment in D only.
[(i) ER 12%, SD 10% (ii) ER 16%, SD 10.9% (iii) ER 14%, SD 9.4% (iv) ER 18%, SD 14.15% (v) ER 20%, SD 18%. Portfolio (v) is the best.]
1.24 [C.A.] A Ltd. has an expected return of 22% and standard deviation of 40%. B Ltd. has an expected return
of 24% and standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. a beta of 1.24. The correlation co-
efficient between the return of A Ltd. and B Ltd. is 0.72. The standard deviation of the market return is 20%.
Suggest:
(i) Is investing in B Ltd. better than investing in A Ltd.?
(ii) If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of return and portfolio standard
deviation?
(iii) What is the market portfolio expected rate of return and how much is the risk-free rate?
(iv) What is the beta of portfolio if A Ltd.’s weight is 70% and B Ltd.’s weight is 30%?
[(i) A: Return 22% with S.D. of 40%; Return 24% with S.D. of 38% (ii) E(R) 22.6%, S.D. 37.06% (iii) Rf = 17.5%, Rm = 22.76%, bP = 0.974]
1.25 [C.A.] The risk free rate of return Rf is 9%. The expected rate of return on the market portfolio Rm is 13%.
The expected rate of growth for the dividend of Platinum Ltd. is 7%. The last dividend paid on the equity stock
of firm A was `2.00. The beta of Platinum Ltd. equity stock is 1.2.
(i) What is the equilibrium price of the equity stock of Platinum Ltd.?
(ii) How would the equilibrium price change when
es
• The inflation premium increases by 2%?
• The expected growth rate increases by 3%?
• The beta of Platinum Ltd. equity rises to 1.3?
[(i) `31.47 (ii) `53.06]
ss
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Dominance
2.1 [C.A.] Following is the data regarding six securities:
C
U V W X Y Z
Return (%) 10 10 15 5 11 10
Risk (s) 5 6 13 5 6 7
h
(i) Assuming three securities will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 80% in U and 20% in W or to invest
rs
100% in Y.
[(i) U, W & Y (ii) 100% in Y is better.]
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2.2 [C.A. twice] The following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (s) 4 5 12 4 5 6
A
(i) Assuming three securities will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A and 25% in C or to invest
100% in E.
[(i) A, C & E (ii) A & C give return 9% with S.D. 6%, E gives return 9% with S.D. 5%]
2.3 [C.A.] A company has a choice of investments between several different equity oriented mutual funds. The
company has an amount of `1 crore to invest. The details of the mutual funds are as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6
Required:
(i) If the company invests 20% of its investment in the first two mutual funds and an equal amount in the
mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in equal amount in
the other two mutual funds, what is the beta of the portfolio?

(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the portfolios expected
return in both the situations given above?
[(i) 1.22 (ii) 1.335 (iii) 14.64%, 16.02%]
Determining whether securities are over- or under-valued

3.1 [C.A.] The beta coefficient of Target Ltd. is 1.4. The company has been maintaining 8% rate of growth
in dividends and earnings. The last dividend paid was `4 per share. Return on Government securities is 10%.
Return on market portfolio is 15%. The current market price of one share of XYZ Ltd. is `36.
(i) What will be the equilibrium price per share of XYZ Ltd.?
(ii) Would you advise purchasing the share?
[(i) `48 (ii) Yes]
3.2 [C.S.] The following information is available in respect of Security-X and Security-Y:
Security b Expected Rate of Return
X 1.8 22.00%
Y 1.6 20.40%
le
Rate of return of market portfolio is 15.3%. If risk-free rate of return is 7%, are these securities correctly priced?
What would be the risk-free rate of return, if they are correctly priced?
ha
[(i) Security X is not correctly priced. (ii) Security Y is not correctly priced. (iii) 7.6%.]
3.3 [C.M.A.] Tara Ltd. comprises only four major investment projects, details of which are as follows:
Project % of market Annual % return Risk % of Correlation with
ok
value during the last 5 years standard deviation the market
Alpha 28 10 15 0.55
Beta 17 18 20 0.75
Gamma 31 15 14 0.84
G
Delta 24 13 18 0.62
The risk-free rate is expected to be 5% per year, the market return is 14% per year and the standard deviation of
market return is 13%.
il
Assume that Tara Ltd.’s shares are currently priced based upon the assumption that the last five years experience
of returns will continue for the foreseeable future.
un
Evaluate whether or not the share price of Tara Ltd. is undervalued/overvalued.

[Required return 12.74%, Actual return13.63%, shares are undervalued.]
3.4 [C.A.] An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution for the
.S
possible economic scenarios and the conditional returns for two stocks and the market index as shown below:
Economic scenario Probability Conditional Returns %
A B Market
Growth 0.40 25 20 18
A
Stagnation 0.30 10 15 13
Recession 0.30 – 5 – 8 –3
C
The risk free rate during the next year is expected to be around 11%. Determine whether the investor should
liquidate his holdings in stocks A and B or on the contrary make fresh investments in them. CAPM assumptions
are holding true.
[Investor should make fresh investment in them.]
3.5 [C.A., C.M.A.] An investor is holding 1,000 shares of Rishabh company. Presently, the rate of dividend
paid by the company is `2 per share and the share is being sold at `25 per share in the market. However, several
factors are likely to change during the course of the year as indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta (b) value 1.4 1.25
Expected growth rate 5% 9%
In view of above factors, whether investor should buy, hold or sell the shares and why?
[Current theoretical return & share value: 20.4%, `13.64. Revised theoretical return & share value: 15%, `36.33.]
3.6 [C.A.] An investor is holding 5,000 shares of X Ltd. Current year dividend rate is `3/share. Market price of
the share is `40 each. The investor is concerned about several factors which are likely to change during the next
financial year as indicated below:

Current Year Next Year
Dividend paid/anticipated per share (`) 3 2.5
Risk free rate 12% 10%
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%
In view of the above, advise whether the investor should buy, hold or sell the shares.
[Current equilibrium price `34.42. Revise price `31.10.]
Computation of Covariance & Correlation Co-efficient

4.1 [C.A.] The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:
Return %
Probability F P
0.30 30 – 10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’, the covariance
between the market portfolio and security and beta for the security.
[Expected return: F 17%, P 14%; CovFP – 168, Beta – 0.636]
4.2 [C.A.] The historical rates of return of two securities over the past ten years are given.
es
Calculate the Covariance and the Correlation coefficient of the two securities:
Years: 1 2 3 4 5 6 7 8 9 10
Security 1: (Return %) 12 8 7 14 16 15 18 20 16 22
Security 2: (Return %) 20 22 24 18 15 20 24 25 22 20
[Cov12 = – 0.8, Corr12 = – 0.0605]
ss
la
4.3 [C.A.] A study by a Mutual fund has revealed the following data in respect of three securities:
Security s (%) Correlation with
Index, Pm
C
A 20 0.60
B 18 0.95
C 12 0.75
h
The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.

(i) What is the sensitivity of returns of each stock with respect to the market?
rs
(ii) What are the covariances among the various stocks?

(iii) What would be the risk of portfolio consisting of all the three stocks equally?
da
(iv) What is the beta of the portfolio consisting of equal investment in each stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in (iv)?
[(i) A 0.80, B 1.14 & C 0.60 (ii) A & B 205.2, A & C 108, B & C 153.90 (iii) 200.244 (iv) 0.8467 (v) Total risk 200.244, Systematic risk 161.29,
Unsystematic risk 38.954]
A
4.4 [C.A. twice] Consider the following information on stocks, A and B:

Year Return on A (%) Return on B (%)
2006 10 12
2007 16 18
(i) The expected return on the portfolio containing A and B in the proportion of 40% and 60% respectively,
(ii) The standard deviation of return from each of the two stocks,
(iii) The covariance of returns from the two stocks,
(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
[(i) E(A) 13%, E(B) 15%, E(P) 14.2% (ii) A 3%, B 3% (iii) CovAB 9% (iv) Corr 1 (v) 3%]
4.5 [C.M.A.] Answer the following:
(i) If beta (b) is 1.50, Rf (risk-free return) is 6% and Rm (market return) is 12%, what should be the return on
the share (Rj) with the beta as given above?
(ii) If the alpha value is + 1.5, 1, 0 (zero) or – 2.4, what would be the corresponding current expected return
from the stock in (i)?

(iii) What investment action would you suggest for each of the four different situations in (ii)?
[(i) 15% (ii) (a) 16.5%, (b) 16%, (c) 15%, (d) 12.6% (iii) (a) & (b) - hold; (c) either hold or sell; (d) sell]
4.6 [C.A.] Following are the details of a portfolio consisting of three shares:
Share Portfolio weight Beta Expected return in % Total variance
A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100
Standard Deviation of Market Portfolio Returns = 10%
You are given the following additional data:
Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
le
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
ha
(iv) Portfolio variance (on the basis of modem portfolio theory given by Markowitz)
Portfolio Optimization
ok
5.1 [C.A., C.S.] A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. of Market price b
shares per share (`)
VSL 10,000 50
G 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2
il
Compute the following:
(i) Portfolio beta.
un
(ii) If the PM seeks to reduce the beta to 0.8, how much risk-free investment should he bring in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk-free investment should he bring in?
[(i) 1.108 (ii) `4,62,050 (iii) `11,08,030]
.S
5.2 [C.A.] XYZ Ltd. has substantial cash flow and until the surplus funds are utilized to meet the future capital
expenditure, likely to happen after several months, are invested in a portfolio of short-term equity investments,
details for which are given below:
Investment No. of shares Beta Market price Expected dividend
A
per share (`) yield

I 60,000 1.16 4.29 19.50%
C
II 80,000 2.28 2.92 24.00%

III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.
[(i) Beta 1.46 (ii) Yes]
5.3 [C.S.] Ritesh holds a well diversified portfolio of stock in XYZ Group. During the last 5 years, returns on
these stock have averaged 20% per year and had a standard deviation of 15%. He is satisfied with the yearly
profitability of his portfolio and likes to reduce its risk without affecting overall returns. He approaches you for
help in finding an appropriate diversification medium. After a lengthy review of alternatives, you conclude – (i)
future average returns and volatility of returns on his current portfolio will be the same as he has historically
expected; and (ii) to provide a quarter degree of diversification in his portfolio, investment could be made in
stocks of the following groups:
Groups Expected Co-relation of Returns Standard
Returns with XYZ Group Deviation

Rekha Ltd. 20% +1.0 15%
Tina Ltd. 20% –1.0 15%
Bipasha Ltd. 20% +0.0 15%
(i) If Ritesh invests 50% of his funds in Rekha Ltd. and leaves the remainder in XYZ Group, would this affect
both his expected returns and his risk? Why?
(ii) If Ritesh invests 50% of his funds in Tina Ltd. and leaves the remainder in XYZ Group, how would this
affect both his expected return and his risk? Why?
(iii) What should Ritesh do? Indicate precise portfolio weightage.
5.4 [C.S.] Consider the following:
Probability of state Rate of return under the
State of economy of economy different states of economy
Share A Share B
Recession 0.2 – 20 10
Normal 0.5 30 20
Boom 0.3 40 30
(i) On the basis of the above information, calculate the expected returns on Share A and Share B.
(ii) You have `10,000 to invest and want to earn 22.5% on you portfolio. Using the expected returns calculated
above, decide how much should you invest in Share A and Share B.
[(i) 23%, 21% (ii) Investment: Share A `7,500, Share B `2,500]
5.5 [C.A.] An investor has two portfolios known to be on minimum variance set for a population of three
es
securities A, B and C having below mentioned weights:
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30
It is supposed that there are no restrictions on short sales.
ss
la
(i) What would be the weight for each stock for a portfolio constructed by investing `5,000 in portfolio X and
`3,000 in portfolio Y?
C
(ii) Suppose the investor invests `4,000 out of `8,000 in security A. How he will allocate the balance between
security B and C to ensure that his portfolio is on minimum variance set?
[(i) A 0.26, B 0.44 & C 0.30 (ii) B `1,600 & C `2,400]
h
5.6 [C.A.] Mr. FedUp wants to invest an amount of `520 lakhs and had approached his Portfolio Manager. The
Portfolio Manager had advised Mr. FedUp to invest in the following manner:
rs
Security Moderate Better Good Very Good Best

Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50
da
You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing Methodology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY is yielding 10%.
(ii) Advisability of replacing Security ‘Better’ with NIFTY.
A
[(i) 10.21% (ii) No effect on portfolio.]

5.7 [C.A.] An investor has decided to invest to invest `1,00,000 in the shares of two companies, namely, ABC
and XYZ. The projections of returns from the shares of the two companies along with their probabilities are as
follows:
Probability ABC(%) XYZ(%)
.20 12 16
.25 14 10
.25 – 7 28
.30 28 –2
(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these shares in equal proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk portfolio.
[(i) ABC: ER 12.55%, SD 12.95%; XYZ: ER 12.1%, SD 11.27% (ii) ER 12.325%, SD 1.25% (iii) ABC 46%, XYZ 54%]
Arbitrage Pricing Theory (APT)

6.1 [C.A.] Mr. X owns a portfolio with the following characteristics:

Security A Security B Risk Free security
Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%
It is assumed that security returns are generated by a two factor model.
(i) If Mr. X has `1,00,000 to invest and sells short `50,000 of security B and purchases `1,50,000 of security A
what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows `1,00,000 at the risk free rate and invests the amount he borrows along with the original
amount of `1,00,000 in security A and B in the same proportion as described in part (i), what is the
sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?
[(i) 0.45, 0.30 (ii) 0.90, 0.60 (iii) 5%]
6.2 [C.A.] Mr. Tamarind intends to invest in equity shares of a company the value of which depends upon
various parameters as mentioned below:
Factor Beta Expected value in % Actual value in %
le
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
ha
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50
ok
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage Pricing Theory?
[17.41%]
Security Market Line & Characteristic Line of a Security

G
7.1 [C.A.] Expected returns on two stocks for particular market returns are given in the following table:
Market Return Aggressive Defensive
7% 4% 9%
25% 40% 18%
il
un
(a) The Betas of the two stocks.

(b) Expected return of each stock, if the market return is equally likely to be 7% or 25%.
(c) The Security Market Line (SML), if the risk-free rate is 7.5% & market return is equally likely to be 7% or 25%.
(d) The Alphas of the two stocks.
.S
[(a) Aggressive 2, Defensive 0.5 (b) Aggressive 22%, Defensive 13.5% (c) 7.5% + bi8.5% (d) Aggressive – 2.5%, Defensive 1.75%]
7.2 [C.A.] The returns on stock A and market portfolio for a period of 6 years are as follows:
Year Return on A (%) Return on market portfolio (%)
A
1 12 8
2 15 12
3 11 11
C
4 2 –4
5 10 9.5
6 – 12 –2
(i) Characteristic line for stock A
(ii) The systematic and unsystematic risk of stock A.
[(i) – 0.58 + 1.202 (Rm) (ii) Systematic risk 69.59% & unsystematic risk 29.88%]
7.3 [C.A., C.S.] The rate of return on the security of Company X and market portfolio for 10 periods are given
below:
Period Return on security X (%) Return on market portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 – 5 8
7 17 –6

8 19 5
9 – 7 6
10 20 11
(i) What is the beta of security X? (ii) What is the characteristic line for security X?
[(i) 0.506 (ii) X = 8.9328 + 0.506Rm]
Sharpe’s Optimal Portfolio

8.1 [C.A.] Ramesh wants to invest in stock market. He has got the following information about individual securities:
Security Expected Return Beta s2ei
A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30
Market index variance is 10% and the risk free rate of return is 7%. What should be the optimum portfolio
assuming no short sales?
[Invest 50.41% in A & 49.59% in F]
Portfolio Management Strategy

9.1 [C.A.] Indira has a fund of `3 lacs which she wants to invest in share market with rebalancing target after
es
every 10 days to start with for a period of one month from now. The present NIFTY is 5326. The minimum
NIFTY within a month can at most be 4793.4. She wants to know as to how she should rebalance her portfolio
ss
under the following situations, according to the theory of Constant Proportion Portfolio Insurance Policy, using
“2” as the multiplier:
(1) Immediately to start with.
la
(2) 10 days later-being the 1st day of rebalancing if NIFTY falls to 5122.96.
(3) 10 days further from the above date if the NIFTY touches 5539.04.
C
For the sake of simplicity, assume that the value of her equity component will change in tandem with that of the
NIFTY and the risk free securities in which she is going to invest will have no Beta.
[(1) Invest `60,000 in equity & balance in risk-free securities (2) Equity `55,426, Risk-free securities `2,42,287 (3) Equity `64,430, Risk-free
h
securities `2,37,785]
Project Beta
rs
10.1 [C.A.] The total market value of the equity shares of O.R.E. Company is `60,00,000 and the total value of
the debt is `40,00,000. The treasurer estimates that the beta of the stock is currently 1.5 and the expected risk
da
premium on the market is 10%. The Treasury bill rate is 8%.

Required: (a) What is the beta of the company’s existing portfolio of assets? (b) Estimate the company’s cost of
capital & the discount rate for an expansion of the company’s present business.
A
[(a) 0.9, (b) 17%]

10.2 [C.A. twice] A project had an equity beta of 1.2 and was going to be financed by a combination of 30%
debt and 70% equity. Assuming debt beta to be zero, calculate the project beta taking risk free rate of return to
be 10% and return on market portfolio at 18%. Also calculate the expected rate of return from this project.
[0.84, 16.72%]

P-1 [C.S.] The following information is given:
Risk-free rate of return 8%
Expected rate of return on market portfolio 16%
b of a security 0.7
(i) Find out the expected rate of return of the security.
(ii) If another security has an expected return of 20%, what must be its beta?
Soln. (i) Computation of expected rate of return
E(R) = Rf + b(Rm – Rf)
= 8 + 0.7 (16 – 8) = 8 + 5.6 = 13.6%
(ii) Computation of beta when expected return is 20%

20 = 8 + b(16 – 8)
20 – 8 = 8 b
12 = 8b
12
b= = 1.5
8
P-2 [C.S.] Stocks A and B have the following historical returns:
Year Stock A’s Stock B’s
Return (RA) Return (RB)
% %
1995 – 12.24 – 5.00
1996 23.67 19.55
1997 35.45 44.09
1998 5.82 1.20
1999 28.30 21.16
le
You are required to calculate the average rate of return for each stock during the period 1995 through 1999.
Assume that someone held a portfolio consisting of 50% of Stock A and 50% of Stock B. What would have been
ha
the realized rate of return on the portfolio in each year from 1995 through 1999? What would have been the
average return on the portfolio during the period? (You may assume that the year ended on 31st March).
Soln. Computation of average rate of return for each stock
ok
− 12.24 + 23.67 + 35.45 + 5.82 + 28.30
Stock A = = 16.2%
5
− 5 + 19.55 + 44.09 + 1.20 + 21.16
Stock B = = 16.2%
G
5
Computation of realized rate of return in each year
As the investments have equal weights, the average return from the portfolio is simply the average of the returns
from the two stocks.
il
− 12.24 − 5
1995 = = – 8.62%
un
2
23.67 + 19.55
1996 = = 21.62%
2
35.45 + 44.09
.S
1997 = = 39.78%
2
5.82 + 1.2
1998 = = 3.51%
2
A
28.30 + 21.16
1999 = = 24.73%
2
C
Computation of average return on the portfolio

16.2 + 16.2
Average return during the period = = 16.2%
2
P-3 [C.A. twice] As an investment manager you are given the following information:
Particulars Initial Dividend/ Market Beta
of securities Price Interest Price
` ` `
A. Cement Ltd. 25 2 50 0.80
Steel Ltd. 35 2 60 0.70
Liquor Ltd. 45 2 135 0.50
B. GOI Bonds 1,000 140 1,005 0.99
The risk free return may be taken at 14%.
(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
(ii) Average return of the portfolio.
Soln. [The problem cannot be solved without the market return. Market return may be assumed or found in the
manner given below.]

Computation of market return
Security Cost Market Price Capital gain Dividend/Interest Total return
Cement Ltd. 25 50 25 2 27
Steel Ltd. 35 60 25 2 27
Liquor Ltd. 45 135 90 2 92
G.O.I. bonds 1,000 1,005 5 140 145
Total 1,105 291
291
Rm = × 100 = 26.33%
1,105
(i) Computation of expected rate of return for each security
E(R) = Rf + b (Rm – Rf)
Cement Ltd. = 14 + 0.8 (26.33 – 14) = 14 + 9.86 = 23.86%
Steel Ltd. = 14 + 0.7 (26.33 – 14) = 14 + 8.63 = 22.63%
Liquor Ltd. = 14 + 0.5 (26.33 – 14) = 14 + 6.17 = 20.17%
G.O.I. bonds = 14 + 0.99 (26.33 – 14) = 14 + 12.21 = 26.21%
(ii) Average return of the portfolio
23.86 + 22.63 + 20.17 + 26.21
Average return = = 23.22%
4
P-4 [C.M.A.] As an investment manager you are given the following information:
Security Today’s price Expected price a Expected dividend
es
` year from today (`) `
A 490 580 7.0
ss
B 180 200 7.0
C 570 640 5.0
D 220 235 –
la
The most recent beta estimates are:
Security Beta
C
A 1.4
B 1.2
C 1.0
D 0.5
h
Expected return in the market is 14% and the risk-free rate of return is 8%.
rs
Calculate for each security: (i) the estimated return based on the CAPM model, and (ii) predicted return.
Also state, giving reasons, whether the securities are undervalued or overvalued.
Soln. (i) Computation of expected return
da
Re = Rf + b(Rm – Rf)
A = 8 + 1.4 (14 – 8) = 8 + 8.4 = 16.4%
B = 8 + 1.2 (14 – 8) = 8 + 7.2 = 15.2%
A
C = 8 + 1 (14 – 8) = 8 + 6 = 14%
D = 8 + 0.5 (14 – 8) = 8 + 3 = 11%
(ii) Computation of predicted return
Security Cost Market Price Capital gain Dividend Total return Return in %
A 490 580 90 7 97 19.8%
B 180 200 20 7 27 15.0%
C 570 640 70 5 75 13.2%
D 220 235 15 – 15 6.8%
Evaluation of securities
Security Expected Predicted Valuation Reason
return return
A 16.4% 19.8% Undervalued Predicted return is more than expected
B 15.2% 15.0% Overvalued Predicted return is less than expected
C 14.0% 13.2% Overvalued Predicted return is less than expected
D 11.0% 6.8% Overvalued Predicted return is less than expected
P-5 [C.S.] An investor is seeking the price to pay for a security, whose standard deviation is 4%. The correlation

coefficient for the security with the market is 0.9 and the market standard deviation is 3.2%. The return from
government securities is 6.2% and from the market portfolio is 10.8%.
The investor knows that, by calculating the required return, he can then determine the price to pay for the
security. What is the required return on the security?
Soln. Computation of Beta co-efficient
si
Beta co-efficient = × Correlation co-efficient
sm
4
= × 0.9 = 1.125
3.2
Computation of required return on the security
= 6.2 + 1.125 (10.8 – 6.2) = 6.2 + 5.175 = 11.375%
P-6 [C.S.] Mohan has a portfolio of 6 securities, each with a market value of `10,000. The current beta (b) of
the portfolio is 1.30 & b of the riskiest security is 1.80. Mohan wishes to reduce his portfolio b to 1.15 by selling
le
the riskiest security and replacing it by another security with a lower b. What must be the b of the replacement
security?
ha
Soln. All securities have equal weight, therefore
Total of betas = 1.3 × 6 = 7.8
Let the beta of the new security be ‘x’.
ok
Total of betas after replacement = 7.8 – 1.8 + x = 6+x
6+x
Average beta after replacement =
6
G
6+x
= 1.15
6
6 + x = 6.9
x = 6.9 – 6 = 0.9
il
The beta of the replacement security should be 0.9.

un
.S
A
C

Chapter
9
Financial Services in India
Investment Banking
Investment banking is the business of raising capital for corporates. An investment bank acts as an intermediary
for raising capital for companies. It also provides other related services. Some of the globally known investment
bankers are Goldman Sachs, Morgan Stanley, J.P. Morgan, etc.
They perform the following functions:
(1) Corporate Finance: The basic function of an investment banker is to handle mergers & acquisitions for
corporate clients. This involves not only the structuring the deal but also negotiating & arranging the
finance by sell the securities, stock or bonds, of a corporate client.
(2) Broking & money management: An investment bank provides broking services to individual clients,
institutional investors like financial institutions, mutual funds, pension funds, etc. It also provides money
management services to very wealthy individuals.
(3) Trading: It also acts as a dealer or market maker. Dealers or market makers create a market for securities
by buying or selling them and provide all important liquidity to the market.
(4) Research: They have a team of research analysts who conduct ongoing research on stocks to give investment
es
advice to their clients on regular basis.
(5) Syndication: This involves forming a temporary group with other investment banks to jointly handle a
large transaction which a single investment bank cannot handle individually due to its large size & risk
involved.
Credit Rating ss
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Credit rating is the evaluation of the credit worthiness of an individual or a business concerns. Credit rating is
a published ranking, based on detailed financial analysis by a credit bureau of an entity’s financial history, and it
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specifically relates to the entity’s ability to meet debt. Credit rating is expressed in alphanumeric symbols for
ease of depiction and comparison. It is an assessment of the credit worthiness of individuals and corporations. It
shows borrower’s history of ability & willingness of borrowing & repayment, as well as the availability of assets
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and extent of liabilities.

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Benefits of credit rating

1. Importance of credit rating for issuers: Investors place great faith on credit ratings and therefore issuers too
have to depend on their critical analysis, even if the rating may not always be favorable to them. Issuers
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with highly rated instruments can access the market even in adverse market conditions. The reputation of a
company depends on the its rating.
2. Importance of credit rating for investors: The main purpose of credit rating is to communicate to the
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investors the relative ranking of the rated entities in terms of the probability of default. In the absence
of such ratings the investor will have to depend on his own perception of risk and return, which may not
always be accurate. Credit rating by skilled and competent professional minimizes the investor’s efforts of
analyzing the investment options by providing him well researched and properly analyzed opinions. A large
number of investors use these credit ratings to modify their portfolios by operating in the secondary market.
Credit rating agencies
Credit Rating Information Services of India Ltd. (CISIL), Investment Information and Credit Rating Agency
(ICRA), Credit Analysis and Research Ltd. (CARE) and Fitch Ratings India (P) Ltd. are some of the popular credit
rating agencies in India.
Sample of Rating Scores
Debentures CRISIL ICRA CARE FITCH
Highest safety AAA LAAA CARE AAA(L) AAA(Ind)
High safety AA LAA CARE AA(L) AA(Ind)
Adequate safety A LA CARE A(L) A(Ind)
Moderate safety BBB LBBB CARE BBB(L) BBB(Ind)
Inadequate safety BB LBB CARE BB(L) BB(Ind)
High risk B LB CARE B(L) B(Ind)
Substantial risk C LC CARE C(L) C(Ind)
Default D LD CARE D(L) D (Ind)
Fixed Deposits
Highest safety FAAA MAAA CARE AAA TAAA
High safety FAA MAA CARE AA TAA
Adequate safety FA MA CARE A TA
CAMEL Model in Credit Rating
CAMEL is the acronym for Capital, Assets, Management, Earnings and Liquidity. This model focuses the credit
rating by evaluating these aspects.
(a) Capital: This involves evaluation of the composition of the capital showing the ratio of internal and external
funds raised for financing the business. Evaluating the capital gearing; in other words the composition of
capital carrying fixed rate of interest or dividend compared to the other sources on which no fixed rate is
payable. The ability of the issue to raise further funds.
(b) Assets: This involves evaluation of the revenue generating capacity of not only the existing assets but also
the assets proposed to be acquired. Evaluating the fair value of the existing assets, their technological
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obsolescence, method used for depreciation & its adequacy, size & age of receivable compared to turnover,
size & level of inventories compared to turnover, etc.
(c) Management: Involvement of management personnel & their effectiveness, team-work, authority, timeliness,
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ability to set and achieve targets, etc.
(d) Earnings: The levels of earnings. Stability, trends and adequacy to service existing & future debts proposed
to be undertaken.
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(e) Liquidity: This involves evaluating the working capital policy adopted. Adequate working capital ensures
that the firm has sufficient liquidity to pay their current liabilities.
Consumer Finance
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With a growth in the salaried class and increase in the disposable income in the hands of the people, more and
more consumers in India are prepared to take a loan to purchase white goods (like refrigerators, TVs, washing
machines, etc.) and automobiles. This has led to the growth of a new line of credit call consumer finance.
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This involves lending for period extending from a few months up to 36 months or even 60 months. These are
personal loans provided by banks and other non-banking finance companies. The loan is easily available and
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particularly so if the consumer has a credit card or a previous record of taking and repaying a loan. The rate of
interest is usually higher that on business loans.
Flat & Effective Rate of Interest
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Financing of consumer durables like TVs, refrigerators, laptops, washing machines, etc. is a highly profitable
business because of the high rate of interest charged. Many financers quote a flat rate of interest. A flat rate
of interest is interest calculated on the amount of the loan for the entire period of the loan without taking
into consideration the fact that the part of the principal will be repaid with each instalment. For example, if
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a loan of `1,00,000 is given @ 10% flat rate of interest for one year then the interest will be `10,000 and the
equated monthly instalment (E.M.I.) will be = `1,10,000 ÷ 12 = `9,166.67 or say `9,167. In reality the rate
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of interest will be much more than 10% because part of the principal amount gets repaid with each monthly
instalment. The interest should actually be charged only on the outstanding principal every month. The effective
rate of interest can be computed from the flat rate as follows:
n
Effective rate of interest p.a. = × 2F
n+1
Where,
n = number of instalments
F = flat rate of interest per annum
Problems
1.1 [C.A.] GKL Ltd. is considering installment sale of LCD TV as a sales promotion strategy. In a deal of LCD
TV, with selling price of `50,000, a customer can purchase it for cash down payment of `10,000 and balance
amount by adopting any of the following options:
Tenure of Monthly Equated Monthly
installments installment
12 `3,800
24 `2,140
Financial Services in India Ɩ 179

Required:
Estimate the flat and effective rate of interest for each alternative.
PVIFA2.05%, 12 = 10.5429 PVIFA2.10%, 12 = 10.5107
PVIFA2.10%, 24 = 18.7014 PVIFA2.12%, 24 = 18.6593
[For 12 months: Flat 14%, Effective 25.85%. For 24 months: Flat 14.2%, Effective 27.26%]
Depository Services
A depository is an organization where the securities of an investor are held in electronic form through the
medium of depository participant.
A depository can be compared to a bank. If an investor wants to utilize the services offered by a depository, the
investor has to open an account with the depository through the depository participant – this is very similar to
opening of an account with any of the branches of a bank in order to utilize the services of that bank.
There are two depositories in India, namely –
1. NSDL – NSDL stands for “National Securities Depository Limited”. It is an organization promoted by IDBI,
UTI, NSEIL to provide facilities for holding & transfer of securities in depository account through electronic
account transfer.
2. CDSL – CDSL stands for “Central Depository Services Limited”. It is an organization floated by Bombay Stock
Exchange to provide facilities for holding & transfer of securities in depository account through electronic
account transfer.
Both the depositories are regulated by Depositories Act, 1996 and the bye-laws and regulation framed thereunder.
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Concept of depository system: A depository holds securities in dematerialized form. It maintains ownership
records of securities and effects transfer of ownership through book entry. The owner of the securities intending
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to avail of depository services opens an account with the depository through a depository participant (DP). The
name of the depository appears in the records of the issuer as registered owner of securities. The name of actual
owner appear in the records of the depository as beneficial owner. The beneficial owner has all the rights and
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liabilities associated with the securities. The securities are transferred from one account to another through book
entry only on the instructions of the beneficial owner.
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Advantages of depository: The main advantages of the depository system are enumerated as under –
1. No requirement of filling up the transfer deed and lodging/dispatching to the transfer agent or company for
transfer.
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2. No bad delivery of securities which happened frequently when s were in paper form.
3. No loss of share certificates in postal transit.
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4. No courier/postal charges.
5. Exemption of stamp duty on transfer of shares.
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6. Shares purchased in electronic mode will be transferred in the name of purchaser within a day of completion
of settlement.
7. Much faster payment on sale of shares.
8. No scope of theft/forgery damage of share certificates.
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9. Minimum handling of paper.

10. Faster disbursement of corporate benefits like bonus, rights shares, etc.
Factoring
Factoring involves collection of debtors through a third party for a fee. Factoring is an arrangement between
a financial intermediary called a ‘factor’ and his client for the collection of receivables. A ‘factor’ takes up the
responsibility of collecting the book debts of the client for a fee. Initially, factoring services were provided only
by subsidiaries of banks but now even private financial companies provide this service. A factor provides the
following services:
(1) Undertake to collect the debts of the client.
(2) Provide advance to the client against such debts.
(3) Take up accounting and administration relating to debtors of the client.
(4) Assume losses on account of bad debts.
(5) Provide relevant advisory services to the client.
A factor may provide some or all of the above mentioned services. The fees charged by the factor are expressed
as a percentage of the debts to be collected and usually to be paid up-front (in advance).

Types of factoring
(1) Recourse[1] factoring: Under this arrangement the factor purchases the receivables of the client but the bad
debts losses are borne by the client.
2) Without Recourse or Non-recourse: Under this arrangement the factor purchases the receivables of the client
and takes full responsibility for bad debt losses. The commission charged is higher than that applicable for
recourse factoring.
(3) Advance factoring: Under this arrangement the factor provides advance or short-term finance to the client.
(4) Maturity factoring: Under this arrangement the factor does not provide advance to the client but pays the
money on a guaranteed payment date or when the amount is collected from the debtors of the client.
(5) Full Factoring: This is a comprehensive arrangement where the factor purchases the receivables of the client,
bears the bad debt losses, provides finance to the client, undertakes accounting & administration of debtors, etc.
(6) Notified factoring: In this type of factoring the debtors of the client are notified that the about the assignment
of the debts and they are directed to make payment directly to the factor and not to the client.
(7) Non-notified or Confidential or Undisclosed factoring: In this type of factoring the debtors of the client are
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not informed about the factoring arrangement and continue to make payment to the client and the client
then makes the payment to the factor as soon as the amount is collected or on the due date.
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Advantages of factoring
Factoring arrangement has the following advantages for the client:
(1) Finance is easily available.
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(2) Bad debts losses can be eliminated.
(3) Saves administration cost.
(4) Financing cost can be reduced or can even be nil if the selling prices of goods/services can be marked-up to
include the factoring cost.
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(5) Factoring drastically reduces the period for which funds are blocked in receivables and this reduces the
working capital cycle.
(6) Reduces the need for working capital.
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(7) Improved liquidity enables the client to pay creditors on time and not only get discounts for early payment
but also improves credit worthiness amongst suppliers.
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Disadvantages of factoring
Factoring may also have some disadvantages like:
(1) The cost of factoring can be quite high, unless the client can mark-up the selling price of its goods/services.
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(2) An organization has to maintain good relations with its customers. The collection policies of the factor may
affect the relations.
Computing cost of factoring
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While computing cost of factoring the following points should be kept in mind:
(1) The factors charge commission on the gross amount of debt to be collected and such fee/commission is to
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be paid upfront, i.e. in advance.

(2) If any advance is sanctioned by the factor then it will be after maintaining a reserve/margin which is usually
in the range of 10% to 20%. Therefore, the advance sanctioned will be 80% to 90% of the receivables. The
margin is to cover the interest charges of the factor, bad debts, discounts & other deductions allowed to
client’s debtors.
(3) Interest is to be calculated on the sanctioned amount after deducting collection charges for
the credit period for which the debt will remain outstanding; i.e. credit period allowed to customers of the
client.
(4) The interest charged by the factor will also be deducted upfront (in advance) by the factor; i.e. from the
sanctioned balance the factor will deduct his fees/commission for collection of the debt & the interest on
advance and pay the net balance to the client.
(5) On availing the services of a factor the firm will save on administrative cost. In case of without recourse
factoring the firm will also save on bad debt losses.
(6) The cost of factoring is computed as follows:
Fees/commission xx
1 The act of turning to something or someone for assistance or security. In case of factoring, it refers to factor not bearing the bad debt losses
arising from the receivables of the client but passing on the such losses to the client. However, this cannot be done in case of non-recourse or
without recourse factoring where the factor must bear the losses arising from bad debts of his client’s debts.

+ Interest on advance paid to the factor xx
xx
– Savings on administrative cost & bad debts. xx
Cost of factoring (for the period of credit to debtors) xx
The savings are for the period of credit allowed to debtors. This cost is then converted to per annum cost &
expressed as a percentage to the amount of advance received. This is useful for the purpose of comparing
the rate of interest charged on a loan by a bank.
!! Comparison may also be done by computing the cost on a per month either in rupees or in percentage.
Students should decide by reading the information in the problem and then deciding what will be convenient.
Problems
2.1 [C.A., C.M.A.] A Ltd. has a total sales of `3.2 crores and its average collection period is 90 days. The
past experience indicates that bad-debt losses are 1.5% on sales. The expenditure incurred by the firm in
administering its receivable collection efforts are `5,00,000. A factor is prepared to buy the firm’s receivables by
charging 2% commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a.
after withholding 10% as reserve.
Calculate the effective cost of factoring to the Firm.
[13.32%/13.8% if 360 days per year is taken]
2.2 [C.A.] The turnover of R Ltd. is `60 lakhs of which 80% is on credit. Debtors are allowed one month to
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clear off the dues. A factor is willing to advance 90% of the bills raised on credit for a fee of 2% a month plus a
commission of 4% on the total amount of debts. R Ltd. as a result of this arrangement is likely to save `21,600
annually in management costs and avoid bad debts at 1% on credit sales.
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A scheduled bank has come forward to make an advance equal to 90% of the debts at an interest rate of 18% p.a.
However, its processing fee will be at 2% on the debts. Would you accept factoring or the offer from the bank?
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2.3 [C.A.] Beanstalk Ltd. manages its accounts receivable internally by its sales and credit department. The
cost of sales ledger administration stands at `10 crores annually. The company has a credit policy of 2/10, net
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30. Past experience of the company has been that on an average 40% of the customers avail of the discount by
paying within 10 days while the balance of the receivables are collected on average 90 days after the invoice
date. Bad debts of the company are currently 1.5% of total sales. The projected sales for the next year are `1,000
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crores.
Beanstalk Ltd. finances its investment in debtors through a mix of bank credit and own long term funds in the
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ratio of 70:30. The current cost of bank credit and long term funds are 13% and 15% respectively.
With escalating cost associated with the in house management of debtors coupled with the need to unburden
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the management with the task so as to focus on sales promotion, the Company is examining the possibility of
outsourcing its factoring service for managing its receivable and has two proposals on hand with a guaranteed
payment within 30 days.
The main elements of the Proposal from Finebank Factors Ltd. are:
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• Advance, 88% and 84% for the recourse and non recourse arrangements.
• Discount charge in advance, 21% for with recourse and 22% without recourse.
• Commission, 4.5% without recourse and 2.5% with recourse.
The main elements of the Proposal II from Roughbank Factors Ltd. are:
• Advance, 84% with recourse and 80% without recourse respectively.
• Discount charge upfront without recourse 21% and with recourse 20%.
• Commission upfront, without recourse 3.6% and with recourse 1.8%.
The opinion of the Chief Marketing Manager is that in the context of the factoring arrangement, his staff would
be able exclusively focus on sales promotion which would result in additional sales of 10% of projected sales.
Kindly advice as a financial consultant on the alternative proposals. What advice would you give? Why?
[Cost with recourse: Finebank `6.11 crores; Roughbank (`2.52 crores). Cost without recourse: Finebank `13.53 crores; Roughbank `2.73 crores.]
2.4 [C.A.] PQR Ltd. has credit sales of `165 crores during the financial year 2014-15 and its average collection
period is 65 days. The past experience suggests that bad debt losses are 4.28% of credit sales.
Administration cost incurred in collection of its receivables is `12,35,000 p.a. A factor is prepared to buy the
company’s receivables by charging 1.95% commission. The factor will pay advance on receivables to the company
at an interest rate of 16% p.a. after withholding 15% as reserve.

Estimate the effective cost of factoring to the company assuming 360 days in a year.
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Chapter
10
Mutual Funds
A mutual fund is a trust that pool the savings of number of investors by issuing units to them and investing funds
in securities in accordance with the objective disclosed in the offer document. A mutual fund is required to be
registered with SEBI before it can collect funds from public.
Organs of Mutual Fund

1. Sponsor: Any person who alone or in combination with body corporate, establishes a mutual fund. The
sponsor initiates the idea to set up a mutual fund. It could be a registered company, scheduled bank or
financial institution. For Birla Mutual Fund, the sponsor is Birla Growth Funds. In a joint venture like Sun
F&C Mutual Fund, Foreign & Colonial Emerging Markets is the sponsor and SUN Securities (India) Ltd.
the co-sponsor. A sponsor has to satisfy certain conditions such as capital adequacy, track record (at least
five years’ operation in financial services), default-free dealings and a general reputation of fairness. The
sponsor appoints the trustees, asset management company (AMC) and custodian.
2. Trustees/Board of trustees – The board of trustees or the trustee company hold the property of mutual fund
in trust as for the benefit of unit holders. Trustees hold a fiduciary[1] responsibility towards unit holders for
protecting their interests. Sometimes the trustee and the sponsor are the same, or they may be different.
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For e.g., in SBI Funds Management, State Bank of India is the sponsor and SBI Capital Markets the trustee.
Trustees float and market schemes, and secure necessary approvals. They check if the AMC’s investments
are within defined limits, whether the fund’s assets are protected, and also ensure that unit holders get their
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due returns. Trustees also review any due diligence[2] done by the AMC. For major decisions concerning the
fund, they have to take unit holders’ consent. They submit periodic returns to SEBI and to the investors.
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3. Fund Managers/AMC – They are the ones who manage the fund’s money. Under the SEBI regulation every
mutual fund has to set up an AMC to be registered under the Companies Act, 1956 to manage the funds of
mutual fund. They should be approved by SEBI and should enter into an agreement with trustees of mutual
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fund to formulate schemes. An AMC takes investment decisions, compensates investors through dividends,
maintains proper accounting and information for pricing of units, calculates the NAV, and provides
information on listed schemes and secondary market unit transactions. It also exercises due diligence on
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investments, and submits quarterly reports to the trustees. A fund’s AMC can neither act for any other fund
nor undertake any business other than asset management.
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4. Custodian – It is agency providing custodial services to the fund. Often an independent organization,
it takes custody of securities and other assets of a mutual fund. Among public sector mutual funds, the
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sponsor or trustee generally also acts as the custodian. A custodian’s responsibilities include receipt and
delivery of securities, collecting income, distributing dividends, safekeeping of units and segregating assets
and settlements between schemes. Custodians can service more than one fund.
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The advantages of investing in mutual funds are as follows:

1. Professional Management: Investors avail the services of experienced and skilled professionals who are
backed by dedicated investment research team that analyses the performance and prospects of the companies
and selects suitable investments to achieve the objectives of the scheme.
2. Diversification: Mutual Funds invest in a number of companies across a broad cross-section of industries
and sectors. This diversification reduces the risk because seldom do all the stock decline at the same time in
same proportion.
3. Tax-free Income: The income from mutual funds is tax-free in the hands of the investor.
4. Convenient Administration: Investing in a mutual fund reduces the paper work and helps investors avoid
many problems such as bad deliveries, delayed payments, follow up with brokers & companies. Thus, mutual
funds save time and make investing easy and convenient.
5. Return Potential: Over a medium to long term, mutual funds have the potential to provide a higher return as
they invest in diversified basket of selected securities.
6. Low Costs: Mutual Funds are a relatively less expensive way to invest compared to directly investing in the
capital markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs
for investors.
1 Involving trust, especially with regard to the relationship between a trustee and a beneficiary.
2 Due diligence refers to an act with a certain standard of care. Here it refers to proper research & appraisal before investments are made.

7. Liquidity: In open ended schemes, the investor get the money back promptly at the net asset value related
prices from the mutual fund. In close ended scheme, the units can be sold on a stock exchange at the
prevailing market price.
8. Transparency: Investors get regular information on the value of their investment in addition to the disclosure
on the specific investments made by the scheme, the proportion invested in each class of assets and the fund
manager investment strategy and outlook.
9. Flexibility: Through features such as regular investment plans, regular withdrawal plans and dividend
reinvestment plans, one can systematically invest or withdraw funds according to one’s needs & convenience.
10. Well Regulated: All mutual funds are registered with SEBI and they function within the provisions of strict
regulation designed to protect the interest of the investors.
Disadvantages of investing in a mutual fund:
Investment in mutual fund are not without disadvantages. These are –
1. Too much diversification results in losing focus.
2. Concentration on investing in blue chip securities, which are highly price, might provide below average or
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average return.
3. Fund managers are not accountable for poor results.
4. Failure to identify the risks of the scheme as distinct from the risks of the market could lead to poor
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performance.
5. Not all fund managers are good and many schemes have lost money.
6. Some funds make claims unrealistic returns which they are not able to deliver and often mis-sell schemes to
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gullible investors. However, SEBI has imposed certain restrictions on advertising to protect investors.
Mutual Fund Schemes

The mutual funds in India offer a wide array of schemes that cater to different needs suitable to age, financial
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position, risk tolerance and return expectations. Mutual Funds may be classified on the following mutually
exclusive basis:
(i) Functional Classification:
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(1) Open-ended schemes: An open ended fund is one that is available for subscription on a continuous
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basis. These do not have a fixed maturity. Investors can conveniently buy and sell units at NAV
related prices at any time. The key feature of an open ended scheme is liquidity.
(2) Close-ended schemes: A close ended scheme has a stipulated maturity period. The fund is open for
initial subscription only for a specified period; e.g. for 15 days or a month. The term of the scheme
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is fixed; e.g. it could be three or five or ten years or even longer, say 20 years. Investors can invest in
the scheme at par at the time of initial public issue. The AMC does not repurchase the units till the
maturity date. To provide the investors with an exit option the units are usually listed on a national
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stock exchange like BSE or NSE or both. An investor can sell his units in the secondary market. A new
investor wanting to join the scheme can do so only by buying the units from the secondary market.
(ii) Portfolio Classification:
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(1) Growth Funds: The aim of the growth funds is to provide capital appreciation over the medium to
long term. Such scheme normally invest a major part of their corpus in equities. Growth schemes are
good for investors having a long term outlook seeking appreciation over a period of time.
(2) Income Funds: The aim of the income fund is to provide regular and steady income to the investors.
Such schemes generally invest in fixed income securities such as bonds, government securities etc.
Income funds are ideal for investors looking for regular income.
(3) Balanced Funds: The aim of the balanced fund is to provide both growth and regular income as
such schemes invest both in equities and fixed income securities in proportion indicated in offer
document. Thus they are also known as hybrid schemes. These are ideal for investors looking for a
combination of income and moderate growth.
(4) Money Market Funds: These schemes generally invest in safer short term instruments such as treasury
bills, commercial paper etc. The aim of money market funds is to provide easy liquidity, preservation
of capital and moderate income. These are ideal for corporate and individual investors as a measure
to park their surplus funds for short periods to earn some income without risk.
(5) Gilt Funds: These funds invest exclusively in government securities. Government securities have no
default risk. NAVs of these schemes fluctuate due to change in interest rates and other economic
factors as is the case with the income or debt oriented schemes.
Mutual Funds Ɩ 185
(iii) Ownership Classification:
(1) Public Sector Funds: These are sponsored by public sector companies. For example, SBI Mutual Fund
sponsored by State Bank of India.
(2) Private Sector Funds: These are sponsored by private sector companies. For example, Reliance Mutual
Fund sponsored by Reliance Capital Ltd.
(3) Foreign Mutual Funds: These are sponsored by foreign companies; e.g. Franklin Templeton Mutual
Fund is sponsored by Templeton International Inc., U.S.A.
Some Important Funds

(1) Exchange Trade Funds (ETFs): The units of a mutual fund are, in most cases, purchased from & sold back
to the asset management company of the mutual fund. An exchange traded fund (ETF) is a fund whose
units are traded on the stock exchange and an investors buys & selling them on such exchange like any
other stock. The sponsor of an ETF enters into an agreement with authorized participants who are market
makers, dealers and large institutional investors to create & redeem units of the ETF. Sometimes, large
institutional investors themselves may be the sponsor of the ETF. The authorized participants contribute
securities in exchange of which they are issued creation units by the fund; for example, a creation unit may
contain 50,000 units of the ETF. These units are a legal claim on the securities held by the fund in trust.
However, only the authorized participants can redeem these units from the fund or take more creation
units. The authorized participants then sell these units to the public on the stock exchanges. Thereafter,
the ETF units are freely traded amongst the public or the authorized participants. Such ETFs can be created
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not only for securities but also for commodities; for example, gold ETFs are popular in India. ETFs track
the value of their underlying in real time. Their low expense ratio makes them more popular than mutual
fund.
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(2) Hedge Funds: The objective of hedge funds is to provide a positive return irrespective of the market return.
The risk involved in also higher. Such funds also borrow money to leverage the return. The fund manager
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is one of the investors and is paid not only a fixed remuneration but also a performance fee. Usually large
institutional investors & wealthy individuals invest in such funds. The minimum investment required is
very high. There is lack of liquidity and the fund manager usually has the authority to limit withdrawals.
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Hedge refers to protection against risk usually by putting a limit on the risk. Earlier hedge funds took up
short positions in a bear market to hedge against downside risk. However, the hedge funds today use a
more aggressive approach taking more risk than the market to provide to provide a high return to investors
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and therefore “hedge funds” is a misnomer.

(3) Fund of Funds: A fund of funds scheme is a mutual fund scheme which invests in schemes of other mutual
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funds instead of directly investing in securities. It thus uses the expertise of other mutual fund managers
by investing in their funds.
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Benefits of Fund of funds scheme:

1. It provides greater diversification by investing in funds of other schemes.
2. For the investor, instead of investing in different mutual funds and keeping a track of them, he can
invest in a FoF and keep track only on the performance of that fund.
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3. The investor can diversify with limited amount of investment.

4. It also enables the investor to benefit from the expertise of various fund managers of multiple mutual
funds scheme in which the FoF scheme invests.
Disadvantages:
1. The investor has to indirectly bear the fees payable to multiple managers. As the diversification
increases, the level of this fees also goes up.
2. Risks associated with underlying funds get added up at this level. The investor faces a risk of varied
judgment of different fund managers.
Net Assets Value (NAV)

The performance of the particular scheme of a mutual fund is denoted by Net Asset Value (NAV). The NAV of
the fund is the amount which a unit holder would receive per unit if the mutual fund were wound up on the
date of declaration of the NAV. It is the net value of the assets of a fund less liabilities of that fund. A separate
NAV is computed for each scheme of the mutual fund. Since market value of the assets changes every day, NAV
of the scheme also varies on a day to day basis. The NAV is denoted as the value of each unit in the scheme on
a particular date. It also includes the dividend, interest and other accruals on the investment in addition to the
market value of the investment, as reduced by the costs and liabilities.

NAV of units under a scheme would be calculated as follows:
Computation of net assets of a scheme –
Particulars ` Valuation Rule
Liquid assets, such as cash xx As per books
All listed & traded securities xx Closing market price
(other than those held as not for sale)
Debentures & bonds xx Closing traded price or yield
Illiquid shares or debentures xx Last known price or book values whichever is lower.
Estimated market price approach can be adopted, if a
suitable benchmark is available.
Fixed income securities xx Current yield
Dividends & interest accrued xx
Other receivables considered good xx
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Other assets xx
xx
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Less: Liabilities
Expenses accrued xx
Liabilities towards unpaid assets xx
Other short- or long-term liabilities xx
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Net assets of the scheme xx
Net assets of the scheme

NAV (`) =
G
Number of units outstanding
The NAV shall be calculated up to four decimals places.
Entry & Exit Load

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‘Entry load’ is a one time fixed fee which is paid by an investor while he buys units of a scheme. This is also
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known as front end load. As per SEBI regulations a mutual fund cannot charge entry load for
purchase of units directly from a mutual fund. However, the investor may have to pay a commission
directly to the intermediary through whom the units are purchased.
Exit load, also called back end load, is deducted by the mutual fund at the time of redemption of units. Exit
.S
loads may or may not be charged to the investors and it varies depending on the period they stay invested in the
scheme. The exit load is computed on the redemption price. The redemption price can be computed from
the NAV as follows:
A
NAV
Redemption price =
1+r
C
Where,
r = rate of exit load in decimal
Expense Ratio
This is the ratio of expenses incurred to run the mutual fund during a year expressed as a percentage to the total
assets under management. Expenses include not only advisory fees but all administrative, advertising, selling
& distribution expenses, etc. Higher ratio will reduce the return to the investors in the scheme. Investors look
for schemes with a low expense ratio. As assets under management fluctuate because of new units issued &
redemptions during the year, expense ratio should be computed on the basis of average assets under management
during the year. If it is computed on a per unit basis then the average of opening & closing NAV for the period
should be taken.
Dividend Options for Investors

An investor has two options for dividends. He may opt for cash dividend in which case the dividend will be paid
to him whenever it is declared. The other option is the dividend reinvestment option. In this case the dividend is
reinvested in the same scheme at the NAV prevailing after the dividend has been declared. In this case the investor
does not get cash but the number of units in his portfolio will increase every time a dividend is declared & paid.
Mutual Funds Ɩ 187

Computing Returns
Investors derive three types of income from units of a mutual fund:
(1) Dividend; [may be paid or reinvested]
(2) Capital gains disbursement; and
(3) Changes in the fund’s NAV per unit (or unrealized capital gains).
(1) Annual Return
The one-year holding period return is computed as follows:
D1 + CG1 + ( NAV1 − NAV0 )
Return = × 100
NAV0
Where,
D 1 = dividend distributed during the year
CG1 = capital gain distributed year
NAV1 = net asset value at the end of the year
NAV0 = net asset value at the beginning of the year
(2) Holding Period Return
Units may be held for a period other than a year. A return computed for such period would be called athe
holding period return.
(i) Holding period of less than one Year: The holding period return for less than one year is calculated in
es
the same way as that of one year by taking the income earned during the period and the opening and
closing NAVs. However, return on investment should always be expressed on per annum basis to put
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it in perspective.
(ii) Holding period of more than one Year: When units are held for a period of more than one year, the
return can be computed in two ways. One method is to simply compute the return over the entire
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period and divide it by the number of years for which the units were held to obtain the simple
average return on investment per annum. The other method is to find the internal rate of return
C
(IRR) which is the compounded annual growth rate per annum.
Evaluation of Mutual Fund Performance

There are many mutual funds available for investment. An investor has to decide which fund s/he wants to
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invest in. For this reason the performance of the mutual fund must be evaluated. Some of the tools available for
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evaluation are:
(1) Sharpe Ratio

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Developed by William Sharpe, the Sharpe Ratio can be used to evaluate the performance of a portfolio. It
measures the premium earned per unit of total risk and is computed as follows:
Rp − R f
Sharpe ratio =
A
sp
Where,
Rp = return from portfolio
sp = standard deviation of portfolio
This measures the premium earned per unit of standard deviation. The higher the ratio the better the
performance of the portfolio.
(2) Treynor Ratio

Developed by Jack Treynor, this model measures the risk premium earned per unit of non-diversifiable risk,
beta. It is computed as follows:
Rp − R f
Treynor ratio =
bp
Where,

bp = beta of security portfolio
This measures the premium earned per unit of beta. The higher the ratio the better the performance of the
portfolio.
(3) Jensen’s Alpha

Developed by Michael Jensen, this model measures the return earned by the fund in excess of the return
expected as per the Capital Asset Pricing Model (C.A.P.M.).
Jensen’s Alpha = Rp – [Rf + bp(Rm – Rf)
Where,
bp = beta of the portfolio
Rm = market return
Higher the alpha better the performance.
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(4) Fama’s Net Selectivity or Fama’s Index
According to Eugene F. Fama some fund managers have the ability to select best stocks out of several with
ha
the same level of risk; this is called selectivity. Hence, their fund is able to deliver a higher return than a
comparable fund with the same level of risk. This can be measured as follows:
 s  
ok
Fama’s Index = Rp –  R f +  p  × (R m − R f )
  sm  
Where,
G
sp = standard deviation of the portfolio
il
Rm = market return
Higher the index better the performance.
un
Problems
1) [C.S.] The redemption price of a mutual fund unit is `12 while the back-end load charges are 3%. You are
.S
required to calculate the net asset value (NAV) and public offer price.
[`12.36; `12.36]
2) [C.S.] The redemption price of a mutual fund unit is `48 while the back-end load charges and 3% respectively.
A
You are required to calculate –

(i) Net asset value (NAV) per unit; and (ii) Public Offer Price of the unit.
[(i) `49.44 (ii)`48]
C
3) [C.S. adapted] Global Mutual Fund has launched a scheme named ‘Grand bonanza’. The net asset value
(NAV) of the scheme is `12 per unit and exit load is 3%. Calculate its the redemption price.
[`11.6505]
4) [C.S.] A unit of Evergrow Equity Fund is redeemed at `15, the exit load being 2.25%. Calculate its NAV.
[`15.3375]
5) [C.A.] A mutual fund that had a net asset value of `16 at the beginning of a month, made income and capital
gain distribution of `0.04 and `0.03 respectively per unit during the month, and then ended the month with a
net asset value of `16.08. Calculate monthly and annual rate of return.
[0.9375% p.m., 11.25% p.a.]
6) [C.A. twice] A Mutual Fund has a NAV of `20 on 1.12.09. During December 2009, it has earned a regular
income of `0.0375 and capital gain of `0.03 per unit. On 31.12.09, the NAV was `20.06. Calculate the monthly
return and annual return.
[0.6375% p.m., 7.65% p.a.]
7) [C.A.] A Mutual Fund having 300 units has shown its NAV of `8.75 and `9.45 at the beginning and at the
end of the year respectively. The Mutual Fund has given two options:
Mutual Funds Ɩ 189

(i) Pay `0.75 per unit as dividend and `0.60 per unit as a capital gain, or
(ii) These distributions are to be reinvested at an average NAV of `8.65 per unit.
What difference it would make in terms of return available and which option is preferable?
[(i) 23.43% (ii) 24.85%]
8) [C.A.] An investor purchased 300 units of a Mutual Fund at `12.25 per unit on 31st December, 2009. As on
31st December, 2010 he has received `1.25 as dividend and `1.00 as capital gains distribution per unit.
Required:
(i) The return on the investment if the NAV as on 31st December, 2010 is `13.00.
(ii) The return on the investment as on 31st December, 2010 if all dividends and capital gains distributions are
reinvested into additional units of the fund at 12.50 per unit.
[(i) 24.49% (ii) 25.22%]
9) [C.A.] Orange purchased 200 units of Oxygen Mutual Fund at `45 per unit on 31 st December, 2009. In
2010, he received `1.00 as dividend per unit and a capital gains distribution of `2 per unit.
Required:
(i) Calculate the return for the period of one year assuming that the NAV as on 31st December 2010 was `48
per unit.
(ii) Calculate the return for the period of one year assuming that the NAV as on 31st December 2010 was `48
per unit and all dividends and capital gains distributions have been reinvested at an average price of `46.00
per unit.
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Ignore taxation.
[(i) 13.33% (ii) 13.62%]
10) [C.A.] The following information is extracted from Steady Mutual Fund’s Scheme:
— Asset Value at the beginning of the month: `65.78
— Annualized return: 15 %
ss
la
— Distributions made in the nature of Income: `0.50 and `0.32 & Capital gain (per unit respectively).
(1) Calculate the month end net asset value of the mutual fund scheme (limit your answers to two decimals).
C
(2) Provide a brief comment on the month end NAV.
[(1) `65.78 (2) There is no change in NAV]
h
11) [C.A.] Mr. X earns 10% on his investments in equity shares. He is considering a recently floated scheme of
a Mutual Fund where the initial expenses are 6% and annual recurring expensed are expected to be 2%. How
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much the Mutual Fund scheme should earn to provide a return of 10% to Mr. X?
[13.64%]
da
12) [C.A.] Mr. A can earn a return of 16% by investing in equity shares on his own. Now his is considering a
recently announced equity based mutual fund scheme in which initial expenses are 5.5% and annual recurring
expenses are 1.5%. How much should the mutual fund earn to provide Mr. A a return of 16%?
[18.43%]
A
13) [C.A.] On 01-07-2010, Mr. X invested `50,000 at initial offer in Mutual Funds at a face value of `10 each
per unit. On 31-03-2011, a dividend was paid @ 10% and annualized yield was 120%. On 31-03-2012, 20%
dividend and capital gain of `0.60 per unit was given. Mr. X redeemed all his 6271.98 units when his annualized
yield was 71.50% over the period of holding.
Calculate NAV as on 31-03-2011, 31-03-2012 and 31-03-2013.
For calculations consider a year of 12 months.
[`18, `10.62, `23.65]
14) [C.A.] Mr. X on 1.7.2000, during the initial offer of some Mutual Fund invested in 10,000 units having
face value of `10 for each unit. On 31.3.2001 the dividend operated by the M.F. was 10% and Mr. X found that
his annualized yield was 153.33%. On 31.12.2002, 20% dividend was given. On 31.3.2003 Mr. X redeemed
all his balance of 11,296.11 units when his annualized yield was 73.52%. What are the NAVs as on 31.3.2001,
31.12.2002 and 31.3.2003?
[`20.50, `25.95, `26.75]
15) [C.A.] Based on the following information, determine the NAV of a regular income scheme on per unit
basis:
` Crores

Listed shares at Cost (ex-dividend) 20
Cash in hand 1.23
Bonds and debentures at cost 4.3
Of these, bonds not listed and quoted 1
Other fixed interest securities at cost 4.5
Dividend accrued 0.8
Amount payable on shares 6.32
Expenditure accrued 0.75
Number of units (`10 face value) 20 lacs
Current realizable value of fixed income securities of face value of `100 106.5
The listed shares were purchased when Index was 1,000
Present index is 2,300
Value of listed bonds and debentures at NAV date 8
There has been a diminution of 20% in unlisted bonds and debentures. Other fixed interest securities are at cost.
le
[`271.30]
16) [C.A.] Based on the following data, estimate the Net Asset Value (NAV) on per unit basis of a Regular
ha
Income Scheme of a Mutual Fund:
` (in lakhs)
Listed Equity shares at cost (ex-dividend) 40.00
Cash in hand 2.76
ok
Bonds & Debentures at cost of these, Bonds not listed 8.96
& not quoted 2.50
G
Amount payable on shares 13.54
il
Current realizable value of fixed income securities of face value of `100 is `96.50.
Number of Units (`10 face value each): 2,75,000
un
All the listed equity shares were purchased at a time when market portfolio index was 12,500. On NAV date, the
market portfolio index is at 19,975.
There has been a diminution of 15% in unlisted bonds and debentures valuation.
.S
Listed bonds and debentures carry a market value of `7.5 lakhs, on NAV date.
Operating expenses paid during the year amounted to `2.24 lakhs.
[`26.3142]
A
17) [C.S.] From the following data, determine the ‘net asset value’ (NAV) of a regular income scheme:
` lakhs
Listed shares at cost (ex-dividend) 20.00
C
Cash in hand 1.23

Bonds & debentures at cost 4.30
Of the above, bonds & debentures not listed and quoted 1.00
Amounts payable on shares 6.32
Current realizable value of fixed income securities of face value of `100 each `106.50
Number of units (face value of `10 each) 2,40,000
All the listed shares were purchased at a time when index was 1,200. On the NAV date, the index is ruling at
2,120. Listed bonds and debentures carry a market value of `5 lakh on NAV date.
[NAV `17.12 per unit]
18) [C.S.] Safal Mutual Fund provides the following information related to one of its schemes:
Size of the scheme: `2,000 crore
Face value of the units: `10 per unit
Number of units outstanding: 200 crore
Mutual Funds Ɩ 191

Market value of Fund’s portfolio: `4,200 crores
Receivables: `100 crores
Accrued income: `100 crores
Liabilities: `150 crores
Accrued expenses: `275 crores
You are required to calculate the net asset value (NAV) of the scheme and rate of return if a unit holder has
purchased units at the NAV of `15 per unit and received a dividend of `2 per unit during the period.
[NAV `19.875; Return 45.83%]
19) [C.A.] A Mutual Fund Co. has the following assets under it on the close of business as on:
Company No. of Shares 1st February 2012 2nd February 2012
Market price per share Market price per share
` `
L Ltd 20,000 20.00 20.50
M Ltd 30,000 312.40 360.00
N Ltd 20,000 361.20 383.10
P Ltd 60,000 505.10 503.90
Total No. of Units 6,00,000
(i) Calculate Net Assets Value (NAV) of the Fund.
(ii) Following information is given:
Assuming one Mr. A, submits a cheque of `30,00,000 to the Mutual Fund and the Fund manager of this
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company purchases 8,000 shares of M Ltd; and the balance amount is held in Bank. In such a case, what
would be the position of the Fund?
(iii) Find new NAV of the Fund as on 2nd February 2012.
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[(i) `78.8366 (ii) 6,38,053.3914 units; Assets `5,03,02,000 (iii) `82.26]
20) [C.A.] Mr. Suhail has invested in three Mutual Fund Schemes as given below:
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Particulars Scheme A Scheme B Scheme C
Date of investment 1-4-2011 1-5-2011 1-7-2011
C
Amount of Investment (`) 12,00,000 4,00,000 2,50,000
Net Asset Value (NAV) at entry date (`) 10.25 10.15 10.00
Dividend received up to 31-7-2011 (`) 23,000 6,000 Nil
NAV as at 31-7-2011 (`) 10.20 10.25 9.90
h
You are required to calculate the effective yield on per annum basis in respect of each of the three Schemes to
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Mr. Suhail up to 31-7-2011.

Take one year = 365 days.
Show calculations up to two decimal points.
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[Scheme A 4.275%; Scheme B 9.86%; Scheme C – 11.77%]

21) [C.A.] On 1-4-2012 ABC Mutual Fund issued 20 lakh units at `10 per unit. Relevant initial expenses
involved were `12 lakhs. It invested the fund so raised in capital market instruments to build a portfolio of `185
A
lakhs. During the month of April 2012 it disposed off some of the instruments costing `60 lakhs for `63 lakhs
and used the proceeds in purchasing securities for `56 lakhs. Fund management expenses for the month of April,
2012 was `8 lakhs of which 10% was in arrears. In April 2012 the fund earned dividends amounting to `2 lakhs
and it distributed 80% of the realized earnings. On 30-4-2012 the market value of the portfolio was `198 lakhs.
Mr. Akash, an investor, subscribed to 100 units on 1-4-2012 and disposed off the same at closing NAV on 30-4-
2012. What was his annual rate of earning?
[12%]
22) [C.A.] A mutual fund made an issue of 10,00,000 units of `10 each on January 01, 2008. No entry load
was charged. It made the following investments:
`
50,000 Equity shares of `100 each @ `160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000
During the year, dividends of `12,00,000 were received on equity shares. Interest on all types of debt securities

was received as and when due. At the end of the year equity shares and 10% debentures are quoted at 175% and
90% respectively. Other investments are at par.
Find out the Net Asset Value (NAV) per unit given that operating expenses paid during the year amounted to
`5,00,000. Also find out the NAV, if the Mutual fund had distributed a dividend of `0.80 per unit during the year
to the unit holders.
[NAV `11.55, After dividend `10.75]
23) [C.A. twice] A has invested in three Mutual Fund Schemes as per detailed below:
MFA MFB MFC
Date of investment 01.12.2013 01.01.2014 01.03.2014
Amount of investment 50,000 1,00,000 50,000
Net Asset Value (NAV) at entry date 10.50 10 10
Dividend received up to 3 1.03.2014 950 1,500 Nil
NAV as at 31.03.2014 10.40 10.10 9.80
Required:
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What is the effective yield on per annum basis in respect of each of the three schemes to Mr. A up to 31.03.2014?
[MFA 2.835%, MFB 10.027%, MFC – 24%]
24) [C.A.] Mr. Sinha has invested in three Mutual fund schemes as per details below:
ha
Scheme X Scheme Y Scheme Z
Date of Investment 01.12.2008 01.01.2009 01.03.2009
Amount of Investment `5,00,000 `1,00,000 `50,000
ok
Net Asset Value at entry date `10.50 `10.00 `10.00
Dividend received up to 31.03.2009 `9,500 `1,500 Nil
NAV as at 31.3.2009 `10.40 `10.10 `9.80
You are required to calculate the effective yield on per annum basis in respect of each of the three schemes to
G
Mr. Sinha up to 31.03.2009.
[2.859%, 10.139%, – 23.55%]
25) [C.A.] T Ltd. has promoted an open-ended equity oriented scheme in 1999 with two plans – Dividend
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Reinvestment Plan (Plan-A) and a Bonus Plan (Plan-B); the face value of the units was Rs.10 each. X and Y
invested `5,00,000 each on 1.4.2001 respectively in Plan-A and Plan-B, when the NAV was `42.18 for Plan
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A and `35.02 for Plan-B, X and Y both redeemed their units on 31.3.2008. Particulars of dividend and bonus
declared on the units over the period were as follows:
Date Dividend Bonus NAV
.S
% Ratio Plan A Plan B

15.9.2001 15 – 46.45 29.10
28.7.2002 – 1:6 42.18 30.05
31.3.2003 20 – 48.10 34.95
A
31.10.2003 – 1:8 49.60 36.00

15.3.2004 18 – 52.05 37.00
24.3.2005 – 1:11 53.05 38.10
C
27.3.2006 16 – 54.10 38.40

28.2.2007 12 1:12 55.20 39.10
31.3.2008 – – 50.10 34.10
You are required to calculate the annual return for X and Y after taking into consideration
the following information :
(i) Securities transaction tax @ 2% on redemption.
(ii) Liability of capital gains to income tax
(a) Long-term capital gain-exempt; and
(b) Short-term capital gains at 10% plus education cess at 3%.
[Plan A 27.67%, Plan 29.29%]
26) [C.A., C.M.A.] Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open-ended equity oriented
scheme “Chanakya Opportunity Fund”. There were three plans viz. ‘A’ - Dividend Re-investment Plan, ‘B’ - Bonus
Plan & ‘C’ - Growth Plan.
At the time of initial Public Offer on 1.4.2004, Mr. Anand, Mr. Bacchan & Mrs. Charu, three investors invested
`1,00,000 each & chosen ‘B’, ‘C’ & ‘A’ Plan respectively.
The History of the Fund is as follows:
Mutual Funds Ɩ 193

Date Dividend % Bonus Ratio Net Asset Value per Unit (F.V. `10)
Plan A Plan B Plan C
28.07.2008 20 30.70 31.40
33.42
31.03.2009 70 5:4 58.42 31.05 70.05
31.10.2012 40 42.18 25.02
56.15
15.03.2013 25 46.45 29.10
64.28
31.03.2013 1:3 42.18 20.05 60.12
24.03.2014 40 1:4 48.10 19.95 72.40
31.07.2014 53.75 22.98
82.07
On 31st July all three Investors redeemed all the balance units.
Calculate annual rate of return to each of the investors.
Consider:
1. Long-term Capital Gain is exempt from Income tax.
2. Short-term Capital Gain is subject to 10% Income tax.
3. Security Transaction Tax 0.2% only on sale/redemption of units.
4. Ignore Education Cess.
[Plant A 67.64%, Plan B 73.33%, Plan C 69.59%]
27) [C.A.] A mutual fund company introduces two schemes i.e. Dividend plan (Plan-D) and Bonus plan
(Plan-B). The face value of the unit is `10. On 1-4-2005, Mr. K invested `2,00,000 each in Plan-D and Plan-B
when the NAV was `38.20 and `35.60 respectively. Both the plans matured on 31-3-2010.
es
Particulars of dividend and bonus declared over the period are as follows:
Date Dividend Bonus NAV
% Ratio Plan D Plan B
30-09-2005 10 39.10 35.60
30-06-2006 1:5 41.15 36.25
ss
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31-3-2007 15 44.20 33.10
15-9-2008 13 45.05 37.25
30-10-2008 1:8 42.70 38.30
C
27-3-2009 16 44.80 39.10
11-4-2009 1:10 40.25 38.90
31-3-2010 40.40 39.70
h
What is the effective yield per annum in respect of the above two plans?
[Plan D 3.645%, Plan B 10.78%]
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28) [C.A.] Cinderella Mutual Fund has the following assets in Scheme Rudolf at the close of business on 31st
March, 2014.
da
Company No. of Shares Market Price Per Share

Nairobi Ltd. 25000 `20
Dakar Ltd. 35000 `300
Senegal Ltd. 29000 `380
A
Cairo Ltd. 40000 `500

The total number of units of Scheme Rudolf are 10 lacs. The Scheme Rudolf has accrued expenses of `2,50,000
and other liabilities of `2,00,000. Calculate the NAV per unit of the Scheme Rudolf.
[`41.57]
29) [C.A.] Cauliflower Limited is contemplating acquisition of Cabbage Limited. Cauliflower Limited has 5 lakh
shares having market value of `40 per share while Cabbage Limited has 3 lakh shares having market value of `25
per share. The EPS for Cabbage Limited and Cauliflower Limited are `3 per share and `5 per share respectively.
The managements of both the companies are discussing two alternatives for exchange of shares as follows:
(i) In proportion to relative earnings per share of the two companies.
(ii) 1 share of Cauliflower Limited for two shares of Cabbage Limited.
Required:
(i) Calculate the EPS after merger under both the alternatives.
(ii) Show the impact on EPS for the shareholders of the two companies under both the alternatives.
[(i) EPS after merger `5, Impact on EPS: 0 for both companies (ii) EPS after merger `5.23, Impact on EPS: Cauliflower Ltd. + `0.23, Cabbage
Ltd. (`0.385)]
30) [C.A.] There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual Fund Ltd. Each having close

ended equity schemes.
NAV as on 31-12-2014 of equity schemes of D Mutual Fund Ltd. is `70.71 (consisting 99% equity and remaining
cash balance) and that of K Mutual Fund Ltd. is `62.50 (consisting 96% equity and balance in cash).
Following is the other information;
Equity schemes
Particulars D Mutual Fund Ltd. K Mutual Fund Ltd.
Sharpe Ratio 2 3.3
Treynor Ratio 15 15
Standard deviation 11.25 5
There is no change in portfolios during the next month and annual average cost is `3 per unit for the schemes of
both the Mutual Funds. If Share Market goes down by 5% within a month, calculate expected NAV after a month
for the schemes of both the Mutual Funds.
For calculation, consider 12 months in a year and ignore number of days for particular month.
31) [C.A.] TUV Ltd. has invested in three Mutual Fund schemes as per the details given below:
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Scheme X Scheme Y Scheme Z
Date of Investment 1-10-2014 1-1-2015 1-3-2015
ha
Amount of Investment (`) 15,00,000 7,50,000 2,50,000
Net Asset value at entry date `12.50 `36.25 `27.75
Dividend received up to March 31, 2015 `45,000 `12,500 Nil
ok
Net Asset value as at March 31, 2015 `12.25 `36.45 `27.55
What will be the effective yield (per annum basis) for each of the above three schemes up to 31st March, 2015?
G
il
un
.S
A
C
Mutual Funds Ɩ 195

Chapter
11
Money Market Operations
Capital markets deal with financial requirements for medium & long term. The short term financial requirements
are met by money markets. A money market deals in short term financial assets; i.e. of less than one year. Some
of the financial instruments in money market are: money at call & short notice, short-term deposits, T-bills,
commercial paper (CP), bills of exchange, inter-corporate deposits (ICD), certificate of deposit (CD), etc.
(1) Commercial Paper (CP): Commercial paper is an unsecured debt instrument issued in the form of a
promissory note issued by highly rated corporates for tenors ranging between 15 days to 360 days. It is
a zero coupon instrument and issued at a discount to face value. The discount is market determined. RBI
regulates the issue of commercial paper. Each note has a face value of `5 lakhs or multiple thereof.
(2) Treasury Bills (T-bills): Treasury bills are short term promissory notes issued by the Central Government
for periods ranging from 14 days to 364 days. They issued at a discount to face value which is `25,000
for the shorter period bills and `1,00,000 for the 364 day bills. The bills are auctioned and the discount is
determined by the bidding. The yield (discount) can be computed as follows:
F − P 365
Y=   × M × 100
 P 
es
Where,
Y = yield
F = face value

P = issue price or purchase price
M = days to maturity
ss
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Problems
C
Commercial Paper
1.1 [C.A.] Calculate the Current price and the Bond equivalent yield (using simple compounding) of a money
market instrument with face value of `100 and discount yield of 8% in 90 days. Take 1 year 360 days.
h
[`92.59, 32%]
rs
1.2 [C.A.] A money market instrument with face value of `100 and discount yield of 6% will mature in 45 days.
(i) Current price of the instrument.
da
(ii) Bond equivalent yield

(iii) Effective annual return.
[(i) `99.25 (ii) 6.129% (iii) 6.129%]
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1.3 [C.A.] Z Co. Ltd. issued commercial paper worth `10 crores as per following details:
Date of issue: 16th January, 2009
Date of maturity: 17th April, 2009
Number of days: 91
Interest rate: 12.04% per annum
What was the net amount received by the company on issue of CP? (Charges of intermediary may be ignored)
[`9,70,87,379]
1.4 [C.S.] Kastro Ltd. issued commercial paper as per the following details:
Date of issue 19th October, 2010
Date of maturity 17th of January, 2011
Interest-rate 7.25% per annum
Face value of commercial paper `10 crore
What was the net amount received by the company on issue of commercial paper?
[`9,82,41,478]
1.5 [C.A.] LMN & Co. plans to issue Commercial Paper (CP) of `1,00,000 at a price of `98,000.
Maturity Period: 4 Months

Expenses for issue of CP are:
(i) Brokerage 0.10%
(ii) Rating Charges 0.60%
(iii) Stamp Duty 0.15%
Find the effective interest rate per annum and the cost of Fund.
[Effective interest 6.12%; Cost of funds 6.97%]
1.6 [C.A.] From the following particulars, calculate the effective rate of interest total cost of funds to Bhaskar
Ltd., which is planning a CP issue:
Issue Price of CP `97,550
Face Value `1,00,000
Maturity Period 3 Months
Issue Expenses:
Brokerage 0.15% for 3 months
Rating Charges 0.50% p.a.
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Stamp Duty 0.175% for 3 month
[Effective rate 10.05%; Cost of funds 11.85%]
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1.7 [C.A.] From the following particulars, calculate the effective interest per annum as well as the total cost of
funds to ABC Ltd., which is planning a CP issue:
Issue price of CP `97,350
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Face value `1,00,000
Maturity period 3 months
Issue expenses:
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Brokerage 0.125% for 3 months
Rating charges 0.5% per annum
Stamp duty 0.125% for 3 months
[Effective rate of interest 10.89%; Cost of funds 12.39%]
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1.8 [C.A.] AXY Ltd is able to issue Commercial Paper of `50,00,000 every 4 months at a rate of 12.5% p.a. The
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cost of placement of Commercial Paper Issue is `2,500 per issue. AXY Ltd, is required to maintain line of credit
`1,50,000 in bank balance. The applicable income tax rate for AXY Ltd. is 30%. What is the cost of funds (after
taxes) to AXY Ltd. for Commercial Paper Issue? The maturity of Commercial Paper is four months.
[9.13%]
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Certificate of Deposit (CDs) & Treasury Bills

2.1 [C.A.] P Co. has to make a payment of `20 lakhs on 16th April, 2010. It has surplus money today i.e., 15th
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January, 2010 and the company has decided to invest in Certificate of Deposit of a leading nationalized bank at
8% per annum. What money is required to be invested now?
[`19,60,890]
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2.2 [C.A.] M Ltd. has to make a payment on 30th January, 2011 of `80 lakhs. It has surplus cash today i.e.,
31st October 2010, and has decided to invest sufficient cash in the banks is certificate of deposit scheme offering
an yield of 8% per annum on simple interest basis. What is the amount to be invested now?
[`78,43,559]
2.3 [C.A.] RBI sold 91 day T-bills of face value of `100 at an yield of 6%. What was the issue price?
[`98.53]
Short-term Investments
3.1 [C.A.] Wonderland Limited has excess cash of `20 lakhs, which it wants to invest in short term marketable
securities. Expenses relating to investment will be `50,000.
The securities invested will have an annual yield of 9%. The company seeks your advice
(i) as to the period of investment so as to earn a pre-tax income of 5%.
(ii) the minimum period for the company to break even its investment expenditure over time value of money.
[(i) 300 days (ii) 100 days]
Money Market Operations Ɩ 197

Foreign Direct Investment (FDI), Foreign
Chapter
12
Institutional Investment (FII) & International
Financial Management
Foreign Currency Convertible Bonds (FCCB)
FCCBs are governed by Issue of FCCBs and Ordinary Shares (through Depository Receipt Mechanism) Scheme,
1993. Paragraph 3(b) of the scheme defines FCCBs as “bonds issued in accordance with the scheme and
subscribed by a non-resident in foreign currency and convertible into ordinary shares of the issuing company in
any manner either in whole or in part, on the basis of any equity related warrants attached to debt instruments”.
Following, are the salient features of FCCBs:
1. FCCBs are similar to convertible debentures/bonds as issued in the Indian Capital Market. They give the
holder thereof the right to convert the bond into equity shares of the issuing company.
2. FCCBs have a fixed rate of interest and are converted into certain number of shares at a pre-fixed price.
3. The bonds are listed and traded on one or more stock exchanges abroad.
4. FCCBs are attractive to issuer company because of lower cost than that of alternative fixed interest debt
instruments.
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5. For the investor these bonds offer an opportunity to participate in the capital growth of a company. He not
only receives fixed income from the bonds as long as he holds them but stands to make a capital gain by
converting the bonds into equity.
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6. FCCBs may be issued in a currency that differs from the currency in which shares of the company are
denominated. Such issues gives the bond holder to participate in foreign stock markets.
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7. It is preferred by foreign investors because of conversion option, dollar denomination servicing and the
arbitrage opportunities during conversion at a discount on prevailing Indian market price.
8. They are generally unsecured.
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Following benefits are derived from FCCBs:
1. The cost of raising equity funds from international market is generally lower than the cost of domestic issue.
2. It implies acceptance of sophisticated western investors which in turn would help to enhance the image of
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the company and its product internationally.

3. It normally offers comparatively better share value.
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4. It will broaden the shareholder base and enhance investors quality.

5. It enables the tapping of international capital.
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6. It is listed and traded in international stock exchange and hence are free from delivery and settlement
problems.
7. It is generally denominated in US dollars and conversion into shares happens subsequently and hence
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reduces foreign exchange risk for the issuer.

8. Dividend, interest and capital gains on investment in Euro Issues instruments carry concessional tax rates.
9. Investors in Euro Issues are not required to comply with a large number of complex formalities and
regulation normally required for investment through domestic stock exchange.
Global Depository Receipts (GDRs)

The most convenient and cost effective method of raising finance abroad for a company is to issue its securities
to a depository bank in a foreign country. The securities are issued in the local currency but the proceeds are
collected in foreign currency. The depository bank then raises funds against these shares by issuing a negotiable
certificate called the Global Depository Receipt (GDR). These GDRs are denominated in a freely convertible
foreign currency like US dollar, Euro, GBP, etc. They are also known as International Depository Receipts (IDRs).
The company may thus raise capital in any country in a cost efficient manner and its subsequent marketing to
local investors is handled by the depository bank in that country. GDRs can be used for issuing any security but
they are most popular for issuing shares and FCCBs. The salient features are as follows:
(1) A company issues securities denominated in local currency to a depositary bank in a foreign country.
Though the securities are denominated in local currency, the issuing company collects the issue proceeds
in foreign currency and thus it is able to utilize the same for meeting the foreign exchange component of
project cost, repayment of foreign currency loans etc.

(2) The depositary bank raises funds by issuing GDRs against these securities. The holder of each GDR is
entitled to a predetermined number of securities mentioned therein. The standard is 10 securities per GDR
but a different ratio may be used. For example, 10 share for every receipt.
(3) The investors in GDRs are primarily large institutions.
(4) The GDRs are then traded on different stock exchanges in the world where they have been listed.
(5) The holders of GDRs are entitled to dividend/interest declared by the company which is paid to them
through the depositary bank.
(6) Holders of GDRs for shares do not have voting rights.
(7) The investors in the GDRs need not have a demat account in the country of the issuing company. Hence, it
allows investors to invest abroad without the hassle of various formalities.
(8) GDR is denominated in foreign currency whereas the securities underlying each GDR are denominated in
domestic currency. Hence there is no exchange risk for the issuer on conversion.
(9) The GDR gives the holder an option to convert the same into securities underlying it and hold securities
instead of GDR. However, the foreign investor may have to open a demat account in the country in which
the issuing company is registered.
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(10) An investor who wants to cancel his GDR may do so by advising the depository and obtain the shares in
lieu of the GDR. In India, the GDR may be cancelled only after a cooling period of 45 days.
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(11) The holder of the GDR is not entitled to any voting rights, so the company does not have the fear of losing
the management control. The right to vote is not denied to the shareholder but is only suspended by the
virtue of an agreement with the depository to the effect that GDR holders are not entitled to any voting
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right on the GDRs held by him.
American Depository Receipts (ADRs)

The most convenient and cost effective method for a non-US company to raise finance in United States is to
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issue its securities to a depository bank in the United States. The securities are issued in the local currency but
the proceeds are collected in US dollars. The depository bank then raises funds against these shares by issuing
a negotiable certificate called the American Depository Receipt (ADR). These ADRs are denominated in dollars.
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They are negotiable certificates which trade on various stock exchanges in the US were they have been listed.
ADRs may be used for issuing shares or bonds.
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The salient features are as follows:

(1) A company issues securities denominated in local currency to a depositary bank in a the United States.
Though the securities are denominated in local currency, the issuing company collects the issue proceeds
in dollars and thus it is able to utilize the same for meeting the foreign exchange component of project
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cost, repayment of foreign currency loans etc.

(2) The depositary bank raises funds by issuing ADRs against these securities. The holder of each ADR is
entitled to a predetermined number of securities mentioned therein. The standard is 10 securities per ADR
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but a different ratio may be used. For example, 10 share for every receipt.
(3) The investors in ADRs are primarily large institutions.
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(4) The ADRs are then traded on different stock exchanges in the United States where they have been listed.
(5) The holders of ADRs are entitled to dividend/interest declared by the company which is paid to them
through the depositary bank.
(6) Holders of ADRs for shares do not have voting rights.
(7) The investors in the ADRs need not have a demat account in the country of the issuing company. Hence, it
allows investors to invest abroad without the hassle of various formalities.
(8) ADR is denominated in foreign currency whereas the securities underlying each ADR are denominated in
domestic currency. Hence there is no exchange risk for the issuer on conversion.
(9) The ADR gives the holder an option to convert the same into securities underlying it and hold securities
instead of ADR. However, the foreign investor may have to open a demat account in the country in which
the issuing company is registered.
(10) An investor who wants to cancel his ADR may do so by advising the depository and obtain the shares in
lieu of the ADR. In India, the ADR may be cancelled only after a cooling period of 45 days.
(11) The holder of the ADR is not entitled to any voting rights, so the company does not have the fear of losing
the management control. The right to vote is not denied to the shareholder but is only suspended by the
virtue of an agreement with the depository to the effect that ADR holders are not entitled to any voting
right on the ADRs held by him.
Foreign Direct Investment (FDI), Foreign Institutional Investment (FII) & International Financial Management Ɩ 199
Euro Convertible Bonds (ECB)
These are convertible bonds issued in foreign currency convertible into predetermined number of equity shares at
a future date. Euro bonds may be issued in any currency and are named after the currency they are denominated
in; e.g. Eurodollar Bonds, Europound Bonds, etc. The conversion is normally at a premium. The bonds carry a
fixed coupon. Sometimes the issuing company may include a put & call option in the terms of the issue. The call
option gives the company an option to enforce an early conversion in case the share price rises steeply before
conversion date. On the other hand the put option gives the investor an option to sell the bond back to the
company at a predetermined price and opt out of the conversion if the share price falls steeply before conversion
date.
International Capital Budgeting

International capital budgeting decisions are more complex than domestic investment decisions. The following
factors make them more complex:
(1) Estimating cash flows from a foreign market requires a good understanding of that market & the mindset of
the people that country.
(2) Cash flows from the foreign project have to be convert into the currency of the parent company and are
subject to exchange rate fluctuations.
(3) Exchange rate fluctuations over a long period of time a almost impossible to predict.
(4) The profits are subject to double taxation.
(5) The rate to be used for discounting has to be determined.
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(6) There may be restriction on remittances of foreign exchange.
(7) Investments are subject to the risk of political uncertainty.
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(8) Estimation of terminal value of such projects is generally difficult.
Evaluation of proposal can be done by any one of the following methods:
(1) Foreign Currency Approach: The foreign currency cash flows are discounted at an appropriate discount rate
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to find the NPV in the foreign currency. The NPV is then converted to domestic currency using spot rate.
(2) Home Currency Approach: The foreign currency cash flows are first converted into domestic currency cash
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flows on the basis of estimated forward rates. The domestic currency cash flows are then discounted at the
appropriate discount rate to arrive at the NPV.
Multinational Cash Management

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Multinational companies must manage their cash efficiently. A multinational company may have surplus cash
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in more than one country and face a shortage of funds in others. The issue is further compounded by the fact
that is surpluses & shortages are in different currencies. How surplus currencies have to be efficiently & cost
effectively converted for meeting the shortages has to be planned carefully. Investing the surplus cash when not
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required is also to be planned. The main objectives of international cash management are:
(1) To minimize currency exposure risk.
(2) To minimize overall cash requirements of the company without disturbing smooth operations of the
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subsidiaries & group companies.

(3) To minimize transaction costs.
(4) Optimize cash flow movements.
(5) Invest excess cash.
Problems
GDR Issue
1.1 [C.A.] Odessa Limited has proposed to expand its operations for which it requires funds of $15 million, net
of issue expenses which amount to 2% of the issue size. It proposed to raise the funds though a GDR issue. It
considers the following factors in pricing the issue:
(i) The expected domestic market price of the share is `300
(ii) 3 shares underly each GDR
(iii) Underlying shares are priced at 10% discount to the market price
(iv) Expected exchange rate is `60/$
You are required to compute the number of GDRs to be issued and cost of GDR to Odessa Limited, if 20%
dividend is expected to be paid with a growth rate of 20%.

[GDRs to be issued 1.1338 million. Cost of GDR 20.76%]
1.2 Excel Ltd. has proposed to expand its operations for which it requires funds of $402 crores net of issue
expenses. it proposes to raise the required funds through GDR issue. It considers the following factors in pricing
the issue:
(1) The expected market price of the company’s equity share in the domestic market is `180 (face value `10
each).
(2) 6 shares underlie each GDR.
(3) The underlying shares are to be priced at a discount of 10% to the market price.
(4) The expected exchange rate is `42/$.
(5) Dividend just paid on equity shares is 15%.
(6) Growth expected on equity shares is 8% p.a.
(7) The issue costs amount to 2% of the issue size.
Compute the number of GDRs that have to be issued and also the cost of GDR to the company.
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[No. of GDRs 17.725 crores. Cost of equity 9.02%]
International Capital Budgeting
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2.1 [C.A.] XY Limited is engaged in large retail business in India. It is contemplating for expansion into a
country of Africa by acquiring a group of stores having the same line of operation as that of India.
The exchange rate for the currency of the proposed African country is extremely volatile. Rate of inflation is
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presently 40% a year. Inflation in India is currently 10% a year.
Management of XY Limited expects these rates likely to continue for the foreseeable future.
Estimated projected cash flows, in real terms, in India as well as African country for the first three years of the
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Year - 0 Year - 1 Year - 2 Year - 3
Cash flows in Indian ` (‘000) – 50,000 – 1,500 – 2,000 – 2,500
Cash flows in African Rands (‘000) – 2,00,000 + 50,000 + 70,000 + 90,000
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XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely. It evaluates
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all investments using nominal cash flows and a nominal discounting rate. The present exchange rate is African
Rand 6 to `1.
You are required to calculate the net present value of the proposed investment considering the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted rate.
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(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s high risk.
(iii) Ignore taxation.
Year - 1 Year - 2 Year - 3
PVIF @ 20% .833 .694 .579
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[NPV –11,156 (` ‘000)]

2.2 [C.A.] A USA based company is planning to set up a software development unit in India. Software developed
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at the Indian unit will be bought back by the US parent at a transfer price of US $10 millions. The unit will
remain in existence in India for one year; the software is expected to get developed within this time frame.
The US based company will be subject to corporate tax of 30% and a withholding tax of 10% in India and will
not be eligible for tax credit in the US. The software developed will be sold in the US market for US $ 12.0
millions. Other estimates are as follows:
Rent for fully furnished unit with necessary hardware in India `15,00,000
Man power cost (80 software professional will be working for 10 hours each day) `400 per man hour
Administrative and other costs `12,00,000
Advise the US company on financial viability of the project. The rupee-dollar rate is `48/$.
[Repatriation amount `22,71,15,000 or $4.7 million]
2.3 [C.A.] ABC Ltd. is considering a project in US, which will involve an initial investment of US $1,10,00,000.
The project will have 5 years of life. Current spot exchange rate is `48 per US $. The risk free rate in US is 8%
and the same in India is 12%. Cash inflow from the project are as follows:
Year Cash inflow
1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000
Calculate the NPV of the project using foreign currency approach. Required rate of return on this project is 14%.
[NPV $1.013 million, NPV `48.624 million]
2.4 [C.M.A. adapted] Endalco Ltd. (EL) of India is planning to set up a subsidiary in the USA (where hitherto
it was exporting) in view of the growing demand for its product and the competition from other MNCs.
The initial project cost (consisting of plant and machinery including installation) is estimated to be US dollar
400 million; working capital requirements are estimated at US dollar 40 million.
The Indian company follows the straight line method of depreciation.
The General Manager (Finance) of EL estimated data in respect of the project as follows:
(i) Variable cost of production and sales: $25 per unit.
(ii) Fixed costs per annum are estimated at $30 million.
(iii) The plant will be producing and selling 5 million units at $100 per unit.
(iv) The expected economic useful life of the plant is 5 years with no salvage value.
The subsidiary of the Indian company is subject to 40% corporate tax rate in the USA and the required return of
such a project is 12%. The current exchange rate between the two countries is `48/US dollar and the dollar is
expected to appreciate by 2% p.a. for the next 5 years.
The subsidiary will be allowed to repatriate 70% of the CFAT every year along with the accumulated arrears
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of blocked funds at year end 5. The withholding taxes are 10%. The blocked funds will be invested in the USA
money market by the subsidiary, earning 4% (free of tax) per year.
Advise EL regarding financial viability of having a subsidiary company in the USA, assuming no tax liability in
India on earnings received by EL from the US subsidiary.
Note: Extract for from the table:
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(i) Future value in year 5 of Re. 1 each during 1 to 4 years invested at 4% per year = 4.246
(ii) The present value factor at 12% discount rate are:
Year 0 1 2 3 4 5
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P.V. 1.000 0.8929 0.7972 0.7118 0.6355 0.5674
[NPV `17,802 million]
International Cash Management

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3.1 [C.A.] Your bank’s London office has surplus funds to the extent of USD 5,00,000 for a period of 3 months.
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The cost of the funds to the bank is 4% p.a. It proposes to invest these funds in London, New York or Frankfurt
and obtain the best yield, without any exchange risk to the bank. The following rates of interest are available at
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the three centres for investment of domestic funds thereat for a period of 3 months.
London 5% p.a.
New York 8% p.a.
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Frankfurt 3% p.a.
The market rates in London for US dollars and Euro are as under:
London on New York Spot 1.5350/90
1 month 15/18
2 month 30/35
3 month 80/85
London on Frankfurt Spot 1.8260/90
1 month 60/55
2 month 95/90
3 month 145/140
At which centre, will the investment be made & what will be the net gain (to the nearest pound) to the bank on
the (to the nearest pound) to the bank on the invested funds?
[(i) London: Gain £1,662 (ii) New York: Gain £3,231 (iii) Frankfurt: Gain £2,047]
3.2 [C.A.] AMK Ltd. an Indian based company has subsidiaries in U.S. and U.K. Forecasts of surplus funds for
the next 30 days from two subsidiaries are as below:
U.S. $12.5 million
U.K. £6 million

Following exchange rate informations are obtained:
$/` £/`
Spot 0.0215 0.0149
30 days forward 0.0217 0.0150
Annual borrowing/deposit rates (Simple) are available.
` 6.4%/6.2%
$ 1.6%/1.5%
£ 3.9%/3.7%
The Indian operation is forecasting a cash deficit of `500 million.
It is assumed that interest rates are based on a year of 360 days.
(i) Calculate the cash balance at the end of 30 days period in rupees for each company under each of the
following scenarios ignoring transaction costs and taxes:
(a) Each company invests/finances its own cash balances/deficits in local currency independently.
(b) Cash balances are pooled immediately in India and the net balances are invested/borrowed for the
30 days period.
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(ii) Which method do you think is preferable from the parent company’s point of view?
[(i) (a) India – `5,02,667, US `5,76,757, UK `4,01,233 (b) `4,86,581 (ii) Immediate pooling]
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Chapter Foreign Exchange Exposure and Risk
13 Management
Some Currency Codes & Symbols
Country Currency ISO Code Symbol
United States United States dollar USD $
United Kingdom British Pound GBP £
Canada Canadian dollar CAD $
Australia Australian dollar AUD $
Switzerland Swiss Franc CHF Fr/SFr
European countries Euro EUR €
India Rupee INR `
Pakistan Pakistani rupee PKR Rs
Hong Kong Hong Kong dollar HKD $
Japan Japanese Yen JPY ¥
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People’s Republic of China Chinese Yuan CNY ¥
Basic Concepts
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Foreign exchange refers to the exchange of one currency with another. The exchange rate is rate at which a
currency is bought or sold. Foreign exchange rates are quoted in two ways: direct quote and indirect quote.
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Direct Quote
A direct quote indicates the home currency that is exchanged for one unit of foreign currency. For example, in
India the price of US dollar is `48.30 per US $. This is written as A/B where A is the units of home currency to be
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paid for every unit of foreign currency B. Thus, INR/USD 48.30 means that `48.30 is to be paid for purchase of $1.
!! Note that in the quotation INR/USD 48.30, 48.30 does not have any currency symbol. It is understood to be the
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first currency in the INR/USD quote.

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Indirect Quote
An indirect quote indicates the units of foreign currency to be paid for 1 unit of home currency and is simply
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the reciprocal of the direct quote. Thus, the dollars to be paid for `1 would be an indirect quote in India and is
computed as:
1 1
= = 0.0207
Direct quote 48.30
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Thus, USD/INR 0.0207 indicates that $0.0207 has to be paid for purchasing `1.
A direct quote can be found from an indirect quote by simply taking the reciprocal of the
indirect quote and vice versa.
In UK, the Great Britain Pound (GBP) to US Dollar (USD) is direct quote; for example GBP/USD 0.7692 indicating
that £0.7692 has to be paid for purchasing US $1. The indirect quote USD/GBP would be = 1/0.7692 = 1.3
indicating that US $1.30 will have to be paid for purchasing £1.
American & European Quotes
Every country will need to have a direct and an indirect quote with every other country and this would make it
impossible to keep track of foreign exchange rates. To overcome this difficulty, the quotes are usually given in
the currency which is acceptable worldwide, i.e. the US dollar. Two quotes are commonly used internationally:
(1) American Quote: An American quote is a direct quote for the United States; i.e. in the form USD/xxx where
‘xxx’ is any other currency.
(2) European Quote: A European quote is an indirect quote for the United States; i.e. in the form xxx/USD
where ‘xxx’ is any other currency. For e.g., INR/USD is a European quote even if INR is not a European
currency.

Bid & Ask Rates
Foreign exchange dealers and banks quote two rates for converting foreign exchange. A ‘Bid’ rate and an ‘Ask’
rate. The ‘bid’ rate is the rate that the bank/dealer bids (offers to pay) for every unit of a foreign currency you
want to sell. The ‘ask’ rate is the rate the dealer asks for (asks you to pay) or at which the bank/dealer will sell
you every unit of a foreign currency. Thus, a bank/dealer may quote INR/USD 62.50 - 61.80. This indicates
that if you want to sell USD then the bank/dealer will pay (‘bid’) `61.80 for every dollar but to buy 1 dollar the
bank/dealer will ‘ask’ you to pay `62.50. The difference between the two rates is called ‘spread’. The spread
helps the banks/dealers to cover their administrative costs and make a profit.
!! While solving problems the students should know which rate to look for. For example, following two quotes are
available: INR/USD 60.50 - 62.00 & GBP/USD 0.67 - 0.70. We have INR with which we want to buy USD and
then convert them into GBP. For buying USD we use the rate 62.00. From the second quote we use the rate 0.67 as
the rate is for buying & selling USD and we will be selling USD to get GBP!
Cross Rates
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!! Internationally a cross rate means an exchange rate that does not have the USD in it. This is because all currencies
are tracked against the USD for convenience. Generally, a cross rate means an exchange rate that does not have the
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home currency in it. From a computation point of view, cross rates can be understood as two or more quotes from
which we can compute another quote.
If foreign exchange rates are available between currency A and B as well as between B and C then the exchange
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rate between A and C can be computed as follows:
A/C = A/B × B/C
For example, INR/USD is 48.30 and GBP/USD is 0.7692. To find INR/GBP we need the rates INR/USD and USD/
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GBP. As USD/GBP is not available, we can find it as the reciprocal of GBP/USD.
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Thus, USD/GBP = = 1.30. Now, INR/GBP is computed as:
0.7692
INR/GBP = INR/USD × USD/GBP
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= 48.30 × 1.30
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= 62.79
This indicates that `62.79 has to be paid for every £1.
Rates
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(1) Cash Rate (T+0) – The rate applicable for immediate settlement (buying or selling) of foreign exchange.
Settlement is done on the date of the transaction itself.
(2) Tom Rate (T+1) – The rate applicable for settlement to be done one day after the transaction date.
(3) Spot Rate (T+2) – The rate applicable for settlement to be done two days after the transaction date.
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(4) Forward Rate (T + >2) – The rate applicable for settlement to be done beyond a period of two days after
the transaction date. Settlement could be 3 days or several months after the transaction date, as agreed
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between the parties.
Computing appreciation or depreciation in a currency

To find the appreciation or depreciation of a currency we need to know the spot price (S) and forward price (F)
per unit of currency for which we want to compute the appreciation or depreciation. In other words, we use
the direct quote to compute appreciation or depreciation in a currency. To find appreciation or
depreciation of the rupee against other currencies we need to known the exchange rate per rupee; i.e. indirect
quote in India. The appreciation or depreciation is the difference between the spot price and futures price
expressed as a percentage per annum of its spot price. If the forward price is higher then it would amount to
appreciation of that currency and vice versa. The appreciation or depreciation is computed as under:
F−S 365
× 100 ×
S n
Where,
F = forward price of the currency
S = spot price of the currency
n = number of days till date of forward price
Foreign Exchange Exposure and Risk Management Ɩ 205

For example, INR/USD rate is 48 today. The forward (90 days) rate being INR/USD 49.
The appreciation in USD is given by:
49 − 48 365
× × 100 = 8.45%
48 90
The depreciation is INR is given by:
To find depreciation in INR, we first need to find the direct quotes for INR. (However, a short-cut formula is also
available)
S: USD/INR = 1/48 = 0.020833.
The forward (90 days) rate of USD/INR = 1/49 = 0.020408
0.020408 − 0.020833 365
× × 100 = – 8.27%
0.020833 90
!! Observe that the rate of appreciation of USD is not the same as depreciation in INR.
Short-cut to find appreciation/depreciation when indirect quote is available –
S−F 365
× 100 ×
F n
Where,
S = spot exchange rate
F = forward exchange rate
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n = number of days till date of forward price
Applying the short-cut to the above illustration:
48 − 49
49
×
365
90
× 100 = – 8.28%
Determining Exchange Rates ss

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The foreign exchange rates are determined by demand and supply of the currency. Demand for a currency is
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influenced by international trade, speculation, balance of payments position of a country, economic fundamentals,
interest rates, inflation rates, etc.
Certain theories help us to determine the theoretical foreign exchange rates that should prevail between two
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currencies. If the actual rates are not equal to the theoretical rates then it will open up opportunities for arbitrage.
Exchange Rate Theories

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(1) Interest Rate Parity Theory (IRPT):

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As per this theory, the interest rates prevailing in two countries will influence the rate of exchange of the
currencies of the two countries. If the interest rates in two countries are different the exchange rates will
move in such a manner that it brings about a parity in interest rate. The currency of the country with
higher interest rate will depreciate to offset the higher rate of interest. For example, the rate of interest in
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India is 10% and that in US is 8%. In an efficient capital market, an investor in the US who has $100 for
investment will want to invest in India to earn higher interest. However, as per the IRPT, he will be denied
this arbitrage opportunity due to depreciation in the value of the rupee.
Value of $100 invested in US after 1 year = $100 (1.08) = $108
Say INR/USD is `48.
Investment in India would be = $100 × `48 = `4,800
Value of `4,800 invested in India after 1 year will be = `4,800 (1.10) = `5,280
If the INR/USD rate remains `48 then the amount of dollars that the US investor will get on maturity –
5,280
= $110 i.e. $2 more than what he could earn by investing in the US.
48
As per IRPT, the value of the investment to US investor will the same as it would have been if he had
invested the sum in US, i.e. $108. In other words, he will be able to buy only $108 with `5,280 he gets
from his investment in India because the value of the rupee will have depreciated. The new rate for the
dollar would be:
`/$ = 5,280/108 = `48.89
The exchange rate of INR/USD will have increased from `48 to `48.89 due to depreciation in the value of
the rupee.

As per this theory, the following condition must hold good –
1 + rh F 1 + rh
= or to find forward rate F= S ×
1 + rf S 1 + rf
Where,
rh = interest rate in home country
rf = interest rate in foreign country
F = forward exchange rate of the foreign currency
S = spot exchange rate of the foreign currency
This method can help us to find out the theoretical forward price of the foreign currency. If the actual
forward price is not equal to the theoretical forward price then it will give rise to arbitrage opportunities.
Interest Rate Differential
As per IRPT the forward premium/discount on the exchange rate will be approximately equal to the
interest rate differential between the two countries.
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Interest rate differential p.a. = Exchange rate differential p.a.
This condition can be expressed as (converted from a forward rate for a period of less than a year):
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F−S 365
× = rh − rf
S n
!! In the above formula the LHS is not multiplied by 100 as the interest rates on the RHS are written in decimal.
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This is convenient for solving.
(2) Purchasing Power Parity Theory (PPPT):

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As per this theory, the exchange rates between the currencies of two countries are determined by the
inflation rates in the two countries. If the inflation rates in the two countries are different then a trader can
benefit by buying goods in the country with lower inflation (lower prices) and selling in the country with
higher inflation (higher prices). However, the PPPT states that the value of the currency of the country
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having higher inflation will depreciate and deny arbitrage opportunities to the trader.
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Say INR/USD is `50 and rate of inflation in India is 5% against 2% in US.

A product is available in the US for $1. The price of a similarly quality product in India should be `50.
Price in US after 2% inflation = $1 (1.02) = $1.02
Price in India after 5% inflation = `50 (1.05) = `52.50
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If the exchange rate does not change then the effective selling price in India in terms of dollars would be –
52.50
= $1.05 i.e. $0.03 more than in the US.
50
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However, as per the PPPT theory this arbitrage opportunity will not be available due to depreciation in the
value of the currency of the country with higher inflation; in this case India. If a US trader sells goods in
India at the higher price of `52.50 when he converts the rupees to USD he will be able to get $1.02, as the
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rupee will have depreciated or the dollar appreciated, and therefore the he does not benefit as this is the
same price that he would get in the US. This gives the new exchange rate as –
52.50
= `51.47
1.02
As per this theory, the following condition must hold good –
1 + ih F 1 + ih
= or to find forward rate F= S ×
1 + if S 1 + if
Where,
ih = inflation rate in home country
if = inflation rate in foreign country
F = forward exchange rate of the foreign currency
S = spot exchange rate of the foreign currency
This method can help us to find out the theoretical forward price of the foreign currency. If the actual
forward price is not equal to the theoretical forward price then it will give rise to arbitrage opportunities.

Arbitrage
Arbitrage refers to simultaneous purchase & sale of the same asset in different markets to take advantage of
temporary difference in prices. Arbitrage opportunities may arise in the following ways –
(1) Geographical Arbitrage: Exchange rates may differ in different markets around the world giving rise to
arbitrage opportunities.
(2) Cross Rate Arbitrage: This would include conversion using cross rates. For example, instead of converting
rupees into dollars directly it may be beneficial to convert rupees into pounds first and thereafter convert
the pounds into dollars. However, the cost of the double conversion should be taken into consideration.
Sometimes, the conversion rupees→dollars→pounds→rupees (or other combination of currencies) results in
a gain if the spread is large enough to cover the cost of the multiple conversions and leave some profit.
(2) Forward Rate Arbitrage: The theoretical and actual exchange rates in the forward market may be different
which will provide arbitrage opportunities.
(3) Interest Rate Differential Arbitrage: Where the interest rate parity theory does not hold then there may be an
opportunity to carry out a covered interest arbitrage. A covered interest arbitrage involves simultaneously
borrowing in one currency & lending in another currency and covering the transaction by entering into a
forward exchange contract. Interest rate that should be prevailing in two countries are compared by using
the Interest Rate Parity Theory. If the IRPT does not hold then there is arbitrage opportunity. If the actual
interest rate in a country in more than what is indicated by the IRPT then investment is made in that
country while borrowing is done in the other country or vice versa.
Hedging
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Risk refers to uncertainty. In foreign currency transactions, risk arises due to fluctuation in the exchange
rates. Fluctuation in exchange rates are not always adverse but the risk arises due to the uncertainty about the
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fluctuation. Risk cannot be eliminated but it has to be managed to an acceptable level. “Acceptable level” of risk
will differ from person to person. It depends upon each person’s ability & willingness to take risk. The different
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types of exchange risks are:
(1) Transaction risk: An enterprise having foreign currency transactions like imports payables, exports
receivables, foreign currency loans & interest payment thereon, etc. are exposed to the risk of adverse
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fluctuation in exchange rates.
(2) Translation risk: This is the risk associated with loss in translation of foreign currency assets, liabilities,
incomes & expenses due to devaluation in currency in which they are denominated.
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(3) Economic risk: The long term adverse fluctuations in the exchange rates may affect the cash flows of the
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firm which in turn affect the value of the firm. For example, a manufacturing facility set up in a foreign
country which was highly profitable becomes totally unviable due to devaluation of the currency of that
country. These risks are difficult to foresee or manage.
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Hedging is a technique which involves taking action to minimize the effect of fluctuation in exchange rate. Some
of the methods available for hedging are:
(1) Home Currency Invoicing
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(2) Leading & lagging.

(3) Forward exchange contracts.
(4) Money market hedge.
(5) Currency futures & options.
(6) Netting
(1) Home Currency Invoicing: The risk of foreign currency rate fluctuation can be avoided by invoicing in the
home currency. As no foreign currency is involved the risk of fluctuation is totally avoided. This method
effectively transfers the risk to the counterparty. This method will be particularly effective for imports
from a country with a strong currency and exports to a country with a weak currency. However, most of
the international transactions are done in the major currencies of the world which may not be the home
currency of either the buyer or the seller — US dollar, British pound, Japanese Yen or Euro.
(2) Leading & lagging: Leading means advancing the date of payments or receipts and lagging means delaying.
In case of imports, a simple way to hedge the risk of exchange rate fluctuations is to make foreign
exchange payments immediately (leading), even if credit period is available, if it is expected that the
foreign currency is likely to appreciate. If the foreign currency is expected to depreciate, then the payment
may be delayed (lagging), even if it involves paying interest for the delay, as it may be beneficial to do
so. Whether it is beneficial to lead or lag can be decided only after computing the cash outflow of each

alternative in the local currency.
In case of exports, conversion of foreign currency can be delayed if the home currency is likely to
depreciate. If home currency is likely to appreciate, then it may be beneficial to convert the foreign into
home currency at an early date. In either case, the opportunity cost of interest on investment should be
taken into consideration.
(3) Forward exchange contracts: An importer or exporter may enter into a forward contract with a bank to
buy or sell foreign exchange. The bank usually allows the client to cancel the contract by paying some
cancellation charges. However, cancellation of the forward contract involves taking an opposite contract
with the bank. For example, an importer has entered into a forward contract with the bank to sell foreign
and to cancel the contract he has to enter into another contract with the bank for purchase of foreign
exchange. The difference between the rates of the two contracts will be profit/loss of the importer.
Sometimes, the date of requirement of foreign exchange may have to be extended. For extending the
contract, the original forward contract has to be cancelled by taking an offsetting position and also paying
cancellation charges thereafter a new forward contract has to be entered into at the prevailing forward
exchange rates.
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(4) Money market hedge: The market for short-term instruments is called money market. Borrowing or lending
for short-term can be undertaken in the money market. Period of borrowing or lending can be as short as 1
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day (24 hours) up to one year.
In case of imports, if it is expected that foreign currency is likely to appreciate then the following steps
are carried out:
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(i) The foreign currency is purchased immediately. The amount purchased is the PV of the foreign
currency liability discounted at the deposit rate applicable to the maturity period.
(ii) Investment is made in the money market in the foreign currency for a period which matures around
the date on which the foreign currency liability is to be paid.
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(iii) The investment maturity date coincides with the liability due date. The investment & interest thereon
will be equal to the liability and the proceeds are used to settle the liability.
To find out the efficacy[1] of this hedge, compute the cash outflow in the local currency and compare with
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other alternatives.
In case of exports, if the foreign currency is likely to depreciate then the following steps are carried
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out:
(i) A loan is taken in such foreign currency. The amount of borrowing will be the PV of the expected
amount in foreign currency discounted at the rate of borrowing applicable for the period from the
date of borrowing to the date when the foreign currency dues are to be received.
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(ii) The foreign currency loan is immediately converted to the home currency. The home currency is
then invested in the local money market till the due date as the proceeds were not due till that date
anyway.
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(iii) When the foreign currency proceeds are received on due date the foreign currency loan together with
the interest will be equal to the proceeds and the proceeds are used to settle the loan.
To find out the efficacy of this hedge, compute the cash inflow in the local currency on the due date and
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compare with other alternatives.

(5) Currency futures & options: Futures and options are available for different currencies. These may be used
to lock in a favourable rate of foreign exchange. However, as the futures and options are of standard size,
it may result in under- or over-hedging. It is better to over-hedge than to under-hedge. In case of imports,
long futures or call option in foreign currency needs to be bought. In case of exports, short futures or put
option in foreign currency needs to be bought.
(6) Netting: If a firm has both receivables & payables in the same foreign currency then the simpled way of
avoiding exchange rate fluctuation risk is to net the two and convert only the remaining amount. This not
only eliminates the exchange rate fluctuation risk for the netted amount but also saves the conversion cost
for the same. Only the net receivable or net payable is exposed to risk. The cost of hedging is also reduced.
Netting has the following variation –
(i) Bilateral Netting: This involves netting between two entities. The net amount is paid or received as
the case may be.
(ii) Multilateral Netting: This involves a group of entities which may be subsidiaries or group companies.
The procedure is more elaborate than bilateral netting as the amounts may be owed to one another
and that too involving different currencies. This is usually handled by the central treasury department.
1 Capacity or power to produce the desired effect.

Where multiple currencies are involved, a common currency as well as the method of establishing
the exchange rate has to be decided for netting.
(iii) EEFC Account for Netting: Reserve Bank of India has the Exchange Earners’ Foreign Currency (EEFC)
Account Scheme whereby export proceeds and certain other inwards remittances in foreign currency
can be retained and used for meeting commitments under current account transactions. Thus, foreign
currency earnings can be used to pay foreign currency obligations.
Nostro, Vostro & Loro Accounts

Banks are the largest dealers in foreign exchange. In the process of such deals they transfer large amounts of
foreign exchange to various accounts on their own account as well as on account of their clients. They also hold
foreign exchange on behalf of other banks. They have accounts of other banks with them and also open their
account with other banks. These accounts are called ‘Nostro’, ‘Vostro’ & ‘Loro’ accounts.
(1) Nostro Account: It is a bank account held in a foreign country by a domestic bank or authorized forex
dealer, denominated in the currency of that country. Nostro accounts are used to settle foreign exchange and
trade transactions. ‘Nostro’ is derived from the Latin word for “our”. A separate account is opened for each
currency.
(2) Vostro Account: It is a bank account of a foreign bank or authorized dealer with a domestic bank in the local
currency. This is the converse of a Nostro account. ‘Vostro’ is derived from the Latin word for “your”.
(3) Loro Account: The Loro account is an account wherein a bank remits funds in foreign currency to another
bank for credit to an account of a third bank. ‘Loro’ is derived from the Latin word for “their”.
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Exchange Position & Nostro Account
Exchange dealers maintain only a small quantity of foreign exchange stock for sale. This is because of the risk
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of rate fluctuation. Whenever foreign exchange is required by a customer they arrange for it to be delivered
subsequently. Therefore, a forex dealer quotes the following exchange rates:
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Exchange rates quoted by dealers
(1) Cash Rate (T+0) – The rate applicable for immediate settlement (buying or selling) of foreign exchange.
Settlement is done on the date of the transaction (T) itself.
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(2) Tom Rate (T+1) – The rate applicable for settlement to be done one day after the transaction date.
(3) Spot Rate (T+2) – The rate applicable for settlement to be done two days after the transaction date.
(4) Forward Rate (T + >2) – The rate applicable for settlement to be done beyond a period of two days after
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the transaction date. Settlement could be 3 days or several months after the transaction date, as agreed
between the parties.
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Exchange position
A foreign exchange dealer places orders for buying & selling foreign currency with a foreign bank. Exchange
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position shows the difference between order for purchase & sales. If the order for purchases exceeds the order
for sales then it is said to be ‘overbought’ position. If the order for sales exceeds the order for purchases then it
is said to be ‘oversold’ position.
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Purchases will cover transactions like: purchases made to cover sale to domestic customers, orders for spot
T.T. purchase of foreign exchange, forward purchase, purchase of bills of exchange in foreign currency which
is sent to the foreign bank for collection, travelers cheques & drafts issued in foreign currency which are to be
cancelled, forward contract for sales which are to be cancelled, etc.
Sales will cover transactions like: foreign currency purchased from domestic customers which has to be sold,
forward contract for purchase of foreign currency which has to be sold forward, sale to cancel forward purchase
contracts, sale of foreign currency received on issue of international travelers cheques/drafts, etc.
Computation for exchange position is shown as follows:
Therefore exchange position is basically like a foreign order book position showing the orders placed for buying
& selling foreign currency and shows both spot as well as forward transactions. The Nostro account
a foreign currency current account showing actual balance of a particular foreign currency and only actual
receipts & payments affect the balance in this account. This account is used for receiving & paying the foreign
exchange. Forward positions do not affect the balance in the Nostro account and receipts/payments are only on
actual transaction dates.
Exchange Position
Particulars Purchase Sales
Opening balance (overbought) xx

or
Opening balance (oversold) xx
Spot purchases xx
Spot sales xx
Forward purchases xx
Forward sales xx
Forward purchases cancelled xx
Forward sales cancelled xx
Bills purchased xx
Travelers cheques/Draft issued xx
Travelers cheques/Draft cancelled xx
Total xx xx
Closing balance (overbought) xx
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or
Closing balance (oversold) xx
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Total xx xx
Nostro Account
Nostro Account is a current account which shows the foreign currency balance therein. Normally a forex dealer
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maintains a credit balance in the account to pay for purchase of foreign currency but the balance does not earn
any interest. Interest is payable if amount is overdrawn. Orders for forward purchase/sales do not affect the
balance in this account as the transaction will happen at a future date.
Cash Position or Nostro Account
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Particulars Credit Debit
(deposits) (withdrawals)
Opening balance (Credit or Debit) xx xx
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Spot purchases xx
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Spot sales xx
Bills realized xx
Travelers cheques/Draft encashed xx
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Total xx xx
Closing balance (credit) xx
or
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Closing balance (overdrawn) xx

Total xx xx
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Problems
Conversion, Cover rate, Appreciation & Depreciation, etc.
1.1 [C.A.] The following 2-way quotes appear in the foreign exchange market:
Spot 2-months forward
`/US $ 46.00/46.25 47.00/47.50
Required:
(i) How many US dollars should a firm sell to get `25 lakhs after 2 months?
(ii) How many Rupees is the firm required to pay to obtain US $ 2,00,000 in the spot market?
(iii) Assume the firm has US $ 69,000 in current account earning no interest. ROI on Rupee investment is 10%
p.a. Should the firm encash the US $ now or 2 months later?
[(i) $53,191.489 (ii) `92,50,000 (iii) `31,74,000]
1.2 [C.S.] The following rates appear in the foreign exchange market:
Spot rate 2-month forward
Re/US $ `45.80/46.05 `46.50/47.00
(i) How many dollars should a firm sell to get `5 crores after 2 months?
(ii) How many rupees is the firm required to pay to obtain US $2,00,000 in the spot market?

(iii) Assume the firm has US $50,000. How many rupees does the firm obtain in exchange of US $?
[(i) US $10,75,268.81 (ii) `92,10,000 (iii) `22,90,000]
1.3 [C.S.] The following direct quotes have been observed from the forex market:
(i) `/US$ : 43.70
(ii) `/UK£ : 77.02
(iii) `/Euro : 53.50
(iv) Forward rate (60 days) for the Euro is `54.50/Euro
(v) DM/Dollar : 1.578 (overseas)
Find – (1) Indirect quotes in respect of (i) to (iii)
(2) Forward discount on the Indian Rupee.
(3) Cross rates for Rupee/DM.
[(1) (i) 0.0229 (ii) 0.0130 (iii) 0.0187 (2) 11.16%; (3) `/DM 27.69]
1.4 [RTP] ABN-Amro Bank, Amsterdam, wants to purchase `15 million against US$ for funding their Vostro
account with Canara Bank, New Delhi. Assuming the inter-bank, rates of US$ is `51.3625/3700, what would
be the rate Canara Bank would quote to ABN-Amro Bank? Further, if the deal is struck, what would be the
equivalent US$ amount.
[`51.3625; US $2,92,041.86]
1.5 [C.A.] XYZ Bank, Amsterdam, wants to purchase `25 million against £ for funding their Nostro account and
they have credited LORO account with Bank of London, London.
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Calculate the amount of £’s credited. Ongoing inter-bank rates are per $, `61.3625/3700 & per £, $ 1.5260/70.
[£2,67,500]
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1.6 [C.S.] During a year, the price of British Gilts (face value £100) rose from £103 to £105 while paying a
coupon of £8. At the same time, the exchange rate moved from $/£ 1.70 to $/£ 1.58. What is the total return to
an investor in US who invested in the above security?
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[1.9645%]
1.7 [C.A.] The price of a bond just before a year of maturity is $5,000. Its redemption value is $5,250 at the
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end of the said period. Interest is $350 p.a. The Dollar appreciates by 2% during the said period.
Calculate the rate of return.
[14.24%]
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1.8 [C.S.] Management of an Indian company is contemplating to import a machine from USA at a cost of
US $15,000 at today’s spot rate of $0.0227272 per rupee. Finance manager opines that in the present foreign
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exchange market scenario, the exchange rate may shoot up by 10% after two months and accordingly he
proposes to defer import of machine. Management thinks that deferring import of machine will cause a loss of
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`50,000 to the company in the coming two months.

As the Company Secretary, you are asked to express your views, giving reasons, as to whether the company
should go in for purchase of machine right now or defer purchase for two months.
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[It will be beneficial to defer the purchase.]

1.9 [C.A., C.S.] You sold Hong Kong $1,00,00,000 value spot to your customer at `5.70/HK$ and covered
yourself in London market on the same day, when the exchange rates were:
US$1 = HK$7.5880 and HK$7.5920
Local inter-bank market rates for US$ were –
US$1 = `42.70 and `42.85
Calculate – (i) cover rate, and (ii) ascertain profit or loss in transaction. Ignore taxation.
[Profit `5,29,000]
1.10 [C.A. twice] The Bank sold Hong Kong Dollar 1,00,000 spot to its customer at `7.5681 and covered itself
in London Market on the same day, when the Exchange Rates were – US $ 1 = HK $ 8.4409 HK $ 8.4500. Local
Inter–Bank Market Rates for US $ were – Spot US $ 1 = `62.7128 `62.9624.
Calculate the Cover Rate and ascertain the Profit or Loss in the transaction. Ignore Brokerage.
[Cover rate `7.4592; Profit `10,890]
1.11 [C.A.] A Bank sold Hong Kong Dollars 40,00,000 value spot to its customer at `7.15 and covered itself in
London Market on the same day, when the exchange rates were:
US$ = HK$ 7.9250 7.9290

Local interbank market rates for US$ were:
Spot US$ 1 = `55.00 55.20
You are required to calculate rate and ascertain the gain or loss in the transaction. Ignore brokerage.
You have to show the calculations for exchange rate up to four decimal points.
[Gain `7,38,800]
1.12 [C.A.] You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T. on
Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = `6.5150. You are required to cover
the transaction either in London or New York market. The rates on that date are as under:
Mumbai `74.3000 `74.3200
London `49.2500 `49.2625
London - Copenhagen DKK 11.4200 DKK 11.4350
New York - Copenhagen DKK 07.5670 DKK 07.5840
In which market will you cover the transaction, London or New York, and what will be the exchange profit or
loss on the transaction? Ignore brokerages.
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[`7,119]
1.13 [C.A. twice] An importer is due to pay the exporter on 28th January 2010, Singapore Dollars of 25,00,000
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under an irrevocable letter of credit. It directed the bank to pay the amount on the due date.
Due to go-slow and strike procedures adopted by its staff, the bank was not in a position to remit the amount
due. The amount was actually remitted on 4th February 2010.
On the transaction, the bank wants to retain an exchange margin of 0.125%.
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The following were the rates prevalent in the exchange market on the relevant dates:
28th January 4th February
Rupee/US$1 `45.85/45.90 `45.91/45.97
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London Pound/Dollars $1.7840/1.7850 $1.7765/1.7775
Pound Sing $3.1575/3.1590 Sing $3.1380/3.1390
What is the effect on account of the delay in remittance? Calculate rate in multiples of .0001.
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[Loss `2,28,250]
1.14 [C.A.] Followings are the spot exchange rates quoted at three different forex markets:
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USD/INR 48.30 in Mumbai

GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
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The arbitrageur has USD 1,00,00,000. Assuming that there are no transaction costs, explain whether there is any
arbitrage gain possible from the quoted spot exchange rates.
[Gain US 1,12,968.26]
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1.15 [C.S.] Calculate the arbitrage gains possible on `10,00,000 from the middle rates given below. Assume
there are no transaction costs –
`76.200 = £1 in London
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`46.600 = $1 in Delhi
$1.5820 = £1 in New York.
[Net profit = `33,624]
1.16 [C.S.] Following are the spot exchange rates quoted at three different forex markets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD 1,00,00,000. Assuming that there are no transaction costs, explain whether there is any
arbitrage gain possible from the quoted spot exchange rates.
[Gain USD 1,12,968.27]
1.17 [C.S.] On the same date that the DM spot rate was quoted at $0.40 in New York, the price of the Pound
Sterling was quoted at $1.80.
(i) What would you expect the price of the Pound to be in Germany?
(ii) If the Pound was quoted in Frankfurt at DM 4.40/Pound, what would you do to profit from the situation?
[(i) 4.5 DM/1£ (ii) Sell DM in Frankfurt and buy Pound giving a profit of 2.27%]
1.18 [C.A.] Your forex dealer had entered into a cross currency deal and had sold US $10,00,000 against

EURO at US $ 1 = EUR 1.4400 for spot delivery.
However, later during the day, the market became volatile and the dealer in compliance with his management’s
guidelines had to square-up the position when the quotations were:
Spot US $1 INR 31.4300/4500
1 month margin 25/20
2 months margin 45/35
Spot US $1 EURO 1.4400/4450
1 month forward 1.4425/4490
2 months forward 1.4460/4530
What will be the gain or loss in the transaction?
[Loss `1,09,201.50]
Local Borrowing Vs Foreign Letter of Credit

An importer may finance his import of capital goods by borrowing. He has the choice of initially borrowing
locally or taking a Letter of Credit (LC) facility offered by a foreign branch. The key points to remember
while solving problems are:
(1) The option with the lower cash outflow in rupee terms for the period applicable to the LC will be chosen.
(I) The cash outflow for the LC will be:
(i) commission for LC at current exchange rate
(ii) interest on local loan taken for paying commission on LC
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(iii) repayment of the cost of import at the exchange rate prevailing at the end of the credit period
& interest thereon.
(II) The cash outflow for the local loan will be:
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(i) loan equal to the cost of import at current exchange rate
(ii) interest on local loan for the period of credit of the LC
(2) The advantage of taking the LC is that a lower interest rate is applicable. The importer does not have to buy
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the foreign currency immediately. The downside could be that if the foreign currency appreciate then it may
prove expensive.
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(3) The importer has to pay the commission to the foreign branch at the current exchange rate. The importer
will borrow money locally to pay commission and interest on loan for commission is a ‘cost’ of this option.
Local loan equal to commission paid must be considered even if not mentioned in the
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problem.
(4) Foreign exchange will have to be bought at the time of repayment of principal and interest to the foreign
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bank at the then prevailing exchange rate. Interest on LC is not compounded.

(5) If loan is taken locally then the loan amount is computed on the basis of current exchange rate. The interest
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is compounded only if the period of compounding is less the period of credit of the LC. For example, it is
given the local loan is obtained at 14% p.a. compounded quarterly but the LC period of credit is 90 days
then there is the question of compounding does not arise. However, if the period of credit of the LC is 180
days then the interest on local loan would be compounded once during this period.
A
2.1 [C.A.] Sun Ltd. in planning to import an equipment from Japan at a cost of 3,400 lakh yen. The company
may avail loans at 18% per annum with quarterly rests with which it can import the equipment. The company
has also an offer from Osaka branch of an India based bank extending credit of 180 days at 2% per annum
against opening of an irrecoverable letter of credit.
Additional information:
Present exchange rate `100 = 340 yen
180 day’s forward rate `100 = 345 yen
Commission charges for letter of credit at 2% per 12 months.
Advise the company whether the offer from the foreign branch should be accepted.
[Outflow with loan `1,092.03 lakhs, Outflow if offer from foreign branch is accepted `1,006.15 lakhs]
2.2 [C.A., C.S., C.M.A.] Indigo Ltd. is planning to import a multi-purpose machine from Japan at a cost of
7,200 lakh Yen. The company can avail loans at 15% interest per annum with quarterly rests with which it can
import the machine. However, there is an offer from Tokyo branch of an India based bank extending credit of
180 days at 2% per annum against opening of an irrevocable letter of credit. Other information:
Present exchange rate `100 = 360 Yen
180 Days forward rate `100 = 365 Yen

Commission charges for letter of credit at 2% per 12 months.
Will you accept the bank’s offer and why?
[Option 2 is cheaper, hence the offer can be accepted.]
2.3 [C.S. twice] Sunshine Ltd. is engaged in the production of synthetic yarn and planning to expand its
operations. In this context, the company is planning to import a multi-purpose machine from Japan at a cost of
¥2,460 lakh. The company is in a position to borrow funds to finance import at 12% interest per annum with
quarterly rests. India based Tokyo branch has also offered to extend credit of 90 days at 2% p.a. against opening
of an irrevocable letter of credit. Other information are as under:
Present exchange rate : `100 = ¥246.
90 Days forward rate : `100 = ¥250.
Commission charges for letter of credit at 4% per 12 months. Advise whether the offer from the foreign branch
should be accepted.
[Yes, the offer from foreign branch should be accepted]
2.4 [C.S.] Astro Ltd. is planing to import a machine from Japan at a cost of 7,640 Yen. The company can avail
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loan at 12% interest per annum with quarterly rests with which it can import the machine. However, there is an
offer from Tokyo branch of an India-based bank extending credit of 180 days at 1.5% p.a. against opening of an
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irrevocable letter of credit. Other information:
Present exchange rate `100 = 382 Yen
180-Day forward rate `100 = 388 Yen
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Commission charges for letter of credit at 2% per 12 months. Advise whether the offer from the foreign branch
should be accepted.
[Outflow: 12% loan `2,121.80 lakhs; Tokyo branch `2,004.86 lakhs]
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Interest Rate Parity Theory (IRPT)
3.1 [C.A.] On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per annum respectively.
The UK £/US $ spot rate is 0.7570. What would be the forward rate for US $ for delivery on 30th June?
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[0.7645]
3.2 [C.A.] The US dollar is selling in India at `55.50. If the interest rate for a 6 months borrowing in India is
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10% per annum and the corresponding rate in USA is 4%.

(i) Do you expect that US dollar will be at a premium or at discount in the Indian Forex Market?
(ii) What will be the expected 6-months forward rate for US dollar in India? and
.S
(iii) What will be the rate of forward premium or discount?

[(i) Premium (ii) `57.13 (iii) 5.87%]
3.3 [C.A.] The US dollar is selling in India at `45.50. If the interest rate for a 6 months borrowing in India is
8% per annum and the corresponding rate in USA is 2%.
A
(i) Do you expect that US dollar will be at a premium or at discount in the Indian Forex Market?
(ii) What will be the expected 6-months forward rate for US dollar in India? and
C
(iii) What will be the rate of forward premium or discount?

[(i) Premium (ii) `46.85 (iii) 5.934%]
3.4 [C.A.] Given the following information:
Exchange-rate Canadian dollar 0.665 per DM (spot)
Canadian dollar 0.670 per DM (3 months)
Interest rates: DM 7% per annum
Canadian dollar 9% per annum
What operations would be carried out to make possible arbitration gains?
[Borrow Canadian dollars and invest in DM]
3.5 [C.S.] Presently, one US $ is worth 140 Japanese Yen in the spot market. The interest rate in Japan on 90
days government securities is 4% per annum. If the interest rate parity theorem holds true and 3-month forward
rate is 138 Yen per US $, what is the implied interest rate in USA? If the actual interest rate is 7% per annum in
USA, what action would follow?
[Interest rate in USA is 9.84%. If rate in USA is 7% then money will flow out of USA]
3.6 [C.A.] Spot rate (US$ 1) = `48.0123
180 days forward rate for US$ 1 = `48.8190

Annualized interest rate for 6 months – Rupee = 12%
Annualized interest rate for 6 months – US $ = 8%
Is there any arbitration possibility? If yes, how an arbitrageur can take advantage of the situation, if he’s willing
to borrow `40,00,000 or US $83,312.
[Gain `10,103]
3.7 [C.A., C.S.] Given following information:
Exchange Rate –
Canadian Dollars 0.666 per DM (spot)
Canadian dollar 0.671 per DM (3 months)
Interest rate DM 8% p.a.
Canadian dollar 10% p.m. p.a.
What operations would be carried out to earn possible arbitrage gains?
[Borrow Canadian dollars and invest in Deutsche marks]
3.8 [C.A., C.S.] The spot exchange rate is `15/€ and the three months forward exchange rate is `15.20/€. The
three month interest rate is 8% p.a. in India and 5.8% p.a. in Germany. Assume that you can borrow `15 lakhs
or €10 lakhs.
(i) Determine whether the interest rate parity is currently holding.
(ii) How would you carry out covered interest arbitrage? Show all steps & determine the arbitrage profit.
[(i) No (ii) `12,040]
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3.9 [C.S. twice] Syntex Ltd. has to make a US $5 million payment in three months’ time. The required amount
in dollars is available with Syntex Ltd. The management of the company decides to invest them for three months
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and following information is available in this context:
– The US $ deposit rate is 9% p.a.
– The sterling pound deposit rate is 11% p.a.
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– The spot exchange rate is $1.82/pound.
– The three month forward rate is $1.80/pound.
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Answer the following questions –
(i) Where should the company invest for better returns?
(ii) Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would
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yield an equilibrium situation?

(iii) Assuming that the US interest rate and the spot and forward rates remain as above, where should the
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company invest if the sterling pound deposit rate were 15% per annum?
(iv) With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium
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sterling pound deposit rate?

[(i) Invest in $ at 9%, (ii) Forward Rate = $ 1.811/£, (iii) Invest in £ Sterling, (iv) 13.54%. p.a.]
3.10 [C.A.] The following table shows interest rates for the United States Dollar and French Francs. The spot
A
exchange rate is 7.05 Francs per dollar. Complete the missing entries:
Particulars 3 Months 6 Months 1 Year
Dollar interest rate (annually compounded) 11½% 12¼% ?
Franc interest rate (annually compounded) 19½% ? 20%
Forward Franc per Dollar ? ? 7.5200
Forward discount on Franc per cent per year ? – 6.3% ?
[3 Months: Fwd FFr/$ 7.17, disc. 1.675%; 6 Months: Franc int. rate 19.8%, Fwd FFr/$ 7.28; 1 Year: $ int. rate 12.5%, disc. 6.25%]
Purchasing Power Parity Theory (PPPT)

4.1 [C.A.] The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot rate for
USD in India is `46. What will be the expected rate after 1 year and after 4 years applying the Purchasing Power
Parity Theory.
[`47.77, `53.50]
4.2 [C.A.] The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5%. The
current spot rate of US $ in India is `43.40. Find the expected rate of US $ in India after one year and 3 years
from now using purchasing power parity theory.
[`44.8751, `47.9762]

Hedging
5.1 [C.A.] In March, 2003, the Multinational industries makes the following assessment of dollar rates per
British pound to prevail as on 1.9.2003:
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(i) What is the expected spot rate for 1.9.2003? (ii) If, as of March, 2003, the 6-month forward rate is $1.80,
should the firm sell forward its pound receivables due in September, 2003?
[(i) $1.81/£ (ii) The firm should not sell forward]
5.2 [C.S.] In September, 1998, the Multinational Industries Inc. assessed the March, 1999 spot rate for pound
sterling at the following rates:
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$1.30/£ with probability 0.15
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(i) What is the expected spot rate for March, 1999? (ii) If the six-month forward rate is $1.40, should the firm
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sell forward its pound receivables due in March, 1999?
[(i) $ 1.41; (ii) Sell the proceeds in spot market.]
5.3 [C.A.] Excel Exporters are holding an Export bill in United States Dollar (USD) 1,00,000 due 60 days
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hence. They are worried about the falling USD value which is currently at `45.60 per USD. The concerned
Export Consignment has been priced on an Exchange rate of `45.50 per USD. The Firm’s Bankers have quoted
a 60-day forward rate of `45.20.
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Calculate:
(i) Rate of discount quoted by the Bank
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(ii) The probable loss of operating profit if the forward sale is agreed to.
[(i) 5.34% (ii) `30,000]
5.4 [C.A.] Shoe Company sells to a wholesaler in Germany. The purchase price of a shipment is 50,000 Deutsche
.S
Marks with term of 90 days. Upon payment, Shoe Company will convert the DM to Dollars. The present spot rate
for DM per Dollar is 1.71, whereas 90-day forward rate is 1.70.
You are required to calculate and explain:
(i) If Shoe Company were to hedge its foreign exchange risk, what would it do? What transactions are
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necessary?
(ii) Is the Deutsche Mark at a forward premium or at a forward discount?
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(iii) What is the implied differential in interest rates between the two countries? (Use Interest Rate Parity
Assumption).
[(i) Forward contract gain $172 (ii) Premium (iii) DM interest rate is lower by 2.37%]
5.5 [C.A.] M/s Omega Electronics Ltd. exports air conditioners to Germany by importing all the components
from Singapore. The company is exporting 2,400 units at a price of Euro 500 per unit. The cost of imported
components is S$ 800 per unit. The fixed cost and other variables cost per unit are `1,000 and `1,500 respectively.
The cash flows in Foreign currencies are due in six months. The current exchange rates are as follows:
`/Euro 51.50/55
`/S$ 27.20/25
After six months the exchange rates turn out as follows:
`/Euro 52.00/05
`/S$ 27.70/75
(1) You are required to calculate loss/gain due to transaction exposure.
(2) Based on the following additional information calculate the loss/gain due to transaction and operating
exposure if the contracted price of air conditioners is `25,000:
(i) the current exchange rate changes to
`/Euro 51.75/80

`/S$ 27.10/15
(ii) Price elasticity of demand is estimated to be 1.5
(iii) Payments and receipts are to be settled at the end of six months.
[(1) Loss `31,20,000 (2) Decrease in profit `11,46,900]
5.6 [C.M.A.] An import house in India has bought goods from Switzerland for SF 10,00,000. The exporter has
given the Indian company two options:
(i) Pay immediately the bill for SF 10,00,000.
(ii) Pay after 3 months with interest @ 5% p.a.
The importer’s bank charges 14% on overdraft. If the exchange rates are as follows, what should the company do?
Spot (`/SF) 30.00/30.50
3-month (`/SF) 31.10/31.60
[Pay immediately and save `4,27,500]
5.7 [C.A., C.S.] An Indian importer has to settle a bill for $1,30,000. The exporter has given the Indian
importer two options:
(i) Pay immediately.
(ii) Pay after 3 months with interest 5% p.a.
The importer’s bank charges 15% on overdraft. If the exchange rates are as follows, what should the company do?
Spot (`/$) 48.35/48.36
3-month (`/$) 48.81/48.83
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[Pay after 3 months and save `95,306]
5.8 [C.A. twice, C.S.] An exporter is a UK based company. Invoice amount is $3,50,000. Credit period is three
months. Exchange rates in London are:
Spot rate ($/£) 1.5865 – 1.5905
3-month forward rate 1.6100 – 1.6140
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Rates of interest in money market:
Deposit Loan
$ 7% 9%
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£ 5% 8%
Compute and show how a money-market hedge can be put in place. Compare and contrast the outcome with a
forward contract.
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[Money market hedge gives gain of £1,051.91]

5.9 [C.S.] An Indian telecom company had approached Punjab National Bank for forward contract of £5,00,000
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delivery on 31st May, 2008. The bank had quoted a rate of `61.60/£ for the purchase of pound sterling from
the customer. But on 31st May, 2008, the customer informed the bank that it was not able to deliver the pound
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sterling as anticipated receivable from London has not materialized & requested the bank to extend the contract
for delivery by 31st July, 2008.
The following are the market quotes available on 31st May, 2008:
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Spot (`/£) 62.60/65

1-month forward premium 20/25
Flat charges for cancellation of forward contract is `500.
You are required to find out the extension charges payable by the telecom company.
[Cancellation charges `5,25,500]
5.10 [C.A.] A customer with whom the Bank had entered into 3 months forward purchase contract for Swiss
Francs 1,00,000 at the rate of `36.25 comes to the bank after two months and requests cancellation of the
contract. On this date, the rates are:
Spot CHF1 = `36.30 36.35
One month forward 36.45 36.52
Determine the amount of Profit or Loss to the customer due to cancellation of the contract.
[Loss `27,000]
5.11 [C.A.] A customer with whom the bank had entered into 3 month’s forward purchase contract for Swiss
Francs 10,000 at the rate of `27.25 comes to the bank after 2 months and requests cancellation of the contract.
On this date, the rates prevailing are:

Spot CHF1 = `27.30 27.35
One month forward 27.45 27.52
What is the loss/gain to the customer on cancellation?
[Loss `2,700]
5.12 [C.A., C.S.] A company operating in a country having the $ as its unit of currency has today invoiced
sales to an Indian company, the payment being due 3 months from the date of invoice. The invoice amount is
$13,750. At today’s spot rate of $0.0275 per `1, is equivalent to `5,00,000.
It is anticipated that the exchange rate will decline by 5% over the 3-month period and in order to protect the
$ payments, the importer proposes to take appropriate action in the foreign exchange market. The 3-month
forward rate is presently quoted as $0.0273.
Calculate the expected loss and to show how it can be hedged by a forward contract.
[Expected exchange loss under present condition `26,316; under forward contract `3,663]
5.13 [C.M.A.] Electronics Ltd., your customer, has imported 5,000 cartridges at a landed cost, in Mumbai, of
US $20 each. The company has the choice of paying for the goods immediately or in 3 months time. It has a
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clean overdraft limit with you where 14% pa. rate of interest is charged.
Calculate which of the following methods would be cheaper to your customer.
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(i) Pay in 3 months time with interest @ 10% and cover risk forward for 3 months.
(ii) Settle now at current spot rate and pay interest on the overdraft for 3 months.
The rates are as follows:
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Mumbai `/$ spot 43.25 - 43.55
3 months swap 35/25
[Outflow: Option (i) `44,38,250; Option (ii) `45,07,425]
5.14 [C.A.] Gibralater Limited has imported 5000 bottles of shampoo at landed cost in Mumbai, of US $ 20
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each. The company has the choice for paying for the goods immediately or in 3 months time. It has a clean
overdraft limited where 14% p.a. rate of interest is charged.
Calculate which of the following method would be cheaper to Gibralter Limited.
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(i) Pay in 3 months time with interest @10% and cover risk forward for 3 months.
(ii) Settle now at a current spot rate and pay interest of the overdraft for 3 months.
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The rates are as follow:

Mumbai `/$ spot 60.25 - 60.55
3 months swap 35/25
.S
[Outflow: Option (i) `61,80,750 Option (ii) `62,66,925]

5.15 [C.A.] A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S. suppliers.
The amount is payable in six months time. The relevant spot and forward rates are:
Spot rate USD 1.5617 - 1.5673
A
6 months’ forward rate USD 1.5455 - 1.5609

The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit rates are 5.5% and 4.5%
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respectively.
Currency options are available under which one option contract is for GBP 12,500. The option premium for GBP
at a strike price of USD 1.70/GBP is USD 0.037 (call option) and USD 0.096 (put option) for 6 months period.
The company has 3 choices:
(i) Forward cover
(ii) Money market cover, and
(iii) Currency option
Which of the alternatives is preferable by the company?
[Outflow: (i) £2,36,103 (ii) £2,36,510 (iii) £2,27,923]
5.16 [C.A.] XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in customers’
currency. Its receipt of US $ 1,00,000 is due on September 1, 2005.
Market information as at June 1, 2005.
Exchange Rates Currency Futures
US $/` US $/` Contract size `4,72,000
Spot 0.02140 June 0.02126
1 Month Forward 0.02136 September 0.02118

3 Months Forward 0.02127
Initial Margin Interest Rates in India
June `10,000 7.50%
September `15,000 8.00%
On September 1, 2005 the spot rate US $/` is 0.02133 and currency future rate is 0.02134. Comment which of
the following methods would be most advantageous for XYZ Ltd.
(a) Using forward contract
(b) Using currency futures
(c) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of the futures contract.
[Cash inflow: (a) `47,01,457 (b) `47,20,639 (c) `46,88,233]
5.17 [C.A.] An importer requests his bank to extend the forward contract for US$ 20,000 which is due for
maturity on 30th October, 2010, for a further period of 3 months. He agrees to pay the required margin money
for such extension of the contract.
Contracted Rate - US$ 1 = `42.32
The US Dollar quoted on 30-10-2010:
Spot - 41.5000/41.5200
3 months’ Premium - 0.87%/0.93%
Margin money for buying and selling rate is 0.075% and 0.20% respectively.
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Compute:
(i) The cost to the importer in respect of the extension of the forward contract, and
(ii) The rate of new forward contract.
[(i) `17,000 (ii) `41.99]
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5.18 [C.A.] An American firm is under obligation to pay interests of Can$ 10,10,000 and Can$ 7,05,000 on
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31st July and 30th September respectively. The Firm is risk averse and its policy is to hedge the risks involved
in all foreign currency transactions. The Finance Manager of the firm is thinking of hedging the risk considering
two methods i.e. fixed forward or option contracts.
C
It is now June 30. Following quotations regarding rates of exchange, US $ per Can $, from the firm’s bank were
obtained:
Spot 1 Month Forward 3 Months Forward
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0.9284-0.9288 0.9301-0.9356
Price for a Can$/US$ option on a U.S. stock exchange (cents per Can $, payable on purchase of the option,
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contract size Can $ 50,000) are as follows:

Strike Price Calls Puts
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(US$/Can$) July Sept. July Sept.

0.93 1.56 2.56 0.88 1.75
0.94 1.02 NA NA NA
A
0.95 0.65 1.64 1.92 2.34

According to the suggestion of finance manager if options are to be used, one month option should be bought at
a strike price of 94 cents and three month option at a strike price of 95 cents and for the remainder uncovered
by the options the firm would bear the risk itself. For this, it would use forward rate as the best estimate of spot.
Transaction costs are ignored.
Recommend, which of the above two methods would be appropriate for the American firm to hedge its foreign
exchange risk on the two interest payments.
[Forward contract]
5.19 [C.A.] NP and Co. has imported goods for US $7,00,000. The amount is payable after three months. The
company has also exported goods for US $ 4,50,000 and this amount is receivable in two months. For receivable
amount a forward contract is already taken at `48.90.
The market rates for ` and Dollar are as under:
Spot `48.50/70
Two months 25/30 points
Three months 40/45 points
The company wants to cover the risk and it has two options as under:
(a) To cover payables in the forward market and

(b) To lag the receivables by one month and cover the risk only for the net amount. No interest for delaying
the receivables is earned. Evaluate both the options if the cost of Rupee Funds is 12%. Which option is
preferable?
[Net amount payable in forward market `1,19,17,200; Net amount payable in by lagging receivables `1,18,42,500. Ans. is by taking the forward
points as direct quotes & not premium points as given in Suggested Answers.]
5.20 [C.A.] An Indian exporting firm, Rohit and Bros., would be cover itself against a likely depreciation of
pound sterling. The following data is given:
Receivables of Rohit and Bros £500,000
Spot rate `56,00/£
Payment date 3-months
3 months interest rate India: 12% p.a.
UK: 5% p.a.
What should the exporter do?
[Gain from money market hedge `4,83,941]
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5.21 [C.A.] Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to €4 million
with a large German retailer on 6 months credit. If successful, this will be the first time that Nitrogen Ltd has
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exported goods into the highly competitive German market.
The following three alternatives are being considered for managing the transaction risk before the order is
finalized.
(i) Invoice the German firm in Sterling using the current exchange rate to calculate the invoice amount.
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(ii) Alternative of invoicing the German firm in Euro and using a forward foreign exchange contract to hedge
the transaction risk.
(iii) Invoice the German first in Euro and use sufficient 6 months sterling future contracts (to the nearly whole
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number) to hedge the transaction risk.
Following data is available:
Spot Rate €1.1750 - €1.1770/£
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6 months forward premium 0.60-0.55 Euro Cents
6 months further contract is currently trading at €1.1760/£
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6 months future contract size is £62500

Spot rate and 6 months future rate €1.1785/E
Required:
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the three proposals.
.S
(b) In your opinion, which alternative would you consider to be the most appropriate and the reason thereof.
[(a) Receipt: (i) £33,98,471 (ii) £33,82,664 (iii) £34,01,305 (b) Option (iii)]
5.22 [C.A.] Z Ltd. importing goods worth USD 2 million, requires 90 days to make the payment. The overseas
A
supplier has offered a 60 days interest free credit period and for additional credit for 30 days an interest of 8%
per annum.
The bankers of Z Ltd offer a 30 days loan at 10% per annum and their quote for foreign exchange is as follows:
C
`
Spot 1 USD 56.50
60 days forward for 1 USD 57.10
90 days forward for 1 USD 57.50
You are required to evaluate the following options:
(i) Pay the supplier in 60 days, or
(ii) Avail the supplier’s offer of 90 days credit.
[Pay in 60 days]
5.23 [C.A.] XYZ Ltd. a US firm will need £3,00,000 in 180 days. In this connection, the following information
is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%

A call option on £ that expires in 180 days has an exercise price of $1.97 and a premium of $0.04.
XYZ Ltd. has forecast the spot rates 180 days hence as below:
Future rate Probability
$1.91 25%
$1.95 60%
$2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(a) a forward contract
(b) a money market hedge
(c) an option contract
(d) no hedging
Show calculations in each case.
[Outflow: (a) $5,88,000 (b) $6,05,741 (c) $5,94,900 (d) $5,86,500]
5.24 [C.A.] A company is considering hedging its foreign exchange risk. It has made a purchase on 1st January,
2008 for which it has to make a payment of US $ 50,000 on September 30, 2008. The present exchange rate is
1 US $ = `40. It can purchase forward 1 US $ at `39. The company will have to make a upfront premium of 2%
of the forward amount purchased. The cost of funds to the company is 10% per annum and the rate of Corporate
tax is 50%. Ignore taxation. Consider the following situations and compute the Profit/Loss the company will
make if it hedges its foreign exchange risk:
(i) If the exchange rate on September 30, 2008 is `42 per US $.
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(ii) If the exchange rate on September 30, 2008 is `38 per US $.
[(i) Gain `1,08,075 (ii) Loss `91,925]
Co. an Indian export firm, which have no foreign subsidiaries:

Currency Inflow Outflow Spot rate ss
5.25 [C.A.] Following are the details of cash inflows and outflows in foreign currency denominations of MNP
Forward rate
la
US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (FFr) 2,00,00,000 80,00,000 7.45 8.12
C
U.K. £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(i) Determine the net exposure of each foreign currency in terms of Rupees.
h
(ii) Are any of the exposure positions offsetting to some extent?

[(i) US$ 16.20 million, FFr 8.04 million, UK£4.10 million, JPY 8 million (ii) JPY]
rs
5.26 [C.A.] EFD Ltd, is an export business house. The company prepares invoice in customers’ currency. Its
debtors of US$ 10,000,000 is due on April 1, 2015.
da
Market information as at January 1, 2015 is:

Exchange rates US$/INR Currency Futures US$/INR
Spot 0.016667 Contract size: `24,816,975
A
1-month forward 0.016529 1-month 0.016519

3-month forward 0.016129 3-months 0.016118
Initial margin Interest rates in India

1-month `17,500 6.5%
3-months `22,500 7%
On April 1, 2015 the spot rate US$/INR is 0.016136 and currency future rate is 0.016134. Which of the following
methods would be most advantageous to EFD Ltd?
(i) Using forward contract
(ii) Using currency futures
(iii) Not hedging the currency risk
5.27 [C.S.] Zed Ltd., an Indian company, has an export exposure of 10 million (100 lakh) Yen, payable in
April end. Yen is not directly quoted against Rupee. The current spot rates are INR/USD = 60.50 and JPY/USD
= 145.60. It is estimated that Yen will depreciate to 159 level and Rupee to depreciate against $ to 61. Forward
rates for April, 2014 are INR/USD = 61.81 and JPY/USD = 155.25.
You are required to —

(i) Calculate the expected loss if hedging is not done. How the position will change if the firm takes forward
cover?
(ii) If the spot rate on 30th April, 2014 was eventually INR/USD = 61.71 and JPY/USD = 155.75, is the decision
to take forward cover justified?
[(i) Loss without hedging `3,19,000; with forward cover loss `1,74,000 (ii) Yes, without forward cover loss would have been `1,93,000]
5.28 [C.S.] Queen Ltd., an Indian company, has an export exposure of ¥100 lakh value at September end. Yen
is not directly quoted against rupee. The current spot rates are INR/USD = 62.685 and JPY/USD = 194.625. It
is estimated that Yen will depreciate to 216 level and rupee to depreciate against dollar to 64.50. Forward rate
for September, 2013 was JPY/USD = 206.025 and INR/USD = 64.335. If the spot rate on 30th September, 2013
was eventually INR/USD = 64.17 and JPY/USD = 206.775, is the decision to take forward cover justified?
[Yes. Loss with forward cover `9.76 lakhs; loss without forward cover `11.75 lakhs.]
5.29 [C.A.] DEF Ltd. has imported goods to the extent of US$ 1 crore. The payment terms are 60 days interest-
free credit. For additional credit of 30 days, interest at the rate of 7.75% p.a, will be charged.
The banker of DEF Ltd. has offered a 30 days loan at the rate of 9.5% p.a. Their quote for the foreign exchange
le
is as follows:
Spot rate INR/US$ 62.50
ha
60 days forward rate INR/US$ 63.15
90 days forward rate INR/US$ 63.45
Which one of the following options would be better?
(i) Pay the supplier on 60th day and avail bank loan for 30 days
ok
(ii) Avail the supplier’s offer of 90 days credit
Exchange Position & Nostro Account

G
6.1 [C.A.] You as a dealer in foreign exchange have the following position in Swiss Francs on 31st October,
2004:
Swiss Francs
Balance in the Nostro A/c Credit 1,00,000
il
Opening Position Overbought 50,000

un
Purchased a bill on Zurich 80,000

Sold forward TT 60,000
Forward purchase contract cancelled 30,000
Remitted by TT 75,000
.S
Draft on Zurich cancelled 30,000

What steps would you take, if you are required to maintain a credit Balance of Swiss Francs 30,000 in the Nostro
A/c and keep as overbought position on Swiss Francs 10,000?
A
[Buy spot SF 5,000 and buy forward SF 10,000]

6.2 A forex dealer has the following position on 1st January, 2015:
C
Nostro a/c balance €1,000 (overdrawn)

Exchange position €1,000 oversold
His euro relating transactions during the month are as follows:
€
Interest on overdrawn balance 5
Export bills purchased 14,000
Export bills realized 18,000
Used for purchase of US$ 5,000
Spot sale 10,000
Draft canceled 2,000
Forward sale 6,000
Draw up his exchange position & cash position on 31st January, 2015. What action should he take if he wants to
maintain an overbought position of €5,000 at the end of the month?
[Exchange position: Bal. oversold €10,005; Cash position: Bal. €1,995 Cr. Action required: Buy forward €15,005]
6.3 Yourbank Ltd. has a Nostro a/c with Barclays Bank PLC, London with a balance of £8,000 as on 1st January,
2015. On the same date, it has a £10,000 overbought exchange position. Its transaction in pound sterling during
the month of January, 2015 are as follows:

£
Forward sale 30,000
Spot purchase 20,000
Drafts issued 12,000
Bills purchased 15,000
Drafts canceled 1,000
Drafts encashed 10,000
Bills realized 10,000
Draw up the exchange position & cash position on 31st January, 2015. What action is required to be taken if
Nostro account balance is to be maintained at £8,000 & exchange position at £10,000 overbought?
[Exchange position: Bal. overbought £4,000; Cash position: Bal. £28,000 Cr. Action required: Sell spot £20,000, Buy forward £26,000]
Foreign Currency Swaps

7.1 [C.A.] You have following quotes from Bank A and Bank B:
Bank A Bank B
SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 months 5/10
6 months 10/15
SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50
3 months 25/20
es
6 months 35/25
Calculate:
(i) How much minimum CHF amount you have to pay for 1 Million GBP spot?
ss
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap points for Spot over 3
months?
la
[(i) CHF 25,86,600 (ii) Discount 28/12]
7.2 [C.A.] A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for a time horizon of
one year. The prevalent interest rates are as follows:
C
Company ¥ Loan $ Loan
A Inc 5% 9%
B Inc 8% 10%
h
The prevalent exchange rate is $1 = ¥120.

They entered in a currency swap under which it is agreed that B Inc will pay A Inc @ 1% over the ¥ Loan interest
rs
rate which the later will have to pay as a result of the agreed currency swap whereas A Inc will reimburse
interest to B Inc only to the extent of 9%. Keeping the exchange rate invariant, quantify the opportunity gain or
da
loss component of the ultimate outcome, resulting from the designed currency swap.
[Gain 1% to both companies]
7.3 [RTP] Drilldip Inc. a US based company has a won a contract in India for drilling oil filed. The project
A
will require an initial investment of `500 crore. The oil field along with equipments will be sold to Indian
Government for `740 crore in one year time. Since the Indian Government will pay for the amount in Indian
Rupee (`) the company is worried about exposure due exchange rate volatility.
(a) Construct a swap that will help the Drilldip to reduce the exchange rate risk.
(b) Assuming that Indian Government offers a swap at spot rate which is 1US$ = `50 in one year, then should
the company should opt for this option or should it just do nothing. The spot rate after one year is expected
to be 1US$ = `54. Further you may also assume that the Drilldip can also take a US$ loan at 8% p.a.
[Net receipt with swap US $36.44 million, without swap US $29.04 million]
7.4 [C.S.] Celina Ltd. wishes to borrow US Dollars at a fixed rate of interest. Priyanka Ltd. wishes to borrow
Japanese Yen at a fixed rate of interest. The amounts required by the two companies are roughly the same at
current exchange rate. The companies have been quoted the following interest rates:
Yen Dollar
Celina Ltd. 4.0% 8.6%
Priyanka Ltd. 5.5% 9.0%
Design a swap that will net a bank, acting as intermediary, 50 basis points per annum. Make the swap equally
attractive to the two companies and ensure that all foreign exchange risk is assumed by the bank.

[Priyanka Ltd. would borrow Yen at 8.3% whereas Celina would borrow Dollars at 5.2%.]
7.5 [C.S.] Soni Ltd. and Toni Ltd. face the following interest rate:
Soni Ltd. Toni Ltd.
US Dollar (Floating rate) LIBOR + 0.25% LIBOR + 2.25%
Japanese Yen (Fixed rate) 1.75% 2%
Toni Ltd. wants to borrow US Dollars at a floating rate of interest and Soni Ltd. wants to borrow Japanese Yen
at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 100 basis point
spread. If the swap is equally attractive to Soni Ltd. and Toni Ltd., what rate of interest will they end up paying?
[Soni Ltd. 1.375% & Toni Ltd. LIBOR + 1.875%]

1) [C.M.A.] Your bank wants to calculate Rupee TT selling rate of exchange for DM since the deposit of DM
1,00,000 in a FCNR account has matured, when:
€1 = DM 1.95583 (locked-in rate)
le
€1 = US $ 1.02348/430
US $ 1 = `48.51/53
ha
What is the Rupee TT selling rate for DM currency?
Soln. INR/DM = INR/USD × USD/DM
= INR/USD × (USD/Euro × Euro/DM)
= 48.53 × (1.02430 × 1/1.95583)
ok
= `25.416
2) [C.A.] On 1st April, 3 months interest rate in the US and Germany are 6.5% and 4.5% per annum respectively.
The $/DM spot rate is 0.6560. What would be the forward rate for DM for delivery on 30th of June?
G
Soln. The forward rate can be computed using IRPT.
US interest rate (home) for 3 months = 6.5% × 3/12 = 1.625% or 0.01625
German interest rate (foreign) for 3 months = 4.5% × 3/12 = 1.125% or 0.01125
il
1 + rh F
= 1
1 + rf S0
un
1 + 0.01625 F1
=
1 + 0.01125 0.6560
.S
0.66666 = 1.01125F1
0.66666
F1 = = 0.6592
1.01125
3) [C.S., C.M.A.] A forex trader wants to earn arbitrage gain. She receives the following data and quotes from
A
Forex and the money market:

Spot rate of US $ `43.30/$
C
6-month forward rate of US $ `43.70/$

Annualized interest rate for 6 months – US $ 4%
Annualized interest rate for 6 months – Rupee 8%
What are the transactions that the trader execute to receive arbitration gain if he’s willing to borrow `43.30
million or US $ 1 million, assuming that no transaction cost or taxes exist?
Soln. US $ interest rate for 6 months = 2% or 0.02
` interest rate for 6 months = 4% or 0.04
Interest rate as per IRPT were to hold, then –
1 + rh F
= 1
1 + rf S0
1 + rh 43.70
=
1.02 43.30
1 + rh = 1.0294
rh = 1.0294 – 1 = 0.0294 i.e. 2.94%
As the actual home interest rate is 4% for 6 months there will be inflow of funds to home country. The trader
will borrow US $10,00,000 and enter into a forward contract to buy US $ at `43.70. Convert the $ loan to INR

for making an INR deposit for 6 months. From the maturity proceeds of the deposit, the $ loan will be repaid
with interest leaving the balance as gain to the trader.
US $10,00,000 loan converted (at spot rate) = $10,00,000 × `43.30 = `4,33,00,000
`
Deposit maturity amount (`4,33,00,000 × 1.04) 4,50,32,000
– $ loan repaid ($10,00,000 × 1.02 × `43.70) 4,45,74,000
Gain 4,58,000
4) [C.M.A.] NBA Bank Ltd. transacted on August 19, 2010 the following:
(i) Sold $10,00,000 two months forward to Alpha Manufacturing Co. Ltd. at `44.50.
(ii) Purchased Euro 10,00,000 two months forward from Beta Trading Co. Ltd. at `47.20.
On October 19, 2010, both the customers approached the bank. Alpha Manufacturing Co. wants the forward
contract to be cancelled while Beta Trading Co. wants the contract to be extended by one month. The following
exchange rates prevailed on that day:
`/$ `/€
Spot 44.60/65 47.75/85
One-month forward 44.75/85 48.00/48.20
Based on the above information (ignoring interest, etc.), you are required to:
(i) Calculate the amount to be paid to or recovered from Alpha Manufacturing Co. due to the cancellation of
the forward contract.
(ii) Calculate the amount to be paid to all recovered from Beta Trading Co. due to the extension of the forward
es
contract.
Soln.
ss
(i) As Alpha Manufacturing Co. Ltd. wants to cancel the contract NBA Bank Ltd. will have to purchase from
it. The spot rate for buying dollars would be `44.60. Thus, NBA Banks Ltd. will suffer a loss of `0.10 per
dollar.
la
`
$ sold to Alpha Manufacturing Co. Ltd. at 44.50
C
$ purchased from Alpha Manufacturing Co. Ltd. at 44.60
Loss per $ to NBA Bank Ltd. 0.10
Payment to be made to Alpha Manufacturing Co. Ltd. = $10,00,000 × `0.10 = `1,00,000
h
(ii) As Beta Trading Co. Ltd. wants to renew the contract, NBA Bank Ltd. will have to sell euro to the company.
The spot rate applicable for selling euro would be `47.85. Thus, NBA Bank Ltd. will earn a profit of `0.65
rs
per euro.
`
da
€ purchased from Beta Trading Co. Ltd. at 47.20

€ sold to Beta Trading Co. Ltd. at 47.85
Profit per € to NBA Bank Ltd. 0.65
Amount to be received from Beta Trading Co. Ltd. = €10,00,000 × `0.65
A
= `6,50,000
A new one month forward contract will be entered into for buying € from Beta Trading Co. Ltd. at `48.00.
5) [C.M.A.] A company, operating in Japan, has today effected sales to an Indian company, the payment being
due 3 months from the date of invoice. The invoice amount is 108 lakh yen. At today’s spot price, it is equivalent
to `30 lakhs. It is anticipated that the exchange rate will decline by 10% over the 3 month and in order to
protect the yen payments, the importer decides to take appropriate action in the foreign exchange market. The
three-month forward rate is presently quoted as 3.3 yen per rupee.
You are required to calculate the expected loss and to show how it can be hedged by a forward contract.
108
Soln. Exchange rate for the invoice = = 3.6 ¥/`
30
Expected rate = 3.6 × 0.9 = 3.24¥/`
1
Expected rupee outflow after 3 months = ¥108 × = `33.33 lakhs
3.24
Expected loss = 33.33 – 30 = `3.33
With forward contract
1
Expected outflow after 3 months = ¥108 × = `32.73 lakhs
3.3

Expected loss = 32.73 – 30 = `2.73 lakhs
Loss can be reduced by entering into a forward contract.
6) [C.M.A.] An Indian company has to settle a bill for $1,35,000. The exporter has given the Indian Company
two options:
(i) Pay immediately.
(ii) Pay after 3 months with interest 6% p.a.
The importer’s bank charges 16% on overdraft. If the exchange rates are as follows, what should the company
do?
Spot (`/$) 48.35/48.36
3-month (`/$) 48.81/48.83
Soln. Outflow in rupees if payment is made immediately
`
Invoice amount ($1,35,000 × `48.36) 65,28,600
Interest (`65,28,600 × 0.16 × 3/12) 2,61,144
le
Total 67,89,744
Outflow in rupees if payment is made after 3-months
ha
`
Invoice amount ($1,35,000 × `48.83) 65,92,050
Interest (`65,92,050 × 0.06 × 3/12) 98,881
Total 66,90,931
ok
It would be better to make the payment after 3 months as the outflow will be lower.
Savings = 67,89,744 – 66,90,931 = `98,813
G
7) [C.A., C.M.A., C.S.] In International Monetary Market (IMM), an international forward bid on 15th
December for one Euro (€) is $1.2816. At the same time, the price of IMM € future for delivery on 15th December
is $1.2806. The contract size of futures is €62,500.
How could the dealer use arbitrage to profit from this situation and how much profit is earned?
il
Soln. The forward bid rate is more than the future delivery rate. A dealer should take a long futures for delivery
and enter into a forward contract to sell €. Arbitrage gain from each long futures contract would be:
un
Arbitrage gain = 62,500 (1.2816 – 1.2806) = $62.50

.S
A
C

Chapter
14
Mergers, Acquisitions & Restructuring
Restructuring
Restructuring means reorganizing the business. It makes the organization more balanced, profitable and enables
it to achieve its objectives in an efficient manner. Such reorganization may be structural or financial. The
includes:
(1) Mergers & acquisitions
(2) Demerger
(3) Reconstruction
(4) Buyback of equity, redemption of preference shares, issue of bonus shares, stock split, issue of convertible
preference shares/debentures, issue of deep discount bonds, etc.
(5) Divestment, like selling of a division.
(6) Internal merging or splitting of departments
Mergers & Acquisitions

Merger: This involves unification of two of two (or more) entities into one. One entity is dissolved.
es
Acquisition: This involves one entity acquiring one of the businesses of another entity.
Horizontal Merger: If two entities in the same line of business merge then it is called a horizontal merger. This
ss
achieves eliminates competition & achieves economies of scale.
Vertical Merger: This involves forward or backward integration of business. If an entity merges with a customer
it is called forward integration. For example, a merger between a rubber manufacturing company and a company
la
manufacturing tyres. If an entity merges with a supplier it is called backward integration. For example, a merger
between a car manufacturing company and a tyre manufacturing company.
C
Conglomerate Merger: Entities have unrelated business may merge. For example, one entity have business
interests in tobacco, clothes & hotels may merge with another with business interests in construction &
engineering. This brings different businesses under one flagship company and increases the debt capacity of the
h
company. It utilizes the resources of the single company more effectively and in the most efficient manner.
Takeover: This refers to the purchase of controlling interest by one company in the share capital of an existing
rs
company. This can be done by any of the following methods:

(1) with an agreement with the majority shareholder;
(2) acquiring new shares with an agreement;
da
(3) purchasing shares from the open market by making an open offer (as per SEBI regulations);
(4) making a buyout offer to the general body of shareholders.
Takeover by Reverse Bid: In case of two entities of unequal size normally it is the smaller entity which is merged
A
into the larger entity. In other words, the smaller entity will be dissolved. However, sometimes the larger entity
is dissolved and merged into the smaller entity. This is known as reverse merger. This is normally done for tax
benefits. If the smaller entity has accumulated losses then its identity is maintained for the purpose of carry
forward and set-off of losses.
Valuation of Business
For the acquisition of a business it needs to be valued. The following are the reasons for valuation:
(1) The value of shares of listed companies may not represent their true value.
(2) Listed share prices can be manipulated.
(3) Value of unlisted shares or shares of not frequently traded must be determined.
There are several techniques for the valuation of a business. Some important methods are:
(1) Net Assets/Asset Backing Method
(2) Capitalized Earnings Method
(3) Fair Value or Berliner Method
(4) Discounted Cash Flow/Free Cash Flow Method
(5) Chop-Shop Method
(1) Net Assets/Asset Backing Method: Under this method the net assets of the business are calculated and

from such figure, the amount due to preference shareholders is deducted. For this purpose, realizable
value of assets is taken into consideration. Assets/liabilities not recorded in the balance sheet should also
be considered. Preference dividend, if not paid, should also be considered. This method is sometimes also
referred to as deemed liquidation method. The figure thus arrived at is the net assets available for equity
shareholders. The value of each equity share is calculated as follows:
Net assets available for equity shareholders
Value of equity share =
Number of equity shares
To find net assets for equity shareholders, we take the market value of the assets and subtract the outside
liabilities as well as preference capital, if any. If information about assets & liabilities is not known then we
find equity shareholders funds instead:
Equity shareholders funds = Equity Capital + Reserves ± Profit/loss on assets (i.e. difference between
book value & market value of assets) – Fictitious assets.
(2) Capitalized Earnings Method: The market price of an equity share can be computed as follows:
Price of an equity share = EPS × PE Ratio
le
This is referred to as capitalization of earnings. Another method of capitalization is:
ha
EPS
Price of an equity share =
Normal ROI
The value of the firm can be determined from the value of the share.
ok
(3) Fair Value or Berliner Method: As per this method, the fair value of a share is taken as the simple average
of the values as per the Net Assets/Asset Backing Method and the Capitalized Earnings Method.
(4) Discounted Cash Flow/Free Cash Flow Method: A business may be valued at the present value of its future
cash inflows discounted at the appropriate rate. This is the most common technique for the valuation of
G
business. The business is to be valued as a going concern but we need a finite number of cash flows. For
this purpose we estimate cash flows for a few initial years with the anticipated growth rate and a terminal
value at the end of that period which is based on the assumption that there will be either no or a constant
il
growth rate thereafter. For example, we estimate cash flows for five years with a 10% growth rate and no
growth rate or a 5% growth rate for perpetuity thereafter. Hence, we will have cash flow for five years
un
and terminal value of the business at the end of five year. The present value of the business can then be
determined at the appropriate discount rate. This method involves the following steps:
(i) Determine the free cash flow for initial period: Free cash flow is the cash flow available for equity
shareholder; i.e., the cash flow from which the company may declare dividend after meeting all its
.S
requirement for capital expenditure & working capital.

Free cash flow = Net profit + Depreciation – (Capital Expenditure + Working Capital Investment)
(ii) Determine the terminal value: This is the value of the business at the end of the initial period. This
A
may be on the basis of no growth or a constant growth till perpetuity. The terminal value can be
C
(a) Terminal value with no growth: Where it is assumed that the cash flows remain constant after
the initial period, the terminal value (TV) is computed as under:
FCF
TV =
k
Where,
FCF = constant annual free cash flow after the terminal year
k = discount rate
(b) Terminal value with constant growth: Where it is assumed that after a high initial growth rate
the cash flows settle down to a low constant growth rate, the terminal value (TV) is computed
as under:
FCFt (1 + g )
TV =
k − g
Where,
FCFt = free cash flow in the terminal year
k = discount rate
g = growth rate
Mergers, Acquisitions & Restructuring Ɩ 229

(c) Terminal value as a multiple of book value: The terminal value (TV) can also be estimated by
multiplying the book value of capital by appropriate market to book value ratio (M/BV).
(d) Terminal value as a multiple of earnings: The terminal value (TV) can also be estimated by
multiplying the last year’s earnings by an appropriate multiple. The current price to earning
(PE) multiple can be used.
(iii) The value of the business is determined as follows:
FCF1 FCF2 FCF3 FCFn TV
Value of business = + + ..... + n
+
1+k (1 + k )2
(1 + k )3
(1 + k ) (1 + k )n
Where,
FCF = free cash flow of future period
n = number of years in the period
k = discount rate
(iv) Value of the shares is determined as follows:
Value of Shares = Value of business – Value of debt taken over
(5) Chop-Shop Method: This method is used for valuing companies which have a presence in different
industries. For example, ITC Ltd. is in the business of tobacco, clothes, cosmetics & toiletries, food &
hotels. In is generally found that the shares of these companies are undervalued and would be worth more
if these businesses were split-up. The “chop-shop” approach attempts to value companies by their various
business segments instead of valuing the company as a single unit. Each industry has its own average
es
valuation ratio. However, where a company has a multi-industry presence it would be inappropriate to
apply the valuation ratio of any one industry. Therefore, this method values the segments as per different
ratios. The ratios frequently used compare total capitalization (debt plus equity) to total sales, to assets,
ss
and to operating income. The final valuation is the average of the three values.
Synergy
la
‘Synergy’ means the working together of two things to produce an effect greater than the sum of their individual
effect. The aim of mergers & acquisitions is to increase the value of the combined firms in such a way that it
C
is more than the mere sum of their individual values. For example, Firm A is valued at `100 crores & Firm B
at `50 crores. If the value after their merger is more than `150 crores then we can say that synergy has been
achieved. Synergy occur because of economies of scale, better market share, better utilization of resources,
h
better efficiency, reduced competition, etc.

Value of Merged Entity
rs
VAB = VA + VB + Synergy Value

Where,
da
VAB = Value of merged firm

VA = Value of acquiring firm
VB = Value of the target firm
A
Synergy Value
Synergy value = VAB – (VA + VB)
Synergy Gain
In the acquisition of a firm, the acquiring firm may pay a price which is more than the value of the firm being
acquired; in other words a premium. The synergy gain in a merger is computed as follows:
Synergy gain = Synergy value – Premium paid
Cost & Gain of Merger

True Cost of Merger/Acquisition
True cost of the merger or acquisition is computed as follows:
`
Value of consideration xx
Less: Value of target company xx
True cost of merger/acquisition xx
The value of consideration may either cash or in the form of shares or combination thereof. The value of shares

should be the taken as the theoretical post-merger value of share computed as under:
VA + VB + Synergy Gain
Theoretical post merger value of share =
Shares of acquiring company + Shares issued to target company
Gain to Acquiring Company

The gain arising to the acquiring company from the merger is computed as follows:
`
Synergy gain xx
Less: True cost of merger/acquisition xx
Gain to acquiring company xx
Determining Exchange Ratio

Where shares are issued by the acquiring company to the shareholders of the target company, the exchange ratio
of shares has to be determined; e.g. ‘m’ number of shares in the acquiring company will be issued in exchange
le
of ‘n’ number of shares held in the target company. This ratio can be determined on any of the following basis:
(a) EPS
ha
(b) Book value per share
(c) Market price per share
(d) Fair value per share
ok
Basis of target firm
Swap ratio =
Basis of acquiring firm
Swap ratio to maintain pre-merger EPS

G
If the post-merger EPS has to be maintained at the pre-merger level then the swap ratio should be in the ratio of
the EPS of the two companies. To ensure that shareholders of the target company are not at a loss
the swap ration should be on EPS basis.
il
Weighted Average Swap Ratio
Selecting an appropriate basis is not always easy. Sometimes companies may use more than one and assign
un
weights to each and arrive at a weighted average swap ratio.
Problems
.S
Valuation of Business
1.1 [C.A.] Following Financial data are available for PQR Ltd. for the year 2008:
(` in lakh)
A
8% debentures 125
10% bonds (2007) 50
C
Equity shares (`10 each) 100

Reserves and Surplus 300
Total Assets 600
Assets Turnovers ratio 1.1
Effective interest rate 8%
Effective tax rate 40%
Operating margin 10%
Dividend payout ratio 16.67%
Current market Price of Share 14
Required rate of return of investors 15%
(i) Draw income statement for the year
(ii) Calculate its sustainable growth rate
(iii) Calculate the fair price of the Company’s share using dividend discount model, and
(iv) What is your opinion on investment in the company’s share at current price?
[(i) Net profit `31.20 lakhs (ii) 6.5% (iii) `6.51 (iv) Investment should not be made as share is overvalued.]

1.2 [C.M.A.] HPL Ltd. is a growing company. Its Free Cash Flows for Equity shareholders (FCFE) have been
growing at a rate of 25% in recent years. This abnormal rate is expected to continue for another 5 years, then
these FCFE are likely to grow at the normal rate of 8%. The required rate of return on these shares, by investing
community is 15%, the firm’s weighted average cost of capital is 12%.
The amount of FCFE per share at the beginning of the current year is `30.
Determine the maximum price an investor should be willing to pay now, bases on free cash flow approach. The
issue price of share is `500.
PV factors at 15% discount rate are:
Year 1 2 3 4 5
PV 0.870 0.756 0.658 0.572 0.497
[`896]
1.3 [C.A.] The valuation of Hansel Limited has been done by an investment analyst. Based on an expected free
cash flow of `54 lakhs for the following year and an expected growth rate of 9%, the analyst has estimated the
value of Hansel Limited to be `1,800 lakhs. However, he committed a mistake of using the book values of debt
and equity.
The book value weights employed by the analyst are not known, but you know that Hansel Limited has a cost of
equity of 20% and post tax cost of debt of 10%.
The value of equity is thrice its book value, whereas the market value of its debt is nine-tenths of its book value.
What is the correct value of Hansel Ltd?
[`974.73 lakhs]
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1.4 [C.A.] A valuation done of an established company by a well-known analyst has estimated a value of `500
lakhs, based on the expected free cash flow for next year of `20 lakhs and an expected growth rate of 5%.
ss
While going through the valuation procedure, you found that the analyst has made the mistake of using the
book values of debt and equity in his calculation. While you do not know the book value weights he used, you
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have been provided with the following information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
C
(iii) The market value of equity is three times the book value of equity, while the market value of debt is equal to
the book value of debt.
You are required to estimate the correct value of the company.
h
[`363.64 lakhs]
rs
1.5 [C.A.] ABC Limited is considering acquisition of DBF Ltd., which has 3.10 crore shares issued and
outstanding. The market price per share is `440.00 at present. ABC Ltd.’s average cost of capital is 12%. The
cash inflows of DEF Ltd. for the next three years are as under:
da
Year ` in crores
1 460.00
2 600.00
A
3 740.00
You are required to calculate the range of valuation that ABC Ltd. has to consider.
Take P.V.F. (12%, 3) = 0.893, 0.797, 0.712
[Minimum `1,364 crores @ `440 per share, maximum `1,415.86 crores @ `456.73]
1.6 [C.A.] Using the chop-shop approach (or Break-up value approach), assign a value for Cranberry Ltd.
whose stock is currently trading at a total market price of €4 million. For Cranberry Ltd, the accounting data
set forth three business segments: consumer wholesale, retail and general centers. Data for the firm’s three
segments are as follows:
Business Segment Segment Segment
Segment Sales Assets Operating Income
Wholesale €2,25,000 €6,00,000 €75,000
Retail €720,000 €5,00,000 €1,50,000
General €25,00,000 €40,00,000 €7,00,000
Industry data for “pure-play” firms have been compiled and are summarized as follows:
Business Segment Capitalization/Sales Capitalization/Assets Capitalization/Operating Income
Wholesale 0.85 0.7 9
Retail 1.2 0.7 8

General 0.8 0.7 4
[€37,66,750]
1.7 [C.A.] AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The valuation is to be
based on the recommendation of merchant bankers and the consideration is to be discharged in the form of
equity shares to be issued by AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists of 80 lakhs shares
of `10 each. The highest and the lowest market quotation during the last 6 months were `570 and `430. For the
purpose of the exchange, the price per share is to be reckoned as the average of the highest and lowest market
price during the last 6 months ended on 31.3.2006.
XY Ltd.’s Balance Sheet as at 31.3.2006 is summarized below:
` lakhs
Sources
Share Capital:
20 lakhs equity shares of `10 each fully paid 200
10 lakhs equity shares of `10 each, `5 paid 50
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Loans 100
Total 350
ha
Uses
Fixed Assets (Net) 150
Net Current Assets 200
Total 350
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An independent firm of merchant bankers engaged for the negotiation, have produced the following estimates of
cash flows from the business of XY Ltd.:
Year ended By way of ` lakhs
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31.3.07 after tax earnings for equity 105
31.3.08 – do – 120
31.3.09 – do – 125
31.3.10 – do – 120
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31.3.11 – do – 100
terminal value estimate 200
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It is the recommendation of the merchant banker that the business of XY Ltd. may be valued on the basis of the
average of (i) Aggregate of discounted cash flows at 8% and (ii) Net assets value. Present value factors at 8% for
years
.S
1-5: 0.93 0.86 0.79 0.74 0.68

(i) Calculate the total value of the business of XY Ltd.
A
(ii) The number of shares to be issued by AB Ltd.; and

(iii) The basis of allocation of the shares among the shareholders of XY Ltd.
[(i) `421.20 lakhs (ii) 84,240 shares (iii) To holders of fully-paid shares: 67,392 shares, partly-paid shares: 16,848 shares]
C
Mergers & Acquisitions

2.1 [C.A.] Elrond Limited plans to acquire Doom Limited. The relevant financial details of the two firms prior
to the merger announcement are:
Elrond Limited Doom Limited
Market price per share `50 `25
Number of outstanding shares 20 lakhs 10 Lakhs
The merger is expected to generate gains, which have a present value of `200 lakhs.
The exchange ratio agreed to is 0.5.
What is the true cost of the merger from the point of view of Elrond Limited?
[`40 lakhs]
2.2 [C.A.] The following information relating to the acquiring Company Abhiman Ltd. and the target Company
Abhishek Ltd. are available. Both the Companies are promoted by Multinational Company, Trident Ltd. The
promoter’s holding is 50% and 60% respectively in Abhiman Ltd. and Abhishek Ltd.:
Abhiman Ltd Abhishek Ltd.
Share Capital (`) 200 lakh 100 lakh
Free Reserve and Surplus (`) 800 lakh 500 lakh

Paid up Value per share (`) 100 10
Free float Market Capitalization (`) 400 lakh 128 lakh
P/E Ratio (times) 10 4
Trident Ltd. is interested to do justice to the shareholders of both the Companies. For the swap ratio weights are
assigned to different parameters by the Board of Directors as follows:
Book Value 25%
EPS (Earning per share) 50%
Market Price 25%
(a) What is the swap ratio based on above weights?
(b) What is the Book Value, EPS and expected market price of Abhiman Ltd. after acquisition of Abhishek Ltd.
(assuming P.E. ratio of Abhiman Ltd. remains unchanged and all assets and liabilities of Abhishek Ltd. are
taken over at book value).
(c) Calculate:
(i) Promoter’s revised holding in the Abhiman Ltd.
(ii) Free float market capitalization.
(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book Value (B.V.), if after acquisition of
Abhishek Ltd., Abhiman Ltd. decided to:
(a) Issue Bonus shares in the ratio of 1:2; and
(b) Split the stock (share) as `5 each fully paid.
[(a) 0.15 shares in Abhiman Ltd. for every share in Abhishek Ltd. (b) Book value `457.14, EPS `45.71, MP `457.10 (c) (i) 54.29% (ii) `731.36
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lakhs (iii) 105 lakh shares, EPS `1.523, B.V. `15.238]
2.3 [C.A.] The following information is given for 3 companies that are identical except for their capital
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structure:
Orange Grape Apple
Total invested capital 1,00,000 1,00,000 1,00,000
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Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
C
Pre-tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Operating Income (EBIT) 25,000 25,000 25,000
Net Income 8,970 12,350 14,950
h
The tax rate is uniform 35% in all cases.

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(i) Compute the Weighted average cost of capital for each company.
(ii) Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give reasons.
da
(iv) If the industry PE ratio is 11x, estimate the price for the share of each company.
(v) Calculate the estimated market capitalization for each of the companies.
[(i) 13.52%, 15.225%, 15.95% (ii) `2,730, `1,025, (`1,700) (iii) Orange (iv) `14.30, `15.94, `15.73 (v) `87,230, `1,32,302, `1,57,300]
A
2.4 [C.A.] T Ltd. and E Ltd. are in the same industry. The former is in negotiation for acquisition of the latter.
Important information about the two companies as per their latest financial statements is given below:
T Ltd. E Ltd.
`10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:
10% Debentures (` Lakhs) 580 –
12.5% Institutional Loan (` Lakhs) – 240
Earning before interest, depreciation and tax (EBIDAT) (` Lakhs) 400.86 115.71
Market Price/share (`) 220.00 110.00
T Ltd. plans to offer a price for E Ltd., business as a whole which will be 1 times EBIDAT reduced by outstanding
debt, to be discharged by own shares at market price.
E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based on the market price. Tax rate for
the two companies may be assumed as 30%.
Calculate and show the following under both alternatives - T Ltd.’s offer and E Ltd.’s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd. after acquisition.

(iv) Expected market price per share of T Ltd. after acquisition.
(v) State briefly the advantages to T Ltd. from the acquisition.
Calculations (except EPS) may be rounded off to 2 decimals in lakhs.
[(i) `569.97 lakhs (ii) 2,59,000 shares (iii) `20.56 (iv) `226.16]
2.5 [C.A.] Abhiman Ltd. is a subsidiary of Janam Ltd. and is acquiring Swabhiman Ltd. which is also a subsidiary
of Janam Ltd.
The following information is given:
Abhiman Ltd. Swabhiman Ltd.
% Shareholding of promoter 50% 60%
Share capital `200 lacs `100 lacs
Free Reserves and surplus `900 lacs `600 lacs
Paid up value per share `100 10
Free float market capitalization `500 lacs `156 lacs
P/E Ratio (times) 10 4
le
Janam Ltd., is interested in doing justice to both companies. The following parameters have been assigned by
the Board of Janam Ltd., for determining the swap ratio:
Book value 25%
ha
Earning per share 50%
Market price 25%
You are required to compute
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(i) The swap ratio.
(ii) The Book Value, Earning Per Share and Expected Market Price of Swabhiman Ltd.,
(assuming P/E Ratio of Abhiman ratio remains the same and all assets and liabilities of Swabhiman Ltd. are
taken over at book value.
G
[(i) 0.148825 shares of Abhiman Ltd. for every share of Swabhiman Ltd. (ii) `516.02, `56.62, `566.20]
2.6 [C.A.] Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the companies are dependent
on the fluctuating business conditions. The following information is given for the total value (debt + equity)
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structure of each of the two companies.
Business Condition Probability Simple Ltd. ` Lacs Dimple Ltd. ` Lacs
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High Growth 0.20 820 1,050

Medium Growth 0.60 550 825
Slow Growth 0.20 410 590
.S
The current debt of Dimple Ltd. is `65 lacs and of Simple Ltd. is `460 lacs.
Calculate the expected value of debt and equity separately for the merged entity.
[Equity `884 lakhs, Debt `515 lakhs]
A
2.7 [C.A.] Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are given
below:
(` in lakhs)
C
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620
Earnings would have witnessed 5% constant growth rate without merger and 6% with merger on account of
economies of operations after 5 years in each case. The cost of capital is 15%.
The number of shares outstanding in both the companies before the merger is the same and the companies agree
to an exchange ratio of 0.5 shares of Yes Ltd. for each share of No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.
(i) Compute the Value of Yes Ltd. before and after merger.
(ii) Value of Acquisition and
(iii) Gain to shareholders of Yes Ltd.
[(i) Before merger `2,708.915 lakhs; after merger `5,308.47 lakhs (ii) `2,599.555 lakhs (iii) `830.065 lakhs]
2.8 [C.A.] LMN Ltd is considering merger with XYZ Ltd. LMN Ltd.’s shares are currently traded at `30.00 per
share. It has 3,00,000 shares outstanding. Its earnings after taxes (EAT) amount to `6,00,000. XYZ Ltd has
1,60,000 shares outstanding and its current market price is `15.00 per share and its earnings after taxes (EAT)

amount to `1,60,000. The merger is decided to be effected by means of a stock swap (exchange). XYZ Ltd has
agreed to a proposal by which LMN Ltd will offer the current market value of XYZ Ltd.’s shares.
Find out:
(i) The pre-merger earnings per share (EPS) and price/earnings (P/E) ratios of both the companies.
(ii) If XYZ Ltd.’s P/E Ratio is 9.6, what is its current Market Price? What is the Exchange Ratio? What will LMN
Ltd.’s post-merger EPS be?
(iii) What should be the exchange ratio, if LMN Ltd.’s pre-merger and post- merger EPS are to be the same?
[(i) Pre-merger EPS & PE: LMN Ltd. `2 & 15, XYZ Ltd. (ii) MP of XYZ Ltd. `9.60; Exchange ratio: 1 share in LMN Ltd. for every 3.125 shares in XYZ
Ltd.; Post-merger EPS `2.16 (iii) Desired exchange ratio: 1 share in LMN Ltd. for every 2 shares in XYZ Ltd.]
2.9 [C.A.] Longitude Ltd. is in the process of acquiring Latitude Ltd. on a share exchange basis. Following
relevant data are available:
Longitude Ltd.
Latitude Ltd.
Profit after Tax (PAT) ` in Lakhs 140 60
Number of Shares Lakhs 15 16
Earning per Share (EPS) ` 8 5
Price Earnings Ratio (P/E Ratio) 15 10
(Ignore Synergy)
(i) Pre-merger Market Value per Share, and
(ii) The maximum exchange ratio Longitude Ltd. can offer without the dilution of
es
(1) EPS and
(2) Market Value per Share
ss
Calculate Ratio/s up to four decimal points and amounts and number of shares up to two decimal points.
[(i) Longitude `120, Latitude `50 (ii) (1) 5:8 (2) 6.67:16]
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2.10 [C.A.] K. Ltd. is considering acquiring N. Ltd., the following information is available:
Company Profit Number of Market value
after tax equity shares per share
C
K. Ltd. 50,00,000 10,00,000 200.00
N. Ltd. 15,00,000 2,50,000 160.00
Exchange of equity shares for acquisition is based on current market value as above.
h
There is no synergy advantage available.

Find the earning per share for company K. Ltd. after merger.
rs
Find the exchange ratio so that shareholders of N. Ltd. would not be at a loss.
[`5.42; 6 shares of K. Ltd. for every 5 shares of N Ltd.]
da
2.11 [C.A.] MK Ltd. is considering acquiring NN Ltd. The following information is available:
Company Earning after No. of Equity Market Value
tax (`) Shares Per Share (`)
A
MK Ltd. 60,00,000 12,00,000 200.00

NN Ltd. 18,00,000 3,00,000 160.00
Exchange of equity shares for acquisition is based on current market value as above.
There is no synergy advantage available.
(i) Find the earning per share for company MK Ltd. after merger, and
(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at a loss.
[(i) `5.42 (ii) 6 shares of MK Ltd. for every 5 shares of NN Ltd.]
2.12 [C.A.] You have been provided the following Financial data of two companies:
Krishna Ltd. Rama Ltd.
Earnings after taxes `7,00,000 `10,00,000
Equity shares (outstanding) `2,00,000 `4,00,000
EPS 3.5 2.5
P/E ratio 10 times 14 times
Company Rama Ltd. is acquiring the company Krishna Ltd., exchanging its shares on a one-to-one basis for
company Krishna Ltd. The exchange ratio is based on the market prices of the shares of the two companies.
Required:

(i) What will be the EPS subsequent to merger?
(ii) What is the change in EPS for the shareholders of companies Rama Ltd. and Krishna Ltd.?
(iii) Determine the market value of the post-merger firm. PE ratio is likely to remain the same.
(iv) Ascertain the profits accruing to shareholders of both the companies.
[(i) `2.83 (ii) Rama Ltd. EPS increase `0.33, Krishna Ltd. EPS decrease `0.67 (iii) `39.62 (iv) `18,48,000 to Rama Ltd., `9,24,000 to Krishna
Ltd.]
2.13 [C.A.] Following information is provided relating to the acquiring company Mani Ltd. and the target
company Ratnam Ltd:
Mani Ltd. Ratnam Ltd.
Earnings after tax (` lakhs) 2,000 4,000
No. of shares outstanding (lakhs) 200 1,000
P/E ratio (No. of times) 10 5
Required:
(i) What is the swap ratio based on current market prices?
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(ii) What is the EPS of Mani L td. after the acquisition?
(iii) What is the expected market price per share of Mani Ltd. after the acquisition, assuming its P/E ratio is
adversely affected by 10%?
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(iv) Determine the market value of the merged Co.
(v) Calculate gain/loss for the shareholders of the two independent entities, due to the merger.
[(i) 1:5 (ii) `15 (iii) `135 (iv) `54,000 lakhs (v) Gain: Mani Ltd. `35 per share & Ratnam Ltd. `7 per share]
ok
2.14 [C.A.] H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The summarized Balance
Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as follows:
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
G
Liabilities: H. Ltd. B. Ltd.
Paid up Share Capital:
– Equity Shares of `100 each 350.00
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– Equity Shares of `10 each 6.50
Reserve & Surplus 950.00 25.00
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1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
.S
Net Current Assets 1,020.00 29.00

Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50
A
H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of the scheme of
buying:
C
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4 years are `300 crores
and `10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.
(3) H Ltd. has a contingent liability of `300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of `100 each to the shareholders of B Ltd. in terms of the exchange ratio as arrived on
a Fair Value basis. (Please consider weights of 1 and 3 for the value of shares arrived on Net Asset basis and
Earnings capitalization method respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalization Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Ltd. on a Fair value basis (taking
into consideration the assumption mentioned in point 4 above.)
[(i) H Ltd. `285.71, B Ltd. `48.46 (ii) H Ltd. `1071.43, B Ltd. `192.31 (iii) H Ltd. `875, B Ltd. `156.3475]
2.15 [C.A.] M/s Tiger Ltd. wants to acquire M/s. Leopard Ltd. The balance sheet of Leopard Ltd. as on 31st
March, 2012 is as follows:

Liabilities ` Assets `
Equity Capital (70,000 shares) 7,00,000 Cash 50,000
Retained earnings 3,00,000 Debtors 70,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors & other liabilities 3,20,000 Plant & Equipment 13,00,000
16,20,000 16,20,000
Additional Information:
(i) Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for every two shares. External liabilities are
expected to be settled at `5,00,000. Shares of Tiger Ltd. would be issued at its current price of `15 per share.
Debentureholders will get 13% convertible debentures in the purchasing company for the same amount.
Debtors and inventories are expected to realize `2,00,000.
(ii) Tiger Ltd. has decided to operate the business of Leopard Ltd. as a separate division. The division is likely to
give cash flows (after tax) to the extent of `5,00,000 per year for 6 years. Tiger Ltd. has planned that, after
6 years, this division would be demerged and disposed of for `2,00,000.
(iii) The company’s cost of capital is 16%.
Make a report to the Board of the company advising them about the financial feasibility of this acquisition.
Net present values for 16% for `1 are as follows:
Years 1 2 3 4 5 6
PV .862 .743 .641 .552 .476 .410
es
[NPV `8,49,000]
2.16 [C.A.] XYZ Ltd. is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at `25. it has
ss
2,00,000 shares outstanding and its earning after taxes (EAT) amount to `4,00,000. ABC Ltd. has 1,00,000
shares outstanding; its current market price is `12.50 and its EAT is `1,00,000. The merger will be effected by
means of a stock swap (exchange). ABC Ltd. has agreed to a plan under which XYZ Ltd. will offer the current
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market value of ABC Ltd.’s shares.
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the companies?
C
(ii) If ABC Ltd.’s P/E ratio is 8, what is its current market price? What is the exchange ratio? What will XYZ
Ltd.’s post merger EPS be?
(iii) What must the exchange ratio be for XYZ Ltd.’s pre-merger and post-merger EPS to be the same?
[XYZ: EPS `2, P/E 12.5; ABC: EPS `1, P/E 12.5 (ii) 8:25 (iii) `2.16]
h
2.17 [C.A.] The following information is provided relating to the acquiring company Efficient Ltd. and the
rs
target Company Healthy Ltd.

Efficient Ltd. Healthy Ltd.
da
No. of shares (F.V. `10 each) `10.00 lakhs `7.5 lakhs

Market capitalization `500.00 lakhs `750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus `300.00 lakhs `165.00 lakhs
A
Promoter’s Holding (No. of shares) 4.75 lakhs 5.00 lakhs

Board of Directors of both the Companies have decided to give a fair deal to the shareholders and accordingly
for swap ratio the weights are decided as 40%, 25% and 35% respectively for Earning, Book Value and Market
Price of share of each company:
(i) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market capitalization of Efficient Ltd. after acquisition,
assuming P/E ratio of firm Efficient Ltd. remains unchanged.
(iv) Calculate free float market capitalization of the merged firm.
[(i) 5:2, 60% (ii) `6.956 (iii) `69.56, `1,999.85 lakhs (iv) `799.94 lakhs]
2.18 [C.A.] Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower Industries Ltd. (SIL).
The particulars of 2 companies are given below:
Particulars Reliable Industries Ltd. Sunflower Industries Ltd.
Earnings After Tax (EA T) `20,00,000 `10,00,000
Equity shares O/s 10,00,000 10,00,000
Earnings per share (EPS) 2 1
PE Ratio (Times) 10 5

Required:
(i) What is the market value of each Company before merger?
(ii) Assume that the management of RIL estimates that the shareholders of SIL will accept an offer of one share
of RIL for four shares of SIL. If there are no synergic effects, what is the market value of the Post-merger
RIL? What is the new price per share? Are the shareholders of RIL better or worse off than they were before
the merger?
(iii) Due to synergic effects, the management of RIL estimates that the earnings will increase by 20%. What is
the new post-merger EPS and Price per share? Will the shareholders be better off or worse off than before
the merger?
[(i) RIL `2 crores, SIL `50 lakhs (ii) Mkt. value `3 crores, EPS `2.40, RIL shareholders gain `40 lakh value (iii) EPS `2.88, Share price `28.80]
2.19 [C.A.] AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two companies are 10,00,000 and
5,00,000 respectively:
(i) Calculate the increase in the total value of BCD Ltd. resulting from the acquisition on the basis of the
following conditions:
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Current expected growth rate of BCD Ltd. 7%
Expected growth rate under control of AFC Ltd., (without any additional
capital investment and without any change in risk of operations) 8%
ha
Current Market price per share of AFC Ltd. `100
Current Market price per share of BCD Ltd. `20
Current Dividend per share of BCD Ltd. `0.60
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(ii) On the basis of aforesaid conditions calculate the gain or loss to shareholders of both the companies, if
AFC Ltd. were to offer one of its share for every four shares of BCD Ltd.
(iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd. pays `22 for each share of BCD
G
Ltd., assuming the P/E Ratio of AFC Ltd. does not change after the merger. EPS of AFC Ltd. is `8 and that
of BCD is `2.50. It is assumed that AFC Ltd. invests its cash to earn 10%.
[(i) `50,00,000 (ii) Gain: AFC Ltd. `22.22 per share, BCD Ltd. `2.22 per share (iii) `2 per share]
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2.20 [C.A.] The following information is provided related to the acquiring Firm Mark Limited and the target
Firm Mask Limited:
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Firm Firm
Mark Limited Mask Limited
Earning after tax (`) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
.S
P/E ratio (times) 10 5

Required:
(i) What is the Swap Ratio based on current market prices?
A
(ii) What is the EPS of Mark Limited after acquisition?

(iii) What is the expected market price per share of Mark Limited after acquisition, assuming P/E ratio of Mark
Limited remains unchanged?
C
(iv) Determine the market value of the merged firm.

(v) Calculate gain/loss for shareholders of the two independent companies after acquisition.
[(i) 1:5 (ii) `10.91 (iii) `109.10 (iv) `240.02 crores (v) Gain to shareholders of Mark Ltd. `18.20 crores & Mask Ltd. 1.82 crores]
2.21 [C.A.] A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one share of
T Ltd.). Following information is provided:
A Ltd. T Ltd.
Profit after tax `18,00,000 `3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS `3 `2
PE Ratio 10 times 7 times
Required:
(i) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
(ii) What is the EPS of A Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of T Ltd.
(iv) What is the expected market price per share of A Ltd. after the acquisition, assuming its PE multiple
remains unchanged?

(v) Determine the market value of the merged firm.
[(i) 90,000 shares (ii) `3.13 (iii) `1.57 (iv) `31.30 (v) `2,15,97,000]
2.22 [C.A.] BA Ltd. and DA Ltd. both the companies operate in the same industry. The Financial statements of
both the companies for the current financial year are as follows:
Balance Sheet
Particulars BA Ltd. DA Ltd.
` `
Current Assets 14,00,000 10,00,000
Fixed Assets (Net) 10,00,000 5,00,000
Total (`) 24,00,000 15,00,000
Equity capital (`10 each) 10,00,000 8,00,000
Retained earnings 2,00,000 –
14% long-term debt 5,00,000 3,00,00
Current liabilities 7,00,000 4,00,000
Total (`) 24,00,000 15,00,000
Income Statement
BA Ltd. DA Ltd.
` `
Net Sales 34,50,000 17,00,000
Cost of Goods sold 27,60,000 13,60,000
es
Gross profit 6,90,000 3,40,000
Operating expenses 2,00,000 1,00,000
Interest 70,000 42,000
Earning before taxes
Taxes @ 50%
Earning after taxes (EAT)
4,20,000
2,10,000
2,10,000 ss
1,98,000
99,000
99,000
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No. of Equity shares 1,00,000 80,000
C
Dividend payment ratio (D/P) 40% 60%
Assume that both companies are in the process of negotiating a merger through an exchange of equity shares.
You have been asked to assist in establishing equitable exchange terms and are required to:
h
(i) Decompose the share price of both the companies into EPS and P/E components; and also segregate their
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EPS figures into Return on Equity (ROE) and book value/intrinsic value per share components.
(ii) Estimate future EPS growth rates for each company.
(iii) Based on expected operating synergies BA Ltd. estimates that the intrinsic value of DA’s equity share would
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be `20 per share on its acquisition. You are required to develop a range of justifiable equity share exchange
ratios that can be offered by BA Ltd. to the shareholders of DA Ltd. Based on your analysis in part (i) and
(ii), would you expect the negotiated terms to be closer to the upper, or the lower exchange ratio limits
A
and why?
(iv) Calculate the post-merger EPS based on an exchange ratio of 0.4:1 being offered by BA Ltd. Indicate the
immediate EPS accretion or dilution, if any, that will occur for each group of shareholders.
(v) Based on a 0.4:1 exchange ratio and assuming that BA Ltd.’s pre-merger P/E ratio will continue after the
merger, estimate the post-merger market price. Also show the resulting accretion or dilution in pre-merger
market prices.
[BA Ltd. EPS `2.10, P/E 19.05, ROE 17.5%; DA Ltd. EPS `1.2375, P/E 12.12, ROE 12.37% (ii) 10.5%, 4.95% (iii) Intrinsic value (upper limit)
0.5:1; Market value (lower limit) 0.375:1 (iv) Post merger EPS `2.341]
2.23 [C.A.] B Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its expected
high growth in earnings and dividends is reflected in its PE ratio of 17. The Board of Directors of B Ltd. has been
advised that if it were to take over firms with a lower PE ratio than it own, using a share-for-share exchange,
then it could increase its reported earnings per share. C Ltd. has been suggested as a possible target for a
takeover, which has a PE ratio of 10 and 1,00,000 shares in issue with a share price of `15. B Ltd. has 5,00,000
shares in issue with a share price of `12.
Calculate the change in earnings per share of B Ltd. if it acquires the whole of C Ltd. by issuing shares at its
market price of `12. Assume the price of B Ltd. shares remains constant.
[EPS will increase from `0.71 to `0.80]

2.24 [C.A.] P Ltd. is considering take-over of R Ltd. by the exchange of four new shares in P Ltd. for every
five shares in R Ltd. The relevant financial details of the two companies prior to merger announcement are as
follows:
P Ltd. R Ltd.
Profit before Tax (` Crore) 15 13.50
No. of Shares (Crore) 25 15
P/E Ratio 12 9
Corporate Tax Rate 30%.
(i) Market value of both the company.
(ii) Value of original shareholders.
(iii) Price per share after merger.
(iv) Effect on share price of both the company if the Directors of P Ltd. expect their own pre-merger P/E ratio to
be applied to the combined earnings.
[(i) P Ltd. `126 crores, R Ltd. 85.05 crores (ii) P Ltd. `142.61 crores, R Ltd. 68.44 crores (iii) `6.47 (iv) P Ltd. share price will rise by 28.4% &
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that of R Ltd. will fall by 8.64%]
2.25 [C.A.] R Ltd. and S Ltd. are companies that operate in the same industry. The financial statements of both
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the companies fox the current financial year are as follows:
Balance Sheet
Particulars R Ltd. (`) S Ltd. (`)
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Equity & Liabilities
Shareholders Fund
Equity Capital (`10 each) 20,00,000 16,00,000
G
Retained earnings 4,00,000
Non-current Liabilities
16% Long twin Debt 10,00,000 6,00,000
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Current Liabilities 14,00,000 8,00,000
Total 48,00,000 30,00,000
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Assets
Non-Current Asset 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
.S
Total 48,00,000 30,00,000

Income Statement
Particulars R Ltd,(`) S Ltd. (`)
A
A. Net Sales 69,00,000 34,00,000

B. Cost of Goods sold 55,20,000 27,20,000
C
C. Gross Profit (A-B) 13,80,000 6,80,000

D. Operating Expenses 4,00,000 2,00,000
E. Interest 1,60,000 96,000
F. Earnings before taxes [C-(D+E)] 8,20,000 3,84,000
G. Taxes ® 35% 2,87,000 1,34,400
H. Earnings After Tax (EAT) 5,33,000 2,49,600
No. of equity shares 2,00,000 1,60,000
Dividend Payment Ratio (D/P) 20% 30%
Assume that both companies are in the process of negotiating a merger through exchange of Equity shares:
(i) Decompose the share price of both the companies into EPS & P/E components. Also segregate their EPS
figures into Return On Equity (ROE) and Book Value/Intrinsic Value per share components.
(ii) Estimate future EPS growth races for both the companies.
(iii) Based on expected operating synergies, R Ltd. estimated that the intrinsic value of S Ltd. Equity share

would he `25 per share on its acquisition. You are required to develop a range of justifiable Equity Share
Exchange ratios that can be offered by R Ltd. to the shareholders of S Ltd. Based on your analysis on parts
(i) and (ii), would you expect the negotiated terms to be closer to the upper or the lower exchange ratio
limits and why?
Demerger, Reconstruction, Buyback, Bonus Shares & Stock Split

Buyback of shares
A company may buy back its equity shares as per the provisions of the Companies Act and the SEBI guidelines.
Buyback of equity shares is normally done at a price which is higher than its market value. Buyback also rewards
the shareholders who do not offer their shares for buyback because the reduced number of outstanding equity
shares increases the earnings per share and therefore the market price of the remaining shares. The company
can buyback its shares in three ways:
(i) Tender offer: The company sends an offer letter to each shareholder offering to buyback a proportionate
number of shares from each shareholder. For example, the company has decided to buyback 10% of its
shares. The holder of 200 shares will get an offer letter for buyback of 20 shares. The shareholders are
free to accept, reject or even offer more shares for buyback which may be considered if other shareholders
reject the offer. The offer to buyback shares is usually made at a price higher than the market price.
(ii) Open market repurchase: The company can also buy its own shares from the stock market like any investor
buys them. In this case the shares will be bought at different prices as per the price at which they are
traded.
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(iii) Negotiated repurchase: In this case the company buys the shares from a large shareholder who holds
a substantial number of shares, e.g. promoters, financial institutions, etc., who are willing to sell their
shares.
ss
Buyback offer indicates that the firm is flush with surplus cash and also confident about its future cash inflows. It
results in increase in earnings per share and dividend per share due to the reduced number of shares and hence
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the market price is expected to rise post buyback. It is also a convenient way to change the capital structure of
the firm without increase cash. The change in debt-equity ratio will benefit the shareholders due to financial
C
leverage.
The value of a firm is based on the future cash inflows and does not depend on the number of shares. Therefore,
the theoretical post-buyback price is computed as follows:
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S × P0
Post buyback price =
S−N
rs
Where, S = Number of shares outstanding before buyback

P0 = Current market price
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N = Number of shares to be bought back

The post buyback price is used to buyback the shares so that the shareholders who offer their shares for buyback
do not lose out.
A
Bonus shares
Instead of, or in addition to, paying dividend a company may issue bonus to the shareholders. This is also called
stock dividend. This is the most tax efficient way of distributing profits to shareholders.
S × P0
Post bonus price =
S+ N
Where, S = Number of shares outstanding before bonus shares are issued
N = Number of bonus shares issued
However, bonus shares do not increase the wealth of the shareholders as the intrinsic value per share stands
decreased.
Split & Reverse split

A stock split refers to reduction in face value of shares; for example, each equity share of face value `10 is split
into two equity shares of face value `5 each. It has been observed that the share price after a stock split is more
than proportionate. A stock split does not change the value of the firm so theoretically if a `10 face value share
has a market value of `60 then after it is split into two shares of `5 each the share should be have a market price
of `30. However, it has been observed that in most cases the market price is above the theoretical proportionate
price. One explanation is that more investors can now “afford” to buy the share and due increase in demand
there is a rise in price. The increase in the number of shares also increase the liquidity of the share.
Reverse split, on the other hand, means consolidation of shares; for example, 10 shares having a face value of
`10 are consolidated into one share with a face value of `100. There is no change in the value of the firm and
hence the market value of each share should rise in the same ratio as the consolidation; for example an equity
share of `10 face value has a market price of `25. If two equity shares of `10 face value are consolidated into
one share of `20 face value then its proportionate value should be `50. Usually, firms with low market value
prefer to consolidate their shares as it makes their share appear to be more “valuable” and may attract the
attention of investors. With increase in demand its market price may rise.
Other things being equal, an increase in the value of a share after a split/reverse split is mostly psychological.
S × P0
Post split price =
N
Where, S = Number of shares outstanding before split/reverse split
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N = Number of shares after split/reverse split
Split or reverse split does not involve any cash outflow for the company and strictly speaking cannot be
considered as an alternative to dividend.
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Problems
Demerger & Reconstruction
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3.1 [C.A.] The following is the Balance-sheet of Grape Fruit Company Ltd as at March 31st, 2011.
Liabilities (` in lakhs) Assets (` in lakhs)
G
Equity shares of `100 each 600 Land and Building 200
14% preference shares of `100 each 200 Plant and Machinery 300
13% Debentures 200 Furniture and Fixtures 50
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Debenture interest accrued 26 Inventory 150
Loan from bank 74 Sundry debtors 70
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Trade creditors 340 Cash at bank 130

Preliminary expenses 10
Cost of issue of debentures 5
.S
Profit and Loss a/c 525

1440 1440
The Company did not perform well and has suffered sizable losses during the last few years. However, it is felt
A
that the company could be nursed back to health by proper financial restructuring. Consequently the following
scheme of reconstruction has been drawn up:
(i) Equity shares are to be reduced to `25 per share, fully paid up;
C
(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal number of shares of `50 each,
fully paid up.
(iii) Debenture holders have agreed to forgo the accrued interest due to them. In the future, the rate of interest
on debentures is to be reduced to 9%.
(iv) Trade creditors will forego 25% of the amount due to them.
(v) The company issues 6 lakh of equity shares at `25 each and the entire sum was to be paid on application.
The entire amount was fully subscribed by promoters.
(vi) Land and Building was to be revalued at `450 lakhs, Plant and Machinery was to be written down by `120
lakhs and a provision of `15 lakhs had to be made for bad and doubtful debts.
Required:
(i) Show the impact of financial restructuring on the company’s activities.
(ii) Prepare the fresh balance sheet after the reconstructions is completed on the basis of the above proposals.
[(i) Reduction in liability `661 lakhs, appreciation in assets `911 lakhs, capital reserve `236 lakhs (ii) B/sheet total `1,165]
3.2 [C.A.] The following information is relating to Fortune India Ltd. having two division, viz. Pharma Division
and Fast Moving Consumer Goods Division (FMCG Division). Paid up share capital of Fortune India Ltd. is
consisting of 3,000 Lakhs equity shares of `1 each. Fortune India Ltd. decided to demerge Pharma Division as

Fortune Pharma Ltd. w.e.f. 1.4.2005. Details of Fortune India Ltd. as on 31.3.2005 and of Fortune Pharma Ltd.
as on 1.4.2005 are given below:
Particulars Fortune Pharma Ltd. Fortune India Ltd.
` `
Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities & Provisions 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 12,300 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh
Board of Directors of the Company have decided to issue necessary equity shares of Fortune Pharma Ltd. of `1
each, without any consideration to the shareholders of Fortune India Ltd. For that purpose following points are
to be considered:
1. Transfer of Liabilities & Assets at Book value.
2. Estimated Profit for the year 2005-06 is `11,400 Lakh for Fortune India Ltd. & `1,470 lakhs for Fortune
Pharma Ltd.
3. Estimated Market Price of Fortune Pharma Ltd. is `24.50 per share.
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4. Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is to be expected for both the
companies.
Calculate:
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1. The Ratio in which shares of Fortune Pharma are to be issued to the shareholders of Fortune India Ltd.
2. Expected Market price of Fortune India Ltd.
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3. Book Value per share of both the Companies immediately after demerger.
[(1) 1 share in Fortune Pharma Ltd. for 2 shares in Fortune India Ltd. (2) `159.60 (3) Fortune India Ltd. `8, Fortune Pharma Ltd. `14]
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Buyback of Shares
4.1 [C.A.] Rahul Ltd. has surplus cash of `100 lakhs and wants to distribute 21% of it to the shareholders. The
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company decides to buyback shares. The Finance Manager of the company estimates that its share price after
re-purchase is likely to be 10% above the buyback price-if the buyback route is taken. The number of shares
rs
outstanding at present is 10 lakhs and the current EPS is `3.

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(i) The price at which the shares can be re-purchased, if the market capitalization of the company should be
`210 lakhs after buyback,
(ii) The number of shares that can be re-purchased, and
(iii) The impact of share re-purchase on the EPS, assuming that net income is the same.
A
[(i) `21.79 (ii) 1.24 lakhs approx. (iii) EPS `3.43]

4.2 [C.A.] Abhishek Ltd. has a surplus cash of `90 lakhs and wants to distribute 30% of it to the shareholders.
The Company decides to buyback shares. The Finance Manager of the Company estimates that its share price
after re-purchase is likely to be 10% above the buyback price; if the buyback route is taken. The number of
shares outstanding at present is 10 lakhs and the current EPS is `3.
(a) The price at which the shares can be repurchased, if the market capitalization of the company should be
`200 lakhs after buyback.
(b) The number of shares that can be re-purchased.
(c) The impact of share re-purchase on the EPS, assuming the net income is same.
[(a) `20.88 (b) 1.29 lakhs (c) `3.44]
Bonus Issue, Stock Split & Reverse Split

5.1 [C.S.] DEF Ltd. with a paid-up capital of `25 crore divided into shares of `10 each has securities premium
balance of `20 crore and retained earnings of `100 crore. The current market price of its share is `60.
Different options before the company are:
– Bonus issue 1:5

– Stock split 2:1
– Reverse split 1:2
It seeks you advice as to the best option it should adopt so as to maximize the market price per share. Also
compute the following under each of the above options:
(i) Total equity capital of the company.
(ii) Market price per share.
(iii) Number of shares outstanding.
(iv) Face value per share.
5.2 [C.M.A.] Nimbus Ltd. has 1,000 shares `10 each raised at a premium of `10 per share. The company’s
retained earnings are `5,52,500. The company’s stock sells for `20 per share.
(a) If a 10% stock dividend is declared then how many new shares would be issued? What would be the market
price of the stock dividend? How would the equity account change?
(b) If the company, instead, declares a 5:1 stock split, how many shares will be outstanding? What would be
new par value? What would be the new market price?
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(c) Suppose if the company declares a 1:4 reverse split, how many shares will be outstanding? What would be
the new par value? What would be the new market value?
[(a) Number of new shares issued = 100, market price after the stock dividend `18.18 (b) Number of new shares issued = 5,000 shares, market
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price after split `4 (c) Number of shares outstanding = 250 shares, market price after the reverse split `80]
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G
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.S
A
C

Present value of `1
Year
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Rate
5% 0.9524 0.9070 0.8638 0.8227 0.7845 0.7462 0.7107 0.6768 0.6446 0.6139 0.5847 0.5568 0.5303 0.5051 0.4810
6% 0.9434 0.8900 0.8396 0.7921 0.7473 0.7050 0.6651 0.6274 0.5919 0.5584 0.5268 0.4970 0.4688 0.4423 0.4173
7% 0.9346 0.8734 0.8163 0.7629 0.7130 0.6663 0.6227 0.5820 0.5439 0.5083 0.4751 0.4440 0.4150 0.3878 0.3624
8%
A
0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 0.5002 0.4632 0.4289 0.3971 0.3677 0.3405 0.3152
9% 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224 0.3875 0.3555 0.3262 0.2992 0.2745

10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 0.3505 0.3186 0.2897 0.2633 0.2394
da
11% 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 0.4817 0.4339 0.3909 0.3522 0.3173 0.2858 0.2575 0.2320 0.2090
12% 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 0.4039 0.3606 0.3220 0.2875 0.2567 0.2292 0.2046 0.1827
rs
13% 0.8850 0.7831 0.6931 0.6133 0.5428 0.4803 0.4251 0.3762 0.3329 0.2946 0.2607 0.2307 0.2042 0.1807 0.1599
h
14% 0.8772 0.7695 0.6750 0.5921 0.5194 0.4556 0.3996 0.3506 0.3075 0.2697 0.2366 0.2076 0.1821 0.1597 0.1401
15% 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323 0.3759 0.3269 0.2843 0.2472 0.2149 0.1869 0.1625 0.1413 0.1229
16%
C
0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538 0.3050 0.2630 0.2267 0.1954 0.1685 0.1452 0.1252 0.1079
17% 0.8547 0.7305 0.6244 0.5337 0.4561 0.3898 0.3332 0.2848 0.2434 0.2080 0.1778 0.1520 0.1299 0.1110 0.0949
la
18% 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704 0.3139 0.2660 0.2255 0.1911 0.1619 0.1372 0.1163 0.0985 0.0835
19% 0.8403 0.7062 0.5934 0.4987 0.4190 0.3521 0.2959 0.2487 0.2090 0.1756 0.1476 0.1240 0.1042 0.0876 0.0736
ss
20% 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615 0.1346 0.1122 0.0935 0.0779 0.0649
es
21% 0.8264 0.6830 0.5645 0.4665 0.3855 0.3186 0.2633 0.2176 0.1799 0.1486 0.1228 0.1015 0.0839 0.0693 0.0573
22% 0.8197 0.6719 0.5507 0.4514 0.3700 0.3033 0.2486 0.2038 0.1670 0.1369 0.1122 0.0920 0.0754 0.0618 0.0507
23% 0.8130 0.6610 0.5374 0.4369 0.3552 0.2888 0.2348 0.1909 0.1552 0.1262 0.1026 0.0834 0.0678 0.0551 0.0448
24% 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751 0.2218 0.1789 0.1443 0.1164 0.0938 0.0757 0.0610 0.0492 0.0397
25% 0.8000 0.6400 0.5120 0.4096 0.3277 0.2621 0.2097 0.1678 0.1342 0.1074 0.0859 0.0687 0.0550 0.0440 0.0351
Tables
Present Value of an Annuity of `1
Years
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Rate
5% 0.9524 1.8594 2.7232 3.5460 4.3295 5.0757 5.7864 6.4632 7.1078 7.7217 8.3064 8.8633 9.3936 9.8986 10.3797
6% 0.9434 1.8334 2.6730 3.4651 4.2124 4.9173 5.5824 6.2098 6.8017 7.3601 7.8869 8.3838 8.8527 9.2950 9.7122
7% 0.9346 1.8080 2.6243 3.3872 4.1002 4.7665 5.3893 5.9713 6.5152 7.0236 7.4987 7.9427 8.3577 8.7455
A 9.1079
CA. Sunil Gokhale: 9765823305

8% 0.9259 1.7833 2.5771 3.3121 3.9927 4.6229 5.2064 5.7466 6.2469 6.7101 7.1390 7.5361 7.9038 8.2442 8.5595
9% 0.9174 1.7591 2.5313 3.2397 3.8897 4.4859 5.0330 5.5348 5.9952 6.4177 6.8052 7.1607 7.4869 7.7862 8.0607
10% 0.9091 1.7355 2.4869 3.1699 3.7908 4.3553 4.8684 5.3349 5.7590 6.1446 6.4951 6.8137 7.1034 7.3667 7.6061
da
11% 0.9009 1.7125 2.4437 3.1024 3.6959 4.2305 4.7122 5.1461 5.5370 5.8892 6.2065 6.4924 6.7499 6.9819 7.1906
12%
rs
0.8929 1.6901 2.4018 3.0373 3.6048 4.1114 4.5638 4.9676 5.3282 5.6502 5.9377 6.1944 6.4235 6.6282 6.8109
13%
h
0.8850 1.6681 2.3612 2.9745 3.5172 3.9975 4.4226 4.7988 5.1317 5.4262 5.6869 5.9176 6.1218 6.3025 6.4624
14% 0.8772 1.6467 2.3216 2.9137 3.4331 3.8887 4.2883 4.6389 4.9464 5.2161 5.4527 5.6603 5.8424 6.0021
C 6.1422
15% 0.8696 1.6257 2.2832 2.8550 3.3522 3.7845 4.1604 4.4873 4.7716 5.0188 5.2337 5.4206 5.5831 5.7245 5.8474
16% 0.8621 1.6052 2.2459 2.7982 3.2743 3.6847 4.0386 4.3436 4.6065 4.8332 5.0286 5.1971 5.3423 5.4675 5.5755
la
17% 0.8547 1.5852 2.2096 2.7432 3.1993 3.5892 3.9224 4.2072 4.4506 4.6586 4.8364 4.9884 5.1183 5.2293 5.3242
18% 0.8475 1.5656 2.1743 2.6901 3.1272 3.4976 3.8115 4.0776 4.3030 4.4941 4.6560 4.7932 4.9095 5.0081 5.0916
ss
19% 0.8403 1.5465 2.1399 2.6386 3.0576 3.4098 3.7057 3.9544 4.1633 4.3389 4.4865 4.6105 4.7147 4.8023 4.8759
20% 0.8333 1.5278 2.1065 2.5887 2.9906 3.3255 3.6046 3.8372 4.0310 4.1925 4.3271 4.4392 4.5327 4.6106 4.6755
es
21% 0.8264 1.5095 2.0739 2.5404 2.9260 3.2446 3.5079 3.7256 3.9054 4.0541 4.1769 4.2784 4.3624 4.4317 4.4890
22% 0.8197 1.4915 2.0422 2.4936 2.8636 3.1669 3.4155 3.6193 3.7863 3.9232 4.0354 4.1274 4.2028 4.2646 4.3152
23% 0.8130 1.4740 2.0114 2.4483 2.8035 3.0923 3.3270 3.5179 3.6731 3.7993 3.9018 3.9852 4.0530 4.1082 4.1530
24% 0.8065 1.4568 1.9813 2.4043 2.7454 3.0205 3.2423 3.4212 3.5655 3.6819 3.7757 3.8514 3.9124 3.9616 4.0013
25% 0.8000 1.4400 1.9520 2.3616 2.6893 2.9514 3.1611 3.3289 3.4631 3.5705 3.6564 3.7251 3.7801 3.8241 3.8593
Tables Ɩ 247
Normal Distribution
A variable may take have values and a collection of such values shows how the variable is distributed; for
example, the marks scored by students in an examination. A Normal Distribution is an even distribution without
any bias and having its values equally distributed above and below its mean. The frequency curve of such a
distribution is a bell shaped curve showing the uniformity of the data distribution. Many physical measurements
and natural phenomenon have been observed to be normally distributed. The Standard Normal Distribution
has useful theoretical properties which can be used to find probabilities for sample results. This is very useful
in economic & business data analysis. Even when the sample data is not exactly evenly distributed the results
obtained from normal distribution study are found to be satisfactory.
Bell-shaped
curve
50% 50%
es
ss
la
Mean (µ)
Normal Distribution Curve
C
h
rs
da
34.134%
68.27%
A
95.44%
99.73%
– 3s – 2s –1s 0 1s 2s 3s
Mean
(1) The normal distribution has mean (µ) = 0 and standard deviation = 1.
(2) The area covered by 3 times the standard deviation (s) on either side of the mean covers nearly the entire
area (99.73%) of the probability distribution.
(3) As the data is evenly distributed (theoretically) on either side of the mean, the area from –1s to 0 will be
the same as from 0 to 1s and so on for two & three times the standard deviation.
(4) A given distribution can be converted into a standard normal distribution by determining the z-score of each
variable in the sample as follows:

x−m
z-score =
s
where,
x = any variable from the sample
m = mean of the sample
s = standard deviation of the sample
(4) We can determine the probability of the variable ‘x’ from the z-score and the table showing the area covered
by the bell shaped curve for value of z.
The z table values can be given in many ways. Out of these, the three common methods are:
(1) Values showing area covered from the mean, i.e. 0, to the z-score. This is the most common and is referred
to as the half-tail.
µ z-score
(2) Values showing cumulative area up to the z-score; and
es
µ z-score
ss
la
(3) Values showing area above the z-score.
C
h
µ z-score
rs
How, the table values are to be used depends upon how the area covered is given and the area (probability) we
want to find out.
da
(. . . see table on next page)

A
CA. Sunil Gokhale: 9765823305 Tables Ɩ 249

Area Under Normal Curve (Half-tail) µ z-score
z 0 1 2 3 4 5 6 7 8 9
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0754
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2258 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2518 0.2549
0.7 0.2580 0.2612 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2996 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3268 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
es
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
ss
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
la
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
C
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
h
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
rs
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
da
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
A
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
3.1 0.4990 0.4991 0.4991 0.4991 0.4992 0.4992 0.4992 0.4992 0.4993 0.4993
3.2 0.4993 0.4993 0.4994 0.4994 0.4994 0.4994 0.4994 0.4995 0.4995 0.4995
3.3 0.4995 0.4995 0.4995 0.4996 0.4996 0.4996 0.4996 0.4996 0.4996 0.4997
3.4 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4998
3.5 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998 0.4998
3.6 0.4998 0.4998 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.7 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.8 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999 0.4999
3.9 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000 0.5000

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C.A.

CA. Sunil Gokhale’s

7. Indian Capital Market - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 101

15. Tables - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 246

in the total capital.

Need to ascertain Cost of Capital

Components of Capital Structure

Cost of Capital, Leverage & Economic Value Added Ɩ 1

2 Ɩ CA. Sunil Gokhale: 9765823305

Cost of Capital, Leverage & Economic Value Added Ɩ 3

Growth (g), if any, can be added in either case.

b = beta co-efficient of the company also called risk index

Operating & Financial Leverage

Cost of Capital, Leverage & Economic Value Added Ɩ 5

Equity capital `6,00,000 `3,50,000

Selling price per unit `30 `250

6 Ɩ CA. Sunil Gokhale: 9765823305

Cost of Capital, Leverage & Economic Value Added Ɩ 7

Capital structure : Equity Capital `170 lakhs

10% Debentures `400 lakhs

8 Ɩ CA. Sunil Gokhale: 9765823305

Gross Margin at 30% 12,000

Tax at 30% 1,800

Current Assets `6,000

Financial Policy & Corporate Strategy Ɩ 9

— the asset turnover ration will remain constant.

What value will the new strategy create?

P.V. 1.000 0.862 0.743 0.641 0.552 0.476

10 Ɩ CA. Sunil Gokhale: 9765823305

Type of firm Ideal ratio

Small firms (which are risker) 6

Project Planning & Capital Budgeting Ɩ 11

Traditional methods (non-discounting models) Modern methods (discounting models)

1. Accounting or Average Rate of Return 1. Discounted Payback Period Method

3. Payback Reciprocal 3. Profitability Index

6. Project Internal Rate of Return (P.I.R.R.)

Accounting or Average Rate of Return (A.R.R.)

12 Ɩ CA. Sunil Gokhale: 9765823305

Average annual cash inflow

Post-payback Profitability Method

Discounted Payback Period

Net Present Value Method (N.P.V.)

Project Planning & Capital Budgeting Ɩ 13

Equal Annualized Criterion

14 Ɩ CA. Sunil Gokhale: 9765823305

Internal Rate of Return (I.R.R.)

Project Planning & Capital Budgeting Ɩ 15

Modified I.R.R. (M.I.R.R.) or Terminal I.R.R.

16 Ɩ CA. Sunil Gokhale: 9765823305

depreciation & tax) over the next 5 years:

the company is 50%.

Project Planning & Capital Budgeting Ɩ 17

1 year 0.885 0.893 0.917 0.943 0.971

18 Ɩ CA. Sunil Gokhale: 9765823305

Project Planning & Capital Budgeting Ɩ 19

The PVIF@ 15% for 10 years are as below:

[NPV: Area A `100.20 lakhs; Area B (`36.04)]

Problems – Selecting an asset where no revenues are generated

Power 2,40,000 2,80,000

Fixed Costs 60,000 80,000

Annuity of `1 (capital recovery factor

22 Ɩ CA. Sunil Gokhale: 9765823305

Problems – Replacing an asset