1.

Time Value of Money

Study Session 1

LOS 1 : Introduction
❖ Time value of Money is the first and the most important chapter of Finance.
❖ Anything connected with Finance is based on the “TIME VALUE OF MONEY”
❖ ` 100 today is Not Equal to ` 100 a year later.
❖ Three Factors determines the Time Value of Money:

Expected Inflation Rate

+
Real Rate of Return on Risk free Investment
+
Risk Premium

LOS 2 : Future Value of a Single Cash Flow

FV = PV × (1 + r) n
 1.2 TIME VALUE OF MONEY

Example:
You invest ` 15,000 for two years that pays you 12% p.a. how much will you have at the end of two
years?
Solution:
FV = PV × (1 + r) n
= 15,000 × (1 + 0.12) 2
= 18,816

LOS 3 : Present Value of a Single Cash Flow

𝐅𝐕
FV = PV × (1 + r) n or PV =
( 𝟏+𝐫)𝐧

Example:
You need ` 10,000 for buying a mobile next year. You can earn 10% on your money. How much do
you need to invest today?
Solution:
FV = 10,000
r = 10%
n = 1 year
FV 10,000
PV =   9090.91
(1+r )n (1+0.10 )1

LOS 4 : Future Value of a Multiple Unequal Cash Flow

Example:
Suppose you receive ` 1000 today, another ` 1200 a year later and ` 1300 two year later. How
much will you have three years from today? Interest Rate @ 10%
Solution:

1000 × (1 + 0.10) 3 = 1331

1200 × (1 + 0.10) 2 = 1452
1300 × (1 + 0.10) 1 = 1430
4213
 1.3

LOS 5 : Present Value of a Multiple Unequal Cash Flow

Example:
Mr. X receives ` 1000, 1500, 1100, 1400 & 400 at the end of year 1, 2, 3, 4 & 5. Rate = 10%,
Calculate PV.

1000 1500 1100 1400 400

+ + + +
(1+0.10 )1 (1+0.10 )2 (1+0.10 )3 (1+0.10 )4 (1+0.10 )5

PV = 4179.30

LOS 6 : Present Value of a Multiple Equal Cash Flow (Period Defined)

a) Present Value of Multiple Equal Cash Flow (Period Defined) :- (at the end of each year)
Example:
Mr. X will receive ` 1000 at the end of each year upto 5 years, Rate = 10%. Find Present Value.

1000 1000 1000 1000 1000

+ + + +
(1+0.10 )1 (1+0.10 )2 (1+0.10 )3 (1+0.10 )4 (1+0.10 )5

Or
PV = 1000 [ PVAF @ 10% for 5 years]  1000 × 3.791  3791

b) Present Value of Multiple Equal Cash Flow (Period Defined) :- (at the Beginning of each
year)
Example:
Mr. X will receive ` 1000 starts from today upto 5 years, Rate = 10%. Find Present Value.

1000 1000 1000 1000 1000

+ + + +
(1+0.10 )0 (1+0.10 )1 (1+0.10 )2 (1+0.10 )3 (1+0.10 )4
 1.4 TIME VALUE OF MONEY

Or
PV = 1000 [1 + PVAF @ 10%, (5 – 1) years]
= 1000 × [1 + 3.17]  4170
Note: If question is silent always assume Deferred Annuity.

LOS 7 : Present Value of Equal Cash Flow upto infinity (Perpetuity/ Indefinite):
(Series of equal Cash Flow arising upto infinite or forever)

𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰

PV =
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐑𝐚𝐭𝐞
Example:
Mr. X will receive ` 1000 at the end of each year upto infinity, Rate = 10%. Find Present Value.
Solution:
1000
PV =  10,000
0.10

LOS 8: Present Value of Growing Cash Flow upto Infinity (Growing Perpetuity)

𝐂𝐅𝟏
PV =
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐑𝐚𝐭𝐞 − 𝐆𝐫𝐨𝐰𝐭𝐡 𝐑𝐚𝐭𝐞

Where CF1 = Cash Flow at the end of year 1.

Example:
Mr. X will receive ` 1000 at the end of year 1, thereafter cash flow will grow by 8% every year upto
infinity, Rate = 10%. Find Present Value.
Solution:
1000
PV =  50,000
0.10 − 0.08
 2.1

Security Valuation
Study Session 2

LOS 1 : Introduction

Note: Total Earnings mean Earnings available to equity share holders

Income Statement
Sales
Less: Variable cost
Contribution
Less: Fixed cost excluding Dep.
EBITDA
Less: Depreciation and Amortization
EBIT
Less: Interest
EBT
Less: Tax
EAT
Less: Preference Dividend
Earnings Available to Equity Share holders
Less: Equity Dividend
T/F to R&S

LOS 2 : SOME BASIC RATIOS

𝐓𝐨𝐭𝐚𝐥 𝐞𝐚𝐫𝐧𝐢𝐧𝐠 𝐚𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐭𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬
❖ EPS =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

𝐓𝐨𝐭𝐚𝐥 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝 𝐭𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬

❖ DPS =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

𝐓𝐨𝐭𝐚𝐥 𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞/ 𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐳𝐚𝐭𝐢𝐨𝐧/ 𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩

❖ MPS =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

𝐓𝐨𝐭𝐚𝐥 𝐑𝐞𝐭𝐚𝐢𝐧𝐞𝐝 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬

❖ REPS =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

OR
❖ REPS = EPS - DPS
 2.2 SECURITY VALUATION

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

❖ Dividend Yield = × 100
𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

❖ Dividend pay-out Ratio = × 100
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

❖ Dividend Rate = × 100
𝐅𝐚𝐜𝐞 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

❖ Earning Yield = × 100
𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐌𝐏𝐒
❖ P/E Ratio =
𝐄𝐏𝐒
𝐑𝐞𝐭𝐚𝐢𝐧𝐞𝐝 𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
❖ Retention Ratio = × 100
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

𝐄𝐏𝐒 − 𝐃𝐏𝐒
= × 100
𝐄𝐏𝐒
OR
❖ Retention Ratio = 1 – Dividend Payout Ratio
Note :
❖ Relationship Between DPR & RR:
RR + DPR = 100% or 1
❖ Dividend yield and Earning Yield is always calculated on annual basis.
❖ Dividend is 1st paid to preference share holder before any declaration of dividend to equity share
holders.
❖ Dividend is always paid upon FV(Face Value) not on Market Value.

LOS 3 : Define Cash Dividends, Stock Dividend ,Stock Split

Cash Dividends: As the name implies, are payments made to shareholders in cash. They come
in 3 forms:
(i) Regular Dividends: Occurs when a company pays out a portion of profits on a consistent basis.
E.g. Quarterly, Yearly, etc.
(ii) Special Dividends: They are used when favourable circumstances allow the firm to make a
one-time cash payment to shareholders, in addition to any regular dividends. E.g. Cyclical Firms
(iii) Liquidating Dividends: Occurs when company goes out of business and distributes the
proceeds to shareholders.
Stock Dividends (Bonus Shares) :
❖ Stock Dividend are dividends paid out in new shares of stock rather than cash. In this case, there
will be more shares outstanding, but each one will be worth less.
❖ Stock dividends are commonly expressed as a percentage. A 20% stock dividend means every
shareholder gets 20% more stock.
 2.3

Stock Splits :
❖ Stock Splits divide each existing share into multiple shares, thus creating more shares. There
are now more shares, but the price of each share will drop correspondingly to the number of
shares created, so there is no change in the owner’s wealth.
❖ Splits are expressed as a ratio. In a 3-for-1 stock split, each old share is split into three new
shares.
❖ Stock splits are more common today than stock dividends.
Effects on Financial ratios:
❖ Paying a cash dividend decreases assets (cash) and shareholders’ equity (retained earnings)
.Other things equal, the decrease in cash will decrease a company’s liquidity ratios and increase
its debt-to-assets ratio, while the decrease in shareholders’ equity will increase its debt-to-equity
ratio.
❖ Stock dividends, stock splits, and reverse stock splits have no effect on a company’s leverage
ratio or liquidity ratios or company’s assets or shareholders’ equity.

LOS 4 : RETURN CONCEPTS

❖ A sound investment decision depends on the correct use and evaluation of the rate of return.
Some of the different concepts of return are given as below:
Required Rate of Return:
An asset's required return is the minimum return an investor requires given the asset's risk. A more
risky asset will have a higher required return. Required return is also called the opportunity cost for
investing in the asset. If expected return is greater (less) than required return, the asset is
undervalued (overvalued).
Price Convergence
If the expected return is not equal to required return, there can be a "return from convergence of
price to intrinsic value."
Letting V0 denote the true intrinsic value, and given that price does not equal that value
𝑽𝟎 − 𝑷𝟎
(i.e., V0 ≠ P0), then the return from convergence of price to intrinsic value is .
𝑷𝟎

If an analyst expects the price of the asset to converge to its intrinsic value by the end of the horizon,
𝑽𝟎 − 𝑷𝟎
then is also the difference between the expected return on an asset and its required return:
𝑷𝟎

𝑽𝟎 − 𝑷𝟎
Expected Return= Required Return +
𝑷𝟎

Example:
Suppose that the current price of the shares of ABC Ltd. is `30 per share. The investor estimated
the intrinsic value of ABC Ltd.’s share to be `35 per share with required return of 8% per annum.
Estimate the expected return on ABC Ltd.
 2.4 SECURITY VALUATION

Solution :
Intel's expected convergence return is (35 - 30)/30 * 100 = 16.67%, and let's suppose that the
convergence happens over one year. Thus, adding this return with the 8% required return, we obtain
an expected return of 24.67%.
Discount Rate
Discount Rate is the rate at which present value of future cash flows is determined. Discount rate
depends on the risk free rate and risk premium of an investment.
Internal Rate of Return
Internal Rate of Return is defined as the discount rate which equates the present value of future
cash flows to its market price. The IRR is viewed as the average annual rate of return that investors
earn over their investment time period assuming that the cash flows are reinvested at the IRR.

LOS 5 : EQUITY RISK PREMIUM

Equity risk premium is the excess return that investment in equity shares provides over a risk free
rate, such as return from tax free government bonds. This excess return compensates investors for
taking on the relatively higher risk of investing in equity shares of a company.
Calculating the Equity Risk Premium
To calculate the equity risk premium, we can begin with the capital asset pricing model (CAPM),
which is usually written:
Rx = Rf + β1 (Rm - Rf) Where:
Rx = required return on investment in "x"(company x)
Rf = risk-free rate of return
βx = beta of "x"
Rm = required return of market

Equity Risk Premium = Rx - Rf = βx (Rm - Rf)

LOS 6 : Concept of Nominal Cash Flow and Real Cash Flow

 2.5

Cash Flow:

Conversion of Real Cash Flow into Money Cash Flow & Vice-versa

Money Cash Flow = Real Cash Flow (1 + Inflation Rate)n

Or
𝐌𝐨𝐧𝐞𝐲 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰
Real Cash Flow =
(𝟏+𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞)𝐧

Discount Rate:

Conversion of Real Discount Rate into Money Discount Rate & Vice-versa

(1 + Money Discount Rate) = (1+ Real Discount Rate) ( 1+Inflation Rate)

PV:
 2.6 SECURITY VALUATION

Discount rate selection in Equity Valuation

❖ While valuing equity shares, only nominal cash flows are considered. Therefore, only nominal
discount rate is considered. The reason is that the tax applying to corporate earnings is generally
stated in nominal terms. Therefore, using nominal cash flow in equity valuation is the right
approach because it reflects taxes accurately.
❖ Moreover, when the cash flows are available to Equity Share Holders only, nominal cost of Equity
is used. And when cash flows are available to all the companies capital providers, nominal after
tax weighted average cost of capital is used.

LOS 7 : Ex – Dividend and Cum – Dividend Price of a share

❖ If Question is Silent, always Assume Ex- Dividend price of share.
❖ If cum-dividend price is given, we must deduct dividend from it.
❖ It may be noted that in all the formula, we consider Ex-Dividend & not Cum-Dividend.

LOS 8 : Valuation Models based on Earnings & Dividends

Walter’s Model :
Walter’s supports the view that the dividend policy plays an important role in determining the market
price of the share.
He emphasis two factors which influence the market price of a share:-
(i) Dividend Payout Ratio.
(ii) The relationship between Internal return on Retained earnings (r) and cost of equity capital (Ke)
Walter classified all the firms into three categories:-
a) Growth Firm:
❖ If (r > K e). In this case, the shareholder’s would like the company to retain maximum amount
i.e. to keep payout ratio quite low.
❖ In this case, there is negative correlation between dividend and market price of share.
❖ If r > K e, Lower the Dividend Pay-out Ratio Higher the Market Price per Share & vice-versa.
b) Declining Firm:
❖ If (r < K e). In this case, the shareholder’s won’t like the firm to retain the profits so that they can
get higher return by investing the dividend received by them.
❖ In this case, there is positive correlation between dividend and market price of share.
❖ If r < K e, Higher the Dividend Pay-out Ratio, Higher the Market Price per Share & vice-versa.
c) Constant Firm:
❖ If rate of return on Retained earnings (r) is equal to the cost of equity capital (K e) i.e.(r = K e). In
this case, the shareholder’s would be indifferent about splitting off the earnings between dividend
& Retained earnings.
❖ If r = K e, Any Retention Ratio or Any Dividend Payout Ratio will not affect Market Price of share.
MPS will remain same under any Dividend Payout or Retention Ratio.
 2.7

Note: Walter concludes:-

❖ The optimum payout ratio is NIL in case of growth firm.
❖ The optimum payout ratio for declining firm is 100%
❖ The payout ratio of constant firm is irrelevant.
Summary: Optimum Dividend as per Walter’s

Category of r Vs. Ke Correlation between Optimum Payout Optimum

the Firm DPS & MPS Ratio Retention Ratio
Growth r >Ke Negative 0% 100 %
Constant r = Ke No Correlation Every payout is Every retention is
Optimum Optimum
Decline r <Ke Positive 100% 0%

Valuation of Equity as per Walter’s

Current market price of a share is the present value of two cash flow streams:-
a) Present Value of all dividend.
b) Present value of all return on retained earnings.
In order to testify the above, Walter has suggested a mathematical valuation model i.e.,

𝒓
𝑫𝑷𝑺 (𝑬𝑷𝑺−𝑫𝑷𝑺)
𝑲𝒆
P0 = +
𝑲𝒆 𝑲𝒆

When
P0 = Current price of equity share (Ex-dividend price)/ Fair or Theoretical or Intrinsic
or Equilibrium or present Value Price per Share
DPS = Dividend per share paid by the firm
r = Rate of return on investment of the firm / IRR / Return on equity
Ke = Cost of equity share capital / Discount rate / expected rate of return/opportunity
cost / Capitalization rate
EPS = Earnings per share of the firm
EPS – DPS = Retained Earning Per Share
Assumptions :
❖ DPS & EPS are constant.
❖ K e & r are constant.
❖ Going concern assumption, company has infinite life.
❖ No external Finance

LOS 9 : Gordon’s Model/Growth Model/ Dividend discount Model

❖ Gordon’s Model suggest that the dividend policy is relevant and can effect the value of the share.
❖ Dividend Policy is relevant as the investor’s prefer current dividend as against the future
uncertain Capital Gain
❖ Current Market price of share = PV of future Dividend, growing at a constant rate
 2.8 SECURITY VALUATION

𝐃𝟎 (𝟏+𝐠) 𝐃𝟏 (𝐧𝐞𝐱𝐭 𝐞𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝) 𝑬𝑷𝑺𝟏 ( 𝟏−𝒃)

P0 = OR P0 = OR P0 =
𝐊 𝐞 −𝐠 𝐜 𝐊𝐞− 𝐠𝐜 𝑲𝒆 − 𝒃𝒓

P0 = Current market price of share.

Ke = Cost of equity capital/ Discount rate/ expected rate of return/ Opportunity cost/
Capitalization rate.
g = Growth rate
D1 = DPS at the end of year / Next expected dividend / Dividend to be paid
D0 = Current year dividend / dividend as on today / last paid dividend
EPS1 = EPS at the end of the year
b = Retention Ratio
1-b = Dividend payout Ratio
Note:
Watch for words like ‘ Just paid ’ or ‘ recently paid ’, these refers to the last dividend D0 and words
like ‘ will pay ’ or ‘ is expected to pay ’ refers to D1 .
Assumptions:
(i) No external finance is available.
(ii) K e & r are constant.
(iii) ‘g’ is the product of its Retention Ratio ‘b’ and its rate of return ‘r’

g=b×r OR g = RR × ROE.
(iv) K e > g
(v) g & RR are constant.
(vi) Firm has an infinite life
Applications
1. EPS1 (1-b) = DPS1
Proof :
EPS1 (1-b) = EPS1 × Dividend payout Rate
DPS1
= EPS1 ×
EPS1

= DPS1
We know that DPR + RR = 1 or 100%
2. If EPS = DPS, RR = 0 then g = 0
D0 (1+g)
P0 =
Ke −g

D0
P0 = as g = 0
Ke
 2.9

𝐄𝐏𝐒
P0 = (˙.˙ EPS = DPS)
𝑲𝒆

3. Calculation of P1 (Price at the end of year 1)

Price at the beginning = PV of Dividend at end + PV of market price at end
𝑫𝟏 +𝑷𝟏
P0 =
(𝟏+ 𝑲𝒆 )

𝟏
4. K e =
𝐏.𝐄 𝐑𝐚𝐭𝐢𝐨
Note:
The above equation for calculating Ke should only be used when no other method of calculation
is available.

LOS 10 : Determination of Growth rate

The sustainable growth rate is the rate at which equity, earnings and dividends can continue to grow
indefinitely assuming that ROE is constant, the dividend payout ratio is constant, and no new equity
is sold.
Method 1: Sustainable growth (g) = (1 - Dividend payout Ratio ) × ROE
Or g = RR × ROE
Method 2 : D n = D0 (1 + g )n-1
D0 = Base year dividend
Dn = Latest (Current year dividend)
n-1 = No. Of times D0 increases to D n

LOS 11: Calculation of Ke in case of Floating cost is given

Floating Cost are costs associated with the issue of new equity. E.g. Brokerage, Commission,
underwriting expenses etc.
❖ If issue cost is given in question, we will take P0 net of issue cost (Net Proceeds).
D1
❖ If floating Cost is expressed in % i.e. P0 (1 – f) =
Ke − 𝑔𝑐
D1
❖ If floating Cost is expressed in Absolute Amount i.e. P0 – f =
Ke − 𝑔𝑐

Note:
❖ K e of new equity will always be greater than K e of existing equity.
❖ Floatation Cost is only applicable in case of new equity and not on existing equity (or retained
earnings).

LOS 12 : Return on Equity (ROE) and Book Value Per Share (BVPS)

EPS = BVPS × ROE

 2.10 SECURITY VALUATION

Note : Calculate P / E Ratio at which Dividend payout will have no effect on the value of the
share.
When r = Ke , dividend payout ratio will not affect value of share.
Example:
1 1
If r = 10% then Ke = 10% and Ke = => 0.10 =
P/ ERatio P/ ERatio
=> P/E Ratio = 10 times

LOS 13 : Over – Valued & Under – Valued Shares

Cases Value Decision
PV Market Price < Actual Market Price Over – Valued Sell
PV Market Price > Actual Market Price Under – Valued Buy
PV Market Price = Actual Market Price Correctly Valued Buy / Sell

LOS 14 : Holding Period Return (HPR)

(𝐏𝟏 − 𝐏𝟎 )+ 𝐃𝟏
HPR =
𝐏𝟎

𝐏𝟏 − 𝐏𝟎 𝐃𝟏
HPR = +
𝐏𝟎 𝐏𝟎

(Capital gain Yield / Return) (Dividend Yield / Return)

 2.11

LOS 15 : Multi-stage Dividend discount Model [ If g >K e ]/ Variable Growth

Rate Model
❖ Growth model is used under the assumption of g = constant.
❖ When more than one growth rate is given, then we will use this concept.
or
If g > K e
❖ A firm may temporarily experience a growth rate that exceeds the required rate of return on firm’s
equity but no firm can maintain this relationship indefinitely.
Value of a dividend- paying firm that is experiencing temporarily high growth =
PV of dividends expected during high growth period.

+
PV of the constant growth value of the firm at the end of the high growth period.

𝑫𝟏 𝑫𝟐 𝑫𝒏 𝑷𝒏
Value = + + .................. + +
(𝟏+𝒌𝒆 )𝟏 (𝟏+𝒌𝒆 )𝟐 (𝟏+𝒌𝒆 )𝒏 (𝟏+𝒌𝒆 )𝒏

𝑫𝒏 ( 𝟏+𝒈𝒄 )
When Pn =
𝑲𝒆 −𝒈𝒄

LOS 16 : IRR Technique & Growth Model

IRR is the discount rate that makes the present values of a project’s estimated cash inflows equal
to the Present value of the project’s estimated cash outflows.
❖ At IRR Discount Rate => PV (inflows) = PV (outflows)
❖ The IRR is also the discount rate for which NPV of a project is equal to Zero.
❖ IRR technique is used when, K e is missing in the Question.
𝐋𝐨𝐰𝐞𝐫 𝐑𝐚𝐭𝐞𝐍𝐏𝐕
❖ IRR = Lower Rate + × Difference in Rate
𝐋𝐨𝐰𝐞𝐫 𝐑𝐚𝐭𝐞 𝐍𝐏𝐕 − 𝐇𝐢𝐠𝐡𝐞𝐫 𝐑𝐚𝐭𝐞𝐍𝐏𝐕

LOS 17 : Price at the end of each year

𝐏𝟏 +𝐃𝟏
P0 =
(𝟏+ 𝐊 𝐞 )𝟏

𝐏𝟐 +𝐃𝟐
P1=
(𝟏+ 𝐊 𝐞 )𝟏

𝐏𝟑 +𝐃𝟑
P2=
(𝟏+ 𝐊 𝐞 )𝟏

𝐏𝟒 +𝐃𝟒
P3=
(𝟏+ 𝐊 𝐞 )𝟏

.
So on
 2.12 SECURITY VALUATION

Los 18 : Negative Growth

𝐃𝟎 ( 𝟏+ 𝐠)
If Positive Growth, then P0 =
𝐊𝐞− 𝐠

𝐃𝟎 ( 𝟏− 𝐠)
If Negative Growth, then P0 =
𝐊𝐞+ 𝐠
Note: We Know g = RR × ROE
Case I EPS > DPS Retention is Positive g = Positive
Case II EPS < DPS Retention is Negative g = Negative
Case III EPS = DPS No Retention g=0

LOS 19 : Valuation Using the H-Model

The earnings growth of most firms does not abruptly change from a high rate to a low rate as in the
two-stage model but tends to decline over time as competitive forces come into play. The H-model
approximates the value of a firm assuming that an initially high rate of growth declines linearly over
a specified period. The formula for this approximation is:

𝑫𝟎 × (𝟏 + 𝒈𝑳 ) 𝑫𝟎 × 𝑯 × (𝒈𝑺 − 𝒈𝑳 )
𝑷𝟎 = +
𝐊 𝐞 − 𝒈𝑳 𝐊 𝐞 − 𝒈𝑳

where:
𝑡
H = = half-life (in years) of high-growth period
2
t = length of high growth period
gS = short-term growth rate
gL = long-term growth rate
r = required return

LOS 20 : Preference Dividend Coverage Ratio & Equity Dividend Coverage Ratio
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐁𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐓𝐚𝐱
Interest Coverage Ratio =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱
Preference Dividend Coverage Ratio =
𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 – 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
Equity Dividend Coverage Ratio =
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐲𝐚𝐛𝐥𝐞 𝐭𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞 𝐡𝐨𝐥𝐝𝐞𝐫𝐬

Note:
The Higher the Better. These Ratios indicates the surplus profit left after meeting all the fixed
obligation.
 2.13

LOS 21 : Cash Flow Base Models

Calculation of FCFF

EBITDA xxx
Less : Depreciation & Amortisation (NCC) xxx
EBIT xxx
Less : Tax xxx
NOPAT xxx
Add : Depreciation (NCC) xxx
Less : Increase in Working Capital (WCInv) xxx
Less : Capital Expenditure (FCInv) xxx
Free Cash Flow For Firm (FCFF) xxx
a) Based on its Net Income:
FCFF= Net Income + Interest expense *(1-tax) + Depreciation -/+ Capital Expenditure –/+
Change in Non-Cash Working Capital
b) Based on Operating Income or Earnings Before Interest and Tax (EBIT):
FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital Expenditure –/+ Change in Non-Cash
Working Capital
c) Based on Earnings before Interest, Tax , Depreciation and Amortisation (EBITDA):
FCFF = EBITDA* (1-Tax) +Depreciation* (Tax Rate) -/+ Capital Expenditure – /+Change in Non-
Cash Working Capital
d) Based on Free Cash Flow to Equity (FCFE):
FCFF = FCFE + Interest* (1-t) + Principal Prepaid - New Debt Issued + Preferred Dividend
e) Based on Cash Flows:
FCFF = Cash Flow from Operations (CFO) + Interest (1-t) -/+ Capital Expenditure
 2.14 SECURITY VALUATION

Calculation of FCFE
Method 1 : If Debt financing ratio is given:

EBITDA xxx
Less : Depreciation & Amortisation xxx
EBIT xxx
Less : Interest xxx
EBT xxx
Less : Tax xxx
PAT xxx
Add : Depreciation × % Equity Invested xxx
Less: Increase in Working Capital × % Equity Invested xxx
Less: Capital Expenditure × % Equity Invested xxx
Free Cash Flow for Equity (FCFE) xxx

Method 2 : If Debt financing ratio is not given:

EBITDA xxx
Less : Depreciation & Amortisation xxx
EBIT xxx
Less : Interest xxx
EBT xxx
Less : Tax xxx
PAT xxx
Add : Depreciation (NCC) xxx
Less: Increase in Working Capital (WCInv) xxx
Less: Capital Expenditure (FCInv) xxx
Add : Net Borrowings xxx
Free Cash Flow for Equity (FCFE) xxx
a) Calculating FCFE from FCFF
FCFE = FCFF - [ Interest ( 1- tax rate) ] + Net borrowing
b) Calculating FCFE from net income
FCFE = NI + NCC - FCInv - WCInv + net borrowing
c) Calculating FCFE from CFO
FCFE = CFO - FCInv + net borrowing

LOS 22 : Valuation Based on Multiples

1. P/E Multiple Approach MPS = EPS × P/E Ratio
𝑬𝑽
2. Enterprise Value to Sales =
𝑺𝒂𝒍𝒆𝒔
𝑬𝑽
3. Enterprise Value to EBITDA =
𝑬𝑩𝑰𝑻𝑫𝑨
EV = market value of common stock + market value of preferred equity + market value
of debt + minority interest – cash & cash equivalents and Equity investments,
investment in any co. & also Long term investments.
EBITDA = EBIT + depreciation + amortization
 3.1

Corporate Valuation
Study Session 3

LOS 1 : Introduction

LOS 2 : Dividend Yield Valuation Method

𝐃𝐏𝐒
Dividend Yield =
𝐌𝐏𝐒

𝐃𝐏𝐒
MPS =
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐘𝐢𝐞𝐥𝐝
Note:
𝐓𝐨𝐭𝐚𝐥 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐚𝐢𝐝
DPS =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

Total Market Value = MPS × Total Number of Equity share

LOS 3 : Earning Yield Valuation Method

𝐄𝐏𝐒
Earning Yield =
𝐌𝐏𝐒

𝐄𝐏𝐒
MPS =
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐘𝐢𝐞𝐥𝐝

𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐚𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐭𝐨 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞 𝐡𝐨𝐥𝐝𝐞𝐫𝐬

Therefore, EPS =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬
 3.2 CORPORATE VALUATION

LOS 4 : P/E Ratio Valuation Model

𝐌𝐏𝐒
P / E Ratio =
𝐄𝐏𝐒

MPS = EPS × P/E Ratio

LOS 5 : Value Based on Future Maintainable Profits (FMP’s)

𝐅𝐮𝐭𝐮𝐫𝐞 𝐌𝐚𝐢𝐧𝐭𝐚𝐢𝐧𝐚𝐛𝐥𝐞 𝐏𝐫𝐨𝐟𝐢𝐭

Value of Business =
𝐑𝐞𝐥𝐞𝐯𝐚𝐧𝐭 𝐂𝐚𝐩𝐢𝐭𝐚𝐥𝐢𝐬𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞

Value of Business – Market Value of Debt = Value of Equity

Calculation of Future Maintainable Profits:
Average Past Year Profits before tax xxx
Add : All Profit likely to arise in Future xxx
All Actual Expenses & Losses not likely to occur in future xxx
Less : All Profit not likely to occur in Future xxx
All Actual Expenses & Losses likely to occur in future xxx
Future Maintainable Profits (FMP’s) before tax xxx
Less : Tax xxx
FMP’s after tax xxx
Note:
Treatment of Sunk Cost
Sunk Cost are those cost which are not relevant for decision making. These cost must be totally
ignored. Example: Allocated Fixed Cost, R & D cost already incurred.

LOS 6 : Net Asset Valuation Method (For Equity)

𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐓𝐨𝐭𝐚𝐥 𝐄𝐱𝐭𝐞𝐫𝐧𝐚𝐥 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐲

NAV per Share =
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞𝐬

Note:
1. The following external liabilities should be deducted
❖ All short term (Current Liabilities) and Long Term Liabilities (Debenture, Loans, etc) including
outstanding and accrued interest.
❖ Provision for Taxation
❖ Liabilities not provided for in the accounts i.e. Contingent Liabilities which have crystallized
now.
❖ Liabilities arising out of prior period adjustment
❖ Preference Share Capital including Arrears of dividend and proposed preferred Dividend
❖ Proposed Equity Dividend (If the objective is to determine ex-dividend value of equity share).
 3.3

2. Total assets doesn’t include Miscellaneous Expenditure to the extend not yet written-off, fictitious
assets, accumulated losses, profit & Loss (Dr.) Balance.
3. NAV may be calculated by using
a) Book Value (BV): The BV of an asset is an accounting concept based on the historical data
given in the balance sheet of the firm.
b) Market Value (MV): The MV of an asset is defined as the price which is prevailing on the
market.
c) Liquidating Value (LV): The LV refers to the net difference between the realizable value of
all assets and the sum total of external liabilities. This net difference belongs to the owners/
shareholders and is known as LV.
4. If question is silent always prefer Market Value weights.

LOS 7 : Economic Value Added (EVA)

It is excess return over minimum return which is expected by the company on its Capital employed.

EVA = NOPAT – K0 × Average Capital Invested

Calculation of NOPAT:
❖ NOPAT means, Net Operating Profit After Tax but before any distribution of Interest, Preference
Dividend and Equity Dividend.
i.e. NOPAT = EBIT (1 – Tax Rate)
Note: It excludes non-operating income & expenses/losses like
❖ Profit/Loss on Sale of Fixed Assets
❖ Interest on non-trade investment
❖ Profit/Loss on trading in shares & bonds
❖ Interest income from Loans & Advances
Calculation of Cost of Overall Capital:
K0 = Cost of Overall Capital = WACC = Weighted Average Cost of Capital
K e W e + K r W r + KDWD + KPWP
Note:
1. K d = Interest (1- Tax Rate)
𝐷1
2. K e = R f + β (R m – R f ) Or Ke= +g
𝑃0

3. K p = Preference Dividend (1 + CDT)

4. Calculation of Average Capital Invested:
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐚𝐭 𝐭𝐡𝐞 𝐛𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 + 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐚𝐭 𝐭𝐡𝐞 𝐄𝐧𝐝 𝐨𝐟 𝐘𝐞𝐚𝐫
𝟐
 3.4 CORPORATE VALUATION

5. Calculation of Capital Invested:

Equity share capital

Add Preference share capital
Reserve & Surplus
Debenture/Bonds
Long-Term Loan
Less P/L (Dr. Balance)
Preliminary Expenses
Miscellaneous Expenditure

Note: It excludes:
❖ Investment in Equity shares & Bonds
❖ Loans & Advances
❖ Non-Trade Investment
𝐄𝐁𝐈𝐓 𝐄𝐁𝐈𝐓
6. Financial Leverage = Or =
𝐄𝐁𝐓 𝐄𝐁𝐈𝐓−𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭

7. EBIT = EBT + Interest

𝑃𝐴𝑇
EBIT = + Interest
(1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑓𝑜𝑟 𝑒𝑞𝑢𝑖𝑡𝑦+𝑃𝑟𝑒𝑓 𝐷𝑖𝑣

EBIT = + Interest
(1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

8. Note :
❖ Operating profits may have to be adjusted using matching concept.
❖ There might be some intangible assets such as patents, trademark etc. which is not shown
in balance sheet, we need to include that in invested capital.
❖ The balance sheet figures of assets & liabilities are at book value. If replacement cost is
provided, take invested capital at replacement cost instead of Book Value.

LOS 8 : Value of Business using EVA Method

Valuation of Business using EVA Method (Assume Constant growth after 2 years):
𝐄𝐕𝐀𝟐 (𝟏+𝐠)
𝐄𝐕𝐀 𝟏 𝐄𝐕𝐀 𝟐 𝐊𝐨 − 𝐠
MVA = + +
( 𝟏+ 𝐊 𝟎 )𝟏 ( 𝟏+ 𝐊 𝟎 )𝟐 ( 𝟏+ 𝐊 𝐨 )𝟐

MVA = Value of Business – Total Capital Employed

Value of Business = Total Capital Employed + MVA

LOS 9 : Discounted Cash Flow approach or Free Cash Flow Approach or

Value of Business using FCFE & FCFF
Under this approach, we will calculate value of business by discounting the future cash flows.
 3.5

Steps Involved:
Step 1: Calculation of Free Cash Flow of each Year.
Step 2: Calculate Terminal Value at the end of forecast period.
Step 3: Compute Discount Rate
Step 4: Calculate Present Value of Business/ Equity by discounting the Cash Flows & Terminal
Value.
Calculation of Terminal Value / Continuing Value / Salvage Value
Terminal Value is calculated at the end of the Project Life or at the end of the forecasted period.
Note:
❖ Given in the Question.
❖ Assumption of Growth Model (Let’s assume Growing Cash Flow after 3 Years)
𝐂𝐅 (𝟏+𝐠)
𝐂𝐅𝟏 𝐂𝐅𝟐 𝐂𝐅𝟑 [ 𝐊𝟑 − 𝐠 ]
𝐨
P0 = 𝟏 + 𝟐 + 𝟑 +
(𝟏+𝐊 𝟎 ) (𝟏+𝐊 𝟎 ) (𝟏+𝐊 𝟎 ) (𝟏+𝐊 𝟎 )𝟑

❖ Assumption of Constant Model/ Perpetuity Approach (Let’s assume Constant Cash Flow
after 3 Years)
𝐂𝐅
𝐂𝐅𝟏 𝐂𝐅𝟐 𝐂𝐅𝟑 [ 𝐊𝟑 ]
𝐨
P0 = 𝟏 + 𝟐 + 𝟑 +
(𝟏+𝐊 𝟎 ) (𝟏+𝐊 𝟎 ) (𝟏+𝐊 𝟎 ) (𝟏+𝐊 𝟎 )𝟑

❖ Continuing value/ Terminal Value is calculated because it is not easy to estimate realistic cash
flows, so we take uniform assumption of Constant Model or Growth Model.

Calculation of FCFF

EBITDA xxx
Less : Depreciation(NCC) xxx
EBT xxx
Less : Tax xxx
NOPAT xxx
 3.6 CORPORATE VALUATION

Add : Depreciation (NCC) xxx

Less : Increase in Working Capital (WCInv) xxx
Less : Capital Expenditure (FCInv) xxx
Free Cash Flow For Firm (FCFF) xxx

Calculation of FCFE
Method 1 : When Debt-financing ratio is given:

EBITDA xxx
Less : Depreciation & Amortisation xxx
EBIT xxx
Less : Interest xxx
EBT xxx
Less : Tax xxx
PAT xxx
Add : Depreciation × % Equity Invested xxx
Less: Increase in Working Capital × % Equity Invested xxx
Less: Capital Expenditure × % Equity Invested xxx
Free Cash Flow for Equity (FCFE) xxx

Calculation of FCFE
Method 2 : When Debt-financing ratio is not given:

EBITDA xxx
Less : Depreciation & Amortisation xxx
EBIT xxx
Less : Interest xxx
EBT xxx
Less : Tax xxx
PAT xxx
Add : Depreciation (NCC) xxx
Less: Increase in Working Capital (WCInv) xxx
Less: Capital Expenditure (FCInv) xxx
Add : Net Borrowings xxx
Free Cash Flow for Equity (FCFE) xxx

LOS 10 : Calculation of Range of Valuation

The range of valuation means we have to calculate minimum & maximum value of business by
using more than one method as indicated in question.

LOS 11 : Valuation with NPV decision

𝐓𝐨𝐭𝐚𝐥 𝐍𝐏𝐕
Revised MPS = Existing MPS ±
𝐓𝐨𝐭𝐚𝐥 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬
 3.7

LOS 12 : Market Value Added (MVA)

From Equity Point of View

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 – 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐄𝐪𝐮𝐢𝐭𝐲

MVA = [ ] for equity shareholders
𝐚𝐬 𝐩𝐞𝐫 𝐦𝐚𝐫𝐤𝐞𝐭 𝐚𝐬 𝐩𝐞𝐫 𝐁𝐨𝐨𝐤𝐬 𝐨𝐟 𝐀/𝐜′𝐬
= MPS × No. of Equity share – Equity Shareholder’s Fund.
Note:

Equity share capital

Add Reserve & Surplus
Less P/L (Dr. Balance)
Preliminary Expenses
Miscellaneous Expenditure

From Overall company’s Point of View

MVA = Value of the company based on Free Cash Flows – Total Capital Employed

Note: Total Capital Employed

Equity share capital
Add Preference share capital
Reserve & Surplus
Debenture/Bonds
Long-Term Loan
Less P/L (Dr. Balance)
Preliminary Expenses
Miscellaneous Expenditure
 1.1

Mergers, Acquisition & Corporate Restructuring

LOS 1 : Introduction
Merger & Acquisition
MERGER (A + B = A)

ACQUISITION (Stake Buyout)

AMALGAMATION (A + B = C)

Reasons for Merger & Acquisition

❖ Economies of Scale
❖ Efficiency Improvement
❖ Power of Market Share – Reduced Competition
❖ Tax Consideration
❖ Combining resources that are complementary.

LOS 2 : Share Exchange Ratio/ Swap Ratio

Swap Ratio may be defined as No. of equity shares issued by Acquiring Company to Target
Company for every one share held by Target Company.
Methods of Calculating the Swap Ratio:
𝐌𝐏𝐒 𝐨𝐟 𝐓𝐚𝐫𝐠𝐞𝐭 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
1. On the basis of MPS Swap Ratio =
𝐌𝐏𝐒 𝐨𝐟 𝐀𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
𝐄𝐏𝐒 𝐨𝐟 𝐓𝐚𝐫𝐠𝐞𝐭 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
2. On the basis of EPS Swap Ratio =
𝐄𝐏𝐒 𝐨𝐟 𝐀𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
𝐍𝐀𝐕 𝐨𝐟 𝐓𝐚𝐫𝐠𝐞𝐭 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
3. On the basis of NAV per Share Swap Ratio =
𝐍𝐀𝐕 𝐨𝐟 𝐀𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
𝐁𝐕𝐏𝐒 𝐨𝐟 𝐓𝐚𝐫𝐠𝐞𝐭 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
4. On the basis of Book Value per share Swap Ratio =
𝐁𝐕𝐏𝐒 𝐨𝐟 𝐀𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
𝐏/𝐄 𝐑𝐚𝐭𝐢𝐨 𝐨𝐟 𝐓𝐚𝐫𝐠𝐞𝐭 𝐂𝐨𝐦𝐩𝐚𝐧𝐲
5. On the basis of P/E Ratio Swap Ratio =
𝐏/𝐄 𝐑𝐚𝐭𝐢𝐨 𝐨𝐟 𝐀𝐜𝐪𝐮𝐢𝐫𝐢𝐧𝐠 𝐂𝐨𝐦𝐩𝐚𝐧𝐲

Note:
Earning available to Equity Shareholder
EPS =
Total number of equity shares

Total Assets − Total External Liability

NAV =
Total number of equity shares

Market Price per Share

P / E Ratio =
Earning Price per Share
 1.2 MERGERS, ACQUISITION & CORPORATE RESTRUCTURING

Negative SWAP Ratio

Acquiring Co.
Swap Ratio =
Target Co.

NPA of Acquiring Co.

e.g. Swap Ratio =
NPA of Target Co.

LOS 3 : Some Basic Concepts

1. Total Number of Equity Shares after Merger
Number of Shares A+B = NA + NB × ER
2. EPS after Merger or EPSA + B or EPS of a Merged Firm/ Combined Firm

𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
EPSA+B = [ ]
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐑

3. MPS after Merger or MPSA + B or MPS of a Merged Firm

Alternative 1: If P/E Ratio is given

MPS A+B = EPS A+B × P/E A+B

Alternative 2: If P/E Ratio is not given

𝐓𝐨𝐭𝐚𝐥 𝐌𝐕 𝐚𝐟𝐭𝐞𝐫 𝐌𝐞𝐫𝐠𝐞𝐫

MPSA+B = [ ]
𝐓𝐨𝐭𝐚𝐥 𝐍𝐨.𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬 𝐚𝐟𝐭𝐞𝐫 𝐌𝐞𝐫𝐠𝐞𝐫
Or
𝐌𝐕𝐀 + 𝐌𝐕𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
MPSA+B = [ ]
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐑

Note:
❖ Answer by both alternative will be different.
❖ Alternative 1 should be preferred whenever any hint regarding P/E after merger is given in
question.
4. Market Value of Merged Firm or MVA + B

Alternative 1: MV A+B = MPS A+B+× [NA + NB × ER]

Alternative 2: MV A+B = MV A + MV
+ B + Synergy

Note:
❖ Answer by both alternative will be different.
❖ Alternative 1 should be preferred
 1.3

5. Equivalent EPS of Target Co. in Merged Firm

Equivalent EPS of Target Co. in Merged Firm = EPS A+B × ER
6. Equivalent MPS of Target Co. in Merged Firm
Equivalent MPS of Target Co. in Merged Firm = MPS A+B × ER

LOS 4 : Gain or Loss

❖ Merger may result into Gain/Loss for acquiring company & target Company.
❖ On the basis of EPS/MPS/Market Value (MV)
A Ltd. B Ltd.
MPS / EPS / MV after Merger XXX XXX
MPS / EPS / MV before Merger XXX XXX
Gain/ Loss XXX XXX

LOS 5 : Maximum Exchange Ratio and Minimum Exchange Ratio

A= Acquiring Company  will try to keep exchange ratio as low as possible. Hence, we calculate
maximum ER for acquiring company.
B= Target Company  will try to keep exchange ratio as high as possible. Hence, we calculate
minimum ER for Target Company.

Case 1: On the basis of EPS:

a) Maximum Exchange ratio for A Ltd.

EPS before Merger = EPS after Merger

EPSA = EPSA + B
𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
EPSA =
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 𝐄𝐑

Solve for ER
 1.4 MERGERS, ACQUISITION & CORPORATE RESTRUCTURING

b) Minimum Exchange ratio for B Ltd.

EPS before Merger = Equivalent EPS after Merger

EPSB = EPSA + B× ER
𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
ESPB = [ ] × ER
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 𝐄𝐑

Solve for ER

Case 2: On the basis of MPS (If P/E Ratio after merge is given i.e. P/E(A+B) is given)
a) Maximum Exchange ratio for A Ltd.

MPS before Merger = MPS after Merger

MPSA = MPSA + B
MPSA = EPSA + B× P/E (A+B)
𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
MPSA = [𝐍 ] × P/E (A+B)
𝐀 + 𝐍𝐁 × 𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 𝐄𝐑

Solve for ER

b) Minimum Exchange ratio for B Ltd.

MPS before Merger = Equivalent MPS after Merger

MPSB = MPSA + B × ER
MPSB = [EPSA + B× P/E(A+B) ] × ER
𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
MPSB = [ ]× P/E(A+B)× ER
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 𝐄𝐑

Solve for ER
 1.5

Case 3: On the basis of MPS (If P/E Ratio after merge is not given):
a) Maximum Exchange ratio for A Ltd.

MPS before merger = MPS after merger

MPSA = MPSA + B
𝐌𝐕𝐀 + 𝐌𝐕𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
MPSA =
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 𝐄𝐑

Solve for ER

b) Minimum Exchange ratio for B Ltd.

MPS before merger = Equivalent MPS after merger

MPSB = MPSA + B × ER
𝐌𝐕𝐀 + 𝐌𝐕𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
MPSB = [ ] × ER
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐱𝐜𝐡𝐚𝐧𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 𝐄𝐑

Solve for ER

LOS 6 : Calculation of % of Holding in New Company

𝐓𝐨𝐭𝐚𝐥 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐟 𝐀 𝐋𝐭𝐝.

For A Ltd. =
𝐓𝐨𝐭𝐚𝐥 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞 𝐨𝐟 𝐀 𝐋𝐭𝐝.+𝐓𝐨𝐭𝐚𝐥 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬 𝐢𝐬𝐬𝐮𝐞𝐝 𝐭𝐨 𝐁 𝐋𝐭𝐝.

𝐓𝐨𝐭𝐚𝐥 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬 𝐢𝐬𝐬𝐮𝐞𝐝 𝐭𝐨 𝐁 𝐋𝐭𝐝

For B Ltd. =
𝐓𝐨𝐭𝐚𝐥 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞 𝐨𝐟 𝐀 𝐋𝐭𝐝.+𝐓𝐨𝐭𝐚𝐥 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬 𝐢𝐬𝐬𝐮𝐞𝐝 𝐭𝐨 𝐁 𝐋𝐭𝐝.

LOS 7 : Free Float Market Capitalization (Value)

❖ “Free Float” means shares which are freely available or freely tradable in the market. Shares
held by promoters are not freely tradable in the market. There shares are subject to certain
restrictions as placed by SEBI.
❖ A Firm’s market float is the total value of the shares that are actually available to the investing
public and excludes the value of shares held by controlling shareholders because they are
unlikely to sell their shares.
❖ Sensex and Nifty is based on Free-Float market Capitalization.
 1.6 MERGERS, ACQUISITION & CORPORATE RESTRUCTURING

Free Float Mkt Capitalization = Free float No. of equity shares ×MPS

Total No. of Equity Shares

(-)
Promotors Holding / Management Holding / Govt. × MPS
Holding / Strategic Holding

LOS 8 : Calculatio of EPSA+B and MPSA+B in case of CASH TAKOVER

1. EPS A+B in case of cash take-over & cash is paid out of borrowed money

𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧−𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 (𝟏−𝐭𝐚𝐱)

EPSA+B = [ ]
𝐍𝐀

2. EPS A+B in case of cash take-over & money is arranged from Business itself

𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧−𝐂𝐚𝐬𝐡 𝐏𝐚𝐢𝐝×𝐎𝐩𝐩𝐨𝐫𝐭𝐮𝐧𝐢𝐭𝐲 𝐜𝐨𝐬𝐭 𝐨𝐟 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭

EPSA+B = [ ]
𝐍𝐀

3. MPS A+B (If P/E ratio after merger is given)

= EPSA+B × P/EA+B

4. MPS A+B (If P/E ratio after merger is NOT given)

𝑴𝑽𝑨 + 𝑴𝑽𝑩 + 𝑺𝒚𝒏𝒆𝒓𝒈𝒚 𝑮𝒂𝒊𝒏−𝑪𝒂𝒔𝒉 𝑷𝒂𝒊𝒅

MPSA+B = [ ]
𝑵𝑨
 1.7

LOS 9 : Purchase Price Premium

𝐎𝐟𝐟𝐞𝐫 𝐏𝐫𝐢𝐜𝐞 𝐭𝐨 𝐭𝐚𝐫𝐠𝐞𝐭 𝐂𝐨. – 𝐌𝐏𝐒 𝐨𝐟 𝐭𝐚𝐫𝐠𝐞𝐭 𝐂𝐨.𝐛𝐞𝐟𝐨𝐫𝐞 𝐌𝐞𝐫𝐠𝐞𝐫

Purchase Price Premium =
𝐌𝐏𝐒 𝐨𝐟 𝐭𝐚𝐫𝐠𝐞𝐭 𝐂𝐨.𝐛𝐞𝐟𝐨𝐫𝐞 𝐌𝐞𝐫𝐠𝐞𝐫

LOS 10 : Purchase Consideration / Cost of Acquisition

❖ PC = Net Payment made by Acquiring Co. to Target Co.

Calculation of PC/ COA

Market Value of Equity Shares Issued by A Ltd. to B Ltd. XXX
(+) Debentures, Preference shares Capital Issued by A Ltd. to B Ltd. XXX
(+) Current Liability paid or Taken over XXX
(+) Any other expenses incurred XXX
(-) Cash in hand or Bank XXX
(-) Sale of any other asset not required in business XXX
Cost of Acquisition / Purchase Consideration XXX
Note:
❖ Cash and current Liabilities must be taken, even if question is Silent.
❖ Sale of any other asset not required should be taken only if clear indication in the Question.

LOS 11 : Components of MPS

LOS 12 : Maximum MPS & Minimum MPS

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐨𝐟 𝐁 𝐋𝐭𝐝.

Minimum MPS offered by A Ltd. To B Ltd. =
𝐍𝐨. 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬 𝐨𝐟 𝐁 𝐋𝐭𝐝.

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐨𝐟 𝐁 𝐋𝐭𝐝. +𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐒𝐲𝐧𝐞𝐫𝐠𝐲

Maximum MPS offered by A Ltd. To B Ltd. =
𝐍𝐨. 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬 𝐨𝐟 𝐁 𝐋𝐭𝐝.
 1.8 MERGERS, ACQUISITION & CORPORATE RESTRUCTURING

LOS 13 : Calculation of EPS A+B when Synergy Gain is Given in Question

1. EPSA+B when Synergy Gain is Expressed in %

(𝐄𝐀 + 𝐄𝐁 ) ( 𝟏+ 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧)

ESPA+B = [ ]
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐑

2. EPSA+B when Synergy Gain is Expressed in Absolute Amount

𝐄𝐀 + 𝐄𝐁 + 𝐒𝐲𝐧𝐞𝐫𝐠𝐲 𝐆𝐚𝐢𝐧
ESPA+B = [ ]
𝐍𝐀 + 𝐍𝐁 × 𝐄𝐑

Note:
If question is silent regarding Synergy Gain, assume it to be NIL.
Synergy Gain – In terms of Earnings & Market Value
Synergy means extra – benefit/ advantage.
1. Synergy In terms of Earnings
Synergy = E A+B – (E A + E B)
2. Synergy In terms of Market Value
Synergy = MV A+B – (MV A + MV B)

LOS 14 : True Cost & True Benefit of Merger

Case 1: When Merger is Financed by Case 2: When Merger is Financed by Stock
Cash
For Acquiring company (A Ltd.) For Acquiring company (A Ltd.)
Cost to A Ltd. Cost to A Ltd.
= Cash paid to B Ltd. – MVB Ltd received = MVA+B × % Holding of B Ltd. – MVB Ltd. received
Benefit of Merger (Synergy Gain) Benefit of Merger (Synergy Gain)
= MVA+B – (MVA Ltd. + MVB Ltd.) = MVA+B – (MVA Ltd. + MVB Ltd.)
Net Benefit (NPV) = Benefit – Cost Net Benefit (NPV) = Benefit – Cost
For Target Company (B Ltd.) For Target Company (B Ltd.)
Benefit (Net Benefit) Benefit (Net Benefit)
= Cash Received – MVB Ltd. sacrificed = MVA+B × % Holding of B Ltd.– MVB Ltd. sacrificed
Note:
Cost of A Ltd. = Benefit for B Ltd.
 5.1

Mutual Funds
Study Session 5

LOS 1 : Introduction
A mutual fund is a common pool of money into which investors place their contributions that are to
be invested in accordance with a stated objective.

A Mutual Fund is the most suitable investment for the cautious investors as it offers an opportunity
to invest in a diversified professionally managed basket of securities at a relatively low cost.
Mutual fund is a type of passive investment. If investors directly investment in market is known as
active investment.

LOS 2 : NAV (Net Asset Value) per unit

As per SEBI Regulation, every mutual fund company should calculate its NAV on a daily basis
(excluding holidays)
𝐍𝐞𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 𝐨𝐟 𝐭𝐡𝐞 𝐒𝐜𝐡𝐞𝐦𝐞
NAV =
𝐍𝐨.𝐎𝐟 𝐮𝐧𝐢𝐭𝐬 𝐎𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠
 5.2 MUTUAL FUND

Net Assets i.e. Total Assets – Total External Liabilities

= [Market Value of Investments + Receivables + Accrued Income + Other Assets]
–
[Accrued Expenses + Payables + Other liabilities]
Note:
❖ NAV signifies the realizable value that the investor will get for each unit that one is holding, if the
scheme is liquidated on that date.
❖ NAV is calculated for each Scheme & not for whole Company.
❖ While using NAV, we should always give preference to market value, If market value is not given
then use book value.

LOS 3 : Calculation of Return (HPR)

Investors derive three type of Return :-
(i) Cash Dividend
(ii) Capital Gain Disbursements
(iii) Change in the Fund’s NAV per unit (Unrealized Capital Gain) [Closing NAV – Opening NAV]

[𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐍𝐀𝐕 – 𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐍𝐀𝐕]+ 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐫𝐞𝐜𝐞𝐢𝐯𝐞𝐝+𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐆𝐚𝐢𝐧 𝐑𝐞𝐜𝐞𝐢𝐯𝐞𝐝

Return = × 𝟏𝟎𝟎
𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐍𝐀𝐕

LOS 4 : Different Plans Under Mutual Fund

1. Dividend Payout Plan : Under this plan, Mutual Fund Co. declares & distributes dividend to its
unitholders on regular basis.
Impact : NAV will fall & no. of units will remain same.
2. Bonus Plan : Free units are distributed to the unitholders like bonus shares.
Impact : NAV will fall & no. of units will increase.
3. Growth Plan : Neither dividend is distributed nor are bonus units given. NAV will be increase to
the extent of growth.
Impact : NAV will change according to the mkt only & no. of units will remain same.
4. Dividend Re–investment Plan : Although dividend is declared but it is not paid. Amount of
dividend is again re-invested at the ex-Dividend NAV price prevailing at the time of declaration.
Impact : NAV will fall & no. of units will increase.

LOS 5 : Expense Ratio

𝐄𝐱𝐩𝐞𝐧𝐬𝐞 𝐈𝐧𝐜𝐮𝐫𝐫𝐞𝐝 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭
Expense ratio =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐍𝐀𝐕
 5.3

Note:
𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐍𝐀𝐕+𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐍𝐀𝐕
Average NAV =
𝟐

LOS 6: Relationship between Return of Mutual fund, Recurring Expenses,

Issue Expenses & Return Desire by Investors (Indifference Point)

Required return by investors

= (Return of Mutual fund – Recurring Expenses) (1 – Issue Expenses)

LOS 7: Entry Load & Exit Load

Entry Load is paid by the investor at the time of purchase of Mutual Fund unit.

Sale Price of NAV = NAV (1 + Entry Load)

Exit Load is paid by the investor at the time of selling of mutual fund units.

Realized value of NAV = NAV (1 – Exit Load)

 6.1

Derivatives Analysis & Valuation (Futures)

Study Session 6

LOS 1 : Introduction

Define Forward Contract, Future Contract.

❖ Forward Contract, In Forward Contract one party agrees to buy, and the counterparty to sell, a
physical asset or a security at a specific price on a specific date in the future. If the future price
of the assets increases, the buyer(at the older, lower price) has a gain, and the seller a loss.
❖ Futures Contract is a standardized and exchange-traded. The main difference with forwards
are that futures are traded in an active secondary market, are regulated, backed by the clearing
house and require a daily settlement of gains and losses.
 6.2 DERIVATIVES ANALYSIS & VALUATION (FUTURES)

Future Contracts differ from Forward C ontracts in the following ways:

Future Contracts Forward Contracts

Organized Exchange Private Contracts
Highly Standardized Customized Contracts
❖ Lot size requirement
❖ Expiry Date
❖ MTM
No Counterparty default risk Counterparty default risk exists
Government Regulated Usually not Regulated

LOS 2 : Position to be taken under Future Market

How to settle / square-off / covering / closing out a position to calculate Profit/ Loss

To Square Off
Long Position Short position
To Square Off
Short Position Long position
 6.3

LOS 3 : Gain or Loss under Future Market

Position If Price on Maturity/ Settlement Price Gain/ Loss
Increase Gain
Long Position
Decrease Loss
Increase Loss
Short Position
Decrease Gain
Note:
❖ Gain/Loss is net of brokerage charge. Brokerage is paid on both buying & selling.
❖ Security Deposit is not considered while calculating Profit & Loss A/c.
❖ Interest paid on borrowed amount must be deducted while calculating Profit & Loss.
❖ A Future contract is ZERO-SUM Game. Profit of one party is the loss of other party.

LOS 4 : How Future Contract can be terminated at or prior to expiration?

❖ A short can terminate the contract by delivering the goods, and a long can terminate the Contract
by accepting delivery and paying the contract price to the short. This is called Delivery. The
location for delivery (for physical assets), terms of delivery, and details of exactly what is to be
delivered are all specified in the contract.
❖ In a cash-settlement contract, delivery is not an option. The futures account is marked-to-
market based on the settlement price on the last day of trading.
❖ You may make a reverse, or offsetting, trade in the future market. With futures, however, the
other side of your position is held by the clearinghouse- if you make an exact opposite
trade(maturity, quantity, and good) to your current position, the clearinghouse will net your
positions out, leaving you with a zero balance. This is how most futures positions are settled.

LOS 5 : Difference between Margin in the cash market and Margin in the future
markets and Explain the role of initial margin, maintenance margin
In Cash Market, margin on a stock or bond purchase is 100% of the market value of the asset.
❖ Initially, 50% of the stock purchase amount may be borrowed and the remaining amount must
be paid in cash (Initial margin).
❖ There is interest charged on the borrowed amount.
In Future Markets, margin is a performance guarantee i.e. security provided by the client to the
exchange. It is money deposited by both the long and the short. There is no loan involved and
consequently, no interest charges.
❖ The exchange requires traders to post margin and settle their account on a daily basis.
 6.4 DERIVATIVES ANALYSIS & VALUATION (FUTURES)

Note:
❖ Any amount, over & above initial margin amount can be withdrawn.
❖ If Initial Margin is not given in the question, then use:

Initial Margin = Daily Absolute Change + 3 Standard Deviation

LOS 6 : Concept of Compounding

Concept of e rt & e –rt (Continuous Compounding)

Most of the financial variable such as Stock price, Interest rate, Exchange rate, Commodity price
change on a real time basis. Hence, the concept of Continuous compounding comes in picture.
Continuous Compounding means compounding every moment. Instead of (1 + r) we will use ert
 6.5

Calculation of ab Calculation of eb

1. √𝒂 12 Times 1. √𝒆 12 Times
2. -1 2. - 1
3. ×b 3. × b
4. +1 4. + 1
5. ×= 12 Times 5. × = 12 Times
Hint : e1 = 2.71828

LOS 7 : Fair future price of security with no income

In case of Normal Compounding

Fair future price = Spot Price (1+r)n

In case of Continuous Compounding

Fair future price = Spot Price × e rt

LOS 8 : Fair Future Price of Security with Dividend Income

 6.6 DERIVATIVES ANALYSIS & VALUATION (FUTURES)

In case of Normal Compounding

Fair Future Price = [Spot Price – PV of Expected Dividend ] ( 1+r)n

In case of Continuous Compounding

Fair Future Price = [Spot Price – PV of Expected Dividend ] × e r t

LOS 9 : Fair Future Price of security when income is expressed in

percentage or when dividend yield is given

In case of Normal Compounding

Fair Future Price = Spot Price [1+(r-y)] n

In case of Continuous Compounding

Fair Future Price = Spot Price × e(r-y) × t

LOS 10 : Fair Future Price of Commodity with storage cost

In case of Normal Compounding

Fair Future Price = [Spot Price + PV of S.C ] ( 1+r) n

In case of Continuous Compounding

Fair Future Price = [Spot Price + PV of S.C ] × e rt

Where PV of S.C = Present Value of Storage Cost

Note: Fair Future Price when Storage Cost is given in percentage(%).

FFP = Spot Price × e (r + s) × t

 6.7

LOS 11 : Fair Future Price of commodities with Convenience yield expressed

in % (Similar to Dividend Yield)
The benefit or premium associated with holding an underlying product or physical good rather than
contract or derivative product i.e. extra benefit that an investor receives for holding a commodity.
In case of Continuous Compounding

Fair Future Price = Spot Price × e(r-c)×t

Note: Fair Future Price when convenience income is expressed in Absolute Amount.

Fair Future Price = [Spot Price - PV of Convenience Income] × e rt

LOS 12 : Arbitrage Opportunity between Cash and Future Market

❖ Arbitrage is an important concept in valuing (Pricing) derivative securities. In its Purest sense,
arbitrage is riskless.
❖ Arbitrage opportunities arise when assets are mispriced. Trading by Arbitrageurs will continue
until they effect supply and demand enough to bring asset prices to efficient( no arbitrage) levels.
❖ Arbitrage is based on “Law of one price”. Two securities or portfolios that have identical cash
flows in future, should have the same price. If A and B have the identical future pay offs and A
is priced lower than B, buy A and sell B. You have an immediate profit.
Difference between Actual Future Price and Fair Future Price?
Fair Future Price is calculated by using the concept of Present Value & Future Value.
Actual Future Price is actually prevailing in the market.
Case Value Future Market Cash Market Borrow/ Invest
FFP < AFP Over-Valued Sell or Short Position Buy Borrow
FFP > AFP Under-Valued Buy or Long Position Sell # Investment
# Here we assume that Arbitrager already hold shares

LOS 13: Complete Hedging by using Index Futures & Beta

Hedging is the process of taking an opposite position in order to reduce loss caused by Price
fluctuation.
❖ The objective of Hedging is to reduce Loss.
❖ Complete Hedging means profit/ Loss will be Zero.
Position to be taken:
a) Long Position should be hedged by Short Position.
b) Short Position should be hedged by Long Position.
Value of Position to be taken:
Value of Position for Complete hedge should be taken on the basis of Beta through index futures.
 6.8 DERIVATIVES ANALYSIS & VALUATION (FUTURES)

Value of Position for Complete Hedge = Current Value of Portfolio × Existing Stock Beta

LOS 14: Value of Position for Increasing & Reducing Beta to a Target Level

Alternative 1 (Hedging Using Index Future)

Step 1 : Decide Position
Case 1 : To Reduce Risk
Long Position Short Index Future
Short Position Long Index Future
Case 2 : To Increase Risk
Long Position Long Index Future
Short Position Short Index Future
Step 2 : Value of Position
Case I: When Existing Beta > Target Beta
Objective: Reducing Risk
Value of Index Position = Value of Existing Portfolio × [Existing Beta – Desired Beta]
Action: Take Short Position in Index & keep your current position unchanged.
Case II: When Existing Beta < Target Beta
Objective: Increase Risk
Value of Index Position = Value of Existing Portfolio × [Desired Beta – Existing Beta]
Action: Take Long Position in Index & keep your current position unchanged
Step 3 : No. of future contracts to be sold or purchased for increasing or reducing Beta to a
Desired Level using Index Futures.

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐈𝐧𝐝𝐞𝐱 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧

No. of Future Contract to be taken =
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐨𝐧𝐞 𝐅𝐮𝐭𝐮𝐫𝐞 𝐂𝐨𝐧𝐭𝐫𝐚𝐜𝐭
 6.9

Alternative 2 (Hedging Using Risk free Investment or Borrowing)

Case 1: Reducing Risk
SELL SOME SECURITIES AND REPLACE WITH RISK-FREE INVESTMENT
Step1: Equate the weighted Average Beta formulae to the new desired Beta
Target Beta = Beta1 × W1 + Beta2 × W2 ( Beta of Risk free investment is Zero)
Step2: Use the weights and decide
Case 2: Increasing Risk
BUY SOME SECURITIES AND BORROW AT RISK-FREE RATE
Step1: Equate the weighted Average Beta formulae to the new desired Beta
Target Beta = Beta1 × W1 + Beta2 × W2 ( Beta of Risk free investment is Zero)
Step2: Use the weights and decide

LOS 15 : Partial Hedge

Value of position in Index Future =

Value of existing Portfolio × Existing beta × percentage (%) to be Hedge

❖ It result into Over-Hedged or Under-Hedged Position

❖ There may be profit or loss depending upon the situation.

LOS 16 : Beta of a Cash and Cash Equivalent

Beta of a cash and Risk free security is Zero.

LOS 17 : Hedging Commodity Risk Through Futures

 6.10 DERIVATIVES ANALYSIS & VALUATION (FUTURES)

LOS 18 : Calculation of Rate of Return

Increase or Decrease in Stock Price (P1 – P0)
(+) Dividend Received
(-) Transaction Cost
(-) Interest Paid on Borrowed Amount
Net Amount Received

𝐍𝐞𝐭 𝐀𝐦𝐨𝐮𝐧𝐭 𝐑𝐞𝐜𝐞𝐢𝐯𝐞𝐝

Rate of return = × 𝟏𝟎𝟎
𝐓𝐨𝐭𝐚𝐥 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

LOS 19 : Hedge Ratio

The Optional Hedge Ratio to minimize the variance of Hedger’s position is given by:-

𝛔𝐒
Hedge Ratio = Corr. (r)
𝛔𝐅

σS = S.D of Δ S
σF = S.D of Δ F
r = Correlation between Δ S and Δ F
Δ S = Change in Spot Price
Δ F = Change in Future Price
 7.1

Derivatives Analysis & Valuation (Options)

Study Session 7

LOS 1 : Introduction

Definition of Option Contract:

An option contract give its owner the right, but not the legal obligation, to conduct a transaction
involving an underlying asset at a pre-determined future date( the exercise date) and at a pre-
determined price (the exercise price or strike price)
There are four possible options position
1) Long call : The buyer of a call option  has the right to buy an underlying asset.
2) Short call : The writer (seller) of a call option has the obligation to sell the underlying asset.
3) Long put : The buyer of a put option  has the right to sell the underlying asset.
4) Short put : The writer (seller) of a put option  has the obligation to buy the underlying asset.
Note:
Meaning of Long position & Short position under Option Contract
 7.2 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

Note:
❖ If question is silent always assume Long Position.
❖ Exercise Price/ Strike Price:
The fixed price at which buyer of the option can exercise his option to buy/ sell an underlying asset.
It always remain constant throughout the life of contract period.
❖ Option Premium:
✓ To acquire these rights, owner of options must buy them by paying a price called the Option
premium to the seller of the option.
✓ Option Premium is paid by buyer and received by Seller.
✓ Option Premium is non-refundable, non-adjustable deposit.
Note:
❖ The option holder will only exercise their right to act if it is profitable to do so.
❖ The owner of the Option is the one who decides whether to exercise the Option or not.

LOS 2 : Call Option

When Call Option Contract are exercised:

❖ When CMP > Strike Price  Call Buyer Exercise the Option.
❖ When CMP < Strike Price  Call Buyer will not Exercise the Option.

Right to Buy reliance Obligation to Sell reliance

share @ 1000 after 3 share @ 1000 after 3
months months if buyer approaches
to do so.
LONG CALL SHORT CALL
OP Paid OP Received
Note :
❖ The call holder will exercise the option whenever the stock’s price exceeds the strike price at the
expiration date.
❖ The sum of the profits between the Buyer and Seller of the call option is always Zero. Thus,
Option trading is ZERO-SUM GAME. The long profits equal to the short losses.
❖ Position of a Call Seller will be just opposite of the position of Call Buyer.
❖ In this chapter, we first see whether the Buyer of Option opt or not & then accordingly we will
calculate Profit & Loss
 7.3

PAY-OFF DIAGRAM

LOS 3 : Put Option

When Put Option Contract are exercised:

❖ When CMP > Strike Price  Put Buyer will not Exercise the Option.
❖ When CMP < Strike Price  Put Buyer will Exercise the Option.

Right to Sell reliance Obligation to Buy reliance

share @ 1000 after 3 share @ 1000 after 3
months months if buyer approaches
to do so.
LONG PUT SHORT PUT
OP Paid OP Received
Note:
❖ Put Buyer will only exercise the option when actual market price is less the exercise price.
❖ Profit of Put Buyer = Loss of Put Seller & vice-versa. Trading Put Option is a Zero-Sum Game.
 7.4 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

PAY-OFF DIAGRAM

Profit or Loss/ Pay off of call Option & Put Option

While calculating profit or loss, always consider option Premium,

Call Buyers (Long Call)

If S – X > 0 If S – X < 0
Exercise the option Not Exercise
Net Profit = S – X – OP Loss = Amount of Premium
Put Buyers (Long Put)
If X – S >0 If X – S < 0
Exercise the option Not Exercise
Net Profit = X – S –OP Loss = Amount of Premium

Calculation of Maximum Loss, Maximum Gain, Breakeven Point for Call & Put Option

Call Option
Maximum Loss Maximum Gain
Buyer (Long) Option Premium Unlimited
Seller (Short) Unlimited Option Premium
Breakeven X + Option Premium

Put Option
Maximum Loss Maximum Gain
Buyer (Long) Option Premium X – Option Premium
Seller (Short) X – Option Premium Option Premium
Breakeven X - Option Premium
 7.5

LOS 4 : Concept of Moneyness of an Option

Moneyness refers to whether an option is In-the money or Out- of the money.
Case I : If immediate exercise of the option would generate a positive pay-off, it is in the money
Case II : If immediate exercise would result in loss (negative pay-off), it is out of the money.
Case III : When current Asset Price = Exercise Price, exercise will generate neither gain nor
loss and the option is at the money.
Call Option Put Option
Case 1 S–X>0 In-the-Money X-S>0
Case 2 S–X<0 Out-of- the-Money X-S<0
Case 3 S=X At-the-Money X=S
Note:
Do not consider option premium while Calculating Moneyness of the Option.

LOS 5 : European & American Options

American Option : American Option may be exercised at any time upto and including the contract’s
expiration date.
European Option : European Options can be exercised only on the contract’s expiration date.
The name of the Option does not imply where the option trades – they are just names.

LOS 6 : Action to be taken under Option Market

LOS 7 : Intrinsic Value & Time Value of Option

Option value (Premium) can be divided into two parts:-
(i) Intrinsic Value
(ii) Time Value of an Option (Extrinsic Value)
Option Premium = Intrinsic Value + Time Value of Option
 7.6 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

Intrinsic Value:
❖ An Option’s intrinsic Value is the amount by which the option is In-the-money. It is the amount
that the option owner would receive if the option were exercised.
❖ Intrinsic Value is the minimum amount charged by seller from buyer at the time of selling the
right.
❖ An Option has ZERO Intrinsic Value if it is At-the-Money or Out-of-the-Money, regardless of
whether it is a call or a Put Option.
❖ The Intrinsic Value of a Call Option is the greater of (S – X) or 0. That is
C = Max [0, S –X]
❖ Similarly, the Intrinsic Value of a Put Option is (X - S) or 0. Whichever is greater. That is:
P = Max [0, X - S]
Time Value of an Option (Extrinsic Value):
❖ The Time Value of an Option is the amount by which the option premium exceeds the intrinsic
Value.
❖ Time Value of Option = Option Premium – Intrinsic Value
❖ When an Option reaches expiration there is no “Time” remaining and the time value is ZERO.
❖ The longer the time to expiration, the greater the time value and, other things equal, the greater
the option’s Premium (price).

Option Valuation

LOS 8 : Fair Option Premium/ Fair Value/ Fair Price of a Call on Expiration

Fair Premium of Call on Expiry = Maximum of [(S – X), 0]

Note:
Option Premium can never be Negative. It can be Zero or greater than Zero.
 7.7

LOS 9 : Fair Option Premium/ Fair Value/ Fair Price of a Put on Expiration

Fair Premium of Put on Expiry = Maximum of [(X – S), 0]

LOS 10 : Fair Option Premium/ Theoretical Option Premium/ Price of a Call

before Expiry or at the time of entering into contract or As on Today

𝐗
Fair Premium of Call = [𝐒 − 𝑡 , 0] Max
(𝟏+𝐑𝐅𝐑)

Or
𝑋
= [S – , 0] Max
𝑒 𝑟𝑡

LOS 11 : Fair Option Premium/ Theoretical Option Premium/ Price of a Put

before Expiry or at the time of entering into contract or As on Today

𝐗
Fair Premium of Put = [(𝟏+𝐑𝐅𝐑)𝐓 – 𝐒, 𝟎] Max

Or
𝑋
=[ – 𝐒, 𝟎] Max
𝑒 𝑟𝑡

LOS 12 : Expected Value of an Option on expiry

Under this approach, we will calculate the amount of Option premium on the basis of Probability.
Expected value of an option at Expiry = ∑ Value of Option at expiry × Probability

LOS 13 : Risk Neutral Approach for Call & Put Option(Binomial Model)
 7.8 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

❖ Under this approach, we will calculate Fair Option Premium of Call & Put as on Today.
❖ The basic assumption of this model is that share price on expiry may be higher or may be lower
than current price.
Step 1: Calculate Value of Call or Put as on expiry at high price & low price
Value of Call as on expiry = Max [( S – X),0]
Value of Put as on expiry = Max [(X – S), 0]
Step 2: Calculate Probability of High Price & Low Price

CMP (1+r)n − 𝐿𝑃 CMP (e rt )− LP

Probability of High Price = or Probability of High Price =
HP − LP HP − LP
Step 3: Calculate expected Value/ Premium as on expiry by using Probability
Step 4: Calculate Premium as on Today
Expected Premium as on expiry
By Using normal Compounding =
(1+r)t

Expected Premium as on expiry

By Using Continuous Compounding =
𝑒 rt

LOS 14 : Two Period Binomial Model

We divide the option period into two equal parts and we are provided with binomial projections for
each path. We then calculate value of the option on maturity. We then apply backward induction
technique to compute the value of option at each nodes.

LOS 15 : Arbitrage Opportunity in Option Contract

❖ When Arbitrage is possible under Option Contract?
Fair Option Premium ≠ Actual Option Premium
❖ Arbitrage Opportunity on Call  Before Expiry
FOP = Fair Option Premium AOP = Actual Option Premium
 7.9

Case I Value Option Market Cash Market Invest

FOP > AOP Under-Valued Long Call Sell # Net Amount

# Assume investor is already holding the required shares.

Case 2 Value Option Market Cash Market Borrow

FOP < AOP Over-Valued Short Call Buy Net Amount

* Arbitrage is not possible  Because there is an opportunity of Huge Loss

Arbitrage Opportunity on Put  Before Expiry

Case I Value Option Market Cash Market Borrow

FP > AP Under-Valued Long Put Buy Net Amount

Case 2 Value Option Market Cash Market Invest

FP < AP Over-Valued Short Put Sell Net Amount

* Arbitrage is not possible  Because there is an opportunity of Huge Loss

LOS 16 : Put Call Parity Theory (PCPT)

Put Call Parity is based on Pay-offs of two portfolio combination, a fiduciary call and a protective
put.
Fiduciary Call
A Fiduciary Call is a combination of a pure-discount, riskless bond that pays X at maturity and a Call.
Protective Put
A Protective Put is a share of stock together with a put option on the stock.

𝐗
PCPT  Value of Call + = Value of Put + S
(𝟏+𝐑𝐅𝐑)𝐓

Protective Put
If on Maturity S > X If on Maturity S < X
Put option is lapse i.e. pay off = NIL Put option is exercise i.e. pay off = X–S
Stock is sold in the Market = S Stock is sold in the Market = S
S X
Fiduciary Call
If on Maturity S > X If on Maturity S < X
Call option is exercise i.e. pay off = S–X Call option is lapse i.e. pay off = NIL
Bond is sold in the Market = X Bond is sold in the Market = X
S X
 7.10 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

Through this theory, we can calculate either Value of Call or Value of Put provided other Three
information is given.
Assumptions:
❖ Exercise Price of both Call & Put Option are same.
❖ Maturity Period of both Call & Put are Same.

LOS 17 : Put - Call Parity Theory  ARBITRAGE

As per PCPT,
X
Value of Call + Value of Put + S
(1+RFR)T

LHS RHS
Case I : If LHS = RHS, arbitrage is not possible.
Case II : If LHS ≠ RHS, arbitrage is possible.
A. If LHS > RHS, Call is Over-Valued & Put is Under-Valued

Option Market Cash Market Net Amount

Short Call Long Put Buy Borrow
i.e. Obligation to sell i.e. Right to sell & Option i.e. Buy one share S+P-C
& Option Premium Premium Paid
Received

B. If LHS < RHS, Call is Under-Valued & Put is Over-Valued

Option Market Cash Market Net Amount

Long Call Short Put Sell Invest
i.e. Right to Buy & i.e. Obligation to buy & i.e. Sell one share S+P-C
Option Premium Option Premium
Paid Received

LOS 18 : Option Strategies

Combination of Call & Put is known as OPTION STRATEGIES.
Types of Option Strategies:
Some important Option Strategies are as follows:
1. Straddle Position
2. Strangle Strategy
3. Strip Strategy
4. Strap Strategy
5. Butterfly Spread
1. Straddle Position :
Straddle may be of 2 types :
 7.11

Long Straddle Short Straddle

Buy a Call and Buy a Put on the same stock Sell a Call and Sell a Put with same exercise
with both the options having the same exercise price and same exercise date.
price.
Option: Buy One Call and Buy One Put Option: Sell One Call and Sell One Put
Exercise Date: Same of Both Exercise Date: Same of Both
Strike Price / Exercise Price: Same of Both Strike Price / Exercise Price: Same of Both
Note: Note:
A Long Straddle investor pays premium on A Short Straddle investor receive premium on
both Call & Put. both Call and Put.
Note:
❖ When an investor is not sure whether the price will go up or go down, then in such case we
should create a straddle position.
❖ If Question is Silent, always assume Long Straddle.
2. Strangle Strategy :
❖ An option strategy, where the investor holds a position in both a call and a put with different
strike prices but with the same maturity and underlying asset is called Strangles Strategy.
❖ Selling a call option and a put option is called seller of strangle (i.e. Short Strangle).
❖ Buying a call and a put is called Buyer of Strangle (i.e. Long Strangle).
❖ If there is a large price movement in the near future but unsure of which way the price
movement will be, this is a Good Strategy.

3. Strip Strategy (Bear Strategy) 4. Strap Strategy (Bull Strategy)

❖ Buy Two Put and Buy One Call Option of ❖ Buy Two Calls and Buy One Put when the
the same stock at the same exercise price buyer feels that the stock is more likely to
and for the same period. rise Steeply than to fall.
❖ Strip Position is applicable when decrease ❖ Strap Position is applicable when increase
in price is more likely than increase. in price is more likely than decrease.
Option: Buy Two Put and Buy One Call Option: Buy Two Calls and Buy One Put
Exercise Date: Same of Both Exercise Date: Same of Both
Strike Price/ Exercise Price: Same of Both Strike Price/ Exercise Price: Same of Both

5. Butterfly Spread :
In Butterfly spread position, an investor will undertake 4 call option with respect to 3 different strike
price or exercise price.
It can be constructed in following manner:
❖ Buy One Call Option at High exercise Price (S1)
❖ Buy One Call Option at Low exercise Price (S2)
S1 + S2
❖ Sell two Call Option ( )
2

LOS 19 : Binomial Model (Delta Hedging / Perfectly Hedged technique) for Call
Writer
Under this concept, we will calculate option premium for call option.
 7.12 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

It is assumed that expected price on expiry may be greater than Current Market Price or less than
Current Market Price.

Steps involved:
Step 1: Compute the Option Value on Expiry Date at high price and at low price
Value of Call as on expiry = Max [(S – X),0]
Step 2: Buy ‘Delta’ No. of shares ‘Δ’ at Current Market Price as on Today. Delta ‘Δ ’ also
known as Hedge Ratio.
Change in Option Premium
Hedge Ratio or ‘Δ’ =
Change in Price of Underlying Asset

OR
Value of call on expiry at High Price –Value of call on expiry at Low Price
=
High Price −Low Price

Step 3: Construct a Delta Hedge Portfolio i.e. Risk-less portfolio / Perfectly Hedge Portfolio
Sell one call option i.e. Short Call ,Buy Delta no. of shares and borrow net amount.
Step 4: Borrow the net Amount required for the above steps

1
B= [Δ × HP − 𝑉𝐶 ]
1+r
Or
1
B= [Δ × LP − 𝑉𝐶 ]
1+r

Where r = rate of interest adjusted for period

Step 5: Calculate Value of call as on today
Borrowed Amount = Amount required to purchase of share – Option Premium Received

B = Δ × CMP – OP
Or
(Option Premium = Δ × CMP – Borrowed Amount)
 7.13

Note: Calculation of Cash flow Position/ Value of holding after 1 year

❖ If on Maturity Actual Market Price is HP
Cash Flow = ∆ × HP – VC
❖ If on Maturity Actual Market Price is S2
Cash Flow = ∆ × LP – VC
Cash Flow at HP and LP will always be same.
Meaning of perfectly hedge position under binomial model
Perfectly hedge position means Profit or Loss will be Zero or NIL. It can be achieved by buying
Δ shares, sell one call option and borrowing the required amount.
Delta is the number of shares which makes the portfolio perfectly hedged i.e. whether the stock
price on maturity goes up or decline, the value of portfolio doesn’t vary i.e. our profit and loss position
will be Zero.

LOS 20 : Black & Scholes Model

Assumptions of BSM Model :
❖ The price of underlying asset follows a log normal distribution
❖ Markets are frictionless. There is no taxes, no transaction cost, no restriction on short sale.
❖ The option valued are European options.
❖ Risk Free continuous compounding interest rate is known and constant.
❖ Annualized volatility of the stock is known and constant.
❖ The underlying asset has no cash flow as dividend, coupons etc.
For Call:
𝐗
Value of a Call Option/ Premium on Call = 𝐒 × 𝐍(𝐝𝟏 ) - × 𝐍(𝐝𝟐 )
𝐞𝐫𝐭

Calculation of d1 and d2
𝐒
𝐥𝐧 [ ]+ [𝐫 +𝟎.𝟓𝟎𝛔𝟐 ]×𝐭 d2 = d1 – σ √𝐭
𝐗
d1 =
𝛔× √𝐭 Or
𝐒
𝐥𝐧 [ ]+ [𝐫 − 𝟎.𝟓𝟎𝛔𝟐 ]×𝐭
𝐗
d2 =
𝛔× √𝐭

For Put:
𝐗
Value of a Put Option/ Premium on Put = × [ 𝟏 − 𝐍(𝐝𝟐 )] − 𝐒 × [𝟏 − 𝐍(𝐝𝟏 )]
𝐞𝐫𝐭

LOS 21 : BSM  when dividend amount is given in the question

Adjust Spot Price (S) or CMP as [Spot Price – PV of Dividend Income]
 7.14 DERIVATIVES ANALYSIS & VALUATION (OPTIONS)

𝐗
Value of a Call Option = [𝐒 − 𝐏𝐕 𝐨𝐟 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐈𝐧𝐜𝐨𝐦𝐞] × 𝐍(𝐝𝟏 ) - × 𝐍(𝐝𝟐 )
𝐞𝐫𝐭
𝐒−𝐏𝐕 𝐨𝐟 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐈𝐧𝐜𝐨𝐦𝐞
𝐥𝐧 [
𝐗
]+ [𝐫 +𝟎.𝟓𝟎𝛔𝟐 ]×𝐭
d1 =
𝛔× √𝐭

d2 = d1 – σ √𝐭

LOS 22 : Put-Call Ratio

Volume of Put Traded
Put- Call Ratio =
Volume of Call Traded

The ratio of the volume of put options traded to the volume of Call options traded, which is used as
an indicator of investor’s sentiment (bullish or bearish)
The put-call Ratio to determine the market sentiments, with high ratio indicating a bearish sentiment
and a low ratio indicating a bullish sentiment.

LOS 23 : Option Greek Parameters

Option price depends on 5 factors:
Option Price = f [S, X, t, r, σ], out of these factors X is constant and other causing a change in the
price of option.
We will find out a rate of change of option price with respect to each factor at a time, keeping others
constant.
1. Delta: It is the degree to which an option price will move given a small change in the underlying
stock price. For example, an option with a delta of 0.5 will move half a rupee for every full rupee
movement in the underlying stock.
The delta is often called the hedge ratio i.e. if you have a portfolio short ‘n’ options (e.g. you have
written n calls) then n multiplied by the delta gives you the number of shares (i.e. units of the
underlying) you would need to create a riskless position - i.e. a portfolio which would be worth
the same whether the stock price rose by a very small amount or fell by a very small amount.
2. Gamma: It measures how fast the delta changes for small changes in the underlying stock price
i.e. the delta of the delta. If you are hedging a portfolio using the delta-hedge technique described
under "Delta", then you will want to keep gamma as small as possible, the smaller it is the less
often you will have to adjust the hedge to maintain a delta neutral position. If gamma is too large,
a small change in stock price could wreck your hedge. Adjusting gamma, however, can be tricky
and is generally done using options.
3. Vega: Sensitivity of option value to change in volatility. Vega indicates an absolute change in
option value for a one percentage change in volatility.
4. Rho: The change in option price given a one percentage point change in the risk-free interest
rate. It is sensitivity of option value to change in interest rate. Rho indicates the absolute change
in option value for a one percent change in the interest rate.
5. Theta: It is a rate change of option value with respect to the passage of time, other things
remaining constant. It is generally negative.
 8.1

Foreign Exchange Exposure & Risk Management

Study Session 8

LOS 1 : Introduction
Three types of transactions associated with foreign exchange risk:
1. Loans(ECB)
2. Investments (Bonds & Equity)
3. Export & Import
Foreign Exchange Risk

Foreign Exchange Market (3 Tier Market)

Note :
In India, Foreign Exchange Market is regulated by RBI.
What is Exchange Rate?
❖ The rate of conversion is the Exchange Rate.
❖ An exchange rate is the price of one country’s currency expressed in terms of the currency of
another country. E.g. A rate of ` 50 per US $ implies that one US $ costs ` 50.
Rule 1 : in an exchange rate two currencies are involved.
Rule 2 : in any transaction involving Foreign Currency, you are selling one currency and buying
another.
 8.2 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

LOS 2 : Home Currency & Foreign Currency

Home Currency: Country’s own currency.
Example:
For India ‘`’/INR is home currency
For USA ‘US $’ or ‘Dollar’ is a home currency
For UK ‘£’ or ‘Pound’ or ‘GBP’ is home currency
Foreign Currency: Any currency other than home currency will be a Foreign Currency
Example:
For India, $, £, etc. will be a foreign currency.
For US ‘`’, £ will be foreign currency.

LOS 3 : Bid & Ask Rate

Bid Rate: Rate at which bank BUYS left hand side currency.
Ask Rate: Rate at which bank SELLS left hand side currency.
One-way Quote: [when Bid and Ask Rate are same]
Example: 1$ = ` 65
Explanation:
Bank buys 1$ at ` 65.
Bank sells 1$ at ` 65.

Two-way Quote: [when Bid and Ask Rate are separately given]
Example:

1$ = ` 62 ---------------------------------------- ` 65

Left Hand Side Bid Rate/ Bank Buying Ask Rate/ Bank Selling
Currency rate of left hand currency rate of left hand currency

Note:
❖ Difference between Bid & Ask rate represents Profit Margin for the bank.
❖ Quotation/ Bid & Ask rate or Exchange Rate is always quoted from the point of view of bank.
❖ Bid Rate must always be less than Ask Rate.
Or
Ask Rate must always be greater than Bid Rate.
❖ Always solve question from the point of view of investor/ Customer unless otherwise stated.
❖ The difference between the Ask & Bid rates is called Spread, representing the profit margin of
dealer.
Spread = Ask Rate – Bid Rate
 8.3

LOS 4 : Direct Quote & Indirect Quote

Direct Quote: Home Currency Price for 1 unit of foreign currency.
Example: 1$ = ` 50 is DQ for Rupee.
Indirect Quote: Foreign Currency Price for 1 unit of Home Currency.
Example: 1Re = 0.0200$ is IDQ for Rupee.
Note:
❖ If a given quotation is direct for one country, then the same quotation will be indirect for another
country and vice-versa.
❖ The concept of DQ and IDQ is only theoretical and don’t have any practical relevance.

LOS 5 : Conversion of Direct Quote into Indirect Quote and vice-versa

Case 1: One-way Quote [When bid & ask rates are same]
❖ Direct Quote can be converted into indirect quote by taking the reciprocal of direct quote.

𝟏
IDQ =
𝐃𝐐

Case 2: Two-way Quote [When bid & ask rates are separately given]
❖ Direct Quote (DQ) can be converted into Indirect Quote (IDQ) by taking the reciprocal of direct
quote and switching the position.
Example: $1 = ` 47.25 --- ` 47.85 (1st Quote)
Convert DQ into the IDQ.
Solution:
DQ => $1 = ` 47.25 --- ` 47.85
1 1
IDQ => 1 Re. = −
47.25 47.85

1 1
1 Re. = −
47.85 47.25
OR 1 Re. = 0.02090 --- 0.02116 (2nd Quote)

Conversion Rules :

❖ Which currency is given in the question, we need that currency in the LHS
of the quote.
❖ Decide whether to Buy that currency or Sell.
❖ If you Buy Bank Sells Use Ask Rate
If you Sell Bank Buys Use Bid Rate
❖ Always Solve question from the point of view of Customer.
 8.4 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

LOS 6 : Spot Rate & Forward Rate

Spot Rate: Rate used for buying & selling of foreign currency at ‘As on Today or Immediately’
Forward rate: Rate used for buying & selling of foreign currency at some future Date i.e. Forward
rate is the rate contracted today for exchange of currencies at a specified future date.

LOS 7 : Premium or Discount

Premium: If the currency is costly or Expensive in future as compared to spot it is said to be at a
premium.
SR => 1$ = ` 45
FR => 1$ = ` 50
In the above quote $ is at Premium.
Discount: If the currency is Cheaper in future as compared to spot it is said to be at a discount.

1
SR => 1Re. = $ = 0.0222
45
1
FR => 1Re. = $ = 0.02
50
We can say that rupee is at discount.
Calculation of Premium or Discount

𝑭𝑹−𝑺𝑹 𝟏𝟐
[ ] × 𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐏𝐞𝐫𝐢𝐨𝐝 × 100
𝑺𝑹

Note: This formula is applicable only for left hand currency

Conclusion:
❖ If one currency is at a premium, then another currency must be at a discount. However, the rate
of premium may not be equal to the rate of discount.
❖ On account of base effect, premium is slightly higher than the discount.

LOS 8 : Calculation of Forward Rate when Spot Rate & Premium or Discount is
given
Example 1:
SR  1$ = ` 48.50
$ is at premium = 5%
Calculate FR?
Solution:
FR  1$ = ` 48.50 (1 + 0.05)
1$ = ` 50.925

LOS 9 : SWAP POINTS/ Forward Margin/ Forward-Spot Differential

Difference between Forward Rate and Spot Rate is known as Swap Points.
 8.5

How to ADD or DEDUCT Swap Points

❖ Swap Point should be Added or Deducted from the last decimal point in the Reverse Order.
❖ Premium  Add Swap Points
❖ Discount  Less Swap Points
If Premium / Discount is not mentioned, we observe the following rules:
Case 1: When Swap Points are in increasing order:
❖ It indicates premium on left hand currency.
❖ In this case, we will add swap points with spot rates to calculate forward rates.
Case 2: When Swap Points are in decreasing order:
❖ It indicates discount on left hand currency.
❖ In this case, we will deduct swap points from Spot Rate to calculate forward rates.
Note : Don’t apply the rule if Premium or Discount is used in the question.

LOS 10 : Cross Rate

Cross Rate between ant two currencies is derived with the help of quotations between these
currencies & third currency.
❖ Cross Rate is normally used in finding out any missing exchange rate.
❖ The calculation of cross rate simply requires you to focus on cancellation of common currencies,
to do so you have to multiply with DQ & IDQ.
❖ Always check ASK Rate > BID Rate.

LOS 11 : Squaring-up the position or Covering the Position or Closing-out the

Position under FOREX
Covering the Position means taking an opposite or reverse position to calculate profit and loss i.e.
we cover our position to book Profit or Loss.

Long Position To Cover Short Position

Short Position Long Position

LOS 12 : Exchange Margin

Exchange Margin is the extra amount or percentage charged by the bank over and above the rate
quoted by it. Eg. Commission, transaction charges, etc.
 8.6 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Actual Selling Rate of Bank: (Add Exchange Margin)

= Ask Rate (1+ Exchange Margin)
Actual Buying Rate of Bank: (Deduct Exchange Margin)
= Bid Rate (1 – Exchange Margin)

LOS 13 : Triangular Arbitrage

It involves 3 currencies represented by 3 corner points of triangle. We will be starting with one
currency, pass through the other two currencies and come back to the original currency. There
are two paths  clockwise and Anticlockwise.
One path will result in profit while the other path will result in Loss.

LOS 14 : Purchasing Power Parity Theory (PPPT)

Calculation of Spot Rate
❖ PPPT is based on the concept of ‘Law of One Price’.
❖ PPPT is based on the fact that price of a commodity in two different market will always be same.
❖ If Price of a commodity in two different market are not same, there will be an arbitrage opportunity
exists in the market.
❖ Suppose Price of a Commodity in India is ` X & In USA is $Y. Spot Rate is 1$ = ` SR
Then X = Y × SR
X
SR =
Y

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐏𝐫𝐢𝐜𝐞 (𝐑𝐬.)

Spot Rate (` / $) =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐏𝐫𝐢𝐜𝐞 ($)
❖ Exchange Rate = Price Ratio
Calculation of Forward Rate
PPPT is also applicable in case of inflation. Suppose Inflation Rate of India is IRs and in US is I$
Forward Rate 1$ = ` F. Now as per PPPT, we have after 1 year:
X (1+ I`) = y (1+ I$ ) × FR
X (1+ 𝐼Rs )
FR =
Y (1+ 𝐼$ )
 8.7

1+ IRs
FR = SR ×
1+ 𝐼$

𝐅𝐑 (𝐑𝐬./$) 𝟏+𝐑𝐮𝐩𝐞𝐞 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧

=
𝐒𝐑 (𝐑𝐬./$) 𝟏+𝐃𝐨𝐥𝐥𝐚𝐫 ($)𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧
Note:
❖ The above equation is applicable for any two given currency.
❖ Determination of Premium or Discount with the help of Inflation Rate: If Inflation Rate of a country
is higher, then the currency of that Country will be at a discount in future and Vice- Versa.
Inflation rate in above equation must be adjusted according to forward period.

Case1: When Period is less than 1 Year. Case2: When Period is more than 1 Year.
𝐅𝐑 (𝐑𝐬./$) 𝟏+𝐏𝐞𝐫𝐢𝐨𝐝𝐢𝐜 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 ( 𝐑𝐬.) 𝐧
= 𝐅𝐑 (𝐑𝐬./$) (𝟏+ 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 (𝐑𝐬.))
𝐒𝐑 (𝐑𝐬./$) 𝟏+𝐏𝐞𝐫𝐢𝐨𝐝𝐢𝐜 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 ( $ ) = 𝐧
𝐒𝐑 (𝐑𝐬./$) (𝟏+ 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞 ($))

LOS 15 : Interest Rate Parity Theory (IRPT)

❖ IRPT states that exchange rate between currencies are directly affected by their Interest Rate.
❖ Assumption: Investment opportunity in any two different market will always be same.

𝐅𝐑 (𝐑𝐬./$) 𝟏+𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 (𝐑𝐬.)

=
𝐒𝐑 (𝐑𝐬./$) 𝟏+𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 ($)

Note:
❖ The above equation is applicable for any two given currency.
❖ Interest Rate should be adjusted according to forward period.
Case1: When Period is less than 1 Year. Case2: When Period is more than 1 Year.
𝐅𝐑 (𝐑𝐬./$) 𝟏+𝐏𝐞𝐫𝐢𝐨𝐝𝐢𝐜 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 ( 𝐑𝐬.) 𝐧
= 𝐅𝐑 (𝐑𝐬./$) (𝟏+ 𝐈𝐧𝐭𝐞𝐫𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 (𝐑𝐬.))
𝐒𝐑 (𝐑𝐬./$) 𝟏+𝐏𝐞𝐫𝐢𝐨𝐝𝐢𝐜 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 ( $ ) = 𝐧
𝐒𝐑 (𝐑𝐬./$) (𝟏+ 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 ($))

Note:
❖ Determination of Premium or Discount with the help of Interest Rate: If Interest rate of a country
is higher, than the currency of that country will be at a discount in future and vice-versa.
❖ If IRPT holds, arbitrage is not possible. In that case, it doesn’t matter whether you invest in
domestic country or foreign country, your rate of return will be same.

LOS 16 : Covered Interest Arbitrage (CIA)

Type 1 Type 2
When Bid and Ask rates are same. If Bid & Ask rates are given separately.
When Investment & Borrowing rates are same Investment & Borrowing rate of a given currency
in one country. is separately given.
# (Short – cut is available) # (Hit & Trial method is used)
❖ When Investment opportunity in any two given countries are different, covered Interest Arbitrage
is possible.
❖ When IRPT is not applicable, then covered interest arbitrage will be applicable.
 8.8 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

❖ The rule is to “ Borrow from one country & Invest in another Country ”.
❖ Suppose Interest Rate of India is INT` And USA is INT$. Spot Rate is 1$ = ` SR, Forward Rate
=> 1$ = ` FR
Let assume Investor is having ` A for investment
Option 1: When investor invest ` A in India:
Amount of ` Received after one year
A1 = A (1 + INT`)
Option 2: When investor invest ` A in USA:
Amount of Equivalent ` Received after one year
𝐀
A2 = [ $ (1 + INT$)] × FR
𝐒𝐑

IF A1 = A2 IF A1 > A2 IF A1 < A2
No arbitrage opportunity. Arbitrage Opportunity is Possible. Arbitrage opportunity is
Arbitrager should invest in India possible.
(Home Country) & borrow from Arbitrager should invest in USA
USA (Foreign Country) (Foreign Country) & borrow from
India (Home Country)
Note:
If in 1st try we have arbitrage profit, then no need to solve 2nd case.
If in 1st try we have arbitrage loss, then 2nd case must be solved.

LOS 17 : Forward Contract

❖ Transaction exposure arises when a firm has a known amount of foreign currency payable or
receivable but home currency equivalent of which is unknown.
❖ Hedging is defined as an activity converted uncertainty into certainty. The simplest hedging
strategy is hedging through forward contract.
❖ In case of foreign currency is to be received in future

❖ In case of foreign currency is to be Paid in future

 8.9

LOS 18 : Money Market Operations

Case 1 : If Foreign Currency is to be received in future:

Step 1: Borrow in Foreign Currency: Amount of borrowing should be such that Amount Borrowed
+Interest on it becomes equal to the amount to be received.
Step 2: Convert the borrowed foreign currency into home currency by using spot Rate.
Step 3: Invest this home currency amount for the required period.
Step 4: Pay the borrowed amount of foreign currency with interest using the amount to be received
in foreign currency. [May be Ignored]
Case 2: When foreign currency is to be paid in future

Step 1: Invest in Foreign currency. Amount of investment should be such that, “Amount Invested
+ Interest on it” becomes equal to amount to be paid
Step 2: Borrow in Home Currency, equivalent amount which is to be invested in foreign currency
using Spot rate.
Step 3: Pay the borrowed amount with interest in Home Currency on Maturity.
Step 4: Pay the outstanding amount with the amount received from investment. [May be ignored]

LOS 19 : Adjusting Exchange rate quotation when exchange margin is attached

to it
Example:
1 Euro = £ 1.7846 ± 0.0004
Solution:
1 Euro = £ 1.7842 ---- 1.7850
 8.10 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

LOS 20 : Foreign Capital Budgeting

Two approaches are followed in case investment is undertaken in foreign country:
❖ Home Currency Approach
❖ Foreign Currency Approach
Home Currency Approach:
Step 1: Compute all cash inflows & outflows arising in foreign currency.
Step 2: Convert these cash Inflows & outflows into home currency by using appropriate exchange
rates (i.e. Forward Rate) (Calculate through Swap Point or IRPT)
Step 3: Compute a suitable discount rate.
Step 4: Compute Home Currency (NPV)
Foreign Currency Approach:
Step 1: Compute all cash inflows & outflows arising in foreign currency.
Step 2: Compute a suitable discount rate ( RADR).
Step 3: Compute Foreign Currency (NPV)
Step 4: Convert foreign currency NPV into Home currency by using Spot Rate
Note:
❖ Answer by both approach will be same.
❖ Discount Rate to be used should be risk-adjusted discount rate (RADR), Since foreign project
involves risk.
(1 + RADR) = (1 + Risk-free rate) (1 + Risk Premium)
❖ Discount Rate or RADR of both the country are different.
❖ Risk Premium of both home country and foreign country are assumed to be same.

LOS 21 : Cancellation/Modification under Forward Contract

Forward Contract are legal binding contracts, which must be fulfilled by each and every party.
In case of cancellation of Forward Contracts, following rules must be followed:
How to cancel Forward Contract
Forward Contracts must be cancelled by entering into a reverse contract.
 8.11

Rate at which contract needs to be Cancelled

Case 1 Cancelled before expiry Forward Rate prevailing as on today for expiry
Case 2 Cancelled on expiry Spot Rate of expiry
Case 3 Cancelled after expiry Spot Rate of the date when customer contracted with the bank.
Case 4 Automatic Cancellation Spot Rate prevailing on 15th day i.e. when grace period ends.

Settlement of Profit/Loss:

Case 1 Cancelled on or before expiry Customer will be eligible for both profit/Loss.
Case 2 Cancelled after expiry or automatic Customer will be eligible only for Loss
cancellation

LOS 22 : Extension of Forward Contract

Step 1: Cancellation of original Contract
Step 2: Entering into a new forward contract for the extended period.

LOS 23 : Early Delivery

The bank may accept the request of customer of delivery at the before due date of forward contract
provided the customer is ready to bear the loss if any that may accrue to the bank as a result of this.
In addition to some prescribed fixed charges bank may also charge additional charges comprising
of:
a) Swap Difference: This difference can be loss/ gain to the bank. This arises on account of
offsetting its position earlier created by early delivery as bank normally covers itself against the
position taken in the original forward contract.
 8.12 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

b) Interest on Outlay of Funds: It might be possible early delivery request of a customer may
result in outlay of funds. In such bank shall charge from the customer at a rate not less than
prime lending rate for the period of early delivery to the original due date. However, if there is an
inflow of funds the bank at its discretion may pass on interest to the customer at the rate
applicable to term deposits for the same period.

LOS 24 : Cancellation after Due Date/ Automatic Cancellation Late Delivery /

Extension after due date
In these cases the following cancellation charges may be payable:
1. Exchange Difference
2. Swap Loss

3. Interest on outlay of funds

 8.13

LOS 25 : Centralized Cash Management & Decentralized Cash Management

System
❖ Under Decentralized Cash Management, every branch is viewed as separate undertaking. Cash
Surplus and Cash Deficit of each branch should not be adjusted.
❖ Under Centralized Cash Management, every branch cash position is managed by single
centralized authority. Hence, Cash Surplus and Cash Deficit of each branch with each other is
accordingly adjusted

LOS 26 : Contribution to Sales Ratio based decision under FOREX

𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 ( 𝐒𝐚𝐥𝐞𝐬−𝐕𝐂)
Contribution to Sales Ratio = × 100
𝐒𝐚𝐥𝐞𝐬
Decision:
Higher the C/S Ratio, Better the position.

LOS 27 : Leading & Lagging

❖ Leading means advancing the timing of payments and receipts.
❖ Lagging means postponing or delaying the timing of payments and receipts.

LOS 28 : Exposure Netting

Netting means adjusting receivable and payables (or inflows & Outflows)

Two conditions must be fulfilled:

1. Netting can be done for same currency.
2. Netting can be done for same period.
Note: In case of Netting, No. of forward contracts can be reduced.
 8.14 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

LOS 29 : Currency Pairs

Currency Pairs are written by ISO Currency codes of the base currency and the counter currency,
separating them with a slash character.

Example:
A price quote of EUR/USD at 1.30851 means
1 Euro = 1.30851 $

LOS 30 : Gain/Loss under FOREX

LOS 31 : Evaluation of Quotation from two Banks

When quotations are received from two banks, customer should select that quotation which is more
beneficial to him.
Example:

LOS 32 : Expected Spot Rate

Expected Spot Rate = ∑ Spot Rates × Probability

LOS 33 : Currency Futures

Steps Involved:
 8.15

Step1: Decide Position

❖ Long Position
❖ Short Position
Note: First we will decide which currency will buy or which currency we will sell then check the
currency on the LHS of the quotation & then accordingly decide Long Position & Short Position

Step 2 : Calculation of Number of contracts/Lots

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧 £ $
No. of Lots = = =
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐨𝐧𝐞 𝐂𝐨𝐧𝐭𝐫𝐚𝐜𝐭 £ £
Note: Convert exposure amount in the same currency as of Lot Size/Contract Size & it will be
converted at CONTRACT RATE.
Step 3: Calculate Settlement Amount/ Total Outflow/Inflow under Future Contract
1. Calculate Profit and Loss under Future Contract

Change in Future Price × No. of Lots × Value of One Contract

2. Calculate Total Receipt/Total Payment using SR on Expiry

3. Calculation of opportunity cost of initial margin if Given

Total Outflow / Inflow under Future Hedging

 8.16 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

LOS 34 : Currency Options

Steps Involved:
Step1: Decide Position
Long Call Short Call
Long Put Short Put
Note: First we will decide which currency will buy or which currency we will sell then check the
currency on the LHS of the quotation & then accordingly decide Long Call & Long Put

Step2 : Calculation of Number of contracts/Lots

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧 $
No. of Lots = = =17.35 or 17 lots
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐨𝐧𝐞 𝐂𝐨𝐧𝐭𝐫𝐚𝐜𝐭 $

Note: Convert exposure amount in the same currency as of Lot Size/Contract Size & it will be
converted at CONTRACT RATE.
Step 3: Now the UNHEDGE POSITION should be hedge through forward market as there is no
lot size requirement under forward market.
Step 4: Calculation of Option Premium paid as on today with opportunity cost on it.

Step 5: Calculate / Total Outflow/Inflow under Option Contract

(i) Option Premium paid as on today with opportunity cost on it.
(ii) Unhedged Position under forward contract
(iii) Under Option Contract using Exercise Price

Total Outflow / Inflow under Option Hedging

 8.17

LOS 35 : Calculation of Return under FOREX

𝐏 𝟏 − 𝐏𝟎 + 𝐈
Return (In terms of Home Currency) = [𝟏 + ] (1+ C) – 1
𝐏𝟎

P0 = Price at the beginning I = Income from Interest/Dividend

P1 = Price at the End C = Change in exchange rate.

LOS 36 : Broken Date Contracts

A Broken Date Contract is a forward contract for which quotation is not readily available.
Example: If quotes are available for 1 month and 3 months but a customer wants a quote for 2
months, it will be a Broken Date Contract. It can be calculated by interpolating between the available
quotes for the preceding and succeeding maturities.

LOS 37 : Implied Differential in Interest Rate

Interest rate is just another name of premium or discount of one country currency in relation to
another country currency (As per IRPT).
Premium or Discount = Difference in Interest Rate
Equation:
𝐅𝐑 (𝐑𝐬./$)–𝐒𝐑(𝐑𝐬./$) 𝟏𝟐
× × 100 = Interest Rate (`) – Interest Rate($)
𝐒𝐑 𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐏𝐞𝐫𝐢𝐨𝐝

LOS 38 : Savings due to Time Value (Discount) & Currency Fluctuation

If the firm decides to pay today rather than in future he may get two types of benefits:
❖ Benefit on account of discount for pre-payment.
❖ Benefit on account of currency fluctuation.

LOS 39 : Nostro Account, Vostro Account and LORO Account

Nostro Account [Ours account with you]
This is a current account maintained by a domestic bank/dealer with a foreign bank in foreign
currency.
Example: Current account of SBI bank (an Indian Bank) with swizz bank in Swizz Franc. (CHF) is
a Nostro account.

Vostro Account [Yours account with us]

This is a current account maintained by a foreign bank with a domestic bank/dealer in Rupee
currency.
 8.18 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT

Example: Current account of Swizz bank in India with SBI bank in Rupee (`) currency

Loro Account [Our account of their Money with you]

This is a current account maintained by one domestic bank on behalf of other domestic bank in
foreign bank in a foreign currency.
In other words, Loro account is a Nostro account for one bank who opened the bank and Loro
account for other bank who refers first one account.
Example: SBI opened Current account with swizz bank. If PNB refers that account of SBI for its
correspondence, then it is called Loro account for PNB and it is Nostro account for SBI.

Note:
❖ SPOT purchase/sale of CHF affects both exchange position as well as Nostro account.
❖ However, forward purchase/sale affects only the exchange position.
1. Nostro A/c (Cash A/c) in Foreign Currency

Particulars Dr. [Debit] outflow Cr. [Credit] Inflow

of Dollars (FC) of Dollars (FC)

2. Exchange Position A/c/

Particulars Long Short

Dollar Buy (FC) Dollar Sell (FC)
8.19
8.20 FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT
 9.1

Interest Rate Risk Management

Study Session 9

LOS 1: Forward Rate Agreement (FRA)

❖ A forward rate Agreement can be viewed as a forward contract to borrow/lend money at a certain
rate at some future date.
❖ These Contracts settle in cash.
❖ The long position in an FRA is the party that would borrow the money. If the floating rate at
contract expiration is above the rate specified in the forward agreement, the long position in the
contract can be viewed as the right to borrow at below market rates & the long will receive a
payment.
 9.2 INTEREST RATE RISK MANAGEMENT

❖ If reference rate at the expiration date is below the contract rate, the short will receive a cash
from the long.
❖ FRA helps borrower to eliminate interest rate risk associated with borrowing or investing funds.
❖ Adverse movement in the interest rates will not affect liability of the borrower.
Payment to the long at settlement is:
𝐝𝐚𝐲𝐬
[𝐅𝐥𝐨𝐚𝐭𝐢𝐧𝐠 (𝐋𝐈𝐁𝐎𝐑) − 𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐑𝐚𝐭𝐞]×
𝟑𝟔𝟎
Notional Principal × 𝐝𝐚𝐲𝐬
𝟏+𝐅𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 (𝐋𝐈𝐁𝐎𝐑) ×
𝟑𝟔𝟎

FRA ARBITRAGE
Step 1 : Calculation of Fair Forward Rate
6 Months Forward rate 3 months from now

Step 2 : Decide from where we should borrow and where should we invest
Step 3 : Calculation of Arbitrage Profit
 9.3

FRA Quotation: Suppose 3 × 9 FRA (Quoted by Bank)

LOS 2 : Currency SWAP

LOS 3 : Interest Rate Swap [ Two Party]

 9.4 INTEREST RATE RISK MANAGEMENT

❖ Two parties exchange their interest rate obligation.

❖ The plain vanilla interest rate swap involves trading fixed interest rate payments for floating rate
payments.
❖ The party who wants fixed-rate interest payments agrees to pay fixed-rate interest.
❖ The Counter party, who receives the fixed payments agrees to pay variable-rate interest/floating
rate interest.
❖ The difference between the fixed rate payment and the floating rate payment is calculated and
paid to the appropriate counterparty.
❖ Net interest is paid by the one who owes it.
❖ Swaps are zero-sum game. What one party gains, the other party losses.
The Net formulae for the Fixed-Rate payer, based on a 360-day year and a floating rate of LIBOR is:
𝐍𝐨.𝐨𝐟 𝐃𝐚𝐲𝐬
(Net Fixed Rate Payment)t = [Swap Fixed Rate – LIBOR t-1] [ ] [National Principal]
𝟑𝟔𝟎

Note:
❖ If this number is positive, fixed-rate payer pays a net payment to the floating-rate party.
❖ If this number is negative, then the fixed-rate payer receives a net flow from the floating rate
payer

LOS 4 : Interest Rate Caps, Floor & Collar

CAP Maximum Rate Borrowings Floating Rate
FLOOR Minimum Rate Investments Floating Rate
Interest Rate Cap : ( Maximum Rate For Borrowing @ Floating )
If a firm borrows at floating rate, it is afraid of interest rate rising, to hedge against the same, it will
buy an interest rate cap i.e. Long call at X=Cap rate
❖ It is a series/portfolio of interest rate Call option on interest rates.
❖ Each particular call option being called a CAPLET.
❖ Caps pay when rate rises above the cap rate.

Interest Rate Floor : ( Minimum Rate For Investment @ Floating )

If a firm invest at floating rate, it is afraid of interest rate falling, to hedge against the same, it will
buy an interest rate Floor i.e. Long put at X=Floor rate
❖ It is a series/portfolio of Interest rate put Option on interest rate. Such particular put option being
called a FLOORLET
❖ Floor pays when rate falls below the Floor Rate.
 9.5

Interest Rate Collar:

❖ It is a combination of a Cap and a Floor.
❖ Premium paid on one option would be compensated with the premium received on selling
another option.
❖ If premium paid on caps is equal to the premium received on floor, then it would be called Zero
Cost Collar.

❖ A floating rate borrower may buy a cap [C+] & simultaneously sells a floor i.e.[P-].Initial outflow
will reduce.( C+ =Long Call & P-=Short Put)

❖ Similarly, a floating rate investor may buy a Floor (P+) & simultaneously sell a Cap (C-). Initial
outflow will reduce.(P+=Long Put & C-=Short Call)
 10.1

Fixed Income Securities

Study Session 10

LOS 1 : Introduction (Fixed Income Security)

Bonds are the type of long term obligation which pay periodic interest & repay the principal amount
on maturity.
Three types of Cash Flows
(i) Interest
(ii) Principal Repayment
(iii) Re-Investment Income
Purpose of Bond’s indenture & describe affirmative and negative covenants
❖ The contract that specifies all the rights and obligations of the issuer and the owners of a fixed
income security is called the Bond indenture.
❖ These contract provisions are known as covenants and include both negative covenants
(prohibitions on the borrower) and affirmative covenants (actions that the borrower promises to
perform) sections.
1. Negative Covenants : This Includes
a) Restriction on asset sales (the company can’t sell assets that have been pledged as
collateral).
b) Negative pledge of collateral (the company can’t claim that the same assets back several
debt issues simultaneously).
c) Restriction on additional borrowings (the company can’t borrow additional money unless
certain financial conditions are met).
2. Affirmative Covenants: This Includes
a) Maintenance of certain financial ratios.
b) Timely payment of principal and interest.
Common Options embedded in a bond Issue, Options benefit the issuer or the Bondholder
❖ Security owner options:
a) Conversion option
b) Put provision
c) Floors set a minimum on the coupon rate
❖ Security issuer option:
a) Call provisions
b) Prepayment options
c) Caps set a maximum on the coupon rate

LOS 2 : Terms used in Bond Valuation

(i) Face Value ` 1,000
(ii) Maturity Year 10 Years
(iii) Coupon rate 10%
 10.2 FIXED INCOME SECURITIES

(iv) Coupon Amount ` 1,000 × 10% = ` 100

p.a.
(v) B0 / Value of the Bond as on Today/ Current Market ` 950
Price/Issue Price/ Net Proceeds
(vi) Yield to Maturity/ Kd / Discount Rate / Required return of 12%
investor / Cost of debt / Expected Return/ Opportunity Cost /
Market Rate of Interest
(vii) Redemption Value/ Maturity Value ` 1,200

Note :
(i) Coupon Rate is used to calculate Interest Amount.
(ii) Face Value is always used to calculate Interest Amount.
(iii) If Maturity Value is not given, then it is assumed to be equal to Face Value.
(iv) If Face Value is not given, then it is assumed to be ` 100 or ` 1000 according to the Question.
(v) If Maturity Year is not given, then it is assumed to be equal to infinity.

LOS 3 : Valuation of Straight Bond / Plain Vanilla Bond

Straight Coupon Bonds are those bonds which pay equal amount of interest and repay principal
amount on Maturity.
Step 1: Estimates the cash flows over the Life of the bond.
Step 2: Determine the appropriate discount rate.
Step 3: Calculate the present value of the estimated cash flow using appropriate discount
rate.

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐯𝐚𝐥𝐮𝐞 𝐨𝐫 𝐏𝐚𝐫 𝐯𝐚𝐥𝐮𝐞

B0 = + + .................. + +
(𝟏+𝐘𝐓𝐌)𝟏 (𝟏+𝐘𝐓𝐌)𝟐 (𝟏+𝐘𝐓𝐌)𝐧 (𝟏+𝐘𝐓𝐌)𝐧

Or
Interest × PVAF (Yield %, n year) + Maturity Value × PVF (Yield %, nth year)
n = No. of years to Maturity

LOS 4 : Coupon Rate Structures

1. Zero – Coupon Bond (Pure Discount Securities)
a) They do not pay periodic interest.
b) They pay the Par value at maturity and the interest results from the fact that Zero – Coupon
Bonds are initially sold at a price below Par Value. (i.e. They are sold at a significant discount to
Par Value).
2. Step – up Notes
a) They have coupon rates that increase over – time at a specified rate.
b) The increase may take place one or more times during the life cycle of the issue.
 10.3

3. Deferred – Coupon Bonds

a) They carry coupons, but the initial coupon payments are deferred for some period.
b) The coupon payments accrue, at a compound rate, over the deferral period and are paid as a
lump sum at the end of that period.
c) After the initial deferment period has passed, these bonds pay regular coupon interest for the
rest of the life of the issue (to maturity).
4. Floating – Rate Securities
a) These are bond for which coupon interest payments over the life of security vary based on a
specified reference rate.
b) Reference Rate may be LIBOR [London Interbank Offered Rate] or EURIBOR or any other rate
and then adds or subtracts a stated margin to or from that reference rate.
New coupon rate = Reference rate ± quoted margin
5. Inflation – indexed Bond (TIPS)
They have coupon formulas based on inflation.
E.g.: Coupon rate = 3% + annual change in CPI

LOS 5 : Valuation of Perpetual Bond/ Irredeemable Bond/ Non – Callable Bond

They are infinite bond, never redeemable, non- callable bond.

𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
Value of Bond =
𝐘𝐓𝐌

LOS 6 : Valuation of Zero-Coupon Bond

❖ Zero- coupon Bond has only a single payment at maturity.
❖ Value of Zero- Coupon Bond is simply the PV of the Par or Face Value.
𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞
Bond value =
(𝟏+ 𝐘𝐓𝐌)𝐧

LOS 7 : Confusion regarding Coupon Rate & YTM

YTM  Required Return / Investor’s Expectation / Mkt. Rate of Interest.
❖ YTM is always subjected to change according to Market Conditions.
Coupon Rate  Rate of Interest paid by the company.
❖ Coupon Rate is always constant throughout the life of the bond and it is not affected by change
in market condition.
❖ Sometimes interest is expressed in terms of Basis Point i.e. 1% = 100 Basis Points

LOS 8 : Valuation of Semi – annual Coupon Bonds

Pay interest every six months
 10.4 FIXED INCOME SECURITIES

𝐘𝐓𝐌 𝐩.𝐚. 𝐂𝐨𝐮𝐩𝐨𝐧 𝐫𝐚𝐭𝐞 𝐩.𝐚

a) b) c) n × 2
𝟐 𝟐
Note:
If quarterly use 4 instead of 2
If monthly use 12 instead of 2

LOS 9 : Valuation of Bond with Changing Coupon Rate

Coupon rate changes from one year to another year as per the terms of bond-indenture.

LOS 10: Over – Valued & Under – Valued Bonds

Case Value Decision
PV of MP of Bond < Actual MP of Bond Over – Valued Sell
PV of MP of Bond > Actual MP of Bond Under – Valued Buy
PV of MP of Bond = Actual MP of Bond Correctly Valued Either Buy/ Sell

LOS 11: Self – Amortization Bond

❖ They make periodic interest and principal payments over the life of the bond. i.e. at regular interval.
❖ Interest is calculated on balance amount.

LOS 12: Holding Period Return (HPR) for Bonds

𝐁𝟏 −𝐁𝟎 + 𝐈𝟏
HPR =
𝐁𝟎

𝐁𝟏 −𝐁𝟎 𝐈𝟏
= +
𝐁𝟎 𝐁𝟎

(Capital gain Yield/ Return) (Interest Yield /Current Yield)

 10.5

LOS 13 : Calculation of Current Yield/ Interest Yield

𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐂𝐨𝐮𝐩𝐨𝐧 𝐏𝐚𝐲𝐦𝐞𝐧𝐭
Current Yield =
𝐁𝐨𝐧𝐝 𝐏𝐫𝐢𝐜𝐞 𝐨𝐫 𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞

Note: Current Yield is always calculated on per annum basis.

1. If existing bond :-
B0 = Current Market Price of Bond (1st preference)
Or
Present value Market Price of Bonds (2nd preference)
2. If new bond issued :-
B0 = Issue Price
Issue Price = Face value – Discount + Premium
3. Company Point of view :-
B0 = Net Proceeds
Net Proceeds = Face value – Discount + Premium (-) Floating Cost

LOS 14 : YTM (Yield to Maturity) / Kd / Cost of debt/ Market rate of Interest/

Market rate of return
❖ YTM is an annualized overall return on the bond if it is held till maturity.
❖ YTM is the IRR of a Bond
❖ It is the annualized rate of return on the investment that the investor expect (on the date of
investment) to earn from the date of investment to the date of maturity. It is also referred to as
required rate of return.
Alternative 1: By IRR technique.
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐯𝐚𝐥𝐮𝐞 𝐨𝐫 𝐏𝐚𝐫 𝐯𝐚𝐥𝐮𝐞
B0 = + + .................. + +
(𝟏+𝐘𝐓𝐌)𝟏 (𝟏+𝐘𝐓𝐌)𝟐 (𝟏+𝐘𝐓𝐌)𝐧 (𝟏+𝐘𝐓𝐌)𝐧

❖ YTM & price contain the same information

• If YTM given, calculate Price.
• If Price given, calculate YTM.
𝐋𝐨𝐰𝐞𝐫 𝐑𝐚𝐭𝐞 𝐍𝐏𝐕
YTM = Lower Rate + × Difference in Rate
𝐋𝐨𝐰𝐞𝐫 𝐑𝐚𝐭𝐞 𝐍𝐏𝐕 − 𝐇𝐢𝐠𝐡𝐞𝐫 𝐑𝐚𝐭𝐞 𝐍𝐏𝐕

Alternative 2: By approximation formula

𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞− 𝐂𝐌𝐏/𝐁𝟎

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 +
𝐧
YTM = 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞+ 𝐂𝐌𝐏/𝐁𝟎
𝟐
 10.6 FIXED INCOME SECURITIES

LOS 15 : YTM (Yield to Maturity) of Semi-Annual Bond

𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞− 𝐂𝐌𝐏/𝐁𝟎

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐟𝐨𝐫 𝟔 𝐦𝐨𝐧𝐭𝐡𝐬 +
𝐧×𝟐
YTM per 6 months = 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞+ 𝐂𝐌𝐏/𝐁𝟎
𝟐

YTM per annum = YTM of 6 month × 2

LOS 16 : YTM of a Zero – Coupon Bond

𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝑽𝒂𝒍𝒖𝒆
Bond value =
(𝟏+ 𝒀𝑻𝑴)𝒏

❖ If YTM is given, calculate B0.

❖ If B0 is given, Calculate YTM.

LOS 17 : YTM of a Perpetual Bond

𝑨𝒏𝒏𝒖𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
Bond value =
𝒀𝑻𝑴

❖ If YTM is given, calculate B0.

❖ If B0 is given, Calculate YTM.

LOS 18 : Calculation of Kd in case of Floating Cost

❖ Floating Cost is cost associated with issue of new bonds.
e.g. Brokerage, Commission, etc
❖ We should take Bond value (B0) Net of Floating Cost.

𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞 − 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭(𝟏−𝐭𝐚𝐱 𝐫𝐚𝐭𝐞) +
𝐧
Kd = 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞+ 𝐍𝐞𝐭 𝐏𝐫𝐨𝐜𝐞𝐞𝐝𝐬
𝟐

LOS 19 : Treatment of Tax

Tax is important part for our analysis, it must be considered if it is given in question.
Two types of Tax rates are given :-
1. Interest Tax rate/ Normal Tax Rate
We should take Interest Net of Tax i.e. Interest Amount (1 – Tax)
 10.7

2. Capital Gain Tax rate

Take Maturity value after Capital Gain Tax i.e. Maturity Value – Capital Gain Tax Amount
Maturity value – (Maturity value – B0) × Capital gain tax rate

𝐌𝐕 𝐧𝐞𝐭 𝐨𝐟 𝐂𝐆 𝐓𝐚𝐱 − 𝐁𝟎
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭( 𝟏−𝐓𝐚𝐱 𝐫𝐚𝐭𝐞) +
𝐧
YTM = 𝐌𝐕 𝐧𝐞𝐭 𝐨𝐟 𝐂𝐆 𝐓𝐚𝐱 + 𝐁𝟎
𝟐

LOS 20 : Yield to call (YTC) & Yield to Put (YTP)

1. Yield to Call
Callable Bond : When company call its bond or Re-purchase its bond prior to the date of Maturity.
Call Price: Price at which Bond will call by the Company.
Call Date: Date on which Bond is called by the Company prior to Maturity.
n: No. of Years upto Call Date.

𝐂𝐚𝐥𝐥 𝐏𝐫𝐢𝐜𝐞− 𝐁𝟎
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 +
𝐧
YTC = 𝐂𝐚𝐥𝐥 𝐏𝐫𝐢𝐜𝐞+ 𝐁𝟎
𝟐

2. Yield to Put
Puttable Bond: When investor sell their bonds prior to the date of maturity to the company.
Put Price: Price at which Bond will put/ Sell to the Company.
Put Date: Date on which Bond is sold by the investor prior to Maturity.
n: No. of years upto Put Date.

𝐏𝐮𝐭 𝐏𝐫𝐢𝐜𝐞− 𝐁𝟎
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 +
𝐧
YTP = 𝐏𝐮𝐭 𝐏𝐫𝐢𝐜𝐞+ 𝐁𝟎
𝟐

LOS 21 : Yield to worst

❖ It is the lowest yield between YTM, YTC, YTP, Yield to first call.
❖ Yield to worst is lowest among all.

LOS 22 : Conversion Value/ Stock Value of Bond

❖ Converted into equity shares after certain period.
❖ Conversion Ratio = No. of share Received per Convertible Bond
❖ When Conversion Value > Bond value, option can be exercised otherwise not.

Conversion Value = No. of equity × MPS at the

shares issued time of Conversion
 10.8 FIXED INCOME SECURITIES

LOS 23 : Credit Rating Requirement

❖ As per SEBI regulation, no public or right issue of debt/bond instruments shall be made unless
credit rating from credit rating agency has been obtained and disclosed in the offer document.
❖ Rating is based on the track record, financial statement, profitability ratios, debt – servicing
capacity ratios, credit worthiness & risk associated with the company.
❖ Higher rated Bonds means low risk and a lower rated bond means high risk.
❖ Higher the risk higher will be the expectation and higher will be the discount rate.

LOS 24 : Strips (Separate Trading of Registered Interest & Principal

Securities) Program
Under this, Strip the coupons from the principal, repackage the cash flows and sell them separately
as Zero – Coupon Bonds, at discount.

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐌𝐚𝐭𝐮𝐫𝐢𝐭𝐲 𝐯𝐚𝐥𝐮𝐞

Value of Bond = + + .................. + +
(𝟏+𝐤 𝐝 )𝟏 (𝟏+𝐤 𝐝 )𝟐 (𝟏+𝐤 𝐝 )𝐧 (𝟏+𝐤 𝐝 )𝐧

Coupon Strips Principal Strips

LOS 25 : Relationship between Coupon Rate & YTM

Bonding Selling At
Par Coupon Rate = Yield to Maturity
Discount Coupon Rate < Yield to Maturity
Premium Coupon Rate > Yield to Maturity

LOS 26 : Cum Interest & Ex-interest Bond Value

❖ When Bond value include amount of interest it is known as Cum-Interest Bond Value, other -
wise not.
❖ If question is Silent, we will always assume ex-interest.
❖ Assume value of Bond (B0) as ex – interest.
❖ If it is given Cum-Interest then deduct Interest and proceeds your calculations.

Full Price = Clean Price + Interest accrued

Or
Cum - Interest Price = Ex – Interest Price + Interest Accrued
 10.9

Valuation of a Bond between two coupon dates

LOS 27 : Relationship between Bond Value & YTM

❖ When the coupon rate on a bond is equal to its market yield, the bond will trade at its par value.
❖ If yield required in the market subsequently rises, the price of the bond will fall & it will trade at a
discount.
❖ If required yield falls, the bond price will increase and bond will trade at a premium.
Crux:
❖ If YTM increases, bond value decreases & vice-versa, other things remaining same.
❖ YTM & Bond value have inverse relationship.
Convexity of a Bond
❖ However, this relationship is not a straight line relationship but it is convex to the origin.
❖ So, we find that price rise is greater than price fall, we call it positive convexity (i.e. % rise is
greater than % fall)

LOS 28 : Value of the Bond at the end of each Year

𝐁 𝟏 + 𝐈𝟏
B0 =
(𝟏+𝐘𝐓𝐌)𝟏

𝐁 𝟐 + 𝐈𝟐
B1 =
(𝟏+𝐘𝐓𝐌)𝟏

.
So on
 10.10 FIXED INCOME SECURITIES

LOS 29 : Relationship between Bond Value & Maturity

❖ Prior to Maturity, a bond can be selling at significant discount or premium to Par value.
❖ Regardless of its required yield, the price will converge to par value as Maturity approaches.
❖ Value of premium bond decrease to par value , value of Discount bond increases to Par value.
❖ Premium and discount vanishes.

LOS 30 : Floating Rate Bonds

❖ Floating Rate Bonds are those bonds where coupon rate is decided according to the Reference
rate (Market Interest Rate).
❖ Coupon Rate should be changed with the change in Reference rate (Market Interest Rate).
❖ In this case

Coupon Rate = YTM

LOS 31 : Duration of a Bond (Macaulay Duration)

❖ Duration of the bond is a weighted average of the time (in years) until each cash flow will be
received i.e. our initial investment is fully recovered.
❖ Duration is a measurement of how long in years it takes for the price of a bond to be repaid by
its internal cash flows.
❖ Duration of bond will always be less than or equal to maturity years.
 10.11

Duration =

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝒗𝒂𝒍𝒖𝒆

𝟏× +𝟐× + .......+𝒏 × + 𝒏×
(𝟏+𝒀𝑻𝑴)𝟏 (𝟏+𝒀𝑻𝑴)𝟐 (𝟏+𝒀𝑻𝑴)𝒏 (𝟏+𝒀𝑻𝑴)𝒏
𝑪𝑴𝑷/𝑩𝟎

LOS 32 : Duration of a Zero - Coupon Bond

Duration of a Zero Coupon Bond will always be equal to its Maturity Years

LOS 33 : Relationship between Duration of Bond & YTM

❖ If YTM increases, Bond Value decreases so duration of the bond decreases (recovery is less) &
vice versa.
❖ Higher the YTM, lower will be duration of a bond. Lower the YTM, higher will be duration of a
bond, other things remaining constant.

LOS 34 : Calculation of yield when Coupon Payment is not available for Re-
Investment

LOS 35 : Modified Duration/ Sensitivity/ Volatility/ Effective Duration

❖ Volatility measures the sensitivity of interest rate to bond prices.
❖ Duration of a bond can be used to estimate the price sensitivity. It can be calculated through
below formula.
❖ Modified duration will always be lower than Macaulay’s Duration.
❖ Volatility measures the % change in the bond value with 1% change in YTM.
Example:
If Volatility is 5%, it means if YTM increases by 1% bond value will decrease by 5% or vice versa.
Method 1:
𝐌𝐚𝐜𝐚𝐮𝐥𝐚𝐲 𝐃𝐮𝐫𝐚𝐭𝐢𝐨𝐧
Modified Duration =
𝟏+ 𝐘𝐓𝐌
 10.12 FIXED INCOME SECURITIES

Method 2:
𝐁𝐕− ∆𝒀 − 𝐁𝐕+ ∆𝒀
Effective Duration =
𝟐 × 𝐁𝐕𝟎 × ∆𝒀

Convexity Adjustment
As mentioned above duration is a good approximation of the percentage of price change for a
small change in interest rate. However, the change cannot be estimated so accurately of convexity
effect as duration base estimation assumes a linear relationship.
This estimation can be improved by adjustment on account of ‘convexity’. The formula for convexity
is as follows:
C* x (∆y)2 x100
∆y = Change in Yield

𝑉+ + 𝑉− − 2𝑉0
C* =
2𝑉0 (Δ2 )

V0 = Initial Price
V+ = price of Bond if yield increases by ∆y
V- = price of Bond if yield decreases by ∆y

LOS 36 : Ratios relaed to Convertible Bond

1. Conversion Premium/ Premium over Conversion Value

= Market value of Convertible bond

(-)
CV (No. of Shares × MPS)

𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐏𝐫𝐞𝐦𝐢𝐮𝐦
% Conversion Premium =
𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐕𝐚𝐥𝐮𝐞

𝑪𝒐𝒏𝒗𝒆𝒓𝒔𝒊𝒐𝒏 𝑷𝒓𝒆𝒎𝒊𝒖𝒎
2. Conversion Premium per share =
𝑪𝒐𝒏𝒗𝒆𝒓𝒔𝒊𝒐𝒏 𝑹𝒂𝒕𝒊𝒐

3. Conversion Parity Price/ No Gain No Loss / Market Conversion Price

When the market value of convertible bond = Conversion Value.

𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐨𝐧𝐯𝐞𝐫𝐭𝐢𝐛𝐥𝐞 𝐛𝐨𝐧𝐝

=
𝐍𝐨.𝐨𝐟 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞 𝐢𝐬𝐬𝐮𝐞𝐝 𝐨𝐧 𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧

OR
= Current MPS + Conversion Premium per share
 10.13

4. Premium Pay Back Period or Break Even Period of Convertible Bond

It is a time period, when bond would be converted into equity share so that the loss on conversion
would be set-off by income from interest.

𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐏𝐫𝐞𝐦𝐢𝐮𝐦
Break Even Period =
𝐅𝐚𝐯𝐨𝐮𝐫𝐚𝐛𝐥𝐞 𝐈𝐧𝐜𝐨𝐦𝐞 𝐃𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐜𝐢𝐚𝐥

OR
𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐁𝐨𝐧𝐝 −𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐕𝐚𝐥𝐮𝐞
=
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐨𝐧 𝐁𝐨𝐧𝐝 − 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐨𝐧 𝐒𝐡𝐚𝐫𝐞

5. Downside Risk or Premium over Non-Convertible Bond

Downside Risk reflects the extent of decline in market value of convertible bonds at which
conversion option become worthless.
= Market value of Convertible bond
(-)
Market value of Non- Convertible bond

𝐃𝐨𝐰𝐧𝐬𝐢𝐝𝐞 𝐑𝐢𝐬𝐤
% Downside Risk/ % Price Decline =
𝐌𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐍𝐨𝐧−𝐜𝐨𝐧𝐯𝐞𝐫𝐭𝐢𝐛𝐥𝐞 𝐛𝐨𝐧𝐝

6. Premium Over Investment Value of Non-Convertible bond / MV of NCB :

𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐂𝐁 −𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 / 𝐌𝐕 𝐨𝐟 𝐍𝐨𝐧−𝐂𝐨𝐧𝐯𝐞𝐫𝐭𝐢𝐛𝐥𝐞 𝐁𝐨𝐧𝐝

=
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 / 𝐌𝐕 𝐨𝐟 𝐍𝐨𝐧−𝐂𝐨𝐧𝐯𝐞𝐫𝐭𝐢𝐛𝐥𝐞 𝐁𝐨𝐧𝐝

7. Floor Value : Floor Value is the maximum of :

a) Conversion Value
b) Market Value of Non-Convertible Bond.
Note: Market Value of Convertible Bond (Assume 5 Years)

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐂𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐕𝐚𝐥𝐮𝐞 (𝐂𝐕𝟓 )

= + + .................. + +
(𝟏+𝐘𝐓𝐌)𝟏 (𝟏+𝐘𝐓𝐌)𝟐 (𝟏+𝐘𝐓𝐌)𝟓 (𝟏+𝐘𝐓𝐌)𝟓

CV5 = MPS at the end of Year 5 × No. of Shares.

LOS 37: Callable Bond

Those bonds which can be called before the date of Maturity.
Step 1 : Calculate Net Initial Outflow.
Step 2 : Calculate Tax Saving on Call Premium & Unamortized Issue Cost.
Step 3 : Calculate Annual Saving on Cash Outflow.
Step 4 : Calculation of Overlapping Interest
 10.14 FIXED INCOME SECURITIES

Step 5 : Calculate Present Value of Total Net Savings by replacing Outstanding Bonds with New
Bonds.

LOS 38: Spot Rate

❖ Yield to maturity is a single discount rate that makes the present value of the bond’s promised
cash flow equal to its Market Price.
❖ The appropriate discount rates for individual future payments are called Spot Rate.
❖ Discount each cash flow using a discount rate i.e. specific to the maturity of each cash flow.

LOS 39: Relationship between Forward Rate and Spot Rate

Forward Rate is a borrowing/ landing rate for a loan to be made at some future date.
1f0 = Spot Rate or Current YTM (rate of 1 year loan)
1f1 = Rate for a 1 year loan, one year from now
1f2 = Rate for a 1 year loan to be made two years from now

Relationship:
(1+S1)1 = (1 + 1f0 )
(1+S2)2 = (1 + 1f0 ) (1 + 1f1)
Or S2 = {(1 + 1f0 ) (1 + 1f1)}1/ 2 – 1
(1 + S3)3 = (1+1f0 ) (1+ 1f1 ) (1 + 1f2 )
Or S3 = {(1 + 1f0 ) (1 + 1f1) (1 + 1f2 )}1/ 3 - 1

LOS 40 : Calculation of After-tax yield of a taxable security & tax-equivalent

yield of a tax-exempt security
After-tax yield = taxable yield × (1 – marginal tax rate)
Taxable-equivalent yield is the yield a particular investor must earn on a taxable bond to have the
same after-tax return they would receive from a particular tax-exempt issue.
𝐭𝐚𝐱−𝐟𝐫𝐞𝐞 𝐲𝐢𝐞𝐥𝐝
Taxable-equivalent yield =
(𝟏−𝐦𝐚𝐫𝐠𝐢𝐧𝐚𝐥 𝐭𝐚𝐱 𝐫𝐚𝐭𝐞)

LOS 41 : Duration of a Portfolio

It is simply the weighted average of the durations of the individual securities in the Portfolio.
Portfolio Duration = W1D1 + W2D2 + W3D3 + ------------------ + WnDn
Market value of bond I
Wi=
Market value of Portfolio

Di = Duration of bond (i)

N = No. Of bonds in the Portfolio
Note :
❖ Other factors are constant, Long term bonds are more volatile than Short term bonds.
 10.15

❖ Other factors are constant, Lower coupon bonds are more volatile than Higher coupon bonds.
❖ Other factors are constant, Lower Yield bonds are more volatile than Higher Yield bonds.

LOS 42 : Interest Rate anticipation Strategy

Bond Portfolio Management
Interest Rate is expected to Fall Interest Rate is expected to Rise

Bond Price are expected to Rise Bond Prices are expected to Fall

To Profit from the same, portfolio duration To Protect / Hedge against the same,
should be increased by shifting from portfolio duration should be decreased by
Short Term Bonds to the Long Term shifting from Long Term Bonds to the Short
Bonds Term Bonds

LOS 43: Hedging Interest Rate Risk using Bond Futures

Profit of seller of futures

= (Futures Settlement Price x Conversion factor) – Quoted Spot Price of Deliverable Bond
Loss of Seller of futures
= Quoted Spot Price of deliverable bond – (Futures Settlement Price x Conversion factor)

An interest rate future is a contract between the buyer and seller agreeing to the future delivery of
any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the price of
the interest-bearing asset for a future date.
Interest rate futures are used to hedge against the risk that interest rates will move in an adverse
direction, causing a cost to the company.
 10.16 FIXED INCOME SECURITIES

For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship
between interest rates and bond prices to hedge against the risk of rising interest rates.
A borrower will enter to sell a future today. Then if interest rates rise in the future, the value of the
future will fall (as it is linked to the underlying asset, bond prices), and hence a profit can be made
when closing out of the future (i.e. buying the future).
Bonds form the underlying instruments, not the interest rate. Further, IRF, settlement is done
at two levels:
❖ Mark-to-Market settlement done on a daily basis and
❖ physical delivery which happens on any day in the expiry month.
Final settlement can happen only on the expiry date. In IRF following are two important terms:
a) Conversion factor: All the deliverable bonds have different maturities and coupon rates. To
make them comparable to each other, RBI introduced Conversion Factor.
(Conversion Factor) x (futures price) = actual delivery price for a given deliverable bond.
b) Cheapest to Deliver (CTD : It is called CTD bond because it is the least expensive bond in the
basket of deliverable bonds.
Profit & Loss = the difference between cost of acquiring the bonds for delivery and the price received
by delivering the acquired bond.
 11.1

Portfolio Management
Study Session 11

LOS 1 : Introduction
❖ Portfolio means combination of various underlying assets like bonds, shares, commodities, etc.
❖ Portfolio Management refers to the process of selection of a bundle of securities with an
objective of maximization of return & minimization of risk.
Steps in Portfolio Management Process
❖ Planning: Determine Client needs and circumstances, including the client’s return objectives,
risk tolerance, constraints and preferences. Create, and then periodically review and Update, an
investment policy statement (IPS) that spells out these needs and Circumstances.
❖ Execution: Construct the client portfolio by determining suitable allocations to various asset
classes and on expectations about macroeconomic variables such as inflation, interest rates
and GDP Growth (top-down analysis). Identify attractive price securities within an asset class
for client portfolios based on valuation estimates from security analysis (bottom-up analysis).
❖ Feedback: Monitor and rebalance the portfolio to adjust asset class allocations and securities
holdings in response to market performance. Measure & report performance relative to the
performance benchmark specified in the IPS.

LOS 2 : Major return Measures

(i) Holding Period Return (HPR) :
HPR is simply the percentage increase in the value of an investment over a given time period.

𝐏𝐫𝐢𝐜𝐞 𝐚𝐭 𝐭𝐡𝐞 𝐞𝐧𝐝−𝐩𝐫𝐢𝐜𝐞 𝐚𝐭 𝐭𝐡𝐞 𝐛𝐞𝐠𝐠𝐢𝐧𝐢𝐧𝐠+𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝

HPR =
𝐩𝐫𝐢𝐜𝐞 𝐚𝐭 𝐭𝐡𝐞 𝐛𝐞𝐠𝐠𝐢𝐧𝐢𝐧𝐠

(ii) Arithmetic Mean Return (AMR) :

It is the simple average of a series of periodic returns.

𝐑 𝟏 + 𝐑 𝟐 +𝐑 𝟑 +𝐑 𝟒 +⋯+𝐑 𝐧
Average Return =
𝐧
(iii) Geometric Mean Return (GMR) :

𝒏
GMR = √(𝟏 + 𝑹𝟏 ) (𝟏 + 𝑹𝟐 ) (𝟏 + 𝑹𝟑 )(𝟏 + 𝑹𝟒 ) … … … (𝟏 + 𝑹𝒏 ) − 𝟏
 11.2 PORTFOLIO MANAGEMENT

LOS 3 : Calculation of Return of an individual security

∑𝐗 E(x) = 𝐗̅ = ∑ 𝐏𝐗𝐢 𝐗 𝐢
̅=
𝐗
𝐧

LOS 4 : Calculation of Risk of an individual security

Risk of an individual security will cover under following heads:

Risk of an Individual Security

Variance Standard Coefficient of

(σ )
2
Deviation (σ) Variation (CV)
 11.3

1. Standard Deviation of Security (S.D) :- (S.D) or σ (sigma) is a measure of total risk / investment
risk.

Standard Deviation (σ)

Past Data Probability Based Data

̅ )𝟐
∑(𝐗−𝐗 ̅ )𝟐
(σ) = √ (σ ) = √∑ 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲(𝐗 − 𝐗
𝐧

Note:
❖ For sample data, we may use (n-1) instead of n in some cases.
x = Given Data, x ̅ = Average Return , n = No. of events/year
̅
❖ ∑(X − X ) will always be Zero (for Past Data)
❖ ∑(X − X̅ ) may or may not be Zero in this case. (for Probability Based Data)
❖ S.D can never be negative. It can be zero or greater than zero.
❖ S.D of risk-free securities or government securities or U.S treasury securities is always
assumed to be zero unless, otherwise specified in question.
Decision: Higher the S.D, Higher the risk and vice versa.
2. Variance

Variance (σ2)

Past Data Probability Based Data

̅ )𝟐
∑(𝐗 − 𝐗 ̅ )𝟐
(𝛔𝟐) = ∑ 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲(𝐗 − 𝐗
𝐧
Decision:
Higher the Variance, Higher the risk and vice versa.
3. Co-efficient of Variation (CV) :
CV is used to measure the risk (variable) per unit of expected return (mean)

𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 𝐨𝐟 𝐗
CV =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞/𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐗

Decision:
Higher the C.V, Higher the risk and vice versa.
 11.4 PORTFOLIO MANAGEMENT

LOS 5 : Rules of Dominance in case of an individual Security or when two

securities are given
Rule No. 1: For a given 2 securities, given same S.D or Risk, select that security which gives
higher return

X Ltd. Y ltd.
σ 5 5
Return 10 15

Decision: Select Y. Ltd.

Rule No. 2: For a given 2 securities, given same return, select which is having lower risk in
comparison to other.

X Ltd. Y ltd.
σ 5 10
Return 15 15

Decision Select X. Ltd.

Rule No. 3:

X Ltd. Y ltd.
σ 5 10
Return 10 25
Decision: Based on CV (Co-efficient of Variation).
When Risk and return are different, decision is based on CV.
CV x = 5/10 = 0.50 CV y = 10/25 = 0.40
Decision:- Select Y. Ltd.

LOS 6 : Calculation of Return of a Portfolio of assets

It is the weighted average return of the individual assets/securities.

Market Value of investments in asset

Where, W i =
Market Value of the Portfolio
Sum of the weights must always =1 i.e. W A + W B = 1
 11.5

LOS 7 : Risk of a Portfolio of Assets

1. Standard Deviation of a Two-Asset Portfolio

σ1,2 = √𝛔𝟐𝟏 𝐰𝟏𝟐 + 𝛔𝟐𝟐 𝐰𝟐𝟐 + 𝟐𝛔𝟏 𝐰𝟏 𝛔𝟐 𝐰𝟐 𝐫𝟏,𝟐

where
r1,2 = Co-efficient of Co-relation σ 1 = S.D of Security 1 σ 2 = S.D of Security 2
w1 = Weight of Security 1 w2 = Weight of Security 2

2. Variance of a Two-Asset Portfolio = (SD)2

3. Co-Variance

̅ ) ( 𝐘− 𝐘
∑( 𝐗− 𝐗 ̅)
Cov X,Y = ̅)(𝐘 − 𝐘
Cov X,Y = ∑ 𝐏𝐫𝐨𝐛. (𝐗 − 𝐗 ̅)
𝐧

X = Return on Asset 1 Y = Return on Asset 2

̅ = mean return on Asset 1
X ̅ = mean return on Asset 2
Y
n = No. of Period
Co-variance measures the extent to which two variables move together over time.
❖ A positive co-variance’s means variables (e.g. Rates of return on two stocks) are trend to
move together.
❖ Negative co-variance means that the two variables trend to move in opposite directions.
❖ A co-variance of Zero means there is no linear relationship between the two variables.
❖ Co-Variance or Co-efficient of Co-relation between risk-free security & risky security will
always be zero.
4. Co-efficient of Correlation
𝐂𝐨𝐯𝟏,𝟐
r 1,2 =
𝛔𝟏 𝛔𝟐
Or
Cov1,2 = r1,2 σ1 σ2
Or

S.D of two-asset Portfolio (σ 1,2) = √𝛔𝟐𝟏 𝐰𝟏𝟐 + 𝛔𝟐𝟐 𝐰𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝐂𝐎𝐕𝟏,𝟐
 11.6 PORTFOLIO MANAGEMENT

❖ The correlation co-efficient has no units. It is a pure measure of co-movement of the two
stock’s return and is bounded by -1 and +1.
❖ +1 means that deviations from the mean or expected return are always proportional in the
same direction, They are perfectly Positively Correlated. It is a case of maximum Portfolio
risk.
❖ -1 means that deviation from the mean or expected values are always proportional in
opposite directions. They are perfectly negatively correlated. It is a case of minimum portfolio
risk.
❖ A correlation coefficient of ZERO means no linear relationship between the two stock’s
return.

LOS 8 : Portfolio risk as Correlation varies

Example:
Consider 2 risky assets that have return variance of 0.0625 and 0.0324, respectively. The assets
standard deviation of returns are then 25% and 18%, respectively. Calculate standard deviations of
portfolio returns for an equal weighted portfolio of the two assets when their correlation of return is
1, 0.5, 0, -0.5, -1.
Solution:

σ portfolio= √σ12 w12 + σ22 w22 + 2σ1 w1 σ2 w2 r1,2 = √(σ1 w1 + σ2 w2 )2

r = correlation = +1
σ portfolio = w1σ1 + w2σ2
σ = portfolio standard deviation = 0.5(25%) + 0.5(18%) = 21.5%
r = correlation = 0.5

σ = √(0.5)2 0.0625 + (0.5)2 0.0324 + 2(0.5)(0.5)(0.5)(0.25)(0.18) = 18.70%

r = correlation = 0

σ = √(0.5)2 0.0625 + (0.5)2 0.0324 = 15.40%

r = correlation = (-) 0.5

σ = √(0.5)2 0.0625 + (0.5)2 0.324 + 2(0.5)(0.5)(˗0.5)(0.25)(0.18) = 11.17%

r = correlation = -1
σ portfolio = w1σ1 - w2σ2
σ = portfolio standard deviation = 0.5(25%) - 0.5(18%) = 3.5%
Note:
❖ The portfolio risk falls as the correlation between the asset’s return decreases.
❖ The lower the correlation of assets return, the greater the risk reduction (diversification) benefit
of combining assets in a portfolio.
❖ If assets return when perfectly negatively correlated, portfolio risk could be minimum.
 11.7

❖ If assets return when perfectly positively correlated, portfolio risk could be maximum.
Portfolio Diversification refers to the strategy of reducing risk by combining many different types
of assets into a portfolio. Portfolio risk falls as more assets are added to the portfolio because not
all assets prices move in the same direction at the same time. Therefore, portfolio diversification is
affected by the:
a) Correlation between assets: Lower correlation means greater diversification benefits.
b) Number of assets included in the portfolio: More assets means greater diversification benefits.

LOS 9 : Standard-deviation of a 3-asset Portfolio

𝛔𝟏,𝟐,𝟑 = √𝛔𝟐𝟏 𝐖𝟏𝟐 + 𝛔𝟐𝟐 𝐖𝟐𝟐 + 𝛔𝟐𝟑 𝐖𝟑𝟐 + 𝟐 𝛔𝟏 𝛔𝟐 𝐖𝟏 𝐖𝟐 𝐫𝟏,𝟐 + 𝟐 𝛔𝟏 𝛔𝟑 𝐖𝟏 𝐖𝟑 𝐫𝟏,𝟑 + 𝟐 𝛔𝟐 𝛔𝟑 𝐖𝟐 𝐖𝟑 𝐫𝟐,𝟑

Or

𝛔𝟏,𝟐,𝟑 = √𝛔𝟐𝟏 𝐖𝟏𝟐 + 𝛔𝟐𝟐 𝐖𝟐𝟐 + 𝛔𝟐𝟑 𝐖𝟑𝟐 + 𝟐 𝐖𝟏 𝐖𝟐 𝐂𝐨𝐯𝟏,𝟐 + 𝟐 𝐖𝟏 𝐖𝟑 𝐂𝐨𝐯𝟏,𝟑 + 𝟐 𝐖𝟐 𝐖𝟑 𝐂𝐨𝐯𝟐,𝟑

Portfolio consisting of 4 securities

𝛔𝟐𝟏 𝐖𝟏𝟐 + 𝛔𝟐𝟐 𝐖𝟐𝟐 + 𝛔𝟐𝟑 𝐖𝟑𝟐 + 𝛔𝟐𝟒 𝐖𝟒𝟐 + 𝟐 𝛔𝟏 𝛔𝟐 𝐖𝟏 𝐖𝟐 𝐫𝟏,𝟐 + 𝟐 𝛔𝟐 𝛔𝟑 𝐖𝟐 𝐖𝟑 𝐫𝟐,𝟑 +
𝛔𝟏,𝟐,𝟑,𝟒 = √
𝟐 𝛔𝟑 𝛔𝟒 𝐖𝟑 𝐖𝟒 𝐫𝟑,𝟒 + 𝟐 𝛔𝟒 𝛔𝟏 𝐖𝟒 𝐖𝟏 𝐫𝟒,𝟏 + 𝟐 𝛔𝟐 𝛔𝟒 𝐖𝟐 𝐖𝟒 𝐫𝟐,𝟒 + 𝟐 𝛔𝟏 𝛔𝟑 𝐖𝟏 𝐖𝟑 𝐫𝟏,𝟑

LOS 10 : Standard Deviation of Portfolio consisting of Risk-free security &

Risky Security
A = Risky Security
B = Risk-free Security
We know that S.D of Risk-free security is ZERO.

σ A,B = √𝛔𝟐𝐀 𝐰𝐀𝟐 + 𝛔𝟐𝐁 𝐰𝐁𝟐 + 𝟐𝛔𝐀 𝐰𝐀 𝛔𝐁 𝐰𝐁 𝐫𝐀,𝐁 = √𝛔𝟐𝐀 𝐰𝐀𝟐 + 𝟎 + 𝟎

σ A,B = σA WA

LOS 11 : Calculation of Portfolio risk and return using Risk-free securities

and Market Securities
❖ Under this we will construct a portfolio using risk-free securities and market securities.

Case 1: Investment 100% in risk-free (RF) & 0% in Market

[S.D of risk free security is always 0(Zero).]
Risk = 0%
Return = risk-free return
 11.8 PORTFOLIO MANAGEMENT

Case 2: Investment 0% in risk-free (RF) & 100% in Market

Risk = σm
Return = Rm

Case 3: Invest part of the money in Market & part of the money in Risk-free (σ of RF = 0)

Return = Rm Wm + RF WRF
Risk of the portfolio = σm × Wm

Case 4: Invest more than 100% in market portfolio. Addition amount should be borrowed at
risk-free rate.

Let the additional amount borrowed weight = x

Return of Portfolio = Rm× (1+ x) – RF × x
Risk of Portfolio = σm × (1+ x)

LOS 12 : Optimum Weights

For Risk minimization, we will calculate optimum weights.

𝛔𝟐
𝐁 − 𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 (𝐀,𝐁)
WA =
𝛔𝟐 𝟐
𝐀 + 𝛔 𝐁 – 𝟐× 𝐂𝐨𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 (𝐀,𝐁)

WB = 1- WA (Since WA + WB = 1)
We know that
Covariance (A,B) = r A,B × σ A × σ B

LOS 13 : CAPM (Capital Asset Pricing Model)

For Individual Security:
The relationship between Beta (Systematic Risk) and expected return is known as CAPM.
Required return/ Expected Return
𝐁𝐞𝐭𝐚 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲
= Risk-free Return + (Return Market – Risk free return)
𝐁𝐞𝐭𝐚 𝐌𝐚𝐫𝐤𝐞𝐭

OR

E (R) = Rf + βs (Rm – Rf)

Note:
❖ Market Beta is always assumed to be 1.
❖ Market Beta is a benchmark against which we can compare beta for different securities and
portfolio.
❖ Standard Deviation & Beta of risk free security is assumed to be Zero (0) unless otherwise
stated.
❖ Rm – Rf = Market Risk Premium.
 11.9

❖ If Return Market (Rm) is missing in equation, it can be calculated through HPR (Holding Period
Return)
❖ R m is always calculated on the total basis taking all the securities available in the market.
❖ Security Risk Premium = β (Rm – Rf)

For Portfolio of Securities:

Required return/ Expected Return = Rf + βPortfolio (Rm – Rf)

LOS 14 : Decision Based on CAPM

Case Decision Strategy

CAPM Return > Estimated Return/ HPR Over-Valued Sell
CAPM Return < Estimated Return/ HPR Under-Valued Buy
CAPM Return = Estimated Return/ HPR Correctly Valued Buy, Sell or Ignore
❖ CAPM return need to be calculated by formula, Rf + β (Rm – Rf)
❖ Actual return / Estimated return can be calculated through HPR (Through data given)

LOS 15 : Interpret Beta/ Beta co-efficient / Market sensitivity Index

The sensitivity of an asset’s return to the return on the market index in the context of market return
is referred to as its Beta.
Note:
❖ Beta is a measure of Systematic Risk.
❖ However, Beta is not equal to Systematic Risk.
Example:
If Beta = 2, it means when market increases by 1%, security will increase by 2% and if market
decrease by 1%, security will decrease by 2%.

𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐑𝐞𝐭𝐮𝐫𝐧 𝐂𝐎𝐕𝐢.𝐦 𝛔𝐢 ∑ 𝒙 𝒚 − 𝒏 𝒙̅ 𝒚

β= β= β = rim β=
̅
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐌𝐚𝐫𝐤𝐞𝐭 𝐑𝐞𝐭𝐮𝐫𝐧 𝝈𝟐𝒎 𝛔𝐦 ∑ 𝒚𝟐 − 𝒏 𝒚
̅𝟐
 11.10 PORTFOLIO MANAGEMENT

Calculation of Beta
1. Beta Calculation with % change Formulae
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐑𝐞𝐭𝐮𝐫𝐧
Beta =
𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐌𝐚𝐫𝐤𝐞𝐭 𝐑𝐞𝐭𝐮𝐫𝐧

Note:
❖ This equation is normally applicable when two return data is given.
❖ In case more than two returns figure are given, we apply other formulas.
2. Beta of a security with Co-variance Formulae
𝐂𝐨−𝐯𝐚𝐫𝐢𝐚𝐧𝐜𝐞 𝐨𝐟 𝐀𝐬𝐬𝐞𝐭 𝐢’𝐬 𝐫𝐞𝐭𝐮𝐫𝐧 𝐰𝐢𝐭𝐡 𝐭𝐡𝐞 𝐦𝐚𝐫𝐤𝐞𝐭 𝐫𝐞𝐭𝐮𝐫𝐧 𝐂𝐎𝐕𝐢.𝐦
β = =
𝐕𝐚𝐫𝐢𝐚𝐧𝐜𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐌𝐚𝐫𝐤𝐞𝐭 𝐑𝐞𝐭𝐮𝐫𝐧 𝛔𝟐
𝐦

3. Beta of a security with Correlation Formulae

COVi.m
We know that Correlation Co-efficient (rim) =
σi σm
to get Cov im = rim σi σm
rim σi σm
Substitute Cov im in β equation, We get β i =
σ2
m

𝛔𝐢
β= rim
𝛔𝐦

4. Beta of a security with Regression Formulae

∑ 𝐱 𝐲 − 𝐧 𝐱̅𝐲̅
β=
∑ 𝐲 𝟐 − 𝐧 𝐲̅ 𝟐

x = Security Return
y = Market Return
Note: Advisable to use Co-Variance formula to calculate Beta.
(Solve Question NO. 9B by using Regression Formulae)

LOS 16 : Beta of a portfolio

It is the weighted average beta of individual security.

Beta of Portfolio = Beta X Ltd. × W X Ltd. + Beta Y Ltd. × W Y Ltd.

Market Value of investments in asset

Where, W i =
Market Value of the Portfolio
 11.11

LOS 17 : Evaluation of the performance of a portfolio (Also used in Mutual Fund)

𝐑𝐏 − 𝐑𝐅 α P = RP – (RF + β (R m – RF))
𝐑𝐏 − 𝐑𝐅 Or
𝛔𝐏 𝛃𝐏 Alpha = Actual Return – CAPM Return

1. Sharpe’s Ratio (Reward to Variability Ratio):

❖ It is excess return over risk-free return per unit of total portfolio risk.
❖ Higher Sharpe Ratio indicates better risk-adjusted portfolio performance.
𝐑𝐏− 𝐑𝐅
Sharpe’s Ratio =
𝛔𝐏

Where RP = Return Portfolio

σP = S.D of Portfolio
Note:
❖ Sharpe Ratio is useful when Standard Deviation is an appropriate measure of Risk.
❖ The value of the Sharpe Ratio is only useful for comparison with the Sharpe Ratio of another
Portfolio.
2. Treynor’s Ratio (Reward to Volatility Ratio):
Excess return over risk-free return per unit of Systematic Risk (β )
𝐑𝐏− 𝐑𝐅
Treynor’s Ratio =
𝛃𝐏

Decision: Higher the ratio, Better the performance.

3. Jenson’s Measure/Alpha:
This is the difference between a fund’s actual return & CAPM return

α P = RP – (RF + β (R m – RF))
Or
Alpha = Actual Return – CAPM Return

It is excess return over CAPM return.

❖ If Alpha is +ve, performance is better.
❖ If Alpha is -ve , performance is not better.
 11.12 PORTFOLIO MANAGEMENT

4. Market Risk - return trade – off:

Excess return of market over risk-free return per unit of total market risk.
𝐑𝐌 − 𝐑𝐅
𝛔𝐌

LOS 18 : Characteristic Line (CL)

Characteristic Line represents the relationship between Asset excess return and Market Excess
return.

Equation of Characteristic Line:

Y=α+βX
Where Y= Average return of Security
X= Average Return of Market
α= Intercept i.e. expected return of an security when the return from the market portfolio
is ZERO, which can be calculated as Y – β × X = α
β= Beta of Security
Note:
COVi,M
The slope of a Characteristic Line is i.e. Beta
σ2
M

LOS 19 : New Formula for Co-Variance using Beta

(Cov A,B) = β A × β B × σ 2 m

LOS 20 : New Formula for Correlation between 2 stocks

Correlation between A & B
rAB = rA, Mkt. × rB, Mkt.
 11.13

LOS 21 : Co-variance of an Asset with itself is its Variance

Cov (m,m) = Variance m

Co-variance Matrix

COV A B C
A 𝜎𝐴2 COVAB COVAC
B COVBA 𝜎𝐵2 COVBC
C COVCA COVCB 𝜎𝐶2

LOS 22 : Correlation of an Asset with itself is = 1

r (A,A) = 1

Correlation Matrix

or A B C
A 1 rAB rAC
B rBA 1 rBC
C rCA rCB 1
 11.14 PORTFOLIO MANAGEMENT

Unsystematic Risk (Controllable Risk):-

❖ The risk that is eliminated by diversification is called Unsystematic Risk (also called unique, firm-
specific risk or diversified risk). They can be controlled by the management of entity. E.g. Strikes,
Change in management, etc.
Systematic Risk (Uncontrollable Risk):-
❖ The risk that remains can’t be diversified away is called systematic risk (also called market risk
or non-diversifiable risk). This risk affects all companies operating in the market.
❖ They are beyond the control of management. E.g. Interest rate, Inflation, Taxation, Credit Policy

LOS 23 : Sharpe Index Model or Calculation of Systematic Risk (SR) &

Unsystematic Risk (USR)
Risk is expressed in terms of variance.
Total Risk (TR) = Systematic Risk (SR) + Unsystematic Risk (USR)

For an Individual Security:

Total Risk (%2) = 𝛔𝟐𝒔

Unsystematic Risk
Systematic Risk (%2)
(%2) (𝛔𝟐𝒆𝒊 )

SR = 𝛃𝟐𝒔 × 𝛔𝟐𝒎 USR = TR – SR

𝛔𝟐𝒔 - 𝛃𝟐𝒔 × 𝛔𝟐𝒎

𝛔𝟐𝒆𝒊 = USR/ Standard Error/ Random Error/ Error Term/ Residual Variance.

For A Portfolio of Securities:

Total Risk = 𝛔𝟐𝒑
or
= ( ∑ W i β i )2 x 𝛔𝟐𝒎 + ∑ W i 2 x USR i

Systematic Risk (%2) Unsystematic Risk (%2)

USR = TR - SR
SRp = 𝛃𝟐𝒑 × 𝛔𝟐𝒎
= 𝛔𝟐𝒑 - 𝛃𝟐𝒑 × 𝛔𝟐𝒎

( ∑ W i β i )2 x 𝛔𝟐𝒎 ∑ W i 2 x USR i
 11.15

LOS 24 : Co-efficient of Determination

❖ Co-efficient of Determination = (Co-efficient of co-relation)2 = r2
❖ Co-efficient of determination (r2) gives the percentage of variation in the security’s return i.e.
explained by the variation of the market index return.
Example:
If r2 = 18%, In the X Company’s stock return, 18% of the variation is explained by the variation of
the index and 82% is not explained by the index.
❖ According to Sharpe, the variance explained by the index is the systematic risk. The unexplained
variance or the residual variance is the Unsystematic Risk.
Use of Co-efficient of Determination in Calculating Systematic Risk & Unsystematic Risk:
❖ Explained by Index [Systematic Risk]

𝑺𝑹
= = 𝒓𝟐 or SR =TR × 𝒓𝟐
𝑻𝑹

i.e. 𝛔𝟐𝒊 × r2
Not Explained by Index [Unsystematic Risk]

𝑼𝑺𝑹
= = 𝒓𝟐 or USR =TR × 1 - 𝒓𝟐
𝑻𝑹

i.e. 𝛔𝟐𝒊 × (1 - r2)

LOS 25 : Portfolio Rebalancing

❖ Portfolio re-balancing means balancing the value of portfolio according to the market condition.
❖ Three policy of portfolio rebalancing:
a) Buy & Hold Policy : [“Do Nothing” Policy]
b) Constant Mix Policy: [“Do Something” Policy]
c) Constant Proportion Portfolio Insurance Policy (CPPI): [“Do Something” Policy]

Value of Equity (Stock) = m × [Portfolio Value – Floor Value]

Where m = multiplier
❖ The performance feature of the three policies may be summed up as follows:
a) Buy and Hold Policy
(i) Gives rise to a straight line pay off.
(ii) Provides a definite downside protection.
(iii) Performance between Constant mix policy and CPPI policy.
b) Constant Mix Policy
(i) Gives rise to concave pay off drive.
(ii) Doesn’t provide much downward protection and tends to do relatively poor in the up market.
(iii) Tends to do very well in flat but fluctuating market.
 11.16 PORTFOLIO MANAGEMENT

c) CPPI Policy
(i) Gives rise to a convex pay off drive.
(ii) Provides good downside protection and performance well in up market.
(iii) Tends to do very poorly in flat but in fluctuating market.
Note:
❖ If Stock market moves only in one direction, then the best policy is CPPI policy and worst policy
is Constant Mix Policy and between lies buy & hold policy.
❖ If Stock market is fluctuating, constant mix policy sums to be superior to other policies.

LOS 26 : Arbitrage Pricing Theory/ Stephen Ross’s Apt Model

Overall Return
= Risk free Return
+
{Beta Inflation × Inflation differential or factor risk Premium}
+
{Beta GNP × GNP differential or Factor Risk Premium}
+ ……. & So on.

Where, Differential or Factor risk Premium = [Actual Values – Expected Values]

LOS 27 : Adjustment in CAPM

When two or more Risk Free Rates are given, we are taking the Simple Average of given Rates.
Effect of Increase & Decrease in Inflation Rates
❖ Increase in Inflation Rates:
Revised RF = RF + RF × Inflation Rate
❖ Decrease in Inflation Rates:
Revised RF = RF − RF × Deflation Rate
 11.17

LOS 28 : Modern Portfolio Theory/ Markowitz Portfolio Theory/ Rule of

Dominance in case of selection of more than two securities
Under this theory, we will select the best portfolio with the help of efficient frontier.

Efficient Frontier:
❖ Those portfolios that have the greatest expected return for each level of risk make up the efficient
frontier.
❖ All portfolios which lie on efficient frontier are efficient portfolios.
Efficient Portfolios:
Rule 1: Those Portfolios having same risk but given higher return.
Rule 2: Those Portfolios having same return but having lower risk.
Rule 3: Those Portfolios having lower risk and also given higher returns.
Rule 4: Those Portfolios undertaking higher risk and also given higher return
In-efficient Portfolios:
Which don’t lie on efficient frontier.
Solution Criteria:
For selection of best portfolio out of the efficient portfolios, we must consider the risk-return
preference of an individual investor.
❖ If investors want to take risk, invest in the Upper End of efficient frontier portfolios.
❖ If investors don’t want to take risk, invest in the Lower End of efficient frontier portfolios.
Note:
CV is not used in this case, CV is only used for selection of one security between many securities
& major drawback is that it always select securities with lower risk.

LOS 29 : Capital Market Line (CML)

The line of possible portfolio risk and Return combinations given the risk-free rate and the risk and
return of a portfolio of risky assets is referred to as the Capital Allocation Line.
❖ Under the assumption of homogenous expectations (Maximum Return & Minimum Risk), the
optimal CAL for investors is termed the Capital Market Line (CML).
❖ CML reflect the relationship between the expected return & total risk (σ).
Equation of this line:
𝛔𝐩
E(R p) = RF + [E (RM) – RF]
𝛔𝐦
 11.18 PORTFOLIO MANAGEMENT

LOS 30 : SML (Security Market Line)

SML reflects the relationship between expected return and systematic risk (β)
Equation:
𝐂𝐎𝐕𝐢,𝐌𝐚𝐫𝐤𝐞𝐭
E (R i) = RFR + [E (R Market) – RFR]
𝛔𝟐
𝐦𝐚𝐫𝐤𝐞𝐭

Beta

❖ If Beta = 0 E(R) = R f
❖ If Beta = 1 E(R) = R m
Graphical representation of CAPM is SML.
According to CAPM, all securities and portfolios, diversified or not, will plot on the SML in
equilibrium.

LOS 31 : Cut-Off Point or Sharpe’s Optimal Portfolio

Calculate Cut-Off point for determining the optimum portfolio
Steps Involved
Ri − Rf
Step 1: Calculate Excess Return over Risk Free per unit of Beta i.e.
βi
 11.19

Step 2: Rank them from highest to lowest.

Step 3: Calculate Optimal Cut-off Rate for each security.

Cut-off Point of each Security

𝐍 (𝐑 𝐢 − 𝐑 𝐟 × 𝛃)
σ2
m ∑𝐢=𝟏
𝛔𝟐
𝐞𝐢
Ci= 𝟐
1+ σ2 ∑ 𝐍 𝛃𝐢
m 𝐢=𝟏 𝟐
𝛔𝐞𝐢

Step 4: The Highest Cut-Off Rate is known as “Cut-off Point”. Select the securities which lies on
or above cut-off point.
Step 5: Calculate weights of selected securities in optimum portfolio.
a) Calculate Z i of Selected Security

βi (Ri − Rf )
ZI= [ − Cut off Point]
σ2
ei βi

b) Calculate weight percentage

𝑍i
Wi =
∑𝑍
 13.1

Miscellaneous
Study Session 13

LOS 1 : Buy Back of shares/Repurchase

Buyback is reverse of issue of shares of a company where the company offers to take back its share
owned by the investors at a specified price.

LOS 2 : Right Shares

Right Shares are those shares which are issued to existing shareholders at a price which is normally
less than Current Market Price.
Choice before Shareholder in respect of Right Issue Effect on Shareholder’s wealth
1. Exercise his rights and subscribe for Right shares. No change in wealth
2. Do not exercise Decrease in Wealth
3. Sell the rights in the market. No change in wealth
4. Exercise his right for few shares and sell the balance No change in wealth
rights in the market.
Theoretical Post Right (Ex-Right) Price per share =
𝐌𝐏𝐒 𝐂𝐮𝐦 𝐑𝐢𝐠𝐡𝐭×𝐄𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐍𝐨.𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬+𝐑𝐢𝐠𝐡𝐭 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞/𝐎𝐟𝐟𝐞𝐫 𝐏𝐫𝐢𝐜𝐞×𝐍𝐨.𝐨𝐟 𝐑𝐢𝐠𝐡𝐭 𝐒𝐡𝐚𝐫𝐞 𝐢𝐬𝐬𝐮𝐞𝐝
𝐄𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐍𝐨.𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬+𝐍𝐞𝐰 𝐍𝐨.𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬

LOS 3 : Venture Capital Investing

Venture Capital Investments are private, non-exchange-traded equity investments in a Business
Venture.
Investments are usually made through limited partnerships, with investors anticipating relatively
high returns in exchange for the illiquidity and high-risk profile of a venture capital investments.
Stages of Venture Capital Investing:
Seed Stage:
Investors are providing Capital in the early stage of the business and may help fund research and
development of product ideas.
Early Stage:
Start-up Financing refers to Capital use to complete Product Development and fund initial marketing
Efforts.
First-Stage : Financing refers to funding to commercial production and sales of the product.
Later Stage : Major Expansion of the Company.
Note:
❖ Conditional probability of failure i.e. 22% in 3rd Year refers to the probability of failing in the 3rd
year provided success in the 1st and 2nd Year.
❖ Joint probability of failure cannot be calculated as joint probability of success because if failure
in 1st Year cannot go in 2nd Year.
 13.2 MISCELLANEOUS

LOS 4 : Moving Averages

Two types of moving Average are:
1. AMA (Arithmetic Moving Average)
2. EMA (Exponential Moving Average)
AMA - Example:

Day 1 2 3 4 5 6 7 8 9 10
Closing Price 40 45 39 42 48 43 52 47 45 38
Calculate 5 day’s AMA?
Solution:

Day Closing Price 5 Days AMA

1 40 —
2 45 —
3 39 —
4 42 —
5 48 42.80
6 43 43.40
7 52 44.80
8 47 46.40
9 45 47.00
10 38 45.00

EMA
EMA today = EMA Yesterday + a × [Price today - EMA Yesterday]
Note:
a = Exponent/ Multiplier/ Smoothing Constant.
‘a’ will always be given in question, however ‘a’ can also be calculated by using following relation:
𝟐
a=
𝟏+𝐏𝐞𝐫𝐢𝐨𝐝
 1.1

LEASING
LOS 1 : Introduction

➢ Leasing is an important source of medium-term financing or leasing is the process of financing

the cost of an asset.
➢ It is an arrangement under which an asset is financed and owned by one party but possessed
and used by the other.

Parties to the lease agreement:-

1. LESSOR:
The OWNER of the asset is known as lessor-who gives assets on lease.
2. LESSEE:
The USER of the asset is known as lessee-who takes asset on lease.

➢ The lease agreement details out the specified period and timing of the sequential payments to
be made by the lessee to the lessor as consideration for the use of the asset. It also
incorporates repayment schedule.

LOS 2: Evaluation from the Point-of-view of Lessee/ Lease or Borrow & Buy
Decision(A Financing Decision)

Loan Option Lease Option

Outflows Outflows
 1.2 LEASING

Interest Net of Tax Lease Rentals Net of Tax

Principal Repayment Repair & Maintenance Net of Tax
Expense Net of Tax
Repair & Maintenance Net of Tax
Inflows: Inflows:
Tax Saving on Depreciation Nil
Salvage value adjusted for Tax
Calculation of Discount Rate Calculation of Discount Rate
Kd = Interest Net of Tax Kd
Leasing is an alternative of Loan Option
Ke Ke
Ko Ko
Present Value of outflow under Loan Present Value of outflow under Lease
option option

Decision: Select the option which gives the least outflow.

Adjustment No. 1
Common items under lease option and loan option can be ignored.
Exception to this rule:
1. Timing Difference.
2. If discount rate is different in both options.
Note :
Repair and Maintenance Expenses are always borne by the user of the Asset unless otherwise
specifically stated.
Insurance expenses are always borne by the owner of the Asset unless otherwise specifically
stated.
Adjustment No. 2
Loan / Principal Repayment

1. Bullet Payment: Principal will be repaid in one shot at the end of Loan term, in this case
interest is calculated for each year.
2. Principal amount of loan repayment: Interest is calculated on Balance amount.
3. Equated Annual Installments: It includes Interest and Principal both.

Adjustment No. 3 : Equated Annual Installment (EAI)

(When installment is paid at the end of each year)

Step1: Equated annual loan repayment inclusive of interest (paid at the end of each year)

𝐀𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐥𝐨𝐚𝐧
EAI =
𝐏𝐕𝐀𝐅(𝐫%,𝐧 𝐲𝐞𝐚𝐫𝐬)
 1.3

Where,
r% = rate of interest before Tax (Charged by bank)
n = Period of Loan

Step 2: Calculate Principal Repayment amount and interest amount from the total equated
Annual Installment
Step 3: Calculate Interest Net of Tax.

When installment is paid from beginning of each year/ annuity due

𝐀𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐋𝐨𝐚𝐧
EAI =
𝟏+𝐏𝐕𝐀𝐅 (𝐫% (𝐧−𝟏)𝐲𝐞𝐚𝐫𝐬)

❖ If silent, we will assume those rentals are paid at the end of each year.

LOS 3: Evaluation from the point of view of Lessor (Investment Decision)

Decision: “Whether to purchase asset and give asset on lease rent or Not”
Step 1: Calculate all cash inflows and all cash outflows of lessor. TABLE

Inflows of Lessor: Out Flows for Lessor:

(i) Lease Rent received net of Tax. Cost of Asset Purchased
(ii) Tax Savings on Depreciation.
(iii) Salvage Value adjusted for Tax.

Step 2: Compute a suitable Discount Rate.

K0 = Cost of Capital
Or
K0 = WACC = K e W e + K d W d + K r W r + K p W p
Step 3: Compute NPV (Net Present Value)
Decision: If NPV is Positive, lessor should lease the asset.

LOS 4: Treatment of Depreciation

➢ Depreciation is always charged by the owner of the Asset.
➢ In case of Loan Option, depreciation is charged by borrower.
➢ Depreciation is a non-cash item, it should not be considered while calculating cash flows.
➢ Tax savings on depreciation should be taken as cash inflows.

Tax Saving on Depreciation = Depreciation Amount ×Tax Rate

Methods of Depreciation:
1. Straight- line Depreciation Method:
Straight-line depreciation allocates an equal amount of depreciation each year over the
asset’s useful life.

𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐂𝐨𝐬𝐭−𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐕𝐚𝐥𝐮𝐞/𝐑𝐞𝐬𝐢𝐝𝐮𝐚𝐥 𝐕𝐚𝐥𝐮𝐞

Depreciation p.a. =
𝐋𝐢𝐟𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐚𝐬𝐬𝐞𝐭
 1.4 LEASING

Note:
If question is silent, always use straight-line method of depreciation.

2. Written-down value Depreciation Method:-

WDV Depreciation = [Cost - Accumulated Depreciation] × % of Depreciation

Note:
If Rate of Depreciation is given use WDV Method

❖ We recognize more depreciation expense in early years of the asset’s life and less
depreciation expense in the later years of life.
3. Sum of Years Digit Method of Depreciation:-

Example:
Cost of Asset = 100
Life = 5 Years
Salvage Value = 10
Calculate Depreciation.

Solution:
Amount to be depreciated = 100 - 10  90
Life = 5 years
Sum =1+2+3+4+5=15
Years Depreciation
1 90 × 5 / 15 = 30
2 90 × 4 / 15 = 24
3 90 × 3 / 15 = 18
4 90 × 2 / 15 = 12
5 90 × 1 / 15 = 6

LOS 5: Treatment of Salvage Value Adjusted for tax – (WDV Depreciation)

1. In Case of Profit
= Salvage Value – Tax Paid on Profit on Sale

2. In Case of Loss
= Salvage Value + Tax Saved on Loss on Sale

Example A (In case of Profit):

Cost of Asset 1,00,000
WDV Dep. 10%
Life 5 Years
Tax@ 50%
Salvage Value 70,000
Calculate Cash inflows & outflows for each year.
Solution:
Year Cash flows
0 (1,00,000)
1 + 5000
 1.5

2 + 4500
3 + 4050
4 + 3645
5 + 3281 + (70,000 – 5476) = 67,805
1. Calculation of Depreciation:
Year Opening Balance WDV@10% Closing Balance
1 100000 10000 90000
2 90000 9000 81000
3 81000 8100 72900
4 72900 7290 65610
5 65610 6561 59049

2. Calculation of Profit & Loss on Sale of Asset:

Original Cost 1,00,000
Less: Depreciation till date 40,951
WDV 59,049
Less: Salvage Value 70,000
Profit on sale 10,951

Tax Payment on Profit on Sale of Asset @ 50% 5,476

Calculation of Salvage value Adjusted for tax = 70000-5476=64524
Example B (In case of Loss):
If Salvage Value is 35,000
Solution:
Year Cash Flows
0 (100000)
1 +5000
2 +4500
3 +4050
4 +3645
5 +3280.50 + (35000 + 12024.50) = 50305

3. Calculation of Profit & Loss on Sale of Asset:

Original Cost 1,00,000
Less: Depreciation till date 40,951
WDV 59,049
Less: Salvage Value 35,000
Loss on sale 24,049
Tax Saving on Loss on Sale of Asset @ 50% 12,024.50

LOS 6 : Treatment of Salvage Value Adjusted for tax – (SLM Depreciation)

Example:
Cost of Asset 1,00,000
SLM Depreciation
Life 5 Years
Tax @ 50%
Salvage Value 20,000
Calculate Cash inflows & outflows for each year.
Solution:
 1.6 LEASING

Year Cash flows

0 (1,00,000)
1 + 8000
2 + 8000
3 + 8000
4 + 8000
5 + 8000 + (20,000 ± 0) = 28,000

Working Note
1. Calculation of Depreciation:

1,00,000 − 20,000
Depreciation p.a = = 16,000 p.a
5
2. Calculation of Profit & Loss on Sale of Asset:
Original Cost 1,00,000
Less: Depreciation till date 80,000
WDV 20,000
Less: Salvage Value 20,000
Profit on sale 0

Note:
When SLM method is used, Salvage Value should not be adjusted for tax purpose, we only
considered SV as inflow unless there is a adjustment related to SV.

Confusion regarding SV
1. If question states that Profit/Loss on sale of assets should be ignored then no need to adjust
SV for Tax purpose.
2. Use words like “Net SV” then no need to adjust SV for Tax purpose.
3. If SV is not given in the question then do not assume SV = 0, accordingly no adjustment of SV.

LOS 7: Treatment of Tax

➢ Cash inflows & Cash outflows should be taken Net of Tax provided cash inflows & outflows
are part of the profit & loss account (Tax Saving or Tax Paid only on revenue items not on
Capital items).
➢ Tax savings should be taken as cash inflows like tax savings on depreciation, tax savings due
to loss on sale of asset.
➢ Treatment of Tax when Cash inflow & Cash outflow arises from the Beginning of each
year.

Example:
Training expense incurred at the beginning of the Year 1 or in Year 0 `10, 000. Tax Rate@40%.
Calculate Inflow & outflow for each year.

Solution:
Alternative 1 (Adjust Tax in year 0 itself):
Year Cash Flow
0 - 10,000 + 4,000 = (-) 6,000
1 Nil
 1.7

Alternative 2: (Preferred by CA Institute) (Adjust Tax at year end 1):

Year Cash Flow

0 -10,000
1 + 4,000

Note:
There will be difference in answer under both alternatives.

LOS 8: Break-even lease rentals

Break-even lease rentals are those rentals at which:

PV of outflow under Loan Option = PV of outflow under Lease Option

LOS 9: IRR Technique / Implied Interest Cost of Lease for Lessor

➢ When discount rate is missing in the question, we use IRR technique.
➢ IRR is the Discount at which NPV is Zero.
➢ IRR is the discount rate at which PV of inflows = PV of Outflows

@NPV +ve

@NPV –ve

𝐋𝐨𝐰𝐞𝐫 𝐫𝐚𝐭𝐞 𝐍𝐏𝐕

IRR = Lower Rate + [ ] × Difference in Rate [HR – LR]
𝐋𝐨𝐰𝐞𝐫 𝐑𝐚𝐭𝐞 𝐍𝐏𝐕−𝐇𝐢𝐠𝐡𝐞𝐫 𝐫𝐚𝐭𝐞 𝐍𝐏𝐕

Break Even Lease Rentals (From the point of view of LESSOR)

PV of Inflow = PV of Output

PV of Lease Rentals Net of Tax

(+)
PV of Tax Savings on Depreciation = Cost of Asset
(+)
PV of SV Adjusted for Tax
(-)
PV of Expense Net of Tax

LOS 10 : Concept of Block of Assets

 Block of Assets means a group of assets falling within a particular class of assets.
 1.8 LEASING

 No depreciation shall be charged in the year in which asset is sold.

 Tax Benefit/Loss on Short Term Capital Loss/Gain shall be calculated on previous year WDV.

LOS 11: Different Plans under lease Rentals

Different plans are offered by lessor to lessee. Some of these are follows:
1. Equal Annual Lease Plans
In this plan, equal amount of lease rentals are paid every year.
2. Stepped-up lease plan
Under this plan lease rentals are increased by a particular percentage every year.
3. Deferred Payment Plan
Under this, lease rentals are deferred for some year (i.e. not paid for few years) and after that
it will be paid according to the terms of the contract.
4. Ballooned Payment plan
Under this plan, low amount lease rentals are paid for few years
At the end of the lease term, a huge amount is paid which is known as Ballooned Payment.

LOS 12: Net Advantage of Leasing (NAL)

➢ NAL is the Net Advantage/ Net Benefit of Leasing over & above the loan/ purchase option.

NAL = PV of Outflow under Loan Option

(–)
PV of Outflow under Lease Option

➢ If NAL is positive lease should be preferred, otherwise purchase (loan option) should be
preferred.

LOS 13 : Treatment of Subsidy for charging Depreciation.

Alternative 1 (Preferred by CA Institute)
Claim Depreciation on the full cost of asset.
Alternative 2
Claim Depreciation on Net Amount of Asset

LOS 14: Evaluation of quotation from two or more Lessor

➢ When Quotations are received from two or more lessor, lessee should select the quotation
which gives least outflows.
➢ When life of two proposals/quotes are not same , we will take decision based on equated
annual annuity(EAA)

𝑷𝑽 𝒐𝒇 𝑶𝒖𝒕𝒇𝒍𝒐𝒘 𝒐𝒓 𝑷𝑽 𝒐𝒇 𝑰𝒏𝒇𝒍𝒐𝒘 𝒐𝒓 𝑵𝑷𝑽

𝑬𝑨𝑨 =
𝑷𝑽𝑨𝑭 @ 𝒓%, 𝒏 𝒚𝒆𝒂𝒓𝒔
 1.9

LOS 15: Calculation of Cost of Asset/ Amount of Loan

Example:
Equate Annual Installment = ` 2,65,000
Life 5 years, Interest Rate = 14%.
Payment starts from the beginning of each year.
Calculate Cost of Asset?
Solution:
Cost of Asset
2,65,000 =
1+PVAF (14 % (5−1)years)

Cost of Asset = 2,65,000 × 3.9137 = 10,37,130

LOS 16: Sales & Lease back Agreement

➢ If you own an asset, you can sell it to a leasing company and take the asset back for use
under a leasing arrangement. This is referred to as “Sales & Lease Back”
➢ The main advantage is that it releases cash from the sale of asset that can be put to
alternate use without giving up the benefits that flow from the existing asset.

LOS 17: Confusing regarding Discount Rate

Lessee & Borrower
K d = Interest (1-Tax), even if cost of capital is separately given in the question.
Lessor
K0 = Cost of Capital / Discount Rate / Desire Rate of Return / Target rate of return
Note:
K0 ,K d , discount rate & Desire rate of return given in the question are always Net of Tax.
Exception to these rules:

 If discount rate is separately given in the question.

E.g 1 : Borrow Vs. Lease

Kd = 12%
Ko = 15% Discount Rate @ 18%

 If PVF table is given in the question for single discount rate.

E.g 2 : Borrow Vs. Lease

Kd = 12%
Ko = 15%

PVF Table @ 18%

 1.1

Capital Budgeting
LOS No. 1: Introduction
➢ Capital Budgeting is the process of Identifying & Evaluating capital projects i.e. projects
where the cash flows to the firm will be received over a period longer than a year.
➢ Any corporate decisions with an IMPACT ON FUTURE EARNINGS can be examined using
capital budgeting framework.
➢ Categories of Capital Budgeting Projects:
(a) Replacement projects to maintain the business
(b) Replacement projects for cost reduction
(c) Expansion projects
(d) New product or market development
(e) Mandatory projects

Types of Capital Budgeting Proposals:

(a) Mutually Exclusive Proposals: when acceptance of one proposal implies the automatic
rejection of the other proposal.
(b) Complementary Proposals: when the acceptance of one proposal implies the acceptance
of other proposal complementary to it, rejection of one implies rejection of all complementary
proposals.
(c) Independent Proposals: when the acceptance/rejection of one proposal doesn’t affect the
acceptance/rejection of other proposal.

LOS No. 2: Net Present Value (NPV)

NPV=PV of Cash Inflows – PV of Cash Outflows
Decision: If NPV is
+ve Accept the project- increase shareholder’s wealth
-ve Reject the project-decrease shareholder’s wealth
Zero Indifferent-No effect on shareholder’s wealth

𝐂𝐅𝟏 𝐂𝐅𝟐 𝐂𝐅𝐧

NPV= - CF0 + + + ---------------+
(𝟏+𝐤)𝟏 (𝟏+𝐤)𝟐 (𝟏+𝐤)𝐧
Where,
CF0 = the initial investment outlay.
CF t = after- tax cash flow at time t
K = required rate of return for project.

LOS No. 3: Profitability Index (PI)/ Benefit cost Ratio/ Desirability Factor/Present
Value Index

𝐏𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐅𝐥𝐨𝐰𝐬
PI =
𝐂𝐅𝟎 𝐨𝐫 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐎𝐮𝐭𝐟𝐥𝐨𝐰𝐬
CF0 = Initial Cash Out Flows
 1.2 CAPITAL BUDGETING

Note:
NPV = - CF0 + PV of future Cash In Flows
CF0 + NPV = PV of Future Cash In Flows
If NPV is given, then
Add Initial outlay in NPV to get, PV of Cash inflows.

Decision:
If NPV is Positive, the PI will be greater than one.
If NPV is Negative, the PI will be Less than one.

Rule:
If PI > 1, Accept the project
PI < 1, Reject the project
PI = 1, Indifferent

LOS No. 4: Pay-Back Period Method (PBP)

The pay- back period (PBP) is the number of years it takes to recover the initial cost of an
investment.
Case I: When Cash inflows are Constant/ equal

𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭/ 𝐨𝐮𝐭𝐟𝐥𝐨𝐰

Pay-back Period =
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰

Case II: When Cash inflows are unequal

Unrecovered Cost
Pay-back Period = Full years until recovery +
Cash Flow during next Year

Decision:
Shorter the PBP, better the project.
Drawback:
PBP does not take into account the time value of money and cash flows beyond the payback
period.
Benefit:
The main benefit of the pay-back period is that it is a good measure of project liquidity.

LOS No. 5: Discount pay-back period

➢ The discounted payback period uses the present value (PV) of project’s estimated Cash flows.
➢ It is the number of years it takes a project to recover its initial investment in present value
terms.
➢ Discounted pay-back period must be greater than simple pay-back period.

LOS No. 6: IRR Techniques (Internal Rate of Return)

➢ IRR is the discount rate that makes the PV of a project’s estimated cash inflows equal to the
PV of the project’s estimated cash outflows.
➢ i.e. IRR is the discount rate that makes the following relationship:

PV (Inflows) = PV (Outflows)
 1.3

 IRR is also the discount rate for which the NPV of a project is equal to ZERO.
Lower Rate NPV
 IRR= Lower Rate + Lower Rate NPV−Higher Rate NPV × Difference in Rate (HR-LR)

How to find the starting rate for calculation of IRR:

Step 1: Calculate Fake Pay-back period:

Initial Investment
Fake Pay-back Period =
Average Annual Cash Flow

Step 2: Locate the above figure in Present Value Annuity Factor Table and take this discount rate
to start the calculation of IRR.

Accept/Reject Criteria:
IRR > Cost of Capital Accept the Proposal
IRR = Cost of Capital Indifferent
IRR< Cost of Capital Reject the Proposal

LOS No. 7: Accounting Rate of Return

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
ARR=
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Note:
𝐍𝐏𝟏 +𝐍𝐏𝟐 +𝐍𝐏𝟑 ……….𝐍𝐏𝐧
Average Net Profit =
𝐧

1. It ignores time value of money.

2. It takes into account accounting profits rather than cash flows.

LOS No. 8: Net Profitability Index or Net PI

𝐍𝐏𝐕
Net PI =
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 / 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐎𝐮𝐭𝐟𝐥𝐨𝐰𝐬

Decision: Higher the Better.

LOS No. 9 : Project NPV/ Project IRR

Total Fund Approach / Overall
Equity Approach
Project Approach
Discount Rate Ke K0
Equity – Share Capital (Fund) +
Debenture + Long-term Loan +
Initial Outflow Equity Share Capital (Fund) Preference Share Capital
Or
Total Cost of Project
 1.4 CAPITAL BUDGETING

Operating Cash Cash Inflow available for overall

Cash Inflow available for equity
Inflows project
SV adjusted for Tax SV adjusted for Tax
Terminal Cash flows
Release of Working Capital Release of Working Capital
NPV that a project earns for the NPV that a project earns for the
NPV
equity share holders company as a whole.

Calculation of Project Cash Flows

Sale Price Per Unit xxx
- Variable Cost Per Unit xxx
Contribution Per Unit xxx
X No. of Unit xxx
Total Contribution xxx
- Fixed Cost xxx
EBDIT xxx
- Depreciation xxx
EBIT
- Tax xxx
NOPAT
Add : Depreciation xxx
CFAT xxx

Note 1 : Treatment of Depreciation

 [EBDIT – Depreciation] [1 – Tax Rate] + Depreciation
Or
 EBDIT (1 – Tax Rate) + Tax saving on Depreciation

Note 2 : Treatment of Interest Cost / Finance Cost

 Finance Cost are already reflected in the Projects required rate of return / WACC / Ko
 This shows that Interest on Long Term Loans as well as its Tax Saving is already considered
by Ko

Note 3 : Treatment of Working Capital

Time
• Introduction of Working Capital Outflow Year 0
• Release of Working Capital Inflow End of project Life

Working Capital should never be adjusted for tax as it is a balance sheet item. Working capital is
also not subject to depreciation.

Note 4 : Treatment of Tax

If we have loss in a particular year, there are two adjustments
1. Set-off : assumed the firm as other profitable business, Loss in a year generate tax savings in
that year.
2. Carry Forward : The company has an individual business or a new business having no other
operations, loss in a year will be carried forward to future years for the purpose of Set-off.

Note 5 : Key Points to Remember

1. Decisions are based on cash flows, not accounting income:
 1.5

❖ Consider INCREMENTAL CASH FLOWS, the change in cash flows that will occur if the
project is undertaken.
2. Sunk costs should not be included in the analysis.
❖ These costs are not effected by the accept/reject decisions. Eg. Consulting fees paid to a
marketing research firm to estimate demand for a new product prior to a decision on the
project.
3. Externities / Cannibalization
❖ When considering the full implication of a new project, loss in sales of existing products
should be taken into account & also consider positive effects on sale of a firm’s other
product line.
4. Cash flows are based on Opportunity Costs.
❖ Opportunity costs should be included in projects costs.
5. The timing of cash flows is important.
❖ Cash flows received earlier are worth more than cash flows to be received later.
6. Cash flows are analyzed on an after-tax basis.

Calculation of Equity Cash Flows

EBITDA xxx
- Depreciation & Amortization xxx
EBIT
- Interest xxx
EBT
- Tax xxx
PAT xxx
Add : Depreciation xxx
Less: Principal Repayment xxx
EQUITY CASH FLOWS xxx

Modified NPV/ IRR

 When Cost of Capital & Re-investment rate are separately given, then we calculate Modified
NPV.
 Modified IRR: It is the discount rate at which Modified NPV is Zero.
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
i.e. Modified NPV = - PV of Cash Outflow
(1+ 𝐾0 )𝑛

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
‘or’ PV of cash outflow =
(1+ 𝐾0 )𝑛

LOS No. 10: Calculation of Risk Adjusted NPV

 1.6 CAPITAL BUDGETING

Risk-Adjusted Discount Rate Method (RADR)

(1+ RADR) = (1+ Risk-free rate) (1 + Risk Premium)
Note:
➢ Under this method, Project should be discounted using risk- adjusted discount rate rather than
risk-free discount rate.
➢ Project having higher risk should be discounted with higher rate.
➢ Higher the risk of the project, higher should be the discount rate.
➢ NPV calculated by using RADR is known as “Risk Adjusted NPV”.
➢ CV is a measure of risk, higher the CV, higher the risk.
➢ Imagine the firm to be market portfolio, Ko can be treated as Rm
RADR = RF + Risk Index (Ko – RF)

Certainty Equivalent Co-efficient (CEC) Method

It involves discounting of certain Cash Flows instead of Total Cash Flows.
Steps involved:
Step 1: Calculate all cash flows arising from the project.
Step 2: Calculate certain cash flow by using CEC (Certainty Equivalent Co-efficient)
Certain Cash Flow = Cash Flow × CEC
Step 3: Compute NPV by taking certain risk-free Cash Flow and risk-free discount rate.
Note:
❖ Higher the CEC, lower the risk and vice-versa.
❖ CEC of cash flow arising in year 0 will always be One.

LOS No. 11: Inflation under Capital Budgeting

1. Cash Flow:

Conversion of Real Cash Flow into Money Cash Flow & Vice-versa

Money Cash Flow = Real Cash Flow (1 + Inflation Rate)n

Or
𝐌𝐨𝐧𝐞𝐲 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰
Real Cash Flow =
(𝟏+𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞)𝐧
 1.7

2. Discount Rate:

Conversion of Real Discount Rate into Money Discount Rate & Vice-versa

(1 + Money Discount Rate) = (1+ Real Discount Rate) ( 1+Inflation Rate)

3. NPV :

Note:
❖ Answer in both the case will be same.
❖ Depreciation is not affected by inflation rate as depreciation is changed on the book value of
the asset & not market value.

LOS No. 12: Replacement Decision

“Whether to repair existing machine”
Or
“Whether to replace the existing machine and buy new machine”

Case 1 : Life of new machine = Remaining Life of Old Machine

(We can apply incremental principle i.e. New – Old)

Initial Investment = Cost of New Machine – SV of Old Machine

Operating CF’s = CFAT from New Machine – CFAT from Old Machine
Terminal CF’s = SV from New Machine – SV from Old Machine

Case 2 : Life of new machine ≠ Remaining Life of Old Machine

We can’t apply incremental principle
Use equated Annual Annuity Approach (EAA)

Steps Involved:
Step 1: Calculate NPV or PV of cash inflow or PV of cash outflow of each project.
Step 2: Calculate equated annual amount by using this formulae:

NPV or PV of cash out flow or PV value of cash Inflow

=
PVAF (k%,n years)
 1.8 CAPITAL BUDGETING

LOS No. 13: Probability Distribution Approach

Expected NPV/ Expected Cash Flow / Expected Value

∑ 𝑵𝑷𝑽 × 𝑷𝒓𝒐𝒃𝒂𝒃𝒊𝒍𝒊𝒕𝒚
Standard Deviation:

σ =√∑[ 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 × (𝐆𝐢𝐯𝐞𝐧 𝐍𝐏𝐕 − 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐍𝐏𝐕)𝟐 ]

➢ Higher the S.D, Higher the risk & Vice-versa.

Co-efficient of Variation (CV):

𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧
CV =
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐍𝐏𝐕
➢ Higher the CV, higher the risk & vice-versa

LOS No. 14: Decision Tree Approach & Joint Probability

Type 1 : Moderately Correlated Cash Flows

➢ Decision Tree is a graphical representation of two or more than 2 years cash flows, which are
dependent to each other.
➢ Joint probability is the product of two or more than two dependent probabilities.
➢ The total of joint probabilities is always equal to 1.
➢ Joint probability is applicable in case of dependent cash flows.

Steps Involved:
Step 1: Identify the various paths or outcomes
Step 2: Compute joint probability.
Step 3: Compute NPV of each path.
Step 4: Compute Expected NPV.
 1.9

Type 2 : Perfectly Correlated Cash Flows

Type 3 : Hiller’s and Hertz’s Model

LOS No. 15: Scenario Analysis

➢ Scenario Analysis is an analysis of the NPV of a project under a series of specific
scenarios (worst, most likely and best scenario) based on macro-economics, industry and
firm-specific facto
➢ Under this, all inputs are set at their most optimistic or pessimistic or most likely levels and
NPV is computed.
➢ Decision is based on the NPV under all scenarios.

LOS No. 16: Sensitivity Analysis

➢ Also known as “What if” Analysis.
➢ Sensitivity Analysis is one of the methods of analyzing the risk surrounding the capital
expenditure Decision and enables an assessment to be made of how responsive the project’s
NPV is to changes in those variables based on which NPV is computed.
 1.10 CAPITAL BUDGETING

➢ Sensitivity Analysis is a tool in the hand of firms to analyze change in the project’s NPV for
a given change in one of the variables.
➢ Under this analysis we try to measure risk of each factor taking NPV=0.
➢ Key factors which are used to calculate NPV are as follows:
Inverse Effect
Cash Inflows Decrease
Cash Outflows Increase
Discount Rate Increase
Life of the project Decrease
➢ Decision Rule
 Management should pay maximum attention towards the factor where minimum
percentage of adverse changes causes maximum adverse effect.
Example:
 If NPV is to become Zero with 5% change in initial investment relative to 10% change in
cash inflows, project is said to be more sensitive to initial investment then to cash inflows.
Note:
Sensitivity Analysis is calculated for each factor separately, keeping other factors constant.

Method 1 : Margin of Safety Approach (MOS)

Set NPV = 0 & Calculate the Break Even Values and Margin of Safety for Each Factor

𝐂𝐡𝐚𝐧𝐠𝐞
Sensitivity (%) = × 100
𝐁𝐚𝐬𝐞

Decision : Most critical / Sensitive Factor is that Factor for which MOS is least.

Method 2 : Shock Approach

Shock each Risk Factor in the adverse direction like 10% / 20% & Find out the Revised NPV
or %age fall in NPV
𝐑𝐞𝐯𝐢𝐬𝐞𝐝 𝐍𝐏𝐕 − 𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐍𝐏𝐕
% Fall In NPV = × 100
𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐍𝐏𝐕

Decision : Most critical / Sensitive Factor is that Factor for which results in Maximum Fall in NPV.

LOS No. 17: Capital Rationing

➢ Capital rationing is the situation under which company is not able to undertake all +ve NPV
projects due to lack of funds.
➢ Firm must prioritize its capital expenditure with the goal of achieving the maximum increase in
value for shareholders.
➢ If the firm has unlimited access to capital, the firm can undertake all projects with +ve NPV.

Divisible Projects
Those projects which can be taken in parts
E.g. Construction of Flats.

Indivisible Projects
Those projects which cannot be taken in parts
E.g. Construction of Ship.
 1.11

Case I: Divisible Project

Steps Involved:
Step 1: Calculate NPV of each project.
Step 2: Identify whether capital rationing exists.
Step 3: Calculate Net Profitability Index or Profitability Index (PI) for each project.
Step 4: Rank the project
Step 5: Allocate money according to rank.

Case II: Indivisible Project

Steps Involved:
Step 1: Calculate NPV of each project.
Step 2: Identify whether capital rationing exists.
Step 3: Take possible combinations of projects taking into consideration limitation of funds.
Step 4: Select that combination which gives highest NPV.

LOS No. 18: Overall Beta/ Asset Beta/ Project Beta/ Firm Beta
Situation 1 :
100 % Equity Firm  Unlevered Firm

β Equity = β Assets = β Overall

Situation 2 :
Debt + Equity Firm  Levered Firm

β Levered = β Unlevered = β Overall = β Assets

➢Overall Beta of the companies belonging to the same industry/sector, always remain same.
➢Equity Beta and debt Beta may change with the change in Capital structure.
➢Overall Beta of a project can’t be changed with the change in capital structure of a particular
company.
➢According to MM, the change in capital structure doesn’t change the overall beta.
➢Debt is always assume to be risk free, so. Debt Beta = 0.
𝑬𝒒𝒖𝒊𝒕𝒚 𝑫𝒆𝒃𝒕 (𝟏−𝒕𝒂𝒙)
Overall Beta = equity Beta × + Debt Beta ×
𝑬𝒒𝒖𝒊𝒕𝒚+𝑫𝒆𝒃𝒕 (𝟏−𝒕𝒂𝒙) 𝑬𝒒𝒖𝒊𝒕𝒚+𝑫𝒆𝒃𝒕 (𝟏−𝒕𝒂𝒙)

Overall Cost of Capital/ Discount Rate

Cost of Capital (K o) = K e We + K d W d
K e = R f + β equity (R m – R f) K o = R f + β Overall (R m – R f)
Or OR (Only applicable when tax
K d = Interest (1 – tax rate) rate is missing)

Note:
❖If interest rate is not given, it is assumed to be equal to risk-free rate.
❖If Beta Debt is not given, it is assumed to be equal to Zero
❖If debt = 0
 1.12 CAPITAL BUDGETING

Overall Beta = Equity Beta

i.e. for 100% equity firm overall beta & equity beta is same

Estimating the project Discount Rate (Pure Play Technique)

CAPM can be used to arrive at the project discount rate by taking the following steps:
1. Estimate the project beta.
2. Putting the value of Beta computed above into the Capital Asset Pricing Model (CAPM) to
arrive at the cost of equity.
3. Estimate the cost of debt.
4. Calculate the WACC for the project.

Proxy Beta (If more than one comparable co. data is given)
➢Sometimes overall beta of similar companies belonging to same sector may be
slightly different.
➢In such case we use proxy beta concept by taking average of all the given companies.

LOS No. 19: Backward Decision Tree

❖ It is a graphical presentation of a decision making situation. We have branches coming out of

nodes.

Decision Nodes  From which this alternative will come out.

Choice Nodes  Certain outcome like High Demand or Low Demand or

success or failure will come out.

❖ The tree is drawn from left to right. However, calculation can be done from right to left.

At Every , Calculate expected value

At Every , Move towards best alternative.

 16.1

Miscellaneous Concepts
Study Session 16

LOS No. 3: Effective Yield under Money Market Operations

𝐅𝐕−𝐈𝐬𝐬𝐮𝐞 𝐏𝐫𝐢𝐜𝐞 𝟏𝟐
Effective Rate of Interest = × × 100
𝐈𝐬𝐬𝐮𝐞 𝐏𝐫𝐢𝐜𝐞 𝐑𝐞𝐪𝐮𝐢𝐫𝐞𝐝 𝐏𝐞𝐫𝐢𝐨𝐝

Cost of Funds:
Effective rate of Interest p.a
+ Brokerage p.a
+ Rating Charges p.a
+ Stamp Duty p.a
= Total cost of Funds p.a

LOS No. 4: Factoring

➢ Factoring is a new concept in financing of accounts receivables. This refers to out right sale of
accounts receivables to a factor or a financial agency.
➢ A factor is a firm that acquires the receivables of other firms. The factoring agency bears the
right of collection and services the accounts for a fee.
➢ Types of Factoring :

Non-Recourse Factoring & Recourse Factoring

a) Non-Recourse Factoring: Normally, factoring is the arrangement on a non-recourse basis
where in the event of default the loss is borne by the factor. i.e if there are bad debts, it will be
borne by the factor.
b) Recourse Factoring: In this type of factoring. the risk of bad debt is borne by the client and not
factor.

Type 1 : Cost Benefit Analysis

a) Benefits of Factoring
a) Reduction of Bad Debts
b) Reduction in Admin cost
c) Reduction in Debtors collection period which will reduce blockage of funds and will save
our opportunity cost of interest (Early Recovery)
d) If company is dependent on Over Draft then it can save interest, if company receives
advance from Factor.

b) Cost of Factoring
a) Commission / brokerage
b) Interest paid to Factor if advances taken

Net Benefit of Factoring

Decision :
 16.2 MISCELLANEOUS CONCEPTS

If net benefit if positive company should go for factoring arrangement.

𝐷𝑒𝑏𝑡𝑜𝑟𝑠
Debtors collection period =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
Type 2 : Effective Cost of Factoring (%age)

𝑁𝑒𝑡 𝐶𝑜𝑠 𝑜𝑓 𝐹𝑎𝑐𝑡𝑜𝑟𝑖𝑛𝑔

Effective Cost of Factory = × 100
𝑁𝑒𝑡 𝐴𝑑𝑣𝑎𝑛𝑐𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑒𝑑

a) Net Advance received from factor

Annual Credit Sale × DCP = Debtors amount received in advance xxx
- reserve required xxx
- commission charged xxx
Amount of advance xxx
- Interest on amount of advance xxx
Net advance received from factor xxx

b) Net cost of factoring

Factor commission xxx
+ interest cost xxx
- Bad Debt saved xxx
- admin cost saved xxx
Net cost of factoring xxx

LOS No. 6: Right Shares

Right Shares are those shares which are issued to existing shareholders at a price which is
normally less than Current Market Price.
Choice before Shareholder in respect of Right Effect on Shareholder’s wealth
Issue
1. Exercise his rights and subscribe for Right No change in wealth
shares.
2. Do not exercise Decrease in Wealth
3. Sell the rights in the market. No change in wealth
4. Exercise his right for few shares and sell the No change in wealth
balance rights in the market.
Theoretical Post Right (Ex-Right) Price per share =
𝐌𝐏𝐒 𝐂𝐮𝐦 𝐑𝐢𝐠𝐡𝐭×𝐄𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐍𝐨.𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬+𝐑𝐢𝐠𝐡𝐭 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞/𝐎𝐟𝐟𝐞𝐫 𝐏𝐫𝐢𝐜𝐞×𝐍𝐨.𝐨𝐟 𝐑𝐢𝐠𝐡𝐭 𝐒𝐡𝐚𝐫𝐞 𝐢𝐬𝐬𝐮𝐞𝐝
𝐄𝐱𝐢𝐬𝐭𝐢𝐧𝐠 𝐍𝐨.𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐒𝐡𝐚𝐫𝐞𝐬+𝐍𝐞𝐰 𝐍𝐨.𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬

LOS No. 7: Calculation of EMI(Equated Monthly Installment)

Amount of loan
EMI, if installment is paid at the end of each month = r%
PVAF [ ,n ×12]
12
 16.3

Amount of loan
EMI, if installment is paid at the beginning of each month = r%
1+ PVAF [ ,(n ×12−1)]
12

LOS No. 8: Consumer Finance

𝑃 (1+𝑛𝑓)
Calculation of EMI =
𝑁
P = Loan Amount
n = No. of Years
f = Flat rate of interest
N = No. of Installments
Effective Annual Cost
𝑁
a) At the end of each month = 2 𝑓
𝑁+1
𝑁
b) At the beginning of each month = 2 𝑓
𝑁−1

LOS No. 10: Venture Capital Investing

➢ Venture Capital Investments are private, non-exchange-traded equity investments in a Business
Venture.

➢ Investments are usually made through limited partnerships, with investors anticipating relatively
high returns in exchange for the illiquidity and high-risk profile of a venture capital investments.

Stages of Venture Capital Investing:

Seed Stage:
Investors are providing Capital in the early stage of the business and may help fund research and
development of product ideas.

Early Stage:
Start-up Financing refers to Capital use to complete Product Development and fund initial
marketing Efforts.
First-Stage Financing refers to funding to commercial production and sales of the product.

Later Stage: Major Expansion of the Company.

Note:
1. Conditional probability of failure i.e. 22% in 3rd Year refers to the probability of failing in the 3rd
year provided success in the 1st and 2nd Year.
2. Joint probability of failure cannot be calculated as joint probability of success because if failure
in 1st Year cannot go in 2nd Year.

LOS No. 11: Moving Averages

 16.4 MISCELLANEOUS CONCEPTS

➢ Two types of moving Average are:

AMA (Arithmetic Moving Average)
EMA (Exponential Moving Average)
AMA
Example:
Day 1 Closing Price
1 40
2 45
3 39
4 42
5 48
6 43
7 52
8 47
9 45
10 38
Calculate 5 day’s AMA?
Solution:
Day1 Closing Price 5 Days AMA
1 40 -
2 45 -
3 39 -
4 42 -
5 48 42.80
6 43 43.40
7 52 44.80
8 47 46.40
9 45 47
10 38 45
EMA
EMA today = EMA Yesterday + a × [Price today - EMA Yesterday]
Note:
a = Exponent/ Multiplier/ Smoothing Constant.
‘a’ will always be given in question, however ‘a’ can also be calculated by using following relation:
𝟐
a=
𝟏+𝐏𝐞𝐫𝐢𝐨𝐝

LOS No. 12: Index Formation

Market Capitalization Weighting:
A market Capitalization weighted index is calculated by summing the total value [Current stock
price times the no. of shares outstanding) of all the stocks in the index.
➢ This sum is then divided by a similar sum calculated during the selected base period.
➢ The ratio is then multiplied by the indexer’s base value)typically 100)

Current Index Value

Current Total Market Value of Index stock
= × Base year index value
Base year total Market value of index stock
 16.5

Example:
If the total market value of the index portfolio on Dec. 31st and Jan 31st are $ 80 million, and
& 95 million, respectively, the index value at the end if January is

$ 95 million
= × 100 = 118.75
$ 80 million
Thus,
118.75−100
Market capitalization – Weighted index percentage return is = × 100 = 18.75%
100

LOS No. 13 : MM Approach (IRRELEVANCE THEORY)

Dividends do not play any role in determination of market value. Market value is rather affected by
earnings and investment.
Formulae:
(𝒏+𝒎)×𝑷𝟏 +𝑬𝟏 −𝐈𝟏
nP0 =
(𝟏+ 𝑲𝒆 )𝟏
n = Existing number of equity shares at the beginning of the year
m = New number of equity shares, issued at year end market price
P0 = Current market price as on today
P1 = Market price per share at the end of year one
E1 = Total earning at the end of year one
I1 = Total investment at the end of year one
Ke = Cost of equity
nP0 = Market value of the company as on today
n+m = Total no of equity share at the end (old + new share)
(n + m)P1 = Total market value of the company at the end.
Amount raised by issue of new equity shares = Investment – [Earning – Dividend]
Assumption:
Funds can raise only by equity & retained earnings.
Note:

➢ The Market Price of a share = PV of dividend paid at end + PV of market price at the end
at the beginning of a period

𝑷𝟏 +𝑫𝟏
P0 =
(𝟏+ 𝑲𝒆 )𝟏

Calculate P1 from this formulae.

➢ New number of equity share
𝐈𝟏 − ( 𝐄𝟏 −n𝐃𝟏 ) 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝟏 − ( 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬𝟏 − 𝐧× 𝐃𝐏𝐒𝟏 )
m= or m =
𝐏𝟏 𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐚𝐭 𝐭𝐡𝐞 𝐄𝐧𝐝(𝐏𝟏 )

Los No. 15: Chop-Shop Method

 16.6 MISCELLANEOUS CONCEPTS

➢ This approach attempts to identify multi-industry companies that are undervalued and would
have more value if separated from each other. In other words as per this approach an attempt
is made to buy assets below their replacement value.

➢ This approach involves following three steps:

Step 1: Identify the firm’s various business segments and calculate the average capitalization
ratios for firms in those industries.

Step 2: Calculate a “theoretical” market value based upon each of the average capitalization
ratios.

Step 3: Average the “theoretical” market values to determine the “chop-shop” value of the
firm.

Example:
Capital/ Sales Ratio = 0.75
Sales = 15,00,000
Calculate Capitalized Value?

Solution:

Capital
= 0.75
Sales

Capitalized Value = Sales × 0.75

= 15,00,000 × 0.75 => 11,25,000