ADVANCED FINANCIAL MANAGEMENT CA.

DINESH JAIN

ADVANCED FINANCIAL
MANAGEMENT

LEARN CONCEPTS WITH

MCQ/EXAMPLES

FOR CA FINAL NEW

SYLLABUS [MAY 2024
ONWARDS]

BY CA. DINESH JAIN

DEDICATED TO MY LOVABLE
FATHER [RAMESH JAIN]

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TABLE OF CONTENTS
Chapter 2 – Risk Management .................................................................................. 3
Chapter 3 – Advanced Capital Budgeting Decisions ............................................ 5
Chapter 4 – Security Analysis .................................................................................. 24
Chapter 5 – Security Valuation................................................................................ 28
Chapter 6 – Portfolio Management ......................................................................... 71
Chapter 8 – Mutual Funds ........................................................................................ 90
Chapter 9 - Derivatives Analysis and Valuation ............................................... 102
Chapter 10 – Foreign Exchange Exposure and Risk Management ................. 127
Chapter 11 – International Financial Management ........................................... 160
Chapter 12 – Interest Rate Risk Management .................................................... 165
Chapter 13 – Business Valuation .......................................................................... 176
Chapter 14 – Mergers, Acquisitions and Corporate Restructuring ................ 194
Summary Theory Notes .......................................................................................... 209

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Chapter 2 – Risk Management

1. What is Value at Risk?

• The VAR concept serves as a valuable tool in risk management by providing insights into the
potential maximum loss under adverse scenarios. The magnitude of this loss is contingent upon
the risk associated with the investment, a metric gauged through the standard deviation.
Loss for a single day = Amount invested x Daily SD x Multiple for respective confidence
level
Loss for 20 days = Daily loss x √𝟐𝟎
Loss for 250 days = Daily loss x √𝟐𝟓𝟎
• To obtain the final Value at Risk, a crucial parameter is introduced—namely, the confidence level.
The final calculation incorporates this factor as follows:
• Multiple for 95% confidence level is 1.65 and 99% confidence level is 2.33
Example:
Suppose you hold worth 2 crore shares of X Ltd. whose market price standard deviation is 2% per day.
Assuming 252 trading days a year, determine maximum loss level over the period of 1 trading day and 10
trading days with 99% confidence level.
Answer:
• Loss for single day = Rs.2 crores x 2% x 2.33 = Rs.9.32 lacs
• Loss for ten days = 9.32 lacs x √10 = Rs.29.47 lacs

2. Daily SD vs Monthly SD vs Annual SD

• Let us assume a month consist of 20 trading days. Hence monthly SD and daily SD from Annual
SD is computed as under
Annual SD
Monthly SD = (𝑜𝑟)Annual SD = Monthly SD x √12
√12
Monthly SD
Daily SD = (𝑜𝑟)Monthly SD = Daily SD x √20
√20
• The crucial point to note is that when converting between monthly and annual standard deviation,
it is incorrect to simply multiply or divide by 12. Instead, the formula requires the use of the
square root of 12.
Example:
You own a portfolio of 10 crores. The daily standard deviation is 2%. What will be the loss for 10 days at
95 percent confidence interval?
a. Rs.104.36 lacs
b. Rs.63.25 lacs
c. Rs.330 lacs
d. Rs.200 lacs
Answer:
Portfolio = 1,000 lacs; Daily SD = 1,000 lacs x 2% = Rs.20 lacs
Daily loss = 20 lacs x 1.65 = Rs.33 lacs
Loss for ten days = Rs. 33 lacs x √10 = Rs. 104.36 lacs
You are holding portfolio of Rs.1,00,000. The standard deviation is 21% per annum. What is monthly VAR
at 99% confidence level?
a. Rs.1,750
b. Rs.4077.50
c. Rs.6,062
d. Rs.14,125
Answer:
Annual SD = 1,00,000 x 21% = Rs.21,000
Monthly SD = 21,000 x √12 = Rs. 6,062.18
Monthly VAR = 6,062.18 x 2.33 = Rs.14,125

3. Reverse working of amount to be invested with target VAR

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• Certain questions may present a target VAR (Value at Risk) that necessitates computation of the
amount to be invested. In such cases, we can assume the initial amount invested as 'X' and
subsequently calculate the same
Example:
Acceptable loss = Rs.2,33,000. Standard deviation of the security is 1.5 percent per day. What is the
maximum acceptable investment where VAR should not exceed acceptable loss? The required confidence
level is 99 percent and the investment is to be done for 9 days.
a. Rs.66,66,667
b. Rs.22,22,222
c. Rs.7,40,741
d. Rs.1,00,00,000
Answer:
Daily SD = 1.50%; SD for 9 days = 1.5% x √9 = 4.50%
Multiple for 99 percent confidence = 2.33
Value at risk = 4.5% x 2.33 x Amount of investment
2,33,000 = 4.5% x 2.33 x Amount of investment
1,00,000
Amount of investment = = Rs. 22,22,222
4.5%

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Chapter 3 – Advanced Capital Budgeting Decisions

Techniques of Capital
Budgeting

Discounted Profitability
Payback NPV ARR IRR
Payback Index

On Average
Investment

On Initial
Investment

1. Payback Method
• Payback refers to the number of years taken to recover the initial investment. It ignores time value
of money
𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 + ( )
𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
Note: Base year refers to the last year in which cumulative cash flow is negative
Example:
A project is likely to generate following cash flows. Compute the payback period?
Year Cash flow
0 -10,00,000
1 4,50,000
2 5,00,000
3 2,50,000
4 2,00,000
Answer:
Year Cash flow Cumulative Cash Flow
0 -10,00,000 -10,00,000
1 4,50,000 -5,50,000
2 5,00,000 -50,000
3 2,50,000 2,00,000
4 2,00,000 4,00,000
Unrecovered cash flow of Base Year 50,000
Payback = Base Year + =2+ = 𝟐. 𝟐𝟎 𝐲𝐞𝐚𝐫𝐬
Cash flow of next year 2,50,000

2. Discounted Payback Method

• Discounted payback refers to the number of years taken to recover the initial investment. It
considers time value of money
Unrecovered discounted cash flow of base year
Discounted Payback = Base year + ( )
Discounted cash flow of next year
Note: Base year refers to the last year in which cumulative cash flow is negative
Example:
A project is likely to generate following cash flows. Compute the discounted payback period if cost of
capital is 10%?
Year Cash flow
0 -10,00,000
1 4,50,000
2 5,00,000
3 2,50,000
4 2,00,000
Answer:

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Year Cash flow PVF @ 10% DCF Cumulative DCF
0 -10,00,000 1.000 -10,00,000 -10,00,000
1 4,50,000 0.909 4,09,050 -5,90,950
2 5,00,000 0.826 4,13,000 -1,77,950
3 2,50,000 0.751 1,87,750 9,800
4 2,00,000 0.683 1,36,600 1,46,400
Unrecovered discounted cash flow of Base Year 1,77,950
Payback = Base Year + =2+ = 𝟐. 𝟗𝟓 𝐲𝐞𝐚𝐫𝐬
Discounted cash flow of next year 1,87,750

3. Net Present Value [Most Commonly Used Method]

• NPV is the excess of Present value of cash inflows over present value of cash outflows
• NPV = PV of cash inflows – PV of cash outflows
Example:
A project with an initial investment of Rs.50,000 generates annual cash inflows of Rs.15,000 for the next
five years. The discount rate for the project is 10%. How much is the NPV of the project?
a. Rs.25,000
b. Rs.6,865
c. Rs.10,000
d. Rs.15,000
Answer:
• NPV = PV of inflows – PV of outflows
• NPV = 15,000 x PVAF (10%,5) – 50,000 = (15,000 x 3.791) – 50,000 = Rs.6,865

4. Profitability Index (or) Benefit Cost Ratio (or) Present Value Index (or) Desirability factor
• It is a ratio of PV of cash inflows (benefits) as compared to present value of cash outflow (cost)
PV of cash inflow
PI =
PV of cash outflow
• PI can be expressed both in times and in percentage
Example:
NPV of the Project = Rs.2,00,000; Initial Outflow = Rs.10,00,000. How much is the Profitability Index?
a. 0.80 Times
b. 1.00 Times
c. 0.20 Times
d. 1.20 Times
Answer:
• NPV = PV of inflow – PV of outflow; 2,00,000 = PV of inflow – 10,00,000
• PV of inflow = Rs.12,00,000
PV of cash inflow 12,00,000
PI = = = 𝟏. 𝟐𝟎 𝐓𝐢𝐦𝐞𝐬
PV of cash outflow 10,00,000

5. Accounting Rate of Return

• It is the ratio of Average PAT to initial investment (or) average investment
Average PAT
ARR on Initial Investment = x 100
Initial Investment
Average PAT
ARR on Average Investment = x 100
Average Investment
Opening Investment + Closing Investment
Average Investment =
2
Closing Investment = Salvage Value
Example:
Initial investment = Rs.5,00,000; Salvage value = Rs.1,00,000; Average PAT = Rs.1,00,000. How much is
the ARR on average investment?
a. 20.00%
b. 40.00%
c. 16.67%
d. 33.33%

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Answer:
Average PAT 1,00,000
ARR on average investment = 𝑥 100 = 𝑥 100 = 𝟑𝟑. 𝟑𝟑%
Average Investment 3,00,000
Opening invt + Closing invt 5,00,000 + 1,00,000
Average investment = = = 3,00,000
2 2

6. Internal Rate of Return

• IRR is the rate of return earned by the project considering time value of money. This technique
also focuses on cash flows
• IRR is the rate of return (Discount rate) at which NPV of the project is zero

NPV IRR
Positive IRR is greater than Discount rate
0 IRR = Discount rate
Negative IRR is less than Discount rate

Steps in computation of IRR:

• In order to calculate IRR, it is essential to have two discounting rates. If these rates are provided
in the question, utilize them; otherwise, it becomes necessary to make an initial assumption or
guess rate and proceed.
• Compute the Accounting Rate of Return (ARR) based on the Average Investment. The initial guess
rate can be set at 2/3 of ARR on Average Investment
• Increase the discount rate if we get positive NPV and decrease the discount rate if we get negative
NPV. Repeat step we get one positive NPV and one negative NPV
NPV at L1
IRR = L1 + ( x (L2 − L1 ))
NPV at L1 − NPV at L2
Note:
• L1 = Lower discount rate
• L2 = Higher discount rate
Short-method for computation of IRR:
• There is only one outflow and number of years are 2,4,8,16….then we can use the below formula
FV = PV x (1 + r)n
• In the above equation, r would be equal to IRR

Future cash flows are perpetual:

Perpetuity Amount
Present Value =
Rate of Interest − Growth Rate

Example:
NPV at discounting rate of 10% = Rs.1,250 and NPV at discounting rate of 11% = -Rs.200. IRR of the
proposal is ________
a. 11.86%
b. 10.86%
c. 9.87%
d. 11.96%
Answer:
1,250
IRR = 10 + x (11 − 10) = 10 + 0.86 = 10.86%
1,250 − (−200)
Example:
Initial Outlay of Project = Rs.50,000, Cost of capital = 12.00%; Life of the project = 4 years. Aggregate future
value of cash inflows = Rs.1,04,896.0. How much is the MIRR of the proposal?
a. 20.35%
b. 21.53%
c. 31.25%
d. 12.25%
Answer:
FV (inflow) = PV (outlflow)x (1 + r)n

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1,04,896.50 = 50,000 x (1 + r)4
2.09793 = (1 + r)4 ; (1 + r) = 1.2035; 𝐇𝐞𝐧𝐜𝐞 𝐌𝐈𝐑𝐑 = 𝟐𝟎. 𝟑𝟓%
Example:
Annual cost saving = Rs.40,000; IRR = 15%; Profitability Index = 1.064 Times; How much is the NPV of the
Project?
Answer:
• IRR is the rate of return at which NPV of the project is zero
• Cost of Project = PV of inflow = 40,000 x PVAF (15%, 4 years) = 40,000 x 2.855 = Rs.1,14,200
PV of inflows
Profitability index =
PV of outflows
PV of inflows
1.064 = ; 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 = (𝟏, 𝟏𝟒, 𝟐𝟎𝟎 𝐱 𝟏. 𝟎𝟔𝟒) = 𝐑𝐬. 𝟏, 𝟐𝟏, 𝟓𝟎𝟗
1,14,200
𝐍𝐏𝐕 = 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰 − 𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰 = 𝟏, 𝟐𝟏, 𝟓𝟎𝟗 − 𝟏, 𝟏𝟒, 𝟐𝟎𝟎 = 𝐑𝐬. 𝟕, 𝟑𝟎𝟗

7. What discount rate to be used for project evaluation?

• Cost of capital specific to the project is generally the discount rate for project evaluation
• Cost of capital can change in case of revision in investor expectation. For instance, cost of capital
can be 10% for year 1 and increase by 2% for every year.
1
PVF of year 1 = = 0.909
1 + Discount rate of year 1 (10%)
0.909
PVF of year 2 = = 0.812
1 + Discount rate of year 2 (12%)
0.812
PVF of year 3 = = 0.712
1 + Discount rate of year 3 (14%)
0.712
PVF of year 4 = = 0.614
1 + Discount rate of year 4 (16%)
Care should be taken to take the previous year discount factor and then divide by (1 + Discount rate of
next year)
Example:
A is working on a capital project valuation and needs to determine the appropriate discount rate. She has
the following information available:
• Risk-free-rate = 8%
• Market Beta = 1.0
• Company Beta = 1.1
• Project Beta = 1.2
• Expected market return = 13%
• Trailing 12-months market return = 12%
Which of the following is closest to the most appropriate discount rate?
a. 13.5%
b. 13.0%
c. 14.0%
d. 12.8%
Answer:
• Discount rate = Risk-free rate + Project Beta x (Market return – Risk-free rate)
• Discount rate = 8% + 1.20 x (13.0% – 8%) = 14.00%
• We will have to use the expected market return as Return of market in the formula
Example:
Discount rate for year 1 = 15%. Discount rate increases by 1% per year. What will be the PVF for year 3?
a. 0.624
b. 0.675
c. 0.641
d. None of the above
Answer:
1
PVF of year 1 = = 0.870
1.15

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PVF of year 1 0.870
PVF of year 2 = = = 0.750
1 + DR of year 2 1.16
PVF of year 2 0.750
PVF of year 3 = = = 𝟎. 𝟔𝟒𝟏
1 + DR of year 3 1.17

8. Rules for computation of Cash flows

• Depreciation: Depreciation, while being a non-cash item, holds significance in cash flow analysis
due to its impact on tax savings. Since depreciation is tax-deductible, the tax benefits derived
from it should be incorporated into cash flow calculations.
• Opportunity Cost: Opportunity cost, representing the value of the next best alternative or the
benefits foregone, must be factored into cash flow calculations. Example: Rent on owned
buildings, Salary of Proprietor
o Opportunity cost given is pre-tax - Deduct before PBT computation
o Opportunity cost given is post-tax – Deduct after PAT computation
• Sunk Cost: Sunk costs, being historical and already incurred, should be ignored in cash flow
computations. Example: Market survey expense, Feasibility study, Research and Development
Cost
• Overheads:
o Apportioned/General/Corporate overheads = Irrelevant
o Specific/Incremental overheads = Relevant
• Working Capital: Changes in working capital have a direct impact on cash flows. An increase in
working capital signifies an outflow, while a decrease denotes an inflow of cash
• Reward Exclusion Principle: Cash flows between the owner (Equity shareholder, Preference
Shareholder, and debenture holder) and the company, such as interest, equity dividends, loans
repaid, and loans taken, should be excluded from cash flow calculations.
• Incremental Principle: When conducting NPV analysis, focus solely on incremental cash flows,
calculated as the cash flow post-project minus the cash flow before the project. This incremental
approach ensures a more accurate assessment of the project's financial viability.
Simple rule for finding a relevant item:
Example 1:
A company will incur marketing expenses of Rs.40,00,000 if they take up a new project. However, the same
will not be incurred in case they are not doing the project
Project

Yes No

Dont
Incur
incur
•In above example, it is a relevant item as the amount varies based on whether we do the project
or not.
Example 2:
A company has incurred market survey expense of Rs.10,00,000 for a new project.
Project

Yes No

Already Already
incurred incurred
In above example, it is an irrelevant expense as the amount does not vary based on whether we do the
project or not.
Example:

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A new project has been apportioned factory overheads of Rs.100 lacs. Factory overheads include
apportionment of general factory overheads except to the extent of insurance charges of Rs.90 lakh per
annum payable on this venture. How much is the relevant factory overhead cost?
a. Rs.100 lacs
b. Rs.90 lacs
c. Rs.10 lacs
d. Rs.190 lacs
Answer:
Relevant Overhead cost = Rs.90 lacs which is specific to this project
Example:
The initial working capital invested in the project amounts to Rs.20,00,000. In the first year, it is anticipated
to rise to Rs.25,00,000, and in the second year, it is expected to decrease to Rs.22,00,000. How much is the
working capital adjustment in year 1 and 2?
a. Outflow of Rs.5,00,000 and Rs.2,00,000 in year 1 and 2 respectively
b. Outflow of Rs.5,00,000 in year 1 and inflow of Rs.3,00,000 in year 2
c. Inflow of Rs.5,00,000 and Rs.2,00,000 in year 1 and 2 respectively
d. Inflow of Rs.5,00,000 in year 1 and outflow of Rs.3,00,000 in year 2
Answer:
Outflow of Rs.5,00,000 in year 1 and inflow of Rs.3,00,000 in year 2
• Working capital has increased in year 1 and hence the same is an outflow of Rs.5,00,000 in year 1
• Working capital has decreased by Rs.3,00,000 in year 2 and hence the same is an inflow in year 2
Example:
The company has invested Rs.2,00,000 in conducting a market survey to assess the market response to its
new product. In accordance with the survey findings, the company intends to spend Rs.10,00,000 towards
machinery and Rs.4,00,000 towards working capital. How much is the initial outflow of the project?
a. Rs.14,00,000
b. Rs.16,00,000
c. Rs.12,00,000
d. Rs.10,00,000
Answer:
Rs.14,00,000
• Market survey expense is a sunk cost and hence irrelevant
• Total outflow = Rs.10,00,000 + Rs.4,00,000 = Rs.14,00,000
Example:
The hospital is contemplating the acquisition of a diagnostic machine, which is expected to generate an
after-tax cash flow of Rs.80,000. Currently, the hospital is outsourcing the diagnostic work and earning
commission income of Rs.20,000. The applicable tax rate for these financial considerations is 40%. How
much is the incremental CFAT due to the new machine?
a. Rs.60,000
b. Rs.1,00,000
c. Rs.68,000
d. Rs.36,000
Answer:
Rs.68,000
• Incremental CFAT = 80,000 – Opportunity cost of Rs.12,000 = Rs.68,000
• Commission income is an opportunity cost and the post-tax commission income currently is
Rs.12,000 (20,000 – 40%)
Example:
A company follows block of assets method of depreciation and it has several other machines in the block.
The company is selling an existing machine with book value of Rs.3,00,000 for Rs.5,00,000. It will purchase
a new machine for Rs.10,00,000. Depreciation rate is 10% and tax rate is 40%. How much is the tax paid on
sale and incremental depreciation in year 1?
a. Rs.80,000 (tax paid) and depreciation of Rs.70,000
b. Nil tax paid and depreciation of Rs.70,000
c. Rs.80,000 (tax paid) and depreciation of Rs.50,000
d. Nil tax paid and depreciation of Rs.50,000
Answer:

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Nil tax paid and depreciation of Rs.50,000
• Company will not pay tax as there are other assets in the block
• Incremental WDV of the block = 10,00,000 – 5,00,000 = Rs.5,00,000
• Incremental depreciation = 5,00,000 x 10% = Rs.50,000

9. Steps in computation of cash flows

Step 1: Initial Outflow
Particulars Amount
Capital expenditure (XXX)
Working capital (XXX)
Total outflow (XXX)
Note:
• There may be some other items of initial outflow such as installation charges, compensation etc.
• We should capture only the amount which has been paid on day 0 in initial outflow. It is possible
that entire purchase price of machine is not paid on day 0. In that case balance amount paid would
be reflected in step 2 (in-between cash flow)

Step 2: In-between cash flows:

Particulars Amount
Incremental Revenues XXX
Incremental cost savings XXX
Less: All costs other than depreciation (XXX)
Profit before depreciation and tax (PBDT) XXX
Less: Depreciation (XXX)
Profit before Tax (PBT) XXX
Less: Tax (XXX)
Profit after Tax (PAT) XXX
Add: Depreciation XXX
Cash flow after tax (CFAT) XXX
Add/Less: Increase/decrease in Working capital XXX
Less: Purchase of additional machinery / payment for original machine (XXX)
Revised CFAT XXX
• Incremental means only the extra revenue generated or extra cost incurred will be considered for
cash flow. This is because company would have earned some revenue even without the new
project

Step 3: Terminal flow:

Particulars Amount
Net salvage value of capital expenditure (Note 1) XXX
Recapture of working capital XXX
Total terminal flow XXX

Note 1: Calculation of Net Salvage Value:

Particulars Amount
Sale value XXX
Less: Book value (XXX)
Capital gain/loss XXX
Tax Paid/saved XXX

Net salvage value (Sale value + Tax saved – Tax Paid) XXX

Step 4: Consolidate the cash flows in the below format and calculate appropriate technique (assuming
life of 5 years):
Year Cash flow
0 Step 1
1 Step 2
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2 Step 2
3 Step 2
4 Step 2
5 Step 2 + Step 3
Examples on computation of Net Salvage Value:
Particulars Example 1 Example 2 Example 3
Sale value 1,00,000 50,000 -
Less: Book value 50,000 50,000 50,000
Capital gain/loss 50,000 - -50,000
Tax paid/saved @ 40% -20,000 - 20,000

Net Salvage Value

[SV +/- Tax] 80,000 50,000 20,000
Note:
• If Sale value is equal to book value, then there is no tax and hence sale value is equal to net salvage
value
• If tax is to be ignored on capital gain, then sale value = Net Salvage Value
• If sale value is 0, it does not mean NSV is zero (Refer Example 3)
• If resale value is equal to cost of removal, then sale value is equal to zero.

Block of Assets Method:

• Under Block of Assets Method, STCL/STCG will not arise unless all assets of that block are sold
(or) the value of block becomes negative
• Depreciation will be calculated on (Existing Block value + Addition - Deletion)
Example:
ABC Limited is considering the replacement of its outdated machine with a new automatic machine,
specifically Model A, which comes with a price tag of Rs.5 lakhs. The existing machine holds a salvage
value of Rs.1 lakh. As part of the upgrade, all current utilities must be replaced with new ones incurring
an additional cost of Rs.2 lakhs. However, the old utilities are expected to yield a salvage value of Rs.0.20
lakhs. How much is the initial outflow?
a. Rs.5,00,000
b. Rs.5,80,000
c. Rs.7,00,000
d. Rs.6,00,000
Answer:
• Initial outflow = Purchase price of new machine + Utilities purchased – Sale value of existing
machine – sale value of utilities
• Initial outflow = 5,00,000 + 2,00,000 – 1,00,000 – 20,000 = Rs.5,80,000
Example:
The company is considering the installation of a new machine that would result in material cost savings
of Rs.2,00,000 and labor cost savings of Rs.4,00,000. Additionally, there will be maintenance costs
associated with the machine amounting to Rs.3,00,000. The machine itself, with a lifespan of 5 years, has a
cost of Rs.10,00,000. How much is the annual CFAT if tax rate is 30%?
a. Rs.3,00,000
b. Rs.3,30,000
c. Rs.2,70,000
d. Rs.2,00,000
Answer:
Particulars Amount
Saving in cost 6,00,000
Less: Maintenance cost -3,00,000
PBDT 3,00,000
Less: Depreciation -2,00,000
PBT 1,00,000

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Less: Tax @ 30% -30,000
PAT 70,000
Add: Depreciation 2,00,000
CFAT 2,70,000
Example:
The company presently incurs a cost of Rs.2 per tonne to dispose of 1,00,000 tonnes of waste. However, it
has identified an alternative approach to process the waste, enabling it to sell the processed waste at Rs.20
per tonne. The processing cost is Rs.15 per tonne. How much is the annual cash flow to be considered in
evaluation of project? Ignore tax
a. Rs.5,00,000
b. Rs.3,00,000
c. Rs.7,00,000
d. Rs.17,00,000
Answer:
Cash flow = 1,00,000 x (20 – 15) + cost saving of 2,00,000 (1,00,000 x 2) = Rs.7,00,000

10. Asset purchase at beginning of year

• Capital budgeting assumes that cash flows will happen at end of year. However, some assets could
be purchased at beginning of the year and these cash flows will be considered in the earlier year.
• Example: Purchase of asset at beginning of year 5 is equal to end of year 4 and this cash flow will
be considered in year 4

11. Impact of losses

• Losses can save taxes as they are set-off against profits of the company
• Immediate set-off is possible if there are other businesses where company is making profits – Tax
saving will be considered as inflow in the year of loss
• Carry forward of losses and set-off against future profits in other scenarios - In this no tax saving
considered in year of loss and lower tax will be considered in year of set-off.
Example:
Following is taken from income statement of a company:
Particulars Year 1 Year 2 Year 3 Year 4
Profit before tax -80,000 50,000 1,20,000 1,10,000
Tax rate = 30%. The loss of any year will be set-off from the profits of subsequent two years. How much is
the Profit after tax of year 3?
a. 1,20,000
b. 84,000
c. 93,000
d. 63,000
Answer:
Rs.93,000
• PAT of year 3 = PBT – Tax paid of year 3
• PAT of year 3 = 1,20,000 – 27,000 = Rs.93,000
Note: Taxable income of year 3 is Rs.90,000 as there is carry forward loss of Rs.30,000 at end of year 2. Tax
paid on Rs.90,000 is Rs.27,000 (90,000 x 30%)

12. Tax Exemption for specific % of Profits

• Effective Tax Rate = Normal Tax Rate x (1 - Exemption %)
Example:
• Tax rate is 40%. 25% of the profits are exempt.
• Effective Tax Rate = 40% x (1 – 25%) = 30.00%
• Hence in this situation we should compute taxes at effective tax rate of 30%

13. Expenses not paid in the year of incurrence

• If an expense is not paid in the year of incurrence, then it would not impact the cash flow.
However, this has tax impact. Hence, we should consider it is an expense in computing PBT and
pay tax on the same.
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• Unpaid expense will be reflected as current liability and hence would be factored in working
capital adjustment

14. Treatment of Subsidy/Government Grant

Subsidy/
Grant

Capital Revenue
Grants Grant

Adjust with cost of Not adjusted with the

Taxable Exempt
asset cost of the asset

Note:
• Question will not clearly specify the treatement for capital grants and we will have to take an
assumption and proceed. If the grant is adjusted with the cost of the asset, then it will lead to
lower depreciation expense

15. Concept of utility value [Not a very logical concept but one problem is there in ICAI Material]
• A project has the potential to yield multiple cash flows, each associated with a given probability.
Each cash flow carries a corresponding utility value
• The utility value of a project is determined by calculating the weighted average of the various
utility values assigned to its cash flows
• Decision: We should select a project having higher utility value

16. FCFF vs FCFE Approach

Approach Cash flow used Discount rate NPV IRR
Long-term funds (D+E+P) FCFF Cost of capital Project NPV Project IRR
Equity shareholders approach FCFE Cost of equity Equity NPV Equity IRR
Note:
• We normally follow FCFF approach for evaluating a project and compute Project NPV by
discounting cash flows at cost of capital
• However, if there are two projects and one project has some financial benefit over other like
lower interest rates, then we should factor the financial benefits in analysis and follow FCFE
approach.
• In FCFE approach we will have to reduce interest and its tax benefit from cash flows and
repayments are also considered in computation of cash flows. FCFE cash flows is discounted at
cost of equity to compute Equity NPV
Example:
Compute FCFF and FCFE from following information:
Particulars Amount
Revenues 10,00,000
Less: Expenses -6,00,000
PBDIT 4,00,000
Less: Depreciation -1,00,000
PBIT 3,00,000
Less: Interest -50,000
PBT 2,50,000
Less: Tax @ 40% -1,00,000
PAT 1,50,000
Capital expenditure 50,000
Working capital increase 25,000
Loans repaid 50,000

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New loans taken 25,000
Equity Dividends Paid 10,000
Answer:
FCFF:
Particulars Amount
PBIT/PBT 3,00,000
Less: Tax @ 40% -1,20,000
PAT 1,80,000
Add: Depreciation 1,00,000
Less: Capital expenditure -50,000
Less: Working capital increase -25,000
FCFF 2,05,000
Note: Items like interest, repayment of loan, new loans taken and equity dividend paid will be ignored in
FCFF approach
FCFE Computation:
Particulars Amount
PBIT 3,00,000
Less: Interest -50,000
PBT 2,50,000
Less: Tax @ 40% -1,00,000
PAT 1,50,000
Add: Depreciation 1,00,000
Less: Capital expenditure -50,000
Less: Working capital increase -25,000
Less: Loans repaid -50,000
Add: New loans taken 25,000
FCFE 1,50,000

17. Adjusted Present Value

• NPV under APV Approach = Base Case NPV – PV of issue costs + PV of debt financing benefit
• Base case NPV: Base Case NPV is computed by discounting cash flows at unlevered cost of equity
• PV of debt financing benefit: PV of debt financing benefit comprise of tax saving + lower interest
rate due to some subsidy. This needs to be discounted at pre-tax cost of debt. In case of perpetual
debt, tax benefit would be equal to amount of debt x tax rate.
• PV of issue cost needs to be deducted as the same would reduce the amount of NPV. Issue cost
can be incurred only on debt (or) on both debt and equity
Example:
A company is taking a loan at the rate of 4 percent. Their normal interest rate on loan is 7 percent. Loan is
for a period of 5 years. Loan amount = Rs.10,00,000 and it would be repaid at one stretch after 5 years. Tax
rate = 30 percent. How much is the present value of debt financing benefit?
Answer:
Particulars Amount PVF @ 7% DCF
Year 1 to 5 12,000 4.100 49,200
Tax Saving on interest (10,00,000 x 4% x 30%)
Year 1 to 5 30000 4.100 1,23,000
Interest saving (10,00,000 x 3%)
Total 1,72,200

18. Equated Annual Benefit (EAB) (or) Equated Annual Cost (EAC)
• EAB/EAC concept needs to be used while comparing two options with unequal lives.
• This concept assumes that process of purchase of asset will be repeated many times.
• We should select a project with lower EAC/higher EAB
NPV
EAB =
PVAF(r, life)

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PV of Outflow
EAC =
PVAF(r, life)
Example:
Company A is evaluating two mutually exclusive projects. Both projects can be repeated indefinitely.
Project A has NPV of Rs.20,000 over three years and Project B has NPV of Rs.25,000 over five years. The
cost of capital is 12%. Which project should the company select?
a. Project A
b. Project B
c. Indifferent between Project A and B
d. Both projects to be rejected
Answer:
We need to compute EAB for selection of the project.
20,000
EAB of Project A = = 8,326
2.402
25,000
EAB of Project B = = 6,935
3.605
We should go ahead with selection of Project A

19. Abandonment Decision

• We are trying to evaluate whether to sell existing machine today (or) use the machine for balance
life and then sell it. Cash flows will be calculated as if we are continuing with the machine.

Step 1: Initial outflow

Particulars Amount
NSV of existing asset at year 0 (XXX)
Working capital (XXX)
Total outflow (XXX)
Note:
• In year 0 there is no actual outflow. But opportunity cost of inflow is there. If we abandon the
machine today, we get back its NSV today. But since we continue with the asset, we don’t get
anything and hence this becomes opportunity cost
• The same logic applies for working capital as well.
Step 2: In-between flows – No change

Step3: Terminal flow:

Particulars Amount
NSV of existing asset at the end of life XXX
Recapture of working capital XXX
Total terminal flow XXX

Step 4: Consolidation of cash flows and calculation of NPV – No change

Conclusion: If the NPV of the project is positive then we should continue with the asset. However, if the
same is negative then we have to abandon the asset
Example:
A company is re-evaluating the decision to continue with an existing machine. The machine was
purchased for Rs.20,00,000 three years ago and is being depreciated based on an economic life of 8 years.
The company is following SLM method of depreciation. The machine can be sold today for Rs.10,00,000.
The tax rate on business profits and capital gains is 25% and 20%. How much is the opportunity outflow
related to old machine today?
a. Rs.10,00,000
b. Rs.9,50,000
c. Rs.10,50,000
d. Rs.10,62,500
Answer:
Opportunity outflow is equal to net salvage value of the machine today.
Particulars Amount
Sale Value 10,00,000
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Less: Book value -12,50,000
[20,00,000 – 3 x 2,50,0000]
Capital loss 2,50,000
Tax saved @ 20% 50,000
Net salvage value [SV + Tax Saved] 10,50,000

20. Replacement Decision

• Under replacement decision we are deciding whether to replace an existing asset with a new asset.
• Cash flows for replacement decision will be done by comparing abandonment cash flow (existing
machine) and new purchase cash flow (new machine)
Step 1: Initial outflow:
• Capital Expenditure of New machine = Rs.1,00,000
• NSV of existing machine today = Rs.20,000
• Incremental cash outflow of replacement = 1,00,000 – 20,000 = Rs.80,000

Step 2: In-between flows:

• Compute CFAT of old machine = Rs.5,00,000
• Compute CFAT of new machine = Rs.8,00,000
• In-between cash flow of replacement decision = Rs.3,00,000 [New – Old]

Step 3: Terminal flow:

• Compute Terminal flow of old machine - This has to be computed assuming we continue with old
machine
• Compute terminal flow of new machine
• Terminal flow of replacement decision = New - Old

Step 4: Compute NPV:

• Compute NPV with replacement cash flows
• NPV positive (Go ahead with replacement) and NPV Negative (reject the replacement)
Example:
A company is considering replacement of an existing machine with a new machine. How much would be
the initial outflow from following information?
Purchase price of the new machine Rs.8,000
Shipping and Installation charge Rs.2,000
Sale price of old machine Rs.6,000
Book value of old machine Rs.2,000
Inventory increases if installed Rs.3,000
Accounts payable increase if installed Rs.1,000
Tax rate on capital gains 25%
a. Rs.7,000
b. Rs.10,000
c. Rs.3,000
d. Rs.5,000
Answer:
Initial outlay = Purchase cost of new machine (Rs.10,000) + WC increase (Rs.2,000) – Net salvage value of
old machine (6,000 – 1,000) = Rs.7,000

21. Types of Replacement Decision

Type 1: Evaluating the Replacement of an Existing Machine with a New One
• Calculate the cash flows associated with the old machine and the new machine.
• Determine the incremental cash flows by subtracting the cash flows of the old machine from those
of the new machine.
• Decide on the basis of the NPV of the incremental cash flows.

Type 2: Determining the Optimal Life of an Asset Yet to be Purchased

• Assume a potential asset life of 4 years.

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• Compute the NPV/PV of outflows for four alternatives (1-year life, 2-year life, 3-year life, and 4-
year life).
• Calculate Equivalent Annual Benefit (EAB) or Equivalent Annual Cost (EAC) for each alternative.
• Decide on the optimum life based on the analysis.

Type 3: When to replace an existing machine:

• Let us assume existing machine has balance life of 2 years
• Consider three alternatives: immediate replacement, replacement at the end of year 1, and
replacement at the end of year 2.
• Compute cash flows, NPV/PV of outflows, and EAB/EAC for each alternative
• Make decision on the basis of above analysis

22. Inflation in Capital Budgeting

• Discount rate/cash flows can be with/without inflation impact.
Type of Cash Flow Discount Rate Inflation
Money/Nominal Money/Nominal Includes
Real Real Excludes
Example:
• Today’s sales = 1,000 units x Rs.50 = Rs.50,000
• Next year sales = 1,200 units x Rs.55 = Rs.66,000
• Real increase = 20% (1,000 units becoming 1,200 units)
• Inflation = 10% (Rs.50 becoming Rs.55)
• Nominal increase = 32% (Rs.50,000 becoming Rs.66,000)

Discounting Rate:
• Money cash flows will be discounted at Money discount rate and real cash flows will be
discounted at real discount rate.

Link between Real Discount Rate and Money Discount Rate:

• (1 + Money Discount Rate) = (1 + Real Discount Rate) x (1 + Inflation rate)
Example:
Inflation rate = 10%; Real discount rate = 4%. How much is nominal discount rate?
a. 14%
b. 14.40%
c. 6%
d. 5.6%
Answer:
(1+ Nominal Discount rate) = (1 + Inflation rate) x (1 + Real discount rate)
(1 + NDR) = (1.10 x 1.04)
NDR = 1.144 – 1 = 0.144 (or) 14.40%
Real revenues of year 2 is Rs.10,00,000. Inflation for year 1 is 10% and year 2 is 8%. How much is nominal
revenues of year 2?
a. Rs.11,00,000
b. Rs.10,80,000
c. Rs.11,88,000
d. Rs.11,66,400
Answer:
Nominal revenues = Real revenues x (1 + Inflation rate of year 1) x (1 + Inflation rate of year 2)
Nominal revenues = 10,00,000 x (1 + 10%) x (1 + 8%) = Rs.11,88,000

23. Expected Value, Standard Deviation and Co-efficient of Variation

• Expected value (NPV/Cash flow) is the weighted average of various possible values with
probability being the assigned weight
• Standard deviation is the expected deviation (upward/downward) from the expected value
(Mean)
• Coefficient of Variation (CV) is risk per unit of return. CV = (SD/Expected NPV)

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Format for computation:
NPV Prob Product Deviation 𝐏𝐝𝟐
-20 0.4 -8 -42 705.6
40 0.5 20 18 162
100 0.1 10 78 608.4
22 1476
• Expected NPV = 22
• SD = √1476 = 38.42
• CV = 38.42/22 = 1.75 Times
Note:
• Product = NPV x Probability
• Deviation = NPV – Sum of Products (22)
• Pd2 = Probability x Deviation x Deviation
Example:
A project is likely to generate cash flows of Rs.1,00,000 (20% probability), 50,000 (40% probability) and -
25,000 (40% probability). How much is the standard deviation?
a. Rs.48,477
b. Rs.27,386
c. Rs.37,417
d. Rs.50,000
Answer:
CF Prob Product Deviation Pd^2
100 0.2 20 70 980
50 0.4 20 20 160
-25 0.4 -10 -55 1210
Total 30 2350
Standard deviation = √2350 = 48.477 x 1,000 = Rs. 48,477
Example:
Project A generates NPV of Rs.10,00,000 and has standard deviation of Rs.5,00,000. Project B has NPV of
Rs.14,00,000 and Standard deviation of Rs.8,00,000. Which project is to be selected if co-efficient of
variation is used as a measure of risk?
a. Project A
b. Project B
c. Indifferent
d. Both projects to be rejected
Answer:
Standard deviation
Co − efficient of variation =
NPV
5,00,000
Project A = = 0.50 times
10,00,000
8,00,000
Project B = = 0.5714 times
14,00,000
Project A is to be selected as the same has lower co-efficient of variation

24. SD for Dependent and Independent Cash Flows

• Dependent cash flows carry inherent risks, as a downturn in one year tends to lead to a series of
consecutive adverse years and vice versa.
• In contrast, independent cash flows are characterized by lower inherent risk, as subsequent cash
flows are not contingent upon the performance of the preceding year.
Steps:
• Step 1: Compute SD of each year cash flow
• Step 2: SD of project would be computed using below format
Year SD PVF DSD 𝐃𝐒𝐃𝟐

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• SD of Dependent Cash Flow = Sum of DSD

• SD of Independent Cash Flow = √Sum of DSD2
Note:
• PVF would be computing using the risk-free rate
• Discounted SD = SD x PVF
• DSD2 = DSD x DSD

Probability of NPV:
• Probability of Dependent cash flow NPV = Probability of the cash flow in year 1
• Probability of independent cash flow NPV = (Probability of the cash flow in year 1)n
Example:
A project has life of 2 years. The probability of the best cash flow is 30% in each year. What would the
probability of best case NPV if cash flows are (i) perfectly correlated and (ii) independent overtime.
a. 30% and 30%
b. 30% and 60%
c. 30% and 9%
d. 9% and 30%
Answer:
Probability of correlated cash flows = 30%
Probability of independent cash flow = 30% x 30% = 9%
Hence 30% and 9% is the answer

25. RADR
• RADR operates on the principle of applying a higher discount rate to risky projects and a lower
discount rate to low-risk projects
• The discount rate is determined by adding the risk-free rate to the risk premium.
• Measurement of risk can be accomplished using standard deviation, coefficient of variation (CV),
or a risk index. The question will specify the connection between the risk factor and the RADR
to be employed
• If a risk index is provided, the RADR formula is expressed as follows: RADR = Risk-free rate +
Risk Index x (Normal Cost of Capital - Risk-free rate). This formula is similar to CAPM
Example:
Risk index of project is 2.00. Minimum required rate of return of the firm is 15% and the risk-free interest
rate is 10%. How much is the RADR?
a. 10%
b. 15%
c. 20%
Answer:
Risk index is basically Beta. RADR = 10 + 2 x (15 – 10) = 20.00%

26. CEF
• Certainty equivalent factor (CEF) is ratio of certain cash flows to uncertain cash flows
• Less the certainty, lower the value of CEF. Hence risk is considered to be more when CEF is less
Steps:
• Convert uncertain cash flows into certain cash flows
o Certain Cash Flow = Uncertain Cash Flow x Certainty equivalent factor (CEF)
• The appropriate discount rate is risk-free rate of return
• Compute NPV
Example:
Project A and B are for a 3-year period. Certainty equivalent factor of project A is 0.80 and project B is 0.70.
Which of these two projects should be discounted with a higher Risk-adjusted discount rate?
a. Project A
b. Project B
c. Same rate for both projects

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Answer:
Project A has a higher CEF whereas Project B has a lower CEF. Higher CEF indicates more certainty and
less risky. Hence Project A is less risky and Project B is riskier. We should therefore use a higher RADR
for Project B.
Example:
Certain cash flow of a project under CEF approach is Rs.2,00,000. CEF factor is 0.80. How much is the
uncertain cash flow?
a. Rs.1,60,000
b. Rs.2,00,000
c. Rs.2,50,000
Answer:
Certain cash flow = Uncertain cash flow x CEF
2,00,000 = Uncertain cash flow x 0.80
2,00,000
Uncertain cash flow = = Rs. 2,50,000
0.80

27. Sensitivity and Scenario Analysis

• Sensitivity and scenario analysis finds out the impact on NPV/decision for changes in input
variables (Capex, selling price, variable cost, fixed cost)
• Sensitivity analysis considers one variable change at a time whereas scenario analysis considers
multiple variable changes at a time.

Two Approaches for Sensitivity Analysis:

Approach 1 (Uniform change in input variable)
• Consider uniform adverse change in every variable and compute the impact on NPV
• Variable which has maximum impact on NPV is the most sensitive factor
Fall in NPV
% change in NPV = x 100
Old NPV

Approach 2 (Change in input parameter to have zero NPV)

• Identify the value of input variable at which NPV will be zero.
• Parameter has lowest sensitivity % is the most sensitive factor
Change
Sensitivity % for input parameter = x 100
Base
Note: Sensitivity analysis for life is done by computing the discounted payback (Discounted payback is
the period for which NPV would be zero.
Example:
Project cost = Rs.12,000; Annual cash flow = Rs.4,500; Cost of capital = 14%; Life = 4 years; PVIFA(14%,4)
= 2.9137, then the sensitivity of the project with respect to project cost is
a. 9.27%
b. 10.27%
c. 9.72%
d. 10.72%
Answer:
PV of cash inflows = 4,500 x 2.9137 = 13,111.65
NPV of project = 13,111.65 – 12,000 = 1,111.65
Project will have zero NPV if the outflow of the project increase by Rs.1,111.65
𝐂𝐡𝐚𝐧𝐠𝐞 𝟏, 𝟏𝟏𝟏. 𝟔𝟓
𝐒𝐞𝐧𝐬𝐢𝐭𝐢𝐯𝐢𝐭𝐲 % = 𝐱 𝟏𝟎𝟎 = 𝐱 𝟏𝟎𝟎 = 𝟗. 𝟐𝟕%
𝐁𝐚𝐬𝐞 𝟏𝟐, 𝟎𝟎𝟎
Example:
Identify the factor which causes maximum sensitivity to the project from the following information:
Base NPV Rs.200 lacs
NPV with 10% variation in Selling price Rs.150 lacs
NPV with 10% variation in cost price Rs.180 lacs
NPV with 10% variation in life Rs.100 lacs
NPV with 10% variation in units sold Rs.160 lacs
a. Selling price

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b. Cost price
c. Life
d. Units sold
Answer:
Project is most sensitive to life factor as 10% variation in life has led to maximum impact on NPV
Example:
A project currently has NPV of Rs.25 lacs. However, the project is sensitive to multiple factors with a
significant variation in the factors causing reversal of investment decision. The analysis is summarized in
the below table
Factor % variation for reversal of decision
Selling price 25%
Cost price 45%
Units sold 70%
Fixed cost 10%
The project is most sensitive to which factor?
a. Selling price
b. Cost price
c. Units sold
d. Fixed cost
Answer:
Project is most sensitive to Fixed cost factor. This is because a small deviation of 10% in fixed cost will lead
to rejection of the project

28. Decision Tree

• Decision tree is a diagrammatical representation of the various alternative course of action. This
is useful for sequential decision making.

Rules:
• A decision tree begins with a decision node. Decision node (D1/D2) is denoted by rectangle. The
value of decision node is highest of the branches coming out from the decision node
• Chance Node (C1/C2) is denoted by circle. The value of chance node is weighted average of the
values of the branches coming out from chance node with probability being the assigned
weight
• A decision tree is drawn from left to right whereas the evaluation is done from right to left

Joint Probability:
• Joint probability refers to the happening of two events together and would be extensively used in
evaluation of decision tree
• Joint Probability = Probability of Event 1 x Probability of Event 2
Example:
Probability of cash flow of Rs.50,000 in year 1 is 40%. If the cash flow turns out to be 50,000 in year 1, then
the probability of getting 24,000 in year 2 is 20%. What is the probability of getting cash flow of 24,000 in
year 2?
a. 20%
b. 80%
c. 8%
d. 40%
Answer:
Probability of earning 24,000 in year 2 = Probability of earning 50,000 in year 1 x Probability of
earning 24,000 in year 2
Probability = 40% x 20% = 8.00%

29. Simulation
• Simulation is an exercise to imitate a real time problem and arrive at expected results for large
number of experiments.
• Final result can be taken as simple average of multiple experiments
Steps:
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• Step 1: Identify parameters (items that don’t change) and variables (items that change) for a project
• Step 2a: For each variable, arrange the values in ascending order and calculate cumulative
probability at the end of each value
• Step 2b: Construct random number class interval for each variable
• Step 3: Based on random number and class interval, select the values of various variables
• Step 4: Compute NPV of each set. The appropriate discount rate to be used is risk-free rate
• Step 5: The simple average of the computed NPV is the final NPV.

Note:
• The appropriate discount rate for simulation exercise is risk-free rate.
Example:
A project is likely to generate following annual cash flows
Cash flow Probability
10,000 0.25
20,000 0.45
30,000 0.30
The company has employed simulation technique to evaluate the project and has started the simulation
exercise. Random number of 70 was generated in the first experiment and this would correspond to annual
cash flow of __________
a. Rs.10,000
b. Rs.20,000
c. Rs.30,000
Answer:
Cash flow of Rs.30,000
Cash flow Prob Cum prob RN
10,000 0.25 0.25 00-24
20,000 0.45 0.70 25-69
30,000 0.30 1.00 70-99
RN of 70 would correspond to annual cash flow of Rs.30,000 as per above table

30. Option in Capital Budgeting

• Under this situation there will be a base project and another option either to expand/abandon.
• We have to first compute the NPV of the base project and the same would be called as base NPV
• We have to separately value the option of expansion/abandonment
• Final NPV of project = Base NPV + Value of option
• If the final NPV is positive we should go ahead with project even if base NPV is negative
Example:
ABC Limited is evaluating a new piece of equipment that will automatically install power windows in cars
coming off the production line. The equipment cost is Rs.35,00,000, and the firm estimates that the present
value of the annual cost savings from installing the equipment is Rs.28,00,000. The production manager is
also considering purchasing a module that will allow the equipment to be used for company’s SUV
production. The additional module represents a real option with a cost of Rs.11,00,000. The production
manager estimates that adding the module would give cost savings of an additional Rs.20,00,000. What is
the NPV of the project before and after considering the real option?
a. -7,00,000 and 2,00,000
b. -7,00,000 and 18,00,000
c. 13,00,000 and 2,00,000
d. -7,00,000 and 9,00,000
Answer:
• NPV of base project = 28,00,000 – 35,00,000 = -7,00,000
• NPV of real option = 20,00,000 – 11,00,000 = 9,00,000
• Hence NPV of the project before is -7,00,000 and after the option is Rs.2,00,000 [-7,00,000 + 9,00,000]

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Chapter 4 – Security Analysis

Security Analysis

Fundamental Analysis Technical Analysis Efficient Market

Hypothesis
No Practical Moving average Run Test
Problems (simple/exponential)
Correlation Test
Breadth Index

Confidence Index

Relative Strength

1. Fundamental Analysis [EIC Analysis]

• Fundamental analysis is based on the assumption that the share prices depend upon the future
dividends expected by the shareholders
• The present value of the future dividends can be calculated by discounting the cash flows at an
appropriate discount rate and is known as the 'intrinsic value of the share'.
• A share that is priced below the intrinsic value must be bought, while a share quoting above the
intrinsic value must be sold
• Fundamental Analysis = Economic Analysis + Industry Analysis + Company Analysis
Example:
A company's financial statements show a significant increase in its accounts receivable balance compared
to previous periods. What would be a prudent action for an analyst conducting fundamental analysis?
a. Consider it a positive sign of increasing sales and future profitability.
b. Investigate further to determine if there are any underlying issues with revenue
recognition or collection
c. Ignore the accounts receivable balance and focus on other financial ratios
d. Assume it is a temporary fluctuation and does not impact the company's financial
health.
Answer:
Investigate further to determine if there are any underlying issues with revenue recognition or collection

2. Technical Analysis
• Technical Analysis is a method of share price movements based on a study of price graphs or
charts on the assumption that share price trends are repetitive, that since investor psychology
follows a certain pattern, what is seen to have happened before is likely to be repeated.

3. Simple Moving Averages (SMA)

• SMA is the average data of most recent observations.
• 5-day SMA is the average price of last 5 days whereas 10-day SMA is the average price of last 10
days.
• Equal weightage is given to all observations in SMA

4. Exponential Moving Averages (EMA)

• In EMA we give extra weights to recent observations and less weights to earlier observations
• Weight of latest observation is exponent value.
2
Value of exponent = ( )
n+1
• Approach 1 to compute EMA: EMA = (Previous day EMA x (1 - Exponent)) + (latest value x
Exponent))
• Approach 2 to compute EMA: New EMA = Previous EMA +/- EMA adjustment
• EMA adjustment = Value of exponent x (Today value - Previous EMA value)

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Format for computation of EMA:
EMA New
Change Adjustment EMA
EMA of (Col 2 - Col (Col 3 x 30-day (Col 3 +
Date Sensex previous day 3) exponent) Col 5)
6 14,522 15,000.00 -478 -29.64 14,970.36
7 14,925 14,970.36 -45.36 -2.81 14,967.55
Example:
An investor is using exponential moving average for the purpose of technical analysis. What is the value
of exponent for 10 days EMA?
a. 0.2000
b. 0.1818
c. 0.2222
d. 0.4000
Answer:
2 2
Exponent = = = 0.1818
n + 1 10 + 1
Simple moving average of Sensex for the month of December 2022 is 60,000. You are planning to evaluate
the technical strength through EMA. The value of exponent is 0.125. Sensex for 1 st trading day stood at
61,000. What would be the new EMA by end of 1 st trading day?
a. 61,000
b. 60,000
c. 60,125
d. 59,875
Answer:
• EMA Adjustment = [Sensex on day 1 – old EMA] x EMA exponent
• EMA Adjustment = [61,000 – 60,000] x 0.125 = 125
• New EMA = Old EMA + EMA Adjustment = 60,000 + 125 = 60,125

5. Breadth Index
• It is an index that covers all securities traded. It is computed by dividing the net advances or
declines in the market by the number of issues traded.
No of securities Advanced − No of securities Declined
Breadth Index =
Total Securities traded
• Interpretation: The breadth index either supports or contradicts the movement of the Dow Jones
Averages. If it supports the movement of the Dow Jones Averages, this is considered sign of
technical strength and if it does not support the averages, it is a sign of technical weakness i.e. a
sign that the market will move in a direction opposite to the Dow Jones Averages.
Example:
Compute breadth index from the following information
Number of securities advanced 25
Number of securities declined 20
Number of securities unchanged 5
a. 0.11
b. 0.10
c. 0.50
d. 5.00
Answer:
Number of securities advanced − Number of securities declined 25 − 20
Breadth index = =
Total number of securities 25 + 20 + 5
Breadth index = 0.10

6. Confidence Index
• It is supposed to reveal how willing the investors are to take a chance in the market. It is the ratio
of high-grade bond yields to low-grade bond yields.

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Yield on high grade bond
Confidence Index =
Yield on low grade bond
• Interpretation: A rising confidence index is expected to precede a rising stock market, and a fall
in the index is expected to precede a drop-in stock price.
Example:
Compute the confidence index from the following information:
Yield on high-grade bonds 6.00
Yield on low-grade bonds 9.00
a. 150%
b. 66.67%
c. 60.00%
d. 90.00%
Answer:
Yield on high grade bonds 6
Confidence index = x 100 = x 100 = 66.67%
Yield on low grade bonds 9

7. RSI Index
• The relative strength concept suggests that the prices of some securities rise relatively faster in a
bull market or decline more slowly in a bear market than other securities i.e. some securities
exhibit relative strength.
Average gain
Relative Strength =
Average loss
100
Relative Strength Index = 100 − ( )
1 + RS
• Interpretation: The RSI ranges from 0 to 100, with values above 70 typically considered
overbought (indicating a potential reversal or correction) and values below 30 indicating
oversold conditions (suggesting a potential upward price movement)
Example:
Compute the Relative Strength index from the following information:
Average gain over last 14 days 8.00
Average loss over last 14 days 10.00
a. 55.56
b. 44.44
c. 100.00
d. 80.00
Answer:
Average gain 8
Relative Strength = = = 0.80
Average loss 10
100 100
Relative Strength Index = 100 − ( ) = 100 − ( ) = 100 − 55.56 = 44.44
1 + RS 1 + 0.80

8. Run Test
• Extract the past price data
• Mention the sign of change in the third column. Sign of price change is +(positive) if index has
moved up and it will be –(negative) if index has come down
• Compute number of positive changes (n1), number of negative changes (n2), and number of
runs. For example, the sign of price change is positive, negative, negative, positive, positive,
positive, negative and positive. In this example r will be taken as 5 (we started with positive and
then it shifted to negative on day 2. It again got changed to positive on day 3. Then sign changed
to negative on day 7 and it got changed to positive on day 8)
• A run would indicate continuous increase/decrease in price. Any change in sign of price change
would indicate a new run
• Compute the tolerable limit for runs and check if actual number of runs is within tolerable limit.
If actual runs is within tolerable limit, then market exhibits weak form of efficiency.
Conversely, if it is outside the limit, then market is inefficient

Tolerable Limit Computation:

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𝟐𝒏𝟏𝒏𝟐
𝐂𝐨𝐦𝐩𝐮𝐭𝐞 𝐌𝐞𝐚𝐧 µ𝐫 = +𝟏
𝒏𝟏 + 𝒏𝟐
(𝑴𝒆𝒂𝒏 − 𝟏)(𝑴𝒆𝒂𝒏 − 𝟐)
𝐂𝐨𝐦𝐩𝐮𝐭𝐞 𝐒𝐃 𝛔𝐫 = √
𝒏−𝟏

• Upper limit = Mean + (SD x t-value)

• Lower Limit = Mean - (SD x t-value)
• t-value is to be computed for given significance level and (n-1) degrees of freedom
Example:
You have decided to do run-test to check the weak form of efficiency. Number of positive changes = 8 and
Number of negative changes = 6. How much is the expected mean of runs?
a. 7
b. 7.86
c. 7.58
d. 8.00
Answer:
2n1 n2 2x8x6
Expected mean of runs = +1= + 1 = 7.86
n1 + n2 8+6

9. Auto-Correlation/Serial Correlation Test

• Identify two data for which correlation is to be computed. Example: Price change of Jan 2021 with
price change of Jan 2022
• Identify change for various observations of data 1 and data 2.
• Absolute changes are considered in Auto-correlation test and % changes are considered in serial
correlation test
• Compute correlation coefficient using format 2 of Portfolio chapter
• If the computed correlation coefficient is closer to +1 or -1, market is inefficient. If the same is
closer to 0 then market exhibits weak form of efficiency

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ADVANCED FINANCIAL MANAGEMENT CA. DINESH JAIN
Chapter 5 – Security Valuation
Security Convertible Miscellaneous
Bond Valuation Money Market
Valuation Instruments Areas

•Walter's •Conversion •Valuation •Computation •Rights Issue

Model Value •YTM and of issue price •Buyback
•Gordon's •Conversion Current Yield •Yield •Enterprise
Model Parity Price •Realized YTM •Clean Price Valuation
•Step-up •Conversion •Duration •Dirty Price •Preference
Growth Model Premium •Volatility shares
•H-Model •Straight Value •Convexity valuation
•PE Multiple •Downside •Immunization •Warrants
Approach Risk Valuation
•Bond refunding
•Earning •Premium
•Forward Rates
Growth Model Payback
Period •Yield Curve
•FCFE Model
•Favourable
income
differential

1. How to calculate price under Walter’s Model?

𝐫
𝐃 ( ) 𝐱(𝐄 − 𝐃)
𝐊𝐞
𝐏𝟎 = ( ) +
𝐊𝐞 𝐊𝐞
Where:
Term Meaning Formula/other notes
𝐏𝟎 Fair Market Price
D Dividend per share Total Dividend
(or)EPS x Payout ratio
Number of shares
R Return on equity (or) EAES EPS
(or)
Internal rate of return (or) Value of Equity Book value per share
Return on retained earnings (or)
Return on investment
E Earnings per share EAES
(𝑂𝑅) Book value per share x ROE
Number of shares
EAES = PAT – Preference Dividend
𝐊𝐞 Cost of equity This is also called as:
• Investor’s required rate of return
• Opportunity cost of capital
• Rate of capitalization
• Cost of capital (100% equity company)
• Equity capitalization rate
Example:
EPS = Rs.10; Payout ratio = 25%; Cost of equity = 10%; Return on equity = 5%. What is the price of share
as per Walter's model?
a) Rs.100
b) Rs.200
c) Rs.175
d) Rs.62.50
Answer:
r 0.05
D ( ) x(E − D) 2.50 ( ) x(10 − 2.50)
Ke
P0 = ( ) + =( ) + 0.10 = 𝑅𝑠. 62.50
Ke Ke 10% 10%

2. How to value share under Gordon’s Model?

D1 D0 (1 + G) EPS1 (1 − retention ratio)
P0 = (or) (or)
Ke − G Ke − G Ke − G
Where:

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Term Meaning Formula/other notes
𝐏𝟎 Fair Market
Price
𝐃𝟏 Dividend of • This is one important assumption as the question would not be clear
next year whether it is nearby dividend (D0) or Distant Dividend (D1)
• If the question is not clear, then we should write our assumption and
also solve answer with both assumption (i.e. taking dividend as D0 and
D1)
• Majority of ICAI answers we will have assumption of taking
dividend as D1 and hence that would be our primary answer and
alternate answer would be by taking the dividend as D0
𝐊𝐞 Cost of Same as per Walter’s Model
equity
G Growth rate Explained in other concepts
Example:
Long term growth of 8% is expected. Company is expected to pay a divided of Rs.4 per share next year.
The cost of equity is 12%. What is the fair value of share?
a) Rs.50
b) Rs.75
c) Rs.100
d) Rs.33.33
Answer:
D1 4
P0 = = = Rs. 100
K e − G 12% − 8%

3. Computation of Price of Different Years

Closing price of a share is equal to opening price + required rate of return. However, share price will fall
by the dividend amount in case company declares dividend. This has led to the following formula for
computing price.
P1 = Po x (1 + K e ) − D1
P2 = P1 x (1 + K e ) − D2
We can use above formula and compute price for different years
Example:
Price at end of year 3 = Rs.300; Cost of equity = 20%. Company will pay Dividend of Rs.10 in year 1, Rs.30
in year 2 and Rs.60 in year 3. How much is the price of share today?
a) Rs.173.61
b) Rs.400.00
c) Rs.237.50
d) Rs.200.00
Answer:
Computation of Price at end of year 2:
𝟑𝟔𝟎
P3 = P2 x (1 + K e ) − D3 ; 300 = P2 x(1 + 0.20) − 60; 360 = 1.20P2 ; 𝐏𝟐 = = 𝟑𝟎𝟎
𝟏. 𝟐𝟎

Computation of Price at end of year 1:

𝟑𝟑𝟎
P2 = P1 x (1 + K e ) − D2 ; 300 = P1 x(1 + 0.20) − 30; 330 = 1.20P1 ; 𝐏𝟏 = = 𝟐𝟕𝟓
𝟏. 𝟐𝟎

Computation of today price:

𝟐𝟖𝟓
P1 = P0 x (1 + K e ) − D1 ; 275 = P0 x(1 + 0.20) − 10; 285 = 1.20P0 ; 𝐏𝟎 = = 𝟐𝟑𝟕. 𝟓𝟎
𝟏. 𝟐𝟎

4. Holding Period Return

Dividend(D1 ) + Capital Appreciation(P1 − P0 )
Holding Period Return = x 100
Opening Price(P0 )
Example:

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Share price on January 1 (Purchase date) = Rs.40; Share price on December 31 = Rs.45; Dividend paid
(December 31) = Rs.5; Cost of equity = 11%; Cost of debt = 8%; Debt: Equity = 1:3. What is the holding
period return (ignore taxes)?
a) 25.00%
b) 12.50%
c) 22.50%
d) 14.00%
Answer:
(45 − 40) + 5
Holding period return = x 100 = 25.00%
40

5. Ex-Dividend Price vs Cum-Dividend Price

• Price computed as per any dividend valuation model would be the ex-dividend price. In case
shares are quoting cum-dividend in the market then the fair cum-dividend price would be equal
to ex-dividend price + Amount of dividend.
• Share price will fall by the amount of dividend once the share goes ex-dividend. Hence, we
should only use the ex-dividend price in formula to compute any missing item.
Example:
The cum dividend price of share is Rs.11 (including dividend of Rs.1). Growth rate is 5%. What is cost of
equity?
a) 15.5%
b) 14.55%
c) 15%
d) 14.09%
Answer:
D1 1.05
Ke = ( ) + G = + 0.05 = 0.155 or 15.50%
P0 10
Note:
• Next-year dividend = 1 + 5% = Rs.1.05
• Price in the above formula is ex-dividend price and the same would be Rs.10 (11 – 1)

6. How to compute Growth Rate?

Approach 1 - Formula based: Growth rate = [IRR (or) ROE] x Retention Ratio
Example:
IRR of company = 20%; Investor's required rate of return = 15%; Dividend = Rs.2 per share; EPS = Rs.5 per
share. What will be the growth rate?
a. 8%
b. 12%
c. 6%
d. 9%
Answer:
Particulars Amount
Payout ratio (DPS/EPS) 40.00%
Retention ratio (100% – Payout ratio%) 60.00%
Growth rate (IRR x Retention ratio) 12.00%
Approach 2 - Based on Past Data:
• Take the first available dividend as Present value and the latest available dividend as future value
• Number of years gap will be taken as n
• Use below formula and compute r as balancing figure. The computed r will be taken as growth
rate
• Future value = Present Value x (1 + r)n
Example:
Dividend of 1996 = Rs.2.115; Dividend of 2002 = Rs.3. The company's earnings and dividend have
experience constant growth. What will be the growth rate in dividends using below information? PVF of
5% for 6 years = 0.746; PVF of 6% for 6 years = 0.705; PVF of 7% for 6 years = 0.666
a. 5%
b. 6%

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c. 7%
d. None of the above
Answer:
Dividend of 1996 = PV = 2.115; Dividend of 2002 = FV = Rs.3;
Present value = Future value x Present Value Factor
2.115
2.115 = 3 x Present Value Factor; Present value factor = = 0.705
3
PVF of 0.705 correspond to 6 years and 6 percent. Hence growth rate of the company is 6 percent

7. Growth rate based on EPS vs DPS

Growth rate should be computed based on EPS. This is because EPS reflects real growth of company and
DPS growth would mirror EPS growth unless there is a change in a payout ratio. This approach is followed
in case growth is computed based on past data.
Example:
SRK Limited is a listed company and it has just announced annual dividend for the year ending 2013-14.
Earnings per share (EPS) and Dividend per share (DPS) for 5 years is as follows:
Particulars 2013-14 2012-13 2011-12 2010-11 2009-10
EPS (Rs.) 14.00 13.60 13.10 12.70 12.20
DPS (Rs.) 8.20 8.10 7.90 7.80 7.70
What is to be considered as growth rate for valuation of share?
a) 3.50%
b) 1.59%
c) 2.50%
d) 2.55%
Answer:
Company had earnings of 12.20 in 2009-10 and the same had increased to 14.00 in 2013-14. This would
mean that 12.20 has become 14.00 in 4 years. Growth rate has been computed based on EPS. This is
because EPS reflects real growth of company and DPS growth would mirror EPS growth unless there
is a change in a payout ratio
Earnings of Year 0 (PV) = 12.20; Earnings of year 4 (FV) = 14.00; n = 4 years; r = ?
❖ Future value = Present Value x (1 + r)n
❖ 14.00 = 12.20 x (1 + r)4
14.00
(1 + r)4 = ( ) ; (1 + r)4 = 1.1475; (1 + r)2 = 1.0712; (1 + r) = 1.035
12.20
❖ r = 3.5% and hence growth rate is 3.5%

8. Time value of Money Concepts

Component of interest rate or discount rate of cash flows:
• Interest rate = Inflation + Real rate of return on risk-free investments + Risk Premium
Future Value of single cash flow:
Future value = Present value x (1 + r)n
Example:
Ram has deposited Rs.55,650 in a bank, which is paying 15 per cent rate of interest on a ten-year time
deposit. Calculate the amount at the end of ten years?
Answer:
Amount = P x (1 + r)n
Amount = 55,650 x (1 + 15%)10 = 55,650 𝑥 4.0456 = Rs. 2,25,138
Present value of single cash flow:
Future value
Present value =
(1 + r)n
Example:
Suppose you have celebrated your 19th birthday. A rich uncle of yours has set up a trust fund for you that
will pay you Rs.2,50,000 when you turn 30. If the time value of money is 9.0%, how much is this fund
worth today?
Answer:
Future value
Present value =
(1 + r)n

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2,50,000
Present value =
(1 + 9%)11
2,50,000
Present value = = Rs. 96,899
2.580
Future value of multiple cash flows:
We need to compute future value of every cash flow and then compute the future value. This concept will
help us in computation of realized YTM.
Example:
An investor will receive Rs.100 of interest for next three years and also receive Principal of Rs.1,000 at end
of third year. How much is the maturity cash flow at end of year 3 if re-investment rate is 8%.
Year Cash flow Period FVF (1 + r)n Future value
1 100.00 2 1.1881 118.81
2 100.00 1 1.0900 109.00
3 1,000.00 0 1.0000 1,000.00
Maturity cash flow 1,227.81
Note:
Future value factor is computing by using the formula of (1 + r)n where r = 8% and n = Number of periods
of investment (Column 3)
Present value of multiple cash flows:
We need to compute present value of every cash flow and then compute the present value. This concept
will be extensively used in security valuation/business valuation
Example:
You are likely to receive Rs.10,000 in year 1, Rs.20,000 in year 2 and Rs.30,000 in year 3. Discount rate =
10%. How much is the worth of the same today?
Year Cash flow PVF @10% DCF
1 10,000 0.909 9,090
2 20,000 0.826 16,520
3 30,000 0.751 22,530
Present Value 48,140
Note:
1
Present value factor is computing by using the formula of (1+r)n
where r = 10% and n = Number of years
of discounting (Column 1)
Present Value of Annuity:
Annuity would mean equal payments or receipts for a specified period.
Present value of Annuity = Annuity Amount x PVAF (r, n)
Example:
Compute the amount of deposit to be made today if you want to receive Rs.25,500 at the end of each of
next 15 years.
Answer:
Present value = Annuity Amount x PVAF(r, n)
Present value = 25,500 x PVAF(10%, 15)
Present value = 25,500 x 7.606 = Rs. 1,93,953
Present value of Perpetuity
CF1
PV =
Discount Rate − Growth Rate
Example:
Assuming that the discount rate is 7% per annum, how much would you pay to receive Rs.50, growing at
5%, annually, forever?
Answer:
CF1 50
Present value = = = Rs. 2,500
Discount rate − Growth Rate 7% − 5%
Loan amortization based on concept of Annuity Factor:
PVAF can be used for various computations such as loan amortization, sinking fund investment etc.
Example:
A has taken a 20-month car loan of Rs.6,00,000. The rate of interest is 12 percent per annum. What will be
the monthly loan amortization?
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Answer:
Present value = Annuity Amount x PVAF(r, n)
6,00,000 = Annuity Amount x PVAF(1%, 20)
6,00,000 = Annuity Amount x 18.045
6,00,000
Annuity Amount = = Rs. 33,250
18.045
Note:
• N = 20 months
• Rate of interest = 12% per annum (or) 1% per month
• We should ensure that time period (months) and rate of interest (1%) is for the same time period
in the above formula

9. Link between EPS, BVPS and ROE

EPS
ROE =
Book value per share
Example:
Book value per share = Rs.100; DPS = Rs.4; Payout ratio = 25%. How much is ROE?
a. 4%
b. 1%
c. 16%
d. 8%
Answer:
Particulars Amount
EPS (DPS/Payout ratio) 16.00
Book value per share 100
ROE (EPS/BVPS x 100) 16.00%

10. How to compute Return on Equity

EAES EPS
ROE = (or)
Book value of equity Book value per share
Note:
Book value of equity = Networth = SC + Reserves – Fictitious Assets
Example:
Profit before Tax = 10,00,000; Tax Rate = 50%; No of equity shares of Rs.10 each =50,000; 10% Preference
capital = 10,00,000; Reserves and Surplus = Rs.45,00,000; Fictitious assets = 10,00,000. How much is ROE?
a) 80%
b) 8%
c) 40%
d) 10%
Answer:
Particulars Amount
Profit before tax 10,00,000
Less: Tax @ 50% -5,00,000
Profit after tax 5,00,000
Less: Preference dividend (10,00,000 x 10%) -1,00,000
EAES 4,00,000
Amount of equity 40,00,000
[Equity share capital + Reserves – Fictitious assets]
ROE [EAES/Amount of equity] 10.00%

11. Computation of cost of equity (Dividend Paying Company with constant growth)
D1
Ke = ( ) + G
P0
Example:
The current share price is Rs.100. Long term growth of 8% is expected. Company is expected to pay a
divided of Rs.4 per share next year. What rate of return does an investor expect?
a. 8%

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b. 12%
c. 12.32%
d. 4.32%
Answer:
D1 4
Ke = ( ) + G = + 0.08 = 0.12 or 12%
P0 100

12. Computation of cost of equity (Dividend Paying company – Planning a new issue and incurs
floatation costs)
A company planning a new issue of equity shares may incur floatation costs such as brokerage, issue
expenses. In such a situation below formula would be used to compute cost of equity
D1
Ke = ( )+G
P0 − 𝐹
Example:
Issue price of a share is Rs.105 and Floatation cost on issue is Rs.5. Long term growth of 8% is expected.
Company is expected to pay a divided of Rs.4 per share next year. How much is the cost of new issue?
a. 8%
b. 12%
c. 12.32%
d. 4.32%
Answer:
D1 4
Ke = ( )+G= + 0.08 = 0.12 or 12%
P0 − F 105 − 5

13. Computation of cost of equity (Dividend Paying Company with multiple growth rates)
If there are multiple growth rates the Gordon’s formula cannot be used to find cost of equity. In that
scenario we need to assume discount rates and get NPV of the cash flows. Once we get one positive and
one negative NPV we can calculate the IRR of the cash flows. The computed IRR would be taken as cost
of equity. We should take care of terminal cash flows while computing NPV as the terminal cash flows
(perpetuity) valuation can change based on discount rate.
Example:
The current share price is Rs.100. Last paid dividend is Rs.10 and the same will grow at 20% for two years.
Growth will stabilize at 10% from third year onwards. How much is the cost of equity? Use Discount rate
of 22% and 23% to compute cost of equity.
a) 22.00%
b) 23.00%
c) 22.98%
d) 22.02%
Answer:
Year Cash flow PVF @ 22% DCF Cash flow PVF @ 23% DCF
0 -100.00 1 -100.00 -100.00 1 -100.00
1 12.00 0.82 9.84 12.00 0.813 9.76
2 14.40 0.672 9.68 14.40 0.661 9.52
2 132.00 0.672 88.70 121.85 0.661 80.54
NPV 8.22 -0.18
Note:
P2 if cost of equity is 22%
D3 14.40 + 10%
P2 = = = 132.00
Ke − G 22% − 10%
P2 if cost of equity is 23%
D3 14.40 + 10%
P2 = = = 121.85
Ke − G 23% − 10%

Computation of cost of equity (IRR):

NPV at L1 8.22
IRR L1 + x (L2 − L1 ) 22 + x (23 − 22) 22.98%
NPV at L1 − NPV at L2 8.22 − (−0.18)

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14. Computation of cost of equity (Non-Dividend Paying Company)
Cost of equity = Rf + Beta x (Rm – Rf)
Example:
Risk-free rate is 6% whereas risk premium of market is 8%. How much is the cost of equity if Beta is 1.5
Times?
a) 9.00%
b) 12.00%
c) 18.00%
d) 21.00%
Answer:
Risk-premium of the market is difference between Rm – Rf.
Cost of equity = 6% + 1.5 x (8%) = 18.00%

15. What is the appropriate Dividend Payout Ratio?

Scenario Payout Ratio
r > Ke 0%
r = Ke Indifferent (Any payout ratio)
r < Ke 100%
Example:
Total earnings = 1,00,000; No of equity shares = 1,00,000 of Rs.10 each; Price Earning Multiple = 8 times.
The company is currently following 100% payout ratio. What should be the optimum payout?
a) 0%
b) 100%
c) Indifferent
Answer:
Total earnings 1,00,000
ROE = = = 10.00%
Value of equity 10,00,000
1 1
Ke = = = 12.50% [K e can be taken as inverse of PE Multiple if payout ratio is 100%]
PE Multiple 8
Optimum payout ratio for the company would be 100% as cost of equity is higher than ROE

16. How to compute cost of GDR?

Cost of GDR works in same manner as cost of equity. GDR will have underlying equity shares and we can
compute the amount of dividend per GDR. Also, it can have floatation cost and hence Price (P0) is replaced
with net proceeds (P0 – F) in the formula.
Example:
Cum-dividend price of share = Rs.400; Dividend = Rs.20. Five shares underly each GDR. Shares will be
priced at discount of 20%. Exchange rate is Rs.100/USD. Growth rate is 10%. What is the net realization
(in USD) per GDR if floatation cost is 5%? Also compute cost of equity?
a) 16.88%
b) 17.24%
c) 16.25%
d) 16.58%
Answer:
Particulars Calculation Amount
Ex-Dividend price per share 400 – 20 380.00
[Real worth of share]
Value of 5 shares 380 x 5 1,900.00
Issue price per GDR (in INR) 1,900 – 20% 1,520
Net realization post FC (in INR) 1,520 – 5% 1,444
Net realization in USD 1,444/100 14.44
D1 (20 + 10%) x 5
Cost of GDR = ( )+G= + 0.10 = 0.0724 + 0.10 = 0.1724 or 17.24%
P0 − F 1,520

17. What is limiting value?

Limiting value is the minimum possible value of a share and same is calculated at a payout ratio which is
opposite of optimum payout ratio.

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Example:
Return on equity = 20%; Cost of equity = 15%; EPS = 10. What will be the limiting value as per walter's
model?
a. 50.00
b. 66.67
c. 88.89
d. 60.00
Answer:
The return on equity is 20% whereas cost of equity is 15%. This is a case of declining firm and hence
optimum payout ratio is 0%. Limiting value is minimum possible value of a share and is computed by
following a payout ratio which is opposite of optimum payout ratio. Hence, we will work with 100%
(opposite of 0%) and compute the answer. EPS is Rs.10 and hence DPS will also be Rs.10 considering 100%
payout ratio.
D 10
P0 = ( ) = = Rs. 66.67
Ke 15%

18. Step-up Growth Model

• This refers to a scenario where growth happens in multiple stages (initial stage, intermediate stage
and final stage)
• Step 1: We should compute dividends till the first year of stabilization phase. Stabilization phase
is reached where growth rate as well as cost of equity is stabilized and will remain same till
perpetuity
• Step 2: Compute the price at beginning of stabilization phase using Gordon’s formula
• Step 3: Discount the above cash flows at cost of equity and arrive at fair value of the share
Example:
Last paid dividend is Rs.10 and the same will grow at 20% for two years. Growth will stabilize at 10% from
third year onwards. Historical Cost of equity is 22% but from today the cost of equity will be 20% due to
lower risk of company. How much is fair value of share?
a) Rs.158.40
b) Rs.50.00
c) Rs.129.92
d) Rs.125.96
Answer:
Step 1: Computation of Dividends till the first year of stabilization phase:
Dividend growth will stabilize at 10% from third year onwards. Hence third year is the year of
stabilization.
Year Dividend
1 12.00
[10 + 20%]
2 14.40
[12 + 20%]
3 15.84
[14.40 + 10%]

Step 2: Computation price at beginning of stabilization phase (Beginning of Year 3 = End of Year 2)
D3 14.40 + 10%
P2 = = = 158.40
Ke − G 20% − 10%

Step 3: Valuation of share at cost of equity of 20% (Future Ke)

Year Cash flow PVF @ 20% DCF
1 12.00 0.833 10.00
2 14.40 0.694 9.99
2 158.40 0.694 109.93
Fair value of share 129.92

19. Linear Fall in Growth Rate

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This would mean that dividend growth rate will fall by same percentage every year. Annual fall in growth
rate = [Total fall in growth rate/Number of years]. If the question does not specify the number of years,
then we will take the same as 1 percent fall every year.
Example:
Dividends will grow at 20 percent for four years. Growth will have a linear fall and stabilize at 14 percent.
What will be the dividend growth in 6th year?
a. 20 percent
b. 14 percent
c. 19 percent
d. 18 percent
Answer:
Growth will have a linear fall and stabilize at 14 percent. It has not been mentioned that fall is for how
many years and hence it will be taken as 1 percent fall every year. Growth rate of year 5 is 19 percent and
growth rate of year 6 is 18 percent
Example:
Dividends will grow at 20 percent for four years. Growth will have a linear fall and stabilize at 14 percent
in year 7. What will be the dividend growth in 6th year?
a. 20 percent
b. 18 percent
c. 16 percent
d. 14 percent
Answer:
20 − 14
Annual fall in growth rate = = 2%
3
Hence Growth rate of year 5 is 18% (20% – 2%) and growth rate of year 6 is 16% (18% – 2%)

20. Change in Growth rate with change in payout ratio

In order to compute future DPS, we should first compute the EPS and based on EPS we should compute
DPS. This approach will ensure correct DPS projection in case there is a change in Dividend Payout Ratio.
Example:
The company has paid out Dividend of Rs.3 per share based on payout ratio of 50%. Earnings and
Dividend will grow at 20 percent for four years. Growth will fall to 10 percent in year 5 and dividend
payout ratio will increase to 60%. Cost of equity of the company is 20%. What should be the MPS at the
end of year 5?
a. Rs.90.30
b. Rs.75.20
c. Rs.82.10
d. Rs.68.40
Answer:
Particulars Amount
EPS of last (DPS/Payout ratio) 6.00
EPS of year 1 (6 + 20%) 7.20
EPS of year 2 (7.20 + 20%) 8.64
EPS of year 3 (8.64 + 20%) 10.37
EPS of year 4 (10.37 + 20%) 12.44
EPS of year 5 (12.44 + 10%) 13.68
EPS of year 6 (13.68 + 10%) 15.05
DPS of year 6 (15.05 x 60%) 9.03
D6 9.03 90.30
Price of year 5 = ( )=( )
Ke − 𝐺 20% − 10%

21. Implied Growth Rate

If the PE Multiple is given in the question and based on that, we can compute current market price. Current
market price can be substituted in Gordon’s formula to get implied growth rate.
Example:
DPS (D0) = Rs.10; Payout ratio = 50%; Current PE Multiple = 10 Times. What is the implied growth rate if
cost of equity is 20%?

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a. 14.92%
b. 15.00%
c. 14.29%
d. None of the above
Answer:
D1 10 x (1 + G) 𝟑𝟎
P0 = ; 200 = ; 40 − 200G = 10 + 10G; 30 = 210G; 𝐆 = = 𝟏𝟒. 𝟐𝟗%
Ke − G 0.20 − G 𝟐𝟏𝟎
Note:
DPS = Rs.10; Payout ratio is 50% and hence EPS is Rs.20 (10/50%). PE Multiple is 10 times and hence the
current market price is Rs.200 (20 x 10)

22. Present Value of Growth Opportunities (PVGO)

PVGO basically represent extra price paid due to growth opportunities of the company. PVGO = Current
market price – Price if there was no growth.
Example:
MPS of company = Rs.100; EPS of company = Rs.8; Cost of equity = 10%. What is present value of growth
opportunities?
a. 80.00
b. 20.00
c. 100.00
d. 50.00
Answer:
PVGO = CMP – Fair price with no growth = 100 – 80 = Rs.20
Fair price with no growth would be computed with company having a payout ratio of 100%. This is
because payout will be 100% (retention of 0%) and the same would lead to no growth.
D 8
Fair price with no growth = ( ) = = Rs. 80
Ke 10%

23. Multiple Cost of Equity

Cost of equity can change in case of revision in investor expectation. For instance, cost of equity can be
10% for year 1 to 4 and thereafter it can be 14%. We should use the respective discount rate for perpetuity
valuation and PVF should be computed based on below rules:
1
PVF of year 1 = = 0.909
1 + Discount rate of year 1 (10%)
0.909
PVF of year 2 = = 0.826
1 + Discount rate of year 2 (10%)
0.826
PVF of year 3 = = 0.751
1 + Discount rate of year 3 (10%)
0.751
PVF of year 4 = = 0.683
1 + Discount rate of year 4 (10%)
0.683
PVF of year 5 = = 0.599
1 + Discount rate of year 5 (14%)
Care should be taken to take the previous year discount factor and then divide by (1 + Discount rate of
next year)
Example:
The company will pay Dividend of Rs.20 in year 1, Rs.24 in year 2 and Rs.30 in year 3. Share will be sold
for Rs.300 at end of year 3. Cost of equity is 10% in year 1 and same will increase by 1% every year due to
higher risk. How much is the fair value of share?
a) 185.83
b) 171.95
c) 179.07
d) 178.74
Answer:
Year Cash flow PVF DCF
1 20.00 0.909 18.18
2 24.00 0.819 19.66
3 330.00 0.731 241.23
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Fair value of share 179.07
Note:
1
PVF of year 1 = = 0.909
1 + Discount rate of year 1 (10%)
0.909
PVF of year 2 = = 0.819
1 + Discount rate of year 2 (11%)
0.819
PVF of year 3 = = 0.731
1 + Discount rate of year 3 (12%)

24. Impact of bonus issue on terminal value

Fair price of share is the present value of future cash flows discounted at cost of equity. If a bonus issue is
made then 1 share can get converted into 1.2 shares (or) 1.5 shares (or) any other number depending on
bonus ratio. Hence, we should consider the selling price of higher number of shares for terminal cash
flow
Example:
Mr.A plans to buy 1 share of company A. The company is expected to give bonus of 1:5 in fourth year. The
share is expected to be sold in 7th year at expected price of Rs.900 each. Incidental expense on sale of share
is 5%. What will be the net realization in year 7?
a. 855.00
b. 900.00
c. 1080.00
d. 1026.00
Answer:
The investor will get 1.2 shares for every 1 share due to bonus issue. Sale value of 1.2 shares = 900 x 1.20 =
1080 and net realization = 1080 - 5% expenses = 1080 - 54 = Rs.1026

25. Impact of transaction cost on Maximum Purchase Price

Fair price of share is the present value of future cash flows discounted at cost of equity. In normal situations
the computed fair value is taken as maximum purchase price. However, the maximum purchase price will
be lower than fair value as the investor will additionally incur incidental expenses on purchase.
Fair value of share
Max Purchase Price =
1 + Transaction cost on purchase
Example:
Present value of future cash inflows = 525. The investor has to be pay 5 percent brokerage on purchase of
share. What shall be the maximum purchase price of share?
a) 525
b) 500
c) 498.75
d) 551.25
Answer:
PV of cash inflows = 525. Hence the maximum outflow has to be Rs.525. The investor has to pay 5 percent
brokerage and hence the maximum purchase price = 525/105% = Rs.500

26. H Model for Three-Stage Dividend Discount Model

• In the first stage dividend grows at high growth rate for a constant period, then in second stage it
declines for some constant period and finally grow at sustainable growth rate.
• H Model is based on the assumption that before extraordinary growth rate reach to normal growth
it declines lineally

𝐃𝟎 (𝟏 + 𝐠 𝐧 ) 𝐃𝟎 𝐇𝟏 (𝐠 𝐜 − 𝐠 𝐧 )
𝐏𝟎 = +
𝐫 − 𝐠𝐧 𝐫 − 𝐠𝐧
Where:
• Gn = Normal growth rate Long run
• Gc = Current growth rate i.e. initial short-term growth rate
• H1 = Half of duration of the transition growth period
Example:
Calculate value of equity share using H Model from the following information:

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Dividend paid in last year Rs.25
Cost of equity 8%
High-growth rate (short-term growth) 12%
Long-term growth rate 5%
Number of years for transition from high-growth to normal rate 5 years
a. 875.00
b. 1020.83
c. 1025.00
d. 1000.00
Answer:
𝐃𝟎 (𝟏 + 𝐠 𝐧 ) 𝐃𝟎 𝐇𝟏 (𝐠 𝐜 − 𝐠 𝐧 )
𝐏𝟎 = +
𝐫 − 𝐠𝐧 𝐫 − 𝐠𝐧
25(1 + 0.05) 25 x 2.5 (0.12 − 0.05)
P0 = + = 875 + 145.83 = Rs. 1,020.83
0.08 − 0.05 0.08 − 0.05

27. Maintenance of Dividend Income

An investor wants to maintain dividend income for meeting his regular expenses. However, the company
may stop paying dividends due to growth opportunities. In that case, the investor can maintain the
dividend income by partial sales of shares till company starts paying dividends again.
Example:
Dividend per share is Rs.2. An investor owns 500 shares of company. He wants to continue to earn same
amount of dividend income ever year. Dividends will not be paid for next three years. Dividend of year 4
is likely to be Rs.2.50. Growth rate is 7% and cost of equity is 8%. How many shares are to be sold in year
2 to get the minimum amount?
a. 4 shares
b. 3 shares
c. 8 shares
d. 5 shares
Answer:
D4 2.50
P3 = = = Rs. 250
K e − G 8% − 7%
P3 250
P2 = = = 𝑅𝑠. 231.48
1 + K e 1 + 8%
Amount needed 1,000
No of shares to be sold in year 2 = = = 4.32 shares
Price 231.48
Note: 4.32 shares will be rounded off to 5 as investor needs minimum 1,000. Sales of 4 shares will not give
Rs.1,000

28. PE Multiple Approach

• Fair Price of share = EPS x PE Multiple
• PE Multiple will be directly given in the question. If the same is not available, then we can
compute PE Multiple as (1/ROE)

Multiple Versions of PE Multiple:

MPS
Trailing 12 month PE Multiple =
EPS of last 12 months
MPS
One − year forward PE Multiple =
EPS of Next Year
MPS
Two − year forward PE Multiple =
EPS of second year from now

Example:
Find out the value of share under PE Multiple Approach is ROE = 8% and EPS = Rs.3.00.
a) Rs.24.00
b) Rs.2.40
c) Rs.37.50
d) Rs.12.50
Answer:

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Particulars Amount
Return on equity 8%
PE Multiple (1/ROE) 12.5
EPS 3.00
Fair market price (EPS x PE Multiple) 37.50

29. Earning Growth Model

𝐄𝐏𝐒𝟏
𝐏𝟎 =
𝐊𝐞 − 𝐆
Example:
Find out the value of share under earning growth model if current EPS = Rs.3.00; Cost of equity = 8%;
Growth rate = 2%
a) Rs.50.00
b) Rs.51.00
c) Rs.37.50
d) Rs.38.25
Answer:
𝐸1 3 + 2%
Market Price Rs.51 per share
(𝐾𝑒 − 𝐺) (8% − 2%)

30. Free Cash Flow Approach

𝐅𝐂𝐅𝐄𝟏
𝐏𝟎 =
𝐊𝐞 − 𝐆
Where:
Term Meaning Formula/other notes
𝐅𝐂𝐅𝐄𝟏 Free cash flow to equity • FCFE = PAT – Equity funding for net capex and
shareholders of next year working capital
• Equity funding for net capex and working capital =
Net Capex and Working Capital x (100 – Debt ratio%)
• Debt ratio basically represent what percentage of
capex and working capital will be funded with debt.
• This approach can be followed if the problem gives data on capital expenditure, depreciation,
working capital change and debt ratio
Example:
EPS = 10; Depreciation per share = 20; Capex per share = 30; WC increase per share = 2; Debt ratio = 0.60.
What will be FCFE per share?
a) 10
b) -2
c) 5.2
d) 2.8
Answer:
Particulars Amount
Net Capex (30 – 20) 10.00
WC increase per share 2.00
Net capex and WC requirement 12.00
Funded with debt (12.00 x 60%) 7.20
Funded with equity (12.00 x 40%) 4.80
FCFE (EPS – Equity needed for capex and WC) 5.20

31. Impact of new project on share price

Share price will get impacted by a new project in case the same has positive/negative NPV. Share price
will increase by the amount of positive NPV per share and vice versa.
New share price = Existing Price + Positive NPV per share − Negative NPV per share
Example:
EPS (100% payout) = Rs.10; MPS = Rs.100. Number of shares = 1,00,000 The company is fully equity
financed. The company plans to do a project Rs.1 Cr at end of year 1. It will generate Rs.21 lacs from year
2 onwards. How much is the new share price?
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a) Rs.210 per share
b) Rs.200 per share
c) Rs.21 per share
d) Rs.100 per share
Answer:
Company is following 100% payout ratio and hence EPS = DPS. Additionally, growth rate will also be
zero.
10
Ke = ( ) + 0 = 10%
100
Year Cash flow PVF @ 10% DCF
1 -1.00 0.909 -0.909
1 2.10 0.909 1.909
[21/10%]
NPV of project 1.000
NPV per share [1 Crore/1 lac] 100.00
New share price [100 + 100] 200.00
Note: Perpetual cash flow is received from year 2 and it is to be valued a year in advance (year 1)

32. Under-valued vs over-valued security

A share is said to be under-valued if current market price is lower than intrinsic value whereas a share is
said to be over-valued if market price is higher than intrinsic value. Intrinsic value is basically computed
as per any of the valuation models. Investor should buy an under-valued security and sell an over-valued
security.
Example:
ABC Limited has a leading price-to-earnings (P/E) ratio of 28 while the median leading P/E of a peer
group of companies within the industry is 38. Based on the method of comparables, an analyst would most
likely conclude that ABC Limited should be:
a) bought as an undervalued stock
b) sold short as an overvalued stock
c) sold as an overvalued stock
d) bought as an overvalued stock
Answer:
Let us assume EPS to be Rs.10. Hence Actual Market price is Rs.280 (10 x 28) whereas fair price based on
industry PE is Rs.380. Hence share is undervalued and the share should be bought.

33. Component of required return

• Required Return = Inflation rate + Real-rate of return on risk-free investment + Risk Premium
• Risk-free rate = Inflation rate + Real rate of return on risk-free investment
• Required return = Risk-free rate + Risk Premium
Example:
Inflation rate = 6%; Real rate of return on investment in A Limited (risky asset) = 10%; Risk premium of A
Limited = 4%. What is the risk-free rate of return?
a) 6%
b) 16%
c) 10%
d) 12%
Answer:
Inflation rate = 6%. Real rate of return on risky asset is 10%. This would mean the return of A Limited is
16% (Inflation + Real rate). Risk Premium of A Limited is 4%. Hence risk-free rate of return = 16% - risk
premium of 4% = 12%

34. Inflation Premium

Inflation premium forms part of risk-free rate of return. Any increase in inflation premium will increase
the risk-free rate and vice versa
Example:

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Risk-free rate of security is 9 percent. Return from market is 13 percent. Beta of Security is 1.3 times. Growth
rate of security is 8 percent. How much is the required return of security if inflation premium increase by
3 percent?
a) 12.80%
b) 14.20%
c) 13.30%
Answer:
• Existing risk-free rate = 9%; Revised risk-free rate = 9% + Inflation premium = 9% + 3% = 12.00%
• Required return = R f + Beta x (R m − R f ) = 12.00 + 1.3 x (13 − 12) = 13.30%

35. Format of Income Statement

Particulars Amount
Sales XXX
Less: Cost of Goods Sold (XXX)
Gross Profit XXX
Less: Operating expenses (Selling and admin expenses) XXX
Operating Profit/EBIT XXX
Less: Interest expenses (Note 1) (XXX)
EBT XXX
Less: Tax (XXX)
EAT XXX
Less: Preference Dividend [Preference capital x Coupon %] (XXX)
Earnings available to equity shareholders XXX
No of equity shares XXX
EPS [EAES/No of equity shares] XXX
Note 1: Interest cost
• Question can give data on interest rates for different types of debt and also an effective interest
rate for entire debt structure.
• If both are given, then overall interest cost = Total debt x Effective interest rate %. Otherwise,
interest
• cost = Sum of (Respective debt x Respective interest rate)
Example:
Rs. In lakhs
8% Debentures 125
10% bonds (2007) 50
Equity shares (Rs.10 each) 100
Reserves and surplus 300
Current Liabilities 25
Assets turnover ratio 1.1
Effective interest rate 8%
Effective tax rate 40%
Operating margin 10%
Compute the amount of PAT of the company?
a) Rs.31.20 lacs
b) Rs.30.60 lacs
c) Rs.52 lacs
d) Rs.51 lacs
Answer:
Particulars Calculation Amount
Sales Total Assets x Asset Turnover 660.00
600 x 1.1
Total Assets = Total liabilities
Total liabilities = Debt + ESC + Reserves + CL
Total liabilities = 125 + 50 + 100 + 300 + 25 = 600
Less: Operating expenses 660 x 90% (594.00)
Operating profit/EBIT 66.00

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Less: Interest (Note 2) 175 x 8% (14.00)
Earnings before tax 52.00
Less: Tax @ 40% 52 x 40% (20.80)
Earnings after tax/EAES 31.20

36. Important Ratios

Ratio Formula Remarks
Current Assets
1 Current Ratio
Current Liabilities
Quick ratio / • Quick assets = Current Assets – Inventories
Quick Assets
2 liquid ratio / acid – Prepaid expenses
test ratio Current Liabilities
• Capital Employed = Equity capital +
Reserves and Surplus + Preference capital +
Total Debt
3 Debt Ratio Debt – Fictitious assets [OR]
Capital Employed
• Capital Employed = Fixed assets + Current
assets – Current liabilities
Total Equity (or)Networth • Equity = Equity capital + Reserves and
4 Equity Ratio
Capital Employed Surplus – Fictitious assets
Debt to equity Total Debt
5
ratio Total Equity
Capital gearing Total Debt + Preference
6
ratio Equity SC + Reserves
Proprietary funds Proprietary funds = Equity capital + Reserves –
7 Proprietary ratio
Total Assets Fictitious assets
EBIT
8 Interest coverage
Interest
Preference
PAT
9 Dividend
coverage ratio Preference Dividend
Equity dividend EAES
10
coverage ratio Equity Dividend
Other variants:
Variant Denominator
Fixed assets Turnover Fixed assets
ratio
Total assets Sales Current asset turnover Current assets
11
turnover ratio Total Assets ratio
Working capital turnover Working capital
ratio
Capital turnover ratio Capital
Employed
Debtors turnover Credit Sales
12
ratio Debtors
Creditors Credit Purchases
13
turnover ratio Creditors
Inventory COGS
14
Turnover ratio Stock
Conversion of • For instance, debtor days = 365/Debtors
365
15 turnover ratios turnover ratio
into days Turnover ratio
Other variants:
Variant Numerator
Gross Profit
16 Gross Profit ratio x 100 Net Profit ratio Net Profit
Sales Operating profit ratio EBIT
COGS ratio COGS

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Pre-tax EBIT
17 x 100
ROI/ROCE Capital Employed
Post-tax EBIT x (1 − Tax rate)
18 x 100
ROI/ROCE Capital Employed
EAES
19 Return on equity x 100
Amount of equity
DPS
20 Dividend Yield x 100
MPS
EPS
21 Earning Yield x 100
MPS
DPS
22 Dividend Rate x 100
Face Value
Earnings per EAES
23
share No of equity shares
Dividend per Total Dividend
24
share No of equity shares
Dividend Payout DPS
25 x 100
Ratio EPS
Example:
Total Debt = 600 lacs; Debt Ratio = 0.40; How much is equity value?
Answer:
Total Debt 600
Debt Ratio = ; 0.40 = ; CE = 1,500 lacs;
Capital Employed CE
CE = Total Debt + Total equity; 1,500 lacs = 600 lacs + Total equity; 𝐓𝐨𝐭𝐚𝐥 𝐞𝐪𝐮𝐢𝐭𝐲 = 𝟗𝟎𝟎 𝐥𝐚𝐜𝐬
Example:
Interest expenses = Rs.400 lacs. Interest expense will increase by 20% and EBIT will increase by 30%. How
much is the revised interest coverage if existing interest coverage is 4 Times.
Answer:
Existing data:
EBIT EBIT
Interest coverage = ; 4.00 = ; EBIT = 1,600 lacs
Interest 400
Revised data:
EBIT 1,600 + 30% 2,080
Interest coverage = = = = 4.33 Times
Interest 400 + 20% 480
Example:
Dividend Yield of Industry = 2.00%; Earning Yield of industry = 0.80%. EPS of Company = Rs.4.00; Payout
ratio = 40%. How much is the fair value of share under dividend yield and earning yield approach.
Answer:
Dividend of company = 4 x 40% = Rs.1.60 per share
Value of share under Dividend Yield Approach:
DPS 1.60 1.60
Dividend Yield = ; 2.00% = ; MPS = = Rs. 80.00
MPS MPS 2%

Value of share under Earning Yield Approach:

EPS 4.00 4.00
Earning Yield = ; 0.80% = ; MPS = = Rs. 50.00
MPS MPS 0.80%
Example:
Current capital employed = 2,000 lacs; Current EBIT = 200 lacs. The company plans to raise Rs.400 lacs in
the form of debt or equity. Return is expected to increase by 2%. What will be the new EBIT of next year?
a) 200 lacs
b) 240 lacs
c) 288 lacs
d) 204 lacs
Answer:
EBIT 200
Current ROCE = = = 10%
Capital Employed 2,000
Revised ROCE = 10% + 2% = 12% and the revised capital employed is 2,000 + 400 = 2,400 lacs; New EBIT
= 2,400 lacs x 12% = Rs.288 lacs
Example:
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Industry sales = 2,000 lacs; ABC's market share = 25%; GP margin = 40%; Expenses other than COGS is
half of COGS. For the next year industry will grow by 10% and ABC's market share will increase to 30%.
What will be the PBT of next year?
a. 50 lacs
b. 66 lacs
c. 200 lacs
d. 264 lacs
Answer:
Particulars Calculation Amount
Next year industry sales 2,000 + 10% 2,200
Next year ABC sales 2,200 x 30% 660
Less: COGS 660 x 60% -396
Gross Profit 660 x 40% 264
Less: Other expenses 396/2 -198
PBT of next year 66
Example:
Gross profit = 20%. Inventory Turnover Ratio = 10 Times; Inventory = 2,00,000. How much is the sales of
the company?
a. Rs.20,00,000
b. Rs.16,00,000
c. Rs.25,00,000
d. Rs.24,00,000
Answer:
COGS COGS
Inventory Turnover Ratio = ; 10 = ; COGS = 20,00,000
Inventory 2,00,000
GP is 20% of sales and hence COGS is 80% of sales
20,00,000
20,00,000 = 80% of sales; Sales = = 25,00,000
80%

37. Fixed Interest and Fixed Dividend Coverage Ratio

If the question states that PAT should cover fixed interest and fixed dividends xx times. In this case this
ratio would be calculated as under:
PAT + Interest
Fixed Interest and Fixed Dividend coverage ratio =
Interest + Preference Dividend
Example:
EBIT = 32,00,000; 12% debt = 64,00,000; Tax rate = 35%; 8% Preference capital of Rs.40,00,000. How much
is the fixed interest and fixed dividend coverage ratio?
Answer:
Particulars Amount
Profit before Interest and Taxes 32,00,000
Less: Interest on debentures (64,00,000 x 12%) (7,68,000)
Profit before tax 24,32,000
Less: Tax @ 35% (24,32,000 x 35%) (8,51,200)
Profit after tax 15,80,800
PAT + Fixed interest
Fixed interest and fixed dividend coverage =
Fixed interest + Fixed Dividend
15,80,800 + 7,68,000
Fixed interest and fixed dividend coverage = = 𝟐. 𝟏𝟔 𝐓𝐢𝐦𝐞𝐬
7,68,000 + 3,20,000

38. Impact of adverse/Favourable ratios on required Yield

Required return of a security can be taken as required return of proxy entity. However, this will have to
increase/decrease based on risk of company under valuation. One easy way to adjusting the required
return is through ratios. For instance, TCS has better coverage ratios than Infosys. This would mean TCS
is less risky than Infosys and hence will have lower required return as compared to Infosys.
Example:

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Capital gearing ratio of industry = 0.75; Equity share capital of company A = 100; R&S of company = 50;
Preference capital = 100; Debt = 200; Required return of industry = 10%. Required return is to be changed
by 2 bps for every 1 bps deviation in capital gearing. What is the required return for company A?
a) 12.50%
b) 11.25%
c) 8.75%
d) 7.50%
Answer:
Debt + Preference 100 + 200
Capital gearing = = = 2 Times
ESC + Reserves 50 + 100
Gearing of company is 1.25 times higher than that of industry. The company is riskier than industry and
hence will need higher return. Higher gearing of 1.25 times will be compensated by higher return of 2.50
% (1.25 x 2) and hence the required return of company A is 12.50%

39. Operating Income vs Net Income

The term operating profit is basically EBIT and net income is basically PAT

40. Theoretical Ex-Rights Price

(Existing shares x Existing Price) + (New shares x Rights Price)
Theoretical ex − rights price =
Existing shares + New shares
Example:
CMP = Rs.130; No of shares outstanding = 10 lacs; Company needs to raise 2 Crores for a new project.
What will be the ex-rights price if the firm offers rights in the ratio of 1:2?
a) 130
b) 93.33
c) 100
d) 150
Answer:
(Existing shares x Existing Price) + (New shares x Rights Price)
Theoretical ex − rights price =
Existing shares + New shares
(10 lacs x 130) + (5 lacs x 40)
Theoretical ex − rights price = = 𝑅𝑠. 100
10 lacs + 5 lacs
Note:
1
New shares issued = 10,00,000 x = 5,00,000
2
200 lacs
Issue price = = Rs. 40
5 lacs

41. Value of one right

Term Meaning
Value of one right share Theoretical ex-rights price – Rights issue price
Value of one right Value of one right
[per share] Rights Ratio
• If the expected post-rights price is given in the question, then the theoretical ex-rights price will
be replaced with expected/actual post-rights price will be used in the above formula
Example:
CMP of stock = 50; Rights issue price = 40; Rights ratio = 1:5; What is the value of a right (per share) when
the stock sells ex-rights at 50?
a) 1.67
b) 2.00
c) None of the above
Answer:
Theoretical value of right = Ex-rights price - Rights issue price
Theoretical value of right = 50 - 40 = Rs.10 per rights share (or) Rs.2 per right per share

42. Rights issue and impact on wealth

Shareholder’s wealth will not be impacted in case a shareholder subscribes to rights issue or sells the rights.
However, the wealth will fall in case the shareholder ignores the rights issue
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Situation 1: Subscription to rights issue:
Particulars Calculation Amount
Existing Wealth Existing shares x Existing price XXX
Revised Wealth:
Value of shares Revised shares x Ex-rights Price XXX
Less: Cash paid for purchase of rights shares (XXX)
Revised wealth XXX

Situation 2: Sale of rights:

Particulars Calculation Amount
Existing Wealth Existing shares x Existing price XXX
Revised Wealth:
Value of shares Existing shares x Ex-rights Price XXX
Add: Cash received on sale of rights XXX
Revised wealth XXX

Situation 3: Ignores rights issue:

Particulars Calculation Amount
Existing Wealth Existing shares x Existing price XXX
Revised Wealth Existing shares x Ex-rights Price XXX
Example:
The current share price is Rs.100. The rights ratio is 1:4. Rights price is 80. Mr.A hold 1,000 shares and has
neither subscribed nor sold rights? What will be the change in networth of Mr A?
a. No Change
b. Networth to improve by Rs.1,00,000
c. Networth to fall by Rs.1,00,000
d. Networth to fall by Rs.4,000
Answer:
(4 shares x 100) + (1 share x 80)
Theoretical ex − rights price = = Rs. 96
4+1
Share price will fall by Rs.4 due to rights issue and hence the investor will have loss of Rs.4,000 (1,000
shares x 4) as he has neither subscribed nor sold rights

43. Impact of Positive/Negative NPV on ex-rights price

If the information on rights issue proceeds is available then we can compute the NPV of the project. Total
NPV (positive/Negative) will have to be added to numerator to compute ex-rights price
Example:
PE Multiple of company = 12 times. Company does a project which cost 200 lacs. Company is expected to
earn 8 percent on the project. Current market price is Rs.200 and company has 1,00,000 shares. It will do
rights issue of 2,00,000 shares at Rs.100. How much is the ex-rights price?
a) 133.33
b) 197.33
c) 138.67
d) 130.67
Answer:
Note 1: NPV of project:
Particulars Calculation Amount
Earnings from project 200 lacs x 8% 16 lacs
Value of project (Earnings x PE Multiple) 16 lacs x 12 192 lacs
Cost of project 200 lacs
NPV of project 192 lacs – 200 lacs -8 lacs
Theoretical exrights price
(Existing shares x Existing Price) + (New shares x Rights Price) − Negative NPV
=
Existing shares + New shares
(1,00,000 x 200) + (2,00,000 x 100) − 8,00,000
Theoretical exrights price = = 𝟏𝟑𝟎. 𝟔𝟕 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
1,00,000 + 2,00,000

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44. Buyback and impact on EPS
Buyback can increase the EPS if the total earnings remain same and the number of shares reduce due to
buyback of shares
Example:
No of shares = 10,000; Share price = Rs.100; Buyback size = 50,000; Current EPS = 3; What will be the post-
buyback EPS if the PAT is maintained?
a) 3
b) 3.16
c) 2.85
d) 3.30
Answer:
Particulars Calculation Amount
Existing PAT (EPS x No of shares) 3 x 10,000 30,000
Buyback size Given 50,000
Buyback price 100
No of shares bought back 50,000/100 500
No of shares post buy-back 10,000 – 500 9,500
Post-buyback EPS 30,000/9,500 3.16

45. Buyback funded with debt

• Buyback can impact the total earnings if buyback is funded with debt. Revised PAT = Existing
PAT – [Interest cost x (1 – Tax rate)].
• The question can also for reverse working to find the amount of acceptable interest expenditure
and the amount of debt. This would help us in finding the buyback price per share and buyback
premium.
Example:
Existing EPS = 10; No of shares = 1,00,000. PE Multiple = 20. The company does buyback of 20 percent of
shares at a premium of 50% to CMP. The same is funded with 10% debt. Tax rate is 30%. What will be the
new EPS?
a) 5
b) 7.25
c) 10
d) 12.50
Answer:
Particulars Calculation Amount
Existing PAT (EPS x No of shares) 10 x 1,00,000 10,00,000
Existing MPS (EPS x PE Multiple) 10 x 20 200.00
Buyback price per share 200 + 50% 300.00
Amount of buyback (Price x No of shares) 300 x 20,000 60 lacs
Interest paid on loan 60 lacs x 10% 6,00,000
After-tax cost of interest 6,00,000 x 70% 4,20,000
New PAT post buyback 10,00,000 – 4,20,000 5,80,000
No of shares post buyback 1,00,000 – 20,000 80,000
Post-buyback EPS 5,80,000/80,000 7.25

46. Impact of Buyback on Book Value Per Share

Buyback will have an impact on book value per share as the overall Networth will decline with decline in
number of shares. Any buyback done at a price different from the book value per share will change the
book value per share.
Existing Networth − Buyback Size
Revised Book value per share =
Exisitng shares − Shares bought back
Example:
The share price of ABC Limited is Rs.5 per share. There are 50 lac shares outstanding and the company
has a book value of Rs.900 lacs. What is the book value per share (BVPS) after the share buyback of Rs.10
lacs?
a. Rs.18.54
b. Rs.21.24
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c. Rs.14.76
d. Rs.18.00
Answer:
900 lacs − 10 lacs
Book value per share = = Rs. 18.54 per share
50 lacs − 2 lacs
Note: Networth will decline by Rs.10 lacs on buyback. It is assumed that buyback is happening at current
market price and hence number of shares bought back is 2 lacs.

47. Convertible Instruments – Conversion Value

Conversion value refers to the value of the instrument once conversion happens.
Term Formula
Conversion Value (or) CMP of share x Conversion ratio
Stock Value
Example:
Face value of bond = Rs.100; Rate of interest on bond = 8%; Return on similar bonds = 9.5%. Term = 4
years. Bond is convertible into 5 shares. CMP of equity share = 15. What is bond's conversion value?
a) 100
b) 95.24
c) 75
d) 15
Answer:
Conversion value = CMP of equity shares x No of shares post conversion = 15 x 5 = Rs.75

48. Convertible Instruments – Conversion Premium

Conversion premium refers to the extra amount paid for buying a convertible instrument in excess of the
conversion value
Term Formula
Conversion premium in Rs. Current market price – Conversion value
(Per convertible instrument)
Conversion premium in Rs. Conversion Premium in Rs.
(Per equity share) Conversion Ratio
Conversion premium in % Conversion Premium in Rs.
x 100
Conversion value
Example:
Face value of bond = Rs.100; CMP of bond = Rs.100 Rate of interest on bond = 8%; Return on similar bonds
= 9.5%. Term = 4 years. Bond is convertible into 5 shares. CMP of equity share = 15. What is bond's
conversion premium per share?
a) 20
b) 15
c) 5
d) 25
Answer:
Conversion premium = CMP - Conversion value; 100 - 75 = Rs.25 per bond (or) Rs.5 per share

49. Convertible Instruments – Straight value (or) Intrinsic value (or) Floor Value (or) Minimum Price
Straight value or intrinsic value is the present value of future interest and principal discounted at investor’s
required rate of return
Example:
Face value of bond = Rs.100; Rate of interest on bond = 8%; Return on similar bonds = 9.5%. Term = 4
years. Bond is convertible into 5 shares. CMP of equity share = 15. What is bond's straight value?
a) 100
b) 75
c) 95.26
d) 89.67
Answer:
Straight value is present value of bond's cash flows discounted at required rate of return. Required rate of
return in this case will be 9.5% as that is the return on similar bonds

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Straight value of bond = (8 x 0.913) + (8 x 0.834) + (8 x 0.762) + (108 x 0.696) = 95.26

50. Convertible Instruments – Downside risk

Downside risk is the potential fall in price of convertible instrument. This can also be called as the premium
over straight value.
Term Formula
Downside risk in Rs. Current market price – Straight value
Downside risk in % Downside Risk in Rs.
x 100
(% of Straight value) Straight value
Downside risk in % Downside Risk in Rs.
x 100
(% of CMP) Current Market Price
Premium over straight value CMP − Straight Value.
x 100
(in %) Straight value
Example:
Face value of bond = Rs.100; CMP of bond = Rs.100; Rate of interest on bond = 8%; Return on similar bonds
= 9.5%. Term = 4 years. Bond is convertible into 5 shares. CMP of equity share = 15. What is downside risk
(in Rs.)?
a) 0
b) 10.33
c) 5.78
d) 25
Answer:
Downside risk = Current Market price - Straight value
Downside risk = 100 - 94.22 = 5.78
Note:
Straight value = (8 x 3.840) + (100 x 0.635) = Rs.94.22

51. Convertible Instruments – Conversion Parity Price

Conversion Parity Price is the expected price of equity share at which investor has no loss/gain on
conversion
Term Formula
Conversion parity Price (or) CMP of convertible instrument
Market Conversion Price (or) Conversion Ratio
Minimum market price at which conversion is to be exercised (or)
Break-even price
Example:
Face value of bond = Rs.100; CMP of bond = Rs.100; Rate of interest on bond = 8%; Return on similar bonds
= 9.5%. Term = 4 years. Bond is convertible into 5 shares. CMP of equity share = 15. What is conversion
parity price?
a) 20
b) 15
c) 100
d) 10
Answer:
CMP of bond
Conversion parity price = = 100/5 = Rs. 20
Conversion ratio

52. Convertible Instruments – Favourable income differential

Favourable income differential is the extra income received from bond vis-à-vis getting dividend income
from equity shares
Term Formula
Favourable income differential per Interest income per bond – Dividend income for equity shares
bond.
Favourable income differential per Favourable income differential per bond.
x 100
share Conversion ratio
Example:

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Face value of bond = Rs.100; Interest rate on bond = 10%. Bond is convertible into 10 shares. Likely
dividend per share is Rs.0.2. What is favorable income differential per share?
a) 9.80
b) 0.20
c) 0.80
d) 8.00
Answer:
Particulars Calculation Amount
Interest income of bond 100 x 10% 10.00
Dividend income per 10 shares 0.20 x 10 2.00
Favorable income differential per bond 10 – 2 8.00
Favorable income differential per share 8/10 0.80

53. Convertible instruments – Premium Payback Period

Premium Payback Period refers to the number of years taken to recover the conversion premium paid.
Term Formula
Premium payback period Conversion premium per bond
Favourable income differential per bond
(OR)
Conversion premium per Share
Favourable income differential per Share
Example:
Conversion premium per bond = Rs.100. One bond is convertible into 10 shares. Favorable income
differential per share = Rs.4. How much is the premium payback period?
a) 25 years
b) 2.5 years
c) 10 years
d) None of the above
Answer:
Particulars Calculation Amount
Conversion premium per bond Rs.100
Favorable income differential per share Rs.10
Favorable income differential per bond 10 x 4 Rs.40
Premium payback period 100/40 2.50 years

54. Valuation of Convertible Bond

Bond is present value of future cash flows discounted at investor’s required rate of return. We need to
redemption cash flow as higher of conversion value of bond on maturity and redeemable value as debt.
However, in some questions the expected conversion value on maturity will not be available and hence
redeemable value will be taken as redemption cash flow.
Example:
Face value = Rs.1,000; Rate of interest = 10%. The bond is convertible into 10 equity shares whose current
market price is Rs.80. Growth rate in equity share is 10%. What will be the terminal cash flow at end of
year 5?
a) 800
b) 1,000
c) 1,288.41
d) None of the above
Answer:
Particulars Calculation Amount
Conversion value at end of year 4 10x(80 x 1.15 ) 1,288.41
Redeemable value 1,000
Terminal value (Higher of two) 1,288.41

55. Floor value or Minimum Price of Convertible Bond

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This is computed by taking the bond’s cash flow as a debt instrument. Redeemable value is taken as
principal redemption value of debt and not the higher value. This is the minimum possible value of bond
and is computed based on assured cash flows of bond.

56. Decision on Conversion

A bond can be converted into equity share only if the conversion value (CMP of share x conversion ratio]
is higher than current market price of bond. If the value is less then we should continue the same as
bond and not opt for conversion
Example:
CMP of bond = Rs.1,200. One bond is convertible into 10 shares. CMP of share is Rs.125. Should the
investor opt for conversion?
a) Yes
b) No
c) Investor would be indifferent on conversion
Answer:
Value if conversion is done = 125 x 10 = Rs.1,250 whereas the CMP of bond = Rs.1,200. We should therefore
go ahead with conversion as the value of bond is higher post conversion

57. Stock Lending

• Stock lending, also known as securities lending, is a financial practice where one party (the lender)
temporarily lends their shares of a particular stock or other securities to another party (the
borrower).
• Lender: They lend their securities to borrowers in exchange for a fee, often a percentage of the
value of the lent securities.
• Borrower: The borrower pays a fee to the lender for the privilege of borrowing the securities. The
borrower would be taking the security to fulfil their commitment if they have done short-sell of
shares
• Income of person lending stock = Lending fees + Dividend income
• Income/loss of person borrowing stock = Profit/loss on price change – Lending fees- bank
guarantee charges
Example:
Mr. A is holding 1000 shares of face value of Rs.100 each of M/s. ABC Ltd. He wants to hold these shares
for long term and have no intention to sell. On 1st January 2020, M/s XYZ Ltd. Has made short sales of
M/s. ABC Ltd.’s shares and approached Mr. A to lend his shares under Stock Lending Scheme with
following terms:
• Lending Fees to be paid by Lender to Borrower = Rs.30,000
• Borrower needs to give Bank Guarantee and the Bank Guarantee charges = Rs.20,000
• Company has paid Dividend in the interim of Rs.20 per share
• Share price quoted at Rs.1,000 on Jan 1, 2020 and it increased to Rs.1,200 by end of short-sell
period
Compute the income of person lending stock and person borrowing stock?
a) Profit of Rs.30,000 and loss of Rs.30,000
b) Profit of Rs.50,000 and loss of Rs.50,000
c) Profit of Rs.50,000 and Loss of Rs.2,50,000
d) Profit of Rs.30,000 and Profit of Rs.1,50,000
Answer:
Income of person lending stock = Lending Fees + Dividend Income = 30,000 + 20,000 = Rs.50,000
Income of person borrowing stock:
• Share price has increased by Rs.200 and this would result in loss for person doing short-sell as
he has sold share at Rs.1,000 and needs to buyback the same at Rs.1,200
• Loss on short-sell = 200 x 1,000 = 2,00,000
• Overall loss = 2,00,000 + Lending fees (30,000) + Guarantee charges (20,000) = Loss of 2,50,000

58. Basic Terms Associated with Bond

Term Meaning
Face value or coupon value Value written across the face of
the certificate

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Coupon rate Interest rate written on the face
of the certificate
Interest Amount (Always on Face Value) Face value x Coupon Rate
Maturity value/Redemption Value Value payable at the end of the
(Assumed as par if problem is silent) life of a bond
Yield to maturity/ Cost of debt/ Discount rate/ Required return of The rate of return earned by an
investor/ Expected return/ Opportunity cost/ Market rate of investor who buys the bond
interest/ prevailing interest rate of similar bond/ Going rate of today and hold it until maturity
interest
Current yield Current yield refers to the ratio
of interest to current market
price

59. Valuation of Bond

• Value in year 0: Value of bond is present value of future cash flows of bond discounted at
investor’s required rate of return.
• Value at end of year 1: Value in year 1 = [Value in year 0 + Discount rate] – Interest of year 1
• Value at end of year 2: Value in year 2 = [Value in year 1 + Discount rate] – Interest of year 2
Example:
The nominal value of 10% bond is Rs.100. The redeemable value is Rs.120 in two years. Investor's expected
rate of return is 14%. What should be the value of bond?
a) 140
b) 71.43
c) 108.74
d) 104
Answer:
Year Cash flow PVF @ 14% DCF
1 10 0.877 8.77
2 130 0.769 99.97
Value of Bond 108.74
Example:
CMP of bond = Rs.1,000; Face value of bond = Rs.1,000; Interest rate on bond = 12%; YTM of bond = 15%.
What will be the price at end of year 2?
a) 1,000
b) 1064.50
c) 1,060
d) 940
Answer:
Particulars Amount
CMP (Day 0) 1,000.00
Add: Required return of year 1 (1,000 x 15%) 150.00
Less: Interest paid in year 1 (1,000 x 12%) -120.00
Fair price at end of year 1 1,030
Add: Required return of year 2 (1,030 x 15%) 154.50
Less: Interest paid in year 2 (1,000 x 12%) -120.00
Fair price at end of year 2 1,064.50

60. Half-yearly Bond

If a bond pays interest half-yearly then we should do half-yearly discounting and the discount rate should
also be half-yearly yield.
Example:
10% bond pays interest in September and March of every year. Face value is Rs.100. YTM is 12%. What
will be current market price with balance life of 2 years?
a) 96.6
b) 107.33
c) 96.53
d) 109.89
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Answer:
It is a half-yearly bond and hence we should opt for half-yearly discounting. Cash flow will be 5 in period
1, 5 in period 2, 5 in period 3 and 105 in period 4. Cash flows will be discounted at half-yearly YTM of 6
percent
Market price = (5 x 0.943) + (5 x 0.890) + (5 x 0.840) + (105 x 0.792) = Rs.96.53

61. Step-up/step-down discount rate

Follow the approach given in multiple cost of equity while doing share valuation. We need to check
whether given rates are forward rates/spot yield. If forward rates are given then we can follow the step-
up or down discount rate approach. However, if spot yield is given then approach changes. PVF of year
2 would be computing by taking 2-year yield and discounting the same for two years.
Example:
Discount rate for year 1 = 10%. Discount rate increases by 2% per year. What will be the PVF for year 3?
a) 0.751
b) 0.675
c) 0.712
d) None of the above
Answer:
1
PVF of year 1 = = 0.909
1.10
PVF of year 1 0.909
PVF of year 2 = = = 0.812
1 + DR of year 2 1.12
PVF of year 2 0.812
PVF of year 3 = = = 0.712
1 + DR of year 2 1.14
Example:
ABC Ltd. wants to issue 9% Bonds redeemable in 3 years at its face value of Rs. 1,000 each. The annual
spot yield curve for similar risk class of Bond is as follows:
Year Interest Rate
1 12%
2 11.62%
3 11.33%
What would be the issue price of the bond?
Example:
Year Cash flow PVF DCF
1 90.00 0.893 80.37
2 90.00 0.803 72.27
3 1,090.00 0.725 790.25
Issue price of Bond 842.89
Note: Spot Yield curve would mean that the given 2 year-yield is for year 0 to 2 and hence PVF would be
computed in below manner:
1
PVF of Year 1 =
1 + 12%
1
PVF of Year 2 =
(1 + 11.62%)2
1
PVF of Year 3 =
(1 + 11.33%)3

62. What is to be used as discount rate of a Bond

• Discount rate: Investor’s required rate of return will be taken as discount rate. This can also be
called as yield of comparable bond (or) going rate of interest.
• Higher-yield offered by company: Sometimes the company may want to give a higher yield to
investor. In this case, the issue price will be computed based on the yield proposed to be given by
the company
Example:
Treasury bill rate = 9%; Discount rate for A rated bond = T bill rate + 3%; Discount rate for AA rated bond
= AAA rate + 1%; Discount rate for AAA rated bond = A rated bond - 2%. What should be the discount
rate for AA rated bond?
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a) 9%
b) 12%
c) 11%
d) 10%
Answer:
Particulars Amount
Discount rate for A rated bond (9 + 3) 12.00%
Discount rate for AAA rated bond (12% - 2%) 10.00%
Discount rate for AA rated bond (10 + 1) 11.00%
Example:
The company plans to issue 10% debentures. Yield on similar debenture is 15%. The company plans to
issue in such a manner it gives 18% return to investors. What should be the discount rate for valuation of
bond?
a) 10%
b) 15%
c) 18%
Answer:
Normally the discount rate would be rate on similar debentures. However, company wants to give return
of 18% and hence the same will be taken as discount rate

63. Annuity Bond

Annuity Bond is wherein annual inflow (interest + Principal) would be same every year. Annual inflow is
calculated as under:
FV of Bond
Annual Inflow =
PVAF(r, n)
Example:
Life of annuity bond = 4 years; Interest rate = 12%; Face value = Rs.1,000. What will be the annual cash
flow?
a) 250
b) 329.27
c) 370
Answer:
CMP 1,000
Annual cash flow = = = Rs. 329.27
PVAF (4 years, 12%) 3.037

64. Broken Period Bond Valuation

Value of bond on a date on which interest is not paid: Let us assume a bond pays interest in June and
December. The above approach of valuation can help in valuing a bond on July 1 and January 1. However,
we are required to calculate the value of bond on Sep 1. In such a scenario we will complete valuation like
this:
Value as on September 1 = Value as on July 1 + Accrued interest for broken period [July 1 to August
31]
Example:
MP as on Jan 1, 2019 = Rs.100. Face value of Rs.100 and interest rate is 10%. Interest is payable half-yearly
on June 30 and December 31. What will be price of the bond on Oct 1, 2019?
a) 107.50
b) 100
c) 102.50
Answer:
Current market price is equal to face value and hence interest rate and YTM will be same. This would
mean that bond will quote at par value of Rs.100 once interest is paid out
Price as on October 1, 2019 = Price as on June 30, 2019 + Accrued interest
Price as on October 1, 2019 = 100 + (100 x 10% x (3/12) = 100 + 2.50 = 102.50

65. Impact of Transaction Cost

• Transaction cost will reduce yield due to extra expense incurred on purchase of bond.
• Yield with transaction cost = Normal Yield x (1 – Transaction cost)

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Transaction cost
Number of days to break − even transaction cost = x No of days
Normal YTM
Example:
A bond pays coupon rate of 10% and is currently quoted at par. 1% is the transaction cost. What is the
effective Yield and time period taken to recover the transaction cost?
a) 9% and 36.5 days
b) 11% and 73 days
c) 9.90% and 36.5 days
d) 10.10% and 73 days
Answer:
Bond is quoted at par and hence YTM of bond is equal to coupon rate
Yield with transaction cost = Normal Yield x (1 − Transaction cost) = 10 x (1 − 0.01) = 9.90%
Transaction cost 1
Number of days to recover = x No of days = x 365 = 36.50 days
Normal YTM 10

66. YTM of Bond

Method 1 Calculate IRR of the bond considering the future cash flows
Method 2 𝐏𝐨𝐬𝐭 𝐭𝐚𝐱 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 + 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐨𝐭𝐡𝐞𝐫 𝐢𝐧𝐜𝐨𝐦𝐞
(Short-cut method) 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐟𝐮𝐧𝐝𝐬 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Where:
Post tax interest income = Interest income x (1 − Tax rate)
𝐑𝐞𝐝𝐞𝐦𝐩𝐭𝐢𝐨𝐧 𝐯𝐚𝐥𝐮𝐞 − 𝐍𝐞𝐭 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐨𝐭𝐡𝐞𝐫 𝐢𝐧𝐜𝐨𝐦𝐞 =
𝐋𝐢𝐟𝐞 𝐨𝐟 𝐢𝐧𝐬𝐭𝐫𝐮𝐦𝐞𝐧𝐭
𝐑𝐞𝐝𝐞𝐦𝐩𝐭𝐢𝐨𝐧 𝐯𝐚𝐥𝐮𝐞 + 𝐍𝐞𝐭 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐟𝐮𝐧𝐝𝐬 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝 =
𝟐
Note:
• Spread of yield from comparable bond: Spread of Bond X= YTM of Bond X – Yield of comparable
bond
Example:
YTM of convertible bond = 10.76%. Yield of comparable bond is 9%. What is the spread of yield of
convertible bond from that of comparable bond?
a) 10.76%
b) 9.00%
c) +1.76%
d) -1.76%
Answer:
Spread of bond = YTM of convertible bond - YTM of comparable bond
Spread of bond = 10.76% - 9% = +1.76%
Example:
Face value of bond = Rs.100; Coupon Rate = 11%; Current Market Price = Rs.97.60. Life = 3 years. How
much is the YTM under short-cut method?
Answer:
Interest + Average other income
Yield =
Average funds employed
Interest = Rs.11
100 − 97.60
Average other income = = 0.80
3
100 + 97.60
Average funds employed = = 98.80
2
𝟏𝟏 + 𝟎. 𝟖𝟎
𝐘𝐢𝐞𝐥𝐝 = 𝐱 𝟏𝟎𝟎 = 𝟏𝟏. 𝟗𝟒%
𝟗𝟖. 𝟖𝟎
Example:
If the market price of the bond is Rs.95; years to maturity = 6 years; coupon rate = 13% p.a. (paid annually)
and issue price is Rs.100. What is the yield to maturity?
Use PVF of 14.00% and 15.00% to compute YTM
Answer:
Year Cash flow PVF @14% DCF PVF @15% DCF
0 (95) 1.000 (95.00) 1.000 (95.00)

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1 to 6 13 3.888 50.54 3.785 49.21
6 100 0.456 45.60 0.432 43.20
1.14 (2.59)
Computation of YTM:
NPV at L1
IRR = L1 + x(L2 − L1 )
NPV at L1 − NPV at L2
L1 = Lower rate of 14%; NPV at L1 = 1.16
L2 = Higher rate of 15%; NPV at L2 = -2.59
1.14 1.14
IRR = 14 + x(15 − 14); IRR = 14 + x (1); 𝐈𝐑𝐑 = 𝟏𝟒 + 𝟎. 𝟑𝟏 = 𝟏𝟒. 𝟑𝟏%
1.14 − (−2.59) 3.73

67. Post-tax YTM

In this case we should consider taxation on interest income and capital gain and consider net inflows of
the investor for computing YTM
Example:
Issue price of bond = Rs.80; Redemption value in year 5 = Rs.120; Face value of bond = Rs.100; Interest rate
on bond = 10%; Tax rate on interest = 30%; Tax rate on capital gain = 20%. What will be the post-tax cash
flow of year 5?
a) 130
b) 120
c) 119
d) 123
Answer:
Particulars Amount
Post-tax interest outflow (10 x 70%) 7.00
Capital gain in year 5 (120 – 80) 40.00
Tax on capital gain (40.00 x 20%) 8.00
Net realization post capital gain (120 – 8) 112.00
Overall realization (Interest (7) + RV (112)) 119.00

68. Relationship between YTM, Coupon Rate and Bond Price

Coupon Rate = YTM Bond will be at par
Coupon Rate > YTM Bond will be at premium
Coupon Rate < YTM Bond will be at discount
Note:
• This would mean that if Bond is quoted at par, then YTM of Bond will be equal to coupon rate
• The above relationship will work only if redemption is happening at par value. If redemption is
at premium/discount, then we need to compute YTM
• Regardless of its required yield, the price will converge to par value as Maturity approaches. Value
of premium/discount will keep reducing with passage of time.
Example:
Interest rate on Bond = 10%; YTM of bond = 12%; what will the bond quote at?
a) Bond will quote at premium
b) Bond will quote at discount
c) Bond will quote at par
Answer:
Bond will quote at discount as the company is not able to meet investor expectations of 12 percent

69. Increase/decrease in interest rates

Any increase/decrease in interest rate will have to be taken as change in investor expectation (yield) and
not as change in bond interest rate. This is because interest rate of a bond/debenture does not change and
would remain as per original terms of debenture

70. Variable Bond

A variable bond is one whose interest rate changes with investor expectation. Interest rate on these bonds
will always be equal to yield prevailing in the market

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Example:
A company issues a variable bond where interest rate changes based on prevailing interest rates. Bond
was issued when interest rate was 10%. It has remaining life of two years and the interest rate is now 8%.
What will be the value of bond today if face value is Rs.1000?
a) 1,000
b) 1,035.30
c) 900
d) None of the above
Answer:
Variable bond is one where prevailing interest rate and interest rate paid on bond will be same. Hence this
bond will always be meeting expectation of bond holders (Provided redemption is also happening at par).
Hence it will always quote at par value which in this case is Rs.1,000

71. Expected Price of Bond

Expected price of bond = Intrinsic value of bond x Beta [There is no logic for this formula. But this is
frequently tested in exams and hence students are requested to remember and apply this]
Example:
Intrinsic value of Bond = Rs.900; Beta of Bond = 1.10 Times.
Expected Price = 900 x 1.10 = Rs.990

72. YTM From company point of view

Company will have inflow on day 0 and will have series of outflow over the life of the bond. Hence while
calculating IRR, we should increase the discount rate if we get negative NPV and decrease the discount
rate if we get positive NPV [Following an approach opposite of normal approach]

73. Current Yield of Bond

Interest
Current Yield =
Current Market Price
Example:
10% Govt of India security is quoted at 125 (Face value of Rs.100). Yield is expected to go up by 1 percent.
What will be the revised price?
a) 90.91
b) 111.11
c) 100
d) None of the above
Answer:
Interest 10
Current yield = = = 8%
CMP 125
Yield will go up by 1 percent and hence it will become 9 percent
10
Revised price = ( ) = Rs. 111.11
9%

74. Yield and Price Relationship

• Yield and price has inverse relationship and any increase in yield will reduce the price and vice
versa
• For an irredeemable bond, current yield formula will be used to find the revised price with the
change in yield. For a redeemable bond, the concept of volatility is used to find the revised price.
Any increase in yield will reduce the CMP and any decrease in yield will increase the CMP

75. Realized Yield

• Realized yield assumes that interim cash flows from a bond will be reinvested at a realistic
reinvestment rate
• Terminal value of cash flows is calculated with the reinvestment rate and the same is compared
with initial outflow
• The IRR of the revised cash flows is the realized yield
Steps:

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• Step 1: Compute the normal cash flow of bond. Compound the cash flows to last year with
reinvestment rate and re-investment period. Reinvestment rate would be given in question and if
the same is not given it would be taken as cost of debt
• Step 2: Add up all maturity cash flows and this would give us the maturity cash flow. We will
have single outflow on day 0 and a single inflow on maturity. IRR needs to be computed for this
cash flow and the same would be called as realized YTM
Note:
• Reinvested interest: Maturity value of interest – normal interest earned
• Intermediate cash flows are not reinvested: If the intermediate cash flows are not re-invested
then the maturity cash flows will be additional of all inflows. Hence maturity cash flows would
be significantly less and based on that we should compute realized YTM.
Example:
You have invested in 8.5% bond with face value of Rs.1,000. Reinvestment rate is 10 percent and has 3
years to maturity. What is the reinvested interest on this bond?
a) 26.35
b) 54.48
c) 309.48
d) 281.35
Answer:
Year Cash flow Reinvestment period FVF FCF
1 85 2 1.21 102.85
2 85 1 1.1 93.50
3 1,085 0 1.00 1,085
Total 1,255 1,281.35
Reinvested interest = 1,281.35 – 1,255 = Rs.26.35
Example:
Compute realized YTM for the above example. Use discount rate of 8% and 9% to compute realized YTM.
Example:
Year Cash flow PVF @ 8% DCF PVF @ 9% DCF
0 -1,000.00 1 -1,000.00 1 -1,000.00
3 1,281.35 0.794 1,017.39 0.772 989.20
NPV 17.39 -10.80
Computation of realized YTM:
YTM (IRR) = NPV at L1
L1 + ( ) x(L2 − L1)
NPV at L1 − NPV at L2
YTM = 17.39
8+ 𝑥 (9 − 8)
17.39 − (−10.80)
YTM = 8 + 0.62
YTM = 8.62%

76. Relationship between normal YTM and realized YTM

Reinvestment rate = IRR Realized YTM = Normal YTM
Reinvestment rate > IRR Realized YTM > Normal YTM
Reinvestment rate < IRR Realized YTM < Normal YTM
Example:
YTM of a bond instrument is 20% and the re-investment rate is 15%. What is the likely realized Yield of
the bond?
a) 20%
b) Greater than 20%
c) Less than 20%
Answer:
Less than 20%. Re-investment has been done at lower than YTM and hence realized YTM would be lower
than normal YTM

77. Duration
Duration of a redeemable bond:

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❖ Step 1: Compute cash flows of bond till maturity
❖ Step 2: Determine PVF using YTM
❖ Step 3: Market price is sum of present value of cash flow discounted at PVF of step 2
❖ Step 4: Divide each year’s cash flow by market to get weights
❖ Step 5: Sum of (time x weights) is duration
Format for computation of duration (assuming a 5-year bond)
Year Cash flow PVF @ YTM DCF Weight Year x Weight
1 Interest
2 Interest
3 Interest
4 Interest
5 Interest +
Principal
Total Duration of bond

Duration of a perpetual bond:

1+y
Duration of a pepetual bond =
y
Duration of zero-coupon bond = Life of bond
Note:
In case of half-yearly bond, we should compute the duration in terms of number of half-years and the
column for year will be replaced with half-year in above table. Similarly, the YTM would be half-yearly
YTM
Example:
YTM of perpetual bond = 8%. What is its duration?
a) 12.5 years
b) 8 years
c) 9 years
d) 13.5 years
Answer:
1 + YTM 1 + 0.08
Duration = ( )= ( ) = 13.5 years
YTM 0.08
Example:
Face value = Rs.1,000; Coupon Rate = 11.00%; Life = 6 years; Yield to Maturity = 15.00%. Compute
duration?
Answer:
Year Cash flow PVF @ 15% DCF Weight Product
1 110 0.870 95.70 0.1128 0.1128
2 110 0.756 83.16 0.0980 0.1960
3 110 0.658 72.38 0.0853 0.2559
4 110 0.572 62.92 0.0742 0.2968
5 110 0.497 54.67 0.0644 0.3220
6 1,110 0.432 479.52 0.5652 3.3912
848.35 4.5747
Duration = 4.5747 years

78. Impact of change in variables on duration of Bond

• Time to maturity: The shorter-maturity bond would have a lower duration and less price risk and
vice versa.
• Coupon rate: Coupon payment is a key factor in calculation of duration of bonds. The higher the
coupon, the lower is the duration and vice versa.
• Yield-to-Maturity (YTM): Higher yield-to-maturity means lower duration and hence, lower
interest rate risk and vice versa.
Example:
Which of the following points is/are true about duration of bonds?
(i) The shorter-maturity bond would have a lower duration and vice versa
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(ii) The higher the coupon, the lower is the duration and vice versa
(iii) Higher YTM would lead to higher duration and lower YTM would lead to lower duration
a) (i) and (ii) is correct
b) (i), (ii) and (iii) is correct
c) (i) and (iii) is correct
d) (ii) and (iii) is correct
Answer:
(i), (ii) is correct
Explanation: Shorter-maturity bonds have lower life and accordingly lower duration. Higher coupon will
lead to higher cash flow during initial years and hence will have lower duration. High discount rate will
lead to lower duration and low discount rate will lead to higher duration

79. Volatility or Modified Duration

𝐃𝐮𝐫𝐚𝐭𝐢𝐨𝐧
𝐕𝐨𝐥𝐚𝐭𝐢𝐥𝐢𝐭𝐲 =
𝟏 + 𝐘𝐓𝐌

80. Volatility of half-yearly Bond

In case of half-yearly bond, we should use half-yearly YTM in formula for computing volatility. However,
duration should be only in terms of years.
Example:
Duration of half-yearly bond = 5.85 years; YTM = 10%. What will be the volatility of bond?
a) 5.32
b) 5.57
c) 6.44
d) 6.14
Answer:
Duration in years 5.85
Volatility = = = 5.57
1 + Relevant YTM 1 + 5%
Bond is paying half-yearly interest and hence we need to use half-yearly YTM to compute volatility

81. Duration and Churning of Portfolio

If yields are expected to increase, price of bond will fall. We should look at reducing the duration of
portfolio in this case and hence we should replace bond of higher duration with bond of lower duration.
Lower duration would imply lower volatility and lower fall in price. The opposite will work if yields are
expected to fall.
Example:
Duration of portfolio is 8 years. Yield is expected to increase in current year. Which action should be taken
by the investor?
a) No action to be taken
b) Increase investment in lower duration bonds by selling higher duration bonds
c) Increase investment in higher duration bonds by selling lower duration bonds
d) Increase investment in both higher and lower duration bonds
Answer:
Yield is expected to increase and hence value of portfolio will decline. We should work on reducing the
duration of the portfolio as lower duration will lead to lower volatility. Hence in this case we should
increase investment in lower duration bonds and sell higher duration bonds

82. Volatility and change in price

• Yield and price of bond is inversely proportional. Price of a bond will fall if Yield increases and
vice-versa
• Percentage change in bond price is computed with the help of volatility
% 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐛𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞 = 𝐕𝐨𝐥𝐚𝐭𝐢𝐥𝐢𝐭𝐲 𝐱 % 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐘𝐓𝐌
Example:
Volatility = 4.5. Yield is expected to increase by 25 bps. What will be the effect on current market price?
a) Price will increase by 4.5%
b) Price will increase by 1.125%
c) Price will decrease by 4.5%
d) Price will decrease by 1.125%
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Answer:
Yield is expected to increase and hence price will fall; % Fall in price = 4.5 x 0.25 = 1.125%

83. Immunization
• Immunization happens if the weighted duration of the portfolio is equal to the period for which
investment is required to be made. This is a level where price risk and reinvestment risk will offset
each other leading to no impact to the investor
• Investor needs money after xx years: This should be interpreted as duration of investment should
be equal to xx years
• Fund an outflow after xx years: This would be interpreted as duration of investment should be
equal to xx years
Example:
Duration of Bond A = 4 years; Duration of Bond B = 10 years; Investor needs money after 6 years. What
should be the investment in Bond A and Bond B?
a) 50% and 50%
b) 100% in Bond A
c) 66.67% in A and 33.33% in B
d) 66.67% in B and 33.33% in A
Answer:
Investment in Bond A = X; Investment in Bond B = 1 - x
Bond Duration Weight Product
A 4 X 4X
B 10 1-X 10-10X
Total 4X + 10 – 10X = 6
Solving we get X as 66.67% and hence 66.67% is investment in Bond A and Balance 33.33% is investment
in Bond B

84. Bond Refunding

• Items related to old Bond: Floatation cost, Discount on issue of debentures, call premium etc
related to old bond has to be written off on day 0 because we are looking at replacing old bond
with new bond
• Items related to new bond: Floatation cost, discount on issue of new bond would be written off
over the life of the new bond
• In-between cash flow: After-tax outflow of old bond – after-tax outflow of new bond. We should
work as if the old bond is continuing when we analyse the cash flows of old bond
• Overlapping interest: This is the extra interest paid because old bond could not be redeemed on
time. Overlapping interest outflow on day 0 = Extra interest paid on old bond x (1 – Tax rate)
• Discount rate: After-tax cost of debt is to be used as discount rate if given in question. If problem
is silent, then after-tax cost of new debt is to be taken as discount rate.

Typical cash flow structure of Bond Refunding question:

Step 1: Calculate Initial Outflow
Particulars Calculation Amount
Redemption value of old Bond (XXX)
Call premium on old Bond Face value of Bonds x Call Premium % (XXX)
Tax benefit on w/o of call premium Call premium x Tax Rate XXX
Tax benefit on w/o of unamortized Original FC (or) Discount XXX
x Balance life x Tax Rate
FC/Discount of old Bond Original Life
Issue value of new bonds XXX
Overlapping interest on Old Bond No of months (XXX)
Face value of Old Bonds x Interest rate x
12
Tax Benefit on w/o of overlapping Overlapping interest x Tax Rate XXX
interest
Initial Outflow XXX

Step 2: In-between flows

Particulars Old Bond New Bond
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Interest cost Face value x Interest Rate Face value x Interest Rate
Less: Tax on interest Interest x Tax Rate Interest x Tax Rate
Less: Tax on floatation costOriginal Floatation Cost Original Floatation Cost
x Tax Rate x Tax Rate
Original Life Original Life
Less: Tax on discount Original Discount Original Discount
x Tax Rate x Tax Rate
Original Life Original Life
Net cash flow XXX XXX
Incremental cash inflow = Cash outflow of Old Bond – Cash outflow of New Bond

Step 2: In-between flows

Particulars Old Bond New Bond
Interest cost Face value x Interest Rate Face value x Interest Rate
Less: Tax on interest Interest x Tax Rate Interest x Tax Rate
Less: Tax on floatation costOriginal Floatation Cost Original Floatation Cost
x Tax Rate x Tax Rate
Original Life Original Life
Less: Tax on discount Original Discount Original Discount
x Tax Rate x Tax Rate
Original Life Original Life
Net cash flow XXX XXX
Incremental cash inflow = Cash outflow of Old Bond – Cash outflow of New Bond

Step 3: Terminal Flow

Particulars Old Bond New Bond
Redemption value XXX XXX
Example:
Bond was issued 5 years ago with flotation cost of Rs.30 lacs. It has balance life of 25 years. Tax rate is 30%.
Bond is to be replaced with new bond. What will be tax benefit on flotation cost?
a) 9 lacs in day 0
b) 7.5 lacs in day 0
c) 30,000 for year 1 to year 30
d) 30,000 for year 1 to year 25
Answer:
Particulars Calculation Amount
Total Floatation Cost 30,00,000
Un-amortized Floatation cost 30,00,000 x (25/30) 25,00,000
Tax benefit on write-off 25,00,000 x 30% 7,50,000
Tax benefit will be taken on day 0 as the old bond will be refunded and closed. Hence all tax benefit of
Rs.7.5 lacs will arise in year 0
Example:
Face value of bond = Rs.200 lacs; Call premium = 10%. Balance life = 10 years. Tax rate = 20%. What will
be the tax benefit on call premium?
a) Rs.4 lacs in day 0
b) Rs.40,000 from year 1 to year 10
c) Rs.40 lacs in day 0
d) Rs.4 lacs from Year 1 to Year 10
Answer:
Call premium = 200 lacs x 10%= 20 lacs; Tax benefit = 20 lacs x 20% = Rs.4 lacs; Tax benefit will be taken
immediately as the old bond is redeemed
Example:
A company is making a new issue of equity shares to refund existing bonds. The existing bonds carry
interest rate of 15% and current outstanding is 6 million. Life of the bond is 5 years. For early redemption
there is prepayment penalty of USD 3,50,000 to be paid. Cost of capital is 10%. How much is the NPV of
bond refunding?
a. USD 11,37,900
b. USD 7,87,900
c. USD 4,37,900
d. NPV is negative
Answer:

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Cash flow
Year (‘000s) PVF @ 10% DCF
0 -6,350 1.000 -6,350.00
1 to 5 900 3.791 3,411.90
5 6,000 0.621 3,726.00
NPV of bond refunding 787.90
• The company will have to pay 6,350 today for bond refunding (6 million + 3,50,000)
• The company will save interest of 900 for a period of 5 years and will save principal payment of
6,000 at end of five years
• NPV of bond refunding = USD 7,87,900

85. Forward Rates

Forward rates work in the same manner as that of step-up or step-down discount rates. We will have the
following two approaches to compute forward rates
Cash flows are given:
• First take one-year bond and find PVF of year 1 as balancing figure such that NPV of bond is zero.
Forward rate of year 1 is computed as under:
1
PVF of year 1 =
1 + Forward rate of year 1
• Then analyse the 2-year bond and get PVF of year 2 as balancing figure such that NPV of bond is
zero. Forward rate of year 2 is computed as under:
PVF of year 1
PVF of year 2 =
1 + Forward rate of year 2
Interest rates are given:
• We will use FRA formula to compute forward rates
FVF for year 2
Forward rate for year 1 to year 2 = −1
FVF for year 1
Example:
1 year interest rate = 10 percent; 2-year interest rate = 12 percent; What will be the forward rate of year 1
to 2?
a) 14%
b) 11%
c) 14.04%
Answer:
FVF of year 2 1.2544
Forward rate of Year 1 to 2 = [ ] − 1 = ( ) − 1 = 14.04%
FVF of year 1 1.10
Example:
The six-year spot rate is 7% and the five-year spot rate is 6%. The implied one-year forward rate five years
from now is:
a) 6.50%
b) 12.14%
c) 5.00%
d) 12.00%
Answer:
FVF for six years (1 + 0.07)6
FRA5x6 = −1= − 1 = 12.14%
FVF for five years (1 + 0.06)5

86. Relationship between Forward Rate and Spot Rate

(1 + Spot rate1 ) = (1 + Forward rate1 )

(1 + Spot rate2 )2 = (1 + Spot rate1 )x (1 + Forward Rate2 )

(or)
(1 + Spot rate2 )2 = (1 + Forward rate1 )x (1 + Forward Rate2 )

(1 + Spot rate3 )3 = (1 + Spot rate2 )2 x (1 + Forward Rate3 )

(or)
(1 + Spot rate3 )3 = (1 + Forward rate1 )x (1 + Forward Rate2 ) x (1 + Forward Rate3 )
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87. Nature of Yield Curve

• Normal yield curve/upward sloping = Interest rates for long-term instruments is higher than
Interest rates for short-term instruments
• Inverted Yield Curve/downward sloping = Interest rates for short-term instruments is higher than
Interest rates for long-term instruments
• Flat Yield Curve = Interest rates for short-term instruments = Interest rates for long-term
instruments

88. Bond Convexity

• Duration can be used to find the new bond price when there are changes in YTM. However,
duration assumes a linear relationship and assumes equal percentage change. But the change in
not linear and can be adjusted using convexity adjustment
• New Price = Old Price + % change as per duration + Convexity adjustment [Convexity adjustment
will always be added even if there is an increase/decrease in Yield]

Computation of convexity:
Δy = Change in Yield
V+ + V− − 2V0
C=
2V0 (Δy 2 )
V+ = Price of bond if yield increases by Δy
V− = Price of bond if yield decreases by Δy

• C = Convexity
• Convexity adjustment (in Rs.) = C x (Δy 2 ) x V0
Convexity Adjustment in Rs.
Convexity Adjustment (%) = x 100
V0
Example:
Compute Convexity of bond based on the following information:
Fair value of bond at 10% YTM 100.00
Fair value of bond at 9% YTM 103.89
Fair value of bond at 11% YTM 96.30
a. 9.50
b. 0.095
c. 0.19
d. 19.00
Answer:
V+ + V− − 2V0 96.30 + 103.89 − 2(100)
Convexity = = = 9.50
2V0 (Δy 2 ) 2(100)(0.01)(0.01)
Example:
Compute Convexity Adjustment for above example:
Convexity adjustment (in Rs.) = C x (Δy 2 ) x V0 = 9.50 𝑥 0.01 𝑥 0.01 𝑥 100 = 0.0950
Convexity Adjustment in Rs. 0.0950
Convexity adjustment (in %. ) = = 𝑥 100 = 0.0950%
CMP 100

89. Valuation of Preference Shares

• Value of redeemable preference share is the present value of future cash flows (Dividend and
Principal) discounted at investor’s required rate of return
Preference Dividend
Value of irredeemable preference share =
Investor Expectation
Example:
11% preference shares of Rs.100 is currently quoted at yield of 13%. What should be the current market
price?
a. 100
b. 84.62
c. 118.18
d. None of the above

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Answer:
Dividend 11
Value of share = = = 84.62
Current yield 13%

90. Valuation of Warrants

Value of Warrant = (CMP − Exercise Price)x Number of equity shares convertible with one warrant
Example:
A company has issued a warrant which can be converted into 10 equity shares by paying Rs.50 per share.
The current market price of the share is Rs.80. How much is the value of warrant?
a) 0
b) Rs.800
c) Rs.500
d) Rs.300
Answer:
Value of warrant = (CMP – EP) x Ratio = (80 – 50) x 10 = Rs.300

91. Enterprise Value

• Total Enterprise value = Equity + Debt + Minority Interest – Cash and cash equivalents
• Operating Enterprise value = Total enterprise value – market value of non-operating assets such
as investments in associates
• Core Enterprise value = Operating enterprise value – Value of non-core assets
Example:
Book value of equity = 1000; Market value of equity = 2000; Reserves and surplus = 200; Value of debt =
800; Cash and cash equivalents = 400. How much is enterprise value?
a) 1600
b) 2400
c) 2600
d) 1800
Answer:
EV = Market value of equity + Debt - Cash and cash equivalents
EV = 2000 + 800 - 400 = 2,400
Example:
Enterprise value = Rs.40,00,000; Value of debt = Rs.10,00,000; Value of cash and cash equivalents =
Rs.5,00,000. How much is the value of equity?
a. 45,00,000
b. 35,00,000
c. 55,00,000
d. 25,00,000
Answer:
Enterprise value = Value of equity + Value of debt - Amount of cash
40,00,000 = Value of equity + 10,00,000 - 5,00,000
35,00,000 = Value of equity

92. Valuation based on EV Multiples

• EV to sales and EV to EBITDA are the commonly used multiples for valuing a company
• EV based on sales = Sales x EV to sales multiple
• EV based on EBITDA = EBITDA x EV to EBITDA Multiple
Example:
Enterprise value of Infosys - 1,000 Crores. EBITDA of Infosys - 250 Crores. What should be the enterprise
valuation of TCS if EBITDA of TCS is 50 Crores?
a) 1000 Crores
b) 50 Crores
c) 200 Crores
d) 250 Crores
Answer:
EV/EBITDA multiple of Infosys = 1000 crores/250 crores = 4 Times;
EV of TCS = EBITDA x 4 times = 50 Cr x 4 = 200 Crores

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Example:
EV to sales multiple of industry = 1.5 times; EV to EBITDA multiple of industry = 5 times; Sales of ABC
Limited = 5,000; EBITDA of ABC Limited = 2,000; What should be the value of ABC Limited?
a) 7,500
b) 10,000
c) 8,750
d) None of the above
Answer:
We have data to calculate Enterprise value on the basis of sales and EBITDA. Final enterprise value will
be average based on sales and EBITDA
EV based on sales = 5,000 x 1.5 = 7,500
EV based on EBITDA = 2,000 x 5 = 10,000
7,500 + 10,000
Average Enterprise value = = 8,750
2

93. Cash return on total investment

1
Cash return on total investment =
EV to EBITDA Multiple
Example:
EV to EBITDA multiple of Company A is 5 Times. How much is the cash return on total investment?
a) 5%
b) 10%
c) 20%
d) 25%
Answer:
Cash return on total investment can be computed as inverse of EV to EBITDA multiple and the same in
this case would be 20% (1/5)

94. Yield of Treasury Bill (or) Discount of Commercial Bill (or) Yield of Certificate of Deposit (or) Yield
of commercial Paper
Maturity Value − Issue Price 365
Annual Yield = x x 100
Issue Price No of days
Example:
CMP of T-bill on March 31= 95,000. Maturity date = July 20; Face value = 1,00,000. What is the yield on
treasury bill?
a) 5%
b) 5.26%
c) 16.44%
d) 17.30%
Answer:
95,000 will become 1,00,000 in 111 days (30 + 31+ 30 + 20)
5,000 365
Yield = ( )x( ) x 100 = 17.30%
95,000 111

95. Computation of issue price of money market instrument

Issue price of money market instrument is to be computed based on the formula for annual yield
Example:
RBI Sold 91 days treasury bill of Rs.100 with yield of 12 percent. What is the issue price?
a) 97.01
b) 97.10
c) 98.00
d) None of the above
Answer:
Let us assume Issue price to be Y
100 − 𝑌 365
12 = 𝑥 ( ) 𝑥 100
𝑌 91
1092Y = 36,50,000 − 36500Y

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36,50,000
Y = = Rs. 97.10
37,592

96. Effective Annual Interest of Money Market Instrument

Annual rate n
EAI = (1 + ) −1
n
Note:
• N = Number of times of compounding in a year = (12/Number of Months) (or) (365/Number of
days)
Example:
You want to deposit Rs.10,000 in a bank certificate of deposit (CD). You are considering the following
banks:
• Bank A offers 5.85% annual interest compounded annually
• Bank B offers 5.75% annual interest rate compounded monthly
• Bank C offers 5.70% annual interest compounded daily
Which bank offers the highest effective annual interest rate and how much?
a) Bank C, 5.87%
b) Bank A, 5.85%
c) Bank B, 5.90%
d) Bank B, 5.80%
Answer:
Answer to this is Bank B and 5.90%
Effective rate of Bank A = 5.85%
5.75% 12
Effective rate of Bank B = (1 + ) − 1 = 5.90%
12
rt 0.057
Effective rate of Bank C = e − 1 = 𝑒 − 1 = 1.0587 − 1 = 5.87%
Daily compounding would basically mean continuous compounding and the same is computed
through ert tables

97. Effect of compensating balance on cost of commercial paper

Particulars Calculation Amount
(in lacs)
Interest cost FV – Amount raised XXX
Cost of placement XXX
Stamp Duty XXX
Issuing and other charges XXX
Rating Charges XXX
Total cost XXX
Net amount raised through CP
Amount raised XXX
Less: Line of credit to be maintained (XXX)
Less: All costs other than interest (XXX)
Effective amount raised XXX
Total Cost 12
Effective cost of CP (pre − tax) = x x 100 = XX%
Effective Amount Raised Number of Months

Effective cost of CP (post − tax) = Pre − tax cost of CP x (1 − Tax Rate)

Example:
Interest cost of CP = 2.5 percent per quarter; Issue period of CP = 6 months; Stamp duty = 0.5 percent of
issue size; Rating charges = 1 percent per annum; Other charges = 0.1 percent per month. How much is
the overall annual cost of CP issue?
a) 13.2 percent
b) 14.2 percent
c) 8.2 percent
d) 9.2 percent
Answer:
Particulars Amount

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Interest cost (2.50 x 4) 10.00
Stamp duty (0.5 x 2) 1.00
Rating charges 1.00
Other cost (0.1 x 12) 1.20
Overall cost 13.20
Example:
Face value of CP = 100 lacs; Interest expense on CP = 4 lacs; The firm is required to keep balance of Rs.5
lacs in line of credit. Issue period of CP = 6 months. What is the annual cost of CP?
a) 8 percent
b) 8.33 percent
c) 8.79 percent
d) 19.78 percent
Example:
Amount realized on issue of CP = 100 -4 = 96 lacs; Net amount available = 96 lacs - 5 lacs = 91 lacs
4 lacs 12
Cost of CP = ( ) x ( ) x 100 = 8.79 percent
91 lacs 6

98. Clean Price and Dirty Price

• Dirty Price = Clean Price + Accrued Interest
• Accrued Interest should be computed based on the rate of interest of original instrument
• Start proceeds = Face value x (Dirty Price/Face value per instrument) x (100 – Margin %)
• Maturity proceeds = Start Proceeds + Rate of interest as per Repo Rate
Example:
Bank A entered into repo transaction at the rate of 8% on 12% GOI Bond, 2021. Clean price of the
instrument is Rs.95 and face value is Rs.100. 240 days of accrued interest is applicable and number of days
in a year is 360. What is the dirty price?
a) 95
b) 100
c) 100.33
d) 103
Answer:
Accrued interest = Face value of Rs.100 x 12% x (240/360) = Rs.8.00
Dirty price = Clean price of Rs.95 + Accrued interest of Rs.8 = Rs.103.00
Example:
Amount of face value for repo transaction = 4 crores. Initial margin = 5%. Clean price = Rs.98. Accrued
interest = Rs.4. what is the first leg proceeds?
a) 3.80 crores
b) 3.724 crores
c) 3.876 crores
d) None of the above
Answer:
Dirty price = 98 + 4 = 102
4 crores
Value of security = ( ) x 102 = 4.08 crores
100
Initial proceeds = 4.08 crores - 5% margin = Rs.3.876 Crores
Example:
Bank A entered into repo on 12% GOI Bond. Initial proceeds is Rs.7,95,20,000. Repo period was for 14 days
and rate of interest on repo is 5%. What is the amount to be repaid?
a) 7,96,72,504
b) 7,98,86,010
c) 7,98,90,093
d) 7,96,74,622
Answer:
14
Interest on repo = 7,95,20,000 x 5% x = 1,52,504
365
Amount to be repaid = 7,95,20,000 + 1,52,504 = 7,96,72,504

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Chapter 6 – Portfolio Management

Overview:
• How to compute risk and return of individual security?
• How to compute risk and return of portfolio?
• How to compute correlation coefficient and covariance?
• Efficient and inefficient securities
• Beta of security (without probability)
• Beta of security (with probability)
• Beta of Portfolio
• How to alter Beta of Portfolio
• Sharpe approach and Markowitz approach for portfolio risk
• Sharpe approach and Markowitz approach for portfolio risk
• Systematic and unsystematic risk
• Use of co-efficient of determination, random error and Specific SD
• Security market line, capital market line and characteristic line
• Concept of Alpha
• Return under APT = two formulae
• Weights for minimum risk = 2 security (formula), 3 securities (critical line) and more than 3
(Sharpe approach)
• Levered and unlevered Beta (or) Equity beta and asset beta
• Portfolio strategies - Constant mix, Buy and Hold and Constant Proportion portfolio insurance
• Real Estate Valuation

1. Return of Security
• Return of security (in Rs.) = Dividend + Capital appreciation
(P1 − P0 ) + D1
Return of security (in %) = x 100
P0
(P1 − P0 )
Return of security (in %) = + Dividend Yield
P0
D1 = Dividend of next year = Dividend rate is to be applied on face value and Dividend yield is to be
applied on market price to get the Dividend Amount
P1 = Price of next year
P0 = Current year price
• If return is given for multiple scenario/years, then expected return is weighted average of various
possible return with probability being the assigned weight.
• If probability is not given then we will assume equal probability for each observation.
• Different Probabilities for Dividend and Capital Gain: A question can have a different
probability for dividend and different probability for price. Let us assume there are 3 possible
dividends and 3 possible prices. This scenario will lead to nine different combinations and joint
probability for each combination is to be calculated. Joint Probability = Probability for Dividend
x Probability for Capital Gain
Example:
You have purchased 5,000 shares of R Limited (Face value of Rs.10) by paying Rs.2,00,000. The company
has paid dividend of 20% and the closing price is Rs.50. How much is the return of R Limited?
Answer:
(50 − 40) + 2
Expected return = 𝑥 100 = 30.00%
40
Note:
• Dividend is computed on face value of Rs.10 per share
• Opening price = 2,00,000/5,000 = Rs.40 per share
Example:
Year Share Price Dividend Yield
Present year 197.00 10%
1 year ago 164.20 12%
2 year ago 155.00 8%

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Answer:
Let us assume present year to be 20224. Hence present year is 2024 (P2), one year ago is 2023 (P1) and two
year ago is 2022 (P0)
P1 − P0 164.20 − 155
Return of 2023 = + Dividend Yield = + 0.12 = 0.0594 + 0.12 = 0.1794 (𝑜𝑟)17.94%
P0 155
P2 − P1 197 − 164.20
Return of 2024 = + Dividend Yield = + 0.1 = 0.1998 + 0.1 = 0.2998 (𝑜𝑟)29.98%
𝑃1 164.20

2. Risk of Security
• Risk of Security is measured through Standard Deviation
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 = √𝐩𝐝𝟐
Format for computing Risk and Return [Format 1]
Probability Return Product Deviation 𝐏𝐝𝟐

Note:
• Probability = Given in question (or) assumed to be equal
• Return is computed as per above paragraph. This would be the most important item in any
problem in portfolio management and students should ensure full certainty of the calculation
• Product = Return x Probability
• Return of security = Sum of product
• Deviation = Column 2 - Sum of product
• Pd2 = Probability x Deviation x Deviation
Example:
Compute the Standard Deviation of Security from the following information
Probability Return
0.20 10
0.30 20
0.40 -10
0.10 -20
a. 20%
b. 10%
c. 14.70%
d. 16.70%
Example:
Prob Return Product Deviation 𝐏𝐝𝟐
0.20 10 2.0 8.0 12.80
0.30 20 6.0 18.0 97.20
0.40 -10 -4.0 -12.0 57.60
0.10 -20 -2.0 -22.0 48.40
2.0 216
Standard Deviation (%) = √216 = 14.70%

3. Computation of Correlation coefficient and Covariance

• Correlation mean relation between two securities. Correlation can range between -1 to +1
Format 2:
Security A Security B
Prob Return Product Deviation 𝑷𝒅 𝟐 Return Product Deviation 𝐏𝐝𝟐 𝐏𝐝𝐚 𝐝𝐛

• 𝐏𝐝𝐚 𝐝𝐛 = Probability x Deviation of A x Deviation of B

COVAB = ∑𝐏𝐝𝐀 𝐝𝐁
CovarianceAB
COR AB =
σA σB

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Co-variance between A and A: Some question can give data on co-variance between security A and
Security A. This basically would mean variance of A itself.
Computation of co-variance through Beta:
Covariance of A and B = Beta of A x Beta of B x Variance of Market
Example:
Co-variance of Security A and B = 0.0200; SD of Security A = 0.40 and SD of Security B = 0.20. How much
is correlation co-efficient between A and B?
a. +0.10
b. +0.05
c. +0.50
d. +0.25
Answer:
Co − variance of security A and B 0.0200
Correlation coefficient = = = +0.25
SD of A x SD of B 0.40 𝑥 0.20
Example:
Compute Co-variance between Security A and B with the help of following information
Year Return on A (%) Return on B (%)
2006 10 12
2007 16 18
a. 3
b. 9
c. 36
d. 6
Answer:
Security A Security B
Year Prob 𝐏𝐝𝐚 𝐝𝐛
Return Product Deviation Return Product Deviation
2006 0.5 10 5 -3 12 6 -3 4.5
2007 0.5 16 8 3 18 9 3 4.5
Total 13 15 9
Co-variance of stocks = Sum of Pda db = 9
Example:
Beta of Company A = 1.50 Times; Beta of Company B = 2 Times; SD of market = 0.10. How much is
covariance between Security A and Security B?
a. 0.30
b. 0.03
c. 0.01
Answer:
Covariance between A and B = Beta of company A x Beta of Company B x Variance of market = 1.50 x 2 x
0.1 x 0.1 = 0.03
Example:
Co-variance between security X and Security X = 4.80; Co-variance between Security X and Security Y =
4.30; Co-variance between Security Y and Security Y = 4.25. How much is the Standard deviation of
Security X?
a. 4.80
b. 4.30
c. 2.19
d. 2.07
Answer:
Covariance between security X and Security X is basically variance of Security X
SD = √4.80 = 2.19

4. Portfolio Return and Portfolio Risk

• Portfolio return is the weighted average of return of individual securities.
• Portfolio risk is not weighted average of risk of individual securities. This is because of correlation
coefficient.
Formula for Portfolio Risk through Markowitz Approach:

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Two Securities = √(σa wa )2 + (σb wb )2 + 2σa σb COR ab
Three Securities = √(σa wa )2 + (σb wb )2 + (σc wc )2 + 2σa σb COR ab + 2σa σc COR ac + 2σb σc COR bc
Note:
• We are basically using the formula of (A+B) 2 for two securities and (A+B+C)2 for three securities
• A = σa wa
• B = σb wb
• C = σc wc
Example:
SD of Security A = 10%; Weight of Security A in portfolio = 60%; SD of Security B = 20%; Weight of Security
B = 40%; Correlation co-efficient between Security A and B is 0.50. How much is the portfolio SD?
a. 14%
b. 15%
c. 12.17%
d. 14.25%
Answer:
Variance of Portfolio = (σa Wa )2 + (σb Wb )2 + 2σa Wa σb Wb COR ab
Variance of Portfolio = (10 𝑥 0.60)2 + (20 x 0.40)2 + 2(10)(0.60)(20)(0.40)(0.50) = 148
Variance of Portfolio = √148 = 12.17%
Example:
The rate of return of Market is 8% and risk-free rate of return is 5%. You are currently holding Rs.1,00,000.
How much should be the investment in market and risk-free asset to get return of 10%?
a. 1,66,667 and 66,667
b. 1,66,667 and -66,667
c. -66,6667 and 1,66,667
d. 66,667 and 1,66,6667
Answer:
Let us assume X to be the proportion of investment in market and (1-X) to be the proportion of investment
in Risk-free security
Security Return Weight Product
Market 8 X 8X
Risk-free 5 1-X 5-5X
Total 10 1 8X + 5 -5X = 10
8X + 5 – 5X = 10; 3X = 5; X = 166.67%; Hence investor should invest 166.67% in market portfolio and borrow
66.67% from risk-free security. Investment in market security = Rs.1,66,667; Borrowing from market =
Rs.66,667

5. Notion of Dominance
A security is said to dominate another security if
• It generates higher return for lower risk
• It generates higher return for same risk
• It generates same return for lower risk
If a security is dominated by another security, it is called inefficient security. Only efficient securities
should form part of portfolio.
Example:
Given the following risky securities
Particulars A B C D E F G H
Return % 10 12.5 15 16 17 18 18 20
Risk % 23 21 25 29 29 32 35 45
Identify the inefficient securities in the given list?
a. B, C, E and F
b. A and D
c. A, D, G and H
d. A, D and G
Answer:
• Security A, D and G are inefficient securities

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• Security B dominates Security A as it generates higher return with lower risk. Hence Security A
is inefficient.
• Security E dominates Security D as it generates higher return with same risk. Hence Security D
is inefficient
• Security F dominates Security G as it generates same return with lower risk. Hence Security G
is inefficient

6. Compensation for Risk

• Compensation for additional risk undertaken can be computed as Sharpe ratio (undiversified) and
Treynor ratio (Diversified)
Return − Risk free rate
Sharpe Ratio =
SD
Return − Risk free rate
Treynor Ratio =
Beta
• Increase in Sharpe Ratio/Treynor Ratio would indicate better returns for the risk undertaken by
the investor
Example:
An investor is currently earning return of 20% with SD of 16%. Investor has added additional investments
to the portfolio which increased its returns to 21% with SD of 15%. Risk-free rate is 6%. Show how well the
Fund will be compensated for the risk undertaken due to inclusion of stocks in the portfolio.
Answer:
Sharpe Ratio = Actual Return − Risk Free Return
( )
Standard Deviation
Existing Sharpe Ratio = 20 − 6
= 0.875 Times
16
Revised Sharpe Ratio = 21 − 6
= 1.000
15
Sharpe Ratio has improved by 0.125 times due to addition of stocks in revised portfolio.

7. Risk-free rate
• Treasury Bond/Government Bond will be taken as risk-free security and risk-free return can be
computed using the below formula:
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
𝐑𝐢𝐬𝐤 − 𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞 =
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁𝐨𝐧𝐝
• If there are multiple risk-free rates given in the question then we can follow one of the below
approaches:
o Aggressive approach: Take risk-free rate as higher rate
o Conservative approach: Take risk-free rate as lower rate
o Moderate approach: Take average as risk-free rates. Follow this approach if problem is
silent
• Hidden risk-free rate of return: There could be a portfolio of securities given in the question and
one of the securities can have a Beta of 0 times. If any security has Beta of 0 time, then the same
will be taken as risk-free rate of return
Example:
RBI has closed the latest auction for Rs.2,500 crores of 182 days bills for the lowest bid of 4.3% although
there were bidders at a higher rate of 4.6% also for lots less than Rs.10 Crores. What should be taken as
risk-free rate if you want to follow an aggressive approach?
a. 4.45%
b. 4.60%
c. 4.30%
Answer:
Aggressive approach is to consider higher rate of 4.60%

8. Risk Premium of Market

• Market risk premium is the difference between market return and risk-free rate
• Return of market should always be higher than risk-free rate and hence risk premium of market
will always be positive. However, some questions can give a scenario of negative risk premium
and we should continue with same figures for solving the question
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9. Beta
• Beta measures the performance of a security in relation to market
• Market has Beta of 1 Time and risk-free security has Beta of 0 Times
• A security can have positive Beta or Negative Beta. Negative Beta indicates negative correlation
between security and market
• Sensitivity of returns to market is also known as Beta
(∑XY − n(Mean of X)(Mean of Y))
𝐅𝐨𝐫𝐦𝐮𝐥𝐚𝟏: 𝐁𝐞𝐭𝐚 =
∑Y 2 − n(Mean of Y)2
N = No. of observations; X = Rate of return of stock; Y = Rate of return of market
• This can be used if probability information is not given in question
SD of Security
𝐅𝐨𝐫𝐦𝐮𝐥𝐚 𝟐: 𝐁𝐞𝐭𝐚 = x Correlation coefficient
SD of Market
• Formula 2 and 3 can be used if data on probability is there
Covariance of Security and Market
𝐅𝐨𝐫𝐦𝐮𝐥𝐚 𝟑: 𝐁𝐞𝐭𝐚 =
Variance of Market
Format 3: Format for Formula 1
Return of security (X) Return of market (Y) XY 𝐘𝟐

•Format 2 is to be used for formula 2 and formula 3

•Observation based on Beta Computation: We should compute the required return as per CAPM
for every year and compare the same with actual return of every year. Based on this, we can advise
on whether to buy or sell the security in that year
Beta computation through price change:
The below formula is not an ideal method for calculating Beta, as price changes may not precisely align
with market movements. Nevertheless, it is commonly employed to assess the price fluctuation of a
security in relation with the overall market (extensively applied in derivative chapter)
% change in security
Beta =
% change in market
Example:
Correlation co-efficient of security A and Market = 0.80; SD of Security A = 20%; SD of market = 25%. How
much is the Beta of Security A?
a. 0.80 Times
b. 0.64 Times
c. 1 Time
d. 1.25 Times
Answer:
SD of Security 0.20
Beta = x Correlation coefficient = x 0.80 = 0.64 Times
SD of Market 0.25
Example:
What is the beta of Hamburg Corp.'s stock if the covariance of the stock with the market portfolio is 0.23,
and the standard deviation of the market returns is 32%?
a. 1.65
b. 0.72
c. 1.40
d. 2.25
Answer:
Co − variance of security and market
Beta =
Variance of market
0.23
Beta = = 2.25
0.32 x 0.32
Example:
A security moved up by 12% when the market moved down by 6%. How much is the beta of the security?

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a. 2 times
b. -2 times
c. 0.5 times
d. -0.5 times
Answer:
% change in security 12
Beta = = = −2 Times
% change in market −6
Example:
Compute Beta of Security A with the help of following information:
Year 2007 Year 2008 Year 2009
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
a. 2 Times
b. 1.2536 times
c. 0.9250 times
d. 1.0836 Times
Answer:
Company A Market
Year return (X) return (Y) XY 𝐘𝟐
2007 13 12 156 144
2008 11.5 11 126.5 121
2009 9.8 9 88.2 81
Sum 34.3 32 370.7 346
Average 11.43 10.67
(∑XY − n(Mean of X)(Mean of Y))
𝐁𝐞𝐭𝐚 =
∑Y 2 − n(Mean of Y)2
(370.7 − 3(11.43)(10.67)) 4.8257
𝐁𝐞𝐭𝐚 = = = 𝟏. 𝟎𝟖𝟑𝟔 𝐓𝐢𝐦𝐞𝐬
346 − 3 (10.672 ) 4.4533

10. Beta (Bullish vs Bearish Market)

• High-beta companies are anticipated to deliver high returns accompanied by increased risk.
Conversely, low-beta companies are expected to yield lower returns with comparatively lower
risk
• During a bull market, where the market is on an upswing, investing in high-beta companies is
advisable for the potential of substantial returns. In contrast, during a bearish market,
characterized by a downturn, it is prudent to consider investments in low-beta companies to
mitigate potential losses
Example:
Stock market is expected to be in bullish phase. You have shortlisted 5 securities from the market and want
to invest in 3 with a minimum of 20% in each of the securities to diversify the risk. Identify the securities
and proportion of investment.
Company Beta
S Limited 1.60
K Limited 1.00
P Limited -0.30
D Limited 2.00
C Limited 0.60
a. S Limited (60%), D Limited (20%) and K Limited (20%)
b. D Limited (60%), S Limited (20%) and K Limited (20%)
c. D Limited (33.33%), S Limited (33.33%) and K Limited (33.33%)
d. D Limited (50%), S Limited (25%) and K Limited (25%)
Answer:
We should invest maximum in securities having higher Beta to maximize returns in bull phase. We are
required to invest in three securities with minimum investment of 20%. Hence, we can invest 60% in
highest Beta Security, 20% in next security and balance 20% in third security.
Example:
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Particulars Sec A Sec B Sec C
Return 12% 14% 16%
• Construct maximum number of portfolio if each portfolio consists of any two Company's shares
in proportion of 65% and 35%
• Which Portfolio would give maximum return
Answer:
• 65% of Sec A and 35% of Sec B
• 65% of Sec B and 35% of Sec A
• 65% of Sec A and 35% of Sec C
• 65% of Sec C and 35% of Sec A
• 65% of Sec B and 35% of Sec C
• 65% of Sec C and 35% of Sec B
Maximum Return:
• We should invest 65% in highest return security (Security C) and 35% in the next highest return
security (Security B)

11. Beta vs Standard Deviation

• Beta and Standard Deviation are measures of risk with different utility
• Beta is useful to assess risk of diversified portfolio whereas Standard Deviation is useful for
assessing risk of undiversified portfolio

12. Concept of fair/Equilibrium return and fair/Equilibrium beta

• Fair /Equilibrium Return refers to the return to be earned as per CAPM formula. This is computed
using Actual Beta.
• Fair/Equilibrium Beta refers to the Beta which a security should possess in alignment with the
return it gives. This is computed using Actual Return
• To summarize Fair return can be computed with Actual Beta and Fair Beta can be computed
with Actual Return
Example:
Return of Security = 20%; Return of market = 15%; Risk-free rate = 10%; Beta of security = 0.50 Times
Fair Return Analysis:
• Fair return/CAPM Return = Rf + Beta x (Rm - Rf)
• Fair return/CAPM Return = 10 + 0.50 x (15 - 10) = 12.50%
• Security should generate return of 12.50% whereas it is generating return of 20%. This is a case of
undervalued company and hence share must be bought.

Fair Beta Analysis:

• Return = Rf + Beta x (Rm - Rf)
• 20 = 10 + Beta x (15 - 10)
• Fair Beta = 2 Times
• Security should have Beta of 2 Times whereas it has Beta of 0.5 Times. Hence security carries lower
risk and hence we should buy security

13. Risk of Portfolio Relative to Market

• We can comment on riskiness of our portfolio in relation to the market by computing Actual Beta
as well as Equilibrium Beta
Actual Beta = Equilibrium Beta Optimum risk
Actual Beta > Equilibrium Beta High Risk
Actual Beta < Equilibrium Beta Low Risk

14. Decision on Purchase/Sale of Security

• We can decide on making fresh investments/liquidation of security by computing Beta of security.
• Beta will help us in calculating required return and same can be compared with actual return.
Actual Return = Required Return Correctly Valued No Action
Actual Return > Required Return Under-valued Buy

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Actual Return < Required Return Over-valued Sell
Example:
The expected returns and Beta of three stocks are given below
Stock A B C
Expected Return 18 11 15
Beta Factor 1.7 0.6 1.2
If the risk free rate is 9% and the expected rate of return on the market portfolio is 14% which of the above
stocks are over, under or correctly valued in the market? What shall be the strategy?
Answer:
Stock Required Return Expected Return Valuation Decision
A 17.50 18.00 Under-valued Buy
9 + 1.7 x (14 – 9)
B 12.00 11.00 Over-valued Sell
9 + 0.6 x (14 – 9)
C 15.00 15.00 Correctly valued Hold
9 + 1.2 x (14 – 9)

15. Portfolio Beta

• Portfolio Beta is the weighted average of beta of individual securities. The same would be
computed using below format
Security Beta Weight Product

• Portfolio Beta can be altered by adding/removing securities. It can also be altered by

borrowing/investing in risk-free security
• Replacing security with NIFTY/SENSEX: An investor can replace a security with
NIFTY/SENSEX if the beta of security is 1 time. This would ensure that overall beta would remain
same
Example:
M/s. Siri Ltd. Has a surplus amount of Rs. 3 crores to invest and has shortlisted the following equity
shares:
Company Beta
S Limited 1.60
K Limited 1.00
P Limited -0.30
D Limited 2.00
C Limited 0.60
How much is the portfolio Beta if 50% is invested in highest Beta Security, 20% is invested in lowest Beta
Security and balance is distributed equally among balance securities?
Security Beta Weight Product
S Ltd 1.60 0.10 0.16
L Ltd 1.00 0.10 0.10
P Ltd -0.30 0.20 -0.06
D Ltd 2.00 0.50 1.00
C Ltd 0.60 0.10 0.06
Total 1.26
Portfolio Beta = 1.26 Times

16. Target Portfolio Beta

• An investor can work with a target beta and would want to fix the weights for achieving the target
Beta. This can be computed by using the weighted average format.
Example:
An investor is targeting overall Beta of 2 Times. He wants to invest in Security A (Beta of 1.5 Times) and
Security B (Beta of 3 Times). What should be the composition to achieve target Beta?

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Security Beta Weight Product
Sec A 1.50 A 1.5A
Sec B 3.00 1-A 3-3A
Total 2 1 1.5A + 3 -3A = 2
• 1.5A + 3 -3A = 2
• -1.5A = -1
1
Investment in Security A = = 0.6667
1.5
Investment in Security B = 1 − 0.6667 = 0.3333

17. Systematic Risk and Unsystematic Risk

• Systematic risk/non-diversifiable risk will impact all companies in the economy and cannot be
avoided by diversification. It arises due to macro factors like GDP growth/unemployment rates
etc.
• Unsystematic risk/diversifiable risk will impact a specific company and arises due to business
and financial risk of specific company. This is also known as specific SD/residual risk/random
error

Computation of Systematic Risk/Unsystematic Risk:

Systematic Risk = Numerator of F2 of Beta Calculation
SD of Security
𝐁𝐞𝐭𝐚 = x Correlation coefficient
SD of Market
𝐁𝐞𝐭𝐚 𝐱 𝐒𝐃 𝐨𝐟 𝐌𝐚𝐫𝐤𝐞𝐭 = 𝐒𝐃 𝐨𝐟 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐱 𝐂𝐨𝐫𝐫𝐞𝐥𝐚𝐭𝐢𝐨𝐧 𝐂𝐨𝐞𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐭
• Either left-hand side or right-hand side of the equation can be used as Correlation Coefficient

Particulars Variance Approach SD Approach

Total Risk Variance of security SD of security
(Beta of security x SD of market)2 Beta of security x SD of market
(or) (or)
Systematic Risk (SD of security x COR sm )2 SD of security x COR sm
Unsystematic Risk Total risk - Systematic risk Total risk - Systematic risk
Example:
SD of Security = 20; SD of Market = 10; Correlation of Security and Market = 0.25 Times
Particulars Variance Approach SD Approach
Total Risk 20 x 20 = 400 20
(SD of Security x Corsm )2 SD of Security x Corsm
Systematic Risk = (20 x 0.25)2 = 25 = 20 x 0.25 = 5
Unsystematic Risk 400 – 25 = 375 20 – 5 = 15
Example:
Total risk of security (SD) = 0.20. Security has perfect positive correlation with market. How much is the
unsystematic risk as per SD approach?
a. 0.20
b. 0
c. 0.10
Answer:
• Security has perfect positive correlation and hence has correlation coefficient of +1
• Systematic risk = SD of security x Correlation = 0.20 x 1 = 0.20
• Unsystematic risk = 0.20 - 0.20 = 0
Example:
Ashwin, CA, examines data for two computer stocks, AAA and BBB, and derives the following results:
Standard deviation for AAA is 0.50. Standard deviation for BBB is 0.50. Standard deviation for the Nifty is
0.20. Correlation between AAA and the Nifty is 0.60. Beta for BBB is 1.00. Ashwin wants you to identify
the stock with the highest systematic and unsystematic risk. _____ has the highest systematic risk and
__________ has the highest unsystematic risk
a. AAA and AAA
b. AAA and BBB
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c. BBB and BBB
d. BBB and AAA
Answer:
0.50
Beta of AAA = ( ) x 0.60 = 1.50. Hence AAA has highest Beta (systematic risk)
0.20
• Unsystematic risk of AAA = 0.50 – (1.50 x 0.20) = 0.20
• Unsystematic risk of BBB = 0.50 – (1 x 0.20) = 0.30
• Hence BBB has highest unsystematic risk. So AAA has highest systematic risk and BBB has
highest unsystematic risk
Example:
A portfolio has been constructed with the following features:
Security Β Random Error, σ€i Weight
A 1.50 6 0.50
B 1.10 10 0.50
Find out the unsystematic risk of the portfolio given that the standard deviation of the market index is
20%.
Answer:
• Random error is basically unsystematic risk. σ€i would mean as per SD approach and hence we
square the same for variance approach. [This is not fully logical but lack of information and
hence we square SD based unsystematic risk to get variance based unsystematic risk]
• Portfolio unsystematic risk = [6 x 6 x 0.5 x 0.5] + [10 x 10 x 0.50 x 0.50] = 34

18. Portfolio risk through Markowitz/Sharpe Approach

Markowitz Approach:
• Markowitz approach uses correlation between each pair of securities to compute Portfolio Risk
• Formula for the same is provided in the section of Portfolio Return and Portfolio Risk Above

Sharpe Approach:
• Sharpe Approach considers co-movement between securities due to change in the market index
• Total risk (Variance) of portfolio as per Sharpe Index Model = Systematic risk of portfolio +
Unsystematic risk of portfolio
o Systematic risk of portfolio = (Beta of portfolio * SD of market) 2
o Unsystematic risk = (W12 * Unsystematic risk) + (W22 * Unsystematic risk) + (Wn2 *
Unsystematic risk)
Example:
Unsystematic risk as per variance approach of Security A = 0.02; Unsystematic risk as per variance
approach of Security B = 0.05; Weight of security A = 80%; Weight of Security B = 20%. How much is
portfolio unsystematic risk?
a. 0.026
b. 0.035
c. 0.0148
d. None of the above
Answer:
• Unsystematic risk = Weighted average of individual unsystematic risk with weights square being
the assigned weights
• Unsystematic risk = [0.02 x 0.80 x 0.80] + [0.05 x 0.20 x 0.20] = 0.0148

19. Co-efficient of determination

• Co-efficient of determination measures systematic risk as a percentage of total risk
Systematic risk
Coefficient of determination =
Total Risk
• The coefficient of determination is referred to as "r" when calculated using the SD approach and
denoted as "r 2 " when determined through the variance approach
• Coefficient of determination under SD approach is equal to Correlation coefficient
Example:
Co-efficient of determination (r) = 0.80; Total variance = 400. How much is the unsystematic risk as per
variance approach?

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a. 80
b. 320
c. 256
d. 144
Answer:
• Coefficient of determination as per variance approach (r^2) = 0.80 x 0.80 = 0.64
• Systematic risk = 400 x 0.64 = 256
• Unsystematic risk = 400 - 256 = 144

20. Investment with margin of 40%

• This would mean that we have borrowed money to the extent of 40% and made 140% investment
in risky portfolio
• Portfolio return = [140% x Return of Risky Portfolio] – [40% x cost of borrowing]
• Portfolio risk = 140% of Risk of Risky Portfolio
Example:
Return of risky portfolio = 20%. You have invested with a margin of 50% and cost of borrowing is 10%.
How much is the return of investor?
a. 20%
b. 10%
c. 30%
d. 25%
Answer:
• Investment in risky portfolio = 1.5 Times; Borrowing = -0.5 times
• Return = [20% x 1.5] + [10% x -0.5] = 25%
Example:
SD of risky portfolio = 20%. You have invested with a margin of 50% and cost of borrowing is 10%. Risk-
free rate is 10%. How much is the risk of investor?
a. 30%
b. 20%
c. 10%
d. 25%
Answer:
SD of combination of risky portfolio and risk-free asset = [SD of risky portfolio x weight of risky portfolio]
= [20 x 1.50] = 30%

21. Fully Diversified Portfolio

• A fully diversified portfolio does not carry unsystematic risk. Hence total risk of fully diversified
portfolio = Systematic risk of fully diversified portfolio
• Return due to sheer skill of portfolio manager = Alpha = Actual return - required return as per
CAPM
• Return due to excess risk taken by Portfolio Manager = Required return as per CAPM for higher
Beta - Market return (beta of 1)
Example:
A portfolio has Beta of 1.5 Times. Risk-free rate is 6% and market return is 9%. How much of the portfolio
return is attributable to the higher risk assumed by portfolio manager?
a. 3%
b. 4.50%
c. 1.50%
d. 9.00%
Answer:
Required return for Beta of 1.5 Times = 6 + 1.50 x (9 – 6) = 10.50% Return of market is 9% for Beta of 1 Time.
Required return of portfolio A is 10.50% for Beta of 1.50 Times Excess return due to higher risk = 10.50%
- 9.00% = 1.50%
Example:
SD of Portfolio A = 2.6250; SD of market is 1.0000. Portfolio A is fully diversified. How much is the Beta of
Portfolio A?
a. 1 Times

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b. 2 Times
c. 2.6250 Times
d. 1.62 Times
Answer:
Portfolio is fully diversified and hence total risk is equal to systematic risk
2.62502 = (Beta x SD of market)2 ; 2.6250 = Beta x 1; Beta of security = 2.6250 Times

22. Characteristic Line, CML and SML

Characteristic Line:
• Characteristic Line = Alpha + (Beta x Return of market)
• Characteristic line is stock specific
• Alpha = Actual return - required return
• Required return = Beta x return of market
Security Market Line (CAPM Equation)
• SML measures risk through Beta - useful for diversified portfolio
• SML Equation: Rf + Beta x (Rm - Rf)
• Equation is not stock specific and can be used for any company
Capital Market Line (CML)
• CML measures risk through SD - useful for undiversified portfolio
𝐒𝐃 𝐨𝐟 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲
𝐂𝐌𝐋 𝐄𝐪𝐮𝐚𝐭𝐢𝐨𝐧: 𝐑𝐟 + 𝐱 (𝐑𝐦 − 𝐑𝐟 )
𝐒𝐃 𝐨𝐟 𝐌𝐚𝐫𝐤𝐞𝐭
• Equation is not stock specific and can be used for any company
Example:
Return of Security A = 12%; Beta of Security A = 2 Times; Return of market = 8%; Risk-free rate = 6%. What
is the characteristic line of Security A?
a. +4% + (2 x Return of market)
b. -4% + (2 x Return of Market)
c. +2% + (1 x Return of Market)
d. -2% + (1 x Return of Market)
Answer:
• Required return as per characteristic line = Beta x Return of Market = 2 x 8% = 16%
• Alpha = Actual return – required return = 12% - 16% = -4.00%
• Characteristic Line = Alpha + (Beta x Return of Market)
• Characteristic Line = -4.00% +(2 x Rm)
Example:
SD of Security A = 12%; Beta of Security A = 1.5 Times; SD of market = 6%; Risk-free rate = 6%. Return of
Market = 10%. How much is the required return as per Security Market Line and Capital Market Line?
a. 14% and 12%
b. 12% and 14%
c. 10% and 14%
d. 14% and 10%
Answer:
Required return as per SML = Rf + Beta x (Rm – Rf) = 6 + 1.50 x (10 – 6) = 12.00%
SD of Security 0.12
Required return as per CML = R f + x (R m − R f ) = 6 + ( 𝑥(10 − 6)) = 14.00%
SD of Market 0.06
Hence answer is 12% and 14%

23. Alpha
• Alpha refers to excess/deficit return earned by security/portfolio. This is calculated by
comparing the actual return with required return
• Required return: Required return can be computed using the following approaches:
o Diversified portfolio (CAPM Approach): Rf + Beta x (Rm – Rf)
o Undiversified portfolio (CML Approach): Required return using the below formula
SD of Security
Capital Market Line = R f + x (R m − R f )
SD of Market
o Characteristic Line Approach: Beta x Return of Market
• Alpha = Actual return – required return
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24. Computation of Rm and Rf using two SML Equations

• If expected return and Beta of 2 securities are given in question, then we can form two CAPM
equations (SML equations).
• We should solve those 2 equations we will be able to calculate market return and risk-free rate of
return.
Example:
Security A has Beta of 1.50 Times and required return of 15.00%. Security B has Beta of 0.50 Times and
required return of 10.00%. How much is the risk-free rate and market return?
a. 5% and 10%
b. 8% and 13%
c. 7.5% and 12.50%
Answer:
Required Return = Rf + Beta x (Rm – Rf)
15.00% = Rf + (1.50 x Rp)
10.00% = Rf + (0.50 x Rp)
Solving the equation, we get risk premium as 5.00% and get risk-free rate as 7.50%
Hence risk-free rate is 7.50% and return of market is 12.50%

25. Arbitrage Pricing Theory

• CAPM Model computes the required return based on single factor (Beta). However, a security
return can be dependent on multiple factors such as GDP growth/Unemployment/Interest
rates/Income level. This limitation of CAPM is addressed in APT Model
• Formula 1: Required return under APT = Rf + [Factor 1 x Risk /Return premium of Factor 1] +
[Factor 2 x Risk /Return premium of Factor 2] + [Factor 3 x Risk /Return Premium of Factor 3]
• Formula 2: Required Return = Rf + [Change in Factor 1 x beta of Factor 1] + [Change in Factor 2 x
Beta of Factor 2] + [Change in Factor 3 x Beta of Factor 3]
Example:
Assume you are attempting to estimate the equilibrium expected return for a portfolio using a two-factor
arbitrage pricing theory (APT) model. One factor is changes in the 30-year T-bond rate and the other factor
is the percentage growth in gross national product (GNP). Assume that you have estimated the risk
premium for the interest rate factor to be 0.02, and the risk premium on the GNP factor to be 0.03. The
sensitivity of the portfolio to the interest rate factor is -1.2 and the portfolios sensitivity to the GNP factor
is 0.80. Given a risk free rate equal to 0.03, what is the expected return for the asset?
a. 5.0%.
b. 7.0%
c. 2.4%.
d. 3.0%.
Answer:
Return under APT = Risk-free rate + [Factor 1 Beta x Risk premium] + [Factor 2 Beta x Risk premium]
Return under APT = 3% + [-1.20 x 2%] + [0.80 x 3%] = 3.00%
Example:
Mr. Tamarind intends to invest in equity shares of a company the value of which depends upon various
parameters as mentioned below:
Factor Beta Expected Value % Actual Value %
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage Pricing
Theory?
a. 9.25%
b. 11.88%
c. 6.63%
d. 17.40%
Answer:
• Return under APT = Risk free rate + (Factor 1 Beta x Change in Factor 1) + (Factor 2 Beta x Change
in Factor 2)

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• Return under APT = 9.25 + (1.20 x 0) + (1.75 x 1.50) = 11.88%

26. Beta and Leverages

• A company may invest in multiple business and the weighted average of beta of various business
would give the company beta/Asset Beta.
Format:
Asset Beta Weight Product

• A company will have multiple liabilities and the weighted average of beta of various liabilities
would give the company beta/Liability Beta
Format:
Liability Beta Weight Product

• Beta computed as per Point (a)/Point (b) would match. Hence Liability side Beta = Assets side
Beta
• We can use Asset Beta to compute the equity Beta. Equity Beta will provide us Cost of Equity
• The overall beta of a firm is constant irrespective of capital structure. As we introduce more debt
in the capital structure the beta of equity will change in such a way that overall beta remains same

Impact of Taxes:
• In case of taxes, weight of debt will be replaced with Debt x (1 - Tax Rate) in Beta computation

Proxy Beta:
• Asset beta of a company can be taken as average Beta of Proxy Companies.
• Proxy company beta can be computed from their Assets side/Liabilities side.

Levered vs Unlevered Beta:

• Unlevered beta is the beta of the assets side ignoring capital structure. Hence unlevered beta is
otherwise Asset beta/overall beta
• Levered Beta factors the risk due to debt in capital structure. Hence levered beta is otherwise
known as equity beta/stock beta
Example:
Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new
project. Affluence's capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%.
Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-
to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire
as the comparable firm, the project beta Affluence should use to calculate the cost of equity capital for this
project is closest to:
a. 0.58
b. 1.18
c. 0.38
d. 1.12
Answer:
Computation of Asset Beta of Proxy Entity:
Source Beta Weight Product
Debt 0.00 1.105 0.00
[1.7 x 65%]
Equity 0.80 1.00 0.80
Overall 0.38 2.105 0.80

Computation of equity Beta of Affluence:

Source Beta Weight Product
Debt 0.00 52.50 0.00
[75 x 70%]
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Equity 1.18 25 29.45
Overall 0.38 77.50 29.45
Equity Beta of Affluence = 1.18 Times
Example:
Two companies are identical in all aspects except capital structure. ABC Limited has a debt-equity ratio of
1:4 and its equity has beta of 1.1. XYZ Limited has a debt-equity ratio of 3:4. Income tax is 30%. Estimate
equity beta of XYZ Limited?
a. 0.9362 Times
b. 1.4277 Times
c. 1.10 Times
d. 3.30 Times
Answer:
Computation of overall Beta of ABC Limited
Source Beta Weight Product
Equity 1.10 4 4.40
Debt 0 0.7 0
Overall 0.9362 4.70 4.40
Computation of Equity Beta of XYZ Limited
Let us assume equity beta of XYZ Limited to be A
Source Beta Weight Product
Equity A 4 4A
Debt 0 2.1 0
Overall 0.9362 6.1 5.7108
[0.9362 x 6.10]
5.7108
4A = 5.7108; A = = 1.4277 Times
4
Equity Beta of XYZ Limited = 1.4277 Times

27. Portfolio Strategies

• Buy and Hold Policy – Rebalancing is not done
• Constant mix policy = Rebalancing of debt and equity is done on every event. Event can be defined
as fixed period/fixed change in value
• Constant proportion Portfolio Insurance – Rebalancing is done. Refer steps below for more details
Steps for CPPI:
• Step 1: Identify floor value
o Floor value would be provided by the investor. This is the maximum drop investment
value accepted by the investor.
o Floor value = Total investment - Maximum % fall in Nifty
• Step 2: Investment in equity = Multiplier x (Total value - Floor Value)
• Step 3: Investment in debt = Total value - Investment in equity
Example:
You have created a portfolio of Rs.2,00,000 with equal investment in debt and equity. Equity market has
declined from 100 to 80 and revived from 80 to 125. How much is the maturity value under buy and hold
policy?
a. 2,00,000
b. 1,80,000
c. 2,25,000
d. 2,30,625
Answer:
1,00,000
Maturity value of equity = 𝑥 125 = 1,25,000
100
Maturity value of debt = 1,00,000
Total maturity value = 1,25,000 + 1,00,000 = Rs.2,25,000
Example:
You have created a portfolio of Rs.2,00,000 with equal investment in debt and equity. Equity market has
declined from 100 to 80 and revived from 80 to 125. How much is the maturity value under constant mix
policy?

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a. 2,00,000
b. 1,80,000
c. 2,25,000
d. 2,30,625
Answer:
Particulars Day 1 Fall before Fall after Maturity
80,000 1,40,625
Equity 1,00,000 [1,00,000 x 80/100] 90,000 [90,000 x 125/80]
Bond 1,00,000 1,00,000 90,000 90,000
Total Value 2,00,000 1,80,000 1,80,000 2,30,625
Example:
Expected Maximum decline in stock market = 10%; Value of portfolio = 10,00,000. How much can be the
investment in equity with a multiplier of ‘2’ as per constant proportion portfolio insurance policy?
a. 1,00,000
b. 2,00,000
c. 9,00,000
d. 8,00,000
Answer:
• Floor value = Investment – Maximum decline = 10,00,000 – 10% = Rs.9,00,000
• Investment in equity = 2 x [Portfolio value – Floor value] = 2 x [10,00,000 – 9,00,000] = 2,00,000

28. Minimum Risk Portfolio

• Portfolio risk is dependent on following variables
o Risk of individual securities
o Correlation coefficient between various securities
• Hence a combination of negative correlation securities can give a portfolio risk which is lower
than minimum risk security
Optimum weights with 2 securities:

Variance of Security 2 − Covariance of 1 and 2

Weight of Security 1 =
Variance of security 1 + Variance of Security 2 − 2Covariance of 1 and 2

Weight of security 2 = 1 – weight of security 1

Three Securities:
• We will need two portfolios which are currently having minimum risk. Using this data, we can
identify a third portfolio which has minimum risk
• We will have to fit a critical line between weights of two securities
• Equation: Weight of Security 1 = a + b (Weight of Security 2)
• We will have to solve two equations. Get value of A and B
• Find out the optimum weights by Substituting the values in above equation
Example:
Portfolio 1 = Security A = 50%, Security B = 25% and Security C = 25%
Portfolio 2 = Security A = 70%, Security B = 20% and Security C = 10%
Requirement: Identify a portfolio 3 where we want to invest 60% in Security A. How much should be the
investment in Security B and C.
Critical line between A and B:
Weight of Security A = a + b(weight of Security B)
0.50 = a +0.25b …………. (Equation 1)
0.70 = a + 0.20b…………. (Equation 2)
Solving equations, we get b = -4 and a = 1.5
Critical line: Weight of Security A = 1.50 – 4(Weight of Security B)
Creation of portfolio with Security A, B and C:
• Weight of security A = 0.60
• Weight of Security A = 1.50 – 4(Weight of Security B)
• 0.60 = 1.50 – 4 (Weight of Security B)
• Weight of Security B = 0.225 (or) 22.50%

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• Weight of Security C = 1.00 -0.60 – 0.225 = 0.175 (or) 17.50%
More than Three Securities:
• Step 1: Rank the various securities in the order of Treynor Ratio (TR)
• Step 2: Rearrange the securities on the basis of ranking
• Step 3: Compute cut-off point
Format for Computation:
Sec TR Beta USR SR SR SR SR SR SR Cur-off
TR x ( ) ∑TR x ( ) ∑( ) 1 +∑( )
USR USR USR USR USR

Note:
• TR = Treynor Ratio
• USR = Unsystematic Risk
• SR = Systematic Risk = Beta x Beta x Variance of Market
• Cut-off Point =Column 8/Column 10

• Step 4: Maximum cut-off value is taken as final cut-off point. Securities with TR > cut-off point
will form part of final portfolio
• Step 5: Compute Z value and weights (in proportion of Z value)
Beta
Z value = Excess cutoff x ( )
USR
Excess cutoff = Treynor Ratio - Cutoff point
Example:
Variance of Security 1 = 167.75; Variance of security 2 = 126.98; Covariance between Security A and B is -
144.25; How much should be the investment in Security 1 to formulate a minimum risk portfolio?
a. 0.50
b. 0.4650
c. 0.5350
d. 0.75
Answer:
Variance of Security 2 − Covariance of 1 & 2
Weight of Security 1 =
Variance of Security 1 + Variance of Security 2 − 2Covariance of 1 & 2
126.98 + 144.25 271.23
Weight of Security 1 = = = 0.4650
167.75 + 126.98 + 2(144.25) 583.23

Example:
An investor has found two portfolio which are on minimum risk.
Portfolio Weight of A Weight of B Weight of C
1 0.50 0.25 0.25
2 0.70 0.20 0.10
He has decided to invest 20% of funds in Security A. How much should he invest in B and C to
have a minimum risk portfolio?
a. 0.475 and 0.325
b. 0.325 and 0.475
c. 0.40 and 0.40
d. 0.25 and 0.55
Answer:
• Weight of Security A = a + b (weight of Security B)
• 0.50 = a +0.25b …………. (Equation 1)
• 0.70 = a + 0.20b…………. (Equation 2)
• Solving equations, we get b = -4 and a = 1.5
Critical line:
• Weight of Security A = 1.50 – 4(Weight of Security B)
• 0.20 = 1.50 – 4(Weight of Security B)
• 4(Weight of Security B) = 1.30
• Weight of Security B = 1.30/4 = 0.325
• Weight of Security C = 1 -0.0325 – 0.20 = 0.475

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29. Real Estate Valuation
Approach 1 (Based on credit side of P&L - Sales Comparison approach
• Value of property = Area in square feet x Adjusted selling price per square feet

Approach 2 (Based on debit side of P&L - cost approach):

• Value of property = Area in square feet x (Construction cost and others per square feet)

Approach 3 (Based on income (Credit – debit:

Perpetual income
Value of property =
Capitalization rate

Approach 4 (Based on cash flows)

• Value of property = PV of future cash flows (rent and property price) discounted at investor
required rate of return
Example:
Assume that a property has a gross annual income equal to Rs.150,000, and that comparable properties
have a gross income multiplier equal to 11.25. The gross income multiplier approach provides a market
value for this property that is closest to:
a. 16,25,000
b. 13,33,333
c. 16,87,500
d. 20,00,000
Answer:
Value of property = 1,50,000 x 11.25 = Rs.16,87,500
Example:
A real estate investment is likely to generate cash flows of Rs.70,000, Rs.50,000 and Rs.65,000 over next
three years. The terminal value of property at end of year 3 is estimated as Rs.3,00,000. Assuming a
required rate of return of 8 percent, determine the fair value of property?
Answer:
Year Cash flow PVF @ 8% DCF
1 70,000 0.926 64,820
2 50,000 0.857 42,850
3 3,65,000 0.794 2,89,810
Fair value of property 3,97,480

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Chapter 8 – Mutual Funds

Overview:
• MF Return vs Individual Return
• Holding period return vs Annualized Return
• Dividend Payout Plan vs Dividend Reinvestment Plan
• Computation of Annualized Return – Direct and Reverse Working
• Reverse-working of units – Dividend Reinvestment Plan and Growth Plan
• NAV computation
• Dividend Equalization
• MF – Performance Evaluation
• Tracking Error

1. MF Return vs Individual Return

Own return
MF return = + Annual expense ratio
1 − Initial expense ratio
Example:
Mr. X can earn return of 10 percent on own. Initial expense ratio is 5% and annual expense ratio is 2%.
How much should the MF earn to give investor return of 12%?
a. 12.53
b. 12
c. 14
d. 14.63
Answer:
Own return 0.12
MF Return = + AER = + 0.02 = 0.1263 + 0.02 = 0.1463 or 14.63%
1 − IER 1 − 0.05
Note: Investor needs a return of 12 percent. Information on return which investor earns is of no use in this
question as question clearly tells that he wants to earn 12 percent

2. MF Return vs Individual Return – Opportunity Cost

A person is required to spend time while investing on his own. However, investing through mutual fund
will save this time and hence the same can give extra income to investor. If a question gives data on this,
then we should prepare a cost-benefit analysis of own investing vs MF investing [Formula based
calculation will not be possible]
Example:
Mr. X can earn 15 percent on own. The MF will give him return of 13 percent. Mr.X portfolio value is
Rs.100 lacs. Mr.X is a chartered accountant and is currently earned professional income of Rs.45 lacs. Mr.
X is spending 10 percent of time in managing his portfolio. If he spends this time on profession, his
professional income will increase proportionately. What is the net gain/loss in investing in MF?
a. Net loss of Rs.2 lacs
b. Net gain of Rs.3 lacs
c. Net gain of Rs.5 lacs
d. Net gain of Rs.2 lacs
Answer:
Particulars Calculation Amount
Net loss in MF investment 100 lacs x 2% (2,00,000)
Increase in professional income 90 = 45 lacs 5,00,000
10 = ?
Net benefit of investing in MF 3,00,000

3. Holding Period Return vs Annual Return

(NAV1 − NAV0 ) + D1 + CG1
Holding period return = x 100
NAV0
(NAV1 − NAV0 ) + D1 + CG1 12
Annual return = x x 100
NAV0 m
Example:

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Opening NAV = Rs.20; Closing NAV at end of Month 3 = 21. Dividend paid in month 1 = Rs.2; Dividend
paid in Month 2 = 0.50; Dividend declared but not yet paid in month 3 = 0.50. What is annualized return
of investor?
a. 20%
b. 80%
c. 17.5%
d. 70%
Answer:
NAV1 − NAV0 + D1 12 21 − 20 + 3 12
Annual return = x x 100 = x x 100 = 80%
NAV0 m 20 3

Note: Investor has earned dividends of Rs.3. It does not matter whether dividend is paid or not as the
same would be paid over the near term and it would have impacted the NAV downwards
Example:
Holding period return for 6 months is 8%. How much is annualized return?
a. 8%
b. 16%
c. 4%
Answer:
12 12
Annual return = HP Return x ( ) = 8 x ( ) = 16.00%
m 6

4. Return for close-ended Schemes

Opening and closing NAV will have to be adjusted for premium and discount in case of close ended fund.
This is because NAV of close-ended fund can quote at premium/discount to normal NAV.
Example:
Example:
NAV as on 1.1.2014 was Rs.10. NAV as on 31.12.2014 is Rs.12. Dividend and capital gain distribution is
Rs.0.50 and 1.50. On 31.12.2014 the unit was trading at discount of 2 percent whereas on 1.1.2014 it was
trading at premium of 2 percent. How much is the annual return?
a. 20%
b. 40%
c. 35.60%
d. 34.90%
Answer:
Particulars Calculation Amount
Unit price as on 1.1.2014 10 + 2% 10.20
Unit price as on 31.12.2014 12 – 2% 11.76
Dividend and capital gain 2.00
Annual return (11.76 − 10.20) + 2.00 34.90%
𝑥 100
10.20

5. Return computation – Days vs Months

• If the date of investment is given in question, then we can compute number of days of investment
and use 365 in numerator for computing annual return. In other situations, we would compute
return using months computation
• No of days of investment = Date of redemption – Date of investment. We can ignore date of
investment and consider date of redemption while computing the number of days of investment.

6. Total Yield of Investor

An MF investor can invest in different schemes and returns for each investment can be computed using
the above formula. For total yield we should consider the below formula:
Capital Gain + Dividend
Total Yield = x 100
Total Amount invested
Example:
Compute total yield of investor from following information:
Particulars MF ‘X’ MF ‘Y’ MF ‘Z’
Initial investment 2,00,000 5,00,000 4,00,000
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Capital gain 10,000 -44,000 16,000
Dividends 6,000 25,000 16,000
Answer:
(10,000 − 44,000 + 16,000) + (6,000 + 25,000 + 16,000)
Total Yield = x 100 = 2.64%
(2,00,000 + 5,00,000 + 4,00,000)

7. Period of holding
Period of holding can be computed using annual return and holding period return
Holding Period Return
Period of Holding = x 365 days (or)12 months
Annual Return
Example:
Holding period return = 2.5%. Annual return = 12%. No of days in year = 365; What is the period of holding
of investment?
a. 76 days
b. 75 days
c. 1,752 days
d. None of the above
Answer:
Holding Period Return 2.5
Period of Holding = x 365 = x 365 = 𝟕𝟔 𝐝𝐚𝐲𝐬
Annual Return 12

8. Dividend Payout vs Dividend Reinvestment Plan

In a dividend payout plan, the investor will get dividend in Rupees and in case of dividend reinvestment
plan dividend will get reinvested and we will get additional units (Dividend Amount/Re-investment
NAV). Return for dividend payout plan would be computed as per the above formula. Return for dividend
re-investment plan would be computed as per the below formula:
Closing value − Opening investment
Holding Period Return = x 100
Opening investment
Closing value − Opening investment 12
Annual Return = x x 100
Opening investment m
Note:
Dividend rate is to be applied on face value of unit to calculate dividend earned by the investor. This will
also help in computing the number of units re-invested in dividend reinvestment plan
Example:
Mr. X invested Rs.1,00,000 when NAV was Rs.10 per unit. The fund declared income distribution of Rs.2
per unit and capital gain distribution of Rs.3 per unit. These amounts were re-invested at NAV of Rs.20
per unit. Closing NAV was Rs.30. What is the rate of return earned by the investor?
a. 250%
b. 275%
c. 200%
d. 100%
Answer:
Particulars Calculation Amount
Units purchased on day 0 1,00,000/10 10,000
Amount of dividend 5 x 10,000 50,000
Re-investment NAV 20.00
Dividend in units 50,000/20 2,500
Closing units 10,000 + 2,500 12,500
Closing value 12,500 x 30 3,75,000
Less: Investment -1,00,000
Return in Rs. 2,75,000
Return in % 𝟐, 𝟕𝟓, 𝟎𝟎𝟎 275.00%
𝐱 𝟏𝟎𝟎
𝟏, 𝟎𝟎, 𝟎𝟎𝟎

9. Computation of closing units

Closing units of MF investor will not be equal to opening units in case of dividend re-investment or bonus
issue. Following formats can be used for computing closing units:

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Dividend Reinvestment Plan:
Dividend
Unit Amount (B) New Total
held (A x Face value x Dividend Reinvestment NAV units units
Date (A) % %) (C) (D= B/C) (A+ D)

Bonus Plan:
Bonus
units
Unit (B = A x Total
held Bonus Bonus units
Date (A) ratio Ratio) (A + B)

Example:
Mr.X invested Rs.1,00,000 on 1.4.2010 (NAV of Rs.20; Face value of Rs.10). MF declared dividend of 20%
on 1.4.2011 (NAV of Rs.25) and it declared dividend of 50% on 1.3.2012 (NAV of Rs.50). How many units
will be allotted on 1.3.2012 due to dividend reinvestment?
a) 400 units
b) 500 units
c) 540 units
d) 1000 units
Answer:
Dividend
Date Unit held % Amount Reinvestment NAV New units Total units
5,000 10,000 25.00 400.00 5,400
1.4.2011 [1,00,000/20] 20% [5,000 x 10 x 20%] [10,000/25] [5,000 + 400]
27,000 50.00 540.00 5,940
1.3.2012 5,400 50% [5,400 x 10 x 50%] [27,000/50] [5,400 + 540]
Example:
Mr.X invested Rs.1,00,000 on 1.4.2015 when NAV was Rs.25 per unit. Bonus ratio was 1:4 on 1.10.2015, 1:5
on 1.4.2017, 2:5 on 1.4.2018. How many units will the investor have on 1.4.2018?
a. 4,000 units
b. 6,000 units
c. 8,400 units
d. 10,000 units
Answer:

Date Unit held Bonus ratio Bonus units Total units

4,000 1,000
1.10.2015 [1,00,000/25] 1:4 [4,000 x ¼] 5,000
1,000
1.4.2017 5,000 1:5 [5,000 x 1/5] 6,000
2,400
14.2018 6,000 2:5 [6,000 x 2/5] 8,400

10. Taxation Impact

Cost of acquisition of bonus units will be taken as zero. Securities Transaction Tax is not allowed as tax
deductible expense while computing long-term capital gain and short-term capital gain

11. Effective Yield

Effective yield is normally computed using the below formula:

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Closing value − Opening investment 12
Annual Return = x x 100
Opening investment m
However, the same can also be computed using IRR method if there is a single inflow and single outflow
scenario and number of years map to a whole number.
Example:
Compute effective yield using annual return method and IRR method from following information:
• Amount invested on day 0 = Rs.2,00,000
• Amount received at end of year 5 = Rs.2,39,003
Return under Annual Return Method:
Particulars Calculation Amount
Amount received on maturity 5,915.93 x 40.40 2,39,003
Less: Amount invested (2,00,000)
Return in Rs. for 5 years 39,003
Return per year 39,003/5 7,800.60
Return in % 𝟕𝟖𝟎𝟎. 𝟔𝟎 3.90%
( 𝒙 𝟏𝟎𝟎)
𝟐, 𝟎𝟎, 𝟎𝟎𝟎

Return under IRR Method:

Year Cash flow PVF@3% DCF PVF@4% DCF
0 -2,00,000 1 (2,00,000) 1 (2,00,000)
5 2,39,003 0.863 2,06,260 0.822 1,96,461
NPV 6,260 (3,539)

IRR = NPV at L1
L1 + ( ) x(L2 − L1)
NPV at L1 − NPV at L2
IRR = 6,260
3+ 𝑥 (4 − 3)
6,260 − (−3,539)
IRR = 3 + 0.64
IRR = 𝟑. 𝟔𝟒%

12. Front-end Load and Back-end Load

Formula for calculating front-end load:
Public offer price − NAV
Front − end Load =
NAV
Formula for calculating back-end load:
NAV − Redemption Price
Back − end Load =
NAV
Note:
• Front-end load is otherwise called as entry load and is added to opening NAV
• Back-end load is otherwise called as exit load and is deducted from closing NAV
Example:
Unit price of MF is Rs.20. The public offer price is Rs.21. How much is the front-end load percent?
a. 1 percent
b. 5 percent
c. 10 percent
d. None of the above
Answer:
Front-end load (in Rs.) = Public offer price – NAV = 21 -20 = 1.00
Public offer price − NAV 21 − 20
Front − end Load (in %) = = x 100 = 5.00%
NAV 20

13. Exit Load vs Lower return from MF

An individual invested in a mutual fund (MF) might come across a fresh purchasing opportunity that
promises improved returns. Nonetheless, the MF investor could potentially incur an exit load if they
choose to exit their current investment prematurely. In this particular situation, it becomes essential to
evaluate the cost of the exit load in comparison to the potential loss in returns. Based on this assessment,
a decision can be made regarding whether it's prudent to sell the mutual fund investment.
Example:
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MF X has given annualized return of 9.733%, MF Y has given annualized return of -11.185% and MF Z has
given annualized return of 15%. Period of holding in MF X, MF Y and MFZ is 300 days, 124 days and 195
days respectively. Past returns are likely to continue in future. Mutual fund is charging an exit load of 5%
for redemption within one year. What action should investor take in MF X and MF Y?
a. Redeem both MF X and MF Y
b. Redeem MF X and don’t redeem MF Y
c. Redeem MF Y and don’t redeem MF X
d. Continue with both MF X and MF Y
Answer:
Decision on MF X:
• Redemption of MF X would be invested in MF Z and this would give additional annualized return
of 5.27% (15 – 9.733). The investor has currently held this for 300 days and holding this for another
65 days can help investor in saving exit load of 5%.
• Return loss in 65 days = 5.27 x (65/365) = 0.94%.
• Investor will loss return of only 0.94% and save exit load of 5% and hence he should continue
holding this for another 65 days. Hence MF X is not to be redeemed.
Decision on MF Y:
• Redemption of MF Y would be invested in MF Z and this would give additional annualized return
of 26.19% (15 –(- 11.185)). The investor has currently held this for 195 days and holding this for
another 170 days can help investor in saving exit load of 5%.
• Return loss in 170 days = 26.19 x (170/365) = 12.20%.
• Investor will loss return of 12.20% and save exit load of 5% and hence he should redeem MF Y
immediately
Final answer:
• Redeem MF Y and don’t redeem MF X

14. Net Asset Value

Net Asset Value (NAV) is the fair value per unit of Mutual Fund (MF). It basically signifies the realizable
value that the investor will get for each unit.
Market value of assets − Value of liabilities
NAV =
Number of units
• Assets of mutual fund include equity investment, debt investment, money market instrument,
cash balance, receivables and other assets
• Liabilities of mutual fund include outstanding expenses, amount payable on shares and other
payables

15. Computation of NAV when Opening net assets details are given and detailed break-up of assets
and liabilities are not available:
In some question, we will not have information on assets and liabilities but details on opening net assets
will be available. Net assets will increase by items like portfolio appreciation, dividend received, income
earned, fresh inflow etc. Similarly, net assets will decrease by items like portfolio depreciation, expenses
incurred, redemption. NAV will be computed in this manner:
Opening Networth + Items increasing networth − Items reducing networth
Closing NAV =
Opening units + New units issued − Redemptions
Example:
Total number of units on day 0 - 1,00,000; NAV on day 0 – 50; New units allotted on day 60 - 20,000 @ NAV
of Rs.60; Portfolio appreciation for full year = 60 lacs; Units redeemed on day 120 - 10,000 @ NAV of Rs.120.
What will be the closing NAV on day 365 post dividend payout of Rs.1 per unit?
a. 100
b. 120
c. 99
d. 119
Answer:
Particulars Calculation Amount
Opening net assets 1,00,000 x 50 50,00,000
Add: Fresh Allotment 20,000 x 60 12,00,000
Add: Portfolio appreciation 60,00,000

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Less: Redemption 10,000 x 120 -12,00,000
Closing net assets 1,10,00,000
Closing units 1,00,000 + 20,000 – 10,000 1,10,000
Closing NAV before dividend 100.00
Less: Dividend -1.00
Closing NAV post dividend 99.00

16. Impact of fresh unit purchase/redemption on NAV

NAV of mutual fund does not change due to fresh inflow/redemption. This is because units change
proportionately with change in Networth. NAV will change if there is a change in value of underlying
assets of Mutual Fund

17. Impact of Dividend Declaration on NAV

NAV will fall by the amount of dividend once the same is declared by Mutual Fund

18. Cash Balance Computation to value NAV

If it is possible to track inflows and outflows of a mutual fund then we are required to compute closing
cash balance by adding inflows and deducting outflows from opening cash balance. Closing cash balance
will form part of assets for computing NAV.
Particulars Amount
Opening Cash Balance (A) XXX
Add: Receipts:
Inflow from unit holders XXX
Sale of shares XXX
Dividend received XXX
Interest received XXX
Other income XXX
Total Receipts (B) XXX
Less: Payments:
Purchase of shares XXX
Expenses paid XXX
Redemption of units XXX
Dividends paid XXX
Total Payments (C) XXX
Closing Cash Balance (A+B-C) XXX

19. Valuation of equity shares and bonds for NAV computation

Valuation of equity shares: Closing value of equity investments can be computed based on index value.
It is computed using below formula:
Closing index value
Closing value of equity = Amount invested x
Index value on date of investment
Valuation of bonds: We can use the formula of current yield to value the bond if the interest rate on bond
and investor expectation (yield) is given in question
Interest of bond
Current yield =
Value of bond
Example:
Equity shares were purchased when index was 1,000. Amount of shares purchased is Rs.20 lacs. Index
value on NAV valuation date is 1,500. What will be the value of shares if underlying shares have
appreciated at double the rate of index appreciation?
a) 30 lacs
b) 60 lacs
c) 20 lacs
d) 40 lacs
Answer:
Index is 1,000 on purchase date and the same has appreciated by 50 percent as the closing index is 1,500.
Shares will appreciate at double the rate and hence shares will appreciate by 100 percent. Closing shares
value = 20 lacs + 100% = 40 lacs
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Example:
Value of 14 percent listed bonds = 20 crores (Face value is Rs.15 crores whereas acquisition cost is Rs.20
crores). Market expectation on listed bonds is 7 percent. What will be the value of listed bonds for
computation of NAV?
a. 30 Crores
b. 20 crores
c. 15 crores
d. 40 crores
Answer:
Particulars Calculation Amount
(in cr)
Interest on listed bonds 15 crores x 14% 2.10
Value of bonds Interest 2.10 30.00
=
Investor expectation 7%

20. Dividends out of realized earnings

An MF may declare dividend as a proportion of realized earnings. Realized earnings = Interest earned +
Dividends earned + Realized capital gain
Example:
A mutual fund sold shares worth Rs.80 lacs for Rs.88 lacs. It also sold another lot of shares worth Rs.75
lacs for Rs.72 lacs. It earned dividend income of Rs.4 lacs. It has decided to distribute 60% of realized
earnings. How much is the overall dividend paid?
a. 9 lacs
b. 8 lacs
c. 7.2 lacs
d. 5.4 lacs
Answer:
Particulars Calculation Amount
Total Capital gain 8 lacs on lot 1 – 3 lacs on lot 2 5,00,000
Total realized gain 5,00,000 + 4,00,000 9,00,000
Dividends paid 9,00,000 x 60% 5,40,000

21. Dividend income on equity shares

• Mutual Funds allocate investments across a range of equity shares, and any dividends declared
by these companies contribute to the mutual fund's earnings.
• When a company issues bonus shares, additional shares are granted to the mutual fund if such an
event occurs. However, in the event of a dividend declaration prior to the bonus record date,
the dividend income will be applicable solely to the original shares held by the mutual fund and
not the newly allocated shares.
Example:
A mutual fund has invested in 10,000 shares (FV of Rs.10 and CMP of Rs.20) of XYZ Limited. XYZ Ltd., on
15th December 2021 in its AGM declared the interim dividend of 10% and bonus shares at 1:10 with the
record date of 28th December 2021. How much is the dividend received by MF from XYZ Limited?
a. Rs.10,000
b. Rs.11,000
c. Rs.20,000
d. Rs.22,000
Answer:
Dividend per share = 10 x 10% = Rs.1.00. Interim dividend will be received only on original shares as the
bonus shares are allotted post dividend declaration. Hence Dividend received is equal to Rs.10,000 (10,000
shares x Rs.1.00)

22. Mutual Fund NAV Computation – Cash and equity component

Cash component of MF will decline by expense per unit whereas equity component will change based on
movement of market. Beta can be used to find the percentage change in equity component when NIFTY
change is given.
% change in equity = Beta x % change in market

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Example:
ABC Mutual Fund has NAV of Rs.25(consisting 90% equity and remaining cash). Annual expense is Rs.4
per unit. The share market declined by 8% over next three months. Beta of ABC Mutual Fund is 1.5 Times.
How much is the NAV of ABC Mutual Fund at end of three months?
Answer:
Particulars Amount
1. Opening NAV 25.00
Represented by equity 22.50
[25.00 x 90%]
Represented by cash 2.50
[25.00 x 10%]
2. Closing NAV 21.30
[19.80 +1.50]
Represented by equity 19.80
[22.50 - 12%]
Represented by cash 1.50
[2.50 – 1.00]
Note:
• Annual expense is Rs.4 per unit and hence proportionate expense for 3 months is Rs.1 per unit
• % change in equity = Beta x % change in market = 1.50 x 8 = 12.00%

23. Impact of Dividend Equalization

• A mutual fund earns income periodically. However, if the NAV is not computed periodically, then
there will be a need to adjust NAV to the extent of Dividend equalization.
Total income earned
Dividend equalization per unit =
Number of units
• Adjustment in issue price: An investor entering into a mutual fund will have to pay issue price.
Issue price = Opening NAV + Dividend equalization adjustment + Entry load
• Adjustment in re-purchase Price: An investor exiting mutual fund will be paid re-purchase price.
Re-purchase price = Opening NAV + Dividend equalization – Exit Load.
• Equalization amount received from MF investor on purchase is added to income of MF. Similarly,
equalization amount paid to MF investor on redemption is deducted from income of MF
Example:
Opening NAV in April = Rs.20. Dividend equalization for the month of April = Rs.1.00. An investor
invested in MF on May 1 at opening NAV(April) + 5% and adjusted for dividend equalization. What is the
purchase price of the investor?
a. Rs.20.40
b. Rs.21.40
c. Rs.19.40
d. Rs.21.00
Answer:
Purchase price = Opening NAV + 2% + Dividend equalization
Purchase price = (20 +2%) + 1 = Rs.21.40
Example:
Opening NAV in April = Rs.20. Dividend equalization for the month of April and May = Rs.1.00 and
Rs.2.00 respectively. An investor exited in MF on June 1 at opening NAV(April) - 3% and adjusted for
dividend equalization. What is the redemption price of the investor?
a. Rs.19.40
b. Rs.16.40
c. Rs.22.40
d. Rs.17.00
Answer:
Redemption price = Opening NAV – 3% + Dividend equalization
Redemption price = (20 – 3%) + 3.00 = Rs.22.40

24. Income available for distribution

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Dividends paid by a mutual fund should be from the income available for distribution and the same is
computed using the following format:
No of units Amount
Particulars (lacs) Per unit (in lacs)
Income of Month 1 Opening units XXX XXX
Add: Inflow from MF buyers
Units issued XXX XXX
(Dividend equalization received on MF issue)
Total income till Month 1 XXX XXX XXX
Income of Month 2 XXX XXX XXX
Total income till Month 2 XXX XXX XXX
Less: Redemption in Month 2
(XXX) XXX (XXX)
(Dividend equalization paid on MF redemption)
Revised income till Month 2 XXX XXX XXX
Income of Month 3 XXX XXX XXX
Income available for distribution XXX XXX XXX
Less: Dividend distributed XXX XXX XXX
XXX XXX XXX

25. Expense Ratio

Annual expense per unit
Expense ratio (based on closing NAV) = x 100
Closing NAV
Annual expense per unit
Expense ratio (based on opening NAV) = x 100
Opening NAV
Annual expense per unit
Expense ratio (based on average NAV) = x 100
Average NAV

Example:
Annual expenses = 20 lacs; No of units = 1 crore; NAV on closing date = 20. What is the annual expense
ratio?
a. 1%
b. 0.2%
c. 10%
Answer:
Particulars Calculation Amount
Expenses per unit 20 lacs/1 crore 0.20
Closing NAV 20
Expense ratio 0.20/20 x 100 1.00%

26. MF Performance Evaluation – Sharpe Ratio (or) Reward to Variability Ratio

This is used for undiversified portfolio. Higher Sharpe Ratio is better.
Expected return − Risk free
Sharpe Ratio =
Standard Deviation
27. MF Performance Evaluation – Treynor Ratio (or) Reward to Volatility Ratio
This is used for diversified portfolio. Higher Treynor Ratio is better.
Expected return − Risk free
Treynor Ratio =
Beta
Example:
Sharpe Ratio of A = 1.5; Sharpe Ratio of B = 1.65; Sharpe Ratio of C = 1.25; Treynor ratio of A = 8; Treynor
Ratio of B = 9; Treynor Ratio of C = 10; The above funds are undiversified. Rank the above three funds in
terms of preference?
a. C,A and B
b. B, A and C
c. A, B and C
d. C, A and B
Answer:

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The funds are undiversified and hence we should do ranking as per Sharpe Ratio. It is better to have higher
Sharpe Ratio. Hence the ranking as per Sharpe Ratio is B, A and C

28. MF Performance Evaluation – Jensen’s Alpha

Alpha = Actual return – Required return as per CAPM. Higher positive Alpha is better
Example:
Risk-free rate of return = 10%; Beta of MF (A) = 1 Times; Jensen's Alpha of MF (A) = 4%; Market return =
14%; SD of MF (A) = 10%. What is reward to volatility ratio of MF (A)?
a. 8
b. 0.80
c. 18
d. 14
Answer:
Particulars Amount
Required return of MF ‘A’ [10 + 1 x [14 -10] 14.00
Jensen’s Alpha 4.00
Actual return of MF ‘A’ [14 + 4] 18.00
Excess return of MF ‘A’ [18.00 – 10.00] 8.00
Beta of MF ‘A’ 1.00
Reward to Volatility Ratio [Treynor Ratio] 8.00

29. MF Performance Evaluation – Negative Values

Sharpe/Treynor/Alpha can be negative if the return of security is lower than risk-free return

30. Tracking error

Tracking error is the deviation of security return as compared to a benchmark return. Standard deviation
of differential return is called tracking error. Differential return = MF return – Benchmark return
Total of deviation column
Variance =
n−1
Example:
Compute tracking error from this information.
Month XYZ Nifty Index Fund Return Nifty 50 return
1 4% 3.7%
2 2% 2.5%
3 -4% -3.2%
4 1% 1.8%
5 6% 7.2%
a. 0.315
b. 0.5652
c. 1.26
d. -0.6
Answer:
Computation of tracking error:
XYZ Nifty Index Fund Nifty 50 Differential
Month Deviation 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧𝟐
Return return return
1 4 3.7 0.3 0.9 0.81
2 2 2.5 -0.5 0.1 0.01
3 -4 -3.2 -0.8 -0.2 0.04
4 1 1.8 -0.8 -0.2 0.04
5 6 7.2 -1.2 -0.6 0.36
Total/
-0.6 1.26
Average
Variance 0.315
SD 0.5612

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Note:
• Differential return = Index fund return – benchmark return
• Deviation = Differential return – average differential return
Total of deviation column 1.26
Variance = = = 0.315
n−1 5−1
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐝𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 (𝐓𝐫𝐚𝐜𝐤𝐢𝐧𝐠 𝐞𝐫𝐫𝐨𝐫) = √0.315 = 𝟎. 𝟓𝟔𝟏𝟐%

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Chapter 9 - Derivatives Analysis and Valuation

Derivatives

Futures Options Others

Valuation Basics CDS

Exotic Options
Arbitrage Net Payoff
CDO
Net realization Valuation

Hedging Delta Hedging

Option Greeks
Maintenance Margin

1. Futures Price vs Spot Price

• Fair futures price can be understood as the price at which futures should quote in futures market.
• Spot market and futures market: A share will be quoted in both cash market and futures market.
Cash market will give us spot price and futures market will give different futures price based on
expiry dates.
• FFP and AFP: Futures market will give us actual futures price. Spot market will give us spot price
and the same would be used to compute fair futures price (using a formula). We can compare FFP
and AFP and based on that we can decide whether futures are overvalued/undervalued or
correctly valued.
• Transaction Price Any transaction in futures market will always happen at Actual Futures Price.
In absence of information, Fair Futures Price can be taken as Actual Futures Price.

2. Valuation of Futures
• Formula 1: Fair futures price = Spot price x (1 + r)n
• Formula 2: Fair futures price = Spot price x 𝑒 𝑟𝑡 (Continuous compounding)
Example:
Computation of Future Value Factor: Future value factor is basically (1+r)n or ert
• Rate of interest = 12% per annum (or) 6% per HY (or) 3% per qtr (or) 1% per month
• Time period = 6 months (or) 1 half year (or) 0.5 year (or) 2 quarters
• Spot price = 20,000
• We should ensure that rate of interest and time period is taken for same periodicity
FFP
Compounding frequency Calculation 𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 𝐟𝐚𝐜𝐭𝐨𝐫 [20,000 x FVF]
Daily ert = e(0.12 x 0.5) 1.061837 21236.7
Monthly (1 + 1%)6 1.0615 21230
Quarterly (1 + 3%) 2 1.0609 21218
Half-yearly (1 + 6%)1 1.06 21200
Annual (1 + 12%)0.5 1.0583 21166
Simple interest (1+6%) 1.06 21200

3. How to compute ert values

x X2 X3 Xn
eX = 1 + + + + ⋯……………+
1! 2! 3! n!
Example:
0.06 0.062 0.063 0.06n
e0.06 = 1 + + + +⋯ +
1! 2! 3! n!
Note:
• The above formula can be used to compute e power values. We can do calculation till 3! and the
same would provide approximately the final answer

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4. Formula Adjustments
• During the futures contract's term, underlying assets may declare dividends, or there might be
associated storage costs for assets like gold.
• The spot price of the share is influenced by these dividend incomes or storage costs, which is
not the case for futures
• Dividend and Storage cost will impact the formula used for computation of Fair Futures Price.
• Dividend in Rupees: If Dividend in given in rupees, then we need to substitute Spot Price with
Adjusted Spot Price. Adjusted Spot Price = Spot Price – PV of Dividend Income
• Dividend yield (y) in percentage: If Dividend in given in percentage, then we need to substitute
r with (r-y)
• Storage cost in Rupees: If storage cost in given in rupees, then we need to substitute Spot Price
with Adjusted Spot Price. Adjusted Spot Price = Spot Price + PV of Storage Costs
• Storage Cost (s) in percentage: If storage cost in given in percentage, then we need to substitute r
with (r+s)
Example [Dividend in Rupees Adjustment]
A stock is currently trading at Rs.100. It will pay dividend of Rs.2 in one month. Interest rate = 12 percent
per annum. Time period =3 months. What is fair futures price? e^0.01 = 1.01005; e^0.02 = 1.02020; e^0.03
= 1.03045
a. Rs.102.02
b. Rs.103.05
c. Rs.104.09
d. Rs.101.00
Answer:
1
PV of dividend income = 0.01 = 0.99
e
Adjusted spot price = Spot price - PV of dividend income = 100 - 0.99 = Rs.99.01
Fair futures price = Adjusted spot price x ert = 99.01 x e0.03 = 99.01 x 1.03045 = 102.02
Example [Storage Cost in Rupees Adjustment]
Spot price of Gold is Rs.800. Interest rate is 12% per annum. What is the fair price of 3 month futures if
storage cost of Rs.5 is to be paid in month 3?
a. Rs.805
b. Rs.824
c. Rs.829
d. Rs.819
Answer:
Adjusted spot price = Spot price + PV of storage costs
5
PV of storage costs = = Rs. 4.85
1 + 3%
Adjusted spot price = 800 + 4.85 = Rs.804.85
Fair futures price = 804.85 x (1+3%) = Rs.829
Example [Dividend Yield in % Adjustment]
On 15th September, the index closed at 1195, and December futures (last trading day December 15) were
trading at 1225. The historical dividend yield on the index has been 3% per annum and the borrowing rate
was 9.5% per annum. How much is the fair futures price assuming one year consist of 365 days?
a. Rs.1,225
b. Rs.1,195
c. Rs.1,214.37
d. Rs.1,223.30
Answer:
No of days = 15 days of Sep + 31 days + 30 days + 15 days = 91 days
Rate of interest = 9.5% per year (or) 2.3685% per 91 days
Dividend Yield = 3% per year (or) 0.7479% per 91 days
FFP = Spot Price x (1 + (r − y)) = 1195x (1 + (2.3685% − 0.7479%)) = 𝟏, 𝟐𝟏𝟒. 𝟑𝟕

5. Dividend Yield computation

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Dividend yield can be different for different months of a year. In such a situation, Dividend yield for
futures valuation is the average dividend yield of the life of the contract
Dividend Income Dividend Income
PV of Dividend Income = (or)
ert (1 + r)t
Storage costs Storage costs
PV of Storage costs = (or)
ert (1 + r)t
Example:
Dividend yield for different months is as under: Jan = 2%; Feb = 4%; Mar = 6%; Apr = 4%; May = 5%; June
= 9%; July = 4%; Aug = 2%; Sep = 1%; Oct = 7%; Nov = 9%; Dec = 10%; What should be taken as dividend
yield for valuing a 4-month futures which expired on Nov 30?
a. 5.25%
b. 8%
c. 4.75%
Answer:
2+1+7+9
Dividend yield = Average dividend yield of 4 months ending Nov 30 = = 4.75%
4

6. Format for computation of Fair Futures Price

Example:
Spot price Rs.1,800
Time period 6 Months (or) 2 quarters (or) 1 half-year (or) 0.5 years
10% per annum (or) 5% per 6 months (or) 2.5% per quarter (or) 0.833% per
Rate of interest month
Dividend Nil
Storage cost Nil
Compounding
frequency Once in 6 months/Simple
Note:
• Same format can be used for reverse-working to get spot price
Example [Reverse working of Spot Price]
BSE sensex on 1st Jan 2022 (Anticipated on 1st Sep 2021) = 58,580; Dividend Yield of index = 6% per annum;
181 days treasury bill rate = 9% per annum; How much is the present value of sensex as on 1 st Sep 2021?
a. 58,580
b. 58,000
c. 59,160
d. 60,000
Answer:
Present value of sensex as on 1st Sep 2021 (Spot price) ??
BSE sensex on 1st Jan 2022 (anticipated on 1st Sep 2021) [Futures 58,580
price]
Time period 4 months
Risk-free rate 9% p.a. (or) 3% per 4M
Dividend Yield 6% p.a. (or) 2% per 4M
Fair Futures Price = Spot Price x (1 + (𝑟 − 𝑦))𝑡
𝟓𝟖, 𝟓𝟖𝟎 = 𝐒𝐩𝐨𝐭 𝐩𝐫𝐢𝐜𝐞 𝐱 (𝟏 + (𝟎. 𝟎𝟑 − 𝟎. 𝟎𝟐))𝟏
𝟓𝟖, 𝟓𝟖𝟎
𝐒𝐩𝐨𝐭 𝐩𝐫𝐢𝐜𝐞 = = 𝟓𝟖, 𝟎𝟎𝟎
𝟏. 𝟎𝟏

7. What Compounding Frequency to take?

Word used in question Compounding frequency
Continuous compounded risk-free rate of interest (CCRFI) Continuous
Daily compounding Continuous
e power value given in question Continuous
One-month interest rate = 12% p.a. Monthly compounding
Interest rate = 0.9% per month Monthly compounding
Interest rate = 2.4% per quarter Quarterly compounding

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Two-month interest rate = 12.5% per annum Every two months
Other situations Simple interest/ Compounding once
Example:
Stock is currently trading at Rs.100. One-month interest rate is 12% per annum. What is the fair futures
price for 3-month expiry?
a. Rs.103
b. Rs.103.03
c. Rs.103.05
Answer:
We will do monthly compounding as the monthly interest rates are given in question
FFP = 100 x (1.01)3 = Rs. 103.03

8. Arbitrage Gain computation and Strategy

Relationship Valuation Futures Spot Action in debt market
AFP > FFP Over-valued Sell Buy Borrow to buy share
FFP < AFP Under-valued Buy Sell Create FD with sale proceeds
AFP = 2,000; FFP = 2,200; Spot price = 1,900 AFP = 2,350; FFP = 2,200; Spot price = 1,900
AFP < FFP AFP > FFP
Futures is undervalued Futures are overvalued
Buy in futures market; sell in spot market Sell in futures market and buy in spot market
Arbitrage gain = Difference between FFP and Arbitrage gain = Difference between FFP and
AFP AFP
Arbitrage gain = Rs.200 Arbitrage gain = Rs.150
Example:
Spot price = Rs.1,000; Life of futures = 6 months; Rate of interest = 6% per half year; Actual futures price =
Rs.1,100; How much is the possible arbitrage gain?
a. Rs.40
b. Rs.20
c. Rs.70
d. Arbitrage not possible
Answer:
Fair futures price = Spot price x (1 + r)n = 1,000 x (1 + 6%) = Rs. 1,060
Arbitrage gain = Difference between AFP and FFP = 1,100 - 1,060 = Rs.40
Example:
Fair futures price = Rs.1,000; Actual futures price = Rs.1,010; What strategy can help in exploiting arbitrage
opportunity and how much will be arbitrage gain/loss?
a. Buy spot and sell futures; Profit of Rs.10
b. Buy spot and sell futures; loss of Rs.10
c. Sell spot and buy futures; Profit of Rs.10
d. Sell spot and buy futures; Loss of Rs.10
Answer:
Buy spot and sell futures; Profit of Rs.10

9. Implied risk-free rate

• Engaging in arbitrage within the market creates an implied return surpassing the standard risk-
free rate. This is attributed to the generation of extraordinary profits without assuming any
associated risks during the arbitrage process
Arbitrage Gain
Implied risk free rate = Normal risk free rate + ( 𝑥 100)
Spot Price
Example:
Spot price = Rs.20,000; Fair Futures Price = Rs.24,000; Actual Futures Price = Rs.25,000; Life of futures = 6
months. How much is the implied risk-free rate assuming no dividend on futures contract?
a. 20%
b. 25%
c. 40%
d. 50%

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Answer:
Fair Futures Price = Spot price x (1 + r)
24,000 = 20,000 x (1 + r); r = 20% per 6 months (or)40% per year
Actual risk-free rate is Rs.20,000. However, the implied risk-free rate is more than actual risk-free rate due
to arbitrage gain. Investor will earn arbitrage gain of Rs.1,000 (Difference between FFP and AFP) and the
same would translate into gain of 5% per half year (or) 10% per year.
Hence implied risk-free rate = 40% + 10% = 50% per annum

10. Cost to Carry

• Cost to carry refers to the total expenses or costs associated with holding an underlying asset until
expiration of futures contracts. It includes various components such as interest costs, dividends
(for financial instruments like stocks), and storage costs (for commodities)
• Cost to Carry = FFP as per Formula – Spot Price
Example:
• Spot Price = Rs.1,000; Adjusted Spot Price = Rs.975.51 (adjusted for dividends) and Fair futures
price = Rs.1,005.22
• Cost to Carry = 1,005.22 – 1,000 = Rs.5.22

11. Convenience Yield

• Convenience yield is the benefit of holding the inventory/product/shares in physical form as
compared to holding in futures.
• Fair futures price = Spot price + Cost to carry - Convenience Yield
• FFP as per question = (FFP as per formula) – CY
• Future value of CY = FFP as per formula - FFP as per question
• Present value of CY = Future value of CY discounted at risk-free rate
Example:
Spot price = Rs.800; Cost to carry = Rs.20; You need to consider Rs.810 as the fair futures price. How much
is the convenience Yield?
a. No convenience yield
b. Rs.20
c. Rs.10
Answer:
Convenience yield = FFP as per formula - FFP as per question
FFP as per formula = Spot price + Cost to carry = 800 + 20 = 820
Convenience yield = 820 - 810 = Rs.10

12. Contango and Backwardation Market

• Normal scenario = Spot price = 2,000; Futures price = 2,050; Market type = Contango market
(upward sloping market). In a normal market, the futures price would be higher than spot price
• Reverse scenario = Spot price = 2,100; Futures price = 2,050; Market type = Backwardation market
(downward sloping market)
• Basis = Spot price - Futures price; Negative Basis = Contango Market; Positive Basis =
Backwardation Market
Example:
Spot price = 2,400; Fair futures price = 2,300; How much is contango/backwardation?
a. Contango of 100
b. Backwardation of 100
c. Neither contango nor backwardation
Answer:
Futures is lower than spot and hence it is backwardation market
Backwardation = Difference between FFP and Spot = 100

13. Computation of Beta (Hedge Ratio)

SD of Spot Price
Beta = x Correlation coefficient
SD of futures Price
Example:

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The variance of spot and futures is 144 and 324. The correlation co-efficient is 0.75. What is the hedge ratio?
a. 0.66
b. 0.50
c. 0.33
d. 1.125
Answer:
Hedge ratio is also known as Beta.
SD of spot price
Beta = x Correlation co − efficient
SD of future price
12
Beta = ( ) x 0.75 = 0.50 Times
18

14. Beta (Hedge Ratio) and Change in Price

• Beta measures the risk of a share in relation to market. Beta > 1 indicates it is riskier than market.
Beta < 1 indicates it is less risky as compared to market
• Beta of 1.5 Times would mean that if market (nifty) increases by 10% then share will increase by
15%. Conversely if market falls by 10%then share will fall by 15%
• % change in share = Beta of share x % change in market
Example:
Beta of share = 2 Times. Share has increased by 20 percent. How much would be the change in market?
a. Increase of 40 percent
b. Decrease of 40 percent
c. Increase of 10 percent
d. Decrease of 10 percent
Answer:
Change in share = Change in market x Beta
20 percent = Change in market x 2
20
Change in market = = 10 percent (increase)
2

15. Physical Settlement and Net Settlement

• Example: You have entered into a contract to buy Gold at Rs.5,000 per gram. Contract was entered
today and has to be executed after 1 year. Price of Gold after one year is 5,600 per gram.

Physical settlement:
• We will pay Rs.5,000 per gram and the shopkeeper will give us Gold

Net settlement/cash settlement:

• Shopkeeper will give a net settlement of Rs.600 per Gram (5,600 - 5,000). This can be understood
as Shopkeeper giving Gold at contracted price of Rs.5,000 per Gram and buying back Gold from
us at CMP of Rs.5,600 per Gram.

Format for computing net settlement:

• Contract to buy Gold at 5,000; Price after 12 months = Rs.5,600
Date Position Action Ref date Rate
01-Feb-24 Original Position Buy 10-Sep-24 -5,000
10-Sep-24 Opposite Position Sell 10-Sep-24 5,600
Total 600

Example:
Contract to sell TCS at Rs.3,200 after 3 months; Price after 3 months = 3,400
Date Position Action Ref date Rate
01-Feb-24 Original Position Sell 10-Dec-23 3,200
10-Dec-23 Opposite Position Buy 10-Dec-23 -3,400
-200
Note:

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• Date = Date on which contract is entered/cancelled/executed
• Position = Original position and opposite position
• Action = Buy (long) and sell (short)
• Reference date = Expiry date of futures contract/ Execution date of futures contract
• Price = Positive if position is Sell and negative if position is Buy
Example:
A stock is currently trading at Rs.125 and is likely to pay annual dividend of Rs.4 after one year. Risk-free
interest rate is 8% per annum. Lot size of contract is 2,000 shares. An investor took short position on futures
and the spot price fell by 6%. How much is the profit or loss on the position taken by the investor?
a. Rs.15,000 (profit)
b. Rs.15,000 (loss)
c. Rs.16,200 (profit)
d. Rs.16,200 (loss)
Answer:
Original futures price:
4
PV of dividend = = 3.70
1.08
Adjusted spot price = 125 – 3.70 = 121.30
Fair futures price = 121.30 x 1.08 = Rs. 131 (or)Rs. 2,62,000 per contract
Revised futures price:
Revised spot price = 125 − 6% = Rs. 117.50
Adjusted spot price = 117.50 – 3.70 = 113.80
Fair futures price = 113.80 x 1.08 = Rs. 122.90 (or)Rs. 2,45,800 per contract

Profit/loss:
Investor originally sold futures for Rs.2,62,000. Now the opposite position (purchase) will be at Rs.2,45,800.
Hence profit = 2,62,000 – 2,45,800 = Rs.16,200
Example:
Mr. X purchased Nifty futures of Rs.2,00,000 on Jan 1. Lot size of Nifty = 10. Nifty spot on expiry was
20,800 whereas futures was 20,805. How much is the profit/loss?
a. Profit of Rs.8,000
b. Loss of Rs.8,000
c. Profit of Rs.8,050
d. Loss of Rs.8,050
Answer:
Profit/loss will be computed using futures price on expiry date
Particulars Calculation Amount
Purchase price 2,00,000/10 20,000
Opposite cancellation rate (SP) 20,805
Profit 10 x (20,805 – 20,000) 8,050

16. Hedging – Perfect Hedge

• Hedging means protection against fall/increase in prices.
• Under hedging the hedger will have an underlying transaction/motive.
• Some of the shares/commodities/metals will not be available in futures market. Hence hedging
can be done through Index futures.
• Index has Beta of 1 whereas underlying asset can have different beta (>1 (or) <1 (or) negative)
• In order to account for changes in risk, the amount to be hedged is adjusted.
• A portfolio will be called as fully hedged if Beta of Portfolio is zero.
Format for computation of amount to be hedged:
Security Beta Weight Product
Shares of A Limited 0.50 20,00,000 10,00,000
Shares of C Limited 1.20 -25,00,000 -30,00,000
Nifty futures 1.00 20,00,000 20,00,000
Overall Beta 0.00 -5,00,000 0
Note:

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• Beta = Risk of security/Market; beta of market = 1 Time
• Weight = Amount of purchase/sales of shares (or) futures. Purchase will be written as positive
weight and sales will be written as negative weight
• Total of weights = Total of Position in spot market; Futures purchase/sale will not be considered
in weights total. This is because no inflow/outflow happens for futures purchase/sale
• Product = Weight x Beta
Number of contracts:
Amount to be hedged (weight of BSE futures)
Number of contracts =
Size of one contract
Example:
You have purchased 2000 shares of ABC Limited. ABC has a beta of 1.1 with the sensex. You have sold
one contract of sensex worth Rs.2,20,000. You have done a perfect hedge with above transactions. What is
the current market price of ABC Limited?
a. 100
b. 110
Answer:
Security Beta Weight Product
ABC Limited 1.10 2,00,000 2,20,000
[2,20,000/1.10]
Sensex 1.00 -2,20,000 -2,20,000
Total 0.00 2,00,000 0
2,00,000
Value of one share = = 100
2,000
Example:
Value of portfolio held = 20,20,000; Beta of portfolio = 2; BSE futures = 10,100; Lot size = 10; How many
contracts should be bought/sold for perfect hedge?
a. Buy 40 contracts
b. Sell 40 contracts
c. Buy 20 contracts
d. Sell 20 contracts
Answer:
We need to sell futures to hedge as we have a long position in spot market
Exposure value x Beta 20,20,000 x 2
No of contracts to be sold = = = 40 contracts
Value of one contract 10,100 x 10
Example:
You buy 10,000 shares of ABC Limited at a price of Rs.20 per share. You got a perfect hedge with position
in Nifty futures. Nifty fell by 2% and shares of ABC Limited increased by 5%. You made overall profit of
Rs.12,000. How much is the Beta of ABC Limited?
a. 2.50 Times
b. -2.50 Times
c. 0.50 Times
d. 2 Times
Answer
Particulars Amount
Profit in ABC Limited [2,00,000 x 5%] 10,000
Profit in Nifty futures [12,000 – 10,000] 2,000
Position in nifty futures [2,000/-2%] -1,00,000
Beta computation:
Security Beta Weight Product
ABC Limited 0.50 2,00,000 1,00,00
Nifty Futures 1.00 -1,00,00 -1,00,00
Total 0 2,00,000 0
Nifty of ABC Limited = 0.50 Times

17. Hedging – Target Beta

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If the question species a target Beta, then the same can be used in the format and accordingly the amount
to be hedged will change
Example:
Value of portfolio held = 10,00,000; Beta of portfolio = 2 times; Size of one futures contract (index) =
Rs.2,00,000; How many contracts to be bought/sold if we want to reduce Beta to 0.6 Times?
a. Sell 7 Contracts
b. Buy 10 contracts
c. Sell 10 contracts
d. Buy 7 contracts
Answer:
Security Beta Weight Product
Portfolio 2.00 10,00,000 20,00,000
Index futures 1.00 -14,00,000 -14,00,000
Total 0.60 10,00,000 6,00,000
14,00,000
No of contracts to be sold = = 7 contracts
2,00,000

18. Hedging – Protection of Specified %

Protection of specified %: If question specifies a protection % (60% for example), then the target Beta
would be existing Beta – 60%. Use this target Beta in the format and compute the amount to be hedged
Example:
Beta of portfolio of investor = 2 Times. He is targeting 120% protection of his portfolio through Nifty
Futures. How much is the target beta of the investor post protection?
a. 4.40 Times
b. 0 Time
c. 2.4 Times
d. -0.40 Times
Answer:
Target Beta = Existing Beta – Protection % = 2 – (120% of 2) = -0.40 Times
Example:
Sale of shares of A Limited = Rs.2,00,000; Beta of A Limited = 1.5 times; The investor wants 50 percent
hedge and hence wants to position to be taken in index futures?
a. Purchase index futures of Rs.1,50,000
b. Purchase index futures of Rs.1,00,000
c. Sell index futures of Rs.1,50,000
d. Sell index futures of Rs.1,00,000
Answer:
Security Beta Weight Product
A Limited 1.50 -2,00,000 -3,00,000
Nifty Futures 1.00 1,50,000 1,50,000
Total 0.75 -2,00,000 -1,50,000
• Purchase index futures of Rs.1,50,000

19. Hedging – Size of one contract

Size of one contract = Actual Futures Price x Lot size. We should ensure that actual futures price is used
for finding size of one contract. Fair futures price should not be used. FFP can be used as proxy for AFP
only if data on AFP is not available
Example:
Fair futures price of Nifty = 20,000; Actual Futures price of Nifty = 19,800; Lot size = 100. How much is the
value of one futures contract?
a. 20,00,000
b. 19,80,000
Answer:
Value of one contract = Actual Futures price x Lot size
Value of one contract = 19,800 x 100 = Rs.19,80,000
Note: We will use fair futures price as actual futures price if there is no information on AFP in question

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20. Modification of Portfolio Beta through Risk-Free Investment/Borrowing
• Increase in beta will happen through borrowing and decrease in beta can happen through risk-
free investment.
• We can use the below format to decide the quantum of investment/borrowing:
Security Beta Weight Product
Risky Portfolio 0.80 25,00,000 20,00,000
Risk-free investment 0.00 15,00,000 0.00
Total 0.50 40,00,000 20,00,000
• In this example we had an existing Beta of 0.80 Times and we have brought the same down to 0.50
times by making a risk-free investment
Example:
Value of portfolio = 20,00,000; Beta of portfolio =2 Times; How much fresh risk-free investment can be
brought in if you want to reduce risk to 0.5 Times? Note: You are not planning to sell shares and bring in
additional money
a. Buy Risk-free investment of Rs.40,00,000
b. Buy Risk-free investment of Rs.60,00,000
c. Buy Risk-free investment of Rs.20,00,000
Answer:
Security Beta Weight Product
Portfolio 2.00 20,00,000 40,00,000
Risk-free investment 0.00 60,00,000 0
Total 0.50 80,00,000 40,00,000
Hence the investor needs to have a portfolio value of Rs.80,00,000 to reduce beta to 0.5 Times. This will be
possible by having share portfolio of Rs.20,00,000 and balance risk-free investment of Rs.60,00,000

21. Normal Rate and CCRFI Rate

• Normal rate can be converted into CCRFI rate using Natural log tables.
• Example: Normal rate = 12%; Naturallog(1.12) = 0.1133 or 11.33%
• CCRFI rate can be converted into normal rate using e^rt tables
• Example: CCRFI = 11.33%; 𝑒 11.33% = 1.12; Normal rate = 12%
Example:
Normal cost of capital is 10.5%.; Natural log (1.1050) = 0.0998; What will be the CCRFI rate of interest for
normal cost of capital of 10.5%?
a. Cannot be calculated with given information
b. 10.5%
c. 9.98%
Answer:
Natural log can help in converting the normal rate to CCRFI. In this case Natural log (1.105) is 0.0998.
Hence, we can say that normal rate of 10.5% is equivalent of CCRFI 9.98%

22. Profit/Loss on different Positions

Original Position Price Profit/Loss
Buy (+) Increase (+) Profit
Buy (+) Decrease (-) Loss
Sell (-) Increase (+) Loss
Sell (-) Decrease (-) Profit
Example:
Investor has entered into a long position of Rs.100 lacs in Nifty futures. He also has a share portfolio which
has Beta of 1.5 times. His share portfolio declined by 4.5 percent. How much would be the profit/loss only
in Nifty futures?
a. Loss of 4.5 lacs
b. Profit of 4.5 lacs
c. Loss of 3 lacs
d. Profit of 3 lacs
Answer:

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Share has beta of 1.5 times and has declined by 4.5 percent. Hence market would have fallen by 3 percent.
We are holding Nifty futures of 100 lacs and Nifty has fallen by 3 percent. Hence loss in Nifty futures is
Rs.3 lacs

23. Effective realization/payment in futures

• Effective realization = Realization as per spot rate + Net settlement in futures
Net settlement can be computed as under:
Date Position Action Reference Date Rate
Day 0 Original Position Sell Day 180 XX
Day 180 Opposite Position Buy Day 180 XX
Net profit/loss per Kg in futures market XX
Note:
Realization/payment will always happen as per spot rate in cash market on maturity rate. Futures rate
will be used for computing net settlement in futures
Example:
Spot position of wheat = Rs.20; You have entered into futures contract to sell wheat at Rs.21. What will be
the net realization if wheat price on maturity date is 25 in spot market and 25.10 in futures market?
a. 25.10
b. 21.00
c. 20.90
d. 21.10
Answer:
Date Position Action Reference Date Rate
Day 0 Original Position Sell Maturity 21.00
Maturity Opposite Position Buy Maturity -25.10
Loss in futures -4.10
Net realization = Spot realization (25) - Loss of Rs.4.10 = 20.90

24. Initial and Maintenance Margin

• Initial margin is the amount to be deposited by buyer/seller of futures with the broker for entering
into futures position. This is like refundable deposit and will ensure that both parties do not
default on their obligations.
• Maintenance margin will be lower than initial margin and we should ensure that balance in
margin account do not go below maintenance margin.
• Margin Call: If the balance in margin account falls short of maintenance margin, then broker will
make a margin call and we should replenish the margin account to the level of initial margin.
• We are also allowed to withdraw money from margin account if the balance in margin account is
more than initial margin.
• Amount withdrawable = Balance in margin account - Initial margin
• Initial margin = Specific % of futures position (or) Daily average change + 3 Times of Standard
Deviation.
Example
You have purchased one lot of Nifty at 10,000. Lot size = 100 units. Initial margin = 8% of contract value.
Nifty has moved to 9,800 on next day. What will be the balance in margin account post profit/loss?
a. 80,000
b. 1,00,000
c. 60,000
d. 40,000
Answer:
• Initial margin = 8 % of contract value = 8% of (100 x 10,000) = 80,000
• Profit/loss = 100 x (9800 - 10,000) = Loss of Rs.20,000
• Margin balance post loss = 80,000 - 20,000 = Rs.60,000
Example:
The average daily absolute change in the value of the contract is Rs.8,000 and standard deviation of these
changes is Rs.4,000. How much should the initial margin be?
a. 12,000
b. 8,000
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c. 20,000
d. 16,000
Answer:
Initial margin = Daily absolute change + (3 x Standard Deviation)
Initial Margin = 8,000 + (3 x 4,000) = Rs.20,000
Example:
Initial margin = 50,000; Maintenance margin = 40,000; Margin account reached balance of Rs.38,000. How
much would be the margin replenishment needed?
a. No replenishment needed
b. Rs.2,000
c. Rs.12,000
Answer:
Margin account has fallen below the maintenance margin and hence we are required to replenish this back
to the level of initial margin (50,000). Replenishment needed = 50,000 - 38,000 = 12,000
Example:
Initial margin = 50,000; Maintenance margin = 40,000; Margin account reached balance of Rs.43,000. How
much would be the margin replenishment needed?
a. No replenishment needed
b. Rs.3,000
c. Rs.7,000
Answer:
Margin balance has not gone below maintenance margin and hence no replenishment is needed
Example:
Initial margin = 50,000; Maintenance margin = 40,000; Margin balance post profit/loss = 70,000; Investor
withdraws 60% of maximum allowed withdrawal. How much was the withdrawal?
a. 18,000
b. 12,000
c. 20,000
d. 30,000
Answer:
Maximum allowed withdrawal = Margin balance - Initial margin = 70,000 - 50,000 = Rs.20,000
Amount withdrawn = 60% of 20,000 = Rs.12,000

25. Return on investment in futures

• Investment made = Margin deposited + Brokerage/ commission;
• Profit = Profit on futures position – Opportunity cost (dividend income) – brokerage expense.
• ROI is computed using below formula:
Profit
ROI = x 100
Investment
Example:
You deposited a margin of Rs.10,000 for entering a futures contract. You also paid a commission of Rs.1,000
to broker. You made a gross profit of Rs.5,000 on futures and paid a commission of Rs.1,000 for exit. How
much is the rate of return earned?
a. 50%
b. 30%
c. 33.33%
d. 27.27%
Answer:
Initial outflow (investment) = 10,000 + 1,000 = Rs.11,000
Net Profit = 5,000 – entry commission (1,000) – exit commission (1,000) = 3,000
3,000
Rate of return = x 100 = 27.27%
11,000

26. Asset Swap

• It is like a normal swap wherein returns from a security is swapped with variable return of another
security/fixed interest of debt instrument
Example:

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ABC Limited has entered into a swap agreement on notional principal of Rs.200 crores. ABC Limited
would pay 1% per quarter and receive the quarterly return of sensex. Sensex value on day 0 and day 90 is
20,000 and 21,000. How much is the net cash flow of ABC Limited?
a. Receive Rs.10 crores
b. Receive Rs.8 crores
c. Pay Rs.10 Crores
d. Pay Rs.8 Crores
Answer:
Amount payable [200 crores x 1%] 2 crores
Change in sensex 21,000 − 20,000
𝑥 100 = 5.00%
20,000
Amount receivable [20 crores x 5%] 10 crores
Net receipt 8 crores

27. Option Contract - Basics

• An option contract is one where one person gets a right to buy/sell a product /share/index at a
specified price but not an obligation to do the same. In short, the option exercising is not
mandatory.

Type of Option:
• Call option = Right to buy but not an obligation to buy
• Put option = Right to sell but not an obligation to sell

Parties to option contract:

• Holder/Buyer = Person who gets the right = Premium has to be paid
• Seller/Writer = Person who gives the right = Premium will be received

Different Players:
• Call holder = Person who buys the right to buy
• Call writer = Person who sells the right to buy
• Put holder = Person who buys the right to sell
• Put writer = Person who sells the right to sell

28. Who can exercise an option

• Option will always be exercised by the holder.
• If an option is exercised, there will be a net settlement. Net settlement will always be positive for
holder and negative for writer
• Holder = Limited loss (premium) but unlimited profit
• Writer = Limited profit (premium) but unlimited loss
Example:
Purchased one 3-month call option with a premium of Rs. 30 and an exercise price of Rs. 550. Purchased
one 3-month put option with a premium of Rs. 5 and an exercise price of Rs. 450. Price on expiry date is
Rs.600. How much is the profit/loss if lot size is 100 shares?
a. Profit of Rs.5,000
b. Loss of Rs.3,500
c. Profit of Rs.1,500
d. Loss of Rs.1,500
Answer:
• Premium paid on call option = 3,000 [30 x 100]
• Premium paid on put option = 500 [5 x 100]
• Call option will not be exercised. Put option will be exercised and will have GPO of Rs.50 and we
will receive Rs.5,000
Net payoff = 5,000 - 3,500 = Rs.1,500
Example:
Exercise price of put option = 1,000; Price of underlying asset on expiry date = 800; Premium received/paid
on put option = 45; How much is the net pay-off of Put writer?

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a. Profit of Rs.45
b. Loss of Rs.200
c. Loss of Rs.155
d. Profit of Rs.155
Answer:
Put option will be exercised and hence gross payoff is negative 200; Premium received is Rs.45; Net payoff
= Negative 200 + 45 = Negative 155

29. American vs European Option

• European option - Option can be exercised only on expiry date
• American option - Option can be exercised at any time on or before expiry date

30. What is exercise price?

• Exercise price/strike price = Price at which we want to buy/sell

31. Status of Option

• In the money option = Option which will be exercised
• At the money = Indifferent (CMP = Strike price)
• Out of the money option = Option will lapse
Example:
CMP of underlying asset = 400; Exercise price of call option = 450; What is the status of call option?
a. In the money
b. At the money
c. Out the money
Answer:
CMP of underlying asset = 400; Exercise price of call option = 450; What is the status of call option?
a. In the money
b. At the money
c. Out the money
Answer:
OTM options are those which won’t be exercised. Exercise price of call option is Rs.450 whereas CMP is
Rs.400. Hence this option won't be exercised currently and so this is an out the money options

32. What action to be taken in Options Market?

• Prices are expected to increase = Long call (or) short Put
• Prices are expected to decrease = Long put (or) short call

33. Intrinsic value vs Time Value

• Intrinsic value is the real value of option. This is basically the net settlement if the option was
to be exercised today
• Premium paid = Intrinsic value + Time value
• Time value is directly proportional with expiry period.
Example:
Exercise price = 1,000; CMP = 1,200. What is the intrinsic value of call option and Put option?
a. 200 & 0
b. 0 & 200
c. 200 & - 200
d. -200 & 200
Answer:
Call option is exercised when actual market price is higher than exercise price. In the given situation it
would be exercised and has intrinsic value of Rs.200. Put option will not be exercised and hence intrinsic
value of 0
Example:
Exercise price of option = 1,000 and 1,100; Premium of above option = 200 and 175; What will be the nature
of above options?
a. Call option

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b. Put option
c. Cannot be said with given information
Answer:
Premium for call option will reduce with the increase in exercise price (purchase price is going up). This
is because increased exercised price would reduce the probability of exercising call option. In the given
question, premium reduces with increase in exercise price and hence the same is a call option
Example:
Exercise price of put option = 100; CMP of underlying asset = 80; CMP of put option = 45; How much is
the time value of option?
a. 20
b. 25
c. 45
d. 0
Answer:
Time value = Option price - Intrinsic value = 45 - 20 = 25

34. Call option vs Put option utility

• A call option restricts maximum purchase price and a put option provides minimum selling price
Example:
You plan to buy shares of TCS Limited. CMP of TCS is Rs.1,000. You currently don't have money and also
intend to pay a maximum of 5 percent more than CMP. What action can be taken in option market to
achieve this?
a. Buy Put option of Exercise price of Rs.1,050
b. Buy call option of Exercise price of Rs.1,050
c. Buy Put option of Exercise price of Rs.950
d. Buy call option of Exercise price of Rs.950
Answer:
Maximum purchase price = 1,000 + 5% = 1,050; We can cap the maximum purchase price by taking a call
option. Exercise price of call option would be Rs.1,050

35. Payoff of option and Break-even Price

Payoff:
• Payoff of option holder = Gross pay-off – Premium Paid
• Payoff of Option writer = Premium received – Gross pay-off paid
Break-even Price:
• Break-even price for call option = Strike Price + Premium
• Break-even price for put option = Strike Price – Premium
Example:
Exercise price of call option = 200; Exercise price of Put option = 220; Premium paid/received on call and
put option = Rs.6 and Rs.4; You have bought one call option and sold one put option. How much will be
the net profit/loss if actual price is Rs.240 on expiry date?
a. Profit of Rs.40
b. Profit of Rs.38
c. Profit of Rs.42
d. Loss of Rs.42
Answer:
Call option will be exercised and GPO will be Rs.40; Put option will not be exercised; Total GPO = Rs.40;
Net premium paid = Rs.2; Final Profit = 40 - 2 = Rs.38
Example:
You have bought a call option with exercise price of Rs.100. You have sold a call option with exercise price
of Rs.80. Premium on Rs.100 option was Rs.10 and Premium on Rs.80 option was Rs.25. What will be the
break-even price?
a. 100
b. 80
c. 115
d. 95
Answer:

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Break-even price is where premium is equal to gross payoff; Net premium received = 25 - 10 = 15. Hence
at break-even gross payoff should be negative Rs.15. This would mean we would lose money on option
written and don’t earn anything on option bought
We will lose Rs.15 on Rs.80 option if the actual market price is Rs.95. At Rs.95, EP of Rs.100 option would
not get exercised and hence we will lose Rs.15 at GPO level
Example:
Exercise price of call option = Rs.100; Premium paid/received = Rs.10; What will be the break-even price?
a. 100
b. 110
c. 90
Answer:
Call option will get exercised if actual price is higher than exercise price. Break-even will happen when
Gross pay-off is equal to premium and hence GPO should be Rs.10. GPO would be Rs.10 if the actual
market price on expiry date is Rs.110
Example:
A stock is trading at Rs.18 per share. An investor believes that the stock will move either up or down. He
buys a call option on the stock with an exercise price of Rs.20. He also buys two put options on the same
stock each with an exercise price of Rs.25. The call option costs Rs.2 and the put options cost Rs.9 each. The
stock falls to Rs.17 per share at the expiration date and the investor closes his entire position. The investor's
net gain or loss is:
a. Rs.4 (Loss)
b. Rs.3 (Loss)
c. Rs.4 (Gain)
d. Rs.3 (Gain)
Answer:
Premium paid = 2 + (9 x 2) = Rs.20. Call option will not be exercised and put option will be exercised on
maturity date. Gross payoff from put option will be Rs.16 (8 x 2) and hence the investor will have a net
loss of Rs.4.00

36. Exercise price prevails on maturity date

• Exercise price will prevail on maturity date would mean that market price on expiry date will be
equal to exercise price. This will make the option at the money and the same will lapse. Value of
such option will be zero on maturity date
Example:
You as an investor had purchased a 3 month call option on the equity shares of X Ltd. of Rs.30, of
which the current market price is Rs. 560 and the exercise price Rs. 590. You expect the price to range
between Rs.540 to Rs.640. The expected share price of X Ltd. and related probability is given below:
Expected Price 540 560 580 600 620 640
Probability 0.10 0.15 0.05 0.35 0.20 0.15
How much is the likely value of call option after three months if the exercise price prevails?
a. Rs.17.00
b. Rs.7.00
c. Rs.50.00
d. Rs.0.00
Answer:
Exercise price prevails would mean that market price on maturity would be equal to exercise price. The
option will lapse and hence the likely value of call option on maturity is 0.

37. Methods of option valuation

• Objective = To determine fair price of option

Methods:
• Put call parity theory
• Replication approach
• Risk Neutral Model
• Binomial Model
• Black Scholes Model
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38. Put Call Parity Theory [Can be used when 3 out of 4 items of equation is available]
• PCPT Equation: Share + Put = Call + PV of EP
Note:
• Share = Share price (or) Adjusted Share price [Share price - PV of Dividend] (or) Adjusted share
Share price
price = Share price x e−yt (or) (1+y) n

• Put = Actual/Fair price of Put

• Call = Actual/fair price of call
• PV of EP = EP discounted at risk-free rate
Creation of Put:
• Share + Put = Call + PV of EP
• Put = Call + PV of EP – Share

Put can be created using the following steps (this is taken from above equation where (+) means
buy/invest and (-) means sell/borrow
• Buying one call
• Invest money equal to Present Value of Exercise Price
• Short-sell share
Example:
Spot price of shares = Rs.100; CCRFI = 12% per annum; Dividend of Rs.2 would be paid in 2 months; Life
of option = 3 Months. Value of Put of an in-the-money option is Rs.10. How much is the value of an in-
the-money Call option?
a. Rs.8.04
b. Rs.12.96
c. Rs.11.00
d. Rs.13.00
Answer:
Share + Put = Call + PV of EP
2
Adjusted share price = Share price – PV of dividend = 100 − 0.02 = 100 − 1.96 = 98.04
𝑒
100
98.04 + 10 = Call + 0.03 ; 108.04 = Call + 97.04; Call = 11.00
e

39. Risk-Neutral Model

• This model can be used only when we have two judgement prices for maturity date.
• Two JP does not mean probability is 50/50
• We should compute upside and downside probability using weighted average format
• Value of call/put = Weighted average of Intrinsic value with probability being the assigned weight
• Above value needs to be discounted to get today's price.
Formula to compute Probability (We don’t use formula for computation of probability)
𝐞𝐫𝐭 − 𝐝
𝐔𝐩𝐬𝐢𝐝𝐞 𝐏𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 =
𝐮−𝐝
Where
r = rate of interest per annum; t = time period in years
JP1
d=
Current Price
JP2
u=
Current Price
Example:
Spot Price = Rs.100; Time period of call option = 1 year; Risk-free rate = 10% (normal rate); Judgement
price = 75 and 125; Exercise price of option = 90
Computation of Probability:
Expected Price of share at end of year 1 = 100 x 1.10 = 110
Price Prob Product
75 P 75P
125 1-P 125-125P

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Total 75P+125-125P = 110
𝟕𝟓𝐏 + 𝟏𝟐𝟓 − 𝟏𝟐𝟓𝐏 = 𝟏𝟏𝟎; −𝟓𝟎𝐏 = −𝟏𝟓; 𝐏 = 𝟎. 𝟑𝟎
• Hence probability of price reaching Rs.75 is 0.30 and probability of price reaching 125 is 0.70
Price IV Prob Product
75 0 0.3 0
125 35 0.7 24.5
Future value of call 24.5
24.50
Present value of call 1.10 = 𝟐𝟐. 𝟐𝟕
Example:
The current price of a flat is Rs.100 lacs. The price can either go up to Rs.110 lacs or Rs.95 lacs by end of
one year. Expected annual rental income of flat is 2 lacs. Risk-free rate of return is 8% per annum. What is
the probability of price increasing to Rs.110 lacs?
a. 86.67%
b. 73.33%
c. 50.00%
d. 80.00%
Answer:
Expected price of flat = 100 x (1 + 8%) – 2 lacs = 106 lacs
Price Probability Product
110 P 110P
95 1-P 95-95P
Total 110P + 95 – 95P = 106
11
15P = 11; P = = 0.7333 (or)73.33%
15

40. Binomial Model

• Under this model we work with 2 judgement prices and compute their upside and downside
probability (Follow RN model approach to get probability)
• Under this model the change can happen multiple times within the expiry date. For example: Call
option with life of 1 year. In this case change can happen every quarter and accordingly there will
be 4 price change in a year.
• Draw a path diagram (decision tree) reflecting the various prices and then do the valuation in the
reverse order
Steps in case of American Option:
• The value of each previous node in decision tree valuation would be higher of the following:
o Value of immediate exercise
o Value of later exercise
Example:
A stock is currently priced at Rs.50. It is known that in the first 6 months of current year from now prices
will either rise by 20% or go down by 20%, further in the later half of the year prices may again up by 20%
or go down by 20%. Suppose risk free rate is 5% continuous compounded and strike rate is Rs.52. How
much is the downside probability?
a. 45.00%
b. 56.35%
c. 43.65%
d. 50.00%
Answer:
Let us assume P to be the probability of price increase by 20% and 1-P to be the probability of price fall by
20%. Risk-free rate of interest is 5% per annum CCRFI
Expected price at end of month 6 = 50 x e(0.05)(0.5) = 50 x e0.025 = 50 x 1.0253 = 51.27
Price Probability Product
60 P 60P
40 1-P 40-40P
Total 60P+40-40P=51.27
11.27
60P + 40 − 40P = 51.27; 20P = 11.27; P = = 0.5635
20
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Hence probability of price raise is 56.35% and probability of price fall is 43.65%

41. Black Scholes Model

• This can be used to value only European options
• It considers the value of option can change due to the various parameters as mentioned below:
Parameter Call Option Put Option
Spot Price Direct Inverse
Time to expiry Direct Direct
Volatility (SD) Direct Direct
Risk-free Rate Direct Inverse
Exercise price (Never changes) - -
• Direct relationship would mean an increase in the parameter would lead to increase in option
premium and inverse relationship would mean an increase in the parameter would lead to
decrease in option premium
Formula:
Value of call option = (S0 x N(d1 )) − (PVEP xN(d2 ))
Where:
S
(Naturallog ( 0 ) + rt + 0.5σ2 t)
d1 = E
σ√t
S0
(Naturallog ( ) + (r − 0.5σ2 )t)
d2 = E (or)d2 = d1 − σ√t
σ√t
Note:
• S0=CMP; r =risk free rate per year; t =time in years and E =Exercise Price
• N(d1) and N(d2) are normal distribution values for the computed d1 and d2
Valuation of Put:
• Value of Put can be arrived through PCPT
Dividend in Rupees:
• Replace spot price with Adjusted Spot price and use the same for computation of call option value
as well as D1
• Adjusted Spot Price = Spot Price – PV of Dividend
Dividend Yield in percentage:
• Spot price cannot be taken directly in question as the given spot price is cum-dividend price
Spot Price
Adjusted Spot Price =
eyt
• For computation of D1 we can do one of the two items:
o Use Adjusted Spot Price in the formula (OR)
o Replace ‘r’ with ‘r-y’ in the formula and use the given spot price as it is.
• Present value of exercise price will always use ‘r’ only even if dividend is given, we shouldn’t
use ‘r-y’. This is because exercise price is on an option and the same does not have dividend
component
Dividend Yield in case of fixed life assets such as patents/Gold mines:
1
Dividend Yield =
Life
Example:
ABC Ltd. is a pharmaceutical company possessing a patent of a drug called ‘Aidrex’, a medicine for aids
patient. Being an approach drug ABC Ltd. holds the right of production of drugs and its marketing. The
period of patent is 15 years after which any other pharmaceutical company produce the drug with same
formula. It is estimated that company shall require to incur $ 12.5 million for development and market of
the drug. As per a survey conducted the expected present value of cashflows from the sale of drug during
the period of 15 years shall be $ 16.7 million. Cash flow from the previous similar type of drug have
exhibited a variance of 26.8% of the present value of cashflows. The current yield on Treasury Bonds of
similar duration (15 years) is 7.8%. How much is the dividend yield in black scholes model for valuation
of option?
a. No dividend
b. 15%

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c. 6.67%
d. 10.00%
Answer:
Benefit of patent will be earned over 15 years and hence annual cash inflow/dividend yield is 6.67% (1/15
years)
Example:
Current market price of share is Rs.930; Exercise price of share is Rs.900; Present value of exercise price as
per BS Model is Rs.888.08; N(d1) = 0.7069; N(d2) = 0.6783; Dividend yield on index is 3% per annum and
life of option is 2 months. How much is the value of call option as per BS model?
a. Rs.55.03
b. Rs.51.78
c. Rs.43.69
d. Rs.46.95
Answer:
2
)
N (d1)x e−yt = 0.7069 x e−0.03 x(12 = 0.7034
Value of call = (S0 x N(d1) x e−yt ) − (PVEP x N(d2))
Value of call = (930 x 0.7034) − (888.08 x 0.6783) = Rs. 51.78
Example:
Current market price of Share = Rs.415; Exercise price of share = Rs.400; Present value of exercise price =
Rs.395.03; N(d1) = 0.6926; N (d2) = 0.6529. How much is the value of call option?
a. Rs.26.27
b. Rs.29.51
c. Rs.19.12
d. Rs.15.00
Answer:
Value of call = (S0 x N(d1)) − (PVEP x N(d2)) = (415 x 0.6926) − (395.03 x 0.6529) = Rs. 29.51

42. How to compute N(d1) and N(d2) values

• A normal distribution consists of two tails with each of them having a probability of 50%. Left-
side tail is for negative values and right-side tail is for positive values
• We need to use cumulative left-side values for computing N(d1) and N(d2)
• Cumulative would mean two tail values for Positive Z and one-tail value for negative Z
• If d1 is positive, N of d1 will be greater than 0.5
Probability values will be given in question and the same could fall in the following categories:
• Value given is cumulative left-side values: Directly use the same to compute N(d1) and N(d2)
• Single tail left side values are given: Add 0.50 for positive Z value and nothing for negative Z
values
• Single tail right side values are given: Probability is decreasing with an increase in Z value. This
would mean they are right side single tail values - Positive Z value (1 – Given Value) and
Negative Z values (0.5 – Given Value)

43. Delta Hedging

• Portfolio is hedged to arrive at riskless portfolio. We hedge the portfolio either through:
o Futures = It uses Beta which doesn’t change frequently
o Options = It uses Delta which changes frequently
• Delta measures absolute change in option premium for change in value of underlying asset
Change in option price
Delta =
Change in underlying asset
• Call Delta: Calls have positive Delta. A deep in the money call option will have delta closer to +1
and deep out the money call option will have delta closer to 0
• Call Delta = N(d1) of Black Scholes Model
• Put delta: Put will have negative delta. A deep in the money put option will have delta closer to -
1 and deep out the money put option will have delta closer to 0.
• Put Delta = Call Delta – 1
Example:

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An investor expects two prices Rs.100 and Rs.80 for shares of TCS Limited. The exercise price of the call
option is Rs.90. How much is the delta of the put option?
a. 1 time
b. 0.50 time
c. -1 time
d. 0 time
Answer:
Spread in stock price 100 − 80
Delta of call option = = = 0.50 Times
Spread in IV 10 − 0
Delta of Put option = Call delta – 1 = 0.50 – 1 = -0.50 Times

44. Replication Approach of Option Valuation

Replication Approach of Option Valuation:
• Concept of delta can be used for valuation of an option using replication approach. Call delta of
0.4 times would mean that one option is equivalent to 0.40 shares
• Hence buying 0.40 shares and writing 1.0 call option is equivalent to risk-less portfolio and would
provide same results for the two judgement prices given. This will help us in arriving at the value
of option today.
Equation:
• 0.40 shares – 1 call option = Risk-free investment
• 0.40 shares = Risk-free investment + 1 call option
• Make two equations for the given judgement prices and get the answer for risk-free investment

Valuation:
• Substitute the risk-free investment value on day 0 in the same equation and get the fair value of
call option
Example:
Delta of call option = 0.3333 Times. What should be the combination of option and share to create risk-less
hedge portfolio?
a. Buy 1 share and Buy 3 call options
b. Buy 3 shares and Buy 1 call options
c. Buy 1 share and Sell 3 call options
d. Buy 3 shares and Sell 1 call options
Answer:
Security Delta Weight Product
Shares 1.00 1.00 1.00
Call option 0.3333 -3.00 -1.00
Total 0.00
Risk-less hedge portfolio would mean overall delta of 0. We should buy 1 shares and sell 3 call options to
create risk-less hedge portfolio

45. Credit Default Swaps

• Premium = Notional Amount x CDS spread. This is the amount to be paid by protection buyer to
protection seller. Any increase in CDS spread would indicate deterioration in credit quality of
underlying bonds
• Cash settlement on default = Notional Amount x (1 – Recovery rate%)
• Index CDS: Index CDS consist of multiple securities and the notional amount of the swap would
decline in case of default made by the constituents of index CDS
• Profit/loss of credit protection buyer = Notional Amount x Change in spread x Duration
• CDS spread = Probability of default x (1 – Recovery rate)
• Probability of survival = 1 – Probability of default (hazard rate)
• Upfront premium = [Coupon – CDS spread] x Duration x Notional Amount. If this amount is
positive then there will be receipt for protection buyer and vice versa
Example:
You bought a CDS contract from Axis Bank on bonds of A Limited by paying annual premium of 1%. The
annual premium has now increased to 3%. What inference does this have on credit quality of Bonds of A
Limited?
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a. No change in credit quality
b. Improvement in credit quality
c. Deterioration in credit quality
Answer:
Premium percentage has increased from 1% to 3.00%. Higher premium basically indicates deterioration
in credit quality of underlying asset (Bonds of Company A)
Example:
Company A has issued 10% bonds of Rs.50,00,000. Investor A has purchased bonds worth Rs.10,00,000 but
is worried about the risk of default. He therefore wants protection against the risk of default and hence
has purchased protection from Axis Bank in terms of CDS contract. Company A has defaulted and the
recovery rate is 25%. How much is the cash settlement amount to be paid by Axis Bank to Investor A?
a. Rs.37,50,000
b. Rs.10,00,000
c. Rs.50,00,000
d. Rs.7,50,000
Answer:
Amount paid by Axis Bank = Default amount x (1 – Recovery rate)
Amount paid by Axis Bank = 10,00,000 x (1 – 25%) = Rs.7,50,000
Example:
You have bought protection using a 2-year CDS on CDX-IG (125 constituent) index. The notional is Rs.200
crores. Company X, an index constituent defaults and trades at 25% of par. Compute the payoff on the
CDS on account of default of X?
a. 1.6 crores
b. 150 crores
c. 1.2 crores
d. 200 crores
Answer:
Notional principal of company X = 200 crores/125 = Rs.1.6 crores
Settlement amount = 1.6 crores – 25% = Rs.1.2 crores
Example:
A CDS has balance duration of 10 years. The original premium was 500 bps and now the premium has
widened to 700 bps. Notional amount of principal of Rs.10,00,000. How much is the gain/loss to protection
buyer?
a. Rs.20,000 (Profit)
b. Rs.20,000 (loss)
c. Rs.2,00,000 (Profit)
d. Rs.2,00,000 (loss)
Answer:
CDS spread has widened and hence the same indicates deterioration in credit quality. Deterioration in
credit quality will lead to profit for the protection buyer.
Profit of protection buyer = 10,00,000 x 2% x 10 years = Rs.2,00,000
Example:
A company issues one-year bond and the same has a probability of default of 2%. The expected recovery
rate is 20%. How much would the CDS spread for this bond?
a. 2.00%
b. 1.60%
c. 4.00%
d. 3.20%
Answer:
CDS spread = Probability of default x (1 – Recovery rate)
CDS spread = 2% x (1 – 20%) = 1.60%

46. Option Greeks

Term Meaning
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.

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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
Theta The change in option price given a one day decrease in time to expiration. Basically it is a
measure of time decay
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.
Vega Sensitivity of option value to change in volatility. Vega indicates an absolute change in option
value for a one percent change in volatility
Example:
Option Vega is 8.02. Current call and put premium is Rs.88.53 and Rs.253.67. How much would be the
revised premium if there is 1 percent increase in volatility?
a. Rs.80.51 and Rs.245.65
b. Rs.96.55 and Rs.245.65
c. Rs.80.51 and Rs.261.69
d. Rs.96.55 and Rs.261.69
Answer:
Volatility has increased and hence both call and put premium will increase. Option Vega is 8.02 and hence
both call and put premium will increase
New call premium = Rs.88.53 + 8.02 = Rs.96.55
New put premium = Rs.253.67 + 8.02 = Rs.261.69
Example:
Put option Rho is -3.86 and current put premium is Rs.20. Risk-free interest rate has decreased by 1 percent.
What would be the new put price post revision in risk-free rate?
a. Rs.20.00
b. Rs.23.86
c. Rs.16.14
Answer:
Put Rho is -3.86. This would mean that put premium will decrease if there is an increase in interest rate
and vice versa. Risk-free interest rate has declined by 1 percent and hence put premium will increase. New
Put premium = 20 + 3.86 = Rs.23.86
Example:
Call option Delta = 0.60 Times; Option Gamma is 0.0010. How much would be the new Put Delta if the
price of the underlying asset decline by Rs.1?
a. -0.3990 Times
b. 0.6010 Times
c. 0.5990 Times
d. -0.4010 Times
Answer:
Original Call Delta = 0.60 Times; Option Gamma is 0.0010 and this would mean that call delta will increase
by 0.0010 for Rs.1 increase in share price and will decline by 0.0010 for Rs.1 decline in share price.
New call delta with Rs.1 decrease in price = 0.60 Times – 0.0010 Time = 0.5990 Times
Put delta = Call delta – 1 = 0.5990 – 1 = -0.401 Times
Example:
Call option Theta is -3.45. Value of call option today is Rs.100. What would be the value of call option next
day assuming other things remain constant?
a. Rs.103.45
b. Rs.100.00
c. Rs.96.55
Answer:
Call theta of -3.45 would mean decline in call option price by 3.45 for one day decrease in time to expiration.
In this case other things have remained constant and hence the new call option price is Rs.96.55 (100 – 3.45)

47. Exotic Options

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• Chooser Options: This option provides a right to the buyer of option after a specified period of
time to decide whether purchased option is a call option or put option. It is to be noted that the
decision can be made within a specified period prior to the expiration of contracts
• Compound Options: Also called split fee option or ‘option on option’. As the name suggests
this option provides a right or choice not an obligation to buy another option at specific price
on the expiry of first maturity date. Thus, it can be said in this option the underlying is an
option. Further the payoff depends on the strike price of second option.
• Barrier options: Though it is similar to plain vanilla call and put options, but unique feature of
this option is that contract will become activated only if the price of the underlying reaches a
certain price during a predetermined period
• Binary Options: Also known as ‘Digital Option’, this option contract guarantees the pay-off
based on the happening of a specific event. If the event has occurred, the pay-off shall be pre-
decided amount and if event it has not occurred then there will be no pay-off
• Asian Options: These are the option contracts whose pay off are determined by the average of
the prices of the underlying over a predetermined period during the lifetime of the option.
• Bermuda Option: It is somewhat a compromise between a European and American options.
Contrary to American option where it can be exercised at any point of time, the exercise of this
option is restricted to certain dates or on expiration like European option.
• Basket Options: In this type of contracts the value of option instead of one underlying depends
on the value of a portfolio i.e., a basket. Generally, this value is computed based on the
weighted average of underlying constituting the basket.
• Spread Options: As the name suggests the payoff of these type of options depend on difference
between prices of two underlying.
• Look back options: Unlike other type of options whose exercise prices are pre-decided, in this
option on maturity date the holder of the option is given a choice to choose a most favourable
strike price depending on the minimum and maximum price of an underlying achieved during
the life time of option.
Example:
A binary option has a fixed payout of Rs.1000 if it finishes "in the money" and a premium of Rs.200. The
option has a 70% chance of finishing "in the money" based on market conditions. If a trader buys 10 binary
options, what is the expected payoff?
a. Rs.3,000
b. -2,000
c. Rs.10,000
d. Rs.5,000
Answer:
The expected payoff is calculated as the probability of finishing "in the money" multiplied by the fixed
payout, minus the premium. Expected payoff = (0.70 x Rs.1,000) – Rs.200 = Rs.700 – Rs.200 = Rs.500. Total
payoff = 500 x 10 options = Rs.5,000
Example:
An Asian call option has a strike price of Rs.50 and is based on the average price of the underlying asset
over the last three months. The average asset price in the first month is Rs.48, in the second month is Rs.52,
and in the third month is Rs.55. How much is the gross payoff to the option buyer on expiration date?
a. Rs.5.00
b. Nil
c. Rs.1.67
d. Rs.2
Answer:
We need to compare strike price with average closing price in case of an Asian option. The average price
is Rs.51.67. Current market price is higher than strike price and hence option will be exercised and the
gross pay-off to option buyer is Rs.1.67
Example:
A lookback call option has a strike price of Rs.80, and the underlying asset's prices during the option's life
are as follows: Rs.75, Rs.82, Rs.78 and Rs.85. The closing price on expiration is Rs.80. What is the profit for
the option holder?
a. Nil
b. Rs.5

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c. Rs.2
d. Rs.3.50
Answer:
Under a lookback option the option holder can choose the most favorable price for deciding on exercise.
Hence the exercise price of Rs.80 can be compared with most favorable price of Rs.85 (highest price) and
the option holder will have a pay-off of Rs.5.00

48. CDO
Introduction:
• CDOs typically pool together various debt instruments, such as bonds, loans, and other fixed-
income assets, to create a diversified portfolio of assets. The cash flows generated from these
assets are used to pay interest and principal to the investors of different tranches.

Types of CDOs:
• Cash Flow Collateralized Debt Obligations (Cash CDOs): Cash CDO is CDO which is backed
by cash market debt or securities which normally have low risk weight. This structure mainly
relies on the collateral’s risk weight and collateral’s ability to generate sufficient cash to pay off
the securities issued by SPV
• Synthetic Collateralized Debt Obligations: Synthetic CDOs do not typically hold actual debt
instruments as collateral. Instead, they use credit derivatives, such as credit default swaps
(CDS), to replicate the performance of a portfolio of reference assets. Accordingly, this structure
is mainly used to hedge the risk rather than balance sheet funding. Further, for banks, this
structure also allows the customer’s relations to be unaffected. This was started mainly by
banks who want to hedge the credit risk but not interested in taking administrative burden of
sale of assets through securitization. Synthetic CDOs can also be categorized as follows:
o Unfunded: It will be comprised only CDs.
o Fully Funded: It will be through issue of Credit Linked Notes (CLN)
o Partially Funded: It will be partially through issue of CLN and partially through CDs
Arbitrage CDOs: Basically, in Arbitrage CDOs, the issuer captures the spread between the return
realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition
to this issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisition of
relatively high yielding securities with large spread from open market.

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Chapter 10 – Foreign Exchange Exposure and Risk Management
Overview:
• Forex Basics
• Premium/discount and appreciation/depreciation
• IRPT and PPT
• Arbitrage
• Currency Invoicing
• Leading and Lagging
• Netting
• Forward Contract
• Money Market Hedge
• Exchange Position and Cash Position
• Currency Futures and Options
• Currency Swaps
• Multiple Forex Hedging Strategies

1. Price Currency and Product Currency

• Exchange rate is the rate at which one currency is exchanged for another. Hence it always involves
2 currencies.
• Example: INR 82 per USD; In this quote first currency (INR) is the price currency and second
currency (USD) is the product currency
• Example: USD 0.0122 per INR; In this quote first currency (USD) is the price currency and second
currency (INR) is the product currency

2. Direct Quote and Indirect Quote

• Direct quote expressed quote as home currency per unit of foreign currency. In short, price
currency will be home currency and product currency will be foreign currency
• Example: INR 82 per USD is a direct quote in India and the same is an indirect quote in USA
Conversion of direct quote into Indirect:
𝟏
𝐃𝐢𝐫𝐞𝐜𝐭 𝐐𝐮𝐨𝐭𝐞 =
𝐈𝐧𝐝𝐢𝐫𝐞𝐜𝐭 𝐐𝐮𝐨𝐭𝐞
Example:
Following are the quotes given by a Mumbai Banker:
• INR 8.8438 per DKR
• AUD 0.03038 per INR
Answer:
Given Quote Nature Calculations Other Quote
INR 8.8438/DKR Direct 1 DKR 0.1131/INR
8.8438
AUD 0.03038/INR Indirect 1 INR 32.9164/AUD
0.03038

3. Two-way Quotes
• This would mean that there will be 2 rates in every quote – Bid rate and Ask Rate
• Bid Rate: Banker’s Buying Rate. The rate at which the bank buys the product currency
• Ask Rate or Offer Rate: Banker’s selling Rate. The rate at which the bank sells the product
currency.
• Example: INR 82.50/83.00 per USD. This would mean 82.50 is the bid rate and 83.00 is the Ask
Rate
• Ask Rate > Bid Rate: Ask Rate can never be less than the Bid rate. This is because banker will
always maintain margins

Middle Rate:
• Simple average of Bid rate and Ask Rate
• There is no utility of this in practical world and the same is primarily used for statistical purposes

Spread:
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• Difference between the Bid rate and Ask Rate. This will be the profit margin for the banker
Spread
Spread % of offer price = x 100
Ask Rate
Spread
Spread % of Bid price = x 100
Bid Rate
Example:
• INR per GBP = 82.50/84.50
Identify various rates:
• Bid Rate = INR 82.50 per GBP (Rate at which bank buys GBP)
• Ask Rate = INR 84.50 per GBP (Rate at which bank sells GBP)
• Middle Rate = INR 83.50 per GBP (Average Rate)
• Spread = INR 2.00 per GBP

4. PIPS
• The numbers after the decimal in quote are called as PIPS
• If the numbers before the decimal in bid and ask is identical then while quoting the ASK portion
of the two-way quote only the PIP is quoted. Example: Rs.67.80 – 67.90 per USD is quoted as
Rs.67.80-90.
• If the numbers in the PIP are same those numbers are not quoted in the two-way quote in case of
ASK. Example Rs.12.315-70 / rand mean 12.315-12.370.
Example:
Spot rate is USD 1.5606 - 950/GBP. What will be the Ask rate for USD/GBP?
a. 1.9500
b. 1.5695
c. 1.5950
d. 950
Answer:
950 will be the last three digits of PIPS portion of the ask rate. Hence Ask rate will be 1.5950.

5. Direct to Indirect Quote conversion in two-way quotes

1
Bid (Direct Quote) =
Ask (Indirect Quote)
1
Ask (Direct Quote) =
Bid (Indirect Quote)
Example:
Spot rate INR/USD = 65.20/80. What will be BID rate for USD/INR?
a. 0.015337
b. 0.015198
c. 0.0125
Answer:
USD 1
BID ( ) =
INR INR
ASK ( )
USD
USD 1
BID ( ) = = 0.015198
INR 65.80

6. Return in Foreign Currency – One way Quote

(1 + Home currency return) = (1 + Foreign currency return)x (1 + Appreciation/Depreciation of FC)
Note: In the formula, the appreciation percentage of the foreign currency should be added, while the
depreciation percentage of the foreign currency should be deducted. It is important to solely consider the
percentages of the foreign currency and not those of the home currency.
Example:
Investment on day 0 = USD 100; Interest earned = USD 10; Value on day 365 = USD 105; USD has
depreciated by 5 percent. What is the return in terms of home currency?
a. 15%
b. 10%
c. 20.75%
d. 9.25%

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Answer:
105 − 100 + 10
USD Return = 𝑥 100 = 15.00%
100
USD has depreciated by 5 percent
(1 + HCR) = (1 + FCR) x (1 - Depreciation percentage of FC)
(1 + HCR) = (1 + 15%) x (1 - 5%);
(1 + HCR) = 1.15 x 0.95;
(1 + HCR) = 1.0925
Home currency return = 9.25%
Example:
USD return = 6.00%; Appreciation of INR = 5%. How much is the INR return?
a. 11.00%
b. 1.00%
c. 11.30%
d. 0.95%
Answer:
(1 + USD return) = (1 + INR return) x (1 + INR Appreciation %)
1.06
(1 + 0.06) = (1 + INR return) x (1 + 0.05); (1 + INR return) = ; INR return = 0.95%
1.05

7. Return in Foreign Currency – Two-way Quotes

• We have the option to calculate returns in both the home currency and the foreign currency
separately [Formula based approach will not work]
• This involves converting all data into a single currency (foreign currency) to determine the foreign
currency return. Likewise, we can convert all data into the home currency to ascertain the home
currency return

8. Commonly used currencies in questions

• INR per JPY = INR 0.5515
• INR per NZD = INR 48.74
• INR per AUD = INR 52.22
• INR per SGD = INR 60.04
• INR per CAD = INR 60.99
• INR per USD = Rs.82.83
• INR per EURO = Rs.86.34
• INR per CHF = Rs. 89.20
• INR per GBP = Rs.98.88
• The above all currencies are costlier than INR except JPY. Costliest currency in the above list is
GBP. This would help in interpretation of quote given in the question

9. Cross Rates
• Two or more different exchange rates are given and we have to find some other exchange rate by
the process of cross-multiplication
A A B
Bid ( ) = Bid ( ) x Bid ( )
C B C
A A B
Ask ( ) = Ask ( ) x Ask ( )
C B C
Example:
USD/GBP rate = 1.5606 – 50; USD/EURO rate = 1.2456 – 600; What will be the bid Euro/GBP rate?
a. 1.2386
b. 1.9439
c. 1.9719
d. 0.7959
Answer:
EURO EURO USD
( ) = ( )x( )
GBP USD GBP
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EURO EURO USD
BID ( ) = BID ( ) x BID ( )
GBP USD GBP
EURO 1
BID ( ) = ( ) x (1.5606)
GBP 1.2600
EURO
BID ( ) = 1.2386
GBP

10. Steps to solve basic problems

• Step 1: Find known and unknown component
• Step 2: Identify the base formula: Unknown component = Known Component x ?
• Step 3: Find what the bank is doing with denominator currency in step 2. If Bank is buying
denominator currency, then we should use Bid rate and if Bank is selling denominator currency,
then we should use Ask rate
• Step 4: Expand the formula with usage of common connecting currency
Example:
You have following quotes from Bank A and Bank B:
Bank A Bank B
SPOT CHF/USD 1.4650/55 CHF/USD 1.4653/60
SPOT USD/GBP 1.7645/60 USD/GBP 1.7640/50
How much minimum CHF amount you have to pay for 1 Million GBP spot?
a. CHF 25,88,073
b. CHF 25,87,490
c. CHF 25,86,608
d. CHF 25,88,956
Answer:
CHF
CHF = GBP x ASK ( )
GBP
CHF USD
CHF = GBP x ASK ( x )
USD GBP
CHF = 10,00,000 x (1.4655 x 1.7650)
CHF outflow = CHF 25,86,608
Note:
• Since there are two banks, the customer can choose either of the two banks. The customer should
choose a bank which leads to lower outflow and higher inflow
• For CHF/USD we are using Bank A as it has lower ASK rate and for USD/GBP we are using Bank
B as it has lower ASK rate
Example:
Quote 1: EUR 1.24-1.40 per GBP; Quote 2: INR 75.25-35 per GBP. How many GBP can be purchased with
INR 1,20,000?
a. 1,977.41
b. 1,974.78
c. 2,232.56
d. 2,229.60
Answer:
Known component = Rs.1,20,000; Unknown component = ? EUR
Euro
Euro = INR x ( )
INR
Euro
Euro = INR x BID ( )
INR
Euro GBP
Euro = INR x BID ( ) x BID ( )
GBP INR
1
Euro = 1,20,000 x1.24 x = 𝐄𝐔𝐑 𝟏, 𝟗𝟕𝟒. 𝟕𝟖
75.35

11. Exchange Margin (EM)

• Exchange margin is extra profit for the bank. It is used to increase the spread.
• EM is deducted from bid rate and added to ask rate.

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• Merchant Rate vs Inter-Bank Rate: Merchant rate (rate for customers) = Inter-bank rate (rate for
banks) +/- Exchange margin

Application of exchange margin in case of cross rates:

Exchange margin can be considered in following two ways
• Apply it directly on final exchange rate (OR)
• Apply it in one of the quotes used in cross-multiplication (Preferably one which has INR in quote)
• Exchange margin on buying rate and selling rate: When the question specifies that the exchange
margin is xx on the buying rate and xx on the selling rate, it may not be explicitly clear whether it
pertains to the banker's buying rate (bid rate) or the customer's buying rate (ask rate). In such
instances, an assumption may be necessary to proceed. The ICAI solution has addressed this
ambiguity by considering the buying rate as the banker's buying rate (BID Rate) and the selling
rate as the banker's selling rate (ASK rate).
• Exchange margin to be taken on direct quote/indirect quote: Sometimes, the direct quote might
not be readily available, and we resort to using (1/Ask rate) to derive the bid rate and (1/Bid rate)
to calculate the ask rate. In such a situation, the application of exchange margin can occur either
after conversion or before conversion. However, there has been inconsistency in the application
of this approach by ICAI, resulting in slight variations in the answers
• We should always add the exchange margin to the Ask rate and subtract the exchange margin
from the Bid rate. For example, if we are computing the Ask rate as (1/Bid rate) and intend to
apply the exchange margin before the quote conversion, then the exchange margin should be
deducted from the Bid rate for the denominator currency.
Example:
Spot INR/USD = 65 - 66; Spot INR/GBP = 80 - 81. Exchange margin is 0.5% for BID rate and 1% for Ask
Rate. What will be Bid and Ask rate for USD/GBP?
a. 1.2061 - 1.2587
b. 1.2109 - 1.2399
c. 1.2133 - 1.2399
d. 1.2109 - 1.2524
Answer:
USD USD INR 1
BID ( ) = BID ( ) x BID ( ) = ( ) x 80 = 1.2121
GBP INR GBP 66
Exchange margin needs to be deducted and 0.5% is 0.0061 and revised bid rate will be 1.2061
USD 1
ASK ( ) = ( ) x 81 = 1.2462
GBP 65
Exchange margin needs to be added and 1% is 0.0125. Revised ask rate will be 1.2587

12. Cover Rate

• Cover transaction refers to the opposite of original transaction. Example: If a forex dealer of a
bank has sold USD, then the cover transaction is buying USD
• Rate at which cover transaction is executed is called cover rate.
• Squaring up of position: Squaring up of position would mean taking an opposite transaction or
taking a cover position. If there is a loss/profit in non-INR currency, then the same can be
converted into INR losses if the INR exchange rates are there in question. If there is a loss we
need to buy foreign currency and if there is a profit we will sell foreign currency
• Whenever a bank deals with some other bank, all transactions will get executed at inter-bank
rate.
• In case of inter-bank dealing, bid/ask rate identification would depend on which bank is initiating
the transaction. Bank which initiates the transaction is like customer and the other bank is the
banker.
Example:
A bank sold HKD 10,00,000 at the rate of Rs.6.5/HKD. He closes the position on the same day when rates
are: INR/USD = 62 – 65; HKD/USD = 7.80 – 8; What will be the profit/loss in this transaction?
a. Loss of Rs.18,33,333
b. Loss of Rs.12,50,000
c. Loss of Rs.13,68,020
d. None of the above

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Answer:
KC = 10,00,000 HKD; UKC = ? INR
INR
INR = HKD x ( )
HKD
INR
INR = HKD x ASK ( )
HKD
INR USD
INR = HKD x ASK ( ) x ASK ( )
USD HKD
1
INR = 10,00,000 x 65 x ( )
7.80
INR = 83,33,333
Profit = Sales proceeds - purchase cost = 65,00,000 - 83,33,333 = Loss of 18,33,333
Example:
You have sold 10,00,000 USD at the rate of Rs.65/USD. You plan to cover the same and the rates are as
under: JPY/INR = 2.05 – 10; JPY/USD = 130.50 - 132.50; How much is the profit/loss?
a. Profit of Rs.13.41 lacs
b. Profit of Rs.28.57 lacs
c. Profit of Rs.19.05 lacs
d. Profit of Rs.3.66 lacs
Answer:
Known component = 10,00,000 USD; Unknown component = ? INR
INR
INR = USD x ( )
USD
We are going to buy USD and banker would sell it. Banker will sell the same at Ask rate
INR JPY
INR = USD x ASK ( ) x ASK ( );
JPY USD
1
INR = 10 lacs x ( ) x 132.50 = INR 646.34 lacs
2.05
Sell proceeds = 10 lacs x 65 = 650 lacs
Profit = 650 lacs - 646.34 lacs = 3.66 lacs

13. Likely rate of one currency against another currency

• Likely rate of Apple would mean Apple is the product
• For instance, likely rate of YEN against USD would mean YEN is the product and hence we
should find (USD/YEN) Quote

14. Interpretation of Quotes [Most critical]

• In the real-world context, currency exchange rates for the Indian Rupee against the US Dollar
(INR/USD) are commonly denoted as USD-INR, with the USD preceding the hyphen. However,
it's important to note that in exam questions, the representation may switch to INR/USD. In such
cases, it is generally acceptable to interpret them as INR per USD.
• Nevertheless, there might be instances where the given quotes seem illogical. In such situations,
it becomes imperative to analyze and interpret the quotes based on the prevailing exchange rates.
During exams, it is crucial to explicitly state if you have interpreted the quote according to the
current exchange rates, deviating from the format provided in the question.
• For instance: USD/INR 80 – 81 would be interpreted as INR 80-81 per USD
Example:
USD/INR rate = 70.85/73; We plan to buy 1,000 USD. Exchange margin is 0.5%.; How much will be the
INR outflow?
a. INR 73,365
b. INR 71,084
c. INR 14.07
d. INR 13.63
Answer:
The given rate has been interpreted as INR/USD based on current exchange rates
INR
INR outflow = USD x ( )
USD

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INR
INR Outflow = USD x Ask ( )
USD
Ask rate given in question is 73.00. We cannot take 73 as pips as the same will make the ask rate lower
than bid rate. That scenario is not possible and hence given 73 is taken as outright rate
• Relevant ask rate = 73 + 0.5% = INR 73.365/USD
• Total outflow = 1,000 x 73.365 = INR 73,365

15. Swap Points

• Meaning: The difference between spot and forward rate is called swap points
• Utility: Forward rate is the rate contracted today to exchange currencies at specified future date.
This rate can be expressed either as:
o Outright Forward Rate
o Swap Rate/Points
• If the swap points are in ascending order, we add them to spot rate and calculate forward rate
• If the swap points are in descending order, we deduct them from spot rate and get forward rate
• Swap premium in descending order: If the question uses the word swap premium, then the same
needs to be added to spot rate. This is despite the fact that given points are in descending order.
This is because the word used in question is swap premium.
Example:
Spot rate for INR/USD= 66.50/90. Swap points = 140/120. What will be forward ask rate for INR/USD?
a. 65.70
b. 210
c. 91.20
d. 68.10
Answer:
Spot Ask rate = 66.90. Swap points are in descending order and same needs to be deducted. Swap points
are 1.40/1.20. Forward ask rate = 66.90 - 1.20 = 65.70

16. Swap Points for Broken Period through Interpolation Technique

• Swap points for broken period: If swap points for 1 month and 3 months is given, then we can
identify swap points for 1.5 months, 2 months, 2.5 months or any other period between 1 month
and 3 months using interpolation technique
Example:
Swap points for 1 month is 100/150; Swap points for 3 months is 300/400; How much will be the swap
points for 2.5 months?
a. 200/275
b. 250/337.50
c. 150/212.50
d. 250/350
Answer:
Particulars Bid rate Ask rate
Swap points for 1 month 100 150
Swap points for 3 months 300 400
Differential points for 2 months 200 250
Proportionate points for 1.5 months 150 187.50
[200 x1.5/2] [250x1.5/2]
Swap points for 2.5 months 250 337.50
[1 month + Proportionate of 1.5 month]

17. Appreciation/Depreciation of Price Currency and Product Currency

• Currency which is appreciating is said to be at a premium and which is depreciating is said to be
at a discount
• Appreciating currency is one which becomes more expensive
• Appreciation or depreciation percentage is computed with the help of below formula:
Forward rate − Spot rate 12
For the product currency = x x 100
Spot rate m

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Spot rate − Forward rate 12
For the price currency = x x 100
Forward rate m
• Appreciation/depreciation percentage is to be separately computed for bid rate and ask rate. If
the answer of the formula is negative, it would mean currency is depreciating and if the answer
is positive, it would mean currency is appreciating
• Appreciation/depreciation percentage for average rate: In this case also we have to separately
compute bid and ask percentage. However, the denominator in this case will be average of spot
and forward rate.
Example:
Spot rate is Rs.50/USD. 3-month forward rate is Rs.52/USD. How much is the appreciation/depreciation
of INR?
a. Appreciation of 4%
b. Appreciation of 16%
c. Depreciation of 3.85%
d. Depreciation of 15.40%
Answer:
SR − FR 12
INR is the price in this question and hence the formula is x ( ) x 100
FR m
50 − 52 12
INR change = x ( ) x 100 = − 15.40%
52 3
We are getting negative answer and hence INR has depreciated by 15.40%
Example:
The spot rate for INR/AUD is 29.45 – 29.90 and the three-month forward rate is 29.36 – 29.80. How much
is the appreciation/depreciation of INR bid rate?
a. Appreciation of 1.23%
b. Depreciation of 1.22%
c. Appreciation of 0.31%
d. Depreciation of 0.31%
Answer:
INR is the product currency in the quote
Premium or discount % Spot rate − Forward rate 12
x x 100
Forward rate m
Using BID Rate 29.45 − 29.36 12 1.23% (appreciation)
x x 100
29.36 3
Example:
An Indian company has imported goods from Japan for 36 lacs YEN. The amount is equivalent to INR 10
lacs today. It is anticipated that exchange rate will change by 10 percent over the medium term. Indian
company promises to take appropriate action in foreign exchange market in order to protect YEN
payments. What is the expected exchange rate after 3 months?
a. YEN 3.60/INR
b. YEN 3.24/INR
c. YEN 3.96/INR
Answer:
YEN 108 lacs
Current spot rate = = YEN 3.60/INR
INR 30 lacs
Exchange rate will change by 10 percent and an Indian importer would be worried about depreciation of
INR. Hence exchange rate change of 10 percent will be interpreted as depreciation of INR. New exchange
rate = YEN 3.60/INR - 10% = YEN 3.24/INR

18. Appreciation/Depreciation percentage direct application for Product Currency

• Any appreciation or depreciation percentage provided in the question should be directly applied
to the product currency. If the percentages are given for the price currency, it is necessary to
convert the quote and then apply the appreciation or depreciation percentage accordingly.
• Interpretation of Discount/Premium %: USD premium on a six month forward is 3% will be
interpreted as premium of 3% for the six-month period directly. This is not like interest rate and
we should not make the same as proportionate premium. We can make it proportionate if the
question specifically mentions USD premium on a six month forward is 3% per annum.
Example:

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The spot exchange rate is USD 2 per GBP. USD has appreciated by 10 percent. What will be the 6-month
forward rate?
a. USD 2.2 per GBP
b. USD 1.8 per GBP
c. USD 1.82 per GBP
Answer:
Any appreciation or depreciation can be added or subtracted to the product. Current quote is USD 2 per
GBP. The quote will be converted as GBP 0.5 per USD. Appreciation of 10 percent will make it GBP 0.55
per USD. This quote will be converted back and it will become USD 1.82 per GBP
Example:
Spot exchange rate EUR 0.8006 per USD. Forward discount on EURO is 4 percent per year. What is the
expected 6-month forward rate of EUR/USD?
a. EUR 0.8166 per USD
b. EUR 0.8326 per USD
c. EUR 0.8169 per USD
d. EUR 0.8339 per USD
Answer:
Spot exchange rate = 0.8006 EURO per USD; Forward discount on EURO is 4% per year and the same
would be 2% for 6 months. Forward discount/premium can be applied only to the product only to get the
forward rate. In the above quote USD is the product and hence we should convert this into the other quote;
0.8006 EURO per USD = 1.2491 USD/EURO
Forward rate = 1.2491 – 2% = 1.2241 USD/EURO (or) 0.8169 EURO/USD

19. Appreciation of One currency > Depreciation of other currency

• The appreciation percentage of one currency will always be higher than the depreciation
percentage of the other currency. This disparity arises due to the usage of different denominators
for the price currency and the product currency
Example:
USD has appreciated by 10% against INR. How much is the likely depreciation of INR?
a. Equal to 10%
b. Greater than 10%
c. Less than 10%
Answer:
Less than 10%
Example:
• Spot rate = USD 0.20 per INR
• Forward rate = USD 0.22 per INR [0.20 + 10%]
0.20 − 0.22
Depreciation of INR = 𝑥 100 = −9.09%
0.22

20. Real Appreciation/Depreciation

• Real and Nominal Rate: (1 + Nominal Return) = (1 + Inflation rate) x (1 + Real rate).
• A question can ask for computing real appreciation/depreciation of currency. In order to compute
the same, we should compute the forward rate adjusted for inflation. (We are computing the forward
rate by adjusting the difference in inflation of two countries. If inflation of home currency is higher than rate
would be adjusted downwards and vice versa)
𝟏 + 𝐔𝐒𝐃 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧
𝐀𝐝𝐣𝐮𝐬𝐭𝐞𝐝 𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐫𝐚𝐭𝐞 (𝐈𝐍𝐑 𝐩𝐞𝐫 𝐔𝐒𝐃) = 𝐀𝐜𝐭𝐮𝐚𝐥 𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐫𝐚𝐭𝐞 𝐱
𝟏 + 𝐈𝐍𝐑 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧
• Post computation of adjusted forward rate, we can go ahead and compute the
appreciation/depreciation using the normal formula. We should compare spot rate and adjusted
forward rate in the formula
Example:
• Spot Rate = INR 42.50/60 per USD
• One-year forward rate = INR 43.85/90 per USD
• Inflation in US = 5%
• Inflation in India = 9%

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Computation of Adjusted Forward Rate:
1 + USD Inflation 1.05
Adjusted forward rate (INR per USD) = Actual forward rate x = 43.85 𝑥 ( ) = 42.24
1 + INR Inflation 1.09
1.05
Adjusted forward rate (INR per USD) = 43.90 𝑥 ( ) = 42.29
1.09

Computation of real appreciation/depreciation of INR (Price Currency)

• Spot Rate = INR 42.50 – 42.60 per USD
• Adjusted Forward Rate = INR 42.24 – 42.29 per USD

Using Bid rate:

SR − FR 12
Appreciation (or) depreciation % = x ( ) x 100
FR m
42.50 − 42.24 12
%= 𝑥 𝑥 100 = 0.61%
42.50 12

Using Ask rate:

42.60 − 42.29 12
%= 𝑥 𝑥 100 = 0.73%
42.60 12
Hence real appreciation is 0.61% and 0.73% for bid rate and Ask Rate

21. IRPT
IRPT:
Formula 𝟏 + 𝐑 𝐡 𝐅𝟏
=
𝟏 + 𝐑 𝐟 𝐞𝟎
R h = Risk free rate of home country
R f = Risk free rate of foreign country
F1 = Forward rate
e0 = Spot rate
Note:
• Home and Foreign Currency: Home currency is always the first currency in the quote and foreign
currency is always the second currency in the quote. Hence in this area INR can become foreign
currency if the given quote is like USD 0.0122/INR [This is very critical whenever we are solving
an IRPT problem]
• Proportionate interest rate: Interest rate should be for the time period of forward rate. If we are
calculating 6-month forward rate, then we should compute interest rate for 6-month period
Example:
Spot rate is Rs.50/USD. 6-month interest rate in India = 12%; 6-month interest rate in USA = 4%. What will
be the forward rate after 6 months?
a. Rs.46.43/USD
b. Rs.48.11/USD
c. Rs.53.85/USD
d. Rs.51.96/USD
Answer:
Spot rate = Rs.50/USD; Risk free rate in home country = 12% per annum (or) 6% per half year; Risk free
rate in foreign country = 4% per annum (or) 2% per half year
1 + R h F1 1 + 0.06 𝐹1
= ; =
1 + R f e0 1 + 0.02 50
1.06
Forward rate = 50 x = Rs. 51.96
1.02
Example:
Spot rate is 1.40 USD/GBP. Interest rate in USA = 5% per annum. Interest rate in London = 10% per annum.
What will be the forward rate of year 2?
a. 1.5273 USD/GBP
b. 1.2833 USD/GBP
c. 1.2756 USD/GBP
d. 1.5365 USD/GBP
Answer:

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Spot rate = 1.40 USD per GBP; Rh (USA rate) = 5% per annum; Rf (UK rate) = 10% per annum
1 + R h F1 (1 + 0.05)2 𝐹1
= ; 2
=
1 + R f e0 (1 + 0.10) 1.40
1.40 x 1.05 x 1.05
Forward rate = = 1.2756 USD/GBP
(1.10 𝑥 1.10)

22. IRPT – Link with interest rates

• Interest rate impact: A currency will depreciate if the interest rates in the country is higher and a
currency will appreciate if the interest rates in country is lower
• Implied difference in interest rates: Implied differential in interest rates would basically mean
the appreciation/depreciation percentage of the currencies. We can compute the percentage for
the product and mention the same as implied differential in interest rates
Example:
USD is likely to depreciate by 2.50% against DM (German Currency). Which of the following information
is true about interest rates?
a. Interest rates in USA and Germany is same
b. Interest rates in Germany is 2.50% more than that of USA
c. Interest rates in Germany is 2.50% lower than that of USA
d. We cannot conclude about interest rates based on the given information
Answer:
USD currency has depreciated and this would mean interest rates in USA is more than that of Germany.
Hence, we can conclude that interest rates in Germany is 2.50% lower than that of USA

23. PPT/Law of One price

PPT/Law of one price:
Formula 𝟏 + 𝐈𝐡 𝐅𝟏
=
𝟏 + 𝐈𝐟 𝐞𝟎
Ih = Inflation rate of home country
If = Inflation rate of foreign country
F1 = Forward rate
e0 = Spot rate
Note:
• Law of one Price: Exchange rate can be computed by comparing the price of a product in one
country with another country.
Example:
Spot rate = Rs.60 per GBP. Inflation in India = 10% per annum; Inflation in UK = 3% per half year. What
will be the forward rate for 3 months?
a. Rs.60 per GBP
b. Rs.64.08 per GBP
c. Rs.60.59 per GBP
d. Rs.61.17 per GBP
Answer:
Spot rate = Rs.60 per GBP; Inflation for 3 months in India = 2.5%; Inflation in UK for 3 months = 1.5%
1.025
Forward rate = 60 x = Rs. 60.59 per GBP
1.015

24. Space Arbitrage [Buy in one Market and Sell in another Market]
• Space arbitrage means buying and selling at the same time in two different markets (bank A
and bank B) (or) (futures market and forward market)
• We should buy at lowest ask rate and sell at highest bid rate and see if we are able to make gain.
This would be called as arbitrage gain
Example:
A pen is available at following markets:
• Market A = Rs.9-10 (Shop keeper’s Purchase price of Rs.9 and selling price of 10)
• Market B = Rs.10 -11
• Market C = Rs.11-12
Strategy:
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To make profits we can buy the product at Rs.10 from market A (lowest Ask rate) and sell it in Market C
at Rs.11 (lowest Bid rate) and make arbitrage gain of Rs.1
Example:
INR/USD in bank A = 65.40 - 67.40; INR/USD in bank B = 68.40 - 70.00; How much will be the arbitrage
gain if the investor can buy/sell 1,00,000 USD?
a. 4,60,000
b. 1,00,000
c. 3,00,000
d. 2,60,000
Answer:
Investor can buy 1,00,000 at lower ask rate of 67.40 from Bank A. Investor can sell 1,00,000 USD to Bank B
at higher bid rate of 68.40. Investor will make gain of Rs.1,00,000 (68,40,000 - 67,40,000)

25. Space Arbitrage [Direct Quote and Indirect Quote]

• Different Exchange rates: If one bank gives exchange rate as (A/B) and another gives exchange
rate as (B/A), we should convert the quotes into common mode (either A/B or B/A) and then
check for arbitrage opportunities
Example:
Citi Bank quotes JPY/ USD 105.00 -106.50 and Honk Kong Bank quotes USD/JPY 0.0090 - 0.0093. How
much is the arbitrage gain if you have USD 1,000.
a. Arbitrage is not possible
b. USD 11.67
c. USD 9.67
d. USD 8.00
Answer:
Quote in Citi bank = JPY 105.00 – 106.50 per USD
Quote in Hong Kong Bank:
JPY 1 JPY 107.53/USD
BID ( ) =
USD 0.0093
USD 1 JPY 111.11/USD
BID ( ) =
JPY 0.0090
Arbitrage opportunity can arise if we sell USD at higher bid rate of JPY 107.53/USD and buy USD at lower
ask rate of JPY 106.50 per USD
Particulars Calculation Amount
Sell 1,000 USD in Hong Kong Market 1,000 x 107.53 JPY 1,07,530

Sell JPY 1,07,530 in Citi Bank 1,07,530 USD 1,009.67

106.50
Arbitrage gain 1,009.67 – 1,000 USD 9.67

26. Covered Interest Rate Arbitrage

• Step 1: Compute fair forward using IRPT formula.
• Step 2: Identify whether arbitrage exists and record the flow of money as per the following details:
Fair FR > Actual FR Borrow in foreign currency and invest in home currency
Fair FR = Actual FR No arbitrage
Fair FR < Actual FR Borrow in home currency and invest in foreign currency
❖ Show how arbitrage gain works
o Borrow in the currency of the country from which money flow in
o Convert @ spot rate into the other currency
o Invest the converted amount
o Take forward cover
o Realize the investment along with the interest thereon
o Reconvert @ the forward rate
o Repay the principal along with the interest thereon
o Compute arbitrage gain
Note:

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• Arbitrage strategy with BID and ASK Rate: We cannot find arbitrage opportunity by calculating
fair forward rate. In this case, we have to follow trial and error method. We should check if
arbitrage is possible if we borrow in currency one and then check the same if we borrow in other
currency
Example:
Spot rate = INR 40/USD; 6-month borrowing rate in India = 10%; 6-month borrowing rate in USA = 4%;
Forward rate = INR 41.50/USD; What will be the arbitrage strategy?
a. Borrow in India and invest in USA
b. Borrow in USA and invest in India
c. Arbitrage is not possible
Answer:
Spot rate = Rs.40/USD; Actual Rh (India) = 10% per annum or 5% per half year; Actual Rf (USA) = 4% per
annum or 2% per half year
Fair Forward Rate calculation
1 + 5% F1
= ; F = Rs. 41.17 per USD
1 + 2% 40 1
• Actual Forward Rate is costlier than Fair Forward Rate. Hence USD is costlier than what fair rate
suggests and hence we should invest in USA by borrowing in India

27. Triangular Arbitrage

• It is an arbitrage strategy to gain by converting currencies and getting back the original currency
again. If we get back more than what we started with, then arbitrage exists
• Example: We have USD in hand. We can convert the same into different currencies in different
markets and reconvert the same to USD
• We have the following quotes in question (INR per USD, INR per GBP and USD per GBP). In this
case we can follow following two routes (trial and error) to check for arbitrage gain
o USD to INR to GBP to USD
o USD to GBP to INR to USD
• Exchange Margin: When the exchange transaction takes place in different markets or banks,
Exchange margin is to be applied on each of the individual quotes (exception to the normal rule on
exchange margin where we have mentioned that EM is to be applied on either the final cross rate or one of
the quotes)
Example:
INR/USD = 48.30; INR/GBP = 77.52; USD/GBP = 1.6231; How much arbitrage gain be made if investor
has 1,00,000 USD?
a. No arbitrage gain
b. Gain of 1,129.70
c. Gain of 1,054.70
d. Gain of 2,154.34
e. None of the above
Answer:
1,00,000 USD can be converted into INR and the same will be Rs.48,30,000. Rs.48,30,000 will be converted
into GBP and the same will be GBP 62,306.50. GBP 62,306.50 will be converted into USD and the same will
be USD 1,01,129.70. Arbitrage gain = 1,01,129.70 - 1,00,000 = 1,129.70 USD

28. Forex Risk Management Techniques

• Currency Invoicing
• Netting
• Leading and Lagging
• Forward Contract
• Money Market Hedge
• Currency Futures and Options
• Currency Swaps

29. Currency Invoicing – Elimination of Exchange Risk

• The importer or the exporter shall eliminate the exchange rate risk by invoicing in home currency

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• Currency invoicing actually does not eliminate the risk but transfers the risk to the counterparty
• However, this is not always possible if counterparty is unwilling to accept the invoicing strategy.
And in such a case if we don’t take forex risk, there is a possibility of loss of business
Example:
An Indian firm is exporting goods to USA. What should be the billing currency if the firm opts for currency
invoicing technique to hedge transaction?
a. INR
b. USD
c. GBP
d. EURO
Answer:
Indian firm should opt for home currency invoicing to hedge transaction. Hence export should be billed
in INR

30. Currency Invoicing – Non-elimination but deciding on the currency

• If the company wants to take exchange rate risk, then we should bill in appreciating currency if
you are exporter and should accept billing in depreciating currency if you are importer
• The basic logic is select a currency which leads to highest inflow of INR in case of exports and
select a currency which leads to lowest outflow of INR in case of imports
Swap points and billing currency:
• If the question has only swap points and then based on that we can decide on billing currency.
• If the swap points are in ascending order and hence currency will appreciate and if the swap points
in descending order and hence currency will depreciate
Example:
INR is going to depreciate 5 percent against USD. INR is going to depreciate 3 percent against GBP.
Counterparty is willing to have the billing either in USD or GBP. What should be the billing currency in
case of Indian importer?
a. GBP
b. USD
c. INR
Answer:
Import of goods will lead to foreign currency liability. We should go for billing in depreciating currency.
Hence INR is preferable. However, counterparty will prefer either in USD or GBP. We should therefore
accept a currency which will have lower appreciation and hence we should prefer GBP
Example:
Gupta Garments exports goods to US. It can elect to bill either in Dollars or in Euro. Payment terms are 90
days. The 90 dollar swap is 1 – 0.5 and for Euro is 1.5 – 2. Which option is advisable?
a. Billing in USD
b. Billing in Euros
c. Indifferent between billing in USD and Euros
Answer:
Gupta Garments should choose a currency which is expected to appreciate (assets should appreciate). The
90-day dollar swap is in descending order and hence dollar is expected to depreciate. Similarly, 90-day
euro swap is in ascending order and hence Euro is expected to appreciate. The company should opt for
billing in Euros (appreciating currency)

31. Currency Invoicing – Conversion of Quote from one currency to another currency
• Question can ask for converting the foreign currency exposure into home currency exposure and
bill the same in home currency. Under this scenario the exposure needs to be converted and the
same can happen at bid rate, ask rate or middle rate. This would depend on negotiation between
the parties.

32. Leading and Lagging

• Lead transaction will happen on day 0 and Lag transaction will happen on due date (For example,
day 90)

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• Outflow/inflow under both options cannot be compared due to time value of money and hence
we should add interest to Lead amount.
• Interest rate will be taken as borrowing rate if we have cash deficit and will be taken as
investment rate if we have cash surplus
• Early receipt: Early receipt of receivables is not in exporter’s hands and hence there can be some
discounting charges for early receipt of receivables
• Commission charges for Letter of Credit: This is an extra expense if the company has to give letter
of credit. Commission has to be paid on day zero and there will be interest expense on commission
to take the same to maturity date
Interest income vs opportunity cost:
• A firm is considering whether to lag receivables beyond normal credit period. Let us assume
normal credit period is 2 months but we are planning to extend the same to 3 months.
• When we are comparing both options either we can consider interest income in option 1 (interest
income from month 2 receipt for 1 month) or consider opportunity cost in option 2 (loss of same
interest income).
• But we should never consider both as the same will lead to double counting of same adjustment
Example:
A company has payable of YEN 10,00,000 after three months. YEN is likely to appreciate by 5% against
INR over next three months. The company is thinking whether to pay this money today or after three
months. It is having cash deficit and borrowing rate in bank is 10 percent per annum. Should the company
make the payment now or wait for three months?
a. Make payment today
b. Make payment after three months
c. Indifferent between two choices
Answer:
Yen (liability) will appreciate by 5 percent over three months. The same would correspond to 20 percent
for a year. Interest rate for borrowing is 10 percent per annum. Hence it is beneficial to borrow money at
10 percent and pay liability today. Else liability will appreciate by 20 percent leading to higher INR
outflow.
Example:
In case of cash surplus appreciation percentage is to be compared with ___________ and in case of cash
deficit appreciation percentage is to be compared with __________ for deciding lead/lag?
a. Investment rate and Investment rate
b. Borrowing rate and Investment rate
c. Investment rate and borrowing rate
d. Borrowing rate and borrowing rate
Answer:
Investment rate and borrowing rate
Example:
Spot rate: Rs.46.00/46.25 per USD; Assume the firm has USD 69,000 in current account earning no interest.
ROI on rupee investment is 12% p.a. What should be the forward rate (INR/USD) for the firm to be
indifferent between converting 69,000 USD into INR today or wait and convert after two months?
a. Rs.47.175 per USD
b. Rs.46 per USD
c. Rs.46.92 per USD
d. Rs.47 per USD
Answer:
Particulars Redeem today Redeem after 2 months
INR receipt today on conversion 31,74,000 -
(69,000 x 46)
Interest income for 2 months 63,480 -
(31,74,000 x 12% x 2/12)
INR receipt on conversion in M2 - 32,37,480
(69,000 x 46.92)
Total inflow in INR 32,37,480 32,37,480
Hence the indifferent forward rate is Rs.46.92 per USD as the same would lead to same inflow in INR
whether we convert today or wait and convert after two months.

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33. Netting
• Netting refers to the process by which dues receivable and dues payable between two parties are
set off against each other
• This helps in reducing forex risk as receivables and payables are netted off against each other
• Net exposure = Inflow - Outflow
• Net exposure can be multiplied with spot, forward rate and spread for computing the final
exposure in INR
Utility of Netting in Cash Management:
• Centralized Cash Management: Convert cash surplus/deficit of each subsidiary into common
currency and use the concept of netting – Make single investment on day 0
• Independent Cash Management: Make decentralized cash investment and find the maturity
value in different currencies – convert into single currency and use the concept of netting to find
the maturity value
• Benefit of centralized cash management = Cash balance as per option 1 – Cash balance as per
option 2

34. Forward Contract

• Meaning: Forward Contract is a contract entered to buy or sell at specific rate on future rate
Decision on taking forward Contract:
• The decision whether to enter into a forward contract or not depends on company’s expectations
Receivable Take a forward contract if INR inflow in forward contract is higher than expected inflow
if hedging was not done
Payable Take a forward contract if INR outflow in forward contract is lower than expected outflow
if hedging was not done
Example:
Forward rate = USD 1.43/GBP; Expected spot rate = USD 1.41/GBP. Should we take a forward cover for
dollar receivables?
a. We should take forward contract
b. We should leave it open
c. Indifferent
Answer:
Let us assume that we have receivable of 100 USD
100
GBP realization if we cover through Forward Contract = = GBP 69.93
1.43
100
GBP Realization if we keep it open = = GBP 70.92
1.41
We have higher realization if the exposure is open and hence we should keep the exposure open
Example:
A company has imported goods worth 1,00,000 USD. Spot rate is INR 74/USD and forward rate is INR
73.50/USD. Current interest rates in India are higher than USA. What is your advise to the company on
taking forward contract?
a. We should take forward contract
b. We should keep the exposure open
c. We are indifferent on taking forward cover
Answer:
Interest rates in India are higher than USA and hence INR will depreciate and USD will appreciate. So as
per IRPT we expected USD liability to appreciate. However, the current exchange rates are indicating USD
depreciation and hence we should go ahead and take forward cover. Outflow under forward contract =
Rs.73,50,000. Expected outflow if exposure is kept open = >74,00,000 (as USD will appreciate)

35. Cover Rate and Profit/loss computation of forward contract

• Cover rate refers to the rate at which a forward contract was entered
• Cover rate for payable = Hedging rate + Upfront premium + Interest on premium
• Cover rate for receivable = Hedging rate - Upfront premium - interest on premium

Profit/Loss:
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• Profit/loss in payable = [FC exposure x Spot rate on maturity date] - [FC exposure x cover rate]
• Profit/loss in receivable = [FC exposure x cover rate] - [FC exposure x spot rate on maturity date]
• Profit/loss is computed by comparing the actual cash flow with the notional cash flow (What
could have been)
Example:
Spot rate = Rs.40/USD; Forward rate = Rs.45/USD Upfront premium to be paid for hedging = 2%. Tenor
of contract = 6 months. Rate of interest = 12% per annum. How much is the effective cover rate for an
importer?
a. Rs.40.80
b. Rs.45.90
c. Rs.40.848
d. Rs.45.954
e. Rs.45.948
Answer:
Cover rate = Forward rate + Premium + Interest on premium
6
Cover rate = 45 + 0.90 + [0.90 x 12% x ] = 45.90 + 0.054 = Rs. 45.954/USD
12
Example:
Cover rate of USD receivable = Rs.45/USD; Actual spot rate on maturity date = Rs.46/USD; Transaction
amount = USD 1,00,000.; How much is the profit/loss by taking forward contract?
a. Loss of 1,00,000
b. Profit of 1,00,000
c. No profit/loss
Answer:
• Realization if FC was not taken = 1,00,000 x 46 = Rs.46,00,000
• Realization by taking FC = 1,00,000 x 45 = Rs.45,00,000
• Loss of Rs.1,00,000 due to forward contract as the net realization is on lower side
Example:
Cover rate of USD payable = Rs.45/USD; Actual spot rate on maturity date = Rs.46/USD; Transaction
amount = USD 1,00,000.; How much is the profit/loss by taking forward contract?
a. Profit of Rs.1,00,000
b. Loss of Rs.1,00,000
c. No profit/loss
Answer:
• INR outflow under FC = 45,00,000
• INR outflow if cover was not taken = 46,00,000
• Net saving/profit by taking FC = 1,00,000
Example:
Current spot rate is INR 50/USD. 6-month Forward rate is INR 55/USD. The company took a forward
contract for 1,00,000 USD payable. Compute the amount of profit/loss if INR depreciated by 4 percent?
(Please work with four decimals)
a. Profit of Rs.3,00,000
b. Loss of Rs.3,00,000
c. Profit of Rs.2,91,667
d. Loss of Rs.2,91,667
Answer:
• Outflow under forward contract = 1,00,000 x 55 = Rs.55,00,000
• Outflow if forward contract was not taken:
o Spot rate = INR 50/USD (or) USD 0.02 per INR
o INR depreciation = 4%; Actual spot rate = 0.02 - 4% = USD 0.0192/INR (or) INR
52.0833/USD
• Outflow if forward contract was not taken = 1,00,000 x 52.0833 = Rs.52,08,333
• We have paid more by taking forward contract and hence there is a loss. Amount of loss =
55,00,000 - 52,08,333 = Rs.2,91,667

36. Expected loss with and without Hedging

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Expected Loss:
• Expected loss if hedging is not done = Compare cash flow at spot rate with cash flow at expected
spot rate
• Expected loss if hedging is done = Compare cash flow at spot rate with cash flow at forward rate
Example:
You have sold goods worth 1,00,000 USD and the same was priced at an exchange rate of Rs.70 per USD.
Current spot rate is Rs.68 per USD and the bankers have indicated a forward rate of Rs.67 per USD. How
much is the profit/loss in operating profit if forward sale is agreed to?
a. INR 1,00,000 (Loss)
b. INR 3,00,000 (Loss)
c. INR 1,00,000 (Profit)
d. INR 3,00,000 (Profit)
Answer:
Loss/gain in operating profit is computed by comparing the billed rate with realization rate. Billed rate is
Rs.70 per USD and the realization rate will be Rs.67 per USD if the forward sale is agreed to. Hence overall
impact in operating profit = 1,00,000 x (70 – 67) = Rs.3,00,000 (loss)

37. Relevant Forward Contract Rate

• A company gets 60 days bill from customer. Transit period is 20 days. This would mean realization
will happen after 80 days. Question gives data on 2 and 3-month period. Relevant period is 2.67
months and the same would be rounded-off to lower period and 2-month forward rate would be
taken for realization.
• Interest calculation on the borrowing in the above example would be for 80 days as the amount
would be repaid after 80 days (The company would have taken a loan against the receivables
amount)
Example:
M/s. Sky products Ltd., of Mumbai, an exporter of sea foods has submitted a 60 days bill for EUR 5,00,000
drawn under an irrevocable Letter of Credit for negotiation. The company has desired to keep 50% of the
bill amount under the Exchange Earners Foreign Currency Account (EEFC). Transit period is 20 days.
Interest on post shipment credit is 8% per annum. The inflow will be realized at an effective rate of INR
80/USD. How much would be the interest paid by the company? Assume 360 days in a year for computing
interest
a. Rs.3,55,556
b. Rs.2,66,667
c. Rs.7,11,111
d. Rs.5,33,333
Answer:
The company would have taken post-shipment credit at 8% for a period of 80 days as the realization will
happen after 80 days (60 days credit + 20 days transit). Company plans to keep 50% funds in EEFC account
and hence balance 50% it will convert in INR and repay the loan. Hence loan taken by the company will
be equal to the planned realization in INR.
Loan taken = 2,50,000 x 80 = Rs.2,00,00,000
𝟖𝟎
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐭𝐨 𝐛𝐞 𝐩𝐚𝐢𝐝 = 𝟐, 𝟎𝟎, 𝟎𝟎, 𝟎𝟎𝟎 𝐱 𝟖% 𝐱 = 𝐑𝐬. 𝟑, 𝟓𝟓, 𝟓𝟓𝟔
𝟑𝟔𝟎
Example:
The company has submitted a 60 days bill of USD 5,00,000 to bank. Transit period of shipment is of 20
days. Forward rates available with the bank are of 1,2 and 3 months. What is the relevant exchange rate
for clearance of bill?
a. 1 month forward rate
b. 2 month forward rate
c. 3 month forward rate
Answer:
The money will be realized in 80 days (60 days bill + 20 days transit period). It will have to be rounded off
to the lower of months (2.67 months) and hence 2 months forward rate is to be taken

38. Closure of Forward Contract

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Closure of forward contract:

Closure of FC

Honour Cancellation Extension

On due date On due date On due date

Before due Before due Before due

date date date

After due After due After due

date date date
• A forward contract can either be honoured, cancelled or extended. This can be done on due date,
before date and after due date. Therefore, there are 9 possible scenarios to close a forward contract.
8 out of these 9 scenarios will involve cancellation of a forward contract and honour on due date
is the only way of honouring the commitment
1. Honour on due date No extra computation
2. Honour before due date • Cancel the contract
• Pay swap loss
• Pay/receive interest
3. Honour after due date • Pay cancellation loss of customer
• Pay effective loss of bank
• Pay/receive interest
4. Cancel on due date • Pay cancellation loss
5. Cancel before due date • Pay cancellation loss
6. Cancel after due date • Pay cancellation loss of customer
• Pay effective loss of bank
• Pay/receive interest
7. Roll-over on due date • Pay cancellation loss
• Enter into new contract (effective loss can also be
computed)
8. Roll-over before due • Pay cancellation loss
date • Enter into new contract (effective loss can also be
computed)
9. Roll-over after due date • Pay cancellation loss of customer
• Pay effective loss of bank
• Pay/receive interest
• Enter into new contract (effective loss can also be
computed)
Format for computation of Cancellation gain/loss:
Date Position Action Reference Date Rate
Original date Original Position Buy (ASK) December 31 -68.00
December 31 Opposite Position Sell (BID) December 31 66.50
December 31 New Position Buy (ASK) March 31 -66.00
Effective rate (Addition of three rates) -67.50
Loss on cancellation per USD (compare 1 with 2) -68.00 + 66.50 -1.50

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Total loss on cancellation -1.50 x 1,00,000 -1,50,000
Effective gain per USD (Compare 1 with 4) -67.50 – (-68.00) 0.50
Total effective gain/loss 0.50 x 1,00,000 50,000
Note:
• Original Position would mean – What action the company want to take on reference date. An
importer will enter into a buy contract and exporter will enter into a sell contract
• Rate will be written as negative if the action is Buy and same will be taken as positive if the action
is Sell
• We should ensure reference date remain same as that of original position date for cancellation of
forward contract
• We should be careful while reading the question. For instance, A customer with whom the bank
had entered into a forward purchase contract. This would mean the original position of the
customer is sell as the bank has entered into purchase contract and customer has entered into a
sell contract
• There are two types of losses in forward contract:
o Cancellation gain/loss = Comparison of original rate with cancellation rate
o Effective gain/loss = Comparison of original rate with effective rate
• Cost to company in respect of extension: We should preferably answer both above losses as ICAI
solution at few places have mentioned cancellation loss and at other places it is effective loss. We
can answer like this “Cost to the importer in respect of extension of forward contract = Rs.17,000
(Loss on cancellation). However, the effective loss for the importer is Rs.9,800”
• Flat cancellation charges: Question can state some flat cancellation charges. This would be taken
as outflow for customer irrespective of whether he is exporter or importer
Example:
A has imported goods worth 1 lac euros payable on 31st December and entered into forward contract
when exchange rate was INR 66-68/EURO. Today is November 30 and the importer wants to honor
contract today. Spot rate is INR 65.50-66.50/EURO and one month forward contract is INR 67.50-
68/EURO. How much would be the total outflow by the importer?
a. Rs.69,00,000
b. Rs.68,00,000
c. Rs.66,50,000
d. Rs.67,00,000
Answer:
Date Position Action Reference Date Rate
Original date Original Position Buy (ASK) December 31 -68.00
November 30 Opposite Position Sell (BID) December 31 67.50
November 30 New Position Buy (ASK) November 30 -66.50
Effective rate -67.00
Loss on cancellation per USD -68.00 + 67.50 -0.50
Total loss on cancellation -0.50 x 1,00,000 -50,000
Effective gain per USD -67.00 – (-68.00) 1.00
Total effective gain 1.00 x 1,00,000 1,00,000
• Contract will get honored at spot ASK rate of November 30. Outflow towards honor of contract =
1,00,000 x 66.50 = Rs.66,50,000
• Cancellation gain/loss: Original contract was taken at ASK rate of Rs.68 and opposite cancellation
rate is 67.50. Net loss on cancellation = 0.50/USD (or) Rs.50,000
• Total outflow = 66,50,000 + 50,000 = Rs.67,00,000
Example:
A customer with whom the Bank had entered into 3 months’ forward purchase contract for Swiss France
10,000 at the rate of Rs. 27.25 comes to the bank after 2 months and request cancellation of the contract.
One-month forward rate on date of cancellation is INR 27.45-27.52 per swiss franc. How much is the
cancellation gain/loss?
a. Loss of Rs.2700
b. Profit of Rs.2700
c. Loss of Rs.2000

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d. Profit of Rs.2000
Answer:
Date Position Action Reference Date Rate
Original date Original Position Sell (BID) Month 3 27.25
Month 2 Opposite Position Buy (ASK) Month 3 -27.52
Loss on cancellation per USD 27.25 – 27.52 -0.27
Total loss on cancellation -0.27 x 10,000 2,700
Original contracted rate = INR 27.25/Swiss franc. The bank has entered into forward purchase and hence
the customer has entered into sale contract. Hence contract will get cancelled at opposite Ask rate of
Rs.27.52/Swiss franc. Loss on cancellation = INR 0.27/Swiss franc (or) Rs.2,700

39. Honour before due date

Example:
On 1 October 2015 Mr. X an exporter enters into a forward contract with a BNP Bank to sell US$ 1,00,000
on 31 December 2015 at Rs.65.40/$. However, due to the request of the importer, Mr. X received amount
on 28 November 2015. Mr. X requested the bank the take delivery of the remittance on 30 November 2015
i.e., before due date. The inter-banking rates on 28 November 2015 was as follows:
❖ Spot rate = Rs.65.22/65.27
❖ One month premium = 10/15
If bank agrees to take early delivery then what will be net inflow to Mr. X assuming that the prevailing
prime lending rate is 18%
Answer:
Computation of swap/cancellation gain/loss:
Date Position Action Reference Date Rate
Oct 1 Original Position Sell (BID) December 31 65.40
Nov 30 Opposite Position Buy (ASK) December 31 -65.42
Nov 30 New position Sell (BID) Nov 30 65.22
Effective rate 65.40 – 65.42 + 65.22 65.20
Swap loss per USD 65.40 – 65.20 0.20
Total Swap loss 0.20 x 1,00,000 20,000

Computation of Interest cost/income:

Particulars Amount
Nov 28 – Bank will buy from customer at original contracted rate -65.40
Nov 28 – Bank will sell at spot rate to some other Bank 65.22
Outflow for banker 0.18
Total outflow for banker (1,00,000 x 0.18) 18,000
Interest cost to be recovered (18,000 x 18% x 31/365) 275
Note:
• Final outflow/inflow = Inflow/outflow as per original contracted rate + swap loss + Interest cost
• Interest cost computation will not be done if the question does not give interest rate in the
question and answer will be completed as per table 1 itself

WN 4: Net realization for customer:

Particulars Amount
Sale of 1,00,000 USD at original rate (1,00,000 x 65.40) 65,40,000
Less: Charges (20,000 + 275) (20,275)
Net realization from customer 65,19,725
Lead vs Lag Analysis in relation with honour before due date:
• We can compare the option of honouring on due date vs honouring before due date by comparing
the overall INR cash flow
• In case of honour before due date we need to add interest saving which will arise due to early
honour and then compare the two options. We will select option having higher INR inflow
Example:
On 1st October, 2020 Mr. Guru, an exporter, enters into a forward contract with the Bank to sell USD
1,00,000 on 31st December 2020 at INR/USD 75.40. However, at the request of the importer, Mr. Guru

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received the amount on 30th November, 2020. Mr. Guru requested the bank take delivery of the remittance
on 30th November, 2020 i.e. before due date. The inter-bank rate on 30th November 2020 was as follows:
• Spot INR/USD 75.22-75.27
• One Month Premium 10/15
Assume 365 days in a year.
How much would be the interest charged/paid by the bank for early remittance?
a. Rs.197 (customer will pay bank)
b. Rs.197 (bank will pay customer)
c. Rs.275 (Customer will pay bank)
d. Rs.275 (Bank will pay customer)
Answer:
Particulars Amount
Nov 30 – Bank will buy from customer -75.40
Nov 30 – Bank will sell at spot rate to some other Bank 75.22
Outflow for banker 0.18
Total outflow for banker (1,00,000 x 0.18) 18,000
Interest cost to be recovered (18,000 x 18% x 31/365) 275
Hence customer will pay Rs.275 to Bank

40. Forward Contract – Customer does not appear on Due Date

• A customer is allowed three working days of grace period for execution of forward contract.
• If the customer does not give instruction in three days, then the contract will get auto-cancelled.
• Even if the customer gives instruction, there will be a cancellation and the customer will have to
pay cancellation loss
Following needs to be paid by the customer
Cancellation Rate Spot rate + margin on the date on which customer appears for cancellation
(Contract will be automatically cancelled 3 days post expiry if the customer does
not appear for cancellation)
Amount payable Difference between customer’s original customer rate and cancellation rate as
by the customer calculated above
Swap loss As per FEDAI norms, banker has to cancel the original contract (taken with some
other bank) and swap it with next available contract. Exchange margin should not
be considered in banker analysis
Interest on outlay Bank will charge interest to the customer on the cancellation charges paid by bank
of funds by cancelling contract on due date. It is calculated on banks original covered rate
and the reverse rate on the maturity date. Interest is calculated till the date of
cancellation of contract or 3 days whichever is later
Total cost to Cancellation charges + Swap loss + Interest on outlay of funds
customer
Note: In any of the above cases, if there is a profit for the bank, the same would not be passed on to the
customer.
Format for computing cancellation rate and amount payable by customer:
Example:
An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on 10th June @
Rs. 64.4000. The bank covered its position in the market at Rs. 64.2800.
The exchange rates for dollar in the interbank market on 10th June and 13th June were:
June 10 June 13
Spot USD 1 63.8000/8200 63.6800/7200
Spot/June 63.9200/9500 63.8000/8500
July 64.0500/0900 63.9300/9900
August 64.3000/3500 64.1800/2500
September 64.6000/6600 64.4800/5600
Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 13th June
for extension of contract with due date on 10 th August. Rates rounded to 4 decimal in multiples of
0.0025. On 10th June, Bank Swaps by selling spot and buying one month forward.
Answer:
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Evaluation from importer point of view:
Date Position Action Reference Date Rate
Apr 10 Original Position Buy (ASK) June 10 -64.4000
June 13 Opposite Position Sell (BID) June 13 63.6175
June 20 New Position Buy (ASK) Aug 10 -64.3150
Effective rate -64.40+63.6175-64.3150 -65.0975
Loss on cancellation per USD -64.40+63.6175 -0.7825
Total loss on cancellation -0.7825 x 2,00,000 -1,56,500
Effective loss per USD -65.0975 – (-64.40) -0.6975
Total effective loss -0.6975 x 2,00,000 -1,39,500
Note:
BID rate on June 13 (Spot rate):
• BID rate = 63.6800 – 0.10% = 63.6163 ~ 63.6175 (multiples of 0.0025)

ASK rate on June 13 for August 10:

• Ask rate without exchange rate = 64.2500
• Final Ask rate = 64.25 + 0.10% = 64.31425 ~ 64.3150

Format for computing swap loss (evaluation from banker point of view):
Date Position Action Reference Date Rate
Apr 10 Original Position Buy (ASK) June 10 -64.28
June 10 Opposite Position Sell (BID) June 10 63.80
June 10 New Position Buy (ASK) June 30 -63.95
Effective rate -64.28+63.80-63.95 -64.43
Loss on cancellation per USD -64.28+63.80 -0.48
Total loss on cancellation -0.48 x 2,00,000 -96,000
Effective loss per USD -64.43 – (-64.28) -0.15
Total effective loss -0.15 x 2,00,000 -30,000
• Swap loss = Effective loss
• Interest cost = Cancellation loss x (No of days /365) x Rate of interest

Final Solution:
Particulars Calculation Amount
Cancellation rate WN 1 63.6175
Amount payable on USD 2,00,000 WN 1 1,56,500
(Loss on cancellation)
Swap loss WN 2 30,000
(Swap loss of banker)
Interest on outlay of funds 3 95
96,000 x 12% x ( )
(This is banker outflow on cancellation due 365
to non-receipt of instructions from customer)
New Contract rate WN 1 64.3150
Total cost 1,56,500 + 30,000 + 95 1,86,595
Example:
An importer booked a forward contract on 10th April with delivery being on 10th June. The customer
appears on June 17 and asks for extension of contract to August 10. What will be the date of cancellation
of contract?
a. June 10
b. June 17
c. June 13
Answer:
Due date of forward contract = June 10; Grace period of honoring the contract = 3 days; Date of cancellation
of contract = Date on which customer appears or 3 days whichever is earlier and hence contract will get
cancelled on June 13

41. Decision on hedging based on average contribution to sales ratio

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• We should compute average contribution to sales ratio for all currencies together and compute
this ratio.
• We will have one ratio if hedging is done and another ratio if hedging is not done. Based on this
analysis we can decide whether to go for hedging or not

42. Time Value and Currency Fluctuation Component

• Time value of money component is the discount a company can get by making early payment.
• 2/10 net 30 would mean we will get 2 percent discount if payment is done in 10 days. Otherwise,
payment should be done in 30 days.
• Currency Fluctuation component is the extra/lesser payment due to appreciation/depreciation of
currency
• Time value of money component = Amount of cash discount x Exchange rate on due date
• Currency fluctuation component = (Payment post discount in FC) x appreciation/depreciation
of FC
Example:
India Imports co., purchased USD 100,000 worth of machines from a firm in New York, USA. The value of
the rupee in terms of the Dollar has been decreasing. The firm in New York offers 2/10, net 90 terms. The
spot rate for the USD is Rs. 55; the 90 days forward rate is Rs. 56. How much is time value of money
component (discount for prepayment) and protection from currency fluctuation if the company decides to
make payment today?
a. Rs.1,10,000 and Rs.1,00,000
b. Rs.1,12,000 and Rs.98,000
c. Rs.1,00,000 and Rs.1,10,000
Answer:
• 2/10 net 90 would mean that the company will get 2 percent discount if the payment is done in
10 days. Hence the company will be making a payment of only 98,000 USD
• Rupee cost of paying the account within 10 days = 98,000 USD x Rs.55 = Rs.53,90,000
• Rupee cost of paying in 90 days = 1,00,000 USD x 56 = Rs.56,00,000
• Saving in payment if early payment is made = 56,00,000 – 53,90,000 = Rs.2,10,000
• Time value of money component = [1,00,000 – 98,000] x Rs.56.00 = Rs.1,12,000
• Currency value fluctuation component = 98,000 x [56 – 55] = Rs.98,000

43. Money Market Hedge

• MMH is a strategy where we create matching asset for a future payable and matching liability for
a future receivable. Hence the asset/liability will be set-off against each other so that forex risk is
eliminated.
Steps in case of exporter:
Particulars Calculation Amount
Day 0:
Identify a foreign currency asset/liability – Foreign USD 3,50,000.00
currency Asset
Create a matching liability – we will take a USD loan 3,50,000 USD 3,42,298.29
which will mature to USD 3,50,000 1 + 2.25%
Convert USD 3,42,298.29 into GBP at spot rate 1 GBP 2,15,214.27
3,42,298.29 𝑥 ( )
1.5905
Invest GBP 2,15,214.27 for three months at the rate of 5% GBP 2,15,214.27
Day 90:
Receive USD 3,50,000 from customer and repay USD Loan USD 3,50,000.00
Redeem GBP deposit along with interest 2,15,214.27 + 1.25% GBP 2,17,904.45

Steps in case of importer:

Particulars Calculation Amount
Day 0:
Identify a foreign currency asset/liability – Foreign EUR 25,00,000
currency Liability

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Create a matching asset– we need to create a EUR 25,00,000 EUR 24,39,024
deposit which will mature to EUR 25,00,000 1 + 2.50%
Deposit rate = 2.5% per quarter
Take a GBP loan at 2% per 3 months which will help 1 GBP 19,51,219
24,39,024 x ( )
in buying EUR 24,39,024 1.25
Convert GBP 19,51,219 into Euros and create Euro EUR 24,39,024
deposit
Day 90:
Redeem Euro deposit along with interest 24,39,024 + 2.5% EUR 25,00,000
Pay supplier with deposit proceeds EUR 25,00,000
Repay GBP loan along with interest of 2% 19,51,219 + 2% GBP 19,90,243
Note:
• Question does not specify the hedging mechanism and has data on interest rates. In this case the
approach to hedging would be through money market hedge
• Interpretation of 180 days deposit/borrowing rate: In practical world, interest rates are normally
expressed for a year and we have 7 days FD rate, 14 days FD rate, 30 days FD rate, 180 days FD
rate and so on. So normally the given interest rate is taken for a year and based on that we compute
proportionate rate for MMH. However, in few places ICAI has directly used the given rate as the
rate for the specific period and not for a year. Therefore, it is necessary for us to write our
assumption on how we are interpreting the interest rates
Example:
ABC Limited based out of India has exported goods to USA. It is going to receive 3,50,000 USD in 6 months.
It plans to hedge exposure through money market. Interest rates in USA are 6%/8% per annum. Compute
the deposit/borrowing in USD?
a. Loan of USD 3,24,074
b. Deposit of USD 3,24,074
c. Loan of USD 3,36,539
d. Deposit of USD 3,36,539
Answer:
We have foreign currency asset (receivable) and hence we need to create a matching liability. We will take
a loan in USD. Proportionate borrowing rate for 6 months is 4%
3,50,000
Loan to be taken = = USD 3,36,539
1 + 4%
Example:
ABC Limited of India has imported goods worth USD 10,00,000 payable in 6 months. Interest rates in USA
are 4%/6% per annum. The spot exchange rate is Rs.81.20-60 per USD. How much is the loan to be taken
to cover this transaction in MMH?
a. USD 9,70,874
b. INR 7.96 crores
c. INR 8.00 Crores
d. None of the above
Answer:
We have USD liability and hence we need to create matching USD asset
10,00,000
Amount of USD deposit to be created = = USD 9,80,392
1 + 2%
INR needed to purchase 9,80,392 USD = 9,80,392 x 81.60 = INR 8.00 Crores
Example:
A UK Company owes a German Company 25 lakhs Euros payable in 3 months. The spot rate EURO/GBP
is 1.25-1.27. The company can borrow pounds @ 8% and deposit pounds @6%. It can borrow Euro @12%
and deposit Euro@10%. How much is the deposit to be created today?
a. EUR 25,00,000
b. EUR 24,39,024
c. GBP 19,51,219
d. EUR 24,27,184
Answer:
We have a foreign currency liability of EUR 25,00,000 and we should create a matching deposit that will
mature to EUR 25,00,000

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25,00,000
Amount of deposit to be created = = EUR 24,39,024
1 + 2.5%
Example:
A Limited of India has sold goods to USA. It wants to hedge the exposure through Money market hedge.
It should borrow in _______ and create a deposit in _________ to complete MMH.
a. INR and USD
b. INR and INR
c. USD and INR
d. USD and USD
Answer:
It has exported goods and hence has foreign currency asset (USD). It should create a matching liability and
hence borrow in USD. The borrowed amount should be converted into INR and deposited
Example:
A company has a payable exposure of EUR 25,00,000. The final amount paid under MMH is GBP 20,00,000.
The forward contract today is EUR 1.20 - 1.22 per GBP. What should the company do for hedging?
a. Go ahead with MMH
b. Go ahead with forward contract
c. Indifferent between MMH and FC
d. Do not hedge the exposure
Answer:
Payable under forward contract:
GBP
GBP = EUR x ASK ( )
EUR
1
GBP = 25,00,000 x ( ) = GBP 20,83,333
1.20
Outflow under forward contract is higher and hence the company should go for MMH to cover the
exposure

44. Transaction Exposure and Operating Exposure

Transaction Exposure:
• Transaction exposure measures the impact on profits due to variation in exchange rates
• Profit impact due to transaction exposure = Profit as per Spot rate - Profit as per expected
spot/forward rate

Operating Exposure:
• Operating exposure measures the change in profits due to changes in operating conditions (Selling
price/units sold/purchase price etc)
• Gain/loss due to transaction exposure = Existing profit as per spot rates – revised profits as per
spot rates

Note:
• Price elasticity of demand measures the percentage change in units sold for a percentage change
in price. If price elasticity of demand is 1.5, then 1 percent increase in selling price will lead to 1.5
percent fall in units sold
Example:
A company can make a profit of Rs.10,00,000 if exports and import settlement is done as per spot rates.
However, the same would decline to Rs.4,00,000 if they are realized and paid as per the due date. How
much is the transaction exposure?
a. 10,00,000
b. 14,00,000
c. 6,00,000
d. 4,00,000
Answer:
Transaction exposure = Profit as per spot rates – Profit as per forward rates
Transaction exposure = 10,00,000 – 4,00,000 = Rs.6,00,000

45. Types of Bank Accounts

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Types of Bank Accounts:
• Nostro Account (Our Account with you): An Indian Bank having a Bank Account in Foreign
country in the home currency of foreign Bank. Example: ICICI Bank having USD account with
CITI Bank USA
• Vostro Account (Your Account with us): A foreign bank having Bank Account in India with an
Indian Bank in INR currency. Example: CITI Bank USA having INR account with ICICI Bank
• Loro Account: An account where a bank remits fund in foreign currency to another bank for credit
to third bank

46. Exchange Position vs Cash Position

• This analysis is from banker point of view as banker will be having multiple forex transactions
daily and hence the forex risk needs to be covered
Cash Position vs Exchange Position:
• Cash Position: This means the actual forex balance and is impacted only when cash flow happens
for a transaction
• Exchange Position: It refers to the extent of overbought/oversold position of a foreign currency
by a bank. This book will record all purchase and sale of foreign currency transactions irrespective
of cash flow

Transaction affecting Exchange position and cash position:

Transaction Exchange position Cash position
Immediate cash flow (Telegraphic Yes Yes
transfer)
Demand draft Yes – Sale No. Will be impacted only when the draft
Transaction is realized
Bills purchase Yes – Buy No. Will be impacted only when the bill
Transaction is realized
Forward purchase/sale Yes No. Will be impacted only on delivery

Format for recording exchange position:

Particulars Purchase/ Sales/
Inflow Outflow

• Exchange Position is more like stores ledger. It will record all inflows as purchases and record all
outflows as sales

Format for recording cash position:

Particulars Receipt/ Payment/
Inflow Outflow

• Cash position is a cash book. It will record all cash inflows and cash outflows

Note:
• Purchase in exchange position: Purchase of bill, Cancellation of demand draft, spot purchase, DD
Purchase, Purchase of cheques not credited to account, outstanding forward purchases, bills
purchased in hand but not due for
• Sales in exchange position: Forward sales, cancellation of forward purchase, Remittance by TT,
Sold forward TT, outstanding forward sales, DD issued but not yet presented for payment
• Inflow in cash position: Spot purchase
• Outflow in cash position: Remittance by TT
Example:
Cancellation of DD issued is recorded as __________
a. Purchase in exchange position

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b. Sale in exchange position
c. Outflow in cash position
d. Inflow in cash position
Answer:
Draft issue is recorded as sale transaction in exchange position. Cancellation of same will reverse the
transaction and the same would be recorded as purchase in exchange position
Example:
Spot sale of foreign currency is recorded as ______________
a. Sale in Exchange position and inflow in cash position
b. Sale in Exchange position and outflow in cash position
c. Purchase in Exchange position and outflow in cash position
d. Purchase in Exchange position and inflow in cash position
Answer:
Sale in Exchange position and outflow in cash position
Example:
How is forward purchase recorded in cash position?
a. Inflow
b. Outflow
c. Not recorded
Answer:
Not recorded

47. Exchange Position vs Cash Position – Maintenance of Desired Balance

• Cash Position: If we want to increase/decrease cash balance then we should do spot
purchase/sales. This will also impact the exchange position.
• Exchange Position: If we also want to change the overbought and oversold position then we can
go for forward purchase/sales. Forward purchase/sales will only impact exchange position
• In short, we should first do the adjustment of cash position and then the exchange position
Example:
A bank has an overbought position of USD 1,00,000 and cash balance of USD 25,000. It wants a cash balance
of USD 80,000 and overbought position of USD 1,50,000. What action should be taken?
a. Spot purchase of USD 55,000 and forward sell of USD 5,000
b. Spot purchase of USD 55,000 and forward purchase of USD 50,000
c. Forward purchase of USD 50,000
d. Spot purchase of USD 55,000 and forward purchase of USD 5,000
Answer:
First we should adjust the cash balance and hence we will do spot purchase of USD 55,000. This will
increase the cash balance to USD 80,000. This transaction will also increase overbought position as USD
1,55,000. We need an over-bought position of USD 1,55,000 and hence we should do forward sell of USD
5,000 to make the final position as USD 1,50,000
Example:
A bank has an overbought position of USD 1,00,000 and cash balance of USD 25,000. It wants a cash balance
of USD 40,000. What action should be taken?
a. Buy USD 15,000 in spot market
b. Sell USD 15,000 in spot market
c. Buy USD 15,000 in forward market
d. Sell USD 15,000 in forward market
Answer:
It has balance of USD 25,000 and should do a spot purchase of USD 15,000 to make the balance USD 40,000

48. Currency Futures

• Currency futures operate similarly to regular futures contracts, but with the distinction of
involving two currencies in the quoted exchange rate. This differs from standard futures, where
the Indian Rupee (INR) is typically paired with another commodity or share.

Format for computing number of futures contract:

Particulars Amount

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Amount of Exposure
Size of one contract
Number of contracts
Action Taken
• Exposure currency vs contract currency: We should ensure that exposure currency and contract
currency is same for computing the number of contracts for both options and futures. In case they
are not same, we should convert the exposure into the other currency by using futures rate or
strike rate of options
• We should take the closest available contract for hedging in case the contract for the exact due date
is not available

Format for computing futures settlement:

Date Position Action Reference Date Rate
Day 0 Original Position Buy Jan 31 (1.50 USD/GBP)
Jan 31 Opposite Position Sell Jan 31 1.47 USD/GBP
Profit per GBP 0.02 USD/GBP
Profit for 16,000 contracts (0.02 x 62.50 x 16,000) USD 20,000
• Final Cash flow = Amount paid/realized at spot rate + Net Settlement
• Non-deliverable forward (NDF) contract would also work as similar to futures while
computing realization/settlement. This is because NDF is also net-settled.
• Margin money in futures: Margin money does not constitute an expenditure for the company.
However, it is initially deposited on day 0 and subsequently returned upon maturity. Therefore,
it is imperative to factor in the interest cost associated with margin money.
Example:
XYZ Ltd. is an export-oriented business house based in Mumbai. The Company invoices in customers’
currency. Its receipt of US $ 1,00,000 is due on September 1,2009. Contract size of currency futures is
Rs.4,72,000 and September futures rate is USD0.02118 per INR. On September 1, 2009 the spot rate US$/Re.
is 0.02133 and currency future rate is 0.02134. How much would be the futures profit/loss on maturity
date?
a. INR 755.20 (Profit)
b. USD 755.20 (Profit)
c. INR 755.20 (Loss)
d. USD 755.20 (Loss)
Answer:
Number of contracts:
Particulars Amount
Amount of exposure USD 1,00,000
Amount of exposure in INR (1,00,000/0.02118) INR 47,21,435
Size of one contract INR 4,72,000
No of contracts 10
Note:
• In this case we will enter into buy contract as we are planning to sell USD and buy INR. INR is the
product currency and hence it will be buy contract.
Futures settlement:
Date Position Action Reference Date Rate
June 1 Original Position Buy Sep 01 (USD 0.02118/INR)
Sep 1 Opposite Position Sell Sep 01 USD 0.02134/INR
Profit per INR USD 0.00016/INR
Total Profit (0.00016 x 10 x 4,72,000) USD 755.20
Example:
On January 5, an Indian firm exported goods to an US firm for a consideration of USD 4,00,000 receivable
on 15th of February. The spot exchange rate is Rs.44/USD and a March dollar future is trading at
Rs.45/USD. You have taken march futures for hedging the receivable. On 15 th February if the exchange
rate in cash market drops to Rs.39/USD and in the futures markets it is trading at Rs.41/USD. How much
is the futures profit/loss?
a. Rs.16,00,000 (loss)
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b. Rs.16,00,000 (profit)
c. Rs.20,00,000 (loss)
d. Rs.20,00,000 (profit)
Answer:
Date Position Action Reference Date Rate
Jan 5 Original Position Sell March 31 Rs.45/USD
Feb 15 Opposite Position Buy March 31 (Rs.41/USD)
Profit per USD Rs.4/USD
Profit for USD 4,00,000 [4,00,000 x 4] Rs.16,00,000
Example:
The corporate treasurer of a US multinational receives a fax on 21st February from its European subsidiary.
The subsidiary will transfer Euro 10 million to the parent company on 16 th August. If the corporate
treasurer plans to hedge through futures in the dollar market, will he buy or sell dollar futures?
a. Long in USD futures
b. Short in USD futures
Answer:
The company plans to sell EUROS and hence it would be buying USD. Hence, we should go long (buy)
USD futures for hedging.

49. Forex Options

Deciding Call Option vs Put Option:
• In a standard options scenario, a call option is typically employed for buying, while a put option
is used for selling. However, in the context of currency options, one must exercise caution and
consider the nature of the transaction in the product currency. It is not always straightforward to
assert that an importer will utilize a call option and an exporter will opt for a put option.
• For example, let's consider an Indian exporter aiming to hedge USD receivables with a strike rate
of USD 0.0122/INR. In this case, INR is the product currency. Therefore, the exporter can buy INR
using a call option and sell INR using a put option. Given that the exporter is selling USD and
buying INR, the appropriate hedging strategy would involve the use of a call option.
Call option and Put option:
• Maximum purchase price in call option = Strike Price + Premium + Interest on Premium
• Minimum selling price in put option = Strike price – Premium – Interest on Premium
• Interest on option premium: Option premium is paid on day 0. We should consider interest cost
on option premium in case interest rate is available in question. If we are having cash deficit then
interest will be considered as per borrowing rates and if we are having cash surplus then interest
would be computed as per investment rates
• Unhedged exposure in options: Example: A company needs 17.40 Contracts to hedge full
exposure. However, we need to round off and this will become 17 contracts. So, there will be some
unhedged exposure. Unhedged exposure can be paid/realized at forward rate/future spot rate
depending on information in question
Example:
XYZ an Indian firm, will need to pay JAPANESE YEN (JY) 5, 00,000 on 30th June. Spot JPY/INR is
1.9516/1.9711. The prices for forex currency option on purchase are as follows:
Strike Price = JY 2.125
Call option (June) = JY 0.047
Put option (June) = JY 0.098
How much is the premium to be paid on hedging the exposure through option route?
a. INR 23,059
b. INR 11,815
c. INR 11,699
d. JPY 11,699
Answer:
• Amount of exposure = JPY 5,00,000 (or) Rs.2,35,294 (5,00,000/2.125)
• Relevant strike price = JPY 2.125/INR. Product currency is INR and this is a contract to buy/sell
INR. The company has to sell INR and hence we should go for put option

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• Premium amount = INR 2,35,294 x JPY 0.098 = JPY 23,059
• Premium in INR = 23,059/1.9516 = INR 11,815
Example:
A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S. suppliers.
The amount is payable in six months time. Currency options are available under which one option
contract is for GBP 12,500. The option premium for GBP at a strike price of USD 1.70/GBP is USD
0.037 (call option) and USD 0.096 (put option) for 6 months period. Which type of option should we
take for hedging?
a. Call option
b. Put option
Answer:
The strike price of option is USD 1.70/GBP. Product currency is GBP and hence we can buy/sell GBP with
option contract. The company needs to buy USD. This can also be considered as selling GBP. The company
plans to sell GBP and hence we should opt for Put option
Example:
An Indian Company buys a 6 month put on 10 lakh USD with a strike price of Rs. 55/$ and a premium of
Re. 2/$. The opportunity cost of money is 6% p.a. If the forward rate when the option was bought was Rs.
55 under what future spots rates would this have proved better than the option contract?
a. <Rs.57.06 per USD
b. >Rs.57.06 per USD
c. <Rs.55.00 per USD
d. >Rs.55.00 per USD
Answer:
• Premium of put option = Rs.2.00 + (2 x 6% x 6/12) = Rs.2.06; Minimum inflow under option
contract = Rs.55.00 – 2.06 = Rs.52.94 per USD. Under option contract the minimum selling price
will be Rs.52.94/USD. However, if the future spot rate is higher than Rs.55/USD, then inflow
will be Spot rate - 2.06.
• Under forward option, the company will receive Rs.55/USD irrespective of future spot rates.
Hence option contract can be beneficial if the inflow under option contract is higher than
Rs.55/USD. Inflow will be Rs.55/USD if spot rate is Rs.57.06/USD (57.06-2.06 = 55). Hence option
contract will be beneficial if future spot rates are higher than Rs.57.06/USD
Example:
An Indian Company buys a 6 month call on 10 lakh USD with a strike price of Rs. 50/$ and a premium of
Re. 1/$. The opportunity cost of money is 12% p.a. At what spot rate on the date of maturity of options
contract would the Indian Company gain?
a. > Rs.50 per USD
b. < Rs.50 per USD
c. > Rs.51.06 per USD
d. < Rs.51.06 per USD
Answer:
• Maximum outflow under option contract = 50 + (50 x 2%) + (1 x 12% x 6/12) = Rs.51.06/USD
• Any spot rates above Rs.51.06/USD, the outflow under option contract will be lower than that of
spot contract. Hence option contract is beneficial above Rs.51.06/USD while comparing option
and spot alternative

50. Investment Decision

Selection of investment Centre:
• The question will specify the currency in which the net gain is to be computed. The following steps
should be followed:
o Invest the specified amount in different currencies and determine the maturity amount
for each.
o Calculate how much of each currency is needed to repay the initial investment plus the
cost of funds.
o The remaining amount after repaying the investment and costs represents the net gain.
o Convert the net gain into the specified currency. Select the currency that results in the
maximum gain.

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Selection of investment option: Sometimes multiple options may give almost the same result and hence
we can be indifferent between two options. We should opt for investment in fixed income security (less
risky) as compared to investment in equity option (riskier)
Example:
CFO of a company has surplus funds and he can invest the same either in index fund of Japan or USA
treasury bills. The maturity amount in INR would remain same for both investments. Where should the
investment be done?
a. Invest in Japan
b. Invest in USA
c. Indifferent between investment in Japan and USA
d. 50% in Japan and 50% in USA
Answer:
Return is same for both options. However, from risk perspective, the investment in fixed income desk of
US is more beneficial as the chance of variation in fixed income securities is less as compared to Equity
Desk. Hence investment should be done in USA.
Example:
ICL an Indian MNC is executing a plant in Sri Lanka. It has raised Rs. 400 billion. 60% of the amount will
be required after six months’ time. ICL is looking an opportunity to invest this amount on 1st April,2020
for a period of six months. How much is the investible amount as of now?
a. Rs.400 billion
b. Rs.160 billion
c. Rs.240 billion
d. Rs.200 billion
Answer:
Amount that can be invested today is the money which is not needed now. Hence 60% of Rs.400 billion
can be invested today.
Example:
US entity has cash surplus of USD 200 million. Interest rates are 1.5%/1.7%. How much cash will it have
in hand after one month?
a. USD 200 million
b. USD 200.25 million
c. USD 200.2833 million
Answer:
Entity has cash surplus and hence investment will be done. The same would be done at lower rate of 1.5%
1
Interest earned = 200 million x 1.5% x = 0.25 million
12
Surplus after one month = USD 200 million + USD 0.25 million = USD 200.25 million
Example:
Indian entity has deficit of Rs.1,000 lacs. Rate of interest in India is 6%/9%. How much will be the Indian
entity deficit after 2 months with financing operations?
a. INR 1,000 lacs
b. INR 1,010 lacs
c. INR 1,015 lacs
d. INR 1,007.50 lacs
Answer:
There is a deficit and hence the amount is to be borrowed. Borrowing will happen at 9%
2
Interest expense for two months = 1000 lacs x 9% x ( ) = Rs. 15 lacs
12
Balance at end of month 2 = 1,000 lacs + 15 lacs = 1,015 lacs

51. Financing Decision

Indifferent Borrowing Rate:
• Rate of interest after 3-months to make the company indifferent between 3-months borrowing and
6-months borrowing: This would basically mean computing a 3 x 6 FRA. The formula for the same
is as under:
FVF for 6 months
3 x 6 FRA = −1
FVF for 3 months

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52. Summary of Hedging Strategies

Available hedging tools:
• Forward contract
• Futures contract [Two types of questions will be there – One in which exposure and contract
currency matches and second in which currencies do not match]
• Options contract [Two types of questions will be there – One in which exposure and contract
currency matches and second in which currencies do not match]
• Money market hedge [For a payable and a receivable]
• Currency invoicing
• No hedge
Other Key Points in Forex Hedging:
• Spot rate (€ per £): 1.998 + 0.002. This needs to be read as bid rate equal to 1.996 [1.998 – 0.002] and
ask rate equal to 2.000 [1.998 + 0.002]
• Exchange exposure risk = Realization using actual spot rates - Realization using expected spot
rates [Forward rate]
Example:
Spot rate (€ per £) = 1.998 + 0.002; Forward rate (€ per £) = 1.979 + 0.004. You need to pay EUR 2,50,000 in
six months. How much would be the GBP outflow if you take forward contract?
a. GBP 1,26,326
b. GBP 1,26,839
c. GBP 1,26,072
d. GBP 1,26,582
Answer:
GBP 1 2,50,000
GBP = EURO x ASK ( ) ; GBP = 2,50,000 x ( )= = 𝐆𝐁𝐏 𝟏, 𝟐𝟔, 𝟓𝟖𝟐
EUR EUR 1.975
BID ( )
GBP
BID rate = 1.979 – 0.004 = 1.975
Example:
H Ltd. anticipates the spot exchange rate in 3-months time to be equal to the current 3-months forward
rate (72.95/73.40). After 3-months the spot exchange rate turned out to be Rs./$: 73/73.42. What is the
foreign exchange exposure and risk of H Ltd. if exposure is 50,000 USD?
Answer:
Particulars Calculation
Expected realization considering future spot rate (50,000 x 72.95) 36,47,500
Actual realization considering actual spot rate (50,000 x 73) 36,50,000
Gain due to foreign exchange risk 2,500

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Chapter 11 – International Financial Management

1. Issues in International Capital Budgeting

Some cash flows in INR and some are in non-INR:
• We will have to forecast future exchange rates using IRPT/PPT
• Forecasted exchange rates can be used to convert cash flows into a single currency.

2. Issues in International Capital Budgeting

INR discount rate vs Non-INR discount rate:
• (1+Risky rate) = (1+Risk-free rate) x (1+Risk premium)
• Risk-premium would remain same for INR currency as well as non-INR currency
Example:
Particulars INR USD
Risk-free rate 10.00 4.00
Risky rate 16.00 ??

For INR:
(1+Risky rate) = (1+Risk-free rate) x (1+Risk premium)
(1 + 0.16) = (1 + 0.10) x (1 + Risk-premium)
Risk-premium = 5.45%

For USD:
(1+Risky rate) = (1+Risk-free rate) x (1+Risk premium)
(1+Risky rate) = (1+ 0.04) x (1+ 0.0545)
Risky rate (USD) = 9.67%
Example:
Required return in INR is 12% per annum. Risk-free rate in India and USA is 8% and 4%. How much is
the required rate of return in USD?
e. 8.00%
f. 16.00%
g. 7.86%
h. 16.31%
Answer:
INR rate analysis:
(1 + R f ) x (1 + risk premium) = (1 + risky rate)
(1 + 0.08) x (1 + risk premium) = (1 + 0.12); Risk Premium = 3.71%

USD discount rate:

(1 + R f ) x (1 + risk premium) = (1 + risky rate)
(1 + 0.04) x (1 + 0.0371) = (1 + 0.12); Risky Rate = 7.86%

3. Issues in International Capital Budgeting

With-holding tax
• With-holding tax is an extra expenditure and the same would reduce the PV of inflows
• Total cost = Cost incurred in host country + Tax paid in host country + Withholding tax paid in
host country. Withholding tax will be taken at lower of DTAA rate and normal tax rate [OR] Net
inflow = CFAT earned – withholding tax
• Withholding tax eligible for credit: In this case this will not be an extra tax and the company
would first pay withholding tax on PBT. Additionally, the company will pay normal tax on PBT
(however withholding tax will be eligible for tax credit and hence there will be lower tax payment). In short
withholding tax will not be an extra expense and will not impact the cash flows.
Example:
PBT of the project = Rs.100 crores; Tax rates in India = 30% corporate tax and 10% with-holding tax. Taxes
paid in India will not be eligible for tax credit in USA. How much is the repatriable amount?
a. Rs.70 crores
b. Rs.60 Crores
c. Rs.63 crores
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d. Rs.77 crores
Answer:
Particulars Calculation Amount
(in Crores)
Profit before tax 100.00
Less: Tax @ 30% 100.00 x 30% -30.00
Profit after tax 70.00
Less: Withholding tax @ 10% 70.00 x 10% -7.00
Amount repatriated 63.00
Example:
PBT of the project = Rs.100 crores; The US based company will be subjected to corporate tax of 30 per cent
and with – holding tax of 10% in India and will be eligible for tax credit in India. How much is the
repatriable amount?
a. Rs.70 crores
b. Rs.60 Crores
c. Rs.63 crores
d. Rs.77 crores
Answer:
Particulars Calculation Amount
(in Crores)
Profit before tax 100.00
Less: Withholding tax @ 10% 100.00 x 10% -10.00
Earnings after withholding tax 90.00
Less: Tax @ 30% 100 x 30% - 10 -20.00
(with-holding tax eligible for tax credit)
Amount repatriated 70.00

4. Withholding tax rate

• Tax rate for withholding should be lower of
o Applicable withholding tax rate and
o Tax as per DTAA
Example:
An MNC company in USA has surplus funds to the tune of USD 10 million for six months. The finance
director of the company is interested in investing in EURO for higher returns. There is DTAA in force
between USA and Germany. Following are the details of the investment
Particulars Amount
EURO/USD Spot 0.4040/41
6 months forward 67/65
Rate of interest for 6 months (p.a.) 5.95%-6.15%
Withholding tax applicable for interest income 22%
Tax as per DTAA 10%
How much would be the withholding tax on interest income?
a. EUR 12,019.00
b. EUR 26,441.80
c. EUR 12,120.00
d. EUR 26,664.00
Answer:
Particulars Calculation Amount
Surplus in USD 1,00,00,000 USD
Euro investment 1,00,00,000 x 0.4040 40,40,000 EUR
Interest earned 40,40,000 x 5.95% x 6/12 1,20,190 EUR
Withholding tax as per DTAA 1,20,190 x 10% 12,109 EUR
[DTAA or normal tax whichever
Is lower]

5. Home currency NPV and Foreign Currency NPV

• Home currency NPV = Foreign currency NPV x Exchange Rate
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Example:
NPV of project is Rs.10,00,000. Spot exchange rate is Rs.50 per USD. How much would be the NPV in USD?
a. Cannot be calculated with given information
b. USD 5 crores
c. USD 20,000
d. USD 10,000
Answer:
NPV in INR = NPV in USD x Spot rate
10,00,000 = NPV in USD x 50; NPV in USD = 10,00,000/50 = USD 20,000

6. Impact of Exchange Restrictions

• Exchange restrictions can impact repatriated cash flows and we should compute NPV based on
repatriated cash flows. Cash flows which are not repatriated will normally be repatriated at end
of the life of the project
Example:
An Indian company is setting up a project in USA. It currently has operations in USA which has surplus
funds of USD 20,00,000. These funds cannot be repatriated to India due to restrictions. New project will
cost USD 50,00,000 and the company would partly fund the investment project with the available surplus
of USD 20,00,000. How much should be the initial outflow for evaluating the project?
a. USD 50,00,000
b. USD 70,00,000
c. USD 30,00,000
Answer:
USD 30,00,000
Explanation: Blocked funds will be used for setting up the project and these blocked funds should be
reduced from the initial outlay to find the real outflow towards the project
Example:
A project will generate cash flows of USD 20,00,000 in year 1, USD 40,00,000 in year 2 and USD 60,00,000
in year 3. Initial investment is USD 80,00,000. There are restrictions on repatriation of funds and only 50%
of profits can be repatriated in each year and the balance cash flows can be repatriated on completion of
project. Non-repatriated amount can be invested in fixed deposit giving return of 2%. Cost of capital is
10%. How much is the NPV of the project?
a. USD 16,28,000 (Positive)
b. USD 13,20,000 (Positive)
c. USD 13,80,380 (Positive)
d. Negative NPV
Answer:
Year Cash flow PVF @ 10% DCF
0 -80,00,000 1.000 -80,00,000
1 10,00,000 0.909 9,09,000
2 20,00,000 0.826 16,52,000
3 90,80,400 0.751 68,19,380
NPV 13,80,380
• Cash flow of year 1 = 20,00,000 x 50% = 10,00,000
• Cash flow of year 2 = 40,00,000 x 50% = 20,00,000
• Cash flow of year 3 = [10,00,000 x 1.02 x 1.02] + [20,00,000 x 1.02] + 60,00,000 = 90,80,400

7.Concept of Average Loan Maturity

• The average loan maturity is determined as the weighted average of the duration outstanding for
the loan. It is computed by taking a weighted average of the period outstanding, where the
weights correspond to the amount outstanding. This calculation is akin to computing the average
due date.
• Interest cost for entire Loan Duration = Loan Taken x Rate of Interest x Average Loan Maturity
Example:

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K Ltd. currently operates from 4 different buildings and wants to consolidate its operations into one
building which is expected to cost Rs. 90 crores. The Board of K Ltd. had approved the above plan and to
fund the above cost, agreed to avail an External Commercial Borrowing (ECB) of GBP 10 m from G Bank
Ltd. Interest Cost is GBP 6 months LIBOR + Margin of 2.50%. The 6-month LIBOR is expected to be 1.05%.
Average Loan Maturity life will be 3.4 years with an overall tenure of 5 years. How much is the expected
interest cost assuming LIBOR remains at 1.05%?
a. GBP 0.8875 million
b. GBP 1.775 million
c. GBP 1.207 million
d. GBP 0.6035 million
Answer:
Interest cost = 10 million x 3.55% x 3.4 years = GBP 1.207 million

8. Project Beta vs Equity Beta

• The concept of levered and unlevered Beta was addressed in the Portfolio Chapter, where the
weight of debt is calculated as Debt x (1 - Tax Rate).
• In International capital budgeting involving two countries, it's possible for the tax rates to differ
between them. This can lead to confusion regarding which tax rate should be used in computing
the weight of debt.
• To address this issue, it is recommended to use the tax rate of the country in which the loan is
taken. This approach ensures consistency and accuracy in determining the weight of debt.
Example:
An Indian company is planning to do a project in Nepal. The company can raise loan for theme park in
Nepal @ 9%. The tax rate in India is 30% and in Nepal it is 20%. The current WACC of the company is 12%.
The company’s current equity beta is 0.45. The company’s funding ratio for the Water Park would be 55%
equity and 45% debt. The company has gathered the relevant information about its nearest competitor in
Nepal. The competitor’s market value of the equity is NPR 1850 crores and the debt is NPR 510 crores and
the equity beta is 1.35. How much is the asset beta and equity beta of the project?
a. 1.132 Times and 1.873 Times
b. 1.132 Times and 1.780 Times
c. 1.106 Times and 1.830 Times
d. 1.106 Times and 1.739 Times
Answer:
Computation of Asset Beta of project based on Competitor:
Security Beta Weight Product
Equity 1.35 1850 2,497.50
Debt 0 408 0
[510 x 0.80]
Firm 1.106 2,258 2,497.50
Note: We have used tax rate of Nepal for computing weight of debt in Nepal. This is because the
competitor is based out of Nepal
Computation of Equity Beta:
Security Beta Weight Product
Equity 1.83 0.55 1.006
Debt 0 0.36 0
[0.45 x 0.80]
Firm 1.106 0.910 1.006
Note: Weight for Debt is taken as Debt x (1 – Tax rate of Nepal). This is because we are taking loan in
Nepalese currency and hence get tax benefits in Nepal.
Final answer is 1.106 Times and 1.830 Times

9. Examples on Cash flow computation

Example:
A proposed foreign investment involves creation of a plant with an annual output of 1 million units. The
entire production will be exported at a selling price of USD 10 per unit. The plant at the current rate of
exchange will have a depreciation of USD 1 million annually. There is a likely decline in value of USD by
10 percent. How much would be the selling price and depreciation in USD post decline in value of USD?
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a. USD 10 and USD 0.9 million
b. USD 10 and USD 1 million
c. USD 9 and USD 0.9 million
d. USD 9 and USD 1 million
Answer:
• Current selling price is in USD and hence there will be no impact on selling price with decline in
value of USD. Selling price will continue to be USD 10
• Depreciation is USD 1 million as per the current rate of exchange. Decline in value of USD will
lead to lower equivalent depreciation of USD 0.9 million [1 million – 10%]
• Hence answer is USD 10 and USD 0.9 million
Example:
A US based company is setting up a subsidiary in USA. The project will involve Additional cash fixed cost
of US $ 30 million p.a. and project's share of allocated fixed cost will be US $ 3 million p.a. based on
principle of ability to share. How much should be taken as fixed cost while evaluating the capital
budgeting decision?
a. USD 30 million
b. USD 33 million
c. USD 27 million
Answer:
USD 30 million. Project’s share of allocated fixed cost is irrelevant as the same is not related to the project.

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Chapter 12 – Interest Rate Risk Management

Overview:
• Interest rate options
• Interest rate futures
• Forward Rate Agreement
• Interest rate swaps

1. Interest Rate Risk

• Variation in my cashflows or profits due to change in interest rates is known as Interest rate Risk
• The risk of change in price of stocks, currency and commodities is hedged through
futures/options (Chapter 9)
Tools Available for Hedging:
• Interest Rate Options
• Interest Rate Futures
• Forward Rate Agreements
• Interest Rate Swaps

2. Interest rate options

• Cap option (Call option) = Cap option restricts the maximum interest outflow. This option will
be exercised if actual interest rate is higher than strike price(rate) - Useful for borrowers
• Floor option (Put option) = Floor options provides for minimum interest inflow. This option will
be exercised if actual interest rate is lower than strike price (Rate) - Useful for Lender
• Collar option = Buying a cap + Selling a floor
• Interest rate guarantee: Interest rate guarantee is either a cap or floor option depending on
whether we are borrower or lender

3. Normal options vs Interest Rate Options

Particulars Call/Put Option Cap/Floor Option
Strike Normal Price Interest Rate
Price
Call/Cap If price in market is more than exercise If actual interest rate in market is more than
price, we would exercise it. Otherwise, it strike rate, we would exercise it. Otherwise,
will lapse and we will buy at lower market it will lapse and we will pay lower interest
price rate
Put/Floor If price in market is less than exercise If actual interest rate in market is lower than
price, we would exercise it. Otherwise, it strike rate, we would exercise it. Otherwise,
will lapse and we will sell at higher it will lapse and we will receive higher
market price interest rate

4. Interest Rate Option (Settlement)

• Payoff of call option = Notional Amount x (Time period/12) x (Actual Rate – Strike Rate)
• Payoff of Floor option = Notional Amount x (Time period/12) x (Strike Rate – Actual Rate)
• Just like a normal option, net settlement will be inflow for holder and outflow for writer
Example:
You have purchased one year cap on notional amount of Rs.100 crores. The strike rate of cap option is 8%.
Interest rate for first quarter is 8.5% and second quarter is 7.5%. How much is the payoff for first and
second quarter?
a. 50,00,000 and 50,00,000
b. 12,50,000 and 12,50,000
c. 12,50,000 and 0
d. 50,00,000 and 0
Answer:
Option will get exercised in the first quarter as the actual interest is higher than cap rate. Payoff of first
quarter = 100 crores x 0.5% x 3/12 = Rs.12,50,000. Option will not be exercised in second quarter and hence
payoff for second quarter is 0

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Example:
You have purchased one year floor on notional amount of Rs.100 crores. The strike rate of floor option is
8%. Interest rate for first quarter is 8.5% and second quarter is 7.5%. How much is the payoff for first and
second quarter?
a. 50,00,000 and 50,00,000
b. 12,50,000 and 12,50,000
c. 0 and 50,00,000
d. 0 and 12,50,000
Answer:
Option will not get exercised in the first quarter as the actual interest is higher than floor rate. Hence payoff
for first quarter is 0. Option will be exercised in second quarter as the actual rate is lower than strike rate.
Payoff for second quarter is 12,50,000 [100 crores x 0.5% x 3/12]

5. Terms Associated with Interest Rate Options

• Notional Amount: Notional Amount is the amount that we intend to lend or borrow
• Reset Period: It refers to the frequency with which interest rates of a loan can be adjusted. Floating
rate of interest is on a benchmark and the same would get reset periodically. We can assume the
reset rate to be applicable for the next period/previous period depending on assumption
Format for computation of total Interest Outflow:
Reset LIBOR No of Our Interest Premium Cap Floor Total
Date days Borrowing paid Paid Receipt Payment Interest
rate

𝐓𝐨𝐭𝐚𝐥 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐏𝐚𝐢𝐝 𝟑𝟔𝟓

𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 = 𝐱 𝐱 𝟏𝟎𝟎
𝐋𝐨𝐚𝐧 𝐀𝐦𝐨𝐮𝐧𝐭 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐝𝐚𝐲𝐬 𝐨𝐟 𝐥𝐨𝐚𝐧
Example:
XYZ Limited issues a GBP 10 million floating rate loan with resetting of coupon rate every 6 months equal
to LIBOR + 0.50%. XYZ is interested in a collar strategy by selling a floor and buying a cap. Strike rate for
cap is 7.00% and collar is 4%. How much is the effective interest cost if LIBOR is 3% on reset date?
a. GBP 3,50,000
b. GBP 1,75,000
c. GBP 4,50,000
d. GBP 2,25,000
Answer:
• Interest paid on base loan = 1,00,00,000 x 3.5% x 6/12 = GBP 1,75,000
• No receipt on cap option as the same would not be exercised
• Floor payment = 1,00,00,000 x 1% x 6/12 = GBP 50,000
• Total outflow = 1,75,000 – 0 + 50,000 = GBP 2,25,000
Example:
XYZ Limited issues a GBP 10 million floating rate loan with resetting of coupon rate every 6 months equal
to LIBOR + 0.50%. XYZ is interested in a collar strategy by selling a floor and buying a cap. Strike rate for
cap is 7.00% and collar is 4%. How much is the cap receipt and floor payment if Libor is 10% on reset date?
a. Cap receipt of GBP 3,00,000 and floor payment of GBP 6,00,000
b. Cap receipt of GBP 3,00,000 and no floor payment
c. Cap receipt of GBP 1,50,000 and floor payment of GBP 3,00,000
d. Cap receipt of GBP 1,50,000 and no floor payment
Answer:
Strike rate of cap option is 7% and actual LIBOR is more than 7%. Hence cap option will be exercised and
there will be a receipt of GBP 1,50,000 [1,00,00,000 x 3% x 6/12]. There will be no payment on floor option
as the same won’t be exercised

6. Option Premium
Lumpsum Premium = Notional Amount x Lumpsum Premium%
Lumpsum Premium
Premium Amortization =
PVAF (Fixed rate of interest, no of reset periods)

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Example:
XYZ Limited borrows £15 Million of six months LIBOR + 10.00% for a period of 24 months. The company
anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at the strike rate of
8.00%. The lumpsum premium is 1.00% for the entire reset periods and the fixed rate of interest is 7.00%
per annum. How much would be the amortized premium per reset period?
a. GBP 1,50,000
b. GBP 40,839
c. GBP 37,500
d. GBP 41,323
Answer:
Lump-sum Premium = 1,50,00,000 x 1% = GBP 1,50,000
Total premium 1,50,000 1,50,000
Premium per reset period = = = = 40,839
PVAF (r, n) PVAF (3.5%, 4) 3.673
Note:
• Premium will be amortized based on the fixed rate of interest. Fixed rate of interest is 7% per
annum and the same will be 3.5% per half-year (reset period). Reset period is taken as six
months as the borrowing is at six-month LIBOR
• Option is for a period of 24 months and hence the same will have 4 reset periods of 6 months

7. Interest Rate Futures

• Interest rate futures can be used to fix the future interest rates. It is similar to normal futures
• Following issues are there in interest rate futures:
o No of contracts in decimals
o Basis risk - Difference between spot interest rate and futures interest rate on expiry date
o Mismatch on loan duration and futures settlement factor
Example:
• A company wants to borrow 100 Crores for 6-month period. Borrowing will be in December.
December 3-month futures are quoted at 94.
• December 3 month futures would mean settlement will be multiplied with (3/12)
• Futures of 94 would mean interest rate is 6% (100 - 94)
• 100 Crore x 6 months = ______________ x 3 months
• 100 Crore x 6 months = 200 Crore x 3 months
• Hence for hedging 100 crores borrowing of 6 months we will enter into 3-month futures contract
for Rs.200 Crores
Example:
Three-month futures are currently quoted at 95. How much is the interest rate indicated by the futures?
a. 95.00%
b. 5.00%
c. -5.00%
d. 20.00%
Answer:
Futures of 95 would mean interest rate of 5.00% (100 – 95)
Example:
ABC Limited wants to borrow Rs.30 lacs for a period of 5 months after 2 months. Three-month futures are
currently quoted at 93 and value of one contract is 5 lacs. How many contracts are needed for hedging?
a. Buy 6 contracts
b. Sell 6 contracts
c. Buy 10 contracts
d. Sell 10 contracts
Answer:
Borrowing 30 lacs for 5 months = Borrowing _______ lacs for 3 months
30 lacs x 5 months = 50 lacs x 3 months
ABC Limited wants to borrow and hence they should sell interest rate futures
50 lacs
No of contracts = = 10 Contracts
5 lacs
Hence, we should sell 10 contracts for hedging

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8. Steps in Interest Rate Futures
Step 1: Identify amount to be hedged:
Borrowing Period
Amount to be hedged = Loan Amount x
Futures Settlement Period

Step 2: Number of contracts to be entered:

Amount to be hedged
Number of Contracts =
Size of one contract

Step 3: Computation of Interest Income/Expense:

Particulars Calculation Amount
Actual interest earned or paid M XXX
Amount x Actual Rate x ( )
12
Net Settlement Step 4 XXX
Effective interest earned/paid XXX
Effective Interest Rate Interest Paid 12 XXX%
x x 100
Loan m

Step 4: Computation of Net Settlement:

Date Position Action Reference Date Rate
Day 0 Original Position Borrow Day 90 XX
Day 90 Opposite Position Invest Day 90 XX
Profit/Loss in % XX
M XXX
Profit (or) Loss in Rupees (No of contracts x Contract size x % x )
12
Futures settlement period:
• Futures settlement period is the most important number to compute profit/loss of futures.
• The futures settlement period pertains to the duration considered for settlement, distinct from
the contract's expiration period

Example:
• Presently in February, a 3-month futures contract for December would have an expiration 11
months away. However, in the computation for settlement (as outlined in step 4 of the table), the
relevant timeframe would be the 3-month period
Example:
ABC Limited will receive Rs.50,00,000 in two months and the same should be deposited for a period of
three months. Three-month futures are currently priced at 93 and the size of one contract is Rs.5,00,000. If
after two months, the futures are priced at 90.75 and interest rate increases to 10.5%, what would be the
effective interest income earned by ABC Limited due to adoption of this strategy?
a. Rs.1,31,250
b. Rs.1,59,375
c. Rs.1,03,125
d. Rs.5,25,000
Answer:
50,00,000
No of contracts = = 10 Contracts
5,00,000
Futures settlement:
Date Position Action Ref date Rate
7.00%
Day 0 Original Lend Day 60 [100 – 93]
-9.25%
Day 60 Opposite Borrow Day 60 [100 – 90.75]
Loss in % -2.25%
Loss in rupees (5,00,000 x 10 x 2.25% x 3/12) -28,125

Effective interest income:

Particulars Calculation Amount

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Interest income 50,00,000 x 10.5% x (3/12) 1,31,250
Loss in futures -28,125
Effective interest income 1,03,125

9. Cheapest to Deliver Bond

• Typically, futures transactions involve net settlement. However, in cases where physical
settlement is preferred, specific bonds mentioned in the contract must be delivered.
• In practical scenarios, the exact bonds specified may not be available in the market. In such
instances, the contract writer may purchase an alternative bond at its quoted market price and
provide it to the contract holder.
• To determine the value of the newly delivered bond, the holder uses a conversion factor.
• Payment made by the holder to the writer = Futures settlement price multiplied by the
conversion factor.
• Cheapest to deliver bond is the one which leads to maximum profit/minimum loss for the seller
of IRF
• Profit = [Inflow - outflow] = [Futures settlement price x Conversion factor] - Quoted price of
the bond
Example:
In March 2020, XYZ Bank sold some 7% Interest Rate Futures underlying Notional 7.50% Coupon Bonds.
6.80 GOI 2029 is an eligible security whose quoted price is 877.50 and conversion factor is 0.9195. Futures
settlement price is 1,000. How much is the profit/loss of XYZ Bank?
a. Rs.122.50 (Profit)
b. Rs.42.00 (Profit)
c. Rs.122.50 (Loss)
d. Rs.42.00 (Loss)
Answer:
We have sold 7.50% coupon bonds but are not able to deliver the same. Hence futures settlement price will
be adjusted based on conversion factor. Final inflow for XYZ Bank = 1,000 x 0.9195 = Rs.919.50. Outflow
to buy 6.80 GOI 2029 is 877.50 and hence net profit of XYZ Bank = 919.50 – 877.50 = Rs.42.00

10. Forward Rate Agreement (FRA)

• FRA is used to freeze future interest rate for borrowing/investment
• Example: Company A wants to borrow after 6 months. Borrowing period = Start of Month 7 till
Month 9. We can enter into FRA agreement to freeze the interest rate for this borrowing. This rate
is technically called as FRA 6 x 9 (End of month 6 till End of Month 9)
• Discounted Net Settlement: FRA's are net settled for the difference in contracted rate and actual
rate. FRA would be settled in Month 6 end (for above example) whereas actual loan outflow will
happen in Month 9. Hence, we are required to discount the FRA settlement amount

Month
FRA (undiscounted settlement) = (Contracted rate − Actual rate) x Notional Amount x ( )
12
Undiscounted Settlement
FRA (Discounted settlement) =
Month
1 + (AR x )
12
Steps:
Step 1: Format for Net Settlement:
Particulars Calculation Amount
Actual Rate XXX
Contracted Rate XXX
Difference XXX
Nature of settlement Pay/Receive
Amount of settlement
(Undiscounted) (Notional Amount x Difference x M/12) XXX
Undiscounted Settlement
Month
Discounted Settlement 1 + (AR x ) XXX
12

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Step 2: Effective Rate of Interest Cost:
Particulars Calculation Amount
Actual Interest Paid Amount x Actual Rate x (M/12) XXX
Discounted Net settlement Step 1 XXX
Effective interest outflow XXX
Effective Interest Outflow 12
Interest cost (%) x x 100 XXX%
Loan Amount m
Example:
ABC Limited plans to borrow Rs.50 Crores for a period of 3 months after 6 months. The Bank has quoted
FRA rate as follows:
3 x 6 FRA Rate 8.20%
3 x 9 FRA Rate 8.50%
6 x 9 FRA Rate 8.00%
6 x 12 FRA Rate 8.60%
The actual interest rate on borrowing date turns out to be 10.00%. How much would be the FRA
Settlement?
a. Rs.25,00,000 (Receipt for ABC Limited)
b. Rs.24,39,024 (Receipt for ABC Limited)
c. Rs.25,00,000 (Payment by ABC Limited)
d. Rs.24,39,024 (Payment by ABC Limited)
Answer:
The company plans to borrow for 3 months after a period of six months. Hence the borrowing period is
month 6 to month 9 and hence ABC Limited would have entered into 6X9 FRA (8.00%) for hedging. Interest
rates have increased to 10.00% and hence ABC Limited will receive FRA settlement
3
50 crores x 2% x
FRA Settlement receipt = 12 = Rs. 24,39,024
0.10
1+( )
4

11. Computation of FRA Rate

• Typically, market interest rates are quoted for immediate borrowing arrangements, known as spot
borrowing. For example, a 3-month interest rate might be quoted at 4.5% per annum, while a 6-
month interest rate could be quoted at 5% per annum.
• However, if our intention is to borrow a loan three months from now for a subsequent three-
month period, we need to ascertain the interest rate applicable from the end of month 3 to the end
of month 6. This financial arrangement is formally referred to as FRA 3 x 6
FVF for 6 months
FRA3x6 = −1
FVF for 3 months
Example:
3-month interest rate is 4.50% per annum and 6-month interest rate is 5.00% per annum. What should be
the 3 months FRA rate at 3 months forward?
a. 8.00%
b. 1.36%
c. 5.44%
d. 2.72%
Answer:
The company wants 3 months FRA rate at 3 months forward. This would technically mean 3x6 FRA
Future value factor for 6 months
3x6 FRA = −1
Future value factor for 3 months
1 + 2.50%
3x6 FRA = − 1 = 1.0136 − 1 = 1.36% per 3 months (or)𝟓. 𝟒𝟒% 𝐩𝐞𝐫 𝐚𝐧𝐧𝐮𝐦
1 + 1.125%

12. FRA and Arbitrage

• Banks typically provide bid and ask rates for FRA, a practice similar to the Forex market. For
instance, an FRA rate range of 6.50 to 6.75 implies that customers have the option to borrow from
the bank at a rate of 6.75% or deposit funds with the bank at a rate of 6.50%.
• Arbitrage is possible only in the following situations:
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o Deposit Rate > Fair FRA Rate
o Borrowing Rate < Fair FRA Rate
Arbitrage steps:
• Let us assume we are analyzing 6 x 12 FRA.
o Actual borrowing rate is lower: If actual borrowing rate is lower than fair FRA rate, then
we should borrow for first 6 months at spot borrowing, next 6 months at actual FRA rate
and invest for 12 months at spot investment rate
o Actual investment rate is higher: If actual investment rate is higher than fair FRA rate,
then we should invest for first 6 months at spot investment, next 6 months at actual FRA
rate and borrow for 12 months at spot borrowing rate
Example:
The 6-month and 12-month LIBOR is 9.60% per annum and 9% per annum. Fair FRA rate for month 6 to
12 is 8.00% per annum and actual FRA rate for month 6 to 12 is 10.50%-11.00%. How can you exploit the
arbitrage opportunity?
a. Borrow for 12 months at 9% per annum and invest for 6 months at 9.60% and balance 6
months at actual FRA rate of 11.00%
b. Borrow for 12 months at 9% per annum and invest for 6 months at 9.60% and balance 6
months at actual FRA rate of 10.50%
c. Invest for 12 months at 9% per annum and borrow for 6 months at 9.60% and balance 6
months at actual FRA rate of 11.00%
d. Invest for 12 months at 9% per annum and borrow for 6 months at 9.60% and balance 6
months at actual FRA rate of 10.50%
Answer:
Fair FRA rate is 8.00%. This would mean that arbitrage is possible if we can borrow at rate lower than
8.00% (or) invest at rate higher than 8.00%. In this case we will be able to invest at FRA rate of 10.50%.
Hence Arbitrage is possible by doing the following:
Borrow for 12 months at 9% per annum and invest for 6 months at 9.60% and balance 6 months at actual
FRA rate of 10.50%

13. Borrower/Investor Action

Particulars Interest rate futures Forward Rate agreement
Borrower Sell Buy
Investor/Lender Buy Sell
Example:
The treasurer of a company expects to receive a cash inflow of $15,000,000 in 90 days. The treasurer expects
short-term interest rates to fall during the next 90 days. What action should he take in FRA to hedge interest
rate risk?
a. Take long position in FRA
b. Take short position in FRA
Answer:
The company needs to invest money and hence they should take a short position in FRA.
Note: FRA should not be confused with IRF. In case of FRA we buy FRA if we are borrowing and sell
FRA if we are investing. On the contrary the action taken is buy IRF if we are investors and sell IRF if we
are borrowers.
Example:
You are planning to borrow Rs.100 crores after 3 months. Which of these actions can help in hedging
interest rate risk?
a. Buy interest rate futures
b. Sell Interest Rate futures
Answer:
A borrower has to sell interest rate futures whereas lender would buy interest rate futures

14. Types of Loans

• Fixed loan: Interest rates remain same for entire duration of loan - Preferable if interest rates are
likely to increase - Preferable if we don’t want to take interest rate risk

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• Floating loan: Interest rates will vary based on benchmark (LIBOR/MIBOR/MCLR) – Preferable
if interest rates are likely to decrease
Example:
ABC Limited has taken a floating rate loan. They have used interest rate swaps and converted the same
into a fixed rate loan. What is the view of ABC Limited on interest rates?
a. No view on interest rates
b. Interest rates will increase
c. Interest rates will decrease
Answer:
A company will convert a floating loan into fixed loan if they expect interest rates to increase. Conversion
of loan will ensure that they are not affected by increase in interest rates

15. Interest rate swap

• An interest rate swap can help a borrower in converting a floating loan to a fixed loan and vice
versa

Structuring of swap arrangement:

• Find the total interest of both combinations and find the ideal combination. An ideal combination
is one which has lower combined cost
• Companies opting for ideal combination: Swap is not possible and no extra calculations to be
done
• Companies opting for other combination: Swap is possible
• Swap gain = Different in total interest of combination 1 and combination 2. Swap gain would be
shared between 2 parties based on the given ratio after paying intermediary charges if any.

IRS Structuring without swap intermediary:

Particulars M Limited S Limited
1. Pay to banker as per ideal rate 8% T + 1.2%
2. S Limited to M Limited (8%) 8%
Receive from S Limited what was paid by M Limited
3. M Limited to S Limited T + 0.3% (T + 0.3%)
Pay our effective borrowing rate to the other company
4. Effective borrowing rate T + 0.3% 8.9%
• Effective borrowing rate = Original borrowing rate – share of swap gain

IRS structuring with swap intermediary:

Particulars Company 1 Company 2
1. Pay to banker as per ideal rate 8% T + 1.20%
2. Swap intermediary to Bank (8%) (T+1.20%)
(Receive what was paid to Bank)
3. Company to swap intermediary T + 0.35% 8.95%
(Pay our effective borrowing rate to intermediary)
4. Effective borrowing rate T + 0.35% 8.95%
• Effective borrowing rate = Original borrowing rate – share of swap gain
Example:
M Limited and S Limited are looking at borrowing a loan and given below is the interest rate offered to
them.
Particulars Fixed rate Floating rate Preference
M Limited 8% T+0.6% Floating
S Limited 9.2% T+1.2% Fixed
There is no swap intermediary in the transaction. Swap gains will be shared equally between two
parties. How much would be the effective borrowing rate of Madagascar Limited?
a. T + 0.60%
b. T + 0.90%
c. T + 0.30%
d. T
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Answer:
• Total interest rate of combination 1 [M limited (fixed) & S Limited (Floating)] = 8% + T + 1.2% =
T+9.2%
• Total interest rate of combination 2 [M limited (floating) & S Limited (fixed)] = T + 0.6% + 9.2% =
T+9.8%
• Ideal combination = Combination 1; This would mean that M Limited should borrow at fixed
rate and S Limited should borrow at floating rate
• Actual scenario: M Limited plans to borrow at floating rate and S Limited plans to borrow at
fixed rate
• Scope for Interest rate swap exist as the ideal and actual scenario does not match
• Swap gain = Difference in total interest of combination 1 & 2 = (T + 9.8%) – (T + 9.2%) = 0.6%
• Share of Gain for M Limited = 0.6/2 = 0.3%
• Effective borrowing rate = T + 0.6% - 0.3% = T + 0.3%
Example:
The following is the interest rates at which ABC Limited and DEF Limited can borrow in two currencies:
Company USD AUD
ABC Limited 5% 12.6%
DEF Limited 7% 13%
ABC Limited wants to borrow in AUD and DEF wants to borrow in USD. A financial institution has offered
to arrange for a currency swap with dealers margin of 0.2% and has agreed to bear exchange risk. How
much would be the effective borrowing rate of ABC Limited through IRS?
a. AUD 12.60%
b. AUD 11.90%
c. USD 5.00%
d. USD 4.30%
Answer:
Structure of interest rates:
Particulars USD AUD
ABC Limited 5% 12.6%
DEF Limited 7% 13%
• Total interest rate of combination 1 [ABC Limited (USD) & DEF Limited (AUD)] = 5% + 13% =
18%
• Total interest rate of combination 2 [ABC Limited (AUD) & DEF Limited (USD)] = 12.6% + 7% =
19.6%
• Ideal combination: Combination 1 – ABC Limited should borrow in USD and DEF Limited
should borrow in AUD
• Actual scenario: Combination 2 – ABC Limited wants to borrow in AUD and DEF Limited
wants to borrow in USD
• Scope for Currency cum interest rate swap exist as the actual scenario does not match with ideal
scenario
• Amount of swap gain = 19.6% - 18% = 1.6%
• Share of swap gain:
o Dealer’s margin (Share) = 0.2%
o ABC Limited’s share = 0.7%
o DEF Limited’s share = 0.7%
• Effective borrowing rate of ABC Limited = Original rate – share of swap gain = 12.60% - 0.70% =
11.90%

16. Hardening and Softening of interest rates

• If interest rates are expected to harden, then it would mean interest rates will go up and we will
go for fixed rate funding. If interest rates are expected to soften, then it would mean interest rates
will come down and we will go for floating rate funding

17. Expectation Theory

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• Expectation theory holds good would mean computation of forward rates with the help of interest
rates of different maturities. We can use FRA formula to compute forward rates

18. Locked in spread with IRS

• A company might have a fixed income liability paired with a floating income asset, or vice versa,
exposing them to interest rate risk. To mitigate this risk, they can employ interest rate swaps
• Through this mechanism, both the asset and liability can be transformed into either fixed or
floating, providing a means to effectively lock in the overall spread and manage interest rate
fluctuations
Example:
Firm A has invested Rs.100 million in fixed rate bonds yielding 8.5 percent. Firm A has raised its loan for
funding its assets through floating rate loan from bank at an interest rate of LIBOR + 0.50%. There is a big
bank which offers interest rate swap. It has quoted rate of 6.40%-6.50% against LIBOR. How much would
be the locked in spread of Firm A if it enters into interest rate swap?
a. 1.50%
b. 1.60%
c. 2.10%
d. 2.00%
Answer:
Particulars Amount
Investment rate 8.5%
Borrowing Rate (LIBOR + 0.50%)
Firm to Big Bank (6.5%)
Big Bank to Firm LIBOR
Locked in spread 1.50%
The company can lock in spread by receiving LIBOR from Big Bank. This will help them in offsetting the
floating LIBOR being paid by them. Big Bank will pay LIBOR to Firm A and against higher rate of 6.50%
from Firm A.

19. Fixed Payment vs Floating Payment

• Fixed payment would be same for every reset period whereas interest under floating rate would
be computed using the below formula:
𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝐝𝐚𝐲𝐬
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐮𝐧𝐝𝐞𝐫 𝐅𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐥𝐞𝐠 = 𝐍𝐨𝐭𝐢𝐨𝐧𝐚𝐥 𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 𝐱 𝐅𝐥𝐨𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐞 𝐱
𝟑𝟔𝟎 𝐨𝐫 𝟑𝟔𝟓
• If the Generic swap is valued on 30/360 days basis then the denominator for computation of
interest would be 360 days
• Fixed Payment vs Floating Payment: Fixed rate of interest is computed on original principal
whereas floating rate of interest can have an element of interest on interest. This is because in
case of change in interest rate we will be computing the interest amount on opening principal
which is equal to notional principal + Interest charged.
Example:
Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six months LIBOR flat. If the notional
principal amount of swap is Rs.50,00,000. The six-month period from the effective date of swap to the
settlement date comprise of 181 days and that the corresponding LIBOR was 6% on the effective date of
swap. Generic swap is valued based on 30/360 days basis. How much is the semi-annual fixed payment
and floating payment?
a. Rs.4,00,000 and 3,00,000
b. Rs.3,00,000 and 1,50,000
c. Rs.2,00,000 and 1,50,833
d. Rs.1,50,000 and 3,01,666
Answer:
1
Semi − annual fixed payment = 50,00,000 x 8% x ( ) = 2,00,000
2
181
Floating payment = 50,00,000 x 6% x ( ) = 1,50,833
360

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20. IRS for a hybrid bond
• A hybrid bond combines fixed interest payments for a certain period with floating interest
payments for another period.
• In some cases, an investor or borrower may desire to convert the entire bond into a fully fixed-
rate or fully floating-rate bond for the entire duration.
• To achieve this, the process involves initially categorizing all years of interest rates as either fixed
or floating based on the relevant data
• Subsequently, a swap is applied for each year, facilitating the conversion of the bond's terms
in accordance with the desired fixed or floating structure.

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Chapter 13 – Business Valuation

Overview:
• Economic Value Added
• Market Value Added
• Valuation of strategy
• Cash flow based valuation
• Relative valuation
• Break-up approach of valuation
• FMP valuation
• Net assets and earnings capitalization
• Internal reconstruction
• WACC and Valuation
• Distress company valuation
• Start-up company valuation

1. Economic Value Added

• Economic Value Added (EVA), serves as a key metric for evaluating a company's financial
performance. It gauges the company's ability to generate wealth beyond the cost of its capital by
taking into account its operating profit after adjusting for taxes.
• Often referred to as economic profit, EVA strives to provide a comprehensive view of a company's
genuine economic success.
• The primary objective of EVA is to evaluate both the company's overall performance and the
effectiveness of its management. It underscores the notion that a business can be deemed truly
profitable only when it consistently generates returns that surpass the cost of capital, thereby
creating value for its shareholders.
• Formula: Economic Value Added = {EBIT x (1-Tax rate)} – {Invested capital x WACC} [OR]
NOPAT – {Invested capital x WACC}

Important note:
• Capital Employed = Long-term money = Debt + Equity + Preference; Equity = Share capital
+Reserves – Fictitious Assets [OR]
• Capital Employed = Total Assets – Current Liabilities
• Capital employed should be based on economic value of assets. This would mean that we can go
ahead and do revaluation of assets/liability. This can also be called as capital employed on
replacement cost basis
Example:
EBIT = Rs.25,00,000; Tax Rate = 40%; Invested Capital = Rs.50 lacs; WACC = 12%; How much is the
Economic Value Added?
a. Rs.19,00,000
b. Rs.9,00,000
c. Rs.11,40,000
d. Rs.6,00,000
Answer:
• EVA = [EBIT x (1 – Tax Rate)] – [Invested capital x WACC]
• EVA = [25,00,000 x (1 – 0.40)] – [50,00,000 x 12%] = Rs.9,00,000
Example:
Fragrance Ltd. has reported a Net Operating Profit after Tax (NOPAT) to Capital Employed as 2.5% plus
Weighted Average Cost of Capital (WACC) for the year 31st March 2021. Economic Value added is Rs. 4
crore as on 31st March 2021. How much is the NOPAT if WACC is 7.5%?
a. Rs.12 crores
b. Rs.8 crores
c. Rs.16 crores
d. Rs.40 crores
Answer:
4 crores
EVA = 2.5% of capital employed; 4 crores = 2.5% of CE; CE = = 160 crores
2.50%
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WACC = 7.50%; Hence NOPAT = 10% of CE = 10% x 160 crores = 16 Crores
Example:
Book value of assets = 2,000 lacs; Replacement cost of assets = 6,000 lacs. What is capital employed for the
purpose of EVA computation?
a. 6,000 lacs
b. 2,000 lacs
c. 4,000 lacs
Answer:
Capital employed has to be on the basis of economic value of assets and the same would be equal to
replacement cost of assets of 6,000 lacs
Example:
Value of EBIT = 2,000 lacs; Tax Rate = 40%; Capital employed = 8,000 lacs; WACC = 10%.; How much is
EVA?
a. 2000 lacs
b. 800 lacs
c. 400 lacs
d. 1200 lacs
Answer:
EVA = (EBIT x (1 - Tax Rate)) - (Capital employed x WACC)
EVA = [2,000 x 60%] - [8,000 x 10%] = Rs.400 lacs

2. EVA Adjustments
Item Impact on EBIT (Profit) Impact on Capital Employed
Advertising, Research and Increase current year profit and Increase capital employed for
Development expenses, Staff deduct economic depreciation the amount added back net of
Training on these items economic depreciation
Depreciation Add accounting depreciation Adjust capital employed by
and deduct economic adding back cumulative
depreciation accounting depreciation and
deduct cumulative economic
depreciation
Non-cash expenses Add back to Profit Add cumulative non-cash
expenses to capital employed
Tax Charge We need to add-back provision -
for tax debited in P&L and
deduct only cash taxes
Example:
The company reported EBIT of 2,000 lacs. The same has been after writing off training expense of 500 lacs.
The benefit of training will be there for five years. What is the adjusted EBIT for computing EVA?
a. 2000 lacs
b. 2500 lacs
c. 2400 lacs
d. 1900 lacs
Answer:
Adjusted EBIT = 2,000 lacs + 500 lacs (Training added back as the same is an asset) - 100 (economic
depreciation as the life is 5 years) = 2,400 lacs

3. Format for computation of WACC

Source Cost Weight Product
Debt 10% 200 20
Equity 15% 400 60
Total 600 80
Sum of Product 80
WACC = = 𝑥 100 = 13.33%
Sum of weights 600

Note:

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• Cost of debt is to be taken as post-tax cost of debt. The same can be computed as Interest rate x (1
– Tax Rate). Alternatively, it can be computed using below formula:
Interest x (1 − Tax)
Kd = x 100
Value of debt

Assumption on cost of debt:

• Cost of debt given in question can be taken as pre-tax (or) post-tax depending on assumption if
clarity is not there in question.
• We should do one check before making assumption. We need to compute (Interest/Debt) and
compare the same with the cost of debt given in question. If the computed number is close to
cost of debt given in question, it would be assumed that the given number is pre-tax cost of
debt.
Example:
Pre-tax cost of debt = 12%; Cost of equity = 16%; Debt/assets ratio = 0.4 Times. Compute WACC if tax rate
is 25%?
a. 14.40 percent
b. 13.20 percent
c. 14.86 percent
d. 14 percent
Answer:
Cost of debt = 12 x (1 - 25%) = 9%; Cost of equity = 16%
WACC = [9% x 40%] + [16% x 60%] = 13.20%
Example:
Pre-tax cost of debt = 12%; Cost of equity = 16%; Debt/equity ratio = 0.4 Times. Compute WACC if tax
rate is 25%?
a. 14.40 percent
b. 13.20 percent
c. 14 percent
d. 14.86 percent
Answer:
Cost of debt = 9 percent; Cost of equity = 16 percent
[9 x 0.4] + [16 x 1]
WACC = = 14 percent
0.4 + 1
Example:
The company has equity share capital of Rs.100 lacs. It has debt of Rs.200 lacs. The company has patent of
Rs.100 which is not recorded in books. Cost of debt after tax is 8% and cost of equity is 14%. how much is
WACC?
a. 11%
b. 14%
c. 10%
d. 8%
Answer:
The company has equity capital of Rs.100 lacs. Value of equity will go up by Rs.100 lacs as the patent hasn't
been recorded in books and hence revised equity value is Rs.200 lacs. The company has debt of Rs.200 lacs
8% x 200 + 14% x 200
WACC = = 11%
200 + 200

4. Operating Income vs Net Income

• Operating income would mean EBIT and Net income would mean PAT

5. EVA Dividend
• EVA is excess generation and same can be paid to equity shareholders without any impact on
company valuation
• If the company does not pay EVA dividend, then value will go up by the amount of EVA
Total EVA
EVA Dividend per share =
Number of equity shares
Example:

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The company has reported EVA of Rs.20,00,000 and has 5,00,000 equity shares. How much the company
can declare as dividend per share before the value of the company would start to decrease?
a. Company cannot declare any extra dividend
b. Rs.2 per share
c. Rs.8 per share
d. Rs.4 per share
Answer:
EVA amount can be declared as dividend without any impact on the valuation of the company
20,00,000
EVA Dividend = = Rs. 4 per share
5,00,000 shares

6. Computation of EBIT using Financial Leverage

EBIT
Financial Leverage =
Preference Dividend
EBT − ( )
1 − Tax
Example:
Financial Leverage = 3 Times; The company has 11% debentures of Rs.400 lacs. How much is the EBIT of
the company?
a. 44 lacs
b. 132 lacs
c. 66 lacs
d. 88 lacs
Answer:
EBIT
Financial leverage =
EBT
EBIT is taken as X; Interest = 400 x 11% = 44 lacs; EBT = X - 44 lacs
X
3 Times = ; 3X − 132 = X; 2X = 132; X = 66 lacs. Hence EBIT is equal to 66 lacs
X − 44

7. Tax Adjustment on EVA computation

• We should deduct cash taxes actually paid while computing NOPAT. However, cash taxes are on
the lower side due to tax benefit on interest
• NOPAT does not deduct interest and hence tax saving on interest should not be considered.
Hence, we should deduct tax saving lost on interest while computing NOPAT
• Approach 1: NOPAT = EBIT x (1 – Tax Rate)
• Approach 2: NOPAT = EBIT – Cash taxes – Tax saving lost on interest
• Approach 3: NOPAT = PAT + Interest net of taxes
Note:
• Any other adjustments having no tax impact shall be added after computing NOPAT

8. PE Multiple Adjustment based on risk

The Price-to-Earnings (PE) Multiple for companies within the same industry is typically expected to align
closely with the industry's average PE Multiple. However, adjustments to the PE Multiple can be made
to account for the varying levels of risk associated with individual companies. Companies with higher
risk profiles tend to exhibit lower PE Multiples, while those with lower risk profiles may command higher
PE Multiples.
Example:
Company A has Debt/Assets ratio of 0.80 Times whereas company B has Debt/Assets ratio of 0.20 Times.
Both companies are identical except for capital structure. Industry PE Multiple is 15 Times. What should
be the likely PE Multiple of Company A and Company P?
e. Both companies can have same PE Multiple
f. PE Multiple of A Limited will be higher than PE Multiple of B Limited
g. PE Multiple of B Limited will be higher than PE Multiple of A Limited
Answer:
Company A carries more risk as reflected in higher debt. Company B carries less risk and hence PE
Multiple of B Limited will be higher than PE Multiple of A Limited

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9. Valuation of firm on basis of EVA
• EVA represent excess earning of the company and hence the same would increase the value of
firm
• Value of firm = Present invested capital + Present value of future EVA
Example:
Current invested capital = Rs.80,00,000. Present value of future EVA = Rs.1,20,00,000. What is the value of
the firm?
a. 80 lacs
b. 120 lacs
c. 200 lacs
d. 40 lacs
Answer:
Value of firm = Invested capital + Present value of future EVA = 80 lacs + 120 lacs = 200 lacs

10. Market Value Added

• Market Value Added = Market Value of Firm – Book Value of Firm
• Market value of Firm = Market value of equity + Market value of Debt + Market value of
Preference
• Book value of firm = Book value of equity (SC + Reserves – Fictitious assets) + Book value of debt
+ Book value of preference
Example:
Market value of equity = 10,000 lacs; Book value of equity = 4,000 lacs; Book value of debt = 2,000 lacs.
How much is market value added?
a. 4,000 lacs
b. 6,000 lacs
c. 2,000 lacs
d. 16,000 lacs
Answer:
• Market value added = Market value of firm - Book value of firm
• Market value of firm = Market value of equity (1,000 lacs) + Market value of debt (2,000 lacs) =
12,000 lacs
• Book value of firm = Book value of equity (4,000 lacs) + Book value of debt (2,000 lacs) = 6,000
lacs
• Market value added = 12,000 lacs - 6,000 lacs = Rs.6,000 lacs
Example:
Equity share capital = Rs.10,00,000 (1,00,000 shares of Rs.10); Reserves and surplus = Rs.40,00,000; Share is
quoted in the market at Rs.80. How much is market value added?
a. 70,00,000
b. 30,00,000
c. 1,30,00,000
d. 40,00,000
Answer:
Book value of firm = 10,00,000 + 40,00,000 = Rs.50,00,000
Market value of firm = 1,00,000 shares x 80 = Rs.80,00,000
Market value added = 80,00,000 - 50,00,000 = Rs.30,00,000
Example:
Book value of equity capital = 200 lacs; Reserves and surplus = 400 lacs; Amount of debt = 150 lacs. Face
value of each share is Rs.10 and MPS is Rs.50. How much is market value added?
a. 750 lacs
b. 400 lacs
c. 800 lacs
d. 650 lacs
Answer:
• Market value added = Market value of firm - Book value of firm
• Market value of firm = (200/10 x 50) + 150 = 1,150 lacs
• Book value of firm = 200 + 400 + 150 = 750 lacs

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• Market value added = 1,150 lacs - 750 lacs = 400 lacs

11. Cash flow-based approach of valuation

• Free Cash flow to Firm: FCFF represents the cash flow that a firm generates from its operations
that is available to all of its capital providers, including both equity and debt holders.
• Free Cash flow to equity shareholders: FCFE represents the cash flow that is available to the
equity shareholders of a company after covering operating expenses, taxes, interest on debt,
repayment of loans and reinvestment needs, such as capital expenditures and working capital
change
Different Approach:
Type of Cash flow Discount Rate Resulting Useful for
Value
Free Cash flow to Firm (FCFF) WACC Value of Firm Equity shareholders and Debt
Holders
Free Cash flow to Equity Cost of Equity Value of Equity Equity Shareholders
(FCFE)
Preferred approach: We should always adopt FCFF approach for valuation of firm. Post valuation of firm,
value of equity is computed as Value of Firm – Amount of debt
Formulae for computation of FCFF and FCFE:
FCFF Computation:
From Net Income Net Income + Non-cash charges + Interest x (1 – Tax rate) – Fixed capital
investment – working capital investment
From EBIT EBIT x (1 – Tax rate) + Non-cash charges – Fixed capital investment –
working capital investment
From EBITDA EBITDA x (1 – Tax rate) + (Depreciation x Tax rate) – Fixed capital
investment – working capital investment
From cash flow from CFO + Interest x (1 – Tax rate) – Fixed capital investment
operations (CFO)
FCFE Computation:
From FCFF FCFF – Interest x (1- Tax rate) + Net borrowing
From Net Net Income + Non-cash charges – Fixed capital investment – working capital
Income investment + Net borrowing
From CFO CFO – Fixed capital investment + Net borrowing
Example:
EBIT of Year 1 = 200 lacs; Interest of Year 1 = 40 lacs; Tax rate = 30%; Depreciation of year 1 = 20 lacs;
Capital expenditure of year 1 is 40 lacs and year 2 is 50 lacs; Decrease in working capital in year 1 is 20
lacs. Capital expenditure is incurred at the start of the year. How much is the FCFF of year 1?
a. 140 lacs
b. 130 lacs
c. 90 lacs
d. 100 lacs
Answer:
Computation of FCFF:
Particulars Amount (in lacs)
EBIT/EBT 200.00
Less: Tax @ 30% -60.00
EAT 140.00
Add: Depreciation 20.00
Less: Capital expenditure -50.00
(Beginning of year 2 is end of year 1)
Add: Decrease in working capital 20.00
FCFF 130.00
Example:
A Limited plans to acquire B Limited. Both are into same industry. B Limited earned a profit of Rs.13,00,000
in last year and had depreciation of Rs.6,00,000. B Limited is no longer required to maintain its own
production facilities and hence it can be assumed that only a minimal amount of cash will have to be

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reinvested to keep its equipment current and for future growth. This amount is estimated at Rs. 1,00,000
per year. The acquisition has synergy gain (post-tax) of Rs.6,00,000. Determine the annual cash flow
expected by A Limited from B Limited if the acquisition is made
a. Rs.19,00,000
b. Rs.18,00,000
c. Rs.25,00,000
d. Rs.24,00,000
Answer:
Particulars Amount
Profit after tax 13,00,000
Add: Depreciation 6,00,000
Add: Synergy gain 6,00,000
Less: Capital expenditure (1,00,000)
Annual cash flow 24,00,000
Example:
EPS = Rs.10 per share; Capital expenditure = Rs.5 per share; Depreciation = Rs.4 per share; Working capital
= Rs.4 per share. Debt ratio = 30%. How much is FCFF per share?
a. 10 per share
b. 5 per share
c. 7.2 per share
d. 8 per share
Answer:
FCFF = EPS + Depreciation - Capital expenditure - Working capital
FCFF = 10 + 4 - 5 - 4 = 5 per share
Example:
PAT = 10,000 lacs; Interest paid = 4,000 lacs; Tax rate = 40%; Capital expenditure is offset by depreciation
and there is no change in working capital. Debt repayment = 2,000 lacs. How much is FCFE?
a. 8,000 lacs
b. 10,000 lacs
c. 12,400 lacs
d. 10,400 lacs
Answer:
FCFE = PAT + Depreciation - Capex - working capital - repayment of loan
FCFE = 10,000 + 0 - 0 - 0 - 2,000 = 8,000 lacs
Example:
Earning after tax = Rs.600 lacs; One-time incomes after tax = Rs.200 lacs; One-time expenses = Rs.100 lacs;
Depreciation = Rs.50 lacs. How much is the free cash flow for valuation under cash flow-based approach
of valuation?
a. Rs.650 lacs
b. Rs.450 lacs
c. Rs.550 lacs
d. Rs.750 lacs
Answer:
Free cash flow needs to adjusted for one-off items which are not likely to recur in future
Free cash flow = 600 lacs – 200 lacs + 100 lacs + 50 lacs = Rs.550 lacs

12. Gross Capex and Net Capex

• Gross Capex = Capital expenditure done by the company which is reflected as Additions in fixed
assets schedule
• Net capex = Increase in net fixed assets wherein gross capex is adjusted for depreciation
• For cash flow computation we can directly deduct net capex (or) we can deduct gross capex and
add back depreciation
Example:
Opening fixed assets = 10,000 lacs. Revenues will increase by 20 percent and fixed asset turnover ratio is
maintained. The depreciation is 10% of opening WDV. How much is the gross capital expenditure of the
year?
a. 2,000 lacs

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b. 1,000 lacs
c. 3,000 lacs
Answer:
Fixed asset turnover ratio is maintained and hence if revenues go up by 20 percent, then fixed assets will
also increase by 20 percent; Closing fixed assets = 10,000 lacs + 20% = 12,000 lacs; Gross capex = 12,000 lacs
- 9,000 lacs (opening WDV - Depreciation) = 3,000 lacs

13. Working capital

• Increase in working capital is an outflow and decrease in working capital is an inflow
• We need to be cautious in computation of change in working capital in case there is a change in
growth rate.
Example:
Revenues of the company = 4,000 lacs. Working capital is 25 percent of revenues. Revenues will increase
by 20 percent for 2 years and thereafter by 10 percent from third year. What is the change in working
capital for year 3?
a. 200 lacs
b. 144 lacs
c. 264 lacs
d. 120 lacs
Answer:
• Revenues of year 1, 2 and 3 = Rs.4800, Rs.5760 and Rs.6336 lacs.
• Working capital of year 1, 2 and 3 =Rs.1200, Rs.1440 and Rs.1584 lacs [25% of revenues];
• Increase in working capital of year 3 = 1584 lacs - 1440 lacs = 144 lacs

14. Relative Approach of Valuation

• Relative Valuation is a method employed to determine the value of a company by conducting a
comparative analysis against its peers or similar entities
• Relative valuation, often referred to as "Valuation by multiples," relies on financial ratios to
calculate a specific metric, known as the "multiple." This multiple is taken as average of multiples
of proxy entities
Example:
What should be the value of C Limited based on Market to sales approach? Company A - Market value =
400; Sales = 500; Company B - Market value = 450; sales = 600; Sales of Company C = 800
a. 620
b. 640
c. 600
d. 680
Answer:
400
Market value to sales ratio for Company A = = 0.80 Times
500
450
Market value to sales ratio for company B = = 0.75 Times
600
0.80 and 0.75
Market value to sales ratio for company C = = 0.775 Times
2
Market value of company C = 800 x 0.775 = 620

15. Break-up Value Approach

• Value the firm using different capitalization basis given in question. Possible capitalization basis
are sales, assets and operating income
• Final value of firm = Average value of firm using multiple basis
Example:
Reliance Limited has three Divisions. Division A is to be valued based on capitalization/sales, Division B
is to be valued based on capitalization/EBITDA and Division C is to be valued based on
capitalization/operating income. Data of three division is as under:
Particulars Division A Division B Division C

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Sales 4,00,000 5,00,000 6,00,000
EBITDA 2,00,000 1,50,000 3,00,000
Operating income 1,00,000 1,20,000 2,00,000
Capitalization/sales multiple for industry is 10 times, Capitalization/EBITDA multiple for industry is 20
times and capitalization/operating income for industry is 25 times. How much is the fair value of Reliance
Limited?
a. 1,50,00,000
b. 1,10,00,000
c. 1,20,00,000
d. 92,50,000
Answer:
Particulars Division A Division B Division C
Sales/EBITDA/OI 4,00,000 1,50,000 2,00,000
Relevant multiple 10.00 20.00 25.00
Value of Division 40,00,000 30,00,000 50,00,000
Value of Reliance Limited = 40,00,000 + 30,00,000 + 50,00,000 = Rs.1,20,00,000

16. Future Maintainable Profits approach of valuation

• FMP = Profit adjusted for extraordinary incomes/expenses and profit/loss from new product
Computation of FMP:
Particulars Calculation Amount
Existing PBT XXX
Less: Extra-ordinary income (XXX)
Add: Extra-ordinary expenses XXX
Profit from new product XXX
Future Maintainable PBT XXX
Less: Tax (XXX)
Future Maintainable PAT XXX
• Value of business is computed using below formula:
Future maintainable PAT
Value of business =
Capitalization factor
• Value of share based on PE Multiple approach with future maintainable PAT:
Particulars Calculation Amount (in lacs)
Future maintainable PAT 98
Less: Preference dividend 1,00,000 x 13 (13)
Earnings available to equity shareholders 85
No of shares 50
EPS 1.7
P/E Multiple 10
Market price per equity share 17
Example:
Eagle Limited reported a profit of Rs.77 lacs after 30% tax for the financial year 2011-12. An analysis of the
accounts revealed that the income included extraordinary items of Rs.8 lacs and an extraordinary loss of
Rs.10 lacs. New product will lead to profit of Rs.28 lacs. How much is the future maintainable PAT?
a. Rs.140 lacs
b. Rs.98 lacs
c. Rs.107 lacs
d. Rs.136 lacs
Answer:
Particulars Calculation Amount (in lacs)
Existing PAT 77
Existing PBT 77 lacs/(1-0.3) 110
Less: Extraordinary income (8)
Add: Extraordinary loss 10
Profit from new product 70 – 20 – 12 – 10 28
Future maintainable PBT 140

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Future maintainable PAT 140 x 70% 98
Example:
Existing PAT of company = 10,00,000; Tax rate = 50%; Extraordinary income included in profit
computation = 5,00,000; Profit of new product = 20,00,000; How much is the future maintainable profit
after tax?
a. 20,00,000
b. 22,50,000
c. 17,50,000
d. 15,00,000
Answer:
10,00,000
Existing PBT = = 20,00,000
50%
Extraordinary income will not continue and hence the same is removed. Revised PBT is Rs.15,00,000. New
product will make profits of Rs.20,00,000 and hence FMP (before tax) is Rs.35,00,000. Future maintainable
profit (after tax) = Rs.17,50,000

17. Net Assets and Earnings capitalization method

Realizable value of assets − Settlement value of liabilities
Value as per net assets method =
Number of shares

FMP
( )
Capitalization
Value as per earnings capitalization method =
Number of shares
Capitalization rate will be given in question. If problem is silent, the same can be computed as under
EPS
Capitalization rate =
Share Price
Note:
• Contingent liabilities: We will have to assume whether these will crystallize or not and consider
the same in net assets method of valuation
Example:
Total Assets of the company = Rs.25,00,000; P&L debit balance (part of total assets) = Rs.5,00,000; Sundry
creditors = Rs.2,00,000; Short-term debt = Rs.1,00,000; Long-term debt = Rs.2,00,000; Preference capital =
Rs.4,00,000; No of equity shares = 1,00,000. How much is the net asset value per share?
a. Rs.16.00
b. Rs.11.00
c. Rs.15.00
d. Rs.20.00
Answer:
• Networth = Total assets – Fictitious assets – Sundry creditors – Short-term debt – long-term debt
– Preference capital
• Networth = 25,00,000 – 5,00,000 – 2,00,000 – 1,00,000 – 2,00,000 – 4,00,000 = Rs.11,00,000
Networth 11,00,000
Net asset value per share = = = Rs. 11.00 per share
Number of shares 1,00,000
Example:
H Limited has total assets of Rs.1,000 Crores. It has preference capital of Rs.100 crores, Long-term debt of
Rs.200 crores and current liabilities of Rs.300 crores. Contingent liability of Rs.200 crores is likely to
crystallize to the extent of 25%. Land is 20% of total assets and its current value is 4 times of book value.
How much is the value of equity as per net assets method?
a. Rs.400 crores
b. Rs.350 crores
c. Rs.950 Crores
d. Rs.1,000 Crores
Answer:
Particulars Calculation Amount
Land (20% of assets) 200 x 4 800.00
Other assets (80%) 800.00
Less: Preference capital -100.00

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Less: Long-term debt -200.00
Less: Current liabilities -300.00
Less: Contingent liability 200 x 25% -50.00
Value of equity as per net assets method 950.00
Example:
A company has total assets of Rs.20,00,000 and outside liabilities of Rs.4,00,000. Assets have realizable
value equivalent to 80% of the book value and there will also be liquidation expenses of Rs.1,00,000. How
much is the net realizable value per share?
a. Rs.16.00 per share
b. Rs.15.00 per share
c. Rs.12.00 per share
d. Rs.11.00 per share
Answer:
Realizable value of assets − liquidation expenses − liabilities
Value per share =
Number of shares
16,00,000 − 1,00,000 − 4,00,000
Value per share = = 11.00 per share
1,00,000
Example:
ABC Limited has automobile division whose value of business is Rs.1,000 Crores. It has liabilities of Rs.500
Crores. The settlement value of liabilities is 20% more than book value. The company plans to sell this
division and has received a quote of Rs.450 Crores to acquire the division. The buyer of the division will
take over all liabilities. What should be the decision of ABC Limited?
a. It can sell automobile division
b. It should not sell automobile division
Answer:
Value of equity of automobile division = 1,000 crores – 600 crores = Rs.400 crores. The company is receiving
consideration of Rs.450 crores and hence ABC Limited can go ahead with automobile division.
Example:
Compute the value of company under capitalization of earning method using the following information:
EPS = Rs.10.00 per share; Share price = Rs.100 per share; Expected annual maintainable profit =
Rs.20,00,000
a. Rs.2,00,000
b. Rs.2,00,00,000
c. Rs.20,00,000
d. Rs.20,00,00,000
Answer:
EPS 10
Capitalization rate = = = 10.00%
Share price 100
Expected Annual Maintainable Profit 20,00,000
Value of business = = = 𝟐, 𝟎𝟎, 𝟎𝟎, 𝟎𝟎𝟎
Capitalization rate 10%
Example:
T Ltd. Recently made a profit of Rs. 50 crore and paid out Rs. 40 crore (slightly higher than the average
paid in the industry to which it pertains). The average PE ratio of this industry is 9. As per Balance Sheet
of T Ltd., the shareholder’s fund is Rs. 225 crore and number of shares is 10 crore. In case company is
liquidated, building would fetch Rs. 100 crore more than book value and stock would realize Rs. 25 crore
less. What would be the value of company as per Net realizable value method?
a. Rs.225 Crores
b. Rs.350 Crores
c. Rs.325 Crores
d. Rs.300 Crores
Answer:
Net realizable value = Rs.225 Crores + 100 Crores – 25 Crores = Rs.300 Crores

18. Net Cash Flow and Book value Approach with Floor Value
Residual Net Cash flow
Value as per net cash flow approach =
K e − Growth
Value as per book value approach = Equity capital + Reserves and Surplus

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Minimum and maximum price:

• Minimum price per share = Lower of value as per above two approaches
• Maximum Price is computed using below formula:
Value of merged firm − Value before merger
Maximum Price =
No of shares of target company
• Floor value = CMP per share of target company
Example:
R Limited and S Limited are operating in same industry. S Limited is planning to acquire R Limited. How
much should be the maximum consideration payable?
Particulars R Limited S Limited Combined Entity
Profit after tax 86,50,000 49,72,000 1,21,85,000
Residual net cash flows per year 90,10,000 54,87,000 1,85,00,000
Required return on equity 13.75% 13.05% 12.50%
a. Rs.14.80 crores
b. Rs.10.60 crores
c. Rs.8.25 crores
d. Rs.6.55 crores
Answer:
Particulars R Limited S Limited Combined entity
Residual net cash flow 90,10,000 54,87,000 1,85,00,000
Cost of equity 13.75% 13.05% 12.50%
Growth rate 0% 0% 0%
𝐍𝐞𝐭 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 6.55 cr 4.20 cr 14.80 cr
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 [ ]
𝐊𝐞 − 𝑮
Consideration payable = Post-merger value of merged firm – Pre-merger value of S Limited
Consideration payable = 14.80 crores – 4.20 crores = Rs.10.60 Crores

19. Internal Reconstruction

Step 1: Computation of capital reserve:
• Capital reserve = Items increasing Networth – Items reducing Networth

Step 2: Prepare Balance Sheet giving effect to changes in various assets and liabilities

20. Wrong WACC and Valuation

• Compute wrong WACC by using value of firm and free cash flow
• Find wrong weights used with WACC format
• Find correct weights and get correct WACC
• Get right value of firm with correct WACC and Free cash flow to firm
Example:
The cost of equity is 20 percent and cost of debt is 10 percent. WACC based on book value weights is 12
percent. The value of equity is thrice its book value, whereas the market value of its debt is nine-tenths of
its book value. What is WACC based on market value weights?
a. 12 percent
b. 15 percent
c. 14.55 percent
d. 16 percent
Answer:
Identification of book value weights:
Source cost Weight Product
Equity 20 X 20X
Debt 10 1-X 10-10X
Total 12 1 20X+10-10X = 12
20X + 10 − 10X = 12; 10X = 2; X = 0.2 Times
• Hence the weight of equity is 20% and weight of debt is 80%

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Computation of WACC with market value weights:

• Weight of equity = 0.20 x 3 = 0.60 Times
• Weight of debt = 0.80 x (9/10) = 0.72 Times

Source cost Weight Product

Equity 20 0.60 12.00
Debt 10 0.72 7.20
Total 1.32 19.20
19.20
WACC = = 14.55%
1.32

21. Computation of per share earning value [Not a logical item]

EBITDA
Earning value of company =
Capitalization rate
Earning value of company
Per share earning value =
No of equity shares
Example:
A Limited made a gross profit of Rs.10,00,000 and incurred indirect expenses of Rs.4,00,000. The number
of issued equity shares is 1,00,000. The company has a debt of Rs.3,00,000 and Reserves to the tune of
Rs.5,00,000. Capitalization rate is 11.25%. Compute the per share earning value of company?
a. Rs.53.33 per share
b. Rs.50.33 per share
c. Rs.55.33 per share
d. Rs.6.00 per share
Answer:
Particulars Amount
Gross profit 10,00,000
Less: Indirect expenses -4,00,000
EBITDA 6,00,000
Earning value of company (6,00,000/11.25%) 53,33,333
Number of shares 1,00,000
Earning value per share 53.33

22. Initial outflow on Acquisition [Cost of Acquisition]

• Cost of acquisition would include consideration given in cash or other than cash such as shares,
debentures issued
Particulars Amount
Market Value of Equity Shares issued XXX
Add: Debentures, Preference capital issued XXX
Add: Loan taken-over or repaid XXX
Add: Other liabilities repaid or taken over XXX
Less: Realizable value of current assets (XXX)
Less: Cash (XXX)
Initial outflow XXX
Example:
A Limited has acquired business of B Limited. It has issued 40,000 equity shares at Rs.20 each. It has issued
12% debentures of Rs.4,00,000 to debenture holders. It has made payment of Rs.6,00,000 to creditors. How
much is the initial outflow for the purpose of computing merger NPV?
a. 8,00,000
b. 6,00,000
c. 12,00,000
d. 18,00,000
Answer:
Initial outflow = Share issued + debentures issued + cash paid = 8,00,000 + 4,00,000 + 6,00,000 =
Rs.18,00,000

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23. Funding required for growth

• Typically, an organization seeks additional funding to accommodate growth. This is because as
revenue increases, there is a corresponding rise in fixed assets and working capital.
• Funding required = Increase in capital employed
• Capital employed = Total Assets – Current Liabilities (or) Fixed Assets + Working Capital
Example:
Total assets = 4,000 lacs; Current liabilities = 1,000 lacs; Revenues of the company will grow at 20 percent.
How much would be the overall funding requirement to finance growth?
a. 800 lacs
b. 1,000 lacs
c. 600 lacs
d. 1,200 lacs
Answer:
Revenue increased by 20 percent and hence company will need additional assets to fund growth. Capital
employed of company will increase by 20 percent to fund this growth. Capital employed = 4,000 lacs -
1,000 lacs = 3,000 lacs; Fund required = Increase in capital employed = 3,000 lacs x 20% = Rs.600 lacs

24. Intrinsic value of Equity (Using SVA Approach)

Intrinsic value of equity = Intrinsic value of Firm + Market value of non-core assets – Value of debt
Example:
Value of firm arrived by discounting cash flows of core operations = Rs.1,000 lacs; Value of debt = Rs.200
lacs; Market value of non-core assets = Rs.100 lacs. How much is the intrinsic value of equity?
a. Rs.900 lacs
b. Rs.700 lacs
c. Rs.800 lacs
d. Rs.1,100 lacs
Answer:
Intrinsic value of equity = Value of firm – value of debt + Value of non-core assets
Intrinsic value of equity = 1,000 – 200 + 100 = Rs.900 lacs

25. Valuation of Distress Companies

• Distress company is one which is not able to meet its fixed commitments (Fixed cost/Fixed
interest)
• Distress can be because of operating leverage (fixed cost in cost structure) or financial leverage
(fixed capital in capital structure) or combination of both
• Going concern assumption may not work for a distress company and hence value of distress
company will be lower than normal firm
• We will have to adjust cash flows due to probability of default as well the discount rate due to
high risk in such companies
Method 1: Modified Discounted Cash Flow Approach:
Scenario based valuation:
• Arrive at various possible scenarios - Do valuation of each scenario -Derive probability for each
situation- Value of firm = Weighted average of various possible values with probability being
the assigned weight
Example:
• Optimistic scenario (20% chance) = Value of 100 crores
• Base case scenario (40% chance) = Value of 50 crores
• Pessimistic scenario (40% chance) = Value of 10 crores
• Value of distress company = (100 cr x 20%) + (50 cr x 40%) + (10 cr x 40%) = 44 Cr

Scenario not possible:

• If Scenario analysis is not possible, then compute only one stream of cash flow. Cash flows needs
to be adjusted for probability of distress
• Expected cash flow = Normal cash flow x (1 - Probability of distress%)
• Probability of distress = 1 - Probability of survival
Method 2: Liquidation value + Going concern value (or) DCF valuation + Distress value:
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• Liquidation value is arrived assuming company may get liquidated over the near term.
Liquidation value be lower than Going concern value. This is normally arrived through net
realizable value approach of asset valuation.
• Going concern value (DCF value) is the present value of future cash flows discounted at required
return. We assume company to continue till perpetuity and hence perpetuity valuation is needed.
• Value of distress company = [Liquidation value x Prob of Distress] + [Going concern value x
Prob of survival]
Example:
ABC Limited is currently going through financial distress. Value of ABC Limited (if it was unlevered) =
Rs.100 crores; Amount of debt = Rs.50 crores; Tax rate = 30%; Distress sale value = Rs.40 crores; Probability
of distress = 40%. How much is the fair value of equity of ABC Limited using APV approach?
a. Rs.91 crores
b. Rs.41 crores
c. Rs.76 crores
d. Rs.26 crores
Answer:
Expected bankruptcy cost = [100 crores – 40 crores] x 40% = Rs.24 crores
Value of ABC Limited = Unlevered firm + Tax benefit on debt – Bankruptcy cost
Value of ABC Limited = 100 crores + (50 crores x 30%) – 24 Crores = Rs.91 Crores
Value of equity = 91 crores – 50 crores = Rs.41 Crores
Method 3: Adjusted Present Value Approach:
• Do valuation of unlevered firm - Discounting of future cash flows at unlevered cost of equity
• Compute tax benefits of debt:
o Perpetual debt: Tax benefit = Amount of debt x Tax rate
o Redeemable debt: Compute tax benefit of every year and discount the same at pre-tax
cost of debt. Pre-tax cost of debt is used as discount rate because the same is proxy for risk
of cash flows related to tax saving.
• Compute bankruptcy cost = [Going concern value – Liquidation Value] x Probability of Default
• Value of firm = Value of unlevered firm + Tax Benefits - Bankruptcy cost

Example:
• Value of unlevered firm = Rs.150 crores
• Amount of debt = 50 crores; Tax rate = 30%
• Liquidation value = 75 crores
• Probability of distress = 40%
Answer:
Formula 1:
• Value of unlevered firm = 150 crores
• Tax benefit on debt = Debt x Tax rate = 50 crores x 30% = 15 crores
• Bankruptcy cost = [Going concern value - Liquidation value] x POD = [150 crores - 75 crores] x
40% = 30 crores
• Value = 150 crores + 15 crores - 30 crores = 135 crores

Formula 2:
• Value = [Going concern value x Probability of Survival] + [Liquidation value x Probability of
Distress] + Tax benefit on debt
• Value = [150 crores x 60%] + [75 crores x 40%] + Tax benefits (50 cr x 30%) = 135 crores
Example:
Value of Going Concern = Rs.100 Crores. Distress value = Rs.50 Crores. The probability of survival is 40%.
How much is the fair value of the company?
a. Rs.150 Crores
b. Rs.75 Crores
c. Rs.70 crores
d. Rs.80 crores
Answer:
Value = [Going concern value x Probability of survival] + [Distress value x Probability of default]
𝐕𝐚𝐥𝐮𝐞 = [𝟏𝟎𝟎 𝐱 𝟒𝟎%] + [𝟓𝟎 𝐱 𝟔𝟎%] = 𝐑𝐬. 𝟕𝟎 𝐜𝐫𝐨𝐫𝐞𝐬

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Method 4: Relative Valuation Method
• Value of firm = Defined base x Multiple
• Defined base can be EBITDA/Sales/Assets etc. Multiple may have to be adjusted downwards to
factor in risk of bankruptcy

26. Valuation of Start-ups

Method 1: Berkus Approach:
• Valuation based on five key success factors such as Basic value, Technology, Execution, Strategic
relationships in its core market and Production and Consequent sales
• A detailed assessment is carried out evaluating how much value the five critical success factors in
quantitative measure add up to the total value of the enterprise. Based on these numbers, the
startup is valued.
• This method caps pre-revenue valuations at $2 million and post-revenue valuations at $2.5
million.
Method 2: Cost-to-duplicate Approach:
• The Cost-to-Duplicate Approach involves taking into account all costs and expenses associated
with the startup and its product development, including the purchase of its physical assets.
• All such expenses are considered determine the startup’s fair market value based on all the
expenses.
• This approach is often criticized for not focusing on the future revenue projections or the assets
of the startup.
Method 3: Comparable Transactions Method:
• Under this method the valuation is done on the basis of valuation of similar start-ups in past.
• With any comparison model, one needs to factor in ratios or multipliers for anything that is a
differentiating factor. Examples would be proprietary technologies, intangibles, industry
penetration, locational advantages, etc. Depending on the same, the multiplier may be adjusted.
Example:
Monika is trying to value ChatApp, a Chat messaging app that currently has 16 million users but does not
generate any revenues. She has identified that WhatsApp was recently valued at USD 450 Billion while
having 450 million users. Considering the difference in size, Monika believes that a size discount of 95
percent should be applied while valuing ChatApp.
a. USD 800 million
b. USD 16 Billion
c. USD 15.2 Billion
d. USD 450 Billion
Answer:
450 billion
Value of one user of whatsapp = = USD 1,000 per user
450 million
Relevant multiple for chatapp = 1,000 − 95% = USD 50 per user
Value of chatapp = 16 million x 50 = USD 800 million
Method 4: Scorecard Valuation Method
• Scorecard Method is another option for pre-revenue businesses. It also works by comparing the
startup to others already funded but with added criteria
• First, we find the average pre-money valuation of comparable companies. Then, we consider
how the business stacks up according to the following qualities:
o Strength of the team
o Size of the opportunity
o Product or service
o Competitive environment
o Marketing, sales channels and partnerships
o Need for additional investment
o Others
• Then we assign each quality a comparison percentage. Essentially, it can be on par (100%), below
average (<100%), or above average (>100%) for each quality compared to competitors/ industry.
For example, the marketing team has a 150% score because it is thoroughly trained and has tested
a customer base that has positively responded. You’d multiply 10% by 150% to get a factor of .15.

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• This exercise is undertaken for each startup quality and the sum of all factors is computed.
Finally, that sum is multiplied by the average valuation in the business sector to get a pre-revenue
valuation
Method 5: First Chicago Method
• This method combines a Discounted Cash Flow approach and a market approach to give a fair
estimate of startup value. It works out: Worst-case scenario, Normal case scenario and Best-case
scenario
• Valuation is done for each of these situations and multiplied with a probability factor to arrive
at a weighted average value.
Method 6: Venture Capital Method:
• This approach is commonly used by early-stage investors and involves estimating the start-up's
future value at the point of an exit event, such as an acquisition or initial public offering (IPO).
• The valuation is based on the expected return on investment that investors seek. For example, if
an investor expects a 10x return on investment within five years, they would estimate the start-
up's value at the time of exit to achieve that target return.
• The above value is discounted at the rate representing an investor’s expected or required rate
of return.
Example:
The founders of a small technology firm are seeking a $3 million venture capital investment from
prospective investors. The founders project that their firm could be sold for $25 million in 4 years. The
private equity investors deem a discount rate of 25% to be appropriate, but believe there is a 20% chance
of failure in any year. The adjusted pre-money valuation (PRE) of the technology firm is closest to (in
millions):
a. 7.24 million
b. 1.19 million
c. 4.19 million
d. 7.19 million
Answer:
Expected cash flow in year 4 = 25 million x 0.84 = 10.24 million
10.24
Current post − money valuation = = 4.19 million
1.254
Pre − money valuation = 4.19 million − 3 million = 1.19 million
Example:
A private equity investor makes a $5 million investment in a venture capital firm today. The investor
expects to sell the firm in four years. He believes there are three equally possible scenarios at termination:
Expected earnings will be $20 million, and the expected P/E will be 10.
Expected earnings will be $7 million, and the expected P/E will be 6
Expected earnings will be zero if the firm fails.
The investor believes an IRR of 25% is appropriate. The expected terminal value and the investor's
pre-money valuation, respectively, are closest to (in $ million):
a. 80.67 and 33.04
b. 80.67 and 28.04
c. 9.00 and 3.67
d. 80.67 and 38.04
Answer:
(20 x 10) + (7 x 6) + 0
Terminal value = = 80.67
3
80.67
Post − money value = = 33.04
1.254
Pre-money value = 33.04 – 5.00 = 28.04
Hence answer is 80.67 million and 28.04 million
Example:
A private equity firm is guaranteed to receive 80% of the residual value of a leveraged buyout investment,
with the remaining 20% owing to management. The initial investment is Rs.500 crores, and the deal is
financed with 70% debt and 30% equity. The projected multiple is 2.0. The equity component consists of:
Rs.120 crores preference shares. Rs.25 crores private equity firm equity and Rs.5 crores management
equity. At exit in 5 years the value of debt is Rs.150 crores and the value of preference shares is Rs.300
crores. The payoff multiple for the private equity firm and for management, respectively, is closest to:
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a. 3.03 and 11
b. 6.34 and 46
c. 4.23 and 24
d. 5.10 and 22
Answer:
Answer is 5.10 and 22.0

Particulars Amount
Expected exit value (500 crores x 2) 1,000.00
Less: Payment of debt -150.00
Less: Payment of preference -300.00
Balance amount for management and PE 550.00
Amount payable to PE [550.00 x 80%] 440.00
Amount payable to management [550 x 20%] 110.00
Total consideration to PE [440 + 300 preference) 740.00
Amount contributed by PE [25 + 120] 145.00
Exit Multiple for PE [740/145] 5.10
Exit multiple for management [110/5] 22.00
Example:
A private equity firm is considering an investment of Rs.17 crores in ABC Limited. ABC Limited’s owners
firmly believe that with PE investment they could develop their "wonder" drug and sell the firm in six
years for Rs.120 crores. Given the project's risk, P&H believes a discount rate of 30% is reasonable. The
pre-money valuation and PE’s ownership is equal to:
a. Rs.7.86 crores and 68%
b. Rs.24.86 crores and 68%
c. Rs.7.86 crores and 14%
d. Rs.24.86 crores and 14%
Answer:
Answer is Rs.7.86 Crores and 68%
120 crores
Post − money valuation of ABC Limited = = Rs. 24.86 Crores
(1 + 30%)6
Pre-money valuation = 24.86 crores – 17 crores = Rs.7.86 Crores
17
% stake acquired = 𝑥 100 = 68.00%
24.86

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Chapter 14 – Mergers, Acquisitions and Corporate Restructuring

Overview:
• Gain from merger
• Cost of merger
• NPV of merger
• Exchange ratio – Simple
• Weighted average Exchange Ratio
• Minimum and Maximum Exchange Ratio
• Free float market capitalization
• Exchange ratio based on adverse parameters
• Bank merger
• Decision on sale of shares

1. Format for doing Merger Analysis

Particulars ABC Limited DEF Limited Merged company
PAT/EAES 2,00,000 5,00,000 7,00,000
No of equity shares 1,00,000 2,00,000 2,62,172
EPS [PAT/ No of shares] 2 2.50 2.67
PE Multiple 20 10 20
MPS [PAT x PE Multiple] 40 25 53.40
No of equity shares 1,00,000 2,00,000 2,62,172
Market value of firm [MPS x No of shares] 40,00,000 50,00,000 1,40,00,000

2. Gain from Merger

• Gain from merger = Value of merged entity – (Pre-merger Value of entity A + Value of entity B)
• This gain will materialize under the following conditions:
o The post-merger price-to-earnings (PE) multiple is superior to the weighted average PE
multiple, OR
o The post-merger cost of capital is better than the weighted average cost of capital, OR
o The earnings of the merged firm surpass the sum of the individual earnings of Entity A
and Entity B, OR
o The cash flows generated by the merged firm exceed the combined cash flows of Entity
A and Entity B.
Example:
Cash flows of Company A = 25 lacs; Cash flows of company B = 20 lacs; Merged firm will have annual
cash flows of 60 lacs due to synergy gain. Pre-merger cost of capital of A Limited = 10%; Pre-merger cost
of capital of B Limited = 20%; Post-merger cost of Capital of merged entity = 8%. How much is the gain
from merger?
e. 400 lacs
f. 750 lacs
g. 75 lacs
h. 150 lacs
Answer:
25 lacs
Value of A Limited before merger = = Rs. 250 lacs
10%
20 lacs
Value of B Limited before merger = = Rs. 100 lacs
20%
60 lacs
Value of merged entity = = Rs. 750 lacs
8%
Merger gain = 750 lacs - 350 lacs = 400 lacs
Example:
Cash flows of Company A = 25 lacs; Cash flows of company B = 20 lacs; Merged firm will have annual
cash flows of 60 lacs due to synergy gain. Pre-merger cost of capital of A Limited = 10%; Pre-merger cost
of capital of B Limited = 20%; Post-merger cost of Capital of merged entity = 8%. A Limited has acquired
B Limited. Consideration paid for acquisition is Rs.150 lacs. How much is the gain for shareholders of B
Limited?

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a. 150 lacs
b. 130 lacs
c. 50 lacs
d. 80 lacs
Answer:
20 lacs
Value of B Limited before merger = = Rs. 100 lacs
20%
Consideration paid in merger = Rs.150 lacs
Gain to shareholders of B Limited = 150 lacs - 100 lacs = Rs.50 lacs

3. Cost of Merger
• Gross cost of cash offer/Consideration paid = No of shares of target company x Cash paid per
share
• Gross cost of stock offer/Consideration paid = No of shares allotted in merger x Post-merger MPS
• True/Net cost of merger = Gross cost of merger – Pre-merger value of target company; This is
also known as Gain of target company shareholders
Example:
A Limited is acquiring B Limited. B Limited currently has 10 crores shares of Rs.50 each. A Limited plans
to pay cash consideration of Rs.60 per share. How much is the gross cost and net cost of merger?
a. Rs.500 crores and 0
b. Rs.600 crores and 0
c. Rs.600 crores and Rs.100 crores
d. Rs.500 crores and Rs.100 crores
Answer:
Gross cost of merger = 10 crores x 60 = Rs.600 crores
Net cost of merger = 600 crores – 500 crores = Rs.100 Crores
Example:
Value of A Limited = 1000 lacs; Value of B Limited = 500 lacs; Synergy gain = 500 lacs; A is acquiring B
Limited and exchange ratio agreed is 1:3. No of shares in both companies are same before merger. How
much is the gross cost and net cost of merger?
a. 500 lacs and 0
b. 1000 lacs and 0
c. 1500 lacs and 1,000 lacs
d. 2000 lacs and 1,500 lacs
Answer:
Post-merger value = 1000 lacs + 500 lacs + 500 lacs = 2,000 lacs
Let us assume no of shares in both companies are 300. Exchange ratio agreed is 1:3 and hence we would
have issued 100 shares for merger; No of shares post-merger = 400
100
Gross cost of merger = 2,000 lacs x ( ) = Rs. 500 lacs
400
Net cost of merger = 500 lacs − 500 lacs = 0
Example:
Net cost of merger = 300 lacs; Pre-merger value of Acquiring company = 1500 lacs; Pre-merger value of
Target company = 700 lacs. Number of shares both acquiring and target before merger is same. Synergy
gain from merger is 300 lacs. What is the swap ratio agreed during merger?
a. 0.8:1
b. 1:1
c. 0.67:1
d. 2:1
Answer:
Consideration paid = Net cost of merger + pre-merger value = 300 lacs + 700 lacs = 1,000 lacs
Value of merged entity = 1500 lacs + 700 lacs + 300 lacs = 2500 lacs; Let us assume that both company had
60 shares each before merger.
1,000 lacs
% of company held by target company shareholders = = 40%
2,500 lacs

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So, acquiring company shareholders hold 60 percent of company and they have 60 shares. Target company
shareholders would have been given 40 shares for 40 percent holding; Exchange ratio = 40:60 (or) 2:3 (or)
0.67:1
Example:
Value of Acquiring Company (A Limited) = Rs.540 lacs; Value of Target Company (B Limited) = Rs.90 lacs.
Synergy gain from merger = Rs.45 lacs; No of shares of A Limited = 30 lacs; No of shares of B Limited = 18
lacs; Exchange ratio = 1:3. How much is the consideration paid?
a. Rs.180 lacs
b. Rs.225 lacs
c. Rs.112.50 lacs
d. Rs.90 lacs
Answer:
Value of merged firm = 540 lacs + 90 lacs + 45 lacs = Rs.675 lacs
675 lacs
Post − merger price = = Rs. 18.75 per share
30 lacs + 6 lacs
Consideration paid = 6 lacs x 18.75 = Rs. 112.50 lacs

4. NPV of merger (or) Gain for acquiring company shareholders

NPV of merger = Gain from merger – True cost of merger
Example:
Value of acquiring company = Rs.1,000 lacs; Value of target company = Rs.600 lacs. Value of merged entity
= Rs.2,000 lacs. The number of shares in both companies are same and exchange ratio offered is 1:2. How
much is the NPV of stock offer?
a. Rs.666.67 lacs
b. Rs.400 lacs
c. Rs.333.33 lacs
d. Rs.66.67 lacs
Answer:
Let us assume both companies are having 100 shares and hence the number of shares offered to target
company is 50 (100 x ½).
50
Consideration paid = 2,000 lacs x ( ) = Rs. 666.67 lacs
150
True cost of merger = 666.67 lacs − 600 lacs = Rs. 66.67 lacs
Gain from merger = 2,000 − (1,000 + 600) = Rs. 400 lacs
𝐍𝐏𝐕 𝐨𝐟 𝐦𝐞𝐫𝐠𝐞𝐫 = 𝟒𝟎𝟎 − 𝟔𝟔. 𝟔𝟕 = 𝐑𝐬. 𝟑𝟑𝟑. 𝟑𝟑 𝐥𝐚𝐜𝐬

5. Post-merger EPS (Stock offer)

PAT of AC + PAT of TC + Synergy Gain
Post merger EPS =
Pre − merger shares of AC + Shares issued to TC
Example:
Existing MPS of A Limited = Rs.40; PE Multiple of A Limited = 20 Times; No of shares of A Limited =
1,00,000; Existing EPS of B Limited = Rs.10; No of shares of B Limited = 40,000. A Limited is acquiring B
Limited by issue of shares and wants to report post-merger EPS of Rs.4. How many shares must A Limited
issue to B Limited.
a. 40,000 shares
b. 50,000 shares
c. 1,50,000 shares
d. 70,000 shares
Answer:
MPS 40
Current EPS of A Limited = = = Rs. 2 per share
PE Multiple 20
Current PAT of A Limited = 2 per share x 1,00,000 = Rs.2,00,000
Current PAT of B Limited = 10 x 40,000 = Rs.4,00,000
Post-merger PAT = 2,00,000 + 4,00,000 = Rs.6,00,000
6,00,000
Maximum shares for EPS of Rs. 4 = = 1,50,000
4
Shares that can be issued in merger = 1,50,000 - 1,00,000 = 50,000 shares

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6. Post-merger EPS (Cash offer)
PAT of AC + PAT of TC − After tax interest cost on borrowing
Post merger EPS =
Pre − merger shares of AC
Example:
Earnings of Target Company = Rs.75,00,000. Acquiring company plans to give cash consideration which
will be funded with 15% loan. Tax rate is 30%. How much is the maximum consideration payable so the
overall EPS of acquiring company is maintained?
a. 500 lacs
b. 714.29 lacs
c. 1000 lacs
d. 250 lacs
Answer:
The company can maintain EPS if the post-tax interest cost on bank borrowing is equal to total earnings of
target company; After-tax cost of debt = 15 x 70% = 10.50%
75 lacs
Maximum borrowing = = Rs. 714.29 lacs
10.5%

7. How Exchange Ratio is determined?

• Write the base values in the order of acquiring company: Target company (based on which
exchange ratio is computed). Switch it around.
• If the company wants to pay some premium then the same needs to be adjusted in base values
before computation of exchange ratio
Example:
MPS of company A = 50; MPS of Company B = 20. Company A wants to acquire company B by paying
premium of 25%. What is swap ratio based on market prices?
a. 50:20
b. 20:50
c. 25:50
d. 20:62.50
Answer:
Base values = 50:20. The company wants to pay a premium of 25 percent and hence the base value for
company B changes as 25. Swap ratio = 25:50

8. PE Multiple of Merged Firm/Weighted Average PE Multiple/Combined PE Multiple to justify

merger
• In case the problem is silent, post-merger PE Multiple would be equal to pre-merger PE Multiple
of acquiring company
(𝐏𝐀𝐓 𝐨𝐟 𝐀𝐂 𝐱 𝐀𝐂 𝐏𝐄 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞) + (𝐏𝐀𝐓 𝐨𝐟 𝐓𝐂 𝐱 𝐓𝐂 𝐏𝐄 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞)
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐄 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞 =
𝐏𝐀𝐓 𝐨𝐟 𝐀𝐂 + 𝐏𝐀𝐓 𝐨𝐟 𝐓𝐂
• A merger is justified if there is no negative gain from merger. A merger will not have merger loss
if Value of merged entity > (Pre-merger Value of AC + Pre-merger Value of TC). This equation
can be used to compute combined PE Multiple to justify merger
𝐏𝐫𝐞 𝐦𝐞𝐫𝐠𝐞𝐫 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀 𝐋𝐢𝐦𝐢𝐭𝐞𝐝 + 𝐏𝐫𝐞 𝐦𝐞𝐫𝐠𝐞𝐫 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁 𝐋𝐢𝐦𝐢𝐭𝐞𝐝
𝐂𝐨𝐦𝐛𝐢𝐧𝐞𝐝 𝐏𝐄 𝐌𝐮𝐥𝐭𝐢𝐩𝐥𝐞 =
𝐏𝐨𝐬𝐭 𝐦𝐞𝐫𝐠𝐞𝐫 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬
Example:
PE Multiple of A Limited = 20 Times; No of shares of A Limited = 1,00,000; PAT of A Limited = 25,00,000.
PE Multiple of B Limited = 40 Times; No of shares of B Limited = 50,000; PAT of B Limited = 50,00,000.
What is the weighted average PE Multiple if these two entities merge together?
a. 30 Times
b. 26.67 Times
c. 33.33 Times
Answer:
Weighted average PE Multiple is to be computed on the basis of PAT of company
[20 x 25,00,000 + 40 x 50,00,000]
Weighted average PE Multiple = = 33.33 Times
[25,00,000 + 50,00,000]

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Earnings of A Limited = 20,00,000; PE Multiple of A Limited = 10 Times; Earnings of B Limited = 40,00,000;
PE Multiple of B Limited = 7.5 Times; Combined earnings will increase by 2,50,000 due to synergy gain
benefits. What should be the minimum combined PE Multiple to justify the merger?
a. 10 Times
b. 8.75 Times
c. 8.33 Times
d. 8 Times
Answer:
Pre-merger value of A Limited = 20 lacs x 10 = 200 lacs; Pre-merger value of B Limited = 40 lacs x 7.5 = 300
lacs; Hence combined firm should have minimum value of 500 lacs
Earnings of combined firm = 20 lacs + 40 lacs + 2.5 lacs = 62.50 lacs
500 lacs
PE Multiple to justify merger = = 8 Times
62.50 lacs

9. Equivalent EPS/MPS
Equivalent EPS (or) MPS for target company shareholders = Post − merger EPS (or) MPS x Exchange Ratio
Example:
A Limited has acquired B Limited with a swap ratio of 1:2. Post-merger EPS is likely to be Rs.40. What is
the equivalent EPS for shareholders of B Limited?
a. Rs.20
b. Rs.40
c. Rs.80
Answer:
1
Equivalent EPS = Post − merger EPS x Exchange ratio = 40 x ( ) = Rs. 20 per share
2

10. Gain/loss per share (or) Impact of merger on EPS/MPS:

Particulars Acquiring company shareholders Target company shareholders
Post-merger MPS/EPS Normal Value Equivalent Value
Less: Pre-merger MPS/EPS Normal value Normal value
Gain/loss per share (A) XXX XXX
Pre-merger number of shares (B) XXX XXX
Total Gain (A x B) XXX XXX
Example:
A is acquiring B Limited. Pre-merger EPS of B Limited is Rs.10. Post-merger EPS of combined entity is
Rs.25. The merger was done by issuing 4,00,000 shares to B Limited shareholders. Existing shares of B
Limited is 10,00,000. What is the impact of merger on EPS for B Limited shareholders?
a. Gain of Rs.15 per share
b. No gain or no loss
c. Gain of Rs.52.50 per share
d. Loss of Rs.15 per share
Answer:
4,00,000
Equivalent EPS = 25 x ( ) = Rs. 10 per share
10,00,000
Pre-merger EPS = Rs.10 per share
Impact of merger on EPS = No gain or no loss
Example:
Pre-merger MPS of A Limited = Rs.100; Pre-merger MPS of B Limited = Rs.200; A is acquiring B Limited
and the expected post-merger MPS is Rs.150. Exchange ratio agreed is 2:1. What is the gain/loss per share
for A Limited and B Limited shareholder?
a. Gain of Rs.50 and Gain of Rs.100
b. Gain of Rs.50 and loss of Rs.50
c. Gain of Rs.50 and loss of Rs.100
d. Gain of Rs.100 and Gain of Rs.50
Answer:
Gain for A Limited = Post-merger MPS - Pre-merger MPS = 150 - 100 = Rs.50
Gain for B Limited = Equivalent MPS - Pre-merger MPS = 300 - 200 = Rs.100

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11. Exchange ratio to maintain EPS/MPS/BVPS

• In case there is no synergy gain, then exchange ratio can be on the basis of the parameter which
needs to be maintained.
• EPS to be maintained = No PAT level gain
• MPS to be maintained = No valuation gain
• BVPS to be maintained = No revaluation of assets/liabilities
• Caution Note: If the company wants to maintain MPS, we should always try under table approach
as the company may have valuation gain due to maintenance of PE Multiple. In short, we can use
same parameter only if there is no gain in that parameter
Example:
EPS of company A = Rs.10; MPS of company A = Rs.100; EPS of company B = Rs.20; MPS of Company B
= Rs.100; Company A plans to acquire company B and wants to maintain its EPS. What should be the
exchange ratio.
a. 1:1
b. 1:2
c. 2:1
Answer:
Exchange ratio should be on the basis of EPS if the company wants to maintain EPS; Base values = 10:20;
Exchange ratio = 20:10 (or) 2:1

12. Maximum/Minimum Exchange Ratio

• Maximum ER is from point of view of acquiring company. This should lead to acquiring company
making no profit at MPS level.
• Minimum ER is from point of view of Target company. This should lead to target company
making no profit at MPS level
• Maximum consideration = Post-merger value of merged firm – Pre-merger value of acquiring
company
• Minimum consideration = Pre-merger value of target company
• Maximum Exchange ratio should ensure pre-merger MPS of acquiring company is equal to post-
merger MPS
• Valuation gain: If a merger has valuation gain, then one of the parties/both parties can gain from
merger. Operating synergies (PAT gain) + Financial Synergies (PE Multiple gain) = Valuation
gain
• Merger is justified when there is no valuation gain or the valuation gain is positive. We should not
have negative valuation gain in merger
Example:
Value of Acquiring Company = 1,000 lacs (10 lac shares x 100); Value of Target company = 500 lacs (50 lac
shares x 10); Merger gain = 500 lacs. What is acceptable minimum and maximum exchange ratio?
a. 0.0667:1 and 0.2000:1
b. 5:1 and 10:1
c. 0.5:1 and 1:1
Answer:
Value of merged firm = 1000 lacs + 500 lacs + 500 lacs = 2,000 lacs
Minimum exchange ratio:
Particulars Value No of shares
Value of acquiring company 1,500 lacs 10,00,000
Value of target company 500 lacs 3,33,333
(Consideration paid) 500
(10,00,000 𝑥 )
1500

Value of merged entity 2,000 lacs 13,33,333

• Minimum exchange ratio is based on minimum consideration of Rs.500 lacs (Pre-merger value of
target company)
• ER = 3,33,333:50,00,000 (or) 0.0667:1

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Maximum Exchange ratio:
Particulars Value No of shares
Value of acquiring company 1,000 lacs 10,00,000
Value of target company 1,000 lacs 10,00,000
(Consideration paid)
Value of merged entity 2,000 lacs 20,00,000
• Maximum exchange ratio is based on maximum consideration of Rs.1,000 lacs.
• Maximum consideration = Post-merger value – pre-merger value = 2,000 lacs – 1,000 lacs =
Rs.1,000 lacs
ER = 10,00,000:50,00,000 (or) 0.20:1

13. Value of Original Company Shareholders

Pre merger value of AC + TC
Value of TC shareholders = ( ) x Shares issued to TC shareholders
Pre merger shares of AC + Shares issued to TC
Pre merger value of AC + TC
Value of AC shareholders = ( ) x Shares held by AC shareholders
Pre merger shares of AC + Shares issued to TC
Example:
No of shares of A Limited = 20,00,000; No of shares issued to B Limited shareholders in merger = 10,00,000;
Value of A Limited (pre-merger) = Rs.250 lacs; Value of B Limited (pre-merger) = Rs.50 lacs What are the
value of original shareholders of A Limited and B Limited?
a. 150 lacs and 150 lacs
b. 200 lacs and 100 lacs
c. 100 lacs and 200 lacs
Answer:
Pre merger value of AC + TC
Value of TC shareholders = ( ) x Shares issued to TC shareholders
Pre merger shares of AC + Shares issued to TC
250 + 50
Value of TC shareholders = ( ) x 10 = 100 lacs
20 + 10
Pre merger value of AC + TC
Value of AC shareholders = ( ) x Shares held by AC shareholders
Pre merger shares of AC + Shares issued to TC
250 + 50
Value of AC shareholders = ( ) x 20 = 200 lacs
20 + 10
Value of A Limited shareholders is Rs.200 lacs and B Limited shareholders is Rs.100 lacs

14. Free-Float Market Capitalization

• Free float market capitalization refers to the total market value of a publicly traded company's
outstanding shares that are available for trading by investors in the open market. It excludes shares
held by promoters
• Free-float market capitalization = Overall market capitalization x non-Promoter shareholding
Example:
Free float market cap = Rs.400 lacs. Promoters hold 80% of the company. There are total 10,00,000 shares
in company. What will be the MPS?
a. Rs.40
b. Rs.32
c. Rs.200
d. Rs.100
Answer:
Free float market cap = 400 lacs; Shareholding by public = 20%
400 lacs
Total market cap of company = = Rs. 2,000 lacs
20%
2,000 lacs
MPS = = Rs. 200 per share
10 lacs

15. Decomposing of Share price

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MPS

PE
EPS
Multiple

ROE BVPS

• MPS = EPS x PE Multiple

• EPS = ROE x BVPS

16. Book Value Per Share

Book value per share (BVPS) is a financial metric that represents the value of a company's common equity
on a per-share basis. It is calculated by dividing the total common shareholders' equity (also known as
net assets) by the number of outstanding common shares.
SC + Reserves − Fictitious Assets
Book value per share =
Number of shares
(OR)
Total Assets (excl Fictitious Assets) − Current liabilities − Long term debt − Preference
BVPS =
Number of shares
Example:
Fixed Assets = 20,00,000; Current Assets = 30,00,000; 10% Loan = 2,00,000; Current liabilities = 8,00,000;
P&L Debit Balance = 5,00,000; No of shares = 2,00,000. What is book value per share?
a) 20
b) 17.50
c) 25.00
d) 22.50
Answer:
Value of equity = Total assets - Outside liabilities
Value of equity = 50,00,000 - 10,00,000 = 40,00,000
40,00,000
Book value per share = = 20 per share
2,00,000
Note: P&L debit balance is not considered as part of total assets in above computation and hence the same
is not required to be deducted
Example:
Total Assets of the company = Rs.25,00,000; P&L debit balance (part of total assets) = Rs.5,00,000; Sundry
creditors = Rs.2,00,000; Short-term debt = Rs.1,00,000; Long-term debt = Rs.2,00,000; Preference capital =
Rs.4,00,000; No of equity shares = 1,00,000. How much is the book value per share?
a. Rs.16.00
b. Rs.11.00
c. Rs.15.00
d. Rs.20.00
Answer:
• Networth = Total assets – Fictitious assets – Sundry creditors – Short-term debt – long-term debt
– Preference capital
• Networth = 25,00,000 – 5,00,000 – 2,00,000 – 1,00,000 – 2,00,000 – 4,00,000 = Rs.11,00,000
Networth 11,00,000
Book value per share = = = Rs. 11.00 per share
Number of shares 1,00,000

17. Impact of bonus/split

• Any changes in the number of equity shares resulting from actions like bonus issues or stock splits
will not have an impact on the overall market capitalization of the company.

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• Market Price per Share (MPS), Earnings per Share (EPS), and Book Value per Share (BVPS), may
undergo changes. However, it's essential to understand that the overall market
capitalization/earnings/book value of the company will remain unchanged despite these
changes.
Example:
Current book value per share = Rs.150. The company plans to make bonus issue of 2:1 and then split 100
rupees shares into 20 shares of 5 rupees each. What will be the book value per share post bonus issue and
split respectively?
a. 100 and 5
b. 50 and 2.5
c. 150 and 7.5
d. 20 and 1
Answer:
The company makes bonus issue of 2 shares for every 1 share. Hence Rs.150 share will become three shares
of Rs.50. Under split one share of Rs.50 will be split into 20 shares and value of each share will be Rs.2.5

18. Minimum vs Maximum Exchange Ratio (Negotiation)

• The ultimate exchange ratio agreed upon during negotiations in a share swap is contingent on the
relative strength of the involved companies
• If the acquiring company is deemed stronger, the final exchange ratio is likely to be closer to
the lower limit. Conversely, if the target company is stronger, the ratio may be closer to the
upper limit.
• The assessment of a company's strength or weakness can be based on various parameters such as
Price-to-Earnings (PE) Multiple, Growth Rate, Return on Equity (ROE), Market Share, Brand
Value, and other relevant factors.
Example:
A Limited (Acquiring company) and B Limited (Target company) are negotiating a merger deal. Two ER
are currently under negotiation 1:2 and 1:3. Acquiring company has better PE Multiple/Growth rate/ROE.
The final exchange ratio is likely to be closer to:
a. 1:2
b. 1:3
c. 1:2.50
Answer:
Acquiring company is stronger company and they would like to pay a lower consideration in merger. Two
exchange ratios under discussion is 0.5:1 (1:2) and 0.33:1 (1:3). Final exchange ratio will be closer to lower
limit of 1:3 or 0.33:1.

19. Impact of Revision in Growth Rate on Value of firm

• Value of firm is highly dependent on growth rate and any change in growth rate will have direct
impact on its valuation
• Compute existing cost of equity using the current growth rate
• Substitute the new growth rate in cost of equity formula and compute its valuation
Example:
Cash flows of Company A = 40 lacs; Expected Cash flows of Company B for next year= 80 lacs; Valuation
of Company B presently is Rs.800 lacs and company B is likely to grow at 10 percent. Post merger Company
B will grow at 15 percent. How much should be the revised value for business of Company B?
a. Rs.800 lacs
b. Rs.1,200 lacs
c. Rs.1,600 lacs
d. Rs.400 lacs
Answer:
80 lacs
Cost of equity of Company B = + 10% = 20%
800 lacs
Revised growth rate = 15%
80 lacs
Revised value = = Rs. 1,600 lacs
20% − 15%

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20. Intrinsic Value
Intrinsic value represents the true or underlying worth of a share, and Market Price per Share (MPS) can
serve as a proxy for this intrinsic value
Example:
A Limited is planning to acquire B Limited. MPS of A Limited and B Limited is 40 and 20. A Limited has
estimated the intrinsic value of B Limited to be 30. What should be the exchange ratio on the basis of
intrinsic value?
a. 2:1
b. 1:2
c. 1.33:1
d. 1:1.33
Answer:
Intrinsic value of B Limited is Rs.30. Intrinsic value of A Limited will be taken as the market price of A
Limited in absence of information. Hence base values are 40:30 and exchange ratio will be 30:40 (or) 1:1.33

21. Computation of Purchase Consideration (When shares allotted are not given in question)
• We should find the percentage shareholding of target company shareholders and compute the
purchase consideration using the below formula:
𝐂𝐨𝐧𝐬𝐢𝐝𝐞𝐫𝐚𝐭𝐢𝐨𝐧 𝐏𝐚𝐢𝐝 = 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐦𝐞𝐫𝐠𝐞𝐝 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 𝐱 % 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐢𝐧𝐠 𝐨𝐟 𝐓𝐂 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬
Example:
Value of acquiring company before merger = 4,000 lacs; Value of acquiring company after merger = 10,000
lacs; Pre-merger no of Shares in both companies are same. The company has allotted 0.5 share for every 1
share of target company. How much is the purchase consideration paid?
a. 5,000 lacs
b. 3,333 lacs
c. 2,000 lacs
d. 1,333 lacs
Answer:
Let us assume no of shares of both companies to be 100
1 50
Shares issued as consideration = 100 x = 50 𝑜𝑟 33.333333% ( )
2 150
50
Consideration paid = 10,000 lacs x ( ) = 3,333 lacs
150
Example:
Value of A Limited = 1000 lacs; Value of B Limited = 500 lacs; Synergy gain = 500 lacs; A is acquiring B
Limited and exchange ratio agreed is 1:3. No of shares in both companies are same before merger. How
much is the gross consideration paid?
a. 500 lacs
b. 1000 lacs
c. 1500 lacs
d. 2000 lacs
Answer:
Post-merger value = 1000 lacs + 500 lacs + 500 lacs = 2,000 lacs
Let us assume no of shares in both companies are 300. Exchange ratio agreed is 1:3 and hence we would
have issued 100 shares for merger; No of shares post merger = 400
100
Value of shares issued = 2,000 lacs x ( ) = Rs. 500 lacs
400

22. Exchange Ratio Based on Adverse Parameters

• Adverse parameters refer to the aspects that a company aims to minimize or reduce. Examples of
such parameters include Gross Non-Performing Assets (NPA), Expense Ratio, and Cost of Goods
Sold (COGS) ratio
• For adverse parameters the exchange ratio will be same as base values and no switching needs to
be done
Example:
Gross NPA of Bank A = 40%; Gross NPA of Bank B = 20%. Number of shares of Bank A = 40,00,000. Bank
B plans to acquire Bank A and exchange ratio is based on GNPA. How many shares are to be issued?

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a. 20,00,000
b. 40,00,000
c. 80,00,000
Answer:
Base values = 20:40. Swapping is not required for negative parameter
20
Shares to be issued = 40,00,000 x ( ) = 20,00,000 shares
40

23. Ratios related to bank merger

GNPA in Rupees
GNPA(%) = x 100
Advances
Networth
Capital Adequacy Ratio (%) = x 100
Risk Weighted Assets

Example:
Networth of Bank A = 100 lacs; CAR = 16%; Networth of Bank B = 200 lacs; CAR = 6%; What is Capital
Adequacy Ratio of merged Bank?
a. 9.33%
b. 12.67%
c. 7.58%
d. None of the above
Answer:
100
Networth of Bank A = 100 lacs; CAR = 16%; Risk weighted assets = = 625 lacs
16%
200
Networth of Bank B = 200 lacs; CAR = 6%; Risk weighted assets = = 3,333.33 lacs
6%
Total Networth of merged bank = 300 lacs; Total risk weighted assets = Rs.3,958.33 lacs
300
CAR = ( ) x 100 = 7.58%
3,958.33
Advances of Bank A = 1000 lacs; GNPA (%) of Bank A= 20%; Advances of Bank B = 2,000 lacs; GNPA of
Bank B = 100 lacs; What will be GNPA (%) of merged Bank?
a. 20%
b. 15%
c. 12.50%
d. 10.00%
Answer:
GNPA of Bank A = 1000 lacs x 20% = Rs.200 lacs
GNPA of Bank B = Rs.100 lacs
300 lacs
GNPA (%) of merged Bank = = 10%
3,000 lacs

24. Dupont Framework for computing ROE

EPS EAES PAT
ROE = (or) (or)
BVPS Book value of equity Equity
PAT Sales Assets
ROE as per Dupont Framework = ( )x ( )x ( )
Sales Assets Equity
ROE as per Dupont Framework = Net Profit margin x Asset Turnover x Equity Multiplier
Note:
• If information on assets is not given then Assets = Debt + Equity
Example:
Net profit margin = 4%; Assets to sales ratio = 0.80; Debt to assets ratio = 40%. How much is the ROE?
a. 12.50%
b. 8.00%
c. 8.33%
d. 5.33%
Answer:

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Net Profit Sales Assets 1 100
ROE = x x =4𝑥 𝑥 = 8.33%
Sales Assets Equity 0.80 60

Debt is 40% of assets and hence equity will be 60% of assets. Therefore, we can say that equity is Rs.60 if
assets is Rs.100. The same has been used in above formula to compute ROE.

25. Bonus issue to reduce promoter Holding

A company may opt for a bonus issue to non-promoter shareholders as a means to lower the percentage
ownership held by promoters. In this scenario, the total value of the firm remains constant, but there will
be a change in the number of shares issued, thereby affecting the value per share.
Example:
Promoters hold 90 percent of a company. They are planning to issue bonus shares to minority shareholders
to bring holding down to 75 percent. What is the bonus ratio?
a. 2:1
b. 1:2
c. 1.5:1
d. 1:1.5
Answer:
Let us assume there are 100 shares in the company. Promoters currently hold 90 shares in company and
minority shareholder hold 10 shares. Target holding of promoter is 75 percent and hence 90 shares would
represent 75 percent holding.
90
Overall shares post bonus = = 120
75%
We need to issue 20 shares as bonus and hence bonus ratio will be 20:10 (or) 2:1

26. Minimum consideration for promoters to relinquish Promoter Holding

• Promoters of a company can enjoy allied benefits such as higher salaries, perquisites due to
controlling stake of promoter holding
• In that case they will need a consideration higher than current market price for them to give up
controlling stake
Value of extra Benefits
Minimum Price = Current Market Price +
No of shares held by promoters
Example:
Current market capitalization of company = 40,00,000. Promoters hold 40 percent of the company. No of
shares of the company = 1,00,000. Promoters and their family members are part of top management and
are currently over-paid. They had received excess remuneration of Rs.2,00,000 per year and the present
value of these remuneration for infinite period is Rs.15,00,000. How much should be the minimum price
per share paid by target company for the promoters to relinquish their controlling interest?
a. Rs.40 per share
b. Rs.45 per share
c. Rs.77.50 per share
d. Rs.80.00 per share
Answer:
Minimum compensation for promoters = Value of shares held (16,00,000) + Value of excess remuneration
(15,00,000) = Rs.31,00,000
31,00,000
Minimum price per share = = Rs. 77.50 per share
40,000 shares

27. Decision on sale of shares

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Decision on sale of
shares

Opportunity cost of Opportunity cost of capital not

capital given given

Calculate earning yield Compare pre-merger and post-

and compare with merger equivalent MPS of Target
opportunity cost of capital company

EG > Cost of capital =

Gain at MPS level = Continue
Continue

EG < Cost of capital = Sell

Loss at MPS level = Sell
shares
Example:
A Limited is planning to acquire B Limited. Current share price of B Limited is Rs.10 and the same got
increased by 20% on merger announcement. Post-merger EPS and MPS will be Rs.2 and Rs.25. Exchange
ratio offered in merger is 0.8:1. Mr. X, an investor, having 10,000 shares of B Ltd. is having another
investment opportunity, which yields annual return of 12% is seeking your advise whether he needs to
offload the shares in the market or accept the shares from A Limited.
a. He should sell shares in market
b. He should accept merger offer
c. Indifferent between sales of shares and acceptance of merger offer
Answer:
Equivalent EPS 2 x 0.8
Earning yield of A Limited = x 100 = 𝑥 100 = 13.33%
CMP 12
Earning Yield from A Limited is better than alternative investment opportunity and hence Mr.X should
accept to merger offer
Example:
A Limited is planning to acquire B Limited. Current share price of B Limited is Rs.14. Post-merger EPS
and MPS will be Rs.3.13 and Rs.31.30. Exchange ratio offered in merger is 0.5:1. Mr. X, an investor, having
100 shares of B Ltd. is seeking your advise whether he needs to offload the shares in the market or accept
the shares from A Limited.
a. He should sell shares in market
b. He should accept merger offer
c. Indifferent between sales of shares and acceptance of merger offer
Answer:
Particulars Calculation Amount
Present market value of shares of B Limited 100 shares x 14 Rs.1,400
No of shares issued on merger 100 x 0.50 50
Value of shares post-merger 50 x 31.304 Rs.1,565
Increase in market value 1,565 – 1,400 Rs.165
We should accept the merger offer as there is an increase in value post merger.

28. Post-merger PAT if retained earnings have already been re-invested

If retained earnings have already been reinvested, the profit after tax (PAT) of individual companies will
continue to grow at their historical growth rate. However, starting from the next fiscal year, the growth
rate will be determined by the expected growth rate of the merged firm.

Post merger PAT of Year 1 = ((PAT of AC + Growth rate) + (PAT of TC + Growth rate) + Synergy gain

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Post merger PAT of Year 2 = Post merger PAT of Year 1 + Merged Company Growth Rate
Example:
Last year earning of Acquiring company = 100 lacs; Growth rate = 10%; Last year earning of Target
company = 50 lacs; Growth rate = 6%; Synergy gain due to merger = 10 lacs and the likely growth rate post
merger is 12%. The companies have just paid dividends and retained earnings have already been re-
invested in new projects. What is the likely PAT of merged firm for year 1?
a. 178 lacs
b. 179.2 lacs
c. 173 lacs
d. 163 lacs
Answer:
Earnings have already been reinvested and hence next year growth will be based on growth rate of
individual companies
Next year PAT = (100 lacs + 10%) + (50 lacs + 6%) + 10 lacs = 173 lacs

29. Distribution of shares in case of partly paid shares

If part of shares is partly paid-up, we should convert partly paid-up shares into equivalent fully paid
shares and then decide the distribution of shares.
Example:
A Limited will issue 1,00,000 shares as consideration to B Limited. B Limited currently has 30,00,000 shares
comprising of 20,00,000 shares of Rs.10 each (fully paid) and 10,00,000 shares of Rs.10 each (partly paid of
Rs.5). How many shares will be issued to Mr.A who holds 1,00,000 fully paid shares and 1,00,000 partly
paid shares?
a. 8,000 shares
b. 6,000 shares
c. 6,667 shares
d. 10,000 shares
Answer:
• Equivalent fully paid shares of B Limited = 20,00,000 + (10,00,000 x 0.50) = 25,00,000
• A Limited will be issuing 1,00,000 shares for 25,00,000 equivalent fully paid shares
• No of equivalent fully paid shares held by Mr.A = 1,00,000 + (1,00,000 x 0.50) = 1,50,000 shares
𝟏, 𝟎𝟎, 𝟎𝟎𝟎
𝐍𝐨 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬 𝐢𝐬𝐬𝐮𝐞𝐝 = 𝐱 𝟏, 𝟓𝟎, 𝟎𝟎𝟎 = 𝟔, 𝟎𝟎𝟎 𝐬𝐡𝐚𝐫𝐞𝐬
𝟐𝟓, 𝟎𝟎, 𝟎𝟎𝟎

30. Fund available for merger

Fund available for merger depends on debt-taking ability of the company and the available cash and cash
equivalents. The same is computed using the below formula:
• Fund available = [Acquirer book equity x Debt/equity ratio] – [Existing debt of two companies] +
Cash available
Example:
A Ltd.’s (Acquirer company) equity capital is Rs. 2,00,00,000. Both A Ltd. and T Ltd. (Target Company)
have arrived at an understanding to maintain debt equity ratio at 0.30:1 of the merged company. Pre-
merger debt outstanding of A Ltd. stood at Rs. 20,00,000 and T Ltd at Rs. 10,00,000 and marketable
securities of both companies stood at Rs. 40,00,000. How much is the total fund available for merger?
a) 60,00,000
b) 40,00,000
c) 70,00,000
d) 30,00,000
Answer:
Particulars Amount
Debt capacity of merged company (2,00,00,000 x 0.30) 60,00,000
Less: Debt of A Limited and T Limited 30,00,000
Balance debt can be raised 30,00,000
Add: Marketable securities 40,00,000
Total fund available 70,00,000

31. Post Merger Shareholding

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• A shareholder can have a percentage holding in both acquiring and target company. The post-
merger shareholding can be computed as under:
No of shares hed in AC + (No of shares held in TC x ER)
Post − merger shareholding =
Post merger no of shares
Example:
A Limited is acquire B Limited. Exchange ratio offered is 1:2. Mr.X holds 10% of A Limited and 5% of B
Limited. A Limited shareholders hold 60% of merged firm. What will be X’s shareholding in merged firm?
a. 7.50%
b. 8.00%
c. 8.33%
d. 15.00%
Example:
Shareholders Total Shares % holding Shares held by Mr.X
A Limited shareholders 60 10% 6 shares
[60 x 10%]
B Limited shareholders 40 5% 2 shares
[40 x 5%]
Total shares 100 8% 8 shares
[8/100]

32. Valuation of debt and equity [Not a logical item]

• Two distinct companies are on the verge of a potential merger, and the question wants us to
determine the combined value of their debt and equity
• Valuation of debt and equity of individual companies: Look at various scenarios and calculate
the individual debt and equity values for each entity separately. In each scenario, the total firm
value is to be allocated between debt and equity, with debt receiving its valuation first, and equity
representing the residual value.
• Value of debt of individual companies = Weighted average of the value of different scenarios
• Value of equity would be arrived in similar manner
• Value of debt of merged entity = Value of debt of company 1 + Value of debt of company 2
• Value of equity of merged entity = Value of equity of company 1 + Value of equity of company 2

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Summary Theory Notes

Chapter 1 - Financial Policy and Corporate Strategy

Advanced Role of CFO:
• Supports strategic and operational decision making
• Emerging roles: Risk management + Supply chain + Mergers acquisitions and corporate
restructuring + Environmental, Social and Governance (ESG) Financing.
Fundamentals of Business = Strategy + Finance + Management
Strategy can be defined as the long-term direction and scope of an organization to achieve competitive
advantage
Functions of Strategic Financial Management:
• Takes care of investment and financing decisions + Focuses on Strategic, Operational and Tactical
level
• Search for investment + Selection of investment + optimal mix + Systems for internal control +
Results for future decision making
Key decisions within scope of financial strategy: Financing decisions, Investment decisions, Dividend
decisions and Portfolio Decisions.
Different types of strategy: Corporate Level Strategy, Business Unit Level Strategy and Functional Level
Strategy
Financial Planning:
• Financial Planning is the backbone of business planning and corporate planning
• It defines the feasible area of operation
• Three components of Financial Planning is summarized in the below equation:
Financial Resources + Financial Tools = Financial Goals
Outcome of financial planning:
• Financial objectives + Financial Decision making + Financial Measures
Interface between financial policy and strategic management:
• Starting point of an organization is money and end-point is also money
• Sources of finance and capital structure are the most important dimensions of a strategic plan
• Another important dimension of interface between the two is investment and fund allocation
decisions
• Dividend decision is another financial decision which can affect the strategic performance of
company
• Hence financial policy cannot be worked out in isolation and it has closer link with overall
organizational performance and growth
Financial Goals and Sustainable Growth:
• Organization need to consider the financial consequences of sales increases and set sales growth
targets consistent with firm’s operating and financial policies
• Organization should focus not only on current stakeholders but also on future stakeholders
• Example of Fuel industry where there is demarketing campaign preaching customers about fuel
conservation
• Incremental growth strategy, profit strategy and pause strategy are other variants of stable growth
strategy
• Important for long-term development. Too fast or too slow growth can impact the company’s
performance in future
What makes an organization financially sustainable:
• Have more than one source of income
• Regular planning
• have adequate financial systems
• Good public image
• Have clear values
• Have financial autonomy
Sustainable Growth Rate:
• Maximum rate of growth in sales that can be achieved with current profitability, asset utilization,
dividend payout and leverage ratios
• How much can an organization grow without borrowing money

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• SGR = ROE x (1 – Dividend Payout Ratio)
• It assumes target capital structure and target dividend payment ratio and increase sales as rapidly
as market conditions allow
What makes an organization sustainable:
• Clear strategic direction
• Identify opportunities
• Adequate administrative and financial infrastructure
• Leverage further resources
• Get community support

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Chapter 2 - Risk Management
Strategic Risk: Company’s strategy becomes less effective and it struggles to achieve its goal
Compliance Risk: Non-compliance with rules and regulations leading to penalties in the form of fine and
imprisonment
Operational Risk: Failure to cope up with day-to-day operational problems
Financial Risk: Unexpected changes in financial conditions (Prices, Exchange Rate, Credit Rating, Interest
rate)
Types of Financial Risk:
• Counter-party risk: Non-honouring of obligations by counter-party
• Political Risk: Normally faced by overseas investors, as the adverse action by the Government of
the host country may lead to huge losses
• Interest rate risk: Variation in cash flow due to change in interest rate. This risk is more important
for banking companies
• Currency risk: Variation in cash flow due to changes in exchange rates
• Liquidity risk: Inability of the company to meet its liabilities.
Financial risk from different point of view:
• Stakeholder’s point of view: Equity shareholders view financial gearing and new lenders view
existing gearing
• Company’s point of view: Excessive borrowing or lending to someone who defaults, can force
company into liquidation
• Government’s point of view: Failure of bank or financial institution leading to spread of distrust
among society at large
Value-at-risk:
• Meaning: VAR answers two basic questions namely (i) what is the worst-case scenario and (ii)
what will be the loss
• Features: Components (Time Period, Confidence Interval and Percentage loss), Statistical method,
Time Horizon (One day, one week, one month etc.), Probability (normal distribution), Control risk
(control risk by setting limits), Z-score
• Application: Measure maximum possible loss, benchmark for performance measurement, fix
trading limits for front-office of treasury department, deciding trading strategies, tool for Asset
and Liability Management in banks
Counter-party risk:
• Hints: Regulatory restrictions, Insolvency, Hostile action of foreign Government, Failure to obtain
necessary resources, Let down by third party
• Measures to manage: Due-diligence, Exposure limits, Credit review and credit limits,
performance guarantees, limiting exposure to a single company or group
Political risk:
• How to assess: Political ranking, country’s macro-economic conditions, Popularity and stability
of current Government, Advise from embassies
• Measures to manage: Local sourcing, Local financing, Prior negotiations, Entering into joint
ventures
Interest rate risk:
• How to assess: Monetary Policy, Government action, Economic growth, Industrial data, Stock
market changes, Investment by Foreign investors
• Measures to manage: Forward rate agreements, Interest rate options, Interest rate futures, Interest
rate swaps
Currency risk:
• How to assess: Government action, Nominal interest rates, Inflation rate, Natural calamities, Wars,
Change of Government
• Measures to manage: Currency invoicing, Forward contract, Currency futures, Currency options,
Currency swaps, Leading and Lagging, Money Market Hedge

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Chapter 3 – Advanced Capital Budgeting Decisions
Impact of inflation:
• Inflation can impact cash flows – Cash flows including inflation are called nominal cash flows and
excluding inflation are called real cash flows
• Nominal cash flow needs to be discounted at Money Discount Rate and Real cash flows should be
discounted at Real Discount Rate
Impact of Technology Change:
• Technology can impact future cash flows and it may lead to replacement of machinery with
improved technology
• Impact of technology on operations: Alter production process, improved quality, delivery time,
flexibility, shortening of product life cycle
• Incorporation of this risk in decision making: Use techniques like sensitivity analysis, scenario
analysis, simulation analysis – Check if company needs to pursue abandonment due to changed
technology and also adjust discount rate to reflect technology risk
Impact of change in Government Policies:
• Government policies can impact future cash flows - They can also impact company’s customer,
suppliers, service providers – Company should check for abandonment if operations are unviable
• Fiscal policy and monetary policies are short-term policies which impact companies and we also
have long-term policies (>5 years) impacting cash flows.
• Impact on domestic capital budgeting decision: Revision in interest rates leading to change in
cost of capital and fiscal policy changes (tax rates) can impact cash flows
• Impact on international capital budgeting decision: Monetary policy (Changes in bank rates and
money supply which impacts exchange rates) + Fiscal policy (Changes in tax rates relating to
foreign income or revision in DTAA)
Risk and uncertainty:
• Risk can be measured and uncertainty cannot be measured
Adjustment of risk in capital budgeting:
• Risk adjustment is critical to know the real value of cash flows – Adjustment of risk helps in
checking whether a project is earning adequate returns compensating the risk undertaken
Sources of risk:
• Internal Factors: Project specific risk (Project completion, error in estimation) + Company specific
risk (Downgrade of credit rating, changes in KMP)
• External Factors: Industry specific risk + Market risk + Competition risk + Risks due to economic
conditions + International risk
Tools for incorporating risk:
• Statistical techniques: Probability + SD + Co-efficient of variation
• Conventional Techniques: RADR + CEF
• Other Techniques: Sensitivity Analysis + Scenario Analysis + Simulation Analysis + Decision
Tree
RADR Approach:
• Risky projects are evaluated at higher discount rate
• Advantages: Easy + Discount factor incorporates risk
• Limitations: Difficulty in finding RADR + NPV can be computed but SD cannot be calculated
CEF Approach:
• Adjustment of cash flows based on certainty of cash flows
• Advantages: Simple and easy + Different levels of risk can be attached to different years
• Disadvantages: No objective method to ascertain certainty equivalent factor
RADR vs CEF:
• CEF is superior to RADR as different levels of risk can be attached to different years – However
RADR is mostly followed as it is easy to adjust discount rate than assigning CEF to each year Cash
flow
Sensitivity Analysis:
• Studies the impact of change in variables on project outcomes – It studies impact of only one
variable at a time
• Advantages: Simple and identifies critical issues

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• Disadvantages: Assumes variables are independent (not related to each other which is unlikely in
real life) + Does not look into probability of changes
Scenario Analysis:
• Evaluates the impact of changes in multiple variables on NPV of the project – We start with
analysis of base case NPV and then compute best case/worst case NPV with changes in multiple
variables at a time
Scenario Analysis Vs Sensitivity Analysis:
• Sensitivity analysis evaluates the impact of change in single variable whereas scenario analysis
considers impact where multiple variable change together
Simulation:
• Involves infinite calculations to obtain possible outcomes by modelling investment projects, cash
flows and key factors affecting project
• Advantages: Predicting market situations + Handling complex inter-relationships
• Limitations: Specifying probability distribution of variable can be difficult + NPV is computed
based on risk-free rate and the same may not give right view of final NPV
Decision-Tree Approach:
• Handles scenario with sequential investment decisions
• Handles two types of situations – Decision (manager has control) and Event (Manager has no
control)

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Chapter 4 – Security Analysis
Security Analysis:
• Systematic analysis of risk and return profile to help a rational investor make a decision on
purchase of security
• Two approaches – Fundamental Analysis and Technical Analysis
Fundamental Analysis:
• Objective is to find intrinsic value which is the present value of future dividends discounted at
appropriate discount rate
• Key variables = EIC Analysis – Economic, Industry and Company Analysis
Economic Analysis:
• Forecast national income and its various components that will have a bearing on specific industry
and the company
• Factors affecting economic Analysis: Focus is on macro-economic factors such as growth rates of
national income, growth rate of industrial sector, inflation and monsoon
Techniques used for Economic Analysis:
• Anticipatory Surveys: Help investors from an opinion on future state of economy by getting
expert opinion on various factors impacting economy
• Barometer/Indicator Approach: Indicators to find how economy will perform in future. There are
leading indicators, roughly coincidental indicators and lagging indicators
• Economic model building approach: Developing a precise and clear relationship between
dependent and independent variables. In this approach forecasting of GBP id done in two ways.
One is by measuring individual components and then adding upto overall GNP. This is then
compared with GNP prediction of independent agency to check for accuracy and consistency
Industry Analysis:
• This is concerned with analysing the expected performance of the specific industry to which the
company belongs. Demand, cost structure and other factors are analysed to identify the prospects
of the company
• Factors: Product life-cycle, Demand supply gap, barriers to entry, Government attitude, state of
competition, cost conditions and profitability, Technology and research
• Techniques: Regression Analysis (consider factors such as GNP, disposable income, per capita
consumption, price elasticity to identify demand) and Input-output Analysis (track flow of goods
across value chain to find changing trends indicating growth/decline of industries)
Company Analysis:
• Factors: Networth/Book value, Sources and uses of funds, Cross-sectional and time series
analysis, size and ranking, Growth record, Financial Analysis, Competitive advantage, Quality of
management, corporate Governance, Regulation, Location and Labour-management relations,
Pattern of existing stock holding, Marketability of shares
• Techniques: Correlation and regression analysis, Trend Analysis and Decision Tree Analysis
Technical Analysis:
• Meaning: Method of study of share price movements based on study of price graphs or charts to
find future trends in share prices
• Assumption: Price is dependent on supply and demand which are governed by several factors,
stock prices move in trends, emphasis is on chart analysis rather than information in financial
statements
• Principles: The market discounts everything, Price moves in trends and History tends to repeat
itself
Dow Theory:
• Two indices: Dow Jones Industrial Average and Dow Jones Transportation Average
• Three classification: Primary movement, secondary movement and daily fluctuations
• Primary movement: Main trend usually for one year to 36 months – commonly called as bear or
bull market
• Secondary movement: Opposite to primary movement and is shorter in duration
• Daily fluctuations: Not part of the interpretation
• Interpretation: Successive highs and lows of stock market averages are higher, then the same
would be bull market. If the successive highs and lows are lower than it is bear market

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• Three moves: First one by far-sighted knowledgeable investors, second one by arrival of earnings
numbers and the third one is of speculative.
Elliott Wave Theory:
• Market exhibited certain repeated patterns or waves. Depending on demand and supply, waves
are generated in the prices
• Types of waves: Impulsive patterns and corrective patterns
• Impulsive Patterns (Basic Waves): 3 or 5 waves in a given direction (upward or downward) – also
called as basis movements which indicates bull or bear phase
• Corrective Patterns (reaction waves): Moves against the basis direction
• One cycle consists of waves made up to two distinct phases (bullish and bearish). On completion
of one cycle, fresh cycle will start with similar impulses
Random Walk Theory:
• This theory states that the behaviour of stock market prices is unpredictable and there is no
relationship between present and future prices
• Change is security prices behave nearly as if they are generated by a suitably designed roulette
wheel
• Supporting arguments: Price cannot be predicted, price trends are statistical expression of past
data, Periodical ups and downs,
Charting techniques:
• Line Chart: Lines are used to connect successive day’s prices. The closing price for each period is
plotted as a point
• Bar Chart: Vertical line (Bar) represents the lowest to the highest price, with a short horizontal line
protruding from the bar representing both the opening and closing prices for the period
• Japanese Candlestick Chart: The bar chart displays stock opening, closing, and highs and lows,
with the color of the candlestick indicating the trend. A black candlestick indicates a lower
closing price, while a white candlestick indicates a higher one. A Doji candlestick indicates no
change or near-no change
• Point and figure chart: They are used to detect reversals in a trend. For plotting a point and figure
chart, we have to first decide the box size and the reversal criterion. The box size is the value of
each box on the chart, for example each box could be 1, 2 or 0.50. The smaller the box size, the
more sensitive would the chart be to price change
Market Indicators:
• Breadth Index: This is computed by dividing the net advances or declines in the market by the
number of shares traded
• Volume of transactions: Rising index/falling index with increasing volume would indicate bull
and bear market respectively
• Confidence Index: Ratio of high-grade bond yields to low-bond grade yields – Explains how
willing the investors are willing to take a change – Rising confidence index is a sign of bull market
and vice versa
• Relative strength Analysis: Some securities generate higher returns in bull market or decline more
slowly in bear market. These securities demonstrate relative strength in the past and this can be
used to buy securities with high relative strength
• Odd-lot theory or Contrary- opinion theory: It assumes that the average person is usually wrong
and the wise course of action is to pursue strategies contrary to popular opinion
Support and Resistance Level:
• When the index/price goes down from a peak, the peak becomes the resistance level. When the
index/price rebounds after reaching a trough subsequently, the lowest value reached becomes
the support level
Tools to interpret price patterns:
• Channel: Series of uniformly changing tops and bottoms gives rise to a channel
• Wedge: A wedge is formed when tops (resistance levels) and bottoms (support levels) change in
opposite direction
❖ Head and Shoulders: It is a distorted drawing of a human form, with a large lump (for head) in
the middle of two smaller humps (for shoulders). This is perhaps the single most important
pattern to indicate a reversal of price trend.
• Triangular or coil formation: Pattern of uncertainty and hence difficult to predict which way price
will break out
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• Flags and Pennants form: Signifies a phase after which the previous price trend is likely to
continue
• Double Top Form: Represents a bearish development – price likely to fall
• Double bottom form: Represents a bullish development – price likely to rise
• Gap: A gap is the difference between the opening price on a trading day and the closing price
of the previous trading day.
Moving average Analysis:
• Buy Signals: Stock price line goes above moving average line when moving average line is
flattering out, stock price falls below rising moving average line, Stock price line which is above
moving average line falls and begins to rise again above moving average line
• Sell Signals: Stock price line goes below moving average line when moving average line is
flattering out, stock price rises above falling moving average line, Stock price line which is below
moving average line rises and begins to fall again below moving average line
Evaluation of Technical Analysis:
• Supporters: Trends persist for some time due to human psychology, shift in demand and supply
are gradual and not instantaneous, information is factored in gradually in price and hence price
movement continues in same direction till information is fully factored in
• Detractors: No convincing explanation, early identification of trends may not be possible, many
people employing technical analysis will lead to decline in value of technical analysis, supporting
random walk theory which is not feasible
Fundamental Analysis vs Technical Analysis:
• Fundamental analysis predicts prices based on economy, industry and company factors whereas
technical analysis predicts future prices based on historical price movements
• Fundamental analysis believes price discounts every information and useful for long-term
investing whereas technical analysis believes in price capturing everything and is useful for short-
term investing
Efficient market theory:
• Conclusion: All available price sensitive information is fully factored in share prices
• Reason why consistent outperformance cannot happen: Free availability of information, keen
competition among market participants and price change will only be on new information
• Misconceptions: Prices factor in all available information, Price will fluctuate but they cannot
reflect fair value due to surprise element, Random movement of stock price indicating stock
market is irrational
• Level of market efficiency: Weak form (Reflect information found in record of past prices and
volumes), semi-strong (past prices + Volumes + Other public information), Strong form (Public as
well as private information)
• Challenges: Limited information processing capabilities, irrational behaviour and monopolistic
influence of powerful institutions and big operators
• Tests to check market efficiency: Serial Correlation Test, Run Test and Filter rules Test
Tools available for equity research:
• Equity Research is a finance or investment banking field that analyzes a company's financial
performance to determine whether to buy, sell, or hold equity shares
• Available tools: Bloomberg terminal, Businessquant, YCharts, MarketXLS

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Chapter 5 – Security Valuation
Expected return and required return:
• Required return represents minimum rate of return which investor wants. This is also called as
cost of capital
• Expected return reflect the return likely to be earned by investors
• Expected Alpha = Expected Return – Required Return
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.
Nominal cash flow and real cash flow:
• Nominal cash flow is the amount of cash flow without any adjustments for inflation. Real cash
flows are company’s cash flow with adjustments for inflation
• Nominal cash flow include inflation and is discounted with nominal discount rate whereas real
cash flow exclude inflation and is discounted with real discount rate
Enterprise value:
• Meaning: Enterprise value is the true economic value of company. EV = Equity + Debt + Minority
Interest – Cash and cash equivalents
• Multiples in relation to EV: EV to sales and EV to EBITDA
Duration:
• Duration is nothing but the average time taken by an investor to collect his/her investment. If an
investor receives a part of his/her investment over the time on specific intervals before maturity,
the investment will offer him the duration which would be lesser than the maturity of the
instrument. Higher the coupon rate, lesser would be the duration.
• Duration is impacted by time to maturity and coupon rate
Immunization:
• Immunization happens if the weighted duration of the portfolio is equal to the period for which
investment is required to be made. This is a level where price risk and reinvestment risk will offset
each other leading to no impact to the investor
Term structure Theory:
• Explains the relationship between interest rates or bond yields and different terms/maturities
• Types of Yield curve: Upward sloping, Downward Sloping, Flat and Humped
• Expectation theory: Long-term interest rates can be used to forecast short-term interest rates
• Liquidity preference theory: Forward rates = Expected future spot rate + liquidity premium to
compensate for exposure to interest rate risk
• Preferred habitat theory (Market Segmentation Theory): Premiums are related to supply and
demand of funds at various maturities and not to the term of maturity
Convexity:
• Duration can be used to find the percentage change in bond price for small change in interest rates.
However, this cannot accurately measure the change
• Accurate measurement can be done with the help of convexity adjustment
C x (Δy)2 x 100
Where
Δy = Change in Yield
V+ + V− − 2V0
C=
2V0 (Δ2 )
V+ = Price of bond if yield increases by Δy
V− = Price of bond if yield decreases by Δy
Modified duration:
• Volatility assumes linear relationship between yield and price change. However, the relationship
is non-linear due to convexity adjustment. Hence, we can say that modified duration is only a
proxy and not an accurate measure of change in price of bond due to change in interest rates
Reverse stock split:
• ‘Reverse Stock Split’ is a process whereby a company decreases the number of shares outstanding
by combining current shares into fewer or lesser number of shares.
• Reasons: Avoiding delisting from stock exchanges, avoiding removal from constituents of index,
to avoid the tag of Penny stock and to attract institutional investors and mutual funds

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Zero Coupon Bond:
• ZCB do not pay interest during the life of the bonds. They are issued at discounted price and the
amount will mature to face value by end of life
Arbitrage pricing theory:
• CAPM formula helps to calculate the market's expected return, APT uses the risky asset's expected
return and the risk premium of a number of macroeconomic factors.
• Required return under APT = R(f) + B1(RP1) + B2(RP2) + …. Bj(RPn)
Money Market:
• Market for meeting short-term funding requirements of corporates and Banks
• Features: Short duration, Large volumes, De-regulated interest rates, highly liquid, safe
investments
Different instruments:
• Call/Notice Money: Call money market is where scheduled commercial banks lend or borrow on
call (overnight) or at short-notice. Under notice money market, funds are transacted for a period
between two to 14 days
• Treasury bills: Short-term promissory notes issued by Government of India at a discount. These
provide investor an opportunity to invest short-term surplus in instruments of varying maturities
• Commercial bills: A commercial bill is a bill of exchange containing a written order from the
creditor to the debtor to pay a certain sum to a certain person after a specified period. The seller
can get the bill discounted and use the same for meeting his working capital needs
• Certificate of Deposit: Term deposits accepted by commercial banks from bulk depositors. These
are issued at discount and the face value is payable at maturity by the issuing bank
• Commercial Paper: Unsecured and negotiable promissory notes issued by high-rated corporate
entities. These are issued directly to the market and used for funding working capital
requirements. Generally, CP is issued at discount and yield is market determined
• Repo and Reverse Repo: Repo rate is the rate at which RBI lends to commercial banks and Reverse
Repo rate is the rate at which Commercial banks lend to RBI. Repo and Reverse Repo refers to
type of transaction in which money market participant raises funds by selling securities and
simultaneously agreeing to repurchase the same along with interest in future
Valuers:
• Purposes for which valuers are required: Mergers/acquisitions/de-mergers/takeovers + Slump
sale/Asset sale/IPR sale + Conversion of debt/security + Capital reduction + Strategic financial
restructuring
• Responsibilities: Integrity and fairness + Professional competence and due care + Independence
and disclosure of interest + Confidentiality + Information management + Not taking expensive
gifts and hospitality + reasonable remuneration and cost reimbursement + Not accepting too many
assignments which can impact execution
• Precautions: Spend adequate time in collecting data and understanding the firm + evaluate factors
other than financial statements such as scalability, growth potential, cross-sell opportunities +
Balance valuation based on numbers/story

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Chapter 6 – Portfolio Management
Activities in Portfolio Management:
• Security selection – construction of feasible portfolios – Deciding the weights/proportion of
securities to form optimal portfolio
Objectives of Portfolio Management:
• Security/safety of principal
• Stability of Income
• Capital Growth
• Marketability (case with which a security can be bought or sold)
• Liquidity (nearness to money)
• Diversification
• Favourable tax status
Five Phases of Portfolio Management:
• Security Analysis – Examining the risk and return of individual characteristics and correlation
among them
• Portfolio Analysis – Creation of large number of portfolios with the available securities
• Portfolio Selection – Identification of efficient portfolio among various set of feasible portfolios
• Portfolio Revision – Constantly monitor the selected portfolio to ensure it its optimal
• Portfolio Evaluation – Assessing the performance of the portfolio over selected period of time
Traditional Approach:
• Investor’s study with an insight on age, health, need for income, attitude towards risk and taxation
status
• Portfolio Objectives – Maximizing investor’s wealth which is subject to risk
• Investment strategy – Balancing liquidity, return, dividends, capital gain etc
• Diversification
• Selection of individual investments – Intrinsic value analysis/expert advice/inside
information/newspaper
Elements of risk:
• Total Risk = Systematic Risk + Unsystematic Risk
• Systematic risk comprises factors that are external to a company and affect a large number of
securities. Systematic risk can be further subdivided into interest rate risk, purchasing power risk
and market risk
• Unsystematic risk includes those factors which are internal to companies and affect only those
particular company. Unsystematic risk can be further subdivided into business and financial risk
Assumptions of Markowitz Model:
• Return adequately summarizes the outcome – Investors visualize a probability distribution of
rates of return – Return can be measured through measures such as NPV and Yield
• Risk estimates are proportional to the variance of return – Investors are risk-averse
• Investment decisions are based on expected return and variance
• Investors are assumed to be rational
Capital asset pricing model:
• Model explains the relationship between expected return, non-diversifiable risk and value of
security
• Systematic risk cannot be diversified and will continue to be there in portfolio – Systematic risk is
measured through beta and it does not remain same for all
• Expected return = Rf + Beta x (Rm – Rf)
Assumptions:
• Efficient market
• Rational investment goals
• Risk aversion is adhered to but sometimes risk seeking behaviour is also adopted
• Assets are divisible and liquid
• Investor can borrow at risk-free rate of interest
• No transaction cost
• No risk of insolvency or bankruptcy
Advantages:
• Measurement of risk-adjusted return

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• Computation of cost of equity for no dividend company
Limitations:
• Reliable beta may not be measured
• Ignoring unsystematic risk – however investor having undiversified portfolio carry this risk
• Information on risk-free rate of interest and expected return of market
Active Portfolio Strategy:
• An APS is followed by most investment professionals and aggressive investors who strive to earn
superior return after adjustment for risk
• APS involves a great deal of time on researching individual companies, gathering extensive
data about financial performance, business strategies and management characteristics
Principles:
• Market timing
• Sector rotation
• Security selection
• Use of specialized investment concept
Passive Portfolio strategy:
• Passive strategy rests on the tenet that the capital market is fairly efficient with respect to the
available information. Example: Index Funds
Guidelines:
• Create a well-diversified portfolio for a level of risk
• Hold the portfolio relatively unchanged over time
Criteria for Bond selection:
• YTM
• Risk of default
• Tax Shield
• Liquidity
Approaches for selection of stock:
• Technical Analysis
• Fundamental Analysis
• Random selection analysis
Level of Efficiency/Approach Technical Analysis Fundamental Analysis Random Selection
Inefficiency Best Poor Poor
Weak form efficiency Poor Best Poor
Semi-strong efficiency Poor Good Fair
Strong form efficiency Poor Fair Best
Portfolio revision and re-balancing strategies:
• Buy and Hold Policy: Also known as ‘do nothing policy’ as no balancing is required
• Constant mix policy: Do something policy that maintains tock exposure at a constant percentage
of total portfolio
• Constant Proportion Portfolio Insurance: Sets a floor value for an asset’s value and this is invested
in safe assets and the balance is invested in equity shares
Asset Allocation Strategies:
• Integrated asset allocation: Allocation that best serves the investor’s needs while incorporating
the capital market forecast is determined
• Strategic Asset Allocation: Optimal portfolio mix based on risk, returns and co-variances are
generated and adjusted periodically to restore target allocation
• Tactical asset allocation: Investor risk tolerance is assumed constant and allocation is changed
based on capital market conditions
• Insured asset allocation: Risk exposure based on portfolio values is adjusted and more value
means more ability to take risk
Fixed Income Portfolio:
• Process: Set objective + Draft guidelines for investment policies + Selection of portfolio strategy
(active/passive) + Selection of securities + Evaluation of performance
• Return computation: Arithmetic rate of return/Time weighted rate of return/Rupee weighted
rate of return/Annualized return

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• Passive Strategies: Buy and Hold Strategy + Indexation strategy + Immunization + Matching cash
flows
• Active Strategies: Forecasting returns and Interest rates (Bullet Strategy + Barbell Strategy +
Ladder Strategy) + Bond swaps (Pure Yield Pickup Swap + Substitution swap + International
spread swap + Tax swap) + Interest rate swaps
Features of alternative investments:
• High fees
• Limited historical data
• Illiquidity
• Less transparency
• Need for extensive research
• Leveraged buying
Characteristics of real estate which makes valuation complex:
• Inefficient market – Illiquidity – Comparison (difficult to find exact comparable property) – High
transaction cost – No organized market
Approaches to value real estate:
• Sales comparison approach – Value based on similar type of property
• Income approach – Perpetual cash flow is discounted at market required rate of return
• Cost approach – Value = Replacement cost of building + Estimated value of land
• Discounted After tax cash flow approach – PV of expected inflows at required rate of return
Gold:
• Popular mode of investment with Jewelry being the most common mode of purchase
• Modes of investment: Gold Bars + SGB + Gold Exchange Traded Funds(ETFs) + E-Gold
Distressed Securities:
• Purchasing the securities of companies that are in or near bankruptcy
• Purpose is to buy securities at low price and revive a sick company to make huge profits
• Arbitrage – Take a long position in debt and short position in equity
• Risks – Liquidity risk, Event Risk, Market Risk and Human Risk
Strategy of portfolio rebalancing where portfolio does not fall below specified value:
• Constant Proportion Portfolio Insurance (CPPI) policy can help in ensuring minimum portfolio
value. We decide a floor value and the same is invested in safe assets such as treasury bill/bonds
• Investment in shares = (Portfolio value – Floor value) x Multiplier

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Chapter 7 - Securitization
Concept of Securitization:
• The process of securitization typically involves the creation of pool of assets from the illiquid
financial assets, such as receivables or loans which are marketable
Features of Securitization:
• Creation of financial instruments
• Bundling and unbundling
• Tool of risk management – Assets securitized on non-recourse basis then the risk of default it
shifted
• Structured finance – Financial instruments are structured to mee the risk return trade of profile of
investor
• Trenching – Each part (Trenche) carries a different level of risk and return
• Homogeneity – Even small investors can afford to invest in small amounts
Securitization in India:
• Citi Bank had pioneered the concept of securitization in India
• Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest
(SARFAESI) Act 2002 was introduced to encourage securitization
• Initially it was started with auto loan receivables and gradually became a major source of founding
for micro finance companies and NBFC
Benefits of Securitization:
From the angle of Originator:
• Off-balance sheet financing
• More specialization in main business
• Helps to improve financial ratios
• Reduced borrowing cost
From the angle of investor:
• Diversification of risk
• Regulatory requirement
• Protection against default
Participants in Securitization:
Primary Participants:
• Originator: It is the initiator of deal or can be termed as securitizer. It is an entity which sells the
assets lying in its books and receives the funds generated through the sale of such assets
• SPV: SPV is created for the purpose of executing the deal. Since issuer originator transfers all
rights in assets to SPV, it holds the legal title of these assets. SPV makes an upfront payment to
the originator, it holds the key position in the overall process of securitization
• Investors: Investors are the buyers of securitized papers
Secondary Participants:
• Obligors: They are the parties who owe money to the firm and are assets in the Balance Sheet
of Originator. The amount due from the obligor is transferred to SPV
• Rating agency: The assets have to be assessed in terms of its credit quality and credit support
available
• Receiving and Paying Agent (RPA): Also, called Servicer or Administrator, it collects the payment
due from obligor(s) and passes it to SPV.
• Agent or Trustee: Trustees are appointed to oversee that all parties to the deal perform in the true
spirit of terms of agreement
• Credit Enhancer: Since investors in securitized instruments are directly exposed to performance
of the underlying and sometime may have limited or no recourse to the originator, they seek
additional comfort in the form of credit enhancement
• Structurer: It brings together the originator, investors, credit enhancers and other parties to the
deal of securitization. Normally, these are investment bankers
Mechanism or steps in Securitization:
• Creation of pool of assets
• Transfer to SPV
• Sale of Securitized Papers
• Administration of assets

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• Recourse to originator
• Repayment of funds
• Credit rating of instruments
Problems in securitization or factors impact growth of securitization in India:
• Stamp duty: Stamp duty even goes upto 12% in some states of India. However, PTC are exempted
from stamp duty. Also, some states have reduced the stamp duty on securitized instruments
• Taxation: No specific provision leading to difference in opinion on taxation
• Accounting: Although securitization is slated to an off-balance sheet instrument but in true sense
receivables are removed from originator’s balance sheet
• Lack of standardization: Every originator follows own format for documentation and
administration leading to lack of standardization
• Inadequate debt market
• Ineffective foreclosure laws: Foreclosure laws are not supportive to lending institutions and this
makes securitized instruments especially mortgaged backed securities less attractive as lenders
face difficulty in transfer of property in event of default by the borrower
Securitization instruments:
• Pass Through Certificates (PTCs): Originator transfers the entire receipt of cash in form of
interest or principal repayment from the assets sold. Thus, these securities represent direct claim
of the investors on all the assets that has been securitized through SPV. Since all cash flows are
transferred the investors carry proportional beneficial interest in the asset held in the trust by
SPV. It should be noted that since it is a direct route any prepayment of principal is also
proportionately distributed among the securities holders.
• Pay Through Security (PTS): In contrast to PTC in PTS, SPV debt securities backed by the assets
and hence it can restructure different tranches from varying maturities of receivables. This
structure permits desynchronization of servicing of securities issued from cash flow generating
from the asset. Further, this structure also permits the SPV to reinvest surplus funds for short
term as per their requirement
• Stripped Securities: Stripped Securities are created by dividing the cash flows associated with
underlying securities into two or more new securities. Those two securities are as follows: (i)
Interest Only (IO) Securities and (ii) Principle Only (PO) Securities. The holder of IO securities
receives only interest while PO security holder receives only principal
Pricing of Securitized Instruments:
• From originator’s point of view: Instruments can be priced at a rate at which originator has to
incur an outflow and if that outflow can be amortized over a period of time by investing the
amount raised through securitization
• From Investor’s point of view: Security price can be determined by discounting best estimate of
expected future cash flows using rate of yield to maturity of a security of comparable security
with respect to credit quality and average life of the securities
Risks in Securitization:
• Credit risk or counterparty risk
• Legal risks
• Market risks (Macroeconomic risk + Prepayment risk + Interest rate risks)
Blockchain Technology:
• Decentralized open ledger with permanent entries and irreversible changes - A blockchain uses a
chain of blocks representing digital information stored in a public database – A simple example of
a blockchain technology is Google Documents
• Working: Transaction initiated + Transaction broadcasted + Validation of transaction by Network
+ Block is added to existing block chain + Transaction is complete
• Application: Financial services + Healthcare + Government + Travel industry + Economic
forecasts
• Risks: No single party is in-charge and hence managing risks can be a challenge + Reliability will
be lost if underlying technology is tampered with + risk of information overload
Tokenization:
• Process of conversion of tangible and intangible assets into blockchain tokens
• Tokenization vs Securitization: Liquidity + Diversification + Trading + New opportunities

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Chapter 8 – Mutual Funds
Meaning of Mutual Fund:
• MF is a trust that pools together the resources of investors to make a foray into investment in
capital market
• Managed by professional money manager
Classification:
Functional Classification:
• Open-ended: Investor can make entry and exit at any time
• Close-ended: Can buy during initial offer or from stock market post listing. It has limited life and
then the scheme is liquidated
• Interval: Combination of open-ended and close-ended
Portfolio Classification:
• Equity fund: Invest in stocks. Following types are there:
o Growth fund – Objective to provide long term capital appreciation
o Aggressive funds – Super normal returns by investing in risky investments like start-ups,
IPOs and speculative shares
o Income funds – Invest in safe stocks having high cash dividends and in high yield money
market instruments
• Debt funds: Invest in debt. Following types are there:
o Bond funds – Invest in fixed income securities
o Gilt funds – Invest mainly in Government securities
• Special Funds:
o Index funds – Invest in stock index (NIFTY/SENSEX)
o International funds – MF raise money in India and investing globally
o Offshore funds – MF raising money globally and investing in India
o Sector funds – Invest in particular industry
o Money market funds – Invest in short-term debt-oriented schemes
o Fund of funds – Invest in other mutual fund schemes
o Capital protection-oriented fund -Objective is to protect the capital invested by investing
in highly rated debt instruments
o Gold funds – Invest in Gold or Gold related instrument
o Quant funds – Works on a data-driven approach for stock selection and investment
decisions + Eliminates the human biasness and subjectivity
Ownership Classification:
• Public sector Mutual Funds
• Private Sector Mutual Funds
• Foreign Mutual Funds
Direct Plan:
• Mutual fund direct plans are those plan where Asset Management Companies or mutual fund
Houses do not charge distributor expenses, trail fees and transaction charges. NAV of the direct
plan are generally higher in comparison to a regular plan.
Types of schemes:
• Balanced fund – Debt portfolio provides stability and equity provides growth. Consist of both
debt and equity
• Equity diversified funds – High level of diversification and ensures risk reduction involved in the
fund
• Equity tax linked savings scheme - To get tax benefit under Section 80C
• Sector funds – Focus on a particular industry
• Thematic funds – Broader outlook than sector funds
• Arbitrage funds – Focus is to earn better return than debt funds and lower volatility than equity
funds
• Hedge funds – Aggressively managed portfolio of investment with a gold of generating high
returns
• Cash fund – Liquid scheme which aims to provide returns with low risk and ensure better
liquidity

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• Exchange Traded Fund - Funds are listed on stock exchanges and their prices are linked to the
underlying securities. Following are the types of ETF Products available in the market: (i) Index
EFTs (ii) Commodity ETFs (iii) Bond ETFs (iv) Currency ETFs
• Fixed maturity plans – Close-ended mutual funds + Invests in CDs, commercial papers, money
market instruments and Non-convertible debentures + it carries credit risk
Advantages of Mutual Funds:
• Professional Management + Diversification + Convenient administration + Higher returns + Low
cost of management + Liquidity + Transparency + Other Benefits – Regular withdrawal and
systematic investment plan + Highly regulated + Economies of scale + Flexibility + Convenience
Drawbacks of Mutual Funds:
• No guarantee of Return + Diversification (Diversification minimizes risk but it does not ensure
maximizing returns) + Selection of proper fund + Cost factor
Trailing commission:
• Amount paid by MF investor to his advisor each year + It provides an incentive to the advisor to
review their customer’s holdings + It is calculated as a percentage of daily average AUM
Expense Ratio:
• Percentage of assets spent on mutual fund operations + Needs to be monitored as high expense
ratio can impact returns
Side Pocketing:
• Separation of risky assets from other investments and cash holding. Money invested in MF linked
to stressed assets gets locked, until the fund recovers the money from the company or could avoid
distress selling of illiquid securities
• Side Pocketing is beneficial for those investors who wish to hold on to the units of the main funds
for long term. Therefore, the process of Side Pocketing ensures that liquidity is not the problem
even in the circumstances of frequent allotments and redemptions.
Tracking error:
• Divergence or deviation of fund’s return from the benchmarks it is following – this is critical for
passive mutual funds
• Higher tracking error would indicate high risk profile
• Tracking error can occur due to transaction cost, fees charged by AMCs, Fund expenses, Cash
holdings and Sampling biasness
Evaluation of MF performance:
• Quantitative parameters: Risk-adjusted returns + Benchmark returns + Comparison to peers +
Comparison Returns of across different economic and market cycles + Financial measures
(Expenses ratio + Sharpe Ratio + Treynor Ratio + Sortino Ratio)
• Qualitative parameters: Quality of portfolio + Track record and competence of fund manager +
Credibility of the fund house team
Role of a fund manager:
• Good performance of the fund being managed
• Role depends on whether it is active fund or passive fund + Active managed funds (Fund
manager plays a crucial role and need to generates Alpha) + Passively Managed Funds (Minimum
tracking error)
• Other key roles: Compliances + Constant monitoring the performance of the fund + Creation of
wealth and protection + Control over works outsourced to third parties
Role of FII in Mutual Funds:
• FII are large foreign groups with substantial investible funds and are registered abroad
• Strong research team and can buy domestic mutual funds directly from issuers or through
registered stock brokers
• FII enhances corporate governance, improve market competition and improve capital flow

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Chapter 9 – Derivatives Analysis and Valuation
Meaning of Derivative Instrument:
• Derivative is a product whose value is to be derived from the value of one or more basic
variables called bases (underlying assets, index or reference rate). The underlying assets can be
Equity, Forex, and Commodity
• The value of derivative instrument changes with the change in value of underlying instrument
Users of derivatives:
• Corporation
• Individual investors
• Institutional investors
• Dealers
Cash market and derivatives market:
• Cash market – Tangible assets are traded; Derivatives market = Contract based on tangible or
intangible assets like index
• We can purchase one share in cash market but there are minimum lots in derivative market
• Cash market is for consumption/investment whereas derivatives market is for hedging, arbitrage
and speculation
• Buying securities in cash market involves putting up all money upfront whereas buying in futures
market only involves margin money
Forward contract and Futures contract:
• Forward contracts are traded on personal basis whereas futures contracts are traded in a
competitive arena
• Forward contracts have no standardized size whereas futures contracts are of standardized size
• Forward contracts are traded in over the counter market whereas futures are traded in stock
exchanges
• Forward contracts are delivered whereas only net settlement happens in futures contract
• Cost of forward contract is based on bid-ask spread whereas futures contracts involve brokerages
• Forward contracts are not subject to mark to market and do not require margins. Futures contract
are subject to mark to market and involves initial and maintenance margin
• Forward contract has credit risk whereas futures contracts do not have credit risk
Marking to Market:
• It implies the process of recording the investments in traded securities (shares, debt-instruments,
etc.) at a value, which reflects the market value of securities on the reporting date. In the context
of derivatives trading, the futures contracts are marked to market on periodic (or daily) basis
Advantages of stock index futures vs stock futures:
• Flexibility to investment portfolio
• Possibility of speculative gains using leverage
• Most cost-efficient hedging
• Stock index futures cannot be easily manipulated
• Less volatile
• Cash settlement
• Less regulatory complexity
• Hedging or insurance protection for a stock portfolio in falling market
Uses/Advantages of stock index futures:
• Changing weights or risk exposures of investment portfolio – Buying/selling index futures can
increase/decrease risk
• Separation of market timing from market selection decisions
• Investors can make money through stock index futures through index arbitrage
• Hedging the value of portfolio
• Possibility of speculative gains through leverage
• Possibility of doing short-sell during falling markets
• Transfer risk quickly and efficiently
Options and Futures:
In options, the buyer of the options has the right but not the obligation to purchase or sell the stock.
However, while going in for a long futures position, the investor is obligated to square off his position at
or before the expiry date of the futures contract

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Factors affecting value of an option:
• Price movement of the underlying instrument
• Time till expiry
• Volatility in stock prices
• Interest rates
Risks of financial products:
• Market risk: Risk due to adverse movement of stock market, interest rates and forex + can be
hedged through normal derivatives
• Credit risk: Known as default risk + Can be hedged through credit derivatives
Working of Credit Default Swaps (CDS):
• Insurance against the risk of default + Credit protection buyer pays a regular premium to credit
protection seller who in turn assumes credit risk
Features:
• Non-standardized contract between buyer and seller
• Normally not traded on any exchange
• International swap and Derivative Association (ISAD) publish the guidelines and rules for CDS
contracts
• Cost of CDS (premium) has positive relationship with risk attached with loans
• Naked CDS – Buying a CDS without purchasing the underlying bonds

Applications:
• Hedging, Arbitrage and Speculation

Parties to CDS:
• Initial borrower + Protection buyer + Protection seller

Settlement in case of default:

• Physical settlement: Face value of bonds would be paid by protection seller and protection buyer
will have to deliver bonds
• Cash settlement: Settlement amount to be paid by protection seller = Face value of bonds x (1 –
Recovery rate)
Collaterized debt obligations (CDO):
• CDO pool together various debt instruments + Investors invest in CDO + CDO pays interest and
principal to investors from the cash flows generated by the assets

Types:
• Cash flow CDO: Backed by cash market debt or securities having low risk
• Synthetic CDO: They do not hold actual debt instruments + However they take credit risk by
taking exposure through CDS
o Unfunded: Only consist of CDS
o Funded: Consist of credit Linked Notes
o Partially Funded: Partially through CLN and CDS
• Arbitrage CDO: Issuer captures spread between return realized collateral underlying the CDO
and cost of borrowing to purchase the collaterals + Additionally fees is also collected for
management of CDO

Risks in CDO:
• Default risk
• Interest rate risk
• Liquidity risk
• Prepayment risk
• Reinvestment risk
• Foreign exchange risk
Financial option and Real option:
• Financial options have underlying assets as financial securities (traded) whereas real options have
underlying assets as projects that are not traded in market

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• Pay-off structure of financial option is specified and fixed whereas pay-off structure of real option
is varied
• Financial options are normally for a year whereas real options are for long period
• Financial options are traded and hence priced in market – Real options are not traded and hence
needs to be valued
Key criteria for considering a commodity under commodity derivatives:
• Standardization + Deliverability + Liquidity + Price volatility + Market demand
Needs of users of commodity derivatives:
• Primary need (Hedger’s need for price risk reduction) + Convenience needs (Flexibility in doing
business + efficient clearing system)
Advantages of commodity market:
• Preference for derivatives as compared to tangible commodities + Less hassles + Indirect
investment in real assets through derivatives

Advantages of commodity futures:

• Easy way to invest in commodities + Multiple categories (Agricultural products + Energy + metal
Types of Commodity swaps:
• Fixed-Floating Swaps: They are just like the fixed-floating swaps in the interest rate swap market
with the exception that both indices are commodity-based indices
• Commodity-for-Interest Swaps: They are similar to the equity swap in which a total return on the
commodity in question is exchanged for some money market rate (plus or minus a spread)
Peculiar characteristics of commodity swaps having a bearing on valuation:
• Cost of hedging + Institutional structure of particular commodity + Liquidity of underlying
commodity + Seasonality + Variability of bid/offer spread + Brokerage fees + Credit risk
Embedded Derivatives:
• An embedded derivative is a derivative instrument that is embedded in another contract - the
host contract. The host contract might be a debt or equity instrument, a lease, an insurance contract
or a sale or purchase contract.
• Derivatives require to be marked-to-market through the income statement, other than qualifying
hedging instruments.
• Example: A coal purchase contract may include a clause that links the price of the coal to a
pricing formula based on the prevailing electricity price or a related index at the date of delivery
Weather derivatives:
• Protection against loss arising due to unfavourable weather patterns – It primarily helps in
managing volume risk, rather than price risk, due to changes in demand of goods due to weather-
related changes
• Underlying asset: Weather which has several dimensions such as rainfall, temperature, humidity,
wind speed
• Weather derivatives vs insurance: Insurance provides protection only against extreme low
probability weather events such as earthquake, floods whereas weather derivatives protect from
all types of risks
• Pricing of weather derivatives is challenging due to data reliability, forecasting difficulties and
temperature modelling challenges.
Electricity derivatives:
• Need: Electricity prices are volatile and hence hedging instruments are needed for generators,
buyers and load-serving entities to reduce price risk
• Forms: Forwards, Futures and Swaps
• Electricity locational basis swap: Holder of the swap agrees to pay or receive the difference
between a specified futures contract price and another locational spot price. This is used to lock-
in a fixed price at a geographic location.
Key lessons from derivatives mishaps:
• Don’t buy any derivative product that you don’t understand
• Due diligence before making Treasury Department as a Profit Centre
• Specify the risk limits
• Separation of Front, Middle and Back Offices
• Ensure that a hedger should not become a speculator
• Carry out Stress Test, Scenario Analysis etc
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Chapter 10 – Foreign Exchange Exposure and Risk Management
Role of SWIFT in foreign exchange:
• SWIFT (Society for Worldwide Interbank Financial Communication) is a messaging system for
business transactions
• SWIFT assigns 3 lettered codes to each country’s currency + It is a standardized communication
system for financial transactions
• Importance of SWIFT: Quick settlement + Reduces operational risk + Reduces costs + Operational
efficiencies + Full backup and recovery system
Payment Gateway:
• Secure virtual mode for transferring cash, authenticating and routing payment details + It helps
in collecting payments on e-commerce sites
• Benefits: Offers convenience, real-time card authorization, efficient transaction processing,
multiple payment options, risk mitigation, real-time reports, customer refund facility and secure
servers
• Challenges: Customer account not available with the bank supporting the payment gateway,
limited bank networks, reliability and customer trust issues
• International payment gateway: Offers global/multi-currency payments and multiple-language
payment interfaces
Nostro, Vostro and Loro Account:
• A bank’s foreign currency account maintained by the bank in a foreign country and in the home
currency of that country is known as Nostro Account or “our account with you”
• Vostro account is the local currency account maintained by a foreign bank/branch. It is also called
“your account with us”.
• The Loro account is an account wherein a bank remits funds in foreign currency to another bank
for credit to an account of a third bank.
Merchant rate and Interbank Rate:
• Exchange rates applied to all types of customers including that for converting inward remittance
in USD to INR are called merchant rates as against the rates quoted to each other by banks in the
interbank market, which are called interbank rates.
• Exchange margin will be added/subtracted to/from the interbank rate to arrive at the merchant
rate for the customer
Techniques for exchange rate forecasting:
• Technical forecasting
• Fundamental forecasting
• Market-based forecasting – Using of market indicators to develop forecasts
• Mixed forecasting
Factors affecting exchange rates:
• Inflation rate
• Interest rate
• Deficit/surplus on capital/current account
• Trade barriers
• Intervention by Central Bank
• Government controls
• Expectations/speculations
Participants in Foreign Exchange Market:
• Non-bank entities – Individuals and corporates buying/selling foreign currency
• Bank
• Speculators – Commercial and investment banks, multinational companies and hedge funds
• Arbitrageurs
• Government
Types of exposure:
• Transaction exposure – Effect of exchange rate on outstanding obligations
• Translation exposure – Also called as Accounting exposure. Effect on owner’s equity because of
the need to translate foreign currency financial statements
• Economic Exposure – Extent to which the value of a company declines due to changes in exchange
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Foreign exchange risk management:
• Meaning: Protection against variation in exchange rates.
• Importance: Helps in reducing costs + Gains competitive advantages + Improve cash flow +
Ensure compliance with regulations
Natural hedging strategy:
• Exporters can use natural hedging strategy for reducing forex risk by availing short-term foreign
currency loans (PCFC/FCNR)
• PCFC is available at a cheaper rate and will also help in using export receivables for PCFC loans
outstanding
Non-deliverable forward contract:
• A cash-settled, short-term forward contract on a thinly traded or non-convertible foreign
currency, where the profit or loss at the time at the settlement date is calculated by taking the
difference between the agreed upon exchange rate and the spot rate at the time of settlement,
for an agreed upon notional amount of funds.
Options vs Futures:
• Writer has obligation to perform in option whereas both parties have obligation in futures
• Premium is to be paid in options. There is no premium in futures
• Limited loss and unlimited gain for holder. Unlimited loss/gain for both parties
• American option can be exercised on any date whereas futures have to be exercised only on
maturity date
Currency Swap:
• Currency swap involve an exchange of liabilities between currencies. It consists of spot exchange
of principal, continuing exchange of interest payment during the term of the swap and re-
exchange of principal on maturity
• Benefits: Hedging, cost savings, permits funding in different currencies, diversification of
borrowings
Strategies for exposure management:
• Low risk: Low reward – All exposures hedged
• Low risk: Reasonable reward – Selective hedging
• High risk: Low Reward – All exposures unhedged
• High risk: High reward – Active trading
Netting:
• Netting helps in minimizing the total value of inter-company fund flows
• Advantages: Reduces the number of cross-border transactions between subsidiaries + Reduces the
need for foreign exchange and hence saved on transaction costs + Improves cash flow forecasting
since cash transfers are made only at end of each period

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Chapter 11 – International Financial Management
Complexities in multinational capital budgeting:
• Conversion of cash flows of foreign projects
• Parent cash flows are different from project cash flows
• Taxation in home country and host country
• Exposure to exchange rate risk
• Impact of inflation
• Repatriation restrictions
• Political risk
• Concession/benefits by host country
Problems faced in international capital budgeting:
• Multinational companies investing elsewhere are subjected to foreign exchange risk
• Due to restrictions imposed on transfer of profits, depreciation charges and technical differences
exist between project cash flows and cash flows obtained by the parent organization
• Presence of two tax regimes makes computation of after tac cash flows difficult
Project cash flows vs Parent cash flows:
• Project cash flows: Evaluation of a project on the basis of own cash flows entails that the project
should compete favourably with domestic firms and earn a return higher than the local
competitors
• Parent cash flows: For evaluation of foreign project from the parent firm’s angle, both operating
and financial cash flows actually remitted to it form the yardstick for the firm’s performance
Foreign currency convertible Bonds (FCCBs):
• A type of convertible bond issued in a currency different than the issuer's domestic currency.
• The investors receive the safety of guaranteed payments on the bond and are also able to take
advantage of any large price appreciation in the company's stock
• Advantages: Flexibility to convert the bond into equity or redeem it, Delayed dilution of equity
for company, easily marketable
• Disadvantages: Exposure to exchange risk, creation of more debt, low interest rate leading to low
income for investor
American Depository Receipts:
• Depository receipts issued by a company in the United States of America (USA) is known as
American Depository Receipts (ADRs)
• An ADR is generally created by the deposit of the securities of a non-United States company
with a custodian bank in the country of incorporation of the issuing company.
• The ADR holder is entitled to the same rights and advantages as owners of the underlying
securities in the home country
Global Depository Receipts:
• A depository receipt is basically a negotiable certificate, denominated in a currency not native to
the issuer, that represents the company's publicly - traded local currency equity shares.
• Depository Receipts issued in the US are called American Depository Receipts (ADRs), which
anyway are denominated in USD and outside of USA, these are called GDRs
Impact of GDR on Indian Capital Market:
• Shifting of Indian Stock market from Bombay to Luxemburg
• Arbitrage possibility in GDR issues
• Indian market is no longer independent from the erst of the world
• Retail investors are completely side-lined
Characteristics of GDR issues:
• Holder gets same benefit as ordinary shareholders without voting rights
• Listed in Luxemburg stock exchange
• Trading happens on over the counter basis
• Freely traded and marketed globally
• Investor earn fixed income by way of dividends
• Liquidation by cancellation of GDR after a cooling off period of 45 days
Euro Convertible Bonds:
• A convertible bond is a debt instrument which gives the holders of the bond an option to convert
the bond into a predetermined number of equity shares of the company.

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• The bonds carry fixed rate of interest and has an option of conversion into equity. The issuer can
also add a call and put option
Other sources of international finance:
• Euro-convertible zero-coupon bond
• Euro-bonds with equity warrants – Carries a coupon rate + Warrants are detachable + Pure bonds
are traded at a discount
• Syndicated bank loans – Large loans from banks + Longer maturity of 5 to 10 years + Interest rate
is generally set with reference to an index
• Euro bonds – Debt instruments denominated in a currency issued outside country of that currency
Example: Yen bond floated in France + It can be in the form of traditional fixed rate bonds (or)
Floating rate notes (or) Convertible bond
• Foreign bonds – Denominated in a currency which is foreign to the borrower
• Euro Commercial papers
• Credit instruments – Multiple types of credit instruments used in effecting foreign remittances
International Financial Centre:
• Hub that deals with flow of funds, financial products and financial services + caters to the needs
of customers outside their own jurisdiction + Provides flexibility in currency trading, banking and
other financial services

Benefits:
• Opportunity for qualified professional to work and pursue global opportunities without leaving
their homeland
• Stops brain drain
• Trading of complicated financial derivatives can be started from India
• Bringing back those financial services transactions presently carried out abroad by overseas
financial institutions/entities or branches or subsidiaries of Indian Financial Market

Constituents:
• Highly developed infrastructure
• Stable Political Environment
• Strategic location
• Quality life
• Rationale regulatory framework
• Sustainable economy
GIFT City:
• GOI operationalized International Financial Services Centre (IFSC) at GIFT Multi-services SEZ in
April 2015
• Single window clearance + Competitive cost of operations with a very competitive tax regime +
Relaxed company law provisions + FEMA rules do not apply in GIFT City
• More and more financial institutions are setting up business units in GIFT due to lower tax rates
and the same can help in provision of foreign currency loans to Indian companies
Sovereign funds:
• State-owned investment fund + Generating money from surplus reserves + Benefits economy and
citizens
• These are created for targeted purposes aiming at protecting revenues, stabilizing exports,
diversifying and earning better returns, funding social and economic development projects
• Classification: Stabilization funds, savings or future generation funds, public benefit pension
funds, reserve investment funds and strategic development SWFs
• Investment vehicles: Sovereign wealth funds (SWF), Public pension funds, State-owned
enterprises and Sovereign wealth enterprises (SWE)
Complexities in International working capital management:
• Wider financing option
• Multiple interest and tax rates
• Forex risk
• Restrictions
• Multiple countries

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• Full capital convertibility: India is currently not under full capital convertibility and restrictions
are there on investments/repatriation
Objectives of international cash management:
• Minimize currency risk
• Minimize cash requirements
• Minimize transaction costs
• Minimize political risk
• Take advantage of economies of scale
Benefits of centralized cash management:
• Maintenance of optimum cash balance
• Managing liquidity requirements
• Optimal usage of hedging strategies
• Generating maximum returns
• Get benefit of multinational netting
• Maximum utilization of transfer pricing mechanism
Ways to optimize cash flow movements:
• Accelerating cash inflows
• Managing blocked funds
• Leading and lagging
• Minimizing tax through transfer pricing mechanism
• Netting
• Investing excess cash

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Chapter 12 – Interest Rate Risk Management
Factors determining interest rates:
• Supply and demand of money
• Inflation
• Government
Benchmark rates:
• Benchmark rates forms the basis for determination of other interest rates + It is also known as
reference rates
• Benchmark rates are crucial in derivative transactions, floating rate loans and are determined by
an independent body
• Popular benchmarks: Secured Overnight Financing Rate (SOFR in USA), Sterling Overnight
Index Average (SONIA in USA), Euro-Short-Term Rate (€STER in Europe), Tokyo Overnight
Average Rate (TONAR in Japan) and Swiss Average Rate Overnight (SARON in Switzerland)
• Indian Benchmark rates: Repo rate + Prime Lending rate + MCLR + MIBOR (Mumbai Interbank
Offered Rate) + MIBID (Mumbai Interbank Bid rate)
Interest rate risk:
• Gap Exposure: Gap or mismatch risk arises from holding assets and liabilities of different maturity
dates or repricing dates, thereby creating exposure to unexpected changes in market interest rates
• Basis Risk: Interest rate of different assets, liabilities and off-balance sheet items may change in
different magnitude. If variation in interest rates cause net interest income to expand, the banks
have experienced favourable basis shifts and if it causes net interest income to contract, the basis
has moved against the banks
• Embedded option risk: Significant change in interest rates may encourage prepayment of debt
and exercise of call/put option on bonds/debentures and/or premature withdrawal of fixed
deposits.
• Yield curve risk: In a floating rate scenario, banks may price their assets and liabilities based on
different benchmarks. If there is non-parallel movement in these benchmarks then the same would
impact NII
• Price Risk: This occurs when assets are sold before their stated maturities. This is particularly
relevant for trading book, which is created for making profit out of short-term movement in
interest rates
• Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows could
be reinvested is called reinvestment risk
• Net interest position risk: Size of non-paying liabilities supports profitability of banks. Interest
rate risk arises when market interest rates are adjusted downwards and bank has more earning
assets then paying liabilities
Methods to hedge interest rate risk:
Traditional Methods:
• Asset and Liability Management: ALM is a comprehensive and dynamic framework for
measuring, monitoring and managing the market risk of a bank. It is the management of
structure of balance sheet (liabilities and assets) in such a way that the net earnings from interest
are maximized within the overall risk preference (present and future) of the institutions.
• Forward Rate Agreements (FRA): Forward Rate Agreement (FRA) is an agreement between two
parties through which a borrower/ lender protects itself from the unfavourable changes to the
interest rate.
Modern Methods:
• Interest Rate Futures (IRF): 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 options: Interest rate options (Interest Rate Guarantee (IRG)) is a right not an
obligation and acts as insurance by allowing businesses to protect themselves against adverse
interest rate movements while allowing them to benefit from favourable movements.
• Interest Rate Swaps: In an interest rate swap, the parties to the agreement, termed the swap
counterparties, agree to exchange payments indexed to two different interest rates.
Types of Interest rate swaps:
• Plain vanilla swap: Also called as Generic swap and it involves exchange of a fixed rate loan to a
floating rate loan
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• Basis Rate Swap: Also called as non-generic swap and it involves exchange between two different
variable rates
• Asset Swap: It is the exchange of fixed rate investments with a floating rate investment
• Amortising Swap: An interest rate swap in which the notional principal for the interest payment
declines during the life of the swap
Swaptions:
Meaning:
• An interest rate swaption is simply an option on an interest rate swap.
Types:
• A fixed rate payer swaption gives the owner of the swaption the right but not the obligation to
enter into a swap where they pay the fixed leg and receive the floating leg
• A fixed rate receiver swaption gives the owner of the swaption the right but not the obligation to
enter into a swap in which they will receive the fixed leg, and pay the floating leg
Uses:
• Useful for active traders as well as for corporate treasurers
• Swap traders can use them for speculation purposes
• Useful for hedging
• Useful for borrowers targeting an acceptable borrowing rate
• Protection against callable/puttable bond issues
Cheapest to Deliver in Interest rate futures:
• The CTD is the bond that minimizes difference between the quoted Spot Price of bond and the
Futures Settlement Price (adjusted by the conversion factor). It is called CTD bond because it is
the least expensive bond in the basket of deliverable bonds.
• 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)

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Chapter 13 – Business Valuation
Approaches of valuation:
• Asset base valuation models: Valuation based on net assets. Variants of asset-based valuation
models are Net asset value/Net realizable value/replaceable value
• Earning based models: Useful when acquiring company intends to continue business of target
company. Valuation is based on income generated and variants of this model are PE ratio/Earning
Yield multiplier/Capitalization of earning
• Cash-flow based approach: Under cash flow-based approach we determine the amount of free
cash flows and discount them at required return to value the company
Steps for valuation of unlisted companies:
• Take the industry Beta and convert the levered beta into unlevered beta
• Adjustment for gaps in accounting policies and accounting adjustments
• Find cost of equity using CAPM
• Find WACC using target debt-equity mix
• Add Goodwill/sweeteners as additional return
• Discount the cash flows at cost of capital
• Sum of PV of cash flows will be the value of firm
Relative Valuation Method:
• Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis to
its peers or similar enterprises. However, increasingly the contemporary financial analysts are
using relative valuation in conjunction to the afore-stated approaches to validate the intrinsic
value arrived earlier
• Steps: Find out the drivers that will be best representative and arrive at multiple, compute the
same through financial rations, find the ratio for comparable firms and then use the same to value
the company
Chop-shop method of valuation:
• Useful for valuation of companies having multiple segments in different industries
• Compute the value of each segment using average capitalization ratios and sum of the values of
all segments will the value of the firm
EVA versus MVA:
• MVA is the true value added that is perceived by the market whereas EVA is a derived value
added
Valuation of a company which is not a going concern:
• Valuation based on liquidation value
• Going concern value will generally be greater than its liquidation value + Going concern company
will have terminal value as the company would continue to earn profits + non-going concern
company implies high risk and creates bad reputation for the company
Why cash flow method cannot be used for valuation of distressed companies?
• Discounted cash flow method assumes terminal value based on perpetual cash flows. However,
this will not be relevant for a distressed firm
• Discount rates used in valuation reflect companies which are operationally and financially sound.
However, this cannot be work in distressed company
Why traditional method cannot be used for valuation of start-ups:
• Income approach: This approach will not work as majority of start-ups are reporting losses
• Asset approach: Startups have negligible assets because a large chunk of their assets are in the
form of intellectual property and other intangible assets
• Market approach: Start-ups are normally disruptors and hence does not have an established
competitor for doing valuation under this method.
Value drivers for start-ups:
• Product
• Management
• Traction (demand for product)
• Revenue
• Industry attractiveness
• Demand-supply
• Competitiveness

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Valuation of digital platforms:
• Income approach – based on cash flows
• Market approach – based on comparable multiples
• Cost approach – based on cost incurred
Valuation of professional/consultancy firms:
• Compute value based on normalized cash flows (adjust for non-recurring items) – Computed
value can be adjusted based on the performance of the firm for various key performance indicators
Impact of ESG:
• Environmental, Social and Governance (ESG) aspects helps in creating sustainable value +
Increasing focus of companies and now this has become must-to-have
• ESG can impact cash flows (Extra spending/saving to comply with ESG aspects) and can also
impact discount rate (Lower discount rate for ESG compliant companies and vice versa)

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Chapter 14 – Mergers, Acquisitions and Corporate Restructuring
Rationale for M&A:
• Synergistic operating economics + Diversification + Taxation + Growth + Consolidation of
production capacities and increasing market power
Types of mergers:
• Horizontal Merger = Merger of two companies in the same industry
• Vertical merger = Two companies having buyer-seller relationship come together
• Conglomerate merger = Merger of firms engaged in unrelated type of business operations.
However, there can still be some common factors such as unification of different kinds of
businesses under one flagship company
• Congeneric merger = Acquirer and target companies are related through basic technologies,
production processes or markets
• Reverse merger = Acquisition of a listed firm by a private company so that private company can
go public
• Acquisition = Purchase of controlling interest by one company in the share capital of an existing
company
Take-over strategies:
When the process of acquisition is unfriendly it is called as takeover. Following are takeover strategies:
• Street Sweep = Acquiring company accumulates larger number of shares before making an open
offer
• Bear Hug = When the acquirer threatens the target company to make an offer, the board of target
company agrees to a settlement
• Strategic Alliance = Offering a partnership rather than a buyout
• Brand Power = Alliance with powerful brands to make the target company brand weak and
buyout the weakened company
Techniques to protect from hostile takeover:
• Divestiture: Target company divests or spins off some of its business. This will make the company
less attractive for acquisition
• Crown Jewels: When a target company uses the tactic of divestiture it is said to sell the crown
jewels
• Poison pill: Tactics used by the acquiring company to make itself unattractive to a potential bidder
is called as Poison Pills
• Poison Put: Target company issue bonds that encourage holder to cash in at higher prices. Cash
drainage will make the target company unattractive
• Greenmail: Incentive offered by the management of the target company to the potential bidder
for not pursuing the takeover
• White Knight: Target company offers to be acquired by a friendly company to escape from a
hostile takeover
• White squire: Selling out of shares to a company that is not interested in a takeover and hence
management of target company will retain the control
• Golden Parachutes: When a company offers hefty compensations to its managers if they get
ousted due to takeover, the company is said to offer golden parachutes
• Pac-man defence: This strategy aims at the target company making a counter bid for the acquirer
company.
Reverse Merger:
• In a 'reverse takeover', a smaller company gains control of a larger one. This type of merger is
also known as ‘back door listing.
• Three tests of reverse merger – Assets of transferor company are greater than the transferee
company, equity capital to be issued by the transferee company pursuant to the acquisition
exceeds its original issues capital and change in control
Divestiture:
• It means a company selling one of the portions of its divisions or undertakings to another
company or creating an altogether separate company
• Reasons: Pay attention on core areas, division is not sufficiently contributing, size is too big to
handle and urgent need of cash
Forms of divestiture/demerger:

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• Sell off/Partial Sell off: Sale of an asset, factory, division, product line or subsidiary by one entity
to another
• Spin-off: Part of the business is separated and created as a separate firm
• Split-up: This involves breaking up of the entire firm into a series of spin off (by creating
separate legal entities).
• Equity Carve Outs: This is like spin off but some shares of the new company are sold in the market
by making a public offer
• Sale of a division: Seller company is demerging its business whereas the buyer company is
acquiring a business
• Demerger or division of family-managed business: Hiving off of unprofitable businesses or
divisions with a view to meeting a variety of succession problems
Ways of doing Ownership Restructuring:
• Going Private: This refers to the situation wherein a listed company is converted into a private
company by buying back all the outstanding shares from the markets.
• Management Buyout: Buyouts initiated by the management team of a company are known as
management buyout. This is useful strategy for exiting those divisions that does not form part of
core business
• Leveraged buyout: Acquisition which is entirely or partially (50% or more) using borrowed funds
• Equity Buyback: Situation wherein a company buys back its own shares from the market. This
increases promoter’s stake due to reduction in capital
Management Buyout Vs Leveraged Buyout:
• MBO – Buyouts initiated by the management team
• LBO – Buyouts primarily funded with debt
• Purpose of LBO: Intention of LBO is to improve the operational efficiency of a firm and increase
the cash flow. Extra cash flow will be used to pay back the debt. Example of LBO: Buyout of Corus
by Tata Steel
How M&A and business restructuring helps in unlocking value:
• Horizontal growth to achieve optimum size, enlarge market share
• Vertical combination to economise costs and eliminate avoidable taxes/duties
• Diversification
• Mobilizing financial resources – Use of idle funds of one company to expand other company
business
• Merging subsidiary with parent company to improve cash flow
• Taking over shell company which has some industrial license
• Restructuring to enhance competitiveness, survival and provide new direction
Steps in successful M&A Programme:
• Manage the pre-acquisition phase + Screen candidates + Eliminate those do not meet the criteria
and value the rest + Negotiate + Post-merger integration
Reasons for failure of M&A:
• Overpayment by acquirers + Over-estimation of value of synergy + Poor post-merger integration
+ Psychological barriers
Cross border M&A:
• Cross-border M&A is one where target and acquiring company are based out of different countries
• Factors contributing to cross border M&A: Globalization of production, Integration of global
economy, Expansion of trade, privatisation of state-owned enterprises and consolidation of
banking industry
IPO without commercial operations:
• Special Purpose Acquisition Companies (SPACs) has come into existence wherein an entity is
set up with the objective to raise funds through an IPO to finance a merger or acquisition of an
unidentified target within a specific time period. It is commonly known as a blank cheque
company
• The main objective of SPAC is to raise money, despite not having any operations or revenues. The
money raised from the public is kept in an escrow account, which can be accessed while making
the acquisition. However, in case the acquisition is not made within stipulated period of time
of the IPO, the SPAC is delisted and the money is returned to the investors

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Chapter 15 – Startup Finance
Definition of Start-up:
• Incorporated as either private limited company or registered partnership or LLP in India not prior
to 5 years
• Turnover in any fiscal year not to exceed Rs.25 Crores
• Should not have been formed by splitting up or reconstruction of business
• Working towards innovation, development, deployment or commercialization of new product,
processes or services driven by technology or intellectual property

Additional Conditions:
• Cease to be a start-up on completion of 5 years or exceeding turnover of Rs.25 Crores
• Shall be eligible for tax benefits only after obtaining certification from the Inter-ministerial Board
Major reasons for sustainable development of start-ups in India:
• Government support
• Pool of talent
• Cost-effective workforce
• Increasing use of internet
• Technology
• Variety of funding options
Innovative ways of financing a start-up:
• Personal Financing: Investors will put money in a deal only if the entrepreneurs are contributing
from their personal source
• Personal credit lines: Based on one’s personal credit efforts. Example: Credit cards
• Family and Friends: These people will generally fund, without even thinking whether the idea
works or not
• Peer-to-peer lending: In this group of people come together and lend money to each other
• Crowd Funding: Small amounts of capital from a large number of individuals
• Micro Loans: Small loan given by single individual or aggregated at a lower interest
• Vendor financing: Company lends money to its customers so that they can buy products from the
manufacturers
• Purchase order financing: Purchase order financing companies often advance the required funds
directly to the supplier.
• Factoring account receivables: Facility given to the seller who has sold the good on credit to fund
his receivables
Pitch Presentation:
• Pitch deck presentation is a short and brief presentation (<20Min) to investors explaining about
the prospects of the company and why they should invest into the startup business.
Steps:
• Introduction – Short introduction to attract the attention of investors
• Team – Introducing the team members
• Problem – Explain the problem that the start-up is going to solve
• Solution – Describing how the company will solve the problems
• Marketing – Explaining the market size of the product and target customers
• Projections – Projected financial statements
• Competition – Highlight the competition and how product/service is different from competitors
• Business model – Explaining the core aspects of the business
• Financing – Utilization of past money raised and an explanation on how much work has been
done
Document that are required to make pitch presentations:
• Income statement
• Cash flow statement
• Balance sheet
Modes of financing startup:
• Bootstrapping: An individual is said to be boot strapping when he or she attempts to found and
build a company from personal finances or from the operating revenues of the new company

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• Angel Investor: Angel investors invest in small startups or entrepreneurs. They are among
entrepreneur’s family and friends. This can either be an one-time investment which can help the
business propel or regular injection of money to support and carry the company through difficult
early stages. Some investments can also be made through crowdfunding platforms or angel
investor networks. Angel investors normally represent individuals, but the entity that provides
funds may be a limited liability company, a business, a trust or an investment fund
• Venture capital funds: Money provided by professionals who alongside management invest in
young, rapidly growing companies that have the potential to develop into significant economic
contributors
Characteristics of venture capital financing:
• Long term horizon – Minimum of 3 years and maximum of 10 years
• Lack of liquidity – Less liquidity on the equity it gets and accordingly would be investing in that
format
• High Risk – Works on principle of high risk and high return
• Equity participation – Investing in the form of equity so it helps to participate in the management
and help the company grow
Advantages of bringing venture capital in the company:
• Injects long-term equity finance
• Shares both risks and rewards
• Practical advice and assistance to the company
• Network of contacts that can add value to the company
• Providing additional rounds of funding to finance growth
• Experiences in preparing a company for IPO
• Facilitate a trade sale
Stages of funding VC:
• Seed money - Start up - First stage - Second stage - Third stage - Fourth stage
Venture capital investment process:
• Deal organization
• Screening
• Due diligence
• Deal structuring
• Post investment activity
• Exit Plan
Structure of venture capital fund in India:
• Domestic funds: Structured as a domestic vehicle for pooling of funds from the investor and an
investment advisor to carry the duties of asset manager
• Offshore funds:
o Offshore structure: Investment vehicle directly makes investments in Indian Portfolio
Companies. Assets are managed by an offshore manager and the investment advisor
carries out due diligence and identifies deals
o Unified structure: Overseas investors pool their assets in an offshore vehicle that
invests in a locally managed trust, whereas domestic investors directly contribute to the
trust.
Methods of Bootstrapping:
• Trade Credit: Credit received from suppliers will help in financing the startup. However, when a
new business is started, suppliers are reluctant to give trade credit
• Factoring: This is a financing method where accounts receivables is sold to a commercial finance
company to raise capital. It is a useful tool for raising money and keeping cash flowing
• Leasing: It will reduce the capital cost and also help lessee to claim tax exemption. It can be easy
to take an asset on lease to avoid paying out lump sum money
Difference between startup and entrepreneurship:
• Start up is a part of entrepreneurship. Entrepreneurship is a broader concept and it includes a
startup firm.
• Aim of startup is to build a concern, conceptualize the idea which it has developed into a reality
and build a product or service. On the other hand, the major objective of an already established
entrepreneurship concern is to attain opportunities with regard to the resources they currently
control.
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• A startup generally does not have a major financial motive whereas an established
entrepreneurship concern mainly operates on financial motive
Priorities and challenges which start-ups in India are facing:
• The priority is on bringing more and more smaller firms into existence
• The main challenge with the startup firms is getting the right talent. Further startups had to
comply with numerous regulations which escalate its cost
Business Model:
• Denotes core aspects of business. It basically explains the way in which a company generates
revenue and makes profit from company operations
• It includes purpose, business process, target customers, offerings, strategies, infrastructure,
organizational structures, sourcing, trading practices, and operational processes and policies
including culture
Peer-to-peer Lending vs Crowd Funding:
• Peer-to-peer lending is in existence for long period of time and crowd funding is a contemporary
source of finance
• In peer-to-peer lending group of people come together and lend money to each other
• Crowdfunding is raising of small amounts of capital from a large number of individuals to finance
a new business initiative.
Unicorn:
• Privately held start-up company which has achieved valuation of USD 1 billion + It needs to have
new ideas + Disruptive innovation + Consumer focus + technology focus
• Next milestone is to become a decacorn which has valuation of USD 10 billion
Succession planning:
• Identifying critical positions and having right individuals for those positions + This will ensure
right people are available for jobs and provides a liquidity event for ownership transfer to rising
employees
• Helps companies promote and advance all employees
Why should an organization go for succession planning?
• Risk Mitigation
• Cause removal – If there are issues with existing leader then he may be barred by court/regulatory
authorities and it would be easy to continue operations with succession planning
• Talent Pipeline
• Conflict resolution mechanism – Helps in promoting open and transparent communication
• Aligning – Helps company to align with culture, vision, direction and values of the business
Steps in business succession strategy:
• Evaluate key leadership positions
• Map competencies required for above positions
• Identify competencies of current workforce
• Bridge leader – Appointment of outsider as a bridge leader in family-owned enterprises to develop
business and prepare young family members into leadership role
Challenges in implementing succession planning:
• Founder mindset might be different than the corporate mindset
• Premature for startups to implement business succession – Startups at early growth stage should
not implement succession planning as the same can slowdown growth
• Founders are the face of startups

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