1.

As an investment advisor, you have been approached by a client called Vikas for
your advice on investment plan. He is currently 40 years old and has Rs.600,000 in
the bank. He plans to work for 20 years more and retire at the age of 60. His
present salary is Rs.500,000 per year. He expects his salary to increase at the rate
of 12 percent per year until his retirement.
Vikas has decided to invest his bank balance and future savings in a balanced
mutual fund scheme that he believes will provide a return of 9 percent per year.
You agree with his assessment.
Vikas seeks your help in answering several questions given below. In
answering these questions, ignore the tax factor.

(i) Once he retires at the age of 60, he would like to withdraw Rs.800,000 per year
for his consumption needs from his investments for the following 15 years (He
expects to live upto the age of 75 years). Each annual withdrawal will be made at
the beginning of the year. How much should be the value of his investments
when Vikas turns 60, to meet this retirement need?
(ii) How much should Vikas save each year for the next 20 years to be able to
withdraw Rs.800,000 per year from the beginning of the 21​st year? Assume that
the savings will occur at the end of each year.
(iii) Suppose Vikas wants to donate Rs.500,000 per year in the last 5 years of his life to
a charitable cause. Each donation would be made at the beginning of the year.
Further, he wants to bequeath Rs.1,000,000 to his son at the end of his life. How
much should he have in his investment account when he reaches the age of 60 to
meet this need for donation and bequeathing?
(iv) Vikas is curious to find out the present value of his lifetime salary income. For the
sake of simplicity, assume that his current salary of Rs.500,000 will be paid
exactly one year from now, and his salary is paid annually. What is the present
value of his life time salary income, if the discount rate applicable to the same is 7
percent? Remember that Vikas expects his salary to increase at the rate of 12
percent per year until retirement.

2. The required return on the market portfolio is 16 percent. The beta of stock A is
1.5. The required return on the stock is 22 percent. The expected dividend
growth on stock A is 12 percent. The price per share of stock A is Rs.260. What is
the expected dividend per share of stock A next year?

What will be the combined effect of the following on the price per share of stock?

(a) The inflation premium increases by 5 percent.

(b) The decrease in the degree of risk-aversion reduces the differential between the
return on market portfolio and the risk-free return by one-half.
(c) The expected growth rate of dividend on stock A decrease to 10 percent.
(d) The beta of stock A falls to 1.1

3. Mr. Nitin Gupta had invested Rs.8 million each in Ashok Exports and Biswas
Industries and Rs. 4 million in Cinderella Fashions, only a week before his
 untimely demise. As per his will this portfolio of stocks were to be inherited by his
wife alone. As the partition among the family members had to wait for one year as
per the terms of the will, the portfolio of shares had to be maintained as they were
for the time being. The will had stipulated that the job of administering the estate
for the benefit of the beneficiaries and partitioning it in due course was to be done
by the reputed firm of Chartered Accountants, Talwar Brothers. Meanwhile the
widow of the deceased was very eager to know certain details of the securities and
had asked the senior partner of Talwar Brothers to brief her in this regard. For this
purpose the senior partner has asked you to prepare a detailed note to him with
calculations using CAPM, to answer the following possible doubts.

1. What is the expected return and risk (standard deviation) of the portfolio?
2. What is the scope for appreciation in market price of the three stocks-are
they overvalued or undervalued?

You find that out the three stocks, your firm has already been tracking two viz.
Ashok Exports (A) and Biswas Industries (B)-their betas being 1.7 and 0.8
respectively. Further, you have obtained the following historical data on the returns
of Cinderella Fashions(C):
Period Market return (%) Return on
Cinderella Fashions (%)

1 10 14
2 5 8
3 (2) (6)
4 (1) 4
5 5 10
6 8 11
7 10 15
On the future returns of the three stocks, you are able to obtain the following
forecast from a reputed firm of portfolio managers.

State of the Probability Returns (in percentage)

Economy Treasury Ashok Biswas Cinderella Sensex
Bills Exports Industries Fashions

Recession 0.3 7 5 15 (10) (2)

Normal 0.4 7 18 8 16 17
Boom 0.3 7 30 12 24 26
 Required: Prepare your detailed note to the senior partner.

4. Shivalik Combines issues a partly convertible debenture for Rs.900, carrying an

interest rate of 12 percent. Rs.300 will get compulsorily converted into two equity
shares of Shivalik Combines a year from now. The expected price per share of
Shivalik Combines’s equity a year from now would be Rs.200. The
non-convertible portion will be redeemed in three equal installments of Rs. 200
each at the end of years 4, 5 and 6 respectively. The tax rate for Shivalik is 35
percent and the net price per share Shivalik would realise for the equity after a year
would be Rs. 180.

(a) What is the value of convertible debenture? Assume that the investors’
required rate of return on the debt component and the equity component
are 12 percent and 16 percent respectively.
(b) What is the post-tax cost of the convertible debenture to Shivalik?
5. Brilliant Limited issues a partly convertible debenture for 1000, carrying an
interest rate of 10 percent. 360 will get compulsorily converted into two equity
shares of Brilliant Limited a year from now. The expected price per share of
Brilliant Limited’s equity a year from now would be Rs.300. The non-convertible
portion will be redeemed in four equal installments of Rs.160 each at the end of
years 3, 4, 5 and 6 respectively. The tax rate for Brilliant is 33 percent and the net
price per share Brilliant would realise for the equity after a year would be Rs. 220.

(a) What is the value of convertible debenture? Assume that the investors’
required rate of return on the debt component and the equity component are 13
percent and 18 percent respectively.
(b) What is the post-tax cost of the convertible debenture to Brilliant?

6. Mr. Banwarilal, a wealthy businessman, has approached you for professional

advice on investment. He has a surplus of Rs. 100 lakhs which he wishes to
invest in share market in the name of his wife on their marriage anniversary
falling due the next week. His wife is a senior employee in BPDL, a reputed
public sector oil marketing company. In the course of your discussions, you
find that he is a first timer to the secondary market and by nature much risk
averse. He also tells you that he had wondered if investing in BPDL itself
could be a good idea as it is quite profitable and is owned by the government.
Besides, his wife would have reasons to know well in advance of any possible
disasters for the company, being their employee for nearly two decades. Also,
she could justifiably be proud of owning such a stake in her company.

While you agree with him on the choice of BPDL, you suggest that by way of risk
reduction, it would be prudent to invest part of the money in ONGD, an equally reputed oil
exploration company, also state owned. At the end of the discussions, before committing the
funds for the next one year, Mr. Banwarilal desires to know from you specific answers to the
following:

1. What would be the likely return and risk if he invests equal amounts in each of the
two stocks?
2. What would be the likely return from a portfolio of the two stocks which could be
the least risky?
3. Out of the above two alternatives, which would you recommend and why? How
many shares of each stock would then have to be bought?

You have the following historical data at your disposal which you intend to use for analysing
the pattern of co-movement between the stocks:

Period( years preceding the current one) 1 2 3 4 5 6 7 8 9 10

Return(in %) on BPDL (R​B​) 32 14 24 -8 -2 15 8 28 -7 -3
ONGD (R​O​) 14 5 - 6 12 22 14 5 -14 26 20
The current market price of a share of BPDL is Rs. 500 and that of ONGD is Rs. 300.

On the future returns on the two stocks over the next one year, you are able to obtain the
following forecast from a reputed firm of portfolio managers:

State of the Economy Probability Return (in %) on

BPDL ONGD
Recession 0.2 -5 -3
Normal 0.5 10 14
Boom 0.3 35 22

7. Seth Ratanlal, who was issueless and widower, had left his substantial wealth
as legacy to his nephew and niece through a will. Detailed instructions had
been left on how the estate should be shared between the two, once both of
them attained the age of majority. A week before his demise he had taken a
fancy to the capital market and had invested a sizeable amount in equity
shares, specifically, Rs.6 million in Arihant Pharma, Rs.4.8 million in Best
Industries and Rs. 1.2 million in Century Limited. As the partition among the
siblings had to wait for at least one more year as the girl was still a minor, the
portfolio of shares had to be maintained as they were for the time being. The
will had entrusted the job of administering the estate for the benefit of the
beneficiaries and partitioning in due course to the reputed firm of Chartered
Accountants, Karaniwala and Karaniwala. Meanwhile the young beneficiaries
were very eager to know certain details of the securities and had asked the
 senior partner of the firm to brief them in this regard. For this purpose the
senior partner has asked you to prepare a detailed note to him with
calculations using CAPM, to answer the following possible doubts.

(i) What is the expected return and risk (standard deviation) of the portfolio?
(ii) What is the scope for appreciation in market price of the three
stocks-are they overvalued or undervalued?
You find that out the three stocks, your firm has already been tracking two viz. Arihant
Pharma (A) and Best Industries (B)-their betas being 1.2 and 0.8 respectively.

Further, you have obtained the following historical data on the returns of Century
Limited(C):

Period Market return (%) Return on

Century Limited (%)

1 8 10

2 (6) 8

3 12 25

4 10 (8)

5 9 14

6 9 11
 On the future returns of the three stocks, you are able to obtain the following forecast
from a reputed firm of portfolio managers.

State of the Probability Returns ( in percentage ) on

Economy Treasury Arihant Best Century Nifty

Bills Pharma Industries Limited

Recession 0.2 6 (10) (8) 15 (8)

Normal 0.4 6 18 12 6 15

Boom 0.4 6 30 20 (10) 25

Prepare your report.

8. You have recently graduated as a major in finance and have been hired as a
financial planner by Jubilee Securities, a financial services company. Your boss
has assigned you the task of investing Rs.1,000,000 for a client who has a
1-year investment horizon. You have been asked to consider only the following
investment alternatives: T-bills, stock A, stock B, stock C, and market index.

The economics cell of Jubilee Securities has developed the probability distribution for the
state of the economy and the equity researchers of Jubilee Securities have estimated the
rates of return under each state of the economy. You have gathered the following
information from them:

Returns on Alternative Investments

State of the Market

T-Bills Stock A Stock B Stock C
Probability Economy
Portfolio

●Recession 0.2 6.0% (18.0%) 25.0% (6.0%) (10.0%)

●Normal 0.5 6.0 20.0 5.0 15.0 16.0

●Boom 0.3 6.0 42.0 (12.0) 26.0 30.0
 Your client is a very curious investor who has heard a lot relating to portfolio theory and
asset pricing theory. He requests you to answer the following question:

a. What is the expected return and the standard deviation of return for stocks A, B, C, and the
market portfolio?
b. What is the covariance between the returns on A and B? returns on A and C? returns on B
and C?
c. What is the coefficient of correlation between the returns of A and B?
d. What is the expected return and standard deviation on a portfolio in which the weights
assigned to stocks A, B, and C are 0.4, 0.4, and 0.2 respectively?
e. The beta coefficients for the various alternatives, based on historical analysis, are as
follows:

Security Beta
T-bills 0.00

A 1.30

B (0.60)

C 0.95

i. What is the SML relationship?

ii. What is the alpha for stocks A, B, and C?
f. Suppose the following historical returns have been earned for the stock market and the
stock of company D.

Period Market D
1 (5%) (15%)

2 4 7

3 8 14

4 15 22

5 9 5

What is the beta for stock D? How would you interpret it?
 9. Jerome D’Souza, a successful bond dealer had come to Bangalore to deliver a
lecture in a seminar organised by a leading bank as part of its training
programme to finance managers. He has been requested to explain the basic
concepts and tools useful in bond analysis. To enable him to make the
presentation Mr. D’Souza has asked you to prepare answers for the following
questions.
a. How is the value of a bond calculated?
b. What is the value of a 8-year, Rs100 par value bond with a 12 percent annual coupon, if its
required rate of return is 8 percent?
c. What is the value of the bond described in part (b) if it pays interest semi-annually, other
things being equal?
d. What is the YTM of a 5-year, Rs 100 par value bond with a 13 percent annual coupon, if it
sells for Rs 95?
e. What is the YTM of the bond described in part (d) if the approximate formula is used?
f. What is the yield to call of the bond described in part (d) if the bond can be called after 2
years at a premium of Rs 5?
g.What is the realised yield to maturity of the bond described in part (d) if the reinvestment rate
applicable to the future cash flows from the bond is 15 percent?
h.The holders of the bond described in part (d) expect that the bond will pay interest as promised,
but on maturity bondholders will receive only 90 percent of par value. What will be difference
between the expected YTM and stated YTM? Use the approximate YTM formula.

10. From Rajendra Place in New Delhi as a sub broker to Dalal Street as a full
fledged stock broker had been a long journey for the ambitious Ramesh
Gupta. While his pet area remained stock broking, the thinning margin has
forced him to diversify into related businesses like portfolio management etc.
A firm believer in acquiring quality manpower, he had spotted talent on
hearing you talk on debt securities in a seminar conducted by the local Rotary
Club. To confirm his instincts, he has invited you to give a lecture to the
board of directors of his company to elucidate certain concepts in bond
analysis. He has requested you to use the following data on bond B which is
currently one of the most actively traded bonds:

Bond B
Face value Rs. 1,000
Coupon (interest rate) 8 percent payable annually
Term to maturity 5 years
Redemption value Rs. 1,000
Current market price Rs. 1,020

a. What is the yield to maturity of bond B?

b. What is the duration of bond B?
c. What is the convexity of bond B?
d. If the yield on bond B increases by 25 basis points, what will be the percentage change in the bond
price?
e. Two years from now, bond B will sell at a yield of 9 percent and the coupon incomes over the next two
years can be reinvested in short-term securities at a rate of 11 percent. What is the expected annualised
rate of return over the two-year period?

11. Arun Dalmia heads the portfolio management schemes division of Pioneer
Investments, a well known financial services company. Arun has been
requested by Matrix Systems to give an investment seminar to its senior
managers interested in investing in equities through the portfolio
management schemes of Pioneer Investments. Dhanush, the contact person
of Matrix Systems, suggested that the thrust of the seminar should be on
equity valuation. Arun has asked you to help him with his presentation.
To illustrate the equity valuation process, you have been asked to analyse Transcend
Remedies which manufactures formulations and bulk drugs. In particular, you have to
answer the following questions:
a. What is the general formula for valuing any stock, irrespective of its dividend pattern?
b. How is a constant growth stock valued?
c. What is the required rate of return on the stock of Transcend Remedies? Assume that the risk- free
rate is 6 percent, the market risk premium is 7 percent, and the stock of Transcend Remedies has a
beta of 1.4.
d. Assume that Transcend Remedies is a constant growth company which paid a dividend of Rs
3.00 yesterday (​Do​ = Rs 3.00) and the dividend is expected to grow at the rate of 15
percent per year forever.
(i) What is the expected value of the stock a year from now?
(ii) What is the expected dividend yield and capital gains yield in the first year?
e. If the stock is currently selling for Rs 400, what is the expected rate of return on the stock?
f. Assume that Transcend Remedies is expected to grow at a supernormal growth rate of 35 percent
for the next 5 years, before returning to the constant growth rate of 15 percent. What will be the
present value of the stock under these conditions? Assuming that the required rate of return is 16
percent, what is the expected dividend yield and capital gains yield in year 3? year 6?
g. Assume that Transcend Remedies will have zero growth during the first 3 years and then resume its
constant growth of 15 percent in the fourth year. What will be the present value of the stock under
these conditions?
 h. Assume that the stock currently enjoys a supernormal growth rate of 35 percent. The growth rate,
however, is expected to decline linearly over the next six years before settling down at 15 percent.
What will be the present value of the stock under these conditions?
i. Assume that the earnings and dividends of Transcend Remedies are expected to decline at a
constant rate of 6 percent per year. What will be the present value of the stock? What will be the
dividend yield and capital gains yield per year? Assume a discount rate of 16 percent.
j. Assume that the earnings and dividends of Transcend Remedies are expected to grow at a rate of 35
percent per year for the next 3 years and thereafter the growth rate is expected to decline linearly for
the following 5 years before settling down at 15 percent per year forever. What will be the present
value of the stock under these conditions, if the discount rate remains 16 percent?

12. Innovative Industries Ltd was set up 15 years ago. After a few years of initial
turbulence, the company found a few market segments in which it had some
competitive advantage. The financials of the company for the last 5 years are
given below:

Rs. in million

Income Statement Summary 20 x 1 20 x 2 20 x 3 20 x 4 20 x 5

●Net sales 2000 2400 2760 3310 3905

●Profit before interest & tax 700 840 995 1195 1480

●Interest 140 151 198 215 282

●Profit before tax 560 689 797 980 1198

●Tax 162 193 220 272 333

●Profit after tax 398 496 577 708 865

●Dividends 160 175 200 269 320

●Retained earnings 238 321 377 439 545

Balance Sheet Summary

●Equity capital (Rs.10 par) 200 200 200 200 200

●Reserves and Surplus 800 1121 1498 1937 2482

●Loan funds 200 220 298 320 450

●Capital employed 1200 1541 1996 2457 3132

●Net fixed assets 800 950 1140 1432 1892

 ●Investments 150 160 170 185 200

●Net current assets 250 431 686 840 1040

1200 1541 1996 2457 3132

●Market price per share(year ended) 180 248 259 352 506

The year 20x5 has just ended. The current market price per share is Rs.506. The market price per
share at the beginning of 20x1 was Rs.160.
(a) What was the geometric mean return for the past 5 years?

(b)Calculate the following for the past 2 years? return on equity, book value per share, EPS, PE ratio,
(Prospective), market value to book value ratio.

(c) Calculate the CAGR of Sales & EPS for the period 20 x 1 – 20 x 5?

(d)Calculate the sustainable growth rate based on the average retention ratio and the average return on
equity for the past 2 years?

(e) Decompose the ROE for the last 2 years in term of 5 factors.

(f) Estimate the EPS for the next year (20 x 6) using the following assumptions.

(i) Net sales will grow at 25%

(ii) PBIT as a percentage of net sales ratios will improve by 2% This means that if it

were x%, it will become x + 2%.

(iii) Interest will increase by 3% over its 20 x 5 value.

(iv) Effective tax rate will be 30%.

(g) Derive the PE ratio using the constant growth model. For this purpose use the following assumptions.

(i) The dividend payout ratio for 20 x 6 will be equal to the average dividend payout ratio for the period
20 x 4 – 20 x 5.

(ii) The required rate of return is estimated with the help of the CAPM (Risk free return = 9%, Market
risk premium = 12%, Beta of Innovative Industries Stock = 1.2).

(iii) The expected growth rate in dividends is set equal to the product of the average return on equity and
average retention ratio for the previous 2 years.
 13. Atlas Corporation was set up 20 years ago. After few years of initial turbulence
the company found a few market segments in which it had some competitive
advantage. The financials of the company for the last five years are given below:

Rs. in million

Income Statement Summary 20 x 1 20 x 2 20 x 20 x 4 20 x 5

3
●Net sales 1500 1620 1700 1800 1920
●Profit before interest & tax 225 235 250 261 285
●Interest 50 54 59 62 67
●Profit before tax 175 181 191 199 218
●Tax 49 52 56 58 64
●Profit after tax 126 129 135 141 154
●Dividends 44 45 50 52 59
●Retained earnings 82 84 85 89 95

Balance Sheet Summary

●Equity Capital (Rs.10 par) 150 150 150 150 150
●Reserves and Surplus 700 784 869 958 1053
●Loan Funds 300 340 350 375 425
●Capital employed 1150 1274 1369 1483 1628
●Net fixed assets 800 825 860 880 940
●Investments 100 108 110 120 130
●Net current assets 250 341 399 483 558
1150 1274 1369 1483 1628
●Market price per share(year end) 85 83 97 103 107

The year 20 x 5 has just ended. The current market price per share is Rs.107. The market
price per share at the beginning of 20 x 1 was Rs.75.

(a) What was the geometric mean return for the past 5 years?

(b) Calculate the following for the past 2 years: return on equity, book value per share, EPS, PE ratio
(Prospective), market value to book value ratio.

(c) Calculate the CAGR of Sales & EPS for the period 20 x 1 – 20 x 5.

(d) Calculate the sustainable growth rate based on the average retention ratio and the average return on
equity for the past 2 years.

(e) Decompose the ROE for the last two years in term of five factors.
(f) Estimate the EPS for the next year (20 x 6) using the following assumptions.

(i) Net sales will grow at 8%

(ii) PBIT / Net sales ratio will improve by 0.5% over its 20 x 5 value.

(iii) Interest will increase by 10% over its 20 x 5 value.

(iv) Effective tax rate will be 30%.

(g) Derive the PE ratio using the constant-growth model. For this purpose use the following assumptions.

(i) The dividend payout ratio for 20 x 6 will be equal to the average dividend payout ratio
for the period 20 x 4 – 20 x 5.

(ii) The required rate of return is estimated with the help of the CAPM (Risk free return =
6% Market risk premium = 8%, Beta of Atlas Corporation’s Stock = 0.9).

(iii) The expected growth rate in dividends is set equal to the product of the average return
on equity and average retention ratio for the previous 2 years.

14. On majoring in finance you have got selected as the finance

manager in Navin Exports, a firm owned by Navin Sharma a
dynamic young technocrat. The firm has been registering
spectacular growth in recent years. With a view to broad base
its investments, the firm had applied for the shares of
Universal Industries a month back during its IPO and got
allotment of 5000 shares thereof. Recently Mr. Sharma had
attended a seminar on capital markets organised by a leading
bank and had decided to try his hand in the derivatives market.
So, the very next day you joined the firm, he has called you for
a meeting to get a better understanding of the options market
and to know the implications of some of the strategies he has
heard about. For this he has placed before you the following
chart of the option quotes of Universal Industries and
requested you to answer the following questions, based on the
figures in the chart.

Universal
Industries Option
Quotes (All
amounts in rupees)
Stock Price: 350
 Calls Puts

Strike Price Jan Feb March Jan Feb March

300 50 55 -* - - -

320 36 40 43 3 5 7

340 18 20 21 8 11 -

360 6 9 16 18 21 23

380 4 5 6 - 43 -

* A blank means no quotation is available

1) List out the call options which are out-of-the-money.

2) What are the relative pros and cons (i.e. risk and reward) of selling a call against
the 5000 shares held, using (i) Feb/380 calls versus (ii) March 320/ calls?
3) Show how to calculate the maximum profit, maximum loss and break-even
associated with the strategy of simultaneously buying say March/340 call while
selling March/ 360 call?
4) What are the implications for the firm, if for instance, it simultaneously writes
March 380 call and buys March 320/put?
5) In what range of values of the stock price will February /340 straddle profitable?
6) What should be value of the March/360 call as per the Black-Scholes Model?
Assume that t=3 months, risk-free rate is 7 percent and the standard deviation is
0.40
7) What should be the value of the March/360 put if the put-call parity is working?