INDEX

INDEX
VOLUME II
VOLUME I

SR. NO. CONTENTS NO. OF PAGE NO.

QUESTIONS

1 Valuation of Securities 93 1

2 Merger and Acquisitions 59 139

3 Portfolio Management 63 259

4 Mutual Funds 34 347

VOLUME II

SR. NO. CONTENTS NO. OF PAGE NO.

QUESTIONS

5 Risk Management 4 398

6 Corporate Valuation and Allied 10 402

7 Foreign Exchange Risk Management 94 418

8 International Financial Management 10 562

9 Derivatives: Options and Futures 61 584

10 Interest Rate Future and Swaps 17 680

11 Advanced Capital Budgeting Decisions 709

CA BHAVIK CHOKSHI iii

 

iv CA BHAVIK CHOKSHI
 Valuation of Securities

CHAPTER 1 VALUATION OF SECURITIES

PART A: CLASSWORK PROBLEMS

Question 1

A bond pays ` 90 interest annually into perpetuity

(i) What is its value if the current yield is 10 percent?
(ii) If the current yield changes to 8% and 12%, then what is its value.

Summary

Detailed Solution

Interest
P0 =
KD

i. When KD = 10%

90
P0 = = ` 900
10%

ii. When KD = 8%

90
P0 = = ` 1125
8%

iii. When KD = 12%

90
P0 = = ` 750
12%

Question 2

A is willing to purchase a five years ` 1,000 par value bond having a coupon rate of 9%. A's
required rate of return is 10%. How much A should pay to purchase the bond if it matures at
par?

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 Valuation of Securities

Summary

Detailed Solution

Years Cash Inflow (CI) DF (10%) PV of CI

1 90 0.9091 81.82
2 90 0.8264 74.38
3 90 0.7513 67.62
4 90 0.6830 61.47
5 1,090 0.6209 676.78
(1,000 + 90) Value 962.07

A should pay a maximum of 962.07 for the bond.

Alternatively: (90 × 3.7908) + (1,000 × 0.6209)
PVAF (10%, 5 Years) PVF (10%, 5th Year)
= 341.17 + 620.9
= 962.07
Reference Note: The relationship between the coupon rate and discount rate is given as:

Coupon rate > Discount rate Market value > Face Value (Premium)
Coupon rate < Discount rate Market value < Face Value (Discount)

Coupon rate = Discount rate Market value = Face Value (Par)

Therefore, if the question says that a bond of ` 1,000 is quoted at par, such bonds will have
coupon rate = discount rate and face value = market price.

Question 3

A PSU is proposing to sell a 8 years bond of ` 1,000 at 10% coupon rate per annum. The bond
amount will be amortized equally over its life. If an investor has a minimum required rate of
return of 8%, what is the bond's present value.

Summary

Detailed Solution

Year Coupons Principal* Total CI DF@8% PV of CI

1 100.0 125 225.0 0.9259 208.33
2 87.5 125 212.5 0.8573 182.18

2 CA BHAVIK CHOKSHI
 Valuation of Securities

3 75.0 125 200.0 0.7938 158.76

4 62.5 125 187.5 0.7350 137.81
5 50.0 125 175.0 0.6806 119.11
6 37.5 125 162.5 0.6302 102.41
7 25.0 125 150.0 0.5835 87.53
8 12.5 125 137.5 0.5403 74.29
Value 1,070.42
* Principal repaid = 1,000/8 = 125 p.a.

Question 4 (Practice Manual [Modified])

The ABC co. is contemplating a debentures issue on the following terms:

Face Value : ` 100 per debentures
Term to Maturity : 7 years
Coupon rate of Interest :
Years 1 - 2 8% p.a.
3 - 4 12% p.a.
5 - 7 15% p.a.
The current market rate of interest on similar debentures is 15% p.a. The co. proposes to
price the issue so as to yield a (compounded) return of 16% p.a. to the investor. Determine the
issue price. Assume redemption at a premium of 5% on Face Value.

Summary

Detailed Solution

Reference Note:
As the question requires us to calculate the issue price, we should take the return which the
Company wants to give to the investors ie 16%. If the value of the bond from the investor’s
perspective was asked, we would have taken 15%
Year Cash Inflow (CI) DF @ 16% (Note) PV of CI
1 8 0.8621 6.90
2 8 0.7432 5.95
3 12 0.6407 7.69
4 12 0.5523 6.63
5 15 0.4761 7.14
6 15 0.4104 6.16
7 120 0.3538 42.46
(105+15) Value 82.93

CA BHAVIK CHOKSHI 3
 Valuation of Securities

Question 5

A 6 years bond of ` 1,000 has an annual rate of interest of 14 per cent. The interest is paid half
yearly. If the required of return is 16 per cent what is the value of bond?

Summary

Detailed Solution

Reference Note:
Coupon rate and discount rate are given on a per annum basis. In case the cash flows are not
annual, the following changes will be made.
1. Coupon rate – Divide by m
2. Discount rate – Divide by m
3. Time period (N) – Multiply by m
Where m = frequency in a year where cash flows are received i.e.
Semi-annual: 2, Quarterly: 4, Monthly: 12

In this question,
Coupon rate = 14%/2 =7%
Term = 6 × 2 = 12 half years
Discount rate = 16%/2 = 8%
Therefore, Bo = (70 × 7.5361) + (1,000 × 0.3971) = ` 924.64
PVAF (8%, 12 Years) PVF (8%, 12th Year)
Reference Note:
As the cash flows for each time period are constant, we can use PVAF in this question.

Question 6 (ICAI Study Material)

Calculate Market Price of:

(i) 10% Government of India security currently quoted at ` 110, but yield is expected to go
up by 1%.
(ii) A bond with 7.5% coupon interest, Face Value ` 10,000 & term to maturity of 2 years,
presently yielding 6% . Interest payable half yearly.

4 CA BHAVIK CHOKSHI
 Valuation of Securities

Summary

Detailed Solution

Part I
In this case, the term (maturity) of bond is not available, hence it is not possible to calculate
YTM or realised yield. However, the current yield can still be calculated even in absence of
maturity and hence we solvedthis question based on current yield.

Interest
Current Yield (Existing) = × 100
Market Price
10
= × 100 = 9.09%
110

Revised Current yield = 9.09% + 1%

= 10.09%
Let Revised Price Be ` x
Interest
Revised Current Yield = × 100 [Let the revised price be x]
Revised Price
10
10.09 = × 100
x

x = ` 99.11
Part II
Interest is paid half yearly. Hence the following numbers should be considered
a. Coupon = 7.5%/2 = 3.75% half year
b. Yield = 6%/2 = 3% half yearly
c. Term = 2×2 = 4 half years
Bo = 375 × 3.7171 + 10,000 × 0.8885
PVAF (3%, 4 Years) PVF (3%, 4th Year)
= ` 10,278.91

Question 7 (RTP Nov 20)

Today being 1st January 2019, Ram is considering to purchase an outstanding Corporate Bond
having a face value of ` 1,000 that was issued on 1st January 2017 which has 9.5% Annual Coupon
and 11 years of original maturity (i.e. maturing on 31st December 2027). Since the bond was
issued, the interest rates have been on downside and it is now selling at a premium of ` 125.75
per bond.

CA BHAVIK CHOKSHI 5
 Valuation of Securities

Determine the prevailing interest on the similar type of Bonds if it is held till the maturity
which shall be at Par.
PV Factors:
1 2 3 4 5 6 7 8 9
6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592
8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500

Summary

Detailed Solution

Reference Note:
In this question we have been asked to find the prevailing interest on similar type of bonds. This
should be the Market interest rate.
The market interest rate can be inferred from YTM that an investor can earn if he were to
invest in outstanding corporate bond today. The return on corporate bond (YTM) should also be
the same as that earned in a similar type of bond (opportunity cost concept)
1. Outstanding Corporate Bond:
Coupon = 9.5%
Face Value = ` 1,000
Original Maturity = 11 years (from 2017)
Years (n) = 9 years (1/1/19 – 31/12/27)
Market Price = ` 1,125.75 (1,000 + 125.75)
2. YTM (Using Trial & Error Method)
At 8%
PVCO = ` 1,125.75
PVCI = 95 × 6.246 + 1000 × 0.500
= ` 1,093.37
At 6%    PVCI = 95 × 6.801 + 1,000 × 0.592
= 1,238.10
Using Interpolation

x − 6% 1,125.75 − 1,238.1
=
8% − 6% 1,093.37 − 1,238.1
x − 0.06% 112.35
=
0.02 144.73

6 CA BHAVIK CHOKSHI
 Valuation of Securities

x - 0.06 = 0.0155
x = 0.0755 i.e. 7.55%
The prevailing Interest Rate on similar bonds (market Interest rates) would be 7.55%

Reference Note:
Usually, we infer the starting point using approximate YTM calculation. However, in the case this
question has given the Rates to be used (table) and hence we have taken the same.

Question 8 (RTP Nov 19)

A hypothetical company ABC Ltd. issued a 10% Debenture (Face Value of ` 1,000) of the duration
of 10 years is currently trading at ` 850 per debenture. The bond is convertible into 50 equity
shares being currently quoted at ` 17 per share.
If yield on equivalent comparable bond is 11.80%, then calculate the spread of yield of the
above bond from this comparable bond.
The relevant present value table is as follows.
Present t1 t2 t3 t4 t5 t6 t7 t8 t9 t10
Values
PVIF0.11, t 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352
PVIF0.13 t 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295

Summary

Detailed Solution

a. Calculation of YTM of 10% Debentures Issued by Hypothetical Ltd.

Using Trial and Error Method:
PV of CO: Market Price of Bond = 850
PVCI
At 11%
= 100 × 5.89 + 1,000 × 0.352 = 941
PVAF (11%, 10 Years) PVF (11%, 10th Year)
At 13%
= 100 × 5.426 + 1,000 × 0.295 = 837.6
PVAF (13%, 10 Years) PVF (13%, 10th Year)

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 Valuation of Securities

Using Interpolation

x − 11% 850 − 941

=
13% − 11% 837.6 − 941

x − 0.11 −91
=
0.02 −103.4
103.4x – 11.37 = 1.82
103.4x = 13.19
x = 12.76%
Spread = YTM of Hypothetical Ltd. bonds - YTM of comparable Bonds
= 12.76% - 11.80%
= 0.96%

Question 9 (Practice Manual)

Based on the credit rating of bonds, Mr. Z has decided to apply the following discount rates for
valuing bonds:
Credit Rating Discount Rate
AAA 364 day T bill rate + 3% spread
AA AAA + 2% spread
A AAA + 3% spread
He is considering to invest in AA rated, ` 1,000 face value bond currently selling at ` 1,025.86.
The bond has five years to maturity and the coupon rate on the bond is 15% p.a. payable annually.
The next interest payment is due one year from today and the bond is redeemable at par.
(Assume the 364 day T-bill rate to be 9%).
You are required to calculate the intrinsic value of the bond for Mr. Z. Should he invest in the
bond? Also calculate the current yield and the Yield to Maturity (YTM) of the bond.

Summary

Detailed Solution

a. Discount Rate
AAA = 9% + 3% = 12%
AA = 12% + 2% = 14%

8 CA BHAVIK CHOKSHI
 Valuation of Securities

b. Intrinsic Value
Bo = 150 × 3.4331 + 1,000 × 0.5194
PVAF (14%, 5 Years) PVF (14%, 5th Year)
= 1,034.37
c. Recommendation:
Mr Z should buy the bond as the Market Price of the bond (1,025.86) < Intrinsic Value
(1,034.37)
Annual Interest
d. Current Yield = × 100
Market Price

150
= × 100
1,025.86

= 14.62%
Reference Note: If the MP was not given, intrinsic value would be considered as the
Market price.
e. Yield to Maturity
Using Trial & Error
PVCO = ` 1,025.86
At 14%, PVCI = 1,034.37 (part b)
At 15%, PVCI = 150 × 3.3522 + 1,000 × 0.4972
PVAF (15%, 5 Years) PVF (15%, 5th Year)
= ` 1,000.03
By Using Interpolation

x − 14% 1, 025.86 − 1, 034.37

=
15% − 14% 1, 000.03 − 1, 034.37

x − 0.14 8.51
=
0.01 34.34

x = 0.14 + 0.0025
x = 0.1425 i.e. 14.25%

Question 10 (ICAI Study Material)

Find the current market price of a bond having face value ` 1,00,000 redeemable after 6 years
maturity with YTM at 16% payable annually and duration 4.3202

CA BHAVIK CHOKSHI 9
 Valuation of Securities

Summary

Detailed Solution

a. Let the annual coupon be ` x

Year (t) Cash Inflow DF @ 16% PVCI t *PVCI
1 X 0.8621 0.8621x 0.8621x
2 X 0.7432 0.7432x 1.4864x
3 X 0.6407 0.6407x 1.9221x
4 X 0.5523 0.5523x 2.2092x
5 X 0.4761 0.4761x 2.3805x
6 1,00,000+x 0.4104 41,040 + 0.4104x 2,46,240 + 2.4624x
41,040 + 3.6848x 2,46,240 + 11.3227x

∑ † × PV of C.l.
Macaulay Duration =
PV of All C .I
2,46,240 + 11.3227x
4.3202 =
41,040 + 3.6848x

4.3202 (41,040 + 3.6848x) = 2,46,240 + 11.3227x

1,77,301.008 + 15.9191x = 2,46,240 + 11.3227x
15.9191x – 11.3227x = 2,46,240 – 1,77,301.008
4.5964x = 68,938.992
x (Coupon) = 14,998.48 (i.e. approx 15,000)
b. Market price = ` 41,040 + 3.6848 × ` 15,000 (approx)
= ` 96,312

Question 11 (Practice Manual)

On 31st March, 2013, the following information about Bonds is available:

Name of Security Face Value Maturity Date Coupon Rate Coupon Date (s)
`
Zero coupon 10,000 31st March, 2023 N.A. N.A.
T-Bill 1,00,000 20th June, 2013 N.A. N.A.
10.71% GOI 2023 100 31 March, 2023
st
10.71 31 March
st

10 % GOI 2018 100 31st March, 2018 10.00 31st March & 30th September

Calculate:
(i) If 10 years yield is 7.5% p.a. what price the Zero Coupon Bond would fetch on 31st March,
2013?

10 CA BHAVIK CHOKSHI
 Valuation of Securities

(ii) What will be the annualized yield if the T-Bill is traded @ 98500?
(iii) If 10.71% GOI 2023 Bond having yield to maturity is 8%, what price would it fetch on
April 1, 2013 (after coupon payment on 31st March)?
(iv) If 10% GOI 2018 Bond having yield to maturity is 8%, what price would it fetch on April
1, 2013 (after coupon payment on 31st March)?

Summary

Detailed Solution

(i) Zero Coupon Bond:

Price on 31/3/13 = 0 + 10,000 × 0.4852
PVF (7.5%, 10th)
= ` 4,852
(ii) T- Bill (to be referred with Money Markets)

F-P 365
Annualized Yield = × 100 ×
P 81
1,00,000 − 98,500 365
= × 100 ×
98,500 18

= 6.86% p.a
(iii) GOI 2023 Bonds on 1/4/13
P = 10.71 × 6.7101 + 100 × 0.4632
PVAF (8%, 10 Years) PVF (8%, 10th Year)
= ` 118.19
(iv) 10% GOI, 2018 bond 1/4/13
Since coupons are paid half yearly = 10% p.a./2
= 5% (for each half year)
Yield = 8% p.a./2
= 4% (for each half year)
Half Years = 5×2
= 10 Half Years
P = 5 × 8.1109 + 100 × 0.6756
PVAF (4%, 10 Years) PVF (4%, 10th Year)
= ` 108.11

CA BHAVIK CHOKSHI 11
 Valuation of Securities

Extra: In case we were asked to find duration in (iv)

Period CI DF @ 4% PVCI T × PVCI
1 5 0.9615 4.81 4.81
2 5 0.9246 4.62 9.24
3 5 0.8890 4.45 13.35
4 5 0.8548 4.27 17.08
5 5 0.8219 4.11 20.55
6 5 0.7903 3.95 23.70
7 5 0.7599 3.80 26.60
8 5 0.7307 3.65 29.20
9 5 0.7026 3.51 31.59
10 105 0.6756 70.94 709.4
108.11 885.52

885.52
Macaulay Duration =
108.11

= 8.19 half years

i.e. 8.19 half years / 2
= 4.10 Years
Reference Note: In case of half yearly cash flows: Duration should be divided by 2 and Convexity
(to be done later) should be divided by (2)2 = 4

Question 12 (Practice Manual)

MP Ltd. issued a new series of bonds on January 1, 2010. The bonds were sold at par (` 1,000),
having a coupon rate 10% p.a. and mature on 31st December, 2025. Coupon payments are made
semiannually on June 30th and December 31st each year. Assume that you purchased an outstanding
MP Ltd. bond on 1st March, 2018 when the going interest rate was 12%.

Required:
(i) What was the YTM of MP Ltd. bonds as on January 1, 2010?
(ii) What amount you should pay to complete the transaction? Of that amount how much
should be accrued interest and how much would represent bonds basic value.

12 CA BHAVIK CHOKSHI
 Valuation of Securities

Summary

Detailed Solution

(i) Since the Market Price = Face Value at the time of issue, the coupon rate would = Discount
Rate (YTM). Hence, the YTM would be 10%,
Extra: For Verification
PVCO = 1,000 (1/1/10)
PVCI (Trial & Error) at 10%
= 100 × 7.8237 + 1,000 × 0.2176 = ` 1,000
PVAF (10%, 16 Years) PVF (10%, 16th Year)
(ii) Price of Bond on 1/3/18

Reference Note:
1. In this case, interest is paid half yearly. However, the acquisition happens on 01/03/18
i.e. within the half year. It would not be possible to find PVAF in case number of half
years come in decimal points. Hence, we modify the solution and find the value of the
bond on 30/6/18 including interest expected to be received on 30/06/18 + PV of all
future interest and principal receipts from 01/07/18 to 31/12/25 i.e value of bond on
1/7/18.
2. Find the NPV of step 1 by discounting it for 4 months (1/3/18 – 30/6/18)
a. Value of Bond
• Coupon = 10% p.a./2 = 5% (for 6 months)
• Discount Rate = 12%/2 = 6% (for 6 months)
• Time (n) = 7.5 years = 15 Half years
Value of bond on 1/7/18 = 50 × 9.7122 + 1,000 × 0.4173
PVAF (6%, 15 Years) PVF (6%, 15th Year)
Value (1/7/18) = 902.91
Interest (30/6/18) = 50 (1,000 × 10% × 6/12)
Value (30/6/18) = 952.91 (902.91 + 50)

1
b. Value of Bond (1/3/18) = 952.91 × (1/3/18 - 30/6/18)
(
(1 + 0.06 × 4 / 6 )
= 956.91 × 1/1.04
(half yearly Interest = 6%. 4 months out of 6 is 4/6)
= 916.26
The amount to be paid to complete the transaction on 1/3/16 is ` 916.26

CA BHAVIK CHOKSHI 13
 Valuation of Securities

c. On 1/3/18, Interest for the month of Jan 18 & Feb 18 would have accrued but have
not yet been received by the seller of the bond. Hence, we need to pay the price of
the bond as well as the interest to the seller.
Therefore, ` 916.26 represents the compensation for the price of the bond as well
as accrued interest for the first 2 months.
Interest accrued = 1,000 × 10% × 2/12
= 16.67
The remaining 916.26 – 16.67 = ` 899.59 represents the basic value of bond.

Question 13

A 5 years bond with 8% coupon rate and maturity value of ` 1,000 is currently selling at ` 925
what is its yield to maturity. Also calculate the Current Yield and Realized Yield

Summary

Detailed Solution

Annual coupon
1. Current Yield =
Market price
1, 000 × 8 %
925

80
× 100
925

= 8.6486% = 8.65%
2. Yield to Maturity
Shortcut for reference: YTM

80 + (1,000 - 925)/5
= = 95/962.5 = 9.870%
(1,000 + 925)/2

Using Trial & Error

PVCO = 925
PVCI: At 10%
= 80 × 3.7908 + 1,000 × 0.6209
PVAF (10%, 5 Years) PVF (10%, 5th Year)
= 303.26 + 620.9
= 924.16

14 CA BHAVIK CHOKSHI
 Valuation of Securities

PVCI: At 9%
= 80 × 3.8897 + 1,000 × 0.6499
PVAF (9%, 5 Years) PVF (9%, 5th Year)
= ` 961.08
YTM by interpolation,
X − 9% 925 − 961.08
=
10% − 9% 924.16 − 961.08

X − 9% 36.08
=
1% 36.92

X = (0.98 × 0.01) + 0.09

X (YTM) = 9.98% p.a
3. Realised Yield
FV = PV (1+r)n
1,400 (WN 1) = 925 (1+r)5

1, 400
= (1+r)5
925

1.5135 = (1+r)5
(1.5135)1/5 = (1+r)
Let x = (1.5135)1/5
Taking log on both sides

1
Log x = log (1.5135)
5

1
Log x = (0.1801)
5

Log x = 0.03602
x = Antilog (0.03602)
x = 1.086
1.086 = (1+r)
r = 0.086 i.e 8.6% p.a.

CA BHAVIK CHOKSHI 15
 Valuation of Securities

WN 1: Value of Future Value (FV)

Year CI
1 80 (1,000 × 8%)
2 80
3 80
4 80
5 1,080
1,400

Question 14 (Practice Manual)

There is a 9% 5 year bond issue in the market. The issue price is ` 90 and the redemption price
` 105. For an investor with marginal income - tax rate of 30% and capital gains tax rate of 10%
(assuming no indexation), what is the post - tax yield to maturity?

Summary

Detailed Solution

In order to calculate the post-tax yield, we should take post-tax cash flows
Purchase price : ` 90 (no tax adjustment)
Term: 5 years
Interest: 100 x 9% = ` 9
Post tax interest = 9 × (1-t)
= 9 × (1-0.3)
= 9 × 0.7
= ` 6.3
In the absence of information, we have assumed that the face value is ` 100.
Post-tax redemption value = 105 - [(105 - 90) × 10%]
= 105 - (15 × 10%)
= 105 - 1.5
= ` 103.5
Post-tax YTM (approx)
6.3 + (103.5 - 90)/5
YTM =
(103.5 + 90)/2

= 9/96.75
= 9.30%
PVCO = ` 90

16 CA BHAVIK CHOKSHI
 Valuation of Securities

PVCI: At 9%
= 6.3 × 3.8897 + 103.5 × 0.6499
PVAF (9%, 5) PVF (9%, 5th)
= ` 91.77

PVCI: At 10%
= 6.3 × 3.7908 + 103.5 × 0.6209
PVAF (10%, 5 Years) PVF (10%, 5th Year)
= ` 88.14

By Interpolation

X − 9% 90 − 91.77
=
10% − 9% 88.14 − 91.77
X − 9% 1.77
=
1% 3.63
X = 0.09 + 0.0049
X = 9.49%
Therefore, post-tax YTM = 9.49% p.a.

Question 15 (ICAI Study Material)

An investor is considering the purchase of the following Bond:

Face value ` 100
Coupon rate 11%
Maturity years

(i) If he wants a yield of 13% what is the maximum price, he should be

ready to pay for?
(ii) If the Bond is selling for ` 97.60, what would be his yield?

Summary

Detailed Solution

(i) Valuation
Bo = 11 × 2.3612 + 100 × 0.6931
PVAF (13%,3 Years) PVF (13%,3rd Year)
= 95.28

CA BHAVIK CHOKSHI 17
 Valuation of Securities

In order to earn yield of 13% the maximum price to be paid should be ` 95.28
(ii) Yield to maturity if price is 97.60
At 12%
PVCO = 97.60
PVCI = 11 × 2.4018 + 100 × 0.7118
PVAF (12%, 3 Years) PVF (12%, 3rd Year)
= 97.60
In case market price is ` 97.60, yield = 12%

Question 16 (ICAI Paper Nov 22)

Mr. X wants to invest ` 1,00,000 in the 7 years 8% bonds in the market (Face Value ` 100) which
were issued 2 years ago.
(i) You are requested to advise him what is the maximum price for bonds to be paid in the
following scenarios:
(1) If Mr. X is expecting minimum 9% return on the bonds
(2) If Mr. X is expecting minimum 7% return on the bonds
(3) If the present rate of similar bonds issued is 8.25%
(4) If the present rate of similar bonds issued is 7.75%
(ii) If the bonds are available at par and 1% is the transaction cost, what is the effective
yield?
(iii) Find the number of days required to breakeven transaction cost if the bonds are available
at par and 2% is the transaction cost.

Summary

Detailed Solution

(i) The maximum price to be paid for Bond

(1) To have a return of 9% return on Bond.

8
= ` 100 ×
9
= ` 88.89
Alternative Answer
8 8 8 8 108
+ + + +
(1.09) (1.09) (1.09) (1.09) (1.09)
1 2 3 4 5

= ` 7.34 + ` 6.73 + ` 6.18 + ` 5.67 + ` 70.19 = ` 96.11

18 CA BHAVIK CHOKSHI
 Valuation of Securities

(2) To have a return of 7% return on Bond.

8
= ` 100 × = ` 114.29
7

Alternative Answer
8 8 8 8 108
+ + + +
(1.07)1
(1.07)2
(1.07)3
(1.07) 4
(1.07) 5

= ` 7.48 + ` 6.99 + ` 6.53 + ` 6.10 + ` 77.00 = ` 104.10

(3) If present rate of similar bond issued is 8.25%

8 8 8 8 108
= + + + +
(1.0825)1 (1.0825)2 (1.0825)3 (1.0825) 4 (1.0825)5

= ` 7.39 + ` 6.83 + ` 6.31 + ` 5.83 + ` 72.66 = ` 99.02

Alternative Answer

8
= ` 100 ×
8.25

= ` 96.97

(4) If present rate of similar bond issued is 7.75%

8 8 8 8 108
= + + + +
(1.0775) (1.0775)
1 2
(1.0775)3
(1.0775) 4
(1.0775)5

= ` 7.42 + ₹ 6.89 + ₹ 6.39 + ₹ 5.94 + ₹ 74.36

= ` 101.00
Alternative Answer

8
= ` 100 ×
7.75

= ` 103.23
8
(ii) Effective yield if transaction cost is 1% =
101
× 100 = 7.92
(iii) No. of Days required for break even

2% × 1, 00, 000 2, 000

= = = 90 days
8% 22.22
1, 00, 000 ×
360

CA BHAVIK CHOKSHI 19
 Valuation of Securities

Alternatively, if 365 days used in Calculation then answer will be as follows:

2% × 1, 00, 000 2, 000

= = = 91.24 days say 91 days
8% 21.92
1, 00, 000 ×
365

BONDS–FORWARD RATE

Question 17 (Practice Manual)

From the following data for government securities, calculate the forward rates:
Face Value (`) Interest Rate Maturity (Years) Current Price (`)
1,00,000 0% 1 91,500
1,00,000 10% 2 98,500
1,00,000 10.5% 3 99,000

Summary

Detailed Solution

Bond A:
91,500 = 0 + 1, 00, 000
(PVCO) (1 + r )
1

91,500 (1 + r1) = 1,00,000

1, 00, 000
1+r1 =
91,500

1+r1 = 1.0929
r1 = 0.929 i.e. 9.29%
Bond B: Let the Forward Rate of Interest for year 2 be r2

Reference Note: The value of the bond is the PV for all future cash flows. In case of forward
rates, the PV is calculated taking the actual rate prevailing in each year separately, whereas in
YTM we take the same rate in each of the years.

10, 000 1,10, 000

98,500 = +
1.0929 ( ) (
1.0929 × 1 + r2 )

20 CA BHAVIK CHOKSHI
 Valuation of Securities

1, 00, 649.648
98,500 = 9,149.968 +
(1 + r )2

1, 00, 649.65
89,350.03 =
(1 + r )
2

1, 00, 649.65
(1 + r2) =
89,350.03

(1 + r2) = 1.1265
r2 = 0.1265 i.e 12.65%
Bond C: Let the Forward Rate of Interest for year 2 be r3

10,500 10,500 1,10,500

99,000 = + +
1.0929 (
1.0929 1.1265 )( ) ( )(
1.0929 1.1265 + 1 + r3 ) ( )
89, 753.35
99,000 = 9,607.47 + 8,528.60 +

(1 + r )
3

89, 753.35
99,000 = 18,136.07 +
(1 + r )
3

89, 753.35
80,863.93 =
(1 + r )
3

(1 + r3) = 1.1099
r3 = 0.1099 i.e. 10.99%
Reference Note: Yield Curve is the graphical presentation of forward rates in each year.

Question 18 (Practice Manual)

ABC Ltd. issued 9%, 5 year bonds of ` 1,000/- each having a maturity of 3 years. The present
rate of interest is 12% for one year tenure. It is expected that Forward rate of interest for
one year tenure is going to fall by 75 basis points and further by 50 basis points for every
next year in further for the same tenure. This bond has a sensitivity to the intrinsic value
(beta) of 1.02 and is more popular in the market due to less credit risk.
Calculate
(i) Intrinsic value of bond
(ii) Expected price of bond in the market

CA BHAVIK CHOKSHI 21
 Valuation of Securities

Summary

Detailed Solution

(i) Forward Rates

1st year: r1 = 12%
2nd year: r2 = 12% - 0.75% = 11.25%
3rd year: r3 = 11.25% - 0.50% = 10.75%
Coupon : 9%
Remaining term : 3 Years
Discount Rates : Forward rates (as above)

(ii) Intrinsic Value (Based on PV of future cash flows)

90 90 1090
= + +
1.12 ( )(
1.12 1.1125 ) ( )( )(
1.12 1.1125 1.1075 )
= 80.36 + 72.23 + 789.89
= 942.48
(iii) Expected Price of Bond in Market
= Intrinsic value × b (Sensitivity)
= 942.48 × 1.02
= 961.33

Question 19 (ICAI Paper Jan 21)

Following are the yields on Zero Coupon Bonds (ZCB) having a face value of ` 1,000 :
Maturity (Years) Yield to Maturity (YTM)
1 10%
2 11%
3 12%

Assume that the term structure of interest rate will remain the same.
You are required to
(i) Calculate the implied one year forward rates
(ii) Expected Yield to Maturity and prices of one year and two year Zero Coupon Bonds at
the end of the first year.

22 CA BHAVIK CHOKSHI
 Valuation of Securities

Summary

Detailed Solution

1. Implied forward rate: The forward rate for year 1 would be the same as YTM for year 1
i.e 10%
2. Forward Rate for year 2
(1 + YTM)2 = (1 + r1) (1 + r2)
(1 + 0.11) 2
= (1 + 0.1) (1 + r2)
1.2321 = 1.1r2 + 1.1
0.1321 = 1.1r2
r2 = 0.1201
i.e. 12.01%
3. Forward Rate for Year 3
(1 + 0.12)3 = (1 + 0.11)2 (1 + r3)
1.4049 = 1.2321 + 1.2321r3
1.2321r3 = 0.1728
r3 = 0.1402
i.e. 14.02%
Alternatively
(1 + YTM3)3 = (1 + r1) (1 + r2) (1 + r3)
(1 + 0.12)3 = (1 + 0.1) (1 + 0.1201) (1 + r3)
1.4049
= 1 + r3
1.2321
1 + r3 = 1.1402
r3 = 14.02%
ii. Actual Position at the end of Year 1:
Bond 1: Since the Original Maturity is 1 Year, this bond would have been redeemed & hence
it would not be outstanding Bond at the end of Year 1.

Bond 2: Remaining Maturity is 1 Year

r2 = 12.01% = YTM
Since the expected interest rate in 2nd year (r2) of 12.01% will actually prevail in 2nd year,
the YTM for this bond would be the required return which a new investor would expect from
this bond considering expected Interest Rate at the end of the first year for 1 year.
i.e YTM = r2 = 12.01%

CA BHAVIK CHOKSHI 23
 Valuation of Securities

Price of Bond 2 at end of Year 1 = 1,000 × 0.8928

PVF (12.01%, 1st Year)
= 892.8
Reference Note: We take 1 year as the remaining maturity because we are at the end of
the 1st Year and a 2 year bond would be redeemed after 1 more year.
Bond 3: Remaining Maturity: 2 years
(1 + YTM)2 = (1 + r2) ( 1 + r3)
(1 + YTM)2 = (1 + 0.1201) (1 + 0.1402)
Let YTM be x
(1 + x)2 = 1.2771
1+x = 1.1301
x = 0.1301 i.e. 13.01%
Price of bond 3 at end of Year 1 = ` 1,000 × 0.7830
PVF (13.01%, 2nd year)
= ` 783

BOND RISK-DURATION

Question 20 (ICAI Study Material)

The following data are available for a bond.

Face Value ` 1,000
Coupon Rate 16%
Years to Maturity 6
Redemption Value ` 1,000
Yield to Maturity 17%

What is the current market price, duration and volatility of this bond? Calculate the expected
market price, if increase in required yield is by 75 basis points.

Summary

Detailed Solution

Year (t) CI DF @ 17% PVCI t × PVCI

1 160 0.8547 136.75 136.75
2 160 0.7305 116.88 233.76
3 160 0.6244 99.90 299.7
4 160 0.5337 85.39 341.56

24 CA BHAVIK CHOKSHI
 Valuation of Securities

5 160 0.4561 72.98 364.9

6 1,160 0.3898 452.17 2,713.02
964.07 4,089.69

(i) Therefore market price of bond is 964.07

4,089.69
(ii) Duration =
964.07

= 4.24 years

Macaulay Duration
(iii) Volatility =
1 + YTM

4.24 years
=
1 + 0.17

4.24
=
1.17

= 3.62 years
(iv) Increase in yield = 75 bps i.e. 0.75%

0.75%
Change in expected market price = -3.62 ×
1%
= -2.72% (negative)
Expected Market Price = 964.07 - 2.72% × 964.07
= ` 937.85
Extra: Cross checking: Revised Yield = 17.75%
160 × 3.5201 + 1,000 × 0.3752
PVAF (17.75%, 6 Years) PVF (17.75, 6th Year)
= ` 938.42 (approximately the same as the price calculated above using modified duration)

Reference Notes:
1. Due to the changes in market interest rates, the market price of a bond fluctuates. Its
sensitivity is based on the modified duration and not the original maturity.
2. There is an inverse relationship between changes in interest rates (yield) and bond
prices. Further, the magnitude of this change can be measured with the help of modified
duration. Hence, in response to an increase (positive) in yield, we have taken modified
duration to be negative.

CA BHAVIK CHOKSHI 25
 Valuation of Securities

Question 21

The Investment portfolio of a bank is as follows:

Government Bond Coupon Rate Purchase Rate Duration
(F.V. ` 100 per Bond) (Years)
G.O.I. 2006 11.68 106.50 3.50
G.O.I. 2010 7.55 105.00 6.50

G.O.I. 2015 7.38 105.00 7.50

G.O.I. 2022 8.35 110.00 8.75

G.O.I. 2032 7.95 101.00 13.00

Face value of total investment is ` 5 crores in each Government Bond. Calculate actual
Investment in portfolio.
What is a suitable action to churn out investment portfolio in the following scenario?
1. Interest rates are expected to lower by 25 basis points.
2. Interest rates are expected to raise by 75 basis points.
Also calculate the revised duration of investment portfolio in each scenario.

Summary

Detailed Solution

1. Calculation of actual investment in the portfolio

` 5, 00, 00, 000

No. of bonds =
100

= 5,00,000 bonds

GOVT BOND Number PRICE INVESTMENT

GOI 2006 5,00,000 106.5 5,32,50,000
GOI 2010 5,00,000 105 5,25,00,000
GOI 2015 5,00,000 105 5,25,00,000
GOI 2022 5,00,000 110 5,50,00,000
GOI 2032 5,00,000 101 5,05,00,000
26,37,50,000

2. Suitable Action in case Interest rates are expected to change

a. Action if interest rates are expected to fall by 0.25%

26 CA BHAVIK CHOKSHI
 Valuation of Securities

In such a case, all the bonds will increase in price, however the longer duration bonds
will increase the most and the shorter duration bonds will increase the least.
Hence, in order to maximise the profits we should sell the shorter duration bonds
and utilise the proceeds to buy the longer duration bonds i.e GOI 2006 should be
sold and SOI 2032 should be purchased.
b. Action if interest rates are expected to rise by 0.75%
In case the interest rates are increasing, the prices of all bonds are expected to fall.
The longer duration bonds will fall the most whereas the shorter duration bonds will
fall the least.
Hence, in order to minimise the losses the longer duration bonds should be sold and
the shorter duration bonds should be purchased i.e GOI 2032 should be sold and
GOI 2006 should be purchased.
3. Portfolio Duration

Reference Note:
Portfolio duration is the weighted average duration of all the individual securities in
the portfolio with the amount invested taken as weights. In case the amount invested is
approximately equal, we can use the simple average instead of weighted average.
In this question, the amounts invested in each category of bonds are approximately equal
and hence ICAI has used simple average. Alternatively weighted average can also be
taken.

Original duration = 3.5 + 6.5 + 7.5 + 8.75 + 13

5
= 7.85 years
REVISED DURATION:

6.5 + 7.5 + 8.75 + 13 + 13

(a) Interest rates fall by 0.25% =
5

= 9.75 years

3.5 + 3.5 + 6.5 + 7.5 + 8.75

(b) Interest rates increase by 0.75% =
5

= 5.95 years

CA BHAVIK CHOKSHI 27
 Valuation of Securities

Question 22 (Practice Manual)

(a) Consider two bonds, one with 5 years to maturity and the other with 20 years to maturity.
Both the bonds have a face value of Rs 1,000 and coupon rate of 8% (with annual interest
payments) and both are selling at par. Assume that the yields of both the bonds fall
to 6%, whether the price of bond will increase or decrease? What percentage of this
increase/decrease comes from a change in the present value of bond’s principal amount
and what percentage of this increase/decrease comes from a change in the present value
of bond’s interest payments?
(b) Consider a bond selling at its par value of ` 1,000, with 6 years to maturity and a 7%
coupon rate (with annual interest payment), what is bond's duration?
(c) If the YTM of the bond in (b) above increases to 10%, how it affects the bond's duration?
And why?

Summary

Detailed Solution

(a) Since both the bonds are selling at par, Face Value equals the Market Price and hence
Coupon rate (8%) will equal the Discount rate (YTM) (8%)
Bond A: 5 years (at 8% YTM)
= 80 × 3.9927 + 1,000 × 0.6806
PVAF (8%, 5 Years) PVF (8%, 5th Year)
= 319.42 + 680.5
= 1,000
Bond A: Revised Price (at 6% YTM)
= 80 × 4.2124 + 1,000 × 0.7473
PVAF (6%, 5 Years) PVF (6%, 5th Year)
= 336.99 + 747.3
= 1,084.18

28 CA BHAVIK CHOKSHI
 Valuation of Securities

Analysis of the Increase in bond price:

INCREASE IN BOND PRICE

84.29 (1,084.29 - 1,000)

Due To Interest Due To Principal

= 336.99 - 319.4 = 747.3 - 680.6
= 17.59 = 66.7
% Due to Interest % Due to Interest
17.59 66.7
= × 100 = × 100
84.29 84.29
= 20.87% = 79.13%

Bond B: 20 Years (at 8% YTM)

= 80 × 9.8181 + 1,000 × 0.2145
PVAF (8%, 20 Years) PVF (8%, 20th Year)
= 785.5 + 214.5
= 1,000
Bond B: 6% (at 6% YTM)
= 80 × 11.4699 + 1,000 × 0.3118
PVAF (6%, 20 Years) PVF (6%, 20th Year)
= 917.59 + 311.8
= 1,229.39

INCREASE IN BOND PRICE

= 229.39 (1,229.39 - 1,000)

Due To Interest Due To Principal

= 917.59 - 785.44 = 311.8 - 214.5

= 132.15 = 97.3
97.3
= 132.15 × 100 = × 100
229.39 229.39
= 57.6% = 42.4%

CA BHAVIK CHOKSHI 29
 Valuation of Securities

As can be seen, the prices of both the bonds are increasing in response to a fall in
discount rate (yield).
(b) Duration at YTM of 10%
Since the bond is selling at par, the coupon rate (7%) would equal the discount rate (yield)
i.e 7%
Year (t) Cl DF @ 7% PVCl t × PVCl Weight (%)
1 70 0.9346 65.42 65.42 6.54
2 70 0.8734 61.14 122.28 6.11
3 70 0.8163 57.14 171.42 5.71
4 70 0.7629 53.40 213.60 5.34
5 70 0.7130 49.91 249.55 4.99
6 1,070 0.6663 712.94 4,277.64 71.29
1,000 5,099.91

∑ t × PVCI
Macaulay’s Duration =
PV of all CI
5, 099.91
=
1, 000

= 5.10 years
(c) Duration at YTM of 10%
Year (t) CI DF @ 10% PVCI t × PVCI Weight (%)
1 70 0.9091 63.64 63.64 7.32
2 70 0.8264 57.85 115.7 6.65
3 70 0.7513 52.59 157.77 6.05
4 70 0.6830 47.81 191.24 5.5
5 70 0.6209 43.46 217.3 5
6 1070 0.5645 604.02 3,624.12 69.48
869.37 4,369.77
∑ t × PV of Cl
Macaulay’s Duration = PV of all Cl
= 4,369.77
869.37
= 5.03 years
As can be seen, as the YTM (Discount Rate) increases from 7% to 10%, the duration of the
bonds will reduce from 5.10 to 5.03 years. This is because a higher weight is given to the earlier
years and a lower weight is given to later years at 10% YTM (as compared to 7% YTM).

30 CA BHAVIK CHOKSHI
 Valuation of Securities

Question 23 (ICAI Paper May 23)

An investor, in the beginning of 2022, has purchased substantial number of 8 year 7.50%, ₹
1000 bond with 5% premium on maturity at a required Yield to Maturity (YTM) of 8.50 %.
However, due to the continuing war in Europe, the inflation is running very high in the economies
of the countries. The yield on the bonds is decreasing. The risk averse investor wants to protect
himself from further loss and decides to sell the bonds in 2023. He has got a proposal from
another investor who is willing to purchase these bonds by shelling out a maximum amount of ₹
797.50 per bond.
Investor follows intrinsic value method for valuation of the Bonds.
You are required to determine
(i) The Market price, Duration and Volatility of the bond.
(ii) Will it be a right decision of the new investor if he is looking for Required Yield to
Maturity (YTM) as 12% p.a. ?
Period 1 2 3 4 5 6 7
PVIF (8.50%, n) 0.9217 0.8495 0.7829 0.7216 0.6650 0.6129 0.5649

Summary

Detailed Solution

(i) (A) Market Price of Bond

= 1,000 X 7.50% X (PVIAF 8.50%,7) + 1,050 X (PVIF 8.5%,7)
= 75 X 5.1185 + 1050 X 0.5649
= 383.89 + 593.15 = ₹ 977.04
(B) Duration of Bond
Year Cash flow P.V. @ 8.5% Proportion of Proportion of
bond value bond value x
time (years)
1 75 0.9217 69.128 0.071 0.071
2 75 0.8495 63.713 0.065 0.130
3 75 0.7829 58.718 0.060 0.180
4 75 0.7216 54.120 0.055 0.220
5 75 0.6650 49.875 0.051 0.255
6 75 0.6129 45.968 0.047 0.282
7 1125 0.5649 635.513 0.651 4.557
977.035 5.695

Duration of the Bond is 5.695 years.

CA BHAVIK CHOKSHI 31
 Valuation of Securities

Alternatively, it can also be calculated as follows:

Year (1) Cash flow PVF (3) PV (4)
(2) (1) x (4)
1 75 0.9217 69.13 69.13
2 75 0.8495 63.71 127.42
3 75 0.7829 58.72 176.16
4 75 0.7216 54.12 216.48
5 75 0.6650 49.88 249.40
6 75 0.6129 45.97 275.82
7 1125 0.5649 635.51 4448.57
977.04 5562.98
5562.98
Duration of the Bond = = 5.69 years
977.04
(C) Volatility of Bond-
Volatility = Duration/(1+YTM)
= 5.695/ (1+0.085) = 5.249
Or = 5.69/ (1+0.085) = 5.24
(ii) PV of Bond @ 12% YTM
= ` 75 PVIAF (12%, 7) + ` 1050 × PVIF (12%, 7)
= ` 75 × 4.5637 + ₹ 1050 × 0.4523
= ` 342.28 + ` 474.92 = ` 817.20
Since, Intrinsic Value of Bond is ₹ 817.20 the decision of new investor is right at purchase
price of ₹ 797.50.
Alternatively, it can also be solved as follows:
Price Difference between Current Selling Price & Intrinsic Value ` 179.54
Price Difference between Current Selling Price & Intrinsic Value
3.50%
Price Difference × 100
Increase in Yield justified
Volatility × P0

Justified YTM (8.50% + 3.50%) 12%

Thus, the decision of investor is right.

Question 24 (ICAI Paper May 19)/(ICAI Paper Nov 18)

The following data are available for three bonds A, B and C. These bonds are used by a bond
portfolio manager to fund an outflow scheduled in 6 years. Current yield is 9%. All bonds have
face value of ` 100 each and will be redeemed at par. Interest is payable annually.

32 CA BHAVIK CHOKSHI
 Valuation of Securities

Bond Maturity (Years) Coupon rate

A 10 10%
B 8 11%
C 5 9%

(i) Calculate the duration of each bond.

(ii) The bond portfolio manager has been asked to keep 45% of the portfolio money in Bond
A. Calculate the percentage amount to be invested in bonds B and C that need to be
purchased to immunise the portfolio.
(iii) After the portfolio has been formulated, an interest rate change occurs, increasing the
yield to 11%. The new duration of these bonds are: Bond A = 7.15 Years, Bond B = 6.03
Years and Bond C = 4.27 years.
Is the portfolio still immunized? Why or why not?
(iv) Determine the new percentage of B and C bonds that are needed to immunize the
portfolio. Bond A remaining at 45% of the portfolio.
Present values be used as follows :
Present Values t1 t2 t3 t4 t5
PVIF0.09,t 0.917 0.842 0.772 0.708 0.650

Present Values t6 t7 t8 T9 t10

PVIF0.09,t 0.596 0.547 0.502 0.460 0.4224

Summary

Detailed Solution

(i) Bond A
Year (t) CI DF @9% PVCI t x PV of CI
1 10 0.917 9.17 9.17
2 10 0.842 8.42 16.84
3 10 0.772 7.72 23.16
4 10 0.708 7.08 28.32
5 10 0.650 6.5 32.50
6 10 0.596 5.96 35.76
7 10 0.547 5.47 38.29
8 10 0.502 5.02 40.16
9 10 0.460 4.6 41.40
10 110 0.4224 46.464 464.64
106.40 730.24

CA BHAVIK CHOKSHI 33
 Valuation of Securities

∑ t × PV of CI 730
Mauclay’s Duration = =
∑ PV of all CI 106.40

= 6.86 years
Bond B
Year (t) CI DF @ 9% PVCI t × PV of CI
1 11 0.917 10.09 10.09
2 11 0.842 9.26 18.52
3 11 0.772 8.49 25.47
4 11 0.708 7.79 31.16
5 11 0.650 7.15 35.75
6 11 0.596 6.56 39.36
7 11 0.547 6.02 42.14
8 111 0.502 55.72 445.76
111.08 648.25

∑ t × PV of CI 648.5
Mauclays Duration = =
∑ PV of all CI 111.08

= 5.84 years
Bond C
Year CI DF @9% PVCI t × PV of CI
1 9 0.917 8.253 8.253
2 9 0.842 7.578 15.156
3 9 0.772 6.948 20.844
4 9 0.708 6.372 25.488
5 109 0.650 70.83 354.25
100 423.99

∑ t x PV of CI 423.99
Mauclays Duration = =
∑ PV of all CI 100

= 4.24 years
(ii) Weights in order to have Immunized Portfolio
In order to create an immunized portfolio, Duration of Liabilities = Duration of Assets i.e
6 years (given for liabilities)
Thus Duration of Assets Portfolio = 6 years
DABC = WaDa + WbDb + WcDc
6 = 0.45 × 6.86 + Wb × 5.84 + Wc × 4.24
6 = 3.087 + 5.84Wb + 4.24Wc - Equation (1)
Wa + Wb + Wc = 1 (Weight in total = 1)
Wb + Wc + 0.45 = 1

34 CA BHAVIK CHOKSHI
 Valuation of Securities

Wb + Wc = 0.55
Wb = 0.55 – Wc
Substituting Wb = 0.55 – Wc in Equation 1, we get
6 = 3.087 + 5.84 (0.55 – Wc) + 4.24 Wc
2.913 = 3.212 – 5.84Wc + 4.24 Wc
0.299 = 1.6 Wc

0.299
Wc =
1.60

= 18.69%
Wb = 0.55 – 0.1869
= 36.31%
Immunized Portfolio:
Wa = 45%
Wb = 36.31%
Wc = 18.69%
(iii) Immunization if Yield changes to 11%
Revised Duration:
= Wa × Da + Wb × Db + Wc × Dc
= 0.45 × 7.15 + 0.3631 × 6.03 + 0.1869 × 4.27
= 6.21 years
Unless given, we have assumed that duration of liabilities continues to be 6 years.
However, duration of assets portfolio is 6.21 years. Hence Duration of liabilities is not
equal to Duration of assets & hence the portfolio is no longer immunized.
(iv) Revised Weights in order to have Immunized Portfolio
Dabc = Wa × Da + Wb × Db + Wc × Dc
In order to create immunized portfolio DLiab = DAssets = 6 Years
6 = 0.45 × 7.15 + Wb × 6.03 + Wc × 4.27
6 = 3.2175 + 6.03 (0.55 – Wc) + Wc × 4.27
2.7825 = 3.3165 – 6.03Wc + 4.27Wc
0.534 = 1.76Wc

0.534
Wc =
1.76

= 0.3034 i.e 30.34%

Wb = 24.66%

CA BHAVIK CHOKSHI 35
 Valuation of Securities

Revised Rebalanced Immunized Portfolio

A = 45%
B = 24.66%
C = 30.34%

Question 25 (ICAI Study Material)

Mr. A will need ` 1,00,000 after two years for which he wants to make one time necessary
investment now. He has a choice of two types of bonds. Their details are as below:
Bond X Bond Y
Face value ` 1,000 ` 1,000
Coupon 7% payable annually 8% payable annually
Years to maturity 1 4
Current price ` 972.73 ` 936.52
Current yield 10% 10%

Advice Mr. A whether he should invest all his money in one type of bond or he should buy
both the bonds and, if so, in which quantity? Assume that there will not be any call risk or
default risk.

Summary

Detailed Solution

1. In this case, we need ` 1,00,000, after 2 years. This may be because there might be a
liability whose payment falls due after 2 years.
Thus, we should create a portfolio of assets in such a way that the duration of this
portfolio equals the duration of liability i.e 2 Years
2. Duration – Bond X
Year (t) CI DF @ 10% PV of CI ∑t × PVCI
1 1,070 0.9091 972.74 972.74
972.74 972.74
∑ t × PVCI
Duration =
∑ PV of CI
972.74
=
972.74

= 1 Year

36 CA BHAVIK CHOKSHI
 Valuation of Securities

3. Duration – Bond Y
Year (t) CI DF @ 10% PVCI t × PVCI
1 80 0.9091 72.73 72.73
2 80 0.8264 66.11 132.22
3 80 0.7513 60.10 180.30
4 1,080 0.6830 737.64 2,950.56
936.58 3,335.81

∑ t × PV of CI
Duration =
∑ PV of CI

3,335.81
=
936.58

= 3.56 Years
c. DLiabities = DAssets = 2
Dxy = Wx × Dx + Wy × Dy
2 = Wx × 1 + (1 – Wx) × 3.56
2 = Wx + 3.56 – 3.56Wx
1.56 = 2.56Wx
Wx = 0.6094 i.e 60.94%
∴ Wy = 1 – Wx i.e. 39.06%
d. Investment in Bond X Investment in Bond Y
= 1,00,000 × 60.94% × 0.8264 1,00,000 × 39.06% × 0.8264
PVF (10%, 2 Years) PVF (10%, 2 Years)
= ` 50,360.82 ` 32,279.18
No. of Bonds No. of Bonds
=50,360.82 32,279.18
972.74 936.58
= 51.77 = 34.46
i.e 52 bonds i.e 34 bonds
Reference Note:
In this question we have been told to find the quantity of bonds to be purchased and not just
%. Hence we will have to allocate the total value needed for meeting the liability i.e ` 1,00,000
between Bonds X and Y in the proportion of their % decided. Further, while determining Amount
to be invested at year 0, we should consider the present value for 2 years.

CA BHAVIK CHOKSHI 37
 Valuation of Securities

Question 26 (ICAI Paper Nov 20)

The following data are available for a bond :

Face Value ` 10,000 to be redeemed at par on maturity
Coupon rate 8.5 per cent per annum
Years to Maturity 5 years
Years to maturity (YTM) 10 per cent
You are required to calculate :
(i) Current market price of the Bond,
(ii) Macaulay’s Duration,
(iii) Volatility of the Bond,
(iv) Convexity of the Bond,
(v) Expected Market price, if there is a decrease in the YTM by 200 basis points
(a) By Macaulay’s Duration based estimate
(b) By Intrinsic Value Method.
Given
Years 1 2 3 4 5
PVIF (10%,n) 0.909 0.826 0.751 0.683 0.621
PVIF (8%,n) 0.926 0.857 0.794 0.735 0.681

Summary

Detailed Solution

(i) Duration and Price

Year (t) CI DF @ 10% PVCI t × PV of CI
1 850 0.909 772.65 772.65
2 850 0.826 702.10 1,404.2
3 850 0.751 638.35 1,915.05
4 850 0.683 580.55 2,322.2
5 10,850 0.621 6,737.85 33,689.25
9,431.50 40,103.35

∑ t x PV of CI
(ii) Macaulay Duration =
∑ PV of CI

40,103.35
=
9, 431.50

= 4.25 Years

38 CA BHAVIK CHOKSHI
 Valuation of Securities

(iii) Current Market Price = 9,431.50

Macaulay Duration
(iv) Volatility =
1 + YTM
4.25
=
(1 + 0.1)
= 3.864
(v) Convexity
Vo = (` 9,431.50) At 10%
V+ = (10% - 2%) At 8%
V- = (10% + 2%) At 12%

Reference Note
As Sub point (v) requires the expected price if YTM changes by 2%, we have calculated V+ and
V- taking difference of 2%
Alternatively, any other difference (of say 1%) can also be taken
V+ (at 8%) = 850 × 3.993 + 10,000 × 0.681
PVAF (8%, 5 Years) PVF (8%, 5th Year)
V+ (at 8%) = ` 10,204.05
V- (at 12%) = 850 × 3.605 + 10,000 × 0.567
PVAF (12%, 5 Years) PVF (12%, 5th Year)
V- = ` 8,734.25

V+ + V− − 2Vo
Convexity (C) =
( )
2
2Vo × YTM

=
(
10,204.05 + 8, 734.25 – 2 × 9, 431.50 )
(2 × 9, 431.50 ) × ( 0.02)
2

75.3
=
7.5452

= 9.98
Convexity Effect = C × (YTM)2 × 100
= 9.98 × (0.02)2 × 100
= 998 × 0.0004
= 0.3992% i.e 0.40%

CA BHAVIK CHOKSHI 39
 Valuation of Securities

Expected Market Price for 2% fall in YTM

a. Based on Duration
YTM Price
- 1% + 3.864
- 2% + 7.73 (cross multiply)

Expected Price = 9,431.5 + 7.73% ×9,431.5

= 10,160.55
b. Based on Intrinsic Value Method
(i.e PV of future CF @ 8%)
= ` 10,204.05 (From point iii)
Extra: Bond Value Based on Duration and Convexity
= 9,431.50 + 7.73% × 9,431.50 + 0.40% × 9,431.5
= 9,431.5 + 729.05 + 37.73 = 10,198.28

Question 27 (Practice Manual)

Pet feed plc has outstanding, a high yield Bond with following features:
Face Value £ 10,000
Coupon 10%
Maturity Period 6 Years
Special Feature Company can extend the life of Bond
to 12 years.

Presently the interest rate on equivalent Bond is 8%.

(a) If an investor expects that interest will be 8%, six years from now then how much he
should pay for this bond now.
(b) Now suppose, on the basis of that expectation, he invests in the Bond, but interest rate
turns out to be 12%, six years from now, then what will be his potential loss/ gain if the
company extents the life of Bond for another 6 years.

Summary

Detailed Solution

a. In case the Investor expects the market interest rate to continue to at remain 8% till the
end of 6 years, the company is unlikely to extend the bond up to 12 years as it will have to
pay coupon rate of 10% in the extension period, whereas the market interest rate is only 8
%. Therefore, the bond is likely to be redeemed after 6 years based on this expectation.

40 CA BHAVIK CHOKSHI
 Valuation of Securities

Price of bond at Year 0 = PV of future CI (for 6 years only)

= 1,000 × 4.6229 + 10,000 × 0.6302
PVAF (8%, 6 Years) PVF (8%,6th Year)
= ` 10,924.90

b. In case the market rate of Interest after 6 Years is 12%, it is likely that the company
will exercise the extension feature as it will have to pay a coupon of 10% when market
interest rate is 12%.
As can be seen, the company has exercised the extension features and hence the value
of the bond at the end of year 6 would be taken as present value of remaining 6 coupons
and principal redemption i.e
Value of Bond = 1,000 × 4.114 + 10,000 × 0.5066
(End of year 6) PVAF (12%, 6 Years) PVF (12%,6th Year)
= ` 9,180
Therefore, Potential Loss = 9,180 (Realisable value after 6 years) – 10,924.90 (Investment)
Loss = ` 1,744.90

BOND REFINANCING

Question 28 (ICAI Study Material)

A firm has a bond outstanding `3,00,00,000. The bond has 12 years remaining until maturity, has
a 12.5 per cent coupon and is callable at ` 1,050 per bond; it had floatation costs of ` 4,20,000,
which are being amortized at ` 30,000 annually. The floatation costs for a new issue will be
` 9,00,000 and the current interest rate will be 10 per cent. The after tax cost of the debt
is 6 per cent. Should the firm refund the outstanding debt? Show detailed workings. Consider
Corporate Income - tax rate at 50%.

Summary

Detailed Solution

Option 1: Continue with old bond issue

Particulars – PV of Net Cash Outflow `
PV of Interest Payments 1,57,19,625

(3,00,00,000 × 12.5%) x (1 - 0.5) × 8.3838

PVAF (6%, 12 Years)

CA BHAVIK CHOKSHI 41
 Valuation of Securities

PV of Principal Repaid 1,49,10,000

(3,00,00,000 0.4970)
PVF (6%, 12th Year)
(-) PV of Tax Saving on Amortization of floatation costs of old issues (1,25,757)

(30,000 × 50% × 8.3838)

PV of Net cash flow outflow 3,05,03,868

Option 2:
Early redeem the old bond and issue the new bond
PV of cash outflow
Particulars – PV of Net Cash Outflow `
Call Premium 7,50,000
[(1,050 – 1,000) × 3,000] × (1 - 0.5)
PV of interest payment of New Bond 1,25,75,700
(3,00,00,000 x 10%) × (1 - 0.5) × 8.3838
PV of Principal Redemption 1,49,10,000
(3,00,00,000 x 0.4970)
PVF (6%, 12th Year)
PV of floatation cost on New Issues 9,00,000
(-) PV of tax saving on amortization of floatation cost on new issue (3,14,393)
(9,00,000/12) × 50% × 8.3838
PVAF (6%,12 Years)
(-) PV of immediate Tax Saving on unamortized floatation cost for old bonds (1,80,000)
(4,20,000 - 30,000 × 12%) × 50%
PV of Net Cash Outflow 2,86,41,307

Since the PV of net cash outflow is lower in the new bond issue, it is advisable to redeem the
existing bonds and issue new bonds.
Reference Note:
Floatation cost of ` 4,20,000 on the old bonds is a sunk cost and hence needs to be ignored.
Further, in case the old bond is redeemed, the unamortized floatation cost is pertaining to the
old bond and should be immediately written off to Profit and Loss A/c and hence immediate tax
deduction will be obtained.

Question 29 (Practice Manual)

Tangent Ltd. is considering calling ` 3 crores of 30 years, ` 1,000 bond issued 5 years ago with
a coupon interest rate of 14 per cent. The bonds have a call price of ` 1,150 and had initially
collected proceeds of ` 2.91 crores since a discount of ` 30 per bond was offered. The initial
floating cost was ` 3,90,000. The Company intends to sell ` 3 crores of 12 per cent coupon rate,
25 years bonds to raise funds for retiring the old bonds. It proposes to sell the new bonds at

42 CA BHAVIK CHOKSHI
 Valuation of Securities

their par value of ` 1,000. The estimated floatation cost is ` 4,25,000. The company is paying
40% tax and its after tax cost of debt is 8 per cent. As the new bonds must first be sold and
then their proceeds to be used to retire the old bonds, the company expects a two months
period of overlapping interest during which interest must be paid on both the old and the new
bonds. You are required to evaluate the bond retiring decision. [PVIFA 8%, 25 = 10.675]

Summary

Detailed Solution

Option 1: Continue with the old Bond

PV of cash outflow
PV of Interest Payments = 2,69,01,000
(3,00,00,000 × 14 %) × (1 – 0.4) × 10.675
PVAF (8%, 25 Years)
PV of Principal Payments = 43,80,000
(3,00,00,000 × 0.146)
PVF (8%, 25th Year)

PV of Tax Saving on Amortization of floatation cost

(3,90,000/30) × 40% × 10.675 = (55,510)
PV of Tax Saving on Amortization of Discount on old issue
(9,00,000/30) × 40% × 10.675 = (1,28,100)
PV of Net Cash Outflow 3,10,97,390
Option 2: Early redeem the old bond and issue the new bond
PV of Interest
(3,00,00,000 × 12% ) × ( 1 – 0.4) × 10.675 = 2,30,58,000

PV of Principal
(3,00,00,000 × 0.146)
PVF (6%, 25th Year) = 43,80,000
PV of Floatation Cost on New Issue = 4,25,000
PV of Call Premium = 27,00,000
(1,150 – 1,000) × 30,000 × (1 - 0.4) × 1
PV of overlapping interest = 4,20,000
(3,00,00,000 × 14% ) × 2/12 × ( 1 – 0.40)

CA BHAVIK CHOKSHI 43
 Valuation of Securities

- PV of Tax Saving on floatation Cost of New Issue = (72,590)

(4,25,000/25) × 40% × 10.675
- PV of Immediate Tax Saving on Unamortized floatation cost for Old Bond = (1,30,000)
(3,90,000/30) × 25 × 40% × 1
- PV of Immediate Tax Saving on Unamortized Discount for Old Bond = (3,00,000)
(9,00,000/30) × 25 × 40% × 1
PV of Net Cash Outflow 3,04,80,410
Entity should refund the old bond and issue the new bond as it will result in a lower net cash
outflow in present value terms.

Note: The overlapping interest on old bond is only for the first 2 months and hence effect of time
is not material, therefore in line with ICAI Solution, we have ignored effect of time. Alternatively
the effect of time can be considered by applying monthly discount factor for 2 months.

BONDS – MISCELLANEOUS TOPICS

Question 30 (Practice Manual)

Tiger Ltd. is presently working with an Earning Before Interest and Taxes (EBIT) of ` 90 lakhs.
Its present borrowings are as follows:
` In lakhs
12% term loan 300
Working capital borrowings:
From Bank at 15% 200
Public Deposit at 11% 100

The sales of the company are growing and to support this, the company proposes to obtain
additional borrowing of ` 100 lakhs expected to cost 16%.The increase in EBIT is expected to
be 15%.
Calculate the change in interest coverage ratio after the additional borrowing is effected and
comment on the arrangement made.

Summary

Detailed Solution

1. Existing Interest (` Lakhs)

12% Loan = (300 × 12%) = 36

44 CA BHAVIK CHOKSHI
 Valuation of Securities

15% Loan = (200 × 15%) = 30

11% Deposit = (100 × 11%) = 11
= 77
2. Existing Interest Coverage Ratio

Existing EBIT 90
= =
Existing Interest 77
= 1.17
3. Revised Interest Coverage Ratio

Revised EBIT 90 + 15%

= =
Revised Interest 77 + (100 × 16%)

= 103.50/93
= 1.11
4. Comments: Due to additional borrowing Interest Coverage Ratio is falling and hence
financial risk of Tiger Ltd. is increasing

Question 31

The HLL has ` 8.00 crore of 10% mortgage bonds outstanding under an open- end scheme. The
scheme allows additional bonds to be issued as long as all of the following conditions are met:
(1) Pre tax interest coverage (Income before tax + Bond interest)/Bond Interest remains
greater than 4
(2) Net depreciated value of mortgage assets remains twice the amount of the mortgage debt
(Assuming 50% of the proceeds of new issue would be added to the base of mortgaged
assets)
(3) Debt-to-equity ratio remains below 0.5.
The HLL has net income after taxes of ` 2 crores and a 40% tax- rate, ` 40 crores in
equity and ` 30 crores in depreciated assets, covered by the mortgage.
Assuming that 50% of the proceeds of a new issue would be added to the base of
mortgaged assets and that the company has no Sinking Fund payments until next year,
how much more 10% debt could be sold under each of the three conditions?

Summary

Detailed Solution

10% Existing bonds = 8 Crs, PAT: 2 Cr, Tax: 40%, Equity: 40 Cr, Mortgage Assets : 30 Cr

CA BHAVIK CHOKSHI 45
 Valuation of Securities

Condition 1
(1) PBT 100 ? (3.33) (through cross multiplication)
(-) Tax (40) ?
PAT 60 2
Let the additional amount of 10% debt be 'x Cr' and assuming PBT to remain constant
after debt issue
PBT + Interest
=4
Interest
(
3.33 + 8 + x 10% ) =4
(8 + x ) 10%
3.33 + 0.8 + 0.1x = 4 (0.8 + 0.1x)
4.13 + 0.1x = 3.2 + 0.4x
0.93x = 0.3x
x = 3.1 Cr
Condition 2

Depreciable Assets
(2) =2
Debt
30 + (50% x)
=2
8+x

30 + 0.5x =16 + 2x
14 = 1.5x
x = 9.33 Cr
Condition 3

Debt
(3) = 0.5
Equity

8+x
= 0.5
40
8 + x = 20
x = 12 cr
In order to satisfy all the 3 conditions, the lower of all 3 values i.e. 3.1 Crores should be
the additional debt issue.

46 CA BHAVIK CHOKSHI