2025

CA FINAL

ADVANCED FINANCIAL
MANAGEMENT
SUPER 90 QUESTIONS

7021953181/7977299310 Bhavik Chokshi

 
INDEX

INDEX

Sr. No. of
Contents Page No.
No. Questions
Valuation of Securities
1. 13 1
(Security Analysis and Security Valuation)
2. Mergers, Acquisitions and Corporate Restructuring 11 23

hi
3. Portfolio Management 10 54

4. Advanced Capital Budgeting Decisions 6 75

ks
5. Mutual Funds 7 85

6. Risk Manangement 1 100

7. Business Valuation 2 102

8.

9.
ho
Foreign Exchange Exposure and Risk Management

International Financial Management

20

4
106

144
C
10. Derivatives Analysis and Valuation 12 153

11. Interest Rates Risk Management 4 184

ik
av
Bh

i CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

CHAPTER 1 VALUATION OF SECURITIES

(SECURITY ANALYSIS AND
SECURITY VALUATION)

Question 1 (Practice Manual)

[Q.9 - AFM 8 (Fast Track) & 9, Q.9 - AFM 10]

Based on the credit rating of bonds, Mr. Z has decided to apply the following discount rates

hi
for valuing bonds:
Credit Rating Discount Rate
AAA 364 day T bill rate + 3% spread

ks
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.

ho
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%).
C
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
ik

Detailed Solution
av

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

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

1 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

= 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)

hi
At 15%, PVCI = 150 × 3.3522 + 1,000 × 0.4972
PVAF (15%, 5 Years) PVF (15%, 5th Year)
= ` 1,000.03

ks
By Using Interpolation

x − 14% 1, 025.86 − 1, 034.37

=
15% − 14% 1, 000.03 − 1, 034.37

x − 0.14
0.01
=
8.51
34.34

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

Question 2 (ICAI Paper Jan 21)

ik

[Q.19 - AFM 8 (Fast Track) & 9, Q.19 - AFM 10]

Following are the yields on Zero Coupon Bonds (ZCB) having a face value of ` 1,000 :
Maturity (Years) Yield to Maturity (YTM)
av

1 10%
2 11%
3 12%
Bh

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.

Summary

Detailed Solution

2 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

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

hi
r2 = 0.1201
i.e. 12.01%
3. Forward Rate for Year 3

ks
(1 + 0.12)3 = (1 + 0.11)2 (1 + r3)
1.4049 = 1.2321 + 1.2321r3
1.2321r3 = 0.1728
r3
i.e. 14.02%
Alternatively
(1 + YTM3)3
=

=
0.1402
ho
(1 + r1) (1 + r2) (1 + r3)
C
(1 + 0.12) 3
= (1 + 0.1) (1 + 0.1201) (1 + r3)
1.4049
= 1 + r3
1.2321
ik

1 + r3 = 1.1402
r3 = 14.02%
ii. Actual Position at the end of Year 1:
av

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.
Bh

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%

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

PVF (12.01%, 1 Year) st

= 892.8

3 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

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

hi
1+x = 1.1301
x = 0.1301 i.e. 13.01%
Price of bond 3 at end of Year 1 = ` 1,000 × 0.7830

ks
PVF (13.01%, 2 year)
nd

= ` 783

Question 3

The following data are available for a bond :

ho
Face Value ` 10,000 to be redeemed at par on maturity
(ICAI Paper Nov 20)
[Q.26 - AFM 8 (Fast Track) & 9, Q.26 - AFM 10]
C
Coupon rate 8.5 per cent per annum
Years to Maturity 5 years
Years to maturity (YTM) 10 per cent
ik

You are required to calculate :

(i) Current market price of the Bond,
(ii) Macaulay’s Duration,
av

(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
Bh

(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

4 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

(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

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

40,103.35
=

ks
9, 431.50

= 4.25 Years
(iii) Current Market Price = 9,431.50

(iv) Volatility

=
hoMacaulay Duration

4.25
1 + YTM
C
(1 + 0.1)
= 3.864
(v) Convexity
ik

Vo = (` 9,431.50) At 10%
V+ = (10% - 2%) At 8%
V- = (10% + 2%) At 12%
av

Reference Note
As Sub point (v) requires the expected price if YTM changes by 2%, we have calculated V+ and
Bh

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

5 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

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

75.3
=
7.5452

= 9.98

hi
Convexity Effect = C × (YTM)2 × 100
= 9.98 × (0.02)2 × 100
= 998 × 0.0004

ks
= 0.3992% i.e 0.40%
Expected Market Price for 2% fall in YTM
a. Based on Duration

Expected Price
YTM
- 1%
- 2%

=
ho
9,431.5 + 7.73% × 9,431.5
Price
+ 3.864
+ 7.73 (cross multiply)
C
= 10,160.55
b. Based on Intrinsic Value Method
(i.e PV of future CF @ 8%)
ik

= ` 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
av

= 9,431.5 + 729.05 + 37.73 = 10,198.28

Question 4 (Practice Manual)

Bh

[Q.36 - AFM 8 (Fast Track) & 9, Q.36 - AFM 10]

Seawell Corporation reported earnings per share of ` 2.10 in 2003, on which it paid Dividend per
share of ` 0.69. As on 01 January, 2004 an analyst expects the earnings to grow at 15% p.a. from
2004 to 2008, and during this period the dividend payout ratio is expected to remain unchanged.
After 2008, the earnings growth rate is expected to drop to a stable rate of 6% and the payout
ratio is expected to increase to 65% of earnings. The firm has a beta of 1.40 currently, and is
expected to have a beta of 1.10 after 2008. The market risk premium is 5.5% and the Treasury
Bond (Risk free) rate is 6.25%.
(a) What is the expected price of the share at the end of 2008
(b) What is the value of the share today (01 Jan 04), using the two stage dividend discount
model

6 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Summary

Detailed Solution

1. Given Data
E0 = 2.10, D0 = 0.69
Earnings growth: 2004 to 2008 = 15%

hi
After 2008
= 6%
0.69
Dividend pay-out: 2004 to 2008 = × 100 = 32.86%
2.1
2008 onwards = 65%

ks
β: 2004 to 2008 = 1.4, After 2008 = 1.1
RM - RF = 5.5%, RF = 6.25%
2. Calculation of dividend & Earnings
YEAR
1 (2004)

2 (2005)
ho EPS
2.42

2.78
DPS
0.80
(2.42 × 32.86%)
0.91
C
3 (2006) 3.20 1.05
4 (2007) 3.68 1.21
5 (2008) 4.23 1.39
6 (2009) 4.48 2.91
ik

(+6%) (4.48 × 65%)

3. Calculation of Ke
Using CAPM
av

Ke = RF + (RM - RF) β
2004 to 2008
β = 1.4
Bh

Ke = 6.25 + (5.5) × 1.4

Ke = 13.95%
After 2008
= 6.25 + (5.5) × 1.1
Ke = 12.3%
4. P0 = PV of (D1 + D2 + D3+ D4 + D5) + PV of (D6 + D7 + .......D∞)
= 3.55 + 24.04. (From WN 1 & WN 2)
= 27.59

7 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

WN 1: PV of D1-D5
Years Dividend Ke @13.95% PV of Dividend
1 0.8 0.8776 0.70
2 0.91 0.7701 0.70
3 1.05 0.6759 0.71
4 1.21 0.5931 0.72
5 1.39 0.5205 0.72
3.55

hi
WN 2: Terminal Value

ks
D6 th
PV of P5 = × PVF (13.95%, 5 Year )
KE - g
2.91
PV of P5 = × 0.5205
( )
PV of P5

PV of P5
=

=
0.123 − 0.06
2.91
0.063
× 0.5205

46.19 × 0.5205
ho
C
PV of P5 = 24.04
Answer:
a. Expected price at year: 5 (2008) = ` 46.19
ik

b. Price Today (1/1/2004) = ` 27.59

Question 5 (ICAI Study Material [Modified])

av

[Q.40 - AFM 8 (Fast Track) & 9, Q.40 - AFM 10]

A share with par value of ` 100 has current market price of ` 500. Annual dividend is 20%. Bonus
shares are expected to be issued during the 5th year @ one share for 4 held. One shareholder
Bh

intends to sell the shares at the end of 8th year. Price of a share is expected to be ` 900 at the
end of the 8th year. Shareholders are required to bear incidental expenses on sale & purchase
of shares @ 10% of Market Price of share. Dividend rate will remain same even after the bonus
issue. Required rate of return is 10%. Ignore taxation. Should the share be purchased and if
yes, at what maximum price?

Summary

Detailed Solution

8 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

P0 = PV of (D1 + D2 + D3 + D4……………+ D8) + PV of Net Sale Proceeds

In this case, there is a bonus issue during the 5th year @ 1:4, that is one share held will get 1
× 1/4 = 0.25 bonus shares, thus the post bonus number of shares held = 1.25 shares.

a. PV of dividend from YR : 1 to 8
Year Dividend DF@10% PV
1-4 20 3.1699 63.40

hi
(100 × 1 × 20%) PVAF (10%;1 - 4)
5-8 25 2.165 54.13
(100 × 1.25 × 20%) PVAF (10%;5-8)
` 117.52

ks
b. PV of Net Sale Proceeds (900 × 1.25 shares) : ` 1,125
(-) Incidental Expense @10% (` 112.5)
Net Sale proceeds
* PVF (10%, 8th Year)
PV of Net Sale proceeds
ho ` 1,012.5
0.4665
` 472.33
C
c. PV of all cash inflows.
= 117.53 (a) + 472.33 (b)
= ` 589.86
ik

d. The above workings have not considered the incidental expense on purchase
Let purchase price be ` 100
av

Purchase price 100 ? ` 536.24 (Through cross multiplication)

+ Incidental expense (10%) 10
Total 110 589.86
Bh

The maximum purchase price of the share (excluding purchase expenses) is ` 536.24.
As this price is greater than the current market price (excluding expenses) that is ` 500, the
share is worth buying today.
Reference Note: Alternatively, ` 589.86 can be compared with ` 550 (500 + 10%) in order to
decide whether the share is worth investing today or not. However, the maximum purchase price
needs to be the standalone price itself (i.e. without considering purchase expenses).

9 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Question 6 (ICAI Study Material)

[Q.49 - AFM 8 (Fast Track) & 9, Q.49 - AFM 10]

Calculate the value of share from the following information:

Profit after tax of the company ` 290 crores
Equity capital of company ` 1,300 crores
Par value of share ` 40 each

Debt ratio of company (Debt/ Debt + Equity) 27%

hi
Long run growth rate of the company 8%
Beta 0.1; risk free interest rate 8.7%

ks
Market returns 10.3%
Capital expenditure per share ` 47
Depreciation per share ` 39

Change in Working capital

Summary
ho ` 3.45 per share
C
Detailed Solution

1. As all the information is given on a per share basis, we will try to find FCFE/share. In
ik

such a case, we need to calculate PAT/share (EPS).

` 1, 300 Cr
No. of shares = = 32.5 Crore Shares
av

` 40

Profit After Tax (PAT)

2. EPS =
No. of Shares

290
Bh

= = ` 8.92/share
32.5

3. In this question, the debt ratio is given and hence an alternative formula can be used to
calculate FCFE/share
FCFE/Share
= PAT/Share (EPS) + Depreciation/Share (I - D) - CAPEX/Share (I - D) -
in WC/Share(I - D)
= 8.92 + 39 (1 - 0.27) - 47 (1 - 0.27) - 3.45 (1 - 0.27)
= 8.92 + 28.47 - 34.31 - 2.51 = 0.56/shares
In the absence of information, we have assumed that FCFE of 0.56 is for year 0 [in line
with ICAI's solution] alternatively it can also be taken as FCFE for Year 1.

10 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

4. Using CAPM
Ke = RF + (RM - RF)
= 8.7 + (10.3% - 8.7%) 0.1
= 8.7% + 0.16%
Ke = 8.86%

FCFE/Share
5. P0 =
Ke - g

hi
0.56 × 1.08
=
0.0886 − 0.08

ks
0.6048
P0 =
0.0086

P0 = 70.33/Share

Question 7 ho (ICAI Paper May 22)

[Q.53 - AFM 8 (Fast Track) & 9, Q.53 - AFM 10]

Following information is available pertaining to ABC Ltd. which is expected to grow at a higher
C
rate for 3 years after which growth rate will stabilize at a lower level.
Base year information is -
EBIT
ik

Revenues Capital Expenditure Depreciation

(After Depreciation)
` 1,000 Cr. ` 150 Cr. ` 140 Cr. ` 100 Cr.

Information for high growth and stable growth period are as follows:
av

Stable Growth
Particulars High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Bh

Growth in Capital Expenditure and Depreciation 20% Capital Expenditure are offset by
Depreciation
Risk free rate 10% 9%
Equity Beta 1.15 1.00
Market Risk Premium 6% 5%
PreTax cost of Debt 13% 12.86%
Debt Equity Ratio 1:1 2:3
Working capital is 25% of Revenue for all time. Corporate Tax Rate is 30%.
You are requested to find out the value of ABC Ltd.

11 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Summary

Detailed Solution

Particulars High growth phase: Stable growth phase:

ke 0.10 + 1.15 x 0.06 = 0.169 or 0.09 + 1.0 x 0.05 = 0.14 or
16.9%. 14%.
kd 0.13 x (1 - 0.3) = 0.091 or 0.1286 x (1 - 0.3) = 0.09 or

hi
9.1%. 9%.
Cost of capital 0.5 x 0.169 + 0.5 x 0.091 = 0.6 x 0.14 + 0.4 x 0.09 =
0.13 or 13%. 0.12 or 12%.

ks
Determination of forecasted Free Cash Flow of the Firm (FCFF)
(` in crores)
Particulars Yr. 1 Yr. 2 Yr. 3 Terminal Year
Revenue
EBIT
EAT
Capital Expenditure
ho
1200.00
180.00
126.00
48.00
1440.00
216.00
151.20
57.60
1728.00
259.20
181.44
69.12
1900.80
285.12
199.58
-
C
Less Depreciation
∆ Working Capital 50.00 60.00 72.00 43.20
Free Cash Flow (FCF) 28.00 33.60 40.32 156.38
ik

Alternatively, it can also be computed as follows:

(` in crores)
Yr. 1 Yr. 2 Yr. 3 Terminal Year
av

Revenue 1200.00 1440.00 1728.00 1900.80

EBIT 180.00 216.00 259.20 235.12
EAT 126.00 151.20 181.44 199.58
Add: Depreciation 120.00 144.00 172.80 190.08
Bh

246.00 295.20 354.24 389.66

Less: Capital Exp. 168.00 201.60 241.92 190.08
∆ WC 50.00 60.00 72.00 43.20
28.00 33.60 40.32 156.38

Present Value (PV) of FCFF during the explicit forecast period is:
FCFF (` in crores) PVF @ 13% PV (` in crores)
28.00 0.885 24.78
33.60 0.783 26.31
40.32 0.693 27.94
` 79.03

12 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

156.38
Terminal Value of Cash Flow =
0.12- 0.10

= ` 7819 Crore
1
PV of the terminal value is = ` 7819 Crore ×
(1.13)3
= ` 7819 Crore x 0.693 = ` 5418.57 Crore
The value of the firm is = ` 79.03 Crores + ` 5418.57 Crores = ` 5497.60 Crores

hi
Question 8 (ICAI Paper May 22)
[Q.55 - AFM 8 (Fast Track) & 9, Q.55 - AFM 10]

Closing Values of NIFTY Index from 3rd to 12th day of the month of January 2022 were as

ks
follows:
Days Date Closing Values of NIFTY Index
1 03/01/2022 17626
2
3
4
5
04/01/2022
05/01/2022
06/01/2022
07/01/2022
ho 17805
17925
17746
17813
C
6 10/01/2022 18003
7 11/01/2022 18056
8 12/01/2022 18212
The simple moving average of NIFTY Index for the month of December 2021 was 17174.
ik

You are required to calculate

(i) The value of exponent for 15 days EMA.
(ii) The exponential moving average (EMA) of NIFTY during the above period. (Calculations
av

to be done up to 2 decimals only)

(iii) Analyse the buy & sell signal on the basis of your calculations
Bh

Summary

Detailed Solution

(i) Value of Exponent for 15 days EMA

= 2 = 0.125
n+1

(ii) EMAt = a X Pt + (1 – a) (EMA (t – 1)) Where, a = exponent, Pt = Price of today

13 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Date 1 2 3 4 5
NIFTY EMA for Previous EMA 2 + 4
day (EMA (t – 1)) 1-2 3 × 0.125
03/01/2022 17626 17174 452 56.50 17230.50
04/01/2022 17805 17230.50 574.50 71.81 17302.31
05/01/2022 17925 17302.31 622.69 77.84 17380.15
06/01/2022 17746 17380.15 365.85 45.73 17425.88
07/01/2022 17813 17425.88 387.12 48.39 17474.27

hi
10/01/2022 18003 17474.27 528.73 66.09 17540.36
11/01/2022 18056 17540.36 515.64 64.45 17604.82
12/01/2022 18212 17604.82 607.18 75.90 17680.71

ks
(iii) A buy (bullish) signal is generated when actual price line (NIFTY in the give case) rises
through the moving average, while a sell a (bearish) signal is generated when actual NIFTY
level declines through the moving averages. In the case under consideration the price line

EMA line only.

Question 9
ho
of NIFTY never breaches the 15 -day EMA line. In-fact it is hovering around the 15-day

(ICAI SM)/(RTP May 23)/(MTP April 21)/

C
(MTP Oct 18)
[Q.67 - AFM 8 (Fast Track) & 9, Q.67 - AFM 10]

The closing value of Sensex for the month of October, 2007 is given below:
ik

Date Closing Sensex Value

1.10.07 2800
av

3.10.07 2780
4.10.07 2795
5.10.07 2830
8.10.07 2760
Bh

9.10.07 2790
10.10.07 2880
11.10.07 2960
12.10.07 2990
15.10.07 3200
16.10.07 3300
17.10.07 3450
19.10.07 3360
22.10.07 3290

14 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

23.10.07 3360
24.10.07 3340
25.10.07 3290
29.10.07 3240
30.10.07 3140
31.10.07 3260

hi
You are required to test the weak form of efficient market hypothesis by applying the run
test at 5% and 10% level of significance.
Following value can be used :

ks
Value of t at 5% is 2.101 at 18 degrees of freedom Value of t at 10% is 1.734 at 18 degrees
of freedom

Summary

Detailed Solution
ho
C
Date Closing Index Sign of Price Charge
1.10.07 2,800
3.10.07 2,780 -
ik

4.10.07 2,795 +
5.10.07 2,830 +
8.10.07 2,760 -
av

9.10.07 2,790 +
10.10.07 2,880 +
11.10.07 2,960 +
Bh

12.10.07 2,990 +
15.10.07 3,200 +
16.10.07 3,300 +
17.10.07 3,450 +
19.10.07 3,360 -
22.10.07 3,290 -
23.10.07 3,360 +
24.10.07 3,340 -
25.10.07 3,290 -
29.10.07 3,240 -

15 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

30.10.07 3,140 -
31.10.07 3,260 +

1. N1, N2, r
N1: Number of positive sign changes = 11
N2: Number of negative sign changes = 8
r: Number of runs = 8

hi
2. Calculate µ and σ

(2N1N2 ) + 1
µ =
(N + N2 )

ks
1

(2 × 11 × 8)
µ = +1
(11 + 8)
µ

σ
=

=
10.26

(
2n1n2 × 2n1n2 - n1 - n2 )
ho
C
(n ) × (n - 1)
2
1
+ n2 1
+ n2

(2 × 11 × 8) ×  2 × 11 × 8 - 11 - 8)
σ =
(11 + 8) × (11 + 8 - 1)
2
ik

27, 632
σ =
av

6, 498

σ = 2.06
3. Limits
Bh

Lower Limit: µ – t × σ
Upper Limit: µ + t × σ
Test at 5% level of significance at 18 degrees of freedom using t - table
Lower limit
= 10.26 – 2.101 × 2.06
= 5.93
Upper limit
= 10.26 + 2.101 × 2.06
= 14.59
Range at 5%: 5.93 – 14.59

16 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Test at 10% level of significance at 18 degrees of freedom using t - table

Lower limit
= 10.26 – 1.734 × 2.06
= 6.69
Upper limit
= 10.26 + 1.734 × 2.06
= 13.83

hi
Range at 10%: 6.69 – 13.83
4. Conclusion
As r is 8 which is within the range of lower limit and the upper limit at both 5% and 10%

ks
level of significance, the market is considered to satisfy the weak form of efficient
market hypothesis.
Reference Note:

ho
A market is considered to be efficient if the price changes are random. In case there
are too few runs or too many runs, then an investor can predict the price movements
by merely looking at the past price data and hence the market would be inefficient.
However, in case the number of runs are within the average range of randomness, it is a
C
little difficult to predict the future price movements looking at the past data and hence
in such a case, the markets are considered to be weak form efficient.
ik

Question 10 (ICAI SM [Modified])/(MTP April 18)/(RTP Nov 22)/

(ICAI Paper July 21)/(ICAI Paper May 19)
[Q.71 - AFM 8 (Fast Track) & 9, Q.71 - AFM 10]
av

Abhishek has a surplus cash of ` 80 lakhs and wants to distribute 30% of it to the shareholders.
The company decides to buy back shares. The finance manager of the Company estimates that
its share price after repurchase is likely to be 10% above the buyback price, if the buyback
Bh

route is taken, The number of shares outstanding at present is 10 lakhs and the current EPS is
` 3. You are required to determine:
a. The price at which the shares can be repurchased if the market capitalization of the
company should be ` 180 lakhs after buyback
b. The number of shares that can be repurchased
c. The impact of share repurchase on the EPS, assuming the net income is same.

Summary

Detailed Solution

17 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

a. Let the Buyback price be ‘x’

Therefore, the post buy-back price would be 1:1x

` 80, 00, 000 × 30%

No. of shares bought back =
x

` 24, 00, 000

=
x

hi
Post buy-back Market capitalisation = Post Buy Back price × Post Buy Back no. of shares
1,80,00,000 = 1.1x × [10,00,000 - 24,00,000/x]
1,80,00,000 = 11,00,000x - 26,40,000

ks
2,06,40,000 = 11,00,000x
x = ` 18.76
Buyback Price = 18.76

b.

No. of shares bought back =
=
ho
` 24, 00, 000
18.76
1,27,932 shares
C
Pre - Buyback PAT
c. Pre-Buyback EPS =
Pre Buyback Shares

Pre - Buyback PAT

`3 =
ik

10, 00, 000

Pre-Buyback PAT = ` 30,00,000

As the PAT remains the same post Buyback
av

30, 00, 000

Post Buyback EPS =
10, 00, 000 - 1, 27, 932
Bh

30, 00, 000

=
8, 72, 068

Post Buyback EPS = ` 3.44

Question 11 (Practice Manual)

[Q.75 - AFM 8 (Fast Track) & 9, Q.75 - AFM 10]

The following data is relating 8.5% Fully convertible debentures issued by JAC Ltd at ` 1,000
Market Price of Debenture ` 900
Conversion Ratio 30
Straight Value of Debenture ` 700
Market Price of Equity Shares on date of conversion ` 25

18 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Expected Dividend per share `1

Required:
(a) Conversion Value
(b) Market Conversion Price
(c) Conversion Premium per share
(d) Ratio of conversion premium
(e) Premium over straight value

hi
(f) Favorable income differential per share
(g) Premium payback period

ks
Summary

Detailed Solution

a.
=
=
Conversion Value = ho
Conversion Ratio × MPS
30 × 25
` 750
C
Market Price of debentures
b. Market Conversion Price / Conversion Parity Price =
30

900
=
ik

30

= 30
av

c. Conversion Premium Per Share = Market Price of Bond - Conversion Value

Conversion Ratio

900 - 750
=
30
Bh

150
=
30
= ` 5/share

Market Price of Bond - Conversion Value

d. Ratio of Conversion Premium =
Conversion Value

900 − 750
=
750

= 0.2:1

19 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

e. Premium Over Straight Value = Market price - Straight Value

= 900 - 700
= ` 200
f. Favourable Income Favourable Income
Differential/Share Differential/Bond

= Annual Income - (Annual Dividend / Share × Conversion Ratio) = Annual Income - (Annual
Conversion Ratio

hi
D
 ividend Per Share ×
Conversion Ratio

ks
(1, 000 × 8.5%) - (1 × 30)
= = (1,000 × 8.5%) - (1 × 30)
30

85 - 30
= = 85 - 30
30

g.
= ` 1.83/share

Premium payback period =

ho Conversion Premium
= ` 55/bond
C
Favourable Income Differential

900 - 750
=
55
ik

150
= = 2.73 years
55

Question 12 (RTP Nov 24)

av

[Q.1 - Additional Question AFM 8 (Fast Track) & 9, Q.85 - AFM 10]

The Bank PK enters into a Repo for 9 days with Bank JJ in 6% Government Bonds 2022 for an
Bh

amount of ` 20 crore. The other relevant details are as follows:

First Leg Payment (Start Proceed) ` 20,00,67,500
Second Leg Payment (Repayment Proceed) ` 20,03,17,590
Initial Margin 1.25%
Days of accrued interest 240

Assume 360 days in a year.

Calculate:
(a) Repo Rate
(b) Dirty Price and
(c) Clean Price

20 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

Summary

Detailed Solution

 No. of days 
(a) Second Leg = Start Proceed x  1 + Repo Rate × 
 360 
 9 
` 20,03,17,590 = ` 20,00,67,500 x  1 + Repo Rate × 

hi
 360 

 9 
1.00125 =  1 + Repo Rate × 
 360 

ks
Repo Rate = 0.05 = 5%
Dirty Price 100 - Initial Margin
(b) First Leg (Start Proceed) = Nominal Value x ×
100 100

` 20,00,67,500 = ` 20,00,00,000 x

10003.375 = 98.75 x Dirty Price

Dirty Price = ` 101.30
ho Dirty Price
100
×
100 -1.25
100
C
(c) Dirty Price = Clean Price + Interest Accrued

240
` 101.30 = Clean Price + 100 × × 6%
ik

360

Clean Price = ` 97.30

av

Question 13 (ICAI Paper Nov 23)

[Q.2 - Additional Question AFM 8 (Fast Track) & 9, Q.86 - AFM 10]
Bh

The following information of AB Ltd., is available below:

Market Value per share – ` 20 per share
Equity Share Capital – 12,00,000 shares @ the face value of ` 10 per share.
The company is planning to issue Rights Shares of the existing shareholders and raise ` 60,00,000
to finance a new project.
You are required:
(i) To calculate the ex-right price of shares and the value of right, if
(a) The company offers one right share for every three shares held.
(b) The company offers two right shares for every five shares held.
(ii) To show the effect of the rights issue on the wealth of shareholder X, who has 1,500 share,
when the company offers on right share for every three shares held assuming:

21 CA BHAVIK CHOKSHI
 VALUATION OF SECURITIES
(SECURITY ANALYSIS AND SECURITY VALUATION)

(a) He subscribes to the Rights issue

(b) He ignores the Rights issue

Summary

Detailed Solution

hi
(i) Ex-right price of share and the value of right
(a) Number of shares to be issued : 4,00,000
Subscription price ` 60,00,000/4,00,000 = ` 15

ks
` 240 Lakh + ` 60 Lakh
Ex − =
Right Price = ` 18.75
1.0202

Value of a Right = ` 18.75 – ` 15 = ` 3.75

ho
Value of a Right Per Share Basis ` 3.75
= = ` 1.25

(b) Number of shares to be issued : 4,80,000

3

Subscription price ` 60,00,000/4,80,000 = ` 12.50

C

` 240 Lakh + ` 60 Lakh
Ex-Right Price = = ` 17.86
16.80 Lakh
Value of a Right = ` 17.86 – ` 12.50 = ` 5.36
ik

Value of a Right Per Share Basis = ` 5.36 × 2 ` 2.14 or ` 5.36 =` 1.07

5 5
av

(ii) (a) Shareholder’s wealth that is holding 1500 shares when firm offers one share
for three shares held and subscribes the offer.
Value of Shares after right issue (2000 X ` 18.75) ` 37,500
Less: Amount paid to acquire right shares (500 x ` 15) ` 7,500
Bh

` 30,000
Wealth before Right Issue = 1500 x 20 = ` 30,000 Thus, there is no change in
the wealth
(b) Shareholder’s wealth that is holding 1500 shares when firm offers one share for
three shares held and does not subscribe the offer.
Value of Shares after right issue (1500 x ` 18.75) = ` 28,125
Thus, if shareholder does not subscribe right offer there will be loss of wealth
of ` 1,875.

22 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

CHAPTER 2 MERGERS, ACQUISITIONS AND CORPORATE

RESTRUCTURING

Question 1 (ICAI Study Material [Modified])

[Q.6 - AFM 8 (Fast Track) & 9, Q.6 - AFM 10]

Following are the financial statements for A Ltd. and B Ltd. for the current financial year. Both
firms operate in the same industry.

hi
Balance Sheet
Particulars A Ltd. B Ltd.

ks
Total current assets ` 14,00,000 ` 10,00,000
Total fixed assets (net) 10,00,000 5,00,000
Total Assets 24,00,000 15,00,000
Equity capital (of ` 10 each)
Retained earnings
14% Long term debt
Total current liabilities
ho 10,00,000
2,00,000
5,00,000
7,00,000
8,00,000
-
3,00,000
4,00,000
C
Total Liabilities 24,00,000 15,00,000

Income Statement
Particulars A Ltd. B Ltd.
ik

Net sales ` 34,50,000 ` 17,00,000

Cost of goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
av

Operating expenses 2,00,000 1,00,000

Interest 70,000 42,000
Earnings before taxes 4,20,000 1,98,000
Taxes (50%) 2,10,000 99,000
Bh

Earnings after taxes (EAT) 2,10,000 99,000

Additional Information: 1,00,000 80,000
Number of equity shares 40% 60%
Dividend payment ratio ` 40 ` 15
Market price per share (MPS)

Assume that the two firms are in the process of negotiating a merger through an exchange of
equity shares. You have been asked to assist in establishing equitable exchange terms, and are
required to:-
(a) Decompose the share prices of both the firms into EPS and PE components, and also
segregate their EPS figures into return on equity (ROE) and book value / intrinsic
value per share (BVPS) components.

23 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

(b) Estimate future EPS growth rates for each firm.

(c) Based on expected operating synergies A Ltd. estimates that the intrinsic value of
B’s equity share would be Rs A 20 per share on its acquisition. You are required to
develop a range of justifiable equity share exchange ratios that can be offered by
A Ltd. to the shareholders of B Ltd. Based on your analysis in part (i) and (ii), would
you expect the negotiated terms to be closer to the upper, or the lower exchange
ratio limits and why?

hi
(d) Calculate the post - merger EPS based on an exchange ratio of 0.4: 1 being offered
by A Ltd. indicate the immediate EPS accretion or dilution, if any that will occur for
each group of shareholders.

ks
(e) Based on a 0.4: 1 exchange ratio, and assuming that A's pre - merger PE ratio will
continue after the merger, estimate the post - merger market price. Show the
resulting accretion or dilution in pre - merger market prices.

Summary

Detailed Solution
ho
C
(a) Calculation of EPS, P/E, ROE, BVPS
Particulars A B
ik

EPS = PAT/Sales ` 2, 10, 000 ` 99, 000

1, 00, 000 80, 000
` 2.10 ` 1.24
av

MPS = EPS × P/E ` 40 ` 15

P/E = MPS 2.1 1.24
` 19.05 Times 12.10 Times
Equity Shareholders Funds 10,00,000 + 2,00,000 8,00,000 + 0
Bh

(ESC + Reserves) ` 12,00,000 ` 8,00,000

BVPS = ESHF/Shares ` 12, 00, 000 ` 8, 00, 000
1, 00, 000 80, 000
= ` 12 ` 10

ROE = PAT × 100 2, 10, 000

× 100
99, 000
× 100
ESHF
12, 00, 000 8, 00, 000
= ` 17.5% = ` 12.38%
EPS = ROE x BVPS = ` 12 × 17.5% = ` 10 × 12.38%
= ` 2.10 = ` 1.24

(b) Calculation of Growth Rate

g=rxb

24 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Particulars A B
ROE (r) 0.175 0.1238
× Retention Ratio (b) × 0.6 × 0.4
(1 – pay out) (1 – 0.4) (1 – 0.6)
Growth Rate 10.5% 4.95%

(c) Range of Justifiable exchange Ratio

Exchange Ratio Based on MPS (Lower Limit)

hi
MPS of B
=
MPS of A

ks
` 15
=
` 40

= 0.375:1

=
I.V of B
ho
Exchange Ratio Based on intrinsic value (IV) (Upper Limit)
C
I.V of A

` 20
= → (assumed to be same as MP)
ik

` 40

= 0.5:1
av

A has a higher EPS, P/E Ratio, BVPS and Growth rate as compared to B and hence is in a
stronger bargaining position as compared to B. Therefore, it is Likely that the exchange
ratio would be closer to the lower limits i.e 0.375:1
Bh

(d) Exchange Ratio – 0.4:1

2,10,000 + 99,000
Post EPS =
1,00,000 + (80,000 × 0.4)

3,09,000
=
1,32,000

= ` 2.34

25 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Impact Analysis – EPS

Particulars A B
Post Merger EPS 2.34 0.936
(2.34 × 0.4)
(-) Pre Merger EPS (2.10) (1.24)
EPS Acceration/Dilution 0.24 (0.304)

(e) Post MPS and Accretion/ dilution

hi
As given, pre-merger P/E (A) = Post-merger P/E = 19.05 times
Post MPS = Post EPS × Post P/E
= 2.34 × 19.05

ks
= 44.58
Impact analysis MPS
A B

Post Merger MPS

- Post Merger MPS

MPS Accretion (dilution)
ho 44.58

(40)
4.58
17.83
(44.58 × 0.4)
(15)
2.83
C
Question 2 (Practice Manual)
[Q.14 - AFM 8 (Fast Track) & 9, Q. 14 - AFM 10]
ik

Bank ‘R’ was established in 2005 and doing banking in India. The bank is facing DO OR DIE
situation. There are problems of Gross NPA (Non Performing Assets) at 40% & CAR/CRAR
(Capital Adequacy Ratio/ Capital Risk Weight Assets Ratio) at 4%. The net worth of the bank is
av

not good. Shares are not traded regularly. Last week, it was traded @ ` 8 per share.
RBI Audit suggested that bank has either to liquidate or to merge with other bank.
Bank ‘P’ is professionally managed bank with low gross NPA of 5%. It has net NPA as 0% and
Bh

CAR at 16%. Its share is quoted in the market @ ` 128 per share. The board of directors of bank
‘P’ has submitted a proposal to RBI for take over of bank
‘R’ on the basis of share exchange ratio.

The Balance Sheet details of both the banks are as follows:

Particulars Bank ‘R’ Bank ‘P’
Amt. In ` Lac Amt. In ` Lac
Paid up share capital (Face: ` 10) 140 500
Reserves & Surplus 70 5,500
Deposits 4,000 40,000
Other liabilities 890 2,500
Total Liabilities 5,100 48,500

26 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Cash in hand & with RBI 400 2,500

Balance with other banks - 2,000
Investment 1,100 15,000
Advances 3,500 27,000
Other Assets 100 2,000
Total Assets 5,100 48,500

It was decided to issue shares at Book Value of Bank ‘P’ to the shareholder of Bank

hi
‘R’. All assets and liabilities are to be taken over at book Value.

For the swap ratio, weights assigned to different parameters are as follows:

ks
Gross NPA 30%
CAR 20%
Market price 40%
Book value

ho
(a) What is the swap ratio based on above weight?
(b) How many shares are to be issued?
10%
C
(c) Prepare Balance Sheet after merger.
(d) Calculate CAR & Gross NPA of Bank ‘P’ after merger.
ik

Summary

Detailed Solution
av

Given Data
Bank R (Target) Bank P (Acquirer)
Bh

Gross NPA 40% 5%

CAR 4% 16%
MPS `8 ` 128
Net NPA - 0%

(a) (i) Calculation of BVPS

Bank: R = 140 + 70 / 14 = ` 15
Bank P = 500 + 5,500 / 50 = ` 120
(ii) Agreed Swap Ratio
Factor Ratio Weight Weight Average
(Ratio * Weight)
1. Gross NPA (adverse) = 5% / 40% 30% 0.0375:1
= 0.125:1

27 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

2. CAR (Favourable) = 4% / 16% 20% 0.05:1

= 0.25:1
3. MPS (Favourable) = ` 8 / ` 128 40% 0.025:1
= 0.0625:1
4. BVPS (Favourable) = ` 15 / ` 120 10% 0.0125:1
= 0.125:1
Agreed swap ratio 0.125:1

hi
(b) Shares to be issued
= 14 Lakhs × 0.125
= 1.75 Lakhs shares

ks
(c) Balance Sheet Acquisition
Purchase consideration (1.75 Lakhs × ` 120 (BVPS)) 210 Lakhs
(-) Net assets of R (5,100 – 4,000 – 890) (210 Lakhs)
Goodwill / Capital reserve
ho NIL

Reference Note: ICAI has taken the issue price at ` 10 (Face Value) and hence there
is Capital Reserve as per ICAI workings. This does not appear to be correct as we have
C
been clearly told that shares of P will be issued at Book Value. Hence, as per our workings,
there would be no Capital Reserve. Instead, we will have Securities Premium.
Combined Entity (Bank P + Bank R)
ik

Balance sheet after merger

Equity & Liabilities ` in Lakhs
Paid up share capital [500 + (1.75 × 10)] 517.5
av

Securities premium [1.75 × (120 – 10)] 192.5

Reserves (5,500) 5,500
Deposits (4,000 + 40,000) 44,000
Other liabilities (890 + 2,500) 3,390
Bh

53,600
Assets
Cash in hand (2,500 + 400) 2,900
Balance with other banks (2,000 + 0) 2,000
Investment (1,100 + 15,000) 16,100
Advances (3,500 + 27,000) 30,500
Other assets (100 + 2,000) 2,100
53,600

28 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

(d) Post Merger CAR & Gross NPA %

Share capital + Reserves and Share Capital × 100

CAR =
Risk weighted assets (RWA)

Share capital + Reserves × 100

i.e. Risk Weighted Assets =
CAR

hi
140 + 70 × 100
BANK R = = 5,250
4

ks
500 + 5,500 × 100
BANK P = = 37,500
16

Combined CAR (after merger)

ho
Therefore, Combined RWA = 5,250+37,500 = 42,750

=
517.5 + 192.5 + 5,500 × 100
42,750
C
6,210 × 100
=
42,750
ik

= 14.53%
Gross NPA (`)
Gross NPA % = × 100
av

Advances

(Because NPAs are related to Advances)

Thus, Gross NPA (`) = Gross NPA (%) × Advances
Bh

Bank R : - 40% × ` 3,500 = ` 1,400

Bank P :- 5% × ` 27,000 = ` 1,350
Combined Gross NPA ` 1,400 + ` 1,350 = ` 2,750

` 1,400 + ` 1,350 × 100

Combined Gross NPA % =
` 3,500 + ` 27,000

2,750 × 100
=
30,500

= 9.02%

29 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Question 3 (ICAI Study Material)/(RTP May 20)

[Q.16 - AFM 8 (Fast Track) & 9, Q.16 - AFM 10]

The following information relating to the acquiring Company Abhiman Ltd. and the target Company
Abhishek Ltd. are available. Both the Companies are promoted by Multinational Company, Trident
Ltd. The promoter’s holding is 50% and 60% respectively in Abhiman Ltd. and Abhishek Ltd.:
Particulars Abhiman Ltd. Abhishek Ltd.
Share Capital (`) 200 lakh 100 lakh

hi
Free Reserve and Surplus (`) 800 lakh 500 lakh
Paid up Value per share (`) 100 10
Free float Market Capitalisation (`) 400 lakh 128 lakh

ks
P/E Ratio (times) 10 4

Trident Ltd. is interested to do justice to the shareholders of both the Companies. For the swap
ratio weights are assigned to different parameters by the Board of Directors as follows:
Book Value

Market Price
ho
EPS (Earning per share)

(a) What is the swap ratio based on above weights?

25%
50%
25%
C
(b) What is the Book Value, EPS and expected Market price of Abhiman Ltd. after acquisition
of Abhishek Ltd. (assuming P.E. ratio of Abhiman Ltd. remains unchanged and all assets
and liabilities of Abhishek Ltd. are taken over at book value).
ik

(c) Calculate:
(i) Promoter’s revised holding in the Abhiman Ltd.
(ii) Free float market capitalization.
av

(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book Value (B.V.), if
after acquisition of Abhishek Ltd., Abhiman Ltd. decided to :
(1) Issue Bonus shares in the ratio of 1 : 2; and
Bh

(2) Split the stock (share) as Rs 5 each fully paid.

Summary

Detailed Solution

1. Calculation of BVPS, EPS, MPS

Particulars Abhimaan Abhishek
1. Shares capital = 200 L 100 L
Paid up capital/Shares
100 10
= 2,00,000 Shares = 10,00,000 Shares

30 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

2. 
BVPS = Share capital + Reserves/ 200 L + 800 L 100 L + 500 L
No.of shares
2 L shares 10 L shares
= ` 500 = ` 60
3. Non Promoter Holding% 100% – 50% 100% – 60%
= 50% = 40%
4. Total Market Cap.
Free Float Market Cap. 400 L 128 L
=

hi
Free Float % 50% 40%
= ` 800 Lakhs = ` 320 Lakhs
5. MPS = Market Cap./Total Share 800 L 320 L

ks
2 L shares 10 L shares
= ` 400 Lakhs = ` 32 Lakhs
6. MPS = EPS × P/E = 400/10 = 32/4
EPS = MPS/P/E = ` 40 = ` 8

2. SWAP Ratio
Particulars
Book Value
ho
Exchange Rate
0.12:1
Weight
25%
Weighted Average
0.03:1
C
(Favourable) (60/500)

EPS 0.2:1 50% 0.1:1

(Favourable) (8/40)
ik

MPS (Favourable) 0.08:1 25% 0.02:1

(32/40)
Agreed Swap Ratio (Part a) 0.15:1
av

` (40 × 2) + ` (8 × 10 Lakhs Shares)

3. Post EPS =
2 Lakhs Shares + (10 Lakhs Shares × 0.15)
Bh

` 80 Lakhs + ` 80 Lakhs
=
2 Lakhs Shares + 1.5 Lakhs Shares

160
=
3.5 L Shares

= ` 45.71
4. Post MPS = EPS × P/E
= 45.71 × 10
` 457.1

31 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

5. Post BVPS
Post BVPS Abhimaan Abhishek
Net Assets 200 + 800 100 + 500
(S.C + Reserves) = 1,000 = 600

Combined Net Assets = 1,000 + 600 = 1,600

1600
Post BVPS =
3.5 L Shares

hi
= 457.14

ks
6. Promoter Holding (Post Acquisition)

(2,00,000 × 50%) + (10,00,000 × 60%) × 0.15

= (Abhimaan & Abhishek)
2,00,000 + (10,00,000 × 0.15)

=
1,00,000 + 90,000
3,50,000
ho
C
= 54.29%
Non Promoter Holding = 100% – 54.29%
= 45.71%
ik

Free Float Market Capitalisation = (3.5 × ` 457.1) × 45.71%

= ` 731.29
No. of shares post bonus and post-split
av

Post-Acquisition Shares 3,50,000

(+) Bonus Shares (3.5 x ½) 1,75,000
Post Bonus Shares 5,25,000
Bh

(Face Value = ` 100)

x Split (` 100/5) 20
Post Bonus and Post-Split Shares 1,05,00,000
Bonus / Split have no impact on post-acquisition combined profit (160 lakhs) and combined Net
Assets (1,600 Lakhs). However as the number of shares increase all else remaining constant the
revised EPS and BVPS are:

` 160 Lakhs
Post Bonus and Split EPS =
105 Lakhs Shares

= ` 1.52

32 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

` 1,600 Lakhs
Post Bonus and split BVPS =
` 105 Lakhs

= 15.24

Question 4 (ICAI SM)/(ICAI Paper May 24)/(MTP Sept 22)

[Q.24 - AFM 8 (Fast Track) & 9, Q.24 - AFM 10]

hi
The equity shares of XYZ Ltd. are currently being traded at ` 24 per share in the market. XYZ
Ltd. has total 10,00,000 equity shares outstanding in number; and promoters' equity holding in
the company is 40%.

ks
PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The estimated present value
of these synergies is ` 80,00,000.
Further PQR feels that management of XYZ Ltd. has been over paid. With better motivation,

ho
lower salaries and fewer perks for the top management, will lead to savings of ` 4,00,000 p.a.
Top management with their families are promoters of XYZ Ltd. Present value of these savings
would add ` 30,00,000 in value to the acquisition.
Following additional information is available regarding PQR Ltd.:
C
Earnings per share : `4
Total number of equity shares outstanding : 15,00,000
Market price of equity share : ` 40
ik

Required:
(i) What is the maximum price per equity share which PQR Ltd. can offer to pay for XYZ Ltd.?
(ii) What is the minimum price per equity share at which the management of XYZ Ltd. will be
av

willing to offer their controlling interest?

Summary
Bh

Detailed Solution

(i) MPP for XYZ Ltd

Particulars Per Share Total
MPS/Share ` 24 2,40,00,000
(+) PV of synergies/share `8 80,00,000
(80,00,000/10,00,000)
(+) PV of cost savings `3 30,00,000
[30,00,000/10,00,000]
MPP ` 35 ` 3,50,00,000

33 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Reference Note:
We are not given the cash inflows that XYZ generates each year. Instead, we are given the
market price. Market price can be derived using Gordon formula i.e. D1 /Ke – g. Assuming
the market price is fairly determined, it will represent the PV of all future Dividends and
hence MPS is considered in the absence of information.
(ii) Minimum Purchase Price expected by promoters/top management
In case the merger goes through, the management will give up 40% stake as well as

hi
settle for a lower compensation assuming they continue with the company. Therefore,
the management will at least (minimum) expect to be compensated for both. Further, the
shares held by promoters are 40% i.e. 10,00,000 x 40% = 4,00,000 shares. Hence, the

ks
evaluation should be done for 4,00,000 shares only.
Particulars Per Share Total
MPS/Share ` 24 96,00,000
(+) Remuneration lost
 30, 00, 000 
 4, 00, 000 
 
ho
Minimum price/share for promoter’s stake
` 7.5

` 31.5
30,00,000

1,26,00,000
C
Extra: Incase minimum purchase price is asked for non-promoter shareholders of XYZ,
then it would be ` 24 (MPS) as they are not foregoing any additional compensation.
ik

Question 5 (ICAI SM)/(MTP Nov 21)/(RTP May 20)/

(MTP April 19)/(MTP Nov 18)
[Q.27 - AFM 8 (Fast Track) & 9, Q.27 - AFM 10]
av

ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They want
to know the value of the new strategy. Following information relating to the year which has just
ended, is available:
Bh

Income Statement `
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000

34 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

If it adopts the new strategy, sales will grow at the rate of 20% per year for three years.
From 4th year onward it will stabilize. The gross margin ratio, Assets turnover ratio, the Capital
structure and the income tax rate will remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.

hi
Summary

Detailed Solution

ks
Reference Note
1. Value of Strategy = Value of ABC under New Strategy – Value of ABC under Existing

2.
Strategy

cash flows upto perpetuity.

ho
The value of the company (under any strategy) can be calculated as the PV of all future

We have been given that under the new strategy (which is applicable for 4 years), growth
C
= 20% for the first 3 years and cash flows stabilize from year 4 onwards. Therefore, in
order to find the Terminal Value at the end of Year 3, we will need to predict the free
cash flows at Year 4 as well.
ik

3. Looking at the current capital structure, assets have been fully financed by equity
(8,000+4,000 = 12,000) and hence there is no debt. Therefore, FCFF = FCFE and Value
of Firm = Value of Equity.
av

Calculation of Free Cash Flow

PV of FCF
Bh

Particulars Y1 Y2 Y3 Y4
PAT (WN : 1) 1,680 2,016 2,419.2 2,419.2
(+) Depreciation (WN : 2) 800 960 1152 1,382.4
(-) Investment in FA (WN : 2) (2,400) (2,880) (3,456) (1,382.4)
(-) Investment in WC (WN : 3) (800) (960) (1,152) NIL
FCF (720) (864) (1,036.8) 2,419.2

Valuation of ABC under the new strategy

Year FCF DF@15% PV of FCF
1 (720) 0.8696 (626.11)
2 (864) 0.7561 (653.27)
3 (1,036.8) 0.6575 (681.7)

35 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

3 16,128 0.6575 10,604.16

 2, 419.2 (1 ) 
 
 0.15 − 0 
 

8,643.08

Working Note 1: Calculation of PAT

Existing PAT Margin = 1,400/20,000 × 100 = 7%

hi
As the gross margin, admin expense % and tax rate remain constant, PAT Margin:
= (20% - 10%) (1-0.3) = 7%

ks
Profit After Tax
Particulars Y1 Y2 Y3 Y4
Sales 24,000 28,800 34,560 34,560

PAT @7%
(20,000 + 20%)
1,680
ho(24,000 + 20%)
2,016
(28,800 + 20%)
2,419.2
+0%
2,419.2

Reference Note: PAT is calculated after deducting all expenses (including depreciation) and
C
hence deprecation would have been implicitly deducted while calculating the above PAT and
hence no separate deduction is done for depreciation.
ik

Working Note: 2: Investment in Fixed Assets (FA)

Reference Note: We have been given that the assets turnover ratio remains the same. This is
interpreted to mean that the Fixed Assets Turnover as well as the Current Assets Turnover will
av

respectively continue to remain unchanged i.e.

Sales
FA Turnover =
FA
Bh

20, 000
=
8, 000

= 2.5

Sales
i.e. FA =
FA Turnover

Since the fixed assets turnover remains unchanged at 2.5, closing fixed assets in each year can
be predicted by substituting sales of each year as follows:
FA for YR1 to YR4

36 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Particulars Y1 Y2 Y3 Y4
Sales 24, 000 28, 800 34, 560 34, 560
FA =
FA Turnover 2.5 2.5 2.5 2.5
Closing FA 9,600 11,520 13,824 13,824

In order to calculate depreciation and investment in FA we can prepare a draft FA a/c

hi
Fixed Assets a/c
Y1 Balance 8,000 By Depreciation (10%) 800
To Bank* 2,400 By Balance 9,600

ks
10,400 10,400
Y2 Balance 9,600 By Depreciation (10%) 960
To Bank* 2,880 By Balance 11,520
12,480 12,480
Y3

Y4
Balance
To Bank*

Balance
ho 11,520
3,456
14,976
13,824
By Depreciation (10%)
By Balance

By Depreciation (10%)
1,152
13,824
14,976
1,382.4
C
To Bank* 1,382.4 By Balance 13,824
15,206.4 15,206.4

* Bank is taken as the balancing figure

ik

Working Note : 3 CA investment

Sales
CA turnover =
av

CA

20, 000
= =5
4, 000
Bh

Sales
CA =
CA turnover (5)

Current Assets Y1 to Y4
Particulars Y1 Y2 Y3 Y4
Sales 24, 000 28, 800 34, 560 34, 560
CA =
CA turnover 5 5 5 5
Current Assets 4,800 5,760 6,912 6,912

Additional Investment 800 960 1152 NIL

(4,800-4,000) (5,760-4,800) (6,912-5,760) (6,912-6,912)

37 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Valuation of ABC under existing Strategy

Since there is no growth, the PAT would remain the same i.e 1,400 from year 1 to perpetuity.
Further, as the asset turnover ratios need to be maintained, CA at the end of each year would
be 20,000/5 = 4000 and hence no additional investment is needed in CA . Similarly, FA at the
end of each year would be 20,000/2.5 = 8,000.
Depreciation on FA = 8,000 × 10% = 800
There would be an increase in FA by 800 in each year.

hi
Fixed Assets a/c
Particulars Amount Particulars Amount
To Balance 8,000 By Depreciation 800

ks
To Bank 800 By Balance 8,000

The value of FCF under the existing Strategy from year 1 to perpetuity would be
Particulars Amount
PAT

(+) Depreciation

(-) Investment in FA
ho 1,400
(20,000 × 7%)
800
(8,000 × 10%)
(800)
C
(-) Investment in CA NIL
FCF 1,400
ik

1400
Value (F) = = 9,333.33
0.15-0
Incremental value of the new strategy = 8,643.08 – 9,333.33
= (690.25)
av

Question 6 (ICAI Study Material)/(RTP Nov 22)

[Q.30 - AFM 8 (Fast Track) & 9, Q.30 - AFM 10]
Bh

AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two companies are 10,00,000 and
5,00,000 respectively:
(i) Calculate the increase in the total value of BCD Ltd. resulting from the acquisition on the
basis of the following conditions:
Current expected growth rate of BCD Ltd. 7%
Expected growth rate under control of AFC Ltd 8%
(without any additional capital investment and without any change in risk of operations)
Current Market price per share of AFC Ltd ` 100
Current Market price per share of BCD Ltd. ` 20
Expected Dividend per share of BCD Ltd. ` 0.60

38 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

(ii) On the basis of aforesaid conditions calculate the gain or loss to shareholders of both the
companies, if AFC Ltd. were to offer one of its shares for every four shares of BCD Ltd.
(iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd. pays ` 22 for
each share of BCD Ltd., assuming the P/E Ratio of AFC Ltd. does not change after the
merger. EPS of AFC Ltd. is ` 8 and that of BCD is ` 2.50. It is assumed that AFC Ltd.
invests its cash to earn 10%.

hi
Summary

Detailed Solution

ks
(i) BCD
D1
1. Existing Ke = +g
P0

=
0.6
20
+ 0.07

0.1   i.e., 10%

ho
C
2. In absence of information, Ke remains constant i.e., 10%

D1
3. P0 = (revised)
Ke - g
ik

= 0.6
0.10 - 0.08
av

P0 = ` 30
4. Increase in value BCD = ` 30 - ` 20
× No of shares. = ` 10/ share × 500,000
Bh

Increase in value. = ` 50,00,000

(ii) (a) Post merger MPS
Particulars Amount
Expected value of AFC'S Business post-merger (10,00,000 × 100) 10,00,00,000
Expected value of BCD'S Business post-merger 1,50,00,000
(5,00,000 × 30)
Expected Market Value (combined) 11,50,00,000
÷ No of Shares (10,00,000 + 5,00,000 × ¼) ÷ 11,25,000
Post-merger MPS ` 102.22

39 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

(b) Impact of Analysis [Gain / Loss]

Particulars AFC BCD
Post-merger MPS 102.22 25.56
(102.22 × ¼)
(-) Pre merger (100) (20)
Gain/Share ` 2.22 5.56
× No of shares 10,00,000 5,00,000
Total Gain to Shareholders 22,20,000 27,80,000

hi
Total 50,00,000

Cash Acquisition

ks
Reference Note: As the acquisition is in cash, no additional shares of AFC need to be issued.
However, if cash is paid we would lose interest (income) on the cash already invested. However,
we would get the earnings of BCD. Considering this we will have to calculate the post merger EPS

(a) Post-merger EPS (AFC)

Particulars
ho
for AFC which can be multiplied by post-merger PE ratio in absence of growth rates of AFC in
order to find the post merger MPS

AFC
C
Pre-merger PAT 80,00,000
(10,00,000 × ` 8)
(-) Loss of interest (11,00,000)
[(500,000 × 22) × 10%]
ik

(+) Pre merger PAT - BCD 12,50,000

(500,000 × 2.5)
Post-merger PAT 81,50,000
av

÷ ÷
Post-merger shares (10,00,000 + 0) 10,00,000
Post EPS ` 8.15
(b) Pre-merger PE of AFC
Bh

MPS
PE =
EPS

100
= = 12.5 times
8

(c) As given, pre-merger PE Ratio of AFC continues to remain same post-merger

Post-merger MPS = ` 8.15 × 12.5
= ` 101.875
Gain For Shareholders
Particulars AFC BCD
Post-merger value 101.875 ` 22
(Cash)

40 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

(-) Pre merger value (100) (20)

Gain / Share 1.875 2
X No of shares 10,00,000 5,00,000
Total Gain ` 18,75,000 ` 10,00,000

Question 7 (ICAI Paper Nov 20)

[Q.38 - AFM 8 (Fast Track) & 9, Q.38 - AFM 10]

hi
ICL is proposing to take over SVL with an objective to diversify. ICL’s profit after tax (PAT)
has grown @ 18 per cent per annum and SVL’s PAT is grown @ 15 per cent per annum. Both the
companies pay dividend regularly. The summarised Profit & Loss Account of both the companies

ks
are as follows:
` in Crores
Particulars ICL SVL
Net Sales
PBlT
Interest
Provision for Tax
ho 4,545
2,980
750
1,440
1,500
720
25
445
C
PAT 790 250
Dividends 235 125

Particulars ICL SVL

Fixed Assets
ik

Land & Building (Net) 720 190

Plant & Machinery (Net) 900 350
Furniture & Fixtures (Net) 30 1,650 10 550
av

Current Assets 775 580

Less: Current Liabilities
Creditors 230 130
Overdrafts 35 10
Bh

Provision for Tax 145 50

Provision for dividends 60 470 50 240
Net Assets 1,955 890
Paid up Share Capital (` 10 per share) 250 125
Reserves and Surplus 1,050 1,300 660 785
Borrowing 655 105
Capital Employed 1,955 890
Market Price Share (`) 52 75

ICL’s Land & Buildings are stated at current prices. SVL’s Land & Buildings are revalued three
years ago. There has been an increase of 30 per cent per year in the value of Land & Buildings.
SVL is expected to grow @ 18 per cent each year, after merger.

41 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

ICL’s Management wants to determine the premium on the shares over the current market
price which can be paid on the acquisition of SVL. You are required to determine the premium
using:
(i) Net Worth adjusted for the current value of Land & Buildings plus the estimated average
profit after tax (PAT) for the next five years.
(ii) The dividend growth formula.
(iii) ICL will push forward which method during the course of negotiations?

hi
Period (t) 1 2 3 4 5
FVIF (30%, t) 1.300 1.690 2.197 2.856 3.713
FVIF (15%, t) 1.15 2.4725 3.9938 5.7424 7.7537

ks
Summary

Detailed Solution

1. Calculation of Adjusted Net Worth

WN-1: PAT adjustment:
ho
C
Reference Note: We have been given that the net worth derived needs to be adjusted by
adding an estimated average PAT for next 5 years. SVL has been growing at 15% p.a and
hence irrespective of the merger, SVL’s PAT will grow at 15% p.a.The above adjustment
ik

may be similar to compensating SVL for its goodwill using super profit method.

PAT Estimated
av

Year `
1 287.500
2 330.625
3 380.219
Bh

4 437.252
5 502.839
Total 1,938.435
(Next 5 Years) [Alternatively, 250 × 7.753]
÷ No of Years 5
Average PAT (Next 5 Years) 387.687

WN 2: Land and Building

Adjusted Value = 190 × (1 + 0.30)3 = ` 417.43 (Alternatively 190 × 2.197)

42 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Adjusted Net Worth – SVL

Particulars ` Crs
Land and Building (WN – 2) 417.43
Plant and Machinery 350
Furniture 10
Current Assets 580
(-) Current Liability (130 + 10 + 50 +50) (240)
(-) Borrowings (105)

hi
(+) Average Estimated PAT adjustment 387.69
Adjusted Net Worth 1,400.12
(-) Pre Merger Market capital of SVL (12.5 Cr × ` 75) (937.50)

ks
Premium 462.62
Reference Note: We have assumed that the PAT given of ` 250 is the PAT of last year.
Alternatively, we can also assume it to be the PAT for the next year.


Calculation of Ke ho
2. Valuation using Dividend growth method i.e., Gordon method.
i.
Reference Note: We have not been given the data relating to CAPM. Hence Ke
should be calculated using Gordon formula. The existing price of ` 75 is based on the
C
existing growth rates of 15% and hence Ke should be calculated based on 15% growth
rate i.e
ik

D1
Ke = +g
Po


Note: We’ve assumed that given dividends are Do, Alternatively, they can be taken
av

as D1
Further, DPS = 125/12.5
= ` 10/share (Do)
Bh

10 × 1.15
Ke = + 0.15
75

= 30.33%
ii. Calculation of expected price at 18% growth

D1
Po =
Ke − g

10 × 1.18
=
0.3033 – 0.18

= ` 95.70

43 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

3. Premium Analysis
Total value as per dividend growth model (95.70 × ` 12.5) 1,196.25
(-) Pre Merger Market Capital of SVI (12.5 × ` 75) (937.50)
Premium 258.75

iii. Conclusion: ICL (acquirer) will push forward the dividend growth method during
negotiations as it results in a lower payout and lower premium.

hi
Current Assets Y:1 to Y : 4
Particulars Y1 Y2 Y3 Y4

ks
Sales 24, 000 28, 800 34, 560 34, 560
CA =
CA turnover 5 5 5 5
Current Assets 4,800 5,760 6,912 6,912

Additional Investment 800

(4,800-4,000)

Valuation of ABC under existing Strategy

ho 960
(5,760-4,800)
1152
(6,912-5,760)
NIL
(6,912-6,912)
C
Since there is no growth, the PAT would remain the same i.e 1,400 from year 1 to perpetuity.
Further, as the asset turnover ratios need to be maintained, CA at the end of each year would
be 20,000/5 = 4000 and hence no additional investment is needed in CA. Similarly, FA at the end
ik

of each year would be 20,000/2.5 = 8,000.

Depreciation on FA = 8,000 × 10% = 800
There would be an increase in FA by 800 in each year.
av

Fixed Assets a/c

Particulars Amount Particulars Amount
To Balance 8,000 By Depreciation 800
Bh

To Bank 800 By Balance 8,000

The value of FCF under the existing Strategy from year 1 to perpetuity would be
Particulars Amount
PAT 1,400
(20,000 × 7%)
(+) Depreciation 800
(8,000 × 10%)
(-) Investment in FA (800)
(-) Investment in CA NIL
FCF 1,400

44 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

1400
Value (F) = = 9,333.33
0.15-0

Incremental value of the new strategy = 8,643.08 – 9,333.33

= (690.25)

Question 8 (ICAI Paper May 19)

[Q.46 - AFM 8 (Fast Track) & 9, Q.46 - AFM 10]

hi
Compute Economic Value Added (EVA) of Good luck Ltd. from the following information:
Profit & Loss Statement
Particulars (` in Lakh)

ks
(a) Income -
Revenue from Operations 2000
(b) Expenses -
Direct Expenses 800
Indirect Expenses 400
(c) Profit before interest & tax(a-b)
(d) Interest
(e) Profit before tax (c - d)
(f) Tax
(g) Profit after tax (e - f)
ho 800
30
770
231
539
C
Balance Sheet
Particulars (` in Lakh)
Equity and Liabilities :
ik

(a) Shareholder's Fund -

Equity Share Capital 1000
Reserve and Surplus 600
(b) Non- Current Liabilities -
av

Long Term Borrowings 200

(c) Current Liabilities 800
Total 2600
Assets :
Bh

(a) Non - Current Assets 2000

(b) Current Assets 600
Total 2600

Other Information:
(1) Cost of Debts is 15%.
(2) Cost of Equity (i.e. shareholders' expected return) is 12%.
(3) Tax Rate is 30%.
(4) Bad Debts Provision of ` 40 lakhs is included in indirect expenses and ` 40 lakhs reduced
from receivables in current assets.

45 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Summary

Detailed Solution

Reference Note: As per ICAI workings, in case a provision for bad debt is created, we should
add back the provision while calculating NOPAT as well as invested capital.
EVA = NOPAT - (Invested Capital × WACC)

hi
= 600 - (1,840 × 11.84%)
= 382.14

ks
Working Note 1: NOPAT
NOPAT = EBIT (1 – t) + Provision for bad debt
= 800 (1 – 0.3) + 40

Alternative

=
=
=
560 + 40 = 600
ho
PAT + Interest (1 –t) + provision for bad debts
539 + 30 (1 – 0.3) + 40 = 600
C
Working Note 2: Invested Capital & WACC
ESC 1,000
(+) Reserves (600 + 40) 640
ik

(+) Long Term Debt 200

Invested Capital 1,840
av

D E
WACC = KD × + Ke ×
D+E D+E

200 1, 640
= 15% × (1 – 0.3) × + 12% ×
Bh

1,840 1, 840

= 11.84%

Reference Note: ICAI has ignored 40 while calculating weights i.e., weights are 200/1,800 and
1,600/1,800. We have reversed 40 of provision for bad debts from profit and therefore, we
have added in Reserves

46 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Question 9 (ICAI Paper Dec 21)

[Q.47 - AFM 8 (Fast Track) & 9, Q.47 - AFM 10]

Following is the information of M/s. DY Ltd. for the year ending 31/03/2021:
Particulars `
Sales ` 1000 Lakh
Operating Expenses Including Interest ` 620 Lakh
8% Debentures ` 250 Lakh
Equity Share Capital (Face value of ` 10 each) ` 250 Lakh

hi
Reserves and Surplus ` 250 Lakh
Market Value of DY Ltd ` 900 Lakh
Corporate Tax Rate 30%

ks
Risk free Rate of Return 7%
Market Rate of Return 12%
Equity Beta 1.4

You are required to-

i.
ii.
ho
Calculate Weighted Average Cost of Capital of DY Ltd.
Calculate Economic Value Added
iii. Calculate Market Value Added
C
Summary
ik

Detailed Solution

(i) Weighted Average Cost of Capital of DY Ltd.

av

Cost of Equity as per CAPM

ke = Rf + β x Market Risk Premium
= 7% + 1.4 x [12% - 7%]
Bh

= 7% + 7% = 14%
Cost of Debt kd = 8% (1 – 0.30) = 5.60%

E D 500 250
WACC (ko) = ke x + kg × = 14.00 × + 5.60 ×
E +D E +D 750 750

= 9.33% + 1.87% = 11.20%

(ii) Economic Value Added (EVA) of DY Ltd.
Particulars ` Lakhs
Sales ` 620 ` 1,000
Operating Expenses (excluding interest) ` 20 ` 600
` 400

47 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Less: Tax @ 30% ` 120

Net Operating Profit after Tax (NOPAT) ` 280

Calculation of Capital Employed

Particulars ` Lakhs
Equity Share Capital 250
Reserves & Surplus 250

hi
8% Debentures 250
Total Capital Employed 750

EVA = NOPAT – (WACC × Total Capital)

ks
EVA = ` 280 Lakh – 0.1120 × ` 750 lakhs
EVA = 196.00 lakhs
(iii) Determination of Market Value Added (MVA)
Particulars
ho
Market value of Equity Stock [` 900 Lakh - ` 250 Lakh]
Equity Fund [` 250 Lakh + ` 250 Lakh]
Market Value Added
` Lakh
650
500
150
C
Alternatively, it can also be computed as follows:
Particulars ` Lakh
Market value of DY Ltd. 900
ik

Capital employed [` 250 Lakh + ` 250 Lakh + ` 250 Lakh] 750

Market Value Added 150
av

RESTRUCTURING

Question 10 (RTP Nov 20)/(MTP Aug 18)/(Practice Manual)

Bh

[Q.48 - AFM 8 (Fast Track) & 9, Q.48 - AFM 10]

The following is the Balance-sheet of Grape Fruit Company Ltd as at March 31st, 2011.
Liabilities (` in lakhs) Assets (` in lakhs)
Equity shares of ` 100 each 600 Land and Building 200
14% preference shares of 200 Plant and Machinery 300
` 100/- each
13% Debentures 200 Furniture and Fixtures 50
Debenture interest accrued and 26 Inventory 150
payable
Loan from bank 74 Sundry debtors 70
Trade creditors 340 Cash at bank 130
Preliminary expenses 10

48 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Cost of issue of 5
debentures
Profit and Loss account 525
1440 1440

The Company did not perform well and has suffered sizable losses during the last few
years. However, it is felt that the company could be nursed back to health by proper financial
restructuring. Consequently the following scheme of reconstruction has been drawn up :

hi
(i) Equity shares are to be reduced to ` 25/- per share, fully paid up;
(ii) Preference shares are to be reduced (with coupon rate of 10%) to equal number of
shares of ` 50 each, fully paid up.

ks
(iii) Debenture holders have agreed to forgo the accrued interest due to them. In the future,
the rate of interest on debentures is to be reduced to 9 percent.
(iv) Trade creditors will forego 25 percent of the amount due to them.

ho
(v) The company issues 6 lakh of equity shares at ` 25 each and the entire sum was to be paid
on application. The entire amount was fully subscribed by promoters.
(vi) Land and Building was to be revalued at ` 450 lakhs, Plant and Machinery was to be
C
written down by ` 120 lakhs and a provision of ` 15 lakhs had to be made for bad and
doubtful debts.

Required:
ik

(i) Show the impact of financial restructuring on the company’s activities.

(ii) 
Prepare the fresh balance sheet after the reconstructions is completed on the
basis of the above proposals.
av

Summary
Bh

Detailed Solution

Reference Note: The restructuring case given is very similar to an internal reconstruction
scenario. In order to assess the impact of restructuring, we need to prepare a capital reduction/
restructuring account. The impact can be shown in the form of a ledger or can also be shown as
a statement. Further, the Balance Sheet needs to be prepared in this case. It need not be in
schedule 3 format. As a general rule, we use the format given in question to prepare our Balance
Sheet in AFM.

49 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

Working Note 1: Journal entries for items not affecting capital reduction account.
13% Debentures A/c Dr. 200
To 9% Debentures 200
Bank A/c (6 × 25) Dr. 150
To Equity Share Capital A/c 150

1. Impact of Restructuring

hi
Capital Reduction/Restructuring A/c
To Plant and Machinery 120 By equity share capital
(6,00,000 × (100 – 25) 450

ks
To Sunday Debtors 15 By Preference share capital
(Provision for bad debts) (2,00,000 × (100 – 50) 100
To Preliminary Expense 10 By debentures interest
Accrued 26
To cost of issue of Debentures

To Profit & Loss A/c

ho
5

525
By trade creditors
(340 × 25%)
By land and building
(450 – 200)
85

250
C
To Capital Reserve          236

911 911

Reference Note: The objective of restructuring scheme is to write off accumulated losses and
ik

fictitious assets. Thus, even if it is not separately given, we will write off the fictitious assets
and accumulated losses.
av

Balance Sheet of Grapefruit Co Ltd & Reduced as at 1/1/12

Capital and liabilities Assets
Equity share capital of 25 each 300 Land and building (200 + 250) 450
Bh

(600 – 450 + 150)

Capital Reserves 236 Plant and machinery (300 – 120) 180
10% Preference Share Capital 100 Furniture 50
9% Debentures 200 Inventory 150
Trade Creditors (840 – 85) 255 Sundry debtors (70 – 15) 55
Loan From Bank 74 Cash at bank (130 + 150) 280
1,165 1,165

50 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

GEARED BETA

Question 11 (Practice Manual)

[Q.49 - AFM 8 (Fast Track) & 9, Q.49 - AFM 10]

ABC, a large business house is planning to sell its wholly owned subsidiary KLM. Another large
business entity XYZ has expressed its interest in making a bid for KLM. XYZ expects that after

hi
acquisition the annual earning of KLM will increase by 10%.
Following information, ignoring any potential synergistic benefits arising out of possible
acquisitions, are available:

ks
Profit after tax for KLM for the financial year which has just ended is estimated to be ` 10
crore.
KLM's after tax profit has an increasing trend of 7% each year and the same is expected to
continue.
ho
Estimated post tax market return is 10% and risk free rate is 4%. These rates are expected
to continue.
Corporate tax rate is 30%.
C
Particulars XYZ ABC Proxy entity for KLM in the same
line of business
No. of shares 100 lakhs 80 lakhs --
ik

Current share price ` 287 ` 375 --

Dividend pay out 40% 50% 50%
Debt : Equity at market values 1:2 1:3 1:4
P/E ratio 10 13 12
av

Equity beta 1 1. 1 1.1

Assume gearing level of KLM to be the same as for ABC and a debt beta of zero.
Bh

You are required to calculate:

(a) Appropriate cost of equity for KLM based on the data available for the proxy entity.
(b) A range of values for KLM both before and after any potential synergistic benefits to
XYZ of the acquisition.

Summary

Detailed Solution

51 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

1. Cost of Equity (Ke) for KLM

(a) Proxy Company
E
β A = βE ×
D (1 − t ) + e

4
= 1.1 ×
1 (1 − 0.3) + 4

4.4
=
4.7

hi
= 0.936
Assuming βA = 0.936 for KLM

ks
E
βA = β E × [KLM]
D(1 − t) + e

0.936 = βE ×

0.936×3.7 = βE
3
3
1 (1 − 0.3) + 3
ho
C
βE = 1.15
Using CAPM,
Ke = RF + (RM – RF) β E
ik

= 4% + (10% - 4%) × 1.15 = 10.9%

b. Valuation:
2. Using Gordon’s Formula
av

 In this case, we have not been given the pay-out ratio for KLM. Hence the range of
values have been calculated considering both pay-out ratios i.e., 40% and 50%.
 Further, the synergy benefits are 10% and hence the adjusted profits considering
Bh

the synergies would be 10 Cr + 10% = 11 Cr. In any case, going forward the growth
rate would be 7%

Total Divided
Value =
Ke – g

Particulars Pay-out – 40% Pay-out – 50%

1. Pre Synergy (10 ×40% ) × 1.07 (10 ×50% ) × 1.07
0.109 − 0.07 0.109 − 0.07
5.35
= 4.28 =
0.039 0.039
= ` 109.74 = ` 137.18

52 CA BHAVIK CHOKSHI
 MERGERS, ACQUISITIONS AND CORPORATE RESTRUCTURING

2. Post Synergy (11×40% ) × 1.07 (11×50% ) × 1.07

0.109 − 0.07 0.109 − 0.07
4.708 5.885
= =
0.039 0.039
= ` 120.72 = ` 150.90

Valuation Using P/E Multiple Approach

In some cases, the P/E ratio of the acquirer (XYZ) remains the same. However, it is also possible

hi
that KLM’s business is different from XYZ in which case its valuation should be done based on
the proxy company’s P/E Ratio. The range of values can be found as follows:
Particulars XYZ P/E (10×) Proxy P/E (12×)

ks
1. Pre-synergy 10 × ` 10 = 12 × ` 10
= ` 100 = ` 120
2. Post synergy = 10 × ` 11 = 12 × ` 11
= ` 110 = ` 132

Range (Lowest – Highest)

Pre – Synergy
(P/E)
: 100 – 137.18
ho
(Gordon)
C
Post – Synergy : 110 - 150.90
(P/E) (Gordon)ADDITIONAL QUESTIONS
ik
av
Bh

53 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

CHAPTER 3 PORTFOLIO MANAGEMENT

Question 1 (ICAI Study Material)

[Q.4 - AFM 8 (Fast Track) & 9, Q.4 - AFM 10]

X Co. Ltd., invested on 1.4.2005 in certain equity shares as below:

Name of Co. No. of Shares Cost (`)

hi
M Ltd. 1,000 (` 100 each) 2,00,000
N Ltd. 500 (` 10 each) 1,50,000

In September, 2005, 10% dividend was paid out by M Ltd. and in October, 2005, 30% dividend

ks
paid out by N Ltd. On 31.3.2006 market quotations showed a value of ` 220 and ` 290 per
share of M Ltd. and N Ltd. respectively. On 1.4.2006, investment advisors indicate (a) that the
dividends from M Ltd. and N Ltd. for the year ending 31.3.2007 are likely to be 20% and 35%,

Probability factor

0.2 220
ho
respectively and (b) that the probabilities of market quotations on 31.3.2007 are as below:
Price / Share of M Ltd. Price / Share of N Ltd.

290
C
0.5 250 310
0.3 280 330
You are required to:
(i) Calculate the average return from the portfolio for the year ended 31.3.2006;
ik

(ii) Calculate the expected average return from the portfolio for the year 2006-07; and
(iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each cases.
av

Summary
Bh

Detailed Solution

(i) Portfolio Return (RMN) for 2005-06

RMN = WMRM + WNRN
Where,

P1 – P0 + D
a. RM = × 100
P0

=
220 – 200 + (100 × 10% )
× 100 (P0 = 2,00,000/1,000 = ` 200)
200

= 15%

54 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

P1 − P0 + D
b. RN = × 100
P0
290 – 300 + (10 × 30% )
= 300
× 100 (P0 = 1,50,000/500 = ` 300)

= (2.33%)
c. Weight

hi
Particulars Amounts (01/04/05) Weights
M 2,00,000 20/35
N 1,50,000 15/35

ks
3,50,000

d. RMN = WMRM + WNRN

=
20
35
× 15% +

7.57%
15
35
× (2.33%)

(ii) Portfolio Return (RMN) for 2006-07

ho
C
P2 − P1 + D
a. RM = × 100
P1
ik

Where P2 = 220 × 0.2 + 250 × 0.5 + 280 × 0.3

= 253
av

Thus,
253 − 220 + (100 × 20% )
× 100 = 24.09%
220

P2 – P1 + D
Bh

b. RN = × 100
P1

Where P2 = 290 × 0.2 + 310 × 0.5 + 330 × 0.3

= 58 + 155 + 99
= 312

312 − 290 + (10 × 35% )

RN = × 100
290

= 8.79%

55 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

c. Calculation of weights
Share Value at start of the year(p1) Weights
M 2,20,000 220/365
(1,000 shares × ` 220)
N 1,45,000 145/365
(500 shares × ` 290)
3,65,000

hi
d. RMN = WMRM + WNRN

220 145
= × 24.09 + × 8.79
365 365

ks
= 14.52 + 3.49
= 18.01%

(iii) Standard Deviation

Reference Note:
ho
1. Standard Deviation can be calculated by either using a range of historic data or based
C
on expectation of future scenarios. We cannot mix the two. In this case, we only
have the past data of 05-06 and hence range of past data is not available. However,
we have a range of expected return in the future. Therefore, we have calculated
ik

standard deviations based on expected data of 2006-2007.

2. Standard deviation can be calculated based on share price or based on % return. The
calculation based on share price ignores dividend. Hence, it is more appropriate to
av

calculate the Standard deviation based on % return (share price + dividend).

1. Calculation of % Returns under each scenario

Bh

Probalitiy Return (M) Return (N)

0.2 220 − 220 + 20 290 – 290 + 3.5 × 100
220 290
= 9.09% = 1.21%
0.5 250 – 220 + 20 × 100 310 – 290 + 3.5 × 100
220 290
= 22.73% = 8.10%
0.3 280 – 220 + 20 × 100 330 − 290 + 3.5 × 100
220 290
= 36.36% = 15%

56 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

M (RM) = 9.09 × 0.2 + 22.73 × 0.5 + 36.36 × 0.3

= 24.09%
N (RN) = 1.21 × 0.2 + 8.1 × 0.5 + 15 × 0.3
= 8.79%

Calculation of Standard deviations

Probability Return (M) P (M – 24.09)2 Return (N) P (N – 8.79)2

hi
M% N%
0.2 9.09 45.00 1.21 11.49
0.5 22.73 0.92 8.10 0.24
0.3 36.36 45.17 15.00 11.57

ks
∑P (M - M) = 91.09 ∑P (N- N )2 = 23.30

σM =

=
∑P ( M − M )
91.09
σM = 9.54%
2

ho
C
∑p( N − n )
2
σN =
= 23.30
= 4.83%
ik

Conclusion: Based on the standard deviations only : M has a higher risk as it has the higher
derivation as compared to N.
av

Question 2 (ICAI SM)/(ICAI Paper May 24)/(RTP May 24)/

(RTP May 19)
[Q.19 - AFM 8 (Fast Track) & 9, Q.19 - AFM 10]
Bh

An investor has decided to invest ` 100,000 in the shares of the two companies, namely, ABC
and XYZ. The projections of returns from the shares of the two companies along with their
probabilities are as follows:
Probability ABC (%) XYZ (%)
0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2

You are required to

a. Comment on return and risk of investment in individual securities
b. Compare the risk and return of these two shares with a portfolio of these shares in equal

57 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

proportions
c. Find out the proportion of each of the above shares to formulate a minimum risk portfolio.

Summary

Detailed Solution

hi
Calculation of σ Covar
Probability R (A)% R(x)% P(A – 12.55) (X – 12.1) P(A –A )2 P (X – X )
0.2 12 16 0.2 × (0.55) × 3.9 = (0.429) 0.06 3.04

ks
0.25 14 10 0.25 × 1.45 × (2.1) = (0.761) 0.53 1.10
0.25 -7 28 0.25 ×(19.55) × 15.9 = (77.71) 95.55 63.2
0.3 28 -2 0.3 × 15.45 × (14.1) =(65.35) 71.61 59.64
(144.25) 167.75 126.98

ho
A = Σ pA = 12 × 0.2 + 14 × 0.25 + (7) × 0.25 + 0.3 × 28 + = 12.55%
X = Σ pX = 16 × 0.2 + 10 × 0.25 + 28 × 0.25 + (2) × 0.3 = 12.1%
C
( )
2
σA= ΣP A − A 167.75 = 12.95%
=

( )
2
σX= ΣP X - X
ik

= 126.98
= 11.27%
av

Solution
Particulars ABC XYZ
Expected Return 12.55% 12.10%
Bh

Risk 12.95% 11.27%

ABC has a higher risk and a higher return as compared to XYZ

B.Wa = 50% Wx = 50%
Rax = WaRa + WxRx
= 0.5 x 12.55+ 0.5 x 12.1
= 12.325%
Covar(ax) = Σp (A – A ) (X – X)
= (144.25)

COR(AX) =
Co var(AX )
=
(144.25 )
s AX s X 12.95×11.27

58 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

= (0.99)

σAX = WA2 x s A2 + Wb 2 + 2WAWX s As X COR(AX )

( 0.5 ) x (12.95 ) + ( 0.5 ) x (11.27 ) + 2 x 0.5 x 0.5 x ( 0.99 ) x12.95 x 11.27

2 2 2 2
=
= 1.44
= 1.20%

hi
On combining XYZ & ABC, the return remains almost the same i.e 12.32% but the risk reduces
significantly i.e it becomes 1.2%

ks
Minimum Risk Portfolio

Wabc =

=
s X2 – CovarAX
s A2 + s X2 – 2 CovarAX

(11.27 ) - ( −144.25 )
2
ho
C
(12.95) + (11.27) – 2 × ( −144.25 )
2 2

271 .26
=
583.21
ik

= 0.4651
Wabc = 46.51%
Wxyz = 1 – Wabc = 1 – 0.4651
av

= 53.49%

In order to get the minimum risk portfolio, we should invest 46.51% in ABC and 53.49 in XYZ
Bh

Question 3 (ICAI Study Material [Modified])

[Q.22 - AFM 8 (Fast Track) & 9, Q.22 - AFM 10]

You are given following information about ABC Ltd.

ABC Ltd. Market India Market Dividend % IRF
Year
Average Price Dividend Per Share

2000 242 20 1812 4 6%

2001 279 25 1950 5 5%

2002 305 30 2258 6 4%

2003 322 35 2220 7 5%

59 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

Calculate the Beta and the expected Return for ABC Ltd using CAPM.

Summary

Detailed Solution

Reference Note:

hi
1. Whenever share prices and dividends are given, we should always convert them into % return
P1 − P0 + D
using × 100 and we should try to calculate b based on % returns only
P0
2. Market (NIFTY/SENSEX) is an index which is a combination of various securities. The

ks
market does not have a separate Face Value and incase a market dividend % is given, it
should be a % of the opening market price only i.e dividend % for a market is interpreted as
D1
dividend yield i.e
P0

RM =
P1 − P0
P0
× 100 +
D1
P0
( given )
ho
In such case, the return formula can be broken up as follows:
C
(i) Calculation of returns ABC

P1 − P0 + D1
R = × 100
ik

P0

279 − 242 + 25
2001 = × 100 =
25.62%
242
av

305 − 279 + 30
2002 = × 100 =
20.07%
279

322 − 305 + 35
2003 = × 100 =
17.05%
305
Bh

Market

P1 − P0 D1
RM = × 100 + × 100
P0 P0

1950 − 1812
2001 = × 100 + 5%
= 7. 62% + 5%
= 12.62%
1812

2258 − 1950
2002 = × 100 + 6%
= 15.79% + 6%
= 21.79%
1950

2220 − 2258
2003 = × 100 + 7% =
−1.68% + 7% =
5.32%
2258

60 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

Year ABC M ∑(A-A )(M-M ) ∑(M-M )2

01 25.62 12.62 4.71 × (0.62) =(2.92) 0.38
02 20.07 21.79 (0.84) × 8.55 =(7.18) 73.10
03 17.05 5.32 (3.86) × (7.92) =30.57 62.73
62.74 39.73 20.47 136.21

∑A 62.74
(a) A == = 20.91%

hi
N 3

∑M
(b) M = = = 13.24%
39.73
N 3

ks
(c) COVARAM=
∑(A − A) (M − M ) = 20.47 = 6.82
N 3

∑ ( M=
- M)
2
136.21
(d)=
s 2
= 45.40

β=
M

(iii) β & Expected Return

COVARAM
=
N

6.82
= 0.15
3

ho
C
2
sM 45.40

Expected Return Using CAPM

Ke = RF + (RM-RF) β
ik

Where, RM = 13.24 (average return 2001, 2002 & 2003)

β = 0.15
av

5% + 4% + 5%
RF = = 4.667 ≅ 4.67%
3

Reference Note:
Bh

Market return is based on the years 2001, 2002 and 2003. Further β is also calculated by
comparing the returns of ABC and the market during 2001, 02 & 03. Hence, RF should be
calculated as the average RF for a comparable period i.e 2001,2002 & 2003.
Ke = 4.67 + (13.24 - 4.67) 0.15
= 5.96%

Question 4 (Practice Manual)

[Q.35 - AFM 8 (Fast Track) & 9, Q.35 - AFM 10]

The rates of return on the security of Company X and market portfolio for 10 periods are given
below:

61 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

Period Return of Security X (%) Return on Market Portfolio (%)

1 20 22
2 22 20

3 25 18

4 21 16

5 18 20

6 -5 8

hi
7 17 -6

8 19 5

ks
9 -7 6

10 20 11
(i) What is the beta of Security X?

ho
(ii) What is the characteristic line for Security X?

Summary
C
Detailed Solution

i. Calculation of β
ik

YEAR RX % RM % ∑(X-X )(M-M) (M-M)2

(x-15)(M-12) (M-12)2
1 20 22 5 × 10 = 50 100
av

2 22 20 7 × 8 = 56 64
3 25 18 10 × 6 = 60 36
4 21 16 6 × 4 = 24 16
5 18 20 3 × 8 = 24 64
Bh

6 (5) 8 (20) × (4) = 80 16

7 17 (6) 2 × (18) = (36) 324
8 19 5 4 × (7) = (28) 49
9 (7) 6 (22) × (6) =132 36
10 20 11 5 × (1)= (5) 1
150 120 357 706

X =
∑x =
150
= 15%
n 10

M=
∑M = 120 = 12%
n 10

62 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

COVAR ( XM ) =
∑ ( X − X )( M −=
M) 357
= 35.7
N 10

∑ ( M − M=
))
2
706
s M2
= = 70.6
N 10
COVARXM 35.7
b = = = 0.51
s M2 70.6
ii. Characteristic line

hi
X = a + bM
Where, a= X + b M
a = 15 - 0.51 × 12

ks
= 15 – 6.12
= 8.88
Characteristic Line : x = 8.88 + 0.51M
Reference Note:
ho
Characteristic line is plotted taking the market (m) on the x-axis and the security (X) on y –axis.
This line measures the characteristic (quality) of β i.e., how well the β can predict the past
C
returns.

Let M = 10
Therefore, X = 8.88 + 0.51M
ik

= 8.88 + 0.51 (10)

= 8.88 + 5.1
= (10,13.98)
av

Let M = 0
Therefore, X = 8.88 + 0.51M
= 0.88 + 0.51 (0)
Bh

= (0,8.88)
We can try to find the values of X at any two random values of M. For example, we have taken
M as 10 and 0. We can draw a line connecting the above points which is called as characteristic
line. Subsequently, we can plot the actual value of X.
In case the plotted points are very close to the characteristic line, it shows a good predictive
capability of β, whereas, if these are points are dispersed widely, it shows poor predictive
capability of β.

63 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

CAPM – SYSTEMATIC & UNSYSTEMATIC RISK

Question 5 (ICAI Study Material)

[Q.38 - AFM 8 (Fast Track) & 9, Q.38 - AFM 10]

The following details are given for X and Y companies' stocks and the Bombay Sensex for
a period of one year. Calculate the systematic and unsystematic risk for the companies' stocks.
If equal amount of money is allocated for the stocks what would be the portfolio risk ?

hi
Particulars X Stock Y Stock Sensex
Average return 0.15 0.25 0.06
Variance of return (s) 2
6.30 5.86 2.25

ks
β 0.71 0.27
Correlation Co-efficient with Sensex 0.424
Co-efficient of determination (r) 2
0.18

Summary

Detailed Solution
ho
C
1. Systematic & Unsystematic risk
Stock X
Systematic Risk = CORXM × s X
2 2
ik

= 0.18 × 6.3
= 1.134
( 0.71)
2
Or b X2 × s=
2
× 2.25
av

= 1.134
Total Risk = s X = 6.3
2

Unsystematic Risk ( EX2 )= 6.3 – 1.134 = 5.166

Bh

Stock Y
( 0.27 )
2
Systematic Risk = bY2 × s=
2
M
× 2.25 = 0.164

Unsystematic Risk EY2  = sY2 − b2Y s2M

= 5.86 – 0.164 = 5.696
2. Calculation of Portfolio Risk (X : 0.5 & Y: 0.5)
In this case, rXY is not available, we need to either calculate, rXY or covar (x,y)
2
COV(x,y) = b X bY s M
= 0.71 × 0.27 × 2.25 = 0.4313

s XY = wX2 s X2 + wY2s Y2 + 2WX WY cov ( X , Y )

64 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

( 0.5 ) 6.3 + ( 0.5 ) 5.86 + 2 ( 0.5 )( 0.5 ) 0.4313

2 2
=

= 3.2556
sXY = 1.80%

Question 6 (ICAI Study Material)/(RTP Nov 20)

[Q.41 - AFM 8 (Fast Track) & 9, Q.41 - AFM 10]

hi
A study by a mutual fund has revealed the following data in respect of 3 securities
Security Std deviation (%) Correlation with Index, pm
A 20 0.60

ks
B 18 0.95
C 12 0.75

The standard deviation of market portfolio (BSE Sensex) is observed to be 15%

1.
2.
3.
4.
ho
what is the sensitivity of the returns of each stock with respect to the market
what are the co variances among the various stocks
what would be the risk of portfolio consisting of all the three stocks equally
what is the beta of the portfolio consisting of equal investments in each stock
C
5. what is the total, systematic and unsystematic risk of the portfolio in 4

Summary
ik

Detailed Solution
av

1. Sensitivity to Market (β)

sA 20
βA = CORAM × = 0.6 × = 0.8
sM 15
Bh

sB 18
βB = CORBM × = 0.95 × = 1.14
sM 12

sc 12
βC = CORCM × = 0.75 × = 0.6
sM 15

2. Covariance among stocks (and not with the market)

Reference Note: Usually we would have used the formula
CovarAB = CORab × σA × σB
However in this question we have been given CORam and not CORAB and hence we can’t use
the above formula. Instead CovarAB can be calculated using 3rd formula since β as well as
σ m is available.

65 CA BHAVIK CHOKSHI
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2
COVARAB = β A × βB × s M
= 0.8 × 1.14 × 152 = 205.2
COVARAC = βA × βC × s M2
= 0.8 × 0.6 × 152 = 108
2
COVARBC = β B × βC × s M
= 1.14 × 0.6 × 152
= 153.90

hi
3. σABC
= WA2s A2 + WB2s B2 + WC2s C2 + 2WAWB COVARAB + 2WAWC COVARAC + 2WBWc COVARBC

ks
2 2 2
1 1 1 1 1 1 1 1 1
=   ×20 +   ×18 +   × 12 +2 × × ×205.2 + 2 × × ×108 + 2 × × ×153.9
2 2 2

3 3 3 3 3 3 3 3 3

= 200.24

4.


= 14.15%
βABC =
=
=
WA βA + WA βB + WC βc ho
1/3 × 0.8 + 1/3 × 1.14 + 1/3 × 0.6
0.85
C
5. Portfolio (with equal weight of A,B,C)

2 2
Systematic Risk = bABC × s M
ik

= (0.85)2 × 152
= 162.56
Total risk = σabc = 14.15 i.e., s ABC = 200.2
2
av

Unsystematic Risk (Portfolio ABC) ( EABC

2
)
= Total Risk (Squared) - Systematic Risk (Squared Term)
= 200.22 – 162.56
Bh

= 37.66
Extra: Random Error = 37.66
= 6.14

Question 7 (ICAI Study Material)

[Q.45 - AFM 8 (Fast Track) & 9, Q.45 - AFM 10]

Mr X owns a portfolio with the following characteristics

Particulars Security A Security B Risk free security
Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected return 15% 20% 10%

66 CA BHAVIK CHOKSHI
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It is assumed that security returns are generated by a 2 factor model

a. If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and purchases
` 1,50,000 of security A what is the sensitivity of Mr X's portfolio to the 2 factors
b. If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he borrows
along with the original ` 1,00,000 in A and B in the same proportion as described in part
1 what is the sensitivity of the portfolio to the 2 factors
c. What is the expected return premium if factor 2?

hi
Summary

ks
Detailed Solution

F1
(a) Portfolio β [ bAB and bAB
F2
]
1. Calculation of Weights
Security
A
B
Amountho
1,00,000 + 50,000
(50,000)
`
1,50,000
(50,000)
Weight
1.5
(0.5)
C
RF 0 0 0
1,00,000 1

2. Sensitivity of Portfolio (A,B) to each factor

ik

AB A B

WA bAF 1 + WB bB
F1 F1
bAB
av

= 1.5 × 0.8 + (0.5) × 1.5 = 0.45

AB A B
F2
bAB WA bAF 2 + WB bBF 2
Bh

= 1.5 × 0.6 + (0.5) × 1.2 = 0.3

(b) Sensitivity of Portfolio (A,B, RF) to each factor (F1, F2)

Reference Note: Borrowing money usually involves issuing debentures which is equivalent to
selling the debentures. In case we had invested in a risk free security (purchased), then it
would have been a part of our portfolio. Similarly, if we borrow (equivalent to selling risk free
security) it should also be considered to be a part of our portfolio with the weights being
negative as security is being sold.
Additionally, we have been told to maintain the same proportion as part (a). Hence another
50,000 of B should be short sold and the additional amount generated would also be invested in
A in a manner similar to part (a).

67 CA BHAVIK CHOKSHI
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i. Calculation of Weights
Securities Amount ` Weight
A 1,00,000 + 50,000 + 1,00,000 + 50,000 3,00,000 3
B (50,000) + (50,000) (1,00,000) (1)
RF (1,00,000) (1,00,000) (1)
1,00,000 1

ii. F1
bABR = WA bAF 1 + WB bBF 1 +WR bRF 1

hi
= 3 × 0.8 + (1) × 1.5 + (1) × 0
= 0.9
= WA bA + WB bB + WR bR
F2 F2 F2 F2
b ABR

ks
= 3 × 0.6 + (1) × 1.2 + (1) × 0
= 0.6
(c) Calculation of return/risk premium of factor-2 (λF2)

ho
We have been given that the returns are generated by a 2 factor model and hence the
expected return for each security would be similar to the required return generated by a 2
factor model i.e.,
Ke = RF + λF1 β F1 + λF2 βF2
C
Thus, A : 15 = 10 + λF1 0.8 + λF2 0.6
i.e 5 = 0.8 λF1 + 0.6 λF2
B : 20 = 10 + λF1 1.5 + λF2 1.2
ik

i.e., 10 = 1.5 λF1 + 1.2 λF2

Multiplying equation 1 by 2 then subtracting equation 2 from 1
10 = 1.6 λF1 + 1.2 λF2
av

10 = 1.5 λF1 + 1.2 λF2

0 = 0.1 λF1
Thus, λF1 = 0
Bh

Thus, Substituting λF1 = 0 in equation 2

10 = 1.5 × 0 + 1.2 λF2
Thus, 10 = 1.2 λF2
λF2 = 10/1.2
λF2 = 8.33%
(Return / Risk premium of factor-2)

Question 8 (ICAI Study Material)/(Practice Manual)

[Q.46 - AFM 8 (Fast Track) & 9, Q.46 - AFM 10]
Mr. Nirmal Kumar has categorized all the available stock in the market into the following types:
(i) Small cap growth stocks

68 CA BHAVIK CHOKSHI
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(ii) Small cap value stocks

(iii) Large cap growth stocks
(iv) Large cap value stocks

Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market
index. Further, more the sensitivity of returns on these categories of stocks to the three
important factor are estimated to be:

hi
Category of Stocks Weight in the Factor I (Beta) Factor II Factor III
Market Index [Market] (Book Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35

ks
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium
[l]

ho
The rate of return on treasury bonds is 4.5% Required:
6.85% -3.5%

(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the market
0.65%
C
index.
(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the “small cap value”
and “large cap growth” stocks. If the target beta for the desired portfolio is 1,
ik

determine the composition of his portfolio.

Summary
av

Detailed Solution
Bh

MARKET INDEX

Small Capital Growth Small Capital Value Large Capital Growth Large Cap Value
(A) (B) (C) (D)
25% 10% 50% 15%

(a) Expected Return for Market using APT.

Ke = RF + λF 1 bF 1 + λF 2 bF 2 + λF 3 bF 3
ABCD ABCD ABCD

Reference: Where RF, λF1, λF2, λF3 are given in Question. Thus we need to calculate
portfolio beta for each of the three factors separately and then substitute it in the

69 CA BHAVIK CHOKSHI
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above formula in order to find the required return for the market portfolio.
Factor 1: Market
bFABCD
1
= WA bFA1 + WB bFB1 + WC bFC1 + WD bFD1

= 0.25 × 0.8 + 0.10 × 0.9 + 0.5 × 1.165 + 0.15 × 0.85

=1
Factor 2: Book Price
bFABCD = WA bFA2 + WB bFB2 + WC bFC2 + WD bFD2

hi
2

= 0.25 × 1.39 + 0.1 × 0.75 + 0.5 × 2.75 + 0.15 × 2.05

= 2.105

ks
Factor 3: Inflation
bFABCD
3
= WA bFA3 + WB bFB3 + WC bFC3 + WD bFD3

= 0.25 × 1.35 + 0.1 × 1.25 + 0.5 × 8.65 + 0.15 × 6.75

Using APT
= 5.8

K = RF + λF 1 bF 1 + λF 2 bF 2 + λF 3 bF 3
ABCD ABCD ABCD ABCD ABCD
ho
ABCD
C
e

= 4.5 + 6.85 × 1 + (3.5) × 2.105 + 0.65 × 5.8

= 7.7525%
ik

(b) Expected return of market (ABCD) using CAPM

In this case Market is F1, hence the risk premium would be (RM – RF) i.e 6.85% and
portfolio β will be 1 as calculated above for F1. Alternatively, we can directly take β of
av

market to itself as 1 under CAPM.

Using CAPM
Ke = RF + (RM – RF) × β
Bh

= 4.5% + 6.85% × 1
= 11.35%

(c) Factor 1: Market

As given, Mr. Nirmal Kumar only wants to hold small capital value (B) and large capital
growth (C) in his portfolio. Further, the target β is against the market (F1) only growth.
WB + WC = 1
Thus, WC = 1 - WB
Using Formula for portfolio β
F1
bBC
= WB bBF 1 + WC bCF 1

1 = WB × 0.9 + (1-WB) × 1.165

70 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

1 = 0.9 WB + 1.165 – 1.165 WB

(0.165) = (0.265 WB)
WB = 0.6226
i.e 62.26%
WC = 1 – 0.6226 = 0.3774
i.e 37.745%

hi
Question 9 (RTP May 21)/(MTP May 20)
[Q.52 - AFM 8 (Fast Track) & 9, Q.52 - AFM 10]

Equity of ABC Ltd. (ABCL) is ` 500 Crores, its debt, is worth ` 290 Crores. Printer Division

ks
segments value is attributable to 64%, which has an Asset Beta (βp) of 1.55, balance value is
applied on Spares and Consumables Division, which has an Asset Beta (βSC) of 1.40 ABCL Debt
beta (βD) is 0.28.
You are required to calculate:
(i) Equity Beta (βE), ho
(ii) Ascertain Equity Beta (βE), if ABC Ltd. decides to change its Debt Equity position by
raising further debt and buying back of equity to have its Debt to Equity Ratio at 1.50.
C
Assume that the present Debt Beta (βD1) is 0.45 and any further funds raised by way of
Debt will have a Beta (βD2) of 0.50.
(iii) Whether the new Equity Beta (βE) justifies increase in the value of equity on account of
ik

leverage?

Summary
av

Detailed Solution
Bh

(i) ABC LTD

The business of ABC Ltd Comprises of the printer Division and spares and consumable
division. Hence, the asset beta should also comprise of both the division i.e.,
βA = 64% × 1.55 + 36% × 1.4
= 1.496
Further, β D = 0.28 (Given)

D D
Thus, βA = βD × + βE ×
D+E D+E

290 500
1.496 = 0.28 × + βE ×
290 + 500 290 + 500

71 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

81.2 500
1.496 = + βE ×
790 790

1.496 = 0.103 + 0.633 βE

1.393
βE = βE = 2.20
0.633

(ii) Revised Equity Beta

hi
We have been told, that some additional debt would be raised. However, the proceeds
generated from additional debt are not separately added to the investment in the
business. Instead they have been used to buyback existing equity. Thus, in case, debt to

ks
equity ratio needs to be 1.5:1
Particulars Total Existing Add/Buyback
Debt 1.5 474 ? 290 184

Equity

Total
1

2.5
ho 316 ?

790
500

790
(474- 290)
(184)
(316 – 500)
C
βA = 1.496 → From 1
Since, ABC is still in the printer’s business (64%) and spares business (36%), the asset β
continues to be 1.496. Further we have been given that the existing debt (D1) has a β of
ik

0.45 and additional debt (D2) has β of 0.5

E D1 D2
βA = bE × + bD × + bD ×
av

D1 + D2 + E 1
D1 + D2 + E 2
D1 + D2 + E

316 290 184

1.496 = bE × + 0.45 × + 0.5 ×
790 790 790
1.496 = 0.4 βE + 0.2817
Bh

1.2143 = 0.4 βE
βE = 3.036
(iii) In case the price per share of equity increase due to increase in Beta, then the higher
leverage (debt) in justified, else not.

Question 10 (RTP May 22)

[Q.53 - AFM 8 (Fast Track) & 9, Q.53 - AFM 10]

Mr. A is holding 1000 shares of face value of ` 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:

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(i) Shares to be borrowed for 3 months from 01-01-2020 to 31-03-2020,

(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of the stock
quoted in Stock Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 01-01-2020.
Other Information:
(a) Cost of Bank Guarantee is 8% per annum,
(b) M/s ABC Ltd.’s share quoted in Stock Exchange on various dates are as follows:

hi
Date Share Price in Share Price in
Scenario - 1 Bullish Scenario - 2 Bearish
01-01-2020 1000 1000

ks
31-01-2020 1020 980
29-02-2020 1040 960
31-03-2020 1050 940

You are required to find out: ho

(c) On 29-02-2020, ABC declares a dividend of 25%

(i) Earning of Mr. A through Stock Lending Scheme in both the scenarios,
(ii) Total Earnings of Mr. A during 01-01-2020 to 31-03-2020 in both the scenarios,
C
(iii) What is the Profit or loss to M/s. XYZ by shorting the shares using through Stock
Lending Scheme in both the scenarios?
ik

Summary

Detailed Solution
av

(i) Earning of Mr. A from stock lending scheme

Scheme
Bh

PARTICULARS BULLISH BEARISH

Leading Fees
January 10.2 9.8
(1,020 × 1%) (980 × 1%)
February 10.4 9.6
(1,040 × 1%) (960 × 1%)
March 10.5 9.4
(1,050 × 1%) (940 × 1%)
Total Lending fees per share 31% 28.8
× Share lent 1,000 1,000
Total lending Fees (earnings) for Mr.A 31,100 28,800
from stock lending

73 CA BHAVIK CHOKSHI
 PORTFOLIO MANAGEMENT

Note:
Apart from the lending fees, Mr.A continues to have the right of an owner and hence
dividend earned during the 3 months will also be enjoyed by Mr. A. However, this dividend
would be earned, irrespective of the stock lending scheme and hence dividend is not
considered in Part – 1. However, it is considered while calculating total earnings in Part-2.
(ii) Total Earnings:
Particulars BULLISH BEARISH

hi
Lending Fees 31,100 28,800
+ Dividend Income 25,000 25,000
[(₹ 100 × 25%) × 1000]

ks
Total Earning 56,100 53,800

(iii) Profit / Loss to M/s XYZ

Particulars BULLISH BEARISH
Lending Charges
Bank Guarantee Charges
[1000 × 8% × 3/12] × 1000
1/1/20 p.a. shares
ho (31,100)
(20,000)
(28,800)
(20,000)
C
Gain/loss on short sold position (50,000) 60,000
[1,000 – 1,050] × 1000 [1,000 – 940] × 1000
S.P C.P S.P C.P
01/01/20 31/03/20 01/01/20 31/03/20
Overall gain /(loss) (1,01,100) 11,200
ik
av
Bh

74 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

CHAPTER 4 ADVANCED CAPITAL BUDGETING DECISIONS

Question 1 [Q.7 - AFM 8 (Fast Track) & 9, Q.7 - AFM 10]

Following are the estimates of the net cash flows and probability of a new project of M/s X Ltd.:
Particulars Year P = 0.3 P = 0.5 P = 0.2

hi
Initial investment 0 4,00,000 4,00,000 4,00,000
Estimated net after tax cash inflows per year 1 to 5 1,00,000 1,10,000 1,20,000
Estimated salvage value (after tax) 5 20,000 50,000 60,000

ks
Required rate of return from the project is 10%. Find:
(i) The expected NPV of the project.
(ii) The best case and the worst case NPVs.

overtime and independent overtime. ho

(iii) The probability of occurrence of the worst case if the cash flows are perfectly dependent

(iv) Standard deviation and coefficient of variation assuming that there are only three
streams of cash flow, which are represented by each column of the table with the given
C
probabilities.
(v) Coefficient of variation of X Ltd. on its average project which is in the range of 0.95 to
1.0. If the coefficient of variation of the project is found to be less risky than average,
ik

100 basis points are deducted from the Company’s cost of Capital Should the project be
accepted by X Ltd?
av

Summary

Detailed Solution
Bh

(i) Expected cash flows:

Year Net cash flows P.V. PV. @ 10%
0 (4,00,000 x 1) (-)4,00,000 1.000 (-)4,00,000
1 to 4 (1,00,000x0.3+1,10,000x0.5 1,09,000 3.170 3,45,530
+ 1,20,000 x 0.2)
5 [1,09,000 + (20,000 x 0.3 + 1,52,000 0.621 94,392
50,000 x 0.5 + 60,000 x 0.2)]
NPV = 39,922

75 CA BHAVIK CHOKSHI
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(ii) ENPV of the worst case

1,00,000 x 3.790 = ₹ 3,79,000 (Students may have 3.791 also the values will change
accordingly)
20,000 x 0.621 = ₹ 12,420/-
ENPV = (-) 4,00,000 + 3,79,000 + 12,420 = (-) ₹ 8,580/-
ENPV of the best case
ENPV = (-) 4,00,000 + 1,20,000 x 3.790 + 60,000 x 0.621 = ₹ 92,060/-.

hi
(iii) (a) Required probability = 0.3
(b) Required probability = (0.3)5 = 0.00243
(iv) The base case NPV = (-) 4,00,000 + (1,10,000 x 3.79) + (50,000 x 0.621)

ks
= ` 47,950/-
ENPV = 0.30 x (-) 8580 + 0.5 x 47950 + 92060 x 0.20 = ₹ 39,813/-
Therefore,

s ENpv =

Therefore, CV = 35,800/39,813 = 0.90

ho
0.3( −8580 − 39,813)2 + 0.5(47950 − 39813)2 + 0.2(92060 − 39813)2 = ₹ 35800 /-
C
(v) Risk adjusted out of cost of capital of X Ltd. = 10% - 1% = 9%. NPV
Year Expected net cash flow PV @ 9%
0 (-) 4,00,000 1.000 (-) 4,00,000
ik

1 to 4 1,09,000 3.240 3,53,160

5 1,52,000 0.650 98,800
ENPV = 51,960
av

Therefore, the project should be accepted.

Question 2 [Q.12 - AFM 8 (Fast Track) & 9, Q.12 - AFM 10]

Bh

The Easygoing Company Limited is considering a new project with initial investment, for a product
“Survival”. It is estimated that IRR of the project is 16% having an estimated life of 5 years.
Financial Manager has studied that project with sensitivity analysis and informed that annual
fixed cost sensitivity is 7.8416%, whereas cost of capital (discount rate) sensitivity is 60%.
Other information available are:
Profit Volume Ratio (P/V) is 70%, Variable cost ` 60/- per unit Annual Cash Flow ` 57,500/-
Ignore Depreciation on initial investment and impact of taxation.

Calculate
(i) Initial Investment of the Project

76 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

(ii) Net Present Value of the Project

(iii) Annual Fixed Cost
(iv) Estimated annual unit of sales
(v) Break Even Units
Cumulative Discounting Factor for 5 years
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%
3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127

hi
Summary

ks
Detailed Solution

(i) Initial Investment

IRR = 16% (Given)
At IRR, NPV shall be zero, thereforeho
Initial Cost of Investment = PVAF (16%,5) x Cash Flow (Annual)
= 3.274 x ` 57,500
C
= ₹ 1,88,255
(ii) Net Present Value (NPV)
Let Cost of Capital be X, then 16 − x = 60% x = 10%
ik

x
Thus NPV of the project
= Annual Cash Flow x PVAF (10%, 5) – Initial Investment
= ` 57,500 x 3.791 – ` 1,88,255
av

= ` 2,17,982.50 – ` 1,88,255 = ₹ 29,727.50

(iii) Annual Fixed Cost
Let change in the Fixed Cost which makes NPV zero is X. Then,
Bh

` 29,727.50 – 3.791X = 0 Thus X = ` 7,841.60

Let original Fixed Cost be Y then, Y × 7.8416% = ₹ 7,841.60
Y = ` 1,00,000
Thus Fixed Cost is equal to ` 1,00,000
(iv) Estimated Annual Units of Sales

` 60
Selling price per unit = = ` 200
100% − 70%

Annual cash flow + Fixed Cost

= Sales Value
P / V Ratio

` 57500 + ` 100000
= ` 225000
0.70

77 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

` 225000
Sales in units = = ` 1125 units
` 200
(v) Break Even Units
Fixed cost 100000
= = 714.285 Units
Contribution per unit 140

Question 3 [Q.16 - AFM 8 (Fast Track) & 9, Q.16 - AFM 10]

hi
XYZ Ltd. requires ` 8,00,000 for an unit. Useful life of project - 4 years. Salvage value - Nil.
Depreciation Charge ` 2,00,000 p.a. Expected revenues & costs (excluding depreciation) ignoring
inflation.

ks
Year 1 2 3 4
Revenues ` 6,00,000 ` 7,00,000 ` 8,00,000 ` 8,00,000
Costs ` 3,00,000 ` 4,00,000 ` 4,00,000 ` 4,00,000

1
ho
Tax Rate 60% cost of capital 10% (including inflation premium).
Calculate NPV of the project if inflation rates for revenues & costs are as follows:
Year Revenues
10%
Costs
12%
C
2 9% 10%
3 8% 9%
4 7% 8%
ik

Summary
av

Detailed Solution

Computation of Annual Cash Flow

Bh

(i) Inflation adjusted Revenues

Year Revenues (`) Revenues (Inflation Adjusted) (₹)
1 6,00,000 6,00,000(1.10) = 6,60,000
2 7,00,000 7,00,000(1.10)(1.09) = 8,39,300
3 8,00,000 8,00,000(1.10)(1.09)(1.08) = 10,35,936
4 8,00,000 8,00,000(1.10)(1.09)(1.08)(1.07) = 11,08,452

(ii) Inflation adjusted Costs

Year Revenues (`) Revenues (Inflation Adjusted) (`)
1 3,00,000 3,00,000(1.12) = 3,36,000
2 4,00,000 4,00,000(1.12)(1.10) = 4,92,800

78 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

3 4,00,000 4,00,000(1.12)(1.10)(1.09) = 5,37,172

4 4,00,000 4,00,000(1.12)(1.10)(1.09)(1.08) = 5,80,124
(iii) Tax Benefit on Depreciation = ₹ 2,00,000 x 0.60 = ` 1,20,000
(iv) Net Profit after Tax
Year Revenues Costs (Inflation Net Profit (`) Tax (`) Net after
(Inflation Adjusted) (3) = (1) - (2) (4) = 60% Profit (`)
Adjusted) (`)(2) of (3) (3) - (4)
(`)(1)

hi
1 6,60,000 3,36,000 3,24,000 1,94,400 1,29,600
2 8,39,300 4,92,800 3,46,500 2,07,900 1,38,600
3 10,35,936 5,37,172 4,98,764 2,99,258 1,99,506

ks
4 11,08,452 5,80,124 5,28,328 3,16,997 2,11,331

Present Value of Cash Inflows

Year Net after Tax Benefit on Cash Inflow PVF PV

1
2
profit
(`)
1,29,600
1,38,600
ho
Depreciation
(`)
1,20,000
1,20,000
(`)

2,49,600
2,58,600
@10%

0.909
0.826
(`)

2,26,886
2,13,604
C
3 1,99,506 1,20,000 3,19,506 0.751 2,39,949
4 2,11,331 1,20,000 3,31,331 0.683 2,26,299
9,06,738

NPV = ` 9,06,738 – ` 8,00,000 = ` 1,06,738

ik

Question 4 [Q.19 - AFM 8 (Fast Track) & 9, Q.19 - AFM 10]

av

A company has an old machine having book value zero – which can be sold for ` 50,000. The
company is thinking to choose one from following two alternatives:
(i) To incur additional cost of ` 10,00,000 to upgrade the old existing machine.
Bh

(ii) To replace old machine with a new machine costing ` 20,00,000 plus installation cost
` 50,000.
Both above proposals envisage useful life to be five years with salvage value to be nil. The
expected after tax profits for the above three alternatives are as under:
Year Old existing Machine (`) Upgraded Machine (`) New Machine (`)
1 5,00,000 5,50,000 6,00,000
2 5,40,000 5,90,000 6,40,000
3 5,80,000 6,10,000 6,90,000
4 6,20,000 6,50,000 7,40,000
5 6,60,000 7,00,000 8,00,000

79 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

The tax rate is 40 per cent.

The company follows straight line method of depreciation. Assume cost of capital to be 15
percent.
P.V.F. of 15%, 5 = 0.870, 0.756, 0.658, 0.572 and 0.497. You are required to advise the company
as to which alternative is to be adopted.

Summary

hi
Detailed Solution

ks
(A) Cash Outflow
Particulars `
(i) In case machine is upgraded:

(ii)
Upgradation Cost
In case new machine installed:
Cost
ho 10,00,000

20,00,000
C
Add: Installation cost 50,000
Total Cost 20,50,000
Less: Disposal of old machine
` 50,000 – 40% tax 30,000
ik

Total Cash Outflow 20,20,000

Working Note:
av

(i) Depreciation – in case machine is upgraded

` 10,00,000 ÷ 5 = ` 2,00,000
(ii) Depreciation – in case new machine is installed
Bh

` 20,50,000 ÷ 5 = ` 4,10,000
(iii) Old existing machine – Book Value is zero. So, no depreciation.
(B) Cash Inflows after Taxes (CFAT)
Old Existing Machine Upgraded Machine
= (iv)-(i)
Year (i) EAT/CFAT (ii) EAT (iii) DEP (iv) CFAT
Incremental
` ` ` `
CFAT `
1 5,00,000 5,50,000 2,00,000 7,50,000 2,50,000
2 5,40,000 5,90,000 2,00,000 7,90,000 2,50,000
3 5,80,000 6,10,000 2,00,000 8,10,000 2,30,000
4 6,20,000 6,50,000 2,00,000 8,50,000 2,30,000
5 6,60,000 7,00,000 2,00,000 9,00,000 2,40,000

80 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

Cash Inflows after Taxes (CFAT)

New Machine
Year (vi) EAT (vii) DEP (viii) CFAT (ix) = (viii) – (i)
` ` ` Incremental CFAT (`)
1 6,00,000 4,10,000 10,10,000 5,10,000
2 6,40,000 4,10,000 10,50,000 5,10,000
3 6,90,000 4,10,000 11,00,000 5,20,000

hi
4 7,40,000 4,10,000 11,50,000 5,30,000
5 8,00,000 4,10,000 12,10,000 5,50,000

P.V. at 15% - 5 Years – on Incremental CFAT

ks
*Acquisition Cost (including installation cost) ` 20,50,000
Less: Salvage Value of existing machine net of Tax ` 30,000
` 20,20,000

Year Incremental
CFAT
`
PVF ho
Upgraded Machine
Total P.V.
`
Incremental
CFAT
New Machine
PVF Total PV
`
C
1 2,50,000 0.870 2,17,500 5,10,000 0.870 4,43,700
2 2,50,000 0.756 1,89,000 5,10,000 0.756 3,85,560
3 2,30,000 0.658 1,51,340 5,20,000 0.658 3,42,160
4 2,30,000 0.572 1,31,560 5,30,000 0.572 3,03,160
ik

5. 2,40,000 0.497 1,19,280 5,50,000 0.497 2,73,350

Total P.V. of CFAT 8,08,680 17,47,930
av

Less: Cash Outflows 10,00,000 20,20,000*

N.P.V. = -1,91,320 - 2,72,070

As the NPV in both the new (alternative) proposals is negative, the company should
Bh

continue with the existing old Machine.

OPTIMUM REPLACEMENT TIME

Question 5  (ICAI SM)/(ICAI Paper May 24)

[Q.22 - AFM 8 (Fast Track) & 9, Q.22 - AFM 10]

A machine used on a production line must be replaced at least every four years. Costs incurred
to run the machine according to its age are:
Age of the Machine (years)
0 1 2 3 4
Purchase price (in `) 60,000

81 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

Maintenance (in `) 16,000 18,000 20,000 20,000

Repair (in `) 0 4,000 8,000 16,000
Scrap Value (in `) 32,000 24,000 16,000 8,000

Future replacement will be with identical machine with same cost. Revenue is unaffected by the
age of the machine. Ignoring inflation and tax, determine the optimum replacement cycle. PV
factors of the cost of capital of 15% for the respective four years are 0.8696, 0.7561, 0.6575
and 0.5718.

hi
Summary

ks
Detailed Solution

Working Notes

Year
0
Replacement Cost
(60,000)
ho
First of all, we shall calculate cash flows for each replacement cycle as follows:
One Year Replacement Cycle
Maintenance & Repair
-
Residual Value
-
Net cash Flow
(60,000)
C
1 - (16,000) 32,000 16,000

Two Years Replacement Cycle

Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
ik

0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) 24,000 2,000
av

Three Years Replacement Cycle

Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
Bh

2 - (22,000) - (22,000)
3 - (28,000) 16,000 (12,000)

Four Years Replacement Cycle

Year Replacement Cost Maintenance & Repair Residual Value Net cash Flow
0 (60,000) - - (60,000)
1 - (16,000) - (16,000)
2 - (22,000) - (22,000)
3 - (28,000) - (28,000)
4 - (36,000) 8,000 (28,000)

82 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

Now we shall calculate NPV for each replacement cycles

1 Year 2 Years 3 Years 4 Years
PVF@ Cash Cash Cash
Year PV PV PV Cash Flows PV
15% Flows Flows Flows
0 1 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000 -60,000
1 0.8696 16,000 13,914 -16,000 -13,914 -16,000 -13,914 -16,000 -13,914
2 0.7561 - - 2,000 1,512 -22,000 -16,634 -22,000 -16,634
3 0.6575 - - - 0 -12,000 -7,890 -28,000 -18,410

hi
4 0.5718 - - - 0 0 -28,000 -16,010
-46,086 -72,402 -98,438 -1,24,968

ks
Replacement Cycles EAC (₹)
46086
1 Year 0.8696
52,997

2 Years

3 Years
ho 72402
1.6257

98438
2.2832

124968
44,536

43,114
C
4 Years 43,772
2.855

Since EAC is least in case of replacement cycle of 3 years hence machine should be replaced
ik

after every three years.

Note: Alternatively, Answer can also be computed by excluding initial outflow as there will be
av

no change in final decision.

Question 6 [Q.25 - AFM 8 (Fast Track) & 9, Q.25 - AFM 10]

Bh

L & R Limited wishes to develop new virus-cleaner software. The cost of the pilot project
would be ` 2,40,000. Presently, the chances of the product being successfully launched on a
commercial scale are rated at 50%. In case it does succeed. L&R can invest a sum of ` 20 lacs
to market the product. Such an effort can generate perpetually, an annual net after tax cash
income of ` 4 lacs. Even if the commercial launch fails, they can make an investment of a smaller
amount of ` 12 lacs with the hope of gaining perpetually a sum of ` 1 lac. Evaluate the proposal,
adopting decision tree approach. The discount rate is 10%.

83 CA BHAVIK CHOKSHI
 ADVANCED CAPITAL BUDGETING DECISIONS

Summary

Detailed Solution

Decision tree diagram is given below:

Invest 20L
Success 0.5 Income 4L perpetuity

hi
C Not to Invest
) B Invest 12L
,000
(2,40 Failure 0.5 Income 1L perpetuity

ks
st D Not to Invest
Te
A
No
Te
st

Evaluation
ho
At Decision Point C: The choice is between investing ` 20 lacs for a perpetual benefit of ` 4 lacs
C
and not to invest. The preferred choice is to invest, since the capitalized value of benefit of ` 4
lacs (at 10%) adjusted for the investment of ` 20 lacs, yields a net benefit of ` 20 lacs.
At Decision Point D: The choice is between investing ` 12 lacs, for a similar perpetual benefit
ik

of ` 1 lac. and not to invest. Here the invested amount is greater than capitalized value of
benefit at ` 10 lacs. There is a negative benefit of ` 2 lacs. Therefore, it would not be prudent
to invest. At Outcome Point B: Evaluation of EMV is as under (` in lacs).
av

Outcome Amount (`) Probability Result (`)

Success 20.00 0.50 10.00
Failure 0.00 0.50 00.00
Bh

Net result 10.00

EMV at B is, therefore, ` 10 lacs.

At A: Decision is to be taken based on preferences between two alternatives. The first is to
test, by investing ` 2,40,000 and reap a benefit of ` 10 lacs. The second is not to test, and
thereby losing the opportunity of a possible gain.
The preferred choice is, therefore, investing a sum of ` 2,40,000 and undertaking the test.

84 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

CHAPTER 5 MUTUAL FUNDS

Question 1 (ICAI Paper May 22)

[Q.8 - AFM 8 (Fast Track) & 9, Q.8 - AFM 10]

Mr. D had invested in three mutual funds (MF) as per the following details:
Particulars MF ‘A’ MF ‘B’ MF ‘C’

hi
Amount of Investment 2,00,000 5,00,000 4,00,000
NAV at the time of purchase 10.00 25.00 20.00
Dividend Yield up to 31.03.2022 3% 5% 4%

ks
NAV as on 31.03.2022 10.50 22.80 20.80
Annualized Yield as on 31.03.2022 9.733% - 11.185% 15%

Assume 1 Year = 365 Days.

out the following: ho

Mr. D has misplaced the documents of his investments. You are required to help Mr. D to find

(i) Number of units allotted in each scheme,

(ii) Value of his investments as on 31.03.2022,
C
(iii) Holding period of his investments in number of days as on 31.03.2022
(iv) Dates of original investments
(v) Total Return on investments,
ik

(vi) Assuming past performance of all three schemes will continue for next one year, what
action the investor should take? What will be the expected return for the next one year
after the above action?
av

(vii) Will your answer as above point no. (vi) changes if the Mutual fund charges exit load of
5% if the investment is redeemed within one year? If so, advise the investor what and
when the action to be taken to optimise the returns.
Bh

Summary

Detailed Solution

(i) Number of Units in each Scheme

Scheme Amount
` 2, 00, 000
MF ‘A’ 20,000
` 10.00

` 5, 00, 000
MF ‘B’ 20,000
` 25.00
` 4, 00, 000
MF ‘C’ 20,000
` 20.00

85 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

(ii) Value of Investment on 31.03.2022

Scheme Amount
MF ‘A’ = 20,000 x ` 10.50 ` 2,10,000
MF ‘B’ = 20,000 x ` 22.80 ` 4,56,000
MF ‘C’ = 20,000 x ` 20.80 ` 4,16,000
Total ` 10,82,000

hi
(iii) Yield on each Fund
Scheme Capital Yield Dividend Yield Total Yield (%)
MF ‘A’ ` 2,10,000 - ` 2,00,000 ` 6,000 ` 16,000.00 8.00

ks
= ` 10,000

MF ‘B’ ` 4,56,000 - ₹ 5,00,000 ` 25,000 - ` 19,000.00 -3.80

= - ₹ 44,000

MF ‘C’

Total
= ` 16,000

No. of Days Investment Held

ho
` 4,16,000 - ` 4,00,000 ` 16,000 ` 32,000.00

` 29,000.00
8.00
C
MF ‘A’ MF ‘B’ MF ‘C’
Period of Holding (Days) 8.00 -3.80 8.00
×365 ×365 ×365
9.733 -11.185 15.00
ik

= 300 Days = 124 Days = 195 Days

(iv) Date of Original Investment 04.06.21 27.11.21 17.09.21

av

` 29, 000
(v) Total Yield = × 100 = 2.636%
` 11, 00, 000
Bh

(vi) If past of all three schemes will continue for next one year, the investor should redeem
the units of MFs ‘A’ and ‘B’ and invest the proceeds in MF ‘C’. The expected return next
will be 15%.
(vii) If the Mutual funds are charging exit load of 5%, if investment is redeemed within one
year, then investor should get redeemed units of MF ‘B’ now and units of MF ‘A’ after 65
days.

Question 2 (ICAI SM)/(Practice Manual)

[Q.11 - AFM 8 (Fast Track) & 9, Q.11 - AFM 10]

Mr. X on 1.7.2000 during the initial offer of some Mutual Fund invested in 10,000 units having
face value of ` 10 for each unit. On 31.3.2001 the dividend offered by the M.F. was 10% and

86 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

Mr. X found that his annualised yield was 153.33%. On 31.3.2002, 20% dividend was given.
On 31.3.2003 Mr. X redeemed all his balance of 11,296.11 units when his annualised yield was
73.52%. What are the NAVs as on 31.3.2001, 31.3.2002 and 31.3.2003?

Summary

Detailed Solution

hi
Reference Note: In this Question, we can infer that the given plan is the dividend re-investment
plan because we have originally invested in 10,000 units only. However, on 31/3/03 - 11,296.11

ks
units have been redeemed. In absence of information about fresh investment or bonus issue, the
increase in numbers of units can be attributed to dividend re investment plan.

2001
Let NAV as on 31/3/01 be ` x per unit ho
Dividend is distributed on 31/3/01 and in case of dividend re-investment plan, new units would
be allotted based on NAV as on 31/3/01 i.e., x
C
Total dividend
Thus, Additional units = NAV on date of distribution
ik

` 1, 00, 000 × 10%

=
x

` 10, 000
=
av

Thus, Annualized yield (01/07/2000 – 31/03/2001) i.e., 9 months

 10, 000 
153.33
=  10, 000 +  × x − 1, 00, 000] × 100 × 12 / 9
Bh

 x 
1, 00, 000

153.33 × 9 10, 000 x – 90, 000

=
100 × 12 1, 00, 000

10, 000x – 90, 000

1.15 =
1, 00, 000

1,15,000 = 10,000x – 90,000

10,000x = 2,05,000
X = ` 20.50 (NAV as on 31/03/01)
New units = ` 10,000 / ` 20.5 = 487.80 units

87 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

Thus units as on 31/3/01 = 10,000 + 487.80

= 10,487.80 units

2002
There is no dividend distribution in year 3 (2003). Hence, any additional units will have to be
attributable to the dividend of year 2002.
New units (2002) = 11,296.11 – 10,487.80

hi
= 808.31

Total Dividend
New units (2002) = NAV on 31 / 3 / 02

ks
Let NAV (31/3/02) be ` y

(10, 487.80 × `10 ) × 20%

808.31 =
y

y = ` 25.95
2003
(NAV as on 31/03/02)

Annualized yield = 73.52% p.a

ho
C
Ref: Return for the entire holding period i.e., 01/07/00 to 31/3/03 i.e., 33 months recorded on
% p.a basis
ik

73.52 =
(11, 296.11 × z ) – 1, 00, 000
× 100 ×
12
1, 00, 000 33

2,02,180 = 11,296.11z – 1,00,000

av

3,02,180 = 11,296.11z
Therefore, z = ` 26.75/unit
Bh

Question 3 (RTP May 23)/(ICAI Paper Nov 20)

[Q.14 - AFM 8 (Fast Track) & 9, Q.14 - AFM 10]

M/S. Corpus an AMC, on 1.04.2015 has floated two schemes viz. Dividend Plan and Bonus Plan. Mr.
X, an investor has invested in both the schemes. The following details (except the issue price)
are available:
Date Dividend (%) Bonus Ratio NAV
Dividend Plan Bonus Plan
1.04.2015 ? ?
31.12.2016 1 :4 (One unit on 4 47 40
units held)
31.03.2017 12 48 42

88 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

31.03.2018 10 50 39
31.12.2018 1 :5 (One unit on 5 46 43
units held)
31.03.2019 15 45 42
31.03.2020 - - 49 44

Additional details
Investment (`) ` 9,20,000 ` 10,00,000
Average Profit (`) ` 27, 748.60

hi
Average Yield (%) 6.40
You are required to calculate the issue price of both the schemes as on 1.04.2015.

ks
Summary

Detailed Solution

(i) Dividend Plan

(a)
(b)
ho
Average Annual gain over a period of 5 Years
Total gain over a period of 5 years (a × 5)
` 27748.60
` 138743
C
(c) Initial Investment ` 920000
(d) Total value of investment (b+c) ` 1058743
(e) NAV as on 31.3.2020 ` 49
ik

(f) Number of units at the end of the period as on 31.03.2019 (d/e) 21607

1 2 3 4 = (2×3) 5 6 = (1×4) 7
(4+5)
av

Period Units Rate Unit Dividend NAV New Units* Balance Units Pre
held value Dividend

31.03.2019 21607 0.15 10 1.5 45 697 20910

Bh

31.03.2018 20910 0.1 10 1 50 410 20500

31.03.2017 20500 0.12 10 1.2 48 500 20000

Issue Price as on 01.04.2015 Investment 920000/Units purchased 20000 (c/i)

= ` 46
* Let the units issued be X
X = (Closing Units/NAV + Dividend) x Dividend
(ii) Bonus Plan
(a) Average Yield 0.064
(b) Investment ` 10,00,000
(c) Gain over a period of 5 years (a × b × 5) ` 3,20,000
(d) Market Value as on 31.03.2019 (b + c) ` 13,20,000

89 CA BHAVIK CHOKSHI
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(e) NAV as on 31.03.2020 ` 44

(f) Total units as on 31.03.2020 (d/e) 30,000
(g) No of units as on 31.12.2018 Pre bonus = 30,000 × 5/(5 + 1) 25,000
(h) No of units as on 31.12.2016 Pre bonus = 25,000 × 4/(4 + 1) 20,000
(i) Issue Price as on 01.04.2015 Investment 10,00,000/Units ` 50
purchased 20000 (b/h)

Question 4 (ICAI SM)/(ICAI Paper Dec 21)/(RTP May 24)/

hi
(RTP Nov 20)/(RTP May 19)/(MTP April 23)/
(MTP Nov 21)
[Q.20 - AFM 8 (Fast Track) & 9, Q.20 - AFM 10]

ks
There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual Fund Ltd. Each having close
ended equity schemes.
NAV as on 31-12-2014 of equity schemes of D Mutual Fund Ltd. is ` 70.71 (consisting 99% equity

balance in cash).
Following is the other information:
ho
and remaining cash balance) and that of K Mutual Fund Ltd. is 62.50 (consisting 96% equity and

Equity Schemes
C
Particulars
D Mutual Fund Ltd. K Mutual Fund Ltd.
Sharpe Ratio 2 3.3
Treynor Ratio 15 15
ik

Standard deviation 11.25 5

There is no change in portfolios during the next month and annual average cost is ` 3 per unit
for the schemes of both the Mutual Funds.
av

If Share Market goes down by 5% within a month, calculate expected NAV after a month for
the schemes of both the Mutual Funds.
For calculation, consider 12 months in a year and ignore number of days for particular month.
Bh

Summary

Detailed Solution

1. D Mutual Fund
NAV0 = ` 70.71 (31/12/14)
NAV1 = ? (31/01/15)
In order to find the change in the value of equity investments, we need to find the β
i.e

90 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

RD − RF
2. Sharpe ratio =
sD
RD - RF
2=
11.25

RD – RF = 22.5

RD - RF
Treynor’s Ratio =

hi
bD

22.5
15 =
bD

ks
bD = 1.5
3. Break – up of NAV
Equity Investments: 70.71 × 99%

Cash: ` 70.71 × 1%
= ` 0.71
= ` 70
ho
C
4. Expected NAV
Equity Investments: ` 70 – (` 70 × 7.5%)
= ` 64.75
Cash: 0.71 – (3/12) = 0.71 – 0.25
ik

= ` 0.46
Expected NAV1 = ` 65.21
av

Reference Note: We have been given that the market falls by 5%. The Equity portfolio of the
DMF has a β of 1.5 and hence the fall in D mutual fund’s equity component equals = 5% × 1.5 =
7.5%
Bh

Further, the cash component Changes as the expenses of ` 3 is the expense per annum per unit,

1
hence the monthly expense = ` 3 × = ` 0.25
12

Question 5 (RTP Nov 20)/(MTP March 19)/(Practice Manual)

[Q.22 - AFM 8 (Fast Track) & 9, Q.22 - AFM 10]

Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering following three
alternatives:
(i) Invest ` 2,00,000 in Mutual Fund X (MFX)
(ii) Invest ` 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)

91 CA BHAVIK CHOKSHI
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Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate of
return is 10% and market rate of return is 12%.
Particulars MFX MFY Mix
MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100

Covariance of returns of MFX, MFY and market portfolio Mix are as follows:

hi
You are required to calculate:
(i) variance of return from MFX, MFY and market return,
(ii) portfolio return, beta, portfolio variance and portfolio standard deviation,

ks
(iii) expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix

Summary

Detailed Solution
ho
C
Given data
Particulars MF- X MF-Y Market (MFX)
Return 15% 14% 12%
ik

COVAR (X Y): 4.3 (Intersection of X and Y in table)

COVAR (X M): 3.37
COVAR (Y M): 2.80
av

Variance
s X2 = 4.80 (Intersection of x with itself)
Bh

s Y2 = 4.25
s M2 = 3.10
Solution:
(i) Variance
Reference: In this question, COVAR (X,X), COVAR (Y,Y) and COVAR (M,M) is given

∑ ( x - x )( x - x )
Thus, COVAR (x,x) =
N

∑ (x − x )
2

=
N

= s X2

92 CA BHAVIK CHOKSHI
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From the given table

Covar (X,X) = s X2 = 4.80
Covar (Y,Y) = s Y2 = 4.25
Covar (M,M) = s M2 = 3.10
(ii) Alternative 1: 100% MF - X
Portfolio Return = RX = 15%
Portfolio β = βx = COVAR (XM) s M2

hi
3.37
=
3.10

ks
bX = 1.087

Portfolio variance = 2σx = 4.8 (given)

Portfolio standard deviation = σx =
Alternative 2: 100% MF-Y = 2.19
Portfolio Return = RY = 14%
ho 4.8 =

Portfolio β = βy = COVARym/ s M2 = 2.8/3.1 = 0.903

2.19
C
Portfolio variance = 2σY = 4.25 (given)
Portfolio standard deviation = σY = 4.472 = 2.06
ik

Alternative 3: MF – X: 60% (1,20,000/2,00,000) and MFY = 40% (80,000/2,00,000)

Portfolio Return = RXY = WxRx + WyRy
= 0.6 × 15% + 0.4 × 14%
av

= 14.6%

Portfolio β = βXy = WXβX + WYβy

Bh

= 0.6 × 1.087 + 0.4 × 0.903

= 1.013

Portfolio Variance = 2σxy = W2X σ2X + W2Yσ2y + 2WX WYCOVAR XY

= 0.62 × 4.8 + 0.42 × 4.25 + 2 × 0.6 × 0.4 × 4.3
= 4.472

Portfolio Standard Deviation = σXY = 4.472 = 2.11

(iii) Alternative 1: 100% X
a. Expected return: (Using CAPM)
Ke = RF + (RM – RF) × βx

93 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

= 10% + (12% – 10%) × 1.087

= 12.174%
b. Systematic Risk = β2x σ2M
= (1.087)2 × 3.10
= 3.663
c. Un-systematic Risk (E2x) = Total Variance (σ2x)– Systematic Risk (E2x)
= 4.8 – 3.663

hi
= 1.137
Alternative 2: 100% Y
a. Expected return (using CAPM)

ks
Ke = RF + (RM - RF) βY
Ke = 10% + (12% - 10%) × 0.903
= 11.806%

b. Systematic Risk
= β2Y × σ2M
= (0.903)2 × 3.10
= 2.528
ho
C
c. Unsystematic Risk
Unsystematic Risk = Total Variance (σ2y) – System Risk (E2y)
= 4.25 – 2.528
ik

= 1.722
Alternative 3
Ke = 10% + (12% -10%) × 1.013 (βXY) = 12.026%
av

Systematic Risk
= (1.013)2 × 3.10
= 3.181
Bh

Unsystematic Risk
= 4.472 – 3.181
= 1.291
Particulars Share Ratio Treynor’s Ratio Jensen’s Alpha
RX – RF/σX Rx – RF/βX Rx - KE
MF - X 15 - 10/2.19 15 - 10/1.087 15 - 12.174
= 2.283 = 4.600 = 2.826
MF - Y 14 - 10/2.06 14 - 10/0.903 14 - 11.806
= 1.942 =4.430 = 2.194
Portfolio 14.6 – 10/2.11 14.6 - 10/1.013 14.6 - 12.026
= 2.180 = 4.541 = 2.574
MTX(Market) 12 - 10/ 3.10 12-10/1 12 - 12
= 1.136 = 2.000 = 0

94 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

Question 6 (RTP May 19)/(MTP April 23)/(MTP Oct 23)/(RTP

Nov 23)/(Practice Manual)
[Q.26 - AFM 8 (Fast Track) & 9, Q.26 - AFM 10]

Indira has a fund of ` 3 lakhs which she wants to invest in share market with rebalancing
target after every 10 days to start with for a period of one month from now. The Present
NIFTY is 5326. The minimum NIFTY within a month can at most be 4793.4. She wants to
know as to how she should rebalance her portfolio under the following situations, according to

hi
the theory of constant proportion portfolio insurance policy, using “2” as the multiplier:
(i) Immediately to start with
(ii) 10 days later being the 1st day of rebalancing if NIFTY falls to 5122.96. 10 days further

ks
from the above date if NIFTY touches 5539.04
For the sake of simplicity, assume that the value of her equity component will change in
tandem with that of the NIFTY and the risk free securities in which she is going to invest will
have no Beta.

Summary
ho
C
Detailed Solution

Immediate Allocation (Day 0)

ik

1. Investment horizon = 1 Month

The Maximum fall (%) = 4,793.4 – 5,326.0 × 100
5,326.0
av

= (10%)
2. Floor Value = ` 3,00,000 – 10% × 3,00,000
= 2,70,000
Bh

Ref → Since the equity changes in tandem with Nifty, the fall in Nifty would help us calculate
the fall in the equity component as well.
3. Cushion = 3,00,000 – 2,70,000
= ` 30,000
4. Allocation to equity (Day 0)
= 30,000 × 2
= 60,000
Thus allocation to debt
= 3,00,000 - 60,000
= 2,40,000

95 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

Day 10
1. Revised Portfolio

60,000 5,326
Equity = ` 57,713
? 5,122.96

Debt (same) ` 2,40,000

Revised Portfolio ` 2,97,713

hi

2. Revised Cushion = ` 2,97,713 – ` 2,70,000 = ` 27,713
3. Rebalancing Portfolio

ks
Equity (27,713 × 2) 55,426 For Reference : [-2,287]
Debt (balancing) 2,42,287 For Reference : [+2,287]
(2,97,713 – 55,426)

Day 20
1.
Portfolio

Revised Portfolio
ho
2,97,713
C
 55, 426 → 5,122.96 
Equity ` 59,928  =
? ← 5, 539.04 
Debt ` 2,42,287
ik

Portfolio ` 3,02,215
2. Revised Cushion
= ` 3,02,215 – ` 2,70,000
av

= ` 32,215
3. Rebalancing Portfolio
Equity (32,215 × 2) 64,430 (Ref + 4,502 - 4,502)
Bh

Debt (balance figure) 2,37,785

Portfolio 3,02,215
Ref - CPPI method allocates more to equity in a rising market (Day 20) and allocates less
to equity in the falling market (Day 10).

Question 7 (ICAI SM)/(MTP Aug 18)/(MTP April 19)/

(RTP May 22)/(ICAI Paper Jan 21)
[Q.28 - AFM 8 (Fast Track) & 9, Q.28 - AFM 10]

On 1st April, an open ended scheme of mutual fund had 300 lakh units outstanding with Net
Assets Value (NAV) of ` 18.75. At the end of April, it issued 6 lakh units at opening NAV plus
2% load, adjusted for dividend equalization. At the end of May, 3 Lakh units were repurchased

96 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

at opening NAV less 2% exit load adjusted for dividend equalization. At the end of June, 70%
of its available income was distributed.

In respect of April-June quarter, the following additional information are available:

Particulars ` in lakh
Portfolio value appreciation 425.47
Income of April 22.950

hi
Income for May 34.425
Income for June 45.450

You are required to calculate

ks
(i) Income available for distribution;
(ii) Issue price at the end of April;
(iii) repurchase price at the end of May; and net asset value (NAV) as on 30th June.

Summary

Detailed Solution
ho
C
(i) Income available for distribution
Particulars `
ik

Income of April 22.950

Income of May 34.425
Income of June 45.450
Dividend Equalisation Received (April) 0.459
av

Dividend Equalisation Paid (May) (0.567)

Income available for distribution 102.717

Income distributed = 102.717 x 70% = 71.9019

Bh

Ref: Assuming 100% distribution

102.717
Dividend = = ` 0.339/u
303

Income available for distribution will also include adjustments for dividend equalisation
received/paid. However, unlike NAV, the amount available for distribution is based on
realised income only and hence portfolio appreciation (unrealised) is not a part of the
income available for calculation.
(ii) Issue price at end of April
Opening NAV 18.750
(+) Entry load (2% × 18.75) 0.375

97 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

(+) Dividend equalisation (WN - 1) 0.0765

Issue Price 19.2015

22.95
WN – 1: April: = 0.0765
300

Ref: Gross proceeds received in April from new unit holders = (` 19.2015 × 6)
= ` 115.209

hi
Out of which, proceeds attributable to dividend equalisation = ` 0.0765 x 6 = ` 0.459

ks
(iii) Redemption/repurchase price at the end of May:
Opening NAV 18.75
(-) Exit Load at 2% (0.375)
(+) Dividend equalisation
 22.95 34.425

 300
April
+
306
=

0.189 

May
ho
0.189
C
Redemption Price 18.564

Ref: Gross proceeds paid to redeeming unit holders in May

ik

= 3,00,000 × ` 18.564
= ` 55.692 Lakhs
Out of which, proceeds attributable to dividend equalisation
av

= 3 × ` 0.189
= ` 0.567 Lakhs
Bh

Extra: There had been no new issue/redemption in June. Hence, we don’t need to find
issue price/redemption price in June. However, in case the dividend equalisation per unit
was to be calculated for June, it would be:
22.95 34.425 45.45
+ +
300 306 303

(iv) NAV on 30th June

Opening Net Asset (300 lakh × ` 18.75) 5,625.00
Add: Portfolio Appreciation 425.47
Add: Issue Proceeds (6 lakh × ` 19.2015) 115.209
Less: Redemption proceeds (55.692)
(3 lakh × ` 18.564)

98 CA BHAVIK CHOKSHI
 MUTUAL FUNDS

Add: Income
April 22.95
May 34.42
June 45.45
Less: Dividend distributed (102.717×70%) (71.90)
Net Assets (30/6) 6,140.91
÷ Units (30/6) 303
NAV (30/6) ` 20.27

hi
Reference Note:
1. We have taken the issue price and redemption price of the new units issued and units
redeemed including dividend equalisation and load adjustments. Therefore, no separate

ks
adjustment needs to be done for dividend equalisation/load at the time of NAV calculation
on 30th June.
2. NAV includes all possible changes in net assets which can arise due to portfolio

ho
appreciation, incomes earned and dividend distribution and also changes in cash balances
due to issue/redemption.
C
ik
av
Bh

99 CA BHAVIK CHOKSHI
 RISK MANAGEMENT

CHAPTER 6 RISK MANAGEMENT

Question 1 (ICAI Paper May 23)

[Q.4 - AFM 8 (Fast Track) & 9, Q.4 - AFM 10]

Mr. Bull is a rational risk taker. He takes his position in a single stock for 4 days in a week. He
does not take a position on Friday to avoid weekend effect and takes position only for four days

hi
in a week i.e. Monday to Thursday. He transfers the amount on Monday morning and withdraws
the balance on Friday morning. He desires to make a maximum investment where Value At Risk
(VAR) should not exceed the balance lying in his bank account. The position by his manager, as

ks
per standing instructions, is taken on the free balance lying in the bank account in the morning
on each Monday.
On Monday morning (before opening of the capital market) he has transferred an amount of

ho
` 11 Crore to his bank account. A fixed deposit also matured on this Monday. The maturity
amount of ` 63,42,560 was also credited to his account by the bank in the morning of the
Monday. However, Mr. Bull received the intimation of the same in the evening. The bank needs
a minimum balance of ` 1,000 all the time. The value of Z score, at the required confidence level
C
of 99 percent is 2.33.
The other information with respect to stocks X and Y, which are under consideration for this
week, is as under:
ik

The other information with respect to stocks X and Y, which are under consideration for this
week, is as under:
X Y
av

Return Probability Return Probability

6 0.10 4 0.10
7 0.25 6 0.20
8 0.30 8 0.40
Bh

9 0.25 10 0.20
10 0.10 12 0.10

You are required to recommend a single stock, where maximum investment can be made

Summary

Detailed Solution

Working Notes:
(1) Security X

100 CA BHAVIK CHOKSHI

 RISK MANAGEMENT

Return (1) Prob. (2) (1) x (2) Deviation2 Deviation2 Deviation2 x Prob.
6 0.10 0.60 -2 4 0.40
7 0.25 1.75 1 1 0.25
8 0.30 2.40 0 0 0
9 0.25 2.25 1 1 0.25
10 0.10 1.00 2 4 0.40
8.00 1.30

hi
Expected Return (Rx) = 8.00% Variance (s X ) = 1.30
Standard Deviation (s X ) = 1.30 = 1.14
(2) Security Y

ks
Return (1) Prob. (2) (1) x (2) Dev. Dev.2 Dev.2 x Prob.
4 0.10 0.40 -4 16 1.60
6 0.20 1.20 -2 4 0.80
8
10
12
0.40
0.20
0.10

Expected Return (RY) = 8.00%

ho 3.20
2.00
1.20
8.00
0
2
4
0
4
16
0
0.80
1.60
4.80
C
Variance (s2 ) = 4.80
Standard Deviation=
(s Y ) =
4.80 2.19
Particulars No. of days X Y
ik

Amount Transferred ` 11,00,00,000 ` 11,00,00,000

Maturity Proceeds of Fixed Deposit ` 63,42,560 ` 63,42,560
Amount available in bank account ` 11,63,42,560 ` 11,63,42,560
av

Minimum balance to be kept ` 1,000 ` 1,000

Available amount which can be used ` 11,63,41,560 ` 11,63,41,560
for potential investment for 4 days
Maximum loss for 4 days at 99% level 4 ` 11,63,41,560 ` 11,63,41,560
Bh

Maximum loss for 1 day at 99% level

Maximum loss for 4 days/ 1 ` 5,81,70,780 ` 5,81,70,780
No. of days
= 116341560/4
Z Score at 99% level 2.33 2.33
Volatility in terms of ` ` 2,49,66,000 ` 2,49,66,000
(Maximum Loss/Z Score at 99% Level)
Standard Deviation 0.0114 0.0219
Maximum Investment (Volatility in ` 2,19,00,00,000 ` 1,14,00,00,000
terms of `/SD)
Recommendation: Position should be taken in X.

101 CA BHAVIK CHOKSHI

 Business Valuation

CHAPTER 7 BUSINESS
BUSINESS VALUATION
VALUATION

Question 1 (ICAI SM)/(Practice Manual)

[Q.5 - AFM 8 (Fast Track) & 9, Q.5 - AFM 10]

H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012. The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as follows:

hi
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
Particulars H. Ltd B. Ltd.
Liabilities

ks
Paid up Share Capital
- Equity Shares of ` 100 each 350.00 --
- Equity Shares of ` 10 each -- 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets
Net Fixed Assets
Net Current Assets
Deferred Tax Assets
ho 220.00
1,020.00
60.00
0.50
29.00
2.00
C
Total 1,300.00 31.50

H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of the
scheme of buying:
ik

(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4
years are ` 300 crores and ` 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.
av

(3) H Ltd. has a contingent liability of ` 300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of ` 100 each to the shareholders of B Ltd. in terms of the
exchange ratio as arrived on a Fair Value basis. (Please consider weights of 1 and 3
Bh

for the value of shares arrived on Net Asset basis and Earnings capitalization method
respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Ltd. on a
Fair value basis (taking into consideration the assumption mentioned in point 4 above.)

Summary

Detailed Solution

102 CA BHAVIK CHOKSHI

 BUSINESS VALUATION

1. Net Asset Value (NAV)

Particulars H B
(` In crores) (` In crores)
Net Fixed Assets 220 0.5
Net Current Assets 1,020 29
Deferred tax Assets 60 2
Less: Contingent Liabilities (300) -
(Note – 1)

hi
Net Assets 1,000 31.5
Divided: Shares ÷ 3.5 0.65
(` 350 ÷ 100) (` 6.5 ÷ 10)

ks
NAV ` 285.71 ` 48.46

Note – 1:
We have assumed that the contingent liability will settle in full i.e., 300 and hence

ho
considered while calculating NAV. (In line with ICAI’s solution)
Alternatively, it can be assumed that the contingent is not expected to be settled in
which case we can take NIL in the above workings.
2. Earning Capitalization Method.
C
` 300 Cr
H = 3,750
0.08

` 10 Cr
ik

B = 125
0.08

Value per Share (V.P.S)

av

3, 750
H = 1,071.43
3.5

125
B = 192.31
Bh

0.65

3. Fair Value Per Share

V .P .S ( NAV ) × 1 + V .P .S (Earnings ) × 3
Fair Value =
1 + 3

285.71 × 1 + 1, 071.43 × 3
H =
1 + 3

3, 500
=
4

= 875

103 CA BHAVIK CHOKSHI

 BUSINESS VALUATION

48.46 × 1 + 192.31 × 3
B =
1 + 3

625.39
=
4

= 156.35

hi
Fair value of B
Exchange Ratio (Based on fair value) =
Fair value of H

156.35
=

ks
875

= 0.1787:1

Question 2
ho (MTP Nov 24)
[Q.1 - Additional Question AFM 8 (Fast Track) & 9, Q.11 - AFM 10]

The ABC Startup has the following expected profits under different scenarios along respective
probabilities:
C
Year Best Case Base Case Worst Case
Revenue Expenses Revenue Expenses Revenue Expenses
1 ` 100,00,000 ` 80,00,000 ` 100,00,000 ` 90,00,000 ` 100,00,000 ` 95,00,000
ik

2 ` 120,00,000 ` 92,40,000 ` 110,00,000 ` 95,70,000 ` 102,00,000 ` 98,94,000

3 ` 144,00,000 ` 108,00,000 ` 121,00,000 ` 102,85,000 ` 104,04,000 ` 101,95,920
Probability 30% 60% 10%
av

You are required to suggest the value of ABC Startup using First Chicago Method assuming that:
(i) Applicable discounting rate is 20%.
(ii) Startup is located in Tax-free Zone.
Bh

(iii) The multiple for Terminal is 10.

(iv) No depreciable assets are held by the ABC Startup.
Note: 1. Present Value Factor (PVF)
Year 1 2 3
PVF@20% 0.8333 0.6944 0.5787

2. Round off the calculation to whole numbers.

Summary

Detailed Solution

104 CA BHAVIK CHOKSHI

 BUSINESS VALUATION

Valuation of Startup under different scenarios:

(i) Best Case Scenario
Particulars Year 1 Year 2 Year 3
Revenue ` 100,00,000 ` 120,00,000 ` 144,00,000
Expenses ` 80,00,000 ` 92,40,000 ` 108,00,000
Cash Flow/ Earnings ` 20,00,000 ` 27,60,000 ` 36,00,000
Terminal Value ` 3,60,00,000
PVF @ 20% 0.8333 0.6944 0.5787 0.5787

hi
PV ` 16,66,600 ` 19,16,544 ` 20,83,320 ` 2,08,33,200
Value of Startup ` 2,64,99,664
(ii) Best Case Scenario

ks
Particulars Year 1 Year 2 Year 3
Revenue ` 100,00,000 ` 110,00,000 ` 121,00,000
Expenses ` 90,00,000 ` 95,70,000 ` 102,85,000
Cash Flow/ Earnings
Terminal Value
PVF @ 20%
PV
` 10,00,000

0.8333
` 8,33,300
ho
` 14,30,000

0.6944
` 9,92,992
` 18,15,000

0.5787
` 10,50,341
` 181,50,000
0.5787
` 105,03,405
C
Value of Startup ` 133,80,038
(iii) Worst Case Scenario
Particulars Year 1 Year 2 Year 3
Revenue ` 100,00,000 ` 102,00,000 ` 104,04,000
ik

Expenses ` 95,00,000 ` 98,94,000 ` 101,95,920

Cash Flow/ Earnings ` 5,00,000 ` 3,06,000 ` 2,08,080
Terminal Value ` 20,80,800
av

PVF @ 20% 0.8333 0.6944 0.5787 0.5787

PV ` 4,16,650 ` 2,12,486 ` 1,20,416 ` 12,04,159
Value of Startup ` 19,53,711
Value of ABC Startup as per First Chicago Method
Bh

= 0.30 x ` 2,64,99,664 + 0.60 x ` 133,80,038 + 0.10 x ` 19,53,711

= ` 79,49,899 + ` 80,28,023 + ` 1,95,371
= ` 1,61,73,293

105 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

CHAPTER 8 FOREIGN EXCHANGE EXPOSURE AND RISK

MANAGEMENT

Question 1 (Practice Manual)

[Q.6 - AFM 8 (Fast Track) & 9, Q.6 - AFM 10]

The following table shows interest rates for the United States dollar and French francs. The
spot exchange rate is 7.05 francs/$. Complete the missing entries:

hi
3 Months 6 Months 12 Months
Dollar interest rate (annually compounded) 11 ½ % 12 ¼ % ?
Franc interest rate (annually compounded) 19 ½ ? 20 %

ks
Forward franc per dollar ? ? 7.5200

Forward discount per franc p.a. ? - 6.3 % ?

Summary

Detailed Solution

ho
C
F
=
(
1 + rF × M /12 )
S (
1 + r$ × M /12 )
ik

S −F 12
Forward discount on French Francs (Non – Base) = × 100 ×
F M

(i) 3 Months
av

F (1 + 0.195 × 3 / 12)
Using IRP = =
FF 7.05 / $ (1 + 0.1150 × 3 / 12 )
Bh

1.04875
F = FF 7.05 / $ ×
1.02875

FF 7.1871/$

∴ Forward Discount on FF

FF 7.05 / $ − FF 7.1871 / $
= × 100 × 12 / 3
FF 7.1871 / $

= (7.63% p.a.) discount on French Franc

106 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

(ii) 6 Months
Forward Discount

FF 7.05 / $ − x 12
(6.3) = × 100 × [Let forward rate be x]
X 6
6 1 FF 7.05 / $ − x
∴ (6.3) × × =
12 100 x

hi
∴ (0.0315 x) = FF 7.05 / $ - x
∴ 0.9685 x = FF 7.05 / $
∴ x = FF 7.2793/$

ks
Using IRP,

FF 7.2793 / $
=
(
1 + x × 6 /12 ) [Let the French interest rate p.a. be x]
( )
FF 7.05 / $

∴ 1.0325 =
1 + 0.1225 × 6 /12

1 + 0.5 x
1.06125
ho
C
∴ 1.0957 = 1+0.5 x
∴X = 0.1914
i.e. = 19.14% p.a.
ik

(iii) 12 Months
Using IRP,

( )
av

FF 7.52 / $ 1 + 0.2 × 12 /12

=
FF 7.05 / $ (1 + x × 12 /12 )

Thus, 1.0667 = 1.2 / 1 + x

Bh

Thus, 1 + x = 1.1250
Thus, x = 0.1250
i.e., 12.5% p.a.

Forward discount on franc.

S −F
= × 100
F

7.05 – 7.52
= × 100
7.52

= (6.25% p.a) discount on French franc

107 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

Question 2 (ICAI SM)/(RTP Nov 18)/(Practice Manual [Modified])

[Q.10 - AFM 8 (Fast Track) & 9, Q.10 - AFM 10]

On December 27, 2002 a customer in Bombay requested a bank to remit DG 2,50,000 to

Holland in payment of import of diamonds under an irrevocable LC. However due to bank strikes,
the bank could effect the remittance only on January 3, 2003. The inter-bank market rates
were as follows:
December 27 January 3

hi
Bombay $/` 100 : 3.15 - 3.10 3.12 - 3.07
London $/£ : 1.7250/60 1.7175/85
DG/£ : 3.9575/90 3.9380/90

ks
The bank wishes to retain an exchange margin of 0.125%. How much does the customer stand
to gain or lose due to the delay?

Summary

Detailed Solution
ho
C
Re-Stated Rates
Rate Dec 27 Jan 3
$/` (Divide by 100) 0.0310/0.0315 0.0307/0.0312
ik

$/£ 1.7250/1.7260 1.7175/1.7185

DG/ £ 3.9575/3.9590 3.9380/3.9390

Reference Note:
av

1. We have been given $/` 100 rate. This can be re-stated as the $/ ` rate by dividing it by
100. As a general rule, we should try to write the bid rate (lower rate) on left hand side
and the ask rate (higher rate) would be written on right hand side.
Bh

2. Base: DG, Customer: Buy, Bank: Sell

Therefore, ASK
December 27
 `  `  $  £ 
 =   ×  × 
 DG ASK  $ A  £ A  DG A

1
= × $1.7260 / £ × 1/DG 3.9575/ £
$ 0.0310 /`

= ` 14.0688/DG

108 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

`
1. Remittance (DG 2,50,000 × ` 14.0688/DG) 35,17,200
Add: Exchange margin at 0.125% 4,396.5
Total cost of remittance (27/12) 35,21,596.5

January 03

hi
 Rs   Rs   $  £ 
  =   ×  × 
 DG A  $ A  £ A  DG A
1 1
= $0.0307 / ` × $ 1.7185 / £ ×

ks
DG 3.9380 / £

= ` 14.2146/DG

2.
Add: exchange margin @ 0.125%
Total cost of remittance (03/01)
ho
Remittance (DG 2,50,000 × ` 14.2146/DG)
`
35,53,650
4,442.06
35,58,092.06
C
Therefore, The total loss due to the bank strike = 35,58,092.06 – 35,21,596.5
ik

= ` 36,495.56

Reference Note / Extra point:

av

In case the given question pertains to an exporter, then the transaction would be at the BID
rate. Further, exchange margin represents transaction cost and it will need to be deducted in
order to find the net cash inflow for the exporter.
Bh

Question 3 (RTP Nov 20 [Modified])/(Practice Manual)/(RTP Nov 23)

[Q.15 - AFM 8 (Fast Track) & 9, Q.15 - AFM 10]

Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas subsidiaries, one
based in Amsterdam and one in Switzerland. The Dutch subsidiary has surplus Euros in the
amount of 725,000 which it does not need for the next three months but which will be needed
at the end of that period (91 days). The Swiss subsidiary has a surplus of Swiss Francs in the
amount of 998,077 that, again, it will need on day 91. The XYZ plc in UK has a net balance of
£75,000 that is not needed for the foreseeable future.
Given the rates below, what is the advantage of swapping Euros and Swiss Francs into Sterling?

109 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

Spot Rate (€) £0.6858- 0.6869

91 day Pts 0.0037 0.0040
Spot Rate (£) CHF 2.3295-2.3326
91 day Pts 0.0242 0.0228

Interest rates for the Deposits

Amount of Currency 91 day Interest Rate % pa

hi
£ € CHF
0 – 100,000 1 ¼ 0
100,001 – 500,000 2 1½ ¼

ks
500,001 – 1,000,000 4 2 ½
Over 1,000,000 5.375 3 1

Note: For calculation purpose use 360 Days a year.

Summary

Detailed Solution
ho
C
Individual Basis
Particulars Interest Amt. after 91 Conversion in £
ik

days
Holland £502,414.71
€ 725,000 x 0.02 x 91/360 € 3,665.28 € 728,665.28 (728,665.28 x 0.6895)
av

Switzerland CHF CHF CHF 999,338.46 £432,651.51

998,077 x 0.005 91/360 1,261.46 (999,338.46÷2.3098)
UK
£ 75,000 x 0.01 x 91/360 £ 189.58 £ 75,189.58 £ 75,189.58
Bh

Total GBP at 91 days £ 1,010,255.80

Swap to Sterling
Particulars Amount
Sell € 7,25,000 (Spot at 0.6858) buy £ £ 4,97,205.00
Sell CHF 9,98,077(Spot at 2.3326) buy £ £ 4,27,881.76
Independent GBP amount £ 75,000.00
£ 1,000,086.76
Interest (£ 1,000,086.76 x 0.05375 x 91/360) £ 13,587.98
Total GBP at 91 days £ 1,013,674.74
Less: Total GBP at 91 days as per individual basis £ 1,010,255.80
Net Gain £ 3,418.94

110 CA BHAVIK CHOKSHI

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Reference Note:
1) In all such questions, ICAI always converts the currency balances into a single currency
(usually parent’s currency) and then compares the cash balance at a single date in a
single currency.
This is irrespective of whether money is needed by the subsidiary or not at a later date
and hence we will also follow the same.
2) The interest rates given will be applicable to the entire principal and hence we will take

hi
the applicable interest rate based on the deposit made.
We should not use the Slab Method like done in Income tax.

ks
Question 4 (RTP May 20)/(Practice Manual)
[Q.18 - AFM 8 (Fast Track) & 9, Q.18 - AFM 10]

A inc and B inc intend to borrow $ 2,00,000 and $ 2,00,000 in yen respectively for a time

Company
A Inc
B Inc
ho
horizon of one year. The prevalent interest rates are as follows:
Yen Loan
5%
8%
$ Loan
9%
10%
C
The Prevalent exchange rate is $1 = Yen 120
They entered in a currency swap under which it is agreed that B inc will pay A inc @ 1% over
the yen loan interest rate which the latter will have to pay as a result of the agreed currency
ik

swap whereas A inc will reimburse interest to B inc only to the extent of 9%.
Keeping the exchange rate invariant, quantify the opportunity gain or loss component of
the ultimate outcome, resulting from the designed currency swap.
av

Summary
Bh

Detailed Solution

Reference Note: Initial

Option – 1: (Direct)
A: Borrow $ 2,00,000 @ 9% p.a
B: Borrow ¥ 2,40,00,000
($ 2,00,000 × ¥ 120 / $) @ 8% p.a

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Option - 2: Swap

hi
At interest payment Date B

ks
Option 1:
A : $ 2,00,000 × 9%
= $ 18,000

B: ¥ 2,40,00,000 × 8%
= ¥ 19,20,000
ho
C
Option 2:
ik
av

Solution:
Bh

Net cost to A under the swap

C.O to bank of A ¥ 12,00,000
(¥ 2,40,00,000 × 5%)
C.I from B swap (¥ 14,40,000)
(¥ 2,40,00,000 × 6%)
Net C.I (¥ 2,40,000)
÷ Exchange rate (Year – 1) ÷ ¥ 120/$
Net C.I (in $) ($ 2,000)
C.O to B – swap ($2 L × 9%] $ 18,000
NET C.O. $ 16,000

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Net cost to A in case of a direct

Borrowing = $ 2,00,000 × 9% $ 18,000
Thus, Ultimate gain to A
= $ 18,000 - $ 16,000 = $ 2,000
Net Cost to B (SWAP)
C.O to bank of B $ 20,000
[$ 2,00,000 × 10%]

hi
C.I from A – SWAP ($ 18,000)
[$ 2,00,000 × 9%]
Net C.O $ 2,000

ks
× Exchange rate (year – 1) × ¥ 120/$
Net C.O ¥ 2,40,000
Add: C.O to A – SWAP ¥ 14,40,000
[¥ 2,40,00,000 × 6%]
Net C.O

ho
Net cost to B in case of a direct borrowing =
=
¥ 16,80,000
¥ 2,40,00,000 × 8%
¥ 19,20,000
C
Thus, Ultimate gain to B = ¥ 19,20,000 - ¥ 16,80,0000
= ¥ 2,40,000
ik

Question 5 (ICAI SM)/(ICAI Paper Nov 20)/(MTP March 23)

[Q.29 - AFM 8 (Fast Track) & 9, Q.29 - AFM 10]

ZX Ltd. has made purchases worth USD 80,000 on 1st May 2020 for which it has to make a
av

payment on 1st November 2020. The present exchange rate is INR/USD 75. The company can
purchase forward dollars at INR/USD 74. The company will have to make an upfront premium
@ 1 per cent of the forward amount purchased. The cost of funds to ZX Ltd. is 10 per cent per
Bh

annum.
The company can hedge its position with the following expected rate of USD in foreign
exchange market on 1st May 2020:
Exchange Rate Probability
(i) INR/USD 77 0.15
(ii) INR/USD 71 0.25
(iii) INR/USD 79 0.20
(iv) INR/USD 74 0.40

You are required to advise the company for a suitable cover for risk.

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Summary

Detailed Solution

$ 80,000
ZX Indian Co.
(After 6 Months)

hi
Reference Note: The rates are given in 3 alphabet terms and hence we can consider applying
the market convention. However, USD is stronger as compared to INR and the given rates

ks
already reflect that. Hence, we are directly taking INR/USD to be `/$
Solution:
1. C.O after 6 months under forward hedge.

A
Particulars
ho
Upfront premium (fees) [$80,000 × ` 74/$ × 1%]
Add: Time value adjustment (Interest))
[` 59,200 × 10% × 6/12]
`
59,200
2,960
C
Effective cost after 6 months (A) 62,160
B Cash outflow after 6 months at forward rate (B) 59,20,000
[$ 80,000 × ` 74/$]
∴ Total cash outflow after 6 months = 62,160 + 59,20,000
ik

(A + B) = 59,82,160
2. C.O after 6 months if unhedged
C. Expected Spot = 77 × 0.15 + 71 × 0.25 + 79 × 0.20 + 74 × 0.40
av

= ` 74.7/$
D. Cash outflow expected after 6 months = $ 80,000 × ` 74.7/$
= ` 59,76,000
Bh

It is advised that ZX Ltd should keep the transaction unhedged as it results in a lower
cash outflow after 6 months.

Question 6 (ICAI SM)/(Practice Manual)

[Q.35 - AFM 8 (Fast Track) & 9, Q.35 - AFM 10]

You, a foreign exchange dealer of your bank, are informed that your bank has sold a T.T. on
Copenhagen for Danish Kroner 10,00,000 at the rate of Danish Kroner 1 = ` 6.5150. You are
required to cover the transaction either in London or New York market. The rates on that
date are as under:

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Mumbai-London ` 74.3000 ` 74.3200

Mumbai-New York ` 49.2500 ` 49.2625
London-Copenhagen DKK 11.4200 DKK 11.4350
New York-Copenhagen DKK 07.5670 DKK 07.5840

In which market will you cover the transaction, London or New York, and what will be the
exchange profit or loss on the transaction? Ignore brokerages.

hi
Summary

Detailed Solution

ks
Original Transaction: Sell –DKK 10,00,000 at ` 6.575/ DKK (S.P)
Cover Transaction: Spot buy – DKK 10,00,000 at ?
Reference Note:

1.
2.
London: ` → £ → DKK
NY: ` → $ → DKK
ho
The cover in this question can happen through any of the following modes.
C
We can cover in the market where the rates are lower.

Solution:
ik

1. London: Intermediate currency (£)

 `  `  £ 
  =  × 
DKK ASK  A  DKK A
£
av

1
= ` 74.32/£ ×
DKK 11.42 / £
Bh

= ` 6.5079/DKK

2. New York: Intermediate currency ($)

 `  `  $ 
  =  × 
 DKK ASK  $ A  DKK A

1
= ` 49.2625 / $ ×
DKK 7.5670 / $

= ` 6.5102/DKK
As it is cheaper to cover (buy) through London, we will use the London market to cover our
transaction.

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Thus, gain / (loss) on covering = [(` 6.5150 / DKK – ` 6.5079) × DKK 10,00,000
= ` 0.0071 / DKK × DKK 10,00,000
= ` 7,100 (Gain)

Reference Note:
In this question, we can see that the entity covering is the bank itself. However, in case the
banker wants to cover, they will have to approach another banker and hence for the purpose of

hi
such a question, our banker who is approaching the other bankers for covering is treated as the
customer.

ks
Question 7 (RTP May 21)/(RTP May 19)/(MTP March 19)/
(Practice Manual)
[Q.46 - AFM 8 (Fast Track) & 9, Q.46 - AFM 10]

information as at June 1, 2005.

Exchange Rates
ho
XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in
customers' currency. Its receipt of US $ 1,00,000 is due on September 1, 2005. Market

Currency Futures
C
US $/` US $/` Contact size `4,72,000
Spot 0.02140 June 0.02126
1 Month Forward 0.02136 September 0.02118
ik

3 Months Forward 0.02127

Initial Margin Interest Rates in India

av

June ` 10,000 7.50%

September ` 15,000 8.00%

On September 1, 2005 the spot rate US $/` is 0.02133 and currency future rate is 0.02134.
Bh

Comment which of the following methods would be most advantageous for XYZ Ltd.
(a) Using forward contract
(b) Using currency futures
(c) Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of the future contract.

Summary

Detailed Solution

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

XYZ $ 1,00,000 (3m)

US Co.
Indian Co (01/09/05)

a. Forward Contracts
1
C.I after 3 months = $ 1,00,000 × = ` 47,01,457
$ 0.02127 / `

b. Futures

hi
Invoice : $ 1,00,000
Contract : ` 4,72,000
∴ Invoice currency ($) is different from contract currency (`)

ks
1. Strategy : Buy ` futures (i.e. equivalent to selling $) (Base: `)
2. Maturity : Sept at $ 0.02118/` (C.P.)
3. No. of contracts
Particulars
Invoice ($)
Divide: September Future Rate
Equivalent Invoice (`)
ho `
$ 1,00,000
÷ $ 0.02118/`
` 47,21,435
C
Divide: Contract Size ÷ ` 4,72,000
No of Contracts 10.003

i.e., 10 Contracts
ik

4. On 01/06/05, buy 10 contracts (September) ` futures at $ 0.02118/` (C.P)

5. Settlement (01/09)
C.I at spot (01/09/05) ` 46,88,233
av

 
 1 
$1, 00, 000 × 
 $ 0.02133 
 ` 
Bh

+ Gain/loss in futures ` 35,406 [C.I.]

($ 0.02134/` - $ 0.02118/`) × ` 4,72,000 × 10
0.02133/`
Less: Interest forgone on margin ` (3,000) [C.O.]
[` 15,000 (sept) × 10 contracts × 8% × 3/12]
Net C.I on 01/09/05 ` 47,20,639
Reference Note: Margin (Deposit)
Unless given, margin (deposit) is required to be paid on futures only and not on forward.
Margin is like a deposit which is used by the exchange to adjust losses if any and in case
there is a gain, the exchange would refund the entire margin along with the gain. In case
there is a loss, the exchange would adjust the loss and refund the balance.

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As the margin is refundable/adjustable, the margin in itself is not a cost. However, the
relevant cost to consider is the opportunity cost on account of the margin.

c. Unhedged
1
C.I on 01/09/05 = $ 1,00,000 × = ` 46,88,233
$0.02133 /`
(i.e. After 3 months )
As the Cash Inflow under the futures contract is the highest, XYZ limited is suggested

hi
to opt for the futures contract.

Question 8 (ICAI SM [Modified])/(RTP May 20)/ (RTP May 21

ks
[Modified])/(Practice Manual [Modified])
[Q.47 - AFM 8 (Fast Track) & 9, Q.47 - AFM 10]
Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to €4 million

ho
with a large German retailer on 6 months credit. If successful, this will be the first time that
Nitrogen Ltd has exported goods into the highly competitive German market. The following
three alternatives are being considered for managing the transaction risk before the order is
finalized.
C
a. Invoice the German firm in Sterling using the current exchange rate to calculate the
invoice amount,
b. Alternative of invoicing the German firm in € and using a forward foreign exchange
ik

contract to hedge the transaction risk,

c. Invoice the German first in € and use sufficient 6 months sterling future contracts (to
the nearly whole number) to hedge the transaction risk.
av

Following data is available:

Spot Rate €1.1750 - €1.1770/£
6 months forward premium 0.60-0.55 Euro Cents
Bh

6 months future contract is currently trading at €1.1760/£

6 months future contact size is £ 62500
Spot rate and 6 months future rate €1.1785/£

Required:
a. Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the three
proposals.
b. In your opinion, which alternative would you consider to be the mostappropriate and the
reason there of.

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Summary

Detailed Solution

Nitrogen € 4 Million
German Co.
UK Co 6 months (b and c) 6 Months

hi
Exporter

Nitrogen £ Equivalent to € 4 Millions

German Co.

ks
(UK Co) 6 months (b and c) 6 Months

a. Invoice in £ (Using current spot rate)

Reference Note: Nitrogen (Sell)
i.e., Nitrogen (Buy)
With £ base currency, we take £ ASK
ho €
£
Bank (Buy)
Bank (Sell)

Alternatively, since the rates are given in Indirect quotes, we can convert them into
C
direct quotes and then solve taking € as base currency.

Solution:
ik

Equivalent invoice (in £) at current spot rate

1
= € 40,00,000 ×
av

€1.1770 / £

= £ 33,98,471
Bh

As the invoice is in £ under this alternative, there is no requirement for hedging and
hence the cash inflow after 6 months will be £ 33,98,471 (credit period of 6 months)
Reference Note: As per the deal, the customer has agreed to pay us € 4 millions. If we
notionally receive € 4 million today and go to the banker to sell the €, the transaction
would happen at the € BID rate since the banker will be buying the €. However, since the
base currency is in £, evaluation would be based on pounds. Banker is buying the € which
is equivalent to selling the £ and hence the £ ASK rate is selected.
b. Invoice in € and take the forward hedge

1
C.I after 6 months = € 40,00,000 ×
€1.1715 / £

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= £ 34,14,426

Working Note – 1 Forward Rates

Spot Rate € 1.1750/£/€ 1.1770/£
Swap points (€ 0.0060/£)/(€0.0055/£)
Descending and Hence deduct
(1€ = 100 cents) (0.6 ⊄ = € 0.0060)/(0.55 ⊄ = € 0.0055)
6 months forward € 1.1690/£ € 1.1715/£

hi
Reference Note: Nitrogen sells € to bank i.e., Bank Buys €, Base currency is £. Banker
buys € and at the same time sells £. Therefore, £ ASK Rate.

ks
General Reference:
In case we are not confident in the bid/ask selection, we can adopt the trial-and-error
method i.e., calculate the cash flow using both rates. In case the entity gets a cash

c.
ho
inflow, the rate which gives us a lower cash inflow should be selected and in case there
is a cash outflow, the rates that gives us a higher cash outflow should be selected.

Invoice in € and futures hedging

C
1. Strategy: BUY £ futures [Equivalent to selling €]
2. Maturity: 6 months @ 1.1760 / £ (C.P)
3. No. of contracts.
ik

Invoice (€) € 40,00,000

Divide: Future rate ÷ € 1.1760/ £
Invoice (£) £ 34,01,361
av

Divide: Future Contract size ÷ 62,500

No. of Contracts 54.42
i.e. 54 Contracts
Bh

1. Today, Nitrogen will buy 54 contracts, 6 months futures @ € 1.1760/£ (C.P)

2. Settlement (6 months later)
Particulars `
C.I at spot (after 6 months) £ 33,94,145
1
[€ 40,00,000 ×
€1.1785 / £

± Gain/(Loss) on futures £ 7,160

 €1.1760  
 €1.1785 / £ −  × £62, 500 × 54 
 £  
 €1 .1785 / £ 
 

C.I after 6 months £ 34,01,305

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Conclusion:
Nitrogen Ltd should invoice in € and take the forward hedge as it results in the highest
cash inflow after 6 months.

Question 9 (ICAI SM)/(MTP Oct 2023)

[Q.51 - AFM 8 (Fast Track) & 9, Q.51 - AFM 10]

A bank enters into a forward purchase TT covering an export bill for Swiss Francs 1,00,000

hi
at ` 32.4000 due 25th April and covered itself for same delivery in the local inter bank market
at ` 32.4200. However, on 25th March, exporter sought for cancellation of the contract as the
tenor of the bill is changed.

ks
In Singapore market, Swiss Francs were quoted against dollars as under:
Spot USD 1 = Sw. Fcs. 1.5076/1.5120
One month forward
Two months forward
Three months forward
ho 1.5150/1.5160
1.5250/1.5270
1.5415/1.5545
C
and in the interbank market US dollars were quoted as under:
Spot USD 1 = ` 49.4302/.4455
Spot/April .4100/.4200
ik

Spot/May .4300/.4400
Spot/June .4500/.4600

Calculate the cancellation charges, payable by the customer if exchange margin required by
av

the bank is 0.10% on buying and selling. Exchange margin to be adjusted in `/$ rate only.

Summary
Bh

Detailed Solution

From the exporter‘s stand point

Original: Forward sell @ ` 32.4000/CHF (S.P)
(25/4)
Cancel: Forward Buy (1 Month) @ ?
(25/3)
Thus: Cancellation rate
1 M ( April) 1M ( April ) 1M ( April )
 Rs   Rs   $ 
 =    × 
 CHF ASK  $ ASK  CHF ASK

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Thus, Working Note - Forward rate (`/$)ASK1 Month (April)

Particulars `
Spot (ASK) ` 49.4455/$
Add: 1 Month premium ` 0.4200/$
(Ascending : Add)
1 Months forward (ASK) ` 49.8655/$
Add : Exchange margin ` 0.0499/$
(` 49.8655/$ × 0.10 %)

hi
Adjusted (`/$)1M(April)ASK ` 49.9154/$

Reference Note: The above rate is going to be used to calculate the C.P and hence the margin

ks
will effectively increase the cost and hence it is to be added. Further, in line with ICAI’s
Solution, we have modified the question and considered the exchange margin to be applicable on
`/$ rate and not CHF/$ rate.

 ` 
 = 
1M
`
 

= ` 49.9154/$ ×
1M
 $ 
× 
 CHF ASK  $ ASK  CHF ASK

1
1M

ho
C
CHF .1.5150/$

= ` 32.9475/CHF (C.P)
Gain/(Loss) for customer on cancellation (After 1m)
ik

= (` 32.40)/CHF - (` 32.9475)/chf) × CHF 1,00,000

= (` 54,750) [Loss to customer]
av

Therefore, the cancellation charge payable by the customer would be ` 54,750 after 1 month.

Question 10 (ICAI SM)/(Practice Manual)

Bh

[Q.53 - AFM 8 (Fast Track) & 9, Q.53 - AFM 10]

An importer requests his bank to extend the forward contract for US$ 20,000 which is due
for maturity on 30th October, 2010, for a further period of 3 months. He agrees to pay the
required margin money for such extension of the contract:
Contracted Rate – 1 US$ = ` 42.32
The US dollar quoted on 30/10/2010
Spot – 41.5000/41.5200
3 months premium (flat) – 0.87% / 0.93%
Margin money for buying and selling rate is 0.075% and 0.20% respectively. Compute:
a. The cost to the importer in respect of extension of the forward contract, and
b. The rate of the new forward contract

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Summary

Detailed Solution

a. From the importer’s standpoint

Original: Forward buy for $ 20,000 @ ` 42.32/$
Cancel: Spot sell for $ 20,000 @ ` 41.50 – 0.075%

hi
Thus, Net Cancellation rate (Net S.P)
= ` 41.50/$ - 0.075%
= ` 41.4689/$

ks
Thus, Gain / (Loss) on cancellation
= (` 41.4689/$ - ` 42.32/$) × $ 20,000
= (` 17,022) [Loss to importer]

Reference Note:
1. 
ho
Transaction cost (margin money) will always increase the cost/reduce the sale
proceeds for the customer. Further the buying / selling rate given in the question will
C
always be the buying / selling rate from the banker’s perspective.
2. At the time of cancellation, the banker buys (customer sells) and hence margin money
for buying rate i.e., 0.075% should be applied. Further as the customer is selling, this
ik

margin money would reduce his sale proceeds and hence needs to be deducted from
the cancellation rate of ` 41.50/$.
b. New Forward Rate:
av

Reference Note: The importer originally intended to buy $. Thus, on extension, the
importer would still continue to take a forward buy contract i.e. the customer buys /
banker sells i.e. ask rate.
Bh

The swap points (%) are given in the ascending order and hence we add. Further margin
money is at the banker’s selling rate i.e. 0.2% will also be added (as it is a cost, it will
increase the customer’s purchase rate)
Spot ($ Ask) (on 30/10/10) ` 41.5200/$
Add: 3 month Forward premium ` 0.3861/$
(` 41.52 × 0.93%)
3 month Forward ($ Ask) ` 41.9061/$
Add: Margin
(41.9061 × 0.2%) ` 0.0838/$
New forward rate ` 41.9899/$
(Under extension)

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Reference Note:
We have been told that the customer agrees to pay the required margin money on
extension. An extension implies a cancellation + a new forward. Therefore, the transaction
charges will be levied on both the cancellation rate as well as the new forward rate.

Question 11 (MTP Oct 18)/(MTP April 21)

[Q.56 - AFM 8 (Fast Track) & 9, Q.56 - AFM 10]

hi
On 1 October 2019 Mr. X an exporter enters into a forward contract with a BNP Bank to sell
US$ 1,00,000 on 31 December 2019 at ` 70.40/$ and bank simultaneously entered into a cover
deal at ` 70.60/$. However, due to the request of the importer, Mr. X received amount on 28

ks
November 2019. Mr. X requested the bank the take delivery of the remittance on 30 November
2019 i.e. before due date. The inter-banking rates on 28 November 2019 were as follows:

Spot ` 70.22/70.27
One Month Swap Points 15/10
ho
If bank agrees to take early delivery, then determine the net inflow to Mr. X assuming that the
prevailing prime lending rate is 10% and deposit rate is 5%.
C
Note:
(i) While exchange rates to be considered upto two decimal points the amount to be rounded
off to Rupees i.e. no paisa shall be involved in computation of any amount.
ik

(ii) Assume 365 days a year.

Summary
av

Detailed Solution
Bh

Mr. X (Exporter)
Original: Forward sale after 3 months @ ` 70.40/$ (S.P → Customers)
for $ 1,00,000

 $BID 
 
 ` 70.22 /$  ` 70.40/$

` 70,22,000 (2) BNP Bank ` 70,40,000 (1)

Sell Spot Nov 19

$ 1,00,000 $ 1,00,000

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Cancel the cover forward

Forward Buy @ ` 70.17/$
= $ 1,00,000 × ` 70.17/$
= ` 70,17,000

Solution:
Particulars `

hi
1. Forward settled $ 1,00,000 × ` 70.40/$
(Cash outflow) = ` 70,40,000
2. Spot sale $ 1,00,000 × ` 70.22/$
(Cash inflow) = ` 70,22,000

ks
3. Cover forward cancelled $ 1,00,000 × ` 70.17/$*
(No cash flow) = ` 70,17,000
1 Month forward = ` 70.22/$ - ` 0.15/$/` 70.27/$ - ` 0.1 / $

1.
ho
= ` 70.07/$ / ` 70.17/$

Thus, Swap gain to be paid to the customers = Spot sell (S.P) – Forward buy (C.P)
[Reference Note: Additional actions which BNP Bank had to take to honour the early
C
delivery]
= ` 70,22,000 – ` 70,17,000
= ` 5,000 [A]
ik

(Gain to Bank paid to customer)

2. Interest on Outlay [Difference of 1 and 2 × interest rate]

av

31
(Cash outflow – Cash inflow) × Borrowing rate ×
365
(1) (2) (Since cash outflow)
Bh

31
= (` 70,40,000 – ` 70,22,000) × 10% p.a ×
365

31
= ` 18,000 × 10% ×
365
(Net cash outflow)
= ` 153 [B] (To be recovered from customer)

3. Thus, Net amount to be paid to the customer by BNP Bank

= ` 5,000 (Paid) – ` 153 (Recovered)
= ` 4,847
(Net paid to customer on early delivery)

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

4. Thus, Net inflow to Mr. X = ` 70,40,000 + ` 4,847

[On early delivery] [Charge/gain on early delivery]
= ` 70,44,847

Question 12 (ICAI SM)/(RTP May 18)/(Practice Manual)

[Q.57 - AFM 8 (Fast Track) & 9, Q.57 - AFM 10]
An importer booked a forward contract with his bank on 10th April for USD 2,00,000 due on

hi
10th June @ ` 64.4000. The bank covered its position in the market at ` 64.2800.

The exchange rates for dollar in the interbank market on 10th June and 13th June were:

ks
Particulars 10th June 13th June
Spot USD 1 ` 63.8000/8200 ` 63.6800/7200
Spot/June ` 63.9200/9500 ` 63.8000/8500
July
August
September
ho
` 64.0500/0900
` 64.3000/3500
` 64.6000/6600
` 63.9300/9900
` 64.1800/2500
` 64.4800/5600

Exchange Margin 0.10% and interest on outlay of funds @ 12%. The importer requested on 13
th
C
th
June for extension of contract with due date on 10 August.
Rates rounded to 4 decimal in multiples of 0.0025.
th
On 10 June, Bank Swaps by selling spot and buying one month forward.
ik

Calculate:
(i) Cancellation rate
av

(ii) Amount payable on $ 2,00,000

(iii) Swap loss
(iv) Interest on outlay of funds, if any
Bh

(v) New contract rate

(vi) Total Cost

Summary

Detailed Solution

Original: Forward Buy $ 2,00,000 @ ` 64.4000/$

(i.e,. Bank : Forward sell $ 2,00,000 @ ` 64.4000/$)
Bank’s original off-setting contracts: Forward Buy $ 2,00,000 @ ` 64.2800/$

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Date of original maturity = 10/6

Actual date of maturity / cancellation = 13/6

(i) Cancellation Rate:

Cancellation happens on 13/6. Hence, the relevant rate would be spot sell @ ` 63.68/$
(Gross S.P)
Thus, cancellation rate = ` 63.68/$ - 0.1 % × ` 63.68 / $

hi
= ` 63.6163/$
Reference Note: Ideally, as given this rate should be rounded off to the nearest 0.0025
i.e., ` 63.6175/$. However, ICAI has ignored the rounding – off in subsequent workings

ks
and hence we have also ignored the same.

(ii) Amount payable (Exchange difference) on $ 2,00,000

ho
= (` 63.6163/$-` 64.4000/$)×$ 2,00,000
= (` 1,56,740) (A) Loss i.e. amount payable due to exchange difference to Bank.

(iii) Swap Loss (on 10/6)

C
 63.8000 
Spot Sell [SP] ($2, 00, 000 ×  `  ` 1,27,60,000
 $ 
ik

 63.9500 
Forward Buy [CP] ($2, 00, 000 ×  `  (` 1,27,90,000)
 $ 

Swap loss payable to bank (B) (` 30,000)

av

(iv) Interest
Cash outflow on original off – setting contract
Bh

[$ 2,00,000 × ` 64.2800 / $] (10/6)

` 1,28,56,000
Cash inflow on spot sale (10/6)
[$ 2,00,000 × ` 63.8000/$] (10/6)
` 1,27,60,000
Net cash outflow (on 10/6)
(` 96,000)
3
Thus, Interest on Net C.O = Rs 96,000 × 12% × 365
= ` 95 [C]
Total cost = ` 1,56,740 + ` 30,000 + ` 95
(A + B + C) = ` 1,86,835

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New contract rate

On 13/6, customer would enter into a new forward buy contract of August

64.2500 ` 64.2500
@` + 0.1 % $
$

= ` 64.3143/$

hi
Question 13 (ICAI SM)/(MTP Oct 19)
[Q.62 - AFM 8 (Fast Track) & 9, Q.62 - AFM 10]

NP and Co has imported goods for US $ 7,00,000. The amount is payable after 3 months.

ks
The company has also exported goods for US $ 4,50,000 and this amount is receivable in two
months. For receivable amount a forward contract is already taken at ` 48.90.

Spot
Two Months
Three Months
ho
The market rates for rupees and dollars are as under:
` 48.50/70
25/30 points
40/45 points
C
The company wants to cover the risk and it has two options as under:
a. To cover payables in the forward market, and
ik

b. To lag the receivables by one month and cover the risk only for the net amount. No
interest for delaying the receivables is earned. Evaluate both the options if cost of
rupee funds is 12%?
av

Summary
Bh

Detailed Solution

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(a) Option – 1: (i) Forward cover for payables

3 month forward rate (`/$)
= ` 48.5/$ + 0.4/` 48.70/$ + 0.45
= ` 48.90/$/` 49.15/$
Particulars Rupees
C.O after 3m ($ 7,00,000 × ` 49.15/$)(A) (3,44,05,000)
C.I after 2m ($ 4,50,000 × ` 48.90) 2,20,05,000

hi
(+) Time value adjustment (Interest) 2,20,050
[2,20,05,000 × 12% × 1/12]
Effective C.I after 3 months (B) ` 2,22,25,050

ks
Thus, Net C.O after 3 months (A - B)
= ` 3,44,05,000 – ` 22,225,050
= ` 1,21,79,950 C.O

Reference Note:
ho
(b) Option-2: Lag receivables (without interest) and take forward for net payable.

If we lag the receivables by 1 month, we will have to first cancel the original forward
C
contract which we have already taken. Further, there is no extension required for this
contract as we will net off the $4,50,000 cash inflow with the amount payable.
Since we have been specifically given that no interest is earned for delaying the
ik

receivables, time value adjustment is not needed and hence time value adjustment is
ignored on lagging.
Net C.O after 3 months (c) (` 1,22,87,500)
av

[($7,00,000-$ 4,50,000) × ` 49.15/$]

Cancellation of existing forward
Original: Forward sell (2 months) at ` 48.90/$ (S.P)
Bh

Cancel: Forward Buy (2 months) at ` 49/$ (C.P)

Thus, 2-month forward Rate:
= ` 48.50/$ + ` 0.25/$/` 48.70/$ + ` 0.30/$
= ` 48.75/$/ ` 49.00/$ $ Ask
Thus, Cancellation rate = ` 49.00/$ (CP)
Gain/(loss) on cancellation (` 45,000)
(` 48.90/$ - ` 49/$) × $ 4,50,000
Add: Time value adjustment (Interest) (` 450)
[` 45,000 × 12% × 1/12]
Effective C.O (Loss) after 3 months (C + D) (` 45,450)
C.O after 3 months ` 1,23,32,950
= ` 1,22,87,500 + ` 45,450

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Conclusion:
It is advised to go with option – 1 i.e, take forward cover for $ 7,00,000 as it results in
a lower cash outflow after 3 months.

Question 14 (ICAI SM)/(ICAI Paper May 19 [Modified])/

(MTP April 18)/(Practice Manual)
[Q.70 - AFM 8 (Fast Track) & 9, Q.70 - AFM 10]

hi
XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following
information is available:
Spot rate 1 £ = $ 2.00

ks
180 days forward rate of £ as of today = $1.96
Interest rates are as follows :
U.K US
180 days deposit rate
180 days borrowing rate ho 4.5%
5%
5%
5.5%

A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium
C
of $ 0.04.

XYZ Ltd. has forecasted the spot rates 180 days hence as below:
ik

Future rate Probability

$ 1.91 25%
$ 1.95 60%
av

$ 2.05 15%

Which of the following strategies would be most preferable to XYZ Ltd.?

(a) A forward contract;
Bh

(b) A money market hedge;

(c) An option contract;
(d) No hedging.
Show calculations in each case

Summary

Detailed Solution

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£ 3,00,000
XYZ (US Firm)
180 Days

a. Forward Contract
C.O after 180 days = £ 3,00,000 × 1.96 / £
= $ 5,88,000

hi
b. Money Market (Question modified, % interest rates are flat rates and not % p.a)
Borrow $ $2/£ Invest £
↓ 5.5 % (flat) ↓ 4.5 % (Flat)

ks
£ 3,00,000 → £ 3,00,000 (Liability)
Leg 1:
Particulars `
Investment in £ today
[£ 3,00,000/1.045 × 1]
× Spot rate
Borrowing in $ today
ho £ 2,87,081

× $ 2/£
$ 5,74,162
C
Add: Interest @ 5.5% (flat) $ 31,579
C.O after 180 days $ 6,05,741

Leg 2:
ik

Particulars `
Investment in £ today £ 2,87,081
Add: Interest @ 4.5% (flat) £ 12,919
av

Investment after 180 days £ 3,00,000

Less: paid for £ liability (£ 3,00,000)

Thus, C.O after 180 days under money market = £ 6,05,741

Bh

c. Option Contract
In this case, we have been given the contract size and hence we will assume that the options
are available for the entire £ 3,00,000 and hence there will be no unhedged portion.
1. Strategy: Long (BUY) call.
2. Maturity: 180 days @ $ 1.97 / £
3. C.O after 180 days.
Spot Exercise Expected Probability Weighted average
cash outflow
$ 1.91 / £ No $ 5,73,000 0.25 $ 1,43,250
(£ 3,00,000 × $ 1.91/ £)
$ 1.95 / £ No $ 5,85,000 0.60 $ 3,51,000
(£ 3,00,000 × $ 1.95 / £)

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$ 2.05 / £ Yes $ 5,91,000 0.15 $ 88,650

( £ 3,00,000 × $ 1.97 / £)
Expected C.O $ 5,82,900
after 180 days
[A]

Expected C.O after 180 days $ 5,82,900

Add: Premium [£ 3,00,000 × $ 0.04/£] $ 12,000

hi
Add: Time value adjustment $ 660
[$ 12,000 × 5.5%] US Borrowing
Effective C.O after 180 days [B] $ 12,660

ks
Unhedged portion -
Effective C.O after 180 days (A + B) $ 5,95,560

Reference Note:

ho
1. In this case, we need to pay the premium in $ today and hence we need to do
a time value adjustment for the premium. In the absence of information about
surplus funds, we have assumed that the entity will borrow £ 12,000 and hence
the interest rate will be 5.5%.
C
2. In case of options, we need to calculate the cash outflow at each rate independently
and then apply the probabilities. We should not calculate the average rate as it
will wrongly assume that the rate after 6 months is $ 1.955/£. Instead the rates
ik

would either be 1.91 or 1.95 or 2.05.

d. No Hedging
Spot Expected C.O after 180 days Probability Weighted Average cash outflow
av

$ 1.91/£ $ 5,73,000 0.25 $ 1,43,250

$ 1.95/£ $ 5,85,000 0.60 $ 3,51,000
$ 2.05/£ $ 6,15,000 0.15 $ 92,250
$ 5,86,500
Bh

Alternatively:
Expected spot rate
= $ 1.91/£ × 0.25 + $ 1.95/£ × 0.60 + $ 2.05/£ × 0.15
= $ 1.955/£
C.O = $ 1.955/£ × £ 3,00,000
= $ 5,86,500

Conclusion:
It is advisable to keep the transaction unhedged as it results in the lowest possible cash outflow
after 6 months.

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Question 15 (ICAI SM)/(MTP March 19)/(Practice Manual)

[Q.75 - AFM 8 (Fast Track) & 9, Q.75 - AFM 10]

You have following quotes from Bank A and Bank B:

Bank A Bank B
SPOT USD/CHF 1.4650/55 USD/CHF 1.4653/60
3 months 5/10
6 months 10/15

hi
SPOT GBP/USD 1.7645/60 GBP/USD 1.7640/50
3 months 25/20
6 months 35/25

ks
Calculate:
(i) How much minimum CHF amount you have to pay for 1 Million GBP spot?
(ii) Considering the quotes from Bank A only, for GBP/CHF what are the Implied Swap
points for Spot over 3 months?

Summary
ho
C
Detailed Solution

Reference Note:
ik

1. The exchange rate quotes are given in capital (and not currency symbols) hence we need
to check for the application of market convention.
GBP and USD are commonly traded currencies and the GBP is stronger than the USD.
av

Based on the exchange rate quotes, the GBP /USD rate is implied to be the $/£ rate.
The same bank is also quoting USD/CHF rate and hence for consistent application, this
rate will also be inferred to be CHF/$ rate (treatment consistent with ICAI solution).
Bh

2. As a customer, we intend to buy 1 million £ and hence the banker would sell the pound.
Hence the transaction would happen at CHF/£ ask rate(£ base currency).
3. Since the customer needs 1 million £ Spot, the forward rates are irrelevant in the 1st
part.
4. The intermediate currency ($) is the same in both the Banks. Therefore, we can individually
take each of the currency needed from the bank where it is the cheapest. For eg: the
 CHF 
1st rate   is lower in Bank A and hence we can buy $ in bank A whereas the 2nd rate
 $  $ 
  is lower in Bank B and hence we can use the $ purchased from Bank A to buy the £
 £
from Bank B. There is no need to do the entire transaction from a single Bank Only. The
above actions will result in the lowest CHF to be paid for 1 million £.

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Solution:

 CHF   CHF  $

(i)   =  × 
 £ A  $ A  £ A

= CHF 1.4655 / $ × $ 1.7650/£

= CHF 2.5866/£
Thus, in order to buy 1million £

hi
= £ 10,00,000 × CHF 2.5866/£
= CHF 25,86,600.
(ii) CHF/£ : 3 Month forward points (Bank –A)

ks
spot spot spot
 CHF   CHF   $
a.   =  × 
 £   $   £

 CHF 



£ 


=
SPOT
 CHF 
= 
 $ BID
ho
SPOT
 $
× 
SPOT

 £ BID
 CHF 
− 
 $ ASK

CHF 1.4650 /$ × $1.7645/£ - CHF 1.4655/$ × 1.7660/£

SPOT
 $
× 
 £ ASK
SPOT
C
= CHF 2.5850/£ - CHF 2.5881/£
3M 3M 3M
 CHF   CHF   $
b. =    × 
ik

 £   $   £

(CHF/$)3M = CHF 1.4650/$ + CHF 0.0005/$ / CHF 1.4655 /$ + CHF 0.0010/$

= CHF 1.4655/$ - CHF 1.4665/$
av

c. ($ / £)3M = $ 1.7645/£ - $ 0.0025/£ / $ 1.7660/£ - $ 0.0020/£

= $ 1.7620/£ - $ 1.7640/£
3M 3M 3M 3M 3M
Bh

 CHF   CHF   $  CHF   $

d.   =   ×  −  × 
 £   $ BID  £ BID  $ ASK  £ ASK

= CHF 1.4655/$ × $ 1.7620/£ - CHD 1.4665/$ × $1.7640/£

CHF 2.5822/£ - CHF 2.5869/£

e. Implied swap point (3 months) (CHF/£) = Forward rate – Spot Rate
= CHF 2.5822/£ - CHF 2.5850/£/CHF 2.5869/£ - CHF 2.5881/£
= CHF 0.0028/£/- CHF 0.0012/£
i.e., 28/12 Points

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Question 16 (ICAI SM)/(Practice Manual)

[Q.76 - AFM 8 (Fast Track) & 9, Q.76 - AFM 10]

M/s Omega Electronics Ltd. exports air conditioners to Germany by importing all the components
from Singapore. The company is exporting 2,400 units at a price of Euro 500 per unit. The cost
of imported components is S$ 800 per unit. The fixed cost and other variables cost per unit are
` 1,000 and ` 1,500 respectively. The cash flows in Foreign currencies are due in six months. The
current exchange rates are as follows:

hi
`/Euro 51.50/55
`/S$ 27.20/25
After six months the exchange rates turn out as follows:

ks
`/Euro 52.00/05
`/S$ 27.70/75

ho
(1) You are required to calculate loss/gain due to transaction exposure
(2) Based on the following additional information calculate the loss/gain due to transaction
and operating exposure if the contracted price of air conditioners is ` 25,000:
(i) the current exchange rate changes to
C
`/Euro 51.75/80
`/S$ 27.10/15
(ii) Price elasticity of demand is estimated to be 1.5
ik

(iii) Payments and receipts are to be settled at the end of six months.

Summary
av

Detailed Solution
Bh

1. Calculation of transaction exposure

Profit Calculation
Particulars Today Current Spot rate after 6 months
Selling price per unit ` 25,750 ` 26,000
(€ 500 × 51.50) (500 € × 52)
Less: Cost of Imported ` (21,800) (` 22,200)
components [S $ 800 × ` 27.25/S $] [ S$ 800 × ` 27.75/S $]
Less: Fixed costs per unit (` 1,000) (` 1,000)
Less: Variable costs per unit (` 1,500) (` 1,500)
Profit per unit ` 1,450 ` 1,300
× no. of units × 2,400 × 2,400
Total Profit ` 34,80,000 ` 31,20,000

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

Loss due transaction exposure = 31,20,000 – 34,80,000

= (` 3,60,000)
Alternative: C.I:
Cash Inflow = (` 52/€ - ` 51.5/€) × €500 × 2,400 = (` 6,00,000) (gain)
Cash Outlfow = (` 27.25/S$ - ` 27.75/S$) × S$800 × 2400 = (` 9,60,000) (loss)
Thus, net transaction exposure (loss) = (` 9,60,000) + ` 6,00,000
= (` 3,60,000)

hi
2. Transaction exposure
a. Profit Calculation
Particulars Current spot rate Spot rate after 6 months

ks
Selling Price per unit ` 25,000 ` 25,000
Less: Cost of Importer (` 21,720) (` 22,200)
component (S$ 800 × ` 27.15/S$) (S$ 800 × ` 27.75/S$)
Less: Fixed Cost per unit (` 1,000) (` 1,000)
Less: Variable Cost per unit
Profit per unit
× No. of units
Total Profit
ho (` 1,500)
` 780
× 2,400
` 18,72,000
(` 1,500)
` 300
× 2,400
` 7,20,000
C
Loss due to transaction exposure = (` 7,20,000 – ` 18,72,00)
= (` 11,52,000) (loss)
Alternative: Cash Outflow
ik

[` 27.75/S$ – ` 27.15/S$] × S$800 × 2,400 Units = (` 11,52,000)

Reference Note:

Note – 1: Transaction exposure is based on the transaction that has already happened
av

i.e., 2,400 units. A change in the quantity demanded will be expected in the future and
hence will not impact the exposure for the transaction already done.
b. Profit/loss due to expected changes in demand
Bh

(i) Equivalent price for European Customers

Based on current spot rate
= ` 25,000/` 51.75/€ (€ BID)
= € 483.09
Based on spot rate after 6 months
= ` 25,000/ ` 52/€ (€ BID)
= € 480.77

€480.77 − € 483.09
(ii) % fall in price = × 100
€ 483.09

= € 483.09

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

= - 0.48%
(iii) % increase in quantity demanded
= (0.48 %) × – 1.5 (Inverse relationship. Hence negative)
= 0.72%
(iv) Change in units
= 2,400 u × 0.72%
= 17.28

hi
= 17 units (increase)
(v) Increase in profit expected due to increase in demand
= 17 units × ` 300 (note 2)

ks
= ` 5,100 (Gain)
(vi) Operating exposure = Transaction exposure ± Changes in profit due to changes in
Quantity demanded.
= (` 11,52,000) + ` 5,100
= ` 11,46,900) ho
(loss)

Note – 2 : The incremental profit on 17 units would be earned after 6 months once the demand
C
changes. Hence, the relevant profit is to be considered after 6 months. However, fixed cost will
not ideally be incurred for the additional 17 units and hence the incremental profit per unit can
also be calculated as 300 + 1,000 = 1,300
ik

Thus, Alternative solution:

Op Exposure = (` 11,52,000) + (1,300 × 17)
av

= (` 11,52,200) + 22,100
= (` 11,29,900)
Bh

ICAI has shown both the methods. However, the 2nd method is more appropriate.

Question 17 (ICAI SM)/(MTP Oct 20)/(MTP March 22)/

(Practice Manual)
[Q.77 - AFM 8 (Fast Track) & 9, Q.77 - AFM 10]

You as a dealer in foreign exchange have the following position in Swiss Francs on 31st October,
2009:
Particulars Swiss Francs
Balance in the Nostro A/c Credit 1,00,000
Opening Position Overbought 50,000
Purchased a bill on Zurich 80,000

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Sold forward TT 60,000

Forward purchase contract cancelled 30,000
Remitted by TT 75,000
Draft on Zurich cancelled 30,000

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

hi
Summary

ks
Detailed Solution

NOSTRO A/C
Cash position as on 31/10/2009
Particulars

Opening
ho Debit
(withdrawal)
-
Credit
(in CHF)

(Deposit)
1,00,000
C
Spot Remittance (paid) 75,000
Total 75,000 1,00,000
Add: Spot deposit (Note :1) 5,000

Closing balance (Cr) 30,000

ik

Total 105,000 1,05,000

av

Exchange Position on 31/10/09 (in CHF)

Particulars Buy Sell
Opening 50,000 -
Purchased bill on Zurich 80,000 -
Bh

Sold Forward - 60,000

Forward purchase cancelled - 30,000
Remitted by TT Spot - 75,000
Draft on Zurich cancelled 30,000 -
Spot deposit (Note-1) 5,000 -
1,65,000 1,65,000
Add: Forward purchase (Note-2) 10,000 -

Net overbought position - 10,000

1,75,000 1,75,000

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 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

Note: 1
The balances in the cash A/c is CHF 25,000. In order to attain a credit balance of CHF 30,000,
we need to buy in the spot market (30,000 – 25,000 = 5,000). Forward purchases do not affect
the cash position and hence in order to alter the cash position, we need to do a spot deposit.
Note: 2
The cash deposit of 5,000 will also alter the exchange position. After considering the 5,000
deposit, the exchange position becomes NIL (1,65,000 – 1,65,000 = 0). However, in order to

hi
ensure an overbought balance of CHF 10,000, we need to enter into a forward purchase contract
of CHF 10,000. We should not do a spot CHF deposit as it would affect the cash position as well.

ks
Question 18 (RTP May 22)/(MTP Oct 22)
[Q.79 - AFM 8 (Fast Track) & 9, Q.79 - AFM 10]

Mr. Mammen, an Indian investor invests in a listed bond in USA. If the price of the bond

rate is 3% payable annually. ho

at the beginning of the year is USD 100 and it is USD 103 at the end of the year. The coupon

Find the return on investment in terms of home country currency if:

(i) USD is Flat.
C
(ii) USD appreciates during the year by 3%.
(iii) USD depreciates during the year by 3%.
(iv) Indian Rupee appreciates during the year by 5%.
ik

(v) Will your answer differ if Mr. Mammen invests in the bond just before the interest payable.

Summary
av

Detailed Solution
Bh

i. USD is flat:
Therefore, the USD value remains the same, the return for an investor is the returns
generated from the bond only i.e.
( $103 − $100 ) + $3 × 100
Return from Bond investment =
$100

(Assume face value = $ 100, ∴ interest = 3) = 6% p.a.

ii. USD appreciates by 3%
Reference:
The return for an Indian investor is made up of return from the bond and the return
from the currency.
If we invest an amount of ` 1, the return of end of year would be calculated as the

139 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

composite return from the bond as well as currency because we are investing in the bond
as well as currency.
Therefore, the return can be calculated as: [(1 ± r) ( 1 ± r) – 1]
Therefore, (1 + 0.06BOND) (1 + 0.03$) – 1
= 0.0918
i.e. 9.18%
Alt: We can assume notional rates, say the spot today equals ` 100/$. Therefore, after 1

hi
year, the expected spot would be ` 103/$. In such a case, the return can be calculated as

$103 × ` 103/$  −  $100 × ` 100/$ + ( $3 × ` 103/$)

   
$100 × ` 100/$

ks
10, 600 − 10, 000 + 309
= × 100
10, 000

= 9.18%

(iii) USD depreciates by 3%

{(1 + 0.06)B (1 - 0.03)$ – 1 }
ho
C
= 1.0282 – 1
= 0.282
i.e. 2.82%
ik

(iv) INR appreciates by 5%

Reference:
We have invested in a USD based bond and hence we want to check whether the $
av

appreciates/depreciates. In case INR appreciates by 5%, it implies that the $ depreciates

by 5% i.e. Return :
= [(1+0.06) (1-0.05)] – 1
Bh

= 0.007 i.e. 0.7 %

(v) As long as the amount invested remains the same, the above return calculations will remain
the same as well; because we will continue to receive the interest since the investment is
happening before interest is paid.

Question 19 (ICAI Paper May 18)/(RTP May 22)/(MTP April 22)

[Q.80 - AFM 8 (Fast Track) & 9, Q.80 - AFM 10]
M/s. Raghu Ltd. is interested in expanding its operation and planning to install manufacturing
plant at US. It requires 8.82 million USD (net of issue expenses/floatation cost) to fund the
proposed project. GDRs are proposed to be issued to finance this project. The estimated
floatation cost of GDRs is 2%.

140 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

Additional information:
(i) Expected market price of share at the time of issue of GDR is ` 360 (Face Value ` 100)
(ii) Each GDR will represent two underlying Shares.
(iii) The issue shall be priced at 10% discount to the market price.
(iv) Expected exchange rate is INR/USD 72.
(v) Dividend is expected to be paid at the rate of 20% with growth rate of 12%.

hi
(1) You, as a financial consultant, are required to compute the number of GDRs to be issued
and cost of the GDR.
(2) What is your suggestion if the company receives an offer from a US Bank willing to

ks
provide an equivalent loan with an interest rate of 12%?
(3) How much company can save by choosing the option as recommended by you?

Summary

Detailed Solution
ho
C
8.82
(i) (a) Issue size = × 100 =
9m
98

2 × (360 − 10% )
Issue price = =9m
ik

` 72 / $

$9
∴ No. of GDR = = 1 mill
$9
av

` 100 × 20%) × 2
(b) KGDR = $9 × ` 72 / $) − 2% + 0.12

= 0.1829
Bh

= 18.30%

(ii) In case a bank is offering the funds @ 12%, we should accept the offer from the bank
since it is cheaper as compared to GDR keeping all other factors constant.
(iii) If the offer from the bank is accepted, there would be a Net saving of 6.3% (18.3% - 12%)

Question 20 (ICAI Paper Nov 23)

[Q.2 - Additional Question AFM 8 (Fast Track) & 9, Q.84 - AFM 10]

A Japanese company imports hi-tech printer cartridges from US worth $ 1 million. The chief
financial officer of the company wishes to know the best strategy for protection against
uncertainty, for the payment that has to be made at the end of 3 months. Financial team of the

141 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

company has collected the following options for evaluation:

Table 1: Exchange rates quoted in FOREX Market:

¥/$ Quotations Bid Price Offer/Ask Price
Spot Rates 146.03 146.63
3M-Forward Rates 144.03 145.00
3M-Forward Rates 146.35 146.70

hi
Table 2: Options Market rates for European options with 3 months expiry.
Type of Option Strike Price (X) (¥/$) Premium (%) for Call & Put Options
Call & Put 145.20 1.6766% (Call) & 1.7414% (Put)

ks
Call & Put 146.00 1.3505% (Call) & 2.1006% (Put)

The expected spot price at expiry is ¥/$: 144.90/145.05

Suggest the best strategy for CFO of the Japanese Company to protect against uncertainty,

(i) Forward Hedge

(ii) Buy 3 months call, X = 145.20
(iii) Sell 3 months put, X = 145.20
ho
with respect to the following alternatives:
C
(iv) Buy call & sell put both having X = 146.00

Summary
ik

Detailed Solution
av

(i) Forward Hedge

Amount payable after 3 months $ 1000000
3 month applicable buying rate ¥ 145/$ Amt. payable in Yen ¥145 million
Bh

(ii) Buy 3 month call option X = ¥ 145.20

If expected spot price after 3 month is ¥ 145.05
Then company would not exercise its option. Accordingly the cost of import will be
Buying Yen in spot Market after 3 month ¥ 145.05 million
Add: Premium Paid ¥ 145.20 x 1.6766%x $ 1 million ¥ 2.43 million
¥ 147.48 million
(iii) Selling 3 month Put at X = ¥ 145.20
If expected spot price after 3 month ¥ 144.90 , then Put Option buyer will exercise his/
her option.
Accordingly the import Bill will be :

142 CA BHAVIK CHOKSHI

 FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT

(iv) Buying Call and selling Put at X = ¥ 146 Net Premium receipt
Premium paid on call option = ¥ 146.00 x 1.3505% ¥ 1.9717 million
Premium Receipt on Put option = ¥ 146.00 x 2.1006% ¥ 3.0669 million
¥ 1.0952 million

If expected spot Rate expiry happens to be ¥ 144.90/145.05, then call option will be
lapsed and Put option by buyer will be exercised. Accordingly, the import bill will be:
Buying US$ under Put Option ¥ 146.00 million

hi
Less: Receipt of Net Premium ¥ 1.09520 million
¥ 144.905 million
Decision: Since expected outflow is least in case of selling Put option, the same strategy
is recommended.

ks
ho
C
ik
av
Bh

143 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

CHAPTER 9 INTERNATIONAL FINANCIAL MANAGEMENT

Question 1 (ICAI SM)/(MTP Aug 18)/(Practice Manual)

[Q.3 - AFM 8 (Fast Track) & 9, Q.3 - AFM 10]

XY Limited is engaged in large retail business in India. It is contemplating for expansion into
a country of Africa by acquiring a group of stores having the same line of operation as that

hi
of India. The exchange rate for the currency of the proposed African country is extremely
volatile. Rate of inflation is presently 40% a year. Inflation in India is currently 10% a year.
Management of XY Limited expects these rates likely to continue for the foreseeable future.

ks
Estimated projected cash flows (for the combined operating project), in real terms, in India
as well as African country for the first three years of the project are as follows:

Cash flows in Indian ` (000)

Cash flows in African Rands (000)
ho Year – 0
-50,000
-2,00,000
Year – 1
-1,500
+ 50,000
Year – 2
-2,000
+ 70,000
Year – 3
-2,500
+ 90,000
C
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year indefinitely.
It evaluates all investments using nominal cash flows and a nominal discounting rate. The present
exchange rate is African Rand 6 to Rs 1.
ik

You are required to calculate the net present value of the proposed investment considering
the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted
av

rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s high
risk.
Bh

(iii) Ignore taxation.

Year – 1 Year – 2 Year – 3
PVIF @ 20% .833 .694 .579

Summary

Detailed Solution

Calculation of NPV
Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744

144 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696

Cash Flows in ` ’000
Real -50,000 -1,500 -2000 -2500
Nominal (1) -50,000 -1,650 -2420 -3327.50
Cash Flows in African Rand ’000
Real -2,00,000 50,000 70,000 90,000
Nominal -2,00,000 70,000 1,37,200 2,46,960
In Indian ` ’000 (2) -33,333 9167 14117 19,965

hi
Net Cash Flow in ` ‘000 (1)+(2) -83,333 7517 11697 16,637
PVF@20% 1 0.833 0.694 0.579
PV -83,333 6,262 8,118 9,633

ks
NPV of 3 years = -59,320 (` ‘000)

NPV of Terminal Value =

16, 637
0.20
ho
48,164 ‘000)
× 0.579 =

Total NPV of the Project = -59,320 (` ‘000) + 48,164 (` ‘000) = -11,156 (` ‘000)
C
Question 2 (ICAI SM)/ICAI Paper Nov 19 [Modified])/(RTP
Nov 18)/(MTP Oct 18)/(MTP May 20)/(MTP Oct 22/
(Practice Manual)
ik

[Q.7 - AFM 8 (Fast Track) & 9, Q.7 - AFM 10]

A multinational company is planning to set up a subsidiary company in India (where hitherto it

was exporting) in view of growing demand for its product and competition from other MNCs.
av

The initial project cost (consisting of Plant and Machinery including installation) is estimated to
be US$ 500 million. The net working capital requirements are estimated at US$ 50 million. The
company follows straight line method of depreciation. Presently, the company is exporting two
Bh

million units every year at a unit price of US$ 80, its variable cost per unit being US$ 40.
The Chief Financial Officer has estimated the following operating cost and other data in
respect of proposed project:
(i) Variable operating cost will be US $ 20 per unit of production;
(ii) Additional cash fixed cost will be 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;
(iii) Production capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage value;
(v) Existing working capital investment for production & sale of two million units through
exports was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case the

145 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

company does not open subsidiary company in India, in view of the presence of competing
MNCs that are in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no variation in the exchange rate of two currencies and all profits
will be repatriated, as there will be no withholding tax, estimate Net Present Value (NPV) of
the proposed project in India.

hi
Present Value Interest Factors (PVIF) @ 12% for five years are as below:
Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674

ks
Summary

Detailed Solution
ho
Financial Analysis whether to set up the manufacturing units in India or not may be carried
C
using NPV technique as follows:
I. Incremental Cash Outflows
Particulars $ Million
Cost of Plant and Machinery 500.00
ik

Working Capital 50.00

Release of existing Working Capital (15.00)
535.00
av

II. Incremental Cash Inflow after Tax (CFAT)

(a) Generated by investment in India for 5 years
Particulars $ Million
Bh

Sales Revenue (5 Million x $80) 400.00

Less: Costs
Variable Cost (5 Million x $20) 100.00
Fixed Cost 30.00
Depreciation ($500Million/5) 100.00
EBIT 170.00
Taxes@35% 59.50
EAT 110.50
Add: Depreciation 100.00
CFAT (1-5 years) 210.50
Cash flow at the end of the 5 years (Release of 35.00
Working Capital)

146 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

(b) Cash generation by exports (Opportunity Cost)

Particulars $ Million
Sales Revenue (1.5 Million x $80) 120.00
Less: Variable Cost (1.5 Million x $40) 60.00
Contribution before tax 60.00
Tax@35% 21.00
CFAT (1-5 years) 39.00
(c) Additional CFAT attributable to Foreign Investment

hi
$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00

ks
CFAT (1-5 years) 171.50

III. Determination of NPV

Year CFAT ($ Million) PVF@12% PV ($ Million)
1-5
5

Less: Initial Outflow

ho 171.50
35
3.6048
0.5674
618.2232
19.8590
638.0822
535.0000
103.0822
C
Since NPV is positive the proposal should be accepted.

Question
3 (RTP May 24)
ik

[Q.1 - Additional Question AFM 8 (Fast Track) & 9, Q.13 - AFM 10]

Mr. Vishwas, a friend of Mr. Pramod who is one of the Directors of Ashirwad Limited, is a citizen
of Mauritius. His immediate family members including his parents, born in India are residing in
av

India. He has many friends in different parts of India, due to which he happens to visit India
on frequent basis. He along with Mr. Pramod evince interest in setting up business in India and
formally incorporate a company to commence their operations. Accordingly, a company is called
Bh

“Aerious Private Ltd.” got incorporated in Mumbai.

To start with he received a business proposal from one of his friends Nimish a consultant It
is estimated that in equivalent terms the business shall require an initial investment of MUR 100
Million and thereafter MUR 2 Million each year will be needed as working capital fund.
He wished to evaluate whether the business proposal is viable or not. The information related
to exchange rate and inflation rate is as follows:
Spot Rate for 1 Mauritian Dollar (MUR) = 1.88 Indian Rupee (INR) The inflation in India is 6%
and in Mauritius is 5%.
It is expected that this inflation rate will remain unchanged for the next 4 years.
INR 8 Crore out of initial investment shall be required for setting up a plant. The useful life
of the plant is 4 years. At the end of 4th year estimated salvage value of this plant shall be INR

147 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

80 lakhs. Depreciation of the plant shall be charged on the basis of straight-line method.
40% of the investment shall be through debt funds from Mauritius at the cost of 10% (post
tax) while remaining funds shall be arranged by him and his friends. They expect a rate of
return of 12% on their funds.

Expected revenues & costs (excluding depreciation) in real term are as under:
Year 1 2 3 4

hi
Revenues (` Crore) 6.00 7.00 8.00 8.00
Costs (` Crore) 3.00 4.00 4.00 4.00

Assume that applicable tax rate in India is 30%. Since there is Double tax avoidance agreement

ks
between India and Mauritius, the company is not required to pay tax in Mauritius if tax has been
paid in India.

Year
1
2
ho
The applicable inflation rates for revenues & costs are as follows:
Revenues
10%
9%
Costs
12%
10%
C
3 8% 9%
4 7% 8%

He wants an expert opinion for the same investment proposal. Demonstrate whether investment
ik

in this project is viable option or not.

Note: 1. Round off calculations upto 4 decimal points.
2. Show INR calculations in Crore and MUR calculations in Million.
av

Summary
Bh

Detailed Solution

(1) Calculation of Discount Factor (WACC)

In this question, discount rate is not given. We can calculate the same based on WACC.

D E
ie WACC = KD × +KE ×
D+E D+E

= 10% × 0.4 + 12% × 0.6

= 11.2%

148 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

We have been given that the debt funds are raised in Mauritius and Mr. Vishwas is also based in
Mauritius and hence the equity funds are also likely to be raised in Mauritius.
Hence, the above WACC would be the Mauritian WACC and hence we should ultimately find the
Mauritian cash flows to be discounted at this WACC.
Further, unless given the WACC would be nominal and hence we will convert the real cash flows
into nominal and then solve.
(2) Calculation of Forward Rates

hi
Using IRP,
F (1 + iIND )
=
S (1 + iMUR )

ks
End of Year INR INR/MUR

1.06
1 F = ` 1.88 / MUR × ` 1.8979
1.05

3
F = ` 1.8979 / MUR ×

F = ` 1.9169 / MUR ×
ho 1.06
1.05

1.06
` 1.9160

` 1.9343
C
1.05

1.06
4 F = ` 1.9343 / MUR × ` 1.9537
1.05
ik

(3) Calculation of Inflation Adjusted Revenue and Cost

a) Revenue
Year Revenue (Inflation Adjusted) (`) ` in cr
av

1 6.00 × 1.1 = 6.6

2 7.00 × 1.1 × 1.09 = 8.393
3 8.00 × 1.1 × 1.09 × 1.08 = 10.359
4 8.00 × 1.1 × 1.09 × 1.08 × 1.07 = 11.084
Bh

b) Cost (Excluding Depreciation)

Year Cost (Inflation Adjusted) (`) ` in cr
1 3.00 × 1.12 = 3.36
2 4.00 × 1.12 × 1.1 = 4.928
3 4.00 × 1.12 × 1.1 × 1.09 = 5.372
4 4.00 × 1.12 × 1.1 × 1.09 × 1.08 = 5.801

(4) Initial Investment and Working Capital

Initial Investment: MUR 100M × ₹ 1.88/MUR = ₹ 188M
= ₹ 18.8 cr

149 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

Working Capital
Y1 – MUR 2M × ₹ 1.8979/MUR = ₹ 8.7958 M = ₹ 0.37958 cr
Y2 - MUR 2M × ₹ 1.9160/MUR = ₹ 3.832 M = ₹ 0.3832 cr
Y3 – MUR 2M × ₹ 1.9343/MUR = ₹ 3.8686 M = ₹ 0.38686 cr
Y4 – MUR 2M × ₹ 1.9527/MUR = ₹ 3.9054 M = ₹ 0.39054 cr

Release of Working Capital (Y4)

hi
= 0.37958 + 0.3832 + 0.38686 + 0.39054
= ₹ 1.54 cr

ks
Reference Note:
(1) We have been given that the initial investment is effectively ₹ 18.8 crores out of which
₹ 8 crore is for plant.

(2)
ho
The remaining ₹ 8 crore of investment maybe in any other asset. It is not assumed to be
working capital (ICAI).
We were given the above values in MUR. However, the release would happen in rupees
and hence we need the calculate the above cash flows is rupees.
C
(3) Calculation of NPV
Y0 Y1 Y2 Y3 Y4
Initial Investment (A) (18.80) - - - -
ik

Revenue (3a) - 6.6 8.393 10.359 11.684

(-) Cost (3b) - (3.36) (4.928) (5.372) (5.801)
(-) Depreciation -
 8 - 0.8  (1.8) (1.8) (1.8) (1.8)
av

 
 4 
1.44 1.665 3.187 3.483
(-) Tax @ 30% (0.432) (0.4995) (0.9561) (1.0449)
Bh

PAT @ 70% 1.008 1.1655 2.2309 2.4381

(+) Depreciation 1.8 1.8 1.8 1.8
Annual CI (B) 2.808 2.9655 4.6309 4.2381
(-) Working Capital Investment (0.37958) (0.3832) (0.38686) (0.39054)
(+) Release of Working Capital - - - 1.54
(+) Salvage - - - - 0.8
(18.8) 2.42842 2.5823 3.64404 6.18756
(÷) Exchange Rate (₹/MUR) 1.88 1.8979 1.9160 1.9343 1.9343
CF MUR × 10 (MUR Million) (100) 12.796 13.478 18.839 31.688
DF @ 11.2% 0.8993 0.8087 0.7273 0.654
(100) 11.50 10.90 13.70 20.72

150 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

NPV = MUR 43.18 Million

Therefore, project should be rejected.
Reference Note:
Additional Requirement in each year given and hence no adjustment for inflation. No specific
additional working capital given, but revenue and cost are growing by 5% and hence working
capital also assumed to grow by 5%. No inflation/No additional working capital requirement given.

hi
Question 4 (MTP March 24)
[Q.2 - Additional Question AFM 8 (Fast Track) & 9, Q.14 - AFM 10]
DK Ltd. is considering an investment proposal in Sri Lanka involving an initial investment of LKR

ks
25 billion. The current spot exchange rate is INR/LKR 0.370. The risk free rate in India is 6%
and the same in Sri Lanka is 5.02%.
The project will generate a cash flow of LKR 5 billion in the first year. The cash flow will increase

ho
by LKR 1 billion each year for the next 4 years. The project will wind up on completion of 5 years
with no salvage value. The required rate of return for the project is 8%
(i) You are required to find out the investment worth of the project by using
(1) Home Currency Approach (2) Foreign Currency Approach
C
(ii) Compare the outcome under both the approaches
Given:
PVIF (8%, t) 0.92593 0.85734 0.79383 0.73503 0.68058
ik

PVIF (7%, t) 0.93457 0.87344 0.81630 0.76290 0.71299

Note: Excepts rates show all calculations in Billion upto four decimal points.
av

Summary

Detailed Solution
Bh

Working Notes:
Calculation of Forward Exchange Rates
End of Year ` `/LKR

1.06
1 0.37 x 0.373
1.052
1.06
2 0.373 x 0.376
1.052
1.06
3 0.376 x 0.379
1.052

151 CA BHAVIK CHOKSHI

 INTERNATIONAL FINANCIAL MANAGEMENT

1.06
4 0.379 x 0.382
1.052
1.06
5 0.382 x 0.385
1.052

1. Home Currency Approach

hi
Year Cash Flow `/LKR Cash flow PVF @ 8% PV
Billion LKR Billion ` Billion `
1 5 0.373 1.865 0.92593 1.7269
2 6 0.376 2.256 0.85734 1.9342

ks
3 7 0.379 2.653 0.79383 2.1060
4 8 0.382 3.056 0.73503 2.2463
5 9 0.385 3.465 0.68058 2.3582

2.
Less: Investment

Foreign Currency Approach

25
ho 0.37
NPV
10.3716
9.2500
1.1216
C
(1 + 0.06) (1 + Risk Premium) = 1.08
1 + Risk Premium = 1.08/1.06 = 1.01887
Therefore, Risk adjusted LKR Rate = 1.01887 × 1.0502 – 1 = 0.07 i.e. 7%
ik

Calculation of NPV
Year Cash Flow PVF @ 7% PV
(Billion LKR) (Billion LKR)
av

1 5 0.93457 4.6729
2 6 0.87344 5.2406
3 7 0.81630 5.7141
4 8 0.76290 6.1032
Bh

5 9 0.71299 6.4169
28.1477
Less: Investment 25.0000
NPV 3.1477

Thus, Rupee NPV of the Project = ` 0.37 × 3.1477 = ` 1.1646 billion

Decision: NPV is positive in the approach so, project will worth investment.

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 DERIVATIVES ANALYSIS AND VALUATION

CHAPTER 10 DERIVATIVES ANALYSIS AND VALUATION

Question 1 [Q.1 - AFM 8 (Fast Track) & 9, Q.1 - AFM 10]

On Aug. 2, Mr. Tandon buys 5 contracts of December Reliance futures at 840. Each contract
covers 50 shares. Initial margin was set at ` 2400 per contract while maintenance margin was

hi
fixed at ` 2000 per contract. Daily settlement prices are as follows:
Aug. 2 818
Aug. 3 866

ks
Aug. 4 830
Aug. 5 846
Mr. Tandon meets all margin calls. Whenever he is allowed to withdraw money from the

1.
2.
3.
Margin call;
Profit & (Loss) on the contracts;
ho
Margin Account, he withdraws half the maximum amount allowed. Compute for each day:

The balance in the Account at the end of the day.

C
Assume that Mr. Tilak sells the same 5 contracts at the same price. If the same margins and
same conditions are applicable, what is the margin call, profit and loss and balance in the account
for Mr. Tilak? Verify buyer's gain is seller's loss. i.e. prove futures are zero sum games.
ik

Summary
av

Detailed Solution

Mr. Tandon (Long reliance futures)

Bh

Initial deposit = 2,400/contract × 5 = 12,000

Maintenance margin = 2,000/contract × 5 = 10,000

As given, the amount can be withdrawn from the margin account whenever there is a gain and
the amount to be withdrawn (if any) = 50% of gain.
Date Opening Profit/loss Withdrawal Closing Margin Adjusted
Balance Balance Call Closing
Aug 2 12,000 (818-840) × 50 × 5 - 6,500 5,500 12,000
= (5,500) (12,000-6,500)
Aug 3 12,000 (866-818) × 50 × 5 (6,000) 18,000 - 18,000
= 12,000

153 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

Aug 4 18,000 (830-866) x 50 x 5 - 9,000 3,000 12,000

= (9,000) (12,000-9,000)
Aug 5 12,000 (846-830) x 50 x 5 (2,000) 14,000 - 14,000
= 4,000 (50% of
4000)
1,500
Net Gain
Or
[(846-840) × 50] × 5

hi
Mr Tilak (Short 5 reliance futures)
Initial : 12,000 (same)

ks
Maintenance : 10,000 (same)
Date Opening Profit/loss Withdrawal Closing Call Adj Closing
Balance Balance
Aug 2

Aug 3

Aug 4
12,000

14,750

12,000
(840-818) × 50 × 5
= 5,500
(818-866) × 50 × 5
= (12,000)
(866-830) x 50 x 5
ho (2,750)

(4,500)
14,750

2,750

16,500
-

9,250
(12,000-2,750)
-
14,750

12,000

16,500
C
= 9,000
Aug 5 16,500 (830-846) x 50 x 5 - 12,500 - 12,500
= (4,000)
1,500
ik

Net Loss
Or
[(840-846)*50]*5
av

As can be seen the overall loss of Mr. Tilak (1,500) is the same as the overall gain of Mr. Tandon
i.e. (1,500).
Bh

Question 2 (RTP May 21)

[Q.3 - AFM 8 (Fast Track) & 9, Q.3 - AFM 10]

The Following data relate to A Ltd.’s Portfolio:

Shares X Ltd. Y Ltd. Z Ltd.
No. of Shares (lakh) 6 8 4
Price per share (`) 1000 1500 500
Beta 1.50 1.30 1.70

The CEO is of opinion that the portfolio is carrying a very high risk as compared to the market
risk and hence interested to reduce the portfolio’s systematic risk to 0.95. Treasury Manager
has suggested two below mentioned alternative strategies:

154 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
(ii) Take appropriate position on Nifty Futures, currently trading at 8250 and each Nifty
points multiplier is 210.
You are required to:
(a) Interpret the opinion of CEO, whether it is correct or not.
(b) Calculate the existing systematic risk of the portfolio,
(c) Advise the value of risk-free securities to be acquired,

hi
(d) Advise the number of shares of each company to be disposed off,
(e) Advise the position to be taken in Nifty Futures and determine the number of Nifty
contracts to be bought/sold; and

ks
(f) Calculate the new systematic risk of portfolio if the company has taken position in
Nifty Futures and there is 2% rise in Nifty.
Note: Make calculations in Rs lakh and upto 2 decimal points.

Summary

Detailed Solution
ho
C
(a) Calculation of Portfolio β
Shares Amount Invested Weights Β β × Weights
ik

No of shares × MP
X 6,000 0.3 1.5 0.45
(6 × ` 1,000)
Y 12,000 0.6 1.3 0.78
av

(8 × ` 1,500)
Z 2,000 0.1 1.7 0.17
(4 × ` 500)
20,000 1.40
Bh

The β of the market is always 1. The portfolio of A Ltd has a β of 1.4 and hence has a
higher risk as compared to the market. Therefore, the opinion of the CEO is correct.
(b) The systematic risk of the portfolio is 1.4 times that of the market
(Reference Note: Usually, the systematic risk can be calculated as β2 × σ2m) σm is not
available in the question and hence we have commented that the systematic risk will be
1.4 times that of the market. Further, we square the terms in order to calculate the
unsystematic risk. Unsystematic risk is not asked in the question and hence we ignore.
(c) Risk free securities in order to have a target β of 0.45:
Reference Note:

155 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

In this question, we have been clearly given to dispose off a part of the existing investment
in order to acquire the risk-free securities. Hence, the total portfolio value will continue
to be ` 20,000 Lakhs.
Let the proportion of risk-free securities in the total portfolio be x. Therefore, the
weights of the portfolio of existing securities will be 1 – x
Thus, 0.95 = 0 × x + 1.4 x (1 – x) [β of risk free securities = 0]
0.95 = 0 + 1.4 – 1.4x

hi
1.4x = 0.45
Thus, x = 0.32
i.e., 32%

ks
Thus, 1 – x = 1 – 0.32 = 0.68
i.e., 68%
Thus, value of risk-free Securities to be acquired = ` 20,000 Lakhs × 32%
= ` 6,400 Lakhs
(d) No of shares to be disposed. ho
We have assumed that X,Y,Z will be disposed proportionately i.e., in the ratio of 0.3 : 0.6
: 0.1 . In order to purchase risk free securities worth 6,400 Lakhs, we will have to dispose
C
the existing shares worth 6,400 lakhs (in the ratio of 0.3 : 0.6 : 0.1)
Shares Value to be disposed Market price / shares No. of shares
X 1,920 L 1,000 1.92 Lakhs
ik

(6,400 × 0.3)
Y 3,840 L 1,500 2.56 Lakhs
(6,400 × 0.6)
Z 640 L 500 1.28 Lakhs
av

(6,400 × 0.1)
6,400
(e) In order to hedge using the NIFTY futures (instead of the risk-free rate) we need to
Bh

short the Nifty futures (i.e., take an off-setting portion)

Thus, the strategy would be to SHORT Nifty futures.
No of contracts to be shorted
Reference Note:
In case a complete hedge was to be taken, we would determine the no. of Nifty futures
to be shorted based on adjusting the portfolio value by 1.4. However, under a complete
hedge, the entire loss/gain on the underlying portfolio will be off-set by the Nifty
futures. Hence, the overall portfolio sensitivity would come down to 0. However, we want
the sensitivity to come down to 0.95 and hence we want the sensitivity to move from 1.4
to 0.95 and hence we should adjust the portfolio value by 1.4 – 0.95. This will ensure that
the excess movement beyond 0.95 will be hedged.

156 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

No. of contracts to be shorted

20, 000 Lakhs × (1.4 − 0.95 )

=
20, 000 8, 250 × 210
Lakhs 0.45
=
17.325 Lakhs

20, 000 Lakhs × 0.45

=
17.325 Lakhs

hi
= 519.48
i.e., 519 Contracts

ks
(f) Portfolio position if Nifty rises by 2%
Ignoring the Nifty futures, the existing 20,000 Lakhs portfolio has a β of 1.4. Therefore,
if the Nifty rises by 2% the portfolio will rise by 2% × 1.4 = 2.8%
Thus, gain on underlying portfolio
(20,000 Lakhs × 2.8%)
Less: Loss on Nifty futures
[(8,250 – 8,415*) × 210] × 519
ho 560 Lakhs

(179.83 Lakhs)
C
 S.P  C.P
1,00,000 (in order to show answer in lakhs)
*8,250 + 2% × 8,250
ik

Net gain on overall position

[Long portfolio + Short Nifty futures] 380.17 Lakhs
av

Amount invested 20,000 Lakhs

380.17
Thus, Net Return = × 100 = 1.90%
20, 000
Bh

Nifty return 2%

1.9%  Portfolio Movement 

Thus, β =  
2%  Nifty movement 

= 0.95
The new systematic risk 0.95
Reference Note:
On shorting a nifty future (or even stock future), we don’t get any immediate cash inflow
and hence the investment continues to remain 20,000 Lakhs. In case we buy/sell in the
spot market, there is an immediate cash outflow/cash inflow. However, in case of futures,
there would be no immediate cash flow.

157 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

Question 3 (ICAI SM)/(Practice Manual)

[Q.14 - AFM 8 (Fast Track) & 9, Q.14 - AFM 10]

On April 1, 2015, an investor has a portfolio consisting of eight securities as shown below:
Security Market Price No. of Shares b Value
A 29.40 400 0.59
B 318.70 800 1.32
C 660.20 150 0.87

hi
D 5.20 300 0.35
E 281.90 400 1.16
F 275.40 750 1.24
G 514.60 300 1.05

ks
H 170.50 900 0.76

The cost of capital for the investor is 20% p.a. continuously compounded. The investor fears a

to protect the interest of his portfolio. ho

fall in the prices of the shares in the near future. Accordingly, he approaches you for the advice

You can make use of the following information:

(i) The current NIFTY value is 8500.
C
(ii) NIFTY futures can be traded in units of 25 only
(iii) Futures for May are currently quoted at 8700 and Futures for June are being quoted at
8850.
ik

You are required to calculate:

(i) the beta of his portfolio.
(ii) the theoretical value of the futures contract for contracts expiring in May and June.
av

Given (e0.03 = 1.03045, e0.04 = 1.04081, e0.05 = 1.05127)

(iii) the number of NIFTY contracts that he would have to sell if he desires to hedge until
June in each of the following cases:
Bh

(A) His total portfolio

(B) 50% of his portfolio
(C) 120% of his portfolio

Summary

Detailed Solution

1. Portfolio β
Security Amount Invested b Value Weight Average
A (29.4 × 400) 11,760 0.59 0.0069

158 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

B (318.70 × 800) 2,54,960 1.32 0.3384

C (660.20 × 150) 99,030 0.87 0.0866
D (5.2 × 300) 1,560 0.35 0.0005
E (281.90 × 400) 1,12,760 1.16 0.1315
F(275.4 × 750) 2,06,550 1.24 0.2576
G (514.60 × 300) 1,54,380 1.05 0.1630
H (170.50 × 900) 1,53,450 0.76 0.1173
9,94,450 Portfolio b 1.1018

hi
2. Theoretical Futures price
a. June Futures (3 months) [01/04/15 – 30/06/15]

ks
As per cost of carry model
F = S (e)rN
= 8,500 × e0.2 x 3/12 (N = 3)


(given)

= 8,500 × e0.05
= 8,500 × 1.05127

F = ` 8935.80
ho
C
b. May Futures (2 months) [1/4/15 – 31/5/15]
F = S × erN
= 8,500 × e 0.2 x 2/12
(N = 2)
ik

= 8,500 × e 0.03333

= 8,500 × 1.03387 (From WN:1)

F = ` 8,787.9
av

WN 1 - e0.03333
We are not given the value for e 0.0333
. However, we are given the values for e 0.03

and e 0.04. e0.03333 lies in between these 2 values and hence we can use interpolation in
Bh

order to find these values.

e0.04 – e0.03 = 1.04081 – 1.03045
e0.01 = 0.01036
e Difference
0.01 0.01036
0.0033 ?
(0.0333 – 0.03)
e0.0033 = 0.01036 × 0.0033 / 0.01
= 0.00342
e0.0333 = e0.03 + e 0.0033
= 1.03045 + 0.00342
e0.0333 = 1.03387

159 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

3. No. of Contracts
Strategy : Sell
Maturity : June futures @ 8,850
Reference Note:
In order to hedge, we need to sell the futures on the exchange and the actual price
prevailing on the exchange is 8,850. In case the actual price was not given, we can take
the theoretical price assuming it to be the same as actual i.e.,

hi
Contract Size
= ` 8,850 × 25
` 2,21,250

ks
a. No. of Contracts for fully hedging (100%)

9, 94, 450 × 1.1

= × 100
2, 21, 250

= 4.94 i.e

b. 50% Hedging
ho
5 Contracts
C
9, 94, 450 × 1.1
= × 50%
2, 21, 250

= 2.47
ik

i.e 2 Contracts
c. 120% Hedging
av

9, 94, 450 × 1.1

= × 120%
2, 21, 250

= 5.93 i.e. 6 Contracts

Bh

Question 4 (ICAI Paper May 19)/(RTP Nov 20)

[Q.18 - AFM 8 (Fast Track) & 9, Q.18 - AFM 10]

A Rice Trader has planned to sell 22000 kg of Rice after 3 months from now. The spot price
of the Rice is ` 60 per kg and 3 months Future on the same is trading at ` 59 per kg. Size of
the contract is 1000 kg. The price is expected to fall as low as ` 56 per kg, 3 months hence.

Required:
(i) to interpret the position of trader in the Cash Market.
(ii) to advise the trader should take in Future Market to mitigate its risk of reduced profit.
(iii) to demonstrate effective realized price for its sale if he decides to make use of future

160 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

market and after 3 months, spot price is ` 57 per kg and future contract price for
closing the contract is ` 58 per kg.

Summary

Detailed Solution

hi
(i) Since the trader has planned to sell rice in the futures market after 3 months, it implies
that he needs to have the rice in order to sell it and hence he should be long in the cash
(Spot) market.

ks
(ii) In case the trader wants to sell the rice after 3 months, it is advisable to use the futures
market and sell at ` 59/kg instead of keeping it unhedged, in which case the expected
selling price would only be ` 56/kg.

ho
(iii) A future’s contract can be settled by taking an off-setting position in a similar futures
contract for the balance unexpired period. In this case, the trader has originally shorted
the rice futures i.e 22 contracts of 1,000 kg each.
On the date of settlement, the futures contract price for closing the contract is ` 58/
C
Kg and hence,
Gain on futures (Net settlement) = (` 59/kg – ` 58/kg) × 1,000 kg × 22 (contracts)
(S.P) (C.P)
ik

= ` 22,000 C.I
Sell 22,000 kg in spot market = ` 12,54,000 C.I
(22,000 kg × ` 57/kg)
av

Total C.I ` 12,76,000

÷ Quantity ÷ 22,000 Kg
Sale price per kg ` 58/kg
Bh

Question 5 (Practice Manual)

[Q.20 - AFM 8 (Fast Track) & 9, Q.20 - AFM 10]

X Baking company's equity share has a present market price per share of ` 28. A 6 month call
option has been written on the stock with an exercise price of ` 30. Presently the option has
a market value of ` 3. At the end of 6 months, you estimate the market price of the stock to
be ` 24 per share with a probability of .1, ` 28 with aprobability of .2, ` 32 with a probability
of .4, ` 37 with a probability of .2, and ` 43 with a probability of. 1.
(a) What is the expected value of share price 6 months hence? What is the expiration
value of the option if that expected value of share price should prevail?
(b) What is the expected value of option price at expiration, assuming that the option is

161 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

held to this time?

(c) Presently, what is the theoretical value of the option?

Summary

Detailed Solution

hi
a. Expected share price after 6 months
(Based on probability based weighted average)
= 24 (0.1) + 28 (0.2) + 32 (0.4) + 37 (0.2) + 43 (0.1)

ks
= ` 32.5

If expected value of 32.5 is to prevail at expiry, then the holder of the call option would

= 32.5 – 30
= ` 2.5
ho
exercise his right to buy at ` 30 and hence the payoff would be:
C
Therefore, at expiration the holder will receive 2.5.
Reference note: Premium is to be paid upfront and hence is not considered in the above
working.
ik

b. Spot at expiry
Spot Price Exercise (Sx > 30) Option payoff Probability
24 No Nil (24 - 30) 0.1
av

28 No Nil (28 - 30) 0.2

32 Yes 2 (32 - 30) 0.4
37 Yes 7 (37 - 30) 0.2
43 Yes 13 (43 - 30) 0.1
Bh

Expected pay off = 0 × 0.1 + 0 × 0.2 + 2 × 0.4 + 7 × 0.2 + 13 × 0.1

= ` 3.5
Reference Note:
The value of the option is dependent on the pay-off generated in each scenario at expiry.
The weighted average of the option pay-off will give us the actual value of the option.
c. Theoretical value of option:
= SO – PV of Xp
= 28 – 30
= Nil

162 CA BHAVIK CHOKSHI

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Exam Notes:
1. In the absence of information on interest rates, we have ignored the present value
calculation in order to determine theoretical value.
2. The value of an option can be minimum 0 and it cannot be negative.

Question 6 (Practice Manual)

[Q.33 - AFM 8 (Fast Track) & 9, Q.33 - AFM 10]

hi
Consider a stock which is quoted at ` 84. A call option on this available at a strike price of
` 87.50. The stock can take values of ` 89 or ` 79 in 3 months. If it takes a value of ` 89, it can
go to either ` 94 or ` 84 in another 3 months and if it takes the value of ` 79 after 3 months, it

ks
can go to either ` 84 or ` 74 in another 3 months. The stock is not expected to pay any dividend.
It is given that the risk free rate is 4%. Find the price of the call option using binomial model.
Using the value of put option, verify the put call parity theorem.

Summary
ho
C
Detailed Solution
ik
av
Bh

WN-1
At N1, N3, N4

S3 × P + S4 × (1 − P )
S1 =
 3
1 + r × 
 12 

163 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

94 × p + 84 × (1 − p )
89 =
 3
1 +  0.04 × 
 12 

94p + 84 − 84p
89 =
1.01

89.89 = 10p + 84

hi
5.89 = 10p
P = 0.589

ks
1 – p = 1 – 0.589 = 0.411

C3 × P + C4 (1 − P )
C1 =
 3

C1 =
1 + r × 
 12 

6.5 × 0.589 + 0 ( 0.411 )

1.01
ho
C
3.83 + 0
C1 =
1.01

C1 = 3.79
ik

Working Note – 2 - At N2 N5 and N6

84q + 74 (1 − q )
av

79 =  3
 1 + 0.04 × 
 12 

79 × 1.01 = 84q + 74 – 74q

Bh

79.79 = 10q + 74
5.79 = 10q
q = 0.579
1 – q = 1 – 0.579
= 0.421

0 × 0.579 + 0 × 0.421
C2 =
1.01

0
C2 =
1.01

C2 = 0

164 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

Reference Note:
The above calculation for C2 Can be avoided and C2 can directly be taken as 0 irrespective of the
probabilities as C5 and C6 are both 0.

WN - 3. At N0, N1, and N2

89 × s + 79 × (1 − s )
84 =
 3

hi
 1 + 0.04 × 
 12 

89s + 79 − 79s
84 =

ks
1.01

84.84 = 10s + 79
5.84 = 10s
S = 0.584

1 – S = 1 – 0.548
= 0.416
ho
C
3.79 × 0.584 + 0 × 0.416
CO =
ik

1 + 0.01

CO = 2.21 + 0
1 + 0.01
av

CO = 2.19

Put Option Valuation

Bh

Reference Note:
The process remains the same for the put option. However, the pay-offs at the final nodes can
be calculated as XP - SX and hence pay-off values would change.
Further, since the probabilities are based on spot prices, they would remain the same
irrespective of whether it is a call option or a put option.

165 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

hi
ks
WN-4. At N1, N3, and N4

P1 =
P3 × P + P4 × (1 − p )
 3
1 + r × 
ho
C
 12 

0 × 0.589 + 3.5 × 0.411

P1 =
 3
1 +  0.04 × 
12
ik

 
0 + 1.44
P1 =
1.01
av

P1 = 1.43

WN - 5. At N2,N5, N6
Bh

3.5 × 0.579 + 13.5 × 0.421

P2 =
 3
1 +  0.04 × 
 12 

2.03 + 5.68
P2 =
1.01

7.71
P2 =
1.01

P2 = 7.63

166 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

WN - 6. Alt N0, N1 and N2

1.43 × 0.584 + 7.63 × 0.416

P0 =
 3
1 +  0.04 × 
 12 

0.84 + 3.17
P0 =
1.01

hi
P0 = ` 3.97

Call put parity theory (Discussed after the question)

ks
P0 + S0 = C0 + PV of XP
LHS : P0 + S0
= 3.97 + 84

RHS
= 87.97

: C0 + PV of XP
ho
C
4 × 0.5
87.50  0.04 
= 2.19 + → Alternative :  1 + 
(1 + 0.04 × 6 / 12)  4 

= 2.19 + 85.78
ik

= 87.97

Since LHS = RHS, call put parity theory applies.

av

Exam Reference:
In case the value of both call and put are asked in the question, we can solve for the call option
Bh

using binomial and directly calculate the value of the put option using call-put parity theory.

P0 + 84 = 2.19 + 87.5/1.02
P0 = 2.19 + 85.78 – 84
P0 = 3.97
[Instead of doing the entire workings)

Question 7 (ICAI Paper Nov 19)

[Q.36 - AFM 8 (Fast Track) & 9, Q.36 - AFM 10]

AB Ltd.'s equity shares are presently selling at a price of ` 500 each. An investor is interested
in purchasing AB Ltd.'s shares. The investor expects that there is a 70% chance that the price

167 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

will go up to ` 650 or a 30% chance that it will go down to ` 450, three months from now. There
is a call option on the shares of the firm that can be exercised only at the end of three months
at an exercise price of ` 550.
Calculate the following:
(i) If the investor wants a perfect hedge, what combination of the share and option should
he select ?
(ii) Explain how the investor will be able to maintain identical position regardless of the

hi
share price.
(iii) If the risk-free rate of return is 5% for the three months period, what is the value of
the option at the beginning of the period?

ks
(iv) What is the expected return on the option?

Summary

Detailed Solution

Reference Note:
ho
C
1. We are asked to find the ratio of the share and the options in order to achieve a perfect
hedge. Hence, we solve considering the riskless hedge approach. Further, we can show
identical position regardless of the share price only under the riskless hedge approach
ik

and hence we have solved accordingly.

2. The probabilities are given in the question. However, they need to be ignored since we
are solving using the riskless hedge method. The probabilities of 70% and 30% are the
av

probabilities as expected by AB. These may be different as compared to the risk neutral
probabilities which we calculate by applying the methods solved in the earlier question.
Bh

Solution:
1. Riskless Hedge

168 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

2. Hedged Portfolio: Buy shares and short call options

Let no. of shares be x and the premium on call options be ` C0
Thus, amount invested in hedged portfolio today
= 500x – C0……………………………………………………………………………………………………………………………………..(1)
3. Since position is hedged , outcome at N1 and N2 will be the same i.e.,
650x – 100 = 450x – 0
Thus, 200x = 100

hi
Thus, x = 0.5…..Part (i)
 C1 − C2 100 − 0 
= = 0.5 
 S − S 650 − 450 
 1 

ks
2

4. Substituting x = 0.5 at
N1 = 650 × 0.5 – 100 = 225

5.
N2 = 450 × 0.5 – 0 = 225 (Part ii)
ho
Since position is risk-free, we will earn a risk-free rate and hence,

PV of position today =
225
C
(1 + 0.5 (flat ) )
= 214.29
6. Amount invested today 500x – C0 (Step – 2) = 214.29 (step – 5)
ik

Thus, 250 – C0 = 214.29

Thus, C0 = 35.71 (Part iii)
Answers:
av

(i) 
In order to have a perfect hedge, we should hold the shares and the options in the
ratio of 0.5:1 i.e., 0.5 shares to be bought for every call option sold.
(ii) 
As can be seen, irrespective of whether the price is 650 or 450, the hedged position
Bh

is worth ` 225 (N1 and N2)

(iii) Value of call option (C0) = ` 35.71
Expected return on the option
An option holder will have to pay ` 35.71 today in order to purchase the call option.
In case this option is held up to maturity, there is a possibility of earning ` 100 (70%
probability) or ` 0 (30% probability)
Thus, expected pay-off for the option
= 100 × 0.70 + 0 × 0.30
= 70

169 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

Thus return (%) for 3 months

= (70 – 35.71)/35.71 × 100
= 96.02%
[Like, P1 – P0/P0 × 100 of portfolio]
Extra: In case % p.a return to be calculated, we will multiply by 12/3.

Question 8 (ICAI SM)/(MTP Oct 22)

hi
[Q.38 - AFM 8 (Fast Track) & 9, Q.38 - AFM 10]

(i) The shares of TIC Ltd. are currently priced at ` 415 and call option exercisable in three
month's time has an exercise rate of ` 400. Risk free interest rate is 5% p.a. and standard

ks
deviation (volatility) of share price is 22% and assuming there is no dividend over the
next three months, is the option worth buying for ` 25?
(ii) Calculate value of aforesaid call option based on Black-Scholes valuation model if the
current price is considered as ` 380.
ho
(iii) What would be the worth of put option if current price is considered ` 380?
(iv) If TIC Ltd. share price at present is taken as ` 408 and a dividend of ` 10 is expected to
be paid in the two month’s time, then, calculate value of the call option.
C
Summary
ik

Detailed Solution

1. Given S0 = ` 415
av

Xp = 400
σ = 22% i.e., 0.22
r = 5% p.a
Bh

t = 3/12 = 0.25 years = 0.25 years

S 
ln  0 
 Xp 
(i)  
 415 
i.e., ln  
 400 

ln [1.0375]
i.e., loge 1.0375
Applying the change of base rule,

log10 1.0375
ln [1.0375] =
log10 e

170 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

0.01598
=
0.4343

= 0.0368

S   ó2 
In  o  + r +  ×t
 Xp   2
2. D1 =
t ×s

hi
 0.22 
2

0.0368 +  0.05 +  × 0.25

 2 

=
0.25 × 0.22

ks
0.05535
=
0.11

= 0.50
Therefore, D2 = D1 – ( t × σ)
= 0.50 – ( 0.25 × 0.22)
= 0.50 – 0.11
= 0.39
ho
C
3. N(D1) = N (0.50)
= 0.5 + 0.1915
= 0.6915
ik

N(D2) = N (0.39)
= 0.5 + 0.1517
= 0.6517
av

4. ert:
= e0.05 × 0.25
= e 0.0125
Bh

Let x = e0.0125
Taking log on both sides
log x = 0.0125 log e
= 0.0125 × 0.4343
= 0.0054
x = Antilog 0.0054
x = 1.0125
5. C0 = S0 × N(D1) – [Xp/ert × N(D2)]
= 415 × 0.6915 – [400/1.0125 × 0.6517]
= 286.97 – 257.46
= 29.51

171 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

The option is worth buying at ` 25 since it is under-valued.

S 
(ii) In  0
:
 Xp 
 

 380 
= In  
 400 

hi
= ln (0.9500)
Applying changes of base rule,

ks
log10 0.95
1. ln (0.9500) =
Log10 e

− 0.0223
=

2. D1
=
0.4343

(0.0513)

= ln 
S   s2
ho

C
0
 + r +  × t
 Xp   2 
 
t ×s
(0.0513) + 0.01855
=
ik

0.11

( 0.03275 )
=
0.11
av

= (0.2977)

Thus, D2 = D1 – ( t ×s )
Bh

= (0.2977) – 0.11
= (0.41)
3. N (D1) = N (- 0.30)
= 0.5 – 0.1179
= 0.3821
N (D2) = N (-0.41)
= 0.5 – 0.1591
= 0.3409

172 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

hi
ks
4. ert

5. C0 = S0 × N (D1) – 
ho
= e0.05×0.25 = 1.0125 (same as part i)

 Xp
( )

× N D2 
C
 ert 

 400 
= 380 × 0.3821 -  × 0.3409 
 1.0125 
ik

= 145.198 – 134.68
= 10.52
(iii) Using call put parity theory
av

S0 = 380
Xp = 400
C0 = 10.52
Bh

P0 = ?
R = 5% p.a
t = 3 months
P0 + S0 = C0 + Xp / ert
[Since C0 based on continuous compounding, PV of Xp should also be based on continuous
compounding]
Thus, P0 + 380 = 10.53 + 400/e0.05 × 0.25
Thus, P0 = 10.52 + 400/1.0125 - 380
Thus, P0 = 25.58

173 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

(iv) Black Scholes Model with dividend

In case the dividend is paid before expiry of the call option, then instead of taking the
spot price directly, we will take the ex-dividend spot price i.e., adjusted S0.
Adjusted S0 = S0 – PV of dividend
= S0 – D / ert
[Black Scholes Model : Continuous compounding]
Where,

hi
t = No. of years (Months / 12) after which dividend is going to be received.
Adjusted S0 = S0 – PV of dividend
= S0 – D/ert

ks
= 408 – 10/e0.05 × 2/12
= 408 – 10/e 0.00833

= 408 – 10/1.0083 (WN – 1)

= 408 – 9.92
= 398.08

Working Note – 1: e0.00833:

ho
C
Let x = 0.00833 log e
= 0.00833 × 0.4343
= 0.0036
ik

Thus x = Antilog (0.0036)

Thus, x = 1.0083
av

Reference Note: Wherever S0 was used, we will use adjusted S0

1. ln (Adjusted S0/XP)
Bh

 398.08 
ln  
 400 

ln (0.9952)
Applying the change of base rule,
loge0.9952 = log100.9952/log10e
= - 0.0021/0.4343
= (0.0048)
s2
ln + (Adjusted S0 /Xp) + (r + ) ×t
2. D1 = ln + 2
t ×s

174 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

 0.222 
(0.0048) + 0.05 +  × 3/12
 2 
=
3
× 0.22
12

=
( 0.0048) + 0.01855
0.11

0.01375
=
0.11

hi
= 0.125
i.e 0.13

ks
Thus D2 = D1 - t ×s
= 0.13 - 0.25 × 0.22


3. N(D1)
= 0.13 – 0.11
= 0.02
= N (0.13)
= 0.5 + 0.0517
ho
C
= 0.5517
ik
av

Bh

N (D2) = N (0.02)
= 0.5 + 0.0080
= 0.5080

175 CA BHAVIK CHOKSHI
 DERIVATIVES ANALYSIS AND VALUATION

4. ert = e0.05 × 0.25 = e0.0125 = 1.0126

 Xp 
5. C0 = Adjusted S0 × N (D1) -   × N (D2)
 ert 
 

= 398.08 × 0.5517 – 400/1.0125 × 0.5080

= 219.62 – 200.69
= 18.93

hi
Question 9 (ICAI SM)
[Q.49 - AFM 8 (Fast Track) & 9, Q.40 - AFM 10]

ks
Suppose MIS Ltd. is considering installation of solar electricity generating plant for light the
staff quarters. The plant shall cost ` 2.50 crore and shall lead to saving in electricity expenses
at the current tariff by ` 21 lakh per year forever.

ho
However, with change in Government in state, the rate of electricity is subject to change.
Accordingly, the saving in electricity can be of ` 12 lakh or ` 35 lakh per year and forever.
Assuming WACC of MIS Ltd. is 10% and risk-free rate of rate of return is 8%.
C
Decide whether MIS Ltd. should accept the project or wait and see.

Summary
ik

Detailed Solution

Note: In this case we have not been told the time horizon for a possible change in the government.
av

We have assumed it to be 1 year.

At the current level (Year 0)

Bh

Particulars Amount
` 21 Lakhs ` 210 Lakhs
PVCI (As per Gordon’s formula) =
0.10 − 0
(-) PVCO (` 250 Lakhs)
NPV (` 40 Lakhs)

Therefore at the current level, if there is no expected change in the government, the NPV is
negative and it is not worth accepting the project.

Evaluation after 1 year

(a) In case the saving in electricity is ₹ 35 Lakhs p.a, then the present value of savings after
1 year

176 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

35 Lakh
= = ` 350 Lakhs
0.10 − 0

Therefore, NPV = 350 - 250 = 100

(b) Similarly, if the savings are ₹ 12 Lakhs p.a, then the present value of these savings after
1 year

hi
12 Lakh
= = ` 120 Lakhs
0.10 − 0

Therefore, NPV = 120 – 250 = (130) lakhs

ks
Reference Note: The evaluation is done in a manner similar to binomial since there are 2
possibilities. It is like saying that on an investment is a share worth 250 today, the share may
possibly become either 350 or 120 after 1 year

ho
C
ik

Reference Note: The binomial evaluation is based on a risk less / risk neutral set up and hence
the relevant rate is binomial would be the risk free rate.
av

Let the probability of up move be ‘p’ and the probability of downmove would be ‘1-p’

350 × p + 120 × (1 − p )
Therefore, 250 =
1 + 0.08
Bh

270 = 350p + 120 – 120p

Therefore, 150 = 230p
Therefore, p = 0.652
Therefore, 1 - p = 1 - 0.652 = 0.348

100 × 0.652 + (130 ) × 0.348

Expected NPV =
1 + 0.08

65.2 − 45.24
=
1.08

19.96
=
1.08

177 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

= 18.48
Since the expected NPV is positive, it is advisable to wait for 1 year
Reference Note: In this Question, there is no separate option given to us by any party. However,
the decision to be made is whether it is worth waiting for a year or not. Hence, if the cash flows
were 12 lakhs, the NPV would be negative. We should not write 0 like we do in case there were
options. Further, the project starts after 1 year and hence the relevant discount rate would be
to compensate for the time value i.e. 8%.

hi
Question 10 (ICAI SM)
[Q.48 - AFM 8 (Fast Track) & 9, Q.50 - AFM 10]

ks
IPL already in production of Fertilizer is considering a proposal of building a new plant to produce
pesticides. Suppose the PV of proposal is ` 100 crore without the abandonment option. However,
if market conditions for pesticide turns out to be favourable the PV of proposal shall increase

ho
by 30%. On the other hand, market conditions remain sluggish the PV of the proposal shall be
reduced by 40%. In case company is not interested in continuation of the project it can be
disposed of for ` 80 crore.
If the risk-free rate of interest is 8% then what will be value of abandonment option.
C
Summary
ik

Detailed Solution

Reference Note: In this case, the date when uncertainty pertaining to market condition is
av

resolved is not given. Further, the date when abandonment option would be available has also
not been given. In line with ICAI solutions, we have assumed that the uncertainty is likely to
be resolved after 1 year and the abandonment option is also available for exercise after 1 year.
Bh

Alternatively, any other time horizon can also be assumed. Further, since there are, exactly
2 possibilities, we can use binomial method. (Since Standard deviation is not available, Black
Scholes method is not possible.)

178 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

hi
ks
Reference Note: An abandonment option gives us a right to sell (exit) and hence is similar to a

ho
put option. After 1 Year if the project is given us 130, we will not exercise the put option which
gives us only 80 and hence the payoff will be nil. However, in case the project is likely to give
only 60, it is advisable to exercise the option and get ` 80 instead of 60 thereby resulting in a
payoff of ` 20.
C
Let the probability of up move be P
Therefore, the probability of downmove be 1 – p
ik

130p + 60 (1 − p )
100 =
(1 + 0.08)
av

Therefore, 108 = 130p + 60 - 60p

48 = 70p
Therefore, p = 0.686
Bh

Therefore, 1 - p = 1 - 0.686 = 0.314

0 × 0.686 + 20 × 0.314
P0 =
1.08

0 + 6.28
= = 5.81
1.08

Question 11 (ICAI SM)

[Q.49 - AFM 8 (Fast Track) & 9, Q.51 - AFM 10]

Suppose MIS Ltd. is considering installation of solar electricity generating plant for light the
staff quarters. The plant shall cost ` 2.50 crore and shall lead to saving in electricity expenses
at the current tariff by ` 21 lakh per year forever.

179 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

However, with change in Government in state, the rate of electricity is subject to change.
Accordingly, the saving in electricity can be of ` 12 lakh or ` 35 lakh per year and forever.
Assuming WACC of MIS Ltd. is 10% and risk-free rate of rate of return is 8%.
Decide whether MIS Ltd. should accept the project or wait and see.

Summary

hi
Detailed Solution

Note: In this case we have not been told the time horizon for a possible change in the government.

ks
We have assumed it to be 1 year.

At the current level (Year 0)

Particulars

PVCI (As per Gordon’s formula) =

(-) PVCO
ho
` 21 Lakhs
0.10 − 0
Amount

` 210 Lakhs

(` 250 Lakhs)
C
NPV (` 40 Lakhs)

Therefore at the current level, if there is no expected change in the government, the NPV is
negative and it is not worth accepting the project.
ik

Evaluation after 1 year

(a) In case the saving in electricity is ₹ 35 Lakhs p.a, then the present value of savings after
1 year
av

35 Lakh
= 0.10 − 0 = ` 350 Lakhs
Therefore, NPV = 350 - 250 = 100
Bh

(b) Similarly, if the savings are ₹ 12 Lakhs p.a, then the present value of these savings after
1 year

12 Lakh
= = ` 120 Lakhs
0.10 − 0

Therefore, NPV = 120 – 250 = (130) lakhs

Reference Note: The evaluation is done in a manner similar to binomial since there are 2
possibilities. It is like saying that on an investment is a share worth 250 today, the share may
possibly become either 350 or 120 after 1 year

180 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

hi
ks
Reference Note: The binomial evaluation is based on a risk less/risk neutral set up and hence
the relevant rate in binomial would be the risk free rate.

Therefore, 250 =
350 × p + 120 × (1 − p )
1 + 0.08
ho
Let the probability of up move be ‘p’ and the probability of downmove would be ‘1-p’
C
270 = 350p + 120 – 120p
Therefore, 150 = 230p
Therefore, p = 0.652
ik

Therefore, 1 - p = 1 - 0.652 = 0.348

100 × 0.652 + (130 ) × 0.348

Expected NPV =
av

1 + 0.08

65.2 − 45.24
=
1.08
Bh

19.96
= = 18.48
1.08

Since the expected NPV is positive, it is advisable to wait for 1 year

Reference Note - 1
1) In this Question, there is no separate option given to us by any party. However, the
decision to be made is whether it is worth waiting for a year or not. Hence, if the cash
flows were 12 lakhs, the NPV would be negative. We should not write 0 like we do in
case there were options. Further, the project starts after 1 year and hence
the relevant discount rate would be to compensate for the time value i.e. 8%.
2) ICAI has calculated probabilities in road option questions (Q48,Q49) using percentage
return method.

181 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

i.e. Rf = Ru. P Rd (1-p) , Alternative Method are possible giving same assurer
Reference Note - 2
Ideally if there was a timing option, then after 1 year if the NPV was negative, we would not
enter into the project and hence the result ant NPV would be nil.However, ICAI has ignored this
and taken the NPV as negative 1.3 and hence we have solved accordingly. This is probably because
ICAI is considering that there are no separate option after 1 year ie we have to go ahead with
the project after 1 year, if we don’t go ahead with the project today. If we necessarily go ahead

hi
with the project we will get +1 cr (65% chance) or – 1.3 cr (35% chance).

Question 12 (ICAI Paper Nov 23)

ks
[Q.63 - AFM 8 (Fast Track) & 9, Q.52 - AFM 10]

Following is the information available pertaining to shares of Omni Ltd.:

Current Market Price (₹) ` 420.00
Strike Price (₹)

ho
Maximum Price (₹) expected in next 3 months’ time
Minimum Price (₹) expected in next 3 months’ time
Continuously Compounded Rate of Interest (p.a) (%)
` 450.00
` 525.00
` 378.00
8.00%
C
ert 1.0202

From the above :

(i) Calculate the 3 months call option by using Binomial Method and Risk Neutral Method.
ik

Are the calculated values under both the models are same?
(ii) State also clearly the basis of Valuation of option under these models.
av

Summary

Detailed Solution
Bh

(i) (1) Call Option value using Binomial Model

` 525 (75)

` 420

` 378 (0)

182 CA BHAVIK CHOKSHI

 DERIVATIVES ANALYSIS AND VALUATION

` 525 – ` 378
=  = 0.51
` 75 – 0
Initial Investment = 0.51 x 420 = 214.20
Value of Portfolio if Price goes down to ` 378 Value of holding 0.51 x ` 378 =
192.78 Accordingly Let ‘P’ be the option price, then
` 214.20 - P = ` 192.78/1.0202 = ` 188.96
P = ` 25.24

hi
(2) Value of Call Option using Risk Neutral Method
Let ‘’P’ be the probability of Price increase, then p x 525 + (1 - p) x 378 = 420(1.0202)
147p = 50.48

ks
p = 0.34
Probability of Price increase = 0.34 Probability of Price decrease= 0.66

(ii)
0.34 × 75 + 0.66 × 0
1.0202
ho
= ` 25.24

Yes, the value of option under both Models is same

Basis of valuation of options:
C
 Binomial model uses an approach called “ Risk less Hedge Approach” to find the
price of the option, by creating a portfolio which will have same value at expiration
irrespective of any price. Hedge means to create an equal and opposite position for
ik

protecting the value of portfolio.

 In Risk Neutral Model, valuation of options is based on arbitrage and is therefore
independent of risk preferences; one should be able to value options assuming any
av

set of risk preferences and get the same answer.

Bh

183 CA BHAVIK CHOKSHI

 INTEREST RATE RISK MANAGEMENT

CHAPTER 11 INTEREST RATE RISK MANAGEMENT

Question 1 (ICAI SM)/(MTP March 19)

[Q.4 - AFM 8 (Fast Track) & 9, Q.4 - AFM 10]

TM Fincorp has bought a 6 x 9 ` 100 crore Forward Rate Agreement (FRA) at 5.25%. On
fixing date reference rate i.e. MIBOR turns out be as follows:

hi
Period Rate (%)
3 months 5.50
6 months 5.70

ks
9 months 5.85

You are required to determine:

(a) Profit/Loss to TM Fincorp. in terms of basis points.
(b) The settlement amount.

Summary
(Assume 360 days in a year) ho
C
Detailed Solution
ik

TM Fincorp
FRA : 01/01/09
Actual borrowing : 01/07/09 (fixing date)
av

Repayment : 30/09/09
FRA : 6 × 9 : Buy interest @ 5.25% C.P
On 01/07/09 : Actual borrowing: 3 months @ 5.50%
Bh

Reference Note:
Fixing date refers to the date when the actual borrowing is intended to be taken i.e. assuming
that the FRA is entered on 01/01/09 and in case of 6 × 9 FRA the fixing date would be 01/07/09
and the borrowing along with interest is to be repaid within 3 months from the date of fixing
i.e. 30/09/09.
Solution
a. The original strategy : Bought FRA [i.e., buy 6 × 9 FRA @ 5.25% (C.P)]
On the fixing date (after 6 months) the spot rate for a 3 months borrowing comes to
5.5%. An existing buy FRA position would be settled through a sell FRA position i.e. we
would take the settlement rate at 5.5% (S.P) i.e.,

184 CA BHAVIK CHOKSHI

 INTEREST RATE RISK MANAGEMENT

Gain/loss (in basis points)

= 5.5% - 5.25%
= 0.25%
i.e. 25 basis points
Reference Note:
On 01/07, the actual borrowing is taken and hence the gain/loss is fixed. Since interest
will subsequently accrue over the next 3 months, the next settlement for interest should

hi
ideally happen after 3 months from the fixing date.
b. Settlement Amount
(i) Settlement amount at the end of borrowing term (i.e., 9th month)

ks
= 100 Crs × (5.50% – 5.25%) % × 3/12
= ` 6,25,000

(ii)

=
ho
On fixing date (i.e., 6th month)

(5.00% − 5.25% ) × ` 100 Crs × 3 / 12

(1 + 0.055 × 3 / 12)
C
6, 25, 000
=
1.01375

= ` 6,16,523
ik

Question 2 (RTP May 18)/(Practice Manual)

[Q.5 - AFM 8 (Fast Track) & 9, Q.5 - AFM 10]
av

Electra space is consumer electronics wholesaler. The business of the firm is highly seasonal in
nature. In 6 months of a year, firm has a huge cash deposits and especially near Christmas
time and other 6 months firm cash crunch, leading to borrowing of money to cover up its
Bh

exposures for running the business.

It is expected that firm shall borrow a sum of €50 million for the entire period of slack
season in about 3 months.

A Bank has given the following quotations:

Spot 5.50% - 5.75%

3 × 6 FRA 5.59% - 5.82%

3 × 9 FRA 5.64% - 5.94%

185 CA BHAVIK CHOKSHI

 INTEREST RATE RISK MANAGEMENT

3 month €50,000 future contract maturing in a period of 3 months is quoted at 94.15

(5.85%).

You are required to determine:

(a) How a FRA, shall be useful if the actual interest rate after 3 months turnout to be:
(i) 4.5% (ii) 6.5%
(b) 
How 3 months Future contract shall be useful for company if interest rate turns

hi
out as mentioned in part (a) above.

Summary

ks
Detailed Solution

Electra Space : Borrower

a. FRA:
1. Strategy: Buy interest rate FRA
2. Maturity: 3 × 9 FRA at 5.94%
ho
C
Reference Note:
The slack season is expected to start after 3 months and is expected to continue for
6 more months and hence the entity needs to borrow for a period of 6 months after 3
ik

months i.e., 3 × 9 FRA is appropriate

Settlement 4.5% 6.5%
Interest cost on spot (€ 1.125 m) (€ 1.625m)
av

borrowing (€ 50 m × 4.5% × 6/12) (€50m × 6.5% × 6/12)

± Gain/loss on FRA (€ 0.36 m) € 0.14 m
((4.5 – 5.94)% × € 50m × 6/12) [(6.5 – 5.94)% × 50m × 6/12)
Net Interest cost (€ 1.485) (€ 1.485)
Bh

Reference Note:

€1.485 12
Effective Interest Rate = × 100 ×
€ 50 6

= 5.94% p.a
As can be seen, irrespective of the spot rate, the effective interest rate is € 1.485
million (5.94%).
b. Interest rate futures:
1. Strategy : Sell bond futures
2. Maturity : 3 months futures contract maturing after 3 m at 94.15 SP

186 CA BHAVIK CHOKSHI

 INTEREST RATE RISK MANAGEMENT

3. No of contract = € 5,00,00,000 / € 50,000 × 6/3

= 2,000 Contracts
4. Today: Electra space would sell 2,000 3 months futures at 94.15 (S.P)
5. On settlement
Particulars 4.5% 6.5%
(i.e. 100 – 4.5 = 95.5) (i.e. 100 – 6.5 = 93.5)
Interest on actual (€ 1.125 m) (€ 1.625 m)
borrowing (€ 50m x 4.5% x 6/12) (€ 50 m × 6.5% x 6/12)

hi
± Gain/loss on futures (€ 0.3375 m) € 0.1625 m
[(94.15-95.5)% x 3/12 x € 50,000] [(94.15-93.5)% x 3/12 x € 50,000]
× 2,000 × 2,000

ks
Net Interest Cost (€ 1.4625) (€ 1.4625)

Reference Note:
Effective interest rate

€1.4625
€ 50
× 100 ×
12
6
= 5.85% ho
Irrespective of the spot rate, the interest cost continues to be € 1.4625 (5.85%).
C
It is advisable to hedge using futures as it results in a lower interest cost.

Question 3 (ICAI SM)/(RTP Nov 22)/(MTP April 18)/(MTP Aug

ik

18)/(MTP Oct 19)/(MTP May 20)/(Practice Manual)

[Q.9 - AFM 8 (Fast Track) & 9, Q.9 - AFM 10]

XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period of 24 months.
av

The company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its
Bankers at the strike rate of 8.00%. The lump sum premium is 1.00% for the entire reset
periods and the fixed rate of interest is 7.00% per annum. The actual position of LIBOR
Bh

during the forthcoming reset period is as under:

Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%

You are required to show how far interest rate risk is hedged through Cap Option.
For calculation, work out figures at each stage up to four decimal points andamount nearest
to £. It should be part of working notes.

187 CA BHAVIK CHOKSHI

 INTEREST RATE RISK MANAGEMENT

Summary

Detailed Solution

Reference Note:
Premium is paid upfront whereas the settlement happens at the end of each reset period. In
order to make the settlement amount at each reset date comparable with the premium, they

hi
need to be brought at the same point of time. This can be done by bringing the payoffs to the
present value or taking the premium to the future value.
ICAI usually converts the upfront premium into the future value by converting it into an

ks
annuity i.e. hypothetically if instead of an upfront premium, the premium was payable in equal
instalments over the settlement period, then what would be the equal instalment payable in each
period for such a premium. This can be calculated as follows:

ho
Premium (upfront) = Z × PVAF (x %, y years)
Where, the discount factor is to be the fixed rate of interest on the date when cap is taken.
If the reset periods are at one year intervals then we will take the discount factor on a per
annum basis and years. However, in case the reset periods are at 6 months intervals then we will
C
take the half yearly interest and also the number of half years.
Upfront premium = £ 1,50,00,000 × 1%
= £ 1,50,000
ik

Interest is payable 6 monthly and the loan is for 24 months.

24 months
Thus, no of half yearly payments = =4
av

6 months

Fixed interest rate (half yearly) = 7 × 6/12

= 3.5%
Bh

Let the equal half yearly premium be £ x

£ 1,50,000 = x × 3.6731 PVAF (3.5%; 4 Half years)

£1, 50, 000

x=
3.6731

x= £ 40,837

Reference Note: This implies that an entity should be indifferent paying £ 150,000 upfront or
£ 40,837 pounds over 4 half years.

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Calculation of the effective pay off under cap (LIBOR > 8%)
Reset LIBOR Cap Cap Pay off Half yearly Effective Pay-off
Period Exercise premium
1 9% Yes 75,000 (£40,837) 34,163
 £1, 50, 00, 000 × ( 9% − 8% ) × 6 / 12
 
2 9.5% Yes 1,12,500 (£40,837) 71,663
 £1, 50, 00, 000 × ( 9.5% − 8% ) × 6 / 12
 

hi
3 10% Yes 1,50,000 (£40,837) 109,163
 £1, 50, 00, 000 × (10% − 8% ) × 6 / 12
 
£ 3,37,500 £ 214,989

ks
Reference Note:
1. The above workings for annualised premium needs to be done if:

2.
on 01/10/12 in Q 15)
ho
a. Premium is paid upfront (Q8 Premium NIL)
b. Fixed rate of interest on the date when cap is taken is given (this rate was not given

Unless given, the strike rate (8%) needs to be compared to LIBOR (and not LIBOR +10%)
C
3. In this case, the reference rate is 6 months LIBOR and hence for a 24 month loan,
there would be 4 reset periods. However, in absence of LIBOR on fourth reset date we
have assumed that the fourth reset date has not yet arrived and the position cannot be
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determined. Hence the calculation is done for 3 reset periods only.

4. In case effective interest at each reset period was asked, it can be calculated as follows:
Reset Interest Capital net pay-off Net interest
av

period
1 14,25,000 (34,163) 13,90,837
 6
19% × £1, 50, 00, 000 × 
 12 
Bh

↓
(9% + 10%)

5. In this case, the additional interest of £ 3,37,500 can be effectively reduced by £

2,14,989 using the CAP option.

Question 4 (ICAI Paper May 23)/(MTP March 23)/(MTP March

21/MTP Oct 21)
[Q.18 - AFM 8 (Fast Track) & 9, Q.19 - AFM 10]

IF an Indian firm has its subsidiary in Singapore and SF a Singapore firm has its subsidiary in
India and face the following interest rates:

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Company IF SF
INR Floating Rate BPLR + 0.5% BPLR + 1.5%
SGD (fixed rate) 3% 3.50%

SF wishes to borrow Rupee loan at a floating rate and IF wishes to borrow SGD at a fixed rate.
The amount of loan required by both the companies is same at the current exchange rate. A
Bank arranges a swap and requires 50 basis points as its commission, which is to be shared
equally. IF requires a minimum gain of 20 basis points and SF requires a minimum gain of 10 basis

hi
points for structuring the deal. The Bank is very keen to structure the deal, even if, it has to
forego a part of its commission.
You are required to find out:

ks
(i) Whether there are any advantages available to IF and SF?
(ii) Whether a swap can be arranged which may be beneficial to both the firms
(iii) What rate of interest will they end up paying? Show detailed working.

Summary

Detailed Solution
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C
(i) If seems to be the relatively stronger party as it can barrow at a cheaper rate in both
the markets.
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However, for the possibility of swap, we need to check whether there exists interest
saving which can be shared after considering banker’s commission
IF SF
av

Desired Fixed Floating

INR Floating BPLR + 0.5% BPLR + 1.5%
SGD Fixed 3% 3.5%
Bh

Combined
Desired: 3% + BPLR + 1.5% = BPLR +4.5%
Alternative: BPLR + 0.5% +3.5% = BPLR +4.0%
Savings = 0.5%
Incase the banker is given 0.5% commission there would be no further interest savings
left for IF and Sf – If requires a minimum 0.2% and SF requires a minimum 0.1%. The
banker is willing to forego some of its commission.
Therefore, incase IF gets 0.2% & SF gets 0.1% there is still 0.5 -0.2- 0.1 = 0.2%
Remaining for the banker.
Hence, the swap can be structured.

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 INTEREST RATE RISK MANAGEMENT

(ii) Ultimate cost of borrowing

Desired - Int saving
IF: 3% 0.2% = 2.8%
SF: BPLR + 1.5% - 0.1% = BPLR +1.4%

hi
ks
Assume SF pays BPLR & IF pays x (Fixed)
ho
We have been told that the banker’s commission of 0.2% will be shared equally.
C
i.e. 0.1 – 1 each – borne by IF & SF
Hence, while SF pays “BPLR”, IF will receive “BPLR – 0.1% and when IF pays “ x SF will
receive “ x - 0.1%”
∴ Net cost of financing:
ik

IF (2.8%) = Pay to bank – Receives from swap + Pay under swap

2.8% = BPLR + 0.5% - (BPLR – 0.1%) + x

x = 2.2%
av

SF (BPLR + 1.4%)
Verification Pay to Bank – Receives under swap + Pay under swap
= 3.5% - (|x| – 0.1-1%) + BPLR
Bh

= 3.5% - (2.2- 0.1)% + BPLR

= BPLR + 3.5% - 2.1%
= BPLR + 1.4%
= LHS = RHS

As can be seen, the ultimate cost of financing for IF is 2.8% and for SF is BPLR + 1.4%
under the swap IF agrees to Pay fixed 2.2% and SF agrees to pay BPLR.
Any other alternative arrangement which gives the same ultimate cost can also apply.
ICAI has assumed that SF reimburse exactly IF’S borrowing cost i.e. BPLR + 0.5% and hence
our x would proportionately adjust to 2.7% (2.2 % + 0.5%)
Ultimate cost of financing would remain the same.

191 CA BHAVIK CHOKSHI