Professional Documents
Culture Documents
STRATEGIC FINANCIAL
MANAGEMENT
(SFM)
By
CA Gaurav Jain
[FCA, CFA L1, NCFM, NISM]
Start Date
Days
End Date
Timing
Evening
28th May
Mon to Fri
06th July
5:00 to 8:30 PM
Morning
18th June
Mon to Sat
21st July
7:00 to 10:30 AM
Morning
23rd July
Mon to Sat
25th Aug
7:00 to 10:30 AM
Evening
20th Aug
Mon to Sat
22nd Sept
5:00 to 8:30 PM
*2
BOND VALUATION
Lists of Concepts
Concept No. 1: Introduction (Fixed Income Security)
Concept No. 2: Terms used in Bond Valuation
Concept No. 3: Valuation of Straight Bond/ Steps in the Bond Valuation
Process
Concept No. 4: Coupon Rate Structures
Concept No. 5: Valuation of Perpectual Bond/ Irredeemable Bond/ Non Callable
Bond
Concept No. 6: Valuation of Zero-Coupon Bond
Concept No. 7: Valuation of Semi annual Coupon Bonds
Concept No. 8: Valuation of Bond with Changing Coupon Rate
Concept No. 9: Over Valued & Under Valued Bonds
Concept No. 10: Self Amortization Bond
Concept No. 11: Holding Period Return (HPR) for Bonds
Concept No. 12: Calculation of Current Yield
Concept No. 13: Normal Yield or Coupon Yield
Concept No. 14: YTM (Yield to Maturity) / Kd / Cost of debt/ Market rate of
Interest/ Market rate of return
Concept No. 15: YTM (Yield to Maturity) / Kd of Half yearly Bond
Concept No. 16: Treatment of Floating Cost
Concept No. 17: Treatment of Tax
Concept No. 18: Yield to call (YTC) & Yield to Put (YTP)
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Face Value
Rs. 1000
(ii)
Maturity Year
10 years
(iii)
Coupon rate
10%
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(v)
Rs. 950
12%
Rs. 1200
Note:
If Maturity Value is not given, then it is assumed to be equal to Face Value.
If Face Value is not given, then it is assumed to be Rs. 100 or Rs. 1000 according to the
Question.
If Maturity Year is not given, then it is assumed to be equal to infinity.
Concept No. 3: Valuation of Straight Bond/ Steps in the Bond Valuation Process
Straight Coupon Bonds are those bonds which pay equal amount of interest and repay principal
amount on Maturity.
Step 1: Estimates the cash flows over the Life of the bond.
Two type of Cash Flows:a) Coupon Payments
b) Return of Principal
Step 2: Determine the appropriate discount rate.
Step 3: Calculate the present value of the estimated cash flow using appropriate discount rate.
B0 =
(
)
(
)
+ .................. +
(
)
Or
Interest PVAF (Yield %, n year) + Maturity Value PVF (Yield %, nth year)
n = No. of years to Maturity
QUESTION NO. 1
A Rs. 1,000 par value bond bearing a coupon rate of 14 per cent matures after 5 years, the
required rate of return on this bond is 13 per cent. Calculate the value of the bond.
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A bond pays Rs. 90 interest annually upto perpetuity, (i) What is its value if the current yield is
10 %? (ii) If the current yield changes to 8% and 12%, then what it its value?
QUESTION NO. 2B
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Maturity Years
Yield
3
5
*
*
12
12
13*
13*
( )
( . )!"
=Rs. 463.1989
(. )!"
QUESTION NO. 3A
Suppose we are considering investing in a zero-coupon bond that matures in 5 years and has a
face value of Rs. 1000. If these bonds are priced to yield 10%, what is the present value of the
bonds?
QUESTION NO. 3B
(RTP)
On 1 June 2003 the financial manager of Gadgets Corporation's Pension Fund Trust is
reviewing strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term
bonds. Interest rates are expected to be quite volatile for the next few years. Among the
pension fund's current investments are two AAA rated bonds:
1. Zero coupon June 2018
2. 12% Gilt June 2018 (interest is payable semi-annually)
The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual
yield may be assumed to be 3%. Both bonds have a par value and redemption value of $ 100.
Required: Estimate the market price of each of the bonds if interest rates (yields):(i) increase by
1 %; (ii) decrease by 1 %. [Given PVF (2.5%, 30) = 0.4767, PVF (3%, 30) = 0.412, PVF (3.5%,
30) = 0.3563]
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#$%
b)
&
c) n 2
(Study Material)
A 6 years bond of Rs. 1,000 has an annual rate of interest of 14 %. The interest is paid half
yearly. If the required rate of return is 16 % what is the value of bond?
QUESTION NO. 4B
(RTP)
Bond face Value: 1000; Issue Value = 900; Interest paid half yearly; Coupon Rate=10%;
Life= 5 years. Calculate YTM?
QUESTION NO. 4C
A bond with 7.5% coupon interest, Face Value Rs. 10,000 & term to maturity of 2 years,
presently yields 6% Interest payable half yearly. Calculate Market Price.
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Value
Decision
10
11
Over Valued
Sell
Under Valued
Correctly Valued
Buy
Either Buy/ Sell
QUESTION NO. 6
Namita owns Rs.1000 face value bond with five years to maturity. The bond has an annual
coupon of Rs.75. The bond is currently priced at Rs.970.Given an appropriate discount rate of
10 % should Namita hold or sell the bond?
A PSU is proposing to sell 8 years bond of Rs. 1000 at 10% coupon rate per annum Bond
amount will be amortized equally over its life. If an investor has a minimum required rate of
return of 8%, what is the bond's present value?
0! 10" 2!
0"
0! 10"
0"
2!
0"
Note: HPR are assumed to be per annum basis unless specified in the question.
QUESTION NO. 8
A had purchased a bond at a price of Rs. 800 with a coupon payment of Rs.150 and sold it for
Rs. 1,000.
a. What is the holding period return?
b. If bond is sold for Rs.750 after receiving Rs. 150 as coupon payment, then what is his
holding period return?
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Example:
Consider a 20-year, Rs. 1000 Par value, 6% annual pay bond that is currently trading at Rs.
802.07. Calculate the current yield.
Solution:
The annual cash coupon payment total:
Annual cash coupon payment = par value X stated coupon rate = Rs. 1000 X 0.06 = Rs. 60
Since the bond is trading at Rs. 802.07, the current yield is:
Current Yield =
:
&.;
QUESTION NO. 9
= 0.0748, or 7.48%
(SFM Study Material)
What is the current yield of the 6.5 % August 2005 maturity bond, which has a maturity value of
Rs. 1000. The current bond price is Rs. 1075.3125?
Concept No. 14: YTM (Yield to Maturity) / Kd / Cost of debt/ Market rate of Interest/
Market rate of return
YTM is an annualized overall return on the bond if it is held till maturity.
Alternative 1: By IRR technique.
B0 =
( 9 )
( 9 )
+ .................. +
( 9 )
( 9 )
Difference in Rate
Example:
Consider a 20year, Rs. 1000 par value bond, with a 6% coupon rate with a full price of Rs.
802.07. Calculate the YTM.
Solution:
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:
( BC )!
:
( BC )D
+ .................. +
K d = 8.0188%
Alternative 2: By approximation formula
YTM =
If existing bond :-
:
( BC )D"
( BC )D"
E 7F
G 7F
It is now January 1,2009, and Mr. X is considering the purchase of an outstanding Municipal
Corporation bond that was issued on January 1,2007, the Municipal bond has a 9.5 percent
annual coupon and a 30-year original maturity. Interest rates have declined since the bond was
issued, and the bond now is selling at 116.575 % of par, or Rs. 1,165.75. Determine the yield to
maturity (YTM) of this bond for Mr. X.
QUESTION NO. 10C
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E 7F
G 7F
14
!""" E LM"
M D
!""" GLM"
D
K
= 5.64%
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H 3O N E 7F
H 3O N G 7F
( 1N )
There is a 9%, 5 year bond issue in the market. The issue price is Rs.90 and the redemption
price is Rs. 105. For an investor with marginal Income tax rate of 30% and capital gains tax of
10% (assuming no indexation), what is the post tax yield to maturity?
Concept No. 18: Yield to call (YTC) & Yield to Put (YTP)
1. Yield to Call
Callable Bond: When company call its bond or Re-purchase its bond prior to the date of
Maturity.
Call Price: Price at which Bond will call by the Company.
Call Date: Date on which Bond is called by the Company prior to Maturity.
YTC =
n = No. of Years upto Call Date.
2. Yield to Put
3 8E 7F
3 8G 7F
Puttable Bond: When investor sell their bonds prior to the date of maturity to the company.
Put Price: Price at which Bond will put/ Sell to the Company.
Put Date: Date on which Bond is sold by the investor prior to Maturity.
YTP =
n = No. of years upto Put Date.
8E 7F
8G 7F
QUESTION NO. 14
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(i) Nominal value of 10% debentures of a company is Rs. 100. The debentures can be called
at call price of Rs. 110 after 4 years. Interests are paid annually. Determine Yield To Call
(YTC) if current market price of debentures is Rs. 102.
(ii) Nominal value of 8% debentures of a company is Rs. 100. The debentures are Puttable at
exercise price Rs. 105 after 5 years. Interests are paid annually. Determine Yield To Put
(YTP) if current market price of debentures is Rs. 103.
P++)-Q 2+./,/R.
#$%
7F
QUESTION NO. 16
A Rs. 100 perpetual bond is currently selling for Rs.95. The coupon rate of interest is 14.5 per
cent and the appropriate discount rate is 16 per cent. Calculate the value of the bond. Should it
be bought? What is its yield at maturity?
S
QUESTION NO. 17
Preferential Ltd issued 30,000,15% Preference Shares of Rs. 100 each, redeemable at 10%
premium after 20 years. Issue Management Expenses were Rs.30,000.Find out the cost of
Preference Capital if they were issued at
(i) Par
(ii) Premium of 10%
(iii) Discount of 10%
17
Kp=
QUESTION NO. 18
S
Preferred Ltd issued 30,000, 15% Preference Shares of Rs.100 each. The cost of issue was
Rs.30,000. Determine the cost of Preference Capital if they were issued at
(i) Par
(ii) Premium of 10%
(iii) Discount of 10%
S5
5
Example:
A companys Rs. 100 par preferred stock pays a Rs. 5.00 annual dividend and has a required
return of 8%. Calculate the value of the preferred stock.
Solution:
Value of preferred stock =
UV
WV
XR.K.
.
= Rs. 62.50
Calculate Market Price of: 10% Government of India security currently quoted at Rs. 110, but
interest rate is expected to go up by 1 %.
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XYZ Ltd. has issued convertible debentures with interest rate of 12%. Every debenture has an
option to convert to 20 equity shares at any time until the date of maturity. Debentures will be
redeemed at Rs. 100 on maturity which is after 5 years. An investor normally requires a rate of
return of 8% p.a. on a five year security. As an investor when will you exercise conversion if the
current market price of equity shares is
(i) Rs. 4
(ii) Rs. 5
(iii) Rs. 6
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Bond
Coupon Strip
Value of Bond =
( 9 )
( 9
9 )
Principal Strip
+ .................. +
Coupon Strips
( 9 )
( 9 )
Principal Strips
QUESTION NO. 23
Nominal Value of 12% bonds issued by a company is Rs. 100.The bonds are redeemable at
Rs. 125 at the end of year 5.Coupons are paid annually. Determine value of interest strip &
principal strip. Annual Yield rate is 10%.
20
Discount
Premium
QUESTION NO. 24
Calculate value of bond if rate of return is (i) 12 % (ii) 10%, (iii) 14%.
Coupon rate = 12%, Bond face value = Rs. 1,000 Redeemable at Par, Maturity 10 years. What
conclusion can you draw?
When the coupon rate on a bond is equal to its market yield, the bond will trade at its par
value.
If yield required in the market subsequently rises, the price of the bond will fall & it will trade
at a discount.
If required yield falls, the bond price will increase and bond will trade at a premium.
Crux:
If YTM increases, bond value decreases & vice-versa, other things remaining same.
YTM & Bond value have inverse relationship.
QUESTION NO. 25A
ICICI Bank Ltd. has issued the following bond:
Face Value of bond
= Rs. 1000
Market Price of bond
= Rs. 750
21
(RTP)
Given a five-year, 8% coupon bond with a face value of Rs. 1,000 and coupon payments made
annually, determine its values given it is trading at the following yields: 8%, 6%, and 10%.
Comment on the price and yield relation you observe. What are the percentage changes in
value when the yield goes from 8% to 6% and when it goes from 8% to 10%?
Concept No. 31: Value of the Bond at the end of each Year
B0 =
B1 =
7
(
)
7
(
)
.
.
.
.
.
.
So on
QUESTION NO. 26
(RTP)
A 7% Bond was issued several years ago when the market interest rate was also 7%.Now the
bond has a remaining life of 3 years when it would be redeemed at par value of Rs. 1,000. The
market rate of interest has increased to 8%. Find out the current market price, price after 1 year
and price after 2 years from today.
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Time to Maturity
3.0 years
2.5
2.0
1.5
1.0
0.5
0.0
YTM = 3%
Rs. 1085.40
1071.74
1057.82
1043.68
1029.34
1014.78
1000.00
YTM = 6%
Rs. 1000.00
1000.00
1000.00
1000.00
1000.00
1000.00
1000.00
YTM = 12%
Rs.852.48
873.63
896.05
919.81
945.00
971.69
1000.00
QUESTION NO. 27
Coupon rate on three bonds A,B & C are 10%, 12% and 8%.Face Value is Rs. 100.On Maturity
all three bonds are repayable at par value. Yield Rate is 10%.Life-5 years. Demonstrate the
following:
(i) A Premium bond decreases as the maturity decreases and becomes equal to par value on
maturity.
(ii) A Discount bond increases as the maturity decreases and becomes equal to par value on
maturity.
(iii) A Par value bond always remains a par value bond till maturity Others things remaining
constant
(RTP)
23
Find the current market price of bond having face value Rs. 1,00,000 redeemable after 6 year
maturity with YTM at 16% payable annually and duration 4.3202 years.
[Given: (1.16) 6 = 2.4364.]
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a) Consider two bonds one with 5 years to maturity and the other with 20 years to maturity.
Both the bonds have a face value of Rs. 1,000 and coupon rate of 8% (with annual interest
payments) and both are selling at par. Assume that the yields of both the bonds fall to 6%,
whether the price of bond will increase or decrease?
b) What percentage of this increase/ decrease comes from a change in the present value of
bond's principal amount and what percentage of this increase/ decrease comes from a
change in the present value of bond's interest payments?
c) Consider a bond selling at par value of Rs. 1,000 with 6 years to maturity and a 7% coupon
rate (with annual interest payment), what is bond's duration?
d) If the YTM of the bond in (b) above increases to 10%, how it affects the bond's duration?
And why?
e) Why should the duration of a coupon carrying bond always be less than the time to its
maturity?
Concept No. 37: Calculation of yield when Coupon Payment is not available for
Re-Investment
QUESTION NO. 32
XL Ltd. has made an issue of 14 per cent non-convertible debentures on January 1, 2007.
These debentures have a face value of Rs. 100 and is currently traded in the market at a price
of Rs.90.The bond is redeemable at par on December 31,2011 at the end of 5 years. Required:
(i)
Estimate the current yield and the YTM of the bond.
(ii) Calculate the duration of the NCD.
(iii) Assuming that intermediate coupon payments are, not available for reinvestment calculate
the realized yield on the NCD.
8 S
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QUESTION NO. 33
:
,
= 60%
,
c
= 40%
Vipin purchased at par a bond with a Face Value of Rs. 1,000. The bond had five year to
maturity and a 10% coupon rate. The bond was called two years later for a price of Rs. 1,200
after making its second annual interest payment. Vipin then reinvested the proceeds in a bond
selling at its Face Value of Rs. 1,000 with three years to maturity and a 7% coupon rate. What
was Vipin's actual YTM over the five-year period?
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Concept No. 41: Downside Risk, Conversion Premium, Conversion Parity Price
1. Downside Risk or Premium over Non-Convertible Bond
Downside Risk reflects the extent of decline in market value of convertible bonds at which
conversion option become worthless.
= Market value of Convertible bond
(-)
Market value of Non- Convertible bond
% Downside Risk/ % Price Decline =
S= >9
3 66
(
)
(
)
+ .................. +
(
)f
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12%
Rs.12
Rs.265
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(. )
.gD
.h
= 1003.21
Concept No. 47: Relationship between Forward Rate and Spot Rate
Forward Rate is a borrowing/ landing rate for a loan to be made at some future date.
1f 0 = Spot Rate or Current YTM (rate of 1 year loan)
1f 1 = Rate for a 1 year loan, one year from now
1f 2 = Rate for a 1 year loan to be made two years from now
Relationship:
(1+S1)1
= (1 + 1f0 )
(1+S2)2
Or S2
= (1 + 1f0 ) (1 + 1f1)
= {(1 + 1f0 ) (1 + 1f1)}1/ 2 - 1
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K
(.c)
K
( ! ]" )
K
(.c)(.K)
+
+
K
( ! ]" )( ! ]! )
K
(.c)(.K) (.:)
K
( ! ]" )( ! ]! ) ( ! ]D )
= Rs. 1000.98
Interest Rate
0%
10%
10.5%
Maturity (Year)
1
2
3
Concept No. 48: Calculation of After-tax yield of a taxable security & taxequivalent yield of a tax-exempt security
After-tax yield = taxable yield (1 marginal tax rate)
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N1H
Example:
Consider a municipal bond that offers a yield of 4.5%. If an investor is considering buying a fully
taxable Government security offering a 6.75% yield, should she buy the Government
security or the municipal bond, given that her marginal tax rate is 35% ?
Solution:
We can approach this problem from two perspectives. First, the taxable equivalent yield on
municipal bond is
bond is preferred.
c.K%
(1.jK)
Alternatively, the after-tax return on the taxable bond is 0.0675 X (1 0.35) = 4.39%.
Thus, the after-tax return on the municipal bond (4.5%) is greater than the after-tax yield on the
taxable bond (4.39%), and the municipal bond is preferred.
Either approach gives the same answer; She should buy the municipal bond.
Bond Principal
Coupon interest
Interest on reinvested coupons
Once we calculate the total amount needed for a particular level of compound return over a
bonds life, we can subtract the principal and coupon payments to determine the amount of
reinvestment income necessary to achieve the target yield.
Example: Calculating required reinvestment income for a bond.
If you purchased a 6%, 10-year Government bond at par, how much reinvestment income must
be generated over its life to provide the investor with a compound return of 6% on a Semi
annual basis?
Solution:
Assuming the bond has par value of Rs. 100, we first calculate the total value that must be
generated ten years (20 semi annual periods) from now as:
P (1+ r)n = 100(1.03)20 = Rs. 180.61
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Miscellaneous Questions
QUESTION NO. 1
Ram purchases a 5 years, bond of Rs. 1000 par value, which pays a coupon of 8%. If Mr.
Ram's required rate of return is 10%, how much he should pay to receive the same principal
amount or face value on Maturity? If the price quoted in the market is Rs.900, then would he
benefit by buying at this price?
QUESTION NO. 2
A Rs.100 perpetual bond is currently selling for Rs.95. Coupon rate of interest is 13.5 %
&appropriate discount rate is 15 %. Calculate fair value of bond. Should it be bought? What is
its YTM.
QUESTION NO. 3
Consider a Deep Discount Bond with the face value of Rs.1000 and with 10 % yield to maturity.
Compute the discount on bond or bond value if the bond's maturity period is one year or two
years or three years or four years or five years.
QUESTION NO. 4 (SFM Study Material)
If a Rs.100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8 years
& interest payable semi-annually then what will be the value of the bond with required rate of
return of 14%?
QUESTION NO. 5 (RTP)
A company proposes to sell ten-year debentures of Rs. 10,000 each. The company would repay
Rs. 1,000 at the end of every year and will pay interest annually at 15 per cent on the
outstanding amount. Determine the present value of the debenture issue if the capitalization
rate is 18 per cent.
QUESTION NO. 6 (RTP)
A Ltd. has sold Rs. 1000,12% perpetual debentures 10 years ago. Interest rates have risen
since then, so that debentures of this company are now selling at 15% yield basis. Determine
the current/indicated / expected market price of the debentures. Would you like to buy the
debentures for Rs.700?
Now assume that the debentures of the company are selling at Rs.825. Moreover, if the 12%,
Rs. 1000 debentures are not perpetual & have 8 years to run to maturity, compute the
approximate effective yield an investor would earn on his investment.
QUESTION NO. 7 (SFM Study Material)
If the price per bond is Rs. 90 and the bond has a par value of Rs. 100, a coupon rate of 14 per
cent, and a maturity period of 6 years, calculate it's Yield to Maturity ?
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