The document discusses bond pricing and provides examples of calculating bond prices. It begins by explaining that a bond's price is determined by comparing its coupon rate to prevailing interest rates. It then provides the basic bond pricing formula and explains how to calculate the price of a bond using present value calculations and discounting future cash flows. The document also discusses accounting for different payment frequencies in the pricing formula.

1. Master of Business Administration- MBA Semester 2
MB0045 –Financial Management
(Book ID: B1134)
Assignment Set- 1
Q.1 . Show the relationship between required rate of return and coupon
rate on the value of a bond.
Ans: It is important for prospective bond buyers to know how to determine the
price of a bond because it will indicate the yield received should the bond be
purchased. In this section, we will run through some bond price calculations for
various types of bond instruments.
Bonds can be priced at a premium, discount, or at par. If the bond’s price is
higher than its par value, it will sell at a premium because its interest rate is
higher than current prevailing rates. If the bond’s price is lower than its par value,
the bond will sell at a discount because its interest rate is lower than current
prevailing interest rates. When you calculate the price of a bond, you are
calculating the maximum price you would want to pay for the bond, given the
bond’s coupon rate in comparison to the average rate most investors are
currently receiving in the bond market. Required yield or required rate of return is
the interest rate that a security needs to offer in order to encourage investors to
purchase it. Usually the required yield on a bond is equal to or greater than the
current prevailing interest rates.
Fundamentally, however, the price of a bond is the sum of the present values of
all expected coupon payments plus the present value of the par value at maturity.
Calculating bond price is simple: all we are doing is discounting the known future
cash flows. Remember that to calculate present value (PV) – which is based on
the assumption that each payment is re-invested at some interest rate once it is
received–we have to know the interest rate that would earn us a known future
value. For bond pricing, this interest rate is the required yield. (If the concepts of

2. present and future value are new to you or you are unfamiliar with the
calculations, refer to Understanding the Time Value of Money.)
Here is the formula for calculating a bond’s price, which uses the basic present
value (PV) formula:
C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
The succession of coupon payments to be received in the future is referred to as
an ordinary annuity, which is a series of fixed payments at set intervals over a
fixed period of time. (Coupons on a straight bond are paid at ordinary annuity.)
The first payment of an ordinary annuity occurs one interval from the time at
which the debt security is acquired. The calculation assumes this time is the
present.
You may have guessed that the bond pricing formula shown above may be
tedious to calculate, as it requires adding the present value of each future
coupon payment. Because these payments are paid at an ordinary annuity,
however, we can use the shorter PV-of-ordinary-annuity formula that is
mathematically equivalent to the summation of all the PVs of future cash flows.
This PV-of-ordinary-annuity formula replaces the need to add all the present
values of the future coupon.
Each full moneybag on the top right represents the fixed coupon payments
(future value) received in periods one, two and three. Notice how the present
value decreases for those coupon payments that are further into the future the
present value of the second coupon payment is worth less than the first coupon
and the third coupon is worth the lowest amount today. The farther into the future
a payment is to be received, the less it is worth today – is the fundamental
concept for which the PV-of-ordinary-annuity formula accounts. It calculates the
sum of the present values of all future cash flows, but unlike the bond-pricing
formula we saw earlier, it doesn’t require that we add the value of each coupon

3. payment. (For more on calculating the time value of annuities, see Anything but
Ordinary: Calculating the Present and Future Value of Annuities and
Understanding the Time Value of Money.)
Accounting for Different Payment Frequencies
In the example above coupons were paid semi-annually, so we divided the
interest rate and coupon payments in half to represent the two payments per
year. You may be now wondering whether there is a formula that does not
require steps two and three outlined above, which are required if the coupon
payments occur more than once a year. A simple modification of the above
formula will allow you to adjust interest rates and coupon payments to calculate a
bond price for any payment frequency:
Notice that the only modification to the original formula is the addition of “F”,
which represents the frequency of coupon payments, or the number of times a
year the coupon is paid. Therefore, for bonds paying annual coupons, F would
have a value of one. Should a bond pay quarterly payments, F would equal four,
and if the bond paid semi-annual coupons, F would be two.
Q. 2. What do you understand by operating cycle?
Ans. An operating cycle is the length of time between the acquisition of
inventory and the sale of that inventory and subsequent generation of a profit.
The shorter the operating cycle, the faster a business gets a return on investment
(ROI) for the inventory it stocks. As a general rule, companies want to keep their
operating cycles short for a number of reasons, but in certain industries, a long
operating cycle is actually the norm. Operating cycles are not tied to accounting
periods, but are rather calculated in terms of how long goods sit in inventory
before sale.
When a business buys inventory, it ties up money in the inventory until it can be
sold. This money may be borrowed or paid up front, but in either case, once the
business has purchased inventory, those funds are not available for other uses.
The business views this as an acceptable tradeoff because the inventory is an

4. investment that will hopefully generate returns, but keeping the operating cycle
short is still a goal for most businesses so they can keep their liquidity high.
Keeping inventory during a long operating cycle does not just tie up funds.
Inventory must be stored and this can become costly, especially with items that
require special handling, such as humidity controls or security. Furthermore,
inventory can depreciate if it is kept in a store too long. In the case of perishable
goods, it can even be rendered unsalable. Inventory must also be insured and
managed by staff members who need to be paid, and this adds to overall
operating expenses.
There are cases where a long operating cycle in unavoidable. Wineries and
distilleries, for example, keep inventory on hand for years before it is sold,
because of the nature of the business. In these industries, the return on
investment happens in the long term, rather than the short term. Such companies
are usually structured in a way that allows them to borrow against existing
inventory or land if funds are needed to finance short-term operations.
Operating cycles can fluctuate. During periods of economic stagnation, inventory
tends to sit around longer, while periods of growth may be marked by more rapid
turnover. Certain products can be consistent sellers that move in and out of
inventory quickly. Others, like big ticket items, may be purchased less frequently.
All of these issues must be accounted for when making decisions about ordering
and pricing items for inventory.
Q.3 What is the implication of operating leverage for a firm?
Ans: Operating leverage: Operating leverage is the extent to which a firm uses
fixed costs in producing its goods or offering its services. Fixed costs include
advertising expenses, administrative costs, equipment and technology,
depreciation, and taxes, but not interest on debt, which is part of financial
leverage. By using fixed production costs, a company can increase its profits. If a
company has a large percentage of fixed costs, it has a high degree of operating
leverage. Automated and high-tech companies, utility companies, and airlines
generally have high degrees of operating leverage.

5. As an illustration of operating leverage, assume two firms, A and B, produce and
sell widgets. Firm A uses a highly automated production process with robotic
machines, whereas firm B assembles the widgets using primarily semiskilled
labor. Table 1 shows both firm’s operating cost structures.
Highly automated firm A has fixed costs of $35,000 per year and variable costs of
only $1.00 per unit, whereas labor-intensive firm B has fixed costs of only
$15,000 per year, but its variable cost per unit is much higher at $3.00 per unit.
Both firms produce and sell 10,000 widgets per year at a price of $5.00 per
widget.
Firm A has a higher amount of operating leverage because of its higher fixed
costs, but firm A also has a higher breakeven point—the point at which total
costs equal total sales. Nevertheless, a change of I percent in sales causes more
than a I percent change in operating profits for firm A, but not for firm B. The
“degree of operating leverage” measures this effect. The following simplified
equation demonstrates the type of equation used to compute the degree of
operating leverage, although to calculate this figure the equation would require
several additional factors such as the quantity produced, variable cost per unit,
and the price per unit, which are used to determine changes in profits and sales:
Operating leverage is a double-edged sword, however. If firm A’s sales decrease
by I percent, its profits will decrease by more than I percent, too. Hence, the
degree of operating leverage shows the responsiveness of profits to a given
change in sales.
Implications: Total risk can be divided into two parts: business risk and financial
risk. Business risk refers to the stability of a company’s assets if it uses no debt
or preferred stock financing. Business risk stems from the unpredictable nature of
doing business, i.e., the unpredictability of consumer demand for products and
services. As a result, it also involves the uncertainty of long-term profitability.
When a company uses debt or preferred stock financing, additional risk—
financial risk—is placed on the company’s common shareholders. They demand
a higher expected return for assuming this additional risk, which in turn, raises a
company’s costs. Consequently, companies with high degrees of business risk

6. tend to be financed with relatively low amounts of debt. The opposite also holds:
companies with low amounts of business risk can afford to use more debt
financing while keeping total risk at tolerable levels. Moreover, using debt as
leverage is a successful tool during periods of inflation. Debt fails, however, to
provide leverage during periods of deflation, such as the period during the late
1990s brought on by the Asian financial crisis.
Q.4 Explain the factors affecting Financial Plan
Ans: To help your organization succeed, you should develop a plan that needs to
be followed. This applies to starting the company, developing new product,
creating a new department or any undertaking that affects the company’s future.
There are several factors that affect planning in an organization. To create an
efficient plan, you need to understand the factors involved in the planning
process. Organizational planning is affected by many factors:
Priorities - In most companies, the priority is generating revenue, and this
priority can sometimes interfere with the planning process of any project. For
example, if you are in the process of planning a large expansion project and your
largest customer suddenly threatens to take their business to your competitor,
then you might have to shelve the expansion planning until the customer issue is
resolved. When you start the planning process for any project, you need to
assign each of the issues facing the company a priority rating. That priority rating
will determine what issues will sidetrack you from the planning of your project,
and which issues can wait until the process is complete.
Company Resources - Having an idea and developing a plan for your company
can help your company to grow and succeed, but if the company does not have
the resources to make the plan come together, it can stall progress. One of the
first steps to any planning process should be an evaluation of the resources
necessary to complete the project, compared to the resources the company has
available. Some of the resources to consider are finances, personnel, space
requirements, access to materials and vendor relationships.

7. Forecasting - A company constantly should be forecasting to help prepare for
changes in the marketplace. Forecasting sales revenues, materials costs,
personnel costs and overhead costs can help a company plan for upcoming
projects. Without accurate forecasting, it can be difficult to tell if the plan has any
chance of success, if the company has the capabilities to pull off the plan and if
the plan will help to strengthen the company’s standing within the industry. For
example, if your forecasting for the cost of goods has changed due to a sudden
increase in material costs, then that can affect elements of your product roll-out
plan, including projected profit and the long-term commitment you might need to
make to a supplier to try to get the lowest price possible.
Contingency Planning - To successfully plan, an organization needs to have a
contingency plan in place. If the company has decided to pursue a new product
line, there needs to be a part of the plan that addresses the possibility that the
product line will fail. The reallocation of company resources, the acceptable
financial losses and the potential public relations problems that a failed product
can cause all need to be part of the organizational planning process from the
beginning.
Q.5 An employee of a bank deposits Rs. 30000 into his PF A/c at the end of
each year for 20 years. What is the amount he will accumulate in his PF at
the end of 20 years, if the rate of interest given by PF authorities is 9%?
Year Amount Interest Total
1 30000 9% 30000
2 30000 9% 32700
3 30000 9% 35643
4 30000 9% 38851
5 30000 9% 42347
6 30000 9% 46159
7 30000 9% 50313
8 30000 9% 54841
9 30000 9% 59777
10 30000 9% 65157

8. 11 30000 9% 71021
12 30000 9% 77413
13 30000 9% 84380
14 30000 9% 91974
10025
15 30000 9% 2
10927
16 30000 9% 4
11910
17 30000 9% 9
12982
18 30000 9% 9
14151
19 30000 9% 4
15425
20 30000 9% 0
Q.6 Mr. Anant purchases a bond whose face value is Rs.1000, and which
has a nominal interest rate of 8%. The maturity period is 5 years. The
required rate of return is 10%. What is the price he should be willing to pay
now to purchase the bond?
Ans: Solution:
Interest payable=1000*8%=Rs. 80, Principal repayment is Rs. 1000
Required rate of return is 10% V0=I*PVIFA(kd, n) + F*PVIF(kd, n)
Value of the bond=80*PVIFA(10%, 5y) + 1000*PVIF(10%, 5y)
= 80*3.791 + 1000*0.621 = 303.28 + 621 =Rs. 924.28
This implies that the company is offering the bond at Rs. 1000 but is worth Rs.
924.28 at the required rate of return of 10%. The investor may not be willing to
pay more than Rs. 924.28 for the bond today.