Final Paper 2

PAPER-2 STRATEGIC FINANCIAL MANAGEMENT

CONTENTS 1

RTP MAY MAY 2017 017

..... ....... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ...

1

2

RTP RTP NOV NOV 2016 016

..... ....... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ...

28

3

RPT RPT MAY MAY 2016 016

.... ...... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... .... .... .... .... ..... ..... .... .... ..... ..... .... ..

59

4

RTP RTP NOV NOV 2015 015

.... ...... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..

84

5

RTP MAY MAY 2015 015

.... ....... ..... .... .... ..... ..... .... ..... ..... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... .... .... .... .... ..... ..... .... .... ..... ..... .... ..... ..... .... .... ..

117

6

SUGGE SU GGEST STED ED ANSW ANSWER ERS S NOV NOV 2016 2016 ....... ........... ........ ........ ........ ........ ....... ....... ........ ........ ........ ........ ........ ........ ....... ...

143

7

SUGGE SU GGEST STED ED ANSW ANSWER ERS S MAY MAY 2016 2016

....... ........... ........ ........ ........ ........ ....... ....... ........ ........ ........ ........ ........ ........ ....... ...

168

8


188

9

SUGGE SU GGEST STED ED ANSW ANSWER ERS S MAY MAY 2015 2015

....... ........... ........ ........ ........ ........ ....... ....... ........ ........ ........ ........ ........ ........ ....... ...

214

10


239

[1]

PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT MANAGEMENT QUESTIONS Merger and Acquisitions

1.

ABC Co. is consider cons idering ing a new sales sale s strategy stra tegy that will be valid vali d for the next 4 years. year s. They want to know the value of the new strategy. Following information relating to the year which has just ended, is available: Income Statement

`

Sales

20,000

Gross margin (20%)

4,000

Adminis Admi nistrati tration, on, Selling Selli ng & distribu dist ribution tion expense expe nse (10%)

2,000 2,00 0

PBT

2,000

Tax (30%)

600

PAT

1,400

Balance Sheet Information Fixed Assets

8,000

Current Assets

4,000

Equity

12,000

If it adopts the new strategy, sales will grow at the rate of 20% per year for three years. 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. Foreign Exchange Risk Management

2.

Bharat Silk Silk Limited, Limited, an established exporter of silk materials, has a surplus of US$ 20 million as on 31st May 2015. The banker of the company informs the following exchange rates that are quoted at three different forex markets: GBP/ INR

99.10

at London

INR/ GBP

0.01

at London

USD/ INR

64.10

at Mumbai

INR/ US$

0.02

at Mumbai

USD/ GBP

0.65

at New York

GBP/ USD

1.5530

at New York

© The Institute of Chartered Accountants of India

[1]

PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT MANAGEMENT QUESTIONS Merger and Acquisitions

1.

ABC Co. is consider cons idering ing a new sales sale s strategy stra tegy that will be valid vali d for the next 4 years. year s. They want to know the value of the new strategy. Following information relating to the year which has just ended, is available: Income Statement

`

Sales

20,000

Gross margin (20%)

4,000

Adminis Admi nistrati tration, on, Selling Selli ng & distribu dist ribution tion expense expe nse (10%)

2,000 2,00 0

PBT

2,000

Tax (30%)

600

PAT

1,400

Balance Sheet Information Fixed Assets

8,000

Current Assets

4,000

Equity

12,000

If it adopts the new strategy, sales will grow at the rate of 20% per year for three years. 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. Foreign Exchange Risk Management

2.

Bharat Silk Silk Limited, Limited, an established exporter of silk materials, has a surplus of US$ 20 million as on 31st May 2015. The banker of the company informs the following exchange rates that are quoted at three different forex markets: GBP/ INR

99.10

at London

INR/ GBP

0.01

at London

USD/ INR

64.10

at Mumbai

INR/ US$

0.02

at Mumbai

USD/ GBP

0.65

at New York

GBP/ USD

1.5530

at New York


[2]

110

FINAL EXAMINATION: MAY, 2017

Assuming Assu ming that there ther e are no transact tran saction ion costs, cost s, advice advi ce the company comp any how to avail ava il the arbitrage gain from the above quoted spot exchange rates. 3.

On January January 28, 2010 an an importer importer customer customer requested requested a bank to remit remit Singapore Singapore Dollar Dollar (SGD) 25,00,000 under an irrevocable LC. However, due to bank strikes, the bank could effect the remittance only on February 4, 2010. The interbank market rates were as follows: January, 28

February 4

Bombay US$1

= ` 45.85/45.90

45.91/45.97

London Pound 1

= US$ 1.7840/1.78 50

1.7765/1.7 775

Pound 1

= SGD 3.1575/3.15 90

3.1380/3.1 390

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? (Calculate rate in multiples of .0001) Mutual Funds

4.

A mutual fund made an issue of 10,00,000 units of ` 10 each on January 01, 2008. No entry load was charged. It made the following investments: Particulars

`

80,00,000

50,000 Equity shares of ` 100 each @ ` 160 7% Government Securities

8,00,000

9% Debentures (Unlisted)

5,00,000

10% Debentures (Listed)

5,00,000 98,00,000

During the year, dividends of ` 12,00,000 were received on equity shares. Interest on all types of debt securities was received as and when due. At the end of the year equity shares and 10% debentures are quoted at 175% and 90% respectively. Other investments are at par. Find out the Net Asset Value (NAV) per unit given that operating expenses paid during the year amounted to ` 5,00,000. Also find out the NAV, if the Mutual fund had distributed a dividend of ` 0.80 per unit during the year to the unit holders. Security Analysis

5.

G holds securities as detailed herein below: Security

Face Value (`)

Numbers

Coupon Rate (%)

Maturity Years

Annual Yield (%)

(i)

Bond A

1,000

100

9

3

12

(ii)

Bond B

1,000

100

10

5

12


[3]

PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT

111

(iii) Preference Shares C

100

1,000

11

*

13*

(iv) Preference Shares C

100

1,000

12

*

13*

* Likelihood of being called (redeemed) at a premium over par. Compute the current value of G’s portfolio. 6.

Capital structure of Sun Ltd., as at 31.3.2003 was as under: (` in lakhs) Equity share capital

80

8% Preference Preference share capital

40

12% Debentures

64

Reserves

32

Sun Ltd., earns a profit of ` 32 lakhs annually on an average before deduction of incometax, which works out to 35%, and interest on debentures. Normal return on equity shares of companies similarly placed is 9.6% provided: (a) Profit after tax covers fixed interest and fixed dividends at least 3 times. (b) Capital gearing ratio is 0.75. (c) Yield on share is calculated calculated at 50% of profits distributed distributed and at 5% on undistributed profits. Sun Ltd., has been regularly paying equity dividend of 8%. Compute the value per equity share of the company. 7.

GHI Ltd., AAA rated rated company company has issued, fully fully convertible convertible bonds bonds on the following following terms, a year ago: Face value of bond

`

Coupon (interest rate)

8.5%

Time to Maturity (remaining)

3 years

Interest Payment

Annual, at the end of year

Principal Repayment

At the end of bond maturity

Conversion ratio (Number of shares per bond)

25

Current market price per share

`

45

Market price of convertible bond

`

1175


1000

[4]

112


AAA rated rate d company co mpany can issue issu e plain p lain vanilla van illa bonds bond s withou wi thoutt conve c onversio rsionn option op tion at an a n intere in terest st rate of 9.5%. Required: Calculate as of today: (i)

Straight Value of bond.

(ii) Conversion Value of the bond. (iii) Conversion Conversio n Premium. (iv) Percentage of downside risk. (v) Conversion Conversio n Parity Price. t PVIF 0.095, t 8.

1

2

3

0.9132

0.8340

0.7617

Closing values values of BSE BSE Sensex Sensex from 6th to 17th day of the month of January of the year 200X were as follows: Days

Date

Day

Sensex

1

6

THU

14522

2

7

FRI

14925

3

8

SAT

No Trading

4

9

SUN

No Trading

5

10

MON

15222

6

11

TUE

16000

7

12

WED

16400

8

13

THU

17000

9

14

FRI

No Trading

10

15

SAT

No Trading

11

16

SUN

No Trading

12

17

MON

18000

Calculate Exponential Moving Average (EMA) of Sensex during the above period. The 30 days simple moving average of Sensex can be assumed as 15,000. The value of exponent for 30 days EMA is 0.062. Give detailed analysis on the basis of your c alculations. International Capital Budgeting

9.

A multinational multinational company company is planning planning to set up a subsidiary company company in India (where (where hitherto it was exporting) in v iew of growing demand for its product and competition from other MNCs. The initial project cost (consisting of Plant and Machinery including


[5]


113

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 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 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. Present Value Interest Factors (PVIF) @ 12% for five years are as below: Year PVIF

1 0.8929

2 0.7972

3 0.7118

4 0.6355

5 0.5674

Leasing

10. P Ltd. has decided to acquire a machine costing ` 50 lakhs through leasing. Quotations from 2 leasing companies have been obtained which are summarised below: Quote A

Quote B

3 years

4 years

Initial lease rent (` lakhs)

5.00

1.00

Annual lease rent (payable in arrears) ( ` lakhs)

21.06

19.66

Lease term

P Ltd. evaluates investment proposals at 10% cost of capital and its effective tax rate is 30%. Terminal payment in both cases is negligible and may be ignored.


[6]

114


Make calculations and show which quote is beneficial to P Ltd. Present value factors at 10% rate for years 1-4 are respectively 0.91, 0.83, 0.75 and 0.68. Calculations may be rounded off to 2 decimals in lakhs. Portfolio Management

11. Sunrise Limited last year paid dividend of ` 20 per share with an annual growth rate of 9%. The risk-free rate is 11% and the market rate of return is 15%. The company has a beta factor of 1.50. However, due to the decision of the Board of Director to grow inorganically in the recent past beta is likely to increase to 1.75. You are required to find out under Capital Asset Pricing Model (i) The present value of the share (ii) The likely value of the s hare after the decision. 12. A company has a choice of investments between several different equity oriented mutual funds. The company has an amount of `1 crore to invest. The details of the mutual funds are as follows: Mutual Fund

Beta

A

1.6

B

1.0

C

0.9

D

2.0

E

0.6

Required: (i)

If the company invests 20% of its investment in the first two mutual funds and an equal amount in the mutual funds C, D and E, what is the beta of the portfolio?

(ii)

If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in equal amount in the other two mutual funds, what is the beta of the portfolio?

(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the portfolios expected return in both the situations given above? Indian Capital Market

13. Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap) on a principal of ` 10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment on the principal. The swap was entered into on Monday, 2 nd August, 2010 and was to commence on 3rd August, 2010 and run for a period of 7 days. Respective MIBOR rates for Tuesday to Monday were:


[7]


115

7.75%,8.15%,8.12%,7.95%,7.98%,8.15%. If Derivative Bank received ` 317 net on settlement, calculate Fixed rate and interest under both legs. Notes: (i)

Sunday is Holiday.

(ii) Work in rounded rupees and avoid decimal working. 14. The following market data is available: Spot USD/JPY 116.00 Deposit rates p.a.

USD

JPY

3 months

4.50%

0.25%

6 months

5.00%

0.25%

Forward Rate Agreement (FRA) for Yen is Nil. 1.

What should be 3 months FRA rate at 3 months forward?

2.

The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA at 6.50 – 6.75%. Is any arbitrage opportunity available?

Calculate profit in such c ase. 15. Given below is the Balance Sheet of S Ltd. as on 31.3.2008: Liabilities

`

Assets

(in lakh) Share capital (share of ` 10) Reserves and surplus Long Term Debts

Land and building 100 Plant and machinery Investments 40 Stock 30 Debtors Cash at bank 170

`

(in lakh) 40 80 10 20 15 5 170

You are required to work out the value of the Company's, shares on the basis of Net Assets method and Profit-earning capacity (capitalization) method and arrive at the fair price of the shares, by considering the following information: (i)

Profit for the current year ` 64 lakhs includes ` 4 lakhs extraordinary income and ` 1 lakh income from investments of surplus funds; such surplus funds are unlikely to recur.


[8]

116


(ii) In subsequent years, additional advertisement expenses of ` 5 lakhs are expected to be incurred each year. (iii) Market value of Land and Building and Plant and Machinery have been ascertained at ` 96 lakhs and ` 100 lakhs respectively. This will entail additional depreciation of ` 6 lakhs each year. (iv) Effective Income-tax rate is 30%. (v) The capitalization rate applicable to similar businesses is 15%. 16. A company is long on 10 MT of copper @ ` 474 per kg (spot) and intends to remain so for the ensuing quarter. The standard deviation of changes of its spot and future prices are 4% and 6% respectively, having correlation coefficient of 0.75. What is its hedge ratio? What is the amount of the copper future it should short to achieve a perfect hedge? 17. Miss K holds 10,000 shares of IBS Bank @ 2,738.70 when 1 month Index Future was trading @ 6,086 The share has a Beta (β) of 1.2. How many Index Futures should she short to perfectly hedge his position. A single Index Future is a lot of 50 indices. Justify your result in the following cases: (i)

when the Index zooms by 1%

(ii) when the Index plummets by 2%. Capital Budgeting with Risk

18. Jumble Consultancy Group has determined relative utilities of cash flows of two forthcoming projects of its client company as follows : Cash Flow in ` Utilities

-15000

-10000

-4000

0

15000

10000

-100

-60

-3

0

40

30

5000 1000 20

10

The distribution of cash flows of project A and Project B are as follows: Project A

Cash Flow (`) Probability

-15000

- 10000

15000

10000

5000

0.10

0.20

0.40

0.20

0.10

- 10000

-4000

15000

5000

10000

0.10

0.15

0.40

0.25

0.10

Project B

Cash Flow (`) Probability

Which project should be selected and why ?


[9]


117

Dividend Decision

19. X Ltd., has 8 lakhs equity shares outstanding at the beginning of the year. The current market price per share is ` 120. The Board of Directors of the company is contemplating ` 6.4 per share as dividend. The rate of capitalization, appropriate to the risk-class to which the company belongs, is 9.6%: (i)

Based on M-M Approach, calculate the market price of the share of the company, when the dividend is – (a) declared; and (b) not declared.

(ii) How many new shares are to be issued by the company, if the company desires to fund an investment budget of ` 3.20 crores by the end of the year assuming net income for the year will be ` 1.60 crores? 20. Write a short note on (a) Lintner’s Model of actual dividend behaviour (b) Necessary conditions to introduce ‘Commodity Derivative’ (c) ‘Starting point and end point of an organisation is money’ (d) Benefits of Real Estate Investment Trusts (REITs) (e) Chop Shop Method of Valuation

SUGGESTED ANSWERS 1. Projected Balance Sheet

Year 1

Year 2

Year 3

Year 4

Fixed Assets (40% of Sales)

9,600

11,520

13,824

13,824

Current Assets (20% of Sales)

4,800

5,760

6,912

6,912

Total Assets

14,400

17,280

20,736

20,736

Equity

14,400

17,280

20,736

20,736

Year 1

Year 2

Year 3

Year 4

24,000

28,800

34,560

34,560

PBT (10%) of sale

2,400

2,880

3,456

3,456

PAT (70%)

1,680

2,016

2,419.20

2,419.20

800

960

1,152

1,382

Projected Cash Flows:

Sales

Depreciation


[10]

118


Addition to Fixed Assets Increase in Current Assets Operating cash flow

2,400

2,880

3,456

1,382

800

960

1,152

-

(720)

(864)

(1,036.80)

2,419.20

Projected Cash Flows:

Present value of Projected Cash Flows: Cash Flows

PVF at 15%

PV

-720

0.870

-626.40

-864

0.756

-653.18

-1,036.80

0.658

-682.21 -1,961.79

Residual Value

-

2419.20/0.15 = 16,128

Present value of Residual value

=

16128/(1.15)3

=

16128/1.521 = 10603.55

Total shareholders’ value

=

10,603.55 – 1,961.79 =

Pre strategy value

=

1,400 / 0.15 = 9,333.33

=

8,641.76 – 9,333.33 =

∴

Value of strategy

8,641.76 - 691.57

Conclusion: The strategy is not financially viable 2.

The company can proceed in the following ways to realise arbitrage gain: (a) Buy Rupees from US$ at Mumbai: ` 64.10 x US$ 2,00,00,000 = ` 128,20,00,000 (b) Convert Rupees from US$ at London: ` 128,20,00,000/99.10 = GBP 1,29,36,427.85 (c) Convert GBP into US$ at New York = GBP 1,29,36,427.85 x 1.5530 = US$ 2,00,90,272.45 There is a Net Gain of = US$ 2,00,90,272.45 - US$ 2,00,00,000 = US$ 90,272.45

3.

On January 28, 2010 the importer customer requested to remit SGD 25 lakhs. To consider sell rate for the bank: US $

=

` 45.90

Pound 1

=

US$ 1.7850

Pound 1

=

SGD 3.1575

Therefore, SGD 1

=

SGD 1

=


`

45.90 * 1.7850 SGD 3.1575

` 25.9482

[11]


Add: Exchange margin (0.125%)

`

119

0.0324

` 25.9806

On February 4, 2010 the rates are US $

=

` 45.97

Pound 1

=

US$ 1.7775

Pound 1

=

SGD 3.1380

Therefore, SGD 1

=

SGD 1

=

Add: Exchange margin (0.125%)

`

45.97 * 1.7775 SGD 3.1380

` 26.0394 `

0.0325

` 26.0719

Hence, loss to the importer = SGD 25,00,000 ( `26.0719 – `25.9806) = ` 2,28,250 4.

In order to find out the NAV, the cash balance at the end of the year is calculated as followsParticulars

Cash balance in the beginning (` 100 lakhs – ` 98 lakhs) Dividend Received

2,00,000 12,00,000

Interest on 7% Govt. Securities

56,000

Interest on 9% Debentures

45,000

Interest on 10% Debentures

50,000 15,51,000

(-) Operating expenses Net cash balance at the end Calculation of NAV

Cash Balance 7% Govt. Securities (at par) 50,000 equity shares @ ` 175 each

5,00,000 10,51,000 `

10,51,000 8,00,000 87,50,000

9% Debentures (Unlisted) at cost

5,00,000

10% Debentures @90%

4,50,000

Total Assets


1,15,51000

[12]

120


No. of Units

10,00,000

NAV per Unit

`

11.55

Calculation of NAV, if dividend of ` 0.80 is paid – Net Assets (` 1,15,51,000 – ` 8,00,000)

`

1,07,51,000

No. of Units

10,00,000

NAV per unit 5.

`

10.75

Computation of current value of G’s portfolio (i)

100 Nos. Bond A, ` 1,000 par value, 9% Bonds maturity 3 years: `

Current value of interest on bond A 1-3 years: ` 9000 × Cumulative P.V. @ 12% (1-3 years)

21,618

= ` 9000 × 2.402 Add: Current value of amount received on maturity of Bond A

End of 3rd year: ` 1,000 × 100 × P.V. @ 12% (3rd year)

71,200

= ` 1,00,000 × 0.712 92,818 (ii) 100 Nos. Bond B, ` 1,000 par value, 10% Bonds maturity 5 years: Current value of interest on bond B 1-5 years:

` 10,000

×

Cumulative P.V. @ 12% (1-5 years)

= ` 10,000 × 3.605

36,050

Add: Current value of amount received on maturity of Bond B

End of 5th year: ` 1,000 × 100 × P.V. @ 12% (5 th year) = ` 1,00,000 × 0.567

56,700 92,750

(iii) 100 Preference shares C, ` 1,000 par value, 11% coupon 11% × 1000 Nos. × ` 100 13%

11,000 =

84,615

0.13

(iv) 100 Preference shares D, ` 1,000 par value, 12% coupon 12% × 1000 Nos. × ` 100 13%

=

12,000

92,308

0.13

Total current value of his portfolio [(i) + (ii) + (iii) + (iv)]


3,62,491

[13]

PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT 6.

121

(a) Calculation of Profit after tax (PAT) `

Profit before interest and tax (PBIT)

32,00,000

Less: Debenture interest ( ` 64,00,000 × 12/100)

7,68,000

Profit before tax (PBT)

24,32,000

Less: Tax @ 35%

8,51,200

Profit after tax (PAT)

15,80,800

Less: Preference Dividend

(` 40,00,000 × 8/100)

3,20,000

Equity Dividend (` 80,00,000 × 8/100)

6,40,000

9,60,000

Retained earnings (Undistributed profit)

6,20,800

Calculation of Interest and Fixed Dividend Coverage

=

PAT + Debenture interest Debenture interest + Preference dividend

=

15,80,800 + 7,68,000 7,68,000 + 3,20,000

=

23,48,800 10,88,000

= 2.16 times

(b) Calculation of Capital Gearing Ratio

Capital Gearing Ratio = =

=

Fixed interest bearing funds Equity shareholders' funds

Preference Share Capital + Debentures Equity Share Capital + Reserves

1,04,00,000 1,12,00,000

=

40,00,000

+ 64,00,000

80,00,000

+ 32,00,000

= 0.93

(c) Calculation of Yield on Equity Shares:

Yield on equity shares is calculated at 50% of profits distributed and 5% on undistributed profits: ( ` ) 50% on distributed profits (` 6,40,000 × 50/100)

3,20,000

5% on undistributed profits ( ` 6,20,800 × 5/100)

31,040

Yield on equity shares


3,51,040

[14]

122


Yield on equity shares %

= =

Yield on shares Equity share capital 3,51,040 80,00,000

×

×

100

100 = 4.39% or, 4.388%.

Calculation of Expected Yield on Equity shares Note: There is a scope for assumptions regarding the rates (in terms of percentage for

every one time of difference between Sun Ltd. and Industry Average) of risk premium involved with respect to Interest and Fixed Dividend Coverage and Capital Gearing Ratio. The below solution has been worked out by assuming the risk premium as: (i)

1% for every one time of difference for Interest and Fixed Dividend Coverage.

(ii) 2% for every one time of difference for Capital Gearing Ratio. (a) Interest and fixed dividend coverage of Sun Ltd. is 2.16 times but the industry average is 3 times. Therefore, risk premium is added to Sun Ltd. Shares @ 1% for every 1 time of difference. Risk Premium = 3.00 – 2.16 (1%) = 0.84 (1%) = 0.84% (b) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75 times. Therefore, risk premium is added to Sun Ltd. shares @ 2% for every 1 time of difference. Risk Premium

= (0.75 – 0.93) (2%) = 0.18 (2%) = 0.36% (%)

Normal return expected

9.60

Add : Risk premium for low interest and fixed dividend coverage

0.84

Add : Risk premium for high interest gearing ratio

0.36 10.80

Value of Equity Share

= Actual yield

Expected yield

7.

(i)

×

Paid-up value of share = 4.39

10.80

×

100 = ` 40.65

Straight Value of Bond = ` 85 x 0.9132 + ` 85 x 0.8340 + ` 1085 x 0.7617 = ` 974.96

(ii) Conversion Value = Conversion Ration x Market Price of Equity Share = ` 45 x 25 = ` 1,125


[15]


123

(iii) Conversion Premium Conversion Premium = Market Conversion Price - Market Price of Equity Share =

` 1,175

25

- ` 45 = ` 2

(iv) Percentage of Downside Risk =

` 1,175 − ` `

974.96

974.96

×100 = 20.52%

(v) Conversion Parity Price =

Bond Price No. of Share on Conversion

=

` 1,175

25

= ` 47

8. Date

1 Sensex

2 EMA for Previous day

3

4

1-2

3×0.062

5 EMA 2+4

6

14522

15000

(478)

(29.636)

14970.364

7

14925

14970.364

(45.364)

(2.812)

14967.55

10

15222

14967.55

254.45

15.776

14983.32

11

16000

14983.32

1016.68

63.034

15046.354

12

16400

15046.354

1353.646

83.926

15130.28

13

17000

15130.28

1869.72

115.922

15246.202

17

18000

15246.202

2753.798

170.735

15416.937

Conclusion – The market is bullish. The market is likely to remain bullish for short term

to medium term if other factors remain the same. On the basis of this indicator (EMA) the investors/brokers can take long position. 9.

Financial Analysis whether to set up the manufacturing units in India or not may be carried using NPV technique as follows: I.

Incremental Cash Outflows $ Million Cost of Plant and Machinery Working Capital Release of existing Working Capital

500.00 50.00 (15.00) 535.00


[16]

124


II.

Incremental Cash Inflow after Tax (CFAT) (a) Generated by investment in India for 5 years Sales Revenue (5 Million x $80) Less: Costs Variable Cost (5 Million x $20) Fixed Cost Depreciation ($500Million/5) EBIT Taxes@35% EAT Add: Depreciation CFAT (1-5 years) Cash flow at the end of the 5 years (Release of Working Capital)

$ Million 400.00 100.00 30.00 100.00 170.00 59.50 110.50 100.00 210.50 35.00

(b) Cash generation by exports $ 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 $ Million Through setting up subsidiary in India

210.50

Through Exports in India

39.00

CFAT (1-5 years)

171.50

III. Determination of NPV Year

CFAT ($ Million)

PVF@12%

PV($ Million)

1-5

171.50

3.6048

618.2232

5

35

0.5674

19.8590


[17]


125

638.0822 Less: Initial Outflow

535.0000 103.0822

Since NPV is positive the proposal should be accepted. 10.

(in lakhs) Quote A

Quote B

5.00

1.00

Calculation of Present Value (PV) of cash payments:

Initial lease rent (PV) Less: PV of tax benefit on initial payment of lease rent `

5.00 lakh x 0.30 x 0.91

(1.365)

-

`

1.00 lakh x 0.30 x 0.91

-

(0.273)

PV of Annual lease rents `

21.06 lakh x 0.7 x 2.49

36.71

-

`

19.66 lakh x 0.7 x 3.17

-

43.63

40.345

44.357

1/2.49

0.402

-

1/3.17

-

0.315

16.20

13.979

Total payments in PV

Capital Recovery Factor (reciprocal of Annuity Factor)

Equated Annual Payment or cash outflow ( ` lakhs)

Conclusion: Since Quote B implies lesser equated annual cash outflow, it is better. 11. The value of Cost of Equity with the help of CAPM

Ke = Rf + β(Rm – Rf ) With the given data the Cost of Equity using CAPM will be: Ke = 0.11 + 1.5(0.15 – 0.11) Ke = 0.11 + 1.5(0.04) = 0.17 or 17% The value of share using the Growth Model: P

=

P=

D0 (1 + g) ke

−

g

20(1 + 0.09) 0.17 − 0.09


[18]

126


P=

21.80 0.08

= ` 272.50

However, if the decision of the Board of Directors is implemented, the beta factor is likely to increase to 1.75. Therefore, Ke = 0.11 + 1.75(0.15 – 0.11) Ke = 0.11 + 1.75(0.04) = 0.18 or 18% The value of share using the Growth Model: P=

D 0 (1 + g) ke − g

P=

20(1 + 0.09) 0.18 − 0.09

P=

21.80 0.09

= ` 242.22

12. With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of

various securities calculated as below: (i) Investment

Beta (β)

Investment ( ` Lacs)

Weighted Investment

A

1.6

20

32

B

1.0

20

20

C

0.9

20

18

D

2.0

20

40

E

0.6

20

12

100

122

Weighted Beta (β) = 1.22 (ii) With varied percentages of investments portfolio beta is calculated as follows: Investment

Beta (β)

Investment ( ` Lacs)

Weighted Investment

A

1.6

15

24

B

1.0

30

30

C

0.9

15

13.5

D

2.0

30

60


[19]


E

0.6

127

10

6

100

133.5

Weighted Beta (β) = 1.335 (iii) Expected return of the portfolio with pattern of investment as in case (i) = 12% × 1.22 i.e. 14.64% Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e., 16.02%. 13. Day

Principal ( )

MIBOR (%)

Interest ( )

Tuesday

10,00,00,000

7.75

21,233

Wednesday

10,00,21,233

8.15

22,334

Thursday

10,00,43,567

8.12

22,256

Friday

10,00,65,823

7.95

21,795

Saturday & Sunday (*)

10,00,87,618

7.98

43,764

Monday

10,01,31,382

8.15

22,358

Total Interest @ Floating

1,53,740

Less: Net Received Expected Interest @ fixed

317 1,53,423

Thus Fixed Rate of Interest

0.07999914

Approx. (*) i.e. interest for two days.

8%

Note: Alternatively, answer can also be calculated on the basis of 360 days in a year. 14. 1.

3 Months Interest rate is 4.50% & 6 Months Interest rate is 5% p.a.

Future Value 6 Months from now is a product of Future Value 3 Months now & 3 Months Future Value from after 3 Months. (1+0.05*6/12) =(1+0.045*3/12) x (1+i3,6 *3/12) i3,6 = [(1+0.05* 6/12) /(1+0.045 *3/12) – 1] *12/3 i.e. 5.44% p.a. 2.

6 Months Interest rate is 5% p.a. & 12 Month interest rate is 6.5% p.a.

Future value 12 month from now is a product of Future value 6 Months from now and 6 Months Future value from after 6 Months.


[20]

128


(1+0.065) = (1+0.05*6/12) x (1+i 6,6 *6/12) i6,6 = [(1+0.065/1.025) – 1] *12/6 6 Months forward 6 month rate is 7.80% p.a. The Bank is quoting 6/12 USD FRA at 6.50 – 6.75% Therefore there is an arbitrage Opportunity of earning interest @ 7.80% p.a. & Paying @ 6.75% Borrow for 6 months, buy an FRA & invest for 12 months

To get

$ 1.065 at the end of 12 months for $ 1 invested today

To pay

$ 1.060# at the end of 12 months for every $ 1 Borrowed today

Net gain $ 0.005 i.e. risk less profit for every $ borrowed # (1+0.05/2) (1+.0675/2) = (1.05959) say 1.060 15. ` lakhs

Net Assets Method

Assets: Land & Buildings

96

Plant & Machinery

100

Investments

10

Stocks

20

Debtors

15

Cash & Bank

5

Total Assets

246

Less : Long Term Debts

30

Net Assets

216

Value per share

(a) Number of shares

1,00,00,000 10

=

(b) Net Assets ` 2,16,00,000 ` 2,16,00,000

10,00,000

= ` 21.6


10,00,000

[21]


129

Profit-earning Capacity Method

` lakhs

Profit before tax

64.00

Less : Extraordinary income

4.00

Investment income (not likely to recur)

1.00

5.00 59.00

Less : Additional expenses in forthcoming years

Advertisement

5.00

Depreciation

6.00

11.00

Expected earnings before taxes

48.00

Less : Income-tax @ 30%

14.40

Future maintainable profits (after taxes)

33.60

Value of business Capitalisation factor

33.60 0.15

224

=

Less : Long Term Debts

30 194

Value per share

1,94,00,000 10,00,000

`

Fair Price of share

`

Value as per Net Assets Method

21.60

Value as per Profit earning capacity (Capitalisation) method

19.40

Fair Price=

21.60 + 19.40 41.00 = = 2 2

19.40

` 20.50

16. The optional hedge ratio to minimize the variance of Hedger’s position is given by:

H=

ρ

σS σF

Where σS= Standard deviation of ΔS σF=Standard deviation of ΔF ρ= coefficient of correlation between ΔS and ΔF

H= Hedge Ratio ΔS = change in Spot price.


[22]

130

FINAL EXAMINATION: MAY, 2017 ΔF= change in Future price.

Accordingly H = 0.75 x

0.04 0.06

= 0.5

No. of contract to be short = 10 x 0.5 = 5 Amount = 5000 x ` 474 = ` 23,70,000 17. Value of Portfolio of Miss. K ( ` 2,738.70X10,000)

Number of index future to be sold by Miss. K is: (i)

` 2,73,87,000

1.2 × 2738.70 × 10000 6,086 × 50

= 108 contract

Justification of the answer if index is zoomed by 1%: Gain in the value of the portfolio ` 2,73,87,000X1%X1.2

` 3,28,644

Loss by short covering of index future is 0.01X6,086X50X108

` 3,28,644

This justifies the result. (ii) Justification of the answer if index is plummets by 2%: Loss in the value of the portfolio ` 2,73,87,000X2%X1.2

` 6,57,288

Gain by short covering of index future is 0.02X6,086X50X108

` 6,57,288

This justifies the result. 18. Evaluation of project utilizes of Project A and Project B Project A Cash flow (in `)

Probability

Utility

Utility value

-15,000

0.10

-100

-10

- 10,000

0.20

-60

-12

15,000

0.40

40

16

10,000

0.20

30

6

5,000

0.10

20

2 2

Project B Cash flow (in `)

Probability

Utility

Utility value

-10,000

0.10

-60

-6


[23]


131

-4,000

0.15

-3

-0.45

15,000

0.40

40

16

5,000

0.25

20

5

10,000

0.10

30

3 17.55

Project B should be selected as its expected utility is more 19. Modigliani and Miller (M-M) – Dividend Irrelevancy Model: P0

=

P1 + D1 1+ K e

Where, Po = Existing market price per share i.e. ` 120 P1 = Market price of share at the year-end (to be determined) D1 = Contemplated dividend per share i.e. ` 6.4 Ke = Capitalisation rate i.e. 9.6%. (i)

(a) Calculation of share price when dividend is declared: P0

=

P1 + D1 1+ K e

120 =

P1 + 6.4 1 + 0.096

120 × 1.096 = P 1 + 6.4 P1 = 120 × 1.096 – 6.4 = 125.12 (b) Calculation of share price when dividend is not declared: P0

=

P1 + D1

120 =

1+ K e P1 + 0 1 + 0.096

120 × 1.096 = P 1 + 0 P1 = 131.52


[24]

132

FINAL EXAMINATION: MAY, 2017 (ii) Calculation of No. of shares to be issued: ( ` in lakhs) Particulars

If dividend declared

If dividend not declared

Net Income

160

160

Less: Dividend paid

51.20

------

Retained earnings

108.80

160

Investment budget

320

320

Amount to be raised by issue of new shares (i)

211.20

160

Market price per share (ii)

125.12

131.52

1,68,797.95

1,21,654.50

1,68,798

1,21,655

No. of new shares to be issued (ii) Or say

20. (a) The classic study of the actual dividend behavior was done by John Lintner in 1956.

The study was conducted in two stages. First, he conducted a series of interviews with businessmen to form a view of how they went about their dividends decisions. He then formed a model on the basis of those interviews which could be tested on a larger data. His formula is D1

= D 0 + [(EPS X Target Payout) – D 0] X A F

Where D1

= Dividend in year 1

D0

= Dividend in year 0

EPS = Earning Per Share AF

= Adjustment Factor

Lintner model has two parameters: (1) The target pay-out ratio and (2) The spread at which current dividends adjust to the target. From the interviews he conducted, it emerged that investment needs were not a major consideration in the determination of dividend policy, rather the decision to change the dividend was usually a response to a significant change in earnings which had disturbed the existing relationship between earnings and dividends. Lintner concluded that (1) Companies tend to set long run target dividends-to-earning ratios according to the amount of positive net present value (NPV) project that are available.


[25]


133

(2) Earning increases are not always sustainable. As a result, dividend policy is not changed until managers can see that new earnings level are sustainable. (b) The following attributes are considered crucial for qualifying for the derivatives

trade: (1) a commodity should be durable and it should be possible to store it; (2) units must be homogeneous; (3) the commodity must be subject to frequent price fluctuations with wide amplitude; supply and demand must be large; (4) supply must flow naturally to market and there must be breakdowns in an existing pattern of forward contracting. The first attribute, durability and storability, has received considerable attention in commodity finance, since one of the economic functions often attributed to commodity derivatives markets is the temporal allocation of stocks. Since commodity derivatives contracts are standardized contracts, the second attribute, requires the underlying product to be homogeneous, so that the underlying commodity as defined in the commodity derivatives contract corresponds with the commodity traded in the cash market. This allows for actual delivery in the commodity derivatives market. The third attribute, a fluctuating price, is of great importance, since firms will feel little incentive to insure themselves against price risk if price changes are small. A broad cash market is important because a large supply of the commodity will make it difficult to establish dominance in the market place and a broad cash market will tend to provide for a continuous and orderly meeting of supply and demand forces. The last crucial attribute, breakdowns in an existing pattern of forward trading, indicates that cash market risk will have to be present for a commodity derivatives market to come into existence. Should all parties decide to eliminate each and every price fluctuation by using cash forward contracts for example, a commodity derivatives market would be of little interest. (c)

No organization can run an existing business and promote a new expansion project without a suitable internally mobilized financial base or both internally and externally mobilized financial base. Sources of finance and capital structure are the most important dimensions of a strategic plan. The generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity shares and / or preference shares for mobilizing ownership capital.


[26]

134


Along with the mobilization of funds, policy makers should decide on the capital structure to indicate the desired mix of equity capital and debt capital. There are some norms for debt equity ratio. However this ratio in its ideal form varies from industry to industry. It also depends on the planning mode of the organization under study. Another important dimension of strategic management and financial policy interface is the investment and fund allocation decisions. A planner has to frame policies for regulating investments in fixed assets and for restraining of current assets. Investment proposals mooted by different business units may be addition of a new product, increasing the level of operation of an existing product and cost reduction and efficient utilization of resources through a new approach and closer monitoring of the different critical activities. Now, given these three types of proposals a planner should evaluate each one of them by making within group comparison in the light of capital budgeting exercise. Dividend policy is yet another area for making financial policy decisions affecting the strategic performance of the company. A close interface is needed to frame the policy to be beneficial for all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the extent of earnings to be retained for future expansion scheme of the firm. It may be noted from the above discussions that financial policy of a company cannot be worked out in isolation of other functional policies. It has a wider appeal and closer link with the overall organizational performance and direction of growth. These policies related to external awareness about the firm, specially the awareness of the investors about the firm, in respect of its internal performance. There is always a process of evaluation active in the minds of the current and future stake holders of the company. As a result, preference and patronage for the company depends significantly on the financial policy framework. And hence attention of the corporate planners must be drawn while framing the financial policies not at a later stage but during the stage of corporate planning itself. (d) Reits typically offer the following benefits: 

For the Investors: REITs as an investment class provide the common man an opportunity to invest in fixed income securities which also provide long term capital appreciation and a natural inflation hedge. It also opens to small investors an arena (i.e. rent generating real estate assets) which was hitherto the monopoly of large investors.



For the Industry: Reits assist in streamlining the real estate sector by creating a new and transparent source of raising finance in the real estate sector. Further, Reits can provide developers with institutional capital to sell their assets and use funds to repay banks and/or utilize the funds for more


[27]


135

development. (e)

This approach attempts to identify multi-industry companies that are undervalued and would have more value if separated from each other. In other words as per this approach an attempt is made to buy assets below their replacement value. This approach involves following three steps: Step 1: Identify the firm’s various business segments and calculate the average

capitalization ratios for firms in those industries. Step 2: Calculate a “theoretical” market value based upon each of the average

capitalization ratios. Step 3: Average the “theoretical” market values to determine the “chop-shop” value

of the firm.


[28]

PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT QUESTIONS Mergers and Acquisiti ons

1.

XYZ, a large business house is planning to acquire ABC another business entity in similar line of business. XYZ has expressed its interest in making a bid for ABC. XYZ expects that after acquisition the annual earning of ABC will increase by 10%. Following information, ignoring any potential synergistic benefits arising out of possible acquisitions, are available: XYZ

ABC

Proxy entity for XYZ & ABC in the same line of business

1025

106

--

` 129.60

` 55

--

1:2

1:3

1:4

--

--

1.1

Paid up Capital ( ` Crore) Face Value of Share is `10 Current share price Debt : Equity (at market values) Equity Beta

Assume Beta of debt to be zero and corporate tax rate as 30%, determine the Beta of combined entity. Foreign Exchange Risk Management

2.

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, 2009. Market information as at June 1, 2009 is: Exchange Rates

Currency Futures

US $/`

US $/`

Contract size

Spot

0.02140

June

0.02126

1 Month Forward

0.02136

September

0.02118

` 4,72,000

3 Months Forward 0.02127 Initial Margin

Interest Rates in India

June

`

10,000

7.50%

September

`

15,000

8.00%

Suppose the XYZ Ltd. has opted for Future Contracts for hedging the risk and on September 1, 2009 the spot rate US $/ ` is 0.02133 and currency future rate is 0.02134, then what will be the variation margin in INR to settle the futures contract.


[29]

56

3.

FINAL EXAMINATION: NOVEMBER, 2016

A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S. suppliers. The amount is payable in six months’ time. The relevant spot and forward rates are: Spot rate

USD 1.5617-1.5673

6 months’ forward rate

USD 1.5455 –1.5609

The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit rates are 5.5% and 4.5% respectively. Currency options are available under which one option contract is for US$ 21250. The option premium for US$ at a strike price of GBP 0.58825/USD is GBP 0.036 (call option) and GBP 0.056 (put option) for 6 months period. The company has 3 choices: (i)

Forward cover

(ii) Money market cover, and (iii) Currency option Which of the alternatives is preferable by the company? Mutual Funds

4.

Based on the following data, estimate the Net Asset Value (NAV) on per unit basis of a Regular Income Scheme of a Mutual Fund on 31-3-2015: (in lakhs)

Listed Equity shares at cost (ex-dividend)

40.00

Cash in hand (As on 1-4-2014)

5.00

Bonds & Debentures at cost of these, Bonds not listed & not quoted

8.96 2.50

Other fixed interest securities at cost

9.75

Dividend accrued

1.95

Amount payable on shares

13.54

Expenditure accrued

1.76

Current realizable value of fixed income securities of face value of ` 100 is ` 96.50. Number of Units ( ` 10 face value each): 275000 All the listed equity shares were purchased at a time when market portfolio index was 12,500. On NAV date, the market portfolio index is at 19,975. There has been a diminution of 15% in unlisted bonds and debentures valuation. Listed bonds and debentures carry a market value of ` 7.5 lakhs, on NAV date.


[30]

PAPER – 2: STRATEGIC FINANCIAL MANA GEMENT

57

Operating expenses paid during the year amounted to ` 2.24 lakhs. Financial Services

5.

Extracts from the forecasted financial statements of ABC Ltd. are given below. `

‘000

`

‘000

Turnover

21,300

Cost of sales

16,400

Gross Profit

4,900

Non-current assets

3,000

Current assets Inventory

4,500

Trade receivables

3,500

Total Assets

8,000 11,000

Trade payables

3,000

Overdraft

3,000

Equity Shares

1,000

Reserves

1,000

Debentures

6,000 2,000 3,000

Total Liabil ities

11,000

XYZ Fincorp, a factor has offered to manage the trade receivables of ABC Ltd. under a servicing and factor-financing agreement. XYZ expects to reduce the average trade receivables period of ABC from its current level to 35 days; to reduce bad debts from 0.9% of turnover to 0.6% of turnover; and to save of ABC ` 40,000 per year on account of administration costs. The XYZ would also make an advance to ABC of 80% of the revised book value of trade receivables. The interest rate on the advance would be 2% higher than the ABC currently pays on its overdraft i.e. 7%. The XYZ would charge a fee of 0.75% of turnover on a withrecourse basis, or a fee of 1.25% of turnover on a non-recourse basis. Assuming 365 days in a year and all sales and purchases are on credit, you are required to evaluate the proposal of XYZ Fincorp. Security Analysis

6.

The following data is related to 8.5% Fully Convertible (into Equity shares) Debentures issued by JAC Ltd. at ` 1000. Market Price of Debenture


`

900

[31]

58


Conversion Ratio

30

Straight Value of Debenture

`

700

Market Price of Equity share on the date of Conversion

`

25

Expected Dividend Per Share

`

1

You are required to c alculate: (a) Conversion Value of Debenture (b) Market Conversion Price (c) Conversion Premium per share (d) Ratio of Conversion Premium (e) Premium over Straight Value of Debenture (f)

Favourable income differential per share

(g) Premium pay back period International Financi al Management

7.

Odessa Limited has proposed to expand its operations for which it requires funds of $ 15 million, net of issue expenses which amount to 2% of the issue size. It proposed to raise the funds though a GDR issue. It considers the following factors in pricing the issue: (i)

The expected domestic market price of the share is ` 300

(ii) 3 shares underly each GDR (iii) Underlying shares are priced at 10% discount to the market price (iv) Expected exchange rate is ` 60/$ You are required to compute the number of GDR's to be issued and cost of GDR to Odessa Limited, if 20% dividend is expected to be paid with a growth rate of 20%. Leasing

8.

R Ltd., requires a machine for 5 years. There are two alternatives either to take it on lease or buy. The company is reluctant to invest initial amount for the project and approaches their bankers. Bankers are ready to finance 100% of its initial required amount at 15% rate of interest for any of the alternatives. Under lease option, upfront Security deposit of ` 5,00,000/- is payable to lessor which is equal to cost of machine. Out of which, 40% shall be adjusted equally against annual lease rent. At the end of life of the machine, expected scrap value will be at book value after providing, depreciation @ 20% on written down value basis. Under buying option, loan repayment is in equal annual installments of principal amount, which is equal to annual lease rent charges. However in case of bank finance for lease


[32]


59

option, repayment of principal amount equal to lease rent is adjusted every year, and the balance at the end of 5th year. Assume Income tax rate is 30%, interest is payable at the end of every year and discount rate is @ 15% p.a. The following discounting factors are given: Year

1

2

3

4

5

Factor

0.8696

0.7562

0.6576

0.5718

0.4972

Which option would you suggest on the basis of net present values? International Capital Budgeting

9.

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. 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 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 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.


[33]

60


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

Portfoli o Management

10. A company has a choice of investments between several different equity oriented mutual funds. The company has an amount of `1 crore to invest. The details of the mutual funds are as follows: Mutual Fund

Beta

A

1.6

B

1.0

C

0.9

D

2.0

E

0.6

Required: (i)

If the company invests 20% of its investment in the first two mutual funds and an equal amount in the mutual funds C, D and E, what is the beta of the portfolio?

(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance in equal amount in the other two mutual funds, what is the beta of the portfolio? (iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be the portfolios expected return in both the situations given above? 11. A Portfolio Manager (PM) has the following four stocks in his portfolio: Security

No. of Shares

Market Price per share ( `)

β

VSL

10,000

50

0.9

CSL

5,000

20

1.0

SML

8,000

25

1.5

APL

2,000

200

1.2

Compute the following: (i)

Portfolio beta.

(ii)

If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring in?


[34]


61

(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he bring in? 12. A has portfolio having following features: Security

β

Random Error σei

Weight

L

1.60

7

0.25

M

1.15

11

0.30

N

1.40

3

0.25

K

1.00

9

0.20

You are required to find out the risk of the portfolio if the standard deviation of the market index (σm) is 18%. Security Valuation

13. The following is the Yield structure of AAA rated debenture: Period

Yield (%)

3 months

8.5%

6 months

9.25

1 year

10.50

2 years

11.25

3 years and above

12.00

(i)

Based on the expectation theory calculate the implicit one-year forward rates in year 2 and year 3.

(ii) If the interest rate increases by 50 basis points, what will be the percentage change in the price of the bond having a maturity of 5 years? Assume that the bond is fairly priced at the moment at ` 1,000. 14. M/s Transindia Ltd. is contemplating calling ` 3 crores of 30 years, ` 1,000 bond issued 5 years ago with a coupon interest rate of 14 per cent. The bonds have a call price of ` 1,140 and had initially collected proceeds of ` 2.91 crores due to a discount of ` 30 per bond. The initial floating cost was ` 3,60,000. The Company intends to sell ` 3 crores of 12 per cent coupon rate, 25 years bonds to raise funds for retiring the old bonds. It proposes to sell the new bonds at their par value of ` 1,000. The estimated floatation cost is ` 4,00,000. The company is paying 40% tax and its after tax c ost of debt is 8 per cent. As the new bonds must first be sold and their proceeds, then used to retire old bonds, the company expects a two months period of overlapping interest during which interest must be paid on both the old and new bonds. What is the feasibility of refunding bonds?


[35]

62


Indian Capital Market

15. XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period of 24 months. 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 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 and amount nearest to £. It should be part of working notes. 16. Suppose a dealer quotes ‘All-in-cost’ for a generic swap at 8% against six month LIBOR flat. If the notional principal amount of swap is ` 5,00,000. (i)

Calculate semi-annual fixed payment.

(ii) Find the first floating rate payment for (i) above if the six month period from the effective date of swap to the settlement date comprises 181 days and that the corresponding LIBOR was 6% on the effective date of swap. In (ii) above, if the settlement is on ‘Net’ basis, how much the fixed rate payer would pay to the floating rate payer? Generic swap is based on 30/360 days basis. 17. A trader is having in its portfolio shares worth ` 85 lakhs at current price and cash ` 15 lakhs. The beta of share portfolio is 1.6. After 3 months the price of shares dropped by 3.2%. Determine: (i)

Current portfolio beta

(ii) Portfolio beta after 3 months if the trader on current date goes for long position on ` 100 lakhs Nifty futures. Capital Budgeting w ith Risk

18. A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling it. A & Co. currently pays no taxes. The replacement machine costs ` 90,000 now and requires maintenance of ` 10,000 at the end of every year for eight years. At the end of eight years it would have a salvage value of ` 20,000 and would be sold. The


[36]


63

existing machine requires increasing amounts of maintenance each year and its s alvage value falls each year as follows: Year

Maintenance ( `)

Salvage (`)

Present

0

40,000

1

10,000

25,000

2

20,000

15,000

3

30,000

10,000

4

40,000

0

The opportunity cost of capital for A & Co. is 15%. Required: When should the company replace the machine? (Notes: Present value of an annuity of ` 1 per period for 8 years at interest rate of 15% : 4.4873; present value of ` 1 to be received after 8 years at interest rate of 15% : 0.3269). 19. XYZ Ltd. is planning to procure a machine at an investment of expected cash flow after tax for next three years is as follows:

`

40 lakhs. The ` (in

Year – 1

Year – 2

lakh)

Year - 3

CFAT

Probability

CFAT

Probability

CFAT

Probability

12

.1

12

.1

18

.2

15

.2

18

.3

20

.5

18

.4

30

.4

32

.2

32

.3

40

.2

45

.1

The Company wishes to consider all possible risks factors relating to the machine. The Company wants to know: (i)

the expected NPV of this proposal assuming independent probability distribution with 7% risk free rate of interest.

(ii) the possible deviations on expected values. 20. Write a short note on (a) Project Appraisal in inflationary conditions (b) Bought Out Deals (BODs) (c) Financial Engineering


[37]

64


(d) Call Money in Context of Money Market (e) Nostro, Vostro and Lora Account SUGGESTED ANSWERS / HINTS 1.

β ungreared for the proxy company = 1.1 × 4 / [ 4 + (1 – 0.3) ] = 0.9362

0.9362 = β Geared of XYZ × 2/ [ 2 + (1 - 0.3)] β Geared of XYZ

= 1.264

0.9362 = β Geared of ABC × 3/ [ 3 + (1 - 0.3)] β Geared of ABC

= 1.155 XYZ

No. of Share (1)

ABC

--

= 102.50 crore

crore `10 = 10.60 crore

Current share price (2)

` 129.60

` 55

--

Market Values (3) = (1) × (2)

` 13284

` 583

Equity beta (4)

1.264

Market Values × Equity beta

` 16790.976

`1025 crore

`106

`10

Portfolio Beta after Merger = 2.

Total

crore

crore

` 13867

crore

1.155 crore

` 673.365

crore

` 17464.341

crore

`17464.341

crore = 1.26 `13867 crore

The number of contracts needed (1,00,000/0.02118)/4,72,000 = 10 Initial margin payable (10 x `15,000)

= `1,50,000

Variation Margin to settle the Future Contract [(0.02134 – 0.02118) x 10 x 472000/-]/0.02133

= ` 35,406

or (0.00016x10x472000)/.02133 = 755.20/0.02133 3.

In the given case, the exchange rates are indirect. These can be converted into direct rates as follows:


[38]


65

Spot rate GBP =

1 USD 1.5617

USD =

GBP 0.64033

1 USD 1.5673

to -

GBP 0.63804

6 months’ forward rate GBP =

1 USD 1.5455

USD =

GBP 0.64704

1 USD1.5609

to -

GBP 0.64066

Payoff in 3 alternatives i.

ii.

Forward Cover

Amount Amou nt payab p ayable le

USD 3,64,897 3,64 ,897

Forward rate

GBP 0.64704

Payable in GBP

GBP 2,36,103

Money market Cover

Amount Amou nt payabl p ayablee PV @ 4.5% for 6 months i.e.

USD 3,64,897 3,64 ,897 1 = 0.9779951 1.0225

USD 3,56,867

Spot rate purchase

GBP 0.64033

Borrow GBP 3,56,867 x 0.64033

GBP 2,28,513

Interest for 6 months @ 7 %

7,998 -

Payable after 6 months iii.

GBP 2,36,511

Currency Currency op tions

Amount Amou nt payabl p ayablee Unit in Options contract Number of contracts USD 3,64,897/ USD 21,250 Exposure covered USD 21,250 x 17 Exposure to be covered by Forward (USD 3,64,897 – USD 3,61,250) Options premium 17 x USD 21,250 x 0.036 Total payment in currency option


USD 3,64,897 3,64 ,897 USD 21,250 17.17 USD 3,61,250 USD 3,647 GBP 13,005

[39]

66


Payment under option (17 x 21,250 x 0.58825)

GBP 2,12,505

Premium payable

GBP

13,005

Payment for forward cover (USD 3,647 x 0.64704)

GBP

2,360

GBP 2,27,870 Thus total payment in: (i)

Forward Cover

2,36,103 GBP

(ii) Money Market

2,36,511 GBP

(iii) Currency Option

2,27,870 GBP

The company should take currency option for hedging the risk. 4.

Particulars Particulars

Adjustment Value ` lakhs

Equity Shares Cash in hand (5.000 – 2.240)

2.760

Bonds and debentures debentures not listed

2.125

Bonds and debentures listed

7.500

Dividends accrued

1.950

Fixed income securities

9.409

Sub total assets (A) Amount Amou nt payable paya ble on share s haress

87.664 13.54 13.5 4

Expenditure accrued

1.76

Sub total liabilities liabiliti es (B)

15.30

Net Assets Value (A) – (B) No. of units Net Assets Value per unit ( ` 72.364 lakhs / 2,75,000) 5.

63.920

Working Notes:

(i)

Present Trade receivables period = 365 365 x 3,500/21,300 3,500/21,300 = 60 days

(ii) Reduction in trade trade receivables under factoring arrangement arrangement


72.364 2,75,000 ` 26.3142

[40]


67

`

Current trade receivables

3,500,000

Revised trade receivables receivables (` 21,300,000 x 35/365)

2,042,466

Reduction in trade receivables

1,457,534

Calculation of benefit of with-recourse offer

As the XYZ’s offer offe r is with recourse reco urse,, ABC will gain the benefit bene fit of bad debts reducing redu cing from 0·9% of turnover to 0·6% of turnover. `

Finance cost saving = 1,457,534 x 0·07

102,027

Adminis Admi nistrati tration on cost c ost saving savi ng

40,000 40,0 00

Bad debt saving = 21,300,000 x (0·009 – 0·006)

63,900

Total saving Additiona Addi tionall interes in terestt on advance adva nce (2,042,4 (2,0 42,466 66 x 0·8 x 0·02) 0· 02)

205,927 32,680 32,6 80

Net benefit before factor fee (A)

173,247

With-recourse With-recours e factor fee = 21,300,000 x 0·0075 (B)

159,750

Net benefit of with-recourse with-recours e offer (A) – (B)

13,497

Calculation of benefit of non-recourse offer

As the offer offe r is without with out recourse reco urse,, the bad debts debt s of ABC will reduce reduc e to zero, zero , as these will be carried by the XYZ, and so the company will gain a further benefit of 0·6% of turnover. `

Net benefit before with-recourse with-recourse factor fee (A) as above

173,247

Non-recourse factor fee ` 21,300,000 x 0·0125 (D)

266,250

Net cost before adjusting for bad debts (E) = (D) – (A) Remaining bad debts eliminated = 21,300,000 x 0·006 (F) Net benefit of non-recourse non-recourse offer (F) – (E)

93,003 127,800 34,797

The XYZ’s offer is financially acceptable on a with-recourse basis, giving a net benefit of non-recourse basis, the XYZ’s offer is not financially acceptable, acceptable, giving a ` 13,497. On a non-recourse net loss of ` 93,003, if the elimination of bad debts is ignored. The difference between the two factor fees ( ` 106,500 or 0·5% of sales), which represents insurance against the risk of bad debts, is less than the remaining bad debts (` 127,800 or 0·6% of sales), which will be eliminated under non-recourse factoring. When this elimination of bad debts is considered, the non-recourse offer from the factor is financially more attractive than the with-recourse offer.


[41]

68

6.


(a) Conversion Value of Debenture

= Market Price of one Equity Share X Conversion Ratio = ` 25 X 30 = ` 750 (b) (b ) Market Conversion Price

=

Market Market Pr ice of Conver Convertib tible le Debent Debentur uree = Conversion Ratio

`

900 = ` 30 30

Conversio n Premium per share (c ) Conversion Market Conversion Price – Market Price of Equity Share = ` 30 – ` 25 = ` 5 (d ) Ratio of Conversion Premium

Conver Conversio sionn premiu premium m per per share share = Mark Market et Pric Pricee of Equi Equity ty Shar Sharee (e)

5 = 20% ` 25 `

Premium over Straight Value of Debenture ` 900 Market Market Pric Pricee of Conver Convertibl tiblee Bond – 1 = – 1 = 28.6% 28. 6% ` 700 Stra Straig ight ht Valu Valuee of Bond Bond

(f)

Favourable income differential per share Coupon Interest from Debenture - Conversion Ratio × Dividend Per Share Conversion Conversion Ratio `

85 - 30 30 × 30

`1

= ` 1.833

(g ) Premium pay back period

Conver Conversio sionn premi premium um per share share = Favo Favour urab able le Inco Income me Diffe Differn rntia tiall Per Per Shar Sharee 7.

5 = 2.73 years ` 1.833 `

Net Issue Size = $15 million Gross Issue =

$15 million = $15.306 million 0.98

Issue Price per GDR in ` (300 x 3 x 90%)

`

810

Issue Price per GDR in $ (` 810/ ` 60)

$13.50

Dividend Per GDR (D1) = ` 2* x 3 =

`

6

* Assumed to be on based on Face Value of ` 10 each share. Net Proceeds Per GDR = ` 810 x 0.98 = ` 793.80


[42]


69

(a) Number of GDR to be issued $15.306 million = 1.1338 million $13.50

(b) Cost of GDR to Odessa Ltd. ke = 8.

6.00 + 0.20 = 20.76% 793.80

Cash Cash outflow under borrow and buy option Working Notes: a.

Calculation of Interest Amount

Year Year

Repayment Repayment of Principal ( )

Principal Outstanding Outstanding ( )

Interest ( )

Closing Balance ( )

1

1,00,000

5,00,000

75,000

4,00,000

2

1,00,000

4,00,000

60,000

3,00,000

3

1,00,000

3,00,000

45,000

2,00,000

4

1,00,000

2,00,000

30,000

1,00,000

5

1,00,000

1,00,000

15,000

-

b.

Depreciation Schedule

Year

Opening Balance ( )

Depreciation ( )

Closing Balance ( )

1

5,00,000

1,00,000

4,00,000

2

4,00,000

80,000

3,20,000

3

3,20,000

64,000

2,56,000

4

2,56,000

51,200

2,04,800

5

2,04,800

40,960

1,63,840

c.

Tax Benefit on Depreciation Depreciation and Interest

Year

Interest ( )

Depreciation ( )

Total ( )

Tax Benefi t @ 30% ( )

1

75,000

1,00,000

1,75,000

52,500

2

60,000

80,000

1,40,000

42,000

3

45,000

64,000

1,09,000

32,700

4

30,000

51,200

81,200

24,360

5

15,000

40,960

55,960

16,788


[43]

70


PV of Cash Outflo w in Borrow and Bu ying Option Year

Cash outfl ow ( )

Tax Benefit ( )

Net Cash Outflow ( )

PVF@15%

PV ( )

1

1,75,000

52,500

1,22,500

0.8696

1,06,526

2

1,60,000

42,000

1,18,000

0.7562

89,232

3

1,45,000

32,700

1,12,300

0.6576

73,848

4

1,30,000

24,360

1,05,640

0.5718

60,405

5

1,15,000

16,788

98,212

0.4972

48,831

5

(1,63,840)

(1,63,840)

0.4972

(81,461) 2,97,381

Cash outflow under borrow and lease option

Cash payment to Lessor/Tax Benefits on Lease Payment (Annual Lease Rent = ` 1,00,000) Year

Net Lease Rent ( )

Security Deposit ( )

Tax Benefit on Gross Lease Rent ( )

Net Cash Outflow ( )

1

60,000*

30,000

30,000

2

60,000

30,000

30,000

3

60,000

30,000

30,000

4

60,000

30,000

30,000

5

60,000

30,000

(2,70,000)

(3,00,000)

* ` 1,00,000 – ` 40,000 = ` 60,000 Cash payment to Bank/ Tax Benefits on Interest Payment Year

Principal Payment ( )

Interest ( )

Total ( )

Tax Benefit on Interest ( )

Net Outfl ow ( )

1

40,000

75,000

1,15,000

22,500

92,500

2

40,000

69,000

1,09,000

20,700

88,300

3

40,000

63,000

1,03,000

18,900

84,100

4

40,000

57,000

97,000

17,100

79,900

5

3,40,000

51,000

3,91,000

15,300

3,75,700


[44]


71

PV of Cash Outflow in Bo rrow and Leasing Opti on Year

Cash outflow to Bank( )

Cash Outflow under Lease ( )

Total ( )

PVF@15%

PV ( )

1

92,500

30,000

1,22,500

0.8696

1,06,526

2

88,300

30,000

1,18,300

0.7562

89,458

3

84,100

30,000

1,14,100

0.6576

75,032

4

79,900

30,000

1,09,900

0.5718

62,841

5

3,75,700

(2,70,000)

1,05,700

0.4972

52,554 3,86,411

Since PV of cash outflow is least in case of borrow and buying option it should be opted for. 9.

Financial Analysis whether to set up the manufacturing units in India or not may be carried using NPV technique as follows: I.

Incremental Cash Outflows $ Million Cost of Plant and Machinery Working Capital Release of existing Working Capital

500.00 50.00 (15.00) 535.00

II.

Incremental Cash Inflow after Tax (CFAT) (a) Generated by investment in India for 5 years $ Million Sales Revenue (5 Million x $80)

400.00

Less: Costs

Variable Cost (5 Million x $20) Fixed Cost Depreciation ($500 Million/5) EBIT Taxes@35% EAT


100.00 30.00 100.00 170.00 59.50 110.50

[45]

72


Add: Depreciation

100.00

CFAT (1-5 years)

210.50

Cash flow at the end of the 5 years (Release of Working Capital)

35.00

(b) Cash generation by exports $ Million 120.00 60.00 60.00 21.00 39.00

Sales Revenue (1.5 Million x $80) Less: Variable Cost (1.5 Million x $40) Contribution before tax Tax@35% CFAT (1-5 years) (c) Additional CFAT attributable to Foreign Investment

$ Million Through setting up subsidiary in India

210.50

Through Exports in India

39.00

CFAT (1-5 years)

171.50

III. Determination of NPV Year

CFAT ($ Million)

PVF@12%

PV($ Million)

1-5

171.50

3.6048

618.2232

5

35

0.5674

19.8590 638.0822

Less: Initial Outflow

535.0000 103.0822

Since NPV is positive the proposal should be accepted. 10. With 20% investment in each MF Portfolio Beta is the weighted average of the Betas of

various securities calculated as below: (i) Investment

Beta (β) Investment (` Lacs)

A B C


1.6 1.0 0.9

Weighted Investment

20 20 20

32 20 18

[46]


D E

73

2.0 0.6

20 20 100 Weighted Beta (β) = 1.22

40 12 122

(ii) With varied percentages of investments portfolio beta is calculated as follows: Investment

Beta (β)

Investment (` Lacs)

Weighted Investment

A

1.6

15

24

B

1.0

30

30

C

0.9

15

13.5

D

2.0

30

60

E

0.6

10

6

100

133.5

Weighted Beta (β) = 1.335 (iii) Expected return of the portfolio with pattern of investment as in case (i)

= 12% × 1.22 i .e. 14.64% Expected Return with pattern of investment as in case (ii) = 12% × 1.335 i.e., 16.02%. 11. Security

No. of shares (1)

Market Price of Per Share (2)

(1) × (2)

% to total (w)

ß (x)

wx

VSL

10000

50

500000 0.4167

0.9

0.375

CSL

5000

20

100000 0.0833

1

0.083

SML

8000

25

200000 0.1667

1.5

0.250

APL

2000

200

400000 0.3333

1.2

0.400

1200000 Portfolio beta (i)

1

1.108 1.108

Required Beta It should become (0.8 / 1.108)

0.8 72.2 % of present portfolio

If ` 12,00,000 is 72.20%, the total portfolio should be ` 12,00,000

× 100/72.20 or

` 16,62,050

Additional investment in zero risk should be (` 16,62,050 – ` 12,00,000) = ` 4,62,050


[47]

74


Revised Portfolio w ill be (ii) To increase Beta to

1.2

It should become 1.2 / 1.108

108.30% of present beta

If 1200000 is 108.30%, the total portfolio should be 1200000 × 100/108.30 or

1108033 say 1108030

Additional investment should be (-) 91967 i.e. Divest ` 91970 of Risk Free Asset Revised Portfolio w ill b e Security

No. of shares (1)

Market Price (1) × (2) of Per Share (2)

% to total (w)

ß (x)

wx

VSL

10000

50

500000

0.4513 0.9

0.406

CSL

5000

20

100000

0.0903 1

0.090

SML

8000

25

200000

0.1805 1.5

0.271

APL

2000

200

400000

0.3610 1.2

0.433

Risk free asset

-9197

10

-91970

-0.0830

1108030

1

Portfolio beta

0

0 1.20

1.20

4

12. βp

=

∑xβ i=1

i

i

= 1.60 x 0.25 + 1.15 x 0.30 + 1.40 x 0.25 + 1.00 x 0.20 = 0.4 + 0.345 + 0.35 + 0.20 = 1.295 The Standard Deviation (Risk) of the portfolio is = [(1.295)2(18) 2+(0.25)2(7) 2+(0.30)2(11) 2+(0.25)2(3) 2+(0.20) 2(9) 2)] = [543.36 + 3.0625 + 10.89 + 0.5625 + 3.24] = [561.115] ½ = 23.69% Al ternativ e A ns wer

The variance of Security’s Return σ2 = β i2 σ2m + σ2εi

Accordingly variance of various securities σ2

Weight(w)

σ2Xw

L

(1.60) 2 (18) 2 + 72 =

878.44

0.25

219.61

M

(1.15) 2 (18) 2 + 11 2 =

549.49

0.30

164.85


[48]


75

N

(1.40)2 (18) 2 + 32 =

644.04

0.25

161.01

K

(1.00) 2 (18) 2 + 92 =

405.00

0.20

81

Variance SD = 13. (i)

626.47

626.47 = 25.03

Implicit rates for year 2 and year 3 2 f 2 = (1 + r 2 ) – 1 1 + r 1

For year 2

2 = (1.1125) - 1 = 1 2 % (1.1050)

(1+ r )3 3 f 3 = -1 (1+ r ) (1+ f ) 1 2

For year 3

=

(1.12)3 (1.1050) (1.12)

(ii) If fairly priced at

-1=

1.404928 1.2376

- 1 = 13.52%

1000 and rate of interest increases to 12.5% the percentage charge will be as follows: Price

`

5 = 1 00 0(1.1 2) = 17 62 .3 41 68 (1.125) 5

1.8020

= 977.99 or ` 987 % charge = 1000 - 978 × 100 = 22 × 100 1000

1000

= 2.2% 14. NPV for bond refundi ng `

PV of annual cash flow savings (W.N. 2) (3,49,600 × PVIFA 8%,25) i.e. 10.675

37,31,980

Less: Initial investment (W.N. 1)

29,20,000

NPV Recommendation: Refunding of bonds is recommended as NPV is positive.


8,11,980

[49]

76


Working Notes: (1) Initial investm ent:

(a) Call premium Before tax (1,140 – 1,000) × 30,000 Less tax @ 40% After tax cost of call prem.

42,00,000 16,80,000 25,20,000

(b) Floatation cost

4,00,000

(c) Overlapping interest Before tax (0.14 × 2/12 × 3 crores) Less tax @ 40%

7,00,000 2,80,000

4,20,000

(d) Tax saving on unamortised discount on old bond 25/30 × 9,00,000 × 0.4

(3,00,000)

(e) Tax savings from unamortised floatation (1,20,000) 29,20,000

Cost of old bond 25/30 × 3,60,000 × 0.4 (2) Annual cash flow savings :

(a) Old bond (i)

Interest cost (0.14 × 3 crores)

42,00,000

Less tax @ 40%

16,80,000

(ii) Tax savings from amortisation of discount 9,00,000/30 × 0.4 (iii) Tax savings from amortisation floatation cost 3,60,000/30 × 0.4

25,20,000 (12,000)

of (4,800)

Annual after tax cost payment under old Bond (A)

25,03,200

(b) New bond (i)

Interest cost before tax (0.12 × 3 crores)

36,00,000

Less tax @ 40%

14,40,000

After tax interest (ii) Tax savings from amortisation of floatation cost (0.4 × 4,00,000/25) Annual after tax payment under new Bond (B) Annual Cash Flow Saving (A) – (B)


21,60,000 (6,400) 21,53,600 3,49,600

[50]


77

15. First of all we shall calculate premium payable to bank as follows:

P=

rp

 1  (1 ÷ i)  i × (1 + i)t  

X A or

rp ×A PVAF(3.5%, 4)

Where P = Premium A = Principal Amount rp = Rate of Premium i = Fixed Rate of Interest t = Time 0.01

=

  1 (1/ 0.035)  0.035 × 1.035 4   0.01

=

1   (28.5714)  0.04016 

× £15,000,000 or

× £15,000,000 or

0.01 (0.966 + 0.933 + 0.901+ 0.871)

£150,000 3.671

× £15,000,000

= £ 40,861

Please note above solution has been worked out on the basis of four decimal points at each stage. Now we see the net payment received from bank Reset Period

Additional interest Amount due to rise in received interest rate from bank

Premium Net paid to received bank bank

Amt. from

1

£ 75,000

£ 75,000

£ 40,861

£34,139

2

£ 112,500

£ 112,500

£ 40,861

£71,639

3

£ 150,000

£ 150,000

£ 40,861

£109,139

TOTAL

£ 337,500

£ 337,500

£122,583

£ 214,917

Thus, from above it can be seen that interest rate risk amount of £ 337,500 reduced by £ 214,917 by using of Cap option. Note: It may be possible that student may compute upto three decimal points or may use

different basis. In such case their answer is likely to be different. 16. (i )

Semi-annual fixed payment = (N) (AIC) (Period)


[51]

78


Where N = Notional Principal amount = `5,00,000 AIC = All-in-cost = 8% = 0.08

 180  = 5,00,000 × 0.08    360  = 5,00,000 × 0.08 (0.5) = 5,00,000 × 0.04 = `20,000/(ii) Floating Rate Payment

 dt  = N (LIBOR)    360  = 5,00,000 × 0.06 ×

181 360

= 5,00,000 × 0.06 (0.503) or 5,00,000 × 0.06 (0.502777) = 5,00,000 × 0.03018 or 0.30166 = `15,090 or 15,083 Both are correct (iii) Net Amount

= (i) – (ii) = `20,000 – `15,090 = `4,910 or = `20,000 – `15,083 = `4,917 17. (i)

Current portf olio

Current Beta for share

= 1.6

Beta for cash

=0

Current portfolio beta

= 0.85 x 1.6 + 0 x 0.15 = 1.36

(ii) Portfoli o beta after 3 month s:

Beta for portfolio of shares =

1.6 =

Change in value of portfolio of share Change in value of market portfolio (Index) 0.032 Change in value of market portfolio (Index)

Change in value of market portfolio (Index) = (0.032 / 1.6) x 100 = 2% Position taken on 100 lakh Nifty futures : Value of index after 3 months


Long = ` 100 lakh x (100 - 0.02)

[52]


79

= ` 98 lakh Mark-to-market paid

= ` 2 lakh

Cash balance after payment of mark-to-market = ` 13 lakh Value of portfolio after 3 months

= `85 lakh x (1 - 0.032) + `13 lakh = `95.28 lakh `100

lakh - `95.28 lakh = 4.72% `100 lakh

Change in value of portfolio

=

Portfolio beta

= 0.0472/0.02 = 2.36

18.

A & Co. Equivalent cost of (EAC) of new machine `

(i)

Cost of new machine now

90,000

Add: PV of annual repairs @ ` 10,000 per annum for 8 years (` 10,000 × 4.4873)

44,873 1,34,873

Less: PV of salvage value at the end of 8 years

6,538

(` 20,000 ×0.3269) 1,28,335 28,600

Equivalent annual cost (EAC) ( ` 1,28,335/4.4873)

PV of cos t of replacin g the old machi ne in each of 4 years with new machine Scenario

Year

Cash Flow

PV @ 15%

(` )

Replace Immediately

0

PV (` )

(28,600)

1.00

(28,600)

40,000

1.00

40,000 11,400

Replace in one year

1

(28,600)

0.870

(24,882)

1

(10,000)

0.870

(8,700)

1

25,000

0.870

21,750 (11,832)

Replace in two years

1

(10,000)

0.870

(8,700)

2

(28,600)

0.756

(21,622)


[53]

80


2

(20,000)

0.756

(15,120)

2

15,000

0.756

11,340 (34,102)

Replace in three years

1

(10,000)

0.870

(8,700)

2

(20,000)

0.756

(15,120)

3

(28,600)

0.658

(18,819)

3

(30,000)

0.658

(19,740)

3

10,000

0.658

6,580 (55,799)

Replace in four years

1

(10,000)

0.870

(8,700)

2

(20,000)

0.756

(15,120)

3

(30,000)

0.658

(19,740)

4

(28,600)

0.572

(16,359)

4

(40,000)

0.572

(22,880) (82,799)

Ad vic e: The company should replace the old machine immediately because the PV of

cost of replacing the old machine with new machine is least. Alternative Solution

Scenario

Year

Cash Outflow

PV @ 15%

PV

Replace immediately

0 1 to 4

(40,000) 28,600

1 2.856

(40,000) 81,682 41,682

Replace after 1 year

1 1 2 to 4

10,000 (25,000) 28,600

0.870 0.870 1.986

8,696 (21,739) 56,800 43,757

Replace after 2 years

1 2 2 3 and 4

10,000 20,000 (15,000) 28,600

0.870 0.756 0.756 1.230

8,700 15,120 (11,340) 35,178 47,658


[54]


81


1 2 3 3 4

10,000 20,000 30,000 (10,000) 28,600

0.870 0.756 0.658 0.658 0.572

8,700 15,120 19,740 (6,580) 16,359 53,339


1 2 3 4

10,000 20,000 30,000 40,000

0.870 0.756 0.658 0.572

8,700 15,120 19,740 22,880 66,440

Ad vic e: The company should replace the old machine immediately because the PV of

cost of replacing the old machine with new machine is least. 19. (i)

Expect ed NPV (` in lakhs) Year I

CFAT

Year II

Year III

P

CF×P

CFAT

P

12

0.1

1.2

12

0.1

1.2

15

0.2

3.0

18

0.3

18

0.4

7.2

30

32

0.3

9.6

40

x or CF

21.

P

CF×P

18

0.2

3.6

5.4

20

0.5

10

0.4

12

32

0.2

6.4

0.2

8

45

0.1

4.5

x or CF

CF×P CFAT

26.60

x or CF 24.50

PV facto r @ 7%

Total PV ( in lakhs)

21

0.935

19.635

26.60

0.873

23.222

24.50

0.816

19.992

PV of cash inflow

62.849

Less: Cash outflow

40.000

NPV

22.849

NPV ( in lakhs)


[55]

82


(ii) Possibl e deviation in the expected value Year I

X- X

X- X

(X - X )2

P1

12 – 21

-9

81

0.1

8.10

15 – 21

-6

36

0.2

7.2

18 – 21

-3

9

0.4

3.6

32 – 21

11

121

0.3

36.30

(X -

X ) 2 P1

55.20

55.20 = 7.43

σ1 = Year II

X- X

X- X

(X - X ) 2

P2

(X - X )2 ×P 2

12-26.60

-14.60

213.16

0.1

21.32

18-26.60

-8.60

73.96

0.3

22.19

30-26.60

3.40

11.56

0.4

4.62

40-26.60

13.40

179.56

0.2

35.91 84.04

84.04 = 9.17

σ2 = Year I II

X- X

X- X

(X - X )2

P3

(X - X )2 × P 3

18-24.50

-6.50

42.25

0.2

8.45

20-24.50

-4.50

20.25

0.5

10.13

32-24.50

7.50

56.25

0.2

11.25

45-24.50

20.50

420.25

0.1

42.03 71.86

σ 3 = 71.86 = 8.48 Standard deviation about the expected value: 55.20

(1.07 )

2

+

84.04

(1.07 )

4

+

71.86 6

(1.07 )

= 12.6574

20. (a) Under conditions of inflation, the project cost estimates that are relevant for a future

date will suffer escalation. Inflationary conditions will tend to initiate the


[56]


83

measurement of future cash flows. Either of the following two approaches may be used while appraising projects under such conditions: (i)

Adjust each year's cash flows to an inflation index, recognising selling price increases and cost increases annually; or

(ii) Adjust the 'Acceptance Rate' (cut-off) suitably retaining cash flow projections at current price levels. An example of approach (ii) above can be as follows: Normal Acceptance Rate

:

15.0%

Expected Annual Inflation

:

5.0%

Adjusted Discount Rate

:

15.0 × 1.05 or 15.75%

It must be noted that measurement of inflation has no standard approach nor is easy. This makes the job of appraisal a difficult one under such conditions. (b) It is a new method of offering equity shares, debentures etc., to the public. In this

method, instead of dealing directly with the public, a company offers the shares/debentures through a sponsor. The sponsor may be a commercial bank, merchant banker, an institution or an individual. It is a type of wholesale of equities by a company. A company allots shares to a sponsor at an agreed price between the company and sponsor. The sponsor then passes the consideration money to the company and in turn gets the s hares duly transferred to him. After a specified period as agreed between the company and sponsor, the shares are issued to the public by the sponsor with a premium. After the public offering, the sponsor gets the shares listed in one or more stock exchanges. The holding cost of such shares by the sponsor may be reimbursed by the company or the sponsor may get the profit by issue of shares to the public at premium. Thus, it enables the company to raise the funds easily and immediately. As per SEBI guidelines, no listed company can go for BOD. A privately held company or an unlisted company can only go for BOD. A small or medium size company which needs money urgently chooses to BOD. It is a low cost method of raising funds. The cost of public issue is around 8% in India. But this method lacks transparency. There will be scope for misuse also. Besides this, it is expensive like the public issue method. One of the most serious short coming of this method is that the securities are sold to the investing public usually at a premium. The margin thus between the amount received by the company and the price paid by the public does not become additional funds of the company, but it is pocketed by the issuing houses or the existing shareholders. (c) “Financial Engineering” involves the design, development and implementation of

innovative financial instruments and processes and the formulation of creative solutions and problems in finance. Financial engineering lies in innovation and


[57]

84


creativity to promote market efficiency. In involves construction of innovative assetliability structures using a combination of basic instruments so as to obtain hybrid instruments which may either provide a risk-return configuration otherwise unviable or result in gain by heading efficiently, possibly by creating an arbitrage opportunity. It is of great help in corporate finance, investment management, trading activities and risk management. Over the years, Financial managers have been coping up with the challenges of changing situations. Different new techniques of financial analysis and new financial instruments have been developed. The process that seeks to adopt existing financial instruments and develop new ones so as to enable financial market participants to cope more effectively with changing conditions is known as financial engineering. In recent years, the rapidity with which corporate finance and investment finance have changed in practice has given birth to new area of study known as financial engineering. It involves use of complex mathematical modelling and high speed computer solutions. Financial engineering includes all this. It also involves any moral twist to an existing idea and is not limited to corporate finance. It has been practiced by commercial banks in offering new and tailor made products to different types of customers. Financial engineering has been used i n schemes of merger and acquisitions. The term financial engineering is often used to refer to risk management. (d ) The Call Money is a part of the money market where, day to day surplus funds,

mostly of banks, are traded. Moreover, the call money market is most liquid of all short-term money market segments. The maturity period of call loans vary from 1 to 14 days. The money that is lent for one day in call money market is also known as ‘overnight money’. The interest paid on call loans are known as the call rates. The call rate is expected to freely reflect the day-to-day lack of funds. These rates vary from day-to-day and within the day, often from hour-to-hour. High rates indicate the tightness of liquidity in the financial system while low rates indicate an easy liquidity position in the market. In India, call money is lent mainly to even out the short-term mismatches of assets and liabilities and to meet CRR requirement of banks. The short-term mismatches arise due to variation in maturities i.e. the deposits mobilized are deployed by the bank at a longer maturity to earn more returns and duration of withdrawal of deposits by customers vary. Thus, the banks borrow from call money markets to meet short-term maturity mismatches. Moreover, the banks borrow from call money market to meet the cash Reserve Ratio (CRR) requirements that they should maintain with RBI every fortnight and is computed as a percentage of Net Demand and Time Liabilities (NDTL).


[58]


(e)

85

In interbank transactions, foreign exchange is transferred from one account to another account and from one centre to another centre. Therefore, the banks maintain three types of current accounts in order to facilitate quick transfer of funds in different currencies. These accounts are Nostro, Vostro and Loro accounts meaning “our”, “your” and “their”. A bank’s foreign currency account maintained by the bank in a foreign country and in the home currency of that country is known as Nostro Account or “our account with you”. For example, An Indian bank’s Swiss franc account with a bank in Switzerland. Vostro account is the local currency account maintained by a foreign bank/branch. It is also called “your account with us”. For example, Indian rupee account maintained by a bank in Switzerland with a bank in India. The Loro account is an account wherein a bank remits funds in foreign currency to another bank for credit to an account of a third bank.


[59]

PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT QUESTIONS Risk Analysis in Capital Budgeting 1.

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 further 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 applicable discount rate is 10%.

2.

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

If applicable Tax Rate is 60% and cost of capital is 10% then calculate project, if inflation rates for revenues & costs are as follows:

3.

Year

Revenues

Costs

1

10%

12%

2

9%

10%

3

8%

9%

4

7%

8%

NPV

of

the

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, it market conditions for pesticide turns out to be favourable the PV of proposal shall increase 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 off for ` 80 crore. If the risk free rate of interest is 8% than what will be value of abandonment option

Leasing 4.

With the following data available compute the Break Even Lease Rental (BELR) that ABC Ltd. should charge from lessee.

` 150 Lakh 5 year

Cost of Machine Expected Useful Life


[60]

58


[60]

58


Salvage Value of Machine at the end of 5 years ` 10 lakh Rate of Depreciation (WDV) 25% Ko 14% Applicable Tax Rate 35% Machine will constitute a separate block for depreciation purpose. Dividend Decisio ns 5.

The following information pertains to M/s XY Ltd. Earnings of the Company

` 5,00,000

Dividend Payout ratio

60%

No. of shares outstanding

1,00,000

Equity capitalization rate

12%

Rate of return on investment 15% (i) What would be the market value per share as per Walter’s model? (ii)

What is the optimum dividend payout ratio according to Walter’s model and the market value of Company’s share at that payout ratio?

Indian Capital Market 6.

BSE

5000

` 10,10,000

Value of portfolio Risk free interest rate

9% p.a.

Dividend yield on Index

6% p.a.

Beta of portfolio 1.5 We assume that a future contract on the BSE index with four months maturity is used to hedge the value of portfolio over next three months. One future contract is for delivery of 50 times the index. Based on the above information calculate: (i)

Price of future contract.

(ii)

The gain on short futures position if index turns out to be 4,500 in three months.

Security Analysis 7.

Following Financial data are available for PQR Ltd. for the year 2008: (` in lakh) 8% debentures

125

10% bonds (2007)

50

Equity shares (` 10 each)

100


[61]

PAPER – 2: STRATEGIC FINANCIAL MANAGEMENT

59

[61]


59

Reserves and Surplus

300

Total Assets

600

Assets Turnovers ratio

1.1

Effective interest rate

8%

Effective tax rate

40%

Operating margin

10%

Dividend payout ratio

16.67%

Current market Price of Share

` 14

Required rate of return of investors

15%

You are required to: (i)

Draw income statement for the year

(ii) Calculate its sustainable growth rate (iii) Calculate the fair price of the Company's share using dividend discount model, and (iv) What is your opinion on investment in the company's share at current price? 8.

The following data are available for a bond

` 1,000

Face value Coupon Rate

16%

Years to Maturity

6

` 1,000

Redemption value Yield to maturity

17%

Calculate the duration and volatility of this bond? Portfolio Theory 9.

Suppose if Treasury Bills give a return of 5% and Market Return is 13%, then determine (i)

The market risk premium

(ii)

β Values and required returns for the following combination of investments.

Treasury Bill

100

70

30

0

0

30

70

100

Market


[62]

60


[62]

60


10. The following information is available of Jay Kay Ltd. and of Market (Index) Jay Kay Limited

Market

Year

Av erag e Share Price ( )

DPS ( )

Av erag e Ind ex

Divid end Yield (%)

Return o n Govt. Bonds

2002 2003 2004 2005

242 279 305 322

20 25 30 35

1812 1950 2258 2220

4 5 6 7

6 5 4 5

Compute Beta Value of the company at the end of the year 2005. 11. 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. What would be the portfolio risk if equal amount of money is allocated among these stocks? X Stock

Y Stock

Sensex

Average return

0.15

0.25

0.06

Variance of return

6.30

5.86

2.25

β

0.71

0.685

Correlation Co-efficient

0.424

Co-efficient of determination (r 2)

0.18

Financial Services 12. Mr. Stanley Joseph has secured from a housing bank, a six year housing loan of ` 12,00,000. The loan was structured as follows: Loan Amount

---

` 12,00,000

Repayment

---

Six equated annual installments, payable in arrears.

Reference Base

---

Prime Lending Rate

Reference Rate

---

9% on the date of loan

Interest on Loan

---

1 percentage point over reference rate of 9%

Annual Installment

---

` 2,75,530

Two years after the loan was granted, the prime rate moves down to 8% and the effective rate on the loan automatically stood revised to 9%. Determine the revised amount of instalment.


[63]


61

[63]


61

13. You have a housing loan with one of India’s top housing finance companies. The amount outstanding is ` 1,89,540. You have now paid an installment. Your next installment falls due a year later. There are five more installments to go, each being ` 50,000. Another housing finance company has offered to take over this loan on a seven year repayment basis. You will be required to pay ` 36,408 p.a. with the first installment falling a year later. The processing fee is 3% of amount taken over. For swapping you will have to pay ` 12,000 to the first company. Should you swap the loan? [Given (PVAF 10%, 5) = 3.791 and (PVAF 8%, 7) = 5.206] 14. A company is considering engaging a factor, the following information is available: (i)

The current average collection period for the Company’s debtors is 80 days and ½% of debtors default. The factor has agreed to pay money due after 60 days and will take the responsibility of any loss on account of bad debts.

(ii)

The annual charge for the factoring is 2% of turnover payable annually in arrears. Administration cost saving is likely to be ` 1,00,000 per annum.

(iii) Annual sales, all on credit, are ` 1,00,00,000. Variable cost is 80% of sales price. The Company’s cost of borrowing is 15% per annum. Assume the year is consisting of 365 days. Should the Company enter into a factoring agreement? Mutual Funds 15. Orange purchased 200 units of Oxygen Mutual Fund at ` 45 per unit on 31st December, 2009. In 2010, he received ` 1.00 as dividend per unit and a capital gains distribution of ` 2 per unit. Required: (i)

Calculate the return for the period of one year assuming that the NAV as on 31st December 2010 was ` 48 per unit.

(ii)

Calculate the return for the period of one year assuming that the NAV as on 31st December 2010 was ` 48 per unit and all dividends and capital gains distributions have been reinvested at an average price of ` 46.00 per unit.

Ignore taxation. Money Market Instrum ents 16. Bank A enters into a Repo for 14 days with Bank B in 12% GOI Bonds 2017 at a rate of 5.25% for ` 5 Crore. Assuming that the clean price be 99.42, initial margin be 2% and days of accrued interest be 292, you are required to determine: (a) Dirty Price (b) Start Proceeds (First Leg) (c) Repayment at Maturity (Second Leg) Note: Assume number of days in a year as 360.


[64]

62


[64]

62


International Financi al Management 17. Opus Technologies Ltd., an Indian IT company is planning to make an investment through a wholly owned subsidiary in a software project in China with a shelf life of two years. The inflation in China is estimated as 8 percent. Operating cash flows are received at the year end. For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in a piece of land. The land will be sold after the completion of project at estimated value of CN¥ 35,00,000. The project also requires an office complex at cost of CN¥ 15,00,000 payable at the beginning of project. The complex will be depreciated on straight-line basis over two years to a zero salvage value. This complex is expected to fetch CN¥ 5,00,000 at the end of project. The company is planning to raise the required funds through GDR issue in Mauritius. Each GDR will have 5 common equity shares of the company as underlying security which are currently trading at ` 200 per share (Face Value = ` 10) in the domestic market. The company has currently paid a dividend of 25% which is expected to grow at 10% p.a. The total issue cost is estimated to be 1 percent of issue size. The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit. The price of unit is expected to rise at the rate of inflation. Variable operating costs are 40 percent of sales. Current Fixed Operating costs is CN¥ 22,00,000 per year which is expected to rise at the rate of inflation. The tax rate applicable in China for business income and capital gain is 25 percent and as per GOI Policy no further tax shall be payable in India. The current spot rate of CN¥ 1 is ` 9.50. The nominal interest rate in India and China is 12% and 10% respectively and the international parity conditions hold. You are required to (a) Identify expected future cash flows in China and determine NPV of the project in CN¥. (b) Determine whether Opus Technologies should go for the project or not, assuming that there neither there is any restriction nor any charges/taxes payable on the transfer of funds from China to India. Foreign Exchange Risk Management 18. Following are the rates quoted at Mumbai for British Pound (£): Spot (£/`)

52.60/70

Interest Rates

India

London

3 m Forward

20/70

3 months

8%

5%

6 m Forward

50/75

6 months

10%

8%

Verify whether there is any scope for covered interest arbitrage, if you can borrow in rupees.


[65]


63

[65]


63

Mergers & Acquisitions 19. Simpson Ltd. is considering a merger with Wilson Ltd. The data below are in the hands of both Board of Directors. The issue at hand is how many shares of Simpson should be exchanged for Wilson Ltd. Both boards are considering three possibilities 20,000, 25,000 and 30,000 shares. You are required to construct a table demonstrating the potential impact of each scheme on each set of shareholders: Simpson Ltd. 1.

Current earnings per year

2.

Shares outstanding

3.

Earnings per share (` ) (1÷ 2)

4.

Wilson Ltd.

2,00,000

1,00,000

3,50,000

50,000

10,000

?

4

10

?

Price per share (` )

40

100

?

5.

Price-earning ratio [4 ÷ 3]

10

10

10

6.

Value of firm (` )

20,00,000

10,00,000

35,00,000

7.

Expected Annual growth rate in earnings in foreseeable future

0

0

0

20. Write a short note on (a) Factors that affect Bond’s Duration (b) Process of Portfolio Management (c) Benefits of International Portfolio Investment (d) Benefits of Debit Card (e) Factors affecting the selection of Mutual Funds SUGGESTED ANSWERS/HINTS 1.

Decision tree diagram is given below:


[66]

64

Combined Post merger Firm ‘A’


[66]

64


Evaluation At Decision Point C: The choice is between investing ` 20 lacs for a perpetual benefit of ` 4 lacs and not to invest. We shall determine the PV of Benefits in perpetuity (Capitalised Value) as follows: =

4lac

`

0.10

= ` 40 lac

Net Benefit = ` 40 lac - ` 20 lac = ` 20 lac The preferred choice is to invest, since the capitalized value yields a net benefit of ` 20 lacs. At Decision Point D: The choice is between investing ` 12 lacs, for a similar perpetual benefit of ` 1 lac, and not to invest shall be based on net benefit as computed above. =

` 1 lac

0.10

= ` 10 lac

Net Benefit = ` 10 lac - ` 12 lac = - ` 2 lac Since, there is a negative benefit of ` 2 lacs. Therefore, it would not be prudent to invest at this point. At Outcome Point B: Evaluation of EMV is as under (` in lacs). Outcome

Amount (` )

Probability

Result (` )

Success Failure Net result

20.00 0.00

0.50 0.50

10.00 00.00 10.00

EMV at B is, therefore, ` 10 lacs. At Decision Point 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. 2.

Computatio n of Annual Cash Flow (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


[67]


65

[67]


65

(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

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 (Inflation Adjusted) (` )(1)

Costs (Inflation Adjusted) (` )(2)

Net Profit (` ) (3) = (1) (2)

Tax (` ) (4) = 60% of (3)

Net after Profit (` ) (3) - (4)

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

4

11,08,452

5,80,124

5,28,328

3,16,997

2,11,331

(iv) Present Value of Cash Inflows Year

Net after Profit (` )

Tax Benefit on Depreciation (` )

Cash Inflow

PVF@ 10%

(` )

PV

(` )

1

1,29,600

1,20,000

2,49,600

0.909

2,26,886

2

1,38,600

1,20,000

2,58,600

0.826

2,13,604

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 3.

Decision Tree showing pay off Year 0

Year 1

Abandonment Pay off

130

0

60

80-60 = 20

100


[68]

66


[68]

66


First of all we shall calculate probability of high demand (P) using risk neutral method as follows: 8% = p x 30% + (1-p) x (-40%) 0.08 = 0.30 p - 0.40 + 0.40p p=

0.48 0.70

= 0.686

The value of abandonment option will be computed as follows: Expected Payoff at Year 1 = p x 0 + [(1-p) x 20] = 0.686 x 0 + [0.314 x 20] = ` 6.28 crore Since expected pay off at year 1 is 6.28 crore. Present value of expected pay off will be: 6.28 1.08

= 5.81 crore.

Thus the value of abandonment option (Put Option) is ` 5.80 crore. 4.

Cost of Machine

` 150,00,000

Less: - PV of Salvage Value (W1)

`

Less: PV of Tax benefit on Depreciation (W2)

` 27,34,184

Less: PV of Tax Saving on STCL at the end of 5 year (W3) `

5,19,400

6,80,478

` 110,65,938 PVIFA for 5 years @14% After tax Break Even Lease Rental = Before Tax BELR =

3.433 1,10,65,938 = 32,23,400 3.433

32,23,400 = ` 49,59,100 (1− 0.35)

Working Notes W1 Salvage Value

=

` 10,00,000

PVF @14%

=

0.5194

PV of Salvage Value

= ` 5,19,400


[69]


67

[69]


67

W2 Table showing calculation of PV of Tax Benefit on Depreciation Year

Opening WDV

Depreciation @ 25%

Closing WDV

(` )

(` )

(` )

FVF @14%

PV (` )

1

150,00,000

37,50,000

11,250,000

0.877

32,88,750

2

112,50,000

28,12,500

84,37,500

0.769

21,62,813

3

84,37,500

21,09,375

63,28,125

0.675

14,23,828

4

63,28,125

15,82,031

47,46,094

0.592

9,36,562 78,11,953

Tax Benefit on Depreciation = ` 78,11,953 X 0.35 = ` 27,34,184 W3 PV of Tax benefit on Short Term Capital Loss (STCL)

5.

WDV at beginning of 5 year as per above table

47,46,094

Less: Salvage Value

10,00,000

STCL

37,46,094

Tax Benefit

13,11,133

PVF at 14%

0.519

PV of Tax Benefit on STCL

6,80,478

M/s XY Ltd. (i)

Walter’s model is given by P=

D+ (E− D)(r / k e ) Ke

Where, P

=

Market price per share.

E

=

Earnings per share = ` 5 (` 5,00,000/ 1,00,000)

D

=

Dividend per share = ` 3 (0.60 x ` 5)

r

=

Return earned on investment = 15%

Ke

=

Cost of equity capital = 12%


[70]

68


[70]

68


0.15 0.15 3+ 2× 0.12 = 0.12 0.12 0.12

3+ (5- 3)× P (ii)

=

=

` 45.83

According to Walter’s model when the return on investment is more than the cost of equity capital, the price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in this case is nil. So, at a pay-out ratio of zero, the market value of the company’s share will be: 0+ (5− 0) 0.12

6.

(i)

0.15 0.12 = ` 52.08

Current future price of the index = 5000 + 5000 (0.09-0.06)

4 = 5000+ 50= 5,050 12

∴ Price of the future contract = ` 50 х 5,050 = ` 2,52,500 (ii) Hedge ratio =

1010000 252500

×

1.5 = 6 contracts

Index after there months turns out to be 4500 1 Future price will be = 4500 + 4500 (0.09-0.06) × = 4,511.25 12 Therefore, Gain from the short futures position is = 6 х (5050 – 4511.25) х 50 = ` 1,61,625 Note: Alternatively we can also use daily compounding (exponential) formula. 7.

Workings: Asset turnover ratio

= 1.1

Total Assets

= ` 600

Turnover ` 600 lakhs × 11

= ` 660 lakhs

Effective interest rate

=

Liabilities

= ` 125 lakhs + 50 lakhs = 175 lakh

Interest

= ` 175 lakhs × 0.08 = ` 14 lakh

Operating Margin

= 10%

Hence operating cost

= (1 - 0.10) ` 660 lakhs = ` 594 lakh

Dividend Payout

= 16.67%

Tax rate

= 40%

Interest Libilities

= 8%


[71]


69

[71]


(i)

69

Income statement (` Lakhs) Sale

660

Operating Exp

594

EBIT

66

Interest

14

EBT

52

Tax @ 40%

20.80

EAT

31.20

Dividend @ 16.67%

5.20

Retained Earnings

26.00

(ii) SGR = G = ROE (1-b) ROE =

PAT and NW = ` 100 lakh + ` 300 lakh = 400 lakh NW

ROE =

` 31.2 lakhs х 100 = 7.8% ` 400 lakhs

SGR = 0.078(1 - 0.1667) = 6.5% (iii) Calculation of fair price of share using dividend discount model D (1+ g) Po = o ke − g

Dividends =

` 5.2 lakhs ` 10 lakhs

= ` 0.52

Growth Rate = 6.5% Hence Po =

` 0.52(1+ 0.065) = 0.15-0.065

` 0.5538

0.085

= ` 6.51

(iv) Since the current market price of share is ` 14, the share is overvalued. Hence the investor should not invest in the company. 8.

To calculate the duration first the we shall calculate Market price of bond as follows: 160 (PVIFA 17%,6) + 1,000 (PVIF 17%,6) = 160 (3.589) + 1,000 (0.390) = 574.24 + 390 = 964.24


[72]

70


[72]

70


1.

Duration Year

Cash flow

P.V. @ 17%

Proportion of Proportion of bond bond value value x time (years)

1

160

0.855

136.80

0.142

0.142

2

160

0.731

116.96

0.121

0.242

3

160

0.624

99.84

0.103

0.309

4

160

0.534

85.44

0.089

0.356

5

160

0.456

72.96

0.076

0.38

6

1160

0.390

452.40

0.469

2.814

964.40

1.000

4.243

Duration of the Bond is 4.243 years 2.

Volatility Volatility of the bonds =

9.

(i )

Duration (1

+

YTM)

=

4.243 1.17

= 3.63%

Market Risk Premium Rm – Rf = 13% - 5% = 8%

(ii) β is the weighted average of investing in portfolios consisting of market ( β = 1) and beta of treasury bills (β = 0) Portfolio

Treasury Bills: Market Portfoli o

1 2 3 4

100:0 70:30 30:70 0:100

R j = Rf +

× (Rm – Rf )

0 5% + 0(13%-5%)=5% 0.7(0)+0.3(1)=0.3 5%+0.3(13%-5%)=7.40% 0.3(0)+0.7(1)=0.7 5%+0.7(13%-5%)=10.60% 1 5%+1.0(13%-5%)=13%

10. Computatio n of Beta Value

Calculation of Returns D + (P1 − P0 ) Returns = 1 × 100 P0

Year

Returns 25+ ( 279- 242)

2002 – 2003

242 30+ ( 305- 279)

2003 – 2004

279

×100 = 25.62% ×100 = 20.07%


[73]


71

[73]


35+ ( 322- 305)

2004 – 2005

305

71

×100 = 17.05%

Calculation of Returns from market Index Year

% of Index Appreciation

Dividend

Yield %

Return %

1950− 1812 × 100 = 7.62% 1812 2258− 1950 × 100 =15.79% 1950 2220− 2258 × 100 =(− )1.68% 2258

2002 − 2003 2003 − 2004 2004 − 2005

Total

5%

12.62%

6%

21.79%

7%

5.32%

Computation of B eta

X=

β= = =

Year

X

Y

XY

Y 2

2002-2003 2003-2004 2004-2005

25.62 20.07 17.05

12.62 21.79 5.32

323.32 437.33 90.71

159.26 474.80 28.30

62.74

39.73

851.36

662.36

62.74 3

= 20.91, Y =

39.73 3

= 13.24

∑ XY − nXY 2

∑ Y2 − nY

851.36 - 3(20.91)(13.24) 2 662.36 - 3(13.24) 851.36 - 830.55 662.36 - 525.89

=

20.81 136.47

= 0.15

11. The co-efficient of determination (r 2) gives the percentage of the variation in the security’s return that is explained by the variation of the market index return. In the X company stock return, 18 per cent of variation is explained by the variation of the index and 82 per cent is not explained by the index. According to Sharpe, the variance explained by the index is the systematic risk. The unexplained variance or the residual variance is the unsystematic risk. Company X: Systematic risk

= β i2

× Variance of market index


[74]

72


[74]

72


= (0.71)2 × 2.25 = 1.134 2

∈ Unsystematic risk( ) i

= Total variance of security return - Systematic risk = 6.3 – 1.134 = 5.166 or = Variance of Security Return (1 - r 2) = 6.3 X (1 - 0.18) = 6.3 X 0.82 = 5.166 2 + = β 2ι x σ m

Total risk

∈2ι

= 1.134 + 5.166 = 6.3 Company Y: 2 2 = βi x σ m

Systematic risk

= (0.685)2 x 2.25 = 1.056 Unsystematic risk

= Total variance of the security return - systematic risk. = 5.86 - 1.056 = 4.804

2  N   N 2 2    σ p =  ∑ Xiβ i  σ m2  +   ∑ Xi ∈i   i=1        i=1 2

= [(0.5 x 0.71 + 0.5 x 0.685) 2 2.25] + [(0.5)2(5.166)+(0.5)2(4.804)] = [(0.355 + 0.3425)2 2.25] + [(1.292 + 1.201)] = 1.0946 + 2.493 = 3.5876 12. Revision in equated Instalments 1.

Determination of Unpaid principal

2.

Re-Computation of EMI for revised period at revised rate Determination of Remaining Principal Opg. Bal

Interest @10%

Total

Repaid

Clg. Bal

(` )

(` )

(` )

(` )

(` )

1

12,00,000

1,20,000

13,20,000

2,75,530

10,44,470

2

10,44,470

1,04,447

11,48,917

2,75,530

8,73,387

Year

Determination of Revised Equated Monthly Installments New Amount

` 8,73,387

New Period

4 years


[75]


73

[75]


New Rate (8% + 1%)

9%

PVAF

3.240

Installment

` 8,73,387 / 3.240

73

= ` 2,69,564

Bank shall revise installment from ` 2,75,530 to ` 2,69,564. 13. Present Interest Rate For a loan of ` 1,89,540 annuity being ` 50,000, PVAF = 3.791 (` 1,89,540 / ` 50,000). From PVAF table for 5 years, this corresponds to 10%. New Interest Rate For a similar loan, annuity being ` 36,408, PVAF = 5.206 (` 1,89,540 / ` 36,408). From PVAF table for 7 years, this corresponds to 8%. Interest Rate is prima facie beneficial. Ad dit ion al Charges (i) Swap Charges

` 12,000

(ii) Processing fee 3% on loan amount (3/100 × ` 1,89,540)

` 5,686

Let us compute the IRR as follows:

` 1,89,540 - ` 12,000 - ` 5,686 =

36,408

36,408 ............... (1+IRR)1 (1+IRR)7

IRR = 10.947% Since interest rate on existing loan is 10% while proposed loan is 10.947% hence proposed loan is more expensive and it is advisable not to swap. 14. The annual change in cash flows through entering into a factoring agreement is:

Savings

(Amount in )

Administration cost saved

(Amount in ) 1,00,000

Existing average debtors [` 1,00,00,000/365) x 80 days]

21,91,781

Average New Debtors

16,43,836

[(` 1,00,00,000/365) x 60 days] Reduction in debtors

5,47,945

Cost there of @80%

4,38,356

Add:

Interest saving @15% p.a. on. ` 4,38,356


[76]

74


65,753

[76]

74


Add:

Bad Debts saved @.005 of

` 1,00,00,000

50,000 Total

Less:

Annual charges @2% of ` 1,00,00,000

2,15,753 2,00,000

Net annual benefits of factoring

15,753

Therefore, the factoring agreement is worthwhile and should be undertaken. 15. (i)

Returns for the year (All changes on a Per -Unit Basis)

` 48 – ` 45 =

Change in Price:

` 3.00

Dividends received:

` 1.00

Capital gains distribution

` 2.00

Total reward

` 6.00

Holding period reward:

` 6.00 ` 45

× 100 = 13.33%

(ii) When all dividends and capital gains distributions are re-invested into additional units of the fund @ (` 46/unit) Dividend + Capital Gains per unit

= ` 1.00 + ` 2.00 = ` 3.00

Total received from 200 units

= ` 3.00 x 200 = ` 600/-.

Additional Units Acquired

= ` 600/` 46 = 13.04 Units.

Total No. of Units

= 200 units + 13.04 units = 213.04 units.

Value of 213.04 units held at the end of the year = 213.04 units x ` 48 = ` 10225.92 Price Paid for 200 Units at the beginning of the year = 200 units x ` 45 = ` 9000.00

16. (a)

Holding Period Reward ` (10225.92 – 9000.00)

= ` 1225.92

Holding Period Reward

=

`1225.92 ` 9000

×

100= 13.62%

Dirty Price = Clean Price + Interest Accrued = 99.42 + 100×

12

×

292

100 360

= 109.1533


[77]


75

[77]


75

(b) First Leg (Start Proceed) = Nominal Value x = ` 5,00,00,000 x

DirtyPrice 100 -Initial Margin × 100 100 109.1533 100- 2 × 100 100

= ` 5,34,85,117 say ` 5,34,85,000 (c) Second Leg (Repayment at Maturity) = Start Proceed x (1+ Repo rate × = ` 5,34,85,000 x (1+ 0.0525×

No. of days ) 360

14

) = ` 5,35,94,199 360

17. Working Notes: 1.

Calculation of Cost of Capital (GDR) Current Dividend (D0)

2.50

Expected Dividend (D1) Net Proceeds (200 – 1% of 200) Growth Rate 2.75 ke = + 0.10 = 0.1139 i.e. 11.39% 198 2.

2.75 198.00 10.00%

Calculation of Expected Exchange Rate as per Interest Rate Parity YEAR 1

EXPECTED RATE (1+ 0.12) = 9.50 × = 9.67 (1+ 0.10)

2 = 9.50× 3.

(1+ 0.12)2 (1+ 0.10)2

Realization on the disposal of Land net of Tax CN¥ 3500000.00 3000000.00 500000.00 125000.00 3375000.00

Sale value at the end of project Cost of Land Capital Gain Tax paid Amount realized net of tax


[78]

76

= 9.85


[78]

76


4.

Realization on the disposal of Office Complex (CN¥) Sale value at the end of project

500000.00

WDV

5.

0.00

Capital Gain

500000.00

Tax paid

125000.00

Amount realized net of tax (A)

375000.00

Computation of Annual Cash Inflows

Year Annual Units Price per bottle (CN¥) Annual Revenue (CN¥) Less: Expenses Variable operating cost (CN¥) Depreciation (CN¥) Fixed Cost per annum (CN¥) PBT (CN¥) Tax on Profit (CN¥) Net Profit (CN¥) Add: Depreciation (CN¥) Cash Flow

1

2

10000 540.00 5400000.00

10000 583.20 5832000.00

2160000.00 750000.00 2376000.00 114000.00 28500.00 85500.00 750000.00 835500.00

2332800.00 750000.00 2566080.00 183120.00 45780.00 137340.00 750000.00 887340.00

(a) Computation of NPV of the project in CN¥

Year

(CN¥)

0

Initial Investment

1

2

835500.00

887340.00

-4500000.00

Annual Cash Inflows Realization on the disposal of Land net of Tax

3375000.00

Realization on the disposal of Office Complex

375000.00

Total

-4500000.00 835500.00 4637340.00

PVF @11.39%

1.000

PV of Cash Flows

0.898

0.806

-4500000.00 750279.00 3737696.00

NPV

-12,025


[79]


77

[79]


77

(b) Evaluation of Project from Opus Point of View (i)

Assuming that inflow funds are transferred in the year in which same are generated i.e. first year and second year.

0

Year Cash Flows (CN¥) Exchange Rate (` / CN¥) Cash Flows (` ) PVF @ 12%

1

2

-4500000.00 835500.00 9.50 9.67 -42750000.00 8079285.00 1.00 0.893 -42750000.00 7214802.00

NPV

4637340.00 9.85 45677799.00 0.797 36405206.00 870008.00

(ii) Assuming that inflow funds are transferred at the end of the project i.e. second year.

0

Year

2

-4500000.00 9.50 -42750000.00 1.00 -42750000.00

Cash Flows (CN¥) Exchange Rate (`/ CN¥) Cash Flows (`) PVF NPV

5472840.00 9.85 53907474.00 0.797 42964257.00 214257.00

Though in terms of CN¥ the NPV of the project is negative but in ` it has positive NPV due to weakening of ` in comparison of CN¥. Thus Opus can accept the project. 18. Particulars Amount borrowed Pounds (£) obtained by converting at spot rate Invest pound for the period Amount of pound received at the end Of the period Convert pounds to ` At forward rate Amount of Re. Loan to be repaid

Option I (3 mths) 100000 100000/52.70 = 1897.53 1.25% 1897.53 × 1.0125 = 1,921.25 1,921.25 × 52.80 = 1,01,442 100000 × 1.02 = 102000

Option II (6 mths) 100000 100000/52.70 = 1897.53 4% 1897.53 × 1.04 = 1,973.43 1,973.43 × 53.10 = 1,04,789 100000 × 1.05 = 105000

Since the amount of Indian Rupees to be Received is less than the amount repaid in both cases there is no scope for covered interest arbitrage by borrowing in Indian Rupees.


[80]

78

FINAL EXAMINATION : MAY, 2016

[80]

78

FINAL EXAMINATION : MAY, 2016

r e ] y f n d x 0 o s b o ’ l 0 s e o ) s d . h 6 0 e r e p d , ) u a n t e ( 0 7 ( l [ 0 m a h L r , i s s w a 5 V o S h 3 s

0 3 0 0 3 0 0 3 , , 5 , 0 3 7 0 , 3 , 8 , 5 3 1 2 2 2

: s r e d l o h s e . r ’ r f d . s r ] e a t d d e ) y o t g h L e d b ( r L l 3 / s n n i n e o d 0 ) f i 7 o n b o / 3 / 8 / h 6 e 0 o t m o ( s 5 2 5 n c 0 m t s t e , p a e o p r r i c s s F a 0 m o w o i 5 ( m h [ P h S S s c a e n s o e s ] s , r . r 0 7 0 y ’ a e 0 s d 0 6 0 b t d 0 e h l 0 6 x 0 s d L o ) ) , , 5 , , m f 5 0 6 2 e 4 h n 0 e ( o ( 0 n o e [ 0 h , 6 , 1 , , s r e w l c 0 1 3 a 5 s l u o i h 1 1 1 e a W s 3 l V b i s s t o y s b p o s s e f P e ( d . r e ’ r o e ] . d n h t d w L d t n t l ) ) o 3 ( 7 o L o n h e i / / 3 / 8 / 4 t ) ( h 2 1 3 ) c e t a n o 1 r s r f [ l e r o a ( i s o F g h p t r W s c m e i a S m p m i l f r a o s i e e t r g ) r ] n g a 0 0 0 n e 1 e h ( i t 0 0 0 ) s d m + n o r 0 3 , 0 , 0 , 0 n p e o ( s 0 5 0 0 a s t e b p ’ 7 7 8 0 . t s r , h e 0 t m m d t u i t u f s N S L o a 5 [ e t a r i o t s t . 0 f ] n a d r 0 o t o e 0 , s L m ) 0 e . e g 2 2 5 r n ( 1 2 3 o d n / a a s ) l e h 1 h l s i ( b c [ W x a E t g n f s d s i T w o ’ . e r . : C e N o d L u d l I 2 t s d t l E l A L G I 0 0 o – s o L M ) 0 f i E 0 0 C h n E 1 0 R 0 0 0 T e r n N e , , , o ( G E o r h e s s a l A s A 0 5 0 A P T b p e i R 2 2 3 N h A T I N m m r a s W F A P . S u i f h 9 o o M S s t 1 N

e s a e r c n i l l i w s e r a h s f o e u l a v e h t s e s a c g n i n i a m e r n i , s e r a h s 0 0 0 0 2 f o o i t a r e g n a h c x e f o e s a c t p e c x e t a h t r a e l c s . i t i s e i e n v o a p b a m o c m o r h t f o s u b h r o T f


[81]


79

[81]


79

20. (a) Following are some of factors that affect bond's duration: (1) Time to maturit y: Consider two bonds that each cost ` 1,000 and yield 7%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration. (2) Coupo n rate: Coupon payment is a key factor in calculation of duration of bonds. If two identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower is the duration. (b ) Portfolio management is a process and broadly it involves following five phases and each phase is an integral part of the whole process and the success of portfolio management depends upon the efficiency in carrying out each of these phases. (1) Securit y Analysi s: Security analysis constitutes the initial phase of the portfolio formation process and consists in examining the risk-return characteristics of individual securities and also the correlation among them. A simple strategy in securities investment is to buy underpriced securities and sell overpriced securities. But the basic problem is how to identify underpriced and overpriced securities and this is what security analysis is all about. There are two alternative approaches to analyse any security viz. fundamental analysis and technical analysis. They are based on different premises and follow different techniques. (2) Portfolio Analysis: Once the securities for investment have been identified, the next step is to combine these to form a suitable portfolio. Each such portfolio has its own specific risk and return characteristics which are not just the aggregates of the characteristics of the individual securities constituting it. The return and risk of each portfolio can be computed mathematically based on the risk-return profiles for the constituent securities and the pair-wise correlations among them. (3) Portfol io Selection : The goal of a rational investor is to identify the Efficient Portfolios out of the whole set of Feasible Portfolios mentioned above and then to zero in on the Optimal Portfolio suiting his risk appetite. An Efficient Portfolio has the highest return among all Feasible Portfolios having identical Risk and has the lowest Risk among all Feasible Portfolios having identical Return. (4) Portf olio Revision: Once an optimal portfolio has been constructed, it becomes necessary for the investor to constantly monitor the portfolio to ensure that it does not lose it optimality. In light of various developments in the market, the investor now has to revise his portfolio. This revision leads to addition (purchase) of some new securities and deletion (sale) of some of the


[82]

80


[82]

80


existing securities from the portfolio. The nature of securities and their proportion in the portfolio changes as a result of the revision. (5) Portfolio Evaluation: This process is concerned with assessing the performance of the portfolio over a selected period of time in terms of return and risk and it involves quantitative measurement of actual return realized and the risk borne by the portfolio over the period of investment. Various types of alternative measures of performance evaluation have been developed for use by investors and portfolio managers. (c ) Benefits of International Portfolio Investment are as follows: (a) Reduce Risk: International investment aids to diversify risk as the gains from diversification within a country are therefore very much limited, because macro economic factors of different countries vary widely and do not follow the same phases of business cycles, different countries have securities of different industries in their market portfolio leading to correlation of expected returns from investment in different countries being lower than in a single country. (b) Raise Return through better Risk – Return Trade off : International Investment aids to raise the return with a given risk and/or aids to lower the risk with a given rate of return. This is possible due to profitable investment opportunities being available in an enlarged situation and at the same time inter country dissimilarities reduce the quantum of risk. (d ) Benefits of Debit cards are as follows: 1)

Obtaining a debit card is often easier than obtaining a credit card.

2)

Using a debit card instead of writing cheques saves one from showing identification or giving his personal information at the time of the transaction.

3)

Using a debit card frees him from carrying cash or a cheque book.

4)

Using a debit card means he no longer has to stock up on traveller’s cheques or cash when he travels

5)

Debit cards may be more readily accepted by merchants than cheques, in other states or countries wherever the card brand is accepted.

6)

The debit card is a quick, “pay now” product, giving one no grace period.

7)

Using a debit card may mean one has less protection than with a credit card purchase for items which are never delivered, are defective, or misrepresented. But, as with credit cards, one may dispute unauthorized charges or other mistakes within 60 days. One should contact the card issuer if a problem cannot be resolved with the merchant.

8)

Returning goods or canceling services purchased with a debit card is treated as if the purchase were made with cash or a cheque.


[83]


81

[83]


(e)

81

Factors affects the selection of Mutual Funds is as follows: (1) Past Performance – The Net Asset Value is the yardstick for evaluating a Mutual Fund. The higher the NAV, the better it is. Performance is based on the growth of NAV during the referral period after taking into consideration Dividend paid. Growth = (NAV1 – NAV0 ) + D1 / NAV0. (2) Timing – The timing when the mutual fund is raising money from the market is vital. In a bullish market, investment in mutual fund falls significantly in value whereas in a bearish market, it is the other way round where it registers growth. The turns in the market need to be observed. (3) Size of Fund – Managing a small sized fund and managing a large sized fund is not the same as it is not dependent on the product of numbers. Purchase through large sized fund may by itself push prices up while sale may push prices down, as large funds get squeezed both ways. So it is better to remain with medium sized funds. (4) Age of Fund – Longevity of the fund in business needs to be determined and its performance in rising, falling and steady markets have to be checked. Pedigree does not always matter as also success strategies in foreign markets. (5) Largest Holding – It is important to note where the largest holdings in mutual fund have been invested. (6) Fund Manager – One should have an idea of the person handling the fund management. A person of repute gives confidence to the investors. (7) Expense Ratio – SEBI has laid down the upper ceiling for Expense Ratio. A lower Expense Ratio will give a higher return which is better for an investor. (8) PE Ratio – The ratio indicates the weighted average PE Ratio of the stocks that constitute the fund portfolio with weights being given to the market value of holdings. It helps to identify the risk levels in which the mutual fund operates. (9) Portfolio Turnover – The fund manager decides as to when he should enter or quit the market. A very low portfolio turnover indicates that he is neither entering nor quitting the market very frequently. A high ratio, on the other hand, may suggest that too frequent moves have lead the fund manager to miss out on the next big wave of investments. A simple average of the portfolio turnover ratio of peer group updated by mutual fund tracking agencies may serve as a benchmark. The ratio is lower of annual purchase plus annual sale to average value of the portfolio.


[84]

[84]


QUESTIONS AND ANSWERS QUESTIONS

International Capital Budgeting 1.

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 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.

Estimated projected cash flows, 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

Year – 0

Year – 1

Year – 2

Year - 3

-50,000

-1,500

-2,000

-2,500

-2,00,000

+50,000

+70,000

+90,000

` (000)

Cash flows in African

Rands (000) 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 ` 1. 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 rate.

(ii)

All cash flows for these projects will be discounted high risk.

at a rate of 20% to reflect it’s

(iii) Ignore taxation. Year - 1

PVIF@20%

Year - 2

.833

.694

Year - 3 .579

Leasing 2.

Khalid Tour Operator Ltd. is considering buying a new car for its fleet for local touring purpose. Purchase Manager has identified Renault Duster model car for acquisition.


[85]

[85]

50

FINAL EXAMINATION:

NOVEMBER, 2015

Company can acquire it either by borrowing the fund from bank at 12% p.a. or go for leasing option involving yearly payment (in the end) of ` 2,70,000 for 5 years. 10,00,000 and would be depreciable at 25% as per WDV method for its owner. The residual value of car is expected to be ` 67,000 at the end of 5 The new car shall cost `

years.

The corporate tax rate is 33%. You are required to:

(a) Calculate which of the two options borrowings or leasing shall be financially more advantageous for the Company. (b) Measure the sensitivity of Leasing/ Borrowing Decision in relation to each of the following parameters: (i)

Rate of Borrowing

(ii)

Residual Value

(iii) Initial Outlay Among above which factor is more sensitive. Swaps 3.

NoBank offers a variety of services to both individuals as well as corporate customers. NoBank generates funds for lending by accepting deposits from customers who are paid interest at PLR which keeps on changing. NoBank is also in the business of acting as intermediary for interest rate swaps. Since it is difficult to identify matching client, NoBank acts counter party to any party of swap. Sleepless approaches NoBank who have already have ` 50 crore outstanding and paying interest @PLR+80bp p.a. The duration of loan left is 4 years. Since Sleepless is expecting increase in PLR in coming year, he asked NoBank for arrangement of interest of interest rate swap that will give a fixed rate of interest. As per the terms of agreement of swap NoBank will borrow `50 crore from Sleepless at PLR+80bp per annuam and will lend ` 50 crore to Sleepless at fixed rate of 10% p.a. The settlement shall be made at the net amount due from each other. For this services

NoBank will charge commission @0.2% p.a. if the loan amount. The present PLR is 8.2%.

You as a financial consultant of NoBank have been asked to carry out scenario analysis of this arrangement. Three possible scenarios of interest rates expected to remain in coming 4 years are as follows:


[86]

[86]


51

Year 1

Year 2

Year 3

Year 4

Scenario 1

10.25

10.50

10.75

11.00

Scenario 2

8.75

8.85

8.85

8.85

Scenario 3

7.20

7.40

7.60

7.70

Assuming that cost of capital is 10%, whether this arrangement should be accepted or not.

Security Analysis 4.

Two companies A Ltd. and B Ltd. paid a dividend of `3.50 per share. Both are anticipating that dividend shall grow @ 8%. The beta of A Ltd. and B Ltd. are 0.95 and 1.42 respectively.

The yield on GOI Bond is 7% and it is expected that stock market index shall increase at an annual rate of 13%. You are required to determine: (a) Value of share of both companies. (b) Why there is a difference in the value of shares of two companies. (c)

If current market price of share of A Ltd. and B Ltd. are `74 and `55 respectively. As an investor what course of action should be followed?

5.

The data given below relates to a convertible bond: Face value

` 250

Coupon rate

12%

No. of shares per bond

20

Market price of share

` 12

Straight value of bond

` 235

Market price of convertible bond

` 265

Calculate:

(i)

Stock value of bond.

(ii)

The percentage of downside risk.

(iii) The conversion premium (iv) The conversion parity price of the stock. 6.

Delta Ltd.’s current financial year’s income statement reports its net income as ` 15,00,000. Delta’s marginal tax rate is 40% and its interest expense for the year was ` 15,00,000. The company has ` 1,00,00,000 of invested capital, of which 60% is debt. In addition, Delta Ltd. tries to maintain a Weighted Average Cost of Capital (WACC) of 12.6%.


[87]

Final Paper 2

Recommend Documents