Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Paper – 14 – ADVANCED FINANCIAL MANAGEMENT

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

The following table lists the learning objectives and the verbs that appear in the syllabus learning
aims and examination questions:

Learning objectives Verbs used Definition

KNOWLEDGE List Make a list of
State Express, fully or clearly, the details/facts
What you are expected to Define Give the exact meaning of
know
Describe Communicate the key features of
Distinguish Highlight the differences between
COMPREHENSION Explain Make clear or intelligible/ state the
meaning or purpose of
What you are expected to Identity Recognize, establish or select after
understand consideration
Illustrate Use an example to describe or explain
something
Apply Put to practical use
Calculate Ascertain or reckon mathematically
APPLICATION
Demonstrate Prove with certainty or exhibit by
practical means
How you are expected to
Prepare Make or get ready for use
apply
Reconcile Make or prove consistent/ compatible
your knowledge
Solve Find an answer to
LEVEL C

Tabulate Arrange in a table

Analyse Examine in detail the structure of
Categorise Place into a defined class or division
ANALYSIS
Compare Show the similarities and/or differences
and contrast between
How you are expected to
Construct Build up or compile
analyse the detail of what you
Priorities Place in order of priority or sequence for
have learned
action
Produce Create or bring into existence
SYNTHESIS Discuss Examine in detail my argument
How you are expected to
utilize the information Interpret Translate into intelligible or familiar terms
gathered to reach an
Decide To solve or conclude
optimum conclusion by a
process of reasoning
EVALUATION Advise Counsel, inform or notify
How you are expected to use
Evaluate Appraise or asses the value of
your learning to evaluate,
make decisions or Recommend Propose a course of action
recommendations

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Paper – 14 – ADVANCED FINANCIAL MANAGEMENT

Time Allowed: 3 hours Full Marks: 100

This paper contains 5 questions. All questions are compulsory, subject to instruction provided
against each question. All workings must form part of your answer.
Assumptions, if any, must be clearly indicated.

Question No. 1 (Answer all questions. Each question carries 2 marks)

1. (a) MN Ltd. has earnings before interest and taxes of `36 crores. The company has 7%
debentures of `72 crores. Cost of equity is 12.5%. Ignore taxes. Calculate the overall cost
of Capital. [2]

Answer:

Market value of Equity = [EBIT -I]/Ke

= [36 - 5.04] Cr. /0.125
= 30.96 /0.125 = ` 247.68 Cr.
Total value of firm (v) = 247.68 + 72.00 = 319.68 cr.
So, Ko = EBIT/V = [36/319.68] x 100 =11.26%.

(b) Mr. Khan purchased 300 units of a MUTUAL FUND at a price of `25 per unit at the
beginning of the year. He paid a front-end load of 5%. The expense ratio of the fund is
2%. The growth rate in fund's security is 15 % during the year. Calculate the rate of Return
of the fund if security sold at the end of the year. [2]

Answer:

Market Value of Investment : 300 × 25 = `7,500

Purchase rate of Unit : 25 × 1.05 = ` 26.25
Total Purchase Consideration : 26.25 × 300 = `7,875
Increase in value : 300 × 25 × 0.15 = `1,125
Expense : 0.02 × 300 × 25 = `150
1,125 -150
Rate of Returns : × 100 = 12.38%
7,875

(c) Ms. Susmita, a prospective investor has collected the following information pertaining to
two securities A and B:
Particulars Security A Security B
Expected Return % 15 18
Standard deviation of Returns % 18 22
Beta 0.90 1.40

Variance of Returns on the market Index is 225 (%) 2. The correlation coefficient between
the returns on securities A and B is 0.75. Find out the Systematic Risk of a portfolio
consisting of these two securities in equal proportions. [2]

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Answer:

The beta of the Portfolio consisting of two securities given that money is allotted equally
between the two assets:
0.90 × 0.50 + 1.4 × 0.5 = 1.15
The Systematic risk of a Portfolio = β2 σ2m
Substituting the value of β2 and σ2m, we get.
(1.15)2 × 225 = 297.56 (%)2.

(d) The current market price of an equity share of THOMAS LTD. is `500. Within a period of 3
months, the maximum and minimum price of it is expected to be `600 and `300
respectively. What should be the value of a 3 months call option under "Risk Neutral"
method at the strike rate of `550, if the risk free rate of interest be 8% p.a.?
[Given e-0.02 = 1.0202] [2]

Answer:

Let the probability of attaining the maximum price be p

 (600 - 500) × p + (300 - 500) × (1 - p) = 500 (e-0.02 - 1)
or 100 p - 200 + 200 p = 500 (1.0202-1)= 500 (0.0202)
or 300 p = 200 + 10.10 = 210.10
210.10
or p = = 0.70
300
0.70 600 - 550  35
Value of call option = = = ` 34.31
1.0202 1.0202

(e) Distinguish between the primary market and the secondary market. [2]

Answer:

In the primary market, securities are offered to public for subscription for the purpose of
raising capital or fund. Secondary market is an equity trading avenue in which already
existing/pre-issued securities are traded amongst investors. Secondary market could be
either auction or dealer market. While stock exchange is the part of an auction market,
Over-the-Counter (OTC) is a part of the dealer market.

(f) MAYANK Ltd. employs 12% as nominal required rate of return to evaluate its new
investment projects. In the recent meeting of the Board of Directors, it has been decided
to protect the interest of shareholders against purchasing power loss due to inflation. The
expected inflation rate in the economy is 5%. Calculate the real discount rate. [2]

Answer:
Real rate = [(1+n) / (1 + i)] -1
= [ (1+0.12) / (1+ 0.05)] -1
= 0.06667 = 6.67%.

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

(g) State the Banking Financial Institutions. [2]

Answer:

Banking institutions are those institutions, which participate in the economy‟s payment
system, i.e., they provide transaction services. Their deposits liabilities constitute a major
part of the national money supply and they can, as a whole, create deposits or credit,
which is money.
(h) Ms. Priyanka buys 10,000 shares of RUDSON LTD. at `50 and obtains a complete hedge of
shorting 400 Nifties, at `2,200 each. She closes out her position at the closing price of the
next day at which point the share of Rudson Ltd. has dropped 2% and the Nifty future has
dropped 1.5%. Calculate the overall Profit/(Loss) of this set of transactions. [2]

Answer:

Value of bought Shares Value of Short future

To-day‟s Valuation 50 × 10000 = ` 5.00 lakh 400 × 2200 = `8.800 lakh
Next day‟s Valuation 49 × 10000 = ` 4.90 lakh 400 × 2167 = ` 8.668 lakh
Profit/ (Loss) (2% dropped) = (` 0.10 lakh) (1.5% dropped) = ` 0.132 lakh

Net Profit = ` (0.132 - 0.10) lakh = `3,200

I. List the advantages of Book Value Weights. [2]

Answer:

Advantages of Book Value weights:

1. The capital structure targets are usually fixed in terms of book value.
2. It is easy to know the book value.
3. Investors are interested in knowing the debt-equity ratio on the basis of book values.
4. It is easier to evaluate the performance of a management in procuring funds by
comparing on the basis of book values.

(j) The Portfolio composition of Mr. Satendra is given below:

(Amount in ` lakh)
Equity 120
Cash/Cash equivalent 40
Total 160
The beta of Equity portion of the Portfolio is 0.85 and the Current Nifty futures is at 4261.5.
The multiple attached to Nifty future is 100. If Mr. Satendra purchases 23 future contracts,
find out his portfolio Beta. [2]

Answer:

120 Lakh × 0.85 + 4261.5 × 100 × 23 = 160 lakh × Beta of Portfolio.

or 102 lakh + 98.0145 lakh = 160 lakh × Beta of Portfolio
or Beta of Portfolio = 1.25

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Question No. 2. (Answer any three questions. Each question carries 8 marks)

2. (a) (i) Mr. S. K. Sinha had purchased 500 units of a scheme of Temple MF at the rate of ` 60
per unit. He held the units for 2 years and got a dividend of 15% and 20% in the first
year, and second year respectively on the face value of ` 10 per unit.
At the end of the second year, the units are sold at the rate of ` 75 per unit. Determine
the effective rate of return per year which Mr. Sinha has earned on this MF scheme.
[5]
Answer:

Total investment made by Mr. Sinha = 500 × 60 = ` 30,000

Dividends received – First Year = ` 1.5 × 500 = ` 750
Dividends received – Second Year = ` 2 × 500 = ` 1,000
Proceeds of Sale for Mr. Sinha = 500 × 75 = ` 37,500
(37500 - 30000) + 1000 + 750
Total Absolute Return = = 30.833%
30000
Effective rate of return is the Compounded Annual Rate, which is „r‟ in the following
equation: 39250 = 30000 (1+r)2

39250
r = Effective rate = - 1 = 14.38% per annum.
30000

2. (a) (ii) List the objectives of the takeout finance scheme. [3]

Answer:

Objectives of the Takeout Finance Scheme:

(a) To boost the availability of longer tenor debt finance for infrastructure projects .
(b) To address sectoral/group/entity exposure issues and asset-liability mismatch
concerns of Lenders, who are providing debt financing to infrastructure projects.
(c) To expand sources of finance for infrastructure projects by facilitating participation
of new entities i.e., medium/small sized banks, insurance companies and pension
funds.

2. (b) (i) State the Trade Credit. Explain the advantages of trade credit. [2+3]

Answer:

Trade credit refers to credit that a buyer firm gets from the suppliers of goods in the
normal course of its operations. It is a dominant part of accounts payable. It appears as
„sundry creditors‟ on the Indian firms‟ balance sheets. Trade credit is a cheaper source of
short term finance than the institutional agencies. It is because suppliers, having better
information and control over buyer than the institutional agencies offer better terms in
extending the trade credit.

The advantages of trade credit are as follows:

 Easy availability: In most of the cases (except financially distressed firms), trade credit
is automatic and does not required any negotiations.

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

 Flexibility: As mentioned earlier, the amount of trade credit is positively associated

with the level of firm‟s operations. It increases (decreases) with the increase (decline)
in firm‟s sales.
 Informality: Trade credit is a spontaneous source of finance, does not require any
formal agreement.

Trade credit seems to be cost free as it does not involve any explicit interest charges.
But it involves implicit cost. Extending trade credit is nothing but financing buyer
purchases; it involves costs to the supplier. Such costs of trade credit may be
transferred to the buyer firm by increased price of goods / services. However, the
extent of such a transfer depends on the bargaining power of supplier and buyer in
the market.

2. (b) (ii) Distinguish between Merchant Banks and Development Banks. [3]

Answer:

Differences between Merchant Banks and Development Banks

Development Banks are specialised financial institutions that act as financial
intermediaries when credit is not available through normal channels. The funding offered
is essentially for industrial and agricultural development in the nature of medium or long
term loans.
They seek to mobilize scarce resources such as capital, technology, entrepreneurial and
managerial talents and channelise them into industrial activities in accordance with plan
priorities. Its objectives are to develop the specific sectors and to improve the economy
in general.
The services offered by development banks and their objectives are different from those
of merchant banks. In India, development banks are usually statutory corporations while
merchant banks are essentially corporate form of organisation.

2. (c) The annualized yield is 3% for 91-day commercial paper and 3.5% for 182 days
commercial paper. Calculate the expected 91-day commercial paper rate 91 days from
now, assuming that we get the same maturity value after 182 days. [8]

Answer:

Assuming the difference is just due to higher future interest rates, an investor should be
able to earn the same return over 182 days using either 182 day paper or a 91 day paper
by rolling over to 91 day paper again after investing in 91 day paper.
Assume that the 182-day paper has a face value of ` 1,00,000. The current price can be
found using:
(F - P) 365
Y= × × 100, Where Y = 3.5, F = 1,00,000, M = 182.
P M
P = ` 98,284.73

Had we invested the same amount in 91-day paper, by substituting P = ` 98,284.73, M =

91 & Y = 3 we get F = ` 99,019.87. That is, such an investment should payoff ` 99,019.87
after 91 days.

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

98284.73 3.5% 100000

182 days

91 days 91 days
I I I

3.0% ?%

98284.73 99019.87 100000

Now, invest ` 99,019.87 in 91-day paper again. It is expected to give a final value of `
1,00,000 (just like the 182 –day paper). When we substitute in the above formula, F = `
1,00,000 & P = ` 99,019.87 and M = 91, we get the 91-day rate in 91-days as 3.97%.

2. (d) (i) Shailesh invested ` 50,000 in debt-oriented fund when the NAV was ` 16.10, and sold
the units allotted when the NAV was ` 17.10 after one year. Assume that there existed
an entry load of 2% and no exit load. He received ` 2 per unit as dividend which is
taxable at 30% during the year. There is no capital gains tax. Calculate the after tax
rupee return from this investment. [4]

Answer:
Shailesh invested ` 50,000, when NAV was ` 16.10 and the sale price was = 16.10 ×
1.02 = ` 16.4220. At this price he was issued 3044.70 (50,000/16.422) units. On this he
received dividend = 3044.7 × 2 = ` 6,089.40. However, dividends are taxable at 30%.
His post tax receipt = 4,262.58. Now if he sells after a year when the NAV is ` 17.10, he
gets full value as there is no exit load.

Rupee return in value

= [Post Tax Div. + (Repurchase Price – Sale Price) × No. of Units]
= 4262.58 + (17.10 – 16.422) × 3044.7
= 6326.89
Rupee return in %
= 6326.89/50000
= 12.65%.

2. (d) (ii) Explain the important development and regulatory steps taken by Forward Market
Commission. [4]

Answer:
Important development and regulatory steps taken by FMC

The Forward Markets Commission is committed towards the development of

institutional capability of the commodity market. The Commission has taken
several steps in this direction, which include sensitizing policy makers and all other
co-traders improving the efficiency of all the participants in the marketing chain

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

by organizing awareness programs, workshops, subject specific consultancies,

study tours, lectures, etc., members.

FMC has set itself an ambitious target for reaching out to various market segments
and grass roots level participants. FMC solicits active collaboration with
Universities, Educational Institutions and other organizations desiring to spread
awareness about Futures Trading in Commodities.

The developmental measures also include the price dissemination among the
farmers through APMCs (spot market regulators).

Question No. 3. (Answer any two questions. Each question carries 10 marks)

3. (a) Fill up the blanks in the following “Break Even Price” table – [10]

Case Option Party Exercise Price Premium Market Price

1 Call Buyer ? 20 160
2 ? Seller 2000 300 1700
3 ? Buyer 50 10 40
4 ? Seller 80 10 90
5 Put Buyer ? 50 250
6 ? Seller 320 50 370
7 Call Buyer 680 100 ?
8 Call Seller ? 80 580
9 Put Buyer 1200 ? 1020
10 Put Seller ? 330 1870

Answer:

Case Option Party Exercise Premium Market Reason / Computation

Price Price
1 Call Buyer 140 20 160 Call → MP = EP + Premium, for Pay Off to
be “0”. → 160 – 20 = ` 140
2 Put Seller 2000 300 1700 2000 – 300 = ` 1700 → MP = EP – Premium.
Therefore, it is a Put Option
3 Put Buyer 50 10 40 50 – 10 = ` 40 → MP = EP – Premium.
Therefore, it is a Put Option.
4 Call Seller 80 10 90 80 + 10 = ` 90 → MP = EP + Premium.
Therefore, it is a Call Option.
5 Put Buyer 300 50 250 Put Option → MP = EP – Premium. → EP =
MP + Premium = 250 – 50 = ` 300
6 Call Seller 320 50 370 320 + 50 = ` 370 → MP = EP + Premium.
Therefore, it is a Call Option.
7 Call Buyer 680 100 780 Call → MP = EP + Premium, for Pay Off to
be “0”. 680 + 100 = ` 780
8 Call Seller 500 80 580 Call → MP = EP + Premium, for Pay Off to
be “0”. → EP = MP – Premium → 580 – 80
= ` 500.

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

9 Put Buyer 1200 180 1020 Put → MP = EP – Premium, for Pay Off to
be “0”. → Premium = EP – MP → 1200 –
1020 = ` 180.
10 Put Seller 2200 330 1870 Put → MP = EP – Premium, for Pay Off to
be “0”. → EP = MP + Premium → 1870 –
330 = ` 2,200.

3. (b) Following information relates to RS Ltd, which manufactures some parts of an

electronics device which are exported to USA, Japan and Europe on 90 days credit
terms.

Cost and Sales information –

Particulars Japan USA Europe

Variable Cost per Unit ` 225 ` 395 ` 510
Export sale price per unit Yen 650 US$10.23 Euro 11.99
Receipts from sale due in 90 Days Yen 78,00,000 US$1,02,300 Euro 95,920

Foreign exchange rate information

Particulars Yen/` US$/` Euro/`
Sopt Market 2.417 – 2.437 0.0214 – 0.0217 0.0177 – 0.0180
3-Months Forward 2.397 – 2.427 0.0213 – 0.0216 0.0176 – 0.0178
3 months spot 2.423 – 2.459 0.02144 – 0.02156 0.0177 – 0.0179

Advice RS Ltd by calculating average contribution to sales ratio whether it should

hedge it‟s foreign currency risk or not. [10]

Answer:

1. Computation of Exchange Rate (Direct Quotes)

Particulars `/Yen `/USD `/Euro

Bid Rate Ask Rate Bid Rate Ask Rate Bid Rate Ask Rate
Spot Market 0.410 0.414 46.08 46.73 55.56 56.50
(1/2.437) (1/2.417) (1/0.0217) (1/0.0214 (1/0.0180) (1/0.0177)
3-Months 0.412 0.417 46.30 46.95 56.18 56.82
Forward (1/2.427) (1/2.397) (1/0.0216) (1/0.0213) (1/0.0178) (1/0.0176)
3 months spot 0.407 0.413 46.38 46.64 55.87 56.50
(1/2.459) (1/2.423) (1/0.02156) (1/0.02144) (1/0.0179) (1/0.0177)
Higher of 3- 0.412 46.38 56.18
Months forward
rate and spot
rate [Bid]
[Forward] [Spot] [Forward]

Bid rate is relevant since the export will be selling Foreign Currency and buying Indian
Rupees:

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

2. Computation of Contribution per Unit in Foreign Currency [Based on 3-months

Rate]
[3-Months Forward vs. 3-Months‟ Spot]

Particulars Japan USA Europe

Spot Forward Bid Rate Ask Rate Bid Rate Ask Rate
(a) Variable Cost per Unit `225.00 `225.00 `395.00 `395.00 `510.00 `510.00
(b) Export sale price per Unit Yen 650 Yen 650 USD USD Euro Euro
[Foreign Currency] 10.23 10.23 11.99 11.99
(c) Relevant Bid Rate `0.407 `0.412 `46.38 `46.30 `55.87 `56.18
(d) Export Sale Proceeds p.u. `264.55 `267.80 `474.47 `473.65 `669.88 `673.60
[(b)×(c)]
(e) Contribution per Unit [(d)–(a)] `39.55 `42.80 `79.47 `78.65 `159.88 `163.60
(f) Contribution Ratio [(e)÷(d)] 15.0% 16.0% 16.7% 16.6% 23.9% 24.3%
(g) Advice Hedge using Do Not Hedge Hedge using
Forward Market Forward Market
Cover Cover

Recommendation: The Company should hedge is foreign currency risk / exposure in

Japanese Yen and Euro, since by hedging, the Company stands to gain a higher
Contribution to Sales Ratio and therefore, higher profit margin. However, for sale to
USA, the Company need not hedge its exposure in Dollars, since moment in Spot
Market is more beneficial than hedging through Forward Market Cover.

3. (c) (i) Given the following information of securities of R Ltd.–

BSE Index 5000

Value of Portfolio ` 10,10,000
Risk Free Interest Rate 9% p.a.
Dividend Yield on Index 6% p.a.
Beta of Portfolio 1.5

We assume that a Futures Contract on the BSE Index with 4 months Maturity is used
to Hedge the value of Portfolio over next 3 months. One Future Contract is for
delivery of 50 times the Index. Based on the information, Calculate – (I) Price of
Future Contract, (II) The Gain on Short Futures Position if Index turns out to be 4,500
in 3 months. [2+(2+2)]
Answer:

I. Computation of Price of Futures Contract

Securities R Ltd.
Spot Price [S x] ` 5,000
Dividend Yield Expected [y] 6% or 0.06
Tenor / Time Period [t] in Years 4 Months or 0.3333 Year
Risk Free Interest Rate [r] 9% or 0.09
Price of Futures Contract [TFP x] = ` 5,000 × e (0.09 – 0.06)×0.3333
TFPx = Sx × e(r-y)×t = ` 5,000 × e 0.03 × 0.3333
= ` 5,000 × e 0.01 = ` 5,000 × 1.0101 = ` 5,050
Therefore, price of the Futures Contract is ` 5,050.

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II. Gain on Short Futures Position

(a) Computation of No. of Contracts to be entered into:

Portfolio Index Beta of Portfolio 10,10,000 1.5

No of Contracts = = = 6 Contracts
Value per Future Contract 5,050 × 50

(b) Computation of Gain on Short-Futures Position (SELL Position)

Total Gain = (Contracted Sale Price – Actual Price) × No. of Contracts
 = (5,050 – 4,500) × 50 units × 6 Contracts
 = 1,65,000.

3. (c) (ii) XYZ Ltd. borrows £20 million of 6 months LIBOR + 0.25% for a period of two years. T,
Treasury Manager of XYZ, anticipates a rise in LIBOR, hence proposed to buy a
Cap Option from ABC Bank at Strike Rate of 7%. The lump sum premium is 1% for
the whole of the three resets period and the Fixed Rate of Interest is 6% p.a. The
actual position of LIBOR during the forthcoming reset period is as follows –

Reset Period LIBOR

1 8.00%
2 8.50%
3 9.00%
You are required to show how far Interest Rate Risk is hedged through Cap Option.
[1+3]

Answer:

1. Computation of Premium Payable

A
Premium Payable = × Underlying Principal
1 1

R × T R × T ×(1+R × T)Y

Where A = Premium Rate = 1% or 0.01

R = Fixed Interest Rate for the Period under Consideration = 6% or 0.06
T = Reset period i.e., frequency of changing the Floating Rates = 6 months or 0.5 Years
Y = Total Number of Reset Periods for the Period under Consideration = 4 Times (2 Years/Reset
Period 0.5)
0.01
= × £ 2,00,000 = £ 53.805
1 1

0.03 0.03 ×1.03)4

2. Effectiveness of Hedge Using Interest Rate Cap

Reset Addl. Int. Rate Add. Int. Amt. = Recd. From Premium paid Net Amount
Period (Actual Less Cap) Bank (Int. Rate × Principal) to bank received from bank
1 8.25% - 7% = 1.25% 200L × 1.25% = £ 2,50,000 £ 53,805 £ 1,96,195
2 8.75% - 7% = 1.75% 200L × 1.75% = £ 3,50,000 £ 53,805 £ 2,96,195
3 9.25% - 7% = 2.25% 200L × 2.25% = £ 4,50,000 £ 53,805 £ 3,96,195
Total £ 10,50,000 £ 1,61,415 £ 8,88,585
Interest Rate Cap has reduced the additional interest cost from £10,50,000 to £ 8,88,585.

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Question No. 4. (Answer any two questions. Each question carries 8 marks)

4. (a) Suppose that all stocks have a rate of return with a standard deviation of 40% and
that the correlation between rates of returns for all pairs of stocks is 0.25. Calculate
the standard deviation of returns of a portfolio which has
I. Equal holdings in 10 stocks; and
II. 38% each invested in two stocks, 3% invested in each of 8 stocks. [4+4]

Answer:

I. The variance of N = 10 stock portfolios would comprise of 10 variance terms +10

(10-1) covariance/correlation terms.
1/2
 N N 
= N  w12 σ2i    wiwjσiσjρij 
 1111 
Since weights, standard deviation and correlation coefficient are same for all the
ten stocks,
1/2
 2 2 2 2

= 10 × w 2 σi +10(10 -1)wi σi ρij 

i1 
= [10 × (1/10) 2 (0.4)2 +10(10 – 1)(1/10)2 (0.40)2 (0.6)] 1/2
= 22.80%

II. The variance of N = 10 stock portfolios would comprise of 10 variance terms + 10

(10 - 1) covariance/correlation terms, i.e. 10 + 90 = 100 terms. Of the 10 variance
terms, we now have two variance term of (0.38 2) (0.42) and 8 variance terms of
(0.032) (0.42). Of the 10 (10 – 1) = 90 covariance/correlation terms, we have two
parts. Consider 2 stocks, whose weights are 38%. We have 2 2 – 2 = 2 covariance/
correlation terms equal to (0.38 2)(0.42)(0.25). Consider 8 stocks, whose weights are
3%. We have 8 2 – 8 = 56 covariance/correlation terms equal to (0.03 2)(0.42)(0.25).
However, we still need to consider the covariance/correlation between each of
these stocks. There are remaining 32 [100 – 10 – 2 – 56 = 32 or 2 (8) (2) = 32 terms]
of these covariance/correlation terms, all equal to (0.38)(0.03)(0.4 2)(0.25), so we
have portfolio risk as:

= [2 × (0.38)2 (0.4)2 + 8 × (0.03)2 (0.4)2 + 2 × (0.38) 2 (0.4)2 (0.25) + 56 × (0.03) 2 (0.4)2

(0.25) + 32 × (0.38) (0.03) (0.4) 2 (0.5)] ½
= 27.48%.

4. (b) You are thinking about investing your money in the stock market. You have the
following two stocks in mind: stock A and stock B. You know that the economy can
either go in recession or it will boom. Being an optimistic investor, you believe the
likelihood of observing an economic boom is two times as high as observing an
economic depression.
State of the Economy Probability RA RB
Boom 10% -2%
Recession 6% 40%
You also know the following about your two stocks:
I. Calculate the expected return for stock A and stock B
II. Calculate the total risk (variance and standard deviation) for stock A and for
stock B

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III. Calculate the expected return on a portfolio consisting of equal proportions in

both stocks.
IV. Calculate the expected return on a portfolio consisting of 10% invested in stock A
and the reminder in stock B.
V. Calculate the covariance between stock A and stock B.
VI. Calculate the correlation coefficient between stock A and stock B.
VII. Calculate the variance of the portfolio with equal proportions in both stocks using
the covariance from answer (V).
VIII. Calculate the variance of the portfolio with equal proportions in both stocks using
the portfolio returns and expected portfolio returns from answer (III). [1×8]

Answer:

I. P(boom)=2/3 and p(recession)= 1/3 (Note that probabilities always add up to 1)

E(R A) = 2/3 × 0.10 + 1/3 × 0.06 = 0.0867 (8.67%)
E(RB) = 2/3 × - 0.02 + 1/3 × 0.40 = 0.12 (12%)

II. SD(RA) = [2/3 × (0.10 – 0.0867)2 + 1/3 × (0.06 – 0.0867)2]0.5 = 0.018856 (1.886%)
SD(RB) = [2/3 × (- 0.02 – 0.12)2 + 1/3 × (0.40 – 0.12)2]0.5 = 0.19799 (19.799%)

III. Portfolio weights: W A = 0.5 and WB = 0.5:

E(Rp) = 0.5 × 0.0867 + 0.5 × 0.12 = 0.10335 (10.335%)

IV. Portfolio weights: W A = 0.1 and WB = 0.9:

E(Rp) = 0.1 × 0.0867 + 0.9 × 0.12 = 0.11667 (11.667%)

V. COV (R A, RB) =
2/3 × (0.10–0.0867) × (- 0.02–0.12) + 1/3 × (0.06-0.0867) × (0.40–0.12) = - 0.0037333

VI. CORR (R A, RB) = - 0.0037333 / (0.018856 × 0.19799) = -1 (Rounding! Remember

the correlation coefficient cannot be less than -1)

VII. VAR(RP ) = 0.5 2 × 0.018856 2 + 0.52 ×0.19799 2 + 2 × 0.5 × 0.5 × - 0.0037333= -

0.008022
SD(RP) = 8.957%
VIII. E(RP Boom) = 0.5 × 0.10 + 0.5 × -0.02 = 0.04 (4%)
E(RP Recession) = 0.5 × 0.06 + 0.5 × 0.40 = 0.23 (23%)
Hence, E(RP) = 2/3 × 0.04 + 1/3 × 0.23 = 0.10335 (10.335%)
And, SD(RP)= 2/3 × (0.04 – 0.10335)2 + 1/3 × (0.23 – 0.10335)2] 0.5 =0.08957 (8.957%).

4. (c) (i) An investor is holding 1000 shares of Fatlass Company. Presently the rate of
dividend being paid by the company is ` 2 per share and the share is being sold
at ` 25 per share in the market. However, several factors are likely to change
during the course of the year as indicated below:

Existing Received
Risk Free Rate 12% 10%
Market Risk Premium 6% 4%
Beta Value 1.4 1.25
Expected Growth Rate 5% 9%
In view of the above factors whether the investor should buy, hold or sell the shares?
And why? [5]

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Answer:

The expected return on Fatlass Co., as per existing data, is given by

RFatlass = Rf + β(Rm – Rf)
Substituting, we get R Fatlass = 0.12 + 1.4 × 0.06 = 20.4%
D (1+g)
Substituting, this for K e in the dividend discount model formula P = 0 .
Ke - g
We get,
P = (2 × 1.05) / (0.204 – 0.05) = ` 13.63
Since the share is selling at ` 25 it is overpriced. He should sell his shares now.

As per the revised data, we would have

RFaltass = 0.10 + 1.25 × 0.04 = 15%
D0(1+g)
Substituting, this for K e in the dividend discount model formula P =
Ke - g
We get,
P = (2 × 1.09) / (0.15 – 0.09) = ` 36.33
Since the share is selling at ` 25 it is under priced, on the basis of the revised data
he should hold the shares.

4. (c) (ii) Explain the two techniques used in Industry Analysis. [3]

Answer:
Techniques used in Industry Analysis:
I. Regression Analysis: Investor diagnoses the factors determining the demand for
output of the industry through product demand analysis. The following factors
affecting demand are to be considered – GNP, disposable income, per capita
consumption / income, price elasticity of demand. These factors are then used to
forecast demand using statistical techniques such as regression analysis and
correlation.
II. Input-Output Analysis: It reflects the flow of goods and services through the
economy, intermediate steps in production process as goods proceed from raw
material stage through final consumption. This is carried out to detect changing
patterns/trends indicating growth/decline of industries.

Question No. 5. (Answer any two questions. Each question carries 10 marks)

5. (a) (i) Beeta Ltd. has furnished the following information:

Earnings per share (EPS) `4
Dividend Payout Ratio 25%
Market Price per share ` 40
Rate of Tax 30%
Growth Rate of Dividend 8%
The company wants to raise additional capital of ` 10 lakhs including beta of ` 4
lakhs. The cost of debt (before tax) is 10% upto ` 2 lakhs and 15% beyond that.
Compute the after tax cost of equity and debt and the weighted average cost of
capital. [1½+1½+2]

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Answer:

I. Cost of Equity Share Capital (Ke)

D
Ke = 1 +g
Po
DPS = 25% of ` 4 = ` 1.00
`1
Ke = + 0.08 = 10.5%
` 40

II. Cost of Debt (Kd)

I 1- t 
Kd (After tax) =
NP
Interest on ` 2,00,000 @ 10% = ` 20,000
Interest on ` 2,00,000 @ 15% = ` 30,000
` 50,000
` 50,000
(Kd) = × (1 – 0.3) = 8.75%
` 4,00,000

III. Weighted Average cost of capital (WACC)

Source Amount in (`) Weight Cost of Capital Weighted Average Cost

(1) (2) (3) (4) (5) = (3) × (4)
Equity 6,00,000 0.6 10.5% 6.30%
Debt 4,00,000 0.4 8.75% 3.50%
10,00,000 1.0 9.80%
[Note: Ke can be computed alternatively taking growth rate into consideration
(D0(1+g)/P0 +g). The values of Ke and WACC then would change accordingly as
10.7% and 9.92% respectively.
5. (a) (ii) X Ltd. a widely held company is considering a major expansion of its production
facilities and the following alternatives are available: (` in lakhs)
Particulars A B C
Share Capital 50 20 10
14% Debentures -- 20 15
Loan from a Financial Institution @ 18% p.a. Rate of Interest -- 10 25

Expected rate of return before tax is 25%. The rate of dividend of the company is not
less than 20%. Corporate taxation rate is 50%. Which of the alternatives you would
choose? Decide by computing rate of return on share capital. [5]

Answer:

Statement Showing Computation of Rate of return on share capital

(` in lakhs)
Particulars A B C
Return on ` 50 lakhs @ 25% 12.50 12.50 12.50
Less: Interest on 14% Debentures -- (2.80) (2.10)
Less: Interest on 18% loan from Financial Institution -- (1.80) (4.50)
EBT/Taxable Profits 12.50 7.90 5.90
Less: Income tax 50% (6.25) (3.95) (2.95)
Profit After Tax available to shareholders 6.25 3.95 2.95

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Share Capital 50 20 10
Rate of return on Share Capital 12.5% 19.75% 29.5%
Comment: From the shareholders point of view Alternative C (highest) is to be chosen.

5. (b) Khan Limited is thinking of replacing its existing machine by a new machine which
would cost ` 60 lakhs. The company‟s current production is 80,000 units, and is expected
to increase to 1,00,000 units, if the new machine is bought. The selling price of the
product would remain unchanged at ` 200 per unit. The following is the cost of producing
one unit of product using both the existing and new machine:

Existing Machine New machine Unit Cost (`)

(80,000 units) (1,00,000 units) Difference
Materials 75.00 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.00 25.00 5.00
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.00 4.75
Allocated Corporate Overheads 10.00 12.50 2.50
183.25 165.50 (17.75)

The existing machine has an account book value of ` 1,00,000, and it has been fully
depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The
supplier of the new machine has offered to accept the old machine for ` 2,50,000.
However, the market price of old machine today is ` 1,50,000 and it is expected to be `
35,000 after 5 year. The new machine has a life of 5 years and a salvage value of `
2,50,000 at the end of its economic life. Assume corporate Income tax rate at 40% and
depreciation is charged on straight line basis for Income tax purposes. Further assume
that book profit is treated as ordinary income for tax purpose. [7+2+1]
The opportunity cost of capital of the Company is 15%. Required:
I. Estimate Net present Value of the Replacement Decision.
II. Estimate the Internal Rate of Return of the Replacement Decision.
III. Should Company go ahead with the Replacement Decision? Suggest.
Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.8000 0.6400 0.5120 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Answer:

I. Statement showing Evaluation of Replacement Proposal

Particulars Time P. V. Factor Amount P. V.

Cash Outflows:
Cost of Machine 60,00,000
Less: Scrap value of Old Machine
S. P. ` 2,50,000
Less: WDV ---
Capital Gain ` 2,50,000

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Less: Tax (40%) `(1,00,000) (1,50,000)

Net Cost of Replacement 0 1 58,50,000 58,50,000
PVCO (A) 58,50,000
Cash Inflows:
Incremental CFAT (See WN1) 1-5 3.3522 22,84,000 76,56,425
Incremental Salvage Value [` 2,50,000 – ` 21,000#] 5 0.4972 2,29,000 1,13,859
PVCI (B) 77,70,284
NPV (B) – (A) 19,20,284

# = (` 35,000) (1 – 0.4) = ` 21,000

Note: Allocated Corporate Overheads are ignored as are irrelevant.

W. N. 1 Computation of Incremental CFAT

Amount in (`)
1–5
(i) Incremental CFBT [See Note (i)] 30,40,000
 `60,00,000 - `2,50,000  (11,50,000)
Less: Depreciation Incremental  -0
 5 years 
Incremental PBT 18,90,000
Less: Tax (40%) -------------- (2) (7,56,000)
Incremental CFAT 22,84,000

Note: (i) Include [Material + Wages & Salaries + Supervision + Repairs and maintenance + Power]
New Machine Expenses = ` 148 per unit
Old Machine expenses = ` 173 per unit
Sales Revenue New Machine = 1,00,000 units
Sales Revenue by old = 80,000 units
= {1,00,000 units [` 200 – ` 148]} – {80,000 units [` 200 – ` 173]}
= ` 52,00,000 – ` 21,60,000 = ` 30,40,000

II. (` „000)
0 1 2 3 4 5
Net Cash Flows (5,850) 2,284 2,284 2,284 2,284 2,513
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV of Cash flows (5,850) 1,903.257 1,586.01 1,321.751 1,101.57 1,009.97
NPV 1,072.56
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV of Cash flows (5,850) 1,756.85 1,351.44 1,039.44 799.63 676.75
NPV (225.89)
1072.56
IRR = 20% + 10% × = 28.27%.
1298.45

III. Advise: The Company should go ahead with replacement project, since it is positive
NPV decision.

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

5. (c) (i) The capital structure of a company as on 31st March, 2015 is as follows:
Amount in (`)
Equity Capital: 6,00,000 Equity Shares of ` 100 each 6 crore
Reserve and Surplus 1.20 crore
12% Debenture of ` 100 each 1.80 crore

For the year ended 31 st March, 2015 the company is expected to pay equity
dividend @ 24%. Dividend is likely to grow by 5% every year. The market price of
equity share is ` 600 per share. Income-tax rate applicable to the company is
30%.
Required:
I. Compute the Current Weighted Average Cost of Capital.
II. The company has plan to raise a further ` 3 crore by way of long-term loan at
18% interest. If loan is raised, the market price of equity share is expected to
fall to ` 500 per share. Calculate the new weighted average cost of capital of
the company. [2+3]

Answer:

I (1- t) `12 (1- 0.30)

(I) Kd = = = 8.4%
NP `100
D ` 24
Ke = 1 +g = + 5% = 9%
Po `600

Computation of Current Weighted Average Cost of Capital

Source Amount in (` in crores) Weights Cost of Capital WACC
Equity 7.20 0.8 9% 7.20%
Debenture 1.80 0.2 8.4% 1.68%
9.00 1.0 8.88%

(II) Cost of Existing Debenture Kd1 = 8.4%

`18 (1- 0.30)
Cost of Loan Kd2 = = 12.6%
100
` 24
Ke = + 5% = 9.80%
` 500

Computation of New Weighted Average Cost of capital

Source Amount (` in crores) Weights Cost of Capital WACC
Equity 7.20 0.6 9.80% 5.88%
Debt (Loan) 3.00 0.25 12.6% 3.15%
Debentures 1.80 0.15 8.4% 1.26%
12.00 1.0 10.29%

5. (c) (ii) List the advantages of a project report. [5]

Answer:

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 Answer to PTP_Final_Syllabus2012_Dec2015_Set 2

Advantages of a Project Report-

I. A Project Report lists the objective in various spheres of business and evaluates them
from the right perspective.
II. Facilitates planning of business by setting guidelines for future action. The successful
implementation of a project depends upon the line of action as suggested in the
project report. Besides, comparison of results will depend upon the projected
profitability and cash flows, production schedule and targets as laid down in the
project report.
III. Identifies constraints on resources viz. manpower, equipment, financial and
technological etc. well in advance to take remedial measures in due course of time.
IV. Helps in procuring finance from various financial institutions and banks which ask for
such detailed information before giving any assistance.
V. Provides a framework of the presentation of the information regarding business
required by Government for granting licenses, etc.

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