P-14 : STRATEGIC FINANCIAL MANAGEMENT

SUGGESTED ANSWERS
SECTION-A

1.
(i) (A)
(ii) (B)
(iii) (B)
(iv) (C)
(v) (A)
(vi) (A/B)
(vii) (D)
(viii) (B)
(ix) (A)
(x) (D)
(xi) (B)
(xii) (D)
(xiii) (A/B/C/D)
(xiv) (B)
(xv) (B)

SECTION – B
2. (a)
(i) Calculation of Net Initial Cash Outflow
Particulars (₹)
Cost of New Machine 1200000
Less: Sale Proceeds of existing machine (240000 - 40000)200000
Net Purchase Price 1000000
Paid in year 0 800000
Paid in year 1 200000

Calculation of Additional Depreciation

1 2 3 4
Year
(₹) (₹) (₹) (₹)
Opening WDV of Machine 1000000 800000 640000 512000
Depreciation on new machine @ 20 % 200000 160000 128000 102400
Closing WDV 800000 640000 512000 409600
Depreciation on old machine (480000 / 8) 60000 60000 60000 60000
Incremental depreciation 140000 100000 68000 42400

Page 1 of 13
 Calculation of Annual Profit before Depreciation and Tax (PBDT)
Particulars Incremental Values (₹)
Sales 1225000
Contribution 612500
Less : Indirect Cost 118750
Profit before Depreciation and Tax (PBDT) 493750

Calculation of Incremental NPV

PV of
Incremental Tax Cash
Year

PVF PBTD PBT Cash

Depreciation @ 30% Inflows
@ 12 % (₹) (₹) Inflows
(₹) (₹) (₹)
(₹)
(5) (6) (7)
(1) (2) (3) (4)
= (4) x 0.30 = (4) – (5) + (3) = (6) x (1)
1 0.893 493750 140000 353750 106125 387625 346149
2 0.797 493750 100000 393750 118125 375625 299373
3 0.712 493750 68000 425750 127725 366025 260610
4 0.636 493750 42400 451350 135405 358345 227907
1134039
Add: PV of Salvage- Year 4 (₹100000 x 0.636) 63600
Less: Initial Cash Outflow – Year 0 800000
Year 1 (₹ 200000 x 0.893) 178600
Less: Working Capital – Year 0 250000
Year 2 (₹ 300000 x 0.797) 239100
Add: Working Capital released – Year 4 (₹ 550000 x 0.636) 349800
Incremental Net Present Value 79739

(ii) Advice:
Since the Incremental Net Present Value (NPV) is positive (₹ 79739), the company should replace
the existing machine with a new machine.

Alternative solution:
Calculation of Net Initial Cash Outflow
Particulars (₹)
Cost of New Machine 1200000
Less : Sale Proceeds of existing machine (240000 - 40000) 200000
Net Purchase Price 1000000
Paid in year 0 800000
Paid in year 1 200000

Calculation of Additional Depreciation

1 2 3 4
Year
(₹) (₹) (₹) (₹)
Opening WDV of Machine 1200000 960000 768000 614400
Depreciation on new machine @ 20 % 240000 192000 153600 122880
Closing WDV 960000 768000 614400 491520
Depreciation on old machine (480000 / 8) 60000 60000 60000 60000
Incremental depreciation 180000 132000 93600 62880

Page 2 of 13
 Calculation of Annual Profit before Depreciation and Tax (PBDT)
Particulars Incremental Values (₹)
Sales 1225000
Contribution 612500
Less: Indirect Cost 118750
Profit before Depreciation and Tax (PBDT) 493750

Calculation of Incremental NPV

Incremental
PVF PBTD PBT Tax Cash inflows PV of Cash
Year Depreciation
@ 12 % (₹) (₹) @ 30% (₹) (₹) Inflows (₹)
(₹ )
(5) (6) (7)
(1) (2) (3) (4)
= (4) x 0.30 = (4) – (5) + (3) = (6) x (1)
1 0.893 493750 180000 313750 94125 399625 356865
2 0.797 493750 132000 361750 108525 385225 307024
3 0.712 493750 93600 400150 120045 373705 266078
4 0.636 493750 62880 430870 129261 364489 231815
1161782
Add: PV of Salvage- Year 4 (₹ 100000 x 0.636) 63600
Less: Initial Cash Outflow – Year 0 800000
Year 1 (₹ 200000 x 0.893) 178600
Less: Working Capital – Year 0 250000
Year 2 (₹ 300000 x 0.797) 239100
Add: Working Capital released – Year 4 (₹ 550000 x 0.636) 349800
Incremental Net Present Value 107482

(ii) Advice:
Since the Incremental Net Present Value (NPV) is positive (₹ 107482), the company should replace
the existing machine with a new machine.

2. (b)
Let normal annual lease rent per annum is χ . (₹ In Lakh)
P. V. of cash inflows must equal the P.V. of cash outflows at 12%
End of Year Cash Flow P. V. Factor Discounted Cash Flows
Assets Cost 0 -300 1 -300
0.893 + 0.797 +
75 x .35
Depreciation Shield 1–4 0.712 + 0.636 79.7475
= 26.25
= 3.038
Lease Rent 1 2 χ x 0.65 0.893 1.1609 χ
Lease Rent 2 2 χ x 0.65 0.797 1.0361 χ
Lease Rent 3 1 χ x 0.65 0.712 0.4628 χ
Lease Rent 4 1 χ x 0.65 0.636 0.4134 χ
Total Inflows of lease rent 3.0732 χ

3.0732 χ = 300 – 79.7475(Depn. Shield)

or, 3.0732 χ = 220.2525(Net cost of ownership)
or χ = 220.2525 / 3.0732 = 71.6688 Lakh
Lease Rent for First Year: 2 x 71.6688 = ₹ 143.3376 Lakh

Page 3 of 13
Lease Rent for Second Year: 2 x 71.6688 = ₹ 143.3376 Lakh
Lease Rent for Third Year: 1 x 71.6688 = ₹ 71.6688 Lakh
Lease Rent for Fourth Year: 1 x 71.6688 = ₹ 71.6688 Lakh

3. (a)
(i) Computation of expected NPV for each project:
Project Titan Project Orion

Cash Flow Probability Weighted Cash Flow Weighted

Probability
(₹ ) Value (₹ ) (₹ ) Value (₹ )
160000 0.15 24000 130000 0.25 32500
200000 0.25 50000 180000 0.35 63000
280000 0.35 98000 300000 0.25 75000
420000 0.25 105000 360000 0.15 54000

Expected Cashflow (E[CF]) ₹ 277000 ₹ 224500

PVIFA (9 %, 3 Years) 2.513 2.513
Total Cash inflow 696101 564169
Less: Initial Investment 500000 500000
Expected NPV 196101 64169

(ii) Calculation of Standard Deviation of cash flows for each project

Project Titan
Deviation from Square of the
Cash Flow Probability Square of the
Expected cashflow deviation x
(A) (P) Deviation (C=B2)
(B=A–Expected Cash flow) Probability (C x P)
160000 0.15 – 117000 13689000000 2053350000
200000 0.25 – 77000 5929000000 1482250000
280000 0.35 3000 9000000 3150000
420000 0.25 143000 20449000000 5112250000
Variance 8651000000
Standard Deviation 93011

Project Orion
Square of the
Deviation from
Cash Flow Probability Square of the deviation x
Expected cash flow
(A) (P) deviation (C=B2) Probability (C x
(B=A–Expected Cash flow)
P)
130000 0.25 – 94500 8930250000 2232562500
180000 0.35 – 44500 1980250000 693087500
300000 0.25 75500 5700250000 1425062500
360000 0.15 135500 18360250000 2754037500
Variance 7104750000
Standard Deviation 84290

Page 4 of 13
 (iii) Determination of coefficient of variation for each project
Coefficient of Variation (CV) = Standard Deviation / Expected Cashflow
CV-Project Titan = 93011/277000 = 0.336
CV-Project Orion = 84290 /224500 = 0.375
(iv) Recommendation: Since, the co-efficient of Variation (CV) is higher for project Orion, it is riskier
than Project Titan. However, Project Titan with lower risk may be preferred.

3. (b)
(i) Computation of Dividends for 7 years.
D1= 6 (1.20) = ₹ 7.20
D2=6(1.20)2 = ₹ 8.64
D3=6(1.20)3 = ₹ 10.37
D4= 6(1.20)4 = ₹ 12.44
D5 = 12.44 (1.19) = ₹ 14.80
D6 = 12.44 (1.19) (1.18) = ₹ 17.47
D7 = 12.44 (1.19) (1.18) (1.17) = ₹ 20.44

Price at the end of 7th Year:

Year Dividend (₹) PVIF@20% PV (₹)
1 7.20 0.8333 6.00
2 8.64 0.6944 6.00
3 10.37 0.5787 6.00
4 12.44 0.4823 6.00
5 14.80 0.4019 5.95
6 17.47 0.3349 5.85
7 20.44 0.2791 5.70
TOTAL 41.50
Current Market Price ₹ 172.45
Less : PV of Dividend upto the year ending 7thyear ₹ 41.50
PV of Expected Market Price at the end of 7th year ₹ 130.95

Let g be the growth rate,

Then = 130.95 = [20.44 (1 + g) x 0.2791] / (0.20 – g)
Or, 130.95 = (5.70 + 5.70g) / (0.20 – g)
Or, 26.19 – 130.95g = 5.70 + 5.70 g
Or, 136.65 g = 20.49
g= (20.49) / (136.65) = 0.15 i.e. 15%
Thus, the stable growth rate after the end of 7th year shall be 15%.

(ii) Since the growth rate is equal to target growth rate, it may worth to purchase the share.

Alternative Solution:
(i) Computation of Dividends for 7 years.
D1 = ₹ 6
D 2 =6 (1.20) = ₹ 7.20
D 3 =6(1.20) 2 = ₹ 8.64
D 4 =6(1.20) 3 = ₹ 10.37
D 5 = 10.37(1.19) = ₹ 12.34
D 6 = 10.37 (1.19) (1.18) = ₹ 14.56
D 7 = 10.37 (1.19) (1.18) (1.17) = ₹ 17.04
Page 5 of 13
 Price at the end of 7th year
Year Dividend (₹) PVF@20% PV (₹)
1 6.00 0.8333 5.00
2 7.20 0.6944 5.00
3 8.64 0.5787 5.00
4 10.37 0.4823 5.00
5 12.34 0.4019 4.96
6 14.56 0.3349 4.88
7 17.04 0.2791 4.76
TOTAL 34.60
Current Market Price ₹ 172.45
Less: PV of Dividends upto the year ending 7th year ₹ 34.60
PV of Expected Market Price at the end of 7th year ₹ 137.85
17.04 (1 + g)
Let g be growth rate then: 137.85 = x 0.2791
0.20 − g
Or, 137.85 = (4.76 + 4.76g) / (0.20 – g)
Or, 27.57 – 137.85 g = 4.76 + 4.76g
By solving the equation,
g = 0.16 i.e. 16%
Thus, the stable growth rate after the end of the7 years shall be 16%.

(ii) Since growth rate is more than target growth rate it is worth to purchase the share.

4. (a)
(i) Value of Zero-Coupon Bond till maturity
Present value of bond = Face Value / (l+r)n
= 100000 /[ (1 + 0.08)10 (1 + 0.09)10 (1 + 0.10)5]
= 100000 x 0.4632 x 0.4224 x 0.6209
= ₹ 12148.26
Value of Bond = ₹ 12148.26

(ii) Value of Zero-Coupon Bond if the issuer exercises the call option at the end of Year 15
Present value of bond= Face Value / (l+r)n
= 101000 / [(1 + 0.08) 10 (1 + 0.09)5]
= 101000 x 0.4632 x 0.6499
= ₹ 30404.40
Value of Bond = ₹ 30404.40

(iii) Value of Zero-Coupon Bond if the investor exercises the put option at the end of Year 18
Present value of bond = Face Value / (1 + r)n
= 80000 / [ (1 + 0.08)10 (1 + 0.09)8 ]
= 80000 x 0.4632 x 0.5019
= ₹ 18598.41
Value of Bond = ₹ 18598.41

(iv) The investor should expect the bond to be held till maturity as lowest present value of bond
(12148.26).

Page 6 of 13
4. (b)
(i) Number of Units in Each Scheme
Fund Alpha:
units = ₹ 250000 ÷ ₹ 11.20 = 22321.43 units

Fund Beta:
Units = ₹ 300000 ÷ ₹ 10.50 = 28571.43 units

Fund Gamma:
Initial Units = ₹ 150000 ÷₹ 10.00 = 15000 units
Bonus (1:10) = 15000 x (1/10) = 1500 units
Total Units = 15000 + 1500 = 16500 units

(ii) Total NAV as on 31-Mar-2025

Fund Units NAV (₹ ) Value (₹ )
Alpha 22321.43 ₹ 11.10 ₹ 247768
Beta 28571.43 ₹ 9.70 ₹ 277143
Gamma 16500 ₹ 10.60 ₹ 174900

Total NAV Value = ₹ 699811

(iii) Total yield (%) on investment
Name of Mutual Funds Capital Yield Dividend Yield Total
Alpha 247768 – 250000 = – 2232 7500 5268
Beta 277143 – 300000 = – 22857 NIL – 22857
Gamma 174900 – 150000 = 24900 3750 28650
Total 11061

Total Yield (%) = (11061 / 700000) x 100= 1.58%

(iv) No. of days investment was held

Name of Mutual Funds Alpha Beta Gamma
Let number of days be X Y Z
Initial Investment 250000 300000 150000
Yield (₹ ) 5268 –22857 28650
Yield (%) 2.11 –7.62 19.10
Period of holding (Days) (2.11 ÷ 10.80) x 365 [(-7.62) ÷ (-13.25)] x 365 (19.10 ÷ 20.45) x 365
= 71 days = 210 days = 341 days

5. (a)
(i) Compute Levered Beta ( βL )
βL = βUL x (1 + D/E)
Omega Hydraulics Ltd. :
βL = 0.90 x (1 + 0.60 )
= 0.90 x 1.60 = 1.44
Vertex Industrial solution Ltd. :
βL = 0.82 x (1 + 0.90 )
= 0.82 x 1.90 = 1.56
Page 7 of 13
 (ii) Computation of Risk-free return (RF)
Particulars Value
Face Value of Treasury Bills 100
Coupon rate on Face Value (in %) 6.50 %
Return on Treasury Bills (in Value) (100 x 6.50 %) 6.5
Market Price of Treasury Bills 95
Risk Free Return (RF) [Actual Return 6.50 / Market Price
95] 6.84%
Risk free return = 6.84 %
Expected Return Using CAPM
E (R ) = RF + β x (RM − RF )
Omega Hydraulics Ltd. :
Ke = 6.84 % + 1.44 x (14.50 % – 6.84 %)
=6.84 % + 11.03% = 17.87 %
Vertex Industrial Solutions Ltd. :
Ke = 6.84 % + 1.56 * (14.50 % – 6.84 %)
=6.84% + 11.95 % = 18.79 %
(iii) Comparison of Actual vs Expected Returns:
Company Expected Return (Ke) Actual Return Performance
Omega Hydraulics Ltd. 17.87 % 16.00 % Underperforming
Vertex Industrial Ltd. 18.79 % 20.00 % Over performing

5. (b)
(i) Assessment of Portfolio Beta
Share Weight (W) Beta (B) (W x B)
ASL 0.35 0.35 0.1225
NSL 0.25 1.25 0.3125
ZNL 0.40 0.80 0.320

Portfolio Beta = 0.755

(ii) Assessment of Residual Variance

ASL = 0.015 – (0.35)2 x (0.12) 2 = 0.0132
NSL = 0.035 – (1.25) 2 x (0.12) 2 = 0.0125
ZNL = 0.020 – (0.80) 2 x (0.12) 2 = 0.0108

(iii) Assessment of Portfolio Variance on the basis of Markowitz Theory

WA x WA x σ2A + 0.35 x 0.35 x 0.015 0.0018
WA x WN x COV (AN) + 0.35 x 0.25 x 0.025 0.0022
WA x WZ x COV (AZ) + 0.35 x 0.40 x 0.035 0.0049
WN x WA x COV (AN) + 0.25 x 0.35 x 0.025 0.0022
2
WN x WN x σ N + 0.25 x 0.25 x 0.035 0.0022
WN x WZ x COV (NZ) + 0.25 x 0.40 x 0.060 0.0060
WZ x WA x COV (ZA) + 0.40 x 0.35 x 0.035 0.0049
WZ x WN x COV (ZN) + 0.40 x 0.25 x 0.060 0.0060
WZ x WZ x  2
Z 0.40 x 0.40 x 0.020 0.0032
0.0334
Page 8 of 13
6. (a)
(i) Weighted Average Portfolio Beta:
No. of Shares Total Value Product
Security MPS (₹ ) Beta
(Lakh) (₹ In Lakh) in Lakh
AS Ltd. 4.50 500 2250 1.40 3150
BM Ltd. 6.00 750 4500 1.20 5400
ZM Ltd. 3.00 250 750 1.60 1200
13.50 7500 9750

9750
Portfolio Beta = = 1.30
7500
(ii) Assessment of Government Securities to be acquired for Beta ( β ) = 0.975
Particulars BETA Amount Product
Govt. Securities O χ O
Other Securities 1.30 1 –χ 1.3– 1.3 χ
Total 1 1.3– 1.3 χ

1.3 − 1.3 χ
Portfolio Beta (β) = 0.975 =
1
Or, 0.975 = 1.3 – 1.3 χ
0.325
χ= = 0.25 i.e. 25 %
1.3
Amount to be invested in Govt. Securities = 7500 x 0.25 = ₹ 1875 Lakh

(iii) No. of shares to be disposed off

M.V. of investment Value of Disposed off MPS No. of Shares to be
Security
(₹ In Lakh) (₹ In Lakh) 25% (₹) disposed off (in Lakh)
AS Ltd. 2250 562.50 500 1.125
BM Ltd. 4500 1125.00 750 1.50
ZM Ltd. 750 187.50 250 0.75
Total 7500 1875.00 3.375

(iv) Analysis of Number of NIFTY Contracts to be bought / Sold:

No. of NIFTY Contracts.
1.3 − 0.975 243750000
750000000 x = = 100 Contracts.
24375 x 100 2437500
No. of NIFTY Contracts to be sold = 100 Contracts

6. (b)
(i) Expected Share Price :
₹ 540 x 0.10 + ₹ 560 x 0.15 + ₹ 580 x 0.05 + ₹ 600 x 0.35 + ₹ 620 x 0.20 + ₹ 640 x 0.15
= ₹ 54 + ₹ 84 + ₹ 29 + ₹ 210 + ₹ 124 + ₹ 96
= ₹ 597
(ii) Value of Call Option (intrinsic value of Option)
₹ 590 – ₹ 590 = Nil

Page 9 of 13
Alternatively:
(ii) If Price after 3 month = ₹ 597
Value of Call option = 597 – 590 = ₹ 7

(iii) If the option is held till maturity the expected Value of Call Option
Expected price (X) Value of Call (C) Probability (P) Expected Value of Option
₹ 540 0 0.10 0
₹ 560 0 0.15 0
₹ 580 0 0.05 0
₹ 600 ₹ 10 0.35 ₹ 3.50
₹ 620 ₹ 30 0.20 ₹ 6.00
₹ 640 ₹ 50 0.15 ₹ 7.50
Total ₹ 17.00

Alternatively, it can also be calculated as follows:

Expected price Exercise price Probability Expected Value of Option CP
(X) (E) (P) (X – E) x P
₹ 540 ₹ 590 0.10 Not Exercised*
₹ 560 ₹ 590 0.15 Not Exercised*
₹ 580 ₹ 590 0.05 Not Exercised*
₹ 600 ₹ 590 0.35 ₹ 3.50 (10 x 0.35)
₹ 620 ₹ 590 0.20 ₹ 6.00 (30 x 0.20)
₹ 640 ₹ 590 0.15 ₹ 7.50 (50 x 0.15)
Total ₹ 17.00

* If the stock price goes below ₹ 590, option is not exercised at all.
(iv) Price to be quoted at the stock exchange to get the value of the call option
Strike Price + Value of Call Option
₹ 590 + ₹ 17 = ₹ 607

7. (a)
(i) Forward Contracts
USD Amount = 500000
Forward Rate = ₹ 84.10
Rupee Outflow = 500000 x 84.10 = ₹ 42050000

(ii) USD Call Option:

Strike Price = ₹ 84.00
Premium = ₹ 0.90
Maximum Effective Rate = ₹ 84.90
Rupee Outflow = 500000 x 84.90 = ₹ 42450000
(iii) Cross Rates:
Forward EUR/INR = ₹ 84.10 ÷1.12 = ₹ 75.089
Cross Currency Hedge via EUR:
USD to Pay = 500000
EUR/USD Forward = 1.12
EUR Required = 500000 ÷ 1.12=446428.57 EUR
INR Outflow = 446428.57 x ₹ 75.089 =₹ 33521874.89
Page 10 of 13
 (iv) Recommendation if INR Expected to Depreciate to ₹ 85.50/USD
Strategy Effective INR Rate Rupee Outflow
Forward Contract ₹ 84.10 ₹ 42050000
Call Option ₹ 84.90(Maximum) ₹ 42450000
Cross Currency via EUR ₹ 33521874.89
No Hedge ₹ 85.50 ₹ 42750000

Recommendation: Globe Tech Ltd. should hedge using the EUR cross-currency route, as it results in
the lowest outflow.

7. (b)
(i) Nominal Interest Rates - Using Fisher Equation:
Average Inflation Rate - India:
Avg. Inflation= (6.3 + 6.8) / 2 = 6.55 %

Fisher Equation:
1 + Nominal rate = (1 + Real rate) x (1 + Expected inflation rate)

India:
1 + Nominal rate = (1+0.012) x (1 + 0.0655)
1 + Nominal rate = 1.0783
Nominal Rate = 0.0783 = 7.83 %

US:
1 + Nominal rate = (1 + 0.015) x (1+ 0.024)
1 + Nominal rate = 1.0394
Nominal Rate = 0.0394 = 3.94 %

(ii) Interest Rate Parity (IRP) based Forward rate:

Forward Rate = Spot Rate x (1 + r INR) / (1 + r USD)
Forward Rate = 82.50 x (1 + 0.0783) / (1 + 0.0394)
Forward Rate = ₹ 85.59 / USD

(iii) Purchase Power Parity (PPP) based Future exchange rate:

Future exchange rate = Spot Rate * (1 + inflation INR) / (1 + inflation USD)
Future exchange rate = 82.50 x (1 + 0.0655) / (1 + 0.024)
Future exchange rate = ₹ 85.84 / USD

Page 11 of 13
8. (a)
Variants of Stablecoin:
(i) Fiat - collateralized stablecoins
This type of stablecoin is linked to the sovereign legal tenders of countries. Some of the most well-
known fiat-collateralized stablecoins, for instance, include Tether and TUSD (True USD). However,
these stablecoins are not created by the central authority.

(ii) Commodity-backed stablecoins

These are backed by reserved assets other than fiat currencies - by commodities. Real estate, gold,
silver, and various other precious metals are examples of commodities. KitcoGold, for example, is
backed by the company's gold reserves, and the token itself is based on the Ethereum - backed ERC-
20 block chain ecosystem.

(iii) Crypto-backed stablecoins

This type of stablecoins is backed by any other cryptocurrency. Due to the volatile nature of
cryptocurrencies, these stablecoins must be overcompensated in order to be collateralized. For
example, to buy $ 500 worth of the crypto-backed stablecoin, Maker DAO’s Dai, one needs to deposit
$ 1000 in ETH.

(iv) Algorithmic stablecoins

These are primarily non-backed stablecoins in which prices, token numbers, and other variables are
manipulated with the help of special algorithms, software, and code in order to better manage supply
and demand.

8. (b)
Different Types of Foreign Bonds are appended as follows:
(i) Yankee Bonds:
These are US dollar denominated issues by foreign borrowers (usually foreign governments or
entities, supranational and highly rated corporate borrowers) in the US bond markets. Reliance
Industries Ltd. has been the most successful corporate to tap this instrument with a 50-year, $50
million Yankee Bond issue in 2013.

(ii) Samurai Bonds:

These are bonds issued by non-Japanese borrowers in the domestic Japanese markets. Borrowers are
supranational and have at least a minimum investment grade rating (A rated). The maturities range
between 3-20 years.

(iii) Bulldog Bonds:

These are sterling denominated foreign bonds which are raised in the UK domestic securities market.
The maturity of these bonds will be either for very short periods (5 years) or for very long maturities
(25 years and above). Bonds with intermediate maturity periods are rare. These bulldog bonds are
generally subscribed by long-term institutional investors like pension funds and life insurance
companies.

(iv) Shibosai Bonds:

These are the privately placed bonds issued in the Japanese markets. The qualifying criteria is less
stringent as compared to Samurai or Euro Yen bonds. Shibosai bonds are offered to a different market
segment that consists of institutional investors, including banks.

Page 12 of 13
8. (c)
A financial institution securitizes part of its balance sheet for three main reasons:
These are discussed below.

(i) Funding the assets that is owns

Banks can use securitization to (1) support rapid asset growth, (2) diversify their funding mix and
reduce cost of funding, and (3) reduce maturity mismatches. Banks aim to optimize their funding
between a mix of retail, interbank, and wholesale sources. Securitization is a prime component in this
mix. Securitization also helps a bank to reduce its funding costs.
(ii) Balance sheet capital management
Banks use securitization to improve balance sheet capital management. Securitization provides (1)
regulatory capital relief, in some cases (depending on the form of the transaction), (2) “economic”
capital relief, and (3) diversified sources of funding.

(iii) Risk Management and Credit risk transfer

Once assets have been securitized, the credit risk exposure on these assets for the originating bank is
reduced considerably. This is because assets have been sold to the SPV. Securitization can also be
used to remove nonperforming assets from banks’ balance sheets. This will remove credit risk as well
as potentially negative sentiment from the balance sheet apart from freeing up regulatory capital as
before.

_____________________________

Page 13 of 13