Answer to PTP_Final_Syllabus 2012_Dec2013_Set 2

Paper 14: Advance Financial Management

(Answer Question No.1 which is compulsory)

Total Allowed: 3hours Full Marks: 100

1.
a) Mr. X earns 10% on his investments in equity shares. He is considering a recently floated
scheme of a Mutual Fund where the initial expenses are 6% and annual recurring
expensed are expected to be 2%.how much the Mutual Fund scheme should earn to
provide a return of 10% to Mr. X? [3]

b) Write any three differences between the primary market and the secondary market.[3]

c) On 1st April, 3 months interest rate in the US and Germany are 6.5 percent and 4.5 percent
per annum respectively. The $/DM spot rate is 0.6560. What would be the forward rate for
DM for delivery on 30th June? [5]

d) An investor is seeking the price to pay for a security, whose standard deviation is 4.00 per
cent. The correlation coefficient for the security with the market is 0.8 and the market
standard deviation is 2.2 per cent. The return from government securities is 5.2 per cent
and from the market portfolio is 9.8 percent. The investor knows that, by calculating the
required return, he can then determine the price to pay for the security. What is the
required return on the security? [4]

e) Nile Ltd. issues 12% debentures of face value `100 each and realized `90 per debenture.
The debentures are redeemable after 12 years at a premium of 10%. Company is paying
tax at 35%.What will be the cost of debt. [2]

f) Tata Ltd. Has a target capital structure of 40% debt and 60% equity for one of its new
subsidiaries. The yield to maturity of the company‘s outstanding bonds is 9% and the tax
rate is 40%. The CFO has calculated the company‘s WACC as 9.96%. What is the
company‘s equity cost of capital? [3]

Solution:
a) Rate of return the fund should earn(r2)

1 1
= x r Recurring expenses x 0.1 0.02 = 0.1264 or 12.64%
1 Initial expenses 1 1 0.06

b) Difference between the primary market and the secondary market

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

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 Answer to PTP_Final_Syllabus 2012_Dec2013_Set 2

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.

c)
Interest Rate parity Theorem – The theorem states that in equilibrium the difference in
interest rates between two countries is equal to the difference between the forward and
spot rates of exchanges. The mathematical formula representing the theorem is given
below:
i A iB F0 S0
1 iB S0

Where,
iA = Interest rate of US 6.5% or 0.065
iB = Interest rate of Germany 4.5% or 0.045
F0 = Forward rate at the end of one year
S0 = Spot rate 1 $ = 0.6560 DM
0.065 0.045 F0 0.6560
1 0.045 0.6560
0.02 F0 0.6560
1.045 0.6560
0.02 x 0.6560 = (1.045 x F0) – (1.045 x 0.6560)
0.01312 = 1.045 F0 – 0.68552
1.045 F0 = 0.68552 + 0.01312
1.045 F0 = 0.69864
F0 = 0.69864/1.045 = 0.66855
Forward rate after 12 months = 0.66855

Forward premium p.a.

= Forward rate – Spot rate = 0.66855 – 0.6560 = 0.01255
Forward premium for 3 months = 0.01255/4 = 0.003137
Forward rate for 3 months for delivery on 30th June
= Spot rate + 3 months forward premium = 0.6560 + 0.003137 = 0.6591
Alternatively,
Particulars USD DM
Spot 0.6560 1.000
Interest rate p.a 6.5% 4.5%
Interest for 91 days 0.0106 0.0112
Amount after 91 days 0.6666 1.0112
Forward rate 0.6666 0.6592
(0.6666/0.6592) 1.0112

Alternatively,
91
0.6560 x[1 (0.065 x )]
Forward rate = 365 0.6592
91
1 (0.045 x )
365

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 Answer to PTP_Final_Syllabus 2012_Dec2013_Set 2

d)
Beta Coefficient
correlatio n coefficient between the security and the market × Std.deviation of the security return
Std.deviation of the market return
(0.8)×(0.04)
1.454
(0.022)

Now, required return on the security : Rate of return on risk free security + beta coefficient
(required return on market portfolio- rate of return on risk free security)
R = Rf + β (Rm - Rf) = 5.2+ 1.454 (9.8-5.2) =11.89%

e)

110 90
12 1 0.35
Cost of debt Kd= 12 7.8 1.67
0.0947 or 9.47%
110 90 100
2

f)
Debt =40%;
Equity; =60%
rd =9%;
Tax rate =40%;
WACC = 9.96%;
rs =?

WACC = (Wd) (rd) (1-T) + (Wce) (rs)

9.96% = (0.4) (9%) (1-0.4)+ (0.6)rs
9.96% = 2.16% +0.6 rs
7.8% = 0.6 rs
rs =13%

Section A
(Answer any two of the following)

2. On 1st April, ABC Mutual Fund issued 20 Lakh Units at `10 per unit. Relevant Initial
Expenses involved were `12 Lakhs. It invested the fund so raised in Capital Market
Instruments to build a Portfolio of `185 Lakhs. During the month of April, it disposed off
some of the instruments costing `60 Lakhs for `63 Lakhs and used the proceeds in
purchasing Securities for `56Lakhs. Fund Management Expenses for the month of April
were `8 Lakhs of which 10% was in arrears. In April, the fund earned Dividends amounting
to `2 Lakhs and it distributed 80% of the realized earnings. On 30th April, the Market ' Mi of
the Portfolio was `198 Lakhs.

Mr. Amit an Investor subscribed to 100 units on 1st April and disposed off the same at
Closing NAV on 30th April. Discuses about his Annual Rate of Earning? [12]

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Solution

Receipts ` lakhs Payment ` lakhs

To opening balance 3.00 By purchase Securities 56.00
To dividends Received 2.00 By Management expenses
To sale Proceeds of 63.00 ( 8.00 less 10% payable) 7.20
investments By earning distributed (Note)
(`5lakhs ×80%)
By closing Balance (Balancing 4.00
figure)
0.80
Total 68.00 Total 68.00

Given the total Initial Investments is `185 Lakhs, out of Issue Proceeds of `200 Lakhs. So,
the balance of `15 Lakhs is attributed towards to Initial Issue Expenses (`12 Lakhs) and
Opening Cash Balance (`3 Lakhs).

Computation of Closing NAV

Particulars `
1. Market Value of Capital Market Instruments (Given) 198.00

2. Cash in Hand (WN 1) 0.80

Total of Assets 198.80

Liabilities: Outstanding Expenses (` 8 Lakhs x 10%) 0.80

Net Asset Valued Lakhs) 198.00

No. of Units Outstanding (In Lakhs) 20.00

Net Assetsof the scheme 198.00 9.90

NAV Per unit = ` 9.90
Number of units outstanding 20.00

Computation of Annual Rate of Earning

i) Realized Dividend and Capital Gains = `4Lakhs ÷ 20lakh units =0.20

D1 CG1 (NA V1 NA V0 ) 0.20 (9.90 10.00)

ii) Return 100 100 = 1% p.m
NA V0 10.00
iii) Annual Return = Monthly Return ×12 = 1×12 = 12.00% p.a.

3.
a) Explain the responsibilities of the NBFCs accepting public deposits with regard to
submission of returns and other information to RBI.
b) Explain the function of Forward market commission of India.
[6+6=12]

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Solution:
a) The NBFCs accepting public deposits should furnish to RBI
i) Audited balance sheet of each financial year and an audited profit and loss
account in respect of that year as passed in the annual general meeting together
with a copy of the report of the Board of Directors and a copy of the report and the
notes on accounts furnished by its Auditors;
ii) Statutory Quarterly Return on deposits - NBS 1;
iii) Certificate from the Auditors that the company is in a position to repay the deposits
as and when the claims arise;
iv) Quarterly Return on prudential norms-NBS 2;
v) Quarterly Return on liquid assets-NBS 3;
vi) Annual return of critical parameters by a rejected company holding public deposits –
NBS 4
vii) Half-yearly ALM Returns by companies having public deposits of ` 20 crores and
above or asset size of ` 100 crores and above irrespective of the size of deposits
holding
viii) Monthly return on exposure to capital market by deposit taking NBFC with total assets
of ` 100 crores and above–NBS 6; and
ix) A copy of the Credit Rating obtained once a year

b) Function of Forward market commission of India are as follows:

i) To advice the Central Government in respect of the recognition or withdrawal of
recognition from any association. It also advices government about any other matter
arising out of the administration of this act.
ii) Second function of the act includes the task of keeping forward market s under
observation and take necessary actions. The actions taken should be according to
powers given to the commission by the “Forward Contract Regulation Act”.
iii) To collect information regarding the trading conditions in respect of goods (to which
any of the provisions of this Act is made applicable) including information regarding
supply, demand and prices. And publish information whenever the Commission thinks
it necessary, It also performs the task of submitting to the Central Government
periodical reports on the operation of this Act and on the working of forward markets
relating to such goods.
iv) To make recommendations generally with a view to improving the organization and
working of forward markets
v) To undertake the inspection of the accounts and other documents of [any
recognized association or registered association or any member of such association]
whenever it considers it necessary.
vi) To perform such specified duties and exercise assigned powers by the “Forward
Contract Regulation Act”.

4.
a) State the problems in the working of state cooperative Banks.
b) A mutual fund made an issue of 10, 00,000 units of `10 each on January 01, 2012. No
entry load was charged. It made the following investments:

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 Answer to PTP_Final_Syllabus 2012_Dec2013_Set 2

50,000 Equity shares of `100 each @ `160 `80,00,000

7% Government securities `8,00,000
9% Debenture (unlisted) `5,00,000
10% Debentures (listed) `5,00,000
`98,00,000
[6+6=12]
Solution:

a) The State Cooperative Banks do suffer from the following problems:-

i) Poor deposits mobilization: These banks have not been successful in raising deposits
as, even now, individual deposits from less than 25 per cent in many States.
ii) Undesirable investment of funds: These banks are not followed the guide of RBI about
the matter of investment of fund. Despite the advice of the RBI, a cautious policy is
not being followed in the matter of investment of the funds which agriculture even
now utilized for the purchase of shares in other cooperative institutions; or in making
huge advances to the primary cooperative societies; and by way of loans to
individuals.
iii) Failure to assess genuineness of borrowing: The banks have failed in assessing the
genuineness of the borrowings of the Central Cooperative Banks. This is evidenced
from the fact that the credit limits of such banks had been fixed on the basis of their
owned funds without taking into account their past performance; and the bank‟s
own financial position.
iv) Ineffective supervision and inspection: Many of the Banks have not taken up this work
in right way. Some of the banks have neither adequate nor separate staff for this
work. Officers of these banks sometimes pay only ad-hoc and hurried visits.
v) Book adjustment: Book adjustments are often made regarding repayment of loans.
The State Cooperative Banks have failed to check the fictitious transactions of the
Central cooperative Banks.
vi) Increasing over dues: The over dues of the Banks have been showing a rising trend.
This is due to the fact that these banks have not followed the prescribed loaning
procedure.
vii) They utilize their reserve funds as working capital.

b) Calculation of net cash balance at the end

`
Cash balance in the beginning (100 lakhs – 98 lakhs) 2,00,000
Dividend received 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
Less: Operating expenses 5,00,000
Net cash balance at the end 10,51,0000

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Calculation of NAV

`
Cash balance 10,51,000
7% Govt. securities (at par) 8,00,000
50,000 equity shares @ ` 175 each 87,50,000
9% Debentures (unlisted) at cost 5,00,000
10% Debentures @ 90% 4,50,000
Total assets (a) 1,15,51,000
No of units (b) 10,00,000
NAV per unit (a)/(b) ` 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 ` 10.75

Section – B
(Answer any one of the following)
5.
a) Pepsi LTD. Exports edible oils to Middle- East and African countries. In June the company
exported an consignment worth $5 million to Zambia. The payment for the same is
expected to realize during the month of September. The company has entered into an
option forward contract for delivery of $5 million over the month of September.
The market quotes on June 30 at the time of entering into the contract were as follows:

June 30, Spot ` /$ 47.05/08

Forward 1 month 23/25 paise
2 month 47/49 paise
3 month 70/72 paise
On September ‗2012, the company approached the bank for extension of the contract
by another two months that is for delivery during the month of November.

The market quotes on September ‘2012 were as follows:

Spot ` /$ 47.58/60
Forward 1 month 18/20 paise
2 month 37/39 paise
3 month 55/57 paise

On November ‗2012, the company approached the bank to cancel the forward contract.
The exchange rates as on November ‗2012 were as follows:

Spot ` /$ 47.97/99
Forward 1 month 16/18 paise
2 month 33/35 paise

You are required to calculate:

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 Answer to PTP_Final_Syllabus 2012_Dec2013_Set 2

(i) The forward arte to be quoted on June 30.

(ii) The exchange rate to be quoted by the bank on September ‘2012 for the
extension of the contract.
(iii) The amount of cash flows due to extension of the contract.
(iv) The exchange rate at which the forward contract to be cancelled on
November; 2012.
(v) The amount of cash flows due to cancellation of the contract.
(Ignore FEDAI margin for merchant quotes.)

b) Considering the following quotes

Spot (Euro/Pound) = 1.6543/1.6557
Spot (Pound/NZ$) =0.27860/0.2800
i) Calculate the % spread on the Euro/Pound Rate
ii) Calculate the % spread on the Pound/NZ$ Rate
iii) The maximum possible % spread on the cross rate between the Euro and the NZ$.

c) Can it be said that ―Derivatives are complex and exotic instruments that Indian investors
will have difficulty in understanding‖?
[10+5+5=20]
Solution:
a)

VEDIKA LTD. (V.T. LTD.)

i) The company obtained a forward cover for its receivable of US $5 million on June 30,
for delivery in September.

The Forward rate to be quoted is: `47.05

Add: 2 months premium since ` 0.47
The Dollar is at premium `47.52

ii) The exchange rate to be quoted on September for delivery November is ` (47.58 +
0.37): `47.95.
iii) On September 01, the company approach for extension by 3 month. The request of
the company is considered by canceling at one month forward selling rate, that is `
47.80 (47.60 +.20).
The amount of cash Flow due to extension of the Contract is as follows:
Bank buys Dollars under original contract at: ` 47.52
Bank sells under cancellation at : ` 47.80
Difference payable by the part is per $ ` 0.28

Amount of CASH FLOW due to extension of the contract is:

` 0.28 x 5000000 = `14.00 lakh.

iv) The Company approached for cancellation on November; 01 which means only
cancellation by one month. The contract would be cancelled at one month forward
selling rate prevailing on the date of cancellation.
That is `47.99 + premium `0.18 =`48.17

v) The amount of CASH FLOW due to cancellation of Forward Contract is as follows:

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Bank buys under original contract at `47.95

Bank Sells on cancelation: `48.17
Amount payable by the company is Per $ `0.22

Total cash flow due to cancellation is `11.00 lakhs.

(5000000 x 0.22)

1.6557 1.6543
b) (i) The % spread on Euro/Pound = x 100 = 0.085%
1.6543
0.2800 0.2786
(ii) % Spread on the pound/NZ $ = x100 = 0.50%
0.2786
(iii) The maximum possible % spread on the cross rate between Є & NZ $
To find out cross rate first
Given Spot (EURO/Pound) = 1.6543/1.6557
Spot (Pound / NZ$) = 0.2786/0.2800
Spot (Euro/NZ$) = 0.2786 x 1.6543 / 0.2800 x 1.6557
= 0.4609/0.4636

0.4636 0.4609
The maximum % spread on Euro/NZ$ = x100 = 0.59%
0.4609

c) Trading in standard derivatives such as forwards, futures and options is already prevalent
in India and has a long history. Reserve Bank of India allows forward trading in Rupee-
Dollar forward contracts, which has become a liquid market. RBI also allows Cross-
Currency options trading.
Forward Market Commission has allowed trading in Commodity Forwards on
Commodities Exchanges which are Called Futures in International markets. Commodities
futures in India are available in turmeric, black pepper, coffee, Gur (jaggery) hessian,
Castor seed oil etc. There are plans to set up commodities futures
Exchanges in soya bean oil as also in cotton. International markets have also been
allowed (dollar denominated contracts) in certain commodities. RBI also allows the users
to hedge their portfolios through derivatives exchanges abroad.
Derivatives in Commodities markets have a long history. The first commodity futures
exchange was set up in 1875 in Mumbai under the aegis of Mumbai Cotton Traders
Association (Dr. A. S. Naik 1968, Chairman, Forward Market Commission, India 1963-68).
History and existence of markets along with setting up of new markets prove that the
concept of Derivatives is not alien in India. In commodity markets there is no resistance
from the users or market participants to trade in commodity futures or foreign exchange
markets. Government of India has also been facilitating the setting up and operations of
these markets in India by providing approvals and defining appropriate regulatory
frameworks for their operations.
This amply proves that the Concept of options and futures has been well ingrained in the
Indian equities market for a longtime and is not alien as it is made out to be. Even to-day
complex strategies of options are being traded in many exchanges which are called teji-
mandi, Jotaphatak, bhav-bhav at different places in India (vohra and Bagari 1998). In

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that sense, the derivatives are not new to India and are also currently prevalent in
various markets including equities markets.

6.
a) The equity share of VCC Ltd. Is quoted at `210. A 3-month call option is available at a
premium of `6 per share and a 3-month put option is available at a premium of `5 per
share. Ascertain the net pay offs to the option holder of a call option and a put option.
i) The strike price in both cases is `220, and
ii) The share price on the exercise day is ` 200, 210, 220, 230, and 240.

Also indicate the price range at which the call and the put options may be gainfully
exercised.

b) Does interest rate parity imply that interest rates are the same in all countries? Also
explain why purchasing power parity might fail to hold.

c) An Indian exporter has sold handicrafts items to an American business house. The
exporter will be receiving US$ 1, 00,000 in 90 days. Premium for a dollar put option with a
strike price of `48 and a 90 days settlement is `1. The exporter anticipates the spot rate
after 90 days to be `46.50.
i) Should the exporter hedge its account receivable in the option market?
ii) If the exporter is anticipating the spot rate to be `47.50 or `48.50 after 90 days,
how would it effect the exporter‘s decision?
[10+5+5=20]

Solution:

a)

Net pay-off for the holder of the call option (Rs.)

Strike price on exercise day 200 210 220 230 240
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 220 220
Outflow (premium) 6 6 6 6 6
Total outflow 6 6 6 226 226
Less: Inflow (sales proceeds) -- -- -- 230 240
Net pay off -6 -6 -6 4 14

Net pay-off for the holder of the put option (Rs.)

Strike price on exercise day 200 210 220 230 240
Option exercise Yes Yes No No No
Inflow (Strike price) 220 220 Nil Nil Nil
Less: Outflow (purchase price) 200 210 -- -- --
Less: Outflow (premium) 5 5 5 5 5
Net pay off 15 5 -5 -5 -5

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Analysis – The loss of the option holder is restricted to the amount of premium paid. The
profit (positive pay off) depends on the difference between the strike price and the
share price on the exercise day.

b) No, interest rate parity implies that an investment in the U.S. with the same risk as a similar
investment in a foreign country should have the same return. Interest rate parity is
expressed as:

Forward Rate 1 (InterestRate in Home Country)

Spot Rate 1 (InterestRate in Foriegn Country)
Interest rate parity shows why a particular currency might be at a forward premium or
discount. A currency is at a forward premium whenever domestic interest rates are
higher than foreign interest rates. Discounts prevail if domestic interest rates are lower
than foreign interest rates. If these conditions do not hold, then arbitrage will soon force
interest rates back to parity.
Purchasing power parity assumes there are neither transaction costs nor regulations
which limit the ability to buy and sell goods across different countries. In many cases,
these assumptions are incorrect which explains why PPP is often violated. An additional
complication, when empirically testing to see weather PPP holds, is that products in
different countries are rarely identical. Frequently, there are real or perceived differences
in quantity, which can lead to price difference in different countries.

c) The Indian exporter will be buying a put option on the US $ to hedge against
depreciation in the US $.
For Settlement price of Rs.46.50/US $
Option PUT
Strike Rs.48/US $
Premium 1/US $
Settlement (Expiration) Rate 46.50

Benefit from put option:

= Max [(Strike rate – Expiration rate), 0] – Premium.
= Max [Rs.48/US $ - Rs.46.50/US $), 0] – re1/US $ = Rs.0.50/US $
As there is benefit in owning the put, so the exporter should hedge using the put option.
Here, if exporter remains unhedged, it will receive Rs.4650000[Rs.46.50/US $ X US $
100000]. But with hedging, using put option, the exporter receives at the end 90 days.
Rs.4700000 [Rs.48/US $ X US $ 100000 – Re.1/US $×US 100000]
For settlement price of Rs.47.50/US $:
Benefit from put option = Max [(Rs.48/US $ - Rs.47.50/US $), 0] – Re1/US $ = (Rs.50/US $)
(Negative)
For settlement price of Rs.48.50/US $:
Benefit from Put option = Max [(Rs.48/US $ - Rs.48.50/US $ 0] – Re 1/US $
= 0 – Re 1/US $ = (Re 1/US $) (Negative).
So, for anticipated of Rs. 47.50/US $ or Rs.48.50/US $, the exporter will not be hedging
through a put option as that does not have positive benefit.

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Section C
(Answer any one of the following)
7. Ms Mitrika an analyst at Ashika Securities Ltd. is considering the stocks of Spark Ltd. And
Global Ltd. For investment. Expected returns on these stocks depend on the growth rate
GDP. The conditional returns of the market and the stocks are given below:

Economic Scenario Probability Return on (%) Return on

GDP growth rate market %
Spark Ltd. Global Ltd.
1.0 - 3.0% 0.18 15 9 7
3.00 - 6.00% 0.24 25 14 11
6.00 – 8.00% 0.26 38 27 18
More than 8.00% 0.32 46 33 25

The expected risk-free return is 6.5%

Assume that CAPM holds good in the market
You are required to
i) Calculate the ex-ante-betas for the two stocks.
ii) Find out whether the stocks of Sparks Ltd. And Global Ltd. Are underpriced or
overpriced.
iii) Calculate the proportion of systematic risk and unsystematic risk for both the
companies.
iv) Determine which stock the analyst would suggest to invest. [16]

Solution:
i) Expected return on stock and variance of spark Ltd.
E (Rs.) = 0.18 x 15 + 0.24 x 25 + 0.26 x 38 + 0.32 x 46 = 33.3%

σ2s (Variance): 0.18 x (15 – 33.3)2 + 0.24 x (25 – 33.3)2

0.26 x (38 – 33.3)2 + 0.32 x (46 – 33.)2
= 60.28 + 16.53 + 5.74 + 51.62 = 134.17%

Expected return on stock and Variance of Global Ltd:

E (RG) = 0.18 x 9 + 0.24 x 14 + 0.26 x 27 + 0.32 x 33 = 22.56%
σ2G (Variance) : 0.18 x (9 – 22.56)2 + 0.24 x (14 – 22.56)2 + 0.26 x (27 – 22.56)2 + 0.32 x
(33 – 22.56)2
= 33.10 + 17.58 + 5.13 + 34.88 = 90.69%

Expected return and variance on Market:

E (RM) = 0.18 x 7 + 0.24 x 11 + 0.26 x 18 + 0.32 x 25= 16.58%

σ2m (Variance): 0.18 x (7 – 16.58)2 + 0.24 x (11 – 16.58)2 + 0.26 x (18 – 16.58)2 + 0.32 x
(25 – 16.58)2= 47.20%

COVSM = 0.18 (15 – 33.3) (7 - 16.58) + 0.24 x (25 – 33.3) (11 – 16.58) + 0.26 (38 – 33.3)
(18 – 16.58) + 0.32 (46 – 33.3) (25 – 16.58)= 78.63%

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CovGM = 0.18 (9 – 22.56) (7 – 16.58) + 0.24 (14 – 22.5) (11 – 16.58) + 0.26 (27 – 22.56)
(18 – 16.58) + 0.32 (33 – 22.56) (25 – 16.58) = 64.61%
Betas:
ß S = COVSM / σ2M = 78.63 / 47.20 = 1.67
ß S = COVSM / σ2M = 64.61 / 47.20 = 1.37

ii) Normal return = Rf + ß (Rm – Rf)

Spark Ltd. : 6.5 + 1.67 (16.58 – 6.5) = 23.33%
Alpha / Excess return = 33.3 – 23.33 = 9.97%
Global Ltd.: 6.5 + 1.37 (16.58 – 6.50) = 20.31%
Excess return / Alpha = 22.56 – 20.31 = 2.25%
The alpha i.e., excess return of both the companies is positive. Hence the stock of
Spark Ltd and Global Ltd is under priced.

iii) Systematic Risk = ß2 x σ2M

Unsystematic Risk = Total Risk – Systematic Risk
Spark Ltd:
Systematic Risk = (1.67)2 x 47.20 = 131.64%
Unsystematic Risk = 134.17 – 131.64 = 2.53%
Proportion of Systematic Risk = (131.64/134.17) x 100 = 98.11%
Proportion of Unsystematic Risk = (2.53/134.17) = 1.89%
Global Ltd:
Systematic Risk = (1.37)2 x 47.20 = 88.59%
Unsystematic Risk = 90.69 – 88.59 = 2.10%
Proportion of Systematic Risk = 88.59/90.69 = 97.68%
Proportion of Unsystematic Risk = 2.10/90.69 = 2.32%

iv) Spark Ltd:

Excess return / stander deviation:
= 9.97/ 134.17 = 9.97/11.58 = 0.86

Global Ltd:
Excess return / stander deviation:
= 2.25 / 90.69 = 2.25/9.52 = 0.24
As the excess return / Alpha to Standard deviation is higher for the stock of Spark Ltd.,
the analyst should suggest to invest on the stock of Spark Ltd.

8.
a) Compute Return under CAPM and the Average Return of the Portfolio from the following
information:
Investment Initial Dividends Market Price at the end of the Beta Risk
Price year Factor
A. Cement Ltd 25 2 50 0.80
Steel Ltd 35 2 60 0.70
Liquor Ltd 45 2 135 0.50
B. govt. of 1,000 140 1005 0.99
Indian Bonds
Risk Free Return=14%.

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b) X Ltd has an expected return of 22% and standard deviation of 40%. B Ltd. has an
expected return of 24% and standard deviation of 38%. A Ltd. Has a beta of 0.86 and b
Ltd. A beta of 1.24.the correlation coefficient between the return of A Ltd. And B Ltd. Is
0.72. The standard deviation of the market return is 20%. Suggest:
i) Is investing in B Ltd. Better than investing in A Ltd.?
ii) If you invest 30% in B Ltd. And 70% in A Ltd., what is your expected rate of return
and portfolio standard deviation?
iii) What is the market portfolios expected rate of return and how much is the risk-
free rate?
iv) What is the beta of portfolio if A Ltd.‘s weight is 70% and B Ltd.‘s weight is 30%?
[8+8=16]
Solution:
a)
1. Computation of Expected Return and Average Return

Securities Cost Dividend Capital Gain Expected Return=Rf+β(Rm – Rf)

Cement Limited 25 2 (50-25)=25 [14+0.80×(26.33-14)]=23.86%
Steel Limited 35 2 (60-35)=25 [14+0.70×(26.33-14)]=22.63%
Liquor Limited 45 2 (135-45)=90 [14+0.50×(26.33-14)]=20.17%
GOI Bonds 1,000 140 (1,005-1,000)=5 [14+0.90×(26.33-14)]=26.21%
Total 1,105 146 145

Notes:
Return on Market Portfolio: Expected Return on Market Portfolio (Rm)

Dividends Capital Gains 146 145

26.33%
Cost of the total Investment 1,105 100

Note: in the absence of return of a market Portfolio, it is assumed that portfolio

containing one unit of the four securities listed above would result in a completely
diversified portfolio, and therefore represent the Market Portfolio.
2. Portfolio‘s Expected Return based on CAPM:
i) If the portfolio contains the above securities in equal proportion in terms of value-
Expected Return = (23.86%+22.63% +20.17%+26.21%) ÷ 4 = 23.22%

ii) If the Portfolio contains one unit of the above securities, then-
Securities Cost Expected Return Product
Cement Limited 25 23.86% 25×23.86 = 596.25
Steel Limited 35 22.63% 35×22.63 = 792.05
Liquor Limited 45 20.17 45×20.17 = 907.65
GOI Bonds 1,000 26.21 1,000×26.21 = 26,210
Total 1,105 28,505.95
Weighted Return 28,505.95 = 25.79%
1,105
Therefore, Expected Return from Portfolio (based on CAPM) = 25.79%

b)
i) Expected return of B Ltd. is 24% as compared to 22% of A Ltd.
Standard deviation of B Ltd. is 24% as compared to 40% of A Ltd.

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 Answer to PTP_Final_Syllabus 2012_Dec2013_Set 2

In view of the above, A Ltd. has lower return and carried higher risk as compared to B
Ltd. Hence, investing in B Ltd. is better than investing in A Ltd. but investing in both A
Ltd. and B Ltd. will cause to yield the advantage due to diversification of portfolio.

ii) RAB = (0.22 x 0.7) + (0.24 x 0.3) = 22.6%

σAB = (0.402 x 0.72) + (0.382 + 0.32) + (2 x 0.7 x0.3 x 0.72 x 0.40 x 0.38)
= (0.16 x 0.49) + (0.1444 x 0.09) + 0.0459648 = 0.078 + 0.0112996 + 0.0459648
= 0.1374

σAB = 2
σAB = 0.1374 =0.37 or 37%

iii) The risk-free rate will be the same for A and B Ltd. Their rates of return are given as
follows:

RA = 22 = Rt + (Rm – Rt) 0.86

RB = 24 = Rt + (Rm – Rt) 1.24
RA – RB = -2 = (Rm – Rt) (-0.38) Rm – Rt = -2/-0.38 = 5.26%
RA = 22 = Rt + (5.6) 0.86 Rt = 17.5%
RB = 24 = Rt + (5.26) 1.24 Rt = 17.5%
Rm – 17.5 = 5.26 Rm = 22.76%

iv) βAB = (βA x WA) + (βB x WB) = (0.86 x 0.7) + (1.24 x 0.3) = 0.974

Section D
(Answer any one of the following)
9.
a) The following information has been extracted from the Balance Sheet of ABC Ltd.as on
31st
December—
Component of Equity Share 12% Debentures 18%Term Loan Total
capital
Amount Rs. In 400 400 1200 2000
Lakhs

i) Determine the WACC of the Company. It had been paying dividends at a

consistent rate of 20% per annum.
ii) What difference will it make if the current price of the Rs.100 share is Rs.160?
iii) Determine the effect of Income Tax on WACC under both the above
situations.(Tax Rate = 40%).

b) ―The concept of capital Budgeting arises in scenarios of uncertainty in cash flows‖

Explain it.
[15+5=20]
Solution:
a)
1. Computation of WACC (based on Book Value Proportions and ignoring Tax)

Component(a) Proportion(b) Indivitual Cost (c) Wacc (d) = (b) × (c)

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Equity Share Capital 4/20 Ke=20% (Dividend Approach) 4.00%

12% Debentures 4/20 Kd= 12% 2.40%
18% Term Loan 12/20 Kd= 18% 10.80%
WACC = Ko = 17.20%
Note: i) Ke = Dividend per Share Equa Market Price per share = `20.
ii) Book Value Proportions have been considered in Column (b) above.

2. (a) Computation of WACC (based on Book Value Proportions and ignoring tax)
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Share Capital 4/20 Ke = 20÷160 = 12.50% 3.57%
12% Debentures 4/20 Kd = 12% 2.40%
18% Term Loan 12/20 Kd = 18% 10.80%
Total ` 2,240 Lakhs WACC = K0 = 15.70%

(b) Computation of WACC (based on Market Value Proportions and ignoring tax)
Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b) ×(c)
Equity Capital ` 640 Lakhs 64/224 Ke=20÷160=12.50% 3.57%
12% Debentures ` 400 Lakhs 40/224 Kd = 12% 2.14%
18% Term Loan ` 1,200 Lakhs 120/224 Kd = 18% 9.64%
Total ` 2,240 Lakhs WACC = K0 = 15.35%
3. Effect of Tax Rate of 35% on WACC
(a) Computation of WACC with tax (Situation 1 above based on Book Value
Proportions)
Component (a) Proportion (b) Individual Cost (c) WACC (d)=(b)×(c)
Equity Share Capital 4/20 Ke = 20% 4.00%
12% Debentures 4/20 Kd = 12%×60% = 7.20% 1.44%
18% Term Loan 12/20 Kd = 18%×60% = 10.80% 6.48%
WACC = K0 = 11.92%
The WACC has reduced from 17.20% to 11.92%, due to tax saving effect.
(b) Computation of WACC with tax (Situation 2 (a) above based on Book Value
Proportions)
Component (a) Proportion (b) Individual Cost (c) WACC (d)=(b)×(c)
Equity Share Capital 4/20 Ke = 20 ÷160 = 12.50% 2.50%
12% Debentures 4/20 Kd = 12%×60% = 7.20% 1.44%

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18% Term Loan 12/20 Kd = 18%×60% = 10.80% 6.48%

WACC = K0 = 10.42%3
The WACC has reduced from 15.70% to 10.42, due to tax saving effect.

(c) Computation of WACC with tax (Situation 2(b) above based on Book Value
Proportions

Component (a) Proportion (b) Individual Cost (c) WACC (d) = (b)×(c)
Equity Capital ` 640 Lakhs 64/224 Ke = 20÷160 = 12.50% 3.57%
12% Debentures ` 400 Lakhs 40/224 Kd = 12%×60% = 7.20% 1.29%
18% Term Loan ` 1,200 Lakhs 120/224 Kd = 18%×60% = 10.80% 5.780%
Total ` 2,240 Lakhs WACC = K0 = 10.64%
The WACC has reduced from 15.35% to 10.64%, due to tax saving effect.

b) Option is right to do an activity, which does not carry any obligation to do the
same. Options in Capital Budgeting refers to those rights or choices purchased,
whereby, the Firm can choose whether or not to exercise the option depending
upon the outcomes till that point.
Value of Option = NPV with Option Less NPV without Option
[Note: Generally, the price ot the option would be available, and the requirement would
be to ascertain the project worth by considering the value of option as an alternative
cash flow.]
Circumstances

i) The concept of Options in Capital Budgeting arises in scenarios of uncertainty in cash

flows. Since Capital Budgeting involves huge capital outlay and generally the
decision is not reversible, negative effect of uncertainty can cripple an organisation.

ii) Generally, the viability or otherwise of a project will be known only after a certain
point in time. Only at that time a clearer picture will emerge, putting at rest to major
portion of uncertainty. However, waiting for that clearer picture may also result in
losing an opportunity.

Examples:

1. Option to Expand: An important option is to expand production if conditions turn

favourable and to contract production if conditions turn bad. The former is
sometimes called a growth option, and the latter may actually involve the shutdown
of production.

2. Option to Abandon: If a project has abandonment value, selling off the project on
“as is where is” basis. This represents a put option (i.e. right to sell). Example: A Flat
Promoter may dispose of his unfinished building to an Industrial House or another Flat
Promoter, instead of proceeding further to sell it as individual units.

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3. Option to Postpone: The option to postpone, also known as an investment timing

option. For some projects there is the option to wait, thereby obtaining new
information.

10.
a) Red Ltd is considering a project with the following cash Flows (in `)

Years Cost of Plant Recurring Cost Savings

0 10,000
1 4,000 12,000
2 5,000 14,000

The Cost of Capital is 9%. Measure the Sensitivity of the project to changes in the Levels of
plant Value, Running Cost and Savings (considering each factor at a time) such that NPV
becomes Zero. The P.V. Factor at 9% are as under:

Year 0 1 2
Factor 1 0.917 0.842

Which factor is the most sensitive to affect the acceptability of the project?

b) Write short note any two

i) Various types of Margins
ii) Rolling Settlement
iii) Global financial System (GFS)
[10+5+5=20]
Solution:
a)
1. Computation of Existing NPV:
S.N. Particulars Cash Flows Year PVF @ 9% Disc. CF
1. Net Savings (Recurring Cost –Savings)
(a) Year 1 8,000 1 0.917 7,336
(b) Year 2 9,000 2 0.842 7,578
2. PV of Inflows 14,914
3. Less: cost of Plant (10,000)
4. Net present Value 4,914
(NPV)

2. Sensitivity of cost of Plant

Particulars Amount (Rs.)
(a) Target Cost of Plant (for NPV = 0) 14,914
(b) Existing Cost 10,000
(c) Change = (a) – (b) 4,914
(d) Sensitivity = (c) ÷ (b) 49.14%

3. Sensitivity of Recurring cost

Particulars Amount (Rs.)
(a) Existing Present Value of Recurring Cost = (4,000 x 0.917) + (5,000 7,878
x 0.842)
(b) Target Recurring Cost = 7,878 + 4,914 12,792

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(c) Change = (a) – (b) 4,914

(d) Sensitivity = (c) ÷ (a) 62.38%

4. Sensitivity of Savings
Particulars Amount (Rs.)
(a) Existing PV of Savings = (12,000 x 0.917) + (14,000 x 0.842) 22,792
(b) Target Savings = (a) – 4,914 17878
(c) Change = (a) – (b) 4,914
(d) Sensitivity = (c) ÷ (a) 21.56%
Conclusion: Hence NPV is most sensitivity to Changes in Savings.

b)
i) Various types of Margins:
Margins (normally in form of cash or T-Bills) are amounts to be maintained by the
Members of the Stock Exchange with the Clearing House. Margins can be
categorized into the following types-
i) Initial Margins on Securities: It is paid by purchasers and short sellers, and generally
functions as a security for loan. It is similar to a down payment required for the
purchase of a security.
ii) Initial Margins on Derivatives: It refers to funds paid as guarantee to ensure that
the party to the transaction will perform its obligation under the contract. Initial
Margin on Derivatives is aimed to cover future changes that may occur in the
value.
iii) Maintenance Margins: It refers to the value over and above the Initial Margin,
which must be maintained in a margin account at all times after the initial margin
requirement, if any, is satisfied.
iv) Variation Margin: It refers to funds that are required to be deposited in, or paid
out of, a margin account that reflects changes in the value of the relevant
instrument.

ii) Rolling Settlement :

A. Settlement: settlement refers to the process in which traders who have made
purchases make payments while those who have sold shares, deliver them. The
stock exchange ensures that Buyers receive their shares and the Sellers receive
payment for the same. The process of settlement is managed by Stock
Exchanges through Clearing House/ Clearing Corporations.
B. Rolling Settlement: A Rolling Settlement is the settlement cycle of the Stock
Exchange, where all trades outstanding at the end of the day have to be settled,
i.e. the buyer has to make payments for securities purchased and seller has to
deliver the securities sold.
C. T+X Days: Settlement is generally specified as „T+X‟ day/s where X= number of
business days from the date of the transactions. In case of T+ 1 Settlement,
transactions entered on a day should be settled within the next working day. In
case of T+2 Settlement; settlement should be made within 2 working days from
the date of transaction.
D. Advantages:
i) Liquidity: investors benefit from the increased liquidity because of payout. i.e.
settlement of money for sale of stocks made by Investors is quicker than in
weekly settlements.
ii) Separation of Cash and Forward Markets: the Rolling Settlement System helps
to keep cash and forward market separate.

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iii) Safety: In case of Rolling Settlements, there is a higher degree of safety

because the settlement is made on a day-to-day basis, and hence
fluctuations can be taken care of (favourable as well as adverse.)
iv) Electronic Trading: Rolling Settlement requires electronic transfers of funds and
demats facilities in respect of securities being traded. This avoids paperwork
and related risks (bad deliveries, forged documents, etc)

iii) Global financial System (GFS):

A brief definition of the global financial system (GFS) is the financial system consisting
of institutions, their customers, and financial regulators that act on a global level.
The term global is often used synonymously with the terms “international” or
“multinational”. Economists do not have a standard definition for a global versus a
multinational company.
Main Players
1. Global or international systemically important financial institutions, e.g., banks,
hedge funds whose failure may cause a global financial crisis, the International
Monetary Fund and the Bank for International Settlements,

2. Customers of the global financial system, which include multinational

corporations, as well as countries, with their economies and government entities, e.g.,
the central banks of the G20 major economies, finance ministries EU, NAFTA, OPEC,
and others.etc.

3. Regulators of the global financial system, many of which play dual roles, in that
they are financial organizations at the same time. These include the above
mentioned International Monetary Fund and Bank for International Settlements,
particularly its “Global Economy Meeting (GEM), in which all systemic emerging
economies‟ Central Bank governors are fully participating, has become the prime
group for global governance among central banks” per Jean-Claude Trichet,
President of the European Central Bank., as well as the financial regulators of the
U.S.A (the US agency quintet of Federal Reserve, Office of Comptroller of the
Currency, Federal Deposit Insurance Corporation, Commodity Futures Trading
Commission, Federal Reserve Board, Securities and Exchange Commission), Europe
(European Central Bank) and the Bank of China, besides others.

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