Institute of Bankers of Sri Lanka

(Established and managed by a Governing Board representing the Central Bank of Sri Lanka, Licensed Banks,
Fellows and Associates under the Institute of Bankers of Sri Lanka (Incorporation) Act No.26 of 1979)

Diploma in Applied Banking & Finance

(DABF)
October 2022 Examination

D 07 Investment Banking

Question Paper & Suggested Answers

These suggested answers have been compiled by the College of Banking and Finance,
Institute of Bankers of Sri Lanka with the assistance of its resource panel.

Institute of Bankers of Sri Lanka

80A, Elvitigala Mawatha, Colombo 08.
TP : +94112425777
Web : www.ibsl.lk
 Institute of Bankers of Sri Lanka
Diploma in Applied Banking and Finance (DABF)
D 07 - Investment Banking
Examination – October 2022

Suggested Answers

1.
(A)
(i) (d) Depositors
(ii) (d) Issue bonds at a higher yield
(iii) (d) Issue of Bonus shares
(iv) (a) When the company’s earnings are negative.
(v) (a) Risk Free Rate
(vi) (d) Qualifications of the management
(vii) (c) Sri Lankan market is undervalued compared to India
(viii) (b) Bond B
(B)
(ix)
1. Discounted Cash flow method
2. Dividend Discount Method
(x)
1. Cash offer
2. Share offer
3. Mixed offer

2.
(i) Horizontal Merger

This is where a company mergers with another company who is in the similar line
of business such as competitors.
One motive behind such merger is to increase the market share.
Another would be to eliminate or curtail the competition for higher profit margins
 Vertical Merger

A vertical merger happens when a company acquires another company that isn't a
direct competitor but could be within the same supply chain.
Main reason for such merger is to unlock synergies such as economies of scale
Another reason could be for diversification.

(ii)
1. Discounted cash flow Method
This method forecasts future expected cash flows of a company and uses a
discount rate to arrive at the present value of the company.

2. Comparable Company analysis

If future cash flows don’t give a meaningful value to a company due to the
behavior of the future cash flows, a comparable company to the target
company can be used to value the target company.

3. Comparable transaction method

In the event where both above methods cannot be adopted, investment
bankers look at similar transaction happened in the past to arrive at an
approximate value and use that as the basis for the valuation of the
company.
(iii)
(a) Staggered board
Companies need board approvals to accept a potential merger or an
acquisition. When board members are elected on annual basis, a staggered
board is elected. This hinders the process of all board of directors being
replaced with new directors who will support a hostile merger or an
acquisition.
(b) Poison pill
As the name indicates, a poison pill is analogous to something that's
difficult to swallow or accept. A company targeted for an unwanted
takeover may use a poison pill to make its shares unfavorable to the
acquiring firm or individual. Poison pills also significantly raise the cost of
acquisitions and create big disincentives to deter such attempts completely

(c) Super Majority Voting rights

A supermajority is an amendment to a company's corporate charter that
requires a large majority of shareholders (generally 67% to 90%) to
approve important changes like mergers and acquisitions.

2
 (iv)
 To extend the market share
 To exploit market imperfections
 Technology transfers
 Product differentiation
 Achieve economies of scale
 Diversification of risks
 Access to new talents
 Economies of scope

3.
(i)
 Illiquidity of investments: Since private equity investments are not traded
on any securities market, we may not be able to exit investments on a timely
basis.
 Unquoted investments: Investing in unquoted securities is risky compared
to investing in securities quoted on a regulated securities exchange due to
less regulation to safeguard investors.
 Competition for attractive investment opportunities: Competition for
finding investment opportunities on attractive terms may be high.
 Reliance on the management of investee companies (agency risk): There
is no assurance that the management of the investee companies will run the
company in the best interests of the private equity firm. This is a concern in
earlier stage deals in which the management may retain a controlling stake
in the company and enjoy certain private benefits of control.
 Loss of capital: High business and financial risks may result in substantial
loss of capital.
 Government regulations: Investee companies’ product and services may
be subject to changes in government regulations that adversely impact their
business model.
 Taxation risk: Tax treatment of capital gains, dividends, or limited
partnerships may change over time.
 Valuation of investments: Valuation of private equity investments is
subject to significant judgment and therefore may be subject to biases.
 Lack of investment capital: Investee companies may require additional
future financing which may not be available.
 Lack of diversification: Investment portfolios may be highly concentrated
and may, therefore, be exposed to significant losses.
 Market risk: Changes in general market conditions (interest rates, currency
exchange rates) may adversely affect private equity investments.

3
(ii)
 Initial Public Offering (IPO) - refers to the process of offering shares of
the private equity firm to the public in a new stock issuance. Highest exit
value relative to other methods. Used when company has strong growth
prospects, operating history and size.
 Secondary Market - Sale to other financial investors or strategic investors.
The advantages are o Highest value in absence of an IPO o Bring portfolio
companies to next level by restructuring, merger, new market etc. and sell
them to a strategic investor or to other PE firm.
 Management Buyout - Firm is sold to the management. Best alignment of
interest, however if significant leverage is used it can reduce the company’s
flexibility.
 Liquidation - Sale of firm’s assets. This option is used if the company is
no longer viable

(iii) Equity capital is more expensive over time than debt capital

 There is tax advantage available raising debt capital than equity capital
 Debt capital does not dilute the ownership of the company
 Debt capital is a way of increasing the return on equity
 Raising equity is more expensive than raising debt
 Debt capital does not have any rights to future profits of the company once
debt is matured and paid.

(iv)
 Initial Public Offering (IPO)
This is the process of offering shares of a private corporation to the public
in a new share issue.
Drawback – this is expensive way of raising capital to a company. Process
is costly as well as cost of equity is higher than debt

 Right Issue
This is the process of issuing rights to existing shareholders to purchase
additional shares of the company at a discount.
Drawback – Existing shareholding percentage may get diluted. This is
because right can be sold in the secondary market to new shareholders

 Private Placement
This is another way of raising equity capital where a company listed or
unlisted issuing new shares to a strategic investor.
Drawback – liquidity risk and higher investment risk

4
4.
(i) Advantages

1. Easy to use. CAPM is an easy to use formula which can be stress tested to
derive range of possible outcomes.
2. It uses the assumption of diversified portfolio which is similar to the market
portfolio
3. CAPM takes in to account systematic risk which is left out in the other
models
4. Business and Financial Risk Variability. When businesses investigate
opportunities, if the business mix and financing differ from the current
business, then other required return calculations, like the weighted average
cost of capital (WACC), cannot be used. However, the CAPM can.
Disadvantages
1. It is assumed the risk free rate is the yield of short term government security
rate which changes constantly
2. Assessing some of the parameters is subjective, such as beta value.
3. It assumes borrowing can be done at the risk free rate is not realistic in the
real world.
4. When using market return, long term market return is used to smoothen out
any short term negative returns. This is more of a backward looking which
does not represent the future.

(ii) Relative Valuation Approach

This is the process used to evaluate the value of a company using the metrics of
other businesses of similar size in the same industry.
Methods used
 Price to earnings per share (P/E)
 Price to Book Value (P/B)
 Price to Sale (P/S)
 Price to Free Cash flow
 Comparable transaction method

Absolute Valuation Approach

An absolute value is a business valuation method that uses discounted cash flow
(DCF) analysis to determine a company's financial worth.

5
 Methods Used
 Dividend Discounted Method
 Discounted Cash flow Method
 Discounted Residual Income Models
 Discounted Asset Models

(iii)
(a) CAPM = Risk Free Rate + equity Beta (Expected Market Return - Risk Free Rate)

20.00% + 1.2 (25.00% - 20.00%) = 26.00%

(b)
WACC = Equity * Cost of Equity + Debt *(cost of Debt*(1-Tax)
Equity + Debt Equity + Debt

[1000/1500 * (26.00%)] + [500/1500 * {18.00 % * (1-36%) = 21.17%

(iv) Gordon Growth Model

Value of a stock = value of the next year dividend = (current year dividend * expected Growth rate)
Cost of equity – expected growth rate

5*(1+.04)/ (.15-.04) = Rs.47.27

5.
(i) This is where a trader takes the best offer or bid in the market to move the market
price in that direction, then sells at a higher price (if prices is pushed up) or buys at
the lower price (if price is pushed down)

(ii) A legitimate order is placed on one side of the market (a buy or sell order) and
multiple illegitimate orders ate placed on the opposite side to lure participants to
trade in favour of the real order.

(iii) Trader buys and sells security at the same time to generate volume and thus
stimulate interest and demand in that security and then buy or sell the security

(iv) Multiple traders get together to manipulate the market in their favor. Traders can
combine their trading volumes and place trades to increase the price of the security
they own or decrease the price of the security they want to buy

6
6.
(i)
* Scope and Purpose
Establishing and building the context regarding investor wealth and define
the investor based on the ability and willingness take risk and define the
responsibilities of the fund manager and risk management structure of the
investment program

* Governance
This defines the responsibilities in carrying out the investment policy
statement, reporting and asset allocation pertaining to the investment
program

* Investment, Return and risk objectives

Defines and states the Risk, return and objective of the investment program
and describes the relevant constraints that affect the investment program

* Risk Management
Evaluates risks via suitable metrics and measure risks. Describes portfolio
rebalancing and asset allocation.

(ii)
* Time constraints
States the duration of the program
* Liquidity constraints
Records any cash outflow requirements during the investment program
* Legal and regulatory constraints
* Tax constraints
* Unique circumstances

(iii) Active fund management is focused on outperforming a predefined benchmark

when managing a portfolio.

Benefits of active fund management are

* Theoretically it aims for higher return over a benchmark. It allows the fund
manager to enhance returns using portfolio management skills

* It gives freedom in stock selection process.

Passive fund management focuses on replicating the investment portfolio to a

comparable benchmark.

7
 Benefits of such method are

 Passive fund management is tax efficient

 It is cost effective since there are lesser number of transactions
 Risk is well diversified
(iv)
* Liquidity

Mr. Jayatissa has two short term liquidity requirements; one is for his
daughter’s wedding and the other is for his son’s university education which
will happen in 2 years.

* Time horizon

Mr Jayatissa’s investment horizon can be identified as short term and long

term. He has two short term investment horizons, one year and two years
and a long term of 15 years at the time of his retirement.

* Unique circumstances

Mr. Jayatissa considers himself as an ethical investor and does not want any
investments to be made in tobacco and alcohol related industry.

7.
(i) The most important aspect of Mr. Sarath’s requirement is his liquidity requirement.
He has first liquidity requirement coming up in 3 years. Therefore, needs to align
part of the investment to generate liquidity in 3 years. Further, capital has to be
preserved so when investment is liquidated, he will have sufficient money to fund
his son’s university education.
Other liquidity requirement will come in 6 years where he will require another 12
million for his younger son. For that, he can consider longer term investments with
higher returns. Considering his current financial position and his willingness to take
above average risk, he is recommended following instruments to achieve his
objectives
Invest 5mn in corporate debt instruments which generate 14% annual return.
This will be able to fund most of his 3 year requirement which is Rs. 8 Mn.
His monthly contributions can be invested in equity market since his ability and the
willingness to take higher risk and the time available for his liquidity requirement,
which will fall in 7 years. This will give sufficient time for his investment to grow

8
 (ii) Based on the given information, after considering Ms. Selvaraja’s risk taking ability
and willingness for the same, is considered, she doesn’t have the ability or the
willingness (considering her current investments) take up higher risks. Further,
given her regular liquidity requirement after 5 years, following is recommended for
her investment portfolio.
Part of her money to be invested in 10 years Treasury bonds which will generate
interim cash flows and rest to be invested in money market deposit for regular cash
flow requirements.

(iii) Given the information, ability to take risk and willingness to take risk is high for
the pension fund. And liquidity requirement of the fund is minimal during the first
10 years. Therefore, fund is in a position to adopt a portfolio with higher return and
relatively higher risk. A combination of equity and high yield corporate debt
instrument portfolio is most suited which will help to grow the fund at a higher rate
assuming relatively high risk levels.

(iv) The most important factor to consider in the above scenario is the requirement for
regular cash flow. Mr. Saparamadhu has invested in government Treasury bonds,
even though considered risk free, only generates cash flows in every six months
and at maturity. However, it can be assumed his requirement does not meet through
this. Therefore, it can be recommended that Money Market deposit and T/Bill
investments (3 months) are best suited assets for Mr. Saparamadhu’s investment
portfolio.

8.
(i) Holding Period Return (HPR) = Selling Price- cost+ dividend received
Cost
HPR = 120-100+2 = 22%
100

(ii)
Amount invested in LKR = 8,000,000.00
T/bill Rate = 30.00%
Return at the end of 1 year in LKR = 10,400,000.00
Forward rate = 1 INR = LKR 10
Maturity value in INR = 1,040,000.00
Investment Return = (1,040,000/1,000,000)-1 = 4.00%
Borrowing cost = 1.00%
Net return = 4.00%-1.00%
= 3.00%

9
(iii)
1. Intra Day limit
2. Open position limit
3. Stop loss limit
4. Take profit limit
5. Value at Risk limit (VaR limits)
6. Trading desk limit

(iv)
Current market price = Rs. 250.00

Right price = Rs.200.00

Ex-right Price = ((250*4) + (1*200))/5 = Rs.240.00

**********

10