Suggested Answer_Syl12_DEC2014_Paper_14

FINAL EXAMINATION
GROUP III
(SYLLABUS 2012)

SUGGESTED ANSWERS TO QUESTIONS

DECEMBER 2014
Paper- 14 : ADVANCED FINANCIAL MANAGEMENT
Time Allowed : 3 Hours

Full Marks : 100

The figures in the margin on the right side indicate full marks.
This paper contains 5 question. 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 stated.
1.

All questions are compulsory:

2 10 = 20

(a) Mention any three economic functions of Financial markets

(b) Following information is available regarding a mutual fund:

Return

13

Risk ()

16

Beta ()

0.90

Risk free rate

10

Calculate Share ratio and Treynors ratio.

(c) Write down the objective of Inter Bank Participation Certificate.

(d) What is Rolling settlement?

(e) Compute the theoretical forward price of the following security for 6 months.
Spot Price (Sx)
Risk free interest rate
[Given: e0.045 = 1.046028]

`160
9%
2

(f) It is given that `/ quote is `100.68 102.95 and `/$ quote is `61.86 62.87. What
would be the $/ quote?
2
(g) A project had an equity beta of 1.3 and was going to be financed by a combination
of 30% debt and 70% equity. Assuming debt-beta to be zero, calculate the project
beta and return from the project taking risk free rate of return to be 10% and return on
market portfolio of 18%.
2
(h) Mr. Varun holds portfolio consisting of two stocks, Stock A and Stock B. Stock A has a
standard deviation of returns of 0.60 and Stock B has a standard deviation of 0.80. The
cor-relation co-efficient of the two stocks' return is 0.50. If Varun holds equal amount of
each stock, what will be risk of the portfolio consisting of two stocks?
2

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Suggested Answer_Syl12_DEC2014_Paper_14
(i) State any two applications of the Behavioural Financial Theory.

(j) Arvind Leasing Company is considering a proposal to lease out a school bus. The bus
can be purchased for `8,00,000 and in turn, be leased out at ` 2,00,000 per year for 8
years with payments occurring at the end of each year. What should be the yearly
lease payment charged by the company in order to earn 20% annual compounded
rate of return before expenses and taxes?
[Given: PVIFA @ 20%, 8 years = 3.837]
2
Answer:
1.

(a) (i) Price discovery; (ii) Liquidity; and (iii) reduction of transaction costs.
(b) Sharpe's ratio = (RP - RF) / = [ 13 -10 ] / 16 = 0.19
Treynor's ratio = (RP - RF) / = [ 13 -10 ] / 0.90 = 3.33
(c) IBPCs are short-term instruments. The objective is to even out the short-term liquidity
within the banking system particularly when there are imbalances affecting the
maturity mix of assets in banking book- thus, they provide a degree of flexibility in
the credit portfolio of banks.
(d) 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 the seller has to deliver the securities sold.
Here, settlement refers to the process in which traders who have made purchases
make payments while those who have sold shares, deliver them.
(e) Forward price of securities = ` 160 e(0.09)(0.50) = ` 160 e0.045 = ` 160 1.046028 = `
167.3645.
(f) The synthetic rate for $ / is to be calculated. Here, rupee, the price currency (i.e.
common currency) is the cheapest among the three currencies involved in the
quotes. The formula is :
$ / = [(` / bid)/ (` / $ask)]: [(`/ ask)/(`/ $bid )] = [100.68/ 62.87]: [102.95/61.86]
= 1.6014 :1.6642 ; So, $/ = $1.6014 - $ 1.6642 (quote).
(g) p is to be ascertained as = [equity + E / (D +E) ] + [debt + E /(D + E)] = (1.30 0.70) + (0 0.3) =0.91
Computation of return from the project = R F + p (RM - RF) = 0.10 + 0.91 (0.18 - 0.10)
= 0.1728 = 17.28 %.
(h)

AB [(A x WA ) (B x WB ) 2 (A x WA x B x WB x AB )]

0.62 0.52 0.82 0.52 2 0.6 0.5 0.8 0.5 0.5

= 0.61 (Risk of the portfolio)
=

(i) Applications of the Behavioral Finance Theory (any two):

(i)
Learning to recognize mistakes
(ii)
Understanding and adapting to other peoples decision making processes.
(iii) Evaluating market trends
(iv) Facilitating the planning process
(v) Impacts of events on the market
(vi) Promoting products to consumers
(j) Lease rent = [8,00,000/PVIFA8 years, 20%] = 8,00,000/3.837 = `2,08,496 p.a.
2.

Answer any three questions:

(a) (i) Mention any three key objectives of Commodity Futures.
(ii)

83=24
3

An investor purchased 300 units of a mutual fund at `12.25 per unit on 31st

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Suggested Answer_Syl12_DEC2014_Paper_14
December, 2012. As on 31st December, 2013 he has received `1.25 as dividend
and `1.00 as capital gains distribution per unit,
Required:
1.

The return on investment if the NAV as on 31st December, 2013 is `13.00.

2.

The return on investment as on 31st December, 2013, if all dividends and capital
gains distributions are reinvested into additional units of the fund at `12.50
per unit.
5

(b) (i) Equi Stable is a portfolio model wherein 20% of Fund value is invested in Fixed
Income Bearing Instruments. The balance of 80% is divided among old industry
stock (iron and steel), Automotive Industry stock, Information Technology stocks,
Infrastructure Company stocks and Financial Services Sector in the ratio of
4:2:6:3:5.
Three mutual funds X, Y and Z offer a fund scheme based on the Equi-stable
portfolio model. The actual return on Equi-Stable portfolios of each of the three
funds for the past 3 years is as follows:
Year
1
2
3
Portfolio X
17.35%
18.70%
21.60%
Portfolio Y
17.20%
18.25%
22.15%
Portfolio Z
17.10%
18.60%
22.00%
Beta factor of the Equi-Stable portfolio is measured at 1.35. Return on market
portfolio indicates that `1,000 invested will fetch `153 in a year (including capital
appreciation and dividend yield). RBI bonds, guaranteed by the Central
Government yields 4.50%.
Rate the fund managers of X, Y and Z.
(ii) Describe any one risk management procedure of clearing house

6
2

(c) (i) A sugar mill in Maharashtra is expected to produce 100 MT of sugar in the month
of February. The current market price today (the month of December) is `22 per
kg. February futures contract in sugar due on 20th February is trading at `25 per
kg. The sugar mill apprehends that the price lesser than `25 per kg will prevail in
February due to excessive supply then.
How can the sugar mill hedge its position against the anticipated decline in
sugar price in February?
6
(ii) Explain any one distinguishing feature of project finance compared to corporate
finance.
2
(d) (i) Moonlight mutual fund is an open-end fund with 50 Lakh units outstanding. You
buy 2,100 units today. The dividend paid and the closing NAV for 2 years are as
follows:
Year

Dividend
NAV
`
`
Today
19
1
0.20
21
2
0.25
23
Calculate Money Weighted rate of Return (MWROR), if you reinvest dividends.
(ii) What you are expected to know about issues in Infrastructure Financing?

4
4

Answer:
2. (a) (i) The key objectives of commodity futures are:
1.

Hedging with the objective of transferring risk related to the possession of physical

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Suggested Answer_Syl12_DEC2014_Paper_14
assets through any adverse movements in price.
2.

Maintaining buffer stock and better allocation of resources as to augment

reduction in inventory and thus the exposure to risk declines.

3. Price stabilization that ensures liquidity.

4. Flexibility, certainty, and transparency in purchase of commodities.

(ii) Return for the year (all charges on a per year basis)
Particulars
Changes in price [13.00 -12.25]
Dividend received
Capital gain distribution
Total return

`/Unit
0.75
1.25
1.00
3.00

Return on investment = [3.00 / 12.25] 100 = 24.49 %

If all dividends and capital gains are reinvested into additional units at ` 12.50
per unit, the position would be :
Total amount reinvested = ` 2.25 300
Additional units added = ` 675 / 12.50
Value of 354 units as on 31.12. 2013
Price paid for 300 units on 31.12. 2012 = 300 ` 12.25
Return = [4,602 - 3,675] / 3,675 =927/3,675

= `675
= 54 units
= `4,602
= `3,675
= 25.22%

(b) (i) Computation of expected rate of return under CAPM:

E (Rx) = RF + Beta [ RM - RF ]; Risk free return = Rf = 4.50 %
Return on market portfolio = RM = 153 /1000 = 15.30 %
Beta of Equi-stable = 1.35
So, Expected return of Equi-stable = 4.50 % +[1.35 (15.30 % - 4.50 %] = 19.08 %
Computation of Alpha factor of 3 Funds
Year

Mutual Funds X
Abnormal return

Actual
return
17.35%

18.70%

18.70 19.08 = (0.38)

21.60%

21.60 -19.08 = 2.52

17.35 19.08 = (1.73)

0.41

Mutual Funds Y
Actual Abnormal return
return
17.20%
17.20 19.08 =
(1.88)
18.25%
18.25-19.08 =
(0.83)
22.15%
22.15-19.08 =
3.07
0.36

Mutual Funds Z
Actual Abnormal
return
return
17.10% 17.10- 19.08
= (1.98)
18.60% 18.60 19.08
= (0.48)
22.00% 22.00 19.08
= 2.92
0.46

Alpha factor:
Fund X = 0.41 / 3years = 0.137 %; Fund Y = 0.36 /3 years = 0.120 %; Fund Z = 0.46 /
3years = 0.153 %
Evaluation: Equitable scheme of mutual fund Z has the highest alpha 0.153 % return
more than the market expectations when compared to 0.137 % and 0.120 % of fund X
and Y. Therefore, fund manager of Mutual fund Z has performed better.
Ranking: Fund manager Z = 1; Fund manager X = 2 and Fund manager Y= 3.

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Suggested Answer_Syl12_DEC2014_Paper_14
2. (b) (ii): Risk management procedures of a clearing house are:
1.

Imposition of membership requirements, including capital requirements and an ongoing monitoring of compliance with such requirements in order to limit the
likelihood of defaults.

2.

Imposition of security deposits, collateral requirements and exposure ceilings to

limit loss by using more than one settlement bank. Another technique to minimize
the risk of settlement of bank failure is to convert customer cash held in deposits at
the settlement bank into securities, e.g. treasury bonds held by the settlement
bank. While a cash deposit account creates a debtor/ creditor relationship
between the bank and its customer for the amount on deposit and a customer
claim against the assets of the bank in the event of its insolvency, customer
securities held by a settlement bank are segregated for the benefit of customer on
its books, are not included in the assets upon its insolvency and can be recovered
by the customer, free of any claim against the bank.

2. (c) (i) Sugar mill is long on the asset in February. Therefore, it needs to sell the futures
contract today. The no. of contracts that needs to be sold is dependent upon the
exposure in the physical assets and the value one needs to cover. Assuming each
contract for sugar is for 10 M.T. the no. of contracts to be sold is 10.
No. of contracts to be sold = Quantity to be hedged / Quantity in each future
contract = 100 M.T./10 M.T. = 10 Contracts.
Sugar mill would go short on futures in December. Prior to February, before the
future contract expires, sugar mill buys futures contract to nullify its position in the
futures contract. The underlying asset, i.e. sugar is sold in the spot market. Prices
realized by sugar mill in two different scenarios of decline or rise in sugar prices,
using the principle of convergence of price on the due date of the contract, is
worked out as follows:
When the price falls to ` 22 per k.g. in the futures contract
Sold futures in December
+25
Bought futures contract in February
-22
Gain in the futures contract
+3
Price realized in the spot mar
+22
`25 per k. g.
Effective price realize
Here, the loss of `3 (`25 - 22) in the spot market is made up by an equal gain in the
futures market.
When the price rises to `26 per k.g. in the futures market
Sold futures contract in December
+25
Bought futures contract in February
-26
Loss in futures contract
-1
Price realized in the spot market
+26
`25 per k. g.
Effective price realized
Here, gain of `1 [`26 25] in the spot market is offset by the equal in the futures
market.
Note : Due to the fact that prices of sugar in the spot market and future market
must converge, a fixed price of `25 per kg. is realized by the sugar mill. The loss or
gain in the spot market is fully compensated by gain/loss in the future market.
2. (c) (ii) Project financing vs. Corporate financing:
Project finance involves significant costs compared to Corporate finance. The
creation of a project company provides an opportunity to create asset- specific,
new governance systems to address the conflicts between ownership and control.

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Two main distinguishing features are:
(1) Enhanced verifiability of cash flows: In project finance, contractual agreements
are possible because of a single, discreet project in legal isolation from the
sponsors and the resultant absence of future opportunities. But, corporate finance
involves a multitude of future and current projects and so the same contractual
agreements cannot be effected.; and
(2) Lack of sponsors, assets, and cash flows: In the case of corporate finance, the
lender has a potentially larger pool of cash flows from which to get paid as
compared to project finance where the cash flows from the project only are used
to pay the investors.
2. (d) (i) MWROR with reinvestment:
When you reinvest 20 p dividend at time 1, the no. of units you buy = [ 0.2 2100] /
21 = 20
Therefore. Total units at the beginning of the 2nd Year = 2100 +20 = 2120.
The cash flow for computing the rupee-weighted return are then:
Time
Return
0
-2100 19 = (-) 39,900
1
0
2
2120 [0.25 + 23] = 49.290
The rupee-weighted return is just the IRR, defined by:
(-) 39,900 + 49,290/(1 + IRR)2 = 0; OR, IRR = [49,290/39,900]0.5 1 = 11.1458%
2. (d) (ii): Issues in infrastructure financing:
1.

Funding gap: It is the most important issue that we face on the front.

2.

Fiscal burden: Here, the point to be noted is that government funds have
competing demands, such as education, health, employment generation among
others. Given that there is a limit to the govt's financing of infrastructure especially
in the context of a rule based fiscal policy framework, it is important to explore
other avenues for financing infrastructure.

3.

Asset-liability mismatch of commercial banks: It is a well known fact that these are
institutions that primarily leverage on short-term liabilities and as such, their ability to
extend long-term loans to the infrastructure sector is limited.

4.

Take-out financing: This offers a window to the bank to free their balance sheet
from exposure to infrastructure loans, lends to new projects and also enables
better management of the asset-liability position.

5.

Investment obligations of Insurance and Pension funds: These institutions leverage

on long-term liabilities. They are constrained by their obligations to invest a
substantial portion of their funds in govt. securities. However, this limits the direct
investment of these institutions in the infrastructure sector.

3. Answer any two questions:

(a)

10 x 2 = 20

(i) From the following data for Government Securities:

Face Value
Interest rate
`
%
1,00,400
0
1,00,400
10
1,00,400
10.5
Calculate the forward rates.
(ii)

Explain any two processes of Credit rating.

Maturity Year
1
2
3

Current Price
`
91,900
98,900
99,400
8
2

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Suggested Answer_Syl12_DEC2014_Paper_14
(b) (i)
(ii)

Write down any four processes for raising equity through ADRs.

Determine the value of option, both call and put, on expiry for the stock of Nirmal
Spice Foods (NSF) Ltd. from the following information:
Exercise Price
`510
Spot price on exercise date ranges between `495 and `525 with interval of `5.
Also state what will be the action on the above range of prices for both the
options.
6

(c) The following information is available for Call option on the stock of MACON LTD:
Current market price
`415
Strike price
`400
Time to expiration (1 year = 360 days)
90 days
Standard deviation of return
22%
Risk-free rate of interest
5%
You are required to compute the value of Call option, using Black- Scholes model.
[Given: N(d1) = N (0.5033) = 0.7019;
N(d2) = N (0.3933) = 0.6628;
Ln (1.0375) = 0.03681; and
e = 2.71828].
10
Answer:
3. (a)(i)
1. Computation of Zero rates [Implied interstate time zero] [under annual compounding]
Particulars
1 year Bond
2 year Bond
3 year Bond
` 91,900
`98,900
` 99,400
Current market price (a)
` 1,00,400
` 1,00,400
` 1,00,400
Redemption price [assumed at par
value]
`8,500
` 1,500
` 1,000
Capital gain (b)
Rate of interest
0%
10%
10.50 %
` 10,040
` 10,542
Annual interest inflow
Period of bond (c)
1 year
2 year
3 year
` 20,080
` 31,626
Total interest inflow (d)
Nil
` 8,500
` 21,580
` 32,626
Total income to a Bondholder (e =
b + d)
` 8,500
` 10,790
` 10,875
Income per annum (f = e / c )
Implied interest rate (f/a)
9.25 %
10.91 %
10.94%
Computation of Forward rates
(a) Forward rate for year 1 = Implied interest rate for one year bond = 9.25%
(b) Forward rate for year 2:
Factor
Notation
Value
Zero rate for 1 year bond
R1
9.25 %
Zero rate for 2 year bond
R2
10.91 %
Tenor of bond 1
T1
1
Tenor of bond 2
T2
2
forward rate for year 2 =[R2 T2 R1 T1]/( T2 T1)
={[10.91 2] - [ 9.25 1]} /[ 2-1] = 12.57 %
RF
12.57%

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Suggested Answer_Syl12_DEC2014_Paper_14
(c) Forward rate for year 3:
Factor
Zero rate for 2 year bond
Zero rate for 3 year bond
Tenor of bond 2
Tenor of bond 3
forward rate for year 3 =[R3 T3 R2 T2]/( T3 T2)
={[10.94 3] - [ 10.91 2]} /[ 3- 2] = 11.00 %

Notation
R2
R3
T2
T3

Value
10.91 %
10.94 %
2
3

RF3

11.00%

3. (a) (ii): Process of credit rating:

The steps are
1. Rating request - The customer [prospective issuer of debt instrument] makes a formal
request to the rating agency. The request spells out the terms of the rating assignment
and condition analysis of the issue, viz. historical performance, competitive position,
business risk profile, business strategies, financial policies and evaluation of outlook for
performance. Information are met through various sources like references, reviews
experience, etc.
2.

Formation of rating team - The credit rating agency forms a team, whose composition
is based on the expertise and skills required for evaluating the business of the issuer.

3.

Initial analysis - On the basis of information gathered, the analyst submits the report to
the rating team. The authenticity and validity of the information submitted influences
the credit rating activity.

4. Evaluation of rating committee - Rating committee is the final authority for assigning
ratings. The rating team makes a brief presentation about the issuer's business and the
management. All the issues identified during discussion are analysed.
5. Actual rating - Rating is assigned and all the issues, which influence the rating, are
clearly spelt out.
6.

Communication to issuer -Assigned rating together with the key issues is

communicated to the issuer's top management for acceptance. The ratings which
are not accepted, are either rejected or reviewed. The rejected ratings are not
disclosed and complete confidentiality is maintained.

7.

Review of rating - If the rating is not acceptable to the issuer, he has a right to appeal
for a rating. These reviews are usually taken up only if the issuer provides fresh inputs on
the issues that were considered for assigning the rating. Issuer's response is presented
to the rating committee. If the inputs are convincing, the committee can revise the
initial rating decision.

8.

Surveillance / monitoring - Credit rating agency monitors the accepted ratings over
the tenure of the rated instrument. Ratings are reviewed every year, unless warranted
earlier. During this course, the initial rating could be retained, upgraded, or
downgraded.

3. (b) (i): Process for raising equity:

1. Issue intermediaries: ADRs are issued by the Overseas Depository Bank, who has a
Domestic Custodian Bank in India.
2.

Deposit of securities: Company willing to raise equity through ADRs should deposit the
securities with the DCB in India.

3.

Authorisation for issue of ADRs: The Indian company authorizes ODB to issue ADR
against the security of the company's equity shares.

4.

Issues of ADR: ODB issues ADRs to investors at a predetermined ratio to the company's
securities.

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Suggested Answer_Syl12_DEC2014_Paper_14
5.

Redemption of ADR : When redeemed, appropriate no. of underlying equity shares is

issued.

6.

Dividend / interest: Indian company pays interest to the ODB, which in turn, distributes
dividends to the ADR holders, based on the prevailing exchange rate.

3. (b)(ii): Call option[Right to buy]:

Situation
A
B
C
D
E
F
G

Exercise
Spot price on
price (`)
Expiry date (`)
510
495
510
500
510
505
510
510
510
515
510
520
510
525

Value of call [Maximum of

SP & EP (`) [SP EP], 0
495-510 = (-)15 0
500 - 510 = (-) 10 0
505 - 510 = (-) 5 0
510-510 =
0 0
515-510 =
5 5
520-510 =
10 10
525-510 =
15 15

Action
Lapse
Lapse
Lapse
Lapse
Exercise
Exercise
Exercise

Put option [Right to sell]:

Situation
A
B
C
D
E
F
G

Exercise
Spot price on
price (`)
Expiry date (`)
510
495
510
500
510
505
510
510
510
515
510
520
510
525

Value of call [Maximum of

EP & SP (`) [EP SP], 0
510 - 495 = 15 15
510 - 500 = 10 10
510 - 505 = 5 5
510- 510 = 0 0
510- 515 = (-) 5 0
510 -520 = (-) 10 0
510 -525 = (-) 15- 0

Action
Exercise
Exercise
Exercise
Lapse
Lapse
Lapse
Lapse

3. (c) :
Basic Data :
Factor
Current market price
Strike Price
Time [90 days]
Risk free rate of return
Standard deviation of return

Notation
S
X
t
r

Value(`)
415
400
0.25
5% or 0.05
0.22

[Ln (S / X) (r 0.502 )x t]
d
t
1
=[Ln (415 /400) + ( 0.05 + 0.5 0.222) 0.25 ] / [ 0.22 0.25]
= [Ln (1.0375) + 0.01855]/ 0.11 = [0.03681 + 0.01855 ] / 0.11 = 0.05536 / 0.11= 0.5033
d2 =d1: - t = 0.5033-[0.22 0.25] =0.5033 - 0.1100 = 0.3933
So, N(d1) = N (0.5033) = 0.7019; AND N(d2) = N (0.3933) =0.6628
Hence, value of call option = [S N(d1)] - [ X x e-rt N(d2)]
= [415 0.7019] - [400/(2.71828)0.05 x 0.25 0.6628]
= [291.2885] - [400/1.01258 0.6628 ] = [291.2885] - [261.8266] = 29.46

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Suggested Answer_Syl12_DEC2014_Paper_14
4. Answer any two questions:
(a) As an investment manager, you are given the following information:
Investment
Initial
Dividend
Market
Price (`)
(`)
Price (`)
Equity Shares of
A Ltd.
70
5
140
B Ltd.
80
5
150
C Ltd.
90
5
270
Govt. of India bonds
1,000
160
1,010

82 = 16
Beta

0.8
0.7
0.5
0.95

Risk-free return may be taken at 16%.

Required:
(1) Expected rate of return of Portfolio using CAPM.
(2) Average return of Portfolio.

6+2=8

(b) A company has a choice of investments between several Equity- oriented Funds. The
company has an amount of `1 crore to invest. The details of the funds are as follows:
Mutual Funds

Beta

1.7

1.0

0.9

2.1

0.7

Required:
(1) If the company invests 20% of its investments in the first two mutual funds, and an
equal amount in the mutual funds O, P and Q, what is the beta of the portfolio?
(2)

If the company invests 15% of its investments in O, 15% in M, 10% in Q and the
balance in equal amount in the other two mutual funds, what is the beta of the
portfolio?

(3)

If the expected return of the market portfolio is 14% at a beta factor of 1.0, what will
be the portfolio's expected return in both the situations given above?
3+3+2=8

(c) (i)

Yamuna Ltd. is an un-levered firm and undertakes three projects A, B and C. The
risk-free rate of return is 8% and the return from the market is 12%. The projects
have a weight of 0.5, 0.3 and 0.2 respectively. Their respective betas are 1.3,1.0
and 0.8.
You are required to compute:
(1) Expected return from each project;
(2) Expected return for the company; and
(3) Cost of capital.
23= 6
(ii) The risk-free rate of interest is 4.25% and market return is 12%. Beta value of
Security B is 2.10. Assume that you had purchased Security B a year ago for `312.
Current market price is `380. Since the price is going up, your friend advises to
buy more units of Security B, before it touches `400 mark.
What is your decision?
2

Answer:
4. (a) Calculation of expected rate of returns of Portfolios:
Investment
Amount
Market price Capital gain Dividend
(`)
(`)
(`)
(`)
Equityshares of
A
70
140
70
5
B
80
150
70
5
C
90
270
180
5

Total
(`)
75
75
185

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Govt. of India bonds
Total

1,000
1240

1,010
1570

10
330

160
175

170
505

Expected rate of return on portfolio = [ 505/1240] 100 = 40.73 %.

CAPM Model
E[RP] = R F + [ R M - RF]
A Ltd = 16 + 0.8 [40.73 -16] = 35.78 %
B Ltd = 16 + 0.7 [40.73 - 16] = 33.31 %
C Ltd = 16 + 0.5 [40.73 - 16] = 28.37 %
G of I Bonds = 16 + 0.95 [40.73 - 16 ] = 39.49 %
(ii) Simple average return of portfolio = [35.78 + 33.31 + 28.37 + 39.49 ] / 4 = 136.95 / 4
= 34.24 %
Average of Beta = [0.80 + 0.70 + 0.50 + 0.95 ] /4 = 0.7375.
ALTERNATIVE APPROACH for Average return:
Weighted average return:
Securities
A
B
C
G. Bonds

Cost
70
80
90
1,000
1,240

Proportion
0.056
0.065
0.073
0.806
1.000

Expected return
35.78
33.31
28.37
39.49

Weighted return %
2.004
2.132
2.043
31.829
38.008

4. (b) Investment in M and N at 20 % each, equal proportion in O, P, and Q.

Mutual Fund
Proportion of Investment
Beta
Proportion Fund beta
M
0.2
1.7
0.34
N
0.2
1.0
0.20
O
0.2
0.9
0.18
P
0.2
2.1
0.42
Q
0.2
0.7
0.14
Portfolio beta
1.28
Investment in O, P, & Q = [1 Investment in M and N]/3 = 0.6/3 = 20%
Investment in M at 15%, O at 15% and Q at 10%, equal proportion in N and P:
Mutual Fund
Proportion of Investment
Beta
Proportion Fund beta
M
0.15
1.7
0.255
N
0.30
1.0
0.300
O
0.15
0.9
0.135
P
0.30
2.1
0.630
Q
0.10
0.7
0.070
PORTFOLIO BETA
1.390
Investment in N and P = [1- INVESTMENT in M, O, and Q]/ 2 = [1 - 0.15 - 0.15 - 0.1] / 2 =
0.30 = 30 %
Expected return from portfolio: Note / Assumption : In the absence of risk-free rate of
return, it is assumed that the expected return from portfolio is to be computed using
Market model, i.e., there is no risk-free return, and the entire fund return moves in line
with the market return. CAPM is not applicable.

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Suggested Answer_Syl12_DEC2014_Paper_14
Expected return = Market return Portfolio
Situation
A
B

Return in `
100 lakhs 17.92% = 17.92 lakhs
100 lakhs 19.46% = 19.46 lakhs

Return in %
14% 1.28 = 17.92%
14% 1.39 = 19.46%

4. (c) (i)
[1] Expected return from each project:
Project
A
B
C

RA = RF + [RM - RF ]

Calculation
8 + 1.3 [12- 8]
8 + 1.0 [12- 8]
8 + 0.8 [12 - 8]

Project's return
13.2
12.0
11.2

[2] Expected return of the asset portfolio of the company:

Project
A
B
C

Weight
0.5
0.3
0.2

Return
13.2
12.0
11.2

Total
Overall cost capital: Method 1: Overall cost capital = R A = 12.44%

WR
6.60
3.60
2.24
12.44

Method 2:
PROJECT
A
B
C

WEIGHT
0.5
0.3
0.2

BETA
1.3
1.0
0.8

Total
Working note: CAPM used

TOTAL BETA
0.65
0.30
0.16
1.11

Ke = RF + [RM - RF ] = 8 + 1.11 [12 - 8] = 12.44 %.

4. (c) (ii) :
CAPM Return =

RF + [RM - RF ] = 4.25 + 2.10 [12 - 4.25] = 20.525 %

Annual Return = (380 - 312)/ 312 = 0.217948 = 21. 80 %

The security is marginally undervalued. The difference is 1.27 % return. The decision is to
BUY.
5.

Answer any two questions:

102=20

(a) A company requires `27 lakhs for the installation of a new unit, which would yield an
annual EBIT of `4,50,000. The companys objective is to maximize EPS. It is considering
the possibility of issuing Equity shares plus raising a debt of `5,40,000, `10,80,000 and
`16,20,000. The current market price per share is `90 which is expected to fall to `72 per
share if the market borrowing were to exceed `12,60,000.
The costs of borrowing are indicated as follows:
Level of
borrowing
Cost of
borrowing

Upto
` 3,60,000

` 3,60,000 to
` 10,80,000

`10,80,000 to
` 16,20,000

12% p.a.

15% p.a.

17% p.a.

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Suggested Answer_Syl12_DEC2014_Paper_14
Assuming a tax rate of 50%, work out the EPS and the Scheme which you would
recommend to the company.
8+2=10
(b) (i) Write down the basic differences between Factoring and Forfeiting.
(ii) Determine the risk- adjusted net present value of the following projects:
Projects
Net cash outlays (`)
Project life
Annual cash inflow (`)
Co-efficient of variation
Risk-adjusted discount rate
PV factor 1 to 5 years at riskadjusted discount rate
(c)

A
1,00,000
5 years
30,000
0.4
12%

B
1,20,000
5 years
42,000
0.8
14%

C
2,10,000
5 years
70,000
1.2
16%

3.605

3.433

3.274

4
6

Indira ammusement park charges `200 each for all rides in the park. Variable costs
amount to ` 50 per ride and fixed costs are `120 Lakhs. Last year's net income was `
90 Lakhs on sale of `280 Lakhs. This year, management expects a cost increase of
20% in variable costs and 10% in fixed costs. To help offset these increases, the
management is considering raising the price of a ride to `250.
Required:
(i) How many rides did this park sell last year?
(ii) If the price increase is not implemented, what is the expected net income for
this year assuming the same volume of activity?
(iii) Compute the price indifference point for the new ride price.
(iv) Compute the Break-even point for this year using the old price and the new
price.
2+3+3+2=10

Answer:
5. (a) Statement showing EPS UNDER DIFFERENT SCHEMES:
Particulars
Scheme 1
Capital required (`)
27,00,000
Less : Debt content (`)
5.40,000
Balance Equity capital required
21,60,000
` 90
Market price per share
No. of equity shares to be issued [
24,000
Equity capital / MPS]

Scheme 2
27,00,000
10,80,000
16,20,000
` 90
18,000

Profitability statement

Scheme 3
27,00,000
16,20,000
10,80,000
` 72
15,000

(Amount in `)
Scheme 3

Scheme 1

Scheme 2

4,50,000

4,50,000

4,50,000

43,200

43,200

43,200

27,000

1,08,000

1,08,000

70,200

1,51,200

2,43,000

EBT

3,79,800

2,98,800

2,07,000

Less: Tax at 50 %

1,89,900

1,49,400

1,03,500

EAT

1,89,900

1,49,400

1,03,500

7.91

8.30

6.90

EBIT
Less: Interest on Debt

1st

Next 7,20,000 at 15 %

3,60,000 at 12 %

Balance at 17%
Total interest

91,800

Earning per share(EPS)

= EAT/ No. of shares
Average interest rate

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Suggested Answer_Syl12_DEC2014_Paper_14
= Total interest / Debt
ROCE = EBIT/ Capital employed

13%

14%

15%

16.67%

16.67 %

16.67 %

Conclusion : EPS is maximum under Scheme 2 and hence, preferable.

Leverage effect: Use of debt funds and Financial leverage will have a favourable effect
only if ROCE > INTEREST RATE. ROCE is 16.67 % and hence upto 15 % interest rate i.e.,
Scheme 2, use of debt will have a favourable impact on EPS and ROE. However, when
interest rate is higher at 17 % financial leverage will have negative impact and hence
EPS falls from ` 8.30 to ` 6.90.
5.

(b) (i) : The basic difference are:

Basis
Factoring
Extent of finance
Usually 80% or 90% of the
Value of invoice is
considered for advance.
Credit worthiness
Factor does the credit
rating of the counter party
in case of a non- recourse
factoring transaction
Services rendered
Day-to-day administration
of sales and other allied
services are provided.
Maturity
Advance are short-term in
nature
(b)

Projects

A
B
C

5.

(c)
(i)

Forfeiting
100% financing

The forfeiting bank relies on

the credibility of availing
bank.
No services are provided.

Advances are generally

medium term.

(ii) Statement showing Determination of Risk-adjusted Net Present Value

Net cash
Outlays (`)

Co- Efficient Risk-adjusted Annual cash PV factor

Discounted
Net
of variation Discount rate
Inflow (`)
1-5 years at Cash inflow
present
risk- adjusted
(`)
value (`)
discount rate
1,00,000
0.4
12%
30,000
3.605
1,08,150
8,150
1,20,000
0.8
14%
42,000
3.433
1,44,186
24,186
2,10,000
1.20
16%
70,000
3.274
2,29,180
19,180

Rides which INDIRA AMUSEMENT PARK sold last year:

= Total sales of rides last year / Charges per ride last year = ` 2,80,00,000 / ` 200 =
1,40,000 rides.

(ii)
Expected net income:
Charges per ride
Less: Expected variable cost per ride [ ` 50 + ` 10]
Contribution per ride

`200
`60
`140

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Suggested Answer_Syl12_DEC2014_Paper_14
No. of rides (same as last year)
Total expected contribution
Less : Expected fixed cost [1,20,00,000 + 10 %]
Expected net income
(iii)

1,40,000
`1,96,00,000
`1,32,00,000
`64,00,000

Price indifference point for the new ride price:

Price indifference point is at which the expected profit remains the same
irrespective of sale price and costs:

Particulars
New ride price
Less: Variable cost
Contribution per ride
Fixed cost of this year [A]
Net income last year [ B]
Contribution required [A + B]

`
250
60
190
1,32,00,000
90,00,000
2,22,00,000

Price indifference point = ` 2,22,00,000/ ` 190 = 1,16,842 rides.

(iv) Break-even point for this year using the old price and the new price:
Break-even point = Fixed costs / Contribution per ride
At old price = ` 1,32,00,000 /` [200 - 60 ] = 94,286 rides
At new price = ` 1,32,00,000 / ` [ 250 - 60] = 69,474 rides.

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