Paper14 Solution

Answer to PTP_Final_Syllabus 2012_Dec2014_Set 2
PAPER-14: Advanced Financial Management
Time Allowed: 3 hours Full Marks: 100
This paper contains 5 questions. All questions are compulsory, subject to instruction provided
against each question. All workings must form part of your answer.
Assumptions, if any, must be clearly indicated.
Question No. 1. (Answer all questions. Each question carries 2 marks)
(a) A company is considering Projects X and Y with following information: [2]
Project Expected NPV Standard deviation

(`) (`)
X 1,22,000 90,000
Y 2,25,000 1,20,000
Which project will you recommend based on coefficient of variation as a measure of risk?
Answer to (a):
SD
CV 
ENPV
90,000
CVX   0.738
1,22,000
1,20,000
CVY   0.533
2,25,000
On the basis of Co-efficient of Variation (C.V). Project Y appears to be less risky and hence
should be accepted.
(b) Define Non-financial Intermediaries? [2]
Answer to (b):
Non-financial intermediaries are those institutions which do the loan business but their resources
are not directly obtained from the savers. Many non-banking institutions also act as
intermediaries and when they do so they are known as non-banking financial intermediaries,
e.g. LIC, GIC, IDBI, IFC, NABARD.
(c) The Beta co-efficient of equity stock of TECHBOARD LTD. is 1.6. The risk-free of return is 12%
and the required rate of return is 18% on the market portfolio. If the dividend expected during
the coming year is `2.50 and the growth rate of dividend and earnings is 8%, at what price
the stock of Techboard Ltd. can be sold (based on the CAPM) ? [2]
Answer to (c):
Expected rate of return: (By applying CAPM)
Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1
Re = Rt + βt (Rm – Rt)
= 12% + 1.6 (18% - 12%)
= 12% + 9.6% = 21.6%
Price of stock : (with the use of dividend growth model formula)
R0 = Dt/P0 + g
0.216 = 2.50/(P0 – 0.08)
Or, P0 = 2.50/(0.216 – 0.08)
= 2.50/0.136 = `18.38
(d) What do you mean by Reverse Book Building? [2]
Answer to (d):
It is method of buy-back of securities. It is an efficient price discovery mechanism adopted

when the company aims to buy the Shares from the public and other Shareholders. This is
generally done when the company wishes to delist itself from the trading exchanges.
(e) PNB Ltd. placed `52 Crores in overnight call with a foreign bank for a day in overnight call.
The call ruled at 5.65% p.a. What is the amount it would receive from the foreign bank the
next day? [2]
Answer to (e):
Amount placed in call = `52 crores

Interest = 5.65% p.a.
Amount receivable next day = Principal + Interest for a day
1 5.65
= `52 Crores + 52 crores × 
365 100
= `52,00,80,493
(f) In September 30, 2013, a six-month Put on VINTEX LTD.'s stock with an exercise price of `75
sold for `6.82. The stock price was `70.00. The risk-free rate was 6% per annum. How much
would you be willing to pay for a CALL on Vintex Ltd.'s stock with same maturity and exercise
price?
[Given. PVIF (6%, ½ year) = 0.9709] and PVIF (6%, 1 year) = 0.9434] [2]
Answer to (f):
Based on put call parity theorem,

C- P = S – PV (EP) or, C = P + S – PV(EP).
Thus, C (call) = 6.82 + 70- 75 × 0.9709
= 76.82 – 72.82 = `4.00
Thus, Price of Six month call = `4.00
(g) A treasury bill is maturing on 28-June- 2014 is trading in the market on 3rd July 2013 at a price
of `92.8918. What is the discount rate inherent in this price? [2]
Answer to (g):
 F  P  365
The formula for calculation of yield of a T- Bill is Y =    100
 P  M
Here P = 92.8918, F = 100, M = 360 days [period from 03/07/13 to 28/06/14 – remember exclude
the maturity date]
 100  92.8918  365

Y=    100 = 7.76%
 92.8918  360
(h) Mr. Mohit is willing to purchase a 5 years ` 1000 par value PSU bond is having a coupon rate
of 9%. His required rate of return is 10%. How much Mr. Mohit should pay to purchase the
bond if it matures at par?
[Given: PVIFA (10%, 5 years) = 3.791 and PVIF (10%, 5 years) = 0.621]
[Given: PVIFA (9%, 5 years) = 3.890 and PVIF (9%, 5 years) = 0.650] [2]
Answer to (h):
If the Bond matures at par Bn = `1,000.

Each interest = `90(1,000 × 0.09), Kd = 10%
Bo = `90 × 3.791 + 1,000 × 0.621
= `962.19
(i) Define Out-of-Pocket Cost? [2]
Answer to (i):
These are costs that entail current or near future cash outlays for the decision at hand. Such
costs are relevant for decision - making, as these will occur in near future. This cost concept is a
short-run concept and is used in decisions on fixing Selling Price in recession, Make or Buy, etc.
Out-of-Pocket costs can be avoided or saved if a particular proposal under consideration is not
accepted.
(j) Mr. Kumar is a fund manager of an equity fund is expected to provide risk premium of 10%
and standard deviation of returns of 16%. Miss Ankita, a client of Mr. Kumar chooses to invest
`70,000 in equity fund and `30,000 in T-Bills. If T – Bills are trading at 7% p.a., the expected
return and standard deviation of return on the portfolio of Miss Ankita will be. [2]
Answer to (j):
Expected return on Equity fund = 7.00 + 10.00= 17%

Expected return on Portfolio of Miss Ankita:
0.70 × 17 + 0.30 × 7 = 14%
Expected Standard deviation of the return on Port folio

= 0.70 × 0.16 + 0.30 × 0
= 11.20%
Question No. 2. (Answer any three questions. Each question carries 8 marks)
2 (a). A has invested in three mutual fund schemes as per details given below:
Particulars MFA MFB MFC

Date on investment 1.12.13 1.1.14 1.3.14
Amount of investment `50000 ` 1 lakh `50000
NAV at entry date ` 10.50 ` 10.00 ` 10.00
Dividend received up to 31.3.04 `950 `1500 Nil
NAV as on 31.3.04 ` 10.40 `10.10 `9.80
Required:
What is the effective yield on per annum basis in respect of each of the three schemes to Mr. A
up to 31.03.14? [8]
Answer to 2 (a):
Particulars MFA MFB MFC

Date on investment 1.12.13 1.1.14 1.3.14
Amount of investment `50000 ` 1 lakh `50000
NAV at entry date ` 10.50 ` 10.00 `10.00
Dividend received up to 31.3.14 `950 `1500 Nil
NAV as on 31.3.14 ` 10.40 `10.10 `9.80
Number of units issued 50000/10.5 = 4762 1 lakh/10 = 10000 50000/10 = 5000
Dividend per unit 950/4762 = 0.20 1500/10000 = 0.15 Nil
Capital Gains per unit (10.4-10.5) = -0.10 (10.10-10.00) = +0.10 (9.80-10) = -0.20
Total 0.10 0.25 -0.20
Yield 0.10/10.5 = 0.95% 0.25/10 = 2.5% -0.2/10 = -2%
Yield per annum = 2.85% 10% -24%
Yield x (12/months of investment)
2(b)(i). Satendra invested `50000 in debt-oriented fund when the NAV was `16.10, and sold the
units allotted when the NAV was ` 17.10 after one year. Assume that there existed an entry load
of 2% and no exit load. He received ` 2 per unit as dividend which is taxable at 30% during the
year. Ignore capital gains tax. What is the after tax rupee return from this investment? [5]
2(b)(ii). NBFC are not being compulsorily registered with RBI. - Justify. [3]
Answer to 2(b)(i):
Satendra invested `50000, when NAV was `16.10 and the sale price was = 16.10 x 1.02 = `
16.4220. At this price he was issued 3044.70 (50000/16.422) units. On this he received dividend =
3044.7 x 2 = `6089.40. However, dividends are taxable at 30%. His post tax receipt - 4262.58. Now
if he sells after a year when the NAV is `17.10, he gets full value as there is no exit load.
Rupee return in value

= (Post Tax Div. + (Repurchase Price - Sale Price) x No. of Units
= 4262.58 + (17.10 - 16.422) x 3044.7
= 6326.89
Rupee return in %
= 6326.89/50000
= 12.65%
Answer to 2(b)(ii):
In terms of Section 45-IA of the RBI Act, 1934, no Non-banking Financial company can
commence or carry on business of a non-banking financial institution without a) obtaining a
certificate of registration from the Bank and without having a Net Owned Funds of ` 25 lakhs (`
two crore since April 1999). However, in terms of the powers given to the Bank. to obviate dual
regulation, certain categories of NBFCs which are regulated by other regulators are exempted
from the requirement of registration with RBI viz. Venture Capital Fund/Merchant Banking
companies/Stock broking companies registered with SEBI, Insurance Company holding a valid
Certificate of Registration issued by IRDA, Nidhi companies as notified under Section 620A of
the Companies Act, 1956, Chit companies as defined in clause (b) of Section 2 of the Chit
Funds Act, 1982, Housing Finance Companies regulated by National Housing Bank, Stock
Exchange or a Mutual Benefit company.
2(c)(i). State five important regulations prescribed by SEBI for the investments that can be made
by a Mutual Fund. [5]
2(c)(ii). The unit price of TSS Scheme of a mutual fund is ` 10. The public offer price (POP) of the
unit is ` 10.204 and the redemption price is ` 9.80. Calculate: (1) Front-end Load, and (2) Back-
end Load. [11/2+11/2]
Answer to 2(c)(i):
SEBI REGULATIONS FOR INVESTMENTS OF A MUTUAL FUND: The investments of a mutual fund are
governed by a set of regulations of the SEBI and the five import; ones are as under:
(i) In all the schemes taken together, a mutual fund shall not own more than 10% of the
company's paid up capital;
(ii) A scheme shall not invest more than 15% of the NAV in debt instruments issued by a single
issuer which are rated not below investment grade by an authorized credit rating agency;
(iii) Barring certain exceptions, a scheme shall not invest more than 10% of its NAV in the equity
shares or equity related instruments of one company;
(iv) A scheme shall not invest more than 5% of its NAV in unlisted equity shares or equity related
instruments in case of an open ended scheme and 10% of its NAV in case of close ended
scheme;
(v) Mutual funds shall mark all investments to market.
Answer to 2(c)(ii):
(1) Calculation of Front-end Load (%)

We know that Sale Price = NAV (1 + Front-end Load %)
Since, Unit Price = ` 10.00, we have NAV = `10. We are given,
Sale Price = ` 10.204
Therefore we have Front-end Load% = 10.204/10 - 1 = 2.04%
(2) Repurchase Price = NAV (1- Back-end Load %)

Since, Unit Price = ` 10.00, we have NAV = ` 10. We are given, Repurchase Price = `9.80
Therefore we have Back-end Load% = 1 - 9.8/10 = 2%
2(d)(i). The RBI offers 91 -day T-Bill to raise `15000 Crores. The following bids have been received.
Bidder Bid rate Amount (` Crores)

A 98.95 18,000
B 98.93 7,000
C 98.92 10,000
(1) What is the yield for each of the price at which the bid has been made?
(2) Who are the winning bidders if it was a yield based auction, and how much of the security
will be allocated to each winning bidder? [3+2]
2(d)(ii). Distinguish between 'Inter Corporate Deposits' and 'Public Deposits'. [3]
Answer to 2(d)(i):
 F  P  365
(1) Yield  Y     100 where, M = 91 days for all.
 P  M
A = 4.26% [Price P = 98.95]
B = 4.34% [Price P = 98.93]
C =4.38% [Price P = 98.92]
(2) As this is a yield based auction, and since the entire amount of ` 5,000 Crores can be
sourced at the lowest yield of ` 4.26% itself, only A's bid would be accepted for ` 15,000
Crores.
Answer to 2(d)(ii):
Inter-corporate Deposits: (i) Short term finance; (ii) Deposits made by one company to another
company and are subject to the provisions of the Companies Act 1956; (iii) Rate of interest varies
depending upon amount involved and time period; and (iv) the risk is very high.
Public Deposits: (i) Both short term and medium term finance; (ii) Deposits from public and
shareholders, subject to the rules prescribed by RBI; (iii) The maximum amount that can be
raised, maturity period, and procedures as per conditions laid down by the RBI; (iv) These
deposits are unsecured loans and are used for working capital requirements.
Question No. 3. (Answer any two questions. Each question carries 10 marks)
3(a)(i). Suppose a dealer Rupam quotes ‘All-in-cost’ for a generic swap at 8% against six month
LIBOR flat. If the notional principal amount of swap is `5,00,000,
(1) Calculate Semi-Annual fixed payment.
(2) Find the first floating rate payment for (1) above if the six month period from the effective date
of swap to the settlement date comprises 183 days and that the corresponding LIBOR was 6%
on the effective date of swap.
(3) In 2 above, if settlement is on ‘Net’ basis, how much the fixed rate payer would pay to the
floating rate payer?
Generic swap is based on 30/360 days basis. [2+2+2]
3(a)(ii). Write down the benefits of Rolling Settlement. [4]
Answer to 3(a)(i):
Computation of Factors
Factor Notation Value
Notional Principal P 5,00,000
Time N 180 days
All in Cost Rate R 0.08
(1) Computation of Semi Annual Fixed Rate Payment

Semi-Annual Fixed Rate Payment = P X (N ÷ 360) X R
= 5,00,000 x (180 ÷ 360) x 0.08
= 5,00,000 x 0.5 x 0.08 = `20,000/-
(2) Computation of Floating Rate Payment
Floating Rate Payment = P x (N ÷ 360) x LIBOR
Where N = Period from the effective date of SWAP to the date of Settlement
= 5,00,000 x (183 ÷ 360) x 0.06
= 5,00,000 x (0.5083) x 0.06 = `15,250.
(3) Computation of Net Amount
Net Amount to be paid by the Person Requiring Fixed Rate Payment = Fixed Rate Payment
Less Floating Rating Payment = `20,000 - `15,250 = `4,750.
Answer to 3 (a)(ii):
(1) In rolling settlements, payments are quicker than in weekly settlements. Thus, investors benefit
from increased liquidity,
(2) It keeps cash and forward markets separate,
(3) Rolling settlements provide for a higher degree of safety,
(4) From an investor’s perspective, rolling settlement reduces delays. This also reduces the
tendency for price trends to get exaggerated. Hence, investors not only get a better price
but can also act at their leisure.
3 (b)(i). Following are the details of cash inflows and outflows in foreign currency denominations
of Mac Co., an Indian export firm, which have no foreign subsidiaries —
Currency Inflow Outflow Spot rate Forward rate

US $ 4,00,00,000 2,00,00,000 48.01 48.82
French Franc (F Fr) 2,00,00,000 80,00,000 7.45 8.12
UK £ 3,00,00,000 2,00,00,000 75.57 75.98
Japanese Yen 1,50,00,000 2,50,00,000 3.20 2.40
(1) Determine the net exposure of each foreign currency in terms of Rupees.
(2) Are any of the exposure positions off-setting to some extent? [6+2]
3(b)(ii). A sold in June Nifty futures contract for `3,60,000 on June 15, For this he had paid an
initial margin of `34,000 to his broker. Each Nifty futures contract is for the delivery of 200 Nifties.
On June 25, the index was closed on 1850. How much profit / loss A has made? [2]
Answer to 3(b)(i):
(1) Computation of Net Exposure
Particulars US $ F Fr UK £ Japan Yen

Inflow (in Lakhs) 400.00 200.00 300.00 150.00
Less: Outflow (200.00) (80.00) (200.00) (250.00)
Net Exposure (Foreign Currency Terms) 200.00 120.00 100.00 (100.00)
Spot Exchange Rate 48.01 7.45 75.57 3.20
Net Exposure (in Rupee Terms based 9602 894 7557 (32)
on Spot Exchange Rate) [200x48.01] [120 x 7.45] [100 x 75.57] [100 x 3.20/10]
Particulars US $ F Fr UK£ Japan Yen

Forward Rate [` , FC] 48.82 8.12 75.98 2.40
Less: Spot Exchange Rate [` / FC] 48.01 7.45 75.57 3.20
Forward Premium/ (Discount) 0.81 0.67 0.41 (0.80)
Net Exposure in Rupee Terms based on 162.0 80.4 41.0 8.0
extent of uncertainty represented [200 x 0.81] [120 x 0.67] [100 x 0.41] [(100)x (0.8)/ 10]
by Premium / (Discount)
(2) Off Setting Position:

(a) Net Exposure in all the currencies are offset by better forward rates. In the case of USD, F Fr
and UK Pound, the net exposure is receivable, and the forward rates are quoted at a
premium for these currencies.
(b) In case of Japanese Yen, the net exposure is payable, and the forward rate is quoted at a
discount. Therefore, a better forward rate is also offsetting the net payable in Japanese Yen.
Answer to 3(b)(ii):
Sale Price per NIFTY Future

= Contract Amount ÷ Lot size
= `3,60,000 ÷ 200
= `1,800
Futures Price as on June 25

= ` 1,850
Loss on Sale of Futures Contract
= (1,850 - 1,800) × 200
= `10,000.
3(c)(i). The following quotes are available.

Spot ($/Euro) 0.8385/0.8391
3-m swap points 20/30
Spot ($/Pound) 1.4548/1.4554
3-m swap points 35/25
Find the 3-m (€/£) outright forward rates. [5]
3(c)(ii). What is swaps? Explain its necessity. Also state financial benefits created by swap
transactions. [2+2+1]
Answer to 3(c)(i)
Given $/Є = 0.8385 / 0.8391 3M fwd = 0.8405 / 0.8421

(Swap points ascending order add to find forward rates)
$/£= 1.4548/1.4554 3M fwd = 1.4513 / 1.4529
(Swap points descending order deduct to find forward rates)
To find Є /£ (3M outright forward rates)

Bid (Є/£) = Bid ( Є /$) x Bid ($/£)
We do not have a quote of Є /$, instead we have $/ Є.
Bid (Є /£) = l/Ask($/Є) x Bid($/£)
Substituting the values,

Bid rate for Є /£= 1/0.8421 x 1.4513 = 1.7234
Similarly Ask (Є /£) = 1/Bid($/Є) x Ask($/£)
= 1/0.8405x1.4529 = 1.7286
 3M outright forward rates (Є /£) = 1.7234 / 1.7286
Answer to 3(c)(ii):
Swaps Exchange of one obligation with another -- Financial swaps are funding technique, which
permit a borrower to access one market and exchange the liability for another market /
instrument - exchange one type of risk with another.
Necessity –
1. Difference in borrowers and investors preference and market access
2. Low cost device
3. Market saturation
4. Differences in financial norms followed by different countries.
Financial Benefits Created by Swap Transactions

 The Theory of Comparative Advantage
 Information asymmetries.
4 (a). Stocks P and Q have the following historical returns —
Year 2009 2010 2011 2012 2013

Stock P’s Return (K ) -12.24 23.68 34.44 5.82 28.30
Stock Q’s Return (K ) -7.00 25.55 44.09 2.20 20.16
You are required to calculate the average rate of return for each stock during the period 2009 to
2013. assume that someone held a Portfolio consisting 50% of Stock P and 50% of Stock Q.
What would have been the realized rate of return on the Portfolio in each year from 2009 to
2013? What would been the average return on the Portfolio during the period? (You may assume
that year ended on 31st March). [3+5]
Answer to 4 (a):
1. Calculation of average rate of return on Portfolio during 2009-2013
Year Stock P’s Return % Stock Q’s Return %

2009 -12.24 -7.00
2010 23.68 25.55
2011 34.44 44.09
2012 5.82 2.20
2013 28.30 20.16
Total 80.00 85.00
Average rate of return 80/5 years = 16% 85/5 years =17%
2. Calculation of realized rate of return on Portfolio during 2009-2013
Stock P Stock Q Total

Year Proportion Return Net Return Proportion Return Net Return Net Return
1 2 3 4=3x2 5 6 7=5x6 8=4+7
2009 0.50 -12.24 -6.12 0.50 -7.00 -3.50 -9.62
2010 0.50 23.68 11.84 0.50 25.55 12.78 24.62
2011 0.50 34.44 17.22 0.50 44.09 22.05 39.27
2012 0.50 5.82 2.91 0.50 2.20 1.10 4.01
2013 0.50 28.30 14.15 0.50 20.16 10.08 24.23
40.00 42.51 82.51
Average rate of return = `82.51 ÷ 5 = 16.50%
4(b)(i). What are the techniques used in Industry Analysis? [2]
4(b)(ii). There are two portfolios L and M. known to be on the minimum various set for a
population of three securities A, B and C. The weights for each of the portfolios are given below:
WA WB WC
Portfolio L 0.18 0.63 0.19
Portfolio M 0.24 0.60 0.16
Ascertain the stock weights for a portfolio made up with investment of ` 3,000 in L and ` 2,000 in
M. [4]
4(b)(iii). The risk free return is 8 per cent and the return on market portfolio is 14 per cent. If the
last dividend on Share ‘A’ was `2.00 and assuming that its dividend and earnings are expected
to grow at the constant rate of 5 per cent. The beta of share ‘A’ is 2.50. Compute the intrinsic
value of share A. [2]
Answer to 4(b)(i):
Techniques Used in Industry Analysis:

(i) Regression Analysis: Investor diagnoses the factors determining the demand for output of
the industry through product demand analysis. The following factors affecting demand are
to be considered - GNP, disposable income, per capita consumption / income, price
elasticity of demand. These factors are then used to forecast demand using statistical
techniques such as regression analysis and correlation.
(ii) Input - Output Analysis: It reflects the flow of goods and services through the economy,
intermediate steps in production process as goods proceed from raw material stage through
final consumption. This is carried out to detect changing patterns/trends indicating
growth/decline of industries.
Answer to 4(b)(ii):
Particulars WA WB WC Total
Portfolio L 0.18 0.63 0.19
Investment in securities
(Weight x investment) 540 1,890 570 3,000
Portfolio M 0.24 0.60 0.16
Investment in securities
(Weight x investment) 480 1,200 320 2,000
Total investment in securities 1,020 3,090 890 5,000
Weight in portfolio 0.204 0.618 0.178
Weight in portfolio is computed as total securities/size of portfolio; for example weight of

securities A is 1,020/5,000 = 0.204, similar for B and C.
Answer to 4(b)(iii):
Computation of Expected Return

Expected Return [E(RA)] = RF + [ βA × (RM - RF)]
= 0.08 + [2.5 x (0.14 - 0.08)]
= 0.08 + 2.5 (0.14 - 0.08) = 0.08 + 0.15 = 0.23
i.e., Ke = 23%
Intrinsic Value of share = D1 ÷ (Ke - g) = D0 X (1+ g) ÷(Ke - g)
= 2 x (1+0.05) ÷(0.25 - 0.05) = ` 11.67
The Intrinsic Value of share A is ` 11.67.
4(c)(i). Mention any four important factors that you would consider for investment decisions in
portfolio management. [2]
4(c)(ii). The Capital of J Ltd, an exclusive software support service provider to B Ltd, is made up of
40% Equity Share Capital, 60% Accumulated Profits and Reserves. J does not have any other
clients. The sensex yields a return of 15%. The risk-less return is measured at 6.75%.
(1) If the shares of J Ltd carry a Beta (βJ) of 1.6, compute cost of capital, and also the beta of
activity support service to B Ltd.
(2) If there is another client, K Ltd, accounting for 35% of Assets of J Ltd, with a Beta of 1.40, what
should be the Beta of B Ltd, so that the equity beta of 1.60 is not affected? In such a case,
what should be expected return from B Ltd and K Ltd? [(2+2)+(1+1)]
Answer to 4(c)(i):
Factors are:
(i) Type of securities; (ii) Proportion of investment in fixed interest / dividend securities; (iii)
Identification of industry (i.e., which particular industry shows potential of growth; (iv) Selection of
company; (v) Objectives of portfolio; (vi) Timing and quantity of purchase of shares; (vii) Risk
tolerance (i.e., conservative investors are risk-averse and aggressive investors generally dare to
take risk).
Answer to 4 (c)(ii):
(1) Computation of Cost of Project & Beta of Project (Software Services to B Ltd)
Description of Factor Measure
 Capital Structure of J Ltd All Equity

 Nature of Capital Structure of J Unlevered
 Beta of Equity of J Ltd [uβ] 1.60
 Project Status (Multiple or Single) Single
 Project Beta (Beta of service to B = βB) To be ascertained
 Rule for Unlevered Firm with Single Project βu = βJ
 Therefore, Beta of Software Services to B Ltd 1.60
Cost of Capital
Cost of Equity (KE) = Return expected on Shares of J Ltd (i.e. E(RJ)]
KE = Expected Return on J under CAPM
= RF + βJ X (RM - RF)]
= 6.75% + [1.60 x (15% - 6.75%)]
= 6.75% + [1.60 x 8.25%] = 6.75% + 13.20% = 19.95%
Beta of Services to B Ltd (Multiple Project Model)

Beta of J Shares Ltd (βJ) under Multiple Project scenario = Weighted Average of Betas of Projects
βJ = WB X β B + W K X β K
1.60 = [(1- 35%) x βB] + [35% x 1.40]
1.60 = 0.65 x βB + 0.49
0.65 βB =1.60 - 0.49
βB =1.11 ÷ 0.65 =1.708
Beta of B Ltd (βB) should be 1.708
(2) Expected Return on Project B and Project K (Under CAPM Method)
Expected Return on Project B [E(RB)]

= RF + [βB X (RM - RF)]
= 6.75% + [1.708 x (15% - 6.75%)] = 6.75% + [1.708 x 8.25%]
= 6.75% + 14.091% = 20.841%
Expected Return on Project K [E(RK)]
= RF + [βK x (RM – RF)]
= 6.75% + [1.40 x (15% - 6.75%)] = 6.75% + [1.40 x 8.25%]
= 6.75% + 11.55% = 18.30%
5 (a)(i). Company Z is operating an elderly machine that is expected to produce a net cash
inflow of ` 40,000 in the coming year and ` 40,000 next year. Current salvage value is ` 80,000
and next year’s value is ` 70,000. The machine can be replaced now with a new machine,
which costs ` 1,50,000, but is much more efficient and will provide a cash inflow of ` 80,000 a
year for 3 years Company Z wants to know whether it should replace the equipment now or wait
a year with the clear understanding that the new machine is the best of the available
alternatives and that it in turn be replaced at the optimal point. Ignore tax. Take opportunity cost
of capital as 10 per cent. Advise with reasons. [3+3+2]
5(a)(ii). XYZ Ltd adopts constant WACC approach and believes that its cost of debt and overall
cost of capital is at 9% and 12% respectively. If the ratio of the market value of debt to the
market value of equity is 0.8, what rate of return do Equity Shareholders earn? Assume that there
are no taxes. [2]
Answer to 5(a)(i):
Statement showing present value of cash inflow of new machine when it replaces elderly
machine now
` `
Cash inflow of a new machine per year 80,000
Cumulative present value for 1-3 years @ 10% 2.48685
Present value of cash inflow for 3 years (` 80,000 x 2.48685) 1,98,948
Less: Cash outflow
Purchase cost of new machine 1,50,000
Less: Salvage value of old machine 80,000 70,000
N.P.V. of cash inflow for 3 years 1,28,948
Equivalent annual net present value of cash 51,852
Inflow of new machine (`1,22,152/2.48685)
Statement showing present value of cash inflow of new machine when it replaces elderly machine
next year
` `
Cash inflow of a new machine per year 80,000
Cumulative present value for 1-3 years @ 12% 2.4019
Present value of cash inflow for 3 years (` 80,000 x 2.48685) 1,98,948
Less: Cash outflow
Purchase cost of new machine 1,50,000
Less: Salvage value of old machine 70,000 80,000
N.P.V. of cash inflow for 3 years 1,18,948
Equivalent annual net present value of cash Inflow ( `1,12,152/2.48685) 47,831
Advise: Since the equivalent annual cash inflow of new machine now and next year is more than
cash inflow (` 40,000) of an elderly machine the company Z is advised to replace the elderly
machine now.
Company Z need not wait for the next year to replace the elderly machine since the equivalent
annual cash inflow now is more than the next year’s cash inflow.
Answer to 5(a)(ii):
Constant WACC implies the use of NOI or M&M Approach. Under M&M Approach,
Ke=Ko+Risk Premium.
So, Ke=K0+ (K0 –Kd) Equity/Debt
On substitution, we have, Ke=12%+(12%-9%)×80%=14.4%
Alternatively,
Ke can be obtained as balancing figure as under --

(Note: Debt: Equity = 0.8 = 4:5)
Component % Individual Cost in % WACC %

Debt 4/9th Kd = 9.00% 9.00% × 4/9th = 4.00%
Equity 5/9th Ke = 8.00 ÷ 5/9th = 14.00% 12% – 4% = 8.00%
(final balancing figure) (balance figure)
5(b)(i). As an executive of a lending institution, what factors should you critically evaluate with
respect to a large industrial project, from the perspectives of environmental and economic
viability? [4]
5(b)(ii). A Production Manager is planning to produce a new product and he wishes to estimate the
raw material requirement for that new product. On the basis of usage for a similar product
introduced previously, he has developed a frequency distribution of demand in tonnes per day
for a two month period. Used this data to simulate the raw material usage requirements for 7
days. Compute also expected value and comment on the result.
Demand Frequency
Tonnes/day No. of days
10 6
11 18
12 15
13 12
14 6
15 3
Random Number: 27, 13, 80, 10, 54, 60, 49. [6]
Answer to 5(b)(i):
Factors to consider for critical evaluation of a large industrial project, from the perspectives of
environmental and economic viability are:
(i) Employment potential.
(ii) Utilisation of domestically available raw material and other facilities.
(iii) Development of industrially backward areas as per government policy.
(iv) Effect of the project on the environment with particular emphasis on the pollution of water
and air to be caused by it.
(v) Arrangements for effective disposal of effluent as per government policy.
(vi) Energy conservation devices, etc. employed for the project.
Other economic factors that influence the final approval of a particular project are:
Internal Rate of return (IRR) and Domestic resources Cost (DRC).
Answer to 5(b)(ii):
Demand Frequency Probability Cumulative Random

Tonnes/day No. of days Probability Numbers
10 6 6÷60 = 0.10 0.10 00 - 09
11 18 18÷60 = 0.30 0.40 10 - 39
12 15 15÷60 = 0.25 0.65 40 - 64
13 12 12÷60 = 0.20 0.85 65 - 84
14 6 6÷60 = 0.10 0.95 85 - 94
15 3 3÷60 = 0.05 1.00 95 - 99
60 1.00
The first seven random numbers (two digits only) are simulated:
Random No. Corresponding

demand Tonnes/day
27 11
13 11
80 13
10 11
54 12
60 12
49 12
82
Mean requirement per = 82 / 7 = 11.7 Tonnes
The expected value (EV) = (10×0.1)+(11×0.3)+(12×0.25)+(13×0.2)+(14×0.1)+(15×0.05)
= 12.05 Tonnes
The difference = 12.05 – 11.7 = 0.35
This indicates that the small sample size of only 7 days had resulted in some error. A much larger
sample should be taken and several samples should be simulated before the simulation results
are used for decision making.
5 (c). VEDAVYAS Ltd. is considering two mutually exclusive projects M and project N. The
Finance Director thinks that the project with higher NPV should be chosen, whereas the Managing
Director thinks that the one with the higher IRR should be undertaken, especially as both projects
have the same initial outlay and length of life. The company anticipates a cot of capital of 10%
and the net after-tax cash flow of the projects are as follows:
Year 0 1 2 3 4 5
Cash flows (`)
Project M (4,00,000) 70,000 1,60,000 1,80,000 1,50,000 40,000
Project N (4,00,000) 4,36,000 20,000 20,000 8,000 6,000
You are required to:
(1) Calculate the NPV and IRR of each project.
(2) State with reasons, which project you would recommended.
(3) Explain the inconsistency in the ranking of the two projects.
Present value Table is given:

Year 0 1 2 3 4 5
PVIF at 10% 1.000 0.909 0.826 0.751 0.683 0.621
PVIF at 20% 1.000 0.833 0.694 0.579 0.482 0.402
(3+4)+2+1=10]
Answer to 5 (c).
(1) Calculation of NPV and IRR
NPV of Project M:
year Cash Flows Discount factor Discounted Discount factor Discounted
(`) (10%) Values(`) (20%) Values (`)
0 (4,00,000) 1.000 (4,00,000) 1.000 (4,00,000)
1 70,000 0.909 63,630 0.833 58,310
2 1,60,000 0.826 1,32,160 0.694 1,11,040
3 1,80,000 0.751 1,35,180 0.579 1,04,220
4 1,50,000 0.683 1,02,450 0.482 72,300
5 40,000 0.621 24,840 0.402 16,080
NPV 58,260 (38,050)
IRR of Project M:
At 20%, NPV is (-) 38,050 and at 10% NPV is 58,260
58260 58260
 IRR = 10 + x10 = 10 + x10 = 10 + 6.05 = 16.05%
58260 38050 96310
NPV of Project N:
year Cash Flows Discount factor Discounted Discount factor Discounted
(`) (10%) Values(`) (20%) Values (`)
0 (4,00,000) 1.000 (4,00,000) 1.000 (4,00,000)
1 4,36,000 0.909 3,96,324 0.833 3,63,188
2 20,000 0.826 16,520 0.694 13,880
3 20,000 0.751 15,020 0.579 11,580
4 8,000 0.683 5,464 0.482 3,856
5 6,000 0.621 3,726 0.402 2,412
NPV 37,054 (5,084)
IRR of Project M:
At 20%, NPV = (-) 5,084 and at 10% NPV = 37,054
37054 37054
 IRR = 10 + x10 = 10 + x10 = 10 + 8.79% = 18.79%
37054 5084 42138
(2) Both the projects are acceptable because they generate the positive NVP at the
company’s cost of capital at 10%. However, the company will have to select PROJECT M
because it has higher NPV. If the company follows IRR method, then PROJECT N should be
selected because of higher internal rate of return (IRR). But when NPV and IRR give
contradictory results, a project with higher NPV is generally preferred because of higher
return in absolute terms. Hence, Project M should be selected.
(3) The inconsistency in the ranking of the projects arises because of the difference in the
pattern of the cash flows. Project M’s major cash flow occur mainly in the middle three years
whereas project N generated the major cash flow in the first year itself.

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Answer to PTP_Final_Syllabus 2012_Dec2014_Set 2

PAPER-14: Advanced Financial Management

Time Allowed: 3 hours Full Marks: 100

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

(a) A company is considering Projects X and Y with following information: [2]

Project Expected NPV Standard deviation

(b) Define Non-financial Intermediaries? [2]

Expected rate of return: (By applying CAPM)

(d) What do you mean by Reverse Book Building? [2]

It is method of buy-back of securities. It is an efficient price discovery mechanism adopted

Amount placed in call = `52 crores

Based on put call parity theorem,

 100  92.8918  365

If the Bond matures at par Bn = `1,000.

(i) Define Out-of-Pocket Cost? [2]

Expected return on Equity fund = 7.00 + 10.00= 17%

Expected Standard deviation of the return on Port folio

Particulars MFA MFB MFC

Particulars MFA MFB MFC

Rupee return in value

(1) Calculation of Front-end Load (%)

(2) Repurchase Price = NAV (1- Back-end Load %)

Bidder Bid rate Amount (` Crores)

3(a)(ii). Write down the benefits of Rolling Settlement. [4]

(1) Computation of Semi Annual Fixed Rate Payment

Currency Inflow Outflow Spot rate Forward rate

(1) Computation of Net Exposure

Particulars US $ F Fr UK £ Japan Yen

Particulars US $ F Fr UK£ Japan Yen

(2) Off Setting Position:

Sale Price per NIFTY Future

Futures Price as on June 25

3(c)(i). The following quotes are available.

Given $/Є = 0.8385 / 0.8391 3M fwd = 0.8405 / 0.8421

To find Є /£ (3M outright forward rates)

Substituting the values,

Similarly Ask (Є /£) = 1/Bid($/Є) x Ask($/£)

Financial Benefits Created by Swap Transactions

4 (a). Stocks P and Q have the following historical returns —

Year 2009 2010 2011 2012 2013

1. Calculation of average rate of return on Portfolio during 2009-2013

Year Stock P’s Return % Stock Q’s Return %

2. Calculation of realized rate of return on Portfolio during 2009-2013

Stock P Stock Q Total

Average rate of return = `82.51 ÷ 5 = 16.50%

4(b)(i). What are the techniques used in Industry Analysis? [2]

Techniques Used in Industry Analysis:

Weight in portfolio is computed as total securities/size of portfolio; for example weight of

Computation of Expected Return

Description of Factor Measure

 Capital Structure of J Ltd All Equity

Beta of Services to B Ltd (Multiple Project Model)

(2) Expected Return on Project B and Project K (Under CAPM Method)

Expected Return on Project B [E(RB)]

Ke can be obtained as balancing figure as under --

Component % Individual Cost in % WACC %

Demand Frequency Probability Cumulative Random

Random No. Corresponding

Present value Table is given:

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