Question Paper

Security Analysis - I (MB331INV) : January 2007

Section A : Basic Concepts (30 Marks)
• This section consists of questions with serial number 1 - 30.
• Answer all questions.
• Each question carries one mark.
• Maximum time for answering Section A is 30 Minutes.

< Answer >

1. If Ramesh buys a 5 year, 10% annuity deposit certificate for Rs.30,328, the annuity he is entitled to
receive over the 5 year period is
(a) Rs.5,000
(b) Rs.6,000
(c) Rs.7,000
(d) Rs.8,000
(e) Rs.9,000.
< Answer >
2. Which of the following statements is/are true regarding functions of secondary market?
I. The investors should be able to dispose of his stock at the most competitive price.
II. It provides liquidity to the investors without any loss.
III. The resulting transaction costs are minimum for the investor.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
3. The number of unique covariance terms required to be calculated in order to calculate the risk of
portfolio of 15 securities by the Markowitz model is
(a) 98
(b) 105
(c) 112
(d) 120
(e) 125.
< Answer >
4. Which of the following statements is not true about the Security Market Lines (SML)?
(a) SML represents normal trade-off between return and risk
(b) The vertical distance of the security’s plot on the graph from the SML is called the security’s
alpha
(c) SML is same as the characteristic line for any security
(d) Ex-post SMLs are used to evaluate the performance of portfolio managers
(e) The slope of the characteristic line is the beta for the particular security involved.
< Answer >
5. The beta of stock A is 2.0 and is currently in equilibrium. The required return on the stock is 15% and
the expected return on the market is 10%. Suddenly owing to economic conditions, the expected return
on the market increases to 15%. Other things remaining the same, what would be the new required return
on the stock?
(a) 17.5%
(b) 20.0%
(c) 22.5%
(d) 25.0%
(e) 30.0%.
 (e) 30.0%.
< Answer >
6. Which of the following statements is/are true with respect to Beta?
I. Beta is the slope of the Security Market Line.
II. Beta measures the non-diversifiable risk.
III. Beta greater than one is referred to as an aggressive security.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
7. Which of the following is/are main objectives of International Organization of Securities Commissions
(IOSCO)?
I. To exchange information on their respective experiences in order to promote the development of
domestic markets.
II. To cooperate and promote high standards of regulation in order to maintain just, efficient and
sound markets.
III. To unite their efforts to establish standards and effective surveillance of international securities
transaction.
(a) Only (II) above
(b) Both (I) and (II) above
(c) Both (I) and (III) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
8. Which of the following departments of SEBI is responsible for regulations regarding underwriters,
registrars to issue, credit rating agencies, share transfer agents, debenture trustees, merchant bankers,
bankers to an issue and portfolio managers?
(a) Primary market department
(b) Secondary market department
(c) Collective investment schemes department
(d) Venture capital department
(e) Investigation, enforcement and surveillance department.
< Answer >
9. Who among the following cannot become members of OTCEI?
(a) Public Listed Corporates
(b) Scheduled Banks
(c) Mutual Funds
(d) Venture Capital Funds
(e) Banking Subsidiaries.
< Answer >
10. Which of the following is not true with respect to the depository system?
(a) Filling up transfer deeds and lodging the same with the company for transfer is necessary
(b) There would not be any bad deliveries
(c) Exemption from paying stamp duty on transfer of shares
(d) Shares purchased in electronic form will be transferred to the investor’s name within a day of
completion of settlement
(e) No scope for forgery of share certificates.
< Answer >
11. Which of the following is/are true in case of the pioneering stage of the industry life cycle?
I. It is difficult to predict which firms will succeed and which firms will fail.
II. Firms pay a high level of dividends.
III. Industry growth is very rapid.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
 (e) Both (II) and (III) above.
< Answer >
12. The major source of exit barriers is/are
I. Specialized assets.
II. Emotional barriers.
III. Strategic interrelationships.

(a) Only (I) above

(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
13. The cash earning per share for Anandam Ceramics Ltd. is 12. The net sales and the depreciation are
Rs.1,000 crores and Rs.20 crores respectively. The net profit margin for the company is 10%. The
earning per share for the company is
(a) Rs. 6.00
(b) Rs. 7.50
(c) Rs.10.00
(d) Rs.12.50
(e) Rs.15.00.
< Answer >
14. Which of the following is not a leading economic indicator?
(a) Utilization of manufacturing capacity
(b) Residential construction
(c) Corporate profits
(d) Level of stock prices
(e) Unemployment.
< Answer >
15. Under CRISIL 500 equity index, which of the following is not the parameter for selection of the
company?
(a) Market capitalization of the company
(b) Industry representation
(c) Trading interests in the scrips
(d) Stock exchanges covered
(e) Fundamentals of the company.
< Answer >
16. Which of the following entry barriers is not considered as natural barrier?
(a) Labor intensive
(b) Capital intensive
(c) Control over raw material
(d) Learning curve
(e) Economies of scale.
< Answer >
17. A company has an ROE of 0.25 and book value of Rs.15.63. The EPS for this company is
(a) 3.11
(b) 3.41
(c) 3.91
(d) 4.51
(e) 5.61.
< Answer >
18. Which of the following is/are true regarding three-stage dividend discount model?
I. An initial period of high-growth.
II. An intermediate period during which the growth declines.
III. A final stable-growth phase.
(a) Only (I) above
(b) Only (III) above
(c) Both (I) and (II) above
(d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
 (e) All (I), (II) and (III) above.
< Answer >
19. Book-building process is different from fixed price process for raising share capital from public. Which
of the following statement(s) is/are true about Book-building process compared to fixed price process?
I. Price at which securities will be offered/allotted is not known in advance to investor. Only an
indicative price range is known.
II. Demand for the securities offered can be known everyday.
III. Payment is made at the time of subscription.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (II) above
(e) Both (I) and (III) above.
< Answer >
20. Which of the following statements is/are not true with respect to an Exchange Traded Fund (ETF)?
I. ETFs primarily invest in the securities of companies that are included in a selected market index.
II. The NAV of the ETF is equal to the value of the underlying index.
III. ETFs cannot be bought or sold on a daily basis like stocks.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) Both (II) and (III) above.
< Answer >
21. The required rate of return on a stock is 12.5% and it is showing a constant growth rate of 9%. If the
stock’s retention rate is 70%, its P/E ratio should be
(a) 7.32
(b) 8.57
(c) 9.34
(d) 10.25
(e) 11.25.
< Answer >
22. Which of the following is/are true regarding advantages of Economic Value Added (EVA)?
I. It is primarily used for evaluating the performance of management.
II. It serves as a proxy for measuring a firm’s stock performance.
III. It can be applied to capital budgeting like NPV.
(a) Only (I) above
(b) Only (II) above
(c) Only (III) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
< Answer >
23. Which of the following statements should an appraiser take into consideration while determining the
discount?
I. Decreased executive’s actual duties and areas of active involvement.
II. Ability of existing successor management to move up the organization ladder.
III. Compensation necessary for replacing the key executive.
IV. Damages that are likely to arise from risks which the company is exposed to as a result of
change in the key position.
(a) Both (I) and (III) above
(b) Both (II) and (IV) above
(c) (I), (II) and (III) above
(d) (II), (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
 (e) All (I), (II), (III) and (IV) above.
< Answer >
24. The leverage ratio used in ROE analysis is
(a) Sales ratio
(b) Profit margin
(c) Total assets to net worth
(d) Tangible net worth to total assets
(e) Long-term debt to equity ratio.
< Answer >
25. Which of the following statement(s) is/are not true regarding the Price/Sales ratio?
I. P/S ratio is useful for valuing companies even with no dividends at all.
II. P/S ratio can be positive or negative.
III. Firms with low profit margins and high P/S ratio are undervalued.
IV. P/S ratio is not influenced by accounting methods.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (III) above
(d) Both (II) and (III) above
(e) (II), (III) and (IV) above.
< Answer >
26. Which of the following is not an application of SML?
(a) Evaluating the performance of portfolio manager
(b) Tests of asset pricing theories
(c) Tests of market efficiency
(d) Identifying mispriced securities
(e) Identifying the factors of pricing of an asset.
< Answer >
27. Which of the following statements is true regarding the semi-strong form of Efficient Market
Hypothesis?
(a) Stock prices fully reflect all historical price information
(b) Runs test is used to test the semi-strong form of market efficiency
(c) Stock prices fully reflect all relevant information including insider information
(d) Stock prices are not predictable using the publicly available information
(e) Relationship between the historical P/E ratios and risk-adjusted market performance supports
semi-strong form of market efficiency.
< Answer >
28. Which of the following is a test for examining weak form of market efficiency?
(a) Filter test
(b) Residual analysis
(c) Event studies
(d) Trading by mutual fund managers
(e) Calendar studies.
< Answer >
29. ABC Ltd. issues right shares which increases the market value of the shares of the company by Rs.150
crore. The aggregate market value of all the shares included in the index before the right issue made is
Rs.2,500 crore. If new base year average after the rights issue is Rs.1,010 crore, what is the base year
average before rights issue?
(a) Rs.1,070.60 crore
(b) Rs.1,005.94 crore
(c) Rs. 952.83 crore
(d) Rs. 949.40 crore
(e) Rs. 823.23 crore.
 < Answer >
30. On April 01, 2003 Deepak Fertilisers purchased a machine costing Rs.2 lakhs. The company provides
depreciation @10% on SLM. With effect from April 01, 2006 it was decided to change the method of
depreciation to WDV method. The rate being the same, the amount of depreciation to be charged for the
year 2006-07 is
(a) Rs. 8,000
(b) Rs.14,000
(c) Rs.22,000
(d) Rs.30,000
(e) Rs.34,000.

END OF SECTION A

Section B : Problems/Caselet (50 Marks)

• This section consists of questions with serial number 1 – 5.
• Answer all questions.
• Marks are indicated against each question.
• Detailed workings/explanations should form part of your answer.
• Do not spend more than 110 - 120 minutes on Section B.
< Answer >
1. The dividend ratio of a company for the current year is 25%.
The expected dividend ratios in future are follows:
Years Dividend ratios (%)
1 20
2 30
3 35

Thereafter it is expected that annual dividend amount will be growing at 8% per annum for an
infinite period. The face value of the firm’s stock is Rs.10 and its beta is 1.25. If the risk free
rate and risk premium on the market are 5% and 5.6% respectively, you are required to
calculate the intrinsic value of the stock.
(8 marks)
< Answer >
2. Construction of a complex, Industrial trade center is proposed to be financed by way of issue
of bonds and equity shares in the proportion of 7:3. The details of the instruments are as
under:
i. Bonds are bearing a coupon rate of 12% per annum maturing in 7 years. The interest
will be compounded semi-annually. To redeem the bonds a sinking fund is established.
The coupon payment is tax deductible.
ii. Equity investors require a return of 16%.
The expected net operating income from the property is Rs.75 lakhs and the effective tax
rate applicable is 35%.
You are required to calculate
a. Capitalization rate.
b. Market value of property.
(7 + 3 = 10 marks)
< Answer >
3. The stock of Hindustan Oil Exploration Ltd. (HOE) is currently trading at Rs.105.95. Based
3. The stock of Hindustan Oil Exploration Ltd. (HOE) is currently trading at Rs.105.95. Based
on the current market price, the P/E ratio is 16.18, P/B ratio is 3.91 and P/S ratio is 6.73.
Other fundamentals of HOE are given below:
Sales Rs.924.54 millions
Net profit Rs.384.84 millions
Net worth Rs.1593.25 millions
Dividend per share Re.1
Number of shares of Rs.10 each. Rs.58.75 millions
Beta 2
The yield on the one-year treasury bill is 5.5% and the equity risk premium in the market is
8.00%.
You are required to
a. Determine the required rate of return for equity holders and the sustainable growth rate
of HOE Ltd.
b. Estimate the P/E, P/B and P/S ratios justified by the fundamentals.
c. Explain whether the stock is fairly valued, overvalued or undervalued based on your
answer in part (b).
(3 + 6 + 3 = 12 marks)

Caselet
Read the caselet carefully and answer the following questions:
4. The caselet states that periodic earnings announcements do serve a purpose as they reveal < Answer >
information that would give a fair idea of the progress of the company. Briefly explain the
non-financial factors to be examined by an investor to assess the progress of the company.
(10 marks)
5. As an analyst, discuss the important characteristics that you would analyze before you identify < Answer >
an industry for investment.
(10 marks)
Periodic earnings announcements may not tell the whole story but they definitely provide the gist of it. These
numbers may lead to higher or lower expectations and affect the valuation of the stock. At times the management may
also resort to window-dressing to meet the forecasts. But does it mean that these numbers are irrelevant? What
information can you glean from interim financial reports? Periodic earnings announcements do serve a purpose as
they reveal information that would give a fair idea of the progress of the company. Additional disclosures, such as
segment reporting, presentation of consolidated results and the geographical break-up, give a lot of information that
would otherwise not be available in public domain at such frequency.
Analyst presentations and conference call transcripts are also available on certain company web sites. These are
valuable sources of information and give insights into the companies' operations and prospects. They give you a feel
of what is happening in a company and where is it heading in terms of business performance. Periodic financial
disclosures also show how the company compared with its peers. They indicate a company's market position and
control within the industry in that particular period and also point to whether a company has the potential to make the
best of the given business conditions. The absence of such periodic disclosure leaves a gap in financial information.
Worse, it could lead to selective disclosures, giving room for insider trading. Small investors would be left in the
lurch due to non-availability of information. The market might witness wider swings due to speculation and selective
disclosure. Information provided in financial statements is useful if scrutinized properly. For instance, the previous
eight quarters' earnings announcements would indicate the trend in margins and earnings growth. Sharp deviations
may require further scrutiny to judge the sustainability.
Any one-off instances having an impact on the earnings should be eliminated. Also, one has to be aware of the
external factors governing the business and their effect on the earnings performance in any period. When making an
investment decision, adequate discounting should be done for any risks associated with the business. This would be
based on the investor's risk-taking ability. It might also pay to take an independent view of the stock without the
market interest in a stock influencing your decision. Any stock that commands a higher valuation than its earnings can
support will be vulnerable to volatility. Markets generally tend to overestimate the earnings growth potential of
certain companies or get carried away by exceptional earnings announcements without looking at the ground realities.
Often, stocks zoom or slump after earnings announcements and trade at valuations that cannot be sustained by
earnings growth. It is better to avoid a stock that commands high multiples when the business environment is
earnings growth. It is better to avoid a stock that commands high multiples when the business environment is
uncertain. Also, avoid momentum investing in such stocks. A little bit of caution and reasoning could protect you
from extreme downside risks. But do remember that numbers are usually factored in the stock price and should not be
taken fully at face value. Future performance would depend on a host of external factors. A fresh investment decision
should be based on the general business environment and the scope for business growth.
END OF SECTION B

Section C : Applied Theory (20 Marks)

• This section consists of questions with serial number 6 - 7.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 25 -30 minutes on section C.

< Answer >

6. Listing means admission of securities for trading on a stock exchange. It is done through a
formal agreement between the stock exchange and the company. In this context, explain how
listing of securities is advantageous to the company as well as to the investor. Also explain
various types of listing of securities.
(10 marks)
< Answer >
7. It is more difficult to liquidate a minority interest in a closely held company than liquidate in a
controlling interest. Discuss the various methods of valuing minority interest.
(10 marks)
END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Security Analysis - I (MB331INV) : January 2007
Section A : Basic Concepts
1. Answer : (d)
30,32830,328
PVIFA(10,5) = Rs.8, 000.
Reason: Annuity = = 3.791
Hence (d) is the correct answer.
2. Answer: (e)
Reason: The functions of secondary markets are:
• The investors should be able to dispose of his stock at the most competitive price. The most
competitive price in case of selling is the highest price, while for buying it is the lowest price.
• It provides liquidity to the investors without any loss.
• That resulting transaction costs are minimum for the investor.
Hence (e) is the correct answer.
3. Answer : (b)
Reason : Number of unique covariance terms is given by :
2 2
n −n 15 − 15
= = 105
2 2 .
Hence (b) is the answer.
4. Answer : (c)
Reason : a. SML typically represents the average or normal trade-off between risk and return for a group of
securities, where risk is measured typically, in terms of the securities betas. Statement (a) is true.
b. The amount by which a security’s return differed from the normal return for its level of risk is
simply the vertical distance of the security’s plot on the graph from the SML. Statement (b) is true.
c. & e. SML is not same as the characteristic line for a simple security. For the characteristic line, the
y-axis represents the returns for a particular security and the x-axis represents the returns for the
market index. The slope of the characteristic line is the beta for the particular security involved.
Therefore statement (c) is not true and statement (e) is true.
d. Ex-post SMLs are used to evaluate the performance of portfolio managers. Statement (d) is true.
5. Answer : (d)
Reason : 15 = Rf + 2 (10 – Rf)
i.e., Rf = 20 – 15 = 5%
Revised R = 5 + 2 (15 – 5) = 25%
6. Answer : (d)
Reason : Beta is the slope of the regression line (characteristic line). Beta measures non-diversifiable risk also
known as systematic risk.Beta greater than one is referred to as an aggressive security.
Therefore, Option (d) is the correct answer.
7. Answer : (e)
Reason : The main objectives of IOSCO are:
• To cooperate and promote high standards of regulation in order to maintain just, efficient and
sound markets.
• To exchange information on their respective experience in order to promote the development of
domestic markets.
• To unite their efforts to establish standards and effective surveillance of international securities
transactions.
• To provide mutual assistance to promote the integrity of the markets by a rigorous application of
the standards and by effective enforcement against offences.
Hence, all statements (I), (II) and (III) are correct.
Hence, option (e) is the correct answer.
8. Answer : (a)
Reason: The department looks after the policy matters and regulaltory issues concerning the primary market. The
department is responsible for regualations regarding underwriters, registrars to issue, credit rating
agencies, share transfer agents, debenture trustees, merchant bankers, bakers to an issue and portfolio
managers. Hence, option is (a) is the correct answer.
9. Answer : (a)
Reason : The following can become members of OTCEI :
Public financial institutions
Scheduled banks
Mutual funds
Venture capital funds and venture capital companies
NBFCs
Banking subsidiaries.
All the above can become members of OTCEI by fulfilling the eligibility norms laid down by OTCEI
such as network, approval of SEBI, infrasructure, standing and experience, etc.,
Hence (a) is the answer.
10. Answer : (a)
Reason: The advantages of depositary syatem to the investors are :
Filling up transfer deeds and lodging the same with the company for transfer is not necessary.
There would not be any bad deliveries
Exemption from paying stamp duty on transfer of shares
Shares purchased in electronic form will be transferred to the investor’s name within a day of completion
of settlement
Faster payments on sale of shares
No scope for forgery of share certificates.
Hence (a) is the correct answer.
11. Answer : (d)
Reason : Statement II is not true for pioneering stage as the dividends become payable only at
growth stage and high dividends can be expected only at stabilization stage.
12. Answer : (e)
Reason: The major source of exit barriers are as follows:
1. Specialized assets
2. Fixed costs of exit
3. Strategic interrelationships
4. Emotional barriers
5. Government and social restrictions.
Hence (e) is the correct answer.
13. Answer : (c)
Reason : Net profit margin = PAT/Sales
∴ PAT = 100 crores
PAT + Depreciation
No. of shares
Cash earning per share =
∴ Number of shares = 10 crores
∴ Earning per share = 100/10 = Rs.10
Therefore, Option (c) is the correct answer.
14. Answer : (e)
Reason : The lead indicator approach is an important forecasting method to forecast the general economic
conditions by identifying economic indicators that turn ahead of the change in general level of economic
activity. Some of the leading economic indicators are the utilization of manufacturing capacity,
residential construction, corporate profits, and the general level of stock prices.
All the first four alternatives are the leading economic indicators, while the last alternative is a lagging
economic indicator.
Therefore answer is (e).
15. Answer : (d)
Reason : Selection of the companies has been made on the basis of four parameters:
a. Market capitalization of the company
b. Industry representation
c. Trading interests in the scrips.
d. Fundamentals of the company.
Hence, option (d) is the correct answer.
16. Answer : (c)
Reason : Control over raw material is an artificial barrier and not a natural. All other are the natural entry
barriers.
Therefore, option (c) is the correct answer.
17. Answer : (c)
Reason: EPS = ROE × book value = 0.25 × 15.63 = 3.91.
18. Answer : (e)
Reason: Three-stage Dividend Discount Model
It is a combination of two-stage model and H-model. This model assumes three stages of growth:
I. An initial period of high-growth
II. An intermediate period during which the growth declines.
III. A final stable-growth phase.
Hence (e) is the correct answer.
19. Answer : (d)
Reason : In book-building process, payment is made only after allocation. In fixed price process payment is made
at the time of subscription whereas refund is possible after allocation.
Hence (d) is the answer.
20. Answer : (e)
Reason : An ETF will primarily invest in the securities of companies that are included in a selected market index.
The NAV of the ETF is equal to a fraction of the the value of the underlying index.
ETFs can be bought or sold on a daily basis like stocks.
Hence (e) is the answer.
21. Answer : (c)

Reason : P0 =

E 0 (1 − R.R) (1 + g)
ke − g
P0 =

P0 (1 − R.R) (1 + g)
=
E0 ke − g
 (1 − 0.70)1.09 0.327
0.125 − 0.09
= = 0.035 = 9.34
22. Answer : (e)
Reason: Advantages of EVA :
• EVA ia primarily used for evalating the performance of management..
• It serve as a proxy for measuring for measuring a firm ‘s stock performance.
• EVA can be applied to capital budgeting like NPV.
Hence (e) is the correct answer.
23. Answer : (e)
Reason: An appraiser, while determining the discount, should take into consideration the following:
I. Decreased executive’s actual duties and areas of active involvement.
II. Ability of existing successor management to move up the organization ladder.
III. Compensation necessary for replacing the key executive.
IV. Damages that are likely to arise form risks which the company is exposed to as a result of change in
the key position.
Hence (e) is the correct answer.
24. Answer : (c)
Reason : According to the Du Pont analysis
Return on equity = Net profit margin x Asset turnover ratio x Asset – Equity ratio
Leverage ratios measure the long-term solvency of a firm. Total assets to net worth is the leverage ratio
used in ROE analysis.
25. Answer : (d)
Reason : P/S ratio is useful for valuing companies even with no earnings, viz., no dividends at all.
P/S ratio can never be negative.
Firms with low profit margins and high P/S ratio are overvalued and those with high profit margins and
low P/S ratios are undervalued.
P/S ratio is not influenced by accounting methods used fro depreciation, inventory, etc.,
Statements (I) and (IV) are true, and statements (II) and (III) are not true. Hence (d) is the answer.
26. Answer : (e)
Reason : Alternatives a), b) and c) are applications of ex-post SML. Whereas alternative d) is an application of
ex-ante SML. Alternative e) is not an application of SML.
27. Answer : (d)
Reason : Weak form of efficiency assert that stock prices fully reflect all historical price information. Runs test is
used to test the weak form of EMH.
Super strong form of efficiency Stock prices fully reflect all relevant information including insider
information.
Semi-strong form of efficiency implies that market prices reflect all publicly available information
concerning past trading as well as fundamental aspects of the firm. Hence stock prices are not predictable
using the publicly available information.
Relationship between the historical P/E ratios and risk-adjusted market performance is evidence against
the semi-strong form of market efficiency.
Hence (d) is the answer.
28. Answer : (a)
Reason: Residual analysis, event studies and calendar studies are tests for examinig semi-strong form of market
efficieny. Trading by mutual fund managers is a method for examinig strong form of market efficiency.
While filter test is a method for examining weak form of market efficiency.
Hence, option (a) is the correct answer.
29. Answer : (c)
NewMarketValue
×
Reason: New Base year Average = Old Base Year Average OldMarketValue
(2500 + 150)
X×
1010 = 2500
X = 952.83
Thus, Old Base Year Average is Rs. 952.83 crore.
Hence, option (c) is the correct answer.

30. Answer : (b)

Reason : SLM
2, 00,000
2003-04 (20,000)
1,80,000
04-05 (20,000)
1,60,000
05-06 (20,000)
1,40,000
Therefore for 2006-07 is (1,40,000)10% = Rs.14,000

Section B : Problems/Caselet
1. Dividend declared during the current year =Rs. 10 × 0.25 = 2.5 < TOP >
Future Dividend
First year = 10 × 0.20 = Rs. 2.00
Second year = 10 × 0.30 = Rs. 3.00
Third year = 10 × 0.35 = Rs. 3.50
Required rate of return = Rf + βA (RM – Rf)
= 5 + 1.25 × 5.6 = 12%
D4
/(1 + K)3
Intrinsic value of the share = D1/(1+K) + D2/(1+K)2 + D3/(1+ k)3 + K − g

2.00 3.00 3.50 3.50 ×1.08

= + 2
+ 3
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)3 (0.12 − 0.08)
= 1.785 +2.392+2.4912+ 67.26 = Rs. 73.93.
2. a. Payments to Bond-holders consists of paying the interest and regular contribution to the < TOP >
sinking fund to pay the principal.
Contribution to the sinking fund every 6 month for 7 years
i
0.12
f 2
n ×f
 i 7×2
1 +  − 1 1 + 0.12  − 1
= 
f = 
2 
= 0.0476
Alternately,
Consider bond price Rs.100 the sinking fund every six month
100
 100 100
FVIFA(6%, 14)
A= = 21.015 = 4.759 i.e. 0.0476 per rupee for six months
Hence, per annum the contribution will be (1 + 0.0476)2 – 1 = 0.0975
After tax effective annual interest = (1 + 0.06)2 – 1 –0.12 × 0.35 = 0.0816
Therefore, total payments on bond = 0.0816 + 0.0975 = 0.1791
Calculation of weighted rates
Instruments % Employed Required of return Weighted rates (%)
(%)
Bonds 70 17.91 12.54
Equity 30 16.00 4.80
17.34
Therefore, the capitalization rate is 17.34%.
Net operating Income 75,00,000
Capitalization rate
b. Market value of the property = = 0.1734 = 4,32,52,595.16

3. = 5.5 + 2 (8) = 21.5% < TOP >

a. Required rate of return
g = ROE × b = 0.2415 × 0.8473 = 20.46%
Here, .
384.84
Net Pr ofit m arg in = = 41.63%
b. 924.54
384.84
Re turn on equity = = 24.15%
1593.25
384.84
EPS = = Rs. 6.55
58.75
1
Dividend pay out ratio = = 15.27%
6.55
Retention ratio = 1-0.1527 = 0.8473
(1 − b )(1 + g ) 0.1527 × 1.2046
P/E = = = 17.68
Ke − g 0.215 − 0.2046
1.
ROE − g 0.2415 × 0.2046
P/B = = = 4.75
Ke − g 0.2150 − 0.2046
2.
NPM × (1 − b ) × (1 + g ) 0.4163 × 0.1527 ×1.2046
P/S = = = 7.36
Ke − g 0.2150 − 0.2046
3.
c. The calculated P/E is more than the current P/E, Therefore as per P/E stock is undervalued.
The calculated P/B is less than the current P/B, Therefore as per P/B stock is slightly
overvalued.
The calculated P/S is greater than the current P/S, Therefore as per P/S stock is undervalued.
4. The important non-financial factors to be examined by an investor are as follows: < TOP >
Business of the company
The investor should know whether the company is a well-established one, whether it has a good
product range and whether its lines of business have considerable potential to grow.
Top Management
The quality of top management team, particularly, the competence and the commitment of the chief
executive officer matters a lot in shaping the destiny of the company.
Product Range
Progressive companies like ITC and Hindustan Lever create competition for their existing products
 Progressive companies like ITC and Hindustan Lever create competition for their existing products
by launching new products with regular frequency. Hence investors must examine whether the
company under review belongs to this group or not.
Diversification
An issue related to that of product range is diversification. To reduce the degree of business risk
and improve profitability, many companies resort to diversification. Hence this issue is to be
carefully examined by the investor.
Foreign Collaboration
Where a company has entered into technical collaboration with a foreign company, the investor
must find out more about the nature of the collaboration agreement.
Availability and Cost of Inputs
If the company depends upon imported raw materials, it is important for the investors to assess the
raw material position, because any shortage of the raw material and/or escalation in the cost of raw
material will adversely affect the profitability.
Research and Development
Progressive companies spend substantial sums of money on R&D to upgrade their existing
products, introduce new products, adapt foreign technology to suit the local conditions, achieve
import substitution, etc.
Governmental Regulations
The investor must assess the implications of governmental regulations such as MRTP Act, FERA,
pollution control regulations etc., for the company under review.
Pattern of Shareholding and Listing
The pattern of shareholding has a bearing on the floating stock available in the market and the
trading volume of these issues will have an effect on the company, hence it will be analyzed by the
investor before taking any investment decision.
5. Before taking a decision for making an investment, every industry has to be analysed thoroughly. < TOP >
The most important of the characteristics that are to be evaluated for an industry are given below:
• Past sales and earnings performance
• Performance of the industry.
• The attitude of the government towards the industry.
• Labor conditions within the industry.
• The competitive conditions as reflected by the existence of the entry barriers and
• The stock prices of the firms in the industry relative to their earnings.
Past sales and earnings performance: For an analyst, past sales and earnings performance of the
firm form a crucial input in forecasting future trends. This is because by examining the contribution
of various factors in the past sales reveals the relevance of these factors individually and relatively
under present conditions.
In any firm sales and the earnings play an important role. These variables will exhibit a degree of
consistency only when the firm has weathered a variety of economic conditions. The analyst form
the observation of these variables will be able to judge the stability of the performance in terms of
sales and earnings as well as the growth rates.
Another crucial factor is that of the relationship between the sales and the fixed costs. The more the
fixed costs, the higher will be the breakeven point and higher will be the sales volume to be
achieved.
Performance of the industry:
By performance, we understand the products and the technology of a particular industry not
becoming obsolete in a short span of time .If the industry is not permanent, then investing in that
industry altogether becomes a loosing proportion. In some of he cases a product with additional
features manufactured by employing superior technology makes the existing product totally
irrelevant or at least results in the manufacturing process becoming a commercially enviable
proposition.
In this age of rapid technological developments, this factor plays a crucial role in industry analysis.
The Government’s role is also important factor affecting the performance of the industry.
The attitude of the government towards the industry:
It is imperative for an analyst that he should be well aware of the various Government policies and
 It is imperative for an analyst that he should be well aware of the various Government policies and
regulations with reference to an industry in which investment is considered. The government
policies like deregulating an industry by allowing foreign investment,, imposing high tariffs on
imports and restrictive legislation have a bearing on their performance. Some of the legal
restrictions result in the profits being very low for a particular industry. Thus an analyst, for that
matter, an investor should be thorough with various government regulations and their implications
and should be able to predict, at least broadly, the changes likely to take place in the regulations in
the near future.
Labor conditions within the industry:
This is an important factor to be considered in industries which are labor intensive .An analyst
should examine the various provisions of the labor laws and also go into the possible reasons that
may halt the production process and its fallout on the profits of the industry .In case of a prolonged
strike ,a labor intensive firm will not only lose its customers and goodwill but also may not be able
to cover its fixed costs in certain cases.
Competitive conditions:
While analyzing this situation, the three general types of barriers that an analyst should concentrate
on ,are
• Existence of product differentiation
• Absolute cost advantages
Advantages rising form economies of scales
The existence of the first barrier assures that a new entrant will not be able to charge as much by the
existing firms. Also he has to spend large amounts of money on advertising to capture an acceptable
share of the market as this situation is usually found in cases where the customers exhibit a high
degree of brand loyalty. By absolute cost advantages, we understand that the existing firms are
capable of producing and distributing the products at lower costs than the new entrants irrespective
of the volume produced. As a result, they enjoy wider profit margins. This may be due to the fact
that the existing firms may have exclusive patents ,own the resources or superior management skills
that are not available to new entrants. Economies of scale are usually realized when the production
are quite high. A new entrant in this case also has to garner a significant market share so that he can
avail the benefits from economies of scale. An analyst or a prospective investor should consider
investment in an industry which is well protected.
Industry share prices relative to its earnings
In addition to the above factors an analyst also has to look at the present share prices. In this case an
underpriced share would be the best bet. Also an analyst should examine the fact that the share
prices are not high due to the overzealous nature of the investors to acquire the shares of the firms
in a new industry. Usually the shares of these companies experience high fluctuations depending on
the crowd behavior.

Section C: Applied Theory

6. Advantages of Listing
Listing of securities on the stock exchanges is advantageous to the company as well as to the investors
as seen hereunder:
a. To the Company
i. The company enjoys concessions under Direct Tax Laws - In such companies the public is
substantially interested resulting in lower rate of income tax payable by them;
ii. The company gains national and international importance by its share value quoted on the
stock exchanges;
iii. Financial institutions/bankers extend term loan facilities in the form of rupee currency and
foreign currency loan;
iv. It helps the company to mobilize resources from the shareholders through ‘Rights Issue’ for
programs of expansion and modernization without depending on the financial institutions in
line with the government policies;
v. It ensures wide distribution of shareholding thus avoiding fears of easy takeover of the
organization by others.
b. To the Investors
i. Since the securities are officially traded, liquidity of investment by the investors is well
 i. Since the securities are officially traded, liquidity of investment by the investors is well
ensured;
ii. Rights entitlement in respect of further issues can be disposed of in the market;
iii. Listed securities are well preferred by bankers for extending loan facility;
iv. Official quotations of the securities on the stock exchanges corroborate the valuation taken
by the investors for purposes of tax assessments under Income Tax Act, Wealth Tax Act,
etc.;
v. Since securities are quoted, there is no secrecy of the price realization of securities sold by
the investors;
vi. The rules of the stock exchange protect the interest of the investors in respect of their
holdings;
vii. Listed companies are obligated to furnish unaudited financial results on a half-yearly basis
within two months of the expiry of the period. The said details enable the investing public to
appreciate the financial results of the company in between the financial year;
viii. Takeover offers concerning listed companies are to be announced to the public. This will
enable the investing public to exercise its discretion on such matters.
Types of Listing
Listing of securities is of five types as follows:
Initial Listing
A company, whose securities have not been listed earlier in a recognized stock exchange, if
desirous of listing its securities, should follow procedures applicable to initial listing.
Listing of Public Issue of Shares and/or Debentures
A company whose shares are listed on a recognized stock exchange may issue shares and/or
debentures to the public for subscription. In such cases the company under the Listing Agreement
has to submit necessary application to the stock exchange(s) for listing of its securities. It may so
happen that a green field company, i.e., a company shortly after incorporation may issue its shares
and/or debentures to the public for subscription. In that event, it has to comply with the formalities
applicable to initial listing.
Listing of Rights Issue of Shares and/or Debentures
Companies whose securities are already listed may issue shares and/or debentures by way of
‘rights’ to the existing shareholders. Under the listing agreement, such companies have to list
shares and/or debentures allotted by way of rights to the shareholders with stock exchange(s).
Listing of Bonus Issue of Shares
Companies which issue bonus shares by capitalization of its reserves, pursuant to the listing
agreement should enlist with the stock exchange(s). Bonus shares should issue by submitting
necessary application form for official quotation of the bonus shares.
Listing of Shares Issued on Amalgamation, Mergers, etc.
Amalgamated companies, which issue shares to the shareholders have to get the shares listed on
the stock exchanges to enable the erstwhile shareholders with such shares.
7. Methods of Valuing Minority Interests
1 Top down approach
2. Horizontal approach
3 Bottom-up approach
TOP-DOWN APPROACH
Steps involved in this method are,
1. Estimate the value of the equity of the firm on control basis
2. Calculate the minority owner’s pro rata interest in the total
3. Estimate the amount of discounts, if nay. In addition, estimation of a further discount for lack of
marketability should also be made.
Step 1
Value of a firm is defined as the value of the classes of equity taken as a whole, assuming no long-term
debt is involved Any of the methods discussed in the earlier part of this chapter can be used to
estimate the value of equity of a firm.
There is a significant difference between control evaluation and non-control evaluations due to the
difference in the way business is analyzed by control buyers and non- control buyers. Control buyers
analyze asset values based on only a few situations. Non-control buyers tend to place emphasis on only
analyze asset values based on only a few situations. Non-control buyers tend to place emphasis on only
earnings.
Step 2
If there is only a single class of stock, (i.e., no warrants or any sort of contingent claims are
outstanding) the proportionate value per share is nothing but the firm value divided by the number of
shares outstanding. But when there are different classes of interests, firm value must be allocated
among them thereby reflecting any dilution from any contingent interest.
Step 3
Discounting is done in two steps. In the first step, discounting is done for minority interest and then in
the second step, it is done for marketability.
HORIZONTAL APPROACH
A minority interst may be valued relatively by referring to other minority interest transactions. When
the value calculated using the valuation approach is a “publicly traded equivalent value”, then the value
needs to be discounted only for lack of marketability. If the value is compared directly with other
closely held minority interests, no interests or premiums may be necessary. But in the absence of past
transactions in company’s own stock, it is very difficult to find reliable data on minority transactions in
representative closely held company stocks.
BOTTOM-UP APPROACH
Minority interest holders realize income in the form of dividends and capital gains (proceeds on the
sales) In this approach, first the dividend cash flows (timing and amounts) should be estimated
followed by projection of capital gains (timing and amount). These two cash flows have to be then
discounted at an appropriate discount rate, which reflects the degree of uncertainly of realizing the
expected return at the time and in the amounts projected. The lack of marketability of the closely held
minority interest can be captured in the discount rate.
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