Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Paper-14: ADVANCED FINANCIAL MANAGEMENT

Time Allowed: 3 Hours Full Marks: 100

The figures in the margin on the right side indicate full marks.
Answer Question No. 1 which is compulsory.
From Section A: Answer any two questions.
From Section B: Answer any one question.
From Section C: Answer any one question.
From Section D: Answer any one question.

Working Notes should form part of the answer.

“Whenever necessary, suitable assumptions should be made and indicated in answer by the
candidates.”

1. (a) A one day repo is entered into on Jan 10, 2013 on an 11.99% 2014 security, maturing on
April 7, 2014. The face value of the transaction is ` 5 Crores. The price of the security is `
115.00. Assume that RBI has lent securities in the first leg to PNB. If the repo rate is 6%,
what is the settlement amount on Jan 10, 2013? [Use 360 days convention] [3]

(b) Write the limitations of Social Cost Benefits Analysis? [3]

(c) RBI sold a 91 days T-Bill of face value of ` 100 at an yield of 7%. What was the issue price?
[3]
(d) Mr. Y on 01.07.2011, during the initial offer of some Mutual Fund invested in 20,000 units
having face value of ` 10 for each unit. On 31.03.2012 the dividend operated by the M.F.
was 10% and Mr. Y found that his annualized yield was 153.33%.On 31.03.2013, 20%
dividend was given. On 31.03.2014 Mr. Y redeemed all his balances of 22,592.23 units
when his annualized yield was 73.52%. What are the NAVs as on 31.03.2012, 31.03.2013
and 31.03.2014? [5]

(e) Calculate the price of 3 months ADS futures, if ADS (FV `10) quotes ` 440 on NSE and 3
months future price quotes at `430 and the 1 month borrowing rate is given as 15% and
the expected annual dividend yield is 25% per annum payable before expiry. Also
examine arbitrage opportunities. [3]

(f) What are the steps involved in calculation of stock market index on a particular date? [3]

Solution:

1. (a) In the first leg RBI has lent securities and receives money from PNB
Stage I:
G Sec pays bi-annual coupons;
Interests are paid on April 7 & October 7.
G Sec Maturity on April 7, 2014;
Days elapsed from October 8, 2012 till Jan 10, 2013 = 24 + 30 + 31 + 9 = 94 days
Accrued Interest: 5 Crores x 0.1199 x 94/360 = ` 1565361
Transaction Value = ` 5 Crores x 115/100 = ` 57500000
Total Settlement amount = ` 59065361 = Money receive by RBI from PNB

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

(b) Social Cost Benefit Analysis is a systematic evaluation of an organization’s social

performance as distinguished from its economic performance. Social Cost Benefits
Analysis is an approach for evaluation of projects. It assesses gains/losses to society as a
whole from the acceptance of a particular project.
(i) Successful application depends upon reasonable accuracy and dependability of
the underlying forecasts as well as assessment of intangibles.
(ii) Technique does not indicate whether given project evaluated on socio-economic
considerations is best choice to reach national goals or whether same resources if
employed in another project would yield better results.
(iii) Cost of evaluation by such technique could be enormous for smaller projects.
(iv) Social Cost Benefit Analysis takes into consideration those aspects of social costs and
benefits which can be quantified.

(c) Issue price of T-bill is at discounted value and redeemed at face value.
Maturity Period 91days
Face Value ` 100
Yield Rate 7% or 0.07
Let the issue price of T-Bill be ‘x’. Then,
100 x 365
0.07 100
x 91
100 x
0.07 4.011
x
0.07x = 401.10-4.011x
4.081x = 401.10
X = 401.10/4.081=98.28
The issue price of T-Bill was ` 98.28.

(d) Yield for 9 months= 153.33% × 9/12 =115%

Amount receivable as on 31.03.2012
= 2,00,000 + (2,00,000×115/100)
= 2,00,000 + 2,30,000
= 4,30,000.
`(4,30,000 20,000)
NAV as on 31.03.2012 =` 20.50
20,000unit s
` 4,30,000
Units as on 31.03.2012 = 20,975.61 units
` 20.50
Dividend as on 31.03.2013 = 20,975.61units × `10×20/100 =`41,951.22
` 41951.22
NAV as on 31.03.2013 =`25.95
22592.23 20975.61
` 2,00,000 (2,00,000 73.52/100 33/12)
NAV as on 31.03.2014
22592.23un its
` 2,00,000 ` 4,04,360
22592.23un its
= `26.75

(e) Future Price = Spot Price + Cost of Carry- Dividend

= 440 + (440 × 0.15 × 0.25) – (10 × 0.25)
= 440 + 16.50 – 2.50
= 454

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

The future price is `454 which is now quoted at `430 in the exchange. The fair value of
Futures is more than the actual future price. So, no arbitrage opportunities exist.

(f) Following steps are involved in calculation of stock market index on a particular date:

a. Calculate market capitalization of each individual company comprising the index.

b. Calculate the total market capitalization by adding the individual market
capitalization of all companies in the index.
c. Computing index of next day requires the index value and the total market
capitalization of the previous day and is computed as follows:
Total market capitalization for current day
Index Value = Index on previous day ×
Total Capitalization of the previous day
d. It should also be noted that Indices may also be calculated using the price weighted
method. Here the share price of the constituent companies form the weights.
However, almost all equity indices world-wide are calculated using the market
capitalization weighted method.

SECTION A
(Answer any two of the following.)

2. (a) Explain briefly Call Money in the context of financial market. [4]

(b) Describe the role of RBI as Governments’ Debt Manager [3]

(c) You are required to compute the annualized cost of fund to XYZ Bank Ltd., Given;
Face value of CD – ` 15 lakhs
Issue price – ` 14,45,000
Tenure – ` 5 months
Stamp duty – ` 0.25% of face value. [5]

Solution:

2. (a) Call Money: The Call Money is a part of the money market where, day to day surplus
funds, mostly of banks, are traded. Moreover, the call money market is most liquid of all
short-term money market segments.

The maturity period of call loans vary from 1 to 14 days. The money that is lent for one
day in call money market is also known as 'overnight money'. The interest paid on call
loans are known as the call rates. The call rate is expected to freely reflect the day-to-
day lack of funds. These rates vary from day-to-day and within the day, often from hour-
to-hour. High rates indicate the tightness of liquidity in the financial system while low rates
indicate an easy liquidity position in the market.

In India, call money is lent mainly to even out the short-term mismatches of assets and
liabilities and to meet CRR requirement of banks. The short-term mismatches arise due to
variation in maturities i.e. the deposits mobilized are deployed by the bank at a longer
maturity to earn more returns and duration of withdrawal of deposits by customers vary.
Thus, the banks borrow from call money markets to meet short-term maturity mismatches.

Moreover, the banks borrow from call money market to meet the cash Reserve Ratio
(CRR) requirements that they should maintain with RBI every fortnight and is computed
as a percentage of Net Demand and Time Liabilities (NDTL).

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

(b) In this role, RBI set policies, in consultation with the government and determine the
operational aspects of rising money to help the government finance its requirements:
Determine the size, tenure and nature (fixed or floating rate) of the loan
Define the issuing process including holding of auctions
Inform the public and potential investors about upcoming government loan auctions
The Reserve Bank also undertakes market development efforts, including enhanced
secondary market trading and settlement mechanisms, authorization of primary dealers
and improved transparency of issuing process to increase investor confidence, with the
objective of broadening and deepening the government securities market.

(c) Face Value = ` 15 lakhs

Issue Price = ` 14,45,000
To find the annualized rate we first find the inherent rate for 5 months and compound the
same to find the annualized rate. The five month rate is given by r which satisfies the
following equation:
r n
D = 1 x x , where D = ` 55000 for an investment of ` 15 lakhs i.e., ` 3.67 for an
100 365
investment of ` 100. Thus, we get r as follows:
r 5
3.67 = 100 x x which implies r = 8.8%
100 12
A CD paying 8.8% p.a. would pay monthly 8.8% / 12 = 0.733%
This when compounded 12 times we get annualized rate:
Amount = 100 x (1 + 0.00733)12 = ` 109.157
i.e. 9.16% on an investment of ` 100.
Cost of funds to the Bank = Effective interest rate + Stamp duty
= 9.16% + 0.25%
= 9.41%

3. (a) What are the benefits of hedge funds? [4]

(b) ASN Ltd. has total sales of `4.50 crores and its average collection period is 120 days. The
past experience indicates that bad debt losses are 2% on sales. The expenditure incurred
by the company in administering its receivable collection efforts are `6,00,000. A factor is
prepared to buy the company’s receivables by charging 2% commission. The factor will
pay advance on receivables to the company at an interest rate of 18% per annum after
withholding 10% as reserve. Assume 360 days in a year.
You are required to calculate effective cost of factoring to the company. [8]

Solution:

3. (a) Benefits of Hedge Funds:

(a) Seek higher returns: Hedge funds strategies generate positive returns in both rising
and falling equity and bond markets.
(b) Investment styles: Huge variety of hedge fund investment styles – may uncorrelated
with each other – provides investors with a wide choice of hedge funds strategies to
meet their investment objectives.
(c) Long term Solution: Hedge funds provide an ideal long-term investment solution,
eliminating the need to correctly time entry and exit from markets.
(d) (i) Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and
volatility and increases returns.

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

(ii) Adding hedge funds to an investment portfolio diversification not otherwise

available in traditional investing.

(b)
MSN Ltd.
Particulars `
Average level of Receivables ` 4,50,00,000 x 120 / 360 1,50,00,000
Factoring commission ` 1,50,00,000 x 2% 3,00,000
Factoring Reserve ` 1,50,000 x 10% 15,00,000
Amount available for advance ` 1,50,00,000 – (3,00,000 + 15,00,000) 1,32,00,000
Factor will deduct interest @ 18%
Interest (` 1,32,00,000 x 18 x 120) / 100 x 360 7,92,000
Advance to be paid = ` 1,32,00,000 – 7,92,000 1,24,08,000
Annual cost of factoring to the firm:
Factoring commission (` 3,00,000 x 360 / 120) 9,00,000
Interest Charges (` 7,92,000 x 360 / 120) 23,76,000
32,76,000
Firms savings on taking factoring service:
Cost of credit administration saved 6,00,000
Cost of bad debts (` 4,50,00,000 x 2%) 9,00,000
Total savings 15,00,000
Net cost to the firm = ` 32,76,000 – ` 15,00,000 = ` 17,76,000
Effective rate of interest to the firm = ` 17,76,000 x 100 / ` 1,24,08,000 = 14.31%
Note: The number of days in a year is assumed to be 360 days.

4. (a) Find delta of the following individual positions of a stock X, given that delta of call = + 1
and of put = - 1;
4 long calls
5 short calls
4 long puts and 4 shares
30 short calls and 3 shares [4]

(b) Mr. A is planning for making investment in bonds of Company X. The details of the bond
are as follows:
Company Face Value Coupon Rate Maturity Period
X `10,000 6% 5 years
The current market price of X Ltd’s bond is `10,796.80. Calculate the duration of the
bond? [8]

Solution:

4. (a)
Position Details Net Delta
4 long calls Delta of Call Positive, Delta of Long Position Positive +4x+1=+4
5 short calls Delta of Call Positive, Delta of Short Position Negative -5 x +1 =-5
4 long puts & 4 shares Delta of: Put Negative; Long Position Negative; -4 +4 =0
Underlying Positive
30 short calls & 3 Delta of: Call Positive; Short Position Negative; - 30 + 3 = - 27
shares Underlying Positive

(b) To Calculate duration of bond we need YTM, which shall be calculated as follows:

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Let us try NPV @ 5%

600 600 600 600 10,600
= + + + + -10,796.80
1 2 3 4 5
(1.05) (1.05) (1.05) (1.05) (1.05)
= ` 571.43 + ` 544.22 + ` 518.30 + ` 493.62 + ` 8,305.38 – ` 10,796.80 = - ` 363.85
Let us now try NPV @ 4%
600 600 600 600 10,600
= + + + + -10,796.80
1 2 3 4 5
(1.04) (1.04) (1.04) (1.04) (1.04)
= ` 576.92 + ` 554.73 + ` 533.40 + ` 512.88 + ` 8,712.43 – ` 10,796.80 = - ` 93.56
Let us now interpolation formula
93.56
= 4% + x (5% - 4%)
93.56 -(-363.85)
93.56
= 4% +
93.56 + 363.85
93.56
= 4% + = 4.20%
457.41
Duration of X Ltd.’s Bond
Year Cash P.V. @ 4.2% Proportion of bond Proportion of bond value x
flow value time (years)
1 600 0.9597 575.82 0.0533 0.0533
2 600 0.9210 552.60 0.0512 0.1024
3 600 0.8839 530.34 0.0491 0.1473
4 600 0.8483 508.98 0.0472 0.1888
5 10600 0.8141 8,629.46 0.7992 3.9960
10,797.20 1.0000 4.4878
Duration of the Bond is 4.4878 years .

SECTION B
(Answer any one of the following.)

5. (a) (i) The rate of inflation in USA is likely to be 3% per annum and in India it is likely to be 6.5%.
The current spot rate of US $ in India is ` 43.40. Find the expected rate of US $ in India after
1 year and 3 years from now using purchasing power parity theory.
(ii) On April1, 3 months interest rate in the UK £ and US $ are 7% and 3% per annum
respectively. The UK £ /US $ spot rate is 0.7570. What would be the forward rate for US $ for
delivery on 30th June? [4+4]

(b) The dollar is currently trading at ` 40. If Rupee depreciates by 10%, what will be the spot rate?
If dollar appreciates by 10% what will be the spot rate? [4]

(c) The following market data is available:

Spot USD/JPY 116
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) FOR Yen is Nil.
1. The 6&12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA
at 6.50-6.75%. Is any arbitrage opportunity available?
Calculate profit in such case. [8]

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Solution:

5. (a) (i) According to Purchasing Power Parity forward rate is

r t
1+ H
Spot rate r
1+ F
So spot rate after one year
1
1+ 0.065
= ` 43.40
1+ 0.03
= ` 43.40 (1.03399)
= ` 44.8751
After 3 years
3
1+ 0.065
` 43.40
1+ 0.03
= ` 43.40 (1.03398)3
= ` 43.40 (1.10544) = ` 47.9761

(ii) As per interest rate parity

1+ in A
S1 = S 0
1+ in B
1+ (0.075) x 312
S1 = £0.7570
1+ (0.035) x 312
1.01875
= £0.7570
1.00875
= £0.7570 x 1.0099 = £0.7645
= UK £0.7645 / US$

(b) To find appreciation or depreciation of a rupee, we need to have a quote of `. Since we

are given $ quote, we need to convert the same to ` Quote. (which is simply the inverse)
i.e., ` 1 = $ 1/40 = $ 0.025
If rupee depreciates by 10%, then = 0.025 – 0.0025 = 0.0225
The new spot rate would be ` 1 = $0.0225.
And, if dollar appreciates by 10%, then we can apply 10% directly to the given $ quote.
Therefore, 40 + 40 x 0.1 = 44.
The new spot rate would be $1 = `44.

(c) 6 Months Interest rate is 5% p.a. & 12 Months interest rate is 6.5% p.a.
Future value 12 month from now is a product of Future value 6 months from now and 6
Months Future value from after 6 Months.
(1+0.065) = (1+0.05*6/12) x (1+i 6.6 *6/12)
i 6.6 = [(1+0.065/1.025) – 1] *12/6
6 Months forward 6 month rate is 7.80% p.a.
The Bank is quoting 6/12 USD FRA at 6.50 – 6.75%
Therefore there is an arbitrage Opportunity of earning interest @ 7.80% p.a. & Paying @
6.75%
Borrow for 6 months, buy an FRA & invest for 12 months

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

To get $ 1.065 at the end of 12 months for $ 1 invested today

To pay $ 1.060# at the end of 12 months for every $ 1 Borrowed today
Net gain $ 0.005 i.e. risk less profit for every $ borrowed
# (1+0.05/2) (1+.0675/2) = (1.05959) say 1.060

6. (a) From the following data for certain stock, find the value of a call option:
Price of stock now = ` 80
Exercise price = ` 75
Standard deviation of continuously compounded annual return = 0.40
Maturity period = 6 months
Annual interest rate = 12%
Given
Number of S.D. from Mean, (Z) Area of the left or right (one tail)
0.25 0.4013
0.30 0.3821
0.55 0.2912
0.60 0.2743
e 0.12x0.5 = 1.062
In 1.0667 = 0.0646 [10]

(b) Write short note on Leading and Lagging [4]

(c) The market received rumour about PQR Corporation’s tie-up with a multinational
company. This has induced the market price to move up. If the rumour is false, PQR
Corporation stock price will probably fall dramatically. To protect from this an investor
has bought the call and put options.
He purchased one 3 months call with a striking price of `42 for `2 premium, and paid `1
per share premium for a 3 months put with a striking price of `40.
(i) Determine the Investor’s position if the tie up offer bids the price of PQR Corporation’s
stock up to `44 in 3 months.
(ii) Determine the Investor’s ending position, if the tie-up programme fails and the price
of the stock falls to `36 in 3 months. [3+3]

Solution:

6. (a) Applying the Black Scholes Formula,

Value of the Call option now:
(-rt)
The Formula C = SN (d1) – Ke N(d2)
2
σ
In(S / K)+(r + )t
d1 = 2
σ t
d2 = d1 - σ t
Where,
C = Theoretical call premium
S = Current stock price
t = time until option expiration
K = option striking price
r = risk-free interest rate
N = Cumulative standard normal distribution
e = exponential term

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

σ = Standard deviation of continuously compounded annual return.

In = natural logarithm
In 1.0667 +(12% + 0.08)0.5
d1 =
0.40 0.5
0.0646 + (0.2)0.5
=
0.40 x 0.7071
0.1646
=
0.2828
= 0.5820
d2 = 0.5820 – 0.2828 = 0.2992
N(d1) = N (0.5820)
N(d2) = N (0.2992)
(-rt)
Price = SN (d1) – Ke N(d2)
= 80 x N(d1) – (75/1.062) x N(d2)
Value of option
75
= 80 N(d1) – x N(d2)
1.062
N(d1) = N (0.5820) = 0.7197
N(d2) = N (0.2992) = 0.6176
75
Price = 80 x 0.7197 – x 0.6176
1.062
= 57.57 – 70.62 x 0.6176
= 57.57 – 43.61
= ` 13.96

(b) Leading and Lagging

It refers to the adjustment of the times of payments that are made in foreign currencies.
Leading is the payment of an obligation before due date while lagging is delaying the
payment of an obligation past due date. The purpose of these techniques is for the
company to take advantage of expected devaluation or revaluation of the appropriate
currencies. Lead and lag payments are particularly useful when forward contracts are
not possible.

It is more attractive to use for the payments between associate companies within a
group. Leading and lagging are aggressive foreign exchange management tactics
designed to take the advantage of expected exchange rate changes. Buckley (1988)
supports the argument.

(c) Cost of Call and Put Options

= (` 2 per share) x (100 share call) + (` 1 per share) x (100 share put)
= ` 2 x 100 + `1 x 100
= ` 300

(i) Price increases to ` 44. Since the market price is higher than the strike price of the put,
the investor will exercise it.
Ending position = (-` 300 cost of 2 option) + (` 2 per share gain on call) x 100
= - ` 300 + 200
Net Loss = - ` 100

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

(ii) The price of the stock falls to ` 36. Since the market price is lower than the strike price,
the investor may not exercise the call option.
Ending position = (-` 300 cost of 2 option) + (` 4 per stock gain on put) x 100
= - ` 300 + 400
Gain = ` 100

SECTION C
(Answer any one of the following.)

7. (a) Mr. X has the following portfolio of four shares:

The risk free rate of return is 7% and the market rate of return is 14%. Determine the
portfolio beta and return.
Name Beta Investment ` Lakhs.
A Ltd. 0.45 0.80
B Ltd. 0.35 1.50
C Ltd. 1.15 2.25
D Ltd. 1.85 4.50
[5]
(b) A Ltd. and B Ltd. are in the same risk class, paying taxes at 33%. They are registering
steady earnings. A study of their financial statements and the market information
highlights the following:
Particulars A Ltd. B Ltd.
Capital Employed `1,500 crores `1,000 crores
Share Capital `850 crores `600 crores
Reserves `650 crores `300 crores
9% Debt - `500 crores
Market value of shares `3,500 crores `1,850 crores
Market value of Debt - `250 crores
Profit after tax `472.50 crores `396 crores
If Equity Beta of A Ltd. is 1.20, ascertain
(i) Cost of equity of B Ltd.
(ii) Beta of Equity of B Ltd. [1+5]

(c) SAIL shares that were quoting at ` 126.80 on 6th February, 2012. Mr. X bought these shares
that day and sold a year later at ` 158.60. Meanwhile SAIL gave dividend of ` 2.75 per
share which Mr. X received. If beta of SAIL is 0.6 with risk free rate at 8% and market
return at 20%, find whether SAIL is overvalued or undervalued. [5]

Solution:

7. (a) Portfolio return is given by CAPM:

Rp = Rf + βp x (Rm – Rf)
Where
n
βp = (w 1 x β1) + (w2 x β2) + ………. + (w n x βn) = w x βi
i=1 i
The individual weights for each stock are:
1 = A Ltd. = 0.80 / 9.05 = 8.84% or 0.088
2 = B Ltd. = 1.50 / 9.05 = 16.57% or 0.166
3 = C Ltd. = 2.25 / 9.05 = 24.86% or 0.249
4 = D Ltd. = 4.50 / 9.05 = 49.72% or 0.497

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Portfolio beta = 0.088 x 0.45 + 0.166 x 1.50 + 0.249 x 1.15 + 0.497 x 1.85 = 1.3036
Thus the portfolio return = 7 + 1.3036 x (14 – 7) = 16.13%

(b) (i) Cost of Equity of B Ltd.

Cost of Equity (K E) = Equity Earnings ÷ Market Value of Equity
= ` 396 Crores ÷ ` 1,850 Crores = 21.40%
(ii) Beta Value of Equity of B Ltd.
Beta of B Ltd. – Beta of its Assets
Since, A Ltd. and B Ltd. are in the same industry and in the same risk class, Beta of
B Ltd. = Beta of A Ltd.
Since A Ltd is an all equity Company, Beta of A Ltd. = Beta of Equity Shares of A
Ltd. = 1.20.
Therefore, Beta of Assets of B Ltd. = 1.20; Beta of Debt = 0
β x Equity β x Debt x (1- Tax)
Equity
 βA = + Debt
Equity + Debt (1- Tax) Equity + Debt (1- Tax)
 1.20 = βE x 1,850 ÷ [1,850 + 250 x (1 – 33%)] + 0
 1.20 = βE x 1,850 ÷ [1,850 + 250 x (1 – 33%)]
 1.20 = βE x 1,850 ÷ [1,850 + 250 x 0.67]
 1.20 = βE x 1,850 ÷ [1,850 + 167.50]
 1.20 = βE x 1,850 ÷ 2,017.50
 1.20 = βE x 0.917
 βE = 1.20 ÷ 0.917 = 1.309

(c) We decided whether SAIL is overvalued or undervalued by comparing the returns.

(P - P )+ D (158.60 -126.80)+ 2.75
One year return of SAIL = 1 0 = = 27.25%
P 126.80
0
However, the fair return as per CAPM can be found to be
= Rf +β (Rm – Rf)
= 8 + 0.6 x (20 – 8) = 15.2%.
Therefore, the actual return i.e. 27.25% far exceeds the fair value of return i.e. 15.2%,
thereby signifying that SAIL is a good stock to invest and considered undervalued.

8. (a) What are the components of risk? [2]

(b) Good Luck Ltd. has been enjoying a substantial cash inflow, and until the surplus funds
are needed to meet tax and dividend payments, and to finance further capital
expenditure in several months time, they have been invested in a small portfolio of short-
term equity investments.
Details of the portfolio, which consists of shares in four UK listed companies, are as
follows.
Company Number of Beta equity Market price Latest Expected return
shares held coefficient per share Dividend on equity in the
(`) yield (%) next year (%)
A Ltd. 60,000 1.20 4.29 6.10 19.50
B Ltd. 80,000 2.30 2.92 3.40 24.00
C Ltd. 1,00,000 0.85 2.17 5.70 17.50
D Ltd. 1,25,000 1.28 3.14 3.30 23.00

The current market return is 20% a year and the Risk free rate is 12% a year.

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

(i) On the basis of the data given, calculate the risk of Good Luck Ltd’s short term
investment portfolio relative to that of the market.
(ii) Recommend, with reasons, whether Good Luck Ltd., should change the composition
of its portfolio. [4+4]

(c) Following information is available in respect of dividend, market price and market
condition after one year.
Market Condition Probability Market Price Dividend per share
(`) (`)
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
The existing market price of an equity share is `106 which is cum 10% bonus debenture of
`6 each, per share. M/s. X Finance Company, has offered the buy-back of debentures at
face value.
Find out the expected return and variability of returns of the equity shares. [3+3]

Solution:

8. (a) Components of Risk

Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk: It represents that portion of Total Risk which is attributable to factors
that affect the market as a whole. Beta is a measure of Systematic Risk.
Unsystematic Risk: It is the residual risk or balancing figure, i.e., Total Risk Less
Systematic Risk.

(b) (i) Computation of Weighted Beta

Security No. of MPS Market value Proportion Beta Portfolio
shares held (`) of investments Beta
[1] [2] [3] [4] [5] [6] [7]=[5]x[6]
A 60,000 4.29 2,57,400 2,57,400 ÷ 11,00,500 = 0.2339 1.20 0.28068
B 80,000 2.92 2,33,600 2,33,600 ÷ 11,00,500 = 0.2123 2.30 0.48829
C 1,00,000 2.17 2,17,000 2,17,000 ÷ 11,00,500 = 0.1972 0.85 0.16762
D 1,25,000 3.14 3,92,500 3,92,500 ÷ 11,00,500 = 0.3567 1.28 0.45658
11,00,500 1 5.63 1.39317

(ii)
Security Valuation under CAPM Expected Ke in Evaluation Strategy
= RF + [β x RM – RF)] the next year %
A 12% + 1.20 (20% - 12%) = 21.60 19.50 Overpriced Sell
B 12% + 2.30 (20% - 12%) = 30.40 24.00 Overpriced Sell
C 12% + 0.85 (20% - 12%) = 18.80 17.50 Overpriced Sell
D 12% + 1.28 (20% - 12%) = 22.24 23.00 Under priced Buy

(c) Existing market price of equity share

= `106 (which is cum 10% bonus debenture of `6 each per share)
Ex-market price of equity share
= `106 – `6 = `100
Total return = Market price + Dividend per share
Good = `115 + `9 = `124
Normal = `107 + `5 = `112

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Bad = `97 + `3 = `100

Calculation of excepted Return

Market condition Probability Total return Cost Net return
(`) (`)
Good 0.25 124 100 24
Normal 0.50 112 100 12
Bad 0.25 100 100 0
Expected Return
= (24 x 0.25) + (12 x 0.50) + (0 x 0.25) = `12
Net return ` 12
= x 100 = x 100 = 12%
Cost `100

Calculation of Variability of Return

Variance = S.D.
S.D. = 0.25 (24 – 12)2 + 0.50 (12 – 12)2 + 0.25 (0 – 12)2
= 0.25(12)2 + 0.50 (0)2 + 0.25 (-12)2
= 36 + 0 + 36
S.D. = 72
S.D. = 8.485

SECTION D
(Answer any one of the following.)

9. (a) Explain briefly the concept of bridge financing. [3]

(b) SD Limited is engaged in large retail business in India. It is contemplating for expansion
into a country of Africa by acquiring a group of stores having the same line of operation
as that of India.
The exchange rate for the currency of the proposed African country is extremely volatile.
Rate of inflation is presently 40% a year. Inflation in India is currently 10% a year.
Management of SD Limited expects these rates likely to continue for the foreseeable
future.
Estimated projected cash flows, in real terms, in India as well as African country for the
first three years of the project are as follows:

Year - 0 Year - 1 Year - 2 Year – 3

Cash flows in Indian `(000) -50,000 -1,500 -2,000 -2,500
Cash flows in African Rands (000) -2,00,000 +50,000 +70,000 +90,000

SD Ltd. assumes year 3 nominal cash flows will continue to be earned each year
indefinitely. It evaluates all investments using nominal cash flows and a nominal
discounting rate. The present exchange rate is African rand 6 to ` 1.
You are required to calculate the net present value of the proposed investment
considering the following:
(i) African rand cash flows are converted into rupees and discounted at a risk adjusted
rate.
(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect its high
risk.
(iii) Ignore Taxation.

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Year -1 Year-2
Year-3
PVIF @ 20% .833 .694
.579
[10]
(c) ABC Limited has decided to go in for a new model of Mercedes Car. The cost of the
vehicle is 40 lakhs. The company has two alternatives: (i) taking the car on finance lease
or (ii) borrowing and purchasing the car.
BMN Limited is willing to provide the car on finance lease to ABC Limited for five years at
an annual rental of ` 8.75 lakhs, payable at the end of the year.
The vehicle is expected to have useful life of 5 years, and it will fetch a net salvage value
of 10 lakhs at the end of year five. The depreciation rate for tax purpose is 40% on written-
down value basis. The applicable tax rate for the company is 35%. The applicable before
tax borrowing rate for the company is 13.8462%.
What is the net advantage of leasing for ABC Limited?
The present value interest factor at different rates of discount are as under:
Rate of Discount Y-1 Y-2 Y-3 Y-4 Y-5
0.138462 0.8784 0.7715 0.6777 0.5953 0.5229
0.09 0.9174 0.8417 0.7722 0.7084 0.6499
[7]

Solution:

9. (a) Meaning: Bridge Finance refers to loans taken by a company usually from commercial
banks, for a short period, pending disbursement of loans sanctioned by financial
institutions.

Sanction:
(a) When a promoter or an enterprise approaches a financial institution for a long-term
loan, there may be some normal time delays in project evaluation, administrative &
procedural formalities and final sanction.
(b) Since the project commencement cannot be delayed, the promoter may start his
activities after receiving "in-principle" approval from the term lending institution.
(c) To meet his temporary fund requirements for starting the project, the promoter may
arrange short-term loans from commercial banks or from the term lending institution
itself.
(d) Such temporary finance, pending sanction of the long term loan, is called as "Bridge
Finance".
(e) This Bridge Finance may be used for - (i) paying advance for factory
land/machinery acquisition, (ii) purchase of equipments, etc.

Terms:
(a) Interest: The interest rate on Bridge Finance is higher when compared to term loans.
(b) Repayment: These are repaid or adjusted out of the term loans as and when
disbursed by the concerned institutions.
(c) Security: These are secured by hypothecating movable assets, personal guarantees
& promissory notes.

(b)
Calculation of NPV
Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696
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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Cash Flows in `‘000

Real -50000 -1500 -2000 -2500
Nominal (1) -50000 -1650 -2420 -3327.50
Cash Flows in African Rand ‘000
Real -200000 50000 70000 90000
Nominal -200000 70000 137200 246960
In Indian `’000 (2) -33333 9167 14117 19965
Net Cash Flow in `’000 (1)+(2) -83333 7517 11697 16637
PVF @ 20% 1 0.833 0.694 0.579
PV -83333 6262 8118 9633
NPV of 3 years = (-83333+6262+8118+9633)=-59320 (`’000)
16637
NPV of Terminal Value = x 0.579 = 48164 (`’000)
0.20
Total NPV of the Project = -59320 (`’000) + 48164 (`’000) = -11156 (`’000)

(c) Calculation of NPV if car is acquired on Finance Lease

Year Lease Tax shield gained Tax shield lost on Net cash Discount P.V. of cash
rentals on lease rental @ depreciation @ outflow factor @ 9% outflows
35% 35%
(a) (b) (c) (a)-(b)+(c)
1 8,75,000 3,06,250 5,60,000 11,28,750 0.9174 10,35,515
2 8,75,000 3,06,250 3,36,000 9,04,750 0.8417 7,61,528
3 8,75,000 3,06,250 2,01,600 7,70,350 0.7722 5,94,864
4 8,75,000 3,06,250 1,20,960 6,89,710 0.7084 4,88,591
5 8,75,000 3,06,250 72,576 6,41,326 0.6499 4,16,798
5 Loss of salvage value 10,00,000 0.6499 6,49,900
Net Present Value of Cash Outflows 39,47,196

Calculation of Depreciation of WDV Basis

Year 1 2 3 4 5
WDV at the beginning of the year 40,00,000 24,00,000 14,40,000 8,64,000 5,18,400
Depreciation @ 40% WDV 16,00,000 9,60,000 5,76,000 3,45,600 2,07,360
WDV at the end of year 24,00,000 14,40,000 8,64,000 5,18,400 3,11,040
Tax shield on depreciation @ 35% 5,60,000 3,36,000 2,01,600 1,20,960 72,576
Net Benefit of Leasing = `40,00,000 – `39,47,196 = `52,804
Suggestion – Since the NPV of leasing is lower than the cost of purchase, it is suggested to
acquire the car on finance lease basis.

10. (a) Skylark Airways is planning to acquire a light commercial aircraft for flying class clients at
an investment of ` 50,00,000.The expected cash flow after tax for the next three years is
as follows:
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The Company wishes to take into consideration all possible risk factors relating to an
airline operation. The company wants to know:
(i) The expected NPV of this venture assuming independent probability distribution with
10% risk free rate of interest.
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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

(ii) The possible deviation in the expected value. [4+6]

(b) A expect to receive (in nominal terms) the following cash flows. Viz. 250, (422) 1,067.
What is the present value, if the real discount rate is 5% and inflation is expected to be
4%, 3.5% and 5% for the following years? [3]

(c) A Ltd has the following book-value capital structure as on 31st March
Equity Share Capital (2,00,000 Shares) `40,00,000
11.5% Preference Shares `10,00,000
10% Debentures `30,00,000
Total `80,00,000
The Equity Shares of the company sell for `20. It is expected that the Company will pay a
dividend of ` 2 per share next year, this dividend is expected to grow at 5% p.a. forever.
Assume 35% corporate tax rate.
1. Compute the Company’s WACC based on the existing Capital Structure.
2. Compute the new WACC if the company raises an additional `40 lakhs debt by
issuing 12% debentures. This would result in increasing the expected Equity dividend
to `2.40 and leave the growth rate unchanged, but the price of equity share will fall to
`16 per share. [4+3]

Solution:

10. (a) (i) Expected NPV (` In lakhs)

Year I Year II Year III
CFAT P CF x P CFAT P CF x P CFAT P CF x P
14 0.1 1.4 15 0.1 1.5 18 0.2 3.6
18 0.2 3.6 20 0.3 6.0 25 0.5 12.5
25 0.4 10.0 32 0.4 12.8 35 0.2 7.0
40 0.3 12.0 45 0.2 9 48 0.1 4.8
x or CF 27.0 x or CF 29.3 x or CF 27.9

NPV PV factor @ 10% Total PV

27 0.9090 24.54
29.3 0.8264 24.21
27.9 0.7513 20.96
PV of cash inflow 69.71
Less: Cash outflow 50.00
NPV 19.71

(ii) Possible deviation in the expected value

Year I
X - X X - X
2 P1 2
X - X X - X P1
14 – 27 -13 169 0.1 16.9
18 – 27 -9 81 0.2 16.2
25 – 27 -2 4 0.4 1.6
40 - 27 13 169 0.3 50.7
85.4

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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

σ1 = 85.4 = 9.241

Year II
X - X X - X
2 P2 2
X - X X - X P2

15 – 29.3 -14.3 204.49 0.1 20.449

20 – 29.3 -9.3 86.49 0.2 25.947
32 – 29.3 2.7 7.29 0.4 2.916
45 – 29.3 15.7 246.49 0.2 49.298
98.61

σ = 98.61 = 9.930
2

Year III
X - X X - X
2 P3 2
X - X X - X P3
18 – 27.9 -9.9 98.01 0.2 19.602
25 – 27.9 -2.9 8.41 0.5 4.205
35 – 27.9 7.1 50.41 0.2 10.082
48 – 27.9 20.1 404.01 0.1 40.401
74.29

σ = 74.29 = 8.619
3
Standard deviation about the expected value:
85.4 98.61 74.29
δ=
2
+
4
+
6
= 70.58 +67.35 + 41.94 = 13.4115.
(1.10) (1.10) (1.10)

(b)
Nominal Inflation Real Cash Flows PV factor of real NPV
Cash Flows Rate discount rate 5%
250 4% 250 / 1.04 = 240.38 0.952 228.84
-422 3.5% -422 / (1.035 x 1.04) = -392.05 0.907 -355.59
1067 5% 1067 / (1.035 x 1.04 x 1.05) = 944.06 0.864 815.67
Total NPV 688.92
Note: We need to take the cumulative effect of inflation in the second year & third year.

Dividend per Share ` 2.00

(c) (i) Ke +g= + 5% = 10% + 5% = 15.00%
Market Price per Share ` 20.00
(ii) Kd Net Proceeds of Issue 30,00,000 =10%(1- 0.35) = 6.50%
(iii) Kp Preference Dividend = 11.50% i.e. ` 1,15,000
Net Proceeds of Issue ` 10,00,000

1. Computation of WACC under present capital structure:

Particulars Amount % Individual Cost WACC
Debt 30,00,000 37.50% Kd = 6.50% 2.44%
Preference Capital 10,00,000 12.50% Kp = 11.50% 1.44%
Equity Capital 40,00,000 50.00% Ke = 15.00% 7.50%
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 Answer to PTP_Intermediate_Syllabus 2012_Jun2014_Set 3

Total 80,00,000 100% WACC = K0 = 11.38%

2. Computation of WACC under revised capital structure:

Component Amount % Individual Cost WACC
Present Debt 30,00,000 25% Kd = 6.50% 1.63%
New Debt at 12% 40,00,000 33.33% Kd = 7.80% 2.60%
Preference Capital 10,00,000 8.33% Kp = 11.50% 0.96%
Equity Capital 40,00,000 33.34% Ke = 20.00% 6.67%
Total 1,20,00,000 100% WACC = K0 = 11.86%

Dividend per Share ` 2.40

Revised Ke = +g= + 5% = 15% + 5% = 20.00%
Market Price per Issue `16.00

New Debt Kd = 12% (1-.035)= 7.8%

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