Question Paper

Security Analysis – I (211) : April 2004

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.
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1. Which of the following scrips is not included at present in S&P CNX Nifty?
Ans
(a) Corporation bank (b) HPCL (c) ACC wer
(d) Sun Pharma (e) Satyam Computers. >
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2. Which of the following is/are true according to H model?
Ans
I. According to the model, if the current growth rate is greater than the normal long run growth rate,
wer
the growth rate eventually decreases
>
II. In the model, we make an assumption that in H years the growth decreases from the abnormal
growth rate to the normal growth rate
III. The intrinsic value of a share according to the model is equal to the value based on the normal
growth rate plus premium due to abnormal growth rate.
(a) Only (I) above
(b) Only (II) above
(c) Both (I) and (II) above
(d) Both (I) and (III) above
(e) All (I), (II) and (III) above.
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3. Which of the following statements is/are true of “market extraction method” to derive the capitalization
Ans
rate of real assets?
wer
I. In this method, net operating income is divided by sales price to get the capitalization rate
>
II. In this method, the rates on equity as well as debt financing rates are weighted according to their
proportions to calculate the capitalization rate
III. In this method, the capitalization rate is the sum of the return required on an asset for its being
non-liquid, and the risk free rate
IV. In this method, comparable property is selected to choose a rate which reflects market sentiments.
(a) Only (I) above (b) Only (II) above (c) Only (III) above
(d) Only (IV) above (e) Both (I) and (IV) above.
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4. Which of the following principles is true while analyzing trend line penetrations?
Ans
(a) The lesser the number of peaks/troughs that touch a trendline, the greater its significance
wer
(b) The breadth of a trendline indicates whether a penetration is significant or not
>
(c) A steep trendline is easily violated by small sideward movements in the price chart, and is not
particularly useful in identifying reversals
(d) Penetration of a steep trendline results in a corrective movement after which the new trend starts
(e) When the peaks of rallies penetrate the trend line and then return, the recurrence of this tendency
indicates that the trend “obeys” the trendline.
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5. Which of the following is not an application of SML?
Ans
(a) Evaluating the performance of portfolio manager wer
(b) Tests of asset pricing theories >
(c) Tests of market efficiency
(d) Identifying mispriced securities
(e) Identifying the factors of pricing of an asset.
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6. The market rate of interest on 2 years bond is 9.75% while the rate on one year bond is 9.25%. The
Ans
forward rate on a one year bond one year from now is 9.5%. The liquidity premium to induce investors
wer
to hold the 2 year bond is
>
(a) –0.25% (b) 0.38% (c) 0.75% (d) 1.20% (e) 2.25%.
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7. Consider the following data:
Ans
Ratios 2002 2003 wer
PBT/NS 13.50 13.25 >
 PAT/PBT 0.87 0.73
NS/TA 1.73 1.82
TA/NW 2.75 2.95
ROE% 55.88 51.93
The fall in ROE has taken place in 2003 primarily due to
(a) Fall in profit margin (b) Increase in leverage
(c) Fall in tax efficiency (d) Increase in asset turnover
(e) Both (a) and (b) above.
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8. Which of the following is true in case of the pioneering stage of the industry life cycle:
Ans
I. It is difficult to predict which firms will succeed and which firms will fail wer
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.
<
9. In an efficient market the correlation coefficient between stock returns for two non-overlapping time
Ans
periods should be
wer
(a) Positive and large (b) Positive and small
>
(c) Negative and large (d) Negative and small
(e) Zero.
<
10. β measures the sensitivity of return of the security vis-à-vis the market return. It is estimated from the
Ans
following regression specification: wer
ri = α + β rm + ei >
where, the notations are in their standard use.
Which of the following is not an assumption in regression analysis regarding error term?
(a) E(ei) = 0 (b) Cov (ei , rm) = 0 (c) Cov (ei , ej) = 0
(d) Var (ei) = 0 (e) None of the above.
<
11. Earnings per share of Piston Ltd. expected at the end of the year 2004-2005 is Rs.18.00. The earnings
Ans
per share in the year 2003-2004 is Rs.16.00. The required rate of return is 25% p.a. and the dividend
wer
payout ratio is 30% which is expected to remain constant. If the earnings are expected to grow at the
>
historical growth rate, the value of the share of the company at the beginning of 2004-2005 is
(a) Rs.72.00 (b) Rs.43.20 (c) Rs.38.40 (d) Rs.21.60
(e) Cannot be determined as the growth rate is higher than the required rate of return.
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12. Which of the following aspects of investing in real assets differ from investing in securities?
Ans
I. The type of income derived wer
II. The manner in which the assets are valued >
III. The way inflation affects real assets.
(a) Only (I) above (b) Only (II) above (c) Only (III) above
(d) Both (I) and (II) above (e) All (I), (II) and (III) above.
<
13. Which of the following statements is/are true?
Ans
I. A unique characteristic line is plotted for each security wer
II. For a characteristic line, the x-axis represents betas for different securities >
III. The slope of the characteristic line is the difference between the market returns and risk-free
returns.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (II) above
(e) Both (II) and (III) above.
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14. Consider the following information:
Ans
Return Variance Weight in the portfolio wer
Stock ABC 16% 484(%)2 0.5 >
Stock XYZ 13% 256(%)2 0.5
If the variance of the portfolio is 132(%)2, the co-efficient of correlation between the stocks is
(a) –0.68 (b) –0.60 (c) –0.30 (d) –0.02 (e) +0.30.
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15. Which of the following statements is/are not true?
Ans
I. The formation of head and shoulder pattern indicates the onset of the bull market
 II. A rise in a momentum index signals the end of a bear market wer
III. The formation of rectangles confirms a reversal. >
(a) Only (I) above (b) Only (II) above (c) Only (III) above
(d) Both (I) and (II) above (e) Both (I) and (III) above.
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16. In which of the following situations, the company profits are inflated?
Ans
I. Switching from straight line method of depreciation to written down value method during later wer
years of the life of the asset. >
II. Writing off miscellaneous expenses over a period of time instead of capitalizing the expenses.
III. Switching from LIFO to FIFO method of inventory valuation during decreasing prices.
(a) Only (I) above (b) Only (III) above
(c) Both (I) and (III) above (d) Both (II) and (III) above
(e) All (I), (II) and (III) above.
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17. In which of the following stages of industry life cycle, the financial policies of a firm become firmly
Ans
established?
wer
(a) Expansion stage (b) Stabilization stage >
(c) Declining stage (d) Pioneering stage
(e) Growth stage.
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18. The required rate of return on a stock is 12.5% and it is showing a constant growth rate of 9%. If the
Ans
stock’s retention rate is 70%, its trailing P/E ratio should be
wer
(a) 7.32 (b) 8.57 (c) 9.34 (d) 10.25 (e) 11.25. >
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19. Consider the following data for a stock:
Ans
Current abnormal growth rate = 8% wer
Normal growth rate = 4% >
Current dividend per share = Rs.3.00
Required rate of return = 12.5%
If the time period during which the current abnormal growth rate will become normal growth rate is 6
years, the premium on the stock due to abnormal growth rate is
(a) Rs.1.41 (b) Rs.4.24 (c) Rs.8.26 (d) Rs.9.21
(e) None of the above.
<
20. Margin in a futures contract depends on the price volatility of the underlying asset. The margin
Ans
requirement can be estimated by calculating
wer
I. Average daily absolute change in the value of futures contract >
II. Average number of transactions of the futures contract
III. Standard deviation of the absolute change in the value of futures contract
IV. Coefficient of variation of the absolute change in the value of futures contract.
(a) Only (I) above (b) Only (III) above (c) Only (IV) above
(d) Both (II) and (IV) above (e) Both (I) and (III) above.
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21. Which of the following can be a form of utility function at expected security return ranging between 10
– 12%? Ans
wer
[U(r) is the expected utility of the investor at the level of return r]. >
(a) U(r) = 25r – r2 (b) U(r) = 3r – 10r2
2
(c) U(r) = 72r + 3r (d) U(r) = 6r – 7r2
(e) Both (b) and (d) above.
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22. A stock which is less risky than the market will have
Ans
I. A beta greater than 1 wer
II. A beta that is less than its correlation coefficient with the market index >
III. A beta less than 1.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) Both (I) and (II) above
(e) Both (II) and (III) above.
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23. A portfolio holding 90 percent of its assets in S &P CNX Nifty stocks in proportion to their market
Ans
capitalization and 10 percent in treasury bills is more sensitive to
wer
a. Systematic risk b. Unsystematic risk >
c. Interest rate risk d. Index risk
e. Both (c) and (d) above.
 <
24. Other things being equal call option premiums for a given asset tend to increase when
Ans
(a) The price of the underlying asset decreases wer
(b) The volatility of the returns on underlying asset decreases >
(c) The time to expiration of the option increases
(d) The exercise price of the option increases
(e) None of the above.
<
25. Which of the following graphs depicts a lead indicator?
Ans
wer
>

(a) (b)

(d)

(e) Both (b) and (c) above.

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26. Consider the following information related to a bond:
Ans
Par Value Rs. 1000
wer
Time to Maturity 20 years
>
Coupon rate ( Interest payable annually) 10%
Current Market Price Rs. 851
Yield to Maturity (YTM) 12%
Other things remaining the same, if the bond starts paying interest semi-annually, then the change in the
market price of the bond will be approximately
(a) – 0.2% (b) – 0.1% (c) + 0.1% (d) + 0.2% (e) No change.
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27. Which of the following is/are true if a firm has a required rate of return equal to the ROE?
Ans
I. The amount of earnings retained by the firm does not affect market price or the P/E wer
II. The firm can increase market price and P/E by increasing the growth rate >
III. The P/E ratio is inversely proportional to the ROE of the firm.
(a) Only (I) 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.
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28. Mr. Arvind holds a stock of company X. Company X is presently paying a dividend of Rs.2 per share
Ans
and required rate of return for Mr. Arvind is 20 percent. If the dividends are expected to grow at a
wer
constant rate of 10 percent, duration of equity is
>
(a) 20 years (b) 5 years (c) 11 years (d) 30 years (e) 40 years.
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29. Rajan is bearish on the stock of the Jindal Corporation and purchased six 3-month put option contracts.
Ans
The strike price is Rs.45 and premium is Rs.5 per stock. After 3 months, market price of Jindal was
wer
Rs.30. The current market price is Rs.44. If contract size is 100, profit realized by Rajan is
>
(a) Rs. 3,000 (b) Rs. 9,000 (c) Rs.12,000 (d) Rs. 6,000 (e) Rs. 500.
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30. Which of the following statements is/are true about ‘gaps’?
Ans
I. The lowest price of the period after the gap is higher than the highest price of the preceding period wer
II. The lowest price of the period after the gap is lower than the highest price of the preceding period >
III. A series of runaway gaps is an indication of exhaustion gap
IV. The highest price of the period after the gap is lower than the lowest price of the preceding period.
(a) Only (I) above (b) Both (I) and (II) above
(c) Both (II) and (III) above (d) (I), (III) and (IV) above
(e) All (I), (II), (III) and (IV) above.
END OF SECTION A
 Section B : Problems (50 Marks)
This section consists of questions with serial number 1 – 6.
Answer all questions.
Marks are indicated against each question.
Detailed workings should form part of your answer.
Do not spend more than 110 - 120 minutes on Section B.
1. On 1.2.2004, Raj.Chemicals Ltd.(RCL) issued partly convertible debentures with face value of Rs.200. The
debenture consists of two parts A and B. Part A is having face value of Rs.100 and will be converted into an equity
share of the company at a premium of Rs. 90.The conversion will take place on 1.2.2005. Part B with a face value
of Rs. 100 will be redeemed in two equal instalments at the end of January in year 2008 and 2009.The amount of
coupon payable on the partly convertible debenture is 10% and the frequency of the interest payment is semi-
annual. The following financial data have been complied by an investment analyst for the purpose of valuing the
bond:
Financial Highlights (Rs. in Crores)

2004-05 2005-06
2002-03 2003-04
(Projected) (Projected)

Net Sales 193.20 152.51 230.45 320.77

Profit After Tax 6.63 8.40 15.99 21.22

Dividend Equity 1.05 1.13 2.10 3.88

Share Capital 3.00 4.57 8.34 8.34

Reserves and Surplus 20.13 35.84 90.60 120.60

The analyst estimates that the appropriate leading P/E1 multiplier for the stock to be 14 and the required rate of
return on PCDS (partly convertible debenture) is around 12% p.a compounded semi-annually.
You are required to
a. Calculate the intrinsic value of the PCD using the estimates prepared by the analyst and the other data. State
the assumptions underlying your calculation.
b. Calculate the conversion value of stock under Part A of PCD assuming that your required rate of return is 17%
Po b
=
E ke − g
p.a .You believe that an indicative P/E1 is defined as P/E1 = 1 Where, b = average payout ratio, ke =
required rate of return, g = sustainable growth rate, is more appropriate for valuing equity shares made
available on conversion.
(6 + 4 = 10 marks) < Answer >
2. During the year 2003-04, three companies Polar Software Ltd., Sonata Airways and Time Auto Ltd. have
announced higher dividends on December 31, 2003. A financial analyst working in a brokerage firm wanted to test
the consistency of the semi-strong form of market efficiency. He estimated the characteristic lines for a period of 4
years on a monthly basis upto September 30, 2003. The relationship between the returns on these three companies
and the market index are represented by following equations.
rP,t = 1.50% + 0.75rmt
rS,t = 1.26% + 1.15 rmt
rt,t = 1.98% + 1.35 rmt
Where rP,t rS,t and rt,t are the returns of Polar Software, Sonata Airways and Time Auto during period t and rm,t is
return of the market index during the same period. The following data pertains to the returns of the companies and
market for the period 3 months before and 3 months after the dividend was declared.

Period Actual return (%) Market return (%)

 (Months) rP,t rS,t rt,t rm,t
Sep 30, 2003 9.75 12.45 14.58 9.85
Oct 31, 2003 9.85 12.35 14.85 9.95
Nov 30, 2003 10.25 12.85 15.35 10.05
Dec 31, 2003 10.45 13.45 15.78 10.25
Jan 31, 2004 10.75 13.38 16.15 10.45
Feb 29, 2004 11.25 14.25 17.35 11.25
Mar 31, 2004 10.85 14.15 17.95 11.45

Using event studies approach you are required to verify the validity of semi-strong form of market efficiency in the
Indian stock market.
(8 marks) < Answer >
3. Suppose the assumptions of CAPM are valid and unlimited borrowing and lending at risk-less rate of interest is
possible. You are required to determine the unknown quantities in the following table.

Expected Standard Deviation

Stock Beta Unsystematic Risk (%)2
Return (%) (%)
Super Cements 12 ? 1.52 15
Cresent Pharma ? 8 0.96 9
DFL Plastics 9 ? 0.80 25
(4 + 2 + 2 = 8 marks) < Answer >
4. India Plastics Ltd. have recently issued the floating rate bonds. The details of the issue is given under:
Face value and Issue
Maturity
Date of issue maturity value Price Coupon Rate
Date
(Rs.) (Rs.)
Annual Prime Lending Rate + 0.65%.
1.04.2004 1,000 950 However minimum coupon is limited to 31.03.2009
10.0%
The term structure of Prime Lending Rate (PLR) for different maturity is given as under:
Maturity as on 31.03.2005 31.03.2006 31.03.2007 31.03.2008 31.03.2009
PLR (%) 9.00 9.15 9.55 10.00 10.15
Considering that the Pure Expectations Hypothesis holds good, you are required to
a. Calculate YTM for the bondholder who has recently been allotted India Plastic bonds at issue price.
b. Estimate duration of the Floating rate bond.
(5 + 5 = 10 marks) < Answer >
5. An analyst is evaluating the stocks of two MNCs for inclusion in the diversified portfolio that he manages for a
pension fund. He wishes to use the price/earnings multiple (PE ratio) to compare the stocks. The analyst has
collected the following information about company A and company B:
Company A Company B
Historical and expected return on equity (ROE) 16% 11%
Historical and expected dividend payout ratio 40% 50%
Beta 1.35 1.05
The expected return on the market index is 11.5 percent and the expected risk-free return is 5.25 percent.
You are required to
a. Calculate the P/E ratios for both companies.
b. Discuss two possible reasons for the difference in the PE ratios of the two companies.
c. Calculate the long-term growth rate expected by the market if Company B’s stock is currently trading at
twelve times its next period forecasted earnings.
(5 + 2 + 2 = 9 marks) < Answer >
 6. The values of S&P CNX Nifty during the last two weeks of January 2004 are given below:

Date Open High Low Close

16-Jan-2004 1944.15 1953.05 1887.10 1900.65
19-Jan-2004 1901.90 1943.10 1874.95 1935.35
20-Jan-2004 1928.80 1957.65 1876.85 1893.25
21-Jan-2004 1895.45 1899.55 1811.35 1824.60
22-Jan-2004 1824.70 1854.55 1756.25 1770.50
23-Jan-2004 1771.10 1858.50 1771.10 1847.55
27-Jan-2004 1847.90 1911.30 1844.65 1904.70
28-Jan-2004 1903.90 1918.45 1846.35 1863.10
29-Jan-2004 1863.00 1883.10 1827.25 1843.60

You are required to

a. Calculate the Relative Strength Index of the Nifty as on 29 January 2004.
b. Interpret the results obtained in (a) above.
(4 + 1 = 5 marks) < Answer >

END OF SECTION B

Section C : Applied Theory (20 Marks)

This section consists of questions with serial number 7 - 8.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 25 -30 minutes on section C.
7. Real estate has for long been viewed as a life time investment in which one does not trade for profit. This perception
is now changing. What are the aspects in which investments in real assets differ from other investments? Explain.
(10 marks) < Answer >
8. FMCG, Pharmaceuticals, IT, Oil and gas, Auto, Engineering, and Banking is the order in which sector (industry)
preferences have moved in the last five years in India. As an analyst, what are the important characteristics you
would analyze before you identify an industry for investment? Discuss.
(10 marks) < Answer >

END OF SECTION C

END OF QUESTION PAPER

Suggested Answers
Security Analysis – I (211) : April 2004
Section A : Basic Concepts

1. Answer : (a) < TOP

Reason : HPCL, ACC, Sun Pharma and Satyam Computers are present in Nifty. only corporation bank is >
not present. .
2. Answer : (d) < TOP
Reason : According to H model there are two phases of growth – abnormal growth rate and long run >
 normal growth rate and it is assumed that in 2H years the growth decreases from abnormal
growth rate to normal growth rate. Hence, statement (II) is not correct.
3. Answer : (e) < TOP
Reason : Statement II relates to Bond of Investment method. Statement III relates to Built-up method >

4. Answer : (c) < TOP

Reason : a is not correct as more than number of peaks and trough that touch a trend line greater its >
significance.
b. is not correct as it is not breadth but the length of the trend line which indicates whether a
penetration is significant or not.
d. is not correct as penetration of steep trend line results in a corrective movement after which
the previous trend continues.
e. is not correct as the peaks of rallies when penetrate the trend line that indicates shift in trend.
5. Answer : (e) < TOP
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.
6. Answer : (b) < TOP
Reason : Assuming pure expectations theory hold good, two years interest rate, ro,2 will be calculated >
from following expressions.
(1 + r0,2)2 = (1 + r0,1) (1+f1,2) = (1+0.0925) (1+0.095) = 1.19629

⇒ r0,2 = 1.19629 − 1 = 0.09375 i.e., 9.375%.

Hence liquidity premium
= 9.75 – 9.375 = 0.375% i.e. 0.38%.
7. Answer : (c) < TOP
Reason : The fall in ROE in 2003 over 2002 is due to fall in profit margin as well as fall in tax efficiency. >
Compared to 1.85% fall in profit margin, tax efficiency has fallen by 16.09%.
8. Answer : (d) < TOP
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.
9. Answer : (e) < TOP
Reason : In an efficient market in weak form which is the first level of efficiency the price movements of >
stocks follow a random pattern. This implies that the correlation coefficient between stock
returns for two non-overlapping periods should be zero.
10. Answer : (d) < TOP
Reason : Variance of error term, Var (ei) is not assumed to be zero infact >

β i2
Var (Ri) = Var (Rm) + Var (ei)
i.e., Total Risk of security i = Systematic Risk + Unsystematic Risk.

11. Answer : (b) < TOP

Expected dividend a year hence >
Re quired rate of return − Growth rate in dividends
Reason : Current value of the share =
In the given case, dividend a year hence = EPS × Dividend payout
= 18 × 0.3 = Rs.5.4
Required rate of return = 0.25
Growth rate (as payout ratio remains constant)
18
−1
= Growth rate in EPS = 16 = 12.5%
 5 .4
Value of the share = 0.25 − 0.125 = Rs.43.2.
12. Answer : (e) < TOP
Reason : Investors in real assets apart from earning financial gains also expect to receive certain psychic >
income. The unique nature, the liquidity risk and not being able to denominate in a particular
currency – all these result in the valuation of real assets to be different from the valuation of
monetary assets. The value of real assets tend to appreciate more rapidly than the rate of
inflation whereas the value of monetary assets tend to reduce whenever the rate of inflation
increases. Hence, all I, II and III are true.
13. Answer : (a) < TOP
Reason : Characteristic line is the regression line between the returns on a security and the market index. >
Returns on a security are plotted on the y-axis and the returns on the index on the x-axis.
Characteristic line is the line of best fit between the actual observation of security returns and
market returns. It represents the relationship between the return on a security and the index.
Hence, each security has a unique characteristic line. Hence, I is true.
As already said above, the x-axis represents the returns on the market and not the betas of the
securities. Hence, II is not true.
The slope of the security represents the beta of the particular security involved. Hence, III is also
not true. Difference between market returns and risk-free return is the slope of Security Market
Line.
14. Answer : (c) < TOP
Reason : Variance of the portfolio of two stocks is calculated as >
ρ12 w w , where
σ 1
2
w12 + σ 2
2
w22 + 2σ 1σ 2 1 2

σ i is variance of the stock

wi is weight of the stock
ρ ij
is the correlation coefficient of two stocks,
In the given case,
484 256 ρ12
484 × 0.52 + 256 × 0.52 + 2 × 0.5 × 0.5 = 132

= 121 + 64 + 176 ρ12 = 132

132 − 121 − 64
ρ12 176
= = – 0.3
15. Answer : (e) < TOP
Reason : Head and Shoulders pattern is by far the most reliable, and widely used, of all reversal patterns. >
The left shoulder signifies the penultimate rally in the bull market. The right shoulder confirms
the beginning of a bear market, as it fails to climb above the previous rally (the head). This
pattern occurs at the end of a bull market and is characterized by two smaller rallies flanking a
higher rally just as the head lies in between two shoulders. Hence, (I) is not true. A series of
minor rallies and reactions, which have almost identical peaks and troughs signal the formation
of a rectangle. A rectangle indicates equal pressure being exercised by buyers and sellers, and
the combat is indecisive until a breakout occurs. The price line may breakout on either side. A
rectangle therefore may be a consolidation pattern or result in reversal. Hence (III) is also not
true and (e) is the answer. A diffusion index or momentum index is computed by calculating the
rate at which a certain group of stocks change price over a given period of time. A rise in the
index signals the onset of a bull market and vice versa. Hence, (II) is true
16. Answer : (a) < TOP
Reason : The depreciation calculated under the written down value method is higher than that calculated >
under the straight line method in the initial years of the life of the asset, and is considerably
lower under WDV method than under straight line method in the later years. Thus, switching
from straight line method to WDV method in the later years will increase the profit figure and
vice versa. Hence, (I) is true. The amortization of preliminary expenses and other miscellaneous
expenditure of a capital nature offers ample scope for increasing or decreasing the profits. There
is no legal rule prescribed for the write-off of such expenditure. When the expenses are written
off over a period of time, the profits during those periods will be low and if such expenses are
capitalized, the profits will be high. Hence, statement (II) results in lower profits. Under
 inflationary circumstances, a company may switch over from the LIFO method to FIFO method
and increase its profits and switching from FIFO to LIFO during decreasing prices result in
increased profits. During decreasing prices, under FIFO method of inventory valuation, the
value of stock consumed will be high and profits will be low whereas under LIFO, the stock
consumed will be low and profits will be high. Hence, switching from LIFO to FIFO the profits
will be decreased and statement (III) is incorrect and the answer is (a).
17. Answer : (a) < TOP
Reason: Financial policies become firmly established at the expansion stage. Hence (a) is the correct >
answer.
18. Answer : (c) < TOP
>
D1 D (1 + g)
= 0
ke − g ke −g
Reason : P0 =
E 0 (1 − R.R) (1 + g)
ke − g
P0 =
P0 (1− R.R)(1+ g)
=
E0 k e −g

(1 − 0.70)1.09 0.327
0.125 − 0.09
= = 0.035 = 9.34
19. Answer : (b) < TOP
>
D 0 [ (1 + g n ) + H (g a − g n )]
r − gn
Reason : According to H-model P0 =
D 0 (1 + g n ) D0 H (ga − gn )
+
r − gn r − gn
=
= Value based on normal growth rate + Premium due to abnormal growth rate
D 0 H (g a − g n ) 3.00 x 3 x (0.8 − 0.04) 9 x 0.04
r − gn 0.125 − 0.4
= = 0.085 = Rs.4.235.
20. Answer : (e) < TOP
Reason : Futures margin depend on the price volatility of the underlying asset. Exchanges generally set >
this margin equal to µ + 3 σ then µ is the average daily absolute change in the value of
contract and σ is standard deviation of these changes over a period of time. Hence only (I) and
(III) are correct and therefore (e) is the answer.

21. Answer : (a) < TOP

Reason : Utility function is always an increasing function of r but at a decreasing rate. Therefore, a utility >
function’s first derivative with respect to r should be positive whereas second derivative should
be negative
δu (r)
> 0 δu (r) < 0
2

δr δr 2
i.e.
For a normal level of return of 10 – 12% range, utility function given in option (a) only satisfies
the above criteria.

22. Answer : (e) < TOP

>
Covim ρim σi σ m σi
ρim
σ2m σ2m σm
Reason : β = = =
If σ i < σ m then β < ρ im
 as we know that correlation coefficient can have maximum value of 1. Therefore beta will
be less than 1.
23. Answer : (a) < TOP
>
Reason : Investing in CNX Nifty stocks in proportion to their market capitalization means investing in the
market portfolio. The investment in market portfolio is affected by the market movements. If the
markets rise, the portfolio gains and vice-versa. The portfolio will be affected positively or
negatively by the market and the portfolio will be more sensitive to systematic risk. Hence the
correct answer is (a).
24. Answer : (c) < TOP
Reason : The time to expiration is directly related to the option premium. Longer the time to expiration, >
higher is the option premium. Thus, other things being equal, call option premiums for a given
asset tend to increase when the time to expiration increases.
25. Answer : (c) < TOP
Reason : A lead indicator is one which peaks out well before the economy peaks and bottoms out well >
before the economy does. Economists use these indicators for forecasting trends in the economy.
Graph C clearly depicts this behavior and hence reflects a lead indicator. Graph B also appears
to depict a lead indicator but a closer examination reveals that it is not giving crystal clear
signals. Hence the answer is (c).
26. Answer : (a) < TOP
Reason : The equation expressing the relationship between Market Price of the bond and YTM is as >
follows
Po = Co × PVIFA(k, n) + F × PVIF(k, n)
Substituting the given values in the equation, we get
Po= 50 × PVIFA(6%, 40) + 1000 × PVIF(6%, 40)
= 50 × 15.046 + 1000 × 0.097 = 849.30
Therefore, the change in market price = (849.30 – 851)/851= – 0.199% = –0.2%
Hence the correct answer is (a).
27. Answer : (e) < TOP
Reason : In a condition such that Required rate of return = ROE, >
According to the Dividend discount model
D1
Ke − g
Po = Where the symbols are in standard use.
D0
(1 + g)
PO E0
EO Ke − g
= Where, D0/E0 is the Dividend payout ratio
(1 + g )(1 − b)
=
Ke − g Where ‘b’ is the retention ratio

Since Ke = ROE and g = ROE × Retention ratio

P0 (1 + g) (1 − b)
=
E 0 ROE − ROE × b
P0 (1 + g) (1 − b)
=
E0 ROE (1 − b)
We get
PO 1+ g
EO
= ROE
Hence from the above derivations we can conclude that
when the growth rate increases, the market price of the share and the price earnings ratio
will increase.
. The amount of earnings retained by the firm does not affect market price or the P/E.
 And
. The P/E ratio is inversely proportional to the ROE of the firm.
Since all the given statements are true the option (e) is the correct answer.
28. Answer : (c) < TOP
1 >
Dividend yield
Reason : Duration =
Where
Dividend per share
Current Market price
Dividend yield =
D1 2(1 + 0.1)
Ke − g
Current market price = = 0.2 − 0.1 = Rs.22
2
∴ Dividend yield = 22 = 0.0909
1
∴ Duration = 0.0909 = 11years.
29. Answer : (d) < TOP
Reason : Cost of put = (Rs. 5 per share) × (100 shares per contract) × (6 contracts) = Rs.3000 >
Put’s intrinsic value = Striking price – Ending price = Rs. 45 – Rs.30 = Rs.15 per share
Total value at maturity = (Rs.15 per share) × (100 shares) × (6 contracts) = Rs.9000
Net gain = Rs .9000 – Rs. 3000 = Rs.6000
30. Answer : (d) < TOP
Reason : The lowest price of the period after the gap is higher than the highest price of the preceding >
period is true.

The lowest price of the period after the gap is lower than the highest price of the preceding
period is false regarding gaps.
A series of runaway gaps is an indication of exhaustion gap is true.
The highest price of the period after the gap is lower than the lowest price of the preceding
period is true.
Hence the option (d) is the correct answer.
Hence the other options (a),(b),(c) and (e) are incorrect.

Section B : Problems
1. a. We will work half year as the unit of time
PV (Part A) = 100X(0.10/2) X PVIFA (6,2) + (Estimated MV of the Share) X PVIF(6,2)
Estimated Market value of the stock on 1.2.2005 = Projected EPS for 2005-06 × Appropriate PE
= 21.22 /0.834 × 14
= Rs. 356.21
PV (Part A) = 5 × 1.8334 + 356.21 × 0.89 = Rs. 326.2
PV (Part B) = 100X(0.10/2) × PVIFA (6,8) + 50X PVIF(6,8)
+ 50 × (0.10/2) × PVIFA (6,2) × PVIF(6,8) + 50X PVIF(6,10)
= 5 × 6.21 + 50 × 0.627 + 2.5 × 1.8334 × 0.627 + 50 × 0.558
= 31.05 + 31.35 + 2.874 + 27.9
= Rs. 93.174
PV (Part A + Part B) = 356.21 + 93.174 = Rs449.384
b. The payout ratio and the long run sustainable growth rate for computing the indicative P/E have been
determined by averaging the relevant data provided in the table:
 Sum of Equity dividends
Sum of Equity earnings
Average Payout =
(1.05 + 1.13 +2.10 +3.88 ) 8.16
(6.63 +8.40 +15.99 +21.22) 52.24
= = = 0.156
Estimated retention ratio = 1 – 0.156 = 0.844
Sum of Equity Earnings
Average ROE = Sum of Net Worth
(6.63 + 8.40+15.99 +21.22) 52.24
(23.13+ 40.41 +98.94 +128.94) 291.42 = 0.179
=
Estimated Sustainable growth rate = 0.179 X 0.844 = 0.151
Indicative P/E = 0.156/(0.17 –0.151) = 8.21
Conversion value = Projected EPS for 2005-06 X Indicative PE
= 21.22 /0.834 X 8.21
= Rs. 208.89
< TOP >
2. First we should find out abnormal return by deducting the actual return from the expected return
Polar Software Limited
Period Actual return Market return Expected return Abnormal return
(r Pt) (rmt) (%) (1.50 + 0.75 rmt)
3 9.75 9.85 8.8875 0.8625
2 9.85 9.95 8.9625 0.8875
1 10.25 10.05 9.0375 1.2125
0 10.45 10.25 9.1875 1.2625
1 10.75 10.45 9.3375 1.4125
2 11.25 11.25 9.9375 1.3125
3 10.85 11.45 10.088 0.7625

Sonata Airways

Actual Market
Period Expected return Abnormal return
return return
(rSt) (rmt) (%) (1.26 + 1.15 (rmt)
3 12.45 9.85 12.5875 -0.1375
2 12.35 9.95 12.7025 -0.3525
1 12.85 10.05 12.8175 0.0325
0 13.45 10.25 13.0475 0.4025
1 13.38 10.45 13.2775 0.1025
2 14.25 11.25 14.1975 0.0525
3 14.15 11.45 14.4275 -0.2775

Time Auto
Period Actual return Market return Expected return Abnormal return
(rT,t) (rmt) (1.98 + 1.35 rmt)
3 14.58 9.85 15.2775 0.6975
2 14.85 9.95 15.4125 0.5625
1 15.35 10.05 15.5475 0.1975
 0 15.78 10.25 15.8175 0.0375
1 16.15 10.45 16.0875 -0.0625
2 17.35 11.25 17.1675 -0.1825
3 17.95 11.45 17.4375 -0.5125

We will now estimate the average abnormal return to each of the months before and after the dividend was announced
Third month before the announcement of dividend
1
AAR(–3) = 3 (0.8625 – 0.1375+ 0.6975) = 1.4225
Second month before the announcement of dividend
1
AAR(–2) = 3 (0.8875- 0.3525 +0.5625) = 1.0975
First month before the announcement of dividend
1
AAR(–1) = 3 (1.2125 + 0.0325+0.1975) = 1.4425
Month during which the dividend was announced
1
AAR (0) = 3 (1.2625+0.4025 + 0.0375) = 1.7025
First month after the announcement of dividend
1
AAR(1) = 3 (1.4125 + 0.1025 – 0.0625) = 1.4525
Second month after the announcement of dividend
1
AAR(2) = 3 (1.3125 + 0.0525-0.1825) = 1.1825
Third month after the announcement of dividend
1
AAR (3) = 3 (0.7625 - 0.2775 –0.5125) = -0.0275
Now we will compute the cumulative Average Abnormal returns for the period of three months before and after the
announcement of dividend.
CAAR = (1.4225 + 1.0975 + 1.4425 + 1.7025 + 1.4525+1.1825 + -0.0275) = 8.2725%.
As the value of CAAR is not close to zero, we conclude that market is not efficient in the semi-strong form.
< TOP >
3. According to CAPM
= Rf + β (Rm – Rf)
= Rf + β S (Rm – Rf) - (I)
= Rf + β D (Rm – Rf) - (II)
(I) – (II)
– RD = (β S – β D) (Rm – Rf)
= (1.52 – 0.80) (Rm – Rf)
= 0.72 (Rm – Rf)
3
0.72 = 4.167 = (Rm – Rf)
Now putting the value of (Rm – Rf) in equation (I)
= Rf + 1.52 × 4.167
= 12 – 6.333 = 5.667%
= 5.667 + 0.96 × 4.167 = 9.667
= 9.667%.
Total risk = Systematic risk + Unsystematic risk

= β σ + σ eC
2
C
2
2
m

βc2 σ m2 + 9
=

(0.96)2 σm + 9
2
=

0.9216 σm
2
(64 – 9) =
55
0.9216 = σ2m

59.68 = σ2m

= 59.68 × (1.52)2 + 15 = 152.88

= 59.68 × (0.80)2 + 25 = 63.19

= 12.36%
= 7.95%.
< TOP >
4. a.
Loading Total Effective Coupon Rate
Year Expected Annual PLR
(%) (%) (%)
2004-05 9.00% 0.65 9.65 10.00
2005-06 [(1.0915)2 ÷ 1.09] – 1 =9.30% 0.65 9.95 10.00
[(1.0955)3 ÷ (1.0925)2] – 1 =
2006-07 0.65 10.80 10.80
10.15%
2007-08 [(1.10)4 ÷ (1.0955)3] – 1 = 11.36% 0.65 12.01 12.01
2008-09 [(1.1015)5 ÷ (1.10)4] – 1 = 10.75% 0.65 11.40 11.40

Therefore, YTM denoted by r can be found out from following expressions

100 100 108 120.1 114 + 1000
+ + + +
1 + r (1 + r )2 (1 + r )3 (1 + r ) 4 (1 + r ) 5
950 =
Consider, r = 12%; R. H. S. = 954.3
At r = 13%; R. H. S. = 920.00
954.3 − 950
i.e., r = 12 + 954.3 − 920
= 12.125 ≅ 12.13% ≅ 12%
b.
Year C.F PV. of C.F (12%) PV. of C.F. x n
1 100.00 89.1822 89.1822
2 100.00 79.5346 159.0693
3 108.00 76.6052 229.8156
4 120.10 75.9724 303.8895
5 1114.00 628.458 3142.289
949.752 3924.245

3924.245
Duration of Floating rate bond = 949.752 = 4.13 years
< TOP >
5. The historical and expected dividend payout ratios are equal for both the companies
For Company A
According to Dividend discount model
D1
ke − g
PO = Where the symbols are in standard use.
Dividing both sides by E1
Po (D1 / E1 ) D1
⇒ = = DPR
E1 ke − g E1
where
ke = 5.25+1.35 (11.50 – 5.25)
= 5.25 + 11.2
= 13.6875
Growth = ROE × retention ratio
= 0.16 × 0.60
= 0.096
Therefore,
0.4 0.4
P/E ratio = 0.136875 − 0.096 = 0.040875 = 9.786
For Company B
Dividing both sides by E1
Po (D 0 / E1 ) D1
⇒ = = DPR
E1 ke − g E1
where
ke = 5.25 + 1.05 (11.5-5.25)
= 11.8125
g = 0.11 × 0.50 = 0.055

0.5
P/E ratio = 0.118125 − 0.055
= 7.92
Alternative method:
The P/E ratio estimated above uses the forecasted EPS for the next period, which is called leading P/E ratio.
Alternatively, P/E ratio can be estimated using the current (latest available) EPS. This is called trailing P/E
ratio:
For company A
Trailing P/E ratio :
Dividing both sides by Eo
D0
(1 + g)
Po E D0
⇒ = 0 = DPR
Eo ke − g E0
Where
ke = 5.25+1.35 (11.50 – 5.25)
= 5.25 + 11.2
= 13.6875
Growth = ROE × retention ratio
= 0.16 × 0.60
= 0.096

Po 0.4(1 + 0.096)
Eo 0.136875 − 0.096
Trailing =
0.4384
= 0.040875
= 10.725
 For company B
Trailing P/E ratio :
D0
(1 + g)
Po E0 D0
⇒ = = DPR
Eo Ke − g E0
where
ke = 5.25 + 1.05 (11.5-5.25)
= 11.8125
g = 0.11 × 0.50 = 0.055

0.5(1.055)
Trailing P/E ratio : 0.118125 − 0.055
= 8.3556

b. The possible reasons for the difference in the PE ratios of the two companies are
(i) Difference in the payout ratios
(ii) Difference in the ROE
(iii) Difference in the Beta values
(i) (iv) Difference in growth rates

c. Calculation of long-term growth rate when the company B’s stock is trading at sixteen times its next
expected earnings.
DPR
ke− g
12 =
0.5
0.118125 − g
12 =
⇒ 1.4175 – 12g = 0.5
⇒ 12g = 0.9175
⇒ g = 7.65%.
< TOP >
6.

Day Closing Nifty value Trend

1 1900.65 –
2 1935.35 Up (+)
3 1893.25 Down (–)
4 1824.60 Down (–)
5 1770.50 Down (–)
6 1847.55 Up (+)
7 1904.70 Up (+)
8 1863.10 Down (–)
9 1843.60 Down (–)

100
1 + RS
RSI = 100 –
Average of up closing prices
Average of down closing prices
RS =

  1935.35 + 1847.55 + 1904.70  

   
  3  
  (1893.25 + 1824.60 + 1770.50 + 1863.10 + 1843.60  
 