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April 2010
CA FINAL1 :
STRATEGIC FINANCIAL MANAGEMENT
SOLUTION
Time Allowed: 3 Hours Max. Marks: 100
Answer 1
Incremental CFAT and NPV (Rs. in lakhs)
Particulars 1 2 3 4 5
Sales 300 300 300 300 300
Add: Cost Savings:
Maintenance
(note
2)
15 15 30 30 30
Cost
of
utilities
2.5 2.5 2.5 2.5 2.5
Labour
Costs (note
3)
17.16 18.87 20.76 22.84 25.12
Less: Incremental Cost
Raw
materials
(note
4)
142.5 142.5 142.5 142.5 142.5
Depreciation
(note5)
25.2 25.2 54 54 54
Insurance
(note
6)
4.12
3.71
3.34
3
2.71
Earning
before Tax
163.04 165.16 153.42 155.84 158.76
Less: Taxes
(0.35)
57.064 57.806 53.607 54.544 55.426
Earning
after Taxes
105.976 107.354 99.723 101.296 102.934
CFAT
(EAT +
Depreciation
)
130.976 132.354 153.723 155.296 156.934
Salvage value 30
Release of working capital 50
(x) PV
factor at .20
0.833 0.694 0.579 0.482 0.402
PV 109.10 91.85 89.01 74.85 95.25
Total present Value (t =15) 460.06
Less: cash outflow 276.55
NPV 183.51
Comments: Since the NPV is positive, replacement of the exiting machines is financially viable.
FINANCIAL ANALYSIS WHETHER TO REPLACE THE EXISTION MACHINES (USING NPV
METHOD)
Incremental cash outflows:
Cost of 3 new machines (Rs.100 lakh × 3) 300,00,000
Additional working capital 50,00,000
Less: Sale proceeds of existing machines 96,00,000
Add: Removal cost of existing machines 4,80,000
Tax on profit on sale of machine (working note1) 11,76,000
Cost of laying off 34 workers (Rs.921000 tax advantage @ .35 i.e. to Rs.3,22,350) 5,98,650
Incremental cash outflows 2,76,54,650
Working Notes
1. Tax on profit on sale of existing machine:
Sale proceeds of existing machine: 96,00,000
(8 × 12,00,000)
Less: Book value (Rs.18 lakh × 8 – Original Cost
accumulated depreciation 28.80 × 3) 57,60,000
Gross profit 38,40,000
Less: Removal Cost (60,000 × 8) 4,80,000
Net Profit 33,60,000
Tax rate 0.35
Taxes payable on profit 11,76,000
2. Saving in Maintenance cost: (Rs. in lakhs)
Year 1 2 3 4 5
Old
Machine
22.5 22.5 67.5 67.5 67.5
New
Machine
7.5 7.5 37.5 37.5 37.5
Saving in
cost
15 15 30 30 30
3. Savings in Labour cost:
Existing labour cost:
Unskilled (18 × Rs.3,500 × 12 months) 7,56,000
Skilled (18 × Rs.5,500 × 12 months) 11,88,000
Supervisor (3 × Rs.6,500 × 12 months) 2,34,000
Maintenance (2 × Rs.5,000 × 12 months) 1,20,000
22,98,000
Proposed labor cost:
Skilled (6 × Rs.7,000 × 12 months) 5,04,000
Maintenance (1 × Rs.6,500 × 12 months) 78,000
Cost savings 17,16,000
Savings in subsequent years will increase by 10%
4. Incremental cost of raw material:
Raw material required for old machine:
(3000000 × Rs.15 per unit × 0.60) 2,70,00,000
Raw material required for new machine
(5000000 × Rs.15 per unit × 0.55) 4,12,50,000
Additional raw material Cost 1,42,50,000
5. Incremental Depreciation: (Rs. in Lakhs)
Years 1 – 2 3 – 5
Depreciation (with new machine) 54.00 54.00
(Rs.100 lakh × 3 – 10 × 3) / 5 years
Depreciation (with old machine) 28.80 
(Rs.18 lakh × 8/5 years)
Incremental Depreciation 25.20 54.00
6. Insurance: (Rs. in lakhs)
Years 1 2 3 4 5
New
Machine
6.00 5.40 4.86 4.37 3.94
Old
Machine
1.88 1.69 1.52 1.37 1.23
Incremental
Insurance
4.12 3.71 3.34 3.00 2.71
Answer 2
(a) If the yield of the bond falls the price will always increase. This can be shown by following calculation.
IF YIELD FALLS TO 6%
Price of 5yr. bond
Rs.80 (PVIFA 6%, 5yrs.) + Rs.1000 (PVIF 6%, 5yrs.)
Rs. 80 (4.212) + Rs. 1000 (0.747)
Rs. 336.96 + Rs. 747 = Rs. 1,083.96.
Increase in 5 year’s bond price = Rs. 83.96
Current price of 20 year bond
Rs. 80 (PVIFA 6%, 20) + Rs. 1,000 (PVIF 6%, 20)
Rs. 80 (11.47) + Rs. 1,000 (0.312)
Rs. 917.60 + Rs. 312.00 = Rs. 1229.60
So increase in bond price is Rs. 229.60
PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL
5 yrs. Bond
Rs. 1,000 (PVIF 6%, 5) – Rs. 1,000 (PVIF 8%, 5)
Rs. 1,000 (0.747) – Rs. 1,000 (0.681)
Rs. 747.00 – Rs. 681.00 = Rs. 66.00
& change in price due to change in PV of Principal
(Rs. 66/ Rs. 83.96) x 100 = 78.6%
20 yrs. Bond
Rs. 1,000 (PVIF 6%, 20) – Rs. 1,000 (PVIF 8%, 20)
Rs. 1,000 (0.312) – Rs. 1,000 (0.214)
Rs. 312.00 – Rs. 214.00 = Rs. 98.00
& change in price due to change in PV of Principal
(Rs. 98/ Rs. 229.60) x 100 = 42.68%
PRICE CHANGE DUE TO CHANGE IN PV OF INTEREST
5 yrs. Bond
Rs. 80 (PVIFA 6%, 5) – Rs. 80 (PVIFA 8%, 5)
Rs. 80 (4.212) – Rs. 80 (3.993)
Rs. 336.96 – Rs. 319.44 = Rs. 17.52
% change in price
(Rs.17.52/ Rs.83.96) x 100 = 20.86%
20 yrs. Bond
Rs. 80 (PVIFA 6%, 20) – Rs. 80 (PVIFA 8%,20)
Rs. 80 (11.47) – Rs. 80 (9.82)
Rs. 917.60 – Rs. 785.60 = Rs. 132
& change in price = (Rs.132/ Rs.229.60 x 100) = 57.49%
(b) Duration in the average time taken to recollect back the investment
Years
(A)
Coupon Payments
(Rs.)
Redemption
(Rs.)
Total (B)
(Rs.)
PVIF @ 7%
(C) (Rs.)
(A )x(B)x (C)
1 70  70 0.935 65.45
2 70  70 0.873 122.22
3 70  70 0.816 171.36
4 70  70 0.763 213.64
5 70  70 0.713 249.55
6 70 1000 1070 0.666 4,275.72
∑ABC 5,097.94
years 098 . 5
1000 . Rs
94 . 5097 . Rs
ice Pr Purchase
ABC
Duration = =
Σ
=
(c) If YTM goes up to 10% , current price of the bond will decrease to
Rs. 70 x PVIFA (10%,6) + Rs. 1000 PVIF (10%,6)
Rs. 304.85 + Rs. 564.00 = Rs. 868.85
Year (A)
Inflow (Rs.) (B)
PVIF @ 10% (C)
(A )x(B)x (C) (Rs.)
1 70 0.909 63.63
2 70 0.826 115.64
3 70 0.751 157.71
4 70 0.683 191.24
5 70 0.621 217.35
6 1070 0.564 3,620.88
∑ABC 4,366.45
New Duration Rs. 4,366.45/ Rs. 868.85 = 5.025 years
The duration of bond decreases, reason being the receipt of slightly higher portion of one’s investment on
the same intervals.
(d) Duration is nothing but the average time taken by an investor to collect his/her investment. If an
investor receives a part of his/her investment over the time on specific intervals before maturity, the
investment will offer him the duration which would be lesser than the maturity of the instrument. Higher
the coupon rate, lesser would be the duration.
Answer 3
(a) (i) According to Purchasing Power Parity forward rate is
t
r
r
F 1
H 1
rate Spot
+
+
So spot rate after one year
1
03 . 0 1
065 . 0 1
40 . 43
+
+
= 43.4 (1.03399)
= 44.8751
After 3 years
3
03 . 0 1
065 . 0 1
40 . 43
+
+
= 43.40 (1.03398)³
= 43.40 (1.10544)
= Rs.47.9762
(ii) As per interest rate parity
S1 = S0
+
+
B in 1
A in 1
S1=0.7570
× +
× +
12
3
) 035 . 0 ( 1
12
3
) 075 . 0 ( 1
= 0.7570 × 1.0099 = 0.7645
S1 = UK £0.7645 / US$
(b) Earning per share for company K. Ltd. after Merger :
Exchange Ratio 160 : 200 = 4: 5
That is 4 shares of K. Ltd. for every 5 shares of N. Ltd.
Therefore, total number of shares to be issued =
5
4
× 2,50,000 = 2,00,000 shares
Therefore, total number of shares of K. Ltd. and N .Ltd.
= 10,00,000 K. Ltd.
+ 2,00,000 N. Ltd
12,00,000
Total profit after Tax = Rs. 50,00,000 K. Ltd.
Rs. 15,00,000 N Ltd.
Rs. 65,00,000
Therefore, E.P.S. (Earning per share) of K. Ltd. after Merger
= 65,00,000/ Rs.12,00,000
= Rs.5.42 Per Share
(ii) To find the Exchange Ratio so that shareholders of N. Ltd. would not be at a Loss:
Present Earnings per share for company K. Ltd.
= Rs.50,00,000/ Rs.10,00,000 = Rs.5.00
Present Earnings Per share for company N. Ltd.
= Rs.15,00,000/ Rs.2,50,000 = Rs.6.00
Therefore, exchange Ratio should be 6 shares of K. Ltd. for every 5 shares of N Ltd.
Therefore, shares to be issued to N. Ltd.
= (2,50,000×6)/5 = 3,00,000 Shares
Therefore, total No. of Shares of K.Ltd. and N. Ltd.
= 10,00,000 K. Ltd.
+ 3,00,000 N. Ltd
13,00,000
Therefore, E.P.S. After Merger
= 65,00,000/13,00,000 = Rs.5.00 Per Share
Total Earnings Available to Shareholders of N. Ltd. after Merger
= Rs.3,00,000 × Rs.5.00 = Rs.15,00,000
This is equal to Earnings prior Merger for N. Ltd.
Therefore, exchange ratio on the Basis of Earnings per Share is recommended.
Answer 4
a)
1006 . 1
3 18 . 0
2586 . 0 08455 . 0
3 18 . 0
3 ) 0162 . 0 07 . 0 ( ) 0882 . 1 ( l
3 18 . 0
3 )
2
18 . 0
07 . 0 ( )
170
185
( l
t
t )
2
r ( )
E
S
( l
d
n
2
n
2
n
1
=
+
=
+ +
=
+ +
=
σ
σ
+ +
=
d
2
= d
1
 t σ =1.10060.31177 = 0.7888
N(d1) = 0.8770 (from table)
N(d2) = 0.7848
Value of option = 7848 . 0
2336 . 1
170
245 . 162 ) 7848 . 0 (
e
170
) 8770 . 0 ( 185 ) d ( N
e
E
) d ( N V
21 . 0
2
rt
1 s
× − = − = − =
= 162.245 – 108.151 = Rs.54.094.
(b) Total premium paid on purchasing a call and put option
= (Rs.30 per share × 100) + (Rs.5 per share × 100).
= Rs.3,000 + Rs. 500 = Rs.3,500
(i) In this case, X exercises neither the call option nor the put option
As both will result in a loss for him.
Ending value =  Rs.3,500 + zero gain
=  Rs.3,500
i.e Net loss = Rs.3,500
(ii) Since the price of the stock is below the exercise price of the call, the call will not be
exercised. Only put is valuable and is exercised.
Total premium paid = Rs.3,500
Ending value = Rs.3,500 + Rs.[(450 – 350) × 100]
= Rs.3,500 + Rs.10,000 = Rs.6,500
Net gain = Rs.6,500
(iii) In this situation, the put is worthless, since the price of the stock exceeds the put’s
exercise price. Only call option is valuable and is exercised.
Total premium paid = Rs.3,500
Ending value = 3,500 +[(600 – 550) × 100]
Net Gain = 3,500 + 5,000 = Rs.1,500
(c)
(i)
PV of cash outflows under leasing alternative
Year After Tax Lease
Payment
PVAF (14%, 4) Total PV
1 – 4 Rs.5,00,000 2.913 Rs.14,56,500
Calculation of instalment payable under Buying option
Present Value Annuity Factor at 16% for 4 years. 2.798
Value of Instalment = Rs.50,00,000/ 2.798 = Rs.17,86,990
Calculation of Interest component in Installments and tax benefit on interest
component.
(Amount in Rs.)
Period Loan in
Beginning
Loan
installment
Interest @
16%
Principal
Repayment
Principal
outstanding
1 50,00,000 17,86,990 8,00,000 9,86,990 40,13,010
2 40,13,010 17,86,990 6,42,082 11,44,908 28,68,102
3 28,68,102 17,86,990 4,58,896 13,28,094 15,40,008
4 15,40,008 17,86,990 2,46,982 15,40,008 Nil
(Balancing Figure)
Calculation of Tax benefits on interest and Depreciation.
Period Interest Depreciation Total Tax Benefit
1 8,00,000 7,50,000 15,50,000 7,75,000
2 6,42,082 7,50,000 13,92,082 6,96,041
3 4,58,896 7,50,000 12,08,896 6,04,448
4 2,46,982 7,50,000 9,96,982 4,98,491
Present value of Cash Outflow under buying alternatives
Year Loan
instalment
Tax Savings
on Interest
and
Depreciation
Net
outflow
Salvage
Value
PVF
(14%)
Present
value
1 17,86,990 7,75,000 10,11,990  0.877 8,87,515
2 17,86,990 6,96,041 10,90,949  0.769 8,38,940
3 17,86,990 6,04,448 11,82,542  0.675 7,98,216
4 17,86,990 4,98,491 12,88,499  0.592 7,62,791
4   (20,00,000) 0.592 (11,84,000)
21,03,462
Recommendation: The lease option is financially better.
(ii)
Determination of Cash Flow after tax
Rs.
Lease Rent receivable 10,00,000
Less: Depreciation 7,50,000
EBIT 2,50,000
Less: Tax @ 50% 1,25,000
EAT 1,25,000
Add: Depreciation 7,50,000
8,75,000
Determination of NPV
Particulars Year Cash Flows PVF @ 14 Present Value
Purchase of
Computer
0 (50,00,000) 1.00 (50,00,000)
Annual Cash
Inflow
14 8,75,000 2.914 25,49,750
Salvage Value 4 20,00,000 0.592 11,84,000
(12,66,250)
Recommendation: The proposal is not financially viable.
(iii) Let desired CFAT to earn a return of 16% is X, then
Rs.50,00,000 =
∑
=
+
+
+
4
1 t
4
) 16 . 0 1 (
000 , 00 , 20 . Rs
) 16 . 0 1 (
X
Rs.50,00,000 = X (2.798) + Rs.20,00,000 (0.552)
Rs.50,00,000 = 2.798 X +11,04,582
Rs.38,95,418 = 2.798 X
X = Rs.13,92,215
Thus, lease rent for IRR of 16% should be Rs.13,92,423.
Answer 5
(a) Investment A
Economic
Climate
Probability (P) Returns %
(R
A
)
P × R
A
R
A
 A R P(R
A
 A R )
2
Dull
Stable
Growth
0.2
0.5
0.3
10
14
20
2
7
6
% 15
5
1
5
5.0
0.5
7.5
00 . 13
So, the variance of return of A is 13 and the standard deviation σ
A
= 00 . 13 =3.6%.
Investment B
Economic
Climate
Probability (P) Returns %
(R
B
)
P × R
B
R
B
 B R P(R
B
 B R )
2
Dull
Stable
Growth
0.2
0.5
0.3
6
15
11
1.2
7.5
3.3
% 12
6
3
1
7.2
4.5
0.3
00 . 12
Variance of Investment B is 12 and the standard deviation is σ
B
= 00 . 12 =3.46%.
In case, one half of the total amount is invested in Investment A and done half in Investment B,
the risk of the portfolio can be calculated as follows:
Economic
Climate
Probability
(P)
Returns % (R
A
) P × R
R
 R P(R
 R )
2
Dull
Stable
Growth
0.2
0.5
0.3
(10+6)/2=8.0
(14+15)/2=14.5
(20+11)/2=15.5
1.60
7.25
4.65
R =
13.50%
5.5
1.0
2.0
6.05
0.50
1.20
75 . 7
The variance of the portfolio is 7.75 and the standard deviation is
σ
(A+B)
= 75 . 7 = 2.78%
Hence, the expected return from the portfolio is 13.50% and the standard deviation of the
portfolio is 2.78%.
Covariance (A,B) of the portfolio can be found as follows:
Economic
Climate
Probability (P)
R
A
 A R R
B
 B R P(R
A
 A R ) (R
B
 B R )
Dull
Stable
Growth
0.2
0.5
0.3
5
1
5
6
3
1
6.0
1.5
1.5
So, the covariance (A, B) is 3.
Now, the correlation between A, B may be found as follows:
Correlation, P
AB
= covariance (A, B)/ σ
A
σ
B
= 3.0/(3.6×3.46) = 0.24
(b) Expected rate of return of shares of ABC Ltd:= % 14
2
17 11
n
R
=
+
=
∑
Expected rate of return of shares of PQR Ltd:= % 14
2
8 20
=
+
Expected rate of portfolio (50% of ABC Ltd. and 50% of PQR Ltd.) = (0.5×14%)+(0.5×14%)=14%
Expected rate of portfolio (60% of ABC Ltd. and 40% of PQR Ltd.) = (0.6×14%)+(0.4×14%)=14%
Standard deviation of ABC Ltd. shares= σ
A
= 3
2
) 14 17 ( ) 14 11 (
2 2
=
− + −
Standard deviation of PQR Ltd. shares= σ
P
= 6
2
) 14 8 ( ) 14 20 (
2 2
=
− + −
Covariance between ABC Ltd. and PQR Ltd.:
Cov = ) R R )( R R (
N
1
n
1 i
P P A A ∑
=
− − = ) 14 8 )( 14 17 ( ) 14 20 )( 14 11 (
2
1
− − + − − = 18
Coefficient of Correlation= Covariance of ABC & PQR = 18 =
σ
A
σ
P
6×3
Portfolio risk in case ABC Ltd. and PQR Ltd. are invested in the ratio of 2:1:
2 1
P A AP P A
2
P
2
P
2
A
2
A
)) r ( 2 ( σ σ ω ω + σ ω + σ ω = σ =
0 ) 6 3 1 (
3
1
3
2
2 36
3
1
9
3
2
2
1
2 2
=


¹

\

× × − × × + × 
¹

\

+ × 
¹

\

Portfolio risk in case ABC Ltd. and PQR Ltd. are invested in the ratio of 1:1= σ =
5 . 1 ) 6 3 1 (
2
1
2
1
2 36
2
1
9
2
1
2
1
2 2
=


¹

\

× × − × × + × 
¹

\

+ × 
¹

\

(c) Calculation of Present Value of Dividend Income
(Figures in Rs.)
Date Div. @ 10% Div. after tax PV factor PV
31.3.2003 100 80 0.91 72.80
31.3.2004 100 80 0.83 66.40
31.3.2005 100 80 0.75 60.00
31.3.2006 100 80 0.68 52.40
31.3.2007 140 112 0.62 69.44
Total Present
Value
Rs. 321.04
Calculation of present value of sale proceeds:
Selling price of 140 shares @ Rs.50 on 31.3.2006 Rs.7000
Less : Total Cost of shares (100 × Rs. 30) Rs.3000
Capital gain Rs.4000
Capital gain tax @ 15% Rs.600
Net gain Rs.3400
Total cash inflow (3400+3000) Rs.6400
(This amount is receivable on 31.3.2008 i.e after 6 years from the date of
purchase).
PV Factor @ 10% for 6 years 0.56
Present value of Rs.6400 6400×0.56=
Rs.3584
Total present value of inflows (3584 + 321.04) Rs.3905.04
Less : cash outflow (cost of purchases) Rs.3000.00
Net present value (gain) Rs.905.04
Since, the net present value (gain) of the investment in shares of A Ltd. is positive @ 10%, therefore,
investor X is getting a return on his investment at a rate more than 10%.
Answer 6
a) Credit Derivatives
Credit derivative is an instrument designed to segregate market risk from credit risk to allow the
separate trading of credit risk. Credit derivatives allow a more efficient allocation and pricing of
credit risk. Credit derivatives are privately negotiated bilateral contracts that allow users to
manage their exposure to credit risk. For example, a bank concerned that one of its customers
may not be able to repay a loan can protect itself against loss by transferring the credit risk to
another party while keeping the loan on its books. This mechanism can be used for any debt
instrument or a basket of instruments for which an objective default price can be determined.
Credit derivatives are traded over the – counter (OTC) in developed markets. OTC trades are
contracts negotiated between counter parties that take place outside the regulated exchanges. This
permits maximum flexibility in structuring a contract that meets the needs of both parties.
Types of Credit Derivatives
The product menu in the credit derivatives market is changing every day, but there are four major
instruments that make up the bulk of the trading volume today: Total Return Swaps, Credit
Default Swaps, Credit Spread Options and Credit Linked Notes. Terminology varies among
market participants, sometimes based on geography. For example, Credit Default Swaps are
sometimes called Credit Swaps.
The benefits associated with credit derivatives:
A loan portfolio manager can achieve any of the following objectives through credit derivatives:
Control credit risks of any debt instrument or basket of instruments by selling or transferring the
credit exposure of the portfolio.
Reduce a particular risk concentration in the portfolio
Create synthetic assets tailored to meet their needs
Provide a diverse menu of global exposures to achieve portfolio diversification
Gain exposure to another bank’s loan portfolio without participating in the syndicate.
b) Translation Exposure
Translation exposure is the risk of the change in the domestic financial performance and position
because of the fluctuating value of assets and liabilities denominated in foreign currencies. It
does not represent real movements of cash between different currency systems, but can clearly
impact both the profit and loss account and the balance sheet on stand alone basis as well as on
consolidated basis. The balance sheet effects are often dismissed as illusory since they have no
cash impact. However the level of assets and liabilities can affect financial ratios calculated using
balance sheet figures, which causes practical problems where the company has restrictions on its
level of borrowings placed by covenants.
Translation exposure is the difference between exposed assets and exposed liabilities. A greater
amount of exposed assets than liabilities will give rise to a positive exposure while a greater
amount of liabilities than assets will give rise to a negative exposure. Companies have at least
three available methods for managing their translation exposure:
• Adjusting fund flows
• Entering into forward contracts
• Exposure netting
Basic hedging strategy for reducing translation exposure is to increase hard currency (likely
to appreciate) assets and decrease soft currency (likely to depreciate) assets, while
simultaneously decreasing hard currency liabilities and increasing soft currency liabilities.
Thus if devaluation appears likely, the basic hedging strategy would be:
• Reduce level of cash
• Tighten credit terms to decrease accounts receivable
• Increase local currency borrowing
• Delay accounts payable
• Sell the weak currency forward.
c) Random Walk Hypothesis
The random walk hypothesis claims that stock prices follow a random or erratic pattern. That is,
people who believe is this theory claim that price movements are unpredictable and as a result,
there’s little that you can do to predict future behavior. An efficient market is one in which the
market price of the security always fully reflects available all information, so it is difficult, if not
impossible to consistently outperform the market by picking undervalued stocks. It is argued that
in an efficient market, random price movements simply reflect a highly competitive market
where investors quickly use and digest any new information. This competition holds security
prices close to their correct (justified) level; as new information becomes available (in a random
manner); adjustments in price are random and quick to follow.
To outperform the market, one must consistently earn more than the required rate of return on
securities. In other words, one must be able to consistently find stocks selling below their
justified prices, and then realize the expected return on the security. In an efficient market,
current prices reflect all information; therefore, current prices equal justified prices, and investors
can expect to earn only the required (risk adjusted) rate of return.
I. Efficient markets do not make high rates of return unavailable, but they make it (nearly)
impossible to consistently earn returns higher than the rates of return required for the risk
levels of the securities purchased. Hence a stock with high rates of return will also be more
risky.
II. Investors can earn high rates of return through luck, or through accepting stocks with
higher risks. They can also minimize transaction and tax expenses, along with unnecessary
risk, to make their returns more satisfactory.
Random walks offer a serious challenge to technical analysis. If prices fluctuations are
purely random, charts of past behavior cannot produce significant trading profits. If the
market is efficient, shifts in supply and demand occur so rapidly that technical measures
simply measure the past and have no implications for the future What’s more, in an
efficient market, extreme competition among investors will keep security prices at or very
close to their justified levels, so fundamental analysis will not lead to returns above those
required by the amount of risk exposure.
d) Capital Market and Money Market
Capital market Money market
Capital market id classified into primary
and secondary market
No such classification exists
Long term Financial instruments are used
meeting long term fund requirements
Short term financial instruments are used
for short term financial needs or investment
of surplus fund
Regulated by SEBI Regulated by RBI/ FIMMDA
Typical instruments are shares, debts and
mutual fund
Typical instruments are commercial papers,
TBill, Gsec etc
Participants are mainly institutional players
as well as retail investors
Participants are mainly banks/ FIs, RBI and
highly rated corporate
Exchange traded OTC
976 132.000 33.579 0.80.40.5 30 .5 30 3 67. Tax on profit on sale of existing machine: Sale proceeds of existing machine: (8 × 12.000 Cost of laying off 34 workers (Rs.5 30 4 67.98.000 4.354 153.650 Working Notes 1.350) 5.000 Add: Removal cost of existing machines 4.60.934 (EAT + Depreciation ) Salvage value 30 Release of working capital 50 (x) PV 0.482 0.51 Comments: Since the NPV is positive.80.00.000 0.5 37.00.76.402 factor at .54.000 Tax on profit on sale of machine (working note1) 11.06 Less: cash outflow 276.5 37.10 91. to Rs.18 lakh × 8 – Original Cost accumulated depreciation 28.000 57.000 (Rs. Saving in Maintenance cost: Year 1 2 Old 22.5 7.60.921000 tax advantage @ .000) Less: Book value (Rs.e.723 155.55 NPV 183.85 89.5 22.000 Additional working capital 50.CFAT 130.01 74.100 lakh × 3) 300.35 11.000 38.00. FINANCIAL ANALYSIS WHETHER TO REPLACE THE EXISTION MACHINES (USING NPV METHOD) Incremental cash outflows: Cost of 3 new machines (Rs.22.5 Machine New 7.20 PV 109. in lakhs) 5 67.76.000 Less: Sale proceeds of existing machines 96.5 37.5 Machine Saving in 15 15 cost 96.76. replacement of the exiting machines is financially viable.833 0.25 Total present Value (t =15) 460.35 i.80 × 3) Gross profit Less: Removal Cost (60.85 95.00.694 0.00.000 × 8) Net Profit Tax rate Taxes payable on profit 2.296 156.3.650 Incremental cash outflows 2.
71 . Insurance: Years New Machine Old Machine Incremental Insurance 1 6.3.60) Raw material required for new machine (5000000 × Rs.56.000 (6 × Rs.40 1.500 × 12 months) (18 × Rs.04.12.500 × 12 months) (3 × Rs.000 × 12 months) 7.000 17.00 (Rs.55) Additional raw material Cost 5.00.100 lakh × 3 – 10 × 3) / 5 years Depreciation (with old machine) (Rs.500 × 12 months) Cost savings Savings in subsequent years will increase by 10% 4.16.000 × 12 months) (1 × Rs.94 1.20 6. Savings in Labour cost: Existing labour cost: Unskilled Skilled Supervisor Maintenance Proposed labor cost: Skilled Maintenance (18 × Rs.00 1–2 54.20. in lakhs) 5 3.000 2.71 3 4.6. Incremental Depreciation: Years Depreciation (with new machine) (Rs.000 5.7.00 54.34 4 4.000 11.70.18 lakh × 8/5 years) Incremental Depreciation 2.50.80 25.500 × 12 months) (2 × Rs.5.6.50.37 3.000 22. in Lakhs) 3–5 54.5.00 28.15 per unit × 0. Incremental cost of raw material: Raw material required for old machine: (3000000 × Rs.52 3.15 per unit × 0.00 1.88.42.000 78.23 2.98.000 4.000 (Rs.12 2 5.000 1.37 1.86 1.34.69 3.3.000 1.88 4.
80 (11.96 Current price of 20 year bond Rs. 1. 83.44 = Rs.312) Rs.60 x 100) = 57. 917.212) – Rs. 1. 20) – Rs. Bond Rs. IF YIELD FALLS TO 6% Price of 5yr. This can be shown by following calculation. 1. 1. 681. 229. 80 (4.) Rs. 80 (9. 98.20) Rs. 1. 80 (PVIFA 8%. 20) Rs. 5) – Rs.132/ Rs. 80 (PVIFA 6%. Bond Rs.60) x 100 = 42.1000 (PVIF 6%. 17. 20) Rs.083.229. 80 (PVIFA 8%. 747.60 PRICE INCREASE DUE TO CHANGE IN PV OF PRINCIPAL 5 yrs.96 + Rs.00 & change in price due to change in PV of Principal (Rs. 5) Rs.00 – Rs. 1.000 (PVIF 6%. 80 (11. 785. 319. 336.49% .993) Rs. 20) + Rs. 1. bond Rs. 80 (PVIFA 6%.312) – Rs.00 – Rs. 1.000 (0. 5yrs.747) – Rs.82) Rs.60 = Rs. 66/ Rs.000 (PVIF 6%.000 (PVIF 8%.) + Rs.17. 1. 229. 83. 917.Answer 2 (a) If the yield of the bond falls the price will always increase. 1.681) Rs. 80 (3. 80 (PVIFA 6%. Bond Rs. 20) – Rs.96) x 100 = 78.96) x 100 = 20.00 = Rs.00 = Rs. 5) – Rs. Increase in 5 year’s bond price = Rs.47) + Rs. 312.83.52/ Rs.000 (0.96 – Rs.747) Rs. 1.68% PRICE CHANGE DUE TO CHANGE IN PV OF INTEREST 5 yrs.6% 20 yrs. 5) Rs. 336.52 % change in price (Rs.60 So increase in bond price is Rs.212) + Rs.214) Rs. Bond Rs. 1229. 98/ Rs. 66. 5yrs.86% 20 yrs. 214.000 (0.80 (PVIFA 6%.60 + Rs. 312.00 = Rs. 1000 (0. 132 & change in price = (Rs.000 (0.47) – Rs.60 – Rs. 747 = Rs. 80 (4.000 (PVIF 8%.000 (0.96.000 (PVIF 6%.00 & change in price due to change in PV of Principal (Rs.
366. If an investor receives a part of his/her investment over the time on specific intervals before maturity.826 0.620. 4.(b) Duration in the average time taken to recollect back the investment Years (A) 1 2 3 4 5 6 Coupon Payments (Rs.1000 (c) If YTM goes up to 10% .) 70 70 70 70 70 1070 PVIF @ 7% (C) (Rs.00 = Rs. 868.097.564 ∑ABC (A )x(B)x (C) (Rs. current price of the bond will decrease to Rs.935 0.85 = 5. 304.45 122.85 + Rs.63 115.098 years Purchase Pr ice Rs.025 years The duration of bond decreases.64 157.94 = = 5.72 5.) (B) 70 70 70 70 70 1070 PVIF @ 10% (C) 0.751 0.366.275.) 0.71 191. lesser would be the duration.64 249.45 New Duration Rs.909 0.683 0.85 Year (A) 1 2 3 4 5 6 Inflow (Rs.36 213.) 1000 Total (B) (Rs. reason being the receipt of slightly higher portion of one’s investment on the same intervals.24 217.) 63.) 70 70 70 70 70 70 Redemption (Rs.22 171.816 0.94 Duration = ΣABC Rs. 70 x PVIFA (10%.873 0. 1000 PVIF (10%. 564.763 0.88 4.6) Rs. .666 ∑ABC (A )x(B)x (C) 65.621 0. the investment will offer him the duration which would be lesser than the maturity of the instrument. (d) Duration is nothing but the average time taken by an investor to collect his/her investment. Higher the coupon rate.45/ Rs.5097.55 4. 868.6) + Rs.713 0.35 3.
= 10.00. Ltd. Ltd. (Earning per share) of K. Ltd 12.P.000 Total profit after Tax = Rs.40 1 + 0.5.00. and N .Ltd.7570 × 1.075) × 3 12 S1=0.47.7645 / US$ (b) Earning per share for company K.42 Per Share .000 = Rs.065 43.00. 65. total number of shares to be issued = 4 × 2. for every 5 shares of N.50.000 N Ltd. Rs.03 = 43.000 N. Ltd.000 = 2.S.000 K. Ltd. Ltd.000 Therefore.000 shares 5 Therefore. after Merger = 65. after Merger : Exchange Ratio 160 : 200 = 4: 5 That is 4 shares of K.00. 15.00. 50. E.00.40 (1. Ltd.7570 1 + (0.12.0099 = 0.7645 S1 = UK £0.40 (1.8751 After 3 years 1 t 1 + 0.035) × 3 12 = 0.000/ Rs. + 2.00. Rs.40 1 + 0. Therefore.4 (1.065 43.03399) = 44.000 K.10544) = Rs.Answer 3 (a) (i) According to Purchasing Power Parity forward rate is 1+ r H Spot rate r 1+ F So spot rate after one year 1 + 0.00. Ltd. total number of shares of K.00.03 = 43.9762 3 (ii) As per interest rate parity S1 = S0 1 + in A 1 + in B 1 + (0.03398)³ = 43.
00 = Rs.00.00.094.7848 Value of option = Vs N(d 1 ) − E 170 170 N(d 2 ) = 185(0.00. Ltd.08455 + 0. E.S. exchange Ratio should be 6 shares of K. Ltd.5. + 3. Ltd. = 10. Answer 4 a) σ2 0. Ltd 13.10.00 Therefore. and N.Ltd.18 3 0. Therefore.3.000×6)/5 = 3. = Rs.30 per share × 100) + (Rs. Therefore.000 Shares Therefore.3.000 = Rs. total No.54.00.σ t =1.7848 ) = 162.00.(ii) To find the Exchange Ratio so that shareholders of N.0882) + (0.000 × Rs. Ltd.50.0162)3 0.00 Per Share Total Earnings Available to Shareholders of N.00. = Rs. Ltd.7888 N(d1) = 0.2336 e e = 162.000 + Rs. Ltd.000 N.7848 = rt 1.000 This is equal to Earnings prior Merger for N. Ltd. for every 5 shares of N Ltd.5.245 − × 0.07 + )3 E 170 l (1.245 – 108.8770 (from table) N(d2) = 0.000 = Rs.00.00 Present Earnings Per share for company N.2586 2 = 2 = n = d1 = σ t 0.18 2 l n (S ) + (r + ) t l n (185 ) + (0.000/13.000/ Rs.000 K.18 3 = 1. exchange ratio on the Basis of Earnings per Share is recommended.5 per share × 100). (b) Total premium paid on purchasing a call and put option = (Rs.07 + 0. Ltd.P.00. after Merger = Rs.3.00.18 3 0.5.2.6.000 Therefore.00. shares to be issued to N.000/ Rs.31177 = 0. of Shares of K.10060.15. = Rs.151 = Rs.1006 d2 = d1. 500 = Rs.000 = Rs. Ltd.500 (i) In this case. would not be at a Loss: Present Earnings per share for company K. X exercises neither the call option nor the put option .00.15. After Merger = 65.50.8770) − 0.50.21 (0. = (2.
990 17.500 + Rs.491 .896 4 2.50.92. Only put is valuable and is exercised.50.982 Period Loan in Beginning 50.50. 2.000 13.17.86.Rs.) Principal outstanding 40.00.094 4 2.46.10.896 7.990 17.000 6.990 Year Total PV Rs.008 Nil Tax Benefit 7.68.96.982 7.86.68.50.86. Interest @ Principal 16% Repayment 1 8.008 Loan installment 17.86.500 Ending value = 3.000 2.3. since the price of the stock exceeds the put’s exercise price.102 15. Only call option is valuable and is exercised.990 (Amount in Rs.40.00.500 (iii) In this situation.00.40.28.082 11.98.500 Calculation of Interest component in Installments and tax benefit on interest component.00.990 17.96.13.50.50.6.Rs.58. the call will not be exercised.000 7.00.082 3 4. Period Interest Depreciation Total 1 8.798 Value of Instalment = Rs.500 + Rs.3.000 12.14.58.08.40. Ending value = .3.000 = Rs. 4) Payment 1–4 Rs.008 (Balancing Figure) Calculation of Tax benefits on interest and Depreciation.913 Calculation of instalment payable under Buying option Present Value Annuity Factor at 16% for 4 years.3.500 (ii) Since the price of the stock is below the exercise price of the call.000 = Rs.000 9.3.102 15.1.990 2 6.46.010 28.04.500 (c) (i) PV of cash outflows under leasing alternative After Tax Lease PVAF (14%.448 4.e Net loss = Rs.041 6.56.000 9.798 = Rs.42.3.500 Net gain = Rs. the put is worthless.000 2 6.[(450 – 350) × 100] = Rs.000/ 2. Total premium paid = Rs.44.000 40.500 + zero gain = .5.500 Ending value = Rs.86.500 + 5.082 7.75.908 3 4.000 15.42.896 13.500 +[(600 – 550) × 100] Net Gain = 3.86. Total premium paid = Rs.3.982 15.6.13.010 28.500 i.As both will result in a loss for him.
50.84.990 17.86.98.000) 0.000) 8.62.940 7.04.499 (20.000 Rs.00.13.00 2.00.00.041 6.00.00.798 X X = Rs.00.20.000 = 2.448 4.25.Present value of Cash Outflow under buying alternatives Year Loan instalment Tax Savings on Interest and Depreciation 7.49.50.491 Net outflow Salvage Value PVF (14%) Present value 1 2 3 4 4 17.582 Rs.000 1.250) Recommendation: The proposal is not financially viable.798 X +11.87.949 11.215 Thus.552) Rs.216 7.16) Rs.990  10.88.11.000 8.423.000 1.542 12.66.750 11.515 8.98.000) 25.990 17.92. then 4 X Rs.75. .96.000 PVF @ 14 1.92.86.877 0.00.04.000 (0.675 0.50.990 10.00.95.20.769 0.50.38.914 0.418 = 2.75.84.000 2.86.592 Present Value (50.462 Recommendation: The lease option is financially better.50.82.798) + Rs.000 6.25. (iii) Let desired CFAT to earn a return of 16% is X.03.90.000 Cash Flows (50.13.000 (12.00.00.000 7.000 = X (2.75.000 7.592 0.791 (11.000) 21. lease rent for IRR of 16% should be Rs.86.38.000 20. 10. (ii) Determination of Cash Flow after tax Lease Rent receivable Less: Depreciation EBIT Less: Tax @ 50% EAT Add: Depreciation Determination of NPV Particulars Year Purchase of 0 Computer Annual Cash 14 Inflow Salvage Value 4 Rs.000 = ∑ + (1 + 0.16) 4 t =1 (1 + 0.592 8.50.990 17.
3 12% 6 3 1 7.2 7.0 (14+15)/2=14.46) = 0.00 Variance of Investment B is 12 and the standard deviation is σB = 12.5 7.5 0.2 0.5 0.50 7.75 and the standard deviation is σ (A+B)= 7. the correlation between A. the risk of the portfolio can be calculated as follows: Economic Probability Returns % (RA) P×R R.5 (20+11)/2=15.0 0. the expected return from the portfolio is 13.2 0.00 =3.20 4.75 = 2. B) is 3. Covariance (A. B may be found as follows: Correlation.6%.Answer 5 (a) Investment A Economic Climate Dull Stable Growth Probability (P) 0.3 (10+6)/2=8.5 1.R B P(RB .50% and the standard deviation of the portfolio is 2.6×3.R A 5 1 5 P(RA .R A RB .78%.R B ) Climate Dull Stable Growth 0. B)/ σA σB = 3.0 1.46%. In case.5 0.R P(R .75 13. Now.60 5. Investment B Economic Probability (P) Returns % P × RB RB .0 1.5 13. the variance of return of A is 13 and the standard deviation σA = 13.B) of the portfolio can be found as follows: Economic Probability (P) RA .50% The variance of the portfolio is 7.R B )2 Climate (RB) Dull Stable Growth 0.R A )2 5. the covariance (A.R )2 Climate (P) 1.R A ) (RB .5 0.0 0.24 .5 6.2 0.0/(3.5 0.65 R= 7.R B P(RA .5 3.2 4.00 =3.2 0.25 2.5 Dull Stable Growth 0. PAB= covariance (A.3 5 1 5 6 3 1 6.00 So.3 6 15 11 1.5 So.3 Returns % (RA) 10 14 20 P × RA 2 7 6 15% RA .3 12.78% Hence.05 1. one half of the total amount is invested in Investment A and done half in Investment B.
) = (0.2003 31.04 .40 60.(b) Expected rate of return of shares of ABC Ltd:= n 2 20 + 8 = 14% Expected rate of return of shares of PQR Ltd:= 2 Expected rate of portfolio (50% of ABC Ltd.00 52. are invested in the ratio of 2:1: σ = (ω 2 σ 2 + ω 2 σ 2 + 2ω A ω P (rAP σ A σ P ))1 2 = A A P P 2 2 2 2 × 9 + 1 × 36 + 2 × 2 × 1 (−1 × 3 × 6) = 0 3 3 3 3 Portfolio risk in case ABC Ltd. shares= σP = Covariance between ABC Ltd.44 Rs.80 66.5×14%)=14% Expected rate of portfolio (60% of ABC Ltd. and PQR Ltd.2005 31. and 40% of PQR Ltd. and PQR Ltd. @ 10% 100 100 100 100 140 Div. 321. are invested in the ratio of 1:1= σ = 2 1 2 × 9 + 1 × 36 + 2 × 1 × 1 (−1 × 3 × 6) 2 2 2 2 1 2 1 = 1 .40 69.91 0.6×14%)+(0.3.83 0.62 Total Present Value (Figures in Rs.3.68 0. after tax 80 80 80 80 112 PV factor 0.3.: 1 1 n Cov = ∑ (R A − R A )(R P − R P ) = (11 − 14)(20 − 14) + (17 − 14)(8 − 14) = 18 2 N i =1 Coefficient of Correlation= Covariance of ABC & PQR = 18 = σA σP 6×3 Portfolio risk in case ABC Ltd.2004 31. and PQR Ltd.2007 Div.) = (0.) PV 72.2006 31. and 50% of PQR Ltd.5 (c) Calculation of Present Value of Dividend Income Date 31.3. shares= σA = (11 − 14) 2 + (17 − 14) 2 =3 2 (20 − 14) 2 + (8 − 14) 2 =6 2 ∑ R = 11 + 17 = 14% Standard deviation of PQR Ltd.75 0.3.4×14%)=14% Standard deviation of ABC Ltd.5×14%)+(0.
4000 Rs.3.3000 Rs. For example.Calculation of present value of sale proceeds: Selling price of 140 shares @ Rs.6400 0.7000 Rs.56= Rs. Credit derivatives are privately negotiated bilateral contracts that allow users to manage their exposure to credit risk. Credit Default Swaps.04 Since.2008 i.3905.3.6400 Rs. Credit Default Swaps are sometimes called Credit Swaps. a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books. the net present value (gain) of the investment in shares of A Ltd. 30) Capital gain Capital gain tax @ 15% Net gain Total cash inflow (3400+3000) (This amount is receivable on 31.00 Net present value (gain) Rs.04 Less : cash outflow (cost of purchases) Rs. sometimes based on geography. investor X is getting a return on his investment at a rate more than 10%. This mechanism can be used for any debt instrument or a basket of instruments for which an objective default price can be determined. Terminology varies among market participants. For example.56 6400×0. but there are four major instruments that make up the bulk of the trading volume today: Total Return Swaps. therefore.e after 6 years from the date of purchase). Credit derivatives allow a more efficient allocation and pricing of credit risk. This permits maximum flexibility in structuring a contract that meets the needs of both parties. Types of Credit Derivatives The product menu in the credit derivatives market is changing every day. Answer 6 a) Credit Derivatives Credit derivative is an instrument designed to segregate market risk from credit risk to allow the separate trading of credit risk.600 Rs. PV Factor @ 10% for 6 years Present value of Rs.2006 Less : Total Cost of shares (100 × Rs.905. is positive @ 10%. OTC trades are contracts negotiated between counter parties that take place outside the regulated exchanges.04) Rs.3400 Rs. The benefits associated with credit derivatives: A loan portfolio manager can achieve any of the following objectives through credit derivatives: Control credit risks of any debt instrument or basket of instruments by selling or transferring the credit exposure of the portfolio.3584 Total present value of inflows (3584 + 321.3000.the – counter (OTC) in developed markets.50 on 31. . Reduce a particular risk concentration in the portfolio Create synthetic assets tailored to meet their needs Provide a diverse menu of global exposures to achieve portfolio diversification Gain exposure to another bank’s loan portfolio without participating in the syndicate. Credit derivatives are traded over. Credit Spread Options and Credit Linked Notes.
The balance sheet effects are often dismissed as illusory since they have no cash impact. However the level of assets and liabilities can affect financial ratios calculated using balance sheet figures. A greater amount of exposed assets than liabilities will give rise to a positive exposure while a greater amount of liabilities than assets will give rise to a negative exposure. It is argued that in an efficient market. and investors can expect to earn only the required (risk. Efficient markets do not make high rates of return unavailable. while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities.adjusted) rate of return. Translation exposure is the difference between exposed assets and exposed liabilities. current prices reflect all information. therefore. but can clearly impact both the profit and loss account and the balance sheet on stand alone basis as well as on consolidated basis. This competition holds security prices close to their correct (justified) level. and then realize the expected return on the security. To outperform the market. In other words. c) Random Walk Hypothesis The random walk hypothesis claims that stock prices follow a random or erratic pattern. An efficient market is one in which the market price of the security always fully reflects available all information. Thus if devaluation appears likely. people who believe is this theory claim that price movements are unpredictable and as a result. Companies have at least three available methods for managing their translation exposure: • Adjusting fund flows • Entering into forward contracts • Exposure netting Basic hedging strategy for reducing translation exposure is to increase hard currency (likely to appreciate) assets and decrease soft currency (likely to depreciate) assets. one must be able to consistently find stocks selling below their justified prices. random price movements simply reflect a highly competitive market where investors quickly use and digest any new information. In an efficient market. the basic hedging strategy would be: • Reduce level of cash • Tighten credit terms to decrease accounts receivable • Increase local currency borrowing • Delay accounts payable • Sell the weak currency forward. as new information becomes available (in a random manner). impossible to consistently earn returns higher than the rates of return required for the risk . It does not represent real movements of cash between different currency systems. current prices equal justified prices. there’s little that you can do to predict future behavior. if not impossible to consistently outperform the market by picking undervalued stocks.b) Translation Exposure Translation exposure is the risk of the change in the domestic financial performance and position because of the fluctuating value of assets and liabilities denominated in foreign currencies. but they make it (nearly) I. one must consistently earn more than the required rate of return on securities. which causes practical problems where the company has restrictions on its level of borrowings placed by covenants. so it is difficult. That is. adjustments in price are random and quick to follow.
so fundamental analysis will not lead to returns above those required by the amount of risk exposure. or through accepting stocks with higher risks. RBI and highly rated corporate OTC . They can also minimize transaction and tax expenses. Gsec etc Participants are mainly banks/ FIs. d) Capital Market and Money Market Capital market Capital market id classified into primary and secondary market Long term Financial instruments are used meeting long term fund requirements Regulated by SEBI Typical instruments are shares. Investors can earn high rates of return through luck. Hence a stock with high rates of return will also be more risky. extreme competition among investors will keep security prices at or very close to their justified levels. If the market is efficient. TBill. charts of past behavior cannot produce significant trading profits.II. to make their returns more satisfactory. Random walks offer a serious challenge to technical analysis. in an efficient market. If prices fluctuations are purely random. shifts in supply and demand occur so rapidly that technical measures simply measure the past and have no implications for the future What’s more. levels of the securities purchased. debts and mutual fund Participants are mainly institutional players as well as retail investors Exchange traded Money market No such classification exists Short term financial instruments are used for short term financial needs or investment of surplus fund Regulated by RBI/ FIMMDA Typical instruments are commercial papers. along with unnecessary risk.
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