SFM Book 3 Merger Mutual and Theory

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CONTENTS
Page No.
o MUTUAL FUND ................................................................................................188-246
o MERGER AND ACQUISITIONS.......................................................................260-380
THEORY
o PART 1 .................................................................................................................. 15-91
o PART 2 ...............................................................................................................114-189
o EXTRA QUESTIONS .........................................................................................190-217
o MIND MAP & SUMMARY................................................................................218-229

o ICAI MAY 2019 EXAMINATION QUESTIONS ...............................................230-235
MUTUAL
FUND
ILLUSTRATIONS 188 - 189
PRACTICE PROBLEMS 190 - 243
SUMMARY 244
MUTUAL FUND - ILLUSTRATIONS
HEDGE FUND FEE CALCULATION
Example 1
Assets under management (500Cr.) at the beginning of the year.

Fees Structure = 2 20
Hurdle rate = 5%
Calculate fund manager's fees as well as net return for investors if the gross
return is 17%
Solution
Management fee 2% 500 = 10 Cr
Since gross return (17%) exceeds hurdle rate (5%), there is excess return of 12%.
Hence incentive fee 20% 12% 500 12Cr.
Total fees for the fund manager = 22 Cr.
Fund Value of the end of the year before fees = 500 1.17 = 585
LESS : fees (22)
Ending fund value 563
63
Net Return = 100 12.6% (563 500)
500
SANJAY SARAF SIR 188

MUTUAL FUND - ILLUSTRATIONS
Example 2
Beginning Fund Value = 500 Cr.

Highest Fund Value since inception = 560 Cr.
Fees Structure - 2/20 subject to high water mark provision.
Calculate fund manager's fee as well as net return for the investors if gross return
this year happens to be
Case 1 - 5%
Case 2 - 10%
Case 3 = 30%
Solution
Particulars Case I Cae II Case III

(a) BV 500 Cr. 500 Cr. 500 Cr.
(b) E.V before fees 475 Cr. 550 Cr. 650 Cr.
(c) Incentive fees No No Yes
(Applicable or not)
(d) M.F (2% × 650-560) 0 0 10
(e) I F (20% × 650-560) 0 0 18
(f) Total fees (D+E) 10 10 28
(g) Ending value net of fee (b-6) 465 540 622
(h) Net return -7% -8% 24.4%
g a
100
a

MUTUAL FUND - PRACTICE PROBLEMS
1. Mr. A can earn a return of 16 per cent by investing in equity shares on his
own. Now he is considering a recently announced equity based mutual
fund scheme in which initial expenses are 5.5 per cent and annual
recurring expenses are 1.5 per cent. How much should the mutual fund
earn to provide Mr. A return of 16 per cent?
(Source :- ICAI)
ANSWER:-
Personal earnings of Mr. A = R1

Mutual Fund earnings = R2
1
R2 R1 Re curring exp enses %
1 Initial exp enses %
1
16% 1.5%
1 0.055
= 18.43%
Mutual Fund earnings = 18.43%
2. A Mutual Fund having 300 units has shown its NAV of ` 8.75 and ` 9.45 at the
beginning and at the end of the year respectively. The Mutual Fund has given
two options:
(i) Pay ` 0.75 per unit as dividend and ` 0.60 per unit as a capital gain, or
(ii) These distributions are to be reinvested at an average NAV of ` 8.65 per
unit.
What difference it would make in terms of return available and which
option is preferable?
(Source :- ICAI)

ANSWER:-
(i) Returns for the year

(All changes on a Per -Unit Basis)
Change in Price: ` 9.45 – ` 8.75 = ` 0.70
Dividends received: ` 0.75
Capital gains distribution ` 0.60
Total reward ` 2.05
2.05
Holding period reward: 100 23.43%
8.75
(ii) When all dividends and capital gains distributions are re-invested
into additional units of the fund @ (` 8.65/unit)
Dividend + Capital Gains per unit = ` 0.75 + ` 0.60 = ` 1.35
Total received from 300 units = ` 1.35 x 300 = ` 405/-
Additional Units Acquired = ` 405/` 8.65 = 46.82 units
Total No. of Units = 300 units + 46.82 units
= 346.82 units.
Value of 346.82 units held at the end of the year
= 346.82 units × ` 9.45 = ` 3277.45
Price Paid for 300 Units at the beginning of the year
= 300 units x ` 8.75 = ` 2,625.00
Holding Period Reward
` (3277.45 – 2625.00) = ` 652.45
652.45
Holding Period Reward = 100 24.86%
2625.00
Conclusion: Since the holding period reward is more in terms of
percentage in option-two i.e., reinvestment of distributions at an average
NAV of ` 8.65 per unit, this option is preferable.

3. Orange purchased 200 units of Oxygen Mutual Fund at ` 45 per unit on 31st
December, 2009. In 2010, he received ` 1.00 as dividend per unit and a capital
gains distribution of ` 2 per unit.
Required:
(i) Calculate the return for the period of one year assuming that the
NAV as on 31st December 2010 was ` 48 per unit.
(ii) Calculate the return for the period of one year assuming that the
NAV as on 31st December 2010 was ` 48 per unit and all dividends
and capital gains distributions have been reinvested at an average price
of ` 46.00 per unit.
Ignore taxation.
(Source :- ICAI)
ANSWER:-
(i) Returns for the year

(All changes on a Per -Unit Basis)
Change in Price: ` 48 – ` 45 = ` 3.00
Dividends received: ` 1.00
Capital gains distribution ` 2.00
Total reward ` 6.00
6.00
Holding period reward: 100 13.33%
45
(ii) When all dividends and capital gains distributions are re-invested
into additional units of the fund @ (` 46/unit)
Dividend + Capital Gains per unit = ` 1.00 + ` 2.00 = ` 3.00
Total received from 200 units = ` 3.00 x 200 = ` 600/-
Additional Units Acquired = ` 600/` 46 = 13.04 Units
Total No. of Units = 200 units + 13.04 units
= 213.04 units

Value of 213.04 units held at the end of the year

= 213.04 units x ` 48
= ` 10225.92
Price Paid for 200 Units at the beginning of the year
= 200 units x ` 45
= ` 9000.00
Holding Period Reward ` (10225.92 – 9000.00)
= ` 1225.92
1225.92
Holding Period Reward 100 13.62%
9000
4. A mutual fund made an issue of 10,00,000 units of ` 10 each on January 01,

2008. No entry load was charged. It made the following investments:
Particulars `
50,000 Equity shares of ` 100 each @ ` 160 80,00,000
7% Government Securities 8,00,000
9% Debentures (Unlisted) 5,00,000
10% Debentures (Listed) 5,00,000
98,00,000
During the year, dividends of ` 12,00,000 were received on equity shares.

Interest on all types of debt securities was received as and when due. At
the end of the year equity shares and 10% debentures are quoted at
175% and 90% respectively. Other investments are at par.
Find out the Net Asset Value (NAV) per unit given that operating expenses
paid during the year amounted to ` 5,00,000. Also find out the NAV, if
the Mutual fund had distributed a dividend of ` 0.80 per unit during the
year to the unit holders.
(Source :- ICAI)

ANSWER:-
In order to find out the NAV, the cash balance at the end of the year
is calculated as follows -
Particulars `
Cash balance in the beginning
(` 100 lakhs - ` 98 lakhs) 2,00,000
Dividend Received 12,00,000
Interest on 7% Gove. Securities 56,000
Interest on 9% Debentures 45,000
Interest on 10% Debentures 50,000
15,51,000
(-) Operating expenses 5,00,000
Net cash balance at the end 10,51,000
Calculation of NAV `
Cash Balance 10,51,000
7% Govt. Securities (at par) 8,00,000
50,000 equity shares @ ` 175 each 87,50,000
9% Debentures (Unlisted) at cost 5,00,000
10% Debentures @ 90% 4,50,000
Total Assets 1,15,51000
No. of Units 10,00,000

NAV per Unit `11.55
Calculation of NAV, if dividend of ` 0.80 is paid –

Net Assets (` 1,15,51,000 – ` 8,00,000) ` 1,07,51,000
No. of Units 10,00,000
NAV per unit ` 10.75

5. On 1-4-2012 ABC Mutual Fund issued 20 lakh units at ` 10 per unit.

Relevant initial expenses involved were ` 12 lakhs. It invested the fund
so raised in capital market instruments to build a portfolio of ` 185 lakhs.
During the month of April, 2012 it disposed off some of the instruments
costing ` 60 lakhs for ` 63 lakhs and used the proceeds in purchasing
securities for ` 56 lakhs. Fund management expenses for the month of April,
2012 was ` 8 lakhs of which 10% was in arrears. In April, 2012 the fund earned
dividends amounting to ` 2 lakhs and it distributed 80% of the realized
earnings. On 30-4-2012 the market value of the portfolio was ` 198 lakhs.
Mr. Akash, an investor, subscribed to 100 units on 1-4-2012 and disposed
off the same at closing NAV on 30-4-2012. What was his annual rate of
earning?
(Source :- ICAI)
ANSWER:-
Amount in Amount in Amount in

` lakhs ` lakhs ` lakhs
Opening Bank (200-185-12) 3.00
Add: Proceeds from sale of 63.00
securities
Add: Dividend received 2.00 68.00
Deduct:
Cost of securities purchased 56.00
Fund management expenses paid 7.20
(90% of 8)
Capital gains distributed = 80% of 2.40
(63-60)
Dividend distributed = 80% of 2.00 1.60 67.20

Closing Bank 0.80

Closing market value of portfolio 198.0

198.80
Less: Arrears of expenses 0.80
Closing Net Assets 198.00
Number of units (Lakhs) 20
Closing NAV per unit (198.00/20) 9.90
Rate of Earning (Per Unit)
Amount
Income received (`2.40 lakhs + ` 1.60 lakhs)/20 lakhs `0.20
Loss: Loss on disposal (` 10 - ` 9.90) `0.10
Net earning `0.10
Initial investment ` 10.00
Rate of earning (monthly) 1%
Rate of earning (Annual) 12%
6. Based on the following data, estimate the Net Asset Value (NAV) on per unit
basis of a Regular Income Scheme of a Mutual Fund on 31-3-2015:
` (in lakhs)
Listed Equity shares at cost (ex-dividend) 40.00
Cash in hand (As on 1-4-2014) 5.00
Bonds & Debentures at cost of these, Bonds not listed 8.96
& not quoted 2.50
Other fixed interest securities at cost 9.75
Dividend accrued 1.95
Amount payable on shares 13.54
Expenditure accrued 1.76

Current realizable value of fixed income securities of face value of ` 100 is `

96.50.
Number of Units (` 10 face value each): 275000
All the listed equity shares were purchased at a time when market
portfolio index was 12,500. On NAV date, the market portfolio index is at
19,975.
There has been a diminution of 15% in unlisted bonds and debentures
valuation.
Listed bonds and debentures carry a market value of ` 7.5 lakhs, on NAV
date.
Operating expenses paid during the year amounted to ` 2.24 lakhs.
(Source :- ICAI)
ANSWER:-
Particulars Adjustment value

` lakhs
Equity Shares 63.920
Cash in hand (5,000-2,240) 2.760
Bonds and debentures not listed 2.125
Bonds and debentures listed 7.500
Fixed income securities 9.409
Sub total assets (A) 87.664
Sub total liabilities (B) 15.30
Net Assets Value (A) - (B) 72.364
No. of units 2,75,000
Net Assets Value per unit (` 72.364 lakhs/2,75,000) ` 26.3142

7. Based on the following data, estimate the Net Asset Value (NAV) 1st
July 2016 on per unit basis of a Debt Fund:
Name of Face Purchas Maturity No. of Coupon Duratio

Security Value e Price Date Securities Date(s) n of
` ` Bonds
10.71% 100 104.78 31st March, 100000 31st March 7.3494
GOI 2028 2028
10% GOI 100 100.00 31st March 50000 31st 5.086
2023 2023 March &
30th
September
9.5% 100 97.93 31st 40000 30th June 4.3949
GOI 2021 December & 31st
2021 December
8.5% 100 91.36 30th June 20000 30th June 6.5205
SGL 2025 2025

All securities were purchased at a time when applicable Yield to
Maturity (YTM) was 10%. On NAV date, the required yield increased by 75
basis point and Cash in hand and accrued expenses were ` 6,72,800 and `
2,37,400 respectively.
(Source :- ICAI)

ANSWER:-
Working Notes:
(i) Calculation of Interest Accrued
Name of Security Maturity Date Amount (`)

10.71% GOI 2028 3 2,67,750
100 100000 10.71%
12
10 % GOI 2023 3 1,25,000
100
12
Total 3,92,750
Note: Interests on two remaining securities shall not be considered as last

interest was paid on 30.06.2016
(ii) Valuation of Securities
Name of Purchase Duration Volatility (+)/(-) Total

SecurityAmount ` of Bonds (%) Amount `
10.71% 1,04,78,000 7.3494 7.3494 -5,25,053 99,52,947
0.75
GOI 2028 1.10
=5.0110
10% GOI 50,00,000 5.086 5.086 -1,81,645 48,18,355
0.75
2023 1.05
=3.6329
9.5% GOI 39,17,200 4.3949 4.3949 -1,22,969 37,94,231
0.75
2021 1.05
8.5% SGL 18,27,200 6.5205 6.5205 -81,230 17,45,970

0.75
2025 1.10
=4.4456
2,03,11,503

Calculation of NAV
Particulars ` crores
Value of Securities as computed above 2,03,11,503
Cash in hand 6,72,800
Interest accrued 3,92,750
Sub total assets (A) 2,13,77,053

Less: Liabilities
Expenditure accrued 2,37,400
Sub total liabilities (B) 2,37,400
Net Assets Value (A) - (B) 2,11,39,653
No. of units 1,00,000
Net Assets Value per unit (` 2,11,39,653/1,00,000) `211.40
8. The following are the data on five mutual funds:

Fund Return Standard Deviation Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50
You are required to compute Reward to Volatility Ratio and rank these
portfolio using:
 Sharpe method and
 Treynor's method
assuming the risk free rate is 6%.
(Source :- ICAI)

ANSWER:-
Sharpe Ratio S = (Rp – Rf)/σp

Treynor Ratio T = (Rp – Rf)/βp
Where,
Rp = Return on Fund
Rf = Risk-free rate
σp = Standard deviation of Fund
βp = Beta of Fund
Reward to Variability (Sharpe Ratio)

Mutual Rp Rf Rp - Rf p Reward to Ranking
Fund Variability
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4
Reward to Volatility (Treynor Ratio)

Mutual Rp Rf Rp - Rf ʤp Reward to Ranking
Fund Volatility
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3

9. The following information is extracted from Steady Mutual Fund’s Scheme:

- Asset Value at the beginning of the month - ` 65.78
- Annualised return - 15 %
- Distributions made in the nature of Income - ` 0.50 and ` 0.32
& Capital gain (per unit respectively).
You are required to:

(1) Calculate the month end net asset value of the mutual fund scheme (limit
your answers to two decimals).
(2) Provide a brief comment on the month end NAV.
(Source:- ICAI)
ANSWER:-
(1) Calculation of NAV at the end of month:

Given Annual Return = 15%
Hence Monthly Return = 1.25% (r)
r
 NAVt  NAVt  1   I t  Gt
NAVt  1
0.0125 
 NAVt  ` 65.78  ` 0.50  ` 0.32
` 65.78
0.82 = NAVt - `64.96
NAVt = `65.78
(2) There is no change in NAV.

10. A Mutual Fund Co. has the following assets under it on the close of business
as on:
Company No. of Shares 1st February 2012 2nd February 2012
Market price per share Market price per
` share
`
L Ltd 20,000 20.00 20.50
M Ltd 30,000 312.40 360.00
N Ltd 20,000 361.20 383.10
P Ltd 60,000 505.10 503.90
Total No. of Units 6,00,000

(i) Calculate Net Assets Value (NAV) of the Fund.
(ii) Following information is given:
Assuming one Mr. A, submits a cheque of ` 30,00,000 to the Mutual Fund
and the Fund manager of this company purchases 8,000 shares of M Ltd;
and the balance amount is held in Bank. In such a case, what would be the
position of the Fund?
Find new NAV of the Fund as on 2nd February 2012.
(Source:- ICAI)
ANSWER:-
(i) NAV of the Fund

` 4,00,000  ` 93,72,000  ` 72, 24,000  ` 3,03,06,000

6,00,000
` 4,73,02,000
  ` 78.8366 rounded to ` 78.84
6,00,000

(ii) The revised position of fund shall be as follows:

Shares No. of shares Price Amount (`)
L Ltd. 20,000 20.00 4,00,000
M Ltd. 38,000 312.40 1,18,71,200
N Ltd. 20,000 361.20 72,24,000
P Ltd. 60,000 505.10 3,03,06,000
Cash 5,00,800
5,03,02,000
30,00,000
No. of units of fund = 6,00,000   6,38,053
78.8366
(iii) On 2nd February 2012, the NAV of fund will be as follows:

Shares No. of shares Price Amount (`)
L Ltd. 20,000 20.50 4,10,000
M Ltd. 38,000 360.00 1,36,80,000
N Ltd. 20,000 383.10 76,62,000
P Ltd. 60,000 503.90 3,02,34,000
Cash 5,00,800
5,24,86,800
` 5, 24,86,800
NAV as on 2nd February 2012 =   ` 82.26
6,38,053

11. On 1st April 2009 Fair Return Mutual Fund has the following assets and
prices at 4.00 p.m.
Shares No. of Shares Market Price Per Share (`)
A Ltd. 10000 19.70
B Ltd. 50000 482.60
C Ltd. 10000 264.40
D Ltd. 100000 674.90
E Ltd. 30000 25.90
No. of units of funds 8,00,000
Please calculate:
a. NAV of the Fund on 1st April 2009.
b. Assuming that on 1st April 2009, Mr. X, a HNI, send a cheque of ` 50,00,000
to the Fund and Fund Manager immediately purchases 18000 shares of C
Ltd. and balance is held in bank. Then what will be position of fund.
c. Now suppose on 2 April 2009 at 4.00 p.m. the market price of shares is as
follows:
Shares `
A Ltd. 20.30
B Ltd. 513.70
C Ltd. 290.80
D Ltd. 671.90
E Ltd. 44.20
Then what will be new NAV.
(Source:- ICAI)

ANSWER:-
(a) NAV of the Fund.

` 1,97,000  ` 2, 41, 30,000  ` 26, 44,000  ` 6,74,90,000  ` 7,77,000

800000
` 9, 52, 38,000
  ` 119.0475 rounded to ` 119.05
800000
(b) The revised position of fund shall be as follows:

Shares No. of shares Price Amount (Rs.)
A Ltd. 10000 19.70 1,97,000
B Ltd. 50000 482.60 2,41,30,000
C Ltd. 28000 264.40 74,03,200
D Ltd. 100000 674.90 674,90,000
E Ltd. 30000 25.90 7,77,000
Cash 2,40,800
10,02,38,000
5000000
No. of units of fund = 800000   842000
119.0475
(c) On 2nd April 2009, the NAV of fund will be as follows:

Shares No. of Price Amount (`)
A Ltd. shares
10000 20.30 2,03,000
B Ltd. 50000 513.70 2,56,85,000
C Ltd. 28000 290.80 81,42,400
D Ltd. 100000 671.90 6,71,90,000
E Ltd. 30000 44.20 13,26,000
Cash 2,40,800
10,27,87,200
` 10, 27,87, 200
NAV as on 2nd April 2009 =   ` 122.075 per unit
842000

12. Based on the following data, estimate the Net Asset Value (NAV) on
per unit basis of a Regular Income Scheme of a Mutual Fund:
` (in lakhs)
Listed Equity shares at cost (ex-dividend) 40.00
Cash in hand 2.76
Bonds & Debentures at cost 8.96
Of these, Bonds not listed & not quoted 2.50
Other fixed interest securities at cost 9.75
Current realizable value of fixed income securities of face value of ` 100 is `
96.50.
All the listed equity shares were purchased at a time when market portfolio
index was 12,500.
On NAV date, the market portfolio index is at 19,975.
There has been a diminution of 15% in unlisted bonds and debentures
valuation.
Listed bonds and debentures carry a market value of ` 7.5 lakhs, on NAV
date.
Operating expenses paid during the year amounted to ` 2.24 lakhs.
(Source:- ICAI)

ANSWER:-
Particulars Adjusted
Value
Equity Shares `63.920
lakhs
Cash in hand 2.760
Bonds and debentures not listed 2.125
Bonds and debentures listed 7.500
Dividends accrued 1.950
Fixed income securities 9.409
87.664
Sub total assets (A)
Less: Liabilities 13.54
Sub total liabilities (B) 72.364
Net Assets Value (A) – (B) 2,75,000
No. of units ` 26.3142
Net Assets Value per unit (` 72.364 lakhs / 2,75,000)

13. Cinderella Mutual Fund has the following assets in Scheme Rudolf at the
close of business on 31stMarch,2014.
Company No. of Shares Market Price Per Share
Nairobi Ltd. 25000 ` 20
Dakar Ltd. 35000 ` 300
Senegal Ltd. 29000 ` 380
Cairo Ltd. 40000 ` 500
The total number of units of Scheme Rudol fare 10 lacs. The Scheme
Rudolf has accrued expenses of ` 2,50,000 and other liabilities of ` 2,00,000.
Calculate the NAV per unit of the Scheme Rudolf.
(Source:- ICAI)
ANSWER:-
Shares No. of Price Amount

Nairobi Ltd. 25,000
shares 20.00 5,00,000
(`)
Dakar Ltd. 35,000 300.00 1,05,00,000
29,000 380.00 1,10,20,000
Senegal Ltd. 40,000 500.00 2,00,00,000
Cairo Ltd.
4,20,20,00
Less: Accrued Expenses
0
Other Liabilities
2,50,000
Total Value
2,00,000
4,15,70,00
No. of Units
0
NAV per Unit (4,15,70,000/10,00,000)
10,00,000
41.57

14. A has invested in three Mutual Fund Schemes as per details below:
Particulars MF A MF B MF C
Date of investment 01.12.2009 01.01.2010 01.03.2010
Amount of investment ` 50,000 ` 1,00,000 ` 50,000
Net Asset Value (NAV) at entry ` 10.50 ` 10 ` 10
date ` 950 ` 1,500 Nil
Dividend received upto 31.03.2010 ` 10.40 ` 10.10 ` 9.80
NAV as at 31.03.2010
Required:
What is the effective yield on per annum basis in respect of each of the
three schemes to Mr. A upto 31.03.2010?
(Source:- ICAI)
ANSWER:-
Scheme Investment Unit Nos. Unit Total NAV

(Investment/NAV NAV 31.3.2010 (Unit
` at entry date) 31.3.2010 Nos. X Unit NAV
` as on 31.3.2010)
`
MF A 50,000 4761.905 10.40 49,523.812
MF B 1,00,000 10,000 10.10 1,01,000
MF C 50,000 5,000 9.80 49,000

Scheme NAV Dividend Total Number Effective

(+) / (–) Received Yield of days Yield (%
(NAV as on ` Change in P.A.) (Total
31.3.2010 – NAV Yield/
Investment) +Dividend Investment)
` ` X (365/No. of
days) X 100
MF A (–)476.188 950 473.812 121 2.858%
MF B (+)1,000 1,500 2,500 90 10.139%
MF C (–)1,000 Nil (–)1,000 31 (–)24%
15. Sun Moon Mutual Fund (Approved Mutual Fund) sponsored open-
ended equity oriented scheme “Chanakya Opportunity Fund”. There
were three plans viz. ‘A’ – Dividend Re- investment Plan, ‘B’ – Bonus
Plan & ‘C’ – Growth Plan.
At the time of Initial Public Offer on 1.4.1999, Mr. Anand, Mr. Bacchan
& Mrs. Charu, three investors invested ` 1,00,000 each & chosen ‘B’, ‘C’ &
‘A’ Plan respectively.
The History of the Fund is as follows:
Date Dividend Bonus Net Asset Value per Unit (F.V. `
% Ratio 10)
Plan A Plan B Plan C
28.07.2003 20 30.70 31.40 33.42
31.03.2004 70 5:4 58.42 31.05 70.05
31.10.2007 40 42.18 25.02 56.15
15.03.2008 25 46.45 29.10 64.28
31.03.2008 1:3 42.18 20.05 60.12
24.03.2009 40 1:4 48.10 19.95 72.40
31.07.2009 53.75 22.98 82.07
On 31st July 2009, all three investors redeemed all the balance units.

Calculate annual rate of return to each of the investors.

Consider:
1. Long-term Capital Gain is exempt from Income tax.
2. Short-term Capital Gain is subject to 10% Income tax.
3. Security Transaction Tax 0.2 per cent only on sale/redemption of units.
4. Ignore Education Cess
(Source:- ICAI)
ANSWER:-
Mrs. Charu Plan A Dividend Reinvestment

(Amount in `)
Date Investment Dividend Dividend NAV Units Closing

payout Re- Unit
(%) invested Balance
(Closing ∑ Units
Units X
Face
value of
`10 X
Dividend
Payout
%)
01.04.1999 1,00,000.00 10.00 10,000.00 10,000.00
28.07.2003 20 20,000.00 30.70 651.47 10,651.47
31.03.2004 70 74,560.29 58.42 1,276.28 11,927.75
30.10.2007 40 47,711.00 42.18 1,131.13 13,058.88
15.03.2008 25 32,647.20 46.45 702.85 13,761.73
24.03.2009 40 55,046.92 48.10 1,144.43 14,906.16

Redemption value 14,906.16 × 53.75 8,01,206.10

Less: Security Transaction Tax (STT) is 0.2% 1,602.41
Net amount received 7,99,603.69
Less: Short term capital gain tax @ 10% on 634
1,144.43 (53.64* – 48.10≈) = 6,340
Net of tax 7,98,969.69
Less: Investment 1,00,000.00
6,98,969.69
*(53.75 – STT @ 0.2%) ≈ This value can also be taken as zero
6,98,969.69 12
Annual average return (%)   100  67.64%
1,00,000 124
Mr. Anand Plan B – Bonus

(Amount in `)
Date Units Bonus Total NAV
units Balance per unit
01.04.1999 10,000 10,000 10
12,500
31.03.2004 22,500 31.05
7,500
31.03.2008 30,000 20.05
7,500
24.03.2009 37,500 19.95
Redemption value 37,500 × 22.98 8,61,750.00

Less: Security Transaction Tax (STT) is 0.2% 1,723.50
Less: Short term capital gain tax @ 10%
7,500 × (22.93† – 19.95) = 22,350 2,235.00
Net of tax 8,57,791.50
Net gain 7,57,791.50

†(22.98 – STT @ 0.2%)

7,57,791.50 12
1,00,000 124
Mr. Bacchan Plan C – Growth
Particulars (Amount in
Redemption value 10,000 × 82.07 8,20,700.00
`)
Less: Security Transaction Tax (S.T.T) is .2% 1,641.40
Less: Short term capital gain tax @ 10% 0.00
Net of tax 8,19,058.60

Net gain 7,19,058.60
7,19,058 12
1,00,000 124
Note: Alternatively, figure of * and † can be taken as without net of
Tax because, as per Proviso 5 of Section 48 of IT Act, no deduction of STT
shall be allowed in computation of Capital Gain.
16. Mr. X, an investor purchased 200 units of ABC Mutual Fund at rate of ` 8.50
p.u., one year ago. Over the year Mr. X received ` 0.90 as dividend and had
received a capital gains distribution of ` 0.75 per unit.
You are required to find out:
a. Mr. X’s holding period return assuming that this no load fund has a NAV
of ` 9.10 as on today.
b. Mr. X’s holding period return, assuming all the dividends and capital
gains distributions are reinvested into additional units as at average price
of ` 8.75 per unit.
(Source:- ICAI)

ANSWER:-
a. Return for the year (all changes on a per unit basis):

Change in Price (` 9.10 - ` 8.50) ` 0.60
Dividends received ` 0.90
Capital gains distributions ` 0.75
Total return ` 2.25
2.25
Holding period return   26.47%
8.50
b. When all dividends and capital gains distributions are reinvested into
additional units of the fund (` 8.75/unit):
Dividends and capital gains per unit: ` 0.90 + ` 0.75 = ` 1.65
Total amount received from 200 units: ` 1.65 X 200 = ` 330.00
Additional units added: ` 330/` 8.75 = 37.7 units
Value of 237.7 units held at end of year: 237.7 units X ` 9.10 = ` 2,163
Price paid for 200 units at beginning of year 200 units X ` 8.50 = ` 1,700
Thus, the Holding Period Return would be:
 No. of units at end of Period  Ending Pr ice 

 No. ofunits at begining of Period  Initial Pr ice
No. of units at begining of Period  Initial Pr ice
2,163  1,700 463
H .P.R    27.24%
1,700 1,700

17. A mutual fund company introduces two schemes i.e. Dividend plan (Plan-D)
and Bonus plan (Plan-B).The face value of the unit is ` 10. On 1-4-2005
Mr. K invested ` 2,00,000 each in Plan-D and Plan-B when the NAV
was ` 38.20 and ` 35.60 respectively. Both the plans matured on 31-3-
2010.
Particulars of dividend and bonus declared over the period are as follows:
Dividend Bonus Net Asset Due (`)
Ratio Value
% Plan B
30-09-2005 10 Plan
39.10D 35.60
30-06-2006 1:5 41.15 36.25
31-03-2007 15 44.20 33.10
15-09-2008 13 45.05 37.25
30-10-2008 1:8 42.70 38.30
What is the effective

27-03-2009yield per annum
16 in respect of the above two plans? 39.10
44.80
11-04-2009 1:10 40.25(Source:-38.90
ICAI)
31-03-2010 40.40 39.70

ANSWER:-
Plan – D
2,00,000
Unit acquired =  5235.60
38.20
Date Units Dividend Reinvestment New Total

held
% Amount Rate Units Units
01.04.2005 5235.60
30.09.2005 5235.60 10 5235.60 39.10 133.90 5369.50
31.03.2007 5369.50 15 8054.25 44.20 182.22 5551.72
5551.72 13 7217.24 45.05 160.20 5711.92
15.09.2008
5711.92 16 9139.07 44.80 204 5915.92
27.03.2009 `
Maturity Value (` 40.40 X 5915.92)
31.03.2010 Less: Cost of Acquisition 2,39,003.17
Total Gain `
2,00,000.00
`
39,003.17
39,003.17 1
∴ Effective Yield =   100  3.90%
2,00,000 5
Alternatively, it can be computed by using the IRR method as follows:
NPV at 4% = -2,00,000 + 1,96,443 = -3,557
NPV at 2% = -2,00,000 + 2,16,473 = 16,473
NPV at LR
IRR  LR   HR  LR
NPV at LR  NPV at HR
16473
 2%   4%  2%  3.645%
16473    3557 

Plan – B
Date Particulars Calculation No. of NAV (`)

Working Units
1.4.05 Investment `2,00,000/35.60 = 5617.98 35.60
30.6.06 Bonus 5617.98/5 = 1123.60 36.25
30.10.08 " 6741.58/8 = 6741.58 38.30
11.4.09 " 7584.28/10 = 842.70 38.90
31.3.10 Maturity Value 8342.71 x ` 39.70 = 7584.28 3,31,205.59
758.43
8342.71
Gain 1,31,205.59
1, 31, 205.59 1
∴ Effective Yield   100  13.12%
2,00,000 5
Alternatively, it can be computed by using the IRR method as follows:
NPV at 13% = -2,00,000 + 1,79,765 = -20,235
NPV at 8% = -2,00,000 + 2,25,413 = 25,413
NPV at LR
IRR  LR   HR  LR
NPV at LR  NPV at HR
25413
 8%   13%  8%  10.78%
25413    20235
18. There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual
Fund Ltd. Each having close ended equity schemes.
NAV as on 31-12-2014 of equity schemes of D Mutual Fund Ltd. is ` 70.71
(consisting 99% equity and remaining cash balance) and that of K Mutual
Fund Ltd. is 62.50 (consisting 96% equity and balance in cash).

Following is the other information:

Particular Equity Schemes
D Mutual Fund K Mutual Fund
Ltd. Ltd.
Sharpe Ratio 2 3.3
Treynor Ratio 15 15
Standard deviation 11.25 5
There is no change in portfolios during the next month and annual average
cost is ` 3 per unit for the schemes of both the Mutual Funds.
If Share Market goes down by 5% within a month, calculate expected NAV
after a month for the schemes of both the Mutual Funds.
For calculation, consider 12 months in a year and ignore number of days for
particular month.
(Source:- ICAI)
ANSWER:-
Working Notes:
(i) Decomposition of Funds in Equity and Cash Components
D Mutual K Mutual Fund
Fund Ltd. Ltd.
NAV on 31.12.14 ` 70.71 ` 62.50

% of Equity 99% 96%
Equity element in NAV ` 70 ` 60
Cash element in NAV ` 0.71 ` 2.50
(ii) Calculation of Beta

(a) D Mutual Fund Ltd.
E  R  R f E  R  R f
Sharpe Ratio = 2 = 
D 11.25

E(R) - Rf = 22.50
E  R  R f 22.50
Treynor Ratio = 15 = 
D D
βD = 22.50/15= 1.50
(b) K Mutual Fund Ltd.
E  R  R f E  R  R f
Sharpe Ratio = 3.3 = 
k 5
E(R) - Rf = 16.50
E  R  R f 16.50
k k
βK = 16.50/15= 1.10
(iii) Decrease in the Value of Equity

Market goes down by Ltd. 5.00% Ltd. 5.00%
Beta 1.50 1.10
Equity component goes down 7.50% 5.50%
(iv) Balance of Cash after 1 month

Cash in Hand on Ltd. ` 0.71 Ltd.` 2.50
31.12.14 ` 0.25 ` 0.25
Less: Exp. Per month
` 0.46 ` 2.25
Balance after 1 month

NAV after 1 month

Ltd. Ltd.
Value of Equity after 1 month
70 x (1 - 0.075) ` 64.75 -
60 x (1 - 0.055) - ` 56.70
Cash Balance 0.46 2.25
65.21 58.95
19. Five portfolios experienced the following results during a 7- year period:
Portfolio Average Annual Standard Correlation
Return (Rp) (%) Deviation with the market
(Sp) returns (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600
Market Risk (σm) 1.2
Market rate of 14.0
Return (Rm) 9.0
Risk-free Rate (Rf)
Rank the portfolios using (a) Sharpe’s method, (b) Treynor’s method and (c)
Jensen’s Alpha.
(Source:- ICAI)

ANSWER:-
Let portfolio standard deviation be σp

Market Standard Deviation = σm
Coefficient of correlation = r
r
Portfolio beta  p

p
Required portfolio return (Rp) = Rf + βp (Rm – Rf)
Portfolio Beta Return from the portfolio (Rp) (%)
A 1.75 17.75
B 0.90 13.50
C 0.65 12.25
D 1.25 15.25
E 0.90 13.50
Portfolio Sharpe Treynor Method Jensen's
Method Alpha
Ratio Rank Ratio Rank Ratio Rank
A 4.00 IV 5.71 V 1.25 V
B 3.00 V 6.67 IV 1.50 IV
C 7.50 I 9.23 I 2.75 II
D 4.25 III 6.80 III 2.25 III
E 4.50 II 9.00 II 3.60 I
20. ANP Plan, a hedge fund currently has assets of ` 20 crore. CA. X, the
manager of fund charges fee of 0.10% of portfolio asset. In addition to it he
charges incentive fee of 2%. The incentive will be linked to gross return
each year in excess of the portfolio maximum value since the inception
of fund. The maximum value the fund achieved so far since inception
of fund about one and half year ago was ` 21 crores.

You are required to compute the fee payable to CA. X, if return on the fund
this year turns out to be
(a) 29%,
(b) 4.5%,
(c) -1.8%
(Source:- ICAI)
ANSWER:-
(a) If return is 29%

`
Fixed fee (A) 0.10% of ` 20 crore 2,00,000
New Fund Value (1.29 x ` 20 crore) 25.80 crore
Excess Value of best achieved (25.8 crore – 21.0 crore) 4.80 crore
Incentive Fee (2% of 4.80 crores) (B) 9,60,000
Total Fee (A)+(B) 11,60,000
(b) If return is 4.5%
`
Fixed (A) 0.10% of ` 20 crore 2,00,000
New Fund Value (1.045 x ` 20 crore) 20.90 crore
Excess Value of best achieved (20.90 crore –21.00 crore) (` 0.10 crore)
Incentive Fee (as does not exceed best achieved) (B) Nil
Total Fee (A)+(B) 2,00,000
(c) If return is (-1.8%)
No incentive only fixed fee of ` 2,00,000 will be paid
21. Mr. A can earn a return of 16 per cent by investing in equity shares
on his own. Now he is considering a recently announced equity based
mutual fund scheme in which initial expenses are 5.5 per cent and annual
recurring expenses are 1.5 per cent. How much should the mutual fund earn
to provide Mr. A return of 16 per cent?
(Source:- ICAI)

ANSWER:-
Personal earnings of Mr. A = R1 = 16%

Mutual Fund earnings = R2
1
R2  R1  Re curring exp enses  %
1  Initial exp enses  %
1
  16%  1.5%
1  0.055
= 18.43%
Mutual Fund earnings = 18.43%
22. On 01-07-2010, Mr. X Invested ` 50,000/- at initial offer in Mutual

Funds at a face value of ` 10 each per unit. On 31-03-2011, a dividend
was paid @ 10% and annualized yield was 120%. On 31-03-2012, 20%
dividend and capital gain of ` 0.60 per unit was given. Mr. X
redeemed all his 6271.98 units when his annualized yield was 71.50%
over the period of holding. Calculate NAV as on 31-03-2011, 31-03-2012 and
31-03-2013.
For calculations consider a year of 12 months.
(Source:- ICAI)
ANSWER:-
Yield for 9 months (120% x 9/12) = 90%

Market value of Investments as on 31.03.2011= ` 50,000/- + (` 50,000x 90%)
= ` 95,000/
Therefore, NAV as on 31.03.2011 = (` 95,000 - ` 5,000)/5,000 = ` 18.00
Since dividend was reinvested by Mr. X, additional units acquired
` 5,000
=  277.78 unit
` 18
Therefore, units as on 31.03.2011 = 5,000 + 277.78 = 5,277.78

Alternatively, units as on 31.03.2011 = (` 95,000/`18) = 5,277.78

Dividend as on 31.03.2012= 5,277.78 x ` 10 x 0.2 = `10,555.56
Capital Gain (5277.78 x ` 0.60) = ` 3,166.67
= `13,722.23
Let X be the NAV on 31.03.2012, then number of new units reinvested will be
`13,722.23/X.
Accordingly, 6,271.98 units shall consist of reinvested units and 5277.78 (as on
31.03.2011).
Thus, by way of equation it can be shown as follows:
` 13,722.23
6, 271.98   5, 277.78
X
Therefore, NAV as on 31.03.2012 = ` 13,722.23/(6,271.98 – 5,277.78)
= ` 13.80
NAV as on 31.03.2013 = ` 50,000 (1+0.715x33/12)/6,271.98
= ` 23.65
23. A mutual fund that had a net asset value of `16 at the beginning of a
month, made income and capital gain distribution of `0.04 and `0.03
respectively per unit during the month, and then ended the month with a
net asset value of `16.08. Calculate monthly and annual rate of return.
(Source:- ICAI)
ANSWER:-
Calculation of monthly return on the mutual funds:
r
 NAVt  NAVt  1   I t  Gt
NAVt  1
or r 
 ` 16.08  ` 16.00    ` 0.04  ` 0.03
16
0.08  0.07
  0.009375 or r  0.9375% or 11.25% p.a.
16

24. On 1st April, an open ended scheme of mutual fund had 300 lakh units
outstanding with Net Assets Value (NAV) of ` 18.75. At the end of April, it
issued 6 lakh units at opening NAV plus 2% load, adjusted for dividend
equalization. At the end of May, 3 Lakh units were repurchased at opening
NAV less 2% exit load adjusted for dividend equalization. At the end of
June, 70% of its available income was distributed.
In respect of April-June quarter, the following additional information are
available:
` in lakh
Portfolio value appreciation 425.47
Income of April 22.950
Income for May 34.425
Income for June 45.450
You are required to calculate
(i) Income available for distribution;
(ii) Issue price at the end of April;
(iii) repurchase price at the end of May; and
(iv) net asset value (NAV) as on 30th June.
(Source:- ICAI)
ANSWER:-
Calculation of Income available for Distribution
Units Per Unit Total

(Lakh) (`) (` In lakh)
Income from April 300 0.0765 22.9500

Add: Dividend equalization 6 0.0765 0.4590
collected on issue 306 23.4090
0.0765
0.1125 34.4250

Add: Income from May 306 0.1890 57.8340

3 0.1890 (0.5670)
Less: Dividend equalization
paid on repurchase 303 0.1890 57.2670
0.1500 45.4500
Add: Income from June 303 0.3390 102.7170
0.2373 (71.9019)
Less: Dividend Paid
303 0.1017 30.8151
Calculation of Issue Price at the end of April
`
Opening NAV 18.750
Add: Entry Load 2% of ` 18.750 (0.375)
Add: Dividend Equalization paid on Issue 19.125

Price 0.0765
19.2015
Calculation of Repurchase Price at the end of May
`
Opening NAV 18.750
Less: Exit Load 2% of ` 18.750 (0.375)
Add: Dividend Equalization paid on Issue Price 18.375
0.1890
18.564

Closing NAV
` (Lakh)
Opening Net Asset Value (` 18.75 × 5625.0000

300) 425.4700
Portfolio Value Appreciation 115.2090
Issue of Fresh Units (6 × 19.2015) 102.8250
Income Received
6268.504
(22.950 + 34.425 + 45.450)
-55.692
(-127.5939)
Less: Units repurchased (3 × 18.564) -
6140.9101
Income Distributed 71.9019
Closing Net Asset Value 303 lakh
Closing Units (300 + 6 – 3) lakh ` 20.2670
∴ Closing NAV as on 30 th June
25. A mutual fund raised ` 150 lakhs on April 1, by issue of 15 lakh units
at ` 10 per unit. The fund invested in several capital market
instruments to build a portfolio of ` 140 lakhs. Initial expense amounted
to ` 8 lakhs. During the month of April, the fund sold certain securities
costing ` 44.75 lakhs for ` 47 lakhs and purchased certain other securities for
` 41.6 lakhs. The fund management expenses for the month amounted to ` 6
lakhs of which ` 50,000 was in arrears. The dividend earned was ` 1.5 lakhs.
80% of the realized earnings were distributed. The market value of the
portfolio on 30th April was ` 147.85 lakhs.
An investor subscribed to 1 unit on April 1 and disposed it off at closing NAV

on 30th April. Determine his annual rate of earning.
(Source:- ICAI)

ANSWER:-
Amount in Amount in
Amount in
Opening Bank (150-140-8) ` lakhs
2.00 ` lakhs `
Add: Proceeds from sale of securities 47.00 lakhs
50.50
Add: Dividend received Deduct: 1.50
Cost of securities purchased 41.60
Fund management expenses paid (6.0 - 5.50
0.5) 1.80 50.10
Capital gains distributed = 80% of 1.20
0.40
(47.00 – 44.75)
147.85
Dividend distributed =80% of 1.5
148.25
Closing Bank
0.50
Closing market value of portfolio
147.75
15.00
9.85
Less: Arrears of expenses
Closing Net Assets
Number of units (Lakhs)
Closing NAV per unit
Rate of Earning
Amount
Income received (1.8+1.2)/15 0.20
Loss: Loss on disposal (10-9.85) 0.15
Net earning 0.05
Initial investment 10.00
Rate of earning (monthly) 0.5%
Rate of earning (Annual) 6%

26. A mutual fund’s opening NAV is ` 20 and its closing NAV is ` 24. If the
expense per unit is ` 0.50, what is the expense ratio?
(Source:- ICAI)
ANSWER:-
Expense Ratio = (Expense incurred per unit / Average NAV)

= 0.50 / (20+24) / 2 = 2.27
27. United Capital is a hedge fund with $250 million of initial capital. United
charges a 2% management fee based on assets under management at year
end, and a 20% incentive fee based on returns in excess of an 8% hurdle rate.
In its first year, United appreciates 16%. Assume management fees are
calculated using end-of-period valuation. Calculate the investor's net return
assuming the performance fees is calculated net of the management fees.
(Source: FOD)
ANSWER:
The net investor return is 12.54%, calculated as:

End of year capital = $250 million × 1.16 = $290 million
Management fee = $290 million × 2% = $5.8 million
Hurdle amount = 8% of $250 million = $20 million;
Incentive fee = ($290 − $250 − $20 − $5.8) million × 20% = $2.84 million
Total fees to United Capital = ($5.8 + $2.84) million = $8.64 million
Investor net return: ($290 − $250 − $8.64) / $250 = 12.54%
28. Capricorn Fund of Funds invests GBP 100 million in each of Alpha Hedge
Fund and ABC Hedge Fund. Capricorn FOF has a “1 and 10” fee
structure. Management fees and incentive fees are calculated
independently at the end of each year. After one year, net of their respective

management and incentive fees, the investment in Alpha is valued at GBP80

million and the investment in ABC is valued at GBP140 million. Calculate
the annual return to an investor in Capricorn net of fees assessed at the fund
of funds level.
(Source: FOD)
ANSWER:
The net investor return 7.9%, calculated as:

First, note that “1 and 10” refers to a 1% management fee, and a 10% incentive
fee.
End of year capital = GBP140 million + GBP80 million = GBP220 million
Management fee = GBP220 million × 1% = GBP2.2 million
Incentive fee = (GBP220 − GBP200) million × 10% = GBP2 million
Total fees to Capricorn = (GBP2.2 + GBP2) million = GBP4.2 million
Investor net return: (GBP220 − GBP200 − GBP4.2) / GBP200 = 7.9%
29. A high water mark of £150 million was established two years ago for a British
hedge fund. The end-of- year value before fees for last year was £140
million. This year's end-of-year value before fees is £155 million. The fund
charges "2 and 20." Management fees are paid independently of incentive fees
and are calculated on end-of-year values. What is the total fee paid this year.
(Source: FOD)
ANSWER:
Management fee is £155 million x 0.02 = £3.1 million.

Incentive fee is (£155 million - £150 million) x 0.20 = £1.0 million.
Total fee is £3.1 million + £1.0 million = £4.1 million.

30. A British hedge fund has a value of £100 million at the beginning of the year.
The fund charges a 2% management fee based on assets under management
at the end of the year and a 20% incentive fee with a soft hurdle rate of
LIBOR + 2.5%. Incentive fees are calculated net of management fees. If the
relevant LIBOR rate is 2.5% and the fund's value at the end of the year before
fees is £120 million, calculate the net return to investors.
(Source: FOD)
ANSWER:
Management fee = £120.0 × 2.0% = £2.4 million.

Gross value at end of year (given) = £120.0 million.
Gross return = (£120.0 / £100.0) − 1 = 20.0%. The soft hurdle rate of 2.5% +
2.5% = 5.0% was exceeded.
Incentive fee = (£120.0 − £100.0 − £2.4) × 20% = £3.52 million.
Total fee = £2.40 + £3.52 = £5.92 million.
Net of fee: £120.00 − £5.92 = £114.08 million.
Net return = (£114.08 / £100.00) − 1 =14.1%.
31. A Hunda Kong hedge fund was valued at HK$400 million last year. At year's
end the value before fees was HK$480 million. The fund charges 2 and 20.
Management fees are calculated on end-of-year values. Incentive fees are
independent of management fees and calculated using no hurdle rate. The
previous year the fund's net return was 2.5%. Calculate the annualized return
for the last two years.
(Source: FOD)
ANSWER:
Management fee is HK$480 million × 0.02 = HK$9.6 million.

Incentive fee is (HK$480 million − HK$400 million) × 0.20 = HK$16.0 million.
Total fee is HK$9.6 million + HK$16.0 million = HK$25.6 million.

Net of fee: HK$480.0 − HK$25.6 = HK$454.4 million

Net return: (HK$454.4 / HK$400.00) − 1 = 13.6%
Two year annualized return is (1.136 × 1.025) 1/2 - 1 = 7.9%
32. Boxer Fund is a hedge fund with a value of £100 million at the beginning of
the year. Boxer Fund charges 1.5% management fee based on assets under
management at the end of the year and a 25% incentive fee with no hurdle
rate. Incentive fees are calculated independent of management fees. The
fund's value at the end of year before fees is £120 million. Compared to a 2
and 20 fee structure, Calculate Boxer Fund's total fees for the year.
(Source: FOD)
ANSWER:
1.5% Management Fee, 2% Management Fee,

25% Incentive Fee 20% Incentive Fee
Management fee £ 120 ×1.5% = £1.8 million £ 120 ×2% = £2.4 million
(£ 120 - £ 100) × 25% = (£ 120 - £ 100) × 25% =
Incentive fee £ 5.0 million £ 4.0 million
Total fees £ 1.8 + £ 5.0 = Spound; 6.8 £ 2.4 + £ 4.0 = Spound; 6.4
million million
33. Autumn field Fund of Funds invests in two hedge funds, DXS and REF
funds. Autumn field initially invested $50.0 million in DXS and $100.0 million
in REF. After one year, DXS and REF were valued at $55.5 million and $104.5
million, respectively, net of both hedge fund management fees and incentive
fees. Autumn field Fund of Funds charges 1.0% management fee based on
assets under management at the beginning of the year and a 10.0% incentive
fee independent of management fees. Calculate the annual net return for
Autumn field Fund of Funds.
(Source: FOD)

ANSWER:
Management fee = $150.0 × 1.0% = $1.5 million

Net value at end of year after hedge fund fees = $55.5 + $104.5 = $160.0 million
Incentive fee = ($160.0 − $150.0) × 10% = $1.0 million
Total fees = $1.5 + $1.0 = $2.5 million
Net of fees: $160.0 − $2.5 = $157.5 million
Net return = ($157.5 / $150.0) − 1 = 5.0%
34. A hedge fund started with an initial investment of 75 million. The end-of-
year value after fees for Year 1 was 70 million. For Year 2, the end-of-year
value before fees is 90 million. The fund has a 2 and 20 fee structure.
Management fees are paid independently of incentive fees and are
calculated on end-of- year values. Incentive fees are calculated using a high
water mark and a soft hurdle rate of 2%. Calculate the total fees paid for
Year 2.
(Source: FOD)
ANSWER:
Management fee = 90 million × 0.02 = 1.8 million.

Gross return = (90 / 75) − 1 = 20.0%. The soft hurdle rate was exceeded.
Because of the high water mark, incentive fees are paid only on the increase in
value above the previous high value of 75 million. Incentive fee = (90 million
− 75 million) × 0.20 = 3.0 million.
Total fee: 1.8 million + 3.0 million = 4.8 million.
35. A Canadian hedge fund has a value of C$100 million at the beginning of the
year. The fund charges a 2% management fee based on assets under
management at the beginning of the year and a 20% incentive fee with a 10%
hard hurdle rate. Incentive fees are calculated net of management fees. The

value at the end of the year before fees is C$112 million. Calculate the net
return to investors.
(Source: FOD)
ANSWER:
Management Fee: C$100.0 × 2.0% = C$2.0 million

Gross value at end of year (given) = C$112.0 million
Incentive fee = [(C$112.0 − C$100.0 − C$2.0 − (C$100.0 × 10.0%)] × 20% = C$0
Total fee = C$2.0 million
Net of fee: C$112.0 − C$2.0 = C$110.0 million
Net return = (C$110.0 / C$100.0) − 1 =10.0%
36. XYZ hedge fund is a U.S. based fund with $200 million of initial
investment capital. The fund specifies a ‘2 and 20’ fee structure with fees
calculated using end-of-period calculation. If, in its first year, XYZ hedge
fund earns a return of 25%, Calculate the investor’s net return.
(Source: FOD)
ANSWER:
25%(200) = $50 million

250 million (2%) = $5 million
(250-200-5) (20%) = $9.0 million incentive fee
Total fees: $14.0 million
Return: 250-200-14/200 = 18%

37. There are two Mutual Funds viz. D Mutual Fund Ltd. and K Mutual Fund
Ltd. Each having close ended equity schemes. NAV as on 31-12-2014 of
equity schemes of D Mutual Fund Ltd. is ` 70.71 (consisting 99%
equity and remaining cash balance) and that of K Mutual Fund Ltd. is
62.50 (consisting 96% equity and balance in cash).
Following is the other information:
Particular Equity Schemes
D Mutual Fund Ltd. K Mutual Fund Ltd.
Sharpe Ratio 2 3.3
Treynor Ratio 15 15
Standard deviation 11.25 5
There is no change in portfolios during the next month and annual average
cost is ` 3 per unit for the schemes of both the Mutual Funds.
If Share Market goes down by 5% within a month, calculate expected NAV
after a month for the schemes of both the Mutual Funds.
For calculation, consider 12 months in a year and ignore number of days for
particular month.
(Source: ICAI)
ANSWER:
Working Notes:
(i) Decomposition of Funds in Equity and Cash Components

NAV on 31.12.14 ` 70.71 ` 62.50
% of Equity 99% 96%
Equity element in NAV ` 70 ` 60
Cash element in NAV ` 0.71 ` 2.50

(ii) Calculation of Beta

(a) D Mutual Fund Ltd.
E R  R f E  R  R f
Sharpe Ratio = 2 = 
σD 11.25
E(R) - Rf = 22.50
E  R   R f 22.50
βD βD
βD = 22.50/15= 1.50
(b) K Mutual Fund Ltd.

E R  R f E  R  R f
Sharpe Ratio = 3.3 = 
σk 5
E(R) - Rf = 16.50
E  R   R f 16.50
βk βk
βK = 16.50/15= 1.10
(iii) Decrease in the Value of Equity

Market goes down by 5.00% 5.00%
Beta 1.50 1.10
Equity component goes down 7.50% 5.50%
(iv) Balance of Cash after 1 month

Cash in Hand on 31.12.14 ` 0.71 ` 2.50
Less : Exp. Per month ` 0.25 ` 0.25
Balance after 1 month ` 0.48 ` 2.25

NAV after 1 month

Value of Equity after 1 month
70 × (1 - 0.075) ` 64.75 -
60 × (1 - 0.055) - ` 56.70
Cash Balance 65.21 2.25
65.21 58.95
38. United Capital is a hedge fund with $250 million of initial capital. United
charges a 2% management fee based on assets under management at year
end, and a 20% incentive fee based on returns in excess of an 8% hurdle rate.
In its first year, United appreciates 16%. Assume management fees are
calculated using end-of-period valuation. Calculate the investor's net return
assuming the performance fees is calculated net of the management fees.
(Source: FOD)
ANSWER:
The net investor return is 12.54%, calculated as:

End of year capital = $250 million × 1.16 = $290 million
Management fee = $290 million × 2% = $5.8 million
Hurdle amount = 8% of $250 million = $20 million;
Incentive fee = ($290 − $250 − $20 − $5.8) million × 20% = $2.84 million
Total fees to United Capital = ($5.8 + $2.84) million = $8.64 million
Investor net return: ($290 − $250 − $8.64) / $250 = 12.54%
39. Capricorn Fund of Funds invests GBP 100 million in each of Alpha Hedge
Fund and ABC Hedge Fund. Capricorn FOF has a “1 and 10” fee
structure. Management fees and incentive fees are calculated
independently at the end of each year. After one year, net of their respective

management and incentive fees, the investment in Alpha is valued at GBP80

million and the investment in ABC is valued at GBP140 million. Calculate
the annual return to an investor in Capricorn net of fees assessed at the fund
of funds level.
(Source: FOD)
ANSWER:
The net investor return 7.9%, calculated as:

First, note that “1 and 10” refers to a 1% management fee, and a 10% incentive
fee.
End of year capital = GBP140 million + GBP80 million = GBP220 million
Management fee = GBP220 million × 1% = GBP2.2 million
Incentive fee = (GBP220 − GBP200) million × 10% = GBP2 million
Total fees to Capricorn = (GBP2.2 + GBP2) million = GBP4.2 million
Investor net return: (GBP220 − GBP200 − GBP4.2) / GBP200 = 7.9%
40. A high water mark of £150 million was established two years ago for a British
hedge fund. The end-of- year value before fees for last year was £140
million. This year's end-of-year value before fees is £155 million. The fund
charges "2 and 20." Management fees are paid independently of incentive fees
and are calculated on end-of-year values. What is the total fee paid this year.
(Source: FOD)
ANSWER:
Management fee is £155 million x 0.02 = £3.1 million.

Incentive fee is (£155 million - £150 million) x 0.20 = £1.0 million.
Total fee is £3.1 million + £1.0 million = £4.1 million.

41. A British hedge fund has a value of £100 million at the beginning of the year.
The fund charges a 2% management fee based on assets under management
at the end of the year and a 20% incentive fee with a soft hurdle rate of
LIBOR + 2.5%. Incentive fees are calculated net of management fees. If the
relevant LIBOR rate is 2.5% and the fund's value at the end of the year before
fees is £120 million, calculate the net return to investors.
(Source: FOD)
ANSWER:
Management fee = £120.0 × 2.0% = £2.4 million.

Gross value at end of year (given) = £120.0 million.
Gross return = (£120.0 / £100.0) − 1 = 20.0%. The soft hurdle rate of 2.5% +
2.5% = 5.0% was exceeded.
Incentive fee = (£120.0 − £100.0 − £2.4) × 20% = £3.52 million.
Total fee = £2.40 + £3.52 = £5.92 million.
Net of fee: £120.00 − £5.92 = £114.08 million.
Net return = (£114.08 / £100.00) − 1 =14.1%.
42. A Hunda Kong hedge fund was valued at HK$400 million last year. At year's
end the value before fees was HK$480 million. The fund charges 2 and 20.
Management fees are calculated on end-of-year values. Incentive fees are
independent of management fees and calculated using no hurdle rate. The
previous year the fund's net return was 2.5%. Calculate the annualized return
for the last two years.
(Source: FOD)
ANSWER:
Management fee is HK$480 million × 0.02 = HK$9.6 million.

Incentive fee is (HK$480 million − HK$400 million) × 0.20 = HK$16.0 million.
Total fee is HK$9.6 million + HK$16.0 million = HK$25.6 million.

Net of fee: HK$480.0 − HK$25.6 = HK$454.4 million

Net return: (HK$454.4 / HK$400.00) − 1 = 13.6%
Two year annualized return is (1.136 × 1.025) 1/2 - 1 = 7.9%
43. Autumn field Fund of Funds invests in two hedge funds, DXS and REF
funds. Autumn field initially invested $50.0 million in DXS and $100.0 million
in REF. After one year, DXS and REF were valued at $55.5 million and $104.5
million, respectively, net of both hedge fund management fees and incentive
fees. Autumn field Fund of Funds charges 1.0% management fee based on
assets under management at the beginning of the year and a 10.0% incentive
fee independent of management fees. Calculate the annual net return for
Autumn field Fund of Funds.
(Source: FOD)
ANSWER:
Management fee = $150.0 × 1.0% = $1.5 million

Net value at end of year after hedge fund fees = $55.5 + $104.5 = $160.0 million
Incentive fee = ($160.0 − $150.0) × 10% = $1.0 million
Total fees = $1.5 + $1.0 = $2.5 million
Net of fees: $160.0 − $2.5 = $157.5 million
Net return = ($157.5 / $150.0) − 1 = 5.0%
44. A hedge fund started with an initial investment of 75 million. The end-of-
year value after fees for Year 1 was 70 million. For Year 2, the end-of-year
value before fees is 90 million. The fund has a 2 and 20 fee structure.
Management fees are paid independently of incentive fees and are calculated
on end-of- year values. Incentive fees are calculated using a high water mark
and a soft hurdle rate of 2%. Calculate the total fees paid for Year 2.
(Source: FOD)

ANSWER:
Management fee = 90 million × 0.02 = 1.8 million.

Gross return = (90 / 75) − 1 = 20.0%. The soft hurdle rate was exceeded.
Because of the high water mark, incentive fees are paid only on the increase in
value above the previous high value of 75 million. Incentive fee = (90 million
− 75 million) × 0.20 = 3.0 million.
Total fee: 1.8 million + 3.0 million = 4.8 million.
45. A Canadian hedge fund has a value of C$100 million at the beginning of the
year. The fund charges a 2% management fee based on assets under
management at the beginning of the year and a 20% incentive fee with a 10%
hard hurdle rate. Incentive fees are calculated net of management fees. The
value at the end of the year before fees is C$112 million. Calculate the net
return to investors.
(Source: FOD)
ANSWER:
Management Fee: C$100.0 × 2.0% = C$2.0 million

Gross value at end of year (given) = C$112.0 million
Incentive fee = [(C$112.0 − C$100.0 − C$2.0 − (C$100.0 × 10.0%)] × 20% = C$0
Total fee = C$2.0 million
Net of fee: C$112.0 − C$2.0 = C$110.0 million
Net return = (C$110.0 / C$100.0) − 1 =10.0%

46. XYZ hedge fund is a U.S. based fund with $200 million of initial
investment capital. The fund specifies a ‘2 and 20’ fee structure with fees
calculated using end-of-period calculation. If, in its first year, XYZ hedge
fund earns a return of 25%, Calculate the investor’s net return.
(Source: FOD)
ANSWER:
25%(200) = $50 million

250 million (2%) = $5 million
(250-200-5) (20%) = $9.0 million incentive fee
Total fees: $14.0 million
Return: 250-200-14/200 = 18%

MUTUAL FUND - SUMMARY
Value of Assets Liabilities

1. NAV
No of units
2. Public offering price = NAV + entry load

Repurchase price = NAV - exit load
3. Holding Period Return

Dividend distribution Capital gain distribution Change in NAV
Beginning NAV
4. Indifference Return
R1
R2 exp
1 i
5. Performance Appraisal
Rp  R f
 Sharpe Ratio 
p
Rp  R f
 Sharpe Ratio 
Bp
 Rp  R f 
 M2    M   Rm  R f 
 p 
 Jensen Alpha  Rp  Re as per SML
R p  RB
 Information Ratio 

s tan dard deviation of R p  RB 

MAY'18 EXAM QUESTIONS
1. The unit price of Equity Linked Savings Scheme (ELSS) of a mutual fund is
`10/-. The public offer price (POP) of the unit is `10.204 and the redemption
price is `9.80.
Calculate:
(i) Front-end Load
(ii) Back end Load
2. Mr. Y has invested in the three mutual funds (MF) as per the following details:
Particulars MF 'X' MF 'Y' MF 'Z'
Amount of Investment (`) 2,00,000 4,00,000 2,00,000
Net Assets Value (NAV) at the time of 10.30 10.10 10
purchase(`)
Dividend Received up to 31.03.2018 (`) 6,000 0 5,000
NAV as on 31.03.2018 (`) 10.25 10 10.20
Effective Yield per annum as on 31.03.2018 9.66 -11.66 24.15
(percent)
Assume 1 Year = 365 days

Mr. Y has misplaced the documents of his investment. Help him in finding the
date of his original investment after
(i) Number of units in each scheme;
(ii) Total NPV;
(iii) Total Yield; and
(iv) Number of days investment held.

3. As an investment manager, you are given the following information:
Particulars Initial Price Dividend Market price Beta (Risk

(`) (`) of the factor)
dividends
(`)
A. Equity
Share:
Manufacturing 30 2 55 0.8
Ltd.
Pharma Ltd. 40 2 65 0.7
Auto Ltd. 50 2 140 0.5
B. Government 1005 140 1010 0.99
of India bonds
By assuming risk free return as 16%, Calculate:

(i) Expected rate of return on the portfolio (aggregate) of investor;
(ii) Expected rate of return of portfolio in each above stated share/bond
using Capital Asset Pricing Model (CAPM); and
(iii) Average Rate of Return.

MERGER
&
ACQUISITIONS
PRACTICE PROBLEMS 260 - 375
SUMMARY 376 - 377

MERGER & ACQUISITIONS - PRACTICE PROBLEM
1. Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the
companies are dependent on the fluctuating business conditions. The
following information is given for the total value (debt + equity) structure of
each of the two companies.
Business Condition Probability Simple Ltd. Dimple Ltd.
` Lacs ` Lacs
High Growth 0.20 820 1050
Medium Growth 0.60 550 825
Slow Growth 0.20 410 590
The current debt of Dimple Ltd. is ` 65 lacs and of Simple Ltd. is ` 460 lacs.
Calculate the expected value of debt and equity separately for the merged
entity.
(Source :- ICAI)
ANSWER:-
Compute Value of Equity

Simple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth
Debt + Equity 820 550 410
Less: Debt 460 460 460
Equity 360 90 -50
Since the Company has limited liability the value of equity cannot be negative
therefore the value of equity under slow growth will be taken as zero
because of insolvency risk and the value of debt is taken at 410 lacs. The
expected value of debt and equity can then be calculated as:

Simple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth Expected
Value
Prob. Value Prob. Value Prob. Value
Debt 0.20 460 0.60 460 0.20 410 450
Equity 0.20 360 0.60 90 0.20 0 123
820 550 410 576
Dimple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth Expected
Value
Prob. Value Prob. Value Prob. Value
Equity 0.20 985 0.60 760 0.20 525 785
Debt 0.20 65 0.60 65 0.20 65 65
1050 825 590 823
Expected Values
` in Lacs
Equity Debt
Simple Ltd. 126 Simple Ltd. 450
Dimple Ltd. 758 Dimple Ltd. 65
884 515

2. Following information is provided relating to the acquiring company

Mani Ltd. and the target company Ratnam Ltd:
Mani Ltd. Ratnam Ltd.
Earnings after tax (` lakhs) 2,000 4,000
No. of shares outstanding (lakhs) 200 1,000
P/E ratio (No. of times) 10 5
Required:
(i) What is the swap ratio based on current market prices?
(ii) What is the EPS of Mani Ltd. after the acquisition?
(iii) What is the expected market price per share of Mani Ltd. after the
acquisition, assuming its P/E ratio is adversely affected by 10%?
(iv) Determine the market value of the merged Co.
(v) Calculate gain/loss for the shareholders of the two independent entities,
due to the merger.
(Source :- ICAI)
ANSWER:-
(i) SWAP ratio based on current market prices:

EPS before acquisition:
Mani Ltd. : ` 2,000 lakhs / 200 lakhs: ` 10
Ratnam Ltd.: ` 4,000 lakhs / 1,000 lakhs: ` 4
Market price before acquisition:
Mani Ltd.: ` 10 × 10 ` 100
Ratnam Ltd.: ` 4 ` 20
SWAP ratio: 20/100 or i.e. 0.20
(ii) EPS after acquisition:
 2,000  4,000  ` 15.00
 200  200 

(iii) Market Price after acquisition:

EPS after acquisition: ` 15.00
P/E ratio after acquisition 10 × 0.9 9
Market price of share (` 15 X 9) ` 135.00
(iv) Market value of the merged Co.:
` 135 × 400 lakhs shares ` 540.00 Crores
Or ` 54,000 Lakhs
(v) Gain/loss per share:
` Crore
Mani Ltd. Ratnam Ltd.
Total value before Acquisition 200 200
Value after acquisition 270 270
Gain(Total) 70 70
No. of shares (pre-merger) (lakhs) 200 1,000
Gain per share(`) 35 7
3. M plc and C plc operating in same industry are not experiencing any
rapid growth but providing a steady stream of earnings. M plc’s
management is interested in acquisition of C plc due to its excess plant
capacity. Share of C plc is trading in market at £4 each. Other date
relating to C plc is as follows:
Particulars M plc C plc Combined
Entity
Profit after tax £4,800,000 £3,000,000 £9,200,000
Residual Net Cash Flow per year £6,000,000 £4,000,000 £12,000,000
Required return on Equity 12.5% 11.25% 12.00%

Balance Sheet of C plc
Assets Amount Liabilities Amount

(£) (£)
Current Assets 27,300,000 Current Liabilities 13,450,000
Other Assets 5,500,000 Long Term Liabilities 11,100,000
Property Plants & Reserve & Surplus 24,750,000
Equipments 21,500,000 Share Capital 5,000,000
(5 million common
shares @ £1each)
54,300,000 54,300,000
You are required to compute:

(i) Minimum price per share C plc should accept from M plc.
(ii) Maximum price per share M plc shall be willing to offer to C plc.
(iii) Floor Value of per share of C plc. Whether it shall play any role in
decision for its acquisition by M plc.
(Source :- ICAI)
ANSWER:-
Working Notes:
Re sidual Cash Flow 4,000,000
Value of C plc    £35, 555, 556
ke  g 0.1125  0
35, 555, 556
Value of per share of C plc =  £7.11
5,000,000
29,750,000
Book Value of per share of C plc =  £5.95
5,000,000
Re sidual Cash Flow 6,000,000
Value of M plc    £48,000,000
ke  g 0.125  0
12,000,000
Value of Combined Entity =  £100,000,000
0.12  0

Value of Synergy = Value of Combined Entity – Individual Value of M plc

and C plc
Value of Synergy = £100,000,000 – (£48,000,000 + £35,555,556) = £16,444,444
4. Hanky Ltd. and Shanky Ltd. operate in the same field, manufacturing newly
born babies’s clothes. Although Shanky Ltd. also has interests in
communication equipments, Hanky Ltd. is planning to take over Shanky
Ltd. and the shareholders of Shanky Ltd. do not regard it as a hostile bid.
The following information is available about the two companies.

Hanky Ltd. Shanky Ltd.
Current earnings ` 6,50,00,000 ` 2,40,00,000
Number of shares 50,00,000 15,00,000
Percentage of retained earnings 20% 80%
Return on new investment 15% 15%
Return required by equity shareholders 21% 24%
Dividends have just been paid and the retained earnings have already been
reinvested in new projects. Hanky Ltd. plans to adopt a policy of retaining
35% of earnings after the takeover and expects to achieve a 17% return on new
investment.
Saving due to economies of scale are expected to be ` 85,00,000 per annum.
Required return to equity shareholders will fall to 20% due to portfolio effects.
Requirements
a. Calculate the existing share prices of Hanky Ltd. and Shanky Ltd.
b. Find the value of Hanky Ltd. after the takeover
c. Advise Hanky Ltd. on the maximum amount it should pay for Shanky Ltd.
(Source :- ICAI)

ANSWER:-
a. Existing share price of Hanky Ltd.

g=rxb
r = 15%
b = 20%
g = 0.15 x 0.2
= 0.03
Next year's dividend
Ex dividend market value 
ke  g
6, 50,00,000  0.8  1.03
  29,75, 55, 556
0.21  0.03
29,75, 55, 556
Value of one share =  59.51 per share
5000000
Existing share price Shanky
g=rxb
= 0.15 x 0.8 = 0.12
Next year's dividend
Ex dividend market value =
ke  g
2, 40,00,000  0.2  1.12
  4, 48,00,000
0.24  0.12
4, 48,00,000
Value of one share =  29.87 per share
1500000
b. Value of Hanky Ltd. after the takeover

Care must be taken in calculating next year’s dividend and the subsequent
growth rate. Next year’s earnings are already determined, because both
companies have already reinvested their retained earnings at the current
rate of return. In addition, they will get cost savings of ` 85,00,000.
The dividend actually paid out at the end of next year will be determined
by the new 35% retention and the future growth rate will take into account
the increased return on new investment.
Growth rate for combined firm, g = 0.17 x 0.35 = 0.06

New cost of equity = 20%
Next year’s earnings = ` 6,50,00,000 x 1.03 + ` 2,40,00,000 x 1.12 + `
85,00,000
= ` 10,23,30,000
Next year’s dividend = ` 10,23,30,000 x 0.65
= ` 6,65,14,500
6,65,14, 500
Market value =  47, 51,03, 571
0.20  0.06
c. Maximum Hanky Ltd. should pay for Shanky Ltd.

Combined value = ` 47,51,03,571
Present Value of Hanky Ltd. = ` 29,75,55,556
= ` 17,75,48,015
5. A Ltd. (Acquirer company’s) equity capital is ` 2,00,00,000. Both A Ltd.

and T Ltd. (Target Company) have arrived at an understanding to maintain
debt equity ratio at 0.30 : 1 of the merged company. Pre-merger debt
outstanding of A Ltd. stood at ` 20,00,000 and T Ltd at ` 10,00,000 and
marketable securities of both companies stood at ` 40,00,000.
You are required to determine whether liquidity of merged company
shall remain comfortable if A Ltd. acquires T Ltd. against cash payment
at mutually agreed price of ` 65,00,000.
(Source :- ICAI)

ANSWER:-
`
Debt capacity of merged company (2,00,00,0000.30) 60,00,000
Less: Debt of A Ltd. and T Ltd. 30,00,000
30,00,000
Add: Marketable securities of both companies 40,00,000
70,00,000
Since the combined liquidity of merged company shall remain
comfortable, it shall be feasible to pay cash for acquiring the T Ltd. against
tentative price of ` 65,00,000.
6. Simpson Ltd. is considering a merger with Wilson Ltd. The data below are in
the hands of both Board of Directors. The issue at hand is how many
shares of Simpson should be exchanged for Wilson Ltd. Both boards are
considering three possibilities 20,000, 25,000 and 30,000 shares. You are
required to construct a table demonstrating the potential impact of each
scheme on each set of shareholders:
Simpson Wilson Combined
Ltd. Ltd. Post merger
Firm 'A'
1. Current earnings per year 2,00,000 1,00,000 3,50,000
2. Share outstanding 50,000 10,000 ?
3. Earnings per share(`) (1÷ 2) 4 10 ?
4. Price per share (`) 40 100 ?
5. Price-earning ratio [4÷ 3] 10 10 10
6. Value of firm(`) 20,00,000 10,00,000 35,00,000
7. Expected Annual growth rate
in earnings in foreseeable
future 0 0 0
(Source :- ICAI)
ANSWER:-
The following table demonstrates the potential impact of the three possible
schemes, on each set of shareholders:-
Number of Exchange Number of Fraction of Value of Fraction of Value of shares

Simpson ratio Simpson Ltd's Simpson shares owned Simpson owned by
Ltd.'s shares [(1)/10,000 shares Ltd. (Post by Wilson Ltd. Simpson Ltd.'s
issued to shares of outstanding merger) Ltd.s' (combined shareholders
shareholders Wilson Ltd.] after merger owned by shareholders Post-merger [(6)35,00,000]
of Wilson Ltd. [50,000+(1)] Wilson [(4)35,00,000] owned by
Ltd.'s Simpson
shareholders Ltd.'s
[(1)/(3)] shareholder
s
[50,000/(3)]
Paper - 2 (2) (3) (4) (5) (6) (7)
STRATEGIC
FINANCIAL
MANAGEME
NT
(1)
20,000 2 70,000 2/7 10,00,000 5/7 25,00,000
25,000 2.5 75,000 1/3 11,66,667 2/3 23,33,333
30,000 3 80,000 3/8 13,12,500 5/8 21,87,500
Thus from above it is clear that except case of exchange ratio of 20000 shares,
in remaining cases the value of shares will increase for both companies.
7. Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the
merged entity are given below:
(` lakhs)
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620

Earnings would have witnessed 5% constant growth rate without merger

and 6% with merger on account of economies of operations after 5 years
in each case. The cost of capital is 15%.
The number of shares outstanding in both the companies before the merger is
the same and the companies agree to an exchange ratio of 0.5 shares of Yes
Ltd. for each share of No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.

(i) Compute the Value of Yes Ltd. before and after merger
(ii) Value of Acquisition and
(iii) Gain to shareholders of Yes Ltd.
(Source :- ICAI)
ANSWER:-
(i) Working Notes:

Present Value of Cash Flows (CF) upto 5 years
Year CF of Yes Ltd. PVF @ PV of CF CF of Merged PV of CF
End (` lakhs) 15% (` lakhs) Entity of Merged
(` lakhs) Entity
(` lakhs)
1 175 0.870 152.25 400 348.00
2 200 0.756 151.20 450 340.20
3 320 0.658 210.56 525 345.45
4 340 0.572 194.48 590 337.48
5 350 0.497 173.95 620 308.14
882.44 1679.27

PV of Cash Flows of Yes Ltd. after the forecast period

CF5  1  g  350  1  0.05  367.50
TV5     3675 lakhs
ke  g 0.15  0.05 0.10
PV of TV5 = `3675 lakhs x 0.497 = `1826.475 lakhs
PV of Cash Flows of Merged Entity after the forecast period
CF5  1  g  620  1  0.06  657.20
TV5     7302.22 lakhs
ke  g 0.15  0.06 0.09
PV of TV5 = `7302.22 lakhs x 0.497 = `3629.20 lakhs
i. Value of Yes Ltd.

Before merger (` After merger (` lakhs)
lakhs)
PV of CF (1-5 years) 882.440 1679.27
Add: PV of TV5 1826.475 3629.20
2708.915 5308.47
ii. Value of Acquisition

= Value of Merged Entity – Value of Yes Ltd.
= `5308.47 lakhs – `2708.915 lakhs = `2599.555 lakhs
iii. Gain to Shareholders of Yes Ltd.

1
Share of Yes Ltd. in merged entity = `5308.47 lakhs x = `3538.98 lakhs
1.5
Gain to shareholder = Share of Yes Ltd. in merged entity – Value of Yes
Ltd. before merger
= `3538.98 lakhs - `2708.915 = `830.065 lakhs
8. XY Ltd. has two major operating divisions, furniture manufacturing and real
estate, with revenues of ` 2600 crore and ` 6200 crore respectively. Following
financial information is available.

Balance Sheet as on 31-3-2015
Liabilities Amount Assets Amount

( `Crore) (`Crore)
Ordinary Shares (` 10 Per Share) 500 Land and Buildings 800
Reserves 1300 Plant and Machinery 1400
Secured Term Loans 600 Current Assets 2500
13% Debenture (` 100 par) 500
Current Liabilities 1800
4700 4700
Summarised cash flow data for XY Ltd. is as follows:

Amount (` Crore)
Sales 8800
Operating expenses 8030
Head Office Expenses 80
Interest 110
Taxation 140
Dividends 150
The company's current share price is ` 118.40, and each debenture is trading
in market at ` 131.
Projected financial data (in ` Crore) in real terms (excluding
depreciation) of the two divisions is as follows:
Year 1 2 3 4 5 6
Onward
Furniture Manufacturing
Operating Profit before Tax 450 480 500 520 570 600
Allocated HO Overheads* 40 40 40 40 40 40
Depreciation 100 80 70 80 80 80
Real Estate
Allocated HO Overheads* 40 30 30 30 30 30
Depreciation 50 50 50 50 50 50
* Allocated HO Overheads reflect actual cash flows.
Other Information:
 Applicable Corporate tax rate is of 30%, payable in the year, the relevant
cash flow arises.
 Inflation is expected to remain at approximately 3% per year.
 The risk free rate is 5.5% and the market return 14%.
 XY Ltd.’s equity beta is 1.15.
 The average equity betas in the Furniture Manufacturing and Realty
Sectors are 1.3 and 0.9 respectively and the gearing levels in Furniture
Manufacturing and Realty sectors by market values are 70% equity
30% debt and 80% equity 20% debt respectively.
 The current cost of the debentures and long term loan are almost identical.
 The debentures are redeemable at par in 15 years' time.
The company is considering a demerger whereby the two divisions shall
be floated separately on the stock market.
Terms of Demerger
(1) The debentures would be serviced by the real estate division and
the long term loans by the furniture manufacturing division.
(2) The existing equity would be split evenly between the divisions,
although new ordinary shares would be issued to replace existing shares.
(3) If a demerger occurs allocated overhead would rise to ` 60 crore per year
for each company.

(4) Demerger would involve single one time after tax cost of ` 160 crore in
the first year which would be shared equally by the two companies.
There would be no other significant impact on expected cash flows.
Required
Using real cash flows and time horizon of 15 year time and infinite
period, evaluates whether or not it is expected to be financially advantageous
to the original shareholders of XY Ltd. for the company to separately float the
two divisions on the stock market.
Note: In any gearing estimates the Furniture Manufacturing division may be

assumed to comprise 55% of the market value of equity of XY Ltd, and Real
Estate division 45%.
Year 1 2 3 4 5 6-15
PVAF @ 10% 0.909 0.821 0.751 0.683 0.621 3.815
PVAF @ 8.5% 0.922 0.849 0.783 0.722 0.665 4.364
(Source :- ICAI)
ANSWER:-
To decide whether the XY Ltd. should go for the option of demerger

i.e. floating two companies for Furniture Manufacturing business and
Real Estate we should compare their values.
Working Notes:
(i) Calculation of Discounting Rates
(a) For Furniture Manufacturing
Market Value of Debt (Secured Loan) ` 600.00 crore
Market Value of Equity (Rs.118.40 x 50 crore x 55%) ` 3256.00 crore
Total ` 3856.00 crore

Gearing Levels
Equity Debt
3256.00 600.00
 84.44%  15.56%
3856.00 3856.00
Since this level of gearing differs from the gearing level of industry to
find out the beta we must re-gear the asset beta taking into
account the current structure. Assuming Debt to be risk free let us
de-gear the beta as follows:
βL
βu 
1   1  T  D /E 
Accordingly,
1.30
βu   1.00
1   1  0.30  30 /70 
Re-gearing
βL = βU [1+ (1 – T) D / E]
βL = 1.00 [1+ (1 – 0.30) 15.56/ 84.44] = 1.129
Cost of Equity using CAPM
Ke = 5.50% + 1.129(14% - 5.50%) =15.10%
Cost of Debt using Short Cut Method
13  1  0.30  
 100  131 
kd  15  0.0609 i.e. 6.09%
100  31
2
WACC of Furniture Manufacturing Division
15.10% x 84.44% + 6.09% x 15.56% = 13.70%
Real WACC =
 1  No min al Rate   1   1  0.1370   1  10.39 say 10%
 1  Inflation Rate   1  0.03 
(b) For Real Estate
Market Value of Debt (Secured Loan) ` 655.00 crore
Market Value of Equity (Rs.118.40 x 50 crore x 45%) ` 2,664.00 crore
Total ` 3,319.00 crore

Gearing Levels
Equity Debt
2,664.00 655.00
 80.27%  19.73%
3, 319.00 3, 319.00
Since this level of gearing is almost equal to the gearing level of
industry the beta of industry shall be the beta of Real Estate
Division and Cost of Equity using CAPM will be:
Ke = 5.50% + 0.90(14% - 5.50%) =13.15%
WACC of Real Estate Division
13.15% x 80.27% + 6.09% x 19.73% = 11.76%
Real WACC =
 1  No min al Rate   1   1  0.1176   1  0.085
 1  Inflation Rate   1  0.03 
(ii) Calculation of Value of Both Division

a. Furniture Manufacturing
Year 1 2 3 4 5 6
Onward
Allocated HO Overheads 60 60 60 60 60 60
Depreciation 100 80 70 80 80 80
290 340 370 380 430 460
Less: Tax @ 30% 87 102 111 114 129 138
203 238 259 266 301 322
Add: Depreciation 100 80 70 80 80 80
303 318 329 346 381 402
Less: One Time Cost 80 - - - - -
223 318 329 346 381 402
PVF @ 10% 0.909 0.826 0.751 0.683 0.621
202.71 262.67 247.08 236.32 236.60

402
Terminal Value   0.621  2496.42
0.10
Total Value of Furniture Manufacturing Division (Infinite
Period)=`3681.80 crore
Total Value of Furniture Manufacturing Division (15 years)
= `1185.38 crore + `402 crore x 3.815 = `2719.01 crore
b. Real Estate Business

Year 1 2 3 4 5 6
Onward
Allocated HO Overheads 60 60 60 60 60 60
Depreciation 50 50 50 50 50 50
210 290 310 330 350 390
Less: Tax @ 30% 63 87 93 99 105 117
147 203 217 231 245 273
Add: Depreciation 50 50 50 50 50 50
197 253 267 281 295 323
Less: One Time Cost 80 - - - - -
117 253 267 281 295 323
PVF @ 8.5% 0.922 0.849 0.783 0.722 0.665
PV 107.87 214.80 209.06 202.88 196.18
323
Terminal value   0.665  2527.00
0.085
Total Value of Furniture Manufacturing Division (Infinite Period) = `
3457.79 crore
Total Value of Furniture Manufacturing Division (15 years)
= `930.79 crore + `323 crore x 4.364 = `2340.36 crore

Summary
Total of two divisions (Infinite Period)
= ` 3681.80 crore + ` 3457.79 crore – ` 1255.00 crore =` 5884.59crore
Total of two divisions (15 years horizon)
= ` 2719.01 crore + ` 2340.36 crore – ` 1255.00 crore =` 3804.37crore
Current Market Value of Equity
= Rs.118.40 x 50 crore = ` 5920.00crore
Decision: Since the total of the two separate divisions with both time
horizons (Infinite and 15 years) is less than the Current Value of Equity
demerger is not advisable.
9. Two companies Bull Ltd. and Bear Ltd. recently have been merged. The
merger initiative has been taken by Bull Ltd. to achieve a lower risk profile for
the combined firm in spite of fact that both companies belong to different
industries and disclose a little co- movement in their profit earning streams.
Though there is likely to synergy benefits to the tune of ` 7 crore from
proposed merger. Further both companies are equity financed and other
details are as follows:
Market Capitalization Beta
Bull Ltd. ` 1000 crore 1.50
Bear Ltd. ` 500 crore 0.60
Expected Market Return and Risk Free Rate of Return are 13% and 8%
respectively. Shares of merged entity have been distributed in the ratio of 2:1
i.e. market capitalization just before merger. You are required to:
a. Calculate return on shares of both companies before merger and after
merger.
b. Calculate the impact of merger on Mr. X, a shareholder holding 4%
shares in Bull Ltd. and 2% share of Bear Ltd.
(Source :- ICAI)
ANSWER:-
a. Expected Return using CAPM

(i) Before Merger
Share of Bull Ltd. 8% +1.50 (13% - 8%)= 15.50%
Share of Bear Ltd. 8% + 0.60 (13% - 8%) = 11.00%
(ii) After Merger

Beta of merged company shall be weighed average of beta of both
companies as follows:
2 1
 1.50   0.60  1.20
3 3
Thus, expected return shall be:
8% + 1.20 (13% - 8%) = 14%
b. Impact of merger on Mr. X

After merger his % holding in merged company shall be:
2 1 1
 4%   2%  3 %
3 3 3
The value of Mr. X’s holdings before merger was:
Bull Ltd. 4%  ` 1000 crore ` 40 crore
Bear Ltd. 2%  ` 500 crore ` 10 crore
` 50 crore
To compute the value of holding of Mr. X, after merger first we

have to compute the value of merged entity as follows:
Bull Ltd. 15.50%  ` 1000 crore ` 155 crore
Bear Ltd. 11%  ` 500 crore ` 55 crore
Synergy Benefits ` 7 crore
` 217 crore

217 crore
Market Capitalization of Merged Entity   1550 crore
0.14
1
Value of Mr. X’s holding = ` 51.67 crore. (` 1550 crore x 3 % )
3
10. XYZ, a large business house is planning to acquire ABC another

business entity in similar line of business. XYZ has expressed its interest
in making a bid for ABC. XYZ expects that after acquisition the annual
earning of ABC will increase by 10%.
Following information, ignoring any potential synergistic benefits arising

out of possible acquisitions, are available:
XYZ ABC Proxy entity for XYZ &
ABC in the same line of
business
Paid up Capital (` Crore) 1025 106 --
Face Value of Share is ` 10
Current share price ` ` 55 --
Debt: Equity (at market values) 129.60 1:3 1:4
Equity Beta 1:2 -- 1.1
--
Assume Beta of debt to be zero and corporate tax rate as 30%,

determine the Beta of combined entity.
(Source :- ICAI)
ANSWER:-
β ungreared for the proxy company = 1.1 × 4 / [ 4 + (1 – 0.3) ] = 0.9362

0.9362  βGeared of XYZ  2 /  2   1  0.3  
βGeared of XYZ  1.264

0.9362  βGeared of XYZ  3 /  3   1  0.3  

βGeared of ABC  1.155
XYZ ABC Total
No. of Share (1) 1025 crore 106 crore --
10 10
= 102.50 cr. = 10.60 cr.
Current share price (2) ` 129.60 `55 --
Market Values ` 13284 cr. ` 583 cr. ` 13867 cr.
(3) = (1)  (2)
Equity beta (4) 1.264 1.155
Market Values  ` 16790.976 cr. ` 673.365 cr. ` 17464.341 cr.
Equity beta
17464.341 crore
Portfolio Beta after Merger   1.26
13867 crore
11. Teer Ltd. is considering acquisition of Nishana Ltd. CFO of Teer Ltd.
is of opinion that Nishana Ltd. will be able to generate operating cash
flows (after deducting necessary capital expenditure) of ` 10 crore per
annum for 5 years.
The following additional information was not considered in the above
estimations.
(i) Office premises of Nishana Ltd. can be disposed of and its staff can be
relocated in Teer Ltd.’s office not impacting the operating cash
flows of either businesses. However, this action will generate an
immediate capital gain of ` 20 crore.
(ii) Synergy Gain of ` 2 crore per annum is expected to be accrued from the
proposed acquisition.
(iii) Nishana Ltd. has outstanding Debentures having a market value of
` 15 crore. It has no other debts.

(iv) It is also estimated that after 5 years if necessary, Nishana Ltd.

can also be disposed of for an amount equal to five times its operating
annual cash flow.
Calculate the maximum price to be paid for Nishana Ltd. if cost of capital of
Teer Ltd. is 20%. Ignore any type of taxation.
(Source :- ICAI)
ANSWER:-
Calculation of Maximum Price to be paid for the acquisition of Nishana

Ltd.
(` Crore)
Year 0 1 2 3 4 5
Operating cash flow - 10.00 10.00 10.00 10.00 10.00
Gain on Sale of office
premises 20.00 - - - - -
Synergy Benefits - 2.00 2.00 2.00 2.00 2.00
Disposal of Nishana Ltd. - - - - - 50.00
Net cash flow 20.00 12.00 12.00 12.00 12.00 62.00
PVF @ 20% 1 0.833 0.694 0.579 0.482 0.402
Present value 20.00 10.00 8.324 6.948 5.784 24.924
Total of Present value 75.984

Less: Market Value of Debentures (15.000)
60.984
Thus, the maximum price to be paid for acquisition of Nishana Ltd. ` 60.984
crore.
12. AB Ltd., is planning to acquire and absorb the running business of XY Ltd.
The valuation is to be based on the recommendation of merchant bankers and
the consideration is to be discharged in the form of equity shares to be issued

by AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists of 80 lakhs

shares of `10 each. The highest and the lowest market quotation during the
last 6 months were `570 and `430. For the purpose of the exchange, the price
per share is to be reckoned as the average of the highest and lowest market
price during the last 6 months ended on 31.3.06.
XY Ltd.’s Balance Sheet as at 31.3.2006 is summarised below:

` lakhs
Sources
Share Capital
20 lakhs equity shares of ` 10 each fully paid 200
10 lakhs equity shares of ` 10 each, ` 5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200
350
An independent firm of merchant bankers engaged for the negotiation,

have produced the following estimates of cash flows from the business of XY
Ltd.:
Year ended By way of `lakhs
31.3.07 After tax earnings for equity 105
31.3.08 do 120
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
terminal value estimate 200

It is the recommendation of the merchant banker that the business of

XY Ltd. may be valued on the basis of the average of (i) Aggregate of
discounted cash flows at 8% and (ii) Net assets value. Present value factors at
8% for years
1-5: 0.93 0.86 0.79 0.74 0.68

(i) Calculate the total value of the business of XY Ltd.
(ii) The number of shares to be issued by AB Ltd.; and
(iii) The basis of allocation of the shares among the shareholders of XY Ltd.
(Source :- ICAI)
ANSWER:-
Price/share of AB Ltd. for determination of ` 500

number of shares to be issued: (` 570 + ` 430)/2
Value of XY Ltd. based on future cash flow
capitalization (105 0.93) + (120  0.86) + (125 
0.79) + (1200.74)  (300  0.68) ` lakhs 592.40
Value of XY Ltd based on net assets ` lakhs 250.00
Average value (592.40 + 250)/2 421.20
No. of shares in AB Ltd to be issued `
4,21,20,000/500 Nos. 84240
Basis of allocation of shares

Fully paid equivalent shares in XY Ltd. (20+5) 2500000
lakhs
Distribution to fully paid shareholders
8424020/25 67392
Distribution to partly paid shareholders 84240-
67392 16848
13. Personal Computer Division of Distress Ltd., a computer hardware

manufacturing company has started facing financial difficulties for the
last 2 to 3 years. The management of the division headed by Mr.
Smith is interested in a buyout on 1 April 2013. However, to make this
buy-out successful there is an urgent need to attract substantial funds
from venture capitalists.
Ven Cap, a European venture capitalist firm has shown its interest to
finance the proposed buy-out. Distress Ltd. is interested to sell the division
for ` 180 crore and Mr. Smith is of opinion that an additional amount of ` 85
crore shall be required to make this division viable. The expected financing
pattern shall be as follows:
Source Mode Amount

(` crore)
Management Equity Shares of ` 10 each 60.00
VenCap VC Equity Shares of ` 10 each 22.50
9% Debentures with attached warrant of ` 100 22.50
each 160.00
Total 8% Loan 265.00
The warrants can be exercised any time after 4 years from now for 10 equity
shares @ ` 120 per share.
The loan is repayable in one go at the end of 8th year. The debentures are
repayable in equal annual installment consisting of both principal and interest
amount over a period of 6 years.
Mr. Smith is of view that the proposed dividend shall not be kept more
than 12.5% of distributable profit for the first 4 years. The forecasted EBIT
after the proposed buyout is as follows:

Year 2013-14 2014-15 2015-16 2016-17

EBIT (` crore) 48 57 68 82
Applicable tax rate is 35% and it is expected that it shall remain unchanged at
least for 5-6 years. In order to attract VenCap, Mr. Smith stated that
book value of equity shall increase by 20% during above 4 years.
Although, VenCap has shown their interest in investment but are
doubtful about the projections of growth in the value as per projections
of Mr. Smith. Further VenCap also demanded that warrants should be
convertible in 18 shares instead of 10 as proposed by Mr. Smith.
You are required to determine whether or not the book value of equity
is expected to grow by 20% per year. Further if you have been appointed by
Mr. Smith as advisor then whether you would suggest to accept the demand
of VenCap of 18 shares instead of 10 or not.
(Source :- ICAI)
ANSWER:-
Working Notes
Calculation of Interest Payment on 9% Debentures
PVAF (9%,6) = 4.486
22.50 crore
Annual Installment =  5.0156 crore
4.486
Year Balance Interest Installment Principal Balance

Outstanding (` Crore) (` Crore) Repayment (` Crore)
(` Crore) (` Crore)
1 22.5000 2.025 5.0156 2.9906 19.5094
2 19.5094 1.756 5.0156 3.2596 16.2498
3 16.2498 1.462 5.0156 3.5536 12.6962
4 12.6962 1.143 5.0156 3.8726 8.8236

Statement showing Value of Equity
Particulars 2013-14 2014-15 2015-16 2016-17

(` Crore) (` Crore) (` Crore) ( ` Crore)
EBIT 48.0000 57.0000 68.0000 82.0000
Interest on 9% Debentures 2.0250 1.7560 1.4620 1.1430
Interest on 8% Loan 12.8000 12.8000 12.8000 12.8000
EBT 33.1750 42.4440 53.7380 68.0570
Tax* @ 35% 11.6110 14.8550 18.8080 23.8200
EAT 21.5640 27.5890 34.9300 44.2370
Dividend @ 12.5% of EAT* 2.6955 3.4490 4.3660 5.5300
18.8685 24.1400 30.5640 38.7070
Balance b/f Nil 18.8685 43.0085 73.5725
Balance c/f 18.8685 43.0085 73.5725 112.2795
Share Capital 82.5000 82.5000 82.5000 82.5000
101.3685 125.5085 156.0725 194.7795
*Figures have been rounded off.

In the beginning of 2013-14 equity was ` 82.5000 crore which has been grown
to ` 194.7795 over a period of 4 years. In such case the compounded growth
rate shall be as follows:
(194.7795/82.5000)¼ - 1 = 23.96%
This growth rate is slightly higher than 20% as projected by Mr. Smith.
If the condition of VenCap for 18 shares is accepted the expected share
holding after 4 years shall be as follows:
No. of shares held by Management 6.00 crore

No. of shares held by VenCap at the starting stage 2.25 crore
No. of shares held by VenCap after 4 years 4.05 crore
Total holding 6.30 crore

Thus, it is likely that Mr. Smith may not accept this condition of VenCap as
this may result in losing their majority ownership and control to VenCap. Mr.
Smith may accept their condition if management has further opportunity to
increase their ownership through other forms.
14. A valuation done of an established company by a well-known analyst has

estimated a value of ` 500 lakhs, based on the expected free cash flow
for next year of ` 20 lakhs and an expected growth rate of 5%.
While going through the valuation procedure, you found that the analyst has
made the mistake of using the book values of debt and equity in his
calculation. While you do not know the book value weights he used, you
have been provided with the following information:
(i) Company has a cost of equity of 12%,
(ii) After tax cost of debt is 6%,
(iii) The market value of equity is three times the book value of equity, while
the market value of debt is equal to the book value of debt.
You are required to estimate the correct value of the company.
(Source :- ICAI)
ANSWER:-
Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as

follows:-
FCFF
Value of Firm  V0 
Ke  g n
Where –
FCFF1 = Expected FCFF in the year 1
Kc = Cost of capital
gn = Growth rate forever
Thus, ` 500 lakhs = ` 20 lakhs /(Kc-g)
Since g = 5%, then Kc = 9%

Now, let X be the weight of debt and given cost of equity = 12% and cost of
debt = 6%,
then 12% (1 – X) + 6% X = 9%
Hence, X = 0.50, so book value weight for debt was 50%
∴ Correct weight should be 150% of equity and 50% of debt.
∴ Cost of capital = Kc = 12% (0.75) + 6% (0.25) = 10.50%

and correct firm’s value = ` 20 lakhs/(0.105 – 0.05) = ` 363.64 lakhs.
15. Abhiman Ltd. is a subsidiary of Janam Ltd. and is acquiring

Swabhiman Ltd. which is also a subsidiary of Janam Ltd.
The following information is given :
Abhiman Ltd. Swabhiman Ltd.
% Shareholding of promoter 50% 60%
Share capital ` 200 lacs 100 lacs
Free Reserves and surplus ` 900 lacs 600 lacs
Paid up value per share ` 100 10
Free float market capitalization ` 500 lacs 156 lacs

P/E Ratio (times) 10 4
Janam Ltd., is interested in doing justice to both companies. The following
parameters have been assigned by the Board of Janam Ltd., for determining
the swap ratio:
Book value 25%
Earning per share 50%
Market price 25%
You are required to compute

(i) The swap ratio.
(ii) The Book Value, Earning Per Share and Expected Market Price of
Swabhiman Ltd., (assuming P/E Ratio of Abhiman ratio remains the

same and all assets and liabilities of Swabhiman Ltd. are taken over at
book value.)
(Source :- ICAI)
ANSWER:-
SWAP RATIO
Abhiman Ltd. Swabhiman Ltd.

` `
Share capital 200 lacs 100 lacs
Free reserves & surplus 900 lacs 600 lacs
Total 1100 lacs 700 lacs
No. of shares 2 lacs 10 lacs
Book value for share ` 550 ` 70
Promoters Holding 50% 60%
Non promoters holding 50% 40%
Free float market capitalization 500 lacs ` 156 lacs
(Public)
Total Market Cap 1000 lacs 390 lacs
No. of shares 2 lacs 10 lacs
Market Price ` 500 ` 39
P/E ratio 10 4
EPS ` 50.00 ` 9.75
Calculation of SWAP Ratio
Book Value 1:0.1273 0.1273 × 25% 0.031825

EPS 1:0.195 0.195 × 50% 0.097500
Market Price 1:0.078 0.078 × 25% 0.019500
Total 0.148825

(i) SWAP Ratio is 0.148825 shares of Abhiman Ltd. for every share of
Swabhiman Ltd.
Total No. of shares to be issued = 10 lakh × 0.148825 = 148825 shares
(ii) Book value, EPS & Market Price.

Total No. shares = 200000 +148825=348825
Total capital = `200 lakh + `148.825 lac = ` 348.825 lac
Reserves = ` 900 lac + ` 551.175 lac = ` 1451.175 lac
` 348.825lac  ` 1451.175 lac
Book value Per Share   ` 516.02
3.48825 lac
or ` 516.02 x 0.148825 = ` 76.80
Total Pr ofit ` 100 lac + ` 97.50 lac
EPS    ` 56.62
No.of shares 3.48825 lac
or ` 56.62 x 0.148825 = ` 8.43
Expected market price = ` 56.62 × PE Ratio= ` 56.62 × 10 = ` 566.20
or ` 566.20 x 0.148825 = ` 84.26
16. AFC Ltd. wishes to acquire BCD Ltd. The shares issued by the two
companies are 10,00,000 and 5,00,000 respectively:
(i) Calculate the increase in the total value of BCD Ltd. resulting from the
acquisition on the basis of the following conditions:
Current expected growth rate of BCD Ltd. 7%
Expected growth rate under control of AFC Ltd., (without
any additional capital investment and without any change
in risk of operations)
Current Market price per share of AFC Ltd ` 100
Current Market price per share of BCD Ltd. ` 20
Current Dividend per share of BCD Ltd. ` 0.60
(ii) On the basis of aforesaid conditions calculate the gain or loss to
shareholders of both the companies, if AFC Ltd. were to offer one of its
shares for every four shares of BCD Ltd.

(iii) Calculate the gain to the shareholders of both the Companies, if AFC Ltd.
pays `22 for each share of BCD Ltd., assuming the P/E Ratio of AFC Ltd.
does not change after the merger. EPS of AFC Ltd. is `8 and that of BCD is
`2.50. It is assumed that AFC Ltd. invests its cash to earn 10%.
(Source :- ICAI)
ANSWER:-
(i) For BCD Ltd., before acquisition

The cost of capital of BCD Ltd. may be calculated by using the following
formula:
Dividend
 Growth%
Pr ice
Cost of Capital i.e., Ke = (0.60/20) + 0.07 = 0.10
After acquisition g (i.e. growth) becomes 0.08
Therefore, price per share after acquisition = 0.60/(0.10-0.08) = `30
The increase in value therefore is = `(30-20) x 5,00,000 = `50,00,000/-
(ii) To share holders of BCD Ltd. the immediate gain is `100 – `20x4 = `20 per
share
The gain can be higher if price of shares of AFC Ltd. rise following
merger which they should undertake.
To AFC Ltd. shareholders (` (In lakhs)
Value of Company now 1,000
Value of BCD Ltd. 150
1,150
No. of shares 11.25
∴ Value per share 1150/11.25= `102.22
Gain to shareholders of BCD Ltd. = `102.22 – `(4 x 20) = `22.22
Gain to shareholders of AFC Ltd. = `102.22 – `100.00 = `2.22

(iii) Gain to shareholders of AFC Ltd:-
Earnings of BCD Ltd. (5,00,000 x 2.50) `12,50,000/-

Less: Loss of earning in cash (5,00,000 x ` 22 x 0.10) ` 11,00,000/-
Net Earning ` 1,50,000/-
Number of shares 10,00,000
Net increase in earning per share 0.15
P/E ratio of AFC Ltd. = 100/8 = 12.50
Therefore, Gain per share of shareholders of AFC Ltd.
= 0.15x12.50 = `1.88
Gain to the shareholders of BCD Ltd. ` (22-20) = `2/- per
share
Alternatively, it can also be computed as follows:
Post-Merger Earnings ` 81,50,000

(10,00,000 x ` 8 + 5,00,000 x ` 2.5 – 11,00,000)
 81, 50,000  ` 8.15
EPS after Merger  
 10, ,00,000 
PE Ratio 12.50
Post Merger Price of Share (` 8.15 x 12.50) ` 101.875
Less: Price before merger ` 100.00
` 1.87 5
Say ` 1.88

17. The following data pertains to XYZ Inc. engaged in software consultancy
business as on 31 December 2010
($ Million)
Income from consultancy 935.00
EBIT 180.00
Less: Interest on Loan 18.00
EBT 162.00
Tax @ 35% 56.70
105.30
Balance Sheet
($ Million)
Liabilities Amount Assets Amount
Equity Stock (10 million 100 Land and Building 200
share @ $ 10 each) Computers & Softwares 295
Reserves & Surplus 325 Current Assets:
Loans 180 Debtors 150
Current Liabilities 180 Bank 100
Cash 40 290
785 785
With the above information and following assumption you are required to
compute.
a) Economic Value Added®
b) Market Value Added.
Assuming that:
(i) WACC is 12%
(ii) The share of company currently quoted at $ 50 each
(Source :- ICAI)

ANSWER:-
(a) Determination of Economic value added (EVA)

$ Million
EBIT 180.00
Less: Taxes @ 35% 63.00
Net Operating Profit after Tax 117.00
Less: Cost of Capital Employed 72.60
[W. No.1] 44.40
Economic Value Added
(b)
$ Million
Market value of Equity Stock [W. No. 2] 500
Equity Fund [W. No. 3] 425
Market Value Added 75
Working Notes:
(1) Total Capital Employed

Equity Stock $ 100 Million
Reserve and Surplus $ 325 Million
Loan $ 180 Million
WACC $ 605 Million
Cost of Capital employed $ 605 Million х 12% 12%
(2) Market Price per equity share (A) $ 72.60 Million
No. of equity share outstanding (B) $ 50
Market value of equity stock (A) х (B) 10 Million
(3) Equity Fund $ 500 Million
Equity Stock
Reserves & Surplus $ 100 Million
$ 325 Million
$ 425 Million
18. R Ltd. and S Ltd. are companies that operate in the same industry. The
financial statements of both the companies for the current financial year are
as follows:
Balance Sheet
Particulars R. Ltd. (` ) S. Ltd (` )
Equity & Liabilities
Shareholders Fund
Equity Capital (` 10 each) 20,00,000 16,00,000
Retained earnings 4,00,000
Non-current Liabilities
16% Long term Debt 10,00,000 6,00,000
Current Liabilities 14,00,000 8,00,000
Total 48,00,000 30,00,000
Assets
Non-current Assets 20,00,000 10,00,000
Current Assets 28,00,000 20,00,000
Total 48,00,000 30,00,000
Income Statement
Particulars R. Ltd. (` ) S. Ltd (` )
A Net Sales 69,00,000 34,00,000
B Cost of Goods sold 55,20,000 27,20,000
C Gross Profit (A-B) 13,80,000 6,80,00
D Operating Expenses 4,00,000 2,00,000

E Interest 1,60,000 96,000
F Earnings before taxes [C-(D+E)] 8,20,000 3,84,000
G Taxes @ 35% 2,87,000 1,34,400
H Earnings After Tax (EAT) 5,33,000 2,49,600

Additional Information:
No. of equity shares 2,00,000 1,60,000

Dividend payment Ratio (D/P) 20% 30%
Market price per share ` 50 ` 20

(i) Decompose the share price of both the companies into EPS & P/E
components. Also segregate their EPS figures into Return On Equity
(ROE) and Book Value/Intrinsic Value per share components.
(ii) Estimate future EPS growth rates for both the companies.
(iii) Based on expected operating synergies, R Ltd. estimated that the
intrinsic value of S Ltd. Equity share would be ` 25 per share on its
acquisition. You are required to develop a range of justifiable Equity
Share Exchange ratios that can be offered by R Ltd. to the shareholders
of S Ltd. Based on your analysis on parts (i) and (ii), would you expect
the negotiated terms to be closer to the upper or the lower exchange
ratio limits and why?
(Source :- ICAI)
ANSWER:-
(i) Determination of EPS, P/E Ratio, ROE and BVPS of R Ltd.& S Ltd.
R Ltd. S Ltd.
EAT (`) 5,33,000 2,49,600
N 200000 160000
EPS (EAT÷N) 2.665 1.56
Market Price Per Share 50 20
PE Ratio (MPS/EPS) 18.76 12.82
Equity Fund (Equity Value) 2400000 1600000
BVPS (Equity Value ÷ N) 12 10
ROE (EAT÷ EF) or 0.2221 0.156

ROE (EAT ÷ EF) 22.21% 15.60%
(ii) Determination of Growth Rate of EPS of R Ltd.& S Ltd.

R Ltd. S Ltd.
Retention Ratio (1-D/P Ratio) 0.80 0.70
Growth Rate (ROE x Retention Ratio) or 0.1777 0.1092
Growth Rate (ROE x Retention Ratio) 17.77% 17.77%
(iii) Justifiable equity share exchange ratio

(a) Market Price Based = MPSS/MPSR = ` 20/ ` 50 = 0.40:1 (lower limit)
(b) Intrinsic Value Based = ` 25/ ` 50 = 0.50:1 (max. limit)
Since R Ltd. has higher EPS, PE, ROE and higher growth expectations the
negotiated term would be expected to be closer to the lower limit, based on
existing share price.
19. Eagle Ltd. reported a profit of ` 77 lakhs after 30% tax for the
financial year 2011-12. An analysis of the accounts revealed that the
income included extraordinary items of ` 8 lakhs and an extraordinary
loss of `10 lakhs. The existing operations, except for the extraordinary items,
are expected to continue in the future. In addition, the results of the
launch of a new product are expected to be as follows:
` In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10


(i) Calculate the value of the business, given that the capitalization rate is
14%.
(ii) Determine the market price per equity share, with Eagle Ltd.‘s share
capital being comprised of 1,00,000 13% preference shares of ` 100
each and 50,00,000 equity shares of ` 10 each and the P/E ratio being 10
times.
(Source :- ICAI)
ANSWER:-
(i) Computation of Business Value

(` Lakhs)
77 110
Profit before tax
1  0.30
Less: Extraordinary income (8)
Add: Extraordinary losses
10
Profit from new product 112
Sales (` Lakhs)
Less: Material costs 70
Labour costs 20
Fixed costs 12 28
10 42 140
Less: Taxes @30% 42.00
Future Maintainable Profit after taxes 98.00
Relevant Capitalisation Factor 0.14
Value of Business (`98/0.14) 700

(ii) Determination of Market Price of Equity Share
Future maintainable profits (After Tax) ` 98,00,000

Less: Preference share dividends 1,00,000 shares ` 13,00,000
of ` 100 @ 13% ` 85,00,000
Earnings available for Equity Shareholders 50,00,000
No. of Equity Shares ` 1.70
85,00,000
Earning per share 
50,00,000 10
PE ratio ` 17
Market price per share
20. The CEO of a company thinks that shareholders always look for EPS.
Therefore he considers maximization of EPS as his company's objective.
His company's current Net Profits are ` 80.00 lakhs and P/E multiple is
10.5. He wants to buy another firm which has current income of ` 15.75 lakhs
& P/E multiple of 10.
What is the maximum exchange ratio which the CEO should offer so that he
could keep EPS at the current level, given that the current market price
of both the acquirer and the target company are ` 42 and ` 105
respectively?
If the CEO borrows funds at 15% and buys out Target Company by
paying cash, how much should he offer to maintain his EPS? Assume tax
rate of 30%.
(Source :- ICAI)

ANSWER:-
(i)
Acquirer Company Target Company
Net Profit ` 80 lakhs ` 15.75 lakhs
PE Multiple 10.50 10.00
Market Capitalization ` 840 lakhs ` 157.50 lakhs
Market Price ` 42 ` 105
No. of Shares 20 lakhs 1.50 lakhs
EPS `4 ` 10.50
Maximum Exchange Ratio 4 : 10.50 or 1 : 2.625
Thus, for every one share of Target Company 2.625 shares of Acquirer
Company.
(ii) Let x lakhs be the amount paid by Acquirer company to Target

Company. Then to maintain same EPS i.e. ` 4 the number of shares to be
issued will be:
 80 lakhs  15.75lakhs   0.70  15%  X  4
20 lakhs
95.75  0.105x
4
20
x = ` 150 lakhs
Thus, ` 150 lakhs shall be offered in cash to Target Company to maintain
same EPS.
21. Elrond Limited plans to acquire Doom Limited. The relevant financial details
of the two firms prior to the merger announcement are:
Elrond Limited Doom Limited
Number of outstanding shares 20 lakhs 10 Lakhs
The merger is expected to generate gains, which have a present value
of `200 lakhs. The exchange ratio agreed to is 0.5. (Source :- ICAI)

ANSWER:-
Shareholders of Doom Ltd. will get 5 lakh share of Elrond Limited, so they
will get:
5 lakh
  20% of shares Elrond Limited
20 lakh  5 lakh
The value of Elrond Ltd. after merger will be:
= ` 50 x 20 lakh + ` 25 x 10 lakh + ` 200 lakh
= ` 1000 lakh + ` 250 lakh + ` 200 lakh = ` 1450 lakh
True Cost of Merger will be:
(` 1450 x 20%) ` 290 lakhs – ` 250 lakhs = ` 40 lakhs
22. Bank 'R' was established in 2005 and doing banking in India. The bank is
facing DO OR DIE situation. There are problems of Gross NPA (Non
Performing Assets) at 40% & CAR/CRAR (Capital Adequacy Ratio/
Capital Risk Weight Asset Ratio) at 4%. The net worth of the bank is not
good. Shares are not traded regularly. Last week, it was traded @` 8 per
share.
RBI Audit suggested that bank has either to liquidate or to merge with other
bank.
Bank 'P' is professionally managed bank with low gross NPA of 5%.It has Net
NPA as 0% and CAR at 16%. Its share is quoted in the market @ ` 128
per share. The board of directors of bank 'P' has submitted a proposal to
RBI for take over of bank 'R' on the basis of share exchange ratio.
The Balance Sheet details of both the banks are as follows:
Bank ‘R’ Bank ‘P’
Amt. in ` lacs Amt. In ` lacs
Paid up share capital 140 500
Reserves & Surplus 70 5,500
Deposits 4,000 40,000
Other liabilities 890 2,500
Total Liabilities 5,100 48,500

Cash in hand & with RBI 400 2,500
Balance with other banks - 2,000
Investments 1,100 1,100
Advances 3,500 27,000
Other Assets 100 2,000
Total Assets 5,100 5,100
It was decided to issue shares at Book Value of Bank 'P' to the shareholders of
Bank 'R'. All assets and liabilities are to be taken over at Book Value.
For the swap ratio, weights assigned to different parameters are as follows:
Gross NPA 30%
CAR 20%
Market 40%
price Book value
Book value
(a) What is the swap ratio based on above weights?
(b) How many shares are to be issued?
(c) Prepare Balance Sheet after merger.
(d) Calculate CAR & Gross NPA % of Bank 'P' after merger.
(Source :- ICAI)
ANSWER:-
(a) Swap Ratio

Gross NPA 5 : 40 i.e. 5/40 x 30% = 0.0375
CAR 4 : 16 i.e. 4/16 x 20% = 0.0500
Market Price 8 : 128 i.e. 8/128 x 40% = 0.025
Book Value 15 : 120 i.e 15/120 x 10% = 0.0125
0.125
Thus for every share of Bank ‘R’ 0.125 share of Bank ‘P’ shall be issued.
(b) No. of equity shares to be issued:

Rs.140 lac
 0.125  1.75 lac share
Rs.10
(c) Balance Sheet after Merger
Calculation of Capital Reserve
Book Value of Shares ` 210.00 lac
Value of Shares issued ` 17.50 lac
Capital Reserve ` 192.50 lac
Balance Sheet
` lac ` lac
Paid up Share Capital 517.50 Cash in Hand & RBI 2900.00
Reserves & Surplus 5500.00 Balance with other banks 2000.00
Capital Reserve 192.50 Investment 16100.00
Deposits 44000.00 Advances 30500.00
Other Liabilities 3390.00 Other Assets 2100.00
53600.00 53600.00
(d) Calculation CAR & Gross NPA % of Bank ‘P’ after merger
Total Capital
CAR / CRWAR 
Risky Weighted Assets
Bank ‘R’ Bank ‘P’ Merged
Total Capital 4% 16%
Risky Weighted Assets ` 210 lac ` 6000 lac ` 6210 lac
Deposits ` 5250 lac ` 37500 lac `42750
Other Liabilities 44000.00 Advances lac
3390.00 Other Assets 30500.00
53600.00 2100.00
53600.00
Rs. 6210 lac
CAR   14.53%
Rs.42750 lac
Gross NPA
GNPA Ratio   100
Gross Deposits
GNPA (Given) 0.40 0.05 ` 6210 lac
GNPA B GNPA s
0.40  0.05 
Rs. 3500 lac Rs. 27000 lac
Gross NPA ` 1400 lac ` 1350 lac ` 2750 lac
23. The following information is provided related to the acquiring Firm Mark
Limited and the target Firm Mask Limited:
Firm Mark Limited Firm Mask Limited
Earning after tax (`) 2,000 lakhs 400 lakhs
Number of shares outstanding 200 lakhs 100 lakhs
P/E ratio (times) 10 5
Required:
(i) What is the Swap Ratio based on current market prices?
(ii) What is the EPS of Mark Limited after acquisition?
(iii) What is the expected market price per share of Mark Limited after
acquisition, assuming P/E ratio of Mark Limited remains unchanged?
(iv) Determine the market value of the merged firm.
(v) Calculate gain/loss for shareholders of the two independent companies
after acquisition.
(Source :- ICAI)
ANSWER:-
Particulars Mark Ltd. Mask Ltd.

EPS ` 2,000 Lakhs/ 200 lakhs ` 400 lakhs / 100 lakhs
= ` 10 `4
Market Price ` 10 × 10 = ` 100 ` 4 × 5 = ` 20

(i) The Swap ratio based on current market price is

` 20 / ` 100 = 0.2 or 1 share of Mark Ltd. for 5 shares of Mask Ltd.
No. of shares to be issued = 100 lakh × 0.2 = 20 lakhs.
(ii) EPS after merger
` 2,000 lakhs  ` 400 lakhs
  ` 10.91
200 lakhs  20 lakhs
(iii) Expected market price after merger assuming P / E 10 times.
= ` 10.91 × 10 = ` 109.10
(iv) Market value of merged firm
= ` 109.10 market price × 220 lakhs shares = 240.02 crores
(v) Gain from the merger
Post merger market value of the merged firm ` 240.02 crores
Less: Pre-merger market value ` 220.00 crores
Mark Ltd. 200 Lakhs × ` 100 = 200 crores ` 20.02 crores
Mask Ltd. 100 Lakhs × ` 20 = 20 crores
Gain from merger
Appropriation of gains from the merger among shareholders:

Mark Ltd. Mask Ltd.
Post merger value 218.20 crores 21.82 crores
Less: Pre-merger market value 200.00 crores 20.00 crores
Gain to Shareholders 18.20 crores 1.82 crores
24. Cauliflower Limited is contemplating acquisition of Cabbage Limited.

Cauliflower Limited has 5 lakh shares having market value of ` 40 per share
while Cabbage Limited has 3 lakh shares
having market value of ` 25 per share. The EPS for Cabbage Limited and
Cauliflower Limited are ` 3 per share and ` 5 per share respectively. The
managements of both the companies are discussing two alternatives for
exchange of shares as follows:

(i) In proportion to relative earnings per share of the two companies.

(ii) 1 share of Cauliflower Limited for two shares of Cabbage Limited.
Required:
(i) Calculate the EPS after merger under both the alternatives.
(ii) Show the impact on EPS for the shareholders of the two companies
under both the alternatives.
(Source :- ICAI)
ANSWER:-
Exchange ratio in proportion to relative EPS

(in `)
Company Existing No. of EPS Total
shares earnings
Cauliflower Ltd. 5,00,000 5.00 25,00,000
Cabbage Ltd. 3,00,000 3.00 9,00,000
Total earnings 34,00,000
No. of shares after merger 5,00,000 + 1,80,000 = 6,80,000
 3.00 
Note: 1,80,000 may be calculated as   3,00,000  
 5.00 
34,00,000
EPS for Cauliflower Ltd. after merger   ` 5.00
6,80,000
Impact on EPS
`
Cauliflower Ltd. shareholders
EPS before merger 5.00
EPS after merger 5.00
Increase/ Decrease in EPS 0.00
Cabbage Ltd.' Shareholders

EPS after the merger 5.00 x 3/5 3.00

Increase/ Decrease in EPS 0.00
Merger effect on EPS with share exchange ratio of 1 : 2

Total earnings after merger `
34,00,000
No. of shares post merger 5,00,000 + 1,50,000 (0.5 × 3,00,000) 6,50,000
EPS (34,00,000 ÷ 6,50,000) 5.23
Impact on EPS
`
Cauliflower Ltd. shareholders
Increase in EPS 0.23
Cabbage Ltd.' Shareholders
EPS after the merger 5.23 x 0.5 2.615
Decrease in EPS 0.385
25. Trupti Co. Ltd. promoted by a Multinational group “INTERNATIONAL

INC” is listed on stock exchange holding 84% i.e. 63 lakhs shares
Profit after Tax is ` 4.80 crores
Free Float Market Capitalisation is ` 19.20 crores.
As per the SEBI guidelines promoters have to restrict their holding to 75% to
avoid delisting from the stock exchange. Board of Directors has decided not
to delist the share but to comply with the SEBI guidelines by issuing Bonus
shares to minority shareholders while maintaining the same P/E ratio.

Calculate
(i) P/E Ratio
(ii) Bonus Ratio
(iii) Market price of share before and after the issue of bonus shares
(iv) Free Float Market capitalization of the company after the bonus shares.
(Source :- ICAI)
ANSWER:-
P/E Ratio:
% of holding No. of Shares
Promoter’s Holding 84% 63 Lacs
Minority Holding 16% 12 Lacs
Total Shares 100% 100%
Free Float Market Capitalization = ` 19.20 crores

Hence Market price = `160 per share
` 19.20 crores

12.00 lacs (` 4.80 crores /75 lac) = ` 6.40 per share
EPS (PAT/No. of Shares) = 25
P/E Ratio (` 160/ ` 6.40)
1. No. of Bonus Shares to be issued:

Promoters holding 84% = 63 lacs shares
Shares remains the same, but holding % to be taken as 75%
63lacs = 84 lacs
Hence Total shares 
75%
Shares of Minority = 84 lacs – 63 lacs
= 21 lacs
Bonus 9 lacs for 12 lacs i.e. 3 bonus for 4 held or 0.75 shares for 1 share

2. Market price before & after Bonus:

Before Bonus = `160 per share
After Bonus
` 4.80 crores = ` 5.71
New EPS = 
84 lacs
New Market Price (25 x ` 5.71) = ` 142.75
3. Free Float Capitalization is

` 142.75 x 21 lacs = ` 29.9775 crores
26. Longitude Limited is in the process of acquiring Latitude Limited on a

share exchange basis. Following relevant data are available:
Longitude Latitude
Limited Limited
Profit after Tax (PAT) ` in Lakhs 140 60
Number of Shares Lakhs 15 16
Earning per Share (EPS) ` 8 5
Price Earnings Ratio (P/E Ratio) 15 10
(Ignore Synergy)
You are required to determine:

(i) Pre-merger Market Value per Share, and
(ii) The maximum exchange ratio Longitude Limited can offer without the
dilution of
(1) EPS and
(2) Market Value per Share
Calculate Ratio/s up to four decimal points and amounts and number
of shares up to two decimal points.
(Source :- ICAI)

ANSWER:-
(i) Pre Merger Market Value of Per Share

P/E Ratio X EPS
Longitude Ltd. ` 8 X 15 = ` 120.00
Latitude Ltd. ` 5 X 10 = ` 50.00
(ii)
(1) Maximum exchange ratio without dilution of EPS
Pre Merger PAT of Longitude Ltd. ` 140 Lakhs
Pre Merger PAT of Latitude Ltd. ` 60 Lakhs
Combined PAT ` 200 Lakhs
Longitude Ltd. ’s EPS `8
Maximum number of shares of Longitude 25 Lakhs
after merger (` 200 lakhs/` 8)
Existing number of shares 15 Lakhs
Maximum number of shares to be exchanged 10 Lakhs
Maximum share exchange ratio 10:16 or 5:8
(2) Maximum exchange ratio without dilution of Market Price Per Share
Pre Merger Market Capitalization of Longitude Ltd. ` 1800 Lakhs
(` 120 × 15 Lakhs)
Pre Merger Market Capitalization of Latitude Ltd. ` 800 Lakhs
(` 50 × 16 Lakhs)
Combined Market Capitalization ` 2600 Lakhs
Current Market Price of share of Longitude Ltd. ` 120
Maximum number of shares to be exchanged of 21.67 Lakhs
Longitude
(surviving company) (` 2600 Lakhs/` 120) 15.00 Lakhs
Current Number of Shares of Longitude Ltd. 6.67 Lakhs
Maximum number of shares to be exchanged (Lakhs)

Maximum share exchange ratio 6.67:16 or 0.4169:1

Note: Since in the question figures given of PAT of both companies
are not matching with figures of EPS X Number of Shares. Hence, if
students computed PAT by using this formula then alternative answer
shall be as follows:
(1) Maximum exchange ratio without dilution of EPS

Pre Merger PAT of Longitude Ltd. ` 120 Lakhs
Pre Merger PAT of Latitude Ltd. ` 80 Lakhs
Combined PAT ` 200 Lakhs
Longitude Ltd. ’s EPS `8
Maximum number of shares of Longitude after 25 Lakhs
merger (` 200 lakhs/` 8)
Existing number of shares 15 Lakhs
Maximum number of shares to be exchanged 10 Lakhs
Maximum share exchange ratio 10:16 or 5:8
(2) Maximum exchange ratio without dilution of Market Price Per Share
Pre Merger Market Capitalization of Longitude Ltd. ` 1800 Lakhs
(` 120 ×15 Lakhs)
Pre Merger Market Capitalization of Latitude Ltd. ` 800 Lakhs
(` 50 ×16 Lakhs)
` 2600 Lakhs
Combined Market Capitalization ` 120
Current Market Price of share of Longitude Ltd. 21.67 Lakhs
Maximum number of shares to be exchanged of
Longitude 15.00 Lakhs
(surviving company) (` 2600 Lakhs/` 120) 6.67 Lakhs
Current Number of Shares of Longitude Ltd
Maximum number of shares to be exchanged (Lakhs)
Maximum share exchange ratio 6.67:16 or 0.4169:1
27. The following information is provided relating to the acquiring

company E Ltd., and the target company H Ltd:
Particulars E Ltd. H Ltd.
(`) (`)
Number of shares (Face value ` 10 each) 20 Lakhs 15 Lakhs
Market Capitalization 1000 Lakhs 1500 Lakhs
P/E Ratio (times) 10.00 5.00
Reserves and surplus in ` 600.00 Lakhs 600.00 Lakhs
Promoter's Holding (No. of shares) 9.50 Lakhs 10.00 Lakhs
The Board of Directors of both the companies have decided to give a

fair deal to the shareholders. Accordingly, the weights are decided as 40%,
25% and 35% respectively for earnings, book value and market price of share
of each company for swap ratio.
Calculate the following:

(i) Market price per share, earnings per share and Book Value per share;
(ii) Swap ratio;
(iii) Promoter's holding percentage after acquisition;
(iv) EPS of E Ltd. after acquisitions of H Ltd;
(v) Expected market price per share and market capitalization of E
Ltd.; after acquisition, assuming P/E ratio of E Ltd. remains unchanged;
and
(vi) Free float market capitalization of the merged firm.
(Source :- ICAI)

ANSWER:-
1.
(i)
E Ltd. H Ltd.
Market capitalisation 1000 lakhs 1500 lakhs
No. of shares 20 lakhs 15 lakhs
Market Price per share ` 50 ` 100
P/E ratio 10 `5
EPS `5 ` 20
Profit ` 100 lakh ` 300 lakh
Share capital ` 200 lakh ` 150 lakh
Reserves and surplus ` 600 lakh ` 330 lakh
Total ` 800 lakh ` 480 lakh
Book Value per share ` 40 ` 32
(ii) Calculation of Swap Ratio

EPS 1 : 4 i.e. 3.0× 40% 1.6
Book value 1 : 0.8 i.e 0.8 × 25% 0.2
Market price 1 : 2 i.e. 2.0 × 35% 0.7
Total 2.5
Swap ratio is for every one share of H Ltd., to issue 2.5 shares
of E Ltd. Hence, total no. of shares to be issued 15 lakh × 2.5 = 37.50
lakh shares
(iii) Promoter’s holding = 9.50 lakh shares + (10× 2.5 = 25 lakh
shares) = 34.50 lakh i.e. Promoter’s holding % is (34.50 lakh/57.50
lakh) × 100 = 60%.
(iv) Calculation of EPS after merger
Total No. of shares 20 lakh + 37.50 lakh = 57.50 lakh
Total Pr ofit 100 lakh  300 lakh 400
EPS   ` 6.956
No. of shares 57.50 lakh 57.50

(v) Calculation of Market price and Market capitalization after merger

Expected market price EPS 6.956 × P/E 10 = ` 69.56
Market capitalization = ` 69.56 per share ×57.50 lakh
shares
= ` 3,999.70 lakh or ` 4,000 lakh
(vi) Free float of market capitalization = ` 69.56 per share × (57.50 lakh ×
40%) = ` 1599.88 lakh
28. H Ltd. agrees to buy over the business of B Ltd. effective 1st April,
2012.The summarized Balance Sheets of H Ltd. and B Ltd. as on 31st March
2012 are as follows:
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.

Paid up Share Capital
Equity Shares of `100 each 350.00
Equity Shares of `10 each 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets: 220.00 0.50

Net Fixed Assets 1,020.00 29.00
Net Current Assets 60.00 2.00
Deferred Tax Assets
H Ltd. proposes to buy out B Ltd. and the following information is provided
to you as part of the scheme of buying:

(1) The weighted average post tax maintainable profits of H Ltd. and B
Ltd. for the last 4 years are ` 300 crores and ` 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%
(3) H Ltd. has a contingent liability of ` 300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of ` 100 each to the shareholders of B Ltd.
in terms of the exchange ratio as arrived on a Fair Value basis. (Please
consider weights of 1 and 3 for the value of shares arrived on Net
Asset basis and Earnings capitalization method respectively for both H
Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd.
under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B
Ltd. on a Fair value basis (taking into consideration the assumption
mentioned in point 4 above.)
(Source :- ICAI)
ANSWER:-
(i) Net asset value

H Ltd. ` 1300 Crores  ` 300 Crores
 ` 285.71
3.50 Crores
B Ltd. ` 31.50 Crores
 ` 48.46
0.65 Crores
(ii) Earning capitalization value

H Ltd. ` 300 Crores /0.08
 ` 1071.43
3.50 Crores
B Ltd. ` 300 Crores /0.08
 ` 192.31
0.65 Crores

(ii) Fair value

H Ltd. ` 285.71  1  ` 1071.43  3
 ` 875
4
B Ltd. ` 48.46  1  ` 192.31  3
 ` 156.3475
4
Exchange ratio `156.3475/ `875 = 0.1787
H Ltd should issue its 0.1787 share for each share of B Ltd.
Note: In above solution it has been assumed that the contingent liability
will materialize at its full amount.
29. The equity shares of XYZ Ltd. are currently being traded at ` 24 per share in
the market. XYZ Ltd. has total 10,00,000 equity shares outstanding in
number; and promoters' equity holding in the company is 40%.
PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The
estimated present value of these synergies is ` 80,00,000.
Further PQR feels that management of XYZ Ltd. has been over paid. With
better motivation, lower salaries and fewer perks for the top management,
will lead to savings of ` 4,00,000 p.a. Top management with their families are
promoters of XYZ Ltd. Present value of these savings would add ` 30,00,000
in value to the acquisition.
Following additional information is available regarding PQR Ltd.:
Earnings per share :`4
Total number of equity shares outstanding : 15,00,000
Market price of equity share : ` 40
Required:
(i) What is the maximum price per equity share which PQR Ltd. can
offer to pay for XYZ Ltd.
(ii) What is the minimum price per equity share at which the management
of XYZ Ltd. will be willing to offer their controlling interest?
(Source :- ICAI)

ANSWER:-
(a) Calculation of maximum price per share at which PQR Ltd. can offer to pay
for XYZ Ltd.’s share
Market Value (10,00,000 x ` 24) ` 2,40,00,000
Synergy Gain ` 80,00,000
Saving of Overpayment ` 30,00,000
` 3,50,00,000
Maximum Price (` 3,50,00,000/10,00,000) ` 35
Let ER be the swap ratio then,
24  10,00,000  40  15,00,000  80,00,000  30,00,000
40 
15,00,000  10,00,000  ER
ER = 0.875
40
MP  PE  EPS  ER   ` 4 x 0.875 = ` 35
4
(b) Calculation of minimum price per share at which the management of
XYZ Ltd.’s will be willing to offer their controlling interest.
Value of XYZ Ltd.’s Management Holding ` 96,00,000
(40% of 10,00,000 x ` 24)
Add: PV of loss of remuneration to top management ` 30,00,000
` 1,26,00,000
No. of Shares 4,00,000
Minimum Price (` 1,26,00,000/4,00,000) ` 31.50
30. M/s Tiger Ltd. wants to acquire M/s. Leopard Ltd. The balance sheet
of Leopard Ltd. as on 31st March, 2012 is as follows:
Liabilities ` Assets `
Retained earnings 3,00,000 Debtors 70,000
12% Debentures 3,00,000 Inventories 2,00,000
Creditors and other liabilities 3,20,000 Plants & Eqpt. 13,00,000

Additional Information:
(i) Shareholders of Leopard Ltd. will get one share in Tiger Ltd. for
every two shares. External liabilities are expected to be settled at `
5,00,000. Shares of Tiger Ltd. would be issued at its current price of ` 15
per share. Debenture holders will get 13% convertible debentures in
the purchasing company for the same amount. Debtors and
inventories are expected to realize ` 2,00,000.
(ii) Tiger Ltd. has decided to operate the business of Leopard Ltd. as
a separate division. The division is likely to give cash flows (after
tax) to the extent of ` 5,00,000 per year for 6 years. Tiger Ltd. has
planned that, after 6 years, this division would be demerged and
disposed of for ` 2,00,000.
(iii) The company’s cost of capital is 16%
Make a report to the Board of the company advising them about the
financial feasibility of this acquisition.
Net present values for 16% for ` 1 are as follows:
Years 1 2 3 4 5 6
PV .862 .743 .641 .552 .476 .410
(Source :- ICAI)
ANSWER:-
Calculation of Purchase Consideration

`
Issue of Share 35000 x `15 5,25,000
External Liabilities settled 5,00,000
13% Debentures 3,00,000
13,25,000
Less: Realization of Debtors and 2,00,000
Inventories 50,000
Cash 10,75,000
Net Present Value = PV of Cash Inflow + PV of Demerger of Leopard Ltd. –

Cash Outflow
= ` 5,00,000 PVAF(16%,6) + ` 2,00,000 PVF(16%, 6) – ` 10,75,000
= ` 5,00,000 x 3.684 + ` 2,00,000 x 0.410 – ` 10,75,000
= ` 18,42,000 + ` 82,000 – ` 10,75,000
= ` 8,49,000
Since NPV of the decision is positive it is advantageous to acquire Leopard
Ltd.
31. The following information is provided relating to the acquiring company

Efficient Ltd. and the target Company Healthy Ltd.
Efficient Ltd. Healthy Ltd
No. of shares (F.V. ` 10 each) 10.00 lakhs 7.5 lakhs
Market capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of shares) 4.75 lakhs 5.00 lakhs
Board of Directors of both the Companies have decided to give a fair deal to
the shareholders and accordingly for swap ratio the weights are decided as
40%, 25% and 35% respectively for Earning, Book Value and Market Price of
share of each company:
(i) Calculate the swap ratio and also calculate Promoter’s holding % after
acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market
capitalization of Efficient Ltd. after acquisition, assuming P/E ratio of
Firm Efficient Ltd. remains unchanged.
(iv) Calculate free float market capitalization of the merged firm.
(Source :- ICAI)

ANSWER:-
Swap Ratio
Efficient Ltd. Healthy Ltd.
Market capitalisation 500 lakhs 750 lakhs
No. of shares 10 lakhs 7.5 lakhs
Market Price per share ` 50 ` 100
P/E ratio 10 5
EPS `5 ` 20
Profit ` 50 lakh ` 150 lakh
Share capital ` 100 lakh ` 75 lakh
Reserves and surplus ` 300 lakh ` 165 lakh
Total ` 400 lakh ` 240 lakh
(i) Calculation of Swap Ratio

EPS 1 : 4 i.e 4.0 × 40% 1.6
Book value 1 : 0.8 i.e. 0.8 × 25% 0.2
Market price 1 : 2 i.e 2.0 × 35% 0.7
Total 2.5
Swap ratio is for every one share of Healthy Ltd., to issue 2.5 shares of
Efficient Ltd. Hence, total no. of shares to be issued 7.5 lakh × 2.5 = 18.75 lakh
shares.
Promoter’s holding = 4.75 lakh shares + (5 × 2.5 = 12.5 lakh shares) =

17.25 lakh i.e. Promoter’s holding % is (17.25 lakh/28.75 lakh) × 100 = 60%
Calculation of EPS, Market price, Market capitalization and free float market
capitalization.

(ii) Total No. of shares 10 lakh + 18.75 lakh = 28.75 lakh

Total capital 100 lakh + 187.5 lakh = ` 287.5 lakh
EPS Total profit 50 lakh  150 lakh 200
 
No.of shares 28.75lakh 28.75
(iii) Expected market price EPS 6.956 × P/E 10 = ` 69.56
Market capitalization = ` 69.56 per share × 28.75 lakh shares
= ` 1,999.85 lakh
(iv) Free float of market = ` 69.56 per share × (28.75 lakh × 40%)
capitalization = ` 799.94 lakh
32. The following information is relating to Fortune India Ltd. having two
division, viz. Pharma Division and Fast Moving Consumer Goods Division
(FMCG Division). Paid up share capital of Fortune India Ltd. is consisting of
3,000 Lakhs equity shares of Re. 1 each. Fortune India Ltd. decided to de-
merge Pharma Division as Fortune Pharma Ltd. w.e.f. 1.4.2009. Details
of Fortune India Ltd. as on 31.3.2009 and of Fortune Pharma Ltd. as on
1.4.2009 are given below:
Particulars Fortune Pharma Fortune India Ltd.
Ltd. `
`
Outside Liabilities
Secured Loans 400 lakh 3,000 lakh
Unsecured Loans 2,400 lakh 800 lakh
Current Liabilities & Provisions 1,300 lakh 21,200 lakh
Assets
Fixed Assets 7,740 lakh 20,400 lakh
Investments 7,600 lakh 7,600 lakh
Current Assets 8,800 lakh 30,200 lakh
Loans & Advances 900 lakh 7,300 lakh
Deferred tax/Misc. Expenses 60 lakh (200) lakh

Board of Directors of the Company have decided to issue necessary equity

shares of Fortune Pharma Ltd. of Re. 1 each, without any consideration to the
shareholders of Fortune India Ltd. For that purpose following points are to be
considered:
1. Transfer of Liabilities & Assets at Book value.
2. Estimated Profit for the year 2009-10 is ` 11,400 Lakh for Fortune India
Ltd. & ` 1,470 lakhs for Fortune Pharma Ltd.
3. Estimated Market Price of Fortune Pharma Ltd. is ` 24.50 per share.
4. Average P/E Ratio of FMCG sector is 42 & Pharma sector is 25, which is to
be expected for both the companies.
Calculate:
1. The Ratio in which shares of Fortune Pharma are to be issued to the
shareholders of Fortune India Ltd
2. Expected Market price of Fortune India (FMCG) Ltd.
3. Book Value per share of both the Companies immediately after Demerger.
(Source :- ICAI)
ANSWER:-
Share holders’ funds

(` Lakhs)
Particulars Fortune India Fortune Pharma Fortune India
Ltd. Ltd. (FMCG) Ltd.
Assets 70,000 25,100 44,900
Outside liabilities 25,000 4,100 20,900
Net worth 45,000 21,000 24,000

1. Calculation of Shares of Fortune Pharma Ltd. to be issued to

shareholders of Fortune India Ltd.
Fortune Pharma
Ltd.
Estimated Profit (` in lakhs) 1,470
Estimated market price (`) 24.5
Estimated P/E 25
Estimated EPS (`) 0.98
No. of shares lakhs 1,500
Hence, Ratio is 1 share of Fortune Pharma Ltd. for 2 shares of Fortune India
Ltd.
OR 0.50 share of Fortune Pharma Ltd. for 1 share of Fortune India Ltd.
2. Expected market price of Fortune India (FMCG) Ltd.

Fortune India (FMCG)
Ltd.
Estimated Profit (` in lakhs) 11,400
No. of equity shares (` in lakhs) 3,000
Estimated EPS (`) 3.8
Estimated P/E 42
Estimated market price (`) 159.60
3. Book value per share

Fortune Pharma Fortune India (FMCG)
Ltd. Ltd.
Net worth (ìn lakhs) 21,000 24,000
No. of shares (` in lakhs) 1,500 3,000
Book value of shares ` 14 `8

33. MK Ltd. is considering acquiring NN Ltd. The following information is

available:
Company Earning after No. of Equity Market Value
Tax (`) Shares Per Share (`)
MK Ltd. 60,00,000 12,00,000 200.00
NN Ltd. 18,00,000 3,00,000 160.00
Exchange of equity shares for acquisition is based on current market value as
above. There is no synergy advantage available.
(i) Find the earning per share for company MK Ltd. after merger, and
(ii) Find the exchange ratio so that shareholders of NN Ltd. would not be at a
loss.
(Source :- ICAI)
ANSWER:-
(i) Earning per share of company MK Ltd after merger:-

Exchange ratio 160 : 200 = 4 : 5.
that is 4 shares of MK Ltd. for every 5 shares of NN Ltd.
∴Total number of shares to be issued = 4/5 × 3,00,000 = 2,40,000 Shares.
∴Total number of shares of MK Ltd. and NN Ltd.=12,00,000 (MK
Ltd.)+2,40,000 (NN Ltd.)
= 14,40,000 Shares
Total profit after tax = ` 60,00,000 MK Ltd.
= ` 18,00,000 NN Ltd.
= ` 78,00,000
∴ EPS. (Earning Per Share) of MK Ltd. after merger
` 78,00,000/14,40,000 = ` 5.42 per share
(ii) To find the exchange ratio so that shareholders of NN Ltd. would not be at
a Loss:
Present earning per share for company MK Ltd.
= ` 60,00,000/12,00,000 = ` 5.00
Present earning per share for company NN Ltd.

= ` 18,00,000/3,00,000 = ` 6.00
∴ Exchange ratio should be 6 shares of MK Ltd. for every 5 shares of NN
Ltd.
∴ Shares to be issued to NN Ltd. = 3,00,000 × 6/5 = 3,60,000 shares
Now, total No. of shares of MK Ltd. and NN Ltd. =12,00,000 (MK
Ltd.)+3,60,000 (NN Ltd.)
= 15,60,000 shares
∴ EPS after merger = ` 78,00,000/15,60,000 = ` 5.00 per share
Total earnings available to shareholders of NN Ltd. after merger =
3,60,000 shares × ` 5.00 = ` 18,00,000
This is equal to earnings prior merger for NN Ltd.
∴ Exchange ratio on the basis of earnings per share is recommended.
34. P Ltd. is considering take-over of R Ltd. by the exchange of four new shares
in P Ltd. for every five shares in R Ltd. The relevant financial details of
the two companies prior to merger announcement are as follows:
P Ltd R Ltd
Profit before Tax (` Crore) 15 13.50
No. of Shares (Crore) 25 15
P/E Ratio 12 9
Corporate Tax Rate 30%

You are required to determine:
(i) Market value of both the company.
(ii) Value of original shareholders.
(iii) Price per share after merger.
(iv) Effect on share price of both the company if the Directors of P Ltd.
expect their own pre-merger P/E ratio to be applied to the combined
earnings
(Source :- ICAI)
ANSWER:-
P Ltd. R Ltd.
Profit before Tax (` in crore) 15 13.50
Tax 30% (` in crore) 4.50 4.05
Profit after Tax (` in crore) 10.50 9.45
Earning per Share (`) 10.50 9.50
 ` 0.42  ` 0.63
25 15
Price of Share before Merger (EPS ` 0.42 x 12 = ` 5.04 `0.63 x 9 = `
x P/E Ratio) 5.67
(i) Market Value of company

P Ltd. = ` 5.04 x 25 Crore = ` 126 crore
R Ltd. = ` 5.67 x 15 Crore = ` 85.05 crore
Combined = ` 126 + ` 85.05 = ` 211.05 Crores
After Merger
P Ltd. R Ltd.
No. of Shares 25 crores 4
15   12 crores
5
Combined 37 crores
% of Combined Equity 25 12
 100  67.57%  100  32.43%
Owned 37 37
(ii) Value of Original Shareholders

P Ltd. R Ltd.
` 211.05 crore x 67.57% ` 211.05 crore x 32.43%
= ` 142.61 = ` 68.44


Combined Value of Entity 211.05 crore
No. of shares after Merger 37 crore
Value of Per Share ` 5.70405
Value of P Ltd. Shareholders (25 crores x ` 5.70405) ` 142.60 crore
Value of R Ltd. Shareholders (12 crores x ` 5.70405) ` 68.45 crore
(iii) Price per Share after Merger

` 19.95 crore
EPS   ` 0.539 per share
37 crore
P/E Ratio = 12
Market Value Per Share = ` 0.539 X 12 = ` 6.47
Total Market Value = ` 6.47 x 37 crore = ` 239.39 crore
MarketValue 239.39 crore
Price of Share   ` 6.47
Number of Shares 37 crore
(iv) Effect on Share Price
P Ltd.
Gain/loss (-) per share = ` 6.47 – ` 5.04 = ` 1.43
6.47  5.04
i.e  100  0.284 or 28.4%
5.04
∴ Share price would rise by 28.4%
R Ltd.
4
6.47  ` 5.18
5
Gain/loss (-) per share = ` 5.18 – ` 5.67 = (-` 0.49)
5.18  5.67
i.e  100    0.864 or    8.64%
5.67
∴ Share Price would decrease by 8.64%.

35. Using the chop-shop approach (or Break-up value approach), assign a
value for Cranberry Ltd. whose stock is currently trading at a total market
price of €4 million. For Cranberry Ltd, the accounting data set forth three
business segments: consumer wholesale, retail and general centers. Data
for the firm’s three segments are as follows:
Business Segment Sales Segment Segment
Segment Assets Operating Income
Wholesale €225,000 €600,000 €75,000
Retail €720,000 €500,000 €150,000
General € 2,500,000 €4,000,000 €700,000
Industry data for “pure-play” firms have been compiled and are summarized
as follows:
Business Capitalization/ Capitalization/ Capitalization/
Segment Sales Assets Operating Income
Wholesale 0.85 0.7 9
Retail 1.2 0.7 8
General 0.8 0.7 4
(Source :- ICAI)
ANSWER:-
Business Capital-to-Sales Segment Sales Theoretical

Segment Values
Wholesale 0.85 €225000 €191250
Retail 1.2 €720000 €864000
General 0.8 €2500000 €2000000
Total value €3055250

Business Capital-to- Segment Assets Theoretical

Segment Assets Values
Wholesale 0.7 €600000 €420000
Retail 0.7 €500000 €350000
General 0.7 €4000000 €2800000
Business Capital-to- Operating Theoretical

Segment Operating Income Values
Income
Wholesale 9 €75000 €675000
Retail 8 €150000 €1200000
General 4 €700000 €2800000
3055250  3570000  4675000

Average theoretical value   3766750
3
Average theoretical value of Cranberry Ltd. = €3766750
36. AB Ltd., is planning to acquire and absorb the running business of XY Ltd.
The valuation is to be based on the recommendation of merchant bankers
and the consideration is to be discharged in the form of equity shares to be
issued by AB Ltd. As on 31.3.2006, the paid up capital of AB Ltd. consists of
80 lakhs shares of `10 each. The highest and the lowest market quotation
during the last 6 months were `570 and `430. For the purpose of the
exchange, the price per share is to be reckoned as the average of the highest
and lowest market price during the last 6 months ended on 31.3.06.

` lakhs
Sources
Share Capital
20 lakhs equity shares of `10 each fully paid 200
10 lakhs equity shares of `10 each, `5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200

350
An independent firm of merchant bankers engaged for the negotiation,

have produced the following estimates of cash flows from the business of XY
Ltd.:
Year ended By way of ` lakhs
after tax earnings for equity 105
31.3.07 Do 120
31.3.08 Do 125
31.3.09 Do 120
31.3.10 Do 100
31.3.11 terminal value estimate 200
It is the recommendation of the merchant banker that the business of XY Ltd.

may be valued on the basis of the average of (i) Aggregate of discounted cash
flows at 8% and (ii) Net assets value. Present value factors at 8% for years
1-5 0.93 0.86 0.79 0.74 0.68

(i) Calculate the total value of the business of XY Ltd.

(ii) The number of shares to be issued by AB Ltd.; and
(iii) The basis of allocation of the shares among the shareholders of XY Ltd.
(Source :- ICAI)
ANSWER:-
Price/share of AB Ltd. for determination of number of shares to be issued:
(` 570 + ` 430)/2 ` 500

Value of XY Ltd based on future cash flow
capitalization ` lakhs 592.40
(105x0.93)+(120x0.86)+(125x0.79)+(120x0.74)x(300x0.68) ` lakhs 250.00
Value of XY Ltd based on net assets 421.20
Average value (592.40+250)/2 Nos. 84240
No. of shares in AB Ltd to be issued ` 4,21,20,000/500
Basis of allocation of shares 2500000
Fully paid equivalent shares in XY Ltd. (20+5) lakhs
Distribution to fully paid shareholders 84240x20/25 67392
Distribution to partly paid shareholders 84240-67392 16848
37. A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares
for every one share of T Ltd.). Following information is provided:
A Ltd. T. Ltd.
Profit after tax `18,00,000 `3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS `3 `2
PE Ratio 10 times 7 times
Market price per share `30 `14

Required:
(i) The number of equity shares to be issued by A Ltd. for acquisition of T
Ltd.
(ii) What is the EPS of A Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of T Ltd.
(iv) What is the expected market price per share of A Ltd. after the
acquisition, assuming its PE multiple remains unchanged?
(v) Determine the market value of the merged firm.
(Source :- ICAI)
ANSWER:-
(i) The number of shares to be issued by A Ltd.:

The Exchange ratio is 0.5
So, new Shares = 1,80,000 x 0.5 = 90,000 shares.
(ii) EPS of A Ltd. After a acquisition:

Total Earnings (` 18,00,000 + ` 3,60,000) `21,60,000
No. of Shares (6,00,000 + 90,000) 6,90,000
EPS (` 21,60,000)/6,90,000) `3.13
(iii) Equivalent EPS of T Ltd.:

No. of new Shares 0.5
EPS `3.13
Equivalent EPS (` 3.13 x 0.5) `1.57
(iv) New Market Price of A Ltd. (P/E remaining unchanged):

Present P/E Ratio of A Ltd. 10 times
Expected EPS after merger ` 3.13
Expected Market Price (`3.13 x 10) ` 31.30

(v) Market Value of merged firm:

Total number of Shares 6,90,000
Expected Market Price `31.30
Total value (6,90,000 x 31.30) `2,15,97,000
38. The following information relating to the acquiring Company Abhiman

Ltd. and the target Company Abhishek Ltd. are available. Both the
Companies are promoted by Multinational Company, Trident Ltd. The
promoter’s holding is 50% and 60% respectively in Abhiman Ltd. and
Abhishek Ltd. :
Abhiman Ltd. Abhishek Ltd.
Share Capital (`) 200 lakh 100 lakh
Free Reserve and Surplus (`) 800 lakh 500 lakh
Paid up Value per share (`) 100 10
Free float Market Capitalisation (`) 400 lakh 128 lakh
Trident Ltd. is interested to do justice to the shareholders of both the
Companies. For the swap ratio weights are assigned to different parameters
by the Board of Directors as follows:
Book Value 25%
EPS (Earning per share) 50%
Market Price 25%
(a) What is the swap ratio based on above weights?

(b) What is the Book Value, EPS and expected Market price of Abhiman
Ltd. after acquisition of Abhishek Ltd. (assuming P.E. ratio of
Abhiman Ltd. remains unchanged and all assets and liabilities of
Abhishek Ltd. are taken over at book value).

(c) Calculate:
(i) Promoter’s revised holding in the Abhiman Ltd.
(ii) Free float market capitalization.
(iii) Also calculate No. of Shares, Earning per Share (EPS) and Book
Value (B.V.), if after acquisition of Abhishek Ltd., Abhiman Ltd.
decided to :
(a) Issue Bonus shares in the ratio of 1 : 2; and
(b) Split the stock (share) as ` 5 each fully paid.
(Source :- ICAI)
ANSWER:-
(a) Swap Ratio

Abhiman Ltd. Abhishek Ltd.
Share Capital 200 Lakh 100 Lakh
Free Reserves 800 Lakh 500 Lakh
Total 1000 Lakh 600 Lakh
No. of Shares 2 Lakh 10 Lakh
Promoter’s holding 50% 60%
Non promoter’s holding 50% 40%
Free Float Market Cap. i.e. 400 Lakh 128 Lakh
relating to Public’s holding 320 Lakh
Hence Total market Cap 800 Lakh 10 Lakh
No. of Shares 2 Lakh ` 32
Market Price ` 400 4
P/E Ratio 10 8
EPS 40 -
Profits (` 2 X 40 lakh) ` 80 lakh
(` 8 X 10 lakh) - ` 80 lakh

Calculation of Swap Ratio

Book Value 1 : 0.12 i.e. 0.12 x 25% 0.03
EPS 1 : 0.2 0.20 x 50% 0.10
Market Price 1 : 0.08 0.08 x 25% 0.02
Total 0.15
Swap ratio is for every one share of Abhishek Ltd., to issue 0.15 shares
of Abhiman Ltd.
Hence total no. of shares to be issued.
10 Lakh x 0.15 = 1.50 lakh shares
(b) Book Value, EPS & Market Price

Total No of Shares 2 Lakh + 1.5 Lakh = 3.5 Lakh
Total Capital ` 200 Lakh + ` 150 Lakh = ` 350 Lakh
Reserves ` 800 Lakh + ` 450 Lakh = ` 1,250 Lakh
Book Value ` 350 Lakh + ` 1,250 Lakh
= ` 457.14 per share
3.5 Lakh
EPS Total Pr ofit ` 80 Lakh ` 80 Lakh ` 160 Lakh
 
No.of Share 3.5 Lakh 3.5
= ` 45.71
Expected Market Price EPS (` 45.71) x P/E Ratio (10) = ` 457.10
(c)
(1) Promoter’s holding
Promoter’s Revised Abhiman 50% i.e. 1.00 Lakh shares
Holding Abhishek 60% i.e. 0.90 Lakh shares
Total 1.90 Lakh shares
Promoter’s % = 1.90/3.50 x 100 = 54.29%

(2) Free Float Market Capitalisation

Free Float Market = (3.5 Lakh – 1.9 Lakh) x ` 457.10
Capitalisation = ` 731.36 Lakh
(3) (i) & (ii)

Revised Capital ` 350 Lakh + ` 175 Lakh = ` 525 Lakh
No. of shares before Split (F.V ` 100) 5.25 Lakh
No. of Shares after Split (F.V. ` 5 ) 5.25 x 20 = 105 Lakh
EPS 160 Lakh / 105 Lakh = 1.523

Book Value Cap. ` 525 Lakh + ` 1075 Lakh
No. of Shares = 105 Lakh
= ` 15.238 per share
39. XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for
each share of ABC Ltd. Relevant financial data are as follows:
Equity shares outstanding 10,00,000 4,00,000
EPS (`) 40 28
Market price per share (`) 250 160
(i) Illustrate the impact of merger on EPS of both the companies.

(ii) The management of ABC Ltd. has quoted a share exchange ratio of
1:1 for the merger. Assuming that P/E ratio of XYZ Ltd. will remain
unchanged after the merger, what will be the gain from merger for ABC
Ltd.?
(iii) What will be the gain/loss to shareholders of XYZ Ltd.?
(iv) Determine the maximum exchange ratio acceptable to shareholders of
XYZ Ltd.
(Source :- ICAI)

ANSWER:-
1. Working Notes
a)
XYZ Ltd. ABC Ltd.
EPS ` 40 ` 28
Profit ` 400,00,000 ` 112,00,000
PE Ratio 6.25 5.71
b) EPS after merger

No. of shares to be issued (4,00,000 x 0.70) 2,80,000
Exiting Equity shares outstanding 10,00,000
Equity shares outstanding after merger 12,80,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 40
(i) Impact of merger on EPS of both the companies

XYZ Ltd. ABC Ltd.
EPS after Merger ` 40 ` 28
EPS before Merger ` 40 ` 28*
Nil Nil
* ` 40 x 0.70
(ii) Gain from the Merger if exchange ratio is 1: 1

No. of shares to be issued 4,00,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 36.57
Market Price of Share (` 36.57 x 6.25) ` 228.56

Market Price of Share before Merger ` 160.00
Impact (Increase/ Gain) ` 68.56
(iii) Gain/ loss from the Merger to the shareholders of XYZ Ltd.
Market Price of Share ` 228.56
Loss from the merger (per share) ` 21.44
(iv) Maximum Exchange Ratio acceptable to XYZ Ltd. shareholders

` Lakhs
Market Value of Merged Entity (` 228.57 x 1400000) 3199.98
Less: Value acceptable to shareholders of XYZ Ltd. 2500.00
Value of merged entity available to shareholders of ABC Ltd. 699.98
Market Price Per Share 250
No. of shares to be issued to the shareholders of ABC Ltd. 2.80
(lakhs)
Thus maximum ratio of issue shall be 2.80 : 4.00 or 0.70 share of XYZ Ltd.
for one share of ABC Ltd.
40. Company X is contemplating the purchase of Company Y, Company X has

3,00,000 shares having a market price of ` 30 per share, while Company Y has
2,00,000 shares selling at ` 20 per share. The EPS are ` 4.00 and ` 2.25 for
Company X and Y respectively. Managements of both companies are
discussing two alternative proposals for exchange of shares as indicated
below:
(i) in proportion to the relative earnings per share of two companies.
(ii) 0.5 share of Company X for one share of Company Y (0.5:1).

You are required:

(i) to calculate the Earnings Per share (EPS) after merger under two
alternatives; and
(ii) to show the impact of EPS for the shareholders of two companies under
both the alternatives.
(Source :- ICAI)
ANSWER:-
Working Notes: Calculation of total earnings after merger

Particulars Company X Company Y Total
Outstanding shares 3,00,000 2,00,000
EPS (`) 4 2.25
Total earnings (`) 12,00,000 4,50,000 16,50,000
(i) (a) Calculation of EPS when exchange ratio is in proportion to relative EPS
of two companies
Company X 3,00,000
Company Y 2,00,000 x 2.25/4 1,12,500
Total number of shares after merger 4,12,500
Company X
EPS before merger = `4
EPS after merger = ` 16,50,000/4,12,500 shares = `4
Company Y
EPS before merger = ` 2.25
EPS after merger
= EPS of Merged Entity after merger x Share Exchange ratio
on EPS basis = ` 2.25
2.25
 ` 4
4

(b) Calculation of EPS when share exchange ratio is 0.5 : 1

Total earnings after merger = ` 16,50,000
Total number of shares after merger = 3,00,000 + (2,00,000 x 0.5)
= 4,00,000 share
EPS after merger = ` 16,50,000/4,00,000 = ` 4.125
(ii) Impact of merger on EPS for shareholders of Company X and Company Y

(a) Impact on Shareholders of Company X
(`)
(b) Impact on Shareholders of Company Y

(`)
Equivalent EPS before merger 2.2500
Equivalent EPS after merger 2.0625
41. AXE Ltd. is interested to acquire PB Ltd. AXE has 50,00,000 shares of ` 10
each, which are presently being quoted at ` 25 per share. On the other
hand PB has 20,00,000 share of ` 10 each currently selling at ` 17. AXE and
PB have EPS of ` 3.20 and ` 2.40 respectively.
a. Show the impact of merger on EPS, in case if exchange ratio is based on
relative proportion of EPS.
b. Suppose, if AXE quote an offer of share exchange ratio of 1:1, then
should PB accept the offer or not, assuming that there will be no
change in PE ratio of AXE after the merger.
c. The maximum ratio likely to acceptable to management of AXE.
(Source :- ICAI)
ANSWER:-
` 240  EPS of PBLtd.

(a) Exchange Ratio   0.75
` 3.20  EPS of AXE Ltd. 
Earning of AXE Ltd. = ` 3.20 х 50,00,000 = ` 1,60,00,000
Earning of PB Ltd. = ` 2.40 х 20,00,000 = ` 48,00,000
Combined earnings after merger = ` 2,08,00,000
Total No. of shares to be issued to PB Ltd. 0.75 х 20,00,000 = 15,00,000
Existing No. of Shares of AXE Ltd. = 50,00,000
65,00,000
208,00,000
EPS after Merger ` 3.20
65,00,000
Statement showing impact on EPS
AXE Ltd. PB Ltd. `
`
EPS before merger 3.20 2.40
EPS after merger (Equivalent in case of PB Ltd.) 3.20 2.40
Thus, there is will be no change in EPS for shareholder of both companies
(b) No. of shares to be issued to AB Ltd. (1:1) 20,00,000

AXE Ltd. PB Ltd.
EAT (`) (A) 160,00,000 48,00,000
No. of Shares (B) 50,00,000 20,00,000
EPS (A)/(B) 3.20 2.40
Market Price Per Share 25 17
PE Ratio 7.8125 7.0833
Market Value of Company AXE Ltd. (50,00,000 x ` 25) ` 1250 lakh ` 340
PB Ltd. (20,00,000 x ` 17) lakh

Position after Merger

EAT after Merger (`160 + ` 48 ) lakhs (C) 208,00,000
No. of Shares (50,00,000 +20,00,000) (D) 70,00,000
EPS after merger (C)/(D) =(E) 208/70
PE Ratio of merger company consuming same as a AXE Ltd. (F) 7.8125
MPS (E) x(F) = (G) 23.21
Market Value of Merged Entity = (G) x (D) =(H) `1624.70
Gain from Merger [(H) - `1250 lakhs - ` 340 lakhs)] lakh
34.70 lakhs
Gain to Shareholders of PB Ltd.

` in lakh
Post Merger Value of PB Ltd (20,00,000 x ` 23.21) 464.20
Less: Pre Merger Value 340.00
Gain to Shareholders of PB Ltd. 124.20
Thus PB Ltd. should accept the offer.
42. ABC Ltd. is intending to acquire XYZ Ltd. by merger and the following
information is available in respect of the companies:
ABC Ltd. XYZ Ltd.
Number of equity shares 10,00,000 6,00,000
Earnings after tax (`) 50,00,000 18,00,000
Market value per share (`) 42 28
Required:
(i) What is the present EPS of both the companies?
(ii) If the proposed merger takes place, what would be the new earning
per share for ABC Ltd.? Assume that the merger takes place by
exchange of equity shares and the exchange ratio is based on the
current market price.

(iii) What should be exchange ratio, if XYZ Ltd. wants to ensure the earnings
to members are as before the merger takes place?
(Source :- ICAI)
ANSWER:-
(i) Earnings per share = Earnings after tax /No. of equity shares
ABC Ltd. = ` 50,00,000/10,00,000 = ` 5
XYZ Ltd. = ` 18,00,000 / 6,00,000 = ` 3
(ii) Number of Shares XYZ limited’s shareholders will get in ABC Ltd.
based on market value per share = ` 28/ 42 × 6,00,000 = 4,00,000 shares
Total number of equity shares of ABC Ltd. after merger = 10,00,000
+ 4,00,000 = 14,00,000 shares
Earnings per share after merger = ` 50,00,000 + 18,00,000/14,00,000 = `
4.86
(iii) Calculation of exchange ratio to ensure shareholders of XYZ Ltd.
to earn the same as was before merger:
Shares to be exchanged based on EPS = (` 3/` 5) × 6,00,000 = 3,60,000
shares
EPS after merger = (` 50,00,000 + 18,00,000)/13,60,000 = ` 5
Total earnings in ABC Ltd. available to shareholders of XYZ Ltd. =
3,60,000 × ` 5 = ` 18,00,000.
Thus, to ensure that Earning to members are same as before, the ratio of
exchange should be 0.6 share for 1 share.
43. K. Ltd. is considering acquiring N. Ltd., the following information is

available :
Company Profit after Tax Number of Equity Market value per
shares share
K. Ltd. 50,00,000 10,00,000 200.00
N. Ltd. 15,00,000 2,50,000 160.00

Exchange of equity shares for acquisition is based on current market value as

above. There is no synergy advantage available :
Find the earning per share for company K. Ltd. after merger.
Find the exchange ratio so that shareholders of N. Ltd. would not be at a loss.
(Source :- ICAI)
ANSWER:-
(i) 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.
4
 Total number of shares to be issued   2, 50,000  2,00,000 share
5
Total number of shares of K. Ltd. and N. Ltd. = 10,000 k Ltd.
+ 2,00,000 N Ltd.
12,00,000
Total profit after Tax = ` 50,00,000 K. Ltd.
` 15,00,000 N Ltd.
` 65,00,000
E.P.S. (Earning per share) of K. Ltd. after Merger

` 65,00,000
  ` 5.42 Per Share
12,00,000
(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.
` 50,00,000
  ` 5.00
` 10,00,000
Present Earnings Per share for company N. Ltd.
`15,00,000
  ` 6.00
`2, 50,000
Exchange Ratio should be 6 shares of K. Ltd. for every 5 shares of N
Ltd.

 Shares to be issued to N. Ltd

2, 50,000  6
  3,00,000 Shares
5
Total No. of Shares of K.Ltd. and N. Ltd.
= 10,00,000 K. Ltd.
+3,00,000 N. Ltd
13,00,000
65,00,000
 E.P.S. After Merger  ` 5.00 Per Share
13,00,000
Total Earnings Available to Shareholders of N. Ltd. after Merger
= ` 3,00,000 × ` 5.00 = ` 15,00,000
This is equal to Earnings prior Merger for N. Ltd.
 Exchange Ratio on the Basis of Earnings per Share is recommended.
44. Herbal Gyan is a small but profitable producer of beauty cosmetics using the
plant Aloe Vera. This is not a high-tech business, but Herbal’s earnings have
averaged around ` 12 lakh after tax, largely on the strength of its patented
beauty cream for removing the pimples.
The patent has eight years to run, and Herbal has been offered ` 40
lakhs for the patent rights. Herbal’s assets include ` 20 lakhs of working
capital and ` 80 lakhs of property, plant, and equipment. The patent is not
shown on Herbal’s books. Suppose Herbal’s cost of capital is 15 percent.
What is its Economic Value Added (EVA)?
(Source :- ICAI)
ANSWER:-
EVA = Income earned – (Cost of capital x Total Investment)

Total Investments
Particulars Amount
Working capital ` 20 lakhs
Property, plant, and equipment ` 80 lakhs

Patent rights ` 40 lakhs

Total ` 140 lakhs
Cost of Capital 15%
EVA= ` 12 lakh – (0.15 x ` 140 lakhs) = ` 12 lakh – ` 21 lakh = -` 9 lakh
Thus Herbal Gyan has a negative EVA of ` 9 lakhs.
45. A Ltd. is studying the possible acquisition of B Ltd. by way of merger. The
following data are available:
Firm After-tax No. of equity Market price per
earnings shares share
A Ltd. ` 10,00,000 2,00,000 ` 75
B Ltd. ` 3,00,000 50,000 ` 60
(i) If the merger goes through by exchange of equity shares and the exchange
ratio is set according to the current market prices, what is the new
earnings per share for A Ltd..
(ii) B Ltd. wants to be sure that its earning per share is not diminished by the
merger. What exchange ratio is relevant to achieve the objective?
(Source :- ICAI)
ANSWER:-
(i) The current market price is the basis of exchange of equity shares,
in the proposed merger, shareholders of B Ltd. will get only 40,000
shares in all or 4 shares of A Ltd. for every 5 shares held by them, i.e.,
50,000  60
 40,000
75
The total number of shares in A Ltd. will then be 2,40,000 and, ignoring
any synergistic effect, the profit will be ` 13,00,000.The new earning
per share (EPS) of A Ltd. will be ` 5.42, i.e., ` 13,00,000/2,40,000.
(ii) The present earnings per share of B Ltd. is `6/- (` 3,00,000 ÷ 50,000) and
that of A Ltd. is `5/-, i.e., ` 10,00,000 ÷ 2,00,000.If B Ltd. wants to
ensure that, even after merger, the earning per share of its
shareholders should remain unaffected, then the exchange ratio will be 6
shares for every 5 shares.
The total number of shares of A Ltd. that will produce ` 3,00,000 profit is
60,000, (3,00,000 ÷ 5), to be distributed among, shareholders of B Ltd.,
giving a ratio of 6 shares in A for 5 shares in B.
Proof:
The shareholders of B Ltd. will get in all 60,000 share for 50,000 shares. It
means after merger,
` 13,00,000
their earning per share will be ` 5/- i.e
2,60,000
In all they will get ` 3,00,000, i.e., 60,000 x 5, as before.
46. There are two companies ABC Ltd. and XYZ Ltd. are in same in
industry. On order to increase its size ABC Ltd. made a takeover bid for
XYZ Ltd.
Equity beta of ABC and XYZ is 1.2 and 1.05 respectively. Risk Free
Rate of Return is 10% and Market Rate of Return is 16%. The growth
rate of earnings after tax of ABC Ltd. in recent years has been 15% and
XYZ’s is 12%. Further both companies had continuously followed constant
dividend policy.
Mr. V, the CEO of ABC requires information about how much premium
above the current market price to offer for XYZ’s shares.
Two suggestions have forwarded by merchant bankers.
(i) Price based on XYZ’s net worth as per B/S, adjusted in light of
current value of assets and estimated after tax profit for the next 5 years.
(ii) Price based on Dividend Valuation Model, using existing growth rate
estimates.

Summarised Balance Sheet of both companies is as follows.
(` In lacs)
ABC XYZ ABC XYZ
Ltd. Ltd. Ltd. Ltd.
Equity Share 2,000 1,000 Land & 5,600 1,500
Capital 4,000 3,000 Building 7,200 2,800
General Reserves 4,200 2,200 Plant &
Share Premium 5,200 1,000 Machinery
Long Term Loans
CurrentLiabilities
Sundry Creditors 2,000 1,100
3,400 2,400
CurrentAssets
Bank Overdraft 300 100 Accounts 3,000 2,100
Tax Payable 1,200 400 Receivable 200 400
Dividend 500 400 Stock - -
Payable 19,400 9,200 Bank/Cash 19,400 9,200
Profit & Loss A/c

(` In lacs)
ABC XYZ ABC XYZ
Ltd. Ltd. Ltd. Ltd.
To Net Interest 1,200 220 By Net Profit 7,000 2,550
To Taxation 2,030 820
To Distributable Profit 3,770 1,510 - -
7,000 2,550 7,000 2,550

To Dividend 1,130 760 By Distributable 3,770 1,510

Profit
To Balance c/d 2,640 750 - -
3,770 1,510 3,770 1,510
Additional information
1. ABC Ltd.’s land & building have been recently revalued. XYZ Ltd.’s have
not been revalued for 4 years, and during this period the average
value of land & building have increased by 25% p.a.
2. The face value of share of ABC Ltd. is ` 10 and of XYZ Ltd. is ` 25 per
share.
3. The current market price of shares of ABC Ltd. is ` 310 and of XYZ Ltd.’s `
470 per share.
With the help of above data and given information you are required to
calculate the premium per share above XYZ’s current share price by two
suggested valuation methods. Discuss which of these two values should
be used for bidding the XYZ’s shares.
State the assumptions clearly, you make.
(Source :- ICAI)
ANSWER:-
(a) Net Assets Method

To compute the value of shares as per this method we shall
compute the Net Assets
(i) Value of Land & Building of XYZ Ltd. = ` 1,500 lac (1.25)4 = ` 3,662.11
lac. Thus, net asset value will be:
Land & Building 3,662.11 lac
Plant & Machinery 2,800.00 lac
Account Receivable 2,400.00 lac
Stock 2,100.00 lac

Bank/Cash 400.00 lac

11,362.11 lac
Less: Bank Overdraft 100.00 lac
Sundry Creditors 1,100.00 lac
Tax Payable 400.00 lac
Dividend Payable 400.00 lac
Long Term Loan 1,000.00 lac
8362.11 lac
(ii) Estimated profit for next 5 years

= ` 1,510 lac (1.12) + ` 1,510 lac (1.12)2 + ` 1,510 lac (1.12)3 + ` 1,510
lac (1.12)4 + ` 1,510 lac (1.12)5
= ` 1,691.20 lac + ` 1,894.14 lac + ` 2,121.44 lac + ` 2,376.01
lac + ` 2,661.14 lac = ` 10,743.93 lac.
The total yield value= ` 8,362.11 lac + ` 10,743.93 lac = ` 19,106.04 lac
XYZ Ltd.s share’s current market value = ` 470 x 40 lacs shares
= ` 1,88,00,00,000 = ` 18,800 lac
The premium is thus ` 306.04 lac (` 19,106.04 lac – ` 18,800 lac) i.e. `
7.65 per share or 1.63% [7.65/470].
This is not a sound basis for valuation as it ignores the time
value of money. The premium of 1.63% above the current market
price is very small compared to those achieved in many real bids.
(b) Dividend Valuation Model

D1 D 1  g 
Po   0
Ke  g Ke  g
760 lac
D0   19 per share.
40 lac
Thus D1 = ` 19(1+0.12) = ` 21.28
Ke using CAPM
Ke = Rf +βj (Rm - Rf) =10% + 1.05(16% - 10%) = 16.3%
` 21.28 ` 21.28
P0    ` 494.88 per share
16.3%  12% 4.3%
The premium is ` 24.88 (` 494.88 – ` 470) i.e. 5.29% above the
current market price.
Thus, this method should be used for bidding shares of XYZ Ltd.’s share
Assumptions
 Valuation is based on a constant growth rate and unchanged dividend
policy.
 It will be more rational to assess the value of XYZ Ltd.
incorporating post merger synergies.
47. The equity shares of XYZ Ltd. are currently being traded at ` 24 per share in
the market. XYZ Ltd. has total 10,00,000 equity shares outstanding in
number; and promoters' equity holding in the company is 40%.
PQR Ltd. wishes to acquire XYZ Ltd. because of likely synergies. The
estimated present value of these synergies is ` 80,00,000.
Further PQR feels that management of XYZ Ltd. has been over paid.
With better motivation, lower salaries and fewer perks for the top
management, will lead to savings of ` 4,00,000 p.a. Top management with
their families are promoters of XYZ Ltd. Present value of these savings would
add ` 30,00,000 in value to the acquisition.
Following additional information is available regarding PQR Ltd.:
Earnings per share : `4
Total number of equity shares outstanding : 15,00,000
Market price of equity share : ` 40
Required:
(i) What is the maximum price per equity share which PQR Ltd. can
offer to pay for XYZ Ltd.?
(ii) What is the minimum price per equity share at which the management of
XYZ Ltd. will be willing to offer their controlling interest?
(Source :- ICAI)
ANSWER:-
(a) Calculation of maximum price per share at which PQR Ltd. can offer to pay
for XYZ Ltd.’s share.
Market Value (10,00,000 x ` 24) ` 2,40,00,000

Synergy Gain ` 80,00,000
Saving of Overpayment ` 30,00,000
Maximum Price (` 3,50,00,000/10,00,000) ` 3,50,00,000
` 35
(b) Calculation of minimum price per share at which the management of XYZ
Ltd.’s will be willing to offer their controlling interest
Value of XYZ Ltd.’s Management Holding ` 96,00,000
(40% of 10,00,000 x ` 24)
Add: PV of loss of remuneration to top management ` 30,00,000
` 1,26,00,000
No. of Shares 4,00,000
Minimum Price (` 1,26,00,000/4,00,000) ` 31.50

48. BA Ltd. and DA Ltd. both the companies operate in the same
industry. The Financial statements of both the companies for the current
financial year are as follows:
Balance Sheet
Particulars BA Ltd. (`) DA Ltd. (`)
Current Assets 14,00,000 10,00,000
Fixed Assets (Net) 10,00,000 5,00,000
Total (`) 24,00,000 15,00,000
Equity capital (`10 each) 10,00,000 8,00,000
Retained earnings 2,00,000 --
14% long-term debt 5,00,000 3,00,00
Current liabilities 7,00,000 4,00,000
Total (`) 24,00,000 15,00,000
Income Statement
BA Ltd. (`) DA Ltd. (`)
Net Sales 34,50,000 17,00,000

Cost of Goods sold 27,60,000 13,60,000
Gross profit 6,90,000 3,40,000
Operating expenses Interest 2,00,000 1,00,000
Earnings before taxes 70,000 42,000
Taxes @ 50% 4,20,000 1,98,00
Earnings after taxes (EAT) 2,10,000 99,000
Additional Information : 2,10,000 99,000
No. of Equity shares 1,00,000 80,000
Dividend payment ratio (D/P) 40% 60%
Market price per share
`40 `15

Assume that both companies are in the process of negotiating a merger

through an exchange of equity shares. You have been asked to assist in
establishing equitable exchange terms and are required to:
(i) Decompose the share price of both the companies into EPS and P/E
components; and also segregate their EPS figures into Return on
Equity (ROE) and book value/intrinsic value per share components.
(ii) Estimate future EPS growth rates for each company.
(iii) Based on expected operating synergies BA Ltd. estimates that the intrinsic
value of DA’s equity share would be `20 per share on its acquisition.
You are required to develop a range of justifiable equity share
exchange ratios that can be offered by BA Ltd. to the shareholders of
DA Ltd. Based on your analysis in part (i) and (ii), would you expect the
negotiated terms to be closer to the upper, or the lower exchange ratio
limits and why?
(iv) Calculate the post-merger EPS based on an exchange ratio of 0.4: 1 being
offered by BA Ltd. and indicate the immediate EPS accretion or dilution,
if any, that will occur for each group of shareholders.
(v) Based on a 0.4: 1 exchange ratio and assuming that BA Ltd.’s pre-merger
P/E ratio will continue after the merger, estimate the post-merger market
price. Also show the resulting accretion or dilution in pre-merger market
prices.
(Source :- ICAI)
ANSWER:-
Market price per share (MPS) = EPS X P/E ratio or P/E ratio = MPS/EPS
(i) Determination of EPS, P/E ratio, ROE and BVPS of BA Ltd. and DA Ltd.
BA Ltd. DA Ltd.
Earnings After Tax (EAT) ` 2,10,000 ` 99,000
No. of Shares (N) 100000 80000
EPS (EAT/N) ` 2.10 ` 1.2375

Market price per share (MPS) 40 15

P/E Ratio (MPS/EPS) 19.05 12.12
Equity Funds (EF) ` 12,00,000 ` 8,00,000
BVPS (EF/N) 12 10
ROE (EAT/EF) × 100 17.50% 12.37%
(ii) Estimation of growth rates in EPS for BA Ltd. and DA Ltd.
Retention Ratio (1-D/P ratio) 0.6 0.4

Growth Rate (ROE × Retention Ratio) 10.50% 4.95%
(iii) Justifiable equity shares exchange ratio
Intrinsic value based = `20 / `40 = 0.5:1 (upper limit)

Market price based = `15 / ` = 0.375:1
= MPSDA/MPSBA 40 (lower limit)
Since, BA Ltd. has a higher EPS, ROE, P/E ratio and even higher
EPS growth expectations, the negotiable terms would be expected to
be closer to the lower limit, based on the existing share prices.
(iv) Calculation of post merger EPS and its effects
Particulars BA Ltd. DA Ltd. Combined

EAT (`) (i) 2,10,000 99,000 3,09,000
Share outstanding (ii) 100000 80000 132000*
EPS (`) (i) / 2.1 1.2375 2.341
EPS Accretion (Dilution) (Re.) (ii) 0.241 (0.301**)

(v) Estimation of Post merger Market price and other effects
Particulars BA Ltd. DA Ltd. Combined

EPS (`) (i) 2.1 1.2375 2.341
P/E Ratio (ii) 19.05 12.12 19.05
MPS (`) (i) / 40 15 44.6
MPS Accretion (Re.) (ii) 4.6 2.84***
* Shares outstanding (combined) = 100000 shares + (.40 × 80000)= 132000

shares
** EPS claim per old share = ` 2.34 × 0.4 ` 0.936
EPS dilution = ` 1.2375 – ` 0.936 `
0.3015
***S claim per old share (` 44.60 × 0.4) ` 17.84
Less: MPS per old share ` 15.00
` 2.84
49. Reliable Industries Ltd. (RIL) is considering a takeover of Sunflower

Industries Ltd. (SIL). The particulars of 2 companies are given below:
Particulars Reliable Sunflower Industries
Earnings After Tax (EAT) Industries
` 20,00,000 Ltd.
` 10,00,000
Equity shares O/s Ltd
10,00,000 10,00,000
Earnings per share (EPS) 2 1
PE Ratio (Times) 10 5
Required:
(i) What is the market value of each Company before merger?
(ii) Assume that the management of RIL estimates that the shareholders of
SIL will accept an offer of one share of RIL for four shares of SIL. If there
are no synergic effects, what is the market value of the Post-merger RIL?

What is the new price per share? Are the shareholders of RIL better or
worse off than they were before the merger?
(iii) Due to synergic effects, the management of RIL estimates that the
earnings will increase by 20%. What are the new post-merger EPS
and Price per share? Will the shareholders be better off or worse off
than before the merger? (Source:- ICAI)
ANSWER:-
(i) Market value of Companies before Merger

Particulars RIL SIL
EPS `2 Re.1
P/E Ratio 10 5
Market Price Per Share ` 20 `5
Equity Shares 10,00,000 10,00,000
Total Market Value 2,00,00,000 50,00,000
(ii) Post Merger Effects on RIL

`
Post merger earnings 30,00,000
Exchange Ratio (1:4)
No. of equity shares o/s (10,00,000 + 2,50,000) 12,50,000
EPS: 30,00,000/12,50,000 2.4
PE Ratio 10
Market Value 10 x 2.4 24
Total Value (12,50,000 x 24) 3,00,00,000
Gains From Merger: `
Post-Merger Market Value of the Firm 3,00,00,000
Less: Pre-Merger Market Value
RIL 2,00,00,000
SIL 50,00,000 2,50,00,000
Total gains from Merger 50,00,000

Apportionment of Gains between the Shareholders:

Particulars RIL(`) SIL(`)
Post Merger Market Value:
10,00,000 x 24 2,40,00,000 --
2,50,000 x 24 - 60,00,000
Less: Pre-Merger Market Value 2,00,00,000 50,00,000
Gains from Merger: 40,00,000 10,00,000
Thus, the shareholders of both the companies (RIL + SIL) are better off
than before
(iii) Post-Merger Earnings:

Increase in Earnings by 20%
New Earnings: ` 30,00,000 x (1+0.20) ` 36,00,000
No. of equity shares outstanding: 12,50,000
EPS (` 36,00,000/12,50,000) ` 2.88
PE Ratio 10
Market Price Per Share: = ` 2.88 x 10 ` 28.80
 Shareholders will be better-off than before the merger situation.
50. XYZ Ltd. wants to purchase ABC Ltd. by exchanging 0.7 of its share for
each share of ABC Ltd. Relevant financial data are as follows:
Equity shares outstanding 10,00,000 4,00,000
EPS (`) 40 28
Market price per share (`) 250 160
(i) Illustrate the impact of merger on EPS of both the companies.

(ii) The management of ABC Ltd. has quoted a share exchange ratio of 1:1
for the merger. Assuming that P/E ratio of XYZ Ltd. will remain
unchanged after the merger, what will be the gain from merger for ABC
Ltd.?

(iii) What will be the gain/loss to shareholders of XYZ Ltd.?

(iv) Determine the maximum exchange ratio acceptable to shareholders of
XYZ Ltd.
(Source :- ICAI)
ANSWER:-
Working Notes
(a)
XYZ Ltd. ABC Ltd.
EPS ` 40 ` 28
Profit ` 400,00,000 ` 112,00,000
PE Ratio 6.25 5.71
(b) EPS after merger

No. of shares to be issued (4,00,000 x 0.70) 2,80,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 40
(i) Impact of merger on EPS of both the companies

XYZ Ltd. ABC Ltd.
EPS after Merger ` 40 ` 28
EPS before Merger ` 40 ` 28*
Nil Nil
* ` 40 x 0.70

(ii) Gain from the Merger if exchange ratio is 1: 1

No. of shares to be issued 4,00,000
Total Profit (` 400,00,000 + ` 112,00,000) ` 512,00,000
EPS ` 36.57
Market Price of Share (` 36.57 x 6.25) ` 228.56
Impact (Increase/ Gain) ` 68.56
(iii) Gain/ loss from the Merger to the shareholders of XYZ Ltd.
Market Price of Share ` 228.56
Loss from the merger (per share) ` 21.44
(iv) Maximum Exchange Ratio acceptable to XYZ Ltd. shareholders

` Lakhs
Market Value of Merged Entity (` 228.57 x 1400000) 3199.98
Less: Value acceptable to shareholders of XYZ Ltd. 2500.00
Value of merged entity available to shareholders of ABC Ltd. 699.98
Market Price Per Share 250
No. of shares to be issued to the shareholders of ABC Ltd. 2.80
(lakhs)
Thus maximum ratio of issue shall be 2.80 : 4.00 or 0.70 share of XYZ Ltd. for
one share of ABC Ltd.
51. XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.’s shares are
currently traded at ` 20. It has 2,50,000 shares outstanding and its earnings
after taxes (EAT) amount to ` 5,00,000. ABC Ltd., has 1,25,000 shares
outstanding; its current market price is ` 10 and its EAT are ` 1,25,000.
The merger will be effected by means of a stock swap (exchange). ABC

Ltd., has agreed to a plan under which XYZ Ltd., will offer the current
market value of ABC Ltd.’s shares:
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both
the companies?
(ii) If ABC Ltd.’s P/E ratio is 6.4, what is its current market price?
What is the exchange ratio? What will XYZ Ltd.’s post-merger EPS be?
(iii) What should be the exchange ratio; if XYZ Ltd.’s pre-merger and post-
merger EPS are to be the same?
(Source :- ICAI)
ANSWER:-
(i) Pre-merger EPS and P/E ratios of XYZ Ltd. and ABC Ltd.
Particulars XYZ Ltd. ABC Ltd.
Earnings after taxes 5,00,000 1,25,000
Number of shares outstanding 2,50,000 1,25,000
EPS 2 1
Market Price per share 20 10
(ii) Current Market Price of ABC Ltd. if P/E ratio is 6.4 = ` 1 × 6.4 = ` 6.40
` 20 ` 6.40
Exchange ratio   3.125 or  0.32
` 6.40 ` 20
Post merger EPS of XYZ Ltd.
` 5,00,000  ` 1, 25,000

2, 50,000   1, 25,000 / 3,125 
` 6, 25,000
  2.16
2,90,000
(iii) Desired Exchange Ratio
Total number of shares in post-merged company
Post  merger earnings ` 6, 25,000
   3,12, 500
Pr e  merger EPS of XYZ Ltd 2

Number of shares required to be issued

= 3,12,500 – 2,50,000 = 62,500
Therefore, the exchange ratio is
62,500 : 1,25,000
62, 500
  0.50
1, 25,000
52. The valuation of Hansel Limited has been done by an investment

analyst. Based on an expected free cash flow of ` 54 lakhs for the following
year and an expected growth rate of 9 percent, the analyst has estimated the
value of Hansel Limited to be ` 1800 lakhs. However, he committed a
mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but
you know that Hansel Limited has a cost of equity of 20 percent and post
tax cost of debt of 10 percent. The value of equity is thrice its book value,
whereas the market value of its debt is nine-tenths of its book value. What is
the correct value of Hansel Ltd?
(Source :- ICAI)
ANSWER:-
Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as

follows:-
FCFF1
V0 
Ke  g n
Where –
FCFF1 = Expected FCFF in the year 1
Kc = Cost of capital
gn = Growth rate forever
Thus, ` 1800 lakhs = ` 54 lakhs /(Kc-g)
Since g = 9%, then Kc = 12%

Now, let X be the weight of debt and given cost of equity = 20% and cost of
debt = 10%, then20% (1 – X) + 10% X = 12%
Hence, X = 0.80, so book value weight for debt was 80%
Correct weight should be 60 of equity and 72 of debt.
 Cost of capital = Kc = 20% (60/132) + 10% (72/132) = 14.5455% and correct
firm’s value = ` 54 lakhs/(0.1454 – 0.09) = ` 974.73 lakhs.
53. T Ltd. and E Ltd. are in the same industry. The former is in negotiation for
acquisition of the latter. Important information about the two companies as
per their latest financial statements is given below:
T Ltd. E Ltd.
` 10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:
10% Debentures (` Lakhs) 580 --
12.5% Institutional Loan (` Lakhs) -- 240
Earning before interest, depreciation and tax 400.86 115.71
(EBIDAT) (` Lakhs)
Market Price/share (` ) 220.00 110.00
T Ltd. plans to offer a price for E Ltd., business as a whole which will
be 7 times EBIDAT reduced by outstanding debt, to be discharged by own
shares at market price.
E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based
on the market price. Tax rate for the two companies may be assumed as 30%.
Calculate and show the following under both alternatives - T Ltd.'s offer and
E Ltd.'s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd. after acquisition.
(iv) Expected market price per share of T Ltd. after acquisition.

(v) State briefly the advantages to T Ltd. from the acquisition.
Calculations (except EPS) may be rounded off to 2 decimals in lakhs.
(Source :- ICAI)
ANSWER:-
As per T Ltd.’s Offer

` in lakhs
(i) Net Consideration Payable
7 times EBIDAT, i.e. 7 x ` 115.71 lakh 809.97
Less: Debt 240.00
569.97
(ii) No. of shares to be issued by T Ltd
` 569.97 lakh/` 220 (rounded off) (Nos.) 2,59,000
(iii) EPS of T Ltd after acquisition 516.57

Total EBIDT (` 400.86 lakh + ` 115.71 lakh) 88.00
Less: Interest (` 58 lakh + ` 30 lakh) 428.57
128.57
Less: 30% Tax 300.00
Total earnings (NPAT) 14.59 lakh
Total no. of shares outstanding (12 lakh + 2.59 lakh)
EPS (` 300 lakh/ 14.59 lakh) ` 20.56
(iv)Expected Market Price:

` in lakhs
Pre-acquisition P/E multiple: 400.86
EBIDAT 58.00
10  342.86
Less: Interest  580  
 100  102.86
Less: 30% Tax 240.00

No. of shares (lakhs) 12

EPS ` 20.00
220 11
Hence, PE multiple
20 ` 226.16
Expected market price after acquisition (` 20.56 x 11)
As per E Ltd’s Plan

` in lakhs
(i) Net consideration payable
6 lakhs shares x ` 110
(ii) No. of shares to be issued by T Ltd
` 660 lakhs ÷ ` 220 3 lakh
(iii) EPS of T Ltd after Acquisition
NPAT (as per earlier calculations) 300.00
Total no. of shares outstanding (12 lakhs + 3 lakhs) 15 lakh
Earning Per Share (EPS) ` 300 lakh/15 lakh ` 20.00
(iv) Expected Market Price (` 20 x 11) 220.00
(v) Advantages of Acquisition to T Ltd

Since the two companies are in the same industry, the following
advantages could accrue:
- Synergy, cost reduction and operating efficiency.
- Better market share.
- Avoidance of competition.
54. M Co. Ltd., is studying the possible acquisition of N Co. Ltd., by way of
merger. The following data are available in respect of the companies:
Particulars M Co. Ltd. N Co. Ltd.
Earnings after tax (`) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share (`) 200 160

(i) If the merger goes through by exchange of equity and the exchange ratio is
based on the current market price, what is the new earning per share for M
Co. Ltd.?
(ii) N Co. Ltd. wants to be sure that the earnings available to its
shareholders will not be diminished by the merger. What should be the
exchange ratio in that case? (Source :- ICAI)
ANSWER:-
(i) Calculation of new EPS of M Co. Ltd.

No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 shares × ` 160/` 200 = 3,20,000 shares
Total no. of shares in M Co. Ltd. after acquisition of N Co. Ltd.
= 16,00,000 + 3,20,000 = 19,20,000
Total earnings after tax [after acquisition]
= 80,00,000 + 24,00,000 = 1,04,00,000
104,00,000
EPS  ` 5.42
19, 20,000 equity shares
(ii) Calculation of exchange ratio which would not diminish the EPS of N Co.
Ltd. after its merger with M Co. Ltd.
Current EPS:
` 80,00,000
M Co. Ltd ` 5
16,00,000 equity shaes
` 24,00,000
N Co. Ltd.  ` 6
4,00,000 equity shaes
Exchange ratio = 6/5 = 1.20
No. of new shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 × 1.20 = 4,80,000 shares
Total number of shares of M Co. Ltd. after acquisition
= 16,00,000 + 4,80,000 = 20,80,000 shares
` 1,04,00,000
EPS [after merger]  ` 5
20,80,000 shares
Total earnings in M Co. Ltd. available to new shareholders of N Co. Ltd.
= 4,80,000 × ` 5 = ` 24,00,000
Recommendation: The exchange ratio (6 for 5) based on market shares is
beneficial to shareholders of 'N' Co. Ltd.
55. ABC Company is considering acquisition of XYZ Ltd. which has 1.5 crores
shares outstanding and issued. The market price per share is ` 400 at present.
ABC's average cost of capital is 12%. Available information from XYZ
indicates its expected cash accruals for the next 3 years as follows:
Year ` Cr.
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider. (PV factors
at 12% for years 1 to 3 respectively: 0.893, 0.797 and 0.712).
(Source :- ICAI)
ANSWER:-
Market Price per share ` 400

Thus value of total business is (` 400 x 1.5 Cr.) ` 600 Cr.
Present Value of cash flows

(` 250 cr x 0.893) + (` 300 cr. X 0.797) + (` 400 cr. X 0.712 ) = ` 747.15 Cr.
Value of per share (` 747.15 Cr. / 1.5 Cr) ` 498.10 per share
Per Share ` Total ` Cr.
Minimum 400.00 600.00
Maximum 498.10 747.15

56. H Ltd. agrees to buy over the business of B Ltd. effective 1st April, 2012.The
summarized Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as
follows:
Balance sheet as at 31 st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.
Paid up Share Capital
-Equity Shares of `100 each
-Equity Shares of `10 each 350.00
Reserve & Surplus 6.50
Total 25.00
950.00
1,300.00 31.50
Assets:
220.00 0.50
Net Fixed Assets
1,020.0 29.00
Net Current Assets
0 2.00
Deferred Tax Assets
Total 60.00
1,300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided
to you as part of the scheme of buying:
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd.
for the last 4 years are ` 300 crores and ` 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.
(3) H Ltd. has a contingent liability of ` 300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of `100 each to the shareholders of B Ltd. in
terms of the exchange ratio as arrived on a Fair Value basis. (Please
consider weights of 1 and 3 for the value of shares arrived on Net

Asset basis and Earnings capitalization method respectively for both H

Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd.
under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B
Ltd. on a Fair value basis (taking into consideration the assumption
mentioned in point 4 above.)
(Source :- ICAI)
ANSWER:-
(i) Net asset value

H Ltd. ` 1300 Crores  ` 300 Crores
 ` 285.71
3.50 crores
B Ltd. ` 31.50Crores
 ` 48.46
0.65 crores
(ii) Earning capitalization value

H Ltd. ` 300 Crores /0.08
 ` 1071.43
3.50 crores
B Ltd. ` 10 Crores /0.08
 ` 192.31
0.65 crores
(iii) Fair value

H Ltd. ` 285.71  1  ` 1071.43× 3
 ` 875
4
B Ltd. ` 48.46  1  ` 192.31× 3
 ` 156.3475
4
Exchange ratio `156.3475/ `875 = 0.1787

H Ltd should issue its 0.1787 share for each share of B Ltd.
Note: In above solution it has been assumed that the contingent

liability will materialize at its full amount.
57. You have been provided the following Financial data of two companies:
Krishna Ltd. Rama Ltd.
Earnings after taxes ` 7,00,000 ` 10,00,000
Equity shares (outstanding) ` 2,00,000 ` 4,00,000
EPS 3.5 2.5
P/E ratio 10 times 14 times
Company Rama Ltd. is acquiring the company Krishna Ltd., exchanging its
shares on a one- to-one basis for company Krishna Ltd. The exchange ratio is
based on the market prices of the shares of the two companies.
Required:
(i) What will be the EPS subsequent to merger?
(ii) What is the change in EPS for the shareholders of companies Rama
Ltd. and Krishna Ltd.?
(iii) Determine the market value of the post-merger firm. PE ratio is likely to
remain the same.
Ascertain the profits accruing to shareholders of both the companies.
(Source :- ICAI)
ANSWER:-
(i) Exchange Ratio 1.1

New Shares to be issued 2,00,000
Total shares of Rama Ltd. (4,00,000+2,00,000) 6,00,000
Total earnings (` 10,00,000 + ` 7,00,000) ` 17,00,000
New EPS (` 17,00,000/6,00,000) ` 2.83

(ii) Existing EPS of Rama Ltd. ` 2.50

Increase in EPS of Rama Ltd (` 2.83 – ` 2.50) ` 0.33
Existing EPS of Krishna Ltd. ` 3.50
Decrease in EPS of Krishna Ltd. (` 3.50 – ` 2.83) ` 0.67
(iii) P/E ratio of new firm (expected to remain same) 14 times
New market price (14 × ` 2.83) ` 39.62
Total No. of Shares 6,00,000
Total market Capitalization (6,00,000 × ` 39.62) ` 2,37,72,000
Existing market capitalization (` 70,00,000 + ` ` 2,10,00,000
1,40,00,000) ` 27,72,000
Total gain
(iv)
Rama Ltd. Krishna Ltd Total
No. of shares after merger 4,00,000 2,00,000 6,00,000
Market price ` 39.62 ` 39.62 ` 39.62
Total Mkt. Values ` 1,58,48,000 ` 79,24,000 ` 2,37,72,000
Existing Mkt. values ` 1,40,00,000 ` 70,00,000 ` 2,10,00,000
Gain to share holders ` 18,48,000 ` 9,24,000 ` 27,72,000
or ` 27,72,000 ÷ 3 = ` 9,24,000 to Krishna Ltd. and ` 18,48,000 to Rama Ltd.
(in 2: 1 ratio)
58. Company X is contemplating the purchase of Company Y. Company X

has 3,00,000 shares having a market price of ` 30 per share, while Company
Y has 2,00,000 shares selling at ` 20 per share. The EPS are ` 4.00 and ` 2.25
for Company X and Y respectively. Managements of both companies are
discussing two alternative proposals for exchange of shares as indicated
below:
(i) In proportion to the relative earnings per share of two companies.
(ii) 0.5 share of Company X for one share of Company Y (0.5 : 1).

You are required:

(i) To calculate the Earnings Per Share (EPS) after merger under two
alternatives; and
(ii) To show the impact on EPS for the shareholders of two companies
under both the alternatives.
(Source :- ICAI)
ANSWER:-
(i) Exchange ratio in proportion to relative EPS

Company Existing No. of shares EPS Total earnings
X 3,00,000 4.00 12,00,000
Y 2,00,000 2.25 4,50,000
Total earnings 16,50,000
No. of shares after merger 3,00,000 + 1,12,500 = 4,12,500
225 
Note : 1,12,500 may be calculated as   2, 00, 000  
 4.00 
16, 50, 000
EPS for Co. X after merger  ` 4.00
4, 12, 500
Impact on EPS
Equivalent EPS of Co. Y
Before merger ` 2.25
After merger (EPS before merger X Share exchange ratio on EPS basis)
` 4.00 X 0.5625 = ` 2.25
(ii) Merger effect on EPS with share exchange ratio of 0.5 : 1

Total earnings after merger `
No. of shares post merger (3,00,000 + 1,00,000 (0.5 × 2,00,000) 16,50,000
EPS 16,50,000 ÷ 4,00,000 4,00,000
Impact on EPS 4.125
Co. X’ shareholders

EPS before merger `4.00

EPS after merger i.e. (16,50,000 ÷ 4,00,000) 4.125
Co. Y' Shareholders
Equivalent EPS after the merger 4.125 x 0.5 2.0625
59. B Ltd. is a highly successful company and wishes to expand by

acquiring other firms. Its expected high growth in earnings and dividends
is reflected in its PE ratio of 17. The Board of Directors of B Ltd. has been
advised that if it were to take over firms with a lower PE ratio than it own,
using a share-for-share exchange, then it could increase its reported
earnings per share. C Ltd. has been suggested as a possible target for a
takeover, which has a PE ratio of 10 and 1,00,000 shares in issue with a
share price of ` 15. B Ltd. has 5,00,000 shares in issue with a share price
of ` 12.
Calculate the change in earnings per share of B Ltd. if it acquires the whole of
C Ltd. by issuing shares at its market price of `12. Assume the price of B Ltd.
shares remains constant.
(Source :- ICAI)
ANSWER:-
Total market value of C Ltd is = 1,00,000 x ` 15 = ` 15,00,000

PE ratio (given) = 10
Therefore, earnings = ` 15,00,000 /10
= ` 1,50,000
Total market value of B Ltd. is = 5,00,000 x ` 12 = ` 60,00,000
PE ratio (given) = 17
Therefore, earnings = ` 60,00,000/17

= ` 3,52,941
The number of shares to be issued by B Ltd. = 1,25,000
` 15,00,000 ÷ 12 = 5,00,000 + 1,25,000
Total number of shares of B Ltd = 6,25,000
The EPS of the new firm is = (`
3,52,941+`1,50,000)/6,25,000
The present EPS of B Ltd is = ` 0.80
= ` 3,52,941 /5,00,000
= ` 0.71
So the EPS affirm B will increase from Re. 0.71 to ` 0.80 as a result of merger.

MERGER & ACQUISITIONS - SUMMARY
1. Exchange Ratio (r)

EPSB P BVPSB
 r or r  B or r 
EPS A PA BVPS A
Generally r is the weighted average of above
2. Synergy in value  VAB  VA  VB 
3. Post Merger EPS
Acquiring firm (A) Target Firm (B)

PATA  PATB  Synergy in earnings
EPSAB  
N A  r  NB
rEPSAB
Compare with EPSA Compare with EPSB
4. Bootstrap Effect
P/E ratio of combined firm after merger = P/E ratio of acquiring firm before
merger
5. True cost of acquisition for firm A = NPV to B
6. Formulas for NPV
 Cash deal, synergy in value

VAB  VA  VB  Synergy
NPVA  VAB  VA
NPVB  Cash PC  VB
 Cash deal, synergy in earnings

PATAB  PATA  PATB  Synergy in earnings
MERGER & ACQUISITIONS - SUMMARY
VAB   P / E ratio   PATAB   Cash PC

NPVA  VAB  VA
NPVB  Cash PC  VB
 Stock deal, synergy in value

VA  VB  Value of synergy
PAB 
N A  rN B
NPVA   PAB  PA  N A
NPVB   rPAB  PB  N B
 Stock deal, synergy in earnings

PATAB  PATA  PATB  synergy in earnings
VAB   P / E ratio   PATAB
VAB
PAB 
N A  rN B
NPVA   PAB  PA  N A
NPVB   rPAB  PB  N B

1. Constant Engineering Ltd. has developed a high tech product which has
reduced the Carbon emission from the burning of the fossil fuel. The product
is in high demand. The product has been patented and has a market value of
`100 Crore, which is not recorded in the books. The Net Worth (NW) of
Constant Engineering Ltd. is `200 Crore. Long term debt is `400 Crore. The
product generates a revenue of `84 Crore. The rate on 365 days Government
bond in 10 percent per annum. Bond portfolio generates a return of 12 percent
per annum. The stock of the company moves in tandem with the market.
Calculate Economic Value added of the company.
2. Intel Ltd., promoted by a Trans National company, is listed on the stock

exchange.
The value of the floating stock is `45 crore. The Market Price per Share (MPS)
is `150.
The capitalization rate is 20 percent.
The promoters holding is to be restricted to 75 per cent as per the norms of
listing requirement. The Board of Directors have decided to fall in line to
restrict the Promoters' holding to 75 percent by issuing Bonus Shares to
minority shareholders while maintaining the same price Earnings Ratio (P/E).
You are required to calculate:

(i) Bonus Ratio;
(ii) MPS after issue of Bonus Shares; and
(iii) Free float Market capitalisation after issue of Bonus Shares.

3. During the audit of the Weak Bank (W), RBI has suggested that the Bank
should either merge with another bank or may close down. Strong Bank (S)
has submitted a proposal of merger of Weak Bank with itself. The relevant
information and Balance Sheets of both the companies are as under:
Particulars Weak Bank (W) Strong Bank Assigned

(S) Weighted (%)
Gross NPA (%) 40 5 30
Capital Adequacy 5 16 28
Ratio
(CAR)/Capital Risk
Weight Asset Ratio
Market Price per 12 96 32
Share (MPS)
Book value 10
Trading on Stock Irregular Frequent
Exchange
Balance Sheet
(` in Lakhs)
Particulars Weak Bank Strong Bank
(W) (S)
Paid up Share Capital (` 10 per Share) 150 500
Reserves & Surplus 80 5,500
Deposits 4,000 44,000
Other Liabilities 890 2,500
Total Liabilities 5,120 52,500
Cash in Hand & with RBI 400 2,500

Balance with Other Banks 2,000
Investments 1,100 19,000

Advances 3,500 27,000

Other Assets 70 2,000
Preliminary Expenses 50
Total Assets 5,120 52,500
You are required to

(a) Calculate Swap ratio based on the above weights;
(b) Ascertain the number of Shares to be issued to Weak Bank;
(c) Prepare Balance Sheet after merger; and
(d) Calculate CAR and Gross NPA of Strong Bank after merger.

THEORY
PART - 1
FIVE CHAPTERS ARE NEW AND VERY IMPORTANT - HENCE

WE ADVISE THAT THESE SHOULD BE DIRECTLY PREPARED
FROM INSTITUTE MATERIAL. (Labelled “From ICAI”).
OF COURSE, CLASS GUIDANCE WILL BE GIVEN TO HELP YOU
UNDERSTAND THESE TOPICS INSTEAD OF SIMPLY MUGGING
THEM UP. (Labelled “From FOD”).
THESE ARE :-
FROM FOD :-
INTERNATIONAL FINANCIAL CENTRE Removed
SECURITIZATION 15 - 25
START UP FINANCE 26 - 36
SMALL AND MEDIUM ENTERPRISES Removed
RISK MANAGEMENT (DONE IN CLASS)
FROM ICAI :-
INTERNATIONAL FINANCIAL CENTRE Removed
RISK MANAGEMENT 48 - 56
SECURITIZATION 57 - 69
START UP FINANCE 70 - 91
SMALL AND MEDIUM ENTERPRISES Removed
INTERNATIONAL FINANCIAL CENTRE
FROM PAGE 1 TO 14
HAS BEEN REMOVED

Securitization - FOD
LEARNING OUTCOMES:
 Introduction
 Concept and Definition
 Benefits of Securitization
 Participants in Securitization
 Mechanism of Securitization
 Problems in Securitization
 Securitization Instruments
 Pricing of Securitization Instruments
 Securitization in India
SANJAY SARAF SIR 15

Situation 1 - A housing finance company has issued a number of housing loan- it

therefore has a stream of future EMI's. However it requires funds right now.
Given its credit profile, it would be very costly to come out with a bond issue
(think Kd). Its assets are however pretty safe in the eyes of the investing public.
Situation 2 - Imagine a retail company or a consumer durable company which

has a large amount of receivables in its books. It wants to get the amount blocked
in those receivables today. However if it issues a conventional bond, prospective
investors will look at its entire fundamentals and not just the receivables and this
would cause kd to be higher.
So, in both of these situations, we are wanting to issue bonds but at the same
time we want the bondholder to look at the assets backing the bond, and not the
issuer who generated those assets. Hence the original company known as
originator, pools a section of its assets and sells it to a SPV.
SANJAY SARAF SIR 16

1. INTRODUCTION
 This sale got to be a true sale - this will require that the securitization should
be without recourse.
 It has to be a bankrupcy remote SPV i.e. the creditors of the originator cannot
lay their hands on the assets sold to SPV.
In other words, the SPV and its assets are remote i.e. unaffected by the
bankruptcy of the originator.
The SPV then unbundles the asset pool and issues asset backed securities
(ABS)
ABS
MBS Non MBS CDO

(in housing loan) (auto loan receivable, credit The asset pool is a
card receivables etc.) portfolios of debt
obligations i.e., loan
and bonds.
RMBS CMBS
Agency RMBS Non Agency RMBS
No credit risk
Only prepayment risk
 In others, credit and prepayment risk.
SANJAY SARAF SIR 17

2. CONCEPT AND DEFINITION

Definition
It may be defined as the conversion of simple but illiquid assets (housing loan,
auto loan, receivables, credit card receivables, etc.) into complex but liquid
securities through the SPV route.
Concept
Features
 Issue of marketable securities against illiquid assets.
 Bundling and unbundling of assets.
 Risk management - If securitisation is without recourse or the originator has
passed on the risk to the security holders.
 Structured finance - The fact that illiquid assets are convertible into liquid
securities  it falls under the domain of structured finance.
Tranching - This means slicing or repackaging credit and pre-payment risk by

issuing different types of securities to suit the risk return profile of different
types of investors.
SANJAY SARAF EDUCATIONAL
SANJAY SARAF INSTITUTE
SIR PVT. LTD. | 18
3. BENEFITS OF SECURITIZATION
 3.1 From the angle of originator
 3.2 From the angle of investor
Originator
1. Off balance sheet financing.

2. Tool for risk management.
3. Improvement in Financial Ratios - especially capital adequacy ratio of banks.
4. Lower cost of funds.
Investor
1. Investment in a diversified portfolio of assets.

2. Regulatory help - Banks are required to lend a percentage to priority sector.
They may invest in securitised paper which is backed by priority sector loans.
3. Lower risk of securitised instrument specially in case of recourse.
SANJAY SARAF SIR 19

4. PARTICIPANTS IN SECURITIZATION
 4.1 Primary Participants
 Originator  Finance company or bank which originates the process.

 Special Purpose Vehicle  Company, trust formed specially for
securitization.
 The Investors  Pension funds, Mutual funds, Banks, Retail Investors,
FI's, FII's.
 4.2 Secondary Participants

 Obligors  The borrower who owes money to the originator.
 Rating Agency  CRISIL, ICRA, who would rate the securitised
instruments.
 Receiving and Paying agent (RPA)  Servicer or administrator who
will collect money from the obligor and pass it on to security holder.
RPA is generally the originator or its affiliate.
 Agent or Trustee  Appointed to safeguard interest of the security
holder.
 Credit Enhancer  Guarantor (Bank or monoline insurance Co.) who
guarantees the securitised instruments and this enables high credit
rating, higher issue price and lower Kd.
 Structurer  The investment banker who assembles all the parties,
looks into the legality of the issue, designs and prices the securitised
instruments.
SANJAY SARAF SIR 20

5. MECHANISM OF SECURITIZATION (Show Diagram)

 5.1 Creation of Pool of Assets  Bundling of assets by originator.
 5.2 Transfer to SPV  true sale.
 5.3 Sale of Securitized Papers  SPV issues securities.
 5.4 Administration of assets  RPA (receiving and paying agent)
 5.5 Recourse to Originator
 5.6 Repayment of funds  RPA pays to holders of securitised instruments.
 5.7 Credit Rating to Instruments  CRISIL and ICRA.
SANJAY SARAF SIR 21

6. PROBLEMS IN SECURITIZATION
 6.1 Stamp Duty  Kd will rise
 6.2 Taxation  lack of clarity and double taxation.
 6.3 Accounting  In whose books securitised asset will come.
 6.4 Lack of standardization  Different types of documentation is done in
India.
 6.5 Inadequate Debt Market  Debt market in India is not developed and is
not liquid
 6.6 Ineffective Foreclosure laws  If the obligor defaults, will the bank be
able to foreclose the property.
SANJAY SARAF SIR 22

7. SECURITIZATION INSTRUMENTS
 7.1 Pass Through Certificates (PTCs)
 7.2 Pay Through Security (PTS)
 7.3 Stripped Securities
 Pass Through Certificates (PTCs)  Single type of securities issued to all

investors - no repackaging of prepayment and credit risk.
 Pay Through Security (PTS)  There is tranching i.e. different types of

securities are issued to repackage credit risk.
Thus, senior has the lowest credit risk and junior has the highest.
 Stripped Securities 

SIR PVT. LTD. | 23
8. PRICING OF THE SECURITIZED INSTRUMENTS

 8.1 From Originator’s Angle
 8.2 From Investor’s Angle
 From Originator's Angle  He would like to price it higher.

 From Investor's Angle  He would like to pay lower price.
c1 c2 cn
Po    ..............
1  r 1  r 2 1  r 
n
SANJAY SARAF SIR 24

9. SECURITIZATION IN INDIA
1. City bank was the first entity to securitise its auto loan receivables.
2. Later other banks like ICICI Bank and HDFC Bank have also raised funds
via securitisation.
3. There are problems on account of which securitisation market has not
developed significantly in India.
4. Sarfesi Act. 2002
5. SEBI has permitted FII's to invest to a certain extent in debt instruments
issued by unlisted companies.
SANJAY SARAF SIR 25

Start up Finance - FOD
LEARNING OUTCOMES:
 Introduction of Startup finance
 Pitch Presentation
 Sources of Funding
 Startup financing through Venture Capital Financing
VENTURE CAPITAL
Venture capital refers to risk capital provided by venture capital funds to venture
capital units. The VCU (Venture Capital Unit) represents a startup promoted by
young technocrats for the purpose of testing a new technology which has not yet
been proven - hence a very high element of risk. This is long term investment
with a horizon of somewhere between 3 to 10 years.
This is illiquid investment as the VCU is not traded in the market place. This
investment is in the form of equity or Quasi equity i.e., convertible bonds or
bonds with warrant. This is an active investment i.e., the VCF (Venture Capital
Fund) takes a position in the VCU's board and continuously provides financial,
technical, marketing and operational advice. One out of ten such investments
turn out to be successful and the return on such successful investments is so high
that it makes up for the losses on the other nine investments which failed.
Thus the features of Venture Capital Investments are

(i) Risk Capital i.e., high risk involved
(ii) Long investment horizon.
(iii) Illiquid investment.
(iv) Active investment.
(v) High return expectations
SANJAY SARAF SIR 26
Structure of Venture Capital
Domestic Fund Offshore fund
Offshore Structure Unified Structure
1. Domestic fund: We have a pooling vehicle set up as a trust or a company

(limited liability partnership for such a fund not allowed in India) in order to
pool funds from domestic investors.
We also have an investment advisor or asset manager who would search for
prospective VCU's for investment.
2. Offshore Structure: In this case, the pooling vehicle is set up outside India as
a LLP managed by an overseas manager. This pooling vehicle directly invests
in portfolio companies in India through the advice of an Indian investment
advisor or asset manager.

SIR PVT. LTD. | 27
3. Unified Structure: This structure mobilizes funds both from overseas

investors as well as domestic investors.
To mobilize funds from overseas investors, we have an offshore pooling
vehicle set up as a LLP.
To mobilize funds from domestic investors, a trust is setup in India. So the
trusts receive funds from domestic investors directly and from overseas
investors indirectly i.e., via the offshore vehicle. The trust then invests in
portfolio companies by using the investment advisor's expertise.

SIR PVT. LTD. | 28
Advantage of venture capital investing to the VCU
1. Category 1 : (Funds related- VCU’s point of view)

i. It is long term equity finance with no legal liability of regular interest
payments.
ii. The VCF is a business partner sharing both risk and reward.
2. Category 2: (Advisory)
iii. Venture capital fund having enormous experience in dealing with so
many VCU's provides valuable financial, technical, marketing and
operational advice.
iv. The VCU can also gain from the vast network and contact of the VCF.
3. Category 3: (Exit related)

v. The VCF may enable the VCU to go for an IPO in Indian markets or
overseas markets.
vi. The VCF can facilitate a strategic or trade sale (It means selling stake to
some other entity in the same industry) or a secondary sale (selling stake
to some other fund).
Venture Capital Process (VCF’s point of view)
SIR PVT. LTD. | 29
Step 1: Deal Generation

How does VCF get to know about potential VCU's or potential startups?
 Parent company provides a lead.
 Referral partners (may be CA firm or boutique investment bank)
 Startup seminars and events.
After getting the lead, the VCF's require a teaser (similar to pitch presentation)
and a detailed investment memorandum which provides all financial details,
projections, tentative valuation, exit windows.
Step 2: Initial Screening

The board committee of the venture capital fund carries out the initial screening
of the deals originated in step 1.
Only a few of those deals are recommended for carrying out due diligence.
Step 3: Due diligence

This involves detailed analysis of the VCU involving the services of experts, law
firms.
Step 4: Deal structuring

This is the stage of negotiation between the VCF and the VCU.
 How much to be invested.
 What stake to be demanded by VCF.
 What form of investment i.e., equity or Quasi equity.
 What control measures, say a board position to be taken by the VCF.
SANJAY SARAF SIR 30

Step 5: Post Investment Activity

(Think about active investment and control).
Step 6: Exit
 IPO
 Strategic or trade sale
 Secondary sale
 Liquidation
Stages of Venture Capital Investing:
(i) Seed Stage - Funds provided for testing the idea R & D stage - high chance
of failure. Generally angel investor invests in this stage (small amount of
investment required).
(ii) Startup Stage - Idea has been proven - need funds for marketing and
product development.
(iii) First Round - Fund required for initiating commercial production and sales.
(iv) Second Round - VCU is selling i.e., generating revenue but not making
profits. It requires funds for operations i.e., working capital.
(v) Third Round - Expansion Capital or Mezzanine finance required by a
profitable VCU.
(vi) Fourth Round - Bridge finance required as a transition to IPO.
Private Equity
This refers to equity which is not listed and not traded. A private equity fund
may be of the following types:
(i) Buyout fund - It goes for an LBO (Leveraged Buy Out).
(ii) Venture Capital Fund - Invests in startups.
(iii) Distressed Securities Funds - Invests in the debt of firms which are on the
verge of bankruptcy. The plan is to turn around that firm and get the debt
stake purchased at cheap valuations converted into equity stake.
SANJAY SARAF SIR 31

(iv) Mezzanine Finance: This is a hybrid investment i.e., somewhere lying

between debt and equity.
1. THE BASICS OF STARTUP FINANCING
 Air Bed and Breakfast (Air BNB) was a startup for the purpose of providing
a best platform for booking rooms with locals rather than hotels.
(Refer to AirBNB Slide Share)
 Pepperfry.com raised $100 million in startup finance - this was the biggest
amount raised in India by a sector focused E-commerce player.
 Swastik logistics, a Gwalior based logistics startup raised `50 crore from
Ascent capital rooted through tranzone capital acting as investment bank.
 Even the best of firms that we know of today like Facebook, Youtube etc. in
the global space and Infosys, Page Industries, Eicher Motors etc. began as a
startup and raised startup funding.
SANJAY SARAF SIR 32

2. SOME OF THE INNOVATIVE WAYS TO FINANCE A STARTUP
 Personal financing  Personal Savings

 Personal credit lines  Unsecured loan from bank
 Family and friends  Angel investing
 Peer-to-peer lending  A group of people providing startup funds to each
other.
 Crowd funding  Social networking
 Microloans  Unsecured loans from individuals
 Vendor financing  Trade credit
 Purchase order financing  Financing i.e., advance provided by customer
 Factoring accounts receivables  Selling your account receivables to a
factor
 Crowd funding  This refers to small amount of funds contributed by a
large number of people via crowded platforms. Its the role of social media.
 Microloans  Unsecured loans from the individuals
 Purchase order financing  Financing i.e., advance provided by customer.
 Factoring accounts receivable  selling your accounts receivable to a
factor.
SANJAY SARAF SIR 33

3. PITCH PRESENTATION
 (i) Introduction  Introduce yourself

 (ii) Team  Elaborately introduce you team
 (iii) Problem  Give an example
 (iv) Solution  About the given problem
 (v) Marketing/Sales  Show the market potential i.e., total market size and
your existing market shares(the proof of the pudding lies in the eating).
 (vi) Projections or Milestones  Targets are sets on the basis of calendar
date.
 (vii) Competition  Do you have the first mover advantage, ease of use of
website differentiating feature.
 (viii) Business Model  How do you propose to earn and what is the
existing strategy that the VC will look upto.
 (ix) Financing  How much funds required - for what Purpose - in what
form i.e debt or equity or hybrid.
Pitch Deck When a startup approaches a Venture Capital (VC) for the first
time, it has to provide a brief overview of its business and management team.
This is usually in the form of a slide share & may be done face to face. This is
called pitch presentation- a challenging task.
SANJAY SARAF SIR 34

4. MODES OF FINANCING FOR STARTUPS

 (i) Bootstrapping
 (ii) Angel Investors
 (iii) Venture Capital Funds
(i) Bootstrapping - When a startup is found and build from personal finance
and/or from the revenues of existing business, we call it boot strapping
Method 1:
Trade Credit  Startup wants to buy raw material worth `60 lakhs - prepare
a well crafted financial plan and visit the supplier - urge to meet the owner or
CFO. Communicate the financial plan and explain how this first credit order
is so important for kick starting the venture.
Method 2: Factoring
Method 3: Leasing i.e., do not buy Plant & Machinery - take them on rent.
(ii) Angel Investors: At the seed stage, the idea has not yet been tested. One has
to invest in R & D to possibly generate a patent. This is extremely risky and
the rule of 100/10/1 applies -
100 proposals
10 shortlisted
1 successful
So, obviously VC's do not get in at this stage. Funding is arranged from friends
and relatives - these people are primarily helping rather than eyeing on profit.
Hence they are known as angel investors.
(iii) Venture Capital Fund (already discussed)
SANJAY SARAF SIR 35

5. STARTUP INDIA INITIATIVE
In order to qualify for a startup in India, We need to get approval from Inter
ministerial Board.
There are four qualifying criteria to be fulfilled-
 The entity should be in existence for less than 5 years.

 Turnover should be less than 25 crores.
 It should be engaged in providing some innovative product or services
involving technology.
 It should not have been formed by the split up of an existing unit.
If a startup is approved by the board, there are several benefits in the form of tax
incentives, financial aid etc.
SANJAY SARAF SIR 36

SMALL AND MEDIUM ENTERPRISES
FROM PAGE 37 TO 39
HAS BEEN REMOVED

INTERNATIONAL FINANCIAL CENTRE
FROM PAGE 40 TO 47
HAS BEEN REMOVED

Risk Management - ICAI
LEARNING OUTCOMES : -
 Identification of types of Risk faced by an organization
 Evaluation of Financial Risks
 Value at Risk (VAR)
 Evaluation of appropriate method for the identification and management of
financial risk.
1. IDENTIFICATION OF TYPES OF RISK FACED BY AN

ORGANIZATION
A business organization faces many types of risks. Important among them
are discussed as below:
1.1. Strategic Risk

A successful business always needs a comprehensive and detailed business
plan. Everyone knows that a successful business needs a comprehensive, well-
thought-out business plan. But it’s also a fact of life that, if things changes, even
the best-laid plans can become outdated if it cannot keep pace with the latest
trends. This is what is called as strategic risk. So, strategic risk is a risk in which a
company’s strategy becomes less effective and it struggles to achieve its goal. It
could be due to technological changes, a new competitor entering the
market, shifts in customer demand, increase in the costs of raw materials, or
any number of other large-scale changes.
We can take the example of Kodak which was able to develop a digital
camera by 1975. But, it considers this innovation as a threat to its core business
model, and failed to develop it. However, it paid the price because when
digital camera was ultimately discovered by other companies, it failed to
develop it and left behind. Similar example can be given in case of Nokia when it
failed to upgrade its technology to develop touch screen mobile phones.
SANJAY SARAF SIR 48

That delay enables Samsung to become a market leader in touch screen mobile
phones.
However, a positive example can be given in the case of Xerox which

invented photocopy machine. When laser printing was developed, Xerox
was quick to lap up this opportunity and changes its business model to
develop laser printing. So, it survived the strategic risk and escalated its
profits further.
1.2. Compliance Risk

Every business needs to comply with rules and regulations. For example
with the advent of Companies Act, 2013, and continuous updating of SEBI
guidelines, each business organization has to comply with plethora of rules,
regulations and guidelines. Non compliance leads to penalties in the form of fine
and imprisonment.
However, when a company ventures into a new business line or a new

geographical area, the real problem then occurs. For example, a company
pursuing cement business likely to venture into sugar business in a different
state. But laws applicable to the sugar mills in that state are different. So, that
poses a compliance risk. If the company fails to comply with laws related to a
new area or industry or sector, it will pose a serious threat to its survival.
1.3. Operational Risk

This type of risk relates to internal risk. It also relates to failure on the part of the
company to cope with day to day operational problems. Operational risk relates
to ‘people’ as well as ‘process’. We will take an example to illustrate this. For
example, an employee paying out ` 1,00,000 from the account of the company
instead of ` 10,000.
SANJAY SARAF SIR 49

This is a people as well as a process risk. An organization can employ another

person to check the work of that person who has mistakenly paid ` 1,00,000 or it
can install an electronic system that can flag off an unusual amount.
1.4. Financial Risk

Financial Risk is referred as the unexpected changes in financial conditions
such as prices, exchange rate, Credit rating, and interest rate etc. Though
political risk is not a financial risk in direct sense but same can be included as
any unexpected political change in any foreign country may lead to country risk
which may ultimately may result in financial loss.
Accordingly, the broadly Financial Risk can be divided into following categories.
1.4.1. Counter Party Risk
This risk occurs due to non-honoring of obligations by the counter party

which can be failure to deliver the goods for the payment already made or
vice-versa or repayment of borrowings and interest etc. Thus, this risk also
covers the credit risk i.e. default by the counter party.
1.4.2. Political Risk

Generally this type of risk is faced by and overseas investors, as the
adverse action by the government of host country may lead to huge loses. This
can be on any of the following form.
 Confiscation or destruction of overseas properties.
 Rationing of remittance to home country.
 Restriction on conversion of local currency of host country into foreign
currency
 Restriction as borrowings.
 Invalidation of Patents
 Price control of products
SANJAY SARAF SIR 50

1.4.3. Interest Rate Risk

This risk occurs due to change in interest rate resulting in change in asset and
liabilities. This risk is more important for banking companies as their balance
sheet’s items are more interest sensitive and their base of earning is spread
between borrowing and lending rates.
As we know that the interest rates are two types i.e. fixed and floating. The risk
in both of these types is inherent. If any company has borrowed money at
floating rate then with increase in floating the liability under fixed rate shall
remain the same. This fixed rate, with falling floating rate the liability of
company to pay interest under fixed rate shall comparatively be higher.
1.4.4. Currency Risk

This risk mainly affects the organization dealing with foreign exchange as their
cash flows changes with the movement in the currency exchange rates. This
risk can be affected by cash flow adversely or favorably. For example, if
rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the
importer who has the liability to pay bill in US$. The best case we can quote
Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).
2. EVALUATION OF FINANCIAL RISK

The financial risk can be evaluated from different point of views as follows:
a. From stakeholder’s point of view: Major stakeholders of a business are
equity shareholders and they view financial gearing i.e. ratio of debt in
capital structure of company as risk since in event of winding up of a
company they will be least prioritized.
Even for a lender, existing gearing is also a risk since company having
high gearing faces more risk in default of payment of interest and principal
repayment.
SANJAY SARAF SIR 51

b. From Company’s point of view: From company’s point of view if a

company borrows excessively or lend to someone who defaults, then it can be
forced to go into liquidation.
c. From Government’s point of view: From Government’s point of view, the
financial risk can be viewed as failure of any bank or (like Lehman
Brothers) down grading of any financial institution leading to spread of
distrust among society at large. Even this risk also includes willful
defaulters. This can also be extended to sovereign debt crisis.
3. VALUE-AT-RISK (VAR)
As per Wikipedia, VAR is a measure of risk of investment. Given the normal
market condition in a set of period, say, one day it estimates how much an
investment might lose. This investment can be a portfolio, capital investment or
foreign exchange etc., VAR answers two basic questions -
i. What is worst case scenario?

ii. What will be loss?
It was first applied in 1922 in New York Stock Exchange, entered the financial
world in 1990s and become world’s most widely used measure of financial risk.
3.1. Features of VAR
Following are main features of VAR
i. Components of Calculations: VAR calculation is based on following three
components :
a. Time Period
b. Confidence Level – Generally 95% and 99%
c. Loss in percentage or in amount
ii. Statistical Method: It is a type of statistical tool based on Standard Deviation.
iii. Time Horizon: VAR can be applied for different time horizons say one
day, one week, one month and so on.
SANJAY SARAF SIR 52

iv. Probability: Assuming the values are normally attributed, probability of

maximum loss can be predicted.
v. Control Risk: Risk can be controlled by selling limits for maximum loss.
vi. Z Score: Z Score indicates how many standard Deviations is away
from Mean value of a population. When it is multiplied with Standard
Deviation it provides VAR.
3.2. Application of VAR

VAR can be applied
a. to measure the maximum possible loss on any portfolio or a trading position.
b. as a benchmark for performance measurement of any operation or trading.
c. to fix limits for individuals dealing in front office of a treasury department.
d. to enable the management to decide the trading strategies.
e. as a tool for Asset and Liability Management especially in banks.
3.3. Example:
The concept of VAR can be understood in a better manner with help of following
example:
Suppose you hold Rs. 2 crore shares of X Ltd. whose market price standard
deviation is 2% per day. Assuming 252 trading days a year, determine maximum
loss level over the period of 1 trading day and 10 trading days with 99%
confidence level.
Answer
Assuming share prices are normally for level of 99%, the equivalent Z score from
Normal table of Cumulative Area shall be 2.33.
Volatility in terms of rupees shall be:
2% of Rs. 2 Crore = Rs. 4 lakh
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The maximum loss for 1 day at 99% Confidence Level shall be:
Rs. 4 lakh x 2.33 = Rs. 9.32 lakh,
and expected maximum loss for 10 trading days shall be:
10  Rs. 9.32 lakh  29.47 lakhs
4. APPROPRIATE METHODS FOR IDENTIFICATION AND

MANAGEMENT OF FINANCIAL RISK
As we have classified financial risk in 4 categories, we shall discuss
identification and management of each risk separately under same category.
4.1. Counter Party risk:

The various hints that may provide counter party risk are as follows:
a. Failure to obtain necessary resources to complete the project or transaction
undertaken.
b. Any regulatory restrictions from the Government.
c. Hostile action of foreign government.
d. Let down by third party.
e. Have become insolvent.
The various techniques to manage this type of risk are as follows:

1. Carrying out Due Diligence before dealing with any third party.
2. Do not over commit to a single entity or group or connected entities.
3. Know your exposure limits.
4. Review the limits and procedure for credit approval regularly.
5. Rapid action in the event of any likelihood of defaults.
6. Use of performance guarantee, insurance or other instruments.
4.2. Political risk:

Since this risk mainly relates to investments in foreign country, company should
assess country
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1. By referring political ranking published by different business magazines.

2. By evaluating country’s macro-economic conditions.
3. By analyzing the popularity of current government and assess their stability.
4. By taking advises from the embassies of the home country in the host
countries.
5. Further, following techniques can be used to mitigate this risk.
i. Local sourcing of raw materials and labour.
ii. Entering into joint ventures
iii.Local financing
iv. Prior negotiations
From the following actions by the Governments of the host country this risk can
be identified;
1. Insistence on resident investors or labour.
2. Restriction on conversion of currency.
3. Repatriation of foreign assets of the local govt.
4. Price fixation of the products.
4.3. Interest Rate Risk:

Generally, interest rate Risk is mainly identified from the following:
1. Monetary Policy of the Government.
2. Any action by Government such as demonetization etc.
3. Economic Growth
4. Release of Industrial Data
5. Investment by foreign investors
6. Stock market changes
The rearrangement of Interest risk has been discussed in greater detail in
separate chapter later on.
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4.4. Currency Risk:

Just like interest rate risk the currency risk is dependent on the Government
action and economic development. Some of the parameters to identity the
currency risk are as follows:
1. Government Action: The Government action of any country has visual

impact in its currency. For example, the UK Govt. decision to divorce
from European Union i.e. Brexit brought the pound to its lowest since
1980’s.
2. Nominal Interest Rate: As per interest rate parity (IRP) the currency
exchange rate depends on the nominal interest of that country.
3. Inflation Rate: Purchasing power parity theory discussed in later chapters
impact the value of currency.
4. Natural Calamities: Any natural calamity can have negative impact.
5. War, Coup, Rebellion etc.: All these actions can have far reaching
impact on currency’s exchange rates.
6. Change of Government: The change of government and its attitude
towards foreign investment also helps to identify the currency risk.
So far as the management of currency risk, it is covered in detail in a separate

chapter.
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Securitization - ICAI
 Introduction
 Concept and Definition
 Benefits of Securitization
 Participants in Securitization
 Mechanism of Securitization
 Problems in Securitization
 Securitization Instruments
 Pricing of Securitization Instruments
 Securitization in India
1. INTRODUCTION
Some companies or firms who are involved in sending the money or making
credit sale must have a huge balance of receivables in their Balance Sheet.
Though they have a huge receivable but still they may face liquidity crunch to
run their business. One way may to adopt borrowing route, but this results
in change debt equity ratio of the company which may not be acceptable
to some stakeholders but also put companies to financial risk which affects
the future borrowings by the company. To overcome this problem the term
‘securitization’ was coined.
2. CONCEPT AND DEFINITION

The process of securitization typically involves the creation of pool of
assets from the illiquid financial assets, such as receivables or loans which
are marketable. In other words, it is the process of repackaging or
rebundling of illiquid assets into marketable securities. These assets can be
SANJAY SARAF SIR 57

automobile loans, credit card receivables, residential mortgages or any other

form of future receivables.
Features of Securitization
The securitization has the following features:
(i) Creation of Financial Instruments – The process of securities can be
viewed as process of creation of additional financial product of securities in
market backed by collaterals.
(ii) Bundling and Unbundling – When all the assets are combined in one pool
it is bundling and when these are broken into instruments of fixed
denomination it is unbundling.
(iii) Tool of Risk Management – In case of assets are securitized on non-
recourse basis, then securitization process acts as risk management as the
risk of default is shifted.
(iv) Structured Finance – In the process of securitization, financial
instruments are tailor structured to meet the risk return trade of
profile of investor, and hence, these securitized instruments are
considered as best examples of structured finance.
(v) Trenching – Portfolio of different receivable or loan or asset are split
into several parts based on risk and return they carry called ‘Trenche’.
Each Trench carries a different level of risk and return.
(vi) Homogeneity – Under each trenche the securities are issued of
homogenous nature and even meant for small investors the who can afford
to invest in small amounts.
3. BENEFITS OF SECURITIZATION
The benefits of securitization can be viewed from the angle of various parties
involved as follows:
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3.1 From the angle of originator

Originator (entity which sells assets collectively to Special Purpose Vehicle)
achieves the following benefits from securitization.
(i) Off – Balance Sheet Financing: When loan/receivables are securitized it
release a portion of capital tied up in these assets resulting in off
Balance Sheet financing leading to improved liquidity position which
helps expanding the business of the company.
(ii) More specialization in main business: By transferring the assets the entity
could concentrate more on core business as servicing of loan is
transferred to SPV. Further, in case of non - recourse arrangement even the
burden of default is shifted.
(iii) Helps to improve financial ratios: Especially in case of Financial
Institutions and Banks, it helps to manage Capital –To-Weighted Asset
Ratio effectively.
(iv) Reduced borrowing Cost: Since securitized papers are rated due to
credit enhancement even they can also be issued at reduced rate as of
debts and hence the originator earns a spread, resulting in reduced cost of
borrowings.
3.2 From the angle of investor

Following benefits accrues to the investors of securitized securities.
1. Diversification of Risk: Purchase of securities backed by different types of
assets provides the diversification of portfolio resulting in reduction of risk.
2. Regulatory requirement: Acquisition of asset backed belonging to a
particular industry say micro industry helps banks to meet regulatory
requirement of investment of fund in industry specific.
3. Protection against default: In case of recourse arrangement if there is any
default by any third party then originator shall make good the least
amount. Moreover, there can be insurance arrangement for compensation
for any such default.
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4. PARTICIPANTS IN SECURITIZATION
Broadly, the participants in the process of securitization can be divided into two
categories; one is Primary Participant and the other is Secondary Participant.
4.1 Primary Participants
Primary Participants are main parties to this process. The primary participants in
the process of securitization are as follows:
(a) Originator: It is the initiator of deal or can be termed as securitizer. It is an

entity which sells the assets lying in its books and receives the funds
generated through the sale of such assets. The originator transfers both
legal as well as beneficial interest to the Special Purpose Vehicle (discussed
later).
(b) Special Purpose Vehicle: Also, called SPV is created for the purpose of
executing the deal. Since issuer originator transfers all rights in assets
to SPV, it holds the legal title of these assets. It is created especially
for the purpose of securitization only and normally could be in form
of a company, a firm, a society or a trust.
The main objective of creating SPV to remove the asset from the Balance
Sheet of Originator. Since, SPV makes an upfront payment to the
originator, it holds the key position in the overall process of
securitization. Further, it also issues the securities (called Asset Based
Securities or Mortgage Based Securities) to the investors.
(c) The Investors: Investors are the buyers of securitized papers which
may be an individual, an institutional investor such as mutual funds,
provident funds, insurance companies, mutual funds, Financial
Institutions etc.
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Since, they acquire a participating in the total pool of

assets/receivable, they receive their money back in the form of interest
and principal as per the terms agree.
4.2 Secondary Participants
Besides the primary participants other parties involved into the

securitization process are as follows:
(a) Obligors: Actually they are the main source of the whole
securitization process. They are the parties who owe money to the firm
and are assets in the Balance Sheet of Originator. The amount due from
the obligor is transferred to SPV and hence they form the basis of
securitization process and their credit standing is of paramount
importance in the whole process.
(b) Rating Agency: Since the securitization is based on the pools of
assets rather than the originators, the assets have to be assessed in
terms of its credit quality and credit support available. Rating agency
assesses the following:
 Strength of the Cash Flow.
 Mechanism to ensure timely payment of interest and principle
repayment.
 Credit quality of securities.
 Liquidity support.
 Strength of legal framework.
Although rating agency is secondary to the process of securitization but it
plays a vital role.
(c) Receiving and Paying agent (RPA): Also, called Servicer or
Administrator, it collects the payment due from obligor(s) and passes it
to SPV. It also follow up with defaulting borrower and if required initiate
appropriate legal action against them. Generally, an originator or its
affiliates acts as servicer.
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(d) Agent or Trustee: Trustees are appointed to oversee that all parties to the
deal perform in the true spirit of terms of agreement. Normally, it takes
care of interest of investors who acquires the securities.
(e) Credit Enhancer: Since investors in securitized instruments are
directly exposed to performance of the underlying and sometime may
have limited or no recourse to the originator, they seek additional
comfort in the form of credit enhancement. In other words, they
require credit rating of issued securities which also empowers
marketability of the securities.
Originator itself or a third party say a bank may provide this
additional context called Credit Enhancer. While originator provides
his comfort in the form of over collateralization or cash collateral, the
third party provides it in form of letter of credit or surety bonds.
(f) Structurer: It brings together the originator, investors, credit enhancers
and other parties to the deal of securitization. Normally, these are
investment bankers also called arranger of the deal. It ensures that deal
meets all legal, regulatory, accounting and tax laws requirements.
5. MECHANISM OF SECURITIZATION
Let us discuss briefly the steps in securitization mechanism:
5.1 Creation of Pool of Assets

The process of securitization begins with creation of pool of assets by
segregation of assets backed by similar type of mortgages in terms of
interest rate, risk, maturity and concentration units.
5.2 Transfer to SPV

One assets have been pooled, they are transferred to Special Purpose
Vehicle (SPV) especially created for this purpose.
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5.3 Sale of Securitized Papers

SPV designs the instruments based on nature of interest, risk, tenure etc. based
on pool of assets. These instruments can be Pass Through Security or Pay
Through Certificates, (discussed later).
5.4 Administration of assets

The administration of assets in subcontracted back to originator which
collects principal and interest from underlying assets and transfer it to SPV,
which works as a conduct.
5.5 Recourse to Originator

Performance of securitized papers depends on the performance of
underlying assets and unless specified in case of default they go back to
originator from SPV.
5.6 Repayment of funds

SPV will repay the funds in form of interest and principal that arises from the
assets pooled.
5.7 Credit Rating to Instruments

Sometime before the sale of securitized instruments credit rating can be done to
assess the risk of the issuer.
The mechanism of Securities is shown below in diagrammatic form.
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6. PROBLEMS IN SECURITIZATION
Following are main problems faced in growth of Securitization of instruments

especially in Indian context:
6.1 Stamp Duty

Stamp Duty is one of the obstacle in India. Under Transfer of Property
Act, 1882, a mortgage debt stamp duty which even goes upto 12% in some
states of India and this impeded the growth of securitization in India. It should
be noted that since pass through certificate does not evidence any debt only able
to receivable, they are exempted from stamp duty.
Moreover, in India, recognizing the special nature of securitized instruments in
some states has reduced the stamp duty on them.
6.2 Taxation
Taxation is another area of concern in India. In the absence of any specific
provision relating to securitized instruments in Income Tax Act experts’ opinion
SIR PVT. LTD. | 64
differ a lot. Some are of opinion that in SPV as a trustee is liable to be taxed in a
representative capacity then other are of view that instead of SPV, investors will
be taxed on their share of income. Clarity is also required on the issues of capital
gain implications on passing payments to the investors.
6.3 Accounting
Accounting and reporting of securitized assets in the books of originator is
another area of concern. Although securitization is slated to an off-balance
sheet instrument but in true sense receivables are removed from originator’s
balance sheet. Problem arises especially when assets are transferred without
recourse.
6.4 Lack of standardization

every originator follows own format for documentation and administration
have lack of standardization is another obstacle in growth of securitization.
6.5 Inadequate Debt Market

Lack of existence of a well-developed debt market in India is another obstacle
that hinders the growth of secondary market of securitized or asset backed
securities.
6.6 Ineffective Foreclosure laws

For last many years there are efforts are going on for effective foreclosure
but still foreclosure laws are not supportive to lending institutions and this
makes securitized instruments especially mortgaged backed securities less
attractive as lenders face difficulty in transfer of property in event of default
by the borrower.
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7. SECURITIZATION INSTRUMENTS
On the basis of different maturity characteristics, the securitized

instruments can be divided into following three categories:
7.1 Pass Through Certificates (PTCs)

As the title suggests originator (seller of eh assets) transfers the entire receipt of
cash in form of interest or principal repayment from the assets sold. Thus, these
securities represent direct claim of the investors on all the assets that has been
securitized through SPV.
Since all cash flows are transferred the investors carry proportional beneficial
interest in the asset held in the trust by SPV.
It should be noted that since it is a direct route any prepayment of principal is
also proportionately distributed among the securities holders. Further, due to
these characteristics on completion of securitization by the final payment of
assets, all the securities are terminated simultaneously.
Skewness of cash flows occurs in early stage if principals are repaid before the
scheduled time.
7.2 Pay Through Security (PTS)

As mentioned earlier, since, in PTCs all cash flows are passed to the
performance of the securitized assets. To overcome this limitation and
limitation to single mature there is another structure i.e. PTS.
In contrast to PTC in PTS, SPV debt securities backed by the assets and hence it
can restructure different tranches from varying maturities of receivables.
In other words, this structure permits desynchronization of servicing of
securities issued from cash flow generating from the asset. Further, this
structure also permits the SPV to reinvest surplus funds for short term as per
their requirement.
Since, in Pass Through, all cash flow immediately in PTS in case of early
retirement of receivables plus cash can be used for short term yield. This
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structure also provides the freedom to issue several debt trances with varying
maturities.
7.3 Stripped Securities

Stripped Securities are created by dividing the cash flows associated with
underlying securities into two or more new securities. Those two securities are as
follows:
(i) Interest Only (IO) Securities
(ii) Principle Only (PO) Securities
As each investor receives a combination of principal and interest, it can be

stripped into two portion of Interest and Principle.
Accordingly, the holder of IO securities receives only interest while PO security

holder receives only principal. Being highly volatile in nature these securities are
less preferred by investors.
In case yield to maturity in market rises, PO price tends to fall as borrower

prefers to postpone the payment on cheaper loans. Whereas if interest rate
in market falls, the borrower tends to repay the loans as they prefer to borrow
fresh at lower rate of interest.
In contrast, value of IO’s securities increases when interest rate goes up in the
market as more interest is calculated on borrowings.
However, when interest rate due to prepayments of principals, IO’s tends to fall.
Thus, from the above, it is clear that it is mainly perception of investors
that determines the prices of IOs and POs.
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8. PRICING OF THE SECURITIZED INSTRUMENTS
Pricing of securitized instruments in an important aspect of securitization.

While pricing the instruments, it is important that it should be acceptable
to both originators as well as to the investors. On the same basis pricing of
securities can be divided into following two categories:
8.1 From Originator’s Angle

From originator’s point of view, the instruments can be priced at a rate at which
originator has to incur an outflow and if that outflow can be amortized
over a period of time by investing the amount raised through securitization.
8.2 From Investor’s Angle

From an investor’s angle security price can be determined by discounting
best estimate of expected future cash flows using rate of yield to maturity
of a security of comparable security with respect to credit quality and average
life of the securities. This yield can also be estimated by referring the yield
curve available for marketable securities, though some adjustments is
needed on account of spread points, because of credit quality of the securitized
instruments.
9. SECURITIZATION IN INDIA
It is the Citi Bank who pioneered the concept of securitization in India by

bundling of auto loans in securitized instruments.
Thereafter many organizations securitized their receivables. Although started

with securitization of auto loans it moved to other types of receivables such
as sales tax deferrals, aircraft receivable etc.
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In order to encourage securitization, the Government has come out with

Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest (SARFAESI) Act, 2002, to tackle menace of Non Performing
Assets (NPAs) without approaching to Court.
With growing sophistication of financial products in Indian Capital Market,

securitization has occupied an important place.
As mentioned above, though, initially started with auto loan receivables, it

has become an important source of funding for micro finance companies
and NBFCs and even now a days commercial mortgage backed securities are
also emerging.
The important highlight of the scenario of securitization in Indian Market is

that it is dominated by a few players e.g. ICICI Bank, HDFC Bank, NHB etc.
As per a report of CRISIL, securitization transactions in India scored to the

highest level of approximately ` 70000 crores, in Financial Year 2016. (Business
Line, 15th June, 2016)
In order to further enhance the investor base in securitized debts, SEBI allowed
FPIs to invest in securitized debt of unlisted companies upto a certain limit.
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Start up Finance - ICAI
 Introduction of Startup finance
 Pitch Presentation
 Sources of Funding
 Startup financing through Venture Capital Financing
1. THE BASICS OF STARTUP FINANCING
Startup financing means some initial infusion of money needed to turn an idea
(by starting a business) into reality. While starting out, big lenders like banks etc.
are not interested in a startup business. The reason is that when you are just
starting out, you're not at the point yet where a traditional lender or investor
would be interested in you. So that leaves one with the option of selling
some assets, borrowing against one’s home, asking loved ones i.e. family and
friends for loans etc. But, that involves a lot of risk, including the risk of
bankruptcy and strained relationships with friends and family.
So, the pertinent question is how to keep loans from family and friends strictly
businesslike. This is the hard part behind starting a business -- putting so much
at risk. But doing so is essential. It's what sets entrepreneurs apart from people
who collect regular salaries as employees.
A good way to get success in the field of entrepreneurship is to speed up initial

operations as quickly as possible to get to the point where outside investors can
see and feel the business venture, as well as understand that a person has taken
some risk reaching it to that level.
Some businesses can also be bootstrapped (attempting to found and build a

company from personal finances or from the operating revenues of the new
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company).They can be built up quickly enough to make money without any help
from investors who might otherwise come in and start dictating the terms.
In order to successfully launch a business and get it to a level where large

investors are interested in putting their money, requires a strong business plan. It
also requires seeking advice from experienced entrepreneurs and experts --
people who might invest in the business sometime in the future.
2. SOME OF THE INNOVATIVE WAYS TO FINANCE A STARTUP
Every startup needs access to capital, whether for funding product development,
acquiring machinery and inventory, or paying salaries to its employee. Most
entrepreneurs think first of bank loans as the primary source of money, only to
find out that banks are really the least likely benefactors for startups. So,
innovative measures include maximizing non-bank financing.
Here are some of the sources for funding a startup:

(i) Personal financing. It may not seem to be innovative but you may be
surprised to note that most budding entrepreneurs never thought of saving
any money to start a business. This is important because most of the
investors will not put money into a deal if they see that you have
not contributed any money from your personal sources.
(ii) Personal credit lines. One qualifies for personal credit line based on
one’s personal credit efforts. Credit cards are a good example of this.
However, banks are very cautious while granting personal credit lines.
They provide this facility only when the business has enough cash flow to
repay the line of credit.
(iii) Family and friends. These are the people who generally believe in
you, without even thinking that your idea works or not. However, the
loan obligations to friends and relatives should always be in writing as a
promissory note or otherwise.
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(iv) Peer-to-peer lending. In this process group of people come together

and lend money to each other. Peer to peer to lending has been there
for many years. Many small and ethnic business groups having similar
faith or interest generally support each other in their start up endeavors.
(v) Crowd funding. Crowd funding is the use of small amounts of capital
from a large number of individuals to finance a new business initiative.
Crowd funding makes use of the easy accessibility of vast networks of
people through social media and crowd funding websites to bring
investors and entrepreneurs together.
(vi) Microloans. Microloans are small loans that are given by individuals at a
lower interest to a new business ventures. These loans can be issued by
a single individual or aggregated across a number of individuals who
each contribute a portion of the total amount
(vii) Vendor financing. Vendor financing is the form of financing in which a
company lends money to one of its customers so that he can buy products
from the company itself. Vendor financing also takes place when many
manufacturers and distributors are convinced to defer payment until the
goods are sold. This means extending the payment terms to a longer
period for e.g. 30 days payment period can be extended to 45 days or
60 days. However, this depends on one’s credit worthiness and payment
of more money.
(viii)Purchase order financing. The most common scaling problem faced by
startups is the inability to find a large new order. The reason is that they
don’t have the necessary cash to produce and deliver the product. Purchase
order financing companies often advance the required funds directly to the
supplier. This allows the transaction to complete and profit to flow up to
the new business.
(ix) Factoring accounts receivables. In this method, a facility is given to the
seller who has sold the good on credit to fund his receivables till the
amount is fully received. So, when the goods are sold on credit, and
the credit period (i.e. the date up to which payment shall be made) is
SANJAY SARAF SIR 72
for example 6 months, factor will pay most of the sold amount upfront and
rest of the amount later. Therefore, in this way, a startup can meet his day
to day expenses.
3. PITCH PRESENTATION
Pitch deck presentation is a short and brief presentation (not more than 20
minutes) to investors explaining about the prospects of the company and why
they should invest into the startup business. So, pitch deck presentation is a
brief presentation basically using PowerPoint to provide a quick overview
of business plan and convincing the investors to put some money into the
business. Pitch presentation can be made either during face to face
meetings or online meetings with potential investors, customers, partners,
and co-founders. Here, some of the methods have been highlighted below
as how to approach a pitch presentation:
(i) Introduction
To start with, first step is to give a brief account of yourself i.e. who are
you? What are you doing? But care should be taken to make it short
and sweet. Also, use this opportunity to get your investors interested
in your company. One can also talk up the most interesting facts about
one’s business, as well as any huge milestones one may have achieved.
(ii) Team
The next step is to introduce the audience the people behind the
scenes. The reason is that the investors will want to know the
people who are going to make the product or service successful.
Moreover, the investors are not only putting money towards the idea but
they are also investing in the team. Also, an attempt should be made to
include the background of the promoter, and how it relates to the new
SANJAY SARAF SIR 73

company. Moreover, if possible, it can also be highlighted that the team

has worked together in the past and achieved significant results.
(iii) Problem
Further, the promoter should be able to explain the problem he is going to
solve and solutions emerging from it. Further the investors should be
convinced that the newly introduced product or service will solve the
problem convincingly.
For instance, when Facebook was launched in 2004, it added some new
features which give it a more professional and lively look in comparison
to Orkut which was there for some time. It enabled Facebook to become
an instant hit among the people. Further, customers have no privacy
while using Orkut. However, in Facebook, you can view a person’s
profile only if he adds you to his list. These simple yet effective
advantages that Facebook has over Orkut make it an extremely popular
social networking site.
(iv) Solution
It is very important to describe in the pitch presentation as to how the
company is planning to solve the problem. For instance, when Flipkart
first started its business in 2007, it brought the concept of e-
commerce in India. But when they started, payment through credit card
was rare. So, they introduced the system of payment on the basis of cash
on delivery which was later followed by other e-commerce companies in
India. The second problem was the entire supply chain system.
Delivering goods on time is one of the most important factors that
determine the success of an ecommerce company. Flipkart addressed this
issue by launching their own supply chain management system to deliver
orders in a timely manner. These innovative techniques used by Flipkart
enabled them to raise large amount of capital from the investors.
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(v) Marketing/Sales
This is a very important part where investors will be deeply interested.
The market size of the product must be communicated to the investors.
This can include profiles of target customers, but one should be prepared
to answer questions about how the promoter is planning to attract
the customers. If a business is already selling goods, the promoter
can also brief the investors about the growth and forecast future
revenue.
(vi) Projections or Milestones

It is true that it is difficult to make financial projections for a startup
concern. If an organization doesn’t have a long financial history, an
educated guess can be made. Projected financial statements can be
prepared which gives an organization a brief idea about where is the
business heading? It tells us that whether the business will be making
profit or loss?
Financial projections include three basic documents that make up a
business’s financial statements.
 Income statement: This projects how much money the business
will generate by projecting income and expenses, such as sales, cost
of goods sold, expenses and capital. For your first year in business,
you’ll want to create a monthly income statement. For the second
year, quarterly statements will suffice. For the following years, you’ll
just need an annual income statement.
 Cash flow statement: A projected cash flow statement will depict how
much cash will be coming into the business and out of that cash how
much cash will be utilized into the business. At the end of each period
(e.g. monthly, quarterly, annually), one can tally it all up to show
either a profit or loss.
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 Balance sheet: The balance sheet shows the business’s overall

finances including assets, liabilities and equity. Typically, one will
create an annual balance sheet for one’s financial projections.
(vii) Competition
Every business organization has competition even if the product or
service offered is new and unique. It is necessary to highlight in the pitch
presentation as to how the products or services are different from their
competitors. If any of the competitors have been acquired, there complete
details like name of the organization, acquisition prices etc. should be also
be highlighted.
(viii) Business Model

The term business model is a wide term denoting core aspects of a
business including purpose, business process, target customers,
offerings, strategies, infrastructure, organizational structures, sourcing,
trading practices, and operational processes and policies including
culture.
Further, as per Investopedia, a business model is the way in which a
company generates revenue and makes a profit from company
operations. Analysts use the term gross profit as a way to compare the
efficiency and effectiveness of a firm's business model. Gross profit is
calculated by subtracting the cost of goods sold from revenues. A
business model can be illustrated with the help of an example. There are
two companies – company A and company B. Both the companies are
engaged in the business of renting movies. Prior to the advent of
internet both the companies rent movies physically. Both the
companies made Rs. 5 crore as revenues. Cost of goods sold was
Rs. 400000. So, the companies made Rs. 100000 as gross profit. After
the introduction of internet, company A started to offer movies online
instead of renting or selling it physically. This change affected the
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business model of company A positively. Revenue is still Rs. 500000.

But the significant part is that cost of goods sold is now Rs. 200000
only. This is because online sales lead to significant reduction of storage
and distribution costs. So, the gross profit increases from 20% to 60%.
Therefore, Company A isn't making more in sales, but it figured out a
way to revolutionize its business model, which greatly reduces costs.
Managers at company A have an additional 40% more in margin to play
with than managers at company A. Managers at company A have
little room for error and they have to tread carefully.
Hence, every investor wants to get his money back, so it's important to
tell them in a pitch presentation as to how they should plan on generating
revenue. It is better to show the investors a list of the various revenue
streams for a business model and the timeline for each of them.
Further, how to price the product and what does the competitor charge
for the same or similar product shall also be highlighted. It is also
beneficial to discuss the lifetime value of the customer and what should
be the strategy to keep him glued to their product.
(ix) Financing
If a startup business firm has raised money, it is preferable to talk about
how much money has already been raised, who invested money into the
business and what they did about it. If no money has been raised till date,
an explanation can be made regarding how much work has been
accomplished with the help of minimum funding that the company is
managed to raise.
It is true that investors like to see entrepreneurs who have invested their
own money. If a promoter is pitching to raise capital he should list how
much he is looking to raise and how he intend to use the funds.
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4. MODES OF FINANCING FOR STARTUPS
(i) Bootstrapping
An individual is said to be boot strapping when he or she attempts
to found and build a company from personal finances or from the
operating revenues of the new company.
A common mistake made by most founders is that they make
unnecessary expenses towards marketing, offices and equipment they
cannot really afford. So, it is true that more money at the inception of
a business leads to complacency and wasteful expenditure. On the other
hand, investment by startups from their own savings leads to cautious
approach. It curbs wasteful expenditures and enable the promoter to be
on their toes all the time.
Here are some of the methods in which a startup firm can bootstrap:
(a) Trade Credit
When a person is starting his business, suppliers are reluctant to give trade
credit. They will insist on payment of their goods supplied either by cash or
by credit card. However, a way out in this situation is to prepare a well-
crafted financial plan. The next step is to pay a visit to the supplier’s
office. If the business organization is small, the owner can be directly
contacted. On the other hand, if it is a big firm, the Chief Financial Officer can
be contacted and convinced about the financial plan.
Communication skills are important here. The financial plan has to be shown.
The owner or the financial officer has to be explained about the business and
the need to get the first order on credit in order to launch the venture. The
owner or financial officer may give half the order on credit and
balance on delivery. The trick here is to get the goods shipped and sell them
before paying to them. One can also borrow to pay for the good sold. But
there is interest cost also. So trade credit is one of the most important
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ways to reduce the amount of working capital one needs. This is

especially true in retail operations.
When you visit your supplier to set up your order during your startup
period, ask to speak directly to the owner of the business if it's a small
company. If it's a larger business, ask to speak to the chief financial officer or
any other person who approves credit. Introduce yourself. Show the officer
the financial plan that you have prepared. Tell the owner or financial
officer about your business, and explain that you need to get your first
orders on credit in order to launch your venture.
The owner or financial officer may give half the order on credit, with the
balance due upon delivery. Of course, the trick here is to get the goods
shipped, and sell them before one has to pay for them. One could borrow
money to pay for the inventory, but you have to pay interest on that
money. So trade credit is one of the most important ways to reduce the
amount of working capital one needs. This is especially true in retail
operations.
(b) Factoring
This is a financing method where accounts receivable of a business
organization is sold to a commercial finance company to raise capital. The
factor then got hold of the accounts receivable of a business organization
and assumes the task of collecting the receivables as well as doing
what would've been the paperwork. Factoring can be performed on a
non-notification basis. It means customers may not be told that their
accounts have been sold.
However, there are merits and demerits to factoring. The process of factoring
may actually reduce costs for a business organization. It can actually
reduce costs associated with maintaining accounts receivable such as
bookkeeping, collections and credit verifications. If comparison can be
made between these costs and fee payable to the factor, in many cases it
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has been observed that it even proved fruitful to utilize this financing
method.
In addition to reducing internal costs of a business, factoring also frees up
money that would otherwise be tied to receivables. This is especially true
for businesses that sell to other businesses or to government; there are
often long delays in payment that this would offset. This money can be used
to generate profit through other avenues of the company. Factoring can be a
very useful tool for raising money and keeping cash flowing.
(c) Leasing
Another popular method of bootstrapping is to take the equipment on lease
rather than purchasing it. It will reduce the capital cost and also help
lessee (person who take the asset on lease)to claim tax exemption. So, it
is better to a take a photocopy machine, an automobile or a van on lease to
avoid paying out lump sum money which is not at all feasible for a startup
organization.
Further, if you are able to shop around and get the best kind of
leasing arrangement when you're starting up a new business, it's much
better to lease. It's better, for example, to lease a photocopier, rather than pay
$3,000 for it; or lease your automobile or van to avoid paying out $8,000 or
more.
There are advantages for both the startup businessman using the
property or equipment (i.e. the lessee) and the owner of that property or
equipment (i.e. the lessor.) The lessor enjoys tax benefits in the form of
depreciation on the fixed asset leased and may gain from capital
appreciation on the property, as well as making a profit from the lease. The
lessee benefits by making smaller payments retain the ability to walk away
from the equipment at the end of the lease term. The lessee may also claim
tax benefit in the form of lease rentals paid by him.
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(ii) Angel Investors

Despite being a country of many cultures and communities
traditionally inclined to business and entrepreneurship, India still ranks
low on comparative ratings across entrepreneurship, innovation and ease
of doing business. The reasons are obvious. These include our old and
outdated draconian rules and regulations which provides a hindrance to
our business environment for a long time. Other reasons are redtapism, our
time consuming procedures, and lack of general support for
entrepreneurship. Off course, things are changing in recent times.
As per Investopedia, Angel investors invest in small startups or
entrepreneurs. Often, angel investors are among an entrepreneur's family
and friends. The capital angel investors provide may be a one-time
investment to help the business propel or an ongoing injection of
money to support and carry the company through its difficult early
stages.
Angel investors provide more favorable terms compared to other lenders,
since they usually invest in the entrepreneur starting the business rather
than the viability of the business. Angel investors are focused on
helping startups take their first steps, rather than the possible profit they
may get from the business. Essentially, angel investors are the opposite of
venture capitalists.
Angel investors are also called informal investors, angel funders,
private investors, seed investors or business angels. These are affluent
individuals who inject capital for startups in exchange for ownership
equity or convertible debt. Some angel investors invest through crowd
funding platforms online or build angel investor networks to pool in
capital.
Angel investors typically use their own money, unlike venture capitalists
who take care of pooled money from many other investors and place them
in a strategically managed fund.
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Though angel investors usually represent individuals, the entity that

actually provides the fund may be a limited liability company, a
business, a trust or an investment fund, among many other kinds of
vehicles.
Angel investors who seed startups that fail during their early stages lose
their investments completely. This is why professional angel investors look
for opportunities for a defined exit strategy, acquisitions or initial public
offerings (IPOs).
(iii) Venture Capital Funds
Evolution
Venture Capital in India stated in the decade of 1970, when the
Government of India appointed a committee to tackle the issue of
inadequate funding to entrepreneurs and start-ups. However, it is only
after ten years that the first all India venture capital funding was started by
IDBI, ICICI and IFCI.
With the institutionalization of the industry in November 1988, the
government announced its guidelines in the “CCI” (Controller of
Capital Issues). These focused on a very narrow description of
Venture Capital and proved to be extremely restrictive and
encumbering, requiring investment in innovative technologies started
by first generation entrepreneur. This made investment in VC highly
risky and unattractive.
At about the same time, the World Bank organized a VC awareness
seminar, giving birth to players like: TDICICI, GVFL, Can bank and
Pathfinder. Along with the other reforms the government decided to
liberalize the VC Industry and abolish the “CCI”, while in 1995
Foreign Finance companies were allowed to invest in the country.
Nevertheless, the liberalization was short-spanned, with new calls for
regulation being made in 1996. The new guidelines’ loopholes created an
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unequal playing ground that favoured the foreign players and gave no
incentives to domestic high net worth individuals to invest in this industry.
VC investing got considerably boosted by the IT revolution in 1997, as the
venture capitalists became prominent founders of the growing IT and
telecom industry.
Many of these investors later floundered during the dotcom bust and most
of the surviving ones shifted their attention to later stage financing,
leaving the risky seed and start-up financing to a few daring funds.
Formation of venture capital has been depicted in the diagram below:
Investors in venture capital funds are shown in the following diagram:
Structure of Venture Capital Fund in India

Three main types of fund structure exist: one for domestic funds and two for
offshore ones:
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(a) Domestic Funds: Domestic Funds (i.e. one which raises funds domestically)
are usually structured as: i) a domestic vehicle for the pooling of funds from
the investor, and ii) a separate investment adviser that carries those duties of
asset manager. The choice of entity for the pooling vehicle falls between a
trust and a company, (India, unlike most developed countries does not
recognize a limited partnership), with the trust form prevailing due to its
operational flexibility.
(b) Offshore Funds: Two common alternatives available to offshore
investors are: the “offshore structure” and the “unified structure”.
Offshore structure: Under this structure, an investment vehicle (an LLC or

an LP organized in a jurisdiction outside India) makes investments directly
into Indian portfolio companies. Typically, the assets are managed by an
offshore manager, while the investment advisor in India carries out the due
diligence and identifies deals.
Unified Structure: When domestic investors are expected to participate in the

fund, a unified structure is used. Overseas investors pool their assets in an
offshore vehicle that invests in a locally managed trust, whereas domestic
investors directly contribute to the trust. This is later device used to make the
local portfolio investments.
Concept of Venture Capital Fund
Venture capital means funds made available for startup firms and small
businesses with exceptional growth potential. Venture capital is money
provided by professionals who alongside management invest in young, rapidly
growing companies that have the potential to develop into significant
economic contributors.
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Venture Capitalists generally:

 Finance new and rapidly growing companies
 Purchase equity securities
 Assist in the development of new products or services
 Add value to the company through active participation.
Characteristics of Venture Capital Financing:
(i) Long time horizon: The fund would invest with a long time horizon in
mind. Minimum period of investment would be 3 years and maximum
period can be 10 years.
(ii) Lack of liquidity: When VC invests, it takes into account the liquidity
factor. It assumes that there would be less liquidity on the equity it gets
and accordingly it would be investing in that format. They adjust this
liquidity premium against the price and required return.
(iii) High Risk: VC would not hesitate to take risk. It works on principle of high
risk and high return. So, high risk would not eliminate the investment
choice for a venture capital.
(iv) Equity Participation: Most of the time, VC would be investing in the form
of equity of a company. This would help the VC participate in the
management and help the company grow. Besides, a lot of board decisions
can be supervised by the VC if they participate in the equity of a company.
Advantages of bringing VC in the company:

 It injects long- term equity finance which provides a solid capital base for
future growth.
 The venture capitalist is a business partner, sharing both the risks and
rewards. Venture capitalists are rewarded with business success and capital
gain.
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 The venture capitalist is able to provide practical advice and assistance to the
company based on past experience with other companies which were in
similar situations.
 The venture capitalist also has a network of contacts in many areas
that can add value to the company.
 The venture capitalist may be capable of providing additional rounds
of funding should it be required to finance growth.
 Venture capitalists are experienced in the process of preparing a
company for an initial public offering (IPO) of its shares onto the stock
exchanges or overseas stock exchange such as NASDAQ.
 They can also facilitate a trade sale.
Stages of funding for VC:
1. Seed Money: Low level financing needed to prove a new idea.

2. Start-up: Early stage firms that need funding for expenses associated with
marketing and product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies that are
selling product, but not yet turning in a profit.
5. Third Round: Also called Mezzanine financing, this is expansion money for a
newly profitable company.
6. Fourth-Round: Also called bridge financing, it is intended to finance the
"going public" process.
Risk in each stage is different. An indicative Risk matrix is given below:
Financial Period (Funds Risk Activity to be

Stage locked in years) Perception financed
Seed Money 7-10 Extreme For supporting a
concept or idea or
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R&D for product

development
Start Up 5-9 Very High Initializing
prototypes
operations or
developing
First Stage 3-7 High Start commercials
marketing
production and
Second Stage 3-5 Sufficiently Expand market and
high growing working
capital need
Third Stage 1-3 Medium Market expansion,
acquisition &
product
development for
profit making
company
Fourth Stage 1-3 Low Facilitating public
issue
VC Investment Process
The entire VC Investment process can be segregated into the following steps:
1. Deal Origination: VC operates directly or through intermediaries. Mainly
many practicing Chartered Accountants would work as intermediary and
through them VC gets the deal.
Before sourcing the deal, the VC would inform the intermediary or its
employees about the following so that the sourcing entity does not waste
time :
 Sector focus
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 Stages of business focus

 Promoter focus
 Turn over focus
Here the company would give a detailed business plan which consists of
business model, financial plan and exit plan. All these aspects are covered in
a document which is called Investment Memorandum (IM). A tentative
valuation is also carried out in the IM.
2. Screening: Once the deal is sourced the same would be sent for
screening by the VC. The screening is generally carried out by a committee
consisting of senior level people of the VC. Once the screening happens, it
would select the company for further processing.
3. Due Diligence: The screening decision would take place based on the
information provided by the company. Once the decision is taken to
proceed further, the VC would now carry out due diligence. This is
mainly the process by which the VC would try to verify the veracity of the
documents taken. This is generally handled by external bodies, mainly
renowned consultants. The fees of due diligence are generally paid by the
VC. However, in many cases, this can be shared between the investor (VC)
and Investee (the company) depending on the veracity of the document
agreement.
4. Deal Structuring: Once the case passes through the due diligence it would
now go through the deal structuring. The deal is structured in such a way
that both parties win. In many cases, the convertible structure is brought in to
ensure that the promoter retains the right to buy back the share. Besides, in
many structures to facilitate the exit, the VC may put a condition that
promoter has also to sell part of its stake along with the VC. Such a clause is
called tag- along clause.
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5. Post Investment Activity: In this section, the VC nominates its nominee

in the board of the company. The company has to adhere to certain
guidelines like strong MIS, strong budgeting system, strong corporate
governance and other covenants of the VC and periodically keep the
VC updated about certain mile-stones. If milestone has not been met the
company has to give explanation to the VC. Besides, VC would also ensure
that professional management is set up in the company.
6. Exit plan: At the time of investing, the VC would ask the promoter or
company to spell out in detail the exit plan. Mainly, exit happens in two
ways: one way is ‘sell to third party(ies)’. This sale can be in the form of IPO
or Private Placement to other VCs. The second way to exit is that promoter
would give a buy back commitment at a pre agreed rate (generally between
IRR of 18% to 25%). In case the exit is not happening in the form of IPO or
third party sell, the promoter would buy back. In many deals, the promoter
buyback is the first refusal method adopted i.e. the promoter would get
the first right of buyback.
5. STARTUP INDIA INITIATIVE
Startup India scheme was initiated by the Government of India on 16th of

January, 2016. The definition of startup was provided which is applicable only in
case of Government Schemes.
Startup means an entity, incorporated or registered in India:

 Not prior to five years,
 With annual turnover not exceeding ` 25 crore in any preceding financial
year, and
 Working towards innovation, development, deployment or
commercialization of new products, processes or services driven by
technology or intellectual property.
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Provided that such entity is not formed by splitting up, or reconstruction,

of a business already in existence. Provided also that an entity shall cease
to be a Startup if its turnover for the previous financial years has exceeded
` 25 crore or it has completed 5 years from the date of incorporation/
registration. Provided further that a Startup shall be eligible for tax benefits
only after it has obtained certification from the Inter-Ministerial Board, setup for
such purpose.
What is a Startup to avail government schemes?
Up to 5 years from its date of incorporation / registration
Incorporated as either a Private Limited Company or a Registered Partnership

Firm or a Limited Liability Partnership
Turnover for any fiscal year has not exceeded INR 25 crore

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Entity should not have been formed by splitting up or reconstruction a

business already in existence
Working towards innovation, development, deployment or commercialization of

new product, processes or services driven by technology or intellectual property.

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SMALL AND MEDIUM ENTERPRISES
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PART - 2
FINANCIAL POLICY & CORPORATE STRATEGY 114 - 117
RISK MANAGEMENT 118
SECURITY ANALYSIS 131 - 137
SECURITY VALUATION 138 - 139
PORTFOLIO MANAGEMENT 140 - 145
MUTUAL FUNDS 146 - 151
DERIVATIVES ANALYSIS AND VALUATION 152 - 158
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 159 - 163
INTERNATIONAL FINANCIAL MANAGEMENT 164 - 167
INTEREST RATE RISK MANAGEMENT 168 - 171
CORPORATE VALUATION 172 - 178
MERGERS, ACQUISITIONS & CORPORATE RESTRUCTURING 179 - 189

FINANCIAL POLICY & CORPORATE STRATEGY
QUESTIONS & SOLUTIONS:
1. Explain the Interface of Financial Policy and Strategic Management.

The interface of strategic management and financial policy will be
clearly understood if we appreciate the fact that the starting point of an
organization is money and the end point of that organization is also
money. No organization can run an existing business and promote a
new expansion project without a suitable internally mobilized financial
base or both i.e. internally and externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of
a strategic plan. The need for fund mobilization to support the expansion
activity of firm is very vital for any organization. The generation of funds
may arise out of ownership capital and or borrowed capital. A company may
issue equity shares and/or preference shares for mobilizing ownership capital
and debentures to raise borrowed capital. Public deposits, for a fixed time
period, have also become a major source of short and medium term
finance. Organizations may offer higher rates of interest than banking
institutions to attract investors and raise fund. The overdraft, cash
credits, bill discounting, bank loan and trade credit are the other sources of
short term finance.
Along with the mobilization of funds, policy makers should decide on
the capital structure to indicate the desired mix of equity capital and debt
capital. There are some norms for debt equity ratio which need to be followed
for minimizing the risks of excessive loans. For instance, in case of public
sector organizations, the norm is 1:1 ratio and for private sector firms, the
norm is 2:1 ratio. However this ratio in its ideal form varies from industry to
industry. It also depends on the planning mode of the organization. For
capital intensive industries, the proportion of debt to equity is much higher.
Similar is the case for high cost projects in priority sectors and for
projects in under developed regions.
Another important dimension of strategic management and financial

policy interface is the investment and fund allocation decisions. A
planner has to frame policies for regulating investments in fixed assets and
for restraining of current assets. Investment proposals mooted by different
business units may be divided into three groups. One type of proposal will be
for addition of a new product by the firm. Another type of proposal will be to
increase the level of operation of an existing product through either an
increase in capacity in the existing plant or setting up of another plant
for meeting additional capacity requirement. The last is for cost
reduction and efficient utilization of resources through a new approach
and/or closer monitoring of the different critical activities. Now, given these
three types of proposals a planner should evaluate each one of them by
making within group comparison in the light of capital budgeting exercise. In
fact, project evaluation and project selection are the two most important jobs
under fund allocation. Planner’s task is to make the best possible allocation
under resource constraints.
Dividend policy is yet another area for making financial policy decisions
affecting the strategic performance of the company. A close interface is
needed to frame the policy to be beneficial for all. Dividend policy decision
deals with the extent of earnings to be distributed as dividend and the extent
of earnings to be retained for future expansion scheme of the firm. From the
point of view of long term funding of business growth, dividend can be
considered as that part of total earnings, which cannot be profitably
utilized by the company. Stability of the dividend payment is a desirable
consideration that can have a positive impact on share prices. The
alternative policy of paying a constant percentage of the net earnings may
be preferable from the point of view of both flexibility of the firm and ability
of the firm. It also gives a message of lesser risk for the investors. Yet some
other companies follow a different alternative. They pay a minimum
dividend per share and additional dividend when earnings are higher
than the normal earnings. In actual practice, investment opportunities
and financial needs of the firm and the shareholders preference for
dividend against capital gains resulting out of share are to be taken into
consideration for arriving at the right dividend policy. Alternatives like
cash dividend and stock dividend are also to be examined while
working out an ideal dividend policy that supports and promotes the
corporate strategy of the company.
Thus, the financial policy of a company cannot be worked out in
isolation of other functional policies. It has a wider appeal and closer
link with the overall organizational performance and direction of growth.
These policies being related to external awareness about the firm, especially
the awareness of the investors about the firm, in respect of its internal
performance. There is always a process of evaluation active in the minds of
the current and future stake holders of the company. As a result preference
and patronage for the company depends significantly on the financial
policy framework. Hence, attention of the corporate planners must be drawn
while framing the financial policies not at a later stage but during the
stage of corporate planning itself. The nature of interdependence is the
crucial factor to be studied and modelled by using an in depth
analytical approach. This is a very difficult task compared to usual cause and
effect study because corporate strategy is the cause and financial policy is the
effect and sometimes financial policy is the cause and corporate strategy is the
effect.
2. Write a short note on Balancing Financial Goals vis-a-vis Sustainable Growth.

The concept of sustainable growth can be helpful for planning healthy
corporate growth. This concept forces managers to consider the financial
consequences of sales increases and to set sales growth goals that are
consistent with the operating and financial policies of the firm. Often, a
conflict can arise if growth objectives are not consistent with the value
of the organization's sustainable growth. Question concerning right
distribution of resources may take a difficult shape if we take into
consideration the rightness not for the current stakeholders but for the
future stakeholders also. To take an illustration, let us refer to fuel industry
where resources are limited in quantity and a judicial use of resources is
needed to cater to the need of the future customers along with the need
of the present customers. One may have noticed the save fuel campaign,
a demarcating campaign that deviates from the usual approach of sales
growth strategy and preaches for conservation of fuel for their use
across generation. This is an example of stable growth strategy adopted by
the oil industry as a whole under resource constraints and the long run
objective of survival over years. Incremental growth strategy, profit
strategy and pause strategy are other variants of stable growth strategy.
Sustainable growth is important to enterprise long-term development. Too
fast or too slow growth will go against enterprise growth and
development, so financial should play important role in enterprise
development, adopt suitable financial policy initiative to make sure
enterprise growth speed close to sustainable growth ratio and have
sustainable healthy development.

RISK MANAGEMENT
1. Explain the significance of VAR.
VAR can be applied

a. to measure the maximum possible loss on any portfolio or a trading
position.
b. as a benchmark for performance measurement of any operation or trading.
c. to fix limits for individuals dealing in front office of a treasury department.
d. to enable the management to decide the trading strategies.
e. as a tool for Asset and Liability Management especially in banks.
2. The Financial Risk can be viewed from different perspective. Explain.
The financial risk can be evaluated from different point of views as follows:
a. From stakeholder’s point of view: Major stakeholders of a business
are equity shareholders and they view financial gearing i.e. ratio of debt in
capital structure of company as risk since in event of winding up of
a company they will be least prioritized.
Even for a lender, existing gearing is also a risk since company having
high gearing faces more risk in default of payment of interest and principal
repayment.
b. From Company’s point of view: From company’s point of view if a
company borrows excessively or lend to someone who defaults, then
it can be forced to go into liquidation.
c. From Government’s point of view: From Government’s point of view, the
financial risk can be viewed as failure of any bank or (like Lehman
Brothers) down grading of any financial institution leading to spread
of distrust among society at large. Even this risk also includes willful
defaulters. This can also be extended to sovereign debt crisis.
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INDIAN FINANCIAL SYSTEM
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SECURITY ANALYSIS
1. Explain the Efficient Market Theory in and what are major misconceptions
about this theory?
Efficient Market Theory was developed by University of Chicago
professor Eugen Fama in the 1960s. As per this theory, at any given
time, all available price sensitive information is fully reflected in
securities' prices. Thus this theory implies that no investor can consistently
outperform the market as every stock is appropriately priced based on
available information.
Stating otherwise theory states that no none can "beat the market" hence
making it impossible for investors to either purchase undervalued stocks
or sell stocks for inflated prices as stocks are always traded at their fair
value on stock exchanges. Hence it is impossible to outperform the
overall market through expert stock selection or market timing and that
the only way an investor can possibly obtain higher returns is by
purchasing riskier investments.
2. Explain Dow Jones theory.

The Dow Theory is one of the oldest and most famous technical
theories. It was originated by Charles Dow, the founder of Dow Jones
Company in late nineteenth century. It is a helpful tool for determining the
relative strength of the stock market. It can also be used as a barometer
of business.
The Dow Theory is based upon the movements of two indices, constructed by
Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA). These averages reflect the aggregate impact

SECURITY ANALYSIS
of all kinds of information on the market. The movements of the market

are divided into three classifications, all going at the same time; the primary
movement, the secondary movement, and the daily fluctuations. The
primary movement is the main trend of the market, which lasts from one
year to 36 months or longer. This trend is commonly called bear or bull
market. The secondary movement of the market is shorter in duration
than the primary movement, and is opposite in direction. It lasts from
two weeks to a month or more. The daily fluctuations are the narrow
movements from day-to-day. These fluctuations are not part of the Dow
Theory interpretation of the stock market. However, daily movements
must be carefully studied, along with primary and secondary movements, as
they go to make up the longer movement in the market.
Thus, the Dow Theory’s purpose is to determine where the market is

and where is it going, although not how far or high. The theory, in practice,
states that if the cyclical swings of the stock market averages are
successively higher and the successive lows are higher, then the market
trend is up and a bullish market exists. Contrarily, if the successive highs and
successive lows are lower, then the direction of the market is down and a
bearish market exists.
Charles Dow proposed that the primary uptrend would have three
moves up, the first one being caused by accumulation of shares by the far-
sighted, knowledgeable investors, the second move would be caused by the
arrival of the first reports of good earnings by corporations, and the last move
up would be caused by widespread report of financial well-being of
corporations. The third stage would also see rampant speculation in the
market. Towards the end of the third stage, the far-sighted investors,
realizing that the high earnings levels may not be sustained, would start
selling, starting the first move down of a downtrend, and as the non-
sustainability of high earnings is confirmed, the second move down would be
SECURITY ANALYSIS
initiated and then the third move down would result from distress selling in
the market.
3. Explain the Elliot Theory of technical analysis.

Inspired by the Dow Theory and by observations found throughout nature,
Ralph Elliot formulated Elliot Wave Theory in 1934. This theory was based on
analysis of 75 years stock price movements and charts. From his studies, he
defined price movements in terms of waves. Accordingly, this theory
was named Elliot Wave Theory. Elliot found that the markets exhibited
certain repeated patterns or waves. As per this theory wave is a movement of
the market price from one change in the direction to the next change in the
same direction. These waves are resulted from buying and selling impulses
emerging from the demand and supply pressures on the market.
Depending on the demand and supply pressures, waves are generated in the
prices.
As per this theory, waves can be classified into two parts:-

 Impulsive patterns
 Corrective patters
Let us discuss each of these patterns.
a. Impulsive Patterns-(Basic Waves) - In this pattern there will be 3 or
5 waves in a given direction (going upward or downward). These waves
shall move in the direction of the basic movement. This movement can
indicate bull phase or bear phase.
b. Corrective Patterns- (Reaction Waves) - These 3 waves are against the
basic direction of the basic movement. Correction involves correcting the
earlier rise in case of bull market and fall in case of bear market.
As shown in the following diagram waves 1, 3 and 5 are directional
movements, which are separated or corrected by wave 2 & 4, termed as
corrective movements.

SECURITY ANALYSIS
Complete Cycle - As shown in following figure five-wave impulses is

following by a three- wave correction (a, b & c) to form a complete cycle
of eight waves.
One complete cycle consists of waves made up of two distinct phases,

bullish and bearish. On completion of full one cycle i.e. termination of
8 waves movement, the fresh cycle starts with similar impulses arising
out of market trading.

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SECURITY ANALYSIS
4. Explain the various indicators that can be used to assess the performance of an
economy.
Economic analysis is used to forecast national income with its various
components that have a bearing on the concerned industry and the company
in particular. Gross national product (GNP) is used to measure national
income as it reflects the growth rate in economic activities and has been
regarded as a forecasting tool for analyzing the overall economy along with its
various components during a particular period.
Some of the techniques used for economic analysis are:

a. Anticipatory Surveys: They help investors to form an opinion about
the future state of the economy. It incorporates expert opinion on
construction activities, expenditure on plant and machinery, levels of
inventory – all having a definite bearing on economic activities. Also
future spending habits of consumers are taken into account.
In spite of valuable inputs available through this method, it has certain
drawbacks:
(i) Survey results do not guarantee that intentions surveyed would
materialize.
(ii) They are not regarded as forecasts per se, as there can be a
consensus approach by the investor for exercising his opinion.
Continuous monitoring of this practice is called for to make this technique
popular.
b. Barometer/Indicator Approach: Various indicators are used to find
out how the economy shall perform in the future. The indicators have
been classified as under:
(i) Leading Indicators: They lead the economic activity in terms of their
outcome. They relate to the time series data of the variables that
reach high/low points in advance of economic activity.
(ii) Roughly Coincidental Indicators: They reach their peaks and
troughs at approximately the same in the economy.
SECURITY ANALYSIS
(iii) Lagging Indicators: They are time series data of variables that
lag behind in their consequences vis-a- vis the economy. They reach
their turning points after the economy has reached its own already.
All these approaches suggest direction of change in the aggregate
economic activity but nothing about its magnitude. The various
measures obtained form such indicators may give conflicting signals
about the future direction of the economy. To avoid this limitation,
use of diffusion/composite index is suggested whereby combining
several indicators into one index to measure the strength/weaknesses in
the movement of a particular set of indicators. Computation of diffusion
indices is no doubt difficult notwithstanding the fact it does not
eliminate irregular movements.
Money supply in the economy also affects investment decisions. Rate of
change in money supply in the economy affects GNP, corporate profits,
interest rates and stock prices. Increase in money supply fuels inflation.
As investment in stocks is considered as a hedge against inflation,
stock prices go up during inflationary period.
c. Economic Model Building Approach: In this approach, a precise and
clear relationship between dependent and independent variables is
determined. GNP model building or sectoral analysis is used in practice
through the use of national accounting framework. The steps used are as
follows:
(i) Hypothesize total economic demand by measuring total income
(GNP) based on political stability, rate of inflation, changes in
economic levels.
(ii) Forecasting the GNP by estimating levels of various components
viz. consumption expenditure, gross private domestic investment,
government purchases of goods/services, net exports.
(iii) After forecasting individual components of GNP, add them up to
obtain the forecasted GNP.

SECURITY ANALYSIS
(iv) Comparison is made of total GNP thus arrived at with that from
an independent agency for the forecast of GNP and then the overall
forecast is tested for consistency. This is carried out for ensuring that
both the total forecast and the component wise forecast fit
together in a reasonable manner.

SECURITY VALUATION
1. Why should the duration of a coupon carrying bond always be less than the
time to its maturity?
The concept of duration is straightforward. 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.
It measures how quickly a bond will repay its true cost. The longer the
time it takes the greater exposure the bond has to changes in the interest
rate environment. Following are some of factors that affect bond's duration:
(i) Time to maturity: The shorter-maturity bond would have a lower
duration and less price risk and vice versa.
(ii) Coupon rate: Coupon payment is a key factor in calculation of duration
of bonds. The higher the coupon, the lower is the duration and vice versa.
Although there are many formulae to calculate the duration. However,
following are commonly used methods:
a. Macaulay Duration: This formula measures the number of years required
to recover the true cost of a bond, considering the present value of all
coupon and principal payments received in the future. The formula for
Macaulay duration is as follows:
n
t*c n*M
 1  i   1  i 
t 1
t n
Macaulay Duration =
P
Where,
n = Number of cash flows
t = Time to maturity
C = Cash flows
SECURITY VALUATION
i = Required yield
M = Maturity (par) value
P = Bond price
b. Modified Duration: This is a modified version of Macaulay duration
which takes into account the interest rate changes because the changes
in interest rates affect duration as the yield gets affected each time the
interest rate varies.
The formula for modified duration is as follows:
 
 Macaulay Duration 
Modified Duration =  
  YTM  
 1  
 n 
Where
n = Number of compounding periods per year
YTM= Yield to Maturity
Some of the terms associated with Bond Valuation are as follows:
2. Write short notes on Zero coupon bonds.

As name indicates these bonds do not pay interest during the life of
the bonds. Instead, zero coupon bonds are issued at discounted price to their
face value, which is the amount a bond will be worth when it matures or
comes due. When a zero coupon bond matures, the investor will receive
one lump sum (face value) equal to the initial investment plus interest
that has been accrued on the investment made. The maturity dates on zero
coupon bonds are usually long term. These maturity dates allow an
investor for a long range planning. Zero coupon bonds issued by banks,
government and private sector companies. However, bonds issued by
corporate sector carry a potentially higher degree of risk, depending on
the financial strength of the issuer and longer maturity period, but they
also provide an opportunity to achieve a higher return.

PORTFOLIO MANAGEMENT
1. Write short note on factors affecting decision of investment in fixed income

securities.
There are certain criteria which must be kept in mind while selecting
securities. The selection criteria for both bonds and equity shares are given as
following:
Selection of Bonds
Bonds are fixed income avenues. The following factors have to be
evaluated in selecting fixed income avenues:
a. Yield to maturity: The yield to maturity for a fixed income avenues
represent the rate of return earned by the investor, if he invests in the fixed
income avenues and holds it till its maturity.
b. Risk of Default: To assess such risk on a bond, one has to look at
the credit rating of the bond. If no credit rating is available relevant
financial ratios of the firm have to be examined such as debt equity,
interest coverage, earning power etc and the general prospect of the
industry to which the firm belongs have to be assessed.
c. Tax Shield: In the past, several fixed income avenues offers tax shields but
at present only a few of them do so.
d. Liquidity: If the fixed income avenues can be converted wholly or
substantially into cash at a fairly short notice it possesses a liquidity of a
high order.
Selection of Stock (Equity Share)

Three approaches are applied for selection of equity shares- Technical
analysis, Fundamental analysis and Random selection analysis.
a. Technical analysis looks at price behaviours and volume data to determine
whether the share will move up or down or remain trend less.
b. Fundamental analysis focuses on fundamental factors like earning

level, growth prospects and risk exposure to establish intrinsic value of a
share. The recommendation to buy hold or sell is based on comparison of
intrinsic value and prevailing market price.
c. Random selection analysis is based on the premise that the market is
efficient and security is properly priced.
Levels of Market Efficiency And Approach To Security Selection
2. Briefly explain the objectives of “Portfolio Management”.

Some of the important objectives of portfolio management are:
(i) Security/Safety of Principal: Security not only involves keeping the

principal sum intact but also its purchasing power.
(ii) Stability of Income: To facilitate planning more accurately and
systematically the reinvestment or consumption of income.
(iii) Capital Growth: It can be attained by reinvesting in growth securities or
through purchase of growth securities.
(iv) Marketability i.e. the case with which a security can be bought or sold:
This is essential for providing flexibility to investment portfolio.
(v) Liquidity i.e. nearness to money: It is desirable for the investor so as to
take advantage of attractive opportunities upcoming in the market.
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(vi) Diversification: The basic objective of building a portfolio is to

reduce the risk of loss of capital and/or income by investing in
various types of securities and over a wide range of industries.
(vii)Favourable Tax Status: The effective yield an investor gets from his
investment depends on tax to which it is subjected to. By minimising
the tax burden, yield can be effectively improved.
3. Discuss the Capital Asset Pricing Model (CAPM) and its relevant
assumptions.
The CAPM distinguishes between risk of holding a single asset and holding a
portfolio of assets. There is a trade off between risk and return. Modern
portfolio theory concentrates on risk and stresses on risk management
rather than on return management. Risk may be security risk involving
danger of loss of return from an investment in a single financial or capital
asset. Security risk differs from portfolio risk, which is the probability of
loss from investment in a portfolio of assets. Portfolio risk is comprised of
unsystematic risk and systematic risk. Unsystematic risks can be averted
through diversification and is related to random variables. Systematic
risk is market related component of portfolio risk. It is commonly measured
by regression coefficient Beta or the Beta coefficient. Low Beta reflects low risk
and high Beta reflects high risk.
As the unsystematic risk can be diversified by building a portfolio, the

relevant risk is the non- diversifiable component of the total risk. As
mentioned earlier, it can be measured by using Beta (β) a statistical
parameter which measures the market sensitivity of returns. The beta for
the market is equal to 1.0. Beta explains the systematic relationship between
the return on a security and the return on the market by using a simple linear
regression equation. The return on a security is taken as a dependent variable
and the return on market is taken as independent variable then Rj = Rf + β
(Rm – Rf). The beta parameter β in this William Sharpe model represents the
slope of the above regression relationship and measures the sensitivity or

responsiveness of the security returns to the general market returns. The
portfolio beta is merely the weighted average of the betas of individual
securities included in the portfolio. Portfolio beta β =  proportion of security
× beta for security.
CAPM provides a conceptual framework for evaluating any investment

decision where capital is committed with a goal of producing future
returns. CAPM is based on certain assumptions to provide conceptual
framework for evaluating risk and return. Some of the important
assumptions are discussed below:
(i) Efficient market: It is the first assumption of CAPM. Efficient market

refers to the existence of competitive market where financial securities
and capital assets are bought and sold with full information of risk and
return available to all participants. In an efficient market, the price of
individual assets will reflect a real or intrinsic value of a share as the
market prices will adjust quickly to any new situation, John J.
Hampton has remarked in “Financial decision making” that although
efficient capital market is not much relevant to capital budgeting
decisions, but CAPM would be useful to evaluate capital budgeting
proposal because the company can compare risk and return to be
obtained by investment in machinery with risk and return from
investment in securities.
(ii) Rational investment goals: Investors desire higher return for any
acceptable level of risk or the lowest risk for any desired level of return.
Such a rational choice is made on logical and consistent ranking of
proposals in order of preference for higher good to lower good and this
is the scale of the marginal efficiency of capital. Beside, transactive
preferences and certainty equivalents are other parameters of rational
choice.
(iii) Risk aversion in efficient market is adhered to although at times

risk seeking behaviour is adopted for gains.
(iv) CAPM assumes that all assets are divisible and liquid assets.
(v) Investors are able to borrow freely at a risk less rate of interest i.e.
borrowings can fetch equal return by investing in safe Government
securities.
(vi) Securities can be exchanged without payment of brokerage,
commissions or taxes and without any transaction cost.
(vii) Securities or capital assets face no bankruptcy or insolvency.
Based on above assumptions the CAPM is developed with the main

goal to formulate the return required by investors from a single investment
or a portfolio of assets. The required rate of return is defined as the
minimum expected return needed so that investors will purchase and
hold an asset.
Risk and return relationship in this model stipulates higher return for higher
level of risk and vice versa. However, there may be exception to this general
rule where markets are not efficient.
Three aspects are worth consideration:

a. Stock market is not concerned with diversifiable risk
b. It is not concerned with an investor having a diversified portfolio
c. Compensation paid is restricted to non-diversifiable risk.
Thus an investor has to look into the non-diversifiable portion of risk on

one side and returns on the other side. To establish a link between the
two, the required return one expects to get for a given level of risk has
been mandated by the Capital Asset Pricing Model.
If the risk free investment Rf is 5%, an investor can earn this return of 5% by
investing in risk free investment. Again if the stock market earns a rate of
return Rm which is 15% then an investor investing in stocks constituting
the stock market index will earn also 15%. Thus the excess return earned over
and above the risk free return is called the risk premium (Rm – Rf) ie
(15% - 5%) = 10% which is the reward for undertaking risk, So, if an
investment is as risky as the stock market, the risk premium to be earned is
10%.
If an investment is 30% riskier than the stock market, it would carry
risk premium i.e. 30% more than the risk premium of the stock market i.e.
10% + 30% of 10% = 10% + 3% = 13%. β identifies how much more risky is an
investment with reference to the stock market. Hence the risk premium that a
stock should earn is β times the risk premium from the market [β ×
(Rm – Rf)]. The total return from an investment is the risk free rate of
return plus the risk premium. So the required return from a stock would
be Rj = Rf + [β × (Rm – Rf)]. In the above example 5% + 1.3 × (15-5) = 18%
The risk premium on a stock varies in direct proportion to its Beta. If the
market risk premium is 6% and β of a stock is 1.2 then the risk premium for
that stock is 7.2% (6% × 1.2) where (Rm – Rf) = 6% and β =1.2

MUTUAL FUND
1. Explain how to establish a Mutual Fund.

Establishment of a Mutual Fund: A mutual fund is required to be registered
with the Securities and Exchange Board of India (SEBI) before it can collect
funds from the public. All mutual funds are governed by the same set of
regulations and are subject to monitoring and inspections by the SEBI.
The Mutual Fund has to be established through the medium of a sponsor. A
sponsor means any body corporate who, acting alone or in combination with
another body corporate, establishes a mutual fund after completing the
formalities prescribed in the SEBI's Mutual Fund Regulations.
The role of sponsor is akin to that of a promoter of a company, who provides

the initial capital and appoints the trustees. The sponsor should be a body
corporate in the business of financial services for a period not less than 5
years, be financially sound and be a fit party to act as sponsor in the eyes of
SEBI.
The Mutual Fund has to be established as either a trustee company or

a Trust, under the Indian Trust Act and the instrument of trust shall be in
the form of a deed. The deed shall be executed by the sponsor in favour of the
trustees named in the instrument of trust. The trust deed shall be duly
registered under the provisions of the Indian Registration Act, 1908. The
trust deed shall contain clauses specified in the Third Schedule of the
Regulations.
An Asset Management Company, who holds an approval from SEBI, is to be

appointed to manage the affairs of the Mutual Fund and it should

MUTUAL FUND
operate the schemes of such fund. The Asset Management Company is set
up as a limited liability company, with a minimum net worth of ` 10 crores.
The sponsor should contribute at least 40% to the networth of the Asset
Management Company. The Trustee should hold the property of the Mutual
Fund in trust for the benefit of the unit holders.
SEBI regulations require that at least two-thirds of the directors of the Trustee
Company or board of trustees must be independent, that is, they should not
be associated with the sponsors. Also, 50 per cent of the directors of AMC
must be independent. The appointment of the AMC can be terminated by
majority of the trustees or by 75% of the unit holders of the concerned scheme.
The AMC may charge the mutual fund with Investment Management and
Advisory fees subject to prescribed ceiling. Additionally, the AMC may
get the expenses on operation of the mutual fund reimbursed from the
concerned scheme.
The Mutual fund also appoints a custodian, holding valid certificate of

registration issued by SEBI, to have custody of securities held by the
mutual fund under different schemes. In case of dematerialized
securities, this is done by Depository Participant. The custodian
must be independent of the sponsor and the AMC.

MUTUAL FUND
An Asset Management Company, who holds an approval from SEBI, is to be

appointed to manage the affairs of the Mutual Fund and it should
operate the schemes of such fund. The Asset Management Company is set
up as a limited liability company, with a minimum net worth of ` 10 crores.
The sponsor should contribute at least 40% to the networth of the Asset
Management Company. The Trustee should hold the property of the Mutual
Fund in trust for the benefit of the unit holders.
SEBI regulations require that at least two-thirds of the directors of the Trustee
Company or board of trustees must be independent, that is, they should not
be associated with the sponsors. Also, 50 per cent of the directors of AMC
must be independent. The appointment of the AMC can be terminated
by majority of the trustees or by 75% of the unit holders of the concerned
scheme.

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MUTUAL FUND
The AMC may charge the mutual fund with Investment Management and
Advisory fees subject to prescribed ceiling. Additionally, the AMC may
get the expenses on operation of the mutual fund reimbursed from the
concerned scheme.
The Mutual fund also appoints a custodian, holding valid certificate of

registration issued by SEBI, to have custody of securities held by the
mutual fund under different schemes. In case of dematerialized
securities, this is done by Depository Participant. The custodian
must be independent of the sponsor and the AMC.
2. What are the advantages of investing in Mutual Funds?

a) Professional Management: The funds are managed by skilled
and professionally experienced managers with a back up of a Research
team.

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MUTUAL FUND
b) Diversification: Mutual Funds offer diversification in portfolio which

reduces the risk.
c) Convenient Administration: There are no administrative risks of share
transfer, as many of the Mutual Funds offer services in a demat form
which save investor’s time and delay.
d) Higher Returns: Over a medium to long-term investment, investors
always get higher returns in Mutual Funds as compared to other
avenues of investment. This is already seen from excellent returns,
Mutual Funds have provided in the last few years. However,
investors are cautioned that such high returns riding on the IT boom
should not be taken as regular returns and therefore one should look at
the average returns provided by the Mutual Funds particularly in the
equity schemes during the last couple of years.
e) Low Cost of Management: No Mutual Fund can increase the cost beyond
prescribed limits of 2.5% maximum and any extra cost of management is
to be borne by the AMC
f) Liquidity: In all the open ended funds, liquidity is provided
by direct sales / repurchase by the Mutual Fund and in case of close
ended funds, the liquidity is provided by listing the units on the Stock
Exchange.
g) Transparency: The SEBI Regulations now compel all the Mutual
Funds to disclose their portfolios on a half-yearly basis. However, many
Mutual Funds disclose this on a quarterly or monthly basis to their
investors. The NAVs are calculated on a daily basis in case of open
ended funds and are now published through AMFI in the newspapers.
h) Other Benefits: Mutual Funds provide regular withdrawal and
systematic investment plans according to the need of the investors.
The investors can also switch from one scheme to another without any
load.
i) Highly Regulated: Mutual Funds all over the world are highly
regulated and in India all Mutual Funds are registered with SEBI and
MUTUAL FUND
are strictly regulated as per the Mutual Fund Regulations which

provide excellent investor protection.
j) Economies of scale: The way mutual funds are structured gives it a
natural advantage. The “pooled” money from a number of investors
ensures that mutual funds enjoy economies of scale; it is cheaper
compared to investing directly in the capital markets which involves
higher charges.
This also allows retail investors access to high entry level markets like real
estate, and also there is a greater control over costs.
k) Flexibility: There are a lot of features in a regular mutual fund
scheme, which imparts flexibility to the scheme. An investor
can opt for Systematic Investment Plan (SIP), Systematic
Withdrawal Plan etc. to plan his cash flow requirements as per his
convenience. The wide range of schemes being launched in India by
different mutual funds also provides an added flexibility to the investor
to plan his portfolio accordingly.

DERIVATIVES ANALYSIS AND VALUATION
1. What are the reasons for stock index futures becoming more popular financial
derivatives over stock futures segment in India?
Stock index futures is most popular financial derivatives over stock
futures due to following reasons:
1. It adds flexibility to one’s investment portfolio. Institutional investors
and other large equity holders prefer the most this instrument in
terms of portfolio hedging purpose. The stock systems do not provide
this flexibility and hedging.
2. It creates the possibility of speculative gains using leverage. Because
a relatively small amount of margin money controls a large amount
of capital represented in a stock index contract, a small change in the
index level might produce a profitable return on one’s investment if
one is right about the direction of the market. Speculative gains in stock
futures are limited but liabilities are greater.
3. Stock index futures are the most cost efficient hedging device
whereas hedging through individual stock futures is costlier.
4. Stock index futures cannot be easily manipulated whereas individual
stock price can be exploited more easily.
5. Since, stock index futures consists of many securities, so being an
average stock, is much less volatile than individual stock price. Further,
it implies much lower capital adequacy and margin requirements in
comparison of individual stock futures. Risk diversification is possible
under stock index future than in stock futures.
6. One can sell contracts as readily as one buys them and the amount of
margin required is the same.
7. In case of individual stocks the outstanding positions are settled
normally against physical delivery of shares. In case of stock index

futures they are settled in cash all over the world on the premise that index
value is safely accepted as the settlement price.
8. It is also seen that regulatory complexity is much less in the case of
stock index futures in comparison to stock futures.
9. It provides hedging or insurance protection for a stock portfolio in a falling
market.
2. Write short note on Marking to market.

It implies the process of recording the investments in traded securities (shares,
debt-instruments, etc.) at a value, which reflects the market value of securities
on the reporting date. In the context of derivatives trading, the futures
contracts are marked to market on periodic (or daily) basis. Marking to
market essentially means that at the end of a trading session, all outstanding
contracts are repriced at the settlement price of that session. Unlike the
forward contracts, the future contracts are repriced every day. Any loss
or profit resulting from repricing would be debited or credited to the
margin account of the broker. It, therefore, provides an opportunity to
calculate the extent of liability on the basis of repricing. Thus, the futures
contracts provide better risk management measure as compared to forward
contracts.
Suppose on 1st day we take a long position, say at a price of ` 100 to be

matured on 7th day. Now on 2nd day if the price goes up to ` 105, the contract
will be repriced at ` 105 at the end of the trading session and profit of ` 5 will
be credited to the account of the buyer. This profit of ` 5 may be drawn and
thus cash flow also increases. This marking to market will result in
three things – one, you will get a cash profit of ` 5; second, the existing
contract at a price of ` 100 would stand cancelled; and third you will receive
a new futures contract at ` 105. In essence, the marking to market feature
implies that the value of the futures contract is set to zero at the end
of each trading day.
3. State any four assumptions of Black Scholes Model.

The Black-Scholes model is used to calculate a theoretical price of an Option.
The Black-Scholes price is nothing more than the amount an option writer
would require as compensation for writing a call and completely hedging the
risk of buying stock. The important point is that the hedger's view about
future stock prices is irrelevant. Thus, while any two investors may strongly
disagree on the rate of return they expect on a stock they will, given
agreement to the assumptions of volatility and the risk-free rate, always
agree on the fair value of the option on that underlying asset. This key
concept underlying the valuation of all derivatives -- that fact that the
price of an option is independent of the risk preferences of investors -- is
called risk-neutral valuation. It means that all derivatives can be valued by
assuming that the return from their underlying assets is the risk-free rate.
The model is based on a normal distribution of underlying asset returns.
The following assumptions accompany the model:
1. European Options are considered,
2. No transaction costs,
3. Short term interest rates are known and are constant,
4. Stocks do not pay dividend,
5. Stock price movement is similar to a random walk,
6. Stock returns are normally distributed over a period of time, and
7. The variance of the return is constant over the life of an Option.
The original formula for calculating the theoretical option price (OP) is as
follows:
OP  SN  d1   Xe  rt N  d 2 

Where:
S  v2 
In     r   t
X  2 
d1 
v t
d 2  d1  v t
The variables are:
S = current stock price
X = strike price of the option
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-
term returns over one year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function
4. Write short note on Embedded derivatives.

An embedded derivative is a derivative instrument that is embedded in
another contract - the host contract. The host contract might be a debt or
equity instrument, a lease, an insurance contract or a sale or purchase
contract. Derivatives require to be marked-to-market through the income
statement, other than qualifying hedging instruments. This requirement
on embedded derivatives are designed to ensure that mark-to-market
through the income statement cannot be avoided by including - embedding
- a derivative in another contract or financial instrument that is not marked- to
market through the income statement.
A coal purchase contract may include a clause that links the price of the coal
to a pricing formula based on the prevailing electricity price or a related index
at the date of delivery. The coal purchase contract, which qualifies for the
executory contract exemption, is described as the host contract, and the
pricing formula is the embedded derivative. The pricing formula is an

embedded derivative because it changes the price risk from the coal price to
the electricity price.
An embedded derivative that modifies an instrument's inherent risk

(such as a fixed to floating interest rate swap) would be considered closely
related. Conversely, an embedded derivative that changes the nature of the
risks of a contract is not closely related.
Most equity- or commodity-linked features embedded in a debt
instrument will not be closely related. This includes puts that force the
issuer to reacquire an instrument based on changes in commodity price
or index, equity or commodity indexed interest or principal payments and
equity conversion features. Puts or calls on equity instruments at specified
prices (that is, not market on date of exercise) are seldom closely related,
neither are calls, puts or prepayment penalties on debt instruments.
Credit derivatives embedded in a host debt instrument are seldom
closely related to it.
The economic characteristics and risks of an embedded derivative are
closely related to the economic characteristics and risks of the host contract
when the host contract is a debt instrument and the embedded derivative is
an interest rate floor or a cap out of the money when the instrument is
issued. An entity would not account for the embedded derivative separately

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from the host contract. The same principle applies to caps and floors in a sale
or purchase contract.
Closely related- Examples of embedded derivatives that need not be separated
A derivative embedded in a host lease contract is closely related to the
host contract if the embedded derivative comprises contingent rentals based
on related sales;
An inflation index term in a debt instrument as long as it is not
leveraged and relates to the inflation index in the economic environment in
which the instrument is denominated or issued;
Not closely related- Examples of embedded derivatives that must be
separated
Equity conversion feature embedded in a debt instrument e.g. investment in
convertible bonds;
Option to extend the term of a debt instrument unless there is a
concurrent adjustment of the interest rate to reflect market prices;
Equity-indexed interest embedded in a debt instrument
Fair Valuing Embedded Derivatives: Embedded derivatives that are

separated from the host contract are accounted for at fair value with
changes in fair value taken through the income statement. Published
price quotations in an active market are normally the best evidence of
fair value.
Valuation techniques are used to determine the fair value of the
derivative if there is no active market that matches the exact terms of the
embedded derivative.
In the case of option derivatives (e.g. puts & calls), the embedded derivatives
should be separated from the host contract and valued based on the stated
terms of the option. It is assumed that an option derivative will not normally
have a fair value of zero initial recognition. In the case of non- option
derivatives, the embedded derivatives should be separated from the host

contract based on its stated and implied terms and is assumed to have a fair
value of zero at initial recognition.
5. Define the term Greeks with respect to options.

The Greeks are a collection of statistical values (expressed as percentages) that
give the investor a better overall view of how a stock has been performing.
These statistical values can be helpful in deciding what options strategies
are best to use. The investor should remember that statistics show trends
based on past performance. It is not guaranteed that the future
performance of the stock will behave according to the historical numbers.
These trends can change drastically based on new stock performance.
Before we discuss these statistical measures let us discuss the factors
that affects the value of option as these statistical measures are related to
changes in the in these factors.

FOREIGN EXCHANGE EXPOSURE & RISK MANAGEMENT
1. “Operations in foreign exchange market are exposed to a number of risks.”

Discuss.
The foreign exchange exposure may be classified under three broad
categories:
Transaction Exposure
It measures the effect of an exchange rate change on outstanding obligations
that existed before exchange rates changed but were settled after the
exchange rate changes. Thus, it deals with cash flows that result from
existing contractual obligations.
Example: If an Indian exporter has a receivable of $100,000 due in six
months hence and if the dollar depreciates relative, to the rupee a cash
loss occurs. Conversely, if the dollar appreciates relative to the rupee, a
cash gain occurs.
The above example illustrates that whenever a firm has foreign currency
denominated receivables or payables, it is subject to transaction exposure
and their settlements will affect the firm’s cash flow position.
It measures the changes in the value of outstanding financial obligation
incurred prior to a change in exchange rates but not due to be settled until
after the exchange rates change.
Thus, it deals with the changes in the cashflow which arise from existing
contractual obligation.
In fact, the transaction exposures are the most common ones amongst
all the exposures. Let’s take an example of a company which exports to
US, and the export receivables are also denominated in USD. While
doing budgeting the company had assumed USDINR rate of 62 per
USD. By the time the exchange inward remittance arrives. USDINR
could move down to 57 leading to wiping off of commercial profit for
exporter. Such transaction exposures arise whenever a business has foreign

currency denominated receipts or payments. The risk is an adverse
movement of the exchange rate from the time the transaction is budgeted till
the time the exposure is extinguished by sale or purchase of the foreign
currency against the domestic currency.
Translation Exposure
Also known as accounting exposure, it refers to gains or losses caused
by the translation of foreign currency assets and liabilities into the
currency of the parent company for consolidation purposes.
Translation exposure, also called as accounting exposure, is the potential
for accounting derived changes in owner’s equity to occur because of the
need to “translate” foreign currency financial statements of foreign
subsidiaries into a single reporting currency to prepare worldwide
consolidated financial statements.
Translation exposures arise due to the need to “translate” foreign

currency assets and liabilities into the home currency for the purpose of
finalizing the accounts for any given period. A typical example of
translation exposure is the treatment of foreign currency loans.
Consider that a company has taken a medium term loan to finance the
import of capital goods worth dollars 1 million. When the import
materialized, the exchange rate was, say, USD/INRR-55. The imported fixed
asset was, therefore, capitalized in the books of the company at ` 550
lacs through the following accounting entry:
Debit fixed assets ` 550 lacs
Credit dollar loan ` 550 lacs
In the ordinary course, and assuming no change in the exchange rate, the
company would have provided depreciation on the asset valued at ` 550

lacs, for finalizing its account for the year in which the asset was
purchased.
However, what happens if at the time of finalization of the accounts the
exchange rate has moved to say USD/INR-58. Now the dollar loan will have
to be “translated” at ` 58, involving a“ translation loss” of a ` 30 lacs. It shall
have to be capitalized by increasing the book value of the asset, thus making
the figure ` 380 lacs and consequently higher depreciation will have to be
provided, thus reducing the net profit.
It will be readily seen that both transaction and translation exposures
affect the bottom line of a company. The effect could be positive as well
if the movement is favourable – i.e., in the cited examples, in case the
USD would have appreciated in case of Transaction Exposure example, or the
USD would have depreciated in case of Translation Exposure, for example,
against the rupee.
An important observation is that the translation exposure, of course,
becomes a transaction exposure at some stage: the dollar loan has to be
repaid by undertaking the transaction of purchasing dollars.
Economic Exposure
It refers to the extent to which the economic value of a company can
decline due to changes in exchange rate. It is the overall impact of
exchange rate changes on the value of the firm. The essence of economic
exposure is that exchange rate changes significantly alter the cost of a firm’s
inputs and the prices of its outputs and thereby influence its competitive
position substantially.

Effects of Local Currency Fluctuations on Company’s Economic Exposure

(Cash inflow)
Effects of Local Currency Fluctuations on Company’s Economic Exposure

(Cash outflow)
2. What do you mean by Nostro, Vostro and Loro Accounts?

In interbank transactions, foreign exchange is transferred from one
account to another account and from one centre to another centre.
Therefore, the banks maintain three types of current accounts in order to
facilitate quick transfer of funds in different currencies. These accounts
are Nostro, Vostro and Loro accounts meaning “our”, “your” and
“their”. A bank’s foreign currency account maintained by the bank in a
foreign country and in the home currency of that country is known as
Nostro Account or “our account with you”. For example, An Indian
bank’s Swiss franc account with a bank in Switzerland. Vostro account is the
local currency account maintained by a foreign bank/branch. It is also
called “your account with us”. For example, Indian rupee account
SIR PVT. LTD. | 162
maintained by a bank in Switzerland with a bank in India. The Loro account is

an account wherein a bank remits funds in foreign currency to another bank
for credit to an account of a third bank.

INTERNATIONAL FINANCIAL MANAGEMENT
1. Write a short note on Instruments of International Finance.

A convertible bond is a debt instrument which gives the holders of the bond
an option to convert the bond into a predetermined number of equity shares
of the company. Usually, the price of the equity shares at the time of
conversion will have a premium element. The bonds carry a fixed rate of
interest. If the issuer company desires, the issue of such bonds may carry two
options viz.
i. Call Options: (Issuer's option) - where the terms of issue of the bonds
contain a provision for call option, the issuer company has the option of
calling (buying) the bonds for redemption before the date of maturity of
the bonds. Where the issuer's share price has appreciated substantially, i.e.
far in excess of the redemption value of the bonds, the issuer company
can exercise the option. This call option forces the investors to convert the
bonds into equity. Usually, such a case arises when the share prices reach
a stage near 130% to 150% of the conversion price.
ii. Put options - A provision of put option gives the holder of the
bonds a right to put (sell)his bonds back to the issuer company at a pre-
determined price and date. In case of Euro-convertible bonds, the
payment of interest on and the redemption of the bonds will be
made by the issuer company in US dollars.
2. What is the impact of GDRs on Indian Capital Market?

A depository receipt is basically a negotiable certificate, denominated in a
currency not native to the issuer, that represents the company's publicly -
traded local currency equity shares. Most GDRs are denominated in
USD, while a few are denominated in Euro and Pound Sterling. The
Depository Receipts issued in the US are called American Depository

Receipts (ADRs), which anyway are denominated in USD and outside of

USA, these are called GDRs. In theory, though a depository receipt can also
represent a debt instrument, in practice it rarely does. DRs (depository
receipts) are created when the local currency shares of an Indian
company are delivered to the depository's local custodian bank, against
which the Depository bank (such as the Bank of New York) issues
depository receipts in US dollar. These depository receipts may trade
freely in the overseas markets like any other dollar-denominated security,
either on a foreign stock exchange, or in the over-the-counter market, or
among a restricted group such as Qualified Institutional Buyers (QIBs).
Indian issues have taken the form of GDRs to reflect the fact that they
are marketed globally, rather than in a specific country or market.
Through the issue of depository receipts, companies in India have been able to
tap global equity market to raise foreign currency funds by way of equity.
Quite apart from the specific needs that Indian companies may have for
equity capital in preference to debt and the perceived advantages of raising
equity over debt in general (no repayment of "principal" and generally
lower servicing costs, etc.) the fact of the matter is quite simple, that no
other form of term foreign exchange funding has been available. In
addition, it has been perceived that a GDR issue has been able to fetch higher
prices from international investors (even when Indian issues were being
sold at a discount to the prevailing domestic share prices) than those
that a domestic public issue would have been able to extract from Indian
investors.
 Impact of GDRs on Indian Capital Market
Since the inception of GDRs a remarkable change in Indian capital
market has been observed as follows:
(i) Indian stock market to some extent is shifting from Bombay to
Luxemburg.
(ii) There is arbitrage possibility in GDR issues.
(iii) Indian stock market is no longer independent from the rest of

the world. This puts additional strain on the investors as they
now need to keep updated with world wide economic events.
(iv) Indian retail investors are completely sidelined. GDRs/Foreign
Institutional Investors' placements + free pricing implies that retail
investors can no longer expect to make easy money on heavily
discounted rights/public issues.
As a result of introduction of GDRs a considerable foreign investment has
flown into India.
 Markets of GDRs
(i) GDR's are sold primarily to institutional investors.
(ii) Demand is likely to be dominated by emerging market funds.
(iii) Switching by foreign institutional investors from ordinary shares into
GDRs is likely.
(iv) Major demand is also in UK, USA (Qualified Institutional Buyers),
South East Asia (Hong kong, Singapore), and to some extent
continental Europe (principally France and Switzerland).
 Mechanism of GDR: The mechanics of a GDR issue may be described

with the help of following diagram.
Company issues

Ordinary shares

Kept with Custodian/depository banks

against which GDRs are issued

to Foreign investors

Characteristics
(i) Holders of GDRs participate in the economic benefits of being ordinary

shareholders, though they do not have voting rights.
(ii) GDRs are settled through CEDEL & Euro-clear international book entry
systems.
(iii) GDRs are listed on the Luxemburg stock exchange.
(iv) Trading takes place between professional market makers on an OTC
(over the counter) basis.
(v) The instruments are freely traded.
(vi) They are marketed globally without being confined to borders of any
market or country as it can be traded in more than one currency.
(vii) Investors earn fixed income by way of dividends which are paid in issuer
currency converted into dollars by depository and paid to investors and
hence exchange risk is with investor.
(viii) As far as the case of liquidation of GDRs is concerned, an investor
may get the GDR cancelled any time after a cooling off period of 45
days. A non-resident holder of GDRs may ask the overseas bank
(depository) to redeem (cancel) the GDRs In that case overseas
depository bank shall request the domestic custodians bank to cancel the
GDR and to get the corresponding underlying shares released in favour
of non-resident investor. The price of the ordinary shares of the issuing
company prevailing in the Bombay Stock Exchange or the National
Stock Exchange on the date of advice of redemption shall be taken
as the cost of acquisition of the underlying ordinary share.

INTEREST RATE RISK MANAGEMENT
1. Write a short note on Forward Rate Agreements.

A Forward Rate Agreement (FRA) is an agreement between two parties
through which a borrower/ lender protects itself from the unfavourable
changes to the interest rate. Unlike futures FRAs are not traded on an
exchange thus are called OTC product. Following are main features of FRA.
 Normally it is used by banks to fix interest costs on anticipated future
deposits or interest revenues on variable-rate loans indexed to LIBOR.
 It is an off Balance Sheet instrument.
 It does not involve any transfer of principal. The principal amount of
the agreement is termed "notional" because, while it determines the
amount of the payment, actual exchange of the principal never takes
place.
 It is settled at maturity in cash representing the profit or loss. A bank that
sells an FRA agrees to pay the buyer the increased interest cost on some
"notional" principal amount if some specified maturity of LIBOR is above a
stipulated "forward rate" on the contract maturity or settlement date.
Conversely, the buyer agrees to pay the seller any decrease in
interest cost if market interest rates fall below the forward rate.
 Final settlement of the amounts owed by the parties to an FRA is
determined by the formula
Payment 
 N  RR  FR  dtm /DY   100
 1  RR  dtm /DY  
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract
prevailing on the contract settlement date; typically LIBOR or MIBOR
FR = Agreed-upon Forward Rate; and

dtm = maturity of the forward rate, specified in days (FRA Days)

DY = Day count basis applicable to money market transactions which
could be 360or 365 days.
If LIBOR > FR the seller owes the payment to the buyer, and if LIBOR<FR
the buyer owes the seller the absolute value of the payment amount
determined by the above formula.
 The differential amount is discounted at post change (actual) interest
rate as it is settled in the beginning of the period not at the end.
Thus, buying an FRA is comparable to selling, or going short, a Eurodollar or
LIBOR futures contract.
Example
Suppose two banks enter into an agreement specifying:
 a forward rate of 5 percent on a Eurodollar deposit with a three-month
maturity;
 a $1 million notional principal; and settlement in one month.
Such an agreement is termed a 1x4 FRA because it fixes the interest rate for a
deposit to be placed after one month and maturing four months after the date
the contract is negotiated.
If the three-month LIBOR is 6 percent on the contract settlement date, the
seller would owe the buyer the difference between 6 and 5 percent interest on
$1 million for a period of 90 days.
Every 1 basis point change in the interest rate payable on a principal of $1
million for a 90-day maturity changes interest cost by $25, so that the
increase in the interest cost on a three-month Eurodollar deposit over the
specified forward rate in this case is $25 x 100 basis points = $2,500.
The $2,500 difference in interest costs calculated above is discounted
back three months using the actual three-month LIBOR prevailing on the
settlement date.
Thus, if 90-day LIBOR turns out to be 6 percent on the contract maturity date
the buyer would receive $2,463.05 = $2,500/[1 + 0.06(90/360)].
2. What do you know about swaptions and their uses?

An interest rate swaption is simply an option on an interest rate swap. It gives
the holder the right but not the obligation to enter into an interest rate swap at
a specific date in the future, at a particular fixed rate and for a specified term.
There are two types of swaption contracts: -
 A fixed rate payer swaption gives the owner of the swaption the right but
not the obligation to enter into a swap where they pay the fixed leg and
receive the floating leg.
 A fixed rate receiver swaption gives the owner of the swaption the right
but not the obligation to enter into a swap in which they will receive the
fixed leg, and pay the floating leg.
Principal Features of Swaptions

A. A swaption is effectively an option on a forward-start IRS, where exact
terms such as the fixed rate of interest, the floating reference interest rate
and the tenor of the IRS are established upon conclusion of the swaption
contract.
B. A 3-month into 5-year swaption would therefore be seen as an option to
enter into a 5-year IRS, 3 months from now.
C. The 'option period' refers to the time which elapses between the transaction
date and the expiry date.
D. The swaption premium is expressed as basis points.
E. Swaptions can be cash-settled; therefore at expiry they are marked to
market off the applicable forward curve at that time and the difference is
settled in cash.
Pricing of Swaptions
The pricing methodology depends upon setting up a model of

probability distribution of the forward zero-coupon curve which undoes a
Market process.

Uses of Swaptions
a. Swaptions can be applied in a variety of ways for both active traders as

well as for corporate treasurers.
b. Swap traders can use them for speculation purposes or to hedge a portion
of their swap books.
c. Swaptions have become useful tools for hedging embedded optionality
which is common to the natural course of many businesses.
d. Swaptions are useful to borrowers targeting an acceptable borrowing rate.
e. Swaptions are also useful to those businesses tendering for contracts.
f. Swaptions also provide protection on callable/puttable bond issues.

CORPORATE VALUATION
1. Differentiate between EVA and MVA.

Economic Value Added (EVA) is a holistic method of evaluating a
company’s financial performance, which means that EVA is used not only as
a mere valuation technique, but also to find the economic contribution of a
company to the society at large. The core concept behind EVA is that a
company generates ‘value’ only if there is a creation of wealth in terms of
returns in excess of its cost of capital invested. So if a company's EVA is
negative, it means the company is not generating value from the funds
invested into the business. Conversely, a positive EVA shows a company is
producing value from the funds invested in it.
Why EVA? Up to now we have seen several financial performance metrics

like ROI, ROCE, etc. and also several approaches based on asset base /
earnings / FCFs to finding out the ‘worth’ of the entity. Then what is the
need for EVA? Or in other words, what is the gap that EVA is trying
to fill in, that others couldn’t?
The answer to the above is the way EVA looks at performance of the
‘management’ of a company. To elaborate, all the approaches seen up to now
were just a function of ‘number-crunching’. But EVA tries to make
management more accountable to their individual decisions and the impact of
decisions on the path to progress of the company. Take a simple example
– if there are two dissimilar but equal risk opportunities that are feasible
and the management needs to take a decision, it would most probably go by
the project which would break-even earlier. In choosing so it is also cutting
down the risk of future losses, fair enough. However, had the management
invested in both the projects, still it would have generated a positive IRR,

CORPORATE VALUATION
though the second one would have had a larger pay-back period. This impact
of management’s strategic decision making comes out evidently in EVA
computations, whereas under the techniques seen till now, this performance-
driven aspect would have never been highlighted. The efficiency of the
management gets highlighted in EVA, by evaluating whether returns are
generated to cover the cost of capital.
EVA is a performance measure for management of the company, and this is as

evident in its calculation formula as ‘the excess of returns over the weighted
average cost of invested capital ‘. The formula is as below –
EVA = NOPAT – (Invested Capital * WACC)
OR
NOPAT – Capital Charge
The concept NOPAT (net operating profit after tax) is nothing but EBIT plus
tax expense. The logic is that we are trying to find out the cash returns that
business operations would make after tax payments. Note that we have left
depreciation untouched here – it being an operational expense for the
limited purposes of EVA. From this NOPAT we need to further identify the
non-cash expenses and adjust for the same to arrive at the ‘actual’ cash
earnings. One common non-cash adjustment would ‘provision for bad and
doubtful debts’, as this would just be a book entry.
After arriving at the correct NOPAT, the next step would be finding the
capital charge. This would involve finding out
a. Invested Capital – Which would be easy from published financials, as

it would be the difference between total assets subtracted by the non-
interest bearing current liabilities, like sundry creditors, billing in
advance, etc. Care should be taken to do the adjustments for non-
cash elements like provision for bad and doubtful debts.
CORPORATE VALUATION
b. Applying the company’s WACC on the invested capital arrived in step (a)
Finally the EVA is computed by reducing the capital charge as calculated by

applying the WACC on the invested capital from the adjusted NOPAT.
2. Relative Valuation is the method to arrive at a ‘relative’ value using a

‘comparative’ analysis to its peers or similar enterprises. Elaborate this
statement.
The three approaches that we saw to arriving at the value of an
enterprise viz. the asset based, the earnings based and the cash flow
based are for arriving at the ‘intrinsic value’ of the same. Relative
Valuation is the method to arrive at a ‘relative’ value using a
‘comparative’ analysis to its peers or similar enterprises. However,
increasingly the contemporary financial analysts are using relative
valuation in conjunction to the afore-stated approaches to validate the
intrinsic value arrived earlier.
The Relative valuation, also referred to as ‘Valuation by multiples,’ uses

financial ratios to derive at the desired metric (referred to as the ‘multiple’)
and then compares the same to that of comparable firms. (Comparable firms
would mean the ones having similar asset and risk dispositions, and
assumed to continue to do so over the comparison period). In the process,
there may be extrapolations set to the desired range to achieve the target set.
To elaborate –
1. Find out the ‘drivers’ that will be the best representative for deriving at the
multiple
2. Determine the results based on the chosen driver(s) thru financial ratios
3. Find out the comparable firms, and perform the comparative analysis, and,
4. Iterate the value of the firm obtained to smoothen out the deviations

CORPORATE VALUATION
Step 1: Finding the correct driver that goes to determine the multiple is
significant for relative valuation as it sets the direction to the valuation
approach. Thereby, one can have two sets of multiple based approaches
depending on the tilt of the drivers –
a. Enterprise value based multiples, which would consist primarily of
EV/EBITDA, EV/Invested Capital, and EV/Sales.
b. Equity value based multiples, which would comprise of P/E ratio and
PEG.
We have already seen the concept and application of Enterprise Value in
previous section. However, in light of relative valuation, we can definitely
add that whereas EV/EBITDA is a popular ratio and does provide critical
inputs, the EV/Invested Capital will be more appropriate to capital intensive
enterprises, and EV/Sales will be used by companies who are cash rich,
have a huge order book, and forecast organic growth thru own capital.
The P/E has a celebrated status amongst Equity based multiples, and the PEG
is more suitable where we are doing relative valuation of either high growth
or sunrise industries.
Step 2: Choosing the right financial ratio is a vital part of success of

this model. A factor based approach may help in getting this correct –
for example – a firm that generates revenue mostly by exports will be
highly influenced by future foreign exchange fluctuations. A pure P/E based
ratio may not be reflective of this reality, which couldn’t pre-empt the impacts
that Br exit triggered on currency values. Likewise, an EV/Invested Capital
would be a misfit for a company which may be light on core assets, or if has
significant investment properties.
Step 3: Arriving at the right mix of comparable firms: This is perhaps

the most challenging of all the steps – No two entities can be same – even if
they may seem to be operating within the same risk and opportunity
CORPORATE VALUATION
perimeter. So, a software company ‘X’ that we are now comparing to a

similar sized company ‘Y’ may have a similar capital structure, a similar
operative environment, and head count size – so far the two firms are on even
platform for returns forecast and beta values. On careful scrutiny, it is now
realized that the revenue generators are different – X may be deriving its
revenues from dedicated service contracts having FTE pricing, whereas Y
earns thru UTP pricing model. This additional set of information dramatically
changes the risk structure – and this is precisely what the discerning investor
has to watch for. In other words, take benchmarks with a pinch of salt.
Take another example – a firm is operating in a niche market, and that

obviously leads to getting comparable firms become a difficult task. In
such cases, one may have to look beyond the current operating market
and identify similar structured companies from other industries – like for
example – a medium sized LPO may have to evaluate based on the specific
divisional figures of a Big 4 firm.
The comparable firm can either be from a peer group operating within the
same risks and opportunities perimeter, or alternatively can be just take
closely relevant firms and then perform a regression to arrive at the
comparable metrics. You would notice that in our example, the LPO is
adopting the later approach. Whereas the company ‘X’ will have to ignore ‘Y’
and search for a similar revenue-risk based company. However, as a last
resort, it may adopt a regression based model as above.
Step 4: Iterate / extrapolate the results obtained to arrive at the correct

estimate of the value of the firm.
Let’s apply the above concepts into a relative valuation illustration:
F Ltd is a small sized company that is not listed. It is however a time tested
company having positive cash flows and a net profit of 9%. The company
has zeroed in two value drivers going forward – a higher than industry
CORPORATE VALUATION
growth rate in sales, and higher internal efficiencies. The market that it
operates in has a couple of large sized listed firms, exhibiting a beta of 1.3 &
1.5 respectively. How do we approach this from a relative valuation point of
view?
We are given two value drivers that essentially point out to future
earnings – so let’s take the EV/EBITDA approach for enterprise valuation.
Assume that on applying the EV techniques, we get an EV of 50 Million. The
next step is to do ring fencing for adoption of the EV approach. Or conversely,
if we were to adopt the elimination way of choosing the right fit, how
do we decide against, say, EV/Invested Capital? An elaborate thought
process requires to be established here, and the decision to be quantified and
documented.
Next, assume we do have a comparable firm. May be its demonstrating the

same characteristics in a larger scale than our company F Ltd. But how do we
get absolutely sure on this? As discussed earlier, we may take similar firms
from dissimilar industries. Or we get the sum-total of all firms within
the industry and then do appropriate regressions to remove both large-
scale factors and structural differences. An important factor would be
leveraged capital. Listed companies do use to a lot more of leverage, and F
Ltd may have to seriously recalibrate if its balance sheet stands light.
And finally, say we have arrived at a conclusion that the comparable firm is
indeed an efficient model and is the correct indicator for appraising F Ltd
– taking the values of comparable firms’ Beta and potential growth
estimates, you can value F Ltd.
A tweak to the above case can be brought by an insistence to use a

P/E based approach. In this scenario, we have a market – ready PE for
the comparable firm called ‘M’, who’s PE is, say, at 10. However, how
CORPORATE VALUATION
do we find out P/E for F Ltd which is an unlisted entity? We have to

necessarily use analytical approach to finding out the correct ‘earnings’ -
adjust for accounting policy mismatches with ‘M’ (F Ltd being an unlisted
entity may have policies that exhibit laxity), adjust for cost of capital, and then
arrive at the adjusted ‘earnings’ to apply the above PE. Alternatively, we may
work out the PEG (the ratio of the PE to the expected growth rate of the firm)
and evaluate the value of F Ltd.
Thus, we can conclude that ‘Relative Valuation’ is a comparative driven

approach that assumes that the value of similar firms can form a good
indicator for the value of the tested firm. There are some assumptions
that are inherent to this model –
i. The market is efficient
ii. The function between the fundamentals and the multiples are linear
iii. The firms that are comparable are similar to structure, risk and growth
pattern

MERGERS, ACQUISITIONS & CORPORATE RESTRUCTURING
1. Explain synergy in the context of Mergers and Acquisitions.

The most common reasons for Mergers and Acquisition (M&A) are:
 Synergistic operating economics: Synergy May be defined as follows:
V (AB) >V(A) + V (B).
In other words the combined value of two firms or companies shall
be more than their individual value Synergy is the increase in
performance of the combined firm over what the two firms are already
expected or required to accomplish as independent firms (Mark L
Sirower of Boston Consulting Group, in his book “The Synergy Trap”).
This may be result of complimentary services economics of scale or both.
A good example of complimentary activities can a company may have a
good networking of branches and other company may have efficient
production system. Thus the merged companies will be more efficient
than individual companies.
On similar lines, economics of large scale is also one of the reasons for
synergy benefits. The main reason is that, the large scale production
results in lower average cost of production e.g. reduction in overhead
costs on account of sharing of central services such as accounting and
finances, office executives, top level management, legal, sales
promotion and advertisement etc.
These economics can be “real” arising out of reduction in factor input
per unit of output, whereas pecuniary economics are realized from
paying lower prices for factor inputs for bulk transactions.
 Diversification: In case of merger between two unrelated companies
would lead to reduction in business risk, which in turn will increase the
market value consequent upon the reduction in discount rate/ required
rate of return. Normally, greater the combination of statistically

independent or negatively correlated income streams of merged

companies, there will be higher reduction in the business risk in
comparison to companies having income streams which are positively
correlated to each other.
 Taxation: The provisions of set off and carry forward of losses as per
Income Tax Act may be another strong season for the merger and
acquisition. Thus, there will be Tax saving or reduction in tax liability of
the merged firm. Similarly, in the case of acquisition the losses of the target
company will be allowed to be set off against the profits of the acquiring
company.
 Growth: Merger and acquisition mode enables the firm to grow at a rate
faster than the other mode viz., organic growth. The reason being the
shortening of ‘Time to Market’. The acquiring company avoids delays
associated with purchasing of building, site, setting up of the plant
and hiring personnel etc.
 Consolidation of Production Capacities and increasing market
power: Due to reduced competition, marketing power increases.
Further, production capacity is increased by combined of two or more
plants. The following table shows the key rationale for some of the well
known transactions which took place in India in the recent past.
Rationale for M & A
Instantaneous growth, Snuffing  Airtel – Loop Mobile (2014)

out competition, Increased market (Airtel bags top spot in Mumbai
share. Telecom Circle)
Acquisition of a competence or a  Google – Motorola (2011)
capability (Google got access to Motorola’s
17,000 issued patents and 7500
applications)
Entry into new markets/product  Airtel – Zain Telecom (2010)

segments (Airtel enters 15 nations of

African Continent in one shot)
Access to funds  Ranbaxy – Sun Pharma (2014)
(Daiichi Sankyo sold Ranbaxy to
generate funds)
Tax benefits  Burger King (US) – Tim
Hortons(Canada) (2014)
(Burger King could save taxes in
future)
Instantaneous growth, Snuffing  Facebook – Whatsapp (2014)
out competition, Increased market (Facebook acquired its biggest
share. threat in chat space)
Acquisition of a competence or a  Flipkart – Myntra (2014)
capability (Flipkart poised to strengthen its
competency in apparel e-
commerce market)
Entry into new markets/product  Cargill – Wipro (2013)
segments (Cargill acquired Sunflower
Vanaspati oil business to enter
Western India Market)
Access to funds  Jaypee – Ultratech (2014)
(Jaypee sold its cement unit to
raise funds for cutting off its
debt)
Tax benefits  Durga Projects Limited (DPL) –
WBPDCL (2014)
(DPL’s loss could be carry
forward and setoff)

As mentioned above amalgamation is effected basically for growth and

sometimes for image. But some of the objectives for which amalgamation may
be resorted to are:
 Horizontal growth to achieve optimum size, to enlarge the market share, to
curb competition or to use unutilised capacity;
 Vertical combination with a view to economising costs and eliminating
avoidable sales-tax and/or excise duty;
 Diversification of business;
 Mobilising financial resources by utilising the idle funds lying with
another company for the expansion of business. (For example,
nationalisation of banks provided this opportunity and the erstwhile
banking companies merged with industrial companies);
 Merger of an export, investment or trading company with an industrial
company or vice versa with a view to increasing cash flow;
 Merging subsidiary company with the holding company with a view to
improving cash flow;
 Taking over a ‘shell’ company which may have the necessary
industrial licences etc., but whose promoters do not wish to proceed with
the project.
An amalgamation may also be resorted to for the purpose of nourishing
a sick unit in the group and this is normally a merger for keeping up the
image of the group.
2. What is take over by reverse bid or Reverse Merger.

In ordinary case, the company taken over is the smaller company; in a
'reverse takeover', a smaller company gains control of a larger one. The
concept of takeover by reverse bid, or of reverse merger, is thus not the
usual case of amalgamation of a sick unit which is non-viable with a healthy
or prosperous unit but is a case whereby the entire undertaking of the
healthy and prosperous company is to be merged and vested in the sick
company which is non-viable. A company becomes a sick industrial
company when there is erosion in its net worth. This alternative is also known
as taking over by reverse bid.
The three tests should be fulfilled before an arrangement can be termed as a
reverse takeover is specified as follows:
i. the assets of the transferor company are greater than the transferee
company,
ii. equity capital to be issued by the transferee company pursuant to the
acquisition exceeds its original issued capital, and
iii. the change of control in the transferee company through the introduction
of a minority holder or group of holders.
This type of merger is also known as ‘back door listing’. This kind of merger
has been started as an alternative to go for public issue without incurring
huge expenses and passing through cumbersome process. Thus, it can be
said that reverse merger leads to the following benefits for acquiring
company:
 Easy access to capital market.
 Increase in visibility of the company in corporate world.
 Tax benefits on carry forward losses acquired (public) company.
 Cheaper and easier route to become a public company.
3. What is an equity curve out? How does it differ from a spin off.
Different ways of divestment or demerger or divestitures are as follows:
Sell off / Partial Sell off

A sell off is the sale of an asset, factory, division, product line or
subsidiary by one entity to another for a purchase consideration payable
either in cash or in the form of securities. Partial Sell off, is a form of
divestiture, wherein the firm sells its business unit or a subsidiary to
another because it deemed to be unfit with the company’s core business
strategy.

Normally, sell-offs are done because the subsidiary doesn't fit into the parent
company's core strategy. The market may be undervaluing the combined
businesses due to a lack of synergy between the parent and the subsidiary. So
the management and the board decide that the subsidiary is better off under a
different ownership. Besides getting rid of an unwanted subsidiary, sell-offs
also raise cash, which can be used to pay off debts. In the late 1980s and early
1990s, corporate raiders would use debt to finance acquisitions. Then, after
making a purchase they would sell-off its subsidiaries to raise cash to service
the debt. The raiders' method certainly makes sense if the sum of the parts is
greater than the whole. When it isn't, deals are unsuccessful.
Spin-off
In this case, a part of the business is separated and created as a
separate firm. The existing shareholders of the firm get proportionate
ownership. So there is no change in ownership and the same shareholders
continue to own the newly created entity in the same proportion as previously
in the original firm. The management of spun-off division is however, parted
with. Spin-off does not bring fresh cash. The reasons for spin off may be:
(i) Separate identity to a part/division.
(ii) To avoid the takeover attempt by a predator by making the firm
unattractive to him since a valuable division is spun-off.
(iii) To create separate Regulated and unregulated lines of business.
Example: Kishore Biyani led Future Group spin off its consumer durables
business, Ezone, into a separate entity in order to maximise value from it.
Split-up
This involves breaking up of the entire firm into a series of spin off (by
creating separate legal entities).The parent firm no longer legally exists
and only the newly created entities survive. For instance a corporate firm
has 4 divisions namely A, B, C, D. All these 4 division shall be split-up to
create 4 new corporate firms with full autonomy and legal status. The original

corporate firm is to be wound up. Since de-merged units are relatively

smaller in size, they are logistically more convenient and manageable.
Therefore, it is understood that spin-off and split-up are likely to
enhance shareholders value and bring efficiency and effectiveness.
Example: Philips, the Dutch conglomerate that started life making light
bulbs 123 years ago, is splitting off its lighting business in a bold step
to expand its higher-margin healthcare and consumer divisions. The new
structure should save 100 million euros ($128.5 million) next year and
200 million euros in 2016. It expects restructuring charges of 50 million
euros from 2014 to 2016.
Equity Carve outs

This is like spin off, however, some shares of the new company are sold in the
market by making a public offer, so this brings cash. More and more
companies are using equity carve-outs to boost shareholder value. A
parent firm makes a subsidiary public through an initial public offering
(IPO) of shares, amounting to a partial sell-off. A new publicly-listed
company is created, but the parent keeps a controlling stake in the newly
traded subsidiary.
A carve-out is a strategic avenue a parent firm may take when one of its
subsidiaries is growing faster and carrying higher valuations than other
businesses owned by the parent. A carve-out generates cash because shares
in the subsidiary are sold to the public, but the issue also unlocks the
value of the subsidiary unit and enhances the parent's shareholder value.
The new legal entity of a carve-out has a separate board, but in most carve-
outs, the parent retains some control over it. In these cases, some portion of
the parent firm's board of directors may be shared. Since the parent has a
controlling stake, meaning that both firms have common shareholders,
the connection between the two is likely to be strong. That said,
sometimes companies carve-out a subsidiary not because it is doing well,
but because it is a burden. Such an intention won't lead to a successful result,

especially if a carved-out subsidiary is too loaded with debt or trouble, even

when it was a part of the parent and lacks an established track record for
growing revenues and profits.
Sale of a Division
In the case of sale of a division, the seller company is demerging its business
whereas the buyer company is acquiring a business. For the first time the
tax laws in India propose to recognise demergers.
Demerger or Division of Family-Managed Business

Around 80 per cent of private sector companies in India are family-
managed companies. The family-owned companies are, under
extraordinary pressure to yield control to professional managements, as,
in the emerging scenario of a liberalised economy the capital markets
are broadening, with attendant incentives for growth. So, many of these
companies are arranging to hive off their unprofitable businesses or
divisions with a view to meeting a variety of succession problems.
Even otherwise, a group of such family-managed companies may
undertake restructuring of its operations with a view also to consolidating
its core businesses. For this, the first step that may need to be taken is to
identify core and non-core operations within the group. The second step
may involve reducing interest burden through debt restructuring along with
sale of surplus assets. The proceeds from the sale of assets may be
employed for expanding by acquisitions and rejuvenation of its existing
operations. The bottom line is that an acquisition must improve
economies of scale, lower the cost of production, and generate and promote
synergies. Besides acquisitions, therefore, the group may necessarily have to
take steps to improve productivity of its existing operations.

4. Write a short note on Horizontal Merger and Vertical Merger.

A merger is generally understood to be a fusion of two companies. The term
“merger” means and signifies the dissolution of one or more companies
or firms or proprietorships to form or get absorbed into another
company. By concept, merger increases the size of the undertakings.
Following are major types of mergers:
(i) Horizontal Merger: The two companies which have merged are in
the same industry, normally the market share of the new
consolidated company would be larger and it is possible that it may
move closer to being a monopoly or a near monopoly to avoid
competition.
(ii) Vertical Merger: This merger happens when two companies that
have ‘buyer-seller’ relationship (or potential buyer-seller relationship)
come together.
(iii) Conglomerate Mergers: Such mergers involve firms engaged in unrelated
type of business operations. In other words, the business activities of
acquirer and the target are neither related to each other horizontally
(i.e., producing the same or competiting products) nor vertically
(having relationship of buyer and supplier).In a pure conglomerate
merger, there are no important common factors between the companies in
production, marketing, research and development and technology. There
may however be some degree of overlapping in one or more of these
common factors. Such mergers are in fact, unification of different
kinds of businesses under one flagship company. The purpose of
merger remains utilization of financial resources, enlarged debt capacity
and also synergy of managerial functions.
(iv) Congeneric Merger: In these mergers, the acquirer and the target
companies are related through basic technologies, production
processes or markets. The acquired company represents an extension
of product-line, market participants or technologies of the acquirer. These
mergers represent an outward movement by the acquirer from its

current business scenario to other related business activities within the
overarching industry structure.
(v) Reverse Merger: Such mergers involve acquisition of a public (Shell
Company) by a private company, as it helps private company to by-pass
lengthy and complex process required to be followed in case it is
interested in going public.
(vi) Acquisition: This refers to the purchase of controlling interest by one
company in the share capital of an existing company. This may be by:
(i) an agreement with majority holder of Interest.
(ii) Purchase of new shares by private agreement.
(iii) Purchase of shares in open market (open offer)
(iv) Acquisition of share capital of a company by means of cash, issuance
of shares.
(v) Making a buyout offer to general body of shareholders.

When a company is acquired by another company, the acquiring company has

two choices , one, to merge both the companies into one and function as
a single entity and, two, to operate the taken-over company as an
independent entity with changed management and policies. ‘Merger’ is
the fusion of two independent firms on co-equal terms. ‘Acquisition’ is
buying out a company by another company and the acquired company
usually loses its identity. Usually, this process is friendly.
Acquisition of one of the business of a company, as a going concern by an

agreement need not necessarily be routed through court, if the transfer of
business is to be accomplished without allotting shares in the transferee
company to the shareholders of the transferor company. This would
tantamount to a simple acquisition. In this case the transferor company
continues to exist and no change in shareholding is expected. If the sale
takes place for a lumpsum consideration without attributing any individual
values to any class of assets, such sales are called slump sales. The capital
gains arising on slump sales were being exempt from income tax based on
a decision of the Supreme Court of India.

SIR PVT. LTD. | 189
THEORY - EXTRA QUESTIONS
1. Commercial borrowing in International market
Commercial borrowings in International Market: In view of the

generally deteriorating soft aid climates, bilateral and multilateral and the
growing pressure of developing fast on a country’s limited economic
resources necessitate a greater recourse to external commercial borrowings,
subject however, to a safe debt-service norms. Till 1979-80, the approach to
commercial borrowing was one of caution and conservation. India entered
the international capital market for raising the foreign currency reserves in
1980. Since then external commercial borrowings have been arranged
constantly and on increasing scale.
The initial process in negotiating syndicated loans and funds on
favourable terms compelled it to explore more sophisticated and complicated
options. Thus, India arranged bond issue in Japan, Germany, Switzerland
apart from the debt in Euro-dollar market by arranging a straight bond
issue. In addition, India also negotiated quasi-bonds offering by way of
Commercial papers. Deals have also been finalized involving swap
options and dual currency arrangements.
Public sector accounts for almost 45% of the total commercial borrowings.
Bulk of these loans have been contracted by public sector units like ONGC,
NELCO, MARUTI, UDYOG AND AIR INDIA etc.
To sum up, the level of commercial borrowings in the International
market should be kept within the generally accepted norms of prudent
economic management, to uphold the ideals of economic freedom.
2. Discretionary and non-discretionary portfolio manager
Discretionary and Non-discretionary portfolio manager: A discretionary

portfolio manager means a portfolio manager who exercises or may,
under a contract relating to portfolio management, exercises any degree of

discretion in respect of the investments or management of the portfolio

of securities or the funds of the client, as the case may be. He shall
individually and independently manage the funds of each client in
accordance with the needs of the client in a manner which does not resemble
a mutual fund.
A non-discretionary portfolio manager shall manage the funds in
accordance with the directions of the client.
A portfolio manager, by virtue of his knowledge, background and experience
is expected to study the various avenues available for profitable investment
and advise his client to enable the latter to maximize the return on his
investment and at the same time safeguard the funds invested.
3. Drawbacks of investments in mutual funds
 There is no guarantee of return as some Mutual Funds may under perform

and Mutual Fund Investment may depreciate in value which may even
effect erosion / Depletion of principal amount
 Diversification may minimize risk but does not guarantee higher return.
 Mutual funds performance is judged on the basis of past performance
record of various companies. But this can not take care of or guarantee
future performance.
 Mutual Fund cost is involved like entry load, exit load, fees paid to Asset
Management Company etc.
 There may be unethical Practices e.g. diversion of Mutual Fund
amounts by Mutual Fund /s to their sister concerns for making gains for
them.
 MFs, systems do not maintain the kind of transparency, they should
maintain

 Many MF scheme are, at times, subject to lock in period, therefore,

deny the market drawn benefits
 At times, the investments are subject to different kind of hidden costs.
 Redressal of grievances, if any , is not easy
4. Exchange traded funds
Meaning : Exchange Traded Funds (ETFs) were introduced in US in 1993 and

came to India around 2002. Exchange-
Traded Funds (ETFs) are mutual fund schemes that are listed and traded on
exchanges like any other stocks. An Exchange Traded Fund (ETF) is a
hybrid product that combines the features of an index fund.
ETFs invest in a basket of stocks and try to replicate a stock market index such
as the S & P CNX Nifty or BSE Sensex
Advantage :
1. By owning an ETF, you get the diversification of an index fund as well as
the ability to sell short, buy on margin and purchase as little as one share.
2. Another advantage is that the expense ratios for most ETFs are lower than
those of the average mutual fund. They have very low operating and
transaction costs , since there are no loads required to purchase ETFs.
3. There is no paper work involved for investing in an ETF. These can
be bought like any other stock by just placing an order with a broker.
4. A great reason to consider Exchange Traded Funds is that they
simplify index and sector investing in a way that is easy to understand. If
investors feel a turnaround is around the corner, they can go long. If,
however, they think ominous clouds will be over the market for some time,
they have the option of going short.

5. The combination of the instant diversification, low cost and the

flexibility that Exchange Traded Funds offer makes these instruments
one of the most useful innovations and attractive pieces of financial
engineering to date.
5. Divestment strategy
Divestment Strategy: It involves selling or liquidating unprofitable

business units or product, divisions or segment of business operations
with negative flows or securities of other companies. Sometimes, it may not
be possible for the organization to carry on a particular line of business
because it does not offer any potential even after turn around action. In that
case, the organization tries to get rid of that business by pursuing a
divestment strategy. There may be a number of economic and non-economic
factors which may lead to divestment of certain businesses. There can be
a number of reasons responsible for following this strategy:
i. Inadequate market share or growth potential because of the
environmental pressure.
ii. Technological changes requiring high investment, which is beyond
the capability of the organization.
iii. Troubled industrial relations.
iv. Other problems, making it unmanageable to carry on the business.
Besides economic reasons, there may be certain non-economic reasons for the
divestment like legal framework, policy of the government, changing life
style of people/society etc. Progressive managements look upon divestment
decision as a step to growth. In fact some of the dynamic managements
in developed countries like U.S.A. do follow a specific objective that in the
next five years 50% of their sales should be from products which are not
more than 2 years old. In pursuit of these objectives they are guided by

the philosophy of change and innovation. Thus, divestment strategy may not
be a sign of decay but of growth.
6. Stack hedging and strip hedging
Stack Hedging and Strip Hedging

For longer – term hedging programmes, such as a two-year loan with three-
monthly rollover dates, more complicated strategies can be adopted, such
as ‘stack hedging’ and ‘strip hedging’
With a stack hedge, the total number of contract needed to hedge the loan are
purchased for the month of the first rollover date. At that date, the remaining,
number of contracts necessary are purchased for the next rollover date,
and so on.
A strip hedge, on the other hand, treats each three-month segment of the loan
as separate entity, and futures contracts are purchased for each rollover date
at the outset of the loan.
7. Bridge finance
It refers to making funds available by commercial banks for meeting

immediate requirements of the business pending release of loans sanctioned
by the financial institutions. As the nature of bridge finance is to fill in
the gap to make immediately the funds available for business, commercial
banks provide this type of finance for short term. The bridge finance
assumes demand character and is guaranteed by the third person. The
term is also used by the financial institutions while making funds available to
the borrower company out of the sanctioned amount pending completion
of various formalities viz., signing loan agreement, and other security
documents. The financial institutions provide this facility only to those
companies who have been sanctioned the loans for project financing. The
financial institutions charge 1% extra interest on the amount of bridge
finance and secure the amount of bridge loan through personal guarantee
of the promoters and hypothecation of the assets of the company and in
addition they also demand pledge of shares of the promoters in the
company. On the completion of the formalities like signing of loan
agreement and documents the demand character of the loan is eliminated
and the amount of the bridge loan is treated as repaid by adjustment at
the time of disbursement of the amount of the loan made by the financial
institutions. In case of banks the amount of loan granted as bridge finance
by the banks to the company is paid directly by financial institutions to the
bank on completion of various formalities. The basic idea in bridge
finance is to provide funds to the company to meet its pressing
requirements immediately.
8. Euro – commercial paper
Euro-commercial Paper (CP)

Like Euronotes under NIFs, CPs are also short-term paper issued by
non-bank borrowers. The principal distinguishing feature is that CPs are
not underwritten by a bank and the issuer, therefore, is one with very
high credentials. The paper is usually issued in higher denominations of the
order of $1,00,000 and the market is dominated by large professional
investors. Although these can be issued in interest-bearing form, they
are usually issued at a discount to face-value and quoted in the secondary
market on a yield basis.
9. Relationship between EVA and MVA
Although EVA is used primarily for evaluating management performance,

it also is being used by external analysts to evaluate management
with the belief that superior internal performance should be reflected in a
company’s stock performance. Several studies have attempted to determine
the relationship between the two variables (EVA and MVA), and the
results have not been encouraging. Although the stock of firms with
positive EVAs has tended to outperform the stocks of negative EVA firms,
the differences are typically insignificant and the relationship does not
occur every year. This poor relationship may be due to the timing of the
analysis (how fast EVA is reflected in stocks) or because the market values
(MVAs) are affected by factors other than EVA—for example, MVA can be
impacted by market interest rates and by changes in future expectations
for a firm not considered by EVA—that is, it appears that EVA does an
outstanding job of evaluating management’s past performance in terms of
adding value. While one would certainly hope that superior past
performance will continue, there is nothing certain about this relationship.
10. What do you mean by Pitch Presentation in context of Start-up Business?
Pitch deck presentation is a short and brief presentation (not more than
20 minutes) to investors explaining about the prospects of the company and
why they should invest into the startup business. So, pitch deck
presentation is a brief presentation basically using PowerPoint to provide
a quick overview of business plan and convincing the investors to put
some money into the business. Pitch presentation can be made either
during face to face meetings or online meetings with potential investors,
customers, partners, and co-founders. Here, some of the methods have
been highlighted below as how to approach a pitch presentation:
i. Introduction
To start with, first step is to give a brief account of yourself i.e. who are
you? What are you doing? But care should be taken to make
it short and sweet. Also, use this opportunity to get your investors
interested in your company. One can also talk up the most interesting
facts about one’s business, as well as any huge milestones one may have
achieved.

ii. Team
The next step is to introduce the audience the people behind the
scenes. The reason is that the investors will want to know the
people who are going to make the product or service successful.
Moreover, the investors are not only putting money towards the idea
but they are also investing in the team. Also, an attempt should be
made to include the background of the promoter, and how it relates
to the new company. Moreover, if possible, it can also be highlighted
that the team has worked together in the past and achieved significant
results.
iii. Problem
Further, the promoter should be able to explain the problem he is
going to solve and solutions emerging from it. Further the investors
should be convinced that the newly introduced product or service
will solve the problem convincingly.
For instance, when Facebook was launched in 2004, it added some
new features which give it a more professional and lively look in
comparison to Orkut which was there for some time. It enabled
Facebook to become an instant hit among the people. Further, customers
have no privacy while using Orkut. However, in Facebook, you can
view a person’s profile only if he adds you to his list. These simple yet
effective advantages that Facebook has over Orkut make it an extremely
popular social networking site.
iv. Solution
It is very important to describe in the pitch presentation as to how
the company is planning to solve the problem. For instance, when
Flipkart first started its business in 2007, it brought the concept of
e- commerce in India. But when they started, payment through credit
card was rare. So, they introduced the system of payment on the basis of

cash on delivery which was later followed by other e-commerce

companies in India. The second problem was the entire supply chain
system. Delivering goods on time is one of the most important factors
that determine the success of an ecommerce company. Flipkart addressed
this issue by launching their own supply chain management system
to deliver orders in a timely manner. These innovative techniques
used by Flipkart enabled them to raise large amount of capital from
the investors.
v. Marketing/Sales
This is a very important part where investors will be deeply
interested. The market size of the product must be communicated to
the investors. This can include profiles of target customers, but one
should be prepared to answer questions about how the promoter is
planning to attract the customers. If a business is already selling
goods, the promoter can also brief the investors about the growth
and forecast future revenue.
vi. Projections or Milestones
It is true that it is difficult to make financial projections for a startup
concern. If an organization doesn’t have a long financial history, an
educated guess can be made. Projected financial statements can be
prepared which gives an organization a brief idea about where is the
business heading? It tells us that whether the business will be making
profit or loss?
Financial projections include three basic documents that make up a
business’s financial statements.
 Income statement: This projects how much money the business
will generate by projecting income and expenses, such as sales, cost of
goods sold, expenses and capital. For your first year in business,
you’ll want to create a monthly income statement. For the second

year, quarterly statements will suffice. For the following years, you’ll
just need an annual income statement.
 Cash flow statement: A projected cash flow statement will depict
how much cash will be coming into the business and out of that
cash how much cash will be utilized into the business. At the
end of each period (e.g. monthly, quarterly, annually), one can tally it
all up to show either a profit or loss.
 Balance sheet: The balance sheet shows the business’s overall
finances including assets, liabilities and equity. Typically, one will
create an annual balance sheet for one’s financial projections.
vii. Competition
Every business organization has competition even if the product or
service offered is new and unique. It is necessary to highlight in the
pitch presentation as to how the products or services are different
from their competitors. If any of the competitors have been acquired,
there complete details like name of the organization, acquisition prices
etc. should be also be highlighted.
viii. Business Model
The term business model is a wide term denoting core aspects of
a business including purpose, business process, target customers,
offerings, strategies, infrastructure, organizational structures, sourcing,
trading practices, and operational processes and policies including
culture.
Further, as per Investopedia, a business model is the way in which
a company generates revenue and makes a profit from company
operations. Analysts use the term gross profit as a way to compare
the efficiency and effectiveness of a firm's business model. Gross
profit is calculated by subtracting the cost of goods sold from
revenues. A business model can be illustrated with the help of an
example. There are two companies – company A and company B.

Both the companies are engaged in the business of renting movies.
Prior to the advent of internet both the companies rent movies
physically. Both the companies made Rs. 5 crore as revenues.
Cost of goods sold was Rs. 400000. So, the companies made Rs.
100000 as gross profit. After the introduction of internet, company A
started to offer movies online instead of renting or selling it
physically. This change affected the business model of company A
positively. Revenue is still Rs. 500000. But the significant part is that
cost of goods sold is now Rs. 200000 only. This is because online
sales lead to significant reduction of storage and distribution costs.
So, the gross profit increases from 20% to 60%.
Therefore, Company A isn't making more in sales, but it figured out a
way to revolutionize its business model, which greatly reduces costs.
Managers at company A have an additional 40% more in margin to
play with than managers at company A. Managers at company A
have little room for error and they have to tread carefully.
Hence, every investor wants to get his money back, so it's important
to tell them in a pitch presentation as to how they should plan on
generating revenue. It is better to show the investors a list of the
various revenue streams for a business model and the timeline
for each of them. Further, how to price the product and what does the
competitor charge for the same or similar product shall also be
highlighted. It is also beneficial to discuss the lifetime value of the
customer and what should be the strategy to keep him glued to their
product.
ix. Financing
If a startup business firm has raised money, it is preferable to talk about
how much money has already been raised, who invested money into the
business and what they did about it. If no money has been raised
till date, an explanation can be made regarding how much work has
been accomplished with the help of minimum funding that the company
is managed to raise.
It is true that investors like to see entrepreneurs who have invested their
own money. If a promoter is pitching to raise capital he should list how
much he is looking to raise and how he intend to use the funds.
11. LBO
Meaning : A Leveraged buy-out (LBO) is an acquisition of a company

in which the acquisition is substantially financed through debt. Typically
in the LBO 90% or more of the purchase price is financed with debt.
An attractive candidate for acquisition through leveraged buyout should
possess three basic attributes :
a. If firm have a good position in its industry with a solid profit history
and reasonable expectations of growth.
b. The firm should have a relatively low level of debt and a high level
of bankable assets that can be used as loan collateral.
c. It must have a stable and predictable cash flows that are adequate to meet
interest and principle payment of the debt and provide adequate working
capital.
Typical advantages of the leveraged buy-out method include:
a. Low capital or cash requirement for the acquiring entity
b. Synergy gains, by expanding operations outside own industry or business,
c. Efficiency gains by eliminating the value-destroying effects of
excessive diversification,
d. Improved Leadership and Management

e. Leveraging: as the debt ratio increases, the equity portion of the

acquisition financing
shrinks to a level at which a private equity firm can acquire a
company by putting up anywhere from 20-40% of the total purchase
price.
f. Acquiring Company pay less taxes because interest payments on debt are
tax-deductible
Recent example: India has experienced a number of buyouts and
leveraged buyouts. A successful example of LBO is the acquisition of
Tetley brand, the biggest tea brand of Europe by TATA Tea of India at 271
million pounds. It was one of the biggest cross border acquisition by
an Indian Company. Another recent example of a leveraged buyout is
Tata Steel ( India ) acquiring Corus ( United Kingdom ) for $11.3 billion.
12. Types of order
Types of orders: Customers in futures and option markets are able to

submit a complete range of dealing instructions to their brokers. This allows
them to give precise instructions as to how their orders will be treated.
Generally, following types of orders are issued:
i. Market order.
ii. Limit order.
iii. Stop loss order.
iv. Guaranteed stop.
v. Market-if-touched order
vi. Spread order.
vii. Scale order.
viii. Opening order.
ix. Closing order.
x. Limit or Market on Close order.

xi. Stop limit order.

xii. Good till cancelled (GTC).
xiii. Public limit order.
13. Entry load and exit load
Entry load and an exit load: Some of the Assets Management

Companies (AMCs) have sales charges, or loads, on their funds (entry
load/or exit load) to compensate for distribution costs. Funds that can
be purchased without a sales charge are known as no-load funds. Entry
load is charged at the time a investor purchases the units of a scheme.
The entry load percentage is added to the prevailing NAV at the time of
allotment of units. Exit load is charged at the time of redeeming (or
transferring an investment between schemes). The exit load percentage
is deducted from the NAV at the time of redemption (or transfer between
schemes). This amount goes to the Asset Management Company and not
into the pool of funds of the scheme.
14. Foreign hedging funds
Foreign hedge funds: Though there is no single accepted definition of a

hedge fund, but such funds are generally unregistered private investment
partnerships of high net worth individuals or funds or investment
corporations which are not subjected to the regulatory requirements in
their country of origin. The Kelkar Committee has characterized such
funds as structures where each customer brings in a minimum of ` 10
lakhs of capital, so that the securities regulator ceases to work for
investor protection and only focuses on contract enforcement and fraud.
Hedge funds are often criticized for their speculative nature with fears
that sudden withdrawals create defaulter in the markets. However, it is
felt that this is a mistaken notion and that such funds react more or less
in the same manner as other participants in the market do to a given set
of information. All hedge funds are not necessarily speculative funds and
it is believed that Indian Capital market regulatory framework has
sufficient checks and balances “to keep the markets safe from potential
abuse and manipulation”
15. Is there any provision for grant of composite loans by banks?
A composite loan limit of Rs.1crore can be sanctioned by banks to enable the

MSME entrepreneurs to avail of their working capital and term loan
requirement through Single Window in terms of RBI Master Circular on
lending to the MSME sector dated July 1, 2010. All scheduled commercial
banks have been advised by our circular RPCD.SME&NFS.
BC.No.102/06.04.01/2008-09 on May 4, 2009 that the banks which have
sanctioned term loan singly or jointly must also sanction working
capital (WC) limit singly (or jointly, in the ratio of term loan) to avoid
delay in commencement of commercial production thereby ensuring that
there areno cases where term loan has been sanctioned and working
capital facilities are yet to be sanctioned. These instructions have been
reiterated to schedule commercial banks on March 11, 2010.
16. Participating notes
Participating Notes (PNs) : Participatory Notes (PNs) are offshore derivative

instruments in the form of contract notes issued by registered Foreign
Institutional Investors (FIIs) against underlying securities to overseas
investors who wish to stay away for the registration hassles. This
makes it possible for such funds to invest even as they stay away from the
glare of the regulator.
The Government of India wants the hedge funds to come and invest in
the Indian capital market directly and not through the participatory
notes. The Government is likely to ease out norms of investment for foreign

hedge funds and a larger play of hedge funds is expected to bring in a

huge amount of fresh liquidity into the capital market. So far their
aggregate investment in capital market during the current fiscal year
(2004-2005) is more than $ 10 billion. The Government wants hedge
funds to register directly with the regulator and not to invest through
participatory notes.
17. Warrants
Warrants : Warrant is an instrument attached to an security/GDRs etc.

It gives the investors an option to get it converted into equity at a later
date. Warrants help the issuer to charge some premium on the
security/GDRs sold and it also helps to increase the demand of the
security/GDR issue. Another advantage to the issuer is that it will not
have to pay dividends on the warrants till the conversion option is
exercised. The disadvantage to the issuer lies in delayed receipt of full
proceeds from the issue and in case the conversion option is not exercised
the expected/proceeds will not be realized.
18. Cross border merger and acquisition
 Cross-border M&A is a popular route for global growth and overseas

expansion. Cross border M&A is also playing an important role in
global M&A. This is especially true for developing countries such as India.
 Factors that motivate multinational companies to engage in cross-
border M&A in Asia include the following:
i. Globalization of production and distribution of products and services.
ii. Integration of global economies.
iii.Expansion of trade and investment relationships on International level.

iv. Many countries are reforming their economic and legal systems,
and providing generous investment and tax incentives to attract foreign
investment.
v. Privatisation of state-owned enterprises and consolidation of the
banking industry.
19. Cash and derivative market
The basic differences between Cash and the Derivative market are as follows :
a. In cash market tangible assets are traded whereas in derivative
markets contracts based on tangible or intangibles assets likes index or
rates are traded.
b. In cash market, we can purchase even one share whereas in Futures
and Options minimum lots are fixed.
c. Cash market is more risky than Futures and Options segment because
in “Futures and Options” risk is often limited.
d. Cash assets may be meant for consumption or investment. Derivative
contracts are for hedging, arbitrage or speculation.
e. The value of derivative contract is always based on and linked to the
underlying security. Though this linkage may not be on point-to-point
basis.
f. In the cash market, a customer must open securities trading account with a
securities depository whereas to trade futures a customer must open a
future trading account with a derivative broker.
g. Buying securities in cash market involves putting up all the money
upfront whereas buying futures simply involves putting up the margin
money.

20. Caps and collars
These are derivatives which a finance manager can use to manage his
cash- flows effectively and also to reduce the risk involved in case of a
major devaluation of currency.
Caps-if a company decides on a particular rate of a currency vis-à-vis the
rupee over which it is not ready to take a risk, it can buy a cap at that rate.
The cost of caps is very prohibitive and can be offset by selling a ‘floor’ which
is just the opposite of cap. Collar – a combination of caps and floors is called
collar.
21. Insider Trading
Meaning: Insider trading refers to using the unpublised information

about the performance or other matters of a company, in dealings with
the securities of the company or In other words Insider Trading
 is a buying or selling or dealing in securities of a listed company,
 by a director, member of management, an employee or any other person
such as internal or statutory auditor, agent, advisor, analyst, consultant
etc.
 who have knowledge of material ‘inside’ information not available to
general public
The word insider has wide connotation. An outsider may be held to be
an insider by virtue of his engaging himself in this practice on the
strength of inside information.
Why Insider Trading is punishable : Insider trading is prohibited by the
SEBI as
i. it results into unfair gains to insiders and harms the interest of
other shareholders

ii. it downgrades the image of the company,

iii. it drives away the investors from the market, and
iv. it causes unwarranted volatility in the prices of the shares of the
company.
22. Takeover by Reverse Bid
Meaning : It is the act of a smaller company gaining control over a larger one.
In ordinary case, the company taken over is the smaller company; in a
‘Reverse Takeover’, a smaller company gains control of a larger one.
Tests For Identifying Takeover by Reverse Bid:
The three tests in a takeover by reverse bid that are required to be
satisfied are, namely,
i. the assets of the transferor company are greater than the transferee
company,
ii. equity capital to be issued by the transferee company pursuant to
the acquisition exceeds its original issued capital, and
iii. the change of control in the transferee company through the introduction
of a minority holder or group of holders.
Takeover by reverse bid could happen where already a significant percent of
the shareholding is held by the transfer company, to exploit economies of
scale, to enjoy better trading advantages and other similar reasons.
23. Types of risks for a swap dealer
In the process of swap, the role of swap dealer is significant insofar as

it brings together two counter-parties whose interests are complementary to
each other. For this role, it takes a small part of the interest payment
flow. Since the principal amount is large, even a small percentage of the
interest payment adds considerably to its profit. But, on the other hand, the

swap dealer has to face a variety of risks. These different forms of risks as
follows:
 Interest-rate Risk
 Exchange-rate Risk
 Credit Risk
 Mismatch Risk
 Sovereign Risk
 Delivery Risk
24. Describe the various parameters to identity the currency risk.
Just like interest rate risk the currency risk is dependent on the Government
action and economic development. Some of the parameters to identity the
currency risk are as follows:
1. Government Action: The Government action of any country has visual
impact in its currency. For example, the UK Govt. decision to divorce
from European Union i.e. Brexit brought the pound to its lowest
since 1980’s.
2. Nominal Interest Rate: As per interest rate parity (IRP) the currency
exchange rate depends on the nominal interest of that country.
3. Inflation Rate: Purchasing power parity theory discussed in later chapters
impact the value of currency.
4. Natural Calamities: Any natural calamity can have negative impact.
5. War, Coup, Rebellion etc.: All these actions can have far reaching
impact on currency’s exchange rates.
6. Change of Government: The change of government and its attitude
towards foreign investment also helps to identify the currency risk.

25. Explain the challenges to Efficient Market Theory.
i. Information inadequacy– Information is neither freely available nor

rapidly transmitted to all participants in the stock market. There is a
calculated attempt by many companies to circulate misinformation.
ii. Limited information processing capabilities – Human information
processing capabilities are sharply limited. According to Herbert Simon
every human organism lives in an environment which generates millions
of new bits of information every second but the bottle necks of the
perceptual apparatus does not admit more than thousand bits per seconds
and possibly much less.
David Dreman maintained that under conditions of anxiety and
uncertainty, with a vast interacting information grid, the market can
become a giant.
iii.Irrational Behaviour– It is generally believed that investors’ rationality
will ensure a close correspondence between market prices and intrinsic
values. But in practice this is not true. J. M. Keynes argued that all
sorts of consideration enter into the market valuation which is in no way
relevant to the prospective yield. This was confirmed by L. C. Gupta
who found that the market evaluation processes work haphazardly
almost like a blind man firing a gun. The market seems to function
largely on hit or miss tactics rather than on the basis of informed
beliefs about the long term prospects of individual enterprises.
iv. Monopolistic Influence – A market is regarded as highly competitive. No
single buyer or seller is supposed to have undue influence over prices. In
practice, powerful institutions and big operators wield grate influence
over the market. The monopolistic power enjoyed by them diminishes
the competitiveness of the market.

26. Relative Valuation is the method to arrive at a ‘relative’ value using a

‘comparative’ analysis to its peers or similar enterprises. Elaborate this
statement.
The three approaches that we saw to arriving at the value of an enterprise

viz. the asset based, the earnings based and the cash flow based are for
arriving at the ‘intrinsic value’ of the same. Relative Valuation is the method
to arrive at a ‘relative’ value using a ‘comparative’ analysis to its peers or
similar enterprises. However, increasingly the contemporary financial
analysts are using relative valuation in conjunction to the afore-stated
approaches to validate the intrinsic value arrived earlier.
The Relative valuation, also referred to as ‘Valuation by multiples,’ uses
financial ratios to derive at the desired metric (referred to as the ‘multiple’)
and then compares the same to that of comparable firms. (Comparable firms
would mean the ones having similar asset and risk dispositions, and assumed
to continue to do so over the comparison period). In the process, there may
be extrapolations set to the desired range to achieve the target set. To
elaborate –
1. Find out the ‘drivers’ that will be the best representative for deriving at the
multiple
2. Determine the results based on the chosen driver(s) thru financial ratios
3. Find out the comparable firms, and perform the comparative analysis,
and,
4. Iterate the value of the firm obtained to smoothen out the deviations
Step 1: Finding the correct driver that goes to determine the multiple is
significant for relative valuation as it sets the direction to the valuation
approach. Thereby, one can have two sets of multiple based approaches
depending on the tilt of the drivers –
a. Enterprise value based multiples, which would consist primarily of
EV/EBITDA, EV/Invested Capital, and EV/Sales.
b. Equity value based multiples, which would comprise of P/E ratio

and PEG.
We have already seen the concept and application of Enterprise Value
in previous section. However, in light of relative valuation, we can definitely
add that whereas EV/EBITDA is a popular ratio and does provide critical
inputs, the EV/Invested Capital will be more appropriate to capital intensive
enterprises, and EV/Sales will be used by companies who are cash rich,
have a huge order book, and forecast organic growth thru own capital.
The P/E has a celebrated status amongst Equity based multiples, and
the PEG is more suitable where we are doing relative valuation of either
high growth or sunrise industries.
Step 2: Choosing the right financial ratio is a vital part of success of this
model. A factor based approach may help in getting this correct – for
example – a firm that generates revenue mostly by exports will be highly
influenced by future foreign exchange fluctuations. A pure P/E based ratio
may not be reflective of this reality, which couldn’t pre-empt the
impacts that Brexit triggered on currency values. Likewise, an
EV/Invested Capital would be a misfit for a company which may be light on
core assets, or if has significant investment properties.
Step 3: Arriving at the right mix of comparable firms: This is perhaps the
most challenging of all the steps – No two entities can be same – even if they
may seem to be operating within the same risk and opportunity
perimeter. So, a software company ‘X’ that we are now comparing to a
similar sized company ‘Y’ may have a similar capital structure, a similar
operative environment, and head count size – so far the two firms are
on even platform for returns forecast and beta values. On careful
scrutiny, it is now realized that the revenue generators are different – X may
be deriving its revenues from dedicated service contracts having FTE
pricing, whereas Y earns thru UTP pricing model. This additional set of
information dramatically changes the risk structure – and this is precisely

what the discerning investor has to watch for. In other words, take
benchmarks with a pinch of salt.
Take another example – a firm is operating in a niche market, and that
obviously leads to getting comparable firms become a difficult task. In
such cases, one may have to look beyond the current operating market
and identify similar structured companies from other industries – like for
example – a medium sized LPO may have to evaluate based on the
specific divisional figures of a Big 4 firm.
The comparable firm can either be from a peer group operating within the
same risks and opportunities perimeter, or alternatively can be just take
closely relevant firms and then perform a regression to arrive at the
comparable metrics. You would notice that in our example, the LPO is
adopting the later approach. Whereas the company ‘X’ will have to ignore
‘Y’ and search for a similar revenue-risk based company. However, as a
last resort, it may adopt a regression based model as above.
Step 4: Iterate / extrapolate the results obtained to arrive at the correct
estimate of the value of the firm.
Let’s apply the above concepts into a relative valuation illustration:
F Ltd is a small sized company that is not listed. It is however a time
tested company having positive cash flows and a net profit of 9%.
The company has zeroed in two value drivers going forward – a higher
than industry growth rate in sales, and higher internal efficiencies. The
market that it operates in has a couple of large sized listed firms, exhibiting a
beta of 1.3 & 1.5 respectively. How do we approach this from a relative
valuation point of view?
We are given two value drivers that essentially point out to future earnings
– so let’s take the EV/EBITDA approach for enterprise valuation. Assume
that on applying the EV techniques, we get an EV of 50 Million. The next step
is to do ring fencing for adoption of the EV approach. Or conversely, if

we were to adopt the elimination way of choosing the right fit, how do we
decide against, say, EV/Invested Capital? An elaborate thought process
requires to be established here, and the decision to be quantified and
documented.
Next, assume we do have a comparable firm. May be its demonstrating
the same characteristics in a larger scale than our company F Ltd. But how do
we get absolutely sure on this? As discussed earlier, we may take similar
firms from dissimilar industries. Or we get the sum-total of all firms
within the industry and then do appropriate regressions to remove both
large- scale factors and structural differences. An important factor would be
leveraged capital. Listed companies do use to a lot more of leverage,
and F Ltd may have to seriously recalibrate if its balance sheet stands light.
And finally, say we have arrived at a conclusion that the comparable firm is
indeed an efficient model and is the correct indicator for appraising F Ltd –
taking the values of comparable firms’ Beta and potential growth estimates,
you can value F Ltd.
A tweak to the above case can be brought by an insistence to use a P/E
based approach. In this scenario, we have a market – ready PE for the
comparable firm called ‘M’, who’s PE is, say, at 10. However, how do we
find out P/E for F Ltd which is an unlisted entity? We have to necessarily use
analytical approach to finding out the correct ‘earnings’ - adjust for
accounting policy mismatches with ‘M’ (F Ltd being an unlisted entity may
have policies that exhibit laxity), adjust for cost of capital, and then arrive at
the adjusted ‘earnings’ to apply the above PE. Alternatively, we may work out
the PEG (the ratio of the PE to the expected growth rate of the firm) and
evaluate the value of F Ltd.
Thus, we can conclude that ‘Relative Valuation’ is a comparative driven
approach that assumes that the value of similar firms can form a good
indicator for the value of the tested firm. There are some assumptions that
are inherent to this model –
i. The market is efficient

ii. The function between the fundamentals and the multiples are linear
iii. The firms that are comparable are similar to structure, risk and growth
pattern.
27. Leading and Lagging
 This technique is used by subsidiaries for optimizing cash flow

movements by adjusting the timing of payments to determine expectations
about future currency movements.
 MNCs accelerate (lead) or delay (lag) the timing of foreign currency
payments through adjustment of the credit terms extended by one unit to
another.
 The technique helps to reduce foreign exchange exposure or to increase
available working capital.
The advantages associated with Leading and Lagging are :
1. No formal recognition of indebtedness is required and the credit terms can
be altered by increase/decrease of the terms on the accounts.
2. It helps in minimizing foreign exchange exposure and helps in
transferring liquidity among affiliates by changing credit terms and is
dependent on the opportunity cost of funds to both paying and receiving
units.
3. It is an aggressive technique aimed at taking advantage of expected
revaluations and devaluations of currency movements.
28. Rolling settlement
A rolling settlement is that settlement cycle of the stock exchange, where all
trades outstanding at end of the day have to settled, which means that the

buyer has to make payments for securities purchased and seller has to deliver
the securities sold.
Benefits of Rolling Settlement :
a. In rolling settlements, payments are quicker than in weekly settlements.
Thus, investors benefit from increased liquidity.
b. It keeps cash and forward markets separate.
c. Rolling settlements provide for a higher degree of safety.
d. From an investor’s perspective, rolling settlement reduces delays. This
also reduces the tendency for price trends to get exaggerated. Hence,
investors not only get a better price but can also act at their leisure
29. Open interest
When a new futures contract starts trading and the sale of the first
contract takes place, the open interest account is opened. Open interest at that
point is one. During the trading life of a futures contract, positions keep
getting opened and closed. Open interest is broadly the outstanding short
position (sellers) on the outstanding long position at any particular point
of time. Except for stock Index futures (SIFs), most other futures
contracts required delivery of the underlying asset.
30. Explain Dow Jones theory.
The Dow Theory is one of the oldest and most famous technical theories. It
was originated by Charles Dow, the founder of Dow Jones Company in late
nineteenth century. It is a helpful tool for determining the relative strength of
the stock market. It can also be used as a barometer of business.
The Dow Theory is based upon the movements of two indices, constructed
by Charles Dow, Dow Jones Industrial Average (DJIA) and Dow Jones
Transportation Average (DJTA). These averages reflect the aggregate impact
of all kinds of information on the market. The movements of the market
are divided into three classifications, all going at the same time; the primary
movement, the secondary movement, and the daily fluctuations. The
primary movement is the main trend of the market, which lasts from one
year to 36 months or longer. This trend is commonly called bear or bull
market. The secondary movement of the market is shorter in duration than
the primary movement, and is opposite in direction. It lasts from two weeks
to a month or more. The daily fluctuations are the narrow movements from
day-to-day. These fluctuations are not part of the Dow Theory
interpretation of the stock market. However, daily movements must be
carefully studied, along with primary and secondary movements, as they
go to make up the longer movement in the market.
Thus, the Dow Theory’s purpose is to determine where the market is
and where is it going, although not how far or high. The theory, in practice,
states that if the cyclical swings of the stock market averages are
successively higher and the successive lows are higher, then the market
trend is up and a bullish market exists. Contrarily, if the successive highs
and successive lows are lower, then the direction of the market is down
and a bearish market exists.
Charles Dow proposed that the primary uptrend would have three moves
up, the first one being caused by accumulation of shares by the
far-sighted, knowledgeable investors, the second move would be caused by
the arrival of the first reports of good earnings by corporations, and the
last move up would be caused by widespread report of financial
well-being of corporations. The third stage would also see rampant
speculation in the market. Towards the end of the third stage, the far-sighted
investors, realizing that the high earnings levels may not be sustained,
would start selling, starting the first move down of a downtrend, and as
the non -sustainability of high earnings is confirmed, the second move down
would be initiated and then the third move down would result from
distress selling in the market.

MIND MAP
&
SUMMARY
Mutual Fund (Mind Map):- Asset - Liabilities
Investors NAV =
No. of Units
Passed Pool their
back to money with
Fund
Returns Manager(s)
Generate Invest in
Securities
Mutual Fund Operation Flow Chart
Reinvestment Plan
Ending Value - Beginning Value
˟ 100
Beginning Value
218
Mutual Fund (Summary):-
Net Asset Value (NAV)
219
Asset- Liabilities
=
No.of units
Expost exercise No concept of E(R) Actual return (Rp) and risk taken is considered
p
= R -R f p
= R -R f
σ p β p
Mergers & Acquisitions (Mind Map)
VAB = VA + VB + VSynergy - Cash PC A + B = AB

NPV to A = VAB - VA
NPV to B = Cash PC - VB
PATAB = PATA + PATB + Synergy in earnings

VAB = éë(Post Merger PE ratio )´ PATAB ùû - Cash PC
NPV to A = VAB - VA
EPSB BVPSB PB
r= or or
Buyout Management Buy in
220
EPSA BVPSA Management
PA
VA + VB + Value of synergy
PAB =
NA + r NB
PAB = PA
PATAB = PATA + PATB + Synergy in earnings

V A B = éë ( P o s t M e r g e r P E r a tio ) ´ P A T A B ùû
VAB βPAB = PB
PAB =
NA + r NB
EPSB BVPSB PB
r= or or
EPSA BVPSA PA
PB
PA
NPVA = (PAB - PA )N A
NPVB = (r PAB - PB )N B
( (
VAB = VA + VB + VSynergy - Cash PC
221
VB + Vsynergy + Values of control
Combined profit = PATAB = PATA + PATB + Synergy in earnings

VAB = éë(Post Merger PE ratio )´ PATAB ùû - Cash PC
NPV to A = VAB - VA
Maximum amount A can pay = VAB - VA or VB + Synergy
2
Style 1:- Exchange Ratio = = 0.40 i.e. 0.40 shares of A for every share of B.
5
5
Style 2:- Exchange Ratio = = 2.50 i.e. 2.5 shares of B required to get one share of A.
2
If we follow Style 1:- Exchange ratio (r) refers to the number of shares of A to be - issued for 1 share of B.
Basis for fixing exchange ratio EPS B Note: Exchange ratio (r) is normally less than 1 but can be > 1, such case
Earnings per share wise r=
[EPS] EPS A arises when small company acquires big companies.
BVPS B
Book value per share wise r= DANGER: If it is a banking merger, EPS to be computed on basis of NPA
[BVPS] BVPS A
(Non Performing Assets) [either % or per share]. We got to defined,
Price wise (P)
PB NPA of Acquirer
r= r=
PA NPA of T arg et
Combined No. of shares = NA + r NB ; This is used to compute post merger GPS
Case 3:- Stock deal Synergy in value Case 4:- Stock deal Synergy in earnings
V + VB + Value of synergy PATAB = PATA + PATB + Synergy in earnings
= PAB = A
NA + r NB VAB = (Post Merger P /E ratio )´ PATAB
222
VAB
PAB =
NA + r NB
P/E ratio after merger if not given we will assume it to be same as pre merger P/E ratio
- Bootstrap Effect
Style of computing NPV in a stock deal
Style 1:- NPV = (Post Merger Price - Pre Merger Price) × No. of shares.
Note:- Remember that while doing this for the target firm you got to take post merger equivalent price.
i.e. rPAB (B ko ek ke badle r shares mila)
Style 2:- NPV = ownership position × combined value - khud ka value

Remember that when synergy in value (case 3 you got to add values of synergy to VA and VB when synergy in earning (case 4) you got to add synergy with
profit of A to & profit of B and then think about PE.
NPVA = (PAB - PA )N A NPVB = (r PAB - PB )N B

PAB = PA βPAB = PB
é VA + VB + Vsynergy ù
PAB = ê ú é PATA + PATB + Synergy in E ù
ë N A + α N B û PAB = ê ú ´ PE ratio
ë N A + α N B û
223
é VA + VB + VSynergy ù
PAB =ê ú é PATA + PATB + Synergy in E ù
ë N A + β N B û PAB = ê ú ´ PE ratio
ë N A + β N B û
[VX + VY ]- VA
224
Management Buyout Management Buy in
Products of Islamic
225
Finance
Mudaraba (Profit sharing and loss bearing)

- equivalent to Venture Capital
Musharaka (Profit and Loss sharing) - equivalent to

Joint Venture
50% 50%
Sukuk (Most Popular) - stands for trust certificate
Funds effort
& bond, used to fund assets via SPV set up in IFCs
DIB B Businessman
& Funds
Ijara
Loss - equivalent to leasing in conventional finance
80% 20%
Murabaha
MUSHARAKA - cost plus profit arrangement
x% y%
Funds
DIB B Businessman
Effort
borne b
y
the ban Loss
k
MUDARABA
226
Asset C F’s C F’s PTC
Pool SPV
passed on to holder
c1 c2 cn
Po = + 2
+ .............. n
1 + r (1 + r ) (1 + r )
227
Theory (Mind Map)
Provides Asset
Domestic Pooling Management Service
VCF Investment Advisor
Investors
Invests in
VCU1 VCU2 VCU3
overseas Manager
To Pool funds
Limited Partners
Provides Asset Management
Lp2 LLP Investment Advisor
offshore Service
228
Lpn
VCU1 VCU2 VCU3
Domestic Investors
Overseas Manager
Limited Partners OFF Shore Investment

Trust Advisor
LLP
VCU1 VCU2 VCU3

229
Other
ICAI MAY 2019
EXAMINATION
QUESTIONS
May 2019 Examination Questions
Mutual Fund
1. A Mutual Fund Company introduces two schemes - Dividend Plan and Bonus
Plan. The face value of the Unit is ` 10 on 1-4-2014. Mr. R invested ` 5 lakh in
Dividend Plan and ` 10 lakh in Bonus Plan. The NAV of Dividend Plan is ` 46
and NAV of Bonus Plan is ` 42. Both the plans matured on 31-03-2019. The
particulars of Dividend and Bonus declared over the period are as follows :
NAV of
NAV of
Dividend
Date Dividend % Bonus Ratio Bonus Plan
Plan
` `
31-12-2014 12% - 47.0 42.0
30-09-2015 - 1:4 48.0 43.0
31-03-2016 15% - 49.5 41.5
30-09-2017 - 1:6 50.0 44.0
31-03-2018 10% - 48.0 43.5
31-03-2019 - - 49.0 44.0
You are required to calculate the effective yield per annum in respect of the
above two plans.
ICAI May 2019 (New Scheme)

2. The following particulars relating to Vishnu Fund Scheme :
Value
Particulars
` in Crores
1. Investments in Shares (at cost)
a. Pharmaceutical companies 79
b. Construction Industries 31
c. Service Sector Companies 56
d. IT Companies 34
e. Real Estate Companies 10
2. Investments in Bonds (Fixed Income)
a. Listed Bonds (8,000, 14% Bonds of ` 15,000 each) 12
b. Unlisted Bonds 7
3. No. of Units outstanding (crores) 4.2
4. Expenses Payable 3.5
5. Cash and Cash equivalents 1.5
6. Market expectations on listed bonds 8.842%
Particulars relating to each sector are as follows :
Sector Index on Index on

Purchase date Valuation date
Pharmaceutical companies 260 465
Construction Industries 210 450
Service Sector Companies 275 480
IT Companies 240 495
Real Estate Companies 255 410
The fund has incurred the following expenses :

Consultancy and Management fees ` 480 Lakhs
Office Expenses ` 150 Lakhs
Advertisement Expenses ` 38 Lakhs
You are required to calculate the following :

i. Net Asset Value of fund
ii. Net Asset Value per unit
iii. If the period of consideration is 2 years, and the fund has distributed ` 3
per unit per year as cash dividend, ascertain the net return (Annualized)
iv. Ascertain the Expenses ratio.
ICAI May 2019 (Old Scheme)
3. A mutual fund has two schemes i.e. Dividend plan (Plan-A) and Bonus plan
(Plan-B). The face value of the unit is ` 10. On 01-04-2016 Mr. Anand invested
` 5,00,000 each in Plan-A and Plan-B when the NAV was ` 46.00 and ` 43.50
respectively. Both the Plans matured on 31-03-2019.
Particulars of dividend and bonus declared over the period are as follows:
Net Asset Value(`)
Date Dividend % Bonus Ratio
Plan - A Plan B
30-06-2016 15% 46.80 44.00
31-08-2016 1: 6 47.20 45.40
31-03-2017 10% 48.00 46.60
17-09-2017 1:8 48.40 47.00
21-11-2017 14% 49.60 47.20
25-02-2018 15% 50.00 47.80
31-03-2018 1:10 50.50 48.80
30-06-2018 12% 51.80 49.00
31-03-2019 52.40 50.00
You are required to calculate the Effective Yield Per annum in respective of
the above two plans.

MERGERS
1. Given is the following information:

Day Ltd. Night Ltd.
Net Earnings ` 5 crores ` 3.50 crores
No. of Equity Share 10,00,000 7,00,000
The shares of Day Ltd. and Night Ltd. trade at 20 and 15 times their respective
P/E ratios.
Day Ltd. considers taking over Night Ltd. by paying ` 55 crores considering
that the market price of Night Ltd. reflects its true value. It is considering both
the following options:
i. Takeover is funded entirely in cash.
ii. Takeover is funded entirely in stock.
You are required to calculate the cost of the takeover and advise Day Ltd. on
the best alternative.
2. R Ltd. and S Ltd. operating in same industry are not experiencing any rapid
growth but providing a steady stream of earnings. R Ltd.' s management is
interested in acquisition of S Ltd. due to its excess plant capacity. Share of
S Ltd. is trading in market at ` 3.20 each. Other data relating to S Ltd. is as
follows :
Balance Sheet of S Ltd.
Liabilities Amount (`) Assets Amount (`)
Current Liabilities 1,59,80,000 Current Assets 2,48,75,000
Long Term Liabilities 1,28,00,000 Other Assets 94,00,000
Reserves & Surplus 2,79,95,000 Property Plants & 3,45,00,000
Equipment
Share Capital 1,20,00,000
(80 Lakhs share of
` 1.5 each)
Total 6,87,75,000 Total 6,87,75,000
Particulars R Ltd. S. Ltd. Combined

(`) (`) Entity (`)
Profit after Tax 86,50,000 49,72,000 1,21,85,000
Residual Net Cash Flows per year 90,10,000 54,87,000 1,85,00,000
Required return on equity 13.75% 13.05% 12.5%
You are required to compute the following :

i. Minimum price per share S Ltd. should accept from R Ltd.
ii. Maximum price per share R Ltd., shall be willing to offer to S Ltd.
iii. Floor Value of per share of S Ltd., whether it shall play any role in
decision for its acquisition by R Ltd.

THEORY

1. State the important features of National Pension Scheme (NPS).
2. List the main applications of Value At Risk (VAR).
3. Briefly explain the steps involved in Mechanism of Securitization.
4. Explain briefly the sources for funding a Start-up.

1. Limitations of Credit Rating
2. Exposure Netting
3. Explain carve out, and its difference from spin off
4. Explain briefly Debt/Asset Securitisation, and its process.
5. What makes an organization sustainable? State the specific steps.

TABLE C
Normal probability distribution table
NUMBER OF STANDARD AREA TO THE LEFT OR NUMBER OF STANDARD AREA TO THE LEFT OR
DEVIATIONS FROM MEAN RIGHT (ONE TAIL) DEVIATIONS FROM MEAN RIGHT (ONE TAIL)
(Z) (Z)
0.00 0.5000 1.55 0.0606
0.05 0.4801 1.60 0.0548
0.10 0.4602 1.65 0.0495
0.15 0.4404 1.70 0.0446
0.20 0.4207 1.75 0.0401
0.25 0.4013 1.80 0.0359
0.30 0.3821 1.85 0.0322
0.35 0.3632 1.90 0.0287
0.40 0.3446 1.95 0.0256
0.45 0.3264 2.00 0.0228
0.50 0.3085 2.05 0.0202
0.55 0.2912 2.10 0.0179
0.60 0.2743 2.15 0.0158
0.65 0.2578 2.20 0.0139
0.70 0.2420 2.25 0.0122
0.75 0.2264 2.30 0.0107
0.80 0.2119 2.35 0.0094
0.85 0.1977 2.40 0.0082
0.90 0.1841 2.45 0.0071
0.85 0.1711 2.50 0.0062
1.00 0.1557 2.55 0.0054
1.05 0.1469 2.60 0.0047
1.10 0.1357 2.65 0.0040
1.15 0.1251 2.70 0.0035
1.20 0.1151 2.75 0.0030
1.25 0.1056 2.80 0.0026
1.30 0.0986 2.85 0.0022
1.35 0.0885 2.90 0.0019
1.40 0.0808 2.95 0.0016
1.45 0.0735 3.00 0.0013
1.50 0.0668
Student’s T-Distribution
Level of Significance for One-Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two-Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
1 3.078 6.314 12.706 31.821 63.657 636.619
2 1.886 2.920 4.303 6.965 9.925 31.599
3 1.638 2.353 3.182 4.541 5.841 12.294
4 1.533 2.132 2.776 3.747 4.604 8.610
5 1.476 2.015 2.571 3.365 4.032 6.869
6 1.440 1.943 2.447 3.143 3.707 5.959

7 1.415 1.895 2.365 2.998 3.499 5.408
8 1.397 1.860 2.306 2.896 3.355 5.041
9 1.383 1.833 2.262 2.821 3.250 4.781
10 1.372 1.812 2.228 2.764 3.169 4.587
11 1.363 1.796 2.201 2.718 3.106 4.437

12 1.356 1.782 2.179 2.681 3.055 4.318
13 1.350 1.771 2.160 2.650 3.012 4.221
14 1.345 1.761 2.145 2.624 2.977 4.140
15 1.341 1.753 2.131 2.602 2.947 4.073
16 1.337 1.746 2.120 2.583 2.921 4.015

17 1.333 1.740 2.110 2.567 2.898 3.965
18 1.330 1.734 2.101 2.552 2.878 3.922
19 1.328 1.729 2.093 2.539 2.861 3.883
20 1.325 1.725 2.086 2.528 2.845 3.850
21 1.323 1.721 2.080 2.518 2.831 3.819

22 1.321 1.717 2.074 2.508 2.819 3.792
23 1.319 1.714 2.069 2.500 2.807 3.768
24 1.318 1.711 2.064 2.492 2.797 3.745
25 1.316 1.708 2.060 2.485 2.787 3.725
26 1.315 1.706 2.056 2.479 2.779 3.707

27 1.314 1.703 2.052 2.473 2.771 3.690
28 1.313 1.701 2.048 2.467 2.763 3.674
29 1.311 1.699 2.045 2.462 2.756 3.659
30 1.310 1.697 2.042 2.457 2.750 3.646
40 1.303 1.684 2.021 2.423 2.704 3.551

60 1.296 1.671 2.000 2.390 2.660 3.460
120 1.289 1.658 1.980 2.358 2.617 3.373
00 1.282 1.645 1.960 2.326 2.576 3.291

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o MIND MAP & SUMMARY................................................................................218-229

PRACTICE PROBLEMS 190 - 243

HEDGE FUND FEE CALCULATION

Assets under management (500Cr.) at the beginning of the year.

SANJAY SARAF SIR 188

Beginning Fund Value = 500 Cr.

Particulars Case I Cae II Case III

SANJAY SARAF SIR 189

Personal earnings of Mr. A = R1

SANJAY SARAF SIR 190

(i) Returns for the year

SANJAY SARAF SIR 191

(i) Returns for the year

SANJAY SARAF SIR 192

Value of 213.04 units held at the end of the year

4. A mutual fund made an issue of 10,00,000 units of ` 10 each on January 01,

During the year, dividends of ` 12,00,000 were received on equity shares.

SANJAY SARAF SIR 193

No. of Units 10,00,000

Calculation of NAV, if dividend of ` 0.80 is paid –

SANJAY SARAF SIR 194

5. On 1-4-2012 ABC Mutual Fund issued 20 lakh units at ` 10 per unit.

Amount in Amount in Amount in

Dividend distributed = 80% of 2.00 1.60 67.20

SANJAY SARAF SIR 195

Closing market value of portfolio 198.0

Rate of Earning (Per Unit)

SANJAY SARAF SIR 196

Current realizable value of fixed income securities of face value of ` 100 is `

Particulars Adjustment value

SANJAY SARAF SIR 197

Name of Face Purchas Maturity No. of Coupon Duratio

Number of Units (` 10 face value each): 100000

SANJAY SARAF SIR 198

Name of Security Maturity Date Amount (`)

Note: Interests on two remaining securities shall not be considered as last

(ii) Valuation of Securities

Name of Purchase Duration Volatility (+)/(-) Total

8.5% SGL 18,27,200 6.5205 6.5205 -81,230 17,45,970

SANJAY SARAF SIR 199

Sub total assets (A) 2,13,77,053

8. The following are the data on five mutual funds:

SANJAY SARAF SIR 200

Sharpe Ratio S = (Rp – Rf)/σp

Reward to Variability (Sharpe Ratio)

Reward to Volatility (Treynor Ratio)

SANJAY SARAF SIR 201

9. The following information is extracted from Steady Mutual Fund’s Scheme:

You are required to:

(1) Calculation of NAV at the end of month:

SANJAY SARAF SIR 202

Total No. of Units 6,00,000

(i) NAV of the Fund

SANJAY SARAF SIR 203

(ii) The revised position of fund shall be as follows:

(iii) On 2nd February 2012, the NAV of fund will be as follows:

SANJAY SARAF SIR 204

SANJAY SARAF SIR 205

(a) NAV of the Fund.