SUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS tof? INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 Marks Question No. 1 (a) Reasons for Correctness: Response to Statement (i): The value of callable bond = Value of non-callable ~ Value of call option The decrease in volatility would cause decrease in value of call option, leading to increase in value of callable bond. Hence, the statement is incorrect. 1 Response to Statement (ii) Change in level of interest rates affects all bonds. Hence, the statement is incorrect. 1 Response to Statement (ii) Value of callable bond= Value of straight bond — Value of call option. As interest rate decreases, the value of call option goes up as well as the value of straight bond. However, the increase in value of callable bond will be less as compared to non-callable bond. Hence, the statement is correct 1 Response to Statement (v) Value of putable bond = _-Value of straight bond + Value of put option. As interest rates increase, the long put in a putable bond hedges against the loss in value; the value of a putable bond falls less rapidly than the value of straight bond. Hence, the statement is correct. 1 (b) Market Value of the Embedded Call Option: Value of callable bond = Value of non-callable — Value of call option 1 Value of call option = Value of non-callable ~ Value of callable bond % Value of call option = Rs.99.55 -Rs.98.23 = Rs.1.32 % (c) Free Cash Flow to Equity: Rs. in million ‘A. Cash flow from operations: Income before interest and tax 1,392.0 % Less: Interest expense 300.0 % Income before tax 1,082.0 % Tax @ 32% 349.4 % Income after tax 742.6 % ‘Add: deprecation 312.0 % Less: Increase in current assets [2,757 - 2,576] (181.0) % ‘Add: Decrease in current iabilities* [(8,614 — 2,215 - 689 = 710} ~ {3,435 — 2,161- 642 = 632}] _78.0 (103.0) 951.6 Y+%et1 B. Cash flow from investing activities: Purchase of PPE (4,441 + 312 - 4,060) (693.0) 1 C,_ Cash flow from financing activities: Increase in notes payable (689 - 642) 47.0 % Long-term debt (2,215 - 2,161) 64.0 101.0 %+1 Free cash flow to equity (A+B + C) 359.6 % *Current liabilities=Total liabilities-notes payable-long-term debt FS RS EE SP Se a aSUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS 20f7 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 Marks (4) Value of Firm To compute value of frm, we need cash flow tothe firm as computed below: Rs. in million Gash flow from operations 1s Add: Interest x (1 ~ 32%) = 300 x68% 2040 % Less: Purchase of fixed assets 930) % Cash flow to fim 4026 % Thus value of the firm as at close of 2015 = —“826x1.085 = ps. 47,747.02 million 2 0.0825*-0.055 *WACC = 50% X79 +50%x9.5% = 8.25% 1 (e) Performance of Mr. Afzal and Mr Bilal Percent (%) Mir, Afzal Mr. Bilal Asset Weights Retum Return Weight Return Return Class “Benchmark Actual Benchmark Actual Benchmark Actual Actual Actual Actual A B c DE=AxC F=BxD HJ _L=Hxd Stock 65.60 ~-—«<5.00 «5.00275 2.80 50 «4.90 245 Hrnen Bond 3585 B.8D 3.90 133137 35 30 1.26 re Cash 10 150.80 040 0.030.068 150.20 0.03 rrr 413.93 BTA we ier Mr Afzal and Mr, Bilal underperformed the benchmarks by 0.18% and 0.37% respectively % (f)_ For Mr. Afzal: Percent (%) Contribution of Asset Allocation Contribution of Security Selection Weights s Return asset Eq Excess BE Contibution EF _ gcggg Actual Contribution class £ 2 weight 53 i EB Retum (oie ow 5 3 BE Performance S 3 Weight Performance & . & A 8 DE=CXD FG THe Stock 5560 500 0.25 6.00 600 0.00 60.00 000 %+% Bond 35 35 0.00 380 0.00380 390 0.10 3500 0.04 %+% Cash 10 15 500 030 002 030 040 0.10 1500 001 %+% 0.23 005 u+% SS SS ESSUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS 3of7 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 Marks For Mr. Bila: Percent (%) Contribution of Asset Allocation Contribution of Security Selection Weights z Return z 3 z asst © = Excess 2S Contibution ¥ cage Actual Contribution class S Weight 53 to E 3 Retum Portfolio to 5 8 22 peromance & & Weight Performance 2 eB g 5 a 5 a a A 8 GBA D ECXD FG HGF I Stock 55 50 6.00 5.00 0.25 500 490 0.10 5000 0.05 %+% Bond 35 35 «0.00 3.80 0.00 380 360 0.20 35.00 0.07 %+% Cash 10 15 500 0.30 0.02 0.30 0.20 -0.10 1500 0.02 %+% 0.23 O14 U+% (9) Maturity C@loption Number of shares Number of option required unity delta to be hedged to hedge the positions* 30 0.54 50,000 92,593 1 90 0.58 50,000 86,207 1 270 0.63 50,000 79,365 1 “Number of shares delta of call option (h) Put-call parity equation may be used to check validity of the Director's apprehensions. x Po =Co -So +> (ter) 1 For 90-day put: Py =5.00-40 + = (140.07) = 4.33 1 For 270-day put: Py 881-40, 4° (140.07) = 6.83 1 ‘The Director's apprehension is correct regarding 270-day put. However, he is not correct about 90-day put, which is fairly priced relative to the call 1 a aE a SP eSSUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS 4of7 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 Marks Question No. 2 (a) (i) Bid yiete Security: Federal Government 3-Month T-Bill ‘Auction date 25-Novs Settlement date 26-Nov-15 T-bill maturity date 17-Feb-16 Number of days till maturity 84 Bid amount per Rs. 100 Bid yield per Bank face value of annum (% ‘ArHamd Lid 98.59 6.2144 1 Star Ltd 98.58 6.2591 1 Taal Lid. 98.57 6.3038 1 W-1: Formula for bid yield= (100-98.59/98.69) x 365+ 84 1 (ii) Weighted average yield a Face value of T-bills bided Bid yield per Wel on (Rs. in million) annum (%) aed ‘Al-Hamd Ltd 150 6.2144 9.3216 % Star Ltd 150 6.2591 9.3887 % Taal Ltd 2,000 6.3038 126.076 % Weighted average yield 6.2951 % W-2: Weighted average yield= (160x6.2144%t 150x6,25919+2,000x6.3038%) + 2,300 1 (b) Price =P Administrative Expenses = 20% x P or 0.2P 1 Total = 1.207 The perpetuity equation , given below, can be used to work out the amount of Prize: 120° ~ 1,500,000 1 i 1.20P = 1,500,000 x 6% % p= 20.000 75.000 1 Here i= 12% + 2 = 6% “ (c) Advantages: ‘+ Diversification: Investment in Mutual Fund is investment in a portfolio or basket of securities, leading to diversification, which reduces the risk ‘+ Professional management: Investment in Mutual Fund relives the investors from day to day investment decisions making as such decisions are made by the Fund managers who are professionals and their decisions are based on research and analysis. ‘+ Liquidity: Investment in Mutual Funds is fairly liquid as units or shares of such funds are traded in the secondary market or can be sold back to the issuers at the prescribed repurchase price. + Small investors: They can invest in these products in view of low minimum investment thresholds (Any 2@1markeach) 02 a A Ee SESUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS 5of7 INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 Marks Disadvantages: ‘+ Costs: Investment in Mutual Fund is subject to entry/exit loads and expenses of running the fund, having potential of eating up significant portions of investors return. 1 ‘+ Investment in Mutual Fund could take away from the investors the joy and thrill of making investment decisions of their portfolio, 1 (d) Based on asset mix, the broad categories of mutual funds schemes are: © Equity schemes + Debt schemes + Hybrid schemes 1 Question No. 3 (a) Under the traditional valuation approach, a single discount rate is used to discount all the cash flows, reflecting overall yield of the bond to equal the current market price. The value of the bond is calculated below. Cashflow Discount Present Year “(Rs) factor @7% , 1 6 0.935 is 2 6 0.873 % 3 6 0.816 e 4 6 0.763 e 5 106 0.713 1 Value of the bond 1 (b) Under the arbitrage free valuation approach, a bond is deemed package of zero-coupon bonds, valuing each at the discount rate appropriate to the timing of its cash flow, as tabulated below: Cash flow Discount Present value factor (Rs.) i 0.948 5688 i 2 0.892 5.380 1 3 0.830 4.981 1 4 0.766 4595 1 5 108 0.703 74.526 1 Value of the bond 95.139 1 () «fy afi, sfyand .f, are computed as follows = [(1.089)° +(1.065)]-1= 6.30% 1 ata [(1.064)*+(1.059)"}-1= 7.41% 1 sfva[(1.069)* +(1.084)"}-1= 8.41% 1 y= [(1.073)° +(1.089)'}-1= 8.92% 1 a A Be SESUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS eof INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 Marks Question No. 4 (a) Itis a strategy of reducing the risk by collecting different assets in a portfolio, the risk of which decreases as more assets become part thereof. This is due to the reason that all assets prices 3 don't move in the same direction Portfolio diversification is dependent upon the following: ‘* Correlation between assets: Low correlation means higher diversification. 1 + Number of assets in the portfolio: More assets lead to higher diversification. d (b) An opportunity to make money without incurring incremental risk is called arbitrage opportunity. 1 Example: Portfolio _E(R) B A 3% 0.50 B 10% 1.00 d c 6.5% 0.75 A portfolio, say D, can be created by combining 50% weight of A and B. E (R) and 6 of this portfolio would be 7.5% and 0.75 respectively. By purchasing portfolio D and short selling portfolio C, an arbitrage opportunity exist to make 1% return without incurring risk as 8 of both portfolios is equal 2 (c)_* Total isk= Systematic risk + unsystematic risk. 1 * Measures of total risk and systematic risk are standard deviation and beta respectively. 1 + Beta of portfolio A = covariance variance = 0,004 + 0.005625 =o71 1 * Beta of portfolio B = covariance = variance = 0,008 + 0.008628 = 0.83 1 * Total risk of portfolios A and B are the same; however, the systematic risk of portfolio A is higher 1 * It therefore, follows that unsystematic risk of portfolio B is higher. 1 Question No. 5 i (a) Dividend in 75 days is irrelevant, % Present value of dividend in 45 days = "> % (1.07) 47 % Forward price (FP) ofthe stock = (45-3.47) x (1.07) 1 2.08 % Value of short position at Day 50 = Vzq = 39-423 _ 1% (1.07)* 95 % SS aSUGGESTED SOLUTIONS) ANSWERS ~ FALL 2016 EXAMINATIONS Tot? INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT - SEMESTER-6 (b) (c) Marks This is an alternative to traditional rational theory of economics decision making. The principal 1 sight of the theory is that investors behave differently when evaluating gains and losses. They are distressed more by the prospective losses than they are happy with prospective 1 gains. They seem to be willing to take more risk to avoid loss than to make gain. They become risk averse when confronted with a choice between sure gain and a gamble that could increase 1 or decrease the sure gain. They become risk takers when faced with a sure loss and gamble that could increase or decrease the sure loss. 1 () Frame dependence: Investors decision making is impacted by the description of 2 problem presented to them. Despite the expected retum of the same amount, investors prefer sure gain over the uncertain one. (ii) Loss aversion: When investor investments go down in their value they stil tend to stick 2 with them in their effort to break even. Investor has hard feeling about selling their investment at loss. (iil) Mental Accounting: Investors have tendency to make mental account of different 2 buckets. They tend to behave conservatively when dealing with one set of investment while they may be aggressive with other investments. Investors. are cautious when dealing with regular income but aggressive when dealing with windfall income. They tend to ignore the fact that it is their money whichever bucket it may fal THE END a A Be SE