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FINANCE LEAGUE 2011 ROUND 1

Questions 1 to 10 carry ONE mark each

Question 1 The correlation between the compensation of a fund manager working at L&T Mutual Fund and Sensex is 0.7. Market risk premium in India is 7% and volatility of Sensex is 15%. What is the market price of risk of fund managers compensation? a) 0.3267 b) 0.0150 c) 0.1500 d) 0.3061

Question 2 Face Bank wishes to sell its $600 billion loan portfolio to a collateralized loan obligation (CLO) trust. The bank uses cash funded balance sheet CDO where the trust sells $570 billion investment grade securities to investors, while the bank retains the equity tranche of the CDO, which is valued at $30 billion. How much regulatory capital did the bank free by selling loans to the CLO trust? a) $30 billion b) $18 billion c) $48 billion d) $45.6 billion

Question 3 Assume that L&T Finance convertible bond with a 6% coupon is currently selling at INR 590 and has a straight value of INR 570. The holders of the bond can convert a bond into 12 shares of common stock. The value of L&T Finances common stock is INR 48, and it pays INR 0.6 in dividends annually. What is the bonds minimum value?

a) INR 576 b) INR 570 c) INR 568 d) INR 590

Question 4 LockedIn Inc. pays out 40% of its earnings in dividends. It has net profit margin and operating margin of 12% and 19% respectively. The required rate of return for the firm is 9%. Its sales are $5,850,000 and ending equity is $6,200,000. What is the firms intrinsic P/E value? a) 13.42% b) 18.13% c) 15.94% d) 19.66%

Question 5 Robinhood Pandey has done a valuation of L&T Finance and he estimates that the stock is underpriced. He buys the stock with an expectation that the stock will remain to be underpriced at the end of the year. If he expects the required return on the stock to be 8%, what could be his expected holding-period return? a) Greater than 8% b) Less than 8% c) Greater than or equal to 8% d) Could be less than, equal to, or greater than 8%

Question 6 Old Hostel Industries produces 40 million pillows and 26 million Bedsheets per year. New Hostel Industries produces 17 million pillows and 14 million Bedsheets per year. The opportunity cost of Old Hostel Industries for producing another 1 unit of pillow is 3 units of Bedsheets and for New Hostel Industries; the opportunity cost of producing another 1 unit of pillow is 5 units of Bedsheets. Assume that unlimited trade is possible between the two industries without any additional cost. The production of Bedsheets by Old Hostel Industries cannot exceed 32 million

and cannot go below 17 million. Also, assume that the total demand for Bedsheets will be exactly 40 million units. What could be the maximum production of Pillows by the two industries? a) 57.8 million b) 58.2 million c) 58.4 million d) 57.6 million

Question 7 Mr. Gogo is evaluating four funds to add to his current portfolio. His current portfolios Sharpe ratio is expected to be 0.65. The funds Sharpe ratios and their respective correlations with Mr. Gogos current portfolio is mentioned in the below table. Sharpe Ratio Fund A Fund B Fund C Fund D 0.54 0.58 0.55 0.47 Correlation with current portfolio 0.86 0.92 0.69 0.74

Which fund should Mr. Gogo add to his current portfolio? a) Fund C b) Fund A c) Fund D d) Fund B

Question 8 Mr. Acha, an investor, is currently invested in a fund that mirrors the performance of the S&P 500 and is curious whether a hedge fund of funds would be a valuable risk budgeting tool for his overall portfolio. Using the below mentioned information, calculate the hurdle rate that a hedge fund of funds must achieve in order to be a valuable addition to the portfolio.

Figure1: Asset Class Expected Returns and Risk Asset Class Expected Monthly Return S&P 500 Lehman Aggregate Russell 2000 MSCI EAFE HFRI Fund of Hedge Funds (FOF) Index T-bills (cash) 0.34% NA NA 1.18% 0.40% 1.78% 1.24% 1.10% 3.98% 1.05% 6.65% 5.40% 1.60% 0.214 0.067 0.218 0.167 0.481 Standard Deviation Sharpe Ratio

Figure 2: Asset Class Correlation Matrix S&P 500 Lehman Aggregate S&P 500 Lehman Aggregate Russell 2000 MSCI EAFE HFRI Index FOF 0.85 0.82 0.35 0.28 0.22 0.18 1.00 0.68 0.40 1.00 0.34 1.00 1.00 0.32 1.00 Russell 2000 MSCI EAFE HFRI FOF Index

a) 0.46% b) 0.92% c) 0.23% d) 0.67%

Question 9 Which of the following is (are) events that can lead to prepayments in a security backed by auto loans? I. Loss or destruction of the automobile.

II. III.

Refinancing of the loan at a lower interest cost. Repossession and subsequent resale.

a) I and II only b) I and III only c) II and III only d) I, II and III

Question 10 A rational investor with a short position is about to deliver a bond. He has four bonds to choose from. The last settlement price is INR 91.42. Which bond will he deliver?

Bond A B C D

Quoted Price (INR) 98.32 99.69 101.89 102.21

Conversion Factor 1.03 1.08 1.04 1.11

a) Bond B b) Bond C c) Bond D d) Bond A

Questions 11 to 20 carry TWO marks each

Question 11 Consider the following information for Weak Ltd. for the year ended March 31, 2011 Particulars Amount (INR million) Earnings before Interest and Taxes (EBIT) 1,792

Fixed costs Profit before Tax (PBT)

512 1,120

Analysts expect the revenue of the company to go up by 6% in the year 2011-12. What should be the change in the Earnings per Share (EPS) of the company in 2011-12, considering no change in relationship with other factors? a) 30.95% b) 28.43% c) 26.82% d) 27.55%

Question 12 Mr. Acha, an active fund manager at L&T Mutual fund, calculates the expected Alphas and residual risk for the three securities as shown below. The risk aversion parameter is 0.20. Compute the optimal net weights for each security.

Security Alpha A B C 2% -1% 0%

Residual Risk 15% 25% 5%

a) WA = 16.7%; W B = 10% WC = 0% b) WA = 66.7%; W B = -16.7% W C = 50% c) WA = 66.7%; W B = -33.3% W C = 66.7% d) WA = 33.3%; W B = -10% WC = 0%

Question 13 Sitara Pan Bhandar Ltd. has a current market value equal to INR 650 million and has outstanding debt equal to INR 225 million. The companys EBITDA has been holding steady at INR 95 million per year, providing an annual return on total capital (debt plus equity) of 10.9%.

An LBO firm recognizes certain inefficiencies at the company and offers to purchase the outstanding equity and pay off the outstanding debt for INR 1 billion. Sitara Pan Bhandar Ltd. accepts the offer. The LBO firm proceeds to pay off the outstanding debt at its face value of INR 225 million. Equity holders receive INR 775 million. This amounts to a premium of 19.2%. The premium is a deal sweetener used to gain the equity holders support. Of the INR 1 billion LBO transaction, only INR 225 million was financed with the investors equity. The remaining INR 775 million was financed with 12% coupon bonds requiring annual debt service of INR 93 million. Subsequent to the LBO, the investors are able to eliminate the operating inefficiencies at the company, increasing EBITDA from INR 95 million to INR 140 million per year. Since the LBO investors will not pay dividends, all of the free cash flow can be used to pay down the debt to a zero balance in six years. After six years, companys EBITDA is expected to grow at a constant rate of 3%. Assuming the companys cost of capital to be 14%, calculate the compounded annual growth of the company. a) 8.62% b) 40.29% c) 33.48% d) 25.13%

Question 14 Mr. Garg, a hedge fund manager has the following options of a particular stock in his portfolio executed in the OTC market.

Type

Position

Delta of Option

Gamma Option

of Vega of Option

Call Call Put Put

750 -1000 1200 -800

0.60 0.75 -0.70 -0.35

1.80 0.60 1.90 1.05

1.60 0.30 0.75 0.70

A traded option is available with a Delta of 0.4, Gamma of 1.2 and Vega of 0.7.

What position in the traded option and in stock will make the portfolio both gamma neutral and delta neutral? a) Short 1825 traded options and Short 1590 shares on stock b) Short 1825 traded options and Long 1590 shares on stock c) Long 1825 traded options and Long 1590 shares on stock d) Long 1825 traded options and Short 1590 shares on stock

Question 15 Mr. Acha and Mr. Garg enter into a 3 year fixed for floating interest rate swap with semi-annual payments. The annualized LIBOR Rates for different time periods is given below.

Years 0.5 1.0 1.5 2.0 2.5 3.0

LIBOR 3.5% 4.0% 4.5% 5.0% 5.5% 6.0%

What is the annualized rate that a fixed payer will have to pay to enter into the swap contract? a) 2.96% b) 3.16% c) 3.06% d) 2.86%

Question 16 Rockstar Ltd. is considering a project in US, which will involve an initial investment of US $1,100,000. The project is expected to have a life of 5 years. Current spot exchange rate is Rs.49.5 per US $. The risk free rate in US is 2% while that in India is 8%. Net cash inflows expected from the project for each of the next 5 years are as follows:

Year 1 2 3 4 5

Cash inflow (USD) 300,000 375,000 450,000 600,000 750,000

Calculate the Net Present Value (NPV) of the project. Assume the required rate of return on the project as 12%. a) INR 24.23 million b) INR 34.04 million c) INR 46.76 million d) INR 53.73 million

Question 17 Capital structure of Moon Limited, as at March 31st, 2011 was as under: Particulars Equity share capital 8% Preference share capital 12% Debentures Reserves and Surplus INR million 1,200 600 960 480

The company earns a profit of INR 480 million annually on an average before deduction of income-tax, which works out to 35%, and interest on debentures. Normal return on equity shares of companies similarly placed is 9.6% provided: (a) Profit after tax covers fixed interest and fixed dividends at least 3 times (b) Capital gearing ratio is 0.75 (c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed profits Moon Ltd. has been regularly paying equity dividend of 8%. Compute the value per equity share (Par value of INR 100) of the company. Assume the risk premium as: 1% for every one time of difference for Interest and Fixed Dividend Coverage 2% for every one time of difference for Capital Gearing Ratio

a) INR 40.6 b) INR 43.5 c) INR 48.1 d) INR 52.2

Question 18 Circuit (Munnas friend) has got admission to a premier B-school. Considering the impact of recession on his business, he has decided to take loan to submit the fees. He has taken a 7year, 11% amortizing loan having a face value of INR 1,500,000. Assume monthly compounding; calculate the total mortgage cost to him? a) 20.55% b) 18.63% c) 19.27% d) 21.45%

Question 19 Mr. Loan-Li has taken INR 10 lakh commercial vehicle loan from L&T Finance. The loan is for 1 year and has an annual interest rate of 9%. What is the price of an IO (interest only security) issued against the loan, assuming that the yield of a 1 year zero coupon government bond is 8% (the yield curve is flat from 0 to 12 months), and the OAS required by the IO investor is 125 basis points. a) INR 11,677 b) INR 16,359 c) INR 13,382 d) INR 14,854

Question 20 What is the price for trade (as percentage of par value) on June 25, 2008 for settlement on May 15, 2009 of the 5.875% US Treasury of March 31, 2011 if the term repo rate is 5% and the bonds yield for regular settlement is 6.475%? Assume that the coupons are reinvested at the term repo rate.

a) 94.33% b) 96.66% c) 93.75% d) 97.28%

Questions 21 to 25 carry THREE marks each

Question 21 Harshad Mehta Inc. yesterday issued an 11% Annual coupon bonds with a time to maturity of 5 years. The bond is trading at INR 500 and has a par value of INR 1000. Assuming a risk free rate of 8.5%, what is the probability that the subscriber will receive all the coupons and principal payment?

Question 22 L&T Insurance is evaluating a companys financial condition to sell a credit default swap on the companys 4 year semi-annual coupon bond. The swap protection is to cover the life of the bond. The default probability each year is 4% (assuming no earlier default). (Assume treasury spot rate curve is flat at 8.5% and recovery rate is 40%) How much spread should L&T Insurance charge?

Question 23 Sonal, an ardent fan of John Abraham is confident about the commercial success of his movie Force. Her confidence is driven from the fact that in first four days, the movie had collected INR 0.5 billion. She wants to profit from this belief. D Company has designed a bet for her. If the revenues for the movie in the next Seven days are more than INR 1 billion, then D company would pay her INR 1 Lakh. If the revenues didnt reach 1 billion, then she would get nothing. How much should D Company charge her for providing her this facility? Additional information: Risk-free rate = 8% Expected volatility = 40%

Question 24 Incredible Ltd. which is specialized in manufacturing paper is planning for expansion to handle a new contract which it expects to obtain. An investment bank approached the company and asked whether it has considered Venture Capital mode for financing the expansion. In 2006, the company had borrowed INR 200 million on which interest is paid at 10% p.a. The company is not listed on any stock exchange. Calculate the value of the Company that could be used in negotiations using the following available information and forecast. Companys forecast turnover for the year ended 31st December, 2010 is INR 4,500 million which is mainly dependent on the ability of the Company to obtain the new contract, the chance for which is 60%, turnover for the following year is dependent to some extent on the outcome of the year to 31st December, 2010. Following are the estimated turnovers and respective probabilities: Year 2010 Turnover (INR million) 4,500 0.6 5,500 5,000 4,000 0.3 4,500 4,200 3,500 0.1 3,800 3,600 0.7 0.3 0.5 0.5 0.6 0.4 Probability Year 2011 Turnover (INR million) Probability

Operating costs inclusive of depreciation are expected to be 40% and 35% of turnover respectively for the years 31st December, 2010 and 2011. Tax rate is 30%. It is assumed that profits after interest and taxes are free cash flows. Growth in earnings is expected to be 25% for the years 2012, 2013 and 2014 which will fall to 10% each year after that. Industry average cost of equity (net of tax) is 15%.

Question 25 On January 1, 2010, L&T Finance leases a machine (super computer) for six years. The lease calls for a payment of $21,000 per year payable at the beginning of each year. The company will return the machine to the lessor at the end of six years who will sell it for scrap. Assume that the interest rate is 11% and L&T Finance depreciates all assets on straight-line basis. What would be the total expense pertaining to this lease reported on the companys income statement for the year ending December 31, 2012?