# PRAVEEN MAHAJAN CLASSES

CA FINAL SFM/ IPCC- Cost & FM

BG3-3E, PASCHIM VIHAR, NEW DELHI
9871255244, 8800684854
STRATEGIC FINANCIAL MANAGEMENT- NOV 2011 (SOLUTION)
1.

(a)

SOLUTION

Orange purchased 200 units of Oxygen Mutual Fund at Rs 45 per unit on
31stDecember, 2009. In 2010, he received Rs1.00 as dividend per unit and a
capital gains distribution of Rs 2 per unit.
Required: - .
(i)
Calculate the return for the period of one year assuming that the NAV as
on 31st December 2010 was Rs 48 per unit.
(ii)
Calculate the return for the period of one year assuming that the NAV as
on 31st December 2010 was Rs 48 per unit and all dividends and capital
gains distributions have been reinvested at an average price of Rs 46.00
per unit.
Ignore taxation
i)

Dividend distributed
Capital gains distribution

(200 X 1)
(200 X 2)

200
400

Return on mutual fund =

Dividend + Capital gain + NAV at
- NAV at the
distributed
distributed
end of the year
beg of the year
NAV at the beg of the year
200
+ 400 + (48x200 - 45x 200) =
1200 =
13.33%
(45x 200)
9000

ii)

Annualised return
Additional units are purchased at an average price of Rs 46 per unit form cash received
under dividend and capital gain distribution
Cash from
=
dividend + capital gain
distribution distribution
NAV
=
200 + 400
= 13.043 units
46
Total no of units in hand at the end of the year
=
200 + 13.043 = 213.043 units
Return on mutual fund =

Dividend + Capital gain + NAV at
- NAV at the
distributed
distributed
end of the year
beg of the year
NAV at the beg of the year
NIL + NIL + (213.043 X 48 – 200 X 45) = 10,226 – 9,000 = 13.62%
200 X 45
9,000

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 1

5

(b)

SOLUTION

An importer is due to pay the exporter on 28th January 2010, Singapore Dollars
of 25,00,000 under an irrevocable letter of credit. It directed the bank to pay
the amount on the due date.
Due to go-slow and strike procedures adopted by its staff, the bank was
not in a position to remit the amount due. The amount was actually remitted on
4th February 2010.
On the transaction, the bank wants to retain an exchange margin of 0.125per cent.
The following were the rates prevalent in the exchange market on the
relevant dates :
28th January
4th February
Rupee/US \$1
Rs 45.85 / 45.90
Rs 45.91/45.97
London Pound/Dollars
\$ 1.7840/1.7850
\$ 1.7765/1.7775
Pound
Sing \$ 3.1575 / 3.1590
Sing \$ 3.1380/3.1390
What is the effect on account of the delay in remittance ? Calculate rate in
multiples of .0001.
Note 1- Exchange rate between rupee and Singapore \$ is not given , so cross currency
.
rate between rupee and sing \$ is to be ascertained
Note 2- Importer has to pay sing\$, so he has to buy sing\$. If exchange rate is in terms .
of Rs/Sing\$ ,ask rate is relevant
Rs__
=
Rs x Us\$ x £___
Sing\$
US\$
£
Sing\$
Rs 45.90 x
US \$ 1.00
Rs__
=
Rs x
Sing\$
US\$

US \$ 1.7850 x £ 1.000______ = Rs 25.9482/Sing\$
£ 1.00
Sing \$ 3.1575

Us\$ x £___
£
Sing\$

Rs 45.97 x
US \$ 1.00

US \$ 1.7775 x £ 1.000_____
£ 1.00
Sing \$ 3.1380

Computation of loss on delay
Sing \$ required x (Ask rate on 04.02.2010- Ask rate on 28.01.2010)
Sing \$ 25,00,000 x (26.0394-25.9482)
Add: Exchange margin of bank (0.125%)
2,28,000x 0.125%
Total loss to importer

(c)

5

= Rs 26.0394/Sing\$

=

2,28,000
285
2,28,285

A company has a book value per share of Rs 137.80. Its return on equity is 15% and
follows a policy of retaining 60 percent of its annual earnings. If the opportunity
cost of capital is 18 percent, what is the price of its share?

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 2

5

Solution

Book value per share =
Return on equity(r)
=
EPS
=
Retention ratio (b)
=
D/P ratio
=
Dividend paid per share=
G

Rs 137.80
15%
Rs 137.80 x 0.15 = Rs 20.67
60%
40%
0.4 x 20.67
= Rs 8.27
=

br
0.60 x 0.15 =
d
Ke-g
8.27
=
0.18- 0.09

Price per share (P0)
=
(Perpetual growth rate model)
P0
=

(d)

Solution

(a)

Rs 91.89

The six months forward price of a security is Rs 208.18. The rate of borrowing is 5
8 percent per annum payable at monthly rates. What will be the spot price?
Future or forward rate = Current price + cost to carry(interest)- dividend inflows
OR
Current price (1+ r)n
208.18
=
P0 (1 + ⁄ )txm

)0.5x12

208.18

=

P0(1+

208.18
208.18

=
=
=

P0 (1+ 0.0067)6
1.0409 P0
208.18
=
1.0409

P0

2.

0.09

Rs 200

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 :
Segment

Segment
Sales

Segment
Assets

Segment 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:

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 3

8

Segment
Wholesale
Retail
General
SOLUTION

Capitalization/
sales
0.85
1.2
0.8

Capitalisation/
Assets
0.7
0.7
0.7

capitalization/
operating income
9
8
4

Break up value of business is average of book value and market value of business
=
Book value + market value
2

Segment

.
Valuation
On the basis
Of sales

Valuation
On the basis
of assets

Valuation
On the basis
of operating income

(sales x capitalization factor)

(sales x capitalization factor)

(Income x capitalization factor)

Wholesale
Retail
General

1,91,250
4,20,000
6,75,000
8,64,000
3,50,000
12,00,000
20,00,000
28,00,000
28,00,000
30,55,250
35,70,000
46,75,000
Average of book value basd on different factors
30,55,250 + 35,70,000 + 46,75,000
= € 37,66,750
3
€ 4 million i.e €40,00,000
37,66,750 + 40,00,000 =
€ 38,83,375
2

(b)

Nitrogen Ltd, a UK company is in the process of negotiating an order
amounting to €4 million with a large German retailer on 6 months credit. If
successful, this will be the first time that Nitrogen Ltd has exported goods into
the highly competitive German market. The following three alternatives are
being considered for managing the transaction risk before the order is finalized.
(i)
Invoice the German firm in Sterling using the current exchange rate to
calculate the invoice amount.
(ii)
Alternative of invoicing the German firm in £ and using a forward
foreign exchange contract to hedge the transaction risk.
(iii) Invoice the German first in € and use sufficient 6 months sterling future
contracts (to the nearly whole number) to hedge the transaction risk.
Following data is available:
Spot Rate
6 months further contract is currently trading at
6 months future contract size is
Spot rate and 6 months future rate

€1.1750 - €1.1770/£
0.60-0.55 Euro Cents
€1.1760/£
£ 62500
€1.1785/£

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 4

Required :
(a) Calculate to the nearest £ the receipt for Nitrogen Ltd, under each of the
three proposals.

4

(b) In your opinion, which alternative would you consider to be the most
appropriate and the reason therefor.

4

SOLUTION
-

Nitrogen Ltd, a UK company is in the process of exporting goods to German
Company for € 4 million
Nitrogen Ltd will sell €’s and receive pounds
If Exchange rate is in terms of £/€ (direct quote), bid rate is relevant, if exchange
rate is in terms of €/£ (indirect quote), ask rate is relevant.
Exchange rates are given in Indirect quote, so relevant rate is ask rate.

Company’s £ receipts under 3 options are-:
i)
Invoicing German firm in £ sterling using current exchange rate
Invoice amount in £ sterling
€ 40,00,000
=
£ 33,98,471
1.1770
£ receipts after 6 months at current exchange rate is 33,98,471
ii)

Invoicing German firm in € and entering into forward hedging contract
Invoice amount to be received after 6 months =
€ 40,00,000
=
€ 1.1770/£
(since swap points are in decending order,£ is to be quoted
At discount in forward market i.e swap points are to be
reduced from spot rate to determine forward rate)
€ 1.1770- 0.0055
= € 1.1715/£
£ receipts after 6 months at forward ask rate of € 1.1715/£
€ 40,00,000
= £ 34,14,426
1.1715

iii)

Invoicing German firm in € and taking hedge from future market
Invoice amount to be received after 6 months =
€ 40,00,000
Note- since €’s are to be received after 6 months, these
are to be sold after 6 months, so in futures market €’s
are to be bought after 6 months, thus today take contract
for selling € futures (or buy £ futures)

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 5

Current rate of 6 month future contract
6 month Futures Exchange rate after 6 months
Exchange rate in spot market after 6 months
Lot size per contract
£ value to be hedged
€ 40,00,000
1.1760
No of £ contracts
£ 34,01,361
62,500

=
=
=
=
=

€ 1.1760/£
€ 1.1785/£
€ 1.1785/£
£ 62,500
£ 34,01,361

=

54.42 = 54 contracts

£ receipts after 6 months in spot market
Amount received from customer after 6 months
€ sold in spot market at spot rate after 6 months
at € 1.1785/£ € 40,00,000
1.1785

=

€ 40,00,000

=

£ 33,94,145

=

£
7160
£ 34,01,305

£ receipts from gain in futures contract
€ payable for buying 54 £ contracts
today 54x62500x1.1760
= € 39,69,000
€ receivable for selling 54 £ contracts
After 6 months 54x62500x1.1785
=€ 39,77,438
€ gain on futures contract

8,438
£ receivable on € gain on futures contract
(sold at spot exchange rate after 6 months)
€ 8,438
1.1785
Total £ receipts after 6 months

Since £ receipts are highest in forward contract so exporter should opt for forward market
hedge

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 6

3

(a)

Helium Ltd has evolved a new sales strategy for the next 4 years. The
following information is given:
Income Statement

10

Rs in thousands

Sales
Gross Margin at 30%
Accounting, administration and distribution expense at 15%
Profit before tax
Tax at 30%
Profit after tax

40,000
12,000
6,000
6,000
1,800
4,200

Balance sheet information
Fixed Assets
Current Assets
Equity

10,000
6,000
15,000

As per the new strategy, sales will grow at 30 percent per year for the next four
years. The gross margin ratio will increase to 35 percent. The Assets turnover
ratio and income tax rate will remain unchanged.
Depreciation is to be at 15 percent on the value of the net fixed assets at the
beginning of the year.
Company's target rate of retum is 14%.
Determine if the strategy is financially viable giving detailed workings.
Statement of cash out flows and cash inflows
Particulars
Cash outflows
Fixed assets

Current assets

Period

Amount Factor(14%) Present value

1end
2end
3end
4end

4,500
5,850
7,605
9,886

0.877
0.770
0.675
0.592

3,946
4,504
5,133
5,852

1end
1,800
0.877
2end
2,340
0.770
3end
3,042
0.675
4end
3,995
0.592
Pv of cash out flows

1,579
1,802
2,053
2,365
27,234

Cash Inflows

Operating
cash inflows

1end
7,730 0.877
2end
10,049 0.770
3end
13,064 0.675
4end
16,982 0.592
PV of cash inflows
NPV
Since NPV is positive so strategy is viable

Statement of operating cash outflows and inflows
Particulars
Sales (grow at 30% p.a)
Gross margin 35% of sales
15% of sales
Depreciation
Profit before taxes
Profit after tax (70% of PBT)
Cash flow after tax
(operating cash flows)

Year1
52,000
18,200

Year2
67,600
23,660

Year3
87,880
30,758

Year4
1,14,244
39,985

(7,800)
(1,500)
8,900
6,230
1500
7,730

(10,140)
(1,950)
11,570
8,099
1,950
10,049

(13,182)
(2,535)
15,041
10,529
2,535
13,064

(17,137)
(3,296)
19,552
13,686
2,535
16,982

CONTD. Next page

6,779
7,738
8,818
10,053
33,388
6,154

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 7

Computation of current assets and fixed assets
Asset turnover ratio
Assets
16,000
Sales
40,000
Fixed assets to sales
Fixed assets
10,000
Sales
40,000
Current assets to sales
Current Assets
6,000
Sales
40,000
Particulars

=

40%

=

25%

=

15%

Year 1

Year2

Year 3

Year 4

13,000
10,000
1,500
Difference between opening and closing balance 3,000
Additions to fixed assets this year
4,500
CURRENT ASSETS
Closing Balance (15% of sales)
7,800
Opening balance
6,000
Additions to current assets during the year 1,800

16,900
13,000
1,950
3,900
5,850

21,970
16,900
2,535
5,070
7,605

28,561
21,970
3,296
6,591
9886

10,140
7,800
2,340

13,182
10,140
3,042

17,137
13,182
3,995

FIXED ASSETS
Closing Balance (25% of sales)
Opening balance
Depreciation (15% of op. balance)

(b)

Pineapple Ltd has issued fully convertible 12 percent debentures of Rs 5,000
face value, convertible into 10 equity shares. The current market price of the
debentures is Rs 5,400. The present market price of equity shares is Rs 430.
Calculate:
(i)
(ii)
the conversion value

Solution

3
3

Conversion value of equity shares
(Value of shares, id debenture is converted into shares today)

=
=

10 equity shares x 430 =Rs 4,300
Market value of debenture

(Amt paid for debenture in excess of conversion value of shares)

Conversion percentage

= Current market price- conversion value
5,400 - 4,300 = Rs 1,100
=
1,100 x 100 = 20.37%
5,400

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 8

4.

(a)
.

SOLUTION

Based on the credit rating of the bonds, A has decided to apply the following
8
discount rates for valuing bonds:
Credit rating
Discount rate
AAA
364-day T-bill rate + 3% spread
AA
A
He is considering to invest in a AA rated Rs 1,000 face value bond currently selling
at Rs 1,025.86. The bond has five years to maturity and the coupon rate on the bond
is 15 percent per annum payable annually. The next interest payment is due one year
from today and the bond is redeemable at par.
(Assume the 364-day T -bill rate to be 9 percent).
You are required to :
(i)
Calculate the intrinsic value of the bond for A. Should he invest in the bond?
(ii)
Calculate the Current Yield (CY) and the Yield to Maturity (YTM) of the bond.

The Discount rate applicable for valuing the AA rated bond of Mr A = 9+3+2 = 14%
Intrinsic value =
of the bond

Present value of
+ Present value of
Interest payments @ 14%
Redeemable amount at 14%
150 x 3.433
+
1,000 X 0.519
514.95
+
519
=
Rs 1,033.95
Since Intrinsic value of the bond is more than current market price of the bond so Mr A
should purchase the bond
Current yield =
Interest payments
=
150____ =
14.62%
Market price
1,025.86
YTM of the bond is the rate at which present value of all future cash outflows of bond is
equal to current market price of the bond
YTM =
Interest +
(Redeemable value – net proceeds)
Life______________
(Redeemable value – net proceeds)
2
150 + 1,000 -1,025.86
5__________
=
14.30%
1,000 -1,025.86
2
Intrinsic value of the bond at 14%
=
Rs 1,033.95
Intrinsic value of the bond at 15%
=
150x3.352 + 1,000 x .497
502.8 + 497
=
Rs 999.8
Using interpolation

=

14 + 8.09_ x 1 = 14.23 %
34.15

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 9

(b)

XYZ Ltd. is considering to acquire an additional computer to supplement its timeshare computer services to its clients. It has two options :
(i)
To purchase the computer for Rs 22,00,000
(ii)
To lease the computer for three years from a leasing company for
Rs 5,00,000 as annual lease rent plus 10 percent of gross time-share
service revenue. The agreement also requires an additional payment of Rs
6,00,000 at the end of the third year. Lease rent is payable at the year end,
and the computer reverts to the lessor after the contract period.
The company estimates that the computer under review now will be worth
Rs 10,00,000at the end of third year. Forecast revenues are :
Year
Rs
1
22,50,000
2
25,00,000
3
27,50,000
Annual operating costs (excluding depreciation/lease rent of computer) are
estimated at Rs 9,00,000 with an additional Rs 1,00,000 for start-up and
training cost at the beginning of the first year. These costs are to be borne by
the lessee. XYZ Ltd. will borrow at 16% interest to finance acquisition of
computer; repayments are to be made according to the following schedule:
Year-end
Principal
Interest
Total
(Rs)
(Rs)
(Rs)
1
5,00,000
3,52,000
8,52,000
2
8,50,000
2,72,000
11,22,000
3
8,50,000
1,36,000
9,86,000
The company uses straight line method to depreciate its assets and pays 50
percent tax on its income.
The management of XYZ Ltd. approaches you for advice. Which
alternative would you recommend and why?

SOLUTION
Alternative 1 Purchase option
 Depriciation
22,00,000 – 10,00,000 =
Rs 4,00,000 p.a
3
 Operating and training costs are common in both alternatives, hence not relevant
 Effective discount rate 16% (1. 0.5) = 8%
Statement of cash flows under purchase option
Particulars
Year 1
Year 2
Year 3
Principal
5,00,000
8,50,000
8,50,000
Interest
3,52,000
2,72,000
1,36,000
Tax saving on Interest
1,76,000
1,36,000
68,000
Depreciation
4,00,000
4,00,000
4,00,000
Tax saving on depreciation
2,00,000
2,00,000
2,00,000
Salvage value
10,00,000

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 10

Particulars
Installment and interest
Payment

Statement of NPV under purchase option
period
Amount
Factor @ 8%
1end
8,52,000
0.926
2end
11,22,000
0.857
3end
9,86,000
0.794

Tax saving on depreciation
And Interest
Salvage value

1end
2 end
3 end
3 end

3,76,000
0.926
3,36,000
0.857
2,68,000
0.794
10,00,000
0.794
NPV of cash flows

Present value

7,88,952
9,61,554
7,82,884
(3,48,176)
(2,87,952)
(2,12,792)
(7,94,000)
8,90,470_

Alternative 2- Lease option
Statement of lease rent
Particulars
Year 1
Year 2
Year 3
Lease rent
5,00,000
5,00,000
5,00,000
10 % of revenue
2,25,000
2,50,000
2,75,000
Lump sum payment
6,00,000
7,25,000
7,50,000
13,75,000
Statement of NPV under Lease option
Particulars
period
Amount
Factor @ 8% Present value
Lease rent
1 end
7,25,000
0.926
6,71,350
2end
7,50,000
0.857
6,42,750
3 end
13,75,000
0.794
10,91,750
Tax savings on lease rent
1 end
3,62,500
0.926
(3,35,675)
2 end
3,75,000
0.857
(3,21,375)
3 end
6,87,500
0.794
(5,45,875)
NPV of cash flows
12,02,925
Since NPV is lower in purchase option, so company should purchase the computer

5

(a)

The following is the Balance-sheet of Grape 'Fruit Company Ltd as at March31st 2011.
Liabilities

(Rs in lakhs) Assets

Equity shares of Rs100 each
14% preference shares of
Rs 100/- each
13 % Debentures
Debenture interest accrued & payable

600

Loan from bank

74
340

200
200
26

(Rs in lakhs)

Land and Building
Plant and Machinery

200
300

Furniture and Fixtures
Inventory

50
150

Sundry debtors
Cash at bank
Preliminary expenses

70
130
10

Cost of issue of

5

debentures
Profit and Loss Account

525

1440

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

1440

Page 11

The Company did not perform well and has suffered sizable losses during the last
few years. However, it is felt that the company could be nursed back to
health by proper financial restructuring. Consequently the following scheme of
reconstruction has been drawn up :
(i)
Equity shares are to be reduced to Rs 25/- per share, fully paid up;
(ii)
Preference shares are to be reduced (with coupon rate of 10%) to equal
number of shares of Rs 50 each, fully paid up.
(iii) Debenture holders have agreed to forgo the accrued interest due to them.
In the future, the rate of interest on debentures is to be reduced to 9
percent.
(iv)
Trade creditors will forego 25 percent of the amount due to them.
(v)
The company issues 6 lakh of equity shares at Rs 25 each and the entire
sum was to be paid on application. The entire amount was fully subscribed
by promoters.
(vi)
Land and Building was to be revalued at Rs 450 lakhs, Plant and
Machinery was to be written down by Rs 120 lakhs and a provision of Rs15
Required :
(i)
Show the impact of financial restructuring on the company's activities.
(ii)
Prepare the fresh balance sheet after the reconstruction is completed on
the basis of the above proposals.
SOLUTION
Particulars
Preliminary expenses
Cost of issue of debentures
Profit and Loss A/c
Plant and machinery
Capital reserve (b/f)

Liabilities
Share Capital
12 lakh equity shares of Rs 25 each
2 lac 10% preference sh of Rs 50 each
Reserve and surplus
Capital reserve
Secured Loans
9% debentures
Loan from bank
Current liabilities

6
4

Reconstruction Account
(Rs in lacs)
Amount
Particulars
Amount
10
Equity share capital (100-25) 6 lac
450
5
Preference share capital ( ⁄ X 200 lacs)
100
525
Accrued Interest on debentures
26
120
85
15
Land and buildings (450 lacs- 200 lacs)
250
236_
_____
911
911___
Balance sheet as on 31/03/2011________(Rs in lacs)____________
Amount
Assets
Amount---Fixed Assets
300
Land and building (200 + 250)
450
100
Plant and machinery (300-120)
180
Furniture and fixtures
50
236
Current assets
Inventory
150
200
Sundry debtors (70 lac- 15 lac)
55
74
Cash at bank (130 lac+ 150 lac)
280
255
1,165

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

______
1,165

Page 12

(b)

Indian importer has to settle an import bill for \$ 1, 30,000. The exporter has given
the Indian exporter two options:
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest at 5 percent per annum.
The importer's bank charges 15 percent per annum on overdrafts. The exchange
rates in the market are as follows:
Spot rate (Rs /\$) : 48.35 /48.36
3-Months forward rate (Rs/\$): 48.81 /48.83

SOLUTION

6

Indian Importer has to pay \$, so he has to buy \$ for such payment. Hence Ask rate is
relevant rate.
Option 1Pay Immediately without any Interest charges
Importer should pay the import bill by taking overdraft from bank @ 15%
Amount payable for imports
\$ 1,30,000
Overdraft from bank \$ 1,30,000 x 48.36
Rs 62,86,800
Interest on overdraft for 3 months 62,86,800 x 15%x
Rs 2,35,755
Total amount payable under option 1

Rs 65,22,555

Option 2Pay after 3 months with interest @ 5%
Importer should pay import bill after 3 months @ 5%, and take3 months forward
hedge
Value of import bill
\$ 1,30,000
Interest payable on import bill \$ 1,30,000 x 0.05 x
\$ 1,625
Total import bill
\$ 1,31,625
Amount payable to buy \$ 1,31,625 @ Rs 48.83
Rs 64,27,249
Amount payable under option 2 is lower than option 1, so option 2 is better

6.

(a)

A Portfolio Manager (PM) has the following four stocks in his portfolio:
_________________________________________________________________
Security
No. of shares
Market price per share (Rs)
β
--------------------------------------------------------------------------------------------------VSL
10,000
50
0.9
CSL
5,000
20
1.0
SML
8,000
25
1.5
APL
2,000
200
1.2
---------------------------------------------------------------------------------------------------Compute the following:
(i)

Portfolio beta.

(ii)

If the PM seeks to reduce the beta to 0.8, how much risk free investment
should he bring in ?

(iii)

If the PM seeks to increase the beta to 1.2, how much risk free investment
should he bring in ?

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 13

8

Solution
Security

VSL
CSL
SML
APL

Portfolio β is weighted average β of securities in the portfolio, weights being
Value of each security in the portfolio
No. of shares Market price per share Market value of investments

10,000
5,000
8,000
2,000

50
20
25
200

Portfolio β =

5,00,000
1,00,000
2,00,000
4,00,000
12,00,000
13,30,000 = 1.108
12,00,000

β

0.9
1.0
1.5
1.2

Value β

4,50,000
1,00,000
3,00,000
4,80,000
13,30,000

β to be reduced to 0.8 by using risk free investment
Portfolio β is weighted average β of securities in the portfolio, weights being
Value of each security in the portfolio
Let risky investment be X
Risk free investment is (12,00,000 – X)
X(1.108) + (12,00,000 – X) (0) = 0.8
12,00,000
1.108 X
=
9,60,000
X
=
9,60,000
= Rs 8,66,426
1.108
Risk free investment
12,00,000 – 8,66,426 =
Rs 3,33,574
%age of risk free investment in portfolio
Rs 3,33,574 X 100 = 27.8%
Rs 12,00,000
β to be increased to 1.2 by using risk free investment
Portfolio β is weighted average β of securities in the portfolio, weights being
Value of each security in the portfolio
Let risky investment be X
Risk free investment is (12,00,000 – X)
X(1.108) + (12,00,000 – X) (0) = 1.2
12,00,000
1.108 X
=
12,00,000 x 1.2
X
=
14,40,000
=
12,99,639
1.108
Risk free investment
12,00,000 – 12,99,639 =
- Rs 99,639
Thus risk free borrowings required for increasing β to 1.2 = 99,639
% of risk free borrowings
=
99,639 x 100 =
8.3%
12,00,000

PRAVEEN MAHAJAN CLASSES CA FINAL SFM / IPCC COST & FM 9871255244, 8800684854

Page 14

(b) ABC established the following spread on the Delta Corporation's stock:

8

(i) Purchased one 3-month call option with a premium of Rs 30 and an
exercise price of Rs 550.
(ii) Purchased one 3-month put option with a premium of Rs 5 and an
.

exercise price of Rs 450.
The current price of Delta Corporation's stock is Rs 500. Determine ABC's
profit or loss if the price of Delta Corporation's stock.
(a) stays at Rs 500 after 3 months.
(b) falls to Rs 350 after 3 months.
(c) rises to Rs 600.

SOLUTION
a. Price stays at Rs 500 after 3 months
X will neither exercise call option nor put option, premium paid on call and put is loss of X
Statement of profit or loss
Gain on call
nil
Gain on put
nil
(30)
(5)
Net profit/(Loss)
(35)
b. Price falls to 350
Market price of stock is less than exercise price of call, the call will not be exercised.
Market price of stock is less than exercise price of Put, so put will be exercised
Statement of profit or loss
Gain on call
nil
Gain on put 450 – 350
100
(30)
(5)
Net profit
65
c. Price rises to 600
Market price of stock is more than exercise price of call, the call will be exercised. Market
price of stock is more than exercise price of Put, so put will not be exercised
Statement of profit or loss
Gain on call
(600- 550)
50
Gain on put
nil