CA Final SFM Question Paper Nov 2020 â€“Â CA Final SFM Study MaterialÂ is designed strictly as per the latest syllabus and exam pattern.

## CA Final SFM Question Paper Nov 2020

Question 1(a).

ZX Ltd. has made purchases worth USD 80,000 on 1st May 2020 for which it has to make a payment on 1st November 2020. The present exchange rate is INR/USD 75. The company can purchase forward dollars at INR/USD 74. The company will have to make an upfront premium @ 1 per cent of the forward amount purchased. The cost of funds to ZX Ltd. is 10 per cent per annum.

The company can hedge its position with the following expected rate of USD in foreign exchange market on 1 st May 2020 :

Exchange Rate | Probability |

(i) INR/USD 77 | 0.15 |

(ii) INR/USD 71 | 0.25 |

(iii) INR/USD 79 | 0.20 |

(iv) INR/USD 74 | 0.40 |

You are required to advise the company for a suitable cover for risk. (Marks 8)

Answer:

1(a)

(a) Hedging the purchases of USD 80,000 to be paid on 1st Nov. 2020 Le. after 6 months using:

Forward Exchange rate @ INR/USD 74

Premium = 1% of USD 80,000 = USD 800

Spot Exchange rate = INR/USD 75

Therefore, amount borrowed for premium (800 Ã— 75) = â‚¹ 60,000

Interest @10% p.a for 6 months = 3000

Total cost of premium = 63,000

= 80,000 Ã— 74 + 63,000

= 59.20.0 + 63000

= â‚¹ 59,83,000

The expected exchange rates with respective probabilities are given as :

Exchange Rate INR/USD | Probabilities |

77 | 0.15 |

71 | 0.25 |

79 | 0.20 |

74 | 0.40 |

Therefore, the expected exchange rate after 6 months will be

77(0.15) + 71(0.25) + 79(0.20) + 74(0.40)

= 74.7

The company can use the other means of hedging like future contracts if $ futures are available the company may buy $ futures, or it may take a call option on USD. As the price has significant variations, a call option would be the most suitable hedging strategy. It may also check the viability of money market hedge.

(b) A two year tree for a share of stock in ABC Ltd., is as follows:

Consider a two years American call option on the stock of ABC Ltd., with a strike price of 98. The current price of the stock is 100. Risk free return is 5 per cent per annum with a continuous compounding and eÂ°Â°5 = 1.05 127.

Using the Binomial Model, calculate:

(i) The probability of price moving up and down;

(ii) Expected pay offs at each nodes ie. N_{1}, N_{2} and N_{3} (round off upto 2 decimal points). (8 Marks)

Answer:

1 (b)

(i) The probability of price moving up and down (using continuous compounding):

P = \(\frac{e^r-d}{u-d}\)

e^{n} = Future value at risk free rate using continuous compounding

d = \(\frac{95}{100}\) = 0.95 (the price mav fall from 100 to 95)

u = \(\frac{108}{100}\) = 1.08 (the price may go up by 8%)

âˆ´ p, the probability of price going up when risk free return is 5% given e^{0.05} = 1.05127

= \(\frac{1.05127-0.95}{1.08-0.95}\)

= \(\frac{0.10127}{0.13}\)

= 0.779

Therefore, the probability of price going down

= [1 – p]

= [1 – 0.779]

= 0.221

(ii) Expected pay off at each modes N_{1}, N_{2}, and N_{3} the strike price of American call option is â‚¹ 98.

Round off upto two decimals = 14.78

This is an American option that can be exercised earlier, but at N(_{2}) if we ex-ercise early, pay off is (108 – 98) = â‚¹ 10, therefore it must be held and the pay off will be â‚¹ 14.78.

So value at (N_{2}) = 14.78

Value at N_{3}

So the values or expected pay off

â‚¹ | |

N_{1} |
11.67 |

N_{2} |
14.78 |

N_{3} |
3.41 |

(c) On Tuesday morning (before opening of the capital market) an investor, while going through his bank statement, has observed that an amount of â‚¹ 7 lakhs is lying in his bank account. This amount is available for use from Tuesday till Friday. The Bank requires a minimum balance of â‚¹ 1000 all the time. The investor desires to make a maximum possible investment where Value at Risk (VaR) should not exceed the balance lying in his bank account. The standard deviation of market price of the security is 1.5 per cent per day. The required confidence level is 99 per cent. (4 Marks)

Given

Answer:

1(c)

The objective in the question is to make maximum possible investment for a 4 days period so that the value at risk (VaR) does not exceed the amount lying in the Bank keeping the minimum balance required.

The Balance lying at Bank = â‚¹ 7,00,000

Minimum Balance to be kept = â‚¹ 1,000

The maximum value at Risk â‚¹ 6,99,000

Let the amount invested by the investor = x

Standard deviation per day = 1.5%

Standard deviation in 4 days = 1.5% Ã— âˆš4

= 1.5% Ã— 2

= 3%

From the standard normal table as provided in the question, the value of Z_{c} corresponding closest to a probability of 99% is 0.9901 and Z value is 2.33.

Therefore, the total value at Risk = Z_{c}Ïƒ

= 2.33(Ïƒ)

Ïƒ = 3% of x

= 0.03.x

âˆ´ VAR = 2.33 Ã— 0.03x

= 0.0699x

Equating

VAR in terms of x and absolute value at Risk (VaR) = 6,99,000

0.0699x = 6,99,000

x = 1,00,00,000

The maximum possible investment that can be made by investor = â‚¹ 1 cr.

Note: It is assumed that investor has funds for investment beyond â‚¹ 7 lakhs in the bank.

Question 2(a).

AB Industries has Equity Capital of â‚¹ 12 Lakhs, total Debt of â‚¹ 8 Lakhs, and annual sales of â‚¹ 30 Lakhs. Two mutually exclusive proposals are under consideration for the next year. The details of the proposals are as under:

Particulars | Proposal no. 1 | Proposal no. 2 |

Target Assets to Sales Ratio | 0.65 | 0.62 |

Target Net Profit Margin (96) | 4 | 5 |

Target Debt Equity Ratio (DER) | 2:3 | 4:1 |

Target Retention Ratio (of Earnings) (%) | 75 | – |

Annual Dividend (? in Lakhs) | – | 0.30 |

New Equity Raised (T in Lakhs) | – | 1 |

You are required to calculate sustainable growth rate for both the proposals. (8 Marks)

Answer:

2(a)

Existing capital structure:-

Equity = â‚¹ 12 lakhs

Debt = â‚¹ 8 lakhs

Total Assets = â‚¹ 12 + â‚¹ 8 = 20 lakhs

Annual sales = â‚¹ 30 lakhs

Asset to sales ratio = \(\frac{2}{3}\) = 0.67

Sustainable growth

g = ROE (1 – Payout ratio)

ROE = \(\frac{\text { Profits After Tax }}{\text { Net Worth }}\) Ã— 100

= \(\frac{\text { PAT }}{\mathrm{NW}}\) Ã— 100

Proposal – 1

Net Worth =12 lakhs

Asset to sales ratio = 0.65

Sales = \(\frac{\text { Asset }}{0.65}\)

= \(\frac{20}{0.65}\) = 30.77 (Rounded off)

Net profit margin = 4%

Net profit = 4% of 30.77

= 1.2308 lakhs

Dividend (Payout = 25% as retention ratio is 75%) = 0.3077

ROE = \(\frac{1.2308}{12}\) Ã— 100 = 10.25%

Sustainable growth = 10.25 Ã— 0.75

= 7.6875%

= 7.69%

Proposal – 2

Further, New equity raised = 1 lakhs

Total equity =12 lakh + 1 lakh = 13 lakh

Debt equity ratio = 4:1

Therefore debt = 4 Ã— 13 = 52 lakh

Total Asset = 65 lakh

Asset to sales ratio = 0.62

Total sales = \(\frac{\text { Assets }}{0.62}\)

= 104.838 lakhs

Net profit margin = 5%

Net profit = 5.2419 lakhs

Dividend distributed = 30,000

Pay out ratio = \(\frac{30,000}{5,24,190}\) Ã— 100 = 5.72%

Retention ratio = 100 – 5.72 = 94.28%

ROE = \(\frac{5.2419}{13}\) Ã— 100 = 40.329&

Sustainable growth = 40.32 (94.28%) = 38%

(b) IB an Indian firm has its subsidiary in Japan and Zaki a Japanese firm has its subsidiary in India and face the following interest rates:

Company | IB | Zaki |

INR floating rate | BPLR + 0.50 % | BPLR + 2.50% |

JPY (Fixed rate) | 2% | 2.25% |

Zaki wishes to borrow Rupee Loan at a floating rate and IB wishes to borrow JPY at a fixed rate. The amount of loan required by both the firms is same at the current exchange rate. A financial institution may arrange a swap and requires 25 basis points as its commission, Gain, if any, is to be shared by the firms equally.

You are required to find out:

(i) Whether a swap can be arranged which may be beneficial to both the firms ?

(ii) What rate of interest will the firms end up paying ? (8 Marks)

Answer:

2(b)

(i) IB has overall strong position but there is comparative advantage in INR floating rate.

The differential between the INR floating rate is 2% where as the differential between the JPY fixed rate is 0.25%. The total potential gain to both parties from the swap is therefore 1.75% per annum. If the financial institution requires a commission of 25 basis points so the benefit to both the parties will be 175 – 25 = 150 basis points. This gain can be shared by both the parties equally, So each party will benefit by 75 basis points.

(ii) IB requires Â¥ or JPY loan which it would have got at 2% but after swap it will cost him 2% – 0.75% = 1.25%.

Zaki requires INR floating loan which it would have borrowed at BPLR + 2.50%.

But after the benefit of 0.75% or 75 basis point, his loan would cost him BPLR + 2.50% – 0.75%

= BPLR + 1.75%

IB

Â¥ loan | |

Borrowing from market | 2% |

Less : Benefit from Swap | 0.75% |

Net interest rate | 1.25% |

Zaki

INR floating | |

Borrowing from market | BPLR + 2.5% |

Less Benefit from Swap | 0.75% |

Net interest rate | BPLR + 1.75% |

(c) Peer – to – Peer Lending and Crowd funding are same and traditional methods of funding. Do you agree ? Justify your stand. (4 Marks)

Answer:

2(c)

Peer to peer lending: Peer to Peer lending has been there for many years. It is a manner of financing when a group of people come together and lend money to each other. Many small and ethnic business groups having similar faith or interest generally support each other in their start up endeavours

Crowd funding: It is the use of small amount 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 web-sites to bring investors and entrepreneurs together.

These are not same as they differ in various points. Crowd funding uses social media and it is not the traditional method of financing. In Peer to Peer lending, there is element of trust and faith and a commonality of interest that group supports the new entrepreneur.

Question 3(a).

The following data are available for a bond :

Face Value â‚¹ 10,000 to be redeemed at par on maturity

Coupon rate 8.5 per cent per annum

Years to Maturity 5 years

Yield to Maturity (YTM) 10 per cent

You are required to calculate:

(i) Current market price of the Bond,

(ii) Macaulayâ€™s Duration,

(iii) Volatility of the Bond,

(iv) Convexity of the Bond,

(v) Expected market price, if there is a decrease in the YTM by 200 basis points

(a) By Macaulayâ€™s Duration based estimate

(b) By Intrinsic Value Method.

Given

(7 Marks)

Answer:

3(a)

Face value of Bond â‚¹ 10,000

Coupon rate 8.5%

Years to maturity 5 yrs.

Yield to maturity (YTM) 10%

(i) Current market price of the Bond

= \(\frac{\text { Coupon interest }}{\text { YTM }}\)

= \(\frac{850}{10 \%_0}\)

= â‚¹ 8500

(ii) Macaulayâ€™s Duration

Using formula :

= 11 – 6.748

= 4.252 yrs.

(iii) Volatility

= 3.865

Therefore, the volatility in the bond is – 3.865 which indicates that for every 1% change in interest rates the price will change by 3.865Qo. This negative sign indicates the inverse relationship between price and interest rates.

(iv) Convexity of the Bond

= \(\frac{\sum n^2 \mathrm{PV}}{\mathrm{V}}\)

n = period

PV is the present value of Cash flows at YTM

V = Î£Pv.

Convexity = \(\frac{187061}{9431.50}\)

= 19.83

(v) Expected market price it there is decrease in the YTM by 200 basis Points:

(a) Using Macaulayâ€™s duration estimates

= 3.865 Ã— 2 = 7.73%

Price = Î£PV = V = 9431.50 (as calculated in Part iv)

729.5 Increase

(7.73% of 9431.50)

New Price = 9431.50 + 729.05

= â‚¹ 10160.55

(b) By intrinsic value Method:

New YTM = 8%

Intrinsic Value = 850 [PVIFA_{58%} + 10,000 [PVIF_{58}]

= 850 (3.993)+ 10,000 (0.681) 3394.5 + 6810

= 10204.05

using [0.926 + 0.857 + 0.794 + 0.735 + 0.68] = 3.993

(b) M/s. Corpus an AMC, on 1-4-2015 has floated two schemes viz. Dividend Plan and Bonus Plan. Mr. X, an investor has invested in both the schemes. The following details (except the issue price) are available:

You are required to calculate the issue price of both the schemes as on 1-4-2015. (10 Marks)

Answer:

3(b)

Calculation of Issue price of:-

(i) Dividend Scheme:-

Initial Investment = â‚¹ 9,20,000

Period of Investment = 1-4-2015-31-3-2020

Duration = 5 yrs.

Average Profit = â‚¹ 27,748.60

Total Profit in 5 yrs. = 27,748.60 Ã— 5 = 138743

Let x units be purchased

Dividend on 31-3-2017 = 12%

on 31-3-2018 = 10%

on 31-3-2019= 15%

Total dividend = 37%

or 37% Ã— 10 = â‚¹ 3.7 per unit

âˆ´ 3.7 Ã— x = 3.7x

NAV on 31-3-2020 = 49

Final Value = 49A

Total value = 49A + 3.7A = 52.7A

Profit = 138743

Initial investment = 9,20,000

52.7x – 9,20,000 = 138743

52.7x = 1058743

x = \(\frac{9,20,000}{20,090}\)

x = 20,090

Issue Price = \(\frac{9,20,000}{20,090}\)

= 45.794 app.

(ii) Bonus Plan

Initial Investment = 10,00,000

Average yield = 6.40%

Yield in 5 Yrs. (6.40 Ã— 5) = 32%

Total Profit = 10,00,000 Ã— 32%

Let the no. of units purchased = x

Bonus received

On 31-12-16 (1:4)

\(\frac{1}{4}\)x = 0.25x

Total Units after bonus = 1 + 0.25x = 1.25x

On 31-12-18 (1:5)

\(\frac{1}{5}\) Ã— 1.25x = 0.25x

Total Units after bonus = 1.25x + 0.25x = 1.5x

Value of investments = 1.5x Ã— 44

on 31-3-2020 = 66x

As the profit is = â‚¹ 320,000

and Initial Investment = â‚¹ 10,00,000

Total value of Investment = â‚¹ 13,20,000

âˆ´ 66x = 1320,000

x = \(\frac{13,20,000}{66}\)

x = 20,000

âˆ´ Issue price = \(\frac{10,00,000}{20,000}\) = â‚¹ 50

The Issue price of units under:

Dividend Plan scheme = â‚¹ 45.794

Bonus Plan scheme = â‚¹ 50.000

(c) An individual attempts to found and build a company from personal finances or from the operating revenues of the new company. What this method is called? Discuss any two methods. (3 Marks)

Answer:

3(c)

This method is called Boot-strapping. When an individual attempts to found and build a company from his personal finances or from the operating revenues of the new company it is known as boot-strapping. If the capital available at the inception of the business is high, there can be wasteful expenditure in marketing etc. If the finances are arranged out of own pocket, there is cautious expenditure. These finances can be arranged through trade-credit, leasing and factoring and other means.

Two other methods can be:

I. Venture capital: Here the start-up has a tremendous potential and is . financed through venture capitalist. Venture capitalists, generally support a great idea, churn it into a commercially viable project, supports in management as well and earns huge profits. It majorly finances through equity participation. When the company starts earning only normal profits, it takes exit route.

II. Angel investors: Angel investors are also known as informal investors or angel funders. They invest in small startups or entrepreneurs. They are generally family and friends. They may provide one time investment or an ongoing injection of money to support and carry the company through its difficult early stages. They generally provide more favourable terms than other lenders.

Question 4(a).

ICL is proposing to take over SVL with an objective to diversify. ICLâ€™s profit after tax (PAT) has grown @ 18 per cent per annum and SVL’s PAT is grown @ 15 per cent per annum. Both the companies pay dividend regularly. The summarised Profit & Loss Account of both the companies are as follows :

â‚¹ in Crores | ||

Particulars | ICL | SVL |

Net Sales | 4,545 | 1,500 |

PBIT | 2,980 | 720 |

Interest | 750 | 25 |

Provision for Tax | 1,440 | 445 |

PAT | 790 | 250 |

Dividends | 235 | 125 |

Undistributed Profits | 555 | 125 |

ICLâ€™s Land & Buildings are stated at current prices. SVLâ€™s Land & Buildings are revalued three years ago. There has been an increase of 30 per cent per year in the value of Land & Buildings.

SVL is expected to grow’ (5 18 per cent each year, after merger.

ICLâ€™s Management wants to determine the premium on the shares over the current market price which can be paid on the acquisition of SVL.

You are required to determine the premium using :

(i) Net Worth adjusted for the current value of Land & Buildings plus the estimated average profit after tax (PAT) for the next five years.

(ii) The dividend growth formula.

(iii) ICL will push forward which method during the course of negotiations ?

(12 Marks)

Answer:

4(a)

(i) Determination of premium Using Net Worth plus estimate PAT

(b) Estimated Profits for Next 5 Years:

Total Estimated Profits = â‚¹ 250 Ã— FVAF (15%, 5)

(Next 5 Years)

250 Ã— 7.753.7 = â‚¹ 1,938.43

Average Profit = \(\frac{1.938 .43}{5}\) = 387.686 Crores

(c) Total Value = 1,012.43 + 387.686

= â‚¹ 1400.16 Crores.

(d) Current MKT. Value = No. of Shares Ã— Market Price

12.5 Crores Ã— â‚¹ 75

â‚¹ 937.5 Crores.

(e) Total Premium = â‚¹ 1400.16 – â‚¹ 937.5

â‚¹ 462.66 Crores.

Premium Per Share = \(\frac{â‚¹ 462.66}{12.5}\) Ã— 100 = â‚¹ 37.0128

(ii) Premium Using Dividend growth formula

Current Market Price (Actual) = â‚¹ 75

Premium Per Share = 98,54 – 75

= â‚¹ 23.54 Per Share

Premium Per Share (in percentage) = \(\frac{23.54}{75}\) Ã— 100

= 31.39%

(iii) Method to be adopter by ICL

Premium on Shares of SVL

(a) as per Net Worth Method: 49.35%

(b) as per Dividend Valuation: 1.39%

Sine, premium payable is less in Dividend Valuation method, it Should be used for bidding Shares of SVL Limited.

(b) USD 10,000 is lying idle in your Bank Account. You are able to get the following quotes from the dealers :

Dealer | Quote |

A | EUR/USD 1.1539 |

B | EUR/GBP 0.9094 |

C | GBP/USD 1.2752 |

Is there an opportunity of gain from these quotes ? (4 Marks)

Answer:

4(b)

It cross currency rates for GBP/US are calculated using quotes of Dealer A and Dealer B., they do not match the quote of Dealer C. There is arbitrage opportunity.

Dealer A = EUR/USD = 1.1539

Step-1 Convert 10,000 USD into Euro through Dealer A

Euros received = \(\frac{10,000}{1.1539}\) = 8666.2622

Step-2 Convert Euroâ€™s into GBP at Dealer B

Quote = EUR/GBP = 0.9094

i.e. 8666.2622 Ã— 0.9094

= 7881.0988

Step-3 Convert GBP thus received into USD at

Dealer C

Quote GBP/USD – 1.2752 therefore, 7881.0988×1.2752 = 10049.977 = 10,050 USD

So a person can use the quotes and can earn USD 50 without any risk.

(c) Side Pocketing enhances the value of the Mutual Fund. Do you agree? Briefly explain the process of side pocketing. (4 Marks)

Answer:

4(c)

Side pocketing does not enhance the value of the mutual fund. Side pocketing in mutual funds leads to separation of risky assets from other investments and cash holdings. The purpose is to make sure that money invested in a mutual fund which is linked to stressed assets gets locked until the fund recovers the money from the company to avoid distress selling of illiquid securities. Whenever, the rating of a mutual fund decreases, the fund shifts the illiquid assets into a side pocket so that current shareholders can be benefitted from the liquid assets. Consequently, the Net Asset Value (NAV) of the fund will then reflect the actual value of the liquid assets.

Side pocketing is beneficial for those investors who wish to hold on to the units of the main funds for long term. Therefore, the process of Side pocketing ensures that liquidity is not the problem even in the circumstances of frequent allotments and redemptions. However, it berefts the unit holders of genuine returns.

Question 5(a).

ICL an Indian MNC is executing a plant in Sri Lanka. It has raised â‚¹ 400 billion. Half of the amount will be required after six monthsâ€™ time. ICL is looking an opportunity to invest this amount on 1st April, 2020 for a period of six months. It is considering two underlying proposals:

Market | Japan | US |

Nature of Investment | Index Fund (JPY) | Treasury Bills (USD) |

Dividend (in billions) | 25 | – |

Income from stock lending (in billions) | 11.9276 | – |

Discount on initial investment at the end | 2% | – |

Interest | – | 5 per cent per annum |

Exchange Rate (1 st April, 2020) | JPY/INR 1.58 | USD/INR 0.014 |

Exchange Rate (30th September, 2020) | JPY/INR 1.57 | USD/INR 0.013 |

You, as an Investment Manager, is required to suggest the best course of option. (8 Marks)

Answer:

Question 5(a).

ICL is executing a plant is Sri Lanka if has raised â‚¹ 400 billion. As half of the amount will be required after six monthsâ€™ time, it is looking forward to invest â‚¹ 200 billion for 6 months on 1-4-2020. It has two alternatives. It can invest in Japan or is in us.

Evaluating the outcome of two proposals and selecting the best course of option:

(i) If investments are made in Japan:

Conversion Value of â‚¹ 200 billion | JPY (Billion) |

Spot Rate@ JPY/INR 1.58 (200 Ã— 1.58) – (A) | 316 |

Dividends return | 25 |

Income form stock lending | 11.9276 |

Value of Investments after 6 months ((& 2% discount) | 309.68 |

Total value of investments after 6 months [Dividends + Income + Value] – (B) | 346.6076 |

Converting the investment into â‚¹ at Exchange rate on 30-9-2020 which is JPY

= â‚¹ 220.7692

Return in Indian currencv

= [220.7692-200] = â‚¹ 20.7692 billion

(ii) If investments are made in US treasury bills.

Initial investment â‚¹ 200 billion Converted into US currency | 200 Ã— 0.014 |

@ Exchange Rate (1st April, 2020) USD = | 2.8 billion |

Interest @ 5% P.a or 2.5% for 6 months = | 0.07 |

Value of investments on 30-9-2020 = | USD 2.87 |

Value in â‚¹ @ Exchange rate on 30th September 2020 i.e 0.013 | 2.87 |

= 0.013 | |

Return in Indian Currency = | 220.7692 |

[220.7692-200] = | 20.7692 billion |

After rounding off upto 4 decimal places, the return in both the options is exactly same, so it does not make a difference where return are compared. But, if risk perspective is looked at, the securities which has less risk for same returns should be preferred. The US treasury bills are less risky in comparison to Japanese index funds, therefore as an Investment manager, it is suggested to invest is US treasury bills.

(b) The following are the details of three mutual funds of MFL :

The yield on 182 days Treasury Bill is 9 per cent annum

You are required to :

(i) Rank the funds as per Sharpeâ€™s measure.

(ii) Rank the funds as per Treynorâ€™s measure.

(iii) Compare the performance with the market. (8 Marks)

Answer:

5(b)

Three mutual funds of MFL are to be compared using sharpeâ€™s, Treynorâ€™s measure and by comparing the performance with the market.

The formula for Sharpe Ratio is :-

In this question variance and coefficient of determination are given

âˆ´ Ïƒ_{mf} = \(\sqrt{\text { variance }_{m i j}}\)

Coeff. of determination = r^{2}

coefficient of correlation = \(\sqrt{r^2}\)

Since,

Beta = r\(\frac{\sigma_s}{\sigma_m}\)

Beta = \(\frac{\sqrt{r^2} \times \sqrt{\text { variance }_{m f}}}{\sqrt{\text { variance }_{m \text { murket }}}}\)

Risk free return is the yield on 182 days T. Bills = 9%

Calculations:-

(i) Sharpeâ€™s Measure

(ii) Treynorâ€™s Measure

(iii) Comparing the return of mutual funds with market, the market has out-performed the funds. As the treasury bill is giving a 9Â°o p.a return, and it is risk fee, the Sharpeâ€™s and Treynorâ€™s measure for market will be zero But the funds have give negative measures. So market has done better than the funds.

Note As no period of investment for mutual funds is given in the question, it’is assumed that the Average return % are annual returns.

(c) In an efficient market, technical analysis may not work perfectly. However, with imperfections, inefficiencies and irrationalities, which characterises the real world, technical analysis may be helpful.

Critically analyse the statement. (4 Marks)

Answer:

5(c)

Technical Analysis is a way of predicting the future movement in stock prices. It is based on three presumptions which are:

- Prices moves in trends
- History tends to repeat itself
- Market discounts everything.

It studies the patterns and past trends and identifies the patterns to predict the share price. It makes use of charts and graphs. The common patterns observed by technical analysts are wedges, channels, head and shoulders, inverse head and shoulders Flags, etc. Technical analysis rendered positive results but it was noted that many positive results were rendered dubious by issues such as data snooping, so that the evidence in support of technical analysis was inconclusive. Many academicians consider it as pseudoscience. Eugene Fama suggested that, â€œevidence for technical analysis is sparse and is inconsistent with the weak form of the efficient market hypothesis.â€™â€™

Technical analysis was not able to predict movement in foreign exchange as it is intervened by central bank which technical analysis is not able to predict.

Detractors of technical analysis believe that it is a useless exercise for the following reasons:

- Most technical analysis is not able to offer a convincing explanation for ‘ the tools employed by them.
- Empirical evidence in support of random walk hypothesis casts its shadow over the usefulness of technical analysis.
- By the time an uptrend and downtrend may have been signaled by tech-nical analysis, it may already have taken place.
- Ultimately technical analysis must be self defeating proposition with more and more people employing it, the value of such analysis tends to decline.

But users do hold that even if technical analysis cannot predict the future, but it certainly helps in identifying trends, tendencies and trading opportunities. If this tool is used together with fundamental analysis and other tools, it can serve a great purpose.

Question 6(a).

An investor is considering to purchase the equity shares of LX Ltd., whose current market price (CMP) is â‚¹ 112. The company is proposing a dividend of 4 for the next year. LX Ltd. is expected to grow @ 20 per cent per annum for the next four years. The growth will decline linearly to 16 per cent per annum after first four years. Thereafter, it will stabilise at 16 per cent per annum infinitely. The investor requires a return of 20 per cent per annum.

You are required

(i) To calculate the intrinsic value of the share of LX Ltd.

(ii) Whether it is worth to purchase the share at this price.

(8 Marks)

Answer:

6(a)

(i) Present value of Expected dividends in future till growth stabilizes to 16% till perpetuity

from the 8th year onwards growth will stabilize to 16% p.a.

D_{8} = D_{7} (1.16)

= 11.36(1.16)

= 13.18

Market price of share at he end of 7th year P(_{7})

The Present value P(_{0}) of share = Total PV of dividends + PV of Price

P(0)= 23.05 + \(\frac{329.50}{(1.20)^7}\)

= 23.05 + 329.50 (0.279)

= 23.05+91.9305

= 114.9805

= â‚¹ 115

Note: The question speaks of linearly declining growth rate from 20% to 16%, but it fails to specify the period during which the decline occurs or the interval of linear decline. Therefore, we have made an assumption that growth will decline by 1% every year till it stabilizes at 16%.

(ii) The intrinsic value of the share is â‚¹ 115 where as, it is being traded at a price of â‚¹ 112. The share of the company is being traded at a discount. Therefore, it is worthwhile to purchase the share at this price.

(b) The Management of a multinational company TL Ltd. is engaged in con-struction of Infrastructure Project. A proposal to construct a Toll Road in Nepal is under consideration of the Management.

The following information is available :

The initial investment will be in purchase of equipment costing USD 250 lakhs. The economic life of the equipment is 10 years. The depreciation on the equipment will be charged on straight line method. EBIDTA to be collected from the Toll Road is projected to be USD 33 lakhs per annum for a period of 20 years.

To encourage investment Nepalese government is offering a 15 year term loan of USD 150 lakhs at an interest rate of 6 per cent per annum. The interest is to paid annually. The loan will be repaid at the end of 15 year in one tranche.

The required rate of return for the project under all equity financing is 12 per cent per annum.

Post tax cost of debt is 5.6 per cent per annum.

Corporate Tax Rate is 30 per cent.

All cash Flows will be in USD.

Ignore inflation.

You are required to advise the management on the viability of the proposal by using Adjusted Net Present Value method.

Given

PVIFA (12%, 10) = 5.650, PVIFA (1296,20) = 7.469, PVIFA (896,15) = 8.559, PVIFA (896, 15) = 0.315 (8 Marks)

Answer:

6(b)

Calculation of viability of proposal using Adjusted Net Present value Method:-

(i) Calculation of unlevered firmâ€™s present value for the project

Given:-

USD 250 Lakhs

USD 33 Lakhs for 20 yrs.

straight line method

10 years

USD 25 Lakhs

Corporate tax = 30%

The cash flows for 1st 10 yrs will be different from cash flows in the remaining 10 years when no tax benefit on depreciation will be available.

So cash inflows from Project for the first 10 yrs.

= (EBIDTA – Depreciation) (1 – t) + Depreciation

= {[33 – 25] [1 – 0.30]} + 25

= 30.6 lakhs

Cash flows from 11th – 20th year

= (EBIDTA) Ã— (1 – tc)

= (33)(1 – 0.30)

= 23.10 lakhs

Required rate of return for all equity financing = 12%

Present value of cash inflows

Year 1 – 10 = 30.6 Ã— 5.650 = 172.89

using PVIFA(12%10)

Year 11-20 = 23.10 Ã— (7.469-5.650)

Using = PVIFA( 12%, 11-20) = 23.10 Ã— (1.819)

Note:

PVIFA (12%, 11-20) = PVIFA (12%, 20) – PVIFA (12%, 10)

Total PV of inflows = 172.89 + 42.0189

= 214.9089

= 214.91 appr.

Value of unlevered firm = Initial Investment – PV of inflows

= 250-214.91

= – 35.09

Benefit of leverage

Le. Benefit of Debt financing

= (Debt Ã— interest rate) Ã— (tax rate) PVIFA (kd. 15)

Amount of Debt = 150 lakhs

rate of interest = 6%

tax rate = 30%

kd ie. cost of debt = 8%

loan tenure = 15 years

Putting the values:-

[150 lakhs x 6%] [0.30] [8.559]

= 23.1093

Adjusted net present value:-

Value of unlevered firm + Debt benefits

= -35.09 + 23.1093

= – 11.9807 lakhs.

As the Adjusted NPV is USD-11.9807 lakhs the proposal is not viable.

(c) Distinguish between Pass Through Certificates (PTC) and Pay Through Securities (PTS). (4 Marks)

OR

Differentiate between Economic Value Added (EVA) and Market Value Added (MVA)

Answer:

6(c)

Pass through certificates: It is a direct route in which originator transfers the entire receipt of cash in the form of interest or principal repayment from the assets sold. The investors carry proportional beneficial interest in the asset held in the trust by SPV. If there is any prepayment of principal, it is also proportionately distributed among the securities holders. On completion of securitization by the final payment of assets, the securities are terminated. Cash flows may be skewed.

Pay through securities: Here the SPV debt securities are backed by the assets and hence it can restructure different tranches from varying maturities of receivables. This structure permits de-synchronization of servicing of securities issued from cash generating from the asset. It also permits the SPV to reinvest surplus funds for short term as well as the freedom to issue different debt tranches with varying maturities. Cash flows will not be skewed in this arrangement.

OR

Economic Value Added (EVA) helps in evaluating the financial performance of a company. It also signifies what an entity’s economic contribution to the society is. The concept behind EVA is that a company generates â€˜valueâ€™ if there is wealth creation. If the returns are in excess of its cost of capital employed.

EVA tries to make management more accountable.

EVA = NOPAT – WACC (Capital employed)

NOPAT = Net operating profit after tax.

Market value added (MVA) means the current market value of the firm minus the capital employed. It also helps in gauging the performance of the enterprise but from a market capitalization point of view. Companies with higher MVA would become pricey and in the short run EVA may exhibit a slightly negative correlation in comparison to the MVA.