Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

PAPER-14: ADVANCED FINANCIAL MANAGEMENT

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

The following table lists the learning objectives and the verbs that appear in the syllabus learning
aims and examination questions:

Learning objectives Verbs used Definition

KNOWLEDGE List Make a list of
State Express, fully or clearly, the details/facts
What you are expected to
know Define Give the exact meaning of
Describe Communicate the key features of
Distinguish Highlight the differences between
COMPREHENSION Explain Make clear or intelligible/ state the
meaning or purpose of
What you are expected to Identity Recognize, establish or select after
understand consideration
Illustrate Use an example to describe or explain
something
Apply Put to practical use
Calculate Ascertain or reckon mathematically
APPLICATION Demonstrate Prove with certainty or exhibit by practical
means
How you are expected to
Prepare Make or get ready for use
apply
your knowledge Reconcile Make or prove consistent/ compatible
Solve Find an answer to
LEVEL C

Tabulate Arrange in a table

Analyse Examine in detail the structure of
Categorise Place into a defined class or division
ANALYSIS Compare Show the similarities and/or differences
and contrast between
How you are expected to
Construct Build up or compile
analyse the detail of what you
have learned Prioritise Place in order of priority or sequence for
action
Produce Create or bring into existence

SYNTHESIS Discuss Examine in detail by argument

How you are expected to
utilize the information
gathered to reach an Interpret Translate into intelligible or familiar terms
optimum
conclusion by a process of Decide To solve or conclude
reasoning
Advise Counsel, inform or notify
EVALUATION
How you are expected to use Evaluate Appraise or asses the value of
your learning to evaluate,
make decisions or Recommend Propose a course of action
recommendations

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 2
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

PAPER-14: Advanced Financial Management

Time Allowed: 3 hours Full Marks: 100

This paper contains 5 questions. All questions are compulsory, subject to instruction provided
against each question. All workings must form part of your answer.
Assumptions, if any, must be clearly indicated.

Question No. 1. (Answer all questions. Each question carries 2 marks)

(a) Can old, sick physically handicapped pensioner who is unable to sign, open pension
account or withdraw his/ her pension from the pension account? [2]

Answer to (a):

A pensioner, who is old, sick or lost both his/her hands and, therefore, cannot sign, can put
any mark or thumb/ toe impression on the form for opening of pension account. While
withdrawing the pension amount he/she can put thumb/toe impression on the
cheque/withdrawal form and it should be identified by two independent witnesses known
to the bank one of whom should be a bank official.

(b) Aircel Communications is trying to estimate the first-year operating cash flow (at t = 1) for a
proposed project. The finance staff has collected the following information:
Projected Sales = ` 1 crore
Operating costs = ` 70 lakhs (not including depreciation)
Depreciation = ` 20 lakhs
Interest expense = ` 20 lakhs
The company faces a 30% tax rate. Calculate the project‘s operating cash flow for the
year (t=1)? [2]

Answer to (b):
Operating Cash Flow: (t = 1)
Sales revenue 1,00,00,000
Operating costs 70,00,000
Depreciation 20,00,000
Operating income before taxes 10,00,000
Taxes (30%) 3,00,000
Operating income after taxes 7,00,000
Add back depreciation 20,00,000
Operating cash flow 27,00,000

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 3
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

(c) The following securities are available in the market for investment
Securities Return % Standard Deviation (%)
Gilt edged security 6 0
Equity of Rolt Ltd. 20 20

If Mr. Vardhan is planning to invest `5,00,000 to construct a portfolio with standard deviation
of 18%, then calculate the return on such portfolio. [2]

Answer to (c):

Variance of Portfolio: Op2 = Wt2Ot2 + Wr2Or2+2WtOtWrOr

Portfolio since Standard deviation of Gilt edged Securities is 0 and its correlation with equity is
also 0 the above formula will reduce to
Op2 = Wr2Or2
Therefore Op = WrOr
Or, 18% = 20% Wr
Hence, Wr = 0.18/0.20 = 0.9 and Wt = 1 – 0.9 = 0.10
Return of portfolio (Rp) = WtRf + WrRr = 0.1 × 6% + 0.9 × 20% = 18.6%
Return (In Rupees) = 0.186 × 5,00,000 = ` 93,000

(d) The following market quotes are available. Assume there are no transaction costs be
possible, calculate the arbitrage gains on ` 10,00,000 from the middle rates given below:
` 76,200 = £ 1 in London
` 46,600 = $ 1 in Delhi
$ 1.5820 = £ 1 in New York [2]

Answer to (d):
Beginning with ` 10,00,000, we can purchase dollars in Delhi to get $ 21,459 (10,00,000/46.6).
Using this we purchase £ 13,564 (21,459/1.582) in New York. Now, we sell these pounds in
London at ` 76.20 per pound to get ` 10,33,577 and make a gain of ` 33,577 (10,33,577 –
10,00,000).

(e) State the term ―Close‖ and ―Closing Price‖ in commodity market. [2]

Answer to (e):

Close: - The period at the end of trading session officially designated by exchange during
which all transactions are considered made ―at the close‖.

Closing price: - The price (or price range) recorded during the period designated by the
exchange as the official close.

(f) Calculate percentage bid-ask spreads in the following cases?

$ 1 = ` 35.15 – 36.45
£ 1 = ` 57.05 – 59.20
DM 1 = ` 21.15 – 21.90
FF 1 = ` 6.10 – 6.28 [2]

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 4
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Answer to (f):

 ` 36.45  35.15 
$1=    100  3.566%
 36.45 
 ` 59.20  57.05 
£1=    100  3.632%
 59.20 
 ` 21.90  21.15 
DM 1 =    100  3.425%
 21.90 
 ` 6.28  6.10 
FF 1 =    100  2.866%
 6.28 

(g) A fund manager is contemplating payment of dividend for his scheme in six months time. He
has cash but wants to park in Bills. He needs at least 8% returns over a period of 6 months
from now. At what price he can purchase a T- Bill from the secondary market? [2]

Answer to (g):

 F - P  365
The formula for calculation of yield of a T – Bill is Y =   × ×100
 P  M

Here P=?, F = 100, M = 6 months = 180 days [Remember to use 365 in the formula]
 100 - P  365
8 =   × 180 ×100 Solving we get P = `96.20
 P 

(h) A put option due to mature is selling at ` 5 on a share which is selling at ` 75. The option has
an exercise price of ` 80, is there an arbitrage opportunity? If yes, show how it works. [2]

Answer to (h):

If the arbitrageur buys a put option by paying ` 5 & also purchase a share at ` 75, his total
cost is ` 80. If he exercises his put option, he will receive the exercise price of ` 80, hence no
arbitrage gain possibility exists.

(i) Khan Ltd. has a target capital structure of 40% debt and 60% equity for one of its new
subsidiaries. The yield to maturity of the company‘s outstanding bonds is 9% and the tax rate
is 30%. The CFO has calculated the company‘s WACC as 9.96%. Find out the company‘s
equity cost of capital. [2]

Answer to (i):

40% Debt; 60% Equity; Kd = 9%; T = 30%; WACC = 9, 96%; Ke =?

WACC = (Wd)(Kd)(1-T)+(We)( Ke)
9.96% = (0.4)(9%)(1-0.3) + (0.6) Ke

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 5
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

9.96% = 2.52% + 0.6 Ke

7.44% = 0.6Ke
Ke = 12.4%

(j) Historicalyy, when the market return changed by 10% the return on the stock of Arihant Ltd
changed by 16%. If the variance of market is 257.81, then calculate the systematic risk of
Arihant Ltd. [2]

Answer to (j):

10% increase in Market return resulted in 16% increase in Arihant Ltd Stock. Thus, the Beta (β)
for the Arihant Ltd stock is 1.60 (i.e. 16% ÷ 10%).
Now Systematic Risk is 2 m2  (1.60)2(257.81)  660%

Question No. 2. (Answer any three questions. Each question carries 8 marks)

2. (a)(i) A Mutual Fund Co. has the following assets under it on the close of business as on:

Company No. of Shares 1st February, 2015 Market Price 2nd February, 2015
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?

III. Find new NAV of the Fund as on 2nd February, 2015 [2+5+1]

Answer to 2(a)(i):
NAV of the fund currently is the market value of securities divided by the outstanding
number of units. In this problem, market value is:

Company 1st February, 2015 2nd February, 2015

No. of Market Value of No. of Shares Market Value of
Shares Price Securities Price Securities

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 6
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

L Ltd 20000 20.0 4,00,000 20000 20.5 4,10,000

M Ltd 30000 312.4 93,72,000 38000 360.0 1,36,80,000
N Ltd 20000 361.2 72,24,000 20000 383.1 76,62,000
P Ltd 60000 505.1 3,03,06,000 60000 503.9 3,02,34,000
4,73,02,000 5,19,86,000
Cash = 30,00,000 – 8,000
Cash 0 5,00,800
× 312.4 = 500800
Total NAV 4,73,02,000 5,24,86,800
Additional Units =
Units 600000 30,00,000 ÷ 78.8867 = 638053.4
38053.4
NAV per unit 78.8367 82.2608

2.(b)(i) Under what circumstances can a company registered as a Collective Investment

Management Company raise funds from the public? [4]

Answer to 2(b)(i):

I. A registered Collective Investment Management Company is eligible to raise funds

from the public by launching schemes.
II. Such schemes have to be compulsory credit rated as well as appraised by an
appraising agency.
III. The schemes also have to approved by the Trustee and contain disclosures, as
provided in the Regulations which would enable to investors to make informed
decision.
IV. A copy of the office document of the Scheme had to be filed with SEBI and if no
modifications are suggested by SEBI within 21 days from the date of filing, then the
collective investment Management company is entitled to issue the offer document
to the public raising funds from them.

2.(b)(ii) Suppose a company issues a Commercial Paper as per the following details:
Date of Issue : 17th January 2015

Date of Maturity : 17th April 2015

No. of Days : 90 days

Face Value : `1,000

Issue price : `985

Credit rating exp. : 0.5% of the size of issue

IPA charges : 0.35%

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 7
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Stamp Duty : 0.5%

Calculate the cost of the commercial paper and yield to investor? [3+1]

Answer to 2 (b)(ii):

 Face Value - Sale Price   360 

We know that  ×   = cost of CP
 Sale Price   Maturity Period 

Numerator = Total Discount = Discount + Rating Charges + IPA charges + Stamp Duty
Therefore Discount [on FV `1,000] = `15 + 5 + 5 + 3.5 = `28.5
28.5 360
Cost of CP =  = 0.1157 or 11.6%
985 90

15 360
Yield to investor =   100 = 6.09
985 90

2.(c)(i) List the unique features of National Level Commodity Exchanges. [4]

Answer: 2 (c)(i):

The unique features of national level commodity exchanges are:

They are demutualized, meaning thereby that they are run professionally and there is
separation of management from ownership. The independent management does not
have any trading interest in the commodities dealt with on the exchange.
They provide online platforms or screen based trading as distinct from the open-out-
cry systems (ring trading) seen on conventional exchanges. This ensures transparency
in operations as everyone has access to the same information.
They allow trading in a number of commodities and are hence multi-commodity
exchanges.
They are national level exchanges which facilitate trading from anywhere in the
country. This corollary of being an online exchange.

2. (c)(ii) You can earn a return of 13 percent by investing in equity shares on your own. You are
considering a recently announced equity mutual fund scheme where the initial issue
expense is 7 percent. You believe that the mutual fund scheme will earn 16.5 percent. At
what recurring expenses (in percentage terms) will you be indifferent between investing
on your own and investing through the mutual fund. [2]

Answer to 2(c)(ii):

Let the annual Recurring expenses be `X

Investors' Expectation
Returns from Mutual funds =   Annualrecurringexpenses
100  IssueExpenses

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 8
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

13
16.5%  x
100  7  %
16.5%  13.97  x
x  16.5  13.97  2.53%

Therefore, the Amount of Recurring Expenses for which the return will be indifferent is 2.53%.

2.(c)(iii) State the 'Hedging Approach' to financing working capital requirements of a firm. [2]

Answer: 2 (c)(ii)
Hedging Approach: It is a method of financing where each asset would be offset with a
financing instrument of the same approximate maturity. With this approach, short-term or
seasonal variation in current assets would be financed with short-term debt; the
permanent component of current assets and all fixed assets would be met with long-term
debt.

The rationale for the policy is that if long-term debt is used to finance short-term needs,
the firm will be paying interest for the use of such funds at times when funds are needed.

2. (d) Analyze the following table and select the best portfolio for an investor who has diversified
holdings: [8]

Market Rf 1 2 3 4 5
Mean 12 6 14 16 26 17 10
SD - Risk 20 - 21 21 30 25 18
Beta 1.0 - 1.15 1.10 1.30 0.90 0.45

Answer to 2 (d):

We know that, for an investor holding diversified holdings, there is virtually no

unsystematic risk present in his portfolio. Therefore, using total risk to measure risk adjusted
return is less relevant. Thus we would use those risk adjusted measures, which uses beta as
a measure of risk.

We know that Treynor ratio is defined as: (Rp - Rf) / βP and

Jensen's alpha is the incremental actual return over the expected return as per CAPM.

Market Rf 1 2 3 4 5
Mean 12 6 14 16 26 17 10
SD - Risk 20 - 21 21 30 25 18
Beta 1.0 - 1.15 1.10 1.30 0.90 0.45
Treynor Ratio 6 - 6.96 9.09 15.38 12.22 8.89

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 9
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Jensen's Alpha 12 - 12.9 12.6 13.8 11.4 8.7

Rank 3 2 1 4 5

We can see that portfolio 3 is the best among the lot. Also there is no dispute as regards
rank 5. However, one may favour portfolio 1 over portfolio 2. Since the difference in alpha
is only marginal, for portfolios 1 & 2, and portfolio 2 has high Treynor ratio as compared to
portfolio 1, we have ranked portfolio 2 ahead of portfolio 1. And finally, though portfolio 4
has higher Treynor, it is the alpha (which is lower) which has pushed down the ranking.

Question No. 3. (Answer any two questions. Each question carries 10 marks)

3. (a)(i) The following data relates to ABC Ltd.‘s share prices:

Current price per share ` 180

Price per share in the 6m futures market: ` 195

It is possible to borrow money in the market for securities transactions at the rate of 12%
per annum.
Required:
I. Calculate the theoretical minimum price of a 6-month futures contract.
II. Explain if any arbitrage opportunities exist. [2+5]

Answer to 3(a)(i):

I. Theoretical Minimum Price of a 6-month forward contract:

Future’s Price = Spot + Cost of Carry – Dividend
F = 180 + 180 × 0.12 × - 0
= 190.80
Thus we see that Futures price by calculation is ` 190.80 and is quoting at ` 195 in the
exchange.

II. Analysis:
Fair Value of Futures LESS than Actual Futures Price;
Futures Overvalued. Hence SELL. Do Arbitrage by buying stock in Cash Market.

Step I
Buy ABC Ltd. stock at ` 180 by borrowing at 12% for 6 months. Therefore his outflows are
Cost of Stock 180.00
Add: Interest @ 12% for 6 months i.e. 0.5 year (180 × 0.12 × 0.5) = 10.80
Total outflows (A) 190.80

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 10
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Step II
He will sell 6-month futures at ` 195. Hence, his inflows are
Sales proceeds of futures 195.00
Add: Dividend received for his stock 0.00
Total outflows (B) 195.00

Inflow – Outflow = Profit earned by Arbitrageur

= 195 – 190.80 = ` 4.20 per share.
Note: We have ignored transaction costs like commission, margin, etc.

3. (a)(ii) Nifty Index is currently quoting at 1300. Each lot is 250. Mr. X purchases a March contract
at 1300. He has been asked to pay 10% initial margin. Calculate the amount of initial
margin. To what level Nifty futures should rise to get a percentage gain of 5%. [1+2]

Answer to 3 (a)(ii):

Initial margin = 10% of Transaction value of futures.

= 0.10 × 1300 × 250
= ` 32500

Now gain = 5% = 0.05 = Return + Investment

= Return ÷ 32500
 Return = ` 1625
i.e., Return per unit = 1625 / 250 = ` 6.50
 Index futures should rise to 1306.50.

3. (b)(i) The annual interest rate is 5% in the United States and 8% in the UK. The spot exchange
rare is £/$ -1.50 and forward exchange rate, with one year maturity, is £/$ = 1.48 In view
of the fact that arbitrager can be borrow $ 1000000 at current spot rate, calculate the
arbitrageur profit/ loss? [6]

Answer to 3 (b)(i):

We first verify the interest rate parity to decide first, whether any arbitrage exists.
We have spot = 1£ = $ 1.50
LHS = (1+rh) = 1 + 0.05 = 1.05
RHS = F/S (1+rf) = 0.987 × (1 + 0.08) = 1.0656 ($ return)
Since LHS ≠ RHS, parity does not exist, and there exists and opportunity to arbitrage.
Since LHS is lower, the borrowing would be done in dollars. The borrowed money would
be converted to £ and invested. The profit can be calculated as follows:

Assume borrowing $1000000. The repayment would be at the rate of 5% in 12 months i.e.,
$ 1000000 × 1.05 = $1050000. $1000000 converted to £ at spot would yield £666667. This on

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 11
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

deposit for 12 months would yield £720000. This converted back to $ would give us
$1065600.

Thus our net arbitrage profit would be = $1065600 - $1050000 = $15600.

Note: Inverse Notations £ / $ - 1.50 used.

3.(b)(ii) An 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 per cent per annum.

The importer‘s bank charges 15 per cent per annum on overdrafts. The exchange rates in
the market are as follows:
Spot rate (`/$): 48.35/48.36
3 Months forward rate (`/$): 48.81 / 48.83
The importer seeks your advice. Give your advice. [2+2]

Answer to 3 (b)(ii):

Total Exposure : $130000

Spot (`/$) : 48.35/48.36
3-month (`/$) : 48.81/48.83

Option I
Pay immediately $ 130000, and pay overdraft interest on rupee proceeds:

Proceeds of immediate payment: $130000 × 48.36 = ` 62,86,800

3 month interest @ 15% i.e. (0.15 × 0.25 × 6286800) = ` 2,35,755
Total Cost = ` 65,22,555

Option II
Pay $ 130000 with interest 5% (130000 + 1625) = $131625
Book forward today at ` 48.83
Total cost = 48.83 × 131625 = ` 64,27,249

Conclusion: Option II is cheaper.

3 (c)(i). For imports from UK, Philadelphia Ltd. of USA owes £650000 to London Ltd., payable on
May, 2014. It is now 12 February, 2015. The following future contracts (contract size
£62,500) are available on the Philadelphia exchange:

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 12
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Expiry Current futures rate

May 1.4900 $/£ 1
June 1.4960 $/£ 1

I. Illustrate how Philadelphia Ltd. can use future contracts to reduce the transaction risk
if, on 20 May the spot rate is 1.5030 $/£ 1 and June futures are trading at 1.5120 $/£.
The spot rate on 12 February is 1.4850 $/£ 1.
II. Calculate the hedge efficiency and comment on it. [8+2]

Answer to 3(c)(i):

I. Philadelphia Ltd. of USA owes £ 650000 to London Ltd., payable on May, 2015. This
company would therefore buy Futures contracts. Since information on June Contracts
are given for both spot and expiry, and the firm can buy either May or June Futures for
hedging, we illustrate the hedging procedure by using June Futures:

Value of exposure today (12th February) = £650000 × 1.4850 = $965250

Since each contract sixe = £ 62,500, the firm can buy 10 June expiry contracts at
$1.4960/£ i.e. can cover the exposure to the extent of £625000, thus leaving the balance
£650000 - £625000 = £25,000 uncovered. When the payment is due in May, the spot rate
would be 1.5030 $/£ and the June contracts would be trading at 1.5120 $/£.

At expiry, the value of exposure would increase to £650000 × 1.5030 = $976950.

Therefore, increase in exposure = $976950 = $965250 = $11,700.

However, since the firm bought futures at 1.4960, it can sell of the same at a higher rate
of 1.5120/£.
This would result in a profit = 10 × 62500 × (1.5120 – 1.4960) = $10000 [Savings due to
hedging]
Net loss = $11700 - $10000 = $1700.

II. Owing to hedging in the futures market the company could reduce its losses by $10000.
i.e., out of a possible loss of $ 11700, $10000 could be saved owing to hedging. Thus
hedging thus hedging efficiency is = $10000/$11700 = 85.5%, which is reasonably good,
despite the inability of the firm to hedge 100% of the exposure.

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 13
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Question No. 4. (Answer any two questions. Each question carries 8 marks)

4 (a). A group of analysis believes that the returns of the portfolios are governed by two vital
factors—
1. the rate of economic growth and 2. the sensitivity of stock to the developments in the
financial markets. The sensitivities of returns with respect to these two factors are denoted
by β1 and beta β1 respectively.

Further these analysts believe that returns on three carefully crafted Portfolios A, B and C
must be predominantly governed by these two factors alone leaving remaining to some
company/ portfolio specific factors. Assume that these three Portfolios A, B, and C are
found to have following beta co-efficients:

Portfolio Expected Return, % β1 β1

A 16.00 1.00 0.80
B 25.00 1.50 1.30
C 32.00 2.00 1.50

Find out the Arbitrage Pricing Theory (APT) equation governing the returns on the
portfolios. [8]

Answer to 4 (a):

Arbitrage Pricing Theory for two factors is

Rp = λ0 + λ1β1 + λ2β2
Putting the given values in the APT to solve for three unknown variables:
For Portfolio A: 16 = λ0 + λ1 ×1.00 + λ2 ×0.80 (1)
For Portfolio B: 25 = λ0 + λ1 ×1.50 + λ2 ×1.30 (2)
For Portfolio C: 32 = λ0 + λ1 ×2.00 + λ2 ×1.50 (3)
Subtracting (1) from (2)
9 = λ1 × 0.50 + λ2 × 0.50 (4)
Subtracting (1) from (3)
16 = λ1 ×1.00 + λ2 ×0.70 (5)
Multiplying (4) with 2, we get
18 = λ1 ×1.00 − λ2 ×1.00 (6)
Subtracting (5) from (6), we get
λ2 = 20/3
Putting the value in (4)
9 = 10/3 + λ1 × 0.50
gives λ1 = 34/3

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 14
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Putting the values of λ1 and λ2 in (3) we get

32 = λ0 + 2 × 34/3 + 1.50 × 20/3
and λ0 = – 2/3
APT would then be Rp = – 2/3 + 34/3 × β1 + 20/3 × β2

4 (b)(i) Mr. Khan has the following investments: [(1+1)+4]

Stock Expected return % Portfolio weight % Beta

ABC 15.00 40 0.6
BAC 25.40 30 1.4
CAB 20.60 30 1.1

I. Calculate the expected return and β of Khan‘s portfolio.

II. Khan has now decided to take on some additional risk in order to increase his
expected return, by changing his portfolio weights. If Khan‘s new portfolio‘s
expected return is 22.12% and its β is 1.165, calculate the weights of his new portfolio.

Answer to 4(b)(i):

I. We can calculate the expected return of Mr. Khan as follows:

E(R) = (0.40)(0.15) + (0.0)(0.254) + (0.30)(0.206) = 0.198 and
βP = (0.40)(0.60) + (0.30)(1.40) + (0.30)(1.10) = 0.990.

II. Let X1 be the new weight on ABC, X 2 be the new weight on BAC and X 3 = 1 – X1 – X2
be the new weight on CAB. Then, we have:
X1 (0.15) + X2 (0.254) + (1 – X1 – X2)(0.206) = 0.2212
X1 (0.0.60) + X2 (1.40) + (1 – X1 – X2)(10.10) = 1.1650

Rearranging these two equations gives:

X1 (-0.056) + X2 (0.048) = 0.0152
X1 (-0.50) + X2 (0.30) = 0.0650

Solving we get X1 = 0.20

X2 = 0.55 and
X3 = 0.25

Therefore the new weights are 20% on ABC, 55% on BAC and 25% on CAB.

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 15
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

4. (b)(ii) Explain ―Re-investment Risk‖ involved in investment in Government Securities. [2]

Answer to 4(b)(ii):

Re-investment Risk:
(i) Re—investment risk is the risk that the rate at which the interim cash flows are re-
invested may fall thereby affecting the returns.
(ii) The most prevalent tool deployed to measure returns over a period of time is the yield-
to-maturity (YTM) method which assumes that the cash flows generated during the life
of a security is reinvested at the rate of YTM.

4. (c)(i) Arvind Mills has expected dividend growth of 7% and the average market return is 12%
per annum. Dividend expected end-year on Arvind is ` 2.50. The company stock has β =
2.00 and the risk free rate us 6%. Calculate the risk-adjusted rate of return on Arvind
assuming the CAPM holds. If the current market price is ` 20, find the fair price of the
equity share. Discuss the risks attached to the investment strategy. [1+1+2]

Answer to 4(c)(i):

Risk adjusted rate of return on Arvind, using CAPM is:

ERi = ERf + βi (ERm – ERf)
= 6% + 2.00(12% - 6%) = 18%

Fair value of Arvind is:

V = D/( ERi – g)
= ` 2.50/ (0.18 - 0.07)
= ` 22.73

Since the Arvind’s equity is underpriced, the investor should buy the equity shares. But the
CAPM measure ERi may not hold for all future periods. If the market price diverges from
the fair value, the demand for the Arvind will shot up till there is equilibrium.

2.(c)(ii) Write short notes on Unsystematic Risk [4]

Answer to 4(c)(ii):

Unsystematic Risk: These are risks that emanate from known and controllable factors,
which are unique and / or related to a particular security or industry. These risks can be
eliminated by diversification of portfolio.

(i) Business Risk:

 It is the volatility in revenues and profits of particular Company due to its market
conditions, product mix, competition, etc.

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 16
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

 It may arise due to external reasons or (Government policies specific to that kind
of industry) internal reasons (labour efficiency, management, etc.)

(ii) Financial Risk (RTP):

 These are risks that are associated with the Capital Structure of a Company. A
Company with no Debt Financing, has no financial risk. Higher the Financial
Leverage, higher the Financial Risk.

 These may also arise due to short term liquidity problems, shortage in working
capital due to funds tied in working capital and receivables, etc.

(iii)Default Risk: These arise due to default in meeting the financial obligations on time.
Non-payment of financial dues on time increases the insolvency and bankruptcy
costs.

Question No. 5. (Answer any two questions. Each question carries 10 marks)

5. (a) GMBH GMBH is in software development business. It has recently been awarded a
contract from an Asian country for computerisation of its all offices and branches spread
across the country. This will necessitates acquisition of a super computer at a total cost of
`10 crore. The expected life of computer is 5 years. The scrap value is estimated at `5
crore. However, this value could even be much lower depending upon the
developments taking place in the field of computer technology.
A leasing company has offered a lease contract will total lease rent of `1.5 crore per
annum for 5 years payable in advance with all maintenance costs being borne by
lessee.
The other option available is to purchase the computer by taking loan from the bank with
variable interest payment payable semi-annually in arrears at a margin of 1% per annum
above MIBOR. The MIBOR forecast to be at a flat effective rate of 2.4% for each 6 month
period, for the duration of loan.
Tax rate applicable to corporation is 30%. For taxation purpose depreciation on
computer is allowed at 20% as per WDV method, with a delay of 1 year between the tax
depreciation allowance arising and deduction from tax paid & capital gain tax arising on
sale of computer. You are required to calculate:
I. Compound annualised post tax Cost of Debt.
II. NPV of lease payment v/s purchase decisions at discount rate of 5% & 6%.
III. The break even post tax Cost of debt at which corporation will be indifferent
between leasing and purchasing the computer.
IV. Which option should be opted for? [1+(3+4)+1+1]

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 17
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Answer to 5 (a):

I. First we shall compute annual interest rate as follows:

Annual Interest Rate = (1.024)2 - 1 = 4.9%

Thus, Pre Tax Interest and Post Tax Interest Rate = 4.9% + 1% = 5.9%
= 5.9% (1 - 0.30) = 5.9% x 0.70 = 4.13%

II. Working Notes:

Calculation of Tax Savings on Depreciation (`)

Year Opening value Depreciation Closing value Tax saving @ 30%
1 10,00,00,000 2,00,00,000 8,00,00,000 60,00,000
2 8,00,00,000 1,60,00,000 6,40,00,000 48,00,000
3 6,40,00,000 1,28,00,000 5,12,00,000 38,40,000
4 5,12,00,000 1,02,40,000 4,09,60,000 30,72,000
5 4,09,60,000 81,92,000 3,27,68,000 24,57,600

Capital Gain tax = (`5,00,00,000 - `3,27,68,000) x 30% = `51,69,600 Total

Tax Liability for Year 5 = `51,69,600 - `24,57,600 = `27,12,000

Statement showing NPV Lease Option (`)

Particulars Period Cash flow 5% 6%
(`) PVF PVCO PVF PVCO
Lease payment 0-4 1,50,00,000 4.546 6,81,90,000 4.465 6,69,76,584
(-) Tax savings 1-5 (45,00,000) 4.329 (1,94,80,500) 4.212 (1,89,54,000)

PVCO (A) 4,87,09,500 4,80,22,584

Statement showing NPV in Borrow & Buy decision (`)

Period Cash flows (`) 5% 6%

PVF PVCO PVF PVCO
Initial outlay 0 10,00,00,000 1.000 10,00,00,000 1.000 10,00,00,000
(-) Tax Savings 1 0 0.962 0 0.943 0
2 (60,00,000) 0.907 (54,42,000) 0.890 (53,58,000)
3 (48,00,000) 0.864 (41,47,200) 0.840 (40,32,000)
4 (38,40,000) 0.823 (31,60,320) 0.792 (30,41,280)
5 (30,72,000) 0.784 (240,84,48) 0.747 (22,94,784)
(+) Tax Liability 6 27,12,000 0.746 20,23,152 0.705 19,11,960
(-) Terminal Value 5 (5,00,00,000) 0.784 (3,92,00,000) 0.797 (3,73,50,000)
PVCO (B) 4,76,65,184 4,98,35,896
Net NPV (B) - (A) (10,44,316) 18,13,312

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 18
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

 `10,44,316 
5%  1% 
III.  ` 28,57,628 
 5.37%

IV. Since the Break Even post tax Cost of debt at which corporation will be indifferent
between leasing and purchasing the computer (i.e. IRR of Lease Option) is 5.37%,
which is higher than the actual post tax cost of borrowing of 4.13%. Hence, it is
advised to the corporation to go for borrow and buy option instead of lease option.

5. (b)(i) ‗Fixed Costs are unrelated to output and irrelevant for decision making purpose in all
circumstances‘.- Justify. [3]

Answer to 5(b)(i):

Fixed Costs are unrelated to output and are generally irrelevant for decision making
purpose. However, in the following circumstances, Fixed Costs become relevant for
decision-making:

1. When Fixed Costs are specifically incurred for any contract,

2. When Fixed Costs are incremental in nature,

3. When the fixed portion of Semi-Variable Cost increases due to change in level of
activity consequent to acceptance of a contract,

4. When Fixed Costs are avoidable or discretionary,

5. When Fixed Costs are such that one cost is incurred in lieu of another (the difference in
costs will be relevant for decision-making).

5.(b)(ii) A company wants to invest in a machinery that would cost ` 50,000 at the beginning of
year 1. It is estimated that the net cash inflows from operations will be `18,000 per annum
for 3 years; if the company opts to service a part of the machine at the end of year 1 at
`10,000 and the scrap value at the end of year 3 will be `12,500. However, of the
company decides not to services the part, it will have to be replaced at the end of year 2
at `15,400. But in this case, the machine will work for the 4th year also and get
operational cash inflow of `18,000 for the 4th year. It will have to be scrapped at the end
of year 4 at `9,000. Assuming cost of capital at 10% and ignoring taxes, will you
recommend the purchase of this machine based on the net present value of its cash
flows?
If the supplier gives a discount of ` 5,000 for purchase, what would be your decision? (The
present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091,
0.8264, 0.7513, 0.6830, 0.6209 and 0.5644). [5+2]

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 19
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Answer to 5(b)(ii):

(i) Statement showing evaluation of mutually exclusive proposals

Particulars Time P. V. Factor Service Part Replace Part
Cash Outflows: Amount P.V. Amount P.V.
Cost of machinery 0 1 50,000 50,000 50,000 50,000
Service cost 1 0.9091 10,000 9,091 --- ---
(+) Replace Part 2 0.8264 --- --- 15,400 12,727
P.V. of Cash Outflows (A) 59,091 62,727
Cash Inflows:
Cash inflows from 1-3 2.4869 18,000
operation
1-4 3.1699 44,764 18,000 57,058
Scrap value of machine 3 0.7513 12,500 9,391
4 0.6830 9,000 6,147
P.V. of Cash Inflows (B) 54,155 63,205
NPV (B) – (A) (4,936) 478

Advise: Purchase machine & Replace the part at end of second year.

(ii) If the supplier gives a discount of `5,000 on purchase of machine

Proposals Service Part Replace Part
NPV 64 5,478
Cumulative P.V.A.F. 2.4869 3.1699
Equivalent Annual NPV 25.73 1,728

Advise: Purchase machine A Replace the part at end of second year.

5.(c)(i) S Ltd. has ` 10,00,000 allocated for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined: [6]
Project Amount (`) Profitability Index
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.20

Advice which of the above investment should be undertaken. Assume that projects are
indivisible and there is no alternative use of the money allocated for capital budgeting.

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 20
 Answer to MTP_Final_Syllabus 2012_Jun2015_Set 1

Answer to 5(c)(i):

Computation of NPV of Viable Projects:

Project NPV(`)
1 3,00,000 x 0.22 = 66,000
3 3,50,000 x 0.20 = 70,000
4 4,50,000 x 0.18 = 81,000
5 2,00,000 x 0.20 = 40,000
6 4,00,000 x 0.20 = 80,000

Combinations Initial Cash Outflows (`) Overall N.P.V. (`)

1,3,5 8,50,000 1,76,000
1,4,5 9,50,000 1,87,000
1,5,6 9,00,000 1,86,000
3,4,5 10,00,000 1,91,000
3,5,6 9,50,000 1,90,000
4,6 8,50,000 1,61,000

Advise: Best combination of projects = 3, 4, 5.

Note: Project 2 should not be considered as it provides a negative NPV.

5.(c)(ii) List the relevance of Social Cost Benefit Analysis for Private Enterprise. [4]

Answer to 5(c)(ii):

Relevance of Social Cost Benefit Analysis for Private Enterprises

I. Social cost benefit analysis is important for private corporations also which have a
moral responsibility to undertake socially desirable projects.
II. If the private sector includes social cost benefit analysis in its project evaluation
techniques, it will ensure that it is not ignoring its own long-term interest, since in the
long run only projects that are socially beneficial and acceptable, will survive.
III. Methodology of social cost benefit analysis can be adopted either from the
guidelines issued by the United Nations Industrial Development Organisation (UNIDO)
or the Organisation of Economic Cooperation and Development (OECD). Financial
Institutions e.g. IDBI, IFCI, etc. even insist on social cost benefit analysis of a private
sector project before sanctioning any loan.
IV. Private enterprise cannot afford to lose sight of social aspects of a project.

Board of Studies, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 21