PAPER2 : MANAGEMENT ACCOUNTING AND FINANCIAL ANALYSIS

QUESTIONS
Swap
1. Suppose you are a treasurer of XYZ plc in the UK. XYZ have two overseas subsidiaries,
one based in Amsterdam and one in Switzerland. The Dutch subsidiary has surplus
Euros in the amount of 7,25,000 which it does not need for the next three months but
which will be needed at the end of that period (91 days). The Swiss subsidiary has a
surplus of Swiss Francs in the amount of 9,98,077 that, again, it will need on day 91.
The XYZ plc in UK has a net balance of 75,000 that is not needed for the foreseeable
future.
Given the rates below, what is the advantage of swapping Euros and Swiss Francs into
Sterling?
Spot Rate / 0.6858- 0.6869
91 day Pts 0.0037 0.0040
Spot Rate /CHF 2.3295- 2.3326
91 day Pts 0.0242 0.0228
Interest rates for the Deposits
91 day Interest Rate %pa
Amount of Currency
CHF
0 100,000 1 0
100,001 500,000 2 1
500,001 1,000,000 4 2
Over 1,000,000 5.375 3 1
Merger andAcquisition
2. Cool-cool Ltd.. makes thermal clothing for winter sports and outdoor work, and is
considering acquiring Sking Shell Ltd. which manufactures and sells ski clothing. Sking
Shell is about one quarter of Frozen's size and manufactures its entire product line in a
small rented factory on a mountaintop in Manali. It costs about Rs.10,00,000 a year in
overhead to operate in the factory. Cool-cool Ltd. produces its output in a less popular in
North but more popular north-east locations. Its factory has at least 50% excess
capacity. Cool-cool's plan is to acquire Sking Shell, and combine production operations
in its north-eastern factory, but otherwise run the companies separately.
Sking Shell's beta is 2.0, Treasury bills currently yield 5% and the Nifty Index is yielding
9%. The corpoarte income tax rate for both firms is 40%. Because Sking Shell will no
longer be maintaining its own production facilities, it can be assumed that only a minimal
amount of cash will have to be reinvested to keep its equipment current and for future
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growth. This amount is estimated at Rs. 1,00,000 per year. Selected financial
information for Sking Shell is as follows:
Revenue Rs. 1,25,00,000
EAT Rs. 13,00,000
Depreciation Rs. 6,00,000
(a) Calculate the appropriate discount rate for evaluating the Sking Shell acquisition.
(b) Determine the annual cash flow expected by Cool-cool Ltd.from Sking Shell if the
acquisition is made (don't forget to include the synergy).
(c) Calculate the value of the acquisition to Cool-cool Ltd.assuming the benefits last for
(1) five years, (2) 10 years, and (3) 15 years.
(d) Sking Shell has 2,50,000 shares of stock outstanding. Calculate the maximum price
Cool-cool Ltd. should be willing to pay per share to acquire the firm under the three
assumptions in part c.
(e) If Cool-cool Ltd. is willing to assume the benefits of the Sking Shell acquisition will
last indefinitely but not grow, what should it be willing to pay per share?
3. In above question , assume that the cash flow from the Sking Shell acquisition grows at
10% from its initial value for one year and then grows at 5% indefinitely (starting in the
third year). Calculate the value of the firm and the implied stock price under these
conditions. Use a terminal value at the beginning of the period of 5% growth. What price
premium is implied in dollars and as a percent of market price if Sking Shell's stock is
currently selling at Rs. 62?
Corpoarte Restructing
4. The Nishan Ltd. has 35,000 shares of equity stock outstanding with a book value of
Rs.20 per share. It owes debt Rs.15,00,000 at an interest rate of 12%. Selected
financial results are as follows.
Income and Cash Flow Capital
EBIT Rs. 80,000 Debt Rs.1,500,000
Interest 1,80,000 Equity 7,00,000
EBT (Rs.1,00,000) Rs.2,200,000
Tax 0
EAT (Rs.1,00,000)
Depreciation Rs. 50,000
Principal repayment (Rs. 75,000)
Cash Flow (Rs.1,25,000)
Restructure the financial line items shown assuming a composition in which creditors
agree to convert two thirds of their debt into equity at book value. Assume Nishan will
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pay tax at a rate of 15% on income after the restructuring, and that principal repayments
are reduced proportionately with debt. Who will control the company and by how big a
margin after the restructuring?
Bond Valuation
5. Given a five-year, 8% coupon bond with a face value of Rs.1,000 and coupon payments
made annually, determine its values given it is trading at the following yields: 8%, 6%,
and 10%. Comment on the price and yield relation you observe. What are the
percentage changes in value when the yield goes from 8% to 6% and when it goes from
8% to 10%?
6. Given a two-year, 8% annual coupon bond with a face value of Rs. 1,000 and withannual
coupon payments that is fully taxable and selling at par, and an identical bond that is tax
free, what would the yield and price on the tax-free bond have to be for an investor in a
35% tax bracket to be indifferent between the two bonds?
Lease Evaluation
7. Mr. Lee wants to acquire a mechanized feed spreader that cost 80,000. He intends to
operate the equipment for 5 years, at which time it will need to be replaced. However, it
is expected to have a salvage value of 10,000 at the end of the fifth year. The asset will
be depreciated on a straight-line basis (16,000 per year) over the 5 years, and Lee is in
a 30 percent tax bracket. Two means for financing the feed spreader are available. A
lease arrangement calls for lease payments of 19,000 annually, payable in advance. A
debt alternative carries an interest of 19,000 annually, payable in advance. A debt
alternative carries an interest cost of 10 percent. Debt payments will be at the start of
each of the 5 years using mortgage type of debt amortization.
(a) Using the present-value method, determine the best alternative.
(b) Using the internal-rate-of-return method, which is the best alternative? Does your
answer differ from that to part a ?
Right Issue
8. The stock of the Soni plc is selling for 50 per common stock. The company then issues
rights to subscribe to one new share at 40 for each five rights held.
(a) What is the theoretical value of a right when the stock is selling rights-on?
(b) What is the theoretical value of one share of stock when it goes ex-rights?
(c) What is the theoretical value of a right when the stock sells ex-rights at 50?
(d) John Speculator has 1,000 at the time Soni plc goes ex-rights at 50 per common
stock. He feels that the price of the stock will rise to 60 by the time the rights
expire. Compute his return on his 1,000 if he (1) buys Soni plc stock at 50, or (2)
buys the rights as the price computed in part c, assuming his price expectations are
valid.
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Business Valuation
9. PQR Ltd. is a management consultancy firm in the industry for the last 10 year. It got
listed its equity share 4 years ago at a Recognized Stock Exchange. The company has
pursued a policy of aggressive growth and specializes in providing services to the entities
in high technology and high growth sectors. The company has no leverage element in
their capital structure and financed by equity shares of Rs.50 Crores of Rs.2 per share
(par value).
The companys result for the year ending 31 March 2009, have just announced. Profit
before tax were Rs.12.66 Crores. As per Chairman cum Managing Directors statement
(included in the forecast column of companys Annual Report for the year ending 31
March 2009) earnings might be expected to rise by 4% which is lower than annual rate
than in the recent years. This is due to global recession especially in US Economy.
XYZ Ltd. is another company, in the same business but has been established much
longer. It sources more to traditional business sectors and its earning track record has
been erratic. In most of the daily newspaper poor management have been blamed for
poor performance of company and due to this stock of the company in market had lost its
value for sometimes. The current earning forecast of XYZ Ltd is also 4% for the
foreseeable future. The capital structure of the company consists of Rs.18 crores equity
share capital of Rs.1 (par value). The Profit before tax of the company for the year
ending 31 March 2009 is Rs.11.25 Crores.
PQR Ltd. has recently approached the shareholders of XYZ Ltd with a bid of five new
share in PQR Ltd for every six shares in XYZ Ltd. Otherwise shareholders can accept a
cash payment @Rs.3.45 per share.
Following the announcement of this bid, the market price of PQR Ltd. shares fell by 10%
whereas the price of Shares of XYZ Ltd. rose up by 14%. The P/E ratio and dividend
yield of these two companies and other two companies in same industry immediately
prior to bid announcement is as follows:
Company Share Price (Rs.) P/E Ratio Dividend yield (%)
High Low
PQR Ltd 4.25 3.25 11 2.4
XYZ Ltd 3.50 2.85 7 3.1
LMN Ltd. 1.87 1.22 9 5.2
DEF Ltd. 2.30 1.59 16 2.4
The Corporate Tax Rate is 30%. PQR Ltd is post tax cost of equity is 13% and XYZ Ltds
cost of equity is 11%.
Evaluate, whether the proposed share-for-share offers likely to be beneficial to
shareholders in both PQR Ltd and XYZ Ltd. Please use the information and merger terms
available above.
You may make appropriate assumption to forecast post merger values.
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Dividend Theory
10. Zumo & Co. is a watch manufacturing company and is all equity financed and has paid
up capital Rs.10,00,000 (Rs.10 per shares)
The other data related to the company is as follows:
Year EPS (Rs.) Net Dividend per share (Rs.) Share Price (Rs.)
2004 4.20 1.70 25.20
2005 4.60 1.80 18.40
2006 5.10 2.00 25.50
2007 5.50 2.20 27.50
2008 6.20 2.50 37.20
Zumo & Co. has hired one management consultant, Vidal Consultants to analyze the
future earnings and other related item for the forthcoming years.
As per Vidal Consultantss report
(1) The earnings and dividend will grow at 25% for the next two years.
(2) Earnings are likely at rate of 10% from 3
rd
year and onwards.
(3) Further if there is reduction in earnings growth occurs dividend payout ratio will
increase to 50%
Assuming the tax rate as 33% (not expected to change in the foreseeable future)
calculate the estimated share price and P/E Ratio which analysts now expect for Zumo &
Co., using the dividend valuation model.
You may further assume that post tax cost of capital is 18%.
Financial Services
11. The following financial information related to Norwason India Ltd.:
2008 2007
Rs. 000 Rs. 000
Sales (all on credit) 37,400 26,720
Cost of sales 34,408 23,781
Operating profit 2,992 2,939
Finance costs (interest payments) 355 274
Profit before taxation 2,637 2,665
2008 2007
Rs. 000 Rs. 000 Rs. 000 Rs. 000
Non-current assets 13,632 12,750
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Current assets
Inventory 4,600 2,400
Trade receivables 4,600 2,200
9,200 4,600
Current liabilities
Trade payables 4,750 2,000
Overdraft 3,225 1,600
7,975 3,600
Net current assets 1,225 1,000
14,857 13,750
8% Bonds 2,425 2,425
12,432 11,325
Capital and reserves
Share capital 6,000 6,000
Reserves 6,432 5,325
12,432 11,325
The average variable overdraft interest rate in each year was 5%. The 8% bonds are
redeemable in ten years time.
A factor has offered to take over the administration of trade receivables on a non-
recourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade
receivables collection period of 30 days and Norwason India Ltd will save Rs.1,00,000
per year in administration costs and Rs. 3,50,000 per year in bad debts. A condition of
the factoring agreement is that the factor would advance 80% of the face value of
receivables at an annual interest rate of 7%.
Evaluate whether the proposal to factor trade receivables is financially acceptable.
Foreign Exchange Management
12. On 30
th
June 2009 when a forward contract matured for execution you are asked by an
importer customer to extend the validity of the forward sale contract for US$ 10,000 for a
further period of three months.
Contracted Rate US$1 = Rs.41.87
The US Dollar quoted on 30.6.2009
Spot 40.4800/40.4900
Premium July 0.1100/0.1300
Premium August 0.2300/0.2500
Premium September 0.3500/0.3750
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Calculate the cost for your customer in respect of the extension of the forward contract.
Rupee values to be rounded off to the nearest Rupee.
Margin 0.080% for Buying Rate
Margin0.25% for Selling Rate
13. You sold 1 million value spot to your customer at 1= Rs.54.60 and covered yourself in
Singapore market on the same day when the exchange rate were as under:
Spot US$ 1 = 0.7373/0.7375
Local inter bank US$ 1 = Rs.40.1850/40.1950
(Brokerage paid Rs.2,000)
Calculate the cross rate nearest to the fourth decimal and ascertain profit or loss in the
transaction to the nearest Rupee.
Decision Tree
14. MCL Technologies is evaluating new software for ERP. The software will have a 3-year
life and cost 1,000 thousands. Its impact on cash flows is subject to risk . Management
estimates that there is a 50-50 chance that the software will either save the company
1,000 thousands in the first year or save it nothing at all. If nothing at all, savings in the
last 2 years would be zero. Even worse, in the second year an additional outlay of 300
thousands may be required to convert back to the original process, for the new software
may result in less efficiency. Management attaches a 40 percent probability to this
occurrence, given the fact that the new software failed in the first year. If the software
proves itself, second-year cash flows may be either 1,800 thousands, 1,400
thousands, or 1,000 thousands, with probabilities of 0.20, 0.60, and 0.20, respectively.
In the third year, cash, inflows are expected to be 200 thousands greater or 200
thousands less than the cash flow in period 2, with an equal chance of occurrence.
(Again, these cash flows depend on the cash flow in period 1 being 1,000 thousands.)
All the cash flows are after taxes.
(a) Set up a probability tree to depict the foregoing cash-flow possibilities.
(b) Calculate a net present value for each three-year possibility, using a risk-free rate of
5 percent.
(c) What is the risk of the project?
Derivatives
15. From the following data compute value of call option using the Black-Scholes Option
Pricing Model (OPM).
Stock Price =Rs. 27.00.
Strike Price = Rs. 25.00
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Time to expiration = 6 Months.
Risk-Free Rate = 6.0%.
Stock Return Variance = 0.11.
16. The following information is available for a call option:
Time to expiration (months) 3
Risk free rate 8%
Exercise price 60
Stock price 70
Call price 14
What is the value of a put option if the time to expiration is 3 months, risk free rate is 8%,
exercise price is 60 and the stock price is 70?
17. Following is a two-period tree for a share of stock in CAB Ltd.:
Now S1 One Period
36.30
33.00
30 29.70
27.00
24.30
Using the Binomial model, calculate the current fair value of a regular call option on CAB
Stock with the following characteristics : X = Rs. 28, Risk Free Rate = 5 percent (per sub
period ). You should also indicate the composition of the implied riskless hedge portfolio
at the valuation date.
18. In March, a derivatives dealer offers you the following quotes for June British pound
option contracts (expressed in U.S. dollars per GBP):
MARKET PRICE OF CONTRACT
Contract Strike Price Bid Offer
Call USD 1.40 0.0642 0.0647
Put 0.0255 0.0260
Call 1.44 0.0417 0.0422
Put 0.0422 0.0427
Call 1.48 0.0255 0.0260
Put 0.0642 0.0647
(a) Assuming each of these contracts specifies the delivery of GBP 31,250 and expires
in exactly three months, complete a table similar to the following (expressed in
dollars) for a portfolio consisting of the following positions:
(1) Long a 1.44 call
66
(2) Short a 1.48 call
(3) Long a 1.40 put
(4) Short a 1.44 put
June Net Initial Call 1.44 Call 1.48 Put 1.40 Put 1.44 Net
USD/GBP Cost Profit Profit Profit Profit Profit
1.36
1.40
1.44
1.48
1.52
(b) Graph the total net profit (i.e., cumulative profit less net initial cost, ignoring time
value considerations) relationship using the June USD/GBP rate on the horizontal
axis (be sure to label the breakeven point(s)). Also, comment briefly on the nature of
the currency speculation represented by this portfolio.
(c) If in exactly one month (i.e., in April) the spot USD/GBP rate falls to 1.385 and the
effective annual risk-free rates in the United States and England are 5 percent and
7 percent, respectively, calculate the equilibrium price differential that should exist
between a long 1.44 call and a short 1.44 put position.
19. In mid-May, there are two outstanding call option contracts available on the stock of MGH
Co.:
Call # Exercise Price Expiration Date Market Price
1 50 August 19 8.40
2 60 August 19 3.34
(a) Assuming that you form a portfolio consisting of oneCall #1 held long and twoCalls
#2 held short, complete the following table showing your intermediate steps. In
calculating net profit, be sure to include the net initial cost of the options.
Price of MGH Stock Profit on Profit on Net Profit on
at Expiration Call #1 Position Call #2 Position Total Position
40
45
50
55
60
67
65
70
75
(b) Graph the net profit relationship in Part a, using stock price on the horizontal axis.
What is (are) the breakeven stock price(s)? What is the point of maximum profit?
(c) Under what market conditions will this strategy (which is known as a call ratio
spread) generally make sense? Does the holder of this position have limited or
unlimited liability?
Futures
20. The following information about copper scrap is given:
Spot price : $10,000 per ton
Futures price : $10,800 for a one year contract
Interest rate : 12%
PV (storage costs) : $500 per year
What is the PV (convenience yield) of copper scrap?
Portfolio Management
21. The following data are available to you as a portfolio manager.
Security Expected Return Beta Standard Deviation
O 0.32 1.70 0.50
P 0.30 1.40 0.35
Q 0.25 1.10 0.40
R 0.22 0.95 0.24
S 0.20 1.05 0.28
T 0.14 0.70 0.18
Composite Index 0.12 1.000 0.20
T-bills 0.08 0.00 0.00
(a) In terms of a security market line (SML) , which of the securities listed above
are undervalued? Why?
(b) Assume that a portfolio is constructed using equal portions of the six stocks
listed above.
(i) Why is the expected return of such a portfolio?
(ii) What would the expected return if this portfolio was increased by 40%
through borrowed funds with the cost of borrowing at 12%?
22. Mr. Nirmal Kumar has categorized all the available stock in the market into the following
types:
(i) Small cap growth stocks
(ii) Small cap value stocks
68
(iii) Large cap growth stocks
(iv) Large cap value stocks
Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the
market index. Further more, the sensitivity of returns on these categories of stocks to the
three important factor are estimated to be:
Category of
Stocks
Weight in the
Market Index
Factor I (Beta) Factor II
(Price Book)
Factor III
(Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%
The rate of return on treasury bonds is 4.5%
Required:
(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the
market index.
(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the small cap
value and large cap growth stocks. If the target beta for the desired portfolio is 1,
determine the composition of his portfolio.
Mutual Fund
23. Consider the following information about the return on Classic Mutual Fund, the market
return and the T-bill returns:
Year Classic Mutual Fund Market Index T-bills
1994 17.1 10.8 5.4
1995 -14.6 -8.5 6.7
1996 1.7 3.5 6.5
1997 8.0 14.1 4.3
1998 11.5 18.7 4.1
1999 -5.8 -14.5 7.0
2000 -15.6 -26.0 7.9
2001 38.5 36.9 5.8
2002 33.2 23.6 5.0
2003 -7.0 -7.2 5.3
2004 2.9 7.4 6.2
2005 27.4 18.2 10.0
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2006 23.0 31.5 11.4
2007 -0.6 -4.9 14.1
2008 21.4 20.4 10.7
The following additional information is available regarding the comparative performance
of five mutual funds:
Return (%) Standard
Deviation (%)
Beta
Alpha 1.95 20.03 0.983 0.819
Beta 11.57 18.33 0.971 0.881
Gama 8.41 22.92 1.169 0.816
Rho 9.05 24.04 1.226 0.816
Theta 7.86 15.46 0.666 0.582
From the above information, calculate all the inputs required for determining the Sharpes
Ratio, Treynors ratio and Jensens ratio.
24. Risk appetite, risk aversion and risk premium are sometimes used interchangeably.
Explain this statement. How investors expectation vary with the variation in the level of
risk appetite.
25. Write Short Notes on
(i) What is relationship between EVA and MVA?
(ii) Explain the term Balance Transfer.
(iii) Stack hedging and Strip hedging
SUGGESTED ANSWERS/HINTS
1. Individual Basis
Holland Total
7,25,000 x 0.02 x 91/360 = 3,665.28 7,28,665.28 = 5,03,434.84
(728,665.28x0.6909)
Switzerland
CHF 9,98,077x 0.005x91/360 =CHF1,261.46 CHF 9,99,338.46 = 4,33,496.05
(9,99,338.462.3053)
UK
75,000x 0.01x 91/365 = 186.99 75,186.99
Total GBP at 91 days 10,12,117.88
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Swap to Sterling
Sell 7,25,000(Spot at 0.6869) buy 4,98,002.50
Sell CHF 9,98,077(Spot at 2.3295) buy 4,28,451.16
Independent GBP amount 75,000.00
1,001,453.66
Interest (1,001,453.66 x 0.05375 x 91/365) 13,420.16
Total GBP at 91 days 1,014,873.82
Less: Total GBP at 91 days as per individual basis 1,012,117.88
Net Gain 2,755.94
2. (a) k
SS
= k
RF
+ (k
M
k
RF
)
SS
= 5% + (9% 5%) 2.0
= 13%
(b) Cash Flow: (Rs.000)
EAT 1,300
Depreciation 600
Operating cash flow 1,900
Savings on factory operation after tax 600
Less reinvested cash (100)
2,400
(c) Value of Sking Shell Acquisition
Planning Horizon
(Rs.000)
5 yrs 10 yrs 15 yrs
Yearly cash flow Rs.2,400 Rs.2,400 Rs.2,400
PVFA
13,n
3.5172 5.4262 6.4624
Value of acquisition Rs.8,441 Rs.13,023 Rs.15,510
(d) Divide by # shares 250,000 250,000 250,000
Offer price Rs. 33.76 Rs. 52.09 Rs. 62.04
(e) Rs.24,00,000/0.13 = Rs.1,84,62,000
Rs.1,84,62,000/2,50,000 = Rs.73.85
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3. (Rs. 000)
Year 1 2 3
Cash flow Rs. 2,400 Rs. 2,640 Rs. 2,772
Value at end of year 2 =
05 . 0 13 . 0
772 , 2 . Rs

=Rs. 34,650
(Rs. 000)
PV = Rs. 2,400[PVF
13,1
] + Rs. 2,640[PVF
13,2
] + Rs. 34,650[PVF
13,2
]
= Rs. 2,400(0.8850) + Rs. 2,640(0.7831) + Rs. 34,650(0.7831)
= Rs. 2,124 + Rs. 2,067 + Rs. 27,134
= Rs. 31,325
Price per share =
000 , 50 , 2 . Rs
000 , 25 , 13 , 3 . Rs
= Rs. 125.30
Premium = Rs. 125.30 Rs. 62 = Rs. 63.30,
Premium is (Rs. 63.30/Rs. 62) = 102.10% of market price.
4. Creditors would convert Rs.10,00,000 in debt to equity by accepting
Rs.1,000,000/Rs.20= 50,000 shares of stock.
The remaining Rs.500,000 of debt would generate interest of
Rs.500,000 0.12 =Rs.60,000
Repayment of principal would be reduced by two thirds to Rs.25,000 per year.
The result is as follows
Income and Cash Flow Capital
EBIT Rs. 80,000 Debt Rs. 500,000
Interest 60,000 Equity Rs. 1,700,000
EBT Rs. 20,000 Rs .2,200,000
Tax 3,000
EAT Rs. 17,000
Depreciation 50,000
Principal repayment (25,000)
Cash Flow Rs. 42,000
After the restructuring there will be a total of (35,000+50,000) 85,000 shares of equity
stock outstanding. The original shareholders will still own 35,000 shares (approximately
41%), while the creditors will own 50,000 shares (59%). Hence the creditors will control
the company by a substantial majority.
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5.
The answer shows the inverse relationship that exists between the price of a bond and its
rate of return.
From 8% to 6%, the percentage change in value is 8.425%; from 8% to 10%, the
percentage change in value is 7.582%.
6. For the investor to be indifferent, the tax-free bonds yield would have to be equal to the
taxable bonds after-tax yield. Given a 35% tax rate, the taxable bonds after-tax yield is
5.2%:
ATY = (1-0.35)0.08 =0.052
Thus, the tax-free bond would have to yield 5.2% for the investor to be indifferent. Given
a 5.2% discount rate, the price of the tax-free bond would have to be Rs. 1,051.92:
7. (a) Lease Alternative:
(1) (2) (3) (4)
End of
Year
Lease
Payment ()
Tax Shield
(1) x 0.30
()
Cash Out
Flow
(1) - (2) ()
PVF @ 7
%*
PV of Cash
Outflows ()
0 19,000 0 19,000 1 19,000
1-4 19,000 5,700 13,300 3.3872 45,050
5 5,700 (5,700) 0.713 (4,064)
59,986
* 10% (1-0.30)
The present value of cash outflows is 59,986.
18 . 924 . Rs
) 10 . 1 (
1000
10 . 0
) 10 . 1 / 1 ( 1
80
) 10 . 1 (
1000
) 10 . 1 (
80
V
25 . 084 , 1 . Rs
) 06 . 1 (
1000
06 . 0
) 06 . 1 / 1 ( 1
80
) 06 . 1 (
1000
) 06 . 1 (
80
V
000 , 1 . Rs
) 08 . 1 (
1000
08 . 0
) 08 . 1 / 1 ( 1
80
) 08 . 1 (
1000
) 08 . 1 (
80
V
5
1 t
5
5
5 t
0
5
1 t
5
5
5 t
0
5
1 t
5
5
5 t
0
= +
(

= + =
= +
(

= + =
= +
(

= + =
=
=
=
92 . 1051
) 052 . 1 (
1000 80
) 052 . 1 (
80
P
2
0
=
+
+ =
73
(b) Debt Alternative:
Annual debt repayments are:
Let X be the annual installment for loan repayment
Then80,000 = X + 3.1699X (3.1699 = PV factor for 4-year annuity at 10%)
X = 80,000/4.1699
X =19,185
End of Year Debt Payment () Principal Amount
Owing()
Annual Interest ()
0 19,185 60,815 0
1 19,185 47,712 6,082
2 19,185 33,298 4,771
3 19,185 17,443 3,330
4 19,187 0 1,774
The principal amount of 80,000 is reduced by the amount of the first payment of
19,185 to give 60,815 at time 0. The last debt payment is slightly higher due to
rounding.
Statement showing the Cash Outflows (Debt Alternative)
(1) (2) (3) (4) (5) (6)
End
of
Year
Debt
Repayment
()
Interest
()
Depreciation
()
Tax
Shield
0.30x
[(2)+(3)]
()
Out-
flows
(1) - (4)
()
PV @
7%
PV
Cash
of
Out
flows
()
0 19,185 0 0 0 19,185 1 19,185
1 19,185 6,082 16,000 6,625 12,560 0.9346 11,738
2 19,185 4,771 16,000 6,231 12,954 0.8734 11,315
3 19,185 3,330 16,000 5,799 13,386 0.8163 10,927
4 19,187 1,774 16,000 5,332 13,855 0.7629 10,570
5 0 0 16,000 4,800 (4,800) 0.7130 (3,422)
5 (7,000) 0.7130 (4,991)
55,322
Residual value x (1 - 0.30)
Conclusion: As the present value of cash outflows under the debt alternative is
lower i.e. 55,322 versus 59,986, hence debt option would be preferred.
74
(b) Schedule of Cash Flows: IRR Analysis of Lease
(1) (2) (3) (4) (5) (6)
End
of
Year
Cost
()
Lease
Payment
()
Depreciation
()
Excess
Tax
Shield
0.30x (L-
D)
()
Post tax
Residual
Value
()
Net cash
Flows
()
0 80,000 19,000 0 0 61,000
1 19,000 16,000 900 (18,100)
2 19,000 16,000 900 (18,100)
3 19,000 16,000 900 (18,100)
4 19,000 16,000 900 (18,100)
5 0 16,000 900 7,000 (6,100)
Solving for the internal rate of return for the last column, we find it to 10.11 percent.
The after tax cost of borrowing of 7 percent is lower, and it dominates. The answer
is the same as in the present value method of analysis, as we would expect.
8. (a)
67 . 1
1 5
40 50
1 N
S P
R
0
0
=
+

=
+

=
(b)
( ) ( )
48.33
6
40 5 50
1 N
S N P
P
0
x
=
+
=
+
+
=
(c) 00 . 2
5
40 50
N
S P
R
x
x
=

=
(d) (1) 1,000/50 =20 shares x 60 = 1,200
1,200- 1,000 = 200
(2) 1,000 / 2 = 500 rights X 4* = 2,000
2,000-1,000 = 1,000
*R
x
= (60 - 40)/5 = 4
9. Working Notes:
PQR Ltd. XYZ Ltd Total
Profit before tax (Rs.crore ) 12.66 11.25 23.91
Tax @ 30% 3.80 3.38 7.18
Profit After tax 8.86 7.87 16.73
No. of Shares (Crores) 25 18 40
Earning Per share (Rs.) 0.3544 0.437 0.4183
PE Ratio before Bid 11 7
75
Pre Bid Price of share (Rs.) 3.90 3.06
Market value of company ( Rs. Crore) 97.50 55.08 152.058
No. of new shares (Post Bid) (Crores) 25 15 40
% of Combined Entity owned (%) 62.50 37.50 100
Value of original shareholders 95.36 57.22 152.58
Price Per share/Post Bid Price announcement 3.81 3.18
(95.36/25) (57.22/18)
Thus from above it can be said that in absence of any synergy benefit arising from such
merger there will be a transfer of wealth from PQR Ltd. to XYZ Ltd. based on the terms of
this offers.
In reality, the price of XYZ Ltd 5 shares is likely to be influenced by the value of cash
alternative and the price that will be observed in the market is likely to be below Rs.3.45
per share.
The major question here is what will be P/E Ratio after the merger. If director of PQR Ltd.
expect there own pre-bid P/E ratio to be applied to the combind earnings. In such case
the market value and share price would be.
Market Value. Rs. 16.73Crores 11 = Rs. 184.03 Crores.
share Per 60 . 4 . Rs
crores 40
184.03 Rs.
Price Share = =
Calculation of Gain/Loss
(a) As PQR Ltd. Shareholders have exactly the same number of shares as they did
before the merger. There share would have rise by 18% as calculated below.
100
90 . 3 . Rs
90 . 3 . Rs 60 . 4 . Rs

(b) XYZ Ltds shareholders have five-sixth the number of their old shares. Their share
value might therefore be expected to rise by 25% as calculated below.
100
06 . 3 . Rs
06 . 3 . Rs * 83 . 3 . Rs

6
5
60 . 4 *
The shareholders of XYZ Ltd are taking more gain from merger in share exchange
because cash alternative is lower and unlikely to be accepted, although it is an
assured amount. The cash offer the premium only to 12.7% calculated as follows.
% 7 . 12 100
06 . 3 . Rs
06 . 3 . Rs 45 . 3 . Rs
= |
.
|

\
|
76
Alternative Method.
We can also use the Dividend Valuation Model by using Gordons Model the price of
Share of PQR Ltd. will be
4.09 Rs.
4% 13%
1.04 0.3544
g - Ke
EPS
=

= =
Using the same assumption the value of XYZ Ltd. would be:
9 Rs.6.4
4% 11%
1.04 0.437
g Ke
EPS
=

=
On the basis of above alternative model share of PQR Ltd is under valued slightly.
Whereas the share of XYZ Ltd is substantially undervalued, may be market is doubtful
about growth prospects due to previous disappointments. If we believe PQR Ltd.s
forecast the PQR Ltd. are getting XYZ Ltds share cheap and especially so if any XYZs
share holders accept the cash offer Rs. 3.45 per share
10. (a) The formula for the Dividend valuation Model is
g K
D
P
e
1
0

=
K
e
= Cost of Capital
g = Growth rate
D
1
= Dividend at the end of year 1
On the basis of the information given, the following projection can be made:
Year DPS (Rs.) PVF @18% PV of DPS (Rs.)
2009 3.13 0.847 2.65
2010 3.91 0.718 2.81
2011 5.33* 0.609 3.25
8.71
*Payout Ratio changed to 50%.
After 2011, the perpetuity value assuming 10% constant annual growth, is:
D
1
= Rs. 5.33 110% = Rs. 5.863
Therefore P
o
from the end of 2011
Rs.73.29
0.10 0.18
5.863 Rs.
=

This must be discounted back to the present value, using the 3 year discount factor
after 18%.
77
Rs.
Present Value of P
0
(Rs. 73.29 0.609) 44.63
Add: Dividends 2009 to 2011 8.71
Expected Market Price of Share 53.34
(b) P/E Ratio
Share Per Earning
) (P Share of Price Market Expected
Ratio E P
1
=
8.60
6.20 Rs.
53.34 Rs.
= =
11.
Current receivables Rs.46,00,000
Receivables under factor (Rs. 3,74,00,000 x 30/365) Rs.30,74,000
Reduction in receivables (Rs. 46,00,000 Rs. 30,74, 000) Rs.15,26,000
Computation of Net Cost of Factoring
(Rs.)
Reduction in finance cost (Rs. 15,26,000 x 0.05) per year (76,300)
Administration cost savings per year (1,00,000)
Bad debt savings per year (3,50,000)
Factors annual fee (3,74,00,000 x 0.03) per year 11,22,000
Extra interest cost on advance
Rs. 30,74,000 x 80% x (7% 5%) per year 49,184
Net cost of factoring 6,44,884
The factors offer cannot be recommended, since the evaluation shows no financial
benefit arising.
12. This extension of forward Contract involves following steps
1. Cancel the contract at TT buying rate.
2. Rebook the contract for three months at the current rate of exchange.
Accordingly
Step 1: Cancel the contract at TT buying rate on 30.6.2009
Rs.
Spot US$ 1 40.4800
Less: Margin 0.080% 0.0324
40.4476
78
Hence TT buying rate Rs.40.45 (Rounded off)
US$ 10,000 @ Rs.40.45 Rs.4,04,500/-
US$ 10,000@ Rs.41.87 Rs.4,18,700/-
Difference in favour of the bank Rs. 14,200/-.
Step 2: New contract to be booked at the appropriate forward rate.
Three months forward rate is as under:
US$ 1 Rs.40.4900 Spot Selling
Add: September Premium Rs. 0.3750
Rs. 40.8650
Add: Margin (0.25%) Rs. 0.1022
Rs. 40.9672
Forward rate to be quoted to the customer is US$ 1 = Rs. 40.97
Thus cost to customer Rs. 14,200/-.
13. Our cost of 1 million
Cross rate Rs. 40.1950/0.7373 = Rs. 54.5165
1 Million @ 54.5165 Rs. 5,45,16,500
Brokerage Rs. 2,000
Rs. 5,45,18,500
Proceeds of sale to customer @ Rs.54.6000 Rs. 5,46,00,000
Profit Rs. 81,500
14. (a)
79
Tabular Presentation
Period 0 Period 1 Period 2 Period 3 Overall
Cash Flow
Thousands

Prob. Cash Flow

Thousands

Cond.
Prob.
Cash Flow
Thousands

Cond.
Prob.
Cash Flow
Thousands

Joint
Prob
Present
Value
Thousands

0.4 -300 1.0 0 0.2 -1,272

0.5 0
0.6 0 1.0 0 0.3 -1,000
0.5 800 0.05 1,550
-1,000
0.2 1,000
0.5 1,200 0.05 1,896
0.5 1,000 0.5 1,200 0.15 2,259
0.6 1,400
0.5 1,600 0.15 2,604
0.5 1,600 0.05 2,967
0.2 1,800
0.5 2,000 0.05 3,313
(b) The expected value of net present value of the project is found by multiplying
together the last two columns above and totaling them as follows.
(c) The standard deviation is :
[0.2(-1,272-661)
2
+ 0.3(-1,000-661)
2
+0.05(1,550-661)
2
+ 0.05(1,896 -661)
2
+0.15(2,259-661)
2
+0.15(2,604-661)
2
+0.05(2,967-661)
2
+0.05(3,313-661)
2
]
1/2
=
1,805 thousands
Thus, the dispersion of the probability distribution of possible net present values is
very wide. In turn, this is due to 50 percent probability of a zero outcome or less.
15. The input variables are:
S = Rs.27.00; X = Rs. 25.00; r
RF
= 6.0%; t = 6 months = 0.5 years; and o
2
= 0.11
Now, we proceed to use the OPM:
V = Rs.27[N(d
1
)] - Rs.25e
-(0.06)(0.5)
[N(d
2
)]
o
o
=
|
|
.
|

\
|
o
+ +
|
.
|

\
|
= T d d and
T
T
2
r
x
s
In
d
1 2
2
1
d
1
=
) 7071 . 0 )( 3317 . 0 (
) 5 . 0 )]( 0.11/2 06 . 0 [( ) 25 27/Rs. Rs. ln( + +
=
2345 . 0
0575 . 0 0770 . 0 +
= 0.5736.
80
d
2
= d
1
- (0.3317)(0.7071) = d
1
- 0.2345
= 0.5736 - 0.2345 = 0.3391.
N(d
1
) = N(0.5736) = 0.5000 + 0.2168 = 0.7168.
N(d
2
) = N(0.3391) = 0.5000 + 0.1327 = 0.6327.
Therefore,
V = Rs. 27(0.7168) - Rs.25e
-0.03
(0.6327) = Rs. 19.3536 - Rs. 25(0.97045)(0.6327)
= Rs. 19.3536 - Rs. 15.3500 = Rs. 4.0036 ~ Rs. 4.00.
Thus, under the OPM, the value of the call option is about Rs. 4.00.
16. According to put-call parity theorem
P
0
=C
0
+
rt
e
E
S
0
= 14 +
25 . 08 .
e
60

70
= 14 +
0202 . 1
60
70 = 2.812
17. u = 33.00/30.00 = 36.30/33.00 = 1.10 d = 27.00/30.00 = 24.30/27.00 = 0.90
r = (1 + .05)
1/2
= 1.0247
p =
90 . 0 10 . 1
90 . 0 0247 . 1
d u
d r

=0.1247/0.20 =0.6235
C
uu
= Max [0, 36.30 28] = 8.30
C
ud
= Max [0, 29.70 28] = 1.70
C
dd
= Max [0, 24.30 28] = 0
C
U
=
( )( ) ( )( )
025 . 1
70 . 1 3765 . 0 30 . 8 6235 . 0 +
=
025 . 1
64 . 0 175 . 5 +
= 5.815/1.025 = Rs. 5.675
81
C
U
=
( )( ) ( )( )
025 . 1
00 . 0 3765 . 0 70 . 1 6235 . 0 +
=
025 . 1
05995 . 1
= Rs. 1.0340
C
U
=
( )( ) ( )( )
025 . 1
0340 . 1 3765 . 0 675 . 5 6235 . 0 +
=
025 . 1
3895 . 0 538 . 3 +
= Rs. 3.83
h = (33.00 27.00)/( 5.681.03) = 6.00/4.65 = 1.29
18. (a) Initial Cost
Cost/Contract x 31,250
long 1.44 Call 0.0422 ($1,318.75)
short 1.48 Call 0.0255 $ 796.88
long 1.40 Put 0.0260 ($ 812.50)
short 1.44 Put 0.0422 $1,318.75
($ 15.62)
J une Net Initial Long Call Short Call Long Put Short Put Total Net
USD/GBP Cost 1.44 Profit 1.48 Profit 1.40 Profit 1.44Profit Profit
1.36 ($15.62) 0 0 1250 -2500 ($1,265.62)
1.40 ($15.62) 0 0 0 -1250 ($1,265.62)
1.44 ($15.62) 0 0 0 0 ($15.62)
1.48 ($15.62) 1250 0 0 0 $1,234.38
1.52 ($15.62) 2500 -1250 0 0 $1,234.38
Example: Long Call 1.44 profit = (1.48 1.44) x 31,250 = $1250
(b)
This position resembles a bull vertical spread. The purchaser of this portfolio is
probably moderately bullish on the exchange rate. We see this from the willingness
to give up the extreme upside in exchange for limiting the downside.
82
(c) This is a simple application of put-call parity
C- P = R * exp(-rf * dt) - X *exp(-rd *dt)
where R is the exchange rate (1.385), X is the exercise price (1.44)
rd (rf) is the domestic (foreign) risk-free rate,
dt is the time to expiration.
C- P = 1.385*exp(-.07*.1667) - 1.44*exp(-.05*.1667) = ($0.0591)
19. (a) Price of MGH Profit on Profit on Net Profit on
Stock at Expiration Initial Cost Call #1 Position Call #2 Position Total Position
40 (1.72) 0.00 0.00 (1.72)
45 (1.72) 0.00 0.00 (1.72)
50 (1.72) 0.00 0.00 (1.72)
55 (1.72) 5.00 0.00 3.28
60 (1.72) 10.00 0.00 8.28
65 (1.72) 15.00 (10.00) 3.28
70 (1.72) 20.00 (20.00) (1.72)
75 (1.72) 25.00 (30.00) (6.72)
(b)
Breakeven points are $51.72 and $68.28. Maximum profit occurs at $60.
Maximum profit occurs when the short calls are at-the-money; at prices above $60,
the losses on the short calls reduce profit.
Breakeven on the low side occurs at the long call strike price ($50) plus sufficient
stock price increase to cover the positions cost ($1.72). This equals $51.72.
Breakeven on the high side occurs with the positions cost ($1.72), profit on the call
(P-$50), and loss of the short calls 2($60-P) equal zero: (P-$50) + 2($60-P) - $1.72
= 0which occurs when price = $68.28
83
(c) The user of this position is betting on low volatility (that prices will stay between
breakeven points). The holder has limited liability for substantial price declines and
unlimited liability for substantial price increases.
20.
1
rate) free - Risk (1
price Futures
+
=
yield e convenienc of
value Present
costs storage
- of value esent Pr price Spot +
( )
1
12 . 1
800 , 10
=10,000 + 500 Present value of convenience yield
Hence the present value of convenience yield is $857.14 per ton.
21. (a)
Security Expected Return Beta
()
Required Return
=0.08 + 0.04
Under Valued
Security
O 0.32 1.70 0.148 UVS
P 0.30 1.40 0.136 UVS
Q 0.25 1.10 0.124 UVS
R 0.22 0.95 0.118 UVS
S 0.20 1.05 0.122 UVS
T 0.14 0.70 0.108 UVS
UVS = Under Valued Security
All the securities listed above are undervalued because their expected returns plot
above the SML.
(b) (i) Expected return on the portfolio
=
6
1
(0.32 + 0.30 + 0.25 + 0.22 + 0.20 + 0.14) = 0.2383
(ii) Expected return on the portfolio
R
P
= XR
M
(X 1) R
P
= (1.4) (0.2383) (0.4) (0.12) = 0.33362 0.048 = 0.28562
22. (a) Method I
Portfolios return
Small cap growth = 4.5 + 0.80 x 6.85 + 1.39 x (-3.5) + 1.35 x 0.65 = 5.9925%
Small cap value = 4.5 + 0.90 x 6.85 + 0.75 x (-3.5) + 1.25 x 0.65 = 8.8525%
Large cap growth = 4.5 + 1.165 x 6.85 + 2.75 x (-3.5) + 8.65 x 0.65 = 8.478%
Large cap value = 4.5 + 0.85 x 6.85 + 2.05 x (-3.5) + 6.75 x 0.65 = 7.535%
Expected return on market index
0.10 x 8.8525 + 0.25 x 5.9925 + 0.15 x 7.535 + 0.50 x 8.478 = 7.7526%
84
Method II
Expected return on the market index
= 4.5% + [0.1x0.9 + 0.25x0.8 + 0.15x0.85 + 0.50x1.165] x 6.85 + [(0.75 x 0.10 +
1.39 x 0.25 + 2.05 x 0.15 + 2.75 x 0.5)] x (-3.5) + [{1.25 x 0.10 + 1.35 x 0.25 +
6.75 x 0.15 + 8.65 x 0.50)] x 0.65
= 4.5 + 6.85 + (-7.3675) + 3.77 = 7.7525%.
(b) Using CAPM,
Small cap growth = 4.5 + 6.85 x 0.80 = 9.98%
Small cap value = 4.5 + 6.85 x 0.90 = 10.665%
Large cap growth = 4.5 + 6.85 x 1.165 = 12.48%
Large cap value = 4.5 + 6.85 x 0.85 = 10.3225%
Expected return on market index
= 0.10 x 10.665 + 0.25 x 9.98 + 0.15 x 10.3225 + 0.50 x 12.45 = 11.33%
(c) Let us assume that Mr. Nirmal will invest X
1
% in small cap value stock and X
2
% in
large cap growth stock
X
1
+ X
2
= 1
0.90 X
1
+ 1.165 X
2
= 1
0.90 X
1
+ 1.165(1 X
1
) = 1
0.90 X
1
+ 1.165 1.165 X
1
= 1
0.165 = 0.265 X
1
265 . 0
165 . 0
= X
1
0.623 = X
1
, X
2
= 0.377
62.3% in small cap value
37.7% in large cap growth.
23.
Classic (R
i
) Market Index (R
m
) T-bills (R
p
) R
i
R
p
R
m
R
p
17.1 10.8 5.4 11.70 5.4
-14.6 -8.5 6.7 -21.30 -15.20
1.7 3.5 6.5 -4.8 -3.00
8.0 14.1 4.3 3.7 9.8
11.5 18.7 4.1 7.4 14.6
-5.8 -14.5 7.0 -12.8 -21.5
-15.6 -26.0 7.9 -23.5 -33.9
85
Sharpes measure index
S = R
p
R
p
/
p
Where,
R
p
= Average Return on portfolio
R
f
= Risk-free rate of return

p
= Standard deviation of portfolio
Classic Mutual Fund- S
p
= R
p
- R
f
/
p
= 9.407 7.360/16.4 = 0.125
Market Index- S
p
= R
m
R
f
/
m
= 8.267 7.360/17.126 = 0.053
Classic Mutual Fund is better on the basis of the Sharpes measure.
Treynors measure
T = R
p
R
f
/
p

p
= Beta value of portfolio.
Using regression technique to fine Beta
b =
2
2
x n x
y x n xy


After making calculation by taking Market Index as (x) and Classic Mutual Fund as (y) the
values are
Market Index (x) (x)
2
Classic (y) (y)
2
(xy)
10.8 116.64 17.1 292.41 184.68
-8.5 72.25 -14.6 213.16 124.1
3.5 12.25 1.7 2.89 5.95
14.1 198.81 8.0 64.00 112.8
18.7 349.69 11.5 132.25 215.05
-14.5 210.25 -5.8 33.64 84.1
38.5 36.9 5.8 32.7 31.1
33.2 23.6 5.0 28.2 18.6
-7.0 -7.2 5.3 -12.3 -12.5
2.9 7.4 6.2 -3.3 1.2
27.4 18.2 10.0 17.4 8.2
23.0 31.5 11.4 11.6 20.1
-0.6 -4.9 14.1 -14.7 -19.0
21.4 20.4 10.7 10.7 9.7
Average 9.406 Average 8.267 Average 7.36
Standard
Deviation 16.40
Standard Deviation
17.126
Standard
Deviation 2.815
86
-26.0 676.00 -15.6 243.36 405.6
36.9 1361.61 38.5 1482.25 1420.65
23.6 556.96 33.2 1102.24 783.52
-7.2 51.84 -7.0 49.00 50.4
7.4 54.76 2.9 8.41 21.46
18.2 331.24 27.4 750.76 498.68
31.5 992.25 23.0 529.00 724.5
-4.9 24.01 -0.6 0.36 2.94
20.4 416.16 21.4 457.96 436.56
x
2
= 5424.72
y = 9.406
y = 141.1
x = 8.267
y
2
= 5361.69 n=15
xy = 5070.99.
Substituting values in the above equation
b =
2
) 267 . 8 ( X 15 72 . 5424
267 . 8 X 406 . 9 X 15 99 . 5070

=
57 . 4399
59 . 3904
=0.88
a = y - x b = 9.406 0.88 x 8.267 = 2.13.
From above calculation Beta value of security = 0.88
Treynors measure of Classic Mutual Fund - T
1
= 9.407 7.360/0.88 = 2.32
Treynors measure of Market Index- T
m
= 8.267 7.360/1.00 = 0.907
Jensens performance measure
jt R - R
ij
=
j
+
j
( mt R - R
ft
)
Where,
jt R = Average return on portfolio j for period t
R
ft
= Risk less rate of interest for period t

j
= Intercept that measures the forecasting ability of the portfolio manager

j
= A measure of systematic risk
mt R = Average return of a market portfolio for period t.
Substituting values in the above equation = 9.406 7.360 =
j
+ 0.88 (8.267 7.360)

i
= 2.046 0.798 = 1.248
87
24. Risk appetite, risk aversion and risk premium are sometimes used interchangeably. They
are, however, distinctly different. Risk aversion is an intrinsic attribute of investors that
leads to the tendency to avoid risk unless adequately compensated. In simple terms, it is
the degree to which investors abhor uncertainty surrounding their investment.
Risk appetite is the willingness to bear risk. It consists of two components. One is the
degree to which investors dislike the associated uncertainty and the other component is
the level of that uncertainty.
Risk premium is the reward for holding a risky investment rather than a risk-free one. It
measures the additional returns that investors require to hold assets whose returns are
more variable than those of low risk ones.
When investors are unwilling to tolerate risk, they require higher returns for bearing risk.
An uncontrollable surge in investor risk appetite can plunge the financial markets into
crisis. On the other hand, collapse of investor appetite for risk will dampen the markets.
When investor risk appetite increases and shifts towards riskier assets, their prices shoot
up, as compared to the less risky ones. One can observe a price rise in low risk assets
relative to riskier investments when sentiments across the market are of diminishing risk
appetite.
Investors with a high risk appetite will invest in aggressive equity instruments in high
risk/high reward sectors. The probability of losing money is as high as is the probability of
reaping rewards. Those with a low risk appetite opt for debt instruments. Between the
two extremes is the category of investors who take moderate risk. Balanced funds or a
mix of equity and debt in their portfolio is best-suited for them.
Sharpe ratio characterises how well the returns of an asset compensates the investor for
the risk he takes. It is the ratio of a portfolio's total returns minus the risk-free rate divided
by standard deviation of the portfolio. It is a measure of performance of the portfolio in
return for bearing risk. Hence, a higher Sharpe ratio implies greater rewards for taking
additional risks. The ratio measures a portfolio's risk-return trade-off, and helps the
investor decide if the investment is worth the risk.
25. (i) Although EVA is used primarily for evaluating management performance, it also is
being used by external analysts to evaluate management with the belief that
superior internal performance should be reflected in a companys stock
performance. Several studies have attempted to determine the relationship between
the two variables (EVA and MVA), and the results have not been encouraging.
Although the stock of firms with positive EVAs has tended to outperform the stocks
of negative EVA firms, the differences are typically insignificant and the relationship
does not occur every year. This poor relationship may be due to the timing of the
analysis (how fast EVA is reflected in stocks) or because the market values (MVAs)
are affected by factors other than EVAfor example, MVA can be impacted by
market interest rates and by changes in future expectations for a firm not
considered by EVAthat is, it appears that EVA does an outstanding job of
evaluating managements past performance in terms of adding value. While one
would certainly hope that superior past performance will continue, there is nothing
certain about this relationship.
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(ii) Home loan repayments are huge commitments that most families face. Sometimes,
there is a huge difference in interest rate between what the borrower currently pays
his bank and what another lender offers. In such a scenario, people consider either
prepaying their loan or switching the lender. Switching to another lender offering
better rates is called balance transfer.
Expenses involved
A balance transfer of the outstanding loan from one bank to another can result in
savings of a few thousand rupees, month after month in your EMIs. Borrowers must
exert due diligence before exploring the balance transfer option. The existing lender
charges a penalty for prepayment and the new lender may seek processing fees.
These expenses must be taken into account while weighing the benefits of a
balance transfer. Some lenders may levy additional switching charges that must be
taken into account as well.
When it works well for you
It makes sense to go ahead with a balance transfer if your net gain is more than one
percent. This is after factoring in the prepayment penalty of two percent and loan
processing charge of 0.5 to one percent. Since lower rates are applicable for a new
borrower (rather than existing borrowers) shop for competitive rates and a good
lender. After the switching exercise, you shouldn't get a rude jolt that the new lender
has increased the rates. So find out if any rate hike is on the cards before switching.
(iii) For longer term hedging programmes, such as a two-year loan with three-monthly
rollover dates, more complicated strategies can be adopted, such as stack hedging
and strip hedging.
With a stack hedge, the total number of contract needed to hedge the loan are
purchased for the month of the first rollover date. At that date, the remaining,
number of contracts necessary are purchased for the next rollover date, and so on.
A strip hedge, on the other hand, treats each three-month segment of the loan as
separate entity, and futures contracts are purchased for each rollover date at the
outset of the loan.