Questions From SM 2020-Sfm

INDEX FOR QUESTIONS FROM STUDY MATERIAL 2020(EXCLUDING
ILLUSTRATIONS)-- SFM
Chap No Chapter Name Page No ICAI Page No

1 Financial Policy and Corporate Strategy 1 1.10
2 Risk Management 2 2.8
3 Security Analysis 03-07 3.31-3.35
4 Security Valuation 08-22 4.24-4.38
5 Portfolio Management 23-38 5.67-5.82
6 Securitization 39 6.10
7 Mutual Funds 40-45 7.17-7.22
8 Derivatives Analysis and Valuation 46-50 8.40-8.44
9 Foreign Exchange Exposure and Risk Management 51-60 9.42-9.51
10 International Financial Management 61 10.28
11 Interest Rate Risk Management 62-64 11.14-11.16
12 Corporate Valuation 65-69 12.25-12.29
13 Mergers, Acquisitions and Corporate Restructuring 70-83 13.38-13.51
14 Startup Finance 84 14.15
1.10 STRATEGIC FINANCIAL MANAGEMENT
Mitsubishi Corporation (MC): New Strategic Direction (charting a new path toward
sustainable growth)
Mitsubishi Corporation has abolished its traditional "midterm management plan" concept of committing
to fixed financial targets three years in the future, in favour of a long-term, circa 2020 growth vision. The
"New Strategic Direction” consists of basic concepts on management policy together with business and
market strategies. It seeks to recognize the Company’s value and upside potential as a sogo
shosha capable of "providing stable earnings throughout business cycles by managing a portfolio
diversified by business model, industry, market and geography".
MC remains dedicated to sustainable growth but as evidenced by its guiding philosophy, the
"Three Corporate Principles", its business activities are even more committed to helping solve
problems in Japan and around the world. Its chief goal is to contribute to sustainable societal
growth on a global scale.
The summary of this New Strategic Direction is:
 Future pull approach eyeing 2020 with a vision to double the business by building a
diversified but focussed portfolio.
 Clear portfolio strategy: Select winning businesses through proactive reshaping of portfolio.
 Grow business and deliver returns while maintaining financial discipline.
TEST YOUR KNOWLEDGE

Theoretical Questions
1. Explain the Interface of Financial Policy and Strategic Management.
2. Write a short note on Balancing Financial Goals vis-a-vis Sustainable Growth.
Answers to Theoretical Questions

1. Please refer paragraph 4
© The Institute of Chartered Accountants of India

1
TEST YOUR KNOWLEDGE

1. Explain the significance of VAR.
2. The Financial Risk can be viewed from different perspective. Explain.
Practical Questions
1. Consider a portfolio consisting of a ` 200,00,000 investment in share XYZ and a
` 200,00,000 investment in share ABC. The daily standard deviation of both shares is 1%
and that the coefficient of correlation between them is 0.3. You are required to determine
the 10-day 99% value at risk for the portfolio?
ANSWERS/ SOLUTIONS
1. Please refer paragraph 3.2
Answers to the Practical Questions
1. The standard deviation of the daily change in the investment in each asset is ` 2,00,000 i.e.
2 lakhs. The variance of the portfolio’s daily change is
V = 22 + 22 + 2 x 0.3 x 2 x 2 = 10.4
σ (Standard Deviation) = 10.4 = ` 3.22 lakhs

Accordingly, the standard deviation of the 10-day change is
` 3.22 lakhs x 10 = ` 10.18 lakh

From the Normal Table we see that z score for 1% is 2.33. This means that 1% of a normal
distribution lies more than 2.33 standard deviations below the mean. The 10-day 99 percent
value at risk is therefore
2.33 × ` 10.18 lakh = ` 23.72 lakh

2
SECURITY ANALYSIS 3.31
Keynes argued that all sorts of consideration enter into the market valuation which is in no way
relevant to the prospective yield. This was confirmed by L. C. Gupta who found that the market
evaluation processes work haphazardly almost like a blind man firing a gun. The market seems to
function largely on hit or miss tactics rather than on the basis of informed beliefs about the long term
prospects of individual enterprises.
(c) Monopolistic Influence – A market is regarded as highly competitive. No single buyer or
seller is supposed to have undue influence over prices. In practice, powerful institutions and big
operators wield grate influence over the market. The monopolistic power enjoyed by them diminishes
the competitiveness of the market.
TEST YOUR KNOWLEDGE

1. Explain the Efficient Market Theory in and what are major misconceptions about this theory?
2. Explain Dow Jones theory.
3. Explain the Elliot Theory of technical analysis.
4. Explain the various indicators that can be used to assess the performance of an economy.
Practical Questions
1. Closing values of BSE Sensex from 6th to 17th day of the month of January of the year 200X
were as follows:
Days Date Day Sensex

1 6 THU 14522
2 7 FRI 14925
3 8 SAT No Trading
4 9 SUN No Trading
5 10 MON 15222
6 11 TUE 16000
7 12 WED 16400
8 13 THU 17000
9 14 FRI No Trading
10 15 SAT No Trading

3
11 16 SUN No Trading
12 17 MON 18000
Calculate Exponential Moving Average (EMA) of Sensex during the above period. The
previous day exponential moving average of Sensex can be assumed as 15,000. The value
of exponent for 31 days EMA is 0.062.
Give detailed analysis on the basis of your calculations.
2. The closing value of Sensex for the month of October, 2007 is given below:
Date Closing Sensex Value

1.10.07 2800
3.10.07 2780
4.10.07 2795
5.10.07 2830
8.10.07 2760
9.10.07 2790
10.10.07 2880
11.10.07 2960
12.10.07 2990
15.10.07 3200
16.10.07 3300
17.10.07 3450
19.10.07 3360
22.10.07 3290
23.10.07 3360
24.10.07 3340
25.10.07 3290
29.10.07 3240
30.10.07 3140
31.10.07 3260
You are required to test the weak form of efficient market hypothesis by applying the run test at 5%
and 10% level of significance.

4
Following value can be used :

Value of t at 5% is 2.101 at 18 degrees of freedom
Value of t at 10% is 1.734 at 18 degrees of freedom
Value of t at 5% is 2.086 at 20 degrees of freedom.
Value of t at 10% is 1.725 at 20 degrees of freedom.
2. Please refer paragraph 2.4.1
1.
Date 1 2 3 4 5
Sensex EMA for EMA
Previous
1-2 3×0.062 2+4
day
6 14522 15000 (478) (29.636) 14970.364
7 14925 14970.364 (45.364) (2.812) 14967.55
10 15222 14967.55 254.45 15.776 14983.32
11 16000 14983.32 1016.68 63.034 15046.354
12 16400 15046.354 1353.646 83.926 15130.28
13 17000 15130.28 1869.72 115.922 15246.202
17 18000 15246.202 2753.798 170.735 15416.937
Conclusion – The market is bullish. The market is likely to remain bullish for short term to
medium term if other factors remain the same. On the basis of this indicator (EMA) the
investors/brokers can take long position.
2.
Date Closing Sensex Sign of Price Charge
1.10.07 2800

5
3.10.07 2780 -
4.10.07 2795 +
5.10.07 2830 +
8.10.07 2760 -
9.10.07 2790 +
10.10.07 2880 +
11.10.07 2960 +
12.10.07 2990 +
15.10.07 3200 +
16.10.07 3300 +
17.10.07 3450 +
19.10.07 3360 -
22.10.07 3290 -
23.10.07 3360 +
24.10.07 3340 -
25.10.07 3290 -
29.10.07 3240 -
30.10.07 3140 -
31.10.07 3260 +
Total of sign of price changes (r) = 8
No of Positive changes = n1 = 11
No. of Negative changes = n2 = 8
2n1n2
µr= +1
n1 + n2
2 × 11× 8
µ = + 1 = 176/19 + 1 = 10.26
11 + 8
∧
2n1n2 (2n1n2 − n1 − n2 )
σ =
r (n1 + n2 )2 (n1 + n2 − 1)
∧
σ = (2 × 11× 8) (22× 11× 8 − 11 − 8) = 176 ×2 157 = 4.252 = 2.06
r (11 + 8) (11 + 8 − 1) (19) (18)

6
Since too few runs in the case would indicate that the movement of prices is not random. We employ
a two- tailed test the randomness of prices.
Test at 5% level of significance at 18 degrees of freedom using t- table
The lower limit
∧
= µ – t × σ =10.26 – 2.101 × 2.06 = 5.932
r
Upper limit
∧
= µ + t × σ =10.26 + 2.101 × 2.06 = 14.588
r
At 10% level of significance at 18 degrees of freedom

Lower limit
= 10.26 – 1.734 × 2.06 = 6.688
Upper limit
= 10.26 + 1.734 × 2.06 = 13.832
As seen r lies between these limits. Hence, the market exhibits weak form of efficiency.
*For a sample of size n, the t distribution will have n-1 degrees of freedom.

7
In the 1970’s Mr. Stephen Alan Ross, professor and economist, introduced the concept of ‘multiple
factors’ that can influence the risk component – motley of ‘macro-economic factors’. So, the basic
idea is to breakdown risks into individual identifiable elements that influence the overall risk in a
proportion (called ‘factor’), and each factor gets assigned its own beta; and the sum total of all the
assets’ ‘sensitivities’ to ‘n’ factors will give the ‘expected rate of return for the asset’.
In a simplistic way, if a particular asset, say a stock, has its major influencers as the ‘interest rate
fluctuations’ and the ‘sectoral growth rate’, then the stocks’ return would be calculated by using the
Arbitrage Pricing Theory (APT) in the following manner:
(a) Calculate the risk premium for both these two risk factors (beta for the risk factor 1 –
interest rate, and beta of the risk factor 2 – sector growth rate; and,
(b) Adding the risk free rate of return.
Thus, the formula for APT is represented as –
R(f) + B1(RP1) + B2(RP2) + …. Bj(RPn)
It is thereby clear that APT strives to model E(R) as ‘a linear function of various macro-economic
factors’ where sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. Note that the APT by itself doesn’t provide for the macro-economic factors that will be
needed to be tested for its sensitivity – however these have to be judicially developed by the
financial analysts keeping in mind the economy they are put in.
TEST YOUR KNOWLEDGE

1. Why should the duration of a coupon carrying bond always be less than the time to its
maturity?
2. Write short notes on Zero coupon bonds.
Practical Questions
1. A company has a book value per share of ` 137.80. Its return on equity is 15% and it
follows a policy of retaining 60% of its earnings. If the Opportunity Cost of Capital is 18%,
what is the price of the share today?
2. ABC Limited’s shares are currently selling at ` 13 per share. There are 10,00,000 shares
outstanding. The firm is planning to raise ` 20 lakhs to Finance a new project.
Required:
What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.

8
SECURITY VALUATION 4.25
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth change from (i) to (ii)? How does right issue increases
shareholders’ wealth?
3. On the basis of the following information:
Current dividend (Do) = ` 2.50

Discount rate (k) = 10.5%
Growth rate (g) = 2%
(i) Calculate the present value of stock of ABC Ltd.
(ii) Is its stock overvalued if stock price is ` 35, ROE = 9% and EPS = ` 2.25? Show
detailed calculation.
4. Piyush Loonker and Associates presently pay a dividend of Re. 1.00 per share and has a
share price of ` 20.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever, what is
the firm’s expected or required return on equity using a dividend-discount model
approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to grow
at a rate of 20% per annum for 5 years and 10% per year thereafter. Now what is the
firm’s expected, or required, return on equity?
5. Capital structure of Sun Ltd., as at 31.3.2003 was as under:
(` in lakhs)
Equity share capital 80
8% Preference share capital 40
12% Debentures 64
Reserves 32
Sun Ltd., earns a profit of ` 32 lakhs annually on an average before deduction of income-
tax, which works out to 35%, and interest on debentures.
Normal return on equity shares of companies similarly placed is 9.6% provided:
(a) Profit after tax covers fixed interest and fixed dividends at least 3 times.
(b) Capital gearing ratio is 0.75.
(c) Yield on share is calculated at 50% of profits distributed and at 5% on undistributed
profits.

9
Sun Ltd., has been regularly paying equity dividend of 8%.

Compute the value per equity share of the company.
6. A Company pays a dividend of ` 2.00 per share with a growth rate of 7%. The risk free rate
is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50.
However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find
out the present as well as the likely value of the share after the decision.
7. Shares of Voyage Ltd. are being quoted at a price-earning ratio of 8 times. The company
retains 45% of its earnings which are ` 5 per share.
You are required to compute
(1) The cost of equity to the company if the market expects a growth rate of 15% p.a.
(2) If the anticipated growth rate is 16% per annum, calculate the indicative market price
with the same cost of capital.
(3) If the company's cost of capital is 20% p.a. & the anticipated growth rate is 19% p.a.,
calculate the market price per share.
8. M/s X Ltd. has paid a dividend of ` 2.5 per share on a face value of ` 10 in the financial
year ending on 31st March, 2009. The details are as follows:
Current market price of share ` 60
Growth rate of earnings and dividends 10%
Beta of share 0.75
Average market return 15%
Risk free rate of return 9%
Calculate the intrinsic value of the share.
9. Saranam Ltd. has issued convertible debentures with coupon rate 12%. Each debenture
has an option to convert to 20 equity shares at any time until the date of maturity.
Debentures will be redeemed at ` 100 on maturity of 5 years. An investor generally requires
a rate of return of 8% p.a. on a 5-year security. As an investor when will you exercise
conversion for given market prices of the equity share of (i) ` 4, (ii) ` 5 and (iii) ` 6.
Cumulative PV factor for 8% for 5 years : 3.993
PV factor for 8% for year 5 : 0.681
10. ABC Ltd. has ` 300 million, 12 per cent bonds outstanding with six years remaining to
maturity. Since interest rates are falling, ABC Ltd. is contemplating of refunding these
bonds with a ` 300 million issue of 6 year bonds carrying a coupon rate of 10 per cent.
Issue cost of the new bond will be ` 6 million and the call premium is 4 per cent. ` 9 million

10
being the unamortized portion of issue cost of old bonds can be written off no sooner the
old bonds are called off. Marginal tax rate of ABC Ltd. is 30 per cent. You are required to
analyse the bond refunding decision.
ANSWERS/SOLUTIONS
1. The company earnings and dividend per share after a year are expected to be:
EPS = ` 137.8 × 0.15 = ` 20.67
Dividend = 0.40 × 20.67 = ` 8.27
The growth in dividend would be:
g = 0.6 × 0.15 = 0.09
Dividend
Perpetual growth model Formula : P0 =
Ke - g
8.27
P =
0 0.18 - 0.09
P0 = ` 91.89
Alternative Solution:
However, in case a student follows Walter’s approach as against continuous growth model given in
previous solution the answer of the question works out to be different. This can be shown as
follow:
Given data:
Book value per share = ` 137.80
Return on equity = 15%
Dividend Payout = 40%
Cost of capital = 18%
∴ EPS = ` 137.80 × 15%
= ` 20.67

11
∴ Dividend = ` 20.67 × 40% = ` 8.27

Walter’s approach showing relationship between dividend and share price can be expressed by
the following formula
Ra
D+ (E - D)
Rc
Vc =
Rc
Where,
Vc = Market Price of the ordinary share of the company.
Ra = Return on internal retention i.e. the rate company earns on retained profits.
Rc = Capitalisation rate i.e. the rate expected by investors by way of return from particular
category of shares.
E = Earnings per share.
D = Dividend per share.
Hence,
.15
8.27 + (20.67 - 8.27) 18.60
Vc = .18 =
.18 .18
= ` 103.35
2. (i) Number of shares to be issued : 5,00,000
Subscription price ` 20,00,000 / 5,00,000 = ` 4
` 1,30,00,000 + ` 20,00,000
Ex-right Pr ice = = ` 10
15,00,000
Value of a Right = ` 10 – ` 4 = ` 6
` 10 − ` 4
Value of a Right Per Share Basis =
2
(ii) Subscription price ` 20,00,000 / 2,50,000 = ` 8
` 1,30,00,000 + ` 20,00,000
Ex-right Pr ice = = ` 12
12,50,000
Value of a Right = ` 12 – ` 8 = ` 4
` 12 − ` 8
Value of a Right Per Share =
4

12
(iii) Calculation of effect of right issue on wealth of Shareholder’s wealth who is holding,
say 100 shares.
(a) When firm offers one share for two shares held.
Value of Shares after right issue (150 X ` 10) ` 1,500
Less: Amount paid to acquire right shares (50X`4) ` 200
`1,300
(b) When firm offers one share for every four shares held.
Value of Shares after right issue (125 X ` 12) ` 1,500
Less: Amount paid to acquire right shares (25X`8) ` 200
`1,300
(c) Wealth of Shareholders before Right Issue `1,300
Thus, there will be no change in the wealth of shareholders from (i) and (ii).
3. (i) Present Value of the stock of ABC Ltd. Is:-
2.50(1.02)
Vo = = `30/-.
0.105 − 0.02
(ii) Value of stock under the PE Multiple Approach

Particulars
Actual Stock Price ` 35.00
Return on equity 9%
EPS ` 2.25
PE Multiple (1/Return on Equity) = 1/9% 11.11
Market Price per Share ` 25.00
Since, Actual Stock Price is higher, hence it is overvalued.

(iii) Value of the Stock under the Earnings Growth Model
Particulars
Actual Stock Price ` 35.00
Return on equity 9%
EPS ` 2.25
Growth Rate 2%
Market Price per Share [EPS ×(1+g)]/(Ke – g) ` 32.79
= ` 2.25 × 1.02/0.07
Since, Actual Stock Price is higher, hence it is overvalued.

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4. (i) Firm’s Expected or Required Return On Equity

(Using a dividend discount model approach)
According to Dividend discount model approach the firm’s expected or required
return on equity is computed as follows:
D1
Ke = +g
P0
Where,
Ke = Cost of equity share capital or (Firm’s expected or required return
on equity share capital)
D1 = Expected dividend at the end of year 1
P0 = Current market price of the share.
g = Expected growth rate of dividend.
Now, D1 = D0 (1 + g) or ` 1 (1 + 0.12) or ` 1.12, P0 = ` 20 and g = 12% per annum
` 1.12
Therefore, K e = + 12%
` 20
Or, Ke = ` 17.6%
(ii) Firm’s Expected or Required Return on Equity
(If dividends were expected to grow at a rate of 20% per annum for 5 years and 10%
per year thereafter)
Since in this situation if dividends are expected to grow at a super normal growth
rate gs, for n years and thereafter, at a normal, perpetual growth rate of gn beginning
in the year n + 1, then the cost of equity can be determined by using the following
formula:
n
Div 0 (1 + gs ) t
P0 = ∑ (1 + K e ) t
+
Div n + 1
×
1
K e - gn (1 + K e )n
t =1
Where,
gs = Rate of growth in earlier years.
gn = Rate of constant growth in later years.
P0 = Discounted value of dividend stream.

14
Ke = Firm’s expected, required return on equity (cost of equity capital).

Now,
gs = 20% for 5 years, gn = 10%
Therefore,
n
D0 (1 + 0.20) t
P0 = ∑ (1 + K e ) t
+
Div 5 + 1
×
1
K e - 0.10 (1 + K e ) t
t =1
1.20 1.44 1.73 2.07 2.49 2.49 (1 + 0.10) 1

0P = 1 + 2 + 3 + 4 + 5 + × 5
e) e) e) e) e) e)
(1 + K (1 + K (1 + K (1 + K (1 + K K
e- 0.10 (1 + K
or P0 = ` 1.20 (PVF1, Ke) + ` 1.44 (PVF2, Ke) + ` 1.73 (PVF3, Ke) + ` 2.07
Rs. 2.74 (PVF5 , K e )
(PVF4, Ke) + ` 2.49 (PVF5, Ke) +
K e - 0.10
By trial and error we are required to find out Ke

Now, assume Ke = 18% then we will have
P0 = ` 1.20 (0.8475) + ` 1.44 (0.7182) + ` 1.73 (0.6086) + ` 2.07 (0.5158) + ` 2.49
1
(0.4371) + ` 2.74 (0.4371) ×
0.18 - 0.10
= ` 1.017 + ` 1.034 + ` 1.053 + ` 1.068 + ` 1.09 + ` 14.97= ` 20.23
Since the present value of dividend stream is more than required it indicates that Ke
is greater than 18%.
Now, assume Ke = 19% we will have
P0 = ` 1.20 (0.8403) + ` 1.44 (0.7061) + ` 1.73 (0.5934) + ` 2.07 (0.4986) + ` 2.49
1
(0.4190) + ` 2.74 (0.4190) ×
0.19 - 0.10
= ` 1.008 + ` 1.017 + ` 1.026+ ` 1.032 + ` 1.043 + ` 12.76
= ` 17.89
Since the market price of share (expected value of dividend stream) is ` 20.
Therefore, the discount rate is closer to 18% than it is to 19%, we can get the exact
rate by interpolation by using the following formula:

15
NPV at LR
K e = LR + × Δr
NPV at LR - NPV at HR
Where,
LR = Lower Rate
NPV at LR = Present value of share at LR
NPV at HR = Present value of share at Higher Rate
∆r = Difference in rates
(` 20.23 −` 20)
K e = 18% + × 1%
R` 20.23 − ` 17.89
` 0.23
= 18% + × 1%
`2.34 = 18% + 0.10% = 18.10%
Therefore, the firm’s expected, or required, return on equity is 18.10%. At this rate the
present discounted value of dividend stream is equal to the market price of the share.
5. (a) Calculation of Profit after tax (PAT)
`
Profit before interest and tax (PBIT) 32,00,000
Less: Debenture interest (` 64,00,000 × 12/100) 7,68,000
Profit before tax (PBT) 24,32,000
Less: Tax @ 35% 8,51,200
Profit after tax (PAT) 15,80,800
Less: Preference Dividend
(` 40,00,000 × 8/100) 3,20,000
Equity Dividend (` 80,00,000 × 8/100) 6,40,000 9,60,000
Retained earnings (Undistributed profit) 6,20,800
Calculation of Interest and Fixed Dividend Coverage
PAT + Debenture interest PAT + Debenture Interest Net of Tax
= or
Debenture interest + Preference dividend Debenture interest + Preference dividend
15,80,800 + 7,68,000 15,80,800 + 4,99,200
= or
7,68,000 + 3,20,000 7,68,000 + 3,20,000
23,48,800 20,80,000
= or = 2.16 times or 1.91 times
10,88,000 10,88,000

16
(b) Calculation of Capital Gearing Ratio

Fixed interest bearing funds
Capital Gearing Ratio =
Equity shareholders' funds
Preference Share Capital + Debentures 40,00,000 + 64,00,000 1,04,00,000

= = = = 0.93
Equity Share Capital + Reserves 80,00,000 + 32,00,000 1,12,00,000
(c) Calculation of Yield on Equity Shares:

Yield on equity shares is calculated at 50% of profits distributed and 5% on
undistributed profits:
(`)
50% on distributed profits (` 6,40,000 × 50/100) 3,20,000
5% on undistributed profits (` 6,20,800 × 5/100) 31,040
Yield on equity shares 3,51,040
Yield on shares
Yield on equity shares % = × 100
Equity share capital
3,51,040
= × 100 = 4.39% or, 4.388%.
80,00,000
Calculation of Expected Yield on Equity shares

Note: There is a scope for assumptions regarding the rates (in terms of percentage for
every one time of difference between Sun Ltd. and Industry Average) of risk premium
involved with respect to Interest and Fixed Dividend Coverage and Capital Gearing Ratio.
The below solution has been worked out by assuming the risk premium as:
(i) 1% for every one time of difference for Interest and Fixed Dividend Coverage.
(ii) 2% for every one time of difference for Capital Gearing Ratio.
(a) Interest and fixed dividend coverage of Sun Ltd. is 2.16 times but the industry
average is 3 times. Therefore, risk premium is added to Sun Ltd. Shares @
1% for every 1 time of difference.
Risk Premium = 3.00 – 2.16 (1%) = 0.84 (1%) = 0.84%
(b) Capital Gearing ratio of Sun Ltd. is 0.93 but the industry average is 0.75
times. Therefore, risk premium is added to Sun Ltd. shares @ 2% for every 1
time of difference.
Risk Premium = (0.75 – 0.93) (2%)
= 0.18 (2%) = 0.36%

17
(%)
Normal return expected 9.60
Add: Risk premium for low interest and fixed dividend coverage 0.84
Add: Risk premium for high interest gearing ratio 0.36
10.80
Value of Equity Share
Actual yield 4.39
= × Paid-up value of share = × 100 = ` 40.65
Expected yield 10.80
6. In order to find out the value of a share with constant growth model, the value of Ke should
be ascertained with the help of ‘CAPM’ model as follows:
Ke = Rf + β (Km – Rf)
Where,
Ke = Cost of equity
Rf = Risk free rate of return
β = Portfolio Beta i.e. market sensitivity index
Km = Expected return on market portfolio
By substituting the figures, we get
Ke = 0.09 + 1.5 (0.13 – 0.09) = 0.15 or 15%
and the value of the share as per constant growth model is
D1
P0 =
(k e - g)
Where,
P0 = Price of a share
D1 = Dividend at the end of the year 1
Ke= Cost of equity
G = growth
2.00
P0 =
(k e - g)
2.00
P0 = = ` 25.00
0.15 - 0.07

18
Alternatively it can also be found as follows:

2.00 (1.07)
= ` 26.75
0.15 - 0.07
However, if the decision of finance manager is implemented, the beta (β) factor is likely to
increase to 1.75 therefore, Ke would be
Ke = Rf + β (Km – Rf)
= 0.09 + 1.75 (0.13 – 0.09) = 0.16 or 16%
The value of share is
D1
P0 =
(k e - g)
2.00
P0 =
0.16 - 0.07 = ` 22.22
Alternatively it can also be found as follows:

2.00 (1.07)
= ` 23.78
0.16 - 0.07
7. (1) Cost of Capital
Retained earnings (45%) ` 5 per share
Dividend (55%) ` 6.11 per share
EPS (100%) ` 11.11 per share
P/E Ratio 8 times
Market price ` 11.11 × 8 = ` 88.88
Cost of equity capital
 Div  ` 6.11
= ×100  + Growth % = × 100 +15% = 21.87%
 Pr ice  ` 88.88
 Dividend 
(2) Market Price =  
 Cost of Capital(%) - Growth Rate(%) 
` 6.11
= = ` 104.08 per share
(21.87-16)%
` 6.11
(3) Market Price = = ` 611.00 per share
(20-19)%

19
Alternative Solution
As in the question the sentence “The company retains 45% of its earnings which are ` 5 per
share” amenable to two interpretations i.e. one is ` 5 as retained earnings (45%) and
another is ` 5 is EPS (100%). Alternative solution is as follows:
(1) Cost of capital
EPS (100%) ` 5 per share
Retained earnings (45%) ` 2.25 per share
Dividend (55%) ` 2.75 per share
P/E Ratio 8 times
Market Price ` 5 × 8 = ` 40
Cost of equity capital
 Div  ` 2.75
= ×100  + Growth % = × 100 +15% = 21.87%
 Pr ice  ` 40.00
 Dividend  ` 2.75
(2) Market Price =   =
 Cost of Capital(%) - Growth Rate(%)  (21.87 - 16)%
= ` 46.85 per share
` 2.75
(3) Market Price = = ` 275.00 per share
(20 - 19)%
D1
8. Intrinsic Value P0=
k−g
Using CAPM
k = Rf +β (Rm-Rf)
Rf = Risk Free Rate
β = Beta of Security
Rm = Market Return
= 9% + 0.75 (15% - 9%) = 13.5%
2.5 ×1.1 2.75
P= = = ` 78.57
0.135- 0.10 0.035

20
9. If Debentures are not converted its value is as under: -
PVF @ 8 % `
Interest - ` 12 for 5 years 3.993 47.916
Redemption - ` 100 in 5th year 0.681 68.100
116.016
Value of equity shares:-
Market Price No. Total

`4 20 ` 80
`5 20 ` 100
`6 20 ` 120
Hence, unless the market price is ` 6 conversion should not be exercised.

10. 1. Calculation of initial outlay:-
` (million)
a. Face value 300
Add:-Call premium 12
Cost of calling old bonds 312
b. Gross proceed of new issue 300
Less: Issue costs 6
Net proceeds of new issue 294
c. Tax savings on call premium
and unamortized cost 0.30 (12 + 9) 6.3
∴ Initial outlay = ` 312 million – ` 294 million – ` 6.3 million = ` 11.7 million
2. Calculation of net present value of refunding the bond:-

Saving in annual interest expenses ` (million)
[300 x (0.12 – 0.10)] 6.00
Less:- Tax saving on interest and amortization
0.30 x [6 + (9-6)/6] 1.95
Annual net cash saving 4.05

21
PVIFA (7%, 6 years) 4.766

∴ Present value of net annual cash saving ` 19.30 million
Less:- Initial outlay ` 11.70 million
Net present value of refunding the bond ` 7.60 million
Decision: The bonds should be refunded

22
PORTFOLIO MANAGEMENT 5.67
(i) Liquidity Risk – These securities may be saleable in the market.

(ii) Event Risk – Any event that particularly effect the company not economy as a whole
(iii) Market Risk – This is another type of risk though it is not important.
(iv) Human Risk – The judge’s decision on the company in distress also play a big role.
TEST YOUR KNOWLEDGE

1. Write short note on factors affecting decision of investment in fixed income securities.
2. Briefly explain the objectives of “Portfolio Management”.
3. Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions.
Practical Questions
1. A stock costing ` 120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
Required:
(i) Calculate the expected return.
(ii) Calculate the Standard deviation of returns.
2. Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two securities B
and D for this purpose. The risk return profile of these securities are as follows :
Security Risk ( σ ) Expected Return (ER)

B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.

23
You are required to calculate the portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100 percent investment in B only;
(ii) 50 percent of the fund in B and the rest 50 percent in D;
(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.
Also indicate that which portfolio is best for him from risk as well as return point of view?
3. Consider the following information on two stocks, A and B :
Year Return on A (%) Return on B (%)

2006 10 12
2007 16 18
You are required to determine:

(i) The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.
(ii) The Standard Deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation coefficient between the returns of the two stocks.
(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
4. Following is the data regarding six securities:
A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6
(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A and
25% in C or to invest 100% in E
5. The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:
Probability Return %
F P
0.30 30 -10

24
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’,
the covariance between the market portfolio and security and beta for the security.
6. The rates of return on the security of Company X and market portfolio for 10 periods
are given below:
Period Return of Security X (%) Return on Market Portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 −5 8
7 17 −6
8 19 5
9 −7 6
10 20 11
(i) What is the beta of Security X?
(ii) What is the characteristic line for Security X?
7. XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of short-
term equity investments, details for which are given below:
Investment No. of Beta Market price per share Expected dividend

shares yield
`
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%
The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;

25
(ii) Whether XYZ should change the composition of its portfolio.

8. Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Portfolio
Manager. The Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best

Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50
You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing
Methodology:
(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY
is yielding 10%.
(ii) Advisability of replacing Security 'Better' with NIFTY.
9. Your client is holding the following securities:
Particulars of Cost Dividends Market Price BETA

Securities
` ` `
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2
Assuming a Risk-free rate of 15%, calculate:
– Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
– Average return of the portfolio.
10. Following are the details of a portfolio consisting of three shares:
Share Portfolio weight Beta Expected return in % Total variance

A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100
Standard Deviation of Market Portfolio Returns = 10%

26
You are given the following additional data:

Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)
11. Mr. Tamarind intends to invest in equity shares of a company the value of which
depends upon various parameters as mentioned below:
Factor Beta Expected value Actual value in %

in %
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial 1.00 7.00 7.50
production
If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage
Pricing Theory?
12. The following are the data on five mutual funds:
Fund Return Standard Deviation Beta

A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50

27
You are required to compute Reward to Volatility Ratio and rank these portfolio using:
♦ Sharpe method and
♦ Treynor's method
assuming the risk free rate is 6%.
ANSWERS/ SOLUTIONS
1. Here, the probable returns have to be calculated using the formula
D P1 − P0
R
= +
P0 P0
Calculation of Probable Returns
Possible prices (P1) P1-P0 [(P1-P0)/ P0 ] x 100

` ` Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.50
140 20 16.67
Alternatively, it can be calculated as follows:

Calculation of Expected Returns
Possible return Probability Product

Xi p(Xi) X1-p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.000

28
4.17 0.2 0.834

8.33 0.3 2.499
12.50 0.2 2.500
16.67 0.1 1.667
X = 7.083
Expected return X = 7.083 per

Alternatively, it can also be calculated as follows:
Expected Price = 115 x 0.1 + 120 x 0.1 + 125 x 0.2 + 130 x 0.3 + 135 x 0.2 + 140 x 0.1 =
128.50
128.50 − 120
Return = × 100 = 7.0833%
120
Calculation of Standard Deviation of Returns
Probable Probability Deviation Deviation Product

squared
return Xi p(Xi) (Xi – X) (Xi – X)² (Xi – X)²p(Xi)
-4.17 0.1 -11.253 126.63 12.66
0.00 0.1 -7.083 50.17 5.017
4.17 0.2 -2.913 8.49 1.698
8.33 0.3 1.247 1.56 0.467
12.50 0.2 5.417 29.34 5.869
16.67 0.1 9.587 91.91 9.191
σ² = 34.902
Variance, σ² = 34.902 per cent

Standard deviation, σ= 34.902 = 5.908 per cent
2. We have Ep = W1E1 + W3E3 + ………… WnEn
n n
and for standard deviation σ2p = ∑∑ w i w jσ ij
i=1 j=1

29
n n
σ2p = ∑∑ w i w jρij σ i σ j
i=1 j=1
Two asset portfolio

σ2p = w21σ21 + w22σ22 + 2 w1w2σ1σ2ρ12
Substituting the respective values we get,
(i) All funds invested in B
Ep = 12%
σp = 10%
(ii) 50% of funds in each of B & D
Ep = 0.50X12%+0.50X20%=16%
σ2p = (0.50)2(10%)2 + (0.50)2(18%)2 +2(0.50)(0.50)(0.15)(10%)(18%)
σ2p = 25 + 81 + 13.5 = 119.50
σp = 10.93%
(iii) 75% in B and 25% in D
Ep = 0.75%X12%+0.25%X20=14%
σ2p = (0.75)2(10%)2 + (0.25)2(18%)2 +2(0.75)(0.25)(0.15)(10%)(18%)
σ2p = 56.25 + 20.25 + 10.125 = 86.625
σp = 9.31%
(iv) All funds in D
Ep = 20%
σp = 18.0%
Portfolio (i) (ii) (iii) (iv)

Return 12 16 14 20
σ 10 10.93 9.31 18
In the terms of return, we see that portfolio (iv) is the best portfolio. In terms of risk we see
that portfolio (iii) is the best portfolio.

30
3. (i) Expected return of the portfolio A and B

E (A) = (10 + 16) / 2 = 13%
E (B) = (12 + 18) / 2 = 15%
N
Rp = ∑ X iR i = 0.4(13) + 0.6(15) = 14.2%
i −l
(ii) Stock A:
Variance = 0.5 (10 – 13)² + 0.5 (16 – 13) ² = 9
Standard deviation = 9 = 3%
Stock B:
Variance = 0.5 (12 – 15) ² + 0.5 (18 – 15) ² = 9
Standard deviation = 3%
(iii) Covariance of stocks A and B
CovAB = 0.5 (10 – 13) (12 – 15) + 0.5 (16 – 13) (18 – 15) = 9
(iv) Correlation of coefficient
Cov AB 9
rAB = = =1
σ A σB 3 × 3
(v) Portfolio Risk
σP = X 2 A σ2 A + X 2Bσ2B + 2X A X B (σ A σBσ AB )
= (0.4 )2 (3)2 + (0.6)2 (3)2 + 2(0.4 )(0.6)(3)(3)(1)

= 1.44 + 3.24 + 4.32 = 3%
4. (i) Security A has a return of 8% for a risk of 4, whereas B and F have a higher risk for
the same return. Hence, among them A dominates.
For the same degree of risk 4, security D has only a return of 4%. Hence, D is also
dominated by A.
Securities C and E remain in reckoning as they have a higher return though with higher
degree of risk.
Hence, the ones to be selected are A, C & E.

31
(ii) The average values for A and C for a proportion of 3 : 1 will be :

(3 × 4) + (1× 12)
Risk = = 6%
4
(3 × 8) + (1× 12)
Return = = 9%
4
Therefore: 75% A E
25% C _
Risk 6 5
Return 9% 9%
For the same 9% return the risk is lower in E. Hence, E will be preferable.
5. Security F
Prob(P) Rf PxR f Deviations of F (Deviation) 2 of F (Deviations) 2 PX
(Rf – ERf)
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 -17 289 86.7
ER f =17 Var f =141
STDEV σ f = 141 = 11.87

Market Portfolio, P
RM PM Exp. Dev. of P (Dev. of (DeV.) 2 (Deviation of F) Dev. of F x
% Return (RM -ERM ) P) 2 PM x (Deviation of Dev. of P) x
RM x PM P) P
-10 0.3 -3 -24 576 172.8 -312 -93.6
20 0.4 8 6 36 14.4 18 7.2
30 0.3 9 16 256 76.8 -272 -81.6
ERM =14 Var M =264 =Co Var PM
σ M =16.25 =- 168
Co Var PM − 168
Beta= = = − .636
σ M2 264

32
6. (i)
Period R X RM R X − R X RM − RM (R X )(
− R X RM − RM ) (R M − RM )2
1 20 22 5 10 50 100
2 22 20 7 8 56 64
3 25 18 10 6 60 36
4 21 16 6 4 24 16
5 18 20 3 8 24 64
6 -5 8 -20 -4 80 16
7 17 -6 2 -18 -36 324
8 19 5 4 -7 -28 49
9 -7 6 -22 -6 132 36
10 20 11 5 -1 -5 1
150 120 357 706
ΣRX ΣRM ∑ (R X − R X )(R M − R M ) ∑ (R M − R M )
2
R X = 15 R M = 12
2
 −

∑  RM − RM 
  = 706 = 70.60
σ2 M =
n 10
 −
 −

∑  R X − R X  R M − R M 
  = 357
CovX M= = 35.70
n 10
Cov X M m 35.70
Betax = = = 0.505
σ 2M 70.60
Alternative Solution
Period X Y Y2 XY
1 20 22 484 440
2 22 20 400 440
3 25 18 324 450
4 21 16 256 336
5 18 20 400 360

33
6 -5 8 64 -40
7 17 -6 36 -102
8 19 5 25 95
9 -7 6 36 -42
10 20 11 121 220
150 120 2146 2157
X = 15 Y = 12
ΣXY - n X Y
=
ΣX 2 - n(X)2
2157 - 10 × 15 × 12 357
= = = 0.506
2146 - 10 × 12 × 12 706
(ii) R X = 15 R M = 12
y = α + βx
15 = α + 0.505 × 12
Alpha (α) = 15 – (0.505 × 12) = 8.94%
Characteristic line for security X = α + β × RM
Where, RM = Expected return on Market Index
∴Characteristic line for security X = 8.94 + 0.505 RM
7. (i) Computation of Beta of Portfolio
Investment No. of Market Market Dividend Dividend Composition β Weighted
shares Price Value Yield β
I. 60,000 4.29 2,57,400 19.50% 50,193 0.2339 1.16 0.27
II. 80,000 2.92 2,33,600 24.00% 56,064 0.2123 2.28 0.48
III. 1,00,000 2.17 2,17,000 17.50% 37,975 0.1972 0.90 0.18
IV. 1,25,000 3.14 3,92,500 26.00% 1,02,050 0.3566 1.50 0.53
11,00,500 2,46,282 1.0000 1.46
2,46,282
Return of the Portfolio = 0.2238
11,00,500
Beta of Port Folio 1.46

34
Market Risk implicit

0.2238 = 0.11 + β× (0.19 – 0.11)
Or, 0.08 β + 0.11 = 0.2238
0.2238 − 0.11
β= = 1.42
0.08
Market β implicit is 1.42 while the port folio β is 1.46. Thus the portfolio is marginally
risky compared to the market.
(ii) The decision regarding change of composition may be taken by comparing the
dividend yield (given) and the expected return as per CAPM as follows:
Expected return Rs as per CAPM is:
Rs = IRF + (RM – I RF) β
For investment I Rs = IRF + (RM – IRF) β
= .11 + (.19 - .11) 1.16
= 20.28%
For investment II, Rs = .11 + (.19 - .11) 2.28 = 29.24%
For investment III, Rs = .11 + (.19 - .11) .90
= 18.20%
For investment IV, Rs = .11 + (.19 - .11) 1.50
= 23%
Comparison of dividend yield with the expected return Rs shows that the dividend
yields of investment I, II and III are less than the corresponding R s,. So, these
investments are over-priced and should be sold by the investor. However, in case of
investment IV, the dividend yield is more than the corresponding Rs, so, XYZ Ltd.
should increase its proportion.
8. (i) Computation of Expected Return from Portfolio
Security Beta Expected Return (r) Amount Weights wr

(β) as per CAPM (` Lakhs) (w)
Moderate 0.50 8%+0.50(10% - 8%) = 9% 60 0.115 1.035
Better 1.00 8%+1.00(10% - 8%) = 10% 80 0.154 1.540
Good 0.80 8%+0.80(10% - 8%) = 9.60% 100 0.192 1.843
Very Good 1.20 8%+1.20(10% - 8%)=10.40% 120 0.231 2.402

35
Best 1.50 8%+1.50(10% - 8%) = 11% 160 0.308 3.388

Total 520 1 10.208
Thus Expected Return from Portfolio 10.208% say 10.21%.
Alternatively, it can be computed as follows:
60 80 100 120 160
Average β = 0.50 x + 1.00 x + 0.80 x + 1.20 x + 1.50 x = 1.104
520 520 520 520 520
As per CAPM
= 0.08 + 1.104(0.10 – 0.08) = 0.10208 i.e. 10.208%
(ii) As computed above the expected return from Better is 10% same as from Nifty, hence
there will be no difference even if the replacement of security is made. The main logic
behind this neutrality is that the beta of security ‘Better’ is 1 which clearly indicates
that this security shall yield same return as market return.
9. Calculation of expected return on market portfolio (Rm)
Investment Cost (`) Dividends (`) Capital Gains (`)
Shares X 8,000 800 200
Shares Y 10,000 800 500
Shares Z 16,000 800 6,000
PSU Bonds 34,000 3,400 –1,700
68,000 5,800 5,000
5,800 + 5,000
Rm = × 100 = 15.88%
68,000
Calculation of expected rate of return on individual security:
Security
Shares X 15 + 0.8 (15.88 – 15.0) = 15.70%

Shares Y 15 + 0.7 (15.88 – 15.0) = 15.62%
Shares Z 15 + 0.5 (15.88 – 15.0) = 15.44%
PSU Bonds 15 + 0.2 (15.88 – 15.0) = 15.18%
Calculation of the Average Return of the Portfolio:
15.70 + 15.62 + 15.44 + 15.18
= = 15.49%.
4

36
10. (i) Portfolio Beta

0.20 x 0.40 + 0.50 x 0.50 + 0.30 x 1.10 = 0.66
(ii) Residual Variance
To determine Residual Variance first of all we shall compute the Systematic Risk as follows:
β2A × σ M
2
= (0.40)2(0.01) = 0.0016
βB2 × σ M
2
= (0.50)2(0.01) = 0.0025
β2C × σ M
2
= (1.10)2(0.01) = 0.0121
Residual Variance
A 0.015 – 0.0016 = 0.0134
B 0.025 – 0.0025 = 0.0225
C 0.100 – 0.0121 = 0.0879
(iii) Portfolio variance using Sharpe Index Model
Systematic Variance of Portfolio = (0.10)2 x (0.66)2 = 0.004356
Unsystematic Variance of Portfolio = 0.0134 x (0.20)2 + 0.0225 x (0.50)2 + 0.0879 x
(0.30)2 = 0.014072
Total Variance = 0.004356 + 0.014072 = 0.018428
(iii) Portfolio variance on the basis of Markowitz Theory
2
= (wA x wAx σ A ) + (wA x wBxCovAB) + (wA x wCxCovAC) + (wB x wAxCovAB) + (wB x wBx
σ B2 ) + (wB x wCxCovBC) + (wC x wAxCovCA) + (wC x wBxCovCB) + (wC x wCx σ 2c )
= (0.20 x 0.20 x 0.015) + (0.20 x 0.50 x 0.030) + (0.20 x 0.30 x 0.020) + (0.20 x 0.50
x 0.030) + (0.50 x 0.50 x 0.025) + (0.50 x 0.30 x 0.040) + (0.30 x 0.20 x 0.020) + (0.30
x 0.50 x 0.040) + (0.30 x 0.30 x 0.10)
= 0.0006 + 0.0030 + 0.0012 + 0.0030 + 0.00625 + 0.0060 + 0.0012 + 0.0060 + 0.0090
= 0.0363
11. Return of the stock under APT
Factor Actual Expected Difference Beta Diff. х
value in % value in % Beta
GNP 7.70 7.70 0.00 1.20 0.00

37
Inflation 7.00 5.50 1.50 1.75 2.63

Interest rate 9.00 7.75 1.25 1.30 1.63
Stock index 12.00 10.00 2.00 1.70 3.40
Ind. Production 7.50 7.00 0.50 1.00 0.50
8.16
Risk free rate in % 9.25
Return under APT 17.41
12. Sharpe Ratio S = (Rp – Rf)/σp

Treynor Ratio T = (Rp – Rf)/βp
Where,
Rp = Return on Fund
Rf = Risk-free rate
σp = Standard deviation of Fund
βp = Beta of Fund
Reward to Variability (Sharpe Ratio)
Mutual Rp Rf Rp – Rf σp Reward to Ranking
Fund Variability
A 15 6 9 7 1.285 2
B 18 6 12 10 1.20 3
C 14 6 8 5 1.60 1
D 12 6 6 6 1.00 5
E 16 6 10 9 1.11 4
Reward to Volatility (Treynor Ratio)

Mutual Rp Rf Rp – Rf βp Reward to Ranking
Fund Volatility
A 15 6 9 1.25 7.2 2
B 18 6 12 0.75 16 1
C 14 6 8 1.40 5.71 5
D 12 6 6 0.98 6.12 4
E 16 6 10 1.50 6.67 3

38
TEST YOUR KNOWLEDGE

1. Differentiate between PTS and PTC.
2. What are the main problems faced in securitisation especially in Indian context?
ANSWERS/ SOLUTIONS

39
MUTUAL FUNDS 77.17
The tracking error can be calculated on the basis of corresponding benchmark return vis a vis
quarterly or monthly average NAVs.
Higher the tracking error higher is the risk profile of the fund. Whether the funds outperform or
underperform their benchmark indices; it clearly indicates that of fund managers are not following
the benchmark indices properly. In addition to the same other reason for tracking error are as follows:
• Transaction cost
• Fees charged by AMCs
• Fund expenses
• Cash holdings
• Sampling biasness
Thus from above it can be said that to replicate the return to any benchmark index the tracking error
should be near to zero.
The Tracking Error is calculated as follows:
TE =
∑ (d- d)
n-1
d = Differential return
^d = Average differential return
n = No. of observation
TEST YOUR KNOWLEDGE

1. Explain how to establish a Mutual Fund.
2. What are the advantages of investing in Mutual Funds?
Practical Questions
1. Mr. A can earn a return of 16 per cent by investing in equity shares on his own. Now he is
considering a recently announced equity based mutual fund scheme in which initial expenses
are 5.5 per cent and annual recurring expenses are 1.5 per cent. How much should the mutual
fund earn to provide Mr. A return of 16 per cent?
2. A mutual fund that had a net asset value of `16 at the beginning of a month, made income
and capital gain distribution of `0.04 and `0.03 respectively per unit during the month, and

40
then ended the month with a net asset value of `16.08. Calculate monthly and annual rate of
return.
3. Cinderella Mutual Fund has the following assets in Scheme Rudolf at the close of business
on 31 s t March,2014.
Company No. of Shares Market Price Per Share
Nairobi Ltd. 25000 ` 20
Dakar Ltd. 35000 ` 300
Senegal Ltd. 29000 ` 380
Cairo Ltd. 40000 ` 500
The total number of units of Scheme Rudol fare 10 lacs. The Scheme Rudolf has accrued
expenses of ` 2,50,000 and other liabilities of ` 2,00,000. Calculate the NAV per unit of the
Scheme Rudolf.
4. A Mutual Fund Co. has the following assets under it on the close of business as on:
1st February 2012 2nd February 2012
Company No. of Shares Market price 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 2012.
1. Establishment of a Mutual Fund: A mutual fund is required to be registered with the Securities
and Exchange Board of India (SEBI) before it can collect funds from the public. All mutual
funds are governed by the same set of regulations and are subject to monitoring and
inspections by the SEBI. The Mutual Fund has to be established through the medium of a

41
MUTUAL FUNDS 77.19
sponsor. A sponsor means any body corporate who, acting alone or in combination with
another body corporate, establishes a mutual fund after completing the formalities prescribed
in the SEBI's Mutual Fund Regulations.
The role of sponsor is akin to that of a promoter of a company, who provides the initial capital
and appoints the trustees. The sponsor should be a body corporate in the business of
financial services for a period not less than 5 years, be financially sound and be a fit party to
act as sponsor in the eyes of SEBI.
The Mutual Fund has to be established as either a trustee company or a Trust, under the
Indian Trust Act and the instrument of trust shall be in the form of a deed. The deed shall be
executed by the sponsor in favour of the trustees named in the instrument of trust. The trust
deed shall be duly registered under the provisions of the Indian Registration Act, 1908. The
trust deed shall contain clauses specified in the Third Schedule of the Regulations.
An Asset Management Company, who holds an approval from SEBI, is to be appointed to
manage the affairs of the Mutual Fund and it should operate the schemes of such fund. The
Asset Management Company is set up as a limited liability company, with a minimum net
worth of ` 10 crores.
The sponsor should contribute at least 40% to the networth of the Asset Management
Company. The Trustee should hold the property of the Mutual Fund in trust for the benefit of
the unit holders.
SEBI regulations require that at least two-thirds of the directors of the Trustee Company or
board of trustees must be independent, that is, they should not be associated with the
sponsors. Also, 50 per cent of the directors of AMC must be independent. The appointment
of the AMC can be terminated by majority of the trustees or by 75% of the unit holders of the
concerned scheme.
The AMC may charge the mutual fund with Investment Management and Advisory fees
subject to prescribed ceiling. Additionally, the AMC may get the expenses on operation of the
mutual fund reimbursed from the concerned scheme.
The Mutual fund also appoints a custodian, holding valid certificate of registration issued by
SEBI, to have custody of securities held by the mutual fund under different schemes. In case
of dematerialized securities, this is done by Depository Participant. The custodian must be
independent of the sponsor and the AMC.

42

1. Personal earnings of Mr. A = R1 = 16%
Mutual Fund earnings = R2
1
R2 = R 1 + Recurring expenses (%)
1 − Initial expenses (%)
1
= × 16% + 1.5%
1 − 0.055
= 18.43%
Mutual Fund earnings = 18.43%
2. Calculation of monthly return on the mutual funds:
(NAV t - NAVt -1 ) + I t +G t
r=
NAVt -1
( ` 16.08 − `v16.00 ) + ( ` 0.04 + ` 0.03 )

Or, r =
16
0.08 + 0.07
= = 0.009375 or, r = 0.9375% or 11.25% p.a.
16

43
MUTUAL FUNDS 77.21
3.
Shares No. of shares Price Amount (`)

Nairobi Ltd. 25,000 20.00 5,00,000
Dakar Ltd. 35,000 300.00 1,05,00,000
Senegal Ltd. 29,000 380.00 1,10,20,000
Cairo Ltd. 40,000 500.00 2,00,00,000
4,20,20,000
Less: Accrued Expenses 2,50,000
Other Liabilities 2,00,000
Total Value 4,15,70,000
No. of Units 10,00,000
NAV per Unit (4,15,70,000/10,00,000) 41.57
4. (i) NAV of the Fund
` 4,00,000 + ` 93,72,000 + ` 72,24,000 + ` 3,03,06,000
=
6,00,000
` 4,73,02,000
= =` 78.8366 rounded to ` 78.84
6,00,000
(ii) The revised position of fund shall be as follows:

L Ltd. 20,000 20.00 4,00,000
M Ltd. 38,000 312.40 1,18,71,200
N Ltd. 20,000 361.20 72,24,000
P Ltd. 60,000 505.10 3,03,06,000
Cash 5,00,800
5,03,02,000
30,00,000
No. of units of fund = 6,00,000 + = 6,38,053
78.8366

44
(iii) On 2nd February 2012, the NAV of fund will be as follows:

L Ltd. 20,000 20.50 4,10,000
M Ltd. 38,000 360.00 1,36,80,000
N Ltd. 20,000 383.10 76,62,000
P Ltd. 60,000 503.90 3,02,34,000
Cash 5,00,800
5,24,86,800
` 5,24,86,800
NAV as on 2nd February 2012 = = ` 82.26 per unit
6,38,053

45
TEST YOUR KNOWLEDGE

1. What are the reasons for stock index futures becoming more popular financial derivatives
over stock futures segment in India?
2. Write short note on Marking to market.
3. State any four assumptions of Black Scholes Model.
4. Write short note on Embedded derivatives.
5. Define the term Greeks with respect to options.
Practical Questions
1. Calculate the price of 3 months PQR futures, if PQR (FV `10) quotes `220 on NSE and the
three months future price quotes at `230 and the one month borrowing rate is given as 15
percent and the expected annual dividend is 25 percent per annum payable before expiry.
Also examine arbitrage opportunities.
2. Sensex futures are traded at a multiple of 50. Consider the following quotations of Sensex
futures in the 10 trading days during February, 2009:
Day High Low Closing
4-2-09 3306.4 3290.00 3296.50
5-2-09 3298.00 3262.50 3294.40
6-2-09 3256.20 3227.00 3230.40
7-2-09 3233.00 3201.50 3212.30
10-2-09 3281.50 3256.00 3267.50
11-2-09 3283.50 3260.00 3263.80
12-2-09 3315.00 3286.30 3292.00
14-2-09 3315.00 3257.10 3309.30
17-2-09 3278.00 3249.50 3257.80
18-2-09 3118.00 3091.40 3102.60
Abshishek bought one sensex futures contract on February, 04. The average daily absolute
change in the value of contract is ` 10,000 and standard deviation of these changes is
` 2,000. The maintenance margin is 75% of initial margin.
You are required to determine the daily balances in the margin account and payment on
margin calls, if any.

46
DERIVATI VES ANALYSIS AND VALUATION 78.41
3. Sumana wanted to buy shares of ElL which has a range of ` 411 to ` 592 a month later.
The present price per share is ` 421. Her broker informs her that the price of this share can
sore up to ` 522 within a month or so, so that she should buy a one month CALL of ElL. In
order to be prudent in buying the call, the share price should be more than or at least ` 522
the assurance of which could not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the probability of
attaining the share price ` 592 so that buying of a one month CALL of EIL at the execution
price of ` 522 is justified. Advice her. Take the risk free interest to be 3.60% and e 0.036 =
1.037.
4. Mr. X established the following spread on the Delta Corporation’s stock :
(i) Purchased one 3-month call option with a premium of ` 30 and an exercise price of
` 550.
(ii) Purchased one 3-month put option with a premium of ` 5 and an exercise price of `
450.
Delta Corporation’s stock is currently selling at ` 500. Determine profit or loss, if the pric e
of Delta Corporation’s :
(i) remains at `500 after 3 months.
(ii) falls at `350 after 3 months.
(iii) rises to `600.
Assume the size option is 100 shares of Delta Corporation.
5. The equity share of VCC Ltd. is quoted at ` 210. A 3-month call option is available at a
premium of ` 6 per share and a 3-month put option is available at a premium of ` 5 per
share. Ascertain the net payoffs to the optionholder of a call option and a put option.
(i) the strike price in both cases in ` 220; and
(ii) the share price on the exercise day is ` 200,210,220,230,240.
Also indicate the price range at which the call and the put options may be gainfully
exercised.
ANSWERS/ SOLUTIONS

47

1. Future’s Price = Spot + cost of carry – Dividend
F = 220 + 220 × 0.15 × 0.25 – 0.25** × 10 = 225.75
** Entire 25% dividend is payable before expiry, which is `2.50.
Thus we see that futures price by calculation is `225.75 which is quoted at `230 in the
exchange.
(i) Analysis:
Fair value of Futures less than Actual futures Price:
Futures Overvalued Hence it is advised to sell. Also do Arbitraging by buying stock in
the cash market.
Step I
He will buy PQR Stock at `220 by borrowing at 15% for 3 months. Therefore, his outflows
are:
Cost of Stock 220.00
Add: Interest @ 15 % for 3 months i.e. 0.25 years (220 × 0.15 × 0.25) 8.25
Total Outflows (A) 228.25
Step II
He will sell March 2000 futures at `230. Meanwhile he would receive dividend for his stock.
Hence his inflows are 230.00
Sale proceeds of March 2000 futures 2.50
Total inflows (B) 232.50
Inflow – Outflow = Profit earned by Arbitrageur
= 232.50 – 228.25 = 4.25
2. Initial Margin = µ + 3 
Where µ = Daily Absolute Change
 = Standard Deviation

48
DERIVATI VES ANALYSIS AND VALUATION 78.43
Accordingly
Initial Margin = ` 10,000 + ` 6,000 = ` 16,000
Maintenance margin = ` 16,000 x 0.75 = ` 12,000
Day Changes in future Values (`) Margin A/c (`) Call Money (`)
4/2/09 - 16000 -
5/2/09 50 x (3294.40 - 3296.50) = -105 15895 -
6/2/09 50 x (3230.40 - 3294.40)= -3200 12695 -
7/2/09 50 x (3212.30 - 3230.40)= -905 16000 4210
10/2/09 50x(3267.50 - 3212.30)= 2760 18760 -
11/2/09 50x(3263.80 - 3267.50)= -185 18575 -
12/2/09 50x(3292 - 3263.80) =1410 19985 -
14/2/09 50x(3309.30 - 3292)=865 20850 -
17/2/09 50x(3257.80 - 3309.30)=-2575 18275 -
18/2/09 50x(3102.60 - 3257.80)=-7760 16000 5485
e rt  d
3. p=
ud
ert = e0.036
d = 411/421 = 0.976
u = 592/421 = 1.406
e 0.036  0.976 1.037  0.976 0.061
p= = = = 0.1418
1.406  0.976 0.43 0.43
Thus probability of rise in price 0.1418
4. (i) Total premium paid on purchasing a call and put option
= (`30 per share × 100) + (`5 per share × 100).
= 3,000 + 500 = `3,500
In this case, X exercises neither the call option nor the put option as both will result
in a loss for him.
Ending value = - `3,500 + zero gain = - `3,500
i.e Net loss = `3,500

49
(ii) Since the price of the stock is below the exercise price of the call, the call will not be
exercised. Only put is valuable and is exercised.
Total premium paid = `3,500
Ending value = – `3,500 + `[(450 – 350) × 100] = – `3,500 + `10,000 = `6,500
 Net gain = `6,500
(iii) In this situation, the put is worthless, since the price of the stock exceeds the put’s
exercise price. Only call option is valuable and is exercised.
Total premium paid = `3,500
Ending value = -3,500 +[(600 – 550) × 100]
Net Gain = -3,500 + 5,000 = `1,500
5. Net payoff for the holder of the call option
(`)
Share price on exercise day 200 210 220 230 240
Option exercise No No No Yes Yes
Outflow (Strike price) Nil Nil Nil 220 220
Out flow (premium) 6 6 6 6 6
Total Outflow 6 6 6 226 226
Less inflow (Sales proceeds) - - - 230 240
Net payoff -6 -6 -6 4 14
Net payoff for the holder of the put option
(`)
Share price on exercise day 200 210 220 230 240
Option exercise Yes Yes No No No
Inflow (strike price) 220 220 Nil Nil Nil
Less outflow (purchase price) 200 210 - - -
Less outflow (premium) 5 5 5 5 5
Net Payoff 15 5 -5 -5 -5
The call option can be exercised gainfully for any price above `226 (`220 + `6) and put
option for any price below `215 (`220 - `5).

50
14.3 High Risk: Low Reward

Perhaps the worst strategy is to leave all exposures unhedged. The risk of destabilization of cash
flows is very high. The merit is zero investment of managerial time or effort.
14.4 High Risk: High Reward
This strategy involves active trading in the currency market through continuous cancellations and
re-bookings of forward contracts. With exchange controls relaxed in India in recent times, a few of
the larger companies are adopting this strategy. In effect, this requires the trading function to
become a profit centre. This strategy, if it has to be adopted, should be done in full consciousness
of the risks.
15. CONCLUSION
Thus, on account of increased globalization of financial markets, risk management has gained
more importance. The benefits of the increased flow of capital between nations include a better
international allocation of capital and greater opportunities to diversify risk. However, globalization
of investment has meant new risks from exchange rates, political actions and increased
interdependence on financial conditions of different countries.
All these factors- increase in exchange rate risk, growth in international trade, globalization of
financial markets, increase in the volatility of exchange rates and growth of multinational and
transnational corporations- combine to make it imperative for today’s financial managers to study
the factors behind the risks of international trade and investment, and the methods of reducing
these risks.
TEST YOUR KNOWLEDGE

1. “Operations in foreign exchange market are exposed to a number of risks.” Discuss.
2. What do you mean by Nostro, Vostro and Loro Accounts?
Practical Questions
1. The price of a bond just before a year of maturity is $ 5,000. Its redemption value is $ 5,250
at the end of the said period. Interest is $ 350 p.a. The Dollar appreciates by 2% during the
said period. Calculate the rate of return.
2. ABC Ltd. of UK has exported goods worth Can $ 5,00,000 receivable in 6 months. The
exporter wants to hedge the receipt in the forward market. The following information is
available:
Spot Exchange Rate Can $ 2.5/£

51
FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT 79.43
Interest Rate in UK 12%

Interest Rate In Canada 15%
The forward rates truly reflect the interest rates differential. Find out the gain/loss to UK
exporter if Can $ spot rates (i) declines 2%, (ii) gains 4% or (iii) remains unchanged over
next 6 months.
3. On January 28, 2013 an importer customer requested a Bank to remit Singapore Dollar
(SGD) 2,500,000 under an irrevocable Letter of Credit (LC). However, due to unavoidable
factors, the Bank could effect the remittances only on February 4, 2013. The inter-bank
market rates were as follows:
January 28, 2013 February 4, 2013
US$ 1= ` 45.85/45.90 ` 45.91/45.97
GBP £ 1 = US$ 1.7840/1.7850 US$ 1.7765/1.7775
GBP £ 1 = SGD 3.1575/3.1590 SGD 3. 1380/3.1390
The Bank wishes to retain an exchange margin of 0.125%

Required:
How much does the customer stand to gain or lose due to the delay?(Note: Calculate the
rate in multiples of 0.0001)
4. In March, 2009, the Multinational Industries make the following assessment of dollar rates
per British pound to prevail as on 1.9.2009:
$/Pound Probability
1.60 0.15
1.70 0.20
1.80 0.25
1.90 0.20
2.00 0.20
(i) What is the expected spot rate for 1.9.2009?
(ii) If, as of March, 2009, the 6-month forward rate is $ 1.80, should the firm sell forward
its pound receivables due in September, 2009?
5. An Indian exporting firm, Rohit and Bros., would be covering itself against a likely
depreciation of pound sterling. The following data is given:
Receivables of Rohit and Bros : £500,000

52
Spot rate : ` 56.00/£

Payment date : 3-months
3 months interest rate : India : 12 per cent per annum
: UK : 5 per cent per annum
What should the exporter do?
6. The rate of inflation in India is 8% per annum and in the U.S.A. it is 4%. The current spot
rate for USD in India is ` 46. What will be the expected rate after 1 year and after 4 years
applying the Purchasing Power Parity Theory.
7. On April 1, 3 months interest rate in the UK £ and US $ are 7.5% and 3.5% per annum
respectively. The UK £/US $ spot rate is 0.7570. What would be the forward rate for US $
for delivery on 30th June?
8. ABC Technologic is expecting to receive a sum of US$ 4,00,000 after 3 months. The
company decided to go for future contract to hedge against the risk. The standard size of
future contract available in the market is $1000. As on date spot and futures $ contract are
quoting at ` 44.00 &` 45.00 respectively. Suppose after 3 months the company closes out
its position futures are quoting at ` 44.50 and spot rate is also quoting at ` 44.50. You are
required to calculate effective realization for the company while selling the receivable. Also
calculate how company has been benefitted by using the future option.
9. XYZ Ltd. a US firm will need £ 3,00,000 in 180 days. In this connection, the following
information is available:
Spot rate 1 £ = $ 2.00
180 days forward rate of £ as of today = $1.96
Interest rates are as follows:
U.K. US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option on £ that expires in 180 days has an exercise price of $ 1.97 and a premium of
$ 0.04.
XYZ Ltd. has forecasted the spot rates 180 days hence as below:
Future rate Probability
$ 1.91 25%
$ 1.95 60%
$ 2.05 15%

53
Which of the following strategies would be most preferable to XYZ Ltd.?

(a) A forward contract;
(b) A money market hedge;
(c) An option contract;
(d) No hedging.
Show calculations in each case
10. A Ltd. of U.K. has imported some chemical worth of USD 3,64,897 from one of the U.S.
suppliers. The amount is payable in six months time. The relevant spot and forward rates
are:
Spot rate USD 1.5617-1.5673
6 months’ forward rate USD 1.5455 –1.5609
The borrowing rates in U.K. and U.S. are 7% and 6% respectively and the deposit rates are
5.5% and 4.5% respectively.
Currency options are available under which one option contract is for GBP 12,500. The
option premium for GBP at a strike price of USD 1.70/GBP is USD 0.037 (call option) and
USD 0.096 (put option) for 6 months period.
The company has 3 choices:
(i) Forward cover
(ii) Money market cover, and
(iii) Currency option
Which of the alternatives is preferable by the company?
ANSWERS/ SOLUTIONS
2. Please refer paragraph 2.
1. Here we can assume two cases (i) If investor is US investor then there will be no impact of
appreciation in $. (ii) If investor is from any other nation other than US say Indian then there
will be impact of $ appreciation on his returns.
First we shall compute return on bond which will be common for both investors.

54
(Price at end - Price at begining)+ Interest

Return =
Price at begining
(5250 − 5000) + 350

=
5000
250 + 350
= =0.12 say 12%
5000
(i) For US investor the return shall be 12% and there will be no impact of appreciation in $.
(ii) If $ appreciate by 2% then return for non-US investor shall be:
Return x 1.02 = 0.12 x 1.02=0.1224 i.e. 12.24%
Alternatively it can also be considered that $ appreciation will be applicable to the amount
of principal as well. The answer therefore could also be
(1+0.12)(1+0.02) -1 =1.12X1.02 - 1 = 0.1424 i.e. 14.24%
2.50 (1 + 0.075)
2. Forward Rate = = Can$ 2.535/£
(1 + 0.060)
(i) If spot rate decline by 2%

Spot Rate = Can$ 2.50 x 1.02 = Can$ 2.55/£
£
£ receipt as per Forward Rate (Can $ 5,00,000/ Can$ 2.535) 1,97,239
£ receipt as per Spot Rate (Can $ 5,00,000/ Can$ 2.55) 1,96,078
Gain due to forward contract 1,161
(ii) If spot rate gains by 4%
Spot Rate = Can$ 2.50 x 0.96 = Can$ 2.40/£
£
Loss due to forward contract 11,094
(iii) If spot rate remains unchanged

£

55

Loss due to forward contract 2,761
3. On January 28, 2013 the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ = `45.90
Pound 1 = US$ 1.7850
Pound 1 = SGD 3.1575
` 45.90 * 1.7850
Therefore, SGD 1 =
SGD 3.1575
SGD 1 = `25.9482
Add: Exchange margin (0.125%) ` 0.0324
` 25.9806
On February 4, 2013 the rates are
US $ = ` 45.97
Pound 1 = US$ 1.7775
Pound 1 = SGD 3.1380
` 45.97 * 1.7775
Therefore, SGD 1 =
SGD 3.1380
SGD 1 = ` 26.0394
Add: Exchange margin (0.125%) ` 0.0325
` 26.0719
Hence, loss to the importer
= SGD 25,00,000 (`26.0719 – `25.9806)= `2,28,250
4. (i) Calculation of expected spot rate for September, 2009:
$ for £ Probability Expected $/£
(1) (2) (1) × (2) = (3)
1.60 0.15 0.24
1.70 0.20 0.34
1.80 0.25 0.45
1.90 0.20 0.38

56
2.00 0.20 0.40

1.00 EV = 1.81
Therefore, the expected spot value of $ for £ for September, 2009 would be $ 1.81.
(ii) If the six-month forward rate is $ 1.80, the expected profits of the firm can be
maximised by retaining its pounds receivable.
5. The only thing lefts Rohit and Bros to cover the risk in the money market. The following
steps are required to be taken:
(i) Borrow pound sterling for 3- months. The borrowing has to be such that at the end of
three months, the amount becomes £ 500,000. Say, the amount borrowed is £ x.
Therefore
 3
x 1 + 0.05 ×  = 500,000 or x = £493,827
 12 
(ii) Convert the borrowed sum into rupees at the spot rate. This gives: £493,827 × ` 56
= ` 27,654,312
(iii) The sum thus obtained is placed in the money market at 12 per cent to obtain at the
end of 3- months:
 3
S = ` 27,654,312 × 1 + 0.12 ×  = ` 28,483,941
 12 
(iv) The sum of £500,000 received from the client at the end of 3- months is used to
refund the loan taken earlier.
From the calculations. It is clear that the money market operation has resulted into a
net gain of ` 483,941 (` 28,483,941 – ` 500,000 × 56).
If pound sterling has depreciated in the meantime. The gain would be even bigger.
6.
End of Year ` `/USD
1 (1+ 0.08)
`46.00 x 47.77
(1+ 0.04)
2 (1+ 0.08)
`47.77 x 49.61
(1+ 0.04)
3 (1+ 0.08)
`49.61 x 51.52
(1+ 0.04)

57
4 (1+ 0.08)
`51.52 x 53.50
(1+ 0.04)
7. As per interest rate parity
 1 + in A 
S1 = S0  
 1 + in B 
 1 + (0.075) × 3 
S1 = £0.7570  12 
 1 + (0.035) × 3 
 12 
 1.01875 
= £0.7570  
 1.00875 
= £0.7570 × 1.0099 = £0.7645
= UK £0.7645 / US$
8. The company can hedge position by selling future contracts as it will receive amount from
outside.
$4,00,000
Number of Contracts = = 400 contracts
$1,000
Gain by trading in futures = (` 45 – ` 44.50) 4,00,000= ` 2,00,000

Net Inflow after after 3 months = ` 44.50 x ` 4,00,000+ 2,00,000 = ` 1,80,00,000
` 1,80,00,000
Effective Price realization = = ` 45 Per US$
$4,00,000
9. (a) Forward contract: Dollar needed in 180 days = £3,00,000 x $ 1.96 = $5,88,000/-
(b) Money market hedge: Borrow $, convert to £, invest £, repay $ loan in 180 days
Amount in £ to be invested = 3,00,000/1.045 = £ 2,87,081
Amount of $ needed to convert into £ = 2,87,081 x 2 = $ 5,74,162
Interest and principal on $ loan after 180 days = $5,74,162 x 1.055 = $ 6,05,741
(c) Call option:
Expected Prem. Exercise Total price Total price Prob. Pi pixi
Spot rate /unit Option per unit for
in 180 £3,00,000xi
days
1.91 0.04 No 1.95 5,85,000 0.25 1,46,250

58
1.95 0.04 No 1.99 5,97,000 0.60 3,58,200

2.05 0.04 Yes 2.01* 6,03,000 0.15 90,450
5,94,900
Add: Interest on Premium @ 5.5% (12,000 x 5.5%) 660
5,95,560
* ($1.97 + $0.04)
(d) No hedge option:
Expected Future Dollar needed Prob. Pi Pi xi
spot rate Xi
1.91 5,73,000 0.25 1,43,250
1.95 5,85,000 0.60 3,51,000
2.05 6,15,000 0.15 92,250
5,86,500
The probability distribution of outcomes for no hedge strategy appears to be most

preferable because least number of $ are needed under this option to arrange
£3,00,000.
10. In the given case, the exchange rates are indirect. These can be converted into direct
rates as follows:
Spot rate
1 1
GBP = to
USD 1.5617 USD 1.5673
USD = GBP 0.64033 - GBP 0.63804

6 months’ forward rate
1 1
GBP = to
USD 1.5455 USD 1.5609
USD = GBP 0.64704 - GBP 0.64066

Payoff in 3 alternatives
i. Forward Cover
Amount payable USD 3,64,897
Forward rate GBP 0.64704
Payable in GBP GBP 2,36,103

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ii. Money market Cover

1 USD 3,56,867
PV @ 4.5% for 6 months i.e. = 0.9779951
1.0225
Spot rate purchase GBP 0.64033
Borrow GBP 3,56,867 x 0.64033 GBP 2,28,512
Interest for 6 months @ 7 % 7,998
-
Payable after 6 months GBP 2,36,510
iii. Currency options

Unit in Options contract GBP 12,500
Value in USD at strike rate of 1.70 (GBP 12,500 x 1.70) USD 21,250
Number of contracts USD 3,64,897/ USD 21,250 17.17
Exposure covered USD 21,250 x 17 USD 3,61,250
Exposure to be covered by Forward (USD 3,64,897 – USD USD 3,647
3,61,250)
Options premium 17 x GBP 12,500 x 0.096 USD 20,400
Premium in GBP (USD 20,400 x 0.64033) GBP 13,063
Total payment in currency option
Payment under option (17 x 12,500) GBP 2,12,500
Premium payable GBP 13,063
Payment for forward cover (USD 3,647 x 0.64704) GBP 2,360
GBP 2,27,923
Thus total payment in:
(i) Forward Cover 2,36,103 GBP
(ii) Money Market 2,36,510 GBP
(iii) Currency Option 2,27,923 GBP
The company should take currency option for hedging the risk.
Note: Even interest on Option Premium can also be considered in the above solution.

60
Also in case of global firms, lead time is larger on various units as they are located far off in
different parts of the globe. Even if they reach the port in time, a lot of customs formalities have to
be carried out. Due to these factors, re-order point for international firm lies much earlier. The final
decision depends on the quantity of goods to be imported and how much of them are locally
available. Relying on imports varies from unit to unit but it is very much large for a vertical set up.
3.10 International Receivables Management
Credit Sales lead to the emergence of account receivables. There are two types of such sales viz.
Inter firm Sales and Intra firm Sales in the global aspect.
In case of Inter firm Sales, the currency in which the transaction should be denominated and the
terms of payment need proper attention. With regard to currency denomination, the exporter is
interested to denominate the transaction in a strong currency while the importer wants to get it
denominated in weak currency. The exporter may be willing to invoice the transaction in the weak
currency even for a long period if it has debt in that currency. This is due to sale proceeds being
used to retire debts without loss on account of exchange rate changes. With regard to terms of
payment, the exporter does not provide a longer period of credit and ventures to get the export
proceeds quickly in order to invoice the transaction in a weak currency. If the credit term is liberal the
exporter is able to borrow currency from the bank on the basis of bills receivables. Also credit terms
may be liberal in cases where competition in the market is keen compelling the exporter to finance a
part of the importer’s inventory. Such an action from the exporter helps to expand sales in a big way.
In case of Intra firm sales, the focus is on global allocation of firm’s resources. Different parts of
the same product are produced in different units established in different countries and exported to
the assembly units leading to a large size of receivables. The question of quick or delayed
payment does not affect the firm as both the seller and the buyer are from the same firm though
the one having cash surplus will make early payments while the other having cash crunch will
make late payments. This is a case of intra firm allocation of resources where leads and lags
explained earlier will be taken recourse to.
TEST YOUR KNOWLEDGE

1. Write a short note on Instruments of International Finance.
2. What is the impact of GDRs on Indian Capital Market?
ANSWERS/ SOLUTIONS

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2.2.4.2 Pricing of Swaptions

The pricing methodology depends upon setting up a model of probability distribution of the forward
zero-coupon curve which undoes a Market process.
2.2.4.3 Uses of Swaptions
a) Swaptions can be applied in a variety of ways for both active traders as well as for
corporate treasurers.
b) Swap traders can use them for speculation purposes or to hedge a portion of their swap
books.
c) Swaptions have become useful tools for hedging embedded optionality which is common to
the natural course of many businesses.
d) Swaptions are useful to borrowers targeting an acceptable borrowing rate.
e) Swaptions are also useful to those businesses tendering for contracts.
f) Swaptions also provide protection on callable/puttable bond issues.
TEST YOUR KNOWLEDGE

1. Write a short note on Forward Rate Agreements.
2. What do you know about swaptions and their uses?
Practical Questions
1. Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap)
on a principal of ` 10 crores and agreed to receive MIBOR overnight floating rate for a fixed
payment on the principal. The swap was entered into on Monday, 2nd August, 2010 and was
to commence on 3rd August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75%,8.15%,8.12%,7.95%,7.98%,8.15%.
If Derivative Bank received ` 317 net on settlement, calculate Fixed rate and interest under
both legs.
Notes:
(i) Sunday is Holiday.
(ii) Work in rounded rupees and avoid decimal working.

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INTEREST RATE RISK MANAGEMENT 711.15
2. M/s. Parker & Co. is contemplating to borrow an amount of `60 crores for a Period of 3
months in the coming 6 month's time from now. The current rate of interest is 9% p.a., but it
may go up in 6 month’s time. The company wants to hedge itself against the likely increase
in interest rate.
The Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30%p.a.
What will be the Final settlement amount, if the actual rate of interest after 6 months
happens to be (i) 9.60% p.a. and (ii) 8.80% p.a.?
ANSWERS/ SOLUTIONS
1.
Day Principal (`) MIBOR (%) Interest (`)
Tuesday 10,00,00,000 7.75 21,233
Wednesday 10,00,21,233 8.15 22,334
Thursday 10,00,43,567 8.12 22,256
Friday 10,00,65,823 7.95 21,795
Saturday & Sunday (*) 10,00,87,618 7.98 43,764
Monday 10,01,31,382 8.15 22,358
Total Interest @ Floating 1,53,740
Less: Net Received 317
Expected Interest @ fixed 1,53,423
Thus Fixed Rate of Interest 0.07999914
Approx. 8%
(*) i.e. interest for two days.
Note: Alternatively, answer can also be calculated on the basis of 360 days in a year.
2. Final settlement amount shall be computed by using formula:
(N)(RR - FR)(dtm/DY)
=
[1 + RR(dtm/DY)]

63
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
contract settlement date;
FR = Agreed-upon Forward Rate; and
dtm = maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could be 360or
365 days.
Accordingly,
If actual rate of interest after 6 months happens to be 9.60%
(` 60 crore)(0.096 - 0.093)(3/12)
=
[1 + 0.096(3/12)]
(` 60crore)(0.00075)
= = ` 4,39,453
1.024
Thus banker will pay Parker & Co. a sum of ` 4,39,453
If actual rate of interest after 6 months happens to be 8.80%
(` 60 crore)(0.088 - 0.093)(3/12)
=
[1 + 0.088(3/12)]
(` 60crore)(-0.00125)
= = - ` 7,33,855
1.022
Thus Parker & Co. will pay banker a sum of ` 7,33,855
Note: It might be possible that students may solve the question on basis of days instead of
months (as considered in above calculations). Further there may be also possibility that the
FRA days and Day Count convention may be taken in various plausible combinations such
as 90 days/360 days, 90 days/ 365 days, 91 days/360 days or 91 days/365days.

64
CORPORATE VALUATION 712.25
Case Study 2
Valuation model for the acquisition of ‘WhatsApp’ by Facebook
Facebook announced the takeover of WhatsApp for a staggering 21.8 billion USD in 2015. The key
characteristics of WhatsApp that influenced the deal were –
a) It is a free text-messaging service and with a $1 per year service fee, had 450 million users
worldwide close to the valuation date.
b) 70% of the above users were active users.
c) An aggressive rate of user account increase of 1 million users a day would lead to pipeline of 1
billion users just within a year’s range.
The gross per-user value would thus, come to an average of USD 55, which included a 4 billion
payout as a sweetener for retaining WhatsApp employees post takeover. The payback for
Facebook will be eventually to monetize this huge user base with recalibrated charges on
international messaging arena. Facebook believes that the future lies in international, cross-
platform communications.
Above information extracted from the official website of business news agency ‘CNBC’
TEST YOUR KNOWLEDGE

1. Differentiate between EVA and MVA.
2. Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis
to its peers or similar enterprises. Elaborate this statement.
Practical Questions
1. ABC Company is considering acquisition of XYZ Ltd. which has 1.5 crores shares
outstanding and issued. The market price per share is ` 400 at present. ABC's average
cost of capital is 12%. Available information from XYZ indicates its expected cash accruals
for the next 3 years as follows:
Year ` Cr.
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider. (PV factors at 12% for years 1 to
3 respectively: 0.893, 0.797 and 0.712).
2. Eagle Ltd. reported a profit of ` 77 lakhs after 30% tax for the financial year 2011-12. An

65
analysis of the accounts revealed that the income included extraordinary items of ` 8 lakhs
and an extraordinary loss of `10 lakhs. The existing operations, except for the extraordinary
items, are expected to continue in the future. In addition, the results of the launch of a new
product are expected to be as follows:
` In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10
You are required to:
(i) Calculate the value of the business, given that the capitalization rate is 14%.
(ii) Determine the market price per equity share, with Eagle Ltd.‘s share capital being
comprised of 1,00,000 13% preference shares of ` 100 each and 50,00,000 equity
shares of ` 10 each and the P/E ratio being 10 times.
3. H Ltd. agrees to buy over the business of B Ltd. effective 1 st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31st March 2012 are as follows:
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.
Paid up Share Capital
-Equity Shares of `100 each 350.00
-Equity Shares of `10 each 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of
the scheme of buying:
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4
years are ` 300 crores and ` 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.

66
(3) H Ltd. has a contingent liability of ` 300 crores as on 31st March, 2012.
(4) H Ltd. to issue shares of ` 100 each to the shareholders of B Ltd. in terms of the
exchange ratio as arrived on a Fair Value basis. (Please consider weights of 1 and 3
for the value of shares arrived on Net Asset basis and Earnings capitalization
method respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Ltd. on a
Fair value basis (taking into consideration the assumption mentioned in point 4
above.)
4. The valuation of Hansel Limited has been done by an investment analyst. Based on an
expected free cash flow of ` 54 lakhs for the following year and an expected growth rate of
9 percent, the analyst has estimated the value of Hansel Limited to be ` 1800 lakhs.
However, he committed a mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but you know that Hansel
Limited has a cost of equity of 20 percent and post tax cost of debt of 10 percent. The value
of equity is thrice its book value, whereas the market value of its debt is nine-tenths of its
book value. What is the correct value of Hansel Ltd?
ANSWERS/ SOLUTIONS
1. VALUATION BASED ON MARKET PRICE
Market Price per share ` 400
Thus value of total business is (` 400 x 1.5 Cr.) ` 600 Cr.
VALUATION BASED ON DISCOUNTED CASH FLOW
Present Value of cash flows
(` 250 cr x 0.893) + (` 300 cr. X 0.797) + ( ` 400 cr. X 0.712 ) = ` 747.15 Cr.
Value of per share (` 747.15 Cr. / 1.5 Cr) ` 498.10 per share

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RANGE OF VALUATION
Per Share ` Total ` Cr.
Minimum 400.00 600.00
Maximum 498.10 747.15
2. (i) Computation of Business Value
(` Lakhs)
77 110
Profit before tax
1 − 0.30
Less: Extraordinary income (8)
Add: Extraordinary losses 10
112
Profit from new product (` Lakhs)
Sales 70
Less: Material costs 20
Labour costs 12
Fixed costs 10 (42) 28
140.00
Less: Taxes @30% 42.00
Future Maintainable Profit after taxes 98.00
Relevant Capitalisation Factor 0.14
Value of Business (`98/0.14) 700
(ii) Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ` 98,00,000
Less: Preference share dividends 1,00,000 shares of ` 100 @ 13% ` 13,00,000
Earnings available for Equity Shareholders ` 85,00,000
No. of Equity Shares 50,00,000
` 85,00,000 ` 1.70
Earning per share = =
50,00,000
PE ratio 10
Market price per share ` 17
3. (i) Net asset value
H Ltd. ` 1300 Crores − ` 300 Crores
= ` 285.71
3.50 Crores

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B Ltd. ` 31.50 Crores

= ` 48.46
0.65 Crores
(ii) Earning capitalization value
H Ltd. ` 300 Crores / 0.08
= ` 1071.43
3.50 Crores
B Ltd. ` 10 Crores / 0.08
= ` 192.31
0.65 Crores
(iii) Fair value
H Ltd. ` 285.71× 1 + ` 1071.43 × 3
= ` 875
4
B Ltd. ` 48.46 × 1 + ` 192.31× 3
= ` 156.3475
4
Exchange ratio `156.3475/ `875 = 0.1787
H Ltd should issue its 0.1787 share for each share of B Ltd.
Note: In above solution it has been assumed that the contingent liability will
materialize at its full amount.
4. Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-
FCFF1
Value of Firm = V0 =
K c − gn
Where –
FCFF1 = Expected FCFF in the year 1
Kc= Cost of capital
gn = Growth rate forever
Thus, ` 1800 lakhs = ` 54 lakhs /(Kc-g)
Since g = 9%, then Kc = 12%
Now, let X be the weight of debt and given cost of equity = 20% and cost of debt = 10%,
then 20% (1 – X) + 10% X = 12%
Hence, X = 0.80, so book value weight for debt was 80%
∴ Correct weight should be 60 of equity and 72 of debt.
∴ Cost of capital = Kc = 20% (60/132) + 10% (72/132) = 14.5455% and correct firm’s value
= ` 54 lakhs/(0.1454 – 0.09) = ` 974.73 lakhs.

69
countries such as India. Kaushik Chatterjee, CFO, of Tata Steel in an interview with McKenzie
Quarterly in September 2009 articulates this point very clearly. To the following question
The Quarterly: Last year was the first in which Asian and Indian companies acquired more
businesses outside of Asia than European or US multinationals acquired within it. What’s behind
the Tata Group’s move to go global?
His respons is as follows:-
“India is clearly a very large country with a significant population and a big market, and the Tata
Group’s companies in a number of sectors have a pretty significant market share. India remains
the main base for future growth for Tata Steel Group, and we have substantial investment plans in
India, which are currently being pursued. But meeting our growth goals through organic means in
India, unfortunately, is not the fastest approach, especially for large capital projects, due to
significant delays on various fronts. Nor are there many opportunities for growth through
acquisitions in India, particularly in sectors like steel, where the value to be captured is limited—for
example, in terms of technology, product profiles, the product mix, and good management.”
Other major factors that motivate multinational companies to engage in cross-border M&A in Asia
include the following:
• Globalization of production and distribution of products and services.
• Integration of global economies.
• Expansion of trade and investment relationships on International level.
• Many countries are reforming their economic and legal systems, and providing generous
investment and tax incentives to attract foreign investment.
• Privatisation of state-owned enterprises and consolidation of the banking industry.
TEST YOUR KNOWLEDGE

1. Explain synergy in the context of Mergers and Acquisitions.
2. What is take over by reverse bid or Reverse Merger.
3. What is an equity curve out? How does it differ from a spin off.
4. Write a short note on Horizontal Merger and Vertical Merger.
Practical Questions
1. B Ltd. is a highly successful company and wishes to expand by acquiring other firms. Its
expected high growth in earnings and dividends is reflected in its PE ratio of 17. The Board
of Directors of B Ltd. has been advised that if it were to take over firms with a lower PE ratio
than it own, using a share-for-share exchange, then it could increase its reported earnings

70
MERGERS ACQUISITIONS & CORPORATE RESTRUCTURING 13.39
per share. C Ltd. has been suggested as a possible target for a takeover, which has a PE
ratio of 10 and 1,00,000 shares in issue with a share price of ` 15. B Ltd. has 5,00,000
shares in issue with a share price of ` 12.
Calculate the change in earnings per share of B Ltd. if it acquires the whole of C Ltd. by
issuing shares at its market price of `12. Assume the price of B Ltd. shares remains
constant.
2. Elrond Limited plans to acquire Doom Limited. The relevant financial details of the
two firms prior to the merger announcement are:
Elrond Limited Doom Limited

Market price per share ` 50 ` 25
Number of outstanding shares 20 lakhs 10 Lakhs
The merger is expected to generate gains, which have a present value of `200 lakhs. The
exchange ratio agreed to is 0.5.
What is the true cost of the merger from the point of view of Elrond Limited?
3. A Ltd. wants to acquire T Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one
share of T Ltd.). Following information is provided:
A Ltd. T. Ltd.
Profit after tax `18,00,000 `3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS `3 `2
PE Ratio 10 times 7 times
Market price per share `30 `14
Required:
(i) The number of equity shares to be issued by A Ltd. for acquisition of T Ltd.
(ii) What is the EPS of A Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of T Ltd.
(iv) What is the expected market price per share of A Ltd. after the acquisition, assuming
its PE multiple remains unchanged?
(v) Determine the market value of the merged firm.
4. XYZ Ltd., is considering merger with ABC Ltd. XYZ Ltd.’s shares are currently traded at `
20. It has 2,50,000 shares outstanding and its earnings after taxes (EAT) amount to `
5,00,000. ABC Ltd., has 1,25,000 shares outstanding; its current market price is ` 10 and

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its EAT are ` 1,25,000. The merger will be effected by means of a stock swap (exchange).
ABC Ltd., has agreed to a plan under which XYZ Ltd., will offer the current market value of
ABC Ltd.’s shares:
(i) What is the pre-merger earnings per share (EPS) and P/E ratios of both the
companies?
(ii) If ABC Ltd.’s P/E ratio is 6.4, what is its current market price? What is the exchange
ratio? What will XYZ Ltd.’s post-merger EPS be?
(iii) What should be the exchange ratio; if XYZ Ltd.’s pre-merger and post-merger EPS
are to be the same?
5. Company X is contemplating the purchase of Company Y. Company X has 3,00,000 shares
having a market price of ` 30 per share, while Company Y has 2,00,000 shares selling at `
20 per share. The EPS are ` 4.00 and ` 2.25 for Company X and Y respectively.
Managements of both companies are discussing two alternative proposals for exchange of
shares as indicated below:
(i) In proportion to the relative earnings per share of two companies.
(ii) 0.5 share of Company X for one share of Company Y (0.5 : 1).
You are required:
(i) To calculate the Earnings Per Share (EPS) after merger under two alternatives; and
(ii) To show the impact on EPS for the shareholders of two companies under both the
alternatives.
6. M Co. Ltd. is studying the possible acquisition of N Co. Ltd., by way of merger. The
following data are available in respect of the companies:
Particulars M Co. Ltd. N Co. Ltd.
Earnings after tax (`) 80,00,000 24,00,000
No. of equity shares 16,00,000 4,00,000
Market value per share (`) 200 160
(i) If the merger goes through by exchange of equity and the exchange ratio is based on
the current market price, what is the new earning per share for M Co. Ltd.?
(ii) N Co. Ltd. wants to be sure that the earnings available to its shareholders will not be
diminished by the merger. What should be the exchange ratio in that case?
7. Simple Ltd. and Dimple Ltd. are planning to merge. The total value of the companies are
dependent on the fluctuating business conditions. The following information is given for the
total value (debt + equity) structure of each of the two companies.

72
Business Condition Probability Simple Ltd. ` Lacs Dimple Ltd. ` Lacs

High Growth 0.20 820 1050
Medium Growth 0.60 550 825
Slow Growth 0.20 410 590
The current debt of Dimple Ltd. is ` 65 lacs and of Simple Ltd. is ` 460 lacs.
Calculate the expected value of debt and equity separately for the merged entity.
8. Yes Ltd. wants to acquire No Ltd. and the cash flows of Yes Ltd. and the merged entity are
given below:
(` In lakhs)
Year 1 2 3 4 5
Yes Ltd. 175 200 320 340 350
Merged Entity 400 450 525 590 620
Earnings would have witnessed 5% constant growth rate without merger and 6% with
merger on account of economies of operations after 5 years in each case. The cost of
capital is 15%.
The number of shares outstanding in both the companies before the merger is the same
and the companies agree to an exchange ratio of 0.5 shares of Yes Ltd. for each share of
No Ltd.
PV factor at 15% for years 1-5 are 0.870, 0.756; 0.658, 0.572, 0.497 respectively.
You are required to:
(i) Compute the Value of Yes Ltd. before and after merger.
(ii) Value of Acquisition and
(iii) Gain to shareholders of Yes Ltd.
9. The following information is provided relating to the acquiring company Efficient Ltd. and
the target Company Healthy Ltd.
Efficient Ltd. Healthy Ltd.
No. of shares (F.V. ` 10 each) 10.00 lakhs 7.5 lakhs
Market capitalization 500.00 lakhs 750.00 lakhs
P/E ratio (times) 10.00 5.00
Reserves and Surplus 300.00 lakhs 165.00 lakhs
Promoter’s Holding (No. of shares) 4.75 lakhs 5.00 lakhs

73
Board of Directors of both the Companies have decided to give a fair deal to the
shareholders and accordingly for swap ratio the weights are decided as 40%, 25% and 35%
respectively for Earning, Book Value and Market Price of share of each company:
(i) Calculate the swap ratio and also calculate Promoter’s holding % after acquisition.
(ii) What is the EPS of Efficient Ltd. after acquisition of Healthy Ltd.?
(iii) What is the expected market price per share and market capitalization of Efficient
Ltd. after acquisition, assuming P/E ratio of Firm Efficient Ltd. remains unchanged.
(iv) Calculate free float market capitalization of the merged firm.
10. T Ltd. and E Ltd. are in the same industry. The former is in negotiation for acquisition of the
latter. Important information about the two companies as per their latest financial
statements is given below:
T Ltd. E Ltd.
` 10 Equity shares outstanding 12 Lakhs 6 Lakhs
Debt:
10% Debentures (` Lakhs) 580 --
12.5% Institutional Loan (` Lakhs) -- 240
Earning before interest, depreciation and tax (EBIDAT) 400.86 115.71
(` Lakhs)
Market Price/share (` ) 220.00 110.00
T Ltd. plans to offer a price for E Ltd., business as a whole which will be 7 times EBIDAT
reduced by outstanding debt, to be discharged by own shares at market price.
E Ltd. is planning to seek one share in T Ltd. for every 2 shares in E Ltd. based on the
market price. Tax rate for the two companies may be assumed as 30%.
Calculate and show the following under both alternatives - T Ltd.'s offer and E Ltd.'s plan:
(i) Net consideration payable.
(ii) No. of shares to be issued by T Ltd.
(iii) EPS of T Ltd. after acquisition.
(iv) Expected market price per share of T Ltd. after acquisition.
(v) State briefly the advantages to T Ltd. from the acquisition.
Calculations (except EPS) may be rounded off to 2 decimals in lakhs.

74
ANSWERS/ SOLUTIONS
1. Total market value of C Ltd is = 1,00,000 x ` 15 = ` 15,00,000
PE ratio (given) = 10
Therefore, earnings = ` 15,00,000 /10
= ` 1,50,000
Total market value of B Ltd. is = 5,00,000 x ` 12 = ` 60,00,000
PE ratio (given) = 17
Therefore, earnings = ` 60,00,000/17
= ` 3,52,941
The number of shares to be issued by B Ltd.
` 15,00,000 ÷ 12 = 1,25,000
Total number of shares of B Ltd = 5,00,000 + 1,25,000 = 6,25,000
The EPS of the new firm is = (` 3,52,941+`1,50,000)/6,25,000
= ` 0.80
The present EPS of B Ltd is = ` 3,52,941 /5,00,000
= ` 0.71
So the EPS affirm B will increase from Re. 0.71 to ` 0.80 as a result of merger
2. Shareholders of Doom Ltd. will get 5 lakh share of Elrond Limited, so they will get:
5 lakh
= = 20% of shares Elrond Limited
20 lakh + 5 lakh
The value of Elrond Ltd. after merger will be:
= ` 50 x 20 lakh + ` 25 x 10 lakh + ` 200 lakh

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= ` 1000 lakh + ` 250 lakh + ` 200 lakh = ` 1450 lakh

True Cost of Merger will be:
(` 1450 x 20%) ` 290 lakhs – ` 250 lakhs = ` 40 lakhs
3. (i) The number of shares to be issued by A Ltd.:
The Exchange ratio is 0.5
So, new Shares = 1,80,000 x 0.5 = 90,000 shares.
(ii) EPS of A Ltd. After a acquisition:
Total Earnings (` 18,00,000 + ` 3,60,000) `21,60,000
No. of Shares (6,00,000 + 90,000) 6,90,000
EPS (` 21,60,000)/6,90,000) `3.13
(iii) Equivalent EPS of T Ltd.:
No. of new Shares 0.5
EPS `3.13
Equivalent EPS (` 3.13 x 0.5) `1.57
(iv) New Market Price of A Ltd. (P/E remaining
unchanged):
Present P/E Ratio of A Ltd. 10 times
Expected EPS after merger `3.13
Expected Market Price (`3.13 x 10) `31.30
(v) Market Value of merged firm:
Total number of Shares 6,90,000
Expected Market Price `31.30
Total value (6,90,000 x 31.30) `2,15,97,000
4. (i) Pre-merger EPS and P/E ratios of XYZ Ltd. and ABC Ltd.
Particulars XYZ Ltd. ABC Ltd.
Earnings after taxes 5,00,000 1,25,000
Number of shares outstanding 2,50,000 1,25,000
EPS 2 1
Market Price per share 20 10
P/E Ratio (times) 10 10
(ii) Current Market Price of ABC Ltd. if P/E ratio is 6.4 = ` 1 × 6.4 = ` 6.40
` 20 ` 6.40
Exchange ratio = = 3.125 or = 0.32
` 6.40 ` 20

76
Post merger EPS of XYZ Ltd.

` 5,00,000 + ` 1,25,000
=
2,50,000 + (1,25,000/ 3.125)
` 6,25,000
= = 2.16
2,90,000
(iii) Desired Exchange Ratio
Total number of shares in post-merged company
Post - merger earnings ` 6,25,000
= = = 3,12,500
Pre - merger EPS of XYZ Ltd 2
Number of shares required to be issued

= 3,12,500 – 2,50,000 = 62,500
Therefore, the exchange ratio is
62,500 : 1,25,000
62,500
= = 0.50
1,25,000
5. (i) Exchange ratio in proportion to relative EPS (in `)
Company Existing No. of shares EPS Total earnings
X 3,00,000 4.00 12,00,000
Y 2,00,000 2.25 4,50,000
Total earnings 16,50,000
No. of shares after merger 3,00,000 + 1,12,500 = 4,12,500

 2.25 
Note: 1,12,500 may be calculated as =  2,00,000 × 
 4.00 
16,50,000
EPS for Co. X after merger = = ` 4.00
4,12,500
Impact on EPS
Equivalent EPS of Co. Y
Before merger ` 2.25
After merger (EPS before merger X Share exchange ratio on EPS basis)
` 4.00 X 0.5625 = ` 2.25

77
(ii) Merger effect on EPS with share exchange ratio of 0.5 : 1
Total earnings after merger ` 16,50,000

No. of shares post merger (3,00,000 + 1,00,000 (0.5 × 2,00,000) 4,00,000
EPS 16,50,000 ÷ 4,00,000 4.125
Impact on EPS
Co. X’ shareholders `
EPS before merger 4.00
EPS after merger i.e. (16,50,000 ÷ 4,00,000) 4.125
Increase in EPS 0.125
Co. Y' Shareholders
EPS before merger 2.2500
Equivalent EPS after the merger 4.125 x 0.5 2.0625
Decrease in EPS 0.1875
6. (i) Calculation of new EPS of M Co. Ltd.
No. of equity shares to be issued by M Co. Ltd. to N Co. Ltd.
= 4,00,000 shares × ` 160/` 200 = 3,20,000 shares
Total no. of shares in M Co. Ltd. after acquisition of N Co. Ltd.
= 16,00,000 + 3,20,000 = 19,20,000
Total earnings after tax [after acquisition]
= 80,00,000 + 24,00,000 = 1,04,00,000
` 1,04,00,000
EPS = = ` 5.42
19,20,000 equity shares
(ii) Calculation of exchange ratio which would not diminish the EPS of N Co. Ltd.
after its merger with M Co. Ltd.
Current EPS:
` 80,00,000
M Co. Ltd. = =`5
` 24,00,000
N Co. Ltd. = =`6
Exchange ratio = 6/5 = 1.20

78
No. of new shares to be issued by M Co. Ltd. to N Co. Ltd.

= 4,00,000 × 1.20 = 4,80,000 shares
Total number of shares of M Co. Ltd. after acquisition
= 16,00,000 + 4,80,000 = 20,80,000 shares
` 1,04,00,000
EPS [after merger] = =`5
20,80,000 shares
Total earnings in M Co. Ltd. available to new shareholders of N Co. Ltd.
= 4,80,000 × ` 5 = ` 24,00,000
Recommendation: The exchange ratio (6 for 5) based on market shares is
beneficial to shareholders of 'N' Co. Ltd.
7. Compute Value of Equity
Simple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth
Debit + Equity 820 550 410
Less: Debt 460 460 460
Equity 360 90 -50
Since the Company has limited liability the value of equity cannot be negative therefore the
value of equity under slow growth will be taken as zero because of insolvency risk and the
value of debt is taken at 410 lacs. The expected value of debt and equity can then be
calculated as:
Simple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth Expected Value
Prob. Value Prob. Value Prob. Value
Debt 0.20 460 0.60 460 0.20 410 450
Equity 0.20 360 0.60 90 0.20 0 126
820 550 410 576
Dimple Ltd.
` in Lacs
High Growth Medium Growth Slow Growth Expected Value
Prob. Value Prob. Value Prob. Value

79
Equity 0.20 985 0.60 760 0.20 525 758

Debt 0.20 65 0.60 65 0.20 65 65
1050 825 590 823
Expected Values
` in Lacs
Equity Debt
Simple Ltd. 126 Simple Ltd. 450
Dimple Ltd. 758 Dimple Ltd. 65
884 515
8. (i) Working Notes:

Present Value of Cash Flows (CF) upto 5 years
Year CF of Yes Ltd. PVF PV of CF CF of PV of CF of
End (` lakhs) @15% (` lakhs) Merged Merged
Entity Entity
(` lakhs) (` lakhs)
1 175 0.870 152.25 400 348.00
2 200 0.756 151.20 450 340.20
3 320 0.658 210.56 525 345.45
4 340 0.572 194.48 590 337.48
5 350 0.497 173.95 620 308.14
882.44 1679.27
PV of Cash Flows of Yes Ltd. after the forecast period

CF5 (1 + g) 350(1 + 0.05) 367.50
TV5 = = = = `3675 lakhs
Ke − g 0.15 − 0.05 0.10
PV of TV5 = `3675 lakhs x 0.497 = `1826.475 lakhs

PV of Cash Flows of Merged Entity after the forecast period
CF5 (1 + g) 620(1 + 0.06) 657.20
TV5 = = = = `7302.22 lakhs
Ke − g 0.15 − 0.06 0.09
PV of TV5 = `7302.22 lakhs x 0.497 = `3629.20 lakhs

80
Value of Yes Ltd.

Before merger (`lakhs) After merger (`lakhs)
PV of CF (1-5 years) 882.440 1679.27
Add: PV of TV5 1826.475 3629.20
2708.915 5308.47
(ii) Value of Acquisition
= Value of Merged Entity – Value of Yes Ltd.
= `5308.47 lakhs – `2708.915 lakhs = `2599.555 lakhs
(iii) Gain to Shareholders of Yes Ltd.
1
Share of Yes Ltd. in merged entity = `5308.47 lakhs x = `3538.98 lakhs
1.5
Gain to shareholder = Share of Yes Ltd. in merged entity – Value of Yes Ltd. before
merger
= `3538.98 lakhs - `2708.915 = `830.065 lakhs
9. Swap Ratio
Efficient Ltd. Healthy Ltd.
Market capitalization 500 lakhs 750 lakhs
No. of shares 10 lakhs 7.5 lakhs
Market Price per share ` 50 ` 100
P/E ratio 10 5
EPS `5 ` 20
Profit ` 50 lakh ` 150 lakh
Share capital ` 100 lakh ` 75 lakh
Reserves and surplus ` 300 lakh ` 165 lakh
Total ` 400 lakh ` 240 lakh
Book Value per share ` 40 ` 32
(i) Calculation of Swap Ratio
EPS 1 : 4 i.e. 4.0 × 40% 1.6

Book value 1 : 0.8 i.e. 0.8 × 25% 0.2
Market price 1 : 2 i.e. 2.0 × 35% 0.7
Total 2.5

81
Swap ratio is for every one share of Healthy Ltd., to issue 2.5 shares of Efficient Ltd.
Hence, total no. of shares to be issued 7.5 lakh × 2.5 = 18.75 lakh shares.
Promoter’s holding = 4.75 lakh shares + (5 × 2.5 = 12.5 lakh shares) = 17.25 lakh
i.e. Promoter’s holding % is (17.25 lakh/28.75 lakh) × 100 = 60%.
Calculation of EPS, Market price, Market capitalization and free float market
capitalization.
(ii) Total No. of shares 10 lakh + 18.75 lakh = 28.75 lakh
Total capital 100 lakh + 187.5 lakh = ` 287.5 lakh
Total profit 50 lakh + 150 lakh 200
EPS = = = ` 6.956
No. of shares 28.75 lakh 28.75
(iii) Expected market price EPS 6.956 × P/E 10 = ` 69.56
Market capitalization = ` 69.56 per share × 28.75 lakh shares
= ` 1,999.85 lakh
(iv) Free float of market capitalization = ` 69.56 per share × (28.75 lakh × 40%)
= ` 799.94 lakh
10. As per T Ltd.’s Offer
` in lakhs
(i) Net Consideration Payable
7 times EBIDAT, i.e. 7 x ` 115.71 lakh 809.97
Less: Debt 240.00
569.97
(ii) No. of shares to be issued by T Ltd
` 569.97 lakh/` 220 (rounded off) (Nos.) 2,59,000
(iii) EPS of T Ltd after acquisition
Total EBIDT (` 400.86 lakh + ` 115.71 lakh) 516.57
Less: Interest (` 58 lakh + ` 30 lakh) 88.00
428.57
Less: 30% Tax 128.57
Total earnings (NPAT) 300.00
Total no. of shares outstanding 14.59 lakh

(12 lakh + 2.59 lakh)

82
EPS (` 300 lakh/ 14.59 lakh) ` 20.56

(iv) Expected Market Price:
` in lakhs
Pre-acquisition P/E multiple:
EBIDAT 400.86
10
Less: Interest ( 580 X ) 58.00
100
342.86
Less: 30% Tax 102.86
240.00
No. of shares (lakhs) 12.00
EPS ` 20.00
220
Hence, PE multiple 11
20
Expected market price after acquisition (` 20.56 x 11) ` 226.16
As per E Ltd’s Plan

` in lakhs
(i) Net consideration payable
6 lakhs shares x ` 110 660
(ii) No. of shares to be issued by T Ltd
` 660 lakhs ÷ ` 220 3 lakh
(iii) EPS of T Ltd after Acquisition
NPAT (as per earlier calculations) 300.00
Total no. of shares outstanding (12 lakhs + 3 lakhs) 15 lakh
Earning Per Share (EPS) ` 300 lakh/15 lakh ` 20.00
(iv) Expected Market Price (` 20 x 11) 220.00
(v) Advantages of Acquisition to T Ltd
Since the two companies are in the same industry, the following advantages could
accrue:
- Synergy, cost reduction and operating efficiency.
- Better market share.
- Avoidance of competition

83
STARTUP FINANCE 714.15
TEST YOUR KNOWLEDGE

1. Explain some of the sources for funding a start-up.
2. What do you mean by Pitch Presentation in context of Start-up Business?
ANSWERS/ SOLUTIONS

84

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INDEX FOR QUESTIONS FROM STUDY MATERIAL 2020(EXCLUDING

Chap No Chapter Name Page No ICAI Page No

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Answers to Theoretical Questions

© The Institute of Chartered Accountants of India

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σ (Standard Deviation) = 10.4 = ` 3.22 lakhs

` 3.22 lakhs x 10 = ` 10.18 lakh

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Days Date Day Sensex

© The Institute of Chartered Accountants of India

Date Closing Sensex Value

© The Institute of Chartered Accountants of India

Following value can be used :

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

At 10% level of significance at 18 degrees of freedom

© The Institute of Chartered Accountants of India

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© The Institute of Chartered Accountants of India

Current dividend (Do) = ` 2.50

© The Institute of Chartered Accountants of India

Sun Ltd., has been regularly paying equity dividend of 8%.

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

∴ Dividend = ` 20.67 × 40% = ` 8.27

© The Institute of Chartered Accountants of India

(ii) Value of stock under the PE Multiple Approach

Since, Actual Stock Price is higher, hence it is overvalued.

Since, Actual Stock Price is higher, hence it is overvalued.

© The Institute of Chartered Accountants of India

4. (i) Firm’s Expected or Required Return On Equity

© The Institute of Chartered Accountants of India

Ke = Firm’s expected, required return on equity (cost of equity capital).

1.20 1.44 1.73 2.07 2.49 2.49 (1 + 0.10) 1

By trial and error we are required to find out Ke

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

(b) Calculation of Capital Gearing Ratio

Preference Share Capital + Debentures 40,00,000 + 64,00,000 1,04,00,000

(c) Calculation of Yield on Equity Shares:

Calculation of Expected Yield on Equity shares

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Alternatively it can also be found as follows:

Alternatively it can also be found as follows:

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

9. If Debentures are not converted its value is as under: -

Value of equity shares:-

Market Price No. Total

Hence, unless the market price is ` 6 conversion should not be exercised.

2. Calculation of net present value of refunding the bond:-

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PVIFA (7%, 6 years) 4.766

© The Institute of Chartered Accountants of India

(i) Liquidity Risk – These securities may be saleable in the market.

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