Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

PAPER-14: Advanced Financial Management

Time Allowed: 3 hours Full Marks: 100

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

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

(a) Are Secured debentures treated as Public Deposit? If not who regulates them? [2]

Answer to (a):

Debentures secured by the mortgage of any immovable property of the company or by any
other asset or with an option to convert them into shares in the company, if the amount
raised does not exceed the market value of the said immovable property or other assets, are
excluded from the definition of ‘Public Deposit’ in terms of Non-Banking Financial Companies
Acceptance of Public Deposits (Reserve Bank) Directions, 1998. Secured debentures are
debt instruments and are regulated by Securities & Exchange Board of India.

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

Answer to (b):

40% Debt; 60% Equity; rd = 9%; T = 40%; WACC = 9, 96%; rd =?

WACC = (Wd)(Rd)(1-T)+(W09)(r3)
9.96% = (0.4)(9%)(1-0.4) + (0.6)r3
9.96% = 2.16% + 0.6r3
7.8% = 0.6r3
r3 = 13%

(c) What types of risk is involved in Investment in Government Securities? [2]

Answer to (c):

Government Securities are usually referred to as risk free securities. However, these securities
are subject to only one type of risk, i.e. interest rate risk. Subject to changes in the overall
interest rate scenario, the price of these securities may appreciate or depreciate.

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

(d) The spot USD/Yen = 190 yen and one year forward rate of USD/Yen = 210 Yen. The prime rate
in US is 15%. What should the Japanese prime rate be? [2]

Answer to (d):
From Interest parity (¥210/$)/(¥190/$) = (1+i¥)/1.15
= i¥ = 27.11%

(e) Write down the objectives of interbank participation certificate? [2]

Answer to (e):

Inter Bank Participation Certificates (IBPC) are short-term instruments to even out the short
term liquidity within the Banking system particularly when there are imbalances affecting the
maturity mix of assets in Banking Book.
It provides a degree of flexibility in the credit-portfolio of Banks. It can be issued by
Scheduled Commercial Bank and can be subscribed by any Commercial Bank.

(f) The spot USD/INR = 43.70 and six-month forward premium is 40 paise (= ` 0.40). Calculate the
annualized forward premium. [2]

Answer to (f):

Annualised Premium = (Premium × 100 × 365)/ (Spot × n)

(Where n = 180)
= (0.40 × 100 × 365)/ (43.70 × 180) = 1.86%

(g) Mr. Pravin requires a monthly payment of ` 1000 for 5 years from a mutual fund that has a
track record of paying 9% per annum. What should be his investment today to get this
amount? [2]

Answer to (g):

The money Parvin invests should given him ` 1000 per month for 5 years @ 9%. This implies that the
monthly interest is 9%/12 = 0.75% and the total number of periods is 5 x 12 = 60. Therefore,
Amount to be invested today = 1000 x PVIFA (0.75%, 60) = 1000 x 48.17337 = ` 48173.37.

(h) The spot and 6 months forward rates of US$ in relation to the rupee (`/$) are ` 48.95/49.13 and
` 49.85/49.96 respectively. What will be the annualized forward margin (premium with
respect to bid price)? [2]

Answer to (h):

Forward margin (premium with respect of Bid Price)

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

12
= [(` 49.85 – ` 48.95) ÷ 48.95] x x 100
6
=0.03677 x 100 = 3.677 i.e., 3.68% per annum

(i) Airtel Communications is trying to estimate the first-year operating cash flow (at t = 1) for a
proposed project. The finance staff has collected the following information:
Projected Sales = ` 1 crore
Operating costs = ` 70 lakhs (not including depreciation)
Depreciation = ` 20 lakhs
Interest expense = ` 20 lakhs
The company faces a 4% tax rate. What is the project‘s operating cash flow for the year
(t=1)? [2]

Answer to (i):
Operating Cash Flow: (t = 1)
Sales revenue 10,00,000
Operating costs 7,00,000
Depreciation 2,00,000
Operating income before taxes 10,00,000
Taxes (40%) 4,00,000
Operating income after taxes 6,00,000
Add back depreciation 20,00,000
Operating cash flow 6,00,000

(j) Mr. Adhiraj is planning to construct a minimum risk portfolio by investing in the shares of
Arihant Ltd. and Suzlon Ltd. The risks associated with the returns of Arihant Ltd. and Suzlon Ltd.
are 23% and 25% respectively. If the co-efficient of correlation between the returns of shares
of both companies is ―O‖, what proportion of funds to be invested in the shares of Arihant
Ltd? [2]

Answer to (j):

Let the proportion of investment to be made in the shares of ARIHANT LTD be WA

For constructing a minimum risk portfolio the condition to be satisfied is
σS 2  COV(A, S)
WA 
σA  σS 2  2COV(A, S)
2


0.252  0
0.232  0.252  2  0
0.0625
  0.5416i.e. 54.16%
0.1154
Where COV(A, S)  ρ ASσ Aσ S
ρ AS  Correlation Coefficient
COV (A,S)  0  0.23 0.25  0

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

2. (a)(i) Two funds are available for investment. Fund X is being launched i.e. 31.12.2013 and
available for investment at ` 10 per unit. A similar Fund Y (same risk profile like Fund X) is also
available for investment at ` 19.45 per unit. The information of quarterly NAV for the next three
quarters are available as given below. Investor Mr. A prefers Fund X and Investor Mr. B prefers
Fund Y for investment through SIP (Systematic Investment Plan) each installment entailing `
2,000 for four quarters including initial investment:

Closing NAV Fund X Fund Y

` `

31.12.2013 10.00 19.45

31.03.2014 11.1567 21.50

30.06.2014 14.7680 27.15

30.09.2014 12.8554 23.69

Which investor (Mr. A or B) would clock a higher return on investment as on 30.09.2014?

(Ignore Time Value of Money). [6]

Answer to 2(a)(i):

Amount (`) FUND X FUND Y

Installment -2000 NAV Units NAV Units
31.12.2013 10.0000 200.0000 19.45 102.8278
31.03.2014 11.1567 179.2645 21.50 93.0233
30.06.2014 14.7680 135.4280 27.15 73.6648
30.09.2014 12.8554 155.5766 23.69 84.4238
Total 670.2691 353.9397
Value of Investment 670.269 × 12.8554 = ` 8,616.58 353.9397 × 23.69 = ` 8,384.83
Return = (8,000.00) = (8,000.00)
Return 616.58/8,000 = 7.71% 384.83/8,000 = 4.81%

Mr. A has fetched a higher return from Fund X.

2. (a)(ii) Define Cash Reserve Ratio. [2]

Answer to 2(a)(ii):

Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must
maintain as cash balance with the Reserve Bank. The Reserve Bank requires banks to
maintain a certain amount of cash in reserve as percentage of their deposits to ensure that
banks have sufficient cash to cover customer withdrawals. The adjustment of this ratio is
done as an instrument of monetary policy, depending on prevailing conditions. Our
centralized and computerized system allows for efficient and accurate monitoring of the
balances maintained by banks with the Reserve Bank of India.

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2. (b) On 24th March. A refinery needs 1,050 barrels of crude oil in the month of September.
The current price of crude oil is ` 3,000 per barrel. September futures contract at Multi
Commodity Exchange (MCX) is trading at ` 3,200. The firm expects the price to go up
further and beyond ` 3,200 in September. It has the option of buying the stock now.
Alternatively it can hedge through futures contract.
(1) If the cost of capital, insurance, and storage is 15% per annum, examine if it is
beneficial for the firm to buy now?
(2) Instead, if the upper limit to buying price is ` 3,200 what strategy can the firm adopt?
(3) If the firm decides to hedge through futures, find out the effective price it would pay
for crude oil if at the time of lifting the hedge (I) the spot and futures price are ` 2,900
and ` 2,910 respectively, (II) the spot and futures price are ` 3,300 and ` 3,315
respectively. [(2+2+4)]

Answer to 2 (b):

(1) If cost of carry (including interest, insurance, and storage) is 15%, the fair price of the
futures contract is s0 x e-rt = 3,000 x e-6/12 x 0.15 = ` 3,233.65.
It implies that if the firm buys crude oil today to be used after six months it would
effectively cost ` 3,233.65 per barrel.

(2) Since futures are trading at ` 3,200 it can lock-in the price of around ` 3,200 through a
long hedge. Under long hedge the firm would buy the futures on crude oil today and sell
it six months later while simultaneously meeting the physical requirements from the
market at the price prevailing at that time. Irrespective of price six months later, the firm
would end up paying a price of around ` 3,200.

(3) If the firm adopts the strategy as mentioned in (ii), the effective price to be paid by the
firm in cases of rise and fall in spot values is shown below:-

Quantity of crude oil to be hedged =1,075 barrels

Size of one futures contract = 100 barrels

No. of futures contracts bought 1,075/100 = 11 contracts (Rounded)

Futures price = ` 3,200

Exposure in futures 3,200 x 11 x 100 = ` 35,20,000

Six months later the firm would unwind its futures position and buy the requirement from
the spot market.
` `

Futures sold at price 2910 3315

Amount of futures sold 32,01,000 36,46,500

Gain/Loss on futures (11 contracts) (3,19,000) 1,26,500

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

Spot Price 2,900 3,300

Actual Cost of buying(1075 barrels) 31,17,500 35,47,500

Effective cost of buying 34,36,500 34,21,000

Effective Price 3,197 3,182

2. (c)(i) ‗Clearing of trades that take place on an exchange happens through the exchange
clearing house.‘- Justify. [5]

Answer to 2(c)(i):

Clearing of trades that take place on an exchange happens through the exchange clearing
house.
A clearing house is a system by which exchanges guarantee the faithful compliance of all
trade commitments undertaken on the trading floor or electronically over the electronic
trading systems. The main task of the clearing house is to keep track of all the transactions
that take place during a day so that the net position of each of its members can be
calculated. It guarantees the performance of the parties to each transaction.

Typically it is responsible for the following:

 Effecting timely settlement.
 Trade registration and follow up.
 Control of the evolution of open interest.
 Financial clearing of the payment flow.
 Physical settlement (by delivery) or financial settlement (by price difference) of
contracts.
 Administration of financial guarantees demanded by the participants.

The clearing house has a number of members, who are mostly financial institutions
responsible for the clearing and settlement of commodities traded on the exchange. The
margin accounts for the clearing house members are adjusted for gains and losses at the
end of each day (in the same way as the individual traders keep margin accounts with the
broker).

2. (c)(ii) Find out NAV per unit from the following information of Scheme Money Plant [3]

Name of the scheme Money Plant

Size of the scheme `100 Lakhs

Face value of the shares `100

Number of the outstanding shares `1 Lakhs

Market value of the fund‘s investments `180 Lakhs

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

Receivables `2 Lakhs

Liabilities `1 Lakh

Answer to 2(c)(ii):

Calculation of NAV per unit:

Particulars Amount

Total Assets Market Value of Fund’s Investment = + Receivables

= ` 180 Lakhs + ` 2 Lakhs
= ` 182 Lakhs

Liabilities ` 1 Lakhs

No. of shares 1 Lakhs

Net Asset Value (Total Assets + Receivables – Liabilities) / No. of shares

=` (182 – 1) Lakhs/ 1 Lakhs
=` 181.00

2. (d)(i) A petrochemical plant needs to process 10,000 barrels of oil in three months time. To
hedge against the rising price the plant needs to go long on the futures contract of crude
oil. The spot price of crude oil is ` 1,950 per barrel, while futures contract expiring three
months from now is selling for ` 2,200 per barrel. By going long on the futures the
petrochemical plant can lock-in the procurement at ` 2,200 per barrel. Assuming the size
of one futures contract of 100 barrels, the firm buys 100 futures to cover its exposure of
10,000 barrels.
Find out the price that would be payable under two scenarios of rise in price to ` 2,400 or
fall in price to ` 1,800 per barrel after three months. [4]

Answer to 2(d)(i):
Figures [in `/barrel)

Price after 3 months ` 1,800/barrel ` 2,400/barrel

Actual purchase price 1,950 1,950

Gain/loss on futures

Bought futures at 2,200 2,200

Sold futures at 1,800 2,400

Profit/loss on futures -400 + 200

Effective Price (`/barrel) 2,200 2,200

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

Here we observe that the loss in the physical position is offset by the gain in the futures
position and vice versa. This results in effective price equal to the price of futures at the
time of setting up the hedge.

2. (d)(ii) ‗As the nation‘s financial regulator, the Reserve Bank handles a range of activities.‘- List
the activities. [4]

Answer to 2(d)(ii):

As the nation’s financial regulator, the Reserve Bank handles a range of activities, including:
 Licensing;
 Prescribing capital requirements;
 Monitoring governance;
 Setting prudential regulations to ensure solvency and liquidity of the banks;
 Prescribing lending to certain priority sectors of the economy;
 Regulating interest rates in specific areas;
 Setting appropriate regulatory norms related to income recognition, asset
classification, provisioning, investment valuation, exposure limits and the like;
 Initiating new regulation.

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

3. (a)(i) Consider a trader who buys an European call option on British Pound with a strike price of
$ 1.6500 and a premium of 2 cents ($0.020). The current spot rate is $ 1.6329. Calculate
his gain/loss when the option expires if the spot rates are as follows. 1.6300, 1.6270,
1.6400, 1.6500, 1.6549, 1.6320, 1.6500, 1.6900, 1.7000. [6]

Answer to 3(a)(i):

Spot Rate Premium Payoff Gain/Loss

1.6300 0.02 0 (0.02)
1.6270 0.02 0 (0.02)
1.6400 0.02 0 (0.02)
1.6500 0.02 0 (0.02)
1.6549 0.02 0.0049 (0.0151)
1.6320 0.02 0 (0.02)
1.6500 0.02 0 (0.02)
1.6900 0.02 0.04 0.02
1.7000 0.02 0.05 0.03

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

3. (a)(ii) Write a note on the process of Dematerialisation. [4]

Answer to 3 (a)(ii):

In order to dematerialise physical securities one has to fill in a DRF (Demat Request Form)
which is available with the DP and submit the same along with physical certificates that are
to be dematerialised. Separate DRF has to be filled for each ISIN. The complete process of
dematerialisation is outlined below:

 Surrender certificates for dematerialisation to your DP.

 DP intimates to the Depository regarding the request through the system.
 DP submits the certificates to the registrar of the Issuer Company.
 Registrar confirms the dematerialisation request from depository.
 After dematerialising the certificates, Registrar updates accounts and informs depository
regarding completion of dematerialisation.
 Depository updates its accounts and informs the DP.
 DP updates the demat account of the investor.

3. (b)(i) Unitech DLS‘s, international transfer of funds amounts to US $20 Lakhs monthly. Presently
the average transfer time is 10 days. It has been proposed that the transfer of funds be
turned over to one of the larger international banks, which can reduce the transfer time to
an average of two days. A charge of 0.5% of the volume of transfer has been proposed
for this service. In view of the fact that the firm‘s opportunity cost of funds is 12%, should
this offer be accepted? [4]

Answer to 3 (b)(i):

Effective Yield on Saving

Period Saved = 10 Days Less 2 Days 8 Days

Cost of Funds 12%p.a.

Percentage Yield for the period saved (8/365 x 12%p.a.) 0.263%

Evaluation
(i) The cost of international transfer of 0.5% is more than the amount of interest saved at
0.263% i.e. more by around 0.237%. Therefore, prima facie the Company should not
opt for the proposal of transferring through International Bank.
(ii) However, saving in time also reduces the exposure of funds to various foreign
exchange risks. The Company has to consider the effect of such exposure and
decide on the proposal of the International Bank. If expected cost of such exposure is
more than 0.237%, then the Company should go for transfer through International
Banks.

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

3.(b)(ii) You as a dealer in foreign exchange have the following position in Swiss Francs on
31.10.2013-

Particulars SFr. Particulars SFr.

Balance in the Nostro A/c Credit 1,00,000 Forward purchase contract 30,000
Opening Position Over bought 50,000 cancelled
Purchased a bill on Zurich 80,000
Remitted by TT 75,000
Sold forward TT 60,000
Draft on Zurich cancelled 30,000

What steps would Mr. Sen take, if he required maintaining a credit balance of S Fr. 30,000
in the? [6]

Answer to 3 (b)(ii):

Particulars Sw. Frcs Particulars Sw.Frcs

To Balance b/d 50,000 By Sales of Forward TT 60,000

To Purchase of Bill on Zurich 80,000 By Forward Purchase Contract
To Cancellation of Draft 30,000 Cancellation 30,000
To Buy Spot TT (Nostro) 5,000 By Remittance by TT (Nostro) 75,000
To Buy Forward (To maintain 10,000 By Balance c/ d (Given) 10,000
Balance)

1,75,000 1,75,000

Dr. Nostro Account Cr.

Particulars Sw. Frcs Particulars Sw. Frcs

To Overbought Remittance 75,000 By Balance b/d 1,00,000

To Balance c/d 30,000 By Buy Spot TT (To maintain 5,000
Balance)

1,05,000 1,05,000

Courses of Action
The Bank has to buy spot TT Sw. Fcs. 5,000 to increase the balance in Nostro Account to
Sw. Fcs. 30,000.
Since the bank requires an overbought position of Sw. Fes. 10,000, it has to buy forward
Sw. Fcs. 10,000.

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

3 (c)(i). A company has borrowed $200 million on floating basis for 3 years. The interest rates are
reset every year. The spread over LIBOR is 25 bps. The company buys a 3 year cap on a
1-year LIBOR with a strike rate of 9% and having a face value of $200 million. The cap
carries a premium of 2% of face value or $4 million. Current 1 year LIBOR is 9%. If the
LIBOR at the end of 1,2 and 3 years are 9.5% 8.5% and 10%. What is the cash flow from
cap each year? Amortize premium equally over three years. [7]

Answer to 3(c)(i):

The strike rate of the cap is Libor which is currently 9%. Since the spread over Libor is 25 bps,
the interest rate applicable on the borrowing would be 9.75%, 8.75% & 10.25% respectively
for the three years. Thus the interest payable in amount terms over three years would be
$1,95,00,000, $1,75,00,000 and $2,05,00,000 respectively. Now, the premium paid for buying
this cap is $4 million. As given in the problem equal amortization would involve $ 13,33,333
each year. The seller of the cap would part with the difference whenever Libor is above the
strike price. Therefore we can construct the cash flow table as follows:

Time Cash Flow Loan Amortization of Cash Flow Total

premium from Cap
0 + 20,00,00,000 — — + 20,00,00,000
1 − 1,95,00,000 − 13,33,333 +10,00,000 − 1,98,33,333
2 − 1,75,00,000 − 13,33,333 — − 1,88,33,000
3 − 2,05,00,000 − 13,33,333 +20,00,000 − 1,98,33,333
3 − 20,00,00,000 — — − 20,00,00,000

3 (c)(ii). State the types of credit risk. [3]

Answer to 3(c)(ii):

Credit risk can be classified in the following way:

 Credit default risk - The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit
obligation; default risk may impact all credit-sensitive transactions, including loans,
Securities and derivatives.
 Concentration risk - The risk associated with any single exposure or group of exposures
with the potential to produce large enough losses to threaten a bank’s core operations.
It may arise in the form of single name concentration or industry concentration.
 Country risk - The risk of loss arising from sovereign state freezing foreign currency
payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).

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

4 (a). A Study by a Mutual Fund has revealed the following data in respect of the three securities:

Security  (%) Correlation with Index, sm

P 20 0.66

Q 18 0.95

R 12 0.75

The Standard Deviation of the Market Portfolio (BSE Sensex) is observed to be 18%.
(1) What is the sensitivity of returns of each stock with respect to the market?
(2) What are the Co-variances among the various stocks?
(3) What would be the risk of portfolio consisting of all the three stocks equally?
(4) What is the beta of the portfolio consisting of equal investment in each stock?
[1+2+4+1]

Answer to 4 (a):

(1) Sensitivity

Security P Q R

Standard Deviation [A] 20.00 18.00 12.00

Correlation to Market Portfolio [B] 0.66 0.95 0.75

Beta (Sensitivity) = [A] X [B] / M 0.73 0.95 0.50

(2) Covariance between the securities

2
Covariance of Returns betw eenthe securities P and Q = CovPQ = βP  βQ  σM

Securities P Q R

Beta 0.73 0.95 0.50

P 0.73 — 0.73 ×0.95 × 324 0.73 0.5 ×0 × 324

Q 0.95 0.73 ×0.95 × 324 — 0.50 × 0.95 × 324

R 0.50 0.73 0.5 ×0 × 324 0.50 × 0.95 × 324 —

Covariance Between Computation

P and Q ρ x  Qx 2 M0.73 × 0.95 × 324 = 224.69

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P and R ρ x  Rx 2M0.73 × 0.50 × 324 = 118.26

Q and R Q x  Rx 2M× 0.50 ×324 = 153.90

(3) Risk of the Portfolio consisting of Equal Investment in each stock Matrix

Securities P Q R
Weights 1/3 1/3 1/3
WP WQ WR
P 1/3 400 224.69 118.26
WP (σP2) (CovPQ) (CovPR)
Q 1/3 224.69 324 153.90
WQ (CovPQ) (σQ2) (CovQR)
R 1/3 118.26 153.90 144
WR (CovPR) (CovQR) (σR2)

Computation of Portfolio Variance (σPQR)2

Computation
Description Product
(W x W x Cov) or (W x W x 2 )
1 W P x W P x σ P2 1/3 x 1/3 x 400 44.44
2 WP x WQ x CovPQ 1/3 x 1/3 x 224.69 24.97
3 WP x WR x CovPR 1/3 x 1/3 x 118.26 13.14
4 WQ x WP x CovPQ 1/3 x 1/3 x 224.69 24.97
5 WQ x WQ x σQ2 1/3 x 1/3 x 324 36.00
6 WQ x WR x CovQR 1/3 x 1/3 x 153.90 17.10
7 WR x WP x CovPR 1/3 x 1/3 x 118.26 13.14
8 WR x WQ x CovQR 1/3 x 1/3 x 153.90 17.10
9 W R x W R x σ R2 1/3 x 1/3 x 144 16
Variance of the Portfolio (σPQR)2 206.86
Standard Deviation (Risk) of the Portfolio (σPQR) 14%

(4) Beta of the Portfolio consisting of equal investment in each stock

Security P Q R

a) Beta 0.73 0.95 0.50

b) Weight 1/3 1/3 1/3

c) Product 0.243 0.317 0.167

Portfolio Beta = 0.243+0.317+0.167 = 0.727

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4. (b)(i) Securities X and Y have standard deviations of 3% and 9%. Nitin is having a surplus of `20
Lakhs for investment in these two securities. How much should he invest in each of these
securities to minimize risk, if the correlation co-efficient for X and Y is — (i) -1; (ii) -0.30;
(iii) 0; (iv) 0.60 [5]

Answer to 4(b)(i):

(i) Basic Values of Factors for Determination of Portfolio Risk

Standard Deviation of Security X X 3%

Standard Deviation of Security Y Y 9%

Correlation co-efficient of Securities X and Y XY -1,- 0.30, 0,0.60

Weight of Security X WX a

Weight of Security Y WY 1-a

(ii) Computation of Investment in Securities

σY 2  Cov XY
Proportionof Investmentin Security X, WX =
σX  σY 2  2Cov XY
2

Proportion of Investment in Security Y, WY = 1 – WX

CovXY= XY x X x Y

If XY is CovXY is Computation Investment

WX = [Y2 - CovXY] [X2 + Y2 - 2CovXY] 0.750 in X

-27 WX = [92 - (-27)] [32 + 92 - 2 x (-27)] 0.250 in Y
-1
(-1x3x9) WX = [81 + 27] [9 + 81 + 54] `15,00,000 in X
WX = 108/144 =0.75 `5,00,000 in Y

WX = [Y2 - CovXY] [X2 + Y2 - 2CovXY] 0.839 in X

-8.1 WX = [92 - (-8.1)] [32 + 92 - 2 x (-8.1)] 0.161 in Y
-0.3
(-0.3x3x9) WX = [81 + 8.1] [9 + 81 + 16.2] `16,78,000 in X
WX = 89.1 / 106.2 =0.839 `3,22,000 in Y

WX = [Y2 - CovXY] [X2 + Y2 - 2CovXY] 0.900 in X

0 WX = [92 - 0] [32 + 92 - 2 x 0] 0.100 inY
0
(0x3x9) WX =[81 -0] [9 + 81-0] ` 18,00,000 in X
WX = 81/90 =0.90 ` 2,00,000 in Y

WX = [Y2 - CovXY] [X2 + Y2 - 2CovXY]

WX = [92 - 16.2] [32 + 92 - 2 x 16.2] Reducing Risk
0.60 16.2 WX = [81 - 16.2] [9 + 81 – 32.4] below 3% is not
(0.6 x 3 x 9) WX = 64.8 / 57.60 = 1.125 > 1 possible.
At this correlation level, risk reduction is not
possible.

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

4. (b)(ii) Discuss the techniques used in company analysis. [3]

Answer to 4(b)(ii):

Techniques Used in Company Analysis:

(1) Correlation & Regression Analysis: Simple regression is used when inter relationship covers
two variables. For more than two variables, multiple regression analysis is followed. Here
the inter relationship between variables belonging to economy, industry and company
are found out. The same is quantified using the correlation co-efficient between the
variables and standard deviation of the variables.
(2) Time Series and Trend Analysis: A Trend line or characteristic line is drawn using the
method of least squares to identify and extrapolate the trend obtained based on a
given Time Series.
(3) Decision Tree Analysis: This involves the use of probability to find out the expected value
arising out a given course of action. In this method various probabilities arc assigned to
states of nature and the expected value of a given course of action is determined.

4. (c)(i) Calculate the market sensitivity index and the expected return on the Portfolio from the
following data;
Standard deviation of an asset 4.5%

Market standard deviation 4.0%

Risk – free rate of return 15.0%

Expected return on market Portfolio 17.0%

Correlation coefficient of Portfolio with market 0.89

What will be the expected return on the Portfolio? If Portfolio beta is 0.5 and the risk free
return is 10%. [2+1]

Answer to 4(c)(i):

Computation of Expected Return

Case (a) Case (b)

Portfolio Beta P = P  M x MP 4.5 ÷ 4 × 0.89 = 1.001 0.5

Exacted Return = RF + P x (RM – RF) 0.15 + [1.001 x (0.17 - 0.15)] 0.10 +[0.5x(0.17 - 0.10)] =
= 17.002% 13.5%

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

4.(c)(ii) ‗Systematic Risk arises out of external and uncontrollable factors, which are not specific
to a security or industry to which such security belongs.‘- Justify. [5]

Answer to 4(c)(ii):

Systematic Risk: It arises out of external and uncontrollable factors, which are not specific
to a security or industry to which such security belongs. It is that part of risk caused by
factors that affect the price of all the securities. Systematic Risk cannot be eliminated by
diversification.

(1) Market Risk:

• These are risks that are triggered due to social, political and economic events.
Example: When CBDT issued a draft circular on how to treat income from trading in
shares, whether as Capital Receipts or Business Receipts, the stock prices fell down
sharply, across all sectors.
• These risks arises due to changes in demand and supply, expectations of the
investors, information flow, investor’s risk perception, etc. consequent to the social,
political or economic events.

(2) Interest Rate Risk:

• Uncertainty of future market values and extent of income in the future, due to
fluctuations in the general level of interest, is known as Interest Rate Risk.
• These are risks arising due to fluctuating rates of interest and cost of corporate debt.
The cost of corporate debt depends on the interest rates prevailing, maturity periods,
credit worthiness of the borrowers, monetary and credit policy of RBI, etc.

(3) Purchasing Power Risk: Purchasing Power Risk is the erosion in the value of money due to
the effects of inflation.

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

5. (a) A company is considering two mutually exclusive projects X and Y. Project X costs
`3,00,000 and Project Y `3,60,000. You have been given below the net present value,
probability distribution for each project:
Project X Project Y

NPV Estimate Probability NPV Estimate Probability

` `

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

30,000 0.1 30,000 0.2

60,000 0.4 60,000 0.3

1,20,000 0.4 1,20,000 0.3

1,50,000 0.1 1,50,000 0.2

(1) Compute the expected net present value of Projects X and Y.

(2) Compute the risk attached to each project i.e., Standard Deviation of each
probability distribution.
(3) Which project do you consider more risky and why?
(4) Compute the profitability index of each project. [4+2+2+2]

Answer to 5 (a):

Project X

NPV Probability NPV Estimate Deviation from Square of the Square of the
Estimate x Probability Expected NPV i.e. deviation deviation x
` 90,000 Probability

` ` ` `

30,000 0.1 3,000 60,000 36,00,000,000 3,60,000,000

60,000 0.4 24,000 30,000 9,00,000,000 3,60,000,000

1,20,000 0.4 48,000 -30,000 9,00,000,000 3,60,000,000

1,50,000 0.1 15,000 -60,000 36,00,000,000 3,60,000,000

Expected 90,000 14,40,000,000

NPV

Project Y
NPV Probability NPV Estimate Deviation from Square of the Square of the
Estimate x Probability Expected NPV i.e. deviation deviation x
` 90,000 Probability
` ` ` `

30,000 0.2 6,000 60,000 36,00,000,00 7,20,000,000

0

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

60,000 0.3 18,000 30,000 9,00,000,000 2,70,000,000

1,20,000 0.3 36,000 -30,000 9,00,000,000 2,70,000,000

1,50,000 0.2 30,000 -60,000 36,00,000,00 7,20,000,000

0

Expecte 90,000 19,80,000,000

d NPV

(1) The expected net present value of Projects X and Y is ` 90,000 each.

Standard Deviation =
(2) Square of the deviation probability

In case of Project X: Standard Deviation = `14,40,000,000

= ` 37,947
In case of Project Y: Standard Deviation = `19,80,000,000

= ` 44,497

(3) Coefficient of variation = standard deviation

Expected net present value
37,947
In case of Project X : Coefficient of variation= = 0.42
90,000
44,497
In case of Project Y : Coefficient of variation= = 0.4944or 0.50
90,000
Project Y is riskier since it has a higher coefficient of variation.

Profitability index = Discounted cash inflow

(4)
Discounted cash outflow

90,000  3,00,000
In case of Project X : Profitability Index = = 1.30
3,00,000

90,000  3,60,000 4,50,000

In case of Project Y : Profitability Index = = = 1.25
3,60,000 3,60,000

5. (b)(i) Determine the risk adjusted net present value of the following projects: [5]

A B C

Net cash outlays (`) 1,00,000 1,20,000 2,10,000

Project life 5 years 5 years 5 years

Annual cash inflow (`) 30,000 42,000 70,000

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

Coefficient of variation 0.4 0.8 1.2

The company selects the risk-adjusted rate of discount on the basis of the co-efficient
of variation:
Coefficient of Risk adjusted rate of Present value factor 1 to 5 years at risk
variation discount adjusted rate of discount

0.0 10% 3.791

0.4 12% 3.605

0.8 14% 3.433

1.2 16% 3.274

1.6 18% 3.127

2.0 22% 2.864

More than 2.0 25% 2.689

Answer to 5(b)(i):

Statement showing the determination of the risk adjusted net present value

Projects Net Coefficient Risk Annual PV factor 1-5 Discounted Net

cash of adjusted cash inflow years at risk cash inflow present
outlays variation discount adjusted rate value
rate of discount
` ` ` ` `

(I) (ii) (iii) (iv) (v) (vi) (vii) = (v) x (viii) =

(vi) (vii) - (ii)

A 1,00,000 0.4 12% 30,000 3.605 1,08,150 8,150

B 1,20,000 0.8 14% 42,000 3.433 1,44,186 24,186

C 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180

5. (b)(ii) List the advantages of Project Report. [5]

Answer to 5(b)(ii):

Advantages of a Project Report –

(1) A Project Report lists the objective in various spheres of business and evaluates them from
the right perspective.
(2) Facilitates planning of business by setting guidelines for future action. The successful
implementation of a project depends upon the line of action as suggested in the project

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

report. Besides, comparison of results will depend upon the projected profitability and
cash flows, production schedule and targets as laid down in the project report.
(3) Identifies constraints on resources viz. manpower, equipment, financial and
technological etc. well in advance to take remedial measures in due course of time.
(4) Helps in procuring finance from various financial institutions and banks which ask for such
detailed information before giving any assistance.
(5) Provides a framework of the presentation of the information regarding business required
by Government for granting licenses, etc.

5. (c) Mr. Samik, a business man has two independent investments A and B available to him:
but he lacks the capital to undertake both of them simultaneously. He can choose to
take A first and then stop, or if A is successful then take B, or vice versa. The probability of
success on A is 0.7, while for B it is 0.4. Both investment require an initial capital outlay of `
2,000, and both return nothing if the venture is unsuccessful. Successful completion of A
will return ` 3,000 (over cost), and successful completion of B will return ` 5,000 (over
cost). Draw the decision tree and determine the best strategy. [4+6]

Answer to 5(c):

(a) The required decision tree is as shown below:

There are three decision points in this tree. These are indicated as 1, 2 and 3.

Evaluation of decision point 3:

I. Accept A (`)
Outcome Probability Conditional Values Expected Values
Success 0.7 3,000 2,100
Failure 0.3 (2,000) (600)
1,500

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 Answer to MTP_Final_Syllabus 2012_Dec2014_Set 1

II. Stop: Expected Value = 0

Evaluation of decision point 2:

I. Accept B (`)
Outcome Probability Conditional Values Expected Values
Success 0.4 5,000 2,000
Failure 0.6 (2,000) (1,200)
800

II. Stop: Expected Value = 0

Evaluation of decision point 1:

I. Accept A (`)
Outcome Probability Conditional Values Expected Values
Success 0.7 3,000+800 2,660
Failure 0.3 (2,000) (600)
2,060

II. Accept B (`)

Outcome Probability Conditional Values Expected Values
Success 0.4 5,000+1,500 2,600
Failure 0.6 (2,000) (1,200)
1,400

III. Do Nothing: Expected Value = 0

Hence, the best strategy is to accept A first, and if it is successful, then accept B.

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