PAPER – 2 : STRATEGIC FINANCIAL MANAGEMENT

QUESTION
Netting of Foreign Exchange liabilities
1. Trueview plc, a group of companies controlled from the United Kingdom includes
subsidiaries in India, Malaysia and the United States. As per the CFO’s forecast that, at
the end of the June 2010 the position of inter-company indebtedness will be as follows:
• The Indian subsidiary will be owed Rs. 1,44,38,100 by the Malaysian subsidiary and
will to owe the US subsidiary US$ 1,06,007.
• The Malaysian subsidiary will be owed MYR 14,43,800 by the US subsidiary and will
owe it US$ 80,000.
Suppose you are head of central treasury department of the group and you are required
to net off inter-company balances as far as possible and to issue instructions for
settlement of the net balances.
For this purpose, the relevant exchange rates may be assumed in terms of £ 1 are US$
1.415; MYR 10.215; Rs. 68.10.
What are the net payments to be made in respect of the above balances?
Foreign Exchange Risk Management
2. Somu Electronics imported goods from Japan on July 1st 2009, of JP ¥ 1 million, to be
paid on 31st, December 2009. The treasury manager collected the following exchange
rates on July 01, 2009 from the bank.
Delhi Rs./US$ Spot 45.86 /88
6 months forward 46.00/03
Tokyo JP ¥/ US$ Spot 108/108.50
6 months forward 110/110.60
In spite of fact that the forward quotation for JP ¥ was available through cross currency
rates, Mr. X, the treasury manager purchased spot US$ and converted US$ into JP ¥ in
Tokyo using 6 months forward rate.
However, on 31st December, 2009 Rs./US$ spot rate turned out to be 46.24 /26.
You are required to calculate the loss or gain in the strategy adopted by Mr. X by
comparing the notional cash flow involved in the forward cover for Yen with the actual
cash flow of the transaction.
3. An automobile company in Gujarat exports its goods to Singapore at a price of SG$ 500
per unit. The company also imports components from Italy and the cost of components
for each unit is € 200. The company’s CEO executed an agreement for the supply of
20000 units on January 01, 2010 and on the same date paid for the imported

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components. The company’s variable cost of producing per unit is Rs. 1,250 and the
allocable fixed costs of the company are Rs. 1,00,00,000.
The exchange rates as on 1 January 2010 were as follows-
Spot Rs./SG$ 33.00/33.04
Rs./€ 56.49/56.56
Mr. A, the treasury manager of company is observing the movements of exchange rates
on a day to day basis and has expected that the rupee would appreciate against SG$
and would depreciate against €.
As per his estimates the following are expected rates for 30th June 2010.
Spot Rs./SG$ 32.15/32.21
Rs./€ 57.27/57.32
You are required to find out:
(a) The change in profitability due to transaction exposure for the contract entered into.
(b) How many units should the company increases its sales in order to maintain the
current profit level for the proposed contract in the end of June 2010.
Capital Budgeting with Inflation
4. In the end of the year 2009, Ms. Diana, Marketing Head of Zagreb Corporation discussed
her idea of introducing a new cosmetic product in the market with Mr. Cable, CEO of the
Corporation from the year 2010.
It is proposed that the product would be directly purchased from outside suppliers and
sold in the market through the corporation’s chain stores in a specialised containers.
Initial Capital investment required for packing machine shall be €1 million to be made in
the year 2009 itself. Further this capital investment will have a ten-year operating life and
five year life for tax purposes.
In addition to capital investment inventory amounting €0.50 million need to be purchased
in year 2009. The purchased inventory will be sold for cash one year after the purchase
for €1 million at 2009 prices and replaced immediately.
Other operating cost excluding depreciation is expected to €2,00,000 per year at 2009
prices.
It is expected that 6% inflation is expected in the country and it is expected that,
inventory cost, sale price and operating costs are expected to increase as per inflation
rate.
You as a financial consultant is required to determine whether project should be
accepted or not. Main assumptions for analysis are as follows:
(i) The cost of capital is 12%.

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(ii) Tax rate is 34%.

(iii) The residual value of investment is Nil.
(iv) Depreciation to be provided on straight line basis starting from the year of purchase
of machinery.
Capital Budgeting with Risk
5. STW Publishing House, a small publisher is publishing economy edition of a new book on
Financial Management. The cost of typesetting and other related cost will be Rs.
1,00,000. The cost of printing per book will be Rs. 20. If additional books are needed at a
later time, the setup cost will be Rs. 50,000 per setup, however, cost of printing the book
shall remain the same.
The book will be sold for Rs. 140 per copy. Royalty to author, commission of agent and
other related delivery charges shall be Rs. 40 per book.
The future sale of book depends upon the review of the book. In case book gets good
review, it is expected that sale of book will 5000 copies per year for three years. On the
other hand, if it gets bad review, the sale will be 2000 copies in the first year and then
sale will be ceased.
Probability for good review is 0.3. Mr. X, owner of publishing house faces a choice
between ordering an immediate production of 15000 copies or 5000 copies, followed by
additional production run at the end of the first year if the book is successful. The cost of
capital is 10%
Using Decision Tree analysis recommend production schedule and decide whether book
should be published or not.
Real Option
6. ABC Ltd. has an opportunity to acquire XYZ Ltd., which has a new AIDS- fighting drug
recently approved by Drug Controller of India. As per one study the new drug’s market
acceptance will be slow due to other competing imported drugs. However, it is belived
that the drug will have meteoric growth potential in the long run as new other applications
are identified.
The R&D and commercialisation costs associated with exploiting new applications are
expected to require an upfront investment of Rs. 6,00,00,000. However, ABC Ltd. can
delay making this investment until it is more confident of the new drug’s actual growth
potential.
It is believed that XYZ Ltd’s research and development efforts give it a five year time
before competitors have similar drug on the market to exploit these new applications. In
case higher growth for the new drug and its related applications do not materialize, ABC
Ltd. estimates that the NPV for XYZ Ltd. will be Rs. 3,00,00,000. In other words, if new
drug does not realise its potential, it makes no sense for ABC Ltd. to acquire XYZ Ltd.

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Cash flows from the previous drug introduction have exhibited an variance equal to 50%
of the present value of the cash flows. Simulating alternative growth scenarios for this
new drug provide an expected value of Rs. 4,00,00,000. The rate of interest on
Government security (corresponding to the term of option) is 6%. You are required to
determine despite the negative NPV associated with the acquisition, does the existence
of the option to delay (valued as call), justify ABC Ltd. acquisition of XYZ Ltd.?
Economic Value Added (EVA) Valuation
7. From the following data compute the value of business using EVA method.
Current Period Projected Periods
2010 2011 2012
Total Invested Capital Rs. 90,00,000 Rs. 1,00,00,000 Rs. 1,10,00,000
Adjusted NOPAT Rs. 12,60,000 Rs. 14,00,000 Rs. 16,00,000
WACC 8.42%
Capital Growth (g) is projected = 6.5% per year after 2012.
Merger and Acquisition
8. The total value (equity + debt) of two companies, A Ltd. and B Ltd. are expected to
fluctuate according to the state of the economy
State of the Probability Value of A Ltd. Value of B Ltd.
economy Rs. in lakh Rs. in lakh
Rapid growth 0.30 720 1150
Slow growth 0.50 520 750
Recession 0.20 380 600
A Ltd. and B Ltd. currently have a debt of Rs. 420 lakhs and Rs. 80 lakhs, respectively.
The two companies are deciding for merger. Assuming that no operational synergy is
expected as a result of the merger, you are required to calculate the expected value of
debt and equity of the merged company.
Also explain the reasons for any difference that exists from the expected values of debt
and equity, if they do not change.
9. AB Ltd. is a firm of recruitment and selection consultants. It has been providing
consultancy for 10 years and obtained a stock market listing 4 years ago. It has pursued
a policy of aggressive growth and specializes in providing services to companies in high-
technology and high growth sectors. It is all-equity financed by ordinary share capital of
Rs. 500 lakh in shares of Rs. 20 nominal (or par) value.
.The company’s results to the end of March 2009 have just been announced. Profits
before tax were Rs.1,266 lakh. The Chairman’s statement included a forecast that
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earnings might be expected to rise by 4%, which is a lower annual rate than in recent
years. This is blamed on economic factors that have had a particularly adverse effect on
information technology companies.
YZ Ltd. is in the same business but has been established much longer. It serves more
traditional service sectors and its earnings record has been erratic. Press comment has
frequently blamed this on poor management and the company’s shares have been out of
favour with the stock market for some time. Its current earnings growth forecast is also
4% for the foreseeable future. YZ Ltd. has an issued ordinary share capital of Rs.1800
lakh in Rs.100 shares. Pre-tax profits for the year to 31 March 2009 were Rs.1,125 lakh.
AB Ltd. has recently approached the shareholders of YZ Ltd. with a bid of 5 new shares
in AB Ltd. for every 6 YZ Ltd. shares. There is a cash alternative of Rs. 345 per share.
Following the announcement of the bid, the market price of AB Ltd. shares fell 10% while
the price of YZ Ltd. shares rose 14%. The P/E ratio and dividend yield for AB Ltd. and YZ
Ltd. immediately prior to the bid announcement are shown below.
2009
High Low Company P/E Dividend yield %
425 325 AB Ltd. 11 2.4
350 285 YZ Ltd. 7 3.1
Both AB Ltd. and YZ Ltd. pay tax at 30%.
AB Ltd.’s post-tax cost of equity capital is estimated at 13% per annum and YZ Ltd.’s at
11% per annum.
Assuming that you are a shareholder in YZ Ltd. You have a large, but not controlling
interest.
You bought the shares some years ago and have been very disappointed with their
performance. Based on the information and merger terms available, plus appropriate
assumptions, to forecast post-merger values, evaluate whether the proposed share-for-
share offer is likely to be beneficial to shareholders in both AB Ltd. and YZ Ltd. Also
identify why the price of share of AB Ltd. fell following the announcement of bid.
Note: As a benchmark, you should then value the two companies AB Ltd. and YZ Ltd.
using the constant growth form of the dividend valuation model.
Business Valuation
10. Using the chop-shop approach (or Break-up value approach), assign a value for Cornett
GMBH. whose stock is currently trading at a total market price of €4 million. For Cornett,
the accounting data set forth three business segments: consumer wholesale, specialty
services, and assorted centers. Data for the firm’s three segments are as follows:
BUSINESS SEGMENT Segment Sales Segment Assets Segment Income
Consumer wholesale €1,500,000 € 750,000 €100,000
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Specialty services €800,000 €700,000 €150,000

Assorted centers €2,000,000 €3,000,000 €600,000

Industry data for “pure-play” firms have been compiled and are summarized as follows:
BUSINESS Capitalization/Sales Capitalization/Assets Capitalization/Operating
SEGMENT Income
Consumer 0.75 0.60 10.00
wholesale
Specialty 1.10 0.90 7.00
services
Assorted 1.00 0.60 6.00
centers
11. ABC (India) Ltd., a market leader in printing industry, is planning to diversify into defense
equipment businesses that have recently been partially opened up by the GOI for private
sector. In the meanwhile, the CEO of the company wants to get his company valued by a
leading consultants, as he is not satisfied with the current market price of his scrip.
He approached consultant with a request to take up valuation of his company with the
following data for the year ended 2009:
Share Price Rs. 66 per share
Outstanding debt 1934 lakh
Number of outstanding shares 75 lakh
Net income 17.2 lakh
EBIT 245 lakh
Interest expenses 218.125 lakh
Capital expenditure 234.4 lakh
Depreciation 234.4 lakh
Working capital 44 lakh
Growth rate 8% (from 2010 to 2014)
Growth rate 6% (beyond 2014)
Free cash flow 240.336 lakh (year 2014 onwards)
The capital expenditure is expected to be equally offset by depreciation in future and the
debt is expected to decline by 30% by 2014.
Required:

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Estimate the value of the company and ascertain whether the ruling market price is
undervalued as felt by the CEO based on the foregoing data. Assume that the cost of
equity is 16%, and 30% of debt repayment is made in the year 2014.

Option Valuation
12. X Ltd.’s share is currently trading at Rs. 220. It is expected that in six months some if
could double or halved (equivalent to a σ=98%). One year call option on X Ltd.’s share
has an exercise price of Rs. 165. Assuming risk free rate of interest to be 20%, calculate.
(a) Value of call option on X Ltd’s share.
(b) Option Delta for the second six month, in case stock price rises to Rs. 440 or falls to
Rs. 110.
(c) Now suppose in 6 months the share price is Rs. 110. How at this point we can
replicate portfolio of call options and risk-free lending.
Dividend Policy
13. The Digital Electronic System Corporation (DESC) pays no cash dividends currently and
is not expected to for the next five years. Its latest EPS was €10, all of which was
reinvested in the company.
The firm’s expected ROE for the next five years is expected to be 20% per year, and
during this time it is also expected to continue to reinvest all of its earnings. It is expected
that starting six years from now the DESC’s ROE on new investments is expected to fall
to 15%, and it is expected that the corporation shall start paying out 40% of its earnings
in form of cash dividends, which it will continue to do forever after. DESC’s market
capitalization rate is 15% per year.
(a) Using DDM model, what is the value of DESC’s share today?
(b) Now suppose that the current market price of share is equal to as computed in (a)
above, then what do you expect to happen to its price over the next year? The year
after?
(c) If you are expecting that DESC to pay out only 20% of earning starting in year 6
then how your estimates will be effected.
14. In December 2009 International Paper Packing (IPP)’s share sold for about £73. As per
security analysts forecast a long-term earnings growth rate of 8.5% is expected. IPP is
expected to pay dividends of £1.68 per share.
(a) Assuming that dividends are expected to grow along with earnings at 8.5% per year
in perpetuity. What rate of return that an investor can expect to earn?
(b) It is expected that IPP to earn about 12% on book equity and shall retain about 50%
of earnings. How these forecasts will change growth rate (g) and cost of equity (K e)?
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Mutual Fund
15. Mr. X, an investor purchased 200 units of ABC Mutual Fund at rate of Rs. 8.50 p.u., one
year ago. Over the year Mr. X received Rs. 0.90 as dividend and had received a capital
gains distribution of Rs. 0.75 per unit.
You are required to find out:
Mr. X’s holding period return assuming that this no load fund has a NAV of Rs. 9.10 as
on today.
Mr. X’s holding period return, assuming all the dividends and capital gains distributions
are reinvested into additional units as at average price of Rs. 8.75 per unit.
16. Following is the historical performance information is available of the capital market and
a Tomplan Mutual Fund.
Year Tomplan Mutual Tomplan Mutual Return on Return on Govt.
Fund Beta Fund return market index securities %
% %
2001 0.90 -3.00 -8.50 6.50
2002 0.95 1.50 4.00 6.50
2003 0.95 18.00 14.00 6.00
2004 1.00 22.00 18.50 6.00
2005 1.00 10.00 5.70 5.75
2006 0.90 7.00 1.20 5.75
2007 0.80 18.00 16.00 6.00
2008 0.75 24.00 18.00 5.50
2009 0.75 15.00 10.00 5.50
2010 0.70 -2.00 8.00 6.00
(a) From above information you are required to calculate the following risk adjusted
return measures for the measures for the Tomplan:
(i) Reward-to-variability ratio
(ii) Reward-to-volatility ratio
(b) Comment on the mutual fund’s performance.
Leasing
17. The following data is related to the C-Max Leasing Inc. :
Investment cost $5 Million
Primary lease term 5 years
Estimated residual value after the primary period Nil
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Pre-tax required rate of return 24%

The C-Max seeks your help in determining the annual lease rentals under the following
rental structures:
(a) Equated,
(b) Stepped (an annual increase of 15 per cent),
(c) Deferred (2 years deferment period).
You are required to compute the relevant annual lease rentals.
Portfolio Management
18. Suppose that in the universe of available risky securities contains a large number of
shares two stocks, identically distributed with E(r) = 15%, or σ = 60%, and with a
common correlation coefficient of ρ= 0.5.
(a) What is the expected return and standard deviation of an equally weighted risky
portfolio of 25 stocks?
(b) What is the smallest number of stocks necessary to generate an efficient portfolio
with a standard deviation equal to or smaller than 43%?
(c) What is the systematic risk in this security universe?
(d) If T-bills are available and yield 10%, what is the slope of the CAL?
Security Analysis (Right Issue)
19. Monopolo Ltd. has a paid-up ordinary share capital of Rs. 2,00,00,000 represented by
4,00,000 shares of Rs. 50 each. Earnings after tax in the most recent year were Rs.
75,00,000 of which Rs. 25,00,000 was distributed as dividend. The current price/earnings
ratio of these shares, as normally reported in the financial press, is 8.
The company is planning a major investment that will cost Rs. 2,02,50,000 and is
expected to produce additional after tax earnings over the foreseeable future at the rate
of 15% on the amount invested.
It was proposed by CFO of company to raise necessary finance by a rights issue to the
existing shareholders at a price 25% below the current market price of the company’s
shares.
(a) You have been appointed as financial consultant of the company and are required
to calculate:
(i) The current market price of the shares already in issue;
(ii) The price at which the rights issue will be made;
(iii) The number of new shares that will be issued;

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(iv) The price at which the shares of the entity should theoretically be quoted on
completion of the rights issue (i.e. the ‘ex-rights price’), assuming no incidental
costs and that the market accepts the entity’s forecast of incremental earnings.
(b) It has been said that, provided the required amount of money is raised and that the
market is made aware of the earning power of the new investment, the financial
position of existing shareholders should be the same whether or not they decide to
subscribe for the rights they are offered.
You are required to illustrate that there will be no change in the existing
shareholder’s wealth.
Bond Valuation
20. NewChem Corporation has issued a fully convertible 10% debenture of Rs. 10,000 face
value, convertible into 20 equity shares. The current market price of the debenture is Rs.
10,800, whereas the current market price of equity share price is Rs. 480.
You are required to calculate (i) the conversion premium and (ii) the conversion value.
Swap
21. TMC Corporation entered into €3.5 million notional principal interest rate swap
agreement. As per the agreement TMC is to pay a fixed rate and to receive a floating
rate of LIBOR.
The Payment will be made at the interval of 90 days for one year and it will be based on
the adjustment factor 90/360. The term structure of LIBOR on the date of agreement is
as follows:
Days Rate (%)
90 7.00
180 7.25
270 7.45
360 7.55
You are required to calculate fixed rate on the swap and first net payment on the swap.
Efficient Market Hypothesis
22. The directors of Denter Inc wish to make an equity issue to finance an $8m expansion
scheme, which has an expected net present value of $1.1m, and to re-finance an existing
$5m 15% Bond that is due for maturity in 5 years’ time. For early redemption of these
bonds there is a $350,000 penalty charge. The company has obtained approval from its
shareholders to suspend their pre-emptive rights and for the entity to make a $15m
placement of shares which will be at the price of 185¢ per share.

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It is estimated that the floatation cost of the issue to be 4% of gross proceeds. Any
surplus funds from the issue will be invested in IDRs, which is currently yielding 9% per
year.
As on date the capital structure of Denter Inc is as follows:
$’000
Ordinary shares (25¢ per share) 8,000
Share premium 11,200
Free reserves 23,100
42,300

15% term Bonds 5,000

11% debenture 2009-2012 9,000
56,300
The entity’s current share price is 190¢, and debenture price $102. Denter can raise
debenture or medium-term bank finance at 10% per year.
Assuming stock market to be semi-strong form efficient and no information about the
proposed uses of funds from the issue has been made available to the public, you are
required to estimate Denter’s expected share price once full details of the placement, and
the uses to which the finance is to be put, are announced.
Financial Analysis
23. Nappp.com plc is a closely held company based Lincolnshire in B2B business offering
logistic services mainly to small and medium sized companies through internet, who
cannot afford sophisticated logistics practices. Company is planning to go for public issue
in the coming year and is interested to know what the company’s share will be worth. The
company engaged a consultant based in Leicestershire. The consultant evaluated
company’s future prospects and made following estimates of future free cash flows.
YEARS
1 2 3 4
Sales £100,000.00 £ 115,000.00 £ 132,250.00 £ 132,250.00
Operating income (earnings
£16,000.00 £18,400.00 £21,160.00 £21,160.00
before interest and taxes)
Less: Cash tax payments (£4,800.00) (£5,520.00) (£6,348.00) (£6,348.00)
Net operating profits after
£ 11,200.00 £ 12,880.00 £ 14,812.00 £ 14,812.00
taxes (NOPAT)
Less: Investments:
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Investment in net working

(£1,695.65) (£1,950.00) (£2,242.50) _
capital
Capital expenditures
(£2,347.83) (£2,700.00) (£3,105.00) _
(CAPEX)
Total investments (£4,043.48) (£4,650.00) (£5,347.50) _
Free cash flow £ 7,156.52 £ 8,230.00 £ 9,464.50 £ 14,812.00
Further, the company’s investment banker had done a study of the company’s cost of
capital and estimated WACC to be 12%. You are required to determine.
(i) Value of Nappp.com plc based on these estimates.
(ii) Market Value Added (MVA) by company supposing that invested capital in the year
0 was £ 31,304.05.
(iii) Value of per share, if company has 2,000 common equity share outstanding and
debt amounting to £ 4,000.
24. What are the various functions of Stock Exchange?
25. What are the various techniques are used in Economic Analysis.

SUGGESTED ANSWERS/HINTS

1.
India Malaysia US
India - Rs. 1,44,38,100 (US$ 1,06,007)
Malaysia (Rs. 1,44,38,100) - MYR 1,443,800
(US$ 80,000)
US US$ 1,06,007 (MYR 14,43,800)
US$ 80,000

Table showing conversion of above position into pound sterling

India Malaysia US Total
£ £ £ £
India - 2,12,013 (74,917) 1,37,096
Malaysia (2,12,013) - 1,41,341 (1,27,209)
(56,537)
US 74,917 (1,41,341) - (9,887)

 56,537

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(1,37,096) 1,27,209 9,887 -

Decision: Central treasury department will instruct the Malaysia subsidiary to pay the
Indian subsidiary £1,27,209 and the US subsidiary to pay the Indian subsidiary £9,887.
2. Here we have to compare the notional cash outflow for the forward rate of JP ¥ and the
actual cash outflow involved in rupees against forward purchase of JP ¥ for dollars in
Tokyo and spot purchase of dollars in Delhi for Rs.
(A) Cash flow of forward purchasing the JP ¥
Rs. /JP ¥ 6 month forward rate
Bid rate = Bid rate of US$ / Ask Rate of JP ¥ = Rs. 46/ JP ¥ 110.60 = Rs. 0.415913
Ask rate = Ask rate of US$ / Bid Rate of JP ¥ = Rs. 46.03/ JP ¥ 110 = Rs. 0. 418454
Hence, Rs./JP ¥ 6 month forward rate = 0.415913/0.418454
Accordingly, if the company had purchased JP ¥ forward against rupees it would
have paid = Rs.418454.50
(B) Cash flow of forward purchasing US$ in spot market and converting into JP ¥
Amount of US dollars to be paid on due date by purchase of JP¥ 1 million in forward
market
= JP¥ 1,000,000/ JP¥ 110 = US$ 9090.91
Cash outflows in rupees against purchase of dollars in on Dec. 31, 2009 = US$
9090.91× Rs. 46.26 = Rs. 420,545.50
(C) Loss or gain due to strategy adopted by Mr. X.
(A) – (B) = Rs.4,18,454.50 – 4,20,545.50 = Rs. 2091.00
Thus, the company paid more Rs. 2,091.00 in the strategy adopted by Mr. X.
3. (a) Let us first calculate the Company’s existing profits
Rs. Rs.
Sales – 20000 x SG$500 x Rs.33 330,000,000
Variable Cost
Imported Raw Material-20000 x €200 x Rs.56.56 226,240,000
Manufacturing Cost- 20000 x Rs. 1,250 25,000,000
Fixed Cost 10,000,000 261,240,000

Profit 68,760,000
After the Rupee appreciation against SG$ and depreciation against €, the
company’s profitability will be
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Rs. Rs.
Sales – 20000 x SG$500 x Rs.32.15 321,500,000
Variable Cost
Imported Raw Material-20000 x €200 x Rs.57.32 229,280,000
Manufacturing Cost- 20000 x Rs. 1,250 25,000,000
Fixed Cost 10,000,000 264,280,000

Profit 57,220,000
Thus profit will decrease by Rs. 11,540,000 ( Rs. 68,760,000 – Rs. 57,220,000)
(b) Let the number of units that need to be sold for keeping the profits at pre
appreciation level be X.

Then
Rs. 68,760,000 = [500 × Rs. 32.15 × X] – [(1250 × X) + (200 × 57.32X) +
10,000,000]
68,760,000 = [16075X – (1250X + 11464X + 10,000,000)]
68,760,000 + 10,000,000= 16075X – 12714X
78,760,000 = 3361X
X = 23433.50 or, 23434 units.
Thus, the company should increase its existing supply from 20000 to 23434 to
maintain the current profit level of Rs. 68,760,000.
4.
Year 2009 2010 2011 2012 2013 2014
€ € € € € €
Investment (1) (1,000,000)
Working Capital 500,000 530,000 561,800 595,508 631,238 669,113
Change in WC 500,000 30,000 31,800 33,708 35,730 37,875
Sales - 1,060,000 1,123,600 1,191,016 1,262,477 1,338,226
COGS (Material) - 500,000 530,000 561,800 595,508 631,238
Operating Cost - 212,000 224,720 238,203 252,495 267,645
Depreciation 200,000 200,000 200,000 200,000 200,000 -
EBT (200,000) 148,000 168,880 191,013 214,474 439,343

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Tax@34% (68,000) 50,320 57,419 64,944 72,921 149,376

Net Income (2) (132,000) 97,680 111,461 126,069 141,553 289,967
+ Depreciation (3) 200,000 200,000 200,000 200,000 200,000 -
+ Change in WC (4) 500,000 30,000 31,800 33,708 35,730 37,875
Cash Flow
(1) + (2) + (3) – (4) (1,432,000) 267,680 279,661 292,361 305,823 252,092
PVF 1 0.8929 0.7972 0.7118 0.6355 0.5674
Present Value (1,432,000) 239,011 222,946 208,103 194,350 143,037

Year 2015 2016 2017 2018 2019 NPV

€ € € € € €
Investment (1)
Working Capital 709,260 751,815 796,924 844,740
Change in WC 40,147 42,556 45,109 47,816 (844,740)
Sales 1,418,519 1,503,630 1,593,848 1,689,479 1,790,848
COGS (Material) 669,112 709,259 751,815 796,923 844,739
Operating Cost 283,704 300,726 318,770 337,896 358,169
Depreciation - - - - -
EBT 465,703 493,645 523,263 554,660 587,940
Tax@34% 158,339 167,839 177,909 188,584 199,899
Net Income (2) 307,364 325,806 345,354 366,076 388,041
+ Depreciation (3) - - - - -
+ Change in WC (4) 40,147 42,556 45,109 47,816 (844,740)
Cash Flow
(1) + (2) + (3) – (4) 267,217 283,250 300,245 318,260 1,232,781
PVF 0.5066 0.4523 0.4039 0.3606 0.3220
Present Value 135,372 128,114 121,269 114,765 396,955 471,922
Since NPV of the project is positive the project should be accepted.
5. Produce 15,000 copies initially
NPV (if review is good) (Probability 0.3)
- Rs. 4, 00,000 + Rs. 5,00,000 PVAIF 3YR., 10% = - Rs. 4,00,000 + Rs. 5,00,000 X2.487
= Rs.8,43,500

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NPV (if review is not good) (Probability 0.7)

Rs. - 4, 00,000 + Rs. 2, 00,000/1.1 = - Rs. 2,18,182
Expected net present value: 0.3 x Rs. 8,43,500 – 0.7 X Rs. 2,18,182 = Rs. 1,00,323
Produce 5,000 copies initially
NPV (if review is good) (Probability 0.3)
- Rs. 2,00,000 - Rs. 2,50,000*/1.1 + Rs. 5,00,000 PVAI 3YR., 10% = - Rs. 4,27,273 + Rs.
5,00,000 X2.487 = Rs.8,16,227
NPV (if review is good) (Probability 0.7)
- Rs. 2,00,000 + Rs. 2,00,000/1.1 = - Rs. 2,00,000 + Rs. 1,81,818 = Rs. - 18,182
Expected net present value: 0.3 x Rs. 8,16,227 – 0.7 X Rs. 18,182 = Rs. 2, 32,141
The expected net present value is larger and the potential loss is smaller if the initial run
is 5,000 copies. The 5,000 copy choice is preferred since it produces both more expected
value and less risk.
* In above answer it has been assumed that to avoid again set up cost in the beginning
of 2nd year 10000 copies will be printed in the end of first year.
6. Value of the asset (PV of projected cash flows for the new drug) (S) = Rs. 4,00,00,000
Exercise price (Investment required to fully develop the new drug) (E) = Rs. 6,00,00,000
Variance of the cash flows (σ) = 0.5
Time to expiration (t) = 5 years
Risk free interest rate (R) = 0.06
Dividend Yield (DY) or opportunity cost (cost of delay = 1/5) = 0.2
C = SN (d1) e-DYt – Ee-RtN(d2)
where

In(S/E) + [R - DY + (1/2)σ2 ]t
d1 =
σ t
d2
= d1 - σ t

DY = Divident yield or opportunity cost.

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In (400/600) + (0.06 - 0.2 + 12 0.5) 5

d1 =
0.5 5
- 0.4055 + 0.5500 0.1445
= = = 0.0914
0.7071 x 2.2361 1.5811
d 2 = 0.0914 - 1.5811 = - 1.4897
N (d1) = N (0.0914) = 0.5359
N (d2) = N (-1.4897) = 0.0681
C = Rs. 400(0.5359)2.7183-0.2x5 – 600(0.0681) (2.7183)-0.06x5
= Rs. 400 x (0.5359) x 0.3679 – 600 x (0.0681) x 0.7408
= 78.86 – 30.27
= Rs. 48.59 lac (value of the call option)
The modest Rs. 48,59,000 value of the call option is insufficient to offset the negative
NPV of Rs. 3,00,00,000 associated with the acquisition. Consequently, ABC Ltd. should
not acquire XYZ Ltd.
7. Valuation Equation
EVAt = NOPATt – (Total Invest Capitalt x WACCt)
EVA1 = Rs. 14,00,000 – (Rs. 1,00,00,000 X 0.0842) = Rs. 5,58,000

EVA2 = Rs. 16,00,000 – (Rs. 1,10,00,000 X 0.0842) = Rs. 6,73,800

Total Valuation Equation
= [Rs. 5,58,000/ (1 + 0.0842)1] + [Rs. 6,73,800/ (1 + 0.0842)2] + {[Rs. 6,73,800 x
(1 + 0.065)] / (0.0842 - 0.065) / (1 +0.0842)2} + Rs. 90,00,000
= Rs. 5,14,665 + Rs. 5,73,207 + Rs. 3,17,95,128 + Rs. 9,000,000
= Rs. 4,18,83,000
8. To find the value of A Ltd. equity shares, subtract the debt of Rs.420 lakh from the total
value.
Recession Slow growth Rapid growth
Value of Equity (40) 100 300
Debt 420 420 420
Total 380 520 720
It should be noted that in above table there is a negative value of equity in recession,
which is not possible because the shares have limited liability. Therefore, we will assume
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that the shares are zero value and the debt has declined to Rs.380 lakhs because of
bankruptcy risk. Therefore the expected value of equity and debt can be calculated as
follows:
Recession Prob. Slow Prob. Rapid Prob. Expected
growth growth Value
Rs. Lakh Rs. Lakh Rs. Lakh Rs. Lakh
Value of Equity 0 0.20 100 0.50 300 0.30 140
Value of Debt 380 0.20 420 0.50 420 0.30 412
Total 380 520 720 552
To find the value of B Ltd’s equity shares subtract debt of Rs.80 lakhs from the total
value.
Recession Prob. Slow Prob. Rapid Prob. Expected
Rs. Lakh growth growth Value
Rs. Lakh Rs. Lakh Rs. Lakh
Value of Equity 520 0.20 670 0.50 1070 0.30 760
Value of Debt 80 0.20 80 0.50 80 0.30 80
Total 600 0.20 750 1150 840
When the two companies merge we have to add the economic values of equity and debt
together. Since the bankruptcy risk is disappeared by combining with a low geared
company the negative Rs.40 lakhs also has to used while calculating the combined firm’s
expected value.
Recession Slow growth Rapid growth Expected
(0.20) (0.50) (0.30) Value
Rs. Lakh Rs. Lakh Rs. Lakh Rs. Lakh
Value of Equity 480 770 1370 892
Value of Debt 500 500 500 500
Total 980 1270 1870 1392

Expected Value of Equity Expected Value of Debt

Rs. Lakh Rs. Lakh
A Ltd. 140 A Ltd. 412
B Ltd. 760 B Ltd. 80
Total 900 Total 492
Combined firm loss in equity capital 8 Increase in debt 8
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After the combination, in the absence of synergy, the total economic value of the
business remains at Rs.1392 lakhs but the expected value or debt has increased by Rs.
8 lakhs at the expense of equity. Because, under the recession there is no longer a
bankruptcy risk for the debt holders of A Ltd.
The cash flows of the combined company may reduce in volatility because of the portfolio
effect and this may further reduce the cost of debt, increasing its value.
9. Assumption: Though in the question it is assumed that there is no operating synergy and
so no increase on the combined earnings; it is unlikely a bid would be launched if
substantial synergy was not estimated.
Share for share offer
AB Ltd. YZ Ltd. Combined
Profit before tax (Rs. lakh) 1,266.00 1,125.00 2,391.00
Less: Tax @ 30% 379.80 337.50 717.30

Profit after Tax 886.20 787.50 1,673.70

Number of shares (lakh) 25.00 18.00 40.00

Earnings Per Share (Rs.) 35.45 43.75 41.84

P/E ratio 11 7
Share price (pre bid) (Rs.) 389.95 306.25 381.53*
Market Value of company (Rs. lakh) 9,748.75 5,512.50 15,261.25
Rs. 15,261.25 lakh
* = Rs. 381.53
40 lakh
Post Bid Price (Combined Entity)
Rs. 41.84 X 11 = Rs. 460 per share
Share for Cash offer
Rs. 460 per share
Thus cash offer is more beneficial for AB Ltd.
Reasons (partially) for the fall in the market price of the shares in the market
Wealth of a shareholder of YZ Ltd. holding 6 shares in YZ Ltd. (Rs.306.25 X 6)
Rs. 1,837.50
Wealth of a shareholder of YZ Ltd. holding 5 shares in combined entity (Rs.381.53 X 5)
Rs. 1,907.65
Thus there seems to be transfer of wealth from the AB Ltd. to YZ Ltd.
Value of shares using the Dividend Growth Model

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(35.45 X 1.04)
=AB = Rs.409.64
( 0.13 – 0.04 )
(43.75 X 1.04)
YZ = = Rs. 650.00
(0.11 − 0.04 )
This would suggest that AB is slightly undervalued, but that YZ is hugely undervalued in
the marketplace. It is possible that the market does not believe YZ’s growth estimates,
given its poor performance to date.
10. Cornett, GMBH. – Break-up valuation
Business Segment Capital-to- Sales Segment Sales Theoretical Values
Consumer wholesale 0.75 €1,500,000 €1,125,000
Specialty services 1.10 €800,000 €880,000
Assorted centers 1.00 €2,000,000 €2,000,000
Total value €4,005,000

Business Segment Capital-to- Assets Segment Assets Theoretical Values

Consumer wholesale 0.60 €750,000 €450,000
Specialty services 0.90 €700,000 €630,000
Assorted centers 0.60 €3,000,000 €1,800,000
Total value €2,880,000

Business Segment Capital-to-Op.Income Segment Income Theoretical Values

Consumer wholesale 10.00 €100,000 €1,000,000
Specialty services 7.00 €150,000 €1,050,000
Assorted centers 6.00 €600,000 €3,600,000
Total value €5,650,000
4,005,000 + 2,880,000 + 5,650,000
Average theoretical value
= = 4,178,333.33 say 4,178,000
3
Average theoretical value of Cornett GMBH. = €4,178,000
11. i. Computation of tax rate
EBIT = 245 lakh
Interest = 218.125 lakh
PBT = 26.875 lakh
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PAT = 17.2 lakh

Tax paid = 9.675 lakh
Tax rate = 9.675 /26.875 = 0.36 =36%
ii. Computation for increase in working capital
Working capital (2009) = 44 lakh
Increase in 2010 = 44 X 0.08 = 3.52 lakh
It will continue to increase @ 8% per annum.
iii. Weighted average cost of capital
Present debt = 1934 lakh
Interest cost = 218.125 lakh / 1934 lakh = 11.28 %
Equity capital = 75 lakh X Rs. 66 = 4950 lakh
4950 1934
Kc = × 16% + × 11.28 (1 − 0.36)
1934 + 4950 1934 + 4950
= 11.51 + 2.028 = 13.54
iv. As capital expenditure and depreciation are equal, they will not influence the free
cash flows of the company.
v. Computation of free cash flows upto 2012
Year 2010 2011 2012 2013 2014
EBIT (1-t) (1) 169.344 182.89 197.52 213.32 230.39
lakh lakh lakh lakh lakh
Increase in working 3.52 lakh 3.80 lakh 4.11 lakh 4.43 lakh 4.79 lakh
capital (2)
Debt repayment (3) - - - - 1934 ×
0.30 =
580.2 lakh
Free cash flows (1) – 165.824 179.09 193.41 208.89 -354.6
(2) –(3) lakh lakh lakh lakh lakh
PVF @ 13.54% 0.8807 0.7757 0.6832 0.6017 0.53
PV of free cash flow 146.04 138.90 132.13 125.69 -187.94
@ 13.54% lakh lakh lakh lakh lakh
Present value of free cash flows upto 2014 = 354.82 lakh
vi. Cost of capital
Debt = 0.7 X 1934 = 1353.8 lakh
Equity = 4950 lakh

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4950 1353.8
Kc = × 16% + × 11.28 (1 - 0.36) =14.11%
4950 + 1353.8 4950 + 1353.8
viii. Continuing value
240.336
× (1/ 1.1354) 5
0.1411- 0.06
= Rs. 1,570.56 lakh
Value of the firm = PV of free cash flows upto 2014 + continuing value –
Market value of outstanding debt
= Rs. 354.82 lakh + Rs. 1,570.56 – Rs. 1,353.80
= Rs. 571.58 lakh
b) Value per share =Rs. 571.58 lakh/ 75 lakh = Rs. 7.62 < Rs. 66 (present
market price)
Therefore, the share price is overvalued in the market.
12. The possible prices of X Ltd.’s share and the associated call option values shown
below:

880
440 (715)
(290)
220
220 (55)
110
(20)
55
(0)

a. Let p is the probability of a rise in the stock price. Then, if investors are risk-neutral:
p (1.00) + (1 – p)(–0.50) = 0.10
p = 0.4
If the stock price in month 6 is Rs.110, then the option will not be exercised. So
expected value of call option is:
[(0.4 × Rs.55) + (0.6 × Rs.0)]
And its worth to be
[(0.4 × Rs.55) + (0.6 × Rs.0)]/1.10 = Rs.20
Similarly, if the stock price is Rs.440 in month 6, then, if it is exercised. The
expected value of call option is
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[(0.4 × Rs.715) + (0.6 × Rs.55)]

And it will be worth
[(0.4 × Rs.715) + (0.6 × Rs.55)]/1.10 = Rs.290
Value of call today is:
[(0.4 × Rs.290) + (0.6 × Rs.20)]/1.10 = Rs.116.36
b. (i) If the price rises to Rs.440:
Rs.715 - Rs. 55
=Delta = 1.0
Rs. 880 - Rs..220
(ii) If the price falls to Rs.110:
Rs.55 - 0
=Delta = 0.33
Rs.220 - Rs. 55
c. If the stock price is Rs.110 at 6 months, the option delta is 0.33. Therefore, in order
to replicate the stock, we buy three calls and lend, as follows:
Initial Stock Stock
Outlay Price = 55 Price = 220
Buy 3 calls -60 0 165
Lend PV(55) -50 +55 +55
-110 +55 +220
This strategy is equivalent to:
Buy stock -110 +55 +220
13. (a) Expected EPS for next years.
EPS1 = €10 (1+0.20) = €12
EPS2 = €12 (1+0.20) = €14.40
EPS3 = €14.40 (1+0.20) = €17.28
EPS4 = €17.28 (1+0.20) = €20.736
EPS5 = €20.736 (1+0.20) = €24.88
EPS6 = €24.88 (1+0.15) = €28.61
Thus D6 = 0.40 (€28.61) = €11.44
Hence, value of DESC’s share 5 years from=
now D6 €11.44
= = €191
r-g 15% - 9%
€191
So value of DESC’s share today is = €94.96
1.155
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(b) The price should rise by 15% per year until year 6. Since there is no capital gain,
the entire return must be in capital gains.
(c) There will be no effect as ROE = r i.e. the value of DESC’s share 5 years from now.
D6 €5.722
= = = €191
r-g 15% - 12%
D1
14. (a) P o = K e - g
£1.68
£73 = = 0.1080
K e - 0.085
Ke = 10.8%
(b) Retained Earnings = 0.50 = b
Thus g = b.r = 0.50 X 12% = 6%
According Ke would be.
£1.68
£73 = = 0.083
K e - 0.06
Ke = 8.30%
15. (a) Return for the year (all changes on a per unit basis):
Change in Price (Rs.9.10-Rs. 8.50) Rs. 0.60
Dividends received Rs. 0.90
Capital gains distributions Rs. 0.75
Total return Rs. 2.25
Rs. 2.25
Holding period return = = 26.47%
Rs. 8.50
(b) When all dividends and capital gains distributions are reinvested into additional
units of the fund (Rs. 8.75/unit):
Dividends and capital gains per unit: Rs. 0.90 + Rs. 0.75 = Rs. 1.65
Total amount received from 200 units: Rs. 1.65 X 200 = Rs. 330.00
Additional units added: Rs. 330/Rs. 8.75 = 37.7 units
Value of 237.7 units held at end of year: 237.7 units X Rs. 9.10 = Rs. 2,163
Price paid for 200 units at beginning of year 200 units X Rs. 8.50 = Rs. 1,700
Thus, the Holding Period Return would be:

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(No. of units at end of Period x Ending Price) - (No. of units at begining of Period x Inittial Price)
=
No. of units at begining of Period x Initial Price

Rs. 2,163 - Rs. 1,700 Rs. 463

H.P.R. = = = 27.24%
Rs. 1,700 Rs. 1,700
16. Working Notes:
(1) Calculation of average of these four variables
Year Tomplan Tomplan Return on Return on
Mutual Fund Mutual Fund market index Govt.
Beta return % % securities %
2001 0.90 -3.00 -8.50 6.50
2002 0.95 1.50 4.00 6.50
2003 0.95 18.00 14.00 6.00
2004 1.00 22.00 18.50 6.00
2005 1.00 10.00 5.70 5.75
2006 0.90 7.00 1.20 5.75
2007 0.80 18.00 16.00 6.00
2008 0.75 24.00 18.00 5.50
2009 0.75 15.00 10.00 5.50
2010 0.70 -2.00 8.00 6.00
Total 8.7 110.5 86.9 59.5
Average 0.87 11.05 8.69 5.95
Thus, the averages are as follows:
Mutual fund beta = 0.87
Mutual fund return = 11.05 per cent
Return on market index = 8.69 per cent
Return on Govt. securities = 5.95 per cent
(2) Standard deviation of returns of Tomplan Mutual fund
Year Mutual fund returns (X) X2
1 -3.00 9.00
2 1.50 2.25
3 18.00 324.00

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4 22.00 484.00
5 10.00 100.00
6 7.00 49.00
7 18.00 324.00
8 24.00 576.00
9 15.00 225.00
10 -2.00 4.00
Total 110.50 2097.25

N∑ X 2 - (∑ X )2
σp =
N2

(10 × 2097.25) - (110.5)2

=
10 × 10

20972.50 - 12210.25
=
100

= 87.62 = 9.36 per cent

(3) Standard deviation of returns on the market index

Year Return on market X2
index (X)
1 -8.50 72.25
2 4.00 16.00
3 14.00 196.00
4 18.50 342.25
5 5.70 32.49
6 1.20 1.44
7 16.00 256.00
8 18.00 324.00
9 10.00 100.00
10 8.00 64.00
Total 86.90 1404.43
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N∑ X 2 - (∑ X ) 2
σm =
N2

(10 × 1404.43) - (86.90)2

=
10 × 10

14,044.30 - 7551.61
=
100

= 64.93
= 8.06
(a) (i) Reward to variability ratio or Sharpe ratio
For Tomplan Mutual Fund
rp - r
f
SR =
σp

11.05 - 5.95
SR = = 0.545
9.36
For Market
rm - r
f
SR =
σm

8.69 - 5.95
SR = = 0.34
8.06
(ii) Reward to volatility ratio or Treynor ratio
For Tomplan Mutual Fund
rp - r f
TR =
βp

11.05 - 5.95
= = 5.86
0.87
For Market

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rm - r f
TR =
βm

8.69 - 5.95
= = 2.74
1
(b) Mutual fund performance
Ratios of the mutual fund and the market is as follows:
Ratio Mutual fund Market index
Sharpe ratio 0.545 0.34
Treynor ratio 5.86 2.74
Thus from above it is clear that the Tomplan Mutual fund has performed better than
the market.
17. (a) Let Equated annual lease rentals be X
Then, X= Investment Cost/PVIFA (24%, 5)
X = $5 Million /2.745
X = $5,000,000/2.745
X = $1,821,500 (Equated annual lease rentals)
(b) Let Stepped lease rental (assuming annual increase of 15 per cent annually) be X:
Then, X× PVIF(24%, 1) + (1.15)X × PVIF(24%, 2) + (1.15)2X × PVIF(24%, 3) +
(1.15)3X × PVIF(24%, 4) + (1.15)4X × PVIF(24%, 5) = $5 Million
i.e 0.806X + 0.7475X + 0.693X + 0.6433X + 0.5964X = $5 Million
3.4862X = $5 Million
X = $5 Million /3.4862 = $1,434,226
Lease rentals (year-wise)
Year 1 2 3 4 5
Lease rent $1,434,226 $1,649,360 $1,896,760 $2,181,280 $2,508,470

(c) Deferred lease rental (deferment of 2 Years)

Denoting X as the equated annual rental to be charged between Years 3–5,
X× PVIF (24%, 3) + X × PVIF (24%, 4) + X × PVIF (24%,5) = $5 million
0.524 X + 0.423 X + 0.341X = $5 million
X= $5 million /1.288 = $ 3.882 million i.e. $3,882,000

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18. The parameters are E(R) = 15, σ = 60, and the correlation between any pair of stocks is
ρ = .5.
a. The portfolio expected return is invariant to the size of the portfolio because all
stocks have identical expected returns. The standard deviation of a portfolio with n
= 25 stock is
1/ 2
σp = σ2 / n + ρ × σ2 ( n - 1) / n

1/ 2
= 602 / 25 + 0.5 × 602 × 24 / 25 = 43.27

b. Because the stocks are identical, efficient portfolios are equally weighted. To obtain
a standard deviation of 43%, we need to solve for n:
602 602 ( n - 1)
432 = + 0.5 ×
n n

1,849n
= 3,600 + 1,800n - 1,800

1, 800
=n = 36.73
49
Thus we need 37 stock and will come in with volatility slightly under the target.
c. As n gets very large, the variance of an efficient (equally weighted) portfolio
diminishes, leaving only the variance that comes from the covariances among
stocks, that is

σρ = ρ × σ 2 = 0.5 × 60 2 = 42.43

d. If the risk-free is 10%, then the risk premium on any size portfolio is 15% - 10% =
5%. The standard deviation of a well-diversified portfolio is (practically) 42.43%;
hence the slope of the Capital Allocation Line (CAL) is
S = 5/42.43 = 0.1178
19. (a) (i) Current market price of shares already in issue:
Rs. 75,00,000
Earnings per share =
4,00,000
= Rs. 18.75
Market price per share
P/E ratio =
Earnings per share
=8
Market price per share = 8 X Rs. 18.75

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= Rs. 150
(ii) Price at which rights issue will be made:
Rs. 150 X 75% = Rs. 112.50
(iii) Number of new shares that will be issued:
Rs. 2,02,50,000
= 180000 shares
Rs.112.50
(iv) Ex-rights price is
4,00,000 1,80,000 15%
Rs.150 × + Rs.112.50 × ×
5,80,000 5,80,000 12.5% *
= Rs. 103.44 +Rs. 41.90
= Rs. 145.34
* The price/earnings ratio is given as 8. This would imply an earnings yield of
(1 ÷ 8) = 12.5% .This is assumed to be the yield or rate of return on existing
funds.
(b) Assume that a shareholder holds 20 shares, the rights issue means addition of
another 9 shares. Theoretical, the selling price of the right to purchase one share
will be (Rs. 145.34 – Rs. 112.50), that is Rs. 32.84. Let us discuss the two cases
first if he opt for taking the right and second if he does not taking the right but
selling it.
(i) Taking up the rights:
Rs.
Market value of 29 shares at £145.34 each 4,214.86
Less: Cost of taking up rights of nine new shares at Rs. 112.50
each 1,012.50
3,202.36
(ii) Selling the rights:
Rs.
Market value of 20 shares at £145.34 each 2,906.80
Add: Sale of 9 rights at Rs. 32.84 each 295.56
3,202.36
20. As per the conversion terms 1 Debenture = 20 equity share (known as the conversion
ratio.)
The conversion terms can also be expressed as: 1 Debenture of Rs. 500 = 1 equity
share.

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(i) The conversion premium measures how much more expensive it is to buy the
convertible debenture than the underlying equity share.
(ii) The cost of buying Rs. 500 debenture (one equity share) is:
108
Rs. 500 × = Rs. 540
100
Comparing this with the cost of buying one equity share from market at Rs.480.
Thus, conversion premium is therefore:
540 - 480
× 100 =
12.5%
480
Therefore, it is more expensive to buy the debenture and get it converted, than to
purchase one equity share directly.
(iii) The conversion value is calculated as the market value of equity shares that is
equivalent to one unit of the convertible debenture.
Conversion value = conversion ratio X MPS (equity shares)
= 20 X Rs. 480
= Rs. 9,600
From this calculation of conversion value, the conversion premium may also be
calculated as below:
Rs. 10800 - Rs.9600
× 100 =
12.5%
Rs.9600
21. (i) The discount bond prices are as follows:
Term Rate% Discount Bond Price
90 days 7.00 B0(90) = 1/(1 + 0.07(90/360)) = 0.9828
180 days 7.25 B0(180) = 1/(1 + 0.0725(180/360)) = 0.9650
270 days 7.45 B0(270) = 1/(1 + 0.0745(270/360)) = 0.9471
360 days 7.55 B0(360) = 1/(1 + 0.0755(360/360)) = 0.9298
The fixed rate is
 1 - 0.9298   360 
 0.9828 + 0.9650 + 0.9471 + 0.9298  X  90  = 0.0734
   
(ii) The first net payment is based on a fixed rate of 7.34 percent and a floating rate of
7 percent:
Fixed payment: €35,00,000(0.0734)(90/360) = €64,225
Floating payment: €35,00,000(0.07)(90/360) = €61,250
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The net is that the party paying fixed makes a payment of €2,975
22. It is well known that in a semi-strong market the share price should accurately reflect new
relevant information when it becomes publicly available. This would include the effect on
Denter of the expansion scheme and the redemption of the term Bonds.
$m $m $m
The existing market value is 190¢ X 32m shares 60.8
The new investment has an expected NPV of $1.1m, which 1.1
will add to market value
The proceeds of the issue will add to market value 15.0 16.1
Issue costs of 4% would reduce market value (0.6)
Expected present value of outflows before redemption is
announced
Interest £750,000 per year ($5m X 15%) X 3.791 2.843
PV of repayment in year 5 $5m X 0.621 3.105 5.948
Redemption cost now (5.000)
Penalty charge (0.350) (5.350)
Present value benefit from early redemption 0.598
Expected total market value 76.898
£ 14,812
23. (i) Terminal value = = £ 1,23,433.33
0.12
Value of the Company = PV of free cash flows =
£ 7,156.52 £ 8, 230.00 £ 9,464.50 £ 123,433.33
+ + +
(1.12)1 (1.12)2 (1.12)3 (1.12)3
= £ 107,544.71
(ii) MVA = Company value – Invested capital
= £ 107,544.71 - £ 31,304.05
= £ 76,240.66
(iii) Company’s value = Debt value + Equity value
£ 107,544.71 = £ 4,000 + Equity value
Equity Value = £ 103,544.71
Equity Value
Value of per share =
Shares Outstanding

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£ 103,544.71
= = £ 51.77
2,000
24. The Stock Exchange is a market place where investors buy and sell securities. Functions
of the stock exchanges can be summarized as follows:
(a) Liquidity and Marketability of Securities: The basic function of the stock market
is the creation of a continuous market for securities, enabling them to be liquidated,
where investors can convert their securities into cash at any time at the prevailing
market price.
It also provides investors the opportunity to change their portfolio as and when they
want to change, i.e. they can at any time sell one security and purchase another,
thus giving them marketability.
(b) Fair Price Determination: This market is almost a perfectly competitive market as
there are large number of buyers and sellers. Due to nearly perfect information,
active bidding take place from both sides. This ensures the fair price to be
determined by demand and supply forces.
(c) Source for Long term Funds: Corporates, Government and public bodies raise
funds from the equity market. These securities are negotiable and transferable.
They are traded and change hands from one investor to the other without affecting
the long-term availability of funds to the issuing companies.
(d) Helps in Capital Formation: There is the nexus between the savings and the
investments of the community. The savings of the community are mobilized and
channeled by stock exchanges for investment into those sectors and units which are
favoured by the community at large, on the basis of such criteria as good return,
appreciation of capital, and so on. It is the preference of investors for individual
units as well as industry groups, which is reflected in the share price, which decides
the mode of investment. Stock exchanges render this service by arranging for the
preliminary distribution of new issues of capital, offered through prospectus, as also
offers for sale of existing securities, in an orderly and systematic manner. They
themselves administer the same, by ensuring that the various requisites of listing
(such as offering at least the prescribed minimum percentage of capital to the
public, keeping the subscription list open for a minimum period of days, making
provision for receiving applications at least at the prescribed centres, allotting the
shares against applications on a fair and unconditional basis) are duly complied
with.
Members of stock exchanges also assist in the flotation of new issues by acting (i)
as brokers, in which capacity they, inter alia, try to procure subscription from
investors spread all over the country, and (ii) as underwriters.
Stock exchanges also provide a forum for trading in rights shares of companies
already listed, thereby enabling a new class of investors to take up a part of the

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rights in the place of existing shareholders who renounce their rights for monetary
considerations.
(e) Reflects the General State of Economy: The performance of the stock markets
reflects the boom and depression in the economy. It indicates the general state of
the economy to all those concerned, who can take suitable steps in time. The
Government takes suitable monetary and fiscal steps depending upon the state of
the economy.
25. Economic analysis is used to forecast national income with its various components that
have a bearing on the concerned industry and the company in particular. Gross national
product (GNP) is used to measure national income as it reflects the growth rate in
economic activities and has been regarded as a forecasting tool for analyzing the overall
economy along with its various components during a particular period.
Some of the techniques used for economic analysis are:
(a) Anticipatory Surveys: They help investors to form an opinion about the future
state of the economy. It incorporates expert opinion on construction activities,
expenditure on plant and machinery, levels of inventory – all having a definite
bearing on economic activities. Also future spending habits of consumers are taken
into account.
In spite of valuable inputs available through this method, it has certain drawbacks:
(i) Survey results do not guarantee that intentions surveyed would materialize.
(ii) They are not regarded as forecasts per se, as there can be a consensus
approach by the investor for exercising his opinion.
Continuous monitoring of this practice is called for to make this technique popular.
(b) Barometer/Indicator Approach: Various indicators are used to find out how the
economy shall perform in the future. The indicators have been classified as under:
(i) Leading Indicators: They lead the economic activity in terms of their outcome.
They relate to the time series data of the variables that reach high/low points in
advance of economic activity.
(ii) Roughly Coincidental Indicators: They reach their peaks and troughs at
approximately the same in the economy.
(iii) Lagging Indicators: They are time series data of variables that lag behind in
their consequences vis-a- vis the economy. They reach their turning points
after the economy has reached its own already.
All these approaches suggest direction of change in the aggregate economic activity
but nothing about its magnitude. The various measures obtained form such
indicators may give conflicting signals about the future direction of the economy. To
avoid this limitation, use of diffusion/composite index is suggested whereby
combining several indicators into one index to measure the strength/weaknesses in
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the movement of a particular set of indicators. Computation of diffusion indices is no

doubt difficult not withstanding the fact it does not eliminate irregular movements.
Money supply in the economy also affects investment decisions. Rate of change in
money supply in the economy affects GNP, corporate profits, interest rates and
stock prices. Increase in money supply fuels inflation. As investment in stocks is
considered as a hedge against inflation, stock prices go up during inflationary
period.
(c) Economic Model Building Approach: In this approach, a precise and clear
relationship between dependent and independent variables is determined. GNP
model building or sectoral analysis is used in practice through the use of national
accounting framework. The steps used are as follows:
(i) Hypothesize total economic demand by measuring total income (GNP) based
on political stability, rate of inflation, changes in economic levels.
(ii) Forecasting the GNP by estimating levels of various components viz.
consumption expenditure, gross private domestic investment, government
purchases of goods/services, net exports.
(iii) After forecasting individual components of GNP, add them up to obtain the
forecasted GNP.
(iv) Comparison is made of total GNP thus arrived at with that from an independent
agency for the forecast of GNP and then the overall forecast is tested for
consistency. This is carried out for ensuring that both the total forecast and the
component wise forecast fit together in a reasonable manner.

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