ANSWERS TO COMPREHENSIVE EXAMINATION 5th May 2018

I i) Risk
ii) SML Security Market Line
iii) Mutual Funds
iv) Zero
v) Financial Risk
vi) stock market
vii) Structure changes
viii) Contrarian Opinion Rules
ix) equilibrium
x) Forward and futures

II

i ii iii iv v v vii viii ix x xi xii xiii xiv xv xvi

b e e c d d a a b c e b e b a b

II
1. P = 2.7(1.05) + 2.7(1.05)2 + 2.7(1.05)3 + 25.00
1.17 (1.17)2 (1.17)3 (1.17)3

= $22.16

2. [(50 - 45 - 3.25) ÷ 3.25] x 3 = 161.54% gain

3. p(t) = $5.04 - $50+ $50(1 + .05)-½ = $3.83

4. ln (X) = 5 ln (1.16/1.06)
ln (X) = 5 ln (1.094)
ln (X) = 5 (.090) = 0.45 X = 1.57

Thus, the P/E ratio would be 1.57 x 10 = 15.7

5. Cyclical companies are those whose sales and earnings will be heavily influenced by
aggregate business activity

Cyclical stocks are those that will experience changes in their rates of return greater than changes
in overall market rates of return

6. Business Tenets

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 Management Tenets
Financial Tenets
Market Tenets

PART B

Ans. 1. i) Expected Return = 3.75 + (0.85)(9.25 – 3.75) = 8.425%

Estimated Return = (61 - 57)  57 = 7.0175%
Estimated Return < Expected Return
∴ Stock is overvalued and should be sold.
ii) 10.5 = X + 1.5(9.5 – X). X = 7.5%.
iii) 0.7(6) = 4.2%

Ans2
i) Initial purchase cost Rs 2500 of which 80% is equity of Rs 2000 and 20% is borrowed
funds of Rs 500
Value of position assuming stock sells at Rs 10 at year’s end is 2500 - 550 (margin and
margin interest = Rs 1950

This would imply loss on investors equity being (1950 – 2000) /2000 = - 2.5%

Value of position assuming stock sells at Rs 12 at year’s end is 3000 – 550 (margin and
margin interest) = 2450

This would represent a gain on investors equity being (2450 – 2000) / 2000 = 22.5%

Expected Return .5 X ( -2.5%) + .5 x 22.5 = -1.25% + 11.25 % = 10.00%

[ 250000(1. 055 )
ii) price = .12−.055
]
−50000 /206263
= Rs 19.43

Ans3..

Discuss the relationships between the required rate of return on a stock, the firm's return on
equity, the plowback rate, the growth rate, and the value of the firm.
If the firm earns more on retained earnings (equity) than the firm's cost of equity capital
(required rate of return), the value of the firm's stock increases; therefore, the firm should retain
more earnings, which will increase the growth rate and increase the value of the firm (share
price).
If the firm earns less on retained equity than the required rate of return and the firm increases the
retention rate and the growth rate, the firm decreases firm value, as reflected by share price. In
this scenario, the shareholders would prefer that the firm pay out more of earnings in dividends,
which the shareholders could invest at a greater rate of return than that earned by the firm (ROE).
If the required rate of return equals the ROE, investors are indifferent between the firm's

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retaining earnings and paying out dividends. As a result, the retention rate and the growth rate in
this scenario have no effect on firm value (stockprice).

Feedback: This question is designed to ascertain the student's understanding of these

relationships, which are important both from the investment and corporate finance perspectives.

ii) We would conclude that the impact of the scandal was a 6% drop in value, the
difference between the 2% gain that we would have expected and the 4% drop actually
observed. One might then infer that the damages sustained from the scandal were $6
million, because the value of the firm fell by 6% of Rs 100 million when investors
became aware of the news and reassessed the value of stock.

4. Rise in advance decline line; increase in volume of trading, high short interest ratio
especially over 1.5 – 2.0; option prices to rise.

ii) MACD measures the difference between two moving averages. A positive MACD
indicates that the 12-day EMA is trading above the 26-day EMA. A negative MACD
indicates that the 12-day EMA is trading below the 26-day EMA. If MACD is positive
and rising, then the gap between the 12-day EMA and the 26-day EMA is widening. This
indicates that the rate-of-change of the faster moving average is higher than the rate-of-
change for the slower moving average. Positive momentum is increasing and this would
be considered bullish. If MACD is negative and declining further, then the negative gap
between the faster moving average (green) and the slower moving average (blue) is
expanding. Downward momentum is accelerating and this would be considered bearish.
MACD centerline crossovers occur when the faster moving average crosses the slower
moving average.

MACD Benefits

One of the primary benefits of MACD is that it incorporates aspects of both momentum
and trend in one indicator

As a momentum indicator, MACD has the ability to foreshadow moves in the underlying
security. MACD divergences can be key factors in predicting a trend change. A negative
divergence signals that bullish momentum is waning and there could be a potential
change in trend from bullish to bearish. This can serve as an alert for traders to take some
profits in long positions, or for aggressive traders to consider initiating a short position.

MACD can be applied to daily, weekly or monthly charts. MACD represents the
convergence and divergence of two moving averages. The standard setting for MACD is
the difference between the 12 and 26-period EMA. However, any combination of moving
averages can be used. The set of moving averages used in MACD can be tailored for each
individual security.

MACD Drawbacks

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One of the beneficial aspects of MACD may also be a drawback. Moving averages, be
they simple, exponential or weighted, are lagging indicators. Even though MACD
represents the difference between two moving averages, there can still be some lag in the
indicator itself. This is more likely to be the case with weekly charts than daily charts.
One solution to this problem is the use of the MACD-Histogram.

MACD is not particularly good for identifying overbought and oversold levels.

MACD calculates the absolute difference between two moving averages and not the
percentage difference. MACD is calculated by subtracting one moving average from the
other. As a security increases in price, the difference (both positive and negative)
between the two moving averages is destined to grow. This makes its difficult to compare
MACD levels over a long period of time, especially for stocks that have grown
exponentially.

Ans 5.

Portfolio Return Beta SD Sharpe Rank Treynor Rank Jensen a Rank

A1 0.15 1.25 0.182 0.66 1 0.096 1 0.02 1
A2 0.1 0.9 0.223 0.31 4 0.077778 3 -0.002 3
A3 0.12 1.1 0.138 0.65 2 0.081818 2 0.002 2
A4 0.08 0.8 0.125 0.4 3 0.0625 4 -0.014 4
Market 0.11 1 0.2 0.4 0.08 0
RFR 0.03 0 0

A1 Portfolio to be selected with multiple rationale and

reasons to be given
ii)

Policy Actual Index Actual

Weight Weight Returns Returns
Stocks 0.65 0.7 0.11 0.12
Bonds 0.3 0.25 0.07 0.08
Cash 0.05 0.05 0.03 0.025

Asset Allocation
Policy x index 0.094
Actual x index 0.096
0.002

Security Selection

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 Actual x Actual 0.10525
Actual x index 0.096
0.00925

Asset Allocation Exess weight

Stocks .05 .12X.05 .006
Bonds -.05 .08X(-.05) -.004
NET .002

Security Selection

Stocks .01 0.7 .007

Bonds .01 0.25 .0025
Cash -.005 .05 -.00025
Net .00925